44544 vol. 1 Summary Global financial tensions appear to have eased somewhat since mid- March, but the external environment faced by the EU10 remains challenging. This reflects continued tight liquidity in capital and credit markets, higher and rising inflation and commodity prices, and outlook The World Bank for weak economic growth in mature markets. External debt issuance by the EU10 countries accelerated markedly since late May, amid the growing realization that higher bond spreads are likely to stay given higher inflation, increased risk aversion and signs that the ECB may raise its key policy rate in the near term. Output is set to grow more slowly in many of the EU10 countries in 2008, with the slowdown most pronounced in Estonia and Latvia. Growth should remain little changed in Bulgaria and Poland this year, however, and pick up in Romania and Hungary. Some cooling down is welcome, EU10 given the imbalances in some countries with large current account deficits and external debt, and high and rising inflation. Higher prices for food and energy, together with increases in excise tax rates in some countries and buoyant domestic demand in others, have Regular boosted inflation further in early 2008. Inflation more than doubled from a year earlier in April 2008 in most countries and poses an increasing challenge. Economic Buoyant revenues and spending restraint have helped improve fiscal positions this year in the Visegrad countries, Bulgaria and Romania. This follows fiscal tightening in most of the region in 2007, with the largest improvements in member states under the EU excessive deficit Report procedure (all Visegrad countries). These procedures are now being abrogated in the Czech Republic, Slovakia and Poland. Higher inflation led central banks to tighten monetary policy this year in most of the EU10 countries. Tighter credit standards by commercial banks and weaker economic activity in some countries have helped slow credit growth, as did falling housing prices in the Baltic countries. June 2008 Main Report............................................................. pages 1-9 In Focus: The Financial Turmoil and the EU10............... pages 10-12 In Focus: The Impact of Rising Food Prices ................... pages 13-15 In Focus: Welcome the Older Back to Work .................. pages 16-19 In Focus: Slovakia Set to Adopt the Euro...................... pages 20-23 In Focus: The Baltics, Fasten Your Seatbelts for Landing.. pages 24-26 Special topic: Public Investment Management in Selected EU Countries Public investment in infrastructure is an essential part of the EU10's convergence strategies. EU policy directives play an important role in the process, but it is becoming increasingly important to build national practices to strengthen effective and efficient management of public infrastructure resources. For public infrastructure This report is prepared by a team led by Ivailo investments to be productive, they need to be supported by strong Izvorski (iizvorski@worldbank.org, tel. 202- institutional processes for planning, appraisal and management. 458-8807) and including Paulina Holda, Stella Strategic planning needs to be closely linked to multi-year fiscal Ilieva, Leszek Kasek, Ewa Korczyc, Matija frameworks. Capacity for appraising the economic cost-benefit of Laco, Anton Marcincin, Catalin Pauna and projects should improve, while project implementation will need to Emilia Skrok. be supplemented by monitoring capacity and ex-post reviews. EU10 Regular Economic Report In Focus: Summary EMBI Stripped Spreads (basis points) 250 The Financial Turmoil and the EU10 (pp 10-12) 200 Bulgaria The impact of the global financial crisis on the EU10 countries has 150 Hungary been moderate so far, but its effects are likely to be more 100 palpable and differentiated across the EU10 later this year, as market turbulence continues to affect the financial system in 50 western Europe and output growth in the eurozone slows. Poland 0 07 07 07 07- 7 07 07 07 08 08 08 8 an-J an-J eb-F Mar r-0pA 70-y 70-l 70-l 70-t 08- Ma un-J 70-v 70-c Ju Ju ug-A ep-S Oc No De an-J an-J eb-F Mar r-0pA Inflation and Food Price Increases (percent, year-on-year) 30 The Impact of Rising Food Prices (pp 13-15) 25 Overall Food Following a relatively stable path of modest increase for over two 20 decades, global food prices began increasing rapidly in late 2006 15 and have soared since to historic highs. Given the increasing 10 integration of the region in the EU and the world economy, global 5 developments have affected substantially food prices and 0 inflation in the EU10 countries. ai aivt a yr .p garulB La onitsE ani huatLi ngauH ainam ainevo hce Cz Re iakav andolP Ro Sl Slo Employment rate (15-64) in 2007 Welcome the Older Back to Work (pp 16-19) 70 EU15 average In the view of tighter labor markets, increasing life expectancies, 65 the need to increase employment among the elderly is one of the urgent policy challenges in the EU10 countries and is crucial to 60 continued convergence with the EU. Employment rates in most EU10 countries are still low and far from Lisbon target despite 55 remarkable improvements in recent years. Employment rates for ai a .p a ai ai a y eni ani ak ani dnal older workers are also substantially lower than the EU15. aniot Es Latv ovlS Rehce hutLi garulB ovlS omR ungarH Po Cz Slovakia Set to Adopt the Euro (pp 20-23) Inflation in Slovakia (percent, year-on-year) 10 Slovakia will formally adopt the euro from the start of 2009, 8 becoming the 16th eurozone member. This achievement caps a 6 SVK HICP 12-month moving average remarkable economic and political transformation that started in 4 1998, during which Slovakia has emerged as the leading reformer 2 among the EU10 countries. Nonetheless, further structural Euro area covergence reforms, accompanied by continued fiscal prudence will be 0 04 05 06 07 08 needed to ensure convergence. 04- 04- 05- 05- 06- 06- 07- 07- an-J May Sep an-J May Sep an-J May Sep an-J May Sep an-J The Baltics: Fasten Your Seatbelts for GDP growth (percent, year-on-year) 16 Landing (pp 24-26) 14 12 10 The Baltic countries are experiencing a sharp slowdown in 8 economic activity after a decade of robust expansion and 6 Estonia impressive convergence on the EU. The adjustment provides an 4 Latvia Lithuania opportunity to retool fiscal and structural policies to support 2 0 further economic flexibility, boost entrepreneurship and attract 40 40 40 40 50 50 50 50 60 60 60 60 70 70 70 70 80 more productive foreign direct investment. 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q EU10 June 2008 Main Report External Environment Despite some signs of normalization of late, the external environment faced by the EU10 remains challenging. One of the important and lasting impacts of the turmoil will be a shift in investors' reassessment and pricing of risk, to be accompanied by tighter financial market conditions. The financial turmoil, which started in mid-2007 in the sub-prime U.S. mortgage market amid falling housing prices, has spread to Figure 1. German Government Bond Yields (in the broader capital and credit markets. Concerns percent) about financial stability resulted in resolute policy 5.0 actions, which included the rescue of Bear Stearns June 2007 in the U.S. in March, large injections of liquidity by 4.5 central banks in Europe and the U.S. against a widening range of collateral, and a cumulative cut 4.0 of U.S. policy interest rates by 300 basis points since late 2007. Following these policy 3.5 May 2008 interventions, yields on U.S. and eurozone government securities have rebounded, as some 3.0 March 2008 confidence has returned while concerns about inflation have risen sharply (Figure 1). Bond spreads 2.5 and the cost of insuring against default on 3 mos 6 mos 1 yr 2 yrs 5 yrs 10 yrs 15 yrs corporate and emerging market bonds have eased since mid-March, but are still higher than in early Source: Bloomberg. 2007 (Figure 2 and Figure 3). Global equity markets have also recovered since mid-March. Figure 2. Credit Default Swaps, Bulgaria, Figure 3. Credit Default Swaps, Baltics (in basis Romania and JPMorgan (in basis points) points) 250 300 200 250 EE 200 LT 150 RO LV BG 150 100 JPM 100 50 50 0 0 07 07-r an-J 70-y 70-l 07 70-v 08 08-r 07 70-r 07-y 70-l 07 70-v 08 80-r 08-y Ma Ju Ma ep-S No an-J 80-y Ma Ma n-aJ Ma Ju Ma p-eS No n-aJ Ma Ma Source: Bloomberg. Source: Bloomberg. While some of the huge uncertainty that underpinned the financial turmoil has dissipated of late, financial market conditions have continued to tighten, with negative implications for bank lending and capital flows. Interbank rates have risen despite the liquidity injections and remain 70-80 basis points above central bank interest rates, a spread substantially higher than in previous years. Banks in the U.S. and in the eurozone report further tightening of credit standards, following substantial losses (split roughly among the two regions) Amid these unfavorable conditions, many governments and private companies in the EU10 postponed external debt issuance earlier this year or resorted to syndicated loans to limit costs. Issuance has rebounded in May and 1 June, however, as market conditions have normalized somewhat, while it is becoming increasingly clear that a return to the recent times of cheap credit will be unlikely in the near future. Led by the financial turmoil, surging commodity prices and tighter financial conditions, global growth appears to be slowing, albeit by less than some observers Table 1. Economic growth, World Bank, IMF and EC projections had earlier anticipated. (in percent, annual) Substantially weaker confidence and growth in industrial 2007 2008f 2009f production in the second quarter EC IMF WB, GDF EC IMF WB, GDF EC IMF WB, GDF suggest that real GDP growth in World 4.6 4.9 3.7 (5.3)* 3.8 3.7 2.8 (4.4) 3.6 3.8 3.2 (4.6) the U.S., which picked up USA 2.2 2.2 2.2 0.9 0.5 1.1 0.7 0.6 1.9 unexpectedly in the first quarter Eurozone 2.6 2.6 2.6 1.7 1.4 1.8 1.5 1.2 1.9 of this year, is on track to slow Germany 2.5 2.5 ... 1.8 1.4 ... 1.5 1.0 ... Russia 8.1 8.1 8.1 7.7 6.8 6.9 7.3 6.3 6.3 to 1 percent in 2008 from 2.2 percent in 2007. This is */ The first of the WB/GDF number is with market weights, in brackets with PPP weights. likely to be mirrored by Sources: EC Spring Forecast 2008; IMF WEO, April 2008; World Bank, Global Development developments in the eurozone, Finance. with real GDP projected to ease to about 2 percent in 2008 and 2009 from 2.6 percent in 2007 (Table 1). Sluggish expansion in the eurozone should have negative implications for growth of EU10 output and exports. The surge in global commodity prices has boosted inflation in the EU10 countries, shrunk real incomes and added to the import bill. Global metal prices appear to have peaked late last year as global growth began slowing, affording some relief to importers, including most of the EU10 countries. Global prices for food and oil, meanwhile, have continued to rise substantially, with each increasing 78 percent in dollar terms (62 percent in euro terms) from the start of 2007 through April 2008. The increase in oil prices to Figure 4. Food and petroleum prices (index, $135 dollars a barrel in mid-June appears to have 2000=100, US$, and dollars per barrel) reflected stronger demand among developing countries, but there are indications of speculative 120 300 pressure as well (Figure 4). Surging food and oil prices Brent Crude $/B (lhs) 110 280 Food (rhs) have boosted global inflation. With the financial 100 260 turmoil ongoing and output growth slowing, rising 240 90 inflation confounds policy choices and makes it likely 220 80 that the global environment will remain unsettled this 200 70 year and perhaps in 2009. While many emerging 180 economies, including the EU10 countries, are 60 160 tightening monetary policy to curb inflation pressures, 50 140 policymakers in most mature economies have either 40 120 6 7 8 cut rates or kept them little changed. The ECB, 06 r-0a 06- 60-l 06 60-v 07 07 08 Ju r-0a 07- 70-l 70-v Ju r-0a however, has signaled that it may move to hike rates an-J M May ep-S No an-J M May ep-S No an-J M soon, after keeping them little changed for a year. Source: World Bank. This follows the surge in eurozone inflation to 3.6 percent year-on-year in May, well-above the ECB's target of "below but close" to 2 percent. Output and Demand Output is growing at a slower pace in many of the EU10 countries thus far this year, led by the Baltic countries. Some cooling down in growth is welcome, especially given the imbalances in some countries with large current account deficits and external debt, and high and rising inflation. In the countries where growth is slowing, the key driver is weaker expansion in domestic demand, combined with smaller increases in exports. The slowdown in domestic demand thus far in 2008 follows stronger expansion in 2007. Real GDP contracted by 0.5 percent during the first quarter in Estonia (seasonally adjusted, quarter-on- quarter) and remained broadly unchanged in Latvia in Lithuania, following substantial slowdown in Estonia 2 and Latvia in 2007. Year-on-year growth in the Baltic countries is still positive (barely so in Estonia), but quarterly seasonally adjusted rates of growth are a more useful guide to developments, especially in times of rapid change (Figure 5 and Figure 30-Figure 32 in the focus note The Baltics: Fasten Your Seatbelts for Landing). Estonia and Latvia