Jobs and Growth: Supporting the European Recovery · 2020-04-07 · The European financial crisis of 2008–09 was unique in its severity and breadth. It caused a deep recession,

I N T E R N A T I O N A L M O N E T A R Y F U N D

EDITORS

Martin Schindler, Helge Berger, Bas B. Bakker, and Antonio Spilimbergo

Jobs and Growth:

Supporting the

European Recovery

©International Monetary Fund. Not for Redistribution

© 2014 International Monetary Fund

Cataloging-in-Publication Data Joint Bank-Fund Library

Jobs and growth : supporting the European recovery / editors, Martin Schindler, Helge Berger, Bas B. Bakker, and Antonio Spilimbergo. — Washington, D.C. : International Monetary Fund, spring 2014. pages ; cm

Includes bibliographical references and index. ISBN: 978-1-48430-446-4

1. Economic development—Europe. 2. Labor market—Europe. 3. Job creation—Europe. I. Schindler, Martin, 1971– . II. Berger, Helge. III. Bakker, Bas Berend. IV. Spilimbergo, Antonio. V. International Monetary Fund.

HC240.S35 2014

Disclaimer: The views expressed in this book are those of the authors and should not be reported as or attributed to the International Monetary Fund, its Executive Board, or the governments of any of its member countries.

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iii

Contents

Foreword v

Country Abbreviations vii

1 Jobs and Growth: Supporting the European Recovery ..................................1 Martin Schindler and Helge Berger

PART I REMOVING OBSTACLES TO GROWTH .............................................. 11

2 Growth and the Importance of Sequencing Debt Reductions across Sectors ...............................................................................................................13

Fabian Bornhorst and Marta Ruiz-Arranz

3 Reducing the Employment Impact of Corporate Balance Sheet Repair .................................................................................................................. 39

Bas B. Bakker and Li Zeng

4 Reducing Public Debt When Growth Is Slow .................................................... 67 S. Ali Abbas, Bernardin Akitoby, Jochen Andritzky, Helge Berger,

Takuji Komatsuzaki, and Justin Tyson

PART II LAYING THE FOUNDATIONS FOR JOBS AND GROWTH .......... 95

5 What Do Past Reforms Tell Us about Fostering Job Creation in Western Europe? ................................................................................... 97

Cristina Cheptea, Jaime Guajardo, Ioannis Halikias, Emilia Jurzyk, Huidan Lin, Lusine Lusinyan, and Antonio Spilimbergo

6 Challenges and Solutions for Fostering Job Creation in the Balkans ...................................................................................................................125

Dmitriy Kovtun, Alexis Meyer Cirkel, Zuzana Murgasova, Dustin Smith, and Suchanan Tambunlertchai

7 Assessing the Gains from Structural Reforms for Jobs and Growth ..................................................................................................................151

Derek Anderson, Bergljot Barkbu, Lusine Lusinyan, and Dirk Muir

8 A Disaggregated Approach to Prioritizing Structural Reforms for Growth and Employment ................................................................................173

Cristina Cheptea and Delia Velculescu


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iv Contents

PART III ACHIEVING SUSTAINABLE GROWTH IN A GLOBALIZED WORLD ......................................................................... 217

9 Making Current Account Adjustment in Europe Growth Friendly ..........219 Ruben Atoyan, Jonathan Manning, and Jesmin Rahman

10 The Role of Vertical Supply Links in Boosting Growth .................................239 Jesmin Rahman and Tianli Zhao

Contributors 259

Index 261


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v

Foreword

The European financial crisis of 2008–09 was unique in its severity and breadth. It caused a deep recession, and unemployment surged across the continent. Stimulative macroeconomic policies, including strong monetary support from the European Central Bank, helped restore stability, and progress was made in strengthening euro area institutions. Nevertheless, growth is picking up only slowly, and with nearly 20 million Europeans still out of work, the crisis is not truly over.

As the need for stabilization measures has receded, it is now time to take a longer view. In Europe, as elsewhere, economic growth is crucial for creating jobs—but lifting growth in a durable manner is no easy undertaking. This is where this book comes in: drawing from the expertise of IMF staff, it proposes a road map for strengthening Europe’s medium-term recovery and boosting pros-pects for its long-term growth.

The IMF has a unique vantage point in this debate. It combines thorough knowledge of European country circumstances, reflecting close relationships with national authorities across the continent, with experience around the world help-ing its global membership respond to policy challenges and financial crises.

Beyond conjunctural policies and the need for deeper integration, the book focuses on three medium-term priorities that will have to be addressed in parallel: reducing high levels of public and private debt, implementing product and labor market reforms, and taking advantage of new growth opportunities through in-novation and further integration into global production and trade linkages.

This road is certainly challenging. Strengthening and sustaining growth is a complex process that requires action on many fronts. But there can be no doubt that this is the time to act and move ahead with ambitious reforms. Fast progress along the road map laid out in this book is important not only for Europe, but for the global economy as a whole.

Christine LagardeManaging Director

International Monetary Fund


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vii

Country Abbreviations

The following three-letter country abbreviations are used in some of the figures in this volume.

Code Country nameALB AlbaniaAUS AustraliaAUT AustriaBEL BelgiumBGR Bulgaria BIH Bosnia and HerzegovinaBLR BelarusCAN CanadaCHE SwitzerlandCYP CyprusCZE Czech RepublicDEU GermanyDNK DenmarkESP SpainEST EstoniaFIN FinlandFRA FranceGBR United KingdomGRC GreeceHRV CroatiaHUN HungaryIRL IrelandISL IcelandISR IsraelITA ItalyJPN JapanKAZ Kazakhstan

(Continued)


viii Country Abbreviations

Code Country nameLTU LithuaniaLUX LuxembourgLVA LatviaMDA MoldovaMKD Macedonia, former Yugoslav Republic ofMLT MaltaMNE MontenegroNLD NetherlandsNOR NorwayNZL New ZealandPOL PolandPRT PortugalROU RomaniaRUS Russian FederationSCG KosovoSLV El SalvadorSRB Serbia SVK Slovak RepublicSVN SloveniaSWE SwedenTUR TurkeyUKR UkraineUSA United States


1

CHAPTER 1

Jobs and Growth: Supporting the European Recovery

MARTIN SCHINDLER AND HELGE BERGER

Five years after the onset of the global financial crisis, Europe’s economy is still fragile. Despite extended crisis management and reform efforts, growth remains anemic and recessions have recurred. In addition, unemployment in many coun-tries has reached stratospheric levels. Notwithstanding recent positive signs amid calmer financial markets, medium-term growth is likely to remain frail owing to continuing weaknesses and vulnerabilities at the country level and in the fabric of European institutions and banks, especially in the euro area.

Some of Europe’s maladies were well known before the crisis, but others came as a surprise. Weaknesses in Europe’s product and labor markets have been widely documented for some time,1 but the risks posed by large imbalances and rising debt in an environment of ailing bank balance sheets and financial fragmentation were less well understood. Perhaps the most surprising development during the crisis was how, in the absence of effective shock absorbers, these weaknesses inter-acted to propagate shocks within individual economies and across national bor-ders, contributing to a period of weakness notable for its depth, breadth, and duration. Without strong growth, the markedly high rates of unemployment and debt in many countries could persist for years, extending the pain of the crisis well into the future. The associated erosion of human capital could depress potential growth in Europe for a generation.

Removing obstacles to growth and employment requires action on multiple fronts. Continued monetary and fiscal support in the near term and progress at the institutional level will be required (however, discussion of monetary policy, and the broader topic of banking union and fiscal union, is left for elsewhere 2 ). Taking the right approach to addressing public and private debt overhangs and strengthening bank balance sheets will help reduce uncertainty, support credit and investment, and foster growth in both the short term and the medium term.

In the medium term, alongside debt-reduction efforts, real sector reforms, including in product and labor markets, can relieve structural bottlenecks across Europe and create new sources of long-term growth by allowing countries to in-tegrate with global production chains.

1Part II of this book reviews in detail the structural reform needed across Europe. 2 Refer to IMF (2013b) for the required policy mix for the euro area. IMF (2013a, 2013d) discuss banking union and fiscal union, respectively. For a discussion of the much broader issues related to inclusive growth see, among others, IMF (2012b).


2 Jobs and Growth: Supporting the European Recovery

CRISIS MANAGEMENT AND REFORMS

When the global crisis first hit, authorities in many countries went beyond the operation of automatic stabilizers and implemented discretionary fiscal stimuli, and central banks reduced policy rates to record lows. Many central banks also introduced unconventional monetary policies, including, in the euro area, a pledge to intervene in sovereign bond markets through Outright Monetary Trans-actions. The euro area also pursued several institutional reforms, such as installing a collective crisis response mechanism and moving toward a unified pan-European approach to bank supervision and resolution. Many countries, especially those under market pressure, also started structural reform programs.

Despite these efforts, the outlook for growth and employment remains fragile. Five years after the Great Recession began, growth remains sluggish in most of Europe ( Figure 1.1 ), and prospects for a robust expansion are modest even in the medium term. Based on the IMF’s January 2014 World Economic Outlook , annual growth in Europe is projected to average 1.6 percent between 2013 and 2017, barely half the 2.6 percent achieved in the five years before the crisis. Unemployment is stubbornly high in all but a few countries. Current account imbalances have improved asymmetrically because large surpluses in some core countries have persisted even as external imbalances in deficit countries have shrunk ( Figure 1.2 ).

Figure 1.1 Real GDP Growth, 2005:Q4–2013:Q3 (SA, 2008:Q3 = 100)

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Euro area Core1

GIIPS2 Emerging Europe3

Russia and Turkey 95th percentile5th percentile

Sources: Haver Analytics; and IMF staff calculations. 1 Simple average of Belgium, France, Germany, and the Netherlands. 2 Simple average of Greece, Ireland, Italy, Portugal, and Spain. 3 Simple average of Bulgaria, Croatia, the Czech Republic, Hungary, Latvia, Lithuania, Poland, Romania, and Ukraine. Note: Due to data availability, Ireland and Luxembourg are excluded from the 2010:Q3 averages. SA = seasonally adjusted.


Schindler and Berger 3

UNRESOLVED WEAKNESSES ARE HOLDING BACK THE RECOVERY

Balance sheets—bank, public, corporate, and household—remain a source of dif-ficulty. Although the immediate crisis response prevented worst-case scenarios and created crucial space for adjustment, it did not actively deal with the unusual combination of balance sheet issues brought about by the crisis. In many Euro-pean countries, already-high debt ratios among households and firms worsened as a result of declining asset prices and weak or negative income growth, and public sector debt increased significantly. Given the slow pace of global demand, there is little hope for either sector simply to grow out of its debt. Instead, the resulting pressure to deleverage—the need to bring down debt by reducing con-sumption, investment, and net government spending—threatens to hamper the recovery. The fact that, at the same time, many banks continue to restrain credit as they build or rebuild capital buffers only adds to these headwinds.

With banks, governments, businesses, and households all trying to repair bal-ance sheets, the risks of negative spillovers from one sector to the others are high. Indeed, Bornhorst and Ruiz-Arranz ( Chapter 2 ) provide evidence suggesting that the harmful growth impact of elevated levels of any one category of private or sovereign debt is amplified when levels of one or more of the others are also high.

In the longer term, structural reform gaps slow growth and adjustment. All European countries would have benefited from structural reform before the crisis, but the need to enable an adjustment of the composition of output—away from precrisis sectors such as construction, which benefited from unsustainable

Figure 1.2a Current Account Balance, 1998–2013 1 (Percent of GDP)

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0

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6

1998 99

2000 01 02 03 04 05 06 07 08 09 10 11 12 13

Greece, Ireland, Italy, Portugal, and Spain

Other euro area

Sources: Haver Analytics; and IMF staff calculations. 1 2013 is based on projections in the October 2013 World Economic Outlook.

Figure 1.2b Unemployment Rate, 2005: Q4– 2013: Q3 (SA, percent)

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Euro zone Core1

GIIPS2 Emerging Europe3

Russia and Turkey 95th percentile

5th percentile

Sources: Haver Analytics; and IMF staff calculations.1Simple average of Belgium, France, Germany, and the Netherlands.2Simple average of Greece, Ireland, Italy, Portugal, and Spain.3Simple average of Bulgaria, Croatia, the Czech Republic, Hungary, Latvia, Lithuania, Poland, Romania, and Ukraine.Note: SA = seasonally adjusted.



housing booms, and toward those that can support exports and future growth—is more pronounced in those countries most affected by the crisis, including Greece, Ireland, Italy, Portugal, and Spain. In a number of cases, current account deficits also point to a need for efforts to raise productivity and for more competitive wage setting. In other European economies, including in the euro area core, sig-nificant untapped reforms remain that can unleash additional growth momen-tum, including in investment and the services sector.

DEALING WITH CRISIS LEGACIES

History confirms that adverse economic conditions do not preclude debt reduc-tions, but they come at a price. As Abbas and others ( Chapter 4 ) show, many past episodes of large and sustained sovereign debt reduction started under adverse conditions, but they were often later supported by accelerating external demand. When output grows rapidly, debt ratios can come down even without substantial deficit reduction. If underlying growth remains low, however, the burden of ad-justment falls more squarely on fiscal policy. In a sample of advanced economies between 1980 and 2011, the success rate of attempted fiscal consolidations dropped from about 40 percent to about 25 percent when growth fell below the country median. Under such circumstances, sovereign debt reduction requires a durable commitment by policymakers to sustain fiscal consolidation and strong efforts to limit the impact of budget tightening on growth. A similar mechanism is in play for private sector debt reduction. Bakker and Zeng ( Chapter 3 ) note that past private sector balance sheet consolidations often were facilitated by higher inflation and fiscal support, neither of which is likely to be forthcoming at the current juncture. They warn that, as a consequence, corporate sector delever-aging this time could lead to significant labor shedding, particularly if labor market institutions inhibit wage adjustment.

Good policies can mitigate the short-term costs of deleveraging. Although there is no alternative to bringing down debt levels, policymakers can still work to protect growth:

• Better microstructures can facilitate the reduction of private sector debt overhangs . Bornhorst and Ruiz-Arranz note that, in the past, the deleveraging after a busting boom tended to match the cumulative precrisis buildup in debt al-most one to one (typically during a course of 5–10 years), bringing debt ra-tios back about to where they started. Such large deleveraging efforts require effective insolvency frameworks featuring, among other mechanisms, fast and flexible personal and corporate bankruptcy proceedings to help avoid lengthy periods of deleveraging and to protect growth. However, despite progress in this direction in a number of countries, ample scope for reform remains.

• Proper sequencing helps. Another finding emerging from Bornhorst and Ruiz-Arranz’s work is that whereas high private sector debt tends to unambigu-ously lower growth, public sector debt is more harmful if the private sector is highly leveraged. This result would suggest that addressing private sector debt reduction first can help mitigate the impact on growth—a principle



mirrored in current IMF advice that countries seek a gradual pace of fiscal consolidation anchored in a credible medium-term framework, if circum-stances allow (IMF, 2013c). Indeed, by protecting growth and thereby facili-tating private sector deleveraging now, governments might be able to improve the conditions for self-sustained growth later on. But as Abbas and others (Chapter 4) warn, “later” must not be “too late”: front-loaded consolida-tions may be necessary if market confidence is critical, as is the case in economies facing particularly high costs of finance.

• The design of fiscal consolidation matters. Abbas and others highlight the importance of designing consolidations to minimize their impact on growth (see also IMF, 2012a). For example, cutting less productive spending, pro-tecting public investment, and shifting the emphasis from direct to indirect taxes will help; some countries might also have scope for additional privati-zation efforts. More generally, consolidation episodes provide opportunities to implement growth-enhancing tax or subsidy reforms. But most impor-tant, to protect growth, public debt-reduction efforts should be undertaken gradually where financing conditions allow and should be anchored in a medium-term framework.

• Structural reforms to boost growth are key. As noted above, the easiest way to bring down debt while avoiding unwanted deleveraging is through higher growth. In addition, the right structural setup can facilitate adjustment in the private sector: as Bakker and Zeng (Chapter 3) show, corporate sector deleveraging has often fallen disproportionately on employment when labor market rigidities have made other types of adjustment more difficult. Labor market reforms can thus help mitigate the extent of labor shedding and, depending on the impact on aggregate demand, boost output growth.

LAYING THE FOUNDATIONS FOR LONG-TERM GROWTH

Improving Europe’s growth potential is crucial. Although the crisis has made the quest for growth more urgent, many observers have noted that growth in the euro area and in other advanced European economies has lagged that of peers since the 1980s ( Figure 1.3 ). Having reached about 90 percent of U.S. per capita GDP in 1980, euro area output today stands at about 70 percent of that mark, with economies such as Greece, Ireland, Italy, Portugal, and Spain measuring less than 60 percent. Much of the relative decline has been explained by weak total factor productivity growth—and action on many fronts will be required to address this shortcoming.

Labor market reform will have an important role, and pursuing the right re-forms is especially important in the current context. Millions of young people are out of work, and starting off into their working lives without a job not only af-fects them directly but also hampers Europe’s future growth potential. Unemploy-ment at a young age means a lack of on-the-job training, depreciating skills, and a less productive workforce tomorrow. By reducing savings and pensions, it also means a longer working life, a less prosperous retirement, or both.



• Making up for lost ground . Cheptea and others ( Chapter 5 ) trace many of the dismal labor market dynamics in Western Europe back to choices made since 1990—which suggests that better choices in the future have the potential to improve the functioning of these markets significantly. Here and elsewhere, however, structural problems extend beyond the labor market: product mar-ket reforms are also required. Simultaneous product and labor market reforms will maximize the impact on potential growth, although reform priorities and their design will differ across countries. For example, many of the Balkan economies that are not members of the European Union (Albania, Bosnia and Herzegovina, Kosovo, Former Yugoslav Republic of Macedonia, Monte-negro, and Serbia) need to address deep-rooted problems arising from a de-layed transition process, poor investment climates, and the resulting low flows of foreign direct investment (Kovtun and others, Chapter 6 ).

• Fighting the disadvantages of duality . Labor market duality has been advanc-ing in recent years, with larger shares of employees in temporary contracts with low employment protection. As Bakker and Zeng show, this dual-ity increases the likelihood that cost-cutting measures in the corporate sector will result in employment cuts. Dual labor markets also bring a host of other potential problems, including income inequality and inefficient training because both workers and firms have lower incentives to invest in human capital when worker turnover is expected to be high. Although some degree of market-driven labor market duality can provide needed flexibility to re-spond to economic shocks, evidence indicates that asymmetric regulation has moved the balance too far in many countries.

A comprehensive reform effort that includes the product and services markets promises sizable gains. Simulations using the IMF’s Global Integrated Monetary and Fiscal model undertaken by Anderson and others ( Chapter 7 ) suggest that comprehensive product market, labor market, and tax reforms could raise real GDP by 4 percent over a medium-term horizon and by up to 12 percent in the

Figure 1.3a Purchasing-Power Parity GDP per Working-Age Population (Relative to U.S. levels)

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Euro area/United StatesPeriphery euro area/United States

Sources: IMF, World Economic Outlook; and OECD.

Figure 1.3b Total Factor Productivity Growth (Average by decade)

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Source: European Commission.



long term. The boost to long-term real GDP is largest in the periphery countries, reflecting larger scope for reform as well as positive trade and technology spillovers from the relatively larger core economies. This is a welcome finding because some of the largest deleveraging needs are in the periphery. The reforms would also boost competitiveness through lower unit labor costs, another area in which large intra–euro area gaps have developed ( Figure 1.4 ). The analysis also points to competi-tiveness benefits in periphery economies, exactly where external demand support is most needed. Thus, reforms could contribute to the needed rebalancing of cur-rent accounts across Europe (see also Atoyan, Manning, and Rahman, Chapter 9 ).

Smart design will increase benefits. Structural reforms are critical to improving the long-term capacity of economies to grow through both more intensive use of resources and higher productivity, but their full impact will take time to develop, (Anderson and others, Chapter 7).

• Comprehensive reforms are better than piecemeal ones . For example, although product market reforms would have a particularly large effect in the euro area, simultaneous labor market reforms will maximize the impact on po-tential growth. Piecemeal reforms should be avoided not just across markets, but also within them. Cheptea and others find that 85 percent of past labor market reforms in Western Europe focused on only a small aspect of institu-tions, were incremental, or both. The explosive growth of youth unemploy-ment in some European economies marked by partial labor market reform is a particularly telling case. The specific reform priorities and their precise design will, however, differ across countries.

• Tailoring reforms to needs is important . As Cheptea and Velculescu ( Chapter 8 ) explain, a one-size-fits-all approach does not work when it comes to structural

Figure 1.4 Unit Labor Costs Relative to Economic and Monetary Union Average, 2001: Q1–2013:Q3 (Nominal, 2001: Q1 = 100)

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Germany Greece

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Sources: Eurostat; Haver Analytics; and IMF staff calculations.



reforms. Their analysis illustrates that different countries can have widely dif-ferent reform needs and cautions that a complete review of policy options should assess not only the benefits of reform but also the costs. While reform costs are hard to measure with any precision, they are likely to differ across countries, suggesting that what structural reform strategy works best will also be country-specific. Together with the analysis in other chapters of this book, this underscores how small differences in the institutional setup of countries, their starting conditions, and their strategies can matter greatly for the out-come of reforms. Further research in this area is clearly needed.

TAKING ADVANTAGE OF CHANGES IN THE GLOBAL ECONOMY

Structural reforms can also play a key role in allowing countries to profit more from the export dynamics provided by global supply chains. As Atoyan, Man-ning, and Rahman ( Chapter 9 ) document, progress in reducing some of the ex-ternal current account imbalances in the euro area has been uneven ( Figure 1.2 ). Although many factors play a role, a significant share of these imbalances can be attributed to a lack of external competitiveness, most strongly in the periphery economies ( Figure 1.4 ). In contrast, many countries in emerging Europe have experienced strong export growth over the last decade by tapping into global production chains. Such production links are gaining in importance as firms seek to unbundle their production processes to take better advantage of low-cost for-eign factors of production. By some measures, the importance of supply links in world manufacturing exports has increased by more than one quarter during 1995–2008 (Rahman and Zhao, Chapter 10 ). As Rahman and Zhao note, some of the same structural reforms that promise to improve competitiveness and raise an economy’s growth potential can also help to build links to other economies, European or other, and to strengthen its integration into cross-border vertical supply networks. As they argue, smaller economies may benefit from a competi-tive labor force and from focusing on niches that are complementary to the pro-duction processes in larger production hubs.

BAD NEWS AND GOOD NEWS

The global financial crisis has been unique in its severity and its complexity, and also in the challenges it has thrown at policymakers. Five years of crisis manage-ment and reform have brought a measure of stability and prevented worse out-comes. But growth remains weak, and many of the underlying vulnerabilities exposed by the crisis are still unaddressed.

In the near term, efforts to bolster the nascent recovery should include further demand support and an effective resolution of the balance sheet weaknesses of the banking sector to jump start credit and private investment. The expeditious completion of the banking union with the ability to undertake a timely, effective,



and least-cost resolution of ailing banks would help remove uncertainty and sup-port growth. If growth remains lackluster and monetary policy options were to be depleted, more fiscal support for activity may be needed.

There is, however, a road map to chart the course toward stronger and sus-tained growth in Europe over the medium term. Although more work is needed, the IMF research collected in this book provides a number of guideposts. Follow-ing them offers an opportunity for stronger and better balanced growth and employment after what has been a long and dismal period of crisis.

• With prolonged economy-wide deleveraging a major threat to medium-term growth, more effective private sector insolvency frameworks are needed to help reduce household and corporate debt. At the same time, fiscal consolida-tion will need to be designed to protect growth, and should be anchored by credible medium-term frameworks.

• Europe’s longer-term growth potential needs to be enhanced by closing structural reform gaps in product and labor markets in a comprehensive manner. Closing these gaps would also position countries to explore new sources of growth in a globalized world.

• At the same time, the measures examined here will need to be comple-mented by further efforts to ensure the effective operation of the infrastruc-ture of the common currency area, especially banking and fiscal union.

Recent macroeconomic and financial developments offer encouraging signs that the worst of the crisis and its aftermath may finally be over. A sustainable recovery—one sufficient to reduce unemployment and debt—is, however, still elusive. Now is the time for governments to get to work on implementing the reforms needed to ensure that more Europeans can at last get back to work.

REFERENCES

International Monetary Fund (IMF), 2012a, Fiscal Monitor—Taking Stock: A Progress Report on Fiscal Adjustment , October (Washington: International Monetary Fund).

———, 2012b, “Income Inequality and Fiscal Policy,” Staff Discussion Note No. 12/8 (Washington: International Monetary Fund).

———, 2013a, “A Banking Union for the Euro Area,” Staff Discussion Note No. 13/1 (Washington: International Monetary Fund).

———, 2013b, Euro Area Policies , 2013 Article IV Consultation, Country Report No. 13/231 (Washington: International Monetary Fund).

———, 2013c, Fiscal Monitor—Fiscal Adjustment in an Uncertain World , April (Washington: International Monetary Fund).

———, 2013d, “Toward a Fiscal Union for the Euro Area,” Staff Discussion Note No. 13/9 (Washington: International Monetary Fund).




PART I

Removing Obstacles to Growth




13

CHAPTER 2

Growth and the Importance of Sequencing Debt Reductions across Sectors

FABIAN BORNHORST AND MARTA RUIZ-ARRANZ

DEBT IN THE EURO AREA

High debt in the euro area is weighing on growth. Countries that experienced a rapid increase in private sector debt in the run-up to the global financial crisis of 2008–09 have had worse unemployment and growth outcomes, and some are still in the middle of deep recessions. Their medium-term growth outlooks are also weak in many cases.

Balance sheet adjustment in the euro area may prove more challenging than in other regions or in other past episodes. Private sector deleveraging is occurring while sovereigns are working to repair their balance sheets, making the overall task daunting in some countries, and a fragmented financial sector with its own bal-ance sheet problems amplifies the effect of private sector balance sheet stress on economic outcomes. Countries in need of adjustment are constrained by a com-mon monetary and exchange rate policy, leaving them little space for maneuver. Finally, simultaneous deleveraging in several euro area members can lead to nega-tive spillovers, further amplifying the harmful impact of country-specific delever-aging on economic activity.

This chapter evaluates indebtedness in the euro area and its implications for growth. The analysis suggests that although the negative growth impact of debt in one sector depends in part on the level of indebtedness in the other sectors, private sector debt may be more detrimental to growth than public sector debt. Policies that directly support the workout of bad debt in the financial and private sectors could therefore yield important benefits. At the same time, the negative impact of private sector deleveraging could be reduced through a more supportive policy mix. The chapter is organized as follows: The next section discusses the links between private sector indebtedness and growth, including the way in which balance sheet stress can arise from high indebtedness, and identifies the feedback loops across sectors. It is followed by a section that takes stock of indebtedness across the euro area, identifying vulnerabilities across sectors and countries. The subsequent section looks at historical episodes to gauge the extent of deleveraging that can be expected, and at the macroeconomic environment that supported previous deleveraging episodes. It also presents


14 Growth and the Importance of Sequencing Debt Reductions across Sectors

econometric evidence linking high debt in the private and public sectors to growth outcomes. The penultimate section offers policy considerations for the euro area, including the lessons that can be drawn from past experience, and the last section offers some conclusions. Chapters 3 and 4 provide a more in-depth look at the reasons for and consequences of high corporate and public debt beyond the euro area.

WHY DEBT MATTERS

Balance Sheet Stress

Indebted private sector agents are more vulnerable to sudden asset price or interest rate shocks or increased volatility. In the context of high debt, adverse economic developments can cause balance sheet stress through both lower asset valuations (e.g., house or equity price declines) and increases in liabilities (e.g., rising interest rates). Deteriorating macroeconomic conditions (higher interest rates or lower growth) can lead to tighter financing conditions and increased rollover risk. Households and firms then often focus on repaying debt and strengthening their balance sheets by improving equity ratios or building liquidity buffers, and life-cycle consumption smoothing or investment return consider-ations become secondary. This shift in behavior can depress demand and create self-reinforcing feedback loops across sectors.

Declines in asset prices have economy-wide consequences. Falling asset prices go beyond one sector of the economy because they affect both borrowers and creditors. For example, falling house prices reduce household wealth, decrease the value of collateral held by banks, increase nonperforming loans (NPLs), and when weak banks require public support, affect the public sector’s balance sheet. Public finances are also affected by lower tax revenue derived from transactions in this asset (e.g., stamp duties). Falling equity prices also reduce a firm’s valuation, thus raising the cost of capital and increasing its financial vulnerabilities, reflected in rising debt-to-equity ratios.

Feedback loops exacerbate downturns, particularly in cases of simultaneous deleveraging of the private, financial, and public sectors ( Figure 2.1 ; IMF, 2012b). Managing deleveraging becomes particularly challenging if all sectors of the economy, including the public and the financial sectors, deleverage simultane-ously. These actions can depress activity further because no sector can expand its balance sheet. The following feedback loops can be at play in a balance sheet re-cession with a weak financial sector:

• Indebted households that need to repair their balance sheets consume and invest less, reducing firms’ profitability and the public sector’s tax revenue.

• Firms faced with a slump in household demand begin to reduce their debt burdens by increasing profit margins, reducing wage costs, and scaling back investment (also see Chapter 3 ). These maneuvers, in turn, feed into lower household income through lower wages and higher unemployment, and also lead to lower tax revenues for the sovereign.


Bornhorst and Ruiz-Arranz 15

• The government’s own consolidation effort requires higher taxes and lower spending, which reduces households’ disposable income, thereby worsening households’ debt-servicing capacity and firm profitability. In turn, public balance sheet weaknesses limit the scope for further assistance to the finan-cial sector (e.g., bank recapitalizations).

• Banks, faced with increasing NPLs from households and firms and high exposure to a potentially weak sovereign, need to rebuild their capital posi-tions by tightening lending standards and increasing lending rates, in turn depressing demand for investment and consumption loans.

Diagnosing Balance Sheet Stress

Gross debt matters, but so do other indicators. A sector’s indebtedness is a key variable driving balance sheet stress and the ability of the sector to absorb shocks. But focusing exclusively on gross debt is not sufficient. The level of sustainable debt in a sector varies across countries depending on initial conditions, including the characteristics of the housing market and the degree of intermediation pro-vided by the banking sector. Debt-to-income ratios can help gauge a sector’s ca-pacity to service debt, and leverage ratios, which link debt to assets, are relevant for assessing debt in relation to a sector’s own balance sheet. Liquid assets, includ-ing financial, and to a lesser extent housing wealth, can be important buffers be-cause they allow agents to draw down savings, and they are relevant for assessing

Figure 2.1 Adverse Feedback Loops from Balance Sheet Effects

Households

Wage and profitincome ↓Benefits ↓

Unemployment ↑

Consumption ↓Investment ↓

Firms

Revenue ↓Borrowing costs ↑

Wages and profit ↓Employment ↓

Taxes ↓Investment ↓

Government

Tax ↑ Expenditure ↓

Tax revenue ↓ Debt ↑

NPLs

Sovereignlinks

Mort-gages

Banks

Source: Authors. Note: NPL = nonperforming loan.



debt sustainability. And because debt stocks tend to change slowly over time, fi-nancial flows can be useful for detecting changes in behavior that signal balance sheet stress, for example, when agents increase their financial surpluses. Other considerations that may alter the implications of the debt overhang include the characteristics of the debt profile, such as the composition, redemption profile, and structure of the investor base.

Analysis of aggregate balance sheet data has its limitations. It cannot identify pockets of vulnerability that may exist within sectors, and it abstracts from distri-butional aspects. For example, assets and liabilities could be concentrated in dif-ferent subsets of the population, and conclusions from an aggregate perspective can be misleading. This chapter provides an overview of indebtedness in the euro area, but it also takes into account more detailed country- and sector-specific analyses made available in other studies.

INDEBTEDNESS AND DELEVERAGING IN THE EURO AREA: STYLIZED FACTS

The Euro Area Debt Level

Debt levels for the euro area as a whole are at par with those in the United States or the United Kingdom, but the deleveraging process has yet to translate into debt reduction ( Figure 2.2 ). In aggregate, household debt is lower than in the United States or the United Kingdom. Corporate debt appears to be higher in the euro area and the United Kingdom than in the United States, though important differences in the size of intercompany loans and trade credit complicate compari-sons in levels. 1 Government debt in the euro area is at comparable levels, but increased less since 2003 than in the United States or the United Kingdom. The euro area also enjoys a comfortable net international investment position. Yet, since 2009, the United States and the United Kingdom have seen a reduction in household debt, and the United Kingdom has also experienced a reduction in corporate debt, whereas the deleveraging process in the euro area has not yet translated into an area-wide reduction in debt. Looking at flows in the euro area shows the private sector’s deleveraging effort, with firms and households in a contractionary net lending position in comparison with other sectors ( Figure 2.3 ; ECB, 2013b).

Variation across Countries

Indebtedness varies across countries and sectors ( Figure 2.4 ). Since early in the first decade of the 2000s, private and public debt increased most sharply in coun-tries now under stress, and both are particularly high in Ireland, Portugal, and

1 See Cussen and O’Leary (2013) for a discussion of consolidated and nonconsolidated corporate debt in the euro area, in particular for Ireland.



Figure 2.2 Indebtedness in the Euro Area, United States, and United Kingdom

–20

0

20

40

60

80

100

120

Euro area

Source: European Central Bank; and Haver Analytics. Source: European Central Bank.Note: Includes intercompany loans and trade credit,which can differ significantly across countries.

Source: IMF, World Economic Outlook. Sources: IMF, International Financial Statistics andWorld Economic Outlook.

United Kingdom United States

Household Sector Debt(percent of GDP)

2003 level

2003–07 change

2008–09 change

2010–12 change

–20

0

20

40

60

80

100

140

120

Euro area United Kingdom United States

Nonfinancial Corporate Sector Debt(percent of GDP)

2003 level

2003–07 change

2008–09 change

2010–12 change

–20

0

20

40

60

80

100

120


General Government Debt(percent of GDP)

2003 level

2003–07 change

2008–09 change

2010–12 change


Net International Investment Position(percent of GDP)

2005 level

2006–07 change

2008–09 change2012

2010–12 change

–40

–35

–30

–25

–20

–15

–10

–5

0

5

10

Households in the euro area are not highly indebted, and overall debt has decreased only little.

Nonfinancial corporate debt in the euro area is somewhat higher than in the United States.

General government debt in the euro area is at par with other advanced economies.

The euro area enjoys a comfortable net international investment position.

Spain, where households, the nonfinancial corporate sector, and the government are all highly indebted compared with their euro area peers. In addition, a num-ber of other countries have high debt in one or two sectors. 2 And when all sectors are highly indebted, sizable net external liabilities have accumulated.

2 See Cuerpo and others (2013) for an identification of countries currently facing private sector delever-aging pressures based on various indebtedness indicators. For an overview, see Buiter and Rahbari (2012) and McKinsey (2012).



Figure 2.3 Euro Area: Net Lending/Borrowing (By sector, percent of GDP)

–8

–6

–4

–2

0

2

4

6

2003 05 07 09 11 13

Nonfinancial firms

Financial firms

General government

Households

Source: European Central Bank.

Figure 2.4 Indebtedness across the Euro Area

0

50

100

150

200

250

300

350

400

450

IRL PRT ESP GRC NLD ITA FRA DEU Euroarea

Indebtedness in the Euro Area(percent of GDP)

2003

20082012

Government Nonfinancial firms Households

Private and public indebtedness has increased sharply in periphery economies.

And many economies have high debt in more than one sector of the economy.

Indebtedness in the Euro Area(by country and sector, in sphere ifdebt higher than 60th percentile)

ITA

BEL

PRTIRLESP

NLD

Government

Nonfinancialfirms

HouseholdsFIN

AUT

SLV, SVKEST

DEU

FRA

GRC

CYPMLT

Sources: European Central Bank; and IMF staff estimates.Note: For the Netherlands, first observation is 2005.Corporate debt includes intercompany loans, whichcan differ significantly across countries.

Sources: European Central Bank; Haver Analytics;and IMF staff estimates.

Nonfinancial Firms

Corporate debt and leverage

Indebtedness of euro area firms increased substantially in the first decade of Eco-nomic and Monetary Union as the result of low real interest rates and prospects of high growth. Higher bank debt, combined with falling equity valuations,



boosted corporate leverage during the crisis, threatening debt sustainability. Al-though firms’ leverage ratios have since fallen, they remain elevated in a number of countries ( Figure 2.5 ). Firm-level data suggest that in some euro area econo-mies up to 20 percent of corporate debt may not be sustainable (IMF, 2013g).

Procyclical financial conditions are weighing on corporate balance sheets. Despite very low monetary policy rates, bank lending rates in many crisis econo-mies remain high because of fragmented financial markets and the impaired transmission of monetary policy (IMF, 2013c). Higher bank lending rates are felt strongly by the bank-dependent small and medium-sized enterprises (SMEs), which constitute a large share in value added. Lending conditions are tight, fur-ther reducing available financing for solvent firms.

Figure 2.5 Corporate Debt

2003 level

2003–07 change

2008–09 change

2010–12 change

–25

0

25

50

75

100

125

150

175

200

IRL PRT ESP FRA NLD ITA DEU GRC Euroarea

Nonfinancial Corporate Sector Debt(percent of GDP)

Average 2006–072012

Increase through peak

0

20

40

60

80

100

120

140

160

180

PRT ITA IRL ESP DEU NLD FRA Euroarea

Corporate Leverage in the Euro Area(Nonfinancial firms,

debt-to-equity ratio, percent)

0

50

100

150

200

250

300

350

400

450

500

2007–08 09 10 11 12

Corporate Insolvencies(index, 2007–08 = 100)

France Germany IrelandItaly Netherlands PortugalSpain

TradablesNontradablesOverall change

–50

0

50

100

150

200

250

ESP PRT ITA NLD DEU FRA

Increase in Corporate Insolvencies(2008–12 growth, in percent, by sector)

Source: European Central Bank. Note: Includes intercompany loans; see Cussen andO'Leary (2013). First observation for the Netherlandsis 2005.

Sources: Haver Analytics; and IMF staff calculations.

Source: Creditreform (2012). Sources: Creditreform (2012); and IMF staff estimates.



Corporate insolvencies and vulnerabilities

Insolvencies have increased markedly where corporate debt is high (see Figure 2.5 ). In most crisis economies, the increase in insolvencies in the nontradables sector is somewhat higher than in the tradables sector, indicative of initial stages of eco-nomic rebalancing. This increase is noteworthy in view of the fact that, despite recent reforms, insolvency procedures in many euro area countries are generally lengthy and costly, and the recovery rate of claims is very low ( Figure 2.6 ; World Bank, 2013).

Pockets of vulnerabilities exist in the corporate sector. In Spain, firms in most sectors are highly leveraged. In particular, corporate indebtedness is high in the real estate and construction sectors, where firms are highly reliant on bank financing, making them vulnerable to interest rate and earnings shocks. In 2010, about a quarter of a sample of 7,000 firms was financially distressed (IMF, 2012c). In Por-tugal, firm profitability is low, particularly for SMEs and micro firms, which ac-count for nearly two-thirds of corporate value added. As a result, the share of debt at risk is increasing, with 20 percent of firms in financial distress, and concentrated in the nontradables sector (IMF, 2013h). In Italy, corporate leverage is particularly

Figure 2.6 Insolvency Regimes

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

IRL

BEL

FIN

AUT

NLD

DEU CYP ES

PIT

AFR

AG

RC

LUX

PRT

SVN

EST

MLT

SVK

OEC

DU

SAG

BR

Average Time Needed to Close a Business(years)

0

5

10

15

20

25

BEL

FIN

NLD

SVN

DEU ES

TFR

AG

RC

IRL

PRT

AUT

MLT

ESP

CYP LU

XSV

KIT

AO

ECD

USA

GBR

Cost of Insolvencies(percent of estate’s value)

0

10

20

30

40

50

60

70

80

90

100

FIN

NLD BE

LIR

LAU

TD

EU ESP

PRT

CYP IT

ASV

KSV

NFR

AG

RC

LUX

MLT

EST

OEC

DU

SAG

BR

Recovery Rate(cents on the dollar creditors, tax authorities, and

employees recover from an insolvent firm)

0

25

50

75

100

EST

MLT

LUX

GR

CFR

ASV

NSV

KIT

AC

YP PRT

ESP

DEU AU

TIR

LBE

LN

LD FIN

Distance to Frontier(100 = best performance in resolving insolvency)

Source: World Bank (2013). Note: OECD = Organisation for Economic Co-operation and Development.



high, with firms, especially SMEs, heavily reliant on short-term bank financing (IMF, 2013f).

Households

Household debt and the housing boom

The turn of the housing cycle triggered sector-wide deleveraging in countries in which real estate bubbles had driven up debt ( Figure 2.7 ), especially in those in which real interest rates had declined and incomes had risen rapidly. Mortgages represent the largest share of household debt in euro area countries (Cussen, O’Leary, and Smith, 2012), and they have been the most significant driver in the

Figure 2.7 Household Debt

–20

0

20

40

60

80

100

120

140

NLD IRL PRT ESP GRC DEU FRA ITA Euroarea

Household Sector Debt(percent of GDP)

80

90

100

110

120

130

140

t=–2

4t=

–22

t=–2

0t=

–18

t=–1

6t=

–14

t=–1

2t=

–10

t=–8

t=–6

t=–4

t=–2 t=0

t=2

t=4

t=6

t=8

t=10

t=12

Household Debt(percent of GDP, long-term

average = 100, peak at t = 0, quarters)

2003 level

2003–07 change

2008–09 change

2010–12 change

ESP FRA Euro area

IRL NLD PRT ITA

–0.4

–0.2

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

IRL

ESP

BEL

GB

RN

LDFR

AS

WE

FIN

ITA

USA

GR

CP

RT

DEU

House Prices: Boom and Bust(distance from long-term average of

price-to-rent and price-to-income ratio)

ESP, 2006:Q4–2012:Q2

IRL, 2007–2011 GBR, 2008:Q1–2011:Q3

USA, 2006:Q3–2012:Q2

FRA, 2007:Q4–2009:Q3

ITA, 2007–2011

NLD, 2009:Q3–20012:Q2

60

80

100

120

140

160

180

–10 –5 0 5 10

Pric

e-to

-inco

me

ratio

(long

-ter

m a

vera

ge=

100)

Net lending/borrowing (percent of GDP)

House Price Adjustment andHousehold Net Borrowing

Peak Latest

Household debt increased rapidly until 2009. And adjustment in euro area countries has just begun.

Source: European Central Bank.Note: First observation for the Netherlands is 2005.

Sources: European Central Bank; and IMF staff estimates.Note: Long-term average since 2000 but varies withdata availability.

Sources: OECD; and IMF staff calculations.Sources: OECD; and IMF staff estimates.



increase of household debt since the start of the euro. When the housing boom burst in 2007–08, households were left with high debt and overvalued assets, particularly in Ireland and Spain. As house prices started to adjust, households moved from a financial deficit to a financial surplus position. In Ireland and Spain, for example, households have now begun to dispose of financial assets and repay debt, and have slashed the acquisition of nonfinancial assets ( Box 2.1 ). Despite these efforts to repair balance sheets, household debt continued to increase until 2009. It has since started to decline in Ireland, and to a lesser extent, in Portugal and Spain. Although the adjustment in house prices has gone far in some coun-tries (e.g., Ireland), prices remain high in others (Spain, France, Netherlands). 3

Buffers and vulnerabilities

Household assets are important buffers, but are also often illiquid. In Spain, for example, high levels of assets and low wealth dispersion—a result of high ownership rates—have been important mitigating factors, because households can dispose of assets to smooth consumption. But in a depressed housing market with high owner occupancy rates, disposing of housing wealth is often difficult. Indebted households have less-liquid financial assets in periphery economies ( Figure 2.8 ; ECB, 2013a), although the sector as a whole has, in many countries, moved toward safe and liquid financial assets since the crisis (Cussen, O’Leary, and Smith, 2012).

The Saving Rate and Household Balance Sheets

The rise in the household saving rate during 2008–10 in many advanced economies can be explained by the sharp decline in asset prices and increase in fiscal deficits. 1 The decrease in wealth associated with the decline in housing and asset prices prompted households to lower consumption and increase saving. In turn, the deterioration in the fiscal position had a strong positive impact on savings—partly reflecting Ricardian equivalence in which the expectation of a future tax increase drives households’ saving relative to their income today.

Since 2010, the deteriorating macroeconomic environment, lower disposable incomes, and higher unemployment have caused a decline in the household saving rate ( Figure 2.1.1 ). Cyclical factors such as higher unemployment lowered the house-hold saving rate as households ran down accumulated assets to smooth consumption.

Indeed, since the crisis the financial transactions that determine household saving have changed considerably, a sign of household balance sheet stress. 2 Precrisis, house-holds were acquiring financial and nonfinancial assets, and at the same time incurring debt. Postcrisis, households have slashed their acquisition of nonfinancial assets, depressing aggregate demand, and are repaying debt by disposing of financial assets ( Figure 2.1.2 ). Although households may still be saving a similar fraction of their incomes, they are doing so by reducing their financial wealth and investing less, with negative consequences for the broader economy.

BOX 2.1

3 A full assessment of house prices would have to go beyond affordability ratios (price-to-income and price-to-rent ratios) and include other fundamentals, including supply constraints (IMF, 2013d, 2013g).



Figure 2.1.1 Household Saving Rate (Percent of disposable income)

IRL PRT NLDITA ESP

0

2

4

6

8

10

12

14

16

2003 04 05 06 07 08 09 10 11 12 1302003 04 05 06 07 08 09 10 11 12 13

Euro areaUnited KingdomUnited States

Euro Area, United Kingdom, and the United States

2

4

6

8

10

12

14

16

18Select European Countries

Household balance sheets are vulnerable to income declines, further asset price corrections, and, down the road, interest rate increases. In most countries with high household debt, sustainability indicators such as debt-to-income or debt-service-to-income ratios have deteriorated (see Figure 2.8 ) owing to falling incomes, with

Sources: European Central Bank; and Haver Analytics. Source: European Central Bank.

Figure 2.1.2 Financial Account Decomposition of the Household Saving Rate

–40

–30

–20

–10

0

10

20

30

40

2003 05 07 09 11 13

Transactions in financial assetsTransactions in financial liabilities

Investment Statistical discrepancySaving rate

Spain: Household Saving Rate(decomposition, percent of gross

disposable income)

–60

–30

0

30

60

2003 05 07 09 11 13

Ireland: Household Saving Rate(decomposition, percent of gross

disposable income)

Sources: European Central Bank; Haver Analytics; and IMF staff estimates.

1 Econometric results are based on a sample comprising Canada, France, Germany, Ireland, Italy, Japan, Spain, the United Kingdom, and the United States for the period 1980–2012. The correlates to explain household saving behavior include wealth, fiscal policy, interest rates, cyclical factors, and demographic factors (see IMF, 2013e). 2 Aggregate savings have a real and financial representation. In real terms, savings are defined as S = ( Y D – C ), in which Y D is disposable income and C is consumption. The concept of savings can also be derived as a result of financial transactions: the savings and investment balance for each sector is equal to its net lending S – I = NL; savings are thus also equal to the difference between transactions in assets and liabilities plus investment (Cussen, O’Leary, and Smith, 2012).



young and low-income households particularly vulnerable. For example, in Spain, 22 percent of households in 2011 were estimated to be vulnerable to stress, but the shares were much higher among poor and young households, where debt-service-to-income ratios can reach 80 percent. The main risk for Spain arises from a further adjustment of housing prices and an increase in interest rates because most mort-gages are indexed to the Euribor (IMF, 2012c). In the Netherlands, house prices are still overvalued based on a range of metrics, and young cohorts would be espe-cially vulnerable to a further drop in prices (IMF, 2013g).

Financial Sector

In many euro area countries, a highly leveraged financial sector impairs interme-diation and burdens the sovereign. Many banks in periphery economies had tra-ditionally relied on wholesale funding, and had built large exposures to sovereigns and the real estate market (IMF, 2013a). The share of NPLs—both from house-holds and firms—has risen rapidly, increasing uncertainty surrounding the banks’ asset quality, and in turn, increasing funding costs and driving down share prices ( Figure 2.9 ). In a fragmented European financial market, such banks face an uphill battle to strengthen their capital positions so they can provision for NPLs, buffer their sovereign exposure, and meet new regulatory requirements.

Figure 2.8 Household Balance Sheets—Survey Results

0

10

20

30

40

50

60

70

NLD ESP DEU FRA PRT GRC ITA

Indebted Households(percent of total)

Euro area average

Euro area average

0

20

40

60

80

100

120

140

160

180

200

NLD PRT ESP FRA ITA GRC DEU

Debt-to-Income Ratio of Indebted Households(percent)

Euro area average

Euro area average

0

5

10

15

20

25

DEU ITA FRA NLD PRT ESP GRC

Net Liquid Assets(percent of annual gross income)

0

2

4

6

8

10

12

14

16

18

20

ESP PRT FRA NLD ITA GRC DEU

Debt-Service-to-Income of Indebted Households(percent)

The share of indebted households is high in the Netherlands but low in Italy.

In the Netherlands, Portugal, and Spain debt is high compared to income.

Buffers are low in some periphery countries. And debt service is high.

Source: European Central Bank (2013a).



Public Debt and the Migration of Debt

Debt migration from the private to the public sector has played an important role as a buffer in the euro area. In the boom phase, the private sector, in particular financial firms, increased their indebtedness while governments were able to re-duce debt. As the private sector entered the deleveraging cycle, debt “migrated” to the public sector—through bank recapitalization, automatic stabilizers, or debt-financed fiscal demand support—and other sectors moved to reduce their debt burdens ( Figures 2.10 and 2.11 ). But with saving lower than investment across all sectors for a number of years, many periphery economies accumulated sizable external debt ( Figure 2.12 ).

Figure 2.10 Sovereign Debt

–25

0

25

50

75

100

125

150

175

NLD DEU FRA ESP IRL PRT ITA GRC Euroarea

2003 level2003–07 change2008–09 change2010–12 change

Source: IMF, World Economic Outlook.

Figure 2.9 A Weak Financial Sector

2007

2012 (or latest)

2012 (or latest)

2007–12

0

5

10

15

20

25

GRC IRL ITA PRT ESP FRA GBR USA NLD DEU

Nonperforming Loans(percent of total loans)

–60

–50

–40

–30

–20

–10

0

10

20

30

DEU FRA USA GBR NLD PRT ESP IRL ITA GRC

Return on Equity(percent)

2007

Source: IMF, Financial Soundness Indicators.



Figure 2.11 Debt Migration

General government Financial firms

Households Nonfinancial firms

General government Financial firms

Households Nonfinancial firms

–20

–15

–10

–5

0

5

10

15

20

ESP IRL FRA GBR ITA PRT USA DEU GRC–20

–15

–10

–5

0

5

10

15

20

ESP IRL FRA GBR ITA PRT USA DEU GRC

Domestic Debt Shares, 2008–12(change of each sector’s share in total debt, percent)

Domestic Debt Shares, 2000–07(change of each sector’s share in total debt, percent)

Precrisis the financial sector debt share expanded. Postcrisis debt migrated to the public balance sheet.

Figure 2.12 External Indebtedness

–150

–75

0

75

PRT GRC IRL ESP ITA FRA1 DEU NLD Euroarea

2005 level

2006–07 change

2008–09 change

2010–12 change

2012

Source: IMF, International Financial Statistics.

1 Data for France are 2011.

High Debt and Economic Outcomes

Balance sheet stress has been associated with weaker economic outcomes ( Fig - ure 2.13 ). In countries in which private sector debt rapidly increased through 2007, growth outcomes have since been weaker. This association also holds for household debt and consumption, as well as for corporate debt and investment. Moreover, in countries in which the corporate sector was highly leveraged in 2007, the increase in unemployment since the crisis has been higher. 4 Finally, a highly

Source: Haver Analytics.

4 In the euro area, high corporate debt is also associated with lower per capita GDP growth during the period 1999–2011 (ECB, 2012). Chapter 3 picks up on this finding and analyzes some of the possible reasons for it.



leveraged financial sector before the crisis has also been associated with higher lending rates after the crisis, creating procyclical financial conditions. Looking ahead, fiscal policy is tightening most in countries in which private sector balance sheet stress was the highest, creating procyclical fiscal conditions.

EXPERIENCE WITH PREVIOUS PRIVATE SECTOR DELEVERAGING EPISODES 5

Household Deleveraging

The magnitude of the post-2000 credit boom was unprecedented. A look at historical episodes can illustrate the scale of the present challenge. In the run-up to the crisis, the increase in household indebtedness in many advanced econo-mies was, on average, 20 percentage points of GDP higher than in past credit

5 Chapter 4 also studies previous deleveraging episodes, but with a focus on public debt and the pos-sible policy measures needed to facilitate debt reductions during episodes of low growth.

Figure 2.13 Balance Sheet Stress and Economic Activity

Note: Balance sheet stress is computed by applying equal weights to two factors: debt levels and debt increases. The specific calculations are (1) the level of debt to GDP in 2007, relative to the sample, and (2) the increase in the level of debt to GDP since 2001, relative to the sample. To compute the indicator, each country is assigned the percentile rank of its own value relative to the sample, for both the level of debt and the increase in debt. The two percentile ranks are then added together, and normalized between 0 and 1. NFC = nonfinancial corporation; SME = small and medium-sized enterprise.

AUTBEL

ESTFIN

FRA

DEU

IRLITA

JPN NLD

PRT

SVK

SVN

ESP

GBR

USA

–10

–5

0

5

10

15

0.0 0.2 0.4 0.6 0.8 1.0

Cha

nge

in o

utpu

t(s

ince

200

8, p

erce

nt)

Balance sheet stress, 2007

Sources: OECD; IMF, World Economic Outlook; and IMFstaff estimates.


Sources: Haver Analytics; and European Central Bank.


Private Sector Balance Sheet Stressand Output

AUT BEL

EST

FINFRA

DEU

IRL

ITA

JPNNLD

PRT

SVKSVN

ESP

GBRUSA

–5

0

5

10

15

20

0.0 0.2 0.4 0.6 0.8 1.0

Incr

ease

in u

nem

ploy

men

tsi

nce

2007


Nonfinancial Firms Balance Sheet Stressand Unemployment

AUT

BEL

ESTFIN

FRA

DEU

IRL

ITA

JPN

NLD

PRT

SVK

SVNESP

GBRUSA

–1

0

1

2

3

4

5

0.0 0.2 0.4 0.6 0.8 1.0

Pla

nned

cha

nge

in o

vera

llba

lanc

e, 2

013–

2015


Private Sector Balance Sheet Stress andPlanned Fiscal Tightening

LUX

BEL

SVK

DEU

PRT

AUT

ESP

FRA

NLD

GRC

SVN ITA

IRL

FIN

2

3

4

5

6

7

8

50 70 90 110 130 150 170 190 210

Lend

ing

rate

s (la

test

)(N

FC

, < 1

mill

ion,

sim

ilar

mat

urity

)

Loan-to-deposit ratio, 2007

Precrisis Leverage and Current Lending Rates(loan-to-deposit ratio and SME lending rates)



cycles. 6 As a result, the level of household debt in 2013, and thus the need to deleverage, is exceptionally large compared with historical episodes. 7

Household debt reduction has barely started. Most banking crises preceded by rapid credit expansions are followed by a protracted period of debt reduction (Tang and Upper, 2010). Historical episodes suggest that the extent of deleverag-ing after the bust matches the size of the debt built up during the boom period almost one-to-one. That is, in most cases, household debt returned to the pre–credit boom level after a protracted period of deleveraging (lasting between 5 and 10 years). With household debt barely off its peak level, the deleveraging process in euro area countries can be expected to take many more years if debt is to return to the 2000 level. By contrast, in the United States, households are two-thirds of the way back to the preboom debt level ( Figure 2.14 ).

In many historical episodes, household deleveraging was facilitated by higher inflation and expansionary fiscal policy:

• Most deleveraging during these episodes was passive—households did not actively pay down debt, instead the debt ratio was eroded by nominal in-come growth. Indeed, the reduction in the stock of debt was small, except in Japan. In episodes without a banking crisis, the stock of debt even in-creased during the deleveraging period (see Figure 2.14 ).

6 Historical episodes include Canada (1979–84), Denmark (1987–94), Germany (2000–11), the United Kingdom (1990–96), Finland (1989–97), Japan (2001–11), Norway (1988–95), and Sweden (1989–95). In the last four, household deleveraging was associated with a banking crisis. These epi-sodes were selected from advanced economies that experienced a reduction in the household-debt-to-disposable-income ratio of more than 10 percentage points. 7 Historical experience offers one possible benchmark. Model-based approaches can also be employed to derive optimal levels of leverage or indebtedness to gauge deleveraging needs (see, e.g., Cuerpo and others, 2013).

Sources: Eurostat; Haver Analytics; national statistical agencies; and IMF staff calculations.

Figure 2.14 Household Deleveraging Episodes

0

20

40

60

80

100

120

140

160

180

GR

CSW

EES

PN

OR

USAPR

TG

BRAUS

IRL

NLD

CYP

DN

K

FIN

CAN

SWE

GBR

DEU JP

NN

OR

DN

K

Increase through peak

Starting point 2000

Starting point2 Postcrisis trough

Latest1

–100

–80

–60

–40

–20

0

20

40

60

DNK SWE NOR FIN DEU CAN JPN GBR

Decomposition of Household Debt Reduction(percentage points of disposable income)

Household Deleveraging Episodes(household debt, percent of GDP)

Real Income

Nominal Debt

Inflation

Deleveraging

1September 2012, except for Denmark, Ireland, and the Netherlands: June 2012; and Cyprus and Norway: end-2011. 2Canada: 1970; Germany and Japan: 1990; others: 1980.

Sources: IMF, World Economic Outlook; Haver Analytics; and OECD.



• Fiscal deficits often increased during deleveraging periods. The magnitude of the fiscal impulse varied across countries, but the cumulative impact was greater than 10 percentage points in Sweden and almost 8 percentage points in Finland ( Fig-ure 2.15 ). 8 Public support was generally larger if deleveraging was the result of a banking crisis because it was complemented by support to the financial sector.

Projections suggest that the macroeconomic environment this time around will be more challenging. Euro area inflation is expected to undershoot the price stability objective and economic activity will remain subdued. Therefore, the role of nominal income growth in assisting the deleveraging process will be much more limited than in the past. 9 Deleveraging this time will have to rely more on paying down debt and is likely to put additional stress on households. Likewise, fiscal policy will be less supportive of private sector deleveraging than in past epi-sodes, because public debt levels are now significantly higher in most countries than in most previous episodes. At the current juncture, market pressures and institutional factors constrain fiscal policy; fiscal consolidation will continue with a turn to primary surpluses in many countries in 2014.

Corporate Deleveraging

Corporate deleveraging has yet to begin in full, as of late 2013. Although the levels of debt are comparable to previous episodes, the increase in corporate debt in the boom cycle was particularly large in Ireland and Spain, compared with historic episodes ( Figure 2.16 ). 10 Episodes of significant corporate deleveraging

Figure 2.15 Fiscal Policy during Deleveraging Episodes

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160

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200

GR

CPR

TIR

LU

SA NLD

ESP

GBR

NO

RD

NK

SWE

AUS

DEU

SWE

CAN

NO

RG

BR FIN

Starting point (historical)

Starting point

Projected 2018

End of deleveraging (historical)

Government Debt during HouseholdDeleveraging (percent of GDP)

–10

–5

0

5

10

IRL

USA

GBR PR

TAU

SES

PG

RC

DN

KSW

EN

LDN

OR

DEU

NO

RG

BR JPN

DN

KC

AN FIN

SWE

Historical episodes ofhousehold deleveraging

Overall Fiscal Balance during Household Deleveraging(change in overall fiscal balance, percent of GDP)

8 The data on fiscal balances in Figure 2.15 exclude bank recapitalization costs. 9 For a discussion of the role of inflation in assisting the deleveraging process, including its costs, see IMF (2013b). 10 Identification of historic corporate deleveraging episodes is based on Ruscher and Wolff (2012), who use the sector’s net lending and borrowing data as a marker, combined with indebtedness data from Cec-chetti, Mohanty, and Zampolli (2011). It comprises episodes with significant debt reductions (10 per-cent of GDP or more), which, on average, lasted six years. A number of shorter episodes of corporate deleveraging identified by Ruscher and Wolff (2012) did not result in significant debt reductions.

Sources: Eurostat; Haver Analytics; national statistical agencies; and IMF staff calculations. Note: For current episodes, measured as the difference between projected overall balance in 2018 and the start of the household deleveraging phase.



suggest that after large booms, an average of two-thirds of the increase in debt is subsequently paid off. In the euro area, corporate leverage has receded from its crisis peak in some countries, but debt-to-income ratios remain high.

The Debt and Growth Nexus

The debate about the relationship between high public debt and growth remains open. A large body of research concludes that high public debt leads to higher interest rates and slower growth (among others, Kumar and Woo, 2010; Reinhart and Rogoff, 2010; Cecchetti, Mohanty, and Zampolli, 2011; Reinhart, Reinhart, and Rogoff; Baum, Checherita-Westphal, and Rother, 2013), although estimates of the debt level considered to be “high” are inconclusive. 11 High debt also makes public finances more vulnerable because it constrains the government’s ability to engage in countercyclical policies.

Fewer studies have attempted to quantify the impact of private sector debt on growth. A notable exception is Cecchetti, Mohanty, and Zampolli (2011), who find that corporate debt of more than 90 percent of GDP and household debt of more than 85 percent of GDP become a drag on growth. IMF (2012a) concludes

11 See, for example, Herdon, Ash, and Pollin (2013) who challenge the findings by Reinhart and Rogoff (2010) and Reinhart, Reinhart, and Rogoff (2012) of a 90 percent of GDP threshold, above which dramatically worse growth outcomes are observed. Another school of thought argues that weak growth causes high debt and not the other way around (e.g., Panizza and Presbitero, 2012).

Figure 2.16 Corporate Deleveraging Episodes (Corporate debt, percent of GDP)

0

50

100

150

200

250

GRC ITA FRA GBR ESP PRT IRL AUS GBR FIN NOR SWE JPN

Increase through peakStarting point 2000 (or earliest)Starting point1

Postcrisis troughLatest (2012:Q4)

Sources: Bank for International Settlements; European Central Bank; Bruegel; and IMF staff estimates.1Historical episodes: AUS: 1988–96; FIN: 1993–96; GBR: 1990–96; JPN: 1989–97; NOR: 2000–05; SWE: 2001–04.



that recessions that are preceded by a run-up in household debt tend to be more severe and protracted. This section looks at growth performance in previous household deleveraging episodes and presents econometric evidence of the way in which high private sector debt hampers growth.

Historical experience suggests that household deleveraging in the euro area will continue to weigh on growth. Average annual real GDP and consumption growth were about 1.5 percentage points lower during the deleveraging period than in the preceding period. The growth underperformance is not found to be higher in those countries in which household deleveraging was also associated with a bank-ing crisis ( Figure 2.17 ). Although history is not destiny, and the number of his-torical episodes from which to draw lessons is limited, the analysis above suggests that headwinds from high debt and deleveraging are likely to persist.

Econometric Analysis

An econometric analysis suggests that the negative growth impact of debt in one sector depends, in part, on the level of indebtedness in the other sectors ( Figure 2.18 ). 12 When the three sectors—government, households, and corporate—have above-average debt levels, the negative growth impact of each category of debt is highest. Results support the hypothesis that the confluence of debt in multiple sectors exacerbates the negative feedback loops that arise in times of crisis. There-fore, headwinds are likely to be particularly strong in those periphery countries in which all sectors are highly indebted.

12 See Appendix 2A for details on the econometric analysis. Growth is measured by the average five-year forward annual real GDP per capita growth rate. Debt is considered to be “high” if it is greater than the mean value in the sample. The mean values, which are technical in nature and specific to the country-years in the sample, are 73 percent of GDP for government debt, 48 percent of GDP for household debt, and 98 percent of GDP for corporate debt. The thresholds identified in Cechetti, Mohanty, and Zampolli (2011) are also used as a robustness test. The main results hold, but the higher thresholds relative to the mean, particularly for household debt, imply that there are very few observa-tions for which debt is high in all sectors at the same time.

Figure 2.17 Historical Growth and Consumption Underperformance

–0.5

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

FIN CAN JPN SWE GBR DNK DEU NOR

Average

Growth Underperformance(deviation from pre-deleveraging average, percent)

–0.5

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

FIN CAN GBR JPN SWE DEU DNK NOR

Average

Consumption Underperformance(deviation from pre-deleveraging average, percent)

Sources: Haver Analytics; and IMF staff estimates.



Figure 2.18 The Impact of High Debt on Growth

–1.5

–1.0

–0.5

0.0

0.5

1.0

Government Households Firms

One sector has high debt

One additional sector has high debt

All sectors have high debt

Source: IMF staff estimates; see footnote 11 and Appendix 2A for details.

The analysis also suggests that private sector debt may be more detrimental to growth than public sector debt. Regressions identify a stronger and more statistically significant association between private sector debt and growth than between government debt and growth.

• High corporate debt and high household debt are associated with negative growth even if each is the only sector indebted in the economy. The negative impact becomes larger the higher the number of sectors with high debt. In particular, an increase in the corporate-debt-to-GDP ratio of 10 percentage points more than the sample average is associated with a subsequent reduction in average annual growth of 7–11 basis points, depending on whether the other sectors are highly indebted. Similarly, an increase in the household-debt-to-GDP ratio of 10 percentage points more than the sample average is associated with a subsequent reduction in average annual growth of 8–13 basis points.

• High public debt is negatively associated with growth only when both the household and corporate sectors are also indebted. In this case, an increase in the government-debt-to-GDP ratio of 10 percentage points more than its sample average is associated with a 6-basis-point reduction in subsequent average annual growth. In contrast, when only the government is indebted or only one additional sector has high debt, the relationship becomes statis-tically insignificant.

POLICY OPTIONS

Dealing with High Debt in the Euro Area

Experience suggests that decisive and properly sequenced policy actions can sup-port deleveraging while mitigating the impact on growth. Where private sector



deleveraging is more advanced (e.g., the United States), measures were taken early on to strengthen financial institutions’ balance sheets. Bank and private debt re-structuring mechanisms have been used more widely, facilitating the workout of NPLs and dispelling doubts about asset quality. These processes were supported by appropriate legislation and institutions. Historical debt-restructuring episodes also show that policies can help facilitate the deleveraging process, including through government-sponsored programs, direct government purchases of dis-tressed assets, and the use of asset management companies to resolve distressed assets. In all such cases, the sequencing and country-specific circumstances are important (Laryea, 2010). Two successful cases of household debt restructuring are the U.S. Home Owners Loan Corporation in 1933 and the experience in Iceland in the recent crisis.

