Fiscal Policy Challenges Facing the New Member States in a Period of Large Capital

Inflows & Substantial Investment Requirements

Armin RiessEuropean Investment Bank

International Seminar for Experts“Catching up after Enlargement”

Cicero FoundationOctober 14-15, 2004

Main questions

Public debt & fiscal deficits that countries

can “afford”?

Role of public investment and other

expenditure?

Role of balance of payments position

(notably capital inflows)?

What do we need to examine?

Key features of CEE economies

Public debt sustainability

Mixed blessing of capital inflows

Real GDP growth projection (in %), 2004

0

1

2

3

4

5

6

7

CZ SL HU SK PL BU RO ES LA LI

Source: European Commission, Economic Forecast, Spring 2004

EU-15 potential

Long-run CEE growth potential 4-5%

Consumer price inflation (in %), 2004

0

2

4

6

8

10

12

LI PL CZ ES SL LA BU HU SK RO

Source: European Commission, Economic Forecast, Spring 2004

2004 CEE average

EU-15/eurozone target

Public debt in CEE & EU-15 (% of GDP), 2004

Source: European Commission, Economic Forecast, Spring 2004

0

20

40

60

80

100

120LU IR

EU

KD

K FI ESSW

E NL

POR FRA

GER BE

L GR IT ES LA LI RO SL CZ

BU SK PO HU

Maastricht 60% criterion

Key features of CEE economies - Summary -

Real economic growth: CEE > EU15

Inflation: CEE > EU15

Nominal economic growth: CEE > EU15

Public debt: CEE < EU15

Public debt sustainability(ad hoc criteria)

Keep public debt/GDP-ratio constant !

Debt/GDP should converge to 60% (Maastricht) !

Debt/GDP should fall to zero(Stability & Growth Pact) !

Debt dynamics

Change in debt/GDP ratio

= fiscal deficit/GDP ratio

– nominal GDP growth • debt/GDP ratio

Fiscal deficit that leaves debt/GDP unchanged

Nominal GDP growth

4% 5% 7%

Fiscal deficit (in % of GDP)

Debt in % of GDP

20% 0.8% 1.0% 1.4%

40% 1.6% 2.0% 2.8%

60% 2.4% 3.0% 4.2%

Where does public investment fit into this picture?

Fiscal deficit can be higher if …

… public investment is large today, but expected to fall in the future.

Is public investment high in CEE?

Public investment in CEE & EU-15 (% of GDP, 1999-2003 average)

Source: European Commission (2003 Spring Forecast) and IMF (Staff Appraisal Reports)

0

2

4

6

8

UK AT

BE

LG

ER

DK IT FI FR

SWE ES

NL PT GR

IRE LU LI

RO SK PL ES

BU

HU LA SL CZ

EU15 average 2.3%

CEE average 3.9%

What about other public expenditure?

High investment today can justify higher fiscal deficit, but …

… other government expenditure may be low today relative to their future level.

Example: public pension expenditure

Public pension expenditure in selected CEE countries (in % of GDP)

Source: European Commission; Occasional Paper 4, July 2003

0

5

10

15

20

CZ HU LI PO RO SL EU

2000 2050

Public debt sustainability - Summary -

Debt sustainability does not imply the same fiscal deficit for all countries

Some government expenditure (investment) may justify higher fiscal deficits, others (pensions) call for fiscal restraint

Public debt sustainability is one thing, macroeconomic stability is another

Capital inflows (in % of GDP)(2001-2003 average for CEE, peak inflow periods otherwise )

0

2

4

6

8

10

12

14

Source: IMF (Staff Appraisal Reports); Begg et al. (2002)

1987-91

1996-91998-9

Capital inflows & current account deficits(in % of GDP, 2001-2003 average)

-2

0

2

4

6

8

10

12

14

HU PL SL ES BU LI RO LA CZ SK

Source: IMF (Staff Appraisal Reports)

Capital inflowsCurrent account deficit

Why do large capital inflows occur?

Higher returns on physical investment

Expected trend appreciation of currency

(Balassa-Samuelson effect)

Why are capital inflows a mixed blessing ?

What’s good: Investment finance higher growth

Too much of a good thing: Overheating of economy (inflation)

Credit boom & banking sector stability

Excessive currency appreciation & competitiveness

How to cope with large capital inflows?

Banking sector stability

Effective prudential regulation & supervision

Overheating of economy Revaluation of exchange rate/exchange rate

flexibility Fiscal austerity

Source: IMF (Staff Appraisal Reports)

-1

1

3

5

ES BU LI LA SL RO SK CZ HU PL

Hard currency pegs

“Flexible” exchange rates

Fiscal deficit & exchange rate regime (% of GDP, 2001-2003 average)

Conclusion

Fiscal policy assessment requires a

country-by-country approach

Coping with ‘dark side’ of capital flows is

key (fiscal) policy challenge

Fiscal policy challenges other than those

concerning the ‘bottom line’