are undergoing a swifter adjustment than earlier projected by most analysts and market participants. It is likely that Lithuania is following suit. Economic expansion among the other countries in the region has remained robust this year, but there are signs of weakness. Economic activity expanded strongly in the first quarter in Slovakia and the Czech Republic, but eased from the pace during the fourth quarter of last year. Growth was broadly unchanged in Bulgaria (7 percent) and in Poland (6 percent year-on-year) and, and picked up strongly in Romania to 8.2 percent and modestly in Hungary. Figure 5. Real GDP growth (in percent y-on-y) Figure 6. Growth of real GDP and domestic demand in 2007 (in percent, year-on-year) 16 14 4Q 07 1Q 08 2007 14 Domestic demand 12 GDP 12 10 10 8 8 6 6 4 4 2 2 0 0 BG CZ EE HU LV LT PL RO SK SI BG CZ EE HU LV LT PL RO SK SI HR -2 Sources: Eurostat and national statistics. Source: Eurostat. This year's developments follow strong real GDP growth in the EU10 countries last year. In 2007, Slovakia, Poland and Slovenia recorded their most rapid expansion since 2000. Slovakia's real GDP surged 10.4 percent last year, the fastest in the EU, while inflation and the current account deficit remained moderate. Stronger investment spending helped propel real GDP by about 6.5 percent in Bulgaria and Poland, but in both countries this was accompanied by larger inflows of foreign direct investment that financed almost in full the wider current account deficits. Growth slowed in Estonia, Latvia, Romania and, much more substantially, in Hungary. The slowdown in Hungary reflected the fiscal adjustment that withdrew the equivalent of about 3.5 percent of GDP from domestic incomes and demand. Domestic demand expanded faster than output growth in most of the EU10 in 2007. Domestic demand contracted only in Hungary, with exports supporting the modest economic expansion (Figure 6). Investment was the key driver of domestic demand in most other countries, with fixed investment surging by about 20 percent in Bulgaria, Poland and Romania, reflecting additions to productive capacity, a boost to residential construction and stepped-up utilization of EU funds (Poland). Private consumption also grew strongly in most countries along with rapid increases in employment and expansion of bank lending, but the pickup in inflation has helped temper such increases, leading to a slowdown this year. Early indicators suggest that output growth will slow substantially in the Baltic countries this year, following an exceptionally strong expansion after the 2004 EU accession and one of the fastest rates of convergence since the early 1990s (Figure 7). Prospects are more mixed for the other countries, with growth projected to remain little changed in Bulgaria and Poland, and pick up in Hungary and in Romania. A much better harvest in 2008 than last year, as is now likely, may well lead to faster growth in Bulgaria and should support the likely pickup in Romania. Economic expansion is likely to slow in the Czech Republic, Slovakia and Slovenia, mainly on account of weaker export growth, given the deeper integration of these countries with the eurozone, and more sluggish expansion in private consumption. 3 Figure 7. Composite economic sentiment indicator (100 denotes no change in sentiment) 150 150 EE LV 150 BG RO 140 CZ HU LT SI 140 PL SK 140 130 130 130 120 120 120 110 110 110 100 100 100 90 90 90 80 80 80 70 70 05 an-J 50-r 50-l 50-t 06 60-l 60-t 07 70-l 70-t 08 70 50 5 60 6 70 7 80 8 Ap Ju Oc an-J 60-r Ap Ju Oc an-J 70-r Ap Ju Oc an-J 80-r 05 Ap n-aJ 50-r 50-l 50- 06 07 08 Ap Ju Oct n-aJ 60-r 60-l 60- Ap Ju Oct n-aJ 70-r 70-l 70- Ap Ju Oct n-aJ 80-r r-0 50-l 50-t r-0 60-l 60-t r-0 70-l 70-t Ap an-J Ap Ju Oc an-J Ap Ju Oc an-J Ap Ju Oc an-J r-0 Ap Source: European Commission. Employment Strong GDP growth has supported continued robust job creation in the region. Unemployment has dipped to about 6 percent in all but three EU10 countries, with the resulting tightening in labor markets contributing to wage pressures. Employment growth was the strongest in Poland and Bulgaria during the first Figure 8. Employment growth, 2007 (in percent) quarter of this year (with increases of about 4.5 percent year-on-year), following robust 6 Industry Agriculture Construction Services increases in 2007 (Figure 8). Employment appears 5 to be rising only modestly in Romania, by 4 contrast. Employment fell only in Hungary in 2007, as the fiscal adjustment helped slow 3 economic expansion (and government 2 employment was trimmed), but employment has 1 so far this year held steady in Latvia and Estonia despite the economic downturn. The reallocation 0 of labor from agriculture to higher-productivity -1 activities is ongoing in most countries and bodes -2 well for future economic growth. Nonetheless, CZ EE HU LV LT PL SK SI BG RO limited internal mobility and growing skill shortages are seen as increasing obstacles to Sources: Eurostat and World Bank staff calculations. doing business. Some governments have started discussing cuts in public administration employment (Bulgaria) or increasing labor inward migration (Bulgaria, Latvia) as a way of tackling these obstacles. Figure 9. Unit labor costs (year-on-year % change, four-quarter moving average, local currency) 25 EE LT LV 25 PL BG RO 20 20 15 15 10 10 5 5 0 0 -5 -5 -10 -10 03 03 03 03 04 04 04 04 05 05 05 05 06 06 06 06 07 07 07 07 30 30 30 30 40 40 40 40 50 50 50 50 60 60 60 60 70 70 70 70 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q Sources: Eurostat and World Bank staff calculations. Robust employment growth and strong outward migration have added to wage and inflation pressures. Growth in unit labor costs has been particularly strong in the Baltic countries, Bulgaria and Romania (Figure 9), 4 countries that have exhibited one of the fastest increases in inflation in the region, while it has been modest in the Czech Republic, Slovakia and Slovenia. The convergence in prices (nominal convergence) has been stronger than real convergence in some of the EU10 countries, however, raising questions about the sustainability of the process. The undergoing adjustment in Estonia and Latvia underscores these concerns. Increasing the supply of labor and labor productivity will be crucial for ensuring that convergence on the EU is sustained. This challenge is made more difficult by continuing outward migration from some countries, including Bulgaria and Romania, while domestic employment still remains low. Employment in those countries, Poland and Slovakia lags mostly among the young and the elderly, despite large gains this decade, especially in Bulgaria. The lag in elderly and youth employment is affected by labor market rigidities, high taxes on labor, and the availability of generous early-retirement and disability schemes. Efforts to address these challenges and boost activity rates have picked up of late (see the focus note Welcome the Elderly Back to Work). Inflation Surging prices for food and energy, together with buoyant domestic demand in many countries, have boosted inflation further in early 2008. Inflation more than doubled in April 2008 from a year earlier in most of the EU10 countries, exceeding 17 percent in Latvia and 11 percent in Bulgaria, Estonia and Lithuania (Figure 10). Inflation in these countries has also reflected hikes in excise tax rates to harmonize them with those in the EU and high growth in nominal wages. Only in Hungary has inflation started to ease, after hikes in regulated prices helped boost inflation to the high single digits in 2007. Figure 10. Harmonized Consumer Price Inflation (percent, year-on-year, Jan-2006 ­ April-2008) 16 18 16 CZ 14 HU 16 LV LT 14 BG RO 12 SK 14 EE SI 12 PL 10 12 10 8 10 8 6 8 6 4 6 4 2 4 2 0 2 0 60 6 70 7 80 0 6 7 06 6 07 7 08 an-J r-0pA 60-l 60- Ju Oct an-J r-0pA 70-l 70- Ju Oct an-J 60-n 60-l 60-t 70-l 70-t Ja r-0pA 60-l 60-t 70-n Ju Ju Ju Oc Ja r-0pA 70-l 70-t 80-n Ju an-J r-0pA Oc an-J r-0pA Oc an-J Oc Ja Source: Eurostat. The contribution of food prices to inflation has been substantial last year and this, ranging from nearly one-half in Bulgaria and Romania to one-fourth in the Czech Republic. Food prices have surged due to a combination of factors, including the global demand for biofuels, rising cost of inputs and the regional droughts (see the focus note The Impact of Rising Food Prices for a more detailed discussion). Increases in energy prices have also been a factor, accounting for about 20 percent of inflation. Other factors have included hikes in excise rates in a number of countries (Bulgaria, the Baltic countries, Czech Republic, and Slovakia) and the increase in the lower VAT rate in the Czech Republic. Excluding food, energy and tax changes, underlying inflation has also risen robustly, thanks to strong domestic demand, wage pressures and currency depreciation (Romania). In some countries, it appears that there are second round effects of the surging food and energy prices through their effect on wages and domestic demand. Currency appreciation, meanwhile, has helped curb inflation pressures in Slovakia, the Czech Republic and Poland. Inflation is likely to remain elevated through most of 2008 before beginning to ease moderately. The key risks to this forecast reflect developments of food prices and wages. Continued increases in demand for biofuels will probably keep global food prices elevated this year, despite the likely further easing of wheat prices. Wage demands appear to be growing, especially in the countries with the highest inflation. Ongoing monetary tightening in Hungary, Poland and Romania should help slow inflation within target (albeit only in 2009 or 2010), as should further currency appreciation in the Czech Republic and Slovakia, and weak domestic demand in the Baltic countries. 5 Balance of Payments Healthy corrections have begun this year in some of the countries with the largest current account deficits, notably Latvia, Estonia and Bulgaria, after these deficits widened Table 2. Current account deficit and export growth */ further in 2007. The external deficit shrank by 10 percent of GDP from a 2006 2007 1Q-07 1Q-08 2006 2007 1Q-07 1Q-08 year earlier in Estonia and 6.5 percent (Current account balance, % of GDP) (Export growth, % yoy, EUR) in Latvia, thanks to a drop in imports in Bulgaria -17.9 -21.5 -19.0 -21.0 26.9 12.2 8.5 25.7 line with the weakening economic Czech -3.1 -2.5 -2.8 -2.3 20.4 18.1 20.1 15.6 Estonia -15.5 -17.4 -17.4 -15.1 24.9 3.9 4.1 3.7 expansion (Table 2). The deficit has Hungary -6.1 -5.0 -5.5 18.5 15.2 18.6 12.0 also narrowed thus far this year in Latvia -22.3 -22.8 -24.5 -21.3 18.2 23.7 26.4 19.4 Lithuania -10.8 -13.7 -11.6 -13.9 18.7 11.2 6.3 30.9 Bulgaria by about 2 percent of GDP Poland -2.7 -3.7 -2.9 -4.0 22.7 14.8 16.1 18.9 from a year earlier on the back of Romania -10.4 -13.9 -11.7 -13.9 16.2 13.7 13.0 13.1 Slovakia -7.0 -5.3 -5.7 30.1 27.3 37.5 18.4 stronger exports, the first decline since Slovenia -2.8 -4.9 -3.0 -5.8 19.6 18.5 21.7 10.3 the deficit began widening in 2002. (Nonetheless, the external deficit in */ Current account deficits on a rolling 12-month basis. Data for the first quarter Bulgaria still exceeds 20 percent of estimated from monthly figures GDP.) Current account deficits appear Sources: Central banks, Eurostat; and World Bank staff calculations. to have continued to improve also in Hungary and Slovakia, in the former reflecting the shift of the merchandise trade deficit to a surplus in line with the fiscal consolidation efforts. In contrast to these developments, the external shortfall widened modestly in Romania and in Lithuania this year. Thus far this year, in all countries but Lithuania, net capital inflows continued to exceed the external deficits, boosting further foreign exchange reserves. Reserves rose by 0.2 billion in Estonia to as much as 0.9 billion in Bulgaria from January through May 2008. In Lithuania, by contrast, the current account deficit widened in the first quarter of 2008 compared with a year earlier (unlike Estonia and Latvia), while net capital inflows fell (similarly to Estonia and Latvia), resulting in a decrease in foreign exchange reserves; reserves fell by 0.8 billion from January through the end of May 2008. This year's developments follow the widening of the current account deficits in 2007 in all EU10 countries but the Czech Republic, Hungary and Slovakia. Current account deficits were more than financed by net capital inflows in 2007, however, and reserves rose in all EU10 countries. Inflows of foreign direct investment (FDI) were almost double the modest and lower deficit in the Czech Republic, and amounted to 90 percent or more of the shortfall in Bulgaria and Poland. By contrast, inflows of FDI financed just about a quarter of the deficit in the Baltic countries and Hungary, and almost nil in Slovenia. Foreign borrowing by domestic banks was the main source of deficit financing in the Baltic countries, but inflows have weakened and turned into a net outflows in early 2008, as banks and their foreign parents (largely from Sweden) reduced exposure along with the slowing of domestic credit expansion. Throughout 2007, foreign borrowing increased somewhat in Bulgaria and in Hungary (where large outflows of portfolio equity have continued). In addition to oversized current account deficits, external debt in some EU10 countries is large and presents risks. Gross external debt in Estonia, Latvia, Bulgaria