42808 World Bank EU8+2 1 Regular Economic Report EU8+2V. January 20081 HIGHLIGHTS OF THE REPORT ---MAIN REPORT--- While the disturbances originating in the sub-prime mortgage market in the US have widened to affect other countries and other markets, and prospects for US growth have become less clear, the fundamentals for the EU8+2 are broadly unchanged, although the level of uncertainty has risen. A prolonged period of globally lower risk appetite is likely along with continuing volatility as reflected in sharp swings in virtually all equity markets, particularly over the last several weeks. This will be challenging for the EU8+2, and the soundness and credibility of policy frameworks will be appreciated by market participants. With the exception of higher-than-expected inflation, the remaining economic fundamentals in the EU8+2 remain in this respect broadly unchanged. GDP growth is still robust, but concerns remain for those countries where large current account gaps persist. The economic outlook for the EU8+2 in 2008 and 2009 is generally positive. However, similar to advanced economies, the baseline scenario is subject to substantial downside risk to economic growth and upside risk to inflation. In 2008-2009, the region will take further, albeit shorter steps on its long road of catching-up to the EU15. GDP growth rates have probably peaked in many countries in the first half of 2007, even they remained robust in the second half of the year. This deceleration is likely to continue through 2008. The slowdown is most pronounced in the Baltic countries. Growth should recover gradually in Hungary which has been undergoing a protracted fiscal consolidation and from mid-2007 has been struggling with weak GDP growth and relatively high inflation. In some respects passing through the turning point in the business cycle is a good thing. The rate of growth was clearly unsustainable in some countries, resulting in the buildup of internal and external imbalances. The challenge going forward is to ensure that this turning point marks the entry into a period of orderly adjustments. Success or failure in rising to this challenge will have an important bearing on the ability of the EU8+2 to continue along a steady income convergence path. Inflationary trends are reasserting themselves across the region despite somewhat weaker pressure on the demand side. Food and oil price rises are a main factor. If these are one-off changes due to such things as the effect of unusual weather on crop yields, the impact should dissipate or reverse relatively quickly. However, to the extent that they reflect more deeply rooted shifts in global energy supply and demand patterns, progressive displacement of food production by biofuel agriculture and the changing tastes and rapid income growth in food deficit countries, more lasting effects are likely. Moreover, unit labor costs are rising in much of the region. This is partly attributable to emerging labor shortages. Credit growth has slowed somewhat in the region but remains high. Finally, the inflation damping effects of currency appreciation in some of the countries with floating rate regimes have now reversed (Romania). Current account deficits (CADs) stabilized in the Baltic countries but are still widening in Bulgaria and Romania. These CADs represent the greatest vulnerability to deteriorating international conditions and are particularly worrisome for those countries with high levels of foreign currency debt. The external imbalances may come down in line with slower GDP growth 1 Prepared by a team of World Bank economists in the region led by Ron Hood and including Paulina Holda, Stella Ilieva, Ivailo Izvorski, Leszek Kasek, Matija Laco, Sanja Madzarevic-Sujster, Anton Marcincin, Catalin Pauna, Emilia Skrok, and Ewa Korczyc. 1 expected in the Baltic countries in 2008, but in Romania and Bulgaria there is little prospect of a turnaround in the near future. FDI coverage of the CADs varies across the region with full or substantial coverage in Bulgaria, the Czech Republic, Poland, and Slovakia. But there is higher reliance on (debt) portfolio flows (Hungary) and other loans (the Baltic countries, Slovenia and increasingly Romania). It is important however to look beyond the immediate market gyrations to see the bigger picture. The ability of the EU8+2 so far to withstand the global turbulence is attributable to several factors. Their banks were not as exposed to the subprime market. Their economies are linked more directly to the EU than the US. While credit has increased rapidly, private borrowers were under-leveraged to start with. Moreover, with the possible exception of Bulgaria and Romania the most exposed countries are beginning to adjust. Still with expected global slowdown, exports may lessen as a driver of growth. Fiscal adjustments will therefore be needed to bring domestic demand under control. Policy responses have so far been relatively muted. The trend has been towards moderate monetary tightening in Poland, the Czech Republic, and Romania. But countries maintaining fixed or tightly managed exchange rate regimes are limited in the extent to which they can rely on monetary policy for demand management, and they will have to use fiscal policy more actively to deal with the reemerging inflationary pressures and still high CADs. While solid growth in 2007 did improve headline fiscal positions compared to initial plans, structural balances were reduced by more than 0.5 percentage points only in Hungary, Poland, Slovakia, Slovenia. Moreover, the latest Convergence Programs (CPs) suggest that only Hungary plans a consolidation of more than 1 percent of GDP, and even the CPs may prove optimistic. Generally, it would appear that budgets for 2008 (and 2009) do not contribute sufficiently to curbing inflation and external imbalances. At the same time, efforts to improve the efficiency and effectiveness of public spending could be stepped up. ---SPECIAL TOPIC--- The special topic looks at satisfaction with life and the provision of public services in the EU8+2. It draws from the Life in Transition Survey (a joint initiative of the European Bank for Reconstruction and Development and the World Bank), conducted in 2006. Overall satisfaction with life in the EU8+2 countries and Croatia is quite high. People who report themselves as being satisfied with their lives outnumber those that do not by 3 to 2. The survey data reveal somewhat mixed findings regarding the impact of transition on peoples' lives. On the one hand, in only five out of the ten EU member states ­ Estonia, Slovenia, Lithuania, Czech Republic and Poland do more respondents agree rather than disagree that their "household lives better now than in 1989". Support for a market versus planned economic systems is highest in Slovenia, Estonia and Slovakia. The level of support for democracy is highest in Slovakia, Slovenia and Hungary. Satisfaction with public service delivery in EU8+2 is generally quite high. On questions regarding quality and efficiency of the interaction with public officials when requesting official documents (e.g. passport, visa, birth or marriage certificates, land register, etc.), satisfied respondents outnumbered the dissatisfied by more than 2:1. After requests for official documents, the public education system receives the next best ratings overall, followed by the public health system. However, there is significant variation across countries, with satisfaction highest in Estonia and lowest in Romania. In terms of priorities for additional government investment, healthcare was rated as the highest: by 43 percent of respondents, followed by education (22 percent), pension (17 percent), housing (10 percent), and infrastructure (4 percent). An overwhelming majority of people in the region favor moderate to strong state involvement in reducing the gap between the rich and the poor. 2 On a more sobering note, the issue of higher corruption seems to figure prominently in public perceptions. In all the countries surveyed, an overwhelming majority of respondents disagree with the statement: "There is less corruption now than in 1989". EXTERNAL ENVIRONMENT The external environment for the EU8+2 remains unsettled, dominated by continued repricing of risk and tighter global credit conditions, signs of increasing weakness in the US economy, rising global inflation and volatile equity markets. Closer to home, confidence within the eurozone has slipped further of late, and together with the rapid appreciation of the euro against the dollar and the pound makes it likely that economic expansion will slow in the eurozone as well. The new member states of the EU have yet to be more substantially affected by these external developments, but risks have risen that a slowdown in output expansion in the US and eurozone will contribute to slowing growth of EU8+2 exports and output. For the countries most dependent on foreign capital inflows to finance external deficits, these effects will be compounded by tighter global credit conditions and growing risk aversion among market participants. 