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A joint initiative of Ludwig-Maximilians-Universität and the Ifo Institute for Economic Research
VOLUME 8, NO. 1
Forum
SPRING
2007
Focus
CHINA AND INDIA
Peter Mandelson
Assar Lindbeck
Raphael Kaplinsky
Nirvikar Singh
Friedrich Sell
Supplement
EMU ENLARGEMENT:
A PROGRESS REPORT
Marek Dabrowski
Specials
THE 2008/2009
EU BUDGET
AIRLINE
REVIEW OF THE
EMISSIONS OF
CARBON DIOXIDE
Iain Begg
John FitzGerald and
Richard S. J. Tol
Spotlight
RECENT
ECONOMIC GROWTH FOR
EMERGING
ASIAN
COUNTRIES
Trends
STATISTICS
UPDATE
CESifo Forum ISSN 1615-245X
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Reproduction permitted only if source is stated and copy is sent to the Ifo Institute
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Forum
Volume 8, Number 1
Spring 2007
_____________________________________________________________________________________
Focus
CHINA AND INDIA
Europe’s trade policy with India and China
Peter Mandelson
3
China’s reformed economy
Assar Lindbeck
8
The impact of China and India on the developing world
Raphael Kaplinsky
15
The dynamics of reform of India’s federal system
Nirvikar Singh
22
Anticipated effects of foreign currency reserve diversification in Asian countries:
Do China and India matter for coordination?
Friedrich L. Sell
32
Supplement
EMU enlargement: A progress report
Marek Dabrowski
39
Specials
The 2008/2009 review of the EU budget: Real or cosmetic?
Iain Begg
45
Airline emissions of carbon dioxide in the European trading system
John FitzGerald and Richard S. J. Tol
51
Spotlights
Recent economic growth and challenges for China, India and other
emerging Asian countries
55
Trends
Statistics update
57
Focus
CHINA AND INDIA
effective integration of China and India into the
global trading system and the establishment of reciprocal access to their growing markets for EU
exporters is a key dimension of EU trade policy.
EUROPE’S TRADE POLICY
WITH INDIA AND CHINA
PETER MANDELSON*
China and India are of course different. They have
different traditions and political systems. They are
following their own paths to development, at their
own pace and based on their own distinct economic
models. And the EU’s policies towards them must be
distinct. But these emerging giants represent a third
of humanity and their reintegration into the global
economy will have huge implications. The EU needs
a coherent strategy for responding. What follows is a
brief assessment of what I regard as the key political
challenges posed by that policy.
E
urope’s political contact with the civilizations of
India and China began with trade. Dutch merchants opened up trade with the coastal Indian states
and then China, and the trade that followed fed a
growing European fascination with Asian cultures
and aesthetics. From India, European merchants
brought textiles, ivory and wooden furniture. From
the Middle Kingdom, the blue and white porcelain
so ubiquitous in seventeenth century Europe that it
became known – and is still known – simply as
China. Four hundred years ago India and China
accounted for half of the world’s economic output.
They remained the two largest economies in the
world until the nineteenth century.
EU-China trade relations
China’s rise has exerted serious pressure on many
European industries, especially in labour intensive
manufacturing. This is a painful adjustment for many
and it is generating significant political pressures.
China is forcing European companies to compete
harder both for their own markets and for export
markets. To a much greater extent than India, whose
8 percent growth is built largely on growing domestic demand, the Chinese focus on export-led growth
has meant a much more assertive posture in
European and global markets. India’s trade accounts
for 1 percent of all trade in goods while China’s is
closer to 8 percent. The increase in China’s trade in
2004 alone was greater than India’s total foreign
trade. China has just become Europe’s largest
import partner and runs a sizeable trade surplus with
Europe.
From an historical perspective, the economic rise of
India and China looks more like the reassertion of
an older and deeper economic order briefly interrupted by the colonial period, Cold War and economic autarky in the twentieth century. From the
perspective of a human lifetime – which is the only
perspective that matters in politics – it is nevertheless part of a seismic shift in the global economic
architecture and one that will have profound political consequences. We live in an economically multipolar world and global politics will soon reflect this
much more explicitly.
China’s manufacturing economy and – to a much
lesser extent – India’s services economy are already
driving deep and painful economic change in
Europe. As the two most salient parts of a rapidly
changing global economy, Europe’s political response to the rise of China and India is likely to be
emblematic of its response to globalization itself.
The large increase in manufactured exports to
Europe from China is chiefly a result of a wider
restructuring of export markets in Asia as a whole,
either through relocation to China from other parts
of Asia or exploitation of China’s role as an entrepot. EU imports from Asia have remained stable at
20 to 25 percent of import trade over the last decade.
But these nuances are not reflected in the popular
Alongside the successful completion of the Doha
Round and the maintenance of the WTO system, the
* EU Trade Commissioner.
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CESifo Forum 1/2007
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process in 2001. China’s average tariff of 8.8 percent
for industrial products is the lowest among the
emerging economies, although serious tariff peaks
remain in key industrial goods like automobiles, textiles and shoes. Moreover, it is not unreasonable to
argue that China’s extraordinary export capacity
and the fact that it will be the largest exporter in the
world by 2010 mean that its political benchmark is
not to be found in the developing world. The EU has
engaged the WTO’s dispute settlement machinery
in testing China’s continued practice of applying tariffs for whole vehicles to imports of vehicle parts – a
practice it explicitly committed to ending on WTO
accession.
European assessment of China’s strength and competitive challenge. There is a political perception in
many parts of Europe that China has grown at
Europe’s expense.
Nevertheless, on balance the EU benefits much
more economically from China’s openness and economic strength than it suffers from the increased
competition in some sectors. By 2010 the Chinese
middle class will number 150 million and its market
for high value goods will be worth more than a trillion euros a year. Its markets for key EU exports will
be concomitantly large: by 2010 it will be the biggest
consumer of wine globally; its market for green technology will be worth 100 billion euros a year and its
market for business services 500 billion euros.1
These unfulfilled commitments extend into the services and investment sectors. China committed to a
limited opening of its telecoms sector when it joined
the WTO in 2001, but despite having subsequently
allocated 16,000 telecoms licenses, only five have
been granted to foreign providers. EU companies
are still prevented from freely choosing joint venture
partners and are often subject to enforced technology transfers through obligatory joint ventures and
local content requirements. In investment, China
maintains ownership and capital caps of between
20 to 25 percent on foreign investment in the banking sector. Branches of foreign banks in China are
subject to discriminatory capitalization requirements relative to local banks. There remains a huge
array of non-tariff and regulatory barriers to the
Chinese market for EU exporters.
European companies have played a significant part
in the flow of capital into Chinese production that
has resulted in more than half of Chinese export
capacity being capitalized by non-Chinese companies. Chinese supply chains allow EU companies to
remain competitive by relocating labour intensive
production out of Europe while keeping management, design and retail in Europe. The OECD has
estimated that cheap goods and inputs from China
help depress inflation by 0.2 percent for 2001 to
2005, with a consequent beneficial decline of interest
rates. A Dutch study suggested that the average
European family saves about 300 euros a year
through cheaper Chinese goods; a benefit that is
largely skewed towards Europe’s poorest consumers. Politicians that advocate large tariff increases for legitimately traded Chinese imports usually
ignore the fact that such tariffs would be socially
regressive, impacting chiefly on poorer consumers of
Chinese-produced clothes, shoes and toys.
Agreements on patents, data exclusivity and intellectual property rights are also still poorly enforced in
China, with serious costs for EU companies operating in the Chinese market. A recent EU study cited
an estimate by EU manufacturing industry in China
that intellectual property fraud costs EU businesses
in China 20 percent of their revenues.
These existing and potential benefits are seriously
qualified by continued problems with access to the
Chinese markets both for exports and investment.
This is expressed at the simplest level by the fact that
for every four containers leaving Shenzhen in China
for Europe, three are still returning empty.
The Chinese government is increasingly recognising
the extent to which poor protection of intellectual
property is affecting China’s own innovation culture
– the Chinese film and music industry, for example, is
being seriously undermined by local piracy. China’s
manufacturing sector remains heavily characterised
by low levels of value-added production and this is
unlikely to change unless Chinese companies have
the confidence to invest creative capital. In 2006
China overtook Germany to become the world’s
fifth biggest filer for patents, but there exists a serious imbalance between legal security and effective
It is true that China is already far ahead of almost all
other emerging economies in opening its market to
trade, chiefly through the heavy pressure on
Chinese tariffs exerted by the WTO accession
1
A recent study commissioned by the European Commission set
out the benefits on a sector-by-sector basis. For details see
http://ec.europa.eu/trade/issues/bilateral/countries/china/pr190207
_en.htm
CESifo Forum 1/2007
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Focus
ing of the strength of protectionist sentiment in
Europe and the United States.
access to enforcement for foreign and domestic companies. This will remain a key focus of EU trade policy in China.
Obviously, Europe has its own responsibilities.
Europe has no interest in challenging the exercise of
legitimate comparative advantage in labour or production costs. Europe for its part must commit to
helping China assume full market economy status
and offering open and fair access to China’s exports,
and it must adjust to the tough Chinese competitive
challenge. We cannot demand openness from China
from behind barriers of our own.
There are other structural trade barrier issues that
Europe will continue to urge China to address. The
focus on export-led growth rather than domestic
consumer demand, and high levels of precautionary
saving by Chinese consumers restrains the necessary
development of a growing consumer economy and
acts as a brake and barrier to others’ exports to
China which would re-balance trade. China’s banking system and financial infrastructure is bending
under the strain of rapid development and needs
urgent reform.
EU-India trade relations
The Indian market has similar potential for Europe,
qualified in the same way by serious obstacles to
market access. India’s growing middle class and
booming services sector are obvious assets for EU
exports and EU capital.
State intervention in the manufacturing sector in
China also remains a persistent problem and this has
resulted in a growing number of anti-dumping cases
against China. Many of these have touched on consumer durables such as leather shoes and have thus
been politically highly sensitive. China’s perennial
complaints about such trade defence action are
disingenuous given the level of state intervention in
China and the degree of restraint shown by the
European Union. They also tend to obscure both the
fact that trade defence measures apply to less than
2 percent of all EU-China trade and that China is
also a big user of anti-dumping.
India invokes none of the anxiety that China does
for the simple reason that it remains a small exporter
to Europe. Much of its economic impact on Europe
has been at the politically less visible level of the services sector. This seems likely to change as India’s
massive capacity and competitiveness in services –
described in books like Thomas Friedman’s and
Clyde Prestowitz’s – is brought to bear on the IT and
IT support sector in Europe and the US. India is also
an increasingly active investor in Europe. Since 2000,
Indian companies have invested more than $10 billion in Europe – a fivefold increase in the last
decade. Indian firms like Infosys, TCS, HCL, Wipro
and Birlasoft have all made impressive inroads into
the EU market, of which the Mittal Steel bid for
Arcelor was only the most dramatic example – not
least because of the unjustifiable defensiveness it
provoked in Europe.
Europe and China are now in the initial stages of
negotiating a new trade and investment agreement
that will start to address some of these issues. But it
seems undeniable that market access in China will
remain a key challenge and a key focus of resources
for EU trade policy for the foreseeable future.
It is also likely to remain the EU’s most heavily
politicized trade relationship. The perception that
China and Europe do not trade on genuinely reciprocal terms encourages a protectionist response that
will only be deflected by more concerted efforts
from China to trade fairly and meet its market access
obligations. A large and resentful constituency in
Europe that has been at the sharp edge of China’s
exploitation of its comparative advantages in lowcost manufacturing has little patience with economic
arguments for the overall economic benefits of
openness to China. China is deeply dependent on
market access to developed economies, but sometimes appears to be willing to call the bluff of those
who argue that that access will ultimately depend on
greater reciprocity. That may be a strategic misread-
Yet this data is chiefly striking in the extent to which
it suggests untapped potential. India still accounts
for only 1.5 percent of world services trade and
1 percent of global merchandise trade despite the
fact that Indians make up one sixth of the world’s
population.
Europe’s exports to India are hardly negligible but
they account for less than 2 percent of our goods
trade and less than 2 percent of EU outward FDI
flows, which is totally out of proportion to India’s
population and the size of its market. In 2003,
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CESifo Forum 1/2007
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huge powers at its heart is fanciful. Their joint leadership and example both among emerging economies and developing countries will be decisive in
reassuring the developing world that the multilateral trading system and progressive trade liberalization
can reflect their interests.
European FDI into India’s was just under 4 billion
euros whilst China’s was 47 billion euros. 1 percent
of global foreign investment goes to India and
15 percent to China.
India’s historically high tariffs have been coming
down through unilateral reform. Its average applied
industrial tariff of around 15 percent is exceptional
for an emerging economy, but it is still twice that of
China and average bound tariff rates are twice as
high. Border protection is sometimes discriminatory,
an issue the EU has recently raised in its WTO consultations over Indian duties on EU wines and spirits, which at 500 percent are some of the highest in
the world.
Equally important will be the acceptance by both
China and India that their growing power creates a
growing obligation to open their markets, not least to
other developing countries. South-south trade
remains the most heavily obstructed trade in the
global economy. With tariffs at historically low levels
in the developed world, the future of tariff liberalization lies largely in the developing world.
Behind the anxiety of many developing countries in
Asia, Africa and Latin America to commit to trade
liberalization is fear of the export power of China in
particular. Because the growing markets of China
and India are as attractive to the manufacturers of
the developing world as they are to those of Europe
– even more so for the low cost manufactures purchased by China and India’s growing cohort of middle and low income consumers – improved market
access is the only way to balance that fear.
The days of the “licence raj” are certainly over. But
India often remains a difficult place for EU companies to invest and trade. It still takes 89 days on
average to start a business in India, more than twice
the time in China. Resolving insolvency takes on
average ten years in India, four times the equivalent
time in China. The IMF’s trade restrictiveness index
gives India a score of 8 – where 10 is the most
restrictive – and China 5. European companies
complain of highly restrictive red tape and discriminatory regulation.
A successful conclusion to the Doha Round would
be a powerful signal and an important step in this
respect. Not only would it cement the principle of
reciprocal liberalization for the emerging economies
but it would open the markets of these economies
further to the developing world. If Doha fails, a similar opportunity is not likely to recur in the foreseeable future.
The decision to launch an FTA between the EU and
India will help reduce many of these barriers. India
has an active interest in encouraging European
investment that can be an important source of capital for India, not least for the infrastructure work
that the Indian government has made a central
strand of improving its competitiveness. The aim is to
liberalize not just goods and services trade, but to
remove non-tariff barriers and establish new rules
on issues such as investment, competition and public
procurement. That means going beyond WTO rules
into areas of mutual interest not yet ready for multilateral agreement at the WTO.
Conclusion
It’s easy to forget from a detached or analytical
position that the impact of the economic rise of
China and India is as much a political issue as an
economic one. Assuming that we are able to dismantle barriers to access in China and India, both
bilaterally and through the multilateral system,
Europe stands to gain hugely from the economic
strength of both – as a source of cheap inputs, as a
market for exports and as a destination and source
of investment in liquidity-rich global capital markets. But both are exploiting comparative advantages in the global economy that are – or are likely
to – exert serious pressure on some sectors of the
European economy.
Systemic aspects
These bilateral aspects of Europe’s trade policy with
China and India are only part of the wider political
challenge of integrating China and India into the
global trading system. China will soon be the largest
exporter in the WTO, and ultimately the largest
economy in the global trading system. India will not
be far behind. The idea that the rules-based WTO
system can function effectively without these two
CESifo Forum 1/2007
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Focus
Convincing our own constituencies that the wider
benefits of this economic pressure outweigh the
costs in isolated sectors is part of Europe’s wider
challenges of adaptation to a globalized economy. It
means a concerted public policy response in Europe
to address the needs of those faced with the impact
of economic change and adaptation. But it also
requires the clear demonstration of reciprocity from
India and China. EU trade policy is the means both
of delivering that reciprocity and securing the
European openness that legitimizes the demands we
make of others.
Obviously, Europe’s relations with both China and
India go much beyond trade. China and India will be
central to the global response to climate change.
They will be central to the geopolitics of energy supply. They are both nuclear powers in neighborhoods
with potential for instability. Yet ordinary Europeans’ first confrontation with India and China is
likely to be as economic powers, changing the shape
of our economic world. That fact alone means that
the management of trade politics will be at the centre of our relationship.
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CESifo Forum 1/2007
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however, more open on the export side than on the
import side – not unlike Japan and South Korea
some time ago. Clearly, the restrictions of foreign
competition on domestic markets (even by foreign
firms with production in China) are in conflict with
the government’s recently expressed ambitions to
pursue a more ambitious competition policy.
CHINA’S REFORMED ECONOMY
ASSAR LINDBECK*
I
t is easy to identify China’s main economic
achievements in connection with the country’s
transition to a new economic system: a GDP growth
rate perhaps as high as 9 to 10 percent per year since
around 1980; an eightfold increase in per capita
income; and a fall from 50 to 10 percent of the share
of the population living in “absolute poverty”. This
last category is then defined as individuals living on
less than one dollar a day. However, it is also important to be clear about the resource costs connected
with China’s rapid growth path as well as lingering,
and in some fields increasing, social problems.
Deficient factor markets
Factor markets have, however, not been reformed to
the same extent as product markets. This shows up in
labor markets, financial markets as well as the market for land. The labor market has a pronounced
insider-outsider character: employees in state firms
are privileged in terms of wages and, even more,
when it comes to various social benefits – a feature
which limits the flexibility of the labor market. The
insider-outsider character of the labor market in
urban areas is accentuated by the household registration system, the urban hukou, which requires a
permit for living in urban areas. While the implementation of the hukou system has recently been
softened, it continues to discriminate against
migrants who have actually settled down in urban
areas without permits. Indeed, the approximately
140 million individuals living in cities without permits today – the so-called “floating population” – are
the most pronounced “urban outsiders”. This is not
only reflected in their relatively low wages, but often
also in particularly unhealthy working conditions, as
well as in their limited access to affordable human
services such as health care and education.
Nature of the economic reforms
Since the late 1970s, when the economic reforms
started, the sequential privatization of collective
agriculture farms, Town and Village Enterprises
(TVEs) and a large number of state firms has drastically changed the ownership structure in the country
– a development accentuated by the entry of new
private firms, domestic as well as foreign. As a result
of these developments, about 60 percent of the
aggregate production in China today seems to take
place in privately controlled firms. China’s economic
system has, however, changed dramatically also in
other dimensions than the ownership structure.
Economic decision-making has been decentralized
from government authorities to households (in the
case of consumption) and to firms (in the case of
production and investment); command has, to a considerable extent, been replaced by economic incentives; administrative processes by markets; monopoly by competition; and autarky by internationalization, codified in China’s entry into WTO in year
2001. Broadly speaking, the Chinese economy is,
Financial markets are even less reformed, and less
developed, than labor markets. Indeed, the poor
functioning of financial markets is a basic weakness
of the economic system in China. For instance, state
banks still dominate the market for loans and, during
the last decades, they have allocated about two thirds
of their lending to public-sector firms, mainly SOEs.
Since the loans have often been quite “soft”, they
have in many cases turned out to be non-performing
(neither being amortized nor paying interest).
Although the emergence of informal credit and cap-
* Institute for International Economic Studies, Stockholm University and IFN Stockholm. The paper largely builds on Lindbeck
(2006) and (2008, forthcoming). The former study, in particular, also
contains relevant references. I am grateful for useful comments on
a draft of this paper from Nannan Lundin and Fredrik Sjöholm.
CESifo Forum 1/2007
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capital”. Clearly, these networks facilitate economic transactions (partly through reduced transaction
costs) among network members, which often
include not only businessmen but also local politicians and public-sector administrators. The network
system means, however, that China is an insideroutsider society also in the business sector; individuals outside the networks are disfavored. The clientele-like relations between representatives of the
public sector and individual businessmen also open
the gates for corruption, since some of the representatives are in charge of regulations and permits
of various types.
ital markets has mitigated the discrimination of private firms, the dual nature of financial markets in
itself is a distortion. New capital injections to state
banks by the government, and a shift of non-performing loans to special asset management institutions have, at least temporarily, “cleaned” the balance sheets of state banks. The non-performing bank
loans seem to have been reduced from about 30 percent to about 10 percent of the stock of bank lending. But a permanent removal of major risks of
financial instability naturally requires that state
banks discontinue their habit of providing soft loans
to state firms. Equally important: a higher quality of
bank lending is necessary for improving the allocative efficiency of investment and production, which
has for a long time also been harmed by the dominance of the government sector in the very thin markets for shares and bonds.
“Asset stripping” in connection with the privatization of firms is another example of corruption in
China – often favoring either the management of the
firms or public-sector administrators, or both.
During the transition period, such asset stripping,
like some other types of kick-backs, has probably
speeded up the creation of a class of private capitalists, which is likely to have been conducive to entrepreneurship. However, if corruption becomes a permanent part of the Chinese economy, it is likely to
have negative consequences for the allocative efficiency of the economy in the long run; at least, this is
a general experience in many other countries. Moreover, it is difficult to get rid of corruption as long as
politicians and public-sector administrators have
something to sell – like permits of various types. This
is an additional argument for further deregulation of
the Chinese economy, in particular by reducing the
requirement of discretionary permits of various
types.
The market for land is even more dominated by the
public sector, simply because all land is owned by
the public sector and leased to private agents.
Naturally, this feature of the economic system has
particularly important consequences in agriculture,
although the present arrangements are vastly more
efficient than the old system with collective agriculture communes. Since land-lease contracts are less
“complete” than ownership contracts, the ownership structure for land is bound to hamper both
investment decisions in existing farms and the consolidation of land holdings, and hence also the possibilities of exploiting potential returns to scale in
agriculture. Land-lease contrasts are also less useful
as collateral for borrowing than ownership contracts. All this means that China pays a heavy price
for its lingering socialist ideology when it comes to
the ownership of agricultural land. While Deng
Xiaoping is famous for his metaphor that “the color
of the cat does not matter as long as it catches
mice”, the color of land contracts in agriculture
does seem to matter.
How, then, should we characterize China’s economic system today? Some observers use the term
“state capitalism”. This is, however, a rather misleading term since more than half of the aggregate
production is performed by private firms.
Moreover, high household savings (20 to 25 percent
of the disposable income) and large plowed-back
profits in private firms are likely to gradually
increase the private share of the ownership of firms
and assets. The term “market socialism”, launched
by Oskar Lange and Abba Lerner in the 1930s, is
misleading for the same reasons. I would simply
characterize the system as a “mixed economy”,
although with some specific characteristics such as
(1) a relatively high openness to the outside world
(as compared to other large countries), (2) more
private ownership of firms than of assets (in particular land and financial assets); (3) considerable
A network economy
Deficiencies in the implementation of the “rule of
law” are another major weakness of the economic
system in China, although the legal system in the
economic field has gradually improved during the
last two decades. To some extent, the remaining
deficiencies are compensated for by informal networks based on personal relations, guanxi, which
may be regarded as a Chinese version of “social
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CESifo Forum 1/2007
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political and bureaucratic interventions in state
enterprises; (4) poorly developed factor markets, in
particular the financial markets; (5) tight networks
among business men partly replacing the ”rule of
law”; and (6) a pronounced insider-outsider division in society at large – in labor and capital markets, in the business community as well as in the
case of social arrangements.
My tentative conclusion is that China has a great
deal to gain from moving to a more intensive growth
strategy by shifting resources from investment in
real capital assets to human capital; increasing the
flexibility in factor markets; raising the relative
prices of energy and raw material (for final users);
and limiting the enormous tear on environmental
resources, in particular land, air and water. Less realcapital intensive production would also boost
employment.
