bank of greece erik berglof 11 february 2011. 2 the transition region’s pre-crisis growth model...

Bank of Greece

Erik Berglof

11 February 2011

2

The transition region’s pre-crisis growth model

Vigour… or just bubbles?

TR 2010: Recovery and Reform – Outline

1. Overview: the argument in a nutshell

2. Developing local currency finance

3. Building export capacity

4. Improving the business environment

South-east Europe 2011: Recovery finally

-8%

-6%

-4%

-2%

0%

2%

4%

6%

8%

10%

Alb

ania

Bo

snia

Bu

lgar

ia

Cro

atia

FY

RM

aced

on

ia

Mo

nte

neg

ro

Ro

man

ia

Ser

bia

Tu

rkey

2009 2010 2011

* EBRD growth forecasts as of 21st January 2011.

*

6

Time to draw lessons from a decade of boom and bust …

Pre-crisis the EBRD region grew as fast as Asia…

…but with high current account deficits…

…resulting in precipitous drop in growth in 2009

Emerging Asia

Latin America

Middle East

EBRD region

7

Does the transition region need to reinvent its approach to growth after the crisis?

New Growth Agenda

for both stronger and safer growth

No “new growth model” But need to address key weaknesses:

Incomplete reforms; unbalanced growth; financial fragilities

Build local currency finance and capital markets Remove obstacles to export growth Improve the business environment

8

Reform areas

A New Growth Agenda

Developing domestic capital markets and local currency finance

Strengthening export growth

Improving business environment

Objectives

Safer growth

Stronger growth

Less FX in credit

Innovation

Improve current account

Developing local currency finance: rationale

increase sources of domestic funding lower dependence on foreign capital inflows

A way of deepening local capital markets

increase share of local currency lending reduce unhedged FX borrowing

De-euroisation/De-dollarisation

Few countries use mainly local currency

0102030405060708090

100

Cro

ati

a

Cze

ch

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p.

Es

ton

ia

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ary

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Tu

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y

Arm

en

ia

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ijan

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laru

s

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org

ia

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ia

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rain

eK

aza

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sta

n

Ky

rgy

zR

ep

.

Ta

jikis

tan

Loans Deposits

CEB ¦ SEE + Turkey ¦ EEC + Russia ¦ CA

Percent of local currency loans and deposits, 2009

g

Low local currency use: longstanding problem

0

20

40

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80

100

Cro

ati

a

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ton

ia

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ep

ub

licB

os

nia

an

dH

erz

.

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lga

ria

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RM

ac

ed

on

ia

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ma

nia

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y

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en

ia

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rba

ijan

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laru

s

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org

ia

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ss

ia

Uk

rain

e

Ka

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tan

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rgy

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ep

ub

lic

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tan

2001 2005 2008

Per cent of all loans

CEB ¦ SEE + Turkey ¦ EEC + Russia ¦ CA

Declines in local currency use: Hungary and Latvia

Increases in local currency use: Turkey, Armenia, and Kazakhstan

Proximate cause: high LC borrowing costs

European countries: LC-FX lending rate spread, 2006-10

-6-4

-20

246

810

1214

Ju

n 0

6

Oc

t 0

6

Fe

b 0

7

Ju

n 0

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t 0

7

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b 0

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b 0

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n 0

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t 0

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Fe

b 1

0

Ju

n 1

0

Albania Estonia Hungary Lithuania

FYR Macedonia Poland Romania

However, this reflects the risk of devaluation

Key question:

Why so many unhedged firms and households take the FX risk?

Potential factors inducing FX risk-taking

1. FX loans too cheap → Deep cause: lack of local financial development

combined with abundant foreign funding

2. FX risk lower individually than socially implicit bailout guarantees; externalities of insolvency

→ Deep cause: distortions

3. FX borrowing risky, but LC borrowing even riskier High ex-post real rates if inflation lower than expected.

→ Deep cause: lack of macro stability

Potential causes for lending in FX

16

Policy remedy

Under-pricing of FX risk

Lack of financial development

Lack of macro stability

Regulation

Local capital market development

Macro stabilisation + institution-building

Diagnosis and policy remedy: country-specific

Big differences in macroeconomic stability

Predictability of Inflation, 2000-2010

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2

4

6

8

10

12

Cro

ati

a

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ch

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ton

ia

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tvia

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an

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lan

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va

k

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ve

nia

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an

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lga

ria

FY

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ma

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ija

n

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laru

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org

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ldo

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rain

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zak

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tan

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rgy

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oli

a

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jik

ista

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rkm

en

ista

n

Uzb

ek

ista

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RMSE of 1 year forecast RMSE of 2 year forecasts

Percentage points

RMSE: Root Mean Square Errors; based on inflation predictions from the IMF’s World Economic Outlook, 2000-2010

