EconomicEconomic TrendsTrends andand ChallengesChallengesinin Central Central andand EasternEastern EuropeEurope

Christoph RosenbergInternational Monetary Fund

IMF Seminar for JournalistsVienna, August 28, 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 needs to be presented needs to be confirmed with country authoritiesconfirmed with country authorities

o The overall macro picture: better than evero But underlying this are challenges in the

run-up to Euro adoption

o Policy Conclusions

Fiscal adjustmentCredit growthCurrency mismatchesExternal imbalancesFinancial sector integrationCreating flexible economies

The overall macro The overall macro picture:picture:

better than everbetter than ever

GrowthGrowth performance performance isis goodgood, , driven by EU accession and the global upswing.driven by EU accession and the global upswing.

0.0

2.0

4.0

6.0

8.0

10.0

12.0

05 06 07p 08p 05 06 07p 08p 05 06 07p 08p 05 06 07p 08p

CE4 Baltics Romania &Bulgaria World

Source: WEO April 2007.

Annual GDP growth (percent)

As a result, the As a result, the CECsCECs are catching up are catching up quickly.quickly.

0

10,000

20,000

30,000

40,000

50,000

60,000

70,000

Bu

lga

ria

Ro

ma

nia

Po

lan

dLa

tvia

Lith

ua

nia

Slo

vaki

aH

un

ga

ryE

sto

nia

Po

rtu

ga

lM

alt

aC

zech

Re

pu

blic

Slo

ven

iaG

ree

ceC

ypru

sS

pa

inIt

aly

Fra

nce

Ge

rma

ny

Fin

lan

dS

we

de

nU

nit

ed

Kin

gd

om

Be

lgiu

mD

en

ma

rkA

ust

ria

Ne

the

rla

nd

sIr

ela

nd

Luxe

mb

ou

r g

United States

Euro area

0

2

4

6

8

10

12

14

16

Po

rtu

ga

lFr

an

ceIt

aly

Cyp

rus

Un

ite

d K

ing

do

mS

pa

inM

alt

aB

elg

ium

Au

stri

aN

eth

erl

an

ds

Ge

rma

ny

De

nm

ark

Ire

lan

dS

we

de

nG

ree

ceH

un

ga

ryS

love

nia

Fin

lan

dLu

xem

bo

urg

Cze

ch R

ep

ub

licP

ola

nd

Bu

lga

ria

Ro

ma

nia

Lith

ua

nia

Slo

vaki

aE

sto

nia

Latv

ia

United States and Euro area

Source: Ameco.

GDP PPP per Capita 2006GDP PPP per capita2006 (percent change)

IInflationnflation isis relativelyrelatively subsubdueddued……

CE4

Baltics

Romania & Bulgaria

World

2.0

3.0

4.0

5.0

6.0

7.0

8.0

2005 2006 2007p 2008p

Source: WEO April 2007.

Annual average CPI (percent)

……especiaespecialllyly considering that rising price levels considering that rising price levels are naturally associated with convergence.are naturally associated with convergence.

Source: Eurostat

CECs. Relative price level vs. relative GDP per capita (PPP), 1995-2006, EU25=100

BG

CZEE

HU LT

PLSK

SI

TU CR

RO

20

30

40

50

60

70

80

90

20 30 40 50 60 70 80 90

Relative per capita GDP at PPPs

Rel

ativ

e pri

ce lev

el

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

-10

-8

-6

-4

-2

0

2

4

05 06 05 06 05 06 05 06 05 06 05 06 05 06 05 06

BU LV LT RO CZ SK* PL* HU*

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

* incl. pension reform costsSource: EC Spring Forecast 2007

EDP/ Maastricht limit

CEC financial markets have outperformed other EMs…

B. Indices of Exchange Rate Against US$(May 10, 2006 =100; (+) = appreciation)

A. Stock Market Indices (May 10, 2006=100)

D. 5-year CDS SpreadsC. External Bond Spreads

75

85

95

105

115

125

135

Jan-

06Fe

b-06

Mar

-06

Apr-0

6M

ay-0

6Ju

n-06

Jul-0

6

Aug-

06Se

p-06

Oct

-06

Nov

-06

Dec

-06

Jan-

07Fe

b-07

Mar

-07

Apr-0

7M

ay-0

7Ju

n-07

CEECsEast AsiaLatin AmericaOther EMsDAX-30 IndexFTSE-All Share Index

Source: Pipat Luengnaruemitchai, Susan Schadler, Do Economists’ and Financial Markets’ Perspectives on the New Members of the EU differ?, IMF Working Paper 07/65.

