metadata: authors: 0: author: Cuaresma,Jesus Crespo
1: author: Oberhofer,Harald
2: author: Smits,Karlis
3: author: Andronova Vincelette,Gallina
count: Poland,Romania,Lithuania,Latvia,Hungary,Estonia,Bulgaria,Croatia,Czechia
docna: 0: docna: Drivers of convergence in eleven eastern
            European countries
docty: Policy Research Working Paper
subtopic: Economic Theory & Research,Industrial Economics,Labor Markets,Tertiary Education,International Trade and Trade Rules,Economic Growth,Rural Labor Markets
teratopic: Environment,Private Sector Development,Macroeconomics and Economic Growth,Social Protections and Labor,Finance and Financial Sector Development
abstracts: cdata!: This paper investigates the drivers of
            growth and prosperity in a group of eleven European
            countries -- Bulgaria, Croatia, the Czech Republic, Estonia,
            Hungary, Latvia, Lithuania, Poland, Romania, Slovenia, and
            Slovakia (the EU11). Since the EU11 began the transformation
            process, this group of emerging countries has made
            impressive strides as developing market economies and is
            anchoring development in European Union institutions. There
            are reasons to believe that the convergence of EU11 income
            per capita to Western European levels will continue, but
            will proceed more slowly. The paper concludes that trade and
            financial integration have sped along at a spectacular pace
            in the EU11 in the recent past, although trade in modern
            services and the integration of government bond and equity
            markets are somewhat behind. As in the rest of Europe,
            demographic developments will pose huge challenges for the
            sustainability of public finance in the EU11 economies. In
            the next several decades, the EU11 labor force is expected
            to contract more than labor forces in the rest of the
            European Union, making it even more urgent that countries in
            the region reform pension systems, change migration policy,
            and find incentives to attract talent to the region. Closing
            the gap with the rest of the European Union in educational
            attainment levels and improving education quality might
            significantly soften the constraints imposed by the
            demographic threats and produce sizable returns in terms of
            additional income convergence.
geo_reg_key: 517208,82689,517190,517191
repnme: repnme: Drivers of convergence in eleven eastern
            European countries
display_title: Drivers of convergence in eleven
            eastern European countries
listing_relative_url: /research/2012/08/16658348/drivers-convergence-eleven-eastern-european-countries
topicv3: Economic Growth m1326241 471,Tertiary Education m1326349 482,Labor Markets m1326488 855,Trade m1326924 698,Labor Productivity m1504060 2756
publishtoextweb_dt: 2012-08-01T00:00:00Z
historic_topic: Environment,Private Sector Development,Macroeconomics and Economic Growth,Social Protections and Labor,Finance and Financial Sector Development
no_of_pages: 34
author_keys: 0: author_key: 966960
1: author_key: 1158011
2: author_key: 124806
3: author_key: 620793
model_extractions: WPS6185 Policy Research Working Paper 6185 Drivers of Convergence in Eleven Eastern European Countries _Jesus Crespo Cuaresma Harald Oberhofer Karlis Smits Gallina A Vincelette_ The World Bank Europe and Central Asia Region Poverty Reduction and Economic Management Department August 2012
Policy Research Working Paper 6185

# **Abstract**

This paper investigates the drivers of growth and prosperity in a group of eleven European countries— Bulgaria, Croatia, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, Slovenia, and Slovakia (the EU11). Since the EU11 began the transformation process, this group of emerging countries has made impressive strides as developing market economies and is anchoring development in European Union institutions. There are reasons to believe that the convergence of EU11 income per capita to Western European levels will continue, but will proceed more slowly. The paper concludes that trade and financial integration have sped along at a spectacular pace in the EU11 in the recent past, although trade in modern services and the integration of government bond and equity markets are somewhat behind. As in the rest of Europe, demographic developments will pose huge challenges for the sustainability of public finance in the EU11 economies. In the next several decades, the EU11 labor force is expected to contract more than labor forces in the rest of the European Union, making it even more urgent that countries in the region reform pension systems, change migration policy, and find incentives to attract talent to the region. Closing the gap with the rest of the European Union in educational attainment levels and improving education quality might significantly soften the constraints imposed by the demographic threats and produce sizable returns in terms of additional income convergence.

This paper is a product of the _Poverty Reduction and Economic Management Department, Europe and Central Asia Region. It is part of a larger effort by the World Bank to provide open access to its research and make a contribution to development policy discussions around the world. Policy Research Working Papers are also posted on the Web at http:// econ.worldbank.org. The author may be contacted at gvincelette@worldbank.org.

_The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the views of the International Bank for Reconstruction and Development/World Bank and its affiliated organizations, or those of the Executive Directors of the World Bank or the governments they represent._ Produced by the Research Support Team
# **DRIVERS OF CONVERGENCE IN ELEVEN EASTERN EUROPEAN COUNTRIES**

By Jesus Crespo Cuaresma, Harald Oberhofer, Karlis Smits, and Gallina A Vincelette<sup>1</sup> JEL: O47;O52; P20; O10 Sector Board: Economic Policy (EPOL) 1 Jesus Crespo Cuaresma is at the Department of Economics, Vienna University of Economics and Business (WU); World Population Program, International Institute of Applied Systems Analysis (IIASA); Wittgenstein Centre for Demography and Global Human Capital (WIC) and Austrian Institute for Economic Research (WIFO). Address: Augasse 2-6, 1090 Vienna (Austria). Email: jcrespo@wu.ac.at.

