40778 v 1 World Bank EU8+2 Regular Economic Report EU8+2 1 May 2007
Public Disclosure Authorized HIGHLIGHTS OF THE REPORT
Output growth gained further pace in 2006 across most countries in the region, but the momentum is likely to generally slow somewhat in 2007. In particular, growth accelerated in Estonia, Latvia, Poland, Slovakia, Slovenia, and Romania, while it remained broadly unchanged in the Czech Republic, Lithuania, and Bulgaria. Only Hungary experienced a slowdown on the back of weakening investment dynamics and the fiscal austerity program. The strong growth performance reflected the continued favorable external environment with strong global growth, low interest rates, and favorable emerging market sentiment. In some countries, notably Latvia but to varying degrees also Estonia, Lithuania, Bulgaria and Romania, booming domestic demand is leading to overheating and current growth rates are unlikely to be sustainable. Growth is expected to slow somewhat in 2007 across the region, except in Poland, Slovakia, and Bulgaria.
Public Disclosure Authorized Strong output growth was associated with rising employment and declining unemployment rates not least in Poland and Slovakia. The services sector accounted for most new jobs (except in the Czech Republic), but construction also contributed importantly in several countries. Meanwhile, labor force participation rates declined in Poland, Lithuania, Slovakia, and the Czech Republic (contributing to lower unemployment) while the opposite was true in Estonia, Hungary, Latvia, and Bulgaria. Tightening labor markets drove real wage growth well into double digit rates in the Baltic countries and Romania during 2006. The outflow of labor from the NMS continues but may be slowing slightly.
Inflationary pressures are mounting in several countries in the region with output above potential, tightening labor markets, and rapid credit growth. Inflation is rising rapidly in the Baltic countries, not least Latvia, and is also trending upward in Poland and the Czech Republic with monetary policy now biased toward tightening. In Hungary, inflation may have spiked
Public Disclosure Authorized under the influence of large administered price increases, with weaker demand and strong forint appreciation supporting a reversal of the trend. Currency appreciation has also been associated with declining inflation in Slovakia and Romania, and interest rates are on a downward path. While a strong fiscal position has helped ease inflationary pressures in Bulgaria, fiscal policy has generally not been adequately supportive in other countries to help contain inflation and real appreciation pressures.
Current account deficits widened further to very high levels in the most vulnerable countries. While exports continued growing strongly across the region, booming domestic demand raised current account deficits to 15 percent of GDP or higher in Latvia, Estonia, and Bulgaria. Meanwhile, the current account deficit narrowed significantly in Hungary thus reducing vulnerability. With FDI inflows generally weaker in the Baltic States, external debt levels increased further, as was the case in Bulgaria owing to sizeable inter-company loans. Meanwhile, external positions remained strong in the Czech Republic and Poland where growth was more balanced. There is little doubt that Latvia is the most vulnerable country in the Public Disclosure Authorized
1 Prepared by a team of World Bank economists in the region led by Thomas Laursen and including Paulina Hołda, Ron Hood, Stella Ilieva, Leszek Kasek, Ewa Korczyc, Matija Laco, Sanja Madzarevic-Sujster, Anton Marcincin, Catalin Pauna, Emilia Skrok, and Karlis Smits. region, but the situation also warrants careful monitoring in Estonia and to some degree Lithuania, Bulgaria and Romania.
Most countries in the region are not taking adequate advantage of the strong growth to improve public finances. The structural budget balance deteriorated in 2006 in all the Visegrad countries except Poland as well as in Slovenia and Romania. Only Bulgaria and Estonia tightened their fiscal stance significantly. The picture is not expected to change significantly in 2007, although Hungary will make an important dent in the very large deficit recorded in 2006 and Poland will continue its very gradual adjustment process. Slovakia aims to bring its deficit just below the critical 3% of GDP threshold which would be needed to adopt the euro from 2009 as planned, but there is very little margin for slippage. All other countries in the region have dropped concrete euro adoption plans, if they ever had any. The need for a more ambitious fiscal policy is particularly acute in Latvia, but Bulgaria and Romania also can hardly afford the fiscal easing envisaged this year. Meanwhile, most countries in the region are taking steps toward improving the quality of their public finances—through lowering high tax rates and curtailing social spending and public wage bills—although most recent initiatives have not been terribly ambitious.
Reform momentum in the region has generally waned owing to post-accession reform fatigue, unstable political situations, and weak administrative capacity. Although small steps are taken now and then to improve the business environment, more complex public administration, legal, and labor market reforms are proving illusive and renewed momentum is needed to sustain the process of rapid real convergence.
--SPECIAL TOPIC--
EU integration—with increased agricultural trade and higher prices for many NMS products as well as reforms to agricultural support policies and institutions—has led to large agricultural income increases albeit with substantial variation between countries, regions, and farm types. The variation in income growth is as pronounced as the diversity in agricultural structures across the region. Farm sizes and factor distribution range from Romania's bipolar farming structures, to Poland's mixed production systems, and the Czech Republic and Slovakia large farm dominated structures. With the relative dominance of (semi-)subsistence farming in many NMS, labor productivity lags far behind the EU15 average.
Despite the diversity in structures, agriculture across all member states is supported through a single sectoral policy, the Common Agricultural Policy (CAP). Within CAP, however, member states have manifold implementation options to program the support instruments under the two so-called pillars of the CAP: Pillar 1 provides income and market support and Pillar 2 provides rural development support.
Under the first Pillar, CAP provides direct income support payments on a per-hectare basis (Single Area Payment Scheme, SAPS). SAPS payment levels vary across countries depending on land productivity, production patterns, and eligibility thresholds (minimum farm size). Support levels are highest in Hungary and lowest in Latvia. Support is being phased in over a ten year period starting from 25% of the EU15 level in the first year of membership. All NMS have opted for the highest allowed eligibility threshold thus promoting farm consolidation and efficiency.
To compensate for potential initial income reductions arising from shifting from national to CAP support regimes, the NMS have been granted the option to top-up direct income support through additional allocations from their national budgets. While, in principle, countries with less protection prior to accession would require less topping-up to maintain income at pre- accession levels during the phasing-in of SAPS, most NMS have opted to implement top-ups close to the maximum permitted level of 30% of EU-15 average support, discouraging
2 restructuring and consolidation in agriculture and at a significant budgetary cost. Further, most NMS have opted to direct the additional funds to selected categories of producers rather than as flat, decoupled payments, thus introducing further distortions.
Under the second Pillar, CAP provides support to rural development through a menu of measures ranging from on-farm investment grants over measures to improve land and environment management to measures aimed at supporting income diversification and quality of life. From these, all member states can almost autonomously select the most suitable mix. While countries with relatively lower labor productivity in agriculture have tended to emphasize competitiveness-oriented measures (and countries with higher per capita incomes have focused more on environmental issues), it is too early to judge the effectiveness of these programs.
The EU8+2 agriculture and rural development challenges cannot be addressed by agricultural policy alone. For effective sector restructuring to take place (e.g., approaches to facilitate a reduction of subsistence farming across the EU-8+2), non-agricultural support policies and institutions have a role to play. Examples are adequate coverage through social security systems; information access through effective socio-economic guidance services; or land market facilitation through transparently registered, tradable property titles. Pure reliance on the provision of direct payments to secure farmer incomes would slow down structural change as it would discourage farmers from restructuring, consolidating or modernizing their farms.
External Environment
1. The world economy looks well set for continued robust growth in 2007 and 2008. A moderate slowdown in the U.S. should be accompanied by sustained growth in the euro area and strong growth in emerging markets and developing countries so that global growth would continue at close to 5% (Table 1).
Table 1. Global growth likely to remain high 1Q06 2Q06 3Q06 4Q06 1Q07e 2006 2007e (y/y) 2008e (y/y) OECD (q/q) IMF IMF EC OECD* IMF EC OECD* World 5.4 4.9 4.8 .. 4.9 4.8 .. USA 1.4 0.6 0.5 0.6 0.5 3.3 2.2 2.2 2.1 2.8 2.7 2.5 Euro area 0.9 1.0 0.6 0.9 0.6 2.6 2.3 2.6 2.7 2.3 2.5 2.3 Japan 0.7 0.3 0.1 1.3 0.5 2.2 2.3 2.3 2.4 1.9 2.1 2.1 Germany 0.8 1.2 0.8 0.9 0.6 2.7 1.8 2.5 2.9 1.9 2.4 2.2 France 0.5 1.1 0.0 0.6 0.5 2.0 2.0 2.4 2.2 2.4 2.3 2.2 Italy 0.8 0.6 0.3 1.1 0.4 1.9 1.8 1.9 2.0 1.7 1.7 1.7 Russia 6.7 6.4 6.5 5.9 5.8 Ukraine 7.1 5.0 4.6 Source: EUROSTAT, Economic forecast Spring 2007. IMF World Economic Outlook 2007. OECD Economic Outlook No.80.*) OECD Economic Outlook No.81
2. Although oil prices have increased again recently, they remain lower than in 2006. The price of Brent crude oil increased from 57.76 $/bbl in February to 67.40 $/bbl in April (Chart 1), but the average price in the first quarter of this year at 58.07 $/bbl was still lower than the 61.92 $/bbl price in 1q2006. Forecasts for this year are moderately positive – the IMF commodity price index2, which includes both fuel and non-fuel price indices, suggests a 2% decline in 2007 y/y, and the average price of crude oil is expected to fall from around US$ 65 last year to US$ 61 in 2007.
2 IMF, April 2007, World Economic Outlook Database.
3
Chart 1. Price of Brent crude oil Chart 2. But is still cheaper than a year increased since January ($/bbl) ago (% change y/y)
78 60 74 50 40 70 30 66 20 62 10 0 58 -10 54 -20 50 -30 Jul-06 Jul-06 Jan-06 Jan-07 Jan-06 Jan-07 Mar-06 Mar-07 Mar-06 Mar-07 Sep-06 Nov-06 Sep-06 Nov-06 May-06 May-07 May-06 May-07
Source: DECPG, World Bank
3. Financing conditions remain favorable. Strong global economic growth, ample liquidity and low market volatility have increased the appetite for risk. The ECB has kept rates unchanged since mid-March at 3.75% and although well below those of the FED (Chart 3), the euro has continued to appreciate vis-à-vis the dollar (Chart 4). Already low sovereign bond spreads narrowed further in April and a rise in stock prices lowered the cost of equity financing (Chart 5, Chart 6). Stock exchanges grew strongly in Slovenia, Bulgaria and Poland.
Chart 3. Policy rates in the US and euro- Chart 4. Appreciation of EUR vis-à-vis area (%) USD (EUR/USD)
6 1.40
5 1.35
4 1.30
3 1.25
2 1.20 EURO z one US 1 1.15 0 Jul-06 Jan-07 Jan-06 Mar-07 Mar-06 Sep-06 Nov-06 May-07 Jan-06 Apr-06 Jul-06 Oct-06 Jan-07 Apr-07 May-06
Source: FED and ECB Source: DECPG, World Bank
4 Chart 5. EMBI+ spreads at Chart 6. Local stock market index advance strongly record-low levels in Croatia, Slovenia, Bulgaria, and Poland. (EMBI+ spreads, Jan06-May07, basis points)
190.0 250 SI_SBI 240 EMBI+ spread 230 170.0 220 BG SOFIX 210 200 150.0 190 180 PL_WIG 130.0 RO_BETR 170 160
150 110.0 Jul-06 Jan-07 Jan-06 Mar-07 Mar-06 Sep-06 Nov-06 May-07 May-06 90.0
EE_OMXT CZ_PX5 HU_BUX 70.0 LT OMXVG SK_SAX LV_OMXRG
50.0 Jan-06 Jan-06 Mar-06 Apr-06 May-06 May-06 Jun-06 Jul-06 Aug-06 Sep-06 Oct-06 Nov-06 Dec-06 Jan-07 Feb-07 Mar-07 Source: www.cbonds.info January 2006 = 100. Source: Reuters
Output Developments
4. The EU8+2 continued their robust economic expansion in 2006. Growth was supported by strong domestic demand and healthy growth of the global economy. However, output growth dropped noticeably in Hungary due to weaker investment dynamics and the introduction of the austerity program in the second half of 2006. Sizeable output gaps (actual output above potential) have emerged in the Baltic countries, Bulgaria, and Romania (Chart 7, Chart 8).
Chart 7. High real GDP growth rates (% Chart 8. Several countries now above yoy) potential output Output gap relative to potential GDP, 2004-2006
EE 14 LV 2004 2005 2006 12 LT 2006 10 HU 2005 BG 8 2004 RO 6 CZ 4 SL 2 PL SK 0 CZ EE HU LV LT PL SK SI BG RO -3 -2 -1 0 1 2
Source: CSOs Note: deviation of actual output from potential output as % of potential GDP Source: EC Economic Forecast
5. The EU8+2 are now growing at rates similar to those of the fastest growing emerging markets. In 2006, economic expansion in most of the EU8+2 exceeded that of many “emerging market” economies (EM) at a comparable level of GDP per capita (e.g., Korea, Malaysia, Russia, Thailand, Turkey and South Africa (Chart 9)).
