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CHINA AND INDIA Peter MandelsonAssar LindbeckRaphael KaplinskyNirvikar SinghFriedrich Sell

SupplementEMU ENLARGEMENT:A PROGRESS REPORT

Marek Dabrowski

THE 2008/2009 REVIEW OF THE

EU BUDGET

AIRLINE EMISSIONS OF

CARBON DIOXIDE

RECENT ECONOMIC GROWTH FOR

EMERGING ASIAN COUNTRIES

A joint initiative of Ludwig-Maximilians-Universität and the Ifo Institute for Economic Research

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VOLUME 8, NO. 1

Iain Begg

John FitzGerald andRichard S. J. Tol

STATISTICS UPDATE

CESifo Forum ISSN 1615-245XA quarterly journal on European economic issuesPublisher and distributor: Ifo Institute for Economic Research e.V.Poschingerstr. 5, D-81679 Munich, GermanyTelephone ++49 89 9224-0, Telefax ++49 89 9224-1461, e-mail [email protected] subscription rate: n50.00Editors: Chang Woon Nam, e-mail [email protected]

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Volume 8, Number 1 Spring 2007_____________________________________________________________________________________

CHINA AND INDIA

Europe’s trade policy with India and ChinaPeter Mandelson 3

China’s reformed economyAssar Lindbeck 8

The impact of China and India on the developing worldRaphael Kaplinsky 15

The dynamics of reform of India’s federal systemNirvikar Singh 22

Anticipated effects of foreign currency reserve diversification in Asian countries:Do China and India matter for coordination?Friedrich L. Sell 32

EMU enlargement: A progress reportMarek Dabrowski 39

The 2008/2009 review of the EU budget: Real or cosmetic?Iain Begg 45

Airline emissions of carbon dioxide in the European trading systemJohn FitzGerald and Richard S. J. Tol 51

Recent economic growth and challenges for China, India and other emerging Asian countries 55

Statistics update 57

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EUROPE’S TRADE POLICY

WITH INDIA AND CHINA

PETER MANDELSON*

Europe’s political contact with the civilizations ofIndia and China began with trade. Dutch mer-

chants opened up trade with the coastal Indian statesand then China, and the trade that followed fed agrowing European fascination with Asian culturesand aesthetics. From India, European merchantsbrought textiles, ivory and wooden furniture. Fromthe Middle Kingdom, the blue and white porcelainso ubiquitous in seventeenth century Europe that itbecame known – and is still known – simply asChina. Four hundred years ago India and Chinaaccounted for half of the world’s economic output.They remained the two largest economies in theworld until the nineteenth century.

From an historical perspective, the economic rise ofIndia and China looks more like the reassertion ofan older and deeper economic order briefly inter-rupted by the colonial period, Cold War and eco-nomic autarky in the twentieth century. From theperspective of a human lifetime – which is the onlyperspective that matters in politics – it is neverthe-less part of a seismic shift in the global economicarchitecture and one that will have profound politi-cal consequences. We live in an economically multi-polar world and global politics will soon reflect thismuch more explicitly.

China’s manufacturing economy and – to a muchlesser extent – India’s services economy are alreadydriving deep and painful economic change inEurope. As the two most salient parts of a rapidlychanging global economy, Europe’s political re-sponse to the rise of China and India is likely to beemblematic of its response to globalization itself.

Alongside the successful completion of the DohaRound and the maintenance of the WTO system, the

effective integration of China and India into the

global trading system and the establishment of reci-

procal access to their growing markets for EU

exporters is a key dimension of EU trade policy.

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.

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 domes-

tic 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.

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 entre-

pot. 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

CHINA AND INDIA

* EU Trade Commissioner.

European assessment of China’s strength and com-petitive challenge. There is a political perception inmany parts of Europe that China has grown atEurope’s expense.

Nevertheless, on balance the EU benefits muchmore economically from China’s openness and eco-nomic strength than it suffers from the increasedcompetition in some sectors. By 2010 the Chinesemiddle class will number 150 million and its marketfor high value goods will be worth more than a tril-lion euros a year. Its markets for key EU exports willbe concomitantly large: by 2010 it will be the biggestconsumer of wine globally; its market for green tech-nology will be worth 100 billion euros a year and itsmarket for business services 500 billion euros.1

European companies have played a significant partin the flow of capital into Chinese production thathas resulted in more than half of Chinese exportcapacity being capitalized by non-Chinese compa-nies. Chinese supply chains allow EU companies toremain competitive by relocating labour intensiveproduction out of Europe while keeping manage-ment, design and retail in Europe. The OECD hasestimated that cheap goods and inputs from Chinahelp depress inflation by 0.2 percent for 2001 to2005, with a consequent beneficial decline of interestrates. A Dutch study suggested that the averageEuropean family saves about 300 euros a yearthrough cheaper Chinese goods; a benefit that islargely skewed towards Europe’s poorest con-sumers. Politicians that advocate large tariff increas-es for legitimately traded Chinese imports usuallyignore the fact that such tariffs would be sociallyregressive, impacting chiefly on poorer consumers ofChinese-produced clothes, shoes and toys.

These existing and potential benefits are seriouslyqualified by continued problems with access to theChinese markets both for exports and investment.This is expressed at the simplest level by the fact thatfor every four containers leaving Shenzhen in Chinafor Europe, three are still returning empty.

It is true that China is already far ahead of almost allother emerging economies in opening its market totrade, chiefly through the heavy pressure onChinese tariffs exerted by the WTO accession

process in 2001. China’s average tariff of 8.8 percentfor industrial products is the lowest among theemerging economies, although serious tariff peaksremain in key industrial goods like automobiles, tex-tiles and shoes. Moreover, it is not unreasonable toargue that China’s extraordinary export capacityand the fact that it will be the largest exporter in theworld by 2010 mean that its political benchmark isnot to be found in the developing world.The EU hasengaged the WTO’s dispute settlement machineryin testing China’s continued practice of applying tar-iffs for whole vehicles to imports of vehicle parts – apractice it explicitly committed to ending on WTOaccession.

These unfulfilled commitments extend into the ser-vices and investment sectors. China committed to alimited opening of its telecoms sector when it joinedthe WTO in 2001, but despite having subsequentlyallocated 16,000 telecoms licenses, only five havebeen granted to foreign providers. EU companiesare still prevented from freely choosing joint venturepartners and are often subject to enforced technolo-gy transfers through obligatory joint ventures andlocal content requirements. In investment, Chinamaintains ownership and capital caps of between20 to 25 percent on foreign investment in the bank-ing sector. Branches of foreign banks in China aresubject to discriminatory capitalization require-ments relative to local banks. There remains a hugearray of non-tariff and regulatory barriers to theChinese market for EU exporters.

Agreements on patents, data exclusivity and intellec-tual property rights are also still poorly enforced inChina, with serious costs for EU companies operat-ing in the Chinese market. A recent EU study citedan estimate by EU manufacturing industry in Chinathat intellectual property fraud costs EU businessesin China 20 percent of their revenues.

The Chinese government is increasingly recognisingthe extent to which poor protection of intellectualproperty is affecting China’s own innovation culture– the Chinese film and music industry, for example, isbeing seriously undermined by local piracy. China’smanufacturing sector remains heavily characterisedby low levels of value-added production and this isunlikely to change unless Chinese companies havethe confidence to invest creative capital. In 2006China overtook Germany to become the world’sfifth biggest filer for patents, but there exists a seri-ous imbalance between legal security and effective

CESifo Forum 1/2007 4

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1 A recent study commissioned by the European Commission setout the benefits on a sector-by-sector basis. For details seehttp://ec.europa.eu/trade/issues/bilateral/countries/china/pr190207_en.htm


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access to enforcement for foreign and domestic com-panies. This will remain a key focus of EU trade pol-icy in China.

There are other structural trade barrier issues thatEurope will continue to urge China to address. Thefocus on export-led growth rather than domesticconsumer demand, and high levels of precautionarysaving by Chinese consumers restrains the necessarydevelopment of a growing consumer economy andacts as a brake and barrier to others’ exports toChina which would re-balance trade. China’s bank-ing system and financial infrastructure is bendingunder the strain of rapid development and needsurgent reform.

State intervention in the manufacturing sector inChina also remains a persistent problem and this hasresulted in a growing number of anti-dumping casesagainst China. Many of these have touched on con-sumer durables such as leather shoes and have thusbeen politically highly sensitive. China’s perennialcomplaints about such trade defence action aredisingenuous given the level of state intervention inChina and the degree of restraint shown by theEuropean Union. They also tend to obscure both thefact that trade defence measures apply to less than2 percent of all EU-China trade and that China isalso a big user of anti-dumping.

Europe and China are now in the initial stages ofnegotiating a new trade and investment agreementthat will start to address some of these issues. But itseems undeniable that market access in China willremain a key challenge and a key focus of resourcesfor EU trade policy for the foreseeable future.

It is also likely to remain the EU’s most heavilypoliticized trade relationship. The perception thatChina and Europe do not trade on genuinely recip-rocal terms encourages a protectionist response thatwill only be deflected by more concerted effortsfrom China to trade fairly and meet its market accessobligations. A large and resentful constituency inEurope that has been at the sharp edge of China’sexploitation of its comparative advantages in low-cost manufacturing has little patience with economicarguments for the overall economic benefits ofopenness to China. China is deeply dependent onmarket access to developed economies, but some-times appears to be willing to call the bluff of thosewho argue that that access will ultimately depend ongreater reciprocity. That may be a strategic misread-

ing of the strength of protectionist sentiment inEurope and the United States.

Obviously, Europe has its own responsibilities.Europe has no interest in challenging the exercise oflegitimate comparative advantage in labour or pro-duction costs. Europe for its part must commit tohelping China assume full market economy statusand offering open and fair access to China’s exports,and it must adjust to the tough Chinese competitivechallenge. We cannot demand openness from Chinafrom behind barriers of our own.

EU-India trade relations

The Indian market has similar potential for Europe,qualified in the same way by serious obstacles tomarket access. India’s growing middle class andbooming services sector are obvious assets for EUexports and EU capital.

India invokes none of the anxiety that China doesfor the simple reason that it remains a small exporterto Europe. Much of its economic impact on Europehas been at the politically less visible level of the ser-vices sector. This seems likely to change as India’smassive capacity and competitiveness in services –described in books like Thomas Friedman’s andClyde Prestowitz’s – is brought to bear on the IT andIT support sector in Europe and the US. India is alsoan increasingly active investor in Europe. Since 2000,Indian companies have invested more than $10 bil-lion in Europe – a fivefold increase in the lastdecade. Indian firms like Infosys, TCS, HCL, Wiproand Birlasoft have all made impressive inroads intothe EU market, of which the Mittal Steel bid forArcelor was only the most dramatic example – notleast because of the unjustifiable defensiveness itprovoked in Europe.

Yet this data is chiefly striking in the extent to whichit suggests untapped potential. India still accountsfor only 1.5 percent of world services trade and1 percent of global merchandise trade despite thefact that Indians make up one sixth of the world’spopulation.

Europe’s exports to India are hardly negligible butthey account for less than 2 percent of our goodstrade and less than 2 percent of EU outward FDIflows, which is totally out of proportion to India’spopulation and the size of its market. In 2003,

European FDI into India’s was just under 4 billioneuros whilst China’s was 47 billion euros. 1 percentof global foreign investment goes to India and15 percent to China.

India’s historically high tariffs have been comingdown through unilateral reform. Its average appliedindustrial tariff of around 15 percent is exceptionalfor an emerging economy, but it is still twice that ofChina and average bound tariff rates are twice ashigh. Border protection is sometimes discriminatory,an issue the EU has recently raised in its WTO con-sultations over Indian duties on EU wines and spir-its, which at 500 percent are some of the highest inthe world.

The days of the “licence raj” are certainly over. ButIndia often remains a difficult place for EU compa-nies to invest and trade. It still takes 89 days onaverage to start a business in India, more than twicethe time in China. Resolving insolvency takes onaverage ten years in India, four times the equivalenttime in China.The IMF’s trade restrictiveness indexgives India a score of 8 – where 10 is the mostrestrictive – and China 5. European companiescomplain of highly restrictive red tape and discrim-inatory regulation.

The decision to launch an FTA between the EU andIndia will help reduce many of these barriers. Indiahas an active interest in encouraging Europeaninvestment that can be an important source of capi-tal for India, not least for the infrastructure workthat the Indian government has made a centralstrand of improving its competitiveness.The aim is toliberalize not just goods and services trade, but toremove non-tariff barriers and establish new ruleson issues such as investment, competition and publicprocurement. That means going beyond WTO rulesinto areas of mutual interest not yet ready for multi-lateral agreement at the WTO.

Systemic aspects

These bilateral aspects of Europe’s trade policy withChina and India are only part of the wider politicalchallenge of integrating China and India into theglobal trading system. China will soon be the largestexporter in the WTO, and ultimately the largesteconomy in the global trading system. India will notbe far behind. The idea that the rules-based WTOsystem can function effectively without these two

huge powers at its heart is fanciful. Their joint lead-ership and example both among emerging eco-nomies and developing countries will be decisive inreassuring the developing world that the multilater-al trading system and progressive trade liberalizationcan reflect their interests.

Equally important will be the acceptance by bothChina and India that their growing power creates agrowing obligation to open their markets, not least toother developing countries. South-south traderemains the most heavily obstructed trade in theglobal economy. With tariffs at historically low levelsin the developed world, the future of tariff liberal-ization lies largely in the developing world.

Behind the anxiety of many developing countries inAsia, Africa and Latin America to commit to tradeliberalization is fear of the export power of China inparticular. Because the growing markets of Chinaand India are as attractive to the manufacturers ofthe developing world as they are to those of Europe– even more so for the low cost manufactures pur-chased by China and India’s growing cohort of mid-dle and low income consumers – improved marketaccess is the only way to balance that fear.

A successful conclusion to the Doha Round wouldbe a powerful signal and an important step in thisrespect. Not only would it cement the principle ofreciprocal liberalization for the emerging economiesbut it would open the markets of these economiesfurther to the developing world. If Doha fails, a sim-ilar opportunity is not likely to recur in the foresee-able future.

Conclusion

It’s easy to forget from a detached or analyticalposition that the impact of the economic rise ofChina and India is as much a political issue as aneconomic one. Assuming that we are able to dis-mantle barriers to access in China and India, bothbilaterally and through the multilateral system,Europe stands to gain hugely from the economicstrength of both – as a source of cheap inputs, as amarket for exports and as a destination and sourceof investment in liquidity-rich global capital mar-kets. But both are exploiting comparative advan-tages in the global economy that are – or are likelyto – exert serious pressure on some sectors of theEuropean economy.


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Convincing our own constituencies that the widerbenefits of this economic pressure outweigh thecosts in isolated sectors is part of Europe’s widerchallenges of adaptation to a globalized economy. Itmeans a concerted public policy response in Europeto address the needs of those faced with the impactof economic change and adaptation. But it alsorequires the clear demonstration of reciprocity fromIndia and China. EU trade policy is the means bothof delivering that reciprocity and securing theEuropean openness that legitimizes the demands wemake of others.

Obviously, Europe’s relations with both China andIndia go much beyond trade. China and India will becentral to the global response to climate change.They will be central to the geopolitics of energy sup-ply. They are both nuclear powers in neighborhoodswith potential for instability. Yet ordinary Euro-peans’ first confrontation with India and China islikely to be as economic powers, changing the shapeof our economic world. That fact alone means thatthe management of trade politics will be at the cen-tre of our relationship.

CHINA’S REFORMED ECONOMY

ASSAR LINDBECK*

It is easy to identify China’s main economicachievements in connection with the country’s

transition to a new economic system: a GDP growthrate perhaps as high as 9 to 10 percent per year sincearound 1980; an eightfold increase in per capitaincome; and a fall from 50 to 10 percent of the shareof the population living in “absolute poverty”. Thislast category is then defined as individuals living onless than one dollar a day. However, it is also impor-tant to be clear about the resource costs connectedwith China’s rapid growth path as well as lingering,and in some fields increasing, social problems.

Nature of the economic reforms

Since the late 1970s, when the economic reformsstarted, the sequential privatization of collectiveagriculture farms, Town and Village Enterprises(TVEs) and a large number of state firms has drasti-cally changed the ownership structure in the country– a development accentuated by the entry of newprivate firms, domestic as well as foreign. As a resultof these developments, about 60 percent of theaggregate production in China today seems to takeplace in privately controlled firms. China’s economicsystem has, however, changed dramatically also inother dimensions than the ownership structure.Economic decision-making has been decentralizedfrom government authorities to households (in thecase of consumption) and to firms (in the case ofproduction and investment); command has, to a con-siderable extent, been replaced by economic incen-tives; administrative processes by markets; monop-oly by competition; and autarky by internationaliza-tion, codified in China’s entry into WTO in year2001. Broadly speaking, the Chinese economy is,

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.

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 mar-

ket 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 regis-

tration system, the urban hukou, which requires a

permit for living in urban areas. While the imple-

mentation 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 per-

mits 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.

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-


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* Institute for International Economic Studies, Stockholm Uni-versity and IFN Stockholm. The paper largely builds on Lindbeck(2006) and (2008, forthcoming).The former study, in particular, alsocontains relevant references. I am grateful for useful comments ona draft of this paper from Nannan Lundin and Fredrik Sjöholm.


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ital markets has mitigated the discrimination of pri-vate firms, the dual nature of financial markets initself is a distortion. New capital injections to statebanks by the government, and a shift of non-per-forming loans to special asset management institu-tions have, at least temporarily, “cleaned” the bal-ance sheets of state banks. The non-performing bankloans seem to have been reduced from about 30 per-cent to about 10 percent of the stock of bank lend-ing. But a permanent removal of major risks offinancial instability naturally requires that statebanks discontinue their habit of providing soft loansto state firms. Equally important: a higher quality ofbank lending is necessary for improving the alloca-tive efficiency of investment and production, whichhas for a long time also been harmed by the domi-nance of the government sector in the very thin mar-kets for shares and bonds.

The market for land is even more dominated by thepublic sector, simply because all land is owned bythe public sector and leased to private agents.Naturally, this feature of the economic system hasparticularly important consequences in agriculture,although the present arrangements are vastly moreefficient than the old system with collective agricul-ture communes. Since land-lease contracts are less“complete” than ownership contracts, the owner-ship structure for land is bound to hamper bothinvestment decisions in existing farms and the con-solidation of land holdings, and hence also the pos-sibilities of exploiting potential returns to scale inagriculture. Land-lease contrasts are also less usefulas collateral for borrowing than ownership con-tracts. All this means that China pays a heavy pricefor its lingering socialist ideology when it comes tothe ownership of agricultural land. While DengXiaoping is famous for his metaphor that “the colorof the cat does not matter as long as it catchesmice”, the color of land contracts in agriculturedoes seem to matter.

A network economy

Deficiencies in the implementation of the “rule oflaw” are another major weakness of the economicsystem in China, although the legal system in theeconomic field has gradually improved during thelast two decades. To some extent, the remainingdeficiencies are compensated for by informal net-works based on personal relations, guanxi, whichmay be regarded as a Chinese version of “social

capital”. Clearly, these networks facilitate econom-ic transactions (partly through reduced transactioncosts) among network members, which ofteninclude not only businessmen but also local politi-cians and public-sector administrators. The networksystem means, however, that China is an insider-outsider society also in the business sector; individ-uals outside the networks are disfavored. The clien-tele-like relations between representatives of thepublic sector and individual businessmen also openthe gates for corruption, since some of the repre-sentatives are in charge of regulations and permitsof various types.

“Asset stripping” in connection with the privatiza-tion of firms is another example of corruption inChina – often favoring either the management of thefirms or public-sector administrators, or both.During the transition period, such asset stripping,like some other types of kick-backs, has probablyspeeded up the creation of a class of private capital-ists, which is likely to have been conducive to entre-preneurship. However, if corruption becomes a per-manent part of the Chinese economy, it is likely tohave negative consequences for the allocative effi-ciency of the economy in the long run; at least, this isa general experience in many other countries. More-over, it is difficult to get rid of corruption as long aspoliticians and public-sector administrators havesomething to sell – like permits of various types. Thisis an additional argument for further deregulation ofthe Chinese economy, in particular by reducing therequirement of discretionary permits of varioustypes.

How, then, should we characterize China’s econom-ic system today? Some observers use the term“state capitalism”. This is, however, a rather mis-leading term since more than half of the aggregateproduction is performed by private firms.Moreover, high household savings (20 to 25 percentof the disposable income) and large plowed-backprofits in private firms are likely to graduallyincrease the private share of the ownership of firmsand assets. The term “market socialism”, launchedby Oskar Lange and Abba Lerner in the 1930s, ismisleading for the same reasons. I would simplycharacterize 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) moreprivate ownership of firms than of assets (in partic-ular land and financial assets); (3) considerable

political and bureaucratic interventions in stateenterprises; (4) poorly developed factor markets, inparticular the financial markets; (5) tight networksamong business men partly replacing the ”rule oflaw”; and (6) a pronounced insider-outsider divi-sion in society at large – in labor and capital mar-kets, in the business community as well as in thecase of social arrangements.

Inefficiencies of the growth strategy

In spite of China’s extraordinary success in termsof GDP growth, there are strong indicators of seri-ous limitations in the efficiency of the growthpath: the resource costs have been relatively high.One indication is the high aggregate investmentratio, today about 43 percent of GDP, which hasresulted in a very high marginal capital-outputratio of 4 to 4.5, indicating rather low capital pro-ductivity. The marginal capital-output ratio hasalso gradually been rising over the last twodecades, which may indicate falling capital pro-ductivity. As compared to the huge investment inreal capital assets, the investment in human capi-tal looks relatively modest around 4.5 percent ofGDP, of which less than 3 percentage points arefinanced via government budgets. Although a highrate of capital accumulation is natural for a coun-try that gives high priority to economic growth,the division between real capital assets and humancapital looks quite lopsided, the proportions beingten-to-one.

The huge consumption of energy, raw materialsand environmental values is another indicationthat the growth path is highly extensive (resource-using), largely a result of distorted prices on suchproducts. Although China has gradually become amore efficient user of energy, the country seems touse twice as much energy per unit of output asother countries (Bergsten 2006, 34). The extensivegrowth path in China is also reflected in the rathermoderate rate of “multi-factor productivitygrowth”,1 which seems to have been about 1.5 to2.5 percent per year during the transition period –a measure of technological and organizationalimprovements.

My tentative conclusion is that China has a greatdeal to gain from moving to a more intensive growthstrategy by shifting resources from investment inreal capital assets to human capital; increasing theflexibility in factor markets; raising the relativeprices of energy and raw material (for final users);and limiting the enormous tear on environmentalresources, in particular land, air and water. Less real-capital intensive production would also boostemployment.

