Regional Outlook: New EU members from Central and Eastern Europe

Anchoring Policies in Uncertain Times

Fall 2006

Susan SchadlerEuropean DepartmentInternational Monetary Fund

Questions

I. How does economic performance in the region shape up by emerging market standards

II. Does this performance warrant markets’ relatively favorable perception of risks

III. What are the policy imperatives given the opportunities, risks and uncertainties facing the region?

Conclusions

• By emerging market (EM) standards, economic performance in CECs is good, but not in class of its own.

• Markets, however, view the CECs in something of a class apart.

• Keeping this good will as euro adoption schedules lengthen and risks rise will require strong, clearly communicated policy anchors,

• But euro adoption remains an irreplaceable opportunity to boost trade and growth and exit growing forex risk.

The global environment, though strong, is becoming more uncertain.

0

1

2

3

4

5

6

7

2001 02 03 04 05 06 07

90% confidence interval70% confidence interval

50% confidence intervalBaseline forecast

Global economic conditions are unusually favorable though downside risks have increased

Source: WEO

Drivers of global growth to shift slightly from US toward Europe, Japan and EMs

0

2

4

6

8

10

12

2001 02 03 04 05 06 07

UnitedStates

Japan

Euro area

China

Real GDP Growth, 2001-07

Source: WEO

Inflation has risen in advanced economies, but should slow in 2007 as oil prices flatten, US economy cools.

-4

-2

0

2

4

6

8

2001 02 03 04 05 06 07

Headline Inflation

UnitedStates

Euro area

Japan

0

20

40

60

80

100

2001 02 03 04 05 06 07 08

Implied futures priceat Aug. 23, 2005

Implied futures priceat Aug. 31, 2006

Oil price--Spot and Futures

Source: WEO

-15

-10

-5

0

5

10

15

1997 99 2001 03 05 07 09 11-2.0

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

1997 99 2001 03 05 07 09 11

Global imbalances still pose substantial risks (Percent of world GDP)

United States Euro area

Japan Emerging Asia

Oil Exporters

Current Account Balance Net Foreign Assets

Source: WEO

I. How does CEC macro picture compare to other EMs?

• Relatively strong growth and low inflation

• But with low savings and high investment, CECs use foreign savings heavily

• This affects the risk profile in three main ways

-Large current account deficits (as other EMs shift to surpluses)

-CECs attract FDI as in other EMs, but private (mostly bank) inflows outpace other EMs

-Growing external indebtedness, household forex exposure

Growth in the CECs has been impressive …

-20

24

68

10

2001 2004 2007 2001 2004 2007 2001 2004 2007 2001 2004 2007

CEECs East Asia Latin America Other EMs

Gro

wth

of R

egio

nal R

eal G

DP

per

capita (

perc

ent)

Real Growth of Regional GDP per capita

Source: WEO

…and average inflation is low.2

46

810

12P

erce

nt

2001 2002 2003 2004 2005 2006 2007

CEECs East AsiaLatin America Other EMs

(Unweighted Average, in percent, 2001-2007)Average CPI Inflation

Source: WEO

Large current account deficits stand out

-50

5-5

05

1998 2001 2004 2007 1998 2001 2004 2007

CEECs East Asia

Latin America Other EMs

Cur

rent

Acc

ount

Bal

ance

(%

of G

DP

)

unweighted average; in percent of GDP; 1998-2007Average Current Account Balance

Source: WEO

Why are CECs different? Low savings and high investment

produce predominantly private sector imbalances.