Inefficiencies of the growth strategy
In spite of China’s extraordinary success in terms
of GDP growth, there are strong indicators of serious limitations in the efficiency of the growth
path: the resource costs have been relatively high.
One indication is the high aggregate investment
ratio, today about 43 percent of GDP, which has
resulted in a very high marginal capital-output
ratio of 4 to 4.5, indicating rather low capital productivity. The marginal capital-output ratio has
also gradually been rising over the last two
decades, which may indicate falling capital productivity. As compared to the huge investment in
real capital assets, the investment in human capital looks relatively modest around 4.5 percent of
GDP, of which less than 3 percentage points are
financed via government budgets. Although a high
rate of capital accumulation is natural for a country that gives high priority to economic growth,
the division between real capital assets and human
capital looks quite lopsided, the proportions being
ten-to-one.
Large income gaps
Uneven regional economic development is another important aspect of the Chinese growth path.
While the GDP growth rate in some provinces has
been more than 12 percent per year since around
1980, it has been only half as high in others. As a
result, per capita income in the most developed
provinces (and large cities) is about seven times as
high as in the least developed ones. Indeed, the
geographical differences are so large that China
resembles a continent, consisting of both semiindustrial countries and some of the poorest countries in the world, rather than an ordinary nation
state. Another aspect of the geographical income
divide is that per capita income is about three
times as high in cities as in the countryside. These
geographical divides are largely the result of the
specific economic policy strategy followed by the
government. One example is the selective opening
of the Chinese economy for foreign direct investment through the Special Economic Zones in
some costal provinces in the 1980s. Other examples are the concentration of infrastructure investment to these provinces and, until recently, the
unfavorable price and tax system for farmers
(except during the early reform years in the early
1980s).
The huge consumption of energy, raw materials
and environmental values is another indication
that the growth path is highly extensive (resourceusing), largely a result of distorted prices on such
products. Although China has gradually become a
more efficient user of energy, the country seems to
use twice as much energy per unit of output as
other countries (Bergsten 2006, 34). The extensive
growth path in China is also reflected in the rather
moderate rate of “multi-factor productivity
growth”,1 which seems to have been about 1.5 to
2.5 percent per year during the transition period –
a measure of technological and organizational
improvements.
The income gaps in the country have, however,
widened also within narrowly defined geographical
areas, such as within municipalities, largely in connection with the increased return on human capital. This is to a considerable extent a side effect of
the shift to an economic system based on economic incentives rather than command – without deliberate policy actions to mitigate the distributional
consequences. For instance, the Gini coefficient for
the overall distribution of household income seems
to have increased from 0.28 in 1980 to 0.40 to 0.45
today.
1
The total factor productivity growth excluding investment in
human capital and reallocation gains in connection with the shrinking agricultural share of the economy (see Lindbeck 2006, 32–33).
Total factor productivity (TFP) growth seems to have been 1.0 to
1.5 percentage points higher than multifactor productivity growth,
as a result mainly of the huge reallocation gains.
CESifo Forum 1/2007
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What explains China’s economic success?
trade because of the huge difference in factor proportions between China and developed countries.
After all, the gains from trade tend to be larger, the
more the factor proportions differ among trading
partners. The situation is more problematic for a
number of developing countries with similar factor
proportions as China, and probably also for some
transition economies in Eastern Europe and former
Soviet Republics. For all these countries, China is
likely to become a serious competitor, in particular
in the field of labor-intensive products.
It is not easy to say which specific features of
China’s new economic system that have been most
conducive to the country’s impressive growth performance from the late 1970s. A trivial, but possibly
correct, answer is that the success depends on the
combination of reforms in all the earlier mentioned
dimensions of the economic system, since this combination seems to have released earlier repressed
individual initiatives. When it comes to GDP
growth, the release of individual incentives has obviously dominated over the brakes on the economic
efficiency of the remaining weaknesses of the economic system. It is, however, also tempting to
hypothesize that the gradualism and the experimental nature of the reforms have been conducive to the
economic success. In particular, gradualism (including the slow reduction of the overstaffing of SOEs)
seems to have helped China balance job creation
and job destruction much better than in transition
countries pursuing a Big Bang strategy. This may
very well be a main explanation as to why China, in
contrast to many other transition economies, avoided negative consequences for GDP growth during
the early period of transition, and a related explosion of unemployment.
However, some observers argue that China today is
also a large producer of human-capital intensive and
high-tech products and that developed countries are
therefore threatened by stiff competition from
China also for such products. This view is based on a
misinterpretation of official trade statistics, however. It is true that China exports large volumes of
products with considerable high-tech content, such
as video recorders, television sets and mobile
phones. But the high-tech content of these products
consists of intermediary products imported from
other countries. The domestic value added in China
of these exported products is, in fact, based on lowskilled labor and low-tech production methods.
Indeed, the domestic value added of the export of
electronic and information technology products
seems to be no more than about 15 percent of the
export value of these products (Branstetter and
Lardy 2006). Moreover, in 2003, the domestic production of semiconductors is reported to have been
less than a tenth of the value of the imports of such
products (Baijia 2004).
As emphasized by Presad and Rajan (2006), for
instance, the gradualist strategy could run into problems in the future. Major coordinated reforms may
be crucial for further economic progress in some
cases, for instance in order to build up market supporting institutions, improve the functioning of factor markets, reduce discretionary government interventions in state enterprises and mitigate corruption.
There is also the risk that a prolonged, gradualist
reform process finally comes to a halt as a result of
the build-up of strong interest groups and the emergence of related “veto points”.
Consequences for the outside world
Today, China is thus most appropriately regarded
as a major assembly platform for imported hightech components – indeed, the major platform of
this kind in the world. As long as China buys most
of its high-tech intermediary inputs from developed and semi-developed countries, it is not likely
to be a large scale threat to high-tech firms in other
countries.
In the future, China’s emergence as an important
actor on international markets may very well be
regarded as a major event in modern economic history – possibly comparable to the entry of the
United States into the world markes in the late 19th
and early 20th century. In several respects, this is
likely to be economically favorable for developed
countries. In particular, new opportunities are
opened for these countries through the gains from
Naturally, in a long-term perspective, China will
probably considerably expand the production of
high-tech products and, in this connection, gradually upgrade its position in the international hierarchy of production tasks. Indeed, the Chinese
authorities have expressed a concern of just being
an assembly platform for foreign firms, rather than
having a vital indigenous technological development. If China succeeds in upgrading its production
11
CESifo Forum 1/2007
Focus
in domestic firms, both the traditional product cycle
and the international “task cycle” (i.e. shifts in the
international location of production tasks within
vertically integrated production processes) is likely
to be speeded up. Developed countries that are able
to continue shifting to new and more sophisticated
products and production tasks do not have much to
fear from this development, although certain
groups of individuals in these countries are bound
to lose, possibly not only in relative but in some
cases also in absolute terms. Countries that are not
flexible enough are likely to run into serious problems – with a likely boost of protectionist pressure
from groups in such countries that find themselves
threatened.
New social arrangements?
Although the new social ambitions so far have been
more pronounced in the rhetoric than in actually
pursued policies, China has clearly entered the
route towards new social arrangements, indeed
towards modest welfare-state institutions.
However, a basic weakness of today’s social
arrangements is the one-sided emphasis on the
interest of urban insiders at the expense of broader
population groups, in particular individuals with
low-income and the rural population in general.
However, when dealing with this issue, it is important to remember that the potentially appropriate
arrangements in the social field differ considerably
between urban and rural areas. In the cities, the
authorities could provide better income security
“simply” by widening the group of citizens covered
by social insurance, such as unemployment insurance, health-care insurance and retirement pensions – although this may require less generosity
towards the most privileged groups today. Social
insurance of this type is less operational in rural
areas. Indeed, unemployment and retirement (and
often also income) of individual households in agriculture are often even difficult to define and document. For the agriculture population, it may, therefore, be easier to rely on crop-failure insurance and
lump-sum transfers rather than ordinary (general)
income insurance. As a comparison, it was rather
late in their development process that today’s
developed countries extended income insurance to
the agriculture population.
Social challenges
The huge increase in per capita income for a billion
of the poorest people in the world, and the drastic
reduction in the number of individuals in China living in “absolute poverty”, do not only constitute an
important economic achievement. These developments also imply important social progress. However, the social development in China has been disappointing during the reform period in several
other respects. One important reason is that the
previous social arrangements, tied to work places
(danwei), broke down at the same time as citizens
became more exposed to market risks. Moreover,
social benefits tied to the individual’s work place
do not sit well in a market economy, where it is
important that social benefits are portable across
workplaces.
The provision of human services suffers from the
same types of problems as the arrangements for
income protection. Once more, the urban insiders
are favored as compared to the rest of the population. Indeed, the distribution of education and
health care seems to be at least as uneven as the distribution of household income. The basic problem is
the way in which such services are financed. For
instance, the government budget today finances
only 63 percent of total spending on education in
the country. The rest is mainly financed by various
organizations, including firms and organizations
connected with firms, but also by out-of-pocket
money from households (in particular in the case of
higher education). Even more striking, in the case of
health care, public budget financing only accounts
for about 40 percent of total spending, and the
remaining part is mainly financed by out-of-pocket
money from households.
Clearly, the political authorities in China are fully
aware both of the serious social problems in the
country and the defects of exiting social arrangements: the huge income gaps across geographical
areas and among individuals, the lack of income
security for the majority of the population and the
uneven distribution of the provision of human
services such as education and health care.
Indeed, at the 11th Congress of the Communist
Party in early 2006, the leadership announced a
shift from the one-sided emphasis on GDP growth
to the new ambition to create a “harmonious”
society with greater concern for regional and
social balance, and hence for future social stability. It remains to be seen to what extent, and how
fast, this announcement will be reflected in actual
policies.
CESifo Forum 1/2007
12
Focus
China, while university education is rapidly expanding. It would seem that China is approaching a pronounced duality (polarization) in terms of schooling, with a rapidly expanding group of individuals
with a high academic education combined with a
large group of individuals with both little theoretical
and vocational training.
It is easy to understand that low-income groups have
serious difficulties in getting adequate schooling and
medical care with these financial arrangements.
Moreover, since local rather than national authorities are responsible for public-sector financing of
education and health care, the huge variations in tax
revenues across local authorities make the provision
of such services highly uneven across geographical
areas. It is difficult to see how these problems could
be effectively dealt with without a shift of a large
part of the financing of education and health care
from private individuals to the public sector
(through taxes or a mandatory insurance premium),
combined with a huge expansion of central government transfers to poor local governments.
Developed countries today also experience serious
efficiency problems in the field of health services
– in some countries largely in the connection with
rationing and queues, in other countries in the
form of cost explosions, partly as a result of ex post
moral hazard (such as unnecessary expensive medical examination and excessive medication and
surgery). China has already encountered similar
efficiency problem – in addition to the poor access
of health services for low-income groups. The efficiency problems are reflected, for instance, in
extremely high prescriptions of drugs and the
application of sophisticated and often hardly necessary surgery for a small fraction of the population (Eggleston et al. 2006).
Social lessons from developed countries
When launching more ambitious social policies,
China could learn a great deal from the experiences
in developed countries. On the “positive” side, the
main lesson might be that it is possible to provide
quite ambitious social arrangements without endangering a continuation of per capita economic
growth. There are, however, important reservations
to this observation. If the generosity of income
insurance exceeds certain limits (which are difficult
to empirically determine in advance), the systems
may not be financially viable in a long-term perspective. One reason is that serious problems of
moral hazard may emerge – an aspect that politicians in developed countries have usually underestimated, or even entirely neglected. In Europe, this is,
for instance, reflected in long spells of unemployment, high sickness absence and a large number of
individuals living on highly subsidized early retirement. Such moral hazard problems may be particularly severe, if social norms against exploiting various benefit systems weaken over time when more
individuals choose to live on such benefits
(Lindbeck 1995). China is well advised to be aware
of such problems when new social arrangements are
considered today.
The complications concerning financing, incentives
(including moral hazard) and efficiency of social
arrangements hardly constitute a basis for delaying
radical reforms in these fields in China – either for
income protection or the provision of human services. However, the complications call for caution to
avoid future “overshooting” of the generosity of the
benefit levels – and related risks of conflicts between
social and economic ambitions. My interpretation of
the international experiences in this field is, however, that the risk for serious conflicts between social
ambitions and concern for efficiency/growth does
not only depend on the level of social spending, but
largely also on the method through which social policies are pursued.
References
Baijia, L. (2004), “Semiconductor Sector Shaking”, China Daily,
September 8, 11.
Bergsten, F., B. Gill, N. Lardy and D. Mitchell (2006), China: The
Balance Sheet, Public Affairs, New York.
In developed countries, serious efficiency problems
have also emerged in the field of human services.
For instance, most developed countries are concerned about low quality in large parts of their
school systems. In China, the corresponding problem is particularly serious for poor sections of the
population. There are also strong indications of
vocational training being poorly developed in
Branstetter, L. and N. Lardy (2006), China’s Embrace of Globalization, NBER Working Paper 12373, July.
Chow, G. (2002), China’s Economic Transition, Oxford: Blackwell.
Eggleston, K., L. Li, Q. Meng, M. Lindelow and A. Wagstaff (2006),
Health Service Delivery in China: A Literature Review, World Bank
Policy Research Working Paper 3978, August.
Farrel, D., S. Lund and F. Marin (2007), “How Financial-System Reforms Could Benefit China”, McKinsey Quarterly 12 January 2007,
http://www.mckinseyquarterly.com/article_abstract.aspx?ar=1785.
13
CESifo Forum 1/2007
Focus
Lindbeck, A. (1995), “Welfare State Disincentives with Endogenous
Habits and Norms”, Scandinavian Journal of Economics 97, 447–494.
Lindbeck, A. (2006), An Essay on Economic Reforms and Social
Change in China, World Bank Policy Research Working Paper 4057,
November.
Lindbeck, A. (2007), “Economic-Social Interaction during China’s
Transition”, The Economics of Transition (forthcoming).
People Daily (2005), “Top Statistics on China’s Economic Figures:
Service Sector”, December 22,
http://english.people.com.cn/200512/21/eng20051221_229856.html.
Prasad, E. S., and G. R. Raghuram (2006), “Modernizing China’s
Growth Paradigm”, American Economic Review 96, 331–336.
CESifo Forum 1/2007
14
Focus
growth in the two largest Asian Driver economies
were unique. In recent years other Asian economies
(for example, Japan and Korea) have experienced
similarly rapid growth paths. However, whilst China
accounted for 20 percent of the world’s population
and India for 17 percent in 2002, at no time did the
combined population of Japan and Korea’s exceed
four percent of the global total (Figure 2). So, unlike
the case of Korea and Japan who could grow without
severe disruption to the global economy, we have to
suspend the “small-country” assumption in the case
of the Asian Drivers. The very high trade intensity of
China’s growth makes the big-country effect particularly prominent in its case. Between 1985 and 2005,
China’s exports rose from $50 billion to $772 billion,
transforming China into the world’s third largest
trading nation.
THE IMPACT OF CHINA AND
INDIA ON THE DEVELOPING
WORLD
RAPHAEL KAPLINSKY*
T
he global economy is undergoing a profound
and momentous shift. The first half of the 21st
century will undoubtedly be dominated by the consequences of a new Asian dynamism. China is likely
to become the second biggest economy in the world
by 2016, and India the third largest by 2035. A cluster of other countries in the Asian region, such as
Thailand and Vietnam, are also growing rapidly.
These newly dynamic Asian economies can collectively be characterised as the “Asian Drivers of
Global Change”. The economic processes they
engender are likely to radically transform regional
and global economic, political and social interactions
and to have a major impact on the environment. This
is a critical “disruption” to the global economic and
political order that has held sway for the past five
decades. It is reshaping the world as we know it,
heralding a new “Global-Asian” era.
Second, China (especially) and India embody
markedly different combinations of state and capi-
Figure 1
GROWTH OF GDP AND EXPORTS FROM ONSET OF RAPID
GROWTH:
CHINA, INDIA, JAPAN AND KOREA
4.0
Growth of GDP
Log GDP
3.5
Role of China and India for global change
3.0
2.5
2.0
As mentioned above, the two key Asian Driver
economies are China and India. But they reflect very
different growth paths. China is integrated into an
outward-oriented regional economy, involving fine
divisions of labour in many sectors. By contrast (at
least until now) India represents much more of a
“standalone” economic system. Yet, notwithstanding
these differences in structure, they pose major and
distinct challenges for the global and developing
economies, for six major reasons.
1.5
1.0
0.5
0.0
1
5
9
13
17
21
25
29
33
37
41
45
33
37
41
45
Growth of Export
Log Exports
6.0
5.0
4.0
3.0
2.0
The first is as a consequence of their size. As Figure 1
shows, from the beginning of their growth spurts
(1979 and 1992, respectively), neither GDP or export
1.0
0.0
1
* Department of Policy and Practice, The Open University.
5
9
13
17
21
25
29
China (1979 - 2005)
Japan (1960-2004)
Korea, Rep. (1963-2005)
India (1992-2004)
Source: World Bank.
15
CESifo Forum 1/2007
Focus
army of unemployed, estimated
at around 150 million compared
SHARE OF GLOBAL POPULATION
in %
to the 83 million people em25
ployed in formal sector manufacturing in 2002 (Kaplinsky
20
2005). As Shenkar observes,
“China’s enormous labor re15
serves, with pay scales radically
10
lower in the hinterland than the
coast and in urban areas (the
5
average income on the farm,
where more than half of the
0
Chinese population lives, is less
1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 2000 2004
than $25 per month), creates
China
India
Japan
Korea, Rep.
the equivalent of a country
Source: World Bank.
within a country; so, instead of
Vietnam or Bangladesh replactalist development compared with the industrialised
ing China as a labour-intensive haven, Hunan will
world. Chinese enterprises have their roots in state
replace Guangdong” (Shenkar 2005, 134). Moreownership, usually arising from very large and often
over by 2030, India, also with a large reserve army
of underemployed, is likely to have a larger popuregionally-based firms (Nolan 2005; Shankar 2005).
lation than China. But China and India are not
They reflect a complex and dynamic amalgam of
content to operate in this world of cheap labour
property rights – “The ownership of each of China’s
and mature technologies, and are investing heavily
large SOEs [state owned enterprises] has spread
in the building of technological capabilities. China,
gradually among a variety of public institutions, each
for example, overtook Japan to become the world’s
of which has an interest in the firm’s performance …
second largest investor in R&D in 2006.
[b]ased on the “ownership maze” and vaguely deFigure 2
fined property rights” (Nolan 2005, 169). With access
to cheap (and often subsidised) long-term capital,
these firms operate with distinctive time-horizons
and are less risk-averse than their western counterparts (Tull 2006). Indian firms are probably less distinct from the western model, although they tend to
be less specialised and often include elements of
social commitment which are largely alien to western firms (Humphrey, Kaplinsky and Saraph 1998).
Associated with these complex forms of ownership
and links to regional and central state bodies,
Chinese firms often operate abroad as a component
of a broader strategic thrust. This is particularly
prominent in China’s advance in Sub-Saharan Africa
(SSA) in its search for the energy and commodities
required to fuel its industrial advance (Kaplinsky,
McCormick and Morris 2006).
Fourth, China and India are associated with very different forms of regional integration. China is part of
a distributed regional network of production, reflecting wider regional competitiveness. Traded goods
‘manufactured in China’ usually emanate from regional production systems – China’s trade deficit
with East Asia grew from $4 billion in 1990 to
$40 billion in 2002, and the region’s share of China’s
merchandise imports grew from 55 to 62 percent in
the same period (Lall and Abaladejo 2004). An
increasing proportion of China’s trade involves the
processing of imported raw materials and intermediates (widely referred to in the literature as “verticalised trade”, see Feenstra 1998). Official data show
that this form of trade grew to $404.8 billion in 2003
(48 percent of the total trade volume), up from
$2.5 billion in 1981 (5.7 percent of total trade)
(NiHaoOuZhou_com 2006). By contrast, Indian
exports are more an outcome of a “national system
of production”, so that the spread effects of the
growth paths of these two Asian Driver economies
are likely to be very different.
The third reason why the Asian Drivers present a
new and significant challenge to the global and
developing economies is that they combine low
incomes and low wages with significant innovative
potential. This means that they are able to compete
across the range of factor prices. The oft-stated
belief (and hope?) that China will run out of
unskilled labour is belied by the size of its reserve
CESifo Forum 1/2007
Fifth, both China and India are now heavily engaged
in global institutions, but whereas India has long
been a participant, China’s global presence is more
16
Focus
private and non-governmental organisations
have on developing countries?
5. Given the enormous resource and energy hunger
of the Asian Drivers, what are the environmental
consequences for other developing countries?
recent. Whilst the nature of their political engagements with the rest of the world differs sharply, they
increasingly affect global and regional governance
(Humphrey and Messner 2006). India plays a major
role as an “advocate” of the interests of the developing countries, for example as the leader of G22 within the WTO. China is pushing the Shanghai
Cooperation Organisation (formed by China,
Russia, Kazakstan, Kirgistan, Tadjikistan and
Uzbekistan) as a significant player in the area of
global energy policies. China and India also provide
a different policy role-model for many developing
economies, with the possible rise of a “Beijing
Consensus” to rival the Washington Consensus.
These dynamics represent a transition from a quasiunilateral US-dominated world order to a multipolar
power constellation. This could lead to new turbulences and conflicts between the rising and the
declining powers within the global governance system (Humphrey and Messner 2006).
Assessing the impact of the Asian driver economies
on the developing word
How might we assess these impacts? We can distinguish three sets of structuring principles to aid this
analysis – the channels of Asian Driver interaction
with the global economy; the distinction between
complementary and competitive impacts; and the
difference between direct and indirect impacts.
Channels of interaction
There are a variety of different channels through
which individual countries interact with other
economies, in their regions and elsewhere. Clearly,
these channels are contingent – they change over
time, and vary in importance depending on factors
such as location, resource endowment, trade links,
and geo-strategic significance. Six key channels stand
out in importance.
Finally, China and India have huge and rapidlygrowing energy needs. China is already the second
largest emitter of greenhouse gases (only exceeded
by the US) and by 2015 its energy demand is expected to roughly double, and India’s to rise by 50 percent. The world’s biocapacity will be severely
stretched if it is to feed China’s and India’s resource
hunger and sustain their growth.
The first of these are the trade links between the
Asian Drivers and the global economy. China’s share
of global merchandise trade had risen to 6.7 percent
by 2004, exceeding that of Japan, and growing particularly rapidly from the mid-1990s, a period in
which the US’s share of merchandise trade fell
appreciably (Table 1). By 2004, China’s share of
global manufacturing exports had risen to 8.3 percent, still below that of the US and Germany but
growing rapidly. By contrast, India’s share of global
merchandise trade was basically stable in the same
period, at a much lower level than China’s. However,
India’s share of global service trade, particularly IT
services grew (although no clear comparative data
are available).
The impact on low income economies: Key issues
Thus, the Asian Drivers are clearly likely to have a
major impact on the global economic, political,
social and environmental economy. But it is only
relatively recently that their impact on low income
economies has been specifically problematised.
Here we can identify five distinct developmentrelated questions
1. What are the consequences of the emergence of
the Asian Drivers for economic growth in other
developing economies and regions?
2. Who are likely to be the losers and winners from
the growing dynamism of the Asian Drivers, within and between low-income economies and
regions?
3. How should developing countries engage with
the global economy in general and the Asian
Drivers in particular?
4. What effect will the shift in global power in institutions of regional and global governance and in
The second major channel of interaction is FDI.