and Hungary remains close or above 100 percent of GDP. The outlook for the EU10's current account deficits is mixed for this year and next. Notably, external shortfalls may well shrink by about 8-10 percent of GDP this year in Estonia and Latvia, as imports fall while exports remain robust. Lithuania's deficit will probably begin narrowing later in the year. The current account deficit is likely to ease modestly in Bulgaria, but remain at about 20 percent. In Poland and Romania it is likely that current account deficits will widen, as output growth remains strong, in Romania above potential. Fiscal Policies Buoyant revenues, reflecting a combination of improved tax collection, surging inflation and stronger inflows of EU funds, have helped improve fiscal positions thus far in 2008 in the Visegrad countries, Bulgaria and Romania. Tax collection continues to improve in Bulgaria and Hungary, thanks to the ongoing formalization of the economy and, in the former, lower tax rates. Revenues were boosted by the receipt of (pre-accession) EU funds in both Bulgaria and Romania, and by the pickup in real GDP growth in Hungary and Romania. Fiscal balances also improved thanks to expenditure restraint in Poland and Hungary, and cuts in social outlays in Slovakia, as unemployment fell. Output contraction is yet to take a more substantial toll on the fiscal positions of the Baltic countries, as larger inflows of EU funds, little change in employment and still strong wage increases helped partly offset smaller indirect tax receipts. Nonetheless, weak growth in the Baltic countries this year, together with cuts in personal income tax rates and contribution rates in Lithuania, are likely to result in fiscal deterioration. Fiscal developments this year build on fiscal tightening in 2007 in all EU10 countries but the Baltic countries and Romania. Improved fiscal positions in the Visegrad countries led the EC to abrogate in early 2008 the excessive deficit procedure (EDP) for all of these countries but Hungary. (The EDP requires that countries bring fiscal positions in line with their medium-term Table 3. Fiscal balance, first objectives, as articulated in their convergence programs.) In Hungary, tax hikes and spending reductions helped cut the general quarter 2006-08 (percent of GDP) government deficit to 5.5 percent of GDP in 2007 from 9.3 percent in Q1-2006 Q1-2007 Q1-2008 2006, a retrenchment that slowed real GDP growth and helped narrow the current account deficit. The fiscal deficits also narrowed Bulgaria 4.3 5.9 12.2 Czech Republic 2.1 1.4 -1.5 substantially in the Czech Republic (to 1.6 percent of GDP), Poland Estonia -0.8 -0.4 1.0 and Slovakia (in both to about 2 percent). Bulgaria's fiscal surplus was Hungary -15.3 -13.4 -8.3 the largest in the EU10 last year after widening modestly further to Latvia 3.8 3.4 2.0 3.4 percent of GDP. In most Visegrad countries and Slovenia, a part Poland -3.8 -1.9 0.6 of the fiscal adjustment was of a structural nature, reflecting Slovakia ... -2.8 0.7 expenditure restraint and cuts in social outlays. Improved tax collection was also important in Hungary. Sources: Eurostat and World Bank staff calculations. In contrast to these improvements, fiscal deficits rose in 2007 in Lithuania and Romania, and fiscal easing was modest in Estonia. Fiscal easing in Estonia and Lithuania reflected largely one-off effects, such as compensation payments to pensioners in Lithuania and the reclassification of some entities within the government sector in Estonia. Figure 11. Fiscal developments, Q1-2008 Smaller fiscal deficits in most EU10 have helped reduce further government debt relative to GDP in (percent of GDP) */ 2007 and thus far in 2008. Eight of the EU10 70 Revenue countries have government debt lower than 60 Expenditure 30 percent of GDP, with Poland's government debt amounting to about 45 percent of GDP and Hungary's 50 to 67 percent (the largest in the EU10 and above the 40 Maastricht limit). Government debt in Estonia and 30 Latvia is below 10 percent of GDP. 20 Some modest further fiscal consolidation is expected in most EU10 countries this year, in line 10 with the countries' medium-term fiscal objectives. 0 Stronger economic growth and some spending 2007 2008 2007 2008 2007 2008 2007 2008 2007 2008 2007 2008 2007 2008 restraint should help reduce the fiscal deficit in BG CZ EE HU LV PL SK Hungary to 4 percent of GDP. Fiscal deficits in */ Bulgaria: general government cash; Hungary: general Romania and the Czech Republic should remain little government cash without local governments; all others: budgetary changed, as should the fiscal surplus in Bulgaria. In central government. contrast to these developments, meeting the Sources: Ministries of finance. convergence program fiscal goals is likely to be challenging in the Baltic countries, given the growth slowdown. In Estonia, for example, the government targets a general government balance this year, rather than the originally budgeted surplus of 1.3 percent of GDP, following the recently announced package of measures to reduce spending by 1.1 percent of GDP. Further budget amendments are likely in the fall. In Poland, the general government deficit is likely to widen to 2.5 percent of GDP, in line with the convergence program, before narrowing again thereafter. 7 Monetary and Exchange Rate Policies Higher inflation and concerns that increases in food and energy prices will become entrenched in inflation expectations have led central banks to tighten monetary policy this year. Key policy rates were hiked in Poland (75 basis points), Hungary (100 basis points) and Romania (175 basis points), and it is likely that more rates hikes are forthcoming in all of these countries. Rates were increased by only 25 basis points in the Czech Republic despite the strong pickup in inflation early this year, amid central bank concerns about the strong koruna. (The key policy rate in the Czech Republic is 25 basis points below the ECB's 4 percent key policy rate.) The central bank in Slovakia has held its key policy rate unchanged for a year, amid concerns about overly rapid koruna appreciation. Exchange rate appreciation has helped limit inflation pressures in the Czech Republic, Hungary, Slovakia and Poland. In Hungary, the authorities abandoned the forint's ±15 percent band in February with a view to strengthening market confidence in their commitment to the inflation target. Following a short period of weakness, the forint has subsequently strengthened, appreciating by almost 9 percent against the euro since the elimination of the band. The central parity of the Slovak koruna was revalued 17.6 percent in late May 2008 ahead of the July decision by the EU on fixing the conversion rate of the koruna prior to Slovakia's entry into the eurozone from the start of 2009, following a rapid appreciation earlier in the year. The authorities intended the revaluation to help limit inflation pressures over the medium term (for more details, see this issue's focus note, Slovakia Set to Adopt the Euro). Figure 12. Key interest rates (in percent, annual) */ 9 CZ HU PL SK 10 7 8 9 6 7 8 6 7 5 BG 5 6 4 5 RO 4 4 3 3 LT 3 2 2 LV 2 1 1 1 0 0 0 06- 60-r 06-l 60-t 07- 70-r 07-l 70-t 08- 80-r 60 6 n- r-0a 60-y 60-l 60-p 60-v 70 7 n- r-0a 70-y 70-l 70-p 70-v 80 8 n- 80-y 60-n r-06a 60-y 60-l 60-v 70-n r-07a 70-y 70-l 70-v 80-n r-08a Jan Ap Ju Oc Jan Ap Ju Oc Jan Ap Ja M Ma Ju Ju Ju Se No Ja M Ma Ju r-0a Se No Ja M Ma Ja M Ma Sep-06 No Ja M Ma Sep-07 No Ja M Sources: Central banks. */ For Bulgaria and Lithuania, overnight interbank interest rates. For the others, key central bank policy rates. Several EU10 central banks have tightened prudential regulations and other requirements in an attempt to slow credit growth. Recent measures have included an increase in reserve requirements in Bulgaria in September 2007. Other measures include higher capital adequacy requirements, tighter supervision, increased on-site and consolidated inspections and enhanced cross-border cooperation agreements. In contrast, there are no administrative restrictions on credit growth in the EU10; restrictions in Bulgaria were abolished from the start of 2007, at the time of EU accession. Restrictions remain in place in Croatia. Amid the ongoing global turmoil and with banks tightening credit standards, credit growth has slowed, albeit modestly in most EU10 countries. The increase in lending has slowed substantially only in Estonia and Latvia and modestly in Bulgaria. Annual credit growth still remains above 50 percent in Bulgaria and Romania, however. Lending has grown moderately in Poland, Slovakia and the Czech Republic, but the pace appears to have picked up somewhat of late in Hungary amid signs of a tentative strengthening of the pace of economic expansion (Figure 13). 8 Figure 13. Credit to private sector growth (in percent, year-on-year) 80 EE LV 80 80 CZ HU LT 70 70 BG RO 70 PL SK SI 60 60 60 50 50 50 40 40 40 30 30 30 20 20 20 10 10 10 0 0 0 06 60-r an-J 60-y 60-l 06 60-v 07 70-r 70-l 07 08 80-r 06- 06- 60-l 60 07- 07- 70-l 70 08- 6 06- 60-l 06 60-v 70-n 7 07- 70-l 07 70-v 80-n 8 Ma Ju Ma ep-S r-0a Ju r-0a Ju r-0a No an-J 70-y 70-v Ma Ju Ma ep-S No an-J 60-n 60-v 70-n 70-v 80-n 60-n Ma Ja Mar Ju May ep-S No Ja Mar Ju May ep-S No Ja Mar Ja M May ep-S No Ja M May ep-S No Ja M Sources: Central banks. 9 EU10 June 2008 In Focus: The Financial Turmoil and the EU10 The impact of the global financial crisis on the EU10 countries has been moderate so far, but its effects are likely to be more palpable and differentiated later this year, as market turbulence continues to affect the financial system in Western Europe and output growth in the eurozone slows. Eurozone demand for exports from the EU10 has held up well thus far, but estimates suggest that the likely slowing of eurozone growth will affect exports and economic activity in the EU10 countries with a lag of about two quarters. For countries that have relied heavily on international financial markets, higher interest rates and tighter financial conditions have contributed to slowing credit growth, which, in most cases, has affected investments in real estate and other nontradable activities. Some EU10 governments delayed external borrowing until recently, while others have shifted issuance in local currencies to shorter maturities. The effects of the financial turmoil are likely to be more profound over the medium term as investors' reassessment shifts more permanently regarding countries with rapid credit growth, oversized current account deficits and large external debt. Such reassessments are common after periods of financial turmoil and they take years to play out. The emphasis on sound macroeconomic and institutional fundamentals looks likely to be much more substantial than in the past, however, given the likelihood that tighter financial conditions will remain for longer, and distinctions among the different countries should come again into sharper focus. These developments will likely be reinforced should growth in the eurozone slow more sharply than currently projected, or should a more disorderly unwinding of the financial tensions resume. Export growth from the EU10 appears to have remained buoyant thus far in 2008, but prospects for weaker eurozone growth suggest that a slowdown is likely. The most important factor driving EU10's exports is demand in the eurozone, with about 65 percent of the EU10's exports directed Figure 14. Real GDP Growth in the Eurozone and EU10 to the eurozone and the correlation export growth (percent, year-on-year) between eurozone growth and EU10 export growth at about 70 percent based on data Real GDP, eurozone (LHS) 3.5 30.0 from this decade (Figure 14). Estimates of Exports, EU10 (RHS) the impact of a slowdown in eurozone 3.0 growth on the EU10 differ and range from 25.0 0.5 to 1 percentage points reduction in 2.5 EU10 real GDP growth for every 20.0 2.0 1 percentage point reduction in eurozone growth. 