Large income gaps

Uneven regional economic development is anoth-er important aspect of the Chinese growth path.While the GDP growth rate in some provinces hasbeen more than 12 percent per year since around1980, it has been only half as high in others. As aresult, per capita income in the most developedprovinces (and large cities) is about seven times ashigh as in the least developed ones. Indeed, thegeographical differences are so large that Chinaresembles a continent, consisting of both semi-industrial countries and some of the poorest coun-tries in the world, rather than an ordinary nationstate. Another aspect of the geographical incomedivide is that per capita income is about threetimes as high in cities as in the countryside. Thesegeographical divides are largely the result of thespecific economic policy strategy followed by thegovernment. One example is the selective openingof the Chinese economy for foreign direct invest-ment through the Special Economic Zones insome costal provinces in the 1980s. Other exam-ples are the concentration of infrastructure invest-ment to these provinces and, until recently, theunfavorable price and tax system for farmers(except during the early reform years in the early1980s).

The income gaps in the country have, however,widened also within narrowly defined geographicalareas, such as within municipalities, largely in con-nection with the increased return on human capi-tal. This is to a considerable extent a side effect ofthe shift to an economic system based on econom-ic incentives rather than command – without delib-erate policy actions to mitigate the distributionalconsequences. For instance, the Gini coefficient forthe overall distribution of household income seemsto have increased from 0.28 in 1980 to 0.40 to 0.45today.


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1 The total factor productivity growth excluding investment inhuman capital and reallocation gains in connection with the shrink-ing agricultural share of the economy (see Lindbeck 2006, 32–33).Total factor productivity (TFP) growth seems to have been 1.0 to1.5 percentage points higher than multifactor productivity growth,as a result mainly of the huge reallocation gains.


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What explains China’s economic success?

It is not easy to say which specific features ofChina’s new economic system that have been mostconducive to the country’s impressive growth per-formance from the late 1970s. A trivial, but possiblycorrect, answer is that the success depends on thecombination of reforms in all the earlier mentioneddimensions of the economic system, since this com-bination seems to have released earlier repressedindividual initiatives. When it comes to GDPgrowth, the release of individual incentives has obvi-ously dominated over the brakes on the economicefficiency of the remaining weaknesses of the eco-nomic system. It is, however, also tempting tohypothesize that the gradualism and the experimen-

tal nature of the reforms have been conducive to theeconomic success. In particular, gradualism (includ-ing the slow reduction of the overstaffing of SOEs)seems to have helped China balance job creationand job destruction much better than in transitioncountries pursuing a Big Bang strategy. This mayvery well be a main explanation as to why China, incontrast to many other transition economies, avoid-ed negative consequences for GDP growth duringthe early period of transition, and a related explo-sion of unemployment.

As emphasized by Presad and Rajan (2006), forinstance, the gradualist strategy could run into prob-lems in the future. Major coordinated reforms maybe crucial for further economic progress in somecases, for instance in order to build up market sup-porting institutions, improve the functioning of fac-tor markets, reduce discretionary government inter-ventions in state enterprises and mitigate corruption.There is also the risk that a prolonged, gradualistreform process finally comes to a halt as a result ofthe build-up of strong interest groups and the emer-gence of related “veto points”.

Consequences for the outside world

In the future, China’s emergence as an importantactor on international markets may very well beregarded as a major event in modern economic his-tory – possibly comparable to the entry of theUnited States into the world markes in the late 19thand early 20th century. In several respects, this islikely to be economically favorable for developedcountries. In particular, new opportunities areopened for these countries through the gains from

trade because of the huge difference in factor pro-portions between China and developed countries.After all, the gains from trade tend to be larger, themore the factor proportions differ among tradingpartners. The situation is more problematic for anumber of developing countries with similar factorproportions as China, and probably also for sometransition economies in Eastern Europe and formerSoviet Republics. For all these countries, China islikely to become a serious competitor, in particularin the field of labor-intensive products.

However, some observers argue that China today isalso a large producer of human-capital intensive andhigh-tech products and that developed countries aretherefore threatened by stiff competition fromChina also for such products. This view is based on amisinterpretation of official trade statistics, howev-er. It is true that China exports large volumes ofproducts with considerable high-tech content, suchas video recorders, television sets and mobilephones. But the high-tech content of these productsconsists of intermediary products imported fromother countries. The domestic value added in Chinaof these exported products is, in fact, based on low-skilled labor and low-tech production methods.Indeed, the domestic value added of the export ofelectronic and information technology productsseems to be no more than about 15 percent of theexport value of these products (Branstetter andLardy 2006). Moreover, in 2003, the domestic pro-duction of semiconductors is reported to have beenless than a tenth of the value of the imports of suchproducts (Baijia 2004).

Today, China is thus most appropriately regardedas a major assembly platform for imported high-tech components – indeed, the major platform ofthis kind in the world. As long as China buys mostof its high-tech intermediary inputs from devel-oped and semi-developed countries, it is not likelyto be a large scale threat to high-tech firms in othercountries.

Naturally, in a long-term perspective, China willprobably considerably expand the production ofhigh-tech products and, in this connection, gradual-ly upgrade its position in the international hierar-chy of production tasks. Indeed, the Chineseauthorities have expressed a concern of just beingan assembly platform for foreign firms, rather thanhaving a vital indigenous technological develop-ment. If China succeeds in upgrading its production

in domestic firms, both the traditional product cycleand the international “task cycle” (i.e. shifts in theinternational location of production tasks withinvertically integrated production processes) is likelyto be speeded up. Developed countries that are ableto continue shifting to new and more sophisticatedproducts and production tasks do not have much tofear from this development, although certaingroups of individuals in these countries are boundto lose, possibly not only in relative but in somecases also in absolute terms. Countries that are notflexible enough are likely to run into serious prob-lems – with a likely boost of protectionist pressurefrom groups in such countries that find themselvesthreatened.

Social challenges

The huge increase in per capita income for a billionof the poorest people in the world, and the drasticreduction in the number of individuals in China liv-ing in “absolute poverty”, do not only constitute animportant economic achievement. These develop-ments also imply important social progress. How-ever, the social development in China has been dis-appointing during the reform period in severalother respects. One important reason is that theprevious social arrangements, tied to work places(danwei), broke down at the same time as citizensbecame more exposed to market risks. Moreover,social benefits tied to the individual’s work placedo not sit well in a market economy, where it isimportant that social benefits are portable acrossworkplaces.

Clearly, the political authorities in China are fullyaware both of the serious social problems in thecountry and the defects of exiting social arrange-ments: the huge income gaps across geographicalareas and among individuals, the lack of incomesecurity for the majority of the population and theuneven distribution of the provision of humanservices such as education and health care.Indeed, at the 11th Congress of the CommunistParty in early 2006, the leadership announced ashift from the one-sided emphasis on GDP growthto the new ambition to create a “harmonious”society with greater concern for regional andsocial balance, and hence for future social stabili-ty. It remains to be seen to what extent, and howfast, this announcement will be reflected in actualpolicies.

New social arrangements?

Although the new social ambitions so far have beenmore pronounced in the rhetoric than in actuallypursued policies, China has clearly entered theroute towards new social arrangements, indeedtowards modest welfare-state institutions.However, a basic weakness of today’s socialarrangements is the one-sided emphasis on theinterest of urban insiders at the expense of broaderpopulation groups, in particular individuals withlow-income and the rural population in general.However, when dealing with this issue, it is impor-tant to remember that the potentially appropriatearrangements in the social field differ considerablybetween urban and rural areas. In the cities, theauthorities could provide better income security“simply” by widening the group of citizens coveredby social insurance, such as unemployment insur-ance, health-care insurance and retirement pen-sions – although this may require less generositytowards the most privileged groups today. Socialinsurance of this type is less operational in ruralareas. Indeed, unemployment and retirement (andoften also income) of individual households in agri-culture are often even difficult to define and docu-ment. For the agriculture population, it may, there-fore, be easier to rely on crop-failure insurance andlump-sum transfers rather than ordinary (general)income insurance. As a comparison, it was ratherlate in their development process that today’sdeveloped countries extended income insurance tothe agriculture population.

The provision of human services suffers from thesame types of problems as the arrangements forincome protection. Once more, the urban insidersare favored as compared to the rest of the popula-tion. Indeed, the distribution of education andhealth care seems to be at least as uneven as the dis-tribution of household income. The basic problem isthe way in which such services are financed. Forinstance, the government budget today financesonly 63 percent of total spending on education inthe country. The rest is mainly financed by variousorganizations, including firms and organizationsconnected with firms, but also by out-of-pocketmoney from households (in particular in the case ofhigher education). Even more striking, in the case ofhealth care, public budget financing only accountsfor about 40 percent of total spending, and theremaining part is mainly financed by out-of-pocketmoney from households.


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It is easy to understand that low-income groups haveserious difficulties in getting adequate schooling andmedical care with these financial arrangements.Moreover, since local rather than national authori-ties are responsible for public-sector financing ofeducation and health care, the huge variations in taxrevenues across local authorities make the provisionof such services highly uneven across geographicalareas. It is difficult to see how these problems couldbe effectively dealt with without a shift of a largepart of the financing of education and health carefrom private individuals to the public sector(through taxes or a mandatory insurance premium),combined with a huge expansion of central govern-ment transfers to poor local governments.

Social lessons from developed countries

When launching more ambitious social policies,China could learn a great deal from the experiencesin developed countries. On the “positive” side, themain lesson might be that it is possible to providequite ambitious social arrangements without endan-gering a continuation of per capita economicgrowth. There are, however, important reservationsto this observation. If the generosity of incomeinsurance exceeds certain limits (which are difficultto empirically determine in advance), the systemsmay not be financially viable in a long-term per-spective. One reason is that serious problems ofmoral hazard may emerge – an aspect that politi-cians in developed countries have usually underesti-mated, or even entirely neglected. In Europe, this is,for instance, reflected in long spells of unemploy-ment, high sickness absence and a large number ofindividuals living on highly subsidized early retire-ment. Such moral hazard problems may be particu-larly severe, if social norms against exploiting vari-ous benefit systems weaken over time when moreindividuals choose to live on such benefits(Lindbeck 1995). China is well advised to be awareof such problems when new social arrangements areconsidered today.

In developed countries, serious efficiency problemshave also emerged in the field of human services.For instance, most developed countries are con-cerned about low quality in large parts of theirschool systems. In China, the corresponding prob-lem is particularly serious for poor sections of thepopulation. There are also strong indications ofvocational training being poorly developed in

China, while university education is rapidly expand-ing. It would seem that China is approaching a pro-nounced duality (polarization) in terms of school-ing, with a rapidly expanding group of individualswith a high academic education combined with alarge group of individuals with both little theoreticaland vocational training.

Developed countries today also experience seriousefficiency problems in the field of health services– in some countries largely in the connection withrationing and queues, in other countries in theform of cost explosions, partly as a result of ex postmoral hazard (such as unnecessary expensive med-ical examination and excessive medication andsurgery). China has already encountered similarefficiency problem – in addition to the poor accessof health services for low-income groups. The effi-ciency problems are reflected, for instance, inextremely high prescriptions of drugs and theapplication of sophisticated and often hardly nec-essary surgery for a small fraction of the popula-tion (Eggleston et al. 2006).

The complications concerning financing, incentives(including moral hazard) and efficiency of socialarrangements hardly constitute a basis for delayingradical reforms in these fields in China – either forincome protection or the provision of human ser-vices. However, the complications call for caution toavoid future “overshooting” of the generosity of thebenefit levels – and related risks of conflicts betweensocial and economic ambitions. My interpretation ofthe international experiences in this field is, howev-er, that the risk for serious conflicts between socialambitions and concern for efficiency/growth doesnot only depend on the level of social spending, butlargely also on the method through which social poli-cies 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: TheBalance Sheet, Public Affairs, New York.

Branstetter, L. and N. Lardy (2006), China’s Embrace of Globa-lization, 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 BankPolicy Research Working Paper 3978, August.

Farrel, D., S. Lund and F. Marin (2007), “How Financial-System Re-forms Could Benefit China”, McKinsey Quarterly 12 January 2007,http://www.mckinseyquarterly.com/article_abstract.aspx?ar=1785.

Lindbeck, A. (1995), “Welfare State Disincentives with EndogenousHabits and Norms”, Scandinavian Journal of Economics 97, 447–494.

Lindbeck, A. (2006), An Essay on Economic Reforms and SocialChange in China,World Bank Policy Research Working Paper 4057,November.

Lindbeck, A. (2007), “Economic-Social Interaction during China’sTransition”, 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’sGrowth Paradigm”, American Economic Review 96, 331–336.


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THE IMPACT OF CHINA AND

INDIA ON THE DEVELOPING

WORLD

RAPHAEL KAPLINSKY*

The global economy is undergoing a profoundand momentous shift. The first half of the 21st

century will undoubtedly be dominated by the con-sequences of a new Asian dynamism. China is likelyto become the second biggest economy in the worldby 2016, and India the third largest by 2035. A clus-ter of other countries in the Asian region, such asThailand and Vietnam, are also growing rapidly.These newly dynamic Asian economies can collec-tively be characterised as the “Asian Drivers ofGlobal Change”. The economic processes theyengender are likely to radically transform regionaland global economic, political and social interactionsand to have a major impact on the environment.Thisis a critical “disruption” to the global economic andpolitical order that has held sway for the past fivedecades. It is reshaping the world as we know it,heralding a new “Global-Asian” era.

Role of China and India for global change

As mentioned above, the two key Asian Drivereconomies are China and India. But they reflect verydifferent growth paths. China is integrated into anoutward-oriented regional economy, involving finedivisions of labour in many sectors. By contrast (atleast until now) India represents much more of a“standalone” economic system. Yet, notwithstandingthese differences in structure, they pose major anddistinct challenges for the global and developingeconomies, for six major reasons.

The first is as a consequence of their size.As Figure 1shows, from the beginning of their growth spurts(1979 and 1992, respectively), neither GDP or export

growth in the two largest Asian Driver economieswere unique. In recent years other Asian economies(for example, Japan and Korea) have experiencedsimilarly rapid growth paths. However, whilst Chinaaccounted for 20 percent of the world’s populationand India for 17 percent in 2002, at no time did thecombined population of Japan and Korea’s exceedfour percent of the global total (Figure 2). So, unlikethe case of Korea and Japan who could grow withoutsevere disruption to the global economy, we have tosuspend the “small-country” assumption in the caseof the Asian Drivers. The very high trade intensity ofChina’s growth makes the big-country effect partic-ularly 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 largesttrading nation.

Second, China (especially) and India embodymarkedly different combinations of state and capi-

* Department of Policy and Practice, The Open University.

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

1 5 9 13 17 21 25 29 33 37 41 45

GROWTH OF GDP AND EXPORTS FROM ONSET OF RAPID

GROWTH:

CHINA, INDIA, JAPAN AND KOREA

0.0

1.0

2.0

3.0

4.0

5.0

6.0

1 5 9 13 17 21 25 29 33 37 41 45

China (1979 - 2005) Japan (1960-2004)

Korea, Rep. (1963-2005) India (1992-2004)

Source: World Bank.

Growth of GDP Log GDP

Growth of ExportLog Exports

Figure 1

talist development compared with the industrialisedworld. Chinese enterprises have their roots in stateownership, usually arising from very large and oftenregionally-based firms (Nolan 2005; Shankar 2005).They reflect a complex and dynamic amalgam ofproperty rights – “The ownership of each of China’slarge SOEs [state owned enterprises] has spreadgradually among a variety of public institutions, eachof which has an interest in the firm’s performance …[b]ased on the “ownership maze” and vaguely de-fined property rights” (Nolan 2005, 169). With accessto cheap (and often subsidised) long-term capital,these firms operate with distinctive time-horizonsand are less risk-averse than their western counter-parts (Tull 2006). Indian firms are probably less dis-tinct from the western model, although they tend tobe less specialised and often include elements ofsocial commitment which are largely alien to west-ern firms (Humphrey, Kaplinsky and Saraph 1998).Associated with these complex forms of ownershipand links to regional and central state bodies,Chinese firms often operate abroad as a componentof a broader strategic thrust. This is particularlyprominent in China’s advance in Sub-Saharan Africa(SSA) in its search for the energy and commoditiesrequired to fuel its industrial advance (Kaplinsky,McCormick and Morris 2006).

The third reason why the Asian Drivers present anew and significant challenge to the global anddeveloping economies is that they combine lowincomes and low wages with significant innovativepotential. This means that they are able to competeacross the range of factor prices. The oft-statedbelief (and hope?) that China will run out ofunskilled labour is belied by the size of its reserve

army of unemployed, estimatedat around 150 million comparedto the 83 million people em-ployed in formal sector manu-facturing in 2002 (Kaplinsky2005). As Shenkar observes,“China’s enormous labor re-serves, with pay scales radicallylower in the hinterland than thecoast and in urban areas (theaverage income on the farm,where more than half of theChinese population lives, is lessthan $25 per month), createsthe equivalent of a countrywithin a country; so, instead ofVietnam or Bangladesh replac-

ing China as a labour-intensive haven, Hunan willreplace Guangdong” (Shenkar 2005, 134). More-over by 2030, India, also with a large reserve armyof underemployed, is likely to have a larger popu-lation than China. But China and India are notcontent to operate in this world of cheap labourand mature technologies, and are investing heavilyin the building of technological capabilities. China,for example, overtook Japan to become the world’ssecond largest investor in R&D in 2006.

Fourth, China and India are associated with very dif-ferent forms of regional integration. China is part ofa distributed regional network of production, reflect-ing wider regional competitiveness. Traded goods‘manufactured in China’ usually emanate from re-gional production systems – China’s trade deficitwith East Asia grew from $4 billion in 1990 to$40 billion in 2002, and the region’s share of China’smerchandise imports grew from 55 to 62 percent inthe same period (Lall and Abaladejo 2004). Anincreasing proportion of China’s trade involves theprocessing of imported raw materials and intermedi-ates (widely referred to in the literature as “verti-calised trade”, see Feenstra 1998). Official data showthat 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, Indianexports are more an outcome of a “national systemof production”, so that the spread effects of thegrowth paths of these two Asian Driver economiesare likely to be very different.

Fifth, both China and India are now heavily engagedin global institutions, but whereas India has longbeen a participant, China’s global presence is more


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0

5

10

15

20

25

1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 2000 2004

China India Japan Korea, Rep.

Source: World Bank.

SHARE OF GLOBAL POPULATION in %

Figure 2


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recent. Whilst the nature of their political engage-ments with the rest of the world differs sharply, theyincreasingly affect global and regional governance(Humphrey and Messner 2006). India plays a majorrole as an “advocate” of the interests of the develop-ing countries, for example as the leader of G22 with-in the WTO. China is pushing the ShanghaiCooperation Organisation (formed by China,Russia, Kazakstan, Kirgistan, Tadjikistan andUzbekistan) as a significant player in the area ofglobal energy policies. China and India also providea different policy role-model for many developingeconomies, with the possible rise of a “BeijingConsensus” to rival the Washington Consensus.These dynamics represent a transition from a quasi-unilateral US-dominated world order to a multipolarpower constellation. This could lead to new turbu-lences and conflicts between the rising and thedeclining powers within the global governance sys-tem (Humphrey and Messner 2006).

Finally, China and India have huge and rapidly-growing energy needs. China is already the secondlargest emitter of greenhouse gases (only exceededby the US) and by 2015 its energy demand is expect-ed to roughly double, and India’s to rise by 50 per-cent. The world’s biocapacity will be severelystretched if it is to feed China’s and India’s resourcehunger and sustain their growth.

The impact on low income economies: Key issues

Thus, the Asian Drivers are clearly likely to have amajor impact on the global economic, political,social and environmental economy. But it is onlyrelatively recently that their impact on low incomeeconomies has been specifically problematised.Here we can identify five distinct development-related questions

1. What are the consequences of the emergence ofthe Asian Drivers for economic growth in otherdeveloping economies and regions?

2. Who are likely to be the losers and winners fromthe growing dynamism of the Asian Drivers, with-in and between low-income economies andregions?

3. How should developing countries engage withthe global economy in general and the AsianDrivers in particular?

4. What effect will the shift in global power in insti-tutions of regional and global governance and in

private and non-governmental organisationshave on developing countries?

5. Given the enormous resource and energy hungerof the Asian Drivers, what are the environmentalconsequences for other developing countries?

Assessing the impact of the Asian driver economieson the developing word

How might we assess these impacts? We can distin-guish three sets of structuring principles to aid thisanalysis – the channels of Asian Driver interactionwith the global economy; the distinction betweencomplementary and competitive impacts; and thedifference between direct and indirect impacts.

Channels of interaction

There are a variety of different channels throughwhich individual countries interact with othereconomies, in their regions and elsewhere. Clearly,these channels are contingent – they change overtime, and vary in importance depending on factorssuch as location, resource endowment, trade links,and geo-strategic significance. Six key channels standout in importance.

The first of these are the trade links between theAsian Drivers and the global economy. China’s shareof global merchandise trade had risen to 6.7 percentby 2004, exceeding that of Japan, and growing par-ticularly rapidly from the mid-1990s, a period inwhich the US’s share of merchandise trade fellappreciably (Table 1). By 2004, China’s share ofglobal manufacturing exports had risen to 8.3 per-cent, still below that of the US and Germany butgrowing rapidly. By contrast, India’s share of globalmerchandise trade was basically stable in the sameperiod, at a much lower level than China’s. However,India’s share of global service trade, particularly ITservices grew (although no clear comparative dataare available).

The second major channel of interaction is FDI.Already the Asian Drivers account for the majorshare of global inward FDI, with China and HongKong alone attracting almost 40 percent of total FDIdestined for developing countries (UNCTAD 2005).But the Asian Drivers are increasingly also a sourceof outward FDI. In some regions – SSA in particular(Kaplinsky, McCormick and Morris 2006) – Chinahas become the major source of new inward FDI,

particularly in economies which because of theirpolitical fragility, have been shunned by westerninvestors for some years. There are four primarytypes of FDI – technology-leveraging, resource-seeking, market-seeking and cost-reducing. Chineseoutward investment clearly fits into the first three ofthese – technology leveraging investments in the US(and, to a lesser extent, the EU), and resource-seek-ing and market-seeking investments predominantlyin other developing economies.

The third channel is finance. Large trade surpluses inboth China and India coupled with these countries’ability to attract FDI and other categories of capitalflows have led to a build-up of large foreign reserves,estimated at more than $1 trillion in 2006. A signifi-cant change in how Asia’s capital surpluses are man-aged could cause an abrupt adjustment in the USinterest rates and the dollar and thereby destabilisethe entire world economy. It could also accelerate aslow-moving structural change which is the gradualweakening of the role of the dollar as the world’smain reserve currency. Both of these developmentshave significant indirect implications for other devel-oping countries, affecting the structure of globalfinancial markets and the competitiveness of theirexchange rates.