5 Chart 9. GDP growth independent of Chart 10. Rapid increase in investment initial conditions Real GDP Growth (% yoy) Real GDP growth rate in 2006, EU8+2 and selected EM
Fixed investment
12 LVA 25 EST Consumption 20 GDP CHNKAZ
10 15
BHR ARG 10 OMNSKK 8 ARE LTU 5 UKR ROM PAN CRIURY RUS 0 POL 6 CZE BGR TUR SAU TUN MYL -5
Real GDP growth % SVN THA KOR IRN MEX ZAF COL ISR CHL KWT 2005 2006 2005 2006 2005 2006 2005 2006 2005 2006 2005 2006 2005 2006 2005 2006 2005 2006 2005 2006 4 HUN HRV CZ EE HU LV LT PL SK SI BG RO BRA DZA 2
5000 10000 15000 20000 25000 GNI per capita PPP (current international $)
Source: IIF,WDI, staff calculations Source: CSOs
6. Domestic demand was the main driver of the EU8+2 expansion in 2006. Private consumption strengthened across the region except in Hungary, supported by gains in employment and disposable income as well as - in some countries - an expansionary fiscal stance (the Czech Republic, Romania, and Slovenia). At the same time, strong upturns in investment were particularly noteworthy in Estonia, Poland, Slovenia and the Czech Republic (Chart 10, Chart 11, Box 1). Investment was boosted by optimistic demand prospects, firm business confidence, high corporate profitability and improved financing conditions (both access to private funds and EU transfers). Net exports contributed negatively to growth in the Baltic States, Romania, Bulgaria and Slovenia, as import growth outpaced exports. By contrast, in light of weaker domestic demand, export-driven growth dominated in Hungary, underpinned by competitiveness gains stemming from the forint’s real depreciation (in ULC terms) and slower growth of real wages.
Chart 11. Domestic demand was the main driver of GDP growth
% points of GDP
25 Final consumption expenditure Gross fixed capital formation Change in inventories Net exports 20 stat. discrepancy
15
10
5
0
-5
-10 2005 2006 2005 2006 2005 2006 2005 2006 2005 2006 2005 2006 2005 2006 2005 2006 2005 2006 2005 2006 LV LT EE SI SK PL CZ HU BG RO
Notes: BG and RO- Gross capital formation Source: CSOs, Eurostat, ISI; staff calculations
7. Growth in investment in 2006 was broad-based, with robust expansion of both construction and equipment investment. Investment in construction dominated in Romania
6 and Lithuania, while in the Czech Republic, Poland, and Slovakia spending on equipment was very dynamic (Chart 12). These developments were echoed in strong increases in gross value added in the construction sector (Chart 13), particularly in Lithuania, Poland, Slovakia and Romania.
Chart 12. Gross fixed capital formation: construction & equipment % yoy
2005 Construction 2005 2006 Construction 2006
2005 Equipment 2005 2006 Equipment 2006 25.0
20.0
15.0
10.0
5.0
0.0 CZ LT PL SI RO
Source: Ameco
8. The sectoral pattern of growth varied significantly between countries in the region. Service-driven growth dominated in the Baltic countries, Slovakia, Bulgaria, and Romania, while industry dominated growth in the Czech Republic and also gained importance in Hungary, Poland, Slovenia, Bulgaria, and Romania (Chart 13). In Slovakia, the strong growth of value added in services was related to a low base in 2005 and the strong production and household incomes in 2006 boosting demand for market-services. Retails sales, repairs of motor vehicles, transport and real estate grew particularly fast.
Chart 13. Industrial production dominates Czech output growth, while services play a dominant role in other NMS
Contribution to Gross Value Added growth (% points of GVA)
15 Agriculture Industry Construction Services GDP 10
5
0
-5 2005 2006 2005 2006 2005 2006 2005 2006 2005 2006 2005 2006 2005 2006 2005 2006 2005 2006 2005 2006 CZ EE HU LV LT PL SK SI BG* RO
Source: CSOs, Eurostat, ISI, staff calculations
Box 1. What is Driving Investments in the EU8+2?
The rapid investment growth in most of the EU8+2 countries in 2006 was fueled by several inter-linked factors: (i) optimistic expectations about future demand (both domestic and external); (ii) high profitability and capacity utilization;
7 and (iii) supportive financing conditions.
The user cost of capital, which stabilized or even declined in many EU8+2 countries, was a supporting factor for investment (Chart 16). Various indicators of financial market development such as credit provided to the private sector, stock market capitalization (Chart 17, Chart 18, Chart 19), and the stock market turnover point to greater ease of raising funds for investment in the EU8+2. In particular, acceleration in mortgage lending boosted growth in construction investment.
High corporate profits also supported investment growth (Chart 20) because enterprises in the region (mainly SMEs) largely finance new investments from internal resources. The gross operating surplus of the corporate sector rose further in many EU8+2 countries while all NMS still maintain a considerable competitive cost advantage owing to their low ULC levels compared to the EU15. Despite recent increases, the estimated aggregate ULCs were still only 35% to 55% of the EU15 level in 2006 (70% Slovenia). (Chart 21. Unit labor costs, PPP adj., EU15=100 ).
Thriving investment activity could also be related to FDI inflows (Chart 22, Chart 23) or stimulated by projects co- financed from EU funds (see external section). FDI inflows still seem to play a crucial role in creating competitive pressure and have important second-round effects on overall investment activity by promoting the development of domestic supplier networks. EU accession has rendered Romania’s and Bulgaria’s advantages as low-cost providers more transparent for international investors, bringing additional stimulus for foreign capital inflows.
Other factors, such as reduced investor uncertainty or improved quality of regulations (including changes in the corporate tax rates, tax credits, depreciation allowances, and other regulations having an impact on ease of doing business3) may also have been at play. Moreover, lower exchange rate volatility in Poland, the Czech Republic and Romania may have supported investment activity due to lower risk premiums (Chart 24, Chart 25).
In contrast, Hungary saw a drop in investment activity in 2006 for the first time in more than ten years. Investment deceleration was driven by reduction in both construction and equipment investment across both corporate and household sectors as well as in the government sector. Fiscal adjustments curbed investment activity of the government- related sectors but also contributed to the decline in household investments. Further, the sharp decline in private investment could be explained by worsening expectations about domestic demand (Table 2), higher user cost of capital (chart 16), lower profitability of the corporate sector (Chart 20), deterioration of the business environment and higher investor uncertainty about economic policy and macro prospects (Chart 23).
Factors Affecting Investment Growth* Buoyant demand expectations High capacity utilization User cost of capital
Chart 14. Real GDP growth, in % Chart 15. Survey (Manufacturing Chart 16. User cost of capital 1/ industry) (1995=100)
2.1 CZ HU LV World excl. EU27 100 EU27 2003 2004 2005 2006 LT PL SK 90 7 As ia (excl. Japan), RHS 8.8 2.05 BG 80 6 8.6 70 2 5 8.4 60 4 50 1.95 8.2 3 40 8 1.9 2 30 20 1 7.8 1.85 10 0 7.6 0 1.8 2003 2004 2005 2006 2007F BG CZ EE HU LT LV PL RO SL SK 2002 2002 2003 2004 2005 2006
Source: EC Economic forecast, May 2007 Source: Statistical Annex of European Source: Ameco, Bloomberg, staff calc. Economy, Spring 2007
3 For instance, the Czech Republic introduced corporate income tax cuts and changes to bankruptcy legislation in 2006.
8 Supportive financing conditions Chart 17. Credit to non-financial Chart 18. Lending for house Chart 19. Stock Market capitalization, corporations, % GDP purchase, % GDP % GDP
45 35 60 2003 2004 2005 2006 40 CZ 30 CZ 50 35 EE 25 EE 30 40 LV LV 25 20 LT LT 30 20 15 HU HU 15 10 20 10 PL PL 10 5 SK 5 SK 0 0 0 2003 2004 2005 2006 2003 2004 2005 2006 BG CZ EE HU LT LV PL RO SI SK
Source: ECB, staff calculations Source: ECB, staff calculations Source: Eurostat, Baltic States: OMX SE
High corporate profitability Advantageous ULC Strong FDI inflow, in particular in new accession countries Chart 20. Gross operating surplus of Chart 21. Unit labor costs, PPP adj., Chart 22. FDI, % of GDP the corporate sector (adjusted for EU15=100 compensations of self-employed), % GDP
80 25.0 50 2003 2004 2005 2006 FDI, outflow FDI, inflow 2003 2006 20.0 45 70 40 60 15.0 35 10.0 30 50 5.0 25 40 20 0.0 30 15 -5.0 10 20 5 -10.0 10 0
BG CZ EE LV LT HU PL RO SK 0 2003 2004 2005 2006 2003 2004 2005 2006 2003 2004 2005 2006 2003 2004 2005 2006 2003 2004 2005 2006 LV LT SK BG RO CZ EE HU LV LT PL SK SI BG RO
Source: Ameco, staff calculations Source: Ameco, Eurostat, staff calculations Source: CBs, staff calculations
Strong FDI inflow, in particular in Low exchange rate volatility new accession countries Chart 23. FDI, % of GDP Chart 24. Six-month rolling standard Chart 25. Six-month rolling standard deviation deviation
25.0 1.4 12 PL RO FDI, outflow FDI, inflow 0.20 0.80 20.0 SK HU (RHS) CZ (RHS) 0.18 1.2 10 0.70 15.0 0.16 1.0 0.60 8 0.14 10.0 0.50 0.8 0.12 5.0 6 0.10 0.40 0.6 0.08 0.0 0.30 4 0.06 0.4 0.20 -5.0 0.04 0.10 0.2 2 0.02 -10.0 0.00 0.00 0.0 0 2003 2004 2005 2006 2003 2004 2005 2006 2003 2004 2005 2006 2003 2004 2005 2006 2003 2004 2005 2006
CZ EE PL SI HU Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Source: CBs, staff calculations Source: ECB, staff calculations Source: ECB, staff calculations
* Charts present selected countries where data are available. 1/ Product of the real long term interest rate and the relative price of capital (the ratio of the fixed investment deflator to the GDP deflator). The measure is simplistic and does not include terms reflecting the corporate tax rate, the rate of investment tax credit and the discounted value of tax depreciation allowances.
9. 2007 is likely to see continued albeit somewhat more moderate growth, but performance is expected to diverge across the region. In most of the EU8+2, output growth
9 weakened in the last quarter of 2006 and data for the first months of 2007 confirm this tendency (Chart 26). Growth momentum slackened most in Latvia, Estonia, Slovakia and Hungary, while in the Czech Republic and Lithuania activity decelerated only marginally compared to Q4-2006. Although quarterly y/y figures imply a gradual cooling down of economic activity, seasonally adjusted q/q data reflect weakening of growth in Q1-2007 only in the case of Lithuania (Chart 27). In Poland and Romania, growth accelerated throughout 2006 (in Poland, growth is estimated to have increased further to around 7.5% y/y in the first quarter of 2007).
For 2007, economic expansion is expected to accelerate in Poland and Slovakia, remain broadly unchanged in Bulgaria, and decelerate in the remaining countries (Table 2). A mild deceleration reflects a change towards more sustainable patterns of growth, at least in the Baltic States and Romania.
Chart 26. GDP growth Chart 27. GDP growth, sa % q/q
% yoy Seasonally adjusted, flash estimates for 1q2007
4 16 1Q 06 2Q 06 3Q 06 1Q 06 2Q 06 3Q 06 14 4Q 06 1Q 07 4Q 06 Q1 07 2006 12 3 10 8 2 6 4 1 2 0 0 CZ EE HU LV LT PL SK SI BG RO CZ EE HU LV LT PL SK SI
Source: CSOs, Q1 07: Preliminary official estimates: Source: CSOs EE, LV, LT, SK, HU; market consensus: PL, CZ
10. Domestic demand will remain the main engine of growth in most NMS (Chart 28). Domestic demand is likely to benefit from steadily improving wage settlements, continuous credit growth, rising EU transfers, and fiscal stimulus (mainly in the Czech Republic, Bulgaria and Romania). In the Baltic countries, although growth of domestic demand is likely to moderate, overheating will remain the greatest challenge. On the other hand, a strong negative contribution to growth from domestic demand is expected in Hungary because of declining household disposable incomes on the back of fiscal tightening. In some countries, the contribution of net exports to growth is likely to decline. In the Baltic States in particular and to a lesser extent in Romania and Bulgaria, a deterioration of unit labor costs is expected to undermine competitiveness and slow down exports (Chart 36, labor section). On the other hand, opening of new production lines and modest growth of unit labor costs will support export performance in Hungary, Slovakia and the Czech Republic, despite the marked appreciation of local currencies. In Romania, a severe drought is likely to affect agricultural output (whose contribution to GDP remains important).
