Seminar Paper:

REGIONAL INEQUALITY IN THE SLOVAK REPUBLIC

Lecturer:

Prof. Dr. Emma Aisbett Junior Professor for International Economics Department of Socioeconomics University of Hamburg

Graduate program:

Master of Arts European Studies

Class:

Globalization, Development, Poverty and Inequality

Delivered by:

Marek Plavcan Wiesendamm 135 22303 Hamburg Matriculation No.: 6410204

Table of Contents
Introduction ......................................................................................................................... 2 1. Convergence and Divergence Hypothesis ................................................................... 3

1.1. Convergence Theories ................................................................................................. 3 1.2. Divergence Theories .................................................................................................... 4 2. Regional Inequalities in Slovakia ................................................................................ 6

2.1. Changes in Regional Disparities.................................................................................. 7 Conclusion .......................................................................................................................... 9 References ......................................................................................................................... 10

Introduction
Since the end of 1990s, Slovakia has experienced a solid period of economic growth. This was described by some observers as a success story and, more creatively, earned it the nickname Tatra Tiger1, which refers to the mountains in the northern part of the country. Indeed, a range of structural reforms in the late 1990s caused an increase in the employment rate and FDI inflows. Additionally, it enhanced the countrys economic growth. The EU accession in 2004 provided another strong pro-growth impetus and, together with the NATO accession, also a sign of political stabilization. Slovak GDP growth rate reached its peak of 10.4% in 2007 and the country successfully adopted Euro as its currency in 2009. However, significant regional inequalities in Slovakia became obvious immediately after the fall of distributive socialist policies in 1989, accompanied by the ultimate split of Czechoslovakia in 1993. Since then, geographic dispersion of economic activities has been shaped by a clear bipolar pattern of growing west and lagging-behind east. Even today, in terms of GDP per capita in purchasing power standards, the western metropolitan region of Bratislava belongs to the riches regions of the EU, outstripping areas such as Oberbayern (the region of Munich), Stockholm or Vienna. On the other hand, two eastern regions, Presov and Kosice, find themselves at the very end of the chart. The main research question of this paper is whether and why the regions of Slovakia at NUTS32 level really diverged in terms of GDP per capita or, on the contrary, experienced a period of cohesion after EU accession. Whereas Aisbett (2005) asked why critics think globalization is bad for the poor, this paper freely continues the discussion by inquiring whether globalization stimulates poor regions within a country to grow faster than rich ones. Relevance of the research question is highlighted by the fact that two opposing theoretical approaches dominate the academic discourse and that its findings might deliver relevant policy implications. The following section sheds more light on the two prevailing theories and, in the end, I examine FDI inflows to individual regions as one of assessing indicators of their growth potential.

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http://www.businessweek.com/adsections/2006/pdf/080706_Slovakia.pdf [Accessed on May 23, 2013] The NUTS classification (Nomenclature of territorial units for statistics) is a hierarchical system for dividing up the economic territory of the EU for the purpose of statistics. From now onwards, I call one NUTS3 unit a region.

1.

Convergence and Divergence Hypothesis

At the time of Slovak accession to the EU in 2004, there was a widespread perception

among many economists that integration and regional inequalities were positively correlated. This means that integration into European structures would deepen regional disparities and, indeed, enrich the west and impoverish the east. Today, at the end of each workweek, trains from the Slovak capital Bratislava heading to the east are enormously overcrowded. The same is true for trains in the opposite direction every Sunday afternoon, when the high number of workers commutes back to their workplaces. This regular oscillation is a result of much better job opportunities and higher wages in Bratislava, but also of much higher cost of living therein. Precisely the opposite few jobs and low pricesis true for eastern Slovakia. Have regional disparities decreased since the country was integrated into the European common market? As it is not possible to summarize all academic views on distributive effects of economic integration and trade liberalization on regional inequality, structured overview is given way at the expense of an extensive survey of literature. Boldrin and Canova (2001, p. 211) identify two broad hypotheses, which differ in their assumptions about the underlying engine of growth. 1.1. Convergence Theories The convergence hypothesis is based on the traditional neo-classical growth model originating in the work of Solow (1956)3. Applied to the regional level, the basic assumption of this model is that returns to capital are higher in poorer regions. As integration and trade liberalization enable free movement of factors of production, capitaltogether with technology and knowledgeflow from wealthier to poorer regions because of higher marginal returns to capital. Consequently, poorer regions grow faster, so that overall convergence in the levels of incomes, costs, productivity and living standards takes place (Barro and Sala-i-Martin, 1991). In general, basic Ricardian logic is also applicable, meaning that all regions realize their comparative advantage, which ultimately benefits all participants (Dunford, 1994). If persisting inequalities occurred, neo-classical economists would most probably explain them
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Cf. Ramsey (1928), Cass (1965) and Koopmans (1965).