The fourth channel of interaction arises in relation toinstitutions of global and regional governance. Theemerging strategies of China and India towards themultilateral institutions such as WTO, UN, WorldBank and IMF, and the global climate regime andthe bilateral interactions between the US, Europeand the Asian Drivers will profoundly change theinternational context for other developing countries(Chan 2006; Messner 2006). This could create new

options for developing countriesif China and India were to playthe role of “voices of the South”in global politics. However, ifthey look primarily to their owninterests, new conflicts betweenthe Asian Drivers and otherdeveloping countries mightarise. China’s close cooperationwith “difficult states” like Sudan,Myanmar, Uzbekistan, andZimbabwe and its close energypartnership with Iran provoketensions with western countriesand demonstrate that the AsianDrivers are able to alter geo-

strategic maps and north–south relationships(Humphrey and Messner 2006).

Migration from the Asian Drivers and interactionswith diaspora communities represents a fifth chan-nel of impact. To some extent, migration is alreadya “fact” of considerable importance with largeChinese and Indian diasporas in Asia. Outwardmigration from India to SSA occurred during thelate 19th century and first half of the twentiethcentury, and in the latter twentieth century extend-ed to Europe, North America and Australasia. Butmore recently, Asian Driver migration has risen,particularly from China to SSA. For example, bysome counts, there are currently more than200,000 Chinese living in South Africa, who aremostly recent migrants. The Chinese population ofLusaka grew from 3,000 to more than 30,000between 1995 and 2005 and Chinese migrant com-munities are increasingly prominent in manyAfrican countries, including from poor regions inChina.

The sixth and final major channel of impact onother economies arises from environmental spill-overs. Rapid growth in China and India consumesnatural resources and generates cross–border envi-ronmental damages within the Asian region.Problems with the use of natural resources arewidely documented. For example, there have beenrepeated denunciations of the activities of illegalChinese timber logging companies in Myanmar. Itis estimated that between one third and one half ofacid rain in South Korea and Japan is the result ofsulphur dioxide emissions from China (Umbach2005). Beyond that, China’s and India’s rapidly ris-ing imports of natural resources from all over theworld are creating environmental problems in


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Table 1

World merchandise trade by region and selected economy

(% share of total)

1948 1953 1963 1973 1983 1993 2003 2004

United

States 21.7 18.8 14.9 12.3 11.2 12.7 9.9 9.2

Europe 31.5 34.9 41.4 45.4 43.5 45.4 46.1 45.3

Japan 0.4 1.5 3.5 6.4 8.0 9.9 6.4 6.4

S. and C.

America 11.4 9.8 6.3 4.3 4.4 3.0 2.9 3.1

Africa 7.3 6.5 5.7 4.8 4.5 2.5 2.4 2.6

Asia 13.6 13.1 12.4 14.9 19.1 26.1 26.1 26.8

China 0.9 1.2 1.3 1.0 1.2 2.5 6.0 6.7

India 2.2 1.3 1.0 0.5 0.5 0.6 0.8 0.8

Source: Kaplinsky and Messner (2007).


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Africa, Latin America and the rest of Asia. Themost important global environmental impact ofrapid growth in the two Asian giant economies willbe their contribution to global climate change.China’s share of worldwide CO2 emissions couldreach 25 percent in 2025, the corresponding figurefor India being 10 to 15 percent.

Complementary and competitive impacts

Simplistically, and as a starting point, the interac-tions between the Asian Drivers, the global econo-my and individual regions and countries can beseen in a binary framework as comprising a rangeof complementary or competitive impacts. Table 2provides some examples, notional, but informed bythe emerging nature of Asian Driver expansion. Ineach of these channels of interaction, we canobserve a mix of complementary and competitiveimpacts. For example, with regard to trade, theAsian Drivers may both provide cheap inputs andconsumer goods, and be a market for the exportsfrom other developing countries. On the otherhand, imports from the Asian Drivers can readilydisplace local producers. In relation to FDI, theAsian Drivers may either be a direct source ofinward FDI or crowd-in FDI from third countriesas parts of extended global value chains. But theAsian Drivers may also compete with othereconomies for global FDI. The rising power of theAsian Drivers in a western dominated global gov-ernance system may strengthen the voice of devel-oping countries in international organizations. Theemerging conflicts between the Asian Drivers, the

US and Europe on energy, resources and marketsmight also marginalize development policy issues inword politics. Similarly, financial flows, environ-mental spill-overs and migration may be eithercomplementary or competitive.

The key element of these interactions is the “forwhom” component. Countries may be affected dif-ferentially – in some cases, for example, the export offabrics from the Asian Drivers may feed productive-ly into a vibrant clothing and textile value chain; inother cases, it may displace a country’s exports andproduction for the domestic market. But theseeffects are not just felt at the national and economy-wide level. They affect groups within countries dif-ferentially. For example, cheap clothing imports fromChina may displace clothing and textile workers, butcheapen wage goods and hence reduce wage costsfor producers in other sectors, which is indeed whathas been occurring in many high-income economiesduring the early years of the 21st century. Theseimpacts on a complementary-competitive axis mayalso change over time, and most importantly, theywill vary for different classes, regions and groupswithin economies.

Direct and indirect impacts

The complementary-competitive axis of impacts isreadily comprehended and widely recognised. Lesswidely acknowledged is the distinction betweendirect and indirect impacts. In part this is becausethe indirect impacts are difficult to measure.However, in many cases, the indirect impacts may in

Table 2

Examples of complementary and competitive impacts

Channels Impact Nature of links

Complementary

Imports of cheap consumer goods from Asian Drivers;

Exports of commodities to Asian Drivers

Trade Competitive Imports from Asian Drivers displace local producers

Complementary Inflows of FDI from Asian DriversFDI

Competitive Competition for US FDI from Asian Drivers

Complementary Loans from Asian Drivers to governments and private actorsFinance

Competitive Low-cost finance from Asian Drivers displaces local

financial intermediaries

Complementary Support for Development Round from Asian Drivers in

WTO

Global Governance

Competitive Asian Drivers side with EU in WTO

Complementary Asian Driver migrants intermediate complementary trade

with home countries

Migration

Competitive Asian Driver migrants displace local entrepreneurs

Complementary Asian Drivers cooperate in regional water projectsEnvironment

Competitive Asian Drivers as significant motors of global climate change

Source: Author’s elaboration.

fact be much more significant than the direct ones.Table 3 gives some examples, for purposes of illus-tration contrasting direct complementary impactswith indirect competitive impacts in Lesotho, a poorSSA economy. In 2000 to 2004 Lesotho’s clothingexports to the US under the African Growth andOpportunity Act (AGOA) scheme grew very rapid-ly, but were undermined in 2005 to 2006 by Chinesecompetition following the removal of MFA quotas(Kaplinsky and Morris 2006). Looking at the tradechannel, thus, direct complementary impacts includ-ed the supply of fabrics used in Lesotho’s clothingexports. On the other hand, the indirect impact onLesotho of China’s growing competitiveness in theUS led to a 17 percent fall in exports during 2005.Whilst some of these exports arose from Taiwanese-owned plants, in other cases potential foreigninvestors in Lesotho preferred to manufactureclothes in China (as well as India and Bangladesh).Lesotho suffered badly from the appreciation of the

rand (to which its currency was tied), an indirectimpact of Southern Africa’s burgeoning commodityexports to China. Lesotho also stands to lose fromChina’s accession to the WTO and the power itmight wield in removing preferential access tomajor markets for the exports of least developedcountries, outweighing any possible positive impactof potential budgetary aid to government. Finally,Lesotho’s major export other than clothing (vulner-able to Asian Driver competition) and unskilledmigrant labour is its water. A change in rainfall pat-terns consequent on global warming is likely to havevery adverse economic impacts.

As in the case of the complementary/competitiveaccess, the impact of the direct and indirectimpacts can be gauged either at the country level,or at intra-national levels, for example withregard to different regions, sectors, classes andgenders.


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Table 3

Examples of direct complementary and indirect competitive impacts on Lesotho

Channels Impact Direct Indirect

Complementary

Asian Driver fabrics used in

Lesotho’s clothing exports

Trade

Competitive

Asian Driver competition in US

squeezes out Lesotho clothing

exports

Complementary Asian Driver investment in

Lesotho’s clothing sector

FDI

Competitive

US foreign investors relocate

clothing factories from Lesotho

to China

Complementary Asian Driver aid for budgetary

support

Finance

Competitive

Asian Driver led realignment of

currencies forces up the value of

the rand, and undermines

profitability of Lesotho’s

clothing exports

Complementary

Budgetary support to

government augments state

power

Global

Governance

Competitive

Asian Driver input into WTO

removes AGOA preferences

Complementary

Chinese migrants facilitate

imports of cheap consumer

goodsMigration

Competitive Chinese migrants squeeze out

local traders

Complementary

Indian solar technologies

enhance energy efficiency in

rural areasEnvironment

Competitive

Asian Driver carbon emissions

lead to global warming and

reduce rainfall in SSA



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Conclusion: There is much that we don’t know

The rapidity of the rise of the Asian Driver econo-mies means that we are only beginning to recognisethe enormity of their likely impact on the worldeconomy in general, and low income economies inparticular. We know that this impact is likely to belarge. We also know that this impact can be transmit-ted through a variety of channels, and have identifiedsix of the more important channels. We also knowthat these impacts might have a combination of com-plementary and competitive impacts. In general,actors in low income economies tend to see moreopportunities and complementary synergies with therise of the Asian Drivers. By contrast, observers inthe high-income countries (particularly those focus-ing on low income economies) tend to be moreaware of competitive impacts. And, finally we alsoknow that these impacts may be direct and indirect.In general, most attention is placed on the directimpacts, since these are more visible through bilater-al relations. But the indirect impacts may often bemore important, and much more difficult to unravel.

These pockets of information are just that – pockets.There is an enormous and urgent task ahead of doc-umenting these emerging impacts, distinguishingbetween different types of economies and regions,and different communities within these countriesand regions. Unless these trends and subtleties areadequately understood, it will be very difficult forlow income countries to maximise the opportunitiesand minimise the threats arising from the rise of theAsian Drivers.

References

Chan, G. (2006), China’s Compliance in Global Affairs, New Jerseyand London: World Scientific.

Feenstra, R. C. (1998), “Integration of Trade and Disintegration ofProduction in the Global Economy”, Journal of Economic Perspec-tives 12, 31–50.

Humphrey, J. and D. Messner (2006), China and Its Impact onGlobal and Regional Governance, Agenda-setting Paper preparedfor DFID, Brighton: Institute of Development Studies.

Humphrey, J., R. Kaplinsky and P. Saraph (1998), Corporate Restruc-turing: Crompton Greaves and the Challenge of Globalisation, NewDelhi: Sage Publications Ltd.

Kaplinsky, R. (2005), Globalization, Poverty and Inequality, Cam-bridge: Polity Press.

Kaplinsky, R. (ed. 2006), Asian Drivers: Opportunities and Threats,IDS Bulletin, 37: 1.

Kaplinsky, R. and D. Messner (2007, forthcoming), “The Impact ofthe Asian Drivers on the Developing World”, World Development.

Kaplinsky, R. and M. Morris (2007, forthcoming), “Do the AsianDrivers Undermine Export-Oriented Industrialisation in SSA?”World Development.

Kaplinsky, R., D. McCormick and M. Morris (2006), The Impact ofChina on SSA, Agenda-setting Paper prepared for DFID, Brighton:Institute of Development Studies.

Lall, S. and M. Albaladejo (2004), “China’s Competitive Perform-ance: A Threat to East Asian Manufactured Exports?”, WorldDevelopment 32, 1441–1466.

Messner, D. (2006): “Instabile Multipolarität. Global Governanceim Schatten des Aufstiegs von China und Indien“, in: Debiel, T.,D. Messner and F. Nuscheler (eds.), Globale Trends 2007/08, FischerVerlag, Frankfurt.

NiHaoOuZhou_com, (2006), Foreign Firms Dominate China’sExports, accessed 30th June 2006.

Nolan, P. (2005), Transforming China: Globalization, Transition andDevelopment, London: Anthem Press.

Shenkar, O. (2005), The Chinese Century: The Rising ChineseEconomy and Its Impact on the Global Economy, The Balance ofPower and Your Job, Upper Saddle, NJ: Pearson Education Inc.

Tull, D. M. (2006), “China’s Engagement in Africa: Scope, Signi-ficance and Consequences”, Journal of Modern African Studies 44,459–479.

Umbach, F. (2005), “Global Energy Security and its GeopoliticalConsequences to EU-Asian relations”, in: van der Geest, W. (ed.),The European Union’s Strategic Interests in East Asia: Vol. 2, ExpertAnalyses 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 Challengeof Global Sustainability, London: Earthscan Publications.

THE DYNAMICS OF REFORM

OF INDIA’S FEDERAL SYSTEM

NIRVIKAR SINGH*

Starting from very different initial conditions interms of political institutions, and pursuing a

very different set of policies, India has followedChina in being an economic reformer as well as astar economic performer. The dimension of reformthat has received the most attention in India is thatof redrawing the boundaries of authority and actionbetween government and market, including liberal-izing government restrictions on international tradeand domestic corporate investment, and changingthe nature of government regulation of the privatesector. What has received less attention in this con-text is the ongoing transformation of India’s feder-al system of governance, through deliberatereforms and through unintended consequences ofother policy changes. This transformation has thepotential to sustain and accelerate economicgrowth in India. Specific reforms, with respect todecentralization to local governments, taxes andintergovernmental transfers have all previouslybeen considered in detail, and continue to be dis-cussed. The contribution of this piece is to put theseindividual changes into the context of the overalldynamics of India’s federal system, so that theprocess can be understood from a positive perspec-tive.1 Thus, we go beyond description (whichreforms have occurred) and prescription (whichreforms are best?) to analysis of the process (whyhave these reforms happened?).2

The plan of the paper is as follows. In the next sec-tion, we summarize India’s federal institutions – as

concisely as possible, given their complexity. Thepolitical institutions that underlie the explicit mech-anisms of fiscal federalism are critical to the analysis,and are highlighted here, in addition to assignmentsof expenditure and revenue authority, and arrange-ments for intergovernmental transfers. In the thirdsection, I give an overview of the reforms that havebeen taking place in the country’s federal structure,including political institutions, fiscal assignments,and intergovernmental transfers and borrowingarrangements. The fourth section offers an analyticalnarrative to explain these developments, and sometentative predictions that follow from this analysis.The final section is a summary conclusion, with sug-gestions for further research.

India’s federal system

India became an independent democratic nation inAugust 1947 and a constitutional republic in January1950. The constitution explicitly incorporated a fed-eral structure, with states as subnational entities thatwere assigned specified political and fiscal authori-ties. However, these states were not treated as inde-pendent sovereigns voluntarily joining a federation.In particular, the states’ boundaries were not invio-late, but have been repeatedly redrawn by centralaction (though often in response to subnational pres-sure), as allowed by the constitution.3 India is nowcomprised of 28 states, six “Union Territories” (UTs)and a National Capital Territory (NCT), Delhi.4 Ingeneral, the constitution was structured to give thecentral government residual authority and consider-


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* Department of Economics and Santa Cruz Center for Interna-tional 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. Iam indebted to Chang Woon Nam for very helpful comments on anearlier draft. I alone am responsible for shortcomings.1 The Chinese experience has received considerably more analyti-cal 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, Rolandand Xu (1999); and Jin, Qian and Weingast (2005).

2 For previous discussions that provide more descriptive detail, seeRao and Singh (2005), Singh and Srinivasan (2005) and Singh andSrinivasan (2006). The last of these does draw on analytical frame-works similar to those used for the China case, as does Singh(2007). Rao and Singh (2007) introduce some of the ideas consid-ered more explicitly in this paper. Sàez (2002) tackles similar issuesto the current piece, but interprets the process and evidence quitedifferently. Sinha (2004) offers a conceptual framework somewhatsimilar to that offered here, though with differences of emphasis.An important cross-country comparison of the dynamics of reformin federal systems is Wallack and Srinivasan (2005).3 In addition, the princely states that existed at the time of inde-pendence, under the umbrella of British rule, were rapidlyabsorbed and consolidated into the new political structure, withtheir special status greatly attenuated, and ultimately (by 1970)totally removed.4 Population sizes for the states range from about half a million to166 million, with a median of about 24 million (2001 census fig-ures). Ten states have populations exceeding 50 million.


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able sovereign discretion over the states, creating arelatively centralized federation. In particular, theassignment of residual political and fiscal authoritiesto the center, either explicitly or through escapeclauses, represents the polar opposite of the princi-ple of subsidiarity,5 found, for example, in UnitedStates and European federal institutions.

The primary expression of statutory constitutionalauthority in India comes through directly electedparliamentary-style governments at the national andstate levels, as well as (relatively new) directly elect-ed government bodies at various local levels. Thenational parliament has two chambers, one (the Lok

Sabha or peoples’ assembly) directly elected in sin-gle member, first-past-the post constituencies, theother (the Rajya Sabha, or states’ council) indirectlyelected by state legislators. The Prime Minister andcouncil of ministers serve as the executive branch,rather than the largely ceremonial President of therepublic. The states, plus the NCT and the UT ofPondicherry, mostly have single-chamber, directly-elected legislatures, with Chief Ministers in the exec-utive role. The other UTs are governed by centralgovernment appointees. Each state also has aGovernor, nominally appointed by the President, buteffectively an agent of the Prime Minister. Over-lapping political authorities at the central and statelevels have been dealt with through intra-party bar-gaining, and, more recently, through explicit bargain-ing and discussion.

Concentration of powers in the hands of the centralgovernment did not create serious conflicts in theearly years of the functioning of the constitutionsince the same political party, the Indian NationalCongress (INC), ruled at the center and in the states.Many potential interstate or center-state conflictswere resolved within the party. The INC was essen-tially an umbrella organization that had pursued acampaign of independence from colonial rule, andthis nationalist history contributed to its initial near-monopoly of political power.

India’s relative political centralization was alsoreflected in bureaucratic and judicial institutions.The national Indian bureaucracy is provided consti-tutional recognition, and there are provisions forindependent bureaucracies in each state. The keycomponent of the bureaucracy is the Indian

Administrative Service (IAS), whose members arechosen by a centralized process and trained togeth-er.They are initially assigned to particular states, andserve varying proportions of their careers at the stateand national levels. The judiciary is a constitutional-ly distinct branch of government at both nationaland state levels, though the legislative/executivebranch exerts influence through appointments andbudget allocations.6 The Supreme Court has broadpowers of original and appellate jurisdiction, and theright to rule on the constitutionality of laws passedby Parliament. In specific issues of center-state rela-tions concerning taxation and property rights, thebasic centralizing features of the constitution havetilted the Court’s interpretations towards the center.More recently, in the 1990s, it has made decisionschecking the center’s ability to override subnationalpolitical authority by means such as dismissing statelegislatures.7 At the state level, the High Courtssuperintend the work of all courts within their juris-dictions, including district8 and other subordinatecourts.

At inception, the Indian constitution clearly laidout the areas of responsibility of the central andstate governments, with respect to expenditureauthority, revenue raising instruments, and legisla-tion needed to implement either. Expenditureresponsibilities are specified in separate Union andState Lists, with a Concurrent List covering areas ofjoint authority. Unspecified residual expenditureresponsibilities are explicitly assigned to the center.Tax powers of the two levels of government arespecified in various individual Articles. Legislativeprocedures for each level, particularly with respectto budgets and appropriations, are also spelled outin the constitution.

Powers of legislation for the center and states followthe responsibilities assigned in the three constitu-tional lists, but there are several broad “escape claus-es,” which give the national parliament the ability tooverride the states’ authority in special circum-stances, with a role for the Supreme Court as arbiterin some cases. The power to amend the constitutionalso resides with the national parliament, with a

5 This principle would assign residual or implicit authorities to thelower level of government.

6 At the local level, IAS members are vested with some judicialauthority.7 On the other hand, the Court has also tended to engage in somecentralizing judicial activism, to enforce laws down to the locallevel.8 In many ways, India’s almost 600 districts are the fundamentaladministrative units of government, in a structure that goes back atleast to the colonial period, in which Indian Civil Service (the pre-cursor of the IAS) officers acted as chief executives of districts.

weak requirement that half or more of the states rat-ify the amendment for it to take effect.

The constitutionally assigned expenditure responsi-bilities of the central government are those requiredto maintain macroeconomic stability (e.g., all mone-tary and financial issues), international trade andrelations, and those having implications for morethan one state, due to economies of scale or spill-overs (e.g., defense, transport and communications,atomic energy, space, oil and major minerals, inter-state trade and commerce, and interstate rivers). Themajor subjects assigned to the states comprise publicorder, public health, agriculture, irrigation, landrights, fisheries and industries and minor minerals.The Concurrent list includes major areas such aseducation and transportation, social security andsocial insurance.

The initial constitutional assignment of tax powers inIndia was based on a principle of separation, with taxcategories being exclusively assigned either to thecenter or to the states. The center was also assignedall unspecified residual tax powers. Most broad-based taxes were assigned to the center, includingtaxes on income and wealth from non-agriculturalsources, corporation tax, taxes on production(excluding those on alcoholic liquors) and customsduty. These were often taxes where the tax revenuepotential was greater, as a result of relatively lowercollection costs, and higher elasticities with respectto growth. At the subnational level, a long list oftaxes was constitutionally assigned to the states, butonly the tax on the sale of goods has turned out to besignificant for state revenues. This outcome is large-ly a result of political economy factors (e.g., rurallanded interests were initially quite powerful in gov-ernment at the state level) that have eroded or pre-cluded the use of taxes on agricultural land orincomes (and even user charges for public irrigationand electricity) by state governments. Inefficienciesarose in indirect taxes because, while in a legal sensetaxes on production (central manufacturing excises)and sale (state sales taxes) are separate, they tax thesame base, causing overlapping and cascading, andeffectively leaving the states less room to choose in-direct tax rates.

The framers of the constitution were aware of theneed for a common market, but included anotherbroad escape clause.9 An early amendment to theconstitution added clauses that enable the centralgovernment to levy taxes on inter-state transactions.

Furthermore, sales taxes have been levied by export-ing states on the inter-state sale of goods, makingthese taxes origin-based, and relatively more distor-tionary in practice. Finally, adding to internal imped-iments to trade, states and localities have been per-mitted to impose various entry taxes, under a sepa-rate (and somewhat inconsistent) constitutional pro-vision.

