EU10 Regular Economic Report

Transcription

1 The World Bank EU1 Regular Economic Report Main Report Working Towards Recovery April 21 Focus Notes: Impact of the crisis on the corporate sector evidence from a firm-level survey Insights for the EU1 and Croatia from the Europe and Central Asia energy outlook 23 This report is prepared by a team led by Kaspar Richter (krichter@worldbank.org) and including Paolo Correa, Stella Ilieva, Mariana Iooty, Leszek Kąsek, Ewa Korczyc, Matija Laco, Sanja Madzarevic-Sujster, Catalin Pauna, Marcin Piątkowski, Stanislav Polak, Emilia Skrok, and Peter Thomson. The team is very grateful for the excellent inputs from the World Bank Global Prospect Group, coordinated by Annette De Kleine. EU1 refers to Bulgaria, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, the Slovak Republic and Slovenia. EU1+1 includes Croatia. 1

2 EU1 April 21 Summary of Main Report After the global financial crisis, signs of recovery are here, but big risks remain in the short run. For a sustained revival, governments need to revisit old issues that have come back to haunt them. Working towards a broad-based recovery requires fiscal consolidation that makes governments slimmer and smarter, and a better investment climate that raises productivity and creates jobs. The EU1 region has begun recovering from the deepest global downturn in recent history in the second half of 29, and is set to return to growth in 21. The outcomes for the EU1 countries in 29 were better than predicted in autumn 29 (Table 1). The rise in global demand for durable goods and capital equipment stabilized trade volumes and, more recently, investments. Industrial production, retail sales and economic sentiment show a continuation of the gradual recovery in early 21. Helped by a recovery in economic activity and public support to the financial sector, systemic risks in financial markets have diminished. Bank, bond and equity markets have improved with a return in confidence and risk appetite. Money markets have stabilized, as banks in EU1 countries and their parent banks in EU1 countries are becoming less reliant on government guarantees and central bank support. Capital flows returned to the EU1 region as Eurobond and domestic bond markets responded well to the rising financing needs of governments in spite of the recent volatility in sovereign bond markets. Equity placement also strengthened gradually in some countries. Large output gaps, downward base effects from energy and food, and well-anchored low inflation expectations have kept inflation in check in the EU1 region. Overall, a fast global recovery, the return of confidence in financial markets, the turning of the inventory cycle, low interest rates and stepped-up utilization of EU funds could support a solid recovery in the EU1 region. While the recovery in the global economy is under way, the outlook for the EU1 region remains fragile. It will take until the second half of 211 before real output will regain its precrisis level. Credit to the private sector remains sluggish. Unemployment is still rising. The duration of unemployment is increasing for many workers, and job market prospects for workers with basic education levels and little work experience are likely to stay impaired for several years. The pace of the recovery also differs starkly across countries, reflecting different initial conditions, external shocks and policy responses. It will be 211 before all EU1 countries experience growth. In addition, the risks to the recovery are stark. Growth could be undermined by a weak recovery in Europe, on which prospects for exports, manufacturing, credit and jobs in the EU1 region depend foremost. Heightened strains could return to financial markets. Concerns about worsening fiscal positions could raise interest rates, crowd out private sector credit growth and dampen the economic recovery. Finally, a prolonged deterioration of economic prospects could undermine public support for reforms ahead of political elections in many EU1 countries. Governments face the challenges to secure the recovery, bring about fiscal consolidation, raise productivity, and generate jobs. In doing so, they continue to balance supporting a broad-based economic recovery with exiting anti-crisis economic policies in a timely manner. Monetary policy remains supportive of the recovery as inflation pressures continue to be moderate. Central banks and financial authorities pursue efforts to strengthen further the resilience of the financial sector. EU1 governments have endorsed sizable multi-year structural fiscal consolidation as the economy gains strength, which will require steadfast attention over the next few years. While convergence to EU income levels has held up remarkably well, the long-term growth prospects of the EU1 region have weakened due to the crisis. As argued in the EU s new Europe 22 strategy for smart, sustainable and inclusive growth, bolstering potential growth and reorienting the economies towards exports requires structural changes in areas such as public finances, education, innovation, and business climate. Such reforms will also help to prevent that the cyclical increase in unemployment turns into structural unemployment. Table 1. Overview of EU1 and EU1 Forecasts and Outcomes GDP growth, annual percent change Fiscal deficit percent of GDP Public debt, percent of GDP Unemployment rate, percent EC Forecast Autumn 29 Actual 29 Forecast 21 EU EU EU EU EU EU EU EU Note: 21 forecasts are based on government projections from the Convergence and Stability Programs 21. 2

3 1Q 7 2Q 7 3Q 7 4Q 7 1Q 8 2Q 8 3Q 8 4Q 8 1Q 9 2Q 9 3Q 9 4Q 9 1Q 7 2Q 7 3Q 7 4Q 7 1Q 8 2Q 8 3Q 8 4Q 8 1Q 9 2Q 9 3Q 9 4Q 9 Recent Developments and Future Prospects Output After the global financial crisis, signs of recovery are here, but big risks remain in the short run. The EU1 economies have begun recovering from the deepest global downturn in recent history in the second half of 29. Helped by the recovery in global production and trade, the world economy stabilized and the main advanced economies are expected to return to growth in 21 (Table 2). The resumption of growth in the third and fourth quarters of 29 of the Table 2. Global growth prospects, percent EU1 region supported the recovery of the EU1 region through exports and capital flows. World The year-on-year decline in the EU1 region United States moderated from -4.6 percent in the second quarter of 29 to -2.1 percent in the fourth Japan quarter of 29, in line with the improvement China from -.7 percent to -2. percent over the European Union same period in the EU1 region (Figure 1). EU1* While quarter-on-quarter growth softened in EU the EU1 from.3 percent in the third quarter Source: Global Economic Prospects 21, to.1 percent in the fourth quarter, it Convergence and Stability Programs Updates strengthened in four of the six EU1 countries 21, World Bank staff calculations. with available data (Figure 2). Overall, the Note: EU1 does not include Portugal EU1 region contracted by 3.6 percent in 29, compared to forecast of 4.2 percent from the October 29 EU1 Regular Economic Report. The recovery is visible across the EU1 region, although some of the improvement is due to the base effect. In the fourth quarter of 29, the expansion in Poland, the only EU country with positive growth in 29, reached over 3 percent. In the Czech Republic, the Slovak Republic, Hungary, Slovenia, Estonia, Lithuania and Latvia, the fourth quarter marked the lowest quarterly year-on-year contraction in 29. The contraction widened over the course of the year only in Bulgaria. In Latvia, Lithuania and Estonia, where the economic adjustment started already in late 27, the loss in output remained in excess of 9 percent in the fourth quarter 29 and in the range percent in 29. Figure 1. EU1 countries and EU1 GDP growth, percent, year-on-year, nsa Figure 2. EU1 countries and EU1 GDP growth, quarter-on-quarter, swda BG EE LV EE LV SI -2 SI -1 SK SK Source: Eurostat, World Bank staff calculations While the narrowing in the trade balance was the principal spur for recovery in 29, the upturn during the second half of 29 relied also on domestic demand. In 29, net exports increased in all EU1 countries due to sharp contraction in exports, except in the Czech 3

4 Republic, supported through currency depreciation in some countries and, later in the year, by a recovery of EU1 export markets (Figure 3). The positive growth contribution of net exports was more than offset by sharp contractions in investment and, to a lesser extent, consumption on the back of low capacity utilization, tightened credit, and weak labor markets. Investment declined in 29 on average by close to one quarter in the EU1 region, and by almost half in Estonia, Latvia and Lithuania. However, investment stabilized in the third and fourth quarters of 29 in most countries, aided by the upturn in global trade and manufacturing, a turn in the inventory cycle, improved financial conditions and counter-cyclical economic policies. Figure 3. EU1 countries and EU1 contribution to GDP growth, percent Gross capital formation Final consumption expenditure Gross domestic product at market prices Net exports Other BG EE LV SK SI EU1 EU1 Source: Eurostat, World Bank staff calculations High-frequency indicators suggest that economic activity in the EU1 region continued its gradual recovery in early 21. Industrial production improved for the 12 th months in a row, reaching positive year-on-year growth in both December 29 and January 21. It expanded more than 8 percent in January 21 in the Slovak Republic, Romania and Poland. Retail sales continued to contract in all countries apart from Poland, but the rate of contraction slowed markedly over the last half a year. The economic sentiment indicator gained over 1 points since March 29. The February 21 indicator fell short of the long-term average of 1 only by 1 points for the EU1 region and 2 points for the EU1 region (Figure 4). The recovery in confidence of businesses and consumers relative to the trough was largest in Hungary, the Slovak Republic, Estonia and Slovenia, and weakest in Bulgaria and Romania. While business confidence in industry improved across the region, confidence in construction worsened with prices of real estate falling and demand for new construction constrained by tighter credit conditions. 4

