http://www.imf.org/external/pubs/ft/reo/2007/EUR/ENG/ereo1107.htm

Overview

• Outlook for the European economy– moderate slowing with risks ahead– financial market turbulence needs to dissipate to validate the

baseline– through turbulence to sustained growth

• Analytical focus: strengthening financial systems– tuning the financial systems of advanced economies– managing rapid financial deepening in emerging Europe – sustaining financial development in emerging Europe

Outlook for the European Economy:moderate slowing with risks ahead

Some slowing ahead, but Europe’s economic outlook remains positive

Europe and the Rest of the World: Real per Capita GDP Growth, 2001–08(Percent)

0

2

4

6

8

10

12

2001 2002 2003 2004 2005 2006 2007 2008

0

2

4

6

8

10

12

Advanced European economiesNew EU membersOther emerging economiesUnited StatesDeveloping AsiaCroatia

projections

Rapidly growing economies set to cool

Emerging Europe: Real GDP Growth, 2001–08 (percent)

0

2

4

6

8

10

12

2001 2002 2003 2004 2005 2006 2007 2008

projections

Central Europe

Baltics

SoutheasternEurope

Recent inflationary pressures

Inflation in new EU members (transition economies)

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

Core inflation rate

Inflation rate

Some of the downside risks have materialized

Euro exchange rate and oil prices compared with the October WEO

October WEO assumptions November 8,2007

Crude oil price per barrel 68.5 92.9US dollars per euro 1.37 1.47euro nominal effective rate (index) 100 102.2

Good fundamentals keep domestic demand in better shape than in the US

Advanced European Economies and United States: Real Domestic Demand Growth, 2001–08(Percent)

Source: IMF, World Economic Outlook

0

1

2

3

4

5

2001 2002 2003 2004 2005 2006 2007 2008

0

1

2

3

4

5

Advanced Europe

Unites States

Convergence is now underway

1996–2000

Source: IMF, World Economic Outlook. Note: PPP is purchasing power parity.

-15

-10

-5

0

5

10

15

6 7 8 9 10 11

-15

-10

-5

0

5

10

15

Europe

Rest of the world

Linear (Europe)

Linear (Rest of the world)

Small divergence in Europe and in the rest

Ave

rage

gro

wth

rat

e o

f P

PP

per

ca

pita

in 1

996

– 2

000

-5

0

5

10

15

20

25

30

6 7 8 9 10 11 12

-5

0

5

10

15

20

25

30Rest of the world

Europe

Linear (Europe)

Linear (rest of the world)Convergence in Europe Lack of convergence in the rest of the

world

Ave

rage

gro

wth

rat

e o

f P

PP

per

ca

pita

, 2

001–

06

PPP GDP per capita in 2001

2001–06

PPP GDP per capita in 1996

0

10

20

30

40

50

60

70

2001 2002 2003 2004 2005 2006 2007 2008

0

10

20

30

40

50

60

70

projections

Central Europe

Baltics

Southeastern Europe

European Regions: PPP GDP per Capitaadvanced European economies = 100 (percent)

Baltics have been catching up faster

Convergence driven by fast economic integrationIntraregional Trade, 1997–06

(Percent of GDP)

Source: IMF Direction of Trade Statistics ; and De Nikolo (2007).

0

5

10

15

20

25

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

0

5

10

15

20

25

Africa

Middle East

Western Hem.

Asia

Europe

EU

0

10

20

30

40

50

Jan-

95

Jan-

96

Jan-

97

Jan-

98

Jan-

99

Jan-

00

Jan-

01

Jan-

02

Jan-

03

Jan-

04

Jan-

05

Jan-

06

Jan-

07

0

10

20

30

40

50

Cross-Country Dispersion of Equity Premiums

But external imbalances in emerging Europe raise concerns

European Regions: Ratio of Current Account Balance to GDP, 2001–08

(Percent)

-10

-8

-6

-4

-2

0

2

4

6

8

2001 2002 2003 2004 2005 2006 2007 2008

-10

-8

-6

-4

-2

0

2

4

6

8

Advanced EuropeanEconomiesNew EU members

Other emerging economies

Croatia

projections

0

20

40

60

80

100

120

Bel

arus

Alb

ania

Rus

sia

Cze

ch R

ep.