10 Chart 28. Domestic demand growth will continue to dominate Contribution to GDP growth, % points of GDP
25 Net export Domes tic Demand 20 15
10
5
0 -5
-10
2006 2007 2006 2007 2006 2007 2006 2007 2006 2007 2006 2007 2006 2007 2006 2007 2006 2007 2006 2007 CZ EE HU LV LT PL SK SI BG RO
Source: EC Spring Forecasts
Table 2. Macro Forecasts
Output growth Inflation CPI average Current account as % of GDP Fiscal balance (GG), % of GDP 2006 2007F 2008F 2006 2007F 2008F 2006 2007F 2008F 2006 2007F 2008F EC 6.1 4.9 4.9 2.1 2.4 2.9 -4.2 -3 -2.7 -2.9 -3.9 -3.6 CZ IMF 6.1 4.8 4.3 2.5 2.9 3.0 -4.2 -4.1 -4.2 EC 11.4 8.7 8.2 4.4 5.1 5.3 -14.8 -15.1 -14.7 3.8 3.7 3.5 EE IMF 11.4 9.9 7.9 4.4 4.8 5.3 -14.8 -12.9 -12.2 EC 3.9 2.4 2.6 4.0 7.5 3.8 -5.8 -3.5 -2.2 -9.2 -6.8 -4.9 HU IMF 3.9 2.8 3.0 3.9 6.4 3.8 -5.8 -5.7 -4.8 EC 11.9 9.6 7.9 6.6 7.2 6.2 -21.1 -22.4 -21.0 0.4 0.2 0.1 LV IMF 11.9 10.5 7.0 6.5 7.3 6.5 -21.1 -23.0 -22.7 EC 7.5 7.3 6.3 3.8 4.7 4.4 -10.8 -12.4 -13.4 -0.3 -0.4 -1.0 LT IMF 7.5 7.0 6.5 3.8 3.5 3.4 -10.8 -12.3 -11.0 EC 6.1 6.1 5.5 1.3 2.0 2.5 -2.3 -3.1 -4.3 -3.9 -3.4 -3.3 PL IMF 6.1 5.8 5.0 1.0 2.2 2.9 -2.3 -2.7 -3.6 EC 8.3 8.5 6.5 4.3 1.7 2.4 -8.3 -4.2 -3.7 -3.4 -2.9 -2.8 SK IMF 8.3 8.2 7.5 4.5 2.4 2.3 -8.3 -5.7 -4.6 EC 5.2 4.3 4.0 2.5 2.6 2.7 -2.6 -2.4 -2.3 -1.4 -1.5 -1.5 SI IMF 5.2 4.5 4.0 3.0 2.7 2.4 -2.6 -2.6 -2.5 EC 6.1 6.1 6.2 7.4 4.2 4.3 -16.0 -16.6 -17.2 3.3 2.0 2.0 BG IMF 6.1 6.0 6.0 7.3 5.3 3.6 -16.0 -15.7 -14.7 EC 7.7 6.7 6.3 6.6 4.6 4.5 -10.7 -12.1 -12.3 -1.9 -3.2 -3.2 RO IMF 7.7 6.5 4.8 6.6 4.5 5.0 -10.7 -10.3 -9.8 Source: IMF - WEO April 2007, EC – Spring Forecasts May 2007 - different from WB projections which are: ↑ higher and ↓ lower than presented in the table.
Labor Market Developments
11. Unemployment rates declined further in the EU8+2 countries. Robust economic growth pulled down unemployment rates particularly in Poland and Slovakia – the two countries with the highest unemployment rates. The unemployment rate in Poland decreased by 8.5 pp over the last two years. Hungary is the only country in the region with a higher unemployment rate compared to 2004 (Chart 29).
11 Chart 29.Unemployment rates continue to fall in EU8+2
Harmonized unemployment rates 25 CZ HU 15 15 LV SI BG RO PL SK LT EE 20 10 10 15
10 5 5 5
0 0 0 1Q 04 2Q 04 3Q 04 4Q 04 1Q 05 2Q 05 3Q 05 4Q 05 1Q 06 2Q 06 3Q 06 4Q 06 1Q 04 2Q 04 3Q 04 4Q 04 1Q 05 2Q 05 3Q 05 4Q 05 1Q 06 2Q 06 3Q 06 4Q 06 1Q 04 2Q 04 3Q 04 4Q 04 1Q 05 2Q 05 3Q 05 4Q 05 1Q 06 2Q 06 3Q 06 4Q 06 Source: Eurostat
12. More jobs are being generated (Chart 30). Employment rose in all countries across the region (from 0.7% in Hungary to 6.7% in Estonia). At the same time, labor participation fell in Poland, Lithuania, Slovakia and Czech Republic contributing further to lower unemployment rates. Meanwhile, increases in the working-age population (in all countries but Bulgaria) and in participation rates (Estonia, Hungary, Latvia and Bulgaria) slowed down the decline in unemployment rates in these countries.
Chart 30. New jobs drove unemployment Chart 31. Jobs were generated, mainly in services rates down in 2006 Contribution to employment growth by sectors; 2005 and 2006 Contribution to change in unemployment rate 8 % change in w orking-age population 5 % change in participation rate Agriculture, hunting, forestry and fishing Indus try Construction Services % change in employment 4 6 3 2 4 1 0 2 -1 0 -2 -3 -2 -4 -5 -4 -6 -3.9 -7 -0.8 -2.0 0.3 -2.1 -2.6-2.9 -0.6 -1.1 2005 2006 2005 2006 2005 2006 2005 2006 2005 2006 2005 2006 2005 2006 2005 2006 2005 2006 2005 2006 CZ EE HU LV LT PL SK SI BG CZ EE HU LV LT PL SK SI BG RO Source: Eurostat; and staff calculations Source: Eurostat
13. The services sector accounted for most new jobs (except in the Czech Republic), but construction also contributed importantly in several countries (Chart 31). The services sector was the main driver of employment growth in all countries, except for the Czech Republic where the majority of new jobs was created in industry. The construction sector played an important role in employment growth in the Baltic countries, Bulgaria, Poland and Slovakia likely because of the real estate boom.
14. Employment growth was driven mainly by upper- and post-secondary graduates (Chart 32). Secondary graduates contributed most to the employment growth in all countries across the region but Slovenia. Employment of unskilled primary and lower secondary graduates diminished in Bulgaria, Romania, Slovenia, Hungary, Poland and Lithuania.
12 Chart 32. Low-educated labor loses jobs Contribution to employment growth by education level (2006) 7 Tertiary Upper secondary and post secondary 6 Primary and low er secondary 5 4 3 2 1 0 -1 -2 CZ EE HU LV LT PL SK SI BG RO
Source: Eurostat
15. Employment rates remain persistently low in many EU8+2 countries. Despite labor market improvements, employment rates in the NMS are still much lower than in the EU15 countries. Poland and Hungary face the biggest challenges in terms of labor market policy, as employment rates in all age groups are well below the EU8+2 average, not to mention EU15 (Table 3). Unemployment traps (see Box 2) - where a mix of high labor taxes and relatively generous unemployment benefits discourage workers from seeking employment - are the highest in Slovenia and Latvia. Low wage traps may also discourage people from increasing their work effort, particularly in Poland (for single wage earners) and in Latvia (for couples with one wage earner and two children).
Table 3. Employment rates low in Poland and Hungary
Employment rates by age, 2006
Employment rates CZ EE HU LV LT PL SK SI BG RO EU15 NMS10 by age 15-24 27.7 31.6 21.7 35.9 23.7 24.0 25.9 35.0 23.2 24.0 40.1 25.4 25-29 74.0 82.1 71.2 77.9 81.4 70.8 72.2 77.5 68.3 69.5 75.0 72.6 30-34 78.4 82.5 75.5 80.4 83.4 76.4 76.3 89.6 75.7 77.3 79.1 77.5 35-39 85.9 85.9 77.6 83.6 84.0 77.8 79.1 90.8 79.7 79.4 80.6 80.1 40-44 89.1 87.2 78.0 84.6 84.3 76.7 82.4 88.8 79.5 79.7 81.2 80.3 45-49 87.5 86.1 75.6 80.3 80.9 71.5 79.8 85.1 77.6 77.0 80.2 76.0 50-54 83.5 81.6 69.0 79.6 75.3 59.8 74.8 74.0 71.3 66.2 75.0 67.4 55-59 62.7 71.8 49.9 66.2 67.3 34.2 47.4 44.8 54.6 48.7 58.5 45.1 60-64 23.1 41.4 13.4 39.2 31.0 17.9 13.6 15.9 22.2 32.4 29.3 19.8 65-74 6.1 19.2 2.6 17.4 7.1 7.3 1.8 10.1 4.1 23.0 6.2 6.9 15-64 65.3 68.1 57.3 66.3 63.6 54.5 59.4 66.6 58.6 58.8 66.0 58.3
lower than NMS10 average
Source: Eurostat
Box 2. Unemployment and low-wage traps discourage formal employment Finding the balance between social protection and incentives to work is a challenging task for EU8+2 countries. Social insurance contributions and taxes can create disincentives to work in the formal sector, particularly for low wage workers. A recent World Bank report (Social Assistance in Central Europe and the Baltic States) analyzes the aggregate impact of taxes and social insurance contributions on labor market incentives in the EU8+2. High levels of social spending can result in unemployment traps where benefits paid to the unemployed and their families are high relative to potential net earnings. The severity of an unemployment trap can be measured as the percentage of gross earnings which is taxed through income tax and social security contributions and the withdrawal of unemployment and other cash benefits when an unemployed person returns to employment. Thus, this indicator can be used to measure how current tax and social policy regulations affect incentives to seek employment.
13 Current tax and social policy regulations appear to Chart 33. Unemployment trap in EU8+2 in 2001 and discourage formal sector employment in most of the 2005: high in Slovenia, but progress in Slovakia, EU8+2. Benefits paid to the unemployed and their families Romania and Hungary. in the EU8+2 are high relative to potential net earnings %; earner of 67% of the Average Production Wage (APW) (Chart 33). 100 2001 2005 Unemployment traps in Slovenia, Latvia and Poland are 90 higher than the EU average. Moreover, in Latvia and 80 Poland they have increased in recent years. In these 70 countries, the effective marginal tax rate for an 60 unemployed person returning to work is around 80 percent 50 of gross earnings – including the effect of taxes and 40 reduced benefits. 30 However, some countries have made impressive strides in 20 this area. Between 2001 and 2005, Slovakia halved the 10 effective taxation rates through its aggressive reform 0 program, reducing the combined effects of taxes and CZ EE HU LV LT PL SK SI BG RO EU25 benefits to the lowest in the region, at 43 percent. Hungary and Romania also managed to reduce the unemployment traps significantly – although they remain Source: Eurostat relatively high. Slight declines were also recorded in the Czech Republic and Lithuania. The low wage trap (or poverty trap) is related to the financial consequences of increasing working hours (or work effort) for low-paid workers. It refers to a situation where an increase in gross in-work earnings fails to translate into a significant net income increase. The low wage trap measures the percentage of gross earnings which is taxed away through the combined effects of income taxes, social security contributions and any withdrawal of social benefits paid in cash when gross earnings increase from 33% to 67% of the average production wage (APW).
Chart 34. Low-wage trap in EU8+2 in 2001 and 2004: high in Poland, Latvia and Slovenia %; earnings increase from 33% to 67% of the APW Single persons without children One income-earner couples with two children 70 140 2001 2005 2001 2005 60 120
50 100
40 80
30 60
20 40
10 20
0 0 CZ EE HU LV LT PL SK SI BG RO EU25 CZ EE HU LV LT PL SK SI BG RO EU25
Source: Eurostat Low-wage traps are particularly high in Poland (Chart 34) for single persons without children and in Latvia for single- earner couples with two children (assumed ages are 4 and 6). A single person without children in Poland faces limited incentives – as she/he loses 65 percent of the gross wage to higher taxes and lower benefits if she/he starts to earn two- thirds instead of one-third of the average wage. It is important to note that average production wages (APW) used for this analysis are significantly higher than minimum wages in many countries. Minimum wage rates range between 35% (Slovakia) and 60% (Slovenia) of APW. Hence, the disincentives for low wage workers may be even more severe.
Poor couples with one wage earner and two children in Latvia no financial incentive to increase their wages. If they earn two-thirds of the average wage instead of the one-third, their marginal effective tax rate is 100 percent of gross earnings. Romania and Hungary provide the strongest incentives to increase wages in order to exit from poverty for low wage single-earner couples with children, with a combined tax rate of 17 and 14 percent, respectively. High levels of unemployment and low-wage traps suggest that current tax and social policy regulations in the EU8+2 discourage formal sector employment. Thus, high social spending in EU8+2 has costs not only in terms of crowding out
14 fiscal space but also limiting employment growth. Further efforts will be needed to restructure social protection, especially given demographic pressures, social exclusion and poverty challenges.
Concerns about dependency traps, growing numbers of working poor, and efforts to meet the Lisbon employment targets, have place a renewed focus on measures to encourage employment and “make work pay” across Europe. Employment-conditional benefits, or “in-work benefits,” which aim to stimulate employment and provide social protection for low wage workers, are common in the EU15 and are gaining currency in the EU8. These include tax credits for low-wage workers, as well as lump sum and other benefits which taper off as wages rise. Source: Social Assistance in Central Europe and the Baltic States, The World Bank 2007 http://siteresources.worldbank.org/INTECA/Resources/EU8_SocAssist_Feb07.pdf
16. Strong output growth, declining unemployment and emerging bottlenecks in several sectors drove real wages to double digit growth rates in the Baltic countries and Romania. In 2006, real wages in Estonia rose by 11.3%, Latvia by 15.6% and Lithuania by 14.7%. Real wage growth in the Visegrad countries and Bulgaria was more moderate - from 3.3% in Slovakia to 4.1% in Hungary. The highest growth rates were recorded in 4Q 2006 - in Latvia it reached 20.3%, and in Romania 18% (yoy) (Chart 35).
Chart 35. Real wages grew fast in the Baltic States and Romania Real wages growth (y-o-y) 15.0 21.0 20.0 CZ PL EE LV RO BG 18.0 SK HU LT SI 15.0 10.0 15.0 10.0 12.0 5.0 9.0 5.0 0.0 6.0 0.0 3.0
-5.0 0.0 -5.0 1Q 05 2Q 05 3Q 05 4Q 05 1Q 06 2Q 06 3Q 06 4Q 06 1Q 05 2Q 05 3Q 05 4Q 05 1Q 06 2Q 06 3Q 06 4Q 06 1Q 05 2Q 05 3Q 05 4Q 05 1Q 06 2Q 06 3Q 06 4Q 06 Source: CSOs
17. ULC growth was most pronounced in the Baltic countries and Romania. Strong growth in nominal wages outpaced growth in productivity causing acceleration in labor cost per unit of output (Chart 36). In the Baltic States, the deterioration in ULC can be attributed mainly to the construction sectors. In the Visegrad countries, ULC growth has been more moderate, with the construction sector in Hungary an exception.