5 Jan-7 Apr-7 Jul-7 Oct-7 Jan-8 Apr-8 Jul-8 Oct-8 Jan-9 Apr-9 Jul-9 Oct-9 Jan-1 Jan-7 Apr-7 Jul-7 Oct-7 Jan-8 Apr-8 Jul-8 Oct-8 Jan-9 Apr-9 Jul-9 Oct-9 Jan-1 Figure 4. EU1 and EU1 economic sentiment indicator (long term average = 1) BG EE LV SI EU1 EU1 SK Source: European Commission, World Bank staff calculations

6 Jan-7 Mar-7 May-7 Jul-7 Sep-7 Nov-7 Jan-8 Mar-8 May-8 Jul-8 Sep-8 Nov-8 Jan-9 Mar-9 May-9 Jul-9 Sep-9 Nov-9 Jan-7 Mar-7 May-7 Jul-7 Sep-7 Nov-7 Jan-8 Mar-8 May-8 Jul-8 Sep-8 Nov-8 Jan-9 Mar-9 May-9 Jul-9 Sep-9 Nov-9 Trade Trade volumes in EU1 are stabilizing, as demand for durable goods and capital equipment is rising. EU1 export growth improved year-on-year from a contraction of 2 percent in May 29 to an expansion of 3 percent in December 29. The recovery in exports was largest relative to the trough for Bulgaria, Romania and Lithuania. Over the same period, the contraction of EU1 imports narrowed from 33 percent to 1 percent (Figure and Figure 6). In December 29, import reductions remained in excess of 14 percent in Latvia, Lithuania, Bulgaria and Estonia, countries with pegged exchange rates to the euro. For example, in Bulgaria, weak demand for investment and intermediate goods and low international prices reduced imports from close to 83 percent of GDP in 28 to 8 percent in 29. With exports growing faster than imports, the trade surpluses widened noticeably in Hungary, the Czech Republic and the Slovak Republic, and the trade deficits declined sharply in the rest of the EU1 region. Figure. Exports performance of EU1, 3mma, percent, year-on-year Figure 6. Imports performance of EU1, 3mma, percent, year-on-year BG EE LV SI BG EE LV SI SK SK Source: Eurostat, World Bank staff calculations The improvement in trade balances contributed to a sharp turnaround of current account balances (Figure 7). This helped EU1 countries to adjust to the reduction in capital flows triggered by the global financial crisis. The changes were more pronounced in countries with high initial current account deficits. Current account deficits turned into surpluses in 29 for Latvia, Estonia, Lithuania and Hungary (estimated), and declined sharply elsewhere in the EU1 region. The only exception is the Czech Republic, where the current account deficit worsened moderately to close to 1 percent of GDP owing to a deteriorating services balance. Income balance improved notably in the Estonia, Latvia and Lithuania, mainly reflecting the drop in repatriated earnings by foreign investors and foreign banks provisioning for non-performing loans. Larger receipts of EU transfers, primarily from increased utilization of available EU funding, contributed to reductions of imbalances across the region. 6

7 Figure 7. External developments in EU1 countries Change in reserves FDI + Portfolio Other investment Current account balance (inverted) SK SI LV EE BG Source: Eurostat, Central Banks, World Bank staff calculations 7

8 Jan-7 Apr-7 Jul-7 Oct-7 Jan-8 Apr-8 Jul-8 Oct-8 Jan-9 Apr-9 Jul-9 Oct-9 Jan-1 Jan-7 Apr-7 Jul-7 Oct-7 Jan-8 Apr-8 Jul-8 Oct-8 Jan-9 Apr-9 Jul-9 Oct-9 Jan-1 Inflation Large output gaps, downward base effects from energy and food, and well-anchored low inflation expectations continued to keep inflation in check in the EU1 region (Figure 8). Inflation trends differed according to the exchange rate regime. Inflation in the Slovak Republic and Slovenia, both members of the European Monetary Union, followed the trends of euro area. Inflation remained close to zero since September 29 in Slovakia, while inflation in Slovenia increased over the last few months due to hikes in excise duties and regulated prices. Bulgaria, Estonia, Latvia and Lithuania, countries under pegged exchange rates, experienced deflation, as improvements in competitiveness required significant downward adjustment in domestic wages and prices. From late-28 to January 21, inflation fell from double-digits to 1.8 percent in Bulgaria, -.3 percent in Lithuania, -1. percent in Estonia and -3.3 percent in Latvia. Inflation was highest among the group of countries with flexible exchange rates, although there were noticeable differences among these countries. Inflation in Czech Republic fell from around 2 percent in January to around zero in July-October 29, due to a weak domestic demand and fairly stable exchange rate. Year-on-year inflation in January 21 varied from 3.9 percent in Poland to.2 percent in Romania and 6.2 percent in Hungary, reflecting pass-through effects from currency depreciation and, in the case of Romania and Hungary, increases in indirect taxes. Figure 8. HICP 1 overall index for EU1, peggers, floaters and Euro area, annual rate of change, percent 2 1 BG EE LV 1 Euro Area Peggers Floaters - SI - SK Source: Eurostat, World Bank staff calculations 1 HICP is a harmonized index of consumer prices. 8

9 Jan-7 Mar-7 May-7 Jul-7 Sep-7 Nov-7 Jan-8 Mar-8 May-8 Jul-8 Sep-8 Nov-8 Jan-9 Mar-9 May-9 Jul-9 Sep-9 Nov-9 Jan-1 Mar-1 1Q 7 2Q 7 3Q 7 4Q 7 1Q 8 2Q 8 3Q 8 4Q 8 1Q 9 2Q 9 3Q 9 4Q 9 1Q 1 Finance The upturn in economic activity around the globe has facilitated the recovery of financial markets. Helped by public support to the financial sector and expansionary economic policies, systemic risks in financial markets have further diminished. Equity and bond markets have improved with a return in confidence and risk appetite (Figure 9). Strong parent and subsidiary links continue to be a source of resilience in the region, even Figure 9. Asset class performance, percent change though cross-border banking Pre-crisis to Trough financing contracted in the EU1 Trough to current region. At the same time, financial conditions remain Exchange rates** more difficult than before the crisis and the increase in Credit to private sector sovereign debt burdens poses risks to financial stability. Capital inflows in the EU1 increased, as governments took advantage of easing external conditions to issue sovereign bonds. From October 29 to February 21, global emerging market capital flows reached close to US$19billion, more than twice the amount of the same period last year. In the EU1 region, they increased over the same period from about US$3 billion to US$28 billion (Figure 11). Total bond issuance was a key factor behind the rise, as bond sales jumped from US$1 billion to US$17 billion in the EU1 region over the same period. The pipeline for bond issuance remains full in light of large fiscal deficits, with many sovereigns announcing plans to issue in coming months, including Russia, Poland, and Ukraine. Equity placement also strengthened gradually, as stock markets in Hungary, Estonia, Romania and Poland saw significant increases since October 29, even though bank lending remained subdued. Stocks CDS spreads* Source: Reuters, Bloomberg, World Bank staff calculations Notes: *CDS spreads are reversed; ** for real effective exchange rates minus denotes depreciation Figure 1. Stock exchange indices in EU1 countries, January 27=1 Figure 11. Capital inflows to EU1, USD billions BG EE LV SI Banks Equity Bond SK Source: Bloomberg, World Bank staff calculations Source: Eurostat, World Bank staff calculations In spite of improvements in the last quarter of 29 in the Czech Republic, Estonia and Latvia, net foreign direct investment dropped below 2 percent of GDP in 29 in all EU1 countries with the exception of Bulgaria and Romania, and turned negative in the Slovak Republic and Slovenia. Czech FDI inflows more than halved in 29. In Bulgaria, overall capital flows declined from 33 percent of GDP in 28 to only 6 percent in 29. Gross reserves 9

