3. Convergence in Emerging Europe: Sustainability and Vulnerabilities
Author: International Monetary Fund. European Dept.
Language:
English
Keywords:
REO; economy; price; bank; current account; deficit; EU accession negotiation; emerging Europe; EU transfer; transition economy; model prediction; Current account imbalances; Structural reforms; Europe
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Abstract

Emerging Europe’s convergence trend is set to continue, based on good fundamentals, although its pace is likely to slow. Concerns about overheating are giving way to those about vulnerabilities. Imbalances in some countries could lead to a more volatile growth experience, with risks of a hard landing. For most emerging economies, macroeconomic and financial policies will need to be further tightened to reduce vulnerabilities, while progress in structural reforms will be essential to sustain smooth convergence over the medium term.

Emerging Europe’s convergence trend is set to continue, based on good fundamentals, although its pace is likely to slow. Concerns about overheating are giving way to those about vulnerabilities. Imbalances in some countries could lead to a more volatile growth experience, with risks of a hard landing. For most emerging economies, macroeconomic and financial policies will need to be further tightened to reduce vulnerabilities, while progress in structural reforms will be essential to sustain smooth convergence over the medium term.

Overview

Convergence continues apace for most of the emerging economies in Europe. After the volatile 1990s, growth in emerging Europe accelerated sharply, reaching rates second only to the ones achieved in emerging Asia. Tighter integration with the more advanced economies of Europe has allowed emerging Europe to grow considerably faster than countries in other regions with similar income levels, allowing it to display real convergence (Figure 22).

Figure 22.
Figure 22.

Convergence in Emerging Europe and in the Rest of the World, 2002–06

Sources: IMF, World Economic Outlook; and IMF staff calculations.Note: Country names are abbreviated according to the ISO standard codes.

Fast growth has been associated with large imbalances in several emerging economies, raising questions about sustainability and concerns about vulnerabilities. Although converging economies are expected to attract foreign savings to help finance investment and smooth consumption, most emerging European economies have current account deficits that are larger for their income levels than the rest of the world’s (Figure 23). Expectations of fast convergence have generated large capital inflows in search of high returns in the region. Capital inflows have contributed to very high levels of external debt in some countries and have increased vulnerabilities to external shocks, such as sharp changes in exchange rates and interest rates, increased risk aversion, and loss of investors’ appetite for emerging markets—risks that have been rising considerably with the ongoing global financial turbulence (see Chapter 2).

Figure 23.
Figure 23.

GDP per Capita and Current Account Balances, 2007

Sources: IMF, World Economic Outlook; and IMF staff calculations.Note: Country names are abbreviated according to the ISO standard codes.

Analysis of emerging Europe’s fundamental growth prospects and vulnerabilities—the subject of this chapter—suggests the following.

The convergence trend of emerging Europe is based on strong fundamentals and is expected to continue.

  • Potential growth, determined by existing fundamentals, is relatively high. Growth-enhancing reforms have progressed in most countries, recent growth has been driven primarily by productivity improvements, and investment has increased throughout the region.

  • Large current account deficits are to some extent expected during regional convergence. Moreover, high levels of foreign direct investment and the absence of strong exchange rate appreciations in the region are reassuring.

  • Financial intermediation has considerable scope to deepen and broaden.

However, the region’s growth is likely to ease.

  • Growth rates in recent years have been well above estimates of potential growth for most countries. Reforms in some parts of the region have not progressed enough to sustain current growth rates.

  • Recent growth has been driven primarily by the production of nontradables while the necessary, gradual shift of capital and labor toward the production of tradables is likely to involve adjustment costs.

  • The pace of financial deepening and capital inflows is expected to slow, in part as a result of the repricing of risk in the context of the global financial turbulence.

The convergence path may be volatile in countries with large external imbalances, with risks of a hard landing.

  • Current account deficits are well above estimates justified by fundamentals and subject to risks of an abrupt adjustment in most cases.

  • High levels of external debt are a source of vulnerability, and debt dynamics are particularly sensitive to exchange rate movements.

  • Balance sheet analysis suggests that there are large exposures of the corporate and household sectors to exchange and interest rate risks, which imply vulnerabilities for the financial sector through credit risks and for the public sector.

Macroeconomic policies could do more to address the region’s imbalances.

  • Indicators suggest that, despite efforts to tighten, monetary conditions seem to have remained on the loose side in most of the region.

  • Fiscal consolidation has not always taken full advantage of rapid growth, and in some countries fiscal balances have deteriorated in structural terms.

Structural reforms have been essential to raise potential growth, suggesting that, together with sound macroeconomic policies, further progress in this area will be key to ensure a smooth convergence in emerging Europe.

The extent to which these conclusions apply varies by region within emerging Europe. The Baltics have accumulated considerably larger external imbalances than the rest of the region. Although faster progress in structural reforms has increased their flexibility, adjustment to shocks may still be difficult, as their fixed exchange rate regimes preclude nominal exchange rate adjustment to cushion the impact of shocks. External imbalances in southeastern Europe, albeit smaller, are also sizable and have been deteriorating. Moreover, these economies lag behind in structural reforms and may lack the capacity to adjust swiftly to shocks. In contrast, most of the central-eastern European economies have smaller external imbalances and are relatively advanced in reforms, thus mitigating vulnerabilities.