Harald Oberhofer is at the Department of Economics and Social Science and Salzburg Centre of European Union Studies (SCEUS), University of Salzburg. Address: Residenzplatz 9, 5010 Salzburg (Austria). Email: <u>Harald.Oberhofer@sbg.ac.at</u> Karlis Smits is a Senior Economist at the Poverty Reduction and Economic Management Department, Europe and Central Asia Region, the World Bank. Address: 1818 H Street, NW. Washington DC 20433. Email: ksmits@worldbank.org Gallina A Vincelette is a Senior Economist at the Poverty Reduction and Economic Management Department, Europe and Central Asia Region, the World Bank. Address: 1818 H Street, NW. Washington DC 20433. Email: gvincelette@worldbank.org
# Introduction<sup>2</sup>

**The European economic growth model has delivered unprecedented welfare to the continent over the last half century.** The model’s blend of enterprise and social inclusion is unique. The resultant continuous process of economic integration in Europe over the last half century boosted economic growth and facilitated income convergence throughout the region, often driven by trade and financial linkages. European enterprises not only profited immensely from integration but are significantly more socially responsible than in other parts of the world. European states invest heavily in education and research and development (R&D) activities and offer social protection to workers both during and after their participation in the labor market. In the last two decades, the virtues of the European growth model have now materialized in the income convergence being experienced by EU11.<sup>3</sup>

**In spite of its remarkable success, several aspects of the European economic growth model require reform to ensure that it is sustainable.** Among the priorities for many European states today are providing incentives for labor mobility, making public finances more sustainable, and adapting social security systems to demographic developments, and harmonizing regulation across borders.

**This paper zeroes in on the EU11 region to explore what is driving their prosperity and growth.**<sup>4</sup> Since they began the transformation process, this group of emerging countries has made impressive strides as developing market economies and is anchoring development in EU institutions. The speed at which economic integration has taken place and its healthy returns in terms of income growth and convergence make the EU11 countries particularly interesting economies to study.

## **The main messages related to the drivers of growth and prosperity in the EU11 are as follows:**

- **Convergence:** The financial crisis had a significant effect on income growth in the region; as a result, the extraordinary income convergence process that took place in the last decade has decelerated. The EU11 region does have good prospects for further convergence dynamics although the speed of income convergence may differ

> 2 The authors are grateful for valuable inputs provided by Ewa Korczyc, Emilia Skrok, and Sebastian Eckardt. We thank Satu Kahkonen, Yvonne M. Tsikata, Peter C. Harrold, Stella Ilieva for comments on earlier drafts of this paper.

> 3 The EU11 group of countries comprises Bulgaria, Croatia, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, Slovenia, and Slovakia. See Annex 1 for a complete list of country groupings.

> 4 This paper adopts the thematic framework presented in  Gill and Raiser (2012) “Golden Growth: Restoring the Luster of the European Economic Model.”

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significantly across economies. Largest gains in income convergence in EU11 will come from closing the gap in human capital investment with EU15.

- **Trade and finance:** Although trade and finance have fueled convergence in incomes and living standards, trade in modern services has not increased concomitantly. Trade will remain pivotal for sustaining economic growth in EU11. Financial integration within EU11 and between EU11 and EU15 will continue, but with a focus on strengthening stability in cross-border banking.

- **Enterprise and innovation** : Firms in EU11 have been successful at creating jobs, raising productivity, and competing in international markets. Innovation indicators, however, suggest that EU11 countries as a group lag behind other EU member states.

- **Labor** : Recent demographic developments in Europe are raising questions about the sustainability of the European growth model. Because of demographics, pension policies as well as policies to close the educational attainment gap and create incentives for labor market participation and the return of skilled workers who have migrated will gain in importance.

- **Government** : EU integration has helped enhance the quality of government by strengthening the rule of law, facilitating economic openness, and promoting voice and accountability. This was achieved mainly through high outlays for social benefits. E11 governments are still larger than in other emerging countries with similar income levels. This differential and shortcomings in government effectiveness are holding back growth. Moreover, pressures for more social spending are likely to rise as the demographics worsen.

# Post-Crisis Prospects for the EU11

## **Europe’s economic growth in the last half century has noticeably narrowed income**

**differentials between countries.** From 1950 through 1973, Western European incomes converged quickly toward those in the United States. Then, by the early 1990s, the incomes of more than 100 million people in the poor south—Greece, southern Italy, Portugal, and Spain—grew closer to those of advanced Europe. The European convergence in consumption levels in the last four decades is unmatched. Annual per capita consumption in the southern periphery of the EU grew by 4 percent, while the 2 percent increase in the wealthier EU members was still impressive.  Except for East Asia, the rest of the world has seen little or no convergence.

3
**Starting with the EU association process of the Czech Republic, Hungary, Poland, Slovakia, Slovenia and the Baltic countries in the mid-1990, another 100 million people were gradually absorbed into the EU, and their incomes also increased quickly.** In 2010 income per capita in Hungary was roughly 47 percent higher than in 1994, and Poland’s income per capita had more than doubled. Income per capita in the EU11 grew 5 percent annually between 1994 and 2010, narrowing the income gap between EU11 and EU15 by more than 6.5 percentage points. The income convergence dynamics for the period were mirrored in similar cross-country labor productivity growth, with the EU11 region moving toward (though still far from) the other EU economies. From an institutional point of view, the EU’s Structural Funds played a particular role for equalizing fiscal capacity across European regions, so as to foster income convergence.

