EconomicEconomic TrendsTrends andand ChallengesChallengesinin New Member StatesNew Member States

Christoph RosenbergInternational Monetary Fund

10th CEI Summit Economic ForumSofia, Nov 21, 2007

Note: These are the authorNote: These are the author’’s own views, not necessarily those of the IMF. Some of the datas own views, not necessarily those of the IMF. Some of the data presented need to be presented need to be confirmed with country authoritiesconfirmed with country authorities

o The overall macro picture: betterthan ever

o But underlying this are challenges in the run-up to Euro adoption

o Policy Conclusions

Fiscal adjustmentCredit growth and currency mismatchesExternal imbalancesCreating flexible economies

OvervieOvervieww

The overall macro The overall macro picture:picture:

better than everbetter than ever

GrowthGrowth performance performance isis still still goodgood, , driven by EU accession driven by EU accession and still solid global growth.and still solid global growth.

Source: WEO October 2007.

Annual GDP growth (percent)

WorldCE4

Baltics

Bulgaria & Romania

-8

-6

-4

-2

0

2

4

6

8

10

12

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007p 2008p

IInflationnflation isis relativelyrelatively subsubdueddued, except in , except in the fixed exchange rate countries.the fixed exchange rate countries.

Source: WEO October 2007.

Annual average CPI (percent)

CE4

Baltics

World

Bulgaria & Romania

0

5

10

15

20

25

30

35

40

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007p 2008p

608

Even headline fiscal deficits are not Even headline fiscal deficits are not looking so bad (except Hungary).looking so bad (except Hungary).

CECs. General Government deficit (ESA 95, percent of GDP)

* incl. pension reform costsSource: Eurostat, EC Autumn Forecast 2007

-10

-8

-6

-4

-2

0

2

4

05 07 05 07 05 07 05 07 05 07 05 07 05 07 05 07 05 07

EE BU LV LT RO SK* PL* CZ HU*

EDP/ Maastricht limit

The The NMSsNMSs have weathered the have weathered the subprimesubprimemarket fallout better that other market fallout better that other EMsEMs

Change in EMBIJuly 16 - November 16 (bps)

Source: IMF GMM, national statistics.

0 10 20 30 40 50 60 70 80 90 100

Serbia

Argentina

Ukraine

Russia

Bulgaria

Brazil

Mexico

Turkey

China

Poland

Hungary

-8 -6 -4 -2 0 2 4 6 8

Mexico

Argentina

Ukraine

China

Hungary

Russia

Slovakia

Brazil

Turkey

Poland

Serbia

Czech Republic

Change in the EURO exchange rate July 16 – November 16(+= depreciation, percent)

……although downside risks have although downside risks have increased:increased:

Sharper than expected squeeze on creditIncreased risk premia, especially in countries with large imbalancesLower FDI from US and Western EuropeLower exports to US and Western Europe

Nevertheless we worry Nevertheless we worry in some countries about in some countries about increasing vulnerabilities increasing vulnerabilities

in the runin the run--up to euro adoption.up to euro adoption.

Macro VulnerabilitiesMacro VulnerabilitiesExternal imbalances are growing, External imbalances are growing, especially in the Balticsespecially in the Baltics

CE4 Baltics

Romania &

BulgariaEM

countries*Asia

1997**General government deficit -5.3 0.2 1.0 1.1 -1.8

C/A balance -5.2 -15.6 -13.1 2.7 -3.3

Gross external debt 57.7 89.8 57.4 51.9 66.5

Gross public debt 43.5 11.3 19.8 42.2 18.5

Reserves/ST debt 115.1 54.8 180.6 175.8 20.1

Credit growth (in percent) 8.4 37.6 22.8 2.5 13.9* EM countries - Argentina,Brazil, Chile, China, Colombia, Indonesia, Peru, Russia, Singapore, Thailand, data for 2005.** Korea, Indonesia, Thailand.Source: IM F GFS, IM F IFS, IM F Art icle IV Consultat ions

Key Macro Indicators 2006 (in percent of GDP)

Macro VulnerabilitiesMacro Vulnerabilities

... but this should not surprise in an environment of rapid growth and still-evolving institutions.

Policy dilemma: how to reduce vulnerabilities without impeding the convergence process?

Analytical challenge: how to distinguish “natural” convergence from overheating

Main ConcernsMain Concerns

Lack of fiscal adjustmentCredit growth and currency mismatchesExternal imbalances and cross-border contagion risks

Lack of fiscal adjustmentLack of fiscal adjustment

Despite healthy growth, public debt Despite healthy growth, public debt ratios are not declining in key ratios are not declining in key CECsCECs..