Chart 36. Unit Labor Costs rising rapidly in the Baltic States and Romania Aggregate ULC (4Q moving average) 20 SI EE BG 20 LT LV RO CZ HU 15 15 PL SK
10 10
5 5
0 0
-5 -5
-10 -10 1Q 03 1Q 03 2Q 03 3Q 03 4Q 04 1Q 04 2Q 04 3Q 04 4Q 05 1Q 05 2Q 05 3Q 05 4Q 06 1Q 06 2Q 06 3Q 06 4Q 1Q 03 1Q 03 2Q 03 3Q 03 4Q 04 1Q 04 2Q 04 3Q 04 4Q 05 1Q 05 2Q 05 3Q 05 4Q 06 1Q 06 2Q 06 3Q 06 4Q
15 ULC in industry (4Q moving average)
15 SI EE 15 BG LT CZ HU 10 10 PL SK
5 5 0 0 -5 -5 -10 -10
-15 -15 -20 -20 1Q 03 1Q 03 2Q 03 3Q 03 4Q 04 1Q 04 2Q 04 3Q 04 4Q 05 1Q 05 2Q 05 3Q 05 4Q 06 1Q 06 2Q 06 3Q 06 4Q 1Q 03 1Q 03 2Q 03 3Q 03 4Q 04 1Q 04 2Q 04 3Q 04 4Q 05 1Q 05 2Q 05 3Q 05 4Q 06 1Q 06 2Q 06 3Q 06 4Q
ULC in construction (4Q moving average) 30 30 25 25 CZ HU PL SK 20 20 15 15 10 10 5 5 0 0 -5 -5 SI EE -10 -10 BG LT -15 -15 1Q 03 1Q 03 2Q 03 3Q 03 4Q 04 1Q 04 2Q 04 3Q 04 4Q 05 1Q 05 2Q 05 3Q 05 4Q 06 1Q 06 2Q 06 3Q 06 4Q 1Q 03 1Q 03 2Q 03 3Q 03 4Q 04 1Q 04 2Q 04 3Q 04 4Q 05 1Q 05 2Q 05 3Q 05 4Q 06 1Q 06 2Q 06 3Q 06 4Q Note: Data for RO for sectors not available Source: Eurostat, CSOs, staff calculations
18. EU15 labor markets remain closed for Bulgarians and Romanians. Labor migration abroad from Bulgaria and Romania remains blocked as the EU15 (with the exception of Finland and Sweden) decided to maintain labor market barriers (Table 4) for the next two years. As a result, legal flows of Bulgarians and Romanians to these countries are likely to be limited. However, certain routes are still accessible as the UK will allow an unlimited number of highly skilled workers and an annual quota of 19,750 lower-skilled workers for specific sectors. From January to April 2007 around 6.5 thousand Romanians and 300 Bulgarians were granted jobs in Ireland despite the restricted access to the Irish labor market. Italy has also announced a sector-specific migration scheme. Bulgarians and Romanians will be allowed to work in Spain if they have been contracted before arrival. And, of course, students and self-employed workers face no restrictions in any EU country.
In contrast, all EU8 countries except Hungary opened their labor markets for migrants from Bulgaria and Romania, but these countries are not the main destination countries of choice.4
Table 4. EU15 restrict inflows of BG and RO workers EU15 EU8 "+2" Receiving countries AT BE DE DK ES FI FR GR IE IT LU NL PT SE UK CY MT CZ EE HU LT LV PL SI SK BG RO BG RO free labor mobility restircted partially restricted Source: www.migrationinformation.org; www.euractiv.com
19. The latest data on migration to the UK and Ireland suggest that the outflow of labor from the NMS remains high although with some early signs of slowing. From May 2004 to
4 The preferred migration destinations for most Bulgarians and Romanians are Southern European countries (notably Spain and Italy).
16 April 2007, Ireland issued 329,660 PPS numbers5 for EU8 nationals, of which 60% were Poles. The highest number of PPS numbers was granted in 3Q 2006. Since then, the number of new applications has been declining (Chart 37). A total of around 555 thousand EU8 nationals were registered in the UK Workers Registration Scheme from May 2004 to December 2006, of which 65% came from Poland. The majority of migrants registered in 3Q 2006 (Chart 38).
Chart 37. Polish and Baltic workers Chart 38… and to the UK dominate migration to Ireland Inflow of EU8 labor to the UK (WRS, ths.) Inflow of EU8 labor to Ireland (PPS, ths.) 45 70 CZ, SK EE, LV , LT CZ EE HU LV LT PL SK SI 40 PL HU, SI 60 35 50 30 25 40 20 30 15 20 10 5 10
0 0 2Q 04 3Q 04 4Q 04 1Q 05 2Q 05 3Q 05 4Q 05 1Q 06 2Q 06 3Q 06 4Q 06 1Q 07 2Q 04 3Q 04 4Q 04 1Q 05 2Q 05 3Q 05 4Q 05 1Q 06 2Q 06 3Q 06 4Q 06 Source: Department of Social and Family Affairs, Source: Accession Monitoring Report May 2004 - Ireland, www.welfare.ie December 2006
Inflation and Monetary Policy
20. Inflationary pressures are mounting in several countries in the region with output above potential, tightening labor markets, and rapid credit growth. Consumer price inflation trended higher in the Baltic countries, reaching a worrisome 8.9% in Latvia in April (Chart 39). In Hungary, harmonized inflation picked up to 9% as increases in indirect taxes, food and regulated prices kept weaker demand from slowing inflation. Meanwhile, in Poland and the Czech Republic, buoyant growth in output and demand has not yet had discernible effects on inflation although pressures are mounting and interest rate hikes have started or are expected later in 2007. In Romania and Slovakia, inflation seems to be on a downward trend helped by significant currency appreciation. In Bulgaria, inflation is declining following a spike in early 2006 on the back of adjustments to alcohol and tobacco prices.
Chart 39.HICP on the rise in Hungary and the Baltic states
% y-o-y
10 10 LV SI 10 CZ HU LT EE 8 PL SK 8 8
6 6 6
4 4 4
2 2 2 BG RO
0 0 0 Jul-05 Jul-06 Jul-06 Jul-05 Jul-05 Jul-06 Jan-05 Oct-05 Jan-06 Oct-06 Jan-07 Oct-06 Jan-07 Oct-05 Jan-06 Jan-05 Apr-05 Apr-06 Apr-07 Jan-05 Oct-05 Jan-06 Oct-06 Jan-07 Apr-07 Apr-06 Apr-05 Apr-05 Apr-06 Apr-07 Source: Eurostat.
5 Personal Public Service number, which is required for those wishing to work in Ireland.
17 21. In most EU8+2 countries, inflation in recent months has been fueled by accelerating growth in prices of services, while the impact of goods prices, including energy, was diminishing. Easing pressures from energy prices in recent months have helped to contain the impact of goods prices on inflation, although new pressures have arisen as prices of food picked up throughout the region. At the same time, the prices of services have accelerated, notably in the Baltic countries (especially in services related to housing and transport in Latvia and Estonia).
22. Rapid money supply expansion, largely driven by capital inflows and brisk private credit expansion, is adding to inflationary pressures. While in the Visegrad countries, money supply growth rates are moderate, they are remarkably higher in the Baltic countries (exceeding 40% in Latvia) but also in Bulgaria and Romania (Chart 40). The contribution of net foreign assets remains negative in most countries, notably in Latvia and Estonia where it reflects growing foreign liabilities of the banking sector to finance the current account deficits. Net foreign assets increased only in Bulgaria and Romania. In most countries, growth of the broad money aggregate M3 is driven by robust private sector credit (Chart 41). In comparison, net credit to the government played a relatively minor role except in Hungary. So far, EU transfers (see External Developments below) seem to have had only a limited direct impact on the monetary environment.
Chart 40. Money supply is growing rapidly in the Baltic States, Bulgaria and Romania
M3 (12M moving average, yoy %) 20 50
40 15 30 10 20 BG EE CZ HU 5 10 LV LT RO PL SK 0 0 Apr-07 Apr-06 Apr-05 Dec-06 Dec-05 Dec-04 Aug-06 Aug-05 Apr-05 Apr-06 Apr-07 Dec-04 Dec-05 Dec-06 Aug-05 Aug-06
Notes: M2 for Estonia and Romania Source: CBs
Chart 41. Credit to private sector drives money supply
Contributions to M3 growth (yoy %)
NFA Credit to GG, net Credit to private sector other items, net NFA Credit to GG, net Credit to private sector other items, net 30 100 25 80 20 60 15 10 40 5 20 0 0 -5 -20 -10 -40 -15 -60 -20 2003 2004 2005 2006 2003 2004 2005 2006 2003 2004 2005 2006 2003 2004 2005 2006 2003 2004 2005 2006
2003 2004 2005 2006 2003 2004 2005 2006 2003 2004 2005 2006 2003 2004 2005 2006 EE LV LT BG RO CZ HU PL SK
Notes: M2 for Estonia and Romania Source: CBs, and staff calculations
18 23. On the positive side, in countries with floating exchange rates, strong appreciation trends helped to relieve price pressures. Strong appreciation trends (Chart 42) worked to contain price pressures via lower import prices, keeping inflation lower than it might otherwise have been given the impressive growth rates (Hungary, Slovakia, Romania, and to a lesser degree the Czech Republic and Poland). Further appreciation resulting from strong fundamentals and capital inflows, including EU funds, should continue to relieve inflationary pressures in these countries. At the same time, rapid real appreciation is threatening to undermine external competitiveness in several countries (see external section).
Chart 42. Exchange rate developments: appreciation of local currencies Czech Republic Hungary Poland
EUR (lhs) NEER ( r hs ) EUR (lhs) NEER ( r hs ) EUR (lhs) NEER (rhs) 34 86 290 106 5.0 110 33 84 280 104 105 102 32 82 270 4.5 100 31 80 100 260 98 95 30 78 250 96 4.0 90 29 76 94 28 74 240 92 85 27 72 230 90 3.5 80 Jul-04 Jul-04 Jul-04 Jan-04 Jan-04 Jan-04 Feb-05 Mar-06 Apr-07 Feb-05 Mar-06 Apr-07 Feb-05 Mar-06 Apr-07 Sep-06 Sep-06 Sep-06 Aug-05 Aug-05 Aug-05 Slovakia Romania
EUR (lhs) NEER ( r hs ) EUR (lhs) NEER (rhs) 42 4.5 250 40 89 230 4.0 38 84 210 36 190 3.5 79 34 170 32 74 3.0 150 Jul-04 Jul-04 Jan-04 Jan-04 Feb-05 Mar-06 Apr-07 Feb-05 Mar-06 Apr-07 Sep-06 Sep-06 Aug-05 Aug-05 Notes: NEER – increase denotes depreciation Source: ECB, EC
24. Problems with keeping inflation under control are set to further delay euro adoption plans in the Baltic countries, and plans were also revised in the Czech Republic. Only Slovakia remains committed to its 2009 target. With inflation forecasts in the Baltic countries being revised upwards on the back of intense wage pressures and overdue hikes in regulated prices, the 2010 euro-zone target date is becoming increasingly unrealistic. In Latvia, where inflation has been running at over 6% for three successive years—with a serious risk of entrenching high inflation expectations—the government endorsed a plan of measures aimed at curbing inflation (Box 3) but it is questionable whether this will be enough. Plans were revised also in the Czech Republic which will not join the ERM2 in mid-2007 as planned, with euro adoption in 2010 formally abandoned and no new target established. Meanwhile, Slovakia remains committed to its 2009 target date, with a mid-March 7.8% revaluation of the koruna’s ERM2 central parity rate increasing the central bank’s room to maneuver in the face of very strong appreciation pressures. Slovakia is the only EU8+2 country to retain a formal euro adoption target date.
25. Monetary policy in the Czech Republic and Poland is likely to follow the tightening cycle of the ECB, while better inflation prospects (and higher interest rates) may allow for some monetary easing in Hungary and Slovakia (Chart 44). Appreciation trends throughout the region helped to tighten monetary conditions (Chart 43) allowing central banks in the Visegrad countries to be less hawkish than would be expected at this point in the cycle. Yet, as
19 inflationary pressures mount, monetary tightening has begun in Poland and is expected in the Czech Republic – the former hiked interest rates in April (+25 bps) with another 50 bps in two steps expected by the market later in 2007. Meanwhile, in Hungary, interest rate cuts of 125 bps from the current level of 8% are widely expected as inflation should return to a downward trend (after peaking in March-April on the wave of the regulated price increases), helped by the renewed buoyancy of the forint. Monetary easing already begun in Slovakia with a 25 bps cut in April and another one may follow given recent monetary developments and favorable inflation expectations for 2008. In Romania, given inflation below expectations, the central bank cut the base interest rate by 150 bps in three steps this year and appears to be focused on reducing interest rate differentials between Romania and the euro-zone.
