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Regional Outlook: New EU members from Central and Eastern Europe Anchoring Policies in Uncertain Times Fall 2006 Susan Schadler European Department International Monetary Fund Questions I. How does economic performance in the region shape up by emerging market standards II. Does this performance warrant markets’ relatively favorable perception of risks III. What are the policy imperatives given the opportunities, risks and uncertainties facing the region? Conclusions • By emerging market (EM) standards, economic performance in CECs is good, but not in class of its own. • Markets, however, view the CECs in something of a class apart. • Keeping this good will as euro adoption schedules lengthen and risks rise will require strong, clearly communicated policy anchors, • But euro adoption remains an irreplaceable opportunity to boost trade and growth and exit growing forex risk. The global environment, though strong, is becoming more uncertain. Global economic conditions are unusually favorable though downside risks have increased 7 6 5 4 90% confidence interval 70% confidence interval 50% confidence interval Baseline forecast 3 2 1 2001 Source: WEO 02 03 04 05 06 07 0 Drivers of global growth to shift slightly from US toward Europe, Japan and EMs Real GDP Growth, 2001-07 12 10 China 8 6 United States 4 Japan 2 Euro area 0 2001 02 Source: WEO 03 04 05 06 07 Inflation has risen in advanced economies, but should slow in 2007 as oil prices flatten, US economy cools. Headline Inflation 8 6 100 United States Oil price--Spot and Futures 80 4 60 2 Implied futures price at Aug. 23, 2005 Euro area 40 0 20 Japan -2 -4 2001 Implied futures price at Aug. 31, 2006 02 Source: WEO 03 04 05 06 07 0 2001 02 03 04 05 06 07 08 Global imbalances still pose substantial risks (Percent of world GDP) United States Euro area Japan Emerging Asia Oil Exporters Current Account Balance Net Foreign Assets 15 2.0 1.5 10 1.0 5 0.5 0 0.0 -0.5 -5 -1.0 -10 -1.5 -2.0 1997 Source: WEO 99 2001 03 05 07 09 11 1997 99 2001 03 05 07 09 11 -15 I. How does CEC macro picture compare to other EMs? • Relatively strong growth and low inflation • But with low savings and high investment, CECs use foreign savings heavily • This affects the risk profile in three main ways -Large current account deficits (as other EMs shift to surpluses) -CECs attract FDI as in other EMs, but private (mostly bank) inflows outpace other EMs -Growing external indebtedness, household forex exposure Growth in the CECs has been impressive … Real Growth of Regional GDP per capita East Asia Latin America Other EMs -2 0 2 4 6 8 10 CEECs 2001 Source: WEO 2004 2007 2001 2004 2007 2001 2004 2007 2001 2004 2007 …and average inflation is low. Average CPI Inflation 8 6 4 2 Percent 10 12 (Unweighted Average, in percent, 2001-2007) 2001 2002 2003 2004 CEECs Latin America Source: WEO 2005 2006 East Asia Other EMs 2007 Large current account deficits stand out Average Current Account Balance unweighted average; in percent of GDP; 1998-2007 East Asia Latin America Other EMs -5 0 5 -5 0 5 CEECs 1998 Source: WEO 2001 2004 2007 1998 2001 2004 2007 Source: WEO China Latvia India Thailand Estonia Korea Slovak Republic Czech Republic Bulgaria Turkey Slovenia Morocco Lithuania Hungary Jordan Romania Indonesia Chile Mexico Malaysia Argentina Russia Brazil Poland Colombia Pakistan South Africa Israel Egypt Peru Philippines Venezuela Jordan South Africa Romania Peru Hungary Bulgaria Pakistan Lithuania Colombia Poland Philippines Estonia Turkey Israel Egypt Slovak Republic Latvia Mexico Brazil Argentina