Source: WEO

010

2030

4050

Perc

ent o

f GD

P

Jord

anSo

uth

Afric

aR

oman

iaPe

ruH

unga

ryBu

lgar

iaPa

kist

anLi

thua

nia

Col

ombi

aPo

land

Phili

ppin

esEs

toni

aTu

rkey

Isra

elEg

ypt

Slov

ak R

epub

lic Latv

iaM

exic

oBr

azil

Arge

ntin

aIn

done

sia

Chi

leC

zech

Rep

ublic

Slov

enia

Mor

occo

Indi

aTh

aila

ndVe

nezu

ela

Rus

sia

Kore

aM

alay

sia

Chi

na

In percent of GDP, Average 2004-2006Gross National Saving

010

2030

4050

Perc

ent o

f GD

P

Chi

naLa

tvia

Indi

aTh

aila

ndE

ston

iaK

orea

Slo

vak

Rep

ublic

Cze

ch R

epub

licB

ulga

riaTu

rkey

Slo

veni

aM

oroc

coLi

thua

nia

Hun

gary

Jord

anR

oman

iaIn

done

sia

Chi

leM

exic

oM

alay

sia

Arg

entin

aR

ussi

aB

razi

lP

olan

dC

olom

bia

Pak

ista

nS

outh

Afri

caIs

rael

Egy

ptP

eru

Phi

lippi

nes

Vene

zuel

a

In percent of GDP; Average 2004-2006Gross Investment

FDI is large, but private (mainly bank) inflows stand out

-20

24

6-2

02

46

1991 1994 1997 2000 2003 1991 1994 1997 2000 2003

CEECs East Asia

Latin America Other EMs

Portfolio Equity Public Debt

Private Debt FDI

Source: World Bank, Global Development Finance Database.

In percent of GDPNet Capital Flows to Emerging Markets, 1991-2004

Inflows finance credit to private (esp. hh) sector. Growth rate, increasing forex exposure stand out

-20 0 20 40 60

ESTONIALATVIA

LITHUANIAVenezuela

TurkeyBULGARIA

JordanROMANIA

SLOVAK REPUBLICBrazilIndia

ArgentinaRussia

SLOVENIACZECH REPUBLIC

ColombiaHUNGARY

PeruSouth Africa

ChileMexico

MoroccoIsrael

IndonesiaPOLAND

ChinaMalaysiaPakistan

Korea, Republic ofThailand

EgyptPhilippines

(2005; In percent)EMs: Real Growth of Bank Credit to Private Sector

Source: WEO

External debt is growing in contrast to other EMs(in percent of GDP)

-20

020

4060

-20

020

4060

1998 2001 2004 20071998 2001 2004 2007

CEECs East Asia

Latin America Other EMs

Gross External Debt Net External Debt

Note: Net external debt is the gross external debt net of foreign assets in central banks and the banking sector.Source: WEO and IFS

II. How do markets view the high growth/high private sector imbalance

situation in CECs?

Different markets tell different stories. But broadly

• Market view improved steadily relative to other EMs during 2003-04 (later in Bulgaria, Romania)

• Perception gap leveled off during 2005

• EM sell-off in spring 2006 affected most CECs, but generally not harshly

• CECs maintain an edge over other EM groups (lower spreads on external debt), but this edge has diminished

CEC equities have outperformed EMs since 2003, though since mid-2005

gap has narrowed10

020

030

040

050

060

0

Jan01 Jan02 Jan03 Jan04 Jan05 Jan06 Jan07date

CEECs East AsiaLatin America Other EMs

(Unweighted Average, by region; Local Currency; Jan 2001=100)Emerging Markets: Equities Indices

Source: Bloomberg

So have currency values against the dollar

9010

011

012

013

0

Jan03 Jul03 Jan04 Jul04 Jan05 Jul05 Jan06 Jul06

CEECs East AsiaLatin America Other EMs

(Unweighted Average; Jan 2003=100; Increase=Appreciation)Emerging Markets: Currencies Against US$

Source: Bloomberg

External debt spreads fell especially rapidly during 2004, but then rose relative to other

EMs25

5010

025

050

010

00E

xter

nal D

ebt S

prea

d (b

asis

poi

nts)

Jan01 Jan02 Jan03 Jan04 Jan05 Jan06 Jan07

NMS East AsiaLatin America Other EMsBulgaria Romania

(Unweighted Average; log scale)Emerging Markets: External Debt Spreads

Source: Bloomberg

CECs were not immune from Spring 2006 EM sell-off, but debt markets less affected than currencies or equities

