• Share
  • Email
  • Embed
  • Like
  • Save
  • Private Content
IMF - Regional Economic Outlook - Europe (May2011)

IMF - Regional Economic Outlook - Europe (May2011)



IMF - Regional Economic Outlook - Europe (May2011)

IMF - Regional Economic Outlook - Europe (May2011)



Total Views
Views on SlideShare
Embed Views



0 Embeds 0

No embeds



Upload Details

Uploaded via as Adobe PDF

Usage Rights

© All Rights Reserved

Report content

Flagged as inappropriate Flag as inappropriate
Flag as inappropriate

Select your reason for flagging this presentation as inappropriate.

  • Full Name Full Name Comment goes here.
    Are you sure you want to
    Your message goes here
Post Comment
Edit your comment

    IMF - Regional Economic Outlook - Europe (May2011) IMF - Regional Economic Outlook - Europe (May2011) Document Transcript

    • World Economic and Financial Sur veysRegional Economic Outlook Europe Strengthening the Recovery M AY 11I N T E R N A T I O N A L M O N E T A R Y F U N D
    • World Economic and Financial Surveys Regional Economic Outlook Europe Strengthening the Recovery 11 MAYI N T E R N A T I O N A L M O N E T A R Y F U N D
    • ©2011 International Monetary Fund Cataloging-in-Publication DataRegional economic outlook. Europe. – Washington, D.C. : International Monetary Fund, 2007- v. ; cm. – (World economic and nancial surveys, 0258-7440) Twice a year. Began with Nov. 07 issue. Some issues have also thematic titles. 1. Economic forecasting – Europe – Periodicals. 2. Europe – Economicconditions – 1945 – Periodicals. I. Title: Europe. II. International Monetary Fund.III. Series: World economic and nancial surveys.HC241.A1 R445ISBN-13 978-1-61635-063-5 Please send orders to: International Monetary Fund Publication Services PO Box 92780 Washington, DC 20090, U.S.A. Tel.: (202) 623-7430 Fax: (202) 623-7201 E-mail: publications@imf.org Internet: www.imfbookstore.org
    • ContentsIntroduction and Overview xi1. Advanced Europe: Tackling the Sovereign Crisis 1 Recovery Continues 1 Turning the Page on the Crisis: Policy Requirements 142. Emerging Europe: Underwriting a Solid Recovery 25 Developments in 2010 25 The Outlook for 2011 and 2012 31 Risks to the Outlook 36 Key Policy Questions Going Forward 413. Financial Integration, Growth, and Imbalances 53 Imbalances and Crisis 54 Why Was the Crisis So Severe? 64 Why Is Resolution of the Crisis So Protracted? 69 Restoring Growth and Preventing Future Excessive Imbalances 83 Conclusions 88Annex: Data and Econometric Approaches 91 Estimating Equilibrium and Excessive Imbalances 91 Estimating Effects of Policies on Excessive Imbalances 91Appendix. Europe: IMF-Supported Arrangements 93References 97Boxes 1.1. Domestic Demand and Recovery in the Large Euro Area Countries 4 1.2. Deleveraging in the Euro Area 10 1.3. Unemployment and Inequality in the Wake of the Crisis 16 2.1. Russia: A Tepid Recovery from a Deep Recession 27 2.2. Turkey’s New Monetary Policy Strategy 32 2.3. Discretionary Fiscal Policies Since the 2008–09 Crisis 43 iii
    • CONTENTS 3.1. Why Did the Currency Board Countries in Emerging Europe Have Such Large Imbalances? 74 3.2. Recent Developments in Bank Competition in Europe 76 3.3. Crisis Resolution and Financial Integration in the United States 78 3.4. How Far Have Current Account Imbalances Adjusted? 81 3.5. How Can the Reemergence of Excessive Imbalances Be Prevented? 86Tables 1. European Countries: Real GDP Growth and CPI In ation, 2009–12 xii 1.1. Selected European Countries: Share of Exports by Destination, 2009 3 1.2. Greece, Ireland, Portugal, and Spain: Authorities’ Measures to Restore Con dence and Regain Competitiveness 15 1.3. Advanced European Countries: Main Macroeconomic Indicators, 2009–12 21 1.4. Selected European Countries: Headline In ation and Contribution of Food and Fuel Prices 23 2.1. Emerging Europe: Growth of Real GDP, Domestic Demand, Exports, and Private Consumption, 2009–12 34 2.2. Emerging Europe: CPI In ation, Current Account Balance, and External Debt, 2009–12 37 2.3. Emerging Europe: Evolution of Public Debt and General Government Balance, 2009–12 40 2.4. Emerging Europe: Selected Financial Soundness Indicators, 2007–10 45 2.5. Emerging Europe: Employment Growth, 2008:Q3–2010:Q3 49 3.1. Selected EU Countries: Sectoral Saving-Investment Balances, 2000–07 60 3.2. Selected EU Countries: Current Account Balances and Real Domestic Demand, 2003–10 65 3.3. Selected EU Countries: Growth in Value Added and Contribution by Sector, 2000–07 67 3.4. Euro Area: Output-Capital Ratios, 2000–07 72Figures 1.1. Euro Area: Contributions to GDP Growth, 2006:Q1–2010:Q4 1 1.2. Euro Area: Current Crisis Compared with Past Episodes, 1960:Q2–2010:Q4 2 1.3. EA4 and Rest of Euro Area (RoEA): Contributions to GDP Growth, 2008:Q2–2010:Q4 3 1.4. Selected European Countries and the United States: Unemployment Rate, January 2006–December 2010 3 1.5. Selected Euro Area Countries: Change in Sovereign and Bank Credit Default Swap (CDS) Spreads, January 2010–March 2011 7iv
    • CONTENTS1.6. Euro Area: Banking Sector Risk Index, 2007–11 71.7. Selected European Countries: Key Short-Term Indicators 81.8. Euro Area: Credit Developments 91.9. Selected Advanced Countries: Claims on Domestic Banks and Public Sector 131.10. Selected European Countries: Headline and Core In ation, January 2006–March 2011 131.11. Selected Advanced European Countries: Changes in General Government Fiscal De cits, 2010–13 201.12. Selected European Countries: Impact of Fiscal Policies on GDP Growth, 2011–12 221.13. Selected European Countries: Residential Real Estate Prices 222.1. Emerging Europe: Contributions to GDP Growth, 2010 262.2. Emerging Europe: Real Exports and Trading Partner Imports, 2009–10 262.3. Emerging Europe: Real Private Sector Credit Growth 262.4. Emerging Europe: Unemployment Rate 262.5. Emerging Europe: In ation, 2008–10 292.6. Emerging Europe: Net Capital In ows 302.7. Emerging Europe: Contributions to GDP Growth, 2011–12 352.8. Emerging Europe: Private Consumption and Investment Ratios, and Employment, 2000–12 352.9. Emerging Europe and Selected Regions: Real Per Capita GDP Growth 352.10. Selected Emerging Market Economies: Costs of Funding and Vulnerabilities 382.11. CESE and EA4 Countries: Funding Costs, 2007–11 392.12. Foreign Bank Presence and Association Between Funding Costs in CESE Countries and the EA4 392.13. Emerging Europe: Fiscal Vulnerability Indicators in Perspective 422.14. Selected Regions: Deterioration of Public Finances 432.15. Emerging Europe and Selected Regions: Bank Regulatory Capital to Risk-Weighted Assets, 2009–10 462.16. Emerging Europe: Private Sector Loans-to-Deposits Ratios 462.17. Emerging Europe: Loans-to-Deposits Ratio and Credit Growth 462.18. Emerging Europe: Property Prices, 2008:Q3–2010:Q4 482.19. Emerging Europe: Stock of Foreign Currency Loans, December 2010 482.20. Emerging Europe: Employment Growth and Projected Export Growth 502.21. Emerging Europe: Changes in Credit to Corporations by Industry, 2008–10 50 v
    • CONTENTS 2.22. Emerging Europe: Foreign Direct Investment Flows by Sector, 2007, 2010 50 2.23. Emerging Europe: Ease of Doing Business Rank, 2010–11 51 2.24. Emerging Europe: Logistics Performance Index, 2007–10 51 3.1. Selected EU Countries: Convergence of Long-Term Government Bond Rates, 1990–2010 55 3.2. Selected EU Countries: Indicators of Financial Integration, 1998–2008 56 3.3. Selected EU Countries: International Investment Position, Liabilities 57 3.4. Selected EU Countries: Components of Debt Securities Liabilities 57 3.5. Selected EU Countries: Cross-Border Mergers and Acquisitions for Selected Target Countries, 2001–07 58 3.6. Euro Area: Current Account Balances in 2007 and Starting Positions in the 1990s 58 3.7. Euro Area: Saving-Investment Balances, 2000–09 59 3.8. Selected EU Countries: Current Account Balances, 1999–2009 61 3.9. External Balances 62 3.10. Euro Area 11: Current Account Imbalance Indicator, 1990–2009 63 3.11. Euro Area 11: Changes in General Government Expenditure, 1995–2007 63 3.12. Selected EU Countries: Real Domestic Demand, Government Revenue, and Expenditure Growth, 2000–07 63 3.13. Europe: Bank Exposure, 2003–10 64 3.14. EA4: Saving-Investment Balance, 1999–2009 65 3.15. Selected EU Countries: Change in Fiscal Balance, 2007–10 66 3.16. Selected Countries: Five-Year CDS Spreads, January 2007–April 2011 66 3.17. Selected EU Countries: Change in Sovereign and Bank Credit Default Swap Spreads, January 2010–March 2011 66 3.18. Selected EU Countries: Exports of Goods, 1995–2009 68 3.19. Euro Area: REER (ULC Manufacturing Based), 1995–2009 68 3.20. Selected EU Countries: Appreciation of REER (ULC Manufacturing Based), 2000–07 68 3.21. Selected EU Countries: Appreciation of REER (ULC Manufacturing Based) Versus Change in Corporate Saving to GDP, 2000–07 69 3.22. Selected EU Countries: Nominal House Prices, 2000:Q1–2010:Q3 70 3.23. Selected EU Countries: Pro tability by Sector, 2000–07 70 3.24. Selected EU Countries: International Investment Position, 2000–09 71 3.25. Selected EU Countries: International Investment Position, 2000–07 72 3.26. Selected EU Countries: In ation, June 2008 73vi
    • CONTENTS3.27. Selected EU Countries: Fiscal Balance, 2007 733.28. Selected EU Countries: Foreign Bank Presence 733.29. Selected EU Countries: Capital In ows and GDP per Capita Growth, 2003–10 843.30. Selected EU Countries: Growth of Real Exports of Goods and Services, Average 2010–11 843.31. REER (ULC Manufacturing Based) 853.32. Selected EU Countries: Labor Productivity 85 vii
    • This Regional Economic Outlook: Europe—Strengthening the Recovery was written by Céline Allard, LoneChristiansen, Phakawa Jeasakul, Yuko Kinoshita, Jeta Menkulasi, Esther Perez, Irina Tytell, JérômeVandenbussche, Nico Valckx, and Johannes Wiegand under the guidance of Bas Bakker andChristoph Klingen, with contributions from Thomas Harjes, David Hofman, Hanan Morsy, ThierryTressel, and Justin Tyson. The Regional Economic Outlook: Europe was coordinated by the Emerging EuropeRegional Division of the IMF’s European Department and overseen by Antonio Borges (Director) ofthe European Department. Cleary Haines, Xiaobo Shao, and Jessie Yang provided research assistance,and Amara Myaing provided administrative assistance. Joanne Blake and Michael Harrup of theExternal Relations Department oversaw the production. The report is based on data as of April 13,2011. The views expressed in this report are those of the IMF Staff and should not be attributed toExecutive Directors or their national authorities. ix
    • Introduction and OverviewThe global recovery is gaining strength, though weak in Greece, Ireland, Portugal, and Spain, wheresigni cant downside risks could still come into play. efforts to work off large precrisis imbalancesThe April 2011 World Economic Outlook projects persist. The Greek and Portuguese economies areworld real GDP growth of 4½ percent in 2011 and projected to be in recession this year.2012, following last year’s slightly stronger 5 percent Growth in emerging Europe is expected to bepace. Emerging and developing economies stronger, at 4.3 percent in 2011 and 2012, afterare expected to expand markedly faster—at 4.2 percent in 2010.1 The recovery is set to broaden6½ percent—than the more sluggish rate of as domestic demand takes over as the main pillar of2½ percent projected for advanced economies. This growth and all countries post positive growth forgrowth setting, and the accommodative monetary the rst time since the 2008–09 crisis. Nonetheless,policies of the major central banks, revived capital large differences in cyclical positions, capital ows to emerging economies. It also conspired—in in ows, current account balances, and in ationaryconcert with adverse supply shocks and concerns pressures remain.about political unrest in the Middle East andNorth Africa—to drive up commodity prices The recoveries in advanced and emerging Europeclose to levels reached before the 2008–09 crisis. are likely to be mutually reinforcing as the continentKey downside risks include (i) oil prices exceeding bene ts from the symbiotic relationship betweenthose currently predicted by futures markets; its two parts, with advanced Europe continuing(ii) signi cant scal and nancial vulnerabilities to absorb the lion’s share of emerging Europe’slurking behind recent benign market developments, exports. In parallel, faster-growing emergingespecially in the euro area; and (iii) overheating in Europe’s importance as a market for advancedemerging market economies. Europe’s rms will expand. But the biggest growth potential derives from building cross-borderAgainst this backdrop, Europe’s recovery is production chains based on national comparativeexpected to solidify. This edition of the Regional advantage in a diverse, yet compact, geographicalEconomic Outlook puts growth for all of Europe at area with vastly improved institutions. German2.4 and 2.6 percent for 2011 and 2012, respectively, rms are in the lead in this effort. Imports fromafter 2.4 percent last year (Table 1). In the baseline, emerging Europe rose to account for 12 percent ofin ation is likely to pick up to 3.8 percent this year Germany’s imports, compared with their 8 percenton the back of the economic upturn and buoyant share in the rest of advanced Europe. Both sharescommodity prices before easing back to 3 percent are still small, leaving ample room for furtherin 2012. This path assumes that the large increase intraregional integration.in food and energy prices remains temporary anddoes not trigger generalized in ation through The main risk to the outlook for Europe arisessecond-round effects, obviating the need for sharp from tensions in the euro area periphery. Othermonetary tightening, which could hurt the recovery. global worries also pose risks, although concerns about overheating in the emerging economies ofReal activity in advanced Europe is projected to the continent are more muted than in other regions.expand by 1.7 and 1.9 percent this year and next,compared with 1.7 percent in 2010. The landscape 1 For purposes of the Regional Economic Outlook,should continue to be varied within advancedEurope, though private demand is expected to emerging Europe comprises (i) central and southeastern Europe with the exception of the Czech Republic andcontinue to strengthen in the core euro area and countries that have adopted the euro, (ii) the Europeanthe Nordic countries, largely offsetting the impact Commonwealth of Independent States (CIS) countries,of scal consolidation on growth, while remaining and (iii) Turkey. xi
    • REGIONAL ECONOMIC OUTLOOK: EUROPE Table 1 European Countries: Real GDP Growth and CPI Inflation, 2009–12 (Percent) Real GDP Growth Average CPI Inflation 2009 2010 2011 2012 2009 2010 2011 2012 Europe¹ -4.5 2.4 2.4 2.6 2.7 3.0 3.8 3.0 Advanced European economies¹ -4.0 1.7 1.7 1.9 0.7 1.9 2.5 1.8 Emerging European economies¹ -5.9 4.2 4.3 4.3 8.5 6.3 7.3 6.2 European Union¹ -4.1 1.8 1.8 2.1 0.9 2.0 2.7 1.9 Euro area -4.1 1.7 1.6 1.8 0.3 1.6 2.3 1.7 Austria -3.9 2.0 2.4 2.3 0.4 1.7 2.5 2.0 Belgium -2.7 2.0 1.7 1.9 0.0 2.3 2.9 2.3 Cyprus -1.7 1.0 1.7 2.2 0.2 2.6 3.9 2.8 Estonia -13.9 3.1 3.3 3.7 -0.1 2.9 4.7 2.1 Finland -8.2 3.1 3.1 2.5 1.6 1.7 3.0 2.1 France -2.5 1.5 1.6 1.8 0.1 1.7 2.1 1.7 Germany -4.7 3.5 2.5 2.1 0.2 1.2 2.2 1.5 Greece -2.0 -4.5 -3.0 1.1 1.4 4.7 2.5 0.5 Ireland -7.6 -1.0 0.5 1.9 -1.7 -1.6 0.5 0.5 Italy -5.2 1.3 1.1 1.3 0.8 1.6 2.0 2.1 Luxembourg -3.7 3.4 3.0 3.1 0.4 2.3 3.5 1.7 Malta -3.4 3.6 2.5 2.2 1.8 2.0 3.0 2.6 Netherlands -3.9 1.7 1.5 1.5 1.0 0.9 2.3 2.2 Portugal -2.5 1.4 -1.5 -0.5 -0.9 1.4 2.4 1.4 Slovak Republic -4.8 4.0 3.8 4.2 0.9 0.7 3.4 2.7 Slovenia -8.1 1.2 2.0 2.4 0.9 1.8 2.2 3.1 Spain -3.7 -0.1 0.8 1.6 -0.2 2.0 2.6 1.5 Other EU advanced economies Czech Republic -4.1 2.3 1.7 2.9 1.0 1.5 2.0 2.0 Denmark -5.2 2.1 2.0 2.0 1.3 2.3 2.0 2.0 Sweden -5.3 5.5 3.8 3.5 2.0 1.9 2.0 2.0 United Kingdom -4.9 1.3 1.7 2.3 2.1 3.3 4.2 2.0 EU emerging economies Bulgaria -5.5 0.2 3.0 3.5 2.5 3.0 4.8 3.7 Hungary -6.7 1.2 2.8 2.8 4.2 4.9 4.1 3.5 Latvia -18.0 -0.3 3.3 4.0 3.3 -1.2 3.0 1.7 Lithuania -14.7 1.3 4.6 3.8 4.4 1.2 3.1 2.9 Poland 1.7 3.8 3.8 3.6 3.5 2.6 4.1 2.9 Romania -7.1 -1.3 1.5 4.4 5.6 6.1 6.1 3.4 Non-EU advanced economies Iceland -6.9 -3.5 2.3 2.9 12.0 5.4 2.6 2.6 Israel 0.8 4.6 3.8 3.8 3.3 2.7 3.0 2.5 Norway -1.4 0.4 2.9 2.5 2.2 2.4 1.8 2.2 Switzerland -1.9 2.6 2.4 1.8 -0.5 0.7 0.9 1.0 Other emerging economies Albania 3.3 3.5 3.4 3.6 2.2 3.6 4.5 3.5 Belarus 0.2 7.6 6.8 4.8 13.0 7.7 12.9 9.7 Bosnia and Herzegovina -3.1 0.8 2.2 4.0 -0.4 2.1 5.0 2.5 Croatia -5.8 -1.4 1.3 1.8 2.4 1.0 3.5 2.4 Macedonia -0.9 0.7 3.0 3.7 -0.8 1.5 5.2 2.0 Moldova -6.0 6.9 4.5 4.8 0.0 7.4 7.5 6.3 Montenegro -5.7 1.1 2.0 3.5 3.4 0.5 3.1 2.0 Russia -7.8 4.0 4.8 4.5 11.7 6.9 9.3 8.0 Serbia -3.1 1.8 3.0 5.0 8.1 6.2 9.9 4.1 Turkey -4.7 8.2 4.6 4.5 6.3 8.6 5.7 6.0 Ukraine -14.8 4.2 4.5 4.9 15.9 9.4 9.2 8.3 Memorandum World -0.5 5.0 4.4 4.5 2.5 3.7 4.5 3.4 Advanced economies -3.4 3.0 2.4 2.6 0.1 1.6 2.2 1.7 Emerging and developing economies 2.7 7.3 6.5 6.5 5.2 6.2 6.9 5.3 United States -2.6 2.8 2.8 2.9 -0.3 1.6 2.2 1.6 Japan -6.3 3.9 1.4 2.1 -1.4 -0.7 0.2 0.2 China 9.2 10.3 9.6 9.5 -0.7 3.3 5.0 2.5 Source: IMF, World Economic Outlook. ¹ Average weighted by GDP valued at purchasing power parity.xii
    • INTRODUCTION AND OVERVIEWStrong policy responses have successfully contained too, buttressed by further progress in strengtheningthe sovereign debt and nancial sector troubles pan-European institutions and governance. Inin the euro area periphery so far, but contagion to emerging Europe, the main concern is mountingthe core euro area, and then onward to emerging nonperforming loans, while capitalization appearsEurope, remains a tangible downside risk. Negative comfortable for now. A second wave of bankfeedback loops between concerns about the stability consolidation and the prospective introductionof government and bank balance sheets are proving of Basel III offer opportunities to strengthen thedif cult to break. And concerns about weak scal sector.and nancial sector balance sheets extend beyond Fiscal consolidation and bank balance sheet repairthe euro area periphery. In emerging Europe, are critical to defusing downside risks. Public debtpublic nances have also sharply deteriorated sustainability is vital to an enduring solution for theand banks are burdened by large numbers of nancial tensions in the euro area and to breakingnonperforming loans. Emerging Europe suffered negative feedback loops between sovereign anddisproportionately in the 2008–09 crisis, so output banking sector instability. Countries under marketgaps generally remain negative—only Belarus and pressure have appropriately front-loaded theirTurkey are growing very fast. In ationary pressures scal adjustments, which they now must seefrom high commodity prices pose challenges for through. Other countries can afford to phase inpolicymakers, especially where output gaps are scal consolidation more gradually, but a coherentclosing, food and energy prices account for a large and credible consolidation strategy embedded inshare in the consumer price index (CPI), and central a medium-term framework is still necessary forbanks’ credibility is less rmly established. rebuilding scal buffers and quelling ever-risingDealing decisively with the nancial tensions in public debt ratios. In emerging Europe, reducingthe euro area requires comprehensive and bold scal vulnerabilities is equally important. Key scalpolicy action. The stakes are high. Unrelenting indicators have deteriorated more than in otherreform efforts at the national level of the crisis- emerging economies and now often exceed prudentaf icted countries need to be the rst line of thresholds. Moreover, where in ation is becomingdefense. Restoring scal health, squarely addressing a concern, consolidation is also called for from aweak banks, and implementing structural reforms demand-management perspective.to restore competitiveness are key. Furtherstrengthening the European Union-wide crisis Monetary policy in the euro area can affordmanagement framework is critical to securing a to remain relatively accommodative, thoughsuccessful overall outcome. The European Union normalization lies ahead as economic slack(EU) decisions of this March are certainly welcome, gradually dissipates. Reemerging in ation risksbut challenges now lie in their implementation. pose an additional challenge. In emerging Europe, in ation is running above target in many countriesRestoring con dence in the euro area’s banking and second-round effects are harder to stave off.system is a prerequisite to turning the page on the Tightening cycles are already under way and scalcrisis. The upcoming round of strong, broad, and policy should support them.transparent stress tests provides an opportunityto address remaining vulnerabilities. But to be The euro area-wide safety net is being strengthenedeffective, the stress tests need to be followed by to address nancial tensions and to avoidcredible restructuring and recapitalization programs. future crises. Commitments have been made toEfforts to strengthen the banking systems in improving lending capacity and pricing undervulnerable countries will need to accelerate, and the European Financial Stability Facility (EFSF).policies to promote deeper integration of the EU Making those commitments operational by lling nancial system—including cross-border merger in the still-missing speci cs is now essential. Theand acquisitions—should be part of the solution permanent successor arrangement, the European xiii
    • REGIONAL ECONOMIC OUTLOOK: EUROPEStability Mechanism (ESM), is taking shape, and Stepping back from nancial integration would beis appropriately larger and more exible than the wrong. Instead, integration should be completedoriginal EFSF. A revamped Stability and Growth and adequate supportive policies should be put inPact (SGP) and the new Excessive Imbalances place. Obstacles to cross-border equity investmentsProcedure (EIP) strengthen crisis prevention. and mergers and acquisitions should be removed so that debt ows are no longer favored. CompetitionLooking at the crises in the euro area periphery, in the nontradable sector should be sharpened andand in emerging Europe, more broadly in the policies should swiftly address any future asset priceaftermath of the Lehman Brothers collapse reveals bubbles to avoid luring investment into relativelycommon patterns and suggests a number of policy unproductive uses. Banking supervision, regulation,lessons. Financial integration in the wake of euro and resolution need to be elevated to the level atadoption contributed to strong cross-border capital which banks operate in a nancially integrated ows into government debt, interbank markets, region.and the nontradable sector. Government bondyields quickly converged across the euro area, Overcoming the crises in Europe ultimatelybanks’ cross-border exposures built up, and the requires restoring productivity growth in thenontradable sector boomed. Policymakers failed af icted countries—a task that goes well beyondto confront asset price bubbles forcefully in the the changes in European governance frameworksrelatively protected nontradable sector, further and the completion of nancial integration. Laborboosting its perceived pro tability. After many years productivity growth fell short in these countriesof ever-higher current account de cits and eroding over the past decade, despite ample access tocompetitiveness, nancing abruptly dried up, nancing from abroad. Fostering the return to aplunging the economies into deep recessions. Large vibrant tradable sector is a multifaceted undertaking,adjustment needs, high indebtedness, and negative but rst results are already in hand in the Balticfeedback loops between banking and sovereign countries and in Bulgaria, as well as in Ireland andinstability make for a protracted recovery. Spain, where export growth is picking up sharply and competitiveness indicators are improving.Yet, nancial integration does not lead inexorablyto such boom and bust cycles and, in fact, The remainder of this edition of the Regionalcan contribute to income convergence. The Economic Outlook discusses in more detail theinternationalization of banking was not adequately outlook and policy priorities for advanced Europematched by regulatory, supervisory, and banking in Chapter 1 and for emerging Europe in Chapter 2.reforms. National authorities retained ultimate The role of nancial integration in the buildup andresponsibility, including for any public rescues. resolution of imbalances within the euro area andMoreover, nancial markets failed to re ect adjacent countries is analyzed in Chapter 3. Themounting vulnerabilities in risk premiums until it Appendix lists current IMF arrangements withwas too late for a soft landing. European countries.xiv