Already the Asian Drivers account for the major
share of global inward FDI, with China and Hong
Kong alone attracting almost 40 percent of total FDI
destined for developing countries (UNCTAD 2005).
But the Asian Drivers are increasingly also a source
of outward FDI. In some regions – SSA in particular
(Kaplinsky, McCormick and Morris 2006) – China
has become the major source of new inward FDI,
17
CESifo Forum 1/2007
Focus
options for developing countries
if China and India were to play
the role of “voices of the South”
in global politics. However, if
2003 2004
they look primarily to their own
9.9
9.2
interests, new conflicts between
46.1
45.3
the Asian Drivers and other
6.4
6.4
developing countries might
arise. China’s close cooperation
2.9
3.1
with “difficult states” like Sudan,
2.4
2.6
Myanmar, Uzbekistan, and
26.1
26.8
Zimbabwe and its close energy
6.0
6.7
partnership with Iran provoke
0.8
0.8
tensions with western countries
and demonstrate that the Asian
Drivers are able to alter geostrategic maps and north–south relationships
(Humphrey and Messner 2006).
Table 1
World merchandise trade by region and selected economy
(% share of total)
1948
1953
1963
1973
1983
1993
United
States
Europe
21.7
31.5
18.8
34.9
14.9
41.4
12.3
45.4
11.2
43.5
12.7
45.4
Japan
0.4
1.5
3.5
6.4
8.0
9.9
S. and C.
America
Africa
11.4
7.3
9.8
6.5
6.3
5.7
4.3
4.8
4.4
4.5
3.0
2.5
Asia
13.6
13.1
12.4
14.9
19.1
26.1
China
0.9
1.2
1.3
1.0
1.2
2.5
India
2.2
1.3
1.0
0.5
0.5
0.6
Source: Kaplinsky and Messner (2007).
particularly in economies which because of their
political fragility, have been shunned by western
investors for some years. There are four primary
types of FDI – technology-leveraging, resourceseeking, market-seeking and cost-reducing. Chinese
outward investment clearly fits into the first three of
these – technology leveraging investments in the US
(and, to a lesser extent, the EU), and resource-seeking and market-seeking investments predominantly
in other developing economies.
Migration from the Asian Drivers and interactions
with diaspora communities represents a fifth channel of impact. To some extent, migration is already
a “fact” of considerable importance with large
Chinese and Indian diasporas in Asia. Outward
migration from India to SSA occurred during the
late 19th century and first half of the twentieth
century, and in the latter twentieth century extended to Europe, North America and Australasia. But
more recently, Asian Driver migration has risen,
particularly from China to SSA. For example, by
some counts, there are currently more than
200,000 Chinese living in South Africa, who are
mostly recent migrants. The Chinese population of
Lusaka grew from 3,000 to more than 30,000
between 1995 and 2005 and Chinese migrant communities are increasingly prominent in many
African countries, including from poor regions in
China.
The third channel is finance. Large trade surpluses in
both China and India coupled with these countries’
ability to attract FDI and other categories of capital
flows have led to a build-up of large foreign reserves,
estimated at more than $1 trillion in 2006. A significant change in how Asia’s capital surpluses are managed could cause an abrupt adjustment in the US
interest rates and the dollar and thereby destabilise
the entire world economy. It could also accelerate a
slow-moving structural change which is the gradual
weakening of the role of the dollar as the world’s
main reserve currency. Both of these developments
have significant indirect implications for other developing countries, affecting the structure of global
financial markets and the competitiveness of their
exchange rates.
The sixth and final major channel of impact on
other economies arises from environmental spillovers. Rapid growth in China and India consumes
natural resources and generates cross–border environmental damages within the Asian region.
Problems with the use of natural resources are
widely documented. For example, there have been
repeated denunciations of the activities of illegal
Chinese timber logging companies in Myanmar. It
is estimated that between one third and one half of
acid rain in South Korea and Japan is the result of
sulphur dioxide emissions from China (Umbach
2005). Beyond that, China’s and India’s rapidly rising imports of natural resources from all over the
world are creating environmental problems in
The fourth channel of interaction arises in relation to
institutions of global and regional governance. The
emerging strategies of China and India towards the
multilateral institutions such as WTO, UN, World
Bank and IMF, and the global climate regime and
the bilateral interactions between the US, Europe
and the Asian Drivers will profoundly change the
international context for other developing countries
(Chan 2006; Messner 2006). This could create new
CESifo Forum 1/2007
18
Focus
US and Europe on energy, resources and markets
might also marginalize development policy issues in
word politics. Similarly, financial flows, environmental spill-overs and migration may be either
complementary or competitive.
Africa, Latin America and the rest of Asia. The
most important global environmental impact of
rapid growth in the two Asian giant economies will
be their contribution to global climate change.
China’s share of worldwide CO2 emissions could
reach 25 percent in 2025, the corresponding figure
for India being 10 to 15 percent.
The key element of these interactions is the “for
whom” component. Countries may be affected differentially – in some cases, for example, the export of
fabrics from the Asian Drivers may feed productively into a vibrant clothing and textile value chain; in
other cases, it may displace a country’s exports and
production for the domestic market. But these
effects are not just felt at the national and economywide level. They affect groups within countries differentially. For example, cheap clothing imports from
China may displace clothing and textile workers, but
cheapen wage goods and hence reduce wage costs
for producers in other sectors, which is indeed what
has been occurring in many high-income economies
during the early years of the 21st century. These
impacts on a complementary-competitive axis may
also change over time, and most importantly, they
will vary for different classes, regions and groups
within economies.
Complementary and competitive impacts
Simplistically, and as a starting point, the interactions between the Asian Drivers, the global economy and individual regions and countries can be
seen in a binary framework as comprising a range
of complementary or competitive impacts. Table 2
provides some examples, notional, but informed by
the emerging nature of Asian Driver expansion. In
each of these channels of interaction, we can
observe a mix of complementary and competitive
impacts. For example, with regard to trade, the
Asian Drivers may both provide cheap inputs and
consumer goods, and be a market for the exports
from other developing countries. On the other
hand, imports from the Asian Drivers can readily
displace local producers. In relation to FDI, the
Asian Drivers may either be a direct source of
inward FDI or crowd-in FDI from third countries
as parts of extended global value chains. But the
Asian Drivers may also compete with other
economies for global FDI. The rising power of the
Asian Drivers in a western dominated global governance system may strengthen the voice of developing countries in international organizations. The
emerging conflicts between the Asian Drivers, the
Direct and indirect impacts
The complementary-competitive axis of impacts is
readily comprehended and widely recognised. Less
widely acknowledged is the distinction between
direct and indirect impacts. In part this is because
the indirect impacts are difficult to measure.
However, in many cases, the indirect impacts may in
Table 2
Examples of complementary and competitive impacts
Channels
Trade
FDI
Finance
Impact
Complementary
Competitive
Complementary
Competitive
Complementary
Competitive
Global Governance
Complementary
Migration
Competitive
Complementary
Competitive
Complementary
Competitive
Source: Author’s elaboration.
Environment
Nature of links
Imports of cheap consumer goods from Asian Drivers;
Exports of commodities to Asian Drivers
Imports from Asian Drivers displace local producers
Inflows of FDI from Asian Drivers
Competition for US FDI from Asian Drivers
Loans from Asian Drivers to governments and private actors
Low-cost finance from Asian Drivers displaces local
financial intermediaries
Support for Development Round from Asian Drivers in
WTO
Asian Drivers side with EU in WTO
Asian Driver migrants intermediate complementary trade
with home countries
Asian Driver migrants displace local entrepreneurs
Asian Drivers cooperate in regional water projects
Asian Drivers as significant motors of global climate change
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Table 3
Examples of direct complementary and indirect competitive impacts on Lesotho
Channels
Impact
Complementary
Direct
Asian Driver fabrics used in
Lesotho’s clothing exports
Trade
Asian Driver competition in US
squeezes out Lesotho clothing
exports
Competitive
Complementary
Asian Driver investment in
Lesotho’s clothing sector
FDI
US foreign investors relocate
clothing factories from Lesotho
to China
Competitive
Complementary
Asian Driver aid for budgetary
support
Asian Driver led realignment of
currencies forces up the value of
the rand, and undermines
profitability of Lesotho’s
clothing exports
Finance
Competitive
Global
Governance
Complementary
Budgetary support to
government augments state
power
Asian Driver input into WTO
removes AGOA preferences
Competitive
Complementary
Migration
Chinese migrants facilitate
imports of cheap consumer
goods
Competitive
Complementary
Environment
Indirect
Chinese migrants squeeze out
local traders
Indian solar technologies
enhance energy efficiency in
rural areas
Asian Driver carbon emissions
lead to global warming and
reduce rainfall in SSA
Competitive
Source: Author’s elaboration.
rand (to which its currency was tied), an indirect
impact of Southern Africa’s burgeoning commodity
exports to China. Lesotho also stands to lose from
China’s accession to the WTO and the power it
might wield in removing preferential access to
major markets for the exports of least developed
countries, outweighing any possible positive impact
of potential budgetary aid to government. Finally,
Lesotho’s major export other than clothing (vulnerable to Asian Driver competition) and unskilled
migrant labour is its water. A change in rainfall patterns consequent on global warming is likely to have
very adverse economic impacts.
fact be much more significant than the direct ones.
Table 3 gives some examples, for purposes of illustration contrasting direct complementary impacts
with indirect competitive impacts in Lesotho, a poor
SSA economy. In 2000 to 2004 Lesotho’s clothing
exports to the US under the African Growth and
Opportunity Act (AGOA) scheme grew very rapidly, but were undermined in 2005 to 2006 by Chinese
competition following the removal of MFA quotas
(Kaplinsky and Morris 2006). Looking at the trade
channel, thus, direct complementary impacts included the supply of fabrics used in Lesotho’s clothing
exports. On the other hand, the indirect impact on
Lesotho of China’s growing competitiveness in the
US led to a 17 percent fall in exports during 2005.
Whilst some of these exports arose from Taiwaneseowned plants, in other cases potential foreign
investors in Lesotho preferred to manufacture
clothes in China (as well as India and Bangladesh).
Lesotho suffered badly from the appreciation of the
CESifo Forum 1/2007
As in the case of the complementary/competitive
access, the impact of the direct and indirect
impacts can be gauged either at the country level,
or at intra-national levels, for example with
regard to different regions, sectors, classes and
genders.
20
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Kaplinsky, R., D. McCormick and M. Morris (2006), The Impact of
China on SSA, Agenda-setting Paper prepared for DFID, Brighton:
Institute of Development Studies.
Conclusion: There is much that we don’t know
The rapidity of the rise of the Asian Driver economies means that we are only beginning to recognise
the enormity of their likely impact on the world
economy in general, and low income economies in
particular. We know that this impact is likely to be
large. We also know that this impact can be transmitted through a variety of channels, and have identified
six of the more important channels. We also know
that these impacts might have a combination of complementary and competitive impacts. In general,
actors in low income economies tend to see more
opportunities and complementary synergies with the
rise of the Asian Drivers. By contrast, observers in
the high-income countries (particularly those focusing on low income economies) tend to be more
aware of competitive impacts. And, finally we also
know that these impacts may be direct and indirect.
In general, most attention is placed on the direct
impacts, since these are more visible through bilateral relations. But the indirect impacts may often be
more important, and much more difficult to unravel.
Lall, S. and M. Albaladejo (2004), “China’s Competitive Performance: A Threat to East Asian Manufactured Exports?”, World
Development 32, 1441–1466.
Messner, D. (2006): “Instabile Multipolarität. Global Governance
im Schatten des Aufstiegs von China und Indien“, in: Debiel, T.,
D. Messner and F. Nuscheler (eds.), Globale Trends 2007/08, Fischer
Verlag, Frankfurt.
NiHaoOuZhou_com, (2006), Foreign Firms Dominate China’s
Exports, accessed 30th June 2006.
Nolan, P. (2005), Transforming China: Globalization, Transition and
Development, London: Anthem Press.
Shenkar, O. (2005), The Chinese Century: The Rising Chinese
Economy and Its Impact on the Global Economy, The Balance of
Power and Your Job, Upper Saddle, NJ: Pearson Education Inc.
Tull, D. M. (2006), “China’s Engagement in Africa: Scope, Significance and Consequences”, Journal of Modern African Studies 44,
459–479.
Umbach, F. (2005), “Global Energy Security and its Geopolitical
Consequences to EU-Asian relations”, in: van der Geest, W. (ed.),
The European Union’s Strategic Interests in East Asia: Vol. 2, Expert
Analyses of East Asian Cooperation, China’s Role and EU Policy,
European Institute for Asian Studies and NOMISMA, Brussels/
Bologna, 194–223, available http://www.asia2015conference.org/ #
UNCTAD (2005), World Investment Report, Geneva: UNCTAD.
World Watch Institute (2005), State of the World 2006. The Challenge
of Global Sustainability, London: Earthscan Publications.
These pockets of information are just that – pockets.
There is an enormous and urgent task ahead of documenting these emerging impacts, distinguishing
between different types of economies and regions,
and different communities within these countries
and regions. Unless these trends and subtleties are
adequately understood, it will be very difficult for
low income countries to maximise the opportunities
and minimise the threats arising from the rise of the
Asian Drivers.
References
Chan, G. (2006), China’s Compliance in Global Affairs, New Jersey
and London: World Scientific.
Feenstra, R. C. (1998), “Integration of Trade and Disintegration of
Production in the Global Economy”, Journal of Economic Perspectives 12, 31–50.
Humphrey, J. and D. Messner (2006), China and Its Impact on
Global and Regional Governance, Agenda-setting Paper prepared
for DFID, Brighton: Institute of Development Studies.
Humphrey, J., R. Kaplinsky and P. Saraph (1998), Corporate Restructuring: Crompton Greaves and the Challenge of Globalisation, New
Delhi: Sage Publications Ltd.
Kaplinsky, R. (2005), Globalization, Poverty and Inequality, Cambridge: Polity Press.
Kaplinsky, R. (ed. 2006), Asian Drivers: Opportunities and Threats,
IDS Bulletin, 37: 1.
Kaplinsky, R. and D. Messner (2007, forthcoming), “The Impact of
the Asian Drivers on the Developing World”, World Development.
Kaplinsky, R. and M. Morris (2007, forthcoming), “Do the Asian
Drivers Undermine Export-Oriented Industrialisation in SSA?”
World Development.
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concisely as possible, given their complexity. The
political institutions that underlie the explicit mechanisms of fiscal federalism are critical to the analysis,
and are highlighted here, in addition to assignments
of expenditure and revenue authority, and arrangements for intergovernmental transfers. In the third
section, I give an overview of the reforms that have
been taking place in the country’s federal structure,
including political institutions, fiscal assignments,
and intergovernmental transfers and borrowing
arrangements. The fourth section offers an analytical
narrative to explain these developments, and some
tentative predictions that follow from this analysis.
The final section is a summary conclusion, with suggestions for further research.
THE DYNAMICS OF REFORM
OF INDIA’S FEDERAL SYSTEM
NIRVIKAR SINGH*
S
tarting from very different initial conditions in
terms of political institutions, and pursuing a
very different set of policies, India has followed
China in being an economic reformer as well as a
star economic performer. The dimension of reform
that has received the most attention in India is that
of redrawing the boundaries of authority and action
between government and market, including liberalizing government restrictions on international trade
and domestic corporate investment, and changing
the nature of government regulation of the private
sector. What has received less attention in this context is the ongoing transformation of India’s federal system of governance, through deliberate
reforms and through unintended consequences of
other policy changes. This transformation has the
potential to sustain and accelerate economic
growth in India. Specific reforms, with respect to
decentralization to local governments, taxes and
intergovernmental transfers have all previously
been considered in detail, and continue to be discussed. The contribution of this piece is to put these
individual changes into the context of the overall
dynamics of India’s federal system, so that the
process can be understood from a positive perspective.1 Thus, we go beyond description (which
reforms have occurred) and prescription (which
reforms are best?) to analysis of the process (why
have these reforms happened?).2
India’s federal system
India became an independent democratic nation in
August 1947 and a constitutional republic in January
1950. The constitution explicitly incorporated a federal structure, with states as subnational entities that
were assigned specified political and fiscal authorities. However, these states were not treated as independent sovereigns voluntarily joining a federation.
In particular, the states’ boundaries were not inviolate, but have been repeatedly redrawn by central
action (though often in response to subnational pressure), as allowed by the constitution.3 India is now
comprised of 28 states, six “Union Territories” (UTs)
and a National Capital Territory (NCT), Delhi.4 In
general, the constitution was structured to give the
central government residual authority and consider-
2 For previous discussions that provide more descriptive detail, see
Rao and Singh (2005), Singh and Srinivasan (2005) and Singh and
Srinivasan (2006). The last of these does draw on analytical frameworks similar to those used for the China case, as does Singh
(2007). Rao and Singh (2007) introduce some of the ideas considered more explicitly in this paper. Sàez (2002) tackles similar issues
to the current piece, but interprets the process and evidence quite
differently. Sinha (2004) offers a conceptual framework somewhat
similar to that offered here, though with differences of emphasis.
An important cross-country comparison of the dynamics of reform
in federal systems is Wallack and Srinivasan (2005).
3 In addition, the princely states that existed at the time of independence, under the umbrella of British rule, were rapidly
absorbed and consolidated into the new political structure, with
their special status greatly attenuated, and ultimately (by 1970)
totally removed.
4 Population sizes for the states range from about half a million to
166 million, with a median of about 24 million (2001 census figures). Ten states have populations exceeding 50 million.
The plan of the paper is as follows. In the next section, we summarize India’s federal institutions – as
* Department of Economics and Santa Cruz Center for International Economics, University of California, Santa Cruz.
This paper draws partly on much of my previous work on this topic,
including joint work with M. Govinda Rao and T. N. Srinivasan. I
am indebted to Chang Woon Nam for very helpful comments on an
earlier draft. I alone am responsible for shortcomings.
1 The Chinese experience has received considerably more analytical attention in this respect, e.g., Montinola, Qian and Weingast
(1995); Qian and Weingast (1996); Qian and Roland (1998); Cao,
Qian and Weingast (1999); Laffont and Qian (1999); Qian, Roland
and Xu (1999); and Jin, Qian and Weingast (2005).
CESifo Forum 1/2007
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Administrative Service (IAS), whose members are
chosen by a centralized process and trained together. They are initially assigned to particular states, and
serve varying proportions of their careers at the state
and national levels. The judiciary is a constitutionally distinct branch of government at both national
and state levels, though the legislative/executive
branch exerts influence through appointments and
budget allocations.6 The Supreme Court has broad
powers of original and appellate jurisdiction, and the
right to rule on the constitutionality of laws passed
by Parliament. In specific issues of center-state relations concerning taxation and property rights, the
basic centralizing features of the constitution have
tilted the Court’s interpretations towards the center.
More recently, in the 1990s, it has made decisions
checking the center’s ability to override subnational
political authority by means such as dismissing state
legislatures.7 At the state level, the High Courts
superintend the work of all courts within their jurisdictions, including district8 and other subordinate
courts.
able sovereign discretion over the states, creating a
relatively centralized federation. In particular, the
assignment of residual political and fiscal authorities
to the center, either explicitly or through escape
clauses, represents the polar opposite of the principle of subsidiarity,5 found, for example, in United
States and European federal institutions.
The primary expression of statutory constitutional
authority in India comes through directly elected
parliamentary-style governments at the national and
state levels, as well as (relatively new) directly elected government bodies at various local levels. The
national parliament has two chambers, one (the Lok
Sabha or peoples’ assembly) directly elected in single member, first-past-the post constituencies, the
other (the Rajya Sabha, or states’ council) indirectly
elected by state legislators. The Prime Minister and
council of ministers serve as the executive branch,
rather than the largely ceremonial President of the
republic. The states, plus the NCT and the UT of
Pondicherry, mostly have single-chamber, directlyelected legislatures, with Chief Ministers in the executive role. The other UTs are governed by central
government appointees. Each state also has a
Governor, nominally appointed by the President, but
effectively an agent of the Prime Minister. Overlapping political authorities at the central and state
levels have been dealt with through intra-party bargaining, and, more recently, through explicit bargaining and discussion.
At inception, the Indian constitution clearly laid
out the areas of responsibility of the central and
state governments, with respect to expenditure
authority, revenue raising instruments, and legislation needed to implement either. Expenditure
responsibilities are specified in separate Union and
State Lists, with a Concurrent List covering areas of
joint authority. Unspecified residual expenditure
responsibilities are explicitly assigned to the center.
Tax powers of the two levels of government are
specified in various individual Articles. Legislative
procedures for each level, particularly with respect
to budgets and appropriations, are also spelled out
in the constitution.
Concentration of powers in the hands of the central
government did not create serious conflicts in the
early years of the functioning of the constitution
since the same political party, the Indian National
Congress (INC), ruled at the center and in the states.
Many potential interstate or center-state conflicts
were resolved within the party. The INC was essentially an umbrella organization that had pursued a
campaign of independence from colonial rule, and
this nationalist history contributed to its initial nearmonopoly of political power.
Powers of legislation for the center and states follow
the responsibilities assigned in the three constitutional lists, but there are several broad “escape clauses,” which give the national parliament the ability to
override the states’ authority in special circumstances, with a role for the Supreme Court as arbiter
in some cases. The power to amend the constitution
also resides with the national parliament, with a
India’s relative political centralization was also
reflected in bureaucratic and judicial institutions.
The national Indian bureaucracy is provided constitutional recognition, and there are provisions for
independent bureaucracies in each state. The key
component of the bureaucracy is the Indian
6 At the local level, IAS members are vested with some judicial
authority.
7 On the other hand, the Court has also tended to engage in some
centralizing judicial activism, to enforce laws down to the local
level.
8 In many ways, India’s almost 600 districts are the fundamental
administrative units of government, in a structure that goes back at
least to the colonial period, in which Indian Civil Service (the precursor of the IAS) officers acted as chief executives of districts.
5 This principle would assign residual or implicit authorities to the
lower level of government.
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Furthermore, sales taxes have been levied by exporting states on the inter-state sale of goods, making
these taxes origin-based, and relatively more distortionary in practice. Finally, adding to internal impediments to trade, states and localities have been permitted to impose various entry taxes, under a separate (and somewhat inconsistent) constitutional provision.
weak requirement that half or more of the states ratify the amendment for it to take effect.
The constitutionally assigned expenditure responsibilities of the central government are those required
to maintain macroeconomic stability (e.g., all monetary and financial issues), international trade and
relations, and those having implications for more
than one state, due to economies of scale or spillovers (e.g., defense, transport and communications,
atomic energy, space, oil and major minerals, interstate trade and commerce, and interstate rivers). The
major subjects assigned to the states comprise public
order, public health, agriculture, irrigation, land
rights, fisheries and industries and minor minerals.
The Concurrent list includes major areas such as
education and transportation, social security and
social insurance.
The situation with respect to local governments is
somewhat distinct from the center-state division of
powers. Two constitutional amendments in 1993 gave
local governments a firmer political footing, but had
to leave many legislative details to the states, since
local government was, and remained in, the State
List. Furthermore most local responsibilities are subsets of those in the State List. There is no “Local
List” as such, but the constitution now includes separate lists of responsibilities and powers of rural and
urban local governments.10 The lists of local expenditure areas, though now broader and more explicit
than was typical of past practice, still overlap considerably with the State List, so most local responsibilities are, in practice, concurrent responsibilities. This
includes major areas such as education, health, water
and sanitation.