CECs. Public debt (percent of GDP)

Source: EC Autumn Forecast 2007

0

10

20

30

40

50

60

70

HU PL SK CZ BU LT RO LV EE EU15

2005 2007

Maximum prudent debt level

Few countries have used the benign global environment and buoyant revenue to reduce deficits to prudent levels.

CECs. Cyclically-adjusted budget balance (percent of GDP)

Source: EC Autumn Forecast 2007

-10

-8

-6

-4

-2

0

2

4

BU EE LV LT SK PL RO CZ HU EU15

2005 2007

Max prudent fiscal deficit

Primary spending in the Primary spending in the NMSsNMSs is high, is high, suggesting that fiscal adjustments should suggesting that fiscal adjustments should start at the expenditure side.start at the expenditure side.

beCZ

de

de

EE

gr

es

fr

ie

itcy

LVLT

HU

mt nl

at

PL

pt si

SK

fi

se

ukno

BURO

BRA

TUR

PHIIND

ARG

10

15

20

25

30

35

40

45

50

55

60

0 10,000 20,000 30,000 40,000

GDP per capita at PPS 2006

Prim

ary

spendin

g (perc

ent of GDP)

Source: AMECO.Data for RO & BU for 2005.

Primary expenditure, 2000-06 average (percent of GDP)

Rapid growth of foreign Rapid growth of foreign exchange credit exchange credit

to the private sectorto the private sector

*Greece 1997-2000Source: IFS, national authorities, IMF staff calculations

0

2

4

6

8

10

12

Balt

ics

Bu

lgari

a &

Rom

an

ia

CE4

Irela

nd

(IE

)

Port

ug

al (P

T)

Gre

ece (

GR

)

Sp

ain

(ES

)

Fin

lan

d

Sw

ed

en

Th

ailan

d

Ind

onesia

Kore

a

CECs: 2002-06

Asia: 1993-97

Non-core EMU:1995-99*

Scandinavia: 1984-89

Credit growth has been brisk.Credit growth has been brisk.Average growth of credit to the private sector

(in percentage points of GDP)

*Greece (Q1.1999)Source: National authorities, calculations based on Schadler et al. (2005)

Private credit still has some room to Private credit still has some room to grow, at least in Central Europe.grow, at least in Central Europe.

EU countries: Bank credit to the private sector: Actual and estimated equilibrium levels (percent of GDP)

0102030405060708090

100

CZ HU PL SK EE LV LT Greece,Portugal,Spain,IrelandActual Estimated

Non-core EMU (1998)CECs countries (2006)

BanksBanks’’ balanced position masks important balanced position masks important shifts in the size and funding of their shifts in the size and funding of their fxfxlending.lending.

Change of foreign currency credits and deposits during 2001-06(in percentage points of GDP)

-10

0

10

20

30

40

50

60

LV EE LT HU BG RO* PL SK CZ

foreign currency-denominated creditsforeign currency-denominated deposits

Source: National authorities, IMF staff estimates* Deposit data for Romania are not available.

FxFx borrowing has become popular, borrowing has become popular, especially in countries witch fixed especially in countries witch fixed exchange ratesexchange rates

0

10

20

30

40

50

60

70

80

90

LV EE LT RO HU BU PL SK CZ

Source: National authorities.

Percent of private sector credit in fx, 2006

Households in some countries are particularly exposed.

Source: MNB

Liabilities

0

2

4

6

8

10

12

14

16

2000Q1

2001Q1

2002Q1

2003Q1

2004Q1

2005Q1

2006Q1

2007Q1

Assets

0

2

4

6

8

10

12

14

16

2000Q1

2001Q1

2002Q1

2003Q1

2004Q1

2005Q1

2006Q1

2007Q1

Liabilities

0

5

10

15

20

25

30

35

Jul-03

Jul-04

Jul-05

Jul-06

Assets

0

5

10

15

20

25

30

35

Jul-03

Jul-04

Jul-05

Jul-06

Households’ net open fx position (percent of GDP)La

tvia

H

ungar

y

Large externalLarge externalstock and flowstock and flow

imbalancesimbalances

Current account deficits are high, Current account deficits are high, especially in the Baltics especially in the Baltics and Southand South--Eastern EuropeEastern Europe……

Source: IMF WEO October 2007.

Current account deficit, 2006 -2008(in percent of GDP)

Emerging Asia

Latin America

Bulgaria & Romania

Baltics

Central Europe

-20

-15

-10

-5

0

5

10

2000 01 02 03 04 05 06 07p 08p

…… largely reflecting the convergence largely reflecting the convergence process.process.

