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European Periphery In The Crisis: First In, First Out? Simor András 50th ACI World Congress 27 May 2011 Main messages • The crisis mostly hit high CA deficit countries in Europe (Eurozone periphery and CEEC) • Remarkable CA adjustment in Central- and East European countries • Sustainable improvement in external position requires rebalanced growth model • Lessons from the region: • Prolonged fiscal consolidation is possible • Nominal depreciation is not the only way for improving export competitiveness • Sluggish and fragile, but finally recovery The primary objective of the MNB shall be to achieve and maintain price stability. Crisis hit countries heavily relying on external financing Current account as a percentage of GDP in 2001 and 2007 Cím: Minta Cím - Előadó: Minta Előadó 3 Two waves of the crisis in Europe Average 5-year CDS-spreads 800 700 600 EA periphery CEEC Far East Latin America 500 400 300 200 100 0 06.2008 09.2008 12.2008 03.2009 06.2009 09.2009 12.2009 03.2010 Simor András: Europe’s Periphery In The Crisis 06.2010 09.2010 4 Two waves of the crisis in Europe Central and East European new member states • At the outset of the crisis, Europe’s eastern periphery became the epicenter of financial turbulence • Large external imbalances financing asset bubbles and/or excessive public indebtness • Currency mismatches • Overoptimistic convergence expectations • Low real interest rates due to perceived low fx volatility • Eroding competitiveness • IMF support for • Hungary (October 2008) • Latvia (December 2008) • Romania (March 2009) • Risk of contagion to the whole region mainly through European parent banks Simor András: Europe’s Periphery In The Crisis 5 Two waves of the crisis in Europe The periphery of the Euro Area • In 2010 Euro Area periphery countries stole the show • Large external imbalances • Public debt starting to explode • Overoptimistic convergence expectations • Eroding competitiveness • Low real interest rates • IMF-EU support for • Greece (May 2010) • Ireland (December 2010) • Portugal (May 2011) • Risk of contagion to the whole Euro Area partly through the European banking system Simor András: Europe’s Periphery In The Crisis 6 Two waves of the crisis in Europe Similarities among the two cases • In each case financial market participants realized that risks were not priced correctly • Multiple equilibria: • Imbalances seemed manageable during the era of high risk appetite • External and/or public debt became unsustainable when risk aversion increased • Lack of independent monetary policy either through: • Common currency or through • Currency pegs or through • Fx denominated loans to unhedged borrowers • Limited fiscal room for manoeuvre Simor András: Europe’s Periphery In The Crisis 7 Cheap financing in EA: blessing or curse? • • Core:Germany, France, Austria, Belgium, Netherlands Periphery: Greece, Ireland, Portugal, Spain Simor András: Europe’s Periphery In The Crisis 8 Common roots of diverse financial imbalances Low real interest rates lead to excessive risk taking • Two coincident factors compressed real interest rates: • Intrinsic to Eurozone accession process: • Interest rate convergence • Enhanced by „europhoria” (high income expectations related to rapid convergence) • Global imbalances, abundant liquidity, high risk appetite • Different manifestations of attractive borrowing conditions: • Private sector debt overhang: credit + asset price boom: Ireland, Portugal, Spain, Baltic countries • Fiscal indulgence: Greece, Hungary • Latent fiscal lenience in many countries: increase in primary expenditures covered by temporary revenues and windfalls from lower debt burden • Financial markets didn’t pay adequate attention to vulnerabilities Simor András: Europe’s Periphery In The Crisis 9 Accumulation of external liabilities in the periphery NIIP as percent of GDP, in 2001 and 2009 Simor András: Europe’s Periphery In The Crisis 10 Attractive borrowing conditions proved too attractive Household debt (percent of GDP) Corporate debt (percent of GDP) Simor András: Europe’s Periphery In The Crisis 11 Common consequences resulting from different financial imbalances • Deterioration in competitiveness: • Allocative inefficiency from overtaxation and rent seeking • Overexpansion of nontradable activities • Increasing unit labor costs • Fiscal sustainability challenges from several factors • „Regular” high deficits only in a few countries • Deceleration of potential growth rates • Countercyclical measures • Disappearing windfall revenues • Financial sector support Simor András: Europe’s Periphery In The Crisis 12 Crisis transformed imbalances into fiscal sustainability challenges Government debt (percent of GDP) Simor András: Europe’s Periphery In The Crisis 13 Crisis triggered fast and large scale CA adjustment • Temporary and permanent factors contributed to the shift in external financing requirement: • Cyclical improvement • Balance sheet deterioration triggered deleveraging • Fx denominated loans • Falling asset prices • Bank