The initial constitutional assignment of tax powers in
India was based on a principle of separation, with tax
categories being exclusively assigned either to the
center or to the states. The center was also assigned
all unspecified residual tax powers. Most broadbased taxes were assigned to the center, including
taxes on income and wealth from non-agricultural
sources, corporation tax, taxes on production
(excluding those on alcoholic liquors) and customs
duty. These were often taxes where the tax revenue
potential was greater, as a result of relatively lower
collection costs, and higher elasticities with respect
to growth. At the subnational level, a long list of
taxes was constitutionally assigned to the states, but
only the tax on the sale of goods has turned out to be
significant for state revenues. This outcome is largely a result of political economy factors (e.g., rural
landed interests were initially quite powerful in government at the state level) that have eroded or precluded the use of taxes on agricultural land or
incomes (and even user charges for public irrigation
and electricity) by state governments. Inefficiencies
arose in indirect taxes because, while in a legal sense
taxes on production (central manufacturing excises)
and sale (state sales taxes) are separate, they tax the
same base, causing overlapping and cascading, and
effectively leaving the states less room to choose indirect tax rates.
With assignment of local tax powers and details of
expenditure assignments left to state-level legislation, there has been considerable variation across
the states, though in general they have provided
very little revenue autonomy to local governments,
especially rural bodies. Local governments have
relied on building and property taxes in the past, as
well as entry taxes for some urban areas, but significant new taxes have not been assigned to local bodies after reform.11 In many cases, states chose to
hold back in devolving the full constitutional list of
local functions,12 and capped village level authority
to directly approve expenditures, often at very low
levels. Paralleling these constraints, local govern-
9
Article 301 of the Constitution states, “subject to the other provisions of this part, trade, commerce and intercourse throughout the
territory of India shall be free”. However, Article 302 empowers
Parliament to impose restrictions on this freedom in the “public
interest” – a term that is both very broad and not clearly defined in
this context.
10 The Union, State and Concurrent Lists are in the Seventh
Schedule, whereas the new responsibilities of rural and urban local
governments are in the Eleventh and Twelfth Schedules, added
through the 1993 amendments.
11 Local governments often have a large number of relatively unimportant taxes at their disposal, including entertainment and profession taxes, but are not permitted to piggyback on significant state
and central taxes such as income and sales taxes.
12 For example, while the constitutional schedule of local responsibilities includes “health and sanitation, including hospitals, primary
health centers and dispensaries,” in practice, the states have maintained control over these functions.
The framers of the constitution were aware of the
need for a common market, but included another
broad escape clause.9 An early amendment to the
constitution added clauses that enable the central
government to levy taxes on inter-state transactions.
CESifo Forum 1/2007
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channels tend to slightly increase horizontal inequality in fiscal capacities.
ments also have little legislative autonomy. This is
particularly true for rural governments, though traditional village level committees (panchayats) have
a history of acting as quasi-legal arbiters and
enforcers through social norms. City governments,
of course, do have a well-established tradition of
local ordinances.
Local governments are even more dependent on
transfers from higher levels. In 2002 to 2003, rural
local governments’ own source revenues were less
than 7 percent of their total revenue and less than
10 percent of their current expenditures (Finance
Commission, 2004). Urban local bodies did somewhat better, with proportions closer to those of the
states. They raised about 58 percent of their revenue
and covered almost 53 percent of their expenditure
from own revenue sources. Note that aggregate local
government revenue and expenditure constituted
just about 1 and 5 percent, respectively, of total government revenue and spending at all levels.17 Thus,
the overall scope, as well as fiscal autonomy, of local
governments in India remains very limited.
At both the state and local levels, revenue authority
falls short of what would allow each level to independently meet its expenditure responsibilities. To
some extent, this is a natural outcome of the different driving forces for assigning revenue authority
and expenditure responsibility.13 In 2004 to 2005, the
states on average raised about 39 percent of combined government revenues, but incurred about
66 percent of expenditures.14 Transfers from the center, including tax-sharing, grants and loans made up
most of the difference, with the states also borrowing
moderately from other sources.
Since 1993, a system of formal state-local transfers
with State Finance Commissions (SFCs) has been
mandated. These SFCs have struggled to formulate
the principles for sharing or assigning state taxes and
fees, and for making grants. There remains considerable variation in the quality of analysis, methodologies used, and implementation of transfers across the
different states. The states’ own fiscal problems have
restricted progress in this dimension. Some states
have been slow to constitute SFCs, and some have
been tardy in implementing their recommendations.
The outcome has been significant uncertainty, which
hampers effective use of funds by local governments.
Sometimes, SFC recommendations have been largely ignored by state governments. Thus, while the SFC
system has made local government financing somewhat more transparent than before, it has not significantly altered the fiscal constraints faced by local
governments.
The constitution provided for tax-sharing between
the center and the states, as well as central grants to
the states. The shares are determined by a constitutionally-mandated Finance Commission, which is
appointed by the President of India every five years
(or earlier if needed). These transfers are mostly
unconditional in nature.15 The Commissions have
developed an elaborate methodology for dealing
with horizontal and vertical fiscal imbalances. In particular, the formula for tax devolution is quite complicated, as a result of attempts to capture simultaneously disparate or even contradictory factors. The
end result of Finance Commission transfers is a mild
degree of horizontal equalization across the states
(Rao and Singh 2005, Chapter 9). A completely separate body, the Planning Commission (PC), makes
categorical grants and loans for implementing development plans. As economic planning gained emphasis in independent India’s early decades, the PC
became a major dispenser of such funds to the states,
and it also coordinates central ministry transfers:16
almost one-third of center-state transfers are made
through these channels. Transfers through these
A final aspect of India’s federal system concerns
subnational borrowing. According to the constitution, states cannot borrow abroad, and they require
central government approval for domestic borrowing whenever they are in debt to the center. In fact,
that condition has prevailed almost invariably,
since the central government was, until fairly
recently, the states’ main source of lending, and
every state is indebted to the center.18 Many central loans are made under the supervision of the
13 Most significantly, mobility across jurisdictions increases as the
size of the jurisdictional unit decreases. A tax base that is mobile
may shrink dramatically in response to a tax, making it harder for
smaller jurisdictions to raise revenue from taxes.
14 These figures are constructed from various tables in RBI (2006).
Both proportions do vary somewhat from year to year, and have
been subject to political cycles. Such calculations still include local
government spending.
15 Some transfers have been earmarked for health and education
spending by the states, and, after 1993, for local governments.
16 There are over 100 ministry-sponsored schemes, ranging from
specific projects to broad programs. Their effectiveness is generally
deemed to be low.
17 This contrasts sharply with China, where the corresponding percentages for revenue and expenditure are about 23 and 51 (Singh
2007).
18 Central loans account for about 22 percent of the states’ present
debt stock (RBI 2006, Appendix Table 36).
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CESifo Forum 1/2007
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central administrative discretion and intergovernmental bargaining to set the rules of the game,
achieving de facto federalism.
Planning Commission (PC), and have been tied to
PC grants in a fixed proportion. Central loans also
include funds from multilateral agencies or other
external sources for specific programs and projects
in particular states, ad hoc loans based on exigencies in individual states, and short term ways and
means advances.
Federal reforms
Despite periodic discussions of constitutional overhaul, India’s political institutions have remained
remarkably stable. The legal underpinnings of these
institutions have not changed dramatically, with the
single exception of the creation of directly-elected
local governments in 1993, as outlined earlier. So
far, that reform has not had major consequences for
the conduct of India’s polity, though it has dramatically increased the number and diversity of elected
officials nationwide. One institutional reform that
did emerge in 1990 was the creation of the InterState Council (ISC), which includes the Prime
Minister, state chief ministers, and several central
cabinet ministers as members, and has become a
forum where political and economic issues of joint
concern can be collectively discussed, and possibly
resolved.21
States also tap the National Small Savings Fund,
consisting of mostly rural savings collected through
post offices.19 Other, effectively captive, sources of
borrowing for the states are mandated pension and
insurance contributions of government employees
(minus payouts), and state-owned financial institutions such as public sector banks. States have also
“borrowed” by delaying payment of bills, especially
in the case of State Electricity Boards (SEBs),
state-government-owned utilities that failed to pay
their bills to the central government-owned
National Thermal Power Corporation. Central
lending – often subject to debt relief or rescheduling – and state borrowing from captive sources have
softened subnational budget constraints in India.
However, overall, this problem is less severe in
India than in Latin America, and perhaps even than
in China.20
Within this relatively static institutional framework,
the 1991 economic reforms, which substantially loosened central government control of foreign and
domestic corporate investment, allowed state governments to become more autonomous actors in
economic policy (e.g., Sinha 2004; Singh and
Srinivasan 2005; Singh 2007), with horizontal competition among (at least some) state governments
replacing rent-seeking interactions with the center.
In this respect, therefore, reforms that liberalized
central government control of the private sector also
promoted greater de facto federalism at the state
level. 22
To place India’s federal system, as summarized
above, in international context, a high-level view
does not obviously distinguish it from other de jure
federations. The constitutional division of powers is
similar in form to many other countries. The use of a
tax sharing arrangement governed by a quasi-independent body parallels arrangements in other exBritish colonies, such as Australia and Canada.
Broad goals of horizontal equalization of fiscal
capacity are also common across many federations.
However, India’s federal system differs in many of
its institutional details and practices, including the
parallel system of plan transfers, the nature of the
formulas used for intergovernmental transfers, and
the institutional mechanisms for intergovernmental
bargaining. Overall, India appears to be much more
centralized than other federations, especially when
size is accounted for. The only comparator on that
dimension is China, which is politically more centralized, but gives local governments much greater fiscal
autonomy. China is also different in relying more on
Tax reform has been a significant and ongoing part
of the overall economic reform process in India.
Initially, the central government emphasized extreme progressivity and narrow targeting, resulting
in a very inefficient tax structure (including prohibitively high tariffs), and tax administration that
was highly susceptible to corruption. Economic
21 The flexibility and breadth of scope of the ISC’s possible concerns distinguish it from the much older National Development
Council (NDC), which has somewhat similar membership, but
focuses only on five-year-plan allocations.
22 The references cited in footnote 1 examine the salience of this
kind of development in China, which remained politically highly
centralized. In the Chinese case, much of this economic decentralization took place down to the local level – this has not happened
in India to date (Singh 2007).
19
This category makes up about 27 percent of states’ debt stock.
See the contributions in Wallack and Srinivasan (2005). While the
references in footnote 1 stress the hardness of subnational budget
constraints in China, particularly for provinces, and early in the
reform process there, more recent evidence suggests that local government budget constraints have softened: see Singh (2007) for references.
20
CESifo Forum 1/2007
26
Focus
reform has led to a substantial rationalization of
the central government tax structure, in terms of
lowering marginal rates, simplification of the rate
structure, and some degree of base broadening.
This reform agenda was laid out in several expert
committee reports, from 1991 to 2004. In the realm
of tax administration, also, some progress has been
made, through simplification of taxes, changes in
administrative procedures and use of information
technology.
Formulas for dividing allocated tax revenues among
the states, and for making Planning Commission
allocations, have remained relatively static over the
years, reflecting the power of precedent. One
change, however, was driven by developments in the
1980s and 1990s.25 By the late 1980s, the fiscal positions of the states, as well as the center, had already
begun to deteriorate. In 1991, fiscal deficits were
quite high, and the process of overall economic
reform was tied to the need for fiscal consolidation
of government. The Eleventh Finance Commission
was the first to be asked to examine government
finances in an integrated manner, and to make recommendations for enhancing fiscal consolidation.
Initial ad hoc attempts by the center to impose fiscal
discipline included “contracts,” in the nature of
MOUs with states that exchanged promises of fiscal
reform for ways and means advances; these ran into
problems of credibility and commitment. The
Eleventh Finance Commission, therefore, recommended that a portion of central-state transfers be
made conditional on fiscal reforms, according to a
preset formula. However, the incentives for fiscal
discipline thus provided were again too weak to be
effective.
Tax reform has been slower at the state level.
However, by early 2007, the center had persuaded
the states to replace the old system of taxation of
interstate sales with a destination-based VAT. This
represents a major improvement in the efficiency of
the tax system, including addressing impediments to
an internal common market. Agreement on this
shift came through the workings of a committee of
state Finance Ministers, which developed a stepwise
implementation plan. The Finance Commission
offered a formula for compensating states for revenue losses during the transition.23 The next step
will be to create a unified Goods and Services Tax
(GST), which combines the central and state VATs.
One anomaly in this transition has been the status of
taxes on services. The original constitution implicitly assigned service taxes to the center, through its
residual powers over taxes. In 2004, the central government chose to add service taxes explicitly to the
Union List, via a constitutional amendment.
According to the new institutional regime for service taxes, they are to be shared with the states, in a
manner to be determined by Parliament, and therefore outside the “common pool” that is divided
among the states by the Finance Commission.
Moving toward a comprehensive GST will include
resolving this anomaly.
The latest approach to encouraging fiscal discipline
involves commitment to explicit targets for deficit
reduction through fiscal responsibility legislation.
The central government and many state governments have passed such legislation. The Twelfth
Finance Commission, in 2004, recommended pushing the remaining states toward this commitment by
tying debt relief (which was also included in the
commission’s charge) to the passage and implementation of fiscal responsibility laws. Even in the
absence of such incentives, fiscal responsibility legislation has created public benchmarks for evaluating
state fiscal performance. The Commission has also
reiterated earlier criticisms of the process of making
plan transfers as being opaque, cumbersome, conceptually ill-defined, and poorly coordinated and
monitored. Arguably, these problems contribute to
difficulties in enforcing hard budget constraints at
the state level.
A major reform of the intergovernmental transfer
system was initiated in 1994, with the recommendation of the Tenth Finance Commission that the original constitutional scheme of revenue change from
only a small number of taxes being shared between
the center and the states, to the entire consolidated
fund of the center being so shared. This change was
implemented through a constitutional amendment
ratified in 2000, and has reduced the incentive of the
central government to discriminate among the different taxes it collects.24
24
For example, in the old arrangement, income taxes were shared,
and almost all assigned to the states, but income tax surcharges
were entirely kept by the center. Unsurprisingly, the central government favored using surcharges whenever possible. As noted in
the previous paragraph, now only service taxes are outside the consolidated sharing arrangement; this anomaly has been obliquely
criticized in the latest Finance Commission’s report.
25 The creation of independently elected local governments has also
given the Finance Commission a new role of making transfers earmarked for local governments, and in monitoring the workings of
the SFCs.
23 A detailed account and analysis of the features of the new system, and the process of adoption, is given by Rao and Rao (2006).
27
CESifo Forum 1/2007
Focus
since regional identities are strong. The Hindispeaking states located in the northern IndoGangetic plain have some degree of homogeneity,
and traditionally were the source of core support.
At the southern extreme of the country, the state of
Tamil Nadu was already asserting its individuality
by the 1960s, with political power at the state level
being impossible without support from a statebased (i.e., Tamil-specific) party. In the 1970s and
1980s, centralization increased, but more as a
response to inherent pulls for a more decentralized
polity (Brass 1990). From 1989 onward, no national
party has been able to form a government at the
center without some degree of coalition-building,
with emergent regional parties claiming pivotal
roles.26 This dynamic of political decentralization
has shaped many of the reforms, as we explain in
this section.
Market borrowing has always been available to the
states, subject to national government control and discretion. However, much of this borrowing has been
through private placements with financial institutions
at controlled interest rates. The Twelfth Finance
Commission recommended that states should,
instead, primarily access the market directly for borrowing, paying market-determined interest rates. The
Commission also proposed ceilings on aggregate borrowing (including state-level guarantees) and debt,
and these constraints would be an important component of a market borrowing regime. Several states
have included such limits in their fiscal responsibility
laws. Furthermore, the central bank (Reserve Bank of
India, or RBI) is actively studying the development of
institutions to support this shift to market borrowing,
including offering mechanisms, secondary markets for
government debt, credit ratings, and methods of regulation and monitoring. The background for this
process is the center’s own shift in the 1990s toward
paying market rates for its borrowing.
There is empirical evidence that central loans, food
assistance and subsidies to the states were all linked
to electoral considerations (Chhibber 1995) in the
1970s and 1980s. Thus, the deepening of rent-seeking
by politicians and interest groups was driven by
intensifying needs of political competition, and powers of patronage for electoral support overwhelmed
concerns about the inefficiency of the system. The
attempt to strengthen local governments can also be
seen in this light. Whereas there had been a decadesold ideological strand favoring decentralization of
government, it was only in the late 1980s that an
attempt was made to institutionalize decentralization through constitutional changes. It has been
argued that the impetus came from the desire of the
national ruling party (the Congress) to balance the
growing power of state-level politicians. This motivation also explains why many states have been reluctant to devolve significant financial powers to their
subordinate local governments. Nevertheless, an
unintended consequence of the change has been a
genuine effort to build local capacity: in particular,
some larger urban governments have received more
political space to pursue policies for local economic
development, including borrowing from the market
for infrastructure projects. NGOs and multilateral
institutions have also been able to be more involved
at the local level.
If one can sum up the different components of federal
system reform that have taken place in about the last
15 years (the approximate period of systematic overall
economic reform and liberalization), tax reform –
working toward conventional microeconomic efficiency – can be characterized as the area where the greatest progress has been made. The scope of the Finance
Commission to make recommendations regarding
overall federal finances has been enhanced significantly, though actual practice has changed less. Some
isolated institutional reforms, such as the tax-sharing
arrangement and the creation of the ISC, have been
significant. On the other hand, many other features,
such as the process of planning and making plan and
programmatic transfers, have changed relatively little.
The proposal to shift to true market borrowing for the
states (and to some extent for larger urban local governments) represents a major reform that is still in
process. At the same time, many of the other efforts to
deal with subnational fiscal deficits have the flavor of
dealing with symptoms rather than causes. Understanding this process of incomplete and piecemeal federal reform therefore requires an analysis of the causes, in terms of political power and bargaining, that goes
to the heart of federal arrangements in India.
Another unintended consequence for India’s federal
system emerged from the liberalization of national
Reform dynamics
26
In some cases, there are overlaps between ideology and region,
as in the communist parties of West Bengal and Kerala. The role of
regional parties is detailed in the references cited in footnote 2.
Political power at the national level in India has
always required some degree of coalition building,
CESifo Forum 1/2007
28
Focus
industrial controls. State governments have been
able to pursue subnational economic agendas more
freely. Regulatory and permission issues for the private sector were now often shifted to the state level
rather than the center (Sinha 2004). States have even
been able to negotiate with multilateral institutions,
in ways that may have shifted potential costs to the
center (Chakraborty and Rao 2006), in the form of
softer budget constraints. Many of the federal system
reforms that have been attempted (e.g., incentives
for overall fiscal discipline) or proposed (e.g., subnational market borrowing) can be seen as responses
to the unintended consequences at the state level of
relaxing national control of private sector economic
activity. Central government motives themselves
reflect a mix of concerns for overall economic performance, as well as a desire for rent-capture. In
some cases, concerns for rent preservation are
salient at the state level, and this hampers overall
reform. The most striking example of this is in the
electric power sector, where the SEBs are loss-making and highly inefficient, but also large public sector
employers: power supply remains perhaps the greatest and longest-standing constraint on India’s growth
(Singh 2006).
tutions deteriorated, and legislative quality and
processes eroded (Kapur and Mehta 2006), there
emerged a gap in the institutions to manage conflicts
with a federal dimension. In fact, ‘center-state relations’ became a topic of urgent concern: the formation of the ISC followed quickly on a 1988 recommendation made by a major governmental commission that was appointed to address this issue. The
ISC has sometimes been seen as too weak and ad
hoc, and it is less transparent than parliament, for
which it substitutes as a discussion and consensusbuilding forum, but it appears to have filled the gap
adequately. For example, how to go forward with the
proposal to change the tax sharing arrangement was
hammered out in the ISC, and other federal matters
such as sharing of inter-state river waters have also
been dealt with there (Richards and Singh 2002;
Kapur 2005). In fact, in areas such as tax reform,
another, more specialized bargaining forum has
emerged using the same model, the “Empowered
Committee” of State Finance Ministers. This committee has made recommendations on the process of
the states’ switch to a VAT (now essentially complete), and tax harmonization such as floor rates to
avoid any “race to the bottom” in tax rates.
It is also true that academic (or technocratic) inputs
have played a role in reforms (Rao and Singh 2007).
Typically, these work through government-appointed expert committees (such as several on tax reform), or through the Finance Commissions, which
can include academics among their members. The
reform of tax sharing owes something to this process,
as does the entire conceptual framework of tax reform. It remains the case, however, that politicians
and bureaucrats choose what to implement, and clarity about who benefits and loses is important. Thus,
changing the basis of tax sharing between the center
and the states in aggregate was much easier than
coordinated reforms of the indirect tax system across
the states. Even making substantive changes in the
formula for allocating transfers across states is difficult in this respect. Only a subset of academically
inspired (and presumably desirable) reform proposals lead to political action, with uncertainty with
respect to consequences for different interest groups
and problems of compensating losers being twin
obstacles to adoption.
One may argue that institutional developments still
lag behind changes in India’s situation with respect
to its federal character. Economic reform has initially benefited some states and regions more than others (Kochhar et al. 2006; Rao and Singh 2005, and
references therein), and increased regional inequality makes it both more important and more difficult
to build winning subnational coalitions for reform.
Most recently, central government policy actions
have been aimed at boosting political support in
poorer, more rural states. Unsurprisingly, buoyant
tax revenues resulting from reform and consequent
higher growth rates have been earmarked for
increased spending on health, education, rural infrastructure, and social insurance, rather than accelerated reduction of the fiscal deficit.
Current federal institutions also get pulled in opposite directions. Thus, the latest Finance Commission
has changed the tax sharing formula to favor betteroff states, while simultaneously increasing targeted
grants to poorer states. In some ways, intergovernmental transfers remain an arena for significant subnational influence activities and bargaining over
division of the government revenue pie. The
Planning Commission has articulated a case for further decentralizing expenditure authority in areas
If one makes the political bargaining process the
focus of understanding the dynamics of reform, it is
clear that the institutions that govern this process are
critical. Arguably, as the INC fragmented, party insti-
29
CESifo Forum 1/2007
Focus
pie. Many of the large countries grappling with economic reform include, unsurprisingly, those with
variants of federal systems (e.g., Brazil, Indonesia,
Russia, and South Africa, in addition to India and
China). There are special challenges for implementing change in countries with multiple layers of political authority and divided sovereignty. The literature
on federalism has not sufficiently addressed the issue
of reform in developing countries with federal structures (Wibbels 2005). Nor has there been adequate
attention to the political determinants of federal
institutions, and how these shape the reform process
(Rodden 2006). This piece contributes to that ongoing research program.
such as health and education, as well as for measuring outcomes of spending from categorical transfers,
but complementary institutional reforms,27 which
would make these objectives feasible, have not been
pursued. The Finance Minister has also raised the
issue of civil service reform (which could have an
important federal dimension), but again there is
enough opposition within government to make such
reforms difficult: in such cases, government decisionmakers are themselves potential losers.
