Economic Trends and Challenges

Economic Trends and Challenges in Central and Eastern Europe Christoph Rosenberg International Monetary Fund IMF Seminar for Journalists Vienna, August 28, 27 Note: These are the author s s own views, not necessarily those of the IMF. Some of the data presented needs to be confirmed with country authorities

o o The overall macro picture: better than ever But underlying this are challenges in the run-up to Euro adoption Fiscal adjustment Credit growth Currency mismatches External imbalances Financial sector integration Creating flexible economies o Policy Conclusions

The overall macro picture: better than ever

Growth performance is good, driven by EU accession and the global upswing. 12. Annual GDP growth (percent) 1. 8. 6. 4. 2.. 5 6 7p 8p 5 6 7p 8p 5 6 7p 8p 5 6 7p 8p CE4 Baltics Romania &Bulgaria World Source: WEO April 27.

7, 6, 5, 4, 3, 2, 1, As a result, the CECs quickly. CECs are catching up 16 14 12 United States 1 8 Euro area 6 United States and Euro area 4 2 B u lg a r ia R o m a n i a P o l a n d L a t v i a L i t h u a n i a S l o v a k i a H u n g a r y E s t o n i a P o r t u g a l M a l t a C z e c h R e p u b l i c S l o v e n i a G r e e c e C y p r u s S p a i n Ita ly F r a n c e G e r m a n y F i n l a n d S w e d e n U n i t e d K i n g d o m B e l g i u m D e n m a r k A u s t r i a N e t h e r l a n d s Ire la n d L u x e m b o u r g P o r t u g a l F r a n c e Ita ly C y p r u s U n i t e d K i n g d o m S p a i n M a l t a B e lg iu m A u s t r i a N e t h e r l a n d s G e r m a n y D e n m a r k Ire la n d S w e d e n G r e e c e H u n g a r y S l o v e n i a F i n l a n d L u x e m b o u r g C z e c h R e p u b l i c P o l a n d B u lg a r ia R o m a n i a L i t h u a n i a S l o v a k i a E s t o n i a L a t v i a Source: Ameco. GDP PPP per Capita 26 GDP PPP per capita26 (percent change)

Inflation is relatively subdued dued 8. Annual average CPI (percent) 7. 6. 5. 4. Baltics Romania & Bulgaria World 3. CE4 2. 25 26 27p 28p Source: WEO April 27.

especiallyly considering that rising price levels are naturally associated with convergence. 9 CECs. Relative price level vs. relative GDP per capita (PPP), 1995-26, EU25=1 8 Relative price level 7 6 5 4 TU BG RO CR PL HU LT SK EE CZ SI 3 2 2 3 4 5 6 7 8 9 Relative per capita GDP at PPPs Source: Eurostat

Even headline fiscal deficits are not looking so bad (except Hungary). 4 CECs. General Government deficit (ESA 95, percent of GDP) 2-2 EDP/ Maastricht limit -4-6 -8-1 5 6 5 6 5 6 5 6 5 6 5 6 5 6 5 6 BU LV LT RO CZ SK* PL* HU* * incl. pension reform costs Source: EC Spring Forecast 27

CEC financial markets have outperformed other EMs A. Stock Market Indices (May 1, 26=1) B. Indices of Exchange Rate Against US$ (May 1, 26 =1; (+) = appreciation) 135 125 115 15 95 85 75 CEECs East Asia Latin America Other EMs DAX-3 Index FTSE-All Share Index 11 18 16 14 12 1 98 96 94 92 9 CEECs East Asia Latin America Other EMs Jan-6 Feb-6 Mar-6 Apr-6 May-6 Jun-6 Jul-6 Aug-6 Sep-6 Oct-6 Nov-6 Dec-6 Jan-7 Feb-7 Mar-7 Apr-7 May-7 Jun-7 Jan-6 Feb-6 Mar-6 Apr-6 May-6 Jun-6 Jul-6 Aug-6 Sep-6 Oct-6 Nov-6 Dec-6 Jan-7 Feb-7 Mar-7 Apr-7 May-7 Jun-7 C. External Bond Spreads D. 5-year CDS Spreads CEECs East Asia Latin America Other EMs CEECs East Asia Latin America Other EMs Jan-6 Feb-6 Mar-6 Apr-6 May-6 Jun-6 Jul-6 Aug-6 Sep-6 Oct-6 Nov-6 Dec-6 Jan-7 Feb-7 Mar-7 Apr-7 May-7 Jun-7 Jan-6 Feb-6 Mar-6 Apr-6 May-6 Jun-6 Jul-6 Aug-6 Sep-6 Oct-6 Nov-6 Dec-6 Jan-7 Feb-7 Mar-7 Apr-7 May-7 Jun-7 1 1 1 1 1 1 Source: Pipat Luengnaruemitchai, Susan Schadler, Do Economists and Financial Markets Perspectives on the New Members of the EU differ?, IMF Working Paper 7/65.