    • 1. Advanced Europe: Tackling the Sovereign CrisisDespite headwinds from sovereign and nancial tensions, Figure 1.1the recovery continues. But downside risks still loom large, Euro Area: Contributions to GDP Growth,and divergences across advanced Europe persist. To avoid 2006:Q1–2010:Q4 (Quarter-over-quarter annualized growth rate, percentage points;a protracted period of low growth punctuated by economic, seasonally adjusted) nancial, and social crises, further bold measures at the 6 6national level are needed to address weak banks, credibly 4 4restore scal health, and bolster structural reforms. 2 2An additional strengthening of the EU-wide policyresponse, building on the March 24–25 decisions, will also 0 0be essential, as will stronger economic governance and an -2 -2integrated nancial stability framework at the EU level -4 -4to prevent the buildup of macroeconomic imbalances as -6 Net exports -6 Gross fixed capital formationwitnessed prior to the crisis. Meanwhile, monetary policy -8 Private consumption -8can remain accommodative, though normalization lies ahead -10 Government consumption -10 GDP growth (percent)as economic slack wanes and the balance of in ation risks -12 -12shifts. 2006:Q1 2006:Q2 2006:Q3 2006:Q4 2007:Q1 2007:Q2 2007:Q3 2007:Q4 2008:Q1 2008:Q2 2008:Q3 2008:Q4 2009:Q1 2009:Q2 2009:Q3 2009:Q4 2010:Q1 2010:Q2 2010:Q3 2010:Q4 Sources: Eurostat; and IMF staff calculations.Recovery Continues Note: Contributions from inventories and statistical discrepancy not shown.Recovery Is Becoming More and strong social safety nets cushioned the blowSelf-Sustained … to households (for instance, in France), sowing the seeds for private consumption to resume graduallyDespite lingering nancial tensions, growth in as the employment outlook stabilized. In turn, theadvanced Europe has strengthened. The initial improvement in pro tability prompted rms tomomentum provided by scal stimulus, the unfreeze the investment plans put on ice duringrestocking cycle, and the global upswing is gradually the crisis, even as banks remained reluctant to lend,giving way to a more broadly based recovery in while the robust recovery in global trade continuedwhich private domestic demand is playing a larger to support the more competitive economies,role (Figure 1.1). And while the worst postwar including Germany and Sweden, which reboundedrecession is likely to leave lasting scars on the level rmly in 2010 (Box 1.1).of output, the recovery is now tracking the patternand timing of past upturns in the euro area, with Conversely, in the most vulnerable euro areagrowth back to precrisis rates two and a half years countries, the correction of precrisis imbalancesafter the failure of Lehman Brothers (Figure 1.2). has forced a major adjustment. Front-loaded scal tightening under intense market pressures andHowever, this general picture masks substantial continuous private sector deleveraging are takingdivergences in growth trajectories (Figure 1.3 and their toll on activity. As detailed in Chapter 3,Table 1 in the Introduction and Overview). The a legacy of poor competitiveness and inappropriateinitial recovery in the core euro area and Nordic trade specialization also hinder export growth, andcountries occurred at a more gradual pace than current account de cits remain large, especiallyelsewhere in the world. But government-supported in Greece and Portugal (Chen, Milessi-Ferretti,work-time reductions minimized the upsurge in and Tressel, forthcoming; and Jaumotte andunemployment (for example, in Germany and Italy) Sodsriwiboon, 2010). In Ireland and Spain, theNote: The main author of this chapter is Céline Allard. correction in credit ows following the burst 1
    • REGIONAL ECONOMIC OUTLOOK: EUROPE Figure 1.2 Euro Area: Current Crisis Compared with Past Episodes, 1960:Q2 2010:Q4 (Annual percentage change) 8 8 30 30 Annual GDP Growth Around Recessions, Annual Export Growth Around Recessions, 6 t = 0 at the Start of the Recession 6 t = 0 at the Start of the Recession 20 20 4 4 10 10 2 2 0 0 0 0 -2 -2 -10 -10 -4 -4 -20 -20 -6 -6 Euro area historical average Euro area historical average Current Current -8 -8 -30 -30 -12 -9 -6 -3 0 3 6 9 12 -12 -9 -6 -3 0 3 6 9 12 8 8 15 15 Annual Consumption Growth Around Recessions, Annual Fixed Investment Growth Around Recessions, 6 t = 0 at the Start of the Recession 6 t = 0 at the Start of the Recession 10 10 4 4 5 5 2 2 5 0 0 0 0 -2 -2 -5 -5 -4 -4 -10 -6 -6 -10 Euro area historical average Euro area historical average Current Current -8 -8 -15 -15 -12 -9 -6 -3 0 3 6 9 12 -12 -9 -6 -3 0 3 6 9 12 Sources: Eurostat; Organization for Economic Cooperation and Development; and IMF staff calculations.of the real estate bubble triggered extensive job hoarding. In some countries, part-time schemesloss in the construction and nancial sectors. further supported job retention. In Germany andThe UK economy is facing considerable short- Norway, for example, the unemployment rate barelyterm uncertainty, as growth turned at in late inched up during the crisis. In contrast, it rose2010—taking out temporary weather-related markedly in some other countries, such as Spaineffects—and scal consolidation accelerates. and Ireland, where activity in the constructionHowever, the adjustment of its exchange rate and sector contracted sharply following the burst ofits accommodative monetary policy stance should housing bubbles, leaving many low-skilled workershelp mitigate the contractionary effect of its sizable without jobs. Youth unemployment, in particular,up-front scal adjustment. increased substantially. In extreme cases like Spain,Unemployment responses to the crisis have varied close to one young worker out of two is now outextensively across countries (Figure 1.4). In most of work, raising the specter of a “lost generation.”of Northern Europe, the deterioration in labor Likewise, temporary contract workers bore themarkets was generally contained compared with greatest burden of the adjustment, and wherepast recessions—despite a more severe output it was not already high before the crisis, thecontraction—with rms resorting to labor long-term unemployment rate is creeping up.2
    • 1. ADVANCED EUROPE: TACKLING THE SOVEREIGN CRISIS Figure 1.3 EA4 and Rest of Euro Area (RoEA): Contributions to GDP Growth, 2008:Q2–2010:Q4¹,² (Cumulative quarter-over-quarter growth rate; percentage points; seasonally adjusted; weighted by real GDP) 6 6 6 6 EA4: Contributions to GDP Growth RoEA: Contributions to GDP Growth 4 4 4 4 2 2 2 2 0 0 0 0 -2 -2 -2 -2 Private consumption -4 Private consumption -4 Government consumption -4 -4 Government consumption Gross fixed capital formation Gross fixed capital formation Inventories -6 Inventories -6 -6 Net exports -6 Net exports GDP growth (percent) GDP growth (percent) -8 -8 -8 -8 2008:Q2–2009:Q1 2009:Q2–Q4 2010:Q1–Q4³ 2008:Q2–2009:Q1 2009:Q2–Q4 2010:Q1–Q4³ Sources: Eurostat; Haver Analytics; and IMF staff calculations. ¹EA4: Greece, Ireland, Portugal, and Spain. ²Statistical discrepancy not shown. ³Data for Greece and Luxembourg are from 2010:Q1 to 2010:Q3. Figure 1.4 Selected European Countries and the United States: Unemployment Rate, JanuaryBecause adjustments have been concentrated in 2006–December 2010these speci c populations, they are likely to be (Percent)associated with losses in human capital and rising 16 16inequality, potentially threatening Europe’s social EA4¹ 14 RoEA² 14cohesion and stability. United States 12 United Kingdom 12 10 10… Despite Divergent Growthand Financial Tensions 8 8 6 6Protracted recessions in part of the euro areapresent challenges to growth in advanced Europe. 4 4So far, the growing traction from domestic demand 2 2 Jul-06 Jul-07 Jul-08 Jul-09 Jul-10 Apr-07 Oct-07 Apr-08 Oct-08 Oct-09 Jan-06 Apr-06 Oct-06 Jan-07 Jan-08 Apr-10 Oct-10 Jan-09 Apr-09 Jan-10has remained immune to the slump in the euroarea periphery. This is not surprising, given limitedtrade linkages between northern Europe and the Sources: Eurostat; Haver Analytics; and IMF staff calculations. ¹EA4: Greece, Ireland, Portugal, and Spain.euro area periphery (Table 1.1). For example, ²Rest of Euro Area (RoEA): Excludes Greece, Ireland, Portugal, and Spain. Table 1.1 Selected European Countries: Share of Exports by Destination, 2009 (Percent of total exports) Germany France United Kingdom Sweden Switzerland EA4¹ 5.9 10.6 12.2 3.9 5.1 Central and Eastern Europe 8.8 4.8 3.5 6.0 3.5 Asia excl. Japan 7.0 4.7 5.2 6.1 5.8 Sources: IMF, Direction of Trade Statistics; and IMF staff calculations. 1 Greece, Ireland, Portugal, and Spain. 3
    • REGIONAL ECONOMIC OUTLOOK: EUROPE Box 1.1 Domestic Demand and Recovery in the Large Euro Area Countries Given lingering uncertainties and market pressures, what does the future hold for domestic demand in the euro area? This box investigates the question using econometric analysis for the four largest countries of the euro area, and nds that growth divergences will continue to be underpinned by differing trajectories for domestic demand. For Germany, the worst of the crisis seems over and domestic demand is set to expand. At the other end of the spectrum, the adjustment in Spain still has a long way to go. France stands in between, as its strong social safety net tends to smooth uctuations. Although domestic demand has recovered moderately, Italy’s growth prospects remain weak against the backdrop of trend losses in competitiveness. While private domestic demand is beginning to play a larger role in the euro area recovery, there are important differences across the four largest economies ( rst gure). Consumption is recovering in France and Italy, while it remains fairly sluggish in Germany and is barely growing in Spain (on a cumulative quarter-over-quarter basis since 2009:Q2). Investment is on the rebound in Germany, but it remains sluggish in Italy and lagging in France, and it continues to plunge in Spain. This box will elaborate on these dynamics and offer some implications for the recovery looking ahead, drawing on behavioral equations for consumption and investment estimated for each of the four large euro area countries. Large Euro Area Countries: Cumulative Quarter-over-Quarter Growth and Contributions (Percentage points) 10 10 10 10 Crisis Recovery 8 (2008:Q2-2009:Q1) 8 8 (2009:Q2-2010:Q4) 8 Gross fixed capital formation 6 Private final consumption expenditure 6 6 6 Net exports 4 4 4 4 Final consumption of general government Inventories 2 2 2 2 GDP 0 0 0 0 -2 -2 -2 Gross fixed capital formation -2 Private final consumption expenditure -4 -4 -4 Net exports -4 Final consumption of general government -6 -6 -6 Inventories -6 -8 -8 GDP -8 -8 Germany France Italy Spain Germany France Italy Spain Sources: Eurostat; and IMF staff calculations. Consumption Improving income and labor market conditions are supportive, while stabilization in credit markets is a boon in Italy and France, although negative wealth effects remain a drag in Spain (second gure). The divergent income dynamics that supported consumption in Spain but not in Germany during the crisis are now reversing (third gure). In Spain, despite skyrocketing unemployment, overall real disposable income was resilient during the crisis, re ecting increased transfers and postponed tax payments. In Germany, despite good employment performance during the crisis, a drop in self-employed earnings and capital income drove real disposable income down marginally. However, disposable income is picking up in Germany and is poised to support consumption in the coming quarters, while ongoing labor market adjustment and scal withdrawal in Spain may weaken consumption. Note: The main author of this box is Irina Tytell.4
    • 1. ADVANCED EUROPE: TACKLING THE SOVEREIGN CRISIS Cumulative Quarter-over-Quarter Consumption Growth and Dynamic Contributions (Percentage points) 7 7 7 7 Crisis Income and labor conditions Recovery (2008:Q2–2009:Q1) Financial and housing wealth (2009:Q2–2010:Q4) 5 5 5 5 Credit conditions Car scrapping 3 Unexplained 3 3 3 Consumption 1 1 1 1-1 -1 -1 -1 Income and labor conditions-3 -3 -3 Financial and housing wealth -3 Credit conditions Car scrapping-5 -5 -5 Unexplained -5 Consumption-7 -7 -7 -7 Germany France Italy Spain Germany France Italy Spain Sources: Eurostat; Haver Analytics; and IMF staff calculations.Wealth effects continue to restrain consumptionin Spain, while they have turned supportive Four Large Euro Area Countries: Real Disposableelsewhere. Wealth effects exerted a strong drag on Incomeconsumption during the downturn in all countries (Index, 2008: Q1=100)but Germany—where real estate prices had 108 108remained muted before the crisis. Since then, the 106 106pickup in nancial wealth and housing prices hasstarted to support consumption again in France 104 104and, to a lesser extent, in Italy. However, Spain 102 102continues to experience a signi cant housing 100 100market correction that will hinder consumption inthe near term. 98 98 96 96While car scrapping schemes played a stabilizing role Germany Spain France Italyduring and beyond the recession, their withdrawal is 94 94 2008:Q1 2008:Q3 2009:Q1 2009:Q3 2010:Q1 2010:Q3weakening consumption. In Germany, almost all the Source: IMF, World Economic Outlook database.support provided during the crisis has already beensubtracted, but in Spain further negative “payback”effects are possible in the coming quarters.InvestmentThe accelerator effect has turned positive, except in Spain, but higher labor costs remain a constraint, as do higher costs of capital,except in Germany (fourth gure).The growth accelerator will continue to support investment as the recovery strengthens, but Spain’s depressedoutlook will remain a constraint. The growth rebound in Germany pushed up demand for capital goods from rms to a much larger extent than in Italy and France. In Spain, a depressed outlook continues to weigh oninvestment decisions.The negative effect of higher labor costs on rms’ pro tability will wane, while stabilizing credit supply is poisedto support investment again, with Spain the exception. Re ecting in part the resilience of employment even as 5
    • REGIONAL ECONOMIC OUTLOOK: EUROPE Box 1.1 (concluded) Large Euro Area Countries: Cumulative Quarter-over-Quarter Investment Growth and Dynamic Contributions (Percentage points) 15 15 15 15 Crisis Recovery 10 (2008:Q2–2009:Q1) 10 10 (2009:Q2–2010:Q4) 10 5 5 5 5 0 0 0 0 -5 -5 -5 -5 -10 -10 -10 -10 -15 Demand -15 -15 Demand -15 Cost of capital Cost of capital -20 Labor cost -20 -20 Labor cost -20 Lending conditions Lending conditions -25 Housing prices -25 Housing prices Unexplained -25 Unexplained -25 Investment Investment -30 -30 -30 -30 Germany France Italy Spain Germany France Italy Spain Sources: Eurostat; Haver Analytics; and IMF staff calculations. output dropped, unit labor costs rose in the wake of the crisis, but the negative pro tability effects are set to fade, and rms are now better positioned to resume investment, having preserved human capital during the downturn. Gradual repair of banks’ balance sheets and the stabilization in lending conditions will, to some extent, provide increasing support to investment, although Spain’s ongoing housing market correction will be a curb in the near term. In addition, increasing tiering in costs of capital will remain a challenge as long as sovereign bond markets stay under pressure.Germany, Sweden, and Switzerland sell less than banking sectors, while pressuring banks’ balance6 percent of their exports to Greece, Ireland, sheets—which contain signi cant amounts ofPortugal, and Spain combined, two to three times domestic sovereign bonds. This adverse feedbackless than combined trade with the dynamic regions loop between the sovereign and the banking sectorsof central and eastern Europe and emerging Asia. in the periphery threatened to fundamentallyThis disconnect is somewhat less evident for the disrupt funding markets (Figure 1.5). PressuresUnited Kingdom, given its tight trade linkages with became increasingly severe in Ireland and led theIreland, although the depreciation of the pound has authorities to embark on an adjustment programcushioned the effects. supported by the EU and the IMF (Appendix). Similarly, Portugal has now asked for externalThe renewed bout of nancial turmoil has nancial assistance.arguably mattered more. As the situation in theIrish banking sector deteriorated, a new wave of Spillovers to the real economy have nonethelessmarket turbulence erupted in November 2010. remained largely con ned to affected countries.Sovereign risks intensi ed again in the euro area The crisis-management framework put in placeperiphery countries, spilling over to more countries, in the spring was activated quickly. The Europeanincluding Belgium and Italy. Government bond Central Bank (ECB) stepped up its Securities Marketsspreads surged to substantially higher levels than Program, which has now accumulated €76.1 billionthose experienced during the turmoil in May 2010. of securities. The European safety net set up in MayThese developments raised further concerns about 2010 was tapped to fund part of the Irish program,periphery governments’ ability to support still-weak with the European Financial Stability Facility (EFSF)6
    • 1. ADVANCED EUROPE: TACKLING THE SOVEREIGN CRISISFigure 1.5 Figure 1.6Selected Euro Area Countries: Change in Euro Area: Banking Sector Risk Index, 2007–111Sovereign and Bank Credit Default Swap (CDS) 4 4Spreads, January 2010–March 2011¹(Basis points) Core Euro Area Banks 3 EA4 Banks² 3Change in banking sector CDS spreads 1,000 1,000 2 2 900 Ireland 900 800 800 2011 Trend line 1 1 700 700 600 Greece 600 0 0 500 Portugal 500 400 400 -1 -1 300 300 Germany Spain 2008 Trend line -2 -2 200 200 Finland Italy 2007 2008 2009 2010 2011 100 Belgium 100 France Netherlands Sources: Bloomberg L.P.; and IMF staff calculations. 0 Austria 0 1 Normalized score from a principal component analysis on 5-year senior -200 0 200 400 600 800 bank credit default swap spreads, estimated using daily data (Jan.1, Change in sovereign CDS spreads 2005–Apr. 15, 2011).The core risk index comprises CDS spreads ofSources: Bloomberg L.P.; Datastream; and IMF staff calculations. 26 banks and the EA4 risk index 13 banks. The first principal component¹ Trendlines indicate changes from January to December 2008 for the 2008 captures 84.5 percent of the common variation across core country bankstrend line, and changes from January 2010 to March 2011 for the 2011 and 86.1 percent across EA4 country banks. 2trend line. EA4: Greece, Ireland, Portugal, Spain.successfully issuing its rst supporting bond in economies, where better employment prospectsJanuary 2011. In addition, the ECB extended the full have improved households’ income outlooks,allotment regime of its re nancing operations until at despite higher commodity prices. Although scalleast July 2011. These measures helped mitigate the consolidation is set to dampen growth somewhat,perception of risk for core countries’ banks, though steps taken to restore the soundness of publicwithout completely eliminating it (Figure 1.6). nances will bolster con dence and help paveAnd a concomitant strengthening of national reforms the way for a more solid medium-term outlook.allowed Spain to decouple from other periphery Robust growth in emerging countries and bettercountries in early 2011. short-term prospects in the United States will continue to provide support to the tradable sector (Figure 1.7), but less so in the euro areaThe Outlook Remains for Uneven periphery countries, which will suffer from deeperGrowth … scal austerity measures, sharper private sector balance sheet deleveraging, and more severeGrowth prospects will depend critically on the structural unemployment. Thus, intra-euro areaway in which the remaining tensions in the euro growth differentials will persist, with 2011 growtharea periphery and European nancial sectors are projected to range between –3 percent in Greeceresolved. Under the assumption of credible policies and 2½ percent or more in Austria, Finland,to restore con dence and address underlying Germany, and Luxembourg.weaknesses (see below), the forecast remains fora gradual and uneven expansion, with countries The outlook also foresees differentiatedunder market pressures continuing to lag behind recoveries outside the euro area, although forthe recovery in northern Europe. Real GDP different reasons. Despite some support from theis projected to expand by 1.6 percent in 2011 depreciated pound and a rapid unfreezing of pastand 1.8 percent in 2012 in the euro area, driven investment decisions, stronger headwinds from aby the strengthening recoveries in Germany, front-loaded scal strategy and higher householdFrance, and other smaller northern euro area debt levels will restrain growth somewhat in the 7
    • REGIONAL ECONOMIC OUTLOOK: EUROPE Figure 1.7 Selected European Countries: Key Short-Term Indicators 10 10 120 120 iBoxx Euro Corporate Yields, Industrial Production, 9 January 2006–April 2011 9 January 2006–January 2011 115 115 (Percent) (Index, January 2006 = 100) 8 8 110 110 7 7 6 6 105 105 5 5 100 100 4 4 3 95 95 3 Euro area 2 90 United Kingdom 90 BBB 2 1 Sweden A AAA 1 85 85 0 0 80 80 Jan-06 Apr-06 Jul-06 Oct-06 Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 Jan-06 Apr-06 Jul-06 Oct-06 Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 Apr-11 Source: Datastream. Sources: Eurostat; Haver Analytics; and IMF staff calculations. 25 25 200 200 Purchasing Managers Index and Selected Equity Markets, 20 Confidence Indicators, 20 180 180 January 2006–April 2011 15 January 2006–March 2011 15 160 (Index, January 2, 2006 = 100) 160 10 10 140 140 5 5 120 120 0 0 100 100 -5 -5 80 80 -10 -10 60 60 Dow Jones Euro Stoxx -15 Euro area: purchasing managers index¹ -15 40 FTSE 100 40 Euro area: consumer confidence indicator² DAX 30 -20 U.K.: purchasing managers index¹ -20 20 20 OMX Stockholm 30 U.K.: Consumer confidence indicator² 0 0 -25 -25 Jan-06 Jan-07 Apr-06 Oct-06 Apr-07 Oct-07 Jan-08 Apr-08 Oct-08 Jan-09 Apr-09 Oct-09 Jan-10 Apr-10 Oct-10 Jan-11 Apr-11 Jul-06 Jul-07 Jul-08 Jul-09 Jul-10 Jan-06 Apr-06 Jul-06 Oct-06 Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 Sources: Eurostat; European Commission Business and Consumer Surveys; Source: Datastream. Haver Analytics; and IMF staff calculations. ¹Seasonally adjusted; deviations from an index value of 50. ²Percentage balance; difference from the value three months earlier.United Kingdom, to 1.7 percent in 2011 and One overarching concern is whether the recovery—2.3 percent in 2012. Switzerland, having suffered and investment, in particular—can proceed despiteless from the global crisis and bene ting from a persistent weaknesses in European bankinghealthy scal outlook, is more advanced in the sectors. As discussed earlier (IMF, 2009), recoveriesrecovery cycle, although the appreciation of its following nancial crises tend to be weak, withcurrency will weigh on exports. All in all, growth rms’ investments suffering particularly badly from sluggish credit. Although these features havecan be expected to converge gradually toward de nitely been at play in advanced Europe sincepotential, at 2.4 percent in 2011 and 1.8 percent 2008, no decisive evidence yet indicates that a truein 2012. In Sweden, rapidly improving nancial credit crunch is taking hold. Household credit hasconditions have propelled the economy out of begun to recover and credit to enterprises appearsrecession faster than elsewhere, but with growth to have bottomed out in the euro area, as banksforeseen at 3.8 percent in 2011 and 3.5 percent in managed to slow down the deleveraging process2012, the rst signs of overheating, especially in the (Figure 1.8 and Box 1.2). Moreover, enterprisereal estate sector, are emerging. credit is typically a lagging indicator because rms8
    • 1. ADVANCED EUROPE: TACKLING THE SOVEREIGN CRISISFigure 1.8Euro Area: Credit Developments20 20 Credit Growth, 2001–11 (Year-over-year, percent)15 15 Loans to nonfinancial corporations Loans to households10 10 5 5 0 0-5 -5 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 240 240 240 240 Outstanding Credit to Households, 2000:Q1–2010:Q4 Outstanding Credit to Nonfinancial Corporations, 230 (Percent of GDP) 230 230 2000:Q1–2010:Q4 230 (Percent of GDP) 220 220 220 220 210 210 210 Credit to nonfinancial 210 corporations 200 200 200 200 Trend (2000–10) 190 190 190 190 180 180 180 180 170 170 170 170 160 160 160 160 Credit to households 150 150 150 150 Trend (2000–10) 140 140 140 140 2000:Q1 2001:Q1 2002:Q1 2003:Q1 2004:Q1 2005:Q1 2006:Q1 2007:Q1 2008:Q1 2009:Q1 2010:Q1 2000:Q1 2001:Q1 2002:Q1 2003:Q1 2004:Q1 2005:Q1 2006:Q1 2007:Q1 2008:Q1 2009:Q1 2010:Q1Sources: European Central Bank; and IMF, World Economic Outlook database.initially nance new investment from internal the EU’s bank resolution proposals, the necessaryresources. Indeed, the balance sheets of large shift away from wholesale funding, and the rms in the core economies are generally in good normalizing of monetary conditions will forceshape, allowing them to self- nance their expansion banks to reprice risk. In the meantime, banks in theprojects and, in some places, to provide funding to euro area periphery countries will also have to worksuppliers—thus alleviating somewhat the tighter through a growing share of doubtful assets.lending standards affecting small and mediumenterprises. Large rms have also continued tappingcapital markets at costs that remain attractive by … With Substantial Downside Riskshistorical standards. Barring a shock to con dence,investment is therefore expected to continue In that context, although the resilience of the globalrecovering in the near term, albeit gradually. recovery could provide somewhat stronger-than-However, constraints on bank intermediation expected momentum to the recovery in advancedare likely to appear during the next few years, as Europe, downside risks still loom large. Japan’sregulatory changes in the context of Basel III and natural disaster, geopolitical problems in the Middle 9
