1

World Bank EU-8 Quarterly Economic Report

July 20041 EU-8

HIGHLIGHTS OF THE REPORT

The Political Economy Background

• The EU-8 countries joined the European Union on May 1, and while this is a major political achievement, the potential economic gains will have to be earned. Income levels range from 40-80 percent of the EU average, regional income disparities are large and rising, unemployment is high in most countries, and pockets of poverty persist in all countries. While full access to the internal market and EU aid programs offer significant opportunities, the challenges are equally daunting. For some countries it will take several decades to approach EU living standards.

• Euro adoption is now the main medium-term economic policy goal, and countries will move at different speeds along this road. All new member countries submitted their convergence programs to the EC in May. Already meeting the key Maastricht criteria or being very close, a few countries joined the ERM-2 in June (Estonia, Lithuania, and Slovenia) and plan to adopt the Euro from January 2007. The Visegrad countries (in particular the Czech Republic, Hungary, and Poland) will need a longer period to bring fiscal deficits - and in some cases inflation (Hungary and the Slovak Republic) - under control, and will not be in a position to adopt the Euro until 2008-10. Sticking to convergence plans will be more important for credibility than the actual timeframe.

• Weak popular support for governments and political instability in some countries is complicating economic policy-making and reform implementation. Elections to the European Parliament in June were characterized by low voter turnout and poor support for incumbent governments in most countries (also the case in Western Europe). Meanwhile, political instability continued in several countries. This likely reflects rising income inequalities, high unemployment in many countries, doubts about the benefits of EU membership, and in some countries persisting governance questions. Meanwhile, populist movements have gained ground in several countries. This is complicating the implementation of key fiscal and other needed reforms.

Macroeconomic Policies and Developments

• The external environment weakened somewhat. Higher oil prices were no help to the wavering recovery in Europe, and higher inflationary pressures led to an increase in U.S. and U.K. interest rates as well as emerging market bond spreads.

• Output growth accelerated further, but inflation also increased. EU-8 output growth reached close to 6 percent in Q1-2004 as growth picked up in several of the Visegrad countries (notably Poland, Hungary, and the Slovak Republic) on the back of stronger domestic demand. Meanwhile, inflation ticked up in most countries, reflecting in part one-off factors related to EU accession.

• Monetary policy was appropriately tightened in some countries. With inflation rising toward target ceilings in Poland and the Czech Republic, and core inflation also edging up, both countries moved to raise interest rates in June. Meanwhile, the Slovak Republic continued to reduce interest rates and also intervened in the foreign

1 This report is based on information available through end-June, 2004.

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exchange market in an attempt to slow the appreciation of the currency. Slovenia also eased monetary policy further as inflation slowed. The current challenge is to control inflationary expectations and avoid temporary price increases feeding into wage settlements.

• Fiscal policy was supported by buoyant revenues related to high nominal output growth, but further underlying adjustment remains elusive. Most countries are on track to meeting fiscal targets in 2004, but reforms and measures that would support the planned reduction in deficits in countries where it is most needed have not yet been agreed or adopted. It is essential that budget plans for 2005 in these countries build in adequate flexibility to ensure that fiscal targets for next year will be met.

• Strong export growth did little to alleviate large current account deficits in several countries.

Special Topic: Regional Policy

• In addition to rapid growth (external convergence), countries also aim for balanced regional development (internal convergence), but there may be a trade-off in the medium term. The EU-8 countries target growth rates of 4-6 percent depending on their initial level of income, but at the same time National Development Plans aim for balanced regional development. Experience from existing EU member countries, including the cohesion countries, suggests that there may be a trade-off between external and internal convergence, at least over the medium term.

• Sound economic policies are key to reducing this trade-off. Securing macroeconomic stability, accelerating structural and institutional reforms, and pursuing a growth-oriented regional policy in the context of EU aid are the key elements in this regard. This includes measures to enhance labor market mobility and housing market flexibility.

• The National Development Plans under preparation for 2007-13 should be improved relative to existing plans. Notably, regional policy should be discussed in the context of broader economic and social objectives, financial and absorptive capacity constraints, and the comparative advantage of various policy instruments.

• EU aid and national co-financing should be directed toward the highest long-run economic returns. This likely includes investment in human capital and key infrastructure projects, particularly in support of emerging, market driven growth poles within countries, as well as spending aimed at improving the overall investment climate. Meanwhile, administrative and technical capacity needs to be strengthened – in particular at lower levels of government - to facilitate full and efficient absorption of EU aid. Needless to say, the additional spending should be consistent with medium-term fiscal consolidation plans.

3

EXTERNAL ENVIRONMENT

The external environment deteriorated somewhat in Q2-2004:

Global oil prices increased further, reaching a peak of around $40 (some 30% higher than the 2003 average). Estimates suggest that a $5 increase in oil prices lowers global growth by about 0.3% in the following year, while a 50% increase in prices results in an output loss of around 0.5% in the Euro area (IMF 2001; OECD 2001).

Other commodity prices also continued climbing (rising by over 25% during the past year).

Interest rates were raised in the U.S. and the U.K. as inflationary pressures mounted. The U.S. dollar strengthened somewhat vis-à-vis the Euro.

Emerging market bond spreads continued rising, reaching around 500 basis-points from a low of around 350 basis-points at the beginning of the year.

The recovery in Western Europe continued to waver, despite ECB interest rates on hold.

Medium-Term Policy

Plans

The new member countries will follow different roads to Euro adoption. The required plans for Euro adoption – Convergence Programs – were submitted to the European Commission (EC) in May. While complying with the key Maastricht criteria is no formal requirement for entry to the ERM-2, the new member countries have acknowledged that at least substantial progress in this regard is needed. Countries must spend a minimum of two years in the ERM-2 without adjustment of the central parity before they can adopt the Euro.

• Some countries (Estonia, Lithuania, and Slovenia) already fulfill the key Maastricht criteria and have fixed or stable exchange rates vis-à-vis the Euro. These countries were admitted to the ERM-2 in June and aim to adopt the Euro from January 2007. The two

EU-8 OVERVIEW OF EU-8

Convergence Programs, Selected Targets 2004 2005 2006 2007 2004 2005 2006 2007 GDP Growth Public Debt Czech Republic 2.8 3.1 3.3 3.5 40.5 41.8 43.2 44.0Estonia 5.3 5.8 5.6 5.9 5.4 5.1 4.7 3.4Hungary 3.4 3.8 4.0 4.3 59.4 57.9 56.8 55.6Latvia 6.7 6.7 6.5 6.5 16.2 16.8 17.3 17.7Lithuania 7.0 7.3 6.6 6.3 22.4 22.2 21.4 21.0Poland 5.0 5.0 5.6 5.6 49.0 51.9 52.7 52.3Slovakia 4.1 4.3 5.0 4.7 45.1 46.4 46.1 45.5Slovenia 3.6 3.7 3.8 3.9 29.1 29.5 29.4 28.4EU-8 4.7 5.0 5.1 5.1 33.4 34.0 34.0 33.5 Inflation Fiscal balance 2004 2005 2006 2007 2004 2005 2006 2007Czech Republic 2.8 2.6 2.2 2.2 -5.6 -4.9 -4.0 -3.5Estonia 3.1 3.0 2.8 2.8 0.7 0.0 0.0 0.0Hungary 6.5 4.5 4.0 3.5 -4.6 -4.1 -3.6 -3.1Latvia 4.5 3.7 3.0 3.0 -2.1 -2.2 -2.0 -2.0Lithuania 0.9 2.0 2.1 2.5 -2.7 -2.5 -1.8 -1.5Poland 1.7 2.0 2.1 1.9 -5.7 -4.2 -3.3 -1.5Slovakia 8.1 4.0 2.9 2.5 -4.0 -3.4 -3.0 -2.0Slovenia 3.3 3.0 2.7 2.6 -1.9 -1.8 -1.5 -0.9EU-8 3.9 3.1 2.7 2.6 -3.2 -2.9 -2.4 -1.8

Source: national Convergence Programs.

crude oil price, us$average spot price of WTI, UK Brent & Dubai crudes

0

10

2030

40

50

60

7080

90

197019721974197619781980198219841986198819901992199419961998200020022004

source: IM F

current us$

real 2004 us$

4

Baltic countries will retain their currency board arrangements in the ERM-2 with unilateral commitments to the fixed exchange rate. Slovenia aims to continue pursuing a stable exchange rate within the standard +/- 15 percent fluctuation band. The central exchange rates (per 1 Euro) for the new ERM-2 currencies are: 15.6466 kroon; 3.4528 litas; and 239.64 tolar. Reflecting the increasing certainty of their smooth conversion to the Euro, Fitch upgraded the sovereign ratings of the Baltic countries and Slovenia by one notch.

• Latvia aims to switch its peg from the SDR to the Euro and join the ERM-2 in January 2005 (in a narrow band of +/- 1 percent). Euro adoption would follow in January 2008. Inflation, while broadly complying with Maastricht criteria at end-2003, remains a concern.

• The Slovak Republic expects to reduce its fiscal deficit to 3 % of GDP and inflation to below 3 percent by 2006. It plans to adopt the Euro from 2008-09. These plans look feasible.