1. Financial turbulence has continued, intensifying risks to output growth in the U.S. and other developed countries. The eruption of the subprime crisis in the U.S. during the summer of 2007 followed a long period of lax monetary policy and loose credit standards, primarily in the U.S., and accelerated financial innovation. With falling U.S. house prices, the pace of delinquencies on sub-prime mortgages has accelerated sharply in 2007, to about 16 percent of all outstanding securitized loans compared with a recent low of 10 percent reached in the middle of 2005 (Chart 1). The pace of delinquencies does not appear to be abating with negative consequences for the future. U.S. house prices, which declined at the fastest pace in almost twenty years during the third quarter of 2007 (contributing to a 4.5 percent decline year-on-year), are predicted by most market participants to continue declining in 2008 (Chart 2). Most market participants are of the view that the plan by the U.S. administration to offer some relief to households with sub-prime mortgages will at best have only a modest impact in slowing the decline in house prices. Chart 1. Delinquencies as Percent of Chart 2. U.S. House Prices, S&P/Case All Loans, U.S. (in percent) Shiller Home Price Index (Feb'97=100) 210 18 Sub-prime Prime 205 16 200 14 195 190 12 185 10 180 8 175 6 170 4 165 2 160 0 155 00-c 10 20 30 40 50 60 70 05 05- 50 06 06- 60 07 07- 70 De un-J 10-c De un-J 20-c De un-J 30-c De un-J 40-c De un-J 50-c De un-J 60-c De un-J n-aJ May ep-S n-aJ May ep-S n-aJ May ep-S Source: Bloomberg. Source: S&P through Bloomberg. 2. Losses on collateralized debt obligations (CDOs) backed by mortgages have sharply reduced bank capital and curbed bank willingness and ability to lend, resulting in substantially tighter credit conditions. Marking down CDOs has resulted in about $50 billion in losses for banks in the U.S. thus far and caused large losses for some banks in Europe. Estimates of further losses vary substantially, from about $150 billion (U.S. Federal Reserve) to as much as $445 billion in a worst case scenario envisaged by a U.S. investment bank. Concerns 3 about bank losses and cash flows have boosted interbank rates2 despite cuts in central bank rates in the U.S. and large injections of liquidity by the Federal Reserve, the ECB and the Bank of England since August 2007. The U.S. Federal Reserve cut its fed funds rate by 100 basis points last year and a further 75 basis points in January. The Bank of Canada and the Bank of England also cut rates by 25 basis points in early December 2007. Further, in mid-December the major central banks3 joined forces to inject additional liquidity into interbank markets and ease pressure on market rates (Chart 3 and Chart 4). Chart 3. Central Bank Interest rates: Chart 4. Three-month Interbank Rate U.S. and ECB, in percent Less Central Bank Rates, in basis points 6 120 Fed funds ECB repo EURIBOR3mo-ECB Repo Rate LIBOR3mo - Fed funds rate 5 100 4 80 3 60 2 40 1 20 0 0 01 n-aJ 10-l 02 03 04 05 06 07 05 06 07 Ju n-aJ 20-l Ju n-aJ 30-l Ju n-aJ 40-l Ju n-aJ 50-l Ju n-aJ 60-l Ju n-aJ 70-l 05- 05- 50-l Ju an-J 50-p 50-v 06- 06- 60-l 07- 07- 70-l Mar Ju May Se No an-J 60-p 60-v Mar Ju May Se No an-J 70-p 70-v Mar Ju May Se No Source: FED and ECB through Bloomberg. Source: Bloomberg. 3. Rate cuts by central banks and injections of liquidity do not appear to have resolved the fundamental problem. Lack of clarity on the amounts of CDOs backed by mortgages that the largest commercial banks hold spawned fears that the losses may spread to other types of mortgages and bank credit as the decline in house prices in the U.S. continues and similar corrections begin in the UK and other developed countries. The outlook for growth and inflation in the U.S. and the eurozone remains subject to substantial risks - on the downside for growth and on the upside for inflation. 4. The impact of tighter credit conditions on economic growth in the EU8+2 has been muted thus far, but it is becoming increasingly likely that expansion in the U.S. and the eurozone will be slower in the near term, with adverse implications for imports from emerging markets, including the EU8+2. Real GDP growth in the U.S. surged 4.9 percent in the third quarter (seasonally-adjusted), the fastest pace in four years, reflecting in part stronger exports due to the depreciation of Table 1. Real GDP Growth Forecasts, the dollar. However, forecasts are for real 2007-2008 GDP growth in the U.S. to slow substantially in the fourth quarter of 2007 and decelerate 2007 2008 in 2008 as a whole from 2007 (Table 1). IMF 1/ EC 2/ OECD 3/ IMF 1/ EC 2/ OECD 3/ U.S. 1.9 2.1 2.2 1.9 1.7 2.0 Eurozone forecasts are for economic Eurozone 2.5 2.6 2.6 2.1 2.2 1.9 expansion to slow further to 2.2 percent in Japan 2.0 1.9 1.9 1.7 1.9 1.6 2008 from 2.6 percent in 2007. Declining Source: ' 1/ October 2007, 2/ Autumn Forecasts, confidence indicators in Germany suggest November 2007, 3/ OECD Economic Outlook No. 81, the slowdown in the eurozone may be December 2007. deeper still. Slower eurozone growth is likely to have negative implications for EU8+2 export and output growth. The impact on the EU8+2 may also reflect tighter financial conditions, with the potential of slowing capital inflows and output growth. 2Spreads have narrowed somewhat in early January but they remain high by historical standards. 3The Federal Reserve, the ECB, the Bank of England, the Swiss National Bank and the Bank of Canada. 4 5. Concerns about the impact of financial turbulence on economic expansion, coupled with rising inflation and inflation expectations, are confounding monetary Chart 5. Inflation, U.S. and Eurozone, policy choices for the central banks. Due in (in percent, year-on-year) part to higher prices for food, imported oil US inflation Eurozone inflation and the weaker dollar, inflation in the U.S. has 5.0 4.5 risen from 2.5 percent year-on-year in 4.0 December 2006 to 3.6 percent in late 2007, 3.5 with the surge most pronounced in the fourth 3.0 2.5 quarter of 2007. Inflation in the eurozone has 2.0 similarly accelerated from 1.9 percent year- 1.5 on-year in December 2006 to 3.1 percent in 1.0 0.5 late 2007, well above the 2 percent targeted 0.0 by the ECB, reflecting higher prices for food 20 20-l 30 30-l 40 40-l 50 50-l 60 60-l 70 70-l (Chart 5). an-J Ju an-J Ju an-J Ju an-J Ju an-J Ju an-J Ju Source: FED and ECB through Bloomberg. 6. Risk aversion has increased markedly during the financial turmoil, boosting demand for U.S. and other government bonds and contributing to a sharp decline in equity market prices during the last quarter of 2007 and January 2008. Demand has been particularly buoyant for shorter-term securities. For Chart 6. Implied volatility, VIX example, yields on one-year U.S. Treasury bills fell to 3.1 percent by early December from 5 35 percent in late July after remaining broadly 30 unchanged from the start of the year (Chart 9). U.S. equity prices fell 7 percent in 25 the fourth quarter, leaving prices up only 20 3 percent for the full year, as measured by the 15 S&P500 index; equity prices in the eurozone posted somewhat smaller declines. (Chart 10) 10 By contrast, markets in emerging markets rose 5 strongly last year, with large price increases in the BRICS (Brazil, Russia, India and China) 0 accompanied by surges in other smaller Jan-07 Mar-07 Jun-07 Aug-07 Oct-07 Jan-08 markets, reflecting in large part investor Source: Reuters. perceptions about improved fundamentals in many of these economies. However, the new year has seen sharp reductions in equity market prices across the globe and volatility close to the highest levels of recent years. 7. Vulnerability to external developments is greatest for countries with widening CADs. The sovereign bond spreads for Romania and Bulgaria have widened much more sharply this year than is the case for other EU8+2 members with lower or at least moderating CADs. 5 Chart 7. Selected EU8+2 bond spreads, in bp BG LT HU PL 120 RO LV 120 SK CZ 100 100 80 80 60 60 40 40 20 20 0 0 Jan-07 Mar-07 May-07 Jul-07 Oct-07 Dec-07 Jan-07 Mar-07 May-07 Jul-07 Oct-07 Dec-07 Notes : 10Y eurobonds, vs. Eurozone Source: Reuters. Chart 8. Equity markets performance low est level in 2H 2007 (vs. Jul 24) recovery from 2H 2007 low s as of end 2007 change from end 2007 as of Jan 22 50.0 40.0 30.0 20.0 10.0 0.0 -10.0 -20.0 -30.0 -40.0 E CZ EE HU LV LT PL X SK BG RO HR aiss acir yekr an liza ai nti nes nawi dn AI 00 AQ DJ DA Ru Af coxie ngoK aisya FTS htu Tu Br gerA M ngoH doIn Mal Ta ilaahT SP5 ASDN So Source: Reuters. 6 Chart 9. Yields on U.S. Treasury Chart 10. Equity Prices, S&P-500 and Securities and LIBOR (in percent) DAX (Rebased index) 7 LIBOR 3 months 200 S&P500 DAX US Treasury 3 months 6 180 160 5 140 4 120 3 100 2 80 06 n-aJ 60-r 06- 60-l 06 60- 07 07 50-l 50-t 60-l 60-t 70-l 70-t Ma Ju May ep-S 50-n 50-r 60-n 60-r 70-n 70-r Nov n-aJ 70-r 07- 70-l 70- Ma Ju May ep-S Nov Ja Ap Ju Oc Ja Ap Ju Oc Ja Ap Ju Oc Source: Federal Reserve and ECB through Bloomberg. Source: Bloomberg. 