Chart 43. Tightening monetary conditions
Monetary condition index Czech Republic Hungary Poland REER REER REER real interest rate real interest rate real interest rate 35 MCI 40 MCI 25 MCI 30 30 20 25 15 20 20 10 15 10 5 10 0 0 5 -5 0 -10 -10 -5 -20 -15
Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Slovakia Romania REER REER real interest rate real interest rate 60 MCI 70 MCI 50 60 40 50 40 30 30 20 20 10 10 0 0 -10 -10
Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Source: EC, CBs, and staff calculations
20 Chart 44. Projection of Central Bank Base Rates, derived from FRAs market (%)
EURO zone CZ HU PL SK RO 10 Projection 9 8 7 6 5 4 3 2 1 0 Jul-07 Jul-06 Jan-07 Jan-06 Mar-07 Mar-06 Sep-07 Nov-07 Sep-06 Nov-06 May-07 May-06 Notes: Projection (as of May 16): central bank interest rate changes derived from interest rate derivatives Source: CBs, and staff calculations
Box 3. Anti-inflation measures adopted by the government of Latvia
On March 6, Cabinet endorsed a plan of measures aimed at curbing inflation. The main steps included in the plan are:
Fiscal responsibility • Commitment not to introduce any budget law amendments that could increase budget expenditures in 2007; • Introduction of a balanced central government budget position in 2008 and planned budget surplus in 2009 and 2010; • Implementation of medium-term budgetary planning framework; • Every year the government will review and approve construction schedules of existing and planned large-scale (over 3.5 mln lats) construction projects undertaken by ministries or local governments; • Limits on growth of wages and salaries in the public sector and a freeze on employment growth in the public sector (budgetary institutions).
Tax policy • Moratorium on introduction of any new tax reductions; • Reduction of tax exemptions on income derived from the sale of real estate; • Increase in the amount of duty and state tax to be paid for real estate and mortgage registration for holders of multiple properties; • Introduction of additional duties on vehicles depending on the engine capacity and the level of emission.
Constraining credit growth • Requirement that commercial banks, leasing companies and other financial service providers evaluate and grant loans considering only the legally reported income of the borrower; • Creation of borrowers' register; • Requirement for mandatory downpayment of not less than 10-15% of the amount of the loan to be issued; • Requirement of full disclosure of sources of legal income for individual transactions and purchases that exceed 50 % of minimum wages.
Labor market and productivity • Broadening of active labor market interventions and improvement of occupational and geographical mobility of labor; • Reduction in the share of informal employment; • Implementation of immigration and re-emigration policy;
21 Energy prices • Promotion of energy efficiency; • Transfer of functions of municipal regulators to the Public Utilities Commission; • Promotion of the use of a dual tariff system for heat energy, distribution of fixed payments over the year and adoption of payments that vary according to consumption. Promotion of competition • Promotion of competition in trade by limiting consolidation of market power and facilitating entry of new market participants; • Monitoring of the trends in the markets for construction materials and fuel. Source: Latvia, Ministry of Finance
External Sector Developments
26. Foreign trade continued to expand robustly at a double-digit pace across the region in 2006. Exports accelerated in the Visegrad countries (in particular Slovakia due to increased production in new car factories) but also in Slovenia and Bulgaria (Chart 45,Chart 46). While growth of exports outpaced imports in Hungary, Slovenia, and Bulgaria, imports grew significantly faster than exports in the Baltic States and Romania (Chart 47).
Chart 45. Robust growth in goods exports Chart 46. Outpaced by import growth … in the Baltic States and Romania
Export growth, EUR % yoy Import growth, EUR % yoy
35 2004 2005 2006 35 2004 2005 2006 30 30 25 25 20 20 15 15 10 10 5 5 0 0 CZ EE HU LV LT PL SK SI BG RO CZ EE HU LV LT PL SK SI BG RO
Source: Eurostat; CBs, CSOs Source: Eurostat; CBs, CSOs
27. Existing external imbalances grew further to very high levels in many of the most vulnerable countries. In 2006, the Baltic States (in particular Latvia) and new EU-entrants (Bulgaria and Romania) recorded double-digit current account deficits, in all cases higher than the year before. The current account deficit narrowed significantly in Hungary and slightly in Slovakia. The Czech Republic was the only country in the region that enjoyed a trade surplus, but significant profit repatriations abroad drove its current account into deficit. Negative net income balances were considerable also in Hungary, Slovakia, Slovenia and Estonia, while only Bulgaria enjoyed a small net income surplus although steadily declining (Chart 47).
22 Chart 47. Current account deficit deteriorated further in many of the most vulnerable countries
Current Account Balance and Components (% of GDP)
10 Trade in goods, net Trade in services, net Inc ome, net Current transfers, net Current account balance 5
0
-5
-10
-15 2004 2005 2006 2004 2005 2006 2004 2005 2006 2004 2005 2006 2004 2005 2006 CZ HU PL SK SI
30 Trade in goods, net Trade in services, net 25 Income, net Current transfers, net 20 Current account balance 15 10 5 0 -5 -10 -15 -20 -25 -30 2004 2005 2006 2004 2005 2006 2004 2005 2006 2004 2005 2006 2004 2005 2006 EE LV LT BG RO Source: national central banks; and staff calculations
28. EU8+2 countries trade mainly with other EU members and the degree of foreign trade openness varies considerably. Slovakia, with an export-to-GDP ratio exceeding 75% (Eurostat trade data), is the most open economy in the region, followed by Hungary, the Czech Republic, Slovenia and Estonia.6 Although the presence of Poland among the countries with the lowest export-to-GDP ratio (around 30%) is not surprising because of the size of its economy, it is more puzzling in the cases of Romania and Latvia (which faces a real challenge in raising its export potential).
29. EU membership not only opens the door to a large market in “old Europe” but also stimulates exchange with other new EU members and the rest of the world (Chart 48). In the last three years, EU8+2 exports to the new (or candidate) countries of the EU and the rest of the world expanded even faster than to the EU15. The share of NMS in total exports was higher in 2006 than in 2004 in every EU8+2 country with the exception of Estonia, ranging from 12% in Romania to 30% in Latvia (Chart 49). At the same time, the share of exports to the EU15 declined (the Baltic countries, Bulgaria, Hungary, and Romania) or remained broadly stable (Slovenia and the Visegrad countries except Hungary). However, the share of the EU15 was still dominant and ranged from 40% in Latvia and Lithuania to over 60% in the Czech Republic, Hungary, and Poland. The share of the “rest of the world” increased (especially in the Baltic countries - partly due to their expansion on the Russian market - and in Bulgaria) or remained fairly stable. While trade barriers between the EU15 and EU candidate countries were removed years before their accession, once in the EU, the NMS started benefiting also from existing trade agreements between the EU and the rest of the world and from the free internal market within the NMS.
6 If trade integration in services were also taken into account, the ranking would be slightly different and Estonia would be the most open economy in the region. However, the geographical breakdown of services exports is not reported.
23
Chart 48. EU8+2 trade mainly with EU members
Geographical destination of exports of the EU8+2 (% of GDP)
80 EU15 NMS RoW 70
60 22.1 50 11.7 13.4 11.9 17.8 6.7 40 7.6 9.1 10.0 30 5.2 8.9 12.1 4.9 3.2 4.5 20 3.9 2.9 6.3 9.1 3.3 10
0 2004 2005 2006 2004 2005 2006 2004 2005 2006 2004 2005 2006 2004 2005 2006 2004 2005 2006 2004 2005 2006 2004 2005 2006 2004 2005 2006 2004 2005 2006 CZ EE HU LV LT PL SI SK BG RO
Chart 49. A big part of foreign trade is inter-regional trade
Geographical destination of exports of the EU8+2, structure in %
100%
80% 18 12 20 13 27 18 18 15 29 9 22 12 60% 10 12 17 30 8 22 10 26
40%
20% EU15 NMS Russia RoW
0% 2004 2005 2006 2004 2005 2006 2004 2005 2006 2004 2005 2006 2004 2005 2006 2004 2005 2006 2004 2005 2006 2004 2005 2006 2004 2005 2006 2004 2005 2006 CZ EE HU LV LT PL SI SK BG RO
Note: NMS – New Member States; RoW – Rest of the World Source: Eurostat
30. Financing of current account deficits has been readily available in most of the EU8+2. Although net FDI covered nearly 50% of the current account deficit in Hungary, the net inflow of portfolio capital in debt instruments (due to interest rates differentials) was more than twice as large. The Baltic States were more dependent on capital inflows in the form of loans and other banking system operations, while in Bulgaria and Romania net FDI more or less matched the C/A deficit (Chart 50).
Persistent concerns about medium- or long-term sustainability of current account deficits were reflected in a sovereign debt rating downgrade in Latvia (from A- to BBB+ with the outlook remaining negative) and downward revision of the outlook in Lithuania (S&P from positive to negative) and Romania (Fitch from positive to stable). By contrast, Poland, with the best external position in the region, enjoyed a long-term rating upgrade by one notch from S&P to the same level (A-) as the Czech Republic.7 Moody’s upgraded the outlook for Bulgaria from stable to positive soon after Bulgaria’s accession to the EU. In 2006, net financing flows fell short of current account deficits leading to reductions in foreign exchange reserves in only two countries - Slovakia and Slovenia.8 On the positive side, the most vulnerable countries recorded increases in reserves.
7 Poland has a S&P long-term foreign currency rating of “A-“ with stable outlook, while the Czech Republic has a positive outlook.
8 In Slovakia, interventions in support of the koruna in 2006 resulted in a reduction of reserves which was not compensated by issues of Eurobonds.
24
Chart 50.Private capital inflows remained buoyant in 2006
Financing of Current Account, % of CAD
500 400 300 200 100 0 -100 -200 -300 -400 2004 2005 2006 2004 2005 2006 2004 2005 2006 2004 2005 2006 CZ EE PL SI***
300 Capital account FDI, net Portfolio investment, equity Portfolio investment, debt Other* Change in reserves** 200
100
0
-100
-200 2004 2005 2006 2004 2005 2006 2004 2005 2006 2004 2005 2006 2004 2005 2006 2004 2005 2006 HU LV LT SK*** BG RO***
Notes: The sum of flows above and below the horizontal axis sums up to 100% (equals the value of the current account deficit) *) financial derivatives, other investment and net errors and omissions; **) negative values denote increase of reserves; ***) portfolio investment include equity and debt Source: NCBs; staff calculations
31. External debt-to-GDP ratios rose sharply in 2006 in the most vulnerable countries due to large external borrowing needs (the Baltic countries, in particular Latvia, and Hungary).9 In most countries in the region, rising external commitments were driven by private non-financial sector lending, including inter-company loans (Chart 51). Hence, the additional lending was usually long-term and did not increase the share of short-term debt in total external debt, except in Slovenia and Bulgaria (Chart 52). Moreover, in 2006 foreign debt-to-GDP ratios were stabilized, in part because of currency appreciation.10 Between end-2005 and end-2006, all currencies in the region appreciated against the US dollar (by 10%-17%) and were stable (fixed) or appreciated against the euro (with the strongest appreciation of the Slovak Crown, Romanian Leu, and the Czech Crown (Table 5).
9 External debt also increased in Bulgaria as a significant part of FDI inflows took the form of inter- company loans.
10 It is not possible to calculate the exact impact of exchange rate movements on external debt-to-GDP ratios because most central banks do not report the currency structure of debt.
25 Chart 51. Large and rising external debt in Chart 52. Driven mainly by long-term Latvia, Estonia, Hungary, and Bulgaria private sector lending
Structure of external debt in 2005-2006, by sector, % Term structure of external debt in 2005-2006, % of GDP
short-term long-term 100% 120 113 General government Monetary authorities Banks Other sectors 99 100 96 Inter-company lending Gross external debt 92 80% 86 80 78 80 75 71 69 60% 61 57 58 60 51 46 44 42 39 39 40% 40
20 20%
0 0% 2005 2006 2005 2006 2005 2006 2005 2006 2005 2006 2005 2006 2005 2006 2005 2006 2005 2006 2005 2006
CZ EE HU LV LT PL SK SI BG RO 2005 2006 2005 2006 2005 2006 2005 2006 2005 2006 2005 2006 2005 2006 2005 2006 2005 2006 2005 2006 CZ EE HU LV LT PL SK SI BG RO Notes: The data for Slovenia is not disaggregated and 2005 Source: National Central Banks data for Romania is not available Source: National Central Banks
Table 5. Appreciation vis-à-vis USD and in several cases vis-à-vis EUR
Exchange rate changes in the EU8+2 countries in 2006, %
CZ EE HU LV LT PL SK SI RO BG EUR -5.4 0.0 -0.5 0.1 0.0 -0.7 -9.1 0.1 -8.4 0.0 USD -15.1 -10.3 -10.7 -10.2 -10.3 -10.8 -18.3 -10.2 -17.8 -10.3 Notes: Minus denotes appreciation of national currencies Source: Reuters, staff calculations
32. In 2006, all countries in the region, with the notable exception of Hungary and Slovenia, coped with varying degrees of real currency appreciation. In countries with flexible currency regimes (free floating or broad band under the ERM2), real appreciation resulted from a strengthening of nominal exchange rates (Visegrad countries except Hungary). In countries with fixed exchange rates (the Baltic States, Bulgaria) but also Romania and Hungary, real appreciation was mainly a consequence of positive inflation rate differentials. Compared to the medium-term average, relative price movements negatively affected competitiveness in all countries in the region (especially in Romania, Slovakia, and the Czech Republic) except Slovenia (Table 6). However, the medium-term position of Poland and Bulgaria deteriorated to a lesser extent if unit labor costs were taken into account. Over the last year, real exchange rates strengthened most in Romania and Latvia.