10 % exposure change remained stable in the last quarter of 29 in the EU1 region, reflecting a pick-up in capital flows, reduction in external financing needs, and support from international partners. Gross external debt increased further owning to buoyant debt creating flows and unfavorable debt dynamics. Gross external debt-to-gdp ratios across the EU1 region increased from 6 percent in 28 to 78 percent of GDP in 29. They ranged from around 4 percent in the Czech Republic to over 1 percent in Hungary, Estonia, Slovenia, Bulgaria, Latvia, and the Slovak Republic. In many EU1 countries, a growing share of the external debt is created by the public sector, as governments tap the external market for new borrowing and refinancing. However, the share of public external debt in overall external debt remains low in e.g. Bulgaria. Conversely, cross-border claims by foreign banks dropped in most EU1 countries in the third quarter of 29 compared to the same period last year, although they stabilized in the third quarter of 29 (Figure 12). With about three-quarters of the EU1 banking assets in foreign ownership, cross-border capital flows in the banking sector remain central to the stability of the financial system and credit provision. As reported by the Bank for International Settlement (BIS), claims of EU1 banks on the EU1 countries in September 29 totaled EUR297bn, unchanged from June 29 and about 8 percent below the peak in December 28. However, the aggregate statistics hide important country and sectoral differences during the third quarter of 29. Claims decreased noticeably in Lithuania and Estonia, but increased markedly in the Czech Republic and Slovenia. Claims decreased by 18 percent on the banking sector, but increased by 2 percent on the nonbanking private sector and 4 percent Figure 12. Change in cross-border claims by foreign banks from the third quarter of 28 to the third quarter of BG 2 SI on the public sector. In addition, EU1 banks claims in local currency Source: BIS, EBRD, World Bank staff calculations. on the EU1 region reached EUR2bn in September 29. This is roughly unchanged compared to June 29 and about 8 percent higher than in March 29, although it remains about 1 percent below the peak in September 28. Poland was the only country that experienced noticeable growth in the third quarter 29. The recent volatility in sovereign bond markets underlines the fragility of financial markets, although investor confidence in the EU1 countries has held up well. Emerging market bond spreads have been broadly stable since October 29 at about 7 basis points above the level posted in June 27. However, the benchmark U.S. Treasury yields have increased basis points since end-november, as investors pay close attention to vulnerabilities arising from high fiscal deficits and public debts. Credit default swap spreads widened and yield curves shifted upwards in a number of euro zone countries, as uncertainty persists over the fiscal imbalances and consolidation plans. By contrast, in the EU1 region, yield curves in the Czech Republic, Poland, Romania and Hungary improved from March 29 to March 21, and credit default swap spreads shifted downwards, or remained stable as in Bulgaria and Romania, since October 29 (Figure 13 and Figure 14). This could be a sign of lower fiscal imbalances in the EU1 region than in the EU1 region and more advanced fiscal adjustment programs as discussed in the fiscal policy section. Alternatively, it could reflect improved global sentiment and liquidity, which have a larger impact on the EU1 region than on the EU1 due to the higher dependence on external capital flows. LV % foreign bank ownership EE SK 1

11 Jan-8 Mar-8 May-8 Jul-8 Sep-8 Nov-8 Jan-9 Mar-9 May-9 Jul-9 Sep-9 Nov-9 Jan-1 Mar-1 Jan-8 Mar-8 May-8 Jul-8 Sep-8 Nov-8 Jan-9 Mar-9 May-9 Jul-9 Sep-9 Nov-9 Jan-1 Mar-1 Jan-7 Apr-7 Jul-7 Oct-7 Jan-8 Apr-8 Jul-8 Oct-8 Jan-9 Apr-9 Jul-9 Oct-9 Jan-1 1M 2M 3M 6M 1Y 2Y 3Y 4Y Y 6Y 7Y 9Y 1Y 11Y 13Y 1Y 3Y Y 1M 2M 3M 6M 1Y 2Y 3Y 4Y Y 6Y 7Y 9Y 1Y 11Y 13Y 1Y 3Y Y Figure 13. Yield curves in the selected EU1 countries, percent March 29 March Source: Bloomberg, World Bank staff calculations Figure 14. Y CDS spreads for EU1 countries (basis points) BG EE LV SI SK Source: Bloomberg, World Bank staff calculations Still, money markets have stabilized, as banks in EU1 countries and their parent banks in EU1 countries are becoming less reliant on government guarantees and central bank support. While interest rate spreads remain elevated for some EU1 countries (Figure 1, Figure 16), the spreads of 3-month rates in interbank markets declined sharply in Bulgaria, Hungary, Romania, Estonia, Latvia and Lithuania. Figure 1. EU1 3M interbank rates, percent Figure 16. EU1 3M interbank rates spreads to 3M LIBOR EUR, percent BG EE LV SI BG EE LV SI SK SK Source: Bloomberg, World Bank staff calculations Source: Bloomberg, World Bank staff calculations Credit to the private sector remains sluggish however, even though the tightening of bank lending standards has moderated. Year-on-year credit growth to households recovered from 11

12 Jan-7 Apr-7 Jul-7 Oct-7 Jan-8 Apr-8 Jul-8 Oct-8 Jan-9 Apr-9 Jul-9 Oct-9 Jan-1 Jan-7 Apr-7 Jul-7 Oct-7 Jan-8 Apr-8 Jul-8 Oct-8 Jan-9 Apr-9 Jul-9 Oct-9 Jan-1 close to zero in October 29 to 12 percent in January 21 in the EU1 region, and was negative only in Lithuania, Latvia and Estonia (Figure 17, Figure 18). By contrast, credit to enterprises remained negative since July 29 in the EU1 region, and was positive in January 21 only in Poland, Romania, Bulgaria and Slovenia. Tight credit markets reflect the need to rebuild capital, concerns about future write-downs, uncertainty about the future regulatory framework and weak credit demand. Figure 17. Credit growth to non-financial enterprises, percent, year-on-year Figure 18. Credit growth households, percent, year-on-year BG EE LV SI BG EE LV SI SK SK Source: European Central Bank, World Bank staff calculations 12

13 change in labor productivity per employee Employment Despite an incipient recovery, the labor market has continued to worsen. In the fourth quarter of 29, in line with trends for the EU overall, year-on-year employment growth was negative across all EU1 countries with available data. It ranged from -.8 percent in Poland to double-digit contractions in Estonia and Latvia. With the exception of the Slovak Republic, the contraction of employment was less than the contraction of output from the third quarter of 28 to the third quarter of 29, as employers avoided layoffs by reducing the number of hours worked per employee (Figure 2). Similarly, the tightening of the labor market conditions prompted an increase in part-time employment over this period. Part time employment increased more than 2. percentage points in Estonia, Latvia and Lithuania. Figure 19. Output vs. employment decline, percent Figure 2. Year-on-year change in labor productivity per employee vs. change in labor productivity per hour worked in 3Q Change in output 3Q 9-3Q 8 (cummulated) Change in employment 3Q 9-3Q 8 LV EE SI SK BG Change in labor productivity per hour worked BG SK LV -4-6 EE Source: Eurostat, World Bank staff calculations Source: Eurostat, World Bank staff calculations Unemployment continues to rise in the EU1 region. Unemployment rates in the EU1 rose from 6. percent in June 28 to 9. percent in January 21, increasing from 2.9 million to 4.6 million persons (Figure 21). Unemployment rose by 1.7 million persons since the trough in June 28. Country differences are large. From June 28 to January 21, unemployment rates increased around 16 percentage points in Latvia, around 1 percentage points in Estonia and Lithuania; and less than 4 percentage points in Slovakia, Czech Republic, Hungary, Slovenia, Bulgaria, Poland, and Romania. 13

14 Jan-7 Apr-7 Jul-7 Oct-7 Jan-8 Apr-8 Jul-8 Oct-8 Jan-9 Apr-9 Jul-9 Oct-9 Jan-1 1Q 7 2Q 7 3Q 7 4Q 7 1Q 8 2Q 8 3Q 8 4Q 8 1Q 9 2Q 9 3Q 9 Figure 21. Harmonized unemployment rates, percent Figure 22. Labor cost index, year-on-year, percent change BG EE LV SI BG EE LV SI SK SK Source: Eurostat, World Bank staff calculations Note: The labor cost index shows the short-term evolution of the total cost of labor, on an hourly basis for employers, including gross wages and salaries, employers social contributions and taxes net of subsidies connected to employment. The duration of unemployment is increasing for many workers. With the labor market deteriorating from the third quarter of 28 onwards, close to two-thirds of those without a job in the third quarter of 29 were less than one year unemployed (Figure 23). At the same time, the crisis made it much harder for workers who had lost their job before the onset of the crisis to return to employment. The share of the labor force unemployed for 12 months or more increased from 2. percent in the third quarter of 28 to 2.9 percent in the third quarter of 29 in the EU1 region, similar to the trends in the EU1 countries (Figure 24). With unemployment levels rising and the number of job vacancies falling, the competition for jobs has increased. In the first quarter of 28, there were 6 unemployed for each job vacancy in the EU1 region. By the fourth quarter of 29, this number had increased to 27. Figure 23. Unemployed by duration in Q3 28 and Q3 29, million Figure 24. Long-term unemployed (12 months of more) as percent of active population months or more Between 6 and 11 months Between 3 and months Between 1 and 2 months Less than 1 month Q 8 3Q 9. 3Q 8 3Q 9 EU1 EU1 SK LV EE BG SI Source: Eurostat, World Bank staff calculations Job market prospects for workers with basic education level and little work experience are likely to stay impaired for several years. The increase in unemployment rate from June 28 to January 21 was 8 percentage points for the 1 to 24 year-olds, compared to only 3 percentage points overall (Figure 2). The unemployment rate rose faster for workers with at most lower-secondary education than the average rate in the Czech Republic, Estonia, Lithuania and Hungary (Figure 26). In addition, since the economic crisis affected especially sectors like construction and manufacturing, job losses are concentrated among men. Male unemployment in January 21 exceeded female unemployment in all EU1 countries, with the largest differences in Estonia, Lithuania and Latvia. 14

