New growth model for the region after the crisis?

1. New growth model for the region after the crisis? Mojmir Mrak Faculty of Economics University of Ljubljana Skopje 26 April 2011

2. Issue to be addressed • Can the return of the region to higher economic growth be achieved with the growth model that has been applied in the pre-crisis period? • If not, what should be the components • of the revised model, or even • of the entirely new growth model

3. Structure of the presentation • Growth performance and economic convergence before the crisis • “Stylized” facts about the region’s pre-crisis growth model ….. • …. but also huge differences between countries / sub-regions • Growth and convergence interrupted during the crisis • Medium-term growth and convergence perspectives • Key elements of the post-crisis growth model

4. A. Growth and economic convergence before the crisis After the initial shock, the transition process facilitated strong economic growth of CSEE Between 1994 and 2008, the region has registered average annual growth rates of over 4%, and even higher than 5 % in the final years of that period Growth rates were high also in comparison with other emerging market regions General picture masks significant differences between individual countries

5. A. Growth and economic convergence before the crisis (II) • Strong economic convergence to the EU average achieved as well • Many NMS already achieved levels between 60 and 80% of the EU-27 average • For EU candidate countries the level is much lower - between 30 and 50% of the EU-27 average Source: Economic Commission

6. B. “Stylized” facts about the region’s pre-crisis growth model • EU accession framework • Formal / institutional integration through Europe Agreements and Stabilisation and Association agreements • Economic integration with the EU through liberalisation of capital flows • Prospects for EU membership through deepening of financial integration

7. B. “Stylized” facts about the region’s pre-crisis growth model (II) Growth in CSEE fueled mainly by high domestic demand (private consumption and inward-oriented investment) Source: Economic Commission

8. B. “Stylized” facts about the region’s pre-crisis growth model (III) High growth was made possible with a distinctive growth model based on large capital flows Source: IMF

9. B. “Stylized” facts about the region’s pre-crisis growth model (IV) • Large capital flows were largely intermediated by subsidiaries of WE banks due to • Prospects for EU membership of the countries in the region • Low interest rates in the euro area • Macroeconomic stabilisation and structural reforms of countries in the region • Low credit penetration offered good business opportunities • Reduced country risk has resulted in an improved access to capital markets at very low price

10. B. “Stylized” facts about the region’s pre-crisis growth model (V) These inflows had negative consequences, such as • Credit booms associated with overheating • Very high proportion of foreign denominated debt Source: IMF

11. B. “Stylized” facts about the region’s pre-crisis growth model (VI) Negative consequences (cont.) • Increasing external vulnerabilities Source: European Commission and IMF

12. C. … but huge differences among individual countries/sub-regions • Summary of “stylized” facts about the region’s pre-crisis growth model…… • EU accession framework • Strong reliance on net capital inflows largely in the form of bank credits • Credit booms • External imbalances • Large proportion of foreign denominated debt • ….. but they mask significant differences among individual countries / sub-regions

13. C. … but huge differences among individual countries/sub-regions (II) Difference No. 1: Volume of current account imbalances Source: Bruegel

14. C. … but huge differences among individual countries/sub-regions (III) Difference No. 2: Structure of current account deficit financing Source: Bruegel

15. C. … but huge differences among individual countries / sub-regions (IV) Difference No. 3: Reliance of banks on non-deposits as a source of credit boom financing

16. C. … but huge differences among individual countries / sub-regions (V) Difference No. 4: Proportion of foreign denominated debt

17. C. … but huge differences among individual countries/sub-regions (VI) • Difference No. 5: Polarisation of exchange rate regimes; no single currency regime is appropriate for all the countries / all the times • Countries with euro • Countries with currency boards and other fixed exchange rate regimes (often problems with appreciation of domestic currencies and current account deficits) • Countries with flexible exchange rate regimes

18. D. Growth and convergence interruped during the crisis In the 4/2008 the region entered into a deep crisis with substantial growth contraction in 2009 and poor growth in 2010 and 2011. Source: World Bank

19. D. Growth and convergence interruped during the crisis (II) In comparison with other emerging countries, economic growth in the region was hit the most drastically by the crisis Source: IMF

20. D. Growth and convergence interruped during the crisis (III) • Poor performance of the region during the crisis could due to overall vulnerability of the region’s growth model • Growth performance has varied widely among the countries; it collapsed most in • Countries with a combination of, first, high external vulnerability causing a sudden stop of capital inflows, and second, high dependence on domestic demand causing its sharp reduction • In some of the more advanced EE countries due to the falling demand for their exports in WE