Sustaining Growth

Growth Led by Domestic Demand

On the supply side, recent growth in emerging Europe has been driven primarily by services, followed by industrial production (Figure 24). The relative expansion of nontradable production (primarily services) is to be expected during the beginning of the convergence process, and is associated with an increase in the relative price of nontradables and wages.25 However, successful convergence eventually requires a turnaround of this process and a shift of resources toward the production of tradables.

Figure 24.
Figure 24.

Emerging Europe: Value Added by Sector, Contributions to Real GDP Growth, 2002–06

(Cumulative percentage points)

Sources: World Bank, World Development Indicators; and IMF staff calculations.

On the demand side, recent growth in emerging Europe has been driven by domestic demand, with a sharp jump in the investment-to-GDP ratios in many countries and rapid growth of consumption (Figure 25). Even though exports have been growing at a respectable pace, the contribution of net exports to growth has been negative in most countries. The large contribution to growth from consumption is mainly explained by its dominant share in GDP. Indeed, investment has been growing faster than consumption during recent years in most of the region.

Figure 25.
Figure 25.

Emerging Europe: Domestic and External Demand, Contributions to Real GDP Growth, 2002–06

(Cumulative percentage points)

Sources: World Bank, World Development Indicators; and IMF staff calculations.

Total Factor Productivity a Key Contributor

Production function estimates provide further insights into the factors that are driving growth in emerging Europe. Growth accounting links growth to the accumulation of capital, changes in the use of labor, and a residual factor, commonly known as total factor productivity (TFP). Growth that is primarily driven by factor accumulation without improving productivity may not prove to be sustainable because of diminishing returns to capital and labor. In contrast, growth driven by a structural transformation that improves the economy’s efficiency would be reflected in faster TFP growth and would signal the capacity to grow faster than the constraints imposed by capital and labor.

Estimates of TFP, using a traditional production function approach, suggest that most of emerging Europe is benefiting from a structural transformation, which bodes well for future growth prospects (Figure 26).26 Growth in emerging Europe has been driven primarily by TFP, and countries with higher TFP growth have been growing faster. Capital accumulation has also been important in most countries; meanwhile, labor has added less and even registered a negative contribution in some countries, with emigration a key factor.27

Figure 26.
Figure 26.

Emerging Europe: Growth Accounting, 2002–06

(Percent per year)

Sources: IMF, World Economic Outlook; and IMF staff calculations.

Structural Reforms Are Essential Drivers of Economic Growth

Reforms that have been found to foster economic growth and productivity explain fast growth in the Baltics and in central-eastern Europe, while lower starting income positions and convergence arguments explain fast growth in southeastern Europe and in the Commonwealth of Independent States (CIS) countries (Table 8).28 The Baltics have progressed considerably faster in structural reforms, reducing the role of the state in the economy and creating a business-friendly environment that has led to larger investment shares. In some of these areas, the Baltics already compare well with the euro area.29 Central-eastern Europe follows, with notable progress in most growth determinants. Both regions are also very open to international trade, are well advanced in the transition process, and have relatively good public infrastructure, a well-educated population, and labor markets that are more flexible than in the euro area. Southeastern Europe has fallen behind in structural reforms, while the CIS countries are lagging even more (these differences may be partly due to the EU harmonization, which drove reforms in the new EU member states in recent years). The lack of reform progress may explain why some countries in these areas have not been growing faster than the rest of emerging Europe, despite starting from a lower income position.30

Table 8.

Determinants of Growth in Emerging Europe, 2003–07

(Unweighted averages; percent unless otherwise indicated)

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Sources: IMF, World Economic Outlook (WEO); World Bank, World Development Indicators (WDI); European Bank for Reconstruction and Development (EBRD); and Economic Freedom Network (EFN).Notes: Southeastern European (SEE) countries: Albania; Bosnia and Herzegovina; Bulgaria; Macedonia, FYR; Romania; and Serbia. Central-eastern European (CEE) countries: the Czech Republic, Hungary, Poland, and the Slovak Republic. Baltics: Estonia, Latvia, and Lithuania. CIS: Belarus, Russia, Moldova, and Ukraine.

Other growth determinants in the region are conducive to convergence, or at least are not an obstacle. The financial sector has been developing at a fast pace across emerging Europe, although this process is far from complete. And the demographic characteristics in the region and human capital indicators are similar to the ones in the rest of Europe.

Financial Deepening May Lose Steam

IMF staff research suggests that, despite recent progress, the financial sectors in emerging European economies still have a long way to go to converge with the more advanced financial sectors in the rest of Europe.31 The stock of domestic bank private sector credit as a share of GDP is still small in most economies in the region relative to income levels. Estimates in Schadler and others (2005), in IMF Country Report 06/169 (for Romania and other new EU member states), and data for 2006 suggest that the credit ratios in the new EU member countries are considerably below their long-run equilibrium, with the exceptions of Latvia and Estonia, which are slightly above equilibrium. Moreover, debt and equity markets have considerable room to develop. Therefore, financial deepening in emerging Europe is part of an equilibrium convergence process that is likely to continue in the medium term.

