Lecture at the University of Finance and Administration, Prague, 25.11.2011

1. The New Member States in the context of the European financial and economic crisis: differentiation and prospectsMichael A Landesmann Lecture at the University of Finance and Administration, Prague, 25.11.2011

2. Topics to be covered Features of the European economic and financial crisis The position of ‘Emerging Europe’: GIPSI and CEECs The ‘growth model’ of the CEECs pre-crisis The crisis and pitfalls in the ‘growth model’ Differentiation across CEE economies Prospects and policy lessons

3. The ‘growth model’ in the NMS prior to the crisis In the last two decades the region experimented with unique model of growth through integration into the EU: Key features Strong institutional anchoring – a model of ‘unconditional convergence’ Trade and FDI integration Financial integration (downhill capital flows) (Labour mobility) Made considerable sense in view of initial conditions Foster institutional build-up after transition Substitute lack of domestic saving by foreign saving Make use of wealth of human capital 3

4. Pre-crisis growth model, cont’d • Integration boosted capital inflows • low level of physical capital offering higher return on capital; complementary highly-educated labour force and low level of wages • EU accession prospect and improvement in the business climate • low level of domestic credit offering the potential for substantial credit expansion • Seemingly low exchange rate risk • Rapid productivity growth; up-grading of production and trade structures

5. Growth – GDP at constant pricesAverage annual growth rates, 2002-2008, in %

6. The NMS/CEECs and the build-up to the crisis Features of the development experiences prior to the crisis Differentiation across NMS/CEECs: - Extent of external imbalances - Private vs. public debt build-up - De- and re-industrialisation and the build-up of export capacity - Differences in the sectoral allocation of FDI

7. CEECs and comparisons with other emerging economies • CE-5: Czech Republic, Hungary, Poland, Slovakia and Slovenia • BB-5: Bulgaria, Romania (SE-2); Estonia, Latvia, Lithuania (B-3) • WB-6: Albania, Bosnia and Herzegovina, Croatia, Former Yugoslav Republic of Macedonia, Montenegro and Serbia; • EU-Coh: (Ireland), Greece, Portugal, Spain • Asia-6: Indonesia, Korea, Malaysia, Philippines, Taiwan and Thailand • Latam-8: Argentina, Brazil, Chile, Columbia, Ecuador, Mexico, Peru and Uruguay

8. Common characteristic 1: Reliance on foreign savings Post-1998, Asia and even Latin America go into surplus Until 2007, most of emerging Europe goes into deficit 10

9. Composition of the current account of the balance of payments, 1995-2009 Note: ASIA-6 excl. Taiwan.Source: IMF International Financial Statistics and IMF WEO October 2010.

10. Composition of the current account of the balanceof payments, 1994-2010, in % of GDP Czech Republic Hungary Poland Slovakia Slovenia Bulgaria Romania Estonia Latvia Lithuania Source: wiiw Database incorporating Eurostat statistics.

11. Net private financial flows in % of GDP, 1993-2009 LATAM-8 ASIA-6 MENA-6 EU-COH CE-5 SEE-2 B-3 WB-6 TR Source: IMF Balance of Payments Statistics. ASIA-6 excl. Taiwan.

12. Common characteristic 2:Credit booms Slowdown in Asia Boom in emerging Europe (from very low levels) Slowdown in LatAm 17

13. CESEE: GDP growth was well above the interest rate before the crisis Nominal interest rate on government debt and nominal GDP growth (%), 2000-2010 Note: Interest rate = government interest expenditures / previous year gross debt.

14. Common characteristic: Foreign bank ownership, 1998-2005(assets owned by foreign banks as % of banking system assets)

15. Common characteristic 3:It’s not mostly public debt If anything, more favourable public debt developments until 2008, especially in BB countries 20

16. Savings and investment in % of GDP CE-5 Baltics SEE NMS-5: CZ,HU,PL,SK,SI (from 2000-2007). SEE: BG (2000-2006) and RO (from 2004-2007). Source: wiiw Annual Database incorporating national statistics, Eurostat.

17. External debt: public and private (% of GDP), 2008 Note: ASIA-4 excl. PH, TW. MENA-4 excl. LB, SY. B-3 excl. FYROM, BA, RS. Source: World Bank, World Databank.