**The global financial crisis and the economic recession in Europe have slowed the pace of income convergence for the EU11 region.** GDP losses in the region hide very marked country differences.  For some EU11 countries, the crisis brought major cumulative GDP losses (Latvia and Estonia), but others were affected only minimally (Poland and Slovakia). From 2005 through 2010 there was considerable income convergence in Poland and Slovakia, but in others (notably Estonia, Hungary, and Latvia) income convergence stagnated relative to the rest of the EU. The speed at which the gap in average income per capita between EU11 and the rest of the EU closes provides a measure of convergence. That fell from 0.70 percent a year for 2000–2004 to 0.42 percent for 2005–2010, but for the latter period the effects of the crisis on income convergence dynamics become abundantly clear. The average gap-closing speed for 2005–2007 was 16 times faster than the 0.06 percent a year recorded for 2008–2010.The link between the initial level of income per capita and subsequent growth is much stronger in the period 2000-2004 than in 20052010.<sup>5</sup> To sum up, while the period 2000-2010 was characterized by a generalized income convergence trend in the region, the “boom-bust” dynamics in several economies of EU11 made the within-decade developments very heterogeneous.

> 5 The correlation between initial income per capita and economic growth, which had averaged (–0.5) for 2000–2004—an indication that the poorer economies in the region were growing faster than richer ones—was only (–0.23) for 2005– 2010.

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**Figure 1. Average Annual Real GDP Growth (Percent)**

<!-- Start of picture text --> 6.0<br>4.0<br>2.0<br>0.0<br>1990-1994 1995-1999 2000-2004 2005-2010<br>-2.0 EU15 North<br>EU15 Continental<br>-4.0<br>EU15 South<br>EU11<br>-6.0<br><!-- End of picture text --> _Source:_ For EU11: World Bank ECACE regional tables; for Western Europe, IMF World Economic Outlook<sup>6</sup>

**Figure 2. GDP per Capita, PPS Percent of EU15 Average**

<!-- Start of picture text --> 73 76<br>68<br>58 55 56 59 59 62<br>49<br>41 43<br><!-- End of picture text --> _Source:_ World Bank ECACE regional tables and IMF WEO _Note:_ Purchasing Power Standard (PPS)

**Table 1. Income Gap Change, EU15 Average and EU11 Economies**

||**1990-**|**1995-**|**2000-**|**2005-**|
|---|---|---|---|---|
||**1994**|**1999**|**2004**|**2010**|
|**EU11**|–**1.36%**|**0.08%**|**0.70%**|**0.42%**|
|Bulgaria|–0.36%|-0.29%|0.34%|0.29%|
|Croatia|–2.45%|0.12%|0.63%|0.23%|
|Czech R.|–1.03%|-0.59%|0.41%|0.57%|
|Estonia|–1.66%|0.46%|1.32%|-0.02%|
|Hungary|–0.97%|-0.10%|0.60%|-0.02|
|Latvia|–2.31%|0.42%|1.06%|-0.05%|
|Lithuania|–2.76%|0.28%|1.05%|0.31%|
|Poland|-0.05%|0.41%|0.31%|1.08%|
|Romania|-0.48%|-0.43%|0.42%|0.30%|
|Slovakia|-1.68%|0.09%|0.71%|1.34%|
|Slovenia|-1.18%|0.45%|0.82%|0.61%|

_Source:_ World Bank ECACE regional tables and IMF WEO _Note:_ Positive values indicate that the gap decreases, negative values indicate that the gap increases 6 EU15 South: Greece, Italy, Portugal, and Spain; EU15 North: Denmark, Finland, Ireland, Sweden, and he United Kingdom; EU15-Continental: Austria, Belgium, France, Germany, Luxemburg, and the Netherlands.

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**While in the last decade income growth differentials have substantially reduced the income gap between EU11 and the rest of the EU, the poor performance of EU15South was also an important factor to explain such a development.** Between 2007 and 2010 the gap between EU11 and EU15 South closed by 0.17 percent annually but the gap between EU11 and EU15-Continental group widened by 0.09 percent.

**How can EU11 countries re-accelerate income convergence with the rest of the EU?** Having identified several plausible scenarios about changes in technology and the accumulation of human and physical capital in EU11, it is possible to project the likelihood of income convergence.<sup>7</sup> From the analysis it appears that the likelihood of EU11 income convergence with EU15 in the long-term is very high, but fully converging will take time. The distribution of relative income per capita in EU11 with respect to EU15 obtained from projection exercises for 2020, 2030, 2040, and 2050 indicate that the income convergence process will continue, and eventually the distribution of relative income per capita will become more concentrated around values that imply full, or close to full, convergence of incomes in EU11 and EU15 (Figure 3).<sup>8</sup>

> 7 We apply a simple income projection model developed to quantify future income convergence prospects for the EU11 region under several scenarios for the future dynamics of physical and human capital accumulation and shifts of the technology frontier. Using the estimated parameters of a panel regression model, Crespo Cuaresma, Havettová, and Lábaj (2012) propose to create income per capita projections for the countries in the European Union based on combinations of paths of physical capital accumulation (high, medium, and low scenarios); human capital dynamics (constant attainment rate and improvement scenarios); and technology frontier shifts (constant and linear extrapolation). By assigning such scenarios to different EU regions (EU11 versus EU15, in our case), the exercise provides 144 potential income paths by country. These can be used to evaluate the potential for EU11 convergence by decade. The combination of scenarios implies that uncertainty about future developments in production factors is explicitly incorporated into the quantification of the income convergence progress (see also Hlouskova and Wagner, 2005, for related income projection models applied to Central and Eastern European economies).

> 8 The results presented here are based on a simulation design that implicitly assigns equal likelihood to all possible scenarios. Weighting income projections by _a priori_ subjective probabilities of occurrence will yield shifts in the projections’ histogram.