9092949698

100102104106108110

Jan-

06

Feb-

06

Mar

-06

Apr-

06

May

-06

Jun-

06

Jul-0

6

Aug-

06

Sep-

06

Oct

-06

Nov

-06

Dec

-06

Jan-

07

Feb-

07

Mar

-07

Apr-

07

May

-07

Jun-

07

CEECs East Asia

Latin America Other EMs

1010

010

00Ja

n-06

Feb-

06M

ar-0

6

Apr

-06

May

-06

Jun-

06Ju

l-06

Aug

-06

Sep

-06

Oct

-06

Nov

-06

Dec

-06

Jan-

07

Feb-

07M

ar-0

7A

pr-0

7M

ay-0

7

Jun-

07CEECs East Asia

Latin America Other EMs

1010

010

00Ja

n-06

Feb-

06

Mar

-06

Apr-

06

May

-06

Jun-

06

Jul-0

6

Aug-

06

Sep-

06

Oct

-06

Nov

-06

Dec

-06

Jan-

07

Feb-

07

Mar

-07

Apr-

07

May

-07

Jun-

07

CEECs East Asia

Latin America Other EMs

...despite receding euro adoption ...despite receding euro adoption prospects.prospects.

2007 2007 2007 2007 2007 2007 2007 20072008 2009 2008 2008 2008 2009 2009

2007 2007 2007 2008 2009 2009 2009 2009 2009 2010 2010 2010 2010 2010 2010

20102012 2012 2012 2012

20102012 2012 2012 2013

2005

2010

2015

2005

2010

2015

2005

2010

2015

Aug05 Nov05 Feb06 May06 Aug06

Aug05 Nov05 Feb06 May06 Aug06Aug05 Nov05 Feb06 May06 Aug06

Slovenia Lithuania Latvia

Estonia Slovak_Republic Czech_Republic

Poland Hungary

Median Value of the ResponsesREUTERS Polls on Euro Adoption Date

Source: Reuters

The fallout from the The fallout from the suprimesuprime mortgage mortgage crisis in the US has had some effects on crisis in the US has had some effects on financial markets.financial markets.

80

90

100

110

120

130

140

150

160Aug-0

6

Sep-0

6

Oct

-06

Nov-0

6

Dec-

06

Jan-0

7

Feb-0

7

Mar-

07

Apr-

07

May-0

7

Jun-0

7

Jul-07

Aug-0

7

CZ HU SK PL

90

100

110

120

130

Aug-0

6

Sep-0

6

Oct

-06

Nov-0

6

Dec-

06

Jan-0

7

Feb-0

7

Mar-

07

Apr-

07

May-0

7

Jun-0

7

Jul-07

Aug-0

7

HUF PLN CZK SKK

0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

Aug-0

6

Sep-0

6

Oct

-06

Nov-0

6

Dec-

06

Jan-0

7

Feb-0

7

Mar-

07

Apr-

07

May-0

7

Jun-0

7

Jul-07

Aug-0

7HU PL SK CZ

0

5

10

15

20

25

30

35

40

45

50

Aug-0

6

Sep-0

6

Oct

-06

Nov-0

6

Dec-

06

Jan-0

7

Feb-0

7

Mar-

07

Apr-

07

May-0

7

Jun-0

7

Jul-07

Aug-0

7

HU PL SK

Exchange rate vs. USDStock markets (Aug 1 = 100)

Foreign currency spreads 1/ Credit Default Swaps Spreads 2/

Source: Bloomberg.1/ Spread of 5-year euro denominated international government bonds versus %-year Bund.

2/ The credit default swap (CDS) is an over-the-counter contract whereby the buyer pays the seller a periodic fee in return for contingent payment by the seller upon default of the issuer of a credit instrument.

Borrowing spreads were less affected Borrowing spreads were less affected than in other Ems.than in other Ems.

Change in EMBIJuly 16-August 22 (bps)

Change in the EURO exchange rate July 16-August 23(+= depreciation, percent)

Source: IMF GMM, national statistics.

0 20 40 60 80 100 120 140 160

Argentina

Serbia

Ukraine

Turkey

Brazil

Russia

Mexico

China

Poland

Hungary

Bulgaria

-5 0 5 10

Brazil

Hungary

Turkey

Poland

Slovakia

Mexico

Argentina

Czech Republic

Russia

Serbia

China

Ukraine

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

External debt 57.7 89.8 57.4 51.9 66.5

Public debt 43.5 11.3 19.8 42.2 18.5

Reserves/ST debt 115.1 54.8 180.6 175.8 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 growthCurrency mismatchesExternal imbalancesCross-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..

0

10

20

30

40

50

60

70

80

HU PL SK CZ BU LT RO LV EE EU15

2005 2007

CECs. Public debt (percent of GDP)

Source: EC Spring Forecast 2007

Maximum prudent debt level

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

-10

-8

-6

-4

-2

0

2

4

BU LV LT SK RO PL CZ HU EU15

2005 2007

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

Source: EC Spring Forecast 2007

Max prudent fiscal deficit

Fiscal policy is even more Fiscal policy is even more procyclicalprocyclicalif one accounts for EU funds.if one accounts for EU funds.