• Poland aims to achieve the fiscal deficit limit in 2007, but this will be a major challenge. Hungary and the Czech Republic have opted for less ambitious but perhaps more realistic fiscal adjustment paths, with deficits targeted to fall below 3 % of GDP only in 2008. Hungary also envisages only a gradual disinflation process, with inflation expected to remain above 3 percent through 2007. In all three countries, Euro adoption is unlikely before 2010.

Some convergence programs are based on optimistic macroeconomic assumptions (especially output growth) and not adequately underpinned by concrete policy plans. The ambitious fiscal adjustment plans in Hungary and Poland are based on relatively optimistic medium-term growth assumptions, while implied fiscal reform plans are not adequately spelled out or political support for plans uncertain. On the other hand, the fiscal adjustment plans for several other countries (including the Czech and Slovak Republics) are not very ambitious in view of the risks. In all Visegrad countries (except the Slovak Republic), fiscal adjustment measures of 2 percent of GDP or more are needed to comply with medium-term fiscal targets. While key expenditure reform measures have been elaborated in Poland, they mostly remain to be approved, and in any case are unlikely to be sufficient. Convergence programs also do not adequately address longer-term sustainability issues related to population aging. This was also broadly the view of the EC in its June 24 assessment.

Political developments

European Parliament (EP) elections in the EU-8 were characterized by low turnout and weak support for governments. Voter turnout was only 31 percent compared to an EU average of 46 percent. This likely reflects doubts about the benefits of EU membership, discontent with national politics and the perception that the outcome would have no particular impact on policies, as well as the fact that several other elections and referenda have taken place in several countries recently (including Slovakia, where the turnout was only 17% - the lowest in the EU). While in the majority of new member countries the opposition won, voters supported the ruling coalition in Slovakia and Slovenia. The eight new member states voted more for right-wing parties and parties without affiliation than other EU member states, although this was a general tendency across the continent.

Composition of European Parliament: Old versus New Percentage composition of EP: actual outcome of elections (EU), outcome in eight new member states (EU-8) and outcome in other states (EU less EU-8). Source: International Herald Tribune, 15 June 2004, and staff calculations.

Socialists Christian Democrats

Conservatists

Liberal Reformist

05

1015202530354045

EUL/

NG

L

GR

/EFA

PES

ELD

R

EPP-

ED

UEN

EDD

no a

ffilia

t.

EUEU-8EU less EU-8

5

Generally, popular support for governing coalitions in the EU-8 is on a downward trend, and political problems continue to surface. Political preferences for ruling coalitions have been on a steady declining path since late 2002, although EU accession in May appeared to be associated with some up-tick. This may, however, be more a manifestation of the typical political cycle rather than the reform agenda that governments pursue. While in Poland a new government led by Marek Belka was finally approved in June after two months of political impasse, its support remains weak and conditional on scaling back key reform plans and a new confidence vote in the fall. In the Czech Republic, Prime Minister Spidla stepped down following the very disappointing EP elections, and efforts are ongoing to form a new government.

Economic developments

Output growth accelerated further in Q1-2004. EU-8 output growth accelerated further to almost 6% (y-o-y) in Q1-2004, rising steadily from only around 4 percent in the second quarter of 2003. The EU-8 group is still led by the Baltic countries growing at an average of 7.8% y-o-y, but with growth returning to single-digits in Lithuania, and rapidly picking up in Poland, the Slovak Republic, and Hungary (6.9%, 5.5% and 4.2%, respectively), the “growth gap” between the Baltic and Visegrad countries appears to be narrowing. Output levels are approaching their potential - if they have not done so already - in most countries.

In the Baltic countries growth is still fueled by private consumption, with a negative contribution from net exports in Latvia and Lithuania (net exports switched to a positive contribution to GDP growth in Estonia. In the Visegrad countries, the picture is mixed, with net exports driving growth in the Slovak Republic and Poland, and domestic demand leading growth in Hungary and the Czech Republic. Fixed investment is increasingly contributing to economic growth, particularly in Hungary, the Czech Republic, Lithuania, and finally in Poland. However, growth and particular its composition was somewhat distorted in Q1-2004 by the imminent EU accession.

Decomposition of 2004Q1 growth, contribution of growth factors to total GDP growth

-6-5-4-3-2-101234567

PL HU CZ SK SI LT LV EESource: Staf f calculat ions; SI and LV: 2003q4

Consumption Fixed investmentStock Net exportGDP grow th

Meanwhile, inflation has been on an upward trend since mid-2003 with a further acceleration in Q2-2004. Inflation has picked up in virtually all EU-8 countries, mainly reflecting the surge in oil and other commodity prices (including food), ongoing administered price changes, one-off price adjustments related to EU accession (including new excise duties and adjustments to VAT), and the acceleration of demand. The various factors are difficult to

Political Preferences for Ruling Coalitions

50

63

75

88

100

11/02 2/03 5/03 8/03 11/03 02/04 05/04

Data for Czech Republic, Latvia, Poland and Slovakia, and staff calculations. Sources: Czech Academy of Sciences, SKDS and Statistical Office of Slovakia. November 2002 = 100.

6

disentangle, not least because of uncertain secondary effects. Core inflation also edged up in several countries, and PPI inflation now exceeds CPI inflation.

Box 1: Impact of higher oil prices on the EU-8 countries

The increase in oil prices affects inflation, the current account, and output growth. EU-8 countries are not significant producers of oil, with domestic production satisfying less than 10% of demand (1 million barrel per day). While countries have improved energy efficiency significantly during the 1990s, imports remain sizeable. The major energy source is natural gas, imported from Russia. They also depend on Russian oil, with the value of liquid fuel imports (oil and petrol) ranging between 1-3% of GDP. While estimates of the effects of higher oil prices are uncertain, including because of substitution, they are not insignificant. For example, structural estimates for Poland suggest that $5 permanent increase in oil prices imply an initial loss of 0.3% of GDP (IMF 2000). Staff calculations suggest that the first round effect on the current account average about -0.5% of GDP, if current high oil prices persisted for a year. The direct impact on consumer prices should be relatively moderate as fuel constitutes less than 5% of the average consumption basket (taxes account for about two-thirds of the final price). Therefore, a 30% increase in oil prices implies a less than 0.5% rise in the overall price index. However, most of the impact on inflation comes through second round effects: the pass through from PPI to CPI (PPI has a much higher fuel component) and a potential feed-back from higher prices to wages.

Estimated first round impact of high oil prices on the current

account, % of GDP Czech Republic -0.6 Estonia -0.7 Hungary -0.3 Latvia n.a. Lithuania 0.0 Poland -0.6 Slovakia -0.3 Slovenia -0.4 EU-8 -0.5 Sources: Energy balances from CSOs; and staff calculations.

EU-accession was associated with various direct or indirect price increases. Food prices have generally been rising since early 2003, but EU accession was associated with further price increases for many food products, particularly sugar, exotic fruits, and meat (reflecting increased demand from the EU for cheaper food in the accession countries). The adjustment of VAT and excise taxes affected different groups of goods in different countries (e.g. construction materials in Poland, pharmaceuticals, books and cinemas in Latvia, catering and household services in the Czech Republic, and heating in Lithuania). The magnitude of such one-off adjustments is estimated to be rather moderate, typically less than 1 percentage point.

With core inflation trending upward, some central banks moved to a tightening cycle. Interest rates were raised by 25 basis points in the Czech Republic and 50 basis-points in Poland. Meanwhile, the Slovak Republic continued to reduce interest rates in an attempt to stem upward pressure on the currency, and Slovenia also eased monetary policy further as inflation slowed. Ongoing interest cuts in Hungary were temporarily put on hold.

There was little progress in reducing underlying fiscal or current account imbalances where these are a major concern. Meanwhile, the external position remained strong in some countries (notably Poland, the Slovak Republic, and Slovenia).

HICP inflation in EU-8, %y-o-y

-2

0

2

4

6

8

03m1

03m2

03m3

03m4

03m5

03m6

03m7

03m8

03m9

03m10

03m11

03m12

04m1

04m2

04m3

04m4

04m5

simple average, source: Eurostat , CSOs

OverallNetFoodTransport & Energy

PPI & CPI inflation in EU-8,

%y-o-y

1

2

3

4

5

03m1

03m3

03m5

03m7

03m9

03m11

04m1

04m3

04m5

simple average, source: Eurostat, CSOs

CPIPPI

7

Reform developments The economic policy agenda in the second quarter of 2004 was dominated by EU accession and the preparation of convergence programs, and new, major reform initiatives in the region were few and far between. Public finance reforms in general and health care reforms in particular are at the top of the agenda in most countries (including Poland and Hungary). The Slovak Republic has moved the furthest in this area with the introduction of co-payments, and results so far have been encouraging. In Poland and the Czech Republic, progress on planned expenditure reforms was stalled because of the political situation.

POLAND The liberal PO was a clear winner in the European Parliament elections. The ruling parties had little support, gaining only 5 out of 54 seats. On the positive side, populists scored much lower than feared.

A new government led by Marek Belka was confirmed. After two months of bargaining, Mr. Belka was finally able to secure the support of the new splinter Social Democratic party (SdPl), but conditional on agreeing to a vote of confidence in October and watering down key pension reforms.