6
**Figure 3. Projections of Income per Capita, EU11 and EU15, Smoothed Distribution**

<!-- Start of picture text --> 8<br>2020<br>2030<br>7<br>2040<br>2050<br>6<br>5<br>4<br>3<br>2<br>1<br>0<br>0 0.2 0.4 0.6 0.8 1 1.2<br>Ratio of average income per capita in EU11 to average income per capita in EU15<br>Frequency<br><!-- End of picture text --> _Source:_ Authors’ calculations based on Crespo Cuaresma, Havettová and Lábaj (2012) _Note:_ The figure plots the (smoothed) histogram of the 144 projections for 2020, 2030, 2040, and 2050. It shows average income in EU11 as a share of EU15 income. As the projection horizon increases, the histograms become "fatter" because of uncertainty about the long-term development of income per capita. As time progresses, the center of the smoothed histogram moves to the right, with a larger share of observations around 0.8–1, which suggests close to full convergence.

**Human capital accumulation dynamics are the key factor in explaining why some EU11 countries are more likely to be successful in closing the income gap with EU15 in the long term.**<sup>9</sup> Differences in income convergence speed within EU11 can be attributed to the sizable gap with EU15 regarding human capital accumulation. To close these differences, further investment in human capital could significantly accelerate income convergence. Investment in human capital can even pay off where educational attainment is already relatively high if demand is rising for skilled workers and employers are running into specific skills shortages (see World Bank 2012). To the extent that human capital investments (in terms of both quantity and quality) affect an economy’s ability to innovate, the benefits for income convergence from policies directed to improving skills may be particularly important.

**In terms of accumulation of production factors, the growth rate of physical capital in the EU11 region has been systematically above that in EU15.** Redirecting investments to more productive sectors seems to be an income convergence priority in the region. The recent crisis has also had a negative effect on innovation policies in EU11, which diverge in innovative capabilities from the rest of the region (Archibugi and Filippetti 2011). Such a

> 9 Recently, a number of scholars have emphasized the prominent role of human capital accumulation as a driver of income growth and convergence in Europe in studies of the determinants of economic growth and income convergence patterns in Europe (see LeSage and Fischer 2008; Crespo Cuaresma, Doppelhofer; and Feldkircher 2012; and Crespo Cuaresma and Feldkircher 2012).

7
development, through its effect on growth in total factor productivity (TFP), poses risks to progress in EU11 income convergence with EU15.

**In a nutshell, while in the last 20 years progress in income convergence with the rest of the EU can be considered a success, the financial crisis jammed on the brakes.** Taking into account current production factor endowments, although heterogeneous across individual economies the prospects of continuing on the convergence path are good for the region as a whole. If the right policies are in place, further gains can be expected from convergence in educational attainment for countries where human capital investment lags behind the EU15 economies. Such a lag, as measured by the difference in the share of working age population with tertiary education to the EU15 average, ranks from 19.7% in Romania to -7.6% in Estonia.

# Trade and Finance: Fueling Economic Growth, Increasing Vulnerability

**Trade and finance—facilitated by the single market of the EU and its forebears— have fueled convergence in incomes and living standards.** In 2009 Europe’s trade in goods was worth about $4.5 trillion, more than East Asia’s and North America’s combined, and trade in services was worth $2.25 trillion, more than the entire rest of the world combined. Today, Europe’s economies are more integrated through trade than those of any other part of the world, stimulating faster convergence in incomes and living standards. EU11 has been especially effective at taking advantage of their opportunities to integrate westward by trading goods and modern business services.

**While trade in goods between the EU15 and the EU11 countries has grown rapidly since the mid-1990s, trade openness varies.** Trade flows relative to GDP are much higher in the EU11 states than elsewhere in the world due to low barriers to goods trade in the Single Market, falling trade barriers for both goods and services, and the relatively small size of economies in the region. However, trade-to-GDP ratios and the direction of intra-EU trade flows vary. Trade-to-GDP ratios in Hungary, the Czech Republic, Estonia, and Slovakia have reached EU15-Continental levels, led primarily by trade in intermediate goods.<sup>10</sup> Location does a lot to explain trading patterns between new and old EU member states. EU15-North, especially Finland, Sweden, and Denmark, are important destinations for exports from Estonia, Latvia, and Lithuania. EU15-Continental countries, especially Germany, are major markets for exports from Poland, the Czech Republic, Hungary, Slovenia, and Slovakia. EU15-South has not been much of a market for exports from EU11

> 10 While EU15-Continental comprises six EU countries (Austria, Belgium, France, Germany, Luxemburg, and the Netherlands), the aggregates are largely driven by Germany. The latter accounts for almost one half of the EU15Continental output.

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<!-- Start of picture text --> mConsumption goods Mlntermediate goods a Capital goods<br>70 Traditional services Mi Modern services<br>60<br>50 iz<br>40 ]<br>30 zz mz<br>20 |<br>Lo<br>i iat 4 W a<br>$z wt ra2 a3 Ww% €F=<br>Pe “A wer<br>4 3 in hoe<br>= Wwe 4 ge<br>im a[=] im5 au<br><!-- End of picture text -->

