Regional Outlook: New EU members from Central and Eastern Europe Anchoring Policies in Uncertain Tim

1
Regional Outlook New EU members from Central and
Eastern EuropeAnchoring Policies in Uncertain
TimesFall 2006Susan SchadlerEuropean
DepartmentInternational Monetary Fund
2
Questions

• I. How does economic performance in the region
  shape up by emerging market standards
• II. Does this performance warrant markets
  relatively favorable perception of risks
• III. What are the policy imperatives given the
  opportunities, risks and uncertainties facing the
  region?

3
Conclusions

• By emerging market (EM) standards, economic
  performance in CECs is good, but not in class of
  its own.
• Markets, however, view the CECs in something of a
  class apart.
• Keeping this good will as euro adoption schedules
  lengthen and risks rise will require strong,
  clearly communicated policy anchors,
• But euro adoption remains an irreplaceable
  opportunity to boost trade and growth and exit
  growing forex risk.

4

• The global environment, though strong, is
  becoming more uncertain.

5
Global economic conditions are unusually
favorable though downside risks have increased
Source WEO
6
Drivers of global growth to shift slightly from
US toward Europe, Japan and EMs
Real GDP Growth, 2001-07
China
United States
Japan
Euro area
Source WEO
7
Inflation has risen in advanced economies, but
should slow in 2007 as oil prices flatten, US
economy cools.
Headline Inflation
Oil price--Spot and Futures
United States
Implied futures price at Aug. 31, 2006
Implied futures price at Aug. 23, 2005
Euro area
Japan
Source WEO
8
Global imbalances still pose substantial risks
(Percent of world GDP)
Current Account Balance
Net Foreign Assets
Source WEO
9
I. How does CEC macro picture compare to other
EMs?

• Relatively strong growth and low inflation
• But with low savings and high investment, CECs
  use foreign savings heavily
• This affects the risk profile in three main ways
• -Large current account deficits (as other EMs
  shift to surpluses)
• -CECs attract FDI as in other EMs, but private
  (mostly bank) inflows outpace other EMs
• -Growing external indebtedness, household forex
  exposure

10
Growth in the CECs has been impressive
Source WEO
11
and average inflation is low.
Source WEO
12
Large current account deficits stand out
Source WEO
13
Why are CECs different? Low savings and high
investment produce predominantly private sector
imbalances.
Source WEO
14
FDI is large, but private (mainly bank) inflows
stand out
15
Inflows finance credit to private (esp. hh)
sector. Growth rate, increasing forex exposure
stand out
Source WEO
16
External debt is growing in contrast to other
EMs(in percent of GDP)
Note Net external debt is the gross external
debt net of foreign assets in central banks and
the banking sector. Source WEO and IFS
17
II. How do markets view the high growth/high
private sector imbalance situation in CECs?

• Different markets tell different stories. But
  broadly
• Market view improved steadily relative to other
  EMs during 2003-04 (later in Bulgaria, Romania)
• Perception gap leveled off during 2005
• EM sell-off in spring 2006 affected most CECs,
  but generally not harshly
• CECs maintain an edge over other EM groups (lower
  spreads on external debt), but this edge has
  diminished

18
CEC equities have outperformed EMs since 2003,
though since mid-2005 gap has narrowed
Source Bloomberg
19
So have currency values against the dollar
Source Bloomberg
20
External debt spreads fell especially rapidly
during 2004, but then rose relative to other EMs
Source Bloomberg
21
CECs were not immune from Spring 2006 EM
sell-off, but debt markets less affected than
currencies or equities
Latam
CECs
Latam
East Asia
Other EM
East Asia
Other EM
CECs
Other EM
Latam
Latam
East Asia
Other EM
East Asia
CECs
CECs
Source Bloomberg
22
Do markets differentiate CECs because of
fundamentals? What are fundamentals?
Economic Risk
Political Risk

• GDP per capita
• Real GDP Growth
• Inflation
• Budget Balance
• Current Account
• Deficits