However, the recent speed of financial deepening in the region may have been extreme. The pace of credit expansion relative to economic growth in emerging Europe has exceeded that in other emerging economies (Figure 27). Also, including loans taken by the nonfinancial sector directly from abroad, the credit-to-GDP ratio is considerably higher (see, for example, evidence for southeastern Europe in Sorsa and others, 2007). Therefore, although the trend of financial deepening is likely to continue in emerging Europe, its pace may slow in the near term, even in the absence of shocks.32 This, in turn, is expected to contribute to a slowing of output growth.

Figure 27.
Figure 27.

Growth and Private Sector Credit Growth, 2002–06

(Percent)

Sources: IMF, World Economic Outlook; and IMF staff calculations.Note: Country names are abbreviated according to the ISO standard codes.

Growth Is Likely to Slow in Line with Potential

Although good fundamentals justify high potential growth rates in emerging Europe, actual growth rates seem to have been even higher, suggestive of overheating pressures.33 Estimates based on a growth model show that potential growth is high throughout the region (Box 8). However, comparisons of the growth model estimates with actual growth rates reveal that all emerging European economies have been growing at above-potential rates in the past five years, except Hungary, which has remained below potential. The difference is the largest for Latvia, Russia, and Ukraine. On average, the region is estimated to have grown faster than potential by 2 percent during 2003–07 (1.8 percent excluding Russia). Therefore, although convergence is expected to continue, its pace may slow. Moreover, the road back to potential may be bumpy in economies where excess demand pressures have led to vulnerabilities.

The estimates also suggest that further structural reforms could substantially increase potential growth rates in emerging Europe, in some cases to even above current growth rates. Continuing with reforms at the same pace as in recent years is estimated to increase potential growth by an average of 1.6 percent annually.

Addressing Vulnerabilities

Some Trends Are Reassuring…

As noted, most emerging European economies have current account deficits that are considerably larger than in similar economies in the rest of the world. Although this makes the region vulnerable to external shocks (see below), other trends are more reassuring.

  • Most of the recent deterioration of current account balances in emerging Europe seems to be driven by an increase in investment (Figure 28). And in almost half of the countries, savings actually rose. In most countries with large deficits, such as the Baltics and Bulgaria, investment increased the most, although in many cases savings also declined. High investment is expected to improve the region’s growth prospects and eventually help reduce the current account deficits.

Figure 28.
Figure 28.

Emerging Europe: Contributions to Current Account Deficit, 2003–07

(Percent)

Sources: IMF, World Economic Outlook; and IMF staff calculations.

  • Foreign direct investment (FDI) has financed most of the current account deficits in emerging Europe in recent years (Figure 29). FDI is less volatile than other capital flows as it cannot leave the country on short notice. One of its key features is that it fully shares in the economic risks and often signals approval of a country’s economic policies and positive expectations about its prospects. Therefore, FDI-financed current account deficits are generally more sustainable and tend to adjust more gradually than deficits financed by debt or portfolio flows (although a sudden stop of FDI inflows cannot be excluded). However, an important caveat is that some of the recent FDI into emerging Europe was linked to privatization and, therefore, may not be repeated. Furthermore, foreign bank borrowing from parent banks has been financing an increasing share of the current account deficits in most countries, primarily in the Baltics and in southeastern Europe.

Figure 29.
Figure 29.

Emerging Europe: FDI Coverage of Current Account Deficit, 2002–06

(Percent)

Sources: IMF, World Economic Outlook; and IMF staff calculations.

Potential Growth Estimates in Emerging Europe Based on a Growth Model

For transition economies, there are several obstacles to estimating potential growth, including short time series, the unavailability of some key variables, measurement issues, and frequent changes in statistical methods. Furthermore, using historical data to estimate potential growth and recent trends to gauge future prospects may lead to false conclusions during structural transformation. However, estimates of potential output growth are still useful in determining to what extent actual growth is driven by temporary factors.

With these caveats in mind, we estimate an econometric growth model based on a large cross-country sample of 107 developed and developing economies, during 1996–2006. The estimated coefficients are used to forecast potential growth in emerging Europe based on the current values of the independent variables in each country.1 Focusing on the past 10 years has a number of advantages: the sample includes transition economies; some cross-country indices are not available for earlier years; and overall data quality has improved since previous years.

The empirical specification is the following:

(Real GDP per capita growth)i = c + βXi + u, for country i = 1,…, n.

The dependent variable is the average per capita purchasing power parity (PPP) real GDP growth rate for each country i; c is the constant term; β is the matrix of parameters to be estimated; Xi is the matrix of independent variables; and u is the error term (see Table 8 in the main text for data sources). Each country has one observation, which is either the average over 10 years or the initial value in 1996, depending on the variable.

The preferred, estimated specification is

Real GDP per capita growth = 11.00(2.93)** −1.38(4.52)*** initial real GDP per capita −7.05(-3.86)*** age dependency rate +0.13(3.93)*** investment/GDP +0.02(1.80)* university enrollment ratio −0.015(-2.34)** inflation rate +0.07(1.50) foreign direct investment/GDP +0.59(3.00)** index of economic freedom in 1995 + 0.86(3.97)*** change in the index of economic freedom during 1995–2005 + 0.90(1.73)* dummy variable for transition +0.67(1.69)* dummy variable for Africa.