26 Table 6. Strong real appreciation in most NMS 2006, especially in Romania and Latvia
Real effective exchange rates in the EU8+2, % change compared to Q4-2005 over last year (yearly averages) compared to medium term average Q4-2006/Q4-2005 2006/2005 Q4-06/avg. 1995-2005 ULCE PGDP PX HICPULCE PGDP PX HICP ULCE PGDP PX HICP 35 trade partners (tp)40 tp 35 trade partners (tp) 40 tp 35 trade partners (tp) 40 tp CZ 3.8 5.6 2.8 4.2 3.8 4.1 5.2 1.4 5.0 4.4 31.9 28.7 11.9 23.8 23.1 EE 6.2 4.4 4.9 3.0 2.4 4.6 3.6 4.1 2.3 1.1 22.2 22.6 14.5 15.6 14.0 LV 10.4 8.4 5.5 4.5 3.8 11.9 8.5 6.1 4.2 2.9 23.4 20.9 26.7 9.0 7.4 LT 6.6 4.9 -1.2 3.1 2.3 5.1 4.4 -1.2 1.3 -0.3 25.3 24.2 24.6 18.4 16.1 HU -1.3 -0.5 -0.6 1.8 1.6 -5.8 -5.2 -2.6 -4.6 -5.1 20.0 16.9 -0.5 20.7 20.1 PL 3.2 1.9 3.5 1.8 1.5 4.9 2.8 2.4 2.5 1.6 4.7 13.5 19.4 14.8 14.1 SI 0.7 1.1 2.2 1.0 0.4 -0.2 0.5 2.1 0.4 -0.7 0.0 1.3 2.6 2.6 1.0 SK 8.7 9.1 6.5 9.5 9.1 4.5 4.6 3.4 5.8 5.2 29.5 32.9 19.8 41.4 40.7 BG 4.2 6.7 8.4 5.3 4.9 2.7 5.8 8.5 5.1 4.0 10.8 24.5 29.6 28.2 26.2 RO 14.0 14.0 10.9 9.1 8.6 12.7 11.5 5.4 7.4 6.6 64.2 64.5 21.5 40.1 39.6 Notes: Positive values denote real effective appreciation of national currencies in a definite period The indicators are based on recent export weight matrices with respect to 35 trade partners and deflated by: unit labor costs in total economy (ULCE), GDP deflator (PGDP), export prices deflator (PX), and the harmonized index of consumer prices (HICP), respectively. Additionally, REERs with respect to 40 trade partners are available using HICP as a price deflator. The broader country coverage includes not only EU27 countries, Norway, Australia, Canada, Japan, the United States, Mexico, New Zealand, Turkey and Switzerland (as in case of the first measure), but also Russia, China, Brazil, Hong Kong and Korea) Source: EU Commission, DG ECFIN
33. Because the EU8+2 countries depend heavily on foreign suppliers of oil and gas, and because energy prices have been much higher in recent years than in the early 2000s, import bills have increased. The net effect is linked to the availability of domestic energy resources or export capacity of energy sectors and is especially negative in Hungary but also significant in Slovakia and Lithuania. Exchange rate developments (a weakening of the US dollar) were not sufficient to compensate for rising prices of energy products on global markets (Table 7). The impact of price fluctuations is not immediate and time lags of some quarters are to be expected because of the prevalence of long-term contracts.
Table 7. Oil and natural gas prices increased significantly in recent years
annual averages Item Unit 2003 2004 2005 2006 Oil, UK Brent US$/barrel 28.85 38.30 54.44 65.39 change, % - 32.8 42.1 20.1 Natural Gas, Russian Federation US$/000 M3 125.51 135.18 212.94 295.65 change, % - 7.7 57.5 38.8 Table 8. …and inflated import bills Exports minus imports of mineral fuels/lubricants in the EU8+1*, % of GDP 2003 2004 2005 2006 CZ -2.8 -1.9 -3.7 -4.4 EE -2.3 -2.5 -2.4 -2.9 HU -2.3 -2.1 -3.0 -6.4 LV -4.0 -4.7 -5.1 -5.7 LT -1.4 0.1 -2.4 -3.4 PL -1.8 -1.6 -2.3 -2.5 SK -4.8 -4.1 -5.5 -6.9 SI -3.2 -4.6 -4.9 -5.3 RO -2.5 -3.0 -2.7 -3.0 Source: Eurostat (based on SITC).*) We do not show Bulgaria because Eurostat data is not consistent with national data
27 34. In 2006, trade balances in mineral fuels/lubricants11 deteriorated in all countries in the region (from 0.1% of GDP in Poland to 3.4% of GDP in Hungary) (Table 8). By comparison, in 2005 the trade balance in this category improved slightly in Romania and remained unchanged in Estonia, while it deteriorated in the remaining eight countries. Trade balances in Romania, Poland, and Estonia were not as strongly affected by rising energy prices because their final energy consumption relies largely on solid fuels and they have significant domestic sources (Table 9, Table 10). Issues related to energy have recently attracted considerable attention by EU institutions (Box 4).
Box 4. EU (Common) Energy Policy?
Energy policy and supply security of energy products became a hot topic during the Spring European Council summit (the first one “at 27”). It ended with an agreement on a so-called “triple 20 formula”.12 This decision sets very ambitious targets for the EU as a whole and for individual countries (e.g. the share of renewables is to increase to 20% from currently around 6% in the overall energy consumption (Table 9) and is likely to translate into higher operating costs of energy-intensive sectors). During the summit, Poland and Lithuania proposed a strengthening of “energy solidarity” among European partners, while some of the NMS (the Czech Republic and Slovakia) endorsed increased reliance on nuclear energy under the new Energy Policy for Europe. Overall energy import dependency varies across EU8+2 countries (Table 10), but all of them, with the exception of Romania, rely heavily on oil and gas supplies from abroad, mainly Russia. Table 9. Final energy consumption by fuel, 2003 Table 10. Energy import dependency, 2003, %
All fuels Solid fuels Oil Gas (Mtoe)
All fuels EU25 49.5 35.4 76.6 53.0 Solid fuels Solid Oil gas Natural Nuclear Renewables EU25 1 726.0 18% 37% 24% 15% 6% EU15 51.8 55.1 79.2 49.2 EU15 1 513.4 15% 40% 24% 15% 6% CZ 24.9 -17.4 95.8 98.2 CZ 43.7 46% 19% 17% 15% 3% EE 27.4 6.8 73.7 100.0 EE 5.5 60% 19% 12% 0% 9% LV 58.7 93.7 101.5 104.4 LV 4.4 2% 30% 32% 0% 35% LT 45.3 98.9 89.5 100.0 LT 9.0 2% 25% 25% 41% 7% HU 61.1 26.8 71.0 83.6 HU 26.7 14% 26% 45% 11% 4% PL 14.3 -23.0 96.5 66.6 PL 94.1 61% 22% 12% 0% 5% SI 53.4 20.4 101.4 99.4 SI 6.9 21% 35% 13% 19% 11% 79.9 90.6 96.8 SK 18.9 24% 19% 30% 24% 3% SK 64.6 BG 19.3 37% 23% 13% 23% 5% BG 46.9 35.9 100.8 94.2 RO 40.5 23% 26% 37% 3% 10% RO 26.1 29.4 30.8 30.8 HR 8.8 8% 55% 28% 0% 9% HR 56.3 99.8 71.5 27.6 Source: Eurostat Note: Import Dependency = Net Imports/(Bunkers+ Gross Inland Consumption). A simplified formula, not taking bunkers into account, is used occasionally. This variant gives higher values for import dependency by overlooking maritime transport. Negative numbers indicate that the country is a net exporter. Values over 100 % are possible due to changes in stocks Source: Eurostat
35. Net EU fund flows has had only a small positive impact on the balance of payments positions of the EU8 countries over the last three years, but this is set to grow sharply in the coming years. Direct payments and other transfers to agriculture (see Special Topic)
11 The category “Mineral fuels, lubricants and related materials” covers: coal, coke and briquettes; petroleum, petroleum products and related materials including crude oil; gas, natural and manufactured including natural gas; and electric current. 12 By 2020, EU Member States have committed themselves to: 1) reducing green house gas emissions by at least 20% as compared to 1990; 2) a 20% saving on EU energy consumption compared to projections for 2020; and 3) a “binding” target of increasing the share of renewables in the overall EU energy “mix” to 20%.
28 recorded in the current account were offset by country contributions to EU; and the small positive net effect appears mainly in the capital account of the balance of payments (Chart 53). However, a much higher wave of net EU flows is expected in the EU8+2 countries during the current 7-year EU financial perspective (Chart 54) thus contributing significantly to the financing of current account gaps in the future (assuming strong absorption). Chart 53. EU transfers will have a Chart 54. High annual inflows… significant BoP impact going forward Net yearly flows of EU funds to EU8 countries, % of BoP impact of EU-related transfers in the EU8 GDP countries, % of GDP
3.5 5.0 Capital 2004-06 avg 3.0 Account 4.0 2007-13 avg 2.5 Current Account (net) 2.0 3.0
1.5 2.0 1.0
0.5 1.0 0.0 0.0 -0.5 LT HU PL EE SK LV CZ SI BG* RO* EU8 -1.0 avg. 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 *) Data on pre-accession aid is not available.
Source: C. Rosenberg, R. Sierhej, Interpreting EU Funds Data for Macroeconomic Analysis in the New Member States, IMF WP/07/77, 2007
Chart 55. Absorption of EU structural funds above 50% in Slovenia, Estonia and Hungary Transfers from the EU as a percentage of funds allocated for financial perspective 2004-2006* 60 2004 2005 2006 2007 50
40 23.2 24.9 27.4
30 10.2 15.3 16.9 19.2 15.2
20 18.3 17.4 14.0 11.5 12.5 8.1 9.8 9.3 10
0 LV CZ LT SK PL HU EE SI
*) status as of January 22, 2007 Source: EC (DG Regional Policy), Polish Ministry of Regional Development
36. Slovenia, Estonia, and Hungary are the most advanced in absorbing the “more difficult” structural funds, but all EU8 countries made major progress in this area in 2006 (Chart 55). Under the n+2 rule, countries must submit claims for reimbursements by end-2008 in order not to lose committed funds. As of late January 2007, no country in the EU had reached the full amount of its commitments. Among the EU15 countries, Ireland, Austria and Spain reached around 80% in 2000-06, while Greece absorbed less than 55% of the total 7-year
29 allocation.13 It is still too early to judge whether the EU8 will follow the Irish or Greek road as far as the effectiveness in absorbing EU structural funds is concerned.
Public Finances
Fiscal stance in 2006-2007
37. Most countries in the region are not taking adequate advantage of the strong growth to improve public finances. The structural budget balance deteriorated in 2006 in all the Visegrad countries except Poland as well as in Slovenia and Romania (Table 12). Latvia and Lithuania pursued broadly neutral fiscal policies despite clear evidence of overheating, not least in Latvia. Only Bulgaria and Estonia tightened their fiscal stance significantly.
38. Revenues in 2006 performed better than expected with tax revenues buoyant on the back of strong wage growth, falling unemployment and improvements in tax administration. All main components of the tax system benefited from robust economic performance. Growth in employment and wages contributed to higher personal income tax intakes in Slovenia, Poland, Estonia, Slovakia and Lithuania. In Bulgaria, strong imports and imports and improved tax compliance contributed to further growth in VAT revenues.
39. The picture is not expected to change significantly in 2007. Hungary will make an important dent in the very large deficit recorded in 2006 and Poland will continue its very gradual adjustment process. Slovakia aims to bring its deficit just below the critical 3% of GDP threshold which would be needed to adopt the euro from 2009 as planned, but there is very little margin for slippage. Fiscal policies are expected to ease in Romania, the Czech Republic and Bulgaria and remain neutral in most other countries in the region.14 However, strong growth and conservative revenue forecasts in many EU8+2 countries are again likely to lead to budget over performance in 2007 (although in Romania the outcome could be worse than planned due to optimistic revenue projections).
• The budget deficit in Hungary reached close to 10% of GDP in 2006 although the mid- year austerity package helped to stabilize public finances. Hungary is targeting a reduction in the general government deficit to 6.8 % of GDP in 2007. Tax increases, subsidy cuts, a nominal wage freeze and trimmed investment outlays should help narrow the general government deficit more than targeted this year to 6-6.5% of GDP.
• In Slovakia, a strong fiscal impulse raised the general government deficit to 3.4% of GDP in 2006. While the fiscal outturn was better than planned for the state budget, the outturn for the other levels of general government in the aggregate was 0.6 percent of GDP lower than budgeted due to worse budget performance in the municipalities. Slovakia has budgeted for a general government deficit of 2.9% of GDP in 2007, very close to the 3% of GDP Maastricht criteria for euro adoption which would need to be met in 2007 for euro adoption to take place in 2009 as planned. While not likely, weaker than expected growth could jeopardize this plan.
13 However, the EU15 were entitled to advance payments of 7% of the total allocation per program, as confronted with 16% for the new EU members. 14 Due to differences in estimates of the structural budget balances by national authorities and the European Commission, there are differences in reported consolidation efforts for 2007 and 2008.
30 Table 11. A decline in output growth of 1 ppt would increase the fiscal deficit by about 0.4 ppt in the Visegrad countries
Cyclically-adjusted budget elasticities Corporate Personal Indirect Social security Current Total tax tax tax contributions expenditure balance Czech Republic 1.39 1.19 1.00 0.80 -0.02 0.39 Hungary 1.44 1.70 1.00 0.63 -0.03 0.47 Poland 1.39 1.00 1.00 0.69 -0.14 0.44 Slovak Republic 1.32 0.70 1.00 0.70 -0.06 0.37 Euro area average 1.43 1.48 1.00 0.74 -0.11 0.48 New EU members 1.38 1.15 1.00 0.71 -0.06 0.42 average Source: Girouard and André (2005), "Measuring cyclically-adjusted budget balances for OECD countries", Economics Department Working Paper No.434, OECD Note: Although the OECD study does not include estimates for other EU8+2 countries, they are likely to be close to the ones estimated for the Czech and Slovak Republics due to similarities in the size of government
• The Czech Republic eased fiscal policy in 2006 (although one-off measures lowered the deficit relative to 2005) and further drift is in the cards for this year with the general government deficit reaching 4% of GDP. This is partly a result of doubling of universal family benefits and increases in social-welfare benefit payments as well as strengthening of general government investment activities. In May 2007, the government approved a package of controversial fiscal measures, including introduction of a flat income tax and cuts in social programs, but it is uncertain if these will pass through Parliament.
