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The World Bank
EU10 Regular Economic Report February 2009 This report is prepared by a team led by Erika Jorgensen ([email protected]) and including Indermit Gill, Chorching Go, Paulina Hołda, Stella Ilieva, Valerie Herzberg, Leszek Kąsek, Ewa Korczyc, Matija Laco, Sanja Madzarevic-Sujster, Siobhan Murray, Catalin Pauna, Mark Roberts, and Emilia Skrok. The EU10 refers to Bulgaria, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, the Slovak Republic and Slovenia. The EU10+1 includes Croatia.
Summary Main Report
As the international economic crisis continues to unfold, spreading from financial markets into the real economy, the EU10 economies find themselves especially hard hit. External demand has collapsed, driven by recession in the region’s main trading partners. Foreign capital inflows to the EU10 are drying up, especially intrabank lending (between EU15 parents and EU10 subsidiaries) and foreign borrowing by companies. A credit crunch within the EU10 has further undermined production, as banks weather a crisis of confidence of lending to each other and to the private sector.
Prospects for global recovery, for private capital flows, and for growth in the EU10 continue to deteriorate. Forecasts are subject to very high degrees of uncertainty, mostly on the downside. The EU10 economies face the challenges of a dearth of international liquidity, exposure to vulnerable banks, and collapsing export markets. The impact will now be felt strongly in the real sector as defaults spread and foreclosures creep up, and as unemployment rises sharply.
The EU10’s heightened vulnerability to this crisis is a by-product of the region’s great success at integrating with the EU and globally, linked through financial as well as trade channels. That integration, although differentiated across the 10 countries, has brought major benefits, including rapid convergence in incomes, improvements in living standards, and a sharp decline in poverty rates. But the easy flow of credit that made this possible was mirrored in rising private sector debt, growing exposure to foreign exchange risks, and easily-financed large current account deficits. The unprecedented series of external shocks have now revealed the financial sector in the EU10 as even more volatile than those in more advanced economies, while the extreme export dependence of some of the EU10, though supportive of high growth in the past, is now pulling the economies downward.
Recent data suggest that external accounts may have deteriorated further in the fourth quarter of 2008, driven by the unfavorable external environment, with export performance weakening more quickly than imports. Furthermore, on the back of weakening investor sentiment, the financing of external positions has proved more difficult for emerging markets in recent months, including for the EU10 where, in many cases, central banks have had to reach into their reserves.
EU10 policymakers’ options are limited. Monetary easing is constrained in a number of countries, and almost all EU10 countries have little to no room for fiscal stimulus because of financing and budgetary constraints. Instead, governments will need to focus on other measures to stabilize the financial sector and on better quality of spending to deliver core services and provide safety nets to the most vulnerable within tight expenditure envelopes. Into the future, the EU10 should continue on the path of integration but with greater cognizance of vulnerabilities and so more focus on, for example, better banking supervision and the management of private capital flows.
In Focus: External Financing Risks in the Banking Sector In Focus: Interbank Markets and Spillover from the Global Crisis In Focus: Domestic Credit Developments In Focus: Is Fiscal Policy Being Used as a Stabilization Mechanism?
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The World Bank
EU10 Regular Economic Report February 2009
Special Topic: Reshaping Economic Geography
The ongoing crisis should spur deeper European integration, rather than a return to the nationalism of the past. The World Development Report 2009, Reshaping Economic Geography, spotlights the implications of the report for EU New Member States. Taking a long-term view which utilizes insights from economic geography and history, it recommends continued efforts to:
• Make economic borders ‘thinner’. In the EU10, economic divisions to the mobility of people and products remain considerable, and reforms to reduce these divisions should remain high on the agenda even during the financial crisis. In the EU15, as governments deliberate economic stimulus programs, they should resist the temptation of nationalism that would make their borders ‘thicker’.
• Welcome rising economic density. The lesson of history is that greater international convergence is accompanied by a concentration of production in leading areas and cities. The EU10 should not resist the domestic concentration of economic activities: they are a necessary part of strategies for growth and competitiveness.
• Deepen institutional convergence. While infrastructure and place-based investments are often seen as the most needed policy measures, the mainstay of a strategy for economic integration in Europe is common institutions that facilitate the mobility of goods, services, capital and labor. New member states should continue their efforts to harmonize trade, financial and employment regulations.
EU New Member States are near global markets but lack sizable domestic markets
Source: World Bank Staff calculations.
3
EU10 Regular Economic Report In Focus: Summary
Level of foreign trade and financial integration in the countries of the region, 2008
0
10
20
30
40
50
60
70
80
90
0 50 100 150 200
Expo
rt/G
DP
Total foreign claims/GDP %
%
Estonia
Latvia
Lithuani
Slovaki Hungary
Bulgari
Czech Rep.
Romania
Poland
Slovenia
Croatia
External Financing Risks in the Banking Sector Large capital inflows have resulted in a build-up of external liabilities across the region in order to finance a growing demand for domestic credit. In the EU10, many countries are exposed to the same external lenders via cross-border loans to banks from their international parent banks. Reliance on cross-border funding exposes these banks to the potential balance sheet pressures of their parent banks. Recently, local liquidity requirements may have become more stringent, disrupting the free flow of funds between parent and subsidiary or branch necessary for well-functioning centralized liquidity management. Given the openness of these economies, the deteriorating global economic outlook has prompted many banks to reassess their business outlook. This assessment may lead to tightened lending conditions, with implications for the real economy. Sources: BIS, EUROSTAT, World Bank Staff calculations
Change in local interbank-Euribor interest rate spread and percent of credit growth externally-financed
0.5
1
1.5
2
2.5
3
3.5
4
4.5
5
5.5
Hungary Estonia Romania CzechRepublic
Slovakia Poland0
10
20
30
40
50
60
70
80percentage pointspercent
Interest rate spreads(rhs)
FX f inanced credit (lhs)
Interbank Markets and Spillover from the Global Crisis Tensions in international money markets spilled over to domestic interbank markets in the EU10 and Croatia (EU10+1) during 2008. The high levels of foreign borrowing and lending of EU10+1 banks has created significant dependence on well-functioning FX swap markets. But liquidity in these markets was significantly impaired in the last quarter of 2008. Pressures spread from the FX swap markets to the EU10+1’s overall domestic interbank markets and FX spot markets, with particularly disruptive effects on the financial systems in Hungary and Latvia. Central banks have intervened to enhance access to domestic and foreign currency liquidity via reserve drawdowns, cuts in reserve requirements, and agreements with foreign central banks. Not surprisingly, local interbank markets were most disrupted in countries where credit growth had been significantly externally financed, highlighting ongoing risks to banks from FX lending. Notes: Change in spreads between averages for December 2008 and
in June 2008; 3-month maturity instruments. Credit growth contributions are derived from banking sector balance sheet data.
Sources: Datastream and DB Research.
Latvia: Loans to residents, y/y, in percent
0
5
10
15
20
25
30
35
40
45
Jan-08
Feb-08
Mar-08
Apr-08
May-08
Jun-08
Jul-08
Aug-08
Sep-08
Oct-08
Nov-08
Dec-08
Mortgage loansCommercial creditIndustrial creditConsumer credit
Domestic Credit Developments The sharp deceleration of credit growth to the private sector in the EU10 and Croatia (the EU10+1) will inevitably squeeze households and enterprises and can only aggravate the worsening recession. Household indebtedness had grown rapidly, particularly mortgage debt; and loans in foreign currencies became dominant in most countries. Facing exchange rate and interest rate risk, households had become much more vulnerable to shocks. The sectors most reliant on bank financing—construction and durable producers—as well as less creditworthy market segments—small and medium enterprises—are likely to be the most affected by tightened credit conditions.
Sources: Central Bank, World Bank Staff calculations.
4
Fiscal policy in EU10 in 2009 under “No Policy Change” Scenario*
LTHU
EE
SK
BGPLLVCZ
SI
RO-2
-1.5
-1
-0.5
0
0.5
1
1.5
2
Cyclical conditions = negative output gap
Cha
nge
in C
yclic
ally
Adj
uste
d B
alan
ce
Counter-cyclicalfiscal loosening
Pro-cyclicalfiscal tightening
Is Fiscal Policy Being Used as a Stabilization Mechanism? In recent weeks, governments around the world have announced huge fiscal stimulus packages in order to address falling output and rising unemployment, unprecedented over the last few decades. Countercyclical fiscal policy is one of the major weapons of core global economies against the crisis. The EU10 governments, however, have limited scope to deal with this crisis through fiscal easing, due to financing and budgetary constraints. Therefore, fiscal policy has not been actively used by EU10 countries to support aggregate demand. The expected deterioration of fiscal balances in the EU10 in 2009 is more likely to be driven by shortfalls in private demand (both structural and cyclical) rather than by discretionary government activism. Notes: CAB = cyclically adjusted balance. *) The forecast is based
on the policy measures disclosed by Governments by the time of the release of the EC report (see the Fiscal Policy section and the Fiscal Policy ’In Focus’ note for details).Since then, Romania’s revised 2009 budget would place the country in the pro-cyclical group.
Sources: Convergence Programs, EC Interim Forecast January 2009, World Bank Staff calculations.
Table of Contents External Environment………………………………………………………………………………………..p. 5 EU10 Financial Markets……………………………………………………………………………………..p. 8 Output and Employment…………………………………………………………………………………….p. 10 Inflation and Monetary Developments ……………………………………………………………..p. 14 Fiscal Policy………………………………………………………………………………………………………….p. 16 Balance of Payments…………………………………………………………………………………………..p. 18
In Focus: External Financing Risks in the Banking Sector……………………………….p. 20 In Focus: Interbank Markets and Spillover from the Global Crisis………………….p. 23 In Focus: Domestic Credit Developments………………………………………………………….p. 27 In Focus: Is Fiscal Policy Being Used as a Stabilization Mechanism?.............p. 32 Special Topic: Reshaping Economic Geography…………………………………………………p. 40 Statistical Annex…………………………………………………………………………………………………..p. 49
5
EU10 February 2009 Main Report
External Environment
Since our last report in October, international financial markets have calmed somewhat, as conditions in interbank markets as well as equity and bond markets are less volatile. Rates have fallen sharply after massive monetary easing and liquidity injection by major central banks. The spread between US$ LIBOR and U.S. T-bill rates (TED spreads) has continued to narrow (Figure 1). However, tension in the term interbank market remains elevated, as reflected in the continued wide spreads between interbank rates and the expected overnight policy rates (overnight index swaps), which still remain above pre-Lehman levels. Beyond the interbank market, banks both in the U.S. and Europe have also been able to issue bonds with government guarantees, relieving part of the short- and medium-term funding pressures. However, bank lending and capital market financing for non-financial borrowers have slowed substantially in both the U.S. and the euro area (in particular, Ireland and Spain) due to risk aversion and tightened credit standards and weakening demand. In fact, funding shortages have begun to push up corporate default rates.
At the same time, equity and bond markets, including those in emerging market economies, have become more stable since October, but equity prices have not recovered and bond spreads remain high. The relative stability in equity markets through January was driven mainly by expectations that the impact of past and expected monetary easing and substantial fiscal relaxation would soften the global recession (Figure 2). EMBIG yields1 have declined somewhat from their November highs, driven by a continued fall in emerging market sovereign yields and to a lesser extent, a slight increase in U.S. Treasury yields (Figure 3). The forthcoming fiscal stimulus and expected deterioration of fiscal balances have raised credit risk spreads and bond yields on U.S. Treasuries as well as European government bonds. Within the euro zone, government spreads over German Bunds has continued to widen, particularly for the most heavily indebted countries. Standard and Poor’s have signaled their concern about mounting government debt levels in Greece, Ireland, Portugal, and Spain, leading to a significant widening in spreads versus Germany (Figure 4, Figure 5).
1 The JP Morgan Emerging Markets Bond Index Global (EMBIG) is a benchmark index that tracks total returns for U.S. dollar-denominated debt instruments (e.g., Eurobonds, Brady bonds, and loans) issued by emerging market sovereign and quasi-sovereign entities, issued outside local markets.
Figure 1. TED Spread (in basis points)
050
100150200250
300350400
450500
Jan-
08
Feb-
08
Mar
-08
Apr-
08
May
-08
Jun-
08
Jul-0
8
Aug-
08
Sep-
08
Oct
-08
Nov
-08
Dec
-08
Jan-
09
Feb-
09
Sources: Reuters, World Bank Staff calculations.
6
Figure 4. Cost of Protection Against Default for Sovereigns, 5-year CDS spread (in basis points)
Figure 5. Government Bond Spreads over German Bund (in basis points)
0
50
100
150
200
250
300
350
Jan-
08
Feb-
08
Mar
-08
Apr-
08
May
-08
Jun-
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Jul-0
8
Aug-
08
Sep-
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Oct
-08
Nov
-08
Dec
-08
Jan-
09
Feb-
09
USA
Germany
UK
Italy
Greece
0
50
100
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200
250
300
350Ja
n-08
Feb-
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Mar
-08
Apr-
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May
-08
Jun-
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Jul-0
8
Aug-
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Sep-
08
Oct
-08
Nov
-08
Dec
-08
Jan-
09
Feb-
09
Spain Portugal
Ireland Greece
Notes: CDS is Credit Default Swaps.
Sources: Reuters, World Bank Staff calculations.
Sources: Reuters, World Bank Staff calculations.
Prospects for global growth in 2009 continue nonetheless to weaken: economic activity is forecast to contract significantly in the major economies, including the euro area. (Table 1) The most striking development of the last quarter remains the degree of synchronization across the global economy, reflected by the particularly sharp declines in manufacturing activity and trade volumes. Industrial production indices collapsed across the major euro zone economies in late 2008, further undermining prospects for 2009. (Figure 6) The global economy is expected to stagnate in the year ahead and may enter a modest recovery only in 2010, according to the IMF’s January 2009 World Economic Outlook Update, as expansionary fiscal and monetary policies take effect. However, the outlook is highly uncertain, and downside risks dominate. The euro area is already in a recession following a fall in GDP for the second consecutive quarter (real GDP dropped by 0.2 percent in the third quarter of 2008). In the euro area, the recession is expected to continue with a further decline of GDP in the first two quarters of 2009 and stabilization towards the end of this year.
Figure 2. MSCI Index (January 2008=100)
Figure 3. Emerging Market Bond Yields vs. U.S. Treasury Yields (in %)
20
30
40
50
60
70
80
90
100
110
120Ja
n-08
Feb-
08
Mar
-08
Apr-
08
May
-08
Jun-
08
Jul-0
8
Aug-
08
Sep-
08
Oct
-08
Nov
-08
Dec
-08
Jan-
09
Feb-
09
MSCI Compposite
MSCI Europe
MSCI Latin America
MSCI Asia Pacif ic
0
2
4
6
8
10
12
14
Jan-
08
Feb-
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Mar
-08
Apr-
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May
-08
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Jul-0
8
Aug-
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Sep-
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Oct
-08
Nov
-08
Dec
-08
Jan-
09
Feb-
09
EMBIGLOBAL
U.S. Treasury Yield
Notes: Morgan Stanley Capital International Emerging Market Index is a free float-adjusted market capitalization index designed to measure equity market performance of emerging markets.
Sources: Reuters, World Bank Staff calculations.
Sources: U.S. Treasury, MorganMarkets, World Bank Staff calculations.
7
Figure 6. Industrial Production in the Euro Area Countries (% change, yoy, saar)
-20
-15
-10
-5
0
5
10
Jan-
07
Mar
-07
May
-07
Jul-0
7
Sep-
07
Nov
-07
Jan-
08
Mar
-08
May
-08
Jul-0
8
Sep-
08
Nov
-08
Euro Area
Germany
France
Italy
Sources: Eurostat, World Bank Staff calculations.
Table 1. Recent Forecasts of Economic Growth (in percent, annual)
EC IMF EC IMF IMF EC IMF IMF
Jan 2009 Jan 2009 Jan 2009 Jan 2009difference from
Nov 2008Jan 2009 Jan 2009
difference from Nov 2008
World 3.3 3.4 0.5 0.5 -1.7 2.8 3.0 -0.8
USA 1.2 1.1 -1.6 -1.6 -0.9 1.7 1.6 0.1
Eurozone 0.9 1.0 -1.9 -2.0 -1.5 0.4 0.2 -0.7
Germany 1.3 1.3 -2.3 -2.5 -1.7 0.7 0.1 -0.4
Japan -0.1 -0.3 -2.4 -2.6 -2.4 -0.2 0.6 -0.5
Russia 5.9 6.2 1.0 -0.7 -4.2 2.3 1.3 -3.2
2008e 2009f 2010f
Sources: EC January 2009 Interim Forecast, IMF World Economic Outlook November 2008 and Update from January 2009.
Economic activity in the emerging markets has been negatively affected by the marked deterioration of underlying global growth and worsening outlook for private capital flows. Net capital flows, projected by the Institute of International Finance, are expected to reach onlyUS$165 billion in 2009, down fromUS$466 billion in 2008 andUS$929 billion in the boom year of 2007. While all components of net private capital inflows have been on the decline, the most pronounced drop is forecast for net bank lending. However, the impact of this slowdown will vary greatly across the region, reflecting a combination of exposure to commodities, exposure to the United States or euro zone as well as domestic policies. Thus, the prospects for the region look particularly bleak, given, variously, large external deficits, reliance on crisis-hit Western European banks, high foreign currency loan exposure or high exposure to exchange rate risk via derivative contracts. The gas conflict between Russia and Ukraine has added an additional downside growth risk, as some countries in the region had to restrict gas supply to large industrial producers (for example, Hungary, Bulgaria, and the Slovak Republic).
Global inflation is plunging in response to the deep economic downturn and the associated collapse in commodity prices. Fear of global recession drove the plunge in commodity prices in the second half of 2008 (Figure 7), but hopes that a global fiscal stimulus will be effective have lifted prices slightly. Despite this,
Figure 7. Food and Petroleum Prices Index(January 2008=100, US$, and US$ per barrel)
20
40
60
80
100
120
140
160
Jan-
08
Feb-
08
Mar
-08
Apr-
08
May
-08
Jun-
08
Jul-0
8
Aug-
08
Sep-
08
Oct
-08
Nov
-08
Dec
-08
Jan-
09
Feb-
09
Brent Crude
Wheat
Sources: GEM World Bank Database, World Bank Staff calculations.
8
the most recent data point to sharp declines in December inflation across a range of countries in Europe, Asia and U.S. With headline inflation already dropping below central bank targets and resource utilization set to fall considerably further in 2009, monetary policymakers are moving aggressively to lower rates. However, in countries where interest rates are already close to zero, the room for maneuver is limited, and there is a heightened risk of deflation.
EU10 Financial Markets
Financial markets in the EU10 have similarly been affected by global investors’ sentiment and are even more volatile than those in advanced economies. EU10 financial markets have been vulnerable to deteriorating investor sentiment, leading to significant pressure for exchange rate depreciation (except for the Slovak Republic and Slovenia which are in the euro zone) and/or a decline in foreign reserves or huge fluctuations in prices of equity and fixed-income instruments. In Latvia, the pressure on the Lat in late 2008, which required central bank interventions of €1.2 billion, eased in mid-December as Nordic central banks provided bridge financing before a €7.5 billion IMF-led stabilization package was finalized (for more on the IMF programs in Latvia and Hungary see Box 1). Countries with flexible exchange rate systems in the region experienced strong depreciation pressures especially in late January and early February: compared to end-2008, the Polish Zloty and the Hungarian Forint lost around 10 percent against the euro, while the Czech Crone and Romanian Leu lost around 5 percent (Figure 8). In early February, stock market indices were much below their levels in early 2008: 20 percent lower in the Slovak Republic, around 50 percent lower in the remaining Visegrad countries, and 70-80 percent declines in Romania, and Bulgaria (Figure 9). Also bond spreads exploded in the region in the fall of 2008 but declined a bit and broadly stabilized in January to early February (Figure 10).
Figure 8. Exchange Rates Against the Euro (January 2008=100)
80
85
90
95
100
105
110
115
120
125
130
Jan-
08
Feb-
08
Mar
-08
Apr-
08
May
-08
Jun-
08
Jul-0
8
Aug-
08
Sep-
08
Oct
-08
Nov
-08
Dec
-08
Jan-
09
Feb-
09
CZ
RO
HU
PL
Notes: An increase denotes LCU depreciation.
Sources: European Central Bank, World Bank Staff calculations.