...despite receding euro adoption prospects. 25 21 215 25 21 215 25 21 215 27 27 27 27 27 27 27 27 27 27 27 21 Source: Reuters Slovenia Lithuania Latvia 28 212 212 212 212 28 29 29 29 29 29 21 212 212 212 29 28 28 28 29 29 Estonia Slovak_Republic Czech_Republic Poland REUTERS Polls on Euro Adoption Date Median Value of the Responses Hungary 21 21 21 21 21 21 213 Aug5 Nov5 Feb6 May6 Aug6Aug5 Nov5 Feb6 May6 Aug6 Aug5 Nov5 Feb6 May6 Aug6

The fallout from the suprime mortgage crisis in the US has had some effects on financial markets. 16 15 Stock markets (Aug 1 = 1) Exchange rate vs. USD 13 CZ HU SK PL HUF PLN CZK SKK 14 12 13 12 11 11 1 1 9 8 9 Aug-6 Sep-6 Oct-6 Nov-6 Dec-6 Jan-7 Feb-7 Mar-7 Apr-7 May-7 Jun-7 Jul-7 Aug-7 Aug-6 Sep-6 Oct-6 Nov-6 Dec-6 Jan-7 Feb-7 Mar-7 Apr-7 May-7 Jun-7 Jul-7 Aug-7.7.6.5.4.3.2.1 Aug-6 Foreign currency spreads 1/ Credit Default Swaps Spreads 2/ Sep-6 Oct-6 Nov-6 Dec-6 Jan-7 HU PL SK CZ Feb-7 Mar-7 Apr-7 May-7 Jun-7 Jul-7 Aug-7 5 45 4 35 3 25 2 15 1 5 Aug-6 Sep-6 Oct-6 Nov-6 Dec-6 Jan-7 Feb-7 Mar-7 HU PL SK Source: Bloomberg. 1/ Spread of 5-year euro denominated international government bonds versus %-year Bund. 2/ The credit default swap (CDS) is an over-the-counter contract whereby the buyer pays the seller a periodic fee in return for contingent payment by the seller upon default of the issuer of a credit instrument. Apr-7 May-7 Jun-7 Jul-7 Aug-7

Borrowing spreads were less affected than in other Ems. Change in EMBI July 16-August 22 (bps) 2 4 6 8 1 12 14 16 Change in the EURO exchange rate July 16-August 23 (+= depreciation, percent) -5 5 1 Argentina Serbia Ukraine Turkey Brazil Russia Mexico China Poland Hungary Bulgaria Brazil Hungary Turkey Poland Slovakia Mexico Argentina Czec h Republic Russia Serbia China Ukraine Source: IMF GMM, national statistics.

Nevertheless we worry in some countries about increasing vulnerabilities in the run-up up to euro adoption.

Macro Vulnerabilities External imbalances are growing, especially in the Baltics Key Macro Indicators 26 (in percent of GDP) CE4 Baltics Romania & Bulgaria EM countries* Asia 1997** General government deficit -5.3.2 1. 1.1-1.8 C/A balance -5.2-15.6-13.1 2.7-3.3 External debt 57.7 89.8 57.4 51.9 66.5 Public debt 43.5 11.3 19.8 42.2 18.5 Reserves/ST debt 115.1 54.8 18.6 175.8 2.1 Credit growth (in percent) 8.4 37.6 22.8 2.5 13.9 * EM countries - Argentina,Brazil, Chile, China, Colombia, Indonesia, Peru, Russia, Singapore, Thailand, data for 25. ** Korea, Indonesia, Thailand. Source: IM F GFS, IM F IFS, IM F Article IV Consultations

Macro Vulnerabilities... but this should not surprise in an environment of rapid growth and stillevolving institutions. Policy dilemma: how to reduce vulnerabilities without impeding the convergence process? Analytical challenge: how to distinguish natural convergence from overheating

Main Concerns Lack of fiscal adjustment Credit growth Currency mismatches External imbalances Cross-border contagion risks