Key ministers from the previous government, including the architect of the fiscal reform plan, Mr. Hausner, have been retained. The government’s program has five points: (i) fight against unemployment, poverty, and social exclusion; (ii) benefiting from the first year of the EU membership and the full use of EU funds; (iii) putting the health care system in order; (iv) better management of state assets and privatization; and (v) Poland's military presence in Iraq. However, the three immediate tasks will be to: (i) push a critical health law through Parliament; (ii) prepare the 2005 budget; (iii) ensure that public debt does not breach key legal thresholds.

Macroeconomic developments were broadly favorable, but affected by EU accession:

Output growth accelerated further in Q1-2004. However, the remarkable growth rate of 6.9% (y-o-y) in Q1-2004 partly reflected extraordinary (2.5% of GDP annualized) stock building by firms in advance of the EU accession. The balance of demand improved somewhat, with growth continuing to be led by exports but also the beginning of a recovery in fixed investment. Data suggests that these trends continued into the second quarter. An EU-accession related spike in retail sales and industrial output in April was reversed in May. Unemployment remained stubbornly high at close to 20%.

Inflation gained momentum in Q2-2004. CPI inflation increased to 3.4% in May (just below the 3.5% target ceiling), and while this was partly due to one-off EU accession related factors and the surge in commodity prices (perhaps around 1 percentage point), all core inflation indicators also edged higher. Food prices accelerated further in the first half of June. The NBP reacted by raising interest rates by 50 basis-points in June, higher than expected by the market, and maintained its tightening bias.

Fiscal performance in 2004 has benefited from buoyant tax revenues, but the gains are not likely to be saved. Higher corporate tax revenues kept the central budget deficit through May at only 33.8% of the annual target, much better than in 2002 and 2003. Tax revenues in 2004 could be some 2-5 billion PLN higher than budgeted, but rather than using them to reduce the deficit, new spending promises have been issued and anticipated savings from the Hausner plan will not be achieved. On the

Central budget tax revenues

7

8

9

10

11

12

Jan Feb Mar Apr May

Source: M oF

2003

2004

8

positive side, local governments appear to be doing better than normal.

Budget plans for 2005 go in the right direction, but could be more ambitious. With a planned further real growth of expenditures of 0.9%, the nominal deficit target would decline to PLN 39 billion (4.1 percent of GDP) compared to a target of PLN 45 billion (5.3 percent of GDP) this year.

Progress on key expenditure reforms as well as privatization largely stalled, reflecting the political situation:

The Hausner plan bills sitting in Parliament moved nowhere, while the support for Mr. Belka of the break-away Social Democratic party was conditioned on a dilution of key reform measures (including pension indexation).

Urgent health sector reforms are under way, but important questions remain. Responding to the ruling by the Constitutional Tribunal that rendered the previous law invalid from 2005 (because of inadequate quality of public funds oversight resulting in a waste of public resources as well as undefined entitlements to health services), a new draft law was sent to Parliament. While addressing the entitlement issue by defining a so-called “negative basket” of health services, that would not be financed from public resources (and at the same time providing for the introduction of private supplementary health insurance), the draft law retains the current highly centralized and wasteful structure of health care provision and it is not clear how it is going to solve the issues challenged by the Constitutional Tribunal. Moreover, the proposed patient co-payments, while minimal, fell prey to political campaigning and were abandoned despite widespread consensus on their usefulness as part of the reform package.

There continues to be strong political resistance to private ownership in financial services and other strategic sectors.

World Bank activities. Two new operations (a roads maintenance project for Euro 100 million and a hard coal reform social mitigation project for Euro 160 million became effective in June. The next coal-sector operation, a mine closure loan for US$ 100 million, has been appraised and approved by the World Bank board. On the non-lending side, a Living Standards Assessment (LSA), Knowledge Economy Assessment (KEA), and Investment Climate Assessment (ICA) were published. A Country Financial Accountability Assessment (CFAA) and a WB/EIB Report on Tertiary Education in Poland have been completed, and a study on Directions in Regional Policy has been submitted to the government.

The IMF concluded its 2004 Article Consultation of Poland on July 12.

SLOVAK REPUBLIC Elections to the European Parliament had the lowest turnout in Europe but, in contrast to most other countries, resulted in victory for the government. Only 17% of voters turned out for the election, but the ruling coalition gained 51% of votes and 8 out of 14 available seats in the EP.

Ivan Gasparovic was elected new President in April. With the coalition presidential candidate, Eduard Kukan, out of the running, Ivan Gasparovic easily defeated Vladimir Meciar in the run-off, winning 60% of the vote. Gasparovic, with the support of Smer, won in 42 of the 50 electoral districts across the country. Meciar and Gasparovic were the two leading figures in the HZDS-led government in 1994-98.

2005 fiscal envelope

bn PLN 2003 2004 2005

Revenues 152.1 154.6 168.4 Expenditures 178.9 199.9 207.2

Deficit 26.8 45.3 38.8 Source: MOF. 2003 brought to rough comparability with 2004-2005 by adjusting for OFE transfers (staff estimates).

9

Macroeconomic developments have been very favorable so far in 2004:

Output growth accelerated to 5.5% in Q1-2004. Growth was led by exports at 16%, in particular automobiles, with net exports contributing 3 percentage points to growth. Additional stimulus came from gradually recovering private consumption.

The current account balance reached a surplus of Sk 4 billion in Jan-Apr 2004. This amounts to 0.2% of GDP and compares to a deficit of Sk 8 billion in the same period of 2003.

Headline inflation increased, but core inflation remained subdued and monetary policy was further eased. CPI inflation increased to 8.3% (y-o-y) in May. Meanwhile, core inflation remained subdued at 2.8%. The NBS continued lowering its interest rates by 50 basis points in late April and the same amount again in late June, bringing the two-week repo rate down to 4.5%. This was in reaction to upward pressures on the currency.

The fiscal outcome for 2004 could be better than budgeted . The state budget in Q1-2004 showed a Sk 1.2bn surplus compared with a Sk 17.8bn deficit in Q1-2003 (although the two are not directly comparable) on the back of strong revenue performance. As a result, the fiscal outcome for 2004 may turn out stronger than the target of -3.9 percent of GDP.

With pension reform completed, attention turned to health and education reform:

The second pension pillar consisting of mandatory pension funds, to be managed by private operators, will operate from January 2005. These funds are to be funded by a 9% contribution from workers’ wages. The new regulatory scheme is under preparation, and effective supervision will be key to the success of the 2nd pillar.

The new legislation on the third pillar of pension system will be submitted to the government in August 2004.

Important steps were taken to stabilize health care finances in H2-2003, including the introduction of small nominal fees, closure of some hospitals while decentralizing/ making autonomous others, requiring referral to higher level hospitals, and introducing online binding quotes for drug providers. This resulted in a decline in visits by 10% for general practitioners and 1% for inpatient care, while annual growth in consumption of medicine dropped from 14% in 2002 to 3% in 2003. The more substantive parts of the health care financing reforms aimed at ensuring sustainability of the are scheduled for the crucial second reading in Parliament in August/ September (this is a package of 6 laws aimed at making all hospitals autonomous, regulating the sector, and laying the foundations for the definition of a “negative” list of items that would not be covered by public health insurance while introducing private supplementary health insurance). In Slovakia private spending on health care is low compared to the OECD and other EU-8 countries.

Booming Exports in Slovakia

1,0001,1001,2001,3001,4001,5001,6001,7001,8001,9002,000

2001.1 2002.1 2003.1 2004.1

In EUR. Sources: Statistical Office of the Slovak Republic; and staff calculations.

10

Parliament opposed a law in the spring of 2004 aimed at establishing tuition fees and scholarships for tertiary education citing the possible negative impact on the poor. The government plans to submit a new law proposal in the fall.

Public finance management reform is progressing well. The 2005 budget process, which is well advanced, will be the first in which all chapters present their budgets in a programmatic and multi-annual format. A new Debt and Liquidity Management Agency is now fully operational and borrowing costs for the Slovak Republic have been reduced. Also, a Financial Policy Institute (FPI) in the Finance Ministry has been established, and its macroeconomic forecasts now form an important input to the budget. A Committee for Macroeconomic Forecasts chaired by the Minister of Finance and including the FPI, the National Bank of Slovakia, the Slovak Academy of Science, the Statistical Office, ING Bank, the Slovak Savings Bank, Tatra Bank and VUB Bank has been set up, and its forecasts are compared with those of the MOF. The process is one of transparent peer review and international best practice.

World Bank activities:

The World Bank’s Executive Board approved a new Country Partnership Strategy (CPS) for the Slovak Republic in May 2004. The CPS covers the period 2005-2007 and focuses on technical assistance and analytical work to support the government’s reform program. A modest lending program of up to $17 million is also envisaged. Priorities include assisting the government in improving fiscal consolidation and management of public finances; further implementation of structural reforms to enhance competitiveness of the economy; and social inclusion and poverty reduction.

The Slovak authorities have completed the Enterprise and Financial Sector Adjustment Program, as evidenced by the successful restructuring and privatization of the three large former state-owned banks, resolution through sale, closure or corrective action of all smaller problem banks, strengthening of bank supervision, and enactment of new legislation in the areas of banking, insurance, and securities markets, commercial law and secured lending. Additionally, satisfactory progress has been made towards resolving public sector arrears, taking bad loans off the books of the state banks, and preparing new laws and regulations on bankruptcy.