15 Change in unemployment rate among young (p.p) Change in unemployment rate among less educated workers Figure 2. Change in unemployment rate from June 28 to January 21 by age (%) Figure 26. Change in unemployment rate from 2Q 28 to 3Q 29 by education (%) 3 LV 2 EE EE 1 LV 1 SK 1 EU1 BG SI EU Change in overall unemployment rate (p.p.) 1 EU1 SI BG - SK Change in overall unemployment rate (p.p.) Source: Eurostat, World Bank staff calculations Economic recessions and poor job prospects weakened wage pressures around the region. In the fourth quarter of 29, hourly labor costs decreased more than percent annually in Lithuania, Estonia and Latvia, where falling wages are crucial for restoring competitiveness in view of the exchange rate pegs. By contrast, they increased in excess of percent in Bulgaria reflecting more intense shedding of low-skilled jobs and raising of minimum insurance thresholds, Poland, the Czech Republic and Romania. In the third quarter of 29, labor costs continued to decelerate relative to the second quarter of 29 across the region except in the Czech Republic (Figure 22). 1

16 Outlook While the recovery in the global economy and trade is under way, the outlook in Europe remains uncertain, as private demand remains subdued. After declining by one third between September 28 and March 29, global trade now is growing again very rapidly. Global exports rose in value terms by 21 percent year-on-year in January 21, supporting a tentative recovery in global GDP. The Euro Zone flash Purchasing Managers Index for the manufacturing sector grew in March at the fastest pace since 27, signaling that the euro area recovery is gathering speed once again after pausing in the fourth quarter. The weakness in the euro, which has dropped about 11 percent against the dollar in the last four months, is making European manufacturing exports more competitive. However, growth is expected to moderate in the coming quarters, as unprecedented policy stimulus measures and temporary factors subside amid strong headwinds from continued high unemployment, low capacity utilization, and tight financial conditions. As these factors abate, high unemployment, low capacity utilization and banking sector deleveraging are expected to weigh on private sector activity. The EU1 region is set to return to growth in 21 and 211 but the rate of growth is likely to be lower than the pre-crisis. According to the latest government forecasts, after contracting by 3.6 percent in 29, the EU1 countries are projected to expand by 1.6 percent in 21 and 3.6 percent in 211. While the EU1 region is set to outgrow the EU1 region in both 21 and 211, the recovery is weak. It will take until the second half of 211 before real output will regain its pre-crisis level, and until 213 or 214 in most countries before actual output will close the gap to potential output. Even then, the expansion is likely to remain below the pre-crisis growth rate of 6 percent, as potential growth could stay low with the decrease in investment, increase in unemployment, restrained financing of research and development (see Focus Note #1), and ageing of the population. The pace of the recovery will differ across the region, reflecting different initial conditions, external shocks and policy responses. Poland, the Slovak Republic, Lithuania, Romania and the Czech Republic are leading the recovery in 21, while Latvia is lagging. At the same time, Lithuania, Estonia and Latvia are expected to see the largest improvements in the growth rate from 29 to 21, ranging from 13 to 17 percentage points. Only in 211 will all EU1 countries experience growth. While commodity prices have edged upwards, inflation is likely to remain subdued in view of large output gaps. Current account deficits are likely to remain below pre-crisis levels in view of weak import demand and shallow capital flows (Table 3). Figure 27. Forecasted GDP growth in EU1 countries and EU1*, year-over-year EU1 EU1-2 LV EE SI SK BG Source: Convergence Program Updates January/February 21, World Bank staff calculations. Note: EU1 does not include Portugal. 16

17 Table 3. Macroeconomic Forecasts for EU1 countries Real GDP growth (annual Harmonized inflation index Current account balance percent change) (annual percent change) (percent of GDP) Bulgaria Czech Republic Estonia Latvia Lithuania Hungary Poland Romania Slovenia Slovakia Source: Convergence Program Updates January/February 21, Central Banks, World Bank staff calculations. There are some upside risks to the outlook. A fast global recovery, the return of confidence in financial markets, the turning of the inventory cycle, low interest rates and stepped-up utilization of EU funds could support a stronger-than-expected upturn of capital and trade flows and private demand. Positive feedback effects from the real and financial sector could accelerate convergence to EU income levels. Downside risks are also significant. First, the main risk is a weak recovery in Europe, as prospects for exports, manufacturing, credit and jobs in the EU1 region depend foremost on a sustainable recovery in the EU1 region. Europe s recovery from the global financial crisis, which triggered a sharp and synchronized contraction, could be sluggish and may still be followed by a relapse. In 29, the economy relied mainly on net exports, reflecting the sharp contraction in imports, and public demand, visible in the sharp increases in fiscal deficits. As these growth drivers diminish in 21, the expansion could weaken. Second, in spite of the recent improvements in global financial markets, heightened financial strains could return, especially if policy support in advanced countries is withdrawn prematurely or policy coordination deteriorates. A renewed deterioration of macroeconomic conditions could lead to a further increase in non-performing loans and additional credit tightening by banks. Alternatively, rising concerns about worsening fiscal positions could unsettle financial markets. The large public debt issuance over the next years could raise interest rates, crowd out private sector credit growth and dampen the economic recovery. Finally, a prolonged deterioration of economic prospects could undermine public support for reforms. This could reduce the Government s ability to implement the needed structural reforms also in view of upcoming political elections in many EU1 countries. Improvements in productivity depend on successful structural reforms in areas such as public finances, labor markets, education, and business climate. Without such reforms, the remaining rigidities in the public sector and the labor and product markets could become a drag for future growth. 17

18 Policies for Recovery Monetary and Financial Policy Government policies continue to balance supporting a broad-based economic recovery with exiting anti-crisis economic policies in a timely manner. A year and a half after the outbreak of the global financial crisis, the EU1 region has managed successfully to shore up economic growth, strengthen financial markets and limit adverse social outcomes. However, the strength of the recovery is uneven across the region, and there are few signs of a robust upturn of the private sector. A key policy issue is when and how to phase out the extraordinary support to the economy and the financial sector, adopted in response to the European Economic Recovery Program from November 28, in order to strike an appropriate balance between stabilization and sustainability concerns. Monetary policy is expected to remain supportive of the recovery as inflation pressures continue to be moderate. The easing in policy rates, started in Europe by the Czech National Bank in August 28, has continued, with reductions in Romania, Hungary and the Czech Republic since December 29. Since the outbreak of the crisis, central banks have lowered the policy rates by 7 basis points in Hungary, 32 in Romania and the euro zone, 27 basis points in the Czech Republic, and 2 basis points in Poland (Figure 28). Low interest rates have aided the recovery, also because they limit excessive foreign exchange appreciation that could hurt competitiveness. However, the policy stance may begin to shift as the output gap declines and inflation pressures resurface, including from global energy prices. Global oil demand turned positive in the fourth quarter of 29. Continued tightening of market conditions has increased crude oil prices, which have traded between US$7-8/barrel since October 29. For the time being, the sluggish recovery, the slack in the economy, and the appreciating domestic currencies are expected to offset price pressures from higher commodity and energy prices. While monetary policy makers face high uncertainty regarding the trends in potential output, capital flows, and inflationary pressures, the EU1 central banks are likely to remain supportive of a recovery as long as the recovery remains uncertain and inflation subdued. Some EU1 countries may also at some point have to manage a surge in capital inflows in order to avoid unwarranted asset price and exchange pressures. Euro adoption remains a central reform anchor for the EU1 countries outside the euro zone, but the large adjustment needs have delayed entry dates for some countries. The Czech Republic, Hungary and Poland, where exchange rate flexibility played a crucial role in absorbing the shock of the global financial crisis, have not announced a specific target date for euro adoption. Estonia appears on target to entering the euro zone in 211. The target dates are 213 for Bulgaria, 214 for Latvia and Lithuania, and 21 for Romania. 18