Conclusions
Explicitly recognizing the political dynamics of federal reforms creates a different perspective for
making policy recommendations. Even in cases
where the reform does not change federal institutions, it may require coordinated action at different
levels of government (e.g., in areas such as agriculture, power supply, health and education: see, in
particular, Singh and Srinivasan 2005). Instead of
examining ideal and isolated reforms, the focus
instead is on political feasibility. Where winners and
losers can be identified, it may be possible to create
packages of reforms that are politically acceptable,
e.g., assigning greater revenue authority to local
governments may be combined with reassigning
some taxes from the center to the states (or allowing piggybacking), and cutting the states’ share of
the consolidated fund of the center (Rao and Singh
2007). Thus, combinations of reforms may be
accepted, where individual reforms would lose: the
traditional economic compensation principle is
implicitly applied in such cases. This approach can
also guide the redesign and changes in the working
of institutions such as the Finance Commission,
Planning Commission, and ISC (e.g. Rao and Singh
2005; Singh and Srinivasan 2006).28
The approach articulated here is also related to
recent work by Rajan and Zingales (2006). They
argue that interest groups, or rent-defending constituencies, may, depending on the initial distribution
of endowments, trump democratic institutions and
block economy-enhancing reforms. In such cases,
direct redistribution is also going to be politically
infeasible. We conjecture that federal systems may
have an additional degree of freedom, where supplementing subnational revenue and expenditure
authorities may also relax political constraints to
economic reforms that provide aggregate benefits.
This is a topic for future research.
References
Brass, P. (1990), The Politics of India Since Independence, New York:
Cambridge University Press.
Cao, Y., Y. Qian, and B. R. Weingast (1999), “From Federalism,
Chinese Style, to Privatization, Chinese Style”, Economics of Transition 7, 103–131.
Chakraborty, P. and M. G. Rao (2006), “Multilateral Adjustment
Lending to States: Hastening Fiscal Correction or Softening the
Budget Constraint?”, Journal of International Trade and Economic
Development 15, 335–358.
Chhibber, P. (1995) “Political Parties, Electoral Competition,
Government Expenditures and Economic Reform in India,”
Journal of Development Studies 32, 74–96.
The perspective taken here for India can be seen in
a more general context. It is an extension of Riker’s
instrumental view of federalism, as “a constitutional
bargain among politicians”, with the motives being
“military and diplomatic defense or aggression”
(Riker 1975, 113–114). Here, bargaining is not just in
constitution making, but also in evolution of subsequent governance, and not just for territorial protection or gain, but also over splitting the economic
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Commission (2005-10), November, http://fincomindia.nic.in/Report
of 12th Finance Commission/index.html
Jin, H., Y. Qian, and B. R. Weingast (2005), “Regional Decentralization and Fiscal Incentives: Federalism, Chinese Style”, Journal of
Public Economics 89, 1719–1742.
Kapur, D. (2005) “The Role of India’s Institutions in Explaining
Democratic Durability and Economic Performance,” in: Kapur, D.
and P. B. Mehta (eds.), Public Institutions in India: Performance and
Design, New Delhi: Oxford University Press.
Kapur, D. and P. B. Mehta (2006), The Indian Parliament as an
Institution of Accountability, Democracy, Governance and Human
Rights Programme Paper 23, United Nations Research Institute for
Social Development, January.
27
Essentially, such reforms would transfer revenue authority,
including spending on personnel, to lower level governments.
Hence, the positive analysis offered here also has some potential
normative implications.
Kochhar, K., U. Kumar, R. Rajan, A. Subramanian and I. Tokatlidis
(2006), India’s Pattern of Development: What Happened, What
Follows?, IMF Working Paper WP/06/22.
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Laffont, J.-J. and Y. Qian (1999), “The Dynamics of Reform and Development in China: A Political Economy Perspective”, European
Economic Review 43, 1105–1114.
Montinola, G., Y. Qian, and B. R. Weingast (1995), “Federalism,
Chinese Style”, World Politics 48, 50–81.
Qian, Y. and G. Roland (1998), “Federalism and the Soft Budget
Constraint”, American Economic Review 88,1143–1162.
Qian Y., G. Roland and C. Xu (1999), “Why is China Different from
Eastern Europe? Perspectives from Organization Theory”, European Economic Review 43, 1085–1094.
Qian, Y. and B. R. Weingast, (1996), “China’s Transition to Markets:
Market-preserving Federalism, Chinese Style”, Journal of Policy
Reform 1, 149–185.
Rajan, R. G. and L. Zingales (2006), The Persistence of Underdevelopment: Constituencies and Competitive Rent Preservation,
NBER Working Paper 12093, March.
Rao, M. G. and K. Rao (2006), Trends and Issues in Tax Policy and
Reform in India, Paper presented at Brookings-NCAER Conference on India, March 2006.
Rao, M. G. and N. Singh (2005), Political Economy of Federalism in
India, New Delhi: Oxford University Press.
Rao, M. G. and N. Singh (2007), “The Political Economy of India’s
Fiscal Federal System and its Reform”, Publius: The Journal of
Federalism, 37, 26–44.
Richards, A. and N. Singh (2002), “Inter State Water Disputes in
India: Institutions and Policies,” International Journal of Water
Resources Development 18, 611–625.
Riker, W. (1975), “Federalism,” in: Greenstein, F. I. and N. W. Polsby
(eds.), Handbook of Political Science, vol. 5, Reading, MA: AddisonWesley.
Rodden, J. (2006), Hamilton’s Paradox: The Promise and Peril of
Fiscal Federalism, New York: Cambridge University Press.
Sáez, L. (2002), Federalism without a Centre: The Impact of Political
and Economic Reform on India’s Federal System, New Delhi: Sage
Publications.
Singh, N. (2006), Services-Led Industrialization in India: Assessment
and Lessons, UCSC Working Paper, December.
Singh, N. (2007), Fiscal Decentralization in China and India:
Competitive, Cooperative or Market Preserving Federalism?,
UCSC Working Paper, January.
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(eds.), Federalism and Economic Reform: International Perspectives,
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Development in India: An Assessment, Conference Paper, Stanford
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of Economic Policy Reform in Asia, May 31–June 3 2006, Revised,
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India: A Historical Institutionalist Approach”, India Review 3, 25–63.
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Reform: International Perspectives, Cambridge, UK: Cambridge
University Press.
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Conflict and Economic Reform in the Developing World, New York:
Cambridge University Press.
31
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Focus
system and the transition to flexible exchange
rates in major markets?
• Some emerging economies nowadays still peg
their currency to the USD or at least manage
their exchange rates. What is the rationale behind
this?
• What are the opportunity costs of accumulating
reserves, and how can these countries hedge the
risk of value losses in terms of domestic currency
of their stock of reserves?
• How can these reserves be continuously diversified? Is there an optimal strategy for the management of these economies’ foreign exchange
reserves?
ANTICIPATED EFFECTS OF
FOREIGN CURRENCY RESERVE
DIVERSIFICATION IN ASIAN COUNTRIES: DO
CHINA AND INDIA
MATTER FOR COORDINATION?
FRIEDRICH L. SELL*
C
hina achieved an extraordinary GDP growth
rate of 10.7 percent in 2006 which is the highest
since 1995. In addition, its level of international
reserves has risen to a level of more than USD 1 trillion. Such continuous foreign currency reserve accumulation since 2000 does not appear to be unique,
however. Other emerging economies like India and
Brazil seem to mimic China’s strategy. Figure 1
demonstrates a clear upward trend in the world’s
international reserve accumulation and it also shows
that China and India have greatly contributed to this
process. China meanwhile accounts for more than
20 percent of these reserves.
Major emerging economies such as China and India
are nowadays in a totally different balance of payments position vis-à-vis the industrialized countries,
especially the United States than in past years. They
are running huge balance of payments surpluses and
their exchange rate policy can have a significant
impact on the size and allocation of the US current
account deficit. Other industrialized countries, too,
are beginning to worry about the exchange rate policies of emerging economies, as they feel that these
hamper their own export potential to these countries. Many emerging economies have organized a
complete turnaround in their exchange rate policies
since the beginning of the new millennium. After the
Regardless of the speculation whether this might
lead to a real depreciation of their currencies or
not, one can a priori argue that the price of their
currencies is (still) definitely
undervalued in the foreign
Figure 1
exchange markets. While most
of these countries have strongly
DEVELOPMENT OF RESERVES IN THE WORLD, CHINA AND INDIA
favoured the USD in the past,
SINCE 2000
Billion USD
they now fear a sharp devalua5 000
tion of the USD. In this context
World foreign exchange reserves
4 500
Foreign currency reserves China
some interesting questions
4 000
Foreign currency reserves India
emerge:
3 500
3 000
• What sense does it make to
hoard foreign currencies
more than 30 years after the
end of the Bretton Woods
2 500
2 000
1 500
1 000
500
0
* Department of Economics, University
of the German Armed Forces Munich. I
would like to thank Beate Sauer for
excellent research assistance.
CESifo Forum 1/2007
2000
2001
2002
2003
2004
2005
(a) World Reserves and China`s Reserves: Sept 2006, India`s Reserves June 2006.
Sources: IMF, People`s Bank of China, Reserve Bank of India.
32
2006 (a)
Focus
and the Canadian dollar are also taken into account
(Siebert 2006). Market experts, however, argue that
the yuan is still strongly pegged to the US dollar.
More precisely, the yuan seems to have recently followed the path of an appreciating crawling peg (see
Figure 2).
experiences gained during the Mexican, the Asian,
the Russian, and the Brazilian financial crises in the
1990s as well as the Argentinean crisis some years
ago, they developed a combination of new strategies
that include: (1) Paying back their debt to international organizations like the IMF as soon as possible1, (2) pegging their currency to a single currency
or to a basket of currencies without committing to a
strict and passive rule as a currency board would
command, (3) accumulating foreign exchange
reserves aimed at better overcoming a balance of
payments crisis or at easily depreciating their own
currency through foreign exchange market interventions.
As a measure of controlling inflation, the People’s
Bank of China (PBC) sells securities in order to
drain off the excess liquidity which is created when
the bank buys foreign currencies. The PBC has made
a huge profit out of its foreign exchange operations.
The PBC sells the yuan-denominated central bank
bonds to the good burghers of Shanghai while buying much higher yielding dollar bonds (McKinnon
and Schnabl 2006). According to the Bank for
International Settlement (BIS), China hereby is
earning up to one percent of its annual GDP. In a
two year period from 2003 to 2004 the stock of sterilization papers increased by about 265 percent,
which expanded again by about 88 percent (or by a
value of USD 117 billion) from 2004 to 2005 – reaching USD 250 billion for the overall stock of bonds.
However, the growth of the stock of central bank
bonds held by domestic banks comprises only slightly more than half of the increase in total reserves.
Hence, not all of the external money is being sterilized; there is also an increase in liquidity leading to
the decline of inter-bank interest rates and the
accompanied strong credit growth.
China and India: Common properties and
differences in exchange rate policy
As Genberg (2006) puts it, the current exchange rate
arrangements in East Asia range from the strict
Hong Kong type of currency board arrangement to
the (managed) float of the Japanese yen. For many
years in the past, China had pegged its currency, the
yuan, to the US dollar. On 21 July 2005, Chinese
authorities announced three important changes in
the exchange rate regime. The major purpose of
these measures was: (1) stabilizing the value of yuan
with reference to a currency basket in the future,
(2) letting the yuan appreciate by 2.1 percent against
the dollar, and (3) allowing the exchange rate to fluctuate within a ± 0.3 percent band around a daily
fixed central parity. In recent years the yuan has
gradually appreciated against the dollar (see
Figure 2).
According to Chinese official
statements, there is presently a
type of basket pegging and the
stabilization of an effective
exchange rate in operation. The
currency basket consists of the
US dollar, the euro, the yen, and
the Korean won. In addition, the
Singapore dollar, the British
pound, the Malaysian ringgit,
the Australian dollar, the Russian rouble, the Thailand baht
The type of exchange rate policy chosen by India
seems to have a number of common elements with
that of China. This applies above all to the accumulation of reserves (see Figure 1). But the dimensions are quite different: India’s reserves amounted
Figure 2
EXCHANGE RATE DEVELOPMENT OF THE YUAN
8.4
CYN per USD
8.3
8.2
8.1
8.0
7.9
7.8
1
Argentina and Brazil have paid in full –
and earlier than expected – their entire
outstanding obligations to the IMF
amounting to USD 15.46 billion and
USD 9.6 billion, respectively in
December 2005.
7.7
2000
2001
2002
2003
2004
2005
2006
2007
Source: Federal Reserve Bank of New York.
33
CESifo Forum 1/2007
Focus
2001, the foreign exchange market interventions of the RBI
have contributed to a continuous increase in the official
reserves of the country (see
Figure 1). The Indian authorities, despite the “structural deficiencies” and the fiscal burden
mentioned above, are scrupulously sterilizing a high percentage of the foreign exchange
market interventions. This has
not been the case in China.
Moreover, the flow of foreign
2006
2007
capital into India has been rising over the years. This also
helps to explain the improved
economic growth in recent
years, but it makes the task of sterilization – which
seems even more important than in China given a
soaring inflation rate (see Figure 4) – much more
difficult for the central bank.
Figure 3
EXCHANGE RATE DEVELOPMENT OF THE RUPEE
50
INR per USD
49
48
47
46
45
44
43
2000
2001
2002
2003
2004
2005
Source: Federal Reserve Bank of New York.
to roughly USD 200 billion in 2006 which represents less than 20 percent of China’s (Reserve
Bank of India 2006). The Reserve Bank of India
(RBI), however, has to struggle even more than the
PBC does in order to neutralize the monetary
effects of the purchase of foreign exchange. Due to
the lack of central bank securities, the RBI has to
fall back on open market operations and must face
the scarcity of obligations denominated in rupee.
And, more importantly, India has been losing
money by accumulating reserves (about 1.2 percent of GDP p.a.), because domestic interest rates
exceed the US level. As a consequence, an additional fiscal burden emerges from central bank
interventions. This also applies to other emerging
economies such as Brazil.
Balance of payments development in China and
India
Let us have a look at the balance of payments position of China and India (see Table 1). China is in the
comfortable position recording a “double surplus”, a
surplus both in the current as well as in the capital
accounts. Both balances add up (after correcting for
errors and omissions) to the increase in international reserves. Notice that the implicit deficit in the
Chinese capital account of 2006 is only due to the
preliminary and asynchronous nature of the report-
Most experts expect the rupee to remain pegged to
the US dollar (Jayakumar et al. 2005). Officially, an
exchange rate determined by
market forces has existed since
Figure 4
June 2004. In fact, Figure 3
INFLATION
shows the exchange rate moveAnnual percentage change
ments in the short run. Taking a
%
6
medium-run perspective, how5
ever, a moderate revaluation of
4
the rupee against the US dollar
can be observed since the
3
spring 2002. On the one hand,
2
this is not a fully unexpected
1
development, given the wellknown weakness of the green0
back in the foreign exchange
-1
markets during the same peri-2
od. Yet, there is something to
2000
2001
2002
2003
2004
be noted. Particularly since
Source: IMF, World Economic Outlook Database, September 2006.
CESifo Forum 1/2007
34
China
India
2005
2006
2007
Focus
Table 1
Development of China’s and India’s Net Exports, Net Capital Flows and Reserves since 2000
Capital Account
Current Account
(USD billion)
(USD billion)
2000
20.5
1.9
2001
17.4
34.8
2002
35.4
32.3
2003
45.9
52.7
2004
68.7
110.7
2005
160.8
63.0
2006
184.2a)
– 15.2b)
a)
IMF estimation. – b) Own calculation. – c) Sept 2006.
China
Changes in Reserves
(USD billion)
– 10.5
– 47.3
– 75.5
– 117.0
– 206.3
– 207.0
– 169.0c)
Source: State Administration of Foreign Exchange, China.
Current Account
(USD billion)
2000
– 4.7
2001
– 2.7
2002
3.4
2003
6.3
2004
14.1
2005
– 5.4
2006
– 10.6
Source: Reserve Bank of India.
India
Capital Account
(USD billion)
10.4
8.8
8.6
10.8
16.7
31.0
24.7
ed data for this year. As opposed to this, India shows
alternating signs in its current account. The capital
account has recently been in surplus and has easily
compensated the current account deficit in some
years. Both countries have accumulated reserves in
every year since 2000. This fact underlines the existence of a strategic exchange rate policy while these
countries have also been forced to solve the sterilization problem in their national monetary policy.
Changes in Reserves
(USD billion)
– 6.4
– 5.9
– 11.8
– 17.0
– 31.4
– 26.2
– 15.0
speculative capital inflows” (Goodfriend and Prasad
2006, 23). In China, the pressure to appreciate the
currency has recently been driven as much by capital
inflows as by current account surpluses (Mohanty
and Turner 2006).
Asian emerging economies, predominantly China
and India, have been accumulating their foreign
exchange reserves mainly in US dollar denominated
assets, primarily US state bonds (Sell 2006). Such a
policy has kept the price of the dollar high and, at the
same time, widened the US current account deficit.
That is why a new fear of floating is arising: the dollar might suffer from a rapid fall in value in the foreign exchange markets which then would necessarily affect the value of other countries’ own foreign
exchange reserves held in dollar denominated assets.
Such a monetary risk would also force the central
banks of a number of emerging economies to continuously buy US dollars and thereby contribute to
the stabilization of the greenback in the international foreign exchange markets (Sell 2007). Of course,
such a policy makes the reserves grow further and
accordingly the size of possible losses which accrue,
at least in domestic currency equivalents, in the case
of a more or less pronounced devaluation of the dollar. This would suggest, at first glance, that the incentives to intervene in the foreign exchange market
will tend to rise.
Autonomous versus coordinated management of
reserves
Beyond the already mentioned flow problems associated with the strategic exchange rate/balance of
payments policy in emerging economies, there is
another problem, which we may call the stock problem. The stock problem emerges from the accumulation of foreign exchange reserves and has two economic aspects. More precisely, it is the stock of
reserves held by a central bank of an emerging economy and the composition of these reserves that matter. In order to keep the exchange rate of the yuan
against the US dollar (more or less) fixed, Chinese
monetary authorities had accumulated around USD
1 trillion by the first quarter of 2007 and “the spike
in the pace of reserve accumulation during the period of 2001 to 2004 is largely attributable to a surge in
35
CESifo Forum 1/2007
Focus
tend to reduce the value of one currency, say the US
dollar, but raise the value of the euro and/or the
British pound in a either progressive or regressive
manner. This mismatch is illustrated in the following, based on a simple example which assumes that
the reserves of China consist of US dollars and
euros exclusively. Formally, the domestic value
equivalent of China’s international reserves can be
expressed as:
This statement, however, only holds with some
qualifications, because, first of all, there is a hidden
free-rider phenomenon (Sell 2006a). One could
also call it an implicit alliance problem. Even
though every single emerging economy (for which
the above described scenario holds) has a great
interest in a stable US dollar, it may be less enthusiastic to contribute to its stabilization by own foreign exchange purchases. A smaller share of US
dollars in its foreign exchange reserves through
diversification (in terms of a portfolio containing
dollars, yen, euros, etc.) serves as a hedge against
expected devaluations of the US dollar. In addition,
a larger number of currencies in the central bank
reserves enables the authorities to switch from the
de facto pegging to the US dollar to a more or less
flexible peg against a basket of different currencies.
In such a basket one would expect the currencies of
the major trading partners of the emerging economy in concern.
(1)
Y
Y
Y
R
=
$ +
{
3
$
4
Reserves
123
1
42
in Yuan Domestic equivalent of USD Domestic equivalent of Euro reserves
reserves
A complete differentiation of equation (1) leads to
the condition:
(2)
Y
Y Y
Y !
dR Y = d$ + $d + d + d = 0 , hence
$
$ Moreover, it is often argued that the longer the
diversification in the currency composition of central bank reserves is postponed, the higher will be
the expected loss in value of the foreign exchange
reserves. Assume as a type of rational expectations
that every monetary authority is well aware of this
matter. Consequently, those emerging economies
with a huge stock of dollar reserves will be tempted
to take the initiative and start with an autonomous
reallocation of their foreign exchange reserves. Yet
such an argument contains a fallacy because it
neglects an important general equilibrium aspect of
(interrelated) foreign exchange markets. When the
central banks of emerging economies sell US dollars, this action tends to depress the price of dollars,
while the other currencies which are exchanged for
dollars will gain in value by exactly the same
amount. In principle, the involved central banks
could, therefore, avoid any value losses in the
process of diversifying their portfolio of foreign
exchange reserves.
Y
Y ! Y
Y
d$ - $d = d + d $
$
Suppose the authorities hold their reserves in the
quantities of USD 1,000 and EUR 500 in the initial
year (period 0); the original exchange rates are
assumed to be 7.76 for the CNY/USD and 10.03 for
the CNY/EUR respectively:
RY = 1,000 . 7.76 + 500 . 10.03 = 12,780
As shown in the following calculation, the risk-free
condition for which the Chinese central bank can
diversify the reserves in the subsequent period (1)
taking advantage of an appreciating (depreciating)
trend of the euro (US dollar) is:
RY = 500 . 7.00 + 917 . 10.12 = 12,780
Example:
In reality, however, the central
banks will surely attempt to minimize those losses. Why is there a
difference between the theory and
the reality? In general, a reallocation of reserves and/or the exchange of currencies within the
portfolio of a central bank’s reserves go along with the ordinary
market forces, which, for example,
CESifo Forum 1/2007
Y
$ 0
d$
0,1
Y
0
Y
d
0,1
–380
$1
0,1
Y
d
$ – 3,880
1
82.53
d 0,1
4,182.51
losses in value = 4,264
36
gains in value = 4,264
Focus
The true problem emerging in this context is not so
much the question of when the process of diversification gets started, but rather how it is organized;
i.e. whether it will occur autonomously or in a coordinated way. An autonomous strategy chosen by a
single (but significant) emerging economy like
China could probably create an unpleasant and
extremely volatile situation in the foreign exchange
markets. The reason is the likelihood of possible
panic reactions among other emerging economies
following the first mover (China in our example).
Each of these countries would then be tempted to
immediately sell as many US dollars as possible in
order to limit the anticipated value losses. The risk
of losses may become more acute if the uncoordinated actions by the central banks selling a high
share of their foreign currency reserves in a short
period of time induce other market participants to
bet against the US dollar, leading to a sharp devaluation of this currency in the end. Although each
involved central bank would behave rationally
from its own point of view, the group of the emerging economies’ central banks could, however,
endanger the stability of the world’s financial markets. This scenario reminds us of panic sales in the
equity markets.
CB2
Hold
Hold
Sell
-1, -1
-1, 0
Intermediate
Reserves
Game
CB1
Sell
0, -1
0, 0
CB2
Hold
Hold
Sell
-1, -1
-3, -1
Large
Reserves
Game
CB1
Sell
How could such a run by the monetary authorities
on their own reserves (!) be possibly avoided? A
possible solution would be for the involved central
banks of emerging economies (especially in Asia)
to agree to proceed in a coordinated way. Not only
the United States, but also other major industrialized countries would have an interest in such coordination, given that they also want to avoid a sharp
depreciation of the dollar. The coordinated sales
of gold carried out by central banks of industrialized countries in recent years, which have more
than an eye on the gold price and its cyclical
moves, could serve as a good example. Let us make
the argument clear by two alternative game situations: When both monetary authorities (CB1,
CB2) have an intermediate level of reserves as
shown in scenario 1, holding reserves is a strictly
dominant strategy and the Nash equilibrium (0, 0)
is in the southeast corner of the payoff matrix. A
central bank which holds its dollar reserves
(regardless of what its counterpart attempts)
receives a negative payoff of – 1. The reason is that
the dollar continues to devalue at a moderate pace
in the international foreign exchange markets and
that continuing to hold reserves means giving up
the gains of diversification (0).