Lack of fiscal adjustment

Despite healthy growth, public debt ratios are not declining in key CECs. 8 CECs. Public debt (percent of GDP) 7 6 5 4 Maximum prudent debt level 3 2 1 HU PL SK CZ BU LT RO LV EE EU15 25 27 Source: EC Spring Forecast 27

Few countries have used the benign global environment and buoyant revenue to reduce deficits to prudent levels. 4 CECs. Cyclically-adjusted budget balance (percent of GDP) 2-2 Max prudent fiscal deficit -4-6 -8-1 BU LV LT SK RO PL CZ HU EU15 Source: EC Spring Forecast 27 25 27

Fiscal policy is even more procyclical if one accounts for EU funds. 2.5 Fiscal stimulus (percent of GDP, 26) 2 1.5 1.5 -.5-1 headline headline excluding transfers to and from the EU HU CZ SK LT LV EE PL Source: Christoph B. Rosenberg and Robert Sierhej, Interpreting EU Funds Data for Macro Analysis in the New Member States, IMF Working Paper 7/77

Primary spending in Central Europe is high, suggesting that fiscal adjustments should start at the expenditure side. Primary spending (percent of GDP) Source: AMECO. Data for RO & BU for 25. 6 55 5 45 4 35 3 25 2 15 1 Primary expenditure, 2-6 average (percent of GDP) BU RO TUR IND PHI BRA HU pt si CZgr PL mt SK cy LV LT EE ARG se fr de fi at de be it nl uk es 1, 2, 3, 4, GDP per capita at PPS 26 ie no

Rapid growth of credit to the private sector

Credit growth has been brisk. 12 CECs: 22-6 Average growth of credit to the private sector (in percentage points of GDP) Non-core EMU: 1995-99* Scandinavia: 1984-89 Asia: 1993-97 1 8 6 4 2 Latvia (LV) Estonia (EE) Lithuania (LT) Bulgaria (BU) Hungary (HU) Romania(RO) Poland (PL) Slovakia (SK) Czech Republic (CZ) Ireland (IE) Portugal (PT) Greece (GR) Spain (ES) Finland Sweden Thailand Indonesia Korea *Greece 1997-2 Source: IFS, national authorities, IMF staff calculations

Indebtedness corresponds to income levels. Private credit to GDP (percent) 25 2 15 1 5 Private credit to GDP and income per capita, EU countries, 25 PL LV LT EE HU SK PT CZ GR SI IT ES DE FR FI DK BE NL AT Source: IFS, Eurostat 8, 13, 18, 23, 28, 33, GDP per capita (purchasing power parities)

Private credit still has some room to grow, at least in Central Europe. EU countries: Bank credit to the private sector: Actual and estimated equilibrium levels (percent of GDP) 12 CECs countries (26) Non-core EMU (1998) 1 8 6 4 2 CZ HU PL SK EE LV LT IE GR* PT ES Actual Estimated *Greece (Q1.1999) Source: National authorities, calculations based on Schadler et al. (25)

Build-up up of currency mismatches in the non-financial sector

Most CECs are exposed to currency risk emanating in the non-financial private sector. CECs.. Economy-wide currency mismatches Net FX position, 26 (in percent of GDP) 3 2 1-1 -2-3 -4-5 HU LV PL* EE LT CZ Change in net FX position, 23-6 (in percent of GDP) 5-5 -1-15 -2-25 -3 HU LV PL* EE LT CZ Sectoral net FX position, 26 4Public Financial NFPS 2-2 -4-6 -8 LV HU PL* EE LT CZ * Data for 25. Source: National authorities.

Banks balanced position masks important shifts in the size and funding of their fx lending. CECs. Change of foreign currency credits and deposits during 21-6 (in percentage points of GDP) 6 5 foreign currency-denominated credits foreign currency-denominated deposits 4 3 2 1-1 LV EE LT HU BG RO* PL SK CZ Source: National authorities, IMF staff estimates * Deposit data for Romania are not available.