19 Jan-8 Feb-8 Mar-8 Apr-8 May-8 Jun-8 Jul-8 Aug-8 Sep-8 Oct-8 Nov-8 Dec-8 Jan-9 Feb-9 Mar-9 Apr-9 May-9 Jun-9 Jul-9 Aug-9 Sep-9 Oct-9 Nov-9 Dec-9 Jan-1 Feb-1 Mar-1 Aug-8 Sep-8 Oct-8 Nov-8 Dec-8 Jan-9 Feb-9 Mar-9 Apr-9 May-9 Jun-9 Jul-9 Aug-9 Sep-9 Oct-9 Nov-9 Dec-9 Jan-1 Feb-1 Mar-1 Figure 28. Policy rates in selected EU countries and Euro Area Figure 29. Nominal exchange rates to EUR, August 28= EU Source: Central Banks, World Bank staff calculations Source: Reuters, World Bank staff calculations Notes: Upward movements denote depreciation Bolstering the resilience of the financial sector remains essential to safeguarding the recovery. In view of the large foreign ownership of the banking system, the stabilization of the banking system in Western Europe has reduced funding risks. The amount of required writedowns of European banks is likely to have come down since autumn 29 due to the recovery in securities prices. Nevertheless, there remains a pressing need to tackle impaired bank assets and facilitate restructuring in home countries of parent banks. Banks face the task of absorbing credit losses that are still on the rise, raise additional capital needed to support the recovery of credit and sustain the recovery under the expected new Basel Capital adequacy standards, and ensure smooth rollover of funding. Bank profitability might be under pressure from loan provisioning, capital and funding strains, and subdued credit expansion. This points to the need for further measures to facilitate bank restructuring, ensure appropriate contingency planning, and strengthen the resilience and stability of the financial system through macro-prudential regulation. 19

20 Fiscal Policy In 29, fiscal policy in EU1 countries shored up the economy through automatic stabilizers and, in some countries, discretionary measures. The EU1 general government deficit doubled from 3.3 percent of GDP in 28 to 6. percent of GDP in 29. This compares to a 17 percent increase, or from 2.6 percent of GDP to 7.1 percent of GDP in 29, in EU1 countries. The larger hike in the fiscal deficit of Western Europe reflects the greater scope for some EU1 countries for anti-cyclical fiscal policy in view of lower reliance on external financing and lower initial fiscal imbalances. Among the EU1 countries, half of the rise in the primary fiscal deficit was due to a rise in the structural deficit rather than cyclical effects (Figure 3). Alternatively, about three-fifths of the rise was due to an increase in public expenditures (Figure 31). But there were large differences across countries. The increase in the primary fiscal deficit exceeded the impact of the cyclical deterioration in Slovenia, Poland, the Czech Republic, and Romania. Revenues fell noticeably in Poland, the Czech Republic, Bulgaria and Romania. In spite of sharp contractions in output, the fiscal deficit moderated in Estonia, and increased only slightly in Hungary. Figure 3. Composition of the increase in the primary fiscal deficit from 28 to 29, percent of GDP Figure 31. Composition of changes in the fiscal deficit in EU1 countries and EU1* from 28 to 29, year-over-year; Structural primary balance Cyclical component Primary balance EU1 LV BG SI SK EE Source: Convergence Program Updates January/February 21, World Bank staff calculations In most EU1 countries, the high fiscal deficits in 29 are therefore not only due to the weak state of the economy, but reflect lack of progress in advancing public expenditure reforms, generous spending and weak public expenditure controls in recent years. From 2 to 28, the fiscal deficit in the EU1 region averaged 3.9 percent of GDP, compared to only 1.6 percent in the EU1 region. Government expenditures exceeded revenues throughout this period in many countries, even at the peak of the economic cycle. Countries with larger fiscal deficits and public debt levels are under greater pressure to step up fiscal adjustments. Hungary and Estonia have already undertaken significant fiscal adjustment based on expenditure reduction. While governments across the region balanced in 29 efforts to stabilize public finances with support for the recovery, fiscal consolidation needs to become the main policy objective as the economy gains strength. Fiscal adjustment is central for rebalancing demand away from public toward private sectors, complying with national public debt limits and the commitments under the Stability and Growth Pact, and protecting priority spending for jobs and growth. In addition, it is also crucial for assuring markets about the sustainability of public finances. While financial market sentiment towards the EU1 region has held up well in spite of concerns about fiscal imbalances in Southern Europe, a loss of market confidence could trigger a sharp rise in interest rates and force painful fiscal retrenchment. In January and February 21, governments reiterated their commitments in the convergence program updates to reducing the fiscal deficit to 3 percent of GDP over the medium-term. Currently, all EU1 countries with the exception of Bulgaria and Estonia have Expenditures Revenues Fiscal deficit EU1 EU1 LV SK SI BG EE 2

21 ongoing EU excessive deficit procedures on the basis of fiscal deficit overruns, along with 12 of the 17 other EU member states. The EU1 countries with ongoing excessive deficit procedures are expected to bring the fiscal deficit below 3 percent of GDP from 211 to 213. In 21, EU1 governments aim to reduce fiscal deficits from 6. percent of GDP in 29 to.8 percent in GDP in 21, while EU1 governments still project on average a widening fiscal deficit (Figure 32). In the EU1 region, all governments apart from Slovenia target lower fiscal deficits. The scale of the fiscal consolidation is set to increase in 211, when fiscal balances are projected to improve from -.8 percent of GDP to -4.7 percent of GDP. By 212, fiscal deficits are supposed to drop by 3. percent of GDP in the EU1 region, compared to 2.7 percent of GDP in the EU1 region (Figure 32). Figure 32. Forecast general government deficit in EU1 countries and EU1*, year-over-year EU1 EU1-12 LV SK SI EE BG Source: Convergence Program Updates January/February 21, World Bank staff calculations Notes: EU1 does not include Portugal EU1 governments have endorsed sizable multi-year structural fiscal consolidation. While EU1 countries have taken steps to address the sharp deterioration in public finances triggered by the crisis, the consolidation of fiscal balances will require steadfast attention over the next few years. The planned fiscal adjustment tends to be gradual, as private demand is still too weak to sustain the recovery. Public debt is projected to increase in 21, with the exception of Bulgaria (Figure 33). Even excluding fiscal costs arising from population aging, primary fiscal balances would have to improve by.1 percent of GDP in the EU1 countries in order to stabilize public debt levels at 29 levels (Figure 34). The recovery in growth is too weak to achieve significant fiscal savings, as actual output is projected to remain below potential output in 212 (Figure 3). Hence, the planned fiscal consolidations are mainly based on structural adjustments in primary balances (Figure 36). However, the European Commission found that the budgetary targets from 211 onwards are based on optimistic growth projections in some countries and often on consolidation strategies insufficiently backed by concrete measures. 21

22 Figure 33. Forecasted general government debt in EU1 countries and EU1*, year-over-year EU1 EU1 SK LV SI BG EE Source: Convergence Program Updates January/February 21, World Bank staff calculations Notes: EU1 does not include Portugal Figure 34. Primary balance adjustment needed to stabilize debt at 29 level Figure 3. Output gap in 28, 29 and 212 (percentage difference between actual and potential output) BG EE SK EU1 SI LV SK EU1 SI BG EE LV Source: Convergence Program Updates January/February 21, World Bank staff calculations The fiscal deficit reductions rely predominantly on downward adjustments in public expenditures (Figure 37). This would ensure that countries do not emerge from the crisis with large public sectors that are a drag on growth. In many countries, key expenditure measures for bringing about the reduction in fiscal deficits are freezes or reductions in public sector wages and pensions, consolidation of discretionary spending and increases in the flexibility of government expenditures. These efforts on the expenditure side are in some countries complemented through measures to broaden the tax base and strengthen tax administration. Since the crisis has undermined the tax base and weakened tax compliance, such policies are crucial to bolster revenue collection. 22

23 Figure 36. Composition of primary deficit reduction from 29 to 212, percent of GDP Figure 37. Composition of fiscal deficit reduction from 29 to 212,percent of GDP Cyclical component Structural primary balance Primary balance Expenditures Revenues Fiscal deficit EU1 LV SI SK BG EE -4 EU1 EU1 LV SK SI BG EE Source: Convergence Program Updates January/February 21, World Bank staff calculations Notes: EU1 does not include Portugal Some countries are preparing legislation to strengthen fiscal institutions. For example, fiscal rules that limit public expenditure increases during an economic upturn could, together with multi-year and performance-based budgeting, contribute to sustainable fiscal finances over the long-term. Ensuring that buoyant revenues in the good times are used to pay off public debt rather than to boost expenditures is vital for ensuring that fiscal policy has adequate flexibility to respond during the bad times, without unraveling fiscal sustainability. This is one of the key fiscal policy lessons of the global financial crisis. In addition, countries are contemplating changes to structural policies, such as increases in retirement ages, in order to strengthen long-term fiscal sustainability in the context of population aging. 23