18. Gross private and public debt (% of GDP), 2009 Source: Eurostat, IMF.

19. Relationshipbetween pre-crisis credit growth and current account balances

20. Differences:Real exchange rate developments Misalignment in the Baltics/Balkans Appreciation hands-in-hands with catching-up in Central Europe Stable real X-rate in Asia post crisis 25

21. Differences:Composition of capital flows NFA as percentage of GDP, 2006-2008 Mostly FDI in central Europe Mostly credit in Baltic countries 26

22. Summary of pre-crisis growth period and differentiation amongst the CEECs • CEE region in general had a classic pre-crisis pattern of catching-up with ‘down-hill’ capital flows; other emerging economy regions had changed their patterns • A lot of differentiation amongst CEECs: - extent of capital inflows - nature and composition of capital inflows - private and public debt build-up - real exchange rate (mis)alignments

23. Differentiation amongst the CEECs:further relevant features • Prior periods of de- and re-industrialisation • Exchange rate regimes • Distortions tradable/non-tradable sectors • Structure and up-grading of export sector

24. Industrial production, cumulative change

25. Differences in the composition of FDI Large part in real estate, finance in Baltic region Large part in manufacturing, infrastructure, trade in central Europe 30

26. Real lending NB/ECB interest rates, 2008-2010CPI-deflated, in % p.a. Flexible ER Fixed ER Note:For Estonia: 1-month interbank lending rate (Talibor); for Lithuania: 1-month interbank lending rate (Vilibor). Source:Eurostat.

27. Structural features: the role of exchange rate regimes ‘Fixers’ and ‘floaters’ amongst the CESEEs Source: wiiw calculations.

28. The crisis and its aftermath • Sudden stops in net capital flows • Turn-around in current accounts: - differences in GDP declines - sharp credit contraction - differences between fix-ex and flex-ex countries

29. GDP, 2008 Q3 = 100 (2005 Q1–2010 Q2) CE-5: Czech Republic, Hungary, Poland, Slovakia and Slovenia Baltic/Balkan-5: Bulgaria, Estonia, Latvia, Lithuania and Romania Asia-6: Indonesia, Korea, Malaysia, Philippines, Taiwan and Thailand Latam-7: Argentina, Brazil, Chile, Columbia, Ecuador, Mexicoand Uruguay Starting point: severe shock and weak recovery

30. Net private financial flowsin % of GDP, 1995-2010 Czech Republic Hungary Poland Slovakia Slovenia Folie 55 Bulgaria Romania Estonia Latvia Lithuania Source: wiiw Database and Eurostat

31. Pre-crisis credit growth and GDP growth in 2009

32. Quarterly GDP developments (2008Q3=100), 2005Q1-2010Q2

33. Bank loans to non-financial private sectorchange in % against preceding year Source: National Bank of respective country.

34. Interest rates on government bondsMaturity 10 years Source: International Finance Statistics (IMF), Eurostat,National Banks and National Ministries of Finance.

35. Real appreciation*, 2008-2010EUR per NCU, PPI deflated, January 2008=100 *Values over 100 indicate appreciation relative to January 2008. Source: wiiw Database incorporating national statistics.

36. Real appreciation*, 2008-2010EUR per NCU, PPI deflated, January 2008=100 *Values over 100 indicate appreciation relative to January 2008. Source: wiiw Database incorporating national statistics.

37. Contributions to the GDP growth ratesin percentage points *) *) Contributions of changes in inventories are not shown. Source: wiiw estimates incorporating national sources.

38. Contributions to the GDP growth ratesin percentage points *) *) Contributions of changes in inventories are not shown. Source: wiiw estimates incorporating national sources.

39. Development of unemployment rates (LFS) Source: wiiw Database incorporating Eurostat statistics.

40. Resurrecting growth? • New constraints following the crisis

41. Constraints following the crisis: Internal factors: • ‘Deleveraging’ of private sector, affects private sector spending; • Public debt has gone up: less fiscal space; • Weak and cautious banking sector; • Differentiated processes of real exchange rate adjustments

42. Constraints following the crisis: External factors: • Volatile risk assessment of the region (debt overhang); • Difficult external (and internal) financing; • Contagion effects of banking crisis in Western Europe: consolidation process of banks’ balance sheets • Reduced growth expectations in the most important export markets; • Crisis in the eurozone: new OCA debate; unfinished governance structure leads to wait-and-see w.r.t. EMU membership

43. Principal policy lessons: In national and EU policy frameworks: neglect of private sector debt build-up relative to public sector Fixed exchange rate regimes bear high risks; much stronger emphasis on OCA criteria on the way to EMU and after Financial market regulation severely underdeveloped; specific issue of cross-border banking Use of taxation or insurance to prevent bubbles in financial markets (sand in the wheels taxes on particular types of investments) Use scope for counter-cyclical policy, but beware of debt sustainability and restructure public finance in growth-enhancing manner Direct policies towards tradable sector: structural policies, avoid distorting macro-policies; use EU funds

44. Unresolved issues: • Will Euro-zone deal with governance issues? • Will there be recapitalisation of banks? • What would be repercussions of a break-up of the Euro-zone? • New timetables – if at all – for further Enlargements and EMU memberships