Rom

ania

Ukr

aine

Pol

and

Bos

nia

and

Her

z.

Tur

key

1/

Mol

dova

Slo

vak

Rep

.

Ser

bia

Lith

uani

a

Bul

garia

Cro

atia

Hun

gary

Est

onia

Latv

ia

0

20

40

60

80

100

120

Average in low- and middle- income economies, 2005

External Debt, 2006(Percent of GDP)

Despite tightening, monetary conditions are looseEmerging Europe: Monetary Conditions, 2000–06

Sources: IMF, International Financial Statistics; and IMF staff calculations. 1/ The Taylor rule is defined as the sum of the output gap, the equilibrium interest rate (assumed to be equal to potential growth estimated using the Hodrick-Prescott filter), expected inflation (assumed to be equal to actual inflation in the past three years), and the inflation gap (assumed to be equal to actual inflation minus an inflation target, which is taken to be the 2 percent European Central Bank target plus 1.5 percent from Balassa-Samuelson effects). The figure shows the average for all emerging European economies. 2/ MCI is the monetary conditions index (equal to 100 in 2000) and is the weighted sum of the changes in the real lending interest rates and in the real effective exchange rates. The figure shows the average for all emerging European economies.

-15

-10

-5

0

5

10

15

2000 2001 2002 2003 2004 2005 2006

70

75

80

85

90

95

100

105

110

Lending interest rate minus Taylorrule 1/

Euro area lending rate

MCI (right scale) 2/

loosening loosening

Financial Market Turbulence: needs to dissipate to validate the baseline

The shock in the U.S. spread into Europe’s money market

Euro Area: Average Interbank Offer Rates, July 25, 2007–November 6, 2007(Percent)

Source: Datastream.

3.5

4.0

4.5

5.0

7/25/07 8/3/07 8/14/07 8/23/07 9/3/07 9/12/07 9/21/07 10/2/07 10/11/07 10/22/07 10/31/07

3.5

4.0

4.5

5.0

Overnight

1 month

3 month

Debt spreads have increasedSpreads in Debt Instruments

(Basis points)

Source: Morgan Stanley.

0

50

100

150

200

250

300

350

400

450

500

Jan-07 Jan-07 Feb-07 Mar-07 Mar-07 Apr-07 May-07 Jun-07 Jun-07 Jul-07 Aug-07 Aug-07 Sep-07 Oct-07

SME Loan BBB 5-yr

UK Non-Conform BBB 3yr

Spanish BBB 5-yr

Credit Card € BBB 5yr

Italian BBB 5-yr

CMBS BBB 5-yr

Dutch BBB 5-yr

iBoxx € Non-Financials BBB

Irish AAA 5-yr

UK Prime MT AAA 5 yr

Emerging Europe not directly affected, but risk spreads have increased

Sovereign Spreads,July 25, 2007–November 2, 2007

(Basis points)

Sources: Bloomberg L.P.; and IMF staff calculations.

0

50

100

150

200

250

Tu

rke

y

Serb

ia

Ukra

ine

Ru

ssia

Isra

el

Bulg

ari

a

Hu

ng

ary

Pola

nd

Cro

atia

Ro

man

ia

Slo

vak R

ep

.