-1

-0.5

0

0.5

1

1.5

2

2.5

HU CZ SK LT LV EE PL

headlineheadline excluding transfers to and from the EU

Fiscal stimulus (percent of GDP, 2006)

Source: Christoph B. Rosenberg and Robert Sierhej, Interpreting EU Funds Data for Macro Analysis in the New Member States, IMF Working Paper 07/77

Primary spending in Central Europe is Primary spending in Central Europe is high, suggesting that fiscal adjustments high, suggesting that fiscal adjustments should start at the expenditure side.should 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 credit Rapid growth of credit to the private sectorto the private sector

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

0

2

4

6

8

10

12

Latv

ia (

LV

)

Est

on

ia (

EE

)

Lit

hu

an

ia (

LT

)

Bu

lgari

a (

BU

)

Hu

ng

ary

(H

U)

Ro

man

ia(R

O)

Po

lan

d (

PL)

Slo

vakia

(S

K)

Cze

ch R

ep

ub

lic

(CZ

)

Irela

nd

(IE

)

Po

rtu

gal

(PT

)

Gre

ece

(G

R)

Sp

ain

(E

S)

Fin

lan

d

Sw

ed

en

Th

ail

an

d

Ind

on

esi

a

Ko

rea

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)

Indebtedness corresponds to income Indebtedness corresponds to income levels.levels.

AT

BE

DK

FI

FRDE

GR IT

NL

PTES

HU

PL SK

EELV

SICZLT

0

50

100

150

200

250

8,000 13,000 18,000 23,000 28,000 33,000

GDP per capita (purchasing power parities)

Pri

vate

cre

dit t

o G

DP (

perc

ent)

Source: IFS, Eurostat

Private credit to GDP and income per capita, EU countries, 2005

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

0

20

40

60

80

100

120CZ

HU PL SK EE

LV LT IE

GR* PT ES

Actual Estimated

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

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)

BuildBuild--up of up of currency mismatches currency mismatches

in the in the nonnon--financial sectorfinancial sector

Most Most CECsCECs are exposed to currency risk are exposed to currency risk emanating in the nonemanating in the non--financial private sector.financial private sector.CECsCECs. Economy. Economy--wide currency mismatcheswide currency mismatches

-50-40-30-20-10

0102030

HU LV PL* EE LT CZ

-30

-25

-20

-15

-10

-5

0

5

HU LV PL* EE LT CZ

-80

-60

-40

-20

0

20

40

LV HU PL* EE LT CZ

Public Financial NFPS

Net FX position, 2006 (in percent of GDP)

Change in net FX position, 2003-06 (in percent of GDP)

Sectoral net FX position, 2006

Source: National authorities.* Data for 2005.

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.

CECs. 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.

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 Current account deficits are high, except in Central Europehigh, except in Central Europe……

-30

-25

-20

-15

-10

-5

0

LV BU EE LT RO SK HU CZ PL

06 07p 08p

Source: IMF WEO April 2007.

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

…… 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.

Net IIP (2006, in percent of GDP)

-60

-50

-40

-30

-20

-10

0

10

20

EE LV HU CZ BU LT SK PL ROLatAmer*TRAsia*

Change in net IIP 2001-2006 (in percentage points of GDP)

Source: National authorities, Milesi-Ferretti and Lane, “ External Wealth of Nations” database.* Data for 2005.

As expected, net As expected, net IIPsIIPs are negative, but unlike in are negative, but unlike in other other EMsEMs they have lately deterioratedthey have lately deteriorated ..

CECs and EMs: International Investment Position

-120

-100

-80

-60

-40

-20

0

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

Asia*

CrossCross--border border financial integrationfinancial integration

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, 2006

Creating flexible Creating flexible economieseconomies

Labor markets seem relatively flexible, Labor markets seem relatively flexible, but are untested.but are untested.

0 20 40 60 80 100

Minimum wage

Union density

Union coverage

Unemployment benefits (1st month)

Unemployment benefits (60th month)

Marginal effective tax rates

Employment protection in regularemployment

Employment protection in temporaryemployment

Collective dismissals

BalticsCECEuro area

Source: OECD.1\ The scale of indicators is from 1-10 from most to least regulated.

Labor market rigidities

NMS, Euro Area and Other OECD Countries: Labor Market Regulations, 2001 1/

012345678

Ger

man

ySw

eden

Finl

and

Italy

Slov

enia

Gre

ece

Nor

way

Chile

Aus

tria

Pola

ndTu

rkey

Euro

are

aLi

thua

nia

Portu

gal

Braz

ilSl

ovak

Rep

Latv

iaM

exic

oD

enm

ark

Belg

ium

Bulg

aria

Fran

ceSp

ain

Rom

ania

Esto

nia

Net

herla

ndSw

itzer

land

Czec

h Re

p.Ir

elan

dA

rgen

tina

Hun

gary

012345678

Average 2001

Labor market regulations

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 wellsustaining convergence and eventually doing wellin the euro in the euro zone.zone.

Hong Kong

Czech Rep.

Slovak Rep.

Hong Kong

Czech Rep.

Slovak Rep.

ConclusionsConclusions

Headline numbers look good, but vulnerabilities are growing, especially in the Baltics (“Running with your shoelaces open”)

So far, CECs have weathered market turmoil surprisingly well

Rather than using the favorable environment to reduce risks, some governments are pouring oil into the fire by pursuing procyclical fiscal policies

Preparation for euro adoption is overly focused on meeting Maastricht criteria

Policy challengesPolicy challenges

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