Will catchingup continue smoothly in the new EU

Will catching-up continue smoothly in the “new” EU Members? Juergen Kroeger Director DG Economic and Financial Affairs European Commission 13 th Dubrovnik Economic Conference June 27 th to July 1 st, 2007, Disclaimer: The views expressed in this presentation are the author’s own and should not be regarded as stating an official position of the European Commission. 1

Outline 1. “New” MS: successful catching-up but imbalances 2. “Floaters”: mostly fiscal imbalances situation and policy; 3. “Fixers”: private sector / financial imbalances situation and policies; 4. Conclusions 2 2

STYLIZED FACTS OF SUCCESSFUL REAL CATCHING-UP Phase 1 : Upswing § Initially real expected rate of upturn has to be high § In order to avoid overheating monetary policy has to be used, not fiscal policy § Tight money in the upswing is necessary to § Contain inflation § Establish demand supply equilibrium § Help establishing inter temporal equilibrium § Appreciation reduces import costs § Current account deficit, covered by FDI, is a counterpart to fill the supply-demand gap. 3 3

STYLIZED FACTS OF SUCCESSFUL REAL CATCHING-UP Phase 2 : Consolidation § Higher investment increases the capital stock : Potential output rises § Domestic supply approaches domestic demand § The marginal real rate of return shrinks to the level of partner countries § Monetary policy is gradually easing § Net exports rising as exchange rate depreciates § Current account moving towards a sustainable level 4 4

1. “New” MS: successful catching-up but imbalances Growth and per-capita income figures indicate that catchingup has been successful… 5 5

1. “New” MS: successful catching-up but imbalances …but other indicators, esp. current account deficits, suggest potential problems ahead, in particular in “fixers”: “Fixers” 6 6

1. “New” MS: successful catching-up but imbalances In some cases, FDI-financing of C/A-deficits is small and/or decreasing: “F I X E R S” 7 7

1. “New” MS: successful catching-up but imbalances C/A deficits are private sector-driven in “fixers”, while being more public sector-driven in “floaters”: “F I X E R S” “F L O A T E R S” 8 8

2. “Floaters”: mostly fiscal imbalances • Room for fiscal consolidation and expenditure rationalization: 9 9

3. “Fixers”: mostly private sector / financial imbalances – Against a backdrop of negative real interest rates… 10 “F I X E R S” 10

3. “Fixers”: mostly private sector / financial imbalances – …high growth in “fixers” predominantly driven by high domestic consumption, while external contribution negative: “F I x e r s” “F l o a t e r s” 11 11

3. “Fixers”: mostly private sector / financial imbalances – Although investment remains strong, it consists to a substantial extent of construction: “Fixers” 12 12

3. “Fixers”: mostly private sector / financial imbalances – And the share of the construction sector in GDP is quite large and growing: “Fixers” 13 13

3. “Fixers”: mostly private sector / financial imbalances – Unit labour cost developments do not bode well for external competitiveness: “Fixers” 14 14

3. “Fixers”: mostly private sector / financial imbalances – Credit growth is reaching staggering levels… “Fixers” 15 15

3. “Fixers”: mostly private sector / financial imbalances – …with credits to households growing particularly fast… (Y-o-y, end-2006) 16 16

3. “Fixers”: mostly private sector / financial imbalances – …and foreign currency lending often dominating: Foreign currency lending as a % of total outstanding credit, 2005 17 17

3. “Fixers”: mostly private sector / financial imbalances – While real estate prices are high… Source: Bank of Latvia 18 18

4. Conclusions • Catching-up has been successful but there are signs of overheating in the “fixers” (and RO), which could hamper the efficient resource allocation and endanger smooth further real convergence; • The remaining policy instruments of the “fixers” to cope with the situation are limited to fiscal policy and structural policies (in particular related to the financial sector); • This could be a lesson for the “floaters” (see e. g. RO) not to peg their exchange rate too early or manage it too tightly and to contain balance sheet exposures to exchange rate movements; 19 19