Session III: Panel discussion Euro and macroeconomic stability Servaas Deroose

1. Ten Years of the Euro Inspirations for the Czech Republic Session III: Panel discussionEuro and macroeconomic stability Servaas Deroose Director DG ECFIN, European Commission Conference hosted by Mr. Miroslav Kalousek, Minister of Finance of the Czech Republic,November 25, 2008

2. Outline • Assessing macroeconomic stability • Domestic: from overheating to hard-landing? • Financial: Are financial systems resilient? • External: Are external positions sustainable? • Lessons from EMU@10 for future € members • Challenges • Policy requirements • Conclusion

3. Real convergence is advancing but remains a long-term challenge GDP per capita in 2007 (in PPS, EU=100) and average change, 2004-2007

4. Growth is slowing considerably due to global and domestic factors (in %, y-o-y)

5. Price level convergence but also demand pressures 12-month average inflation (in %, y-o-y)

6. Financially-driven convergence – large capital inflows and extension of external balance sheets

7. 100% 100% Czech Republic 90% 90% Hungary Poland 80% 80% Slovakia Romania 70% 70% 60% 60% 50% 50% 40% 40% 30% 30% Bulgaria Estonia 20% 20% Latvia 10% 10% Lithuania 0% 0% 2002 2003 2004 2005 2006 2007 H1-08 2002 2003 2004 2005 2006 2007 H1-08 Very rapid financial deepening from a low base (less pronounced amongst ‘floaters’) Domestic credit growth (in % of GDP)

8. Large external imbalances (especially in ‘fixers’) Balance on current account (in % of GDP)

9. Fiscal positions External constraints seem to matter for fiscal performance General government balance and government debt (in % of GDP; 2007)

10. Exchange rate developments vs. euro, monthly averages (index numbers, Jan 2007 = 100)

11. Lessons from EMU@10 for future euro area members (1 - challenges) • Price stability: equilibrium real appreciation complicates inflation control ; shorter history of anti-inflation policy and lower credibility ; conflict between fiscal and monetary authorities ; wage catching up • Effective adjustment capacity(incl. stabilisation): • To deal with shocks without exchange rate instrument (but nominal exchange rate flexibility acts also as shock propagator, hence less ‘cost’ of giving up the XR instrument); • Relatively more frequent and persistent common shocks with asymmetric impact (exchange rates, terms of trade, shifting comparative advantages…); asymmetric shocks still possible (see Spain, Ireland, …) • Correction of large current account imbalances may require long and painful disinflation processes if coupled with stagnating productivity • EMU and financial integration help efficient resource allocation and allow for longer adjustment periods, but managing credit booms can be a challenge (already well before euro adoption) • Do not lose sight of long-term challenges: sustain high potential growth, in a context of ageing, globalisation (with more rapid shifts in comparative advantages)

12. Lessons from EMU@10 for future euro area members(2 – policy needs) • Improved budgetary control to reduce the risk of fiscal policy pro-cyclicality; budgetary frameworks in NMS are less developed and assessing cyclical component even more challenging • Sustainability of public finances • Quality of public finances ; bias towards current expenditure in NMS • Flexible and integrated goods and factor markets • More efficient use of labour resources (participation rates, structural unemployment, skill mismatches) • Business environment and investment climate (innovation, FDI, education, favour entry /exit of firms) • Growth-enhancing use of capital inflows ; NMS are receiving huge inflows , included EU funds; utilisation has differed a lot across NMS • Effective supervision and regulation of financial markets ; NMS experience accelerated financial development

13. Fiscal policy • Fiscal policy has to balance multiple challenges • need for well-targeted public spending (infrastructure, education and R&D) vs • fiscal policy key to rein in demand pressures and overheating risks, especially in fixed XR regimes • Preventing imbalances may require substantial surpluses of longer periods • Quality of public finances (pro-growth priorities)

14. Coping with financial deepening and credit growth • Vigilance to prevent the build-up of imbalances and vulnerabilities • Prudential and administrative measures • Raise minimum capital adequacy ratio • Strengthen loan-loss provisioning • Mandatory loan-to-income or loan-to-value limits • Strengthen supervisory framework • Improvements in credit registers • Strengthening risk management, expand stress testing • Harness cross-border supervision

15. Structural policy implications • Boost external competitiveness • Ensure favourable business environment and investment climate • Encourage innovation and entrepreneurship to maintain competitiveness and move up the value-added chain • Move toward high value-added and fast-growing sectors • Sectoral composition of exports • Productivity growth in the tradables sector • Enhance internal economic adjustment • NMS will have to manage underlying structural divergences for some time • Ensure functioning of goods, services and labour markets • labour mobility, skill development & wage flexibility • wage setting in line with productivity gains • Entrepreneurship, etc.

16. Conclusion • Catching-up is proceeding but accompanied by varying imbalances • Euro adoption – readiness more important than timing • Ability to cope with country-specific adjustment needs • Adequate preparation in fiscal, structural and prudential domains • Short-term challenges: deal with fall-out from the financial crisis; manage orderly unwinding of imbalances among the ‘fixers’, keep progress towards convergence on track for the ‘floaters