-1, -3
-2, -2
Referring to scenario 2, where both monetary
authorities have a large level of reserves, things
become more complicated. If one of the central
banks sells its dollars in the foreign exchange market, the devaluation of the dollar will accelerate. If
the other central bank continues holding dollars, its
losses will be extremely high, say (– 3). The selling
authority also faces losses, but these are in part compensated by the investment in appreciating currencies (– 1). If both authorities get rid of their dollars,
the downward trend of the dollar will be much more
pronounced. Hence, each central bank incurs losses
(– 2) in this case, which are greater than in the case
of jointly holding dollars (– 1). Therefore, the northeast corner could be a coordination equilibrium, provided that both central banks are confident that neither will sell dollars. If each central bank is convinced that the other will sell dollars, then the southeast corner will be a Nash-equilibrium.
Outlook
The answer to the question in the title of this paper
is yes: China and India matter for the coordination of
foreign currency reserve diversification in Asian
37
CESifo Forum 1/2007
Focus
countries. Their importance for the distribution of
international reserves among the economies in the
world is gradually growing. Reserve diversification is
incompatible with an aggressive intervention policy
in the foreign exchange markets which aims at keeping one’s own currency undervalued against the US
dollar. On the other hand, such a policy goes perfectly along with a medium-term strategy of stabilizing the value of the domestic currency against a basket of currencies. A basket peg offers the advantage
of combining higher stability (rule character) with
sufficient flexibility (to external shocks).
References
Genberg, H. (2006), Exchange Rate Arrangements and Financial
Integration in East Asia: On a Collision Course?, Österreichische
Nationalbank, Working Paper 122, 1–20.
Goodfriend, M. and E. Prasad (2006), A Framework for Independent Monetary Policy in China, IMF Working Paper 06/111.
International Monetary Fund (2004 to 2007), IMF Survey,
Washington D. C., various issues.
Jayakumar, V., T. H. Yoo and Y. J. Choi (2005), Exchange Rate System in India. Recent Reforms, Central Bank Policies and Fundamental Determinants of the Rupee-Dollar-Rates, Korea Institute
for International Economic Policy, Working Paper 05-06, Seoul.
McKinnon, R. and G. Schnabl (2006), China’s Exchange Rate and
International Adjustment in Wages, Prices, and Interest Rates:
Japan Déja Vu? CESifo Working Paper 1720.
Mohanty, M. S. and P. Turner (2006), “Foreign Exchange Reserve
Accumulation in Emerging Markets; what are the domestic implications?”, BIS Quarterly Review, September, 39–52.
Reserve Bank of India (2006), Report of Foreign Exchange Reserves
http://www.rbi.org.in/scripts/HalfYearlyPublications.aspx?head=
Report%20on%20Foreign%20Exchange%20Reserves (accessed
14 February 2007).
Sell, F. L. (2006), The New Exchange Rate Policy in the Emerging
Market Economies – with Special Emphasis on China, Universität
der Bundeswehr München. Institut für Volkswirtschaftslehre,
Discussion Papers 18/2.
Sell, F. L. (2006a), „Ein schwankender Riese. China ist zwar reich an
Devisen – aber arm an widerspruchsfreien Konzepten in der Währungspolitik“, Financial Times Deutschland 232/48 of 29 November
2006, p. 30.
Sell, F. L. (2007), „Ein Ausweg aus dem Währungsdilemma“,
Frankfurter Allgemeine Zeitung 16 of 19 January 2007, 20.
Siebert, H. (2006), China – Understanding a New Global Player,
Kiel Working Paper 1278.
CESifo Forum 1/2007
38
Supplement
Only after the EU accession of the first ten NMS had
been formally completed could the EMU enlargement process finally begin and could various earlier
arguments and hypotheses related to this process be
empirically tested. At the end of 2006, two and half
years after the first wave of EU Eastern Enlargement and the first ERM-2 accession decisions, it
seems that a good moment has come to reconsider
old arguments and concerns.
EMU ENLARGEMENT:
A PROGRESS REPORT
MAREK DABROWSKI*
The date of the formal EU accession did not mean
the end of the integration effort of new member
states to fully participate in the Single European
Market, when taken in its broader sense, including
the EU common currency.1 Apart from joining the
Economic and Monetary Union (EMU), new members are still waiting to join the Schengen zone and
have full access to labor markets of certain old member states (OMS). There are also specific transitory
provisions in many other chapters of the acquis
related to agriculture, environment, infrastructure,
free capital movement, taxes, etc.
This paper can be seen as a progress report that
focuses on the following key issues: a short overview
of candidates’ situation with respect to EMU accession, the formal Treaty obligation to join EMU vs.
the actual freedom of choice of the entry date, revisiting the pros and cons of adopting a common currency, the relevance of the Maastricht criteria and
fears regarding the ERM-2 mechanism and the
political economy and politics of EMU enlargement. The final part provides a summary and policy
conclusions.
The purpose of this paper is to focus on EMU enlargement, which – from an economic point of view
– seems to be the most important part of the unfinished integration agenda, and is also raising the
biggest controversies.2 The advocates of rapid EMU
enlargement stressed the high level of trade and
business cycle integration of the New Member States
(NMS) with the eurozone, and the potential benefits
for the NMS in terms of decreasing transaction costs
and exchange rate risk. Opponents pointed out the
costs of meeting the Maastricht criteria and giving
up the supposed shock-absorbing role of the
exchange rate. There were also some political and
economic concerns in the Old Member States
(OMS). The former came down to retaining a carrot
which could be granted or withheld from the NMS
depending on their good behavior, and some understandable concerns about how responsibly they were
likely to behave after EU accession. Economic fears
were mostly related to the controversial hypothesis
that the accession of rapidly-growing countries
would increase the inflationary pressure and interest
rates in the eurozone, which would have an additional contractionary impact on the slower-growing
economies of some OMS (see Rostowski 2006;
Zoubanov 2006).
A progress report
The EMU accession process of the NMS could only
formally begin after the NMS had officially joined
the EU, i.e. after May 1, 2004.3 Joining the new
Exchange Rate Mechanism (ERM-2) was the first
institutional step on this road. So far, seven NMS
have joined this mechanism, thus demonstrating
their desire to follow a fast-track accession to EMU.
These have been: Estonia, Lithuania and Slovenia
(all three joined in June 2004), Cyprus, Latvia and
Malta (May 2005) and Slovakia (November 2005).
On the other hand, the three biggest NMS – Czech
Republic, Hungary and Poland – do not have binding
and credible plans to join the Eurozone yet. Hungary
has officially declared its interest to introduce the
euro at the beginning of the next decade but a serious fiscal crisis, suffered by this country recently,
makes any predictions in this respect very uncertain.
Fiscal imbalances (although less severe than in the
Hungarian case) and political reluctance to address
them right away can be considered the main obstacles to the Czech Republic’s and Poland’s EMU
accession. In addition, some leading politicians and
political parties currently in power in these two
countries run on a somewhat euro-skeptical ideological platform, part of which is a desire to postpone
euro adoption.
* CASE – Center for Social and Economic Research, Warsaw.
1 Formally, the concept of a Single European Market refers to four
basic freedoms, i.e. free movement of goods, services, capital and
people. It does not include a common currency (which is the key
element of the Economic and Monetary Union, another institutional block of the EU). However, as the decrease in transaction
costs has been the main rationale behind introducing the euro, our
interpretation, which considers a common currency as the important part of a common market, seems to be economically justified.
2 The author of this paper and the institute, which he represents
(CASE) actively contributed to this debate.
3
39
January 1, 2007 in case of Bulgaria and Romania.
CESifo Forum 1/2007
Supplement
While prospects for a relatively fast EMU enlargement looked pretty good (at least with respect to the
smaller NMS) in the second half of 2005, they
became gloomier in 2006, mostly as a result of a rigid
interpretation of the Maastricht inflation criterion.
Among the first three countries that joined ERM-2
in June 2004 and that had originally planned to introduce the euro on January 1, 2007, Estonia was effectively discouraged from applying for EMU membership on the grounds that its actual inflation rate well
exceeded the reference value. Lithuania, where
HICP breached the criterion by 0.1 percentage
points only, asked the Commission to prepare the
convergence report, which came to a negative decision on its EMU entry (CR 2006, 9). The Commission’s negative verdict was approved by ECOFIN.
Only Slovenia received a “green light” to enter the
Eurozone in January 2007.
(in spite of not having the opt-out option), can serve
as an example, which perhaps some euro-skeptical
NMS will follow.
Lithuania’s case had a negative influence on the follow-up debate on prospects and the timetable of
EMU accession both in the EU as the whole and in
the NMS, discouraging some of them from undertaking more radical adjustment policies, particularly in
the fiscal sphere. The timetable of EMU enlargement has become uncertain and has lost political
momentum.
If the NMS are not effectively obliged by the Treaty
to join EMU soon and the political attitude of EMU
incumbents to fast-track Eurozone enlargement is
not necessarily encouraging, what are the economic
arguments for joining EMU? Answering this question requires coming back to the well-known discussion on the costs and benefits of joining a common
currency area, i.e. to the seminal papers of Mundell
(1961) and McKinnon (1963). However, the limited
size of this paper allows only for summarizing the
main findings4:
In addition, present EMU members, which must
grant an approval to each candidate country to join
both ERM-2 and EMU (by qualified majority voting
or in unanimous voting – in the case of determining
the conversion exchange rate), possess great discretionary power to determine the speed of EMU
enlargement. So far most of them as well as the
Commission and the ECB are following a very cautious approach, discouraging NMS from rapid EMU
entry (“don’t rush” advice) and trying to use all formal opportunities to delay this process.
Net benefits of EMU enlargement
Is EMU accession mandatory?
1. Most of the NMS represent a very high share of
trade with other EU countries (70 to 80 percent
or even more). The share of trade with the
Eurozone is smaller (due to trade relations
with non-EMU members of the EU) but still
ranges from 40 to 60 percent of total trade
(with only Latvia and Lithuania representing
lower figures). However, when all the NMS will
have joined EMU, this share will increase significantly (through absorption of substantial
intra-NMS trade). Generally, the level of trade
and investment integration of the NMS with
the EU and EMU is not, on average, worse
than in the case of incumbent EMU members,
implying potential benefits from decreasing
transaction costs and decreasing risk of asymmetric shocks.
2. The NMS exhibit an increasing co-movement of
their business cycles with those of EMU countries, although the speed of convergence varies
At first glance, the question seems to be wrong as
the NMS do not formally have an opt-out option
like Denmark and UK. They are legally obliged to
join EMU at some point. However, according to
Article 4 of the Treaty of Accession (signed in April
2003 in Athens) the NMS obtained the status of
“Member States with derogation” regarding EMU
membership (CR 2004, 2) and the derogation period has not been determined. Moreover, joining
EMU requires an active effort by each candidate to
meet the nominal convergence and legal criteria of
the Treaty.
This can take many years if a country is not interested in joining quickly. It is enough to continue a floating exchange rate regime, which excludes both
ERM-2 and EMU membership. Thus the NMS possess de facto a great room for maneuver as to when
they will adopt the common currency. In extreme
cases, it would be possible to postpone EMU membership almost indefinitely. The case of Sweden,
which has not joined EMU or even the ERM-2 yet
CESifo Forum 1/2007
4 For more detail analysis see, among others, Dabrowski, Rostowski
et al. (2006); EFN (2006 Spring).
40
Supplement
3.
4.
5.
6.
concern that the rapidly growing economies of the
NMS could increase the inflation pressure in the
enlarged Eurozone and lead to an overly restrictive
monetary policy.
among countries. This implies a gradually decreasing risk of asymmetric shocks.
According to the endogeneity hypothesis (see
Frankel and Rose 1998), enlarging the euro area
will create additional trade (see Maliszewska
2006) and investment flows and speed up the convergence of business cycles. These effects can be
particularly strong in countries now running flexible exchange rate regimes.
In the world of increasing financial integration,
room for sovereign monetary policies in small
open economies is gradually diminishing: their
central banks cannot risk “leaning against the
wind” (see Dabrowski 2004) and must follow, in
one way or another, the monetary policy decisions of the monetary authorities of the biggest
monetary areas (ECB in case of NMS). This puts
in question the main argument in favor of postponing EMU entry, i.e. retaining an instrument of
monetary/exchange rate accommodation to
asymmetric shocks.
Joining the Eurozone also means eliminating the
risk of currency crises for NMS. While the last
few years did not see any spectacular financial
turbulences in emerging markets, this does not
mean that NMS are totally immune from this
risk. The end of this unique period of extremely
low interest rates may bring about a new wave of
speculative attacks against emerging-market currencies.
Rapid EMU entry can also bring substantial fiscal benefits, especially for countries (such as
Hungary and Poland), which have a high public
debt burden, high primary deficits and must offer
higher yields to purchasers of their debt instruments (all three factors are closely interrelated).
For these countries, the strategic policy decision
of early EMU accession would mean starting fiscal adjustment sooner and enjoying lower interest rates earlier which would both result in lower
nominal debt, other things being equal (see
Dabrowski, Antczak and Gorzelak 2006).
Re-examination of the Maastricht criteria
The four criteria of nominal convergence (as preconditions for joining EMU) were formulated in the
beginning of the 1990s in the Maastricht Treaty. The
purpose was not merely to enlarge the EU territory
and number of member countries, but to create a
monetary union (as well as a new currency) among
countries, whose inflation rates and long-term interest rates varied greatly (in some EU countries inflation well exceeded 10 percent). Besides, the global
macroeconomic and financial environment was quite
different at that time. Some of the EU-12 members
still had capital controls. Global financial markets
were less developed and sophisticated. Therefore the
room for a sovereign monetary policy was larger,
even in countries which belonged to EMS.
It is fair to say that from the very beginning the
mutual consistency of these criteria raised some
doubts and was, in fact, only possible under some
additional assumptions. The two requirements of the
fiscal criterion represent the best example here (see
Gros, Mayer and Ubide 2004). The deficit ceiling of
3 percent of GDP is consistent with the debt ceiling
of 60 percent of GDP only under the assumption of
a 5 percent growth rate of nominal GDP. If average
nominal growth is lower (which has been the case for
EMU as a whole and for most of its members for a
number of years) the deficit must be correspondingly lower.
An even more serious inconsistency affects both,
exchange rate stability and the inflation criteria.
Fixing the exchange rate makes the inflation rate
mostly exogenous for the monetary authorities, particularly in a world of free capital movements. And
inflation differences exceeding what is tolerable
under the inflation criterion can result from various
sources, such as differences in productivity growth
(the Harrod-Balassa-Samuelson effect), changes in
the demand structure (in favor of non-tradable services), or initial differences in purchasing power
parity (PPP) of individual currencies. The NMS,
growing faster than the OMS and starting with
lower levels of development, can experience all
these sources of higher inflationary pressure and
The limited economic potential of the NMS compared to the EMU-125 means that the latter will gain
less, in terms of transaction costs and potential trade
and investment creation, than the former. However,
for the same reason, economic risks for the OMS will
also be negligible. This includes the afore-mentioned
5
In 2004, the total GDP of 10 NMS amounted to only 5.6 percent
of the total GDP of the future EMU-22 (twelve current members
and ten candidates). The total share of the five smallest NMS
(Baltics, Cyprus and Malta) amounted to only 0.7 percent (see
EFN, 2006 Spring, Table 3.2).
41
CESifo Forum 1/2007
Supplement
thus face the risk of breaching the inflation criterion, which is what really happened in the case of the
Baltic countries.
few years have been characterized by calm on
emerging markets.
An additional difficulty can result from the fact that
the reference value for the inflation criterion is calculated on the basis of a simple arithmetic average
of the three best-performing EU members, which
do not have to be EMU members. With substantial
differentiation of inflation rates inside the EU, it is
possible that the three best performers, representing a very small share of overall EU GDP, can set
the reference value well below the average inflation
rate of the entire EU (and indeed EMU) and the
actual rate of most of their members. Lithuania’s
failure to meet the inflation criterion by a very narrow margin in the spring of 2006, when the reference value was set by two non-EMU countries,
Poland and Sweden, demonstrates the high probability of the above scenario. Obviously, such an outcome does not say too much about a candidate’s
nominal convergence with the current EMU.6 And
what are the effective policy tools to bring inflation
down in countries like Estonia or Lithuania that
have run currency boards for many years and have
balanced or surplus budgets?
Political economy and the politics of EMU
enlargement
The policy conditionally attached to EMU accession
may serve as a powerful incentive for fiscal adjustment and associated reforms, mostly in the social
policy sphere, as has been demonstrated by the experiences of many current EMU members in the second half of 1990s. However, this kind of incentive
mechanism can only work if the candidate knows
that the reward (EMU membership) is truly available and welcomed by the other members.
I am not suggesting any softening of those entry criteria, which: (i) are very important for the collective
economic safetyor EMU (avoiding free riding under
the umbrella of the monetary union); and (ii) remain
under the control of each candidate. This relates, in
the first instance, to fiscal criteria, which should be
closely observed and executed without any waiver,
perhaps even with some additional safety margin,
taking into account the fact that the NMS are enjoying a unique period of post-enlargement catch-up
growth and that they will face serious long-term fiscal problems as a result of population aging (even
more than in Western Europe). This means that the
NMS should run balanced or surplus budgets (like
Estonia).7 On the other hand, the competent examination of candidates’ performance must take into
account that some of the macroeconomic variables
remain under limited control of national economic
policy, such as the inflation rate under a fixed exchange rate regime.
A similar inconsistency may also relate to the ERM
mechanism itself, which was originally designed as a
narrow fluctuation band around a central parity, but
was formally widened to a ± 15 percent range after
the 1992 EMS crisis. This is a kind of hybrid monetary regime under which the central bank tries to
simultaneously manage the exchange rate and interest rates (liquidity). Historical experience shows that
such a regime is prone to speculative attacks, as was
experienced by many current EMU members in
1992 to 1993 (Wyplosz 2004).
Punishing the best macro- and microeconomic performers such as Estonia and Lithuania for missing
an inflation criterion that they are unable to control,
issues the wrong political signal. It not only discourages good performers, but also those countries that
are facing a complex fiscal adjustment agenda on
their road to the euro. This leads euro-skeptical and
opportunistic politicians in countries suffering fiscal
problems to ask, “If the reward is problematic and
the NMS are not very welcomed in the Eurozone
yet, then why should we risk making unpopular
decisions?”
So far, the central banks of the ERM-2 participants
have not experienced problems with keeping the
exchange rates of their currencies close to the
declared parity, except for the National Bank of
Slovakia, which had to defend the koruna when it
came under market pressure after a general election on June 17, 2006. However, there are two
important caveats here. First, five out of seven
ERM-2 members have had currency boards or
fixed pegs for many years, so they do not, in fact,
run sovereign monetary policies. Second, the last
6 Lithuania’s twelve-month HICP in March 2006 (2.7 percent) was
higher by only 0.4 percentage points than the average inflation of
the Eurozone.
CESifo Forum 1/2007
7 And
Pact.
42
this condition is, in fact, required by the Stability and Growth
Supplement
enlargement results in net welfare losses for the
NMS and delays hopes of their income catching up
with that of the OMS. It will also limit the net benefits of those NMS that joined EMU first because
some of their important trading partners will remain
outside the common currency area. Thirdly, financial
markets have until now assumed a scenario of relatively quick EMU enlargement. This explains the
relatively low NMS risk premiums. However, when
investors realize that this process will be postponed
for good, the risk premiums will probably increase,
thus weakening growth perspectives and adding to
fiscal problems. Any adverse shock such as political
problems in any single country or financial turbulences on other emerging markets may trigger a
financial crisis in the periphery of the enlarged EU.
Fourth, applying ‘second-rate’ status to most NMS
will negatively influence the Union’s ability to meet
key economic and political challenges in the near
future.
This skepticism is further fuelled by the demands of
real convergence (meaning closing the income per
capita gap between the EMU candidates and the
Eurozone) or criticism of the NMS’ persistent current account deficits (see Bundesbank 2006) caused
by large FDI inflows. Both arguments are based on
economic misconceptions and do not have a formal
ground in the Treaty.
The attempt to slow down EMU enlargement can be
considered part of a wider phenomenon: public
opinion and politicians in some OMS have become
reluctant not only to continue the EU enlargement
process (with respect to Turkey and Western Balkan
countries) but also to complete the 2004 and 2007
enlargement agenda. Apart from EMU enlargement,
the Schengen zone enlargement and the opening of
OMS labor markets to the NMS labor force are also
going to be delayed. This may signal a political intention to have, at least temporarily, two categories of
EU members, with the “core” built around the current EMU. It is hard to believe, however, that this
two-tier membership will benefit the EU and help
solve its fundamental economic and political problems, such as finding a compromise on the proposed
constitution that was frozen by the negative results
of the French and Dutch referenda in 2005.
The “don’t rush” policy should be abandoned in
favor of clear incentives to speed up the fiscal adjustment of the EMU candidates as a precondition of
their membership in the common currency area,
even with the additional safety margin comparing to
the Maastricht criteria. On the other hand, the inflation performance should be interpreted more flexibly, at least reflecting its partly exogenous character
under fixed exchange rate regimes. This flexibility
may go in two directions:
Summary and conclusions
Until now, the EMU enlargement process has developed slowly. This results not only from “postenlargement fatigue” and euro-skepticism in some of
the NMS (demonstrated by the inability of certain
countries i.e. Czech Republic, Hungary and Poland
to address fiscal problems), but also from resistance
to admitting the NMS to the euro area from the
“incumbent” side. The negative assessments of
Lithuania and Estonia’s eligibility are the best examples of this phenomenon. Ironically, this has affected
the two best economic performers and de facto longtime members of the Eurozone (they run eurodenominated currency boards).
1. The inflation criterion should be applied to assess
macroeconomic (mostly monetary) policies in
the period preceding the adoption of the ERM-2
central parity and should subsequently be abandoned. It should be completely abandoned in the
case of EMU candidates running well-established
euro-denominated currency boards.
2. In addition, the reference value should relate to
the average inflation rate in the Eurozone
instead of the average of the three best performing EU members.
References
Continuation of the “don’t rush” policy will have
negative economic and political consequences for
both, the NMS and the European Union as a whole.
First, it will discourage the NMS from carrying out
fiscal adjustment and from continuing reforms in
politically sensitive areas such as social welfare.
Secondly, as the potential benefits of joining the
euro area outweigh their costs, delaying EMU
CR (2004), Convergence Report 2004 – Technical annex, A Commission Services Working Paper, SEC(2004) 1268, Brussels: Commission of the European Communities, October 20,
http://europa.eu.int/comm/economy_finance/publications/
european_economy/convergencereports2004_en.htm
CR (2006), Report from the Commission. Convergence Report 2006
on Lithuania. Brussels: Commission of the European Communities,
May 16, COM(2006) 223
http://europa.eu.int/comm/economy_finance/publications/european_economy/2006/report_lithuania.pdf
43
CESifo Forum 1/2007
Supplement
Dabrowski, M. (2004), Costs and Benefits of Monetary Sovereignty
in the Era of Globalization, in: Dabrowski, M., J. Neneman and
B. Slay (eds.): Beyond Transition. Development Alternatives and
Dilemmas, Aldershot: Ashgate Publishing Limited.
Dabrowski, M., M. Antczak, and M. Gorzelak (2006), “Fiscal Challenges Facing New Member States”, Comparative Economic
Studies 58, 252–276.
Deutsche Bundesbank (2006), “Determinants of the Current
Accounts in Central and East European EU Member States and the
Role of German Direct Investment”, Monthly Report, Deutsche
Bundesbank, January,
http://www.bundesbank.de/download/volkswirtschaft/mba/2006/
200601mba_en_determinants.pdf
EFN (2006), Convergence and Integration of the New Member
States to the Euro Area, Economic Assessment of the Euro Area:
Forecasts and Policy Analysis. Spring 2006, EUROFRAME – European Forecasting Network, March 2006,
http://www.euroframe.org/fileadmin/user_upload/euroframe/efn/
spring2006/EFN_Spring06_Report.pdf
Frankel, J. A. and A. K. Rose (1998), “The Endogeneity of the Optimum Currency Area Criteria”, Economic Journal 108, 1009–1025.