through imperfect mobility of the factors of production, such as labor market rigidity. Mankiw et al. (1992) found strong evidence in favor of the Solow model, whereas Barro and Sala-iMartin (1991) confirmed overall convergence for the United Kingdom and Italy. Similarly, the Heckscher-Ohlin-Samuelson4 model also seems to suggest reduction of inequalities in poorer countries. That is to say, higher-income countries tend to be abundant in capital and skilled labor, whereas lower income countries in less-skilled labor. Therefore, [o]penness should increase inequality in countries where capital and skilled labor are abundant, but it should have the opposite effect where less-skilled labor is relatively abundant (Brune and Garrett, 2005, p. 401). In a weak version of the convergence hypothesis, transfers of technology, knowledge and innovation also play a crucial role. However, wrong socioeconomic measures may hinder their full utilization. Unnecessary governmental intervention, serving as an artificial barrier to trade, reduces the incentive to adopt the most efficient technique, thereby preserving enclaves of low total factor productivity (Boldrin and Canova, 2001 p. 214). Therefore, convergence is partly conditional upon full adoption of most efficient techniques and complementary government policies. Nevertheless, given that in 2004 Slovakia was a low-income country relatively abundant in less-skilled labor, poorer regions should have experienced higher economic growth according to both the strong and weak version of the convergence hypothesis. 1.2. Divergence Theories Critics of the previous view have always argued that growth is a spatially selective and cumulative process, which is likely to increase regional inequalities (Petrakos, 2009 p. 34). According to divergence theories, economic integration creates regional winners and losers, and any comparative advantage plays merely a secondary role. Several strands have developed so far along two main sub-approaches: the endogenous growth theory by Romer (1994) and the new economic geography by Krugman (1991) and Krugman and Venables (1995). Whereas the endogenous growth theory elaborates on the decisive importance of human capital and knowledge, the new economic geography focuses
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Interestingly, Rodrguez-Pose and Gill (2006) derived a completely opposite message from the H-O model, predicting higher inequality for a country which had already been divided into core and periphery at the time of opening to trade. They assumed that integration enhances trade in manufactured good and the manufacturing sector had already been concentrated in the core.

on trade costs and increasing returns. The following paragraphs shed light on the major interlinked arguments of these approaches supporting the thesis that integration intensifies existing core-periphery patterns or helps to create new ones. Agglomerations and economies of scale. Concentrated localization of firms decreases the marginal cost and allows them to benefit from increasing returns to scale. As integration essentially opens new markets and facilitates the utilization of foreign resources, the incentive to create agglomerations is even more powerful. That is, new available factors of production are likely to be sent to the industrialized core regions within a country, which then grow relatively faster and leave the disadvantaged regions further behind (Krugman, 1991; Dunford, 1994; Fingleton and McCombie, 1998; Puga, 1999; Paluzie 2001; Petrakos, 2009). This argument is also supported by Hirschmans (1958) forward linkages, meaning proximity to marketsbe they other firms or final consumersand backward linkages in the sense of proximity to suppliers of inputs. Both forward and backward linkages attract new firms and workers. Human capital, knowledge spill-overs and infrastructure. Many studies emphasize that regions abundant in the highly skilled labor force and those supporting science and R&D tend to be more innovative and grow faster (Lucas, 1988; Dunford, 1994; Rodrguez-Pose and Gill, 2006). These regions are usually already industrialized areas with higher wages. From an extreme perspective, Martin (1997) concludes that an improvement of education in poorer regions may lead to a sort of brain-drain toward rich regions and result in overall higher growth, but divergence. Market structure. From a similar perspective as in the previous point, urbanized and industrial areas are likely to specialize in high-tech industries and services. Integration is supposed to favor trade in more competitive industries, whereas the regions which specialize in agriculture or low-tech industries will be exposed to increased competition. As a result, divergence will take place because of regional specialization in different sectors (Krugman, 1991; Paluzie 2001). Geographical proximity to the European gravity center5 is often used as an indicator of why some regions catch up faster than others. Regions located far from main growth poles

Some authors argue that the European gravity center is the area inside of the pentagon shaped by London, Paris, Milan, Munich and Hamburg (Fana & Lpez-Rodrguez, 2004).

are worse accessible and they will receive a smaller number of lower order activities or will be totally ignored by foreign capital (Petrakos, 2009, p. 36). Finally, a weak version of the divergence hypothesis assumes that, in order to reach sustainable growth in all areas, a minimum level of initial endowment to produce positive externalities should be achieved in poor regions. Without any intervention, regions form socalled convergence clubs, meaning they tend to converge at constant speed within6 several groupings based on their initial abundance of endogenous inputs (Boldrin and Canova, 2001). To conclude, the main outcome provided by the divergence theories is that there is a trade-off between economic growth and convergence (Martin and Ottaviano, 1999; Boldrin and Canova 2001; Martin, 2002). Since economic integration provides a strong pro-growth stimulus, inequality among regions is claimed to be an inevitable necessity. The weak version of the divergence hypothesis suggests that regions diverge less under an appropriate regional policy mix.