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UK

Po

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ania

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rkey

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man

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atia

Bu

lgar

ia

Ser

bia

Alb

ania

FY

RO

M

BiH

Ru

ssia

Geo

rgia

Ukr

ain

e

Arm

enia

Mo

ldo

va

Aze

rbai

jan

Bel

aru

s

Kaz

akh

stan

Mo

ng

olia

Uzb

ekis

tan

Kyr

gyz

Rep

ub

lic

Taj

ikis

tan

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rkm

enis

tan

FX forward market liquidityMoney market liquidity (up to 3 months)Money market interest rate benchmark

28

CEB SEE + Turkey EEC + Russia CA

New EBRD index:

Money market development varies greatly

New EBRD index:

Government bond markets also vary

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Germ

any

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erland

s

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eden

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ain

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mark

Po

rtug

al

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land

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ng

ary

Lith

uan

ia

Latvia

Esto

nia

Tu

rkey

Bu

lgaria

Ro

man

ia

Alb

ania

Cro

atia

FY

RO

M

Serb

ia

BiH

Ru

ssia

Ukrain

e

Arm

enia

Mo

ldo

va

Azerb

aijan

Geo

rgia

Belaru

s

Kazakh

stan

Kyrg

yzstan

Mo

ng

olia

Uzb

ekistan

Tajikistan

Tu

rkmen

istan

Advanced EuropeanMarkets

CEB SEE + Turkey EEC + Russian Fed. CA

Primary Market Development Secondary Market Development Secondary Market Liquidity

493 153 35 30 26

TurkmenistanTajikistan

AzerbaijanMongolia

KazakhstanUkraine

Moldova

Kyrgyz Rep

Belarus

FYROM

Latvia

BulgariaLithuania

ArmeniaGeorgia

UzbekistanAlbania

Croatia

Romania

Hungary

Turkey

Russia

Poland

0123456789

10

0 2 4 6 8 10

Inflation prediction (RMSE) in Percentage Points

Mon

ey a

nd B

ond

Mar

ket

Dev

elop

men

t

Share of Foreign Currency in Loans and deposits

≥ 75%40-75%≤ 40%

Mapping obstacles to local currency finance

20

LC development vs. FX risk management

In highly euroised countries, LC market development without exchange rate flexibility is not plausible (Latin American experience)

Hence, countries that are firmly committed to hard pegs will need to live with Euroisation, and manage its risks

bigger onus on regulation; country insurance mechanisms to cover FX liquidity gaps in a

crisis and prevent amplification of FX shocks

A framework for country-specific reform

Hard peg in anticipation of Euro?

No Yes

Macro-institutional credibility meets minimum standards

Further reform macro institutions (including monetary policy frameworks); build track record; Further develop local currency markets Develop regulation;Hungary, most south-eastern European countries; Armenia, Georgia, Russia

Develop regulation Fiscal consolidation/reformsBaltics; Bulgaria

Macro-institutional credibility weak

Reform macro institutions; build track record; Country insurance.Ukraine; Central Asia, some Western Balkans countries

Building export capacity: rationale

lower current account deficits lower dependence on foreign capital inflows

More balanced growth

link between exports and innovation

Strengthen long run growth

But which way did the causality run? More innovative firms are better exporters, or Exports help innovation (e.g., larger market to recoup costs)

• US and German data: causality runs from productivity to exporting

• Emerging markets: Exporting makes firms more productive/innovative– Aw, Chung, Roberts (2000) for Korea and Taiwan;

Hallward-Driemeier et al (2005) for East Asia; Jiang et al (2009) for China

– De Loecker (2007) for Slovenia

Which way causality runs – the evidence

Substantial effect, especially for R&D spending

Marginal probability of innovation

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R&D spending (leftscale)

Product innovation(right scale)

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Exp

orte

r

Exp

orte

r

Non

-Exp

orte

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Non

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orte

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Pre-crisis: exports remarkably successful…

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China EBRDregion

China EBRDregion

0.000.02

0.040.060.08

0.100.120.14

0.160.18

Share of world exports (left scale)

Export market concentration (right scale)

Source: IMF, Direction of Trade Statistics.

200

02

008

200

02

008

200

02

008

200

0

200

8

28

… but past export growth drivers are fading

ULC grew much faster

2007 average trading partner tariff only 5.5%

2010-15 trading partner to grow 1 percentage point lower than before crisis

Labour costs elsewhere in the CEE catching up with advanced countries

Tariffs already low, few further gains from trade arrangements

Slower projected growth

of large trading partners

-1 1 3 5 7 9 11

LatviaRomania

EstoniaLithuaniaHungaryBulgaria

MexicoSlovenia

Slovak Rep.Korea

PolandBrazil

Multiple of U.S. ULC growth, 2001-2008

29

Invigorating exports requires structural reforms

Statistical analysis points to three key policy instruments:

reducing or adapting to non-tariff barriers increasing efficiency of customs reducing corruption and entrench rule of law

Basis: panel regression of real export growth on institutional indicators, tariff barriers, nontariff barriers, and controls (average trading partner real GDP growth, real effective appreciation); 130 countries; 1999-2009.