24 212 Structural and Labor Policy The global financial crisis has slowed but not reversed the convergence process of the EU1 countries. Eurostat data on GDP per capita in purchasing power standards (PPS) for the 27 EU member states show that EU1 countries are set to remain far closer to the EU average in 211 than in 2 (Figure 38). Apart from Latvia, Lithuania and Estonia, whose economies contracted by doubledigits in 29, the countries are projected to remain in 211 not far off their peak of convergence in 28. Poland, the only EU country to have avoided recession in 29, is forecast to continue convergence to EU levels at roughly the same speed as prior to the crisis. Based on these numbers, the sustainability of the convergence process is not in question. Deep economic integration will remain a crucial feature of the European convergence model. Figure 38. EU1 countries GDP per capita in purchasing power standards (EU27 = 1) Source: Eurostat, World Bank staff calculations. While convergence might be holding up remarkably well, EU1 countries nevertheless face a large reform agenda to shore up long-term growth prospects. The crisis might well have led to a permanent loss in potential output. First, the crisis could result in a decline in investment for various reasons, including higher cost of capital, lower profitability, Figure 39. Potential growth in 24-7 and and lower capital inflows. This damages the 212 by EU1 member country, percent productive capacity of the economies. 7 Second, a decline in economic activity could raise the level and duration of 6 unemployment, harming the quality and quantity of labor. Third, future productivity might also get undermined as lower 4 profitability reduces spending on research SK and developments and credit remain 3 EU1 constraint for innovative companies (see SI BG LV Focus Note #1). Finally, rebalancing the 2 sources of growth from non-tradables, such 1 EE as finance, real estate and construction, to the tradable sector will be challenging, as countries around the globe are aiming to increase export shares. Indeed, according to government estimates, potential growth Source: Convergence Program Updates in 212 is still going to be about 1.3 January/February 21, European Commission percentage points below the levels of 24 World Bank staff calculations. to 27 (Figure 39). The crisis has reemphasized the importance of supporting potential growth through structural change, as envisioned in the EU s new Europe 22 strategy for smart, sustainable and inclusive growth. Boosting potential growth would limit the fiscal deterioration resulting from the crisis, and would help to tackle the multiple challenges arising from globalization, energy deficiency (see Focus Note #2), climate change, and population aging. The reform agenda is vast, ranging from increasing labor force participation, to strengthening higher education and innovation, and to cutting red tape and reducing regulatory costs for doing business BG LV EE SK SI

25 Unemployment is expected to decline only starting in 211. The number of unemployed is expected to increase from 4.1 million in 29 to 4.4 million in 21. Governments in all EU1 countries, with the exception of Romania, project higher unemployment in 21 than in 29 (Figure 4). In view of the weak recovery, companies are likely to postpone hiring of new workers until growth is on a firm footing, especially as many businesses have reduced the number of hours worked per worker during the crisis. In addition, a number of EU1 countries, including Bulgaria, Czech Republic, Romania and Slovakia, have begun consolidating the size of the public sector in view of fiscal pressures and the desire to strengthen the efficiency of public administration. Figure 4. Forecasted harmonized unemployment rates in EU1 and EU1** countries, percent EU1 EU1 LV EE SK BG SI Source: Convergence Program Updates January/February 21, World Bank staff calculations. Notes: EU1** does not include Portugal, France and UK. To ensure a balanced and inclusive economic recovery, labor market policies are central to the exit strategies of EU 1 governments. A main challenge faced by the governments in the region is to prevent the cyclical increase in unemployment from turning into structural unemployment. This, in turn, is related to the issue of labor markets flexibility. In the precrisis period, as countries were growing fast and labor demand surpassed labor supply, the debate around the flexibility of the labor markets in the new EU states was overshadowed by issues such as wage dynamics versus productivity growth or skills shortages. As the mismatch has been reversed during the crisis, it is important in some countries that governments take steps to reduce labor market rigidities, including by revisiting employment protection legislation 2

26 EU1 October 29 Summary of In Focus Notes Focus Note # 1 Impact of the crisis on the corporate sector evidence from a firm-level survey The global economic crisis changed dramatically the market conditions under which the corporate sector operates. The deleveraging of financial institutions increased capital costs and reduced credit availability, while adjustments in the exchange rate for countries with flexible exchange rates raised the price of imported inputs and turned exports more competitive. The contraction in global trade decreased foreign and, as a second round effect, domestic demand. To these steep shifts in market conditions particularly severe in the EU1 countries - the corporate sector need to respond by either reducing output, increasing their productivity (possibly through restructuring operations) or exiting the market. This process of structural adjustment to new market conditions may in turn have important effects on the potential growth of the EU1 economies. This note will use firm level date to address the main impacts of the crisis on the corporate sector of some of EU1 countries and to discuss the prospects of economic growth for the region. Focus Note # 2 Insights for the EU1 and Croatia from the Europe and Central Asia energy outlook 23 The latest Europe and Central Asia (ECA) energy outlook suggests a shortage of both primary and derivative energy supplies if the current policy environment is not changed. Unless ECA countries start to invest much more in energy in coming years, by 23 the region as a whole will become a net energy importer in contrast to its current role as an exporter. Western Europe is heavily dependent on energy imports from this region, but with the financial capacity to secure the energy supplies it needs (albeit at the expense of others). In contrast, the region s energy-importing countries are caught between Western Europe, which has increasing import needs, and the region s exporters, whose exports will likely decline. Energy-importing countries in ECA face the prospect of being squeezed both financially and in terms of energy access. These developments will have significant implications for the EU1 and Croatia. In order to avoid shortages in primary energy supplies (mainly gas), they could increase reliance on coal, which is locally available but more polluting, but such a shift would be in conflict with the EU fight against climate change. Or they may want to postpone shutting down aging nuclear reactors. In this light, the EU climate change and energy policies constitute huge challenges for some of the EU1. The best option for these countries is to focus on energy efficiency, which, despite dramatic improvements over the last two decades, has not yet reached EU1 levels. 26

27 EU1 April 21 In Focus: Impact of the crisis on the corporate sector evidence from a firm-level survey The global economic crisis dramatically changed the market conditions facing the corporate sector 2. The deleveraging of financial institutions increased capital costs and reduced credit availability, while the contraction in global trade decreased foreign and, as a second round effect, domestic demand. To these steep shifts in market conditions particularly severe in the EU1 countries -- the corporate sector had to respond by either reducing output; increasing their productivity (possibly through restructuring operations) or exiting the market. This note uses firm level data to examine the main impacts of the crisis on the corporate sector of some of EU1 countries and highlights some concerns that need to be addressed for sustained growth going forward. The Effects of the Global Economic Crisis on the Corporate Sector What do firm-level data tell us about the crisis impact on the corporate sector in EU1 Region? The World Bank s Enterprise Financial Crisis Survey Figure 41. The main effects of the crisis on enterprises (EFCS) - covering 1,686 firms in six countries (Turkey, Romania, Latvia, BG 78.1 Lithuania, Hungary and Bulgaria) increased the level of 7.3 from manufacturing, retail and debt other service sectors 3 - was LV 7.4 increased input cost conducted in June/July 29 with the objective of addressing the 7.8 reduced access to credit effects of the crisis on key aspects 78. drop in demand for its of the corporate sector, including products or services sales, employment and finances. TR 71.3 other Despite the magnitude of the credit % 2% 4% 6% 8% 1% crunch, the survey indicates that the majority of firms considered the contraction in total demand to be the most important impact of Percent of firms Source: World Bank the crisis on their business. More than 7 percent of firms in each of the countries covered cited the drop in demand as the most important effect of the crisis, compared with increase in the level of debt, increase in input cost, or reduced access to credit (Figure 41). Reflecting the demand-side impact of the crisis, firms in all countries experienced a decline in their sales. The average drop in sales in 29/28 was significant in all countries, but was particularly steep in Latvia and Lithuania, where the average sales contraction was 48.4 percent and 48 percent, respectively (Figure 42). 2 Prepared by Paulo Correa and Mariana Iootty. This focus notes draws on the World Bank s Enterprise Note n. o 9 by the same authors. 3 Turkey is the exception where only the manufacturing sector was targeted. 27