Figure 9. Stock Market Indices (January 2008=100)
Figure 10. Euro EMBIG Spreads
0
20
40
60
80
100
120
Jan-
08
Feb-
08
Mar
-08
Apr-
08
May
-08
Jun-
08
Jul-0
8
Aug-
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Sep-
08
Oct
-08
Nov
-08
Dec
-08
Jan-
09
HU_BUX PL_WIG
CZ_PX SK_SAX
BG_SOFIX RO_BETRON BG
RO
SK
HU
PL
CZ
0
200
400
600
800
1000
Jan-
08
Feb-
08
Mar
-08
Apr-
08
May
-08
Jun-
08
Jul-0
8
Aug-
08
Sep-
08
Oct
-08
Nov
-08
Dec
-08
Jan-
09
Feb-
09RO
SK
HU
BG
PLCZ
Sources: ISI, World Bank Staff calculations. Notes: The difference between the yield on each bond and a euro
government yield of the same maturity, duration weighted.
Sources: Morgan Markets, World Bank Staff calculations.
9
Furthermore, looming recession in core markets is further affecting prospects for emerging markets, including the EU10, through the sharp slowdown in trade and private capital inflows. This is undermining growth prospects in the EU10, until recently identified as one of the safest regions across emerging markets but now seen as increasingly exposed to credit worries, recession in the euro zone and accumulating banking problems. As a result, long-term foreign currency ratings and outlooks for EU10 countries have been cut in recent months, in particular for the Baltic countries, Hungary, Bulgaria and Romania, with the latter now the only EU member state with a non-investment grade rating (Fitch and S&P). Some of these countries are on a negative watchlist and more downgrades are likely (Table 2).
Box 1. IMF Programs in Hungary and Latvia
Hungary was severely hit by the global credit crunch, which prompted a request for an IMF-led financing package in October 2008. Hungary was one of the first emerging economies affected by the financial crisis, despite the fact that the government has made an impressive effort to address the serious fiscal and macroeconomic imbalances generated in the first half of the decade and restore investor confidence. However, the crisis reduced overall risk tolerance, and Hungary was still perceived as a high risk country due to the large liabilities that had been accumulated since 2000. The international financial crisis started affecting Hungary and other emerging markets in mid-2007, with the suspension of redemptions from several investment funds in the U.S. This increased global concern about a systemic crisis and resulted in a contraction of equity markets worldwide. The outflows from the Hungarian equity market and their impact on equity prices were pronounced and sustained. The second major shock happened in early 2008, when several negative pieces of news in the U.S. (e.g., large bank losses, downgrading of instruments and bond insurers) led to additional contractions of international capital flows, affecting for the first time the Hungarian bond market. As a result, foreign holdings of government bonds declined substantially, sovereign credit default swap (CDS) spreads increased, and government bond yields increased significantly above interbank swap rates with the same maturity.
The third major shock happened in September 2008. Following the collapse of Lehman Brothers, Hungary experienced massive outflows from the government bond market, and sovereign CDS spreads increased dramatically. The government debt market eventually became illiquid, as indicated by the high interest swap spreads. During this period, Hungarian banks also experienced net reductions in funding from third party institutions (foreign banks and other investors excluding parent banks), including restricted access to the FX swap market. The lack of access to foreign exchange resulted in a sharp depreciation of the exchange rate and eventually led the central bank to request a €5 billion facility from the European Central Bank. To counter these unprecedented pressures, the Government announced a consolidation package involving further lowering of budget deficit targets for 2009 beyond the targets set in Hungary’s convergence plan for adopting the euro.
In October, the government requested a €20 billion international rescue package led by the IMF and including the European Commission and the World Bank (under discussion), in order to restore
Table 2. Current Foreign Currency Sovereign Ratings for the EU10
S&P MOODY's FITCHrating BBB Baa3 BBB-
outlook Negative Stable Stablerating A A1 A+
outlook Stable Stable Stablerating A A1 A-
outlook Negative Negative Negativerating BBB- Baa1 BBB-
outlook Negative Negative Negativerating BBB+ A2 BBB+
outlook Negative Negative Negativerating BBB A3 BBB
outlook Negative Negative Stablerating A- A2 A-
outlook Stable Stable Stablerating BB+ Baa3 BB+
outlook Negative Stable Negativerating A+ A1 A+
outlook Stable Positive Stablerating AA Aa2 AA
outlook Stable Positive Stablerating BBB Baa3 BBB-
outlook Negative Stable Stable
Bulgaria
Czech R.
Estonia
Latvia
Slovakia
Slovenia
Croatia
Lithuania
Hungary
Poland
Romania
Sources: S&P, Moody’s and Fitch.
10
investor confidence and stabilize financial markets. An IMF-supported program was approved in early November, aiming to limit the output costs of the current crisis, restore investor confidence, and avoid negative spillovers to other countries. The core measures under the program are designed to improve fiscal sustainability and strengthen the financial sector: fiscal consolidation, based on agreed spending cuts; passage of a fiscal responsibility law; progress on key structural reforms linked to long-term sustainability; establishment of a Capital Base Enhancement Fund and a Refinancing Guarantee Fund to increase bank capital and guarantee wholesale interbank funding; and central bank facilities to manage domestic currency liquidity within the inflation targeting framework.
Later in December 2008, after the economy slid into recession and after taking over its second-largest bank (PAREX Bank), the government of Latvia also had to seek the support of an IMF-led €7.5 billion bailout package (or about 35 percent of GDP), with a leading role for the IMF and support from the EU, Nordic countries, the World Bank and others2. The 27-month IMF program is based on preserving the existing exchange rate within the narrow band and therefore requires exceptionally strong domestic adjustment policies and sizable external financing. Apart from the near-term focus on financial sector stabilization, the program focuses primarily on fiscal and income policies with a large fiscal consolidation (7 percent of GDP in 2009), including measures both on the revenue side (mainly VAT rate increase and real estate/capital income tax) and on the spending side (15 percent cut in salaries for public institutions, 25 percent cut in expenditure for procurement and for subsidies and transfers, excluding healthcare). Fiscal consolidation will be backed by complementary strategies in debt restructuring and structural reforms, the latter including strengthening public financial management as well as comprehensive reforms of the education, civil service, state administration and the healthcare systems. Furthermore, policies will be introduced to support the rebalancing of the economy and recovery of growth prospects.
Output and Employment
The recession spillover from the old to the new EU member states, already visible last year, will further cut the EU10 average growth rate in 2009. With another downward revision for the euro zone countries in the wake of data on the unprecedented fall in industrial production in the last two months of 2008, projected 2009 growth for the EU10 dropped to below 0.3 percent (Figure 11). A combination of rapidly weakening domestic demand (Figure 13) and a deteriorating external environment already pushed two Baltic countries (Estonia and Latvia) into recession in the third quarter, a state last observed in the late 1990s. In Lithuania and Hungary, growth rates turned negative in the 4th quarter of 2008 (Figure 12). The slowdown in the 3rd quarter was relatively broad-based across countries. Agriculture registered positive growth due to last year’s good weather and low base from 2007 (and Bulgaria, Hungary, Romania displaying exceptional growth rates due to a particularly low base in 2007). Moreover, high frequency indicators such as industrial production suggest more countries in the region may enter a technical recession by early 2009 (Figure 14).
2 Of which the IMF will provide €1.7 billion, the EU €3.1 billion and Nordic states of Sweden, Denmark, Finland and Norway €1.8 billion. In addition, the World Bank is to give €400 million (under discussion) while the EBRD, the Czech Republic, Poland and Estonia will jointly give €500 million.
11
Figure 11. Real GDP Growth (% change, yoy)
Figure 12. Real GDP Growth (% change, yoy)
-2-101234567
2007 2008 2009 F
EU10 Eurozone
-12-10-8-6-4-202468
10
BG CZ EE HU LV LT PL RO SK SI
1Q 08 2Q 083Q 08 4Q 082008
Sources: Eurostat, National Statistical Offices, World Bank Staff calculations.
Notes: Data for 2008 and 4Q 2008 is preliminary.
Source: National Statistical Offices.
Figure 13. Contribution to GDP Growth, 1Q-3Q 2008 (in percentage points)
-15
-10
-5
0
5
10
15
20
1Q 0
8
2Q 0
8
3Q 0
8
1Q 0
8
2Q 0
8
3Q 0
8
1Q 0
8
2Q 0
8
3Q 0
8
1Q 0
8
2Q 0
8
3Q 0
8
1Q 0
8
2Q 0
8
3Q 0
8
1Q 0
8
2Q 0
8
3Q 0
8
1Q 0
8
2Q 0
8
3Q 0
8
1Q 0
8
2Q 0
8
3Q 0
8
1Q 0
8
2Q 0
8
3Q 0
8
CZ EE HU LV LT PL SK SI BG
Net exportsGross capital formationFinal consumption expenditureOther
Sources: Eurostat, National Statistical Offices, World Bank Staff calculations.
Figure 14. Volume Index of Industrial Production (% change, yoy, unadjusted)
-20-15
-10-5
05
1015
20
Jan-
07
Mar
-07
May
-07
Jul-0
7
Sep-
07
Nov
-07
Jan-
08
Mar
-08
May
-08
Jul-0
8
Sep-
08
Nov
-08
CZ HUPL SK
-20
-15-10
-5
0
510
15
20
Jan-
07
Mar
-07
May
-07
Jul-0
7
Sep-
07
Nov
-07
Jan-
08
Mar
-08
May
-08
Jul-0
8
Sep-
08
Nov
-08
LV SILT EE
-20
-15
-10
-50
5
10
15
20
Jan-
07
Mar
-07
May
-07
Jul-0
7
Sep-
07
Nov
-07
Jan-
08
Mar
-08
May
-08
Jul-0
8
Sep-
08
Nov
-08
ROBG
Sources: National Statistical Offices, Eurostat, World Bank Staff calculations.
Economic sentiment and prospects have been deteriorating rapidly in the region (Figure 15). The economic sentiment indicators from January 2009 stand well below the long-term average in all of the countries in the region. A broad-based recession might deepen in the Baltic countries, with GDP contracting in 2009 by 5 to as much as 7 percent (in Latvia), in Hungary by about 3 percent, while countries such as Bulgaria, the Czech Republic, Poland, Romania, the Slovak Republic and Slovenia might see growth decelerating to between zero to two percent. Private investment, which was a key driving force in the 2004-2007 upturn, faces an abrupt slowdown on the back of a substantial
12
drop in capacity utilization rates, the deterioration of the external environment led by recession in the EU15 and tighter financing conditions. A rebound of investment and consumption will be the key determinants of any recovery in the region.
Figure 15. Economic Sentiment Indicator (decline denotes deterioration)
405060708090
100110120130
Jan-
07
Mar
-07
May
-07
Jul-0
7
Sep-
07
Nov
-07
Jan-
08
Mar
-08
May
-08
Jul-0
8
Sep-
08
Nov
-08
Jan-
09
CZ HUPL SK
405060708090
100110120130
Jan-
07
Mar
-07
May
-07
Jul-0
7
Sep-
07
Nov
-07
Jan-
08
Mar
-08
May
-08
Jul-0
8
Sep-
08
Nov
-08
Jan-
09
EE LVLT SI
405060708090
100110120130
Jan-
07
Mar
-07
May
-07
Jul-0
7
Sep-
07
Nov
-07
Jan-
08
Mar
-08
May
-08
Jul-0
8
Sep-
08
Nov
-08
Jan-
09
BG RO
Sources: European Commission, World Bank Staff calculations.
The outlook for 2009 growth is gloomy and subject to high uncertainty, mostly on the downside. This is because of huge uncertainty related to the scale of influence of the global crisis on the EU10 economies via three main channels: i) a collapse of external demand due to a recession in the region’s main trading partners (already visible in sharply falling car production in the Czech Republic, the Slovak Republic and Hungary), but also weaker prospects for exports to Ukraine and Russia; ii) lower foreign capital inflow, including lower foreign direct investment (FDI) inflows which have been the backbone of fixed investment but also the drying up of intrabank lending (between EU15 parents and EU10 subsidiaries) and direct external borrowing by companies; and, iii) a credit crunch, with banks less willing to lend to each other and the private sector due to the crisis of confidence. An additional external shock has been the halted supplies of natural gas from Russia in January which have harmed, in particular, Bulgaria, Hungary and the Slovak Republic. Following the large contraction in industrial production in late 2008, data for January may be even weaker as a result of suspended production in a number of companies owing to the January gas crisis and, more generally, deepened recession in trading partners.
The most recent official forecasts in Convergence Program (CP) updates from about November/December 2008 and the EC interim forecast from January 2009 assume a sharp slowdown of economic activity, disinflation, improvement of external imbalances, and deterioration of fiscal balances in 2009 as compared to 2008 (Table 3). Although in the past, differences between CP and EC forecasts often reflected greater optimism on the part of governments, in current circumstances, the differences largely reflect the timing of the forecasts and the ongoing deterioration in the macroeconomic environment.
13
Table 3. Recent Official National and EU Macroeconomic Forecasts (in %, or as % of GDP for Current Account and Fiscal Balances)
2008 2009 2008 2009 2008 2009 2008 2009CP 6.5 4.7 12.4 6.7 -24.0 -22.2 3.0 3.0EC 6.4 1.8 12.0 5.4 -24.7 -20.8 3.2 2.0CP 4.4 3.7 6.4 2.9 -2.4 -2.1 -1.2 -1.6EC 4.2 1.7 6.3 2.6 -0.9 -2.1 -1.2 -2.5CP -2.2 -3.5 10.6 4.2 -12.2 -7.2 -1.9 -1.7EC -2.4 -4.7 10.6 3.2 -10.1 -5.7 -2.0 -3.2CP -2.0 -5.0 15.4 5.9 -14.8 -7.3 -3.5 -5.3EC -2.3 -6.9 15.3 6.8 -14.9 -6.5 -3.5 -6.3CP 3.5 -4.8 11.2 5.4 -12.6 -4.0 -2.9 -2.1EC 3.4 -4.0 11.1 5.6 -12.6 -7.0 -2.9 -3.0CP 1.3 -0.9 6.2 4.5 -6.8 -5.2 -3.4 -2.6EC 0.9 -1.6 6.1 2.8 -7.2 -5.5 -3.3 -2.8CP 5.1 3.7 4.2 2.9 -5.1 -4.2 -2.7 -2.5EC 5.0 2.0 4.2 2.9 -5.6 -5.6 -2.5 -3.6CP na na na na na na na naEC 7.1 2.7 4.0 2.9 -6.0 -6.2 -2.2 -2.8SR na na na na na na na naEC 4.0 0.6 5.5 0.9 -6.0 -5.8 -0.9 -3.2CP na na na na na na na naEC 7.8 1.8 7.9 5.7 -12.9 -11.9 -5.2 -7.5
Slovenia
Romania
Lithuania
Hungary
Poland
Slovakia
Bulgaria
Czech Rep.
Estonia
Latvia
Real GDP growth HICP CA Balance Fiscal balance
Notes: HICP – Harmonized Index of Consumer Prices; CA Balance – Current Account Balance; Fiscal Balance – General Government Balance according to ESA’95.
Sources: Convergence Programs from November/December 2008 (CP) and EC Interim Forecast, January 2009 (EC).
The significant slowdown in economic activity has begun affecting EU10 labor markets. Unemployment was significantly up in last months of 2008 in the Baltics, and this trend is expected to continue through 2009 (Figure 16). In Latvia, the main wave of layoffs is still ahead (including envisaged cuts in public sector employment), which may result in an unemployment rate increasing to well above 10 percent in 2009. Although this may be in part due to seasonal factors, unemployment rates in Bulgaria, the Czech Republic, Hungary, and the Slovak Republic started to rise in late 2008 and early 2009 with sizeable layoffs in construction, automobile and electronics manufacturers as a result of shrinking orders amidst the global economic slowdown.
Figure 16. Harmonized Unemployment Rates (in %)
0
2
4
6
8
10
12
Jan-
07
Mar
-07
May
-07
Jul-0
7
Sep-
07
Nov
-07
Jan-
08
Mar
-08
May
-08
Jul-0
8
Sep-
08
Nov
-08
CZ HUPL SK
0
2
4
6
8
10
12
Jan-
07
Mar
-07
May
-07
Jul-0
7
Sep-
07
Nov
-07
Jan-
08
Mar
-08
May
-08
Jul-0
8
Sep-
08
Nov
-08
LV SILT EE
0
2
4
6
8
10
12
Jan-
07
Mar
-07
May
-07
Jul-0
7
Sep-
07
Nov
-07
Jan-
08
Mar
-08
May
-08
Jul-0
8
Sep-
08
Nov
-08
ROBG
Sources: Eurostat, World Bank Staff calculations.
Judged from the hiring expectations of businesses in the region, there is little prospect for expansion of employment in 2009 (Figure 17). Construction, textiles and the car industry are expected to be the hardest hit. In Bulgaria, gas shortages have aggravated the difficulties facing exporters as orders had to be delayed or cancelled; these further cutbacks are expected to exert additional downward pressure on labor costs in 2009. Vacancies in the Czech Republic shrank by more than half in January 2009, according to employment intermediation agencies. In February 2009, Slovenia reconsidered subsidizing a shorter work week to salvage jobs as its €12 billion bank guarantee plan, announced in October, failed to revive lending and spur economic activity.
14
Falling inflation and rising unemployment rates have begun to moderate wage pressures, although this is not yet visible in the figures available for Romania (Figure 18). In 2009, wage pressures should continue to lessen across the region, although the extent will depend on local labor market rigidities. In the third quarter of 2008, average real wages were still rising very quickly in the faster growing economies, led by Romania (15.4 percent from a year earlier) and Bulgaria (9.1 percent). In Poland, wage growth has been gradually decelerating. Such easing is not yet imminent in Romania which, despite the slowdown of the economy, still faces strong wage rigidity with the average real net wage up 14.0 percent in October (much above productivity growth, estimated at 8-9 percent y/y). In Hungary, a moderate growth of private sector wages of 3-5 percent was recommended for 2009 by the tripartite labor council. Sizeable layoffs are planned in relatively well-performing countries like Poland and the Slovak Republic.
Figure 18. Real Growth of Wages (% change, yoy)
-5
0
5
10
15
20
25
1Q 0
7
2Q 0
7
3Q 0
7
4Q 0
7
1Q 0
8
2Q 0
8
3Q 0
8
CZ PLSK HU
-5
0
5
10
15
20
25
1Q 0
7
2Q 0
7
3Q 0
7
4Q 0
7
1Q 0
8
2Q 0
8
3Q 0
8
EE LVLT SI
-5
0
5
10
15
20
25
1Q 0
7
2Q 0
7
3Q 0
7
4Q 0
7
1Q 0
8
2Q 0
8
3Q 0
8
BG RO
Sources: National Statistical Offices, World Bank Staff calculations.
Inflation and Monetary Developments
With GDP growth weakening in late 2008 and into 2009, world commodity prices falling, current inflation and expectations for future inflation have eased dramatically across the region. After reaching its peak in mid-summer 2008 (Figure 19), consumer inflation started to fall back quickly. It has been pushed down by its all sub-components: core inflation (which is related to weakening domestic demand and restricted credit expansion), energy prices (especially of fluid fuels3), and food prices (due to a relatively good harvest and lower international demand). Sharp declines of headline (year-on-year) price indices resulted also from a very high statistical base in the second half of 2007, when the region suffered from the upswing of prices related to the global food and fuel crisis. 3 While prices of “fuels and lubricants for personal transport equipment” increased in double digits in early 2008 across the region and above 20 percent in the Baltic Countries, in December 2008 they fell by a range from 9.8 percent y/y in Estonia to 21.7 percent y/y in the Czech Republic. This category constitutes from 2.9 percent (Slovak Republic) to 7.9 percent (Bulgaria) of the HICP baskets. A 10 percent decrease of fuel prices directly leads to 0.3-0.8 percentage point lower headline inflation and contributes to lower inflation pressure of other goods and services indirectly.
Figure 17. Business Climate Indicator - Employment Expectations for Three Months Ahead
-60
-50
-40
-30
-20
-10
0
10
20Ja
n-07
Mar
-07
May
-07
Jul-0
7
Sep-
07
Nov
-07
Jan-
08
Mar
-08
May
-08
Jul-0
8
Sep-
08
Nov
-08
Jan-
09
Estonia
Latvia
Lithuania
-60
-50
-40
-30
-20
-10
0
10
20
Jan-
07
Mar
-07
May
-07
Jul-0
7
Sep-
07
Nov
-07
Jan-
08
Mar
-08
May
-08
Jul-0
8
Sep-
08
Nov
-08
Jan-
09
Bulgaria Czech Republic
Poland Romania
Sources: European Commission, World Bank Staff calculations.