• Poland plans to cut social security contributions rates by 3% in 2007 and another 4% in 2008. Based on the strong revenue performance in the early part of 2007, the budget deficit this year is still expected to come in at about 0.5% of GDP less than targeted.
• While strong revenues in Latvia led to a small fiscal surplus in 2006, the budget for 2007 envisaged a significant easing of fiscal policy with the balance swinging back into deficit. As part of the recently adopted anti-inflation plan (see Box 3), the authorities have committed to blocking any supplemental expenditure during 2007. If strong revenue over-performance continues to persist in 2007, Latvia could achieve a broadly balanced budget outcome this year making the fiscal stance neutral. Nevertheless, a stronger fiscal effort is called for help address the current macroeconomic imbalances.
• The fiscal balance in Romania deteriorated in 2006 due to numerous budget revisions during the year. The initial deficit target 0.5% of GDP was revised to 2.5% of GDP during the budget revisions in 2006, although the outturn was slightly better (despite exceptional payments made in December for damage to property seized under the communist regime). A further significant easing of fiscal policy is budgeted for this year with the deficit reaching 2.8% of GDP.
• Bulgaria’s fiscal balance improved after the introduction of spending restraint aimed at reducing risks of a widening current account deficit. The fiscal surplus reached more than 3% of GDP in 2006. Bulgaria continues to implement measures to cut primary spending that would allow it to reach a surplus of 2.3% of GDP in 2007 (compared to the sharp decline to 0.8% of GDP envisaged in the budget).
31 Table 12. General Government Balance 2005-09
% of GDP
Actual Source: National CP European Commission* 2005 2006 2007f 2008f 2009f 2007f 2008f Headline GG balance Bulgaria 1.9 3.3 0.8 1.5 1.5 2.0 2.0 Czech Republic -3.5 -2.9 -4.0 -3.5 -3.0 -3.9 -3.6 Estonia 2.3 3.8 1.2 1.3 1.6 3.7 3.5 Hungary -7.8 -9.2 -6.8 -4.3 -3.2 -6.8 -4.9 Latvia -0.2 0.4 -1.3 -0.9 -0.4 0.2 0.1 Lithuania -0.5 -0.3 -0.9 -0.5 0.0 -0.4 -1.0 Poland -4.3 -3.9 -3.4 -3.1 -2.9 -3.4 -3.3 Romania -1.4 -1.9 -2.7 -2.4 -1.9 -3.2 -3.2 Slovakia -2.8 -3.4 -2.9 -2.4 -1.9 -2.9 -2.8 Slovenia -1.5 -1.4 -1.5 -1.6 -1.0 -1.5 -1.5 Structural budget balance 2005 2006 2007f 2008f 2009f 2007f 2008f Bulgaria 1.3 2.8 0.4 1.0 1.1 1.6 1.8 Czech Republic -2.0 -2.8 -4.2 -3.6 -3.0 -4.1 -3.8 Estonia 2.4 3.3 0.6 1.2 1.6 3.5 3.8 Hungary -8.4 -9.4 -5.7 -3.8 -2.8 -6.1 -4.6 Latvia -0.2 0.0 -1.8 -1.1 -0.5 0.0 0.4 Lithuania -0.9 -0.6 -1.7 -1.0 -0.2 -0.6 -1.0 Poland -4.2 -4.0 -3.4 -3.1 -3.0 -3.6 -3.3 Romania -1.2 -2.2 -3.7 -3.4 -2.7 -3.5 -3.3 Slovakia -1.2 -3.3 -3.0 -2.5 -1.9 -3.4 -3.3 Slovenia -1.1 -1.5 -1.6 -1.8 -1.0 -1.7 -1.7 Consolidation effort 2005 2006 2007f 2008f 2009f 2007f 2008f Bulgaria .. 1.5 -2.6 0.6 0.1 -1.2 0.2 Czech Republic .. -0.8 -0.4 0.6 0.6 -1.3 0.3 Estonia .. 0.9 -1.1 0.6 0.4 0.2 0.3 Hungary .. -1.0 4.1 1.8 1.0 3.3 1.5 Latvia .. 0.2 -0.9 0.7 0.6 0.0 0.4 Lithuania .. 0.3 0.6 0.7 0.8 0.0 -0.4 Poland .. 0.2 0.5 0.4 0.3 0.4 0.3 Romania .. -1.0 -0.4 0.4 0.6 -1.3 0.2 Slovakia .. -2.1 0.8 0.6 0.6 -0.1 0.1 Slovenia .. -0.4 0.1 -0.2 0.8 -0.2 0.0
Note: The structural balance equals the headline balance minus the cyclical component minus one-off measures. However, it includes the deficit due to the introduction of the 2nd pension pillar. Unlike the fiscal impulse, it does not adjust for the effect of EU funds. The consolidation effort equals the difference between the structural balances net of the 2nd pension pillar cost Source: EC (2007), Spring Economic Forecasts; national Convergence Programs (December 2006, January- March 2007); and staff calculations (consolidation effort based on EC forecasts)
Medium-term fiscal plans
40. All EU8+2 countries are planning (further) fiscal consolidation in 2008-09, but these plans are generally not adequately underpinned by concrete policy measures. Poland and the Czech Republic both plan to reduce their fiscal deficits to just below 3% of GDP by 2009, while it would remain slightly above the critical threshold of 3% of GDP in Hungary. Slovakia plans to continue gradually reducing its deficit to below 2% of GDP in 2009, and Romania is aiming for a similar level following the ongoing expansion. Bulgaria and Estonia would remain in surplus over the medium term, while Lithuania would eliminate its small deficit by 2009. The fiscal significance of the reforms pursued or announced remains, however, uncertain, especially as challenges in important areas such as labor taxation and social spending do not seem to be fully addressed. The approach to fiscal reforms is in general ad-hoc rather than systematic.
32
The European Commission15 has expressed reservations with respect to achieving medium-term fiscal goals in several EU8+2 countries (italics):
• In Romania, the budget deficits are expected to be larger than planned in 2008 and 2009 mostly because of the risk of expenditure overruns and unsubstantiated tightening in 2009. Romania envisages a reduction of up to 6% in social security contributions in 2008.
• In Latvia, there are risks linked to high inflation and external imbalances that might result in growth slowing down to less than the planned 9% rate in 2007 and 7.5% in 2008 and 2009. Meanwhile, plans to cut the income tax rate from 25% to 15% by 2009 have been deferred.
• In Hungary, the planned correction of the excessive deficit by 2009 hinges on rigorous implementation of the consolidation measures announced in the 2007 budget and in the new CP as well as the further specification and timely adoption of the announced additional structural reform measures.
• In Poland, for 2008 and 2009, the planning of deficit-reducing measures is vague and their implementation and effects remain uncertain. The budgetary outcomes could be worse than targeted in the CP. The risks mainly stem from the favorable macroeconomic scenario for the period 2008-2009, significant uncertainties about the effective implementation of planned reforms as well as from the lack of information on the measures supporting the envisaged expenditure restraint (especially consumption and social transfers), which appear to be in an early conceptual phase.
The budget balance is expected to improve due to fiscal savings from the introduction of a new Public Finance Act in 2008 (announced in early April) that entails liquidation of the smaller extra-budgetary funds, units and agencies and gradual introduction of performance budgeting rules. Meanwhile, the Government in May approved draft legislation on annual pension valorization from 2008 introducing again a link wages (so that indexation would depend on both consumer price inflation and 20% of average wage growth. The new law is expected to pass easily and cost the budget around 0.6% of GDP from 2008 onwards. Further, Deputy PM Gosiewski (the new coordinator for Social Insurance Reform) has announced the principles for legislation on so-called bridge pensions, giving privileges mainly to teachers, which would cost around 0.1-0.2% of GDP from 2008 onwards. The proposed principles are worrisome because they cover whole professions (not only persons working in difficult conditions), will stimulate early retirement, and may encourage other professions to fight for privileges.
41. The Visegrad countries and Slovenia are generally aiming to reduce the size of their large public sectors (except Slovakia). Hungary, Poland, Slovakia and Slovenia all plan to cut public spending by more than three percentage points by 2009 (Chart 56, Chart 57). Meanwhile, the lower spending Baltic countries are raising spending levels, as are Bulgaria and Romania.
15 As expressed in its “Recommendation for a Council Opinion on the Convergence Programme” for the various countries (February-March 2007).
33 Chart 56. Planned lowering of revenues Chart 57. Hungary, Poland, Slovakia, and Slovakia, Slovenia, and Poland Slovenia lowering spending
60% 60% 2005 2006 2007p 2008p 2009p 2005 2006 2007p 2008p 2009p
50% 50%
40% 40%
30% 30%
20% 20%
10% 10%
0% 0% CZ EE HU LV LT PL SK SI BG RO CZ EE HU LV LT PL SK SI BG RO Source: Eurostat and medium-term plans from National convergence programs (Romania and Bulgaria pre-accession programs)
42. Most countries are shifting slowly from direct to indirect taxes. Several countries are in the process of reducing corporate and personal income taxes and social security contributions. Following its income tax reform in 2004, tax revenues continue to fall as a result of a policy change to lower the tax base. Further, the VAT rate on medicines and selected medical aids was reduced to 10%. Personal income tax reductions were introduced in Lithuania and Estonia in 2006. Early indications show that this had a positive effect on revenues due to a reduction in the share of undeclared employment in Lithuania. In 2007, Bulgaria introduced another cut of corporate income tax to 10% from 15% in 2006.
43. EU8+2 countries are moving slowly to improve the quality of spending. The high levels of social spending in Hungary, Poland, and Slovenia would be scaled back, but even Estonia and particularly Slovakia - countries with relatively low levels of social spending - are expected to consolidate this spending category further over the medium term (Chart 58). The Czech Republic, Hungary, Lithuania, Poland and Slovakia plan a gradual reduction in the size of collective consumption (Chart 60). In Hungary, the public wage bill would decrease from 12.6% of GDP in 2005 to 10.2% in 2009 if plans are followed through (Chart 59). Capital spending plans diverge significantly across the region (Chart 61). While capital spending would remain broadly stable at around 4% of GDP for the regions as a whole, it is set to rise sharply in Romania (although the ability to increase investment tends to be significantly overestimated). An increase is also expected in the Czech Republic and Lithuania, while it would decline to a questionably low level in Slovakia. The implementation of capital spending plans largely depends on success of implementation of EU financed infrastructure projects.
34 Chart 58. Social transfers being Chart 59. Public wage bill also shrinking
reduced in most NMS Compensation to employees (% of GDP) Total social transfers in % of GDP 14 35 2005 2006 2007p 2008p 2009p 2005 2006 2007p 2008p 2009p 12 30
10 25
8 20
6 15
10 4
5 2
0 0 CZ EE HU LV LT PL SK SI BG RO CZ EE HU LV LT PL SK SI BG RO Chart 60. Collective consumption Chart 61. Public capital spending rising mostly declining in most NMS (Slovakia and Romania in % of GDP opposite extremes) Gross fixed capital formation spending (% of GDP)
16 10 2005 2006 2007p 2008p 2009p 14 9 2005 2006 2007p 2008p 2009p 8 12 7 10 6 8 5
6 4
3 4 2 2 1 0 0 CZ EE HU LV LT PL SK SI BG RO CZ EE HU LV LT PL SK SI BG RO Source: Eurostat and convergence programs 2006 (Bulgaria and Romania pre-accession programs)
Structural Reforms
44. Reform fatigue has become increasingly evident in the region as the incentive offered by the process of EU accession has disappeared. With the first phase of reforms virtually completed, leading to the development of democratic institutions, the prevalence of the rule of law and the establishment of functioning market economies, progress on the second phase of reforms, centered on good governance, business-friendly regulations, competitive markets and infrastructure, is uneven. In infrastructure, only Lithuania was upgraded in 2006 by the EBRD, while in competition only Estonia and Romania scored higher than in 2005.
45. Enhancing the efficiency of the judiciary and improving the business environment and competitiveness have emerged as reform priorities in many NMS. In Bulgaria and Romania, the greatest challenges are in the area of anti-corruption and judicial reforms, while Estonia and Slovenia intend to focus on competitiveness and innovation.
46. In most EU8+2 countries, the privatization momentum slackened but governments took steps to address weaknesses in the business environment. Large privatization programs—near
35 completion in most of the countries—have slowed down considerably. Bulgaria is the only country that appears determined to complete the privatization of the energy sector, including district heating. In other countries, the sale of state assets is sporadic. Lithuania has sold a large oil company, while the Czech Republic plans to sell a minority stake in the main power firm. To enhance its business climate, Bulgaria has simplified taxpayer services and is establishing a new business registration agency. In the Czech Republic a new bankruptcy law, to be passed in 2008, is likely to speed up bankruptcy procedures, while Poland has announced new laws to facilitate business registration, to be implemented in 2008. A new labor code to be approved in Slovakia, intended to bring regulations in line with the EU, could hamper the flexibility of the labor market.
47. Reforms in anti-corruption and judiciary are advancing, but inefficiencies remain, both in the institutional and legal framework level and in courts, where procedures and regulations are often cumbersome. Measures to improve court management and shorten the time needed to enforce a contract are to be implemented in Poland. In Bulgaria, constitutional amendments have been approved in early 2007, with a view to strengthening the accountability and independence of the judiciary, while the prosecutor’s office has been reinforced to increase capacity to target high profile corruption investigations. In Romania, Parliament has approved the establishment of the National Integrity Agency, in charge of monitoring the wealth of politicians and civil servants. In both countries, as well as in the Czech Republic, Estonia and Lithuania, prominent politicians and business people are under investigation, although the number of prosecutions has been very limited so far. Progress in anti-corruption and judicial reform in Bulgaria and Romania will be central in the EC monitoring report to be issued in June 2007.