2.

Regional Inequalities in Slovakia

In his chapter in a World Bank report, Bruncko (2003, p. 190) rather favoured the

divergence hypothesis by stating that the EU integration was not likely to boost the local demand for Slovak firms situated in the east, and could exacerbate economic disparities between the capital and the rest of the country. As the theories actually provide a reasonable explanation for both developments, it may be that his statement was based on empirical evidence from other countries. However, in spite of abundant research, empirical findings are also ambiguous. Consider the so-called Cohesion Countries which entered the EU in 1981 (Greece) and 1986 (Portugal, Spain). Precisely after the accession in 1981, Greek regions converged faster than ever before (cf. Petrakos and Saratsis 2000; Bouvet, 2008). Inequalities in Portugal had been falling constantly between 1977 and 1995, although they increased in the early 1990s (Bouvet, 2008; Cant et al., 2000). In Spain, inequalities fell in the 1980s, although, contrary to Portugal, they did not increase again in the 1990s. Countries that entered the EU in 1995 (Austria, Sweden and Finland) were no less ambiguous. Inequalities clearly increased in Finland and Sweden, but sharply decreased in Austria (Bouvet, 2008; Melchior, 2008; Petrakos, 2009).
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Convergence occurs within convergence clubs, but not among them. Since more endowed regions converge faster than the less endowed ones, divergence takes place among all regions.

2.1.

Changes in Regional Disparities

TABLE 2-1 REGIONAL GDP PER CAPITA (per cent of Slovak average) Region Bratislava Trnava Trenn Nitra ilina Bansk Bystrica Preov Koice Total 2004 226 106 93 88 81 82 60 88 100 2005 243 108 88 89 82 72 59 84 100 2006 233 122 93 86 81 74 55 84 100 2007 236 120 92 84 84 74 55 82 100 2008 231 115 91 85 87 75 59 82 100 2009 244 111 89 85 87 73 58 78 100 2010 241 112 89 83 89 74 57 79 100

Source: Statistical Office of the Slovak Republic

The first observation is that regional GDP per capita diverged. In comparison to 2004, the percentage of GDP per capita has increased in three regions: Bratislava, Trnava and ilina. It went down in other five regions, most notably in Koice and Bansk Bystrica. A closer look confirms that Bratislava may be described as an agglomeration with GDP per capita of 241% of average in 2010with less than 12% of the population producing more than 27% of the Slovak GDP.
TABLE 2-2 PRODUCTIVITY AND WAGE DIFFERENTIALS (per cent of Slovak average) Productivity* Region Bratislava Trnava Trenn Nitra ilina Bansk Bystrica Preov Koice 2004 182,4 94,9 84,5 91,7 83,7 92,5 67,9 102,4 2007 195,4 108,4 87,7 83,2 85,9 82,5 59,9 97,1 2010 202,7 102,1 84,8 84,9 93,3 78,8 62,8 90,5 Average monthly wage 2004 132,8 92,7 87,9 83,7 88,0 84,1 79,2 97,6 2007 131,1 95,1 87,1 82,4 88,1 83,7 74,5 93,7 2010 128,9 91,7 85,4 82,7 89,2 82,6 77,2 93,1

* Regional value added per person employed. Sources: Statistical Office of the Slovak Republic, authors calculations

The question arises, whether this disparity between Bratislava and other regions is also reflected in differentials in wages and productivity. Table 2-2 shows rates for three referential years: 2004 as the year of EU accession, 2007 as the pre-crisis year and 2010 for the most recent data. The Table 2-2 shows an important figure: within the given period, workforce productivity diverged. It increased in three western regions (Bratislava, Trnava and ilina) whereas regional differentials in monthly wages stayed approximately at the same level. One way of observing the effects of economic integration is to focus on FDI inflows. After the accession, some foreign companies were in the position to choose the target region of their investments. Some observers would then argue that FDI inflows were allocated in regions with the cheapest labor force (Preov, Nitra, Bansk Bystrica). On the other hand, divergence theories would suggest that FDI flowed to regions with high productivity relatively to wages (Bratislava).
TABLE 2-3 REGIONAL FDI INFLOWS UNTIL 2011 Region Bratislava Trnava Trenn Nitra ilina Bansk Bystrica Preov Koice Total
Source: National Bank of the Slovak Republic

(Mil. Eur) 26 806 640 2 769 659 1 847 027 1 586 338 2 635 227 997 493 369 024 2 630 501 39 641 910