Indonesia Chile Czech Republic Slovenia Morocco India Thailand Venezuela Russia Korea Malaysia China 0 0 10 10 30 20 30 Percent of GDP 20 40 40 50 50 Why are CECs different? Low savings and high investment produce predominantly private sector imbalances. Gross National Saving Gross Investment In percent of GDP, Average 2004-2006 In percent of GDP; Average 2004-2006 FDI is large, but private (mainly bank) inflows stand out Net Capital Flows to Emerging Markets, 1991-2004 In percent of GDP Portfolio Equity Private Debt Public Debt FDI East Asia Latin America Other EMs -2 0 2 4 6 -2 0 2 4 6 CEECs 1991 1994 1997 2000 2003 1991 Source: World Bank, Global Development Finance Database. 1994 1997 2000 2003 Inflows finance credit to private (esp. hh) sector. Growth rate, increasing forex exposure stand out EMs: Real Growth of Bank Credit to Private Sector (2005; In percent) Philippines Egypt Thailand Korea, Republic of Pakistan Malaysia China POLAND Indonesia Israel Morocco Mexico Chile South Africa Peru HUNGARY Colombia CZECH REPUBLIC SLOVENIA Russia Argentina India Brazil SLOVAK REPUBLIC ROMANIA Jordan BULGARIA Turkey Venezuela LITHUANIA LATVIA ESTONIA -20 Source: WEO 0 20 40 60 External debt is growing in contrast to other EMs (in percent of GDP) Gross External Debt Net External Debt East Asia Latin America Other EMs -20 0 20 40 60 -20 0 20 40 60 CEECs 1998 2001 2004 20071998 2001 2004 Note: Net external debt is the gross external debt net of foreign assets in central banks and the banking sector. Source: WEO and IFS 2007 II. How do markets view the high growth/high private sector imbalance situation in CECs? Different markets tell different stories. But broadly • Market view improved steadily relative to other EMs during 2003-04 (later in Bulgaria, Romania) • Perception gap leveled off during 2005 • EM sell-off in spring 2006 affected most CECs, but generally not harshly • CECs maintain an edge over other EM groups (lower spreads on external debt), but this edge has diminished CEC equities have outperformed EMs since 2003, though since mid-2005 gap has narrowed Emerging Markets: Equities Indices 100 200 300 400 500 600 (Unweighted Average, by region; Local Currency; Jan 2001=100) Jan01 Jan02 Jan03 Jan04 date CEECs Latin America Source: Bloomberg Jan05 Jan06 East Asia Other EMs Jan07 So have currency values against the dollar Emerging Markets: Currencies Against US$ 90 100 110 120 130 (Unweighted Average; Jan 2003=100; Increase=Appreciation) Jan03 Jul03 Jan04 Jul04 CEECs Latin America Source: Bloomberg Jan05 Jul05 Jan06 East Asia Other EMs Jul06 External debt spreads fell especially rapidly during 2004, but then rose relative to other EMs Emerging Markets: External Debt Spreads 25 50 100 250 500 1000 (Unweighted Average; log scale) Jan01 Jan02 Jan03 Jan04 NMS Latin America Bulgaria Source: Bloomberg Jan05 Jan06 East Asia Other EMs Romania Jan07 CECs were not immune from Spring 2006 EM sell-off, but debt markets less affected than currencies or equities (May 10, 2006=100) CECs East Asia 96 90 95 Latam Latam 98 100 Currencies Against US$ 100 Equity Indices (May 10, 2006=100) Other EM 94 85 East Asia Other EM 92 80 CECs May 10, 2006 --> Mar06 Apr06 May06 Jun06 Jul06 Aug06 Sep06 Feb06 Mar06 Apr06 May06 Jun06 Jul06 External Debt Spreads 5-year CDS Spreads (in basis points; log scale) (in basis points; log scale) Aug06 Sep06 Other EM 200 Latam 200 May 10, 2006 --> Jan06 400 Feb06 400 Jan06 East Asia Other EM 100 100 Latam 50 50 East Asia May 10, 2006 --> Jan06 Feb06 Mar06 Source: Bloomberg Apr06 May06 CECs 25 25 CECs Jun06 Jul06 Aug06 Sep06 May 10, 2006 --> Jan06 Feb06 Mar06 