Source: Bloomberg

25

50

100

200

400

Jan06 Feb06 Mar06 Apr06 May06 Jun06 Jul06 Aug06 Sep06

May 10, 2006 -->

(in basis points; log scale)External Debt Spreads

25

50

100

200

400

Jan06 Feb06 Mar06 Apr06 May06 Jun06 Jul06 Aug06 Sep06

May 10, 2006 -->

(in basis points; log scale)5-year CDS Spreads

80

85

90

95

100

Jan06 Feb06 Mar06 Apr06 May06 Jun06 Jul06 Aug06 Sep06

May 10, 2006 -->

(May 10, 2006=100)Equity Indices

92

94

96

98

100

Jan06 Feb06 Mar06 Apr06 May06 Jun06 Jul06 Aug06 Sep06

May 10, 2006 -->

(May 10, 2006=100)Currencies Against US$

CECs

East Asia

Other EM

Latam

CECs

Other EMEast Asia

Latam

CECsCECs

East Asia

East Asia

Latam

Latam

Other EM

Other EM

Do markets differentiate CECs because of “fundamentals”? What are

“fundamentals”?Economic Risk

•GDP per capita•Real GDP Growth•Inflation•Budget Balance•Current Account Deficits

Political Risk

Index based on 12 political and socio-economic conditions

Financial Risk

•External debt/GDP•External debt service ratio•Current account/ exports•Official reserves/ imports•Exchange rate stability

Global Financial Conditions

•Implied volatility index•30-day Fed Fund futures rate•Volatility of Fed Fund futures

Econometric analysis asks how much of debt spreads are explained by

“fundamentals”• Analysis establishes relationship of debt spreads to

“fundamentals” using data from 26 Ems

• Separates each country’s spread into two parts:

-that explained by “fundamentals”

-that not explained by “fundamentals”

• The part not explained by fundamentals reflects some non-quantifiable influence on markets’ perception of risk—e.g. EU membership or prospects for euro adoption.

Results show markets differentiate CECs beyond what “fundamentals”

warrant-5

000

500

1000

1500

Bas

is P

oint

s

01 02 03 04 05 06 07

CEECs East AsiaLatin America Other EMs

Average Residuals, by region

All CECs enjoy the regional advantage which seems to have stabilized at about 100 bps…

-50

0-2

50

02

50

50

0-5

00

-25

00

25

05

00

Jan01Jan02Jan03Jan04Jan05Jan06 Jan01Jan02Jan03Jan04Jan05Jan06 Jan01Jan02Jan03Jan04Jan05Jan06

Bulgaria Hungary Lithuania

Poland Romania Slovak Republic

Res

idua

ls in

bas

is p

oint

s (i

nclu

ding

cou

ntry

fixe

d ef

fect

s)

Residuals in basis points

..and seem not to be influenced by receding euro adoption prospects.

2007 2007 2007 2007 2007 2007 2007 20072008

20092008 2008 2008

2009 2009

2007 2007 20072008

2009 2009 2009 2009 20092010 2010 2010 2010 2010 2010

20102012 2012 2012 2012

20102012 2012 2012

2013

2005

2010

2015

2005

2010

2015

2005

2010

2015

Aug05 Nov05 Feb06 May06 Aug06

Aug05 Nov05 Feb06 May06 Aug06Aug05 Nov05 Feb06 May06 Aug06

Slovenia Lithuania Latvia

Estonia Slovak_Republic Czech_Republic

Poland Hungary

Median Value of the ResponsesREUTERS Polls on Euro Adoption Date

Source: Reuters

Summarizing the picture so far

• Strong economic performance

• Classic risks from private sector imbalances— investment-savings gaps, rising indebtedness fed by rapid growth of bank credit

• Markets appear impressed by the strong growth but not concerned by large imbalances.

• Sine qua non in this high risk/high return strategy is to meet market expectations for sustained, strong growth

III. What policy anchors can reinforce market good will, sustain growth?

• Euro adoption

-medium-long term boost for trade, growth

-eliminate emerging market risk premium

-exit strategy from growing private sector forex exposures

• But with euro adoption schedules receding, it is losing its value as a near-term benchmark

• Markets to judge CECs increasingly on conventional policy anchors

Policy anchors must work in tandem to achieve five policy goals

• Low inflation (inflation targeting/currency board)

• Moderate current account deficits (restraining fiscal policy)

• Financial sector soundness (supervision)

• Transparent risk (transparency of public and private accounts)

• Competitive business environment (low wage and nonwage costs of doing business)

