Bank of Greece Erik Bergl of 11 February 2011

1. Bank of Greece Erik Berglof 11 February 2011

2. The transition region’s pre-crisis growth model Vigour…or just bubbles? 2

3. TR 2010: Recovery and Reform – Outline Overview: the argument in a nutshell Developing local currency finance Building export capacity Improving the business environment

4. South-east Europe 2011: Recovery finally * * EBRD growth forecasts as of 21st January 2011.

5. TR 2010: Recovery and Reform – Outline Overview: the argument in a nutshell Developing local currency finance Building export capacity Improving the business environment

6. Time to draw lessons from a decade of boom and bust … Pre-crisis the EBRD region grew as fast as Asia… …but with high current account deficits… …resulting in precipitous drop in growth in 2009 Emerging Asia Latin America Middle East EBRD region

7. Does the transition region need to reinvent its approach to growth after the crisis? New Growth Agenda for bothstronger and safergrowth • No “new growth model” • But need to address key weaknesses: • Incomplete reforms; unbalanced growth; financial fragilities • Build local currency finance and capital markets • Remove obstacles to export growth • Improve the business environment 7

8. Less FX in credit Improve current account Innovation A New Growth Agenda Reformareas Objectives Safer growth Developing domestic capital markets and local currency finance Strengthening export growth Stronger growth Improving business environment

9. TR 2010: Recovery and Reform – Outline Overview: the argument in a nutshell Developing local currency finance Building export capacity Improving the business environment

10. Developing local currency finance: rationale A way of deepening local capital markets • increase sources of domestic funding • lower dependence on foreign capital inflows De-euroisation/De-dollarisation • increase share of local currency lending • reduce unhedged FX borrowing

11. Few countries use mainly local currency Percent of local currency loans and deposits, 2009 g CEB ¦ SEE + Turkey ¦ EEC + Russia ¦ CA

12. Low local currency use: longstanding problem Declines in local currency use: Hungary and Latvia Increases in local currency use: Turkey, Armenia, and Kazakhstan CEB ¦ SEE + Turkey ¦ EEC + Russia ¦ CA

13. Proximate cause: high LC borrowing costs European countries: LC-FX lending rate spread, 2006-10

14. However, this reflects the risk of devaluation Key question: Why so many unhedged firms and households take the FX risk?

15. Potential factors inducing FX risk-taking • FX loans too cheap → Deep cause: lack of local financial development combined with abundant foreign funding • FX risk lower individually than socially • implicit bailout guarantees; externalities of insolvency → Deep cause: distortions • FX borrowing risky, but LC borrowing even riskier • High ex-post real rates if inflation lower than expected. → Deep cause: lack of macro stability

16. Potential causes for lending in FX Diagnosis and policy remedy: country-specific Policy remedy Lack of macro stability Macro stabilisation + institution-building Lack of financial development Local capital market development Under-pricing of FX risk Regulation 16

17. Big differences in macroeconomic stability Predictability of Inflation, 2000-2010 RMSE: Root Mean Square Errors; based on inflation predictions from the IMF’s World Economic Outlook, 2000-2010

18. New EBRD index: Money market development varies greatly CEB SEE + Turkey EEC + Russia CA

19. New EBRD index: Government bond markets also vary

20. Mapping obstacles to local currency finance Share of Foreign Currency in Loans and deposits ≥ 75% 40-75% ≤ 40% 20

21. LC development vs. FX risk management • In highly euroised countries, LC market development without exchange rate flexibility is not plausible (Latin American experience) • Hence, countries that are firmly committed to hard pegs will need to live with Euroisation, and manage its risks bigger onus on regulation; country insurance • mechanisms to cover FX liquidity gaps in a crisis and prevent amplification of FX shocks

22. A framework for country-specific reform

23. TR 2010: Recovery and Reform – Outline Overview: the argument in a nutshell Developing local currency finance Building export capacity Improving the business environment

24. Building export capacity: rationale More balanced growth • lower current account deficits • lower dependence on foreign capital inflows Strengthen long run growth • link between exports and innovation • But which way did the causality run? • More innovative firms are better exporters, or • Exports help innovation (e.g., larger market to recoup costs)

25. Which way causality runs – the evidence • US and German data: causality runs from productivity to exporting • Emerging markets: Exporting makes firms more productive/innovative • Aw, Chung, Roberts (2000) for Korea and Taiwan; Hallward-Driemeier et al (2005) for East Asia; Jiang et al (2009) for China • De Loecker (2007) for Slovenia

26. Substantial effect, especially for R&D spending

27. Pre-crisis: exports remarkably successful… 2000 2008 2000 2008 2000 2008 2000 2008 Source: IMF, Direction of Trade Statistics.

