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SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND

Restarting growth in Europe after the Great Recession: CEE vs. other countries

CEEI conference, 26.11.2012

Seppo Honkapohja Bank of Finland

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I. Introduction

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SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND

♦ My objective is to provide an overview of economic growth issues in the CEE countries.

– Discussion relies on comparisons to the EU / Euro area countries.

♦ I first look at the past:

– Did the EU membership facilitate the convergence process by speeding up economic growth in CEE countries?

– Are the per capita GDP levels converging to the EU average in line with the convergence hypothesis?

– How did CA and public sector balances develop in CEE countries?

– What about unemployment in CEE countries vs. other EU/euro countries?

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♦ Second, I consider the impact of the financial crisis on the growth performance of the CEE countries?

– How deep was the decline in GDP caused by the Great Recession?

• How did the CEE countries adjust to the recession relative to other EU / euro countries.

♦ Third, what are the current directions of development in CEE countries?

– Have the CEE countries been able to resume growth?

– How are they doing in terms of export performance?

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SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND

II. Convergence and growth

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♦ Figure 1 shows the ratios of per capita GDP to EU

average from 1995 to 2011. Early period:

– Most CEE countries turned into positive growth in the second half of 1990’s.

– Most countries (Slovenia, Slovak Republic, Poland, Estonia, Hungary, Lithuania, Latvia) had achieved turnaround in growth already in 1995.

– For a few countries (Czech Republic, Bulgaria, Romania) reaching steady positive growth took a few years longer.

♦ EU membership from 2004 seems to have provided a boost to the CEE economies, as rates of convergence accelerated.

– Hungary is an exception here.

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SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND

Per capita GDP, ratio to EU average (PPP)

0 % 10 % 20 % 30 % 40 % 50 % 60 % 70 % 80 % 90 % 100 %

1995 1997 1999 2001 2003 2005 2007 2009 2011

Slovenia

Czech Republic Slovak Republic Poland

Estonia Hungary Lithuania Latvia Bulgaria Romania

Source: World Bank

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♦ The Great Recession led to a short episode of non- convergence toward EU average for most of the CEE countries:

– Some countries continued convergence (Czech Republic, Slovak Republic, Poland, Bulgaria).

♦ In the recovery period GDP convergence was resumed for most CEE countries:

– This is the case for Poland, Slovak Republic, Estonia, Latvia, and Lithuania.

– There is weak convergence for Czech Republic and Bulgaria.

– Divergence has continued for Slovenia, Hungary and Romania.

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SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND

Growth performance

♦ A related but different viewpoint obtains from looking at absolute GDP levels.

♦ Figure 2 considers GDP levels of the euro area, the

high-rated countries, the crisis (or GIIPS) countries and a group of non-euro CEE countries.

– For both the high-rated euro countries and these CEE countries the level of GDP in 2012 is on average higher than the pre-

recession peak.

• These CEE countries have done even better than high-rated euro countries.

• I conjecture that these CEE countries have maintained

competitiveness or done needed adjustments. I will consider adjustments later.

– In contrast, the euro area average level of GDP is currently below the pre-recession peak.

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GDP levels

100 110 120 130 140 150 160

95 100 105 110 115 120 125

2000 2005 2010

High rated countries* GIIPS** Euro area CEE*** (RHS) 2000/I = 100

* Germany, France, Netherlands, Belgium, Austria and Finland

** Greece (11-12 estimate), Italy, Ireland, Portugal and Spain

*** Bulgaria, Czech Republic, Hungary, Poland and Romania Sources: Eurostat and Bank of Finland

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SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND

III. Inflation and cost competitiveness

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♦ Looking at inflation, it is seen that inflation in these CEE countries has been higher than in the euro area.

– This is to be expected by the convergence hypothesis.

– The overheating period saw some widening in the inflation differential.

– There is also some narrowing of the inflation differential right after the 2009 recession.

• Most recently the gap has begun to widen again.

♦ Another notable feature is that there are clear inflation differentials inside the euro area.

– The difference between the high-rated crisis euro countries is visible, except for the recession period in 2009.

– Right now the differential is close to one percent per annum.

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SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND

Inflation

-1 0 1 2 3 4 5 6 7

2005 2006 2007 2008 2009 2010 2011 2012 High rated countries* GIIPS** Euro area CEE***

% change y-o-y

* Germany, France, Netherlands, Belgium, Austria and Finland

** Greece (11-12 estimate), Italy, Ireland, Portugal and Spain

*** Bulgaria, Czech Republic, Hungary, Poland and Romania Sources: Eurostat and Bank of Finland

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♦ The next slide shows the development of unit labor costs from year 2000 to 2012 in the CEE and the GIIPS

countries.

– Until about 2005, there were steady increases in ULC.

• Poland and Lithuania are exceptions.

– In the boom years ULC’s rose a lot, Poland is the exception.

♦ There are big differences in the ULC movements after the boom.