    • REGIONAL ECONOMIC OUTLOOK: EUROPE Box 1.2 Deleveraging in the Euro Area Assets-to-Capital Ratios (Level) Despite some reduction since the beginning of the crisis—mainly through higher capital—euro 30 30 area banks’ leverage remains high by international Dec 2004 25 Sep 2008 25 standards.1 In the run-up to the crisis, euro area Dec 2010 banks had high leverage multiples (asset to capital 20 20 ratios) that allowed them to turn relatively low 15 15 operating performance into high return on equity ( rst gure). This high leverage was achieved 10 10 through heavy reliance on short-term wholesale funding, which dried up as counterparty risk 5 5 concerns related to subprime and periphery debt 0 0 exposures surged. Reductions in bank leverage United Kingdom Austria Belgium Germany Spain Finland France Greece Ireland Italy Luxembourg Netherlands Portugal EUR4¹ Euro area United States ratios have been particularly strong in the euro area periphery (Ireland, Greece, and Spain), even though large banks in these countries were generally less leveraged than those in the core. Sources: ECB Monetary and Financial Institutions (MFI) statistics; and Deleveraging also occurred in core countries, IMF staff calculations. ¹EUR4 is the weighted average of France, Germany, Italy, and Spain. particularly in Austrian, Belgium, French, and Italian banks. The reduction was achieved mostly through an increase in capital buffers, although a decline in assets took place in the context Contributions to Change in Bank Leverage of bank restructuring in Ireland, Belgium, and (Percent) Luxembourg (second gure). 40 40 While the overall level of assets changed relatively 20 20 little, two speci c classes of assets—international claims and loans—contracted signi cantly in the 0 0 wake of the crisis. International claims, which -20 -20 expanded steadily in the years before the crisis, contracted sharply as interbank markets froze during -40 -40 the global crisis, and again during the Greek crisis in May 2010 as wholesale funding markets came -60 Contribution of change in capital and reserves -60 under stress (third gure). Among domestic claims, Contribution of change in total assets Change in bank leverage -80 -80 the bulk of the adjustment was driven by loans to Austria Belgium Germany Spain Finland France Greece Ireland Italy Luxembourg Netherlands Portugal EUR4¹ Euro area United Kingdom United States non nancial corporations, which declined in the periphery (Ireland, Spain), but also in countries whose banks were exposed to subprime products (Germany, Belgium). Lending to households has Sources: ECB Monetary and Financial Institutions (MFI) statistics; and been more resilient overall and continued to expand IMF staff calculations. in the majority of countries (fourth gure). ¹EUR4 is the weighted average of France, Germany, Italy, and Spain. Note: The main authors of this box are Thierry Tressel and Nico Valckx. 1 Data for euro area countries and the United Kingdom are based on ECB and Bank of England statistics on monetary and nancial institutions’ (MFI) aggregate balance sheets, that is, the sum of the harmonized balance sheets of all the MFIs resident in the country. Data for the United States are from the U.S. Federal Deposit Insurance Corporation for all commercial banks. There may be methodological differences with other data sources that use consolidated banking (group-level) data.10
    • 1. ADVANCED EUROPE: TACKLING THE SOVEREIGN CRISISOngoing regulatory reforms to reduce banking Change in International Claims of Euro Area Bankssector vulnerabilities may reinforce deleveraging (Billions of U.S. dollars)pressures. The new set of regulations known as 10,000 10,000Basel III designed by the Basel Committee onBanking Supervision (BCBS) requires higher and 8,000 8,000better quality of capital, especially for systemically 6,000 Total international claims 6,000important nancial institutions (SIFIs). IMF analysis 4,000 Claims vis-à-vis related offices 4,000estimates that implementation of the Basel III rules 2,000 2,000over a three-year period could reduce EuropeanSIFIs core Tier 1 ratios by as much as 2.1 percentage 0 0points, from 9.0 to 6.9 percent (Ötker-Robe, -2,000 -2,000Pazarbasioglu, and others, 2010), some of which -4,000 -4,000would need to be offset by banks. This could entail 2005:Q1–2008:Q2 2008:Q3–2009:Q2 2009:Q3–2010:Q1 2010:Q2–Q3 Source: BIS locational banking statistics by nationality.in particular further deleveraging during the comingyears and result in further contractions in some assetclasses if retained earnings fall short or additional Change in Loan Volume,capital cannot be raised easily. However, because September 2008–December 2010implementation is spread out over eight years—until (Billions of euros)early 2019—the impact on assets may be weaker. 250 250In turn, deleveraging is likely to dampen future 200 Loans to households 200activity, although the effect appears manageable. 150 Loans to nonfinancial corporations 150Deleveraging affects real activity through twoopposing channels. Lower bank leverage has 100 100a con dence-enhancing effect as larger capital 50 50buffers increase banking sector soundness and lead 0to lower risk premiums and cheaper funding, in 0turn supporting credit. Nonetheless, deleveraging -50 -50caused by the shrinking of assets can constrain -100 -100bank credit supply, and hence, activity. Estimatescoordinated by the Financial Stability Board and the -150 -150BCBS—in which the IMF participated—suggest, -200 -200however, that the impact on aggregate output Netherlands Euro area Germany Portugal Belgium Finland Greece Austria France Ireland Spain EUR4¹ Italyof the transition toward higher capital standardswould remain modest: An increase by 1 percentagepoint in the capital target over an eight-year period Sources: ECB Monetary and Financial Institutions (MFI) statistics; andwould shave off 0.1 percent from the level of GDP staff calculations. ¹ France, Germany, Italy, and Spain.(Macroeconomic Assessment Group, 2010).Deleveraging would also negatively affect credit. A complementary econometric panel analysis shows thatcredit growth, both to rms and households, is negatively affected by bank leverage. The effects are relativelylarge for the corporate sector, with a 10 percent increase in bank leverage estimated to reduce credit growthto non nancial enterprises by 2¾ percent in the euro area. Because initial conditions differ, the impact variesacross euro area countries ( fth gure). The analysis also points to the role of household indebtedness indampening credit, both to households and rms, suggesting that the legacy of the crisis and necessary privatesector balance sheet adjustment will weigh on lending in the near term, independently of bank deleveraging.A 10 percent increase in the household debt ratio is estimated to reduce credit growth by 3 percent in the euroarea, as banks compensate for higher risks or lower return on their stock of mortgages, or on new loans, bytightening lending standards across a broader set of borrowers, while more indebted households reduce theirdemand for credit. 11
    • REGIONAL ECONOMIC OUTLOOK: EUROPE Box 1.2 (concluded) Euro Area Countries: Estimated Effects of Bank and Household Leverage on Credit Growth Relative to the Euro Area Average¹ (Percentage points) 2.0 2.0 2.0 2.0 Nonfinancial Corporations Households 1.5 1.5 1.5 1.5 1.0 1.0 1.0 1.0 0.5 0.5 0.5 0.5 0.0 0.0 0.0 0.0 -0.5 -0.5 -0.5 -0.5 -1.0 -1.0 -1.0 -1.0 -1.5 -1.5 -1.5 -1.5 Household debt Household debt -2.0 Bank leverage -2.0 -2.0 Bank leverage -2.0 -2.5 -2.5 -2.5 -2.5 Italy Italy Spain Spain Ireland Ireland Austria France Austria France Greece Finland Greece Finland Belgium Belgium Portugal Portugal Germany Germany Netherlands Netherlands Sources: ECB Monetary and Financial Institutions (MFI) statistics; and IMF staff calculations. ¹The model estimates, at a quarterly frequency for a panel sample of euro area countries and for the period 2008–2010, the relationship between credit growth and the log of bank leverage and log of household debt-to-GDP ratio of the previous quarter. The chart reports the estimated impacts on credit growth of initial leverage and household debt for each country, all expressed in deviation from the euro area average.East, and disruptions to energy supplies could by a shrinking investor base. In addition, asderail global growth, with detrimental consequences explained in the April 2011 Global Financialfor the most export-dependent European countries, Stability Report (IMF, 2011), banks’ reluctanceand for private consumption. Deep-rooted nancial to deleverage—as they then have to book theand structural problems in the most vulnerable accompanying losses—have made them increasinglyeuro area countries are likely to keep European eager to nd alternative funding sources to reducecon dence volatile, and new spells of anxiety in dependence on wholesale markets. In some nancial markets could emerge if, for example, the countries (for example, Spain and Greece), thispolitical resolve to tackle the crisis disappoints. has triggered a competition war for retail deposits, putting unsustainable pressures on interest margins.A major point of pressure in the immediate future In other countries, covered bonds issuance hasstems from large rollover needs in euro area picked up, but over-collateralization required evenperiphery countries from both the banking and for the best rated banks means that only a limitedthe sovereign sectors. Combined bonds due in portion of their balance sheets can be funded in2011 amount to 10 percent of GDP or more in this way. And reliance on ECB funding has becomeGreece, Portugal, and Spain—roughly twice the entrenched for a number of second-tier banks2007 amount. Rollover needs have also increased in large European countries; nearly all banks insigni cantly in Belgium, Ireland, and the United Greece, Ireland, and Portugal; and some small andKingdom. More generally, crisis-related funding mid-sized Spanish saving banks.pressures in high-de cit countries have forcedgovernments to assume additional risks by shifting With liquidity pressures remaining acute, a negativeto shorter maturities and to rely more heavily on shock could rapidly spill over through the peripheryprivate syndication (De Broeck and Guscina, 2011). and potentially beyond. Despite some reductionIn periphery countries, this pressure is compounded during the last year, cross-border exposures12
    • 1. ADVANCED EUROPE: TACKLING THE SOVEREIGN CRISIS Figure 1.9 Selected Advanced Countries: Claims on Domestic Banks and Public Sector¹ Germany Germany France France United Kingdom Claims on EA3² (Percent of total bank equity) Other EA countries³ Claims on Spain Other EA countries³ United Kingdom (Percent of total bank equity) Spain Italy Italy Japan Japan 2009:Q4 2010:Q3 2009:Q4 2010:Q3 United States United States 0 10 20 30 40 50 60 70 0 20 40 60 80 100 120 Germany Germany France France United Kingdom Other EA countries³ Other EA countries³ Claims on EA3² United Kingdom Spain (Percent of equity of banks Claims on Spain with foreign exposures4) (Percent of equity of banks Italy Italy with foreign exposures4) Japan Japan 2009:Q4 2010:Q3 2009:Q4 2010:Q3 United States United States 0 10 20 30 40 50 60 70 0 20 40 60 80 100 120 Sources: Bank of England; Bankscope; BIS Consolidated Banking Statistics; IMF, International Financial Statistics; and IMF staff calculations. ¹The exposures were adjusted using data from the Bank of Ireland to account for the fact that a significant portion of the claims are claims on foreign banks domiciled in Ireland. ²EA3: Greece, Ireland, and Portugal. ³Other EA countries includes Austria, Belgium, Ireland, Portugal, and the Netherlands. 4 The exposures are calculated in percent of the equity of banks that have foreign exposures. Banks that do not have exposures to Greece, Ireland, Portugal, and Spain are not included in the computation.remain sizable and concentrated within euro area Figure 1.10creditor countries (Waysand, Ross, and de Guzman, Selected European Countries: Headline2010) (Figure 1.9). Hence, the system would still and Core Inflation, January 2006–March 2011 (Percent; year-over-year change)be severely tested if euro area stresses were tointensify. 6 6 Core, euro area¹ Headline, euro area 5 Core, United Kingdom¹ 5 Headline, United KingdomInflation Picks Up 4 4In ation will continue to pick up throughout 2011 3 3against the backdrop of accelerating commodity 2 2prices. In the euro area, headline in ation is 1 1expected to exceed the 2 percent ECB target formost of 2011 before moderating to 1.7 percent in 0 02012, although the impact on core in ation and -1 -1in ation expectations is seen to be minimal for Jan-06 Apr-06 Jul-06 Oct-06 Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Apr-10 Jul-10 Oct-10 Jan-11now (Figure 1.10). Higher in ation is foreseenthroughout the currency union: in the core, higher Sources: Eurostat; Haver Analytics; national authorities; and IMF staff calculations.commodity prices are accompanied by narrowing ¹Harmonized index of consumer price inflation (excluding energy, food,output gaps (for example, in Finland), while in alcohol, and tobacco). 13
    • REGIONAL ECONOMIC OUTLOOK: EUROPEthe periphery, indirect tax changes contribute to are the foundation for restoring con dence in thepositive headline in ation. Ireland, nonetheless, countries under severe market pressures. In theis expected to experience subdued price increases euro area periphery, adjustments to past imbalancesin 2011, at 0.5 percent, following two years of will take time to deliver better growth andde ation. Outside the euro area, the pickup in employment prospects. Measures to date have beenin ation has been further ampli ed in the United wide ranging (Table 1.2). But it will be essential forKingdom by a series of VAT increases and the governments to maintain their resolve to tacklelagged effects of the currency depreciation: scal consolidation, repair their nancial systems,in ation is expected to stay signi cantly above the and continue critical structural reforms.Bank of England target, at 4.2 percent in 2011, Structural reforms will also be needed elsewherebefore cooling to 2 percent in 2012, as base effects in Europe because solid sustainable growth willcome into play. In contrast, monetary tightening be a major postcrisis antidote to entrenchedand the unfolding appreciation of the krona are unemployment, declining standards of living, andexpected to keep Sweden’s in ation more stable, at deteriorating scal positions. Efforts to increase2 percent in both years, despite the strength of its employment rates in the core euro area and toeconomy. Switzerland too is expected to continue improve educational outcomes in the whole regionexperiencing very low in ation, at just 1 percent, would go a long way to achieving these goals.as the appreciation of the currency feeds through. In Scandinavian countries, measures are alreadyNonetheless, in all countries, in ation risks have in the works to lower labor taxation (Sweden) orbecome tilted to the upside, and guarding against reorient labor market policies toward upgradingsecond-round effects will be critical. skills (Denmark). The agreement by European leaders on the “Pact for the euro” is encouragingTurning the Page on the Crisis: in the sense that it cuts through the debate about whether and what reforms are still needed, butPolicy Requirements national authorities must now commit to thePolicy actions taken in Europe since the emergence immediate implementation of speci c actions.of the sovereign debt turmoil helped to contain the In parallel, better surveillance needs to be establishedcrisis, but not suf ciently to decisively put it behind within the euro area to ag and to nip in the budus. Bold steps are needed to assuage market concerns future macroeconomic imbalances to avoid a replayabout sovereign and nancial risks and to tackle of the current crisis (see Chapter 3).the underlying root causes of the crisis. Ultimately, These reforms can and should go hand in hand withmore rather than less economic and nancial reducing inequalities, which are strongly linked tointegration will be key to the region’s success, along unemployment and more generally to the low ratewith a strengthening of euro area-wide economic of labor utilization in Europe (Box 1.3). In countriesgovernance. Although policymakers have started where unemployment remains unacceptably high,addressing these dif cult issues—most notably measures put in place to improve labor marketat the March 2011 European Council—further functioning also aim to equalize opportunities forimprovements in the macroeconomic landscape all citizens, by reducing rents for insiders in bothwill depend on rapid implementation of their the labor and product markets. Pension reformscommitments. that lengthen the contribution period in line with rising life expectancy increase intergenerationalStrong National Policies as the First fairness (for example, in France, Greece, and Spain). Measures to harmonize employment protectionLine of Defense between types of job contracts should reduce theStrong national policies to rectify structural disproportionate burden on temporary workers—weaknesses remain crucial throughout Europe and those last hired and rst red. Removing the14
    • 1. ADVANCED EUROPE: TACKLING THE SOVEREIGN CRISISTable 1.2Greece, Ireland, Portugal, and Spain: Authorities’ Measures to Restore Confidence and RegainCompetitiveness Fiscal Financial Structural Greece * Front-loaded fiscal adjustment (measures * Introduction of government- * Freeze/reduction in minimum wages worth 8 percent of GDP in 2010), through guaranteed uncovered bank bonds and relaxation of collective dismissal and elimination of 13th and 14th month bonuses usable as collateral at the ECB. employment protection regulation to facilitate and freeze of public wages and of pensions; * Set-up of a financial stability fund job reallocation. increase in VAT rates, indirect taxes, and as a backstop for capital needs for * Reform of collective bargaining system, in nontax revenues; cuts in operation costs viable banks under pressure. particular to allow firms to opt out of industry- and investment spending; rationalization of * Strengthened banking level agreements. pharmaceutical spending; wage cuts and supervision through enhanced * Liberalization of regulated professions. tariff increases in public enterprises. reporting requirements and * Liberalization of road transportation sector; * Reduction in public employment reduced reporting lags. and reform of the railway sector. through attrition. * Strengthening of the competition authority. * Pension reform aimed at reducing * Easing of business licensing and start- pension spending from 12½ percent of ups; and full implementation of the Services GDP to 2½ percent over 2010–60. Directive. * Reforms to fight tax evasion, improve * Fast-tracking of large investment projects. tax compliance, and improve budget controls and fiscal reporting. Ireland * Front-loaded medium-term * Asset valuation and stress * Removal of structural impediments to consolidation plans (measures worth tests to provide an assessment competitiveness, including by amending 6 percent of GDP in 2009–10, 9½ percent of capital needs to achieve a competition legislation. of GDP over 2011–14) through public regulatory capital ratio of 10.5 * Reform of benefits system to incentivize sector wage and employment reductions; percent. work and eliminate unemployment traps. social transfer reforms (including through * Prudential liquidity assessment * Independent assessment of the electricity entitlement reforms); savings on capital to calibrate stable funding of the and gas sectors, with possible privatization of spending; a broader income tax base; banking system. state-owned assets, to reduce energy costs. and VAT increase. * Substantial downsizing of the * Institutional reforms, including a banking system, including by medium-term budgetary framework and unwinding noncore assets and a budgetary advisory council. resolution of unviable banks. * Increase in the retirement age starting * Strengthening of the bank in 2014 and reform of public sector resolution framework. pension entitlements for new entrants. * Strategy to address the financial weakness of credit unions. Portugal1 * Front-loaded fiscal adjustment, through * Set up a financial stability facility * Administrative and credit-support measures tax increases, cuts in public wages by for liquidity and capital support. targeted at export-oriented firms. 5 percent, hiring and pension freeze, * Banks increased core tier * Reforms of the wage-bargaining system, cuts in social spending and transfers to 1 capital ratio to 8 percent reduction of dismissal costs, and promotion of local governments. following Bank of Portugal’s flexibility in working hours. * Introduction of quarterly fiscal targets. recommendation. * Reinforcement of active labor market * Reforms under way to introduce a policies, especially for young job seekers. medium-term budgetary framework, * Deregulation of the rental market. program budgeting, and an independent * Measures to reduce informal activity, fraud, fiscal council. and tax evasion. Spain * Front-loaded fiscal adjustment (4.1 * Law on savings banks to allow * Reduction in dismissal costs and criteria, percent of GDP measures in 2010–11) equity-like instruments to have and reform of the collective bargaining through tax increases, a 5 percent cut voting rights, reform their legal system, in particular to allow firms to opt out of and freeze in public wages, pension statute with option to become collective agreements. freeze, and cuts in investment and listed, and strengthen corporate * Reinforcement of active labor market subnational government spending. governance requirements. policies, and enhanced links between * Improved dissemination and * Increase in core capital to 8 vocational training, businesses, and the transparency of regional budgets. percent and to 10 percent for general education system. * Pension reform, with increases in the institutions reliant on wholesale * Cut in social contributions for part-time statutory retirement age, the length of funding and with limited private employment of the young and the long-term contribution for full pension rights, and shareholding. unemployed. the reference period to compute pension. * Individual recapitalization plans * Simplification of administrative procedures to requested and assessed by Banco set up a business. de España. * Greater independence and powers of * Extended support of the FROB network industry regulators. (public recapitalization fund) * Improved incentives for the rental market through the purchase of common and removal of tax incentives for housing equity. investment.Source: IMF staff.1Measures predating the authorities’ request for external financial assistance. 15
    • REGIONAL ECONOMIC OUTLOOK: EUROPE Box 1.3 Unemployment and Inequality in the Wake of the Crisis Unemployment rose more in the euro area periphery than in other European countries, but youth and temporary workers everywhere were particularly hard hit by the crisis. In most of northern Europe, the deterioration in labor markets was generally contained compared with past recessions—despite the sharper output contractions experienced this time—with rms resorting to labor hoarding, and in some countries part-time schemes further supported job retention. In contrast, unemployment rose more sharply in some peripheral countries, such as Spain and Ireland, where the burst of housing bubbles exacerbated the recession ( gure). And the more fragile segments of the labor market—young, low-skilled, and temporary workers—suffered the most. With long-term unemployment slowly creeping up, there is a risk that many unemployed will become discouraged and leave the labor market. This would have adverse consequences on Europe’s social fabric, public nances, and growth. How have labor market developments likely affected income inequality in Europe during the crisis? What features of labor markets aggravated the impact of the crisis on inequality? And what can be done to alleviate the problem? Cross-country econometric analysis of the determinants of inequality in Organization for Economic Cooperation and Development countries (over a period, 1980–2005, that does not include the recent crisis) suggests that the recession likely exacerbated inequality through rising unemployment and dwindling job creation, despite the safety nets and automatic stabilizers at work. A jobless recovery or ingrained long-term unemployment could further worsen economic disparities and undermine both economic performance and social cohesion. “How” the economy recovers and grows (that is, which income groups bene t the most) will matter for income inequalities. Cross-country differences in income inequality re ect the interplay of labor, social, and educational factors. In line with the literature, the following robust results were found (see table): • Labor utilization signi cantly in uences income distribution. Unemployment is found to have a regressive impact on income equality, and a higher employment rate is associated with lower economic disparities. Social expenditures play an important role in alleviating income inequality across all speci cations, highlighting the supporting role of unemployment bene ts in times of crisis, and more generally of social protection in assisting the most vulnerable. Educational attainment, proxied by the share of population with at least secondary education, is associated with a more even income distribution. • The longer the unemployment duration, the higher the income inequality. Both short- and long-term unemployment widen income dispersion, with a slightly higher coef cient for the latter, re ecting deeper income losses as the spell of unemployment lengthens. • Better job opportunities for underutilized groups enhance equity. Higher employment rates for women and youth reduce disparities. • Dual labor markets worsen inequality. A higher share of temporary contracts in total employment contributes to widening income distribution because it tends to be associated with more wage and bene t disparity between the temporary and permanent workforces. This is particularly relevant for countries that used a “dual” system to enhance labor market exibility, resulting in increased use of temporary contracts. The results suggest that the rise in unemployment during the crisis increased inequality by an estimated 2 percentage points in the euro area as a whole, and by as much as 10 percentage points in Greece, Ireland, Portugal, and Spain, where the labor market situation deteriorated much more sharply. The recession also increased the number of discouraged workers who dropped out of the labor force, a factor that is likely to have Note: The main author of this box is Hanan Morsy.16