The situation with respect to local governments issomewhat distinct from the center-state division ofpowers.Two constitutional amendments in 1993 gavelocal governments a firmer political footing, but hadto leave many legislative details to the states, sincelocal government was, and remained in, the StateList. Furthermore most local responsibilities are sub-sets of those in the State List. There is no “LocalList” as such, but the constitution now includes sep-arate lists of responsibilities and powers of rural andurban local governments.10 The lists of local expen-diture areas, though now broader and more explicitthan was typical of past practice, still overlap consid-erably with the State List, so most local responsibili-ties are, in practice, concurrent responsibilities. Thisincludes major areas such as education, health, waterand sanitation.

With assignment of local tax powers and details ofexpenditure assignments left to state-level legisla-tion, there has been considerable variation acrossthe states, though in general they have providedvery little revenue autonomy to local governments,especially rural bodies. Local governments haverelied on building and property taxes in the past, aswell as entry taxes for some urban areas, but signifi-cant new taxes have not been assigned to local bod-ies after reform.11 In many cases, states chose tohold back in devolving the full constitutional list oflocal functions,12 and capped village level authorityto directly approve expenditures, often at very lowlevels. Paralleling these constraints, local govern-


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9 Article 301 of the Constitution states, “subject to the other provi-sions of this part, trade, commerce and intercourse throughout theterritory of India shall be free”. However, Article 302 empowersParliament to impose restrictions on this freedom in the “publicinterest” – a term that is both very broad and not clearly defined inthis context.10 The Union, State and Concurrent Lists are in the SeventhSchedule, whereas the new responsibilities of rural and urban localgovernments are in the Eleventh and Twelfth Schedules, addedthrough the 1993 amendments.11 Local governments often have a large number of relatively unim-portant taxes at their disposal, including entertainment and profes-sion taxes, but are not permitted to piggyback on significant stateand central taxes such as income and sales taxes.12 For example, while the constitutional schedule of local responsi-bilities includes “health and sanitation, including hospitals, primaryhealth centers and dispensaries,” in practice, the states have main-tained control over these functions.


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ments also have little legislative autonomy. This isparticularly true for rural governments, though tra-ditional village level committees (panchayats) havea history of acting as quasi-legal arbiters andenforcers through social norms. City governments,of course, do have a well-established tradition oflocal ordinances.

At both the state and local levels, revenue authorityfalls short of what would allow each level to inde-pendently meet its expenditure responsibilities. Tosome extent, this is a natural outcome of the differ-ent driving forces for assigning revenue authorityand expenditure responsibility.13 In 2004 to 2005, thestates on average raised about 39 percent of com-bined government revenues, but incurred about66 percent of expenditures.14 Transfers from the cen-ter, including tax-sharing, grants and loans made upmost of the difference, with the states also borrowingmoderately from other sources.

The constitution provided for tax-sharing betweenthe center and the states, as well as central grants tothe states. The shares are determined by a constitu-tionally-mandated Finance Commission, which isappointed by the President of India every five years(or earlier if needed). These transfers are mostlyunconditional in nature.15 The Commissions havedeveloped an elaborate methodology for dealingwith horizontal and vertical fiscal imbalances. In par-ticular, the formula for tax devolution is quite com-plicated, as a result of attempts to capture simulta-neously disparate or even contradictory factors. Theend result of Finance Commission transfers is a milddegree of horizontal equalization across the states(Rao and Singh 2005, Chapter 9). A completely sep-arate body, the Planning Commission (PC), makescategorical grants and loans for implementing devel-opment plans. As economic planning gained empha-sis in independent India’s early decades, the PCbecame 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 madethrough these channels. Transfers through these

channels tend to slightly increase horizontal inequal-ity in fiscal capacities.

Local governments are even more dependent ontransfers from higher levels. In 2002 to 2003, rurallocal governments’ own source revenues were lessthan 7 percent of their total revenue and less than10 percent of their current expenditures (FinanceCommission, 2004). Urban local bodies did some-what better, with proportions closer to those of thestates. They raised about 58 percent of their revenueand covered almost 53 percent of their expenditurefrom own revenue sources. Note that aggregate localgovernment revenue and expenditure constitutedjust about 1 and 5 percent, respectively, of total gov-ernment revenue and spending at all levels.17 Thus,the overall scope, as well as fiscal autonomy, of localgovernments in India remains very limited.

Since 1993, a system of formal state-local transferswith State Finance Commissions (SFCs) has beenmandated. These SFCs have struggled to formulatethe principles for sharing or assigning state taxes andfees, and for making grants. There remains consider-able variation in the quality of analysis, methodolo-gies used, and implementation of transfers across thedifferent states. The states’ own fiscal problems haverestricted progress in this dimension. Some stateshave been slow to constitute SFCs, and some havebeen tardy in implementing their recommendations.The outcome has been significant uncertainty, whichhampers effective use of funds by local governments.Sometimes, SFC recommendations have been large-ly ignored by state governments. Thus, while the SFCsystem has made local government financing some-what more transparent than before, it has not signif-icantly altered the fiscal constraints faced by localgovernments.

A final aspect of India’s federal system concernssubnational borrowing. According to the constitu-tion, states cannot borrow abroad, and they requirecentral government approval for domestic borrow-ing whenever they are in debt to the center. In fact,that condition has prevailed almost invariably,since the central government was, until fairlyrecently, the states’ main source of lending, andevery state is indebted to the center.18 Many cen-tral loans are made under the supervision of the

13 Most significantly, mobility across jurisdictions increases as thesize of the jurisdictional unit decreases. A tax base that is mobilemay shrink dramatically in response to a tax, making it harder forsmaller 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 havebeen subject to political cycles. Such calculations still include localgovernment spending.15 Some transfers have been earmarked for health and educationspending by the states, and, after 1993, for local governments.16 There are over 100 ministry-sponsored schemes, ranging fromspecific projects to broad programs. Their effectiveness is generallydeemed to be low.

17 This contrasts sharply with China, where the corresponding per-centages for revenue and expenditure are about 23 and 51 (Singh2007).18 Central loans account for about 22 percent of the states’ presentdebt stock (RBI 2006, Appendix Table 36).

Planning Commission (PC), and have been tied toPC grants in a fixed proportion. Central loans alsoinclude funds from multilateral agencies or otherexternal sources for specific programs and projectsin particular states, ad hoc loans based on exigen-cies in individual states, and short term ways andmeans advances.

States also tap the National Small Savings Fund,consisting of mostly rural savings collected throughpost offices.19 Other, effectively captive, sources ofborrowing for the states are mandated pension andinsurance contributions of government employees(minus payouts), and state-owned financial institu-tions such as public sector banks. States have also“borrowed” by delaying payment of bills, especiallyin the case of State Electricity Boards (SEBs),state-government-owned utilities that failed to paytheir bills to the central government-ownedNational Thermal Power Corporation. Centrallending – often subject to debt relief or reschedul-ing – and state borrowing from captive sources havesoftened subnational budget constraints in India.However, overall, this problem is less severe inIndia than in Latin America, and perhaps even thanin China.20

To place India’s federal system, as summarizedabove, in international context, a high-level viewdoes not obviously distinguish it from other de jure

federations. The constitutional division of powers issimilar in form to many other countries. The use of atax sharing arrangement governed by a quasi-inde-pendent body parallels arrangements in other ex-British colonies, such as Australia and Canada.Broad goals of horizontal equalization of fiscalcapacity are also common across many federations.However, India’s federal system differs in many ofits institutional details and practices, including theparallel system of plan transfers, the nature of theformulas used for intergovernmental transfers, andthe institutional mechanisms for intergovernmentalbargaining. Overall, India appears to be much morecentralized than other federations, especially whensize is accounted for. The only comparator on thatdimension is China, which is politically more central-ized, but gives local governments much greater fiscalautonomy. China is also different in relying more on

central administrative discretion and intergovern-mental bargaining to set the rules of the game,achieving de facto federalism.

Federal reforms

Despite periodic discussions of constitutional over-haul, India’s political institutions have remainedremarkably stable. The legal underpinnings of theseinstitutions have not changed dramatically, with thesingle exception of the creation of directly-electedlocal governments in 1993, as outlined earlier. Sofar, that reform has not had major consequences forthe conduct of India’s polity, though it has dramati-cally increased the number and diversity of electedofficials nationwide. One institutional reform thatdid emerge in 1990 was the creation of the Inter-State Council (ISC), which includes the PrimeMinister, state chief ministers, and several centralcabinet ministers as members, and has become aforum where political and economic issues of jointconcern can be collectively discussed, and possiblyresolved.21

Within this relatively static institutional framework,the 1991 economic reforms, which substantially loos-ened central government control of foreign anddomestic corporate investment, allowed state gov-ernments to become more autonomous actors ineconomic policy (e.g., Sinha 2004; Singh andSrinivasan 2005; Singh 2007), with horizontal compe-tition among (at least some) state governmentsreplacing rent-seeking interactions with the center.In this respect, therefore, reforms that liberalizedcentral government control of the private sector alsopromoted greater de facto federalism at the statelevel. 22

Tax reform has been a significant and ongoing partof the overall economic reform process in India.Initially, the central government emphasized ex-treme progressivity and narrow targeting, resultingin a very inefficient tax structure (including pro-hibitively high tariffs), and tax administration thatwas highly susceptible to corruption. Economic


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19 This category makes up about 27 percent of states’ debt stock.20 See the contributions in Wallack and Srinivasan (2005).While thereferences in footnote 1 stress the hardness of subnational budgetconstraints in China, particularly for provinces, and early in thereform process there, more recent evidence suggests that local gov-ernment budget constraints have softened: see Singh (2007) for ref-erences.

21 The flexibility and breadth of scope of the ISC’s possible con-cerns distinguish it from the much older National DevelopmentCouncil (NDC), which has somewhat similar membership, butfocuses only on five-year-plan allocations.22 The references cited in footnote 1 examine the salience of thiskind of development in China, which remained politically highlycentralized. In the Chinese case, much of this economic decentral-ization took place down to the local level – this has not happenedin India to date (Singh 2007).


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reform has led to a substantial rationalization ofthe central government tax structure, in terms oflowering marginal rates, simplification of the ratestructure, and some degree of base broadening.This reform agenda was laid out in several expertcommittee reports, from 1991 to 2004. In the realmof tax administration, also, some progress has beenmade, through simplification of taxes, changes inadministrative procedures and use of informationtechnology.

Tax reform has been slower at the state level.However, by early 2007, the center had persuadedthe states to replace the old system of taxation ofinterstate sales with a destination-based VAT. Thisrepresents a major improvement in the efficiency ofthe tax system, including addressing impediments toan internal common market. Agreement on thisshift came through the workings of a committee ofstate Finance Ministers, which developed a stepwiseimplementation plan. The Finance Commissionoffered a formula for compensating states for rev-enue losses during the transition.23 The next stepwill 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 oftaxes on services. The original constitution implicit-ly assigned service taxes to the center, through itsresidual powers over taxes. In 2004, the central gov-ernment chose to add service taxes explicitly to theUnion List, via a constitutional amendment.According to the new institutional regime for ser-vice taxes, they are to be shared with the states, in amanner to be determined by Parliament, and there-fore outside the “common pool” that is dividedamong the states by the Finance Commission.Moving toward a comprehensive GST will includeresolving this anomaly.

A major reform of the intergovernmental transfersystem was initiated in 1994, with the recommenda-tion of the Tenth Finance Commission that the orig-inal constitutional scheme of revenue change fromonly a small number of taxes being shared betweenthe center and the states, to the entire consolidatedfund of the center being so shared. This change wasimplemented through a constitutional amendmentratified in 2000, and has reduced the incentive of thecentral government to discriminate among the dif-ferent taxes it collects.24

Formulas for dividing allocated tax revenues amongthe states, and for making Planning Commissionallocations, have remained relatively static over theyears, reflecting the power of precedent. Onechange, however, was driven by developments in the1980s and 1990s.25 By the late 1980s, the fiscal posi-tions of the states, as well as the center, had alreadybegun to deteriorate. In 1991, fiscal deficits werequite high, and the process of overall economicreform was tied to the need for fiscal consolidationof government. The Eleventh Finance Commissionwas the first to be asked to examine governmentfinances in an integrated manner, and to make rec-ommendations for enhancing fiscal consolidation.Initial ad hoc attempts by the center to impose fiscaldiscipline included “contracts,” in the nature ofMOUs with states that exchanged promises of fiscalreform for ways and means advances; these ran intoproblems of credibility and commitment. TheEleventh Finance Commission, therefore, recom-mended that a portion of central-state transfers bemade conditional on fiscal reforms, according to apreset formula. However, the incentives for fiscaldiscipline thus provided were again too weak to beeffective.

The latest approach to encouraging fiscal disciplineinvolves commitment to explicit targets for deficitreduction through fiscal responsibility legislation.The central government and many state govern-ments have passed such legislation. The TwelfthFinance Commission, in 2004, recommended push-ing the remaining states toward this commitment bytying debt relief (which was also included in thecommission’s charge) to the passage and implemen-tation of fiscal responsibility laws. Even in theabsence of such incentives, fiscal responsibility legis-lation has created public benchmarks for evaluatingstate fiscal performance. The Commission has alsoreiterated earlier criticisms of the process of makingplan transfers as being opaque, cumbersome, con-ceptually ill-defined, and poorly coordinated andmonitored. Arguably, these problems contribute todifficulties in enforcing hard budget constraints atthe state level.

23 A detailed account and analysis of the features of the new sys-tem, and the process of adoption, is given by Rao and Rao (2006).

24 For example, in the old arrangement, income taxes were shared,and almost all assigned to the states, but income tax surchargeswere entirely kept by the center. Unsurprisingly, the central gov-ernment favored using surcharges whenever possible. As noted inthe previous paragraph, now only service taxes are outside the con-solidated sharing arrangement; this anomaly has been obliquelycriticized in the latest Finance Commission’s report.25 The creation of independently elected local governments has alsogiven the Finance Commission a new role of making transfers ear-marked for local governments, and in monitoring the workings ofthe SFCs.

Market borrowing has always been available to thestates, subject to national government control and dis-cretion. However, much of this borrowing has beenthrough private placements with financial institutionsat controlled interest rates. The Twelfth FinanceCommission recommended that states should,instead, primarily access the market directly for bor-rowing, paying market-determined interest rates. TheCommission also proposed ceilings on aggregate bor-rowing (including state-level guarantees) and debt,and these constraints would be an important compo-nent of a market borrowing regime. Several stateshave included such limits in their fiscal responsibilitylaws. Furthermore, the central bank (Reserve Bank ofIndia, or RBI) is actively studying the development ofinstitutions to support this shift to market borrowing,including offering mechanisms, secondary markets forgovernment debt, credit ratings, and methods of regu-lation and monitoring. The background for thisprocess is the center’s own shift in the 1990s towardpaying market rates for its borrowing.

If one can sum up the different components of federalsystem reform that have taken place in about the last15 years (the approximate period of systematic overalleconomic reform and liberalization), tax reform –working toward conventional microeconomic efficien-cy – can be characterized as the area where the great-est progress has been made. The scope of the FinanceCommission to make recommendations regardingoverall federal finances has been enhanced signifi-cantly, though actual practice has changed less. Someisolated institutional reforms, such as the tax-sharingarrangement and the creation of the ISC, have beensignificant. On the other hand, many other features,such as the process of planning and making plan andprogrammatic transfers, have changed relatively little.The proposal to shift to true market borrowing for thestates (and to some extent for larger urban local gov-ernments) represents a major reform that is still inprocess. At the same time, many of the other efforts todeal with subnational fiscal deficits have the flavor ofdealing with symptoms rather than causes. Under-standing this process of incomplete and piecemeal fed-eral reform therefore requires an analysis of the caus-es, in terms of political power and bargaining, that goesto the heart of federal arrangements in India.

Reform dynamics

Political power at the national level in India hasalways required some degree of coalition building,

since regional identities are strong. The Hindi-speaking states located in the northern Indo-Gangetic plain have some degree of homogeneity,and traditionally were the source of core support.At the southern extreme of the country, the state ofTamil Nadu was already asserting its individualityby the 1960s, with political power at the state levelbeing impossible without support from a state-based (i.e., Tamil-specific) party. In the 1970s and1980s, centralization increased, but more as aresponse to inherent pulls for a more decentralizedpolity (Brass 1990). From 1989 onward, no nationalparty has been able to form a government at thecenter without some degree of coalition-building,with emergent regional parties claiming pivotalroles.26 This dynamic of political decentralizationhas shaped many of the reforms, as we explain inthis section.

There is empirical evidence that central loans, foodassistance and subsidies to the states were all linkedto electoral considerations (Chhibber 1995) in the1970s and 1980s. Thus, the deepening of rent-seekingby politicians and interest groups was driven byintensifying needs of political competition, and pow-ers of patronage for electoral support overwhelmedconcerns about the inefficiency of the system. Theattempt to strengthen local governments can also beseen in this light. Whereas there had been a decades-old ideological strand favoring decentralization ofgovernment, it was only in the late 1980s that anattempt was made to institutionalize decentraliza-tion through constitutional changes. It has beenargued that the impetus came from the desire of thenational ruling party (the Congress) to balance thegrowing power of state-level politicians. This motiva-tion also explains why many states have been reluc-tant to devolve significant financial powers to theirsubordinate local governments. Nevertheless, anunintended consequence of the change has been agenuine effort to build local capacity: in particular,some larger urban governments have received morepolitical space to pursue policies for local economicdevelopment, including borrowing from the marketfor infrastructure projects. NGOs and multilateralinstitutions have also been able to be more involvedat the local level.

Another unintended consequence for India’s federalsystem emerged from the liberalization of national


Focus

26 In some cases, there are overlaps between ideology and region,as in the communist parties of West Bengal and Kerala. The role ofregional parties is detailed in the references cited in footnote 2.


Focus

industrial controls. State governments have beenable to pursue subnational economic agendas morefreely. Regulatory and permission issues for the pri-vate sector were now often shifted to the state levelrather than the center (Sinha 2004). States have evenbeen able to negotiate with multilateral institutions,in ways that may have shifted potential costs to thecenter (Chakraborty and Rao 2006), in the form ofsofter budget constraints. Many of the federal systemreforms that have been attempted (e.g., incentivesfor overall fiscal discipline) or proposed (e.g., subna-tional market borrowing) can be seen as responsesto the unintended consequences at the state level ofrelaxing national control of private sector economicactivity. Central government motives themselvesreflect a mix of concerns for overall economic per-formance, as well as a desire for rent-capture. Insome cases, concerns for rent preservation aresalient at the state level, and this hampers overallreform. The most striking example of this is in theelectric power sector, where the SEBs are loss-mak-ing and highly inefficient, but also large public sectoremployers: power supply remains perhaps the great-est and longest-standing constraint on India’s growth(Singh 2006).

It is also true that academic (or technocratic) inputshave played a role in reforms (Rao and Singh 2007).Typically, these work through government-appoint-ed expert committees (such as several on tax re-form), or through the Finance Commissions, whichcan include academics among their members. Thereform of tax sharing owes something to this process,as does the entire conceptual framework of tax re-form. It remains the case, however, that politiciansand bureaucrats choose what to implement, and clar-ity about who benefits and loses is important. Thus,changing the basis of tax sharing between the centerand the states in aggregate was much easier thancoordinated reforms of the indirect tax system acrossthe states. Even making substantive changes in theformula for allocating transfers across states is diffi-cult in this respect. Only a subset of academicallyinspired (and presumably desirable) reform propos-als lead to political action, with uncertainty withrespect to consequences for different interest groupsand problems of compensating losers being twinobstacles to adoption.

If one makes the political bargaining process thefocus of understanding the dynamics of reform, it isclear that the institutions that govern this process arecritical.Arguably, as the INC fragmented, party insti-

tutions deteriorated, and legislative quality andprocesses eroded (Kapur and Mehta 2006), thereemerged a gap in the institutions to manage conflictswith a federal dimension. In fact, ‘center-state rela-tions’ became a topic of urgent concern: the forma-tion of the ISC followed quickly on a 1988 recom-mendation made by a major governmental commis-sion that was appointed to address this issue. TheISC has sometimes been seen as too weak and adhoc, and it is less transparent than parliament, forwhich it substitutes as a discussion and consensus-building forum, but it appears to have filled the gapadequately. For example, how to go forward with theproposal to change the tax sharing arrangement washammered out in the ISC, and other federal matterssuch as sharing of inter-state river waters have alsobeen dealt with there (Richards and Singh 2002;Kapur 2005). In fact, in areas such as tax reform,another, more specialized bargaining forum hasemerged using the same model, the “EmpoweredCommittee” of State Finance Ministers. This com-mittee has made recommendations on the process ofthe states’ switch to a VAT (now essentially com-plete), and tax harmonization such as floor rates toavoid any “race to the bottom” in tax rates.

One may argue that institutional developments stilllag behind changes in India’s situation with respectto its federal character. Economic reform has initial-ly benefited some states and regions more than oth-ers (Kochhar et al. 2006; Rao and Singh 2005, andreferences therein), and increased regional inequali-ty makes it both more important and more difficultto build winning subnational coalitions for reform.Most recently, central government policy actionshave been aimed at boosting political support inpoorer, more rural states. Unsurprisingly, buoyanttax revenues resulting from reform and consequenthigher growth rates have been earmarked forincreased spending on health, education, rural infra-structure, and social insurance, rather than accelerat-ed reduction of the fiscal deficit.

Current federal institutions also get pulled in oppo-site directions. Thus, the latest Finance Commissionhas changed the tax sharing formula to favor better-off states, while simultaneously increasing targetedgrants to poorer states. In some ways, intergovern-mental transfers remain an arena for significant sub-national influence activities and bargaining overdivision of the government revenue pie. ThePlanning Commission has articulated a case for fur-ther decentralizing expenditure authority in areas

such as health and education, as well as for measur-ing outcomes of spending from categorical transfers,but complementary institutional reforms,27 whichwould make these objectives feasible, have not beenpursued. The Finance Minister has also raised theissue of civil service reform (which could have animportant federal dimension), but again there isenough opposition within government to make suchreforms difficult: in such cases, government decision-makers are themselves potential losers.