A Pension Policy Note is being prepared, work has started on a Living Standards Assessment, and technical assistance on Higher Education Financing is continuing.

Number of Visits in Ambulances Number of Hospitalizations Low Private Spending on Health

13,000,000

13,500,000

14,000,000

14,500,000

15,000,000

15,500,000

16,000,000

16,500,000

1H2002 2H2002 1H2003 2H2003

420,000425,000

430,000435,000

440,000445,000

450,000455,000

460,000465,000

470,000475,000

1H2002 2H2002 1H2003 2H2003

0

1

2

3

4

5

6

7

8

9

OECD Slovakia EU8

Public Private

Source: Ministry of Health Care, Slovakia. Source: Ministry of Health Care, Slovakia. In % of GDP. Source: OECD 2003

Health at Glance

11

HUNGARY Political situation. The opposition Fidesz won the European Parliament elections with 48% of the votes, while the ruling center-left coalition led by the Socialists gained only 42%.

Macroeconomic developments were mixed:

Output growth increased further to 4.2% in Q1-2004, increasingly driven by investment and exports. Household consumption growth has slowed with real wage growth moderating and the credit boom easing.

CPI inflation spiked to 7.6% (y-o-y) in May. However, around one-third of the increase in inflation in recent months is due to adjustments to the VAT system (the 0% rate was increased to 5%, the 12% rate was increased to 15%, and several items were moved to the highest 25% rate from January 1). Also, core inflation has picked up. Following the increase of 600 basis-points in interest rates in the second half of 2003, the NBH has been easing interest rates gradually in 2004 but put further cuts on hold since May. The inflation target is 3.5 +/- 1% by end-2005.

The current account deficit appears to have stabilized at around 9% percent of GDP since Q3-2004.

The fiscal deficit in 2004 is likely to exceed the revised official target of 4.6% of GDP (5.8% of GDP under GFS) by about ½ percent of GDP (this is still lower than the outcome of –5.9% of GDP in 2003) unless action is taken soon. 80-90% of the measures included in the February fiscal package were of a temporary nature, and further measures amounting to 2-3 percent of GDP are likely to be needed to achieve the official deficit target for 2005 (and further measures of 1-2 percent of GDP may be needed over the medium term). This reflects in part ongoing risks from off-budget activities and contingent liabilities. The contemplated postponement of part of 13th month pensions and government wages to January 2005 or further delays in capital spending will be of little help. The government plans to reduce revenues by 0.5 percent of GDP in 2005 while keeping capital spending unchanged, implying that current spending needs to be cut by 0.5 percent of GDP relative to 2004. It hopes to achieve this through streamlining of government, reduced health care spending, reduction in special government programs, and local government reform.

Fundamental reforms continue to appear illusive. Some progress has been made in preparing fiscal reforms, but much remains to be done to rationalize and improve the quality of health and education, downsize public sector employment, consolidate local governments, reduce subsidies, and address the longer-term challenges of population aging. Further tax reforms are also needed to reduce high labor taxes and the top VAT rate, while broadening tax bases.

Progress has been made on Army reform.

The government ordered an across-the-board 15% price cut on pharmaceuticals from April 1 2004, valid for 180 days. A new law was approved by the Parliament that gives the government full price-setting power over pharmaceuticals on a permanent basis beginning on January 1 2005. Subsequently, the government and pharmaceutical companies have concluded an agreement through 2007. Further, plans are being developed to introduce “health care managers.”

Tighter spending controls have been imposed on Ministries (spending of unused funds from previous years must be approved by the Minister of Finance).

Hungary, current account % of GDP

-10%

-8%

-6%

-4%

-2%

0%

02q4 03q103q2 03q3 03q4 04q1

Source: NBH

CA deficitservices account2

12

The government is trying to offer local governments financial incentives to consolidate, but the issue is now with the Constitutional court.

The finance ministry is developing a multi-year tax and budget reform plan. The plan is likely to include changes to or the elimination of the unpopular local business tax and certain state subsidy programs.

The IMF concluded its 2004 Article IV consultation of Hungary on May 10.

CZECH REPUBLIC Poor results in the European Parliament elections led to the resignation of Prime Minister Spidla. The EP elections brought defeat to the ruling three-party government coalition, led by the Czech Social Democratic Party (CSSD), which gained only 4 of total 24 seats. The CSSD did not support Spidla in a subsequent party vote, and he resigned as Prime Minister and party chairman on July 1. Stanislav Gross, the interior minister and deputy prime minister, was selected as new party leader and has been given the role of trying to form a new government.

Macroeconomic developments in early 2004 were generally disappointing:

Output growth weakened slightly in Q1-2004. Growth at 3.1%, slightly below the rate of the previous two quarters, was led by private investment and to a lesser extent private consumption, while the negative contribution from net exports increased further. Revised GDP series based on ESA95 were published by the Statistical Office on July 1.

Inflation picked up. CPI inflation increased to 2.7% (y-o-y) in May, the highest rate since April 2002. Indirect tax changes (mainly the introduction of VAT on phone calls, but also a shift of some items from the lower 5% rate to the higher rate - this was lowered from 22% to 19% percent from May 1) and oil prices are estimated to account for about 1 percentage point of the increase in inflation. However, core inflation is also edging up and expected to approach the 3% target during 2005. The CNB raised interest rates by 25 basis-points in June.

The current account deficit increased. The current account deficit reached 6.8% of GDP in Q1-2004. This reflected both a worsening of the trade balance and increased profit remittances.

The fiscal deficit is likely to increase to over 6 percent of GDP in 2004 (GFS). This would be the highest deficit (adjusted) in Czech history. Measures of up to 2% of GDP are likely to be needed to achieve medium-term fiscal targets.

The remaining privatization agenda has largely stalled, and while some progress has been made on fiscal reforms, much remains to be done. Some important expenditure reforms were introduced in the context of the first fiscal package in the fall of 2003 (notably tightening of sick-leave benefits; parametric changes to the pension system, including further increase in the retirement age for men to 63 years, tighter early retirement provisions, and commitment to stick to the minimum pension indexation provisions; certain changes to state social support, including cancellation of poorly targeted transport benefits, separation of family benefits from working income to improve work incentives, and reduced housing support), but fundamental social expenditure reforms, notably pensions and health, are on hold. The health care system is running large losses, and while the

General Government Balance: IMF and EC view

-14

-12

-10

-8

-6

-4

-2

0

1998 1999 2000 2001 2002 2003 2004

IMF definition

ESA95

Sources: IMF World Economic Outlook (April 2004); and EUROSTAT (Spring 2004 Economic Forecasts).

13

pension system finances should be stabilized through 2015, serious problems loom later on as the population ages. Also, there is a need to reduce high labor taxes. Further, there are signs that quasi-fiscal activities are continuing.

A new Budgetary Rules Law was approved by the lower house on June 30, calling for the approval of medium-term expenditure ceilings by Parliament (the 2004-06 MTEF for the state budget and state funds introduced in the fall of 2003 was by Government resolution only, and has not been effective). However, wider coverage would have been desirable.

The lowering of the high VAT rate was to be used for easing corporate taxation through shorter depreciation periods and increased tax allowances for R&D, but this has not yet happened. Higher tax credits are planned for low-income families in 2005.

There are plans to shift the management of health benefits to employers in return for lower health contributions to improve control.

SLOVENIA The ruling coalition fared relatively well in European Parliament elections gaining 46% of votes and three out of seven seats. The voter turnout was 28%.

The Slovenian People's Party (SLS) withdrew from the center-left governing coalition in April. Nonetheless, the coalition retains a stable 57% majority in Parliament. The center-left Liberal Democracy of Slovenia (LDS), which leads the government, remains the country's most popular party. The government sponsored non-binding referendum on restoration of rights of residence to several thousand non-Slovenian ex-Yugoslavs which were removed a decade ago was rejected. The issue has now been referred to the courts.

Macroeconomic developments were favorable:

Output growth accelerated to 3.7% in Q1-2004 (from an average of 2.3% in 2003).

CPI inflation declined to 3.8% in May. This compares to 4.6% in December 2003 and diverges from the trend seen elsewhere in the region. In April social partners adopted a wage policy agreement for 2004 and 2005 which links private sector wages to expected domestic inflation, expected inflation in the EU and expected movements in the SIT/EUR exchange rate (no longer to past domestic inflation). Real wage growth would be restrained to at least one percentage point below the rise in labor productivity. The BS continued its process of reducing interest rates, cutting these by 50 basis points in June (now 2.25 percentage points lower than in December 2003).

The current account in the first quarter recorded a small surplus. This reflected both favorable trade developments and a reduction in profit remittances.

The general government deficit in 2003 was revised down to 1.4% of GDP from the original estimate of 2% of GDP. The fiscal deficit in the first two months of 2004 amounted to only 0.2% of GDP thanks to buoyant revenues (in part related to one-off income from liquidation of the Slovenian Development Corporation).

Reforms. Slovenia is continuing to make progress in the liberalization of utilities and transportation, and health care reforms are currently under discussion.