15
Figure 19. Consumer Price Indices (% change, yoy)
02468
1012141618
Jan-
07
Mar
-07
May
-07
Jul-0
7
Sep-
07
Nov
-07
Jan-
08
Mar
-08
May
-08
Jul-0
8
Sep-
08
Nov
-08
CZ HUPL SK
02468
1012141618
Jan-
07
Mar
-07
May
-07
Jul-0
7
Sep-
07
Nov
-07
Jan-
08
Mar
-08
May
-08
Jul-0
8
Sep-
08
Nov
-08
EE LVLT SI
02468
1012141618
Jan-
07
Mar
-07
May
-07
Jul-0
7
Sep-
07
Nov
-07
Jan-
08
Mar
-08
May
-08
Jul-0
8
Sep-
08
Nov
-08
BG RO
Source: National Statistical Offices.
As noted above, the crisis is now beginning to feed through to higher joblessness rates, which will increasingly reduce cost-push factors (although not yet in Romania). In this context, even adjustments of regulated prices and indirect taxes in early 2009 did not change the positive inflation outlook for the year. The bargaining power of employees shifted drastically, and mounting pressure on wage increases was replaced by concerns about preserving existing jobs. January is frequently a time for routine increases of regulated prices and indirect taxes, but these adjustments should not prevent headline inflation from falling given the deflation of underlying energy products. In Romania, a freeze in administrative prices, especially of energy, is under consideration.
Inflation easing is also supported by a rapid deceleration in domestic credit, driven by more limited access to external funding, be it from parent foreign banks or from wholesale markets, and banks’ reluctance to extend new credit (Figure 20). If the current trend continues in the Baltics, the stock of credit to the private sector will increase only by single-digit rates, if at all. In Bulgaria and Romania, the downward trend is also visible. In Visegrad counties and Slovenia, credit moderated slightly over recent months. This may be misleading in the case of Poland and Hungary, since taking into account the depreciation effect, the data show significant slowdown of credit activity (see more in the ‘In Focus’ Note on Domestic Credit Developments). Some countries already report a deteriorating quality of bank portfolios. In Estonia, non-performing loans (NPL) rose to 8.1 percent of total loans in November, up from 6.5 percent in October. In response to the escalating financial crisis, bank lending strategies have become more conservative. The pursuit of safety is now dominating the search for profit. This involves creating bigger liquidity cushions, reducing FX exposure, and increasing bank deposit rates.
Figure 20. Growth of Credit to Private Sector (% change, yoy)
0
1020
3040
50
6070
80
Jan-
07
Mar
-07
May
-07
Jul-0
7
Sep-
07
Nov
-07
Jan-
08
Mar
-08
May
-08
Jul-0
8
Sep-
08
Nov
-08
CZ HUPL SKSI
010
2030
4050
6070
80
Jan-
07
Mar
-07
May
-07
Jul-0
7
Sep-
07
Nov
-07
Jan-
08
Mar
-08
May
-08
Jul-0
8
Sep-
08
Nov
-08
EE LVLT
010
203040
5060
7080
Jan-
07
Mar
-07
May
-07
Jul-0
7
Sep-
07
Nov
-07
Jan-
08
Mar
-08
May
-08
Jul-0
8
Sep-
08
Nov
-08
BG RO
Sources: Central Banks, World Bank Staff calculations.
Monetary authorities across the region have taken steps to maintain confidence and support the effective functioning of financial systems. These measures are aimed at preserving trust and liquidity in financial markets through the expansion of term liquidity management operations and foreign exchange swap operations (Poland, Hungary), the reduction of mandatory reserve requirements (Bulgaria, Latvia), FX interventions (Latvia, Romania), or increased availability of repo operations (in some countries together with a reduction of key policy rates). (See more on this in the ‘In Focus’ Note on Interbank Markets and Spillover from the Global Crisis.) All countries strengthened their deposit guarantee schemes for households in line with EU-wide guidelines (see the previous issue of the RER).
16
Where feasible, monetary authorities have cut interest rates (Figure 21). The Czech authorities started the easing cycle in monetary policy in late summer 2008, while Poland began in November 2008. In Hungary, interest rate policy over recent months (a gradual relaxation following a sharp increase of 300 basis points on October 22) has been connected to the easing of inflationary pressure and the situation on money markets as well as the emergency lending program led by the IMF and supported by the EU and the World Bank (under discussion). In Romania, interest rates have remained unchanged at a high level through early 2009 as the 3Q 2008 data suggested economic overheating, and fiscal policy turned highly expansionary in the 4th quarter. However, given the considerable economic slowdown envisaged by leading indicators, in early February 2009, interest rates were cut by 25 basis points.
Looking forward, the recent large depreciations in countries with flexible exchange rate regimes limit the scope for monetary policy easing. As mentioned earlier in the report, in the late summer 2008 a trend of strong appreciation reverted to rapid depreciations, spurred by foreign capital outflow from debt and equity markets. Within a few months, local currencies lost more or less all that they had gained against the euro during the last three to four years. On the other hand, imported inflation is going down, and profit margins tend to be pro-cyclical.
Against this background, adoption of the euro has become both more attractive and more complicated. In January 2009, the Slovak Republic became the 16th member of the euro zone and now enjoys the relative financial stability of a big monetary union. The transition from Slovak crowns to euro went technically smoothly. Euro adoption remains a strategic medium-term objective in the Baltic countries, with Estonia targeting 2011 and Latvia and Lithuania 2011-2012. While earlier the main obstacle was inflation above the reference value, now the main challenge ahead is meeting the Maastricht fiscal requirement. In late November 2008, the Polish government approved a road map to euro adoption in 2012. With that in mind, ERM2 entry is targeted for mid-2009. As euro adoption requires amending Poland’s Constitution, political consensus is needed but seems so far to be elusive. According to the Czech central bank Governor, in the Czech Republic euro adoption is feasible in 2013-2015. This said, the financial and economic crisis is complicating fulfillment of almost all convergence criteria: exchange rate stability (due to huge exchange rate volatility), fiscal control (as a drastic slowdown of growth or recession may push the deficit and debt levels up), and inflation moderation (although countries in the region are currently experiencing rapid disinflation, the reference value may be very low as the EU15 enters into a recession).
Fiscal Policy
Budget deficits have widened in 2008 in all EU10 countries but Bulgaria (with an ongoing surplus) and Hungary. The deceleration in economic growth coupled with high rigidity in spending have exacerbated fiscal pressures in the EU10. Governments have largely succeeded in containing these pressures through 2008, but 2009 is likely to present additional challenges. Only Hungary, Latvia and Romania have exceeded the 3 percent of GDP deficit threshold. Bulgaria was the only country that ended 2008 with a surplus of 3 percent of GDP (as initially planned), despite approved additional spending of around 1.2 percent of GDP earlier in the year. The Czech Republic, the Slovak Republic and Poland have largely attained their deficit targets. In Hungary, continued spending reduction and improved tax compliance has led to further fiscal consolidation and the budget deficit has declined to 3.3 percent of GDP, from around 5 percent of GDP in 2007.
The fiscal position has deteriorated substantially in Romania in 2008 despite robust growth, while budgets in the Baltic countries were severely affected by cyclical factors. In Romania, a highly pro-cyclical fiscal policy in an overheated economy coupled with a sharp deterioration of revenue collection in the last months of the year led to a record budget deficit of around 5.2
Figure 21. Policy Interest Rates (in %)
0
2
4
6
8
10
12
14
Jan-
08
Mar
-08
May
-08
Jul-0
8
Sep-
08
Nov
-08
Jan-
09
CZ PLHU ROEURO
Source: Central Banks.
17
percent of GDP. In Lithuania, the fiscal deficit has widened to an estimated 2.9 percent of GDP, from an initial target of 0.5 percent of GDP primarily due to a low collection of indirect taxes and limited spending cuts in the context of the October 2008 elections. The economic contraction in Estonia has eroded the fiscal space, but the country has succeeded in containing its fiscal deficit to around 2 percent of GDP following emergency spending cuts in the summer, from an initially planned 1.3 percent of GDP surplus. In Latvia, poor revenue collection has pushed the budget deficit above 3 percent of GDP from an intended 1 percent of GDP surplus.
A further deterioration of fiscal balances can be expected in most EU10 countries in 2009 on the back of both cyclical and structural factors. Due to the economic downturn, revenue collection is likely to worsen in countries that face recessions or a rapid deceleration in economic growth, expected fall in employment, weakening export activity and declining consumer confidence. Furthermore, according to the recent EC forecast4 (Table 3), in most of the EU10, structural fiscal positions could deteriorate further. In contrast, in Hungary, Lithuania, Estonia, and the Slovak Republic, structural positions are expected to improve (Figure 22), in the case of Hungary in the context of the IMF-EU support program. The new Romanian Government has just approved and submitted to the Parliament a budget deficit of 2 percent of GDP for 2009, which would represent a major improvement from the EC forecast. Depending on macroeconomic developments, governments in the region may need to adjust expenditures further, especially in countries which built their 2009 budgets on what appear now to be optimistic macroeconomic projections5. Bulgaria is planning a surplus of 3 percent of GDP in 2009 and is limiting spending releases to 90 percent of appropriated amounts, which provides a buffer of 2.4 percent of GDP in case of significant worsening of revenue performance. Also the goal of some EU10 countries to join the euro zone in the near future should reinforce fiscal discipline.
Given initial fiscal conditions and financing constraints, countries in the region have little or no room for discretionary fiscal impulses. The limited room for fiscal stimuli in some countries results also from high vulnerabilities related to external and internal imbalances. In the most vulnerable countries, the authorities are strongly committed to maintaining the existing fixed exchange rates, which in turn requires strong domestic adjustment, including in fiscal policy. As part of the IMF-led
4 The EC forecast is based on the policies disclosed by Governments by the time of the release of the report (January 2009). In the meantime, some countries have already adopted or announced additional policy measures (see the text for details). 5 If the worst case scenario materializes and growth slows down to 1.7 percent in 2009 instead of 3.7 percent assumed in the drafting of the budget, the Polish Government has identified around 1.3 percent of GDP of potential budget savings, proposed by respective ministers and coordinated with the Prime Minister.
Figure 22. Projected General Government (Headline) and Structural Fiscal Balance in 2008-2009 in the “No Policy Change” Scenario*, (% of GDP)
2.1
-2.4 -2.8 -2.8-1.6
-5.4 -5.8-4.6
-2.9-4.0
-2.8-3.4 -3.7 -4.1 -4.0
-2.2-3.1
-7.4
-8.9
2.2
-10
-8
-6
-4
-2
0
2
4
2008 2009 2008 2009 2008 2009 2008 2009 2008 2009 2008 2009 2008 2009 2008 2009 2008 2009 2008 2009
BG CZ EE LV LT HU PL SK SI RO
Structural balance Headline balance
Notes: The structural fiscal balance is derived by subtracting the cyclical component of the budget balance and one-off and other temporary measures from the overall fiscal balance. *) The forecast is based on the policies disclosed by Governments by the time of the release of the EC report (see text).
Source: European Commission Interim Forecasts, January 2009.
18
rescue package, Latvia is aiming for a 7 percent of GDP fiscal adjustment in 2009. Lithuania and Estonia have also taken steps to stay within the 3 percent deficit limit, including by introducing belt-tightening measures for the public sector. A prudent fiscal policy reflected in a budget surplus in Bulgaria should help maintain confidence in the currency board. In Romania, the new Government has signaled its determination to correct existing fiscal slippages by unveiling a series of measures aimed at achieving a budget deficit of 2 percent of GDP. In response to the economic crisis and in line with the European Economic Recovery Plan, several EU10 countries have allowed automatic stabilizers to work, and a few adopted fiscal packages aimed at sustaining aggregate demand (see the ‘In Focus’ Note: Is Fiscal Policy Being Used as a Stabilization Mechanism?). It is doubtful that they would have any further room for fiscal relaxation.
The context reinforces the need to devote more policy attention to institutional strengthening of public finance management systems and their performance orientation to both manage fiscal consolidation and restore the sources of growth, including by improving the absorption of EU funds. Within current expenditure envelopes, governments will need to focus on better quality of spending to deliver core services and provide safety nets to the most vulnerable. Moreover, commitment to reverse the widening of the fiscal balances when the economy picks up again is important for the long-term sustainability of public finances and for avoiding debt upsurges.
Balance of Payments
Against this background of shrinking export markets, private demand slowdown and fiscal loosening, external positions are adjusting only slowly. The current account position of the Baltic countries, who experienced hard landing earlier, showed some improvement in the 3rd quarter, but deficits remained broadly unchanged in other countries (Figure 23). Current account deficits continued to narrow substantially in Estonia and Latvia, in the latter by 13 percentage points of GDP from a year earlier in the 3rd quarter of 2008, as imports contracted in line with the rapid economic slowdown. Significant adjustment started also in Lithuania over the same period. In Bulgaria, the external deficit decreased only modestly, and the trade deficit remained very large, with imports pulled by still strong domestic demand while exports started to weaken under faltering external demand. Similar factors are affecting external trade in other countries, with trade balances starting to weaken gradually in the Czech Republic, Hungary, Poland, Slovenia and the Slovak Republic. In some of these countries, current account deficits increased, notably in Hungary where further drag came from deteriorating income balance affected by profit repatriation.
Most recent trends suggest that external positions deteriorated further in the 4th quarter (except in the Baltic countries) as export performance weakened more quickly than imports. Looking at the most recent monthly trade data (available through November), the adjustment trends have continued in the Baltics, with shrinking imports (and lower prices of energy) allowing for further current account adjustment. However, at the same time, export growth has slumped. Export weakening could be seen also in other countries (Figure 24). Prospects for further reductions in current account deficits driven by exports are increasingly bleak, undermined by the looming global slowdown. The expected improvement in 2009 in most of the EU10 will be based on import contraction.
Figure 23. Current Account and Trade Balances, 1Q-3Q 2008* (% of GDP)
-30-25-20-15-10-505
10
1Q 0
8
2Q 0
8
3Q 0
8
1Q 0
8
2Q 0
8
3Q 0
8
1Q 0
8
2Q 0
8
3Q 0
8
1Q 0
8
2Q 0
8
3Q 0
8
1Q 0
8
2Q 0
8
3Q 0
8
CZ HU PL SK SI
Trade in goods, net Current account balance
-30-25-20-15-10-505
10
1Q 0
8
2Q 0
8
3Q 0
8
1Q 0
8
2Q 0
8
3Q 0
8
1Q 0
8
2Q 0
8
3Q 0
8
1Q 0
8
2Q 0
8
3Q 0
8
1Q 0
8
2Q 0
8
3Q 0
8
EE LV LT BG RO
Trade in goods, net Current account balance
* On annualized basis.
Sources: Central Banks; World Bank Staff calculations.
19
To make matters worse, the financing of external positions has proved more difficult for emerging markets in recent months on the back of weakening investor sentiment, including for the EU10. In many cases, EU10 central banks have, therefore, had to reach into their reserves. While foreign direct investment remained relatively stable, most recent monthly data showed significant outflows of portfolio investment in the Czech Republic (in November) and in Poland (in October). In the former, this was balanced by other investment operations of the banking sector; in the latter, however, central bank reserves have been decreasing since September. In the Baltic countries, other investment (dominated by the operations of the banking sector), which had been the major source of financing for current account deficits, turned negative, leading to a decrease in reserves in Estonia and Lithuania6. In Bulgaria, reserves decreased in October (largely as a result of the reduction in the rate of minimum required reserves) while in November, they increased slightly as the current account deficit was largely financed by other investment.
Meanwhile, in several EU10 countries, the stock of external debt remains very large, reflecting the heavy dependence in recent years on debt flows to finance large external shortfalls. In Lithuania, gross external debt equaled 72 percent of GDP in the third quarter 2008, while in Bulgaria, Estonia, Hungary, Slovenia, and Latvia, it exceeded 100 percent of GDP (and reaching 137 percent for Latvia). Moreover, in some countries a significant part of external debt is short term, with this share exceeding 35 percent in Bulgaria, Latvia, and Estonia. (See also the ‘In Focus’ Note on External Financing Risks in the Banking Sector.)
6 Surprisingly, balance of payments data for Latvia show an increase in reserves, but this is accompanied by very large positions on net errors and omissions. This could be a result of under/overestimated flows in the current account, or some capital account flows.
Figure 24. Exports and Imports Growth (% change, yoy)
-20-10
01020
3040
2Q 3Q Oct
-N
ov 2Q 3Q Oct
-N
ov 2Q 3Q Oct
-N
ov 2Q 3Q Oct
-N
ov 2Q 3Q Oct
-N
CZ HU PL SK SI
Exports Imports
-20-10
01020
3040
2Q 3Q Oct
-N
ov 2Q 3Q Oct
-N
ov 2Q 3Q Oct
-N
ov 2Q 3Q Oct
-N
ov 2Q 3Q Oct
-N
ov
EE LV LT BG RO
Exports Imports
Sources: Eurostat, World Bank Staff calculations.
20
EU10 February 2009 In Focus: External Financing Risks in the Banking Sector7
Since the beginning of this decade, external factors (a prolonged period of low nominal and real interest rates driven by a global savings glut) and domestic factors (capital account liberalization, financial sector reforms and EU accession) combined to spur large capital inflows into the EU10 countries. This high integration of EU10 financial markets with the global economy has been matched, in general, by equivalent integration of production and great success at exporting (Figure 25). This has brought major benefits to the countries in the region, including convergence in incomes, improvements in living standards and a sharp decline in poverty rates. At the same time, however, it has resulted in a build-up of external liabilities across the region. Especially the Baltic countries, Croatia, Hungary, and the Czech Republic display high ratios of foreign liabilities to GDP. Moreover, the composition of capital inflows has changed over time. While foreign direct investment initially made up the bulk of the inflows, debt liabilities have gained importance in recent years. For a large part, this reflected intrabank lending between EU15-based parent banks and subsidiaries or branches in the EU10 to finance an accelerating demand for domestic credit. Direct external borrowing by non-bank financial intermediaries and non-financial corporations has increased rapidly as well, particularly after authorities tries to curtail the expansion of bank credit.
The banking sector’s access to foreign capital has facilitated lending in foreign currency. In some countries, like Romania, this has been encouraged by restrictive monetary policies trying to compensate for pro-cyclical fiscal stances. Financial instruments denominated in or indexed to foreign currencies, in particular the euro, are widely used in the region, in particular in the Baltics, Hungary, Romania and Croatia. Foreign financing has enabled banks to expand lending more rapidly than the expansion of the domestic deposit base would have allowed (Figure 26). Also, the cost of funding in domestic markets for branches and subsidiaries is usually higher than the cost from their foreign parent banks. Moreover, the maturity of external funds may be more easily tailored to comply with the matching requirements of host country supervisors. When banks refinance themselves abroad to on-lend in foreign currency, the currency risk is passed to the client. But this, seemingly, did not matter for the client: exchange rate pegs
7 Contributed by Matijo Laco at [email protected].
Figure 25. Level of Foreign Trade and Financial Integration in the Countries of the Region, 2008
0
10
20
30
40
50
60
70
80
90
0 50 100 150 200
Expo
rt/G
DP
Total foreign claims/GDP %
%
Estonia
Latvia
Lithuani
Slovaki Hungary
Bulgari
Czech Rep.
Romania
Poland
Slovenia
Croatia
Notes: Total foreign clams are BIS reporting banks’ cross-border claims in all currencies plus the local claims of their foreign affiliates in foreign currency plus foreign affiliates local claims in local currency.
Sources: BIS, EUROSTAT, World Bank Staff calculations.
Figure 26. Loan to Deposit Ratio (in %)
0 50 100 150 200 250
CZ
EE
HU
LV
LT
PL
SK
BG
RO
SI
HR200420062008
Sources: ECB, Central Banks.
21
in most EU10 countries have been perceived as credible and, hence, the associated currency risk has been considered low. Currencies with flexible rates, on the other hand, seemed bound to appreciate. But also in countries with more volatile exchange rates, such as Hungary, foreign currency borrowing by the private sector has been popular, perhaps because of the considerable savings expected on interest payments as well as expectations of appreciating local currencies. Across the region, this dependence on foreign borrowing has made local banks dependent on a well–functioning FX swap market and has increased the risk of pressures that central banks may face on their FX reserves (see ‘In Focus’ Note: Interbank Markets and Spillover from the Global Crisis). In countries with flexible exchange rates, banks also face elevated credit risk when borrowers have to reimburse FX loans in the face of a depreciating local currency.
