SECTION of DOCUMENT:
Wages, Prices and Exchange Rates: Competitiveness vs. Convergence
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Leon Podkaminer *
Introduction: some basic facts
Nominal wage growth in CEE manufacturing
Inflation in central and East European (CEE), though gradually falling, has been recently much higher than in the EU. Under such conditions the average nominal wages in CEE are also bound to be rising rather fast. Whether rising nominal wages universally "cause" inflation, or rather rising prices universally "cause" higher wages cannot be conclusively answered. Wages and prices "spiral" through cost-price and demand-pull adjustments. There are many interfering country-specific factors. The spreads between price indices and the indices of nominal wages have not followed a uniform patterns across the CEE countries (see Table 1).
Table 1. Average yearly growth rates (%) of nominal wage in manufacturing and of selected prices
1/ Gross value added
As can be seen, with roughly the same inflation rates the nominal wage in Poland rose much faster than in Hungary (in the latter the real wage hardly increased). In Slovenia, Slovakia and the Czech Republic rising wages were also not fully reflected in prices. The opposite happened in Romania and Bulgaria: there inflation was higher than nominal wage growth rates.
Clearly, rather different "transmission mechanisms" linking wages and prices are at work in different countries. Of course, it is not our immediate purpose to elaborate on these mechanisms - we will come back to inflation prospects later. What seems important are just two observations: first, inflation will be subsiding in the CEE
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countries relatively slowly: deceleration to the average EU levels may take some time; second, the average nominal wage is likely to keep rising, generally in line with the overall inflation - though some variations in this tendency may occur over time.
Labour productivity and unit labour costs
Generally, labour productivity (real gross value added per employee) in manufacturing has been rising everywhere in CEE countries considered in this paper (see Table 2).
Table 2. Average yearly growth rates (%) of output, employment, labour productivity and unit labour costs in manufacturing
Source: WIIW. (The rates are for the same periods as in Table 1).
Again, the factors underlying the productivity growth are quite different across countries. Only in Poland and Slovakia have productivity gains been due to rising output at practically unchanged employment levels. In Hungary, Slovenia and the Czech Republic employment cuts and output increases have both contributed positively to productivity improvement, while in Bulgaria and Romania productivity gains have been due to falling employment under falling (or stagnant) output.
Interestingly, there is no obvious link between changes in unit labour costs and other sets of indicators. Observe, for instance, that rising labour productivity is differently "rewarded" (in terms of real wages). Strong gain in the Hungarian productivity was not rewarded at all (real wage growth was about zero). Strong gains in Poland were rewarded (relatively ungenerously), with a 4.3% real wage growth. Weaker gains in the Czech Republic, Slovenia and Slovakia were rewarded more generously (real wage rising 4%, 3.5% and 3.1% respectively). Gains in Romania and Bulgaria were "punished" with falling real wages (-3.3% and -2.4% respectively). This observation may be important because one sometimes hears opinions about a kind of causality running from rising labour productivity to rising real wages.
The most striking difference is between Poland and Hungary - the two countries with the most impressive productivity growth rates. In Poland the ULC rose by 3.6% p.a. - in Hungary they declined by 5% p.a. Whatever the reason for this difference, in Poland the share of wages in GVA has been rising - and the Hungarian share contracting rather strongly. This quite likely also says something about the reasons for the strong growth of
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output in Poland: with rising labour income the domestic demand (primarily private consumption) may have been sufficiently strong to support production at little changed employment levels. But, at the same time rising Polish ULC may have reduced external competitiveness. In Hungary stagnating labour incomes may have prevented a similarly strong expansion of domestic demand and output and the maintenance of employment. However, with falling labour costs, Hungarian manufacturing may have been gaining on external competitiveness. In the remaining countries, the gains in ULC may have been too low to increase external competitiveness sufficiently. At the same time, the losses on ULC were too small to generate sufficiently strong domestic demand.