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<!-- Start of picture text --> 90.0<br>80.0 .<br>70.0 OModern services services<br>60.050.050.0 a Tracitional_ services<br>40.0<br>30.0 a Capital goods Capital goods goods<br>20.0<br>10.0 Blntermediate goods<br>0<br>coe oe DOO Yo m Consumption Consumption goods<br>s5ahpheeeeeeeepheeeeebeeSAPP EREeeeSAPP EREeSAPP EREe EREee ebeeSAPP EREeeeSAPP EREeSAPP EREe EREee o essEos SGEos SG SG<br>a¢ uu 2 S%o ws<br>Se TC 5 e a u<br>8 8<br>MM o<br>" a<br><!-- End of picture text --> <!-- Start of picture text --> 90.0<br>30.0<br>70.0 B Modern services Modern services services<br>60.050.050.0 A Traditional7 Traditional7 services<br>40.0<br>30.0 § Capital goods goods<br>20.0<br>100 i Intermediate goods goods<br>0 8 Consumption :goodsgoods<br>C8 v pF Roe Yo<br>Beez<br>556ees7°ees7°7° 8hs5s55 he§§ &aa fsFEERESeSGoS8FEERESeSGoS8RESeSGoS8SeSGoS8SGoS8oS88<br>go vu Z poo mg =<br>et 5S eeu<br>ova a<br>rr]<br><!-- End of picture text --> 90.0 90.0 30.0 80.0 . 70.0 B Modern services Modern services services 70.0 OModern services services 7 _ 60.050.050.0 A Traditional7 Traditional7 services 60.050.050.0 a Tracitional_ services 40.0 40.0 30.0 § Capital goods goods 30.0 a Capital goods Capital goods goods 20.0 20.0 100 i Intermediate goods goods 10.0 Blntermediate goods 0 8 Consumption :goodsgoods 0 C8 v pF Roe Yo Beez coe oe DOO Yo m Consumption Consumption goods 556ees7°ees7°7° 8hs5s55 he§§ &aa fsFEERESeSGoS8FEERESeSGoS8RESeSGoS8SeSGoS8SGoS8oS88 s5ahpheeeeeeeepheeeeebeeSAPP EREeeeSAPP EREeSAPP EREe EREee **o** essEos SGEos SG SG go vu Z poo mg = a¢ uu 2 S%o ws et 5S eeu Se TC 5 e **a** u 5i ova 8 8 rr] MM o " a
<!-- Start of picture text --> 100<br>90<br>80<br>70<br>60<br>50 MEU South<br>40 MEU Cont<br>30<br>0 mEU North<br>10<br><!-- End of picture text -->
**Figure 9. Capital Flows, Average of Group Median Values, (Percentage of GDP)**

<!-- Start of picture text --> 2001-2004 2005-2008<br>24<br>20<br>16<br>12<br>8<br>4<br>0<br>-4<br>-8<br>-12<br>-16<br>EU15 EU Coh. EU11 SEE E. prtn. East Asia LAC EU15 EU Coh. EU11 SEE E. prtn. East Asia LAC<br>FDI Portfolio Other Total Capital Flows CA Balance FX Reserves, change<br><!-- End of picture text --> _Source:_ Gill and Raiser (2012); World Bank staff calculations.

_Note:_ EU coh = EU cohesion countries; E. prtn = EU eastern partnership countries; LAC = Latin America and the Caribbean region; CA = current account; FX = foreign exchange.

**In some cases financial integration and closeness to Western European finance led to excesses, making EU11 countries vulnerable to financial deleveraging of Euro area banks.** Access to finance made it possible to borrow from abroad for investment not only to fuel growth and convergence but also to finance the consumption that has made these economies vulnerable to sudden reversals in capital flows. Financial integration has led to rapid growth in private credit in EU11. The credit growth was supported not only by such supply factors as access to finance but also by demand for housing and consumer durables. Moreover, residential overcrowding in the new EU countries was much worse than in the old EU member states (Figure 10).

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therefore expected not only to significantly contribute to job creation and job security but also to be globally competitive. This belief also induces more widespread regulations in social and environmental policies

**Over the last decade European firms have been successful in creating new jobs, increasing the value added to their products, and exporting to foreign markets.** This general trend was driven by EU11 countries as well as those in EU15-North and EU15Continental. In EU11 economies, from 2002 to 2008 growth in average employment was about 2.7 percent and in value-added about 5.6 percent; meanwhile the same countries were exporting the equivalent of about 54 percent of GDP to foreign markets.

**Fueled by the expansion of the services and construction industries, EU11 was generating almost twice as much employment as EU15,** even though in much of the region growth in manufacturing jobs was negative. From 2002 to 2007 the number of jobs in service industries grew above 3 percent in Latvia, Romania and Estonia and reached its overall maximum of 5.9 percent in Lithuania. In contrast, between 2002 and 2007 growth in Slovenian manufacturing jobs averaged just 0.6 percent, and manufacturing employment actually shrank in Hungary (–0.9 percent) and Latvia (–1.4 percent). Negative employment growth dynamics in the more traditional industrial sectors have been evident throughout the EU11.

**Within EU11, the firms that are creating jobs are of different sizes.** In the Slovakia, Estonia, and Romania, for example, employment growth occurs mainly in firms with less than 10 employees, while in Bulgaria and Poland, it is large firms that are net job creators. From 2002 to 2007, in Slovakia average annual employment growth in firms with less than 10 employees was 11.4 percent, while it was just 0.4 percent for larger firms. In the same period in Hungary, the number of jobs in firms with less than 10 employees decreased by 0.1 percent, but employment in large firms great about 10 times faster (to about 1 percent).

**Since 2000, an increase in labor productivity has led EU11value-added to grow more than twice as fast as in the EU15.** Not only did EU15-South fail to gain much in productivity in the last decade, firms there tend to be less internationally competitive. Although in absolute terms, labor productivity is substantially higher in EU15 than EU11, the gap has narrowed significantly over time. From 1995 to 2009, for instance, EU11 countries made the largest productivity gains in the whole EU, with productivity shooting up by 2.5 percent in service industries and about 5 percent in manufacturing.

