Introduction

The twelve states¹ that entered the European Union (EU) in 2004 achieved considerable macroeconomic stabilization during the accession process. The Central and Eastern European (CEE) countries among them went through the transition from central planning to market economies, beginning with severe recessions, high inflation, and financial instability. In due course, the inflation rates came down and nominal interest rates declined. Public debt has been stabilized, though high and persistent deficits and the need for further fiscal adjustments are still critical issues in several cases.

In the years to come, the new EU member states will face two principal challenges in formulating macroeconomic policies. The first is to manage the continued and likely rapid process of further real economic convergence, which will come with high real GDP and productivity growth rates and large capital inflows. The second is to achieve the degree of nominal convergence required to enter into (the Third Stage of) European Monetary Union (EMU). These two challenges are not unrelated, as rapid growth and large capital inflows can make it more difficult to achieve nominal convergence, although, as we have argued in a recent paper (von Hagen and Traistaru-Siedschlag, 2006), there are good reasons to believe that real convergence would be easier to manage for some of the countries at least, if they were allowed to adopt the euro immediately. Both challenges relate mainly to fiscal policy: Managing capital inflows, because fiscal policy can absorb part of their demand effects; and nominal convergence, because the sustainability of public finances is part of the requirement for entering EMU.

Lifting capital controls and restrictions on foreign currency trade was one of the conditions these states had to meet to qualify for EU membership. Thus, the CEE countries went from being largely closed to being largely open to international capital flows. This paper discusses their experience with capital account liberalization and with coping with large capital inflows. We begin in Section 2 with a discussion of basic economic characteristics and the real convergence achieved so far. In Section 3, we discuss the pace and sequencing of capital account liberalization and the degree of international financial integration achieved so far. Given the different initial conditions and economic characteristics of Cyprus and Malta, we focus on the CEE group. Further, in Section 4 we analyze trends and patterns of capital inflows in these countries in recent years. Some stylized facts are useful for understanding the macroeconomic implications and policy challenges of coping with large capital inflows discussed in Section 5. Finally we conclude in Section 6 with policy implications for emerging Asian countries.

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