– Some countries have carried out major downward adjustments, notably Latvia, Lithuania, Estonia among CEE countries.

– All GIIPS countries except Italy have also improved.

– A few countries show steady increase, Romania, Bulgaria,

Hungary, Slovenia, Slovakia, and Poland (where level is low).

♦ Adjustments in labor market are occuring.

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SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND

Unit labor costs

0 50 100 150 200 250 300 350 400 450

60 80 100 120 140 160 180 200 220 240

2000 2005 2010

Bulgaria Czech Republic Estonia Ireland

Greece Spain Italy Latvia

Lithuania Hungary Poland Portugal

Slovenia Slovakia Romania (RHS)

Source: Eurostat and European Commission 2000/I = 100

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IV. Imbalances: external, public, private

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SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND

♦ As regards external balances, for most CEE countries CA deficits widened somewhat before the boom and this widening increased significantly during the boom.

– Czech Republic and Poland are exceptions.

– Strong capital inflows led to higher demand for non-tradeables and loss of competitiveness.

– For Baltic countries this development was strongest and resulted in nearly 25% CA deficit in 2006-7 in worst cases.

♦ When the Great Recession hit, the improvements were quite fast, reflecting a sudden stop in capital inflows.

– CA deficits are now in the 0-5 percent range.

– Bulgaria and Romania even have small CA surplus.

♦ In GIIPS countries CA deficits also increased in the

boom, but now the GIIPS countries are adjusting toward balance.

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Current account balances in CEE

-30 -25 -20 -15 -10 -5 0 5 10 15

1999 2001 2003 2005 2007 2009 2011

% of GDP

Hungary Bulgaria Estonia Latvia Lithuania Czech Rep.

Poland Romania

Source: European Commission, ECB and Bank of Finland

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SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND

Current account balances

-8 -6 -4 -2 0 2 4 6

2000 2005 2010

High rated countries* GIIPS** Euro area

% of GDP

*Germany, France, the Netherlands, Belgium, Austria and Finland.

** Greece, Ireland, Italy, Portugal and Spain.

Sources: European Commission, ECB and Bank of Finland calculations.

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♦ Next, I consider fiscal balances of CEE and EU

countries.

♦ The CEE countries are divided into two groups: countries with floating exchange rate and those with a fixed

exchange rate (Baltics and Bulgaria).

– Public sector balances move in tandem in the three groups.

– EU countries and floating CEE countries had deficits in the first half of last decade.

• CEE countries with fixed exchange rate had small deficits or surpluses.

– The deficits became smaller in the boom years 2005-2007.

– In the recession deficits worsened a lot, after which there have been improvements.

– Currently, deficits still prevail in the 2 -4.5 percent range.

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SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND

Public sector balance

-12 -10 -8 -6 -4 -2 0 2

2001 2003 2005 2007 2009 2011

% of GDP

EU (27 countries) CEE - Firm fix CEE - Floating

Source: European Commission and Bank of Finland calculations

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Private sector indebtedness

♦ We already took a look at the current account, which

tells the deficit or surplus in the overall – both private and public – balance of saving minus investments of an

economy.

– During the boom years the current account deficits reflected high private consumption and investments.

♦ What about the private sector imbalances? How has private sector indebtedness developed over time in the CEE vs. the euro area?

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SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND

♦ Since year 2000 private sector debt in the euro area has increased from 130% of GDP to 170%.

– This reflected mainly the developments in the GIIPS countries.

– But indebtedness increased also in the high rated countries

♦ Although the level in the CEE countries is way below the

“old EU countries”, also there the private debt/GDP level increased from 70% to 100% (over 40% / 30 pp).

– Within the CEE countries the differences are large

– In Hungary and Bulgaria the private debt/GDP ratio is almost twice as high (150%) as in Czech and Poland (80%)

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Private sector indebtedness

0 20 40 60 80 100 120 140 160 180 200

2001 2003 2005 2007 2009 2011

High rated countries* GIIPS** Euro area CEE***

% of GDP

Source: European Central Bank.

* Germany, France, Netherlands, Belgium, Austria and Finland

** Greece, Italy, Ireland, Portugal and Spain

*** CEE = Bulgaria, Czech Republic, Hungary and Poland

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SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND

V. Unemployment

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♦ Last part of my overview concerns unemployment.

♦ As is well-known, the CEE countries had relatively high rates of unemployment in the first years of last decade.

– The group of CEE countries here consists of Bulgaria, Czech Republic, Hungary, Poland and Romania.

– It was even higher than average unemployment in the crisis countries of the euro area.

– CEE unemployment crept up initially, but from 2004 onward – when most CEE countries joined the EU – unemployment

started to decline fairly rapidly.

– The boom made the rate of decline in unemployment even faster.

• By 2008 the unemployment rates in these CEE countries was the same as in the euro area.

– Poland dominates the data to some extent.

