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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 A quarterly journal on European economic issues Publisher and distributor: Ifo Institute for Economic Research e.V. Poschingerstr. 5, D-81679 Munich, Germany Telephone ++49 89 9224-0, Telefax ++49 89 9224-1461, e-mail [email protected] Annual subscription rate: n50.00 Editors: Chang Woon Nam, e-mail [email protected] Heidemarie C. Sherman, e-mail [email protected] Reproduction permitted only if source is stated and copy is sent to the Ifo Institute www.cesifo.de 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. 3 CESifo Forum 1/2007 Focus 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 4 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, 5 CESifo Forum 1/2007 Focus 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 6 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. 7 CESifo Forum 1/2007 Focus 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 8 Focus 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 9 CESifo Forum 1/2007 Focus 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 10 Focus 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 19 CESifo Forum 1/2007 Focus 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 Focus 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. 21 CESifo Forum 1/2007 Focus 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 22 Focus 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. 23 CESifo Forum 1/2007 Focus 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 24 Focus 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). 25 CESifo Forum 1/2007 Focus 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 Finance Commission (2004), Report of the Twelfth Finance 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. 28 CESifo Forum 1/2007 30 Focus 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. Singh, N. and T. N. Srinivasan (2005), Indian Federalism, Globalization and Economic Reform, in: Srinivasan T. N. and J. Wallack (eds.), Federalism and Economic Reform: International Perspectives, Cambridge, UK: Cambridge University Press. Singh, N. and T. N. Srinivasan, (2006), Federalism and Economic Development in India: An Assessment, Conference Paper, Stanford Center for International Development Conference on Challenges of Economic Policy Reform in Asia, May 31–June 3 2006, Revised, October. Sinha, A. (2004), “The Changing Political Economy of Federalism in India: A Historical Institutionalist Approach”, India Review 3, 25–63. Wallack, J. and T. N. Srinivasan (ed. 2005), Federalism and Economic Reform: International Perspectives, Cambridge, UK: Cambridge University Press. Wibbels, E. (2005), Federalism and the Market: Intergovernmental Conflict and Economic Reform in the Developing World, New York: Cambridge University Press. 31 CESifo Forum 1/2007 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 Online information services of the CESifo Group, Munich The Ifo Newsletter is a free service of the Ifo Institute and is sent by e-mail every month. It informs you (in German) about new research results, important publications, selected events, personal news, upcoming dates and many more items from the Ifo Institute. If you wish to subscribe to the Ifo Newsletter, please e-mail us at: [email protected]. CESifo publishes about 20 working papers monthly with research results of its worldwide academic network. 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