Targeted policies

Progress on improving insolvency frameworks in the euro area has so far been uneven. Reforms to insolvency frameworks take time, and effective implementa-tion is key to success but often difficult to achieve. A number of countries have moved to strengthen their insolvency frameworks and institutions (Liu and Rosen-berg, 2013), including Austria, Germany, Greece, Ireland, Italy, Portugal, and Spain. Despite this progress, insolvency procedures are not widely used and the insolvency regimes remain inefficient and costly in many countries (see Figure 2.6 ). National insolvency regimes may need to be made more effective, for example, by facilitating out-of-court settlements, reducing time for insolvency proceedings, and providing more flexibility to deal with personal or corporate bankruptcy. Stronger institutions—experienced judges and insolvency administrators—would also help support insolvency processes. In many cases, the stigma associated with bankruptcy also needs to be overcome.

Debt reprofiling, restructuring, or default in the corporate and financial sec-tors can reduce private sector indebtedness, often with overall macroeconomic benefits. When creditor seniority is respected and common principles are applied, the workout of bad debt can help catalyze new economic activity. But debt re-structuring also damages creditor-debtor relationships, imposes losses on other agents, and creates moral hazard.

Policies can help guide this restructuring process, thereby mitigating its costs. Repairing the financial sector is, however, essential to addressing the balance sheet problems in the corporate and household sectors.

• Strengthening bank balance sheets and working out NPLs is a precondition. The workout of private debt requires adequate provisioning and capital buf-fers in the banking system to absorb losses. Only then will banks have incen-tives to restructure their exposures to distressed borrowers. This acceptance of restructuring could be helped further by the provision of tax incentives (or the removal of tax disincentives) for debt write-offs. Policies to encour-age debt write-offs and help facilitate the transfer of nonperforming assets to new owners would also support the repair of bank balance sheets. A pan-European backstop for solvent banks would help break the negative feedback loop between banks and sovereigns and reduce financial market



fragmentation. Debt restructuring in the corporate sector could be sup-ported further by making more use of debt-equity swaps and out-of-court procedures to support the early rescue of viable firms. Asset management companies, private or with some government participation, could in some cases help accelerate the restructuring of corporate debt while taking weak assets off the banks’ balance sheets (Laryea, 2010).

• In the household sector, direct debt-service support (e.g., through guaran-tees or deferred interest) can help vulnerable households avoid bankruptcy while minimizing moral hazard. Government-sponsored programs can also encourage banks to reschedule household debt (Laeven and Laryea, 2009). Wealth encumbrance could be modified where needed, for example, by easing mortgage payments for highly indebted, low-income households whose property has been foreclosed upon. Personal insolvency frameworks should be geared toward facilitating a fresh start for financially responsible individuals.

Policy mix and structural policies

A measured pace of fiscal adjustment, and monetary policy actions to reduce fi-nancial fragmentation, would further facilitate balance sheet adjustment. Coun-tercyclical fiscal policy is effective in balance sheet recessions, but debt sustainability and market access considerations constrain its use. Within these constraints, get-ting the pace of consolidation right is essential. Monetary policy should aim to address impairments to the normal transmission of the monetary policy stance, thereby reducing financial market fragmentation, and helping reduce corporate and household borrowing costs, especially in the euro area periphery.

Structural policies can also help support private sector deleveraging or mitigate its impact. For example, the development of capital markets could help reduce firms’ reliance on bank financing. And labor market reforms could increase firms’ flexibility to absorb demand shocks through adjustments in working hours and pay or, when needed, by freeing up labor to facilitate sectoral reallocation. More generally, structural reforms can help the process of private sector deleveraging through their longer-term impact on growth. Chapters 7 and 8 in this book dis-cuss many of the challenges associated with designing and implementing the right structural reform mix.

CONCLUSION

Balance sheet adjustment in the euro area is an uphill battle at the current junc-ture. In other deleveraging episodes, high nominal and real growth, exchange rate depreciation, and monetary easing supported balance sheet adjustments. For many euro area economies, however, the policy space is much more constrained: exchange rate devaluations can only happen internally, and if successful, put downward pressure on prices. The real growth outlook is weak throughout the region and beyond. And, because monetary transmission is impaired, monetary



easing is not, at present, effective in lowering interest rates, especially with a frag-mented financial sector amplifying the negative effects of protracted private sector deleveraging.

The results of this chapter support the hypothesis that the presence of debt in more than one sector exacerbates the negative feedback loops that arise in times of crisis. When all sectors (government, households, and firms) are highly in-debted, the negative growth impact of each category of debt is highest. The analy-sis also suggests that private sector debt may be more detrimental to growth than public sector debt, which indicates that headwinds are likely to be particularly strong in the periphery, where all sectors are highly indebted.

An accelerated cleanup of private and financial sector balance sheets can help prevent a protracted period of stagnation. Delays and resistance to working out NPLs in the banking system, and lengthy procedures for personal and corporate bankruptcies, increase uncertainty about the extent of the problem and put fur-ther downward pressure on asset prices and firm performance. At the aggregate level, these feedback loops can trigger debt deflation dynamics. Therefore, in addition to providing a supportive macroeconomic environment, targeted poli-cies to support debt workouts should be considered.



APPENDIX 2A. ECONOMETRIC ANALYSIS

The econometric analysis builds on Cechetti, Mohanty, and Zampolli (2011) and their data on debt levels for a panel of 18 Organisation for Economic Co- operation and Development countries for 1980–2009.

The empirical specification is derived from the neoclassical Solow growth model in which per capita income growth depends on the initial level of physical and human capital, the saving rate, population growth rate, and technology. Measures of public and private sector debt are also added to the specification. Panel data regressions are estimated using country-specific and time-specific fixed effects. More specifically, the equation is

g i,t 1, t k y i,t 'X i,t 'D i,t μ i t i,t,t k ,

where • g i,t +1, t + k is the k -year forward average of annual real GDP per capita growth

between years t+ 1 and t+k (the analysis uses k = 5); • y i,t is the log of real per capita GDP at time t ; • X i,t includes gross saving as a share of GDP; population growth; number of

years spent in secondary education as a proxy for the level of human capital; the dependency ratio; openness to trade measured by the sum of the ratio of exports and imports to GDP; consumer price index inflation as a mea-sure of macroeconomic stability; the ratio of liquid liabilities to GDP as a measure of financial development; and a dummy to control for banking crises;

• D i,t includes, depending on the specification, the ratio of debt to GDP of the public or private sectors (household and corporate sectors) as well as interactions with dummy variables indicating whether the debt ratios are above a threshold level;

• μ i and t are country-specific and time-specific dummies. Least squares dummy variable (LSDV) estimation is used. The presence of a

lagged dependent variable in the right-hand side (dynamic panel) implies that the estimates may be biased, but given the small panel size ( N = 18), neither general-ized method of moments nor instrumental variables have been shown to outper-form LSDV.

The analysis tries to assess whether the growth impact of high debt in one sec-tor depends on the level of indebtedness in other sectors. Debt is considered “high” if it is above the sample mean. The thresholds are 73 percent of GDP for public debt, 98 percent of GDP for corporate debt, and 48 percent of GDP for household debt. For instance, in the specification for estimating the impact of public debt on growth and its differential impact depending on the level of in-debtedness in the private sector, the regressor 'D i,t becomes

α α1 2α 3 4α ,D D2α H Dα Dα4α Hi,t

Pi,D tP PH ,

P HH i,D tCDα2α HiD t

P H P



in which D Pi,t is the ratio of public debt to GDP, H j is a dummy variable taking

the value of one if public ( j = P ), household ( j = H ), or corporate ( j = C ) debt is above the sample mean, respectively. Given the above specification, 1 + 2 is the estimated impact of high public debt on growth when the household and corporate sectors are not highly indebted. Similarly, 1 + 2 + 3 is the estimated impact when the household sector, in addition to the public sector, is highly in-debted. When all sectors are highly indebted, the estimated impact of government debt on growth is given by 1 + 2 + 3 + 4 .

REFERENCES

Baum, A., C. Checherita-Westphal, and P. Rother, 2012, “Debt and Growth: New Evidence for the Euro Area,” ECB Working Paper No. 1450 (Frankfurt: European Central Bank).

Buiter, W., and E. Rahbari, 2012, Debt of Nations: Mr. Micawber’s Vindication: Causes and Consequences of Excessive Debt (New York, New York: Citigroup).

Cecchetti, S.G., M.S. Mohanty, and F. Zampolli, 2011, “The Real Effects of Debt,” BIS Work-ing Paper No. 352 (Basel: Bank for International Settlements).

Creditrefom, 2012, Insolvencies in Europe 2011/12 (Frankfurt: Creditreform). Cuerpo, C., I. Drumond, J. Lendvai, P. Pontuch, and R. Raciborski, 2013, “Indebtedness,

Deleveraging Dynamics and Macroeconomic Adjustment,” European Economy, Economic Papers 477 (Brussels: European Commission).

Cussen, M., and B. O’Leary, 2013, “Why Are Irish Non-Financial Corporations So Indebted?” Quarterly Bulletin 01/13 (Dublin: Central Bank of Ireland).

———, and D. Smith, 2012, “The Impact of the Financial Turmoil on Households: A Cross Country Comparison,” Quarterly Bulletin 02/12 (Dublin: Central Bank of Ireland).

European Central Bank (ECB), 2012, “Corporate Indebtedness in the Euro Area,” Monthly Bulletin , February, pp. 87–103.

———, 2013a, The Eurosystem Household Finance and Consumption Survey: Results from the First Wave , Statistics Paper Series 2/13 (Frankfurt).

———, 2013b, “Integrated Euro Area Accounts for the Fourth Quarter of 2012,” Box 4 in Monthly Bulletin , May (Frankfurt), pp. 46–50.

Herdon, T., M. Ash, and R. Pollin, 2013, “Does High Public Debt Consistently Stifle Economic Growth? A Critique of Reinhardt and Rogoff,” PERI Working Paper No. 322 (Amherst, Massachusetts: Political Economy Research Institute).

International Monetary Fund (IMF), 2012a, “Dealing with Household Debt,” Chapter 3 in World Economic Outlook, April (Washington: International Monetary Fund).

———, 2012b, “Household Consumption, Wealth, and Saving,” Chapter 1 in Ireland: Selected Issues Paper, IMF Country Report No. 12/265 (Washington: International Monetary Fund).

———, 2012c, Spain: Vulnerabilities of Private Sector Balance Sheets and Risks to the Finan-cial Sector: Technical Note, Financial Sector Assessment Program (Washington: International Monetary Fund).

———, 2013a, European Union; Financial System Stability Assessment, IMF Country Report No. 13/75 (Washington: International Monetary Fund).

———, 2013b, “Fiscal Adjustment in an Uncertain World,” in Fiscal Monitor , April (Washington: International Monetary Fund).

———, 2013c, “Fragmentation, the Monetary Transmission Mechanism, and Monetary policy in the Euro Area,” Chapter 1 in Euro Area Policies: Selected Issues, Country Report No. 13/232 (Washington: International Monetary Fund).

———, 2013d, France: Housing Prices and Financial Stability, Technical Note, Financial Sector Assessment Program (Washington: International Monetary Fund).

———, 2013e, “Household Savings Ratio in Spain—How Low Can it Go?” in Spain: Selected Issues Paper, IMF Country Report No. 13/245 (Washington: International Monetary Fund).



———, 2013f, Italy: The Financial Situation of Italian Households and non-Financial Corpora-tions and Risks to the Banking System, Technical Note, Financial Sector Assessment Program (Washington: International Monetary Fund).

———, 2013g, The Kingdom of the Netherlands: Staff Report of the 2013 Article IV Consultation, IMF Country Report No. 13/48 (Washington: International Monetary Fund).

———, 2013g, Global Financial Stability Report: Old Risks, New Challenges, April (Washington: International Monetary Fund).

———, 2013h, “Portugal’s Corporate (De) Leveraging,” Chapter 3 in Portugal: Selected Issues Paper, IMF Country Report No. 13/19 (Washington: International Monetary Fund).

Kumar, M.S., and J. Woo, 2010, “Public Debt and Growth,” IMF Working Paper 10/174 (Washington: International Monetary Fund).

Laeven, L., and T. Laryea, 2009, “Principles of Household Debt Restructuring,” IMF Staff Discussion Note 09/15 (Washington: International Monetary Fund).

Laryea, T., 2010, “Approaches to Corporate Debt Restructuring in the Wake of the Financial Crisis,” IMF Staff Discussion Note 10/02 (Washington: International Monetary Fund).

Liu, Y., and C.B. Rosenberg, 2013, “Dealing with Private Debt Distress in the Wake of the European Financial Crisis: A Review of the Economics and Legal Toolbox,” IMF Working Paper 13/44 (Washington: International Monetary Fund).

McKinsey Global Institute, 2012, Debt and Deleveraging: Uneven Progress on the Path to Growth (New York, New York: McKinsey Global Institute).

Panizza, U., and A.F. Presbitero, 2012, Public Debt and Economic Growth: Is There a Causal Effect? Money and Finance Research Group Working Paper No. 65 (Ancona: Univ. Politecnica Marche).

Reinhart, C.M., and K. Rogoff, 2010, “Growth in a Time of Debt,” American Economic Review: Papers and Proceedings , Vol. 100, No. 2, pp. 573–78.

Reinhart, C.M., V.R. Reinhart, and K. Rogoff, 2012, “Debt Overhangs Past and Present,” NBER Working Paper No. 18015 (Cambridge, Massachusetts: National Bureau of Economic Research).

Ruscher, E., and G.B. Wolff, 2012, “Corporate Balance Sheet Adjustment: Stylized Facts, Causes and Consequences,” Bruegel Working Paper 2012/03 (Brussels: Bruegel).

Tang, G., and C. Upper, 2010, “Debt Reduction after Crises,” Bank for International Settlements Quarterly Review , September, pp. 25–38.

World Bank, 2013, Doing Business 2013 (Washington: World Bank). http://www.doingbusiness . org/.



http://www.doingbusiness.org/

http://www.doingbusiness.org/

39

CHAPTER 3

Reducing the Employment Impact of Corporate Balance Sheet Repair

BAS B. BAKKER AND LI ZENG

CORPORATE BALANCE SHEETS MATTER FOR EMPLOYMENT

Corporate sector balance sheets in many euro area economies are in need of repair, but fixing them will have significant implications for other sectors in the economy. Private households are struggling with high debt ( Chapter 2 ), as are sovereigns ( Chapter 4 ). All three sectors face the challenge of reducing their liabilities and repairing their balance sheets, but a simultaneous effort to deleverage is likely to create adverse feedback loops among the three. There is a particularly direct link between corporates and private households: the latter derive most of their income from employment in the corporate sector, while at the same time, a reduction in household spending so that funds can be used to pay off debt will negatively affect corporate profits and possibly employment. This chapter focuses squarely on the link between corporate deleveraging and firms’ employment decisions.

Since the onset of the global crisis, labor market developments among Euro-pean Union countries have been strikingly different. These differences are clearly visible in unemployment rates. Between 2008 and 2012, the unemployment rate increased to 25.0 percent from 11.4 percent in Spain, but declined to 5.5 percent from 7.5 percent in Germany. The contrast is even starker in the employment data. Between 2008 and 2011, employment dropped by 14 percent in Ireland, but increased by 2 percent in Poland and Germany.

These differences partly result from differences in real GDP growth. A scatter chart of real GDP growth and employment growth between 2008 and 2011 shows a strong correlation between the two (top panel of Figure 3.1 ). Latvia, which had the largest decline in real GDP between 2008 and 2011, also experi-enced one of the largest reductions in employment.1 And Poland, which had the largest increase in real GDP during this time period, also had one of the best employment outcomes.

1Latvia’s official employment data show a larger decline in employment between 2008 and 2011 (25 percent) than the data in this chapter (13 percent). This discrepancy is the result of a break in the official data: figures for 2011 and beyond are based on a new labor force survey, whereas data for 2010 and earlier are based on an old labor survey. To prevent the break in the series, this chapter uses the old labor force survey data for both 2008 and 2011. Splicing the old and new series gives very similar results.


40 Reducing the Employment Impact of Corporate Balance Sheet Repair

However, in a number of countries, the losses in employment far exceed what could be expected given the drop in GDP, particularly in Bulgaria, Ireland, and Spain (bottom panel of Figure 3.1). Bulgaria, for example, saw a decline in real GDP of 3 ⅓2 percent between 2008 and 2011, whereas employment dropped by a stagger-ing 12 percent. Similarly, Spain had roughly the same decline in GDP as Italy, but

Figure 3.1 Real GDP and Employment Growth, 2008–11

IRLBGRESP

POL

SVK

PRT

LTU

EST

LVA

SWE

SVN

DNK

CZEFRA

NLD

FIN

GRC

AUTGBR

DEUBEL

ITAHUN

y = 0.769x – 2.4057R 2 = 0.5951

–18

–15

–12

–9

–6

–3

0

3

6

9

–15 –12 –9 –6 –3 0 3 6 129

Real GDP and Employment Growth, 2008–11(percent)

Real GDP growth

Em

ploy

men

t gro

wth

–9

–6

–3

0

3

6

Irela

ndBu

lgar

iaSp

ain

Pola

nd

Slov

ak R

epub

licPo

rtuga

lLi

thua

nia

Esto

nia

Latv

iaSw

eden

Slov

enia

Den

mar

k

Cze

ch R

epub

licFr

ance

Net

herla

nds

Finl

and

Gre

ece

Aust

ria

Uni

ted

King

dom

Ger

man

yBe

lgiu

mIta

lyH

unga

ry

Employment Growth Not Explained by Real GDPGrowth, 2008–11 (percentage points)

Source: IMF, World Economic Outlook database.


Bakker and Zeng 41

employment in Italy dropped by only 2 percent, while employment in Spain fell by 11 percent. Indeed, in Bulgaria, Ireland, and Spain, Okun’s relationship between output and employment seems to have shifted since 2008, with large employment losses relative to GDP declines (Figure 3.2a). This contrasts with other countries, for which the relationship does not seem to have changed much (Figure 3.2b).2

This chapter aims to explain why employment growth in some countries has been so dismal. To this end, it compares employment growth between 2008 and 2011 in 23 European Union countries.3,4 The focus is on employment growth differences for the entire three-year period, rather than in individual years, to bet-ter highlight the structural factors that may have played a role in these differences. The key findings are that

• Corporate restoration of profits5 after a precrisis borrowing binge has been a key factor behind the dismal employment performance in a number of countries, and

• There is a tradeoff between wage adjustment and employment losses, and in some countries—particularly those with dual labor markets—employment losses would have been smaller if wages had adjusted more.

Indeed, corporate debt6 increased sharply in a number of countries during the precrisis boom years, often accompanied by an erosion of profitability. When the crisis hit, firms in these countries tried to address the debt overhang by cutting back investment and raising corporate profitability and saving—by closing down loss-making production capacity and by reducing the wage bill. The latter, ac-complished through reductions in wages or employment, accounted for a large share of the improvements in profit shares during the 2008–11 period, as

2Whereas Okun’s Law traditionally focuses on the relationship between economic growth and unem-ployment , this study focuses on the relationship between economic growth and employment —which is not affected by changes in labor force participation. See Ball, Leigh, and Loungani (2013) for a discus-sion of the relationship between cyclical unemployment (i.e., the deviation of unemployment from the nonaccelerating inflation rate of unemployment) and the output gap. 3The analysis ends in 2011 because profit and balance sheet data for the nonfinancial corporate sector—which are an important part of this study—were not yet available for most countries for 2012. This study includes all European Union members with the exception of Cyprus, Luxembourg, Malta, and Romania. Romania has been excluded because of data problems: between 2008 and 2011, total employment declined by only 2⅓2 percent, a number that does not seem consistent with the sharp drop in the number of employees (12 percent). Bulgaria is also excluded in parts of the chapter be-cause of data problems: the wage bill and wage share in 2007 seem to have been underestimated in the national accounts, probably reflecting the large size of the informal economy. The underestimation of the wage bill (an important component of household income) is evident in the very negative house-hold saving rates in that year (−33 percent of disposable income; −17 percent of GDP). 4The data on corporate profits and debt are from the European Central Bank’s Integrated Economic and Financial Accounts by Institutional Sector (http://sdw.ecb.europa.eu/reports.do?node= 1000002340_ALLPDF). The data were accessed through Haver Analytics. 5 In this chapter, the profit share is defined as the share of the gross operating surplus in gross value added, where the gross operating surplus is gross value added minus employee compensation. 6 Corporate debt is calculated from the European Central Bank’s Integrated Economic and Financial Accounts balance sheet data as the sum of two liabilities: securities other than shares, and loans.


http://sdw.ecb.europa.eu/reports.do?node=1000002340_ALLPDF



Figure 3.2a Real GDP and Employment: Where Okun’s Law Has Not Held Up (2008 = 100)

20022003

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Bakker and Zeng 43

Figure 3.2b Real GDP and Employment: Where Okun’s Law Has Held Up (2008 = 100)

2000

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20052006

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20082009

2010 2011

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indicated by a strong negative correlation between changes in the profit share and employment and output growth: profit shares increased most in countries with the largest drop in employment and output. By contrast, those economies that saw more moderate declines in GDP and employment—or even an increase—in general saw a decline in their profit shares.

The adjustment through employment, rather than through wages, was espe-cially pronounced in countries with higher degrees of labor market duality. In these countries, wage adjustment has tended to be more limited, reflecting the strong position of insiders. Much of the increase in corporate profitability—the reduction in the wage share—has been the result of a reduction in employment rather than a reduction in average wages.

LITERATURE REVIEW

This chapter combines the findings of several strands of literature:• Financial shocks can affect employment through channels that go beyond

the impact of output declines. IMF (2010), in a study of output and unem-ployment dynamics in advanced economies during the Great Recession, shows that countries with similar output declines often had markedly differ-ent changes in unemployment. It finds that “during recessions, financial crises, large house price busts, and other sector shocks raise unemployment beyond the level predicted by Okun’s law” (IMF, 2010, p. 69). Reinhart and Rogoff (2009) find that in the aftermath of banking crises, the duration of unemployment increases (averaging more than four years) is considerably longer than that of output declines (averaging roughly two years).

• Corporate debt overhangs can affect output and employment. Lamont (1995) argues that during economic downturns, funding pressures may force corpo-rates to repair their balance sheets, which affects their hiring and firing deci-sions. The employment impact of a given output shock may thus critically depend on the corporate sector’s balance sheet, resulting in potentially very different labor market adjustments. In a similar vein, Koo (2008) suggests that corporate balance sheet repair was a fundamental driver of Japan’s prolonged recession of 1991–2005. Banco de Espana (2013) finds that since 2008, Spanish firms with higher starting levels of debt going into the crisis have cut investment and employment more sharply than those with lower debt.

• Labor market duality can lead to excessive labor shedding during downturns. OECD (2012) shows that a higher prevalence of temporary contracts is as-sociated with more labor shedding during economic downturns.7 It links the

7 OECD (2012) tries to explain the differences in resilience exhibited by labor markets during eco-nomic downturns. Its analysis is built upon the literature searching for underlying determinants of structural unemployment, including, among others, OECD (2006) and Bassanini and Duval (2006a, 2006b, 2009). It finds that structural policies and institutions matter for labor market resilience, and that those structural policies and institutions that are conducive to good structural labor market out-comes are also good for labor market resilience.


Bakker and Zeng 45

prevalence of temporary contracts to the severity of employment protection, a finding also reported in Cahuc, Charlot, and Malherbet (2012), Boeri (2011), and IMF (2010).

CORPORATE BALANCE SHEET REPAIR AND THE PRECRISIS BORROWING BINGE

The strong increase in corporate profitability since 2008 in some countries re-flects a debt overhang that resulted from a borrowing binge during the precrisis boom years. Between 2003 and 2008, debt of the nonfinancial corporate sector increased sharply (Figure 3.3). Debt increases were particularly large in Bulgaria, Ireland, and Spain. High indebtedness has in many cases forced firms to cut in-vestment and employment, thereby boosting profits.

The debt increase was the counterpart to a sharp deterioration in the non - financial corporate sector’s saving–investment balance. By 2008, corporate invest-ment exceeded saving by more than 5 percent of GDP in Latvia, Spain, Slovenia, Bulgaria, and Portugal (Figure 3.4). The large gap made firms vulnerable to a sudden deterioration of financing conditions. A saving–investment gap did not exist in all countries though: in the Netherlands, the United Kingdom, Sweden, and Finland, corporate saving exceeded investment.

The deteriorating saving–investment balance reflected both rising investment, and—in about half of the countries—a decline in corporate saving, that is, re-tained profits (Figure 3.4). The decline in corporate saving probably was the

Figure 3.3 Debt of the Nonfinancial Corporate Sector, 2008 versus 2003 (Percent of GDP)

0

30

60

90

120

150

180

Irela

ndSw

eden

Portu

gal

Spai

nBu

lgar

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ak R

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nia

Cze

ch R

epub

licPo

land

2008 2003

Source: Haver Analytics. Note: Debt of the nonfinancial corporate sector is the sum of the stock of securities (other than shares) and the stock of loans.



Figure 3.4 Nonfinancial Corporate Sector: Saving-Investment Balance, 2003 and 2008 (Percent of GDP)

–15

–10

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0

5

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herla

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Saving–Investment Balance, 2008 and 2003

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Investment, 2008 and 2003

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Saving, 2008 and 2003

2008 2003

2008 2003



Bakker and Zeng 47

Figure 3.5 Nonfinancial Corporate Sector: Change in Saving-Investment Balance, 2003–08 (As share of GDP, percentage points)

–10–8–6–4–202468

1012

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Change in Saving-Investment Balance

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Change in Saving

–4

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Change in Investment




result of rising wage costs, driven by tightening labor markets. The relative importance of these factors differed across countries (Figure 3.5): in Portugal, the increase was largely the result of a drop in saving, whereas in countries such as Slovenia and Poland, it was mainly due to an increase in investment.

These developments did not occur at the same scale in all countries. Indeed, in some countries, such as the Czech Republic, Germany, the Netherlands, Poland, and the Slovak Republic, there was little or no increase in corporate debt, and the financing gap remained very small—or positive.

Once the global crisis hit and capital flows dropped, the large saving short-falls were no longer sustainable, and during the next few years, firms managed to reduce the gaps substantially.8 Between 2008 and 2011, corporate saving-investment balances improved in almost all countries (Figure 3.6, top panel). The improvement was most dramatic in Latvia, Lithuania, and Spain. By 2011, the saving–investment balance of the nonfinancial corporate sector had become positive in all but six countries (Figure 3.7).

Part of the improvement in the saving–investment balance resulted from a drop in investment. The drop in investment was most severe in emerging Europe (Figure 3.6, bottom panel), likely reflecting a combination of the unwinding of a stronger precrisis investment boom and more severe financing pressures— particularly for countries that were not part of the euro area.9

Another contribution came from the improvement in corporate saving—the result of an increase in corporate profitability. Corporate saving increased in most countries, with particularly large increases in Latvia, Lithuania, Spain, and Ireland.

THE IMPACT OF CORPORATE RESTRUCTURING ON OUTPUT AND EMPLOYMENT

Higher corporate saving was the result of an increase in the profit share, and a corre-sponding drop in the wage share. Countries that saw sharp increases in their corporate-saving-to-GDP ratios all had large increases in their profit shares (Figure 3.8).

The large differences in the extent to which corporate profit shares increased between 2008 and 2011 are striking. Profit shares increased sharply in the Baltic countries, Ireland, and Spain. By contrast, they declined in the Netherlands, Germany, and other core euro area countries.

These differences likely reflect varying pressures to improve corporate profit-ability across countries. Pressures to increase profitability were particularly severe in countries in which corporate debt had increased substantially, or in which profitability had eroded during the boom years. Countries in which the saving shortfalls were small, profitability had not eroded, or corporate debt had not

8 Emerging Europe experienced a sudden stop of private capital inflows in late 2008 after the default of Lehman Brothers. In the euro area periphery, the slowdown of private capital inflows was more gradual and partly linked to the growing weakness of the euro area banking sector. 9 For a discussion of the experience of emerging Europe in the global financial and economic crisis, see Bakker and Klingen (2012).


Bakker and Zeng 49

Figure 3.6 Nonfinancial Corporate Sector: Change in Saving-Investment Balance, 2008–11 (As share of GDP, percentage points)

–2

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Change in Saving–Investment Balance

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Change in Saving

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Change in Investment




Figure 3.7 Nonfinancial Corporate Sector: Saving–Investment Balance, 2011 versus 2008 (Percent of GDP)

–15

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15Po

rtuga

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2008 2011


Figure 3.8 Nonfinancial Corporate Sector: Change in Profit Share versus Change in Saving, 2008–11

GBR

AUT

BEL

DNK

FRA DEU

ITA

NLD

SWEFIN

GRC

IRL

PRT

ESP

CZE

SVK

EST

LVA

HUN

LTU

SVN

y = 0.549x + 1.1415

R 2 = 0.5817–6

–4

–2

0

2

4

6

8

10

–6 –3 0 3 6 9 12

Change in profit (as share of gross value added, percentage points)

Cha

nge

in c

orpo

rate

sav

ing

(as

shar

e of

GD

P, p

erce

ntag

e po

ints

)

Sources: Haver Analytics; and IMF, World Economic Outlook database.

increased much, experienced much less pressure to increase profits—profits often declined because firms kept their labor forces on board despite drops in output.

The increase in profit share since 2008 is linked to the precrisis deterioration in profits and increase in corporate debt. Countries in which profits had fallen


Bakker and Zeng 51

sharply during the boom years saw a rebound in profits (Figure 3.9), as did countries that had experienced large increases in corporate debt. It is noteworthy that the sharpest increases in corporate profitability occurred in countries in which debt had increased and profitability had fallen during the precrisis years (Figure 3.10, bottom right quadrant).

Figure 3.9 Profit Share Changes during 2003–08 vs. Profit Share Changes during 2008–11 (As share of gross value-added, percentage points)

AUT

BEL

CZE

DNK

EST

FIN

FRA

DEU

GRC

HUN

IRL

ITA

LVA LTU

NLD

POL

PRT

SVK

SVN

ESP

SWE

GBR

y = –0.67x + 0.6694R 2 = 0.5318

–6

–4

–2

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2

4

6

8

10

–14 –12 –10 –8 –6 –4 –2 0 2 4 6Changes during 2003–08

Cha

nges

dur

ing

2008

–11


Figure 3.10 Profit Share Increase since 2008 versus Precrisis Balance Sheet Deterioration

AUT

BEL

CZEDNK

EST

FINFRA

DEUGRC HUN

IRL

ITA

LVA

LTU

NLDPOL

PRT

SVK

SVN

ESPSWE

GBR

–20

–15

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10

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poin

ts, a

s sh

are

of g

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ue a

dded

)

Change in debt, 2003–08 (percentage points, as share of GDP)

Source: Haver Analytics. Note: Bubble size indicates the profit share increase in 2008–11. For instance, Latvia has the largest bubble because the profit share of its nonfinancial corporate sector increased by 10 percentage points between 2008 and 2011, highest among all countries. The bubble size is set to 0.05 (the smallest bubbles) for countries whose profit shares declined between 2008 and 2011.



10 For instance, Central Bank of Ireland (2011) points out that while employment contracted consider-ably more than predicted by GDP in Ireland, this was partially a compositional effect. Output in the high-profit broad chemical sector increased to 2011 while value added from the low-productivity, employment-intensive construction sector fell over the same period.

Figure 3.11 Change in Profit Share of Nonfinancial Corporate Sector versus Real GDP Growth, 2008–11

AUT BELCZE

DNK EST

FIN

FRA

DEU

GRC

HUN IRLITA

LVA

LTU

NLD

POL

PRT

SVK

SVN

ESP

SWE

GBR

–15

–10

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5

10

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–6 –3 0 3 6 9 12


Rea

l GD

P g

row

th (

perc

ent)


Equally striking is the negative relationship between the increase in profit share and GDP growth (Figure 3.11). Profit shares increased sharply in several countries with large output declines, whereas they declined in a number of core euro area countries in which output increased. This suggests that—for this par-ticular period—causality did not go from GDP growth to profits, but rather that corporate restructuring (which boosted corporate profits) had a negative impact on GDP.

Profit share increases are associated with poor employment outcomes (Figure 3.12). Countries in which the profit share increased sharply have seen significant losses in employment, whereas countries in which employment has held up well have generally seen a decline in profit share during this period.

Poorer employment outcomes reflect, in part, that countries with larger in-creases in profit shares saw bigger output drops and bigger increases in labor productivity (Figure 3.13). The increase in productivity likely indicates restruc-turing by enterprises to produce the same output with fewer workers. It may also denote a composition effect because sectors with lower labor productivity (including, in particular, the construction sector in some countries) were hit disproportionally by the crisis.10


Bakker and Zeng 53

Figure 3.13 Change in Profit Share of Nonfinancial Corporate Sector versus Labor Productivity Growth, 2008–11

AUTBEL

CZEDNK

EST

FIN

FRA

DEU

GRCHUN

IRL

ITA

LVA

LTU

NLD

POL

PRT

SVK

SVN

ESP

SWE

GBR

–6

–4

–2

0

2

4

6

8

10

12

–6 –3 0 3 6 9 12


Labo

r pr

oduc

tivity

gro

wth

(pe

rcen

t)

y = 0.4032x + 1.1553R ² = 0.2204

Sources: Haver Analytics; IMF, World Economic Outlook database; and IMF staff calculations.

Figure 3.12 Change in Profit Share of Nonfinancial Corporate Sector versus Employment Growth, 2008–11

AUT

BEL

CZE

DNK

EST

FIN

FRA

DEU

GRC

HUN

IRL

ITA

LVA

LTU

NLD

POL

PRT

SVK

SVN

ESP

SWE

GBR

y = –0.8232x – 3.0334R2 = 0.4539

–16

–14

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4

–6 –3 0 3 6 9 12


Em

ploy

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(pe

rcen

t)


The combination of a sharp increase in labor productivity and a decline in output is strikingly different from the positive relationship observed during normal times. Between 2003 and 2008, faster GDP growth was associated with higher labor productivity growth (Figure 3.14, top panel). Between 2008



and 2011, this relationship broke down, and labor productivity growth was fastest in some of the countries with the largest output declines (Figure 3.14, bottom panel).

Changes in profit shares can explain much of the residuals in the GDP– employment growth scatter chart in the top panel of Figure 3.1 (Figure 3.15). The increase in profit share and the residual in the GDP–employment growth scatter chart are strongly correlated; countries that had sharp increases in profit shares had worse employment outcomes than would be expected given their out-put changes.

Figure 3.14 Real GDP and Labor Productivity Growth (Percent)

AUT

BEL

BGR

CZE

DNK

EST

FIN

FRA

DEU GRC

HUN

IRL

ITA

LVA

LTU

NLD

POL

PRT

SVK

SVN

ESP

SWE

GBR

y = 0.6661x – 2.1097R2 = 0.7487

–5

0

5

10

15

20

25

30

35

40

0 5 10 15 20 25 30 35 40 45

Labo

r pr

oduc

tivity

gro

wth

Real GDP growth

2003–08

AUT

BEL

BGR

CZEDNK

EST

FIN

FRA

DEU

GRC HUN

IRL

ITA

LVALTU

NLD

POL

PRTSVK

SVN

ESP

SWE

GBR

–8

–4

0

4

8

12

16

–15 –10 –5 0 5 10 15

Labo

r pr

oduc

tivity

gro

wth

Real GDP growth

2008–11

Sources: IMF, World Economic Outlook database; and IMF staff calculations.


Bakker and Zeng 55

THE ROLE OF LABOR MARKET DUALITY

European countries exhibit large differences in the duality of their labor markets. In 2007, almost a third of employment in Spain consisted of temporary contracts, whereas in the Baltics, the share was less than 5 percent (Figure 3.16).

Labor market duality is another likely factor behind the large differences in employment growth. For a given a level of output, increases in profit shares—that is, declines in wage shares—can be brought about through either reductions in employment or reductions in wages. In countries with high degrees of labor mar-ket duality—under which insiders are well protected but a significant group of workers are on temporary contracts—much of the adjustment can be expected to occur through employment reductions rather than wage cuts because insiders—who set wages—have little incentive to adjust, while outsiders can easily be fired.

The evidence shows that in countries with high shares of temporary employ-ment, real wage growth is much less sensitive to unemployment changes. The top panel of Figure 3.17 shows the beta coefficients in the regression real wage growth =

unemployment ratet for the 2000–11 period. In countries on the far left of the figure, real wages adjust relatively strongly in response to unemployment, whereas in countries on the far right, there is very little adjustment.

The bottom panel of Figure 3.17 shows that there is a strong relationship be-tween wage sensitivity and the degree of labor market duality—the higher the share of temporary employment, the less responsive real wages are to unemployment rates.

To the extent that reductions in firms’ wage bills result from firms’ efforts to improve profits, larger wage reductions can help mitigate employment losses. The

Figure 3.15 Change in Profit Share of Nonfinancial Corporate Sector versus Employment Growth Not Explained by Real GDP Growth, 2008–11

AUT

BEL

CZE DNKEST

FIN FRA

DEU

GRC

HUN

IRL

ITA

LVA

LTU

NLD

POLPRT

SVK

SVN

ESP

SWE

GBR

y = –0.461x + 0.9289R2 = 0.3983

–12

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–6 –3 0 3 6 9 12

Change in profit of nonfinancial corporate sector(as share of gross value added, percentage points)

Em

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exp

lain

ed b

yre

al G

DP

gro

wth

(pe

rcen

tage

poi

nts)

Sources: Haver Analytics; and IMF, World Economic Outlook database. Note: The sample is slightly different from previous figures because Bulgaria is excluded as the result of missing information.



Figure 3.16 Share of Temporary Employment, 2007 (Percent)

0

5

10

15

20

25

30

35

Estonia

Lithu

ania

Latvi

a

Bulgar

ia

Slovak

Rep

ublic

United

King

dom

Hunga

ry

Irelan

d

Czech

Rep

ublic

Belgium

Austri

a

Denm

ark

Greec

eIta

ly

Germ

any

Franc

e

Finlan

d

Sweden

Nethe

rland

s

Sloven

ia

Portu

gal

Poland

Spain

Sources: International Institute of Labor Studies (2012); and Organisation for Economic Co-operation and Development Statistics (stats.oecd.org/).

11 Detailed data information is provided in Tables 3A.1 and 3A.2 in the appendix to this chapter. 12 Both instrumental variables have strong links with the profit share change during the crisis period, as shown in Table 3.3.

more wages adjust, the smaller are the employment reductions needed to reduce the wage bill. This tradeoff is reflected in the relatively larger employment losses that occur in dual labor markets.

ECONOMETRIC ANALYSIS

Econometric regression analysis confirms that the three factors discussed so far (real GDP growth, corporate balance sheet repair, and labor market duality) all contributed to the large cross-country differences in employment growth during 2008–11:11

• Real GDP growth was the most important factor behind differences in employment growth, contributing to about two-thirds of the cross-country differences (Table 3.1, Columns 1 and 2).

• Profit share increase was the second most important factor. When included in the regression alone, it explained about one-third of the cross-country variation (Table 3.1, Columns 3 and 4); and when added to a regression that also included real GDP growth, it improved the R2 from 0.64 (Table 3.1, Column 1) to 0.80 (Table 3.1, Column 5). The regression takes into ac-count the fact that the profit share increase may be endogenous by using the precrisis debt increase and profit share decline as instrumental variables.12


Bakker and Zeng 57

Figure 3.17 Real Wage Sensitivity and Labor Market Duality

–2.0

–1.5

–1.0

–0.5

0.0

0.5

1.0U

nite

d Ki

ngdo

mLa

tvia

Lith

uani

aBe

lgiu

mH

unga

rySl

oven

iaEs

toni

aG

reec

eBu

lgar

iaIre

land

Finl

and

Aust

riaG

erm

any

Portu

gal

Pola

ndFr

ance

Spai

nD

enm

ark

Slov

ak R

epub

licIta

lyN

ethe

rland

sSw

eden

Cze

ch R

epub

lic

Real Wage Sensitivity to Unemployment Rate

Note: Coefficients from regressing real wage growth on unemployment using 2000–11 data, with smaller values indicating stronger real wage declines in response to higher unemployment rates.

AUT

BEL

BGR

CZE

DNK

EST

FIN

FRADEU

GRC

HUN

IRL

ITA

LVALTU

NLD

POLPRTSVK

SVN

ESP

SWE

GBRy = 0.0403x – 0.9124

R2 = 0.2371

–2.0

–1.5

–1.0

–0.5

0.0

0.5

1.0

0 5 10 15 20 25 30 35

Real Wage Sensitivity to Unemployment Rateand Labor Market Duality

Share of temporary employment, 2007 (percent)

Rea

l wag

e se

nsiti

vity

to u

nem

ploy

men

t

Sources: International Institute of Labor Studies (2012); Organisation for Economic Co-operation and Development Statistics (stats.oecd.org/); IMF, World Economic Outlook database; and IMF staff calculations. Note: Romania is excluded because the relatively small increase in its unemployment rate is not consistent with the sharp drop in employment of employees.

• Adding the share of temporary employment further improved the fit of the model, raising the R2 from 0.84 (Table 3.1, Column 6) to 0.89 (Table 3.1, Column 8).13

The results are robust to introducing other precrisis imbalance measures into the model. Two often discussed imbalance measures—current account deficits

13 Column 8 includes a dummy variable for the Slovak Republic because it is an outlier in that its share of temporary workers did not seem to have a significant impact on its employment losses during the sample period. The results are robust to dropping any other single country from the sample.



TABLE 3.1

Determinants of Employment Growth during 2008–11Dependent variable:

Employment

growth, 2008–11

(1)

OLS

(2)

OLS

(3)

IV

(4)

IV

(5)

IV

(6)

IV

(7)

IV

(8)

IV

Real GDP growth, 2008–11 (percent)

0.757***(0.126)

0.783***(0.129)

0.553***(0.109)

0.571***(0.102)

0.615***(0.113)

0.681***(0.096)

Nonfinancial corporate profit change1 (percentage points, as share of gross value added)

−1.281***(0.282)

−1.386***(0.307)

−0.669***(0.175)

−0.755***(0.167)

−0.682***(0.169)

−0.812***(0.143)

Share of temporary employment in 2007 (percent)

−0.110(0.067)

−0.182***(0.059)

Dummy variable for the Slovak Republic

−3.242(3.218)

−5.353(4.653)

−5.483**(2.316)

−7.710***(2.103)

Constant −2.119***(0.727)

−1.906**(0.757)

−2.332**(0.962)

−1.952*(1.055)

−1.756***(0.557)

−1.349**(0.546)

−0.203(1.086)

1.377(0.997)

Observations 22 22 22 22 22 22 22 22

R 2 0.643 0.661 0.344 0.323 0.807 0.841 0.830 0.890

Note: IV = instrumented variables; OLS = ordinary least squares. Standard errors are in parentheses. Regressions in Columns 2, 4, and 6 include a dummy variable for the Slovak Republic. The inclusion of the dummy is not essential for the regressions in Columns 2, 4, and 6, but allows consistent comparisons with the regression in Column 8. 1 Instrumented by the debt increase and profit share decline during 2003–08. *, **, and *** indicate significance at the 10 percent, 5 percent, and 1 percent levels, respectively.

and the size of the construction sector—are considered in the regressions in Table 3.2. When included alone with real GDP growth, the relationship between these two measures (in levels or as precrisis changes) and employment growth during the 2008–11 period was indeed strong. But when they are added to the model (Column 8 of Table 3.1), they are not statistically significant and do not seem to bring any extra explanatory power, while the original regressors all remain highly significant. Admittedly, the various precrisis imbalance measures tend be correlated. Countries in which corporate debt increased rapidly during the boom years often had high and widening current account deficits as well.14

An analysis of the quantitative contribution of each of the three factors confirms the important role of the increase in corporate profits in the large drop in employ-ment that occurred in a number of countries. Figure 3.18 shows the quantitative contribution of each of the factors to employment growth, using the results of the regression analysis. It shows that among all the countries in which employment

14 By contrast, the correlation between the size of the construction sector and the buildup of corporate debt was very low.


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TABLE 3.2

Check on Other Precrisis Imbalance Measures

Dependent variable:

(1) (2) (3) (4) (5) (6) (7) (8) (9) (10)Employment growth, 2008–11

Current account deficits, 2008 (percent of GDP) −0.286**(0.106)

0.081(0.106)

0.066(0.113)

Increase of current account deficits, 2003–08 (percentage points, as share of GDP)

−0.432**(0.182)

0.009(0.171)

−0.019(0.172)

Size of construction sector (percent of gross value added)

−0.890***(0.260)

0.304(0.351)

0.245(0.351)

Increase in size of construction sector, 2003–08 (percentage points, as share of gross value added)

−0.475(0.416)

0.524(0.365)

0.528(0.374)

Real GDP growth, 2008–11 (percent) 0.536***(0.137)

0.751***(0.126)

0.615***(0.128)

0.686***(0.122)

0.630***(0.108)

0.731***(0.113)

0.728***(0.128)

0.715***(0.098)

0.778***(0.143)

0.706***(0.125)

Nonfinancial corporate profit change1 (percentage points, as share of gross value added)

−0.855***(0.177)

−0.814***(0.160)

−0.904***(0.214)

−0.867***(0.159)

−0.919***(0.232)

−0.863***(0.174)

Share of temporary employment in 2007 (percent) −0.202***(0.068)

−0.184**(0.079)

−0.217**(0.077)

−0.178***(0.060)

−0.227**(0.084)

−0.173**(0.080)

Dummy variable for the Slovak Republic −8.645***(2.612)

−7.749***(2.321)

−9.314***(3.057)

−10.274***(2.863)

−9.760**(3.399)

−10.215***(3.039)

Constant −1.570**(0.667)

1.593(1.102)

−1.601**(0.690)

1.407(1.185)

4.258**(1.950)

−0.158(2.035)

−1.641*(0.834)

0.998(1.040)

0.312(2.104)

0.934(1.223)

Observations 22 22 22 22 22 22 22 22 22 22

R 2 0.741 0.885 0.725 0.889 0.779 0.875 0.666 0.892 0.875 0.893

Note: Standard errors are in parentheses. 1 Instrumented by the debt increase and profit share decline during 2003–08. *, **, and *** indicate significance at the 10 percent, 5 percent, and 1 percent levels, respectively.



dropped by more than 7 percent, with the notable exception of Greece,15 the in-crease in profits accounted for more than 50 percent of job losses.16 For example, in Latvia, where employment decreased by 13 percent during 2008–11, about 7 percentage points were accounted for by the increase in the profit share.

Labor market duality contributed significantly to employment reductions in a few countries as well. Among the countries with employment declines, the con-tribution of labor market duality exceeded 4 percentage points in Spain, Poland, and Portugal.

The change in profit share of the nonfinancial corporate sector during 2008–11 is closely linked to the precrisis profitability decline and debt increase (Table 3.3). Countries with larger precrisis debt increases and more severe profitability declines tended to have larger increases in profit shares during the crisis period. The two factors together accounted for almost 60 percent of the variation in cross-country profit share increases during 2008–11.

Regression of employment growth on the precrisis deterioration in the profit share and increase in debt explains two-thirds of the cross-country variation in employment growth between 2008 and 2011 (Table 3.4, Column 3), suggesting that the mechanism described in this chapter has been important.

Figure 3.18 Decomposition of Employment Growth, 2008–11

–20

–15

–10

–5

0

5

10

15Po

land

Ger

man

yBe

lgiu

mSw

eden

Aust

riaFr

ance

Uni

ted

King

dom

Net

herla

nds

Cze

ch R

epub

licH

unga

ryIta

lyFi

nlan

d

Slov

ak R

epub

licD

enm

ark

Slov

enia

Portu

gal

Esto

nia

Lith

uani

aG

reec

eSp

ain

Latv

iaIre

land

Em

ploy

men

t gro

wth

(pe

rcen

t)

Due to GDP growthDue to profit share changeDue to share of temporary workersDue to other factors

Sources: Haver Analytics; IMF, World Economic Outlook database; and IMF staff estimates. Note: Decomposition is based on the regression in Column 8 of Table 3.1 .

15 In Greece, which did not have a corporate borrowing boom before the crisis, the drop in employ-ment largely seems to reflect the drop in output. 16 The impact of profit share increases on employment is even larger if the impact of profit share in-creases on GDP growth is taken into account. In countries in which profit shares increased sharply, GDP growth was very negvative (Figure 3.11).


Bakker and Zeng 61

POLICY IMPLICATIONS

The analysis in this chapter suggests that the large employment losses in many countries have been the result of a corporate adjustment process that helped restore the financial health of the corporate sector. It is noteworthy that profits in several of the most crisis-affected countries, after sharply deteriorating in the precrisis years, have rebounded strongly. Although the adjustment has deepened the recession, it has also helped set the stage for renewed growth.

It is difficult to predict when the corporate adjustment will have run its course. There is no “norm” for the profit share, and preboom levels may have been too low given the increased debt level. However, signs are appearing in at least some of the crisis-hit countries that the process may be nearing its end. In Ireland, the profit share stopped increasing in 2012, and the wage bill ended its decline (Fig-ure 3.19). These signs are also visible in employment, which started growing again, and unemployment, which has started to come down.

TABLE 3.3

Explanation of Nonfinancial Corporate Profit Share Change during 2008–11

Dependent variable: Profit

share change 2008–11 (1) (2) (3)

Debt increase 2003–08 0.138***(0.036)

0.064(0.040)

Profit share change 2003–08

−0.660***(0.135)

−0.488***(0.170)

Constant −1.422(0.996)

0.608(0.634)

−0.470(0.915)

Observations 22 22 22

R 2 0.422 0.544 0.597

Note: Standard errors are in parentheses. *, **, and *** indicate significance at the 10 percent, 5 percent, and 1 percent levels, respectively.

TABLE 3.4

Employment Growth during 2008–11 and Precrisis Balance Sheet and Profitability Deterioration

Dependent variable: Employment growth, 2008–11 (1) (2) (3)

Nonfinancial corporate sector debt-to-GDP ratio change, 2003–08 (percentage points)

−0.180***(0.040)

−0.090*(0.043)

Nonfinancial corporate sector profit change, 2003–08 (percentage points, as share of gross value added)

0.837***(0.151)

0.594***(0.182)

Constant −0.437(1.112)

−3.120***(0.707)

−1.596(0.980)

Observations 22 22 22

R 2 0.500 0.606 0.680

Note: Standard errors are in parentheses. *, **, and *** indicate significance at the 10 percent, 5 percent, and 1 percent levels, respectively.



The results also suggest that there is a tradeoff between wage adjustment and employment losses and that in some countries employment losses would have been smaller if wages had adjusted more. To restore profits, firms need to reduce the wage bill, which can occur through either price adjustment or quantity adjustment. The less wages adjust, the higher will be the decline in employment. Countries with dual labor markets tend to have less adjustment of wages, and consequently have seen larger declines of employment. Wage adjustment is pref-erable to employment adjustment because the former helps distribute the burden more equitably, while the latter negatively affects human capital and the potential growth rate.

Figure 3.19 Ireland: The Resumption of Employment Growth

45

47

49

51

53

55

57

59

61

2003:Q1 2006:Q1 2009:Q1 2012:Q1

Firms’ efforts to increase the profit share seemto have ended...

Profit Share(percent of value added, four-quarter movingaverage)

6

7

8

9

10

11

12

2003:Q1 2006:Q1 2009:Q1 2012:Q1

...and firms are no longer reducing the wage bill.

Wage Bill(billions of euros, four-quarter movingaverage)

–10

–8

–6

–4

–2

0

2

4

6

8

2003:Q1 2006:Q1 2009:Q1 2012:Q1

Employment Growth(percent, year-over-year)

Employment growth has turned positive...

0

2

4

6

8

10

12

14

16

18

2003:Q1 2006:Q1 2009:Q1 2012:Q1

Unemployment Rate(percent)

....and the unemployment rate has started todecline.



Bakker and Zeng 63

The way in which the corporate sector adjusts matters greatly for other sectors. The impact on aggregate demand, which depends to a large degree on employ-ment decisions, will affect private households’ ability to repair their balance sheets. And in an adverse outcome with large employment losses and pronounced increases in nonperforming loans, banks may require additional help from the sovereign, in turn complicating and worsening public debt dynamics. Yet, as Chapter 4 shows, such difficulties need not dominate; history provides examples of successful consolidations in, and despite, adverse conditions.



APPENDIX 3A. DATA FOR REGRESSION ANALYSIS

APPENDIX TABLE 3A.1

Data Sources and Variable Construction

Variable name Data sources Variable construction Remarks 1

Employment growth, 2008–11 (percent)

IMF, World Economic Outlook database

= 100 × (total employment 2011/total employment 2008 − 1)

Real GDP growth, 2008–11 (percent)


= 100 × (real GDP 2011/real GDP 2008 − 1)

Nonfinancial corporate sector profit share change, 2008–11 (percentage points)

Haver Analytics (EUDATA, Annual Integrated Economic & Financial Accounts by Sector)

= profit share 2011 − profit share 2008, where profit share = 100 × (1 − compensation of employees/gross value added)

Compensation of employees series code: Y*ND1

Gross value added series code: Y*NB1G

Nonfinancial corporate sector profit share change, 2003–08 (percentage points)

Haver Analytics (EUDATA, Annual Integrated Economic & Financial Accounts by Sector)

= profit share 2008 − profit share 2003, where profit share = 100 × (1 − compensation of employees/gross value added)

Compensation of employees series code: Y*ND1

Gross value added series code: Y*NB1G

Nonfinancial corporate debt-to-GDP ratio change, 2003–08 (percentage points)

Haver Analytics (EUDATA, (1) Annual Integrated Economic & Financial Accounts by Sector, and (2) Harmonized ESA95 GDP)

= debt-to-GDP ratio 2008 − debt-to-GDP ratio 2003, where debt-to-GDP ratio = 100 × nonfinancial corporate sector debt stock (securities other than shares + loans)/GDP

Nonfinancial corporate sector securities other than shares series code: C*LCSO

Nonfinancial corporate sector loans series code: C*LCLO

GDP series code: A*GDPEShare of temporary

employment, 2007 (percent)

OECD, Online OECD Employment database (http://stats.oecd.org/Index.aspx?Dataset Code=TEMP_I); International Institute of Labor Studies (2012)

For data from OECD, the selection is “all persons (sex)” + “total (age)” + “dependent employment (employment status).” Information for Latvia and Lithuania was retrieved from IILS (2012)

Current account deficits, 2008 (percent of GDP in U.S. dollars)


+ indicates current account deficits

Increase in current account deficits, 2003–08 (percentage points, as share of GDP in U.S. dollars)


= current account deficits in 2008 − current account deficits in 2003

+ indicates increase of current account deficits

Share of construction sector in gross value added, 2008 (percent)

Haver Analytics (EUDATA, Harmonized ESA95 GDP)

= 100 × gross value added of construction/gross value added

Construction gross value added series code: A*VCSN

Gross value added series code: A*GVAN

Increase in size of construction sector, 2003–08 (percentage points, as share of gross value added)

Haver Analytics (EUDATA, Harmonized ESA95 GDP)

= share of construction sector 2008 − share of construction sector 2003

Construction gross value added series code: A*VCSN

Gross value added series code: A*GVAN

1 In the series codes, * stands for the 3-digit country codes used in the IMF International Financial Statistics .


http://stats.oecd.org/Index.aspx?DatasetCode=TEMP_I



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APPENDIX TABLE 3A.2

Data for Econometric Analysis

IFS

code Country

Employment

Growth, 2008–

11 (percent)

Real GDP

Growth,

2008–11

(percent)

Nonfinancial

Corporate Profits-

to-GDP Ratio

Change, 2008–11

(percent)

Nonfinancial

Corporate Profits-

to-GDP Ratio

Change, 2003–08

(percent)

Nonfinancial

Corporate Debt-to-

GDP Ratio Change,

2003–08 (percent)

Share of

Temporary

Employment,

2007

(percent)

Current Account

Deficit in 2008

(percent of GDP

in U.S. dollars)

Increase in Current

Account Deficits, 2003–

08 (percentage points,

as share of GDP in U.S.

dollars)

Share of

Construction

Sector in Gross

Value Added,

2008 (percent)

Increase in Size of

Construction

Sector, 2003–08

(percentage points,

as share of gross

value added)

112 United Kingdom −0.9 −1.5 −0.1 1.0 13.8 5.9 −1.0 0.7 7.6 0.5122 Austria 0.9 0.8 −0.6 1.6 4.6 8.9 4.9 3.2 7.1 −0.3124 Belgium 1.8 1.4 −0.6 1.7 11.7 8.7 −1.3 −4.7 5.8 0.8128 Denmark −4.2 −3.9 1.7 −2.1 31.1 9.1 2.9 −0.6 6.0 0.7132 France −0.9 0.1 −2.9 1.0 9.3 15.1 −1.7 −2.5 6.6 1.3134 Germany 2.0 1.8 −1.8 4.3 −2.8 14.6 6.2 4.3 4.2 −0.2136 Italy −1.8 −3.4 −2.5 −3.2 16.5 13.2 −2.9 −2.1 6.4 0.6138 Netherlands −1.1 −1.0 −1.6 2.7 −6.7 18.1 4.3 −1.3 5.9 0.2144 Sweden 1.3 4.6 1.7 2.3 19.7 17.5 9.0 2.1 5.2 0.6172 Finland −2.4 −2.9 −3.7 −1.3 19.1 16.0 2.6 −2.2 7.3 1.3174 Greece −10.1 −13.1 0.8 0.6 19.9 10.9 −14.9 −8.4 6.8 0.2178 Ireland −13.8 −4.8 9.3 −9.8 74.6 8.1 −5.7 −5.7 7.0 −0.9182 Portugal −6.9 −3.2 0.5 −1.7 20.7 22.4 −12.6 −6.2 7.3 −0.4184 Spain −10.7 −3.7 6.7 −1.0 48.5 31.7 −9.6 −6.1 13.6 1.5935 Czech Republic −1.4 −0.5 −2.1 −0.1 −0.6 8.6 −2.1 3.9 6.8 0.1936 Slovak Republic −3.3 2.4 −2.9 4.2 −7.9 5.1 −6.6 −0.7 9.6 5.1939 Estonia −7.6 −5.6 5.8 −7.9 35.9 2.1 −9.2 2.1 9.8 3.3941 Latvia −13.3 −13.5 9.9 −14.2 32.3 3.5 −13.2 −5.1 10.1 3.8944 Hungary −1.8 −4.0 2.2 1.3 39.6 7.3 −7.4 0.6 4.9 −0.6946 Lithuania −9.9 −8.5 7.7 −6.0 19.4 2.5 −13.3 −6.5 11.2 4.3961 Slovenia −6.0 −6.2 −2.9 0.5 34.5 18.5 −6.2 −5.4 8.4 2.1964 Poland 2.1 10.1 3.9 3.1 1.3 28.2 −6.6 −4.1 7.7 1.5

Minimum −13.8 −13.5 −3.7 −14.2 −7.9 2.1 −14.9 −8.4 4.2 −0.9Maximum 2.1 10.1 9.9 4.3 74.6 31.7 9.0 4.3 13.6 5.1Mean −4.0 −2.5 1.3 −1.0 19.7 12.5 −3.8 −2.0 7.5 1.2Standard deviation

5.0 5.3 4.2 4.7 19.7 7.9 6.9 3.8 2.2 1.6

Sources: International Institute of Labor Studies (2012); Haver Analytics; and IMF, World Economic Outlook database. Note: IFS = International Financial Statistics .



REFERENCES

Bakker, B., and C. Klingen, eds., 2012, How Emerging Europe Came through the 2008/09 Crisis: An Account by the Staff of the IMF’s European Department (Washington: International Mon-etary Fund).

Ball, L.M., D. Leigh, and P. Loungani, 2013, “Okun’s Law: Fit at Fifty?” NBER Working Paper No. 18668 (Cambridge, Massachusetts: National Bureau of Economic Research).

Banco de Espana, 2013, “Spanish Non-Financial Corporations’ Debt since the Start of the Crisis: A Disaggregated Analysis,” Economic Bulletin , January (Madrid).

Bassanini, A., and R. Duval, 2006a, “The Determinants of Unemployment across OECD Countries: Reassessing the Role of Policies and Institutions,” OECD Economic Studies No. 42, 2006/1 (Paris: Organisation for Economic Co-operation and Development).

———, 2006b, “Employment Patterns in OECD Countries: Reassessing the Role of Policies and Institutions,” OECD Social, Employment and Migration Working Paper No. 35 (Paris: Organisation for Economic Co-operation and Development).

———, 2009, “Unemployment, Institutions, and Reform Complementarities: Reassessing the Aggregate Evidence for OECD Countries,” Oxford Review of Economic Policy , Vol. 25, pp. 40–59.

Boeri, T., 2011, “Institutional Reforms and Dualism in European Labor Markets,” in Handbook of Labor Economics , Vol. 4B, ed. by O. Ashenfelter and D. Card (Amsterdam: Elsevier) pp. 1173–236.

Central Bank of Ireland, January 2011, Central Bank Quarterly Bulletin (Dublin). Cahuc, P., O. Charlot, and F. Malherbet, 2012, “Explaining the Spread of Temporary Jobs and

Its Impact on Labor Turnover,” CEPR Discussion Paper No. 8864 (Washington: Center for Economic and Policy Research).

European Central Bank (ECB), Integrated Economic and Financial Accounts by institutional sector. http://sdw.ecb.europa.eu/reports.do?node=1000002340_ALLPDF.

International Institute of Labor Studies, 2012, World of Work Report 2012: Better Jobs for a Better Economy (Geneva: International Labor Office).

International Monetary Fund (IMF), 2010, “Unemployment Dynamics during Recessions and Recoveries: Okun’s Law and Beyond,” World Economic Outlook , Chapter 3, April (Washing-ton: International Monetary Fund).

Koo, R., 2008, The Holy Grail of Macroeconomics: Lessons from Japan’s Great Recession (Singapore: John Wiley & Sons (Asia) Pte. Ltd.).

Lamont, O., 1995, “Corporate-Debt Overhang and Macroeconomic Expectations,” American Economic Review , Vol. 85, No. 5, pp. 1106–17.

Organisation for Economic Co-operation and Development (OECD), 2006, OECD Employ-ment Outlook (Paris: Organisation for Economic Co-operation and Development).

Reinhart, C., and K. Rogoff, 2009, “The Aftermath of Financial Crises,” American Economic Review, Vol. 99, No. 2, pp. 466–72.

———, 2012, “What Makes Labour Markets Resilient During Recessions?” OECD Employ-ment Outlook , Chapter 2 (Paris: Organisation for Economic Co-operation and Development).



67

CHAPTER 4

Reducing Public Debt When Growth Is Slow

S. ALI ABBAS, BERNARDIN AKITOBY, JOCHEN ANDRITZKY, HELGE BERGER, TAKUJI KOMATSUZAKI, AND JUSTIN TYSON

GROWTH AND FISCAL CONSOLIDATION ARE DRIVING DEBT

Dealing with high public debt is never easy, but the current environment poses new challenges for many advanced economies. 1 Sovereign debt is approaching historical highs, largely reflecting the work of automatic stabilizers, countercycli-cal fiscal policy, and financial sector bail-outs. In past episodes of debt reversals, output growth and fiscal adjustment were the main drivers. However, a weak medium-term growth outlook complicates the task of putting debt back on a clearly declining path. Thus, the burden of adjustment is shifted further on to fiscal policy at a time when fiscal accounts are already under pressure from un-derlying structural changes such as continued population aging and rising health care spending. And although front-loaded consolidations can have positive cred-ibility effects and ease the pain of fiscal adjustment through lower risk premi-ums, they are unlikely to fully offset the short-term adverse impact on economic activity.

Adding to the challenge is the fact that the public sector is not alone in its need to deal with high levels of debt. The previous two chapters highlighted the similar challenges of debt reductions and balance sheet repair that private households ( Chapter 2 ) and corporates ( Chapter 3 ) face. In a situation in which virtually all participants in an economy have to reduce spending and increase saving, the impact on economic activity is even more severe, further complicating the need for deleveraging.

Yet, some of the most successful historical public debt reversals have started under adverse circumstances and provide encouraging examples for the task

The authors would like to thank Ariel Binder, Vizhdan Boranova, and Thomas Dowling for excellent research assistance. The chapter is based on Abbas and others (2013). 1 The terms public debt, sovereign debt, and debt are used interchangeably in this chapter, but all refer to the same concept: gross general government debt recorded at face value, as a share of GDP. For countries for which data on general government debt were not available, central government debt data were used instead.


68 Reducing Public Debt When Growth Is Slow

ahead. 2 Many periods of large and lasting debt reductions started in times of high debt, high interest rates, and low initial rates of growth. Ultimately, supportive external demand and monetary policy helped economic growth and offset the contractionary impact of initial large fiscal adjustments, and typically, reductions in debt-to-GDP ratios have coincided with pick-ups in growth. Because the growth environment is more challenging in the current context, and given that other options for reducing debt are unlikely to provide much support, 3 debt reductions will require an even more sustained commitment to fiscal consolidation and careful design.

The cost to growth could be sizable in the short term and may initially increase the debt ratio because of fiscal multiplier effects. A gradual pace of fiscal adjust-ment will be credible only if embedded in a medium-term fiscal consolidation strategy buttressed by strong budget institutions. Other growth-enhancing mea-sures, such as structural reforms, will be important to improving growth potential in the medium term and to helping reduce the debt ratio durably. Where fiscal accounts are weaker and sovereign interest rates are higher, the pace of adjustment will have to be more ambitious.

The chapter proceeds in five parts. The next section discusses the scale of the problem, which is unprecedented, at least in peacetime. The subsequent section focuses on the economics of debt reversals using several methodologies to decompose changes in debt-to-GDP ratios and explore tradeoffs. The third sec-tion analyzes large debt reversals from the past. The fourth section discusses pol-icy alternatives for supporting fiscal adjustment processes, and the final section concludes.

PUBLIC DEBT IN ADVANCED ECONOMIES: THE SCALE OF THE PROBLEM

Sovereign debt in many advanced economies is approaching historical highs. 4 The median debt-to-GDP ratio in advanced economies rose from about 45 percent at the start of the crisis to about 74 percent by the end of 2012—a level not seen since the years just after World War II ( Figure 4.1 ). 5 The debt-to-GDP ratio at mid-2013 is about 90 percent or higher for many Group of Seven economies and a number of euro area economies ( Table 4.1 ). Debt ratios in these countries are forecast to peak in 2013–14 at levels some 40 percent of GDP higher than their precrisis levels.