Difficult liquidity and financing conditions have characterized the financial sector both globally and in EU10 countries since the second half of 2008. A lack of confidence in the banking sector led to soaring financing costs. Widening spreads confirm increased cost of funds. Developments in the published CDS8 spreads of parent banks of domestic banks reflect the faltering confidence in the banking sector (Figure 27). At the same time, significant differences could be observed for individual banks, depending on their rating and business model. Bank rescue packages in a number of large EU countries and the U.S. have improved conditions in global money markets, but normalization is far from being reached. In this environment, banks in the EU10 with large deposit deficits are particularly exposed. These deficits are especially high in the Baltic countries but also in Romania and Hungary.
In the EU10, many countries are exposed to the same external lenders via crossborder loans to banks from their international parent banks (Figure 28). From a creditor perspective, bank claims are concentrated in few countries—Austria, Belgium, France, Germany, Italy, the Netherlands, Greece and Sweden—which account for three-quarters of total claims on the region. In principle, foreign ownership can be a source of stability for emerging market banking systems, but the reliance on cross-border funding also exposes these banks to the potential balance sheet pressures of their parent banks in mature markets. If the foreign parents’ ability to provide financing becomes limited, this adversely affects the availability of liquidity in local banks across the region. Lenders may also view the EU10 as a ‘cluster’ and may withdraw their funds if the outlook about the ‘cluster’ turns negative.
Home country regulators may create further tensions by forcing parent banks to build liquidity and, via asymmetries in the scope of regulation and supervision which are conducted largely nationally, the business practice of integrated cross-border financial institutions. A foreign bank’s exposure might be small in the EU10 relative to its overall portfolio, but its exposure could be a significant share in the local market. Thus, it may create a mismatch in regulatory attention. Recently, local liquidity requirements may have become more stringent, disrupting the free flow of funds between parent and subsidiary or branch necessary for well-functioning centralized liquidity management. Local subsidiaries probably also do not benefit from government recapitalization schemes in the parent country, forcing greater reliance on domestic funding.
8 A credit default swap contract is similar to insurance, allowing one party to buy protection against a company or country defaulting or restructuring debt over a certain period of time. CDS spreads are similar to regular corporate bond spreads in reflecting the market's view of default risk.
Figure 27. European Banks’ 5-year CDS (bps)
0
50
100
150
200
250
300
350
400
450
Jan-
08
Feb-
08
Mar
-08
Apr-
08
May
-08
Jun-
08
Jul-0
8
Aug-
08
Sep-
08
Oct
-08
Nov
-08
Dec
-08
Jan-
09
Feb-
09
RZBSociete GeneraleUnicreditIntesaERSTESEB Bank
Sources: Bloomberg, Datastream, World Bank Staff calculations.
22
Figure 28. Geographic Breakdown of Foreign Claims in the Banking Sector
EU7 and Croatia
24.2%
8.9%
9.6%
14.0%
19.1%
4.8%0.4%
18.9%Austria
Belgium
France
Germany
Italy
Netherlands
Sw eden
Other
Baltics
66.5%
24.4%
1.9%
7.2%
Notes: EU7 refers to EU10 without the Baltics.
Sources: BIS, World Bank Staff calculations.
In light of ongoing uncertainty about the size of the downturn and the quality of bank assets, markets are exerting pressure on banks to improve their risk profile and build up capital buffers. In the absence of willing investors, many countries have been forced to inject capital into their banking sectors. Meanwhile, banks started shrinking their balance sheets and/or reallocated assets towards safe instruments such as government bonds. When creditworthy borrowers are denied credit, this behavior--collectively--not only amplifies the downturn but also contributes to a structural misallocation of resources, detrimental to growth in the more medium-run.
Finally, as most EU10 countries are highly open economies, the deteriorating global economic outlook has also prompted many banks to reassess their business outlook. This concerns especially highly trade-dependent economies such as Hungary, the Slovak Republic, the Czech Republic and Estonia. Such reassessment is also being associated with tightening lending conditions, with likely negative effects on the real economy. (See the ‘In Focus’ Note on Domestic Credit Developments).
23
EU10 February 2009 In Focus: Interbank Markets and Spillover from the Global Crisis9
Ongoing tensions and volatility in international money and interbank markets spilled over to the less-developed domestic interbank markets in the EU10 and Croatia (EU10+1) during 2008. The high levels of foreign borrowing and lending of EU10 banks has created significant dependence on well-functioning FX swap markets. But liquidity in these markets was significantly impaired in the last quarter of 2008, with bid-ask spreads surging in forward exchange markets. Pressures spread from the FX swap markets to the EU10+1’s overall domestic interbank markets and FX spot markets, with particularly disruptive effects on the financial systems in Hungary and Latvia. Central banks have intervened to enhance access to domestic and foreign currency liquidity via reserve drawdowns, cuts in reserve requirements, and agreements with foreign central banks. The European Central Bank has provided some support for local FX swap markets. Not surprisingly, local interbank markets were most disrupted in countries where credit growth had been significantly externally financed, highlighting ongoing risks to banks from FX lending. These recent episodes will likely encourage policymakers to consider more carefully the risks to domestic banks generated by foreign exchange transactions.
Interbank money markets in the EU10 are smaller and shallower than in the rest of the EU and are dominated by unsecured borrowing and FX swaps. In line with the EU10 countries’ overall level of economic and financial development, their interbank markets are less developed than money markets in the some of the larger and older EU member states. While a large range of activities can be observed in the broader euro money markets, including important roles for interest rate derivatives and secured transactions (e.g., repos10), unsecured borrowing11 and FX swaps account for the bulk of transactions in the EU10 (Figure 29). Reflecting short-term liquidity management needs of banks, turnover in the unsecured market in the EU10 is concentrated in the overnight segment. FX swaps are used by banks to raise foreign currency such as the euro at short maturities, to hedge foreign currency assets or to provide local currency liquidity to foreign banks investing in domestic securities. While the euro dominates FX swap markets, other currencies such as the Swiss franc are also relevant. The importance of FX swaps in the EU10 may stem from the extent of foreign bank ownership and parent-subsidiary liquidity relationships and/or substantial bank lending in foreign currency. It should be noted that while these statistics display the characteristics of euro-denominated money markets, we find similar patterns for local currency money markets.12 But there are also differences within the EU10: in the small, nearly completely euro-ized Baltic economies, the turnover of local interbank transactions appears to be rather negligible.
9 Contributed by Valerie Herzberg at [email protected].
10 Repurchase agreements (repos) allow a party to borrow securities and sell them short in the belief that they can be bought back in the market at a cheaper price by the time they must be returned. 11 Unsecured borrowing involves one bank entering into an agreement to borrow from another bank a certain sum, with the promise to repay at a certain maturity an amount equal to this sum plus interest accumulated over the period. 12 For Poland, for example, see National Bank of Poland, Financial System Development in Poland, 2005.
24
Shocks emanating in global money markets spilled over to the economies of the EU10+1, to a large extent via FX swap markets. One defining characteristic of the current global financial crisis has been the occurrence of repeated, severe tensions and sporadic complete standstill of international money and interbank markets. Euro money markets had been experiencing significant strain since August 2007, but, reflecting increased concerns about liquidity and counterparty credit risk in the aftermath of Lehman Brothers’ bankruptcy, LIBOR-OIS (overnight index swap) spreads in the major currencies surged to historical peaks in the second half of 2008.13 U.S. dollar FX swap markets also dried up, reflecting U.S. banks’ increasing reluctance to engage in FX swap transactions with increasingly fragile-looking EU financial institutions which needed U.S. dollars to close liquidity gaps of associated structured vehicles incorporated in the EU but funded in U.S. dollars.14 Liquidity in the FX swap markets of the EU10+1 was significantly impaired in the last quarter of 2008 as evidenced by the sudden surge in bid-ask spreads in forward exchange markets (Figure 30). The timing of volatility peaks suggests that this occurred in many cases before other money markets and financial markets were affected (Table 4). Incorporated outside the euro zone, most banks in the EU10+1 have no direct access to the European Central Bank’s provision of euro liquidity. Again, with foreign and parent banks hoarding euro liquidity, local institutions faced difficulties hedging their euro asset exposure through the euro FX swap market and could not raise short-term euro funding.
Stresses in FX swap markets have had repercussions in overall EU10+1 domestic interbank markets and in FX spot markets. In Hungary, domestic interbank markets dried up during October (Figure 31) as did the government bond market because foreign investors could no longer swap euros to obtain Hungarian forints necessary to rollover domestic public debt. Liquidity in domestic interbank markets has also been impaired in other countries, including Poland, Romania, and the Czech Republic. In Poland, the widened gap between Euribor and implied euro funding rates since November highlight that liquidity tensions have persisted in domestic interbank markets in comparison with the euro zone (Figure 31). In countries with floating exchange rate regimes (such as Poland, the Czech Republic, and Hungary), currencies came under severe pressure as agents turned from the FX swap to the spot market to meet and hedge obligations. In a few cases, foreign
13 The LIBOR-OIS spread can be a measure of banking sector counterparty risk. Overnight Index Swaps (OIS) are instruments that allow financial institutions to swap the interest rates they are paying without having to refinance or change the terms of the loans they have taken from other financial institutions. Typically, when two financial institutions create an overnight index swap (OIS), they are swapping cashflows based on variable and fixed interest rates. Unlike the unsecured interbank loans referred to by LIBOR, the degree of counterparty risk in an OIS is small. When the LIBOR-OIS spread is increasing, it may therefore indicate that banks believe there is a higher risk of banking sector default and that the credit markets are not functioning as smoothly as they could be.
14 See ECB, December 2008 Financial Stability Report.
Figure 29. Euro Money Market Structure in 2007/2008 for the EU and EU10
Figure 30. Bid-Offer Spread of 3-Month Forward Exchange Rates against the Euro
0%
10%
20%
30%
40%
50%
60%
70%
Other Secured Unsecured FX sw aps
Total market EU 10
0
0.5
1
1.5
2
2.5
3
3.5
4
Jan-07
Apr-07
Jul-07
Oct-07
Jan-08
Apr-08
Jul-08
Oct-08
Jan-09
0
0.01
0.02
0.03
0.04
0.05
0.06
0.07Hungary (lhs)
Croatia (rhs)
Poland
Forint Zloty, Kuna
Notes: EU10 here refers to Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Slovenia, the Slovak Republic, Malta and Cyprus. “Other” includes T-bills, commercial paper, overnight index swaps, and other.
Source: ECB Money Market studies (2007/2008).
Source: Datastream.
25
currency shortages led depositors to question the viability of individual banks (e.g., OTP in Hungary, Parex bank in Latvia), requiring emergency measures, including large IMF-led rescue packages, to restore confidence.
Table 4. Volatility Sequence in FX Swap and Interbank Markets, August to December 2008
Start date of increased volatility Hungary Czech Republic Poland Romania
FX swap rate 9th October 20th September 13th September 17th September
Local currency interbank rate 27th October 10th October 10th October 10th October
Notes: Volatility measured as 17-day standard deviation for 3-months maturity. Source: Datastream.
EU10+1 countries have responded to the stresses in interbank markets in various ways. Central banks throughout the region drew down foreign exchange reserves to meet demands by local banks. Croatia, Latvia, Bulgaria, and Hungary eased mandatory reserve requirements to enhance liquidity. The National Bank of Poland also considered such a move, and in late January 2009 decided to buy back early NBP bonds maturing in 2012. It also introduced FX swaps in operations with local banks. The Hungarian government’s banking sector support package (costing about 2.2 percent of GDP) included guarantees to interbank lending.15 Some central banks sought agreements with central banks in other countries. The ECB set up repo agreements worth up to €5 billion and €10 billion with Magyar Nemzeti Bank and National Bank of Poland respectively in October and November 2008 to support local FX swap arrangements with local banks.16 Similar agreements were signed between the central banks of Denmark and Sweden with Latvijas Banka. Some central banks in the region lowered interest rates (Hungary, Poland, Czech Republic), facilitated by similar reductions in the ECB refinancing rate since November 2008 (Figure 31).
The extent to which disturbances in FX swap markets have spilled over to other markets appears to have depended on the particular characteristics and vulnerability of each country. In particular, countries where the contribution of external financing to credit growth has been important, such as Hungary, the Baltics, or Romania, have so far experienced a larger increase in the local interbank risk premium than countries such as the Czech Republic, the Slovak Republic, or Poland were credit growth has been mostly domestically financed (Figure 32).17 Of course, the Slovak Republic’s interbank rates were also driven by expectations about entry into the euro zone, which took place as planned in January 2009. Hungary’s markets were also influenced by its relatively large domestic currency public debt stock that is partly financed through foreign portfolio flows. Given a smaller public debt and/or more reliance on domestic investors, rollover risks appear to have been smaller in the Czech Republic, the Slovak Republic and Poland.
15 This mirrored the extension of guarantees to interbank lending announced by euro zone governments in October 2009. Related measures have been under discussion in other EU10 countries. 16 This followed a number of larger swap agreements between the central banks of major currencies in December 2007 and again in September 2008 and coincided roughly with bilateral agreements between the U.S. Federal Reserve and a number of large emerging market economies (Mexico, Korea, and Singapore). See BIS, Quarterly Review December 2008, “International Banking and Financial Developments”. 17 For more on the financing structure of banks in central and eastern Europe, see Z. Walko “ The refinancing structure of banks in selected CESEE Countries,” OENB Financial Stability Report (December 2008).
26
Recent experience has highlighted some lesser publicized channels through which FX transactions pose risks to banks. Until now, it was widely assumed that banks faced no direct FX risks from lending in foreign currency because exposures could be easily hedged via well-functioning FX swap markets. However, if FX markets dry up, banks can no longer hedge. Then, to avoid currency mismatches, they may turn to the spot FX market, but if exchange rates are floating, this activity will accentuate downward pressure on local currencies. Banks, in addition, face increased liquidity risks if they cannot honor liquidity commitments in foreign currency, exposing them to reduced market and depositor confidence. Countries with fixed exchange rates may see their FX reserve buffer erode, again with implications for market confidence. Finally, FX swap markets are, in some cases, crucial for the working of government bond markets, in particular when a large part of domestic currency debt is held offshore.
The recent stress episodes also suggest that policymakers in the region may want to assess how to incorporate these risks more directly into their policymaking framework. There may be implications for prudential policies on banks’ liquidity risk management. Central banks might want to review insurance mechanisms to secure the provision of foreign exchange in periods of stress, including the optimal size and composition of FX reserves. Cooperation agreements with other central banks may also need to be examined. In many cases, arrangements were not available ex ante but were established during the crisis to restore confidence in the market. Beyond these general lessons, in the absence of detailed information on the precise mechanisms and on amounts drawn, it is difficult to assess how effective these measures have been and whether there is room for improvement.
Figure 31. 3-Month FX Swap-Implied Euro Rate, Local Interbank Rates and Euribor, Hungary and Poland
Figure 32. Change in Local Interbank-Euribor Interest Rate Spread and Percent of Credit Growth Externally-Financed
1.01
1.03
1.05
1.07
1.09
1.11
1.13
Jul-0
8
Aug-
08
Aug-
08
Sep-
08
Sep-
08
Sep-
08
Oct
-08
Oct
-08
Nov
-08
Nov
-08
Dec
-08
Dec
-08
Euro implied
FX sw ap rate
1+cost of f inance in % at 3 months Blue= Hungary
Red=PolandLocal Interbank
Euribor
0.5
1
1.5
2
2.5
3
3.5
4
4.5
5
5.5
Hungary Estonia Romania CzechRepublic
Slovakia Poland0
10
20
30
40
50
60
70
80percentage pointspercent
Interest rate spreads(rhs)
FX f inanced credit (lhs)
Notes: The euro-implied FX swap rate is the cost of borrowing in uncollateralized local currency (e.g., in forints) and swapping into euros with a forward agreement to reconvert into local currency at maturity. Under covered interest parity, this funding cost should be equal to funding for the same maturity at Euribor.
Source: Datastream.
Notes: Change in spreads between averages for June and December 2008; 3-month maturity instruments. Credit growth contributions are derived from banking sector balance sheet data.
Sources: Datastream and DB Research.
27
EU10 February 2009 In Focus: Domestic Credit Developments18
The sharp deceleration of credit growth to the private sector in the EU10 and Croatia (the EU10+1), after half a decade of exuberance, will inevitably squeeze households and enterprises and can only aggravate the worsening recession. The region experienced very rapid credit growth in recent years, which was generally viewed positively as supporting rapid convergence to the EU15, but at the same time it contributed to the emergence of sizable macroeconomic and financial vulnerabilities. Household indebtedness has grown rapidly across the region and across income groups, accounted for by an increasing proportion of mortgages. With a large proportion of mortgages denominated in foreign currency or linked to the exchange rate and at floating interest rates, households have greatly increased their vulnerability to exchange rate and interest rate shocks. Lending to the corporate sector has been more subdued. By late 2008, loans in foreign currencies constituted the majority of bank loans in most countries in the region (except in the Czech Republic, the Slovak Republic, and Poland) (Figure 33). As highlighted in the previous note, stresses in domestic interbank markets have affected local banks and depressed credit supply. The sectors most reliant on bank financing--construction and durable producers—as well as less creditworthy market segments—small and medium enterprises--are likely to be the most affected by tightened credit conditions.
Over the last 5 years, bank credit to the private sector had expanded rapidly in all countries in the region, with growth ranging from 14 percentage points of GDP in Croatia to 42 percentage points in Latvia. Starting from relatively low levels, it more than doubled in Lithuania, Bulgaria, and Romania. While credit expansion in the Baltic countries, Slovenia, and Croatia peaked during 2005-2006, in the remaining countries (in particular, Bulgaria and Romania), it accelerated in 2007 and through the first half of 2008.
The credit expansion in 2004-2008 was largely a result of increased loans to households, including both consumer and mortgage loans, while growth in corporate sector loans has remained more modest in most countries. The credit expansion of 2004-2008 was driven mainly by the household sector (Figure 34), partly because this segment was underdeveloped across the region. Credit to non-financial corporations expanded more slowly or remained broadly stable as a percentage of GDP with the exception of Bulgaria.19 As a result, the share of household loans in bank portfolios has increased significantly in all countries. Among loans to households, mortgages have been growing particularly fast, especially in 2005-2006, while consumer credit accelerated strongly in 2007-2008 (Figure 35). In late 2008, the stock of households’ non-housing loans was much
18 Contributed by Leszek Kasek at [email protected].
19 In 2004, the Bulgarian National Bank introduced a number of measures, including administrative ceilings on credit to contain its growth (which were subsequently revoked end-2006). These ceilings led to selling of some corporate loans abroad to parent banks. When the ceilings were removed, some of these credits were bought back by domestic banks, which helps to explain the jump in credit to corporates as a share of GDP in 2008 as compared to 2006.
Figure 33. Share of FX Denominated Bank Loans in Loans to the Private Sector (%, 2004-2008)
0102030405060708090
100
2004
2006
2008
*20
0420
0620
08*
2004
2006
2008
*20
0420
0620
08*
2004
2006
2008
*20
0420
0620
08*
2004
2006
2008
*20
0420
0620
08*
2004
2006
2008
*CZ EE HU LV LT PL SK BG RO
FCU LCU
Sources: Central Banks, World Bank Staff calculations.
28
higher than the stock of housing loans in Bulgaria and Romania and more or less the same in Hungary and Poland. In the remaining countries, mortgage loans dominated the composition of bank loans to households.
Figure 34. Structure of Bank Loans to the Private Sector (% of GDP, 2004-2008)
Figure 35. Household Loans by Purpose (% of GDP, 2004-2008)
0
10
20
30
40
50
60
70
80
90
100
2004
2006
2008
*20
0420
0620
08*
2004
2006
2008
*20
0420
0620
08*
2004
2006
2008
*20
0420
0620
08*
2004
2006
2008
*20
0420
0620
08*
2004
2006
2008
*CZ EE HU LV LT PL SK BG RO
Non-financial corporations Households Other
0
510
1520
25
3035
4045
50
2004
2006
2008
2004
2006
2008
2004
2006
2008
2004
2006
2008
2004
2006
2008
2004
2006
2008
2004
2006
2008
2004
2006
2008
2004
2006
2008
SK BG CZ EE LV LT HU PL RO
OtherConsumerMortgage
Notes: 2008* refers to data from November 2008.
Sources: Central Banks, World Bank Staff calculations.
Sources: Central Banks, World Bank Staff calculations.
