European Economics GLOBAL SGH European Economics.

European Economics

GLOBAL SGHEuropean Economics

European Economics

Economic growth and real convergence in new EU member countries

European Economics – Economic growth and real convergence in new EU…

1. Pre-crisis growth rates in new EU member rates.

2. Main forces driving the real convergence process.

3. The global financial-economic crisis and emerging Europe.

4. Characteristics of recovery in emerging Europe.

5. Future challenges of recovery in emerging Europe.


Introduction

• Emerging Europe was, on average, the worst performing region during the Global Financial-Economic Crisis (GFEC)

• This presentation examines:

(1) why the economies of emerging Europe performed so badly; and

(2) what effects this is likely to have on the future development of the economies of the region, i.e., has the crisis changed the future economic trajectory of the region?

(3) how is this likely to shape the political risk environment in the near future?


ConvergenceAverage GDP growth over 2000-2007 was among the

fastest in the region and the world…

graph


Convergence…leading to progress in convergence with EU per capita

income levels…

graph


Convergence

• What explained this level of performance?

Institutional reforms of 1990s – most countries become market economies by 2000, except Belarus, and several Central Asian economies.

Facilitating a more rational allocation of resources than under socialism - growth in tradables, services, etc., with a corresponding decline in the share of heavy industry.

Liberalization of domestic economies and transnational sectors sees rapid integration of region within global economy through high trade openness (e.g., ratio of foreign trade to GDP increased faster than anywhere else, EE has a greater share of global exports than China).


Convergence

• What explained this level of performance?

Undervalued real exchange rates compensate for institutional weaknesses, boosting competitiveness in 1990s and early 2000s.

Prospect of EU accession helped boost trade and investment ties between core EU economies and CEE, e.g., FDI penetration, foreign bank ownership, other capital flows, etc.


Convergence – growth models

Contributions to GDP growthgraph


Convergence

FDI stock graph


Convergence

Foreign ownership in banking sectorgraph


Convergence

• Signs of overheating before crisis?

Increased capital flows (not a region-specific phenomenon over this period) lead to real effective exchange rate appreciation from mid-2000s onwards

While competitiveness is only marginally affected (exports still grew at a fast pace), growth models switch from transition emphasis on services and tradables sector growth to a a rise in domestic consumption and investment based on rapid growth in imports of goods and capital (unlike east Asia)


Convergence

• Signs of overheating before crisis?

Components of GDP growth over period sees declining contribution of net exports to growth

This is justified as a natural element of convergence, with expansion in residential investment, services, etc., considered desirable given the socialist legacies

Growth rates reach record levels in some countries, but evidence of overheating (e.g., CA balances, inflation, credit growth, house prices, etc) in many cases


Crisis ‘Growth reversal’ during GFEC among the worst in the world

graph


Crisis

• What explains the severity of growth reversals?

• A number of hypothesized determinants:

• Financial vulnerabilities: large and persistent current account deficits; excessive expansion of domestic lending; foreign currency exposure, etc.

• Trade vulnerabilities: dependence on raw materials (some CIS), or EU-oriented manufactures; unsophisticated export structures; excessive trade openness; export of labour (remittances), etc.

• Institutional vulnerabilities: perhaps poor rule of law, corruption, policy instability, absence of financial sophistication (!), accounted for region’s poor performance?


Crisis

• What does statistical analysis can tell us?

• For individual countries, not a lot – each case has its own characteristics (e.g., remittances in Armenia and Moldova)

• But, it does suggest that, on average, many common explanations are not as important as some argue: Trade vulnerabilities largely unimportant (open v. closed, sophisticated

v. basic, raw materials [Saudi Arabia v. Russia], etc) Most financial vulnerabilities insignificant (FDI stock, foreign bank

ownership, external debt, currency pegs, current account balances, etc) Institutional quality of little importance, in EE

• In short, rate of pre-crisis credit growth and pre-crisis government stock of debt are two most important factors in explaining severity of growth reversals


Recovery?