***, **, and * denote statistical significance at the 1, 5, and 10 percent level, respectively; the number of observations is 107; the adjusted R2 is 0.59; heteroscedasticity-consistent t-statistics are in parentheses.

The results suggest that, keeping everything else constant, a country with a relatively low income level, a low dependency ratio, a large investment share, a low inflation rate, and a relatively educated population grows faster. The index of economic freedom, which measures a number of different aspects of macroeconomic and structural policies and reforms, has a positive and statistically significant estimate.2 The FDI-to-GDP ratio has a positive coefficient but is statistically significant at only the 15 percent level. Separate constants for transition economies and for African countries have positive estimates.

The estimate of the dummy variable for transition economies suggests that these economies have been growing faster during the past 10 years than would be justified by the growth determinants in this specification—by about 0.9 percent annually in terms of per capita GDP, with most of these economies having collapsed at the beginning of their transition. However, this “growth bonus” may not continue in the future, or at least not to the same extent.

Using these estimates and the latest values of the independent variables for each emerging European economy gives a range of potential growth estimates and the growth impact of economic reforms (see table; some countries are dropped from the sample because of missing values for some of the growth determinants). The lower end of the range assumes that the transition growth bonus will not continue in the medium term, while the upper end assumes that it will. The range with no reforms assumes no further progress in structural reforms (the index of economic freedom remains at its 2005 level), which may be an extreme assumption, while the range with reforms assumes that structural reforms continue at the same pace, which may also be an extreme assumption because past reforms started from a very low level. In the main text, the average of all these estimates is used as the potential growth rate for each economy.

Potential and Actual Growth of Real GDP in Emerging Europe

(Percent)

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Sources: IMF, World Economic Outlook; and IMF staff calculations.

A dummy variable for Turkey has a statistically significant estimate of 1.7, which is taken into account in the range of potential growth in the table.

1 A similar methodology was used in Schadler and others (2005) for central-eastern Europe, in Moore and Vamvakidis (forthcoming) for Croatia, and in IMF Country Report 06/345 for Macedonia, FYR.2 For more information on the index of economic freedom, see www.freetheworld.com.

  • Exchange rate appreciation does not seem to explain the accumulation of external imbalances in emerging Europe (Figure 30). There is no significant correlation between the changes in current account balances in emerging Europe and the changes in real effective exchange rates in recent years (the latter are also not correlated with the levels of the current account deficits).

Figure 30.
Figure 30.

Emerging Europe: Change in Current Account Balance and Real Effective Exchange Rate Appreciation, 2003–07

(Percent)

Sources: IMF, World Economic Outlook; and IMF staff calculations.Note: Country names are abbreviated according to the ISO standard codes.

  • Emerging Europe has been gaining market share. As a share of world imports, exports of goods and services (excluding oil) have risen in all countries in the region since 2002—in some considerably so (Figure 31). Therefore, competitiveness problems do not seem to explain the large current account deficits in the region.

Figure 31.
Figure 31.

Emerging Europe: Percentage Change in Export Market Shares in the World Economy, 2002–06 1/

Sources: IMF, World Economic Outlook; and IMF staff calculations.1/ Goods and services excluding oil.

… But Current Account Deficits Are Well Above Estimates Based on Fundamentals

Estimates of expected current account deficits based on fundamentals suggest that some countries in emerging Europe have excessive external imbalances. Although such estimates are subject to uncertainty and very sensitive to empirical specification, their gaps from actual deficits in most countries in the region are substantial and suggest the need for an adjustment in the medium term, signs of which are beginning to appear.34

Multiple methodologies are used to estimate equilibrium current account deficits; the so-called CGER approach is the standard at the IMF.35 Recent IMF staff reports for emerging European countries have published such estimates.36 In this section, we discuss new results from three alternative methodologies.

First, results from the simulation of an empirical model on the determinants of current account balances in Europe in Abiad, Leigh, and Mody (2007) give mixed results for selected new EU members. This model takes financial integration explicitly into account and, therefore, is particularly relevant for emerging Europe.37 The results suggest that current account deficits in the past five years have been considerably larger than would be justified by fundamentals in Latvia and Estonia, somewhat larger in Lithuania, Hungary, and the Slovak Republic, and smaller in the Czech Republic and Poland (Figure 32).38

Figure 32.
Figure 32.

Current Account Model Predictions and Actual Balances in Selected New EU Members

(Percent of GDP)

Sources: IMF, World Economic Outlook; and IMF staff calculations.

Second, estimates of current account balances for new EU member states based on the macroeconomic balance approach show that fundamentals justify larger deficits in the region than in other emerging market economies, but not to the extent seen in some countries (Box 9). The Baltics and, more recently, Bulgaria and Romania have diverged from the model predictions. This divergence seems to be mainly driven by cyclical and structural factors, but also by economic policies. Although deviations from model predictions are not conclusive evidence of disequilibrium, particularly given the sensitivity of such estimates to the empirical specification, an adjustment would require the shift of resources to the tradable sectors and a slowing of domestic demand.