As mentioned in the Main Report, while the timing has varied across economies, credit growth has slowed down significantly across the region. The slowdown of credit is even more pronounced than suggested by raw data if the effect of depreciation on the stock of FX denominated loans is excluded. For example, in Poland, if the effect of zloty depreciation is removed, the downward trend is reasonably clear in recent months across most types of bank loans to households and enterprises (Figure 36). There is also evidence to suggest that the credit slowdown has caught all countries of the region, irrespective of their degree of vulnerability. In the Czech Republic (Figure 37), new flows of bank credit to households remained broadly stable in late 2008, but new loans to corporations declined in November and December. In Latvia, all major types of bank credit decelerated significantly in 2008, from around 40 percent y/y in early 2008 to around 10-15 percent in late 2008 (Figure 38). A recent NBP report (based on a survey of credit committees in banks) covering 2008 Q4 and perspectives for 2009 Q1 shows that banks in Poland have already tightened and expect further tightening of credit conditions for all borrowers (Figure 39).
Figure 36. Poland: Loans Excluding Exchange Rate Depreciation (y/y, in %, Dec 2006-Dec 2008)
Bank loans to enterprises Bank loans to households
0
10
20
30
40
50
60
70
80
90
Dec
-06
Feb-
07
Apr
-07
Jun-
07
Aug
-07
Oct
-07
Dec
-07
Feb-
08
Apr
-08
Jun-
08
Aug
-08
Oct
-08
Dec
-08
TotalInvestment loansPurchase of real propertyLoans on current account and working capital loans
0
10
20
30
40
50
60
70
80
90
Dec
-06
Feb-
07
Apr
-07
Jun-
07
Aug
-07
Oct
-07
Dec
-07
Feb-
08
Apr
-08
Jun-
08
Aug
-08
Oct
-08
Dec
-08
Total loans Consumer loans
Housing loans
Sources: NBP staff estimations, World Bank Staff calculations.
Debt vulnerabilities in the household sector have grown in recent years, exposing households to macroeconomic shocks and a rising risk of default. Although the share of households with a mortgage across the region is generally smaller than in the EU15 countries, it has been growing fast. A large share of housing loans is foreign currency denominated, exposing households to exchange rate risks. Naturally, the degree of vulnerability depends on exchange rate arrangements. In
29
addition, mortgages with variable (adjustable) interest rates account for the largest share of mortgage lending, exposing households to interest rate shocks. According to World Bank estimations based on the Statistics on Income and Living Conditions (SILC) survey in Hungary and the Slovak Republic, mortgages are more common among richer households, but even in the lowest income quintile, significant numbers of households hold mortgages. Debt service is a higher share of income for poorer households, and stress testing shows that default risk is concentrated there. Importantly, the simulations also found that unemployment shocks (rather than exchange rate or interest rate shocks) have the highest impact on probability of default.
Figure 37. Czech Republic: Loans to Non-Financial Sectors Other than Government: Flows (not seasonally-adjusted, in CZK billions)
Figure 38. Latvia: Loans to Domestic Financial Institutions, Non-Financial Corporations and Households (y/y, not seasonally-adjusted, %)
-20
-10
0
10
20
30
40
50
Dec-07 Feb-08 Apr-08 Jun-08 Aug-08 Oct-08 Dec-08
Corporations Households - consumerHouseholds - housing Households - other
0
5
10
15
20
25
30
35
40
45
Jan-08
Feb-08
Mar-08
Apr-08
May-08
Jun-08
Jul-08
Aug-08
Sep-08
Oct-08
Nov-08
Dec-08
Mortgage loansCommercial creditIndustrial creditConsumer credit
Notes: Calculated from monthly differences in levels adjusted for reclassification, other revaluation, exchange rate variations and any other changes that do not arise from transaction. As of Feb. 2: €1 = 27.87 CZK.
Sources: CNB, World Bank Staff calculations.
Sources: LNB, World Bank Staff calculations.
Figure 39. Poland: Expectations for Credit Conditions to the Private Sector (decline means tightening of credit conditions, in %)
Notes: The values are calculated as difference between positive and negative responses. ST – short-term, LT – long-term.
Sources: NBP survey of bank credit departments, World Bank Staff calculations.
Deteriorating economic conditions may have encouraged banks to adopt more prudent lending attitudes, and businesses and households are likely to face tighter credit conditions for some time to come. Recent significant depreciations in countries with floating exchange rate regimes have translated into higher debt burdens and raise the probability of debt servicing problems. Some countries in the EU10 are already reporting increases in non-performing loan ratios in late 2008 (for example, in the Baltic countries, Romania, and Poland). At the same time, banks’ funding costs are
-100%
-80%
-60%
-40%
-20%
0%
20%
40%
60%
80%
100%
1Q 0
72Q
07
3Q 0
74Q
07
1Q 0
82Q
08
3Q 0
84Q
08
1Q 0
9
1Q 0
72Q
07
3Q 0
74Q
07
1Q 0
82Q
08
3Q 0
84Q
08
1Q 0
9
1Q 0
72Q
07
3Q 0
74Q
07
1Q 0
82Q
08
3Q 0
84Q
08
1Q 0
9
1Q 0
72Q
07
3Q 0
74Q
07
1Q 0
82Q
08
3Q 0
84Q
08
1Q 0
9
1Q 0
72Q
07
3Q 0
74Q
07
1Q 0
82Q
08
3Q 0
84Q
08
1Q 0
9
1Q 0
72Q
07
3Q 0
74Q
07
1Q 0
82Q
08
3Q 0
84Q
08
1Q 0
9
Large enterprisesST loans
Large enterprisesLT loans
SMEs ST loans SMEs LT loans HHs mortgageloans
HHs consumerloans
Enterprises Households
30
being pushed up, due to higher spreads in FX wholesale markets and aggressive competition among banks to expand their retail deposit base. Many banks have also been drawing widely on central bank facilities. Asset price inflation has gone into reverse, reducing the value of collateral. All these factors will be reflected in weaker profitability of the banking sector and will discourage new lending, contributing to a potentially prolonged negative downward cycle.
The slowdown in credit is likely to dampen activity first in those sectors most reliant on bank financing. In combination with local recession—rising unemployment and shrinking incomes—along with the collapse of export orders—in particular for cars, data on production through November 2008 show construction and production of consumer durables (Figure 40-Figure 41) like cars (Figure 42) as hard hit, but subsequent data will provide a fuller picture of how credit constraints are feeding through the EU10 economies.
Figure 40. Production of Consumer Durables (Nov. 2007-Nov. 2008, y/y, %)
Figure 41. Production of Consumer Durables (Nov. 2007-Nov. 2008, y/y, %)
-30
-20
-10
0
10
20
30
40
50
60
Nov-07 Jan-08 Mar-08 May-08 Jul-08 Sep-08 Nov-08
BG CZ PL RO SK
-50-40-30-20-10
01020304050
Nov-07 Jan-08 Mar-08 May-08 Jul-08 Sep-08 Nov-08
EE HR HU LT LV
Figure 42. Manufacture of Transport Equipment (y/y, %)
-40
-30
-20
-10
0
10
20
30
40
50
Nov-07 Jan-08 Mar-08 May-08 Jul-08 Sep-08 Nov-08
CZ HU PL RO SK
Sources: Eurostat, World Bank Staff calculations.
With concerns about solvency on the rise, banks may also be tempted reallocate assets towards highly creditworthy borrowers. Government bonds typically top the list of desirable assets in periods of high risk aversion. The scale of crowding out by credit to the public sector is naturally related to the level of public borrowing needs and whether bonds are issued in the domestic market or externally. In such circumstances, access to credit becomes most challenging for small and medium enterprises with weaker risk profiles. This may require public intervention through state guarantees, and some countries already announced these kinds of measures (for example, Poland and Hungary). October and November data from Hungary suggests a significant decline in (net) new loans to enterprises and households, offset somewhat by loans in foreign currencies (Figure 43) and the rising role of bank claims on the public sector in new bank claims on residents (Figure 44), a reflection of the deterioration of fiscal positions described in the main report.
How much room remains for such fiscal activism is the subject of the next ‘In Focus’ Note.
31
Figure 43. Hungary: Loans to Non-Financial Corporations and Households (transactions, seasonally-adjusted, in HUF billions)
Figure 44. Hungary: Bank Claims on Residents (transactions, not seasonally-adjusted, in HUF billions)
-400
-300
-200
-100
0
100
200
300
400
500
Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 Jul-08 Oct-08
in FX to householdsin HUF to householdsin FX to corporationsin HUF to corporations
-200
-100
0
100
200
300
400
500
600
Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 Jul-08 Oct-08
Other Residents
General Government
Notes: The data takes into account monthly changes in stocks caused by transactions, i.e. it does not include the effects of exchange rate changes, price changes and other volume changes.
Sources: National Bank of Hungary, World Banks Staff calculations.
32
EU10 February 2009 In Focus: Is Fiscal Policy Being Used as a Stabilization Mechanism?20
Governments around the world have announced discretionary fiscal stimulus packages in recent weeks in order to address falling output and rising unemployment. From a global growth perspective, one of the largest plans announced so far has come from the Chinese government. The package of measures, with a total cost of US$586 billion, or about 7 percent of GDP21, includes investments, mostly in transport and rural infrastructure, and environmental protection. Under the American Recovery and Reinvestment Program, just signed into law in the US, US$787 of additional spending, or about 3 percent to GDP, will be executed in 2009 and 2010. In Europe, the fiscal stimulus looks more modest. The European Economic Recovery Plan (EERP) called for a Europe-wide fiscal stimulus of around 1.5 percent of GDP (Box 2). So far, the EU governments have adopted discretionary fiscal measures amounting to 1.5 percent of GDP in 2009-10, with Germany being on the high side with packages (approved in October, November, and announced on January 12) that amount to over 1.25 percent of GDP in 2009 and another 0.5 percent of GDP in 2010, slightly above the total envisaged by the EERP. The total cost of the support package for the European economy in 2009 and 2010, including the effect of automatic stabilizers and extra-budgetary financing facilities, is estimated at around 4 percent of GDP.22
Box 2. European Economic Recovery Plan (EERP)
The European Commission adopted an ambitious EERP on November 26, 2008, which was endorsed by the European Council on December 12, 2008. The immediate priority of the EERP is to mitigate the potential impact of financial turmoil on the real economy and, thereby, boost market confidence. The Plan consists of two main pillars.
The first pillar is a major impulse to boost demand, amounting to €200 billion, or about 1.5 percent of EU GDP. It consists of a budgetary expansion in the Member States of €170 billion and EU funding in support of immediate actions worth €30 bn.
A second pillar supports a number of priority actions, grounded in the Lisbon Strategy. They are designed to adapt the EU economies to long-term challenges such as climate change and ageing. The Plan notes that implementation of structural reforms must continue with a view to raising potential growth.
Source: ECFIN Quarterly Report on the Euro Area, Volume 7 N° 4 (2008)
In the face of the global demand shock and with monetary policy reaching its limit in places, a discretionary impulse of significant magnitude, over and above the already important role of automatic stabilizers, is necessary to insure against the prospect of a deep and long-lived recession (Box 3). Of course, the debate over the appropriate role of fiscal policy in managing the business cycle has persisted for many years. One school of thought argues that taxes, transfers, and spending can be used judiciously to lean against fluctuations in the normal business cycle, especially to the extent that economic fluctuations are mainly due to markets falling out of equilibrium instead of reacting to changes in fundamental factors such as productivity. Others contend that fiscal policy actions are generally either ineffective or make things worse, because the actions are ill-timed or they create damaging distortions. However, the current crisis is quite obviously not a normal turn of the business cycle and now there is widespread recognition that monetary policy needs the support of fiscal stimulus, in particular because in some countries nominal interest rates have been approaching zero or the channels of monetary policy transmission has been in some way impeded. To enhance the effectiveness of fiscal stimuli, they should be timely, targeted, and
20 Contributed by Emilia Skrok at [email protected]. 21 Based on IIF estimates, Global Economic Monitor, January 2009. 22 Based on ECFIN projections, Quarterly Report on the Euro Area, Volume 7 No 4, 2008.
33
temporary.23 The stimulus should be targeted to areas where the budget multiplier is expected to be large and support the productivity of the economy in the medium- to long-run (e.g., public investment or infrastructure). Moreover, its precise magnitude should depend on the extent of the expected decline in private sector demand and should therefore be reviewed in light of economic challenges (e.g., increasing unemployment, credit constrained firms and households). Although many countries might benefit from a fiscal stimulus, not all countries can afford it. The space for discretionary fiscal expansion is contingent on the state of the economy, and thus linked to external and internal balances as well as debt and reserve positions24. There is no question that a number of countries with large current account surpluses and low debt have considerable scope for fiscal activism.
Many EU10 governments, in contrast, have limited scope to deal with this crisis through fiscal easing, due to financing and budgetary constraints. In some cases, the room for fiscal expansion is limited by the fact that belt-tightening is required to restore order to the balance of payments and reduce large refinancing needs (Hungary, Romania, Croatia and the Baltic States). In Romania, the deterioration comes from the unfunded increase in pension benefits, cuts in the social security contribution rates, discretionary allocations to sub-national governments and other decisions of the outgoing government taken in 2008. The new government that came to power at the turn of the year has announced and approved a series of tightening measures that may at least partially offset the deterioration in the fiscal balance. Moreover, high public debt burdens or sizeable contingent liabilities put additional constraints on fiscal activism in Croatia and Hungary. In high deficit or high debt countries, a stimulus could prove less effective as it would further raise sustainability concerns and slow down necessary adjustment. To be sure, there are countries which have been running smaller external deficits in recent years (Poland, the Czech Republic, the Slovak Republic and Slovenia) and may have greater room for fiscal stimulation. In practice however, a strong fiscal expansion beyond the operation of automatic stabilizers is also limited in these countries in the view of fiscal challenges related to prospective euro adoption. For instance, in Poland, planned ERM II and euro zone entry impose a limit on fiscal expansion. In the Slovak Republic, tighter fiscal policy is needed to maintain low inflation in the long term. Hence, the size (and composition) of the fiscal stimulus varies sharply across the EU10 countries, at least in part aligned with the space for fiscal stimulus.
23 For a more detailed discussion, see Lawrence H. Summers, “The state of the U.S. economy,” presentation at Brookings Institution forum, http://www.brookings.edu/~/media/Files/events/2007/1219_economy/20071219_summers.pdf, Washington DC, December 19, 2007. Also Gene Sperling, “Ways to get the economic stimulus right this time,” Bloomberg.com, December 17, 2007. Also Chad Stone and Kris Cox, “Economic policy in a weakening economy: principles of fiscal stimulus,” Center on Budget and Policy Priorities, Washington, DC, January 8, 2008. 24 Generally, countries with large current account surpluses, fiscal surplus, low debt and large central bank reserves are best placed to initiate a fiscal stimulus. By contrast, in countries with large internal and external balances, a fiscal stimulus would further diminish the confidence of investors into the economy, and speed up capital outflows. See World Bank, PREM note on the financial crisis, January 2009.
34
So far, fiscal policy has generally not been actively used by EU10 countries to support aggregate demand. Many of the governments in the region have decided not to strengthen automatic stabilizers with discretionary loosening of fiscal policy and have not offered discrete fiscal stimulus packages (Figure 45). Instead, the authorities seem to be counting on the effects from previously announced tax cuts (Czech Republic, Bulgaria, and Poland) or a reshuffling of existing plans rather than net new commitments, as well as accelerated absorption of EU funds (the latter in accordance with the European Economic Recovery Plan). On top of this, most of the national stabilization plans comprise various guarantees and loan subsidies (Table 5). Moreover, in countries where the scale of the economic downturn is set to be particularly severe (Romania, Hungary, Lithuania, and Estonia), the governments have had no option but to enact sizeable fiscal restraint. Most recently, the new government of Romania has approved a revised 2009 budget with a reduced deficit of 2 percent of GDP, driven by spending cuts, which would now place the country in the pro-cyclical group. Substantial expenditure cuts (Lithuania, Hungary), wide-ranging tax changes (Lithuania), and depletion of the fiscal reserves accumulated during boom times (Estonia) have more than offset the deterioration in the fiscal balances due to the financial crisis. Thus, for the countries mentioned, fiscal policy is likely to be a pro-cyclical and not a stabilizing force.
In contrast, Slovenia is offering some discretionary fiscal boost to its economies in 2009. This is reflected in a deterioration of its expected structural deficit (Figure 46). Slovenia is following the global trend and has adopted fiscal measures to cope with the financial crisis. The stabilization package, worth about 2 percent of GDP, includes both tax rate reductions and spending increases (e.g., subsidies for R&D, new technology investment, wages at the predefined companies.)
In the rest of the countries, fiscal policy is likely to be broadly neutral after adjusting for the cyclical component and taking into account a margin of possible error. However, any assessment of fiscal responses to the financial crisis must be interpreted with caution, as it is extremely difficult to size up the discretionary fiscal stimulus correctly. This is in part because plans are changing continuously; in part, because countries announce measures as part of the package that were already underway; in part, because the impact is spread out over different time periods and the estimation of the size of output gaps is difficult when the demand shock is so large and widespread.
Figure 45. Fiscal Policy in EU10 in 2009 under “No Policy Change” Scenario *)(January 2009)
LTHU
EE
SK
BGPLLVCZ
SI
RO-2
-1.5
-1
-0.5
0
0.5
1
1.5
2
Cyclical conditions = negative output gap
Cha
nge
in C
yclic
ally
Adj
uste
d B
alan
ce
Counter-cyclicalfiscal loosening
Pro-cyclicalfiscal tightening
Notes: CAB = cyclically adjusted balance. *) The forecast is based on the policy measures disclosed by Governments by the time of the release of the EC report (see the text and the Fiscal Policy section for details).
Sources: Convergence Programs, EC Interim Forecast January 2009, World Bank Staff calculations.
35
Table 5. Summary of the EU10’s National Stabilization Plans
Fiscal instruments
AFS offset
by DFS Only AFS
AFS strengthened
by DFS Spending Revenue/Tax Selected off-budget measures
CZ
√ redirection ↓ planned earlier Capital injections to banks borrowing to exporters, SMEs
HR √ ↓ + redirection ↑ planned earlier Decreased amount for guarantee issuance.
BG √ ↓ + redirection ↓ planned earlier Capital injections to bank providing credit guarantees to exporters, SMEs.
HU √ ↓ EU-funded measures: investment subsidies, credit guarantees, and refinancing facilities to SMEs
LV √ ↓ + redirection ↓ direct taxes
↑ indirect taxes
Capital injections to a bank; system of export loan guarantees to be established
LT √ ↓ + redirection ↓ direct taxes
↑ indirect taxes
Stimulus package incl. support to business in getting credit, speeding up the use of EU funds and easing labor market regulations
EE √ ↓ , depleting reserve ↑ Credit guarantees for exporters (SMEs)
RO √ ↓ (new government)
↑ (old government)
↓ planned earlier
↑ direct taxes
Credit guarantees for SMEs and exporters planned as part of the anti-crisis plan; renewed focus on EU funds absorption
PL √ ↓ ↑+ redirection ↓ planned earlier
Increase in limit of state guarantees, support lending to SMEs, acceleration investment projects co-financed from EU funds
SK √ ↑ under discussion ↓ under discussion Increase in limit for state-guaranteed loans by companies
SI √ ↑ ↓
Notes: DFS- discretionary fiscal policy, AFS- automatic fiscal stabilizer, + “and”
Source: World Bank Staff calculations.
To sum up, the expected deterioration in the EU10’s public finances in 2009 is likely to be driven by cyclical and structural shortfalls rather than by discretionary government activism. Still, given the optimistic growth assumptions embedded in many budgets, fiscal balances are likely to deteriorate in almost all countries, as growth disappoints and inflation eases more quickly (Figure 46), (here referring to overall budget stances rather than the cyclically adjusted balances shown in Figure 45). Romania and Latvia are facing substantial deteriorations in fiscal deficits, with Lithuania a more moderate deterioration. EU10 countries are, however, embarking on a range of other policy initiatives (Table 6) to counter the crisis, as discussed earlier. It is too early to assess the effectiveness of these other policy actions.
