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  1. Will catching-up continue smoothly in the “new” EU Members?Juergen KroegerDirectorDG Economic and Financial AffairsEuropean Commission13th Dubrovnik Economic ConferenceJune 27th to July 1st, 2007,Disclaimer: The views expressed in this presentation are the author’s own and should not be regarded as stating an official position of the European Commission.

  2. Outline “New” MS: successful catching-up but imbalances “Floaters”: mostly fiscal imbalances  situation and policy; “Fixers”: private sector / financial imbalances  situation and policies; Conclusions 2

  3. STYLIZED FACTS OF SUCCESSFUL REAL CATCHING-UP Phase 1 : Upswing • Initially real expected rate of upturn has to be high • In order to avoid overheating monetary policy has to be used, not fiscal policy • Tight money in the upswing is necessary to • Contain inflation • Establish demand supply equilibrium • Help establishing inter temporal equilibrium • Appreciation reduces import costs • Current account deficit, covered by FDI, is a counterpart to fill the supply-demand gap. 3

  4. STYLIZED FACTS OF SUCCESSFUL REAL CATCHING-UP Phase 2 : Consolidation • Higher investment increases the capital stock : Potential output rises • Domestic supply approaches domestic demand • The marginal real rate of return shrinks to the level of partner countries • Monetary policy is gradually easing • Net exports rising as exchange rate depreciates • Current account moving towards a sustainable level 4

  5. 1.“New” MS: successful catching-up but imbalances Growth and per-capita income figures indicate that catching-up has been successful… 5

  6. 1.“New” MS: successful catching-up but imbalances …but other indicators, esp. current account deficits, suggest potential problems ahead, in particular in “fixers”: “Fixers” 6

  7. 1.“New” MS: successful catching-up but imbalances In some cases, FDI-financing of C/A-deficits is small and/or decreasing: “F I X E R S” 7

  8. 1.“New” MS: successful catching-up but imbalances C/A deficits are private sector-driven in “fixers”, while being more public sector-driven in “floaters”: “F I X E R S” “F L O A T E R S” 8

  9. 2. “Floaters”: mostly fiscal imbalances • Room for fiscal consolidation and expenditure rationalization: 9

  10. 3. “Fixers”: mostly private sector / financial imbalances • Against a backdrop of negative real interest rates… “F I X E R S” 10

  11. 3. “Fixers”: mostly private sector / financial imbalances • …high growth in “fixers” predominantly driven by high domestic consumption, while external contribution negative: “F I x e r s” “F l o a t e r s” 11

  12. 3. “Fixers”: mostly private sector / financial imbalances • Although investment remains strong, it consists to a substantial extent of construction: “Fixers” 12

  13. 3. “Fixers”: mostly private sector / financial imbalances • And the share of the construction sector in GDP is quite large and growing: “Fixers” 13

  14. 3. “Fixers”: mostly private sector / financial imbalances • Unit labour cost developments do not bode well for external competitiveness: “Fixers” 14

  15. 3. “Fixers”: mostly private sector / financial imbalances • Credit growth is reaching staggering levels… “Fixers” 15

  16. 3. “Fixers”: mostly private sector / financial imbalances • …with credits to households growing particularly fast… (Y-o-y, end-2006) 16

  17. 3. “Fixers”: mostly private sector / financial imbalances • …and foreign currency lending often dominating: Foreign currency lending as a % of total outstanding credit, 2005 17

  18. 3. “Fixers”: mostly private sector / financial imbalances • While real estate prices are high… Source: Bank of Latvia 18

  19. 4. Conclusions • Catching-up has been successful but there are signs of overheating in the “fixers” (and RO), which could hamper the efficient resource allocation and endanger smooth further real convergence; • The remaining policy instruments of the “fixers” to cope with the situation are limited to fiscal policy and structural policies (in particular related to the financial sector); • This could be a lesson for the “floaters” (see e.g. RO) not to peg their exchange rate too early or manage it too tightly and to contain balance sheet exposures to exchange rate movements; 19

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