28. … but past export growth drivers are fading ULC grew much faster Labour costs elsewhere in the CEE catching up with advanced countries Tariffs already low, few further gains from trade arrangements 2007 average trading partner tariff only 5.5% 2010-15 trading partner to grow 1 percentage point lower than before crisis Slower projected growth of large trading partners 28

29. Invigorating exports requires structural reforms • Statistical analysis points to three key policy instruments: • reducing or adapting to non-tariff barriers • increasing efficiency of customs • reducing corruption and entrench rule of law Basis: panel regression of real export growth on institutional indicators, tariff barriers, nontariff barriers, and controls (average trading partner real GDP growth, real effective appreciation); 130 countries; 1999-2009.

30. Top priorities to improve export-friendliness* * Based on deviations from mean values 30

31. TR 2010: Recovery and Reform – Outline Overview: the argument in a nutshell Developing local currency finance Building export capacity Improving the business environment

32. Improving the business environment (BE) Key to long run growth • Of course! Defined as everything that may matter for growth – from institutions to education to finance But which aspect? • BEEPs may help, by ranking constraints from the perspective of entrepreneurs. • But there are significant hurdles

33. BEEPS as a guide to reforms: problems • Not all “constraints” reflect public goods • Tax rates, credit constraints Differences in demand for public goods • E.g. fast growing firms may complain more Different “reference points” or propensities to complain across countries and perhaps constraints • E.g. Montenegro vs. Serbia Relating perceived constraints to actual reforms

34. Approach in TR 2010. • Focus on 10 constraints that represent public goods • Ignore tax rates, credit constraints Focus on relative perceived constraints • De-mean reported constraints using firm means Adjust for firm characteristics • Establish relative perceived constraints of a representative firm in each country Relate adjusted constraints to actual reforms via comparisons of similar countries; identifying significant changes over time; and regression analysis. Note: 1 and 3 follows Carlin and Shaffer (2010)

35. Example: Absolute BEEPS scores suggest Montenegro much better than Serbia in all areas … Absolute constraint severity difference wrt severity in avg country with same GDPPC

36. …while relativeconstraints highlight priority business concerns in both countries Relative constraint severity % difference wrt avg constraint severity in each country

37. Relative score method reveals skills availability and corruption as top constraints Number of countries where a constraint is among top three concerns

38. Cross-country and over-the-time analysis help identify examples to follow within regions Tax administration: Estonia Corruption since 1999: Georgia Change in rel. severity of corruption constraint, ’99-’08 Relative severity of tax administration constraint

39. Spend more and BETTER on education Skills constraint more binding in richer countries Traditional education measures do not necessarily relieve skills constraint Labour with primary / secondary / tertiary education Expenditure on primary / secondary education Literacy rate Primary education completion rate Public education spending Ensure schools provide relevant education

40. No complacency: now is time to reform Urgent need to enhance the growth model to avoid serious post-recovery risks Particularly if capital inflows pick up again Structural reforms to boost growth in a tougher environment Prepare for sustainable long-term growth 40

41. Thank you

42. Backup slide: assets of insurance corporations and pension funds

43. Weakness (1): incomplete reforms - 43

44. Weakness (2): unbalanced growth 44

45. Weakness (3): financial sector fragilities 45

46. Computing relative scores • Absolute score comparisons are impossible • Removes firm-level tendency to complain Remove firm-level mean score Relative BEEPS score for business environment aspect i, firm j Absolute (raw) BEEPS score for business environment aspect i, firm j Firm-level mean calculated from the 10 relevant constraint area scores