BG

CZ

DK

EE

IE

GRES

FRIT

CY

LV

LT HU

MT

NL

AT

PL

PTRO

SI

SK

FI SE

UK

DE

-15

-10

-5

0

5

10

0 5000 10000 15000 20000 25000 30000 35000 40000

GDP PPP per capita, 2006

Curr

ent

acco

unt

def

icit ,2002-2

006

GDP per capita and current account deficit

Source: Eurostat, IFS and staff calculations.

Are large external imbalances a risk?Are large external imbalances a risk?

Optimists:The EU’s “halo” effectFavorable structure of financing (EU funds, remittances, FDI, low portfolio inflows)Presence of large EU banks

Pessimists:Historical evidence of large capital inflows (October 2007 WEO)EU accession does not provide enough protectionDebt financing is potentially vulnerable to sudden stopsForeign capital mainly goes to the non-tradable sector => capacity to repayForeign banks create new vulnerabilities

Balance sheet exposures between Balance sheet exposures between banking systems warrant a crossbanking systems warrant a cross--country country perspective.perspective.

Source: BIS

89.288.380.595.394.188.792.849.6ROW

0.44.11.01.61.60.50.61.0Other EM

0.51.07.01.21.70.41.014.6Other EM Europe

0.10.10.10.22.2Slovenia

2.50.10.65.6Slovakia

0.80.40.58.7Romania

0.16.24.80.20.80.51.02.8Poland

3.20.12.90.1Lithuania

2.60.13.30.1Latvia

0.32.60.20.70.01.26.2Hungary

3.93.60.1Estonia

0.10.61.00.22.68.9Czech Republic

0.50.9Bulgaria

9.96.611.41.92.610.35.634.7EU10

FinlandPortugalItalyFranceGermanySwedenBelgiumAustria

(as percent of total exposure)

Bank's exposure in EM countries, 2007Q02

Creating flexible Creating flexible economieseconomies

Source: IMD World Competitiveness* Excluding Lithuania and Latvia

0 2 4 6 8 10

Iceland

Turkey

Hungary

Estonia

Poland

Slovenia

average

Indonesia

Germany

France

Bes

tper

fom

ers

EU8*

Wors

tper

form

ers

0 2 4 6 8 10

Taiwan

Iceland

Hungary

Estonia

Slovenia

Poland

average

China

Indonesia

Portugal

Bes

tper

fom

ers

EU8*

Wor

stper

form

ers

Flexibility and adaptability (0-10) Adaptability of companies (0-10)

EU15

US

EU15

US

A flexible business environment is essential for A flexible business environment is essential for sustaining convergence and eventually doing well sustaining convergence and eventually doing well in the euro zone.in the euro zone.

Hong Kong

Czech Rep.

Slovak Rep.

Hong Kong

Czech Rep.

Slovak Rep.

A flexible economy is key to increase A flexible economy is key to increase the speed limit and to eventually the speed limit and to eventually reverse current account deficitsreverse current account deficits

0

2

4

6

8

10

12

T-1

T+

1

T+

3

T+

5

T+

7

T+

9

T+

11

T+

13

T+

15

T+

17

T+

19

T+

21

T+

23

Years

Curr

en

t acc

ou

nt

defi

cit

Model (high flexibility)

Model (low flexibility)

Two stages of convergence

Source: IMF staff simulations.For simulation details see R. Bems and P. Schellekens, Finance and Convergence: What's Ahead for Emerging Europe?, IMF WP 07/244.

Conclusion: Conclusion: ““Running with your shoelaces openRunning with your shoelaces open””

Headline numbers look goodNMS have so far weathered the subprimemarket fallout well

But:Vulnerabilities are growing, especially in the BalticsGovernments have made little use of the favorable environment

Policy challengesPolicy challenges

Cool off economies during a surge in capital inflows and rapid credit growth => tightening fiscal policies is often the only available toolIn countries with flexible exchange rates, do not resist nominal appreciation (October 2007 WEO)Financial sector supervision, including of cross-border exposuresPrepare for euro adoption by creating flexible economies and sound institutions

Thank you!Thank you!

Christoph B. RosenbergSenior Regional Representative

International Monetary FundRegional Office for Central Europe and Baltics

Ul. Zielna 37C0-108 Warszawa

Tel.: + 48 22 338 67 00E-mail: cee-office@imf.org

Visit our website at: www.imf.org/cee