World Bank EU8+2 Regular Economic Report EU8+2 1 May 2007
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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.