8. The unsettled external environment also reflects elevated and, of late, volatile prices for oil and other commodities. Oil prices have risen substantially, in part due to Chart 11. Oil Prices, Brent (in dollars geopolitical concerns and rising demand and euros per barrel) among developing countries. Oil prices 100 Brent, US$ per barrel approached US$100 per barrel recently and 90 Brent, euros per barrel were roughly 11 percent higher in dollar terms 80 70 in 2007 than in 2006 (but little changed in 60 euro terms (Chart 11). Poor harvests caused in 50 part by drought were an important factor in 40 boosting world wheat prices by 30 percent last 30 20 year in dollar terms (19 percent in euro 10 terms). Higher prices for oil, natural gas and 0 9 0 1 2 3 4 5 6 7 other energy, together with the surge in 99 00 01 02 03 04 05 06 07 r-9a r-0a r-0a r-0a r-0a r-0a r-0a r-0a r-0a cereal prices, have added to inflation in M p-eS M p-eS M p-eS M p-eS M p-eS M p-eS M p-eS M p-eS M p-eS developed and emerging economies. Source: IFS OUTPUT DEVELOPMENTS While strong growth dynamics were maintained in 3Q in most of EU8+2 countries, with domestic demand remaining the main driver of growth, signs of weakening are visible on the horizon. Consumption seems to be moderating due to weaker overall consumer confidence, slower real wage growth and some deceleration of credit to the private sector which is also affecting investment. Although a slowdown is on the way in a number of the EU8+2 in 2008- 2009, growth will still remain solid. 7 9. In 3Q 2007, strong growth dynamics were maintained in most of the EU8+2, and only Estonia and Bulgaria recorded a sharp slowdown as compared to the 2Q 2007. Output growth even accelerated in Lithuania, Romania, Slovakia, and Slovenia. In the latter country, as indicated by the Bank of Slovenia, overheating may become an issue. In Lithuania, growth sped up partly due to a base effect relating Chart 12. GDP growth rates (% yoy) to oil refining capacity problems in late 2006. Output growth remained strong in 16 Poland as well, surprising on the upside in 1Q 07 2Q 07 3Q. By contrast, a sharp slowdown continued 14 3Q 07 2006 in Estonia after a period of overheating. In 12 Hungary, growth slowed further reaching 10 historic lows, and decelerated also in 8 Bulgaria, due to a huge slump in agriculture 6 and a slowdown in investment. Meanwhile, 4 in Latvia, which developed the deepest 2 imbalances in the region, GDP growth has 0 not moderated yet, although early indicators CZ EE HU LV LT PL SK SI BG RO suggest a turning point may be approaching. Source: CSOs. 10. Domestic demand, which remains the main driver of growth across the region, shows signs of weakening in countries with the most unbalanced growth structure (Chart 13). Hungary remains an exception as only net exports and stocks contributed positively to GDP growth. In the Czech Republic, growth in 3Q was fuelled by domestic demand with a marginal contribution from net exports. Growth in Slovakia was broadly balanced with the highest positive contribution from external demand in the region. In the remaining countries, only domestic demand contributed to growth, although the negative contribution from net exports varied significantly across countries. External imbalances have started to narrow in the Baltic countrie and Bulgaria but widened in Romania and Poland. Chart 13. Contribution to GDP growth, yoy, percentage points 25 Final consumption expenditure Gross fixed capital formation Change in inventories Net exports 20 Statistical discrapency 15 10 5 0 -5 -10 -15 07 07 07 07 07 07 07 07 07 07 07 07 07 07 07 07 07 07 07 07 07 07 07 07 07 07 07 07 07 07 1Q 2Q 3Q 1Q 2Q 3Q 1Q 2Q 3Q 1Q 2Q 3Q 1Q 2Q 3Q 1Q 2Q 3Q 1Q 2Q 3Q 1Q 2Q 3Q 1Q 2Q 3Q 1Q 2Q 3Q CZ EE HU LV LT PL SK SI BG RO Source: CSOs, Eurostat, ISI, staff calculations. 8 11. With the exception of Poland, Slovakia Chart 14. Final consumption (%, yoy) and Slovenia, consumption started to moderate on the back of a slowdown in 25 4Q 06 1Q 07 2Q 07 real wage and credit growth and overall 3Q 07 2006 weaker consumer confidence (Chart 14). In 20 Hungary, the year-on-year decline in 3Q was 15 a bit lower than in 2Q. Consumption growth is weakening because of higher interest 10 rates and tighter lending conditions, 5 introduced internally by banks. Overall consumer sentiment is weakening, as 0 evidenced by retail sales and confidence -5 indicators. In late 2007, in all countries in CZ EE HU LV LT PL SK SI BG RO the region consumer confidence indicators were in negative territory (Chart 15). Source: CSOs. However, sentiment improved markedly in Poland and may be related to the outcome of general elections and expectations regarding the new government. Chart 15. Consumer confidence indicator 10 CZ PL SK SI 30 EE LV LT BG RO HU 5 20 10 0 0 -5 -10 -10 -20 -15 -30 -40 -20 -50 -25 -60 06 6 07 7 06 6 07 7 an-J r-0pA 60-l 60-t Ju Oc an-J r-0pA 70-l 70-t Ju Oc an-J r-0pA 60-l 60-t Ju Oc an-J r-0pA 70-l 70-t Ju Oc Note: The consumer confidence indicator is constructed as the average of the balances (positive less negative answers, in percentage points) of the answers to the questions on the financial situation of households, the general economic situation, unemployment expectations (with inverted sign) and savings, all over the next 12 months; balances are seasonally adjusted. Source: EC. 12. Weakening business confidence indicators also reflect developments in the Chart 16. Gross fixed investment (%, enterprise sector. Investment growth yoy) slowed further in most countries of the region or remained relatively stable (the 40 4Q 06 1Q 07 2Q 07 35 Czech Republic and Poland). It accelerated 3Q 07 2006 30 only slightly in Slovakia and markedly in 25 Romania, mainly due to construction 20 investment. 15 10 5 0 -5 -10 CZ EE HU LV LT PL SK SI BG RO Source: CSOs. 9 Box 1. Real GDP growth in income approach in 2000-2006 The analysis of economic growth using the income approach confirms that in countries with the tightest labor markets, growth is increasingly driven by employee compensation (the Baltic countries and Romania). In other EU8+2 countries growth is mainly due to rising gross operating surpluses of enterprises. However, over recent years the contribution of employee compensation to overall growth increased in Bulgaria, Poland and Slovakia. In the Czech Republic and Slovenia, the relative contribution of the two components of income remained relatively stable over the last few years. In Hungary, by contrast, labor market easing in 2006 was reflected in a sharply lower contribution of employee compensation to GDP growth. Chart 17. Contribution to GDP growth, income approach 20 Compensation of employees 10 Taxes minus subsidies Gross operating surplus Czech Republic0 Estonia 12 12 9 9 6 6 3 3 0 0 -3 -3 -6 -6 -9 -9 2000 2001 2002 2003 2004 2005 2006 2000 2001 2002 2003 2004 2005 2006 Latvia Lithuania 12 12 9 9 6 6 3 3 0 0 -3 -3 -6 -6 -9 -9 2000 2001 2002 2003 2004 2005 2006 2000 2001 2002 2003 2004 2005 2006 Hungary Poland 12 12 9 9 6 6 3 3 0 0 -3 -3 -6 -6 -9 -9 2000 2001 2002 2003 2004 2005 2006 2000 2001 2002 2003 2004 2005 2006 Slovakia Slovenia 12 12 9 9 6 6 3 3 0 0 -3 -3 -6 -6 -9 -9 2000 2001 2002 2003 2004 2005 2006 2000 2001 2002 2003 2004 2005 2006 10 Bulgaria Romania 12 12 9 9 6 6 3 3 0 0 -3 -3 -6 -6 -9 -9 2000 2001 2002 2003 2004 2005 2006 2000 2001 2002 2003 2004 2005 2006 Notes: The contribution to real GDP growth was calculated assuming the following deflators provided by Eurostat: for compensation of employees - final consumption of households and for taxes linked to imports and production minus subsidies - taxes less subsidies (from supply side of GDP decomposition). Gross operating surplus in constant prices was calculated as residual, GDP minus compensation of employees minus taxes less subsidies (all indicators in constant prices). Source: AMECO, Eurostat; and staff calculations. The findings above are reflected in expenditure Chart 18. Link between employee developments: employee compensation and compensation and consumption consumption expenditure of households are 25 closely correlated across the region in recent 2006 2005 2004 2003 years (Chart 18). Countries where the noit 20 contribution of employee compensation to overall growth was increasing (the Baltic countries, umps 15 Romania and recently Poland) experienced an onc upsurge in household consumption. d 10 holes 5 At the same time, the increasing contribution of employee compensation usually means a ouh 0 diminishing contribution of gross operating -2 0 2 4 6 8 10 12 14 16 18 20 surplus of companies, as a sustained increase in compensation of employees wages (for labor which is increasingly scarce) tends to drive up production costs. Real growth rates, yoy. Source: CSOs. 13. In 2008-2009, a moderate slowdown is on the way in all EU8+2 except Hungary, which should eventually recover. But growth well above 5% across the region can be still regarded as robust (Table 2). Following the period of overheating, growth in the Baltic countries will start to ease, with the 2008 forecast for Estonia being revised downwards to 5.2% (in the latest CP). Latvia will also pass a turning point, while in Lithuania consumption will still remain relatively strong in 2008 on the back of the January 2008 cut in the income tax rate from 27% to 24%. Some easing is also expected in Slovenia and the Visegrad countries, except Hungary, which should perform better after bottoming out in the second half of 2007. Only in Bulgaria and Romania is strong growth expected to remain broadly at the 2007 level. 