    • 1. ADVANCED EUROPE: TACKLING THE SOVEREIGN CRISIS Impact of the Crisis on the Labor Market The recession had diverse impacts on real GDP Labor hoarding raised unit labor costs in a number and unemployment. of countries. 5 5 16 16 (Changes between 2007:Q4 and 2009:Q4) (Changes between 2007:Q4 and 2009:Q4) Percent Change in Unit Labor Cost 14 14 Percent Change in Real GDP NOR 12 FIN 12 0 CHE 0 LUX NOR GRC NZL FRA TUR USA 10 GRC 10 AUT BEL CAN SVK DNK GBR BEL LUX CZE 8 8 PRT DEU CZE NZL DEU NLD MEX ESP AUT POL CAN -5 GBR ISL -5 6 NLD ITA SWE 6 JPN ITA HUN HUN SVK DNK FRA SWE 4 ESP 4 FIN AUS 2 2 -10 -10 KOR JPN USA 0 0 IRL -2 -2 IRL -15 -15 -4 -4 -2 0 2 4 6 8 10 12 -2 0 2 4 6 8 10 12 Change in the Unemployment Rate Change in the Unemployment Rate Structural initial conditions mattered for long-term Employment response was contained in this recession compared unemployment responses. with historical episodes despite a much sharper output contraction. 5 5 3 3 Structural Capacity Indicator and Long-Term Euro Area: Annual Employment Growth Around Recessions,Change in Long-term Unemployment Unemployment Rate¹ t=0 at the Start of the Recession 4 4 2 2 ESP IRL Rate (2007Q4-2009Q4) 3 3 1 1 2 2 0 0 PRT 1 GBR ITA 1 SWE FRA DNK FIN GRC -1 -1 0 AUT 0 BEL NLD -1 -1 -2 -2 DEU Euro area historical Current -2 -2 -3 -3 0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 -12 -9 -6 -3 0 3 6 9 12 Structural Capacity IndicatorSources: Eurostat; Fraser Institute; Organization for Economic Cooperation and Development; World Economic Forum; and IMF staff calculations.¹Structural capacity indicators are constructed as country averages of assigned scores from 1 to 3 on the nine variables of the structural reform heatmap byDarius and others (2010), where a higher score indicates a greater need for structural reforms. further exacerbated income disparities. On the other hand, social safety nets are likely to have cushioned the impact of unemployment on inequality. This suggests the following policy recommendations: • More inclusive labor markets will be required to narrow income inequalities. Evidence shows that a pervasive dual system, with a exible temporary workforce and a highly protected permanent workforce, can actually increase unemployment (Blanchard and Landier, 2002; Jaumotte, 2010; and Dao and Loungani, 2010). Combining that evidence with the analysis here suggests that reforms to rebalance employment protection—with a view to supporting job creation—by relaxing protection on regular workers while enhancing it for temporary workers would be bene cial for income equality, too. Improving wage-bargaining arrangements to allow wages to re ect productivity more closely in countries where they have grown most out of line would also help. • Active labor market measures could help reduce structural unemployment. Longer unemployment duration poses a risk of entrenching cyclical unemployment into a structural phenomenon as workers lose human capital and become detached from the labor force. Lam (forthcoming) found evidence of the effectiveness of certain active 17
    • REGIONAL ECONOMIC OUTLOOK: EUROPE Box 1.3 (concluded) Determinants of the Gini Coefficient (1) (2) (3) (4) (5) (6) (7) Unemployment 0.21 * 0.46 *** (0.12) (0.09) Long-term unemployment 0.50 *** (0.15) Short-term unemployment 0.38 * (0.22) Employment -0.15 *** -0.22 *** (0.06) (0.04) Women employment -0.16 *** (0.03) Youth employment -0.09 *** (0.03) Temporary contract employment 0.13 * (0.07) Social expenditures to GDP -0.76 *** -0.86 *** -0.87 *** -0.71 *** -0.64 *** -0.81*** -0.80 *** (0.08) (0.08) (0.08) (0.07) (0.08) (0.08) (0.11) Population share with at least -0.09 *** -0.08 *** -0.08 *** -0.09 *** -0.08 *** -0.08 *** -0.04 secondary education (0.03) (0.03) (0.03) (0.03) (0.03) (0.03) (0.04) Constant 58.47 *** 47.97 *** 48.49 *** 64.00*** 56.27 *** 55.53 *** 47.37 *** (0.03) (2.28) (3.20) (2.24) (2.67) (3.24) Observations 107 107 104 107 107 107 83 Adjusted R-squared 0.68 0.65 0.65 0.67 0.68 0.61 0.51 Note: Standard errors are in parentheses; * denotes significance at the 10 percent level, ** denotes significance at the 5 percent level, *** denotes significance at the 1 percent level. The equations include time dummies and are estimated using two-stage least squares with instrumenting for social expenditures with size of government. labor market measures, such as job-search assistance, training, and incentives to private sector employment, in improving employment rates and, in turn, countering structural unemployment. • The young need to be better integrated into the labor market. Policies could ensure better integration between employment services and the education system through outreach programs, training, apprenticeships, and access to job-search assistance measures.hurdles to entering closed professions and decisively • The lending capacity and pricing of the facilities ghting tax evasion will level the playing eld, too. were adjusted. Policymakers committed toFinally, tighter regulation on banks will ensure that increasing the effective lending capacity of thethe fallout from excessive risk taking by a few does EFSF to €440 billion—but without yet specifyingnot have to be shouldered by taxpayers. how. The lending capacity of the European Stability Mechanism (ESM), the successor to the EFSF beyond 2013, will reach €500 billion usingA Stronger Euro Area-Wide Safety Net a combination of paid-in capital, callable capital,European leaders took further steps to strengthen and guarantees. Pricing for ESM loans will bethe crisis management framework at their March in line with IMF pricing principles. Accordingly,2011 summit, but a number of elements of the the loan conditions for Greece have been relaxedrequired comprehensive package remain to be through a decrease in the interest rate and anclari ed. The main new elements are threefold. extension in maturity, but not those for Ireland.18
    • 1. ADVANCED EUROPE: TACKLING THE SOVEREIGN CRISIS• Decisions to provide nancing under the and banking risks. The agenda includes reducing ESM will be made by mutual agreement in the uncertainty about asset quality, increasing capital Eurogroup—by which non-abstaining member buffers of viable banks, and identifying and states must agree unanimously—on the basis of resolving insolvent banks. While the July 2010 EU debt sustainability analysis, which will involve the stress tests increased transparency with regard to IMF. In addition to lending to member countries, banking sector exposures, they failed to identify the euro area-wide facilities will be allowed to the most pressing risks, as evidenced in Ireland participate in primary markets in the context where the two largest banks—at the core of the of a program with strict conditionality, on an country’s dif culties—passed the stress tests. The exceptional but yet-to-be de ned basis. new round of stress tests to be released in June 2011 will need to be far more probing. And to give• Private sector involvement in the context of teeth to these tests, member states need to put in ESM loans will remain an action of last resort, place credible and speci c ex ante plans to deal with decided on a case-by-case basis consistent with the vulnerable institutions identi ed by the stress IMF policies, and nancing will be provided tests. In some countries, such as Ireland, Spain, and only if debt sustainability is demonstrated to the United Kingdom, national supervisors have be achievable. Collective actions clauses will already moved ahead. But in many other countries, be introduced starting in June 2013 and ESM the resolve to put the banking sector on a stronger loans will enjoy preferred creditor status. footing still needs to be demonstrated.Clearer parameters for the crisis management An additional issue is that nancial integration inmechanisms are certainly welcome but challenges EU banking markets remains incomplete. Whilenow lie in their implementation. The larger effective capital ows cross borders with little impediment,size of the EFSF should bolster market con dence, and banks transact freely in the money market,provided the mechanism by which this is secured other elements of the nancial system, includingis clari ed as soon as possible, and a decision on portfolio allocation, securitization, and retailadapting the interest rate charged on EFSF loans banking, remain very much national affairs.taken to help support scal sustainability. Beyond Moreover, apart from some regional clusters,2013, the proposed permanent facility, with its cross-border mergers and acquisitions are stillemphasis on prevention and early support, provides limited. This is unfortunate because deepera robust and orderly framework for assisting nancial integration carries the potential to alleviateeuro area members, including through strict some of the current banking sector weaknesses,conditionality to support discipline. To broaden the allowing, in particular, for the injection of freshavenues of support, though, some added exibility capital in circumstances where domestic sourcesin the instruments would be helpful. Additionally, are constrained. Clearing the obstacles to furtherin the shorter run, the interdependence between nancial integration will require rapid progress onnational banking systems and sovereigns remains the single rulebook for banks and harmonization ofunaddressed, and the onus of dealing with nancial supervisory practices. Standardization of productssector issues was left squarely with the national and more uniform consumer protection regimes areauthorities, despite the high potential for cross- also needed (see Chapter 3 for more details).border contagion. The need for an integrated, pan-EuropeanAccelerate Financial Sector Reforms approach to supervision and regulation has become even more evident. The European Supervisoryand Resume Financial Integration Authorities (ESAs) and European Systemic RiskIndeed, addressing weaknesses in the banking Board (ESRB)—all launched in January 2011—sector remains a prerequisite for breaking the will provide much needed tighter coordinationnegative interaction between sovereign debt risks of nancial supervision and macroprudential 19
    • REGIONAL ECONOMIC OUTLOOK: EUROPEpolicies within the euro area and the EU. Adequate of cross-border EU credit institutions, therebyresources, good information gathering and sharing, underpinning a truly single nancial market whileand focused coordination of their activities will be maintaining nancial stability.critical to the success of these new institutions.Moving toward a robust and exible framework Restore Fiscal Healthfor crisis management and resolution, with Securing public debt sustainability constitutesappropriate tools and mandates to intervene another vital ingredient to an enduring solution toand resolve ailing institutions at an early stage, is the crisis. With the recovery gradually broadening,equally urgent. The EU proposal to harmonize now is the time to start reconstituting the scalthese tools across countries is the right step buffers that proved essential during the recessiontoward ensuring more orderly ex ante solutions. and to secure medium-term sustainability. AbsentBut more needs to be done to progress from such action, markets would feel increasinglya setting structured along national lines to an uncomfortable funding ever-rising public debtintegrated EU framework that fully addresses in Europe—as they did in the most vulnerableunavoidable coordination problems. Clear rules euro area countries—in turn, jeopardizing thefor allocating losses to private stakeholders and recovery. Getting the speed, size, and compositionsharing the burden of potential public support of the scal adjustment right is imperativeamong member states are still missing; so are too. Sovereigns that have come under marketmechanisms for rapid nancing of resolution scrutiny have had no choice but to front-load theefforts—including through a deposit guarantee consolidation, but other European countries canscheme prefunded by the industry. Ultimately, afford to phase in the tightening to smooth overonly a European Resolution Authority would be time the negative impact on domestic demand andable to deal cost effectively with the resolution employment. Figure 1.11 Selected Advanced European Countries: Changes in General Government Fiscal Deficits, 2010–13 (Percentage points of GDP) 2 2 2 2 Changes in General Government Fiscal Deficits Changes in General Government Primary Deficits and Expenditures 0 0 0 0 -2 -2 -2 -2 -4 -4 -4 -4 Primary deficit -6 -6 -6 -6 2013 over 2010 adjustment Primary expenditures 2011 over 2010 adjustment -8 -8 -8 -8 Euro area Other advanced Euro area Other advanced EA4¹ EA4¹ (without EA4) economies -10 (without EA4) economies -10 -10 -10 Germany Italy Cyprus Austria Malta Greece Spain Portugal Iceland Israel Norway Italy Cyprus Austria Slovak Republic France Netherlands Finland Luxembourg Belgium Ireland² United Kingdom Sweden Switzerland Slovak Republic France Netherlands Germany Finland Malta Luxembourg Belgium Ireland² Greece Spain Portugal Iceland Israel Sweden Norway Switzerland United Kingdom Source: IMF staff calculations. 1 Greece, Ireland, Portugal, and Spain. 2 Excluding bank support measures for Ireland.20
    • 1. ADVANCED EUROPE: TACKLING THE SOVEREIGN CRISIS Table 1.3 Advanced European Countries: Main Macroeconomic Indicators, 2009–12 (Percent) General Government Overall Current Account Balance to GDP Balance to GDP¹ 2009 2010 2011 2012 2009 2010 2011 2012 Advanced European economies² 0.5 0.8 0.9 0.9 -6.3 -6.1 -4.5 -3.6 Euro area -0.6 -0.6 0.0 0.0 -6.3 -6.1 -4.4 -3.6 Austria 2.9 3.2 3.1 3.1 -3.5 -4.1 -3.1 -2.9 Belgium 0.8 1.2 1.0 1.2 -6.0 -4.6 -3.9 -4.0 Cyprus -7.5 -7.0 -8.9 -8.7 -6.0 -5.4 -4.5 -3.7 Estonia 4.5 3.6 3.3 3.1 -2.1 0.2 -1.0 -0.7 Finland 2.3 3.1 2.8 2.6 -2.9 -2.8 -1.2 -1.1 France -1.9 -2.1 -2.8 -2.7 -7.6 -7.7 -6.0 -5.0 Germany 5.0 5.3 5.1 4.6 -3.0 -3.3 -2.3 -1.5 Greece -11.0 -10.4 -8.2 -7.1 -15.4 -9.6 -7.4 -6.2 Ireland -3.0 -0.7 0.2 0.6 -14.4 -32.2 -10.8 -8.9 Italy -2.1 -3.5 -3.4 -3.0 -5.3 -4.6 -4.3 -3.5 Luxembourg 6.7 7.7 8.5 8.7 -0.7 -1.7 -1.1 -0.8 Malta -6.9 -0.6 -1.1 -2.3 -3.7 -3.8 -2.9 -2.9 Netherlands 4.6 7.1 7.9 8.2 -5.4 -5.2 -3.8 -2.7 Portugal -10.9 -9.9 -8.7 -8.5 -9.3 -7.3 -5.6 -5.5 Slovak Republic -3.6 -3.4 -2.8 -2.7 -7.9 -8.2 -5.2 -3.9 Slovenia -1.5 -1.2 -2.0 -2.1 -5.5 -5.2 -4.8 -4.3 Spain -5.5 -4.5 -4.8 -4.5 -11.1 -9.2 -6.2 -5.6 Other EU advanced economies Czech Republic -1.1 -2.4 -1.8 -1.2 -5.8 -4.9 -3.7 -3.6 Denmark 3.8 5.0 4.8 4.8 -2.8 -4.9 -3.6 -2.6 Sweden 7.2 6.5 6.1 5.8 -0.8 -0.2 0.1 0.4 United Kingdom -1.7 -2.5 -2.4 -1.9 -10.3 -10.4 -8.6 -6.9 Non-EU advanced economies Iceland -10.4 -8.0 1.1 2.1 -9.0 -6.8 -4.6 -1.3 Israel 3.6 3.1 3.3 3.1 -5.6 -4.1 -3.2 -2.2 Norway 13.1 12.9 16.3 16.0 10.4 10.9 13.0 12.7 Switzerland 11.5 14.2 13.2 12.8 0.8 0.2 0.3 0.6 Memorandum European Union² -0.2 -0.1 -0.2 -0.1 -6.8 -6.6 -4.8 -4.0 Source: IMF, World Economic Outlook database. ¹ Net lending only. Excludes policy lending. ² Weighted average. Government balance weighted by purchasing power parity GDP; current account balance by U.S. dollar-weighted GDP.Along this metric, current plans are appropriately year and for 2012–13, while Germany approachesdifferentiated (Figure 1.11). Greece, Ireland, the task at a slower pace. For the euro area as aPortugal, and Spain, as well as the United whole, the scal improvement will reachKingdom—where the scal position deteriorated 1¾ percentage points of GDP this year andrelatively more during the recession—have ¾ percentage point the next two years (Table 1.3).committed substantial scal consolidation for this In addition, the expected composition of the 21
    • REGIONAL ECONOMIC OUTLOOK: EUROPEconsolidation in the euro area and other European Figure 1.12countries over the next three years is broadly Selected European Countries: Impact of Fiscalappropriate, with the bulk of the de cit reduction Policies on GDP Growth, 2011 12¹ (Percentage points)occurring through expenditure reductions. 1.0 1.0The negative impact of scal consolidation ongrowth is expected to be limited this year for 0.5 0.5most European countries, but more substantial in 0.0 0.02012—a suitable timing given the strengthening -0.5 -0.5recovery. Lagged effects from the stimulusmeasures still occurring in 2010 in most countries -1.0 -1.0will likely smooth the effects of the consolidation -1.5 Revenue 2011 -1.5 Expenditure 2011measures, with the drag on growth this year -2.0 Revenue 2012 -2.0 Expenditure 2012ranging from 1½ to 2 percentage points in Greece, Total 2011 Total 2012Portugal, and Spain to ½ percentage point or less -2.5 -2.5 Switzerland Italy Spain Ireland France Austria Greece Belgium Sweden Portugal Germany Netherlands United Kingdom²in Austria, Germany, Ireland, and Switzerland(Figure 1.12).Still, these scal consolidation strategies will onlyfully work if embedded in credible medium-term Source: Ivanova and Weber (forthcoming), based on IMF, World Economicplans. Some countries—such as Greece, Ireland, Outlook database. ¹ The approachapplies multipliers to the changes inPortugal, and Spain, but also Austria, France, public expenditure and revenue ratios to GDP, both in the domesticGermany, Italy, and the United Kingdom—have country and in its trade partners, to derive the impact on growth. Fiscal policy affects growth in the same year and in the following year (laggedalready elaborated speci c consolidation plans effect).beyond this year. Others have yet to esh ² United Kingdom estimates use weighted average of fiscal year numbers.them out.Set the Stage for Gradual MonetaryPolicy Normalization Figure 1.13With the recovery in train, monetary policy should Selected European Countries: Residentialalso move closer to normalization. In countries Real Estate Pricesmost advanced in the recovery cycle, central (Percent change, in real terms)banks have already started raising policy rates France(for example, Israel, Norway, and Sweden). The Finland 2010:Q4 (year-over-year)¹ECB has recently followed suit as the output gap Austria 2000–07(year-over-year Switzerland average)²in the euro area is gradually closing—even after Swedentaking into account scal consolidation. In a few Belgiumcountries both inside and outside the euro area, Portugal Germanystrong momentum in mortgage credit and housing United Kingdomprices highlights the risk that assets could become Netherlands Italyovervalued again when loose monetary conditions Spainare in place for too long (for example, Austria, Greece IrelandFinland, France, Sweden, and Switzerland) (Figure -15 -10 -5 0 5 10 151.13). Conversely, in the United Kingdom, where Sources: Bank for International Settlements; Organization for Economicthe recovery is currently more tepid and scal Cooperation and Development; Global Property Guide; and national sources. ¹Latest data for Belgium, Finland, Greece, Ireland, Italy, and the Netherlandstightening stronger, policy rate normalization may are 2010:Q3.need to proceed more slowly. ²Average data for Austria are 2001–07.22
    • 1. ADVANCED EUROPE: TACKLING THE SOVEREIGN CRISIS Table 1.4 Selected European Countries: Headline Inflation and Contribution of Food and Fuel Prices Dec-09 Feb-11¹ of which: Contribution of which: Contribution Inflation from food and fuel Inflation from food and fuel Euro area 0.9 0.1 2.4 1.8 United Kingdom 2.8 0.7 4.0 1.7 Sweden 2.8 0.9 1.2 0.7 Denmark 1.2 0.1 2.6 1.7 Switzerland 0.2 -0.2 0.5 0.4 Sources: Eurostat; and IMF staff caclulations. ¹ For United Kingdom, data are for January 2011.In the shorter term, commodity price increases Strengthen Preventive Surveillancepose a challenge to the anti-in ation credentials In the run-up to the crisis, the Stability and Growthof central banks: following the recent surge in Pact (SGP) failed to prevent the trend increasecommodity prices, fuel and food in ation now in public debt. Stronger enforcement, as well asaccounts for between half and three-quarters of required corrective actions on a preemptive basis—current headline in ation across Europe, in sharp even before the Excessive De cit Procedure iscontrast with just a year ago (Table 1.4). Although activated—and until medium-term objectivescore in ation is projected to remain low, and the are reached, will go some way to improving itsimpact of recent increases in commodity prices effectiveness. However, national scal frameworksshould prove temporary, central banks will have must also be strengthened, given memberto keep a watchful eye on wage developments and states’ reluctance to relinquish additional scalin ation expectations for potential second-round prerogatives to the center. Some countries haveeffects. Removal of automatic wage indexation announced their intentions to introduce nationalmechanisms in countries where they are still in scal rules (for example, Germany and France).place (for example, Spain) would help prevent these There is also room to strengthen scal governancesecond-round effects from materializing. arrangements, transparency, and public nance management at the national level. The planned EUIn the euro area, remaining fragility in the nancial directive to de ne minimum standards and goalssystem could hold growth back, justifying a exible for such frameworks should help ensure they areapproach to exiting extraordinary crisis measures. fully in line with common objectives.The eventual exit will need to occur gradually asnational actions to strengthen banking sectors are Coordination fell short of identifying the broaderimplemented and systemic uncertainty recedes. risks of growing macroeconomic imbalancesDepending on these, the ECB may need to within the EU, and even more important, withinextend further in time its regime of full-allotment the euro area. As further detailed in Chapter 3,re nancing for some of its liquidity operations, rather than a lack of scal integration, it was thewhile re ning its collateral framework to discourage inability of national authorities to react to localsystemic bidding, minimize distortions to market- developments in credit, demand, and wages that ledbased bank nancing, and avoid moral hazard to the buildup and eventual bursting of imbalancesassociated with unlimited liquidity provisions. in some countries, with detrimental consequencesMeanwhile, macroprudential policies will need to for the area as a whole. The new Excessiveplay a larger role in mitigating risks in member Imbalance Procedure should be strengthened tocountries where these conditions encourage less provide an effective platform for discussing andcautious lending behaviors. coordinating national responses at the EU level. 23
    • 2. Emerging Europe: Underwriting a Solid RecoveryEmerging Europe returned to growth last year, but Exports Were Key for Getting the Recoveryperformance varied widely across the region, re ecting the Under Way …idiosyncratic legacies of previous boom-bust cycles. For 2011and 2012, an economic expansion of 4¼ percent is projected Exports expanded by a solid 9.3 percent, puttingwith much less disparity in intraregional growth, as domestic legs under the recovery in emerging Europe.demand takes over as the main driving force. Policymakers’ Exports were the rst demand component toemphasis should be on protecting the solidifying recovery rebound following the 2008–09 crisis, buoyedagainst still-considerable downside risks from unsettled by the pickup in growth of critical trading partnersglobal and euro area nancial markets and from reemerging in advanced Europe, especially Germany.in ationary pressures. To this end, they need to tackle scal By end-2010, export volumes matched or exceededand nancial sector vulnerabilities. Fiscal policy should precrisis levels in most countries. In contrast, thesupport monetary policy to the extent possible to stave off recovery of domestic demand came later and oftenprice pressures in the wake of high global commodity prices struggled to sustain itself (Figure 2.1).1and narrowing output gaps. For the many countries hard hit In an encouraging sign, average export growthby the 2008–09 crisis, bringing down unemployment while during 2009–10 outpaced growth of tradingreorienting their economies toward the tradable sector remains partner imports (Figure 2.2). Export sectorsan ongoing task. seem to be generally competitive and able to gain share in their traditional markets, expand beyond them, or improve the quality of their productDevelopments in 2010 mix. This speaks to competitiveness gains fromOn the Back of an Overall Favorable External postcrisis real devaluations. Relative incentives to produce tradables have also improved given thatEnvironment, Emerging Europe Turned the pro t margins for nontradables fell sharply in theCorner in 2010 aftermath of the 2008–09 crisis.Emerging Europe put the deep recession of 2009 rmly behind it and expanded by 4.2 percent … While Domestic Demand Developments Werein 2010, broadly in line with projections in the Mixed across the Regionprevious Regional Economic Outlook. Exportsbene ted from the revival of global demand, while On average, domestic demand growth in the regionfeared spillovers from sovereign debt trouble in the was a strong 5.8 percent. However, this averageeuro area periphery did not materialize. Recoveries primarily re ects powerful dynamics in Poland andof domestic demand were uneven across the region Turkey, both countries where precrisis overheatingthough, giving rise to large growth disparities. had been more contained, and in the EuropeanPoland and Turkey grew strongly, at higher-than- CIS countries, which bene ted directly or indirectlyexpected rates of 3.8 and 8.2 percent, respectively. from the rebound of commodity prices. InA heat wave and surging oil prices had opposing contrast, domestic demand still declined in theeffects on Russia’s growth, which came in at rest of the region, albeit not as much as in 2009.4 percent. The recovery remained in its infancy inmuch of southeastern Europe. 1 The early revival of exports did not always translate into a sizable contribution of net exports to economic growth in 2010. The subsequent pickup of domestic demand was strong in some countries, reducing theNote: The authors of this chapter are Phakawa Jeasakul, growth contribution or even turning it negative for theChristoph Klingen, and Jérôme Vandenbussche. year as a whole. 25