28 Percent Percent Figure 42. Average drop in sales (29/28), by country Source: World Bank BG LV TR Figure 43. Percent of firms with sales increase (29/28) by country BG LV TR Percent 1 At the same time however, some enterprises experienced sizable growth. Despite the generalized drop in demand, about 1 percent of total firms on average in the six countries experienced significant growth in sales. This ranged from roughly 1 percent in Turkey and Bulgaria, to around percent in Hungary, Latvia and Lithuania (Figure 43). Figure 44. Debt Profile of Corporate Sector By the peak of the crisis, the share of the corporate sector debt in foreign currency was considerable and debt maturity concentrated in the short term. The EFCS shows that approximately 41 percent of firms in the six countries hold foreigndenominated debt. On average, 26.4 percent of the corporate sector s debt was foreign-currency denominated, with some countries such as Hungary, Latvia and Romania, showing higher foreign currency debt at 3.3, 39.4 and 31.2 percent respectively (Figure 44) 4. Firms reacted to the crisis by increasing the use of internal funds to finance working capital and delaying payments to tax authorities or suppliers. Firms reacted to the crisis by relying more on their internal resources to finance working capital. When comparing the end of fiscal year 28 to June/July 29, the proportion of firms that financed 1 percent of their working capital with their internal funds or retained earnings increased in all countries. This increase was particularly relevant in Bulgaria (31.9 percentage points) and Hungary (24. percentage points). Another frequent response to the liquidity constraint was delaying payments to tax authorities and suppliers. Payment adjournments for more than one week were especially relevant in Latvia and Lithuania, where the proportions of delayed firms were, respectively,. percent and.7 percent. Firms actively sought to restructure their debt. Filing for insolvency or bankruptcy was less frequent than the use of state aid. Approximately 14 percent of companies in all of the six countries covered by the EFCS attempted to restructure their debt in the 12 months ending in June/July 29. This process seemed to be more intense in Latvia and Lithuania, where almost Source: World Bank BG LV TR 21.8 average percent of total liabilities with a term of maturity less than one year average percent of total liabilities denominated in foreign currency 4 The survey is not fully representative with regard to foreign currency debt. For example, in Hungary official data shows that the share of bank loans in foreign currency as percent of total loans for corporate sector in 28 was 6.3 percent rather than 3.3 percent as according to the survey. Except in Turkey where the question was not included in the questionnaire. 28

29 2 percent of firms have restructured their outstanding liabilities. 6 Figure 44 shows that this result was larger for the subsample of firms with overdue payments to any financial Figure 4. Insolvency, Debt Restructuring and institution, particularly in Hungary and State Aid Latvia, where 6.8 percent and percent, respectively, of delayed firms tried to restructure their debt. Almost 2 percent 4 of all companies applied for insolvency or bankruptcy in the 12 months that preceded the survey. This proportion increases when considering only the firms with overdue BG LV TR payments. In that case, almost 6 percent of Percent of firms overdue on obligations that have filed for firms filed for insolvency or bankruptcy. INSOLVENCY/BANKRUPTCY Percent of firms overdue on obligations that have tried to RESTRUCTURE any of There are differences across coutnries their liabilities Percent of firms overdue on obligations that have applied for STATE AID however: in Bulgaria and Latvia, a negligible proprotion of firms with overdue obligations Source: World Bank filed for insolvency or bankruptcy, while in Hungary the use of these last resource measures was more significant, at 9.9 percent (Figure 4). In all EU countries, the state aid instrument was more frequently used than insolvency or bankruptcy measures, though less employed than debt restructuring. 7 On average, 8.3 percent of firms applied for state aid in the previous 12 months (as of June/July 29). Within the subsample of firms with overdue payments, the proportion of firms that applied for state aid was higher in all countries, except in Bulgaria and Latvia. Differential Impact of the crisis on firms and its implications In this section, we examine more closely the impact of the crisis on different types of firms and briefly discuss some potential concerns to sustain growth going forward. First, our analysis shows that the sales growth of the more innovative firms was more affected by the global economic downturn. Using a panel data constructed from the merger between EFCS and Enterprise Survey 28 (see Box 1), we applied panel-data estimators which showed a statistically significant difference in sales growth performance between innovative (young) and non-innovative (older) companies, over the period, when controlling for firm characteristics. Box 1. A unique panel data for 1686 firms in ECA region Linking data from the EFCS to data from the 28 Enterprise Survey (ES) allow us to construct a unique panel data for the 1,686 firms before and after the crisis. The ES 28 provides information on firm characteristics, various performance measures and the business environment, most of them refereed to fiscal year of 27, the pre-crisis scenario. The merger between the two datasets was possible since the EFCS covers a subsample of firms drawn from the set of firms interviewed in the ES 28. As the participation in EFCS was voluntary and the entire original sample of the ES, which covered 2,499 firms, was contacted to determine whether these firms were still in existence or if they had failed and/or became inactive, the sampling weights of the ES 28 were adjusted, based in the non-response firms. These adjusted weights were then used in order to produce the estimations that are, therefore, representative for the nonagricultural private economy within each country In this panel, we can then compare the sales growth rates for the refereed categories of firms - young or older firms; and innovative or non-innovative - in both pre and post-crisis periods. The sales growth rates before and after the crisis for these categories of firms are computed. For 6 In Bulgaria and Romania, the proportion of companies attempting to restructure their debt is lower: 12.1 percent in Bulgaria and 4.9 percent in Romania. 7 The survey did not make any reference to a particular legal definition of state aid. State aid was broadly defined as any form of assistance, subsidy, or program offered by the State. 29

30 the pre-crisis period, we computed the compound average annual growth rate of sales in the In this case, we previously converted sales values of 24 and 27 (based on ES 28 data) from original local currencies to current US dollars using exchange rate from International Financial Statistics Database. For the post crisis period, we use annual growth rate of sales in the period, according to EFCS. The age classification was made through a dummy for firms up to five years old, while the identification of an innovative company used as a criterion the introduction of new product or process in the period 24-27, according to ES 28. Data show that for all of the six countries covered by the EFCS innovative firms account for an expressive proportion of total firms, while young firms make the smallest groups. The average proportion of innovative companies of these countries was estimated in 49 percent, while young companies accounted for only 8 percent, on average, of the total firms. In particular, the panel data analysis showed that when comparing the pre and post crisis periods and controlling for firm-specific characteristics (as age, innovation status, size, export orientation, use of skilled workforce, country and sector), the sales growth performance of innovative companies decreased 16 percentage points more than non-innovative companies. 8 The results were statistically significant at % level. In order to examine if these results are robust to the way innovative firms are classified, the panel data analysis was repeated using the development of R&D activities in the as an alternative criterion to categorize innovative firms. The results were confirmed. The sales growth performance of companies with R&D activities has decreased 2 percentage points more than firms without R&D activities. 9 This difference was statistically significant at 1% level. Since innovation and R&D tend to positively affect productivity (Aw, Roberts and Xu (28) 1 ) innovative firms tend to lead growth. (The link between findings from firm-level studies of innovation and theories of aggregate technological change and growth can be found in Klette and Kortum (24)). Thus the fact that these firms have been disproportionately affected is of some concern Second, the analysis also finds that young companies suffered significantly more than older firms. Evidence from the same panel data analysis also showed that when differences in age, innovation status, size, export orientation, use of skilled workforce, country and sector are taken into account, the reduction of sales growth performance of young firms was 2 percentage points larger than older firms over time. This result was statistically significant at 1% level. 11 Since in general, conditional on size and survival rate, young firms are expected to grow at faster rate than older firms, among other reasons due to diminishing returns from learning (see Klepper and Thompson (27) 12 ; Dunne, Roberts and Samuelson (1989) 13 ), young firms can play an important role in exerting competitive pressures that are conducive to productivity growth. Conversely, a prematurely aging enterprise sector could reduce productivity growth. 8 The FGLS estimator provided a difference of percentage points, while through the pooled FGLS estimator the difference was estimated in 1.97 percentage points. The results of these econometric analyses are available upon request. 9 The within pooled FGLS estimator provided a difference of 2 percentage points. The results of these econometric analyses are available upon request. 1 Aw, Bee Y., Mark J. Roberts and Daniel Y. Xu (28), R&D Investments, Exporting and the Evolution of Firm Productivity, American Economic Review, Papers and Proceedings, 98:2, pp The FGLS estimator provided a difference of 2.67 percentage points, while through the pooled FGLS estimator the difference was estimated at 17.2 percentage points (and statistically significant at 1% level). The results of these econometric analyses are available upon request. 12 Klepper, S., & Thompson, P. (27). Submarkets and the evolution of market structure. RAND Journal of Economics 34(4): Dunne, Timothy, Roberts, Mark. J, and Larry, Samuelson, (1989). "The Growth and Failure of U.S. Manufacturing Plants," The Quarterly Journal of Economics, MIT Press, vol. 14(4):