La

tvia

Lithu

ania

Cze

ch

Rep

. 0

50

100

150

200

250

Positive change from Jul. 25,2007

Negative change from Jul. 25, 2007

Stock markets recovered ground lost in turbulence

0

50

100

150

200

250

300

350Ja

n-05

Mar

-05

Jun-

05

Sep

-05

Dec

-05

Feb

-06

May

-06

Aug

-06

Nov

-06

Jan-

07

Apr

-07

Jul-0

7

Oct

-07

0

50

100

150

200

250

300

Emerging European

economies

Advanced European

economies

Daily Stock Market Indices, January 2005–November 2007

Contagion possible

Asset Share of Foreign-Owned Banks(percent)

0

20

40

60

80

100

Rus

sia

Ukr

aine

Slo

veni

a

Mac

edon

ia

Latv

ia

Rom

ania

Ser

bia

Pol

and

Bul

garia

Hun

gary

Cze

ch R

epub

lic

Mon

tene

gro

Bos

nia

and

Her

zego

vina

Cro

atia

Lith

uani

a

Alb

ania

Slo

vak

Rep

ublic

Est

onia

0

20

40

60

80

1002000

2005

Average in 2005

Average in 2000

Lower confidence in advanced economies may affect emerging Europe

EU-27 Confidence Indicators,January 2004–October 2007

Source: European Commission.

-15

-10

-5

0

5

10

Jan-

04

Apr

-04

Jul-0

4

Oct

-04

Jan-

05

Apr

-05

Jul-0

5

Oct

-05

Jan-

06

Apr

-06

Jul-0

6

Oct

-06

Jan-

07

Apr

-07

Jul-0

7

Oct

-07

-15

-10

-5

0

5

10

Industrial confidence indicator

Consumer confidence indicator

Through Financial Turbulence to Sustained Growth

The immediate challenge for policymakers is to:

• Restore confidence in key financial markets

• Support economic activity

• Contain inflationary pressures

Disclosure of losses in financial institutions is the key for reducing uncertainty

Emerging Europe needs to buckle up to manage financial speeding

• The best is yet to come from the financial sector– Debt and equity markets have room to grow– New member states will benefit from EU harmonization and integration– Improving institutions will reinforce the foundations of financial

development for non-EU members

• Financial supervisors need to stay on the ball– speed entails risk, supervision more important than ever

• Raise prudential standards– Remove distortions in bank lending– Increase capital requirements where necessary– Establish risk-based and forward-looking supervision

• Upgrade supervisory cooperation and coordination

• Enhance disclosure of risk

Risk management needs to keep up with innovation

• Financial innovation comes with risks– the sub-prime mortgage crisis has exposed flaws in private

and public prudential frameworks

• What needs to be done?– better liquidity management (mostly a private sector matter

but also task for supervisors to make sure it is adequate)– improved risk assessment models and due diligence– balanced review of prudential arrangements, financial safety

nets, and crisis resolution mechanisms – more transparency

But we should not lose the “patient” during the “operation”

• All traditional forms of financial intermediation have gone through tests

• Benefits from innovation: – lower cost of finance when banks are able to sell securities to

institutional investors– a wider menu of investment options, and– increased access of households which boosts welfare

Financial innovation is a positive force and has contributed to Europe’s recent good performance

Financial Innovation in Europe,June 1995–June 2007

Source: European Securitization Forum; Bank for International Settlements,Quarterly Review, Table 23A. 1/ Notional principals in trillions of U.S. dollars. 2/ Billions of euros.

0

20

40

60

80

100

120

140

160

180

200Ju

n-9

5

De

c-9

5

Jun-

96

De

c-9

6

Jun-

97

De

c-9

7

Jun-

98

De

c-9

8

Jun-

99

De

c-9

9

Jun-

00

De

c-0

0

Jun-

01

De

c-0

1

Jun-

02

De

c-0

2

Jun-

03

De

c-0

3

Jun-

04

De

c-0

4

Jun-

05

De

c-0

5

Jun-

06

De

c-0

6

Jun-

07

0

50

100

150

200

250

300

Turnover of exchange-traded derivatives in Europe(left scale) 1/

European securitization issuance (right scale) 2/

Fiscal policy in need of a healthy diet to prepare for tomorrow

European Regions: General Government Balance, 2003–08 (Percent of GDP)