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<!-- Start of picture text --> 6<br>: BTotal windustry m Services<br>4<br>3<br>2<br>1<br>0<br>EUS North © EUL5 Continental EUL5 South EULL<br><!-- End of picture text --> <!-- Start of picture text --> Total m Start-up Operations Institutions<br>100<br>40<br>80<br>70<br>60<br>50<br>EUI5 North EUI5 EUI5 South EVIL<br>Continental<br><!-- End of picture text -->
<!-- Start of picture text --> Average productivity, 2008 Annual value-added growth, 2003-08<br>thousand USS per employee percent<br>Domestic<br>Czech —_ Foreign<br>Republic es re<br>Poland 26 49 7 124<br>. 25 5.6<br>Slovenia 41 10.1<br>Croatia 23 34 4.1 6.6<br>19 29<br>Estonia aa 24<br><!-- End of picture text -->
<!-- Start of picture text --> ERD expenditure, 4% of GDP<br>25<br>mPubk<br>za MiBuskres:<br>LS<br>13<br>5<br>os<br>WUE Herts muLs FELIS Sept mua Sate eter<br>tantinasiel Parkearaile<br><!-- End of picture text -->
# Labor: Overwhelming Demographic Challenges

**The degree of social protection European workers enjoy in the form of employment protection and social benefits is significantly higher than in any other developed region.** The generosity of the social protection system allows Europeans to maintain a balance between work and leisure. While this pillar of the European growth model has obvious benefits for workers, it discourages labor participation and is a burden on the public finances. Europeans do indeed work less and retire earlier than Americans. Over the last four decades the effective retirement age in Europe has systematically declined in Europe even though life expectancy has risen significantly. Relatively low labor mobility adds to the problems Europe faces in achieving efficient allocation of labor within and between countries.

**EU11 social protection indicators do not seem to be systematically different from those in the rest of Europe.** Though EU11 employment protection laws tend to be less stringent than elsewhere in the EU, its market protection indices have been converging with those of the EU15 in recent decades, both because Western European economies have adopted more liberal labor market policies and because EU11 countries have increased protection.

**Figure 15. Employment Protection Index**

**Figure 16. Hiring and Firing Practices Index**

<!-- Start of picture text --> OECD employment protection index Hiring and firing practices index, 2010<br>4.00 7.0<br>3.50 6.0<br>3.00<br>5.0<br>2.50<br>4.0<br>2.00<br>3.0<br>1.50<br>2.0<br>1.00<br>0.50 1.0<br>0.00 0.0<br>Source: OECD Indicators of Employment Protection Source: World Bank Doing Business<br>Note: Scale from 0 (least stringent) to 6 (most restrictive)<br><!-- End of picture text -->

**Labor costs have accordingly risen faster in EU11 than in EU15, in line with the convergence in labor productivity** . Current labor productivity levels correlate strongly with labor costs per hour (see Figure 17), both within EU11 countries and between EU11 and EU15 countries. In this sense, economic fundamentals appear to be responsible for the

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large increases in unit labor costs in EU11 over the last decade. For the case of EU15, such a correlation exists but is not as robust as in the case of EU11, suggesting that institutional factors play a more important role as determinants of unit labor costs differences in high productivity countries.

**Given the relatively generous social protection system, expected demographic developments are among the most formidable obstacles to the sustainability of the European growth model.** With employment protection high, social benefits generous, and reduced mobility, the most important methods for improving workforce productivity in the long term are to increase labor market participation and both develop skills and attract talent, meanwhile ensuring fiscal sustainability.

**Figure 17. Labor Productivity and Labor Costs per Hour, 2009**

<!-- Start of picture text --> 200.0<br>Luxembourg<br>180.0<br>160.0 Ireland<br>140.0<br>120.0<br>100.0<br>Finland Netherlands Sweden<br>Denmark<br>80.0 Austria<br>United Kingdom Belgium<br>France<br>60.0 Spain Germany<br>Italy<br>40.0 Greece<br>Slovenia<br>Slovakia<br>20.0 Lithuania Poland Hungary Estonia Czech Republic Portugal<br>Romania Latvia<br>Bulgaria<br>0.0<br>0 5 10 15 20 25 30 35 40<br>Labor cost per hour (euro)<br>Labor productivity<br><!-- End of picture text --> _Source:_ World Bank and Eurostat

**Together the expected shrinkage of the working-age population and the dramatic rise in the proportion of the population above age 65 pose a serious threat to the European growth model.**<sup>16</sup> The median age in EU11, which is currently comparable with the rest of Europe, is expected to increase 6.8 years on average by 2050 (Figure 18). In the rest of the EU the increase is expected to be 5.8 years.<sup>17</sup> The old-age dependency ratio in the EU11 will deteriorate with the share of the elderly in the population reaching 33 percent in 2060 from 16 percent in 2010. Currently, there are about 5 persons of working

> 16 The demographic prospects of economies in Central and Eastern Europe were discussed extensively in World Bank (2007). See Annex 2 for more detail.

> 17 These figures are based on the median scenario of the UN World Population Projections.

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age for every person in pension age in the EU11. By the year 2060, this is expected to fall to less than 1.5 persons of working age for every person.

**Since labor participation and savings rates both tend to be lower for older people, such a demographic development has direct effects on macroeconomic factors of production.** If age-specific behavior with respect to participation in the labor market and saving is held constant, without remarkable increases in productivity, EU11 income per capita is likely to grow more slowly.