21. D. During the crisis development (IV) • Dramatic decline of economic growth in the region interrupted its more than a decade long period of strong real economic convergence towards the average EU-27 level • In 2009, per capita GDP in PPP terms as percentage of EU-27 • Declined in 5 out 12 NMS (the 3 Baltic states, Hungary and Slovenia) • Stagnated in another 2 NMS (Czech republic and Malta)

22. E. Medium-term growth and convergence perspectives The crisis has affected dramatically potential and actual growth of region as well as the output gap, i.e., the relationship between them In the pre-crisis period, the region had highly positive output gap During the crisis, the output gap turned into strongly negative territory as the actual growth felt dramatically (to around -4 per cent in 2009 and below +1 per cent in 2010)

23. E. Medium-term growth and convergence perspectives (II) Potential growth rate of the region before the crisis was at an annual level of 4 to 5% High potential growth was a reflection of the region’s good economic fundamentals for strong economic growth The main driver of the region’s economic growth at that time was TFP growth, i.e., a part of total output growth not explained by capital and labor and is a fact a reflection of increased productivity achieved reforms

24. E. Medium-term growth and convergence perspectives (III) Contribution of TFP to the region’s growth TFP growth in the region faster than in other regions Source: IMF

25. E. Medium-term growth and convergence perspectives (IV) During the crisis, the region’s potential growth declined significantly; for NMS, for example, it roughly halved between 2007 and 2013 Source: Economic Commission

26. E. Medium-term growth and convergence perspectives (V) The decline of potential growth is especially dramatic for Baltic states; from an annual rate of around 6 per cent in the period 1999 – 2008 to below 2 per cent in the period 2009 – 2013

27. E. Medium-term growth and convergence perspectives (VII) Factors contributing to the potential growth decline of the region • Changed international environment is less growth supporting (crisis of confidence; access to capital more difficult and expensive; lower growth in WE; regulatory changes requiring from banks higher capital requirements) • On internal side, growth will be negatively affected by lower private demand (household credit growth already declined) as well as public demand (significantly worsened fiscal position requires strong fiscal consolidation)

28. E. Medium-term growth and convergence perspectives (X) In contrast to the pre-crisis period, real economic convergence of the region towards WE average is expected to be significantly slower over the next medium-term period with some countries of the region probably growing even slower than their counterparts in WE On a longer run, however, it is expected that developments will turn back to the normal “catching up process” with less developed region growing again faster than WE

29. F. Key elements of the post-crisis growth model • As the pre-crisis growth model of relying heavily on domestic demand and massive capital inflows has proven to be unsustainable for the region, the question arises whether • the existing model should be revised, or • an entirely new growth model may be needed • There are two sets of elements on which the post-crisis growth model of region will be based • National policy reforms • Adjustments in the EU integration model

30. F. Key elements of the post-crisis growth model (II) • National policy reforms No.1: increase of domestic savings (private and public) and consequently a reduction of the reliance on foreign savings • Private savings; An improved business environment should increase potential returns and thus savings ratio and stimulate the shift of investments towards tradable sector and exports • Public savings; significantly deteriorated fiscal position of many countries needs to be corrected through a process of fiscal consolidation

31. F. Key elements of the post-crisis growth model (III) • National policy reforms No.2: adjustements in macro-economic and financial policy. These policies • will have to be more proactive in managing capital inflows including stimulating these flows to be channeled into tradable sector and exports • should stimulate greater reliance on domestic sources of credit funding and discourage excessive leveraging what would contribute to mitigation of external vulnerabilities and make domestic financial system more resistant to external shocks

32. F. Key elements of the post-crisis growth model (IV) • National policy reforms No. 3: structural reforms aimed at increasing productivity • Institutional changes; The status of these reforms id far from consistant among sectors and countries • Human resource development; it includes reforms in the areas of education, R&D development as well as innovation absorption and creation • Labour sector reforms; they are even more needed in the context of rapidly ageing population of many countries in the region

33. F. Key elements of the post-crisis growth model (V) • Adjustments in the EU integration model; The model has proved to be beneficial for the region (single market; access to EU funds; policy and institutional anchors; support in manging the crisis), but adjustments are needed as well • Growth strategy of the EU (Europe 2020) has to be better adjusted to the needs of NMS • Risks of financial integration have to be recognized, better assessed and appropriately managed • Euro adoption conditions (Maastricht criteria) should be adjusted to new circumstances

34. Conclusions Due to structural characteristics of the region (small economies fully integrated into the EU) there seems to be no room for application of an entirely new growth model What, however, is realistic is the revision of the pre-crisis growth model so as to be less vulnerable to external shocks On a medium term, reduced reliance on foreign savings will have a price in lower growth On a longer-term, growth perspectives depend largely on the interplay of the national policies and adjustments in the EU integration model