48. The proposed social welfare reforms are not terribly ambitious given the high share of social spending in GDP and well-documented inefficiencies. The Czech Republic plans to reconfigure family subsidies and reduce sickness benefits, but the proposed changes are not substantial. Hungary has taken measures to rationalize healthcare expenditure, including by reducing subsidies for pharmaceuticals and introducing co-payments for doctors visits, but the resistance to hospital closures is strong. In Lithuania, health reforms center on improving access to primary health and reforming compulsory health insurance. Romania has taken steps to introduce a second pension pillar, likely to become effective in 2008, while Hungary has decided to postpone the reform of the under-funded public pension system.
49. Greater efforts are needed to improve the efficiency of public spending. The objective of income convergence depends on enhanced competitiveness and productivity that in turn depend on efficient use of public resources devoted to building human and physical capital. Yet progress has been slow as demonstrated by the case of vocational education (Box 5).
Box 5. Fiscal Efficiency and Vocational Education in EU8 Countries16
Unit labor costs in regional VE systems are higher than in GE. Specific features of VE translate into higher unit costs than in general education (GE) (Chart 62), although spending on VE is relatively small and declining (Chart 63). VE unit costs are higher than GE because of: lower student-teacher ratio than in GE, larger number of non-teaching staff, larger premises of VE schools, including underutilized workshops and dormitories, stipends for students, and higher spending on equipment.
16 Based on the World Bank study “Fiscal Efficiency and Vocational Education in the EU8 Countries”, September 2006, http://siteresources.worldbank.org/INTECA/Resources/EU8_FiscalEfficiency_Sep06.pdf
36 Chart 62. VE unit cost exceeds this of GE Chart 63. Falling public Expenditures on VE Percentage by which VE unit costs exceed GE unit costs in % of GDP, 1998-2004 Poland, Czech Republic, Lithuania 2003, 2004
70% 61% 0.8 60% 0.7 50% 0.6 40% 0.5 27% 30% 0.4 20% 16% 0.3 Poland 0.2 10% Slovakia 0% 0.1 Lithuania Poland - upper 2nd Czech - upper 2nd Lithuania - upper 0.0 2nd 1998 1999 2000 2001 2002 2003 2004
Source: Country Questionnaires Source: Country Questionnaires
Higher unit costs of vocational education do not translate into better labor market outcomes. There is not much difference between VE and GE leavers in Poland and Slovakia in terms of unemployment and average earnings. In Poland, upper-secondary VE delivers slightly lower unemployment rates (Chart 64) than does GE for both males and females, but makes very little difference to average earnings (Chart 65). Chart 64. Unemployment rate by level of education and Chart 65. Average earnings by level of education and sex, population aged 15+, 2004, Poland sex, population ages 15+, 2004, Poland
30% 5000 Male Female 4500 Male Female 25% 4000
3500 20% 3000
2500 15% 2000 PLN per month 10% 1500 1000
5% 500
0 0% Tertiary Tertiary Pos t Upper Upper Low er Low er Tertiary Post Upper 2ndary Upper 2ndary Low er 2ndary Low er 2ndary (Masters +) (Licentiate secondary 2ndary gen 2ndary voc 2ndary voc 2ndary gen secondary gen voc voc gen etc.)
Source: LFS
In Slovakia the picture of earnings is very similar. The average pay of secondary GE graduates is slightly lower than VE/technical graduates and there is basically no difference in unemployment rates between all upper-secondary graduates (Chart 66, Chart 67). Chart 66. Unemployment rate by level of education and Chart 67. Average earnings by level of education and sex, population aged 25-34, 2004, Slovakia sex, population ages 15+, 2004, Slovakia
30 400 Males Females 350 Males Females 25 300 20 250
15 200 SKK '000 150 10 100
5 50
0 0 Tertiary Upper 2ndary Upper 2ndary Apprenticeship Secondary Apprenticeship Basic Tertiary Upper 2ndary Upper 2ndary Apprenticeship Secondary w ithout Apprenticeship general voc/tech w ith exam w ithout exam w ithout exam general voc/tech w ith exam exam w ithout exam
Source: Country Questionnaires In Lithuania, where VE unit costs are the highest, VE leavers in the 25-34 age group do worse than GE leavers in terms of both unemployment rates and average earnings. Although females with upper-secondary VE have lower unemployment
37 rates, both sexes have considerably lower average pay than GE graduates (Chart 68, Chart 69). Chart 68. Unemployment rate by level of education and Chart 69. Average earnings by level of education and sex, population aged 25-34, 2004, Lithuania sex, population ages 15+, 2004,Lithuania
25% 16000 Male Female Male Female 14000 20% 12000
15% 10000
8000
10% 6000
4000 5% 2000
0% 0 University or Professional Specialized Post-2ndary Upper 2ndary Upper 2ndary Low er 2ndary University or Professional Specialized Post-2ndary Upper 2ndary Upper 2ndary Low er 2ndary college college 2ndary voc gen voc gen college college 2ndary voc gen voc gen
Source: LFS
Demand for VE is falling as parents and students across EU8 countries show increasing preference for GE. Since 1990, the share of vocational education in total secondary enrolment has fallen significantly in all EU8 countries, except the Czech Republic. The most significant decline was in Poland, Lithuania and Latvia (Chart 70). At the same time, enrolment rates in tertiary education have soared. The pace of expansion has been particularly fast in Hungary, Poland, Slovenia and Latvia (Chart 71). This increasing preference for GE is a response to labor market outcomes - higher education graduates can expect much lower unemployment rates and much higher earnings than leavers from either type of secondary education.
Chart 70. Falling demand for VE Chart 71. While GE enrolment soars Students in VE as % of all secondary students, EU8 countries, Gross enrolment rates, higher education, 1990-2004 1990-2004 90% 90.0
80% 80.0 Czech Republic 70.0 Czech Republic 70% Hungary Hungary 60.0 60% Poland Poland Slovakia 50.0 Slovakia 50% Slovenia Slovenia 40.0 Estonia 40% Es tonia % of 19-24 age group 30.0 Latvia Latvia 30% 20.0 Lithuania Lithuania 20% 10.0 1990 1992 1994 1996 1998 2000 2002 2004 1990 1992 1994 1996 1998 2000 2002 2004
Source: Eurostat Source: TransMONEE database It is time to move away from the dual secondary education system and its dichotomous distinction between academic and vocational education since this leads to educational inefficiencies, social clustering and increasing social disparities. VE should become increasingly post-secondary and its primary purpose should be to deliver to employers flexible and trainable recruits with broad rather than narrow skills which will not become obsolete with changes in technology and industrial structure. To improve outcomes and reduce VE costs, practical training should be entirely in-plant and beneficiaries should pay a higher proportion of the cost.
50. All countries recognize that poor functioning of the public administration remains a central impediment to an efficient allocation of resources but few have undertaken systematic reforms to address the challenges. Important administrative capacity limitations are manifested at all stages of planning, policy, budgeting, and HR management, although performance varies from country to country (Box 6). Following far-reaching reforms in recent years, Latvia and Lithuania have made strong progress on improving the quality of their public administrations and are now close to the EU benchmarks in many areas, notably on planning and policy coordination. In Estonia, the introduction of e-governance tools appears to have
38 contributed decisively to improved services delivery. Bulgaria is also gaining speed in implementing e-government. Slovakia implemented successful reforms in its MOF, but this did not spread to the rest of the government. Hungary has recently embarked on restructuring of the central public administration as part of its fiscal austerity plan. Romania is in the process of reviewing the pay framework for civil servants and contractual workers.
51. The absence of well-established medium term expenditure frameworks (MTEFs) also affects the capacity to allocate resources in a predictable and effective manner. While several countries in the region have or are planning to introduce elements of MTEFs, these have yet to emerge as effective and credible frameworks for medium-term fiscal planning in most countries.
Box 6. Administrative Capacity in the New Member States17 The quality of public management varies significantly across the region, but all countries have similar symptoms of ill- developed management systems and insufficient skills and experience among public administration staff.
Most of the countries appear to have developed effective systems to deal with core EU-related issues, such as the transposition of EU legislation, but their record in key areas such as fiscal management, planning and policy remains uneven. The Baltic states have improved important aspects of their public sector management systems, Hungary and the Czech Republic seem to have made little progress, while Poland, Slovakia and Slovenia are placed somewhere in between.
While vertical policy management is of a reasonable standard, horizontal management is not, with the exception of Lithuania and Latvia. Performance management exhibits similar patterns. Weaknesses in strategic planning and policy coordination appear to be a special concern, especially in the utilization of the EU structural and cohesion funds.
Failure to establish merit-based civil services and increasing politicization are main weaknesses. Incentive and management systems do not ensure the attraction and recruitment of high-skilled staff. In some areas, the situation has worsened relative to the pre-accession period, especially as regards horizontal management systems.
Compared with the EU15, the NMS receive low marks in practically all fields, with the exception of the Baltic countries which do relatively well in some areas, often being on par with the EU 15. The results of the benchmarking exercise and systems used are summarized below (Table 13).
Table 13. Quality of policy and skills of public sector staff Area of POLICY PEOPLE study Aspect of Performance Strategic EI Policy HR HR horizontal Politico-admin Incentives study management planning Coordination legislation management relations Scoring CAF CAF Sigma Sigma Sigma Sigma Metcalfe system 0-5 0-5 1-7 1-7 1-7 1-7 Poland 0.5 0.5 4 6/7 6/7 7 5 Hungary 1 1.5 5 5 5 5 Czech 1 1.5 3 6/7 6/7 Slovakia 1 1.5 3 6/7 6/7 7 Slovenia 1 1.5 5 5 Lithuania 3 4 8 5 5 2 3 Latvia 3 3.5 7 5 5 3 2 Estonia 1 1.5 5 5
The benchmarking systems used:
The CAF rating scale 0–no evidence or only anecdotal evidence of an approach; 1–an approach is planned; 2–an approach is planned and implemented; 3–an approach is planned and implemented and reviewed; 4–an approach is planned and implemented and
17 Based on “Administrative Capacity in the New Member States: The Limits of Innovation?”, December 2006, World Bank, http://siteresources.worldbank.org/INTECA/Resources/EU8_AdminCapacity_Dec06.pdf
39 reviewed on the basis of benchmarking data and adjusted accordingly; 5–an approach is planned and implemented and reviewed on the basis of benchmarking data and adjusted accordingly and fully integrated into the organization.
The Metcalfe scale 9 Overall strategy 8 Establishing priorities 7 Setting parameters for action 6 Arbitration of policy differences 5 Search for agreement on policies 4 Avoiding divergences among organizations 3 Consultation with other organizations (feedback) 2 Communication to other organizations (information exchange) 1 Independent organizational decision-making
The SIGMA ratings 1–standard achieved; 2–standard substantially achieved; 3–standard only partially achieved; 4–standard not yet achieved but progress being made; 5–standard not yet achieved; 6–standard not likely to be achieved in the medium term; 7– standard unlikely to be achieved under present arrangements.
Vulnerability Indicators in the EU8+2 in 2006
CZ EE HU LT LV PL SI SK BG RO
GDP growth, SNA (real, %, yoy) 6.1 11.4 3.9 7.5 11.9 6.1 5.2 8.3 6.1 7.7 Current account balance, (4Q cumulative, % of GDP) -4.2 -14.8 -5.8 -10.8 -21.1 -2.3 -2.6 -8.3 -15.8 -10.7 FDI (4Q cumulative, % of GDP) 3.3 3.5 2.8 5.1 7.4 2.9 -1.0 6.9 15.9 9.4 Total gross external debt (eop, % of GDP) 38.0 95.8 87.9 60.7 112.8 45.9 80.3 51.7 78.4 32.4 Change of international reserves in euro (eop, relative to previous -4.7 28.7 4.3 36.7 113.3 2.4 -21.4 -0.3 21.1 56.1 period, %) Reserves-to-short-term debt ratio (eop, %) 192.3 48.9 160.4 101.1 152.4 144.6 106.3 208.5 148.1 342.7 Money Supply-to-Reserves ratio (eop, %) 306.9 319.4 309.1 239.4 133.0 338.0 290.0 158.1 183.6 83.0 Credit to private sector (eop, % of GDP) 40.6 83.4 54.8 50.2 85.8 32.8 68.8 38.8 47.4 27.0 Growth rate of credit to the private sector (avg, %) 20.1 41.9 17.3 40.7 59.2 24.6 26.5 23.0 24.6 52.3 Foreign currency loans to the private sector (eop, % of loans to 10.4 78.2 49.6 52.2 76.7 26.4 66.9 44.8 46.2 priv. sect.) Short-term (3M) interest rates spreads to euro area (avg, basis -78.0 2.0 415.0 3.0 130.0 113.0 50.0 125.0 61.0 497.0 points) Change of stock exchange index (avg, relative to previous period, 18.0 11.1 18.6 2.1 43.9 45.9 11.6 -7.6 8.3 31.5 %)
Sovereign credit rating according to S&P's A-/P/A-2 A/S/A-1 BBB+/N/A-2 A/S/A-1 A-/S/A-2 BBB+/S/A-2 AA/S/A-1+ A/S/A-1 BBB+/S/A-2 BBB-/P/A-3
The symbols in line with S&P ratings denote the outlook, S= Stable, N=Negative, P=Positive Source: CBs, ISI, IMF IFS, staff calculations
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