36
Figure 46. Economic Growth and Fiscal Balance in 2009
-10
-8
-6
-4
-2
0
2
4
6
EC
GO
V EC
GO
V EC
GO
V EC
GO
V EC
GO
V EC
GO
V EC
GO
V EC
GO
V EC
GO
V EC
GO
V
BG CZ EE HU LV LT PL RO SK SI
GG def GDP grow th
Sources: GOV = Convergence Programs, for Romania Budget 2009, for the Slovak Republic most recent MOF ‘s forecasts, EC Interim Forecast January 2009,
Box 3. Automatic Fiscal Stabilizers – Key Facts
Definition The idea behind automatic fiscal stabilizers (AFS) is that they reduce output fluctuations via components of fiscal accounts (taxes, unemployment insurance system), which react automatically to changes in the economic cycle, increasing deficits in a downswing and decreasing them in an upswing. For example, in a recession, fewer taxes are collected, which operates to support private incomes and damps the adverse movements in aggregate demand. On the other hand, during an economic boom, more taxes are collected, counteracting the expansion in aggregate demand. Similarly, higher unemployment benefit payments in a downturn support domestic demand and act vice versa in an upswing. The effectiveness of AFS The effectiveness (or strength) of automatic fiscal stabilizers depends on:
- the degree of budget sensitivity (i.e., the response of government revenue and spending to economic fluctuations), including the size of the government sector, progressivity of the tax system, reliance on cyclically-sensitive tax bases, and the level and structure of unemployment benefits.
- the size of fiscal multipliers, (i.e., the subsequent impact on activity of these cyclically-induced changes in government revenue and spending); and,
- the type of economic shock.
37
The operation of automatic stabilizers depends also on whether macroeconomic shocks are on the demand or supply side and their duration. Stabilizers seem to be most effective in the case of temporary demand shocks, especially consumption shocks, as these tend to be “tax-rich”. In the case of supply shocks, e.g., a temporary surge in oil prices that fuels inflation and depresses output, automatic stabilizers would help to boost output, but could raise inflation even further. If the supply shocks were permanent (e.g., long-term productivity or labor supply) and changed potential output, then the operation of automatic stabilizers could delay the necessary adjustment of the economy to the new equilibrium and result in higher inflation during the adjustment period. Strength of automatic stabilizers in Europe There have been a number of studies devoted to estimating the percentage of fluctuation in output smoothed by the operation of automatic stabilizers (Table B1). The results from empirical studies differ. Automatic stabilizers are estimated to be most effective in a 2005 OECD study showing smoothing of cyclical fluctuations by around 25 percent. In contrast, the National Institute of Economic and Social Research (NIESR) study of the euro zone countries indicates only 11 percent smoothing. Finally, the 2001 EC study based on QUEST model indicates that 20 percent of fluctuations are smoothed.
Table B1. Effectiveness of automatic stabilizers across the EU15 countries
European
Commission* OECD NIESR
QUEST model Interlink Nigem**
Belgium 24 22 5
Denmark 31 – –
Germany 17 31 18
Greece 22 14 –
Spain 17 17 13
France 23 14 7
Ireland 26 10 7
Italy 21 23 5
Netherlands 20 36 6
Austria 23 7 12
Portugal 30 – 10
Finland 20 58 7
Sweden 31 26 –
UK 18 30 – Weighted Average 20 25 11
*) European Commission (2001), “Public Finances in EMU – 2001”, European Economy No. 3, page 70 and pp.188-190.
**) NiGEM results are from Barrell and Pina (2002).
Source: UK Treasury 2003.
Sources: Fiscal stabilization and the EMU, Discussion Paper, UK Treasury, 2003. Brunila A., M. Buti, and J. Veld, Cyclical stabilization under SGP: How effective are automatic stabilizers?, Discussion Paper, Bank of Finland, 2002. Di Bella, C. G., Automatic fiscal stabilizers in France, Working Paper, IMF, 2002. Girouard, N. and Ch. Andrer, Measuring cyclically-adjusted budget balances for OECD countries, Working Paper, OECD, 2005. Sperling, Gene, “Ways to get the economic stimulus right this time,” Bloomberg.com, December 17, 2007. Stone, Chad and Kris Cox, “Economic policy in a weakening economy: principles of fiscal stimulus,” Center on Budget and Policy Priorities, Washington, DC, January 8, 2008. Summers, Lawrence H., “The state of the U.S. economy,” Presentation at Brookings Institution forum, http://www.brookings.edu/~/media/Files/events/ 2007/1219_economy/20071219_summers.pdf, Washington DC, December 19, 2007.
38
Table 6. Policy Measures Other than Fiscal Undertaken and Planned between September 2008 and Early-February 2009 in Reaction to the Financial Crisis
Bulgaria Czech Republic Estonia Latvia Lithuania Hungary Poland Romania Slovak
Republic Slovenia Croatia
Quasi-Fiscal and Economic
Increased credit lines to SMEs or exporters √ √ Announced √ Planned √ √
Increase in Treasury Guarantees Announced Announced (but with
limits) Announced √ Announced Announced √
Decrease due to savings plan
More effective absorption of EU funds √ √ √ √ √ √ √ √
Commitment to euro adoption
Target year for euro adoption In 2011 In 2012 In 2012 In 2012 In 2014 Euro since 2009
Euro since 2007
Labor Market Regulations
Flexible working hours Announced Announced √ √ Ban on Sunday
work Temporary wage subsidies √ √ √
Moderation of public wages in 2009
10% increase
Wages to increase
Staff cuts and freezes
Staff cuts, 15% cut of salary fund
Proposed cuts of salaries
Nominal cuts
Reduction of bonuses, wages to
increase 5%
6% increase
Monetary
Interest Rate Cuts 175 bp
200 bp after an
earlier hike of 300 bp
175 bp 25 bp
225 bp, including the ECB
cuts in 2009
225 bp, made by the ECB
Fixed 6% repo rate
Lower Mandatory Reserve Requirements
From 12% to 10%, 5% for funds from abroad, and no MRR for
govt. deposits
From 5% to 3%
(maturities > 2 years), from 7% to 5% (other)
From 5% to 2% Considered From 20% to
18% From 17% to 14%
Liquidity Provision
- More REPO operations √ √ √ Yes √ √
39
- More flexibility in collateral requirements
√ √ √ (by ECB)
√ (by ECB)
- FX swaps
Swap line of EUR 500
million from Sweden and
Denmark
Swap facility of up to €5 billion in the ECB
In EUR and CHF, swap facility up to EUR10 billion in the ECB
Swap line of
EUR260 million
- Other
Marginal lending facility
Early buy-
back of NBP bonds
Reduced minimum required
amount of FX claims from 28.5% to 25%
Exchange rate interventions √ √ √
Support to Banking Systems Loans to financial institutions from the Treasury
Loan guarantees to banks √ √
Capital injection √ √
√ Capital Base
Enhancement Fund
Considered to state-owned banks
Savings Bank can be capitalized
√
Asset purchases
Bank nationalization √
Guarantees to bank deposits
- Private Persons √ to EUR 50 Thousand √
√ to EUR 50 Thousand
√ to EUR 50 Thousand
√ to EUR 50 Thousand
√ to EUR 50 Thousand
√ to EUR 50 Thousand
√ to EUR 50 Thousand
√ Unlimited
√ Unlimited
√ to EUR 54 Thousand
- Enterprises
- Interbank transactions √
Financial Supervision Tighter lending regulations, in particular on foreign currency lending
√
√ Reformed regulator (HFSA)
√ √ √
Towards enterprises
Bulgaria Czech R. Estonia Latvia Lithuania Hungary Poland Romania Slovak R. Slovenia Croatia Source: World Bank Staff calculations based on national sources.
40
EU10 February 2009 Special Topic: Reshaping Economic Geography25
This special topic is based on the World Development Report 2009, Reshaping Economic Geography, and spotlights the implications of the report for the EU10.26 Taking a long-term view which utilizes insights from economic geography and history, it recommends continued efforts to:
• Make economic borders thinner. In the EU10, economic divisions to the mobility of people and products remain considerable, and reforms to reduce these divisions should remain high on the agenda even during the financial crisis. In the EU15, as governments deliberate economic stimulus programs, they should resist the temptation of nationalism and make their borders thicker.
• Welcome rising economic density. The lesson of history is that greater international convergence is accompanied by a concentration of production in leading areas and cities. The EU10 should not resist the domestic concentration of economic activities: they are a necessary part of strategies for growth and competitiveness.
• Deepen institutional convergence. While infrastructure and place-based investments are often seen as most needed policy measures, the mainstay of a strategy for economic integration in Europe are common institutions that facilitate the mobility of goods, services, capital and labor. New member states should continue their efforts to harmonize trade, financial and employment regulations.
Some Economic History
The formation of the North Atlantic Treaty Organization (NATO) in April 1949 marked the beginning of the Cold War. With much of Eastern Europe under Soviet control, the continent was divided by an iron curtain, impermeable to flows of goods, services, people and ideas. Western Europe flourished while the East floundered. While GDP per capita in 14 Western European economies grew more than threefold between the 1950s and the 1990s, the economies of Eastern Europe progressed more slowly. Regional integration in the West would help former laggards such as Italy, first, then Ireland, Portugal, Spain, and Greece leave the ranks of poor Europeans nations and converge to West European averages (Figure 47).
The driver of West European growth was a combination of market economies, a philosophy of rising regional cooperation, and the push of global economic integration. Spurred by the political will to avoid repeated conflict, the agreement on cooperation in the coal and steel industries in 1951 grew into a more ambitious project. In 1957, the six members of the European Coal and Steel Community signed the Treaty of Rome, creating the European Economic Community (EEC). By 1970, the EEC had adopted its first full plan for economic and monetary integration. Though this plan was to fail and integration to stall, the years that followed saw the broadening of the EEC, as another six countries joined between 1973 and 1986. 1986 also marked the signing of the Single European Act, which emphasized the free mobility of capital and put Western Europe back onto the road to full monetary integration.27
Fast forward two decades. The chain of events that began with the fall of the Berlin Wall in November 1989 and the collapse of the former Soviet Union in 1991 is complete. The Iron Curtain was removed and Bulgaria, the Czech Republic, Hungary, Poland, Romania, the Slovak Republic, and Slovenia, and the three Baltic states of Estonia, Latvia and Lithuania, became members of an 25 Contributed by Indermit Gill, Chorching Goh, and Mark Roberts, with special thanks to Siobhan Murray for her superb cartographic assistance. For questions, please contact Chorching Goh ([email protected]). The World Development Report 2009, Reshaping Economic Geography is available at http://www.worldbank.org/wdr2009. 26 The EU10 refers to Bulgaria, the Czech Republic, Estonia, Latvia, Lithuania, Hungary, Poland, Romania, the Slovak Republic, and Slovenia. 27 Based on “Geography in Motion: Overcoming Division in Western Europe” in World Development Report 2009.
41
expanded European Union, an economic zone based on the principles of democracy, markets and the free mobility of goods, capital and labor. Together, the 27 countries of the EU have a combined population of almost 500 million people28 and account for more than 30 percent of the world's GDP.29 But the legacy of division has meant that the EU10 countries lag considerably behind. While these economies have brought 123 million people into the EU, they have reduced its average level of GDP per capita by an estimated 15.6 percent.
Figure 48. A Politically Divided Europe Saw Economic Divergence GDP per capita in selected Western and Eastern European economies, 1949-1989
0
2,000
4,000
6,000
8,000
10,000
12,000
14,000
16,000
18,000
20,000
Year (1949-1989)
GD
P pe
r cap
ita (1
990
inte
rnat
iona
l dol
lars
)
Denmark United Kingdom Sweden Netherlands Belgium FranceFinland Germany Austria Italy Ireland Spain Portugal Greece Bulgaria Czechoslovakia Hungary Poland Romania Yugoslavia
Source: Based on data from Maddison (2008), "Statistics on World Population, GDP and per capita GDP, 1-2006 AD", downloaded from http://www.ggdc.net/maddison/.
Economic Division—Thick Borders Impede Specialization
East European poverty relative to western prosperity is indeed a legacy of division for over half a century. In the west, market forces operating within restored democratic frameworks enabled people and firms to gravitate towards the areas of maximum opportunity. This facilitated the build-up of economic density in a core area which now stretches across Western Europe from London to Paris, through Brussels and Frankfurt and down to Milan. The density built in this core area has propelled the western economies forward. But while geographic distance to density in the west was not long, Eastern European economies were denied access by division.
Eastern European economies still remain, relatively speaking at least, divided from the density of Europe's core economic area.
28 Eurostat figures for 2008. 29 International Monetary Fund, World Economic Outlook Database, October 2008.
42
Figure 49 shows the thickness of economic borders, which has contributed to a discrepancy between market potential in west and central Europe (Figure 50). Real market access—which measures the size of nearby markets including the home economy— in the EU10 falls short of that in Europe's leading economies. Good access to foreign markets should facilitate the building of domestic density which promotes real market potential through the growth of the domestic economy. In turn, enhanced real market access should lead to a further improvement in foreign market potential because growth of the domestic economy enlarges the markets which neighboring countries can themselves access. 30
Figure 49. EU10 Countries Need to Make Their Borders Thinner, and EU15 Should Not Thicken Its Economic Borders as It Deliberates Fiscal Stimulus
Source: Based on Map 3.2, chapter 3 of the World Development Report 2009 Reshaping Economic Geography. The width of borders is proportional to a summary measure of each country’s restrictions to the flow of goods, capital, people, and ideas with all other countries.
30 See Mayer (2008), "Market Potential and Development", background paper prepared for the World Development Report 2009.
43
Figure 50. Higher Divisions, Greater Economic Distance, and Lower Density Mean Poorer Market Access in the EU10 Real market potential relative to the US, 2005
Source: Based on estimates in Mayer (2008), "Market Potential and Development", background paper prepared for World Development Report 2009 Reshaping Economic Geography.
44
Economic Density—Agglomeration Should Be Facilitated
Density refers to the intensity of economic activity per unit of land area and can be measured by, for example, the level of GDP generated per square kilometer of land. Figure 51 shows Eastern Europe’s economic topography. It portrays a landscape which is spiky rather than flat, reflecting the fact that market forces generate a tendency for economic activity to concentrate in some areas rather than others. While the spikes in Germany, Austria and Italy resemble part of a vast mountain range which spreads westward into the other established members of the EU, those in Eastern Europe show up as small foothills. This reflects the great difference in density which separates the EU's newest members from the rest. In particular, economic density across the EU’s subnational areas shows a strong association with GDP per capita.
This correlation is no accident. Econometric evidence demonstrates that economic density facilitates higher productivity and well-being.31 Economically dense settlements of activity and people have production advantages. These include "thick" markets which help to improve the variety of goods available for final consumption and a vibrant base of suppliers for industries of local importance. They also include the existence of a pool of labor, which improves the efficiency of the local labor market, and leads to beneficial spillovers of knowledge both within and between local industries.
Figure 51. Mountains in the West, Hills in the East The Economic Topography of Central Europe and the Baltics
Source: Geographic Information Systems Laboratory in the World Bank's Development Economics Research Group.
31 See Ciccone, Antonio (2002), "Agglomeration Effects in Europe", European Economic Review, vol. 46, pp 213-217. In particular, Ciccone derives the prediction of a positive relationship between GDP per capita and the natural log of economic density from an explicit theoretical urban economics model which has micro-foundations for agglomeration economies. He verifies the existence of this relationship using a much more restricted sample of EU NUTS1 regions than was used to construct figure 50. Ciccone demonstrates, through the use of an instrumental variable identification strategy, that the correlation which he finds is not driven by reverse causation from GDP per capita to density.
45
Since its inception, the European Union has had a strong commitment to tackling disparities in productivity and well-being across its member states and regions. The expansion to incorporate former COMECON countries from Eastern Europe has reinforced this commitment, given that their relative poverty implies that disparities within the Union are now wider than ever.
The EU has designated three objectives for its new "Cohesion Policy" in the period 2007-2013, to which it has allocated total funding of €348 billion. By far the most important of these is the "convergence objective", under which almost 82 percent of cohesion policy spending falls. In turn, some 71 percent of spending under the convergence objective is earmarked for NUTS2 regions which have GDP per capita levels of less than 75 percent of the EU average. Inevitably, the majority of these regions are in new member states. 23 percent of convergence objective spending is reserved for member states which have a level of gross national income (GNI) per capita less than 90 percent of the EU average, again primarily the new Eastern European members.
The aim of all of this spending is to "reduce structural disparities between EU regions, foster balanced development throughout the EU and promote real equal opportunities for all."32 This is often equated with spatial equality and the desire to "smooth out" the economic landscape. The World Development Report suggests that such an approach may be misguided, at least at the stage of development of much of the EU10. Economic growth, by its nature, is spatially unbalanced. The convergence of Eastern with Western Europe requires policies that facilitate the building of economic density in the leading areas of the EU10. Some of the hills in the new member states will grow into mountains, making the topography of density spikier: a more prosperous central Europe will not be flat.
The experience of Western European and other advanced countries suggests that increased spatial concentration will initially lead to rising spatial disparities in productivity and perhaps initially in living standards. Cities and leading regions will pull away from the more remote and rural areas. Over time, with migration, redistributive tax systems and a commitment to the universal provision of health, education, security and other basic amenities, spatial disparities in living standards diminish. So while economic density continues to increase, its benefits are shared more widely.
Economic density is higher in the most prosperous and largest EU countries—France, the UK, and Germany. But the six most unequal countries in terms of the spatial dispersion of GDP per capita levels are Latvia, Estonia, Hungary, the Slovak Republic, Bulgaria and Romania (Figure 53). Clearly, a smoother economic landscape is not synonymous with a reduction in spatial inequalities in well-being. Further, the economies which have grown fastest in the EU over the period 2001-2005, i.e. the most successful of the Eastern European economies, are also those which have experienced the largest increases in spatial inequality (see Figure 52). (For Ireland’s experience with rapid convergence, see Box 4.)
While many of the EU10 nations are building density and fostering international catch-up, rising spatial inequality may have to be temporarily tolerated. However, although faster national growth will mean larger disparities between subnational areas, it may bring forward the day when the living standards of even the poorest regions will have converged to EU average levels.
32 Activities of the European Union: Summary of Regional Policy Legislation website (http://europa.eu/scadplus/leg/en/s24000.htm).
46
Figure 53. Higher Economic Density, Higher Standards of Living NUTS2 regions in the EU10
y = 4867.4x + 11196R2 = 0.6917
0
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-2 -1 0 1 2 3 4 5
ln(Density - millions of GDP per sq km, EUR, PPS)
GD
P pe
r cap
ita (E
UR
, PPS
)
Note: This is based on data for 2005 for 48 NUTS2 regions in Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland and Slovenia. Source: Eurostat (http://epp.eurostat.ec.europa.eu/portal/page?_pageid=1090,
30070682,1090_33076576&_dad=portal&_schema=PORTAL).
Figure 54. Initially, Prosperity in Leading Areas Exacerbates Spatial Inequality Faster growing EU countries have seen larger increases in spatial disparities
y = 0.0062x + 0.0269R2 = 0.4462
0
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-4.00 -2.00 0.00 2.00 4.00 6.00 8.00
Absolute increase in concentration, 2001-05
Gro
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pa)
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1-05
Notes: For a given country, the dispersion of regional GDP is defined as the sum of the absolute differences between regional and national GDP per inhabitant (measured at current market prices), at NUTS level 3, weighted with the regional share of population. The value of the dispersion of GDP per inhabitant is zero, if the values of regional GDP are identical in all regions of the country or economic area (such as EU27), and it will show, ceteris paribus, an increase, if the differences between the values of regional GDP per inhabitant among regions are rising.
Source: generated using online tools supplied by Eurostat.
47
Box 5. Economic Concentration Accompanied Faster Convergence in Western Europe
Between 1977 and 2000, Ireland’s per capita GDP grew from 72 percent of the EU average to 116 percent. What was behind Ireland’s success?
Since joining the EU in 1973, Ireland received about €17 billion in EU Structural and Cohesion Funds through 2003. In the first two rounds of EU funding, the entire country was classified as an Objective One area. Between 1993 and 2003, cohesion funds supported 120 infrastructure projects at a cost of about €2 billion. The choice of projects was based on a national development plan, focused on investments in infrastructure that stimulated long-term national economic growth. These included investments in leading areas and in connecting leading and lagging areas, such as the M50 (Dublin Ring Road), M1 (Dublin-Belfast), and improvements in the N4 (Dublin-Sligo), N7 (Dublin-Limerick), and N11 (Dublin-Rosslare).
The Irish also invested in education and training to improve the business environment nationwide. With its skilled labor force and good logistics, it has become a popular destination for U.S. firms wishing to reach European markets. In 2004, Irish-based U.S. firms exported US$55 billion worth of goods and services, mostly destined for Europe.