1.5 15.0 This report forecasts a slowdown in EU10 1.0 growth in 2008 to about 5 percent (average 10.0 weighted by previous year' nominal GDP), 0.5 down from 6.2 percent in 2007. About a 5.0 0.0 0.4 percentage points of the reduction is due to the projected slowdown in the -0.5 0.0 Baltic countries, with most of the rest 1Q 01 4Q 01 3Q 02 2Q 03 1Q 04 4Q 04 3Q 05 2Q 06 1Q 07 4Q 07 reflecting the assumption of weaker Sources: Eurostat, World Bank staff calculations. expansion in EU10 exports. Direct spillovers to the financial systems of the EU10 have been limited so far. The parents of most of the largest banks present in the EU10 have not experienced losses related to mortgage lending or complex derivatives in mature markets (Société Générale's large trading loss from financial derivatives is of a different nature). Nonetheless, many banks in the region and their parents have begun tightening credit standards, as they have become more mindful of the risks inherent in some of the fastest growing economies. The impact has been somewhat differentiated, depending to a large extent on the degree of funding of domestic credit 10 expansion through foreign borrowing. With the exception of the Czech Republic and Poland, domestic credit exceeds the stock of domestic deposits in most EU10, with reliance on foreign borrowing, largely through parent banks (Table 4). This dependence is by far the highest in Latvia and the other Baltic countries, but is also oversized in Romania and Hungary. In the Czech Republic and Poland, by contrast, fewer banks than in the Baltics, Romania or Bulgaria rely on foreign borrowing to finance domestic credit expansion. Table 4. Ratio of Domestic Loans to Domestic Deposits (in percent) Baltics Bulgaria Czech Hungary Poland Romania Slovakia 2005 158 102 83 131 82 122 105 2006 176 100 84 138 83 139 107 2007 200 108 85 131 93 148 108 Mar-08 215 122 90 134 100 160 113 Sources: ECB, World Bank staff calculations. Reappraisal of risk in emerging markets has been one of the key consequences of the current financial turmoil. This has resulted in increased bond spreads and higher cost of protection against default. Spreads on local currency government bonds have risen strongly in Latvia and Hungary this year, but Table 5. Spreads on 10-year Government Bonds rather modestly in some of the others and have Relative to German Bunds (in basis points) actually fallen in Bulgaria and Slovakia. In the former, spreads have fallen this year after 2005 2006 2007 Dec-07 Apr-08 rising in 2007, thanks to further reductions in government borrowing. In the latter, spreads Bulgaria 52 44 32 85 76 declined as prospects for eurozone entry Czech Republic 19 4 9 46 68 Latvia 52 39 107 103 189 firmed (Table 5). Nonresident holdings of Lithuania 35 34 33 48 55 government-issued local currency-denominated Hungary 325 336 253 265 398 securities have been volatile in some countries, Poland 187 148 127 161 195 but have ultimately been on an upward trend Romania 372 346 292 287 330 because of the considerably increased yields. Slovenia 45 8 31 31 43 In Bulgaria, nonresident holding have Slovakia 17 68 27 50 42 quadrupled this year to 4.3 percent of Greece 23 31 28 34 51 domestic government debt. In Hungary, nonresident holdings remain at one-third of Source: Eurostat. domestic government debt at the end of March, little changed compared with the middle or end of 2007, following large swings earlier in the year. Spreads on existing external debt have risen substantially as Table 6. EMBIG Stripped Spreads, well (Table 6). Until May, most EU10 governments delayed June 2007 - May 2008 (in basis points) issuance of foreign-currency denominated bonds, but signs of improvement in international sentiment have brought several new large issues. The latest issue are also likely to June-2007 May-2008 Minimum Maximum have reflected the growing realization that while the financial turmoil may be easing, higher spreads are likely to stay, Poland 61 98 56 132 Hungary 72 133 62 187 reflecting tighter financial conditions. Higher inflation, Bulgaria 72 145 57 240 meanwhile, is likely to make issuance in domestic currencies even more expensive. The Czech Republic issued a 2 billion 10-year Eurobond in late May at a spread of 68 basis points over Source: JPMorgan. German bunds, followed by Hungary with a 1.5 billion 10-year Eurobond at (95 basis points) and Romania with 750 million in mid-June (213 basis points). Other issuance earlier this year included a 10-year 400 million bond by Latvia, CHF350 million in two bonds issued by Hungary and CHF 475 million by Poland, as well as a 750 million syndicated loan by Croatia. Slovenia, the only eurozone member among the EU10 countries, also issued a 1 billion Eurobond earlier this year. The negative impact on currencies has been limited to the Romanian leu and the Hungarian forint. The leu depreciated 22 percent from the middle of 2007 until late January 2008, but has since then moved sideways. The Hungarian forint weakened substantially from late-2007 until March this year, when a decision by the 11 authorities to abandon the forint's ±15 percent band against the fixing to the euro led to a sharp reduction in nonresident holdings of forint-denominated government bonds (but these later recovered). Subsequent interest rate hikes have helped appreciate the forint to its strongest levels since early 2004 (and 9 percent against the euro since mid-march), while foreign investors appear to have returned to the market. In contrast to these developments, strong fundamentals and robust investor confidence have underpinned continued appreciation of the Czech koruna, the Polish zloty and the Slovak koruna, the latter case supported by firming prospects of eurozone entry. 12 EU10 June 2008 In Focus: The Impact of Rising Food Prices Following a relatively stable path of modest increase for over two decades, global food prices began increasing rapidly in late 2006 and have soared since to historic highs. Global food prices rose by 76 percent in dollar terms from September 2006 through early 2008, with the increase in 2008 amounting to about 28 percent (Figure 15-Figure 18). This rapid increase in global food prices has affected balance of payments positions in the EU10 and contributed to a substantial pickup in inflation that has eroded real incomes and trimmed economic expansion. These developments, in turn, have added to pressure to increase wages that may spill into further inflation pressures unless effectively tackled. Figure 15. Global Food Prices (US$, 1998- Figure 16. Global Fertilizer Prices (US$, Jan- 2000=100) 2002=100) 300 900 Food Price Index 800 250 Urea Cereals 700 Oils and Fats 600 TSP 200 500 400 150 300 200 100 100 50 0 2000 2001 2002 2003 2004 2005 2006 2007 Apr- 02 20-l 03 30-l 04 40-l 05 50-l 06 60-l 07 70-l 08 08 n-aJ Ju n-aJ Ju n-aJ Ju n-aJ Ju n-aJ Ju n-aJ Ju n-aJ Sources: FAO, World Bank staff calculations. Source: World Bank staff calculations. Figure 17. EU10 Food Prices (2005=100) Figure 18. EU10 Inflation and Food Price Increases (HICP, percent, y-y, April 2008) 150 30 Overall Food 140 bread and cereals oils and fats 25 130 meat 20 120 15 110 10 100 5 90 80 0 2001 2003 2005 70-r 07 07 70- 08 BG LV EE LT HU RO SI CZ SK PL Ap un-J 70-c ug-A Oct De eb-F 80-r Ap Sources: Eurostat, World Bank staff calculations. Source: Eurostat. The global increase in food prices was largely concentrated in cereals, edible oils and fats. Prices for these products almost doubled from a year earlier in April 2008. Within cereals, wheat prices surged most substantially starting in July 2007, while increases in maize and barley prices have been somewhat smaller. However, while wheat prices dropped in April and May this year, prices of maize and, since the start of 2008, 13 rice, continued to surge. (Prices of wheat appear to have fallen, thanks to a good harvest in the northern hemisphere thus far and the lifting of restrictions on wheat exports from Ukraine.) Despite these steep price increases in grains and related animal feed, prices of meat and dairy products rose more modestly, increasing 25 percent year-on-year in early 2008. There is considerable disagreement among experts as to the contribution of factors accounting for the steep increase in global food prices, but it appears that the role of biofuels production is substantial. Biofuels production is estimated to have accounted for half to three-fourths of the increase in global dollar food prices from 2002 through 2007, according to recent World Bank and IMF publications.1 Biofuels production (ethanol in the U.S. and biodiesel in the EU) has been propped by generous subsidies and tariffs and supported by government mandates. Nearly 90 percent of the increase in global maize production between 2004 and 2007 was used for ethanol production, while more than one-third of vegetable oils went for production of biodiesel. (Ethanol produced in Brazil comes from sugar cane, by contrast, and has had a negligible effect so far on sugar prices. Areas under sugar cane cultivation, moreover, have been increased but not at the expense of areas for growing wheat or maize.) The rapid increase in prices for fertilizers and other inputs in agriculture, together with dollar depreciation, have also added to global food prices. With petroleum prices surging, fertilizer prices have more than doubled over the last year, which would add further to food prices in the future. High oil prices are boosting transportation costs in agriculture. World petroleum prices grew by more than 70 percent y-o-y in April 2008, and with forecast for oil prices to rise further from the $135 a barrel in early June, pressures on food prices may well rise in the near term. With markets already tight due to strong biofuel demand and global stocks falling to the lowest levels in more than a decade, price pressures were further boosted by the regional droughts in 2006 and 2007, recent export bans and restrictions in a number of grain exporting countries, and speculation. Global food price developments have affected substantially food prices and inflation in the EU10 countries, given the increasing integration of the region in the EU and the world economy. Twelve-month increases in domestic food prices were in the double digits by April 2008 in all countries but Poland. The highest increases were registered in Bulgaria and Latvia (more than 20 percent), driven by 30 percent or more increases in prices for bread and edible oils, the two commodity groups that have been mostly affected by global developments. In addition to global food prices, adverse weather conditions throughout the EU10 reduced harvests in 2006 and 2007, especially in Bulgaria, Romania and Hungary. In the case of Bulgaria, the drought resulted in a severe 30 percent collapse in agriculture value-added last year that boosted the country's reliance on imports. There is a strong correlation between food prices increases and wage increases in the EU10 countries, with the former feeding into stronger demands for higher pay that are having a second round effects on food and overall prices. By contrast, the overall correlation between food inflation and levels of food prices is very weak in most EU10 countries despite the tight link between the two in Bulgaria and Latvia. The outlook for food prices in 2008 remains mixed. The latest data on global food prices seem to suggest that market participants are betting on a further fall in wheat prices this year on the assumption of a bounty harvest. Most forecasts for maize and edible oils, however, suggest prices will remain elevated and perhaps increase further in the short term. The outlook for food prices is much more uncertain over the medium term, and reflects judgments about policies to expand the area under cultivation, raise the productivity of agricultural land, enhance energy efficiency, and change the incentives for biofuels mandates and production in the US and the EU. Whether such policies are modified or abandoned is not clear, although pressure has increased for changes to biofuels mandates in the US and the EU. Research into biofuel technologies could focus on the use of non-food crops for the production of biofuels to ease the pressures on food prices, but the viability of these technologies may well take substantial time to be ascertained. Further increases in petroleum and other energy prices, should these materialize, will also feed into the cost of agriculture inputs, including transportation and fertilizers. On the other hand, supply side policies (including at the EU and global level) aimed at enhancing the productivity of agriculture could help dampen pressure on food prices. Such supply policies include increased investment in rural infrastructure, a boost to agriculture research, and more active natural resource management. Improving the regulation and incentives for energy efficiency initiatives would also continue to be an important factor for 1The World Bank, Global Development Finance, 2008, and IMF, World Economic Outlook, April 2008. 14 containing energy prices that could help limit or reverse increases in food prices. The planned large absorption of EU funds for agriculture, especially in Bulgaria and Romania, will also probably have a positive effect on agriculture productivity and output, at least in the medium term. All in all, a rapid reversal of the sharp increase in food prices since late 2006 seems unlikely. Food prices may well peak in 2009 or 2010 and then ease as supply increases, but it is likely that over the longer term prices will remain above the low levels before 2006. In the near term, efforts to contain inflation and inflation expectations should be of substantial value. These efforts would need to include steps to keep nominal wage increases in line with core inflation and productivity to avoid second-round effects on inflation. Social protection systems will also need to be strengthened to improve the targeting of transfers to the most vulnerable, given the substantial impact of the rising food prices on living standards. 