2 This is also broadly the conclusion of other papers on this topic. See, for example, IMF (2012b, Chapter 3). 3 The options of privatization and asset sales remain challenging, particularly because the growth outlook is weak and many assets are held by local authorities. Other options, such as reducing debt through higher inflation, may be unavailable and, in any case, would come with their own significant risks. 4 The sample includes 30 advanced economies (see Appendix 4A) and 3 euro area economies not in the advanced economies sample (Cyprus, Luxembourg, and Malta). 5 GDP-weighted averages are higher, increasing from about 60 percent at the start of the crisis to about 100 percent of GDP (IMF, 2013a).


Abbas and others 69

Figure 4.1 Developments in Gross Debt and Structural Balance in Advanced Economies

–6

–4

–2

0

2

4

6

8

0

20

40

60

80

100

120

1945 55 65 75 85

The Great Recession triggered an increase in debtnot seen since after World War II.

After worsening during the crisis,structural balances started to recover.

95 2005

GDP growth, 30 advanced economies(right scale)GDP growth, euro area (right scale)Debt-to-GDP ratio, 30 advanced economies(left scale)Debt-to-GDP ratio, euro area (left scale)

All advanced economiesEuro area

Gross Debt-to-GDP Ratio and Real GDP Growth(percent)

–6

–5

–4

–3

–2

–1

0

2000 02 04 06 08 10 12

Structural Balance(percent of GDP)

Sources: IMF, Historical Public Debt database; IMF, Fiscal Monitor; IMF, World Economic Outlook ; and IMF staff calculations.

TABLE 4.1

Main Macroeconomic Indicators for Selected Advanced Economies (Percent unless otherwise indicated)

2012 2013–18 Average Forecast

Debt (percent

of GDP)

Real Marginal

Interest Rate Inflation Rate

Real Average

Interest Rate ( r )Real Growth

Rate ( g ) r−g

Selected euro area France 90 0.6 1.6 0.6 1.3 –0.7 Germany 82 –0.5 1.7 1.5 1.1 0.4 Ireland 118 4.1 1.6 2.7 2.3 0.3 Italy 127 2.2 1.4 2.9 0.7 2.2 Portugal 124 7.8 1.3 2.1 0.9 1.2 Spain 84 3.4 1.2 2.8 0.2 2.6 Non-euro area G7 Canada 86 0.4 1.9 1.9 2.3 –0.4 Japan 238 0.9 1.8 0.4 1.3 –0.9 United

Kingdom90 –0.2 2.1 1.5 1.7 –0.2

United States 106 –0.3 2.0 1.1 3.0 –1.8

Sources: IMF, World Economic Outlook database (July 2013); and IMF staff calculations. Note: G7 = Group of Seven.

The debt surge reflects the direct effect of the recession as well as other factors. The collapse in revenues caused by the Great Recession has been a key driver of the debt buildups. But other factors also played an important role, including the fiscal stimulus carried out in response to the crisis and financial sector support (e.g., in Iceland and Ireland). Overall, structural balances in advanced economies



worsened by about 4 percent of GDP on average before recovering ( Figure 4.1 , right panel).

High and increasing levels of public debt can lead to higher interest rates and slower growth. Although the idea of precise “debt thresholds” remains under discussion, many studies find that high debt levels have a negative effect on growth (IMF, 2013a). High debt also makes public finances more vulnerable to future shocks, both by constraining the ability of governments to engage in coun-tercyclical policies and by increasing the primary surplus needed to stabilize the debt ratio following an adverse shock to growth or interest rates. Indeed, when debt is high, there is a risk of falling into a bad equilibrium caused by self-fulfilling expectations. The looming surge of age-related spending will complicate the task for countries that have to bring down high debt (IMF, 2013).

Even more important is the diminished outlook for growth. The household, corporate, and financial sector deleveraging that followed the financial crisis has dampened the medium-term growth outlook. 6 Based on World Economic Outlook projections (IMF, 2013b), average output growth in advanced economies will be about 2 percent during 2013–18, significantly below the 3.3 percent growth that the same economies recorded during 1980–2007. Lower growth means not only higher structural deficits as tax revenue weakens and spending plans struggle to adjust to the low-growth environment; it also affects the debt ratio through the denominator (see the next section).

The combination of low growth and high interest rates makes debt reversal particularly challenging for some high-debt countries. When interest rates are high, financing debt becomes more expensive, complicating efforts to reduce debt. The financial crisis has led to sharply higher interest rates for countries with low growth rates facing market pressures (e.g., in the euro area periphery). In other countries perceived as “safe havens,” interest rates have fallen and growth rates have been less weak ( Table 4.1 ). Given the uncertainty surrounding both groups of countries, it is not easy to predict the future path of the interest rate–growth differential, which is what influences debt dynamics.

THE ECONOMICS OF DEBT REVERSALS

First Cut: What Drives the Debt Ratio?

A first look suggests that the primary fiscal balance plays an important role in the debt ratio. Based on a sample of four-year rolling changes in the debt ratios of 27 advanced economies between 1980 and 2011, debt-reduction spells were more frequent during periods with higher primary balances (that is, the fiscal balance excluding interest payments). 7 Similarly, debt increases are more frequent when primary balances are below average. Figure 4.2 (top left panel) shows four-year

6 As mentioned, the previous chapters focus in more detail on deleveraging needs in the household (Chapter 2) and the corporate (Chapter 3) sectors. 7 The sample includes the 30 advanced economies listed in Appendix Table 4A.1, excluding Israel (because of hyperinflation in the 1980s), and Norway and Singapore (because of their particular net asset positions).


Abbas and others 71

changes in the debt-to-GDP ratio conditioned on whether the cumulative primary balance for the period is above (high) or below (low) the country-specific median.

Growth appears to be the other key factor. The historical record confirms that a decline in the debt ratio is more likely when real GDP growth is high. Figure 4.2 (top right panel) shows four-year changes in the debt-to-GDP ratio conditioned on whether growth during the four years is above (high) or below (low) the country-specific median. Other factors, such as inflation, interest rates, and stock-flow

Figure 4.2 Density of Debt Changes Conditional on Macroeconomic Variables

0

5

10

15

20

25

–40 –30 –20 –10 0 10 20 30 40 50 60 70

Fre

quen

cy

0

5

10

15

20

25

Fre

quen

cy

0

5

10

15

20

25

Fre

quen

cy

0

5

10

15

20

25

Fre

quen

cy

Four-year debt ratio change (percent of GDP)–40 –30 –20 –10 0 10 20 30 40 50 60 70

Four-year debt ratio change (percent of GDP)

–40 –30 –20 –10 0 10 20 30 40 50 60 70Four-year debt ratio change (percent of GDP)

–40 –30 –20 –10 0 10 20 30 40 50 60 70Four-year debt ratio change (percent of GDP)

Low four-year primary balanceHigh four-year primary balance

Debt declines are associated with higherprimary balances...

...and higher growth.

Debt dynamics do not differ visibly whether inflationis low or high...

...or whether the real interest rate is low or high.

Low growthHigh growth

Low real interest rateHigh real interest rate

Low inflationHigh inflation

Sources: IMF, World Economic Outlook ; and IMF staff calculations. Note: Each panel shows two densities of debt ratio changes where primary balances, growth rates, rates of inflation, and real interest rates are below (low) or above (high) the country median.



adjustments (SFAs), 8 also affect debt dynamics. However, their impact on the distribution of changes in debt ratios is less clear cut than for fiscal effort and output growth ( Figure 4.2 , bottom panels).

A decomposition of debt-reduction spells using standard debt dynamics seems to confirm these impressions. 9 For all debt-reduction episodes, the combined growth effect (i.e., the sum of the impact of real GDP growth and automatic stabilizers) reduced the debt ratio by 2 percent of GDP annually. By contrast, the structural primary balance contributed to a debt reduction of 3.1 percent of GDP per year. The interest rate bill is another relevant factor: interest expenditure added more than 3 percentage points of GDP annually to the debt stock, on aver-age ( Figure 4.3 ). SFAs and the net impact of inflation played much smaller roles. SFAs were a relatively small factor during debt-reduction spells, increasing the debt ratio by about 1 percentage point, on average. This low impact also holds for inflation, which can lower the debt ratio through higher nominal GDP and tax

8 SFAs reflect the difference between the annual change in gross debt and the budget deficit. They can arise for different reasons, including valuation changes and other transactions that affect debt but not the deficit (such as the privatization or realization of contingent liabilities) (Baum, Poplawski-Ribeiro, and Weber, 2012). 9 Debt-reduction spells are defined as at least four years of declining debt ratios, allowing for one ex-ception year. For example, a period of four years that combines three years of debt reduction with one year when the debt ratio increases up to 2 percentage points will be included in the sample.

Figure 4.3 Contribution to Annual Debt Ratio Reductions (Percent of GDP)

–3.1ppt

–2.0ppt

–1.6ppt

+3.4ppt

+0.9ppt

–2.3ppt

–8

–7

–6

–5

–4

–3

–2

–1

0

Structuralprimarybalance

Growth Inflation Interestexpenditure

Stock-flowadjustment

Total

Inter-quartilerange

Mean

Sources: IMF, World Economic Outlook ; and IMF staff calculations. Note: ppt = percentage point.


A

bb

as a

nd

oth

ers

73

–12

–10

–8

–6

–4

–2

0pe

rcen

t of G

DP

High Growth

2.4 ppt–3.3 ppt

Hig

h R

eal I

nter

est R

ate

28%

–1.2 ppt

–1.4 ppt

0.4 ppt

Percent of all observations

4.1 ppt

–12

–10

–8

–6

–4

–2

0

perc

ent o

f GD

P

Moderate Growth

–12

–10

–8

–6

–4

–2

0

perc

ent o

f GD

P

Low

Rea

l Int

eres

t Rat

e

–12

–10

–8

–6

–4

–2

0

perc

ent o

f GD

P

1.0 ppt

–3.7 ppt

7%

–3.4 ppt

–4.9 ppt

3.2 ppt

8.1 ppt


Growth Inflation Stock flowadjustment

Interestexpenditure

Debt ratiochange


Growth Inflation Stock flowadjustment

Interestexpenditure

Debt ratiochange

–3.4 ppt 3.4 ppt

34%

–2.5 ppt

–1.5 ppt 0.9 ppt

3.4 ppt

1.7 ppt–2.9 ppt

31%

–1.7 ppt

–1.3 ppt 1.1 ppt

3.1 ppt

Figure 4.4 Debt Ratio Changes Conditional on Growth and Interest Rates

Sources: IMF, World Economic Outlook ; and IMF staff calculations. Note: ppt = percentage points. Numbers in ovals indicate proportion of all debt reduction spells that had each combination of growth and interest rates.



revenues and by compressing the real interest rate, but which played a small role empirically. 10

On average, debt reductions tend to be larger when growth rates are high and interest rates are low. Whereas the average annual reduction in debt is 3.4 percent of GDP when growth is high and interest rates are low, it is only 1.7 and 2.4 per-cent of GDP, respectively, when growth is lower or interest rates are higher ( Figure 4.4 ). Fewer debt reversals occurred in a challenging environment of mod-erate growth and high interest rates (7 percent of 127 debt-reduction spells), and the declines were more gradual (1 percent of GDP per year). Periods of high growth are defined as four years of growth greater than 2 percent (allowing for one exceptional year), which is the average projected growth rate for advanced economies from 2013 to 2018; moderate growth is defined as between 0 and 2 percent.

Indeed, fiscal effort is more likely to be successful when growth is stronger. Only 26 percent of all fiscal consolidation spells—defined as a large adjustment in the cyclically adjusted primary balance (CAPB) 11 —were successful in reducing debt levels when growth was below median. When growth was above median, the success rate increased to 41 percent. Here, success is defined as at least a one-year overlap between a consolidation spell and a debt-reduction spell—significant consolidation may eventually lead to a fall in debt, even if there are spells within the consolidation period in which a decline in debt ratios did not occur. There were also fewer attempts to consolidate when growth was below the median—only about one-third of consolidations took place when growth was below the median. 12 This result suggests that the association of higher growth with larger debt reductions, given CAPB improvements described above, goes beyond the simple denominator effect.

THE MECHANICS: GROWTH, FISCAL POLICY, AND INTEREST RATES

Fiscal consolidation and growth are critical to improving the debt ratio, but eco-nomic conditions and fiscal policy interact in complex ways. Changes in the debt-to-GDP ratio can be decomposed into three contributing factors: (1) the interest rate–GDP growth rate differential, (2) the primary balance, and (3) SFAs. These three factors all interact with each other ( Figure 4.5 ).

10 Figure 4.3 separates out the impact of inflation on the denominator in the debt ratio (i.e., disen-tangles nominal GDP growth). However, inflation still affects the numerator through nominal inter-est expenditure, but in the opposite direction. The net impact on the debt ratio is consequently smaller than implied by Figure 4.3, as evidenced by Figure 4.2. 11 As in Abbas and others (2010), consolidation spells are identified by a cumulative improvement in the CAPB of more than 5 percent of GDP, for episodes lasting at least three years. In a given episode, the CAPB should not be reversed by more than 1 percentage point from one year to the next. 12 Similar findings hold when, instead of relying on CAPB changes, consolidation episodes are identi-fied by policy intentions. Abbas and others (2013) provide more detail using the Devries and others (2011) action-based data set of fiscal consolidation.


Abbas and others 75

• Fiscal consolidation improves the primary balance, which directly reduces the amount of funds the government has to borrow, and hence the level of debt.

• However, lower government spending and higher taxes tend to have a nega-tive effect on growth (the fiscal multiplier), which could increase the debt-to-GDP ratio in the short term. 13

• Any change in GDP will, in turn, affect the fiscal deficit through automatic stabilizers, thus eroding some of the fiscal effort. 14 Together with the fiscal multiplier effects, this erosion means that fiscal consolidation may worsen the debt-to-GDP ratio in the short term, if the starting debt levels and fiscal multipliers are high (Eyraud and Weber, 2013).

• As the health of public finances improves, interest rates can drop (e.g., Gia-vazzi and Pagano, 1996; Alesina and Perotti, 1995; Alesina and Ardagna, 2010), further improving the budget balance. 15 Lower interest rates can also affect the economy: if low rates encourage investors and consumers to spend more, GDP will rise and the debt-to-GDP ratio will fall.

Illustrative examples further show the importance of these factors for debt reversals. The underlying model (Abbas and others, 2013) assumes that GDP

13 The size of these effects also depends on various factors. Spilimbergo, Symansky, and Schindler (2009) describe how accommodative monetary policy can increase the multiplier during fiscal expan-sions, while IMF (2010) and Woodford (2011) show how a policy rate close to the zero lower bound can worsen the economic impact of fiscal consolidation. Batini, Callegari, and Melina (2012) and Blanchard and Leigh (2013) highlight the finding that multipliers can be higher in recessions. 14 When growth is accompanied by asset price booms, it can improve both headline and structural balances, complicating the assessment of both fiscal space and stance. 15 If risk premiums respond to debt levels, the effect of consolidation is more ambiguous because a short-term increase in the debt ratio could further exacerbate debt levels through higher yields (Batini, Callegari, and Melina, 2012).

Figure 4.5 Economic Determinants of the Debt Ratio

Direct effect

Direct effect

Automatic stabilizers

Growth, inflation

Multipliers

Consolidation Interestrate

DY

Source: Authors’ illustration. Note: D = debt; Y = output.



evolves in line with long‐term potential growth, abstracting from cyclical forces. Relative to a baseline calibrated according to euro area averages (at end-2012), the speed of any debt reversal resulting from fiscal consolidation in-creases considerably if growth is more buoyant, interest rates are lower, or both ( Figure 4.6 ).

Fiscal policy and growth also interact in the long term. In certain circum-stances, discretionary policy changes can affect long-term potential growth. For example, DeLong and Summers (2012) argue that a process of hysteresis links the short-term cycle to the long-term trend, implying more persistent fiscal policy effects. Such declines in potential growth, in turn, can lead to an unwanted dete-rioration in the structural balance despite the apparent absence of discretionary policy (Mauro and others, 2013).

TRADEOFFS

Faster fiscal adjustment comes with tradeoffs. Front-loading a fiscal consolidation to achieve a given debt reversal within a certain time will have a larger up-front growth cost than would a more gradual approach, because of the multiplier effect. However, the gradual approach requires higher levels of the primary balance later in the period to compensate for the delayed improvement in primary flows ( Figure 4.7 ). 16 State-dependent multipliers in downturns exacerbate the economic cost of the

Figure 4.6 Factors Driving Debt Reversals

40

50

60

70

80

90

100

110

120

t–1 t t+1 t+2 t+3 t+4 t+5 t+6 t+7 t+8 t+9 t+10

Deb

t-to

-GD

P r

atio

BaselineWith fiscal effortWith fiscal effort and higher growthWith fiscal effort, higher growth, and lower interest rate

Assumptions:Baseline real growth: 1.2 percent (excluding dragfrom risk premium). Maturity (average): 7 years.Starting debt-to-GDP ratio: 90 percent.

per 1 percent of GDP adjustment.Credibility effect: 15 basis points

Fiscal multiplier: 1 and persists for 4 years.

Underlying interest rate: 2 percent.

Note: The structural primary balance is adjusted by 2 percent of GDP in year t and 1 percent more in year t + 1. Higher growth and lower interest scenarios, respectively, increase and decrease baseline rates by 1 percentage point.


Abbas and others 77

up-front strategy, if the up-front adjustment were to tip the economy into a reces-sion, whereas potential interest bill gains from credibility effects would lower the needed level of the primary balance. This suggests that short-term pain now must be weighed against the economic and political difficulties of generating higher over-all primary surpluses for a prolonged period. 17

Another tradeoff centers on the multiplier effect and credibility. Although fiscal consolidation comes at the cost of initially lower economic activity, it can help

Figure 4.7 Growth and Primary Balance Paths for Achieving a Given Debt Reduction

–2

–1

0

1

2

3

4

5

6

Primary Balances(percent of GDP)

Up-front adjustment requires a lowerprimary balance...

...but with more pronounced short-term costs(especially if multipliers are state dependent).

–9

–8

–7

–6

–5

–4

–3

–2

–1

0

1

Deviations from Baseline Output Levels(percent)

t–1 t t+1 t+2 t+3 t+4 t+5 t+6 t+7 t+8 t+9 t+10 t–1 t t+1 t+2 t+3 t+4 t+5 t+6 t+7 t+8 t+9 t+10

GradualUp-frontUp-front (state-dependent multiplier)

GradualUp-frontUp-front (state-dependent multiplier)

Assumptions:Baseline real growth: 1.2 percent (excluding drag from riskpremium). Maturity (average): 7 years.Starting debt-to-GDP ratio: 90 percent. Credibility effect: 15 basis points per 1 percent of GDP

adjustment.Fiscal multiplier (regular): 1 and persists for 4 years.

Underlying interest rate: 2 percent.

GDB Fiscal multiplier (state-dependent): 1.5, peaks in t+1and persists for 5 years.

Note: The structural primary balance is adjusted to meet a 60 percent of GDP target by year t+10 under two strategies: gradual adjustment over five years (total adjustment needed is 6 percent of GDP) or up-front adjustment (total adjust-ment needed is 4.8 percent of GDP with regular multiplier and 5.3 percent of GDP with state-dependent multiplier).

16 Under the assumption of a constant multiplier, the cumulative output loss is the same in either sce-nario. When multipliers are state dependent (higher in deep recessions), the output loss from up-front consolidation would be larger. The framework is reasonably robust to variations in key parameters. For example, allowing the fiscal multiplier to vary within a plausible range of 0.2 to 1.5—a range capturing the vast majority of recent research on advanced economies (Mineshima, Poplawski-Ribeiro, and Weber, forthcoming)—does not significantly alter the main findings. 17 See Zeng (forthcoming) for a discussion of the difficulties in sustaining a high primary surplus.



Figure 4.8 Debt Reversals with Credibility Effects

t–1 t t+1 t+2 t+3 t+4 t+5 t+6 t+7 t+8 t+9 t+10 t–1 t t+1 t+2 t+3 t+4 t+5 t+6 t+7 t+8 t+9 t+10

With fiscal effort

With credibility

Baseline

With fiscal effort

With credibility

–3

–2

–1

0

1

2

3

4

Deviations from Baseline Output(percent)

Credibility effects drive higher growth...

100

110

120

130

140

150

160

170

Debt(percent of GDP)

...and faster debt reduction.

Multiplier effect

Assumptions:Baseline real growth: 1.2 percent (excluding drag fromrisk premium).Starting debt-to-GDP ratio: 130 percent(closer to D_max of 170).Fiscal multiplier: 1 and persists for four years.Baseline primary balance: –1.

Underlying interest rate: 2 percent.Maturity (average): 7 years.Credibility effect: 30 basis points per 1 percent ofGDP adjustment.

Note: The structural primary balance is adjusted by 2 percent of GDP in year t and another 1 percent of GDP in year t +1.

reduce sovereign risk premiums. In general, the balance will depend on the urgency of restoring market credibility, as well as on factors such as the size of the output gap, openness, and the simultaneity of the fiscal effort elsewhere (aggregate mul-tipliers are larger for synchronized consolidations because of the weaker offset from external demand). In some cases, excessive front-loading, by undermining social and political cohesion, might hurt rather than help market confidence.

Both the multiplier effect and the credibility effect have important implica-tions for debt dynamics. To illustrate the underlying mechanics, Figure 4.8 shows a modified baseline scenario in which debt dynamics include a stronger risk premium effect from reductions in the debt level given that the starting level of the debt ratio is higher. 18 A fiscal consolidation over two years pushes up the debt ratio because of the multiplier effect, before leading to a gradual reduction in debt levels. The risk premium linked to the degree of fiscal effort is made stron-ger, which generates a larger credibility effect that helps bring down debt more rapidly. 19 The credibility effect assists debt reduction through two channels: lowering the interest bill of the sovereign (direct effect) and stimulating economic

18 Batini, Callegari, and Melina (2012) show that up-front consolidation can worsen the debt level relative to a gradual effort and that this effect is exacerbated if risk premiums are linked to the debt level. In their simulation, multipliers vary according to the cycle.


Abbas and others 79

activity by also lowering private sector borrowing costs (indirect effect through lower output losses) ( Figure 4.8 ).

LARGE DEBT REVERSALS IN THE PAST

Some of the largest debt reversals among advanced economies since 1980 started in difficult economic conditions. The stylized facts and simulation results in the previous sections caution that debt reversals in times of low growth can be diffi-cult but not impossible—a fact also reflected in the past episodes discussed below.

Since 1980, 26 large debt-reduction episodes of varying lengths occurred in 20 advanced economies ( Figure 4.9 , and Appendix 4B). In each of these episodes, the debt-to-GDP ratio declined by more than 5 percentage points, from debt

Figure 4.9 Components of Major Debt Reductions in Advanced Economies Since 1980 (Percent of GDP)

–80

–40

0

40

80

120

160G

RC

200

0–03

(3)

JPN

198

4–91

(7)

AU

T 2

001–

07 (

6)

NLD

200

4–07

(3)

PR

T 1

995–

00 (

5)

DN

K 1

985–

89 (

4)

GB

R 1

986–

91 (

5)

GB

R 1

996–

01 (

5)

NZ

L 19

86–8

8 (2

)

FIN

199

4–02

(8)

US

A 1

993–

00 (

7)

ITA

199

4–03

(9)

ISR

200

4–08

(4)

SW

E 1

985–

90 (

5)

CY

P 2

004–

08 (

4)

CH

E 2

005–

11 (

6)

NLD

199

3–01

(8)

ES

P 1

996–

07 (

11)

ISL

1995

–05

(10)

SW

E 1

996–

08 (

12)

CA

N 1

996–

07 (

11)

NZ

L 19

92–0

7 (1

5)

BE

L 19

93–0

7 (1

4)

DN

K 1

993–

07 (

14)

ISR

198

9–00

(11

)

IRL

1987

–07

(20)

AV

G (

8)

A positive value indicates a debtreduction

Stock-flow residualReal interest rate

Cyclical growth (including cyclical primary balance)Potential growth

Structural primary balance Debt reductionGrowth-interest differential

Sources: IMF, World Economic Outlook ; and IMF staff calculations. * Total contribution of components over entire debt reduction period (length of period in years in parentheses).

19 Conceptually, the fiscal effort can have a larger impact if the risk premium reacts to the fiscal bal-ance. Linking the risk premium to the expected primary deficit (Corsetti and others, 2012), we find that up-front fiscal consolidation is less detrimental to economic activity, and in cases of severe fiscal stress and constrained monetary policy it may even be expansionary.



levels of more than 50 percent of GDP. Notable characteristics include the following:

• Historical background . The majority of the episodes started in the 1990s, reflecting, among other things, growth-supported consolidations in the Anglo-Saxon economies (Ireland, New Zealand, the United Kingdom, and the United States), targeted improvements to public finances in Europe in the run-up to the introduction of the euro, and the large adjustments fol-lowing the Nordic financial crises of the early 1990s.

• Size . The average reduction in debt across these episodes was 26 percent of GDP, from an average starting point (79 percent of GDP) similar to current levels. Out of the 26 episodes, 22 resulted in debt reductions of at least 11 percent of GDP.

• Duration and speed . The average episode spanned eight years, with the short-est one being New Zealand’s in 1986–88, which coincided with double-digit inflation. The longest running one was Ireland’s in 1987–2007, where growth averaged 5.7 percent. The average pace of debt reduction was about 3 percentage points of GDP per year.

Not surprisingly, growth conditions and fiscal consolidation were the main driv-ers behind these large debt reversals. Figure 4.9 shows the major debt-reduction components for the 26 episodes. Although the debt reductions vary by duration (ranging from 3 to 20 years), by size (from 6 to 84 percent of GDP), and by type of economy (large, small, European, and other advanced), the broad pattern is captured by the average bar on the extreme right of the figure. The average con-tribution of the structural primary balance was about equal to the total size of debt reduction. The typical growth–interest rate differential was close to zero (Appendix 4B). The data suggest that high structural primary surpluses occurred during periods of both high and low growth. In fact, to the extent that any cor-relation is visible, it seems that countries generate higher primary surpluses when the economic environment is weaker, perhaps to compensate for low growth ( Figure 4.10 ). However, average growth fell below 2 percent in only 3 of the 26 episodes, which cautions that budget surpluses might have occurred mostly beyond a minimum level of growth. 20

Some of the largest debt reductions were achieved when initial conditions were particularly difficult ( Figure 4.11 ). 21 During the period 1989–2007, seven advanced economies (Austria, Belgium, Denmark, Iceland, Israel, the Netherlands, and New Zealand) managed to achieve debt reductions averaging about 40 percent of GDP, in spite of initially high debt levels (averaging 90 percent of GDP), and zero or modest growth (averaging 0.3 percent). In another important episode—Italy during 1994–2003—debt was reduced by 18 percentage points from 122 percent of GDP, despite economic growth averaging a modest 0.7 percent in the three years before

20 Other than the identified debt-reduction periods, growth remained below the 2 percent threshold in 25 percent of the years since 1980, as compared with 19 percent during debt-reduction episodes. 21 “Initial conditions” refers to the year in which the debt-to-GDP ratio peaked.


Abbas and others 81

22 The averages hide larger individual exchange rate movements. In 24 of the 26 debt-reduction epi-sodes, a depreciation of the real effective exchange rate was observed at some point during the four years preceding the start of the debt reduction, with the depreciation exceeding 10 percent in 16 of them. The average cumulative depreciation of the real effective exchange rate for the 24 episodes was 13 percent, more than half of which was reflected in nominal effective exchange rate adjustments. The nominal effective adjustments, in turn, came by way of both abrupt changes or devaluations (such as in Finland, Ireland, Italy, Portugal, Spain, the United Kingdom, and Sweden—the latter two corre-sponding to the 1992 exit from the European Exchange Rate Mechanism) and more gradual deprecia-tions in the context of floating exchange rates (as in Belgium, Denmark, and the Netherlands).

Figure 4.10 Real GDP Growth, Structural Primary Balance, and Size of Initial Debt (Advanced economies since 1980)

–1

0

1

2

3

4

5

6

7

8

9

10

0 1 2 3 4 5 6 7

Str

uctu

ral p

rimar

y ba

lanc

e (p

erce

nt)

Real GDP growth (percent)

100 percent of GDP

Source: IMF staff calculations. Note: Real GDP growth and primary balance data are calculated as averages observed over the debt reduction period. Size of bubble equals debt to GDP ratios.

the debt reduction and 1½ percent during the debt reduction. These episodes sug-gest that when countries try hard, large debt reversals can be achieved even in low-growth environments.

Despite difficult initial conditions, a number of factors helped bring debt ratios down eventually. In particular, external demand and falling interest rates provided crucial growth support as fiscal consolidation efforts picked up ( Figure 4.12 ):

• External demand conditions improved in the lead-up to debt reductions . The typical episode was characterized by gradual real exchange rate depreciation and rising exports three years before debt ratios began to reverse (year t in Figure 4.12 ). 22 The exchange rate stabilized as debt began to fall, but export value growth remained about 10 percent until t + 2 before moderating.



Figure 4.11 Size of Debt Reduction versus Initial Levels of Key Variables (Advanced economies since 1980)

JPN(84) GRC(00)

AUT(01)NLD(04) PRT(95)DNK (85)

GBR(86)GBR(96)NZL(86)

FIN(94)USA(93) ITA(94)ISR(04)

SWE(85)CYP(04)CHE(05)NLD(93)

ESP(96)ISL(95)SWE(96)

CAN(96)

NZL(92)

BEL(93)

DNK(93)

IRL(87)

0

10

20

30

40

50

60

70

80

90

0 1 2 3 4 5 6 7 8 9

Deb

t red

uctio

n (p

erce

nt o

f GD

P)

0

10

20

30

40

50

60

70

80

90

Deb

t red

uctio

n (p

erce

nt o

f GD

P)

0

10

20

30

40

50

60

70

80

90

Deb

t red

uctio

n (p

erce

nt o

f GD

P)

0

10

20

30

40

50

60

70

80

90

Deb

t red

uctio

n (p

erce

nt o

f GD

P)

Initial real marginal interest rate (percent)

JPN(84)GRC(00)AUT(01)

NLD(04)

PRT(95)DNK (85)GBR(86)GBR(96) NZL(86)

FIN(94) USA(93) ITA(94)ISR(04)

SWE(85) CYP(04)

CHE(05) NLD(93)

ESP(96)

ISL(95) SWE(96)CAN(96)

NZL(92) BEL(93)

DNK(93)ISR(89)

IRL(87)

40 60 80 100 120 140 160Initial debt ratio (percent of GDP)

JPN(84)GRC(00)AUT(01)

NLD(04)

PRT(95)DNK (85) GBR(86)

GBR(96)NZL(86) FIN(94)

USA(93)ITA(94) ISR(04)SWE(85)

CYP(04)CHE(05)

NLD(93)ESP(96)

ISL(95) SWE(96)CAN(96)

NZL(92)

BEL(93)DNK(93) ISR(89)

IRL(87)

–1 0 1 2 3 4 5Initial real GDP growth (percent)

JPN(84)

GRC(00)

AUT(01)NLD(04)

PRT(95)

DNK (85)GBR(86)GBR(96)NZL(86)

FIN(94)

–2 –1 0 1 2 3 4 5 6 7 8 9 10Initial structural primary balance (percent of GDP)

Source: IMF staff calculations. *Year in parentheses refers to the start of the debt reduction period.

• Falling short-term rates suggest supportive monetary policy, leading to a fall in longer-term rates starting in t −2 ahead of the drop in debt ratios. The reduction in Treasury bill rates started as early as t −4 and continued, at a declining rate, throughout the observation period for most episodes. Short-term rates fell from higher levels, which meant that monetary support was uncon-strained by the zero lower bound. Previous analyses, such as IMF (2012b), have also highlighted the importance of supportive monetary policy in reducing high public debt ratios.

• The start of the typical debt-reduction episode coincided with a pick-up in growth . Real GDP growth picked up by almost 2 percentage points in the


Abbas and others 83

Figure 4.12 Evolution of Key Variables through Debt Reduction Episodes (Advanced economies since 1980)

–2

–1

0

1

2

3

4

5

6

7

t−5 t−4 t−3 t−2 t−1 t t+1 t+2 t+3 t+4 t+5 t−5 t−4 t−3 t−2 t−1 t t+1 t+2 t+3 t+4 t+5




Per

cent

of G

DP

Median Structural Primary Balance(25th to 75th percentile region shaded)

0

1

2

3

4

5

6

perc

ent

Median Real GDP Growth(25th to 75th percentile region shaded)

0

2

4

6

8

10

12

14

Per

cent

Median Inflation(25th to 75th percentile region shaded)

–6

–4

–2

0

2

4

6

Per

cent

Median REER Appreciation(25th to 75th percentile region shaded)

–5

0

5

10

15

20

Per

cent

Median Export Value Growth(25th to 75th percentile region shaded)

0

1

2

3

4

5

6

7

8

9

Per

cent

Median Real Long-Term Interest Rate(25th to 75th percentile region shaded)

0

2

4

6

8

10

12

14

16

Per

cent

Median Short-Term Treasury Bill Rate(25th to 75th percentile region shaded)

0

1

2

3

4

5

6

Per

cent

Median Private Consumption Growth(25th to 75th percentile region shaded)

Structural primary balance strengthened... ...and real GDP growth picked up ...

...while inflation was low and continued to declineduring debt reduction episodes.

Some moderate real depreciation took placebefore debt reduction set in...

...while export growth picked up quite strongly,supporting growth.

Real long-term interest rates started to declineahead of the debt reduction episode...

...partly explained by an easing in monetaryconditions, also supporting growth.

Consumption growth picked up in thecourse of the debt reduction episodes.

Source: IMF staff calculations.



first year of falling debt. This pick-up followed the strengthening of the external environment and falling interest rates, and it came with a rapid increase in domestic demand starting in t .

• Fiscal effort strengthened as growth picked up . Although the structural primary balances were positive, on average, in the years preceding the debt peak, they improved significantly in t and continued to strengthen as debt fell.

• Inflation did not contribute to the large debt reversals in the sample. In fact, inflation fell and would have led to increasing debt ratios, all else equal.

An improving growth environment was an important feature of successful debt-reduction experiences. The fact that growth did not decline in the year before the debt peak—a year of relatively strong fiscal consolidation—suggests that sup-portive monetary policy, falling long-term rates, and the healthy external environ-ment likely played a part in reducing the size of the fiscal multiplier. Moreover, the improving outlook for economic activity likely supported the politics of the fiscal effort in that year. 23 Eventually, lower borrowing costs and the rapid pick-up in real private consumption helped drive down debt ratios and also mitigated the impact of the fiscal adjustment that started in t . Structural primary balances peaked four years into debt reduction.

DEALING WITH DEBT WHEN GROWTH IS LOW

Although the advanced economy experience suggests that debt reduction is achievable even under adverse circumstances, the current and expected growth outlook is probably more challenging than in past episodes. In the absence of growth, the burden of adjustment falls on fiscal consolidation and, given mori-bund credit markets, the zero lower bound on nominal interest rates, and the still sizable output gap, the expectation is for fiscal multipliers to be larger than in more normal times. What is the best combination of fiscal, monetary, and struc-tural reform to reduce debt vulnerabilities? What are the options for fiscal policy, and could other approaches, such as inflation and privatization, provide support?

Fiscal Policy

If multipliers are large, getting the pace of fiscal adjustment right is critical. Fiscal consolidation can hurt growth and exacerbate debt levels in the short term; there-fore, if financing allows, adjustment should be conducted at a pace that balances the need to improve structural primary balances against the need to not under-mine the recovery. 24 Excessive delay may also be costly because markets could lose

23 Cottarelli and Jaramillo (2012, p. 7) note that markets have a strong focus on near-term growth prospects, hence, a better growth outlook could also support fiscal adjustment through lower borrow-ing costs. 24 The fact that external demand helped during the debt-reduction episodes analyzed earlier also suggests that international coordination is important. Simultaneous consolidation across many advanced econo-mies tends to amplify the adverse effect on growth, suggesting that fiscal action should be sequenced and coordinated to reduce the size of the fiscal multiplier.


Abbas and others 85

confidence in the government’s commitment to fiscal sustainability and demand higher interest rates. Thus, for many countries with adequate financing space, the safest course of action will be gradual but sustained fiscal consolidation to achieve a certain reduction in the debt level, supported by a prolonged commitment to deliver larger primary surpluses later. However, if sovereign market access is threatened and risk premiums are approaching prohibitive levels, smoothing the required consolidation may not be feasible and establishing credibility through front-loaded adjustment might be needed.

Strong fiscal institutional frameworks can help. Even if countries have fiscal space, the short-term effects on growth of faster consolidation need to be bal-anced against the decrease in risks from lower levels of debt. To avoid the loss in credibility that could come with substituting for adjustment today a promise to adjust tomorrow, the fiscal path should be embedded in a credible fiscal consolidation strategy, buttressed by strong budget institutions (IMF, 2012a, 2013a).

The package of fiscal adjustment measures should aim to mitigate the negative impact on growth. This mitigation can be achieved by shifting resources to bud-get components with higher multipliers. For example, increasing indirect taxes and reducing direct taxes—the so-called fiscal devaluation—can provide support to labor demand and improve the trade balance. On the expenditure side, cutting the least productive current spending is likely to have a smaller detrimental effect on growth than cutting investment or support for the most vulnerable citizens.

Monetary Policy

In an environment of public sector deleveraging, monetary policy should remain accommodative, with due regard for country conditions. With fiscal consolida-tion acting as a drag on growth, monetary stimulus needs to be kept in place, especially in countries in which the output gap remains large. This means keeping policy rates at low levels and maintaining ample liquidity, subject to inflationary expectations remaining well anchored. If downside risks materialize, further rate reductions should be considered, if possible, along with additional unconven-tional measures, especially in economies in which policy rates are near the zero lower bound. Broken monetary policy transmission mechanisms caused, for in-stance, by a weak banking system, should be addressed.

Privatization

In the past, the privatization of public assets has figured prominently in debt-reduction strategies, including in IMF-supported programs. Privatization can help lower public debt through two channels. First, if properly executed, privatization may help boost overall productivity, raising potential growth and thus helping debt dynamics. Second, privatization can affect the SFA factor in public debt dynamics if proceeds from the privatization are used to pay down debt and reduce interest expenditure. In the past, proceeds from privatization have been sizable in advanced economies. For instance, Portugal collected about 16 percent of GDP in privatization revenue during 1996–2000; Italy collected



7 percent during 1997–2001; and Greece and Spain each collected about 6 per-cent during four-year periods. At the same time, the revenue loss arising from the sale of those assets would also have to be considered to assess the longer-term impact on public finances.

Is selling additional government assets an option in the future? Public fi-nancial assets are still large in advanced economies (more than 40 percentage points of GDP, on average, half of that in the form of shares and other equity. However, reliance on privatization for debt-reduction purposes requires careful planning and realism. Most equity holdings are in the hands of sub - national governments that may lack the incentive to sell assets, for example, because of their relatively low levels of debt. The majority of public nonfinan-cial assets (such as land and buildings) are also owned by regional and local governments and may be difficult to monetize. Moreover, in the economic climate of 2013, asset liquidation may not yield the same revenue as it has in the past. In addition, only a very small share of nonfinancial assets is consid-ered by the authorities to be “salable” (see IMF, 2013, for a discussion on privatization).

Inflation

In principle, higher inflation could help reduce public debt. 25 Inflation can affect the primary balance, for example, if income brackets are not indexed under a progressive income tax. Governments can also capture real resources by base money creation, but the scope for raising seigniorage is limited by the small size of base money. The largest impact inflation could have would be from eroding the real value of debt. Assuming a constant debt maturity structure, no impact of inflation on economic growth, and a one-for-one adjustment of nominal interest rates on newly issued debt to inflation (full Fisher effect), simulations for Group of Seven countries suggest that a hypothetical increase in inflation from World Economic Outlook baseline levels to 6 percent for five years would reduce the aver-age net debt ratio by less than 10 percentage points by the end of the period, for most countries. The effect drops rapidly after five years because an increasingly large share of securities will have been issued at higher interest rates. This result is consistent with the empirical finding that inflation has not been a significant contributor to past debt reversals.

However, higher inflation would be accompanied by significant challenges and risks. As a practical matter, it might be difficult to raise inflation to a meaningful level in the current economic environment, as evidenced by Japan’s experience in the past few decades. More important, reliance on inflation to erode debt could lead to fiscal dominance, with inflation rates drifting even higher as confidence in the future value of money is lost. As a result, inflation expectations could become unanchored, thus undermining the credibility of the monetary frameworks built

25 This section is based on Akitoby, Komatsuzaki, and Binder (forthcoming).


Abbas and others 87

since 1980—often at significant economic cost (IMF, 2013)—to control infla-tion. Unanchored inflation expectations could reduce the demand for debt of longer tenor, further eroding any upside from higher inflation, which could ulti-mately reduce economic growth.

Structural Reforms to Raise Longer-Term Growth

Structural reforms can increase growth and help reduce debt ratios in the longer term. Barkbu, Rahman, and Valdés (2012) survey the large empirical literature and conclude that there is substantial evidence that structural reforms can increase growth. Their simulations using the IMF’s Global Integrated Monetary and Fiscal model show that a combination of large-scale labor, product market, and pension reforms that halve the distance of all euro area countries from best-practice bench-marks can increase GDP by 4 ⅓2 percent during a five-year horizon. However, the beneficial growth effects of structural reforms tend to accumulate slowly. Mean-while, a lack of short-term demand support—be it monetary or fiscal—can have long-term effects in the opposite direction, for example, through hysteresis in the labor market. To be successful, structural reforms will also have to be granular, targeting particular weaknesses. In the European example, targeted reforms would include, among other things, tackling labor market dualism and weak competi-tiveness in the south and obstacles to higher labor participation and a more vi-brant services sector in the north. 26

CONCLUSION

Many advanced economies face significant challenges in reducing their public debt levels. Although public debt is approaching secular highs, the continued weak medium-term growth outlook complicates the task of putting debt on a clearly declining path. Also, monetary policy is operating at or close to the lower bound and at the same time, there is little to be gained from higher rates of infla-tion (which would come with risks) or ambitious privatization efforts (which could prove difficult in the current environment). This combination of factors suggests that the burden of lowering debt levels will fall more squarely on fiscal consolidation.

Successful past debt reversals in advanced economies often began under adverse circumstances. Output growth and fiscal policy were the main drivers behind 26 past successful episodes of public debt reduction. Although some past successful episodes started under challenging initial conditions, strong external demand and an accommodative interest rate environment supported output growth as fiscal consolidation efforts continued.

26 Many of these issues are touched upon in more detail in other chapters in this book: Chapters 7 and 8 discuss the impact of structural reforms and the importance of “granularity,” respectively, while Chapters 5 and 6 consider the labor market challenges and policy issues in different European economies.



The current and expected growth environments, however, might make suc-cessful debt reversal even harder to achieve. As a consequence, debt reductions will require both a sustained commitment to fiscal consolidation and careful design. Fiscal consolidation is needed to keep public finances sustainable, but it also diminishes demand and further lowers growth in the short term because of fiscal multiplier effects. Initially, the debt ratio may actually increase. Up-front consolidations, although sometimes unavoidable, can lead to greater output losses than would gradual efforts, but they can also reduce risk premiums more quickly, especially if debt levels are high initially and the overall magnitude of the needed adjustment is relatively large. Whether front- or back-loaded con-solidations lead to more lasting success also depends on political factors, such as the ability to sustain a commitment to consolidation. In any case, positive cred-ibility effects are likely to provide only partial offsets to short-term pain.

What should policymakers do? For countries with good financial market ac-cess, the answer is to consolidate gradually but with a credible medium-term strategy, buttressed by strong budget institutions. This approach will minimize the adverse impact on growth, particularly if multipliers vary over time. In coun-tries in which fiscal accounts are weaker and sovereign borrowing rates are higher, the pace of consolidation has to be more ambitious. In all cases, it makes good sense to plan the adjustment path in structural terms to avoid the procyclical tightening that can accompany a focus on headline deficits. This can be achieved by, for example, focusing on a set of agreed-upon fiscal measures that take into account the need to protect the most vulnerable citizens and safeguard spending programs with strong positive growth effects (e.g., high-return infrastructure projects or key active labor market policies).

In the medium term, success will be much more likely if consolidation efforts are accompanied by ambitious structural reforms. Growth-enhancing measures, such as selected structural reforms (in particular, in product and labor markets), are important for improving growth potential in the medium term, for mitigating the adverse growth impact from continued fiscal consolidation, and for helping reduce the debt-to-GDP ratio in a durable way. The remainder of this book touches on many dimensions of these medium-term challenges.


Abbas and others 89

APPENDIX TABLE 4A

Euro Area Advanced

Full Sample Main Episodes

Economics of Debt

Reversals

Large Debt Reversals in

the Past

Australia * *Austria * * * *Belgium * * * *Canada * * *Cyprus * *Czech Republic * *Denmark * * *Estonia * * *Finland * * * *France * * *Germany * * *Greece * * * *Hong Kong SAR

* *

Iceland * * *Ireland * * * *Israel * *Italy * * * *Japan * * *Korea * *Luxembourg *Malta *Netherlands * * * *New Zealand * * *Norway *Portugal * * * *Singapore *Slovak Republic

* * *

Slovenia * * *Spain * * * *Sweden * * *Switzerland * * *United Kingdom * * *United States * * *

Source: IMF staff.

APPENDIX 4A. COUNTRY SAMPLES USED IN THE ANALYSES


90

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du

cing

Pu

blic D

eb

t Wh

en

Gro

wth

Is Slo

w

APPENDIX 4B . MAJOR DEBT-REDUCTION EPISODES IN ADVANCED ECONOMIES SINCE 1980 APPENDIX TABLE 4B

Episode

Length

(years)

Debt

Reduction

(percent of

GDP)

(from to)

Speed of Debt

Reduction

(percentage

points of GDP

per year)

Average Level Observed over Episode (percentage points)

Structural

Primary Balance

(percentage

points of GDP)

Interest

Rate–Growth

Differential

Real

Effective

Interest

Rate

Real GDP

Growth

Rate

Nominal

Effective

Interest Rate

CPI

Inflation

Greece 2000–03 3 6 (104 98) 2.0 0.9 −2.6 2.0 4.5 5.6 3.5Japan 1984–91 7 6 (74 67) 0.9 4.2 −2.4 2.9 5.4 5.3 2.3Austria 2001–07 6 7 (67 60) 1.1 0.9 0.3 2.8 2.5 4.7 1.8Netherlands 2004–07 3 7 (52 45) 2.4 2.0 −0.6 3.0 3.1 4.6 1.6Portugal 1995–2000 5 11 (59 48) 2.1 0.1 −0.2 4.0 4.2 6.5 2.4Denmark 1985–89 4 12 (68 57) 3.0 8.5 6.8 8.7 1.4 12.5 3.5United Kingdom 1986–91 5 12 (50 38) 2.5 1.7 0.2 2.9 2.7 8.7 5.7United Kingdom 1996–2001 5 14 (51 38) 2.7 3.6 1.6 5.1 3.5 6.6 1.3New Zealand 1986–88 2 14 (72 58) 6.9 1.1 −6.3 −5.3 1.0 5.2 11.1Finland 1994–2002 8 16 (58 41) 2.0 4.4 0.8 4.8 4.0 6.6 1.7United States 1993–2000 7 17 (72 55) 2.5 2.0 −2.0 2.1 4.0 4.6 2.5Italy 1994–2003 9 18 (122 104) 2.0 4.3 2.3 3.9 1.6 6.8 2.8ISR 2004–08 4 21 (98 77) 5.1 1.5 −1.0 3.0 5.1 5.2 2.1Sweden 1985–90 5 21 (61 40) 4.2 3.2 0.7 3.3 2.6 9.7 6.2Cyprus 2004–08 4 23 (72 49) 5.7 4.4 −3.2 2.3 4.2 5.0 2.7Czech Republic 2005–11 6 25 (72 47) 4.2 1.8 −1.2 1.0 2.1 1.7 0.8Netherlands 1993–2001 8 28 (78 51) 3.5 2.7 0.8 4.4 3.5 6.8 2.4Spain 1996–2007 11 31 (67 36) 2.8 2.1 −1.7 2.1 3.8 5.1 2.9Israel 1995–2005 10 34 (59 25) 3.4 3.2 −1.2 3.4 4.6 7.0 3.5Sweden 1996–2008 12 34 (73 39) 2.9 3.3 0.5 3.6 3.0 5.0 1.3


A

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as a

nd

oth

ers

91

Canada 1996–2007 11 35 (102 67) 3.2 6.7 1.8 5.1 3.3 7.3 2.1New Zealand 1992–2007 15 45 (62 17) 3.0 4.2 1.2 4.8 3.6 7.1 2.1Belgium 1993–2007 14 50 (134 84) 3.6 4.9 1.4 3.8 2.4 5.7 1.8Denmark 1993–2007 14 53 (80 28) 3.8 4.2 2.0 4.5 2.4 6.6 2.0Israel 1989–2000 11 53 (147 84) 4.8 0.7 −11.3 −4.0 5.9 5.9 10.3Ireland 1987–2007 20 84 (109 25) 4.2 3.6 −3.1 2.7 5.7 5.6 2.9Simple average 8 26 (79 53) 3.2 3.1 −0.6 3.0 3.5 6.2 3.2Median 7 25 (72 49) 3.0 3.0 0.0 3.0 4.0 6.0 2.0

Source: IMF staff calculations. Note: CPI = consumer price index.



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PART II

Laying the Foundations for Jobs and Growth




97

CHAPTER 5

What Do Past Reforms Tell Us about Fostering Job Creation in Western Europe?

CRISTINA CHEPTEA, JAIME GUAJARDO, IOANNIS HALIKIAS, EMILIA JURZYK, HUIDAN LIN, LUSINE LUSINYAN, AND ANTONIO SPILIMBERGO

SHOCKS AND LONG-STANDING REFORM GAPS

Between 2007 and 2012, Western Europe lost about 4 million jobs. Unemploy-ment, youth and long-term unemployment in particular, reached unprecedented levels, especially in the euro area periphery. However, the effect of the crisis dif-fered across countries, with only some experiencing very large surges in unem-ployment. To a great extent, these unprecedented unemployment levels can be understood through the prism of cyclical adjustment and as a reflection of the deleveraging needs in many sectors, as discussed in Chapter 3 : faced with having to repair their balance sheet exposures and restore profitability, many firms re-sorted to reducing their wage bills, often through employment reductions. This chapter complements that analysis by taking a longer, more structural view of labor market performance in Western Europe. 1 Its main conclusion is that recent labor market outcomes were also significantly influenced by structural policies undertaken in the past 20 years and the way these policies interacted with institu-tions and longer-term or structural shocks.

The past two decades presented European economies with two main changes in the economic environment: the information and communication technology (ICT) revolution and globalization. Many European countries’ delays in adopting new technologies left them vulnerable to increased competition from emerging market countries. Inflexible labor market institutions became an important im-pediment to allocating labor efficiently given that these two global shocks created the need for vast labor reallocation across sectors, which, in turn, required more flexible labor markets, especially as concurrent euro adoption meant that nominal wage increases could no longer be accommodated by nominal exchange rate ad-justments. The next section discusses in a cross-country context how these shocks interacted with preexisting institutions and their implications for labor market

1Chapter 6 focuses on labor market experiences in the Balkan economies.


98 What Do Past Reforms Tell Us about Fostering Job Creation in Western Europe?

outcomes, in light of findings from the literature. The subsequent section describes the policy responses to these challenges and the labor market implica-tions of different policy choices. It is followed by a section that discusses indi-vidual country experiences, in particular those in Germany, Italy, and Spain.

DIAGNOSIS—INTERACTION OF SHOCKS AND INSTITUTIONS

Two Structural Shocks and the Euro

In the late 1990s, the United States experienced high levels of investment in rapidly advancing ICT, followed by strong productivity growth in the services sector early in the first decade of the 2000s ( Jorgenson, Ho, and Stiroh, 2005). In contrast, during the same period the European Union (EU) economies registered, on aver-age, a significant productivity slowdown. As a result, the productivity gap between the two began widening about 1995 ( Figure 5.1 ). The EU productivity slowdown was largely due to slower multifactor productivity growth in services, particularly in trade, finance, and business services (van Ark, O’Mahony, and Timmer, 2008).

Some EU countries also faced strong competition from emerging markets because globalization resulted in the entry of major exporters into the world market and in large flows of foreign direct investment. On the trade side, in-creased competition came mainly from the EU’s enlargement via Eastern Europe and from China’s entry into the global supply chain.

At the same time, adoption of the euro limited member countries’ ability to accommodate nominal wage increases by devaluation—any real exchange rate adjustment had to fall on relative prices, reflected in the correlation between

Figure 5.1 Labor Productivity per Hour Worked (Index, 1995=100)

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1970 75 80 85 90 95 2000 05

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EU-15

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Source: EU KLEMS database. Note: EU-15 comprises Austria, Belgium, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal, Spain, Sweden, and the United Kingdom.


Cheptea and others 99

wages and the nominal effective exchange rate, which turned from strongly nega-tive in the pre-euro era to insignificant after its adoption ( Figure 5.2 ).

Economic and Monetary Union (EMU) also created expectations that the periphery economies, on the back of a rapid decline in borrowing costs and abun-dant global liquidity, would catch up with higher-income EMU countries, which led to large foreign capital inflows to the periphery. However, the bulk of the in-flows financed consumption and investment that yielded low returns, particularly in the nontradables sector, with limited impact on potential growth. Additionally, real appreciation following euro adoption favored nontradables and reduced ex-port competitiveness, limiting the pace of convergence for some countries, relative to others in the EU ( Figure 5.3 ).

Figure 5.2 Correlation between Wages and Nominal Effective Exchange Rate (NEER) (Annual percent change)

AUTBEL

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Source: OECD database.

Figure 5.3 Convergence Growth in European Union

AUTBEL

BGR

CYP

CZE

DNK

FIN

EST

FRADEUGRC

HUN IRL

ITA

LVA

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LUX

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Sources: AMECO database; and IMF staff estimates.



Structural Shocks and Institutions Interact

Although not the only impediment, the existing labor market institutions proved inadequate for coping with the ICT revolution, delaying new technology adoption and improvement in productivity growth, and potentially contributing to lower investment in human capital. 2 Slow productivity growth also left many European countries vulnerable to competition from non-European emerging markets, with existing institutions hampering the needed labor reallocation across sectors. 3 These hindrances had implications for employment, unemployment, and wages.

High unemployment and long unemployment duration

Relatively strict employment protection legislation (EPL) in much of Europe adversely affected labor market outcomes. Although its impact on unemployment is theoretically and empirically ambiguous because it tends to lower both entry into and exit from employment, high EPL increased average unemployment du-rations and gave rise to dual labor systems in many economies. 4 Because employ-ment protection was higher for workers on permanent contracts, firms shifted hiring toward more temporary workers, 5 especially affecting the young and the low skilled and making them more vulnerable to employment losses, particularly in downturns. Firms also had less incentive to train temporary workers, limiting human capital accumulation and longer-term growth.

Generous unemployment benefits are also thought to increase the level and duration of unemployment by raising reservation wages. By protecting labor market insiders from the risk of income loss, unemployment benefits reduce the sensitivity of wages to general economic conditions, thereby preventing a swift adjustment in the aftermath of shocks (Blanchard and Wolfers, 2000).

Moreover, wage-setting institutions in several Western European countries made wages less responsive to the productivity slowdown, often forcing adjust-ment through employment. 6 Theory suggests a hump-shaped relationship between unemployment and the degree of centralization and coordination of wage bargain-ing: both full decentralization and full centralization lead to lower unemployment rates, while an intermediate level of coordination yields the worst labor market outcome (Calmfors and Driffill, 1988). Intermediate systems are characteristic of many Western European economies.

2See Colecchia and Schreyerb (2002) on how ICT adoption increases productivity growth and Chap-ter 7 of this book on how structural reforms could boost productivity growth. 3This chapter complements Blanchard (2005) by introducing two recent shocks and studying the interaction of these shocks and labor institutions. 4Blanchard, Jaumotte, and Loungani (2013) discuss in more detail how high employment protection and generous unemployment benefits could hamper the reallocation of workers to jobs, a reallocation that is needed to sustain growth (micro flexibility). 5See OECD, 2006; Betcherman, 2012; Bentolila and Dolado, 1994; Blanchard and Landier, 2002; Cahuc and Postel-Vinay, 2002; Dolado, García-Serrano, and Jimeno, 2002; Jaumotte, 2011; and Nunziata and Staffolani, 2007 6Blanchard, Jaumotte, and Loungani (2013) also discuss in more detail how certain types of bargain-ing systems can hamper an economy’s ability to adjust to macroeconomic shocks (macro flexibility).



High unit labor cost

Some features of European labor market institutions may constrain productivity through more than one channel. First, they may dampen firms’ incentives to in-novate and grow (Braguinsky, Branstetter, and Regateiro, 2011). Second, strong EPL could interfere with optimal labor reallocation across sectors (OECD, 2010; Betcherman, 2012; Martin and Scarpetta, 2012). Third, high unemployment benefits can hinder optimal matching, for example, by discouraging the low-skilled from accepting productive jobs (OECD, 2007). 7

In addition to affecting export competitiveness directly, the initially higher unit labor cost (ULC) in the EA periphery relative to Eastern European newcom-ers to the EU may have prevented early entry into the global supply chain. The experience of successful Eastern European countries suggests that attracting up-stream producers or hubs that will locate a part of their downstream production in these countries can be helpful for economic performance: over time, this action created a virtuous circle whereby domestic value added increased hand in hand with foreign value added, enhancing the role of exports in growth and encourag-ing new technology adoption (see Chapter 10 in this book).

POLICY RESPONSES AND LABOR MARKET OUTCOMES

Similar Global Shocks but Different

Domestic Policy Responses

Overall, technology and globalization shocks have resulted in a substantial and steady decline in the relative demand for low-skilled labor in most countries. However, policymakers responded differently to these changes. The United States relied mainly on wage flexibility to absorb these structural shocks, resulting in strong employment growth, but also a widening wage–skill gap. By contrast, many continental European countries made more use of redistributive (typically wage-compressing) institutions—including EPL, unemployment insurance (UI) systems, and early retirement—to limit income inequality, but at the cost of lower employment (Bertola, 1999; and Layard and Nickell, 1999).

Although capturing general trends, this characterization masks important in-stitutional asymmetries among European countries. Esping-Andersen (1990) di-vides European labor markets into four broad models:

• Anglo-Saxon countries, featuring limited government intervention, weak unions, decentralized bargaining allowing for substantial wage dispersion, low labor taxes, and employment-linked social benefits and active labor market (ALM) policies.

• Continental European countries, featuring strong unions and centralized bargaining, high labor taxes, generous UI, and, in some cases, strong EPL.

7However, it should be noted that very low unemployment benefits may also hinder optimal matching because many unemployed have to leap at the first offer.



• Mediterranean countries, relying heavily on stringent EPL and centralized bargaining, but offering low UI and limited ALM policies.

• Scandinavian countries, relying more on UI rather than EPL to address unemployment risk, and also featuring high labor taxes, strong unions, and compressed wage structures.

This taxonomy remains broadly relevant today, with the notable exception of recent developments in wage dispersion and UI replacement rates for the Medi-terranean country group ( Figure 5.4 ). 8

Figure 5.4 Evolution of Labor Institutional Arrangements

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1980s1990s2000s

1980s1990s2000s

Source: Aleksynska and Schindler (2011).

8Although the broad labor market taxonomy proposed by Esping-Andersen (1990) remains instruc-tive, a finer gradation could be devised, for example, based on differences in EPL across workers or on different durations of unemployment benefit eligibility.



Partial Reform and Duality—Analytical Issues

An assessment of partial reforms requires taking a general equilibrium perspective with a focus on the impact on labor wedges of long-term changes in job creation and destruction rates. 9 To provide a perspective on the analytics, the general equi-librium effects of certain market policies studied by Boeri (2011), holding other policies unchanged, are summarized here:

• Increase in unemployment benefits (UB). This reform’s short- and long-term effects are in the same direction. Higher UBs increase workers’ reservation wages and, in the medium term, the job separation rate, and lower the job-finding rate, unambiguously raising unemployment and average wages.

• Increase in firing taxes (EPL). On impact, EPL lowers the job destruction rate (by maintaining lower-productivity matches) and increases wages (through a stronger employee bargaining position). In the longer term, however, a tighter labor market could offset these effects, depending on ALM policies and the generosity of UB. The overall impact on unemploy-ment and wages is thus ambiguous, entailing both lower job-loss and job-finding probabilities, potentially even reversing the short-term effects.

• Increase in employment-conditional incentives (ALM). On impact, these in-centives decrease wages at the low end and reduce unemployment. Long-term effects include a lower productivity threshold at which matches can be maintained and longer average job duration, unambiguously reinforcing the partial equilibrium effects. The overall result is lower unemployment and lower average wages, with the effects being larger in the long term (higher job-finding rate combined with lower job-loss probability). 10

• Increase in activation programs (ALM). The short-term effects are similar to the ALM scheme discussed above because lower recruitment costs raise the vacancy-to-unemployment ratio. Longer-term effects are in the opposite direction, however, because lower turnover costs lead to job destruction at a higher productivity threshold. The overall impact includes both higher job-finding and job-loss rates, with an ambiguous effect on unemployment and wages, possibly reversing the partial equilibrium effect.

A comprehensive reform strategy necessary to support employment would generally extend beyond the labor market sphere. Therefore, addressing features of the broader tax and welfare system may also be crucial. High marginal tax rates and social welfare systems with high replacement rates could generate ad-ditional “second-best” issues, entailing supply constraints, demand constraints, or both, in specific segments of the labor market even if substantial labor mar-ket liberalization has already been achieved. For instance, reforms that focus

9Search models by Mortensen and Pissarides (1999), Blanchard and Diamond (1989), and Boeri (2011) formalize these insights. 10However, this analysis does not internalize the government’s budget constraint: higher distortionary taxes to finance the employment subsidy would partly offset the beneficial labor market impact.



only on reducing wages at the low-skill end would not appreciably improve labor market performance to the extent that high marginal tax rates or welfare benefit replacement rates for this segment of the labor market keep reservation wages high. These factors appear especially relevant in the current context be-cause the low-skilled are also the main victims of the recent ICT and globaliza-tion shocks.

Implications of labor market duality

Given the asymmetric impact of the ICT and globalization shocks, some govern-ments opted for separate institutional regimes for low-skilled workers, typically in the form of temporary contracts exempted from regulations applying to regular contracts. Duality can affect labor market outcomes in two broad ways: (1) indi-rectly through interaction with labor market and fiscal reforms and (2) directly by affecting employment volatility over the cycle and by altering the stabilizing properties of the social safety net. Asymmetric labor market reforms in a dual setting can have a profoundly different impact on labor market outcomes com-pared with the homogeneous case. To illustrate, three of the reforms discussed above are examined, drawing again on Boeri (2011):

• Increase in UB. If applied only to regular jobs, the impact on job destruction remains as above. However, with a different regime now available for entry jobs under temporary contracts, the job creation rate is unaffected. The end result is still an increase in unemployment, but lower than in the homoge-neous case, and a larger skill wage premium on continuing jobs.

• Increase in firing taxes (EPL). If applied only to regular jobs, increased fir-ing taxes would increase the wage tenure profile and the share of employ-ment in entry jobs, exacerbating duality—because the rate of conversion of temporary into regular contracts falls and the average duration of continuing jobs increases. Compared with the homogeneous case, duality is accompanied by less ambiguity, that is, unemployment is more likely to decline.

• Increase in employment subsidies for entry jobs (ALM). This reform does not affect the job-destruction rate for permanent contracts, but increases the job-finding rate and job-destruction rate for temporary contracts because the rate of conversion of temporary into regular contracts declines. This suggests increased ambiguity about the reform’s impact under duality com-pared with the homogeneous case—under duality, employment subsidies could end up raising unemployment.

The implications of duality for incorporating reform of the tax and benefit systems into a comprehensive reform strategy appear more straightforward. In the face of recent shocks, the rationale for introducing temporary contracts has been to support employment at the low-skill end of the labor market. This is the segment in which high marginal tax rates and welfare benefit replacement rates are likely to keep reservation wages high, making fiscal reform all the more urgent.



Transitional dynamics of labor market outcomes

Transition to the long-term equilibrium can be a protracted process. When low-EPL temporary contracts are introduced alongside regular contracts with prohibitively strict EPL, the long-term equilibrium would require a “corner solution,” with all employment under temporary contracts (with permanent contracts disappearing via attrition), and no long-term employment gains. In the transition, however, employers can take advantage of the low-EPL regime at the start of the reform to boost employment in good times, even though the long-term equilibrium would look very different—a pattern that Boeri and Garibaldi (2007) term the “honeymoon effect.” There is a fundamental asym-metry here because there would be no scope to exploit the more flexible con-tract regime in bad times.

Beyond its impact via interaction with reforms, duality can affect labor market outcomes (and other macro variables) more directly:

• Given the level of EPL for permanent contracts, a higher degree of duality (that is, a higher share of temporary contracts) would mean a higher elastic-ity of employment to output, and hence higher volatility of employment over the cycle; this is the flip side of the honeymoon effect.

• Given more generous UI for workers under permanent contracts, a higher degree of duality would mean reduced coverage of income support schemes for job losers, implying smaller automatic stabilizers and leading to addi-tional output and employment volatility over the cycle.

Precrisis Reforms and Labor Market Outcomes

Against this background, three cases of comprehensive reforms stand out among advanced European countries: the early efforts by the United Kingdom and the Netherlands, and the more recent German reforms:

• The U.K. reform effort spanned the early 1980s to the mid-1990s. The initial emphasis was on fostering decentralized wage bargaining in the direc-tion of wage moderation, flexibility, and differentiation. Supporting policies included reductions in marginal tax rates, especially at the low end with the introduction of a negative income tax, and reductions in both the level and duration of UB. Later stages of the reform focused on further improving incentives, with emphasis on making social benefits conditional on employment—the “welfare-to-work” program.

• The Netherlands reforms covered approximately the same period. A wage moderation agreement in the early 1980s was supplemented by major labor market and fiscal reforms. Fiscal consolidation provided room for a steady reduction in labor taxes, and sharp reductions in benefit replacement rates, particularly disability benefits, eased supply-side constraints. Moreover, EPL was significantly loosened, and a separate youth minimum wage was set at one-fifth of the national minimum wage.

