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The Baltics: Real and Nominal Convergence in the Runup to the Euro Marco Buti European Commission St

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Title: The Baltics: Real and Nominal Convergence in the Runup to the Euro Marco Buti European Commission St


1
The Baltics Real and Nominal Convergence in the
Run-up to the EuroMarco ButiEuropean
CommissionStockholm, 14 April 2005
EUROPEAN COMMISSION DIRECTORATE GENERAL ECONOMIC
AND FINANCIAL AFFAIRS Economies of the Member
States
2
Outline
  • The Baltics some stylized facts
  • Convergence scenarios
  • Steep and stable convergence (best case)
  • Boom/bust and/or growth slowdown (worse case)
  • 3. Policy instruments, in particular fiscal
    policy
  • Conclusion

3
1. The Baltics some stylized factsReal
Convergence Need (I)
  • Among countries with lowest per-capita incomes in
    RAMS
  • but highest growth rates

4
1. The Baltics some stylized factsReal
Convergence Need (II)
  • although growth has been relatively volatile in
    comparison to other RAMS and to the euro area.

5
1. The Baltics some stylized factsFinancial
Sector Convergence Need
  • among the RAMS with the least developed financial
    sectors
  • but highest expansion rates
  • although stable starting position and high
    foreign ownership

6
1. The Baltics some stylized factsMonetary,
Fiscal and External Environment (I)
  • hard exchange rate pegs
  • ? low inflation (but LV) and interest rates
  • underpinned by strong fiscal positions and a
    relatively flexible economy
  • but also relatively large current account
    deficits,

7
1. The Baltics some stylized factsMonetary,
Fiscal and External Environment (II)
  • which are, in some countries, increasingly less
    financed by FDI
  • and which reflect high negative private
    savings-investment balances

8
1. The Baltics some stylized factsTarget Dates
for Euro Adoption
  • Among the earliest concerning euro adoption

9
1. The Baltics some stylized factsMaastricht
criteria
  • and closest to the Maastricht criteria.

10
2. Convergence Scenarios (a) Steep and Stable
Convergence
  • High rates of return attract high investment
  • High income expectations stimulate consumption
  • Investment risks and future incomes are assessed
    correctly
  • ? correct risk premia prevent unsustainable
    developments
  • Domestic credit growth and widening current
    account deficits have sound domestic
    counterparts
  • Current account deficits are financed by stable
    FDI (which also has beneficial microeconomic
    spillovers knowledge transfer, etc.)

11
2. Convergence Scenarios (b) Boom/Bust and/or
Growth Slowdown (I)
  • High rates of return attract high investment
  • High income expectations stimulate consumption
  • BUT Investment risks and future incomes are NOT
    assessed correctly
  • ? exuberance / overly benign risk premia
  • Domestic credit growth is mis-allocated (asset
    price bubbles) widening current account
    deficits have un-sound counterparts
  • Current account deficits are financed by
    unhedged, debt-creating, volatile and short-term
    capital inflows

12
2. Convergence Scenarios (b) Boom/Bust and/or
Growth Slowdown (II)
  • If no timely self-correction (e.g. consumption
    slowdown of overly indebted households), boom
    will become unsustainable
  • ? crisis (triggered externally or
    internally/endogenously)
  • With flexible exchange rate or soft peg
    classical bust
  • ? exchange rate turbulences, potential banking
    crisis in particular if unhedged
    foreign-currency borrowing, sharp output
    contractions.
  • With a very credible hard peg/currency board or
    after euro-adoption adjustment more through
    domestic relative prices if inflexible economy
  • ? protracted growth slowdown.

13
3. Policy Instruments Overview
  • EU accession and further EU integration
  • Stable policy frameworks and orientations.
  • Shield against contagion from third countries
    (but not against intra-group contagion).
  • However, domestic policies remain key.
  • Basically, four areas
  • Structural (real sector) policies
  • Prudential and supervisory policy
  • Monetary policy
  • Fiscal Policy

14
3. Policy Instruments (a) Structural (real
sector) policies
  • From Copenhagen to Lisbon
  • ? particularly relevant areas in the Baltics
  • RD, innovation, education
  • Infrastructure and competition in services
  • Labour market participation and structural
    unemployment
  • Resilience and stability continued strengthening
    of governance frameworks (e.g. code for
    corporate governance insolvency frameworks)

15
3. Policy Instruments (b) Prudential and
Supervisory Policies
  • Contribute to growth and stability by helping to
    avoid misallocation of credit due to market
    imperfections (moral hazard, asymmetric
    information, etc.)
  • Effective in avoiding boom-bust scenarios as long
    as systemic risks are internalised by supervisors
    gtgt help the emergence of the right risk premia
  • Instruments financial system stress-tests
    intensified cross-border cooperation, etc.

16
3. Policy Instruments(c) Monetary Policy
  • Monetary policy leeway depends on monetary and
    exchange rate framework.
  • In the Baltics hard pegs/currency boards and
    after euro adoption
  • ? no room for interest rates to address
    specifically domestic problems (like credit
    boom).
  • Therefore, fiscal policy will have to carry more
    responsibility for guiding domestic developments.

17
3. Policy Instruments (d) Fiscal Policy two
functions
  • Growth enhancement
  • Macroeconomic stability
  • and the interplay between growth and stability

18
3. Policy Instruments (d.I) Fiscal Policy
Growth enhancement
  • Right incentives for the private sector for work,
    job creation and investment, etc.
  • ? sometimes connected with upfront cost (tax
    reforms, pension reforms)
  • Provision of public goods infrastructure
    investment, education, etc.
  • ? higher expenditures in these areas
  • ? Requires in many cases growth-oriented
    restructuring of public finances (higher
    quality) but could also suggest a less
    favourable fiscal balance

19
3. Policy Instruments(d.I) Fiscal Policy Growth
enhancement
  • In Baltics relatively small government sector
    but still scope for restructuring (e.g.
    government consumption)

20
3. Policy Instruments(d.I) Fiscal Policy EU
Funds
  • Baltics get highest support (estimated net
    payments from the EU budget in 2004 to 2006 in
    of GDP)

21
3. Policy Instruments(d.II) Fiscal Policy
Macroeconomic stability
  • Baltics in principle no problems with SGP-rules
    and debt sustainability
  • But Prudent fiscal policy requires to go beyond
    SGP
  • No wrong signals to market investor confidence
  • No pro-cyclicality use good times
  • No over-estimation of structural revenues in
    boom-phase
  • ? Requires potentially improved fiscal balance.

22
3. Policy InstrumentsFiscal Policy Growth vs.
Stability?
  • No trade-off in the long run as stability is a
    necessary condition for smooth growth
  • Potentially in the short-run, but
  • Possibility for public finance restructuring
  • Strong fiscal frameworks
  • EU funds

23
4. Conclusions the convergence triangle
  • Economic and financial integration can foster
    real and nominal convergence Baltics can be the
    ".
  • Domestic policies play key role in ensuring a
    best-case scenario, i.e. real convergence,
    nominal convergence, macro-financial stability.
  • Fiscal policy is pivotal and needs to be prudent
    beyond SGP.

Economic/financial integration
Towards a successful participation in euro area
Risks to macro-financial stability
Nominal convergence
Real convergence
Apparent or real trade-off?
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