15 EU10 June 2008 In Focus: Welcome The Older back to Work The need to increase employment among the elderly is one of the urgent policy challenges in the EU10 countries amid tighter labor markets, increasing life expectancies. Increasing employment could help ease labor market pressures and reduce strains on pension systems. In this note, we focus on the former. Despite remarkable improvements in recent years, employment rates in most EU10 countries are still low and vary substantially across the region. Overall employment rates (15-64 years old) in 2007 approached the 70 percent Lisbon Strategy target only in Estonia and Latvia. Rates are below 60 percent in Poland, Hungary, Croatia and Romania and slightly above this threshold in Slovakia and Bulgaria, a surge in the latter since 2000 notwithstanding (Figure 19). Employment rates for older workers are substantially behind the EU15, despite large increases this decade in most countries, notably in Bulgaria. The Czech Republic and the Baltic States perform relatively well, with rates close or above the 50 percent Stockholm target to Figure 19. EU employment rates, ages 15-64 (in be achieved by 2010 (Figure 20). percent) Some countries in the region recently 80 implemented or scheduled changes in 2000 2007 their policies for older workers. The 75 Lisbon target for aged 15-64 years changes are not in the right direction in all 70 countries, however. From 2008, Hungary 65 tightened eligibility criteria for disability pensions and improved the rehabilitation 60 ` system and by 2013 incentives for early 55 retirement will be reduced. In February 50 2008, the Polish government started social atl dnal Ma aitao y ar ylaIt aina ai m gr a . l d a ak UK kra bu ani nia aivt yna surp consultation on the Program 50+ Po Cr nguH m ecee ecna epR airts Ro ovlS airagl Fr h La mr dnaln nede mn Gr Bu iulgeB mex hutiL Sp ainevo anelrI Sl onitsE Fi Cy Au "Generational Solidarity." The program Lu eczC ugatroP Ge Sw sdnalreht De Ne aims at "making work pay" for the elderly (compared with reliance on social Figure 20. EU employment rates, ages 55-64 (in transfers), increasing labor market percent) flexibility, and lowering the costs of employing older workers (Box 1). By 80 2000 2007 contrast, amendments to the pension 70 system in Croatia in 2007 reduced the 60 Stockholm target for aged 55-64 years penalty rate for early retirement from 50 4 percent to 1 percent a year and increased 40 minimum and disability pensions, reversing 30 some of the achievements of the 1998 20 pension reform. 10 0 Pension outlays are the main component at gr y yl ai a n a ar any su UK aivt k a en of social protection expenditures in the Mal andloP Ita miulgeB ak ecna airts ecee Fr Au Gr iaralguB paiS ep.Rh ndsal ugalt m ani orP andlerI andlniF pr Cy La onitsE region. In recent years, pension outlays bumex ungH ainevoSl ovlS manioR Lu eczC herteN erG hutLi enmarD edwS have remained high and little changed in Poland, Slovenia, Croatia and Hungary. Source: Eurostat. Spending in the Baltics and Slovakia, by contrast, is smaller (Table 7). Expenditure on old-age pensions topped the list of pension expenditure. However, disability spending is high in Poland, the Czech Republic, Hungary and Croatia. The EU10 will face significant demographic pressures in the coming decades that will have negative fiscal implications. Demographic pressures reflect three key factors: increasing life expectancy, low fertility rates, and the baby-boom generation born in early years after the World War II reaching retirement age. The old-age 16 dependency ratio (the number of people aged 65 years and older as a share of people aged 15­64 years) is set to rise strongly in the EU10 and the demographic "pyramid" shift to an "inverted cone," exerting substantial pressure on pension and health systems. The dependency ratio would peak approximately 20 years later in the region than in most other EU countries. Table 7. Social protection benefits 2005 (percent of GDP) Total social Anticipated Early Country protection Total pensions Old age Disability Other** old age retirement* benefits Bulgaria 15.5 8.0 6.0 1.1 .. 0.8 0.1 Czech Rep. 18.4 8.4 6.9 0.2 .. 1.1 0.2 Estonia 12.3 5.9 4.1 1.0 .. 0.6 0.2 Hungary 21.4 9.8 7.2 0.9 0.1 1.4 0.2 Latvia 11.9 6.3 5.1 0.2 .. 0.8 0.2 Lithuania 12.8 6.6 5.3 0.2 0.1 0.9 0.1 Poland 19.1 12.7 7.8 2.1 0.4 1.6 0.8 Romania 13.9 6.2 5.3 0.0 0.2 0.5 0.2 Slovakia 16.4 7.6 6.3 0.1 0.1 0.9 0.2 Slovenia 23.0 10.5 6.5 2.6 0.2 0.9 0.3 EU15 26.7 12.3 9.5 0.4 0.1 1.1 1.2 Croatia 26.3 11.5 7.1 .. .. 2.8 1.7 */ Early retirement for labor market reasons and due to reduced capacity to work. **/ Including survivor pensions. Source: Eurostat. Factors explaining inactivity among the elderly Demographic trends have been exacerbated by misguided policies of early retirement. Such an approach was adopted in the 1970s and 1980s in Western Europe in reaction to adverse economic shocks. Although many EU countries (the Netherlands, Ireland, Denmark and Finland) started to reverse this policy in the early 1990s, many transition countries introduced such an approach to help alleviate the impact of enterprise restructuring and labor shedding. This policy was based on the wrong premise that early pensioners create space for younger workers to enter the labor market. This turned out to be naďve, as the economy is not a zero-sum game. Moreover, the early retirement increased the tax and contribution burden on existing workers, affecting negatively labor markets. Table 8. The elderly (55-64 years of age) by labor force status, 2006, (in thousands unless indicated otherwise) (thousands) BG CZ EE HU LV LT PL RO SK SI HR Total 968 1,401 148 1,211 256 353 4,055 2,267 560 232 546 Active 416 669 91 423 146 187 1,243 971 205 77 199 Employed 384 633 87 406 136 175 1,138 946 185 75 187 Unemployed 33 36 4 17 10 12 106 25 20 2 12 Inactive 552 732 58 788 110 166 2,812 1,296 354 154 347 in percent of total inactive -retired 64 93 54 77 66 59 55 43 81 70 73 -family reasons 6 1 0 1 0 0 4 4 0 7 10 -illness or disability 19 4 33 17 20 32 29 18 16 18 11 -other 11 2 13 5 14 9 12 35 3 4 7 Source: Eurostat. Certain labor market policies and institutions have a negative impact on overall employment rates, especially among the elderly. As demonstrated in the OECD Employment Outlook 2006, the tax wedge and unemployment benefits appear to be the most important determinants of overall employment rates while group-specific policies (implicit taxes on continued work, statutory retirement age, tax incentives to part-time work or family-friendly policies) seem to play a minor role.2 Hence, less generous coverage rates and lower tax wedges should improve overall labor market outcomes. Stringent labor and product market regulations (PMR) appear to have a positive effect on employment of the elderly (smaller layoff risk for incumbent older workers seems to outweighs the negative impact of employment protection and PMR on hiring rates). 2OECD Employment Outlook 2006, Boosting jobs and incomes, Paris. 17 In countries with poorly performing labor markets, higher taxes on labor (relative to the treatment of other sources of income) and availability of non-employment benefits are the key factors explaining inactivity among the elderly. Early retirement and disability benefits are among the most important non- employment benefits. The correlation between effective retirement age and employment rate is also strongly positive. In Poland, the number of inactive because of illness or disability is significantly higher than the remaining EU10; an access to disability pension is also a pathway to exit from the labor market (Table 8). The confluence of high taxes on labor and the availability of non-employment benefits are highly relevant for Poland, the country with the biggest gap relative to the Stockholm target among the EU10, as confirmed by a recent study.3 In the general pension system (ZUS), in almost all cases the decision to retire is determined by the age at which the insured is entitled to a pension and the required number of years of contributions. Currently, eight out of ten Poles retire before reaching the statutory retirement age of 60 for women and 65 for men. Statistically, high-income earners with higher educational attainment or better overall qualifications, enjoying better health status and frequently self-employed, tend to leave the labor market later. Other obstacles exist. Although temporary employment is largely available, especially in Slovenia and Poland, part-time work arrangements are less popular than in the EU15. Less than 5 percent of workers were employed part-time in Bulgaria, the Czech Republic, Hungary and Slovakia, compared with one-fifth in Western Europe. Lessons for the region in labor mobilization Over the last decade many OECD countries reformed social benefits to limit their impact on labor markets. Publicly-subsidized early retirement benefits have been gradually phased out and eligibility for disability benefits tightened (many countries granted benefits on a temporary basis, with regular periodic re- examination). The Netherlands even re-validated existing disability benefit claims of all beneficiaries younger than 50 years. People with partial or temporary limitations on work capacity can be granted a benefit status with partial work-availability requirements (the Netherlands, the UK, Australia, and New Zealand). Many OECD or EU countries introduced various measures to increase the participation and employment rates among elderly. The measures aimed at: (i) reducing financial disincentives through tightened eligibility to early retirement, invalidity schemes and unemployment benefits; provisions that facilitate combining pensions with income from work, actuarial adjustments to early (or late) receipt of regular old-age pensions; (ii) alleviating of employer barriers through age-discrimination legislation, information campaigns and guidelines for promoting age diversity in the workplace, reducing the importance of seniority in wage-setting, age-specific wage subsidies or labor tax reductions, and (iii) improving employability through more suitable working conditions and working-time arrangements; career counseling; provision of educational support; job- search assistance; help with self-employment; and use of information and education campaigns.4 In the 1990s and 2000s, some EU countries also implemented special programs to stimulate employment of older workers. They included Finland (FinnAge - Respect for the Ageing program from the early 1990s or the Finnish National Program on Ageing Workers from 1998-2002), the United Kingdom (New Deal 50plus introduced nationally in April 2000) and Ireland (National Workplace Strategy, Supporting Older Workers launched in 2005). Policy measures in selected European countries were supportive for "making work pay" and also had a positive budget impact. In Ireland, Denmark, the Netherlands, Finland and the UK, progress in employing older workers has been impressive. Employment rates among the elderly increased by 10-20 percentage points during 1990-2007 and are now above the 50 percent EU target. Reforms enacted included the elimination of a benefit for the handicapped and in-patient care reimbursement and reduced paid sick-leave benefits (Netherlands), cuts in anticipated old-age pensions (Denmark), reductions in early retirement benefits due to reduced capacity to work (Finland). The UK reduced spending on disability pensions and Ireland on old-age pensions. A study5 analyzed policies for older workers in some OECD countries and found that the integrated approach was most developed in Finland, while in the other countries policies were more fragmented. Active-age policies bring benefits to both workers and employers. Programs for the elderly need to be adequately funded and seen 3Ministry of Labor and Social Policy, January 2008, Deactivation of people in pre-retirement age (Dezaktywacja osób wieku okoloemerytalnym), Góra M., Sztanderska U., Giza-Poleszczuk A., Liwiski J., Profile PR, Warsaw. 4Ilmarinen J., 2005, Ageing and the quality of Worklife in the European Union, FIOH, Helsinki. 5Taylor P., 2002, New policies for older workers. Transitions after 50 series. The Policy Press, Southampton. 18 as part of the diversity of work life, be based on flexible models and solutions, emphasize the role of preventing problems, be tested and evaluated, and be persistent. Integrated programs addressed to older worker have not been yet applied in the EU10, but since the mid- 1990s they have been reforming their pension systems, combining measures to delay retirement and link benefits more closely to contributions. Statutory funded pension schemes, which strengthen the incentives to work longer and increase personal involvement and responsibility, were introduced in Hungary, Croatia, Poland, Estonia, and Latvia in the late 1990s, followed by Bulgaria in 2000, Lithuania in 2004 and Slovakia in 2005. In Romania, the second pillar was introduced in May 2008. Some EU10 reward deferred retirement through higher accrual factors. For example, the Czech Republic offers a more generous accrual rate of 1.5 percent for every 90 days rather than the annual 1.5 percent for deferring retirement. In Estonia, if retirement is deferred, the pension entitlement is increased by 0.9 percent for every extra month of deferral after the statutory retirement age. Box 1. Program 50+ "Generational Solidarity" in Poland The increase of labor activity is a policy priority for the Polish government. The implementation of the program is projected to increase employment among those 50 years of age or older by 0.7-0.8 million (currently 3.4 million people out of 12.4 million in this age group are employed), with a cumulative positive budgetary impact of PLN15-16 billion (1.4 percent of 2007 GDP). The implementation document for the program is set to be prepared by September 2008. The program assumes a reduction of inactivity incentives created by social transfers, which should lead to a higher effective retirement age and gradual equalization of the statutory retirement age. Its main element is the act on "bridge pensions" for people working in special conditions to replace all early retirement schemes. In addition, the program proposes further labor market reforms, including: learning programs for older workers and promotion of