• The “Hartz reforms” in Germany are discussed in greater detail below.



In other EU countries, the reform record is more mixed. Although the total number of recorded instances of reforms during the period 1980–2007, at 868, was quite large, they can be generally described as fragmentary, incremental, and pursuing mixed objectives 11 (Aleksynska and Schindler, 2011):

• In most cases, reforms covered limited aspects of labor market institutions: 85 percent of the recorded reforms relate to a single area.

• The vast majority of recorded reforms (slightly fewer than 90 percent on EPL and more than 90 percent on UB) were incremental in magnitude, rather than discrete, and are unlikely to have made a discernible impact on labor market institutions. 12

• Implemented reforms were often internally inconsistent, as illustrated by their impact on the wedge between the marginal product of labor and its opportunity cost. Although the implemented ALM reforms were predomi-nantly in the direction of reducing the wedge, reforms in EPL, UB, and early retirement were split almost 50–50 between wedge-reducing and wedge-increasing. UB reforms in particular substantially raised replacement rates in France, Switzerland, and three of the four Mediterranean countries (Italy, Portugal, and Spain)—for the latter group, undermining the effec-tiveness of a moderate loosening of EPL.

• Reforms strengthened duality in some cases. Among implemented reforms, “large” reforms tended to be predominantly “two-tier” (geared only to spe-cific segments of the population); moreover, two-tier reforms tended to make up large shares of each reform category—ranging from 45 percent of UB reforms to 75 percent of early retirement reforms. Regarding the inter-action of reforms with preexisting institutional asymmetries, four two-tier reforms out of five actually widened asymmetries in regulatory regimes, thereby strengthening duality (Boeri, 2011). 13

Cross-country comparisons suggest that comprehensive reform carries sub-stantial benefits. Following their reforms, Germany, the Netherlands, and the United Kingdom performed better than most other EU countries in unemploy-ment ( Figure 5.5 ) and labor force participation ( Figure 5.6 )—and the impact of reforms seems to materialize fairly quickly.

Regarding reforms reinforcing duality, employment typically surged after the introduction or extension of temporary contract regimes, consistent with a hon-eymoon effect. However, the expansion of dual regimes increased labor market turnover and employment volatility, even under a favorable macroeconomic

11There is, however, an inherent arbitrariness in how reforms are measured. For example, should a reform package consisting of lower tax rates and lower UBs be counted as one reform or two? 12EPL is an example: although 199 reforms were recorded, only three countries (Germany, the Neth-erlands, and the United Kingdom) registered a change in EPL score between 1980 and 2007. 13These concerns are particularly relevant for countries such as Italy and Spain, where the scope of temporary contracts has been expanded substantially.



environment: during the period 2004–08, the transition probability from em-ployment to unemployment was much higher for temporary than for regular contracts, ranging from 5 to 25 times across euro area countries (ECB, 2012).

Postcrisis Experience in the Euro Area

The financial crisis caused marked divergence in labor market performance in the EA. Employment losses ranged from −0.4 percent to −16 percent (peak to trough) across EA countries ( Figure 5.7 )—a degree of divergence far exceeding cross-country differences in output losses. The sectoral composition of the economy (particularly the shares of industry, finance, and construction), as well as workforce age composition and human capital, carry explanatory power for employment dy-namics (ECB, 2012). But differences in employment performance across countries also reflected differences in institutional structures and structural reform paths.

Figure 5.5 Unemployment Rate (Percent)

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25

AUTNLD LU

XDEU

USADNK

BELGBR

FINSW

DIT

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EU15PRT

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Figure 5.6 Labor Force Participation Rate (Percent)

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In the periphery, where capital inflows helped compensate for losses in com-petitiveness before the crisis, the absence of past reforms now adds to the drag on activity and employment. The reverse also holds—the two EA “comprehensive reformers,” Germany and the Netherlands, have seen the elasticity of unemploy-ment with respect to output decline, whereas it was much higher in almost all other EA countries (see Figure 5.7 ). This dichotomy suggests that comprehensive reform can be very effective in providing enough flexibility to insulate the labor market, at least temporarily, from even very large output shocks.

Labor market developments during the crisis also confirm that extensive dual-ity tends to increase the sensitivity of employment to fluctuations in output; during major economic downturns, this would amount to a reverse honeymoon effect as employers respond by shedding temporary workers. Indeed, countries with a high incidence of temporary contracts have experienced large employment losses during the crisis. The average probability of becoming unemployed has been almost 12 times higher for temporary workers than for workers under regu-lar contracts (ECB, 2012). The estimated transition probability from employ-ment to unemployment reached levels of more than 14 percent in Spain and Estonia, and about 10 percent in France, Finland, and the Slovak Republic.

Since the onset of the crisis, most EA countries have introduced additional measures to support employment. On the supply side, ALM policies have been the most common instrument: almost all countries have introduced additional training programs for the unemployed, and about half have stepped up job search assistance. Some countries have moved to extend UB (benefit levels, duration, or eligibility criteria). 14 On the demand side, employment subsidies were most widely resorted to—including subsidies for short-time work schemes for workers

Figure 5.7 Employment and Unemployment during the Crisis

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14By tightening UB eligibility, Greece has been an exception in this regard.



facing layoffs and fiscal incentives to hire unemployed workers. About half of the EA countries pursued reductions in nonwage labor costs, mainly by cutting social security contributions. 15

Although these measures broadly served their purposes and generally pre-vented further increases in labor market duality, they were no substitute for genuine reforms. In fact, it could be argued that increasing UB generosity could be counterproductive if it changed incentives in the longer term. And some of the reforms undertaken—for example, measures inspired by the success of the Ger-man Hartz reforms—might be less effective under different conditions elsewhere. Finally, care must still be exercised in interpreting the role existing labor market institutions played in economic outcomes. For example, Schindler (2013) argues that the temporary nature of the shock to the German economy was an important reason for the effectiveness of its short-term work schemes in preventing layoffs. The Germany case study below will take up some of these issues.

CASE STUDIES

To further help disentangle the role of institutions, policies and shocks, this section discusses the experiences in Germany, Italy, and Spain in greater detail ( Table 5.1 ).

TABLE 5.1

Germany, Italy, and Spain: Labor Market Institutions and Reforms at a Glance

Germany Italy1 Spain1

Nondiscriminatory unfair dismissal

Precourt resolution required

Some Yes Yes

Pretrial conciliation mandatory

Yes Yes Yes

Pretrial conciliation outcome enforceable

Yes n.a. Yes

Conditions defined Broadly, “socially justified” No YesReinstatement

mandatoryYes, but rarely applied; either party can dissolve

Yes, if “manifestly unfounded”

No, employer decides

Compensation (if not reinstated)

12–18 months wages 12–24 months wages Maximum 24 months wages2

Mandatory legal representation

No Yes No

Length of procedure 14.3 months 23–26 months n.a.

Fair dismissals

Severance pay 0.5 month for each year of service

3 Maximum 12 months

Application to public sector

No No Yes

(Continued)

15However, a few countries faced with tight fiscal constraints, including Estonia and Greece, actually raised social security contributions.



Case Study 1: Germany

The German labor market has weathered the Great Recession particularly well. Despite a severe recession, labor market conditions remained remarkably stable. From peak to trough, Germany’s real GDP fell 6.8 percent—its biggest decline in the post-war period and also larger than the recessions in the United Kingdom, the United States, or even Spain. In contrast to most other EU countries, how-ever, the German unemployment rate remained flat ( Figure 5.8 ), and then fell by end-2012 to its lowest level in 30 years. The low unemployment rate was not the result of lower activity rates either, with the employment share in the population remaining on an upward trend.

TABLE 5.1 (Continued )

Germany, Italy, and Spain: Labor Market Institutions and Reforms at a Glance

Germany Italy1 Spain1

Fixed-term contracts (FTCs)

Objective and material reasons for FTC

Yes, with exceptions Yes, excluding first FTC Yes

Incentives in favor of open-ended contracts

No Yes Yes

Maximum number of successive FTCs

4 2 2

Maximum cumulative duration of successive FTCs

24 months 36 months 24 months

Internal flexibility (vs. national contracts)

Opt-out clauses Largely used Allowed, but little used Eased for fi rms in distress4

Short-time schemes Yes Yes Yes

Other

Focus on activation policies

Strong Little Some

Unemployment insurance

Linked to activation Gradual move to universal

Not addressed in the reform

Memo: Labor market outcomesUnemployment

(%, October 2013)5.2 12.5 26.7

Temporary employ - ment (% total employ - ment, 2005–10)

12.9 9.7 24.7

Inactivity rate (% of 15–64 year old; 2010)

23.4 37.8 26.6

Public expenditure on ALMP (% GDP, 2005–09)

0.9 0.5 0.8

Sources: Eurostat; International Labor Organization; OECD database; and IMF staff. Note: ALMP = active labor market policies; n.a. = not applicable. 1 Reflects the latest reform proposals, where applicable. 2 For contracts signed after February 10, 2012; otherwise maximum of 42 months’ wages. 3 No severance pay as such; there is an end-of-employment contract indemnity, a wage share set aside by employer and paid upon employment termination. 4 Priority given to the use of firm-level agreements over industry- or region-wide collective agreements.



Figure 5.8 Unemployment after the Cycle Turned (Peak quarter real GDP = 100)

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United StatesItaly

Sources: OECD database; and IMF staff calculations. Note: For euro area, Germany, Spain, and the United Kingdom, 2008:Q1=100; for the United States 2007:Q4 =100; for Italy 2007:Q3 =100.

Most observers agree that the labor market reforms enacted early in the first decade of the 2000s played a major role in limiting job losses during the crisis. The “Agenda 2010” and a series of reforms implemented between 2003 and 2005 (Hartz I–IV) had three main goals: (1) improve the quality of employment services and reorient them from passive income support to activation of the unemployed, (2) increase incentives to take up employment by reducing welfare benefits, and (3) deregulate the labor market (Jacobi and Kluve, 2006). Unemployment benefit duration was reduced further in 2006, and early retirement options were phased out between 2006 and 2010 (OECD, 2012). These actions had three major effects (OECD, 2012):

• Increased labor market efficiency . Job matching improved as employment of-fices were reorganized and temporary employment agencies were estab-lished. This improvement can be seen by the inward movement of the Beveridge curve after the reforms ( Figure 5.9 ) (Gartner and Klinger, 2010). Moreover, labor inflows from unemployment increasingly became directed to employment instead of inactivity (Fahr and Sunde, 2009).

• Enhanced firms ’ flexibility to manage employment through the cycle . Introduc-tion of working time accounts allowed for greater use of flexible working hours. Rules governing hiring of temporary workers were also loosened.

• Reduced work disincentives for older workers . Early retirement options were curtailed, making voluntary dismissal of older employees more difficult. As a result, workers with longer tenure became less likely to enter unemploy-ment, and their employment rates also increased (Dlugosz, Stephan, and Wilke, 2009).



Wage moderation also played an important role in the good performance of the German labor market (OECD, 2012). Between 2000 and 2008, the nominal ULC in Germany remained essentially flat (and fell 7½ percent in real terms) whereas it swelled by almost 15 percent in the euro area ( Figure 5.10 ). In fact, wage moderation may account for as much as 20 percent of the “missing” decline in employment in Germany during the crisis (Burda and Hunt, 2011). Three factors likely contributed:

• The Hartz reforms , via their impact on work incentives and the reservation wage, especially for the low-skilled (Gartner and Klinger, 2010);

Figure 5.9 Germany: Beveridge Curve

5

6

7

8

9

10

11

12

150 250 350 450 550

Une

mpl

oym

ent r

ate

(per

cent

)

Job vacancies (thousands)

2005–07

2008–09

2010–12

2012

2010

2005Hartz IV

Sources: Deutsche Bundesbank; and Statistisches Bundesamt.

Figure 5.10 Nominal Unit Labor Cost (Index, 2000:Q1=100)

90

100

110

120

130

140

United Kingdom

Italy

Spain

Euro area

Germany

2000 01 02 03 04 05 06 07 08 09 10 11 12

Source: Eurostat.



• Declining bargaining power of trade unions , with union density declining by almost 5½ percentage points between 2000 and 2008, ending up 13 per-centage points below the EU average (OECD, 2012); and

• Competition from Eastern Europe , with outsourcing of part of the produc-tion chain to Eastern Europe supporting productivity—an effect estimated by Hansen (2010) and Marin (2010) to have been as high as 20 percent. 16

The nature of the recent recession also influenced labor market outcomes. Before the crisis, more than 60 percent of GDP growth in Germany came from net exports ( Figure 5.11 ). Uncertainty about whether the boom would last prob-ably contributed to a low elasticity of employment growth to GDP growth in the manufacturing sector (OECD, 2012). Once the Great Recession started, Ger-many was hit by collapsing world trade. With the trade shock perceived as tem-porary, firms had room to retain labor in expectation of the upcoming recovery. Burda and Hunt (2011) estimate that about 40 percent of the missing employ-ment decline during the recession can be explained by lower-than-expected job creation before the crisis.

Working time flexibility is another relevant factor ( Figure 5.12 ). In response to the crisis, German firms significantly cut working hours while keeping employ-ment unchanged. Two factors encouraged working time flexibility:

• Short-time work programs ( Kurzarbeit ). Firms could participate in the scheme if they otherwise would have had to cut employment by at least 10 percent

Figure 5.11 Germany: Contributions to Real GDP Growth

(Percent)

–20

–10

0

10

20

30

Spain UnitedKingdom

UnitedStates

Euro area Germany Italy

40

Net exportsPrivate consumptionPublic consumptionInvestmentsReal GDP growth

2001:Q1 to Peak

Peak to Trough

Sources: Eurostat; and IMF staff calculations.

16See IMF (2013) for a detailed discussion of the German–Central European supply chain.



for economic reasons, and if they had exhausted other measures to cut hours. Workers whose hours were cut at least 10 percent were then eligible for short-time work benefits for the reduced hours equal to the unemployment benefits replacement rate. Participating firms paid the social security contri-butions on the hours not worked, reducing incentives to abuse the scheme. Boeri and Bruecker (2011) estimate that as many as 435,000 jobs may have been saved by the Kurzarbeit.

• Working time accounts . To smooth hours worked over the cycle, employ-ees’ hours were recorded on individual accounts, allowing for a buildup of credit during booms that could be drawn down during recessions, re-ducing the need for paid overtime. By 2005, the share of workers with working time accounts increased to 48 percent, from 33 percent in 1998 (Gross and Schwarz, 2007). Burda and Hunt (2011) estimate that this scheme contributed significantly to employment stability during the crisis.

What lessons does the German labor market experience hold for other coun-tries? The answer is, unfortunately, not a simple one. For example, although short-term work schemes operate in many countries, their replacement rates, duration, and eligibility differ, resulting in significant deadweight costs (Boeri and Bruecker, 2011). Working time accounts resulted in significant employment sav-ings in Germany but may not be as effective in countries with larger shares of small and medium-sized enterprises. Labor market reforms likely reduced long-term unemployment and increased welfare for employed households. Benefit re-duction may have, however, contributed to higher income inequality and lower lifetime consumption of the remaining unemployed (Krebs and Scheffel, 2013), though this effect may be difficult to disentangle from the worldwide rise in in-equality experienced in recent decades.

Figure 5.12 Germany: Evolution of Labor Input and Its Components (Percent)

–16

–12

–8

–4

0

4

8

2000 2002 2004 2006 2008 2010 2012

Hours workedUnemployment

ParticipationWorking-age populationLabor input

Sources: Eurostat; and IMF staff calculations.



Figure 5.13 Italy: Labor Market Evolution, 1998–2012

50

75

100

125

150

80

90

100

110

120

Total(index; level in 1998 = 100)

Employment

Population age 15–64

Inactive

Unemployment(right scale)

0

2

4

6

8

35

45

55

65

1998 2002 06 101998 2002 06 10

1998 2002 06 101998 2002 06 10

Total(percent of working-age population)

Employment

Inactive


20

40

60

80

100

120

60

80

100

120

Youth(index; level in 1998 = 100)

Employment

Population age 15–24

Inactive


6

8

10

12

14

15

35

55

75

Youth(percent of youth population)

Employment

Inactive


Sources: Istituto nazionale di statistica (Istat); and IMF staff calculations.

Case Study 2: Italy

The Great Recession hit Italy hard as well. By 2010, real per capita GDP had dropped 10 percent below its 2007 level, no higher than its 1998 level. Employment declined sharply early in the crisis before eventually stabilizing, with the south of the country, and young and temporary workers, particularly affected ( Figure 5.13 ).

The crisis has exposed and exacerbated the structural weaknesses of Italy’s labor market—its duality along various dimensions (age, skill, sector, region, wages, social safety net), high inactivity, and a mismatch between wages and pro-ductivity ( Figure 5.14 ).

• The labor market is segmented between protected permanent workers and many, especially younger, workers moving from one short-term contract to another, with limited possibilities—and little incentive—to accumulate human capital (productivity loss), to find a better match in the absence of the social safety net (efficiency loss), and to contribute toward future pen-sions (longer-term sustainability risk).

• Wage setting reflects neither regional productivity differences nor firm-specific factors, and although wage flexibility is allowed, in reality it has meant flexibility only in the upward direction. Derogation clauses from



national agreements have hardly been applied in practice. Rigidities at the core and high firing costs for permanent workers (especially because of an inefficient judicial system) have further encouraged atypical contracts. 17 Thus, despite overall wage moderation, wage-productivity gaps have per-sisted, eroding competitiveness.

• The social safety net against unemployment risk is fragmented and uneven. It has inhibited efficient worker mobility and reallocation and, combined with decentralized and limited ALM policies, has failed to promote job matching and training. Italy’s large wage supplementation fund (Cassa Inte-grazione Guadagni) is not designed explicitly for temporary shocks, but it can be used in cases of structural adjustment, potentially delaying needed restructuring or liquidation.

• Female and youth participation rates, especially in the south, are among the lowest in the OECD, reflecting poor job prospects, tax disincentives, and a large informal economy and home production. The transition probability from unemployed to inactive is higher than in other countries, especially for women and in the south, while inactivity tends to be almost permanent (Boschetto and others, 2011).

• In some regions, heavy reliance on attractive public sector jobs has led to significant distortions in the private sector and in educational choices, con-tributing to employment rigidities (Alesina, Danninger, and Rostagno, 2001).

Figure 5.14 Italy: Growth, Productivity, and Labor Input, 1990–2012

–6

–3

0

3

6

1990 92 94 96 98 2000 02 04 06 08 10 12

Real GDP, Productivity, and Labor Input(percent change)

0

3

6

9

12

–6

–4

–2

0

2

4

1990 92 94 96 98 2000 02 04 06 08 10 12

Total Hours Worked and Components(percent change)

Hours per employeeEmployment rateLabor force participation rateWorking-age populationTotal hours workedUnemployment rate (percent; right scale)

Output per hourTotal hours workedGDP

Sources: Organisation for Economic Co-operation and Development; and IMF staff calculations.

17The labor cost reduction associated with the expansion of fixed-term contracts amounted to 10.4–22.4 percent in 1995–2003 (Cipollone and Guelfi, 2006).



What led to such profound weaknesses in Italy’s labor market, and what role have past reforms, shocks, and other factors played in this process?

The 1997 Treu reform and the 2003 Biagi reform aimed to promote and de-regulate temporary and atypical contracts, encourage fixed-term employment, and provide incentives for part-time work. Other important measures included the effective opening toward fixed-term contracts in 2001 and the introduction of generous tax incentives for hiring workers at least 25 years old with open-ended contracts. Despite earlier reform attempts, rigidities persisted, and employment protection for permanent workers remained high. The reforms focused “on the margin,” primarily affecting youth. The proliferation of temporary contracts with no social protection also made the social safety net increasingly unequal. 18

The Treu reform had a positive impact on participation and employment rates, but increased gender, regional, and skill duality. Total labor input increased sharply in 1998, and was followed by an increase in employment that was partly offset by a drop in hours worked per employee. The unemployment rate declined by 2¾ percentage points between 1997 and 2002 in both the north and the south, but still stood at 16½ percent in the south in 2002 (as compared with 4.2 per cent in the north). Empirical evidence shows that the Treu reform improved matching effi-ciency in the north, particularly for skilled workers, but had the opposite effect for unskilled workers in the south. Competition between skilled and unskilled workers increased, especially in the south (Destefanis and Fonseca, 2006).

Responding to global shocks (see the section titled “Policy Responses and Labor Market Outcomes”), the Biagi reform was more comprehensive, but the only measures adopted related to flexibility in labor market entry. Proposed re-forms of unemployment benefits, decentralized bargaining, and labor tax reduc-tion failed largely as a result of union opposition, and industrial relations deteriorated. The Biagi reform further entrenched duality, youth employment stagnated or fell, and the share of temporary workers among youth increased from less than 20 percent in 1997 to almost 50 percent in 2011.

The global financial crisis struck Italy just when industrial restructuring was be-ginning to bear fruit, involving nearly half the firms in industry and nonfinancial services. The economy had returned to growth in 2004–07, with negative total factor productivity growth reversed, and in 2007 the unemployment rate declined to 6.1 percent—its lowest level since 1981. In response to the crisis, firms cut back on labor input, turned to more flexible work arrangements, and resorted to the wage supplementation fund, which was extended to cover previously ineligible fixed-term and atypical contracts; tax incentives for hiring youth and women were also introduced.

The crisis induced wide-ranging labor market reforms. The Fornero reform aimed to create a more inclusive labor market, by undoing some of the previous reform measures, which had led to increased flexibility at the margin (“bad flex-ibility”) and duality. The reform covered unemployment insurance and protec-tion of permanent workers, but did not address flexibility at the core, female

18See, for example, Schindler (2009) for a review of pre-2008 labor market reforms in Italy.



participation, or public sector employment. Some reversal in inactivity from its past trend has occurred, but is still too early to assess the overall impact of the reform, the near-term benefits of which for growth and employment are likely to be modest if not negative (Lusinyan and Muir, 2013).

There is clearly room for additional structural efforts, in particular to further reduce duality; increase labor market participation, especially for youth and women; and better match wages and productivity through a more flexible, open-ended contract for new hires that gradually increases employment protection with tenure. This type of contract would also facilitate the employment of young workers. To help increase female participation, the effective marginal tax rates for married second earners would need to be reduced. The agreements among social partners to allow derogation from national contracts should be made more operational. And greater differentiation of public wages across regions would support private wage flexibility and employment, especially in the south.

Case Study 3: Spain

Spain has had the highest unemployment rate among the EU-15 countries for most of the past 30 years. Following a sharp decline between 1994 and 2007, unemploy-ment rose to more than 20 percent after the crisis hit, more than double the EU-15 average. Wages in Spain also rose faster than the EU-15 average and exceeded produc-tivity growth during most of the past 30 years, leading to widening ULC differentials with the EU-15. Since the crisis, this differential has moderated ( Figure 5.15 ) as the result of strong productivity growth as labor was shed, not because of lower wages.

Institutions play a large role in Spain’s labor market performance. Spain’s un-employment has not only been among the highest, is has also been the most countercyclical and volatile in the OECD. Its dynamic Okun’s coefficient is the largest in the OECD, standing at more than twice the OECD average during 1990–2011 ( Figure 5.16 ). These differences are only partly explained by the

Figure 5.15 Spain: Unemployment Rate and Unit Labor Cost

0

5

10

15

20

25

30

1980 83 86 89 92 95 98 2001 04 07 10


–10

–5

0

5

10

15

20

25

Unit Labor Cost(annual percent change)

1980 83 86 89 92 95 98 2001 04 07 10

MaximumSpainEU-15Minimum

MaximumSpainEU-15Minimum

Source: Organisation for Economic Co-operation and Development.



Figure 5.16 Spain: Unemployment Rate and Okun’s Coefficient

0

5

10

15

20

25

Mar-07 Mar-08 Mar-09 Mar-10 Mar-11


Spain

OECD average

0.0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

LUX

DE

UN

OR

JPN

AU

TIT

AC

HE

NZ

LG

BR

DN

KIR

LP

RT

NLD

CA

NB

EL

FIN

AU

SU

SA

FR

AS

WE

ES

P

Dynamic Okun’s Coefficient, 1990–2011

Average

Countries in sample that experienced ahousing sector boom and bust

Sources: Organisation for Economic Co-operation and Development; Eurostat; and IMF staff calculations.

boom and bust of the Spanish housing sector during first decade of the 2000s—most economies in the sample experienced at least one similar event. Rather, the volatility of unemployment in Spain seems to be in large part due to wage rigidity, insufficient flexibility of working conditions, and high labor market duality.

• Wage rigidity contributed to the increase in unemployment in Spain during 2008–09. Wages reacted little to unemployment and were more correlated to past inflation than in other OECD economies, reflecting widespread wage indexation. Spain’s nominal labor compensation rose by 6 and 4 per-centage points in 2008 and 2009, respectively (4 percentage points in real terms in both years), contrasting with the wage moderation seen in the rest of the OECD ( Figure 5.17 ). Wages have moderated since 2010 because of agreements among the social partners, but the decline in real labor compen-sation since 2010 has not been enough to offset the cumulative differential created during 2008–09.

Figure 5.17 Spain: Labor Compensation

–2

0

2

4

6

8


Nominal Labor Compensation(annual percent change)

Spain

OECD average

–2

0

2

4

6


Real Labor Compensation(annual percent change)

Spain

OECD average




Figure 5.18 Spain: Hours Worked per Employee ( Index, 2007 = 100 )

96

98

100

102

104


Spain

OECD average


Figure 5.19 Spain: Employees on Open-Ended and Temporary Contracts

94

96

98

100

102

104

106


Open-Ended Contracts(index, 2007 = 100)

Spain

European Union

60

70

80

90

100

110


Temporary Contracts(index, 2007 = 100)

Spain

European Union

Source: Eurostat.

• Spain’s inflexible working time also contributed to the rise in unemployment. Industry- or region-wide collective agreements restrict the ability of firms to modify working conditions (e.g., hours worked) to adjust to shocks. Hours worked per employee increased since mid-2008, contrasting with the fall in the OECD ( Figure 5.18 ). This difference during 2008–09 seems to be the result of inflexible working time in Spain’s collective agreements, but the difference in 2010–11 may also reflect higher uncertainty and larger dis-missal costs.

• Spain’s labor market is marked by a high degree of duality ; the country has the largest share of workers on temporary contracts in the OECD. Spanish firms adjusted to the crisis by dismissing temporary workers ( Figure 5.19 ) instead of reducing wages or working time, largely accounting for Spain’s much larger employment decline than the EU average (under similar declines in GDP).



Figure 5.20 Spain: Unemployment Rate and Share of Temporary Contracts

0

5

10

15

20

25

30

1977 81 85 89 93 97 2001 05 09 1977 81 85 89 93 97 2001 05 09


10

15

20

25

30

35

40

Share of Temporary Contracts(percent)

Source: Instituto Nacional de Estadisticas.

• At the same time, Spain’s dismissal costs in open-ended contracts range between 33 and 45 days per year worked (with a maximum of 42 months) for unfair dismissals ,19 compared with an EU-15 average of 21 days per year worked (with a maximum of 24 months). Dismissal costs under temporary con-tracts, however, are much lower in Spain, at nine days per year worked. This large gap is responsible for the use of a large share of temporary workers as an insurance mechanism against adverse shocks.

Several reforms were introduced in the 1990s and 2000s to reduce labor mar-ket duality. Enacted when unemployment was low or declining, these reforms promoted hiring with open-ended contracts and more stringent regulation on temporary contracts ( Figure 5.20 ). Duality, however, was not reduced because severance payments for open-ended contracts were lowered only marginally.

Two additional reforms in 2010 and 2011 attempted to foster job creation (reduce job destruction) by cutting dismissal costs for permanent contracts, by easing opt-out from collective agreements, and by giving firms more flexibility to set working time. Once again, however, these reforms made only marginal changes to the existing legislation, and left open the possibility of allowing sectoral agreements to supersede firm-level agreements if social partners agreed to do so.

The reform introduced in 2012 promises a significant improvement in the functioning of the labor market by reducing duality, wage rigidity, and firms’ internal inflexibility:

• Duality is reduced by lowering the costs of unfair dismissals for permanent workers, easing and clarifying the use of fair dismissals for firms in distress, reducing procedural costs, and eliminating the need for prior administrative approval. The goal is to make fair dismissals the regular channel for dismiss-ing workers with permanent contracts in distressed firms.

19Dismissals are deemed unfair when the labor authorities determine that the employers’ decision to terminate the employment contracts is not due to objective economic, technical, organizational, or production reasons (collective dismissals), or to a serious contractual breach (individual dismissals). Dismissals are deemed fair in the opposite case.



• Wage rigidity and firms’ internal inflexibility are reduced by giving priority to firm-level agreements over wider collective agreements. The reform also allows distressed firms to change working conditions, temporarily suspend contracts, and reduce working time. In addition, it limits the automatic extension of expired collective agreements to one year.

The reform’s success hinges on implementation; the effectiveness of past re-forms was compromised, in part, by restrictive interpretation by the courts. The reform could also be strengthened by harmonizing protection for open-ended and temporary contracts and by eliminating indexation and automatic extension of expired collective agreements (ultra activity). In the absence of sufficiently rapid progress, policymakers should prepare contingency plans, for example, by moving to an opt-in system for collective bargaining.

CONCLUSION

Employment and growth are high on the policy agenda in Europe, and rightly so. High unemployment rates hinder growth and undermine political consensus for reforms. Unemployment among youth is especially difficult to accept and con-strains potential growth. The dismal state of European labor markets is not just the product of an unprecedented crisis. This chapter argues that the current crisis response stems from an inadequate policy response in several countries in Western Europe (especially in the periphery) to shocks before the global financial crisis.

These shocks changed the relative demand for skilled and unskilled labor and required new flexibility. Some countries responded to the challenges; for example, the United Kingdom, the Netherlands, and Germany implemented important and comprehensive reforms that improved labor market performance and miti-gated the economic and social costs of the crisis. Other countries, especially in the periphery, implemented partial and incomplete reforms, likely constrained by political realities and by the power of insiders. Partly masked by high precrisis growth, the internal policy contradictions exploded with a dramatic increase in unemployment, especially in youth unemployment, when the crisis hit.

Key lessons from these experiences are that partial or incomplete reforms may be counterproductive and lead to negative outcomes, and that the benefits of comprehensive labor market reform extend to periods of crisis—in fact, a well-functioning labor market that facilitates adjustment is particularly helpful during crisis periods. But an effective structural reform strategy must go beyond labor markets: efficiently operating product markets and strong legal frameworks and fiscal institutions are key ingredients to improving a country’s economic perfor-mance, including during crises. Chapters 7 and 8 address such broader structural reform packages from various angles.

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Schindler, M., 2013, “What Does the Crisis Tell Us about the German Labor Market?” in Germany in an Interconnected World Economy , ed. by Ashoka Mody (Washington: Interna-tional Monetary Fund).

van Ark, B., M. O’Mahony, and M.P. Timmer, 2008, “The Productivity Gap between Europe and the United States: Trends and Causes,” Journal of Economic Perspectives , Vol. 22, No. 1 (Winter 2008), pp. 25–44.


125

CHAPTER 6

Challenges and Solutions for Fostering Job Creation in the Balkans

DMITRIY KOVTUN, ALEXIS MEYER CIRKEL, ZUZANA MURGASOVA, DUSTIN SMITH, AND SUCHANAN TAMBUNLERTCHAI

Different countries face different labor market challenges, and reforms to address these challenges must be carefully tailored to specific country circumstances. Chapter 5 discussed key labor market problems and policy challenges with a focus on advanced Western Europe. Much has also been written about reforms the euro area periphery, including Chapters 7 and 8 in this book. The group of economies considered here—Southeastern Europe’s Balkan region—complements this pic-ture and offers an important, though less extensively discussed, case study for the potential of structural reforms to overcome bottlenecks, especially those in the labor market.

Labor markets in a number of Southeastern European countries are character-ized by high levels of unemployment and low rates of job creation. Many of these economies also face a unique set of challenges: labor market problems are espe-cially severe among the emerging market economies that are not members of the European Union, namely, Albania, Bosnia and Herzegovina, Kosovo, the former Yugoslav Republic (FYR) of Macedonia, Montenegro, and Serbia. Given their many similarities and challenges, this set of countries, henceforth referred to as the “Balkan countries,” is the focus of this chapter.

In particular, this chapter aims to (1) bring to light the relatively weak perfor-mance of the Balkan labor markets in a cross-country context; (2) analyze the factors that may have contributed to this long-standing problem—the unfinished transition process, the institutional setup of the labor markets, including possible market rigidities, and labor cost factors; and (3) present a range of policy recom-mendations for tackling these problems.

HOW DO BALKAN LABOR MARKETS COMPARE WITH OTHERS IN EUROPE?

Labor market conditions and developments in the six Balkan countries share a number of similarities, and on the whole they are considerably worse than in other European countries. One striking factor is the very low employment rates—the


126 Challenges and Solutions for Fostering Job Creation in the Balkans

Figure 6.1 Selected Labor Market Indicators, 2006–12

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Sources: CEA ; country authorities; Eurostat; Haver Analytics; Organisation for Economic Co-operation and Development; and IMF staff calculations. Note: NMS = new member states of the European Union. See Appendix 6A for expansion of country abbreviations and composition of country groups. 1 2007 data used in place of 2006 data. 2 2011 data used in place of 2012 data. 3 Registered unemployment used in place of labor force data. 4 2007:Q2 data used in place of 2006.


Kovtun and others 127

average ratio of employed persons to the working-age population in these countries was 46 percent in 2012, compared with 64 percent in the euro area and 63 percent among the new member states of the European Union (NMS) 1 ( Fig ure 6.1 ). This rate reflects low activity rates 2 and high unemployment rates. The Balkan countries also have some of the highest youth and long-term unemployment rates in the region ( Figure 6.2 ). 3

The weak labor market performance in the Balkan countries is a key social concern—it undermines medium- and long-term economic growth and poses major challenges for policymaking. The low rates of employment mean forgone production, and the unemployed risk losing their skills, making it harder for them to find employment in the future. This cycle may, in turn, increase the natural rate of unemployment (hysteresis). The very low employment rate of young people may impede the process of acquiring human capital and increase dependency on support systems, diminishing the countries’ long-term growth potential. Finally, the high rates of unemployment create a burden on public fi-nances in the form of social benefits for the jobless, and could undermine social cohesion.

High rates of unemployment in the Balkan countries persisted through the boom years of the 2000s. For example, between 2004 and 2008, when real annual growth in the Balkan countries averaged 5 ⅓2 percent, unemployment rates remained high. The degree of responsiveness of unemployment to economic cycles can be gauged from Okun’s coefficient, which measures the correlation between contemporaneous changes in GDP and the unemployment rate (Okun, 1962). Figure 6.3 confirms that the Balkan countries have a lower Okun’s coef-ficient than the NMS and the euro area periphery countries, and the nature of unemployment is more long lasting. 4

DIAGNOSIS: WHAT CAN EXPLAIN POOR LABOR MARKET PERFORMANCE?

Various factors can explain labor market outcomes. 5 For the Balkan countries, these factors are organized into three groups: (1) the more standard “labor market institutional factors,” which influence the ease with which the unemployed can be matched to available job vacancies, and also with which firms can adjust

1 The NMS comprise Bulgaria, Croatia, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, the Slovak Republic, and Slovenia. The countries referenced in this chapter and their abbreviations are shown in Appendix 6A. 2 The activity rate is defined as those employed or seeking employment as a share of the working-age population. 3 Long-term unemployment is defined as unemployment spells of 12 months or more. 4 For more detailed estimates of Okun’s coefficients in individual countries, see Ball, Leigh, and Loun-gani (2013). 5 See the survey study by Layard, Nickell, and Jackman (2005) for a summary of many of these factors.



employment; (2) the “cost factors,” which tend to raise wages despite excess sup-ply in the labor market, and which are, to some extent, a reflection of the rigidities summarized under (1); and (3) the more unique “structural factors,” capturing the Balkan countries’ processes of transition and European integration, which appear to correspond to the persistent nature of their labor market problems.

Figure 6.2 Youth and Long-Term Unemployment, 2006–12

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Sources: Country authorities; Eurostat; and IMF staff calculations. Note: NMS = new member states of the European Union. See Appendix 6A for expansion of country abbreviations and composition of country groups. 1 2011 data used in place of 2012:Q3 data. 2 Youth unemployment rate ages 15–29. 3 2007 data used in place of 2006 data; 2011 data used in place of 2012 data.



Institutional Rigidities in Labor Markets

Strong employment and social protection systems were important features of centrally planned economies. Although these systems have largely been disman-tled, their legacy remains in some aspects of the Balkan countries’ labor markets—if not in legislation then in workers’ attitudes.

Unemployment and unemployment benefits

When properly designed, social assistance and unemployment benefit programs reduce poverty and hardship for the most vulnerable. In practice, however, such programs can induce moral hazard by allowing program recipients to substitute benefits for productive work, at times at large social costs (Hansen and Imrohoro-glu, 1992). Similar to remittances, social and unemployment benefits relax house-hold budget constraints and alter labor-leisure decisions, and thus affect the job search behavior of the unemployed, the duration of their unemployment, and their labor force participation (Katz and Meyer, 1990; Meyer, 1990; Cullen and Gruber, 1997; Lalive, 2008). Moreover, fiscal resources tied up in benefits cannot be used for productivity-enhancing investments, such as in infrastructure or human capital development.

For the Balkan countries, unemployment benefits in relation to wages fall at or below the average level in a cross-country comparison ( Figure 6.4 ). Benefit duration follows the standard 12-month limit in most countries. Given the preva-lence of long-term unemployment in the region, benefit coverage is likely to have

Figure 6.3 GDP Growth and Changes in Unemployment, 1993–2011

y = –0.32x + 1.05

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y = –0.44x + 0.93

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Sources: IMF, World Economic Outlook database; and IMF staff calculations. Note: NMS = new member states of the European Union.



expired for a large portion of the unemployed. The role of unemployment bene-fits in explaining the high rates of unemployment in the Balkan countries is thus likely to be limited. However, although the benefits themselves may not contrib-ute to the high unemployment rates, their administration can affect unemploy-ment spells. Unemployment benefits in the Balkan countries are not typically accompanied by active labor market policies, though such policies have been shown to matter in helping workers return to employment (Blanchard, Jaumotte, and Loungani, 2013).

Differences in social benefits emerge across the Balkan countries. Benefits are particularly high in Bosnia and Herzegovina and Montenegro ( Figure 6.5 ), but are in line with or below the sample average in other Balkan countries. Lack of

Figure 6.4 Size and Duration of Unemployment Benefits

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Sources: Country authorities; Organisation for Economic Co-operation and Development (2012); and IMF staff calculations. Note: NMS = new member states of the European Union. See Appendix 6A for expansion of country abbreviations and composition of country groups. Data for several Balkan countries are not available. 1 Average of new member states excluding Croatia. 2 Average of European Union countries.



benefit targeting also appears to be a problem for Bosnia and Herzegovina, where less than a quarter of the benefits are received by the poorest quintile (Mitra, Selowsky, and Zalduendo, 2010). This poor targeting occurs because many ben-efits are “rights based” rather than “needs based.” In other Balkan countries, however, targeting accuracy is quite high, with more than 50 percent of benefits

Figure 6.5 Social Assistance Spending and Targeting

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Sources: Mitra, Selowsky, and Zalduendo (2010); World Bank, Europe and Central Asia Social Protection Database; and IMF staff calculations. 1 For comparability purposes, the figure only includes social assistance provided in cash.



going to the poorest quintiles in Serbia, Montenegro, and Kosovo (Mitra, Sel-owsky, and Zalduendo, 2010). Therefore, with the exception of Bosnia and Herzegovina, social benefits do not appear to have contributed significantly to the high unemployment outcomes in the Balkan countries.

Employment protection legislation

Labor market institutions in most countries feature elements of employment protection legislation (EPL) to provide a degree of protection to workers and to encourage investment in workers’ firm-specific skills. However, protective measures can bend too far and create inefficiencies (Blanchard, Jaumotte, and Loungani, 2013). In addition to restricting hiring and firing, Bassanini, Nun-ziata, and Venn (2009) find that overly strict EPL depresses productivity growth because firms are less able to adjust to technology and market changes that require labor reallocation. In such conditions of lower turnover, workers themselves face greater challenges to switching jobs, and the unemployed face greater barriers to entry, thereby prolonging their unemployment spells. Evi-dence from the literature confirms a clear positive relationship between EPL and long-term unemployment (Layard, Nickell, and Jackman, 2005). Findings from a panel study of 97 countries for 1985–2008 suggest that in addition to reducing long-term unemployment, greater labor market flexibility may also reduce overall and youth unemployment, with hiring and firing regulations and costs having the strongest effects (Bernal-Verdugo, Furceri, and Guil-laume, 2012).

Labor market practices in the Balkan countries have traditionally been rigid and afforded workers high protection. In the socialist era, workers “owned” factors of production and exercised self management: the system was strong on workers’ rights and weak on allocation of risks (Annex in OECD, 2008). Since the disintegration of the socialist economies, substantial labor market reforms have been undertaken, with the reform momentum having picked up since the middle of the past decade. Redundancy costs in most of the Balkan countries appear to be in line with those in the more advanced emerging mar-ket economies, with the possible exception of Albania, whereas redundancy rules appear to be relatively tight in Bosnia and Herzegovina and Serbia ( Fig-ure 6.6 ). Anecdotal evidence suggests that reforms remain incomplete and differences between legislated and actual practices continue to persist. In Serbia, for example, redundancy cost is not high per se, but total severance payments are based on the length of lifetime employment rather than tenure at the most recent workplace, creating a strong disincentive to hire workers with many years of experience.

The apparent effort to increase labor market flexibility in most Balkan coun-tries is an encouraging sign, but judicial enforcement will need to accompany the legislative changes. Because increased labor market flexibility in the Balkan coun-tries is a recent phenomenon, it may be some time before its effects take hold and the current high unemployment rates are reduced.



Wage bargaining structure

Theory suggests that the degree of centralization of wage bargaining can affect unemployment, and fully centralized or fully decentralized bargaining systems offer the best results (Scarpetta, 1996). Under the centrally planned systems in the Balkan countries, all workers were unionized and wage bargaining was com-pletely centralized. Since the start of the transition process, union coverage has declined and become more fragmented. Nevertheless, union coverage in the Balkan countries remains extensive compared with the NMS and other EU coun-tries (European Commission, 2008). Furthermore, the fragmented nature of the unions may lead to inefficient bargaining, contributing to the high unemploy-ment rates. One such example is Serbia, in which wage agreements negotiated

Figure 6.6 Employment Protection

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Sources: World Bank, Doing Business database (2012); and World Economic Forum (2011). Note: NMS = new member states of the European Union. See Appendix 6A for expansion of country abbreviations and composition of country groups.



with trade unions are imposed on all firms in the sector, regardless of union membership.

Are Labor Costs Too High?

Unit labor costs

Labor costs, which include workers’ wages and benefits as well as social contribu-tions and taxes paid by employers and employees, affect hiring decisions and can contribute to unemployment if they are out of line with labor productivity. In the same vein, rising labor costs are not necessarily a problem if accompanied by com-mensurate increases in labor productivity—a natural part of the income conver-gence process. A key measure of labor competitiveness that captures movements in costs and productivity is the unit labor cost (ULC), calculated as the ratio of labor costs to real GDP. Changes in ULCs affect firms’ profitability and, there-fore, their labor demand.

The boom years leading up to the global financial crisis were characterized by significant capital inflows from advanced to emerging European economies, including the Balkan countries. These capital inflows drove up wages across all countries. However, productivity gains in many countries did not keep up with wage increases, resulting in very rapid ULC growth ( Figure 6.7 ). Since the onset of the crisis in 2008, ULC growth moderated throughout Europe and declined in the Baltic countries (Estonia, Latvia, Lithuania) as a result of flex-ible labor markets and a significant downward wage adjustment. By compari-son, among the Balkan countries, only Albania experienced a reduction in ULCs. In Bosnia and Herzegovina, the ULC deceleration was driven by con-tinued productivity growth rather than wage moderation, and in Serbia by a euro-denominated wage decline. In Montenegro, wages continued to outpace productivity significantly.

Exchange rate regimes played an important role in relative wage competitive-ness across countries. Despite continued increases in local currency wages, Alba-nia improved and Serbia contained the deterioration of its wage competitiveness through currency depreciations. Other Balkan countries (Bosnia and Herzegov-ina, FYR Macedonia, and Montenegro) did not benefit from such exchange rate adjustments given that these countries’ currencies are either pegged to the euro or euroized.

Wage rigidities

Real wage rigidities can limit downward wage adjustments and aggravate unemployment problems, particularly during economic downturns. In the years following the financial crisis, countries such as Montenegro and Bosnia and Her-zegovina continued to see growth in real wages despite rising unemployment ( Figure 6.8 ). Such an impairment in the wage adjustment mechanism can be an outcome of institutional rigidities including high employment protection and inflexible wage bargaining structures.



Figure 6.7 Unit Labor Costs and Nominal Wages, 2004–11

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Productivity growth (euro, minus = increase)Wage growth (euro)ULC growth (euro)

Productivity growth (euro, minus = increase)Wage growth (euro)ULC growth (euro)

Less currency depreciationWage growth (national currency)Wage growth (euros)

Sources: Haver Analytics; IMF, World Economic Outlook database; and IMF staff calculations. Note: NMS = new member states of the European Union; ULC = unit labor cost. See Appendix 6A for expansion of country abbreviations and composition of country groups. Data for several Balkan countries are not available.



Minimum wages

The purpose of minimum wages is distributional: to ensure that low-skilled workers receive pay that is sufficient to live on (Blanchard, Jaumotte, and Loungani, 2013). However, minimum wages distort labor market outcomes by reducing the scope for downward wage adjustments and compressing the wage distribution (Tonin, 2004). In general, wider wage ranges are thought to support employment growth because firms can hire profitably across the skills spectrum (OECD, 1993). By forcing a compression in the wage distribution, minimum wages create disincentives to hire low-skilled workers, thereby increasing unem-ployment among the very population they are intended to support.

The restrictiveness of minimum wages can be proxied by the ratio of mini-mum to average wage. Rutkowski (2003) suggests that for countries with high unemployment concentrated among young and low-skilled workers, this ratio should not exceed one-third. According to this rule of thumb, all Balkan econo-mies except Montenegro have excessively high minimum wages ( Figure 6.9 ).

Tax wedges

Social security contributions and labor taxes are nonwage labor costs that create a wedge between the employer’s cost of hiring a worker and the wage that the worker receives (OECD, 1993). If costs cannot be passed on to workers, employ-ers adjust by decreasing their labor demand, resulting in higher unemployment.

Figure 6.8 Unemployment and Wages

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Sources: Haver Analytics; OECD; and IMF staff calculations. Note: See Appendix 6A for expansion of country abbreviations.



Evidence in the literature confirms this relationship (Alesina and Perotti, 1997; Nickell and Layard, 1999; Daveri and Tabellini, 2000; Blanchard and Wolfers, 2000), albeit with varying estimated sizes of the coefficients (Castellino and Fornero, 2003). In a similar vein, if workers do not fully internalize the expected benefits from taxes on their labor, the decreased net wages are a disincentive to work (Summers, 1989). Workers thus reduce their labor supply, with those at the margin withdrawing from the labor force altogether.

Figure 6.9 Minimum Wage and Tax Wedge

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CZ

EB

GR

PO

LLV

AG

RC

ES

TA

UT

SV

NF

RA

NLD

EU

RIT

AS

VK

BIH

1,3

MK

D1

PR

TE

SP

NO

RJP

NU

SA

GB

RC

HE

IRL

Tax Wedge, 2008

Sample average

Sources: Country authorities; Eurostat; Koettl and Weber (2012); and World Bank (2011c). Note: NMS = new member states of the European Union. See Appendix 6A for expansion of country abbreviations and composition of country groups. Data for several Balkan countries are not available. The tax wedge is defined as the share of income tax and social security contributions by employers and employees to total labor costs. 1 Values are for 2009. 2 Data represents the Federation of Bosnia and Herzegovina. 3 Data represents the Republika Srpska of Bosnia and Herzegovina.



Although labor taxes in the Balkan countries have recently fallen because of competition to attract foreign investors, social insurance contributions remain high in many countries. Serbia, for example, has a high tax wedge largely as the result of such contributions ( Figure 6.9 ). These large tax wedges likely contribute to the problems of high unemployment and low participation, and possibly explain the large informal economies observed in some Balkan countries.

Structural Hurdles from Unfinished Transitions

A range of labor market rigidities is something the Balkan countries have in com-mon with many other economies, both advanced and emerging. More unique to the region are the structural hurdles from an unfinished transition. Despite geo-graphic proximity to the EU, the Balkan countries are latecomers to European integration. In the process of transition, standard growth theory predicts that lower-income economies converge toward higher incomes via several distinct channels. First, capital flows from advanced economies to ones with lower capital-to-labor ratios can increase labor productivity and allow for a transfer of knowl-edge and technology (e.g., through foreign direct investment [FDI] flows). Abiad, Leigh, and Mody (2009) find that in Europe—including in NMS—capital flows from relatively rich to relatively poor countries, and that these flows are associated with accelerated income convergence. The second channel involves labor flows, as workers move across borders in search of higher wages. Finally, fiscal transfers reduce differences in incomes among countries, but can also lead to more persis-tent differences in labor market outcomes. 6

What distinguished the convergence of Balkan economies from that in the NMS was the relative strength of these channels. In particular, FDI inflows in the Balkan countries have been smaller and labor outflows significantly larger than in peer countries. The fiscal transfers channel has been limited for the Balkan coun-tries because they are not members of the EU.

Capital and labor flows

Successful transitions during the 1990s in Central European NMS were generally associated with comprehensive structural reforms that attracted significant inflows of FDI and promoted job creation. Despite unemployment having possibly in-creased in the short term (Burda, Bean, and Svejnar, 1993), the reforms allowed development of the private sector that eventually provided conditions for reducing unemployment rates. The infusion of capital from abroad—especially greenfield FDI—played a key role in developing new businesses or even entire new sectors of the economy and provided a chance for workers dismissed from the declining areas to be reabsorbed by new economic activity. Although other types of capital, such as equity flows, have also shown positive relationships with growth under specific

6 For example, Spilimbergo (1999) shows in a theoretical framework how wage and unemployment differences between a more and a less developed region in an integrated labor market can persist be-cause of large fiscal transfers from the former to the latter region.



circumstances, only FDI inflows proved to be a robust and significant driver of output growth (Aizenman, Jinjarak, and Park, 2011) because they provide a more stable long-term foundation for transfers of technology, know-how, managerial skills, and international marketing networks. Broader changes in the economy can, in turn, reduce the natural rate of unemployment (Ball and Mankiw, 2002).

The literature on economic development suggests that convergence to higher income levels involves structural change. This change includes flows of both capital and labor from lower-productivity sectors, such as those involved with primary products, to sectors with higher potential productivity gains, such as manufacturing and services (Rodrik and McMillan, 2011). Agriculture also experiences productiv-ity gains, but at a slower rate than other sectors. Recent research on the Middle East and North Africa has also emphasized the importance of appropriate structural change to boost growth and absorb the supply of labor (World Bank, 2011a).

Unlike the NMS, the Balkan countries were delayed in their transition to market-based economies by the conflicts of the 1990s and the need for postcon-flict rebuilding. Significant reforms largely began only after 2000, nearly a full decade after the NMS. Although the Balkan countries made significant progress in the transition, many critical reforms—such as privatization, enterprise restruc-turing, and promoting a competitive business environment—were still incom-plete when the global financial crisis erupted. These delays have stifled FDI and reduced opportunities for job creation ( Figure 6.10 ).

The delayed transition and low FDI put the Balkan economies at a disadvan-tage in diversifying away from traditional sectors. They have a higher share of agriculture than the EU or the NMS on average, and a smaller share of industry than the NMS ( Figure 6.11 ). Thus, sectors that provided a source of employment in successful transitions in other countries—such as export-oriented industries—have been lagging behind in the Balkan countries. Furthermore, in some coun-tries (e.g., Serbia and Montenegro), unemployment has been aggravated by con-tinued labor shedding from the declining sectors, while new sectors have not developed fast enough to absorb the dismissed workers.

Although the inflow of FDI was weaker in the Balkan countries than in their peers, the outflow of labor has been much stronger. The rates of emigration from the Balkan countries increased significantly during the 1990s, in some cases to dramatic levels. The migration motives were unique in many respects for the Balkan countries, particularly related to the social and institutional instability surrounding the breakup of the former Yugoslavia. Although not all of the emi-grants were in the labor force, the unique impetus behind emigration in the Balkan countries led to a major “brain drain” effect, which further diminished aggregate human capital (Beine, Docquier, and Rapoport, 2001, 2006) and growth potential ( Figure 6.12 ). 7

7 Beine, Docquier, and Rapoport (2006) quantify the loss of skilled labor based on census and regis-tered data from 12 OECD countries, using the immigrant’s age of entry as a proxy for the level of education.



Remittances

Remittances can affect labor market outcomes. The theoretical literature typically suggests that households’ efforts to engage in the labor market depend on several factors, including non-work-related income supporting their budgets. In particu-lar, any type of steady household income relaxes budget restrictions and affects labor-leisure decisions (Cahuc and Zylberberg, 2004). As set forth in Blanchard, Jaumotte, and Loungani (2013), non-work-related income, such as unemploy-ment insurance, affects reservation wages and increases unemployment duration.

Figure 6.10 Business Environment, Foreign Direct Investment, and Unemployment

0

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30

HU

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ALB

FDI Stock per Capita, 2011(thousands of U.S. dollars)

ALB

BIH

MKD

SRB

BGR

ROU

ESTLVA

LTU

POL

CZE

SVK

HRV

y = –0.9677x+ 21.772

y = –5.855ln(x) + 25.202

0

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cent

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Unemployment Rates versus FDI, 2011

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PS

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NE

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RP

OL

CZ

ER

OU

HR

VA

LB ITA

SR

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RC

KO

SB

IH

Ease of Doing Business, 2012(percentile rank)

0.0

0.5

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R

RO

UH

RV

MK

DS

VN

ALB

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SM

NE

UK

RS

RB

BIH

BLR

Composite EBRD Index, 20121

Sources: Country authorities (labor force surveys); and European Bank for Reconstruction and Development (2012). Note: FDI = foreign direct investment; IIP = international investment position; NMS = new member states of the Euro-pean Union. See Appendix 6A for expansion of country abbreviations and composition of country groups. Data for sev-eral Balkan countries are not available. 1 Average of six EBRD transition indicators (large-scale privatization, small-scale privatization, governance and enterprise restructuring, price liberalization, trade and foreign exchange system, and competition policy).



One strand of the literature looking at the impacts of remittances on labor market dynamics focuses on the insurance aspect of this flow of individual transfers (Amuedo-Dorantes and Pozo, 2006b). This family-provided insurance and self-insurance mechanism can play a role similar to that of unemployment insurance, and hence can impact individuals’ incentives to search for and take up paid work.

Figure 6.11 Gross Value Added by Sector, 2011

0.0

0.2

0.4

0.6

0.8

1.0

EuropeanUnion

NMS1 Croatia Bosniaand

Herzegovina

Montenegro Serbia FYRMacedonia

Albania2

Services/other Construction Industry excluding construction Agriculture, hunting, and forestry

Sources: Bosnia and Herzegovina labor force survey; Haver Analytics; Statistical Office of the Republic of Serbia; and IMF staff calculations. Note: NMS = new member states of the European Union. 1 Calculated using each new member country’s weight in GDP. 2 Data for 2010.

Figure 6.12 Labor Migration and Brain Drain

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40

BIH

ALB

SR

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ES

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LVA

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RO

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N

2000 1990

Stock of Permanent Emigrants, 1990–2000(percent of total population living within borders)

0

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30

KA

ZR

US

UK

RLV

AB

GR

LTU

CZ

EH

UN

ES

TS

VN

RO

UP

OL

SR

BA

LBS

VK

HR

VB

IHM

KD

Brain Drain Estimates, 2000/01 Census Data(percent, skilled emigrants who lefthome country at age 22 or older)

Sources: Beine, Docquier, and Rapoport (2006); United Nations (2012); and World Bank, Global Bilateral Migration database. Note: See Appendix 6A for expansion of country abbreviations. Data for several Balkan countries are not available.



Because the length of the unemployment period depends on the job seeker’s abil-ity to wait for a job that meets expectations, unemployment insurance as well as remittances could increase long-term unemployment.

Remittances inflows in the Balkan countries are strikingly high relative to the NMS, and in fact are among the highest in the world. 8 Remittances may have allowed their recipients extended periods of job search, which could also have exacerbated the skill decline. Remittances may have also increased the reservation wage and thus reduced domestic workers’ willingness to accept lower-paid jobs. 9 This effect may help explain the high proportion of long-term unemployment in the region. Figure 6.13 indicates a strong relationship between remittances and unemployment or activity rates for the Balkan countries and the NMS, support-ing the view that high remittances reduce the effort of the active population to

Figure 6.13 Remittances and Labor Market Performance, 2011

ALB

BIHMKD

MNE

SRB

BGR

ROU

SVN

HUN

EST

LVA LTU

POL

CZE

SVK

HRV

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40

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Une

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(pe

rcen

t)

Inflow of remittances (percent of GDP)

Unemployment Rates versus Remittance Inflows

ALB

BIH

MKD

MNE

SRB

BGRROU

SVN

HUN EST

LVA

LTU

POL

CZESVK

0

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6

8

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12

14

40 50 60 70 80

Rem

ittan

ces

(per

cent

of G

DP

)

Activity rate (percent)

Activity and Remittances

Sources: Country authorities; country labor force surveys; Eurostat; and World Bank (2012b). Note: Data for Kosovo are not available. For Albania, left panel uses registered unemployment, right panel shows 2010 data for activity rate. For the Former Yugoslav Republic of Macedonia, official remittances data most likely underreport the true remittance inflows, given that private transfers stood at about 19 percent of GDP in 2011, according to IMF statistics.

8 Remittances definition and data are from World Bank (2011b). For some countries, using private transfers from the balance of payments statistics could be more precise and indicate a much higher level of potential remittances—particularly for FYR Macedonia. Nonetheless, to ensure comparability, the narrower World Bank definition is used in this chapter. 9 The empirical effects of remittances on employment in emerging market economies are not clear cut. Micro‐level data from Armenia show that remittances reduce job-seeking efforts (Grigorian and Mel-konyan, 2011), while evidence from remittances sent by Latin American working migrants from the United States to their home countries is ambiguous: Amuedo-Dorantes and Pozo (2006a) find that the overall female labor supply declines because of remittance income, although only in rural areas. Diverse effects are noticeable for men, depending on type and location of work. An increase in remit-tances seems to have a negative impact on formal employment for men in rural and urban areas, but a positive impact on informal work, rendering the overall effect ambiguous.



engage in paid work. Finally, remittances may have indirectly supported social stability in the Balkan countries because their role as a safety net for households helped mitigate the negative social impact of high unemployment.

SUMMARY AND POLICY IMPLICATIONS

How can employment levels and the longer-term growth potential of the Balkan countries be raised? The analysis so far has examined a wide range of hypotheses about factors that may have contributed to labor market outcomes, and it is im-portant to understand which of these factors are most relevant and where the Balkan countries fall short of best practice. To provide a broader comparative perspective, this section assesses the relative relevance of each factor in contribut-ing to the labor market outcomes in the Balkan countries, as well as in the NMS.

The cross-country “heat map” ( Figure 6.14 ) summarizes the degrees to which different factors discussed in previous sections contribute to labor market prob-lems. For the most part, the rankings were constructed by dividing the minimum-to-maximum range of each indicator into three equal parts. The significance of each individual indicator is reflected with one of three rankings: 1 (dark blue, or the least favorable for job creation), 2 (medium blue), and 3 (light blue, or the most favorable for job creation), with gray indicating values that are not available. In special cases, outliers were excluded. Average indicators are displayed as follows: values 1 to 1.5 (dark blue), 1.5 to 2.5 (medium blue), and 2.5 and above (light blue). The heat map serves only to provide an overview of where problems are most likely to emerge; this methodology was adopted because of its simplicity and tractability (Appendix 6B provides more details on the methodology).

Grouping indicators under the three factors discussed in this chapter—structural, labor market–related institutional, and cost—provides a summary of the impact of that factor on each country’s labor market outcome. 10 Averaging across all factors produces an overall country average (last row of the table). Simi-larly, averaging the rankings of a particular indicator across countries summarizes the overall prevalence of that problem in the region.

A distinct pattern emerges from the heat map. Most of the Balkan countries suffer from deeply rooted structural problems related to the delayed transition, the poor investment climate, and the resulting low FDI inflows. Only FYR Mace-donia fares better, mainly because it has recently improved its business environ-ment. By contrast, the NMS, particularly the countries that entered the EU in 2004, appear well advanced in this area. The labor market institutional factors in the Balkan region as a whole appear not to be out of line with the NMS; there-fore, they are not likely to be the driving force behind the relatively worse labor market outcomes in the Balkan countries. Nevertheless, some divergence across countries is evident: FYR Macedonia and Albania, which have undertaken a series of reform efforts, do not seem to be in danger of significant future problems. In

10 The groupings are calculated as an arithmetic average of the indicators’ rankings under each factor.


14

4 C

ha

llen

ge

s an

d S

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tion

s for Fo

sterin

g Jo

b C

rea

tion

in th

e B

alka

ns

Figure 6.14 Cross Country Heat Map

Possible factors MKD ALB MNE SRB BIH KOS AVG POL CZE SVK EST HUN LVA LTU SVN HRV ROM BGR AVG

Structural factors 2.3 1.5 1.7 1.0 1.0 1.0 1.4 2.5 2.8 3.0 3.0 3.0 2.8 2.5 2.7 2.3 2.0 2.3 2.6 Progress in structural reforms 2 2 1 1 1 1 1.3 3 3 3 3 3 3 3 2 2 2 2 2.6 Business environment 3 2 2 1 1 1 1.7 2 2 3 3 3 3 3 3 2 2 2 2.5 FDI per capita 1 1 … 1 1 … 1.0 2 3 3 3 3 2 2 … 2 1 2 2.3 Remittances 3 1 2 1 1 1 1.5 3 3 3 3 3 3 2 3 3 3 3 2.9

Labor market institutional factors 2.6 2.6 2.0 1.8 1.7 2.5 2.2 2.8 2.8 2.4 2.4 2.4 2.2 2.2 2.0 1.8 2.4 2.6 2.4 Redundancy rules 3 3 2 1 2 2 2.2 2 3 2 2 3 1 2 2 1 2 3 2.1 Redundancy cost (weeks of salary) 2 1 2 1 2 … 1.6 3 3 3 2 2 3 2 2 2 3 3 2.5 Social benefits 3 3 1 2 1 3 2.2 3 … 2 3 2 3 2 2 1 1 3 2.2 Unemployment benefits (share of wage) 2 3 … 2 … … 2.3 3 2 2 2 2 1 2 1 … 3 1 1.9 Unemployment benefits (duration) 3 3 3 3 … … 3.0 3 3 3 3 3 3 3 3 3 3 3 3.0

Labor costs 2.0 2.3 1.8 1.8 1.5 … 1.8 2.4 2.4 2.2 2.0 2.0 1.6 2.0 1.8 2.5 2.0 1.4 2.0 Euro-denominated ULC growth (pre-2008) 2 2 1 1 … … 1.5 3 3 3 2 2 1 2 3 3 1 1 2.2 Euro-denominated ULC growth (post-2008) 2 3 2 2 2 … 2.2 2 2 3 3 2 3 3 2 3 2 1 2.4 Exchange rate flexibility (ER regime) 1 3 1 3 1 … 1.8 3 3 1 1 3 1 1 1 1 3 1 1.7 Minimum wage 3 1 3 2 2 … 2.2 3 3 2 3 2 2 3 1 3 3 3 2.5 Labor taxes 2 … … 1 1 … 1.3 1 1 2 1 1 1 1 2 … 1 1 1.2

Average 2.3 2.1 1.8 1.5 1.4 … 1.8 2.6 2.6 2.5 2.5 2.5 2.2 2.2 2.2 2.2 2.1 2.1 2.3

Rankings of average values:1 ≤1.52 >1.5 and ≤2.53 >2.5

… Values not available

Source: IMF staff estimates. Note: ER = exchange rate; FDI = foreign direct investment; ULC = unit labor cost. See Appendix 6A for expansion of country abbreviations. In this heat map, higher scores were assigned for lower unemployment benefits (UB) and social assistance (SA) levels. In principle, very low (or zero) levels of UB and SA are not optimal, either. In the heat map sample, UB varied from 18 percent of average wage in Albania to 70 percent in Slovenia, and SA varied from about 1 percent of GDP in Latvia to close to 4 percent of GDP in Bosnia and Herzegovina. Countries within the subsamples are sorted by the total average score.



other Balkan economies, rigid labor market institutions add to the structural problems and further worsen labor market outcomes. The cost factors seem broadly similar on aggregate in the Balkan countries and the NMS, and appear to pose issues for Montenegro, Serbia, and Bosnia and Herzegovina. During the boom period these problems were masked by the large capital inflows that fueled the Balkan economies, but were revealed by the crisis and have become more binding.

Despite the wide divergence of labor market reforms across the Balkan econo-mies, some of them face the same challenges as advanced Europe. For example, high employment protection, including significant redundancy costs, complicates the reallocation of labor in the Balkan countries as well as in many advanced European economies. However, a distinct feature separates the Balkan countries from other European countries—the large unfinished structural reform agenda stands out as the most significant barrier to improving labor market outcomes.

Structural factors are likely to have the predominant effect on the poor labor market outcomes in the Balkan countries because they shape the underlying na-ture and viability of the economies. Therefore, to alleviate labor market problems, priority should be given to reforms that foster structural change, help attract FDI, and reduce the natural rate of unemployment and thus promote job creation. These reforms include, for example, strengthening macroeconomic stability and improving the numerous aspects of the business environment. Without address-ing these issues, any improvement in the institutional setup of labor markets or cost factors would likely have a limited impact on job creation. Nevertheless, in-stitutional rigidities should be addressed because they compound the impact of structural problems in the labor markets. In this regard, there is scope to ease redundancy costs and revamp redundancy rules in Albania, change the severance payment formula in Serbia, and pursue social welfare reforms with the aim of better targeting benefits in Bosnia and Herzegovina and Serbia. The need to re-duce labor market rigidities and improve cost competitiveness indicates that wage bargaining should be moved closer to the company level in Bosnia and Herze-govina, Montenegro, and Serbia; minimum wages should be reduced in Albania and Serbia; and the tax wedge should be reduced in Serbia. In addition, imple-menting policies that enhance the skills of the labor force would boost labor productivity.