Third, estimation of a model of intertemporal optimization during regional convergence in emerging Europe leads to similar conclusions. In this model, based on Blanchard and Giavazzi (2002), emerging economies converge toward the more advanced economies in the region by borrowing in international capital markets.39 The current account balances of emerging economies depend on a time effect, relative per capita income, demographic factors, and the business cycle. Foreign borrowing finances relatively high consumption and investment in the present, based on expectations that living standards will improve in the future. Therefore, fast growth in emerging economies is associated with large current account deficits, which would describe what one has seen in emerging Europe in recent years. The model can be used to forecast the levels of the current account balances that are consistent with regional convergence in emerging Europe.

Current Account Sustainability in the EU-101

The fact that most new members of the European Union have been running current account deficits that are, on average, larger than those experienced by other emerging market economies appears to be justified by fundamentals (figure). Using the so-called macroeconomic balance approach, an equilibrium relationship between the current account balance and a set of fundamentals that determines a country’s saving and investment positions was estimated on a sample of 59 industrial and developing countries. The resulting larger predicted current account deficits in the EU-10 are driven by two factors: a larger share of dependent population and a much lower net foreign assets position (first table).

box9fig1

Current Account Balances and Model Predictions

Percent of GDP

Sources: IMF, World Economic Outlook; and IMF staff calculations.

The demographic profile of the EU-10 is closer to the one in industrial Europe than that in other emerging market countries outside Europe. Having a larger share of old-age dependent population lowers national saving, implying a larger current account deficit. In addition, foreign investors’ greater confidence in the growth prospects of the EU-10 and the higher dependence of the latter on foreign capital for growth are reflected in a lower net foreign assets position. Unlike emerging Asia, where growth has mostly been self-financed, emerging Europe’s convergence is financed from abroad. Robustness checks also point to the desirability of excluding non-European emerging market countries from the sample. Doing so produces slightly larger current account model predictions for the EU-10.

Current Account Regression

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Note:***, ** and * denote significance at the 1, 5, and 10 percent level, respectively.

Medium-term values of the variables are obtained from the WEO database.

Takes the value of 1 if total receipts of remittances and workers’ compensation equal 5 percentage points of GDP or higher.

To what extent have actual current account balances in the EU-10 diverged from the model predictions? There is a wide cross-country variation, with Slovenia and Poland, on one end, showing mostly positive deviations, and the Baltic countries and the Slovak Republic, on the other end, showing persistently negative deviations. Within this latter group, the Slovak Republic has reduced its divergence over time, whereas the Baltics have been moving in the opposite direction, joined recently by Bulgaria and Romania.

The divergence of actual current account balances from their “annual” model predictions, which are calculated using coefficients from the current account balance regression and annual values of the fundamental variables, can be explained by three kinds of factors: cyclical or temporary (the output gap and capital inflows brought in by EU accession), structural (export composition and cost competitiveness in the manufacturing sector), and policy-related (the exchange rate regime and financial sector policies) factors.2 Because structural and policy variables are also statistically significant, in addition to cyclical and temporary variables, in explaining the variation in divergence in the EU-10, the results suggest that the elimination of large deficits is likely to require an improvement in export performance (second table).

In fact, the experience of countries where large deficits were absent (Poland and Slovenia) or have been brought down over time (the Czech Republic, the Slovak Republic, and Hungary) demonstrates the importance of exports. While imports increased rapidly in all of the EU-10, exports took off in a determined fashion only in this subgroup. This takeoff, in turn, was facilitated not just by strong growth and increasing market shares, but also by a composition that became increasingly diversified in favor of products with higher technological content and productivity growth that favored the tradable sector.

The question is whether the rest of the EU-10 countries, all of which are running double-digit current account deficits, can follow the same script. Concerns about external stability have mounted in these countries, given their sizable external debt, blistering pace of credit growth, rising domestic wage pressures, and limited policy flexibility. High and increasingly negative net foreign asset positions imply that the deterioration in the income balance in coming years is likely to offset the expected improvement in the transfer balance. Hence, a turnaround in the trade and services balance will be essential to obtain the needed adjustment and will require a very strong export performance in addition to a slowdown in domestic demand.

Divergence from Current Account Balance Regression

Dependent variable = actual current account balance/GDP – annual norm current account balance/GDP

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Note:***, **, *denote significance at the 1 percent, 5 percent, and 10 percent level, respectively.

The ratio of unit labor costs in the overall economy and manufacturing sector relative to trading partners. An increase implies a more competitive manufacturing sector.

Overhead costs in the financial sector. current account balance/GDP

Note: The main author of this box is Jesmin Rahman (based on Rahman, forthcoming).1 The EU-10 comprises the following new members of the European Union: Bulgaria, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, the Slovak Republic, and Slovenia.2 For this analysis, the regression coefficients are obtained from the estimation results using industrial and European emerging market countries only.