CPI, annual index

0

1

2

3

4

5

6

7

8

Jul-02 Jan-03 Jul-03 Jan-04

Source: Statistical Office of the Republic of Slovenia

14

World Bank activities. The World Bank in partnership with the government of Slovenia published a book titled Slovenia: From Yugoslavia to the European Union. The contributors — many of them the architects of Slovenia’s current transformation — analyze the country’s three-fold transition from a command to a market economy, from a regionally based to a national economy, and from a part of the Socialist Federative Republic of Yugoslavia to a member of the European Union.

The IMF concluded its 2004 Article IV consultation of Slovenia on May 7.

LITHUANIA

In the European Parliament elections, 5 of 13 mandates were won by the Labor Party. The rest of the seats were split between 5 parties. The outcome of the elections seems to indicate that the opposition is gaining more support before the Parliamentary elections, scheduled for September.

Following a lengthy process, President Paksas was impeached. Valdas Adamkus narrowly defeated Kazimiera Prunskiene in the final round of elections for a new President. The pro-western Adamkus, who had been unexpectedly defeated by Paksas in the previous election, has stated he would ensure sustainability of Lithuania's foreign policy and pay closer attention to social affairs and internal issues.

Macroeconomic developments in the first half of 2004 present a mixed picture:

Real GDP expanded by 7.7% (y-o-y) in Q1-2004, slightly lower than in previous quarters. Growth was led by private consumption, but investment also expanded at a brisk pace. Meanwhile, import growth continued to outpace export growth, negatively affecting the overall growth rate.

After a prolonged period of deflation, the harmonized CPI index increased by 1.0% y-o-y in May. As in the neighboring countries, this increase reflects the higher oil and food prices as well as one-off price adjustments related to EU accession.

The current account deficit increased significantly in Q1-2004. The current account deficit reached 8.9% of GDP (compared to 3.8% of GDP in the corresponding period of 2003 and 6.9% of GDP in 2003). The increase was driven by rapidly growing domestic demand. The positive balance of services also worsened somewhat in the first months of 2004.

The fiscal deficit is expected to increase to 2.7 percent of GDP in 2004 compared to 1.7% of GDP in 2003. The budgetary stance does not seem to provide a sufficient safety margin against breaching the 3% of GDP deficit threshold in 2004-2005, including because growth projections for next year seem optimistic.

World Bank activities. The Bank hosted its first Development Marketplace in Lithuania in June. The event was organized in cooperation with the United Nations Development Program (UNDP) and the Baltic-American Partnership Program (BAPP). Over 200 representatives of Lithuania’s non-governmental, public and private sector organizations attended.

15

LATVIA The European Parliament elections on June 12 were won by two right-wing opposition parties (“Fatherland and Freedom” and “New Era” which received 4 and 2 seats respectively out of 9 total). Increasing popular support for these former coalition partners could spell trouble for the current minority government.

On the macroeconomic side, strong growth is continuing, but the external current account deficit remains large and inflation has increased:

Real GDP growth accelerated further in Q1-2004 to 8¾ percent (y-o-y) from 7½ percent in 2003. Growth continued to be led by domestic demand. Leading indicators suggest that strong growth continued in the second quarter.

CPI inflation surged to 6.2 percent (y-o-y) in May 2004 from 3.6 percent at end-2003 (PPI inflation reached 7.4 percent). The acceleration in inflation is largely explained by the rise in fuel and food prices, changes in regulated prices, tax increases related to EU accession (introduction of excise tax on fuel and VAT on pharmaceuticals), and the depreciation of the lats vis-à-vis the Euro. However, strong credit and domestic demand growth is also likely to be adding to inflationary pressures.

The current account deficit is expected to rise further to over 9 percent of GDP in 2004 from about 8½ percent of GDP in 2003 on the back of strong import growth. Nevertheless, competitiveness does not appear to be a serious concern. Net FDI is expected to increase in 2004 after a marked decline in 2003.

The fiscal deficit is expected to remain around 2 percent of GDP in 2004-07. Revenues are over-performing and a supplementary budget is planned for the fall. It is unclear how these fiscal plans are consistent with the objective of balancing the budget over the medium term, although the absence of a MTEF makes this difficult to assess.

There has been little further progress on reforms. Efforts are focused on combating corruption and money laundering, improving the business environment, and public sector reforms. However, privatization of energy and telecommunications companies is slow, and the civil service pay reform has been pushed back.

World Bank activities. Recent World Bank activities include a seminar on Enhancing Latvian Competitiveness in the EU. The World Bank is also currently preparing Implementation Completion Reports for the Welfare Reform project and the State Revenue Service Modernization project. Similar activities will be carried out in the near future for the Education Improvement and Health projects.

Latvia: Key Price Indices (% change y-o-y)

0

1

2

34

5

6

7

8

Jan-

03

Mar

-03

May

-03

Jul-0

3

Sep-

03

Nov

-03

Jan-

04

Mar

-04

May

-04

CPI PPI

Source: Statistical Office of Latvia.

16

ESTONIA The opposition Social Democrats won in the European Parliament elections, earning three out of six seats. The voter turnout was only 26.7%. The political situation has become more uncertain during the last few months. Although the current ruling coalition was able to maintain its position after the disagreements on the tax cuts last year, it seems that its future could be threatened by increasing contradictions within the coalition.

Output growth accelerated in Q1-2004 to 6.8%, driven by robust domestic demand but also a positive contribution from net exports. Inflation increased slightly in May reflecting mainly EU-accession related tax changes.

The fiscal situation remains favorable. The budget recorded a surplus of 2½% of GDP in 2003. Estonia continues its commitment to achieve a balanced budget, and has postponed the proposed reduction in income taxes until 2005. Looking further ahead, increasing health care costs and pressures from population aging are a concern. Estonia has recently adopted a multi-year budget framework.

High current account deficits persisted. Following a record-high deficit of 13% of GDP in 2003, the current account recorded a deficit of 12% of GDP in Q1-2004. This is driven by the ongoing credit boom and large profit remittances. Should an orderly and sequenced reduction of the external imbalance not materialize through a recovery of private domestic savings, a fiscal policy aiming at balanced budgets might not be sufficient to support the planned correction of the current account deficit.

The World Bank has no active projects in Estonia.

Current Account Deficit% of GDP

11.4 %

8 .6 %

4 .4 %5.5% 5.6 %

10 .2 %

13 .2 %

0%

2%

4%

6%

8%

10%

12%

1997

1998

1999

2000

2001

2002

2003

Source:Eest i Pank

17

Special Topic: Regional Policy in EU-8

1. Background

The eight Central European and Baltic countries joined the EU on May 1, 2004. While membership of the Union offers significant opportunities in terms of access to the internal market with free movement of goods and services (including factor services, although with some provisional arrangements for labor mobility) and to enhanced regional aid programs as well as support to agriculture through the Common Agriculture Program (again with some phasing in), it also poses significant challenges, including because of increased competition from both existing and other new member countries. It will be no panacea for rapid growth and external convergence or reduction in national income disparities (internal convergence). Average incomes in the EU-8 countries range from 40-80 percent of the EU average (lowest in Latvia and highest in Slovenia), and disparities between regions in individual countries are large, although on the whole no larger than in some other European countries. There will be a long period of catching up ahead, in some cases spanning several decades, and there may be a trade-off between rapid external and internal convergence, at least over the medium term.

This trade-off has been evident both in the accession countries and in existing EU member countries (Figure 1). Periods of rapid growth have typically been associated with rising internal income disparities, and the fastest growing countries over the last decade have in general experienced the largest widening of internal income disparities. This reflects the emergence of growth poles resulting from economies of scale and factor agglomeration. Some countries have supported such growth poles, while others have sought to counteract their effects through regulation and interventionist policies. Some countries have been more successful than others in managing this inherent trade-off and achieved more or less rapid convergence of all its constituent regions toward average EU income levels. This is mainly due to sound overall economic policies, but also to carefully designed national development strategies and regional

policies. Among the existing “cohesion” countries, Ireland has been the star performer. Figure 1a. GDP/Head and Regional Disparities Figure 1b. Growth and Regional Disparities (2000) (1995-2000)

Source: Eurostat.

Regional development has become an increasingly explicit part of overall economic policy objectives in the EU-8 countries in tandem with increasing national income disparities during the transition period and integration with the EU. In the early to mid-1990s, emphasis was more on assisting regions suffering from a decline in traditional industries, with interventions having more of an ad hoc character reflecting acute political pressures and scarce budgetary resources rather than being part of a well-defined and financed regional development strategy. This gradually changed with the pre-accession partnerships with the EU, including financial

60

70

80

90

100

110

120

5 15 25 35 45Disparities in GDP/head in PPS by region (NUTS2) within member states

UKFrance

BelgiumAustria

Ger.

ItalyFinland

SwedenNeth.

Spain

PortugalGreece

0.40.60.8

11.21.41.6

0 0.5 1 1.5 2 2.5 3Annual growth rate of disparities in GDP/head by region within

member stated (in log)

GD

P gr

owth

rate

(in

log)

Finland

SwedenNeth.

UKGreece

Port.Spain

ItalyGer.

Austria France

Belgium

18

support for regional development through various EU aid programs.2 With EU accession, significant increases in aid flows have been based on formal national and regional development programs agreed with the EU in the context of Community Support Frameworks for the largest new member countries and Single Programming Documents for the smaller ones. These initially covered the remainder of the current EU budget period through 2006, but in many cases remained more focused on how to use the additional funds rather than discussing the objectives, potential trade-offs, strategies, and programs and projects as well as the role of regional policy within broader economic and social objectives and policies. These challenges will be carried forward to the next EU budget and programming round through 2013, which is already being prepared.