14. Global supply-side factors will sustain inflationary pressures despite some easing of domestic demand. In 2008, an upturn in inflation is projected in all EU8+2 except Hungary on the back of global trends in food and energy prices and increases in excise duties and regulated prices in some countries. Thus, supply-side developments are likely to dominate and weakening domestic demand may not translate into inflation easing. However, domestic demand moderation in most countries, except Poland, Bulgaria and Lithuania, will result in trimming of current account deficits. On the fiscal front, most of the EU8+2 officially plan to maintain broadly neutral positions in 2008. 11 Table 2. Macroeconomic projections for the EU8+2, % Ouput growth Inflation (HICP average) Current account (% of GDP) Fiscal balance (GG, % of GDP) 2006 2007 2008 2009 2006 2007 2008 2009 2006 2007 2008 2009 2006 2007 2008 2009 CZ EC 6.4 5.8 5.0 4.9 2.1 3.0 3.8 3.2 -3.1 -2.8 -2.4 -2.3 -2.9 -3.4 -2.8 -2.7 IMF 5.6 4.6 2.9 4.4 -3.4 -3.5 CP 5.9 5.0 5.1 2.4 3.9 2.3 -2.6 -2.2 -1.2 -3.4 -2.9 -2.6 EE EC 11.2 7.8 6.4 6.2 4.4 6.3 7.3 4.8 -15.5 -14.6 -12.3 -10.9 3.6 3.0 1.9 1.0 IMF 8.0 6.0 6.0 7.0 -16.9 -15.9 CP 7.4 5.2 6.1 6.6 8.6 5.6 -15.6 -11.7 -10.2 2.6 1.3 1.0 HU EC 3.9 2.0 2.6 3.4 4.0 7.7 4.9 2.8 -6.5 -4.4 -3.4 -2.7 -9.2 -6.4 -4.2 -3.8 IMF 2.1 2.7 7.6 4.5 -5.6 -5.1 CP 1.7 2.8 4.0 7.9 4.8 3.0 -4.9 -4.0 -3.3 -6.2 -4.0 -3.2 LV EC 11.9 10.5 7.2 6.2 6.6 9.6 9.8 6.0 -22.3 -23.8 -21.6 -19.8 -0.3 0.9 0.8 0.5 IMF 10.5 6.2 9.0 8.9 -25.3 -27.3 CP 10.5 7.5 7.0 10.1 12.5 7.2 -23.5 -20.3 -18.3 0.3 0.7 1.0 LT EC 7.7 8.5 7.5 6.3 3.8 5.6 6.5 5.2 -10.8 -13.9 -14.4 -14.6 -0.6 -0.9 -1.4 -0.8 IMF 8.0 6.5 5.2 4.6 -14.0 -12.6 CP 9.8 5.3 4.5 5.8 6.5 5.1 -13.5 -14.2 -15.4 -0.9 -0.5 0.2 PL EC 6.2 6.5 5.6 5.2 1.3 2.5 2.8 2.9 -3.2 -4.3 -5.5 -6.2 -3.8 -2.7 -3.2 -3.1 IMF 6.6 5.3 2.2 2.7 -3.7 -5.1 CP 6.5 5.5 5.2 2.4 2.4 2.5 -2.3* -4.0 -5.2 -5.9 -3.0 -3.0 -2.8 SK EC 8.5 8.7 7.0 6.2 4.3 1.7 2.5 3.0 -7.0 -4.4 -2.9 -2.0 -3.7 -2.7 -2.3 -2.4 IMF 8.8 7.3 2.4 2.0 -5.3 -4.5 CP 8.8 6.8 5.8 1.7 2.3 2.6 -8.3* -4.0 -2.6 -1.9 -2.5 -2.3 -1.8 SI EC 5.7 6.0 4.6 4.0 2.5 3.5 3.7 2.9 -2.5 -3.5 -2.6 -1.8 -1.2 -0.7 -1.0 -0.8 IMF 3.2 3.1 -3.4 -3.1 CP 5.8 4.6 4.1 3.4 3.5 2.8 -3.5 -3.1 -2.0 -0.6 -0.9 -0.6 BG EC 6.1 6.3 6.0 6.2 7.4 7.1 7.3 5.8 -15.7 -18.1 -17.7 -17.6 3.2 3.0 3.1 3.1 IMF 6.0 5.9 8.2 7.9 -20.3 -19.0 CP 6.4 6.4 6.8 7.2 6.9 4.4 -21.0 -21.9 -21.2 3.1 3.0 3.0 RO EC 7.7 6.0 5.9 5.8 6.6 4.7 5.6 4.6 -10.3 -13.7 -15.5 -16.2 -1.9 -2.7 -3.2 -3.9 IMF 6.3 6.0 4.3 4.8 -13.8 -13.2 CP 6.1 6.5 6.1 4.8 5.7 4.0 -12.6 -10.5 -10.1 -2.9 -2.9 -2.9 Notes: *Current account deficit projections and historical figures in Poland and Slovakia as provided in Convergence Programs and are based on data available data before statistical revisions. Source: EC: Economic Forecast, Autumn 2007; IMF: World Economic Outlook, October 2007; CPs: Convergence Programs 2007. LABOR MARKET DEVELOPMENTS Labor market performances in the region have further improved with unemployment rates reaching historically low levels and employment rates increasing. Real wage growth is slowing in most countries in the region, but remains strong especially in Latvia and Romania. Despite the wage moderation, unit labor costs continue to rise in much of the region. 15. With the exception of Hungary unemployment rates in the EU8+2 are now at the lowest level since 1Q 2000. While in 1Q 2000 unemployment rates across the region ranged from 7 to 19%, and the average rate was at almost 13%, in 3Q 2007 unemployment rates were in single digits in all countries but Slovakia (11.3%). Poland has made the most significant progress by reducing the unemployment rate by half within the past 3 years. 16. Lower unemployment rates result mainly from higher demand for labor and go hand in hand with higher employment rates (Chart 19). Still, only the Baltic countries, Slovenia, and the Czech Republic come close to the Lisbon Strategy target of a 70% employment rate. Significantly, three out of these five countries (Estonia, Slovenia, and the Czech Republic) are the best performers in the PISA assessment in the region (see Box 2). Although labor market performance is improving in the remaining countries too, their employment rates remain 10 percentage points or more below the Lisbon target. 12 Chart 19. Employment rates, % 70 CZ HU 70 70 PL SK BG RO 65 65 65 60 60 60 LV SI 55 55 55 LT EE 50 50 50 50 50 60 60 70 70 05 05 06 06 07 07 50 50 60 60 70 70 1Q 3Q 1Q 3Q 1Q 3Q 1Q 3Q 1Q 3Q 1Q 3Q 1Q 3Q 1Q 3Q 1Q 3Q Source: Eurostat, staff calculations. 17. Educational attainment and quality of education are significant determinants of employment rate differentials within countries. Tertiary education gives at least an 80% guarantee of employment in all EU8+2 while employment rates of those with primary and lower secondary education vary strongly across the region (from 15% in Slovakia to almost 50% in Slovenia). In the Baltic countries, the Czech Republic, Slovenia, and Bulgaria, 70% or more of the labor force with upper secondary and post secondary education is employed (see Table 3). People from this category and those with higher education contributed positively to overall employment growth between 3Q 2006 and 3Q 2007 in all countries with the exception of Estonia and Latvia (Chart 20). Table 3. Employment rate by Chart 20. Contribution to employment growth by educational educational attainment, % attainment, % Primary and Upper secondary Total lower and post Tertiary Primary and low er secondary Upper secondary and post secondary Tertiary secondary secondary 7.0 3Q 06 65.4 24.0 71.7 83.0 CZ 6.0 3Q 07 66.3 25.1 72.6 83.3 3Q 06 67.9 32.0 72.6 87.0 5.0 EE 3Q 07 70.2 34.9 75.4 87.3 4.0 3Q 06 57.6 28.1 65.3 80.8 HU 3.0 3Q 07 57.7 28.3 64.9 79.6 2.0 3Q 06 68.0 38.0 73.4 88.1 LV 3Q 07 69.0 39.5 74.8 87.9 1.0 3Q 06 64.2 25.2 68.5 87.0 0.0 LT 3Q 07 66.1 27.4 69.5 88.2 -1.0 3Q 06 55.6 25.1 59.2 82.2 PL 3Q 07 -2.0 57.8 26.4 61.6 82.1 3Q 06 59.9 14.8 67.9 83.3 -3.0 SK 3Q 07 60.7 15.2 68.7 81.8 3Q 3Q 3Q 3Q 3Q 3Q 3Q 3Q 3Q 3Q 3Q 3Q 3Q 3Q 3Q 3Q 3Q 3Q 3Q 3Q 3Q 06 67.2 43.7 69.8 87.3 SI 3Q 07 69.0 47.5 71.5 86.5 06 07 06 07 06 07 06 07 06 07 06 07 06 07 06 07 06 07 06 07 3Q 06 60.3 31.7 69.0 82.0 BG 3Q 07 62.7 33.6 71.0 83.8 CZ EE HU LV LT PL SK SI BG RO 3Q 06 60.9 43.1 66.1 86.5 RO 3Q 07 60.5 43.4 65.0 85.8 Source: Eurostat. 18. PISA 2006 reveals that 15-year old students in the region generally perform below the OECD average. Only young Estonians and Slovenians performed above the OECD average in science, reading and mathematics. The Czechs performed better than the OECD average in two areas, while Poles and Hungarians did in one (reading and science, respectively). The remaining five countries in the region scored below the OECD average in all three areas (see Chart 21). The very sizeable gaps for Romania and Bulgaria are particularly disturbing. Box 2. Performance of the EU8+2 and Croatia in PISA 2006 PISA (Program for International Student Assessment) was launched in 1997 by the OECD. It represents a commitment by governments to monitor the outcomes of education systems in terms of student achievement on a regular basis and within an internationally agreed common 13 framework. PISA has now become the most comprehensive and rigorous international program for assessing student performance and providing data on the student, family and institutional factors. The first PISA survey was conducted in 2000 and focused on reading literacy. PISA 2003 focused on mathematics and PISA 2006 focused on science, but also examined student attitudes towards science and their awareness of the opportunities that science competencies may bring, and of science learning opportunities and environments offered by their schools. It also placed student performance in the context of other factors, such as gender, socio-economic background and school policies and practices, providing insights into how they influence the development of knowledge and skills at home and at school and analyzing what the implications are for policy development. Chart 21. A distance of the national score from the OECD average, points 40 science reading mathematics 20 0 -20 -40 -60 -80 -100 -120 EE SI CZ PL HU LV SK LT BG RO Notes: Positive distance stands for better than OECD average performance. Source: OECD (2007). 