-8

-6

-4

-2

0

2

4

6

2003 2004 2005 2006 2007 2008

Advanced EuropeanEconomiesNew EU members

Other emerging economies

EU, structural balance

Croatia

projections

Recent labor market reforms have paid off, but unemployment still high

0

5

10

15

20

1998 1999 2000 2001 2002 2003 2004 2005 2006

60

65

70

75

80

85

90

95

100

Advanced economies, unemployment rate (left axis)

New EU members (left axis)

Other emerging economies (left axis)

EUR, Labor force participation rate (right axis)

Croatia

Europe: Labor Market Developments, 1998-2006

Structural reforms, the protein for the muscles of an economy: makes it stronger and more flexible

Index of Economic Freedom: Ranking Compared with the Rest of the World, 2005

Switzerland 4 Portugal 38United Kingdom 5 Israel 44Estonia 8 Spain 44Ireland 9 Czech Republic 52Finland 11 France 52Iceland 11 Italy 52Luxembourg 11 Bulgaria 56Denmark 15 Greece 56Netherlands 15 Poland 56Austria 18 Moldova 76Germany 18 Croatia 82Cyprus 22 Romania 82Hungary 22 Macedonia 86Latvia 22 Slovenia 91Lithuania 22 Turkey 91Norway 22 Albania 97Sweden 22 Bosnia and Herzegovina 97Malta 32 Russia 112Slovak Republic 32 Ukraine 112Belgium 38

Source: Fraser Institute.

Reducing role of the state and cutting red tape essential in emerging Europe

EBRD Average Transition Indicator, 2005

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

HUNGARY

CZECH REP.

ESTONIA

POLAND

SLOVAK Rep

.

LITHUANIA

LATVIA

BULGARIA

CROATIA

SLOVENIA

ROMANIA

ARMENIA

GEORGIA

MACEDONIA

, FYR

RUSSIA

ALBANIA

KAZAKHSTAN

KYRGYZ REP.

UKRAINE

MOLDOVA

AZERBAIJAN

SERBIA

BOSNIA A

ND HERZ.

TAJIKIS

TAN

UZBEKISTAN

BELARUS

TURKMENIS

TAN

Emerging Asia’s flexibility allows faster growth

0

2

4

6

8

10

12

2001 2002 2003 2004 2005 2006 2007 2008

0

2

4

6

8

10

12

projectionsDeveloping Asia and Emerging Europe: Real GDP Growth, 2001–08 (percent)

Summarizing

• Moderate slowing with risks ahead– Europe is set to weather financial turbulence relatively well– Emerging Europe has been resilient, but risks have risen

• Europe needs stronger financial systems– Financial innovation needs to continue/risk management needs to

keep up– Emerging Europe needs to manage financial speeding/the best is yet

to come

• Reforms key to sustained growth– Fiscal policy should prepare for tomorrow– Structural reforms are necessary to increase growth and deliver the

promise of convergence

Ireland has shown fast convergence is possible(GDP per capita in US$, difference with EU-6)

19881998

-20000

-15000

-10000

-5000

0

5000

10000

15000

20000

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

-20000

-15000

-10000

-5000

0

5000

10000

15000

20000

1988

But Portugal needs a second chance to make inroads on convergence

Source: IMF staff estimates.

Per Capita GDP: Deviation from EU-6(In $US)

-20000

-15000

-10000

-5000

0

5000

10000

15000

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

-20000

-15000

-10000

-5000

0

5000

10000

15000

What does all this mean for Croatia?

• Progress has been achieved in recent years…• …but the reform process must be stepped up to sustain

fast growth and address external vulnerabilities • This means more ambitious fiscal consolidation by

expenditure from very high levels• Steps to strengthen financial sector supervision should

continue• Structural reforms is the way for a successful

convergence• The current monetary policy framework is suitable for

Croatia, but needs support from other policies

Analytical focus: strengthening financial systems

• Tuning the financial systems of advanced economies

• Managing rapid financial deepening in emerging Europe

• Sustaining financial development in emerging Europe

Financial systems in advanced Europe have become increasingly sophisticated, but there is

ample room for progressFinancial Index by Subindices, 1995 and 2004

Source: IMF, World Economic Outlook.