On external competitiveness
The eventual effects of changing ULC on external competitiveness must be seen in a broader international (primarily the EU) context. There are three facts to be mentioned here:
To start with, the ULC in the EU manufacturing sector keep falling, though at modest rates (in Germany by about 1.1% over the period 1992-1999). On that ground alone, all CEE except for Hungary, Slovenia and Romania have been losing out on competitiveness to the EU even more than is suggested by ULC growth rates from Table 2 (and Hungary, Slovenia and Romania gaining less). However, this is only a part of the whole story.
The second argument relates to the growth rates of real ULC. In Table 2, they are calculated from movements of the ratio of total wage bill to nominal GVA - both at current domestic wage rates and prices, which means they are the same as when recalculated with the current exchange rates. However, this introduces a certain bias when it comes to comparison with the ULC dynamics (or absolute position) of the EU countries
[In 1996 the Hungarian total unit labour costs (TULC) in manufacturing (the ratio of wage bill plus other labour-related costs to gross value added) was estimated at about 71% of the corresponding Austrian TULC. The highest TULC was in Slovenia (72% of the Austrian level), Poland (66%) and Romania (56%) - the lowest in Slovakia and the Czech Rep. (50-51%). No comparable information for Bulgaria is available for 1996.] .
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Finally, even if the "quality" dimension discussed above were of little importance, there are other aspects of changing external competitiveness not reflected by the growth rates of ULC. In the market (both domestic and the EU), the products of the CEE manufacturing compete with foreign goods with prices which do not necessarily reflect the labour costs alone. Insofar as the material input-intensities of production in the CEE countries improve (that is decline) at lower speeds than in the EU; costs of the products (adjusted for the exchange rate movements) may rise, relative to costs of the comparable EU products, too fast.
Real exchange rates (defined as nominal exchange rates deflated by unit labour costs in manufacturing) have been generally falling, in all CEE countries, except Hungary and Poland
[Table 3 may suggest that Polish RER has not been appreciating during the period under consideration. This is inaccurate - from 1995 though 1998 there was a real appreciation (-2.8% p.a.)which consumed the effects of depreciation (+3.3% p.a.) over 1992-95. The general trends towards appreciation in Romania, Slovakia and the Czech Republic were occasionally disturbed, during the periods under consideration, by "emergency" devaluations taking effect in the Czech Rep. in 1997, in Slovakia in 1999and in Romania in 1994 and 1997. Hungary has had a depreciating currency since 1995 after a costly experience of strong real appreciation in the early 1990s.]
Table 3. Annual average growth rates (%) of nominal and real exchange rates and developments on trade balance
1/1997; 2/1998; 3/1995.
Source: WIIW. (The rates are for the same periods as in Table 1).
The real depreciation in PPI terms (exchange rates adjusted for the producer prices in industry) was on the whole much more pronounced. In PPI terms all CEE countries have had real appreciation - including Hungary and Poland. However, the PPI-adjusted appreciation was not very strong in Slovenia, Hungary and Slovakia (in Slovakia, however, only because of strong devaluation which took place as late as 1999. In earlier years, the appreciation was much higher). Strong real appreciation was observed in Bulgaria, the Czech Republic and Romania.
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In Poland, the calculated appreciation rate does not tell the whole truth (see footnote 3). There has been a tendency towards a strong real appreciation in Poland, as well. And that was reinforced by wage developments - quite strong real wage growth and fast rising real unit labour cost.
One consequence of the real appreciation has been the deterioration of the trade balances, perhaps most spectacularly in the Czech Republic and Bulgaria. In Romania the expansion of the trade deficit has been restricted by falling real wages. Moderate magnitudes of real wage changes in Slovenia and Slovakia explain expansion of trade deficits as well (in Slovakia the improvement in trade balance occurred only in 1999 - in 1998 it was twice the 1999 level). Only in Hungary did the trade deficit narrow - and this is quite certainly a combined effect of the real exchange rate developments(strong depreciation when adjusted for ULC, moderate appreciation when adjusted for PPI) - and "frozen" real wages.