Conclusions

Explicitly recognizing the political dynamics of fed-eral reforms creates a different perspective formaking policy recommendations. Even in caseswhere the reform does not change federal institu-tions, it may require coordinated action at differentlevels of government (e.g., in areas such as agricul-ture, power supply, health and education: see, inparticular, Singh and Srinivasan 2005). Instead ofexamining ideal and isolated reforms, the focusinstead is on political feasibility. Where winners andlosers can be identified, it may be possible to createpackages of reforms that are politically acceptable,e.g., assigning greater revenue authority to localgovernments may be combined with reassigningsome taxes from the center to the states (or allow-ing piggybacking), and cutting the states’ share ofthe consolidated fund of the center (Rao and Singh2007). Thus, combinations of reforms may beaccepted, where individual reforms would lose: thetraditional economic compensation principle isimplicitly applied in such cases. This approach canalso guide the redesign and changes in the workingof institutions such as the Finance Commission,Planning Commission, and ISC (e.g. Rao and Singh2005; Singh and Srinivasan 2006).28

The perspective taken here for India can be seen ina more general context. It is an extension of Riker’sinstrumental view of federalism, as “a constitutionalbargain among politicians”, with the motives being“military and diplomatic defense or aggression”(Riker 1975, 113–114). Here, bargaining is not just inconstitution making, but also in evolution of sub-sequent governance, and not just for territorial pro-tection or gain, but also over splitting the economic

pie. Many of the large countries grappling with eco-nomic reform include, unsurprisingly, those withvariants of federal systems (e.g., Brazil, Indonesia,Russia, and South Africa, in addition to India andChina). There are special challenges for implement-ing change in countries with multiple layers of polit-ical authority and divided sovereignty. The literatureon federalism has not sufficiently addressed the issueof reform in developing countries with federal struc-tures (Wibbels 2005). Nor has there been adequateattention to the political determinants of federalinstitutions, and how these shape the reform process(Rodden 2006). This piece contributes to that ongo-ing research program.

The approach articulated here is also related torecent work by Rajan and Zingales (2006). Theyargue that interest groups, or rent-defending con-stituencies, may, depending on the initial distributionof endowments, trump democratic institutions andblock economy-enhancing reforms. In such cases,direct redistribution is also going to be politicallyinfeasible. We conjecture that federal systems mayhave an additional degree of freedom, where supple-menting subnational revenue and expenditureauthorities may also relax political constraints toeconomic 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 Tran-sition 7, 103–131.

Chakraborty, P. and M. G. Rao (2006), “Multilateral AdjustmentLending to States: Hastening Fiscal Correction or Softening theBudget Constraint?”, Journal of International Trade and EconomicDevelopment 15, 335–358.

Chhibber, P. (1995) “Political Parties, Electoral Competition,Government Expenditures and Economic Reform in India,”Journal of Development Studies 32, 74–96.

Finance Commission (2004), Report of the Twelfth FinanceCommission (2005-10), November, http://fincomindia.nic.in/Reportof 12th Finance Commission/index.html

Jin, H., Y. Qian, and B. R. Weingast (2005), “Regional Decentrali-zation and Fiscal Incentives: Federalism, Chinese Style”, Journal ofPublic Economics 89, 1719–1742.

Kapur, D. (2005) “The Role of India’s Institutions in ExplainingDemocratic Durability and Economic Performance,” in: Kapur, D.and P. B. Mehta (eds.), Public Institutions in India: Performance andDesign, New Delhi: Oxford University Press.

Kapur, D. and P. B. Mehta (2006), The Indian Parliament as anInstitution of Accountability, Democracy, Governance and HumanRights Programme Paper 23, United Nations Research Institute forSocial Development, January.

Kochhar, K., U. Kumar, R. Rajan, A. Subramanian and I. Tokatlidis(2006), India’s Pattern of Development: What Happened, WhatFollows?, IMF Working Paper WP/06/22.


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27 Essentially, such reforms would transfer revenue authority,including spending on personnel, to lower level governments.28 Hence, the positive analysis offered here also has some potentialnormative implications.


Focus

Laffont, J.-J. and Y. Qian (1999), “The Dynamics of Reform and De-velopment in China: A Political Economy Perspective”, EuropeanEconomic 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 BudgetConstraint”, American Economic Review 88,1143–1162.

Qian Y., G. Roland and C. Xu (1999), “Why is China Different fromEastern Europe? Perspectives from Organization Theory”, Euro-pean Economic Review 43, 1085–1094.

Qian, Y. and B. R. Weingast, (1996), “China’s Transition to Markets:Market-preserving Federalism, Chinese Style”, Journal of PolicyReform 1, 149–185.

Rajan, R. G. and L. Zingales (2006), The Persistence of Under-development: Constituencies and Competitive Rent Preservation,NBER Working Paper 12093, March.

Rao, M. G. and K. Rao (2006), Trends and Issues in Tax Policy andReform in India, Paper presented at Brookings-NCAER Confe-rence on India, March 2006.

Rao, M. G. and N. Singh (2005), Political Economy of Federalism inIndia, New Delhi: Oxford University Press.

Rao, M. G. and N. Singh (2007), “The Political Economy of India’sFiscal Federal System and its Reform”, Publius: The Journal ofFederalism, 37, 26–44.

Richards, A. and N. Singh (2002), “Inter State Water Disputes inIndia: Institutions and Policies,” International Journal of WaterResources 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:Addison-Wesley.

Rodden, J. (2006), Hamilton’s Paradox: The Promise and Peril ofFiscal Federalism, New York: Cambridge University Press.

Sáez, L. (2002), Federalism without a Centre: The Impact of Politicaland Economic Reform on India’s Federal System, New Delhi: SagePublications.

Singh, N. (2006), Services-Led Industrialization in India:Assessmentand 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, Globali-zation 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 EconomicDevelopment in India: An Assessment, Conference Paper, StanfordCenter for International Development Conference on Challengesof Economic Policy Reform in Asia, May 31–June 3 2006, Revised,October.

Sinha, A. (2004), “The Changing Political Economy of Federalism inIndia:A Historical Institutionalist Approach”, India Review 3, 25–63.

Wallack, J. and T. N. Srinivasan (ed. 2005), Federalism and EconomicReform: International Perspectives, Cambridge, UK: CambridgeUniversity Press.

Wibbels, E. (2005), Federalism and the Market: IntergovernmentalConflict and Economic Reform in the Developing World, New York:Cambridge University Press.

ANTICIPATED EFFECTS OF

FOREIGN CURRENCY RESERVE

DIVERSIFICATION IN ASIAN COUN-TRIES: DO CHINA AND INDIA

MATTER FOR COORDINATION?

FRIEDRICH L. SELL*

China achieved an extraordinary GDP growthrate of 10.7 percent in 2006 which is the highest

since 1995. In addition, its level of internationalreserves has risen to a level of more than USD 1 tril-lion. Such continuous foreign currency reserve accu-mulation since 2000 does not appear to be unique,however. Other emerging economies like India andBrazil seem to mimic China’s strategy. Figure 1demonstrates a clear upward trend in the world’sinternational reserve accumulation and it also showsthat China and India have greatly contributed to thisprocess. China meanwhile accounts for more than20 percent of these reserves.

Regardless of the speculation whether this mightlead to a real depreciation of their currencies ornot, one can a priori argue that the price of theircurrencies is (still) definitelyundervalued in the foreignexchange markets. While mostof these countries have stronglyfavoured the USD in the past,they now fear a sharp devalua-tion of the USD. In this contextsome interesting questionsemerge:

• What sense does it make tohoard foreign currenciesmore than 30 years after theend of the Bretton Woods

system and the transition to flexible exchangerates in major markets?

• Some emerging economies nowadays still pegtheir currency to the USD or at least managetheir exchange rates. What is the rationale behindthis?

• What are the opportunity costs of accumulatingreserves, and how can these countries hedge therisk of value losses in terms of domestic currencyof their stock of reserves?

• How can these reserves be continuously diversi-fied? Is there an optimal strategy for the manage-ment of these economies’ foreign exchangereserves?

Major emerging economies such as China and Indiaare nowadays in a totally different balance of pay-ments position vis-à-vis the industrialized countries,especially the United States than in past years. Theyare running huge balance of payments surpluses andtheir exchange rate policy can have a significantimpact on the size and allocation of the US currentaccount deficit. Other industrialized countries, too,are beginning to worry about the exchange rate poli-cies of emerging economies, as they feel that thesehamper their own export potential to these coun-tries. Many emerging economies have organized acomplete turnaround in their exchange rate policiessince the beginning of the new millennium. After the


Focus

0

500

1 000

1 500

2 000

2 500

3 000

3 500

4 000

4 500

5 000

2000 2001 2002 2003 2004 2005 2006 (a)

World foreign exchange reserves

Foreign currency reserves China

Foreign currency reserves India

Sources: IMF, People`s Bank of China, Reserve Bank of India.

DEVELOPMENT OF RESERVES IN THE WORLD, CHINA AND INDIA

SINCE 2000Billion USD

(a) World Reserves and China`s Reserves: Sept 2006, India`s Reserves June 2006.

Figure 1

* Department of Economics, Universityof the German Armed Forces Munich. Iwould like to thank Beate Sauer forexcellent research assistance.


Focus

experiences gained during the Mexican, the Asian,the Russian, and the Brazilian financial crises in the1990s as well as the Argentinean crisis some yearsago, they developed a combination of new strategiesthat include: (1) Paying back their debt to interna-tional organizations like the IMF as soon as possi-ble1, (2) pegging their currency to a single currencyor to a basket of currencies without committing to astrict and passive rule as a currency board wouldcommand, (3) accumulating foreign exchangereserves aimed at better overcoming a balance ofpayments crisis or at easily depreciating their owncurrency through foreign exchange market inter-ventions.

China and India: Common properties and differences in exchange rate policy

As Genberg (2006) puts it, the current exchange ratearrangements in East Asia range from the strictHong Kong type of currency board arrangement tothe (managed) float of the Japanese yen. For manyyears in the past, China had pegged its currency, theyuan, to the US dollar. On 21 July 2005, Chineseauthorities announced three important changes inthe exchange rate regime. The major purpose ofthese measures was: (1) stabilizing the value of yuanwith reference to a currency basket in the future,(2) letting the yuan appreciate by 2.1 percent againstthe dollar, and (3) allowing the exchange rate to fluc-tuate within a ± 0.3 percent band around a dailyfixed central parity. In recent years the yuan hasgradually appreciated against the dollar (seeFigure 2).

According to Chinese officialstatements, there is presently atype of basket pegging and thestabilization of an effectiveexchange rate in operation. Thecurrency basket consists of theUS dollar, the euro, the yen, andthe Korean won. In addition, theSingapore dollar, the Britishpound, the Malaysian ringgit,the Australian dollar, the Rus-sian rouble, the Thailand baht

and the Canadian dollar are also taken into account(Siebert 2006). Market experts, however, argue thatthe yuan is still strongly pegged to the US dollar.More precisely, the yuan seems to have recently fol-lowed the path of an appreciating crawling peg (seeFigure 2).

As a measure of controlling inflation, the People’sBank of China (PBC) sells securities in order todrain off the excess liquidity which is created whenthe bank buys foreign currencies. The PBC has madea huge profit out of its foreign exchange operations.The PBC sells the yuan-denominated central bankbonds to the good burghers of Shanghai while buy-ing much higher yielding dollar bonds (McKinnonand Schnabl 2006). According to the Bank forInternational Settlement (BIS), China hereby isearning up to one percent of its annual GDP. In atwo year period from 2003 to 2004 the stock of ster-ilization papers increased by about 265 percent,which expanded again by about 88 percent (or by avalue of USD 117 billion) from 2004 to 2005 – reach-ing USD 250 billion for the overall stock of bonds.However, the growth of the stock of central bankbonds held by domestic banks comprises only slight-ly more than half of the increase in total reserves.Hence, not all of the external money is being steril-ized; there is also an increase in liquidity leading tothe decline of inter-bank interest rates and theaccompanied strong credit growth.

The type of exchange rate policy chosen by Indiaseems to have a number of common elements withthat of China. This applies above all to the accu-mulation of reserves (see Figure 1). But the dimen-sions are quite different: India’s reserves amounted

7.7

7.8

7.9

8.0

8.1

8.2

8.3

8.4

2000 2001 2002 2003 2004 2005 2006 2007

Source: Federal Reserve Bank of New York.

EXCHANGE RATE DEVELOPMENT OF THE YUAN

CYN per USD

Figure 2

1 Argentina and Brazil have paid in full –and earlier than expected – their entireoutstanding obligations to the IMFamounting to USD 15.46 billion andUSD 9.6 billion, respectively inDecember 2005.

to roughly USD 200 billion in 2006 which repre-sents less than 20 percent of China’s (ReserveBank of India 2006). The Reserve Bank of India(RBI), however, has to struggle even more than thePBC does in order to neutralize the monetaryeffects of the purchase of foreign exchange. Due tothe lack of central bank securities, the RBI has tofall back on open market operations and must facethe scarcity of obligations denominated in rupee.And, more importantly, India has been losingmoney by accumulating reserves (about 1.2 per-cent of GDP p.a.), because domestic interest ratesexceed the US level. As a consequence, an addi-tional fiscal burden emerges from central bankinterventions. This also applies to other emergingeconomies such as Brazil.

Most experts expect the rupee to remain pegged tothe US dollar (Jayakumar et al. 2005). Officially, anexchange rate determined bymarket forces has existed sinceJune 2004. In fact, Figure 3shows the exchange rate move-ments in the short run. Taking amedium-run perspective, how-ever, a moderate revaluation ofthe rupee against the US dollarcan be observed since thespring 2002. On the one hand,this is not a fully unexpecteddevelopment, given the well-known weakness of the green-back in the foreign exchangemarkets during the same peri-od. Yet, there is something tobe noted. Particularly since

2001, the foreign exchange mar-ket interventions of the RBIhave contributed to a continu-ous increase in the officialreserves of the country (seeFigure 1). The Indian authori-ties, despite the “structural defi-ciencies” and the fiscal burdenmentioned above, are scrupu-lously sterilizing a high percent-age of the foreign exchangemarket interventions. This hasnot been the case in China.Moreover, the flow of foreigncapital into India has been ris-ing over the years. This alsohelps to explain the improvedeconomic growth in recent

years, but it makes the task of sterilization – whichseems even more important than in China given asoaring inflation rate (see Figure 4) – much moredifficult for the central bank.

Balance of payments development in China andIndia

Let us have a look at the balance of payments posi-tion of China and India (see Table 1). China is in thecomfortable position recording a “double surplus”, asurplus both in the current as well as in the capitalaccounts. Both balances add up (after correcting forerrors and omissions) to the increase in internation-al reserves. Notice that the implicit deficit in theChinese capital account of 2006 is only due to thepreliminary and asynchronous nature of the report-


Focus

43

44

45

46

47

48

49

50

2000 2001 2002 2003 2004 2005 2006 2007

Source: Federal Reserve Bank of New York.

EXCHANGE RATE DEVELOPMENT OF THE RUPEE

INR per USD

Figure 3

-2

-1

0

1

2

3

4

5

6

2000 2001 2002 2003 2004 2005 2006 2007

China

India

Source: IMF, World Economic Outlook Database, September 2006.

INFLATION

%Annual percentage change

Figure 4


Focus

ed data for this year. As opposed to this, India showsalternating signs in its current account. The capitalaccount has recently been in surplus and has easilycompensated the current account deficit in someyears. Both countries have accumulated reserves inevery year since 2000. This fact underlines the exis-tence of a strategic exchange rate policy while thesecountries have also been forced to solve the steril-ization problem in their national monetary policy.

Autonomous versus coordinated management ofreserves

Beyond the already mentioned flow problems asso-ciated with the strategic exchange rate/balance ofpayments policy in emerging economies, there isanother problem, which we may call the stock prob-lem. The stock problem emerges from the accumula-tion of foreign exchange reserves and has two eco-nomic aspects. More precisely, it is the stock ofreserves held by a central bank of an emerging econ-omy and the composition of these reserves that mat-ter. In order to keep the exchange rate of the yuanagainst the US dollar (more or less) fixed, Chinesemonetary authorities had accumulated around USD1 trillion by the first quarter of 2007 and “the spikein the pace of reserve accumulation during the peri-od of 2001 to 2004 is largely attributable to a surge in

speculative capital inflows” (Goodfriend and Prasad2006, 23). In China, the pressure to appreciate thecurrency has recently been driven as much by capitalinflows as by current account surpluses (Mohantyand Turner 2006).

Asian emerging economies, predominantly Chinaand India, have been accumulating their foreignexchange reserves mainly in US dollar denominatedassets, primarily US state bonds (Sell 2006). Such apolicy has kept the price of the dollar high and, at thesame time, widened the US current account deficit.That is why a new fear of floating is arising: the dol-lar might suffer from a rapid fall in value in the for-eign exchange markets which then would necessari-ly affect the value of other countries’ own foreignexchange reserves held in dollar denominated assets.Such a monetary risk would also force the centralbanks of a number of emerging economies to con-tinuously buy US dollars and thereby contribute tothe stabilization of the greenback in the internation-al foreign exchange markets (Sell 2007). Of course,such a policy makes the reserves grow further andaccordingly the size of possible losses which accrue,at least in domestic currency equivalents, in the caseof a more or less pronounced devaluation of the dol-lar. This would suggest, at first glance, that the incen-tives to intervene in the foreign exchange marketwill tend to rise.

Table 1

Development of China’s and India’s Net Exports, Net Capital Flows and Reserves since 2000

China Current Account

(USD billion)

Capital Account

(USD billion)

Changes in Reserves

(USD billion)2000 20.5 1.9 – 10.5

2001 17.4 34.8 – 47.3

2002 35.4 32.3 – 75.5

2003 45.9 52.7 – 117.0

2004 68.7 110.7 – 206.3

2005 160.8 63.0 – 207.0

2006 184.2a)

– 15.2b)

– 169.0c)

a) IMF estimation. –

b) Own calculation. –

c) Sept 2006.

Source: State Administration of Foreign Exchange, China.

IndiaCurrent Account

(USD billion)

Capital Account

(USD billion)

Changes in Reserves

(USD billion)2000 – 4.7 10.4 – 6.4

2001 – 2.7 8.8 – 5.9

2002 3.4 8.6 – 11.8

2003 6.3 10.8 – 17.0

2004 14.1 16.7 – 31.4

2005 – 5.4 31.0 – 26.2

2006 – 10.6 24.7 – 15.0

Source: Reserve Bank of India.

This statement, however, only holds with somequalifications, because, first of all, there is a hiddenfree-rider phenomenon (Sell 2006a). One couldalso call it an implicit alliance problem. Eventhough every single emerging economy (for whichthe above described scenario holds) has a greatinterest in a stable US dollar, it may be less enthu-siastic to contribute to its stabilization by own for-eign exchange purchases. A smaller share of USdollars in its foreign exchange reserves throughdiversification (in terms of a portfolio containingdollars, yen, euros, etc.) serves as a hedge againstexpected devaluations of the US dollar. In addition,a larger number of currencies in the central bankreserves enables the authorities to switch from thede facto pegging to the US dollar to a more or lessflexible peg against a basket of different currencies.In such a basket one would expect the currencies ofthe major trading partners of the emerging econo-my in concern.

Moreover, it is often argued that the longer thediversification in the currency composition of cen-tral bank reserves is postponed, the higher will bethe expected loss in value of the foreign exchangereserves. Assume as a type of rational expectationsthat every monetary authority is well aware of thismatter. Consequently, those emerging economieswith a huge stock of dollar reserves will be temptedto take the initiative and start with an autonomousreallocation of their foreign exchange reserves. Yetsuch an argument contains a fallacy because itneglects an important general equilibrium aspect of(interrelated) foreign exchange markets. When thecentral banks of emerging economies sell US dol-lars, this action tends to depress the price of dollars,while the other currencies which are exchanged fordollars will gain in value by exactly the sameamount. In principle, the involved central bankscould, therefore, avoid any value losses in theprocess of diversifying their portfolio of foreignexchange reserves.

In reality, however, the centralbanks will surely attempt to mini-mize those losses. Why is there adifference between the theory andthe reality? In general, a realloca-tion of reserves and/or the ex-change of currencies within theportfolio of a central bank’s re-serves go along with the ordinarymarket forces, which, for example,

tend to reduce the value of one currency, say the USdollar, but raise the value of the euro and/or theBritish pound in a either progressive or regressivemanner. This mismatch is illustrated in the follow-ing, based on a simple example which assumes thatthe reserves of China consist of US dollars andeuros exclusively. Formally, the domestic valueequivalent of China’s international reserves can beexpressed as:

(1)

A complete differentiation of equation (1) leads tothe condition:

(2)

, hence

Suppose the authorities hold their reserves in thequantities of USD 1,000 and EUR 500 in the initialyear (period 0); the original exchange rates areassumed to be 7.76 for the CNY/USD and 10.03 forthe CNY/EUR respectively:

RY = 1,000 . 7.76 + 500 . 10.03 = 12,780

As shown in the following calculation, the risk-freecondition for which the Chinese central bank candiversify 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


Focus

{Y Y Y

R = $ + �$ �

Reservesin Yuan Domestic equivalent of USD Domestic equivalent of Euro reserves

reserves

� � � �� 123 14243

Y Y Y Y Y !dR d$ $d d� �d 0

$ $ � �

� � � � � � � �= + + + =� � � � � � � ��

Y Y Y Y!d$ -$d d� �d

$ $ � �

� � � � � � � �= +� � � � � � � �

� � � � � � � �

Example:

0

Y

$

� ��

0,1Y

d$

� ��

0

Y

�

� ��

0,1Y

d�

� ��

1$ –380

0,1d $ – 3,880

1� 82.53

0,1d � 4,182.51

� losses in value = 4,264 � gains in value = 4,264


Focus

The true problem emerging in this context is not somuch the question of when the process of diversifi-cation gets started, but rather how it is organized;i.e. whether it will occur autonomously or in a coor-dinated way. An autonomous strategy chosen by asingle (but significant) emerging economy likeChina could probably create an unpleasant andextremely volatile situation in the foreign exchangemarkets. The reason is the likelihood of possiblepanic reactions among other emerging economiesfollowing the first mover (China in our example).Each of these countries would then be tempted toimmediately sell as many US dollars as possible inorder to limit the anticipated value losses. The riskof losses may become more acute if the uncoordi-nated actions by the central banks selling a highshare of their foreign currency reserves in a shortperiod of time induce other market participants tobet against the US dollar, leading to a sharp deval-uation of this currency in the end. Although eachinvolved central bank would behave rationallyfrom its own point of view, the group of the emerg-ing economies’ central banks could, however,endanger the stability of the world’s financial mar-kets. This scenario reminds us of panic sales in theequity markets.

How could such a run by the monetary authoritieson their own reserves (!) be possibly avoided? Apossible solution would be for the involved centralbanks of emerging economies (especially in Asia)to agree to proceed in a coordinated way. Not onlythe United States, but also other major industrial-ized countries would have an interest in such coor-dination, given that they also want to avoid a sharpdepreciation of the dollar. The coordinated salesof gold carried out by central banks of industrial-ized countries in recent years, which have morethan an eye on the gold price and its cyclicalmoves, could serve as a good example. Let us makethe argument clear by two alternative game situa-tions: When both monetary authorities (CB1,CB2) have an intermediate level of reserves asshown in scenario 1, holding reserves is a strictlydominant strategy and the Nash equilibrium (0, 0)is in the southeast corner of the payoff matrix. Acentral bank which holds its dollar reserves(regardless of what its counterpart attempts)receives a negative payoff of – 1. The reason is thatthe dollar continues to devalue at a moderate pacein the international foreign exchange markets andthat continuing to hold reserves means giving upthe gains of diversification (0).