    • REGIONAL ECONOMIC OUTLOOK: EUROPEFigure 2.1 Figure 2.2Emerging Europe: Contributions to GDP Growth, Emerging Europe: Real Exports and Trading20101 Partner Imports, 2009–10(Percentage points) (Real annual average growth in percent) 15 Private consumption 15 20 20 12 Government consumption 12 Trading partner imports 9 Gross fixed capital formation² 9 15 Exports 15 Net exports 6 GDP 6 10 Difference 10 3 3 0 0 5 5 -3 -3 0 0 -6 -6 -9 -9 -5 -5-12 -12 -10 -10 Turkey Belarus Moldova Ukraine Russia Poland Albania Serbia Lithuania Hungary Montenegro Latvia Average Bosnia & Herzegovina Macedonia, FYR Bulgaria Romania Croatia Weighted average Albania Macedonia, FYR Bosnia & Herzegovina Romania Lithuania Bulgaria Serbia Moldova Russia Hungary Poland Latvia Belarus Turkey Montenegro Croatia Ukraine Average Weighted averageSources:IMF, World Economic Outlook database; and IMF staff estimates. Sources: IMF, World Economic Outlook database; and IMF staff estimates.1 Contributions from inventories and statistical discrepancy not shown.²Investment in the case of Macedonia, FYR. adjustment. Differences in the policy stance alsoHigh unemployment, restricted credit, subdued played a role. Global commodity prices heavilycon dence, and lack of policy space all weighed in uenced developments in Russia (Box 2.1).on spending (Figures 2.3 and 2.4).Divergent domestic demand developments were Inflation Is Picking Up …also responsible for the region’s stark intraregional Disin ation is giving way to a pickup of in ationgrowth disparities. Economic performance ranged as the global recovery takes hold (Figure 2.5).from growth of more than 7½ percent in Belarus In ation fell sharply in the wake of the 2008–09and Turkey to contractions of about 1½ percent in crisis, reaching a trough between March 2009Croatia and Romania. This variation mainly re ects (Albania and Hungary) and July 2010 (Polandthe legacy of boom-bust cycles that differed across and Russia). It has since drifted up to reachcountries in size, timing, and speed of postcrisisFigure 2.3 Figure 2.4Emerging Europe: Real Private Sector Emerging Europe: Unemployment RateCredit Growth1 (Seasonally adjusted, percent)(Percent, 12-month change) 20 20 50 50 18 18 40 133.6 40 December 2010 16 September 2008 16 30 30 20 20 14 14 10 10 12 12 0 0 10 10-10 Latest (Nov. 2010, Dec. 2010, Jan. 2011, or Feb. 2011) -10 Average Jan. 2007–Sep. 2008-20 -20 8 8 Belarus Turkey Moldova Albania Serbia Kosovo Russia Poland Macedonia, FYR Croatia Romania Bulgaria Ukraine Bosnia & Herzegovina Hungary Latvia Montenegro Simple average Weighted average Lithuania 6 6 4 4 2 2 0 0 Croatia Latvia Turkey Lithuania Hungary Bulgaria Poland Russia Romania UkraineSources: IMF, International Financial Statistics; and IMF staff calculations.1 Derived from stock data in domestic currency, adjusted by CPI inflation.May include valuation effects from foreign-currency-denominated loans. Sources: Haver Analytics; and IMF, World Economic Outlook database.26
    • 2. EMERGING EUROPE: UNDERWRITING A SOLID RECOVERYBox 2.1Russia: A Tepid Recovery from a Deep RecessionRussia’s recent experience, during both the crisis and the recovery, has differed notably from that of othercountries in the region. These differences re ect Russia’s reliance on commodity exports, signi cant policyshortcomings, and some one-off factors.CrisisDuring the global crisis, Russia’s swing in growth was appreciably larger than in most other countries ( rst gure). This weak performance occurred despite Russia’s formidable reserve holdings and large current accountand scal surpluses before the crisis—characteristics that, other things equal, should have put it in a relativelystrong position to weather the storm. The output collapse also de ed the relatively strong policy response by theauthorities—a massive scal stimulus, large-scale liquidity support to the banking system, and deft managementof the ruble exchange rate (at the cost of about US$200 billion in reserves), which bought time for the privatesector to hedge its foreign exchange exposures.The main explanation for the depth of the slump during the crisis is Russia’s dependence on its oil and gassectors, which left it highly exposed to the sharp decline in oil prices in the second half of 2008. Although energydirectly accounts for about two-thirds of Russia’s exports and for an estimated 20 percent of GDP, the overallimpact of oil prices on the Russian economy extends beyond these numbers as, indirectly, oil prices are keydeterminants of capital ows, credit availability, investment, and incomes. In addition, oil prices are importantfor public nances because every US$10 per barrel decline in oil prices reduces scal revenues by some 62 billionrubles (about 1½ percent of GDP).The abrupt drop in oil prices during the crisis highlighted the connection between oil prices and capital owsto Russia when Russian corporations hedged their uncovered foreign currency exposures, triggering massivecapital out ows. In turn, as cheap foreign funding dried up, long-standing weaknesses in the banking sector wereexposed and private sector credit collapsed, thereby compounding the recession.At the same time, as in many other countries in the region, adjustment from precrisis overheating—which inRussia had been fueled by expansionary scal and monetary policies owing to weak policy frameworks—furtherdeepened the downturn.RecoveryRussia has experienced only a sluggish recovery from the recession thus far. Real GDP grew 4 percent in 2010,about half of which re ected carryover from 2009. Even though estimates of potential growth have beenlowered from about 5½ percent before the crisis to about 4 percent at present, this performance could beregarded as somewhat disappointing when considering the large remaining output gap, the continued highlyaccommodative policies of the government, and strongly rebounding world oil prices. Several factors havecontributed to this outcome.First, a historic heat wave and drought in the summer temporarily derailed Russia’s recovery. The severe weather,which lasted for several weeks, affected harvests, construction activity, industrial production, and retail activity,and was the key contributor to a sharp contraction of real GDP in the third quarter (0.9 percent, quarter overquarter, seasonally adjusted). The dismal third quarter had a large downward effect on average GDP growthfor the year in 2010, even though some catching up from summer production losses likely took place in thefourth quarter.Note: The main author of this box is David Hofman. 27
    • REGIONAL ECONOMIC OUTLOOK: EUROPE Box 2.1 (continued) Second, Russia continued to experience substantial GDP Growth, 2006–11 capital out ows in 2010, in sharp contrast to many (Percent) other emerging market economies and despite high oil 15 15 prices. In addition to scheduled debt repayments, the out ows likely re ected investors’ renewed focus, in the 10 10 wake of the crisis, on the lack of progress in addressing 5 5 the economy’s fundamental underlying problems. These problems include, in particular, the poor investment 0 0 climate—as evidenced by Russia’s consistently low Russia CIS excluding Russia -5 -5 scores on the World Bank’s Doing Business indicators Central and Eastern Europe (where Russia ranks 123rd for overall ease of doing -10 -10 2006 2007 2008 2009 2010 2011 business) and other international comparisons—and Sources: National authorities; and IMF staff calculations. persistent weaknesses in monetary and scal policy frameworks. Non-oil Fiscal Deficits and Target, 2008–13 Third, the slow recovery also re ects ongoing problems (Percent of GDP) in the banking system, including a large overhang of 0 0 nonperforming and restructured loans. Credit growth -2 -2 remained stagnant through the rst quarter of 2010 and -4 -4 recovered only timidly in the course of the year. -6 -6 Fourth, structural reforms—much needed to develop the -8 -8 economy’s productive capacity and develop new engines -10 Long-term non-oil -10 deficit target = 4.7 of sustainable growth—remained stalled, and investors -12 percent of GDP -12 perceived the prospects for their reinvigoration to be -14 Non-oil deficit -14 Target -16 limited in the run-up to the 2012 elections. -16 2008 2009 2010 2011 2012 2013 Policies Sources: Russian authorities; and IMF staff calculations. Against the background of this fragile recovery, the Inflation: CPI, Food and Core, 2007–11 Russian authorities have continued their exit from crisis- (Annualized seasonally adjusted three-month moving average related policy support. However, the exit strategy has growth rate) not been suf ciently bold and is undermined by weak 35 35 policy frameworks, posing further risks to a sustainable 30 30 recovery. 25 25 20 20 On the scal policy side, the withdrawal of the massive 15 15 stimulus provided during the crisis has been lagging. 10 10 Most of the scal expansion during the crisis took the 5 CPI 5 form of permanent measures, which increases the risk Food 0 Core (trimmed mean) 0 that the stimulus will not be reversed and that scal -5 -5 policy will become procyclical as the economy recovers 2007 2008 2009 2010 2011 further. At 12.9 percent of GDP, the 2010 federal Sources: Russian authorities; and IMF staff calculations. government non-oil de cit—which should be the anchor for scal policy in an oil-producing country like Russia, given the volatility of oil prices and the nonrenewable nature of oil—remains nearly 8 percentage points higher than the government’s long-term target of 4.7 percent of GDP, a target that remains appropriate (second gure). The 2011–13 budget envisages a reduction in the federal non-oil de cit of only 2.5 percent of GDP over three years, mostly resulting from a signi cant hike in the payroll tax, a reduction in civil service28
    • 2. EMERGING EUROPE: UNDERWRITING A SOLID RECOVERY employment, and cuts in investment—a combination of adjustments that is, overall, unlikely to be supportive of long-term growth. On the monetary side, the Central Bank of Russia (CBR) has been slow to respond to rising in ation, owing in part to concerns about growth. Monetary easing was paused in June but policy rates effectively remained on hold for the remainder of the year despite a surge in in ation from a low of 5½ percent in July to 9.5 percent in March 2011 (third gure). Although spikes in food and petroleum prices largely drove the sharp increase in in ation, core in ation has also been steadily on the rise, pointing to signi cant second-round effects. Following an initial increase in the CBR deposit rate by 25 basis points in late December 2010, in February 2011, the CBR raised both the deposit rate and several of its key lending rates by 25 basis points, more clearly signaling the start of a tightening cycle. The CBR also raised reserve requirements in February and March. In the nancial sector, the extraordinary liquidity support extended to banks during the crisis has been withdrawn and regulatory forbearance is being unwound. However, banks remain fettered by bad loans, with weak balance sheets weighing on credit growth. Delays in implementing consolidated supervision and connected lending regulations amplify nancial sector risks. Against this background, the outlook remains for a moderate recovery in Russia with GDP growth projected to reach 4.8 percent in 2011. Higher-than-projected oil prices could result in a more favorable growth outcome in the short term, but achieving a sustainable recovery will require completion of the exit from crisis-related support, strengthening scal and monetary policy frameworks, and reinvigorating the structural reform agenda. Regarding the latter, President Medvedev’s recently proposed 10-point action plan to improve Russia’s investment climate—which includes measures to enhance governance and business infrastructure, and reduce the in uence of the state in the economy—is an encouraging step in the right direction, but effective and timely implementation of these measures is key.Figure 2.5 conditions have yet to reassert their dominanceEmerging Europe: Inflation, 2008–10 over price developments. Output gaps are still(Percent, year-over-year) substantially negative in most countries, or, where14 14 they are not, strong demand is accommodated12 12 by wider external de cits. Nonetheless, in ation10 10 currently runs above target in Albania, Belarus, Weighted average 8 8 Moldova, Poland, Serbia, Romania, and Russia, 6 Average 6 although indirect tax hikes explain much of 4 4 Romania’s overrun. In ation in Serbia ared up 2 2 even while its output gap was strongly negative, 0 0 amid currency weakness—a reminder that spare Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Apr-10 Jul-10 Oct-10 capacity by itself offers insuf cient protectionSource: IMF, Information Notice System. from in ation.7.1 percent at end-2010, ½ percentage point … And External Imbalances Remain Mostlymore than anticipated in the previous Regional in Check, Often Easily Financed by RevivingEconomic Outlook. So far, price developments re ect Capital Flowsprimarily global factors, such as food and energyin ation, as well as the one-off effects from The regional current account deficit came toindirect tax hikes.2 Countries’ domestic demand ½ percent of GDP in 2010—little changed from the year before and preserving the large2 Indirecttax increases are estimated to have contributed external adjustment of 2008–09. Countries0.6 percentage points. with externally driven recoveries generally saw 29
    • REGIONAL ECONOMIC OUTLOOK: EUROPEtheir current account positions improve further. were broadly stable for the region as a whole—Russia and Ukraine benefited from pronounced appreciation was strongest in Turkey (4 percent),terms-of-trade gains and their current account and depreciation was largest in Serbia (9 percent).balances did not change dramatically despite a On average, they remained 14.5 percent depreciatedstrong rebound in domestic demand. However, from their peak in August 2008.buoyant domestic demand translated into sharply Capital in ows primarily took the form of portfoliowider external deficits in Belarus, Moldova, investment. Traditionally, portfolio investmentand Turkey. Poland’s current account deficit makes up less than 10 percent of in ows to thealso widened. region, with bank/other investment and foreignCapital ows are returning to the region, direct investment (FDI) accounting for the rest inalbeit, compared with the boom years, in more roughly equal shares. In 2010, however, two-thirdsmodest amounts and in a more discriminatory of the in ows were portfolio investment, withway (Figure 2.6). Poland and Turkey were the banks still in no mood to ramp up leverage andmain magnets for foreign investors, in light of direct investors more cautious about the region’stheir favorable recent growth records and the prospects. This eased the nancing of governmentaccessibility of their capital markets. However, de cits, although at the price of public nances nancially less integrated countries and economies becoming more vulnerable to the vagaries ofstill struggling to overcome the crisis or beset nancial markets.3by large vulnerabilities were shunned. Serbia, for Nine countries in the region maintain activeexample, suffered exchange rate weakness during or precautionary arrangements with the IMFmuch of last year. Russia, traditionally an important (Appendix). In light of selective and potentiallydestination for emerging market investors, could unstable capital ows, a number of countriesnot attract net in ows in 2010, amid a poor received balance of payments support from theinvestment climate and persistent weaknesses in its IMF. FYR Macedonia secured a precautionarymonetary and scal frameworks. credit line, and Poland renewed and augmentedExchange rate developments also re ected the its exible credit line in January 2011. The stand-return of selected capital in ows. Over the course by arrangement with Belarus was completedof the year, nominal effective exchange rates in March 2010, although the need for external adjustment has since resurfaced. Hungary’sFigure 2.6 program supported by the EU and the IMF lapsedEmerging Europe: Net Capital Inflows1 in October 2010.(Percent of GDP) Credit remains tight in the region, although with a 35 30 2010² 35 30 few exceptions. The worst of the credit crunch is 25 2009 25 20 15 2005:Q1–2008:Q2³ 20 15 over, but real credit still contracts in just under half 10 5 10 5 of the region’s economies. At the other end of the 0 0 -5 -5 spectrum, Belarus and Turkey experienced double--10 -21.4 -10-15 -15 digit growth. In between are a number of countries, Kosovo Belarus Moldova Turkey Latvia Albania Poland Montenegro Ukraine Bosnia & Herzegovina Macedonia, FYR Croatia Serbia Romania Hungary Bulgaria Russia Lithuania Weighted average such as Poland, that have returned to positive but moderate credit growth (Figure 2.3). In general, credit growth in the region remains constrained by 3 In 2007, nonresidents held more than 40 percent ofSources: Haver Analytics; and IMF, International Financial Statistics. Hungary’s public debt denominated in domestic currency,1 Excludes financial transactions with the IMF and the EU under Balanceof Payments support programs and SDR allocations. the highest share in the region. The crisis of 2008–09 was2 Data for Kosovo and Montenegro are 2010:Q1–Q3. particularly quick to spill over to Hungary when foreigners3 No data are available for Kosovo. exited the government bond market en masse.30
    • 2. EMERGING EUROPE: UNDERWRITING A SOLID RECOVERYrising nonperforming loans, already highly leveraged … And Monetary Policy Took First Steps towardborrowers, and the tightness of critical funding Tighteningfrom foreign parent banks. Between late-2008 andmid-2010, western banks reduced their exposure A number of countries tightened monetaryto emerging Europe by a cumulative 15 percent. policy. Poland and Russia stepped up their anti-A small increase in exposure occurred in the third in ationary rhetoric toward year-end as in ationquarter of 2010—the result of renewed ows to a rose and followed up with hikes of headline policyfew well-performing countries. rates early this year. Fast-growing Turkey raised reserve requirements and increased the volatilityEquity markets in emerging Europe generally of market interest rates, then subsequentlyperformed well in 2010 on the back of the global lowered policy rates, to defuse risk to nancialand regional recoveries, low global interest rates, and stability from capital in ows and rapid credita return of risk appetite. Unsurprisingly, economies growth (Box 2.2). Rate hikes in Hungary anddoing well or displaying strong indications of a Serbia responded to in ationary pressures, butdecisive turnaround recorded the best performance were also motivated by the need to alleviatein equity markets. Poland and Turkey, and to a lesser nancial strains (Hungary) and to continueextent Russia, fall in the rst category with equity building central bank credibility in the face ofmarket gains between 20 and 30 percent. By end- currency depreciation (Serbia). Albania hiked2010, stock market indices exceeded their precrisis policy rates in late March.peaks in Turkey and had some 20 percent to go inPoland and Russia. Sharply improved economic Poland, Serbia, and Turkey also adoptedprospects in Latvia, Lithuania, and Ukraine meant macroprudential measures to contain risky lendinglarge stock market gains and recovery levels similar and in ationary pressures. Turkey introducedto those in Poland and Russia. In contrast, stock ceilings for loan-to-value ratios for housing loansmarkets advanced little from their depressed and increased minimum payments on credit cardlevels in southeastern Europe, with its edgling balances. Poland’s regulators tightened criteria foreconomic recovery. Hungary’s nancial markets the assessment of retail loans and required highermoved sideways amid changing directions in debt-service-to-income ratios for foreign currencyeconomic policy. loans. The Serbian authorities moved to phase out a credit subsidy program. Most countries continued to phase out their crisis-Concerns about Deficits Motivated Fiscal related support measures for the banking sector,Consolidation … although lowered required reserve ratios remain common and outstanding liquidity support is stillThe region’s scal de cit narrowed from considerable in Belarus and Ukraine. Moreover,6.1 percent of GDP in 2009 to 4.5 percent of regulatory frameworks were strengthened inGDP in 2010. Most of the improvement was many countries.cyclical, as the recovery lifted revenues andRussia’s treasury bene ted from oil- and gas-related receipts, but many countries also adopted The Outlook for 2011 and 2012tightening measures. Fiscal consolidation effortsdiffered across countries: Albania, Bulgaria, Latvia, High frequency indicators point to a continuationLithuania, Moldova, and Romania all put in place of the recovery in 2011. Industrial productionmeasures in excess of 2 percent of GDP in an is currently expanding in most countries in theeffort to curb high de cits; Poland refrained from range of 5–15 percent, with little sign of loss ofdiscretionary scal policy changes; and Belarus momentum; industrial con dence is improvingand Russia actually loosened scal policy further too. Only in Croatia and Serbia are industrieslast year. still struggling to sustain growth. On the demand 31
    • REGIONAL ECONOMIC OUTLOOK: EUROPE Box 2.2 Turkey’s New Monetary Policy Strategy In response to surging capital in ows, the Central Bank of Turkey (CBT) stepped up its efforts to safeguard nancial stability. Differences in the phasing of business cycles around the world translated for Turkey into stronger domestic than external demand, a widening current account de cit nanced primarily through short- term in ows, and rapid credit expansion. Against this background, the CBT has emphasized both nancial and price stability in its policy decisions since November 2010. This is consistent with the CBT’s mandate in the Central Bank Law to enhance the stability of the nancial system, although price stability remains its primary objective. The CBT has also called for a coordinated response from the nancial supervision and scal authorities to the nancial stability concerns arising from large capital in ows. In the view of the CBT, the simultaneous achievement of price and nancial stability goals requires additional policy tools. The CBT saw the policy interest rate as unable to deliver both objectives simultaneously—the level appropriate to containing in ation could accentuate risks to nancial stability by attracting additional capital ows. The CBT has therefore expanded its toolkit, using the policy interest rate to achieve the in ation target while direct liquidity measures—reserve requirements and the CBT’s interest rate corridor—are assigned to moderating credit growth and lengthening the duration of capital ows and bank funding. In line with this strategy, the CBT’s monetary policy has several key elements: Greater volatility of short-term market interest rates. The CBT drastically cut its overnight borrowing rate (the rate at which banks place deposits at the CBT) by 400 basis points to 1¾ percent in early November to push down the short end of the yield curve. This measure was reinforced by periodic adjustments to the amount of auctioned repurchase agreements (repos) to generate greater volatility in short-term market interest rates within the now- wider interest rate corridor. The corridor was widened slightly further in December. Liquidity withdrawal. Required reserves on lira-denominated liabilities were raised in several steps from November to April to withdraw liquidity, while rates were differentiated by maturity to lengthen the duration of bank funding and broaden the base.1 In addition, daily preannounced foreign currency purchases by the CBT were sharply scaled back in steps from US$140 million in mid-December to US$50 million at the beginning of 2011, thereby reducing the creation of counterpart domestic liquidity. Lowering the policy rate. With headline in ation projected to decline sharply in the near term, the policy interest rate was reduced by ½ percentage point in December to curb the trend appreciation of the lira. A further cut of ¼ percentage point was made in January. The CBT regards its new strategy as similar in spirit to conventional in ation targeting. It considers the combination of tools—repo rate, required reserve ratios, interest rate corridor—as its new policy instrument, and that the mix can be adjusted as needed to secure both price and nancial stability. Moreover, it expects that the recently taken measures tightened the policy stance, with the higher required reserve ratios more than offsetting the loosening effect of the lower policy rate. Turkey’s new monetary policy strategy has achieved some success, but its ability to contain in ation and credit growth has yet to be proved ( gure). The strategy has been effective at moderating exchange rate pressures, as can be seen from the decoupling of the lira from other emerging market currencies since mid-November. Note: The main author of this box is Justin Tyson. 1 Proceeds from repos with foreign banks and domestic nonbanks were included in the base. As a result, the required reserve base is very comprehensive and includes all banks’ liabilities with the exception of proceeds from CBT and domestic bank repos.32
