Central, Eastern, and Southeastern Europe: The Past and Future of Convergence

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1 Central, Eastern, and Southeastern Europe: The Past and Future of Convergence LSE SU Emerging Markets Forum London, March 1, 218 Bas B. Bakker Senior Regional Resident Representative for Central, Eastern and Southeastern Europe

2 Global growth in 218 is highest since Global Real GDP growth according to various WEO vintages (Percent) 4. WEO Update Jan-218 WEO Oct WEO Apr

3 Advanced economies are growing around 2 ¼ percent, China and India, 7, other EMCs, 3½ 14 Real GDP Growth (Percent) China and India EMs excl. China and India Advanced Economies

4 USA will grow by 2.7 percent, euro area by 2.2, and Japan by Real GDP Growth (Percent) 4 2 USA Japan -2 Euro Area

5 Unemployment rate in advanced countries is near pre-crisis low 9 Unemployment Rate in Advanced Economies (Percent)

6 Fed has started to tighten, ECB rates are expected to remain low for longer 3.5 US and EA Policy Rates and Forecasts (Percent) FOMC Projections Fed ECB Survey of Professional Forecasters. ECB

7 In CESEE, CIS recovering and non-cis growing strongly 1 Real GDP growth (Percent) Other CESEE CIS

8 NON-CIS CESEE 8

9 Growth is rapid, and unemployment is falling sharply Real GDP growth (Percent) Unemployment Rate (Percent) Baltics SEE EU 2 SEE non-eu 4 CE SEE non-eu 1 5 Baltics SEE EU CE

10 Unemployment is now below pre-crisis levels in many countries 14 Cumulative Changes in Unemployment Rate (28Q1=, seasonally adjusted) SRB 8 EST LTU 6 LVA 4 SVK HUN 2 POL CZE 8 HRV 6 4 SVN BGR 2 ROU MNE BIH ALB* MKD 217Q3: *For ALB 212Q1= 1

11 Growth in the region is not as high as in the pre-crisis years Real GDP growth in CESEE excl. CIS (Percent) Max Average Min 27 level

12 2 year average employment growth But employment growth in many countries is as high as during pre-crisis peaks GDP growth vs. employment growth (Percent, 2 year average) 3 CE-5 2 SEE 2 1 Post-crisis Post-crisis Pre-crisis Pre-crisis year average GDP growth 12

13 Inflation, which was very low in has picked up recently 8 CPI Inflation (Percent) 6 4 CESEE excl. CIS 2 Euro Area

14 Energy and food prices played key role in pickup of inflation 4 Oil and Food Prices (Percent, Y/Y, 6 months moving average) Oil Price Food and Beverage Price Index

15 But wage growth has also accelerated 18 Nominal Wage Growth (Percent, Y/Y) Q3 215Q4 2-2 MNE BIH MKD SRB POL HRV LVA SVN CZE SVK LTU EST BGR HUN ROU 15

16 Growth in 218 will continue to be strong External demand expected to remain strong in the next quarters Consumption is solid as employment is growing rapidly and wages are accelerating Investment further boosted by pick-up of EU funds 16

17 What will this imply for labor markets? 3 Employment and Working Age Population Growth in CESEE (Excl. TUR and CIS, percent) 2 Employment growth Working Age Population Growth and UN projection

18 This would be the good time to create fiscal space and reduce structural deficits Particularly given that debt is much higher than pre-crisis levels. 9 8 General Government Debt (Percent of GDP) EST UVK BGR CZE LVA LTU ROU MKD BIH SVK POL SRB ALB MNE HUN SVN HRV 18

19 Unfortunately, many countries with too high structural deficits are reverting to pro-cyclical loosening 3 General Government Structural Balance (Percent of GDP) ROU POL HUN SVK HRV EST LVA SVN BGR SRB BIH CZE LTU 19

20 CIS 2

21 In , Russia and Ukraine suffered from shocks, and Belarus from spillovers Collapse of commodity prices Sudden stop in capital flows to Russia, result of sanctions on Russia Conflict in Ukraine Cumulative Change in GDP, (percent) -14 Ukraine Belarus Russia 21

22 Foreign reserves (USD index, H1 213=1) Reserves drawdown Exchange rate flexibility was unavoidable given the limited buffers Foreign reserves and XR depreciation (6-month moving averages) RUS Depreciation UKR 216 BLR USD exchange rate (index, H1 213=1) 22

