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The impact of the EU's Structural and Cohesion Funds on real convergence in the

EU

Dr. Reiner MartinEU Countries DivisionEuropean Central Bank

Warsaw, 27 November 2003

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Introduction

"The evidence examined in [the 2nd Cohesion Report] shows that over the previous programming periods (1989-93 and 1994-99) Community cohesion policies have had some notable success. This is perhaps most visible in the case of the regions where development is lagging behind, where there has been a general process of catching up in economic and social terms." (European Commission, 2001).

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Introduction

“The best thing the EU could do for Greece is to cut off the structural funds immediately (…); anybody who works hard at a regular business is regarded as an idiot, since it’s much easier to set up a project to draw in European subsidies.” (The Economist 27 March 2003, quoting a ‘senior Greek official in Brussels’).

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Overview

• Introduction• The EU’s Structural and Cohesion Funds• Infrastructure and human capital as determinants for

real convergence • Evaluations of the Structural and Cohesion Funds• Conclusions

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The EU’s Structural and Cohesion Funds

• Main aim is to improve long-term growth and employment prospects (supply-side approach)

• No fiscal federalism• No sector-specific policy like the Common

Agricultural Policy (CAP)• Less firm-level oriented than most national

regional policies

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European regional policy objectives during the 2000-06 period

The EU’s Structural and Cohesion Funds

• Relatively poor regions (Objective 1)• Regions with specific economic problems

(Objective 2) • Education, training and employment outside Objective 1

regions (Objective 3)

Cohesion Fund for relatively poor Member States

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Population covered by European regional policy objectives (in %)

The EU’s Structural and Cohesion Funds

Source: European Commission.

Objective 1 and 6 2 and 5b 1 2 Total Total1994 1994 2000 2000 1994 2000

Austria 4 37 3 25 41 28Belgium 13 19 ./. 12 32 12Denmark ./. 16 ./. 10 16 10Finland 17 38 21 31 55 52Germany 21 19 17 13 40 30Greece 100 ./. 99 ./. 100 99Spain 60 24 58 22 84 80Sweden 5 21 5 14 26 19France 4 42 3 31 46 34Ireland 100 ./. 25 ./. 100 25Italy 37 19 33 13 56 46Luxembourg ./. 43 ./. 28 43 28Netherlands 2 22 ./. 15 24 15Portugal 100 ./. 65 ./. 100 65UK 6 36 8 24 42 32EU 15 27 25 22 18 52 40

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EU resources for structural action

The EU’s Structural and Cohesion Funds

• From EUR 8 billion per year (1989) to 32 billion in

1999 (1999 prices)• From 20% of EU budget (1987) to above 35% (1999)• European Summit in Berlin (1999) resulted in slight

decline of available resources for 2000-06 compared

to 1994-99

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EU resources committed to structural action, 2000-06Breakdown according to Member State and objective*

The EU’s Structural and Cohesion Funds

* Million EUR, 1999 prices

Source: European Commission.

Obj. 1 Obj. 2 Obj. 3 CohesionFund

CommunityInitiatives

Total

Germany 19,958 3,510 4,581 ./. 1,608 29,657Greece 20,961 ./. ./. 3,060 862 24,883Spain 38,096 2,651 2,140 11,160 1,958 56,005Ireland 3,088 ./. ./. 720 166 3,974Italy 22,122 2,522 3,744 ./. 1,172 29,560Portugal 19,029 ./. ./. 3,300 671 23,000Other 12,700 13,771 13,585 ./. 3,844 43,900EU 15 135,954 22,454 24,050 18,240 10,281 210,979

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Functional distribution of EU Funds in Ireland, Greece, Portugal and Spain, 1994-99 (in %)*

The EU’s Structural and Cohesion Funds

Type of expenditure Greece Spain Ireland Portugal

Structural Fund expendituresInfrastructure 45.9 40.4 19.7 29.7Human resources 24.6 28.4 43.9 29.4Productive environment 27.8 30.5 36.2 35.7

Cohesion Fund expendituresTransport infrastructure 51.2 49.7 50.0 48.1Environment 48.8 50.3 50.0 51.9

*Cohesion Fund expenditures refer to the period 1993-99.

Source: European Commission

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Financial resources for Acceding Countries

The EU’s Structural and Cohesion Funds

• Until 2004 EUR 3 billion per year for all 12 AC and

Candidate Countries (1999 prices)• Between May 2004 and end 2006 EUR 21.7 billion for

10 AC (1999 prices)• 2/3 of this will be Structural Funds, 1/3 Cohesion Fund• AC likely to be fully eligible for Objective 1 status (except

Prague, Bratislava and Cyprus)

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Determinants of real convergence

Convergence theory• Free movement of goods and factors of production ensures

that all regions achieve their technologically determined optimal level of capital intensity

• Economic integration will lead to ‘automatic’ convergence• Conditional convergence theory: allows for regional/national

differences in production technologies

Divergence theory• Stresses differences in technology, transport costs and external

effects• Policy action is required to bring about convergence

Empirical evidence for last 20 years for the EU shows convergence at the national level but less so at the regional level

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Determinants of real convergence

Infrastructure and real convergence• Public infrastructure supports long-run growth by providing

complementary inputs for private production• However, the net positive effect on production depends on

whether it crowds in more private investment than it crowds out

Why public infrastructure?