• Characteristics of recovery in emerging Europe:

• Export-led recovery - CEE benefit from German expansion; CIS from higher commodity prices and return to growth in Russia

• ‘Credit-less’ recovery & restocking

• Current accounts have narrowed rapidly

• Sharp swing in private sector financial balances, with much dampened consumption and investment

• Rates of growth generally anaemic


Recovery?

• Regressions: what accounts for anaemic recovery?

• Size of pre-crisis credit expansion (EBRD, 2010)

• Size of post-crisis credit growth

• Size of fiscal stimulus – Russia, Poland

• Benefits of REER depreciation

• Commodity exports/total exports, 2008


Future challenges and political risks

• 1. Credit growth likely to be depressed:

• Debt overhang (NPLs yet to peak in many countries) in many countries/sectors likely to affect supply of and demand for credit.

• International conditions also unfavourable, e.g., increased capital ratios (Basel III) in parent banks, changing regulations, sovereign debt crises in Eurozone, potential reversal of central bank liquidity provision in advanced countries, etc.

• 2. Fiscal discipline required in future:

• Not obviously a trigger for crisis in EE, but balances were boosted by pre-crisis boom; need for readjustment to lower revenues.

• Moreover, balances have deteriorated in responses to contraction in domestic demand (even in Estonia, Bulgaria, Hungary).



• 3. Deteriorating demographic profile

• All sub-regions except Central Asia and Caucasus set for dramatic population decline over next 40 years.

• Dependency ratios also due to rise.

• Implications for long-term fiscal balances, capacity for debt servicing, domestic sources of investment (as savings diminish).

• 4. So, need to shift resources to tradables

• Need to raise domestic investment in tradables sectos

• Raise productivity (1/3 -1/2 EU) and capital levels (2/3 EU-15)

• Need for complementary policies, such as exchange rate policy and financial market regulation

• And to remove obstacles to investment and improve business environment through structural policies, e.g., infrastructure, education, labour markets



• 5. Effects of fiscal austerity :

• Most countries of the region are now tightening budgets, most severely in Baltic and SEE regions. But will also be the case in future as revenues contract from boom year peaks.

• Can cause deterioration in public services, social welfare, and in quality of infrastructure, all of which will affect business environment.

• Also, potential for social conflict over distribution of shrinking pie.

• 6. Demographic profile challenges:

• Fiscal austerity reduces scope for orderly solution to worsening demographic profiles.

• As well as economic effects (i.e., effect on budgets), there is the related threat of how the ‘age of ageing’ affects political mobilization, e.g., parties organized around age, onerous tax rates on the young, need for increased immigration, etc.



• 7. Migration risks:

• Inward migration may be the only way to sustain economic growth in some cases – this poses risks in many cases, e.g., in Russia and Ukraine there are many negative attitudes towards groups that are likely to be the source of inward labour flows.

• Conversely, in countries where prospects look bleak, further emigration may be destabilizing, e.g., Baltic republics, Russian educated strata, etc.

• 8. Failure of structural transformation:

• Unless investment in tradables occurs, growth and living standards are likely to be lower, but economic competition may also be reduced.

• This could result in lower political competition, leading to greater corruption, tendencies toward autocracy, unaccountable government structures, etc.



• 9. Successful structural transformation:

• But if structural transformation is successful in authoritarian regimes (Kazakhstan, Russia, Ukraine), there is the prospect of new groups challenging the status quo.

• In regimes that have minimal infrastructural power - i.e., increased state capacity through persuasion rather than coercion - new economic development may cause political instability.

• 10. Below trend growth reducing rent-seeking opportunities:

• Where elites rule through rent-sharing (Russia, Kazakhstan, Ukraine, etc), any reduction in either commodity prices and/or economic growth rates, a shrinking rent base may cause distributional conflict.


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