    • 2. EMERGING EUROPE: UNDERWRITING A SOLID RECOVERY Monetary and Exchange Rate Indicators 115 60 40 115 National Currency per U.S. Dollar Cumulative Liquidity Injections Since June 2010 (December 31, 2010 = 100) (Billions of Turkish Lira) 30 40 110 110 20 Turkey 20 10 Peers¹ 105 105 0 0 -10 -20 Change in government deposits 100 Change in reserve requirements² -20 100 Net CBT lending -40 Foreign exchange interventions -30 Net liquidity supply/base money (right scale) 95 95 -60 -40 Sep-10 Nov-10 Dec-10 Feb-11 Apr-11 Jun-10 Aug-10 Oct-10 Dec-10 Feb-11 Apr-11 9 9 10 10 Interest Rates Yield Curve 8 (Percent) 8 (Compounded rates in percent; polynomial trend) 9 Mar. 31, 2011 9 7 7 6 6 8 8 5 5 4 4 Oct. 28, 2010 7 Dec. 31, 2010 7 3 3 CBT overnight deposit rate 2 One-week repo rate 2 6 Jan. 19, 2011 6 Istanbul stock exchange repo rate 1 Istanbul stock exchange repo rate (10-day moving avg.) 1 One-month swap rate 0 0 5 5 Jun-10 Aug-10 Oct-10 Dec-10 Feb-11 Apr-11 0 5 10 15 20 25 30 35 40 45 Months to Maturity Sources: Bloomberg, L.P.; Central Bank of Turkey; and IMF staff calculations. ¹Simple average of Brazil, Chile, Colombia, Hungary, Indonesia, Poland, Korea, South Africa, and Thailand. ²Calculated as the net liquidity injection implied by July 2010, Sep., 2010, Dec., 2010 , Jan., 2011 and Feb., 2011 changes in the reserve requirement ratios. This decoupling likely re ects the lower average and higher volatility of returns on very short-term in ows (as can be seen from the initial decline in the short end of the yield curve and the increased variability in the market repo rate). However, rapid credit growth continues unabated, and the recent nominal depreciation will add to in ation pressures from a closed output gap and global commodity price increases. The limited progress made through March in slowing credit growth may be due in part to the cuts in the policy rate. This is because the CBT is injecting suf cient liquidity to enable banks to meet the higher required reserve ratios while also allowing interbank interest rates to settle, on average, near the new lower policy rate. Moreover, with banks borrowing more from the CBT, their marginal funding costs have fallen—because of the lower policy rate and exemption of CBT repos from required reserves—reducing the need for higher interest rates on bank loans. Market concerns about the effectiveness and sustainability of the lower policy rate may underpin the 200-basis-point increase in government bond yields in recent months.side, retail sales growth is rmly back in positive long-term averages. Indeed, senior loan of cersterritory everywhere except Croatia, Bulgaria, report higher demand for credit from enterprises.and Romania. Consumer con dence improved Demand for loans by households is also up,across the board, though often from low levels. though not yet in Romania. A long period withWith industrial production recovering, capacity ever-tighter credit standards seems to be drawingutilization has picked up and is now close to to a close. 33
    • REGIONAL ECONOMIC OUTLOOK: EUROPE Table 2.1 Emerging Europe: Growth of Real GDP, Domestic Demand, Exports, and Private Consumption, 2009–12 (Percent) Real Domestic Demand Real Private Consumption Real GDP Growth Growth Real Exports Growth1 Growth 2009 2010 2011 2012 2009 2010 2011 2012 2009 2010 2011 2012 2009 2010 2011 2012 Baltics2 -15.9 0.7 4.1 3.9 -26.2 1.6 5.0 4.1 -13.2 14.1 9.2 7.5 -20.1 -2.6 2.7 3.0 Latvia -18.0 -0.3 3.3 4.0 -27.6 -0.9 3.0 4.3 -14.1 10.3 7.0 5.7 -24.1 -0.1 3.0 4.0 Lithuania -14.7 1.3 4.6 3.8 -25.4 3.0 6.1 4.0 -12.7 16.3 10.5 8.5 -17.7 -4.1 2.5 2.4 Central Europe2 -0.1 3.3 3.6 3.4 -3.1 2.9 3.2 3.4 -7.4 11.0 7.5 6.7 0.2 2.0 3.2 3.3 Hungary -6.7 1.2 2.8 2.8 -10.8 -1.6 2.3 2.5 -9.6 13.9 9.3 8.7 -6.8 -2.6 1.5 2.2 Poland 1.7 3.8 3.8 3.6 -1.0 4.0 3.4 3.7 -6.8 10.2 7.0 6.2 2.0 3.2 3.6 3.6 Southeastern Europe– -6.6 -0.9 1.9 4.1 -12.8 -1.9 1.0 4.0 -6.9 14.0 9.4 8.0 -9.5 -1.5 1.7 4.0 EU2 Bulgaria -5.5 0.2 3.0 3.5 -12.7 -4.5 3.0 3.5 -11.2 16.2 9.8 7.5 -7.6 -1.2 3.6 4.0 Romania -7.1 -1.3 1.5 4.4 -12.9 -1.0 0.3 4.2 -5.3 13.1 9.3 8.2 -10.2 -1.7 1.0 4.1 Southeastern Europe– -3.0 0.8 2.5 3.6 -7.2 -3.3 1.3 3.4 -12.8 14.0 9.3 6.8 -4.2 -1.0 1.1 3.4 non-EU2 Albania 3.3 3.5 3.4 3.6 3.1 -8.0 4.1 2.6 -1.7 29.0 1.2 7.6 6.5 -5.1 3.3 2.4 Bosnia and -3.1 0.8 2.2 4.0 -6.4 -1.4 1.3 4.1 -6.2 9.7 6.0 4.8 -3.9 0.8 0.8 3.3 Herzegovina Croatia -5.8 -1.4 1.3 1.8 -9.3 -5.1 0.7 2.0 -16.2 4.1 3.3 2.1 -8.5 -1.2 0.1 0.5 Kosovo 2.9 4.0 5.5 5.2 ... ... ... ... ... ... ... ... ... ... ... ... Macedonia, FYR -0.9 0.7 3.0 3.7 -2.9 -1.1 2.4 3.8 -10.7 22.7 18.7 13.0 -3.9 1.1 2.4 3.9 Montenegro, -5.7 1.1 2.0 3.5 -16.9 -3.3 -1.2 1.2 -22.4 9.0 8.2 5.3 -13.4 6.8 -2.3 -0.1 Republic of Serbia, Republic of -3.1 1.8 3.0 5.0 -8.6 -1.2 0.9 4.8 -15.0 19.1 16.6 10.2 -2.4 -1.3 1.3 6.6 European CIS countries2 -8.2 4.2 4.9 4.6 -14.4 6.5 7.6 6.1 -7.3 10.0 3.4 4.2 -5.7 3.4 7.2 6.8 Belarus 0.2 7.6 6.8 4.8 -1.1 10.3 6.1 5.0 -9.0 5.1 13.3 4.7 0.0 8.6 6.9 6.9 Moldova -6.0 6.9 4.5 4.8 -18.6 9.6 5.9 5.5 -12.1 12.8 7.1 9.2 -8.0 9.0 5.8 5.3 Russia -7.8 4.0 4.8 4.5 -14.0 6.3 7.8 6.3 -4.7 10.2 2.4 3.8 -4.9 2.8 7.1 7.0 Ukraine -14.8 4.2 4.5 4.9 -22.6 6.2 6.3 5.3 -25.1 10.4 5.9 6.7 -13.9 5.9 7.5 5.3 Turkey -4.7 8.2 4.6 4.5 -7.2 12.2 5.3 5.1 -5.3 2.6 6.2 6.1 -2.2 7.3 6.1 5.7 Emerging Europe2,3 -5.9 4.2 4.3 4.3 -10.9 5.8 5.6 5.2 -7.3 9.3 5.4 5.4 -4.5 3.3 5.6 5.6 New EU member -3.5 2.2 3.0 3.5 -7.0 1.4 2.4 3.4 -9.0 13.0 8.3 6.8 -3.1 0.6 2.4 3.3 states2,4 Memorandum Czech Republic -4.1 2.3 1.7 2.9 -3.7 1.1 1.0 2.2 -10.8 18.0 10.3 6.3 -0.2 0.4 0.9 2.3 Estonia -13.9 3.1 3.3 3.7 -20.5 -3.8 3.5 3.7 -18.7 21.7 4.1 4.9 -18.8 -1.9 2.4 2.4 Slovak Republic -4.8 4.0 3.8 4.2 -7.9 2.7 1.8 3.6 -15.9 16.4 8.5 6.6 0.3 -0.3 2.3 3.8 Slovenia -8.1 1.2 2.0 2.4 -10.1 0.4 1.0 2.2 -17.7 7.8 6.8 5.7 -0.8 0.5 1.2 2.2 European Union2,5 -4.1 1.8 1.8 2.1 -4.2 1.3 1.0 1.6 -12.6 10.1 6.6 5.1 -1.7 0.8 1.2 1.6 Source: IMF, World Economic Outlook database. 1 Real exports of goods and services. 2 Weighted average. Weighted by GDP valued at purchasing power parity. 3 Includes Albania, Belarus, Bosnia and Herzegovina, Bulgaria, Croatia, Hungary, Kosovo, Latvia, Lithuania, FYR Macedonia, Moldova, Republic of Montenegro, Poland, Romania, Russia, Republic of Serbia, Turkey, and Ukraine. 4 Includes Bulgaria, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, Slovak Republic, and Slovenia. 5 Includes Austria, Belgium, Bulgaria, Cyprus, Czech Republic, Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Ireland, Italy, Latvia, Lithuania, Luxembourg, Malta, Netherlands, Poland, Portugal, Romania, Slovak Republic, Slovenia, Spain, Sweden, and the United Kingdom.34
    • 2. EMERGING EUROPE: UNDERWRITING A SOLID RECOVERYGrowth Should Hold Steady at Slightly More Than Figure 2.7 Emerging Europe: Contributions to GDP4 Percent This Year and Next … Growth, 2011–121 (Percentage points, annual average)Growth projections for 2011 and 2012 havebeen revised up slightly for emerging Europe, to 10 Private consumption 10 8 Government consumption 84.3 percent in both years (Table 2.1). 6 Gross fixed capital formation² Net exports 6 GDP 4 4• Exports will likely continue to support growth. 2 2 Trading partner imports are projected to 0 0 -2 -2 expand by 6½ percent, down from the rebound -4 -4 Belarus Ukraine Turkey Russia Moldova Lithuania Serbia Poland Latvia Albania Macedonia, FYR Bulgaria Romania Hungary Montenegro Croatia Average Bosnia & Herzegovina Weighted average rates of last year but still solid. The region’s exporters are expected to retain much of the edge they gained in the previous two years.• Domestic demand will become the main pillar of growth as it catches up to recover in those Sources: IMF, World Economic Outlook database; and IMF staff estimates. countries where it had languished. Private 1 Contributions from inventories and statistical discrepancy not shown. consumption and investment are both expected ²Investment in the case of Macedonia, FYR. to do well, as suggested by the improved Figure 2.8 readings for con dence, credit tightness, and Emerging Europe: Private Consumption and capacity utilization (Figure 2.7). Investment Investment Ratios, and Employment, 2000–12 and consumption ratios should stabilize and (Simple averages across countries of the region) start to pick up modestly, reversing some 102 98 of their steep declines in the wake of the Employment (Index, 2008 = 100) 100 2008–09 crisis. In a virtuous cycle, the initial Private consumption and gross fixed capital formation 96 domestic demand impulse lifts incomes and 98 (percent of GDP, right scale) 94 employment, further strengthening domestic 96 92 demand (Figure 2.8). 94 90• Consequently, intraregional growth 92 differentials are abating. Growth rates are 90 88 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 expected to be positive in all countries this year for the rst time since the crisis and will move Sources: IMF, World Economic Outlook database; and IMF staff calculations. into a relatively narrow range of 1¾ percent to 5¼ percent by 2012. Very fast growth in Figure 2.9 Belarus and Turkey is projected to slow as Emerging Europe and Selected Regions: Real the macroeconomic policy stance tightens Per Capita GDP Growth and base effects run their course, respectively. (Percent per year) The Baltics, Bulgaria, and, with somewhat of 9 9 a delay, Romania will reap the full-year effect 8 7 8 7 of the ongoing recovery. Growth in Russia 6 6 5 5 will also likely strengthen, by an estimated 4 4 ¾ percentage point, absent a repeat of last 3 3 2 2 year’s heat wave. In Poland, growth is expected 1 1 to hold steady. Hungary’s government is 0 0 -1 -1 putting in place considerable scal stimulus 2000–08 2009–10 2011–12 China and India Sub-Saharan Africa through tax cuts nanced by a rollback of Developing Asia excl. China and India Middle East and North Africa Emerging Europe Latin America and the Caribbean pension reform, while also imposing special Emerging and developing economies levies on selected industries. Growth there is Sources: IMF, World Economic Outlook database; and IMF staff calculations. 35
    • REGIONAL ECONOMIC OUTLOOK: EUROPE projected to pick up to a moderate pace of and decline over the course of 2012 (Table 2.2). some 2.8 percent. By end-2011, in ation will still exceed 5 percent in Bulgaria, Kosovo, FYR Macedonia, Serbia, Turkey, and all European CIS countries. These projections assume that the second-round effects… A Performance Similar to That in Other from the large commodity price increases that haveEmerging Markets, Apart from China and India already occurred will be small—the result of still considerable negative output gaps in most countriesIn per capita terms, emerging Europe is projected of the region.to expand at a rate similar to the rates in otheremerging market regions—only China and Indiaare expected to enjoy considerably higher growth(Figure 2.9). However, no extra rebound effect Risks to the Outlookis expected from the especially deep recession in Commodity Prices Pose a Downside Risk to the2009, suggesting that the recession was largelya correction to excessive growth in the precrisis Outlookyears. High commodity prices pose adverse risks to the in ation and growth outlook.The Outlook for the Overall External Positions • Food and energy prices account for a large shareIs Benign… in the CPIs of the region.4 The full rst-roundRegional Economic Outlook projections put this year’s effects on consumer prices of global commodityaggregate current account de cit at 0.3 percent price increases to date might yet be unfolding.of GDP, essentially unchanged from 2010, and And commodity prices might turn out to beexpect a widening to 1.1 percent of GDP next higher than suggested by futures prices amidyear (Table 2.2). Russia’s current account surplus unexpectedly tight supply conditions.rises further in 2011, but it is expected to fall back • Negative output gaps may put less downwardsomewhat in 2012 as the balance of payments pressure on wages and prices than envisaged.impact from buoyant import growth is no longer Estimates of output gaps are inherentlytrumped by rising oil prices. Elsewhere, rising oil imprecise. Moreover, spare capacity in theprices put pressure on current account balances economy as a whole might not curb wage andthis year. Current account balances deteriorate in price demands when underemployed resourcesthe Baltics, Bulgaria, Hungary, and Poland, but all cannot be reallocated to high demand sectors inde cits should remain easily nanced by FDI and the short term.net transfers from the EU. In Turkey, Belarus, andSerbia, deteriorations build on already large de cits • Monetary policymakers will need to stay onin 2010 and therefore are a cause for concern. high alert. Even countries with well-anchoredExternal debt ratios are set to decline very gradually, in ation expectations may nd it hard to avoidremaining above 75 percent of GDP in Bulgaria, second-round effects if rst-round effects areCroatia, Hungary, Latvia, Lithuania, Montenegro, large or persistent, as global commodity pricesRomania, and Ukraine. rise disproportionately over the medium term. • Even if second-round effects on in ation are largely avoided, high commodity prices can… While Inflation Is Projected to RemainModerate 4 Shares range from 25 percent in Hungary to 60 percentCurrent projections hold that in ation will remain in Ukraine. This compares to a euro area average ofunchanged at 7.1 percent at the end of this year, slightly more than 20 percent.36
    • 2. EMERGING EUROPE: UNDERWRITING A SOLID RECOVERYTable 2.2Emerging Europe: CPI Inflation, Current Account Balance, and External Debt, 2009–12(Percent) CPI Inflation CPI Inflation Current Account Balance Total External Debt (Period average) (End of period) to GDP to GDP 2009 2010 2011 2012 2009 2010 2011 2012 2009 2010 2011 2012 2009 2010 2011 2012 Baltics1 4.0 0.3 3.1 2.5 0.3 3.2 2.9 2.4 6.2 2.5 0.5 -1.2 118.2 117.4 109.6 103.0 Latvia 3.3 -1.2 3.0 1.7 -1.4 2.4 1.9 2.3 8.6 3.6 2.6 1.5 156.3 165.2 152.0 141.2 Lithuania 4.4 1.2 3.1 2.9 1.3 3.6 3.5 2.5 4.5 1.8 -0.9 -2.9 91.4 85.7 82.2 78.5 Central Europe1 3.6 3.1 4.1 3.0 3.9 3.3 3.8 2.8 -1.8 -2.2 -2.8 -3.1 85.3 83.5 83.7 81.5 Hungary 4.2 4.9 4.1 3.5 5.6 4.2 3.9 3.2 -0.5 1.6 1.5 0.9 153.3 143.9 140.6 131.5 Poland 3.5 2.6 4.1 2.9 3.5 3.1 3.8 2.7 -2.2 -3.3 -3.9 -4.2 64.9 66.8 68.4 68.5 Southeastern Europe– 4.7 5.3 5.7 3.5 3.9 7.0 4.4 2.8 -5.5 -3.4 -4.2 -4.4 81.4 80.6 82.4 78.5 EU1 Bulgaria 2.5 3.0 4.8 3.7 1.6 4.4 5.3 2.4 -10.0 -0.8 -1.5 -2.0 113.6 102.3 94.7 88.2 Romania 5.6 6.1 6.1 3.4 4.8 8.0 4.0 3.0 -4.2 -4.2 -5.0 -5.2 71.8 74.2 78.7 75.6 Southeastern Europe– 3.7 3.2 6.1 3.1 3.1 5.1 4.9 3.0 -7.8 -5.7 -6.9 -6.6 78.4 78.4 73.8 72.5 non-EU1 Albania 2.2 3.6 4.5 3.5 3.7 3.4 4.0 2.9 -14.0 -10.1 -11.2 -9.8 33.5 41.6 37.7 39.1 Bosnia and -0.4 2.1 5.0 2.5 0.0 3.1 5.0 2.5 -6.9 -6.0 -6.0 -5.7 54.9 54.6 58.6 58.4 Herzegovina Croatia 2.4 1.0 3.5 2.4 1.9 1.9 3.5 2.4 -5.5 -1.9 -3.6 -3.6 101.9 99.3 93.4 91.4 Kosovo -2.4 3.5 8.2 2.1 0.1 6.6 5.6 2.0 -16.8 -17.3 -23.1 -25.6 ... ... ... ... Macedonia, FYR -0.8 1.5 5.2 2.0 -1.6 3.0 7.5 2.0 -6.4 -2.8 -4.2 -4.8 57.5 56.5 57.3 58.2 Montenegro, 3.4 0.5 3.1 2.0 1.5 0.7 3.0 1.8 -30.3 -25.6 -24.5 -22.1 97.8 100.2 99.0 97.5 Republic of Serbia, Republic of 8.1 6.2 9.9 4.1 6.6 10.3 6.0 4.0 -6.9 -7.1 -7.4 -6.6 78.7 81.6 74.0 72.8 European CIS countries1 12.2 7.2 9.5 8.1 9.2 8.9 8.9 7.6 2.9 3.6 4.2 2.7 43.1 37.3 30.7 28.1 Belarus 13.0 7.7 12.9 9.7 10.1 9.9 13.0 9.0 -13.0 -15.5 -15.7 -15.2 44.9 51.5 57.9 63.4 Moldova 0.0 7.4 7.5 6.3 0.4 8.1 7.5 5.0 -8.5 -10.9 -11.1 -11.2 65.5 67.4 70.3 74.0 Russia 11.7 6.9 9.3 8.0 8.8 8.8 8.5 7.5 4.1 4.9 5.6 3.9 38.6 32.3 25.5 22.6 Ukraine 15.9 9.4 9.2 8.3 12.3 9.1 10.2 7.7 -1.5 -1.9 -3.6 -3.8 88.0 83.9 80.7 80.3 Turkey 6.3 8.6 5.7 6.0 6.5 6.4 7.0 5.4 -2.3 -6.5 -8.0 -8.2 43.7 40.7 43.7 46.2 Emerging Europe1,2 8.5 6.3 7.3 6.2 7.0 7.1 7.1 5.8 -0.1 -0.5 -0.3 -1.1 57.3 52.0 47.7 45.4 New EU member 3.2 2.9 3.9 2.9 2.9 3.7 3.6 2.7 -2.0 -2.2 -2.6 -2.8 75.7 75.1 73.9 71.2 states1,3 Memorandum Czech Republic 1.0 1.5 2.0 2.0 1.0 2.3 2.2 2.0 -1.1 -2.4 -1.8 -1.2 45.5 47.4 44.0 42.0 Estonia -0.1 2.9 4.7 2.1 -1.7 5.4 3.5 2.0 4.5 3.6 3.3 3.1 125.8 117.6 100.5 95.0 Slovak Republic 0.9 0.7 3.4 2.7 0.1 1.3 3.4 2.9 -3.6 -3.4 -2.8 -2.7 71.9 72.1 70.4 67.8 Slovenia 0.9 1.8 2.2 3.1 1.8 1.9 3.0 2.7 -1.5 -1.2 -2.0 -2.1 105.2 113.8 113.3 114.4 European Union1,4 0.9 2.0 2.7 1.9 1.2 2.5 2.5 1.9 -0.2 -0.1 -0.2 -0.1 ... ... ... ...Source: IMF, World Economic Outlook database.1 Weighted average. CPI inflation is weighted by GDP valued at purchasing power parity, and current account balances and external debt are weighted by U.S. dollar GDP.2 Includes Albania, Belarus, Bosnia and Herzegovina, Bulgaria, Croatia, Hungary, Kosovo, Latvia, Lithuania, FYR Macedonia, Moldova, Republic of Montenegro, Poland,Romania, Russia, Republic of Serbia, Turkey, and Ukraine.3 Includes Bulgaria, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, Slovak Republic, and Slovenia.4 Includes Austria, Belgium, Bulgaria, Cyprus, Czech Republic, Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Ireland, Italy, Latvia, Lithuania, Luxembourg,Malta, Netherlands, Poland, Portugal, Romania, Slovak Republic, Slovenia, Spain, Sweden, and the United Kingdom. 37
    • REGIONAL ECONOMIC OUTLOOK: EUROPE still hurt growth through several channels. In an adverse scenario in which western banks take Most countries would have to cope with a signi cant hit, they might have to resort to sizable sizable adverse terms-of-trade effects. cuts of their exposures to emerging Europe, and Domestic, as well as external, demand would access to funding might become more dif cult suffer if in ationary pressures make tighter generally for all but the strongest of borrowers as macroeconomic policies necessary in both investors become more averse to vulnerabilities. emerging Europe and its trading partners. Even less drastic developments could prompt Tighter policies could also spell the end of the western banks to curtail nancing for banks in favorable nancing conditions that sovereigns emerging Europe, which would choke off the in the region now generally enjoy. edgling recovery of private credit and derail the good prospects for growth in the baseline.Sovereign Debt Problems in the Euro Area Are Against this background, the authorities inAnother Concern emerging Europe should make every effort to reduce vulnerabilities. Government nancing costsStrong nancial and economic linkages with are sensitive to vulnerabilities, especially those in theadvanced Europe mean that an escalation of the scal and nancial sectors, and have become moresovereign debt problems in the euro area could so since the crisis (Figure 2.10).have serious repercussions for emerging Europe. Fortunately, nancial tensions in the euro area haveFigure 2.10 not prompted nancial markets to price in an extraSelected Emerging Market Economies: risk premium for emerging Europe, re ecting theCosts of Funding and Vulnerabilities1 expectation that sovereign debt problems in the 7.0 7.0 euro area periphery will remain containedCDS spread (in basispoints, on log scale)2 2010 log(CDS) = 4.30 + 1.88 OVI 6.5 Spring 2008 R² = 0.29 6.5 and will be resolved without major disruptions. 6.0 6.0 5.5 5.5 Still, nancing costs in emerging Europe, just as in 5.0 5.0 emerging market economies more generally, depend 4.5 4.5 4.0 log(CDS) = 4.41 + 1.49 OVI 4.0 on country-speci c vulnerabilities and on global 3.5 0.0 R² = 0.22 3.5 risk appetite. 0.2 0.4 0.6 0.8 1.0 Overall Vulnerability Index (OVI) 7.0 7.0 • Sovereign bond spreads in emergingCDS spread (in basispoints, on log scale)2 6.5 2010 Spring 2008 log(CDS) = 4.53 + 1.15 PFVI R² = 0.15 6.5 Europe and the euro area countries that 6.0 6.0 have experienced most market pressures 5.5 5.5 5.0 5.0 (Greece, Ireland, Portugal, and Spain)5 have 4.5 4.5 demonstrated little correlation with each other. 4.0 log(CDS) = 4.75 + 0.6 PFVI 4.0 3.5 R² = 0.07 3.5 Over the past two years, spreads for sovereigns 0.0 0.2 0.4 0.6 0.8 1.0 in emerging Europe have been trending Public Finance Vulnerability Index (PFVI) 7.0 7.0 downward while for some euro area countriesCDS spread (in basispoints, on log scale)2 2010 they have risen sharply (Figure 2.11, panel 1). log(CDS) = 4.75 + 1.01 FSVI 6.5 Spring 2008 R² = 0.10 6.5 6.0 5.5 6.0 Financing conditions in emerging Europe have 5.5 5.0 5.0 instead moved in lockstep with other emerging 4.5 4.5 markets, with global risk appetite driving both 4.0 log(CDS) = 4.69 + 0.59 FSVI 4.0 3.5 R² = 0.04 3.5 (Figure 2.11, panel 2). Even when controlling 0.0 0.2 0.4 0.6 0.8 1.0 Financial Sector Vulnerability Index (FSVI)Sources: Datastream; IMF, World Economic Outlook database; and IMF staff 5 Defined as euro area countries with average bondcalculations. spreads over 10-year German bunds of 200 bps or more1 Covers 36 economies that have CDS spread data. Outliers such asArgentina, Pakistan, and Venezuela are excluded. during January to mid-April 2011. Spreads range from2 Average over January–March 2008 for spring 2008, and January–March just under 900 bps for Greece to just over 200 bps in theand July–September 2010 for combined spring and fall 2010. case of Spain.38
    • 2. EMERGING EUROPE: UNDERWRITING A SOLID RECOVERYFigure 2.11 Figure 2.12CESE and EA4 Countries: Funding Costs, Foreign Bank Presence and Association2007–11 Between Funding Costs in CESE Countries 1,200 EMBI Spreads in CESE Countries and 10-year Government 1,200 and the EA41 Bond Spreads in the EA4 1,000 1,000 CESE EMBI spreads to changes in Response coefficient of changes in (Basis points) CESE countries - 0.25 0.25 800 higher spreads2 800 0.20 Romania 0.20 EA4 bond yield spreads 2 600 600 Lithuania CESE countries - 0.15 0.15 400 lower spreads1 400 0.10 0.10 200 200 Poland Hungary EA43 CESE countries4 0.05 Ukraine Bulgaria 0.05 0 0 Jan-07 Aug-07 Feb-08 Sep-08 Apr-09 Nov-09 Jun-10 Jan-11 0.00 Croatia 0.00 Serbia 1,000 90 -0.05 -0.05 Russia y = 0.0021x - 0.0262 900 EMBI Spreads and VIX 80 -0.10 R² = 0.175 -0.10 Turkey 800 70 700 -0.15 -0.15 Global (basis points, 60 600 0 10 20 30 40 50 60 70 left scale) 50 500 Exposure of BIS reporting banks (assets in percent of GDP) 40 400 Response coefficient of changes in CESE 300 30 interbank interest rates to changes in 200 20 0.6 0.6 VIX (percentage y = -0.0021x + 0.1861 EA4 bond yield spreads 2 100 10 0.5 Romania 0.5 CESE countries (basis points, left scale)2 points, right scale) R² = 0.0722 0 0 Jan-07 Aug-07 Feb-08 Sep-08 Apr-09 Nov-09 Jun-10 Jan-11 0.4 0.4 0.3 0.3 Dynamic Response of Changes in Costs 3.0 Russia Latvia 3.0 of Funding in CESE Countries to Other Regions5 Asia and Latin 0.2 Ukraine 0.2 2.0 America EMBI 2.0 0.1 Hungary 0.1 spreads6 1.0 1.0 Turkey Lithuania 0.0 Poland 0.0 0.0 0.0 Bulgaria Czech Republic Estonia -0.1 -0.1 -1.0 -1.0 EA4 bond yield spreads Croatia -0.2 -0.2 -2.0 -2.0 0 10 20 30 40 50 60 70 80 90 -3.0 -3.0 Exposure of BIS reporting banks (assets in percent of GDP) Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10Sources: Bloomberg L.P.; Datastream; and IMF staff calculations. Sources: Bloomberg L.P.; and IMF staff calculations.1 Simple average for Bulgaria, Poland, Russia, Serbia, and Turkey. 1 The EA4 comprise Greece, Ireland, Portugal, and Spain.2 Simple average for Croatia, Hungary, Lithuania, Romania, and Ukraine. 2 Response coefficient is the regression coefficient from regressing changes in3 Simple average for Greece, Ireland, Portugal, and Spain (the EA4). costs of funding in CESE countries on changes in costs of funding in the EA44 Simple average for Bulgaria, Croatia, Hungary, Lithuania, Poland, over the period starting from 2007. These changes of costs in funding areRomania, Russia, Serbia, Turkey, and Ukraine. also controlled for VIX, TED, and their interactions with the crisis occurrence.5 Dynamic response is the regression coefficient from regressing changesin costs of funding in CESE countries on counterpart changes in otherregions together with a constant term based on a moving window over between spreads in euro area countries under26 weeks. Costs of funding refer to EMBI spreads for emerging marketeconomies and 10-year bond spreads for countries in the EA4. Changes market pressure and in emerging Europe isin costs of funding are also controlled for global financial market conditions independent of Western banks’ exposure toincluding TED, VIX, and their interactions with the crisis occurrence.6 Simple average of regional EMBI spreads. the local economy, and small in any event (Figure 2.12, panel 1). For example, exposure for such global factors, there is no convincing to Hungary is some 60 percent of GDP evidence of a systematic link with spreads in compared with exposure to Poland of about the euro area countries facing market pressure 20 percent of GDP. Yet, the association (Figure 2.11, panel 3). Apparently, nancing of these countries’ spreads with spreads in conditions in these euro area countries affect euro area countries under market pressure emerging Europe only to the extent that they is about the same and very small. Likewise, register on a global scale. local interbank interest rates seem no more sensitive to spreads in euro area high-spread• Emerging European countries that depend countries with heavy dependence on funding heavily on nancing from Western banks seem from Western banks than in those without to be no more affected by developments in (Figure 2.12, panel 2). Apparently, nancial euro area high-spread countries than is the rest markets are not yet concerned about spillovers of the region. The strength of the association through the bank funding channel. 39
