Fiscal Policy Challenges Facing the New Member States in a Period of Large Capital Inflows & Substantial Investmen

1. International Seminar for Experts “Catching up after Enlargement” Cicero Foundation October 14-15, 2004 Fiscal Policy Challenges Facing the New Member States in a Period of Large Capital Inflows & Substantial Investment Requirements Armin Riess European Investment Bank

2. 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)?

3. What do we need to examine? • Key features of CEE economies • Public debt sustainability • Mixed blessing of capital inflows

4. Real GDP growth projection (in %), 2004 Long-run CEE growth potential 4-5% EU-15 potential Source: European Commission, Economic Forecast, Spring 2004

5. Consumer price inflation (in %), 2004 2004 CEE average EU-15/eurozone target Source: European Commission, Economic Forecast, Spring 2004

6. Public debt in CEE & EU-15 (% of GDP), 2004 Maastricht 60% criterion Source: European Commission, Economic Forecast, Spring 2004

7. Key features of CEE economies - Summary - • Real economic growth: CEE > EU15 • Inflation: CEE > EU15  Nominal economic growth: CEE > EU15 • Public debt: CEE < EU15

8. Public debt sustainability(ad hoc criteria) • Keep public debt/GDP-ratio constant ! • Debt/GDPshould converge to 60% (Maastricht) ! • Debt/GDP should fall to zero (Stability & Growth Pact) !

9. Debt dynamics Change in debt/GDP ratio = fiscal deficit/GDP ratio – nominal GDP growth • debt/GDP ratio

10. Fiscal deficit that leaves debt/GDP unchanged

11. 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?

12. CEE average 3.9% EU15 average 2.3% Public investment in CEE & EU-15(% of GDP, 1999-2003 average) Source: European Commission (2003 Spring Forecast) and IMF (Staff Appraisal Reports)

13. 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

14. Public pension expenditure in selected CEE countries(in % of GDP) Source: European Commission; Occasional Paper 4, July 2003

15. 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

16. Capital inflows (in % of GDP)(2001-2003 average for CEE, peak inflow periods otherwise ) 1998-9 1996-9 1987-91 Source: IMF (Staff Appraisal Reports); Begg et al. (2002)

17. Capital inflows & current account deficits(in % of GDP, 2001-2003 average) Capital inflows Current account deficit Source: IMF (Staff Appraisal Reports)

18. Why do large capital inflows occur? • Higher returns on physical investment • Expected trend appreciation of currency (Balassa-Samuelson effect)

19. 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

20. 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

21. Fiscal deficit & exchange rate regime(% of GDP, 2001-2003 average) “Flexible” exchange rates Hard currency pegs Source: IMF (Staff Appraisal Reports)

22. 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’