lending channel: • Normal procyclical behavior (temporary) • Scarce, more expensive, shorter maturity funding • Shift towards a business model relying more extensively on domestic savings • Fiscal adjustment Simor András: Europe’s Periphery In The Crisis 14 The adjustment process is on the way in Eastern Europe Significant improvement in the current account… 10 5 Estonia 0 percent of GDP 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Greece Hungary -5 Ireland Latvia Lithuania -10 Portugal Romania -15 Spain -20 -25 Simor András: Europe’s Periphery In The Crisis 15 The adjustment process is on the way in Eastern Europe …primarily attributable to the improving trade balance Change in trade balance (between 2008Q1 and 2010Q4; percentage point) 30 25 20 15 10 5 0 0 2 4 6 8 10 12 14 16 18 Change in current account (between 2008 and 2010; percentage point) empty circles: Estonia, Hungary, Latvia, Lithuania, Romania full circles: Greece, Ireland, Portugal, Spain Simor András: Europe’s Periphery In The Crisis 16 The adjustment process is on the way in Eastern Europe Falling investments and cut in households’ consumption expenditures improved the trade balance Simor András: Europe’s Periphery In The Crisis 17 The adjustment process is on the way in Eastern Europe Corporate investments were halved in the Baltics (and in Ireland) percentage change in volume relative to 2008Q1 10 0 2008 2009 2010 Estonia -10 Ireland Greece -20 Spain Latvia Lithuania -30 Hungary Portugal -40 Romania -50 -60 Simor András: Europe’s Periphery In The Crisis 18 From CA adjustment to rebalanced growth • In order to restore growth while preventing CA deterioration we have to: • Return to fiscal sustainability • Improve external competitiveness • Important lessons from the region • Protracted fiscal adjustment is possible • External competitiveness can be improved without large depreciation • Deleveraging subdue domestic demand, but green shoots are gradually taking over Simor András: Europe’s Periphery In The Crisis 19 Lessons from the region Prolonged fiscal adjustment is possible Hungary: 2006-2014 • Consolidation fatigue + detours: • Immediate market reaction exerts discipline • Not spectacular: • Cyclical deterioration hides structural improvement • Some measures improves (only) long term sustainability • Nonkeynesian effects are delayed: • Even if longer term prospects improve, little immediate reaction in terms of investment and job creation: • Low capacity utilization • Credit constrains Simor András: Europe’s Periphery In The Crisis 20 Fiscal consolidation is difficult yet possible in bad times 5 General government structural balance 0 as a percentage of GDP 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Bulgaria Czech Republic Greece -5 Hungary Ireland Italy Poland -10 Portugal Spain -15 -20 Simor András: Europe’s Periphery In The Crisis 21 Lessons from the region: External competitiveness can be improved without large depreciation Real unit labor cost developments, 2000=100 Simor András: Europe’s Periphery In The Crisis 22 Less employment protection facilitates wage flexibility Simor András: Europe’s Periphery In The Crisis 23 Competitiveness friendly fiscal consolidation can accelerate nominal wage adjustment • Lessons from Hungarian governments’ actions • Expenditure cuts are preferred to tax increases • Tax restructuring: from PIT to VAT • Less advisable: shifting the tax burden to banking sector (+ network industries) • Labor market reform: • Tighter eligibility conditions for social transfers • Further relaxation of employment protection laws Simor András: Europe’s Periphery In The Crisis 24 2008 50 50 40 40 30 30 20 20 10 10 0 0 Belgium France Germany Austria Italy Hungary Sweden Czech Republic Finland Spain Netherlands Denmark Slovak Republic Portugal Turkey Norway Greece Poland Luxembourg United Kingdom Iceland Japan Canada United States Ireland Australia Switzerland Korea New Zealand Mexico 60 Belgium Hungary Germany France Austria Italy Sweden Finland Czech Republic Greece Denmark Turkey Netherlands Slovak Republic Spain Norway Portugal Poland Luxembourg United Kingdom Canada United States Japan Switzerland Iceland Ireland Australia New Zealand Korea Mexico Decreasing personal income tax rate facilitates faster wage adjustment 60 2010 Simor András: Europe’s Periphery In The Crisis 25 Sluggish and fragile, but finally recovery Stocks matter, prolonged deleveraging causes subdued recovery in domestic demand Simor András: Europe’s Periphery In The Crisis 26 Sluggish and fragile, but finally recovery …, however exports and capacity utilization are reaching pre-crisis levels in countries with significant RER adjustment Simor András: Europe’s Periphery In The Crisis 27 Summary • Fast CA adjustment can be triggered by shifts in capital flows • Permanent improvement in external positions requires rebalanced growth • Lessons from the region: • Prolonged fiscal consolidation is possible • Nominal depreciation is not indispensable for improving export competitiveness Simor András: Europe’s Periphery In The Crisis 28