    • REGIONAL ECONOMIC OUTLOOK: EUROPE Table 2.3 Emerging Europe: Evolution of Public Debt and General Government Balance, 2009–121 (Percent of GDP) General Government Balance Public Debt 2009 2010 2011 2012 2009 2010 2011 2012 Baltics2 -8.7 -7.7 -5.8 -4.2 30.8 39.1 43.1 43.8 Latvia3 -7.8 -7.9 -5.3 -1.9 32.8 39.9 42.5 41.0 Lithuania -9.2 -7.6 -6.0 -5.5 29.6 38.7 43.5 45.4 Central Europe2 -6.6 -7.1 -3.7 -4.2 56.7 60.8 60.7 61.3 Hungary4 -4.3 -4.1 3.9 -4.3 78.4 80.4 76.6 76.9 Poland -7.2 -7.9 -5.7 -4.2 50.9 55.7 56.6 57.3 Southeastern Europe-EU2 -5.6 -5.7 -3.9 -2.6 25.8 30.5 32.8 32.8 Bulgaria3 -0.9 -3.6 -2.6 -1.5 15.6 18.0 19.7 20.0 Romania -7.3 -6.5 -4.4 -3.0 29.6 35.2 37.8 37.7 Southeastern Europe-non-EU2 -4.5 -4.4 -4.5 -3.9 37.5 41.8 42.6 43.6 Albania3 -7.5 -3.7 -4.6 -4.6 60.2 59.7 59.9 60.4 Bosnia and Herzegovina -5.6 -4.0 -3.0 -1.9 35.4 36.9 41.4 41.4 Croatia3 -4.1 -5.3 -6.3 -6.1 35.4 40.0 44.1 47.6 Kosovo3 -0.7 -2.9 -3.3 -4.1 ... ... ... ... Macedonia, FYR -2.7 -2.5 -2.5 -2.2 23.9 24.8 26.8 27.4 Montenegro, Republic of3 -6.5 -3.8 -3.4 -2.5 40.7 44.1 43.1 42.2 Serbia, Republic of3 -4.3 -4.5 -4.1 -2.8 36.8 44.0 40.5 39.8 European CIS countries2 -6.0 -3.7 -1.7 -1.8 14.3 14.1 13.3 13.8 Belarus3 -0.7 -1.8 -1.9 -2.0 20.0 22.4 25.3 27.1 Moldova3 -6.3 -2.5 -1.9 -0.7 31.6 29.8 30.4 32.4 Russia3 -6.3 -3.6 -1.6 -1.7 11.0 9.9 8.5 8.8 Ukraine3 -6.2 -5.8 -2.8 -2.5 35.3 40.5 42.6 43.5 Turkey3 -6.2 -3.4 -2.2 -2.0 45.5 41.7 39.4 37.6 Emerging Europe2,5 -6.1 -4.5 -2.5 -2.4 29.5 30.1 29.4 29.4 New EU member states2,6 -6.4 -6.5 -3.9 -3.7 43.4 48.1 49.4 50.1 Memorandum Czech Republic -5.8 -4.9 -3.7 -3.6 35.4 39.6 41.7 43.4 Estonia -2.1 0.2 -1.0 -0.7 7.2 6.6 6.3 6.0 Slovak Republic -7.9 -8.2 -5.2 -3.9 35.4 42.0 45.1 46.2 Slovenia3 -5.8 -5.7 -2.0 -3.3 35.4 37.2 42.3 44.9 European Union1,7 -6.8 -6.6 -4.8 -4.0 72.3 78.2 80.6 81.8 Source: IMF, World Economic Outlook database. 1 As in the World Economic Outlook, general government balances reflect IMF staff’s projections of a plausible baseline, and as such contain a mixture of unchanged policies and efforts under programs, convergence plans, and medium-term budget frameworks. 2 Average weighted by GDP valued at purchasing power parity. 3 Reported on a cash basis. 4 Fiscal surplus in 2011 reflects revenue from rollback of pension reform. Assets of 11 percent of GDP are transferred from private-sector to public pension funds. 5 Includes Albania, Belarus, Bosnia and Herzegovina, Bulgaria, Croatia, Hungary, Kosovo, Latvia, Lithuania, FYR Macedonia, Moldova, Republic of Montenegro, Poland, Romania, Russia, Republic of Serbia, Turkey, and Ukraine. 6 Includes Bulgaria, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, Slovak Republic, and Slovenia. 7 Includes Austria, Belgium, Bulgaria, Cyprus, Czech Republic, Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Ireland, Italy, Latvia, Lithuania, Luxembourg, Malta, Netherlands, Poland, Portugal, Romania, Slovak Republic, Slovenia, Spain, Sweden, and the United Kingdom.40
    • 2. EMERGING EUROPE: UNDERWRITING A SOLID RECOVERYKey Policy Questions (Figure 2.13).6 Debt stock vulnerabilities are high in Albania and Hungary, as well asGoing Forward arguably in Poland.7 Albania and Hungary, along with Turkey, also have uncomfortablyIn light of these downside risks to the outlook high short-term government debt, whichand the considerable slack evident in many exposes them to rollover risk. High scaleconomies in emerging Europe, policymakers face de cits constitute a considerable owthree main policy questions. What should be done vulnerability in Latvia, Lithuania, Poland, andto reduce scal and nancial vulnerabilities? How Romania. Foreign-currency-denominated debtfar has the region progressed in switching to a is high in Hungary and Serbia, exposing theirnew growth model driven by the tradable sector? public nances to exchange rate risk.What can policymakers do to nudge it toward thatmodel? • Emerging Europe’s public nances no longer compare favorably with other emerging markets (Figure 2.14). In 2007, both de cit and public debt indicators for the region matched upFiscal Policy well against other emerging markets, but 2012 de cit ratios are expected to remain aboveFiscal Positions Are Set to Tighten in 2011 those in Latin America and emerging Asia, andand Remain Unchanged in 2012 public debt has lost much of the edge it onceThe region’s scal de cit is projected to decline had over emerging Asia.from 4½ percent of GDP in 2010 to 2½ percent • The cross-regional comparison does notof GDP in 2011, and remain largely unchanged in take into account particularly pronounced2012 (Table 2.3). Discretionary measures equivalent population aging in emerging Europe and theto 1.7 percent of GDP are chie y responsible for strains it will inevitably put on public nances.8the 2011 de cit reduction. Much of the regionalimprovement is attributable to Russia, while Recent experience further underscores the needconsolidation measures in the rest of the region for robust scal positions with regard to solvencyare similar to last year’s (about 1 percent of GDP).Poland is assumed to put in place consolidation 6 Key fiscal indicators that should not exceed prudentmeasures of about one percent of GDP, in thresholds include public debt, the fiscal balance, public debt exposed to foreign currency risk, and public debtline with its convergence plan. A few countries, exposed to rollover risk, all expressed as a percentage ofincluding Croatia, Hungary, Kosovo, and Turkey, GDP. The primary gap is generally another key indicatorgo against the grain and loosen their scal stances. of fiscal vulnerability. However, in emerging Europe theProjections for 2012 do not factor in signi cant primary gap identifies the same countries as particularlyfurther measures for the region as a whole. vulnerable as the primary balance and is therefore omitted. The primary gap is defined as the difference between theDespite this consolidation, scal vulnerabilities actual and the debt-stabilizing primary balance. 7 Poland’s debt-to-GDP ratio of 56 percent of GDP is highremain elevated in many countries. by emerging market standards. However, Poland has set• Public debt ratios in 2012 will still be trending aside assets of some 15 percent of GDP in second-pillar upward in two-thirds of the countries and will private pension funds, much more than other countries. exceed 40 percent of GDP in half the region. Public debt net of these assets is close to the emerging market average. Assets of second-pillar private pension• Aggregate indicators disguise much weaker funds are also considerable in Hungary but public debt net public nances in individual countries. Key of these assets is still uncomfortably high. 8 Over the next 20 years, the old-age dependency ratio scal vulnerability indicators in many countries will rise to 29 percent in emerging Europe compared are above both emerging market averages with 18 percent in Latin America and the Caribbean and and, even more so, prudent thresholds in Asia according to U.S. Census Bureau projections. 41
    • REGIONAL ECONOMIC OUTLOOK: EUROPEFigure 2.13Emerging Europe: Fiscal Vulnerability Indicators in Perspective(Percent of GDP) 8 8 100 100 Fiscal Balance Gross Public Debt 2010 Hungary 6 6 90 90 2007 Bosnia & Herzegovina 4 4 80 80 Macedonia, FYR Montenegro 2 2 70 70 Albania Lithuania Romania Serbia Ukraine Croatia Poland Turkey Latvia 0 0 60 60 Average of 50 Average of 50 emerging emerging market -2 market economies -2 50 50 economies -4 Moldova -4 40 40 Belarus Macedonia, FYR Moldova Turkey Belarus Bulgaria Russia Montenegro Albania Bosnia & Herzegovina Hungary Serbia -6 -6 30 30 Croatia Bulgaria Ukraine Romania Russia -8 -8 20 20 Lithuania Latvia Poland 2010-10 -10 10 2007 10-12 -12 0 035 35 45 45 Short-Term Public Debt Debt Exposed to Currency Risk (Remaining maturity basis) 40 4030 30 2010 2007 Bosnia & Herzegovina Hungary 2010 35 35 Serbia 2007 Lithuania Croatia Latvia25 25 Macedonia, FYR Albania 30 30 Average of 5020 20 emerging Ukraine Albania 25 market 25 economies Hungary Bosnia & Herzegovina Turkey 20 2015 15 Croatia Macedonia, FYR Serbia Turkey Romania Lithuania 15 15 Poland Ukraine Bulgaria Latvia10 10 Bulgaria 10 10 Russia Poland Romania Average of 50 5 5 Russia emerging market economies 5 5 0 0 0 0Sources: IMF, World Economic Outlook database; and IMF staff calculations.and liquidity. The possibility of pernicious feedback justifying the very increase in nancing costs. As theloops between nancing costs and de cits means problems in the euro area periphery demonstrate,that buffers need to be built into public nances, and reassessment of solvency risks by nancial marketsthe more jittery nancial markets are the bigger the can be swift and come with little warning. Emergingbuffers need to be. Otherwise, a jump in nancing Europe’s own experience in the 2008–09 crisiscosts can call public solvency into question, thus highlights liquidity risk—even governments with little42
    • 2. EMERGING EUROPE: UNDERWRITING A SOLID RECOVERYFigure 2.14 debt found themselves cut off from nancing onSelected Regions: Deterioration affordable terms.of Public Finances(Percent of GDP) Evolution of Public Evolution of Public Fiscal Consolidation Will Need to Continue Sector Deficits Debt Stocks 5 5 55 55 Although signi cant consolidation has occurred in 4 4 50 50 3 3 a number of countries, and further consolidation 45 45 2 2 40 40 is planned, the repairs to public nances remain 1 1 35 35 a work in progress. Public revenues are unlikely 0 0-1 -1 30 30 to return to the levels at the height of the-2 -2 25 25 boom (Box 2.3). Consolidation efforts should 20 20-3 Emerging Latin Emerging -3 Emerging Latin Emerging be supplemented by a strengthening of scal Europe America Asia and the Europe America Asia and the frameworks to include enhanced transparency, Caribbean Caribbean better public nancial management, and stronger 2007 2010 2012 2007 2010 2012 governance arrangements.Sources: IMF, World Economic Outlook database; and IMF staff calculations. Box 2.3 Discretionary Fiscal Policies Since the 2008–09 Crisis Fiscal efforts during 2009–12 differ widely across Emerging Europe: Discretionary Fiscal countries but on aggregate they are perhaps smaller Measures, 2009–121 than generally believed (first figure).1 A number of (Percent of GDP) countries, such as the Baltic countries, Bosnia and 20 2009 20 15 2010 15 Herzegovina, Romania, and Serbia, put in place 10 2011 10 2012 very large consolidation measures. These actions 5 Cumulative 5 0 0 were motivated by the need to address rapidly rising -5 -5 deficits, preserve exchange rate pegs, or respond to -10 -10 -15 -15 market pressures. In another group of countries, Latvia Lithuania Serbia Romania Bosnia & Herzegovina Belarus Ukraine Albania Moldova Montenegro Hungary Bulgaria Macedonia, FYR Poland Croatia Russia Kosovo Simple average Weighted average including Bulgaria, Montenegro, and Poland, fiscal policy is countercyclical, with stimulative discretionary measures in the downturn and largely balancing restrictive measures during the recovery. Russia stands out as having implemented very significant fiscal Source: IMF staff calculations. stimulus operations, only part of which are expected 1 Positive (negative) values indicate consolidation (stimulus) measures; discretionary policy measures as factored into the projections for the April 2011 to be rolled back this year and next. As a result World Economic Outlook. Excludes Turkey. of Russia’s large weight in the regional economy, cumulative discretionary fiscal measures in emerging Europe are expansionary to the tune of 1.5 percent of GDP, even though most countries implemented more consolidation measures than stimulus measures. The quality of the scal measures varies. On the positive side, some 70 percent of the adjustment for the average country comes from expenditure-side rather than revenue-side measures (second gure). Expenditure-focused scal adjustment is typically more durable and less contractionary than reliance on tax hikes and other levies (IMF, 2010e). However, Russia implemented much of its stimulus through permanent expenditure measures, Note: The main author of this box is Christoph Klingen. 1 The quantifications of fiscal measures are estimates by IMF country desks. They are consistent with the overall fiscal projections of this Regional Economic Outlook. Future fiscal measures may include what is implicit in governments’ medium-term budget plans, EU convergence programs, or arrangements with the IMF. 43
    • REGIONAL ECONOMIC OUTLOOK: EUROPE Box 2.3 (concluded) Emerging Europe: Composition of Discretionary Emerging Europe: Discretionary Fiscal Fiscal Measures, 2009–121 Measures and Change of Fiscal Balance, 2008–121 (Percent of GDP) (Percent of GDP) 20 20 20 Discretionary measures 20 Revenue 15 Other factors affecting the fiscal balance 15 15 Expenditure 15 Change in fiscal balance 10 Overall 10 10 10 5 5 5 5 0 0 0 0 -5 -5 -5 -5 -10 -10 -10 -10 -15 -15 -15 -15 Poland Latvia Romania Ukraine Albania Moldova Serbia Hungary Lithuania Belarus Kosovo Montenegro Bosnia & Herzegovina Macedonia, FYR Bulgaria Croatia Russia Average Weighted average Latvia Lithuania Serbia Romania Bosnia & Herzegovina Belarus Ukraine Albania Moldova Montenegro Hungary Bulgaria Macedonia, FYR Poland Croatia Russia Kosovo Average Weighted average Source: IMF staff calculations. Sources: IMF, World Economic Outlook database; and IMF staff calculations. 1 1 Positive (negative) values indicate consolidation (stimulus) measures; Positive (negative) values indicate consolidation (stimulus) measures; discretionary policy measures as factored into the projections for the discretionary policy measures as factored into the projections for the April 2011 World Economic Outlook. Excludes Turkey. April 2011 World Economic Outlook. Excludes Turkey. and Hungary has relied on tax hikes for selected industries. A number of countries also resorted to diverting contributions to private second-pillar pension funds to the public pension system. These additional revenues reduce the headline de cit in the short term but fail to improve public nances in the long term because future pension expenditure rises commensurately. Therefore, they are not considered scal measures here. Hungary went further: participants in the second pillar would forgo most of their rights under the public pension system unless they transferred their accumulated pension assets back to the public pension system. Most opted for the transfer, enabling Hungary to book a large scal surplus in 2011. Any further cyclical de cit improvement after 2012 is likely to be small. Headline scal balances deteriorate signi cantly during 2009–12, even more than identi ed discretionary scal measures would suggest. On average, they decline by 2.9 percentage points compared with cumulative stimulus measures worth 1.5 percent of GDP (third gure). It seems fair to assume that any remaining economic slack in 2012 is probably quite limited and that revenues not recovered by then will probably be lost permanently. These losses have been very large in some countries, re ecting mainly the evaporation of boom-related revenues. In the absence of fresh measures, one would therefore expect scal balances to remain broadly unchanged from 2012 onward.Continued scal consolidation would not only reduce built around gradual scal adjustment, albeit operating scal vulnerabilities, it increasingly would also be at country-speci c speeds, to demonstrate that policieshelpful from a demand-management perspective. are on the right track.In quickly growing countries, stepped-up scalconsolidation would ease the burden on monetary Reducing Financial Sectorpolicy—an important consideration in an environmentin which higher interest rates might attract unduly large Vulnerabilitiescapital ows. Countries with still- edgling recoveries Not All Countries’ Banking Systems Are Backwill have to tread more carefully, but the general lesson to Business as Usual Yet …that recent events have put a premium on soundpublic nances still applies and con dence effects Banking system pro tability is uneven across thefrom tackling scal weaknesses decisively should not region (Table 2.4). Banks in Turkey went throughbe discounted. Successful strategies will need to be the crisis relatively unscathed, and Russian banks’44
    • 2. EMERGING EUROPE: UNDERWRITING A SOLID RECOVERY Table 2.4 Emerging Europe: Selected Financial Soundness Indicators, 2007–101 (Percent) Return on Assets Nonperforming Loans to Total Loans Country 2007 2008 2009 2010 Latest 2007 2008 2009 2010 Latest Albania 1.6 0.9 0.4 0.7 Dec. 3.4 6.6 10.5 13.9 Dec. Belarus 1.7 1.4 1.4 1.7 Dec. 1.9 1.7 4.2 3.5 Dec. Bosnia and Herzegovina 0.9 0.4 0.1 -0.5 Sept. 3.0 3.1 5.9 9.2 Sept. Bulgaria 2.4 2.1 1.1 0.9 Dec. 2.1 2.5 6.4 11.9 Dec. Croatia 1.6 1.6 1.1 1.2 Dec. 4.8 4.9 7.8 11.2 Dec. Hungary 1.2 0.8 0.7 0.1 Dec. 2.3 3.0 6.7 9.1 Dec. Latvia 2.0 0.3 -3.5 -1.6 Dec. 0.8 3.6 16.4 19.0 Dec. Lithuania 1.7 1.0 -4.2 -0.3 Dec. 1.0 4.6 19.3 19.7 Dec. Macedonia, FYR 1.8 1.4 0.6 0.8 Dec. 7.5 6.7 8.9 9.0 Dec. Moldova 3.9 3.5 -0.5 0.5 Dec. 3.7 5.2 16.4 13.3 Dec. Montenegro 0.7 -0.6 -0.7 -2.7 Dec. 3.2 7.2 13.5 21.0 Dec. Poland 1.9 1.5 0.8 1.1 Dec. 5.2 4.5 8.0 8.8 Dec. Romania 1.0 1.6 0.2 -0.1 Dec. 2.6 2.8 7.9 11.9 Dec. Russia 3.0 1.8 0.7 1.9 Dec. 2.5 3.8 9.5 8.2 Dec. Serbia 1.7 2.1 1.3 1.2 Sept. ... 11.3 15.5 17.8 Sept. Turkey 2.6 1.8 2.4 2.2 Dec. 3.6 3.8 5.6 3.8 Dec. Ukraine 1.5 1.0 -4.4 -1.5 Dec. 3.0 3.9 13.7 15.3 Dec. Memorandum Middle East² ... 1.5 1.3 1.4 Dec. 5.6 4.4 5.2 5.2 Dec. Latin America³ 2.4 1.8 2.1 2.5 Dec. 2.4 2.7 3.4 2.5 Dec. Asia4 1.3 1.3 1.3 1.5 Dec. 5.5 3.8 3.4 2.9 Dec. Source: IMF, Global Financial Stability Report (April 2011). ¹ Refer to the Global Financial Stability Report, April 2011, for detailed notes on cross-country variations in the definitions of the variables. ² Average of Jordan, Lebanon, Morocco, Oman, and United Arab Emirates. ³ Average of Argentina, Brazil, Chile, Colombia, and Mexico. ⁴ Average of China, India, Indonesia, Malaysia, Philippine, and Thailand.pro ts rebounded strongly. The deterioration of yet in sight. Support measures are being phasedthe quality of Russian banks’ loan books came to out quickly or have been phased out entirelya halt during 2010 as the result of ever-higher oil in countries less affected by the crisis or thatprices. Banking systems are gradually returning recovered quickly, such as Moldova and Poland.to normalcy in most other countries, yet the In contrast, support measures are likely to remainrecent evolution of pro tability and asset quality in place where the banking sector is still healingindicators suggests that the next few quarters will (Latvia and Ukraine) or where the macroeconomicremain challenging in Bosnia, Latvia, Lithuania, outlook is still cloudy (Croatia).Montenegro, Romania, and Ukraine. Banks Have Managed to Maintain Comfortable… Justifying a Differentiated Pace for Withdrawal Capital Buffers But Many Remain Dependentof Crisis-Related Measures on Access to External FundingA full exit from liquidity and solvency support Banks’ capital adequacy ratios remained highmeasures taken during the 2008–09 crisis is not in 2010, on par with other emerging market regions 45
    • REGIONAL ECONOMIC OUTLOOK: EUROPEFigure 2.15 Figure 2.17Emerging Europe and Selected Regions: Bank Emerging Europe: Loans-to-Deposits RatioRegulatory Capital to Risk-Weighted Assets, and Credit Growth (Percent)2009–10(Percent) 35 3535 35 30 Belarus 30 Real credit growth, 201030 30 25 Turkey 2010 2009 2525 25 20 2020 20 y = -0.096x + 17.076 15 15 Serbia15 15 R² = 0.20310 10 10 10 5 Albania Macedonia Poland 5 5 5 Russia 0 0 0 Moldova Croatia Hungary 0 Moldova Ukraine Belarus Serbia Turkey Croatia Russia Macedonia, FYR Bulgaria Latin America¹ Middle East² Montenegro Lithuania Bosnia & Herzegovina Albania Asia³ Romania Latvia Hungary Poland -5 Romania Bulgaria -5 -10 LithuaniaUkraine -10 Latvia -15 -15 0 50 100 150 200 250 300 Loans-to-deposits ratio, Dec. 2009 Source: IMF, International Financial Statistics. Notes: Credit growth is not corrected for currency movements. Deposits data exclude nonresident deposits.Source: IMF, Global Financial Stability Report (April 2011).1 Average of Argentina, Brazil, Chile, Colombia, and Mexico.2 Averageof Jordan, Lebanon, Morocco, Oman, and United Arab Emirates.3 Average of China, India, Indonesia, Malaysia, the Philippines, and Thailand. with higher loans-to-deposits ratios saw weaker credit growth (Figure 2.17). For banks that depend on the continued availability of parent funding, the stricterless affected by the crisis and signi cantly above capital requirements that parents will soon faceregulatory minimums (Figure 2.15). This re ects under Basel III imply less room for supporting theirconservative dividend policies, recapitalization expansions. Banks that rely on short-term wholesalewith public or private funds (as in Belarus, Croatia, funding will likely experience direct constraints onHungary, Latvia, and Ukraine), and in some cases, their ability to tap this source in anticipation ofcountercyclical regulatory policies. future compliance with the new Net Stable FundingHowever, despite recent improvements, loans-to- Ratio liquidity standard.deposits ratios remain high in many countries of theregion, potentially limiting the ow of new credit A Second Wave of Consolidation Has Started nanced externally (Figure 2.16). In 2010, countries and Is an Opportunity to Strengthen the SectorFigure 2.16 Consolidation has been limited until recently, butEmerging Europe: Private Sector Loans-to- several banks are about to change hands as troubledDeposits Ratios western European parent banks reconsider their(Percent) presence in some emerging European markets.300 300250 2008 2010 250 Perhaps surprisingly, consolidation took place only200 200 on a small scale during the height of the crisis,150 150 re ecting strong liquidity support from parent100 100 banks—themselves often supported by their 50 50 countries’ governments and central banks—as well 0 0 as swift domestic policy action. The consolidation Latvia Belarus Ukraine Lithuania Hungary Serbia Bulgaria Poland Romania Russia Croatia Turkey Macedonia, FYR Moldova Albania Czech Republic that did occur centered on domestically owned banks in Ukraine and Russia. Recently, however, a few western European banksSource: IMF, International Financial Statistics. directly affected by the sovereign debt crisis in theNote: Deposits data exclude nonresident deposits. euro area periphery put their Polish subsidiaries up46
    • 2. EMERGING EUROPE: UNDERWRITING A SOLID RECOVERYfor sale to preserve capital for their core domestic discussed revisions to Basel II’s Pillar 1 and theoperations.9 At the same time, several Austrian, introduction of new liquidity standards, Basel III alsoBelgian, and German banks that bene ted from contains revisions to the supervisory review processstate aid, and in some cases took large losses in (Pillar 2), including extended guidance on rm-wideemerging Europe during the recession, are looking governance and risk-management practices andto divest a signi cant part of their business in the the design and implementation of sound stress-region.10 These transfers of assets from weaker testing programs, which are particularly relevant forto stronger owners should enable greater access the region. The reciprocity agreement embeddedto capital and enhance capacity to nance credit in the operation of the proposed countercyclicalgrowth in the future.11 capital buffer, whereby internationally active banks would be required by their home supervisors to calculate the capital buffer add-on for exposures toA Strategy for Basel III Implementation Needs to a country, whether booked at the local subsidiariesBe Designed Soon … or offshore, will also promote a level playing eldThe transition to the Basel III framework is an that was badly lacking during the most recent boomopportunity to further strengthen the resilience of (Caruana, 2010). The new macroprudential focusthe region’s banking systems.12 Beyond the much of Basel III implies that governance arrangements for nancial stability will need to be reviewed, and9 Allied Irish Banks (Ireland) sold its subsidiary to Banco that the consistency between microprudential,Santander (Spain); EFG Eurobank (Greece) sold macroprudential, and monetary objectives,70 percent of its subsidiary to Raiffeisen (Austria); and press instruments, and policies must be examined soon.reports suggest that Banco Comercial Portugues (Portugal)is mulling the sale of its Polish unit Bank Millennium.10 Hypo Alpe Adria (Austria), which was nationalized … So Supervisors Need to Remain Vigilantin December 2009, has announced it would start selling Supervisors need to keep abreast of persistentassets in the region in 2012 (see Bloomberg, 2010b),while Volksbanken AG (Austria) is reported to be aiming and emerging vulnerabilities. The legacy of thefor the sale of a majority share of its operations in the boom-bust cycle is still present in most countries.region in the first half of 2011 (see Bloomberg, 2010c). Real estate prices remain depressed or keep falling,KBC (Belgium) committed to sell its subsidiaries in and are often supported by formal or informalRussia and Serbia as well as its 31 percent share of the barriers to initiating foreclosure proceedings.largest bank in Slovenia (see FT.com, 2009). BayernLB(Germany) is contemplating selling its Hungarian unit The share of foreign currency loans is close to peakMKB (see Bloomberg, 2010a). WestLB (Germany) levels, making the broader economy vulnerablealready sold its Hungarian subsidiary in July 2009 to to exchange rate pressures and exposing banksdomestic investors. to indirect currency risk (Figures 2.18 and 2.19).11 In addition, the second largest Russian bank, VTB, As recommended in a recent European Bankannounced its acquisition of a controlling share of Coordination Initiative report on local currencyBank of Moscow on March 21, 2011, and the Latviangovernment is preparing for a privatization of Citadele and capital market development (EBCI, 2011),Bank in the near future. Citadele Bank is the “good bank” supervisors should ensure that the pricing of foreignthat emerged from the recent restructuring of Parex currency loans adequately re ects the associatedBank, the country’s second largest bank, which had been credit and nancial stability risks.13 The ongoingnationalized in November 2008 to avoid its collapse. sovereign debt troubles in the euro area pose funding12 The new framework was published on December 15,2010. For EU countries, the Basel III framework will risks for the region’s banks. Furthermore, borrowers’be transposed into EU legislation through the Capital debt servicing capacity could come under strainRequirements Directive IV, for which the European should persistent in ation pressures prompt steeper-Commission is expected to deliver a proposal later this than-expected interest rate hikes.year. Russia and Turkey are Basel Committee members,and are therefore expected to implement the accordwithin the agreed 2013–19 time frame. 13 See in particular recommendation no. 9 of the report. 47