• Index based on 12 political and socio-economic
  conditions

Financial Risk
Global Financial Conditions

• External debt/GDP
• External debt service ratio
• Current account/ exports
• Official reserves/ imports
• Exchange rate stability

• Implied volatility index
• 30-day Fed Fund futures rate
• Volatility of Fed Fund futures

23
Econometric analysis asks how much of debt
spreads are explained by fundamentals

• Analysis establishes relationship of debt spreads
  to fundamentals using data from 26 Ems
• Separates each countrys spread into two parts
• -that explained by fundamentals
• -that not explained by fundamentals
• The part not explained by fundamentals reflects
  some non-quantifiable influence on markets
  perception of riske.g. EU membership or
  prospects for euro adoption.

24
Results show markets differentiate CECs beyond
what fundamentals warrant
25
All CECs enjoy the regional advantage which seems
to have stabilized at about 100 bps
26
..and seem not to be influenced by receding euro
adoption prospects.
Source Reuters
27
Summarizing the picture so far

• Strong economic performance
• Classic risks from private sector imbalances
  investment-savings gaps, rising indebtedness fed
  by rapid growth of bank credit
• Markets appear impressed by the strong growth but
  not concerned by large imbalances.
• Sine qua non in this high risk/high return
  strategy is to meet market expectations for
  sustained, strong growth

28
III. What policy anchors can reinforce market
good will, sustain growth?

• Euro adoption
• -medium-long term boost for trade, growth
• -eliminate emerging market risk premium
• -exit strategy from growing private sector
  forex exposures
• But with euro adoption schedules receding, it is
  losing its value as a near-term benchmark
• Markets to judge CECs increasingly on
  conventional policy anchors

29
Policy anchors must work in tandem to achieve
five policy goals

• Low inflation (inflation targeting/currency
  board)
• Moderate current account deficits (restraining
  fiscal policy)
• Financial sector soundness (supervision)
• Transparent risk (transparency of public and
  private accounts)
• Competitive business environment (low wage and
  nonwage costs of doing business)

30
Inflation targeting/currency boards anchor
wage/price expectations
Source WEO
31
but, with open capital accounts, are inefficient
in

• Curbing surges in capital inflows
• Reducing large current account deficits
• Sustaining competitiveness
• Addressing risks of private sector forex exposure

32
Fiscal policy most CECs have stabilized public
debt ratios at moderate or low levels
Source WEO
33
But in some, rising debt or insufficient
credibility requires more than discretionary
policy

• Fiscal responsibility laws are increasingly used
  in other EMs to sustain/signal commitment
• Expenditure or deficit ceiling
• Fiscal transparency code
• Medium-term budgeting commitment

34
And when growth is strong and private imbalances
large, fiscal policy needs to go beyond debt
stabilization

• In boom conditions fiscal policy becomes the sole
  macroeconomic policy instrument that can
• Relieve demand pressures
• Contain current account deficit
• Limit appreciation

35
Challenges to financial sector soundness increase
the stakes for supervision
Household Financial Leverage (In percent)
Hungary
Poland
Czech Republic
Turkey
Sources WEO and PDR
36
Transparencythere cant be too much

• No ready measures of transparency
• Wide agreement that deficiencies were central to
  Asian currency crises in the 1990s
• Key is to ensure that risks are clear to
  investors and leveraged residents
• Ensure that public accounts are clear, complete
• Guard against impressions of implicit guarentees

37
Preserving competitiveness wages and other costs
of doing business
Source National Statistical Offices
Source World Banks Doing Business Indicators
38
Conclusions

• Economic performance in CECs is good by EM
  standards, but not in class of its own.
• Markets, however, view the CECs in something of a
  class apart. CEC edge is shrinking but still
  significant.
• To keep this good will as euro adoption prospects
  recede, policy anchors need to be clearly
  communicated/oriented toward sustaining high
  growth.
• Euro adoption is a major opportunity and should
  remain a key goal of policy