Source: MNB Households in some countries are particularly exposed. Households net open fx position (percent of GDP) 16 Liabilities 14 16 Assets 14 12 12 1 1 8 8 6 6 4 4 2 2 2Q1 21Q1 22Q1 23Q1 24Q1 25Q1 26Q1 27Q1 2Q1 21Q1 22Q1 23Q1 24Q1 25Q1 26Q1 27Q1 35 Liabilities 3 35 Assets 3 25 25 2 2 15 15 1 1 5 5 Latvia Hungary Jul-3 Jul-4 Jul-5 Jul-6 Jul-3 Jul-4 Jul-5 Jul-6

Large external stock and flow imbalances

Current account deficits are high, except in Central Europe CECs. Current account deficit, 26-28 (in percent of GDP) -5-1 -15-2 -25 6 7p 8p -3 LV BU EE LT RO SK HU CZ PL Source: IMF WEO April 27.

largely reflecting the convergence process. Current account deficit,22-26 1 5-5 -1-15 GDP per capita and current account deficit PL SK RO LT HU BG LV EE FI SE NL DE DK AT FR SI IT UK IE MT CZ CY ES GR PT 5 1 15 2 25 3 35 4 GDP PPP per capita, 26 Source: Eurostat, IFS and staff calculations.

As expected, net IIPs are negative, but unlike in other EMs they have lately deteriorated. CECs and EMs: International Investment Position Net IIP (26, in percent of GDP) -2-4 -6-8 -1-12 Change in net IIP 21-26 (in percentage points of GDP) 2 1-1 -2-3 -4-5 HU EE LV BU LT PL BU SK CZ RO TR LatAsia* Amer* -6 EE LV HU CZ BU LT SK PL ROLatAmer*TR Asia* Source: National authorities, Milesi-Ferretti and Lane, External Wealth of Nations database. * Data for 25.

Cross-border financial integration

Balance sheet exposures between banking systems warrant a cross-country country perspective. Bank's exposure in EM countries, 26 (as percent of total exposure) Austria Belgium Sweden Germany France Italy Portugal Finland EU1 34.7 5.6 1.3 2.6 1.9 11.4 6.6 9.9 Bulgaria.9.5 Czech Republic 8.9 2.6.2 1..6.1 Estonia.1 3.6 3.9 Hungary 6.2 1.2..7.2 2.6.3 Latvia.1 3.3.1 2.6 Lithuania.1 2.9.1 3.2 Poland 2.8 1..5.8.2 4.8 6.2.1 Romania 8.7.5.4.8 Slovakia 5.6.6.1 2.5 Slovenia 2.2.2.1.1.1 Other EM Europe 14.6 1..4 1.7 1.2 7. 1..5 Other EM 1..6.5 1.6 1.6 1. 4.1.4 ROW 49.6 92.8 88.7 94.1 95.3 8.5 88.3 89.2 Source: BIS

Creating flexible economies

Labor markets seem relatively flexible, but are untested. 8 7 6 5 4 3 2 1 Labor market regulations NMS, Euro Area and Other OECD Countries: Labor Market Regulations, 21 1/ Average 21 Germany Sweden Finland Italy Slovenia Greece Norway Chile Austria Poland Turkey Euro area Lithuania Portugal Brazil Slovak Rep Latvia Mexico Denmark Belgium Bulgaria France Spain Romania Estonia Netherland Switzerland Czech Rep. Ireland Argentina Hungary Labor market rigidities 2 4 6 8 1 8 7 6 5 4 3 2 1 Minimum wage Union density Union coverage Unemployment benefits (1st month) Unemployment benefits (6th month) Marginal effective tax rates Employment protection in regular employment Employment protection in temporary employment Collective dismissals Source: OECD. 1\ The scale of indicators is from 1-1 from most to least regulated. Baltics CEC Euro area

A flexible business environment is essential for sustaining convergence and eventually doing well in the euro zone. Flexibility and adaptability (-1) Adaptability of companies (-1) 2 4 6 8 1 2 4 6 8 1 Best perfomers EU8* Worst performers Hong Kong Iceland Turkey Hungary Estonia Czech Rep. Slovak Rep. Poland Slovenia average EU15 Indonesia Germany France Source: IMD World Competitiveness * Excluding Lithuania and Latvia US Worst Best perfomers EU8* performers Hong Kong Taiwan Iceland Czech Rep. Hungary Estonia Slovak Rep. Slovenia Poland average EU15 US China Indonesia Portugal

Conclusions Headline numbers look good, but vulnerabilities are growing, especially in the Baltics ( Running with your shoelaces open ) So far, CECs have weathered market turmoil surprisingly well Rather than using the favorable environment to reduce risks, some governments are pouring oil into the fire by pursuing procyclical fiscal policies Preparation for euro adoption is overly focused on meeting Maastricht criteria

Policy challenges Cool off economies during a surge in capital inflows and rapid credit growth => tightening fiscal policies is often the only available tool Financial sector supervision, including of cross-border exposures Prepare for euro adoption by creating flexible economies and sound institutions