life-long- learning, elimination of unemployment contribution for employers hiring workers within five years before retirement, reforming labor market intermediation services, more effective active labor market programs, facilities for women willing to re-enter the labor market after child birth, and social campaigns to promote longer working lives. The EU10 countries have made progress in curtailing or abolishing early retirement schemes or benefits. In Slovakia, pensions decrease by 0.5 percent for each month taken before normal retirement age (0.4 percent in Estonia and Lithuania), and in Hungary early retirement schemes for the unemployed were cut back.6 In Poland, the government proposed in May 208 regulations on the so-called "bridge pensions" (available between the end of work career and statutory retirement age) (Box 1). The reform is fundamental, as early retirement schemes should be replaced by "bridge pensions" only for those working in conditions justified by medical criteria. These reforms build on earlier labor reforms in Poland, including the reduction in the invalidity social contribution rate from 13 percent to 6 percent of gross salary (in 2007-08). Recommendations in brief In the light of empirical evidence and useful lessons learned from international experience, reform efforts to promote longer working lives should include the following measures: 1) Further strengthen the link between contributions and benefits; 2) Reduce special retirement privileges for certain groups of workers and review disability pensions; 3) Adjust retirement ages in line with increases in life expectancy. Equalize the legal retirement age for men and women to help reduce the gender gap in pension entitlements (especially given that women live longer than men); 4) Review unemployment benefits, especially for elderly workers; 5) Create conditions conducive to job retention (in particular in relation to health and safety), flexible working arrangements (including part-time work and career breaks) and care services; 6) Introduce various "soft measures" to promote age management in enterprises and help reduce prejudices related to the employment of older workers. 6European Commission, Adequate and Sustainable Pensions, Synthesis report, 2006. 19 EU10 June 2008 In Focus: Slovakia set to adopt the euro Slovakia will formally adopt the euro from the start of 2009, becoming the 16-th eurozone member. This achievement caps a remarkable economic and political transformation that started in 1998, during which Slovakia has emerged as the leading reformer among the EU10 countries. Nonetheless, euro adoption will be just another step in the process of convergence on the more advanced EU economies that Slovakia has been riding so successfully so far. Further structural reforms, accompanied by continued fiscal prudence will be needed to ensure convergence. The benefits of adopting the euro include the elimination of exchange rate risk, the reduction in risk premia and transaction costs, and the fostering of greater financial integration with the other eurozone countries. All of these have, in the case of the eurozone thus far, lead to greater trade in goods and services and increased cross-border capital flows. Some of the risks in adopting the single currency include the possibility of building up imbalances, and the possible susceptibility of Slovakia and the rest of the eurozone to asymmetric shocks. Progress made by Slovakia Slovakia embarked on ambitious economic reforms rather late, only when The Milestones of Slovakia's journey to euro adoption it appeared on the edge of financial crisis 2004 Sep Government adopted "Strategy for Adoption of the Euro" in 1998. The authorities began bold macroeconomic stabilization, bank 2005 Nov Slovakia entered the ERM II with a central parity of 38.4550 SK/EUR with ±15 percent fluctuation bands. privatization, structural and fiscal reforms. In 2003-04, follow-up major 2007 Mar The koruna's central parity was revalued to 35.4424 SK/EUR. reforms of the business environment and 2008 Apr In its Spring Forecast, the EC discusses that Slovakia should continue income taxes, together with investment fulfilling the Maastricht criteria in 2008 and 2009. incentives, brought large-scale 2008 May The EC and the ECB assessed that Slovakia met all the Maastricht investment in automotive and electrical criteria. The ECB expressed "considerable concerns" about longer- production. Growth accelerated term inflation sustainability. markedly, the fiscal position improved May 29 The koruna's central parity was revalued to 30.1260 SK/EUR. and the current account deficit June 3 ECOFIN approved Slovakia euro adoption. narrowed. These reforms enabled Slovakia to join the EU in 2004 with the July The conversion rate to be set. first wave of countries from Central and Eastern Europe. The Slovak government began planning for euro adoption after accession, setting January 2009 as the target date. The government that came to power in 2006 confirmed the date and continued pressing ahead with the needed reforms despite some investor skepticism following the elections. The fiscal deficit fell further and the central bank allowed continued koruna appreciation to help curb inflation. Prospects that Slovakia would be able to join the eurozone from the start of 2009 firmed in late 2007 and early 2008, and the EC forecast in April 2008 that Slovakia should continue fulfilling the Maastricht criteria in 2008 and 2009. The ECB was more skeptical about the medium-term sustainability of these achievements, but also acknowledged that Slovakia meets the Maastricht criteria. Slovakia was confirmed as the member of eurozone in June; the conversion rate is to be set in July 2008. Compliance with the Maastricht criteria The EC and the ECB assessed in May 2008 that Slovakia met all the Maastricht criteria (Table 1). A brief discussion follows. Inflation: Meeting the inflation criterion has been complicated by the need to adjust upward regulated prices and excise tax rates. Inflation developments until 2007 reflected to a large extent increases in regulated prices (which, together with fuels make about one-fifth of the consumption basket). Since 2007, inflation has been 20 affected mostly by food and energy prices. Food Table 9. Slovakia and the Maastricht Criteria prices fell after EU accession, but have picked up since late 2007 as in the other EU10 countries. Maastricht reference Transport prices also fell through the middle of 2007, Slovakia value but have risen sharply thereafter. Core inflation, as a Fiscal deficit, %GDP 2.0 3.0 result, picked from 0.5 percent year-on-year in August 2005 to 4.5 percent in March 2008 (Figure 21). Govenrment debt, %GDP 29.0 60.0 Inflation, % 2.2 3.2 Exchange rate: Slovakia entered the ERMII in Long - term interest rate, % 4.5 6.5 November 2005, with the koruna pegged at the rate of Sources: Eurostat and the ECB. SK38.4550/. The central parity was revalued twice thereafter, the last time on May 29, 2008 to Figure 21. Inflation (In percent, year-on-year) SK30.1260/, or a 22 percent revaluation in 36 months. Exchange rate appreciation has averaged 6 25 percent a year since 2000, more than the 5- Headline CPI 5.5 percent in the other Visegad countries, helping 20 Regulated prices curb inflation during a period of very strong economic Core inflation convergence. 15 Fiscal balance and government debt: Slovakia has 10 made substantial progress in reducing the fiscal deficit (and government expenditures). Thanks to the 5 two fiscal packages (1998-2002) and continued bold reforms, the fiscal deficit fell to 2 percent of GDP in 0 2007 from 12.2 percent in 2000. Government spending 20 20-l 30 30-l 40 40-l 50 50-l 60 60-l 70 70-l 80 dropped from 51 percent of GDP in 2000 to 37 percent an-J Ju an-J Ju an-J Ju an-J Ju an-J Ju an-J Ju an-J in 2007, well below any other eurozone country. This significant reduction in the fiscal deficit and Source: Slovak authorities. expenditures was achieved despite the introduction of second-pillar pensions that added 1.3 percent of GDP a year to outlays. Government debt fell from 50 percent of GDP in 2000 to 29 percent in 2007. With inflation and the fiscal deficit under control, nominal long-term interest rates declined to below Maastricht levels. A common criticism of the rapid fiscal consolidation is that it resulted in lower capital investment and outlays on education and healthcare. The introduction of a more efficient e-government is also being postponed, and Slovakia scores poorly on education achievement compared with the neighboring countries. This criticism does not seem valid; the lower capital investment, for example, has resulted from weaker institutional capacity. The expected effect of the EMU Slovakia is the poorest country to join the eurozone after Portugal, with GDP per capita of 62 percent of the eurozone average, but its macroeconomic indicators are one of the best compared with recent EMU entrants (Greece, Malta, Portugal and Spain). Inflation, long-term interest rates and government debt are lower in Slovakia than in this group of comparators (Figure 22 - Figure 25). Euro adoption appears to have a strong positive impact on the country's economy. Typically, real GDP growth has accelerated, while interest rates have fallen substantially. In the earlier entrants and in Slovakia, interest rates broadly converged to the levels of the euro area months prior to formal entry, spurred by investors' anticipations. Lower interest rates helped boost investment rates and inflows of foreign direct investment in most countries (except Greece). Although FDI usually finance a small part of domestic investments, they tend to be positively correlated with it and are perceived as a signal of good growth perspectives. Potential risks Synchronization with the euro zone. Retaining a national currency and independent monetary policy has often been pointed out as a benefit if asymmetric shocks affect the adopting country and the currency area it is joining. Given Slovakia's tight integration with the eurozone at present, such risks are modest. More than 70 percent of Slovakia's exports are to the eurozone and business cycles seem highly correlated. Most empirical 21 studies, including our simple correlation analysis show that Slovakia's synchronization with the euro area cycle has recently increased.7 The financial sectors of Slovakia and the eurozone are also increasingly integrated. Figure 22. GDP per capita PPP, year of Figure 23. Comparative price level indices joining (eurozone average = 100) (EU15=100), year of joining* 200 120 1999 2001 180 1999 2001 2007 2008 2009 160 100 140 80 120 100 60 80 60 40 40 20 20 0 0 LU AT NL IE BE DE IT FI FR ES PT GR SI CY MT SK FI IE AT DE FR BE NL IT LU PT ES GR SI CY MT SK Source: Eurostat. */ For SI, ML, CY, SK data from 2006. Source: Eurostat. Figure 24. Fiscal balance, year before Figure 25. Government debt, year before joining (in percent of GDP) joining (in percent of GDP) 1998 2000 2006 2007 2008* 140 4 3.4 1998 2000 2006 2007 2008* 3.3 120 3 2.3 2 1.7 100 1 80 0 60 -1 -0.9-0.8 -2 -1.2 40 -1.8 -2.0 -3 -2.2 -2.6 -2.5 -3.1 20 -4 -3.4-3.2 -3.7 -5 0 PT ES IT FR AT DE NL BE FI IE LU GR SI CY MT SK BE IT NL AT ES DE FR IE PT FI LU GR SI MT CY SK Source: Eurostat. Source: Eurostat. In the future, however, given the rapid pace of change in Slovakia, the eurozone and worldwide, asymmetries could develop. Such asymmetries could result from various sources, including failure to catch up with the more advanced countries, failure to sustain innovation, or temptation to succumb to existing specialization. In the latter case, if Slovakia retains its specialization in automotive production without moving up the value chain, the risk of asymmetric shocks may well rise in the future. The key in this respect is to increase the flexibility of the economy and its innovation potential, so as to enable it to react more nimbly. Macroeconomic imbalances: Other risks reflect the possibility of credit and external imbalances building up, if lower interest rates (below the "natural rate of interest") after the adoption of the euro result in a credit boom, as is often the case. Recent research demonstrates that the "natural rate" in Slovakia is likely to be above the eurozone level. Thus, lower nominal interest rates after eurozone entry, combined with a possibly higher inflation (see below), would result in negative short-term real interest rates that could well bring about a credit boom, similar to those observed in Portugal and Ireland after their EMU accession. Such a risk could be limited by the ongoing global tightening of lending and other structural policies. Inflation, meanwhile, may well accelerate in Slovakia after the eurozone entry. On the potential risks, beyond demand-driven price increases, the ECB warned about: (1) fixing the exchange rate will eliminate the disinflationary effects due to currency appreciation; (2) tight labor market conditions may result in accelerating wage growth; (3) energy prices and (4) the catching-up process. 