**The expected decline in labor force participation is larger and much more persistent in EU11 than in EU15.** Taking into account the sizable differences in participation rates by educational attainment, methods put forward by Loichinger (2012) were used to obtain projections of the labor force for EU11 and the rest of the EU for 2015 through 2055 (Figure 19).<sup>18</sup> The resultant benchmark labor force growth projections for EU11 and the rest of the EU suggest that the fall in the labor force in EU11 will be more dramatic than in the rest of Europe. The loss in labor force for the forthcoming decades is expected to be of approximately 19% between 2010 and 2050 in EU11, compared to 3% in the rest of the EU. The policy challenges posed by such changes in age structure in EU11 are thus even more urgent than in EU15.

<!-- Start of picture text --> Figure 18. Median Age in EU Countries, Figure 19. Labor Force Growth<br>2010 Projections, EU and EU11, 2015–2055<br><!-- End of picture text --> <!-- Start of picture text --> 0.04<br>44 EU11<br>42 0.03 Rest of EU<br>40 0.02<br>38<br>0.01<br>36<br>0<br>34 2015 2020 2025 2030 2035 2040 2045 2050 2055<br>-0.01<br>32<br>-0.02<br>30<br>-0.03<br>-0.04<br>Median age<br>Growth in labor force (%)<br>Cyprus Ireland Luxembourg Malta United Kingdom France Spain Denmark Netherlands Sweden Portugal Belgium Greece Austria Finland Italy Germany Slovakia Poland Romania Lithuania Czech Republic Estonia Hungary Latvia Croatia Bulgaria Slovenia<br><!-- End of picture text --> _Source:_ UN World Population Prospects (2010) _Source:_ Loichinger (2012) 18 The method combines age-, sex-, and educational attainment-specific participation rates obtained from the European Labor Force Survey with population projections by age, sex and education calculated using the probabilistic population projection methods described by KC et at (2010) 20
**The issues associated with these demographic developments are aggravated because EU11 does a poor job of attracting migrants.** The difference between EU11 and EU15 in net migration rates is remarkable (Figure 20).  The rate at which highly skilled workers leave the EU11 is the highest of the EU regional aggregates (Figure 21). To the extent that EU11 economies evolve toward innovation and technologically advanced products, a shortage of skills could constrain economic growth in the region. Creating incentives to bring skilled individuals back may soon become a priority for EU11 economies.

**Figure 20. Net Migration Rates by Region**

**Figure 21. Emigration Rates of People with Tertiary Education**

<!-- Start of picture text --> Net migration, per 1,000 population<br>30<br>25<br>20<br>15<br>10<br>5<br>0<br>-5<br>-10<br>-15<br>-20<br>-25<br>EU15 North EU15 EU15 South EU11 SEE Eastern<br>Continental Partnership<br>Source: World Bank<br><!-- End of picture text --> <!-- Start of picture text --> Emigration rate of tertiary educated (% of total tertiary<br>educated population)<br>25<br>20<br>15<br>10<br>5<br>0<br>EU15 North EU15 EU15 South EU11 SEE Eastern<br>Continental Partnership<br>Source: World Bank<br><!-- End of picture text -->

**Apart from increasing the retirement age, policies to increase EU11 labor participation rates will necessarily have to incentivize and retain highly skilled individuals.** A wage premium as high as 25–30 percent was found recently for workers in Eastern Europe who had experience in Western Europe (Iara, 2008). Standard estimates of the returns to education in the region may thus not be very informative for domestic policy if decisions to migrate, and eventually to return, are taken into account. Such earning differentials have potent signaling effects for education decisions. They also may turn the EU11 “brain drain” into a “brain rental” by enabling the return of skilled emigrants to the region.<sup>19</sup> Such beneficial effect, however, requires impulses in terms of demand for skills in EU11 and thus the fostering of innovation activities and entrepreneurship to attract talented emigrants back to the region.

> 19 See also the theoretical underpinnings in Mayr and Peri (2009).

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**Figure 22. Tertiary Education, Age Group 30–34, 2010**

**Figure 23. Projections of Income per Capita, 2050: Benchmark Scenario and EU11 Human Capital Investment Improvement Scenario**

<!-- Start of picture text --> 2.5<br>Tertiary education attainment, % of pop. aged 30- 2050, benchmark<br>34 2050, human capital improvement in EU11<br>40 2.0<br>35<br>30 1.5<br>25<br>20 1.0<br>15<br>10 0.5<br>5<br>0 0.0<br>EU15 North EU15 EU15 South EU11 SEE Eastern 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1.0 1.1 1.2 1.3<br>Continental Partnership<br>Income per capita in EU11, proportion of EU15<br>Density<br><!-- End of picture text --> _Source:_ International Institute for Applied _Source:_ Crespo Cuaresma, Havettová and Lábaj (2012); World Systems Analysis (IIASA) and Vienna Institute Bank staff calculations of Demography (VID)

**Persistent sizable differences in participation rates by educational attainment can be seen in the EU (Figure 22), and are significantly larger for women.** Currently, the share of EU11 population aged 30-34 with tertiary education is about 21 percent, compared to more than 30 percent in EU15-Continental and EU15-North. Further educational expansion at the tertiary level may to some extent be effective in attenuating the detrimental effects of population aging. The average for individuals with tertiary education in EU11 also hides considerable differences between countries in the region. Certain economies might thus earn significant income growth dividends from using investments in human capital to increase participation.