23 but increased inflation and reduced real wages 3 CPI Inflation in European CIS (Percent, weighted average) max 1 Average monthly wages (USD) RUS 5 1 BLR 5 min 25 UKR Q1'21 Q1'212 Q1'214 Q1'216 23

24 Ukraine and Russia are now recovering (helped by rising oil prices) Real GDP growth in Russia, other CIS countries and changes in oil prices (Percent, y/y) RUS BLR RUS -5 Oil prices (right axis) UKR

25 Near-term prospects show solid growth 4. Real GDP Growth Projections (Percent) BLR RUS UKR 25

26 CONVERGENCE: PAST 26

27 Since the abolition of communism, most of CESEE has become much richer both in absolute and relative terms 27

28 But not all countries have done equally well 28

29 Compare Poland vs Ukraine Poland has done much better than Ukraine In 1989 they were equally rich Now Poland is three times as rich Why? Poland more macro-stability Poland reformed more and earlier Poland has better institutions 29

30 Difference is clearly visible on satellite pictures. Nightlights intensity 3

31 Macro-stabilization occurred much earlier in Poland CPI Inflation (Percent y/y) 18 GDP Per Capita (Thousands of 216 US$) Poland Ukraine Ukraine 2 Poland

32 Poland has not had any crisis; Ukraine has had three Exchange Rates vs EUR (Percent m/m) GDP Level (Index, 1997=1) 6 Russian crisis GFC Ukrainian crisis 22 Russian crisis GFC Ukrainian crisis 5 2 Poland Ukraine PLN UAH

33 Poland reformed earlier and deeper Average of EBRD Transition Indicators Max 4. Poland 3.5 Ukraine

34 Better institutions Poland has much better institutions Worldwide Governance Indicators, 216 (CESEE countries in global ranking) Poland Ukraine Voice and Accountability Political Stability Government Effectiveness Regulatory Quality Rule of Law Control of Corruption 34

35 CONVERGENCE: FUTURE 35

36 After deep crisis in 29, convergence has resumed (except in CIS) Real GDP per capita (Percent of Germany) CE-5 Baltics 4 3 SEE EU CIS 2 SEE non-eu

37 But growth is slower than pre-crisis 1 GDP growth (Percent, 3 year moving average) Baltics SEE non-eu CIS SEE EU CE

38 As investment rates are lower (except CIS) 35 Investment Rate (Percent of GDP, 3 year moving average) 3 Baltics SEE EU 25 CE-5 2 SEE non-eu* CIS *Excl. MKD 38

39 The working age population is declining (leading to less labor supply).5 Working Age Population Growth (Population ages years, 5 year moving average). SEE non-eu SEE EU CE-5 CIS -1.5 Baltics

40 And TFP growth is lower 7 TFP Growth (Percent, 5-year moving average) CIS Baltics SEE EU 1 CE SEE non-eu

41 Productivity is too low to sustain rapid GDP growth 8 GDP Growth and Labor Productivity in CESEE (Excl. TUR and CIS, percent) 6 4 GDP growth 2 Labor Productivity

42 As employment growth cannot continue to grow so much faster than the working age population 3 Employment and Working Age Population Growth in CESEE (Excl. TUR and CIS, percent) 2 Employment growth Working Age Population Growth and UN projection

43 What can be done to boost TFP growth? Improve institutions Improve legal systems and government effectiveness Improve tax efficiency Address infrastructural gaps 43

44 Government effectiveness not as strong as in Western Europe World Governance Indicators, 216 (Ranges from -2.5 (weak) to 2.5 (strong) governance performance) 44

45 Judicial systems are also weaker Judicial Independence, 215 Impartial Courts, 215 Below 25 percentile Between 25 and 75 percentile Above 75 percentile Source: World Economic Forum. Note: Worldwide distribution excluding LICs 45

46 How would institutional reforms help? Better institutions hold the promise of retaining emigration of skilled workers Effective protection of property rights provides stronger incentives for investment Institutions affect innovation and productivity through enhanced trust, cooperation, commitment, and contract enforcement 46

47 CONCLUSION 47

48 Concluding thoughts CESEE has done nicely in recent years with strong growth and rapidly declining unemployment Growth is not as high as pre-crisis The challenge will be to continue current growth rates Productivity growth will need to pick up; at some stage labor market will become constraint Reforms and improvements of institutions will help 48

49 Thank you