Will catching-up continue smoothly in the “new” EU Members? Juergen Kroeger Director DG Economic...

Will catching-up continue smoothly in the “new” EU Members?

Juergen KroegerDirector

DG Economic and Financial AffairsEuropean Commission

13th Dubrovnik Economic Conference

June 27th to July 1st, 2007,

Disclaimer: The views expressed in this presentation are the author’s own and should not be regarded as stating an official position of the European

Commission.

2

Outline

1. “New” MS: successful catching-up but imbalances

2. “Floaters”: mostly fiscal imbalances situation and policy;

3. “Fixers”: private sector / financial imbalances situation and policies;

4. Conclusions

3

STYLIZED FACTS OF SUCCESSFUL REAL CATCHING-UP

Phase 1 : Upswing Initially real expected rate of upturn has to be high

In order to avoid overheating monetary policy has to be used, not fiscal policy

Tight money in the upswing is necessary to Contain inflation

Establish demand supply equilibrium

Help establishing inter temporal equilibrium

Appreciation reduces import costs

Current account deficit, covered by FDI, is a counterpart to fill the supply-demand gap.

4

STYLIZED FACTS OF SUCCESSFUL REAL CATCHING-UP

Phase 2 : Consolidation Higher investment increases the capital stock : Potential

output rises

Domestic supply approaches domestic demand

The marginal real rate of return shrinks to the level of partner countries

Monetary policy is gradually easing

Net exports rising as exchange rate depreciates

Current account moving towards a sustainable level

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1.“New” MS: successful catching-up but imbalances

Growth and per-capita income figures indicate that catching-up has been successful…

PER-CAPITA INCOME 1997-2006(% of EU-15, PPS)

0

10

20

30

40

50

60

70

80

90

100

110

BG RO PL LV LT SK HU EE CZ SI HR

1997 2006

EU-15 average

6


…but other indicators, esp. current account deficits, suggest potential problems ahead, in particular in “fixers”:

“Fixers”

Current account balance

-24-22-20-18-16-14-12-10

-8-6-4-202

BG EE LV LT CZ HU PL RO SI SK NMS HR euro area

% of GDP

2004 2005 2006 2007 (f) 2008 (f)

7


In some cases, FDI-financing of C/A-deficits is small and/or decreasing:

“F I X E R S”

Net FDI (% of current account deficit)

-100

-50

0

50

100

150

200

250

300

350

400

BG EE LV LT CZ HU PL RO SI SK HR

%

2003 2004 2005 2006

8


C/A deficits are private sector-driven in “fixers”, while being more public sector-driven in “floaters”:

“F I X E R S” “F L O A T E R S”

Current account and domestic counterparts (2006) (% of GDP)

0.1

-8.8-7.7

-10.3

-2.2

-5.9-4.1

-10.7

-21.1

-15.8-13.9

-25

-20

-15

-10

-5

0

5

10

BG EE LV LT CZ HU PL RO SK HR Euroarea

Public sector (S-I)

Private sector (S-I)CA - deficit

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2. “Floaters”: mostly fiscal imbalances

• Room for fiscal consolidation and expenditure rationalization:

Composition of general government expenditure in 2006

0

10

20

30

40

50

60

BG EE LV LT CZ HU PL RO SI SK HR euroarea

% GDPOther

GFCF

Interest

Subsidies

Soc. benefits otherthan in kind

Soc. transfers inkind

Collective cons.

10

3. “Fixers”: mostly private sector / financial imbalances

– Against a backdrop of negative real interest rates…

“F I X E R S”

Short term real interest rates

Euro area

Euro area

BG

BGCZ

CZ

EE

EE

LV

LV

LT

LT

HU

HU

PL

PL

RO ROSI

SI

SK

SK

-4

-3

-2

-1

0

1

2

3

4

5

6

2003 2004 2005 2006

Euro area BG CZ EELV LT HU PLRO SI SK

11


– …high growth in “fixers” predominantly driven by high domestic consumption, while external contribution negative:

“F I x e r s” “F l o a t e r s”

Contributions to GDP growth (2006)(percentage points)

6.1

11.4 11.9

7.56.1

4.05.8

7.7 8.3

4.82.7

-10

-5

0

5

10

15

20

25

BG EE LV LT CZ HU PL RO SK CR Euroarea

Net exportsConsumptionInventoriesInvestmentGDP growth

12


– Although investment remains strong, it consists to a substantial extent of construction:

“Fixers”

Share of construction in total investment, year 2005

0

5

10

15

20

25

30

35

BG EE LV* LT CZ HU PL RO SI SK HR euroarea

% GDP

Total investmentConstruction (excl. Housing)Housing

* Data for Latvia (LV) are for 2004.

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– And the share of the construction sector in GDP is quite large and growing:

“Fixers”

Construction sector

0

1

2

3

4

5

6

7

8

9

BG EE LV LT CZ HU PL RO SI SK HR euroarea

% GDP

2004 2005 2006

14


– Unit labour cost developments do not bode well for external competitiveness:

Nominal unit labour cost - Manufacturing

LV

HUBG

EE

LT

CZ

PL

RO

SISK

euro area

-15

-10

-5

0

5

10

15

20

2003 2004 2005 2006

% y-o-y

“Fixers”

15


– Credit growth is reaching staggering levels…

“Fixers”

Domestic Credit

-20

-10

0

10

20

30

40

50

60

70

80

BG EE LV LT CZ HU PL RO SI SK HR NMS euroarea

% y-o-y2003/2002 2004/2003 2005/2004

16


– …with credits to households growing particularly fast…(Y-o-y, end-2006)

0

10

20

30

40

50

60

70

80

90

RO LV LT EE PL SK CZ BG HU

household sector

non-financialcorporations

Fixers

Fixer

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– …and foreign currency lending often dominating:

Foreign currency lending as a % of total outstanding credit, 2005

0,0%

10,0%

20,0%

30,0%

40,0%

50,0%

60,0%

70,0%

80,0%

EE LV LT BG RO HU SK PL CZ

households

corporates

Fixers Floaters

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– While real estate prices are high…

Source: Bank of Latvia

Appartements: ratio of price per m2 in the capital to gross average wage

LV ES FR EE PL CZ IT SI LT IE DK FI NL LU DE AT BE

3.5

3

2.42.2 2.2

2.1

1.61.5 1.5 1.5

1.3 1.2 1.2

0.7 0.7 0.6 0.6

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4. Conclusions

• Catching-up has been successful but there are signs of overheating in the “fixers” (and RO), which could hamper the efficient resource allocation and endanger smooth further real convergence;

• The remaining policy instruments of the “fixers” to cope with the situation are limited to fiscal policy and structural policies (in particular related to the financial sector);

• This could be a lesson for the “floaters” (see e.g. RO) not to peg their exchange rate too early or manage it too tightly and to contain balance sheet exposures to exchange rate movements;

Will catching-up continue smoothly in the “new” EU Members? Juergen Kroeger Director DG Economic...

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