The real problems
The experience of CEE on the relationship between wages, productivity and exchange rates has been rather mixed, generally leading to rather pessimistic conclusions:
A proper "policy-mix"
For the CEE countries the real problem for the future is to sustain a rather strong rise in domestic demand (i.e. real wages) and hence output while not allowing an excessive increase in the trade deficit (which requires proper evolution of external competitiveness). In short, the "ideal" would combine the positive features of the Polish and Hungarian experiences. Of course, one can wonder whether such an ideal can
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function - with good results - in practical life. Quite certainly some additional conditions may have to be fulfilled.
First of all, there must be a possibility of controlling the level of the nominal exchange rate - with a view to preventing undue real appreciation. Only Hungary and Slovenia have followed exchange-rate policies aiming at restricting such appreciation. (Until 1995 Poland also kept real appreciation in check through a sliding-peg ER regime). In Bulgaria, with the "hard fix" of the currency, there was, after 1996, no possibility whatsoever of preventing any real appreciation, no matter how strong. In the remaining CEECs, the relatively free float of their currencies (combined with a relatively high degree of liberalisation of capital flows) does not rule out strong real appreciation over rather long periods of time - even if at the same time the trade deficits balloon and the domestic output stagnates.
Second, there must be a possibility of controlling the wage development. Otherwise, an excessive growth in nominal wages will imply a rise in ULC that will not be sustainable, resulting in the loss of competitiveness. Of course, in increasingly private CEE economies the governments do not have a direct say on wage developments (at least outside the state-owned sector - and often not even there). What we observe in practice is that whenever there is an "excessive" growth of wages and/or rising trade deficit, a mix of restrictive monetary and fiscal policies is applied. The idea is then to cool down growth. As far as wages are concerned the underlying idea is that the growth slowdown will reduce the demand for labour - which in turn should moderate wage growth. This, of course, can work (though rather slowly and with considerable delay) - provided the unemployment generated in the course of the cooling-down operation is so massive as to have an impact on wages. But, the policy misses the point because at the same time it of course hinders output growth. Recent Polish experience (1998-2001) also suggests that the "cooling operation" may be successful in creating massive unemployment without impeding the growth of average wage. Besides, such an operation is likely to be counterproductive on yet another count. The monetary austerity may lead to excessive currency appreciation (via induced increases in interest rates). Whatever is "gained" by way of weakening wages, is then lost by way of strengthening the exchange rate.
A more efficient way of controlling real wages does exist and has proven its value in many successful industrial economies. Since the early 1950s, wages in Austria have been effectively controlled through the agreements within the Social Partnership System. The recent successful performance of Ireland can also be attributed, at least partly, to its effective Social Partnership System. The obvious advantage of having such a system is that it is capable of preventing stagnation or decline in real wages whenever high unemployment unduly restricts domestic demand and output (through keeping wage rates unduly depressed).
The correct "policy-mix" would then primarily involve a choice of proper values for wage rates and exchange rates. Certainly, no manipulation of the exchange rates alone can produce satisfactory results when wages (and/or prices) run away. This is a lesson from numerous failed stabilisation programs that assume, for example, the application of fixed exchange rate ("nominal exchange rate anchor"). As a rule these programs generate unsustainable real appreciation and trade deficits, usually combined with massive losses in output and employment.
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It is equally wrong to stake everything on attempts to engineer a fall in wages while letting exchange rate free. Unless the exchange rate complies with our wishes and properly declines, weak wages will dampen the domestic demand and output - also of services and non-exportable tradable goods, while at the same time not necessarily restoring external competitiveness.
Third, the effectiveness of any mix of wage and exchange rate policies could be greatly enhanced by selective protectionism and/or other policies aiming at promotion of selected export industries (or import-substitution industries). This postulate may, however, be rather difficult to follow: the CEE countries have, rather foolishly, agreed to liberalise their imports from the EU [This is reflected in the dramatic reduction of effective tariff rates. For instance in Poland the tariff rate (the ratio of customs duties collected to value of imports) fell from 20.6% in 1993 to 4.6% in 1999.] and pledged to restrict meaningful involvement in active industrial policy.