Inflation targeting/currency boards anchor wage/price expectations…

05

1015

Israe

lM

oroc

coPO

LAND Ch

ina

LITH

UANI

ACZ

ECH

REPU

BLIC

Chile

Peru

Mal

aysia

SLOV

ENIA

Kore

a, R

epub

lic o

fSo

uth

Afric

aES

TONI

AM

exico

Thai

land In

dia

HUNG

ARY

Jord

anSL

OVAK

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CCo

lom

bia

Braz

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LGAR

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Philip

pine

sPa

kista

nEg

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Turk

eyAr

gent

ina

ROM

ANIA

Indo

nesia

Russ

iaVe

nezu

ela

2004-06Average Inflation

Source: WEO

…but, with open capital accounts, are inefficient in

• Curbing surges in capital inflows

• Reducing large current account deficits

• Sustaining competitiveness

• Addressing risks of private sector forex exposure

Fiscal policy: most CECs have stabilized public debt ratios at

moderate or low levels

Source: WEO

510

1520

2530

Publ

ic D

ebt i

n pe

rcen

t of G

DP

2002 2003 2004 2005 2006

Slovenia Czech RepublicLithuania RomaniaLatvia Estonia

Low Public Debt CECs

3040

5060

70Pu

blic

Deb

t in

perc

ent o

f GD

P

2002 2003 2004 2005 2006

Hungary PolandSlovak Republic Bulgaria

High Public Debt CECs

But in some, rising debt or insufficient credibility requires more than

discretionary policy

Fiscal responsibility laws are increasingly used in other EMs to sustain/signal

commitment

– Expenditure or deficit ceiling– Fiscal transparency code– Medium-term budgeting commitment

And when growth is strong and private imbalances large, fiscal policy needs to go beyond debt stabilization

In boom conditions fiscal policy becomes the sole macroeconomic policy instrument that can

• Relieve demand pressures

• Contain current account deficit

• Limit appreciation

Challenges to financial sector soundness increase the stakes for supervision

0.2 0.7 0.9 1.2 1.3 1.4 1.7 2.0 2.1 2.1 2.2 2.5 2.9 3.03.9 4.1 4.1

4.7 4.9 5.25.8

7.78.3 8.3

8.99.810.3

13.6

15.615.7

20.0

25.0

05

1015

2025

ES

TON

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Chi

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pt

Note: Data may not be fully comparable across countries due to regulatory differences

(2005; In Percent of Total Loans)EMs: Nonperforming Loans Household Financial Leverage

(In percent)

0

5

10

15

20

25

30

35

2000 2001 2002 2003 2004 2005

Sources: GFSR September 2006Note: Household leverage is defined as the ratio of household liabilities to household assets.Sources: WEO and PDR

Hungary

Czech Republic

Poland

Turkey

Transparency—there can’t be too much

• No ready measures of transparency

• Wide agreement that deficiencies were central to Asian currency crises in the 1990s

• Key is to ensure that risks are clear to investors and leveraged residents

• Ensure that public accounts are clear, complete

• Guard against impressions of implicit guarentees

Preserving competitiveness: wages and other costs of doing business

16 17 18 23 24 25 26 28 2936

43 49 52 5461 65 66

74 75 78 7991 93 96101

115121126134135

164165

050

100

150

200

LITH

UAN

IAES

TON

IATh

aila

ndKo

rea,

Rep

ublic

of

LATV

IAM

alay

sia

Isra

elC

hile

Sout

h Af

rica

SLO

VAK

REP

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exic

oR

OM

ANIA

CZE

CH

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Mor

occo

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ilPh

ilipp

ines Indi

aIn

done

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ypt

2006Rank of Ease of Doing Business Indicators

050

01,

000

1,50

02,

000

2,50

0

Indo

nesi

a

Chin

a

Bulg

aria

Rom

ania

Mal

aysi

a

Slov

ak R

epub

lic Pola

nd

Hung

ary

Czec

h Re

publ

ic

Slov

enia

Kore

a, R

epub

lic o

f

in US Dollars; 2005Average Wage in Manufacturing Sector

Source: World Bank’s Doing Business IndicatorsSource: National Statistical Offices

Conclusions

• Economic performance in CECs is good by EM standards, but not in class of its own.

• Markets, however, view the CECs in something of a class apart. CEC edge is shrinking but still significant.

• To keep this good will as euro adoption prospects recede, policy anchors need to be clearly communicated/oriented toward sustaining high growth.

• Euro adoption is a major opportunity and should remain a key goal of policy