Economic Update Fiscal Divergence?

1. Economic UpdateFiscal Divergence? Europe and Central Asia Region World Bank Office of the Chief Economist Poverty Reduction and Economic Management Sector Management Unit Human Development Sector Management Unit Berlin May 5, 2010

2. Main points • Before the crisis, fiscal performance improved across the region • Revenues rose, deficits fell, and fiscal policies improved with few exceptions • During the crisis, fiscal policy responses differed in the east and west • Reliance on automatic stabilizers in most countries • Fiscal stimulus programs in resource-rich economies. • After the crisis, fiscal adjustment priorities will be even more differentiated • Education and infrastructure in much of region • Social insurance in Central and Southern Europe • Reducing stimulus and energy subsidies in middle-income Former Soviet Union

3. Outline Backdrop to fiscal focus Before the crisis During the crisis After the crisis Fiscal consolidation 3

4. Backdrop • Emerging Europe and Central Asia hit harder than other developing regions • Growth and fiscal prospects for the region are bleaker than for others • The region also has a daunting climate action agenda

5. Worst fiscal performance Fiscal Balance, Percentage of GDP (2005-2013)

6. Weakest growth prospects Real GDP Growth, Annual percentage rate (2005-2013)

7. Highest energy intensity Energy intensity of GDP (kilotons per GDP PPP, $, 2000)

8. Before the crisis • Revenues rose rapidly as trade and consumption based tax collections increased • Spending rose almost as fast in aggregate, but steady as share of GDP • Fiscal balances improved across the region, with a few exceptions (Hungary and Georgia) • But budgeting and spending efficiency did not improve as much

9. Revenues rose Steady increase as share of GDP, but aggregate increased from $700bn in 2000 to $1.2 trillion in 2007 General Government Revenue, 2000-2007 (% of GDP)

10. Spending up almost as much Steady as a share of GDP, but rose in aggregate from $700 billion to $1.1 trillion General Government Spending, 2000-2007 (% of GDP) 10

11. Fiscal balances got better Spending increased in east, more controlled in the west Composition of changes in the fiscal balance, 2000-2007 (% GDP)

12. Fiscal policies improved Outside the EU-10, the quality of fiscal policy improved Source: World Bank Country Policy and Institutional Assessments; measure of the Quality of Fiscal Policy, 1999-2008

13. Public R&D spending rose In the EU-10 and Turkey, spending on R&D increased Source: World Bank, ECA Regional Tables. 13

14. During the Crisis • Government revenues fell everywhere, but more in the east • Public spending rose as a share of GDP, but stable in aggregate • Fiscal balances deteriorated everywhere, but more in the east • Oil and gas exporters implemented fiscal stimulus programs, but exit unclear

15. All relied on automatic stabilizers Only ECA’s oil exporters implemented discretionary fiscal stimulus programs Contributions of changes in deficits, 2008-2009, % of GDP, median values

16. Big fiscal imbalances emerged Expenditures responsible for rising deficits everywhere; big revenue declines in SE Europe and parts of the CIS Contributions of changes in deficits in 2007-2010, share of GDP

17. And public debt has grown Public debt in Central and Southern Europe, and the non-oil rich CIS will be close to 40 percent in 2010 Projected public debt, % of GDP

18. After the crisis • Growth projected not to recover to pre-crisis levels • Fiscal stimulus programs will not deliver growth • Pressures to increase spending • Projected divergence in spending and revenue trends within the region

19. Lower growth post-crisis GDP growth in 2010 will be about 5 percentage points lower than what was expected before the crisis Projected economic growth rates, before and after crisis

20. More pressure to reform pensions ECA’s spending on social security resembles that in wealthier countries Spending on social assistance and insurance, % of GDP; most data from 2000 to 2003 20 Source: World Bank staff and OECD Social Expenditure Database.

21. More pressure to invest in education More enterprises are complaining that the skills of workers are becoming an obstacle for business 21 Source: BEEPS 2005 & 2008; percentage of firms indicating that skills and education of available workers is some form of constraint on business.

22. More pressure to invest in infrastructure More enterprises are complaining that electricity is becoming an obstacle for doing business Source: BEEPS 2005 & 2008; percentage of firms indicating that Electricity is some form of constraint to business 22

23. Divergence in region will grow EU-10 adjustments will resemble those in middle income countries in East Asia and Latin America Forecasted Adjustments (2009 to 2013)

24. Fiscal consolidation • Requires a closer look by country • Requires making social sector reform a priority in many countries • Requires reducing energy subsidies in much of the former Soviet Union • Requires exit strategies from fiscal stimulus in oil and gas exporting countries 24

25. Post-crisis pressures • Slower growth likely for most economies • ECA may not go back to pre-crisis growth rates soon • Many governments will be fiscally weaker • Public debt levels will be higher after the crisis, and tax revenues possibly structurally diminished • More pressure to address climate change • Pressure on emerging Europe to mitigate, on Eurasian countries to adapt

26. Governments in ECA are bigger Government spending is greater than in Latin America and Emerging Asia today (and Germany in 1960) Share of Spending in GDP, latest year EU-15 median ECA median Germany 1960 Latin America median Emerging Asia median Note: Plot values reflect ECA countries

27. Social benefits and wage bills are high in the west Social spending and employee compensation dominates the budget Economic Classification of Expenditures, 2008

28. Energy subsidies are big in the east Energy is priced below cost in much of the former Soviet Union Long-run marginal generation cost (6.5-7.5 cents per KWh) Source: ERRA Tariff Database; weighted average electricity tariffs for residential consumers in 2008, US$ cents / KWh 28

29. Seven cases Automatic stabilizers and discretionary spending helped during 2009, except in Ukraine and Serbia Composition of change in fiscal balance, 2009

30. Priorities differ by country Social security and education needs reform in many, combined with idiosyncratic mix of priorities Source: World Bank Public Expenditure reviews and Development Policy Loan documents; see annexed case study summaries. 30

31. Conclusion: Tough fiscal prospects 31 Before the crisis: Between 2000 and 2007, buoyant revenues allowed big spending increases—but fiscal balances were improved. During the crisis: Revenues fell in much of the region, spending was steadied by automatic stabilizers in many and stimulus spending in a few—but fiscal balances deteriorated in most. After the crisis: Crisis made fiscal reform priorities clearer and more differentiated between countries—but generally tighter fiscal circumstances likely.