**EU11 investments in human capital are also expected to significantly accelerate the income convergence process.** In order to quantify their effect on convergence, the previous income projection exercise was repeated assuming that EU11 invests more than EU15 in human capital.<sup>20</sup> The results (Figure 23) indicate that EU11 countries have ample room to speed up income convergence significantly by investing in skills formation. Based on both the benchmark scenario and a scenario implying that EU11 invests more in human capital, the distributions of relative income per capita in 2050 for EU11 compared to EU15 indicate that a virtuous interplay of increased labor market participation and higher income growth is likely to result from further human capital investments. This is particularly true for countries that have larger gaps with EU15 in terms of educational

> 20 Following Crespo Cuaresma, Havettová and Lábaj (2012), we assume that this share will grow at a speed estimated from the historical experience of countries at similar levels of educational attainment while tertiary educational attainment rates in the rest of Europe remain constant. That scenario implies that EU11 would over time build up a positive differential in human capital accumulation with respect to the rest of the EU that would materialize in a difference of 8 percentage points in the tertiary education attainment rate by 2050.

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attainment and thus ample scope for increasing tertiary education attainment rates. In contrast, to improve labor participation through education policy in economies with already high educational attainment, it would be necessary to improve the quality of the educational system.

**In sum, the demographic developments that are likely throughout Europe in the next few decades pose particular problems for EU11.** To keep the economic growth model sustainable as society ages and labor force participation plunges, policies are needed to increase labor market participation (e.g., by raising the retirement age) and attract back skilled workers who have migrated. Over the long-term, further EU11 investments in human capital are likely to fuel labor market participation rates and economic growth.

# Institutions Converge, Differences Remain

**For the last decade EU11 governments have been larger than those in emerging economies outside Europe, but smaller than in EU15.** European governments tend to be large: the median government size was larger by 11 percent of GDP in EU15 and 13 percent in Eastern Europe than among their peers in other regions. In 2010, government spending accounted for over half of GDP in EU15 and over two-fifths in EU11. Only in Slovenia and Hungary is the size of the government comparable to the average in EU15. The smallest governments were those of Bulgaria and Romania. Social expenditures explain the variations (Figure 24). The composition of revenues also varies significantly between old and new EU countries (Figure 27). For instance, EU11 countries collect more in indirect taxes and nontax revenues than EU15 countries, but corporate and individual taxes still account for a small share of revenues.

**A large government is a drag on growth.** Over time, big governments tend to create sclerotic bureaucracies that crowd out employment in the private sector and lead to dependence on public transfers and public wages. Large public administrations can also produce organized interest groups keener on exploiting their powers for their own benefit than on facilitating a prosperous private sector (Olson 1982). Econometric results show a powerful inverse relationship in Europe between initial government size and subsequent growth, though not worldwide (Gill and Raiser, 2012). The results suggest that in Europe a 10 percentage point increase in initial government spending as a share of GDP is associated with a reduction in annual real per capita GDP growth of about 0.6–0.9 percentage points a year.

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<!-- Start of picture text --> Latvia<br>Germany<br>Lithuania<br>Sweden<br>Slovakia<br>Netherlands<br>Malta<br>Spain<br>Belgium<br>Rowania<br>Denmark<br>Bulgaria<br>Evil<br>United Kingdom<br>Coech Republic<br>Finland<br>Slovenia<br>Hungary<br>Franee<br>Estonia<br>El 15<br>Austria<br>Portugalcyprus<br>Ireland<br>Poland<br>Luxembourg<br>ltaly<br>Greece<br>96.5 oF O75 98 98.5 99 99.5<br><!-- End of picture text --> <!-- Start of picture text --> 25<br>2<br>15<br>1<br>05<br>—EU11 ——EU North<br>—EUSouth ——EU Cont<br>0<br>wo oo 2 TM ri t+ ui Ww be oo an S<br>mH Pail 2 2 2 2 2 2 2 2 2 4<br>mno aa o“ 2m o“ 2m o“ 2m o“ 2m o“ o“<br><!-- End of picture text -->
<!-- Start of picture text --> 15 | Growth differential<br>B® change in cyclically adjusted<br>primary balance<br>10 ®@ Other factors<br>5<br>0<br>2008-2010 2010-2012<br><!-- End of picture text -->
# How to Sustain Medium-term Growth in the EU11?

There are reasons to believe that convergence of EU11 income per capita to Western European levels will continue, but will proceed more slowly. Trade and financial integration have sped along at a spectacular pace in EU11 in the recent past, although trade in modern services and the integration of government bond and equity markets are somewhat behind. As in the rest of Europe, demographic developments will pose huge challenges for the sustainability of public finance in the EU11 economies. In the next several decades the EU11 labor force is expected to contract more than labor forces in the rest of the EU, making it even more urgent that countries in the region reform pension systems, change migration policy, and find incentives to attract talent to the region. Closing the gap with the rest of the EU in educational attainment levels and improving education quality might significantly soften the constraints imposed by the demographic threats and produce sizable returns in terms of additional income convergence.

In spite of the good prospects of further income convergence to EU15, the lessons drawn from the recent growth experience in EU15-South bring to the forefront the latent risks in terms of constraints to sustainable medium-run economic growth. The analysis in this paper identifies certain areas where structural features that may be growth-hampering in EU11 economies resemble those of countries in EU15-South. The lessons learned from the EU15-South region should help EU11 countries to optimize reform policies in order to achieve further income growth. In this respect, measures to improve the business environment, the government quality and spending efficiency, all factors which have been claimed responsible for slowing economic growth in EU15-South, need to be prioritized in the policy agenda of the EU11 economies. In addition, further developing the institutional basis for fostering innovation activities should be given a privileged treatment as an instrument to achieve income convergence. This is more the case since the recent crisis has led to a divergent trend in innovation spending within the EU.

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