Apr06 May06 Jun06 Jul06 Aug06 Sep06 Do markets differentiate CECs because of “fundamentals”? What are “fundamentals”? Economic Risk Political Risk •GDP per capita •Real GDP Growth •Inflation •Budget Balance •Current Account Deficits Index based on 12 political and socioeconomic conditions Financial Risk •External debt/GDP •External debt service ratio •Current account/ exports •Official reserves/ imports •Exchange rate stability Global Financial Conditions •Implied volatility index •30-day Fed Fund futures rate •Volatility of Fed Fund futures Econometric analysis asks how much of debt spreads are explained by “fundamentals” • Analysis establishes relationship of debt spreads to “fundamentals” using data from 26 Ems • Separates each country’s spread into two parts: -that explained by “fundamentals” -that not explained by “fundamentals” • The part not explained by fundamentals reflects some non-quantifiable influence on markets’ perception of risk—e.g. EU membership or prospects for euro adoption. Results show markets differentiate CECs beyond what “fundamentals” warrant -500 0 500 1000 1500 Average Residuals, by region 01 02 03 04 CEECs Latin America 05 East Asia Other EMs 06 07 All CECs enjoy the regional advantage which seems to have stabilized at about 100 bps… Residuals in basis points Hungary Lithuania Poland Romania Slovak Republic -500 -250 0 250 500 -500 -250 0 250 500 Bulgaria Jan01Jan02Jan03Jan04Jan05Jan06 Jan01Jan02Jan03Jan04Jan05Jan06 Jan01Jan02Jan03Jan04Jan05Jan06 ..and seem not to be influenced by receding euro adoption prospects. REUTERS Polls on Euro Adoption Date Median Value of the Responses 2007 2007 2005 2010 2007 Lithuania 2007 2007 2007 Estonia 2015 2005 2010 2015 Slovenia 2007 2007 2007 2007 Latvia 2008 2007 2009 2008 Slovak_Republic 2008 2009 2009 2009 2009 2009 2015 2005 2010 2012 2012 2010 2010 Hungary 2012 2010 Aug05 2012 2012 2012 2012 Nov05 Feb06 May06 2013 2010 Nov05 Source: Reuters Feb06 May06 Aug06Aug05 2008 2009 2009 Czech_Republic Aug05 Poland 2008 Aug06 2010 2010 2010 2010 Nov05 Feb06 May06 Aug06 Summarizing the picture so far • Strong economic performance • Classic risks from private sector imbalances— investment-savings gaps, rising indebtedness fed by rapid growth of bank credit • Markets appear impressed by the strong growth but not concerned by large imbalances. • Sine qua non in this high risk/high return strategy is to meet market expectations for sustained, strong growth III. What policy anchors can reinforce market good will, sustain growth? • Euro adoption -medium-long term boost for trade, growth -eliminate emerging market risk premium -exit strategy from growing private sector forex exposures • But with euro adoption schedules receding, it is losing its value as a near-term benchmark • Markets to judge CECs increasingly on conventional policy anchors Policy anchors must work in tandem to achieve five policy goals • Low inflation (inflation targeting/currency board) • Moderate current account deficits (restraining fiscal policy) • Financial sector soundness (supervision) • Transparent risk (transparency of public and private accounts) • Competitive business environment (low wage and nonwage costs of doing business) Source: WEO Israel Venezuela Russia Indonesia ROMANIA Argentina Turkey Egypt Pakistan Philippines LATVIA BULGARIA Brazil Colombia SLOVAK REPUBLIC Jordan HUNGARY India Thailand Mexico ESTONIA South Africa Korea, Republic of SLOVENIA Malaysia Peru Chile CZECH REPUBLIC LITHUANIA China POLAND Morocco 0 5 10 15 Inflation targeting/currency boards anchor wage/price expectations… Average Inflation 2004-06 …but, with open capital accounts, are inefficient in • Curbing surges in capital inflows • Reducing large current account deficits • Sustaining competitiveness • Addressing risks of private sector forex exposure Fiscal policy: most CECs have stabilized public debt ratios at moderate or low levels 25 20 15 10 5 30 40 50 60 Public Debt in percent of GDP 30 Low Public Debt CECs 70 High Public Debt CECs 2002 2002 2003 2004 Hungary Slovak Republic Source: WEO 2005 Poland Bulgaria 2006 2003 2004 Slovenia Lithuania Latvia 2005 Czech Republic Romania Estonia 2006 But in some, rising debt or insufficient credibility requires more than discretionary policy Fiscal responsibility laws are increasingly used in other EMs to sustain/signal commitment – Expenditure or deficit ceiling – Fiscal transparency code – Medium-term budgeting commitment And when growth is strong and private imbalances large, fiscal policy needs to go beyond debt stabilization In boom conditions fiscal policy becomes the sole macroeconomic policy instrument that can • Relieve demand pressures • Contain current account deficit • Limit appreciation Challenges to financial sector soundness increase the stakes for supervision EMs: Nonperforming Loans Household Financial Leverage (In percent) (2005; In Percent of Total Loans) 25 25.0 35 20 20.0 Hungary 30 15 15.615.7 25 10 13.6 5 7.7 5.2 4.7 4.9 9.8 20 10.3 Poland 15 Czech Republic 5.8 10 5 Note: Data may not be fully comparable across countries due to regulatory differences Sources: WEO and PDR Egypt Morocco Philippines Indonesia Israel Jordan China Thailand Pakistan ROMANIA POLAND India Malaysia Argentina SLOVENIA Brazil CZECH REPUBLIC Turkey Russia Colombia LITHUANIA Peru BULGARIA HUNGARY Mexico SLOVAK REPUBLIC Venezuela South Africa Chile Korea, Republic of LATVIA ESTONIA 0 0.2 2.9 3.0 2.2 2.5 1.7 2.0 2.1 2.1 1.2 1.3 1.4 0.9 0.7 3.9 4.1 4.1 8.3 8.3 8.9 Turkey 0 2000 2001 2002 2003 2004 Sources: GFSR September 2006 Note: Household leverage is defined as the ratio of household liabilities to household assets. 2005 Transparency—there can’t be too much • No ready measures of transparency • Wide agreement that deficiencies were central to Asian currency crises in the 1990s • Key is to ensure that risks are clear to investors and leveraged residents • Ensure that public accounts are clear, complete • Guard against impressions of implicit guarentees LITHUANIA ESTONIA Thailand Korea, Republic of LATVIA Malaysia Israel Chile South Africa SLOVAK REPUBLIC Mexico ROMANIA CZECH REPUBLIC BULGARIA SLOVENIA Peru HUNGARY Pakistan POLAND Jordan Colombia Turkey China Russia Argentina Morocco Brazil Philippines India Indonesia Venezuela Egypt Korea, Republic of Slovenia Czech Republic Hungary Poland Slovak Republic Malaysia Romania Bulgaria China Indonesia 0 0 500 50 100 150 200 1,000 1,500 2,000 2,500 Preserving competitiveness: wages and other costs of doing business Average Wage in Manufacturing Sector Rank of Ease of Doing Business Indicators in US Dollars; 2005 2006 164165 91 93 16 17 24 25 26 28 29 18 23 36 52 54 43 49 61 65 66 Source: National Statistical Offices Source: World Bank’s Doing Business Indicators 134135 126 115121 96101 74 75 78 79 Conclusions • Economic performance in CECs is good by EM standards, but not in class of its own. • Markets, however, view the CECs in something of a class apart. CEC edge is shrinking but still significant. • To keep this good will as euro adoption prospects recede, policy anchors need to be clearly communicated/oriented toward sustaining high growth. • Euro adoption is a major opportunity and should remain a key goal of policy