19. Labor markets are tightening as labor shortages become more evident. The resulting increase in real wages in 3Q 2007 varies considerably across the region. Wage pressure remains high in the EU8+2, and even the where there has been some moderation of real wages (Baltic countries, Bulgaria, and Romania) it results largely from an acceleration of inflation rather than deceleration of nominal wages. Unit labor cost dynamics in the Visegrad countries and Slovenia still remain moderate as compared with the Baltic countries, Bulgaria, and Romania (Chart 22- Chart 23). The persistence of wage pressure may undermine countries' competitiveness and weaken their prospects for high and sustainable economic growth. Chart 22. Real wage growth, yoy, % 25.0 CZ PL 25.0 EE LV 25.0 BG RO 20.0 SK HU 20.0 LT SI 20.0 15.0 15.0 15.0 10.0 10.0 10.0 5.0 5.0 5.0 0.0 0.0 0.0 -5.0 -5.0 -5.0 50 50 50 60 60 60 60 70 70 70 05 05 05 06 06 06 06 07 07 07 05 05 05 06 06 06 06 07 07 07 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q Note: Data in line with CSO methodology Source: CSOs, staff calculations. 14 Chart 23. ULC economy wide (4Q moving average), yoy, % 25 SI EE BG 25 LT LV RO CZ HU 20 20 PL SK 15 15 10 10 5 5 0 0 -5 -5 -10 -10 03 03 03 03 04 04 04 04 05 05 05 05 06 06 06 06 07 07 07 03 03 03 03 04 04 04 04 05 05 05 05 06 06 06 06 07 07 07 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q Source: CSOs, Eurostat, WIIW, staff calculations. 20. Regional differences within individual EU8+2 countries are considerable and may interact with country-wide minimum wage rates. These regional differences are also related to educational attainment as people with lower education levels are overrepresented in lagging regions. Hence, uniform economy-wide minimum wages may prevent the local labor market from clearing at a lower level of wages (see Box 3). Box 3. The minimum wage may be too high for unqualified workers in lagging regions Does the minimum wage matter? Twenty EU member states have a statutory national minimum wage despite the potentially negative impact on employment. While on average the minimum wage is too low ­ compared to the average wage ­ to affect a significant number of workers in the economy as a whole, it could affect unqualified workers in lagging regions. Regional data for EU8+2 from 2002-2006 indicate that the ratio of the minimum to the average wage is low in the regions surrounding capital cities, but is as high as 59% in some regions of Bulgaria. The ratio is falling in almost all countries, but especially in Hungary and Latvia. Bulgaria, is one of a few countries where the ratio increased, on average by 3.4 percentage points every year. More importantly, the variance of regional ratios has fallen in half of the countries ­ in Estonia, Hungary, Latvia, Romania and Slovenia. The ratio of minimum to average wages for unqualified workers is much higher than the economy-wide average. It reached 64% in the Czech Republic in 2006 and 68% in Slovakia in 2005. Unfortunately, regional figures are not available for more countries, but it seems reasonable to assume that the ratio for unqualified workers could be at about 60 to 80% of the economy and nation-wide average. This could drive unqualified workers in lagging regions out of the formal labor market. Minimum to average wage, 2002 Minimum to average wage, Minimum to average wage, whole 2006 region, 2002-06, extreme values 80 max min mean 80 max min mean 80 70 70 max min mean 70 60 60 60 50 50 50 40 40 40 30 30 30 20 20 20 10 10 10 0 0 0 BG CZ EE HU LV LT PL RO SK SI BG CZ EE HU LV LT PL RO SK SI 2002 2003 2004 2005 2006 15 Minimum to average wage, Variance of minimum to Minimum to average wage, whole region, 2002-06, averages average wage, 2006 unqualified workers, 2006 80 max min mean 45 70 max min mean 70 68 40 66 60 35 64 50 30 62 25 40 60 20 58 30 15 56 20 54 10 10 52 5 50 0 0 2002 2003 2004 2005 2006 CZ HU SK BG CZ EE HU LV LT PL RO SK SI Source: CSOs, staff calculations Note: in %. Romania only 2002-05, Lithuania 2003-2006. Source: Eurostat, CSOs and WB staff. INFLATION, EXCHANGE RATE DEVELOPMENTS, AND MONETARY POLICIES 21. Inflation, both headline and underlying rates, accelerated sharply in late 2007 throughout the region, driven by a combination of supply and demand factors. While the upturn in inflation was largely anticipated, the magnitude of the increase generally was not. Rising food and energy prices are common drivers in all countries. Persistently high consumption fuelled by credit and some country-specific factors (such as a sharp Romanian Leu depreciation in November) and energy price adjustments, have also contributed. By December 20074, inflation reached double digit levels in Latvia and Bulgaria. It was getting close to double digits in Estonia; it was persistently high in Lithuania, Romania and Hungary, and above inflation targets in the Visegrad countries, except Slovakia. Chart 24. HICP- all, y/y, % 16 16 16 CZ 14 LV LT HU 14 14 BG RO 12 SK 12 EE SI 12 PL 10 10 10 8 8 8 6 6 6 4 4 4 2 2 2 0 0 0 60 6 70 7 6 7 06 07 an-J r-0pA 60-l 60-t 60-l 60-t 70-l 70-t 60-l 60- 70-l 70- Ju Oc an-J r-0pA 70-l 70-t 60-n Ju Oc Ja r-0pA 70-n Ju Oc Ja r-0pA Ju Oc an-J 60-r Ap Ju Oct an-J 70-r Ap Ju Oct Source: Eurostat. 22. Food prices are a main driver of accelerating inflation. This may be partly explained by the catch-up of relatively low levels of food prices in EU 8+2 vis-à-vis EU 155 and the greater weight of food in the EU8+2 consumption basket (see Chart 27). As of November 2007, year-on- year food price increases ranged from 7% in Slovakia and 7.4% in Poland to 19.5% in Latvia and 4 At end-December CPI inflation was 14.1% in Latvia, 12.5% in Bulgaria, 9.6% in Estonia, 8.1% in Lithuania, 7.4% in Hungary, 6.6% in Romania, 5.6% in Slovenia, 5.4% in the Czech Rep., 4.0% in Poland and 3.4% in Slovakia. 5 According to Eurostat, prices of food and non-alcoholic beverages were, in 2006, 56% in Bulgaria, 64% in Lithuania, 67% in Poland and Slovakia, 69% in the Czech Rep. and Latvia, 71% in Hungary and Romania, 75% in Estonia and 87% in Slovenia, relative to the EU 27 average. 16 21.1% in Bulgaria. However, with the exception of Bulgaria, the steepest food price hikes do not seem to have occurred in the countries with the lowest initial price levels, suggesting that domestic market competition and structures, as well as subsidy schemes promoted by national governments6 have an important contribution to the formation of food prices. High food prices have prompted some calls for the reintroduction of price controls (Lithuania) and VAT cuts (Romania). Also the EC decision to abolish import tariffs for cereals in order to streamline imports from third countries, while welcome, may offer only limited relief from internal price pressures, as international prices themselves are high. Chart 25. HICP-food, y/y, % 30 CZ 30 30 25 HU LV LT 25 25 SK BG RO 20 EE SI PL 20 20 15 15 15 10 10 10 5 5 5 0 0 0 -5 -5 -5 50 5 60 6 70 7 5 6 7 05 06 07 an-J r-0pA 50-l 50-t 50-l 50-t 60-l 60-t 70-l 70-t 50-l 50- 60-l 60- 70-l 70- Ju Oc an-J r-0pA 60-l 60-t Ju Oc an-J r-0pA 70-l 70-t 50-n Ju Oc Ja r-0pA 60-n Ju Oc Ja r-0pA 70-n Ju Oc Ja r-0pA Ju Oc an-J 50-r Ap Ju Oct an-J 60-r Ap Ju Oct an-J 70-r Ap Ju Oct Source: Eurostat. 23. Increased demand from emerging markets, adverse supply shocks and the pickup in the demand for biofuels are the main factors behind booming global food prices7. The impact of these factors on inflation has been felt both directly and indirectly. The direct effect reflects the fact that the share of food in total consumer expenditure and headline inflation is significant in the EU8+2 and tends to be negatively correlated with income. The indirect effect stems from the tendency for food price dynamics to feed through to demands for non-food prices including higher wage compensation. IMF simulations suggest that worldwide food price inflation has been a significant determinant of non-food inflation in emerging and low income economies, while it has had a negligible impact in developed economies. 6See the May 2007 issue of the EU 8+2 RER Special Topic for a detailed analysis of agriculture in EU 8+2. 7See the IMF World Economic Outlook October 2007 for a detailed discussion. 17 Chart 26. Food and energy contribution to HICP in Jan- Chart 27. Share of food and energy in HICP Nov 2006 and 2007, % basket (%) 12.0 HICP-other items 70 HICP- food and non-alcoholic beverages HICP-energy 10.0 60 Food and non-alcoholic beverages Energy 8.0 50 6.0 40 4.0 30 2.0 20 0.0 10 2006voN 2007voN 2006voN 2007voN 2006voN 2007voN 2006voN 2007voN 2006voN 2007voN 2006voN 2007voN 2006voN 2007voN 2006voN 2007voN 2006voN 2007voN 2006voN 2007voN 0 an-J an-J an-J an-J an-J an-J an-J an-J an-J an-J an-J an-J an-J an-J an-J an-J an-J an-J an-J an-J RO LT LV BG PL EE HU CZ SI SK EA13 EU27 CZ EE HU LV LT PL SK SI BG RO Source: Eurostat. 24. The record high global energy prices - especially - oil, have also contributed to the pickup in inflation. These have led to upward fuel price adjustments, also linked to the protracted weakness of the USD, given the relatively high dependence of the region on imported fuels. Housing, electricity and water costs increased by 20.1% y/y in Latvia and by 11.3% y/y in Lithuania in November 2007. Strong inflationary effects from energy price increases were also discernable in Estonia, Poland and the Czech Republic. 25. Upward adjustments in administered prices are contributing further to overall price increases. Gas and electricity tariff increases are anticipated in the Baltic countries and Poland. Further pressures arise from the gradual harmonization of excise duties to the EU levels (e.g. on tobacco and in some countries on fuels). 