Most important, the broad-based nature of labor market problems will require equally broad-based policy solutions. Focusing on any single area would be unlikely to result in significant success. This conclusion is broadly consistent with those of Chapter 5 regarding the importance of comprehensive structural reforms. Finally, the policy reform effort must be sustained to deliver a tangible improve-ment in labor market outcomes.



APPENDIX 6A. COUNTRIES REFERENCED IN THE CHAPTER AND THEIR ABBREVIATIONS

APPENDIX TABLE 6A

Country Grouping/Country Acronym

Balkan countries Balkans Albania ALB Bosnia and Herzegovina BIH Kosovo KOS Macedonia, former Yugoslav Republic of MKD Montenegro MNE Serbia SRB

New Member States NMS Bulgaria BGR Croatia HRV Czech Republic CZE Estonia EST Hungary HUN Latvia LVA Lithuania LTU Poland POL Romania ROU Slovak Republic SVK Slovenia SVN

Other European economies

Austria AUT Belarus BLR Belgium BEL Germany DEU Denmark DNK Spain ESP Finland FIN France FRA United Kingdom GBR Greece GRC Ireland IRL Italy ITA Luxembourg LUX Moldova MDA Netherlands NLD Portugal PRT Russian Federation RUS Sweden SWE Turkey TUR Ukraine UKR

Non-European countries

Armenia ARM Azerbaijan AZE Georgia GEO Kazakhstan KAZ Kyrgyz Republic KGZ Tajikistan TJK Uzbekistan UZB



APPENDIX 6B. UNDERLYING DATA AND RANKING METHODOLOGY USED IN THE HEAT MAP

APPENDIX TABLE 6B

Indicator Underlying Data Underlying Sample

Rankings1

Dark

Blue (“1”)

Medium

Blue (“2”)

Light

Blue (“3”)

Structural Indicators

Progress in structural reforms

The European Bank for Reconstruction and Development’s 2012 Transition Report: the average of six transition indicators (large- and small-scale privatization; governance and enterprise restructuring; price liberalization; trade and foreign exchange system; and competition policy).

15 countries shown on the upper-right panel in Figure 6.10.

<3.4 ≥3.4 but <3.7

≥3.7

Business environment

Percentile ranking in “Ease of Doing Business, 2012” database of the World Bank.

Sample of 31 European economies. 2

<53.8 ≥53.8 but <75.8

≥75.8

Foreign direct investment (FDI)

FDI stock per capita in thousands of U.S. dollars.

14 countries shown on the bottom-left panel in Figure 6.10.

<5.7 ≥5.7 but <9.8

≥9.8

Remittances Inflow of remittances as a percentage of GDP.

16 countries shown on Figure 6.13.

≥7.9 ≥4.3 but <7.9

<4.3

Institutional Factors

Employment protection laws

World Bank (2012): Cumulative score based on responses to eight questions related to redundancy rules.

31 countries shown on the upper panel in Figure 6.6.

2–4 5–6 7–8

Firing costs (weeks of salary)

World Economic Forum (2011): Redundancy costs in weeks of salary.

31 countries shown on the bottom panel in Figure 6.6.

≥46 ≥23 but <46

<23

Social benefits Social assistance spending in percent of GDP.


≥2.8 ≥1.7 but <2.8

<1.7

Size of unemploy - ment benefits

Unemployment benefits as percentage of gross average wage (for a single person without children).


≥56.6 ≥33.3 but <56.6

<33.3

Duration of unemploy ment benefits

Maximum duration of unemploy - ment benefits in months


≥27 ≥16 but <27

<16

Labor Costs Euro-denominated

ULC growth (Pre-2008)

Average annual rate of ULC growth during 2005–08 period.


≥11.2 ≥5.8 but <11.2

<5.8

(Continued)



APPENDIX TABLE 6B (Continued)

Indicator Underlying Data Underlying Sample

Rankings1

Dark

Blue (“1”)

Medium

Blue (“2”)

Light

Blue (“3”)

Euro-denominated ULC growth (Post-2008)

Average annual rate of ULC growth during 2005–08 period.

29 countries shown on the middle panel in Figure 6.7.

≥3.4 ≥0.4 but <3.4

<0.4

Exchange rate flexibility (exchange rate regime)

Exchange rate regimes. Countries in the heat map

Fixed … Flexible

Minimum wage Minimum wage as a percentage of average wage.


≥46.3 ≥35.1 but <46.3

<40.4

Labor taxes Tax wedge defined as the share of income tax and social security contributions by employers and employees over total labor costs.


≥49 ≥40.4 but <49

<27.2

1 The rankings were constructed by dividing the minimum-to-maximum range of each indicator into three equal parts. The following outliers were disregarded when constructing minimum-to-maximum ranges: Hungary in the FDI category, Belgium in the unemployment benefits category, Portugal in the firing costs category, and Ireland in the labor taxes category. 2 The sample includes ALB, AUT, BGR, BIH, CZE, DEU, DNK, ESP, EST, FIN, FRA, GBR, GRC, HRV, HUN, IRL, ITA, KOS, LTU, LUX, LVA, MKD, MNE, NLD, POL, PRT, ROU, SRB, SVK, SVN, SWE.



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151

CHAPTER 7

Assessing the Gains from Structural Reforms for Jobs and Growth

DEREK ANDERSON, BERGLJOT BARKBU, LUSINE LUSINYAN, AND DIRK MUIR

STRUCTURAL REFORMS AND GAPS IN EURO AREA COUNTRIES

Euro area countries, particularly those in the periphery, have made strong prog-ress on their structural reform agendas since the global financial crisis. The crisis created the impetus to implement difficult, but needed, structural reforms. In particular, important labor market reforms aimed at reducing labor adjustment costs and promoting employment have been put in place in Greece, Italy, Portu-gal, and Spain, while countries in the core have primarily focused on increasing labor force participation, for example, through pension reform. Product market reforms have pursued market liberalization and deregulation, mainly in the pe-riphery, although the overall progress on implementing the European Union (EU) Services Directive has been slow in both the periphery and the core.

Progress has been impressive, but important structural gaps still exist, with specific priorities varying across countries. 1 Indicators of product market regula-tion and the degree of competition in various sectors of the economy suggest scope for easing regulation and strengthening competition in the euro area vis-à-vis the Organisation for Economic Co-operation and Development (OECD) frontier cases. Although some euro area countries (notably, Ireland) are among the OECD best-practice cases, product markets are, on average, more heavily regulated and less open to competition in the euro area than in other advanced economies ( Figure 7.1 , left panel), reflected also in higher price markups, which is a proxy measure for the degree of competition, especially in services ( Figure 7.1 , right panel).

There is also significant scope for making European labor markets more inclu-sive, dynamic, and efficient, while recognizing that there is no single optimal

Research assistance was provided by Pedro Espaillat. The chapter builds on Barkbu and others (2012) and Lusinyan and Muir (2013). 1IMF (2013a) discusses the key priorities for euro area countries, based on in-depth country-specific analyses carried out by IMF country teams as part of economic surveillance or program work.


152 Assessing the Gains from Structural Reforms for Jobs and Growth

Figure 7.1 Selected Indicators of Product Market Regulation and Competition

1.27

2.46

1.351.25

2.63

1.92

1.28

2.34

0.980.92

1.24

0.880.830.73

0.47

OverallPMR

Professionalservices

Administrativeburden

on start-ups

Product Market Regulation (PMR)(index scale of 0 to 6 from

least to most restrictive; 2008)1

1.37

1.18

1.56

1.47

1.21

1.66

1.27 1.16

1.401.32

1.28

1.36

Totaleconomy Tradables1

Marketservices

Degree of Competition: Estimated Price Markups(markup >1 implies prices > marginal costs

and indicates market power)

Euro area (EA) EA periphery2 EA core3

Non-EA advanced OECD OECD frontier4


United States

Sources: Organisation for Economic Co-operation and Development (2013); and IMF staff estimates.1Averages are purchasing-power-parity-GDP weighted.2Euro area periphery comprises Greece, Ireland, Italy, Portugal, and Spain.3Euro area core comprises Austria, Belgium, Finland, France, Germany, and the Netherlands.4Three countries with least-restrictive regulations (Ireland, the United Kingdom, and the United States for “Overall PMR”; Ireland, Sweden, and the United Kingdom for “Professional services”; Ireland, Germany, and New Zealand for “Administrative burden on start-ups”).

Sources: Christopoulou and Vermeulen (2008); and IMF staff estimates.1Manufacturing and construction.2Italy and Spain, purchasing-power-parity-GDP weighted.3Austria, Belgium, Finland, France, Germany, and the Netherlands, purchasing-power-parity-GDP weighted.

labor market model. Employment protection is more stringent in the euro area than elsewhere in advanced OECD countries ( Figure 7.2 , left panel), which can have a negative impact on labor productivity (Bassanini, Nunziata, and Venn, 2009). Unemployment insurance is relatively more generous while retirement incentives encourage early exit from the labor force. In addition to labor adjust-ment costs, the tax wedge is high in most euro area countries, and reducing it by shifting taxation from direct to indirect taxes could further boost employment, growth, and competitiveness. The use and scale of active labor market policies vary across the euro area. Strengthening such policies, together with other mea-sures to boost labor force participation (e.g., child care support), can have an important impact on employment, employability, and efficiency of job matching, which would help address the problems of low labor utilization, especially female and youth, that many euro area countries are facing ( Figure 7.2 , right panel).

QUANTIFYING THE IMPACT OF STRUCTURAL REFORMS

This chapter analyzes the potential macroeconomic impact of structural reforms that would help narrow the structural gaps in the euro area. For each of the euro


Anderson and others 153

Figure 7.2 Selected Indicators of Labor Market Institutions and Performance

24.3

42.4

27.5

20.4

39.2

11.6

26.6

44.6

30.3

8.0

27.6

7.16.8

19.3

39.8

EPL for regularemployment

(index from 0/least to 60/

most restrictive,2008)2

Tax wedge(percentageof total labor

compensation,2011)

ALMPspending perunemployed

(percentage ofGDP per

capita, 2010)

Labor Market Institutions1

50

60

70

80

90

Euroarea (EA)

EAperiphery1

EAcore2

Non-EAadvanced

OECD

OECDfrontier3

Labor Force Participation Rates, 2011(percent of respective population groups)


Non-EA advanced OECD OECD frontier5

Youth (ages 20 to 24)

Female

Sources: Organisation for Economic Co-operation and Development (OECD ) (2013); and IMF staff estimates.Note: ALMP = active labor market policies; EPL = employment protection legislation.1Averages are purchasing-power-parity-GDP weighted.2The original index is multiplied by 10.3Euro area periphery comprises Greece, Ireland, Italy, Portugal, and Spain.4Euro area core comprises Austria, Belgium, Finland, France, Germany, and the Netherlands.5For EPL, three countries with least-restrictive regulations (Canada, the United Kingdom, and the United States).For tax wedge, three advanced OECD economies with lowest tax wedge (Australia, New Zealand, and Switzerland). For ALMP, six countries with highest ALMP spending (Austria, Denmark, the Netherlands, Norway, Sweden, and Switzerland).

Source: Organisation for Economic Co-operation and Development Labour Force Statistics database.1Euro area periphery comprises Greece, Ireland, Italy, Portugal, and Spain.2Euro area core comprises Austria, Belgium, Finland, France, Germany, and the Netherlands.3Three countries with the highest participation rates (Australia, the Netherlands, and Switzerland for youth participation rate; Iceland, Sweden, and Switzerland for female participation rate).

area countries, the simulation models the impact of closing roughly 50 percent of the gap with OECD frontier cases in labor and product market policies as well as improving the functioning of the pension and tax systems. Product market reforms seek to reduce anticompetitive regulations, lower barriers to entry, and increase competition. Labor market reforms are more varied, and include reduc-ing employment protection legislation, reducing unemployment benefits, increas-ing child care support, implementing active labor market programs, and enacting pension-related reforms such as increasing the standard retirement age and increasing the incentive to work between the ages of 60 and 65. Finally, revenue-neutral tax reforms shift taxation from labor and corporate income to consump-tion. OECD empirical estimates of the dynamic effects of structural reforms on macroeconomic variables such as labor participation, unemployment, and



productivity are used as inputs to the model to generate the estimates of the im-pact of reforms on real GDP. 2

To quantify the impact, the IMF’s Global Integrated Monetary and Fiscal model, a general equilibrium model that features nominal and real adjustment costs and incomplete asset markets, is used. 3 The model brings together economic agents that optimize freely (firms maximize profits, and households maximize utility based on a consumption-leisure choice) and liquidity-constrained agents that consume their income fully. The analysis in this chapter uses a six-region version, composed of the core euro area countries, the euro area periphery coun-tries, the United States, emerging Asia, Japan, and the rest of the world. 4

Several key features drive the short-term dynamics of the reform impact. The euro area core and periphery regions follow a common inflation targeting regime. Fiscal policy is independently determined in each region and is based on a policy rule that ensures long-term sustainability 5 while allowing for short-term counter-cyclical stabilization policies. The gradual implementation of reforms, combined with the gradual adjustment of labor supply and capital in response, drives the difference between short- and long-term effects. The simulations are conducted with monetary policy that accommodates the increase in inflation in the short term, complementing the positive effects on real GDP.

Households and firms are assumed not to believe initially that the government will successfully enact its reform agenda, which affects their behavior. Households and firms base their current decisions and expectations only on the reforms actually implemented up to that point. However, the government continues to implement its reforms each year, so households and firms continually update their decisions, gradu-ally adjusting their expectations. After five years, households and firms are assumed to believe fully that the entire announced reform package will be implemented. This process of gradual acceptance affects the outcome in the short to medium term, but the long-term outcome will be the same as if households and firms immediately believe in the full implementation of the announced reform package (see the section titled Reform Implementation: Macroeconomic and Policy Environment).

The analysis has some limitations. In particular, employment is represented only as total hours worked, but it cannot be further decomposed into the unem-ployment rate, the participation rate, or average hours worked. The way the equilibrium wage is set does not allow involuntary unemployment to be captured. In addition, the analysis is conducted around an initial steady state that does not account for different cyclical or competitiveness positions across countries, which could affect the extent of possible reforms or their full effects. The estimates are

2For a detailed discussion of the methodology used to obtain the empirical estimates of the impact of structural reforms, see, for example, Bouis and Duval (2011); updated estimates have been used in the simulations in this chapter. 3Kumhof and others (2010) and Anderson and others (2013) provide details on the theoretical foun-dations and properties of the Global Integrated Monetary and Fiscal model. 4In what follows, the euro area periphery comprises Greece, Ireland, Italy, Portugal, and Spain; the remainder of the euro area countries make up the core euro area. 5By doing so, this analysis abstracts from considerations of the way different sovereign debt levels may impact fiscal policy and its effects.



therefore only illustrative examples of what might be achieved in the short and long terms. The section titled Reform Implementation: Macroeconomic and Policy Environment looks at how reform implementation and its impacts may be affected by policy credibility, price stickiness, and demand conditions.

The Benchmark Scenario

Structural reforms can raise real GDP markedly, though the full effects of reforms only materialize with time. This section uses estimates of the distance from the OECD frontier cases to consider the scope and potential gains from reforms and constructs a benchmark scenario (see Table 7.1 ), using as a baseline the IMF’s country-specific projections, as reflected in the April 2013 World Economic Out-look . The dynamic effects of different reforms on real GDP, employment, and competitiveness for the periphery and core euro area countries are discussed.

Product market reforms

Euro area countries tend to have higher markups than other advanced economies, indicating substantial scope for gains from reforms. Reforms are assumed to close roughly half the gap between the countries’ current regulatory burden and a fron-tier measure (defined differently for different reforms) within 13 years, but the reforms are front-loaded into the first 5 years ( Table 7.1 ). The empirical estimates of the impact on productivity from reducing regulatory barriers are based on Bourlès and others (2010), and take into account the short-term dynamics of reforms in Bouis and others (2012), as well as the estimates for markups from other sources, such as Forni, Gereli, and Pisani (2010). The regulatory burden indicators are estimated using the OECD’s survey-based product market regula-tion index (Boylaud and Nicoletti, 2003). In the tradables sector, the indicators cover product market regulations, such as state control of business enterprises, legal and administrative barriers to entrepreneurship, and barriers to international trade and investment. The nontradables sector consists of retail trade, network industries, and professional services. The indicators for retail trade are barriers to entry, operational restrictions, and price controls; for professional services, they are barriers to entry and conduct regulation in the legal, accounting, engineering, and architectural professions; and for network industries they are barriers to entry and public ownership in the energy, transport, and communications sectors.

Increasing competition in the tradables and nontradables sectors in the euro area could raise the level of real GDP by 1¾ percent after five years and by more than 7 percent in the long term. The first-year impact on real GDP would, how-ever, be limited to ¼ percent ( Figure 7.3 ). Greater competition would reduce the cost of goods and services to consumers, leading to an increase in consumption, investment, and exports. The increased demand for goods would increase firms’ demand for factors of production, putting upward pressure on real wages. Em-ployment would be lower because the stronger income effect outweighs the sub-stitution effect, driven mostly by reforms in the tradables sector.

The euro area’s competitiveness would slightly improve in the long term. With labor productivity almost 7 percent higher, unit labor cost would decline. In the



TABLE 7.1

Assumptions for Structural Reforms

Reform Proxy Phasing

Other Assumptions (percent,

except as noted)

Product Market Reforms Core Periphery

Increasing competition in the tradables sector

Decrease in the markup on tradable goods

Reform measures increase productivity for 13 years. Not fully credible until the 6th year.

Tradables Markup

Decrease

4.9 6.7

Increasing competition in the nontradables sector

Decrease in the markup on nontradable goods, decrease in the wage markup


Nontradables Markup

Decrease

14.8 21.0Wage Markup Decrease

22.5 40.4

Labor Market Reforms Core Periphery

Easing employment protection

Increase in economy-wide labor-augmenting productivity


Productivity Increase

0.8 0.6

Strengthening active labor market policies

Increase in labor supply, increase in government consumption

Increased fiscal spending phased in over 2 years. Increase in labor supply over 13 years. Not fully credible until the 6th year.

Labor Supply Increase

0.1 0.2Fiscal Spending Increase

0.2% of GDP 0.2% of GDP

Increasing female participation through child care

Increase in labor supply, increase in government consumption

Increased fiscal spending phased in over 2 years. Increase in labor supply over 13 years. Not fully credible until the 6th year.


0.4 0.5Fiscal Spending Increase


Reducing unemployment benefits through the average replacement rate

Increase in labor supply, decrease in transfers to LIQ households

Decrease in transfers phased in over 2 years. Increase in labor supply over 13 years. Not fully credible until the 6th year.


0.4 0.6Transfers Decrease


Reducing pension benefits

Increase in labor supply, decrease in transfers to LIQ households

Decrease in transfers phased in over 6 years. Increase in labor supply over 13 years. Not fully credible until the 6th year.


0.3 0.2Transfers Decrease


Tax Reforms Core Periphery

Revenue-neutral tax switching

Increase in the value-added tax offset by cuts to labor and corporate income taxes over two years

Phased in over two years. Immediately credible.

VAT Revenue/GDP

Increase (percentage

points)

1.75 1.25

Labor Tax Revenue/GDP

Decrease (percentage

points)

1.0 0.75Capital Tax Revenue/GDP

Decrease (percentage

points)

0.75 0.5

Sources: OECD; and IMF staff estimates. Note: LIQ = liquidity-constrained.



Figure 7.3 Product Market Reforms

–2

0

2

4

6

8

0 1 2 3 4 5 10 L.R. 0 1 2 3 4 5 10 L.R.Years

0 1 2 3 4 5 10 L.R. 0 1 2 3 4 5 10 L.R.Years

0 1 2 3 4 5 10 L.R. 0 1 2 3 4 5 10 L.R.Years

0 1 2 3 4 5 10 L.R. 0 1 2 3 4 5 10 L.R.Years

Years

Years

Years

Years

Real GDP(percent deviation from baseline)

0

2

4

6

8

10

Consumption(percent deviation from baseline)

0

1

2

3

4

5

6

7

8

Investment(percent deviation from baseline)

–0.4

–0.3

–0.2

–0.1

0.0

0.1

0.2

0.3

Employment(percent deviation from baseline)

0

1

2

3

4

5

6

7

Real Wage(percent deviation from baseline)

–0.5

–0.4

–0.3

–0.2

–0.1

0.0

0.1

0.2

0.3

Unit Labor Cost(percent deviation from baseline)

–1.0

–0.5

0.0

0.5

1.0

Real Effective Exchange Rate(percent deviation from baseline; “+” = appreciation)

–0.4

–0.3

–0.2

–0.1

0.0

0.1

Trade Balance to GDP(percentage point deviation from baseline)

Reforms in the tradables and nontradables sectorsReforms in the tradables sector

Sources: Global Integrated Monetary and Fiscal model simulations using OECD and IMF staff estimates. Note: L.R. is the long run (2060).



TABLE 7.2

Simultaneous Reform Packages, Decomposition of Real GDP (Percent deviation from baseline)

Year 1 Year 2 Year 5 Long Run

Euro Area Periphery

Benchmark scenario 1.4 2.7 4.8 15.4 Product and labor reforms 0.9 1.8 4.2 14.5 Product market reforms 0.3 0.6 2.4 10.0 Tradables sector 0.1 0.3 1.1 3.8 Nontradables sector 0.2 0.4 1.3 6.2 Labor market reforms 0.6 1.1 1.6 3.5 Employment protection 0.0 0.1 0.2 0.5 Active labor market policy 0.2 0.3 0.1 0.2 Female participation rate 0.4 0.7 0.2 0.7 Unemployment insurance 0.0 –0.1 0.5 0.9 Pensions 0.1 0.2 0.3 0.7 Tax reforms 0.4 0.6 0.6 1.0

Euro Area Core

Benchmark scenario 1.1 2.1 3.7 10.6 Product and labor reforms 0.7 1.3 2.8 9.2 Product market reforms 0.1 0.3 1.3 5.7 Tradables sector 0.0 0.1 0.6 2.6 Nontradables sector 0.1 0.3 0.8 3.1 Labor market reforms 0.5 0.9 1.2 2.8 Employment protection 0.0 0.1 0.2 0.7 Active labor market policy 0.1 0.2 0.1 0.2 Female participation rate 0.2 0.3 0.2 0.5 Unemployment insurance 0.1 0.2 0.1 0.4 Pensions 0.1 0.1 0.4 0.6 Tax reforms 0.4 0.7 0.8 1.4

Euro Area

Benchmark scenario 1.2 2.3 4.1 12.3 Product and labor reforms 0.7 1.5 3.3 11.0 Product market reforms 0.2 0.5 1.7 7.2 Tradables sector 0.1 0.2 0.8 3.0 Nontradables sector 0.1 0.3 1.0 4.2 Labor market reforms 0.5 0.9 1.4 3.0 Employment protection 0.0 0.1 0.2 0.6 Active labor market policy 0.1 0.2 0.1 0.2 Female participation rate 0.3 0.4 0.2 0.5 Unemployment insurance 0.1 0.1 0.3 0.6 Pensions 0.1 0.2 0.3 0.7 Tax reforms 0.4 0.7 0.8 1.2

Sources: Global Integrated Monetary and Fiscal model simulations using OECD and IMF staff estimates.

long term, the euro would depreciate in real terms by almost 1 percent and the nominal trade balance would slightly improve after an initial deterioration driven by strong imports.

Gains from product market reforms are more extensive in the periphery than in the core. Almost half of the gains from product market reforms originate in the periphery, despite it representing only one-third of the economic size of the euro area ( Table 7.2 ).



Labor market reforms

The benchmark scenario for labor market reforms comprises policies that increase labor supply and ease adjustment. Labor market institutions are a key reform priority, but involve many factors that need to be taken into account when chart-ing a course for reforms and that may vary in importance across countries (Blanchard, Jaumotte, and Loungani, 2013). To model the impact of labor mar-ket reforms, estimates are used from Bassanini and Duval (2006), taking into account the short-term dynamics as found in Bouis and others (2012) for reforms to ALMP, unemployment, and EPL, and from Jaumotte (2003).

Active labor market policies (ALMP) aim to encourage the nonemployed to retrain and return to the labor market. The analysis assumes that countries increase the ratio of ALMP spending per unemployed to GDP per capita relative to the average within a set of countries with high ALMP spending (Denmark, Austria, the Netherlands, Norway, Sweden, and Switzerland). This assumption is imple-mented through a permanent increase in government spending for two years, fi-nanced through an increase in public debt and an increase in labor supply.

Unemployment insurance helps workers insure against unemployment, but may also lead to lower employment and longer unemployment duration. The impact of a reduction in the average replacement rate (ARR) of unemployment insurance benefits relative to the average within a set of countries with low re-placement rates (Australia, Canada, Japan, New Zealand, the United Kingdom, and the United States) is considered. This impact is implemented in the model through a reduction in government spending and an increase in labor supply.

• Employment protection legislation (EPL) encourages stable employment rela-tionships, but may also hamper the reallocation process, with a negative impact on productivity (e.g., Martin and Scarpetta, 2012). Countries are assumed to ease employment protection relative to the average of the three lowest levels observed across OECD economies. The impact of this easing is implemented using the OECD estimates of increased labor productivity in both the tradables and nontradables sectors.

• Increased availability of public child care services can increase labor supply, es-pecially of women, by reducing the opportunity cost of employment. The analysis assumes that countries increase the ratio of public child care spending to GDP per capita relative to the average of countries with the highest public child care spending (Denmark, Norway, Sweden, and the United Kingdom). This increase in child care spending is modeled through a permanent increase in government spending for two years and an increase in labor supply.

Labor market reforms also cover pension reform. Pension reform would con-sist of both an increase in the retirement age by two years and a move to actuarial neutrality (a zero implicit tax rate on continued employment for workers between the ages of 60 and 65). This reform would lead to permanently lower pension outlays (represented by a reduction in transfers to liquidity-constrained house-holds), allowing for a permanent reduction in government debt, and to an in-crease in labor supply.



The labor market reforms could have a positive but modest impact on real GDP of 1½ percent after five years and 3 percent in the long term. The short-term gain would be limited to ½ percent of GDP, but still double the impact of product market reforms ( Figure 7.4 ). In the short term, households would per-ceive the changes in policies regarding ALMP, ARR, and child care as temporary, and would not fully commit to supplying more labor. Similarly, because produc-tivity gains from EPL would not be fully realized in the short term, its impact would be marginal. Wages would fall in the medium term because the positive effects of higher demand for euro area goods, and hence for the factors of produc-tion, would still take time to materialize, but would still increase in the long term. The effects would also be apparent in the dynamics of consumption, which would decline notably after five years before increasing in the long term. In the long term, most of the increase would be driven by the reforms that boost labor supply. However, the productivity impact from EPL would be substantial, ac-counting for more than a quarter of the impact on real GDP.

Euro area competitiveness and labor productivity would improve in the long term. Although there would be downward pressure on productivity from the in-crease in labor supply, it would be offset by the EPL reforms. Therefore, the unit labor cost is lower, reinforced by the decline in real wages resulting from higher labor supply. With more labor available for production, firms’ demand for capital would also increase, and investment would be permanently higher. Cheaper goods being produced in the euro area would also lead to a permanent real exchange rate depreciation of almost 1 percent and a slightly stronger external position.

Labor market reforms would have a stronger short-term impact than product market reforms, but their effect would become relatively muted. According to OECD estimates, the euro area is not too distant from OECD frontier cases in ALMPs and child care services. The effects of these reforms on productivity and GDP are empiri-cally found to be relatively small (Barnes and others, 2011; Bouis and Duval, 2011).

However, the fiscal implications of labor reforms would be positive for the euro area. In the long term, the decrease in spending on pensions and unemploy-ment insurance would lead to a fall in the level of government debt in the euro area as a whole of almost 20 percent of GDP (with the largest reduction in debt occurring in the periphery countries). Because there would be less demand for global saving to maintain the level of euro area debt, the global interest rate would decline permanently, by about 10 basis points.

Labor market reforms would have a larger impact in the periphery than in the core. The long-term gains in real GDP would be 3½ percent in the periphery and 2¾ percent in the core ( Table 7.2 ). The periphery could gain most from reforms to unemployment insurance, female labor market participation, and pensions; for the core, the gains would be largest from reforms to EPL and pensions.

Revenue-neutral tax reforms

Revenue-neutral tax reform shifts the tax burden away from distortionary direct taxes to indirect taxes, increasing the incentives to work and invest. In particular, “fiscal devaluation,” which is a budget-neutral shift from employers’ social contributions



Figure 7.4 Labor Market Reforms

0 1 2 3 4 5 10 L.R. 0 1 2 3 4 5 10 L.R.Years Years

0 1 2 3 4 5 10 L.R. 0 1 2 3 4 5 10 L.R.Years Years

0 1 2 3 4 5 10 L.R. 0 1 2 3 4 5 10 L.R.Years Years

0 1 2 3 4 5 10 L.R. 0 1 2 3 4 5 10 L.R.Years Years









+Active labor market policiesChild care Pension reform

+Employment protection legislation+Average replacement rate

–1

0

1

2

3

4

–1.0

–0.5

0.0

0.5

1.0

1.5

2.0

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

0.0

0.5

1.0

1.5

2.0

2.5

–0.8

–0.6

–0.4

–0.2

0.0

0.2

0.4

–0.6

–0.4

–0.2

0.0

0.2

0.4

0.6

–1.0

–0.8

–0.6

–0.4

–0.2

0.0

0.2

0.4

–0.3

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toward value-added taxes (VAT), has been shown in the empirical literature to in-crease output and employment (see, for example, IMF, 2012). Because labor-related tax revenues constitute a large share of the revenues in the euro area, transferring this burden to VAT would increase the incentive to work and to hire labor, leading to an increase in labor supply and real GDP (Allard and others, 2010). Similarly, a shift away from corporate income taxes to VAT would increase the return on capital, lead-ing to higher investment and real GDP. Tax revenues can be increased by broadening the tax base as well as by increasing tax rates. The table below shows the size of the revenue-neutral tax reform that is assumed to be implemented in the core and the periphery of the euro area over two years, starting in 2013.

A shift in taxation from direct to indirect taxes could raise real GDP by ¾ per-cent after five years and 1¼ percent in the long term. In the first year, GDP would be higher by almost ½ percent ( Figure 7.5 ). The medium-term impact would be dampened because households and firms believe that the reforms are temporary. Therefore, although consumption tax increases would immediately affect consum-ers’ marginal propensity to consume, the direct tax cuts would not have as large an offsetting effect on household and firm behavior. Consumption would fall after five years, although it would increase in the long term. Employment, after a posi-tive short-term reaction, would be only marginally higher in the long term (although the real wage would increase). Because the tax cuts would affect the cost of capital and labor directly, competitiveness would improve. The unit labor cost would fall slightly despite increasing real wages, exports would rise by about 1 percent in the long term, and the real exchange rate would depreciate.

An increase in consumption taxes would lower household consumption, but the positive effects from removing tax distortions would be much greater. In the long term, the labor income tax cut would offset the negative effects from con-sumption taxes on households’ spending power and would provide an incentive for more labor supply. The corporate income tax cut would reduce the cost of capital faced by firms, encouraging greater demand for capital and labor. The as-sumption that firms only gradually believe in the implementation of the reforms would slow this process.

Combining all structural reforms

Simultaneous implementation of product market, labor market, and tax reforms would be larger than the sum of the components. The impact on real GDP would be 4 percent after five years and 12 percent in the long term ( Figure 7.6 ). 6

Assumed Two-Year Change in Tax Instruments as a Share of GDP

Corporate Tax Labor Tax Value-Added Tax

Core −0.75 −1.0 1.75Periphery −0.5 −0.75 1.25

6These results differ from those reported in IMF (2013a, 2013b) because these simulations include fiscal reforms, assume a larger gap to close through product market reforms, and use more updated data and a different model.



Product market reforms would strongly boost consumption even as labor market and tax reforms act as a drag, especially in the short term. Employment would increase in both the medium and long terms, a reflection of the impact of labor market and tax reforms. Real wages would still be higher, despite downward pres-sure from the labor market reforms. The unit labor cost would decline, and a strong labor productivity increase, driven by product market reforms, would dominate.

Reform Coordination, Spillovers, and Intra–Euro Area

Rebalancing

Synergies would come into play from the simultaneous implementation of reforms in the core and the periphery. Implementing the benchmark reform scenario si-multaneously in both regions would provide slightly larger gains than the added effect from reform packages implemented in each region in isolation ( Table 7.3 ). Spillovers would be greater from the core to the periphery of the euro area than from the periphery to the core ( Tables 7.4 and 7.5 ). If the periphery reformed alone, the core would gain ¼ percent of real GDP. However, if the core reformed alone, the periphery would gain ½ percent of real GDP in the short term and 1½ percent of real GDP in the long term. First, the periphery exports more to the core

Figure 7.5 Fiscal Reforms

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0 1 2 3 4 5 10 L.R. 0 1 2 3 4 5 10 L.R.Years Years




Exports(percent deviation from baseline)

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Figure 7.6 Benchmark Scenario

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0 1 2 3 4 5 10 L.R. 0 1 2 3 4 5 10 L.R.Years

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than it imports, so if the core reforms by itself, the export increase by the periphery (and the positive effects on periphery real GDP) would be greater than vice versa. Second, the model assumes that productivity improvements would spill over from the more advanced core countries. 7 Finally, the model assumes that monetary

7Cross-country spillovers solely from trade linkages are relatively weak (as is the case in dynamic sto-chastic general equilibrium models in general), but technology and positive productivity spillovers can be important. We explicitly model a link in which productivity spills over from countries that reform to their closest trading partners based on work in Coe and Helpman (1995), Coe, Helpman, and Hoffmaister (1997), and Lumenga-Neso, Olarreaga, and Schiff (2005).

TABLE 7.3

Individual versus Simultaneous Reform Packages, Decomposition of Real GDP (Percent deviation from baseline)


Reforms Implemented Individually by Euro

Area Core and Euro Area Periphery

All reforms 1.0 2.1 4.0 12.1 Product and labor reforms 0.6 1.3 3.3 10.9 Product market reforms 0.2 0.5 1.7 7.2 Labor market reforms 0.1 0.3 0.8 2.2 Tax reforms 0.4 0.7 0.8 1.2

Reforms Implemented Simultaneously by

Euro Area Core and Euro Area Periphery



TABLE 7.4

Structural Reforms in the Periphery, Decomposition of Real GDP (Percent deviation from baseline)


Structural Reforms in the Euro Area Periphery


Spillovers to the Euro Area Core





TABLE 7.5

Structural Reforms in the Core, Decomposition of Real GDP (Percent deviation from baseline)


Structural Reforms in the Euro Area Core


Spillovers to the Euro Area Periphery


Global Integrated Monetary and Fiscal model simulations using OECD and IMF staff estimates.

policy would remain accommodative in the short term, leading to higher inflation, thereby reducing real interest rates and boosting real GDP.

Reforms in the periphery would boost competitiveness and help rebalancing, even if the core reforms simultaneously. The spillovers from increased productiv-ity of one region to the other would lead to extra expansion of their productive capacities, further driving up both employment and real wages ( Table 7.6 ). Con-sequently, greater gains occur in labor productivity under simultaneous reform. However, the decline in the real effective exchange rate and unit labor costs would not be as great in the long term under simultaneous reform—both regions are producing goods more cheaply, and one region could not have achieved the com-petitive advantage that would result if only one region had reformed. Nonethe-less, in the simultaneous reform scenario, rebalancing between the core and the periphery would still occur because the periphery would depreciate against the core (albeit not as strongly) because it has a more comprehensive package of re-forms, which would be reinforced by larger productivity spillovers from the core (larger than the effect of its own productivity reforms spilling over to the core).

In addition, simultaneous reform in both the core and the periphery would have a long-term positive, but modest, impact on the global economy. The rest of world’s real GDP would be about ½ percent above baseline in the long term ( Table 7.7 ). The short-term spillovers would be negative for the rest of the world because the euro would depreciate. However, in the long term, spillovers from the euro area would be larger, emanating from higher productivity levels and a posi-tive income effect in the euro area that would increase the euro area demand for goods from the rest of world. Also, because the euro area debt-to-GDP ratio would decline by 20 percentage points from pension and unemployment reforms in the long term, a larger pool of global savings would be available for investment, thereby driving down the global real interest rate. This lower interest rate would lower the global cost of capital and stimulate the global economy.



TABLE 7.6

Structural Reforms Individually or Simultaneously (Percent deviation from baseline)


Core when only Core Reforms

Real GDP 0.8 1.6 3.4 10.2Employment 0.9 1.6 1.8 3.0Real wages 0.1 0.2 0.8 6.1Unit labor cost 0.2 0.3 −0.7 −0.8Labor productivity −0.2 −0.2 1.2 5.9Real bilateral periphery exchange rate 0.0 −0.1 −0.9 −2.3Real effective exchange rate −0.3 −0.4 −0.9 −2.5

Core when Entire Euro Area Reforms

Real GDP 1.1 2.1 3.7 10.6Employment 1.4 2.4 2.0 3.0Real wages 0.3 0.6 1.3 6.9Unit labor costs 0.6 0.9 −0.4 −0.5Labor productivity −0.3 0.4 1.4 6.7Real bilateral periphery exchange rate 0.0 0.1 0.3 1.5Real effective exchange rate −0.4 −0.5 −0.7 −1.8

Periphery when only Periphery Reforms

Real GDP 0.7 1.5 4.1 13.6Employment 0.7 1.4 2.3 4.2Real wages 0.0 −0.2 0.4 7.7Unit labor costs 0.0 −0.3 −1.3 −1.2Labor productivity −0.1 0.0 1.4 7.6Real bilateral core exchange rate 0.0 −0.2 −1.1 −3.7Real effective exchange rate −0.2 −0.3 −1.1 −3.9

Periphery when Entire Euro Area Reforms

Real GDP 1.4 2.7 4.8 15.4Employment 1.7 2.9 2.6 4.2Real wages 0.3 0.7 1.6 9.9Unit labor costs 0.6 0.9 −0.6 −0.8Labor productivity −0.3 −0.3 2.0 9.7Real bilateral core exchange rate 0.0 −0.1 −0.3 −1.5Real effective exchange rate −0.4 −0.4 −0.9 −3.2


TABLE 7.7

The Benchmark Scenario: Effects on the Rest of the World, Decomposition of Real GDP (Percent deviation from baseline)


Euro Area

Total 1.2 2.3 4.1 12.3 Core 1.1 2.1 3.7 10.6 Periphery 1.4 2.7 4.8 15.4

Rest of the World

Total 0.0 0.1 0.0 0.4 United States 0.0 0.0 0.0 0.3 Japan 0.0 0.0 −0.1 0.2 Emerging Asia 0.0 0.0 −0.2 0.0 Remaining countries 0.1 0.1 0.0 0.6




REFORM IMPLEMENTATION: MACROECONOMIC AND POLICY ENVIRONMENT

Potential gains from structural reforms could be sizable, but various macroeco-nomic and policy factors may affect their actual impact. This section focuses on three such factors:

• Policy credibility; • Short-term price stickiness; and • Initial demand conditions.

The Role of Policy Credibility

The speed at which gains could be realized in the euro area is affected by the degree of credibility of the announced reform packages. In the benchmark sce-nario, households and firms believe only gradually that the reform package will be fully implemented beyond the reforms carried out in the current year. If in-stead they immediately believed in implementation of the reform package as an-nounced, the increase in real GDP would be faster ( Figure 7.7 ). The households that can save would embrace the future increase in wealth from the promised continuation of the reform early on and would immediately increase their consumption.

The labor market would also behave very differently. If there were full policy credibility, households and firms would foresee the potential for future produc-tion, and more labor would be used in the short term, until such time that firms could invest enough to generate a higher capital stock to permanently increase their productive capacity. In the benchmark case, the labor response would be much weaker because no long-term changes in labor demand would be perceived initially. After the sixth year, labor would pick up as the full future benefits come

Figure 7.7 The Role of Credibility in the Benchmark Scenario

0 1 2 3 4 5 10 L.R. 0 1 2 3 4 5 10 L.R.Years Years

Immediately Credible: Real GDP(percent deviation from baseline)

Stepwise Credible: Real GDP(percent deviation from baseline)

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to be understood, and firms still would not have enough capital in place. So, if households and firms believe in the future path of reform, employment would peak early (in year 3) and then decline. Otherwise, employment would build gradually and would peak at a lower level (in year 6), but the peak would be sustained for a longer time. Once households and firms fully believe in the reform package, the results are the same as under the case in which they believe in the reform package from the start.

The Role of Short-Term Price Stickiness

Competition-enhancing structural reforms reduce price and wage markups, but short-term costs of adjustment matter as well. Changes in markups would have short- and long-term effects on macroeconomic aggregates, but they do not di-rectly affect the short-term dynamics of prices. In the short term, prices are driven by nominal adjustment costs present in the economy. In the benchmark scenario, changes in prices from any given shock take roughly 50 percent longer to work their way through the economy than in the most flexible major region, the United States. However, as markets become more competitive, the speed of price adjust-ment can be expected to increase.

An assumption of more flexible prices in the euro area does not materially af-fect the results. The analysis assumes that the monetary policy rule in the euro area has the same level of aggressiveness as in the United States, given that this property is related to the short-term stickiness of prices. The benchmark reform scenario is tested under this different assumption, without considering the transi-tion path from higher to lower price stickiness. The outcomes can be read as the upper bound of the effects on the transition dynamics from their impact on product and labor market reforms ( Table 7.8 ). The long-term results remain unchanged, while there are slightly greater gains in the short term because firms

TABLE 7.8

The Role of Price Stickiness in the Short Term, Decomposition of Real GDP (Percent deviation from baseline)


Euro Area

All reforms Benchmark scenario 1.2 2.3 4.1 12.3 Price stickiness similar to United States 1.8 2.8 4.0 12.3Product market reforms Benchmark scenario 0.2 0.5 1.7 7.2 Price stickiness similar to United States 0.3 0.5 1.7 7.2Labor market reforms Benchmark scenario 0.5 0.9 1.4 3.0 Price stickiness similar to United States 0.7 1.1 1.4 3.0Tax reforms Benchmark scenario 0.4 0.7 0.8 1.2 Price stickiness similar to United States 0.5 0.8 0.8 1.2




and households more rapidly adjust their prices and wages to reflect the future changes in the economy, thereby incurring lower costs from short-term inertia.

The Role of Demand Conditions

Weak demand and excess capacity conditions may limit the short-term output response to reforms. In particular, balance sheet concerns and low confidence encumber private sector decisions, thereby weakening demand and possibly hin-dering the effectiveness of supply-side reforms. For example, relaxing employ-ment protection may not stimulate hiring in the short term, but increase unemployment. Similarly, reducing unemployment insurance or increasing the retirement age would lower disposable income if those induced to seek work can-not find jobs. Overall, there are considerable uncertainties about the immediate effects of implementing structural reforms during a recession.

An illustration estimates the worst-case impact of weak demand conditions by assuming that firms would not hire any additional workers. No hiring would occur despite the increase in labor supply that comes from labor market reforms such as increased child care, ALMP, and reduced unemployment insurance ben-efits. In reality, labor demand would most likely increase in the long term, al-though the negative short-term effects could occur. Demand for other factors of

Figure 7.8 Impact of Weaker Initial Demand Conditions

0 1 2 3 4 5 10 L.R. 0 1 2 3 4 5 10 L.R.Years Years



Weaker demand conditionsModified benchmark scenario

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production would also be lower compared with the benchmark scenario. To dis-cuss the lower bound effectively, the analysis only considers the case in which reforms are immediately and fully believed in by households and firms, and compares this to the version of the benchmark scenario implemented in the same manner (as shown in the left panel of Figure 7.7 ).

The short-term impacts on real GDP would be substantial because real GDP would fall in the first year instead of increasing. The shortfall could be as high as 4 percent of real GDP ( Figure 7.8 ), driven primarily by labor market reforms. Real wages would decline relative to the benchmark because the increase in labor supply would allow firms to slash wages, and the marginal product of labor would decline.

Product market and tax reforms would still be fairly effective in the medium term under restricted labor demand. Both sets of reforms act on both factors of production, capital and labor. So although employment may not increase in this scenario, capital will increase by almost enough to overcome the weakness in labor demand. On the demand side, labor income, on balance, would be lower than in the benchmark scenario, although households that save would experience higher wealth from the notable increase in the capital stock (which is an increase in the equity of firms). Moreover, the depreciation in the real effective exchange rate would be greater because all goods would be even cheaper, not only from the decrease in markups and increase in productivity from the reforms, but also from the long-term decline in real wages in response to rigid labor demand.

CONCLUDING REMARKS

The analysis illustrates that structural reforms in the euro area can increase its real GDP markedly, though it may take time for their full potential to be achieved. Structural reforms are critical to improving the long-term capacity of economies to grow through both more intensive use of resources and higher productivity. Weak demand conditions may dampen the already small short-term impact. The long-term gains are largest in the periphery countries, where growth is most needed. Reforms would also boost euro area competitiveness. The largest gains for euro area countries could come from product market reforms; labor market re-forms could have a positive but more modest impact on real GDP. Simultaneous implementation of product and labor market reforms would generate an addi-tional GDP payoff.

REFERENCES

Allard, C., L. Everaert, with A. Annett, A. Chopra, J. Escolano, D. Hardy, M. Mülheisen, and B. Yontcheva, “Lifting Euro Area Growth: Priorities for Structural Reforms and Governance,” IMF Staff Position Note 10/19 (Washington: International Monetary Fund).

Anderson, D., B. Hunt, M. Kortelainen, M. Kumhof, D. Laxton, D. Muir, S. Mursula, and S. Snudden, 2013, “Getting to Know GIMF: The Simulation Properties of the Global Inte-grated Monetary and Fiscal Model,” IMF Working Paper 13/55 (Washington: International Monetary Fund)

Barkbu, B., J. Rahman, R. Valdés, and a staff team, 2012, “Fostering Growth in Europe Now,” IMF Staff Discussion Note 12/7 (Washington: International Monetary Fund).



Barnes, S., R. Bouis, P. Briard, S. Dougherty, and M. Eris, 2011, “The GDP Impact of Reform: A Simple Simulation Framework,” OECD Economics Department Working Paper No. 834 (Paris: Organisation for Economic Co-operation and Development).

Bassanini, A., and R. Duval, 2006, “Employment Patterns in OECD Countries: Reassessing the Role of Policies and Institutions,” OECD Economics Department Working Paper No. 486 (Paris: Organisation for Economic Co-operation and Development).

Bassanini, A., L. Nunziata, and D. Venn, 2009, “Job Protection Legislation and Productivity Growth in OECD Countries,” Economic Policy, Vol. 24, No. 4, pp. 349–402.

Blanchard, O., F. Jaumotte, and P. Loungani, 2013, “Labor Market Policies and IMF Advice in Advanced Economies during the Great Recession,” IMF Staff Discussion Note No. 13/02 (Washington: International Monetary Fund).

Bouis, R., O. Causa, L. Demmou, R. Duval, and A. Zdzienicka, 2012, “The Short-Term Effects of Structural Reforms: An Empirical Analysis,” OECD Economics Department Working Paper No. 949 (Paris: Organisation for Economic Co-operation and Development).

Bouis, R., and R. Duval, 2011, “Raising Potential Growth after the Crisis: A Quantitative As-sessment of the Potential Gains from Various Structural Reforms in the OECD Area and Beyond,” OECD Economics Department Working Paper No. 835 (Paris: Organisation for Economic Co-operation and Development).

Bourlès, R., G. Cette, J. Lopez, J. Mairesse, and G. Nicoletti, 2010, “Do Product Market Regu-lations in Upstream Sectors Curb Productivity Growth? Panel Data Evidence for OECD Countries,” NBER Working Paper No. 16520 (Cambridge, Massachusetts: National Bureau of Economic Research).

Boylaud, O., and G. Nicoletti, 2003, “Regulatory Reform in Retail Distribution,” OECD Economic Studies No. 32, 2001/I 253 (Paris: OECD Publishing).

Christopoulou, R., and P. Vermeulen, 2008, “Markups in the Euro Area and the US over the Period 1981–2004,” European Central Bank Working Paper No. 856 (Frankfurt: European Central Bank).

Coe, D.T., and E. Helpman, 1995, “International R&D Spillovers,” European Economic Review , Vol. 39, No. 5, pp. 859–87.

———, and A.W. Hoffmaister, 1997, “North-South R&D Spillovers,” Economic Journal, Vol. 107, No. 440, pp. 134–49.

International Monetary Fund (IMF), 2012, Italy: Selected Issues , IMF Country Report No. 12/168 (Washington: International Monetary Fund).

———, 2013a, Euro Area: Staff Report for the 2013 Article IV Consultation , IMF Country Re-port No. 13/231 (Washington: International Monetary Fund).

———, 2013b, “IMF Multilateral Policy Issues Report: 2013 Spillover Report,” IMF Policy Paper (Washington: International Monetary Fund).

Jaumotte, F., 2003, “Female Labour Force Participation: Past Trends and Main Determinants in OECD Countries,” OECD Economics Department Working Paper No. 376 (Paris: Organ-isation for Economic Co-operation and Development).

Kumhof, M., D. Laxton, D. Muir, and S. Mursula, 2010, “The Global Integrated Monetary and Fiscal Model: Theoretical Structure,” IMF Working Paper 10/34 (Washington: Interna-tional Monetary Fund).

Lumenga-Neso, O., M. Olarreaga, and M. Schiff, 2005, “On Indirect Trade-Related R&D Spillovers,” European Economic Review , Vol. 49, No. 7, pp. 1785–98.

Lusinyan, L., and D. Muir, 2013, “Assessing the Macroeconomic Impact of Structural Reforms: The Case of Italy,” IMF Working Paper 13/22 (Washington: International Monetary Fund).

Martin, J., and S. Scarpetta, 2012, “Setting It Right: Employment Protection, Labour Realloca-tion and Productivity,” De Economist, Vol. 160, No. 2, pp. 89–116.

———, 2013, Economic Policy Reforms 2013: Going for Growth (Paris: Organisation for Economic Co-operation and Development).


173

CHAPTER 8

A Disaggregated Approach to Prioritizing Structural Reforms for Growth and Employment

CRISTINA CHEPTEA AND DELIA VELCULESCU

A GRANULAR APPROACH TO REFORM

Achieving sustained growth is no simple feat, given that it involves important policy choices and tradeoffs. Chapter 7 shows that designing structural reform packages can be difficult. But the challenges run even deeper. Details matter when complicated institutional changes are required, and details can get overlooked be-yond the general statement that labor and product markets require reform. And the process of choosing and implementing reforms—from fiscal outlays to the need to adapt legal and institutional frameworks and dealing with complications posed by political economy considerations—is not costless. Were it not for these costs, most countries would likely have implemented most reforms a long time ago.

This chapter takes a disaggregated look at reform options and uses a simple model to illustrate and weigh their benefits and costs. Despite a plethora of avail-able structural indicators and databases, policy recommendations sometimes lack specificity. Focusing on the EU-27 countries,1 this chapter first assesses the cross-country impact on growth of a large number of institutional indicators and then develops a simple framework for prioritizing them, based on their impact on growth, but also taking into account the relative costs of reforming them. Based on both, a reform efficiency variable is constructed that can help rank reform options. The analysis expands on the methodology developed by Tavares (2004) for Portugal to include a broader set of institutional determinants of growth, covering a longer period (1960–2010), a broader set of countries, and, most im-portant, a richer set of reform cost specifications.2

The results suggest that a more detailed analysis can be helpful. First, taking a disaggregated approach allows policymakers to focus on those aspects of a measure for which improvements would have the largest relative impact on growth. Second,

1EU-27 countries are Austria, Belgium, Bulgaria, Cyprus, the Czech Republic, Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Ireland, Italy, Latvia, Lithuania, Luxembourg, Malta, the Netherlands, Poland, Portugal, Romania, the Slovak Republic, Slovenia, Spain, Sweden, and the United Kingdom.2See also Cavalcanti, Magalhaes, and Tavares (2008), who use this methodology for Brazil.


174 A Disaggregated Approach to Prioritizing Structural Reforms for Growth and Employment

explicitly taking into account the costs of reforms can change the priority assigned to different actions. For example, one measure may have a large growth impact but could be very costly to implement, whereas another with more moderate growth effects may be more cost efficient. However, the way costs are calculated matters greatly for the results, and policymakers will have to make case-specific assessments of the benefits and costs associated with an available set of policy options.

EMPIRICAL ANALYSIS

The empirical analysis starts with the identification of a broad range of cross-country structural indicators. Drawn from a variety of sources, these variables cover the labor market, product and service markets, the business environment, the judicial system, credit and finance, corporate governance, research and devel-opment, trade, infrastructure, education, and measures of corruption.3 GDP data were taken from the IMF World Economic Outlook database and, where missing, from the Angus Maddison database. No political or other very general or subjec-tive indicators were included, and those that duplicated information were dropped. In all, close to 350 indicators were initially considered.

The next step is to estimate the correlation of each structural indicator with long-term growth. In line with Tavares (2004), a cross-sectional empirical analysis was conducted for 194 countries, following the standard neoclassical growth model.4 Average yearly growth in the period 1960–2010 was regressed on initial GDP per capita and, one-by-one, each structural indicator. Because institutions change slowly and the focus of the study is on long-term growth, average yearly growth for 1960–2010 was used as the dependent variable.5 The approach stresses transparency and robustness, while omitting potentially endogenous explanatory variables such as investment rates, and employs a standard linear regression model. The analysis does not aim to establish causality, but rather to identify potential structural indicators that appear to be correlated with growth. More specifically, for each structural indicator the model took the following form:

GDP growth1960–2010 = 0 + 1 ln GDP1960 + 2 Institutional Variable. (8.1)

3Sources include the Bertelsmann Transformation Index; Economic Freedom of the World (Gwartney, Lawson, and Hall, 2012); Freedom House; the Organisation for Economic Co-operation and Devel-opment (OECD); the PRS International Country Risk Guide; Transparency International; the World Bank’s Doing Business Report; the World Bank’s Worldwide Governance Indicators; and the World Economic Forum databases; and a number of academic papers, in particular, Botero and others (2003); Djankov and others (2002a, 2002b); La Porta and others (2003); Knack and Kugler (2002); Treisman (2007); Evans and Rauch (1999); and Feld and Voigt (2003).4Ordinary least squares regressions were run, with standard errors corrected for heteroskedasticity. Not all indicators were available for all countries for the period specified, and in some cases a smaller sample was used.5The initial level of GDP per capita serves as a proxy for the convergence effect because countries with higher initial levels of income will tend to grow more slowly than countries that are still catching up. For a literature review on convergence, see Caselli, Esquivel, and Lefort (1996) and Li and Zhou (2011).


Cheptea and Velculescu 175

A large number of potentially relevant structural indicators were selected. Specifically, 121 variables were identified as significant (see Appendices 8A and 8C),6 including all indicators related to corruption, research and development, corporate governance, and infrastructure, regardless of definition or source. Other indicators also showed a significant correlation with growth, in particular those for education, trade, credit and finance, the legal system, and business regulation. In line with the existing literature, product and service market characteristics played a role, even though the results were hampered by smaller sample sizes; significant correlations between labor market characteristics and growth were somewhat more difficult to find (for example, only 16 of 65 labor market indica-tors turned out to be statistically significant) (DeFreitas and Marshall, 1998; Nickell and Layard, 1999; Becker and Gordon, 2008).

REFORM AREAS AND PRIORITIES: A COST-BENEFIT ANALYSIS

Reforms and Growth

Drawing on Tavares (2004), the indicators are used to compare different ap-proaches to structural reform (see Appendix 8B). This approach aims to determine which structural areas could potentially bring particularly large growth dividends under the assumption that the correlations identified earlier allow for the struc-tural indicators to drive growth to some extent. A later second step discusses how costs could be brought into the assessment of reform priorities. At this stage, two indices are calculated that (1) capture how far a country would have to go to reach best practice in a given reform area, and (2) yield the potential growth impact of such a move. These indices are examined for the EU-27 in aggregate, for selected subregions, and for individual countries.

• The relative distance from best practice is estimated as the difference between the structural index for each European Union (EU) country and the average of the world’s top five countries in each category (taking into account whether a higher index reflects better or worse performance), divided by the index for best practice:7

Rel Distance =−Index Index

IndexCountry Best

Best

(8.2)

• This indicator helps to identify and rank structural gaps at the price of some simplification. In particular, for transparency and uniformity of treatment, it

6Significance was selected at the 10 percent confidence level. Regressions were run with different time periods. Results were broadly robust, although significance diminishes as the period is shortened.7Note that unlike in Tavares (2004), where best practice is defined as the EU average, this study takes the best five countries in the world as a proxy for best practice for each area analyzed. In many cases, this turns out to be the more ambitious benchmark.



abstracts from the fact that, depending on the area and definition of the indices applied, having a minimal level of regulation might be optimal.

• The impact on growth is calculated as the product of the reform-specific regression coefficient estimated in the cross-country regressions and the country-specific difference between the structural index for each EU coun-try and the index for the top five. This calculation provides an indication of the magnitude of the maximum growth impact a specific structural reform could achieve if it moved an individual EU country to best practice in that area (implicitly assuming that the growth impact is linear in the absolute distance). Thus,

Growth impact = × (IndexCountry − IndexBest). (8.3)

These estimates should be treated as broad gauges of the relative impor-tance of particular indicators for growth and not be interpreted as precise point estimates.

Distance to benchmark

Based on the distance-to-benchmark metric, the EU-27, as a group, has large opportunities for reform in labor markets, business regulation, product markets, and legal structures (Figure 8.1). Employment protection in the EU, as mea-sured by high redundancy costs, appears to have the largest measured distance to best practice, next to a number of indicators of ease of doing business, includ-ing the cost of getting electricity, starting up a business, and getting a construc-tion permit, as well as the time to register property. Product and service market regulation and the market structure for gas were also far from best practice, as were legal indicators such as the cost of resolving insolvency and bounced check collection.

Based on this approach, Southern and Eastern European countries show rela-tively large reform gaps. For this analysis the EU-27 are split into five groups: Core (Austria, Belgium, France, Germany, Luxembourg, and the Netherlands), South (Cyprus, Greece, Italy, Portugal, and Spain),8 North (Denmark, Finland, and Sweden), UK-Ireland, and East (Bulgaria, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, the Slovak Republic, and Slovenia). There are clear geographical distinctions between these groups with regard to performance on the reform measures (Table 8.1), with the South faring relatively worse on in-dicators of labor market redundancy costs and starting a business, among others.9

For the East countries, the cost of electricity and registering property, among oth-ers, are relatively farthest from best practice. The North countries lag most on

8Malta is not included in the summary tables given limited data coverage.9The aggregate UK-Ireland also features relatively high redundancy costs, although labor market regu-lations vary between the two countries.



Figure 8.1 EU-27: Top 10 Indicators: Relative Distance from Best Practice

0 20 40 60 80

Use of command and control regulation

Bounced check collection: Statutory regulation

Operational restrictions

Cost of resolving insolvency

Gas: Market structure

Cost of dealing with construction permits

Days registering property

Cost of starting a business

Cost of getting electricity

Redundancy costs

Source: IMF staff calculations.Note: The x-axis represents the relative distance from best practice, estimated as the difference between the structural index for the EU and the average of the world's top five countries in each category, divided by the index for best practice.

TABLE 8.1

Relative Distance from Best Practice by Country Group

Core South North UK-Ireland East Euro Area

Redundancy costs 77.3 125.0 43.0 49.0 57.0 84.6Cost of getting electricity 14.5 35.9 12.9 18.6 59.7 27.0Cost of starting a business 16.7 52.1 2.1 1.5 20.5 23.6Days to register property 19.4 10.4 5.9 17.6 21.3 17.0Cost of dealing with construction permits 11.9 13.7 16.5 11.3 14.1 11.4Gas: Market structure 4.3 4.7 6.2 4.8 7.9 5.6Cost of resolving insolvency 5.0 7.3 2.5 3.7 6.4 5.6Operational restrictions 8.2 6.7 7.2 4.7 2.2 6.1Bounced check collection: Statutory regulation of evidence

4.8 7.4 3.2 1.5 6.5 5.7

Use of command and control regulation 6.1 7.6 2.8 3.7 4.8 5.4Barriers to foreign direct investment 4.5 6.0 4.5 1.8 6.7 5.2Tenant eviction: Statutory regulation of evidence 4.4 7.0 3.2 1.3 5.9 5.4Administrative burdens for sole proprietor firms 3.9 6.7 3.4 0.4 6.8 4.8Barriers to trade and investment 4.0 5.4 3.6 0.7 7.4 4.9Days for dealing with construction permits 4.0 8.4 1.5 2.7 4.8 5.4Days to start a business 4.4 5.9 3.7 4.2 5.0 4.2Electricity: Public ownership 3.3 3.3 4.5 3.0 4.5 3.8Protection of existing firms 3.5 3.6 5.0 3.0 1.5 3.2

Source: IMF staff calculations.Note: See text for composition of groups. The table shows the top 10 areas for relative distance to best practice for each group of countries. Gray = values higher than 10; blue = values between 5 and 10; and yellow = values lower than 5.

costs of construction permits and protection of existing firms, with the latter also highly relevant for the Core (covered under operational restrictions).

For most European countries, business regulation and labor market indicators top the list for largest relative distance to best practice (Table 8.2). Out of 29 indicators that fell in the top 10 areas farthest from best practice for at least one


17

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an

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mp

loym

en

t TABLE 8.2

Ranking of Relative Distance from Best Practice (Ranked 1–10, 1 being the farthest from best practice)

Au

stri

a

Bel

giu

m

Fran

ce

Ger

man

y

Luxe

mbo

urg

Net

her

lan

ds

Cypr

us

Gre

ece

Ital

y

Port

uga

l

Spai

n

Den

mar

k

Fin

lan

d

Swed

en

Un

ited

Kin

gdom

Irel

and

Bu

lgar

ia

Czec

h R

epu

blic

Esto

nia

Hu

nga

ry

Latv

ia

Lith

uan

ia

Pola

nd

Rom

ania

Slov

ak R

epu

blic

Slov

enia

Cost of getting electricity 1 4 5 5 3 4 4 5 2 2 2 1 6 2 2 1 2 2 3 1 2 3 1 2 3Redundancy costs 1 1 1 1 1 1 2 4 1 1 1 1 1 1 3 1 1 1 2 1 4 2 1 1Days to register property 5 2 2 2 2 3 8 5 4 5 4 3 4 4 4 5 4 1 4 8 2Cost of dealing with construction permits 3 6 4 2 6 3 3 5 2 2 2 3 4 2 10 7 6 3 4Cost of starting a business 2 3 3 9 3 2 1 1 4 3 6 3 5 2 3 3 2 5 10Cost of resolving insolvency (% of estate) 6 9 8 7 6 8 8 10 7 5 6 5 8 9 5Gas: Market structure 9 10 8 7 5 8 4 5 10 5 7 3 10 6 9Bounced check collection: Index, statutory regulation of evidence 10 7 7 10 10 6 6 8 10 7 6 4 7 5Tenant eviction: Index, statutory regulation of evidence 6 6 9 9 9 7 9 8 7 6 6 6Operational restrictions 8 7 3 9 4 6 8 10 3 3 6 8Days to start a business 7 4 10 6 7 5 9 8 5 7Days dealing with construction permits 10 7 5 9 8 9 9 8 9Barriers to trade and investment 4 8 4 10 6 8 8 3Barriers to foreign direct investment 8 10 7 8 3 5 4Administrative burdens for sole proprietor firms 5 7 8 7 4 9 10Use of command and control regulation 5 4 3 9 5 6 8Explicit barriers 9 6 8 9 6 7Protection of existing firms 8 6 5 9 7Electricity: Public ownership 5 7 4 6Electricity indicator 10 7 9Licensing: Engineers 10 9 9Procedures to start a business 9 10Years to resolve insolvency 10 10Duration of specialized education for accountants 9 10Duration of specialized education for architects 7 7Duration of specialized education for engineers 10 8Licensing: Architects 10 10Sector-specific administrative burdens 9 7Involvement in business operation 10

Source: IMF staff calculations.Note: Gray = ranks of 3 and lower; yellow = ranks between 4 and 6; and blue = ranks of 7 and higher.



country, 15 relate to reforms of product and services markets. Redundancy costs in the labor market were also relevant for 18 countries (Figure 8.2). With some exceptions, many European countries also appear to fall short of best practice as judged by business regulation indicators.

Impact on growth

Turning from the size of reform gaps to their possible impact on growth, the EU-27 as a group appears to benefit most from addressing areas such as research and development (R&D), access to finance, legal institutions, and infrastructure (Figure 8.3). A high ranking reflects the combination of large reform potential in these areas—that is, a large relative distance to the benchmark—and relatively large estimated growth impacts ( from the equations). Thus, for example, de-spite the large gap in employment protection legislation, addressing this area does not appear among the ones with a relatively high growth impact for the EU-27. Similarly, improving the ease of doing business does not appear to have a large effect on growth in Europe. By contrast, dealing with corruption and improving the legal framework are shown to strongly influence growth in the EU. Moreover, even if not identified among the areas lagging most relative to best practice, spending on R&D and fostering innovation through patenting policies are im-portant to driving growth in Europe. Finally, in line with the literature, improv-ing the affordability of financial services through increased competition would beneficially affect growth (Levine, 2004; Rajan and Zingales, 1998; Rioja and Valev, 2004).

The average growth impact of closing identified reform gaps would appear to be the largest for the South and East groups of countries (Figure 8.4). For these two groups, the average estimated growth dividends from structural reforms are double those of the Core, and close to three times as high as those for the North.

Figure 8.2 Relative Distance to Best Practice: Redundancy Costs in Labor Market

0

50

100

150

200

250Po

rtuga

lG

erm

any

Cyp

rus

Spai

nLu

xem

bour

gSl

oven

iaEs

toni

aH

unga

ryFr

ance

Lith

uani

aFi

nlan

dSw

eden

Slov

ak R

ep.

Gre

ece

Uni

ted

King

dom

Cze

ch R

epub

licIre

land

Net

herla

nds

Latv

iaBe

lgiu

mPo

land

Italy

Bulg

aria

Rom

ania

Aust

riaD

enm

ark

Source: IMF staff calculations.Note: The y-axis represents the relative distance from best practice, estimated as the difference between the structural index for the EU and the average of the world's top five countries in each category, divided by the index for best practice.