2. Regional Disparities within the EU8 Countries

Regional disparities in GDP per capita

Regional economic disparities have generally widened significantly in the EU-8 countries since the mid-1990s. Developments in regional disparities have closely mirrored growth patterns, with the initial transition and negative output shock associated with declining inequalities and the recovery of growth being followed by rising disparities. As discussed above, this relationship between growth and regional income distribution is not unique to the transition economies.

Similar to the case in existing EU cohesion countries, the growth process has been led by the emergence of growth poles around the largest cities. While in most countries this has centered around the capital city and surrounding area, in Poland five metropolitan areas have rivaled Warsaw. Most countries are characterized by an absence of networks of small and medium-sized towns, except to some extent Czech Republic and Slovenia.

Table 1: Internal Disparities in Selected EU Countries

Highest GDP per capita / lowest GDP per capita,

2000

Coefficient of spatial variation. GDP/head,

2000

Highest Unemployment per

capita / lowest unemployment per

capita, 2001

Coefficient of spatial variation.

Unemployment, 2001 Poland 2.21 19.7 = 7.7 / 38.9* 1.88 18.9 Spain 1.99 20.3 3.66 39.2 Belgium 2.91 35.6 4.92 54.8 Portugal 1.44 21.1 2.59 34.3 Hungary 2.4 32.7 5.65 61.7 Czech Republic 2.69 46.3 4.53 45.2 Italy 2.19 24.8 8.27 77.1 Greece 1.69 13.6 2.72 28.3 Germany 2.83 24.7 5.45 52.7 France 2.08 19.6 2.93 29.9 *7.7% is the regional standard deviation of EU15 =100 for GDP/head (PPS) in 2000. 38.9% is the Polish GDP/head as a % of EU15 at the NUTS-2 level. Sources: Eurostat; Staff calculations. The highest regional income disparities are found in the largest countries (notably the Slovak and Czech Republics as well as Hungary), but they are also sizeable in the smaller countries (Slovenia and the Baltic countries).3 Thus, in the Slovak and Czech Republics, the richest regions have per capita incomes around 3 times higher than the poorest regions (Table 1). Measured differently, in these countries the 20 percent of the population living in the most prosperous regions have incomes that are twice as high as the 20 percent living in the poorest regions (in Hungary, the difference is even larger at 2.5 times). Or using yet another measure,

2 The EU Treaty calls for a reduction in disparities between the levels of development of the various regions and the backwardness of the least favored regions or islands, including rural areas (Article 158). Regional aid is provided through Structural Funds (PHARE which supports infrastructure development, SMEs, and employment; ISPA which supports environmental protection and transport development; and SAPARD which supports agriculture and rural development) and Cohesion Funds. 3 The four small countries are each defined as only region from the EU perspective.

19

in Hungary and Latvia one-third of the population account for more than 50 percent of GDP (Table 2).

However, regional disparities in GDP per capita (or unemployment) are generally no larger in the accession countries than among EU cohesion countries or in Italy and Germany that are characterized by a rich North (Italy) or West (Germany) and a poor South (Italy) or East (Germany).

Sources of regional income disparities

Regional income disparities reflect at their root historical and geographical factors, exacerbated by the transition process. Different productive structures have emerged, market access and infrastructure developments have varied, and factor concentration has occurred to exploit economies of scale and agglomeration effects. As a result, large productivity differences have emerged, while compressed wage structures have resulted in equally large differences in unit labor costs, competitiveness, unemployment, and poverty. In general, regions dominated by traditional state-owned industries have declined, as have rural regions dominated by agriculture and related industries where low productivity has been exposed in tandem with declining support and increasing competition. These are typically the most remote regions in the countries, furthest away from the new main markets in Western Europe or bordering other lower income countries or regions. Meanwhile, regions closer to Western markets and along major transport corridors have performed much better, benefiting from large FDI inflows and shifting toward production of services, consumer goods, and higher technology industry.

Factor concentration

This process has been associated with an increasing concentration of capital. Investment, including FDI, has been concentrated around the major cities, which from the outset also had the most developed tertiary education facilities and highest level of human capital and best infrastructure. These differences have been exacerbated over time, including because of low labor mobility not least among the older and less educated population. Poland generally has a lower concentration of factors reflecting its more dispersed centers of people and economic activity. Some examples:

The concentration of university graduates in the capital cities of the Czech and Slovak Republics as well as Hungary is 2-3 times higher than the national average.

In the Slovak Republic, the investment-output ratio is twice the national average, and in Poland more than one-half of all investment takes place in the largest cities. In both countries, the capital region invests about 7 times more per capita than the average region.

In the Slovak Republic, one-third of small- and medium-sized enterprises (SMEs) (less than 50 employees) are located in Bratislava region. In Poland, the number of SMEs is around 10 percent of the population in the major cities, around twice as many as in some other areas.

In Hungary and the Czech and Slovak Republics, close to two-thirds of inward FDI typically goes to the capital region. In Poland, the Warsaw region receives around one-quarter of FDI and two other regions with large cities (Lodz and Poznan) combined another one-quarter.

A similar pattern emerges for spending on research and development (R&D).

Productivity, wages and ULC; competitiveness and unemployment

These factors have resulted in large differences in productivity between regions, in particular between rural and urban regions and between traditional and new industries. In the Slovak Republic, for example, productivity in the Bratislava region is around 1.5 times the national

Table 2: Share of Population and Area Accounting for 50 percent of GDP Share of population/area accounting for 50% of GDP

population area # of regions

Poland 41% 27% 16

Hungary 34% 15% 7

Lithuania 39% 25% 10

Czech R. 39% 25% 8

Latvia 33% n.a. 5

Spain 40% 12% 18

Belgium 37% 18% 11

Italia 40% 29% 11

Portugal 38% 16% 7

Finland 41% 10% 6 Source: Eurostat, national stat offices, WB staff calculations

20

average and more than twice as high as in the weakest region. These productivity differences are not mirrored by equal wage dispersion, especially in industry. In Bratislava industrial productivity is more than twice the national average, while wages are only around 30 percent higher. Similarly in Poland, wages are somewhat higher in the Warsaw region, but more or less flat across the rest of the country. As a result, production costs (unit labor costs) diverge significantly, rendering some regions uncompetitive and exacerbating already high, structural unemployment:

In the Slovak Republic, unemployment varies between 6 percent in the capital city region and 25 percent in several, marginalized regions (Nitra, Banska Bystrica, Presov, and Kosice).

In the Czech Republic, unemployment varies between 4 percent in Prague and 13 percent in Moravia.

In Poland, unemployment is generally very high and variation thus less (between 17 and 26 percent).

In the Baltics, the Northeast region of Estonia and the Latgale region in Latvia have unemployment rates that are twice the national average.

Labor mobility

Low and skewed labor mobility has hindered a smoothing of regional income and employment disparities. Labor mobility is generally low, and the young and best educated people tend to be the most mobile thus potentially exacerbating the human capital gap between regions. While this is not a unique phenomenon in the EU-8 countries, but rather typical of Western European countries in general and some in particular, and many of the reasons are the same, it is even more of a problem owing to the major changes that are taking place in the economic landscape.

Low labor mobility undoubtedly reflects both cultural factors and skills mismatches that are not easily overcome, but also inadequate transportation links and imperfections in the housing market that make it difficult and expensive to move, even on a daily commuting basis (commuting is estimated to be less than one-third of the level in the existing EU member countries. Poorly developed financial markets also make it difficult to finance a move, even when this may be desired by individuals or families, resulting in a liquidity trap. Furthermore, there may be other important disincentives for labor to migrate within countries, in particular the compressed wage structure (including because of uniform minimum wages) and generous social transfers, not least when adjusted for differences in the cost of living.

Living standards

Real GDP per capita numbers may overestimate real income differences owing to commuting, income transfers, and differences in the cost of living. In Poland, for example, an adjusted measure has been computed (Gross Regional Disposable Income at Purchasing Power Parity), which reveals significantly smaller differences in living standards: in the Warsaw city region, GDP per capita is 3 times higher than the national average, but real disposable income only 50 percent higher. Similarly, in the Slovak Republic, differences in disposable income between the richest and poorest region is only around 30 percent, and price differences may well even this out.

Thus, several studies find no clear association between unemployment and poverty at the regional level. Employment and poverty is more closely linked to specific sectors or sub-sectors (for example workers from former state-owned farms in Poland, who do not own land), or even individual characteristics. Evidence from other countries (including the UK and France) shows that the initial distribution of human resources and increasing returns to education are behind most of the observed changes in income distribution, including between regions.

21

3. Regional Development Policies

EU aid and co-financing

Virtually all NUTS-2 regions in the new EU8 member countries (only exceptions are Prague and Bratislava) have incomes below 75 percent of the EU average, meaning that they are eligible for the main structural funds support under Objective 1. With country incomes below 90 percent of the EU average, all countries are also eligible for cohesion fund support.