Gros, D., T. Mayer and A. Ubide (2004), The Nine Lives of the Stability Pact, A Special Report of the CEPS Macroeconomic Policy
Group, Center for European Policy Studies, Brussels.
Maliszewska, M. (2006), EMU Enlargement and Trade Creation, in:
Dabrowski, M. and J. Rostowski (eds.), The Eastern Enlargement of
the Eurozone, Heidelberg: Springer.
McKinnon, R. (1963), “Optimum Currency Areas”, American Economic Review 53, 717–25.
Mundell, R. (1961), “A Theory of Optimum Currency Areas”, American Economic Review 51, 657–65.
Rostowski, J. (2006), “When Should the New Member States Join
EMU?”, in: Dabrowski, M. and J. Rostowski (eds.), The Eastern Enlargement of the Eurozone, Heidelberg: Springer.
Wyplosz, C. (2004), “Exchange Rate Regimes after Enlargement”,
in: Dabrowski, M., J. Neneman and B. Slay (eds.), Beyond Transition.
Development Alternatives and Dilemmas, Aldershot: Ashgate
Publishing Limited.
Zoubanov, N. (2006), “Uneven Growth in a Monetary Union”, in:
Dabrowski, M. and J. Rostowski (eds.), The Eastern Enlargement of
the Eurozone, Heidelberg: Springer.
CESifo Forum 1/2007
44
Special
selectively. More importantly, it can help to shift the
agenda for what the EU budget should do.
THE 2008/2009 REVIEW OF
THE EU BUDGET:
REAL OR COSMETIC?
But is there the political will to enable it to be a catalyst for change? This paper describes the flaws in
the budget that the review is intended to address, discusses options and concludes with a number of proposals for reform.
IAIN BEGG*
The European Community budget is, arguably,
among the least satisfactory elements of EU economic governance and one which, moreover, has
proved to be remarkably resistant to change since it
was last subjected to major reform in 1988. In the
intervening period, there has been no radical development, despite the increase in membership of the
union from 12 to 27, completion of the internal market, and the extension of EU ambitions in external
policy from development to international security.
Monetary union has gone from a distant prospect to
a euro that will be well into its adolescence by the
end of the current Multi-annual Financial Framework (MFF) in 2013, which is formerly known as the
Financial Perspective – FP.
What is at issue?
There is widespread agreement about the shortcomings of the budget, well-captured in the jibe of Buti
and Nava (2003, 1) that it is a “historical relic”. The
biggest element of expenditure has long been support for agriculture, a declining sector of economic
activity, while the other major component of spending is for cohesion: policies aimed mainly at the economic development of lower-income regions and
Member States. Together, agricultural and cohesion
have accounted for some three-quarters of EU
spending over the last three decades, including the
1999 to 2006 spending period that has just ended. All
other EU policies, as well as the administrative costs
of the Union compete for the remaining quarter,
equivalent to just one quarter of a percentage point
of EU GDP.
It is noteworthy that in the extensive reform of economic governance that took place in 2005, it is the
budget which emerged least altered, despite the fact
that it underwent a presentational makeover that,
for example, saw “structural operations” re-defined
as “cohesion for growth and employment”, albeit
with much the same level of resources. While the
seemingly vast capacity of the EU to fudge deals
cannot be ignored in looking to the future of the
budget, it is hard to see how the present system can
survive beyond the present budgeting period of 2007
to 2013. In an intriguing paradox, the long periods
involved seem to make reform more difficult, rather
than giving ample time for reflection.
Although many facets of the budget look different
or have acquired new labels, it is striking how little
changed the budget of 2007 is from those of the late
1980s. Some might dispute this assertion, but as
Table 1 shows, in practice the main features have
evolved only to a limited extent. It is still almost the
same size as a proportion of EU GDP; it continues to
be dominated by expenditure on agriculture and
cohesion; and the UK rebate is as hotly contested as
ever. Politically, the most telling change is that there
are now more net contributors than twenty years
ago, but the proliferation of back-door rebates has
made the whole picture more blurred and the solutions found ever more ad hoc.
It is against this backdrop that the EU is now gearing up for a review of the budget, due to take place
in 2008/2009, and supposed to be subject to no
taboos. All headings of expenditure are to be examined and the terms of reference also make clear that
the UK rebate is to be on the table, offering some
hope that things might change, despite the disappointing outcome of the 2005 deal (Begg and
Heinemann 2006). Consequently, the review offers
the first opportunity for many years for the EU budget to be re-thought from first principles, at least
An important issue is how big the EU budget should
be. Over the last two decades, it has hovered around
1 percent of EU GNI. At this level it is just 2.5 percent of aggregate public spending in the EU which
means that the room for genuine manoeuvre in the
budget is, inevitably, severely circumscribed. Nor
does the budget have any role in stabilisation policy,
as is the norm for the highest tier of policy-making
elsewhere (even in the US, the federal government
* London School of Economics.
45
CESifo Forum 1/2007
Special
Table 1
Budget features compared
Facet of budget
Own resources ceiling
1988–1992 (FP)
Rising to 1.2%
of GDP
Planned: 1.17%
of GNP
Out-turn: 0.99%
51.4%
2007–2013 (MFF)
1.24% of GNI
Share of cohesion
spending, % by end of
FP/MFF
Administration costs, %
end of FP/MFF
Formal abatement
30.2%
35.6%
4.7%
6.0%
UK
UK
Implicit “rebates”
DE
DE, NL, AT, SE
Actual expenditure
commitments, average
over FP
Share of CAP spending,
% end of FP/MFF
Share of funding from
VAT: 58% (average)
inter-governmental
GNP: 9% (average)
transfers
Source: Author’s elaboration.
Planned: 1.05% of GNI
32.0% direct payments,
with an additional 8.2%
on other elements
VAT: 16% (2007)
GNI: 69% (2007)
Major changes made in 1992
and 2002 in the character of the
CAP, but real level of spending
maintained
Shift from “cohesion 4” to
recently acceded members
Increase partly caused by
re-definitions
Relatively minor changes in
formula
Increasingly messy and opaque
arrangements
Switch from VAT resource to
GNI resource, but de facto both
transfers
to bring back as a juste retour. As Le Cacheux (2005)
aptly describes it, the obsession with net contributions “poisons” the whole debate.
accounts for over 20 percent of GNP), and it does
not explicitly contribute to the re-distribution of
income through social transfers, as might be expected from the highest level of governance in a fiscal
federation (Oates 1999). That said, the budget plainly does have a distributive effect insofar as it transfers resources to farmers – increasingly, after successive reforms of the Common Agricultural Policy
(CAP), in the form of direct income subsidies rather
than the much reviled production subsidies – and to
the regions eligible for cohesion spending, in the
form of targeted public investment.
Timing and context
There will be three stages to the review: an initial
‘key issues’ paper from the Commission to launch a
period of consultation; the publication of firm proposals by the Commission, probably late in 2008,
drawing on background research and the outcome of
the consultation process; then the usual wrangling
about what should be agreed. It is important, though,
not to harbour illusions about what the 2008/2009
review will change. In particular, it is unlikely to
result in much alteration of the existing MFF – seen
by too many as a ‘done deal’ that cannot be unpicked
thread by thread without the whole garment disintegrating. Nor does there seem to be much enthusiasm
for change on the funding side of the budget, not
least because the present system of own resources
that funds the EU budget has one great virtue,
namely that it ensures that the EU obtains the
money it needs. Any switch to a “tax for Europe” or
any other revenue source would create a degree of
uncertainty in this regard.
Instead of being a source of EU level public goods,
some critics argue that the budget is dominated by
re-distributive expenditure. Indeed, Blankart and
Kirchner (2003) argue that the institutional arrangements for settling the budget predispose it towards
redistributive policies, echoing the pork barrel mentality familiar in the US congress. Moreover, there is
little scope for using straightforward economic principles to determine how spending at EU level would
“add value”. Worse, the issue of added value only
rarely surfaces in the acrimonious negotiations
around the budget. Instead the focus of attention
has, especially in the last two settlements (1999 and
2005, although this orientation dates back to the
wielding of the handbag by Mrs. Thatcher in the
early 1980s), been on how much the respective heads
of government and finance ministers have been able
CESifo Forum 1/2007
Comment
Marginal increase, but offset by
lower take-up
There has been a tendency for
the out-turn to under-shoot
The rigidities in the system of decision-making (not
least the requirement for unanimity), path depen-
46
Special
hard budget constraint. But it does distinguish the
EU from other governments which have to balance
revenue raising with expenditure in a more systematic way. A second feature of the system is that it is
easy to predict how much each Member State will
contribute s a proportion of national income. The
current system is, broadly, proportional, with each
Member State expected ex-ante to pay-in roughly
1 percent of its GNI, although the various abatement
mechanisms alter the actual payments.
dency and the power of vested interests make
reform of the EU budget an uphill task. There is,
nevertheless, a potentially auspicious conjunction of
scheduling in the next three years. 2009 will see the
end of the mandates of the current Commission and
European Parliament. Under the provisions of the
re-launched Lisbon strategy, new triennial National
Reform Programmes are due to be formulated in
2008 and launched in 2009 and the parallel Community Lisbon Programme will also need to be
renewed. In addition, there is or is likely to be new
political leadership in key larger Member States. A
“health-check” – which could in effect be a review –
on the CAP is also envisaged. Hence, there is a window of opportunity for more extensive change than
has been feasible in recent rounds. This suggests that
the principal ambition of the review should be to
shift the terms of the debate for subsequent funding
periods (that is, beyond 2013) and to provide a
roadmap for the reform of the budget.
What could be on a reform agenda?
The mandate for the reform of the revenue side of
the budget refers to “resources, including the UK
rebate”. The former can be interpreted either as a
call for minor revision of the existing own resources
or, at the other extreme, as an invitation to assign
genuinely “owned” taxes to the EU level. An obvious simplification of the existing system would be
the abolition of the VAT resource by consolidating it
into the GNI resource, recognising that the distinction is artificial.
The revenue side of the budget
Introducing new taxes for Europe would be much
bolder, yet already seems to be a step too far politically, despite the fact that it has consistently been on
the EU agenda since the 1988 budget reform. In
interviews, Dalia Grybauskaite, the EU Budget
Commissioner has made clear her opposition to
opening-up this question now, although a report by a
prominent member of the European Parliament
(Lamassoure 2007) has made a strong case for moving in stages to a new system in which there are
explicit EU taxes. The Commissioner’s fear is, in
part, that if the review attempts to tackle too many
topics, it will succeed with none of them.
Although the Treaty (Art. 269, TEC) stipulates that
the EU should be funded by own resources, only a
small proportion (currently just under 15 percent) of
the revenue comes from instruments that are genuinely European, namely the levies and duties
imposed at European level – the “traditional” own
resources (ToR). Starting in 1979, the bulk of the
EU’s revenue has come from, initially, a proportion
of the proceeds of national value added tax, complemented after 1988 by a fourth resource calibrated on
national income (now GNI). These two resources
are, in a legal sense, own resources because they are
formally incorporated in the Inter-Institutional
Agreement between the European Parliament, the
Commission and the Council. But in an economic
sense, they are inter-governmental transfers, rather
than readily identifiable revenue sources. This has a
number of ramifications.
Possible criteria for an EU tax include standard tax
principles (including equity – especially between
Member States – economic efficiency, sufficiency
and cost of collection), assurance that the new instrument would not add to the aggregate fiscal burden
(revenue neutrality), and political considerations
such as a link to EU policies, visibility and transparency. No conceivable EU tax will ever be ideal
and there are bound to be problems of various sorts
in any tax that might be envisaged to “pay for Europe”. But designing one that fulfils enough of the relevant criteria is not an especially daunting challenge
and many conceivable options have been discussed
over the year (see Cattoir 2004; Le Cacheux 2007).
Collecting a tax at EU level may even diminish
Because the GNI resource is residual in that it rises
or falls to match the EU’s expenditure commitments,
there is no risk of the EU “running out of money” as
happened in earlier periods. The corollary is that the
major political decisions about the EU budget concern the EU’s expenditure, with the revenue adjusting passively. This is not, as it might be in other circumstances, a recipe for fiscal laxity, since the overall
cap on the budget, together with the ceilings for different headings of expenditure effectively impose a
47
CESifo Forum 1/2007
Special
Commission claims that as much as 40 percent of the
EU budget is aimed at this objective. However, this
claim can be made only by including the cohesion
budget as part of growth and employment. This is
not without justification insofar as the economic
development of less competitive regions contributes
to aggregate EU competitiveness, but the fact remains that cohesion spending is about countering
the market forces that result in polarisation and is
paid for by, implicitly, taxing richer regions.
anomalies or externalities resulting from its collection at Member State level, such as arbitrariness in
which Member State levies taxes on bases that are in
fact pan-European profits, for example.
The problems arise at the political level. Opponents
of an EU tax claim, inter alia, that:
• It would increase the overall tax burden – which
it plainly would not if revenue neutrality is respected.
• Citizens would question why they were paying for
the EU – which is, in fact precisely the point of the
transparency and visibility argument for having a
tax.
• Introducing a “new” tax is a political non-starter –
a claim which has no empirical support.
• Because the present system of own resources
assures adequate funding, the maxim “if it ain’t
broke, don’t fix it” should apply, especially when a
tax for Europe would inevitably create new problems and anomalies – a standpoint that has its
merits, but which is also a recipe for inertia.
CESifo Forum 1/2007
But what the budget does not do systematically is to
allocate resources to genuinely European public
goods, for which there is an evident added value
from producing them at supranational problem.
Spill-over arguments could, for example, be adduced
to support EU wide infrastructure networks or
research, and it would not be hard to make a case for
higher spending on internal security. As a result, the
question that ought to be behind that of “how big
should the budget be” namely, “when is it better to
spend at EU level”, is scarcely posed, let alone
answered.
Expenditure
What are fair contributions to the EU budget?
There are several explanations for the current mix of
spending in the EU, few of which reflect underlying
principles of public finance. The most clear-cut is the
Treaty base which stipulates that there shall be a
common agricultural policy (CAP) and funding for
cohesion through the Structural Funds. However, the
scale of expenditure on these two sets of policies is a
political choice and the way they are distributed
among Member States partly to give “money back”.
There is also a Treaty base for research funding and
various other internal policies, while the Union manifestly could not function without administrative outlays. Here, too, the level of expenditure is a matter of
political choice. For other key components of EU
economic governance such as macroeconomic stabilisation, the Lisbon reform agenda or sustainable
development, the legal base is much weaker. Yet
with the Commission placing the (Lisbon) Partnership for Growth and Jobs at the heart of its political
work programme, it might have been expected that it
would feature prominently in EU expenditure over
the coming years.
There are three different ways of measuring how
much each Member States pays in to the EU budget,
each telling a different story: ex-ante gross payments; payments after allowing for abatements and
other adjustments; and net contributions. All have
become increasingly devoid of principles over the
years because of ad hoc adjustments. Corrections
designed to contain net balances include the “fee”
paid to Member States for collecting the two traditional own resources (increased to 25 percent in
1999, largely to give money back to the Netherlands); differing take-up rates for VAT instead of a
single one; and, in the 2007 to 2013 MFF, a reduced
take-up rate of the GNI resource for the Netherlands and Sweden. Together with the formal rebate
for the UK and the reduced contribution to the UK
rebate offered to four Member States (which
increases the burden on the remaining twenty-two),
all of these manipulations mean that the actual payments to the EU of five of the richer Member States
are, in fact, lower as a proportion of GNI than the
poorer Member States.
Heading 1 of the 2007 to 2013 MFF is, indeed, identified as money to be spent on growth and employment and, in its more sanguine pronouncements, the
The effect of these corrections is to increase the
share of GNI paid-in by other countries. At the richer end of the spectrum, France has had to pay most
48
Special
changes in the 2007 to 2013 MFF. But it will have
served its purpose if it establishes a clear and principled blueprint for the future shape of the budget.
Offering credible ways forward or clarifying the
options in seven key areas would constitute real
progress. They are as follows.
in this regard. But the fact that the recently-acceded
countries also have to pay more has been a source of
dismay. In addition, the payments have to be made
quarterly, whereas receipts from many of the multiannual programmes, such as the Structural Funds,
tend only to be received with a lag and are subject to
certain conditions. The upshot is that a country such
as Poland may face a less favourable cash-flow in the
short-term. These revenue arrangements have
caused friction, with the recently acceded Member
States dismayed to find that they have to pay
“upfront” for the British abatement.
• The rigid ceiling of 1.24 percent of GNI for the
budget, and the de facto ceiling of just over 1 percent should be abandoned in favour of a “policies
first” approach. There is plainly no political will to
endow the EU level with fiscal resources comparable to the federal or central level in other polities, but that need not preclude a somewhat larger budget, provided that it can be justified. The
current own resources ceiling reinforces the sentiment, first, that payments to the EU are tantamount to a club fee and, second, that the primary
objective in budget negotiations should be to
maximise “money back”. In this logic, the main
function of the ceiling is to contain the commonpool problem and thus limit the distributive transfers from the budget. But in the process, little
thought is given to what public goods the EU
should provide.
• A robust means of showing that there is added
value from funding public goods at the EU level
has to be put in place. This should be based on
analytic concepts, such as externalities and
economies of scale, and adapted to the unique
institutional circumstances of the EU. A key test
should be whether spending at EU level improves
the quality/efficiency trade-off of public spending,
and the presumption should be that assigning a
spending competence to the EU level should
result in either the same or lower level of total
public spending. Where there are reasons (such as
national sensitivities) for retaining a particular
public good at national level, the rationale should
be made explicit.
• A substantial reduction in the share of the CAP
would nevertheless free resources (and, perhaps
more importantly, create political room for
manoeuvre) for other purposes, alter the arithmetic of net contributions and have a positive
effect on the EU’s position in the Doha Round
negotiations. The details are bound to be contentious, but there are essentially two ways of
achieving the outcome, bearing in mind that an
agricultural policy remains a Treaty commitment:
co-financing of the existing CAP from national
exchequers or further changes in the CAP itself
that reduce its budgetary demands.
Nevertheless, the key issue is net contributions,
which are the difference between abated gross payments into the EU budget and expenditure received
from it. The net contributions arise almost entirely
on the expenditure side of the budget, albeit for differing reasons. CAP spending has an uneven geographical incidence because it automatically favours
countries with large farming industries, while its distributive impact has – so far – been unpredictable,
favouring large farmers in some circumstances and
low-income ones in others. Cohesion policy is deliberately targeted at lower income or competitively
weak regions, and can thus be seen as a policy that
has more explicit equity-related aims. Spending on
other policies reflects diverse objectives. Thus, the
research budget is supposed to be allocated principally on the basis of excellence, which tends to
favour Member States (and, within them, specific
regions) with well-developed research capacities –
usually richer ones.
Overall, therefore, the distributive impact of the EU
budget is partly intentional and partly a by-product
of the way policies are designed and implemented.
The tension at the core of this system for allocating
spending is that more attention tends to be paid to
how much a country receives rather than whether
the policy is well-conceived from the perspective of
the EU as a whole by producing public goods.
Proposals and conclusions
The 2008/2009 review of the EU budget is an opportunity to achieve an irreversible shift in the economics and politics of the EU budget, but success cannot
be taken for granted and it would not be at all surprising if the ended without firm agreement on how
to move forward. There seems little prospect that the
review will result in anything other than marginal
49
CESifo Forum 1/2007
Special
• A coherent and transparent system for funding the
budget is needed, with an end to ad hoc arrangements. Again, there are two approaches: fund the
budget entirely from intergovernmental transfers
from Member States (with some reflection on
whether fairness should be achieved by keeping
the payments purely proportional or having a
degree of progressivity); or establish “owned”
taxes for Europe. The inter-governmental transfer
approach has the undeniable merit that it works
and (unless the possibility of reneging, as has
occurred sporadically for international organisations, arises) will continue to work to assure adequate resources. Taxes for Europe would be
messier, but more in keeping with the Treaty and
with accepted norms of accountability.
• Net contributions should no longer be abated.
Instead, it should be incumbent on Member
States to accept that once the major decisions on
expenditure are taken, the distributive consequences should be accepted. Inevitably, this
would lead to Member States holding out for
policies that favour them, but the overall impact
should be to make scrutiny of policies more
intensive.
• If a case can be made for purely re-distributive
transfers among Member States, it might as well be
through an explicit fiscal equalisation. The political problems associated with schemes such as the
German Finanzausgleich are well-known, but
they offer a more coherent and politically open
means of settling the question than each finance
ministry showing up for the periodic MFF negotiations with an increasingly elaborate Excel
spreadsheet into which the latest proposals are
fed so as to work out net balances.
• The political and budgetary cycles should be better
aligned. It is an open question whether the optimal combination would be for the budget to be
mid-point to mid-point of the five-yearly cycle for
the Commission and the European Parliament or
precisely aligned. It is difficult to see why the budget should be on a seven-year cycle.
the budget is the continuing uncertainty about what
the EU is supposed to be, an uncertainty that makes
it hard to define what sorts of public goods the EU
should provide. The answer may only be implemented a decade or more hence, but will the 2008/2009
review be far-sighted enough to provide a roadmap
to it?
References
Blankart, C. B. and C. Kirchner (2003), The Deadlock of the EU
Budget: An Economic Analysis of Ways In and Ways Out, CESifo
Working Paper 989.
Begg I. (2005) Funding the European Union, London: The Federal
Trust.
Begg, I. and F. Heinemann (2006), New Budget, Old Dilemmas,
Centre for European Reform Briefing Note (available at
www.cer.org.uk)
Cattoir, P. (2004), Tax-based EU Own Resources: An Assessment,
Taxation Papers Working Paper 1/2004, Luxembourg: OPEC.
Lamassoure, A. (2007), The Future of the European Union’s Own
Resources, Draft Report, BUDG_PR(2007)382623, European
Parliament.
Le Cacheux, J. (2005), Le budget européen: le poison du juste retour,
Etudes et Recherches 41, Paris: Notre Europe.
Le Cacheux, J. (2007, forthcoming), Funding the EU Budget with a
Genuine Own Resource: The Case for a European Tax, Etudes et
Recherches, Paris: Notre Europe.
Oates, W.E. (1999), “An Essay on Fiscal Federalism”, Journal of
Economic Literature 37, 1120–1149.
An immediate reaction to this list is sure to be that it
exemplifies the old joke about the economist on a
desert island confronted with a tin of food, who
answers the question “how do we open it?” by stating “assume a tin opener”. But even if some of the
forgoing proposals seem fanciful, the sceptical reader is invited to write down on a blank sheet of paper
what would be included if an EU budget were
designed from first principles. The difficulty facing
CESifo Forum 1/2007
50
Special
choice – each of which would reduce carbon dioxide
emissions (Bates et al. 2000; Wit et al. 2002, 2005;
Wulff and Hourmouziadis 1997). This would dampen
the price signal to the traveller, so that this model
overestimates the economic impacts but underestimates the effect on emissions. The results suggest
that this is not a major problem. Note that aircraft
and fuel are fixed in the short-term. Airport authorities and air control determine the most crucial
aspects of flight behaviour – taxiing, take-off, and
landing – although the airlines pay for the emissions;
little change is expected, therefore.