Ireland’s rapid convergence toward the incomes of Europe’s leaders was accompanied by a rising spatial concentration of economic activity. Compared with the other cohesion countries—Greece, Portugal, and Spain—Ireland’s economic concentration rose much more (see Figure B4.1). But its per capita income grew much faster too. In 1977, Greece, Ireland, and Spain had per capita incomes of about US$9,000; Portugal’s was about US$6,000. By 2002, Portugal had an income of US$11,000, and Greece and Spain close to US$15,000; Ireland’s per capita income had risen to US$27,500.
Today, almost all regions in the new member nations in Central Europe qualify for EU financial support. They should consider the Irish example of using the funds for international convergence and not—until later stages—for spreading out economic production domestically.
Figure B4.1. As Ireland’s Income Rapidly Grew, Economic Concentration Increased
Evolution of regional incomes
12
12.5
13
13.5
14
14.5
15
15.5
16
16.5
17
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
years
ln (v
aria
nce)
Greece Portugal Ireland Spain
Source: Based on Box 8.4 in World Development Report 2009.
Promoting Prosperity in the EU10—Institutions That Unify All Places
What is the best way for the EU10 states to build density, converge to Western European levels of prosperity and reduce disparities in living standards between places? How can the new member states achieve domestic integration and attain high-income levels? The World Development Report suggests that the most important integration instrument for economies close to major world markets is to strengthen their institutions.
48
The key for countries close to world markets is to undertake institutional reforms and improve domestic governance to fully integrate with the large markets nearby. Free trade alone does not bring the full benefits of integration. Institutional reforms include moving to a sound macroeconomic environment that contains inflation and an efficient fiscal system that does not rely on distorted trade policies for budget revenues. They also include establishing a sound institutional framework that limits corruption and improves governance.
Although Turkey has had a free trade agreement with the EU for many years, it did not receive significant foreign direct investment until it embarked on major institutional reforms associated with membership talks. The policies and governance standards in countries close to large world markets have to converge to those in the nearby high income region. Indeed, multinational firms are more likely to locate in a country if it has both institutional and physical connections to a larger market. The large market nearby also has a strong incentive to foster sound policy and governance frameworks in nearby small markets to ensure the stability of its neighborhood. These two factors make the coordination of national policies in neighborhoods close to large world markets both desirable and feasible. The prospect of joining the EU has accelerated the pace of reform in Central Europe. And the prospect of better access to the U.S. market triggered policy reforms in Mexico long before North American Free Trade Agreement took effect.33
The Stabilization and Association Agreements between the EU and the Balkans specify the legal and regulatory reforms to be undertaken before joining the EU. The Balkans have also signed an intraregional free trade agreement, the CEFTA, to replace the patchwork of 32 bilateral agreements formerly governing their intraregional trade. The new agreement simplifies and harmonizes rules of origin and extends the trade and transport facilitation initiative launched in 2000. The region has also established a common power market and signed an open sky agreement with the EU that could boost tourism. The Balkan region is close enough to the EU to permit tight integration of its companies into pan-European production networks. Governments can facilitate regional production chains linking their supply capacity to that of the EU by signing mutual recognition agreements, conformity assessments, and other trade-related coordination initiatives.
Despite their membership of the EU (and in the cases of The Slovak Republic and Slovenia, their being in the euro zone), EU10 states need to continue to reduce the thickness of their borders. Despite considerable progress (to fulfill the Copenhagen criteria to join the EU for example), continued domestic institutional reform is required. This is particularly the case for Hungary, Bulgaria, Romania, Slovenia, the Czech Republic and Poland, all of which lag behind the leading EU economies in the Ease of Doing Business rankings.34 And Bulgaria lost €220 million of EU funding from the European Union due to unresolved concerns over governance.35 Improvements in governance are needed to attract investment and facilitate the growth of density in Eastern European cities.
Likewise, strengthening common institutions within each of these EU’s new members will be the most important measure. Specifically, universal provision of basic and social services and improved land markets will increase labor mobility and land use convertibility. Historically, such mobility has been the primary mechanisms for both building density and spatial convergence of living standards within countries. The most striking example of the power of migration to affect convergence is the German unification (see Box 6).
But though migration from Eastern European countries to other EU countries will play a role in promoting international convergence, it may end up being a relatively weak force. About 350,000 Polish workers may have migrated between May 2004 and December 2005 to fill jobs in the UK labor market, but many of these workers have since returned home.36 And as unemployment once again rises across Europe, there is likely to be less demand in the UK and other rich European economies for migrant workers, at least for the next few years. For now, a more important policy priority may
33 International Monetary Fund (1998) for the EU enlargement; Schiff and Wang (2003) for NAFTA. 34 Admittedly, however, although the East European countries cited all lag the rankings of the UK, Ireland, Finland, Sweden, Belgium, Germany, the Netherlands, Austria and France, they do all have better rankings than Greece and also, except in the case of Poland, Italy. For the full list of rankings see http://www.doingbusiness.org/economyrankings/. 35 Article entitled "EU Strips Millions from Bulgaria", published on 25th November 2008 on the BBC website (http://news.bbc.co.uk/1/hi/world/europe/7748300.stm). 36 The Guardian, "345,000, migrants since EU expansion, figures show", Wed 1st March, 2006.
49
be the facilitation of migration to density, including urban-rural migration, within individual EU10 nations. In any case, the aim should improve the flow of workers, goods and services between poor and more prosperous places, instead of trying to make every poor place prosperous.
The willingness of Europeans to move has, historically, been low compared to Americans. This has been in part the result of artificially “thicker” borders. As borders “thin”, both domestic and EU-wide policies can help as they facilitate the mobility of goods, money and people. During times of prosperity, there is the danger of pursuing the elusive goal of “spatially balanced growth”, which means fighting prosperity itself. During times of crisis, growing protectionism may be the greatest danger to economic recovery.
Box 7. The German Integration: Convergence and Concentration with Mobile Labor
With the fall of the Berlin Wall in 1989, direct migration from East to West Germany became possible. By 2007 more than 1.7 million people had left the east, of about 17 million East Germans at the time of the fall of the Berlin wall. (See Box Figure B.5.1).
Box Figure B5.1. Migration from East To West Germany After the Fall of the Berlin Wall (net migration, 1991–2005, in thousands)
Box Figure B5.2. Wages in the East and West Converged During This Period
(black line=1992, red line=2005)
0
20
40
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140
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1992
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Migration produced one desired outcome: incomes became more equal between the two areas (see Box Figure B5.2). While the cross-country distribution of income in 1992 was clearly bimodal, with the counties in the east forming the lower peak (black curve), this was smoothed by 2005 (red curve). Although the counties from the east are still located at the left of the distribution, their economic distance to western counties has shortened.
Convergence in incomes has also produced a more surprising outcome. Almost all counties with more young women than men are in the economically dynamic areas of Germany, which also have better institutions of higher learning. In 2004, in the 18–29 age group, there were only 90 women for every 100 men in East Germany (including Berlin). Why did East German women move to the economically dynamic areas, while men tend to stay behind? Two possible explanations: First, women are on average more successful in school and higher education, which makes it easier for them to study or to find a job in the economically more dynamic parts of Germany. Second, it is harder for women to find an attractive job locally in the lagging areas than it is for men, because these places are dominated by traditionally male jobs in agriculture, manufacturing, and construction.
Source: Based on Box 8.2 in World Development Report 2009.
50
STATISTICAL ANNEX 2005 2006 2007 2008 1Q 08 2Q 08 3Q 08 4Q 08 Sep-
08 Oct-08
Nov-08
Dec-08
Real GDP growth, (% change, y/y)37 Bulgaria 6.3 6.3 6.2 6.0 7.1 7.1 6.8 3.6 Czech Republic 6.3 6.8 6.0 3.5 4.7 4.5 4.3 1.0 Estonia 9.2 10.4 6.3 -3.6 0.2 -1.1 -3.5 -9.4 Hungary 4.0 4.1 1.1 0.6 1.7 2.0 0.8 -2.0 Latvia 10.6 12.2 10.0 -4.6 0.5 -1.9 -5.2 -10.5 Lithuania 7.8 7.8 8.9 3.2 7.0 5.2 2.9 -1.5 Poland 3.6 6.2 6.7 4.8 6.0 5.8 4.8 3.0 Romania 4.1 7.9 6.0 7.8 8.2 9.3 9.1 4.5 Slovakia 6.5 8.5 10.4 6.4 9.3 7.9 7.0 2.7 Slovenia 4.3 5.9 6.8 4.0 5.7 5.5 3.8 1.2 Croatia 4.3 4.8 5.6 2.1 4.3 3.4 1.6 -1.0 Industrial production (%, y/y) Bulgaria 6.7 6.1 9.3 1.1 4.2 6.5 0.3 -6.6 2.5 -2.3 -9.3 -8.3 Czech Republic 6.7 11.2 9.0 0.4 5.6 6.1 4.2 -13.2 8.9 -7.6 -17.4 -14.6 Estonia 10.9 10.1 6.7 -6.2 -0.8 -4.3 -3.6 -16.6 0.5 -11.7 -21.4 -16.7 Hungary 7.0 9.9 8.2 -1.1 7.0 4.5 -2.5 -13.1 -1.0 -7.4 -12.2 -19.6 Latvia 5.7 4.9 0.5 -6.6 -2.7 -4.5 -7.0 -12.5 -2.9 -8.9 -18.0 -10.7 Lithuania 7.1 7.3 4.0 2.7 7.3 7.4 1.8 -4.8 6.1 -3.0 -6.9 -4.4 Poland 4.1 12.1 9.7 3.9 8.9 8.3 3.0 -4.6 6.8 -0.1 -9.2 -4.4 Romania 2.2 7.1 5.4 1.0 5.5 6.7 2.4 -10.8 3.8 -2.8 -11.5 -18.0 Slovakia 3.0 9.9 13.0 2.0 7.2 7.2 2.7 -8.1 5.8 0.0 -9.2 -15.1 Slovenia 3.1 6.2 6.3 -1.5 1.8 3.5 -1.1 -10.3 5.5 -2.8 -13.9 -14.3 Croatia 5.1 4.6 5.6 1.8 5.0 4.0 0.1 -1.9 3.0 -0.7 -3.5 -1.5 Volume indices of retail sales (excl. motor vehicles, automotive fuel, %, y/y) Bulgaria 14.4 13.2 11.1 5.4 11.2 7.7 4.4 -1.6 Czech Republic 3.8 6.5 6.8 0.9 2.0 2.2 1.9 -2.2 4.9 -2.3 -3.8 -0.8 Estonia 12.0 19.0 15.2 -3.7 0.6 -2.7 -4.6 -7.9 -6.4 -6.5 -9.0 -8.2 Hungary 5.6 4.3 -2.8 -1.2 -2.6 -1.4 -0.1 -1.4 -2.7 Latvia 21.2 19.7 19.9 -7.8 -1.1 -4.4 -10.1 -15.6 -12.3 -14.5 -16.3 -16.1 Lithuania 12.9 7.2 12.4 5.5 14.6 7.1 3.0 -2.9 0.9 1.0 -2.1 -7.5 Poland 2.1 12.0 14.6 9.7 15.7 11.8 7.4 3.9 8.3 5.0 1.1 5.7 Romania 24.3 16.4 13.7 16.0 16.7 17.6 4.6 16.8 8.4 2.4 3.0 Slovakia 9.7 8.8 5.4 6.7 14.2 5.7 5.8 1.2 4.6 4.6 2.2 -3.2 Slovenia 6.8 1.7 5.5 6.5 5.7 6.1 7.9 3.9 3.2 Croatia 2.8 2.4 3.3 0.8 3.1 0.4 0.4 -0.3 1.9 -0.6 -1.6 1.2 Unemployment rates (%, NSA, LFS data) Bulgaria 10.2 9.0 6.9 6.6 5.9 5.1 Czech Republic 7.9 7.1 5.3 4.4 4.7 4.2 4.3 4.4 Estonia 7.9 5.9 4.7 5.5 4.2 4.0 6.2 7.6 Hungary 7.2 7.5 7.4 8.0 7.6 7.7 Latvia 8.7 6.8 6.0 6.5 6.3 7.2 Lithuania 8.4 5.7 4.4 4.9 4.5 5.9 Poland 17.7 13.8 9.6 8.1 7.1 6.6 Romania 7.5 7.6 6.8 6.3 5.6 5.4 Slovakia 16.3 13.4 11.2 10.5 10.1 9.0 Slovenia 6.7 6.1 5.0 5.1 4.2 4.1 Croatia 13.0 11.5 9.6 10.0 7.9 7.0
37 GDP data for 2008 and 4Q 2008 are preliminary figures
51
2005 2006 2007 2008 1Q 08 2Q 08 3Q 08 4Q 08 Sep-08
Oct-08
Nov-08
Dec-08