Referring to scenario 2, where both monetaryauthorities have a large level of reserves, thingsbecome more complicated. If one of the centralbanks sells its dollars in the foreign exchange mar-ket, the devaluation of the dollar will accelerate. Ifthe other central bank continues holding dollars, itslosses will be extremely high, say (– 3). The sellingauthority also faces losses, but these are in part com-pensated by the investment in appreciating curren-cies (– 1). If both authorities get rid of their dollars,the downward trend of the dollar will be much morepronounced. Hence, each central bank incurs losses(– 2) in this case, which are greater than in the caseof jointly holding dollars (– 1). Therefore, the north-east corner could be a coordination equilibrium, pro-vided that both central banks are confident that nei-ther will sell dollars. If each central bank is con-vinced that the other will sell dollars, then the south-east corner will be a Nash-equilibrium.

Outlook

The answer to the question in the title of this paperis yes: China and India matter for the coordination offoreign currency reserve diversification in Asian

CB2

Hold Sell

CB1

Hold

Sell

-1, -1 -1, 0

0, 00, -1

CB2

Hold Sell

CB1

Hold

Sell

-1, -1 -3, -1

-2, -2-1, -3

IntermediateReserves

Game

LargeReserves

Game

countries. Their importance for the distribution ofinternational reserves among the economies in theworld is gradually growing. Reserve diversification isincompatible with an aggressive intervention policyin the foreign exchange markets which aims at keep-ing one’s own currency undervalued against the USdollar. On the other hand, such a policy goes per-fectly along with a medium-term strategy of stabiliz-ing the value of the domestic currency against a bas-ket of currencies. A basket peg offers the advantageof combining higher stability (rule character) withsufficient flexibility (to external shocks).

References

Genberg, H. (2006), Exchange Rate Arrangements and FinancialIntegration in East Asia: On a Collision Course?, ÖsterreichischeNationalbank, Working Paper 122, 1–20.

Goodfriend, M. and E. Prasad (2006), A Framework for Inde-pendent 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 Sys-tem in India. Recent Reforms, Central Bank Policies and Funda-mental Determinants of the Rupee-Dollar-Rates, Korea Institutefor International Economic Policy, Working Paper 05-06, Seoul.

McKinnon, R. and G. Schnabl (2006), China’s Exchange Rate andInternational Adjustment in Wages, Prices, and Interest Rates:Japan Déja Vu? CESifo Working Paper 1720.

Mohanty, M. S. and P. Turner (2006), “Foreign Exchange ReserveAccumulation in Emerging Markets; what are the domestic impli-cations?”, BIS Quarterly Review, September, 39–52.

Reserve Bank of India (2006), Report of Foreign Exchange Reserveshttp://www.rbi.org.in/scripts/HalfYearlyPublications.aspx?head=Report%20on%20Foreign%20Exchange%20Reserves (accessed14 February 2007).

Sell, F. L. (2006), The New Exchange Rate Policy in the EmergingMarket Economies – with Special Emphasis on China, Universitätder Bundeswehr München. Institut für Volkswirtschaftslehre,Discussion Papers 18/2.

Sell, F. L. (2006a), „Ein schwankender Riese. China ist zwar reich anDevisen – aber arm an widerspruchsfreien Konzepten in der Wäh-rungspolitik“, Financial Times Deutschland 232/48 of 29 November2006, 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.


Focus


Supplement

EMU ENLARGEMENT:A PROGRESS REPORT

MAREK DABROWSKI*

The date of the formal EU accession did not meanthe end of the integration effort of new memberstates to fully participate in the Single EuropeanMarket, when taken in its broader sense, includingthe EU common currency.1 Apart from joining theEconomic and Monetary Union (EMU), new mem-bers are still waiting to join the Schengen zone andhave full access to labor markets of certain old mem-ber states (OMS). There are also specific transitoryprovisions in many other chapters of the acquis

related to agriculture, environment, infrastructure,free capital movement, taxes, etc.

The purpose of this paper is to focus on EMU en-largement, which – from an economic point of view– seems to be the most important part of the unfin-ished integration agenda, and is also raising thebiggest controversies.2 The advocates of rapid EMUenlargement stressed the high level of trade andbusiness cycle integration of the New Member States(NMS) with the eurozone, and the potential benefitsfor the NMS in terms of decreasing transaction costsand exchange rate risk. Opponents pointed out thecosts of meeting the Maastricht criteria and givingup the supposed shock-absorbing role of theexchange rate. There were also some political andeconomic concerns in the Old Member States(OMS). The former came down to retaining a carrotwhich could be granted or withheld from the NMSdepending on their good behavior, and some under-standable concerns about how responsibly they werelikely to behave after EU accession. Economic fearswere mostly related to the controversial hypothesisthat the accession of rapidly-growing countrieswould increase the inflationary pressure and interestrates in the eurozone, which would have an addi-tional contractionary impact on the slower-growingeconomies of some OMS (see Rostowski 2006;Zoubanov 2006).

Only after the EU accession of the first ten NMS hadbeen formally completed could the EMU enlarge-ment process finally begin and could various earlierarguments and hypotheses related to this process beempirically tested. At the end of 2006, two and halfyears after the first wave of EU Eastern Enlarge-ment and the first ERM-2 accession decisions, itseems that a good moment has come to reconsiderold arguments and concerns.

This paper can be seen as a progress report thatfocuses on the following key issues: a short overviewof candidates’ situation with respect to EMU acces-sion, the formal Treaty obligation to join EMU vs.the actual freedom of choice of the entry date, revis-iting the pros and cons of adopting a common cur-rency, the relevance of the Maastricht criteria andfears regarding the ERM-2 mechanism and thepolitical economy and politics of EMU enlarge-ment. The final part provides a summary and policyconclusions.

A progress report

The EMU accession process of the NMS could onlyformally begin after the NMS had officially joinedthe EU, i.e. after May 1, 2004.3 Joining the newExchange Rate Mechanism (ERM-2) was the firstinstitutional step on this road. So far, seven NMShave joined this mechanism, thus demonstratingtheir desire to follow a fast-track accession to EMU.These have been: Estonia, Lithuania and Slovenia(all three joined in June 2004), Cyprus, Latvia andMalta (May 2005) and Slovakia (November 2005).On the other hand, the three biggest NMS – CzechRepublic, Hungary and Poland – do not have bindingand credible plans to join the Eurozone yet. Hungaryhas officially declared its interest to introduce theeuro at the beginning of the next decade but a seri-ous fiscal crisis, suffered by this country recently,makes any predictions in this respect very uncertain.Fiscal imbalances (although less severe than in theHungarian case) and political reluctance to addressthem right away can be considered the main obsta-cles to the Czech Republic’s and Poland’s EMUaccession. In addition, some leading politicians andpolitical parties currently in power in these twocountries run on a somewhat euro-skeptical ideolog-ical platform, part of which is a desire to postponeeuro adoption.

* CASE – Center for Social and Economic Research, Warsaw.1 Formally, the concept of a Single European Market refers to fourbasic freedoms, i.e. free movement of goods, services, capital andpeople. It does not include a common currency (which is the keyelement of the Economic and Monetary Union, another institu-tional block of the EU). However, as the decrease in transactioncosts has been the main rationale behind introducing the euro, ourinterpretation, which considers a common currency as the impor-tant 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 January 1, 2007 in case of Bulgaria and Romania.

While prospects for a relatively fast EMU enlarge-ment looked pretty good (at least with respect to thesmaller NMS) in the second half of 2005, theybecame gloomier in 2006, mostly as a result of a rigidinterpretation of the Maastricht inflation criterion.Among the first three countries that joined ERM-2in June 2004 and that had originally planned to intro-duce the euro on January 1, 2007, Estonia was effec-tively discouraged from applying for EMU member-ship on the grounds that its actual inflation rate wellexceeded the reference value. Lithuania, whereHICP breached the criterion by 0.1 percentagepoints only, asked the Commission to prepare theconvergence report, which came to a negative deci-sion on its EMU entry (CR 2006, 9). The Commis-sion’s negative verdict was approved by ECOFIN.Only Slovenia received a “green light” to enter theEurozone in January 2007.

Lithuania’s case had a negative influence on the fol-low-up debate on prospects and the timetable ofEMU accession both in the EU as the whole and inthe NMS, discouraging some of them from undertak-ing more radical adjustment policies, particularly inthe fiscal sphere. The timetable of EMU enlarge-ment has become uncertain and has lost politicalmomentum.

Is EMU accession mandatory?

At first glance, the question seems to be wrong asthe NMS do not formally have an opt-out optionlike Denmark and UK. They are legally obliged tojoin EMU at some point. However, according toArticle 4 of the Treaty of Accession (signed in April2003 in Athens) the NMS obtained the status of“Member States with derogation” regarding EMUmembership (CR 2004, 2) and the derogation peri-od has not been determined. Moreover, joiningEMU requires an active effort by each candidate tomeet the nominal convergence and legal criteria ofthe Treaty.

This can take many years if a country is not interest-ed in joining quickly. It is enough to continue a float-ing exchange rate regime, which excludes bothERM-2 and EMU membership. Thus the NMS pos-sess de facto a great room for maneuver as to whenthey will adopt the common currency. In extremecases, it would be possible to postpone EMU mem-bership almost indefinitely. The case of Sweden,which has not joined EMU or even the ERM-2 yet

(in spite of not having the opt-out option), can serveas an example, which perhaps some euro-skepticalNMS will follow.

In addition, present EMU members, which mustgrant an approval to each candidate country to joinboth ERM-2 and EMU (by qualified majority votingor in unanimous voting – in the case of determiningthe conversion exchange rate), possess great discre-tionary power to determine the speed of EMUenlargement. So far most of them as well as theCommission and the ECB are following a very cau-tious approach, discouraging NMS from rapid EMUentry (“don’t rush” advice) and trying to use all for-mal opportunities to delay this process.

Net benefits of EMU enlargement

If the NMS are not effectively obliged by the Treatyto join EMU soon and the political attitude of EMUincumbents to fast-track Eurozone enlargement isnot necessarily encouraging, what are the economicarguments for joining EMU? Answering this ques-tion requires coming back to the well-known discus-sion on the costs and benefits of joining a commoncurrency area, i.e. to the seminal papers of Mundell(1961) and McKinnon (1963). However, the limitedsize of this paper allows only for summarizing themain findings4:

1. Most of the NMS represent a very high share oftrade with other EU countries (70 to 80 percentor even more). The share of trade with theEurozone is smaller (due to trade relationswith non-EMU members of the EU) but stillranges from 40 to 60 percent of total trade(with only Latvia and Lithuania representinglower figures). However, when all the NMS willhave joined EMU, this share will increase sig-nificantly (through absorption of substantialintra-NMS trade). Generally, the level of tradeand investment integration of the NMS withthe EU and EMU is not, on average, worsethan in the case of incumbent EMU members,implying potential benefits from decreasingtransaction costs and decreasing risk of asym-metric shocks.

2. The NMS exhibit an increasing co-movement oftheir business cycles with those of EMU coun-tries, although the speed of convergence varies


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4 For more detail analysis see, among others, Dabrowski, Rostowskiet al. (2006); EFN (2006 Spring).


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among countries. This implies a gradually de-creasing risk of asymmetric shocks.

3. According to the endogeneity hypothesis (seeFrankel and Rose 1998), enlarging the euro areawill create additional trade (see Maliszewska2006) and investment flows and speed up the con-vergence of business cycles. These effects can beparticularly strong in countries now running flex-ible exchange rate regimes.

4. In the world of increasing financial integration,room for sovereign monetary policies in smallopen economies is gradually diminishing: theircentral banks cannot risk “leaning against thewind” (see Dabrowski 2004) and must follow, inone way or another, the monetary policy deci-sions of the monetary authorities of the biggestmonetary areas (ECB in case of NMS). This putsin question the main argument in favor of post-poning EMU entry, i.e. retaining an instrument ofmonetary/exchange rate accommodation toasymmetric shocks.

5. Joining the Eurozone also means eliminating therisk of currency crises for NMS. While the lastfew years did not see any spectacular financialturbulences in emerging markets, this does notmean that NMS are totally immune from thisrisk. The end of this unique period of extremelylow interest rates may bring about a new wave ofspeculative attacks against emerging-market cur-rencies.

6. Rapid EMU entry can also bring substantial fis-cal benefits, especially for countries (such asHungary and Poland), which have a high publicdebt burden, high primary deficits and must offerhigher yields to purchasers of their debt instru-ments (all three factors are closely interrelated).For these countries, the strategic policy decisionof early EMU accession would mean starting fis-cal adjustment sooner and enjoying lower inter-est rates earlier which would both result in lowernominal debt, other things being equal (seeDabrowski, Antczak and Gorzelak 2006).

The limited economic potential of the NMS com-pared to the EMU-125 means that the latter will gainless, in terms of transaction costs and potential tradeand investment creation, than the former. However,for the same reason, economic risks for the OMS willalso be negligible. This includes the afore-mentioned

concern that the rapidly growing economies of theNMS could increase the inflation pressure in theenlarged Eurozone and lead to an overly restrictivemonetary policy.

Re-examination of the Maastricht criteria

The four criteria of nominal convergence (as pre-conditions for joining EMU) were formulated in thebeginning of the 1990s in the Maastricht Treaty. Thepurpose was not merely to enlarge the EU territoryand number of member countries, but to create amonetary union (as well as a new currency) amongcountries, whose inflation rates and long-term inter-est rates varied greatly (in some EU countries infla-tion well exceeded 10 percent). Besides, the globalmacroeconomic and financial environment was quitedifferent at that time. Some of the EU-12 membersstill had capital controls. Global financial marketswere less developed and sophisticated.Therefore theroom for a sovereign monetary policy was larger,even in countries which belonged to EMS.

It is fair to say that from the very beginning themutual consistency of these criteria raised somedoubts and was, in fact, only possible under someadditional assumptions. The two requirements of thefiscal criterion represent the best example here (seeGros, Mayer and Ubide 2004). The deficit ceiling of3 percent of GDP is consistent with the debt ceilingof 60 percent of GDP only under the assumption ofa 5 percent growth rate of nominal GDP. If averagenominal growth is lower (which has been the case forEMU as a whole and for most of its members for anumber of years) the deficit must be corresponding-ly lower.

An even more serious inconsistency affects both,exchange rate stability and the inflation criteria.Fixing the exchange rate makes the inflation ratemostly exogenous for the monetary authorities, par-ticularly in a world of free capital movements. Andinflation differences exceeding what is tolerableunder the inflation criterion can result from varioussources, such as differences in productivity growth(the Harrod-Balassa-Samuelson effect), changes inthe demand structure (in favor of non-tradable ser-vices), or initial differences in purchasing powerparity (PPP) of individual currencies. The NMS,growing faster than the OMS and starting withlower levels of development, can experience allthese sources of higher inflationary pressure and

5 In 2004, the total GDP of 10 NMS amounted to only 5.6 percentof the total GDP of the future EMU-22 (twelve current membersand ten candidates). The total share of the five smallest NMS(Baltics, Cyprus and Malta) amounted to only 0.7 percent (seeEFN, 2006 Spring, Table 3.2).

thus face the risk of breaching the inflation criteri-on, which is what really happened in the case of theBaltic countries.

An additional difficulty can result from the fact thatthe reference value for the inflation criterion is cal-culated on the basis of a simple arithmetic averageof the three best-performing EU members, whichdo not have to be EMU members. With substantialdifferentiation of inflation rates inside the EU, it ispossible that the three best performers, represent-ing a very small share of overall EU GDP, can setthe reference value well below the average inflationrate of the entire EU (and indeed EMU) and theactual rate of most of their members. Lithuania’sfailure to meet the inflation criterion by a very nar-row margin in the spring of 2006, when the refer-ence value was set by two non-EMU countries,Poland and Sweden, demonstrates the high proba-bility of the above scenario. Obviously, such an out-come does not say too much about a candidate’snominal convergence with the current EMU.6 Andwhat are the effective policy tools to bring inflationdown in countries like Estonia or Lithuania thathave run currency boards for many years and havebalanced or surplus budgets?

A similar inconsistency may also relate to the ERMmechanism itself, which was originally designed as anarrow fluctuation band around a central parity, butwas formally widened to a ± 15 percent range afterthe 1992 EMS crisis. This is a kind of hybrid mone-tary regime under which the central bank tries tosimultaneously manage the exchange rate and inter-est rates (liquidity). Historical experience shows thatsuch a regime is prone to speculative attacks, as wasexperienced by many current EMU members in1992 to 1993 (Wyplosz 2004).

So far, the central banks of the ERM-2 participantshave not experienced problems with keeping theexchange rates of their currencies close to thedeclared parity, except for the National Bank ofSlovakia, which had to defend the koruna when itcame under market pressure after a general elec-tion on June 17, 2006. However, there are twoimportant caveats here. First, five out of sevenERM-2 members have had currency boards orfixed pegs for many years, so they do not, in fact,run sovereign monetary policies. Second, the last

few years have been characterized by calm onemerging markets.

Political economy and the politics of EMU enlargement

The policy conditionally attached to EMU accessionmay serve as a powerful incentive for fiscal adjust-ment and associated reforms, mostly in the socialpolicy sphere, as has been demonstrated by the expe-riences of many current EMU members in the sec-ond half of 1990s. However, this kind of incentivemechanism can only work if the candidate knowsthat the reward (EMU membership) is truly avail-able and welcomed by the other members.

I am not suggesting any softening of those entry cri-teria, which: (i) are very important for the collectiveeconomic safetyor EMU (avoiding free riding underthe umbrella of the monetary union); and (ii) remainunder the control of each candidate. This relates, inthe first instance, to fiscal criteria, which should beclosely observed and executed without any waiver,perhaps even with some additional safety margin,taking into account the fact that the NMS are enjoy-ing a unique period of post-enlargement catch-upgrowth and that they will face serious long-term fis-cal problems as a result of population aging (evenmore than in Western Europe). This means that theNMS should run balanced or surplus budgets (likeEstonia).7 On the other hand, the competent exami-nation of candidates’ performance must take intoaccount that some of the macroeconomic variablesremain under limited control of national economicpolicy, such as the inflation rate under a fixed ex-change rate regime.

Punishing the best macro- and microeconomic per-formers such as Estonia and Lithuania for missingan inflation criterion that they are unable to control,issues the wrong political signal. It not only discour-ages good performers, but also those countries thatare facing a complex fiscal adjustment agenda ontheir road to the euro. This leads euro-skeptical andopportunistic politicians in countries suffering fiscalproblems to ask, “If the reward is problematic andthe NMS are not very welcomed in the Eurozoneyet, then why should we risk making unpopulardecisions?”


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6 Lithuania’s twelve-month HICP in March 2006 (2.7 percent) washigher by only 0.4 percentage points than the average inflation ofthe Eurozone.

7 And this condition is, in fact, required by the Stability and GrowthPact.


Supplement

This skepticism is further fuelled by the demands ofreal convergence (meaning closing the income percapita gap between the EMU candidates and theEurozone) or criticism of the NMS’ persistent cur-rent account deficits (see Bundesbank 2006) causedby large FDI inflows. Both arguments are based oneconomic misconceptions and do not have a formalground in the Treaty.

The attempt to slow down EMU enlargement can beconsidered part of a wider phenomenon: publicopinion and politicians in some OMS have becomereluctant not only to continue the EU enlargementprocess (with respect to Turkey and Western Balkancountries) but also to complete the 2004 and 2007enlargement agenda.Apart from EMU enlargement,the Schengen zone enlargement and the opening ofOMS labor markets to the NMS labor force are alsogoing to be delayed.This may signal a political inten-tion to have, at least temporarily, two categories ofEU members, with the “core” built around the cur-rent EMU. It is hard to believe, however, that thistwo-tier membership will benefit the EU and helpsolve its fundamental economic and political prob-lems, such as finding a compromise on the proposedconstitution that was frozen by the negative resultsof the French and Dutch referenda in 2005.

Summary and conclusions

Until now, the EMU enlargement process has devel-oped slowly. This results not only from “post-enlargement fatigue” and euro-skepticism in some ofthe NMS (demonstrated by the inability of certaincountries i.e. Czech Republic, Hungary and Polandto address fiscal problems), but also from resistanceto admitting the NMS to the euro area from the“incumbent” side. The negative assessments ofLithuania and Estonia’s eligibility are the best exam-ples of this phenomenon. Ironically, this has affectedthe two best economic performers and de facto long-time members of the Eurozone (they run euro-denominated currency boards).

Continuation of the “don’t rush” policy will havenegative economic and political consequences forboth, the NMS and the European Union as a whole.First, it will discourage the NMS from carrying outfiscal adjustment and from continuing reforms inpolitically sensitive areas such as social welfare.Secondly, as the potential benefits of joining theeuro area outweigh their costs, delaying EMU

enlargement results in net welfare losses for theNMS and delays hopes of their income catching upwith that of the OMS. It will also limit the net bene-fits of those NMS that joined EMU first becausesome of their important trading partners will remainoutside the common currency area.Thirdly, financialmarkets have until now assumed a scenario of rela-tively quick EMU enlargement. This explains therelatively low NMS risk premiums. However, wheninvestors realize that this process will be postponedfor good, the risk premiums will probably increase,thus weakening growth perspectives and adding tofiscal problems. Any adverse shock such as politicalproblems in any single country or financial turbu-lences on other emerging markets may trigger afinancial crisis in the periphery of the enlarged EU.Fourth, applying ‘second-rate’ status to most NMSwill negatively influence the Union’s ability to meetkey economic and political challenges in the nearfuture.

The “don’t rush” policy should be abandoned infavor of clear incentives to speed up the fiscal adjust-ment of the EMU candidates as a precondition oftheir membership in the common currency area,even with the additional safety margin comparing tothe Maastricht criteria. On the other hand, the infla-tion performance should be interpreted more flexi-bly, at least reflecting its partly exogenous characterunder fixed exchange rate regimes. This flexibilitymay go in two directions:

1. The inflation criterion should be applied to assessmacroeconomic (mostly monetary) policies inthe period preceding the adoption of the ERM-2central parity and should subsequently be aban-doned. It should be completely abandoned in thecase of EMU candidates running well-establishedeuro-denominated currency boards.

2. In addition, the reference value should relate tothe average inflation rate in the Eurozoneinstead of the average of the three best perform-ing EU members.