• Public good case• Increasing-returns-to-scale/natural monopoly case

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Determinants of real convergence

Empirical evidence• Major methodological problems (e.g. accounting for

quality differences, reverse causality)• There is reasonable evidence of positive effects of public

investment on growth• Benefits of public investment are greatest in countries

with a low level of infrastructure capital stock• Identification of key infrastructure bottlenecks is crucial

in order to ensure an appropriate return on public infra-structure investments

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Determinants of real convergence

Human capital and real convergence• Endogenous growth theory gives considerable importance

to human capital as explanatory factor for growth• Idea that human capital also increases the capacity to

innovate and to adapt new technologies

Why public investment?• Social returns to individuals’ investments in education

might outweigh private returns• Case for publicly subsidised education is reinforced if

credit markets are imperfect

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Determinants of real convergence

Empirical evidence

• Methodological problems (proxies for human capital, reverse causality)

• Some evidence that education is beneficial for growth but weaker than theory would suggest

• Diminishing returns on education, primary education being the one with the highest return

• On-the-job training and adult education could be also beneficial but the available evidence is rather limited

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Evaluations of the EU Funds

Types of evaluations• Evaluations for specific projects or programmes• Analyses based on aggregate public investment or EU

transfers as explanatory variable• Macroeconomic models

Some common problems• Lack of sufficiently long and detailed regional time series

for many variables• Funds have operated for relatively short period

(particularly problematic for the identification of supply-side effects)

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Evaluations of the EU Funds

Evaluations for specific projects or programmes• Quality of the evaluations varies considerably• Somewhat less interesting from a macroeconomic

perspective• Indispensable for making the right choices in designing

concrete projects and programmes• Venables and Gasiorek (1999) use models based on

economic geography to investigate inter-regional spill-over effects of major CF funded infrastructure investments

• Location of such projects crucial for extra-regional effects

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Evaluations of the EU Funds

Econometric tests using cross-section or panel-data analyses

• This strand of evaluations suffers in particular from data constraints

• On balance rather pessimistic although there is some heterogeneity in the results

• Recurrent issue is the impact of the quality of national institutions in the recipient countries on the effectiveness of the Funds

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Evaluations of the EU Funds

HERMIN• HERMIN introduces the effect of the Funds in two ways:

1. Standard expenditure and income shocks2. Policy externalities (Increased TFP, increased

attractiveness for FDI, enhanced ability of endogenous industries to compete abroad)

• Simulation assumes funding to terminate after 2006• Supply-side effects of 1-2% GDP growth per year for

Cohesion Countries and Eastern Germany

Macroeconomic models• Results differ considerably, depending on the model

specifications and the ways in which the models take the impact of the Funds into account

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Evaluations of the EU Funds

HERMIN simulation results on the impact of Objective 1 CSFs 2000-06 on the level of real GDP in the Cohesion Countries and Eastern Germany(in % deviation from baseline)

Source: Hallet (2002)

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Evaluations of the EU Funds

QUEST II• QUEST II model is forward-looking, with behavioural

equations based on the intertemporal optimisation of households and firms

• Real interest and exchange rates are determined endogenously, so that possible crowding-out effects can be taken into account

• Impact of Funds is modelled as increase in the public capital stock, which impacts on a neo-classical production function

• For 2000-06 the results of QUEST II simulations for the Cohesion Countries are low compared to HERMIN

• HERMIN and QUEST II estimates for supply-side effects are more similar

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Evaluations of the EU Funds

QUEST II simulation results on the impact of Objective 1 CSFs 2000-06 on the level of real GDP in the Cohesion Countries (in % deviation from baseline)

Source: Hallet (2002)

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Conclusions

• Short-term redistribution and demand effects of the Funds more easily identifiable and relatively undisputed

• Considerable uncertainty about the long-term supply-side effects

• ‘Smallest common denominator’• Well designed measures to upgrade infrastructure and to

increase human capital are likely to have a positive impact on growth

• In particular in regions where infrastructure and human capital are likely to represent growth bottlenecks

• On balance the results suggest that EU regional policy can have a positive long-term impact on economic growth in the recipient countries and regions

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Conclusions

Improvements to the current system of regional support

• Further strengthen the focus on physical and human capital building

• Improvements of Member States’ administrative capacity could become a new priority for the Funds

• Further simplifications of the procedures• Improved co-ordination between EU regional policy,

national regional policy and non-spatial European and national policies

• Further spatial concentration of support • Enlargement shifts main dimension of income differences

from regions to countries• Allocation of funding may thus need to become more

strongly based on national socio-economic characteristics

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Conclusions

More far-reaching lessons• Funds can only exert a positive impact on real

convergence if the supported countries are characterised by a stable macro-economic environment and institutional and microeconomic structures that are conducive to growth

• Low level of inflation and sound budgetary policies• Regulatory framework that facilitates the setting-up and

growth of endogenous companies as well as FDI, a business-friendly tax system, sound financial markets

• Look more closely at the link between factor returns and productivity in order to ensure for example that wage-setting systems take local productivity differences sufficiently into account

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Thank you for your attention!