30

Top priorities to improve export-friendliness*

* Based on deviations from mean values

Improving the business environment (BE)

Of course! Defined as everything that may matter for growth – from institutions to education to finance

Key to long run growth

BEEPs may help, by ranking constraints from the perspective of entrepreneurs.

But there are significant hurdles

But which aspect?

BEEPS as a guide to reforms: problems

Tax rates, credit constraints1. Not all “constraints” reflect public goods

E.g. fast growing firms may complain more

2. Differences in demand for public goods

3. Different “reference points” or propensities to complain across countries and perhaps constraints E.g. Montenegro vs. Serbia

4. Relating perceived constraints to actual reforms

Approach in TR 2010.

Ignore tax rates, credit constraints

1. Focus on 10 constraints that represent public goods

De-mean reported constraints using firm means2. Focus on relative perceived constraints

3. Adjust for firm characteristics Establish relative perceived constraints of a

representative firm in each country

4. Relate adjusted constraints to actual reforms via comparisons of similar countries; identifying significant changes over time; and regression analysis.

Note: 1 and 3 follows Carlin and Shaffer (2010)

Example: Absolute BEEPS scores suggest Montenegro much better than Serbia in all areas …

-1

-0.8

-0.6

-0.4

-0.2

0

0.2

Infr

astr

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ure

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cces

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Ski

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vaila

bili

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Tax

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or

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ula

tio

n

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sto

ms

Lic

ence

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urt

s

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on

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me

Montenegro Serbia

Ab

solu

te c

on

stra

int

seve

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nc

e w

rt s

ev

eri

ty i

n a

vg

co

un

try

wit

h s

am

e

GD

PP

C

…while relative constraints highlight priority business concerns in both countries

-0.2

-0.1

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0.1

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Infr

astr

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ence

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Montenegro Serbia

Rel

ativ

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ty

%

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co

ns

tra

int

se

ve

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in

ea

ch

co

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try

0

5

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Ski

lls

Cor

rupt

ion

Tax

Adm

inis

trat

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Infr

astr

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re

Crim

e

Labo

rR

egul

atio

n

Lice

nce

Land

acc

ess

Central Europe and Baltics (CEB) South-eastern Europe (SEE) and Turkey

Eastern Europe and Caucasus (EEC) and Russia Central Asia (CA)

Relative score method reveals skills availability and corruption as top constraints

Number of countries where a constraint is among top three concerns

Cross-country and over-the-time analysis help identify examples to follow within regions

Tax administration: Estonia Corruption since 1999: Georgia

Re

lativ

e s

eve

rity

of

tax

ad

min

istr

atio

n c

on

stra

int

Ch

an

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in r

el.

seve

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of

corr

up

tion

co

nst

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t, ’9

9-’0

8

Spend more and BETTER on education

– Skills constraint more binding in richer countries – Traditional education measures do not necessarily

relieve skills constraint– Labour with primary / secondary / tertiary education– Expenditure on primary / secondary education– Literacy rate– Primary education completion rate– Public education spending

Ensure schools provide relevant education

40

No complacency: now is time to reform Urgent need to enhance the growth model to avoid

serious post-recovery risks Particularly if capital inflows pick up again

Structural reforms to boost growth in a tougher environment

Prepare for sustainable long-term growth

Thank you

Backup slide: assets of insurance corporations and pension

funds

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Per cent of GDP

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55US$ billion

Assets as a share of GDP US$ value of assets

2,347 423 110

Weakness (1): incomplete reforms -

CROSVNLAT

LIT

RUS

TKM

UZBBEL

TAJ

AZE

BIH

KYRMON

SRBKAZ

FYRUKR

GEOMDVMNE

ARMALB

TURROMBGRSVK

POLEST

HUN

1

1.5

2

2.5

3

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4.5

1 1.5 2 2.5 3 3.5 4 4.5

Traditional country-level transition indicators

Ne

w E

BR

D s

ecto

r in

dic

ato

rs

43

44

Weakness (2): unbalanced growth

45

Weakness (3): financial sector fragilities

Relative BEEPS score for business

environment aspect i, firm j

jj CC /)

10/

iijj CC

ijC(

Computing relative scores

Absolute (raw) BEEPS score for

business environment

aspect i, firm j

ijC

1. Absolute score comparisons are impossible

2. Removes firm-level tendency to complain

Firm-level mean calculated from the 10 relevant

constraint area scores

Remove firm-level mean score

bank of greece erik berglof 11 february 2011. 2 the transition region’s pre-crisis growth model...

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