The new EU-8 member countries will have access to EUR 22 billion during 2004-06 or around EUR 7 billion a year in financial support (1999 prices). Structural funds and national co-financing are likely to amount to around 25 percent of all public expenditure on structural investment. In the first short programming period upon EU accession, interventions will be limited to a number of priority areas to achieve maximum impact and simplify implementation. In the four largest new member states (Poland, Hungary, and the Czech and Slovak Republics), assistance will be implemented through Community Support Frameworks (accompanied by Operational Programs), and for others through Single Programming Documents. In all cases, the foundation for these frameworks are national development plans.

Programming, partnership, concentration, and additionality remain core principles of structural funds, but how funds are used is increasingly the responsibility of member countries. Except for large projects (over EUR 50 million), project selection rests with the member state or region.

National development plans

The national development plans (NDPs) generally reflect a mix of external and internal convergence objectives, although in some cases more explicitly than in others. They all aim at both growth and balanced regional development, and include similar strategies focused on enhancing competitiveness of industry, developing human resources, building infrastructure and transport links, restructuring agriculture and promoting rural development, and protecting the environment. Some countries (notably the Czech Republic, Hungary, and Slovenia) see development of tourism as a key element in their regional development strategy.

Some NDPs appear more geared toward supporting growth poles, including regional urban centers (e.g. the Slovak Republic and Latvia), others appear more focused on direct support to marginal regions (e.g. Estonia, Lithuania, and Slovenia), and others again have a larger focus on regions affected by the transition process. In part, these nuances reflect the particular situation in the different countries, but some also appear more market-oriented and less interventionist than others. This is hardly surprising given the variety of experience in the EU and the cohesion countries.

As a result, the allocation of funds between major programs (infrastructure, human resources, productive investment, and direct regional support) differs among the new member countries. Most countries have relatively large allocations for infrastructure, and relatively little for human resource development. Thus, in Poland, Slovenia, and the Czech Republic, about one-half of total resources are devoted to infrastructure investments, while the other half is split more or less equally between other productive and human capital investment (Table 3). In contrast, Ireland devoted more than one-third to human capital development.

Most programs identify a large number of different areas for intervention and often lack a clear focus and strategic vision. For many, there is only limited analysis of the interaction between structural funds and national policies. Overall economic and social objectives are not clearly defined, potential trade-offs not analyzed, constraints (financial and technical) not adequately discussed, and the comparative advantage of alternative policy instruments not identified.

22

Table 3: Sector Composition of Structural Funds in Selected EU Countries (Percent)

1989-1993 Greece Spain Italy Portugal Ireland EU-13* Poland Slovenia Czech Rep

Infrastructure Human resources Productive investment Others Total**

32 32 34 2

100

19.5 24.5

56 0

100

. 30

.

. 100

1994-1999 Infrastructure Human resources Productive investment Others Total**

46 24 30 0

100

37 24 30 8

100

35 14 50 1

100

30 27 39 5

100

20 31 45 4

100

30 25 41 5

100

2000-2006*** Infrastructure Human resources Productive investment Others Total**

43 19 26 12

100

42 25 28 4

100

37 20 40 3

100

22 24 38 15

100

49 36 15 0

100

34 24 35 7

100

53 22 23 2

100

50 24 25 1

100

52 20 26 3

100

*Without Denmark and Luxembourg; in the years 1989-1993 without Austria, Finland and Sweden. **Not necessarily 100 due to rounding. ***For new Member States it is 2004-2006. Sources: Staff estimates based on EC (1995, 2001); Poland (2003).

4. Policy Recommendations

Regional (or national development) policy should be formulated within a broader context that discusses country’s overall economic and social objectives, the constraints on achieving these (both financial and technical), and the available policy instruments

This would include a macro-fiscal framework consistent with achieving medium-term fiscal sustainability, as outlined in several countries’ recent convergence programs.

The significant delays in using pre-accession financial assistance demonstrates that this would also include a careful assessment of technical and administrative capacity constraints at different levels of government.

Such strategic considerations may well reveal some trade-off, at least over the medium term, between external and internal convergence. The impact of other policies on regional incomes and development would also be more clearly revealed.

In such a framework, it is likely that regional policy would emerge as best directed toward supporting market-driven growth poles, where rates of return are likely to be highest:

Investments in needed human and physical capital, in particular higher education and life-long learning programs, and key infrastructure, including communications and transport networks, and research and development.

Resources should also be used to support improvement in the general investment climate and strengthening of technical and administrative capacity, especially at the lower levels of government.

Public interventions should generally be focused on addressing market failures and externalities.

Not only are the benefits of such growth poles likely to spread, especially as they become increasingly connected, but other policies are also likely to be better suited for addressing regional income and development concerns, including not least fiscal and labor market policies.

Intergovernmental fiscal relations are key to dealing with disparities in regional income bases, training, education, and health policies should be used to support adaptation of skills and longer term strengthening of human capital, and targeted social safety nets

23

should be designed to protect those unable to acquire the needed skills or become employed.

Meanwhile, disincentives for labor mobility should be reduced so that people to a greater extent can and will move to where the jobs are. This includes improving transportation and housing facilities (especially the rental market) and reducing disincentives from social transfers and high reservation wages. Reform of the farmers’ pension system and more flexibility in the minimum wage are key in this regard.

Effectiveness of regional policies depend on sound and stable macro frameworks, a careful choice of strategic priorities, financial absorption (administrative and institutional capacity), and the quality of projects (effective selection and implementation systems).

Increased focus on Lisbon and Gothenburg priorities (knowledge and innovation) and in lagging regions on institutional capacity building.

Public-Private Partnership (PPP) arrangements attractive in view of co-financing requirements, budget constraints, need for efficient public services, growing market stability, and the process of privatization.

Evaluations suggest that either centralized or decentralized approaches are more efficient than intermediate solutions.

We encourage the national authorities in the EU-8 countries to keep these considerations in mind as they prepare their next National Development Plans for the period 2007-13. This would provide the best support for the countries, their constituent regions, and their citizens to converge rapidly toward EU living standards.

Sources:

National Development Programs; Community Support Frameworks and Single Programming Documents; Poland Regional Policy Study (2004, draft); Poland Living Standards Assessment (2004); Slovak Republic Development Policy Review (2003); Latvia Poverty Assessment (2004).

24

ANNEX EU-8 countries at a glance

2003 POL HUN CZK SVK SVN LTU LTV EST Population, mn 38.2 10.2 10.2 5.4 2.0 3.5 2.3 1.4 GDP per capita, US$d 5,228 7,755 8,097 5,811 10,170 4,978 4,265 5,863 CPI inflation, %y-o-ya 0.8 4.7 0.1 8.5 5.6 -1.2 2.9 1.3 GDP growth, %y-o-ya 3.7 2.9 3.1 4.2 2.3 9.0 7.5 5.1 Gen. government deficit, % of GDPa -4.1e -5.9 -12.9f -3.5 -1.8 -1.7 -1.8 2.6 Current account deficit, % of GDPa -2.0 -8.9 -6.5 -0.9 0.1 -6.9 -8.7 -13.2 Unemployment rate, % labor forcea 19.9 5.8 7.8 17.4 6.7 12.4 10.6 10.0 interest rate, comm. LT lendinga 5.8 10.5 5.1 7.5 10.2 5.4 5.2 5.4 Gen. government debt, % of GDPbc 45.1e 57.9 30.7f 45.1 27.4 23.6 14.4 2.8 External debt, % of GDPd 45.5 34.5 34.4 49.0 71.9 41.4 85.8 72.3

Ruling party/coal. (% support in polls) low medium-low low low high medium low medium-

low Changes since last Report in bold. a-year average, b-year end, c-estimated, d-latest data, e - excludes open pension fund related debt and deficit (as reported by Eurostat), f –includes a guarantee-related deficit and debt of agencies (as reported by Eurostat) Source: National Statistical Offices, World bank, EC, Eurostat, ECB, OECD, staff assessment

The Maastricht Criteria and EU-8, 2003 EU-8

Harmonized Inflation

Interest ra

Fiscal balance

Public debt

Maastricht

EU-8

Poland Harmonized Inf lation

Interest rate

Fiscal deficit

Public debt

Maastricht

Poland

Hungary Harmonized Inflation

Interest rate

Fiscal deficit

Public debt

Maastricht

Hungary

Czech Harmonized Inflation

Interest rate

Fiscal deficit

Public debt

Maastricht

CzechRepublic

Slovak Harmonized Inflation

Interest rate

Fiscal balance

Public debt

Maastricht

Slovakia

Slovenia Harmonized Inflation

Interest rate

Fiscal deficit

Public debt

Maastricht

Slovenia

Lithuania Harmonized Inflation

Interest rate

Fiscal deficit

Public debt

Maastricht

Lithuania

Latvia Harmonized Inf lation

Interest rate

Fiscal def icit

Public debt

Maastricht

Latvia

Estonia Harmonized Inflation

Interest rate

Fiscal deficit

Public debt

Maastricht

Estonia

The Maastricht criteria: inflation 2.9%, Interest rate 6.1%, Fiscal balance –3% of GDP, and Public debt 60% of GDP. Source: EUROSTAT