Figure 8.4 Average Growth Effect from Institutional Reforms

0.0

0.2

0.4

0.6

0.8

1.0

1.2

East South Core UK-Ireland North

Source: IMF staff calculations.Note: The y-axis represents the average growth increase across all types of indicators.

Figure 8.3 EU-27: Top 10 Indicators: Impact on Growth

0.0 0.5 1.0 1.5 2.0 2.5

Affordability of financial services

Quality of railroad infrastructure

Government procurement ofadvanced technology products

Efficiency of legal frameworkin settling disputes

Corruption (2000–11)

Impartial courts

Ease of access to loans

Company spending on researchand development

Venture capital availability

Utility patents granted permillion population

Source: IMF staff calculations.Note: The x-axis represents the percent increase in growth for the EU-27 as whole if each country moves to best practice in corresponding indicator.

There is, however, some heterogeneity among country groups (Table 8.3): for the North, the largest growth dividends come from labor market reforms helping to link pay with productivity, from stimulating R&D through patenting policies, and from corporate reforms protecting investors by facilitating disclosure. For the UK-Ireland, in addition to patents, the availability of venture capital, access to loans, and strengthening government procurement of high-tech products appear relatively more important for growth. And for the South, patenting policies and



spending on R&D, together with the availability of corporate finance, including venture capital, and judicial reforms appear to be growth enhancing.

At the country level, the estimated potential growth impact of closing the re-form gaps in all areas is largest in Bulgaria, Romania, and Greece (Figure 8.5). At the other end of the spectrum, Denmark, Finland, and Sweden appear to gain rela-tively little from institutional reforms, mostly because they are already close to the reform benchmarks. At the same time, the countries vary significantly with regard to the individual reforms that would have relatively larger growth impacts.

Focusing on the area with the largest growth dividend in each of the EU-27 countries, facilitating patenting and ensuring impartiality of courts appear most frequently. In line with a growing literature, patent policies appear to spur innova-tion and to be one of the areas most beneficial to growth in several EU-27 coun-tries (see, among others, Josheski and Koteski, 2011). Judicial reforms to increase the efficiency and impartiality of courts also appear important in some countries.

TABLE 8.3

Impact on Growth by Country Group (Cumulative percent change)

Core South North UK-Ireland East Euro area

Utility patents granted 1.85 2.71 1.11 2.15 2.75 2.25Venture capital availability 1.41 2.43 0.76 2.16 2.51 1.93Company spending on R&D 1.05 2.72 0.22 1.29 2.75 1.89Ease of access to loans 1.32 2.29 0.66 2.53 2.31 1.79Impartial courts 0.74 2.44 0.17 0.93 2.74 1.61Corruption 1.20 2.19 0.13 0.77 2.58 1.63Efficiency of legal framework in settling

disputes0.88 2.37 0.15 0.93 2.52 1.62

Government procurement of advanced technology products

1.14 1.94 0.84 1.78 2.12 1.55

Quality of railroad infrastructure 0.55 1.65 0.72 1.38 2.02 1.58Affordability of financial services 0.67 1.90 0.65 1.42 2.42 1.40Intellectual property protection 0.65 2.17 0.23 0.56 2.48 1.34Efficiency of legal framework in challenging

regulations0.60 2.13 0.03 0.84 2.36 1.38

Protection of minority shareholders’ interests 1.09 1.64 0.01 1.18 2.31 1.42University-industry collaboration in R&D 0.74 2.11 0.28 0.35 2.10 1.43Control of corruption 0.55 1.66 0.02 0.66 2.46 1.22Quality of roads 0.40 1.04 0.44 1.11 2.49 1.06Availability of scientists and engineers 1.15 1.39 0.32 0.87 1.95 1.35Strength of auditing and reporting standards 0.75 1.79 0.30 1.45 1.72 1.25Average years of schooling 1.09 1.77 0.46 1.00 1.00 1.57Strength of investor protection index 1.45 1.38 1.07 0.31 1.26 1.30Legal enforcement of contracts 0.67 1.57 0.91 1.08 1.21 1.27Pay and productivity 1.17 1.78 1.14 0.72 0.90 1.25Regulation of credit, labor, and business 1.03 1.60 0.78 1.02 0.96 1.20Internet access in schools 0.88 1.88 0.08 1.24 1.08 1.12Electricity: Public ownership 0.57 0.58 0.79 0.52 0.79 0.66Protection of existing firms 0.57 0.59 0.81 0.49 0.16 0.52

Source: IMF staff calculations.Note: R&D = research and development. See text for composition of groups. The table shows the top 10 areas that affect the growth of each group of countries. Numbers represent percent increase in growth if the country group moves to best practice in the corresponding indicator. Gray = values higher than 1.5; blue = values between 1 and 1.5; and yellow = values lower than 1.



The Role of Reform Costs

If structural reforms could be implemented at no cost, chances are that most re-form gaps would be closed quickly. But in practice, the process of choosing and implementing reforms can be complicated and requires significant effort. Real-world decisions take place under uncertainty, even if there is a road map for re-form. Moreover, fiscal outlays may need to be considered—for example, it can be costly to adapt legal and institutional frameworks, and the political economy of structural reforms can be involved, requiring policymakers to invest scarce politi-cal capital and wrestle with strong vested interests.

Against this background, policymakers will often need to select reforms by weighing their benefits against the costs. A given reform may have a very large growth impact, but may also be costly to implement. Making this tradeoff explicit requires formalizing the notion of costs—something inherently difficult and fur-ther complicated by distributional and intergenerational concerns. Those who pay the cost of reforms may not necessarily be the same groups that benefit most from them—reform costs are incurred in the short term, while the benefits ac-cumulate over the medium to long term. An exploratory step in this direction builds on the concept of reform gaps by assuming that the larger the distance from best practice, the larger the cost, or effort, required to get to best practice.10

For simplicity and ease of comparison, reform cost functions are also assumed to

10A more general specification would consider the “optimal” level of the reform index for which the marginal growth impact is equal to the marginal cost. For simplicity, and in line with what has been assumed in the calculation of growth impact, we only consider a discrete choice between staying at the current level or going all the way to best practice.

Figure 8.5 Average Growth Effect from Institutional Reforms

0.0

0.3

0.6

0.9

1.2

1.5

1.8

Bulg

aria

Rom

ania

Gre

ece

Latv

iaPo

land

Lith

uani

aSl

ovak

Rep

.Ita

lySl

oven

iaC

zech

Rep

.H

unga

ryPo

rtuga

lSp

ain

Cyp

rus

Esto

nia

Fran

ceIre

land

Aust

riaBe

lgiu

mLu

xem

bour

gG

erm

any

Net

herla

nds

Uni

ted

King

dom

Den

mar

kFi

nlan

dSw

eden

Source: IMF staff calculations.Note: The y-axis represents the average growth increase across all types of indicators.



be identical across all reforms and countries.11 These general features notwith-standing, the shape of the cost function matters—for example, on the way from zero to best practice, the largest barriers might be at the beginning, the middle, or the end. Given the lack of empirical or theoretical priors regarding the shape of such cost functions, this chapter considers two functions with opposite shapes—one concave and one convex—to illustrate the possible differences in reform ranks. More specifically,

• Reform costs are convex in the reform gap. This specification follows Tavares (2004), who calculated the cost of reform as the relative position of each EU country compared with best practice for each indicator, divided by the cur-rent level of the indicator in each EU country. This approach can be inter-preted as the percent change required to move from the status quo to best practice. In both cost specifications, the closer a country’s position to the benchmark, the lower the cost of bridging the remaining distance. But the convex shape of this specification suggests that the costs decline relatively strongly early on, at lower levels of the index. Formally,

Cost convex( ) .=−Index Index

IndexCountry Best

Country

(8.4)

• Reform costs are concave in the reform gap. As an alternative, a second cost formulation is considered, defined as the natural logarithm of the relative distance to best practice. This method yields a concave cost function, sug-gesting that the reform cost declines more substantially only when nearer the benchmark. That is,12

Cost (concave) = ln(|IndexCountry – IndexBest| + 1). (8.5)

Based on these illustrative cost functions, a reform efficiency index can be cal-culated as the impact on growth relative to the reform cost, or “bang for the buck.” Thus, if a country is found to be equally far away from best practice in several areas, decision makers can be thought to prioritize reforms on the basis of their growth dividends relative to the costs (as noted earlier, this abstracts from distributional implications of costs and benefits). Given the different shapes of the two cost functions, the resulting efficiency indices also have different shapes

11For example, one would probably not expect that reducing the relative distance of “Documents to Import” to the benchmark would have the same cost associated with it as moving the same distance on a broader area such as “Regulatory Trade Barriers.” For tractability, this distinction is not reflected in either cost calculation.12We add 1 to the absolute value of the reform gap to avoid negative cost values and to make sure that the expression is well defined for countries that have reform gaps of zero.



and will, in general, give rise to different reform rankings. The reform efficiency indices are calculated as follows:

Efficiency convex( ) =× −( )

−

α Index IndexIndex

Country Best

Country IIndexIndex

IndexBest

Country

Country= ×α (8.6)

and

Efficiency concave Index Index

IndexCountry Best

Coun

( )ln

=× −( )α

ttry BestIndex− +( )1 (8.7)

The different European regions have distinctly different reform cost structures, reflecting their relative reform gaps. Overall, reforms are most costly in the East and South groups of European countries (Figure 8.6).13 They also exhibit dis-tinctly different cost rankings (Table 8.4). Twelve reforms fall in the top 10 for at least two country groups under each of the two cost specifications. Only unem-ployment benefit reform makes the top 10 under both cost functions and appears to be among the least costly for the East, South, and Core groups under concave costs, and for the UK-Ireland group under convex costs. Legal reforms are also among the least costly for the South and East (under both cost specifications) and

Figure 8.6 Average Reform Costs

0.0

0.4

0.8

1.2

1.6

2.0

Core North UK-Ireland South East

Convex model

Concave model

Source: IMF staff calculations.Note: The y-axis represents the relative distance from best practice, estimated as the difference between the structural index for the EU and the average of the world's top five countries in each category, divided by the index for best practice.

13The high level of average reform costs under a convex specification is due to the large relative dis-tance from best practice of this group on a few indicators (including corruption, regulatory quality, and patents granted).



for the Core group under concave costs. Trade reforms, however, are least costly for the Core and UK-Ireland under convex costs, while reforming professional services costs relatively less for the North and the UK-Ireland under concave costs. Finally, improving infrastructure has relatively low costs for the Core group under a convex cost specification, and improving credit market regulations is least costly for the East.

The two reform efficiency indices have different implications for reform rank-ings in the EU-27. As expected, in most cases the differences in the shapes of the

TABLE 8.4

Required Costs by Country Group (lowest cost) (Ranked 1–10, 1 being the least costly)


(Convex function)

Regulatory trade barriers 3 2 8 1Compliance cost of importing and exporting 1 6 4 1 5 2Integrity of the legal system 6 1 6 3Nontariff trade barriers 7 4Credit market regulations 1 5Strength of auditing and reporting standards 10 6Quality of air transport infrastructure 2 4 7Prevalence of trade barriers 5 8Effectiveness of antimonopoly policy 7 8 9Internet access in schools 5 7 10Judicial independence 2 5Unemployment benefits index 3 3Protection of property rights 4 7Legal structure and security of property

rights9 4

Quality of roads 5 10Depth of credit information index 9 9

(Concave function)

Tenant eviction: Statutory regulation of evidence

1 3 10 2 1

Civil rights index 7 7 2Bounced check collection: Index, mandatory

time limits4 2 4 3

Bounced check collection: Statutory regulation of evidence

2 5 3 4

Unemployment benefits index 3 1 10 1 5Barriers to entrepreneurship 8 4 9 6Barriers to trade and investment 5 6 9 6 7Dismissal procedures index 9 5 8Product market regulation 10 8 10 9Bounced check collection: Index, professionals

vs. laymen10 10

Duration of compulsory practice for engineers

8 1 1

Duration of specialized education for architects

3 2

Regulatory quality 6 9

Source: IMF staff calculations.Note: Gray = ranks of 3 and lower; blue = ranks between 4 and 6; and yellow = ranks of 7 and higher.



assumed cost functions also translate into different shapes for the efficiency indi-ces and, therefore, can lead to different reform prioritizations (Figures 8.7 and 8.8, and Table 8.5).14 This suggests that caution is needed when moving from this conceptual framework to policymaking.

Figure 8.7 EU-27: Top 10 Indicators: Efficiency of Reform (convex model)

0 1 2 3 4 5 6 7

Prevalence of trade barriers

Availability of scientists and engineers

Quality of air transport infrastructure

Regulatory trade barriers

Effectiveness of antimonopoly policy

Internet access in schools

Protection of minority shareholders’ interests


Legal structure and security of property rights

Strength of auditing and reporting standards


Figure 8.8 EU-27: Top 10 Indicators: Efficiency of Reform (concave model)

0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0


Control of corruption

Company spending on research and development




Unemployment benefits index

Bounced check collection:Statutory regulation of evidence


Civil rights index


14For example, the convex specification indicates that the ratio of benefits to costs (efficiency) will be highest around the center of the range of reform levels; by contrast, the concave function suggests that efficiency at the tail-ends will be higher at more intermediate values.



However, some reform areas do make the top 10 lists under both specifica-tions. For example, irrespective of cost function specification, reforms to ensure the affordability of financial services by increasing competition in the banking sector and those to protect minority shareholder interests appear particularly ef-ficient in Europe. This result could be an indication that some efficiency-based reform indicators are more robust to the uncertainty regarding the appropriate modeling of the underlying cost function than others. This result is not driven by a particularly high growth impact, because neither example appears among the reform areas with the highest growth impact in most economies. Looking across countries, 13 reforms fall in the top 10 least costly reforms for at least one EU-27 country under both convex and concave cost specifications. These include re-forms to improve technology, infrastructure (airports and roads), trade (customs procedures), competition, education, financial services, and corporate governance and reporting, and to reduce corruption.

TABLE 8.5

Efficiency of Reform by Country Group (Ranked 1–10, 1 being the most efficient)


(Convex function)

Strength of auditing and reporting standards 1 1 2 2 1 1Legal structure and security of property rights 2 3 1 1 3 2Affordability of financial services 3 2 4 5 5 3Protection of minority shareholders’ interests 6 4 3 6 6 4Effectiveness of anti-monopoly policy 5 9 5 3 8 5Quality of air transport infrastructure 4 5 9 8 6Regulatory trade barriers 7 6 10 4 7Internet access in schools 8 10 6 2 8Availability of scientists and engineers 7 8 9 9 9Prevalence of trade barriers 8 7 10University-industry collaboration in R&D 10 10 4Irregular payments and bribes 9 7 7

(Concave function)

Civil Rights Index 1 1 1 1 1 1Tenant eviction: statutory regulation of evidence 2 2 2 2 2Unemployment benefits index 4 3 4 2 3Check collection: statutory regulation of evidence 3 3 3 3 4Venture capital availability 5 4 8 5 6 5Affordability of financial services 6 7 7 4 6Protection of minority shareholders’ interests 6 9 7 7Company spending on R&D 5 10 8 8Ease of access to loans 10 8 4 10 9Government procurement of advanced tech prod. 8 9 6 10Strength of auditing and reporting standards 7 10 8Dismissal procedures index 7 5Effectiveness of anti-monopoly policy 10 9

Source: IMF staff calculations.Note: Gray = ranks of 3 and lower; blue = ranks between 4 and 6; and yellow = ranks of 7 and higher.



CONCLUSION

This chapter presents a highly stylized framework that, in principle, can help prioritize structural reforms. Building on the methodology of Tavares (2004), potential reform priorities are considered based on a large number of indicators for the EU-27. The approach highlights the importance of combining the iden-tification of granular reform gaps—the relative distance to best practice—with an assessment of the economic impact of such reforms. To make informed decisions, policymakers must also take the cost of reforms into account, and the chapter proposes a simple framework for doing both.

The results point toward some potential reform areas important for growth. Structural reforms that appear to have the largest growth benefit in the EU-27 countries include those boosting innovation and R&D, financial sector reforms facilitating the private sector’s access to finance, strengthening legal institutions, and improving infrastructure. Within Europe, structural reforms are particularly important for the South and East European countries, where the growth divi-dends can be substantially larger than elsewhere in Europe.

This chapter also highlights the need for further research into the benefits and costs of structural reforms. The examination of the growth effect of reforms would benefit from a more in-depth econometric analysis, which could include additional dependent variables, including the effects of interactions among vari-ables, various timeframes, and other model-selection techniques. Moreover, al-though taking costs into account when prioritizing reforms makes good economic sense, the relationship between reform efforts and costs could take many forms. And there are strong indications that the particular assumptions made about this relationship matter for the resulting reform rankings. Indeed, reform cost specifi-cations, together with other indirect reform costs, nonlinearities, distributional and intertemporal concerns, sociopolitical considerations—including the need to protect vulnerable groups, address inequality, boost employment, address inter-generational concerns, and so on—and other country-specific circumstances would also need to be further investigated and carefully considered by policymak-ers in developing their structural reform priorities.



APPENDIX 8A. DEPENDENT VARIABLE: GROWTH OF REAL PER CAPITA GDP, 1960–2010

APPENDIX TABLE 8A

Variable Initial Income Indicator

Number of

Observations R2

Legal system

Bounced check collection: Formalism index

−0.782*** −0.321** 98 0.310.127 0.149

Bounced check collection: Index, mandatory time limits

−0.803*** −1.228** 98 0.300.128 0.611

Bounced check collection: Index, professionals vs. laymen

−0.778*** −0.945* 99 0.290.128 0.563

Bounced check collection: Index, statutory regulation of evidence

−0.821*** −2.095** 99 0.310.129 0.970

Cost of enforcing contracts (% of claim) −0.919*** −0.037*** 163 0.360.105 0.005

Cost of resolving insolvency (% of estate) −0.668*** −0.047*** 152 0.230.107 0.012

Efficiency of legal framework in challenging regulations

−0.734*** 0.964*** 135 0.400.097 0.143

Efficiency of legal framework in settling disputes

−0.725*** 0.889*** 135 0.400.096 0.132

Impartial courts −0.658*** 0.450*** 135 0.220.109 0.184

Integrity of the legal system −0.847*** 0.451*** 120 0.380.112 0.068

Judicial independence −0.661*** 0.138** 163 0.200.108 0.056

Legal enforcement of contracts −0.812*** 0.480*** 134 0.290.118 0.088


−1.077*** 0.882*** 137 0.550.095 0.078

Procedures for enforcing contracts −0.682 −0.052** 163 0.200.109 0.022

Protection of property rights −0.895*** 0.672*** 124 0.570.089 0.065

Recovery rate of resolving insolvency (cents on the dollar)

−0.938*** 0.039*** 163 0.370.105 0.005

Tenant eviction: Index, statutory regulation of evidence

−0.826 −2.147** 99 0.290.132 1.033

Years to resolve insolvency −0.668*** −0.454** 152 0.270.103 0.091

Corporate governance

Ease of shareholder suits index −0.008 0.189* 146 0.020.192 0.106

Extent of disclosure index −0.661*** 0.138** 163 0.200.108 0.056

Prevalence of foreign ownership −0.721*** 0.846*** 135 0.340.102 0.157


−0.708*** 1.234*** 135 0.420.094 0.170


−0.942*** 1.247*** 135 0.450.099 0.156

(Continued )




Number of

Observations R2

Strength of investor protection index −0.734*** 0.368*** 163 0.250.108 0.094

Business regulations

Administrative burdens on startups −1.434*** −0.360** 40 0.670.179 0.164

Administrative requirements −0.605*** 0.299** 124 0.220.115 0.135

Barriers to entrepreneurship −1.529*** −1.117*** 40 0.710.165 0.328

Barriers to foreign direct investment −1.349*** −0.508*** 40 0.690.148 0.178

Burden of government regulation −0.610*** 0.375* 135 0.210.109 0.209

Bureaucracy costs −1.128*** −0.774*** 124 0.540.102 0.080

Business regulations −0.685*** 0.764*** 136 0.270.110 0.150

Cost of dealing with construction permits −0.780*** −0.001*** 162 0.310.104 0.000

Cost of getting electricity −0.927*** 0.000*** 163 0.350.106 0.000

Cost of starting a business −0.879*** −0.013*** 163 0.330.106 0.002

Cost of tax compliance −0.560*** 0.145** 134 0.160.116 0.071

Days dealing with construction permits −0.680*** −0.003*** 162 0.230.107 0.001

Days registering property −0.691*** −0.008*** 163 0.230.107 0.002

Days to start a business −0.662*** −0.013** 133 0.220.111 0.006

Licensing restrictions −0.721*** 0.398*** 134 0.320.107 0.065

Procedures to start a business −0.656*** −0.073* 133 0.210.112 0.043

Regulation of credit, labor, and business −0.686*** 0.635*** 137 0.220.116 0.163

Regulatory quality −1.060*** 1.224*** 168 0.480.095 0.127

Regulatory restrictions on the sale of real property

−0.627*** 0.214** 134 0.170.122 0.088

Infrastructure

Government involvement in infrastructure sector

−1.315*** −0.308* 40 0.660.156 0.154

Quality of air transport infrastructure −0.942*** 1.004*** 135 0.500.093 0.109

Quality of port infrastructure −0.887*** 0.894*** 135 0.460.096 0.111

Quality of railroad infrastructure −0.942*** 0.702*** 117 0.410.121 0.099

Quality of roads −0.890*** 0.855*** 135 0.500.092 0.095

APPENDIX TABLE 8A (Continued )




Number of

Observations R2

Labor

Civil rights index −0.576*** −3.106** 83 0.220.145 1.209

Cooperation in labor-employer relations −0.741*** 0.961*** 135 0.440.106 0.206

Dismissal procedures index −0.577*** −1.354** 83 0.200.147 0.652

Flexibility of wage determination −0.610*** −0.301* 135 0.210.109 0.171

Hiring and firing regulations, minimum wage

−0.538*** 0.145*** 134 0.180.112 0.051

Pay and productivity −0.757*** 0.851*** 135 0.270.111 0.217

Redundancy costs −0.674*** −0.006** 131 0.220.114 0.003

Unemployment benefits index −1.012*** 2.052*** 83 0.270.187 0.592

Credit and finance

Affordability of financial services −0.887*** 1.260*** 135 0.480.094 0.147

Capital controls −0.626*** 0.136** 136 0.170.119 0.053

Credit market regulations −0.632*** 0.352*** 137 0.190.116 0.117

Depth of credit information index (0−6) −0.781*** 0.239** 163 0.230.113 0.067

Ease of access to loans −0.842*** 1.079*** 135 0.380.103 0.168

Financing through local equity market −0.672*** 0.805*** 135 0.360.098 0.136

Foreign ownership or investment restrictions

−0.819*** 0.606*** 124 0.360.109 0.105

Getting credit: Strength of legal rights index (0−10)

−0.658*** 0.130** 163 0.200.108 0.060

International capital market controls −0.690*** 0.276*** 137 0.220.116 0.070

Venture capital availability −0.874*** 1.192*** 135 0.390.103 0.178

Corruption

Control of corruption −1.089*** 1.227*** 168 0.510.092 0.118

Corruption (2000−11) −0.995*** 0.545*** 164 0.430.099 0.064

Favoritism in decisions of government officials

−0.771*** 0.826*** 135 0.350.103 0.145

Irregular payments and bribes −1.031*** 0.962*** 135 0.51

Product and services markets

Administrative burdens for sole proprietor firms

−1.453*** −0.352*** 40 0.690.168 0.129

Airlines −1.477*** −0.438*** 40 0.740.145 0.109

(Continued )




Number of

Observations R2

Airlines: Public ownership −1.358*** −0.191*** 40 0.690.150 0.068

Barriers to entry in services −1.237*** 0.288** 40 0.660.146 0.135


−1.175*** −0.182* 37 0.690.158 0.099

Duration of specialized education for accountants

−1.188*** −0.175* 37 0.680.158 0.101


−1.328*** −0.120* 37 0.690.153 0.062

Duration of specialized education for engineers

−1.265** −0.119* 37 0.690.150 0.062

Effectiveness of antimonopoly policy −0.778*** 1.206*** 135 0.420.096 0.167

Electricity indicator −1.342*** −0.206* 40 0.660.165 0.110

Electricity: Public ownership −1.237*** −0.175** 40 0.670.145 0.079

Explicit barriers −1.557*** −0.981*** 40 0.780.138 0.195

Gas: Market structure −1.469*** −0.144** 37 0.760.150 0.071

Involvement in business operation −1.434*** −0.448*** 40 0.710.154 0.139

Licensing: Architects −1.581*** −0.099* 36 0.760.160 0.057

Licensing: Engineers −1.584*** −0.118** 36 0.770.149 0.049

Operational restrictions −1.418*** 0.212** 37 0.780.148 0.098

Price controls −0.631*** 0.188** 130 0.180.123 0.074

Product market regulation −1.588*** −1.106*** 40 0.760.148 0.238

Protection of existing firms −1.195*** 0.218*** 40 0.710.134 0.065

Public ownership −1.350*** −0.396** 40 0.670.156 0.168

Rail: Public ownership −1.228*** −0.234* 40 0.650.149 0.136

Requirements in education for engineers −1.242*** −0.178** 37 0.690.149 0.086

Restrictions to competition in seven industries

−1.502*** −0.620** 40 0.680.187 0.250

Scope of public enterprise sector −1.370*** −0.381*** 40 0.690.152 0.137

Sector-specific administrative burdens −1.384*** −0.284* 40 0.650.182 0.165

State control −1.459*** −0.577*** 40 0.710.154 0.171

Telecommunications: Market structure −1.604*** −0.368*** 38 0.780.145 0.125

Use of command and control regulation −1.408*** −0.331*** 40 0.710.150 0.102

APPENDIX TABLE 8A (Continued )




Number of

Observations R2

Trade

Barriers to trade and investment −1.460*** −0.841*** 40 0.740.141 0.203

Burden of customs procedures −0.828*** 1.046*** 135 0.400.100 0.156

Compliance cost of importing and exporting

−0.877*** 0.513*** 134 0.430.103 0.061

Cost to export (U.S.$ per container) −0.745*** −0.001*** 163 0.320.102 0.000

Cost to import (U.S.$ per container) −0.773*** −0.001*** 163 0.300.104 0.000

Days to export −0.853*** −0.066*** 163 0.410.097 0.008

Days to import −0.876*** −0.055*** 163 0.400.098 0.007

Documents to export (number) −0.901*** −0.481*** 163 0.360.103 0.069

Documents to import (number) −0.909*** −0.471*** 163 0.420.098 0.057

Nontariff trade barriers −0.832*** 0.555*** 137 0.310.117 0.121

Prevalence of trade barriers −0.849*** 0.985*** 135 0.310.112 0.202

Regulatory trade barriers −0.916*** 0.695*** 136 0.420.105 0.084

Research and development

Availability of scientists and engineers −0.831*** 1.146*** 135 0.390.101 0.175

Company spending on R&D −0.831*** 1.046*** 135 0.420.098 0.143


−0.730*** 1.137*** 135 0.360.100 0.190

Intellectual property protection −0.960*** 0.972*** 135 0.500.095 0.109

Quality of scientific research institutions −0.933*** 0.934*** 135 0.430.101 0.124

University-industry collaboration in R&D −0.911*** 1.128*** 135 0.460.097 0.139

Utility patents granted per million population

−0.740*** 0.011*** 135 0.340.102 0.002

Education

Average years of schooling −1.245*** 0.402*** 96 0.490.133 0.063

Internet access in schools −1.212*** 1.034*** 135 0.540.102 0.103

Quality of the educational system −0.792*** 0.777*** 135 0.320.106 0.151

Note: *, **, *** indicate significance at the 10 percent, 5 percent, and 1 percent levels, respectively.


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APPENDIX TABLE 8B

Significance

(1) (2) (3) (4) (5) (6) (7) (8) (9) (10)

(2)−(1) (4) × (3) (3) / (1) (5) / (6) (3) / (2) ln (3) (5) / (9)

Indicator

Index

EU-27

Best Five in

World Difference Coefficient

Impact on

Growth

Required

Reform Effort

(convex)

Efficiency of

Reform (convex)

Relative Distance

to Best Five

Required Reform

Effort (concave)

Efficiency of

Reform

(concave)

Labor marketCooperation in labor-employer

relations*** 4.5 6.0 1.4 0.961 1.4 0.3 4.3 0.2 0.9 1.5

Pay and productivity *** 4.0 5.4 1.3 0.851 1.1 0.3 3.4 0.3 0.9 1.3Civil rights index ** 0.6 0.3 −0.3 −3.106 1.0 0.5 1.9 1.2 0.3 3.6Hiring and firing regulations *** 5.7 10.0 4.3 0.145 0.6 0.7 0.8 0.4 1.7 0.4Unemployment benefits index *** 0.7 1.0 0.3 2.052 0.6 0.4 1.4 0.3 0.2 2.3Dismissal procedures index ** 0.4 0.0 −0.4 −1.354 0.5 1.0 0.5 0.4 0.3 1.6Redundancy costs ** 28.3 0.4 −27.9 −0.006 0.2 1.0 0.2 69.7 3.4 0.0

Product and services marketsEffectiveness of antimonopoly

policy*** 4.6 5.6 1.0 1.206 1.3 0.2 5.5 0.2 0.7 1.8

Electricity: Public ownership ** 3.7 0.0 −3.7 −0.175 0.6 1.0 0.6 3.7 1.6 0.4Airlines *** 1.4 0.0 −1.4 −0.438 0.6 1.0 0.6 1.4 0.9 0.7Price controls ** 5.7 8.8 3.1 0.188 0.6 0.6 1.1 0.4 1.4 0.4State control *** 2.2 1.2 −1.0 −0.577 0.6 0.5 1.3 0.9 0.7 0.8Public ownership ** 3.1 1.7 −1.4 −0.396 0.5 0.4 1.2 0.8 0.9 0.6Scope of public enterprise sector *** 3.2 1.8 −1.4 −0.381 0.5 0.4 1.2 0.8 0.9 0.6Telecommunications: Market

structure*** 2.9 1.4 −1.4 −0.368 0.5 0.5 1.1 1.0 0.9 0.6

APPENDIX 8B. EU-27: IMPACT ON GROWTH, REQUIRED REFORM EFFORT, AND EFFICIENCY OF REFORM


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*** 1.8 0.3 −1.5 −0.352 0.5 0.8 0.6 4.8 0.9 0.6

Gas: Market structure ** 4.1 0.6 −3.5 −0.144 0.5 0.9 0.6 5.9 1.5 0.3Explicit barriers *** 0.7 0.1 −0.5 −0.981 0.5 0.8 0.6 3.9 0.4 1.2Use of command and control

regulation*** 1.8 0.3 −1.5 −0.331 0.5 0.8 0.6 5.2 0.9 0.5

Product market regulation *** 1.3 0.9 −0.5 −1.106 0.5 0.3 1.5 0.5 0.4 1.3Protection of existing firms *** 2.9 0.0 −2.9 −0.163 0.5 1.0 0.5 2.9 1.3 0.3Restrictions to competition in

seven industries** 2.0 1.3 −0.7 −0.620 0.5 0.4 1.2 0.6 0.6 0.8

Rail: Public ownership * 3.9 2.0 −1.9 −0.234 0.5 0.5 0.9 1.0 1.1 0.4Duration of specialized

education for architects* 3.7 0.0 −3.7 −0.120 0.4 1.0 0.4 3.7 1.6 0.3

Licensing: Engineers ** 3.6 0.0 −3.6 −0.118 0.4 1.0 0.4 3.6 1.5 0.3Duration of specialized

education for engineers* 3.5 0.0 −3.5 −0.119 0.4 1.0 0.4 3.5 1.5 0.3

Involvement in business operation

*** 1.3 0.4 −0.9 −0.448 0.4 0.7 0.6 2.4 0.6 0.6

Requirements in education for engineers

** 2.1 0.0 −2.1 −0.178 0.4 1.0 0.4 2.1 1.1 0.3

Licensing: Architects * 3.8 0.0 −3.8 −0.099 0.4 1.0 0.4 3.8 1.6 0.2Airlines: Public ownership *** 1.9 0.0 −1.9 −0.191 0.4 1.0 0.4 1.9 1.1 0.3Sector-specific administrative

burdens* 1.5 0.3 −1.2 −0.284 0.3 0.8 0.4 3.9 0.8 0.4


* 4.3 1.2 −3.1 −0.099 0.3 0.7 0.4 2.6 1.4 0.2

Electricity indicator * 1.5 0.4 −1.1 −0.206 0.2 0.7 0.3 2.5 0.7 0.3Duration of compulsory practice

for engineers*** 1.1 0.0 −1.1 −0.182 0.2 1.0 0.2 1.1 0.7 0.3

Business regulationsBureaucracy costs *** 3.0 1.4 −1.6 −0.774 1.3 0.5 2.3 1.2 1.0 1.3Business regulations *** 6.2 7.8 1.6 0.764 1.3 0.3 4.7 0.2 1.0 1.3

(Continued )


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APPENDIX TABLE 8B (Continued )

Significance

(1) (2) (3) (4) (5) (6) (7) (8) (9) (10)

(2)−(1) (4) × (3) (3) / (1) (5) / (6) (3) / (2) ln (3) (5) / (9)

Indicator

Index

EU-27

Best Five in


Impact on

Growth

Required

Reform Effort

(convex)

Efficiency of

Reform (convex)

Relative Distance

to Best Five

Required Reform

Effort (concave)

Efficiency of

Reform

(concave)

Business regulations (continued)Regulation of credit, labor, and

business*** 7.1 8.8 1.7 0.635 1.1 0.2 4.5 0.2 1.0 1.1

Licensing restrictions *** 7.4 9.9 2.4 0.398 1.0 0.3 3.0 0.2 1.2 0.8Administrative requirements ** 3.5 6.6 3.0 0.299 0.9 0.9 1.1 0.5 1.4 0.7Regulatory quality *** 1.3 1.9 0.6 1.224 0.8 0.5 1.5 0.3 0.5 1.6Burden of government

regulation* 3.1 5.1 2.0 0.375 0.8 0.7 1.2 0.4 1.1 0.7

Days dealing with construction permits

*** 189.1 32.8 −156.3 −0.003 0.5 0.8 0.7 4.8 5.1 0.1

Barriers to foreign direct investment

*** 1.2 0.2 −1.0 −0.508 0.5 0.8 0.6 5.1 0.7 0.7


** 7.5 9.8 2.3 0.214 0.5 0.3 1.6 0.2 1.2 0.4

Barriers to entrepreneurship *** 1.3 1.0 −0.4 −1.117 0.4 0.3 1.5 0.4 0.3 1.3Administrative burdens on

startups** 1.6 0.5 −1.1 −0.360 0.4 0.7 0.6 2.1 0.7 0.5

Cost of tax compliance ** 7.2 9.5 2.3 0.145 0.3 0.3 1.0 0.2 1.2 0.3Procedures to start a business * 5.7 1.6 −4.1 −0.073 0.3 0.7 0.4 2.5 1.6 0.2Days registering property *** 31.8 1.8 −30.0 −0.008 0.2 0.9 0.3 16.6 3.4 0.1Days to start a business ** 14.0 2.5 −11.5 −0.013 0.2 0.8 0.2 4.6 2.5 0.1Cost of starting a business *** 5.0 0.2 −4.8 −0.013 0.1 1.0 0.1 21.9 1.8 0.0Cost of dealing with

construction permits*** 57.5 3.9 −53.5 −0.001 0.1 0.9 0.1 13.6 4.0 0.0

Cost of getting electricity *** 154.5 4.2 −150.3 0.000 0.0 1.0 0.0 36.1 5.0 0.0


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Research and developmentUtility patents granted per

million population*** 46.6 264.4 217.7 0.011 2.3 4.7 0.5 0.8 5.4 0.4

Company spending on R&D *** 3.9 5.8 1.9 1.046 2.0 0.5 4.0 0.3 1.1 1.9Government procurement of

advanced technology products

*** 3.8 5.2 1.5 1.137 1.7 0.4 4.3 0.3 0.9 1.8

Intellectual property protection *** 4.6 6.3 1.6 0.972 1.6 0.4 4.5 0.3 1.0 1.6University-industry collaboration

in R&D*** 4.4 5.7 1.3 1.128 1.5 0.3 4.9 0.2 0.8 1.8


*** 4.6 5.8 1.2 1.146 1.4 0.3 5.2 0.2 0.8 1.8

Quality of scientific research institutions

*** 4.7 6.1 1.4 0.934 1.3 0.3 4.4 0.2 0.9 1.5

TradeBurden of customs procedures *** 4.7 6.0 1.3 1.046 1.3 0.3 4.9 0.2 0.8 1.6Prevalence of trade barriers *** 5.2 6.4 1.1 0.985 1.1 0.2 5.1 0.2 0.8 1.5Documents to import (number) *** 5.2 3.0 −2.2 −0.471 1.1 0.4 2.5 0.7 1.2 0.9Nontariff trade barriers *** 7.2 8.8 1.5 0.555 0.9 0.2 4.0 0.2 0.9 0.9Documents to export (number) *** 4.5 2.8 −1.7 −0.481 0.8 0.4 2.2 0.6 1.0 0.8Regulatory trade barriers *** 7.8 9.0 1.1 0.695 0.8 0.1 5.4 0.1 0.8 1.0Compliance cost of importing

and exporting*** 8.1 9.4 1.3 0.513 0.7 0.2 4.2 0.1 0.8 0.8

Cost to export (U.S.$ per container)

*** 1,024.4 504.2 −520.2 −0.001 0.4 0.5 0.9 1.0 6.3 0.1

Days to export *** 11.2 5.2 −6.0 −0.066 0.4 0.5 0.7 1.1 1.9 0.2Days to import *** 11.4 4.8 −6.6 −0.055 0.4 0.6 0.6 1.4 2.0 0.2

Cost to import (U.S.$ per container) *** 1,092.0 505.8 −586.2 −0.001 0.3 0.5 0.6 1.2 6.4 0.1Barriers to trade and investment *** 0.4 0.1 −0.4 −0.841 0.3 0.8 0.4 4.8 0.3 1.0

(Continued )


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Significance

(1) (2) (3) (4) (5) (6) (7) (8) (9) (10)

(2)−(1) (4) × (3) (3) / (1) (5) / (6) (3) / (2) ln (3) (5) / (9)

Indicator

Index

EU-27

Best Five in


Impact on

Growth

Required

Reform Effort

(convex)

Efficiency of

Reform (convex)

Relative Distance

to Best Five

Required Reform

Effort (concave)

Efficiency of

Reform

(concave)

Legal systemImpartial courts *** 5.1 7.9 2.8 0.627 1.8 0.6 3.2 0.4 1.3 1.3Efficiency of legal framework in

settling disputes*** 4.0 5.9 1.9 0.889 1.7 0.5 3.5 0.3 1.1 1.6


*** 4.0 5.6 1.6 0.964 1.5 0.4 3.8 0.3 1.0 1.6


*** 7.0 8.6 1.6 0.882 1.4 0.2 6.2 0.2 1.0 1.5

Judicial independence *** 4.8 6.5 1.7 0.787 1.4 0.4 3.8 0.3 1.0 1.4Protection of property rights *** 6.9 8.9 2.0 0.672 1.3 0.3 4.7 0.2 1.1 1.2Legal enforcement of contracts *** 5.2 7.7 2.5 0.480 1.2 0.5 2.5 0.3 1.3 1.0Recovery rate of resolving

insolvency*** 60.6 90.9 30.3 0.039 1.2 0.5 2.3 0.3 3.4 0.3

Integrity of the legal system *** 8.2 10.0 1.8 0.451 0.8 0.2 3.7 0.2 1.0 0.8Bounced check collection:

Formalism index** 3.6 1.4 −2.2 −0.321 0.7 0.6 1.2 1.5 1.2 0.6


** 0.3 0.1 −0.3 −2.315 0.6 0.8 0.7 5.1 0.2 2.6

Bounced check collection: Statutory regulation of evidence

** 0.3 0.1 −0.3 −2.095 0.6 0.8 0.7 5.4 0.2 2.4

Years resolving insolvency ** 1.9 0.7 −1.2 −0.454 0.6 0.6 0.9 1.8 0.8 0.7Bounced check collection: Index

professionals vs. laymen* 0.6 0.0 −0.6 −0.945 0.5 1.0 0.5 0.6 0.4 1.2

Cost of enforcing contracts (% of claim)

*** 20.6 7.6 −13.0 −0.037 0.5 0.6 0.8 1.7 2.6 0.2

Procedures for enforcing contracts

** 31.8 23.4 −8.4 −0.052 0.4 0.3 1.7 0.4 2.2 0.2


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Cost of resolving insolvency (% of estate)

*** 10.5 1.6 −8.9 −0.047 0.4 0.8 0.5 5.6 2.3 0.2

Bounced check collection: Index mandatory time limits

** 0.3 0.0 −0.3 −1.228 0.4 1.0 0.4 0.3 0.3 1.4

Credit and FinanceVenture capital availability *** 2.9 4.6 1.7 1.192 2.0 0.6 3.5 0.4 1.0 2.0Ease of access to loans *** 3.1 4.8 1.7 1.079 1.9 0.6 3.3 0.4 1.0 1.9Affordability of financial services *** 4.6 5.9 1.3 1.260 1.6 0.3 5.8 0.2 0.8 2.0Financing through local equity

market*** 3.7 5.2 1.6 0.805 1.3 0.4 2.9 0.3 0.9 1.3

Foreign ownership and investment restrictions

*** 6.9 8.5 1.6 0.606 1.0 0.2 4.2 0.2 0.9 1.0

International capital market controls

*** 6.1 8.4 2.3 0.276 0.6 0.4 1.7 0.3 1.2 0.5

Capital controls ** 5.4 9.2 3.8 0.136 0.5 0.7 0.7 0.4 1.6 0.3Credit market regulations *** 8.5 10.0 1.4 0.352 0.5 0.2 3.0 0.1 0.9 0.6Getting credit: Strength of legal

rights index** 7.0 10.0 3.0 0.130 0.4 0.4 0.9 0.3 1.4 0.3

Depth of credit information index ** 4.5 6.0 1.5 0.239 0.4 0.3 1.1 0.3 0.9 0.4

Corporate GovernanceProtection of minority

shareholders’ interests*** 4.6 5.8 1.2 1.234 1.5 0.3 5.6 0.2 0.8 1.9


*** 5.2 6.3 1.0 1.247 1.3 0.2 6.5 0.2 0.7 1.8

Strength of investor protection index

*** 5.7 9.0 3.3 0.368 1.2 0.6 2.1 0.4 1.5 0.8

Prevalence of foreign ownership *** 5.1 6.3 1.2 0.846 1.0 0.2 4.3 0.2 0.8 1.3Extent of disclosure index ** 6.2 10.0 3.8 0.138 0.5 0.6 0.9 0.4 1.6 0.3Ease of shareholder suits index * 6.4 9.4 3.0 0.128 0.4 0.5 0.8 0.3 1.4 0.3

(Continued )


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Significance

(1) (2) (3) (4) (5) (6) (7) (8) (9) (10)

(2)−(1) (4) × (3) (3) / (1) (5) / (6) (3) / (2) ln (3) (5) / (9)

Indicator

Index

EU-27

Best Five in


Impact on

Growth

Required

Reform Effort

(convex)

Efficiency of

Reform (convex)

Relative Distance

to Best Five

Required Reform

Effort (concave)

Efficiency of

Reform

(concave)

InfrastructureQuality of railroad infrastructure *** 4.1 6.4 2.3 0.702 1.6 0.6 2.9 0.4 1.2 1.4Quality of roads *** 4.8 6.4 1.7 0.855 1.4 0.4 4.1 0.3 1.0 1.5Quality of port infrastructure *** 5.1 6.6 1.5 0.894 1.4 0.3 4.5 0.2 0.9 1.5Quality of air transport

infrastructure*** 5.3 6.6 1.3 1.004 1.3 0.2 5.3 0.2 0.8 1.6


* 3.1 1.3 −1.8 −0.308 0.6 0.6 1.0 1.4 1.0 0.5

EducationAverage years of schooling *** 8.5 11.7 3.2 0.402 1.3 0.4 3.4 0.3 1.4 0.9Quality of the educational

system*** 4.2 5.8 1.6 0.777 1.2 0.4 3.3 0.3 0.9 1.3

Internet access in schools *** 5.4 6.4 1.0 1.034 1.1 0.2 5.6 0.2 0.7 1.5

CorruptionCorruption (2000–11) *** 6.1 9.3 3.2 0.545 1.8 0.5 3.3 0.3 1.4 1.2Favoritism in decisions of

government officials*** 3.6 5.5 1.9 0.826 1.6 0.5 3.0 0.3 1.1 1.5

Control of corruption *** 1.1 2.3 1.2 1.227 1.5 1.1 1.4 0.5 0.8 1.9Irregular payments and bribes *** 5.1 6.6 1.5 0.962 1.5 0.3 4.9 0.2 0.9 1.6

Source: IMF staff calculations.



APPENDIX 8C. DATA DESCRIPTION AND SOURCES

APPENDIX TABLE 8C

Variable Description

Labor

Civil rights index Measures the degree of protection of vulnerable groups against employment discrimination as the average of the five following variables: Labor discrimination on grounds of race is expressly prohibited by law; Labor discrimination on grounds of gender is expressly prohibited by law; Statutory duration of maternity leave with 100 percent earnings; Minimum working age; Mandatory minimum wage. Source: Botero and others (2003).

Cooperation in labor-employer relations

“How would you characterize labor-employer relations in your country?” [1 = generally confrontational; 7 = generally cooperative], 2010–11 weighted average. Source: World Economic Forum database.

Dismissal procedures index

Measures worker protection granted by law or mandatory collective agreements against dismissal. It is the average of the following seven dummy variables, each of which equals 1 (1) if the employer must notify a third party before dismissing more than one worker, (2) if the employer needs the approval of a third party before dismissing more than one worker, 3) if the employer must notify a third party before dismissing one redundant worker, (4) if the employer needs the approval of a third party to dismiss one redundant worker, (5) if the employer must provide relocation or retraining alternatives for redundant employees before dismissal, (6) if there are priority rules applying to dismissal or layoffs, and (7) if there are priority rules applying to reemployment. Source: Botero and others (2003).

Flexibility of wage determination

“How are wages generally set in your country?” [1 = by a centralized bargaining process; 7 = up to each individual company], 2010–11 weighted average. Source: World Economic Forum database.

Hiring and firing regulations

This subcomponent is based on the World Bank’s Doing Business Difficulty of Hiring Index, which is described as follows: “The difficulty of hiring index measures (1) whether fixed-term contracts are prohibited for permanent tasks; (2) the maximum cumulative duration of fixed-term contracts; and (3) the ratio of the minimum wage for a trainee or first-time employee to the average value added per worker. An economy is assigned a score of 1 if fixed-term contracts are prohibited for permanent tasks and a score of 0 if they can be used for any task. A score of 1 is assigned if the maximum cumulative duration of fixed-term contracts is less than 3 years; 0.5 if it is 3 years or more but less than 5 years; and 0 if fixed-term contracts can last 5 years or more. Finally, a score of 1 is assigned if the ratio of the minimum wage to the average value added per worker is 0.75 or more; 0.67 for a ratio of 0.50 or more but less than 0.75; 0.33 for a ratio of 0.25 or more but less than 0.50; and 0 for a ratio of less than 0.25.” Countries with higher difficulty of hiring are given lower ratings. Sources: Economic Freedom of the World database; and World Bank Doing Business database.

Pay and productivity “To what extent is pay in your country related to productivity?” [1 = not related to worker productivity; 7 = strongly related to worker productivity], 2010–11 weighted average. Source: World Economic Forum database.

Redundancy costs Redundancy costs in weeks of salary, 2009. The lower the value the better. Source: World Bank, Doing Business.

Unemployment benefits index

Measures the level of unemployment benefits as the average of months of contributions or employment for unemployment benefits, percentage of salary deducted for unemployment benefits, waiting period for unemployment benefits, and unemployment benefits net replacement rate. Source: Botero and others (2003).

Product and services markets


Measures the administrative burdens on the creation of sole proprietor firms. The latest available data are for 2008. The index ranges from 0 to 6, 6 being more restrictive and 0 having no restrictions or regulations. Source: OECD database.

(Continued)




Airlines The air transportation indicator is constructed based on the indicators for entry regulation and public ownership; and it covers passenger transport, international and domestic routes. The latest available data are for 2008. The index ranges from 0 to 6, 6 being more restrictive and 0 having no restrictions or regulations. Source: OECD database.

Airlines: Public ownership

Public ownership in air transport is covered by reporting the percentage shares owned by the government in the largest company. The latest available data are for 2008. The index ranges from 0 to 6, 6 being more restrictive and 0 having no restrictions or regulations. Source: OECD database.

Barriers to entry in services

Entry regulations cover provisions that either raise the cost of accessing retail markets or create explicit barriers for certain types of outlets. The indicator includes information on two regulations that potentially increase costs, registration requirements and licensing requirements, and three regulations that impose barriers, restrictions on the range of products that can be sold, restrictions on the range of services that can be supplied, and restrictions on the establishment of large outlets. The indicator also includes information on the extent to which incumbents are protected from new entry, either because they are granted legal monopoly rights or because they are involved in decisions concerning new licenses. The latest available data are for 2008. The index ranges from 0 to 6, 6 being more restrictive and 0 having no restrictions or regulations. Source: OECD database.


This indicator is constructed based on the duration of compulsory practice necessary to become a full member of the engineering profession. The latest available data are for 2008. The index ranges from 0 to 6, 6 being more restrictive and 0 having no restrictions or regulations. Source: OECD database.


The index is based on three components: duration of specialized education, university, or other higher degree; the duration of compulsory practice necessary to become a full member of the profession; and the professional exams that must be passed to become a full member of the profession. The latest available data are for 2008. The index ranges from 0 to 6, 6 being more restrictive and 0 having no restrictions or regulations. Source: OECD database.



Duration of specialized education for engineers


Effectiveness of antimonopoly policy

“To what extent does antimonopoly policy promote competition in your country?” [1 = does not promote competition; 7 = effectively promotes competition], 2010–11 weighted average. Source: World Economic Forum database.

Electricity indicator The electricity indicator is constructed based on the indicators for entry regulation, public ownership, vertical integration, and market structure. The latest available data are for 2008. The index ranges from 0 to 6, 6 being more restrictive and 0 having no restrictions or regulations. Source: OECD database.

Electricity: Public ownership

Indicators for public ownership record the prevailing ownership structure in the various segments of the electricity, ranging from fully private to fully public. The scoring allows for mixed ownership arrangements in which the natural monopoly segments remain in public hands. The latest available data are for 2008. The index ranges from 0 to 6, 6 being more restrictive and 0 having no restrictions or regulations. Source: OECD database.

APPENDIX TABLE 8C (Continued)




Explicit barriers Explicit barriers comprise ownership barriers, tariffs, and discriminatory provisions. The latest available data are for 2008. The index ranges from 0 to 6, 6 being more restrictive and 0 having no restrictions or regulations. Source: OECD database.

Gas: Market structure This index measures the market share of the largest company in the gas production and import industry; the gas transmission industry; and the gas supply industry. The latest available data are for 2008. The index ranges from 0 to 6, 6 being more restrictive and 0 having no restrictions or regulations. Source: OECD database.

Involvement in business operation

Involvement in business operation measures state control in setting prices in road freight, air transport, retail distribution, and some telecommunications services; and the use of command and control regulation. The latest available data are for 2008. The index ranges from 0 to 6, 6 being more restrictive and 0 having no restrictions or regulations. Source: OECD database.

Licensing: Accounting This indicator measures how many services the accounting profession has an exclusive or shared exclusive right to provide. The latest available data are for 2008. The index ranges from 0 to 6, 6 being more restrictive and 0 having no restrictions/regulations. Source: OECD database.

Licensing: Engineers This indicator measures how many services the engineering profession has an exclusive or shared exclusive right to provide. The latest available data are for 2008. The index ranges from 0 to 6, 6 being more restrictive and 0 having no restrictions or regulations. Source: OECD database.

Operational restrictions

This indicator is based on the protection of existing firms and the regulations concerning shop opening hours. The latest available data are for 2008. The index ranges from 0 to 6, 6 being more restrictive and 0 having no restrictions or regulations. Source: OECD database.

Price controls The more widespread the use of price controls, the lower the rating. The survey data of the International Institute for Management Development’s World Competitiveness Yearbook (various editions) were used to rate the countries (mostly developed economies) covered by the report. Other sources were used to categorize other countries. Countries were given a rating of 10 if no price controls or marketing boards were present. If price controls were limited to industries for which economies of scale may reduce the effectiveness of competition (e.g., power generation), a country was given a rating of 8. If price controls were applied in only a few other industries, such as agriculture, a country was given a rating of 6. If price controls were levied on energy, agriculture, and many other staple products that are widely purchased by households, a rating of 4 was given. If price controls applied to a significant number of products in both agriculture and manufacturing, the rating was 2. A rating of zero was given if there was widespread use of price controls throughout various sectors of the economy. Source: Economic Freedom of the World database.

Product market regulation

The product market regulation (PMR) indicator covers formal regulations in the following areas: state control of business enterprises, legal and administrative barriers to entrepreneurship, and barriers to international trade and investment. The PMR indicators are based primarily on explicit policy settings and only account for formal government regulation. Thus, the indicators only record “objective” data about rules and regulations, as opposed to “subjective” assessments of market participants in indicators based on opinion surveys. This isolates the indicators from context-specific assessments and makes them comparable across countries, but also results in some limitations. “Informal” regulatory practices, such as administrative guidance or self-disciplinary measures of professional associations, are only captured to a very limited extent in the PMR indicators system. The scale of indicators is 0–6 from least to most restrictive. Source: OECD database.

(Continued )




Protection of existing firms

Are professional bodies or representatives of trade and commercial interests involved in licenses or permits needed to engage in commercial activity (not related to outlet sitting); licenses or permits needed for outlet sitting (in addition to compliance with general urban planning provisions); or compliance with regulation especially designed for large-outlet licensing decisions? Are there products that can only be sold in outlets operating under a local or national legal monopoly (franchise)? The index ranges from 0 to 6, 6 being more protective and 0 having no protection. Source: OECD database.

Public ownership This indicator measures the percentage of shares in the largest companies owned by national, state, or provincial authorities, with ownership ranging from fully private to fully public. The scoring allows for mixed ownership arrangements in which the natural monopoly segments remain in public hands. The index ranges from 0 to 6, with 6 being the highest public share and 0 the lowest. Source: OECD database.

Rail: Public ownership This indicator is based on the percentage of shares owned by government in operation of the infrastructure sector, the passenger transport sector, and the freight transport sector. The index ranges from 0 to 6, with 6 being the highest public share and 0 the lowest. Source: OECD database.

Requirements in education for engineers

This indicator is constructed based on three measures: the duration of the university degree or other higher degree program; the duration of compulsory practice necessary to become a full member of the profession; and the exams that must be passed to become a full member of the engineering profession. The latest available data are for 2008. The index ranges from 0 to 6, 6 being more restrictive and 0 having no restrictions or regulations. Source: OECD database.

Restrictions to competition in seven industries

This indicator measures restrictions to competition in seven industries: electricity, gas, air passenger transport, rail transport, road freight, postal services, and telecommunications. The indicators cover transmission, distribution, and supply in electricity and gas; infrastructure as well as passenger and freight services in rail transport; domestic and international routes in air passenger transport; basic letter, parcel, and courier services in post; and trunk, long distance, and mobile services in telecommunications. In each industry, the indicators include the following low-level indicators: barriers to entry in all sectors; public ownership in all sectors except road freight; vertical integration in electricity, gas, and rail transport; market structure in rail transport, gas, and telecommunications; and price controls in road freight. The latest available data are for 2008. The index ranges from 0 to 6, 6 being more restrictive and 0 having no restrictions or regulations. Source: OECD database.

Scope of public enterprise sector

This indicator measures the pervasiveness of state ownership across business sectors as the proportion of sectors in which the state has an equity stake in at least one firm. The latest available data are for 2008. The index ranges from 0 to 6, 6 being more restrictive and 0 having no restrictions or regulations. Source: OECD database.

Sector-specific administrative burdens

This indicator reflects administrative burdens in the road transport and retail distribution sectors. The latest available data are for 2008. The index ranges from 0 to 6, 6 being more restrictive and 0 having no restrictions or regulations. Source: OECD database.

State control This indicator is based on the percentage of shares in the largest companies owned by state, as well as the state involvement in business operation. The latest available data are for 2008. The index ranges from 0 to 6, 6 being more restrictive and 0 having no restrictions or regulations. Source: OECD database.

APPENDIX TABLE 8C (Continued )




Telecommunications: Market structure

The indicator for market structure in telecommunications is based on the market share of new entrants in each of the telecommunications services covered by the indicator to gauge the extent to which existing regulations actually succeed in promoting competition. The latest available data are for 2008. The index ranges from 0 to 6, 6 being more restrictive and 0 having no restrictions or regulations. Source: OECD database.

Use of command and control regulation

Use of command and control regulation indicates the extent to which government uses coercive (as opposed to incentives-based) regulation in general and in specific services sectors. The latest available data are for 2008. The index ranges from 0 to 6, 6 being more restrictive and 0 having no restrictions or regulations. Source: OECD database.

Business regulations

Administrative burdens on start-ups

Measures the minimum number of mandatory procedures required to register a public limited company, the minimum number of services (number of public and private bodies to contact to register a public limited company), the minimum direct and indirect costs, and the number of working days required to complete all mandatory procedures for registering a public limited company. The index ranges from 0 to 6, 6 being more restrictive and 0 having no restrictions or regulations. Source: OECD database.

Administrative requirements

This subcomponent is based on the Global Competitiveness Report question: “Complying with administrative requirements (permits, regulations, reporting) issued by the government in your country is (1 = burdensome, 7 = not burdensome).” Source: Economic Freedom of the World database.

Barriers to entrepreneurship

Comprises detailed indicators of (1) the features of the licensing and permit system; (2) the communication and simplification of rules and procedures; (3) economy-wide administrative burdens on start-ups of corporate firms; (4) economy-wide administrative burdens on the start-up of sole-proprietor firms; (5) industry-specific administrative burdens on start-ups of retail distribution and road freight companies; (6) the scope of legal barriers to entry (in 24 manufacturing and services industries); and (7) the existence of antitrust exemptions for public enterprises or government-mandated behavior. The index ranges from 0 to 6, 6 being more restrictive and 0 having no restrictions or regulations. Source: OECD database.

Barriers to foreign direct investment

The foreign direct investment index focuses on four types of measures: equity restrictions, screening and approval requirements, restrictions on foreign key personnel, and other operational restrictions (such as limits on purchase of land or on repatriation of profits and capital). The discriminatory nature of measures is the central criterion for deciding whether a measure should be scored. Nevertheless, nondiscriminatory measures are also covered when they are burdensome for foreign investors. This is the case, in particular, for rules regarding nationality of key personnel and directors. The index covers 22 sectors, the scores for which are averaged to obtain a country score. The scale of indicators is 0–6 from least to most restrictive. Source: OECD database.

Burden of government regulation

“How burdensome is it for businesses in your country to comply with governmental administrative requirements (e.g., permits, regulations, reporting)?” [1 = extremely burdensome; 7 = not burdensome at all], 2010–11 weighted average. Source: World Economic Forum.

Bureaucracy costs This subcomponent is based on the Global Competitiveness Report question: “Standards on product and service quality, energy and other regulations (outside environmental regulations) in your country are: (1 = Lax or nonexistent, 7 = among the world’s most stringent).” Source: Economic Freedom of the World database.

(Continued )




Business regulations The more widespread the use of price controls, the lower the rating. The survey data of the International Institute for Management Development’s World Competitiveness Yearbook (various editions) were used to rate the countries (mostly developed economies) covered by the report. Other sources were used to categorize other countries. Countries were given a rating of 10 if no price controls or marketing boards were present. If price controls were limited to industries in which economies of scale may reduce the effectiveness of competition (e.g., power generation), a country was given a rating of 8. If price controls were applied in only a few other industries, such as agriculture, a country was given a rating of 6. If price controls were levied on energy, agriculture, and many other staple products that are widely purchased by households, a rating of 4 was given. If price controls applied to a significant number of products in both agriculture and manufacturing, the rating was 2. A rating of zero was given If there was widespread use of price controls throughout various sectors of the economy. Source: Economic Freedom of the World database.

Cost of dealing with construction permits

Cost is recorded as a percentage of the economy’s income per capita. Only official costs are recorded. All the fees associated with completing the procedures to legally build a warehouse are recorded, including those associated with obtaining land use approvals and preconstruction design clearances; receiving inspections before, during, and after construction; getting utility connections; and registering the warehouse property. Nonrecurring taxes required for the completion of the warehouse project are also recorded. The building code, information from local experts, and specific regulations and fee schedules are used as sources for costs. If several local partners provide different estimates, the median reported value is used. Data are as of 2011. Source: World Bank Doing Business database.

Cost of getting electricity

Cost is recorded as a percentage of the economy’s income per capita. Costs are recorded exclusive of value-added tax. All the fees and costs associated with completing the procedures to connect a warehouse to electricity are recorded, including those related to obtaining clearances from government agencies, applying for the connection, receiving inspections of both the site and the internal wiring, purchasing material, getting the actual connection works, and paying a security deposit. Information from local experts and specific regulations and fee schedules are used as sources for costs. If several local partners provide different estimates, the median reported value is used. In all cases the costs exclude bribes. Data are as of 2011. Source: World Bank Doing Business database.

Cost of starting a business

Cost is recorded as a percentage of the economy’s income per capita. It includes all official fees and fees for legal or professional services if such services are required by law. Fees for purchasing and legalizing company books are included if these transactions are required by law. The company law, the commercial code, and specific regulations and fee schedules are used as sources for calculating costs. In the absence of fee schedules, a government officer’s estimate is taken as an official source. In the absence of a government officer’s estimate, estimates of incorporation lawyers are used. If several incorporation lawyers provide different estimates, the median reported value is applied. In all cases the costs exclude bribes. Data are as of 2011. Source: World Bank Doing Business database.

Cost of tax compliance

This subcomponent is based on the World Bank’s Doing Business data on the time required per year for a business to prepare, file, and pay taxes on corporate income, value-added or sales taxes, and taxes on labor. Source: Economic Freedom of the World database.

Days dealing with construction permits

This measure captures the median duration that local experts indicate is necessary to complete a procedure in practice. It is assumed that the minimum time required for each procedure is one day. Data are as of 2011. Source: World Bank Doing Business database.





Days registering property

This measure captures the median duration that property lawyers, notaries, or registry officials indicate is necessary to complete a procedure. It is assumed that the minimum time required for each procedure is one day. Although procedures may take place simultaneously, they cannot start on the same day. It is assumed that the buyer does not waste time and commits to completing each remaining procedure without delay. If a procedure can be accelerated for an additional cost, the fastest legal procedure available and used by the majority of property owners is chosen. If procedures can be undertaken simultaneously, it is assumed that they are. It is assumed that the parties involved are aware of all requirements and their sequence from the beginning. Time spent gathering information is not considered. Data are as of 2011. Source: World Bank Doing Business database.

Days to start a business

Number of days required to start a business, 2010. Source: World Bank Doing Business database.

Licensing restrictions This subcomponent is based on the World Bank’s Doing Business data on the time in days and monetary costs required to obtain a license to construct a standard warehouse. Zero-to-10 ratings were constructed for (1) the time cost (measured in number of calendar days required to obtain a license) and (2) the monetary cost of obtaining the license (measured as a share of per capita income). These two ratings were then averaged to arrive at the final rating for this subcomponent. Source: Economic Freedom of the World database.

Procedures to start a business

Number of procedures required to start a business, 2010. A higher value means more procedures. Source: World Bank Doing Business database.

Regulation of credit, labor, and business

This index is composed of three categories: credit market regulations, labor market regulations, and business regulations. The credit market component is an average of the following subcomponents: ownership of banks, foreign bank competition, private sector credit, and interest rate controls or negative real interest rates. Source: Economic Freedom of the World database.

Regulatory quality Regulatory quality measures the incidence of market-unfriendly policies such as price controls or inadequate bank supervision, as well as perceptions of the burdens imposed by excessive regulation in areas such as foreign trade and business development. Source: World Bank Governance Indicators database.


This subcomponent is based on the World Bank’s Doing Business data on the time measured in days and monetary costs required to transfer ownership of property that includes land and a warehouse. Zero-to-10 ratings were constructed for (1) the time cost (measured in number of calendar days required to transfer ownership) and (2) the monetary cost of transferring ownership (measured as a percentage of the property value). These two ratings were then averaged to arrive at the final rating for this subcomponent. Source: Economic Freedom of the World database.

Trade

Barriers to trade and investment

The barriers to international trade and investment indicator is based on explicit barriers such as barriers to foreign direct investment, discriminatory barriers and tariffs, and regulatory barriers. This domain includes detailed indicators of (1) barriers to share-ownership for nonresident operators (economy-wide and in the telecommunications and air travel industries); (2) discriminatory procedures in international trade and competition policies; (3) regulatory barriers to trade; and (4) average (production-weighted) tariffs. The index ranges from 0 to 6, 6 being more restrictive and 0 having no restrictions or regulations. Source: OECD database.

Burden of customs procedures

“How would you rate the level of efficiency of customs procedures (related to the entry and exit of merchandise) in your country?” [1 = extremely inefficient; 7 = extremely efficient], 2010–11 weighted average. Source: World Economic Forum.

(Continued )




Compliance cost of importing and exporting

This subcomponent is based on the World Bank’s Doing Business data on the time cost (i.e., nonmoney) of procedures required to export or import a full 20-foot container of dry goods that contains no hazardous or military items. Countries in which it takes longer to export or import are given lower ratings. Zero-to-10 ratings were constructed for (1) the time cost to export a good (measured in number of calendar days required) and (2) the time cost to import a good (measured in number of calendar days required). These two ratings were then averaged to arrive at the final rating for this subcomponent. Source: Economic Freedom of the World database.

Cost to export (U.S.$ per container)

Cost measures the fees levied on a 20-foot container in U.S. dollars. All the fees associated with completing the procedures to export the goods are included. These include costs for documents, administrative fees for customs clearance and technical control, customs broker fees, terminal handling charges, and inland transport. The cost does not include customs tariffs and duties or costs related to ocean transport. Only official costs are recorded. Data are as of 2011. Source: World Bank Doing Business database.

Cost to import (U.S.$ per container)

Cost measures the fees levied on a 20-foot container in U.S. dollars. All the fees associated with completing the procedures to import the goods are included. These include costs for documents, administrative fees for customs clearance and technical control, customs broker fees, terminal handling charges, and inland transport. The cost does not include customs tariffs and duties or costs related to ocean transport. Only official costs are recorded. Data are as of 2011. Source: World Bank Doing Business database.