AIRLINE EMISSIONS OF
CARBON DIOXIDE IN THE
EUROPEAN TRADING SYSTEM
JOHN FITZGERALD AND
RICHARD S. J. TOL*
Carbon dioxide emissions from international aviation are small but growing much faster than other
greenhouse gas emissions. To date, aviation emissions have been excluded from climate policy, inter
alia because it is an international industry regulated
by consensus. Recently, however, the European
Commission has announced that aviation emissions
will be part of the European Trading System (ETS)
for carbon dioxide. Specifically, permits will be needed for all emissions from flights from and to an airport in the European Union.1 This note investigates
the implications for emissions, for travel patterns,
and for the financial position of airlines.
The model
Simulations are done with the Hamburg Tourism
Model (HTM), version 1.3. Previous work focussed
on climate change (Hamilton et al. 2005a,b; Bigano
et al. 2005). The current version is designed to
analyse climate policy (Tol forthcoming).
HTM predicts the numbers of domestic and international tourists from 207 countries, and traces the
international tourists to their destinations. Tourism
demand is primarily driven by per capita income.
Destination choice is driven by income, climate,
coast, and travel time and cost. Carbon pricing would
increase the travel cost, but leave other factors unaffected. See Tol (forthcoming) for details.
This note builds on Tol (forthcoming). That paper
was written when taxing aviation emissions was a
remote prospect, and the policy scenarios there differ from the current policy proposals – particularly,
the previous paper considers a global tax, while the
current paper studies a European permit trade.
Similarly, Michaelis (1997), Olsthoorn (2001) and
Wit et al. (2002) analyse different policies than what
is currently being proposed.
Data were primarily taken from WTO (2003) and
EuroMonitor (2002). Behavioural relationships were
estimated for 1995 (the most recent year with reasonably complete data coverage), and used to interpolate the missing observations. Observations on
travel time and travel cost are very limited. Here,
travel time and cost are assumed to be linear in the
distance between airports, using data for Heathrow,
Europe’s busiest airport. The airfare elasticity of destination choice equals – 1.50 + 0.14lny, where y is the
average per capita income in the country of origin.
For UK travellers, the elasticity equals – 0.45, which
compares well to the estimates of Oum et al. (1990),
Crouch (1995), Witt and Witt (1995) and Wohlgemuth (1997).
The paper only considers international aviation
demand by tourists. Domestic air travel is excluded,
as is travel for business purposes. There is a global
database of reasonable quality on international
tourist travel – but there is nothing of the sort for
domestic tourist travel or for business travel. So, a
choice has to be made between comprehensiveness
in a geographic sense, and comprehensiveness in a
travel sense. The current paper opts for the former,
which of course does not make the latter less relevant. Note that business travellers are less likely to
respond to price changes than are tourists.
The paper only considers shifts in demand induced
by an increase in the price of air travel. Of course,
carbon pricing would also induce changes in flight
behaviour, aircraft technology, and perhaps fuel
The model was used to predict tourist numbers for
1980, 1985, and 1990, and shown to have a predictive
power of well above 70 percent.
* Economic and Social Research Institute, Dublin.
1 http://ec.europa.eu/environment/climat/aviation_en.htm
Carbon dioxide emissions equal 6.5 kg C per passenger for take-off and landing, and 0.02 kg per pas-
51
CESifo Forum 1/2007
Special
account for 19 percent of all tourism aviation emissions. However, emissions on flights to and from the
EU account for 58 percent of global emissions. The
difference is because Europe is a popular holiday
destination for people from all over the world, and
tourists from outside the EU fly longer distances.
Note that airlines have questioned the jurisdiction of
the European Commission.
senger-kilometre (Pearce and Pearce 2000). No holidays at less than 500 km distance (one way) are
assumed to be by air, and all holidays beyond 5000
km are assumed to be by air; in between the fraction
increases linearly with distance. For island nations,
the respective distance are 0 and 500 km. Total modelled emissions in 2000 are 140 million metric tonnes
of carbon, which is 2.1 percent of total emissions
from fossil fuels. This is from tourism only. Total
international aviation is responsible for some 3 percent of global emissions.2 There are no published
numbers on the share of tourism in total international travel.
Emissions
Figure 1 shows the effect of carbon dioxide emissions trading. The change in global CO2 emissions
is approximately linear in the permit price. This is
no surprise if one considers the scale of change in
emissions: Global emissions from international
tourism aviation fall by less than 0.14 percent if the
permit price is 240 €/tC. If the price of permits is as
it was in early January of 2007, emissions fall by
0.01 percent. For emissions by EU residents, the
respective numbers are 0.28 percent and 0.02 percent.
Scenarios and Results
Scenarios
The model was calibrated for 1995. From 1995 to
2004, populations and economies grow as observed.
Between 2005 and 2020, growth rates gradually converge to the SRES A1 scenario (Nakicenovic and
Swart 2001). The price of oil is kept constant at the
price in September 2006. Results are presented for
2010 only, and in deviations from the baseline, so that
the baseline details are largely irrelevant.
Tourist numbers
The change in international arrivals in the European
Union is larger than the change in emissions, as nonEU tourists choose the fly to other destinations. Still
numbers are small, less than a 0.6 percent drop. The
reduction in tourist numbers is not evenly spread in
Europe. Peripheral island nations such as Cyprus,
Malta, and Ireland see the largest reductions
(– 1.16 percent, – 1.04 percent and – 0.90 percent, for
240 €/tC). Slovakia (– 0.43 percent) is affected least
– generally, central countries that can also be
reached by car or train face below-average impacts.
Eight different prices of carbon permits are considered, all in euro per tonne of carbon: 0, 5, 10, 18, 25,
50, 100, and 240 €/tC; 0 €/tC is the base case; 5 €/tC
(25 €/tC) corresponds to the median in Tol’s (2005)
meta-analysis of the marginal damage cost of carbon
for a 3 percent (1 percent) pure rate of time preference; 240 €/tC is the value recommended by Stern et
al. (2006); 18 €/tC was the price
of carbon permits in the ETS at
January 5, 2007; 10, 50 and
Figure 1
100 €/tC are round numbers in
EMISSIONS AS A FUNCTION OF PERMIT PRICE
between.
global aviation carbon emissions (% change)
0.00
Following the proposal by the
European Commission, permits
are assumed to be needed for all
emissions from flights to and
from any airport in the European Union. Norway has announced it will join, while Iceland and Switzerland are
assumed to follow suit. People
residing in the European Union
-0.02
-0.04
-0.06
-0.08
-0.10
-0.12
-0.14
0
25
50
2
See http://themes.eea.europa.eu/Environmental_issues/climate/indicators.
CESifo Forum 1/2007
Source: Own calculation.
52
75
100
125
150
175
200
225
250
permit price (€/tC)
Special
given assets with a total value of €3.0 billion per
year. At the permit price advocated by Stern et al.
(2006), the subsidy would amount to €39.6 billion. In
comparison, the US industry received a hand-out of
€1.9 billion in response to the 9/11 terrorist attack on
the World Trade Center.3
Countries outside the EU would attract more
tourists – the number of European tourists would
fall only slightly as these tourists pay for their carbon
emissions wherever they go, but tourists from China,
Japan and the USA would be diverted from Europe
to other countries. Nepal and South Korea gain more
than 1 percent for a 240 €/tC permit price.
An annual subsidy of this size to incumbents would
increase the barriers to entry for new airlines.
Grandparenting similarly rewards slow-growing
airlines at the expense of fast-growing ones. Lowcost carriers face a proportionally higher price
increase than other carriers. These three effects
imply a reduction in competition in the air travel
market. As taxiing, take-off and landing are more
energy-intensive than cruising, tradable permits hit
companies that specialise in short-haul flights relatively harder than companies that specialise in
long-haul flights.
Airlines
HTM does not explicitly include airline behaviour,
but the observed behaviour of power utilities in the
current ETS may be a good analogue for what will
happen in the air travel market. As demand is price
inelastic, the costs of carbon permits are by and
large passed on to electricity consumers. This is
because the effect on the price of electricity is too
small to have much effect on competition. In air
travel, the price effect is even smaller, while airlines’
emissions are more homogenous so that the competition effect is smaller too. It is therefore safe to
assume that the price of permits will be passed on to
the travellers.
If carbon permits were auctioned rather than grandparented, the airline industry would not receive the
wind-fall discussed above. Instead, the money would
flow to the government. If the government spends
that money wisely or cuts taxes, then this corresponds to a redistribution of a relatively small
amount of money from air travellers to the general
public.
Currently, permits are grand-parented in the ETS,
that is, companies receive their permits for free; and
the amount of permits is proportional to the emissions in a base year. To date, allocated permits are in
fact almost equal to the expected emissions in the
target year – the basic reason why the permit price is
so low.
Airports
European airports would see a reduction in number
Under these assumptions, Figure 2 shows the value
of travellers. As discussed above, the changes in the
of the grandparented permits to the airline industry
number of tourists to and from Europe are very
as a function of the permit price. At the permit price
small. However, the number of transiting passengers
of early January 2007, the airline industry would be
may fall more substantially. Under the proposed
rules, emission permits are needFigure 2
ed for the entire trip New YorkFrankfurt-Johannesburg, but
SUBSIDY TO THE AIRLINE INDUSTRY AS A FUNCTION OF PERMIT PRICE
none for the longer trip New
permit value (bln €)
45
Yo r k - D u b a i - Jo h a n n e s b u r g.
Similarly, a trip London-Dubai40
Sydney would require less car35
bon permits than a trip London30
Singapore-Sydney, but emit
25
more CO2. Over the longer term,
20
hubs may develop just beyond
15
the European Union – as
10
Switzerland has not entered into
5
the ETS, Zurich International
Airport may be that hub.
0
0
25
50
75
100
125
150
175
200
225
250
permit price (€/tC)
Source: Own calculation.
3
53
The Economist, September 15, 2005.
CESifo Forum 1/2007
Special
Hamilton, J. M., D. J. Maddison and R. S. J. Tol (2005), “The Effects
of Climate Change on International Tourism”, Climate Research 29,
255–268.
Discussion and conclusion
In sum, including aviation emissions in the European
Trading System for carbon dioxide appears to be neither effective nor efficient. Of course, the first best
solution for an emission reduction policy is to have a
permit market that covers all emissions, including
those from aviation. However, the current market is
partial, and including aviation should not be the first
priority for extending market coverage. The effect on
emissions is minimal, even if the permit price reaches heights that are inconceivable today. If this were
the only drawback, one may dismiss the inclusion of
aviation emissions in the ETS as largely irrelevant,
but a step in the right direction. However, in the current regime of grandparenting permits, this policy is
in fact tantamount to a substantial subsidy to the airline industry – at the expense of travellers and without perceptible gains for the environment. European
politicians would create the impression of leadership
on climate policy while in fact contributing almost
nothing to emission reduction.
Michaelis, L. (1997), Special Issues in Carbon/Energy Taxation:
Carbon Charges on Aviation Fuels – Annex 1 Export Group on the
United Nations Framework Convention on Climate Change Working
Paper no. 12, Organization for Economic Cooperation and Development, Paris, OCDE/GD(97)78.
Nakicenovic, N. and R. J. Swart (2001) IPCC Special Report on
Emissions Scenarios. Cambridge: Cambridge University Press.
Olsthoorn, A. A. (2001), “Carbon Dioxide Emissions from International Aviation: 1950-2050”, Journal of Air Transport Management 7, 87–93.
Oum, T. H., W. G. Waters, II, and J. S. Yong (1990), A Survey of Recent Estimates of the Price Elasticities of Demand for Transport,
World Bank, Washington DC, 359.
Pearce, B. and D. W. Pearce (2000), Setting Environmental Taxes for
Aircraft: A Case Study of the UK, CSERGE, London, GEC 2000–26.
Stern, N., S. Peters, V. Bakhshi, A. Bowen, C. Cameron, S. Catovsky,
D. Crane, S. Cruickshank, S. Dietz, N. Edmonson, S.-L. Garbett,
L. Hamid, G. Hoffman, D. Ingram, B. Jones, N. Patmore,
H. Radcliffe, R. Sathiyarajah, M. Stock, C. Taylor, T. Vernon,
H. Wanjie, and D. Zenghelis (2006), Stern Review: The Economics of
Climate Change, HM Treasury, London.
Tol, R .S. J. (2005), “The marginal damage costs of carbon dioxide
emissions: an assessment of the uncertainties”, Energy Policy 33,
2064–2074.
Tol, R. S. J. (forthcoming), “The Impact of a Carbon Tax on International Tourism”, Transportation Research D: Transport and the
Environment.
Wit, R. C. N., J. W. M. Dings, P. Mendes de Leon, L. Thwaites,
P. Peeters, D. Greenwood, and R. Doganis (2002), Economic Incentives to Mitigate Greenhouse Gas Emissions from Air Transport
in Europe, CE Delft, Delft, 02.4733.10.
The results presented here are uncertain and
require substantial caveats. A sensitivity analysis on
the many assumptions is not given. However, Tol
(forthcoming) shows that the sensitivity of the
results is less than an order of magnitude – even if
the impact of carbon pricing on emissions were ten
times larger, it would still be very small. The lack of
technological and behavioural responses in the
model seems to be the most significant omissions –
but the stock of aircraft turns over only very slowly,
while taxiing, take-off and landing behaviour is in
fact not affected by the proposed carbon pricing.
Therefore, including aviation emissions in the ETS
will, at best, have no effect on emissions and, at
worst, have no effect on emissions but give a handsome subsidy to the airlines.
Wit, R. C. N., B. H. Boon, A. van Velzen, A. Cames, O. Deuber, and
D. S. Lee (2005), Giving Wings to Emissions Trading – Inclusion of
Aviation under the European Trading System (ETS): Design and
Impacts, CE, Delft, 05.7789.20.
Witt, S. F. and C.A. Witt (1995), “Forecasting Tourism Demand: A
Review of Empirical Research”, International Journal of Forecasting 11, 447–475.
Wohlgemuth, N. (1997), “World Transport Energy Demand Modelling – Methodologies and Elasticities”, Energy Policy 25, 1109–1119.
WTO (2003), Yearbook of Tourism Statistics, World Tourism Organisation, Madrid.
Wulff, A. and J. Hourmouziadis (1997), “Technology Review of
Aeroengine Pollutant Emissions”, Aerospace Science and Technology 8, 557–572.
References
Bates, J., C. Brand, P. Davison, and N. Hill (2000), Economic
Evaluation of Emissions Reductions in the Transport Sector of the
EU, AEA Technology Environment, Abingdon.
Bigano, A., J. M. Hamilton and R. S. J. Tol (2005), The Impact of Climate Change on Domestic and International Tourism: A Simulation
Study, Research unit Sustainability and Global Change FNU-58,
Hamburg University and Centre for Marine and Atmospheric
Science, Hamburg.
Crouch, G. I. (1995), “A Meta-Analysis of Tourism Demand”, Annals
of Tourism Research 22, 103–118.
Euromonitor (2002), Global Market Information Database,
http://www.euromonitor.com/gmid/default.asp
Hamilton, J. M., D. J. Maddison and R. S. J. Tol (2005), “Climate
Change and International Tourism: A Simulation Study”, Global
Environmental Change 15, 253–266.
CESifo Forum 1/2007
54
Spotlights
exports. Such a close trading relationship is the reason why the IMF forecasts a slight decline of the
economic growth rate of the NIEs in 2007, since
the growth and, consequently, the import demands
of these advanced economies are expected to
decelerate.
RECENT ECONOMIC GROWTH
AND CHALLENGES FOR CHINA,
INDIA AND OTHER EMERGING
ASIAN COUNTRIES
However, there are some additional near-term
China and India have recently been the growth
risks to the economic outlook for the emerging
engines of the Asian economies. In the last three
Asian countries. First of all, there is a general fear
years, from 2004 to 2006, the real GDP growth rate
that, in the absence of a properly functioning maramounted to 10 percent and 8 percent in China
ket mechanism, the investment-led growth will
and India, respectively. Similarly high economic
lead China into one boom-bust cycle after anothgrowth is anticipated in China also in 2007, while
er, with each boom less sustainable than the previthe IMF projects a slight decline of the growth rate
ous one. The current exceptionally rapid investof India from 8.3 percent in 2006 to 7.3 percent in
ment growth could result in overinvestment, real
2007 (Figure 1).1 Economic growth in China has
estate speculation and falling profits for the cormostly been triggered by the rapid increase in
porate and financial sectors in China. An expaninvestment and net exports. On the other hand, in
sion of private investment is required, however, to
India inflation has picked up due to rising oil
prices and strong domestic
demand, which forced the
Figure 1
Reserve Bank of India to raise
REAL GDP GROWTH IN ASIAN COUNTRIES
interest rates (Figure 2). The
Annual percentage change
%
effect of higher oil prices and
12
tighter monetary controls as a
10
policy response were also the
major causes of the slow eco8
nomic growth in the ASEAN-4
6
countries (Indonesia, Thailand,
Philippines and Malaysia) in
4
2005 and 2006. A slight growth
2
improvement is expected in
these countries in 2007.
0
2004
Economic expansion in the
newly industrialised economies
(NIEs) during the last two
years was particularly led by
the increase in exports of electronic goods. The NIEs have
also benefited from the rapid
growth of the Chinese economy
and the favourable economic
performance of some advanced
economies including the Unites
States and Japan. These two
developed countries have traditionally been the major destinations of these countries’
2005
China
India
2006
ASEAN-4
NIEs
2007
Japan
Source: IMF.
Figure 2
DEVELOPMENT OF CONSUMER PRICES IN ASIAN COUNTRIES
Annual percentage change
%
10
8
6
4
2
0
-2
2004
2005
1
International Monetary Fund (IMF),
World Economic Outlook, September
2006, Washington DC, Ch. 2
China
India
2006
ASEAN-4
NIEs
2007
Japan
Source: IMF.
55
CESifo Forum 1/2007
Spotlights
Figure 3
DEVELOPMENT OF ACCOUNT BALANCE IN ASIAN COUNTRIES
Percent of GDP
%
8
6
tion also appears to be necessary
at both the central and the state
government levels of India. Taxbase broadening combined with
subsidy cuts would be an appropriate policy option.
4
NCW
2
0
-2
-4
2004
2005
China
India
2006
ASEAN-4
NIEs
2007
Japan
Source: IMF.
revive economic growth in the ASEAN-4 and
many other emerging Asian countries.
Secondly, although many emerging Asian countries have had current account surpluses (Figure
3) and have accumulated substantial foreign currency reserves, they could also be vulnerable to a
sudden deterioration in international financial
market conditions. Furthermore, due to strong
domestic demand growth accompanied by high oil
prices, some Asian countries could experience a
further deterioration in their current accounts
(for example, India and Thailand). For China,
however, the IMF recommends a substantial
revaluation of the renminbi to dampen the growth
of the current account surplus and to give the central bank control of domestic monetary conditions. According to the IMF’s assessment, the central bank’s present policy focus on reducing the
renminbi’s fluctuation against the dollar has made
effective liquidity control difficult, and the small
interest rate increases have not been sufficient to
restrain the strong credit growth, which, in turn,
has contributed to the investment boom in this
country.
The favourable economic outlook provides opportunities for fiscal reforms in a number of Asian emerging countries. In particular India, Pakistan and the
Philippines require urgent budget consolidation and
the reduction of public debt. Since governments in
the Philippines and Indonesia have a large share of
foreign debt, a continuous fiscal improvement would
also lead to reduced vulnerability of these countries’
economies to external shocks. In spite of the prevailing strong spending pressures, a gradual consolida-
CESifo Forum 1/2007
56
Trends
FINANCIAL CONDITIONS
IN THE EURO AREA
In the three-month period from December 2006 to February 2007,
short-term interest rates rose continuously. The three-month EURIBOR increased from an average 3.68% in December to 3.82% in
February. Ten-year bond yields rose from 3.90% in December 2006 to
4.12% in February 2007. In the same period of time the yield spread
widened from 0.22% (December) to 0.35% (January) and 0.30%
(February).
The German stock index DAX reached over 6,700 points in early 2007.
The Euro STOXX also rose in parallel, averaging 4,159 in January and
4,230 in February. The Dow Jones Industrial continued to rise in
February, averaging 12,631 points. However, all these stock market indicators declined in March.
The annual rate of growth of M3 stood at 9.8% in January 2007,
unchanged from the previous month. The three-month average of the
annual growth rate of M3 over the period November 2006 – January
2007 rose to 9.7%, from 9.2% in the period October 2006 – December
2006.
In January 2007 the monetary conditions index has continued its decline
that has started in late 2005, signalling greater money tightening. This is
the result of rising real short-term interest rates and a rising real effective
exchange rate of the euro.
57
CESifo Forum 1/2007
Trends
EU
SURVEY RESULTS
According to the first Eurostat estimates, euro area real GDP grew by
0.9% in the fourth quarter of 2006, compared to the previous quarter. In
the third quarter of 2006 growth rates were 0.6% in both the euro area
and the EU25.
The EU Economic Sentiment Indicator increased in both the EU and
the euro area in February. The indicator rose by 1.3 points in the EU and
by 0.5 of a point in the euro area, to 112.0 and 109.7, respectively. Overall
economic confidence improved in France, Italy, Poland and the UK,
while it decreased in Germany and Spain.
* The industrial confidence indicator is an average of responses (balances) to the
questions on production expectations, order-books and stocks (the latter with
inverted sign).
** New consumer confidence indicators, calculated as an arithmetic average of the
following questions: financial and general economic situation (over the next
12 months), unemployment expectations (over the next 12 months) and savings
(over the next 12 months). Seasonally adjusted data.
In February 2007 managers’ production expectations remained constant
in the EU, while their assessment of order books and stocks of finished
products improved in the manufacturing sector. The assessment of order
books improved from 2.4 in January to 4.2 in February. Capacity utilisation also rose to 84.1 in the first quarter of 2007 from 83.5 in the previous
quarter.
In February 2007 the industrial confidence indicator rose in the EU, while
it remained unchanged in the euro area. Yet, the indicator remains at a
very high level in both areas. Consumer confidence also improved in both
the EU and the euro area. In both areas, the consumer confidence indicators remained on an upward trend and stand well above their longterm average.
CESifo Forum 1/2007
58
Trends
EURO AREA
INDICATORS
The Ifo indicator for the economic climate in the euro area improved in
the first quarter of 2007 following a moderate cooling in the second half
of 2006. The improvement applied to both the assessments of the current
economic situation as well as to the expectations for the coming six
months. The Ifo indicator thus predicts a continuation of the robust
European economic upturn in the first half of 2007.
The exchange rate of euro against the US dollar averaged 1.31 $/€ in
February 2007, slightly up from 1.30 $/€ in January. In December 2006
the rate amounted to 1.32 $/€, one of the highest values since 1993.
Euro area unemployment (seasonally adjusted) declined to 7.4% in
January 2007 compared to 7.7% in the previous five months, and was
lower than the year earlier rate of 8.3%. EU25 unemployment stood at
7.5% in January 2007, the lowest in the investigated years as well: This
value is 0.8 points lower than a year earlier. Among the EU Member
States the lowest rate was registered in Denmark (3.2% in December
2006), the Netherlands (3.6%) and Estonia (4.2%). Unemployment rates
were the highest in Poland (12.6%) and Slovakia (11.0%).
Euro area annual inflation (HICP) was 1.8% in February 2007,
unchanged from January. A year earlier the rate was 2.3%. An EU-wide
HICP comparison shows that in February 2007 the lowest annual rates
were observed in Malta (0.8%), France, Cyprus and Finland (all 1.2%),
and the highest rates in Hungary (9.0%), Latvia (7.2%), Bulgaria and
Estonia (both 4.6%). Year-on-year EU 12 core inflation (excluding energy and unprocessed foods) rose to 1.90% in February 2007 from 1.78%
in January.
59
CESifo Forum 1/2007
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