Kari E.O. Alho*, Ville Kaitila** and Mika Widgrén*** Speed of Convergence and Relocation: New EU Member Countries Catching up with the Old**** * ETLA and University of Helsinki ** ETLA *** Turku School of Economics, ETLA, CEPR and CesIfo **** ETLA DP No. 963, ENEPRI WP No. 34 May 2005
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Kari E.O. Alho*, Ville Kaitila** and Mika Widgrén*** Speed of Convergence and Relocation: New EU Member Countries Catching up with the Old**** * ETLA and.
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Kari E.O. Alho*, Ville Kaitila** and Mika Widgrén***
Speed of Convergence and Relocation: New EU Member Countries Catching up
with the Old****
* ETLA and University of Helsinki** ETLA*** Turku School of Economics, ETLA, CEPR and CesIfo**** ETLA DP No. 963, ENEPRI WP No. 34
May 2005
Background and motivation
• Convergence of the new EU member countries (NMCs) is vital for the homogeneity of the EU– How fast and– How sustainable is the convergence process,
both in real and nominal terms?
• There are fears of relocation of production and jobs from the EU-15 to the NMCs
Aims to analyse
• The real and nominal convergence of the NMCs (ACCs) towards the EU-15:– Real income– Consumption– Price level– Wage level– Balassa-Samuelson framework with several extensions
• The impact of this process, through relocation, on the EU-15:– In terms of GDP– National income– Aggregate growth model
Figure 1 Real convergence: GDP per capita (PPP) in the NMCs, EU-15 = 100
0
10
20
30
40
50
60
70
80
1992 1994 1996 1998 2000 2002 2004* 2006*
Czech Republic Estonia HungaryLatvia Lithuania PolandSlovak Republic Slovenia NMC8
Source: European Commission
Figure 2. Nominal convergence: Price level(ratio of current exchange rate to PPP exchange rate) in the NMCs, EU-15 = 100
Czech Republic Estonia HungaryLatvia Lithuania PolandSlovak Republic Slovenia NMC8
Source: International Monetary Fund, World Economic Outlook Database
Building a dynamic CGE model for convergence
• A model for the new member countries (NMC)– Two sectors, open and sheltered– Introduction of the basic message from empirical convergence literature: growth
rate decelerates as convergence proceeds, see below– Capital accumulation in the open sector through partial adjustment– A combination of forward-looking and liquidity-constrained consumption
behaviour– International labour mobility based on existing gap in real wages– Inflow of FDI has a spillover effect on domestic TFP, endogenous growth
• A model for EU-15– Outflow of capital through FDI flows into the NMCs, motivated by outsourcing of
production to low cost NMCs– Utilisation of this gain in competitiveness in EU-15 production– Budgetary transfers between the EU-15 and NMCs through the EU budget
• Both regions are open to the world economy, the convergence process does not have an influence on the global prices or interest rates
Combining the basic message of convergence to the model:
tt
t
Qg
Q1
0 1 *1
log
Let us fix the long-run equilibrium: at time T QT = QT* and gT = gT*
This calibrates the parameters β0 and β1, given the initial growth rate g and g*, and the initial ratio of income levels.
Let productivity growth in the open sector be 6% and the sheltered sector be 4.5% p.a.
The basic Balassa-Samuelson framework combined with beta convergence
0
10
20
30
40
50
60
70
80
90
100
2000 2005 2010 2015 2020 2025 2030
Income level
Price level
Wage level
Combining uncertainty with the basic B-S framework
2 2 21 1 *( ) (1 ) ( )rel rel
t t gV q V q
0
10
20
30
40
50
60
70
80
90
100
2000 2005 2010 2015 2020 2025 2030
baseline 50% 95%
Specification of a CGE model
• Endogenous growth in NMCs: TFP growth in the NMCs is a function of FDI inflows
* 1, 1 1 1 1 0 0
111 * log / 1 t
Tt T t t t Ttt
Kfdi KfdiKfdiA A g q q a g
K Kfdi
The human capital/income in NMCs and relative income in NMCs in ratio to EU-15
15
20
25
30
35
40
45
2000 2005 2010 2015 2020 2025 2030
0.4
0.5
0.6
0.7
0.8
0.9
1
human capital/income, leftscale
relative income, right scale
Aggregate consumption: sum of that of liquidity (income) constrained and forward-looking consumers
The model for EU-15
1* *1
Q Y *M Qwhere
Outsourcing improves the profitability of EU production
*1
** , / *1Y
PPP P where Kfdi K
So technology is in this sense endogenous. The FDI is determined through a portfoliobalance equation,
0/ * ( ( ( * / *))NMCKfdiopt K s r d p p
Actual Kfdi follows then through partial adjustment
GDP, the real wage, National Income and Income ofincumbent EU-15 nationals, endogenous FDI (scenario 1)in relation to baseline of fixed stock of inward FDI
0.994
0.996
0.998
1.000
1.002
1.004
1.006
1.008
2000 2005 2010 2015 2020 2025 2030
QEUDIFFQEUNATINCDIFF
WEURDIFFYINCUMBDIFF
-.6
-.4
-.2
.0
.2
.4
2000 2005 2010 2015 2020 2025 2030
DLOGQDLOGK
DKFDIDLOGL
Decomposition of difference, %, in EU-15 GDP between the scenarios
Policy questions raised by the model
• Inflation in NMCs seems to be quite a persistent problem, average 4% p.a.?
• Foreign indebtedness a looming problem if a vigorous growth continues?
• Outsourcing not a problem for the EU-15 in a GE sense? Of course, this depends on the magnitude of the shock, but it was in the simulation quite sizeable in itself.
• There is a polarising outcome with respect to further integration in the EU-15.