Days to export The time for exporting is recorded in calendar days. The time calculation for a procedure starts from the moment it is initiated and runs until it is completed. If a procedure can be accelerated for an additional cost and is available to all trading companies, the fastest legal procedure is chosen. Fast-track procedures applying to firms located in an export processing zone are not taken into account because they are not available to all trading companies. Ocean transport time is not included. It is assumed that neither the exporter nor the importer wastes time and that each commits to completing each remaining procedure without delay. Procedures that can be completed in parallel are measured as simultaneous. The waiting time between procedures—for example, during unloading of the cargo—is included in the measure. Data are as of 2011. Source: World Bank Doing Business database.

Days to import The time for importing is recorded in calendar days. The time calculation for a procedure starts from the moment it is initiated and runs until it is completed. If a procedure can be accelerated for an additional cost and is available to all trading companies, the fastest legal procedure is chosen. Fast-track procedures applying to firms located in an export processing zone are not taken into account because they are not available to all trading companies. Ocean transport time is not included. It is assumed that neither the exporter nor the importer wastes time and that each commits to completing each remaining procedure without delay. Procedures that can be completed in parallel are measured as simultaneous. The waiting time between procedures—for example, during unloading of the cargo—is included in the measure. Data are as of 2011. Source: World Bank Doing Business database.





Documents to export (number)

All documents (such as customs clearance, port and terminal handling, bank, and transportation) required per shipment to export the goods are recorded. It is assumed that the contract has already been agreed upon and signed by both parties. Documents required for clearance by government ministries, customs authorities, port and container terminal authorities, health and technical control agencies, and banks are taken into account. Since payment is by letter of credit, all documents required by banks for the issuance or securing of a letter of credit are also taken into account. Documents that are renewed annually and that do not require renewal per shipment (for example, an annual tax clearance certificate) are not included. Data are as of 2011. Source: World Bank Doing Business database.

Documents to import (number)

All documents (such as customs clearance, port and terminal handling, bank, and transportation) required per shipment to import the goods are recorded. It is assumed that the contract has already been agreed upon and signed by both parties. Documents required for clearance by government ministries, customs authorities, port and container terminal authorities, health and technical control agencies, and banks are taken into account. Since payment is by letter of credit, all documents required by banks for the issuance or securing of a letter of credit are also taken into account. Documents that are renewed annually and that do not require renewal per shipment (for example, an annual tax clearance certificate) are not included. Data are as of 2011. Source: World Bank Doing Business database.

Nontariff trade barriers

This subcomponent is based on the Global Competitiveness Report survey question “In your country, tariff and non-tariff barriers significantly reduce the ability of imported goods to compete in the domestic market.” The question’s wording has varied slightly over the years. Source: Economic Freedom of the World database.

Prevalence of trade barriers

“In your country, to what extent do tariff and non-tariff barriers limit the ability of imported goods to compete in the domestic market?” [1 = strongly limit; 7 = do not limit], 2010–11 weighted average. Source: World Economic Forum.

Regulatory trade barriers

This variable is composed of two main elements: nontariff trade barriers and compliance cost of importing and exporting. Source: Economic Freedom of the World database.

Legal system

Bounced check collection: Formalism index

This index measures substantive and procedural statutory intervention in judicial cases at lower-level civil trial courts, and is formed by adding up the following indices: (1) professionals vs. laymen, (2) written vs. oral elements, (3) legal justification, (4) statutory regulation of evidence, (5) control of superior review, (6) engagement formalities, and (7) independent procedural actions. The index ranges from 0 to 7, where 7 means a higher level of control or intervention in the judicial process. Source: Djankov and others (2002a).

Bounced check collection: Index, mandatory time limits

This indicator measures the presence of mandatory time limits in the procedure. The index is calculated as the average of (1) term for admission, (2) term to present evidence, (3) term to present defense, (4) term for judgment, (5) term for compliance, (6) term for notification of judgment. The index ranges from 0 to 1, where higher values mean more mandatory deadlines. Source: Djankov and others (2002a).

Bounced check collection: Index, professionals vs. laymen

This index measures whether the resolution of the case relies on the work of professional judges and attorneys, as opposed to other types of adjudicators and lay people. The index is the normalized sum of (1) general jurisdiction court, (2) professional vs. nonprofessional judge, and (3) whether legal representation is mandatory. The index ranges from 0 to 1, where higher values mean more participation by professionals. Source: Djankov and others (2002a).

(Continued )




Bounced check collection: Index, statutory regulation of evidence

This index measures the level of statutory control or intervention of the administration, admissibility, evaluation, and recording of evidence. The index is formed by the normalized sum of the following variables: (1) judge cannot introduce evidence, (2) judge cannot reject irrelevant evidence, (3) out-of-court statements are inadmissible, (4) mandatory prequalification of questions, (5) oral interrogation only by judge, (6) only original documents and certified copies are admissible, (7) authenticity and weight of evidence defined by law, and (8) mandatory recording of evidence. The index ranges from 0 to 1, where higher values mean higher statutory control or intervention. Source: Djankov and others (2002a).

Cost of enforcing contracts (% of claim)

Cost is recorded as a percentage of the claim, assumed to be equivalent to 200 percent of income per capita. No bribes are recorded. Three types of costs are recorded: court costs, enforcement costs, and average attorney fees. Court costs include all court costs and expert fees that Seller (plaintiff ) must advance to the court, regardless of the final cost to Seller. Expert fees, if required by law or commonly used in practice, are included in court costs. Enforcement costs are all costs that Seller (plaintiff ) must advance to enforce the judgment through a public sale of Buyer’s movable assets, regardless of the final cost to Seller. Average attorney fees are the fees that Seller (plaintiff ) must advance to a local attorney to represent Seller in the standardized case. Data are as of 2011. Source: World Bank Doing Business database.

Cost of resolving insolvency (% of estate)

The cost of the proceedings is recorded as a percentage of the value of the debtor’s estate. The cost is calculated on the basis of questionnaire responses and includes court fees and government levies; fees of insolvency administrators, auctioneers, assessors. and lawyers; and all other fees and costs. Data are as of 2011. Source: World Bank Doing Business database.


“How efficient is the legal framework in your country for private businesses in challenging the legality of government actions and/or regulations?” [1 = extremely inefficient; 7 = highly efficient], 2010–11 weighted average. Source: World Economic Forum.

Efficiency of legal framework in settling disputes

“How efficient is the legal framework in your country for private businesses in settling disputes?” [1 = extremely inefficient; 7 = highly efficient], 2010–11 weighted average. Source: World Economic Forum.

Impartial courts This component is from the Global Competitiveness Report question, “The legal framework in your country for private businesses to settle disputes and challenge the legality of government actions and/or regulations is inefficient and subject to manipulation (= 1) or is efficient and follows a clear, neutral process (= 7).” The question’s wording has varied slightly over the years. Source: Economic Freedom of the World database.

Integrity of the legal system

This component is based on the International Country Risk Guide, Political Risk Component I., for Law and Order: “Two measures comprising one risk component. Each sub-component equals half of the total. The ‘law’ sub-component assesses the strength and impartiality of the legal system, and the ‘order’ sub-component assesses popular observance of the law.” Source: PRS Group, International Country Risk Guide (various years).

Judicialindependence

“To what extent is the judiciary in your country independent from influences of members of government, citizens, or firms?” [1 = heavily influenced; 7 = entirely independent], 2010–2011 weighted average. Source: World Economic Forum.

Legal enforcement of contracts

This component is based on estimates of the time and money required to collect a clear-cut debt. The debt is assumed to equal 200 percent of the country’s per capita income if the plaintiff has complied with the contract and judicial judgment is rendered in his favor. Zero-to-10 ratings were constructed for (1) the time cost (measured in number of calendar days required from the moment the lawsuit is filed until payment) and (2) the monetary cost of the case (measured as a percentage of the debt). These two ratings were then averaged to arrive at the final rating for this subcomponent. Source: World Bank Doing Business database.






This index measures the degree to which collateral and bankruptcy laws protect the rights of borrowers and lenders and thus facilitate lending. The index ranges from 0 to 10, with higher scores indicating that collateral and bankruptcy laws are better designed to expand access to credit, 2011. Source: Economic Freedom of the World database.

Procedures for enforcing contracts

A procedure is defined as any interaction, required by law or commonly used in practice, between the parties or between them and the judge or court officer. This includes steps to file and serve the case, steps for trial and judgment, and steps necessary to enforce the judgment. Data are as of 2011. The number of procedures range from 0 to 55. Source: World Bank Doing Business database.

Protection of property rights

This component is from the Global Competitiveness Report question “Property rights, including over financial assets, are poorly defined and not protected by law (= 1) or are clearly defined and well protected by law (= 7).” Source: Economic Freedom of the World database.

Recovery rate of resolving insolvency (cents on the dollar)

The recovery rate is recorded as cents on the dollar recouped by creditors through reorganization, liquidation, or debt enforcement (foreclosure) proceedings. The calculation takes into account the outcome: whether the business emerges from the proceedings as a going concern or the assets are sold piecemeal. Then the costs of the proceedings are deducted (1 cent for each percentage point of the value of the debtor’s estate). Finally, the value lost as a result of the time the money remains tied up in insolvency proceedings is taken into account, including the loss of value due to depreciation of the furniture. Consistent with international accounting practice, the annual depreciation rate for furniture is taken to be 20%. The furniture is assumed to account for a quarter of the total value of assets. The recovery rate is the present value of the remaining proceeds, based on end-2010 lending rates from the International Monetary Fund’s International Financial Statistics, supplemented with data from central banks and the Economist Intelligence Unit. Data are as of 2011. Source: World Bank Doing Business database.

Tenant eviction: Index of statutory regulation of evidence

This index measures the level of statutory control or intervention of the administration, admissibility, evaluation, and recording of evidence. The index is formed by the normalized sum of the following variables: (1) judge cannot introduce evidence, (2) judge cannot reject irrelevant evidence, (3) out-of-court statements are inadmissible, (5) mandatory prequalification of questions, (5) oral interrogation only by judge, (6) only original documents and certified copies are admissible, (7) authenticity and weight of evidence defined by law, and (8) mandatory recording of evidence. The index ranges from 0 to 1, where higher values mean a higher statutory control or intervention. Source: Djankov and others (2002a).

Years resolving insolvency

Time for creditors to recover their credit is recorded in calendar years. The period of time measured by Doing Business is from the company’s default until the payment of some or all of the money owed to the bank. Potential delay tactics by the parties, such as the filing of dilatory appeals or requests for extension, are taken into consideration. The longer it takes to resolve insolvency, the higher the values. Data are as of 2011. Source: World Bank Doing Business database.

Education

Average years of schooling

Average years of schooling of population older than 25 in 2000 or last year available (1990 for Estonia, Kazakhstan, Latvia, Lithuania, and Vietnam, and 1980 for St. Vincent) from Barro and Lee database.

Internet access in schools

“How would you rate the level of access to the Internet in schools in your country?” [1 = very limited; 7 = extensive], 2010–11 weighted average. Source: World Economic Forum database.

(Continued )




Quality of the educational system

“How well does the educational system in your country meet the needs of a competitive economy?” [1 = not well at all; 7 = very well], 2010–11 weighted average. Source: World Economic Forum database.

Credit and finance


“To what extent does competition among providers of financial services in your country ensure the provision of financial services at affordable prices?” [1 = not at all; 7 = extremely well], 2010–11 weighted average. Source: World Economic Forum database.

Capital controls The International Monetary Fund reports on up to 13 types of international capital controls. The zero-to-10 (better) rating is the percentage of capital controls not levied as a share of the total number of capital controls listed, multiplied by 10. Source: Economic Freedom of the World database.

Credit market regulations

This component is an average of the following subcomponents: ownership of banks, foreign bank competition, private sector credit, and interest rate controls or negative real interest rates. A higher value indicates less regulation. Source: Economic Freedom of the World database.

Depth-of-credit-information index

The depth-of-credit-information index measures rules and practices affecting the coverage, scope, and accessibility of credit information available through either a public credit registry or a private credit bureau. The index ranges from 0 to 6, with higher values indicating the availability of more credit information, from either a public credit registry or a private credit bureau, to facilitate lending decisions. If the credit registry or bureau is not operational or has coverage of less than 0.1 percent of the adult population, the score on the depth of credit information index is 0. Data are as of 2011. Source: World Bank Doing Business database.


“How easy is it to obtain a bank loan in your country with only a good business plan and no collateral?” [1 = very difficult; 7 = very easy], 2010–11 weighted average. Source: World Economic Forum database.

Financing through local equity market

“How easy is it to raise money by issuing shares on the stock market in your country?” [1 = very difficult; 7 = very easy], 2010–11 weighted average. Source: World Economic Forum database.

Foreign ownership or investment restrictions

This subcomponent is based on the following two Global Competitiveness Report questions: “How prevalent is foreign ownership of companies in your country? 1 = Very rare , 7 = Highly prevalent”; and “How restrictive are regulations in your country relating to international capital flows? 1 = Highly restrictive, 7 = Not restrictive at all.” Source: Economic Freedom of the World database.

Getting credit: Strength of legal rights index

The strength of legal rights index measures the degree to which collateral and bankruptcy laws protect the rights of borrowers and lenders and thus facilitate lending. The index ranges from 0 to 10, with higher scores indicating that collateral and bankruptcy laws are better designed to expand access to credit. Data are as of 2011. Source: World Bank Doing Business database.

International capital market controls

This index is composed of two parts: foreign ownership or investment restrictions and capital controls. A higher value means less-restrictive capital controls. Source: Economic Freedom of the World database.


“In your country, how easy is it for entrepreneurs with innovative but risky projects to find venture capital?” [1 = very difficult; 7 = very easy], 2010–11 weighted average. Source: World Economic Forum database.

Research and development (R&D)


“To what extent are scientists and engineers available in your country?” [1 = not at all; 7 = widely available], 2010–11 weighted average. Source: World Economic Forum database.





Company spending on R&D

“To what extent do companies in your country spend on R&D?” [1 = do not spend on R&D; 7 = spend heavily on R&D], 2010–11 weighted average. Source: World Economic Forum database.


“Do government procurement decisions foster technological innovation in your country?” [1 = no, not at all; 7 = yes, extremely effectively], 2010–11 weighted average. Source: World Economic Forum database.

Intellectual property protection

“How would you rate intellectual property protection, including anticounterfeiting measures, in your country?” [1 = very weak; 7 = very strong], 2010–11 weighted average. Source: World Economic Forum database.

Quality of scientific research institutions

“How would you assess the quality of scientific research institutions in your country?” [1 = very poor; 7 = the best in their field internationally], 2010–11 weighted average. Source: World Economic Forum database.

University-industry collaboration in R&D

“To what extent do business and universities collaborate on research and development (R&D) in your country?” [1 = do not collaborate at all; 7 = collaborate extensively], 2010–11 weighted average. Source: World Economic Forum database.

Utility patents granted per million population

Number of utility patents (i.e., patents for invention) granted in 2010, per million population, 2010. Source: United States Patent and Trademark Office; United Nations Population Fund.

Corporate governance

Ease of shareholder suits index

The ease of shareholder suits index has six components: what range of documents is available to the shareholder plaintiff from the defendant and witnesses during trial; whether the plaintiff can directly examine the defendant and witnesses during trial; whether the plaintiff can obtain categories of relevant documents from the defendant without identifying each document specifically; whether shareholders owning 10 percent or less of the company’s share capital can request that a government inspector investigate the buyer-seller transaction without filing suit in court; whether shareholders owning 10 percent or less of the company’s share capital have the right to inspect the transaction documents before filing suit; and whether the standard of proof for civil suits is lower than that for a criminal case. The index ranges from 0 to 10, with higher values indicating greater powers of shareholders to challenge the transaction. Data are as of 2011. Source: World Bank Doing Business database.

Extent of disclosure index

The extent of disclosure index has five components: which corporate body can provide legally sufficient approval for the transaction; whether immediate disclosure of the transaction to the public, the regulator, or the shareholders is required; whether disclosure in the annual report is required; whether disclosure by Mr. X to the board of directors is required; whether it is required that an external body, for example, an external auditor, review the transaction before it takes place. A score of 0 is assigned if no disclosure on the transaction is required. The index ranges from 0 to 10, with higher values indicating greater powers of shareholders to challenge the transaction. Data are as of 2011. Source: World Bank Doing Business database.

Prevalence of foreign ownership

“How prevalent is foreign ownership of companies in your country?” [1 = very rare; 7 = highly prevalent], 2010–11 weighted average. Source: World Economic Forum database.


“In your country, to what extent are the interests of minority shareholders protected by the legal system?” [1 = not protected at all; 7 = fully protected], 2010–11 weighted average. Source: World Economic Forum database.


“In your country, how would you assess financial auditing and reporting standards regarding company financial performance?” [1 = extremely weak; 7 = extremely strong], 2010–11 weighted average. Source: World Economic Forum database.

(Continued )




Strength of investor protection index

The strength of investor protection index is the average of the extent of disclosure index, the extent of director liability index, and the ease of shareholder suits index. The index ranges from 0 to 10, with higher values indicating more investor protection. Data are as of 2011. Source: World Bank Doing Business database.

Infrastructure


This indicator measures the percentage of shares in the infrastructure companies owned by national, state, or provincial authorities. The index ranges from 0 to 6, with 6 being the highest public share and 0 the lowest. Source: OECD database.

Quality of air transport infrastructure

“How would you assess passenger air transport infrastructure in your country?” [1 = extremely underdeveloped; 7 = extensive and efficient by international standards], 2010–11 weighted average. Source: World Economic Forum database.

Quality of port infrastructure

“How would you assess port facilities in your country?” [1 = extremely underdeveloped; 7 = well developed and efficient by international standards]. For landlocked countries, the question is as follows: “How accessible are port facilities?” [1 = extremely inaccessible; 7 = extremely accessible], 2010–11 weighted average. Source: World Economic Forum database.

Quality of railroad infrastructure

“How would you assess the railroad system in your country?” [1 = extremely underdeveloped; 7 = extensive and efficient by international standards], 2010–11 weighted average. Source: World Economic Forum database.

Quality of roads “How would you assess roads in your country?” [1 = extremely underdeveloped; 7 = extensive and efficient by international standards], 2010–11 weighted average. Source: World Economic Forum database.

Corruption

Corruption (2000–11) The average score of the Transparency International index of corruption perception between 2000 and 2011. The index provides a measure of the extent to which corruption is perceived to exist in the public and political sectors. The index focuses on corruption in the public sector and defines corruption as the abuse of public office for private gain. It is based on assessments by experts and opinion surveys. The index ranges between 0 (highly corrupt) and 10 (highly clean).

Control of corruption “Control of corruption” measures perceptions of corruption, conventionally defined as the exercise of public power for private gain. The particular aspects of corruption measured by the various sources differ somewhat, ranging from the frequency of “additional payments to get things done,” to the effects of corruption on the business environment, to measuring “grand corruption” in the political arena or in the tendency of elite forms to engage in “state capture.” A higher number means a country has more control of corruption. Source: World Bank Governance Indicators database.

Favoritism in decisions of government officials

“To what extent do government officials in your country show favoritism to well-connected firms and individuals when deciding upon policies and contracts?” [1 = always show favoritism; 7 = never show favoritism], 2010–11 weighted average. Source: World Economic Forum database.

Irregular payments and bribes

Average score across the five components of the following Executive Opinion Survey question: “In your country, how common is it for firms to make undocumented extra payments or bribes connected with (a) imports and exports; (b) public utilities; (c) annual tax payments; (d) awarding of public contracts and licenses; (e) obtaining favorable judicial decisions.” In each case, the answer ranges from 1 (very common) to 7 (never occurs), 2010–11 weighted average. Source: World Economic Forum database.

APPENDIX TABLE 8C ( Continued )



REFERENCES

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Cavalcanti,T., A. Magalhaes, and J. Tavares, 2008, “Institutions and Economic Development in Brazil,” Quarterly Review of Economics and Finance, Vol. 8, No. 42, pp. 412–32.

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Djankov, S., R. La Porta, F. Lopez-de-Silanes, and A. Shleifer, 2002a, “Courts: the Lex Mundi Project,” NBER Working Paper No. 8890 (Cambridge, Massachusetts: National Bureau of Economic Research).

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Economic Freedom of the World database available at: http://www.freetheworld.com/datasets_efw.html

Evans, P., and J.E. Rauch, 1999, “Bureaucracy and Growth: A Cross-National Analysis of the Effects of ‘Weberian’ State Structures on Economic Growth,” American Sociological Review,Vol. 64, No. 5 (October), pp. 748–65.

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Josheski, D., and C. Koteski, 2011, “The Causal Relationship between Patent Growth and Growth of GDP with Quarterly Data in the G7 Countries: Cointegration, ARDL and Error Correction Models, “ MRA papers (Shtip, Macedonia: Goce Delcev University). http://mpra.ub.uni-muenchen.de/33153/.

Knack, S., and M. Kugler, 2002, “Constructing an Index of Objective Indicators of Good Governance,” PREM Public Sector Group (Washington: World Bank).

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Nickell, S., and R. Layard, 1999, “Labor Market Institutions and Economic Performance,” in Handbook of Labor Economics, Vol. 3, ed. by O. Ashenfelter and D. Card (Amsterdam: Else-vier) pp. 3029–84.

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PART III

Achieving Sustainable Growth in a Globalized World




219

CHAPTER 9

Making Current Account Adjustment in Europe Growth Friendly

RUBEN ATOYAN, JONATHAN MANNING, AND JESMIN RAHMAN

REBALANCING AND REFORMS

The analysis in the previous chapters focuses on how to enhance the functioning and the efficiency of countries’ economies. However, repairing balance sheets in the private and public sectors, and implementing reforms to product and labor markets, will not only help economies reach their full potential, these actions can also make them more competitive, adding the “pull” from external demand to the “push” of domestic reforms to open the door to a faster, sustainable impact from the structural reforms. One important aspect of positioning countries to success-fully partake in global markets is the integration with cross-border supply chains, discussed in detail in chapter 10 . Another is the ongoing adjustment process of current account (CA) imbalances within the euro area (EA).

The common currency and the widening of the European membership have shaped the external environment of EA countries and emerging Europe. Al-though not always driven by the same factors, some countries, such as Germany, accumulated ever-larger overall CA surpluses, largely with respect to non-EA coun-tries; as CA balances worsened substantially in other EA countries, particularly those in the periphery. 1 Although Greece and Portugal already had sizable CA defi-cits at the time of their accession to the euro, Spain had only a moderate deficit, and Ireland a balanced CA. During 1999–2007, all of these countries except Por-tugal saw their CA balances worsen. Such dynamics, however, were not confined to countries inside the EA—similar dynamics played out in a number of emerging European economies outside the EA, particularly those with fixed exchange rate regimes, with CA deficits in some reaching unsustainable levels of as high as 25 percent of GDP in the run-up to the financial crisis. 2

The authors gratefully acknowledge helpful comments from Céline Allard, Bas Bakker, Helge Berger, Mali Chivakul, Albert Jaeger, Kenneth Kang, Wojciech Maliszewski, Alasdair Scott, Antonio Spilim-bergo, Alexander Tieman, Thierry Tressel, Shengzu Wang, and seminar participants in the European Department. 1The EA periphery is defined in this chapter to comprise Greece, Ireland, Portugal, and Spain. 2The set of emerging European economies with fixed exchange rate regimes consists of Bulgaria, Es-tonia, Latvia, and Lithuania.


220 Making Current Account Adjustment in Europe Growth Friendly

This chapter aims to explain rebalancing across European countries. Large precrisis CA deficits necessitate a correction, a task that is greatly complicated by the absence of the exchange rate as an independent policy tool. The challenge for both the EA periphery and emerging European countries with limited exchange rate flexibility is finding the right set of policies to secure growth-friendly rebal-ancing and orderly adjustment. 3 But there are also important differences. The EA periphery countries have more-closed economies, implying a much larger growth impact from fiscal policy, particularly during recessions, and constraints on the scope for fiscal consolidation. At the same time, unlike the emerging European countries, the EA periphery countries have access to emergency financing that can provide a cushion against private capital outflows. There are also structural differences in labor market flexibility and in export structure. Finally, the level of indebtedness, particularly for households, is considerably higher in the EA pe-riphery countries, posing an additional challenge to the adjustment process.

The chapter proceeds as follows: The next section describes the CA boom and bust of recent years, and is followed by a section that outlines stylized facts about saving and investment. The subsequent section provides a summary of empirical results from a reduced-form estimation of CA determinants. The final section discusses policy implications discerned from the previous sections and concludes.

THE BOOM AND THE BUST

The story of widening CA imbalances in European countries has been well docu-mented (e.g., Rahman, 2008; Berger and Nitsch, 2010; Jaumotte and Sodsriwi-boon, 2010; Chen, Milesi-Ferretti, and Tressel, 2012; Atoyan, Jaeger, and Smith, 2012). 4 A short summary plays like this: bank-intermediated large-scale foreign capital inflows fueled a domestic demand boom, which spilled over into imports and consequently widened the CA deficit ( Figure 9.1 ). For countries in the EA periphery, a rapid decline in borrowing costs and abundant global liquidity fur-ther facilitated large foreign capital inflows, while for emerging Europe, accession to the European Union (EU) signaled prospects for faster income convergence and ushered in an era of abundant foreign capital flows.

Because credit benefited various nontradables sectors, ranging from construc-tion to retail, growth was built on unsustainably high domestic demand. Moreover, large increases in wages and prices—often rooted in expectations of fast income convergence—gradually eroded the role of the tradables sector in these economies. The result was a deterioration of competitiveness and an excessive buildup of debt,

3This chapter does not investigate whether adjustment has been “complete” against some equilibrium benchmark, but simply explains how changes in CA balances have been affected by changes in various explanatory variables. It also does not address the issue of intra–euro area imbalances and instead treats countries in the EA as individual countries without an exchange rate policy option, just like the fixed exchange rate economies in emerging Europe. 4Atoyan, Manning, and Rahman (2013) provide a more detailed survey of the recent related literature.


Atoyan, Manning, and Rahman 221

mostly owed to foreigners, without corresponding debt-servicing capacity or cre-ation of policy space to counter the inevitable downturn.

Despite some common themes, demand booms and associated widening of CA deficits were driven by somewhat different factors in the EA periphery and emerging Europe. Large precrisis CA deficits in emerging Europe were predomi-nantly a private sector undertaking, resulting from actions by both households and nonfinancial corporates (NFCs), and the public sector recorded a small surplus everywhere except Lithuania ( Figure 9.2 ). In the EA periphery, the private sector also played an important role—household imbalances were large in Greece and Ireland, resulting from a consumption and housing boom, and NFCs’ imbal-ances were significant drivers of CA deficits in Portugal and Spain. But especially in Greece and Portugal, public sector imbalances also contributed significantly to precrisis CA deficits.

STYLIZED FACTS ABOUT SECTORAL SAVING AND INVESTMENT

Before the Crisis

A disaggregation of sectoral saving and investment in these countries for 1999–2007 shows important cross-country differences: CA widening was caused pre-dominantly by an investment boom in emerging Europe, whereas it was driven by a consumption boom (i.e., reduced saving) in the EA periphery countries ( Figure 9.3 ).

• For emerging European countries with fixed exchange rates, the widening CA deficits during 1999–2007 mostly reflected increasing corporate invest-ment and declining household saving. Many of these economies were still undergoing transition during the years leading up to the financial crisis. The associated investment needs, including from privatization efforts, were in

Figure 9.1 Capital Flows and the Current Account in the European Union, 1999–2007

BGRHRV

CZE

DNK

EST

FIN FRA

DEU

GRC

HUN

ITA

LVA

LTU

NLD

POL

PRT

ROUSVK

SVN

ESP

SWE

–20

0

20

40

60

80

100

120

0 100 200 300 400

Capital flows fueled credit growth...

Cha

nge

in p

rivat

e cr

edit,

199

9–20

07(p

erce

nt o

f GD

P)

Cumulative capital inflows, 1999–2007(percent of GDP)

AUT

BEL

BGR

HRV

CYP

CZEDNK

FIN

FRA

DEU

GRC

HUN

IRLITA

LVA

LTU

LUXNLD POL

PRT

ROU

SVKSVN

ESP

SWE

GBR

–25

–20

–15

–10

–5

0

5

10

0 20 40 60 80 100 120

...which resulted in domesticdemand booms and widened CA deficits.

Cha

nge

in c

urre

nt a

ccou

nt b

alan

ce,

1999

–200

7 (p

erce

nt o

f GD

P)

Cumulative change in real domestic demandgrowth, 1999–2007 (percent)

Sources: IMF, International Financial Statistics ; IMF, World Economic Outlook ; and IMF staff calculations.



Figure 9.2 Euro Area Periphery and Emerging Europe: Sectoral Current Account Balance, 2002–11 (Percent of GDP)

–50

–40

–30

–20

–10

0

10

2005 2006 2007 2008 2009 2010

Bulgaria1

Financial corporationsand discrepancy2

General government

Nonfinancial corporations

Households

Current account balance

–45

–30

–15

0

15

2002 2004 2006 2008 2010

Estonia

–50

–40

–30

–20

–10

0

10

20

2002 2004 2006 2008 2010

Latvia

–30

–20

–10

0

10

20

2002 2004 2006 2008 2010

Lithuania

–45

–30

–15

0

15

2002 2004 2006 2008 2010

Greece

–30

–15

0

15

2002 2004 2006 2008 2010

Ireland

–30

–20

–10

0

10

2002 2004 2006 2008 2010

Portugal

–30

–20

–10

0

10

2002 2004 2006 2008 2010

Spain


General government


Households



General government


Households



General government


Households



General government


Households



General government


Households



General government


Households



General government


Households


Sources: Eurostat; Haver Analytics; IMF, World Economic Outlook ; and IMF staff estimates. 1 Data for Bulgaria only available from 2005 onward. 2 Some discrepancy arises from comparing the current account balance to saving-investment data.



Figure 9.3 Euro Area Periphery and Emerging Europe: Contribution of Saving and Investment to Changes in Current Account, 1999–2007 (Percent of GDP)

Saving Investment Current account

Nonfinancial corporations investment

Household saving

Nonfinancial corporations saving

Household investment

Contribution to current account


Household saving


Household investment

Current account

Saving Investment Contribution to current account

Saving Investment Current account Saving Investment Contribution to current account

–25

–20

–15

–10

–5

0

5

10

BGR EST LVA LTU GRC IRL PRT ESP

Change in Private Saving andInvestment, 1999–20071

–40

–30

–20

–10

0

10

20

30


Average Private Saving and Investment,1999–20072

–25

–20

–15

–10

–5

0

5

10


Change in Private Saving and Investment,2002–071,3

–40

–30

–20

–10

0

10

20

30


Average Private Saving and Investment,2002–072,3

–30

–20

–10

0

10

20


Change in Public Saving and Investment,1999–20071

–10

–5

0

5

10


Average Public Saving and Investment,1999–20072

Sources: Eurostat; Haver Analytics; IMF, World Economic Outlook; and IMF staff calculations. 1 A decline in savings and increase in investment recoreded as a negative number. 2 Positive investment recorded as a negative number. 3 Private sector components available only from 2002 onward. Data for Bulgaria only available from 2005 onward.



large part met by foreign direct investment inflows rather than debt. Except for Estonia, which also experienced a housing boom, increasing investment was mostly undertaken by NFCs. All four emerging European countries also experienced large declines in household saving because of increased consumption.

• For EA periphery countries, the rise in the CA deficit during 1999–2007 mostly reflected declining private sector saving with saving in NFCs declining everywhere, and in Portugal (and more modestly in Spain), household saving also falling. Changes in private investment were more mixed because household investment increased substantially in Greece, but fell in Ireland and Portugal. Investment by NFCs increased modestly dur-ing the boom period everywhere except Ireland.

Public sector imbalances were important in some EA periphery economies as discussed above, but played mostly a secondary role in the precrisis CA widening episodes in emerging Europe:

• In the EA periphery, public sector investment showed little movement dur-ing the boom period whereas public saving declined everywhere but Spain, indicating a largely procyclical fiscal widening.

• Conversely, emerging Europe experienced an increase in public sector in-vestment, although much lower than the increase in private sector invest-ment. Public sector saving also improved, benefiting from windfall revenues from booming domestic demand on the back of abundant foreign financ-ing. Small and improving public sector balances during the precrisis boom, however, masked a procyclical fiscal stance in most countries (Rahman, 2010). Pursuing a procyclical fiscal policy during these years had medium-term consequences: not only did fiscal policy fail to dampen the growing and unsustainable domestic demand boom, it hampered the ability of coun-tries to provide the needed fiscal support once the boom turned to bust. However, unlike in the EA periphery, private gross capital inflows were of such magnitudes that even a more conservative fiscal policy would not have been sufficient to lean against the wind in these countries (Atoyan, Jaeger, and Smith, 2012).

The Crisis and Beyond

Since the peak of the crisis, these two regions adjusted at different paces ( Figures 9.2 and 9.4 ). Whereas most countries in emerging Europe saw a sharp and quick adjustment in their CA deficits, rebalancing in EA periphery countries progressed at a slower pace, with CA balances starting to pick up only in 2012. On average, the four emerging European countries showed a CA adjustment of 4.9 percentage points of GDP per year from 2008 through 2011, with most coun-tries adjusting enough to reverse their entire precrisis widening (starting in 2000) by 2011. After a sharp adjustment, the household sector in the Baltic countries even returned to a deficit in 2012, signaling a resumption of private consumption and an end of household deleveraging ( Figure 9.2 ). The sharp adjustment was due



Figure 9.4 Euro Area Periphery and Emerging Europe: Contributions to Current Account, 2004–12 (Percent of GDP)

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Bulgaria Estonia Latvia Lithuania Greece Ireland Portugal Spain

Current Account Balance

2007200920112012

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2004–07 2008–12 2004–07 2008–12 2004–07 2008–12 2004–07 2008–12Bulgaria Estonia Latvia Lithuania

2004–07 2008–12 2004–07 2008–12 2004–07 2008–12 2004–07 2008–12Greece Ireland Portugal Spain

Emerging Europe: Change in Contributions to Current Account Balance

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20Euro Area Periphery: Change in Contributions to Current Account Balance

Transfers balance

Services balance

Exports of goods

Income balance

Imports of goods


Transfers balance

Services balance

Exports of goods

Income balance

Imports of goods


Sources: Haver Analytics; IMF, International Financial Statistics ; IMF, World Economic Outlook ; and IMF staff calculations.



to a sudden stop of capital inflows from parent companies and banks, which had funded the precrisis, investment-led CA widening and credit boom. Credit growth came to a halt from double-digit levels, choking off domestic demand.

CA deficits in the EA periphery, particularly in Greece and Portugal, while smaller as a share of GDP than in emerging Europe, have adjusted at a slower pace. For Greece, the household sector remains a large contributor to the CA deficit, and in Portugal, adjustment by NFCs has been much slower than else-where. In Ireland and Spain, the private sector reached a balanced position by 2009 or 2010, and CA deficits are now mainly accounted for by large public sector deficits that were nonexistent before the crisis. Because the balance sheet adjustments of these countries’ highly indebted households and NFCs will have negative consequences for growth, the public sector is likely to continue to re-cord deficits, reflecting both weak revenues and the need to provide support to the economy.

The composition of adjustment has also been different across countries. For emerging Europe, rebalancing during 2008–12 was primarily export led ( Figure 9.4 ). Although there was an initial import compression because sudden stops or withdrawals of foreign capital halted financing and choked demand for imports, wage adjustment in the tradables sector and growth in trading partners—the EA in the early phase, and non-EA countries later—supported exports. Purfield and Rosenberg (2010) conclude that the internal devaluation strategy pursued by these countries relied on an unprecedented fiscal and nominal wage adjustment. This strategy allowed for a more growth-enhancing adjustment and may also have reflected their stronger integration with vertical cross-border supply chains (see also Chapter 10 ). In contrast, import compression was stronger in the EA periphery, acting as the main contributor to rebalancing during 2008–12 in Greece and Portugal, while exports have been a significant factor in rebal-ancing in Spain and Ireland ( Figure 9.4 ).

Steps to preserve financial sector stability and efforts to facilitate private sector debt restructuring also played key roles in improving external balances and com-petitiveness in these economies. In the EA periphery countries, imports con-tracted much less than in emerging Europe, if at all, but more important, exports did not provide the needed support, at least not until 2012. The weaker export performance in most EA periphery countries, between which much trade take place, reflects weaker import demand in partner countries, a smaller share of trad-able goods in production, and slower wage and price adjustments.

The slower import contraction in the EA periphery is also partly explained by availability of financing. In the run-up to the crisis, deficits, both public and private, were financed by cheap private credit made possible by falling interest rates that converged to the EA average because investors assumed EA membership signaled a low risk of default. As private financing began to slow during the bust, deficits continued to be financed by the European Central Bank through its Trans-European Automated Real-Time Gross Settlement Express Transfer (TARGET 2) facility, thus dampening the need for import contraction. Sinn and Wollmershaeuser (2011) and Merler and Pisani-Ferry (2012) document that without TARGET 2 support, many of the EA periphery countries would have



experienced a balance of payments crisis. Indeed, until mid-2012 the CA deficits of Greece and Portugal were almost entirely financed by TARGET 2 credits, while TARGET 2 support for Ireland accommodated major capital flight in ex-cess of fully covering the CA deficit. 5

There are also differences in rebalancing in these two regions with regard to saving and investment behavior ( Figure 9.5 ). Most of the rebalancing in the EA periphery is taking place via declining private sector investment while private sav-ing has not improved much, except in Spain and Portugal. Given that declining private saving was the main force behind CA widening in the EA periphery, the current composition of rebalancing has not addressed the source of CA excesses built up during the boom period. Moreover, an adjustment that relies heavily on investment cuts has negative implications for growth and potential growth in these economies. Adjustment in emerging Europe has been driven by a combina-tion of declining investment and increasing saving. Large saving by households in emerging Europe probably reflects sizable declines in house prices, which is not the case for EA periphery countries except Ireland. For the public sector, the saving-investment position worsened in both groups of countries as one would expect during recessions. For both groups, expenditure increased as a proportion of GDP, whereas revenue performance differed, reflecting the length of the reces-sion and fiscal measures.

EMPIRICAL RESULTS AND COUNTRY-SPECIFIC DISCUSSIONS

Data and Methodology

This section aims to provide an understanding of the driving forces behind the differing CA dynamics in the two groups of countries by estimating a reduced-form model of the CA. The analysis uses explanatory variables along three dimen-sions: an economy’s cyclical position, its external competitiveness, and its external environment ( Table 9.1 ). All three dimensions are clearly interlinked; neverthe-less, this simplistic representation offers a useful and intuitive framework for ana-lyzing the relative importance of different groups of factors for CA developments before and during the crisis. 6

• Cyclical position. To account for the large cross-country variations in cyclical positions driven by the dynamics of private and public saving and invest-ment, the model includes variables capturing capital inflows (the liability side of external financing), real credit growth to the private sector, and the unemployment rate, in addition to the overall general government balance (as a percentage of GDP).

5See Atoyan, Manning, and Rahman (2013) for details. 6It is important to acknowledge that some of the explanatory variables included in the empirical analy-sis (e.g., real effective exchange rates and capital flows) may not be purely exogenous to CA develop-ments. Thus, the model estimates are subject to estimation bias to the extent that reverse causality exists.



Figure 9.5 Euro Area Periphery and Emerging Europe: Contribution of Saving and Investment to Changes in Current Account and House Prices, 2000–12

Saving Investment Current account

Saving Investment Current account Expenditure Revenue


Change in Private Saving and Investment,2007–121 (percent of GDP)


Change in Private Saving and Investment,2007–111 (percent of GDP)


Change in Public Saving and Investment,2007–121 (percent of GDP)


Change in General Government Revenueand Expenditure, 2007–12 (percent of GDP)

House Prices2

(year-over-year percent change)House Prices2

(year-over-year percent change)

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BulgariaEstonia

LatviaLithuania3

GreeceIreland

PortugalSpain

Sources: Eurostat; Haver Analytics; IMF, World Economic Outlook; and IMF staff calculations. 1 A decline in saving and increase in investment recorded as a negative number. 2 Data for 2012 as of Q3. 3 Data for 2012 as of Q2.


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TABLE 9.1

European Advanced and Emerging Market Economies: Current Account Adjustment, 2000–12 1

Dependent

variable: Current

account balance

(percent of GDP)

R1 R2 R3 R4 R5 R1 R2 R3 R4 R5 R1 R2 R3 R4 R5

All Countries in Sample Advanced Economies2 Emerging Market Economies3

Cyclical factors

General government balance (percent of GDP) 4

0.098 0.176 0.031 0.147 0.217** 0.300** 0.439*** 0.288** 0.427*** 0.619*** −0.043 −0.184 −0.094 −0.148 −0.398***

Interacted with crisis dummy

0.338*** 0.285** 0.360*** 0.344*** 0.292** 0.002 0.089 0.003 0.156 0.201 0.218 0.281 0.228 0.186 0.394***

Real private credit growth (year-over-year percent change) 5

−0.070*** −0.051** −0.028 −0.042** −0.056*** −0.123*** −0.138*** −0.096** −0.185*** −0.151*** −0.018 −0.002 −0.005 0.002 −0.015


−0.161*** −0.117*** −0.162*** −0.129*** −0.078** −0.168*** −0.139 −0.084 −0.044 −0.212* −0.034 −0.015 −0.027 −0.026 0.002

Unemployment rate (percent)

0.758*** 0.545*** 0.649*** 0.926*** 0.410*** 0.522*** 0.394** 0.701*** 0.320** 0.243 0.253* 0.237


−0.336 −0.358* −0.416** −0.670*** −0.254 −0.314 −0.110 −1.059*** 0.151 −0.005 −0.018 0.092

Total capital inflows (percent of GDP)

−0.028*** −0.028** −0.026*** −0.024* −0.017 −0.033*** −0.026*** −0.026*** −0.023*** −0.021 −0.353*** −0.367*** −0.357*** −0.343*** −0.386***


−0.003 0.004 −0.026 −0.015 −0.021 0.003 −0.017 −0.019 −0.015 −0.046** −0.197** −0.136* −0.190* −0.162* −0.075

External

competitiveness

Floating exchange rate regime dummy

0.381 1.631 2.810*** 1.024 2.081*** 3.145*** 2.082** 4.491*** 2.199** 3.514*** 1.685 0.438 0.659 0.304 0.803

(Continued )


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TABLE 9.1 ( Continued )

European Advanced and Emerging Market Economies: Current Account Adjustment, 2000–12 1

Dependent

variable: Current

account balance

(percent of GDP)

R1 R2 R3 R4 R5 R1 R2 R3 R4 R5 R1 R2 R3 R4 R5

All Countries in Sample Advanced Economies2 Emerging Market Economies3

Nominal effective exchange rate (year-over-year percent change) 5

−0.027 0.036 0.077 0.086 −0.066 −0.028


−0.165* −0.116 0.029 0.194 −0.071 −0.038

GDP deflator to trade-weighted GDP deflator (year-over-year percent change)

−0.408*** 0.025 −0.181**


−0.046 0.193 −0.019

Manufacturing wages to trade-weighted manufacturing wages (hourly, euro) 6

−0.116*** −0.082*** −0.079*** −0.080*** 0.223* 0.178


0.089** 0.074* 0.100** 0.038 −0.108 −0.127

ULC-based real effective exchange rate (year-over-year percent change) 5

−0.064** −0.077** −0.081*** 0.054 0.091 −0.039 −0.072** −0.073*** −0.081***


−0.087** −0.065** −0.044 −0.125** −0.109** −0.152* −0.001 −0.003 0.016


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External

environment

Partners‘ GDP growth (year-over-year percent change)

−0.210 −0.265** −0.248 −0.231** 0.011


−0.032 −0.197 1.510*** 0.866*** −0.280

Partners‘ import growth (year-over-year percent change)

−0.032 −0.009 −0.046 −0.082* 0.001 −0.128*** −1.481*** 0.004 −0.072 −0.043


−0.096 −0.037 0.011 0.558*** 0.183** 0.244* 1.259*** −0.091 0.002 −0.021

VIX −0.090** −0.083** −0.113*** −0.031 −0.056 −0.153*** −0.127*** −0.105*** −0.070* −0.113*** −0.145** −0.051 −0.083 −0.092* −0.130***

Other .Household liabilities (percent of gross national income)

−0.125*** −0.089*** −0.000


0.025 0.022 −0.031

Number of observations

286 286 264 300 300 165 165 154 180 180 121 121 110 120 120

R 2 0.663 0.684 0.762 0.716 0.471 0.771 0.785 0.835 0.800 0.410 0.887 0.890 0.865 0.887 0.848Country dummies

Yes Yes Yes Yes No Yes Yes Yes Yes No Yes Yes Yes Yes No

Note: ULC = unit labor cost; VIX = Chicago Board Options Exchange Volatility Index. 1 Unless otherwise indicated, all variables are expressed in changes from 2000 levels. 2 Austria, Belgium, Cyprus, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Malta, the Netherlands, Portugal, Spain, Sweden, and the United Kingdom. 3 Bulgaria, Croatia, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, the Slovak Republic, and Slovenia. 4 Cash balance for Ireland excludes bank recapitalization. 5 Data for 2012 as of 2012:Q3. 6 Data as of 2011. *, **, and *** indicate variable is statistically significant at the 10 percent, 5 percent, and 1 percent levels, wrespectively.



• External competitiveness. To account for the diverging trends in external competitiveness, the model tests the importance of relative wages in manu-facturing (expressed as a ratio of those in trading partners), and the unit labor cost–based (ULC-based) real effective exchange rate (REER). Because price competitiveness is likely to be influenced by differences in monetary policy and exchange rate regimes, a floating exchange rate regime dummy is also included.

• External environment. The model accounts for movements in trading part-ners’ demand as proxied by the growth in trade-weighted real GDP or im-ports. The overall market sentiment toward risk is also controlled for through inclusion of the Chicago Board Options Exchange Market Volatil-ity Index (VIX index).

In addition, household indebtedness is included to capture balance sheet effects on private sector saving and investment decisions. To account for poten-tial crisis-driven nonlinearities and to explicitly differentiate between the driv-ing forces during the boom and crisis periods, the model includes interaction terms between explanatory variables and a crisis dummy variable. 7 This inclu-sion is important to accommodate the interplay of additional possible effects of heightened stress in the financial markets, a collapse in export demand, or changes in attitudes toward consumption-saving decisions of economic agents. To assess the relative importance of factors explaining changes in the CA bal-ance, the estimation strategy developed by Fernandez-Arias (1996) and Atoyan, Jaeger, and Smith (2012) is followed. The reduced-form equation for the CA deficit is estimated by ordinary least squares using annual data for 2000–12 for a panel of 28 European countries (EU members). Country-specific effects are treated as unobservable. These effects are estimated as the residual movements in the CA balance that are not accounted for by other variables in the model. To facilitate cross-country comparisons without relying on an implausible as-sumption of structural similarity, all variables in the model are expressed as deviations from 2000 levels. This transformation eliminates structural differ-ences across countries and the model explains the changes in CA deficit (i.e., CA adjustment) in terms of changes in the explanatory variables, taking 2000 as a benchmark.

Results

In summary, CA dynamics in emerging Europe and advanced Europe were driven by different factors. The precrisis CA developments in emerging Europe were driven by capital flows and competitiveness, as captured by the REER-ULC, whereas precrisis CA developments in advanced Europe were driven by the fiscal balance, real credit growth, capital flows, the exchange rate regime, and the un-employment rate ( Tables 9.1 and 9.2 ). 8 These differences partly reflect the relative

7The crisis dummy variable is equal to 1 in 2008–11 and zero in other years. 8See Atoyan, Manning, and Rahman (2013) for a detailed discussion of the estimation results.



roles of private investment and consumption in the widening of CA deficits in these two groups, and the differing roles of fiscal policy. 9 During the postcrisis adjustment, for emerging Europe, capital inflows made a difference highlighting the significance of financing or capital account developments in determining the CA in emerging economies. For advanced Europe, postcrisis CA developments have been affected by competitiveness (REER-ULC), real credit growth, and import demand from partner countries.

Although these empirical findings are useful for describing the qualitative characteristics of the CA dynamics, individual developments are important for understanding the heterogeneity of the driving forces in each country. Therefore, the estimated model is used to decompose CA adjustments into proximate causes. The decompositions are constructed by taking the value of each explanatory vari-able for the country in each period (measured as the change from its 2000 level) and multiplying by the corresponding estimated coefficient in the preferred model specification (regression 4 in Table 9.1 ) using the whole sample. Four EA periphery countries: Ireland, Greece, Portugal, and Spain ( Figure 9.6a ), and four emerging European countries with fixed exchange rate regimes, Estonia, Bulgaria, Latvia, and Lithuania ( Figure 9.6b ) are discussed in more depth below.

EA Periphery

For Ireland , CA imbalances widened during 2004–08, then sharply improved during 2009–10, closing the gap completely. During 2006–08, capital inflows

TABLE 9.2

Emerging and Advanced Europe: Variables Affecting Pre- and Postcrisis Current Account Adjustment

Emerging Europe1 Advanced Europe2

Precrisis Capital Account Developments

Capital flows, REER-ULC Fiscal balance, real private credit growth, exchange rate regime, unemployment rate, and capital flows

Postcrisis Capital Account Developments

Capital flows Real credit growth, REER-ULC, partner country import growth

Note: REER-ULC = real effective exchange rate–unit labor cost. 1 Sample includes Bulgaria, Croatia, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, the Slovak Republic, and Slovenia. 2 Sample includes Austria, Belgium, Cyprus, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Malta, the Netherlands, Portugal, Spain, Sweden, and the United Kingdom.

9An interesting observation is that fiscal balance does not seem to have a statistically significant impact during the boom period for the whole sample or the emerging market subsample. This is either be-cause headline fiscal balances did not vary much during the boom years, masking pronounced deterio-ration in structural fiscal positions, or their movements were relatively small compared with the movements in other cyclical variables, such as capital inflows or credit growth. For advanced Europe, headline fiscal balances affected CA developments significantly during the boom period, reflecting greater variability and possibly a higher impact of fiscal policy in this group, given the relatively low degree of trade openness in some economies.


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Figure 9.6a Euro Area Periphery: Empirical Decomposition, 2001–12 (Percent changes from 2000)

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Greece Ireland

Portugal Spain

Error

External environment

Capital inflows

Partner import growth

Unemployment rate

ULC-based REER

Real credit growth

Government balance

Fixed effect

Actual change in CA

Source: IMF staff estimates. Note: CA = current account; REER = real effective exchange rate; ULC = unit labor cost. Empirical decomposition discounts actual data by estimated coefficients found in R4 of Table 9.1. In the case of interaction with the crisis dummy, actual data are discounted by the estimated coefficient for the crisis dummy. The contribution to changes in the current account shown is the sum of both discounts (coefficients of explanatory variable and the crisis dummy).


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Figure 9.6b Emerging Europe: Empirical Decomposition, 2001–12 (Percent changes from 2000)

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2001 02 03 04 05 06 07 08 09 10 11 12 2001 02 03 04 05 06 07 08 09 10 11 12

Bulgaria Estonia

Latvia Lithuania

Error

External environment

Capital inflows

Partner import growth

Unemployment rate

ULC-based REER

Real credit growth

Government balance

Fixed effect

Actual change in CA

Source: IMF staff estimates. Note: CA = current account; REER = real effective exchange rate; ULC = unit labor cost. Empirical decomposition discounts actual data by estimated coefficients found in R4 of Table 9.1. In the case of interaction with the crisis dummy, actual data are discounted by the estimated coefficient for the crisis dummy. The contribution to changes in the current account shown is the sum of both discounts (coefficients of explanatory variable and the crisis dummy).



seemed to matter in CA widening. The contribution of the household sector, which was the main driver of precrisis widening, does not seem to take place through lower unemployment but through higher wages and real credit growth. The sharp adjustment in the postcrisis years was driven by credit contraction, capital flow reversal, rising unemployment, and rising partner country demand for Irish imports.

Greece has seen a more modest and slower adjustment. Precrisis widening during 2004–07 was largely the result of lower unemployment and capital inflows. An appreciating REER-ULC contributed to the widening until 2009. Postcrisis adjust-ment has been aided by credit contraction, and from 2011 onward, higher unem-ployment, causing the household sector to adjust. The fiscal position is keeping CA imbalances wide. A positive contribution from wage adjustment has just begun to kick in in 2012.

Portugal’s CA imbalances were very large in early 2000. Thus, the dependent variable, which measures the CA as deviations from its 2000 level, does not show a large widening. Portugal is the only country in which unemployment contrib-uted to CA adjustment during the precrisis years. This is consistent with the fact that, unlike in the other three countries, the household sector contributed little to the precrisis widening because high unemployment held back household con-sumption. Nonetheless, the household sector made positive contributions to CA adjustment after the crisis. Until recently, large fiscal deficits, even with private sector adjustment resulting from higher unemployment and credit contraction, have prevented CA adjustment. A depreciating REER-ULC’s contribution to adjustment increased in 2012.

For Spain , the precrisis CA widening was driven mostly by domestic demand as captured by declining unemployment. Postcrisis CA adjustment has taken place through a reversal in unemployment and through credit contraction, both of which have affected private consumption and investment. The large, signifi-cant, and persistent role of Spanish unemployment since the crisis may reflect the particular role the construction sector played in the economy’s precrisis growth and employment. Given that some of the construction jobs may be permanently lost, a high unemployment rate may persist and continue to contribute to higher household saving and CA adjustment, unless jobs are created in other sectors. Large fiscal deficits, which are, in part, a result of poor growth, are acting as a drag on the CA adjustment.

Emerging Europe

In Bulgaria , large CA imbalances resulted, in part, from sharply falling unemploy-ment rates and credit growth. Capital flows were another significant driver of the CA during 2000–08. During the postcrisis years, Bulgaria’s adjustment—the largest in Europe—has been helped by a slowdown in credit growth. It is impor-tant to note, however, that a significant part of CA movements in Bulgaria, both before and in the aftermath of the crisis, remains unexplained by the model.

For the three Baltic countries , precrisis developments are, to a degree, similar to those of Bulgaria, given the strong role of declining unemployment. Whereas



an appreciating REER-ULC played more of a role in CA widening for Estonia and Latvia, real credit growth aided the widening in Lithuania. During the post-crisis years, lower demand caused by a credit crunch, capital outflows, and higher unemployment helped with the sharp CA adjustment in Estonia and Latvia. CA adjustment in the Baltic countries also benefited from higher exports through diversification away from the EA.

Finally, although the overall explanatory power of the estimated model is strong, unexplained residuals are larger at the peak of the crisis (2008–09), par-ticularly for countries that experienced abrupt and large reversals in CA deficits. This outcome seems to suggest the likely presence of additional nonlinear effects that go beyond what is modeled here.

POLICY IMPLICATIONS AND CONCLUSIONS

This chapter’s analysis of CA developments in Europe suggests that, generally speaking, similar dynamics played out in the EA periphery and emerging Euro-pean countries with fixed exchange rate regimes during the precrisis years, when strong private sector–led domestic demand booms created large CA imbalances. In emerging Europe, rising investment played a stronger role than declining sav-ing. In the EA periphery, CA imbalances were mostly due to declining private sector savings. Public sector deficits contributed to external imbalances in the EA periphery countries of Greece and Portugal, but not in emerging Europe. How-ever, fiscal policy during the boom years was procyclical and failed to dampen overheating or to create the needed policy space to offset the economic downturn that followed.

A dramatic swing in market sentiment during the global financial crisis left countries with no choice but to adjust. CA imbalances declined throughout the region, but adjustment relied largely on expenditure reduction. The key finding of this chapter is that adjustment has been facilitated mainly by import compres-sion induced by credit crunches and skyrocketing unemployment as well as—to a larger extent in emerging Europe—by large upfront fiscal adjustment forced by a lack of financing. Relying on import compression alone, however, has had se-vere contractionary effects for these economies, especially in the EA periphery, just when growth was needed to improve the fiscal balance and restore market confidence.

The adjustment was somewhat faster, and the adverse impact of import com-pression somewhat mitigated, in emerging Europe, where significant wage adjustment, enabled by relatively more flexible labor markets, aided export com-petitiveness and allowed for faster export growth. At the same time, lower levels of household indebtedness helped with the return of private sector consumption. This, in turn, has allowed output and domestic demand to rebound much more quickly than in the EA periphery. In contrast, adjustment in the EA periphery initially relied heavily on import compression, although exports later played a more important role in rebalancing in Spain and Ireland. Structural problems in the tradables sector, the small tradables base, and weak supply chains have cast a



shadow over the export sector’s recovery in some periphery countries, particularly Greece. A larger share of intra-periphery trade and an external environment of tepid global growth further exacerbated these problems.

The comparative experiences of these two groups highlight the importance of the appropriate mix of policies, both macroeconomic and structural, especially when monetary policy is constrained by a fixed exchange rate. In particular, some of the characteristics that structural reforms seek to establish will also help with external adjustment. For example, flexible conditions in the labor market can facilitate wage adjustment without placing most of the burden of adjustment on employment. But such price adjustments can also contribute to external competi-tiveness and help achieve rebalancing needs in a growth-friendly manner, which would also support medium-term growth. As the next chapter shows, wage and price adjustments can play an important role in helping develop, or strengthen, a country’s position in global production chains—and plugging into these supply chains is an important channel through which countries can benefit from growth in world trade.

REFERENCES

Atoyan, R., A. Jaeger, and D. Smith, 2012, “The Pre-Crisis Capital Flow Surge to Emerging Europe: Did Countercyclical Fiscal Policy Make a Difference?” IMF Working Paper 12/222 (Washington: International Monetary Fund).

Atoyan, R., J. Manning, and J. Rahman, 2013, “Rebalancing: Evidence from Current Account Adjustment in Europe,” IMF Working Paper 13/74 (Washington: International Monetary Fund).

Berger, H., and V. Nitsch, 2010, “The Euro’s Effect on Trade Imbalances,” IMF Working Paper 10/226 (Washington: International Monetary Fund).

Chen, R., G. Milesi-Ferretti, and T. Tressel, 2012, “External Imbalances in the Euro Area,” IMF Working Paper 12/236 (Washington: International Monetary Fund).

Fernandez-Arias, E., 1996, “The New Wave of Private Capital Inflows: Push or Pull?” Journal of Development Economics , Vol. 48, pp. 389–418.

Jaumotte, F., and P. Sodsriwiboon, 2010, “Current Account Imbalances in the Southern Euro Area,” IMF Working Paper 10/139 (Washington: International Monetary Fund).

Merler, S., and J. Pisani-Ferry, 2012, “Sudden Stops in the Euro Area,” Bruegel Policy Contribu-tion, Issue 2012/06 (Brussels: Bruegel).

Purfield, C., and C.B. Rosenberg, 2010, “Adjustment under a Currency Peg: Estonia, Latvia and Lithuania during the Global Financial Crisis 2008–09,” IMF Working Paper 10/213 (Wash-ington: International Monetary Fund).

Rahman, J., 2008, “Current Account Developments in New Member States of the European Union: Equilibrium, Excess, and EU-Phoria,” IMF Working Paper 08/92 (Washington: In-ternational Monetary Fund).

———, 2010, “Absorption Boom and Fiscal Stance: What Lies ahead in Eastern Europe,” IMF Working Paper 10/97 (Washington: International Monetary Fund).

Sinn, H., and T. Wollmershaeuser, 2011, “Target Loans, Current Account Balances and Capital Flows: The ECB’s Rescue Facility,” NBER Working Paper No. 17626 (Cambridge, Massa-chusetts: National Bureau of Economic Research).


239

CHAPTER 10

The Role of Vertical Supply Links in Boosting Growth

JESMIN RAHMAN AND TIANLI ZHAO

EXPORT NETWORKS MATTER

The external environment is critical in the quest for growth. Strong global demand can provide the lift that amplifies the fruits of structural reforms, while global headwinds can mean a delay. As Chapter 9 highlighted, however, the reforms that will provide growth in the longer term can also be important to facilitating the medium-term external rebalancing required in many European countries.

The nature of international trade has changed dramatically in the past few decades. Production processes have increasingly involved production chains stretching across many countries, with each nation specializing in one or more stages of production. As a result, intra-industry trade now dominates world mer-chandise trade, and because products cross borders multiple times, world trade has grown faster than both global GDP and global value added in manufacturing ( Figure 10.1 ). In this globalized environment, reforming the domestic economy, while necessary, may not be sufficient if done in isolation. Countries need to find their place in these cross-border production chains to benefit the most from global trade and output growth.

The analysis of vertical supply links poses a data challenge. Official trade sta-tistics are measured in gross terms that include both intermediate inputs and final products, thus double counting the value of those goods that cross international borders more than once. As cross-border production links become more impor-tant, official trade statistics are becoming less meaningful as a gauge of the value contributed by a country in a particular sector, also reducing their usefulness as a tool for measuring export competitiveness and informing policy advice. Figure 10.2 illustrates this point: suppose a German car maker ships $50,000 worth of car components to Hungary. A factory in Hungary then assembles the car and sells it to a dealership in France for $55,000.The gross or official trade statistics would record $50,000 worth of exports from Germany to Hungary as well as $55,000 worth of export from Hungary to France. But in value-added terms, Hungary’s exports to France would be only $5,000. 1

For additional technical detail, see Rahman and Zhao (2013). 1In the example, Hungary’s value added is identical to the value of net exports, but this is not generally the case. For example, gross and value-added exports of a country are identical only when no imported

(continued )


240 The Role of Vertical Supply Links in Boosting Growth

A larger role for supply links in export growth implies a large and possibly increasing role of foreign value added. However, if a country’s export growth is driven mostly by value crossing borders rather than domestic production, its impact on growth and employment may be smaller. These issues have particular relevance for many European countries. Since the mid-1990s, a number of Cen-tral European economies, such as the Czech Republic, Hungary, Poland, and the Slovak Republic, experienced export-led growth. As discussed in IMF (2013), these countries have strengthened their trade links to Germany considerably since the mid-1990s, with large export increases in knowledge-intensive sectors. At the

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Hungary

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France

$50,000

$55,000France

Germany

$50,000

$5,000

Hungary

Source: Authors’ illustration.

Figure 10.1 Real GDP and Exports Growth, World and Europe (Index, 2000 = 100)

Figure 10.2 Trade Flow in Gross Terms and Value-Added Terms

inputs were used in the export production. Thus, when no imported inputs are used in the production of exports, gross and value-added exports are (weakly) greater than a country’s net exports. Although the concept of value-added exports is different from that of net exports, both are relevant for assessing an economy’s competitiveness.


Rahman and Zhao 241

same time, a number of other European countries, including some in the euro area (EA) periphery, travelled a different growth path, relying instead on domestic demand and fast credit growth. To what extent can the first group’s export success be attributed to plugging into the pan-European supply chain, and what factors helped them achieve this success? For countries in the EA periphery that are des-perately looking to increase exports to rebalance their external positions and bring back growth, answers to these questions can provide valuable lessons.

To get a true picture of a country’s export growth, the foreign-value-added component needs to be stripped from total exports. By analyzing trends and developments in the decomposed flow data, this chapter aims to improve the understanding of international trade in Europe: where value is created, the role of vertical supply links in export growth, what factors contribute to the growth of supply links, and how countries’ comparative advantages are affected by sup-ply links over time. The analysis begins by dissecting gross export statistics in the next section. The subsequent section uses the decomposed trade statistics to look at the role of vertical supply chains in overall export growth and competi-tiveness developments. Then regression analysis is used to explore the factors that contribute to a firm’s decision to locate part of its production abroad. The regression analysis is followed by a section that looks closely at a set of European countries to see which have successfully benefited from being part of the supply network. Conclusions and related policy implications are discussed in the final section.

DISSECTING GROSS EXPORTS IN EUROPE

The shortcomings of gross trade statistics have been well recognized (Hummels, Ishiib, and Yi, 2001; Ando and Kimura, 2003; Koopman, Wang, and Wei, 2008; Koopman and others, 2011; and Breda, Cappariello, and Zizza, 2008). The con-ceptual framework developed in Koopman and others (2011) is adopted in this chapter to decompose sources of value added in exports into five main categories depending on the location of value added and stage of production ( Figure 10.3 ): (1) domestic value added in final goods, (2) domestic value added in intermediate goods not processed for further export, (3) domestic value added in intermediate goods processed for export to third countries, (4) domestic value added that is exported to another country but returns to the original country for export to a third country, and (5) value added imported from abroad as inputs into exports, that is, foreign value added. This enables first, a connection to be made between gross or official statistics and value added statistics in merchandise and services trade, and then allows all value added embedded in a country’s exports to be distributed to its original sources at the country and product levels.

The five-category value-added decomposition for manufacturing and services exports, respectively, are made using a world input-output table. The world input-output table used in this study is based on a World Input-Output Database (WIOD) by Timmer (2012), covering 27 European Union countries and 13 other major countries in the world during 1995 to 2009. The 40 countries



included in the world input-output table for this analysis cover more than 85 per-cent of world GDP. 2 The data are disaggregated at the industrial level, covering intermediate and final goods usage for 35 industries.

Components 1 through 4 provide the value of exports that is created domesti-cally, and component 5 provides the value of exports created abroad. In the terminology of Figure 10.3 , components 1 and 2 tell how much of a country’s exports are created as stand-alone exports, that is, outside any supply chain, and components 3 through 5 capture exports generated by supply links. Supply link–related exports have two components: upstream, which include domestic value added intermediate exports that are processed for further export (components 3–4), and downstream, which include foreign value added exports (component 5). A large share of foreign value added in a country’s exports signifies its position as a downstream processor or assembler.

Based on the above decomposition, some of the key developments in manufac-turing and services exports observed during 1995–2008 include the following:

• The share of domestic value added has declined. During 1995–2008, the aver-age share of domestic value added (components 1–4) in manufacturing exports in the sample countries declined to 62 percent from 72 percent ( Figure 10.4 ). Similar declines were visible in Europe and subgroups of

Gross exports

Domestic valueadded (DV)

Exported inintermediatesprocessed forre-export to

third countries(3)

Exported inintermediates

that returnto homecountries

(4)

Othercountries’

DV inintermediates

(5)

Exported infinal goods

(1)

Exported inintermediatesnot processed

for furtherexport

(2)

Foreign valueadded (FV)

Source: Koopman and others (2011).

Figure 10.3 Decomposition of Gross Exports into Value-Added Exports

2The WIOD contains an additional region (Rest of the World) as a proxy for the aggregate of all other countries in the world. Annex 2 in Rahman and Zhao (2013) provides a detailed description of the WIOD.