7NBS (2007), "Analysis of Convergence of the Slovak economy", June 2007; Savva, Neanidis and Osborn, 2007 "Business Cycle Synchronization of the Euro Area with the New and Negotiating Member Countries" www.socialsciences.manchester.ac.uk/cgbcr/discussionpapers/index.html 22 Figure 26. GDP per capita (change relative Figure 27. Current account balance (in percent to eurozone average, t= year of joining) of GDP, t= year of joining) 15 5 PT ES PT ES 3 GR SI 10 1 GR SI -1 5 -3 -5 -7 0 -9 t-4 t-3 t-2 t-1 t t+1 t+2 t+3 t+4 t+5 t+6 t+7 t+8 t+9 -11 -5 -13 -15 -10 t-4 t-3 t-2 t-1 t t+1 t+2 t+3 t+4 t+5 t+6 t+7 t+8 Source: Eurostat. Source: Eurostat. Figure 28. Fiscal balance (in percent of Figure 29. HICP (% change, 12 month moving GDP, t= year of joining) average) 4 6 PT ES 2 GR SI 5 0 4 -2 3 -4 PT 2 -6 ES GR -8 1 SI -10 0 t-4 t-3 t-2 t-1 t t+1 t+2 t+3 t+4 t+5 t+6 t+7 t+8 t-12 t-6 t t+6 t+12 t+18 t+24 t+30 t+36 Source: Eurostat. Source: Eurostat. There are several mitigating factors. While increases of prices in the non-tradable sector were estimated to have contributed 1-2 percentage points to inflation in Central and Eastern Europe in the mid-2000s, their effect is projected to be smaller in Slovakia because of higher labor productivity and, thus far, lower wage growth in the tradable sector.8 Slovakia's wage increases in recent years have been subdued, and there are no signs that these are set to accelerate beyond productivity and core inflation. This argument is supported by the flexibility of Slovakia's labor markets. Furthermore, the weight of non-tradable goods and services in the Slovak consumption basket is less than 20 percent. The ongoing tightening of global financial conditions should also help, as should the recent revaluation of the koruna's central parity. Nonetheless, these factors need to be supplemented by continue prudent fiscal policies and further emphasis on reforms to enhance the economy's flexibility and innovative capacity. 8See IMF, 2005, Maintaining Competitiveness Under Equilibrium Real Appreciation: the Case of Slovakia, WP 05/65. The NBS (2007) study quoted above projects that the Balassa-Samuelson effect would add 0.7 percentage points a year to inflation in 2007-2009. 23 EU10 June 2008 In Focus: The Baltics, Fasten Your Seatbelts for Landing The Baltic countries are experiencing a sharp slowdown in economic activity after a decade of robust expansion and impressive convergence on the EU, topped by extraordinary growth following EU Figure 30. GDP growth (percent change) accession in 2004. Estonia led the slowdown starting Estonia Latvia Lithuania last year, with sentiment and output slowing rapidly in 12 one of the most flexible and competitive economies in 10 8 the world. Latvia and Lithuania were slower to follow. 6 The slowdown has been largely focused in retail trade, 4 transport and real estate activities ­ led by falling 2 housing prices. On the expenditure side, the slowdown 0 has reflected weakening of almost all components of -2 domestic demand, partly offset in Estonia and Latvia 70 70 70 70 80 70 70 70 70 80 70 70 70 70 80 by a contraction in imports. In contrast to almost 1Q 2Q 3Q 4Q 1Q 1Q 2Q 3Q 4Q 1Q 1Q 2Q 3Q 4Q 1Q universal forecasts of soft landing, output contracted yoy qoq in seasonally adjusted terms in Estonia in the first Sources: Eurostat and statistical offices. quarter of 2008 compared with the last quarter of 2007 and was little changed in Latvia and Lithuania (Figure 30-Figure 32 and Figure 5 in the main report). These developments are helping unwind large imbalances that will very likely leave the Baltic economies in a stronger shape to advance convergence. Important lessons can also be learned from the recent experience, moreover. These include the need to be proactive to stem the build-up of large imbalances, through tighter fiscal policies and more determined prudential financial sector supervision. Figure 31. Industrial production (percent Figure 32. Retail sales (percent change, year- change, year-on-year) on-year) 20 EE LV LT 36 EE LV LT 16 32 12 28 24 8 20 4 16 0 12 -4 8 4 -8 0 -12 -4 Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Sources: Eurostat and statistical offices. Sources: Eurostat and statistical offices. The economies of the Baltic countries began growing strongly in the 1990s, building on ambitious economic reforms, anchored in the currency board arrangements in Estonia and Lithuania and the exchange rate peg in Latvia and supported by fiscal prudence. Economic expansion took a firmer hold as prospects for EU accession improved and accelerated after 2004, more than doubling levels of income per capita in the Baltic countries relative to the EU average since 1993. But expansion began to be driven more by robust investment in non-tradable sectors, in particular real estate, accompanied by a surge in housing prices and supported by rapid credit expansion. The latter was financed by strong bank borrowing from abroad that contributed to boosting external debt substantially. Inflows of foreign direct investment weakened, and were dominated by intercompany borrowing rather than direct equity inflows, adding to external debt. Labor markets tightened amid buoyant employment increases and outward migration, leading to very strong wage growth. This, together with the surge in consumer borrowing, supported strong private consumption. 24 The rapid economic expansion sowed, as usual, the seeds of its slowdown. Consumer sentiment began to worsen, led by Estonia starting in early 2007 and followed by Latvia, as household debt service costs rose and inflation began to undermine real incomes. Growth in retail sales began to slow at about the same time, and growth in housing prices soon began to give way to declines. Banks, meanwhile, began to reassess credit risks, large foreign exposures and large lending in foreign currency, led by reassessments by parent banks whose Baltic exposures had grown rapidly. (Swedish banks, for example, derived one-third of their profits last year from the Baltic countries.) This reassessment began well before the turmoil prompted by the sub-prime crisis in the U.S., but clearly was influenced by international financial tensions. Banks tightened credit standards which, combined with higher interest rates and the slowdown in economic activity, began slowing credit growth in early 2007. Lending increases have fallen to 25 percent year-on-year in Estonia and Latvia in the first half of 2008 and 38 percent in Lithuania from 60-70 percent in recent years (Figure 13 in the main report). It appears that further slowdown in credit growth is in store given the weakening of output expansion and economic sentiment. The slowdown has been accompanied by a downward adjustment in imports in Estonia and Latvia that is narrowing the oversized current account deficits this year, a welcome development. Estonia has again led the adjustment, with imports falling 5.6 percent year-on-year in the first quarter and remaining on a downward trend. The slowdown has been less pronounced in Latvia. All in all, the first quarter current account deficit in Estonia fell by 10 percent of GDP from a year ago and in Latvia by about 6.5 percent, an extraordinary adjustment. Meanwhile, exports and imports accelerated in Lithuania as trade in oil and related products more than doubled in the first quarter; net of this effect, however, growth in imports appears to be also slowing. Figure 33. Trade balance Figure 34. Import growth Figure 35. Export growth (percent of GDP) (percent change, year-on-year) (percent change, year-on-year) 06 06 06 06 07 07 07 07 08 60 EE LV LT 50 EE LV LT 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 50 40 0 40 30 -5 30 -10 20 20 -15 10 -20 10 0 -25 0 -30 -10 -10 -35 EE LV LT Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Sources: Central banks; and Bank staff calculations. While foreign banks are reassessing risks and capital flows are easing, foreign exchange reserves have not fallen in Estonia and Latvia. Indeed, the downward adjustment in current account deficits has so far been larger than the decline in bank borrowing from abroad. In Lithuania, by contrast, the current account deficit widened this year while net capital inflows roughly halved, resulting in a sizable reduction in foreign exchange reserves. Developments clearly warrant careful monitoring, especially given the large size of private external and domestic debt in the Baltic countries. Despite the rapid economic slowdown, there are no signs of an increase in joblessness as yet. Unemployment has eased steadily over the last several years in all Baltic countries, with the trend continuing last year and this; unemployment fell by about one percentage point in April from a year earlier in Estonia (to 4.3 percent) and in Latvia (5.2 percent), while remaining broadly unchanged in Lithuania (4.5 percent). Developments so far this year, in seasonally adjusted terms, do not point to an increase in unemployment. Wage growth has eased somewhat, but has remained buoyant, with wages expanding 25 percent year-on-year on average in the first quarter. It is likely that the failure of unemployment to increase may reflect lags of adjustment to labor markets, but a part is likely to be due to the possibility of workers to take jobs in most EU member states. It is increasingly likely that as the adjustment in economic activity continues, so will the downward adjustment in employment. Inflation is also showing no signs of abating, reflecting higher food and energy prices and hikes in excise tax rates to harmonize them with those in the EU. Spillovers from continued rapid wage increases are an important factor as well. Indeed, inflation reached new highs early this year, rising to almost 18 percent year- on-year in Latvia and about 12 percent in both Estonia and Lithuania. Net of energy and food prices, core inflation has also risen to new records, reflecting pressures from continued large wage increases and suggesting that soaring inflation may be boosting inflationary expectations that could sustain strong inflation despite the 25 economic downturn. Furthermore, hikes in regulated prices for heating and other utilities planned for this summer will also add fuel to the fire, challenging the authorities. Challenges are also emerging on the fiscal side, as revenues are falling short of projections in the original 2008 budgets that were based on much stronger growth assumptions. The shortfall is limited, however, by the continued strong wage increases and no reduction in employment, developments that are keeping revenues from personal income taxes robust for now. Nonetheless, other revenue categories are weakening, prompting budget revisions. In Estonia, the government has passed a supplementary budget that reduces expenditures by more than 1 percent of GDP this year, targeting a general government balance. This revised target compares with an initially planned surplus of 1.3 percent of GDP. Further expenditure cuts may be needed to accomplish this goal, however. A budget revision is likely in Latvia in the coming months as well. The current adjustment recalls the rather negative experience of Portugal starting with its eurozone entry. Portugal recorded impressive gains in relative income convergence in the run-up to joining the eurozone in the second half of the 1990s. This rapid convergence was driven by strong expansion of domestic demand, further fuelled by lax fiscal policy. The surge in demand was not followed by an increase in the economy's supply potential, however, as the reforms needed to make that a reality were lagging. The sharp fall in interest rates immediately before and after eurozone entry helped accelerate credit growth, supporting a shift of resource allocation from tradables to nontradables. Rapid wage increases followed suit, as did an expansion of the current account deficit fueled by imports of largely consumer goods. External competitiveness came under pressure and from 1999 the economy started to slow down. A recession began in 2002, followed by sluggish expansion, all of which combined to reduce Portugal's income per capita from near 80 percent of the EU average in 2000 to 72 percent in 2007, erasing most gains in relative income increases in the 1990s. A more positive interpretation of the adjustment in the Baltics starts with the realization that the slowdown is helping unwind large imbalances and bring more sustainable rates of expansion and convergence. While the depth and speed of the adjustment is difficult to predict, it provides an opportunity to retool structural policies to support further economic flexibility, boost entrepreneurship and attract more productive foreign direct investment. Building on the countries' remarkable high ranking on ease of doing business and education achievement (especially in Estonia), the adjustment offers a chance to reorient economies more toward innovative, higher value-added production. The outcome of this process will provide an important lesson for other EU10 countries. The experience of the Baltic countries in the aftermath of the Russian crisis, although not directly related, allows for optimism. An important lesson from the ongoing adjustment relates to the need to maintain prudent macroeconomic policies and engage in preemptive actions to stem the build-up of large imbalances. This is all the more important for small countries with inflexible exchange rates that are tightly integrated into the global economy. In periods of abundant liquidity, as was the case over the last decade, small economies with open capital accounts and fixed exchange rates experienced significant capital inflows. Economic flexibility is important to ride this through. It is even better, however, to preemptively curb the build-up of imbalances, provided that policies to do so do not restrain unduly economic convergence. 