The results show that large current account deficits in emerging Europe are only partly driven by regional convergence. Most of these deficits are at levels within equilibrium ranges (determined by a 95 percent confidence band) during regional convergence (Table 9). However, these ranges are wide, and the deficits of most emerging European economies are well above the central estimates within these ranges. Moreover, three economies have deficits above the estimated ranges: Latvia, Bulgaria, and Estonia.40

Table 9.

Sustainability of Current Account Deficits Based on a Model of Regional Convergence, 2007

(Percent)

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Sources: IMF, World Economic Outlook; and IMF staff calculations.

High External Debt Causes Concerns

A number of emerging European economies have levels of external debt that, as a share of GDP, are considerably higher than in most other emerging economies. High levels of external indebtedness, as well as of domestic debt in foreign exchange, could expose parts of the region to shocks, including rollover difficulties, sharp interest rate and exchange rate movements, changes in investors’ sentiments, and changes in the expansion plans of foreign banks, which own the lion’s share of banking assets in most countries. Repayment would require that indebted economies either export their way out or reduce their domestic demand. The first path is obviously preferable, but achieving it will depend on progress with reforms.41

While most debt is of medium- and long-term maturities, reserve coverage of short-term debt is low in a number of countries. A ratio of short-term debt to central bank foreign reserves higher than 100 is not usually considered to provide a sufficient buffer during shocks. About half of emerging European economies are well below this limit, about one-fourth are very close to or somewhat above it, and the rest (the Baltics and Belarus) are well above it (Figure 33).42

Figure 33.
Figure 33.

Emerging Europe: Ratio of Short-Term Debt (Remaining Maturity) to Foreign Exchange Reserves, 2007

(Percent)

Sources: IMF, World Economic Outlook; and IMF staff calculations.1/ Original maturity.

Based on a methodology described in Milesi-Ferretti and Razin (1997), a standard debt-accounting framework can be used to determine the dynamics of external debt in response to a number of adverse shocks (Table 10).43 Three shocks are considered: a 20 percent depreciation of the exchange rate (only for countries with floating exchange rates), an increase in lending interest rates of 2 percentage points, and a fall of real GDP growth by 2 percent from the baseline of the IMF’s World Economic Outlook.

Table 10.

Responses of External Debt-to-GDP Ratio to Adverse Shocks, 2007–11

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Sources: IMF, World Economic Outlook; and IMF staff simulations.

Assuming no further accumulation of reserves.

With respect to the euro. The table does not report results for an exchange rate shock in countries with a currency board arrangement or a fixed euro exchange rate.

All three shocks are projected to lead to higher debt levels in the medium term than in the baseline projections. The exchange rate shock has a considerably stronger impact on debt than the other two shocks, which have almost the same impact. The exchange rate shock has the most severe impact on Hungary and Croatia. The growth and interest rate shocks have the most severe impact on Latvia, Bulgaria, Hungary, Croatia, and Estonia.

Balance Sheet Analysis Indicates Vulnerabilities

Recent IMF staff work has emphasized balance sheet vulnerabilities in a number of emerging European economies. The balance sheet approach analyzes the economy as a system of interlinked sectoral balance sheets (public, private financial, corporates, and households), focusing on stocks, in contrast to traditional macroeconomic analysis, which is typically concerned with aggregate flow variables. The balance sheet approach clarifies intersectoral linkages and provides useful insights into balance sheet maturity, currency, and capital structure mismatches, which may exacerbate a country’s vulnerability to shocks.

This approach is particularly relevant for emerging European countries with high levels of foreign currency debt. A balance sheet analysis may show sectoral exposures that are netted out in a country’s aggregate balance sheet. Problems in servicing foreign currency debt in one sector may quickly spread to other sectors, with broader economic implications.

Although this research is at an early stage and requires building extensive sectoral data sets, which are not always available even for advanced economies, some early conclusions can be drawn based on the recent IMF studies for selected emerging European economies.44

  • Banks have a net liability position with the nonresident sector and a net asset position with the domestic nonfinancial private sector. These positions reflect intermediation of funds from the former sector—primarily parent foreign banks—to the latter, in the form of bank loans, and could make these banks vulnerable to sudden stops.

  • Although domestic lending in foreign currencies provides banks with hedging from exchange rate risks, the banks remain indirectly exposed to such risks through credit risks, as most of their debtors (domestic private nonfinancial sector) are not hedged.45

  • The banking sector is exposed to interest rate risk. Floating interest rates in most mortgages provide a cushion, but even in these cases banks remain indirectly exposed to interest rate risks through credit risks.

  • With a large share of mortgages in their loan portfolios, banks could also be vulnerable to developments in the real estate market.

  • The balance sheets of the domestic private nonfinancial sector (corporates and households) are subject to exchange rate risks from large and rising foreign currency exposures and to domestic and foreign interest rate risks from debt in variable interest rates. Although households also have large foreign currency deposits, borrowers may be distinct from savers and thus subject to these risks.

  • Public sector balance sheets are generally strong (with the exception of Hungary). Moreover, some governments have been refinancing external debt in the domestic market. However, the large foreign currency exposures of the nonfinancial private sector imply fiscal risks in case of a severe downturn.