26. High credit growth remains an important source of excess demand, though signs of deceleration are visible in some countries. On the back of higher interest rates and weakening sentiment, credit growth is slowing in Latvia and Estonia, but borrowing is largely in euros (Chart 28). Over 75% of outstanding household credit in these two countries is euro- denominated. In Lithuania, credit growth (although slowing) remains strong, with household lending growing at around 60% y/y. There are no convincing signs of a credit slowdown in Bulgaria or Romania. In Poland, domestic credit growth appears to have stabilized at around 30%, and household lending continues to expand quickly. Chart 28. Credit to private sector growth, yoy, % 80 CZ HU 80 EE LV 80 LT SI 70 PL SK 70 70 BG RO 60 60 60 50 50 50 40 40 40 30 30 30 20 20 20 10 10 10 0 0 0 06 06- an-J 60-y 60-l 06 60-v 07 07- 70-l 07 06 60- 60- 60-l 06 07 70- 70- 70-l 07 06 6 06- 60-l 06 60-v 07 7 07- 70-l 07 70-v Mar Ju Ma ep-S r-0a r-0a No an-J 70-y 70-v Mar Ju Ma ep-S No n-aJ Mar Ju May p-eS 60-v No n-aJ Mar Ju May p-eS 70-v No an-J M Ju May ep-S No an-J M Ju May ep-S No Source: CBs, staff calculations. 18 27. The rapid and possibly protracted upswing in inflation is feeding into inflation expectations, complicating macroeconomic management. This has already been reflected in collective wage negotiations, renewing calls for monetary policy to stay on a tightening path to keep inflation expectations anchored to the targets. A tighter monetary stance would also serve to improve savings-investment ratios which remain low in some countries. Chart 29. Central Bank Base Rates, % 9 CZ HU PL SK 10 8 9 7 8 6 7 BG 5 6 4 5 RO 3 4 2 3 1 2 0 1 60-n 6 r-0a 06- 60-l 60 60-v 70-n 7 r-0a 07- 70-l 70 70-v 0 Ja M Ju May ep-S 06 06- 06 07 07- 07 No Ja M Ju May ep-S No n-aJ 06-r 60-l 60-v Ma Ju May ep-S No n-aJ 07-r 70-l 70-v Ma Ju May ep-S No Source: CBs. 28. While the balance of risks for future inflation remains on the upside, policy responses need to find a balance between a manageable slowdown and overshooting. As most countries are approaching the end of their cyclical upswing, the policy challenge is to achieve a soft landing by avoiding an excessively tight stance while still containing inflation. With GDP growth slowing and inflation picking up, central banks find themselves in a difficult position in terms of policy trade-offs. The fragility of eurozone growth and uncertainties surrounding the interest rate cycle of the ECB augment the challenges. Sudden swings in foreign capital flows could put substantial pressure on currencies (as in Romania in November-December) causing debt to soar in local currency terms. 29. Inflationary pressures stemming from both cyclical and structural factors complicate the euro adoption agenda. Slovakia is expected to join the EMU in 2009. But although fiscal outcomes are solidly on track, remaining inflation pressures are complicating its path to the euro and demanding greater policy focus on structural adjustment. And once inside the euro zone, as the example of Slovenia suggests, the process of real convergence can still lead to overheating and the resurfacing of inflation. International comparison of price levels suggest that the catching up process will continue to contribute to price convergence pressures (see Box 4). Box 4. Preliminary Results of the International Comparison Program 2005 (ICP) on Purchasing Power Parities and price levels Purchasing power parities (PPPs) and price level benchmarks can provide valuable insight into the nature and magnitude of inflationary pressures transition economies are likely to encounter as part of the convergence process. In mid-December 2007, the ICP and the Eurostat-OECD PPP program released preliminary estimates of internationally comparable purchasing power parities (PPPs) and price levels benchmarked to the year 2005 for 146 economies. The ICP collected data on prices of more than 1,000 goods and services. PPPs are used instead of exchange rates to convert national economic measures such as gross domestic product into a common currency, unaffected by transitory movements of market exchange rates. By taking account of price level differences between countries, PPPs allow comparisons of market size, the structure of economies, and what money can buy. 19 The ICP shows which economies are the most and the least expensive. Table 4. Price levels of GDP components The Price Level Index (PLI) is the ratio of a country's PPP divided by its Price level index, US level = 100 exchange rate to the US dollar. An Gross Fixed index over 100 means prices are Country Private Collective Capital GDP Consumption consumption Formation higher on average than in the US, and Bulgaria 38 38 22 60 one less than 100 means prices are Czech Rep. 60 56 46 81 relatively lower. The most expensive Estonia 62 59 40 88 economies in the world are Iceland, Hungary 65 60 51 89 Denmark, Switzerland, Norway, and Latvia 53 52 32 81 Ireland with indices ranging from 154 Lithuania 53 50 34 85 to 127 percent. The range is greater Poland 59 57 42 75 at the other end of the spectrum with Romania 49 49 28 71 Slovakia 56 52 38 83 more than 40 economies showing a Slovenia 77 77 66 80 PLI of 40 percent or below. The Croatia 66 66 49 81 cheapest economies are Tajikistan, Cyprus 91 92 86 91 Ethiopia, Gambia, Kyrgyz Republic, Malta 72 71 55 82 and Bolivia USA 100 100 100 100 Source: ICP 2005. Comparison of price level indices by GDP and its three main components show the existence and wide-ranging nature of price convergence gaps in the EU8+2. The well-known "Balassa-Samuelson effect" explains that poorer countries experience higher inflation during the catch-up process as these price gaps are closed . GDP price levels in the region vary from 38% of the US level in Bulgaria * to 77% in Slovenia (Table 4). This suggests that the need for price convergence in the first euro area entrant from the region ­ Slovenia - was moderate: its relative price level was high to start with. By comparison the rest of the EU8+2 had price levels equal to just on average 55% of the US level (56% in Slovakia - the next country hoping to join the Eurozone). Prices of collective consumption component exhibit the greatest dispersion across EU8+2 countries, while prices of gross capital formation vary the least. The price level index for private consumption appears similar to that for overall GDP, because it is the largest component of GDP. Because government services are not traded across countries, there is little pressure for these prices to converge. At the same time, investment consists of a larger share of traded goods ­ such as equipment goods - so there is less price variation across countries because of international competition. While the prices of investment goods in the EU8+2 have largely converged to the EU average level, prices of consumption goods and services, in particular public ones, will have to adjust during the catching-up process. * On Balassa-Samuelson effect see also the previous edition of the Regular Economic Report, September 2007. 30. Relatively tight labor markets, continuing strong credit expansion, and gradual adjustment of non-tradable good prices are expected to remain inflationary factors over the medium term. Because of these factors and rising uncertainty concerning supply-side developments, inflation is expected to be higher in 2008 than in 2007 across the region with the exception of Hungary. 31. There has been a cooling off of the housing markets in some countries. Scattered evidence from Estonia and Latvia points in this direction, while housing still remains the fastest growing sector in Romania, and is growing strongly in Bulgaria. 20 EXTERNAL SECTOR DEVELOPMENTS Considerable current account deficits (CADs) and high external debt still raise concerns. In 2007, current account positions deteriorated in most of the EU8+2, particularly in the Baltic countries, Romania, and Bulgaria. Rapid credit growth, financed by substantial borrowing abroad contributed to widening current account deficits and pushed external debt levels higher. Short-term debt increased in most of the countries in recent years, with attendant rollover risks. 32. The underlying external vulnerabilities, current account deficits and high external debt, are large and mostly rising. The largest external imbalances in the region, recorded in the Baltic countries, Romania, and Bulgaria, are primarily generated by the private sector. Public sectors do not contribute to them at all in Bulgaria, Estonia and Latvia (Chart 30- Chart 31). Chart 30. Savings-Investment Gap, % of Chart 31. Public Sector Savings and GDP, 2006-2007e Investments, % of GDP, 2006-2007e Public sector savings Public sector investments Public sector Private sector CAB 10 10 5 8 0 6 -5 4 -10 2 -15 -20 0 -25 -2 -30 -4 2006 2007 2006 2007 2006 2007 2006 2007 2006 2007 2006 2007 2006 2007 2006 2007 2006 2007 2006 2007 0062 0072 0062 0072 0062 0072 0062 0072 0062 0072 0062 0072 0062 0072 0062 0072 0062 0072 0062 0072 BG CZ EE LV LT SI HU PL RO SK BG CZ EE LV LT SI HU PL RO SK The current account balance is the difference between a country's savings and its investment (CAB= S-I), which can be divided into public and private sector CAB = (Sg-Ig)+(Sp-Ip). Private sector investments are calculated as gross capital formation minus public sector investments; the latter is derived from the GFS - Capital Investments. Country's savings is calculated as the sum of country's investments and public sector savings. Public sector savings is derived from GFS, as a difference between current revenues and current expenditures. Source: EUROSTAT, NCB's, MoF, staff calculations. 