31 Third, the more skill intensive firms were more affected with their employment falling more significantly than those of the less skill intensive firms. Data from EFCS show that fulltime employment of skill-intensive enterprises (firms employing more than 2 percent of workers with university degrees) fell in all countries during the crisis, except in Hungary. The average skilled intensive firm showed a reduction of 2 permanent workers when comparing June/July 29 with December 27. Turkey experienced the largest average drop in permanent workers, 8.9 workers in the same period. Going forward, should there be persistent (long duration) unemployment of highly skilled workers, this could lead to a deterioration in the human capital base of countries. Another obstacle for achieving and sustaining higher rates of economic growth relates to an emerging re-specialization towards services and domestic-oriented activities. Productivity gains in service sectors, driven among other factors by the diffusion of information and communication technologies, were one of the major determinants of productivity growth in the US in past decades. In many countries in Europe, however, services sectors productivity gains have lagged behind in comparison to those of the industrial sector. Export-orientated firms also tend to present higher productivity growth than domestic oriented ones, when size, age and skills are controlled for. While is still early to identify a new pattern of economic specialization in the surveyed economies, preliminary results indicates that a likely expansion of domestic oriented firms and firms from the service sector. For instance, data from EFCS show that, among firms reporting sales increase in Turkey, almost 66 percent belonged to the food, textiles, or chemical sectors and were mainly domestic oriented. 14 In Bulgaria, on the other hand, more than percent of firms that reported a demand growth were in wholesale and retail activities. The same phenomenon happened in the other four countries, where most of the growing firms were clustered in the retail (1.9 percent) and wholesale (34.9 percent) sectors. These findings suggest that as the recovery takes hold and demand strengthens, it will be very important to address any obstacles including for example access to finance to the resumption of entry and growth of the more innovative and skill intensive firms. As was stressed in EU1 Regular Economic Report from October 29, sustained growth in the region will need to increasingly rely on the knowledge economy and will require improving the skills of workforce and ensuring that these skills are productively employed. 14 In Turkey, the shares of sales directed to the domestic market in the chemicals, food and textiles sectors were 81.6 percent, 74. percent, 47.6 percent, respectively. 31

32 EU1 April 21 In Focus: Insights for the EU1 and Croatia from the Europe and Central Asia energy outlook 23 The latest Europe and Central Asia (ECA) energy outlook suggests a shortage of both primary and derivative energy supplies if the current policy environment is not changed. 1 Unless ECA countries start to invest much more in energy in coming years, by 23 the region as a whole will become a net energy importer in contrast to its current role as an exporter. Western Europe is heavily dependent on energy imports from this region, but with the financial capacity to secure the energy supplies it needs (albeit at the expense of others). In contrast, the region s energy-importing countries are caught between Western Europe, which has increasing import needs, and the region s exporters, whose exports will likely decline. Energy-importing countries in ECA face the prospect of being squeezed both financially and in terms of energy access. These developments will have significant implications for the EU1 and Croatia. In order to avoid shortages in primary energy supplies (mainly gas), they could increase reliance on coal, which is locally available but more polluting, but such a shift would be in conflict with the EU fight against climate change. Or they may want to postpone shutting down aging nuclear reactors. In this light, the EU climate change and energy policies constitute huge challenges for some of the EU1. The best option for these countries is to focus on energy efficiency, which, despite dramatic improvements over the last two decades, has not yet reached EU1 levels. Wider regional and European context The ECA region has 1 percent of the world s primary energy production and substantial energy assets concentrated in a few countries (about 9 percent of world oil reserves and 31 percent of conventional gas reserves). Russia alone accounts for about 1 percent of world primary energy production, 4. percent of oil reserves, and 27 percent of gas reserves. Azerbaijan, Kazakhstan (rich in oil), Turkmenistan and Uzbekistan (rich in gas) are also big producers. Coal resources are more evenly distributed with Russia, Ukraine, Kazakhstan, Poland, Czech Republic, Turkey, Serbia and Kosovo having substantial production and/or reserves. The coal quality ranges from high quality thermal and coking coal in Russia to low quality lignite and brown coal in Southeast Europe. Mining conditions also vary from lower cost surface mining in Russia and Central Asia to higher cost underground mining in Central Europe. The latest ECA energy outlook 16, covering Central and Eastern Europe and the Commonwealth of Independent States (CIS) suggests a shortfall in its primary and derivative energy supplies over the next 2 to 2 years. The region has been underinvesting in the sector for years, as maintenance and upgrading of the stock of energy assets became an early investment casualty of the economic decline associated with transition. As the region s economy recovered, both production and consumption of energy increased. However, the deterioration in the asset base and the associated loss of both capacity and efficiency proved such that by the end of 27, a number of countries in the region were experiencing periodic energy shortages, and a serious energy crunch appeared imminent. The global financial crisis has dampened energy demand significantly, creating temporary breathing room before energy availability again becomes a serious concern. However, the respite is temporary some to 6 years as it is assumed that the region as a whole will recover to the 28 level of output by 213. From 211, ECA is expected to resume its long term growth rate of almost percent per year, which will translate into 4.4 percent average annual growth for the period 2-23 (Table 4). The very recent upturn in energy investments falls short of what will be needed, and given the long lead times 1 This note was written by Leszek Kasek, based on the ECA Energy Flagship, under the guidance of Peter Thomson and the World Bank ECA Energy team. 16 World Bank, Lights Out? Challenges Facing the Emerging Economies of Eastern Europe and the Former Soviet Union, Washington D.C. 32

33 Jan- Aug- Mar-1 Oct-1 May-2 Dec-2 Jul-3 Feb-4 Sep-4 Apr- Nov- Jun-6 Jan-7 Aug-7 Mar-8 Oct-8 May-9 Dec-9 required to construct new facilities, countries need to start investing now if they are to be able to provide the energy supplies needed to support the resumption of robust economic growth that is anticipated once the economies turn around. Table 4. Projected average annual growth rates in 2-23 for Europe and Central Asia and the EU1 and Croatia (EU1+1) ECA EU1+1 Real GDP 4.4 % 4.2 % Electricity Consumption 3.1 % 2.4 % Primary Fuel Consumption 1.9 % 2.2 % Source: World Bank, 21. Over the next 2 years the region as a whole needs to invest about $3.3 trillion (about 3% of cumulative GDP) if it is to meet the energy demands that the economic outlook would call for. As an example, in order to maintain gas production levels in Russia, Gazprom would need to invest about $1 billion per year (and $2 billion to meet anticipated increases in demand) but even with rising annual investment levels between 26 and 28, its investment in gas exploration and development in 28 ($8.6 billion) remained well short of this level. For the region overall, the public sector alone cannot provide sufficient funding, and so countries need to create an environment that will attract private capital. In addition public sector enterprises that have the capability of funding their investment requirements will have to allocate the required funds. If the current policy environment is not changed and the ECA energy sector does not start to invest much more in coming years, by 23 Figure 46. Crude oil and natural gas prices in 2-29 Natural gas, Europe, $/mmbtu (RHS) 18 Source: World Bank Global Economic Monitor Database the region as a whole will become a net energy importer in contrast to its current role as an energy exporter. In this situation, the energy importing countries in the region will be squeezed between the richer countries of Western Europe and the region s exporters whose exports will likely decline. This difficult prospect is compounded by the deterioration of the energy infrastructure, including power generation and district heating Crude oil, Brendt, $/b (LHS)

34 Figure 47. Total additions to available generating capacity required for projected generation (GW) About 13 GW needed, USD 39 billion (in 28 USD) Source: World Bank, 21. It is essential, therefore, that ECA countries move quickly to put in place an enabling environment that provides secure ownership rights, is transparent and subject to the rule of law to support private investment in the sector. While the funds to finance primary fuel investments are expected to be available in Russia and other oil and gas producing countries in the region, they must be targeted to develop the necessary upstream production facilities and transportation infrastructure. The oil and gas producers face geological and climate challenges which require more costly state of the art technologies. Without appropriate investments, primary energy supplies and export receipts will decline. This will have serious implications for countries in Western and Eastern Europe that rely on these import sources. Mitigating actions are also required in ECA on the demand side, as more energy saved increases export potential and Table. ECA s energy investment needs top $3 trillion. Projected energy sector investment needed by 23 23, USD billions Sector Amount Required (US$ billions) Crude Oil 9 Refining 2 Gas 23 Coal 1 Electricity 1, Heating Total 3,3 Source: World Bank staff calculations decreases investment needs. According to the IEA World Energy Outlook 26, an additional $1 invested in more efficient electrical equipment and appliances may avoid more than $2 in production investment. Energy efficiency has a huge untapped potential in ECA. In addition the region has significant opportunities to reduce energy waste especially through gas flaring and venting. Some gas flaring is needed to ensure safe operation, but in ECA energy producers, most associated gas is flared because there are inadequate incentives to use the gas. Russia is the biggest gas flarer worldwide, flaring and venting BCM of associated gas in 2, Kazakhstan flared and vented 8.8 BCM of gas, while Azerbaijan, Turkmenistan, and Uzbekistan - 7 BCM altogether. For comparison, EU1+1 yearly natural gas consumption amounted to about 6 BCM in 28. Piped natural gas trades at $1 to more than $3 per TCM, putting the annual value of the region s flared and vented gas at $1 2 billion. It added about 2 million tons of carbon dioxide equivalents (MtC2e) into the atmosphere (equal to the combined GHG emissions of Bulgaria, Romania, and Croatia in 2). There are also technical and commercial gas 34