In sum, a balance sheet analysis for selected emerging European economies suggests that large exposures to exchange rate and interest rate risks on the part of the corporate and household sectors imply some vulnerabilities for the financial sector through credit risks, and indirectly for the public sector in case of a severe shock.

Running Sound Macroeconomic Policies

In many cases, macroeconomic policies in emerging Europe have not been tightened sufficiently in response to overheating pressures. In some countries, instead of “leaning against the wind,” policies may have added fuel to the fire. Fiscal policy, in particular, has not always stepped in to manage domestic demand in the absence of monetary policy in fixed exchange regimes.

Monetary Conditions Seem Loose

Fast credit growth and overheating pressures in a number of emerging European countries are driven partly by low borrowing costs. Real lending interest rates fell during recent years in most countries in the region. Moreover, corporates, and increasingly households, in emerging Europe are able to borrow directly from abroad and take advantage of even lower interest rates, albeit at the expense of incurring exchange rate risk.

Monetary policy has not always managed to tighten monetary conditions as needed. Open capital accounts, high euroization (in some cases), financial deepening and integration, and fear of floating of exchange rates (in some cases) have weakened the effectiveness of monetary policy. Tightening measures in some countries, such as higher reserve requirements and credit controls, have not been effective in slowing foreign borrowing and credit growth as desired, and have been often circumvented by lenders and borrowers.46 Indeed, monetary conditions seem to be loose throughout emerging Europe.

According to the Taylor rule, monetary conditions have loosened in emerging Europe during recent years (Figure 34), particularly in the Baltics after 2003.47 Loosening in central and southeastern Europe followed, but at a much slower pace. Monetary conditions in the rest of the region started from a very loose position in 2003, were tightened up until 2006, but started loosening again in 2007.48

Figure 34.
Figure 34.

Emerging Europe: Lending Interest Rate minus Taylor Rule Interest Rate, 2003–07 1/

Sources: IMF, World Economic Outlook; and IMF staff calculations.1/ Positive if monetary conditions are tight.2/ Albania; Bosnia and Herzegovina; Bulgaria; Croatia; Macedonia, FYR; Romania; Republic of Serbia.3/ The Czech Republic, Hungary, Poland, and the Slovak Republic.4/ Estonia, Latvia, and Lithuania.5/ Belarus, Moldova, Russia, Turkey, and Ukraine.

The monetary conditions index shows a similar trend (Figure 35).49 The index suggests a loosening of monetary conditions throughout the region in recent years. However, in contrast with what is suggested by the Taylor rule, monetary conditions seem to have been relaxed the most in southeastern Europe and the least in the Baltics.

Figure 35.
Figure 35.

Emerging Europe: Monetary Conditions Index, 2007 1/

Sources: IMF, World Economic Outlook; and IMF staff calculations.1/ Loosening when falling below 100; 2003 = 100.2/ Estonia, Latvia, and Lithuania.3/ The Czech Republic, Hungary, Poland, and the Slovak Republic.4/ Belarus, Moldova, Russia, Turkey, and Ukraine.5/ Albania, Bosnia and Herzegovina, Bulgaria, Croatia, Macedonia, FYR, Romania, Republic of Serbia.

Fiscal Consolidation Is Insufficiently Ambitious

Most emerging European economies have taken advantage of the strong cycle to improve their fiscal balances. Strong, growth-driven revenue performance in recent years has fostered fiscal consolidation just by allowing the automatic stabilizers to operate. Overheating and vulnerability concerns in some economies prompted calls for even tighter policies to offset strong private sector demand and create room to support the economy in case of a severe downturn.

However, adjusting for the cycle, progress in fiscal consolidation in the region has been mixed (Figure 36).50 During the past five years, fiscal balances improved by less in structural terms than actual balances in all countries in the region except Albania. In nine economies, fiscal balances deteriorated in structural terms, despite the improvement of actual balances in five of them. Structural balances improved by an annual average of more than ½ percentage point of GDP only in Croatia, Bosnia and Herzegovina, Turkey, and Poland in this sequence. In structural terms, only Belarus, Bosnia and Herzegovina, Macedonia, FYR, Estonia, and Bulgaria had fiscal surpluses in 2007. This outcome ran counter to a well-accepted rule (consistent with a long-run objective of the EU’s Stability and Growth Pact) for a balanced budget over the cycle.51

Figure 36.
Figure 36.

Change in Actual and Structural Fiscal Balances, 2003–07 1/

(Percent of GDP)

Sources: IMF, World Economic Outlook; and IMF staff calculations.1/ The structural balances do not take into account spending related to pension reform and spending related to EU transfers.2/ Russia's structural balance is assumed to be equal to the non-oil balance.

Policy Agenda

The analysis in this chapter suggests that, although emerging economies in Europe are set to continue converging toward their more advanced European peers, the recent pace of convergence may not be sustainable and, in some cases, may have increased vulnerabilities to shocks and risks of a hard landing. Addressing these vulnerabilities is crucial to ensure smooth convergence in the medium term and, in some countries, a soft landing.

The IMF’s recent policy recommendations for the region, which are also supported by the empirical results in this chapter, can be summarized as follows:

  • Enact structural reforms to increase potential growth by ensuring fair market competition, reducing the role of the state in the economy, improving the business environment, cutting red tape, reforming the judiciary, and progressing in the EU harmonization process in EU-candidate countries.