25

Forecasts 2004 2005 CNS EC GOV IMF OECD WB CNS EC GOV IMF OECD WB GDP Czech Republic 3.2 2.9 2.8 3.0 3.1 3.6 3.4 3.1 3.4 3.4 Estonia 5.4 5.3 5.5 5.0 5.9 5.8 5.0 5.0 Hungary 3.4 3.2 3.4 3.2 3.3 3.2 3.9 3.4 3.8 3.4 3.8 3.7 Latvia 6.2 6.7 6.5 6.0 6.2 6.7 6.0 6.0 Lithuania 6.9 7.0 6.7 6.2 6.6 7.3 6.3 6.2 Poland 5.4 4.6 5.7 4.7 4.7 5.5 5.2 4.8 5.0 4.0 4.5 4.7 Slovakia 4.4 4.0 4.1 3.9 4.3 4.0 4.8 4.1 4.3 4.1 4.8 4.0 Slovenia 3.2 3.6 3.5 3.6 3.7 4.1 CPI Czech Republic 3.1 2.8 2.8 3.5 3.0 3.0 2.8 2.6 3.0 2.5 Estonia 2.8 3.1 3.0 3.8 2.9 3.0 2.5 3.0 Hungary 6.5 6.9 6.5 6.5 6.9 6.5 4.5 4.6 4.5 4.2 4.8 4.9 Latvia 4.0 4.5 5.0 4.5 3.5 3.7 3.0 3.0 Lithuania 1.0 0.9 1.1 1.0 2.2 2.0 2.5 2.8 Poland 2.8 2.3 2.5 3.0 1.8 2.7 3.3 3.0 2.8 2.4 3.0 2.6 Slovakia 7.8 8.2 8.1 7.8 7.6 7.8 3.7 4.5 4.0 4.2 3.0 3.7 Slovenia 3.6 3.3 3.7 3.2 3.0 3.3 Fiscal deficit Czech Republic -5.9 -5.6 -5.6 -8.4 -5.1 -4.9 -5.2 -8.1 Estonia 0.7 0.7 0.8 0.6 0.0 0.0 0.0 -0.1 Hungary -4.9 -4.6 -4.6 -5.2 -5.2 -4.3 -4.1 -3.6 -4.6 -4.6 Latvia -2.2 -2.1 -2.2 -2.0 -2.0 -2.2 -1.9 -2.0 Lithuania -2.8 -2.7 -2.8 -2.5 -2.6 -2.5 -2.4 -2.1 Poland -5.0 -6.0 -5.7 -7.4 -5.7 -7.0 -4.3 -4.5 -4.2 -7.0 -5.5 -6.0 Slovakia -4.1 -4.0 -4.0 -4.0 -4.0 -3.9 -3.4 -3.8 -3.7 -3.9 Slovenia -1.7 -1.9 -1.7 -1.8 -1.8 -1.6 Current account Czech Republic -6.5 -6.8 -6.2 -5.4 -6.2 -6.5 -6.6 -6.0 -4.8 -5.9 Estonia -11.5 -13.0 -11.0 -10.8 -9.1 -11.4 -7.5 -9.6 Hungary -5.4 -8.5 -5.3 -8.5 -8.2 -5.1 -8.0 -4.3 -7.6 -8.0 Latvia -10.1 -9.0 -9.3 -8.8 -10.9 -8.8 -8.1 -8.1 Lithuania -6.2 -5.3 -6.7 -5.7 -5.9 -5.3 -6.7 -5.5 Poland -2.0 -2.3 -2.6 -2.3 -2.5 -2.2 -2.3 -2.8 -3.0 -2.9 -2.4 -2.5 Slovakia -1.7 -2.5 -2.0 -2.9 -1.7 -2.3 -2.4 -4.0 -2.7 -3.5 -2.9 -3.8 Slovenia -0.5 -1.3 -0.6 -0.6 -1.0 -1.0 Unemployment rate Czech Republic 8.2 8.5 9.6 8.3 8.2 8.7 9.3 8.3 Estonia 9.7 10.0 9.3 9.6 9.4 8.9 Hungary 5.9 5.7 5.9 6.2 5.9 6.0 5.6 5.9 6.7 5.7 Latvia 10.3 9.9 10.5 10.1 9.2 10.0 Lithuania 11.5 11.3 10.0 10.7 10.3 9.7 Poland 19.0 19.6 19.5 19.4 19.7 18.1 19.3 18.8 16.9 19.2 Slovakia 16.1 16.5 16.4 15.4 16.6 15.4 15.9 15.9 14.9 15.5 Slovenia 6.4 5.9 6.7 6.2 5.5 6.4 Notes: CNS national Consensus report, EC European Commission, GOV Government. Source: CNS: national Ministry of Finance. EC: Spring 2004 Economic Forecasts. GOV: Convergence Programs, except of Slovenian current account and unemployment rate – latest PEP. IMF: World Economic Outlook, April 2004, except of Hungary and Slovenia – IMF Article IV Consultation, Staff Report, May 2004. OECD: OECD Economic Outlook May 2004. WB: WB Regional ECA Database. Data for Slovakia updated.

26

Exchange rates source: ISI Emerging Markets (vertical axes span an approx. +/- 7% range). LTU, EST, LVA not shown (currency boards for LTU and EST; +/- 1% SDR peg for LVA). Eurobond spreads source: Bloomberg (relative to comparator German bonds). Vertical lines: 1y average (bold), 1y average +/- 1 st. deviation (dashed), and 1y min/max (thin line). Diamond: 6 months ago; square: 1 year ago.

Recent Quarterly Indicators

GDP growth, %y-o-y

Inflationa, %y-o-y

Current Accountb, % GDP

Unemployment Ratea, % of labor force

2002 2003 03q4 04q1 2002 2003 03q4 04q1 2002 2003 04q1 2002 2003 03q4 04q1

Czech R. 1.5 3.1 3.3 3.1 1.8 0.1 0.9 2.4 -6.0 -6.5 -6.7 7.3 7.8 8.1 8.7 Estonia 7.2 5.1 6.2 6.8 3.6 1.3 1.0 0.4 -10.2 -13.2 -12.0 10.3 10.0 9.3 10.1 Hungary 3.5 2.9 3.6 4.2 5.3 4.7 5.4 6.8 -7.1 -8.9 -9.1 5.8 5.8 5.5 6.1 Latvia 6.4 7.5 7.5 8.8 1.9 2.9 3.5 4.3 -7.6 -8.7 -9.4 12.0 10.6 10.3 11.5 Lithuania 6.8 9.0 10.6 7.7 0.3 -1.2 -1.3 -1.2 -5.2 -6.9 -8.9 13.8 12.4 11.6 13.0 Poland 1.4 3.7 4.7 6.9 1.9 0.8 1.5 1.6 -2.7 -2.0 -1.6 19.7 19.9 19.3 20.7 Slovak R. 4.4 4.2 4.7 5.5 3.3 8.5 9.6 8.3 -7.9 -0.9 0.0 18.5 17.4 17.4 19.3 Slovenia 3.4 2.3 2.5 3.7 7.5 5.6 4.9 3.7 1.4 0.1 0.2 6.4 6.7 6.7 6.8 a\ period average; b\ four-quarter rolling ratio; Source: CANSTAT Bulletin, National Statistical Offices, Staff calculations

Poland

4.3

4.4

4.5

4.6

4.7

4.8

4.9

Apr May Jun

Hungary

240

245

250

255

260

265

270

275

Apr May Jun

Czech R.

30

31

32

33

34

Apr May Jun

Slovak R.

38

39

40

41

42

43

Apr May Jun

Slovenia

220

225

230

235

240

245

250

Apr May Jun

Poland

48

121620242832364044485256606468

Apr May Jun

Hungary

48

121620242832364044485256606468

Apr May Jun

Czech R.

48

121620242832364044485256606468

Apr May Jun

Slovak R.

48

121620242832364044485256606468

Apr May Jun

Slovenia

48

121620242832364044485256606468

Apr May Jun

Lithuania

48

121620242832364044485256606468

Apr May Jun

Latvia

48

121620242832364044485256606468

Apr May Jun

Estonia

48

121620242832364044485256606468

Jan Feb Mar

EMBI+ spread

350

370

390

410

430

450

470

490

510

530

550

570

590

610

630

650

670

690

Apr May Jun

--- S h o r t t e r m s t a b i l i t y i n d i c a t o r s ---Exchange rate, LCU/Euro

Eurobond spreads

27

__________________________________________________________________________________

Warsaw Office 53 Emilii Plater St, 00-113 Warsaw

Tel (+48 22) 5208000, Fax (+48 22) 5208001, www.worldbank.org.pl Roger Grawe, Country Director Central Europe and Baltics

Thomas Laursen, Lead Economist, Central Europe and Baltics Marcin Sasin, Country Economist (Poland, Hungary)

Bratislava Office Vilnius Office Riga Office European Business Center Jogailos St 4, 2001 Vilnius Smilsu St 8, 5th floor Suche myto 1 Tel (+370 5) 2107680 1162 Riga 811 03 Bratislava Fax (+370 5) 2107681 Tel (+371 7) 220744 Tel (+421) 257526721 Mantas Nocius, Country Manager Fax (+371 7) 814245 Fax (+421) 257526701 Dina Grube, Manager Ingrid Brockova, Country Manager Andrejs Jakobsons, Country Economist Anton Marcincin, Country Economist (Latvia, Estonia, Lithuania) (Slovakia, Czech Republic, Slovenia)