Notes: traditional bank intermediation: a higher score indicates less reliance of the financial system on traditional bank lending and a greater degree of competition among banks; capital market development: a higher score indicates more developed stock and private bond markets; new financial intermediation: a higher score indicates a stronger presence of nonbank financial institutions and more prevalent use of financial innovations.

0

0.2

0.4

0.6

0.8

Un

ited

Sta

tes

Un

ited

Kin

gd

om

Au

stra

lia

Ne

the

rla

nd

s

Ca

na

da

No

rwa

y

De

nm

ark

Sw

ed

en

Ita

ly

Sp

ain

Jap

an

Fra

nce

Fin

lan

d

Be

lgiu

m

Ge

rma

ny

Po

rtu

ga

l

Au

stri

a

Gre

ece

Traditional banking intermediation, 2004

Capital market development, 2004

New financial intermediation, 2004

Traditional banking intermediation, 1995

Capital market development, 1995

New financial intermediation, 1995

0.8

0.6

0.4

0.2

0

Rapid financial deepening in emerging Europe, but mainly fast expansion of bank credit

Credit to Non-Financial Corporations and Households(percent of GDP)

2000 2001 2002 2003 2004 2005 2006

Average yearly

changeBulgaria 14.9 16.3 21.4 28.5 41.4 50.1 62.1 6.7Croatia 46.9 45.6 56.2 63.3 66.5 78.4 89.1 6.0Czech Republic 34.2 31.1 33.2 34.5 38.5 45.0 1.8Estonia 28.5 30.4 33.0 37.6 48.1 67.4 95.4 9.6Hungary 35.6 35.5 36.3 42.9 45.6 50.8 55.6 2.9Latvia 19.5 25.8 31.8 40.6 51.1 70.8 93.1 10.5Lithuania 14.8 15.0 16.7 23.0 28.6 38.3 54.0 5.6Poland 24.3 25.3 26.5 28.2 26.9 28.8 34.7 1.5Romania 12.4 13.5 15.3 18.6 21.5 25.9 34.6 3.2Russia 15.7 18.8 20.9 24.8 27.4 30.6 33.6 2.6Serbia 12.0 14.9 14.4 18.1 23.3 24.3 2.1Slovakia 32.3 29.7 35.3 40.1 2.0Slovenia 44.4 46.9 49.0 51.7 54.9 67.4 76.9 4.6Ukraine 12.2 14.6 19.5 27.4 28.9 37.1 51.7 5.6Turkey 30.7 32.8 25.0 24.9 27.8 34.4 43.2 1.8

Financial development in emerging Europe: the best is yet to come

Outstanding Debt Securities, 2006 (Percent of GDP)

Sources: Bank for International Settlements; Standard & Poor's; Bloomberg L.P.; national authorities; and IMF, World Economic Outlook. Note: Euro area average excludes Luxembourg and Slovenia.

0

50

100

150

200

250

Ro

ma

nia

Bo

snia

& H

erz

.

Be

laru

s

Mo

ldo

va

Ma

lta

Slo

venia

Ma

cedo

nia

, F

YR

Ukr

ain

e

La

tvia

Est

on

ia

Lith

ua

nia

Bu

lgari

a

Ru

ssia

Cro

atia

Slo

vak

Re

p.

Cze

ch R

ep.

Po

land

EM

s L

atin

Am

eri

ca

Tu

rke

y

EM

s A

sia

Hu

ng

ary

U.K

.

Eu

ro a

rea

U.S

.

0

50

100

150

200

250

Financial institutionsCorporationsGovernment

Equity markets: growing capitalization, but limited liquidity

Equity Market Turnover and Capitalization, 2006

Sources: Datastream; Standard & Poor's; Bloomberg L.P.; and IMF, World Economic Outlook. Note: Euro area average excludes Luxembourg and Slovenia. EM = emerging markets. Country names are abbreviated according to the ISO standard codes.