  • Implement policies to ensure macroeconomic stability, address external imbalances, and reduce vulnerabilities, including tightening monetary policies where available, and advancing in fiscal consolidation well beyond what is driven by the operation of automatic stabilizers during the expansion stage, particularly in countries with limitations in conducting monetary policy. Wage increases should be in line with productivity improvements. Fiscal distortions that might create incentives for excessive private sector borrowing should also be reconsidered and in some cases eliminated.52

  • Implement policies to strengthen the financial sector and create buffers to help adjust to shocks, including prudential measures, such as larger risk weights for foreign currency lending to unhedged borrowers and limits on loan-to-value and debt service–to-income ratios. Establishing credit registries and strengthening nonbank financial sector supervision would substantially increase the effectiveness of these measures.

These policies will ensure that convergence continues in emerging Europe. As discussed in Chapter 1, a gradual slowing of growth, which seems to be already under way in parts of the region, is the most likely scenario. However, a more abrupt adjustment cannot be excluded, given the considerable vulnerabilities in some countries. High levels of external debt in some cases suggest that these vulnerabilities will continue well into the medium term, making progress in implementing the recommended policies and reforms essential to prepare the region for unexpected shocks and to reduce external imbalances and the resulting vulnerabilities over time.

Within Same Series

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Cover Regional Economic Outlook, April 2008, Europe
Regional Economic Outlook, April 2008, Europe
Reassessing Risks
Author: International Monetary Fund. European Dept.
ISBN:
9781589067134
ISSN:
2071-4157
Publication Date:
12 Apr 2008
Publisher:
International Monetary Fund
DOI:
https://doi.org/10.5089/9781589067134.086
Pages:
69
  • View in gallery

    Convergence in Emerging Europe and in the Rest of the World, 2002–06

  • View in gallery

    GDP per Capita and Current Account Balances, 2007

  • View in gallery

    Emerging Europe: Value Added by Sector, Contributions to Real GDP Growth, 2002–06

    (Cumulative percentage points)

  • View in gallery

    Emerging Europe: Domestic and External Demand, Contributions to Real GDP Growth, 2002–06

    (Cumulative percentage points)

  • View in gallery

    Emerging Europe: Growth Accounting, 2002–06

    (Percent per year)

  • View in gallery

    Growth and Private Sector Credit Growth, 2002–06

    (Percent)

  • View in gallery

    Emerging Europe: Contributions to Current Account Deficit, 2003–07

    (Percent)

  • View in gallery

    Emerging Europe: FDI Coverage of Current Account Deficit, 2002–06

    (Percent)

  • View in gallery

    Emerging Europe: Change in Current Account Balance and Real Effective Exchange Rate Appreciation, 2003–07

    (Percent)

  • View in gallery

    Emerging Europe: Percentage Change in Export Market Shares in the World Economy, 2002–06 1/

  • View in gallery

    Current Account Model Predictions and Actual Balances in Selected New EU Members

    (Percent of GDP)

  • View in gallery

    Current Account Balances and Model Predictions

    Percent of GDP

  • View in gallery

    Emerging Europe: Ratio of Short-Term Debt (Remaining Maturity) to Foreign Exchange Reserves, 2007

    (Percent)

  • View in gallery

    Emerging Europe: Lending Interest Rate minus Taylor Rule Interest Rate, 2003–07 1/

  • View in gallery

    Emerging Europe: Monetary Conditions Index, 2007 1/

  • View in gallery

    Change in Actual and Structural Fiscal Balances, 2003–07 1/

    (Percent of GDP)

Convergence in Emerging Europe and in the Rest of the World, 2002–06

GDP per Capita and Current Account Balances, 2007

Emerging Europe: Value Added by Sector, Contributions to Real GDP Growth, 2002–06

(Cumulative percentage points)

Emerging Europe: Domestic and External Demand, Contributions to Real GDP Growth, 2002–06

(Cumulative percentage points)

Emerging Europe: Growth Accounting, 2002–06

(Percent per year)

Growth and Private Sector Credit Growth, 2002–06

(Percent)

Emerging Europe: Contributions to Current Account Deficit, 2003–07

(Percent)

Emerging Europe: FDI Coverage of Current Account Deficit, 2002–06

(Percent)

Emerging Europe: Change in Current Account Balance and Real Effective Exchange Rate Appreciation, 2003–07

(Percent)

Emerging Europe: Percentage Change in Export Market Shares in the World Economy, 2002–06 1/

Current Account Model Predictions and Actual Balances in Selected New EU Members

(Percent of GDP)

Current Account Balances and Model Predictions

Percent of GDP

Emerging Europe: Ratio of Short-Term Debt (Remaining Maturity) to Foreign Exchange Reserves, 2007

(Percent)

Emerging Europe: Lending Interest Rate minus Taylor Rule Interest Rate, 2003–07 1/

Emerging Europe: Monetary Conditions Index, 2007 1/

Change in Actual and Structural Fiscal Balances, 2003–07 1/

(Percent of GDP)

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