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SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND

Unemployment

5 7 9 11 13 15 17 19

2000 2005 2010

High rated countries* GIIPS** Euro area CEE***

%

* Germany, France, Netherlands, Belgium, Austria and Finland

** Greece (11-12 estimate), Italy, Ireland, Portugal and Spain

*** Bulgaria, Czech Republic, Hungary, Poland and Romania Sources: Eurostat and Bank of Finland

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♦ After the 2009 recession the CEE unemployment rate climbed above the unemployment rate of the high-rated euro countries.

- but it remained below the euro area average.

♦ Looking at GIIPS countries, the rate of unemployment went below that of the high-rated euro countries in 2004.

- Unemployment in GIIPs countries shot up in the recession.

- It has continuously increased ever since.

♦ Overall, unemployment development in the CEE

countries, shows their ability to carry out adjustment.

- Adjustment in CEE was substantial. The figure does not include Baltics, which we know adjusted very fast.

- In contrast, GIIPS countries have had difficulties. Adjustment are gradual.

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SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND

♦ Part of the ability to carry out domestic adjustments is connected to the degrees of market regulation and rigidities.

– The CEE countries have more flexibility in labor market regulation (OECD index of employment protection).

– The CEE countries (shown in red) tend to have lower degree of regulation. Comments:

• Data is missing for some CEE countries.

• Ireland, the Nordics and the Netherlands have also low degrees of employment protection.

• Other GIIPS countries are among the more regulated economies.

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Labor market regulation

0 1 2 3 4

OECD employment protection index

Source: OECD

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SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND

♦ An indicator of product market regulation tells a similar

story

.

- CEE countries that belong to OECD tend to have low regulation. Poland is an exception.

♦ There exist, of course, a variety of indicators about

business conditions. Ease of Doing Business rankings:

- Performance of the CEE countries shows wide variation in this respect.

- The Baltics and Slovenia do well, while several more central and southern countries (Bulgaria, Romania, Hungary,

Poland) get a relatively low score on par with Italy and Portugal.

♦ The EBRD transition indicator shows an improving trend in financial systems for most CEE countries.

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Regulatory impact

0,0 0,1 0,2 0,3 0,4 0,5

Wholesale and retail trade; repairs

Source: OECD

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SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND

VI. Openness and integration

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♦ Finally, I take a look at the future in terms of openness and foreign trade.

♦ The CEE countries have been open economies with export/GDP ratios mostly 40-70 percent range in years 2000-2004.

– In this period there are no clear trends on average.

♦ After joining the EU, these countries have on the whole become even more open.

• Romania and Estonia are exceptions to some extent.

– This can be contrasted with the degree of openness of the GIIPS countries.

• The average export/GDP ratio of GIIPS has remained constant around 30 percent in the period 2000-2007.

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SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND

Exports/GDP

0 10 20 30 40 50 60 70 80 90 100

2000 2002 2004 2006 2008 2010

% of GDP

Estonia Hungary

Slovak Republic Lithuania

Czech Republic Slovenia

Bulgaria Latvia Poland GIIPS Romania

Source: Eurostat and Bank of Finland calculations

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♦ There was some decline in openess in the recession.

– Export shares of Poland, Romania and Latvia did not decline in the recession.

♦ The recovery years 2009-2011 show a remarkable

increase in exports/GDP ratio for most CEE countries.

– Poland and Romania are exceptions here.

– Development in the GIIPS countries different in this period.

• The average export/GDP ratio is basically flat at 30 percent.

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SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND

♦ I next look at the destinations of the CEE exports.

– The share of CEE exports to the euro area has mostly been on a declining trend.

• The 2009 recession was an exception, but trend has reappeared after it.

– Exports to EU give a partly different picture (not shown).

• For some countries this share has increased,

• for others (Czech, Hungary, Latvia, Lithuania) there is a decreasing trend.

– Looking at export destinations in more detail reveals that Russia’s role has been increasing for most CEE countries.

• Slovakia and Slovenia are exceptions here.

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Share of exports going to the euro area

25 % 30 % 35 % 40 % 45 % 50 % 55 % 60 % 65 % 70 % 75 %

2002 2004 2006 2008 2010

Czech Republic Hungary

Poland Slovenia Romania

Slovak Republic Bulgaria

Estonia Lithuania Latvia

Source: IMF Direction of Trade database

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SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND

Conclusions

♦ It is comforting that the CEE countries have, on the whole, been able to resume growth after the Great Recession.

♦ The necessary ability to adjust downward was in place, so that the adverse consequences of the recession were relatively moderate.

♦ The important sources that have helped the adjustment are:

– The labor and product markets were relatively flexible.

– The levels of private and public indebtedness were lower than in other European countries, especially GIIPS countries.

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♦ As regards the future, it must be emphasized that these economies are open, so that success in foreign trade is critical:

– the current export performance shows improvement,

– and share of exports to euro area is going down indicating perhaps some more diversity.

♦ This performance suggests that the outlook for most CEE countries is comforting.

♦ Maintaining and improving competitiveness of the

economy is the key challenge to CEE countries.

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SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND

Thank you!

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