33. In 3Q 2007, current account deficits (4-quarter cumulative) stabilized in the Baltic countries but are still widening in Bulgaria and Romania. However, according to forecasts from the Convergence Programs, for 2007 as a whole, CADs in Lithuania and Latvia should have widened further as compared to 2006 (Chart 30). In 3Q 2007, export growth picked up in all countries in the region, except in Romania, but imports advanced even faster. In Estonia, for the first time in the last year and a half, an improvement in merchandise trade was noted, as domestic demand growth slowed and exports grew faster than imports. 34. Rising current account deficits are largely attributable to negative trade balances, particularly in the Baltic countries, Bulgaria, Romania and Slovenia. In the Czech Republic, the deterioration of the factor income account played a significant role in increasing the current account deficit, mainly because of rising returns on FDI and interest payments. By contrast, because of prior FDI inflows, Slovakia managed to boost its export capacity and recorded a marked improvement in its trade balance, thus lowering the current account deficit. However in Bulgaria sizable FDI inflows over the last several years have not affected as much export performance. 21 35. In most cases deficits were largely covered by private capital Chart 32. Basic Balance (CA+FDI+portfolio inflows. Along with foreign direct investments) in 2006-2007, % of GDP investment, these capital inflows have primarily consisted of credit 5 intermediated by banks and have 0 fueled rapid credit growth, mostly -5 in foreign currency. In Bulgaria, the Czech Republic, and Poland FDI -10 fully financed the CADs. Portfolio -15 investment was buoyant in -20 Hungary, where strong inflows of -25 foreign capital in debt instruments 06 70 70 06 70 70 06 70 70 06 70 70 06 70 70 06 70 70 06 70 70 06 70 70 06 70 70 06 70 70 easily compensated the large 20 2Q 3Q 20 2Q 3Q 20 2Q 3Q 20 2Q 3Q 20 2Q 3Q 20 2Q 3Q 20 2Q 3Q 20 2Q 3Q 20 2Q 3Q 20 2Q 3Q outflow from equities. In the Baltic CZ EE PL SI HU LV LT SK BG RO countries and Slovenia, banking Source: CBs, Eurostat, staff calculations. sector foreign borrowing remains the primary source of financing. In Slovakia and Romania the CAD coverage by FDI was significant, but the latter also increasingly relied on debt flows. 36. Large borrowing abroad was reflected in rising gross external debt levels in 2007. Gross external debt-to-GDP ratios ranged from 36.1 percent in Romania, through around 90 percent in Bulgaria and Slovenia, to over 100 percent in Estonia and Latvia. In the Baltic countries, a growing share of the external debt is created in the banking sector, while in Hungary the growth of banks' external debt was matched by that of the government, and gross external debt reached 91.2 percent of GDP. The widening current account gaps are also financed by parent bank funding. Inter-company lending formed a significant portion of the overall gross external debt in the region ranging from around 8 (Latvia) to 34 (Bulgaria) percent. Short-term debt has increased in most of the countries in recent years, raising rollover risks. Chart 33. External debt in 2005-2007, % of GDP 140 Government Banks Other sectors Short-term debt Government Banks Other sectors Short-term debt 120 140 100 120 100 80 80 60 60 40 40 20 20 0 0 07 07 07 07 07 05 06 07 05 06 07 05 06 07 05 06 07 05 06 07 0052 0062 20 20 20 20 20 20 20 20 20 3Q 0052 0062 3Q 0052 0062 3Q 0052 0062 3Q 0052 0062 20 3Q 3Q 3Q 3Q 3Q 3Q CZ LT PL SK RO EE LV HU BG SI Source: NCB's, staff calculations. 22 PUBLIC FINANCE All countries in the region have taken advantage of the solid growth in 2007 to save some of the unanticipated revenue increases and improve their headline fiscal positions relative to the initial plans. However, structural deficits were reduced by more than 0.5 percentage points only in Hungary, Poland, Slovakia and Slovenia. Official plans for 2008 budget from the latest Convergence Programs (CPs) reveal that only Hungary plans a consolidation of more than 1 of GDP, while the fiscal positions of the rest would be similar to 2007. However, the EC autumn forecasts suggest that fiscal positions in 2008 may be slightly worse (by 0.2-0.3% of GDP) than officially projected in Hungary, Poland, and Romania and almost 1% of GDP worse in Lithuania. Heightened risks of a worsening global environment and a slowdown of the world economy could adversely affect the execution of budgets this year. In addition, countries with substantial external current account deficits need to keep fiscal accounts flexible to counteract to increased vulnerabilities. At the same time, efforts to improve the efficiency and effectiveness of public spending could be stepped up. Generally, it seems that budgets for 2008 (and 2009) do not contribute sufficiently to curbing inflation and external imbalances. 37. All countries in the region anticipate better fiscal outcomes in 2007 in their revised convergence programs compared to the initial targets presented a year before. Bulgaria, Estonia, Latvia and Slovenia, project to outperform their fiscal targets by a higher margin than the others. Lithuania did not take Chart 34. Fiscal Positions in 2007: planned advantage of robust economic growth to improve its fiscal stance and left its v/s expected outcome (% of GDP) planned deficit for 2007-09 unchanged. 4 planned Mainly on the back of higher than expected outcome expected revenues, Poland should have 2 ended 2007 with a fiscal deficit below 0 the Maastricht threshold, while Hungary and the Czech Republic will likely have -2 improved their deficits to 6.2% and 3.4% of GDP, respectively8. Slovakia expects -4 to achieve a better fiscal outturn -6 despite higher than planned spending related with the pension reform. -8 CZ EE HU LV LT PL SK SI BG RO 38. Improvements in fiscal balances in Note: The date includes costs of pension reforms. 2007 (based on convergence programs' Source: Convergence Programs, November, December 2007. estimates) were driven mostly by higher-than-planned revenues due to robust economic growth and rising inflation rather than efforts to consolidate spending. The revenue over-performance in most of the countries was concentrated in direct taxes, and in the Czech Republic, Hungary, and Romania, in social contributions on the back of better labor market performance and rising salaries. Improvements in compliance with tax legislation in Bulgaria, the Czech Republic, and Hungary reflected changes in tax policy or enhanced revenue administration. Expenditure execution was more or less as planned with a few exceptions, mainly related to savings from interest payments (Hungary, Slovakia, and Bulgaria), subsidies (Hungary, Romania), and lower than expected capital spending, mainly in Romania. The latter country revised downwards its estimate of capital spending of 9.7 percent of GDP to 7 percent while Bulgaria revised upwards capital spending by 2 percentage points of GDP. Execution of expenditures during the first 10- 11 months of 2007, however, suggests that neither Bulgaria nor Romania are likely to achieve the levels projected for the year owing to lower than expected absorption of EU funds. 8As of mid-January, the Finance Minister sees Hungary's ESA95 budget deficit shrinking even to 5.7-5.8% of GDP in 2007. 23 39. In 2007, fiscal tightening was most pronounced in Hungary, while Poland, Latvia, and Slovakia expect to narrow their fiscal deficits by close to 1 percentage point of GDP (Chart 35). Latvia should even achieve a small surplus for the first time since 1997 although even greater fiscal tightening is warranted to help contain domestic demand pressures. Improvements in fiscal positions were achieved through adjustments in operations and maintenance, and wage spending, which reached 1 percentage point of GDP in Hungary, Latvia, and Slovakia. Hungary and Slovakia adjusted downwards their public investment spending. Only some countries experienced a slight worsening of their fiscal balances because of higher social spending (the Czech Republic) and higher capital spending and the contribution to the EU budget (Romania). Estonia had a fiscal surplus although it was lower than in 2006, while Bulgaria is expected to achieve the same or slightly higher fiscal surplus. 