(% of Slovak average) 67,6% 7,0% 4,7% 4,0% 6,6% 2,5% 0,9% 6,6% 100%

Until 2011, FDI inflows to Bratislava have been higher than twice the inflows to all other regions taken together, contributing thereby to overall divergence. Although it may seem paradoxical, foreign direct investments flowed to the region with wages high above the average. This can be explained precisely by confirming the hypothesis of divergence. New investments accelerated economic growth of the most endowed region and created a selfrepeating cyclical effect. This effect is illustrated by the rise in GDP per capita rate in the Table 2-1. On the contrary, regions with the lowest productivity-wage ratio experienced economic decline. The arguments in support of divergence presented in the section 1.2. fit quite well for Bratislava. The region has extraordinary conditions for realizing economies of scale both at

firm and industry level. High share of services on the market structure, good infrastructure, well-educated labor force and close proximity to Vienna even enhance these tendencies.

Conclusion
In the first section, I presented two contradicting approaches: convergence and divergence theories. A simple observation of GDP per capita changes and FDI inflows revealed that foreign investments to Slovakia ignored cheap labor and flowed to more developed regions. Under these conditions, regional GDP per capita diverged, which precisely confirms that not only people, but also regions tend to gain from globalization [and integration] in proportion to the amount of wealth they already had (Aisbett, 2005, p. 35). As Dunford (1994, p. 105) aptly points out, [g]reater market integration may [] exacerbate regional inequalities and conflict with another EU objective of greater economic and social cohesion. Moreover, if growth and convergence are mutually exclusive, as divergence theories suggest, it may have serious policy implications for the European regional policy of cohesion. Creation of subsidized jobs in underdeveloped regions without increasing productivity of the workforce therein seems to be wasting of European funds. This proves the example of the region Preov, where in 2007 the worker with a productivity rate of 59,9% received 74,5% of the average wage and the region attracted 0,9% of FDI inflows. How to address, given these findings, the divergent development among regions? Puga (1999, p. 29) suggests that the observed process is part of a much broader story in which labor mobility plays the decisive role: The agglomeration of industry tends to raise local wages in locations with relatively many firms. If higher wages lead workers to relocate towards more industrialised regions, this intensifies agglomeration while eliminating wage differentials. If instead workers do not move across regions, interregional wage differentials persist.

In other words, high enough number of workers needs to relocate in response to wage differentials in order to decrease regional inequality. Recalling the initial narrative about full trains heading to Bratislava from the beginning of the first section, we may draw a synthesizing conclusion. If higher labor mobility is indeed the key to decrease regional inequality, perhaps the trains are not full enough, yet.

References
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Mankiw, G. N., Romer, D., Weil, D. N., 1992. A Contribution to the Empirics of Economic Growth. Quarterly Journal of Economics, 107(2), pp. 407-37. Martin, P., 1997. Can Regional Policies Affect Growth and Geography in Europe? CERAS, Paris and CEPR, London. [online] Available at: <http://www.enpc.fr/ceras/martin/WORLDECO.pdf> [Accessed 10 September 2013]. Martin, P., 2002. Public Policies and Economic Geography. CERAS-ENPC and CEPR. [online] Available at: <http://www.enpc.fr/ceras/martin/martin-regionapolicy21octeng.pdf> [Accessed 10 September 2013]. Martin, P., Ottaviano, G. I. P., 1999. Growing locations: Industry location in a model of endogenous growth. European Economic Review, 43, pp. 281-302. Melchior, A., 2008. Regional Inequality and Convergence in Europe, 1995-2005. CASE Center for Social and Economic Research, Warsaw. [online] Available at: <http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1393693> [Accessed 10 September 2013]. Paluzie, E., 2001. Trade policy and regional inequalities. Papers in Regional Science, 80(1), pp. 67-85. Petrakos, G., 2009. Regional growth and inequalities in the European Union. School of Engineering, University of Thessaly, Discussion Paper Series, 15(2), [online] <http://www.prd.uth.gr/research/DP/2009/uth-prd-dp-2009-2_en.pdf> [Accessed 10 September 2013], pp. 23-44. Petrakos, G., & Saratsis, Y., 2000. Regional inequalities in Greece. Papers in Regional Science, 79(1), pp. 57-74. Puga, D., 1999. The Rise and Fall of Regional Inequalities. European Economic Review, 43(2), pp. 303-334. Ramsey, F. P., 1928. A Mathematical Theory of Saving. Economic Journal 38(152), pp. 543 559. Rodrguez-Pose, A. & Gill, N., 2006. How does trade affect regional disparities? How Does Trade Affect Regional Disparities. World Development, 34(7), pp. 1201-1222. Romer, P. M., 1994. The Origins of Endogenous Growth. Journal of Economic Perspectives, 8(1), pp. 3-22. Solow, Robert M., 1956. A Contribution to the Theory of Economic Growth. Quarterly Journal of Economics, 70(1), pp. 65-94.

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