References

CR (2004), Convergence Report 2004 – Technical annex, A Com-mission Services Working Paper, SEC(2004) 1268, Brussels: Com-mission 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 2006on Lithuania. Brussels: Commission of the European Communities,May 16, COM(2006) 223 http://europa.eu.int/comm/economy_finance/publications/euro-pean_economy/2006/report_lithuania.pdf

Dabrowski, M. (2004), Costs and Benefits of Monetary Sovereigntyin the Era of Globalization, in: Dabrowski, M., J. Neneman andB. Slay (eds.): Beyond Transition. Development Alternatives andDilemmas, Aldershot: Ashgate Publishing Limited.

Dabrowski, M., M. Antczak, and M. Gorzelak (2006), “Fiscal Chal-lenges Facing New Member States”, Comparative EconomicStudies 58, 252–276.

Deutsche Bundesbank (2006), “Determinants of the CurrentAccounts in Central and East European EU Member States and theRole of German Direct Investment”, Monthly Report, DeutscheBundesbank, January,http://www.bundesbank.de/download/volkswirtschaft/mba/2006/200601mba_en_determinants.pdf

EFN (2006), Convergence and Integration of the New MemberStates to the Euro Area, Economic Assessment of the Euro Area:Forecasts and Policy Analysis. Spring 2006, EUROFRAME – Euro-pean 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 Opti-mum Currency Area Criteria”, Economic Journal 108, 1009–1025.

Gros, D.,T. Mayer and A. Ubide (2004), The Nine Lives of the Stabil-ity Pact, A Special Report of the CEPS Macroeconomic PolicyGroup, Center for European Policy Studies, Brussels.

Maliszewska, M. (2006), EMU Enlargement and Trade Creation, in:Dabrowski, M. and J. Rostowski (eds.), The Eastern Enlargement ofthe Eurozone, Heidelberg: Springer.

McKinnon, R. (1963), “Optimum Currency Areas”, American Eco-nomic Review 53, 717–25.

Mundell, R. (1961), “A Theory of Optimum Currency Areas”, Ame-rican Economic Review 51, 657–65.

Rostowski, J. (2006), “When Should the New Member States JoinEMU?”, in: Dabrowski, M. and J. Rostowski (eds.), The Eastern En-largement 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: AshgatePublishing Limited.

Zoubanov, N. (2006), “Uneven Growth in a Monetary Union”, in:Dabrowski, M. and J. Rostowski (eds.), The Eastern Enlargement ofthe Eurozone, Heidelberg: Springer.


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Special

THE 2008/2009 REVIEW OF

THE EU BUDGET:REAL OR COSMETIC?

IAIN BEGG*

The European Community budget is, arguably,among the least satisfactory elements of EU eco-nomic governance and one which, moreover, hasproved to be remarkably resistant to change since itwas last subjected to major reform in 1988. In theintervening period, there has been no radical devel-opment, despite the increase in membership of theunion from 12 to 27, completion of the internal mar-ket, and the extension of EU ambitions in externalpolicy from development to international security.Monetary union has gone from a distant prospect toa euro that will be well into its adolescence by theend of the current Multi-annual Financial Frame-work (MFF) in 2013, which is formerly known as theFinancial Perspective – FP.

It is noteworthy that in the extensive reform of eco-nomic governance that took place in 2005, it is thebudget which emerged least altered, despite the factthat it underwent a presentational makeover that,for example, saw “structural operations” re-definedas “cohesion for growth and employment”, albeitwith much the same level of resources. While theseemingly vast capacity of the EU to fudge dealscannot be ignored in looking to the future of thebudget, it is hard to see how the present system cansurvive beyond the present budgeting period of 2007to 2013. In an intriguing paradox, the long periodsinvolved seem to make reform more difficult, ratherthan giving ample time for reflection.

It is against this backdrop that the EU is now gear-ing up for a review of the budget, due to take placein 2008/2009, and supposed to be subject to notaboos. All headings of expenditure are to be exam-ined and the terms of reference also make clear thatthe UK rebate is to be on the table, offering somehope that things might change, despite the disap-pointing outcome of the 2005 deal (Begg andHeinemann 2006). Consequently, the review offersthe first opportunity for many years for the EU bud-get to be re-thought from first principles, at least

selectively. More importantly, it can help to shift theagenda for what the EU budget should do.

But is there the political will to enable it to be a cat-alyst for change? This paper describes the flaws inthe budget that the review is intended to address, dis-cusses options and concludes with a number of pro-posals for reform.

What is at issue?

There is widespread agreement about the shortcom-ings of the budget, well-captured in the jibe of Butiand Nava (2003, 1) that it is a “historical relic”. Thebiggest element of expenditure has long been sup-port for agriculture, a declining sector of economicactivity, while the other major component of spend-ing is for cohesion: policies aimed mainly at the eco-nomic development of lower-income regions andMember States. Together, agricultural and cohesionhave accounted for some three-quarters of EUspending over the last three decades, including the1999 to 2006 spending period that has just ended. Allother EU policies, as well as the administrative costsof the Union compete for the remaining quarter,equivalent to just one quarter of a percentage pointof EU GDP.

Although many facets of the budget look differentor have acquired new labels, it is striking how littlechanged the budget of 2007 is from those of the late1980s. Some might dispute this assertion, but asTable 1 shows, in practice the main features haveevolved only to a limited extent. It is still almost thesame size as a proportion of EU GDP; it continues tobe dominated by expenditure on agriculture andcohesion; and the UK rebate is as hotly contested asever. Politically, the most telling change is that thereare now more net contributors than twenty yearsago, but the proliferation of back-door rebates hasmade the whole picture more blurred and the solu-tions found ever more ad hoc.

An important issue is how big the EU budget shouldbe. Over the last two decades, it has hovered around1 percent of EU GNI. At this level it is just 2.5 per-cent of aggregate public spending in the EU whichmeans that the room for genuine manoeuvre in thebudget is, inevitably, severely circumscribed. Nordoes the budget have any role in stabilisation policy,as is the norm for the highest tier of policy-makingelsewhere (even in the US, the federal government* London School of Economics.

accounts for over 20 percent of GNP), and it doesnot explicitly contribute to the re-distribution ofincome through social transfers, as might be expect-ed from the highest level of governance in a fiscalfederation (Oates 1999). That said, the budget plain-ly does have a distributive effect insofar as it trans-fers resources to farmers – increasingly, after succes-sive reforms of the Common Agricultural Policy(CAP), in the form of direct income subsidies ratherthan the much reviled production subsidies – and tothe regions eligible for cohesion spending, in theform of targeted public investment.

Instead of being a source of EU level public goods,some critics argue that the budget is dominated byre-distributive expenditure. Indeed, Blankart andKirchner (2003) argue that the institutional arrange-ments for settling the budget predispose it towardsredistributive policies, echoing the pork barrel men-tality familiar in the US congress. Moreover, there islittle scope for using straightforward economic prin-ciples to determine how spending at EU level would“add value”. Worse, the issue of added value onlyrarely surfaces in the acrimonious negotiationsaround the budget. Instead the focus of attentionhas, especially in the last two settlements (1999 and2005, although this orientation dates back to thewielding of the handbag by Mrs. Thatcher in theearly 1980s), been on how much the respective headsof government and finance ministers have been able

to bring back as a juste retour. As Le Cacheux (2005)aptly describes it, the obsession with net contribu-tions “poisons” the whole debate.

Timing and context

There will be three stages to the review: an initial‘key issues’ paper from the Commission to launch aperiod of consultation; the publication of firm pro-posals by the Commission, probably late in 2008,drawing on background research and the outcome ofthe consultation process; then the usual wranglingabout what should be agreed. It is important, though,not to harbour illusions about what the 2008/2009review will change. In particular, it is unlikely toresult in much alteration of the existing MFF – seenby too many as a ‘done deal’ that cannot be unpickedthread by thread without the whole garment disinte-grating. Nor does there seem to be much enthusiasmfor change on the funding side of the budget, notleast because the present system of own resourcesthat funds the EU budget has one great virtue,namely that it ensures that the EU obtains themoney it needs. Any switch to a “tax for Europe” orany other revenue source would create a degree ofuncertainty in this regard.

The rigidities in the system of decision-making (notleast the requirement for unanimity), path depen-


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Table 1

Budget features compared

Facet of budget 1988–1992 (FP) 2007–2013 (MFF) Comment

Own resources ceiling Rising to 1.2%

of GDP

1.24% of GNI Marginal increase, but offset by

lower take-up

Actual expenditure

commitments, average

over FP

Planned: 1.17%

of GNP

Out-turn: 0.99%

Planned: 1.05% of GNI There has been a tendency for

the out-turn to under-shoot

Share of CAP spending,

% end of FP/MFF

51.4% 32.0% direct payments,

with an additional 8.2%

on other elements

Major changes made in 1992

and 2002 in the character of the

CAP, but real level of spending

maintained

Share of cohesion

spending, % by end of

FP/MFF

30.2% 35.6% Shift from “cohesion 4” to

recently acceded members

Administration costs, %

end of FP/MFF

4.7% 6.0% Increase partly caused by

re-definitions

Formal abatement UK UK Relatively minor changes in

formula

Implicit “rebates” DE DE, NL, AT, SE Increasingly messy and opaque

arrangements

Share of funding from

inter-governmental

transfers

VAT: 58% (average)

GNP: 9% (average)

VAT: 16% (2007)

GNI: 69% (2007)

Switch from VAT resource to

GNI resource, but de facto both

transfers



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dency and the power of vested interests makereform of the EU budget an uphill task. There is,nevertheless, a potentially auspicious conjunction ofscheduling in the next three years. 2009 will see theend of the mandates of the current Commission andEuropean Parliament. Under the provisions of there-launched Lisbon strategy, new triennial NationalReform Programmes are due to be formulated in2008 and launched in 2009 and the parallel Com-munity Lisbon Programme will also need to berenewed. In addition, there is or is likely to be newpolitical 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 win-dow of opportunity for more extensive change thanhas been feasible in recent rounds. This suggests thatthe principal ambition of the review should be toshift the terms of the debate for subsequent fundingperiods (that is, beyond 2013) and to provide aroadmap for the reform of the budget.

The revenue side of the budget

Although the Treaty (Art. 269, TEC) stipulates thatthe EU should be funded by own resources, only asmall proportion (currently just under 15 percent) ofthe revenue comes from instruments that are gen-uinely European, namely the levies and dutiesimposed at European level – the “traditional” ownresources (ToR). Starting in 1979, the bulk of theEU’s revenue has come from, initially, a proportionof the proceeds of national value added tax, comple-mented after 1988 by a fourth resource calibrated onnational income (now GNI). These two resourcesare, in a legal sense, own resources because they areformally incorporated in the Inter-InstitutionalAgreement between the European Parliament, theCommission and the Council. But in an economicsense, they are inter-governmental transfers, ratherthan readily identifiable revenue sources. This has anumber of ramifications.

Because the GNI resource is residual in that it risesor falls to match the EU’s expenditure commitments,there is no risk of the EU “running out of money” ashappened in earlier periods. The corollary is that themajor political decisions about the EU budget con-cern the EU’s expenditure, with the revenue adjust-ing passively. This is not, as it might be in other cir-cumstances, a recipe for fiscal laxity, since the overallcap on the budget, together with the ceilings for dif-ferent headings of expenditure effectively impose a

hard budget constraint. But it does distinguish theEU from other governments which have to balancerevenue raising with expenditure in a more system-atic way. A second feature of the system is that it iseasy to predict how much each Member State willcontribute s a proportion of national income. Thecurrent system is, broadly, proportional, with eachMember State expected ex-ante to pay-in roughly1 percent of its GNI, although the various abatementmechanisms alter the actual payments.

What could be on a reform agenda?

The mandate for the reform of the revenue side ofthe budget refers to “resources, including the UKrebate”. The former can be interpreted either as acall for minor revision of the existing own resourcesor, at the other extreme, as an invitation to assigngenuinely “owned” taxes to the EU level. An obvi-ous simplification of the existing system would bethe abolition of the VAT resource by consolidating itinto the GNI resource, recognising that the distinc-tion is artificial.

Introducing new taxes for Europe would be muchbolder, yet already seems to be a step too far politi-cally, despite the fact that it has consistently been onthe EU agenda since the 1988 budget reform. Ininterviews, Dalia Grybauskaite, the EU BudgetCommissioner has made clear her opposition toopening-up this question now, although a report by aprominent member of the European Parliament(Lamassoure 2007) has made a strong case for mov-ing in stages to a new system in which there areexplicit EU taxes. The Commissioner’s fear is, inpart, that if the review attempts to tackle too manytopics, it will succeed with none of them.

Possible criteria for an EU tax include standard taxprinciples (including equity – especially betweenMember States – economic efficiency, sufficiencyand cost of collection), assurance that the new instru-ment would not add to the aggregate fiscal burden(revenue neutrality), and political considerationssuch as a link to EU policies, visibility and trans-parency. No conceivable EU tax will ever be idealand there are bound to be problems of various sortsin any tax that might be envisaged to “pay for Euro-pe”. But designing one that fulfils enough of the rel-evant criteria is not an especially daunting challengeand many conceivable options have been discussedover the year (see Cattoir 2004; Le Cacheux 2007).Collecting a tax at EU level may even diminish

anomalies or externalities resulting from its collec-tion at Member State level, such as arbitrariness inwhich Member State levies taxes on bases that are infact pan-European profits, for example.

The problems arise at the political level. Opponentsof an EU tax claim, inter alia, that:

• It would increase the overall tax burden – whichit plainly would not if revenue neutrality is res-pected.

• Citizens would question why they were paying forthe EU – which is, in fact precisely the point of thetransparency and visibility argument for having atax.

• Introducing a “new” tax is a political non-starter –a claim which has no empirical support.

• Because the present system of own resourcesassures adequate funding, the maxim “if it ain’tbroke, don’t fix it” should apply, especially when atax for Europe would inevitably create new prob-lems and anomalies – a standpoint that has itsmerits, but which is also a recipe for inertia.

Expenditure

There are several explanations for the current mix ofspending in the EU, few of which reflect underlyingprinciples of public finance. The most clear-cut is theTreaty base which stipulates that there shall be acommon agricultural policy (CAP) and funding forcohesion through the Structural Funds. However, thescale of expenditure on these two sets of policies is apolitical choice and the way they are distributedamong Member States partly to give “money back”.There is also a Treaty base for research funding andvarious other internal policies, while the Union man-ifestly could not function without administrative out-lays. Here, too, the level of expenditure is a matter ofpolitical choice. For other key components of EUeconomic governance such as macroeconomic stabil-isation, the Lisbon reform agenda or sustainabledevelopment, the legal base is much weaker. Yetwith the Commission placing the (Lisbon) Partner-ship for Growth and Jobs at the heart of its politicalwork programme, it might have been expected that itwould feature prominently in EU expenditure overthe coming years.

Heading 1 of the 2007 to 2013 MFF is, indeed, iden-tified as money to be spent on growth and employ-ment and, in its more sanguine pronouncements, the

Commission claims that as much as 40 percent of theEU budget is aimed at this objective. However, thisclaim can be made only by including the cohesionbudget as part of growth and employment. This isnot without justification insofar as the economicdevelopment of less competitive regions contributesto aggregate EU competitiveness, but the fact re-mains that cohesion spending is about counteringthe market forces that result in polarisation and ispaid for by, implicitly, taxing richer regions.

But what the budget does not do systematically is toallocate resources to genuinely European publicgoods, for which there is an evident added valuefrom producing them at supranational problem.Spill-over arguments could, for example, be adducedto support EU wide infrastructure networks orresearch, and it would not be hard to make a case forhigher spending on internal security. As a result, thequestion that ought to be behind that of “how bigshould the budget be” namely, “when is it better tospend at EU level”, is scarcely posed, let aloneanswered.

What are fair contributions to the EU budget?

There are three different ways of measuring howmuch each Member States pays in to the EU budget,each telling a different story: ex-ante gross pay-ments; payments after allowing for abatements andother adjustments; and net contributions. All havebecome increasingly devoid of principles over theyears because of ad hoc adjustments. Correctionsdesigned to contain net balances include the “fee”paid to Member States for collecting the two tradi-tional own resources (increased to 25 percent in1999, largely to give money back to the Nether-lands); differing take-up rates for VAT instead of asingle one; and, in the 2007 to 2013 MFF, a reducedtake-up rate of the GNI resource for the Nether-lands and Sweden. Together with the formal rebatefor the UK and the reduced contribution to the UKrebate offered to four Member States (whichincreases the burden on the remaining twenty-two),all of these manipulations mean that the actual pay-ments to the EU of five of the richer Member Statesare, in fact, lower as a proportion of GNI than thepoorer Member States.

The effect of these corrections is to increase theshare of GNI paid-in by other countries. At the rich-er end of the spectrum, France has had to pay most


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in this regard. But the fact that the recently-accededcountries also have to pay more has been a source ofdismay. In addition, the payments have to be madequarterly, whereas receipts from many of the multi-annual programmes, such as the Structural Funds,tend only to be received with a lag and are subject tocertain conditions. The upshot is that a country suchas Poland may face a less favourable cash-flow in theshort-term. These revenue arrangements havecaused friction, with the recently acceded MemberStates dismayed to find that they have to pay“upfront” for the British abatement.

Nevertheless, the key issue is net contributions,which are the difference between abated gross pay-ments into the EU budget and expenditure receivedfrom it. The net contributions arise almost entirelyon the expenditure side of the budget, albeit for dif-fering reasons. CAP spending has an uneven geo-graphical incidence because it automatically favourscountries with large farming industries, while its dis-tributive impact has – so far – been unpredictable,favouring large farmers in some circumstances andlow-income ones in others. Cohesion policy is delib-erately targeted at lower income or competitivelyweak regions, and can thus be seen as a policy thathas more explicit equity-related aims. Spending onother policies reflects diverse objectives. Thus, theresearch budget is supposed to be allocated princi-pally on the basis of excellence, which tends tofavour Member States (and, within them, specificregions) with well-developed research capacities –usually richer ones.

Overall, therefore, the distributive impact of the EUbudget is partly intentional and partly a by-productof the way policies are designed and implemented.The tension at the core of this system for allocatingspending is that more attention tends to be paid tohow much a country receives rather than whetherthe policy is well-conceived from the perspective ofthe EU as a whole by producing public goods.

Proposals and conclusions

The 2008/2009 review of the EU budget is an oppor-tunity to achieve an irreversible shift in the econom-ics and politics of the EU budget, but success cannotbe taken for granted and it would not be at all sur-prising if the ended without firm agreement on howto move forward.There seems little prospect that thereview will result in anything other than marginal

changes in the 2007 to 2013 MFF. But it will haveserved its purpose if it establishes a clear and princi-pled blueprint for the future shape of the budget.Offering credible ways forward or clarifying theoptions in seven key areas would constitute realprogress. They are as follows.

• The rigid ceiling of 1.24 percent of GNI for the

budget, and the de facto ceiling of just over 1 per-

cent should be abandoned in favour of a “policies

first” approach. There is plainly no political will toendow the EU level with fiscal resources compa-rable to the federal or central level in other poli-ties, but that need not preclude a somewhat larg-er budget, provided that it can be justified. Thecurrent own resources ceiling reinforces the senti-ment, first, that payments to the EU are tanta-mount to a club fee and, second, that the primaryobjective in budget negotiations should be tomaximise “money back”. In this logic, the mainfunction of the ceiling is to contain the common-pool problem and thus limit the distributive trans-fers from the budget. But in the process, littlethought is given to what public goods the EUshould 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 onanalytic concepts, such as externalities andeconomies of scale, and adapted to the uniqueinstitutional circumstances of the EU. A key testshould be whether spending at EU level improvesthe quality/efficiency trade-off of public spending,and the presumption should be that assigning aspending competence to the EU level shouldresult in either the same or lower level of totalpublic spending.Where there are reasons (such asnational sensitivities) for retaining a particularpublic good at national level, the rationale shouldbe made explicit.

• A substantial reduction in the share of the CAP

would nevertheless free resources (and, perhapsmore importantly, create political room formanoeuvre) for other purposes, alter the arith-metic of net contributions and have a positiveeffect on the EU’s position in the Doha Roundnegotiations. The details are bound to be con-tentious, but there are essentially two ways ofachieving the outcome, bearing in mind that anagricultural policy remains a Treaty commitment:co-financing of the existing CAP from nationalexchequers or further changes in the CAP itselfthat reduce its budgetary demands.

• A coherent and transparent system for funding the

budget is needed, with an end to ad hoc arrange-

ments. Again, there are two approaches: fund thebudget entirely from intergovernmental transfersfrom Member States (with some reflection onwhether fairness should be achieved by keepingthe payments purely proportional or having adegree of progressivity); or establish “owned”taxes for Europe.The inter-governmental transferapproach has the undeniable merit that it worksand (unless the possibility of reneging, as hasoccurred sporadically for international organisa-tions, arises) will continue to work to assure ade-quate resources. Taxes for Europe would bemessier, but more in keeping with the Treaty andwith accepted norms of accountability.

• Net contributions should no longer be abated.

Instead, it should be incumbent on MemberStates to accept that once the major decisions onexpenditure are taken, the distributive conse-quences should be accepted. Inevitably, thiswould lead to Member States holding out forpolicies that favour them, but the overall impactshould be to make scrutiny of policies moreintensive.

• 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 politi-cal problems associated with schemes such as theGerman Finanzausgleich are well-known, butthey offer a more coherent and politically openmeans of settling the question than each financeministry showing up for the periodic MFF negoti-ations with an increasingly elaborate Excelspreadsheet into which the latest proposals arefed so as to work out net balances.

• The political and budgetary cycles should be better

aligned. It is an open question whether the opti-mal combination would be for the budget to bemid-point to mid-point of the five-yearly cycle forthe Commission and the European Parliament orprecisely aligned. It is difficult to see why the bud-get should be on a seven-year cycle.

An immediate reaction to this list is sure to be that itexemplifies the old joke about the economist on adesert island confronted with a tin of food, whoanswers the question “how do we open it?” by stat-ing “assume a tin opener”. But even if some of theforgoing proposals seem fanciful, the sceptical read-er is invited to write down on a blank sheet of paperwhat would be included if an EU budget weredesigned from first principles. The difficulty facing

the budget is the continuing uncertainty about whatthe EU is supposed to be, an uncertainty that makesit hard to define what sorts of public goods the EUshould provide. The answer may only be implement-ed a decade or more hence, but will the 2008/2009review be far-sighted enough to provide a roadmapto it?

References

Blankart, C. B. and C. Kirchner (2003), The Deadlock of the EUBudget: An Economic Analysis of Ways In and Ways Out, CESifoWorking Paper 989.

Begg I. (2005) Funding the European Union, London: The FederalTrust.

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 OwnResources, Draft Report, BUDG_PR(2007)382623, EuropeanParliament.

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 aGenuine Own Resource: The Case for a European Tax, Etudes etRecherches, Paris: Notre Europe.