40. Nevertheless, only half of the EU8+2 (Hungary, Poland, Latvia, Slovakia, and Slovenia) reduced their structural deficits in 2007 (Chart 36). The remaining countries had either a broadly neutral position (Bulgaria) or loosened their structural positions (the Czech Republic, Estonia, Lithuania, and Romania). Chart 35. General Government Balance Chart 36. Fiscal Consolidation Effort in (% of GDP) 2007 (pps of GDP) 6 5 2006 2007e 2008p 2007 2008 2009 4 4 2 3 0 2 -2 1 -4 -6 0 -8 -1 -10 -2 CZ EE HU LV LT PL SK SI BG RO CZ EE HU LV LT PL SK SI BG RO Source: Convergence Programs, November, December Notes: Consolidation effort is the difference between 2007 structural balance in 2007 and 2006. A positive consolidation indicates fiscal tightening. Source: Convergence Programs, November, December 2007. 41. Official fiscal plans for 2008 show a mixed picture with all countries but Hungary remaining below or at the 3 percent of GDP deficit threshold. Hungary aims to have the most improvement in its high fiscal deficit, the Czech Republic projects reaching a deficit compliant with the Maastricht criteria, while Latvia and Lithuania expect improvements in their fiscal balances of 0.4 percentage points of GDP. Slovakia is planning a smaller decrease in the fiscal balance, which is projected to reach 2.3 percent of GDP. Romania, Poland, and Bulgaria envisage unchanged fiscal positions in 2008 compared with 2007 while Estonia and Slovenia plan for a worsening of their fiscal balances. To achieve these fiscal targets, Romania, Bulgaria, and Estonia expect to raise additional revenues of over 1 percentage point of GDP with Romania aiming highest (an increase of 2.4 percentage points of GDP) assuming improved compliance with social security legislation as a result of lowering the rates. (Details of the structural changes planned for 2008 are provided in Error! Reference source not found.). 24 42. Some of the planned revenue increases may not materialize given the worsening global environment and its potential dampening effect on growth. There is also uncertainty associated with the effect of planned tax cuts9 on revenue performance. On the expenditure side, most of the adjustment will take place in non-interest current spending with a continuing decline in wage spending, albeit one that is moderate compared to 2007 (and in social spending in the Czech Republic). Slovakia and Slovenia will rely on small expenditure cuts in almost all items, while the Czech Republic plans sizeable spending cuts). Romania and Bulgaria have ambitious capital spending plans reaching Chart 37. Absorption of the EU Structural and Cohesion 8.2 percent of GDP in Funds in the EU8 (2004-2006 EU financial perspective), Romania as the as of 31 October, 2007 absorption of EU structural funds is % of Commitments % of Payments % of Payments from EC 120% expected to pick up 106% substantially. Given the 101% 101% 100% 00%1 00%1 % absorption capacity track 91 % 86 record, it is not certain if % 80% 74 these plans will be 61% % % realized in these two % 60% 54 57% 59% 57 58% 54% 54 49% 48% 50% 53% 51% 53% countries. In 2008, the 51% 48% EU8+2 will have to absorb 40% from 40-60% of funds from the financial 20% perspective 2004-2006 or they will lose the 0% SI LV LT EE PL HU CZ SK assigned funds. (Chart 37). Source: Ministry of Regional Development, Poland, 2007. 43. In line with improved fiscal positions and strong GDP growth, almost all EU8+2 (but the Czech Republic and Slovakia) managed to reduce their debt to GDP ratios (Chart 38- Chart 39). Bulgaria, Estonia, Latvia, and Slovenia which achieved primary surpluses were able reduce their debt to GDP ratios the most. Active debt management transactions and cautious new borrowing policy in 2007 and earlier years led to a decline in interest spending from 1.3 to 1.2 percent of GDP in Bulgaria. Poland also reduced its interest spending which contributed to a decline in the debt-to-GDP ratio in 2007 compared to a slight increase in 2006. Chart 38. Gross General Government Debt, % of GDP 70 2006 2007 2008 2009 2010 60 50 40 30 20 10 0 CZ EE HU LV LT PL SK SI BG RO Source: Convergence Programs, November, December, 2007, and staff calculations. 9 The corporate income tax rate is reduced in the Czech Republic, social contribution rates go down in Poland and Romania, personal income tax rates are cut in Bulgaria, the Czech Republic, Estonia, and Lithuania, while Slovakia is introducing lower VAT rates on medicines and selected medical tools. 25 Chart 39. Contributions to Changes in General Government Debt to GDP Ratio, 2007 8 6 0.2 4 0.3 2 0 -2 -4 -1.3 -1.2 -0.6 -1.5 -6 -0.6 -0.5 -8 -0.2 -3.0 BG CZ EE HU LV LT PL RO SK SI Primary balance Interest payments Privatization Nominal GDP growth Other Source: Convergence Programs, November, December, 2007, and staff calculations. 44. Medium term fiscal plans seem more ambitious than the 2008 budgets with all countries (but Romania and Estonia) planning fiscal consolidation and most of them strengthening their public expenditure management systems. (For a detailed presentation of medium-term fiscal plans see Error! Reference source not found. in the Annex). Medium-term institutional improvements in the fiscal accounts focus on introducing more stringent fiscal rules (Bulgaria, the Czech Republic, Hungary, and Slovakia), strengthening or introducing performance-oriented budgeting (Bulgaria, Poland) or improving the accounting system (Slovakia). STRUCTURAL REFORMS Rapid economic growth has reduced the sense of urgency for reform and with a few exceptions there has been little progress on broader structural reforms recently. With the first-phase ("market-enabling') and second-phase ("market-deepening") reforms almost completed across the region, progress on the third-phase of reforms, centered on business-friendly regulations, infrastructure, enhanced competition and good governance has been erratic. Ease of doing business 45. Changes in the Ease of Doing Business show a mixed picture as since last year. Doing Business currently ranks Bulgaria among the top global reformers, improving in many areas, including dealing with licenses, paying taxes and enforcing contracts. It was also the top reformer in paying taxes in 2006/07, due to a sizable reduction of the tax burden and a significant simplification of the process of paying taxes. The Czech Republic was the runner-up among labor law reforms, adopting a new labor code that replaced its 1965 code. In contrast, some countries slipped backward. Slovenia (in the area of employing workers and getting credit) and Hungary (in the area in paying taxes) are among the countries with the largest negative reforms. 26 Table 5. Positive changes in ranking of Doing Business Indicators in 2006/2007 Starting Dealing Trading a with Employing Registering Getting Protecting Paying Across Enforcing Closing a business Licenses Workers Property Credit Investors Taxes Borders Contracts Business CZ EE HU LV LT PL SK SI BG RO Source: Doing Business database. 46. The Baltic countries remain the most "business friendly" countries in the region (all are above EU15 average rank), with Estonia ranking highest: in 17th place among the 178 countries reviewed. The worst regional performer is Poland, followed by the Czech Republic and Slovenia. The most common reforms in the region, occurring in half the countries, involved: easing property registration, simplifying tax administration and increasing the flexibility of employment regulations. At the same time, some indicators of business regulation have worsened. These include protecting investors, getting credit and starting a business. Chart 40. Ranking on ease of doing business in 2006/2007 EE 17 OECD (non EU) 18 LV 22 LT 26 EU15 29 SK 32 EU8+2 42 HU 45 BG 46 RO 48 SI 55 CZ 56 PL 74 0 10 20 30 40 50 60 70 80 Source: Doing Business database. Improving infrastructure and enhancing competition 47. The 2007 EBRD Transition Report found limited reform progress in the EU8+2. The only upgrades were financial sector development (Latvia, Lithuania and Romania). In Latvia there were improvements to banking regulations, particularly anti-money laundering procedures while in Lithuania securities legislation and regulation were both improved. In Romania, development of the financial sector was largely a market-based response to earlier reforms and privatizations. There were also some notable developments in specific areas of infrastructure. Hungary received an infrastructure score upgrade for railways following the establishment of a regulatory office and freight service, and an increase in competition in railway freight transportation. 27 48. Although all EU8+2 countries are close to the maximum of the EBRD index on progress of transition, there are further challenges to increase private sector involvement in infrastructure and introduce more effective competition (see Chart 41 and Chart 42). Chart 41. Infrastructure transition scores in Chart 42. Market and trade transition 2007 scores in 2007 Roads Railw ays Competition Policy Price liberalisation Electric pow er Water and w aste w ater Trade & Forex system 4.5 Telecommunications Maximum Maximun 4.5 4.0 4.0 3.5 3.5 3.0 er 3.0 2.5 sco 2.5 2.0 noit 2.0 1.5 si 1.5 1.0 anrT1.0 0.5 0.5 0.0 0.0 CZ EE HU LV LT PL SK SI BG RO CZ EE HU LV LT PL SK SI BG RO Source: EBRD. 28