26 STATISTICAL ANNEX 2004 2005 2006 2007 2Q 07 3Q 07 4Q 07 1Q 08 Jan- Feb- Mar- Apr- 08 08 08 08 Real GDP, SNA (%, y/y) Bulgaria 6.6 6.3 6.3 6.2 7.3 4.9 6.9 7.0 Czech Republic 4.5 6.3 6.8 6.6 6.6 6.4 6.6 5.2 Estonia 8.3 10.2 11.2 7.1 7.6 6.4 4.8 0.1 Hungary 4.8 4.1 3.9 1.3 1.2 0.9 0.8 1.7 Latvia 8.7 10.6 12.2 10.3 11.0 10.9 8.0 3.3 Lithuania 7.3 7.9 7.7 8.8 8.0 10.8 8.0 6.9 Poland 5.3 3.6 6.2 6.6 6.4 6.4 6.1 6.1 Romania 8.5 4.1 7.7 6.0 5.6 5.7 6.6 8.2 Slovakia 5.2 6.6 8.5 10.4 9.3 9.4 14.3 8.7 Slovenia 4.4 4.1 5.7 6.1 6.0 6.4 4.7 5.4 Croatia 4.3 4.3 4.8 5.6 6.6 5.1 3.7 Consumption, SNA (real, %, y/y) Bulgaria 5.4 5.3 7.3 4.9 5.0 4.2 4.5 4.7 Czech Republic 0.9 2.6 3.5 4.2 4.2 4.0 4.0 1.9 Estonia 5.8 8.7 12.4 8.2 10.3 5.6 3.9 0.2 Hungary 2.4 3.1 2.6 -2.2 -2.7 -1.1 -1.3 -1.6 Latvia 8.1 9.4 18.0 12.6 15.2 11.7 1.5 2.7 Lithuania 11.2 10.1 10.5 9.9 9.7 7.2 8.4 10.5 Poland 4.0 2.7 5.1 4.2 5.2 5.2 3.9 4.1 Romania 10.2 9.6 9.3 10.0 11.4 9.0 8.9 13.5 Slovakia 3.6 5.3 6.7 5.5 5.0 6.9 4.4 6.6 Slovenia 3.0 2.8 4.1 2.7 1.6 3.9 3.1 3.4 Croatia 3.5 2.8 3.1 5.5 5.6 5.7 4.7 Gross capital formation, SNA (%, y/y) Bulgaria 14.9 27.9 20.0 21.5 29.6 13.5 11.5 Czech Republic 9.1 -0.8 10.5 9.6 11.4 10.4 6.4 7.2 Estonia 11.1 8.1 23.5 11.4 17.1 9.9 8.5 -2.4 Hungary 8.2 -4.2 -3.9 6.1 7.7 1.0 1.9 -2.8 Latvia 22.4 9.0 18.2 12.3 27.7 17.7 -2.9 -6.8 Lithuania 18.7 2.0 3.9 15.1 38.4 15.3 6.9 12.0 Poland 14.7 1.4 16.8 19.1 28.1 21.5 12.7 17.3 Romania 19.4 1.8 26.2 23.5 11.5 29.4 24.0 -71.6 Slovakia 14.3 15.3 6.2 7.2 5.6 1.1 25.6 3.6 Slovenia 10.5 0.4 9.9 17.8 26.6 19.6 7.6 17.6 Croatia 4.8 6.3 10.5 6.0 5.7 1.6 7.8 Gross fixed capital formation, SNA (%, y/y) Bulgaria 13.6 23.3 14.7 21.7 24.7 19.7 14.0 15.5 Czech Republic 3.9 1.8 6.5 5.8 5.8 4.5 7.5 2.0 Estonia 4.4 9.9 22.4 7.8 21.8 -5.7 5.6 5.2 Hungary 7.6 5.3 -2.8 1.0 -0.8 -2.6 2.6 -5.4 Latvia 23.8 23.6 16.3 2.9 11.5 6.9 2.6 5.1 Lithuania 15.5 10.9 17.4 15.8 18.7 15.8 8.4 10.7 Poland 6.4 6.5 15.6 20.4 19.0 16.7 15.2 15.7 Romania 11.1 12.6 19.3 28.9 28.4 32.2 28.0 33.2 Slovakia 5.0 13.8 8.4 7.9 5.9 6.5 8.9 2.4 Slovenia 7.3 2.5 8.4 17.2 21.8 18.7 8.6 17.1 Croatia 5.0 4.9 10.9 6.5 5.8 5.7 4.0 27 2004 2005 2006 2007 2Q 07 3Q 07 4Q 07 1Q 08 Jan- Feb- Mar- Apr- 08 08 08 08 Exports, SNA (real, %, y/y) Bulgaria 12.8 8.5 8.7 5.2 5.3 5.4 6.0 9.2 Czech Republic 20.7 11.6 15.8 14.6 14.1 15.6 13.1 12.5 Estonia 16.6 20.5 8.3 1.5 3.3 -2.9 -0.2 -5.4 Hungary 15.6 11.5 18.9 14.2 14.6 14.9 10.4 13.9 Latvia 9.4 20.3 6.5 11.1 6.4 10.3 17.1 6.5 Lithuania 4.4 17.7 12.2 4.7 3.2 11.2 1.1 8.5 Poland 14.0 8.0 14.6 9.1 7.2 8.2 8.2 13.4 Romania 13.9 7.7 10.6 8.7 3.5 4.8 14.9 24.6 Slovakia 7.9 13.5 21.0 16.0 18.1 8.5 16.0 12.2 Slovenia 12.5 10.1 12.3 13.0 13.0 15.1 9.3 6.3 Croatia 5.7 4.6 6.9 5.7 8.9 7.3 2.1 Imports, SNA (real, %, y/y) Bulgaria 14.6 13.1 14.0 9.9 11.1 9.3 5.7 5.8 Czech Republic 17.9 5.0 14.2 13.8 14.1 15.2 10.9 10.8 Estonia 15.5 16.3 17.1 2.8 3.5 -0.4 -0.7 -3.8 Hungary 13.4 6.8 14.5 12.2 13.1 13.5 9.1 10.2 Latvia 16.6 14.8 19.3 15.0 22.5 15.5 -1.8 -1.6 Lithuania 14.9 17.2 13.8 9.1 14.7 9.2 2.5 14.5 Poland 15.2 4.7 17.4 10.9 13.6 12.5 8.2 13.7 Romania 22.1 16.0 22.4 26.1 22.7 24.7 28.6 35.2 Slovakia 8.8 15.5 17.7 10.4 13.2 3.0 11.6 12.9 Slovenia 13.3 6.7 12.2 14.1 16.2 18.2 8.6 9.4 Croatia 4.6 3.5 7.3 5.8 6.4 7.0 6.0 Industrial production (%, y/y) Bulgaria 17.1 6.7 6.1 9.3 9.0 10.4 8.5 4.2 8.2 5.4 -1.1 8.8 Czech Republic 9.6 6.7 11.2 8.2 9.5 7.2 8.2 6.2 8.6 11.9 -1.9 12.2 Estonia 10.5 10.9 10.1 6.7 8.1 5.5 5.3 -0.8 4.3 4.0 -9.5 5.0 Hungary 7.4 7.0 9.9 8.1 7.8 9.4 6.5 7.1 6.4 13.0 1.9 11.8 Latvia 5.3 6.0 5.1 0.4 0.9 1.5 -1.7 -2.6 1.1 -3.4 -5.5 3.5 Lithuania 10.8 7.1 7.3 4.0 3.0 8.7 5.8 7.4 6.5 11.3 4.5 15.7 Poland 12.3 4.1 12.1 9.7 8.8 8.2 8.6 8.9 10.7 15.0 1.0 14.9 Romania 5.4 2.2 7.1 5.4 4.6 5.1 4.3 5.5 6.0 7.6 3.0 13.3 Slovakia 4.2 3.0 9.9 13.0 14.1 12.0 10.8 7.2 8.8 14.0 -1.1 13.5 Slovenia 4.8 3.1 6.2 6.3 7.1 6.0 3.6 1.8 0.3 7.9 -2.9 9.1 Croatia 3.7 5.1 4.6 5.6 7.0 4.5 3.1 5.0 6.7 8.1 0.2 6.9 Volume indices of retail sales (excl. motor vehicles, automotive fuel, %, y/y) Bulgaria 14.5 14.4 13.2 11.1 13.1 8.4 9.0 11.3 Czech Republic 3.0 3.8 6.5 6.8 7.3 6.4 5.2 1.9 3.1 5.4 -2.1 Estonia 15.5 12.0 19.5 14.5 16.3 13.0 6.7 0.7 0.0 6.0 -4.0 0.0 Hungary 5.7 5.6 4.3 -2.8 -3.1 -4.2 -3.8 -1.4 -3.0 -0.6 -0.7 Latvia 12.5 21.2 19.7 19.9 24.3 20.2 7.1 -1.1 -0.6 1.1 -3.9 1.2 Lithuania 10.7 12.9 7.2 12.4 14.7 12.4 9.8 15.1 13.8 21.9 9.7 12.6 Poland 7.1 2.1 12.0 14.6 13.8 14.4 13.2 15.7 16.1 19.2 11.7 14.0 Romania 17.6 24.3 16.4 13.4 29.6 18.8 16.0 13.2 24.4 10.5 26.6 Slovakia 6.2 9.7 8.8 5.4 7.8 4.3 5.7 14.2 15.6 16.6 10.5 7.2 Slovenia 3.8 6.8 1.7 5.5 3.9 5.8 6.1 6.8 6.6 15.3 -1.6 5.3 Croatia 2.6 2.8 2.4 3.3 3.8 1.6 1.7 3.1 1.7 4.8 2.7 0.2 28 2004 2005 2006 2007 2Q 07 3Q 07 4Q 07 1Q 08 Jan- Feb- Mar- Apr- 08 08 08 08 Unemployment rates (%, NSA, LFS data) Bulgaria 12.2 10.2 9.0 6.9 6.8 6.6 6.1 6.5 Czech Republic 8.3 8.0 7.2 5.4 5.3 5.2 4.9 4.7 Estonia 10.4 8.1 6.0 4.8 5.0 4.2 4.1 4.2 Hungary 5.9 7.2 7.5 7.4 7.0 7.2 7.7 8.0 Latvia 10.1 9.0 7.0 6.1 6.0 5.9 5.3 6.5 Lithuania 11.4 8.4 5.7 4.4 4.1 3.9 4.2 4.9 Poland 19.4 18.0 14.0 9.7 9.6 9.0 8.5 8.1 Romania 8.1 7.5 7.6 6.8 6.5 6.0 6.1 Slovakia 18.6 16.3 13.4 11.2 11.1 11.2 10.3 10.5 Slovenia 6.1 6.7 6.1 5.0 4.5 4.4 4.7 5.1 Croatia 14.1 13.0 11.5 9.6 9.1 8.4 9.7 Consumer price inflation (% change, y/y) Bulgaria 6.1 5.0 7.3 8.4 4.7 11.2 12.5 13.3 12.5 13.2 14.2 14.6 Czech Republic 2.8 1.9 2.5 2.8 2.5 2.5 4.8 7.4 7.5 7.5 7.1 6.8 Estonia 3.0 4.1 4.4 6.6 5.7 6.4 9.0 11.1 11.0 11.3 10.9 11.4 Hungary 6.8 3.6 3.9 8.0 8.6 7.7 7.1 6.9 7.1 6.9 6.7 6.6 Latvia 6.2 6.7 6.5 10.1 8.6 10.3 13.6 16.4 15.8 16.7 16.8 17.5 Lithuania 1.2 2.7 3.7 5.7 4.8 5.9 7.8 10.6 9.9 10.8 11.3 11.7 Poland 3.5 2.1 1.0 2.5 2.4 2.0 3.5 4.1 4.0 4.2 4.1 4.0 Romania 11.9 9.0 6.6 4.8 3.8 5.0 6.7 8.0 7.3 8.0 8.6 8.6 Slovakia 7.5 2.7 4.5 2.8 2.5 2.5 3.3 4.0 3.8 4.0 4.2 4.3 Slovenia 3.6 2.5 2.5 3.6 3.0 3.6 5.5 6.6 6.4 6.5 6.9 6.5 Croatia 2.1 3.3 3.2 2.9 2.1 2.9 4.9 5.9 6.2 5.8 5.7 5.7 PPI (%, averagey/y) Bulgaria 6.0 6.9 6.9 8.4 6.3 8.1 11.5 14.4 13.2 14.6 15.3 13.6 Czech Republic 5.7 3.1 1.5 4.1 4.1 3.9 5.0 5.6 6.0 5.6 5.3 4.7 Estonia 2.9 2.1 4.5 8.3 8.5 8.7 8.8 8.3 8.3 8.4 8.1 7.3 Hungary 3.5 4.3 6.5 0.2 -0.5 -2.6 0.2 5.0 4.3 4.9 5.7 6.5 Latvia 8.6 7.8 10.3 16.1 17.8 16.7 14.3 10.9 10.9 11.4 10.5 12.1 Lithuania 6.8 13.5 2.8 19.4 4.8 5.4 16.7 21.7 21.8 22.3 20.8 19.7 Poland 7.0 0.7 2.3 2.3 2.0 1.7 2.3 3.0 2.9 3.2 2.9 2.5 Romania 19.1 10.6 11.6 8.1 7.5 6.1 9.3 14.4 13.0 14.7 15.6 15.5 Slovakia 2.6 5.3 5.7 2.2 -1.7 -3.0 -0.1 3.5 2.8 3.7 4.0 3.8 Slovenia 4.3 2.7 2.3 4.1 4.6 4.0 3.5 3.4 3.5 3.4 3.3 3.3 Croatia 3.5 3.0 2.9 3.9 2.5 3.7 5.4 7.5 7.4 7.5 7.6 7.7 Exchange rate (nominal, LCU/EUR, period average) Bulgaria 2.0 2.0 2.0 2.0 2.0 2.0 2.0 2.0 2.0 2.0 2.0 2.0 Czech Republic 31.9 29.8 28.3 27.8 28.3 27.9 26.8 25.6 26.1 25.4 25.2 25.1 Estonia 15.6 15.6 15.6 15.6 15.6 15.6 15.6 15.6 15.6 15.6 15.6 15.6 Hungary 251.7 248.1 264.3 251.4 248.3 251.8 252.9 259.3 256.0 262.2 259.9 253.8 Latvia 0.7 0.7 0.7 0.7 0.7 0.7 0.7 0.7 0.7 0.7 0.7 0.7 Lithuania 3.5 3.5 3.5 3.5 3.5 3.5 3.5 3.5 3.5 3.5 3.5 3.5 Poland 4.5 4.0 3.9 3.8 3.8 3.8 3.7 3.6 3.6 3.6 3.5 3.4 Romania 0.0 3.6 3.5 3.3 3.3 3.2 3.4 3.7 3.7 3.7 3.7 3.6 Slovakia 40.0 38.6 37.2 33.8 33.8 33.6 33.4 33.1 33.5 33.1 32.5 32.4 Slovenia 239.1 239.6 239.6 Croatia 7.5 7.4 7.3 7.3 7.3 7.3 7.3 7.3 7.3 7.3 7.3 7.3 29 2004 2005 2006 2007 2Q 07 3Q 07 4Q 07 1Q 08 Jan- Feb- Mar- Apr- 08 08 08 08 Exchange rate (nominal, LCU/USD, period average) Bulgaria 1.6 1.6 1.6 1.4 1.5 1.4 1.3 1.3 1.3 1.3 1.2 1.3 Czech Republic 25.7 24.0 22.6 20.3 20.9 20.3 18.5 17.1 17.5 16.5 16.0 16.2 Estonia 12.6 12.6 12.5 11.4 11.6 11.4 10.8 10.4 10.5 10.3 9.9 10.0 Hungary 202.6 199.7 210.5 183.8 184.2 183.2 174.4 173.1 173.7 174.3 165.1 161.5 Latvia 0.5 0.6 0.6 0.5 0.5 0.5 0.5 0.5 0.5 0.5 0.4 0.4 Lithuania 2.8 2.8 2.8 2.5 2.6 2.5 2.4 2.3 2.3 2.3 2.2 2.2 Poland 3.7 3.2 3.1 2.8 2.8 2.8 2.5 2.4 2.4 2.3 2.2 2.2 Romania 3.3 2.9 2.8 2.4 2.4 2.4 2.5 2.5 2.5 2.4 2.3 Slovakia 32.3 31.0 29.7 24.7 25.0 24.4 23.1 22.1 22.6 21.4 20.6 20.6 Slovenia 192.4 192.7 191.0 Croatia 6.0 5.9 5.8 5.4 5.5 5.3 5.1 4.9 4.9 4.8 4.6 4.6 Exports of goods (EUR, %, y/y) Bulgaria 19.7 18.6 26.9 12.2 8.8 12.5 19.2 25.7 28.3 33.1 17.7 Czech Republic 28.8 13.2 20.4 18.1 16.8 18.4 17.4 15.6 20.0 23.6 4.9 Estonia 19.3 29.6 24.9 3.9 5.4 0.2 5.9 3.7 3.7 6.9 0.9 Hungary 17.3 13.2 18.5 15.2 16.5 17.5 9.2 12.0 16.8 16.9 3.5 Latvia 26.0 28.7 18.2 23.7 24.4 22.4 22.1 19.4 18.0 27.9 13.5 Lithuania 21.4 26.9 18.7 11.2 7.9 15.5 14.7 30.9 21.1 46.0 27.1 Poland 26.9 19.2 22.7 14.8 14.9 14.8 13.6 18.9 19.5 23.8 14.0 Romania 21.3 17.5 16.2 13.7 11.3 13.2 17.2 13.1 17.4 22.0 1.9 Slovakia 15.5 14.9 30.1 27.3 30.0 22.2 22.1 18.4 20.4 29.6 6.9 Slovenia 16.6 17.6 19.6 18.5 18.1 20.1 14.7 10.3 15.2 17.4 0.6 Croatia 18.1 9.6 16.7 9.1 17.3 13.6 4.4 8.2 19.7 9.5 -2.2 Imports of goods (EUR, %, y/y) Bulgaria 20.9 26.2 26.0 18.4 18.3 17.0 19.0 21.6 18.6 31.9 15.6 Czech Republic 23.0 9.3 20.7 15.9 15.2 17.0 14.0 17.0 19.6 23.8 8.6 Estonia 16.9 22.5 30.4 5.8 7.7 1.8 2.9 -5.6 -4.7 -0.2 -10.9 Hungary 15.2 9.9 16.5 11.3 12.5 12.1 7.1 9.4 13.4 12.7 2.8 Latvia 23.3 22.6 31.5 21.3 28.2 22.1 5.4 4.8 3.4 14.1 -2.2 Lithuania 16.8 25.5 23.5 14.5 17.8 14.0 11.4 29.6 25.9 27.2 35.1 Poland 19.5 13.3 23.8 17.4 19.7 16.2 14.6 20.5 19.1 27.1 16.1 Romania 24.0 23.9 25.1 25.1 25.7 23.9 19.7 11.8 10.8 17.0 8.2 Slovakia 20.6 16.0 28.2 23.1 26.5 19.3 19.1 15.8 20.0 21.7 7.2 Slovenia 16.7 14.5 17.6 19.7 23.6 21.5 14.3 13.3 20.1 18.5 3.5 Croatia 6.6 12.0 14.4 10.1 10.9 10.2 11.1 13.5 27.4 13.6 3.1 30 2004 2005 2006 2007 2Q 07 3Q 07 4Q 07 1Q 08 Jan- Feb- Mar- Apr- 08 08 08 08 Trade balance (% GDP) Bulgaria -11.9 -20.2 -22.2 -25.5 -24.8 -25.4 -25.5 -25.2 Czech Republic -0.5 2.0 2.0 3.3 2.8 3.0 3.3 3.1 Estonia -17.0 -13.7 -17.7 -17.0 -18.3 -17.9 -17.0 -15.5 Hungary -3.0 -1.7 -1.0 1.4 0.3 1.1 1.4 Latvia -20.2 -18.9 -25.6 -24.5 -27.0 -26.6 -24.5 -23.0 Lithuania -10.6 -11.4 -14.1 -14.6 -15.7 -15.2 -14.6 -14.8 Poland -2.3 -0.9 -2.0 -3.7 -3.1 -3.3 -3.7 -3.7 Romania -8.7 -9.8 -12.0 -14.8 -14.7 -15.0 -14.8 -14.7 Slovakia -3.6 -5.0 -4.5 -1.2 -2.5 -1.7 -1.2 Slovenia -3.8 -3.6 -3.8 -5.0 -4.6 -4.8 -5.0 -5.5 Croatia -23.4 -24.0 -23.6 -23.3 -23.7 -23.2 -23.3 Current account balance (%GDP) Bulgaria -5.3 -12.4 -17.9 -21.5 -20.2 -21.3 -21.5 -21.0 Czech Republic -5.2 -1.6 -3.1 -2.5 -2.7 -2.8 -2.5 -2.3 Estonia -12.3 -10.0 -15.5 -17.4 -17.4 -18.0 -17.4 -15.1 Hungary -8.4 -6.8 -6.0 -5.0 -5.3 -5.2 -5.0 Latvia -12.9 -12.6 -22.5 -22.9 -25.6 -25.6 -22.9 -21.3 Lithuania -7.7 -7.2 -10.8 -13.7 -13.7 -13.8 -13.7 -13.9 Poland -4.1 -1.2 -2.7 -3.7 -3.5 -3.8 -3.7 -4.0 Romania -8.4 -8.6 -10.4 -14.0 -13.1 -13.5 -14.0 -13.9 Slovakia -7.8 -8.4 -7.0 -5.3 -5.5 -4.8 -5.3 Slovenia -2.7 -2.0 -2.8 -4.9 -4.0 -4.1 -4.9 -5.8 Croatia -5.0 -6.3 -7.6 -7.9 -7.6 -7.3 -7.9 FDI, net (% GDP) Bulgaria 9.1 14.7 23.2 20.5 20.4 21.6 20.5 17.8 Czech Republic 3.6 9.4 3.2 4.5 3.8 3.7 4.5 4.0 Estonia 5.8 15.6 3.5 4.5 3.3 3.4 4.5 4.6 Hungary 3.3 5.0 2.8 1.1 -0.1 -0.2 1.1 Latvia 4.3 3.7 7.5 7.2 8.1 8.1 7.2 6.9 Lithuania 2.3 2.7 5.1 3.5 5.9 6.3 3.5 3.0 Poland 4.8 2.3 2.9 3.4 3.1 3.5 3.4 2.9 Romania 8.4 6.6 8.9 6.3 8.5 8.3 6.3 6.0 Slovakia 7.2 4.1 6.8 3.5 4.4 3.6 3.5 Slovenia 0.8 -0.2 -0.7 -0.2 -0.5 -1.2 -0.2 0.5 Croatia 2.3 4.1 7.2 8.5 9.4 9.3 8.5 Portfolio investment, net (% GDP) Bulgaria -2.0 -5.5 0.7 -1.8 -0.3 -0.8 -1.8 -1.1 Czech Republic 1.9 -2.7 -0.8 -1.5 -0.2 -1.0 -1.5 -1.3 Estonia 6.0 -15.7 -8.1 -2.5 -3.0 -0.8 -2.5 -0.9 Hungary 6.7 4.0 5.7 -1.4 4.9 1.5 -1.4 Latvia 1.7 -0.7 0.2 -1.5 -1.3 -1.3 -1.5 1.3 Lithuania 0.9 -1.0 -0.8 -0.8 -2.5 -2.5 -0.8 0.2 Poland 3.7 4.1 -0.9 -1.2 -1.7 -2.0 -1.2 -1.3 Romania -0.7 1.0 -0.2 0.1 -0.3 0.3 0.1 0.2 Slovakia 2.1 -2.0 2.9 -0.6 0.1 0.2 -0.6 Slovenia -2.4 -5.2 -4.7 -6.8 -8.9 -6.5 -6.8 -4.3 Croatia 1.0 -3.8 -1.5 -0.1 -1.0 -1.3 -0.1 31 2004 2005 2006 2007 2Q 07 3Q 07 4Q 07 1Q 08 Jan- Feb- Mar- Apr- 08 08 08 08 General Government balance (ESA95) Bulgaria 1.4 1.8 3.0 3.4 Czech Republic -2.9 -3.6 -2.6 -1.6 Estonia 1.7 1.8 3.6 3.2 Hungary -6.4 -7.8 -9.3 -5.5 Latvia -1.0 -0.4 -0.2 0.0 Lithuania -1.5 -0.5 -0.5 -1.2 Poland -5.7 -4.3 -3.8 -2.0 Romania -1.2 -1.2 -2.2 -2.5 Slovakia -2.4 -2.8 -3.6 -2.2 Slovenia -2.3 -1.5 -1.2 -0.1 Croatia -5.0 -3.9 -- -- General Government revenues (ESA95, % GDP) Bulgaria 41.2 41.0 39.4 41.2 Czech Republic 42.2 41.4 41.0 40.8 Estonia 35.9 35.4 36.6 36.9 Hungary 42.4 42.1 42.6 44.6 Latvia 34.7 35.2 37.7 38.0 Lithuania 31.8 33.1 33.4 34.3 Poland 36.9 39.0 40.0 40.4 Romania 32.4 32.3 33.1 34.4 Slovakia 35.4 35.3 33.5 34.7 Slovenia 44.2 44.5 44.1 43.2 Croatia General Government expenditures (ESA95, % GDP) Bulgaria 39.7 39.2 36.4 37.8 Czech Republic 45.1 44.9 43.6 42.4 Estonia 34.1 33.5 33.0 33.7 Hungary 48.9 49.9 51.9 50.1 Latvia 35.8 35.6 37.9 38.0 Lithuania 33.4 33.6 33.9 35.6 Poland 42.6 43.3 43.8 42.4 Romania 33.6 33.5 35.3 36.9 Slovakia 37.8 38.1 37.2 36.9 Slovenia 46.5 46.0 45.3 43.3 Croatia General government debt (% GDP) Bulgaria 37.9 29.2 22.7 18.2 Czech Republic 30.4 29.7 29.4 28.7 Estonia 5.1 4.5 4.2 3.4 Hungary 59.4 61.6 65.6 66.0 Latvia 14.9 12.4 10.7 9.7 Lithuania 19.4 18.6 18.2 17.3 Poland 45.7 47.1 47.6 45.2 Romania 18.8 15.8 12.4 13.0 Slovakia 41.4 34.2 30.4 29.4 Slovenia 27.6 27.5 27.2 24.1 Croatia Oil (Brent) USD/BBL 37.7 53.4 64.3 71.1 66.1 73.5 87.6 95.3 90.7 93.4 101.8 108.8 Exch. Rate (USD/EUR) 1.244 1.244 1.244 1.244 1.348 1.374 1.449 1.498 1.472 1.475 1.553 1.575 Source: Eurostat, EC, WIIW, CSOs, NCBs, World Bank, IMF IFS, staff calculations. Note: Cut-off data for data selection: June 16, 2008 32