BA

BGHR

CZ

EE

HU

LVLT

MK

MT

MDME

PL

RO

RU

RS

SK

SI

TR

UA

GB

US

Euro area

EMs Lat. Am.

EMs Asia

0

20

40

60

80

100

120

140

0 20 40 60 80 100 120 140

0

20

40

60

80

100

120

140

Tur

nove

r (p

erce

nt)

Capitalization (percent of GDP)

Emerging Europe needs to turn imbalances around over time

Two Stages of Convergence

Source: IMF staff simulations. Notes: Flexibility refers to capital and labor market flexibility. The time intervals are expressed in years. For simulation details, see Bems and Schellekens (2007).

0

2

4

6

8

10

12

T-1 T

T+

1

T+

2

T+

3

T+

4

T+

5

T+

6

T+

7

T+

8

T+

9

T+

10

T+

11

T+

12

T+

13

T+

14

T+

15

T+

16

T+

17

T+

18

T+

19

T+

20

T+

21

T+

22

T+

23

T+

24

Time

Cur

rent

acc

ount

def

icit

(per

cent

of G

DP

)

0

2

4

6

8

10

12

Model (high flexibility)

Model (low flexibility)

Hard to tell who has been speeding, but only highly flexible economies can afford large imbalances

Productivity, Flexibility, and the Current Account

Source: IMF staff calculations and simulations.

Note: Empirical data: annual geometric average growth rate in total factor productivity over 2000–05 and maximum current account deficit to GDP ratio over 2000–05. Simulated data: shock consists of a persistent increase in productivity growth. For simulation details, see Bems and Schellekens (2007).

PolandCzech Republic

Slovenia

Lithuania

Estonia

Latvia

Slovak Republic

Hungary

0

5

10

15

20

25

0 1 2 3 4 5 6

Productivity growth rate (percent)

Max

imum

cur

rent

acc

ount

def

icit

(per

cent

of G

DP

)

0

5

10

15

20

25

Model (high flexibility)

Model (low flexibility)

Policy implications

• Managing the risks of the expansion stage– err on the side of caution– Hitting the brake desirable, but not always possible – Supervisors need to stay on the ball

• Meeting the challenges of the reorientation stage– Fostering flexibility and financial development

• Raising prudential standards– Bank distortions– Capital requirements– Risk-based supervision

• Upgrading supervisory cooperation & coordination– Across borders, between home and host supervisors– Within borders, between bank and nonbank supervisors

• Enhancing risk disclosure– Disclosure requirements – Public awareness campaigns

Supervisors need to stay on the ball by building buffers and reducing vulnerabilities

• Fostering flexible labor and capital markets– Flexibility in terms of not only hiring, firing and hours but also skills is

required for labor markets– Diverse financial systems are needed for capital markets– Rigid exchange rates strengthen these needs

• Improving financial infrastructure

– Creditor protection, corporate governance, credit information help channel resources to tradable sector

– Developing missing market segments will help mobilize domestic savings

– Building the government securities market

Fostering flexibility and financial development will help turn around imbalances smoothly

Reinforcing the foundations of financial development

Institutional Quality Index, 2006

Sources: Freedom House; and International Country Risk Guide, 2006. Notes: Institutional quality index is the sum of property rights, control of corruption, bureaucracy quality, and rule of law indices. It ranges from 0 to 4. Euro area average excludes Luxembourg and Slovenia.

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

Alb

ania

Bel

arus

Rus

sia

Ukr

aine

Rom

ania

Bul

garia

Mol

dova

EM

s A

sia

EM

s La

tin A

mer

ica

Lith

uani

a

Tur

key

Latv

ia

Cro

atia

Slo

vak

Rep

.

Pol

and

Slo

veni

a

Hun

gary

Est

onia

Cze

ch R

ep.

Mal

ta

Eur

o ar

ea

Uni

ted

Sta

tes

Uni

ted

Kin

gdom

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

Average emerging Europe

Average non-EU European emerging economies

Average EU emerging economies

Next REO: Europe April 2008