Rahman and Zhao 243

countries in Europe, in which the share of domestic value added in total exports declined by 9 to 13 percentage points. The decline in the share of domestic value added in services trade was less pronounced, reflecting a lower degree of fragmentation in international trade in services.

• The role of supply links has increased. During 1995–2008, the average share of world manufacturing exports produced via supply links (components

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As supply-link-related exports increased, the share of domestic VA declined in manufacturing . . .

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2008

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2008

Source: Authors’ calculation using world input-output table based on Timmer (2012). Note: Advanced Europe = Austria, Belgium, Denmark, Finland, France, Germany, Italy, the Netherlands, Sweden, and the United Kingdom. Emerging Europe = Estonia, Hungary, the Czech Republic, Latvia, Lithuania, Poland, Romania, the Slovak Republic, Slovenia, and Turkey. Euro area periphery = Greece, Ireland, Spain, and Portugal. VA = value added.

Figure 10.4 The Role of Domestic Value Added and Supply Links in Exports Growth, 1995–2008 (Percent of total exports)



3–5) rose to 54 percent from 42 percent ( Figure 10.4 ). Increases of similar magnitude were experienced by Europe and country subgroups in Europe. For services, the average share of supply link–related exports increased to 42 percent from 32 percent, indicating a pace of increase similar to that in manufacturing.

These observations suggest that cross-border supply chains have become in-creasingly important in Europe, especially in emerging Europe, with nearly half of manufacturing value added produced abroad. But what does this mean for the external environment of countries seeking growth? For example, does foreign value added boost overall export growth in the countries participating in supply chains, and to what extent are supply links beneficial for employment, growth, and competitiveness?

To shed light on these issues, the analysis starts by normalizing gross exports and its two main subcomponents, domestic and foreign value added, by GDP. An increasing exports-to-GDP ratio indicates that a country’s growth is becoming more oriented toward international trade and, possibly, cross-border joint pro-duction. The percentage increase in gross exports to GDP is simply the sum of the percentage increases in the ratios of domestic and foreign value added of ex-ports to GDP.

Figure 10.5 compares growth in domestic-value-added exports and gross ex-ports during 1995–2008. Although increases in domestic-value-added exports account for much of gross export growth in many countries, for a large number of them (most notably, Belgium and Bulgaria), increases in gross exports as a share of GDP during 1995–2008 mostly reflect increasing foreign value added. The lower panel of Figure 10.5 shows the average ratio of domestic-value-added ex-ports to GDP in European countries during 1995–2008.

Further to this point, the European countries are divided into four groups based on the increase in the ratio of domestic-value-added exports of goods and services to GDP during 1995–2008 ( Table 10.1 ), with a view also to investigating the implications of increasing supply links on competitiveness. An increase in this share indicates that a country increased its export orientation in growth during this period, which can be interpreted as an improvement in competitiveness.

The results show that most European countries in the sample increased their domestic value-added-exports-to-GDP ratio, that is, they increased the export orientation of their economies. However, this outcome needs to be viewed in the context of a country’s level of export orientation. Table 10.1 shows the average domestic-value-added-exports-to-GDP ratio in European countries during 1995–2008 along with the respective increases during the same period. A position in the upper-left corner in Table 10.1 indicates high and increasing export orien-tation of domestic production, whereas a position in the lower-right corner shows low and declining export orientation during 1995–2008.

Table 10.1 suggests a positive correlation between initial levels of export orienta-tion and future increases. That is, on average, countries with higher levels of export orientation strongly increased their export orientation, whereas those with lower levels of domestic value added in GDP had much lower increases or actually de-clines. This absence of convergence could be driven simply by standard economies


Rahman and Zhao 245

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Figure 10.5 Domestic-Value-Added Exports in Europe, 1995–2008

of scale or network externalities, but in the present context, the question that arises is whether and to what extent increasing cross-border supply linkages may have played a role. Figure 10.6 (left panel) exhibits a strong positive relationship between the change in a country’s foreign value added—which has been a strong engine of export growth in much of Europe—and domestic-value-added exports expressed as a percentage of GDP.

More formally, the correlation between foreign-value-added growth and do-mestic value added up to five years later is tested by regressing the growth in domestic value added on growth in foreign value added (and year dummies) for various lags using the following equation:

log log ,DVDV

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t mVV

t mVV i iYearr− −m

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in which m denotes the lag length.



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Figure 10.6 Exports during 1995–2008

TABLE 10.1

Domestic-Value-Added Export Performance in Europe, 1995–2008

Growth of Domestic-Value-Added Exports/GDP during Period

Domestic-Value-

Added Exports/GDP

Increased More

Than 10 Percentage

Points

Domestic-Value-

Added Exports/GDP

Increased 5–10

Percentage Points

Domestic-Value-

Added Exports/GDP

Increased Less Than

5 Percentage Points

Domestic-Value-

Added Exports/GDP

Declined

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Cyprus, Turkey

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Foreign-value-added and future growth in domestic-value-added exports are positively and statistically significantly related for all lag specifications ( Table 10.2 ). These results do not establish causality, but a plausible interpreta-tion is that increasing foreign-value-added exports during 1995–2008 helped


Rahman and Zhao 247

downstream assembly producers to expand and create jobs and growth, subse-quently resulting in increasing domestic-value-added exports. Because world GDP growth was driven by growth in world trade, and world trade growth was driven by supply links, foreign and domestic value added were complementary to each other, creating a virtuous circle for countries able to plug into regional or global vertical supply chains. Convergence did not appear to play a role: countries that had higher export-to-GDP ratios in 1995, such as China, the Czech Republic, Hungary, the Slovak Republic, and Taiwan Province of China, maintained or further strengthened their positions over time ( Figure 10.6 , right panel).

These two findings, that foreign-value-added exports contribute positively to domestic-value-added exports and that countries have retained or strengthened their competitive positions in exports, are related. To the extent that world trade is increasingly characterized by supply links and that these links take time to es-tablish, it is not surprising that countries that were already well linked in 1995 are the ones that benefited disproportionately from growth in exports. This finding suggests that a successful strategy of export-led growth depends on, among other factors, finding an appropriate position in the value-added chain and nurturing this vertical relationship.

Countries that are not already well linked in the European supply chains thus have an additional difficulty in increasing the role of exports in growth. The extent of integration with supply links, measured both by the number of links and the volume of trade flowing through these links, is low in some EA periph-ery countries, such as Greece and Portugal. The following section investigates what factors help establish these supply links, including the role that policy can play.

TABLE 10.2

Impact of Foreign-Value-Added Growth on Domestic-Value-Added Growth

1-year lag 2-year lag 3-year lag 4-year lag 5-year lag

Foreign value added growth in period t −1

0.0151

(0.47)Foreign value added growth in period t −2

0.1014*


0.0947*


0.0934*


0.0789*

(2.57)

R 2 0.5901 0.6522 0.6167 0.6179 0.616

Note: Standard errors are reported in parentheses. * denotes significance at the 1 percent level.



WHAT FACTORS HELP COUNTRIES ESTABLISH SUPPLY LINKS?

The analysis so far shows that several European countries have increased their export-to-GDP ratios during 1995–2008 through integration with supply links. These countries linked with hubs, such as Austria, Germany, or Sweden, and managed to attract a part of the downstream production. Over time, that created a virtuous circle whereby foreign and domestic value added increased hand in hand, enhancing the role of exports in growth. Because success in export-led growth depends on plugging into this virtuous circle, it is important to investigate what factors contribute to a country’s decision to send a part of its production abroad.

This analysis uses an augmented gravity model to explore this question empiri-cally. Following McCallum (1995), the following specification is considered:

ln ( FV ijt ) 0 1 ln( Y it Y jt ) 2 ln( G it G jt ) 3 ln Dist ij ∑ k CX k ∑ n S n ∑μ t T t ijt

(10.2)

in which t denotes time and i and j denote countries, and the variables are defined as follows (described in more detail below; see also Rahman and Zhao, 2013):

• FV ij is the foreign value added from country i embodied in country j ’s exports;

• Y is nominal GDP; • G is GDP per capita; • Dist ij is the distance between countries i and j ; • CX k is the set of gravity control variables (see below); • S n is the set of structural variables; • T is the set of time controls; • ij is the error term. In the baseline, the equation is estimated using ordinary least squares (OLS)

with time dummies. To check for the robustness of the estimated results, OLS with no control and two-way fixed effects with both time and country-pair dum-mies is used. In the robustness tests, fixed effects are chosen over random effects as indicated by the Hausman test. The fixed-effects model is not used in the baseline because it does not allow distinguishing between the free trade agree-ment (FTA) dummy and the country-pair effects, given that the former incorpo-rates the latter. All time and country-pair dummy variables are statistically significant.

Augmented Gravity Variables

A broad set of explanatory variables is included. In addition to the standard variables in the original gravity equation (including GDP, per capita GDP, and the distance between each country pair), dummy variables are also included for


Rahman and Zhao 249

common language, common border, FTA, and whether the country is a resource exporter, as well as the tariff rate of the downstream outsourced country j . 3 The purpose is to control for as many variables as possible that may explain the value-added flows between two countries. The term ∑ k CX k in equation (10.2) can therefore be expressed as

∑ k CX k 1 ComLang ij 2 ComBorder ij 3 FTA ij 4 ResourceExporter i 5 Tariff j .

(10.3)

The estimation results show all gravity variables to be statistically significant with the expected signs ( Table 10.3 ). For example, reducing the distance between countries by 1 percent increases the value of foreign-value-added exports by 0.5 per-cent. Similarly, increasing the host country’s market size (i.e., GDP) by 1 percent increases foreign-value-added exports by 0.6 percent. A higher level of GDP, a shorter distance between two countries, the presence of a common border and common language, and the existence of an FTA all positively affect a country’s decision to locate a part of its export production in another country.

Structural Variables

In addition, a list of structural variables are included that are commonly thought to drive fragmentation of export production. These include the labor cost differ-ential, the initial level of similarities in industrial structure, and exchange rate volatility: 4

∑ n S n 1 ( ULC it ULC jt ) 2 Sim ijt 3 VolatilityEX ijt . (10.4)

The estimation results show a statistically significant positive coefficient for the unit labor cost differential, which is equal to the unit labor cost in country i minus the unit labor cost in country j . One interpretation is that countries with higher unit labor costs would have larger incentives to start outsourcing some of their downstream production processes to countries with lower unit labor costs ( Table 10.3 ), resulting in increased foreign value added in the

3The common language dummy variable is set to 1 if two countries with bilateral trade activities speak the same language; the common border dummy variable is set to 1 if two countries with a bilateral trade relationship share the same border. The FTA dummy variable is set to 1 if two countries have an FTA. The resource exporter dummy variable is set to 1 if the source country is a major natural resources exporter (e.g., Australia, Brazil, Canada, Russia). The downstream tariff variable is the weighted mean of the tariff applied to manufactured products by the downstream country. 4We also experimented with including a variable capturing the statutory corporate tax differential between source and recipient country in the regression. The variable showed a positive relationship with foreign-value-added exports, meaning higher taxes in the source country cause exporters to locate abroad. However, because the coefficient was very small and statistically significant at 10 percent in two of the estimation methods, we excluded the variable from the final version of the regression.



downstream country. 5 This result is consistent with Sinn (2004, 2006) who ar-gues that Germany’s high wages and rigid labor market stimulated a wave of international relocation of production to seek lower costs, especially in the auto - motive sector, in neighboring Eastern European countries in the early 1990s.

The impact of industrial similarity on foreign-value-added exports from coun-try i and j is also estimated. 6 Because fragmentation within product or intra-industry trade is an important driver of supply links, two countries with similar

TABLE 10.3

Regression Results of Determinants of Foreign-Value-Added

Variable OLS with no Control

OLS with Time Control

(Baseline) Two-Way Fixed Effects

(1) (2) (3)

Log of GDP_1 0.8255** 0.8272** 0.6695**(0.0057) (0.0057) (0.0957)

Log of GDP_2 0.6127** 0.6100** -0.8357**(0.0057) (0.0058) (0.0986)

Log of GDP per capita_1 −0.1052** −0.1018** −0.0127(0.0102) (0.0104) (0.0910)

Log of GDP per capita_2 0.1656** 0.1807** 1.2998**(0.0120) (0.0121) (0.0934)

Log of distance −0.5378** −0.5370**(0.0111) (0.0112)

Common language dummy 0.6847** 0.6731**(0.0399) (0.0398)

Common border dummy 0.7629** 0.7618**(0.0370) (0.0368)

Resource-rich dummy 0.3089** 0.3088**(0.0262) (0.0261)

Free trade agreement dummy

0.3350** 0.3507** 0.0731**(0.0245) (0.0261) (0.0115)

Downstream tariff −0.0179** −0.0112** −0.0359**(0.0035) (0.0037) (0.0020)

Exchange rate volatility −1.5051** −1.6656** 0.9182**(0.3819) (0.3851) (0.1423)

Difference in unit labor costs

0.8801** 0.8872** 0.5983**(0.0908) (0.0903) (0.0801)

Industry similarity −1.7370** −1.8217**(0.2458) (0.2450)

Note: In the first four variables, 1 denotes source country and 2 denotes recipient country. Standard errors in parentheses. Number of observations is 17,640. ** denotes significance at the 1 percent level. * denotes significance at the 10 percent level.

5We note that for existing cross-border production chains, one would expect the sign to be negative: an increased cost differential would provide incentive to reduce the value created in the higher-cost (upstream) country and reduce its share in the production process (i.e., reducing the relative impor-tance of foreign value added). Thus, the positive sign we find suggests that the initial outsourcing deci-sion (which leads to a positive sign) dominates the adjustment of ongoing outsourcing arrangements in the sample; however, we leave a closer examination of this issue for future research. 6For a given country pair ( i , j ), this index is constructed using the sum of the squares of the differences between the sectoral composition of country i ’s exports and the sectoral composition of country j ’s exports. See Rahman and Zhao (2013) for details. A low value indicates high similarity.


Rahman and Zhao 251

initial export structures are more likely to link. In manufacturing trade, this likeli-hood to link may also be driven by the probable availability of skilled labor if two countries have similar export or industrial structures.

To give an example, Figure 10.7 shows the similarity index between Germany and a set of countries; a lower value implies higher export similarity with Ger-many. This index shows a strong similarity between the export structure of Germany and four highly export-oriented Central European countries in 1995, which grew stronger by 2008. For EA periphery countries, whereas Spain and Portugal increased their similarities with Germany’s export structure during 1995–2008, Ireland and Greece decreased theirs ( Figure 10.7 ). 7 The estimation shows a strong negative coefficient for the initial industrial similarity index: al-though causality cannot be inferred, vertical integration is likely to occur between countries with similar industrial structures ( Table 10.3 ). This result is statistically robust across estimation methods.

Last, the exchange rate could be a potentially important determinant of bilateral trade and vertical integration outcomes—producers presumably would prefer building production links with countries whose exchange rates are more stable. The

0.00

0.05

0.10

0.15

0.20

0.25

Czech

Repub

licSlov

ak

Repub

lic

Hunga

ry

Poland

Spain

Portu

gal

Irelan

d

Greec

e

19952008

Source: Authors’ calculation using world input-output table based on Timmer (2012). Note: A higher value indicates lower export similarity.

Figure 10.7 Emerging Europe and Euro Area Periphery: Similarity Index of Exports with Germany

7Note that the disaggregation divides total exports of goods and services into only 35 sectors and therefore cannot capture quality differences or levels of refinement within a particular product. An index with more disaggregated product-level data may better capture the degree of industrial similarity between a hub and a host.



large literature on exchange rate volatility and trade does not offer a consensus on the appropriate method for measuring such volatility. The most widely used mea-sure is the standard deviation of the first difference of the log of the exchange rate. This measure has the property that it will equal zero if the exchange rate follows a constant trend, which presumably could be anticipated and therefore would not be a source of uncertainty. Clark and others (2004) argue that real rates are preferable on theoretical grounds. Here, exchange rate volatility is measured by the standard deviation of the first difference of the log of the real bilateral exchange rate.

The role played by the bilateral exchange rate is unclear. The results show a negative and statistically significant relationship between foreign-value-added exports and volatility of the bilateral exchange rate in the two OLS specifications, but an equally significant positive coefficient in the two-way fixed effects specifi-cation. Even though it would seem intuitive for a higher degree of exchange rate uncertainty to adversely affect cross-border joint production decisions, the switch in signs suggests that more work is needed to assess this relationship more conclusively.

To evaluate and compare the contribution of each variable in the above regres-sion (which are measured in different units) on foreign-value-added trade, the standardized coefficient is computed for the baseline model (OLS with time control) by transforming all independent variables to ones with zero mean and unitary standard deviations. These standardized coefficients indicate by how many standard deviations a dependent variable will change per standard deviation increase in the independent variable ( Table 10.4 ).

The traditional gravity variables are dominant in explaining supply links as captured by foreign value added: large economic size and close distance to supply hubs have much larger impacts than the structural variables that are, to some extent, under the control of policymakers, such as FTAs, tariffs, exchange rate volatility, and ULCs. But it is important that the impact of such variables is not zero, and significant reforms will also have substantial impacts, either directly, as measured here, or indirectly. For example, structural reforms could raise eco-nomic growth and, by implication, future economic size. Thus, economic reform measures have an important role to play in countries’ efforts to increase their supply-chain linkages.

SUPPLY LINKS AND REVEALED COMPARATIVE ADVANTAGE

The value-added decomposition sheds some light on the supply-chain linkages across countries, but it can also help provide a better understanding of where countries stand with regard to their comparative advantage. Balassa (1965) pro-posed the concept of revealed comparative advantage (RCA), which compares the sectoral composition of exports in one country with that of world exports, but Koopman and others (2011) have shown that the problem of multiple counting in official trade statistics makes the computation of RCA misleading. An RCA based on the value-added decomposition of exports eliminates the distortion of


Rahman and Zhao 253

multiple counting by focusing on domestic value added and can thus provide a more accurate assessment of a country’s RCA.

This analysis looks at four successful central European countries that achieved export-led growth through greater integration with supply links to see how their tradables sectors evolved during 1995–2008 with regard to comparative advan-tage. The RCA is calculated as the share of a sector in a country’s total exports divided by the world average share of the same sector in world exports. An RCA value of greater than 1 indicates a sector in which the country has an RCA. Domestic-value-added exports are disaggregated into manufacturing and services, and further divided into labor-, capital-, and knowledge-intensive sectors. 8 Based on this calculation, some key observations follow ( Table 10.5 ):

• Central European countries enhanced their comparative advantage in manufac-turing over time. In 1995, none of the four countries had a comparative ad-vantage in knowledge-based manufacturing. By 2008, they had all acquired such advantage in addition to retaining and improving their RCA in labor- and capital-intensive manufacturing. Strong and growing supply links with European hubs enabled these countries to move up the value ladder.

• The evolution of RCA is in line with the supply links. For example, the Czech Republic and the Slovak Republic started with RCAs in all three services category in 1995 but moved to recreate RCA in manufacturing. Over time, the Czech Republic’s and the Slovak Republic’s RCAs became closer to that of Germany. The harmonization of RCA reflects the dominance of supply links between each of these two countries and Germany. In contrast, the role of manufacturing decreased in some EA periphery countries.

TABLE 10.4

The Standardized (Beta) Coefficients

Variable Standardized Coefficient

Log of GDP_1 0.672Log of GDP_2 0.4961

Log of GDP per capita_1 −0.048Log of GDP per capita_2 0.085Log of distance −0.266Common language dummy 0.066Common border dummy 0.089Resource-rich dummy 0.052Free trade agreement dummy 0.071Downstream tariff −0.015Exchange rate volatility −0.0181

Unit labor costs differentials 0.044Industry similarity index −0.029

1 Results not robust across all three specifications.

8The RCA index is based on a total of six sectors: labor-, capital-, and knowledge-intensive manufac-turing and labor-, capital-, and knowledge-intensive services, respectively. Thus, a country could have an RCA in a maximum of five sectors.



The analysis zooms in further on product-level export data to see whether performance was driven by particular products ( Figure 10.8 ). The importance of the transport equipment and machinery industries is seen in the export success stories of these countries. During 1995–2008, exports of all major categories more than doubled in these four countries, but exports of machinery and trans-port equipment increased by 7–22 times. The dominance of machinery and transport equipment exports is overwhelming. The share of these products in total exports of goods and services increased from about 10 percent to more than

TABLE 10.5

Evolution of Revealed Comparative Advantage in Manufacturing and Services: Emerging Europe and Euro Area Periphery, 1995–2008

Manufacturing, 1995 Manufacturing, 2008

Labor-

intensive

Capital-

intenstive

Knowledge-

intensive

Labor-

intensive

Capital-

intenstive

Knowledge-

intensive

Portugal 3.42 0.94 0.57 2.40 1.25 0.72

Spain 0.93 1.21 1.04 1.04 1.40 1.07

Ireland 0.34 1.79 1.01 0.13 0.83 0.87

Greece 1.6 1.3 0.0 0.4 0.7 0.2

Czech Republic 1.29 1.30 0.56 1.10 1.28 1.28

Hungary 0.68 1.06 0.50 0.42 0.85 1.26

Poland 1.95 1.39 0.59 1.72 1.41 1.01

Slovak Republic 1.05 1.61 0.60 1.09 1.41 1.14

China 3.55 1.03 0.64 2.61 0.70 1.28

Germany 0.64 1.07 1.48 0.69 1.16 1.61

Services, 1995 Services, 2008

Labor-

intensive

Capital-

intensive

Knowledge-

intensive

Labor-

intensive

Capital-

intensive

Knowledge-

intensive

Portugal 0.67 2.09 0.86 1.26 2.45 0.89

Spain 0.54 1.09 0.81 0.55 1.26 1.59

Ireland 0.39 0.23 1.82 1.69 0.54 3.90

Greece 2.9 3.0 0.5 2.0 9.0 0.6

Czech Republic 1.89 1.53 1.09 0.79 1.11 0.55

Hungary 2.50 2.39 1.62 2.27 1.07 0.82

Poland 1.32 0.90 0.58 1.08 1.16 0.48

Slovak Republic 1.88 1.32 1.05 1.14 0.88 0.62

China 0.86 0.74 0.12 1.34 1.10 0.54

Germany 0.55 0.63 0.51 0.55 0.84 0.71

RCA < 0.5 2 < RCA < 3

0.5 < RCA < 1 RCA > 3

1 < RCA < 2



Rahman and Zhao 255

20 percent during this period in Hungary, the Czech Republic, and the Slovak Republic. This attests to the role of finding a few niche sectors to secure success in a supply link–driven trade environment.

What lessons can be learned from the analysis of countries’ RCAs? Supply links are more dominant in manufacturing, and successful linking often involves finding niche manufacturing sectors, although Ireland’s experience shows that successful linking can also occur through services. Most EA periphery countries have an RCA in services. Improving their export performance would require le-veraging this RCA in the services sector.

CONCLUSION

In Europe and elsewhere, finding ways to raise living standards through strong and sustainable growth is the key policy imperative. This chapter suggests an increasingly important strategy for raising growth: plugging into and taking ad-vantage of production patterns that increasingly involve several countries along the supply chain. Taking advantage of new data and an innovative methodology, this chapter highlights that reforms can improve countries’ external environment in a sustainable fashion by helping them plug into cross-border production chains. Thus, structural reforms will not only help growth ( Chapters 7 and 8 )

Figure 10.8 Sectoral Export Performance in Selected Central European Countries, 1995–2008

0

5

10

15

20

25

Czech Republic Slovak Republic Hungary Poland

2008

exp

orts

val

ue in

mul

tiple

of 1

995

valu

e

Agriculture and mining Light industries Heavy industriesBasic and fabricated metal Machinery Transport equipmentConstruction and retail Transport services Other services




and external adjustment ( Chapter 9 ) in the medium term, but will also provide a crucial link to global demand in the longer term.

The analysis in this chapter shows that the strongest export performances globally and in Europe during 1995–2008 were the result of successful integra-tion with supply links. This integration often relied on a few niche sectors rather than the entire spectrum of tradable products. These findings reflect firms’ in-creasing incentives in a globalized world to unbundle the production process across borders to take advantage of low-cost foreign factors of production. The success of emerging Europe relative to the EA periphery also serves as a cautionary tale for what can happen when higher-cost and distant producers get superseded by closer and lower-cost ones in a supply chain. For countries in the EA, especially those in the periphery with a particular need for improving their external trade positions, key lessons are that future success in export growth will, to a significant degree, depend on successfully linking to supply chains. For example, based on the analysis, Spain would be well served by integrating more strongly into supply links given its larger size, sizable existing links, geographical proximity to Ger-many, as well as an export structure that is similar to Germany’s. For large coun-tries such as Spain, future research should look into how they could benefit most, that is, whether to increase their links with a larger export hub like Germany or strengthen their own positions as export hubs. Greece, by contrast, would face more of a challenge given its small size, services-heavy export structure, and geo-graphic location; however, further liberalization of services trade in Europe, in addition to finding niche sectors and developing a competitive wage structure, could deliver stronger export-led growth. Greater links with upstream export hubs in Europe would greatly help many of these countries improve their export prospects, and further structural reforms could help them move up the value chain.

REFERENCES

Ando, M., and F. Kimura, 2003, “The Formation of International Production and Distribution Networks in East Asia,” NBER Working Paper No. 10167 (Cambridge, Massachusetts: Na-tional Bureau of Economic Research).

Balassa, B., 1965, “Trade Liberalization and Revealed Comparative Advantage,” Manchester School of Economic and Social Studies , Vol. 33, No. 2, pp. 99–123.

Breda, E., R. Cappariello, and R. Zizza, 2008, “Vertical Specialization in Europe: Evidence from the Import Content of Exports,” Working Paper No. 682 (Rome: Bank of Italy).

Clark, P., N. Tamirisa, A. Sadikov, S.J. Wei, and L. Zeng, 2004, “Exchange Rate Volatility and Trade Flows—Some New Evidence” (Washington: International Monetary Fund). http://www.imf.org/external/np/res/exrate/2004/eng/051904.htm.

Hummels, D., J. Ishiib, and K. Yi, 2001, “The Nature and Growth of Vertical Specialization in World Trade,” Journal of International Economics , Vol. 54, pp. 75–96.

International Monetary Fund (IMF), 2013, German–Central European Supply Chain–Cluster , IMF Country Report No. 13/263 (Washington: International Monetary Fund).

Koopman, R., W. Powers, Z. Wang, and S. Wei, 2011, “Give Credit where Credit Is Due: Trac-ing Value-Added in Global Production Chains,” NBER Working Paper No. 16426 (Cam-bridge: National Bureau of Economic Research).


http://www.imf.org/external/np/res/exrate/2004/eng/051904.htm

http://www.imf.org/external/np/res/exrate/2004/eng/051904.htm

Rahman and Zhao 257

Koopman, R., Z. Wang, and S. Wei, 2008, “How Much of Chinese Export Is Really Made in China? Assessing Domestic Value-Added when Processing Trade Is Pervasive,” NBER Working Paper No. 14109 (Cambridge, Massachusetts: National Bureau of Economic Research).

McCallum, J., 1995, “National Borders Matter: Canada-US Regional Trade Pattern,” American Economic Review , Vol. 85, No. 3, pp. 615–23.

Rahman, J., and T. Zhao, 2013, “Export Performance in Europe: What Do We Know from Supply Links?” IMF Working Paper 13/62 (Washington: International Monetary Fund).

Sinn, H.W., 2004, “Bazaar Economy,” IFO-Viewpoint No. 50 (Munich: CESifo). ———, 2006, “The Pathological Export Boom and the Bazaar Effect—How to Solve the Ger-

man Puzzle,” CESifo Working Paper No. 1708 (Munich: CESifo). Timmer, M., 2012, “The World Input-Output Database (WIOD), Contents, Sources and

Methods,” WIOD Working Paper No. 10 (Brussels: European Commission).




259

Contributors

S. Ali Abbas is a Senior Economist in the European Department of the IMF.

Bernardin Akitoby is Division Chief in the Fiscal Affairs Department of the IMF.

Derek Anderson is a graduate student in Economics at the University of Virginia.

Jochen Andritzky is an Economist in the European Department of the IMF.

Ruben Atoyan is the IMF’s Resident Representative to Bosnia and Herzegovina.

Bas B. Bakker is Advisor in the European Department of the IMF.

Bergljot Bjørnson Barkbu is the IMF’s Deputy Resident Representative to the European Union.

Helge Berger is Advisor in the European Department of the IMF.

Fabian Bornhorst is the IMF’s Resident Representative to Brazil and Bolivia.

Cristina Cheptea is a Senior Research Analyst in the European Department of the IMF.

Jaime Guajardo is a Senior Economist in the Asia & Pacific Department of the IMF.

Ioannis Halikias is a Senior Economist in the European Department of the IMF.

Emilia Jurzyk is an Economist in the European Department of the IMF.

Takuji Komatsuzaki is an Economist in the Fiscal Affairs Department of the IMF.

Dmitriy Kovtun is a Senior Economist in the European Department of the IMF.

Huidan Lin is an Economist in the European Department of the IMF.

Lusine Lusinyan is a Senior Economist in the Western Hemisphere Department of the IMF.

Jonathan Manning is a Research Analyst in the European Department of the IMF.

Alexis Meyer-Cirkel is an Economist in the Strategy, Policy, and Review Depart-ment of the IMF.

Dirk Muir is an Economist in the Research Department of the IMF.

Zuzana Murgasova is Advisor in the European Department of the IMF.

Jesmin Rahman is Deputy Chief in the European Department of the IMF.


260 Contributors

Marta Ruiz-Arranz is Deputy Division Chief in the Fiscal Affairs Department of the IMF.

Martin Schindler is a Senior Economist in the European Department of the IMF.

Dustin Smith is a Research Analyst in the European Department of the IMF.

Antonio Spilimbergo is Advisor in the European Department of the IMF.

Suchanan Tambunlertchai is an Economist in the Strategy, Policy, and Review Department of the IMF.

Justin Tyson is a Senior Economist in the European Department of the IMF.

Delia Velculescu is Deputy Chief in the European Department of the IMF.

Li Zeng is an Economist in the European Department of the IMF.

Tianli Zhao is a Ph.D. candidate in Economics at Cornell University.


261

Index

[Page numbers followed by b, f, n, or t refer to boxes text, figures, footnotes, or tables, respectively.]

A

Active labor market policies classification of European economies by,

101 – 102 effects of, 103 , 104 , 106 , 116 , 152 ,

159 , 160 goals of, 159 implementation in Europe, 108 – 109

Albania labor market challenges in, 6 , 125 , 132 ,

143 – 145 strategies for promoting job growth in,

145 See also Balkan economies

B

Balance sheet problems consolidation to minimize impact on

growth, 5 cross-border spillovers in simultaneous

deleveraging, 13 cross-sector spillovers, 3 , 14 , 31 – 32 , 35 ,

63 euro area debt levels, 16 , 17 f future prospects, 29 growth and, 26 – 27 , 27 f , 30 – 31 , 32 indicators of, 15 – 16 migration of debt from private to public

sector, 25 , 26 f as obstacle to recovery, 3 – 4 , 13 ,

34 – 35 significance of, for economic perfor-

mance, 14 – 15

See also Debt reduction, financial sector; Debt reduction, private sector; Debt reduction, sovereign

Balkan economies business environment of, 139 , 140 f ,

143 capital flows, 138 – 139 , 140 f , 143 , 145 causes of poor performance of,

127 – 128 , 143 – 145 countries of, 125 , 146 t . See also specific

country cross-country heat map of, 143 , 144 f current account imbalances in, 222 f data sources, 147 – 148 t employment protection legislation in,

132 employment/unemployment rates in,

125 – 127 , 126 f , 128 f , 129 f , 140 f future challenges and opportunities for,

6 growth, 129 f labor and human capital flows, 138 ,

139 , 141 f labor market challenges in, 125 labor market comparison to European

core countries, 125 – 127 , 126 f labor tax wedges in, 136 – 138 , 137 f lessons from reform experience of, 125 minimum wage in, 136 , 137 f remittances to, 142 – 143 sectoral distribution, 139 , 141 f strategies for promoting job growth in,

145 unemployment benefits program of,

129 – 132 , 130 f , 131 f


262 Index

unfinished reforms as barrier to job growth, 138 – 143

unit labor costs in, 134 , 135 f wage bargaining in, 133 – 134 wage rigidities in, 134 , 136 f See also Emerging European economies

with fixed exchange rates Banking sector

affordability of financial services, 179 financial services access, 179 , 180 , 187 ,

188 indebtedness in, 24 lending rates, 19 measures of policy efficiency in, 191 t migration of debt to public sector from,

25 , 26 f nonperforming loans, 24 , 25 f reform efficiency analysis, 198 t reforms to increase competition in, 187 reforms to promote near-term growth,

8 – 9 reforms to support deleveraging and

growth, 32 – 34 return on equity, 24 , 25 f See also Debt reduction, financial sector

Bosnia and Herzegovina labor market challenges in, 6 , 125 , 132 ,

145 strategies for promoting job growth in,

145 unemployment benefits in, 130 – 131 See also Balkan economies

Brain drain, 139 , 141 f Bulgaria

corporate saving – investment balance, precrisis, 45

global financial crisis outcomes in, 40 potential growth impacts of policy

reforms, 181 See also Emerging European economies

with fixed exchange rates Business environment, 190 t

of Balkan countries, 139 , 140 f , 143 best practices analysis of policies in

Europe, 176

effects on growth, 179 , 190 t reform efficiency analysis, 195 – 196 t

C

Capital flows to Balkan economies, 134 , 138 – 139 ,

140 f , 145 evolution of current account imbalances

in Europe, 220 , 221 f , 232 , 233 – 236 postcrisis, 48 , 48 n , 108 , 225 – 226 , 233 precrisis, 134 See also Foreign direct investment

Central bank responses to financial crisis, 2 , 226

Central European countries. See Czech Republic; Hungary; Poland; Slovak Republic

Child care services, 159 China, 98 , 247 Competitiveness

cost-benefit analysis of reform to pro-mote, 187

evolution of current account imbalances in Europe, 220 – 221

labor market reforms and, 160 product market reforms and, 151 , 152 f ,

155 reform strategies to enhance, 7 structural shocks preceding global

financial crisis and, 97 – 98 Construction sector employment, 57 – 58 ,

59 t Corporate debt

economic sector distribution, 20 evolution of current account imbalances

in Europe, 221 growth and, 26 – 27 , 27 f , 30 – 31 , 32 historical experience with deleveraging,

29 – 30 , 30 f household balance sheet linkage, 39 insolvency risk, 20 – 21 interaction in multi-sector debt, 31 , 35 ,

39 international comparison, 16 , 17 f


Index 263

linkage to employment, 44 , 60 migration to public sector, 25 , 26 f postcrisis current account adjustment,

226 precrisis, 41 , 45 – 48 , 45 f , 50 – 51 , 60 saving – investment balance, postcrisis,

48 saving – investment balance, precrisis,

45 , 46 f , 47 f unemployment and, 26 , 27 f , 39 variation within euro area, 16 – 17 ,

18 – 19 , 18 f , 19 f See also Debt reduction, private sector

Corporate governance, 189 – 190 t , 199 t Corporate profit

employment negatively correlated with, 52 , 53 f , 54 , 55 f , 58 – 60 , 61 , 61 t

labor productivity and, 52 , 53 f negative correlation with output

growth, 52 , 52 f , 54 postcrisis, precrisis borrowing, 45 – 48 postcrisis, precrisis debt and, 60 postcrisis employment and, 41 – 44 postcrisis growth of, 48 – 51 , 50 f , 51 f postcrisis wage bill and, 41 – 44 precrisis wage bill and, 45 – 48 pressure to increase, precrisis, 48 – 50 See also Corporate debt

Corruption, 179 , 187 , 191 t , 200 t Credibility of reforms, 77 – 79 , 78 f , 85 ,

168 – 169 , 168 f Current account balances

cyclical position and, 227 , 229 t decomposition, 233 – 237 , 234 f , 235 f determinants of, in Europe, 227 – 233 ,

233 t employment and, 57 – 58 , 59 t external competitiveness and,

229 – 230 t , 232 external environment and, 231 t , 232 future challenges, 220 import compression and, 237 lessons from adjustment experiences in

Europe, 238 patterns, 219

postcrisis evolution, 224 – 227 , 225 f , 237 – 238

postcrisis savings and investment pat-terns, 228 f

precrisis savings and investment pat-terns, 221 – 224 , 223 f , 228 f

rationale for adjustment, 219 recent evolution of, 220 – 221 , 221 f ,

229 – 231 t recovery from global financial crisis, 2 ,

3 f regional differences in, 8 , 221 – 224

Cyclically adjusted primary fiscal balances, 74

Czech Republic corporate saving – investment balance,

precrisis, 48 trade, 247 , 251 , 253

D Debt reduction, financial sector

consolidation strategies, 15 in feedback loop in balance sheet reces-

sion, 14 – 15 , 15 f , 35 policy prescriptions to mitigate impact

on growth, 32 – 34 reform rationale, 35

Debt reduction, private sector consolidation strategies, 14 effects of cross-sector simultaneous dele-

veraging, 13 in feedback loop in balance sheet reces-

sion, 14 – 15 , 15 f , 31 , 35 , 39 future challenges for, 4 historical experience with, 27 – 30 policy prescriptions to mitigate impact

on growth, 4 – 5 , 9 , 32 – 34 public sector debt reduction and, 4 – 5 reform rationale, 13 – 14 , 35

Debt reduction, sovereign consolidation strategies, 15 design and sequencing of policies for,

4 – 5 effects of cross-sector simultaneous dele-

veraging, 13


264 Index

in feedback loop in balance sheet reces-sion, 14 – 15 , 15 f

fiscal consolidation and, 74 – 76 future challenges in, 70 growth and, 4 , 5 , 71 – 72 , 71 f , 73 f , 74 historical experiences with, 90 – 91 t lessons from historical experience,

67 – 68 mechanisms of, 70 – 76 primary fiscal balances and, 70 – 71 , 71 f ,

72 private sector debt and, 4 – 5 See also Fiscal consolidation for public

debt reduction in low-growth condi-tions; Public debt

Deleveraging. See Debt reduction, finan-cial sector; Debt reduction, private sector; Debt reduction, sovereign

Denmark, 181 Duality, labor market

associated problems, 6 , 44 – 45 , 104 , 105 , 106 – 107 , 108

causes of, 44 – 45 , 100 employment growth and, 55 , 57 , 58 t ,

60 , 105 in Italy, 115 , 117 , 118 patterns and trends, 6 , 55 , 56 f reform effects on, 104 , 105 , 106 – 107 ,

109 , 117 , 121 as reform target, 87 in Spain, 120 , 120 f

E

Early retirement, 101 , 106 , 111 , 152 , 170 Education, 175 , 187 , 193 t , 200 t Emerging European economies with fixed

exchange rates challenges to current account adjust-

ment, 220 countries of, 219 n decomposition of current account,

235 f , 236 – 237 determinants of current account imbal-

ances in, 232 – 233 , 233 t

evolution of current account imbal-ances, 48 , 48 n , 219 , 220 , 221 , 222 f

export growth, postcrisis, 8 , 226 postcrisis current account, 224 – 226 ,

225 f , 227 , 237 – 238 postcrisis savings and investment in,

228 f precrisis savings and investment in,

221 – 224 , 223 f , 228 f , 237 public sector debt in, 224 similarity index of exports, 251 , 251 f

Employment in Balkan economies, 125 – 127 , 126 f ,

128 f , 129 f case studies of labor policies and out-

comes, 109 – 122 causes of postcrisis changes in, 41 – 44 ,

56 – 60 , 58 t , 60 f , 97 , 122 construction sector, 57 – 58 , 59 t corporate debt and, 26 , 27 f , 44 , 60 corporate profit and, 52 , 53 f , 54 , 55 f ,

56 , 58 t current account balance and, 57 – 58 ,

59 t , 232 , 236 financial shock effects on, 44 – 45 global crisis outcomes, 39 – 41 , 40 f , 97 growth and, 39 – 44 , 40 f , 42 f , 43 f , 52 ,

56 , 58 t labor market duality and, 57 , 60 , 104 ,

105 , 106 – 107 lessons from postcrisis corporate adjust-

ment, 61 – 63 medium-term strategies to promote, 1 minimum wage rules and, 136 modeling product market reform out-

comes, 155 near-term strategies to promote, 1 partial equilibrium effects of labor poli-

cies, 103 – 104 , 122 postcrisis corporate profits and, 41 – 44 ,

61 , 61 t postcrisis outcomes of labor market

reforms, 107 – 108 , 108 f regional comparison, 3 f remittances and, 140 – 143 , 142 n


Index 265

structural policies influencing, 97 tax reform to promote, 160 – 162 unemployment rate in European coun-

tries (1990s – 2010s), 107 f , 126 f , 128 f , 129 f

unfinished reforms in Balkans as barrier to growth in, 138 – 143

wage adjustment and, 41 – 44 , 55 – 56 , 62

work time flexibility, 113 – 114 See also Employment protection legisla-

tion; Labor costs; Labor market; Wages

Employment protection legislation in Balkan economies, 132 best practices analysis of policies in

Europe, 176 classification of Euorpean economies

with, 101 – 102 growth and, 179 labor market duality and, 104 , 105 outcomes of, 100 , 101 , 103 , 106 , 132 ,

159 , 160 productivity and, 159 redundancy rules and costs in Europe,

132 , 133 f , 176 , 179 transitional dynamics of, 105

Estonia corporate investment in, 224 employment in, 108 See also Emerging European economies

with fixed exchange rates Euro adoption, 98 – 99 , 99 f Euro area

comprehensive approach to reform in, 7 corporate debt in, 18 – 19 , 19 f corporate insolvencies in, 20 – 21 current account balances, 8 , 219 debt in, as challenge to growth, 13 – 14 debt patterns in, 16 – 17 , 17 f , 18 f debt reduction strategies, 32 – 35 financial sector balances in, 24 , 25 f future prospects, 87 historic public sector deleveraging epi-

sodes in, 27 – 32

household assets in, 22 , 24 f household debt in, 21 – 24 , 21 f , 23 f , 24 f labor costs in, 112 , 112 f net lending/borrowing, 16 , 18 f policy response to financial crisis, 2 postcrisis labor market, 107 – 109 precrisis growth, 5 , 68 , 69 f public debt in, 25 , 25 f recommendations for monetary policy

in, 34 Euro area periphery

capital inflows, 48 n , 99 challenges to current account adjust-

ment in, 220 current account balances in, 219 ,

220 decomposition of current account in,

233 – 236 , 234 f determinants of current account imbal-

ances in, 8 , 232 – 233 , 233 t evolution of current account imbalances

in, 220 , 221 , 222 f , 224 labor costs in, 101 modeling labor market reform out-

comes in, 160 modeling product market reform out-

comes in, 158 , 158 t postcrisis current account in, 224 , 225 f ,

226 – 227 , 227 , 237 – 238 postcrisis savings and investment in,

228 f precrisis savings and investment in, 221 ,

223 f , 224 , 228 f , 237 projected outcomes of structural

reforms in, 7 , 171 similarity index of exports, 251 , 251 f simultaneous structural reforms in euro

core area and, 163 – 166 , 165 t , 166 t , 167 t

structural reforms in response to global financial crisis, 122 , 151

trade balance, postcrisis, 226 unemployment in, 97 See also Balkan economies; Greece,

Ireland, Italy, Portugal, and Spain


266 Index

Euro core area corporate profit in, 48 , 52 current account balances, 2 , 2 f growth spillovers to periphery, 6 – 7 modeling labor market reform out-

comes in, 160 modeling product market reform out-

comes in, 158 , 158 t opportunities for growth in, 4 productivity in, 6 f simultaneous structural reforms in euro

periphery and, 163 – 166 , 165 t , 166 t , 167 t

structural reforms in response to global financial crisis, 151

Europe aggregate debt level, 16 , 17 f best practices analysis of structural

reforms in, 178 t , 179 f corporate debt in countries of, 16 – 17 ,

18 – 21 , 19 f current account balances in, 219 export growth of, 240 – 241 , 240 f future challenges and opportunities for,

1 , 9 growth trends, 2 , 2 f historical debt reduction experiences in,

79 – 84 , 79 f , 81 – 83 f historical growth compared to U.S., 5 ,

6 f household balance sheets in, 23 f ,

24 f household debt in countries of, 16 – 17 modeling structural reform outcomes

in, 152 – 166 net lending/borrowing patterns in, 18 f postcrisis labor market reforms and out-

comes in, 151 – 152 , 153 f product market reform outcomes in,

158 , 158 t projected outcomes of structural

reforms in, 171 public debt in countries of, 16 – 17 recent ( 2005 – 2013 ) economic perfor-

mance, 1 , 2 , 2 f , 3 f

regional differences, 176 – 177 , 177 t , 179 – 181 , 180 f , 184 – 185 , 184 f , 185 t , 187 t

shortcomings of postcrisis structural reforms, 151 – 152

structural reforms in response to global financial crisis, 151

vulnerability to global financial crisis, 1 See also Balkan economies; Emerging

European economies with fixed exchange rates; Euro area; Euro area periphery; Euro core area

European Central Bank, 226 – 227 European Union

new member states of, 127 , 133 , 138 , 139 , 142 , 143 – 145

postcrisis labor developments in, 39 , 41 , 98

precrisis convergence growth in, 99 f Exchange rate

in evolution of current account imbal-ances, 232

export growth and, 251 – 252 labor market reform outcomes for, 160 in public debt reduction outcomes of

fiscal consolidation, 81 wages and, before and after euro adop-

tion, 98 – 99 , 99 f See also Emerging European economies

with fixed exchange rates Exports

benefits of intra-euro reform coordina-tion, 163 – 165

data shortcomings, 239 , 241 from emerging European economies,

225 f , 226 , 237 of euro area periphery, 99 , 101 , 225 f ,

226 , 237 – 238 exchange rate stability and, 251 – 252 foreign-value-added component,

239 – 241 German, 113 , 113 f global competition, 98 , 101 historical debt-reduction experiences

and, 81 , 83 f


Index 267

policy reforms for long-term growth, 8 , 155 – 158 , 162

recent evolution of value-added compo-nents, 242 – 247

sector-related performance in, 254 – 255 , 255 f

significance of, for growth, 101 , 239 , 240 f , 244 , 255 – 256

similarity between economies as factor in growth of, 250 – 251 , 251 f

value-added decomposition of, 241 – 242 , 242 f

See also Value-added trade; Vertical sup-ply links

F

Financial services access, 179 , 180 , 187 , 188 , 199 t

Finland, 45 , 108 , 181 Firing taxes, 103 , 104 Fiscal consolidation for public debt reduc-

tion in low-growth conditions credibility effects in implementation of,

77 – 79 , 78 f , 85 current challenges to, 69 – 70 , 84 economic determinants of success

in, 74 – 76 , 75 f , 76 f , 80 – 84 , 81 f , 82 f , 83 f

external demand and, 81 historical experiences with, 4 , 67 – 68 ,

70 – 74 , 79 – 84 , 79 f , 87 , 90 – 91 t inflation and, 84 , 86 – 87 interest rates and, 72 – 74 , 75 – 76 , 82 monetary policy and, 82 , 85 policy implementation considerations,

4 – 5 , 9 , 68 , 84 – 85 , 88 private sector debt reduction and, 67 privatization and, 85 – 86 short-term effects, 67 , 68 , 75 , 76 – 78 ,

84 – 85 , 88 structural reforms and, 87 , 88

Fiscal policy during deleveraging episodes, 4 , 28 – 29 ,

29 f

in emerging European economies, 224 , 233

in euro area periphery, 220 , 237 evolution of current account imbalances

in Europe, 232 – 233 to facilitate balance sheet adjustment,

34 public debt reduction, 67 See also Fiscal consolidation for public

debt reduction in low-growth condi-tions

Foreign direct investment flows to Balkan economies, 6 , 138 – 139 ,

140 f , 143 , 145 precrisis global competition and, 98

Former Yugoslavia Republic of Macedonia, 6 , 125 , 143 – 145 . See also Balkan economies

France, 108

G

Germany corporate balance sheets in, 4 , 48 current account balance in, 219 global financial crisis outcomes in, 39 growth composition, 113 , 113 f labor costs in, 112 , 112 f labor market institutions and reforms

in, 109 – 110 t labor market outcomes of precrisis

reforms in, 106 , 108 , 122 labor market policies and outcomes in,

110 – 114 , 113 f , 114 f similarity index of exports, 251 , 251 f unemployment rate, 110 , 111 f , 112 f work time flexibility, 113 – 114

Global financial crisis (2008) causes of employment outcomes after,

41 – 44 corporate profit after, 41 – 44 , 45 – 51 corporate saving-investment balance

before, 41 , 45 – 48 , 47 f , 48 f current economic performance and, 1 ,

2


268 Index

employment outcomes, 39 – 41 , 40 f , 97 Europe's vulnerability to, 1 growth outcomes, 69 f lessons from corporate adjustment after,

61 – 63 obstacles to recovery from, 3 – 4 , 5 – 6 policy response to, 2 , 3 , 69 , 117 – 118 ,

151 public debt outcomes, 67 , 68 – 70 recovery outcomes to date, 1 , 2 , 2 f , 3 f structural balances, 69 – 70 , 69 f

Global Integrated Monetary and Fiscal model, 6 – 7

Globalization integration in cross-border production

chains to promote growth, 239 , 244 , 255 – 256

significance of, in economic recovery, 239

See also Technology and globalization shocks

Greece current account balance, 219 employment, 58 – 60 potential growth impacts of policy

reforms, 181 privatization experience, 85 – 86 trade policy, 256 See also Euro area periphery; Greece,

Ireland, Italy, Portugal, and Spain Greece, Ireland, Italy, Portugal, and Spain

composition of output, 3 – 4 current account balance, 221 , 224 GDP, 5 growth spillovers from Euro core to, 6 – 7 policy response to global financial crisis,

151 See also Euro area periphery; individual

country Growth

balance sheet stress and, 14 – 15 , 26 – 27 , 27 f , 30 – 31 , 32

contributions to, 113 , 113 f corporate profit negatively correlated

with, 52 , 52 f , 54

effects of global financial crisis, 1 effects of multi-sector debt, 31 employment and, 39 – 44 , 40 f , 42 f , 43 f ,

56 , 58 t external environment for, 239 future prospects for, 1 , 2 , 68 , 70 global economic linkages for, 8 global effects of intra-euro area coordi-

nation of reforms, 166 , 167 t importance of exports in, 239 – 241 integration in cross-border production

chains for, 239 , 244 , 255 – 256 labor market reform outcomes, 160 labor productivity and, 52 – 54 , 54 f long-term strategies for, 5 – 8 macroeconomic indicators, 69 t medium-term strategies to promote, 1 ,

9 , 68 near-term strategies to promote, 1 , 8 – 9 policy performance indicators and vari-

ables, 189 – 193 t product market reform outcomes, 155 ,

158 t projected outcomes of structural

reforms, 171 reform efficiency effects on, 176 ,

179 – 181 , 180 f regional comparison, 2 f regional differences in policy impacts

on, 179 – 181 , 180 f , 181 f research needs, 188 sovereign debt and, 4 , 5 , 70 , 73 f , 74 structural reforms to increase, 87 tax reform to promote, 162 , 162 t , 163 f U.S. versus Europe, 5 , 6 f See also Fiscal consolidation for public

debt reduction in low-growth condi-tions

H

Households balance sheet recovery to date, 28 corporate balance sheet linkage, 39 current vulnerabilities, 22 – 24


Index 269

debt, growth and, 30 – 31 , 32 debt patterns within euro area, 16 – 17 ,

17 f , 18 f , 21 – 22 , 21 f evolution of current account imbalances

in Europe, 221 – 224 , 232 , 236 in feedback loop in balance sheet reces-

sion, 14 – 15 , 31 , 35 , 39 historical deleveraging episodes, 27 – 29 ,

28 f , 31 labor market reform outcomes for, 160 migration of debt to public sector from,

25 , 26 f outcomes of consumption tax increase,

162 policies to support debt reduction of,

34 policy credibility among, 168 – 169 postcrisis current account, 226 – 227 prospects for recovery, 29 savings, 22 b , 23 f

Housing market, 21 f , 22 Hungary, 247 , 251 , 253

I

Iceland, 33 Implementation of reform

challenges in, 173 comprehensive policy approach to, 7 ,

162 – 163 country-specific approach to, 7 – 8 effects of demand conditions, 170 – 171 ,

170 f fiscal consolidation for public debt

reduction, 4 – 5 , 9 , 68 , 84 – 85 , 88 intra-euro area coordination, 163 – 166 ,

165 t , 166 t , 167 t role of policy credibility in, 77 – 79 , 78 f ,

85 , 168 – 169 , 168 f short-time price stickiness in, 169 – 170 ,

169 t unfinished reforms in Balkans as barrier

to job growth, 138 – 143 Inflation

public debt and, 71 – 74 , 86 – 87

public debt reduction outcomes of fiscal consolidation and, 84

Information and communications technol-ogy. See Technology and globaliza-tion shocks

Infrastructure investment, 187 , 188 , 190 t , 200 t

Insolvency corporate trends and vulnerabilities,

20 – 21 current regime, 20 , 20 f , 33 distance to best practices in current pol-

icies, 176 procedural reforms to reduce private

sector debt overhang, 4 , 9 recent regime reforms, 33

Interest rates public debt and, 70 , 71 – 74 , 73 f in public debt reduction outcomes of

fiscal consolidation, 82 International investment position, 16 ,

17 f Ireland

corporate balance sheets, 48 current account balance, 219 employment growth, 61 , 62 f global financial crisis outcomes in, 39 ,

40 household balance sheets, 22 , 23 f indebtedness in, 16 – 17 precrisis corporate debt, 45 public debt reduction in, 80 See also Euro area periphery; Greece,

Ireland, Italy, Portugal, and Spain Italy

Biagi reforms, 117 future challenges and opportunities,

118 global financial crisis outcomes in,

40 – 41 indebtedness in, 20 – 21 labor market institutions and reforms,

109 – 110 t labor market policies and outcomes,

115 – 116 , 115 – 118 , 116 f


270 Index

privatization experience, 85 – 86 public debt reduction experience in,

80 – 81 response to global financial crisis,

117 – 118 Treu reforms, 117 unemployment in, 115 , 115 f , 117 wage setting in, 115 – 116 See also Greece, Ireland, Italy, Portugal,

and Spain

J

Japan, 44

K

Kosovo labor market challenges in, 6 , 125 unemployment benefits in, 132 See also Balkan economies

L

Labor costs in Balkan economies, 134 , 135 f in euro area periphery, 101 euro area reforms to reduce, 109 external competitiveness of, current

account imbalance and, 230 – 231 t , 232

global competitiveness and, 101 growth of value-added exports and,

149 – 150 intra-euro area, 7 , 7 f , 112 , 112 f , 118 f ,

147 t productivity and, 134 reform strategies to reduce, 7 , 160 ,

161 f , 162 , 163 , 166 , 167 t tax wedges in Balkan economies,

136 – 138 , 137 f , 145 tax wedges in euro area, 152 , 153 f See also Wages

Labor market activity rates, 125 – 127 , 126 f

best practices policies in Europe, 176 , 177 – 179

case studies of policies and outcomes, 109 – 110 t , 109 – 122

effect of demand conditions in reforms, 170 – 171

emigration from Balkan countries, 139 , 141 f

global economic trends and, 97 – 98 growth impacts of structural reforms in,

180 intermediate coordination outcomes,

100 lessons from precrisis reform experi-

ences, 122 measures of policy efficiency in, 191 t modeling structural reform outcomes,

152 – 155 , 159 – 160 , 161 f , 171 obstacles to recovery, 5 – 6 outcomes of precrisis reforms, 105 – 107 partial equilibrium effects of policies,

103 – 104 , 122 participation rates in European coun-

tries, 107 f , 152 , 153 f policy impediments to productivity

gains, 100 – 101 policy variation among European econ-

omies, 101 – 102 , 102 f postcrisis outcomes, 107 – 108 , 108 f postcrisis structural reforms and out-

comes, 151 – 152 , 153 f rationale for comprehensive approach to

reform, 7 reform credibility as outcomes factors

in, 168 – 169 , 168 f reform efficiency analysis, 194 t reform strategies for long-term growth,

6 – 7 , 9 remittances and, 140 – 143 structural problems of Balkan countries,

127 – 128 , 143 – 145 structural reforms in response to global

financial crisis, 151 structural reforms to promote growth,

87


Index 271

transition to long-term equilibrium, 105

women's participation in, 159 , 160 See also Duality, labor market;

Employment; Labor costs Latvia


employment, 60 global financial crisis outcomes in, 39 See also Emerging European economies

with fixed exchange rates Legal system

growth and, 179 , 180 – 181 , 188 measures of policy efficiency in, 189 t reform efficiency analysis, 198 t See also Insolvency

Lithuania. See Emerging European econo-mies with fixed exchange rates

M

Migration from Balkan countries, 139 , 141 f

Minimum wage in Balkan economies, 136 , 137 f , 147 labor market distortions from, 136 median wage and, 102 f purpose, 136 youth, 105

Monetary policy bank lending rates, 19 to facilitate balance sheet adjustment,

34 public debt reduction outcomes of fiscal

consolidation and, 82 , 84 , 85 response to global financial crisis, 2

Monitoring, indicators of balance sheet stress, 15 – 16

Montenegro labor market challenges in, 6 , 125 , 145 strategies for promoting job growth in,

145 unemployment benefits in, 130 , 132 See also Balkan economies

N

Netherlands corporate saving – investment balance,

precrisis, 45 , 48 household balance sheets, 24 f labor market outcomes of precrisis

reforms, 106 , 108 , 122 New Zealand, 80

O

Okun's Law, 40 f , 41 n , 42 f , 43 f , 118 Organisation for Economic Co-operation

and Development, 118 , 151 , 152 Outright Monetary Transactions, 2

P

Patent systems, 180 , 181 Pension reforms, 159 Poland


global financial crisis outcomes in, 39 trade, 251 , 253

Portugal corporate saving – investment balance,

precrisis, 45 , 48 current account balance, 219 indebtedness in, 16 – 17 , 20 privatization experience, 85 See also Euro area periphery; Greece,

Ireland, Italy, Portugal, and Spain Price stickiness, 169 – 170 , 169 t Privatization, 85 – 86 Productivity, labor

convergence growth in, 99 , 100 f corporate profit and, 52 , 53 f effects of employment protection legis-

lation, 159 growth and, 52 – 54 , 54 f information and communications tech-

nology revolution and, 98 institutional impediments to gains in, 100


272 Index

labor costs and, 134 modeling structural reform outcomes,

155 – 158 , 157 f , 158 t , 160 spillovers of intra-euro area rebalancing,

165 – 166 trends preceding global financial crisis,

98 , 98 f Product market(s)

best practices analysis of policies in Europe, 176 , 177 – 179

effects of demand conditions in reform of, 171

measures of policy efficiency in, 191 – 192 t

modeling structural reform outcomes, 152 – 158 , 171

rationale for comprehensive approach to reform, 7

reform credibility as outcomes factors in, 168 , 168 f

reform efficiency analysis, 194 t reform goals, 153 reforms in response to global financial

crisis, 151 , 152 f reform strategies for long-term growth,

6 – 7 , 9 Public debt

current concerns, 67 , 68 – 70 evolution of current account imbalances

in Europe, 221 , 224 future challenges, 67 , 87 , 88 growth and, 30 , 32 , 70 interest rate linkage, 70 international comparison, 16 , 17 f migration of private sector debt to, 25 , 26 f simultaneous private sector debt, 31 , 35 trends, 25 , 25 f variation within euro area, 16 – 17 , 18 f ,

25 f See also Debt reduction, sovereign

R

Reform efficiency modeling best practices analysis in, 175 ,

176 – 179 , 177 f , 178 t , 179 f

cost-benefit analysis in, 182 – 188 , 184 f , 185 t , 186 f , 187 t

countries of analysis in, 173 n data sources, 174 , 201 – 214 t findings, 188 , 194 – 200 t goals of, 174 indices, 175 – 176 measurement of policy impacts on

growth in, 176 , 179 – 181 , 180 f methodology, 173 , 174 – 176 rationale, 173 – 174 reform gaps identified in, 176 – 179 research needs, 188 variables and indicators, 175 ,

189 – 193 t , 202 – 214 t Remittances

to Balkan countries, 142 – 143 effect on labor market, 140 – 143

Research and development, 179 , 180 – 181 , 188 , 193 t , 197 t

Retirement age, 101 , 106 , 111 , 152 , 170

Revealed comparative advantage, 252 – 255 , 254 t

Romania, 181

S

Savings corporate sector, 45 – 48 , 46 f , 47 f evolution of current account imbalances

in Europe, 221 – 224 , 223 f , 227 , 237 household, 2 b , 23 f See also Balance sheet problems

Serbia labor market challenges in, 6 , 125 , 132 ,

138 , 145 strategies for promoting job growth in,

145 unemployment benefits in, 132 wage bargaining in, 133 – 134 See also Balkan economies

Service markets, 191 – 192 t Slovak Republic

corporate saving – investment balance in, precrisis, 48


Index 273

employment in, 108 trade, 247 , 251 , 253

Slovenia, 45 , 48 Small- and medium-sized enterprises,

indebtedness in, 20 – 21 Spain

corporate balance sheets in, 44 , 48 current account balance in, 219 employee dismissal costs in, 121 employment in, 108 global financial crisis outcomes in, 39 ,

40 – 41 household balance sheets in, 22 , 23 f , 24 indebtedness in, 16 – 17 , 20 labor costs in, 118 , 118 f , 119 , 119 f ,

122 labor market duality in, 120 , 121 , 121 f labor market institutions and reforms

in, 109 – 110 t labor market policies and outcomes in,

118 – 122 precrisis corporate debt, 45 privatization experience of, 85 – 86 recommendations for supply chain link-

age, 256 unemployment in, 118 – 119 , 118 f , 119 f work schedules, 120 , 120 f See also Euro area periphery; Greece,

Ireland, Italy, Portugal, and Spain Stimulus spending, 2 , 69 , 85 Stock flow adjustments, public debt and,

71 – 72 Structural reforms

best practices analysis, 175 , 176 – 179 , 177 f , 178 t , 179 f

comprehensive approach to, 7 , 162 – 163

cost-benefit analysis, 182 – 188 . See also Reform efficiency modeling

cost of, 182 country-specific approach to, 7 – 8 for debt reduction, 5 external environment and, 239 to facilitate balance sheet adjustment,

32 – 34 in fiscal consolidation, 87 , 88

growth impacts, 179 – 181 , 180 f to increase growth, 87 for long-term growth, 5 – 7 modeling macroeconomic variables in

outcomes of, 152 – 166 obstacles to recovery, 3 – 4 postcrisis employment outcomes and, 97 to promote integration into global sup-

ply networks, 8 rationale, 171 research needs, 188 response to global financial crisis, 151 role of policy credibility in outcomes of,

168 – 169 , 168 f shortcomings of postcrisis implementa-

tion, 151 – 152 , 152 f short-term costs of, 169 – 170 , 169 t spillovers of intra-euro area rebalancing,

163 – 166 , 165 t , 166 t , 167 t strategies to promote job growth in

Balkan countries, 145 unfinished transitions in Balkan coun-

tries, 138 – 143 See also Reform efficiency modeling

Sweden, 45 , 181

T

Taiwan, 247 Tax policy

labor market outcomes, 103 – 104 labor tax wedges, 136 – 138 , 137 f , 152 outcomes of consumption tax increase,

162 outcomes of precrisis labor market

reforms, 106 reform strategies for long-term growth,

6 – 7 revenue-neutral reform outcomes,

160 – 162 Technology and globalization shocks

impediments to competitive European response to, 97 – 98 , 100 , 101

labor market duality and impact of, 104 labor market institutions impeding

response to, 100


274 Index

labor productivity outcomes, 98 , 99 f , 100

policy responses of European econo-mies, 97 – 98 , 101 , 122

Total factor productivity historical growth in Europe and, 5 as obstacle to recovery, 5

Trade regulations cost-benefit analysis of reform in, 187 measures of policy efficiency in, 193 t modeling structural reform outcomes,

155 reform efficiency analysis, 197 t

Trade unions, 113 , 133 – 134 Trans-European Automated Real-time

Gross Settlement Express Transfer facility, 226 – 227

U

Unemployment benefits in Balkan economies, 129 – 132 , 130 f ,

131 f classification of European economies by,

101 – 102 in Germany, 111 labor market duality and, 103 , 104 modeling outcomes of reforms in, 159 ,

160 moral hazard risk in, 129 postcrisis implementation, 108 – 109 unemployment rate and, 100 , 106

United Kingdom corporate saving – investment balance,

precrisis, 45 debt level, 16 , 17 f labor market outcomes of precrisis

reforms, 106 , 122 United States

debt level, 16 , 17 f European economic growth versus,

5 , 6 f Home Owners Loan Corporation, 33 recovery from financial crisis, 28 technology investments, 98

V

Value-added taxation, 160 – 162 Value-added trade

data collection shortcomings, 239 , 241 data sources, 241 – 242 decomposition of components, 241 ,

242 , 242 f determinants of growth in, 248 – 252 ,

250 t domestic share, 242 – 243 , 244 , 245 f ,

246 t impact on growth and employment,

240 recent trends, 242 – 244 , 243 f revealed comparative advantage and,

252 – 255 supply link-related exports, 242 ,

243 – 244 , 246 – 247 , 247 t Vertical supply links

data collection challenges, 239 determinants of growth in value-added

trade, 248 – 252 revealed comparative advantage and,

252 – 255 , 254 t significance of, in economic recovery, 8 ,

239 , 244 , 255 – 256 structural reforms to promote, 8

W

Wages bargaining systems in Balkan econo-

mies, 133 – 134 employment rates correlated with

adjustments in, 62 exchange rate and, before and after euro

adoption, 98 – 99 , 99 f labor market duality and, 55 – 56 , 57 f labor market reform outcomes for, 160 lessons from current account adjust-

ment experiences, 238 partial equilibrium effects of labor poli-

cies, 103 – 104 postcrisis corporate profit and, 41 – 44


Index 275

postcrisis employment and, 41 precrisis corporate profit and, 45 – 48 rigidities in Balkan economies, 134 , 136 f in Spain, 119 , 119 f , 122 See also Labor costs

World Economic Outlook, 70 , 155

Y

Youth unemployment, 7 , 97 , 122 , 153 f in Balkan economies, 127 , 128 f , 132 in Italy, 115 f , 116 , 117 minimum wage rules and, 105 , 136