III. On convergence to the EU
The inflation problem
Certainly it would be very advantageous to have very low inflation in the CEE countries - provided this could co-exist with high growth of output. In principle one can imagine a low-inflation CEE economy with high growth. The problem is that we have not yet seen such an animal. One reason for this may have been that conventional fiscal-monetary policy mixes, even if successful (which often is not the case) on lowering inflation, have invariably depressed growth as well. The ensuing periods of relaxation of the fiscal-monetary austerity aiming at some growth acceleration, even if successful, bring back higher inflation, too. On the whole, in all CEE countries the overall trend towards lower inflation is visible. There is a possibility that eventually a kind of an acceptable compromise between inflation and growth will be worked out in individual CEE countries. There is no doubt that such a compromise may alleviate the task of controlling wages and exchange rates. There are still good grounds to believe that even under very favourable conditions, inflation is likely to be substantially higher in the CEE countries than in the EU.
As long as the maintenance of acceptable levels of external competitiveness requires currency devaluation (whether through systematic adjustments as, until recently, in Hungary, or in big-bang jumps forced by accumulating deficits, as in Slovakia, Czech Rep. or Romania in the past), this will have some inflationary consequences through higher prices of imported goods. To some degree then, inflation and devaluation feed on each other. As long as there is inflation, devaluation may have to follow. As long as there are devaluations, there is inflation. Nonetheless this is not necessarily a hopeless situation. In the process the pass-through rates (at which devaluation transmits itself to domestic prices) may be falling (also on account of rising efficiency of utilisation of
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imported intermediate goods). And a gradual fall in inflation may help to reduce the levels of necessary devaluations. Of course, it may be argued that with strongly rising labour productivity and falling unit labour costs the external competitiveness need not suffer so that there may be no reason to devalue. Let us hope that this will eventually happen - as it has happened in countries which succeeded in overcoming backwardness (such as Austria and the NIC). But this is not yet the case in CEE. As we have seen, even in Hungary (where wages are completely contained and labour productivity and unit labour costs are improving) strong devaluation (and comparatively high inflation) have been essential.
Tendency towards equalisation of the prices of tradable goods
At current exchange rates, the domestic prices of tradable goods are cheap in the CEE countries. Certainly, this also reflects their generally lower quality (but also lower production costs and/or lower mark-ups on costs, as well as lower much lower real disposable incomes). With overall growth in the CEE countries (and their progressing integration with the EU) there will be some tendency towards convergence in the prices of tradable goods. For the CEE countries that will mean a rise in the prices in question (for more on this see Appendix).
Rising prices of services
Everywhere in the CEE countries services are even cheaper than in the EU (see Table 1 in the Appendix). It is also true to say that in the CEE countries the prices of services have been rising faster than prices of tradable goods (see Table 4).
The process whereby prices of services increase faster than those of tradable goods is likely to continue in the future - especially if there is overall output growth (in either sector). This may be related to relatively high income elasticity of demand for services in the low-income CEE countries. Also, one cannot exclude the appearance of the so-called Balassa-Samuelson effects [I have some doubts about the applicability of the Balassa-Samuelson effect (as popularly interpreted) to the inflation problem. Empirically, the B-S effect seems to have been obtained in (a limited) number of the CEE countries. Namely, in all countries labour productivity in manufacturing (the dominant tradables' sector) rose faster than in trade services (the dominant service sector) - but that was not coupled with the falling relative price (ratio of GVA deflators) of the two sectors in Bulgaria and the Czech Rep.. Moreover, contrary to an essential assumption underlying B-S, wage rates in trade services rose much faster than in manufacturing (except in Romania and Hungary). Thus, the observed relative price developments may be rather due to wage developments than to productivity trends. (I compare manufacturing with trade services - and not the whole tradables and services sectors - primarily because of the availability of relatively reliable data on wage rates).] .
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Table 4. Yearly growth rates (%) of selected prices
1/ Manufacturing, mining and agriculture;
Source: WIIW. (The rates are for the same periods as in Table 1).
The exchange rate problem
A direct consequence of the likelihood of inflation being substantially higher in the CEE countries than in the EU is the necessity to adjust, from time to time, or more or less continuously, their exchange rates. This rules out (or should rule out) any early membership in the EMU (let alone adoption of the Euro) for most if not all CEE countries. In this sense the CEE countries will remain "outsiders" for quite a long time - even after formally joining the EU.
