Convergence Prospects for CEE Countries M. Sc. Dissertation Paper ACADEMY OF ECONMIC STUDIES DOCTORAL SCHOOL OF FINANCE AND BANKING Mihaescu Flaviu Coordinator: Professor Moisa Altar

Convergence: Hypotheses Poor countries catch-up with the rich ones. The farther the initial level of (per capita) output from the steady state, the faster the growth. Equation:

Convergence: Major drawbacks “Steady states”: different countries have different steady states Unconditioned convergence holds only for some countries / regions E.g.: U.S. states, Japanese prefectures and OECD regions They have the same steady states

Conditional Convergence Conditional convergence accounts for different steady states Conditioning variables may be: Government consumption Domestic savings Domestic investments

Conditional Convergence Equation: Empirical evidence: Barro and Sala-i-Martin (1991), Mankiw, Romer and Weil (1990), Sachs and Warner (1995)

Unconditional Convergence: CEEC11 Premises for convergence: the same pattern of output growth EU accession candidates and proximity converging structure of the economies legislative and institutional approximation openness of trade

Unconditional Convergence: CEEC11 Average Growth Initial Level Average Growth Vs. Initial Level of GNP per capita, PPP,

Conditional Convergence: Accounting for Different Steady-States Split the 11 countries group by EU - Accession criteria: 1998 Group: Poland, Czech Republic, Estonia, Hungary and Slovenia 2000 Group: Bulgaria, Lithuania, Latvia, Romania, Slovak Republic plus Croatia

Conditional Convergence: Accounting for Different Steady-States 1998 Group SpainThe 1998 Group will have the per capita income level of Spain as steady state (about 80% of EU level) 2000 Group GreeceThe 2000 Group will have the per capita income level of Greece as steady state (about 60% of EU level)

Conditional Convergence: Accounting for Different Steady-States The highlighted countries are those from the 1998 group and their per-capita GNP was divided by Spain’s. The rest – not highlighted – are the 2000 group countries plus Croatia and they have Greece as steady state.

Conditional Convergence Average Growth Initial Level Average Growth Vs. Initial Level of relative GNP per capita, PPP,

Unconditional Convergence in Expanded Sample 24 countries sample, CEEC11 + CIS countries + Turkey Average Growth Vs. Initial Level of GNP per capita at PPP in expanded sample,

Unconditional Convergence in Expanded Sample Regression output (CIS is a dummy variable for CIS countries):

Conditional Convergence: Conditioning Variables

With a = β = γ 1 = γ 2 = [0.005] [0.017] [0.019] [0.037] R - sqr. = 0.803F-stat. = [0.007] Adj. R - sqr. = 0.719

Conditional Convergence: Conditioning Variables Institutional Quality“Institutional Quality” comprises voice and accountability, politically instability and violence, government effectiveness, regulatory burden, rule of law and graft. Trade“Trade” is the sum of imports and exports divided by GDP, all at PPP, and it is often taken as a measure of openness.

Timing Convergence The 1998 group (Czech Republic, Estonia, Hungary, Poland and Slovenia) will reach Spain or approximately 80 percent of EU average per capita income in 16 – 18 years The 2000 group (Bulgaria, Latvia, Lithuania, Slovak Republic, Romania plus Croatia) will reach Greece or approximately 60 percent of EU average income also in 16 – 18 years.

Scenario Analysis Assumptions: “Trade” will increase with one Standard Deviation “Institutional Quality”: the 1998 Group will improve their institutional quality with 2 points, while the 2000 Group will improve with 4 points. “Optimistic” scenario assumes a 9% speed of convergence, the “pessimistic” one a 2.4%, while the “intermediate” one assumes 6%.

Scenario Analysis

Convergence of “Cohesion”Countries to EU Average Vs. Initial levels of per –capita income, EU-14,

Convergence of “Cohesion”Countries to EU Conditioning variables: a = β = γ 1 = γ 2 = γ 3 = [0.006] [0.077] [0.013] [0.003] R - sqr. = 0.809Adj. R - sqr. = 0.777

Scenario Analysis Scenario 1: Theoretical assumptions - GC = 10% and DI = 30% Scenario 2: Average values of GC and DI for CEECs, Scenario 3: Average values of GC and DI for Greece, Spain and Portugal, Scenario 4: Average values of GC and DI for Ireland,

Scenario Analysis

σ - Convergence Output gap between the group members decline over time σ - convergence does dot imply β - convergence, nor conversely “catch-up at the top and downward convergence at the bottom” (Ben- David, 1997)

σ - Convergence

Var(Group1998) = * trend [0.00] [0.02] R – sqr = 0.56 Var(Group 2000) = * trend [0.00] [0.00] R – sqr = 0.88 Variance trend for restricted sample,

Ergodic Distribution Considers the entire income distribution Follows Quah (1997) Transition probabilities matrix of moving from one income group to another. The diagonal probabilities show the probability of staying in the same income group, while the off-diagonal probabilities are the probabilities of moving from one income group to the subsequent one (up or down).

Ergodic Distribution The ergodic distribution is: Where P is the transition probabilities matrix. The ergodic distribution can be obtained as the left eigenvector corresponding to the unit eigenvalue. (Because each row of the matrix sums to one)

Ergodic Distribution Number of observations per income group ( as a % of EU average)

Ergodic Distribution

Initial and ergodic distribution

Conclusions β - convergence is achieved after controlling for different steady statesβ - convergence is achieved after controlling for different steady states σ - convergence shows that there is rather divergence among 2000 Group countries, while 1998 Group countries do also exhibit σ - convergence σ - convergence shows that there is rather divergence among 2000 Group countries, while 1998 Group countries do also exhibit σ - convergence The ergodic distribution shows that there is convergence among CEEC 11 countries, namely the 2000 Group will converge in per capita income to the 1998 Group.The ergodic distribution shows that there is convergence among CEEC 11 countries, namely the 2000 Group will converge in per capita income to the 1998 Group.