Consumer price inflation (% change, y/y) Bulgaria 5.0 7.3 8.4 12.3 13.3 15.0 12.2 9.3 11.0 10.9 9.1 7.8 Czech Republic 1.9 2.5 2.8 6.3 7.4 6.8 6.7 4.7 6.6 6.0 4.4 3.6 Estonia 4.1 4.4 6.6 10.4 11.1 11.4 10.9 8.3 10.5 9.8 8.0 7.0 Hungary 3.6 3.9 8.0 6.1 6.9 6.8 6.3 4.3 5.7 5.1 4.2 3.5 Latvia 6.7 6.6 10.1 15.4 16.4 17.7 15.8 12.0 14.9 13.8 11.8 10.5 Lithuania 2.7 3.7 5.7 11.1 10.6 12.1 11.7 9.3 11.0 10.5 9.1 8.5 Poland 2.1 1.0 2.5 4.2 4.1 4.3 4.7 3.7 4.5 4.2 3.7 3.3 Romania 9.0 6.6 4.8 7.8 8.0 8.6 8.1 6.8 7.3 7.4 6.7 6.3 Slovakia 2.7 4.5 2.8 4.6 4.0 4.5 5.1 4.8 5.4 5.1 4.9 4.4 Slovenia 2.5 2.5 3.6 5.7 6.6 6.6 6.1 3.4 5.5 4.9 3.1 2.1 Croatia 3.3 3.2 2.9 6.1 5.9 6.6 7.4 4.5 6.4 5.9 4.7 2.9 PPI (%, y/y) Bulgaria 6.9 6.9 8.4 10.8 14.4 13.0 12.1 3.6 11.2 8.9 2.9 -1.0 Czech Republic 3.1 1.5 4.1 4.4 5.6 5.1 5.5 1.6 5.5 3.9 1.2 -0.2 Estonia 2.1 4.5 8.3 7.2 8.3 7.3 7.1 5.9 6.3 6.3 6.2 5.2 Hungary 4.3 6.5 0.2 5.3 5.0 5.3 3.9 6.9 4.7 7.8 7.1 5.8 Latvia 7.8 10.3 16.1 11.5 10.9 12.3 12.5 10.3 12.0 11.5 10.1 9.5 Lithuania 13.5 2.8 19.4 18.5 21.7 22.0 25.0 5.5 23.4 16.0 5.3 -4.9 Poland 0.7 2.3 2.3 2.6 3.0 2.5 2.1 2.5 2.3 2.6 2.4 2.6 Romania 10.6 11.6 8.1 15.9 14.4 17.2 19.7 12.1 18.6 16.7 11.7 7.9 Slovakia 5.3 5.7 2.2 2.8 3.5 4.1 3.5 0.2 2.9 3.1 -0.4 -2.2 Slovenia 2.7 2.3 4.1 3.9 3.4 3.9 5.2 3.0 4.8 4.0 3.1 2.0 Croatia 3.0 2.9 3.9 8.5 7.5 8.7 11.1 6.7 10.3 8.8 6.5 4.7 Exchange rate (nominal, LCU/EUR, period average) Bulgaria 2.0 2.0 2.0 2.0 2.0 2.0 2.0 2.0 2.0 2.0 2.0 2.0 Czech Republic 29.8 28.3 27.8 24.9 25.6 24.8 24.1 25.3 24.5 24.8 25.2 26.1 Estonia 15.6 15.6 15.6 15.6 15.6 15.6 15.6 15.6 15.6 15.6 15.6 15.6 Hungary 248.1 264.3 251.4 251.5 259.3 248.0 236.1 263.4 240.7 260.2 265.3 265.0 Latvia 0.7 0.7 0.7 0.7 0.7 0.7 0.7 0.7 0.7 0.7 0.7 0.7 Lithuania 3.5 3.5 3.5 3.5 0.7 0.7 0.7 0.7 3.5 3.5 3.5 3.5 Poland 4.0 3.9 3.8 3.5 3.6 3.4 3.3 3.8 3.4 3.6 3.7 4.0 Romania 3.6 3.5 3.3 3.7 3.7 3.7 3.6 3.8 3.6 3.7 3.8 3.9 Slovakia 38.6 37.2 33.8 31.3 33.1 31.4 30.3 30.4 30.3 30.5 30.4 30.2 Slovenia 239.6 239.6 0.0 Croatia 7.4 7.3 7.3 7.2 7.3 7.3 7.2 7.2 7.1 7.2 7.1 7.2 Exchange rate (nominal, LCU/USD, period average) Bulgaria 1.6 1.6 1.4 1.3 1.3 1.3 1.3 1.5 1.4 1.5 1.5 1.5 Czech Republic 24.0 22.6 20.3 17.1 16.7 15.8 16.5 19.4 17.4 18.9 20.0 19.5 Estonia 12.6 12.5 11.4 10.7 10.2 10.0 10.6 12.1 11.1 12.3 12.3 11.8 Hungary 199.7 210.5 183.8 172.1 171.0 155.2 161.1 201.2 171.8 201.1 204.1 198.4 Latvia 0.6 0.6 0.5 0.5 0.5 0.4 0.5 0.6 0.5 0.6 0.6 0.5 Lithuania 2.8 2.8 2.5 2.4 2.3 2.2 2.3 2.7 2.5 2.7 2.7 2.6 Poland 3.2 3.1 2.8 2.4 2.3 2.2 2.2 2.9 2.4 2.8 3.0 3.0 Romania 2.9 2.8 2.4 2.5 2.4 2.3 2.4 2.9 2.7 2.9 3.0 3.0 Slovakia 31.0 29.7 24.7 21.3 21.5 19.8 20.6 23.5 21.5 23.9 23.9 22.8 Slovenia 192.7 191.0 174.1 Croatia 5.9 5.8 5.4 4.9 4.8 4.6 4.8 5.6 5.0 5.6 5.6 5.4 Real effective exchange rate, CPI based (%, y/y), (negative value= depreciation) Bulgaria -0.1 9.3 7.2 6.8 10.2 12.1 9.0 6.2 7.4 7.0 4.9 6.8 Czech Republic 2.2 4.9 6.8 11.4 16.1 19.3 19.6 6.7 15.3 11.7 6.1 2.2 Estonia 0.5 4.9 6.5 5.3 8.9 8.8 7.4 4.9 6.6 5.1 3.8 5.6 Hungary 0.6 2.1 10.8 3.1 2.6 5.6 10.5 -3.8 7.5 -3.2 -4.7 -3.4 Latvia -1.2 5.1 9.1 7.5 13.3 13.2 9.6 7.2 8.9 7.8 6.3 7.5 Lithuania -0.9 5.5 5.1 5.8 7.9 9.3 7.8 6.0 6.7 5.7 4.8 7.3 Poland 5.2 3.5 7.3 7.2 11.8 14.6 16.3 -2.3 13.1 3.6 -2.2 -8.3 Romania 10.5 9.9 6.4 -3.5 -2.6 -3.7 -4.8 -5.6 -4.0 -7.2 -5.0 -4.8 Slovakia 1.0 9.4 8.7 7.0 3.9 7.7 10.1 10.3 11.0 9.2 8.9 12.8 Slovenia -0.8 0.2 1.1 Croatia -1.0 -2.2 -4.0 -6.8 -7.8 -7.0 -5.8 -3.0
52
2005 2006 2007 2008 1Q 08 2Q 08 3Q 08 4Q 08 Sep-08
Oct-08
Nov-08
Dec-08
Exports of goods (EUR, %, y/y) Bulgaria 18.6 24.1 15.0 25.8 22.3 17.9 17.0 -1.4 -15.0 Czech Republic 13.2 20.4 18.2 17.0 22.2 17.0 17.8 -2.0 -12.5 Estonia 29.6 24.8 4.1 4.2 4.9 13.8 24.2 12.6 -18.9 Hungary 13.2 18.5 16.1 14.1 13.1 5.7 8.8 -5.9 -10.8 Latvia 28.7 18.2 23.7 21.8 13.7 19.0 28.4 8.1 -13.3 Lithuania 26.9 18.7 11.1 30.7 36.1 34.4 41.0 23.9 17.1 Poland 19.2 22.7 15.9 18.8 21.3 16.5 18.7 -5.0 -16.0 Romania 17.5 16.2 13.8 15.5 22.9 20.3 18.6 14.2 -8.1 Slovakia 14.9 30.1 27.3 19.3 21.6 17.7 20.2 9.5 -7.7 Slovenia 17.6 19.6 18.7 10.8 12.1 7.4 14.4 1.1 -12.7 Croatia 9.6 16.7 9.1 8.3 7.8 15.3 17.8 -12.1 1.9 Imports of goods (EUR, %, y/y) Bulgaria 26.2 5.2 41.7 22.1 33.2 18.3 16.4 12.7 -11.7 Czech Republic 9.3 20.7 16.2 18.1 19.1 14.9 19.4 4.4 -7.8 Estonia 22.5 30.5 6.7 -3.3 -5.3 1.3 5.2 -2.7 -20.3 Hungary 9.9 16.5 11.9 11.6 12.6 7.0 9.8 -3.8 -10.7 Latvia 22.6 31.5 21.6 7.5 -1.8 -3.8 7.9 -7.5 -22.9 Lithuania 25.5 23.5 15.4 29.4 21.3 21.1 25.9 8.8 -7.2 Poland 13.3 23.8 19.6 21.7 23.2 20.2 20.4 1.1 -11.5 Romania 23.9 25.1 25.1 15.2 18.9 18.2 28.2 5.1 -16.1 Slovakia 16.0 28.2 23.1 20.2 20.7 17.4 23.9 8.0 -5.2 Slovenia 14.5 17.6 19.8 14.7 15.9 12.8 13.2 4.4 -12.4 Croatia 12.0 14.4 10.1 13.8 15.7 15.7 27.7 -0.6 -4.8 Trade balance (% GDP) Bulgaria -20.2 -22.0 -25.3 -25.1 -26.8 -26.7 Czech Republic 2.0 2.0 3.4 3.3 3.6 3.7 Estonia -13.9 -18.3 -17.6 -16.2 -14.5 -13.0 Hungary -2.5 -2.3 0.3 0.7 0.8 0.5 Latvia -18.9 -25.6 -25.3 -23.7 -21.7 -19.7 Lithuania -11.3 -13.9 -15.1 -15.6 -14.8 -13.5 Poland -0.9 -2.0 -4.0 -4.0 -4.1 -4.3 Romania -9.8 -12.0 -14.8 -14.7 -14.4 -14.4 Slovakia -5.0 -4.5 -1.2 -0.9 -1.0 -1.1 Slovenia -3.6 -3.7 -4.8 -5.4 -6.2 -7.0 Croatia -24.0 -24.4 -25.2 -25.6 -26.3 -26.6 Current account balance (%GDP) Bulgaria -12.4 -17.8 -21.8 -22.1 -24.3 -24.1 Czech Republic -1.3 -2.6 -1.8 -1.7 -2.5 -2.3 Estonia -10.0 -16.7 -18.1 -15.6 -14.3 -12.0 Hungary -7.5 -7.5 -6.4 -6.6 -6.5 -7.0 Latvia -12.5 -22.5 -23.8 -22.0 -19.7 -16.4 Lithuania -7.1 -10.6 -14.6 -15.6 -15.5 -14.4 Poland -1.2 -2.7 -4.7 -4.9 -5.1 -5.2 Romania -8.6 -10.4 -14.0 -13.9 -13.7 -14.0 Slovakia -8.4 -7.0 -5.3 -5.5 -6.6 -6.6 Slovenia -1.7 -2.5 -4.2 -5.3 -6.0 -6.1 Croatia -6.3 -7.9 -8.6 -9.7 -10.6 -10.8 FDI, net (% GDP) Bulgaria 14.7 23.3 21.8 19.9 20.0 18.0 Czech Republic 9.4 2.8 4.5 4.1 4.7 4.9 Estonia 15.7 4.2 5.3 4.7 5.7 5.5 Hungary 5.0 3.2 1.6 1.9 4.2 2.4 Latvia 3.6 7.5 7.1 6.8 5.2 4.7 Lithuania 2.6 5.1 3.6 2.8 2.8 2.5 Poland 2.3 3.1 4.3 3.6 3.4 2.8 Romania 6.6 8.9 6.3 6.0 6.6 6.4 Slovakia 4.1 6.8 3.5 3.3 2.7 2.6 Slovenia -0.1 -0.6 -0.8 0.4 0.5 0.3 Croatia 4.1 7.5 9.3 8.4 8.1 7.0
53
2005 2006 2007 2008 1Q 08 2Q 08 3Q 08 4Q 08 Sep-08
Oct-08
Nov-08
Dec-08
Portfolio investment, net (% GDP) Bulgaria -5.5 0.8 -1.8 -1.1 -1.8 -2.7 Czech Republic -2.7 -0.8 -1.5 -1.3 0.0 1.3 Estonia -16.0 -8.0 -2.4 -1.7 0.3 0.5 Hungary 3.9 5.6 -1.6 -2.1 -1.5 1.7 Latvia -0.8 0.2 -2.5 0.4 0.8 1.2 Lithuania -1.0 -0.8 -0.8 0.2 0.0 0.7 Poland 4.1 -0.9 -1.2 -1.4 -0.5 0.7 Romania 1.0 -0.2 0.1 0.2 0.0 -0.2 Slovakia -2.0 2.9 -0.6 1.6 1.1 1.6 Slovenia -4.6 -4.7 -6.6 -3.8 -3.5 -4.0 Croatia -3.8 -1.6 0.0 1.4 1.2 0.5 General Government balance (ESA95) Bulgaria 1.8 3.0 3.4 Czech Republic -3.6 -2.6 -1.6 Estonia 1.8 3.6 3.2 Hungary -7.8 -9.3 -5.5 Latvia -0.4 -0.2 0.0 Lithuania -0.5 -0.5 -1.2 Poland -4.3 -3.8 -2.0 Romania -1.2 -2.2 -2.5 Slovakia -2.8 -3.6 -2.2 Slovenia -1.5 -1.2 -0.1 Croatia -4.0 -2.4 -1.6 General Government revenues (ESA95, % GDP) Bulgaria 41.0 39.4 41.2 Czech Republic 41.4 41.0 40.8 Estonia 35.4 36.6 36.9 Hungary 42.1 42.6 44.6 Latvia 35.2 37.7 38.0 Lithuania 33.1 33.4 34.3 Poland 39.0 40.0 40.4 Romania 32.3 33.1 34.4 Slovakia 35.3 33.5 34.7 Slovenia 44.5 44.1 43.2 Croatia 44.5 44.8 46.0 General Government expenditures (ESA95, % GDP) Bulgaria 39.2 36.4 37.8 Czech Republic 44.9 43.6 42.4 Estonia 33.5 33.0 33.7 Hungary 49.9 51.9 50.1 Latvia 35.6 37.9 38.0 Lithuania 33.6 33.9 35.6 Poland 43.3 43.8 42.4 Romania 33.5 35.3 36.9 Slovakia 38.1 37.2 36.9 Slovenia 46.0 45.3 43.3 Croatia 48.5 47.2 47.6 General government debt (% GDP) Bulgaria 29.2 22.7 18.2 Czech Republic 29.7 29.4 28.7 Estonia 4.5 4.2 3.4 Hungary 61.6 65.6 66.0 Latvia 12.4 10.7 9.7 Lithuania 18.6 18.2 17.3 Poland 47.1 47.6 45.2 Romania 15.8 12.4 13.0 Slovakia 34.2 30.4 29.4 Slovenia 27.5 27.2 24.1 Croatia 43.8 41.0 38.0 Source: Eurostat, EC, WIIW, CSOs, NCBs, World Bank, IMF IFS, staff calculations.
Note: Cut-off data for data selection: February10, 2008
54
CHARTS ANNEX Figure 55. Construction Production Index (% change, yoy, unadjusted)
-30-20-10
0102030405060
Jan-
07
Mar
-07
May
-07
Jul-0
7
Sep-
07
Nov
-07
Jan-
08
Mar
-08
May
-08
Jul-0
8
Sep-
08
Nov
-08
CZ HUPL SK
-30-20-10
0102030405060
1Q 0
7
2Q 0
7
3Q 0
7
4Q 0
7
1Q 0
8
2Q 0
8
3Q 0
8
4Q 0
8
LV LTEE
-30-20-10
0102030405060
Jan-
07
Mar
-07
May
-07
Jul-0
7
Sep-
07
Nov
-07
Jan-
08
Mar
-08
May
-08
Jul-0
8
Sep-
08
Nov
-08
RO BG SI
Source: Statistical Offices, Eurostat, World Bank Staff calculations.
Figure 56. Retail Sales Index (% change, yoy, unadjusted)
-20-15-10-505
101520253035
Jan-
07
Mar
-07
May
-07
Jul-0
7
Sep-
07
Nov
-07
Jan-
08
Mar
-08
May
-08
Jul-0
8
Sep-
08
Nov
-08
CZ HUPL SK
-20-15-10-505
101520253035
Jan-
07
Mar
-07
May
-07
Jul-0
7
Sep-
07
Nov
-07
Jan-
08
Mar
-08
May
-08
Jul-0
8
Sep-
08
Nov
-08
LV SILT EE
-20-15-10-505
101520253035
Jan-
07
Mar
-07
May
-07
Jul-0
7
Sep-
07
Nov
-07
Jan-
08
Mar
-08
May
-08
Jul-0
8
Sep-
08
Nov
-08
RO
Source: Statistical Offices, Eurostat, World Bank Staff calculations.
Figure 57. Real Growth of Wages (% change, yoy)
-5
0
5
10
15
20
25
1Q 0
7
2Q 0
7
3Q 0
7
4Q 0
7
1Q 0
8
2Q 0
8
3Q 0
8
CZ PLSK HU
-5
0
5
10
15
20
25
1Q 0
7
2Q 0
7
3Q 0
7
4Q 0
7
1Q 0
8
2Q 0
8
3Q 0
8
EE LVLT SI
-5
0
5
10
15
20
25
1Q 0
7
2Q 0
7
3Q 0
7
4Q 0
7
1Q 0
8
2Q 0
8
3Q 0
8
BG RO
Source: Statistical Offices, World Bank Staff calculations.
Figure 58. Exchange rates (USD/LCU)
USD/CZK
14151617181920212223
Jan-
08
Feb-
08
Mar
-08
Apr-
08
May
-08
Jun-
08
Jul-0
8
Aug-
08
Sep-
08
Oct
-08
Nov
-08
Dec
-08
Jan-
09
Feb-
09
USD/EEK
9.09.5
10.010.511.011.512.012.513.0
Jan-
08
Feb-
08
Mar
-08
Apr-
08
May
-08
Jun-
08
Jul-0
8
Aug-
08
Sep-
08
Oct
-08
Nov
-08
Dec
-08
Jan-
09
Feb-
09
USD/HUF
140150160170180190200210220230240
Jan-
08
Feb-
08
Mar
-08
Apr-
08
May
-08
Jun-
08
Jul-0
8
Aug-
08
Sep-
08
Oct
-08
Nov
-08
Dec
-08
Jan-
09
Feb-
09
USD/LVL
0.40
0.45
0.50
0.55
0.60
Jan-
08
Feb-
08
Mar
-08
Apr-
08
May
-08
Jun-
08
Jul-0
8
Aug-
08
Sep-
08
Oct
-08
Nov
-08
Dec
-08
Jan-
09
Feb-
09
USD/LTL
2.02.12.22.32.42.52.62.72.82.9
Jan-
08
Feb-
08
Mar
-08
Apr-
08
May
-08
Jun-
08
Jul-0
8
Aug-
08
Sep-
08
Oct
-08
Nov
-08
Dec
-08
Jan-
09
Feb-
09
USD/PLN
2.02.22.42.62.83.03.23.43.63.8
Jan-
08
Feb-
08
Mar
-08
Apr-
08
May
-08
Jun-
08
Jul-0
8
Aug-
08
Sep-
08
Oct
-08
Nov
-08
Dec
-08
Jan-
09
Feb-
09
55
USD/BGN
1.2
1.3
1.4
1.5
1.6
Jan-
08
Feb-
08
Mar
-08
Apr-
08
May
-08
Jun-
08
Jul-0
8
Aug-
08
Sep-
08
Oct
-08
Nov
-08
Dec
-08
Jan-
09
Feb-
09
USD/RON
2.02.22.42.62.83.03.23.43.6
Jan-
08
Feb-
08
Mar
-08
Apr-
08
May
-08
Jun-
08
Jul-0
8
Aug-
08
Sep-
08
Oct
-08
Nov
-08
Dec
-08
Jan-
09
Feb-
09
USD/HRK
4.44.64.85.05.25.45.65.86.0
Jan-
08
Feb-
08
Mar
-08
Apr-
08
May
-08
Jun-
08
Jul-0
8
Aug-
08
Sep-
08
Oct
-08
Nov
-08
Dec
-08
Jan-
09
Feb-
09
Source: ISI, Reuters
Figure 59. Exchange rates (EUR/LCU)
EUR/CZK
20212223242526272829
Jan-
08
Feb-
08
Mar
-08
Apr-
08
May
-08
Jun-
08
Jul-0
8
Aug-
08
Sep-
08
Oct
-08
Nov
-08
Dec
-08
Jan-
09
Feb-
09
EUR/PLN
3.03.23.43.63.84.04.24.44.64.8
Jan-
08
Feb-
08
Mar
-08
Apr-
08
May
-08
Jun-
08
Jul-0
8
Aug-
08
Sep-
08
Oct
-08
Nov
-08
Dec
-08
Jan-
09
Feb-
09
USD/HUF
220230240250260270280290300
Jan-
08
Feb-
08
Mar
-08
Apr-
08
May
-08
Jun-
08
Jul-0
8
Aug-
08
Sep-
08
Oct
-08
Nov
-08
Dec
-08
Jan-
09
Feb-
09
EUR/RON
3.03.23.43.63.84.04.24.44.6
Jan-
08
Feb-
08
Mar
-08
Apr-
08
May
-08
Jun-
08
Jul-0
8
Aug-
08
Sep-
08
Oct
-08
Nov
-08
Dec
-08
Jan-
09
Feb-
09
EUR/HRK
7.0
7.1
7.2
7.3
7.4
7.5
Jan-
08
Feb-
08
Mar
-08
Apr-
08
May
-08
Jun-
08
Jul-0
8
Aug-
08
Sep-
08
Oct
-08
Nov
-08
Dec
-08
Jan-
09
Feb-
09
Source: ISI, Reuters
Figure 60. Stock Market Price Indices
600
800
1000
1200
1400
1600
1800
2000
Jan-
08
Feb-
08
Mar
-08
Apr-
08
May
-08
Jun-
08
Jul-0
8
Aug-
08
Sep-
08
Oct
-08
Nov
-08
Dec
-08
Jan-
09
Feb-
09
PX Index Czech Republic
200
300
400
500
600
700
800
Jan-
08
Feb-
08
Mar
-08
Apr-
08
May
-08
Jun-
08
Jul-0
8
Aug-
08
Sep-
08
Oct
-08
Nov
-08
Dec
-08
Jan-
09
Feb-
09
TALSE Index Estonia
10000
15000
20000
25000
30000Ja
n-08
Feb-
08
Mar
-08
Apr-
08
May
-08
Jun-
08
Jul-0
8
Aug-
08
Sep-
08
Oct
-08
Nov
-08
Dec
-08
Jan-
09
Feb-
09
BUX Index Hungary
200
300
400
500
600
700
Jan-
08
Feb-
08
Mar
-08
Apr-
08
May
-08
Jun-
08
Jul-0
8
Aug-
08
Sep-
08
Oct
-08
Nov
-08
Dec
-08
Jan-
09
Feb-
09
RIGSE Index Latvia
100
200
300
400
500
600
Jan-
08
Feb-
08
Mar
-08
Apr-
08
May
-08
Jun-
08
Jul-0
8
Aug-
08
Sep-
08
Oct
-08
Nov
-08
Dec
-08
Jan-
09
Feb-
09
VILSE IndexLithuania
10000
20000
30000
40000
50000
60000
Jan-
08
Feb-
08
Mar
-08
Apr-
08
May
-08
Jun-
08
Jul-0
8
Aug-
08
Sep-
08
Oct
-08
Nov
-08
Dec
-08
Jan-
09
Feb-
09
WIG Index Poland
200
500
800
1100
1400
1700
2000
Jan-
08
Feb-
08
Mar
-08
Apr-
08
May
-08
Jun-
08
Jul-0
8
Aug-
08
Sep-
08
Oct
-08
Nov
-08
Dec
-08
Jan-
09
Feb-
09
SOFIX Index Bulgaria
2000
4000
6000
8000
10000
12000
Jan-
08
Feb-
08
Mar
-08
Apr-
08
May
-08
Jun-
08
Jul-0
8
Aug-
08
Sep-
08
Oct
-08
Nov
-08
Dec
-08
Jan-
09
Feb-
09
BET Index Romania
1000
2000
3000
4000
5000
6000
Jan-
08
Feb-
08
Mar
-08
Apr-
08
May
-08
Jun-
08
Jul-0
8
Aug-
08
Sep-
08
Oct
-08
Nov
-08
Dec
-08
Jan-
09
Feb-
09
CROBEX Index Croatia
56
300
350
400
450
500
Jan-
08
Feb-
08
Mar
-08
Apr-
08
May
-08
Jun-
08
Jul-0
8
Aug-
08
Sep-
08
Oct
-08
Nov
-08
Dec
-08
Jan-
09
Feb-
09
SKSM Index Slovak Republic
2000
4000
6000
8000
10000
12000
Jan-
08
Feb-
08
Mar
-08
Apr-
08
May
-08
Jun-
08
Jul-0
8
Aug-
08
Sep-
08
Oct
-08
Nov
-08
Dec
-08
Jan-
09
Feb-
09
SVSM Index Slovenia
Source: Reuters
Figure 61. Credit Default Swap Spreads, Government, 5Y (in percent)
0
1
2
3
4
Jan-
08
Feb-
08
Mar
-08
Apr-
08
May
-08
Jun-
08
Jul-0
8
Aug-
08
Sep-
08
Oct
-08
Nov
-08
Dec
-08
Jan-
09
Feb-
09
Czech Republic5Y CDS
0
1
2
3
Jan-
08
Feb-
08
Mar
-08
Apr-
08
May
-08
Jun-
08
Jul-0
8
Aug-
08
Sep-
08
Oct
-08
Nov
-08
Dec
-08
Jan-
09
Feb-
09
Slovakia5Y CDS
0
1
2
3
4
5
6
Jan-
08
Feb-
08
Mar
-08
Apr-
08
May
-08
Jun-
08
Jul-0
8
Aug-
08
Sep-
08
Oct
-08
Nov
-08
Dec
-08
Jan-
09
Feb-
09
Hungary5Y CDS
012345678
Jan-
08
Feb-
08
Mar
-08
Apr-
08
May
-08
Jun-
08
Jul-0
8
Aug-
08
Sep-
08
Oct
-08
Nov
-08
Dec
-08
Jan-
09
Feb-
09
Bulgaria5Y CDS
012345678
Jan-
08
Feb-
08
Mar
-08
Apr-
08
May
-08
Jun-
08
Jul-0
8
Aug-
08
Sep-
08
Oct
-08
Nov
-08
Dec
-08
Jan-
09
Feb-
09
Lithuania5Y CDS
0
1
2
3
4
Jan-
08
Feb-
08
Mar
-08
Apr-
08
May
-08
Jun-
08
Jul-0
8
Aug-
08
Sep-
08
Oct
-08
Nov
-08
Dec
-08
Jan-
09
Feb-
09
Poland5Y CDS
012345678
Jan-
08
Feb-
08
Mar
-08
Apr-
08
May
-08
Jun-
08
Jul-0
8
Aug-
08
Sep-
08
Oct
-08
Nov
-08
Dec
-08
Jan-
09
Feb-
09
Romania5Y CDS
0
1
2
3
4
5
6
Jan-
08
Feb-
08
Mar
-08
Apr-
08
May
-08
Jun-
08
Jul-0
8
Aug-
08
Sep-
08
Oct
-08
Nov
-08
Dec
-08
Jan-
09
Feb-
09
Croatia5Y CDS
Source: MorganMarkets