The convergence in real income levels
One should forget any significant convergence in real income levels unless the EU permits specific national policies to be followed by the CEE countries. More specifically, the EU should discourage the CEE countries from policies expressly aimed at the achievement of low inflation and the satisfaction of other Maastricht criteria, or the stability of exchange rates.
In addition, it would certainly be very helpful if the EU allowed other policies which in the past enabled convergence within the EU itself. Here one should mention the reintroduction (or maintenance) of controls on short-term capital movements (with the goal of reducing unsound appreciation), the reintroduction of some barriers to certain selected imports - also from the EU-, and other forms of active industrial policy.
A CEE country dutifully observing all EU instructions on Maastricht criteria, exchange rate stability, free capital and trade, hands-off policy on domestic industry is very likely to share the fate of the former GDR - the only difference being on the levels of Western subsidies.
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Inflationary consequences of the equalization of prices or tradable consumer goods
Price levels in the transition economies are generally much lower than in Western Europe. This is reflected in the ratios of their Purchasing Power Parities (PPPs) to the exchange rates (both calculated versus West European countries) assuming values much below 1. For example, in 1996 2.564 Czech korunas bought 1 Austrian schilling (1 koruna bought 0.39 ATS) on the Czech foreign exchange market. (See Table A1.) At the same time, 1.031 CZK spent on consumption in the Czech Republic bought, on average, goods and services worth 1 ATS in Austria (1 koruna bought goods worth 0.97 ATS).
To some extent, the low price levels in the transition countries are a consequence of the particularly low prices of services (and this, in turn, is largely due to low incomes resulting in a relatively weak demand for services). As a rule, the disparities between the exchange rates and PPPs for goods are much lower though still quite wide, especially for very-low income countries.
The ongoing liberalization of trade between the West European (EU) countries and the transition economies (especially the Candidate Countries) is expected to lead, in perspective, to some convergence of the price levels of tradable goods. The process will certainly be assisted by the ongoing progress in transportation (falling transport costs), unification of qualitative standards and expansion of transnational corporations producing and selling basically the same goods in both the EU and the transition countries. Certainly, the transport costs will continue to prevent a perfect equalization of the prices of goods even in the far future, and other factors such as imperfect information and price discrimination are unlikely to be phased out completely. (It may even be expected that price discrimination, i.e., tailoring the prices of basically the same goods to the local conditions, and particularly to the local income levels, may in fact intensify.)
Even if it is assumed that the factors preventing equalization of prices are of negligible significance, it is not quite obvious whether for the transition countries the whole process would mean an increase in the price levels.
Things are relatively clear in a partial analysis. In such an analysis, which assumes a given exchange rate and absence of any impediments to trade, any tradable good in a small country must have the same price (at the exchange rate) as that prevailing in the large trading partner. Put differently, a partial analysis assuming a given exchange rate must conclude that the price level for any tradable good must equal one. (Otherwise there would exist non-exploited arbitrage possibilities.) This means that the domestic price of each tradable good in the transition countries will indeed rise, its PPP eventually equating the exchange rate.
There is a certain difficulty in generalizing the proposition on the effects of price equalization for all goods, jointly. One does not know whether the equalization of prices of all (or of sufficiently many) goods would not somehow affect the exchange rate. Of course, if the equalization of prices of all goods leaves the exchange rate unaffected, one would have inflation (at least as far as tradable goods are concerned). But, theoretically,
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other outcomes are also possible. Much will depend on the foreign trade flows associated with changing prices. Should the equalization be combined with greater exports and/or lower imports, one would expect smaller trade and current account deficits and hence, generally, a strengthening of the exchange rate. This would mean that the gaps between the PPPs for at least some goods might narrow without their domestic prices rising the full distance (to the levels implied by the initial value of the exchange rate). By the same token, domestic prices of some (initially already relatively less under-priced) goods may even fall. The final effects of changes brought about by the equalization of prices under improving trade balances are therefore even theoretically hard to predict. The opposite situation, of price equalization combined with worsening trade balances and weakening exchange rates, is equally well thinkable.