Oates, W.E. (1999), “An Essay on Fiscal Federalism”, Journal ofEconomic Literature 37, 1120–1149.


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AIRLINE EMISSIONS OF

CARBON DIOXIDE IN THE

EUROPEAN TRADING SYSTEM

JOHN FITZGERALD AND

RICHARD S. J. TOL*

Carbon dioxide emissions from international avia-tion are small but growing much faster than othergreenhouse gas emissions. To date, aviation emis-sions have been excluded from climate policy, inter

alia because it is an international industry regulatedby consensus. Recently, however, the EuropeanCommission has announced that aviation emissionswill be part of the European Trading System (ETS)for carbon dioxide. Specifically, permits will be need-ed for all emissions from flights from and to an air-port in the European Union.1 This note investigatesthe implications for emissions, for travel patterns,and for the financial position of airlines.

This note builds on Tol (forthcoming). That paperwas written when taxing aviation emissions was aremote prospect, and the policy scenarios there dif-fer from the current policy proposals – particularly,the previous paper considers a global tax, while thecurrent paper studies a European permit trade.Similarly, Michaelis (1997), Olsthoorn (2001) andWit et al. (2002) analyse different policies than whatis currently being proposed.

The paper only considers international aviationdemand by tourists. Domestic air travel is excluded,as is travel for business purposes. There is a globaldatabase of reasonable quality on internationaltourist travel – but there is nothing of the sort fordomestic tourist travel or for business travel. So, achoice has to be made between comprehensivenessin a geographic sense, and comprehensiveness in atravel sense. The current paper opts for the former,which of course does not make the latter less rele-vant. Note that business travellers are less likely torespond to price changes than are tourists.

The paper only considers shifts in demand inducedby an increase in the price of air travel. Of course,carbon pricing would also induce changes in flightbehaviour, aircraft technology, and perhaps fuel

choice – each of which would reduce carbon dioxideemissions (Bates et al. 2000; Wit et al. 2002, 2005;Wulff and Hourmouziadis 1997).This would dampenthe price signal to the traveller, so that this modeloverestimates the economic impacts but underesti-mates the effect on emissions. The results suggestthat this is not a major problem. Note that aircraftand fuel are fixed in the short-term. Airport author-ities and air control determine the most crucialaspects of flight behaviour – taxiing, take-off, andlanding – although the airlines pay for the emissions;little change is expected, therefore.

The model

Simulations are done with the Hamburg TourismModel (HTM), version 1.3. Previous work focussedon climate change (Hamilton et al. 2005a,b; Biganoet al. 2005). The current version is designed toanalyse climate policy (Tol forthcoming).

HTM predicts the numbers of domestic and interna-tional tourists from 207 countries, and traces theinternational tourists to their destinations. Tourismdemand is primarily driven by per capita income.Destination choice is driven by income, climate,coast, and travel time and cost. Carbon pricing wouldincrease the travel cost, but leave other factors unaf-fected. See Tol (forthcoming) for details.

Data were primarily taken from WTO (2003) andEuroMonitor (2002). Behavioural relationships wereestimated for 1995 (the most recent year with rea-sonably complete data coverage), and used to inter-polate the missing observations. Observations ontravel time and travel cost are very limited. Here,travel time and cost are assumed to be linear in thedistance between airports, using data for Heathrow,Europe’s busiest airport.The airfare elasticity of des-tination choice equals – 1.50 + 0.14lny, where y is theaverage per capita income in the country of origin.For UK travellers, the elasticity equals – 0.45, whichcompares well to the estimates of Oum et al. (1990),Crouch (1995), Witt and Witt (1995) and Wohl-gemuth (1997).

The model was used to predict tourist numbers for1980, 1985, and 1990, and shown to have a predictivepower of well above 70 percent.

Carbon dioxide emissions equal 6.5 kg C per pas-senger for take-off and landing, and 0.02 kg per pas-

* Economic and Social Research Institute, Dublin.1 http://ec.europa.eu/environment/climat/aviation_en.htm

senger-kilometre (Pearce and Pearce 2000). No hol-idays at less than 500 km distance (one way) areassumed to be by air, and all holidays beyond 5000km are assumed to be by air; in between the fractionincreases linearly with distance. For island nations,the respective distance are 0 and 500 km.Total mod-elled emissions in 2000 are 140 million metric tonnesof carbon, which is 2.1 percent of total emissionsfrom fossil fuels. This is from tourism only. Totalinternational aviation is responsible for some 3 per-cent of global emissions.2 There are no publishednumbers on the share of tourism in total interna-tional travel.

Scenarios and Results

Scenarios

The model was calibrated for 1995. From 1995 to2004, populations and economies grow as observed.Between 2005 and 2020, growth rates gradually con-verge to the SRES A1 scenario (Nakicenovic andSwart 2001). The price of oil is kept constant at theprice in September 2006. Results are presented for2010 only, and in deviations from the baseline, so thatthe baseline details are largely irrelevant.

Eight different prices of carbon permits are consid-ered, 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 carbonfor a 3 percent (1 percent) pure rate of time prefer-ence; 240 €/tC is the value recommended by Stern etal. (2006); 18 €/tC was the priceof carbon permits in the ETS atJanuary 5, 2007; 10, 50 and100 €/tC are round numbers inbetween.

Following the proposal by theEuropean Commission, permitsare assumed to be needed for allemissions from flights to andfrom any airport in the Euro-pean Union. Norway has an-nounced it will join, while Ice-land and Switzerland areassumed to follow suit. Peopleresiding in the European Union

account for 19 percent of all tourism aviation emis-sions. However, emissions on flights to and from theEU account for 58 percent of global emissions. Thedifference is because Europe is a popular holidaydestination for people from all over the world, andtourists from outside the EU fly longer distances.Note that airlines have questioned the jurisdiction ofthe European Commission.

Emissions

Figure 1 shows the effect of carbon dioxide emis-sions trading. The change in global CO2 emissionsis approximately linear in the permit price. This isno surprise if one considers the scale of change inemissions: Global emissions from internationaltourism aviation fall by less than 0.14 percent if thepermit price is 240 €/tC. If the price of permits is asit was in early January of 2007, emissions fall by0.01 percent. For emissions by EU residents, therespective numbers are 0.28 percent and 0.02 per-cent.

Tourist numbers

The change in international arrivals in the EuropeanUnion is larger than the change in emissions, as non-EU tourists choose the fly to other destinations. Stillnumbers are small, less than a 0.6 percent drop. Thereduction in tourist numbers is not evenly spread inEurope. Peripheral island nations such as Cyprus,Malta, and Ireland see the largest reductions(– 1.16 percent, – 1.04 percent and – 0.90 percent, for240 €/tC). Slovakia (– 0.43 percent) is affected least– generally, central countries that can also bereached by car or train face below-average impacts.


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-0.14

-0.12

-0.10

-0.08

-0.06

-0.04

-0.02

0.00

0 25 50 75 100 125 150 175 200 225 250

EMISSIONS AS A FUNCTION OF PERMIT PRICE

global aviation carbon emissions (% change)

Source: Own calculation.

permit price (€/tC)

Figure 1

2 See http://themes.eea.europa.eu/En-vironmental_issues/climate/indicators.


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Countries outside the EU would attract moretourists – the number of European tourists wouldfall only slightly as these tourists pay for their carbonemissions wherever they go, but tourists from China,Japan and the USA would be diverted from Europeto other countries. Nepal and South Korea gain morethan 1 percent for a 240 €/tC permit price.

Airlines

HTM does not explicitly include airline behaviour,but the observed behaviour of power utilities in thecurrent ETS may be a good analogue for what willhappen in the air travel market. As demand is priceinelastic, the costs of carbon permits are by andlarge passed on to electricity consumers. This isbecause the effect on the price of electricity is toosmall to have much effect on competition. In airtravel, the price effect is even smaller, while airlines’emissions are more homogenous so that the compe-tition effect is smaller too. It is therefore safe toassume that the price of permits will be passed on tothe travellers.

Currently, permits are grand-parented in the ETS,that is, companies receive their permits for free; andthe amount of permits is proportional to the emis-sions in a base year. To date, allocated permits are infact almost equal to the expected emissions in thetarget year – the basic reason why the permit price isso low.

Under these assumptions, Figure 2 shows the valueof the grandparented permits to the airline industryas a function of the permit price. At the permit priceof early January 2007, the airline industry would be

given assets with a total value of €3.0 billion peryear. At the permit price advocated by Stern et al.(2006), the subsidy would amount to €39.6 billion. Incomparison, the US industry received a hand-out of€1.9 billion in response to the 9/11 terrorist attack onthe World Trade Center.3

An annual subsidy of this size to incumbents wouldincrease the barriers to entry for new airlines.Grandparenting similarly rewards slow-growingairlines at the expense of fast-growing ones. Low-cost carriers face a proportionally higher priceincrease than other carriers. These three effectsimply a reduction in competition in the air travelmarket. As taxiing, take-off and landing are moreenergy-intensive than cruising, tradable permits hitcompanies that specialise in short-haul flights rela-tively harder than companies that specialise inlong-haul flights.

If carbon permits were auctioned rather than grand-parented, the airline industry would not receive thewind-fall discussed above. Instead, the money wouldflow to the government. If the government spendsthat money wisely or cuts taxes, then this corre-sponds to a redistribution of a relatively smallamount of money from air travellers to the generalpublic.

Airports

European airports would see a reduction in numberof travellers. As discussed above, the changes in thenumber of tourists to and from Europe are verysmall. However, the number of transiting passengersmay fall more substantially. Under the proposed

rules, emission permits are need-ed for the entire trip New York-Frankfurt-Johannesburg, butnone for the longer trip NewYork-Dubai-Johannesburg.Similarly, a trip London-Dubai-Sydney would require less car-bon permits than a trip London-Singapore-Sydney, but emitmore CO2. Over the longer term,hubs may develop just beyondthe European Union – asSwitzerland has not entered intothe ETS, Zurich InternationalAirport may be that hub.0

5

10

15

20

25

30

35

40

45

0 25 50 75 100 125 150 175 200 225 250

SUBSIDY TO THE AIRLINE INDUSTRY AS A FUNCTION OF PERMIT PRICE

permit value (bln €)

Source: Own calculation.

permit price (€/tC)

Figure 2

3 The Economist, September 15, 2005.

Discussion and conclusion

In sum, including aviation emissions in the EuropeanTrading System for carbon dioxide appears to be nei-ther effective nor efficient. Of course, the first bestsolution for an emission reduction policy is to have apermit market that covers all emissions, includingthose from aviation. However, the current market ispartial, and including aviation should not be the firstpriority for extending market coverage.The effect onemissions is minimal, even if the permit price reach-es heights that are inconceivable today. If this werethe only drawback, one may dismiss the inclusion ofaviation emissions in the ETS as largely irrelevant,but a step in the right direction. However, in the cur-rent regime of grandparenting permits, this policy isin fact tantamount to a substantial subsidy to the air-line industry – at the expense of travellers and with-out perceptible gains for the environment. Europeanpoliticians would create the impression of leadershipon climate policy while in fact contributing almostnothing to emission reduction.

The results presented here are uncertain andrequire substantial caveats. A sensitivity analysis onthe many assumptions is not given. However, Tol(forthcoming) shows that the sensitivity of theresults is less than an order of magnitude – even ifthe impact of carbon pricing on emissions were tentimes larger, it would still be very small. The lack oftechnological and behavioural responses in themodel 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 infact not affected by the proposed carbon pricing.Therefore, including aviation emissions in the ETSwill, at best, have no effect on emissions and, atworst, have no effect on emissions but give a hand-some subsidy to the airlines.

References

Bates, J., C. Brand, P. Davison, and N. Hill (2000), EconomicEvaluation of Emissions Reductions in the Transport Sector of theEU, AEA Technology Environment, Abingdon.

Bigano, A., J. M. Hamilton and R. S. J. Tol (2005), The Impact of Cli-mate Change on Domestic and International Tourism: A SimulationStudy, Research unit Sustainability and Global Change FNU-58,Hamburg University and Centre for Marine and AtmosphericScience, Hamburg.

Crouch, G. I. (1995), “A Meta-Analysis of Tourism Demand”, Annalsof 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), “ClimateChange and International Tourism: A Simulation Study”, GlobalEnvironmental Change 15, 253–266.

Hamilton, J. M., D. J. Maddison and R. S. J. Tol (2005), “The Effectsof Climate Change on International Tourism”, Climate Research 29,255–268.

Michaelis, L. (1997), Special Issues in Carbon/Energy Taxation:Carbon Charges on Aviation Fuels – Annex 1 Export Group on theUnited Nations Framework Convention on Climate Change WorkingPaper no. 12, Organization for Economic Cooperation and De-velopment, Paris, OCDE/GD(97)78.

Nakicenovic, N. and R. J. Swart (2001) IPCC Special Report onEmissions Scenarios. Cambridge: Cambridge University Press.

Olsthoorn, A. A. (2001), “Carbon Dioxide Emissions from Inter-national Aviation: 1950-2050”, Journal of Air Transport Manage-ment 7, 87–93.

Oum, T. H., W. G. Waters, II, and J. S. Yong (1990), A Survey of Re-cent Estimates of the Price Elasticities of Demand for Transport,World Bank, Washington DC, 359.

Pearce, B. and D. W. Pearce (2000), Setting Environmental Taxes forAircraft: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 ofClimate Change, HM Treasury, London.

Tol, R .S. J. (2005), “The marginal damage costs of carbon dioxideemissions: an assessment of the uncertainties”, Energy Policy 33,2064–2074.

Tol, R. S. J. (forthcoming), “The Impact of a Carbon Tax on Inter-national Tourism”, Transportation Research D: Transport and theEnvironment.

Wit, R. C. N., J. W. M. Dings, P. Mendes de Leon, L. Thwaites,P. Peeters, D. Greenwood, and R. Doganis (2002), Economic In-centives to Mitigate Greenhouse Gas Emissions from Air Transportin Europe, CE Delft, Delft, 02.4733.10.

Wit, R. C. N., B. H. Boon, A. van Velzen, A. Cames, O. Deuber, andD. S. Lee (2005), Giving Wings to Emissions Trading – Inclusion ofAviation under the European Trading System (ETS): Design andImpacts, CE, Delft, 05.7789.20.

Witt, S. F. and C.A. Witt (1995), “Forecasting Tourism Demand: AReview of Empirical Research”, International Journal of Forecast-ing 11, 447–475.

Wohlgemuth, N. (1997), “World Transport Energy Demand Modell-ing – Methodologies and Elasticities”, Energy Policy 25, 1109–1119.

WTO (2003), Yearbook of Tourism Statistics, World Tourism Orga-nisation, Madrid.

Wulff, A. and J. Hourmouziadis (1997), “Technology Review ofAeroengine Pollutant Emissions”, Aerospace Science and Tech-nology 8, 557–572.


Special


Spotlights

RECENT ECONOMIC GROWTH

AND CHALLENGES FOR CHINA,INDIA AND OTHER EMERGING

ASIAN COUNTRIES

China and India have recently been the growthengines of the Asian economies. In the last threeyears, from 2004 to 2006, the real GDP growth rateamounted to 10 percent and 8 percent in Chinaand India, respectively. Similarly high economicgrowth is anticipated in China also in 2007, whilethe IMF projects a slight decline of the growth rateof India from 8.3 percent in 2006 to 7.3 percent in2007 (Figure 1).1 Economic growth in China hasmostly been triggered by the rapid increase ininvestment and net exports. On the other hand, inIndia inflation has picked up due to rising oilprices and strong domesticdemand, which forced theReserve Bank of India to raiseinterest rates (Figure 2). Theeffect of higher oil prices andtighter monetary controls as apolicy response were also themajor causes of the slow eco-nomic growth in the ASEAN-4countries (Indonesia, Thailand,Philippines and Malaysia) in2005 and 2006. A slight growthimprovement is expected inthese countries in 2007.

Economic expansion in thenewly industrialised economies(NIEs) during the last twoyears was particularly led bythe increase in exports of elec-tronic goods. The NIEs havealso benefited from the rapidgrowth of the Chinese economyand the favourable economicperformance of some advancedeconomies including the UnitesStates and Japan. These twodeveloped countries have tradi-tionally been the major desti-nations of these countries’

exports. Such a close trading relationship is the rea-son why the IMF forecasts a slight decline of theeconomic growth rate of the NIEs in 2007, sincethe growth and, consequently, the import demandsof these advanced economies are expected todecelerate.

However, there are some additional near-termrisks to the economic outlook for the emergingAsian countries. First of all, there is a general fearthat, in the absence of a properly functioning mar-ket mechanism, the investment-led growth willlead China into one boom-bust cycle after anoth-er, with each boom less sustainable than the previ-ous one. The current exceptionally rapid invest-ment growth could result in overinvestment, realestate speculation and falling profits for the cor-porate and financial sectors in China. An expan-sion of private investment is required, however, to

-2

0

2

4

6

8

10

2004 2005 2006 2007

China India ASEAN-4 NIEs Japan

Source: IMF.

DEVELOPMENT OF CONSUMER PRICES IN ASIAN COUNTRIES

Annual percentage change%

0

2

4

6

8

10

12

2004 2005 2006 2007


Source: IMF.

REAL GDP GROWTH IN ASIAN COUNTRIES

Annual percentage change%

Figure 2

Figure 1

1 International Monetary Fund (IMF),World Economic Outlook, September2006, Washington DC, Ch. 2

revive economic growth in the ASEAN-4 andmany other emerging Asian countries.

Secondly, although many emerging Asian coun-tries have had current account surpluses (Figure3) and have accumulated substantial foreign cur-rency reserves, they could also be vulnerable to asudden deterioration in international financialmarket conditions. Furthermore, due to strongdomestic demand growth accompanied by high oilprices, some Asian countries could experience afurther deterioration in their current accounts(for example, India and Thailand). For China,however, the IMF recommends a substantialrevaluation of the renminbi to dampen the growthof the current account surplus and to give the cen-tral bank control of domestic monetary condi-tions. According to the IMF’s assessment, the cen-tral bank’s present policy focus on reducing therenminbi’s fluctuation against the dollar has madeeffective liquidity control difficult, and the smallinterest rate increases have not been sufficient torestrain the strong credit growth, which, in turn,has contributed to the investment boom in thiscountry.

The favourable economic outlook provides opportu-nities for fiscal reforms in a number of Asian emerg-ing countries. In particular India, Pakistan and thePhilippines require urgent budget consolidation andthe reduction of public debt. Since governments inthe Philippines and Indonesia have a large share offoreign debt, a continuous fiscal improvement wouldalso lead to reduced vulnerability of these countries’economies to external shocks. In spite of the prevail-ing strong spending pressures, a gradual consolida-

tion also appears to be necessaryat both the central and the stategovernment levels of India. Tax-base broadening combined withsubsidy cuts would be an appro-priate policy option.

NCW


Spotlights

-4

-2

0

2

4

6

8

2004 2005 2006 2007


Source: IMF.

DEVELOPMENT OF ACCOUNT BALANCE IN ASIAN COUNTRIES

Percent of GDP%

Figure 3


Trends

FINANCIAL CONDITIONS

IN THE EURO AREA

The annual rate of growth of M3 stood at 9.8% in January 2007,unchanged from the previous month. The three-month average of theannual growth rate of M3 over the period November 2006 – January2007 rose to 9.7%, from 9.2% in the period October 2006 – December2006.

In January 2007 the monetary conditions index has continued its declinethat has started in late 2005, signalling greater money tightening. This isthe result of rising real short-term interest rates and a rising real effectiveexchange rate of the euro.

In the three-month period from December 2006 to February 2007,short-term interest rates rose continuously. The three-month EURI-BOR increased from an average 3.68% in December to 3.82% inFebruary. Ten-year bond yields rose from 3.90% in December 2006 to4.12% in February 2007. In the same period of time the yield spreadwidened 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 and4,230 in February. The Dow Jones Industrial continued to rise inFebruary, averaging 12,631 points. However, all these stock market indi-cators declined in March.

According to the first Eurostat estimates, euro area real GDP grew by0.9% in the fourth quarter of 2006, compared to the previous quarter. Inthe third quarter of 2006 growth rates were 0.6% in both the euro areaand the EU25.

The EU Economic Sentiment Indicator increased in both the EU andthe euro area in February.The indicator rose by 1.3 points in the EU andby 0.5 of a point in the euro area, to 112.0 and 109.7, respectively. Overalleconomic 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 thequestions on production expectations, order-books and stocks (the latter withinverted sign).** New consumer confidence indicators, calculated as an arithmetic average of thefollowing questions: financial and general economic situation (over the next12 months), unemployment expectations (over the next 12 months) and savings(over the next 12 months). Seasonally adjusted data.

In February 2007 the industrial confidence indicator rose in the EU, whileit remained unchanged in the euro area. Yet, the indicator remains at avery high level in both areas. Consumer confidence also improved in boththe EU and the euro area. In both areas, the consumer confidence indi-cators remained on an upward trend and stand well above their long-term average.

In February 2007 managers’ production expectations remained constantin the EU, while their assessment of order books and stocks of finishedproducts improved in the manufacturing sector. The assessment of orderbooks improved from 2.4 in January to 4.2 in February. Capacity utilisa-tion also rose to 84.1 in the first quarter of 2007 from 83.5 in the previousquarter.

EU SURVEY RESULTS


Trends


Trends

The exchange rate of euro against the US dollar averaged 1.31 $/€ inFebruary 2007, slightly up from 1.30 $/€ in January. In December 2006the rate amounted to 1.32 $/€, one of the highest values since 1993.

The Ifo indicator for the economic climate in the euro area improved inthe first quarter of 2007 following a moderate cooling in the second halfof 2006. The improvement applied to both the assessments of the currenteconomic situation as well as to the expectations for the coming sixmonths. The Ifo indicator thus predicts a continuation of the robustEuropean economic upturn in the first half of 2007.

Euro area unemployment (seasonally adjusted) declined to 7.4% inJanuary 2007 compared to 7.7% in the previous five months, and waslower than the year earlier rate of 8.3%. EU25 unemployment stood at7.5% in January 2007, the lowest in the investigated years as well: Thisvalue is 0.8 points lower than a year earlier. Among the EU MemberStates the lowest rate was registered in Denmark (3.2% in December2006), the Netherlands (3.6%) and Estonia (4.2%). Unemployment rateswere 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-wideHICP comparison shows that in February 2007 the lowest annual rateswere observed in Malta (0.8%), France, Cyprus and Finland (all 1.2%),and the highest rates in Hungary (9.0%), Latvia (7.2%), Bulgaria andEstonia (both 4.6%). Year-on-year EU 12 core inflation (excluding ener-gy and unprocessed foods) rose to 1.90% in February 2007 from 1.78%in January.

EURO AREA INDICATORS

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