Table A1: Purchasing power parities, exchange rates, per capita consumption for 1996, and the calculated inflation indices
While a satisfactory determination of the effects of price equalization on the level of the exchange rate in the transition countries remains a task for the future, one can, nonetheless, ask some questions about the consequences of the process, assuming that the exchange rate is left unchanged.
[This is a variant of a time-honoured assumption of the neo-classical pure theory of international trade, which escapes the questions about exchange rates by postulating balanced trade. The assumption of constancy of exchange rate is also important in practical terms. This is so because as will be briefly discussed it pervades much of the monetary policy in the transition countries.]
The specific question worth addressing is about the inflationary effects of price equalization in the transition countries. The answer to this question requires some additional assumptions (beyond that on unchanged exchange rates). First, it is assumed that equalization of prices of goods does not affect the prices of services. Second, it is
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assumed that cost and supply conditions (also as far as production of services is concerned) are not affected by the equalization of the prices of goods. Certainly, both additional assumptions are very heroic. In particular, they imply that labour swallows the rising prices of goods without demanding wage increases. In actual practice, rising prices of some goods are unlikely to leave wages unchanged and rising wages are very likely to force increases in the prices of services. One can imagine price-wage-costs spirals put into operation by the equalization. Actual eventual inflationary effects of equalization may stand in no proportion to the magnitude of inflation reflecting equalization and equalization alone.
Under the assumption made above, the calculation of inflation indices due solely to price equalization is quite straightforward. All one has to do is to apply the Laspeyres formula [Application of other conventional price indices is not quite possible here. For example, to calculate the Paasche index one would have to assess the changes due to equalization in the level and structure of consumption.], with the initial PPPs as prices for services in both the pre- and post-equalization period, and with the initial PPPs as prices for goods in the pre-equalization period and the exchange rates as prices for goods in the post-equalization period.
Table A1 contains the results of the calculation of the so understood inflation indices based on the data derived from the European Comparison Project for 1996. The original ECP data was recalculated. The recalculation covered only consumption items. It involved, among other things, the exclusion of data on 'net consumption abroad' and a suitable aggregation of all consumption items into two sub-aggregates: goods (tradable) and services (non-tradable).
The last column of Table A1 suggests that, should the prices of goods throughout Europe converge to Austrian (or German [Austria and Germany, though not identical in terms of price levels and consumption structure, are practically indistinguishable as far as the inflation indices are concerned. The convergence of the German to Austrian prices of goods would result in 0.5% inflation in Germany. Conversely, the convergence of Austrian to the German prices of goods would result in, approximately, 0.5% deflation. The inflation indices from Table 1, lowered by about 0.5 percentage points, approximate inflation resulting from the convergence of prices of goods to the German level.]) levels, one would, in most cases, expect some inflation. While that inflation would be rather low as far as major EU countries are concerned (with a deflation in France), it would be quite high in all transition countries (as well as in Turkey), with the highest inflation levels in Bulgaria and Romania. It must be reiterated here that the inflation indices from Table A1 have been derived using the 'heroic' assumptions of unchanged prices of services and unchanged wages. In practice increases in the prices of goods are likely to precipitate increases in both wages and prices of services. The actual inflation unleashed by the equalization may be much higher than suggested by Table A1.
The final remark worth making is about the internal consistency of some goals of the monetary policy being apparently pursued in many transition countries. The goals in question include, simultaneously, (a) stabilization of prices (meaning chasing the Maastricht criterion on inflation), and (b) stabilization of the exchange rates with a view to joining the European Monetary Union (and ultimately but relatively soon adoption of the Euro).
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In the light of our inflation estimates both goals appear rather incompatible at least if, at the same time, complete liberalization of trade with the EU is assumed. Stability of the exchange rate in a country with highly under-priced goods does imply inflation. Either one or the other goal has to be abandoned. Worse still, as practice has repeatedly shown, the attempts at meeting such incompatible goals usually end in developments resulting in both goals being abandoned.
© Friedrich Ebert Stiftung | technical support | net edition fes-library | März 2002