    • REGIONAL ECONOMIC OUTLOOK: EUROPEFigure 2.18 Figure 2.19Emerging Europe: Property Prices, Emerging Europe: Stock of Foreign2008:Q3–2010:Q4 Currency Loans, December 2010(Index, 2008:Q3=100) (Percent) 100 100 Foreign Currency Loans as a Share of Private Sector Credit110 110 Selected New Member States: Property Prices Selected New Member States: Property Prices 80 80100 Hungary Hungary 100 Household 60 60 Corporate Poland Poland Indexed 90 90 40 40 20 20 80 80 Bulgaria Bulgaria 0 0 Belarus Russia Turkey Poland Moldova Ukraine Macedonia, FYR Bulgaria Hungary Romania Albania Serbia Lithuania Croatia Latvia 70 70 Lithuania Lithuania 60 60 Latvia Latvia 50 50 40 40 100 100 2008:Q3 2009:Q1 2009:Q3 2010:Q1 2010:Q3 Foreign Currency Loans as a Share of GDP 80 80Sources: BIS, Property Price Statistics; and IMF staff calculations. HouseholdNote: All prices are in local currency. 60 Corporate 60 Indexed 40 40110 110 Selected Emerging Europe Countries: Property Prices 20 20100 Russia 100 0 0 Belarus Russia Turkey Macedonia, FYR Moldova Poland Romania Albania Ukraine Serbia Croatia Latvia Hungary Bulgaria Lithuania Serbia 90 90 Croatia 80 80 70 70 Sources: IMF, International Financial Statistics; and IMF, World Economic 60 Ukraine 60 Outlook database. Note: Breakdown between corporate and household is not available for 50 50 indexed loans. Data for Turkey are for November 2010. 40 40 2008:Q3 2009:Q1 2009:Q3 2010:Q1 2010:Q3Sources: BIS, Property Price Statistics; Centar Nekretnina; Statistical need to reorient toward the tradable sector toOffice of the Republic of Serbia; Blagovist; and IMF staff calculations. achieve sustainable growth.14 Although the deepNote: Prices in Russian rubles (Russia), euros (Croatia, Serbia), andU.S. dollars (Ukraine). recession of 2009 has mostly corrected the large external imbalances built up in the boom years, many resources have been idled. With the oldCross-border cooperation also remains essential. growth model exposed as unsustainable, the goalFor the new member states, the launch of the must now be to reengage most of these resourcesEuropean Supervisory Authorities and the in a vibrant tradable sector. Empirical evidenceEuropean Systemic Risk Board as described in suggests that export activity has a signi cantChapter 1 offers the opportunity to reconcile the positive effect on both research and developmentgoal of developing effective cross-border oversight spending and on product innovation,15 thus,with enhancing a single EU nancial market (IMF, greater reliance on external demand could yield2010a, Box 7). 14 See also European Bank for Reconstruction andShifting Resources to the Tradable Development (EBRD, 2010). Several countries inSector central Europe, such as the Czech Republic, Hungary, and the Slovak Republic, already have large tradableA New Growth Model Is Needed sectors. As these countries show, having a vibrant export sector is not the same as running currentAs emphasized in previous editions of the Regional account surpluses.Economic Outlook, many economies in the region 15 See EBRD (2010), Chapter 4.48
    • 2. EMERGING EUROPE: UNDERWRITING A SOLID RECOVERY Table 2.5 Emerging Europe: Employment Growth, 2008:Q3–2010:Q3 (Percent) Construction, Financial Total Intermediation, and Real Estate Manufacturing Country 2008:Q3–2010:Q3 2009:Q3–2010:Q3 2008:Q3–2010:Q3 2009:Q3–2010:Q3 2008:Q3–2010:Q3 2009:Q3–2010:Q3 Turkey 2.7 5.0 4.5 7.1 0.3 8.8 Macedonia, FYR 2.3 1.0 ... ... ... ... Montenegro -2.9 -10.9 ... ... ... ... Poland 0.5 0.8 4.2 0.2 -4.6 -4.7 Russia -0.7 0.7 -0.6 1.3 -3.6 0.5 Hungary -1.3 1.4 0.0 2.8 -4.1 1.7 Bosnia and Herzegovina -2.0 -1.6 -3.4 -3.9 -5.9 -4.8 Ukraine -2.0 0.2 ... ... ... ... Romania -1.9 -1.9 4.8 4.7 -0.9 -0.9 Albania -2.8 -5.7 ... ... ... ... Moldova -3.2 -1.8 -2.1 2.5 -5.0 -3.5 Croatia -3.9 -5.2 ... ... ... ... Bulgaria -4.3 -5.2 -9.8 -15.4 -6.4 -3.8 Serbia -5.2 -2.8 ... ... ... ... Lithuania -6.2 -5.1 -11.0 -6.0 -10.8 -6.9 Latvia -8.6 0.1 -17.2 -4.2 -7.0 8.2 Sources: Eurostat; Haver Analytics; and IMF staff calculations. Note: All data are annualized.more stable GDP growth and stronger total factor across sectors have been detected.17 Except forproductivity growth.16 Latvia and Turkey, employment has not grown faster in the tradable sector than in the nontradable sector during the past few quarters. Projected realIts Gestation Will Likely Take Some Time export growth for 2011–12 is generally unrelated toThe cross-sectoral reallocation of labor continues, the change in employment since the onset of theand countries will have a hard time exporting crisis (Figure 2.20). Thus, the pace of job creationtheir way out of high unemployment quickly. in the tradable sector will likely fall short of the rateIn most countries, employment still lingers far needed to reabsorb the unemployed quickly.below precrisis level, and employment growth in Signs of reallocation of capital from thecountries with large declines in employment in nontradable to the tradable sector are also stillthe year following September 2008 has not been scant. Data on the sectoral distribution ofstronger than elsewhere in the region since then domestic credit to corporations suggest that(Table 2.5). Where external imbalances were the reallocation has yet to get under way in countrieslargest, employment has declined more in the with the largest precrisis external imbalances. Innontradable than in the tradable sector, but only Bulgaria and Lithuania, the ratio of credit to thetentative signs of the required labor reallocation primary and tradable secondary sectors to GDP16 At the same time, large productivity improvements are 17 The tradable sector is proxied by manufacturing,still to be gained in the nontradable sector throughout and the nontradable sector is proxied by construction,the region. financial intermediation, and real estate. 49
    • REGIONAL ECONOMIC OUTLOOK: EUROPEFigure 2.20 Figure 2.21Emerging Europe: Employment Growth and Emerging Europe: Changes in Credit toProjected Export Growth Corporations by Industry, 2008–10(Percent) (Percentage points of GDP)Average real export growth, 2011–12 16 16 18 18 14 Agriculture, fishing, forestry, mining, and manufacturing 14 16 16 12 Construction 12 FYR Macedonia 10 Other 10 14 Serbia 14 8 8 6 6 12 12 4 4 10 Lithuania 10 2 2 Hungary 0 Bulgaria 0 8 Romania 8 -2 -2 Moldova Latvia Montenegro Ukraine Poland Turkey -4 -4 6 6 Hungary Lithuania Albania Ukraine Russia Bulgaria Latvia Romania Kosovo Turkey Serbia Belarus Bosnia & Bonia & Herzegovina 4 Albania Herzegovina 4 Croatia Russia 2 2 0 0 -20 -15 -10 -5 0 5 10 Employment growth, 2008:Q3–2010:Q3Sources: Haver Analytics; IMF, World Economic Outlook database. Sources: National central banks; Haver Analytics; and IMF, World Economichas not increased signi cantly more (or decreased Outlook database. Note: For Bulgaria and Ukraine, data for "other" include only loans toless) than that of credit to the other sectors since nonfinancial corporations. For Albania, change is from 2008 to 2009.end-2008 (Figure 2.21). In Latvia and Romania,that ratio has grown at a slower pace than thatof credit to the construction sector. Data on Figure 2.22foreign direct investment (FDI) ows are slightly Emerging Europe: Foreign Directmore encouraging (Figure 2.22). In the Baltics, Investment Flows by Sector, 2007, 2010 (Percent of GDP)Croatia, and Serbia, FDI ows to the primaryand tradable secondary sectors, even if small, 35 30 2007 Agriculture, fishing, mining, and manufacturing 2007 Financial intermediation 35 30achieved the same level (as a share of GDP) in 25 2007 Construction and real estate¹ 2007 Others 25 2010 Agriculture, fishing, mining, and manufacturing²2010 as in 2007 despite the general decline of 20 15 2010 Financial intermediation² 2010 Construction and real estate¹ ² 20 15FDI ows to the region. In Bulgaria, they are 10 2010 Others² 2010 Total 10now higher than ows into construction, real 5 0 5 0estate, and nancial intermediation. However, -5 -5 Bosnia Turkey Latvia Ukraine Lithuania Hungary Serbia Croatia Poland Bulgaria Kosovosuch ows have signi cantly declined in mostother countries. Sources:Central bank web sites; and national authorities. Note: Data for Hungary include equity capital only, and exclude specialPublic Policies Can Spur the Transformation purpose entities. ¹Latvia, Turkey, and Ukraine: Construction and real estate, renting,In the short to medium term, macroeconomic and business activities. ²Poland: Data are for 2009.policies can encourage the transformation to thetradable sector through their effects on the real sector wage moderation and highly productiveexchange rate. In countries with xed exchange public investment.18rates, scal policy can support competitiveness bypreventing overheating that would draw resources Although budgetary resources are scarcer in theto the nontradable sector. Countries with exible postcrisis environment and scal consolidationexchange rates should emphasize scal rather than is a priority, public investment in human capitalmonetary tightening as the recovery progresses. and structural reforms are needed to brightenRegardless of the exchange rate regime, scal policy medium-term growth prospects. Honkapohja (2010)can support the adjustment to the new growthmodel through permanent shifts in the composition 18On the revenue side, discriminatory taxation by sectorof public expenditures, especially through public of economic activity is best avoided.50
    • 2. EMERGING EUROPE: UNDERWRITING A SOLID RECOVERYFigure 2.23 development. Similar investments in emergingEmerging Europe: Ease of Doing Business Rank, Europe would enhance productivity growth2010–11 and shift production toward increasingly more160 160 sophisticated products. At the same time, the extent140120 140 120 of the necessary sectoral reallocation of human 2011100 2010 100 resources calls for support for training programs 80 80 60 60 to address skill mismatches and, in many cases, 40 20 40 20 for further labor market reforms. Also, micro- 0 0 competitiveness could be supported through Macedonia, Lithuania Latvia FYR Hungary Bulgaria Romania Turkey Montenegro Belarus Poland Albania Croatia Serbia Moldova Bosnia & Kosovo Russia Ukraine Herzegovina further improvements in the business environment, in particular in the European CIS and western Balkan countries where announced reform plansSource: World Bank, Ease of Doing Business database, 2011. still await implementation (Figure 2.23). SuchNote: Countriesare ranked from best to worst out of a group of 183 countries. improvements would be particularly effective in making skilled labor emigration relatively lessFigure 2.24 attractive and return migration more attractive.Emerging Europe: Logistics Performance Export potential could also be increased directly byIndex, 2007–10 investments in infrastructure and, more broadly, by4.0 2010 4.0 support for logistics chains. The region still needs3.5 3.5 2007 signi cant improvements in physical infrastructure.3.0 3.02.5 2.5 With limited domestic scal space, nancing2.0 2.0 such large projects would be a good use of EU1.5 1.5 funds. Public-private partnerships should also be1.0 1.0 sought and innovative private sector nancing Montenegro Albania Moldova Ukraine Russia Bosnia & Herzegovina Serbia Croatia Macedonia, FYR Bulgaria Romania Hungary Lithuania Turkey Latvia Poland mechanisms, such as the credit enhancement recently proposed by the European Commission, should be explored.19 Improvements in logistics and removal of nontariff barriers would also directly bene t export performance. The 2010 World BankSource: World Bank. Logistics Performance Index documents both aNote: Countries are graded on a scale from 1 (worst) to 5 (best). general improvement in this matter across the region and large scope for intraregional convergence of the western Balkans and the CIS toward the new EUexplains how Finland managed to rebound from member states and Turkey (Figure 2.24).a deep nancial crisis in the early 1990s andexperience signi cant structural change throughpublic investments in education and research and 19 See European Commission (2011). 51
    • 3. Financial Integration, Growth, and ImbalancesIn the run-up to the crisis, nancial integration in Europe by the 2008–09 nancial crisis. In the euro areaboosted investment and reduced saving in countries that periphery, strong cross-border capital ows in thepreviously had high interest rates. As capital in ows run-up to the crisis fueled credit, asset price, andincreasingly went into the nontradable sector and contributed domestic demand booms, which led to a surgeto credit and housing booms, countries in the euro area in imports, rapid expansion of the nontradableperiphery and countries in emerging Europe with xed sector, deterioration of competitiveness, andexchange rates built up large current account imbalances, widening current account de cits. This patternwith ultimately unsustainable trajectories of net external was also observed in countries with exchangeasset positions. Financial markets did not pay suf cient rates pegged to the euro in anticipation of earlyattention to these vulnerabilities, and policies did too little euro area entry. When capital ows slowed,to address market failures. When capital ows slowed, the the domestic demand booms ended, and sharpboom ended, and sharp recessions ensued. The absence of recessions ensued.EU-wide institutions to deal with banking crises and the The legacy of the boom years and subsequentincomplete integration of capital markets compounded the crisis is likely to depress growth in the euro areacrisis. To overcome the crisis decisively, the most critical factor periphery and countries with exchange rates peggedin the longer run is restoring growth in the crisis-af icted to the euro for some time. The debt overhang incountries. To prevent new crises, more vigilance is needed, the private sector and sharply deteriorated publicbetter institutions to deal with nancial sector problems nances will subdue domestic demand, while themust be developed, and more, rather than less nancial and erosion of competiveness during the boom iseconomic integration is needed. bound to depress exports. In the absence of laborThe establishment of the Economic and Monetary mobility and exchange rate exibility, and withUnion (EMU) in 1999 marked an important step limited wage and price adjustment capacity,toward nancial integration in Europe. In 1999, turning these dynamics around is proving to be11 member states of the European Union (EU) quite challenging.adopted the euro as their common currency, and This chapter rst discusses the contribution ofsix more countries followed in the subsequent nancial integration to rising current accountyears.1 Several countries in central and eastern imbalances before the crisis. It shows how nancialEurope (CEE)—notably the Baltic countries and integration led to sharp compression of interestBulgaria—pegged their currencies unilaterally to the rate differentials, which boosted investment andeuro, thus tying their monetary policies to that of reduced saving in countries that previously had highthe European Central Bank (ECB). interest rates, and how strong credit and housingRising current account imbalances accompanied booms led to massive current account de cits. nancial integration, and countries with high The chapter then reviews why the unwinding ofcurrent account de cits were particularly hard hit the imbalances led to such a severe crisis. It will show that the widening of current account de cits ultimately was the result of an unsustainable andNote: The main authors of this chapter are Lone risky growth pattern, which went on for too long asChristiansen, Yuko Kinoshita, Jeta Menkulasi, Esther markets paid insuf cient attention to risingPerez, Irina Tytell, Nico Valckx, and Johannes Wiegand. risks, and policies did too little to address these1 Austria, Belgium, Finland, France, Germany, Ireland, market failures.Italy, Luxembourg, the Netherlands, Portugal, and Spain.They were followed by Greece (2002), Slovenia (2007), The aggravation of the crisis by the absence ofCyprus, Malta (both 2008), the Slovak Republic (2009), EU-wide institutions to deal with banking crisesand Estonia (2011). and by the incomplete integration of capital 53
    • REGIONAL ECONOMIC OUTLOOK: EUROPEmarkets is also discussed. Although the EU has Imbalances and Crisisfostered nancial integration by relaxing constraints,harmonizing various aspects of the nancial The elimination of exchange rate risk in the wakesystem, and adopting a common currency, this of monetary integration led to rapid reductions inprocess has been allowed to outpace development risk premiums and to interest rate convergence,of the institutions necessary to support the single particularly for money market and government nancial market. In the absence of EU-wide bond rates (Figure 3.1). Progress in scalinstitutions, the approach to dealing with banking consolidation, aimed at meeting the Maastricht debtsector problems remained national throughout the and de cit criteria, further reduced risk premiums.crisis. Banking and sovereign debt problems have In the rst half of the 1990s, the governments ofthus exacerbated each other, leading to vicious Finland, Italy, Portugal, and Spain still paid spreadscircles in the periphery. of 400 basis points or more over German bund rates, re ecting a history of frequent devaluations.Finally, the chapter discusses that while the crisis In the run-up to the euro introduction, during 1995has led to a sharp adjustment of earlier current to 1998, these spreads disappeared almost entirely,account imbalances, just dealing with imbalances is bringing immediate and tangible bene ts in thenot enough. The most critical factor in the longer form of lower funding costs for the public sector,term is restoring GDP growth in the crisis-affected corporations, and households. The process repeatedcountries, with stronger roles for the tradable sector itself for countries adopting the euro at later stages,and exports, and less reliance on the nontradable as well as for the hard peg countries in emergingsector, capital ows, and domestic demand. Europe that had tied their currencies to the euro.Ultimately, growth and convergence will need to Interest rate convergence tended to be far lessbe backed by productivity increases. To foster pronounced in the central European countries thatef ciency increases and prevent the reemergence kept exible exchange rates, and for countries thatof imbalances, better policies are needed at the were not members of the EU.3national level, while better governance at the EUlevel would give teeth to such policies. Monetary integration also encouraged larger cross-border nancial exposures (Figure 3.2).The chapter focuses on the original EMU members, In the banking sector, the share of interbankGreece, the Baltic countries, and Bulgaria. loans to banks within the euro area increased fromThese countries shared the euro, or had a hard 15 percent in the late 1990s to 25 percent in thepeg to the euro, for at least ve years before the late 2000s, and to 20 percent from 10 percent forstart of the global crisis in 2007.2 To highlight the interbank loans to banks in the EU but outside therole of nancial integration, as opposed to trade euro area. In addition, home bias for investmentintegration, developments in four central European funds’ allocations of equity and debt securitiescountries (the Czech Republic, Hungary, Poland, declined signi cantly.4and the Slovak Republic), which during the run-upto the global crisis all had exible exchange Not all nancial markets became equally integrated:rates, are compared with developments in the by 2007, debt markets had become most integrated,focus countries. while cross-border ows in foreign direct investment (FDI) and equity portfolio investment remained more limited. External debt liabilities 3 The exception is the Czech Republic. 4 By contrast, retail lending remained largely within2 Cyprus, Malta, Slovenia, and the Slovak Republic, which national borders because banking groups typicallyentered the euro area between 2007 and 2009, did not expanded into other European countries by establishingmeet this criterion. Luxembourg is excluded because of branches or subsidiaries rather than through direct cross-its small size and role as a financial center. border lending.54
    • 3. FINANCIAL INTEGRATION, GROWTH, AND IMBALANCES Figure 3.1 Selected EU Countries: Convergence of Long-Term Government Bond Rates, 1990–2010 (Percent) 20 20 20 20 Austria France Belgium Greece Finland Ireland 15 Germany 15 15 Italy 15 Netherlands Portugal Spain 10 10 10 Germany 10 5 5 5 5 0 0 0 0 1990 1993 1996 1999 2002 2005 2008 1990 1993 1996 1999 2002 2005 2008 20 20 20 20 Bulgaria Czech Republic Estonia Hungary Latvia Poland 15 15 15 Slovak Republic 15 Lithuania Germany Germany 10 10 10 10 5 5 5 5 0 0 0 0 2001 2003 2005 2007 2009 2001 2003 2005 2007 2009 Source: IMF, International Financial Statistics.were generally several times larger than FDI and The Widening of External Imbalancesexternal equity investment (Figure 3.3). Within The decline in interest rates boosted investment anddebt markets, a number of countries’ cross-border reduced saving in countries where interest rates hadholdings were largely con ned to sovereign debt previously been high. The impact was particularly(Figure 3.4). pronounced in relatively poor countries becauseCross-border mergers and acquisitions remained the expected rapid income growth there madesmall compared with domestic mergers and borrowing more attractive (Figures 3.6 and 3.7,acquisitions (Figure 3.5), and remained much lower and Table 3.1).than mergers and acquisitions across regions in the • Household balances deteriorated as householdUnited States (Umber, Grote, and Frey, 2010). High saving declined and residential real estateconcentration of corporate control (Becht and investment increased. Countries with housingMayer, 2000), regulatory differences (particularly price booms saw the largest deterioration in thein the application of takeover regulations), and saving-investment balance.predictability of national regulatory agenciesseem to have been the most important barriers to • Corporate balances worsened as corporatecross-border equity ows, including in the banking saving declined, probably as a result of thesector in the EU (Koehler, 2007; and Campa and increase in unit labor costs (see next section).Moschieri, 2008). In the hard peg countries, corporate investment 55
    • REGIONAL ECONOMIC OUTLOOK: EUROPE Figure 3.2 Selected EU Countries: Indicators of Financial Integration, 1998–2008 (Percent) 70 70 70 70 Investment Funds’ Holdings of Equity Issued in Other Euro Investment Funds’ Holdings of Debt Securities Issued in Area Countries and the Rest of the World Other Euro Area Countries and the Rest of the World 60 (Percent of total holdings of equity) 60 60 (Percent of total holdings of debt securities) 60 50 50 50 50 40 40 40 40 30 30 30 30 20 20 20 20 10 10 10 10 Other euro area countries Other euro area countries Rest of the world Rest of the world 0 0 0 0 Dec-98 Jun-00 Dec-01 Jun-03 Dec-04 Jun-06 Dec-07 Dec-98 Jun-00 Dec-01 Jun-03 Dec-04 Jun-06 Dec-07 35 35 35 35 Interbank (MFI) Outstanding Loans by Residency of Issuer MFI Cross-Border Holdings of Debt Securities Issued (Percent of total holdings of loans) by Euro Area Governments and Non-MFIs 30 30 30 (Percent of total holdings of debt securities) 30 25 25 25 25 20 20 20 20 15 15 15 15 10 10 10 10 5 5 5 5 Other euro area countries Other euro area countries-government bonds Rest of EU Other euro area countries-corporate bonds 0 0 0 0 Dec-98 Jun-00 Dec-01 Jun-03 Dec-04 Jun-06 Dec-07 Dec-98 Jun-00 Dec-01 Jun-03 Dec-04 Jun-06 Dec-07 Source: European Central Bank. Note: MFI stands for monetary financial institutions. booms also contributed signi cantly to the took many years of internal devaluation to correct. current account deterioration. An additional factor hurting its competitiveness was the convergence of interest rates in theBy contrast, in countries where income levels wake of the euro’s introduction, which negatedand interest rate levels had already converged, Germany’s comparative advantage of low funding nancial integration did not further compress costs. Corporate investment was weak, re ectinginterest rates, and domestic demand remained both weak domestic demand and outsourcing tomuch more muted. In fact, private sector balances suppliers in emerging Europe.improved, although partly for reasons not directlyrelated to nancial integration. Corporate saving Current account balances in the EU started toincreased because wage moderation led to an widen as a result, peaking in 2007 (Figures 3.8, 3.9,increase in the share of pro ts in national income. and 3.10). Current account balances deterioratedGermany had entered the euro area with an sharply in Ireland, Spain, and the hard pegimpaired competitive position, re ecting in part countries. By 2007, current account de cits inthe overhang from German reuni cation, which Greece, Portugal, Spain, and the hard peg countries56
    • 3. FINANCIAL INTEGRATION, GROWTH, AND IMBALANCESFigure 3.3 Figure 3.4Selected EU Countries: International Selected EU Countries: Components of DebtInvestment Position, Liabilities1 Securities Liabilities1(Percent of GDP) (Percent of GDP)350 350 769 Debt 100 100 Debt Securities: Government 1999300 300 90 90 1999 2007 Average2 80 2007 80 70 70250 250 60 60 50 50200 200 40 40 30 30150 150 20 20 10 10100 100 0 0 Greece Austria Italy France Belgium Portugal Germany Finland Netherlands Spain Ireland Lithuania Bulgaria Latvia Estonia 50 50 0 0 Italy Spain Latvia Ireland Austria France Greece Finland Estonia Belgium Bulgaria 1999 2007 Portugal Germany Lithuania Netherlands 100 100 Debt Securities: Others 1999 90 90 80 292 2007 80350 350 70 70 FDI 60 60 300 50 50300 2007 1999 Average2 40 40 30 30250 250 20 20 10 10200 200 0 0 Austria Ireland Netherlands Spain Germany France Italy Greece Finland Portugal Estonia Latvia Belgium Bulgaria Lithuania150 150100 100 Sources: IMF, Balance of Payments Statistics database; and IMF, World 50 50 Economic Outlook database. 1 For Ireland, 2001 instead of 1999 data have been used reflecting lack of 0 0 data availability. Italy Spain Latvia Ireland Austria France Greece Finland Estonia Belgium Portugal Bulgaria 1999 2007 Germany Lithuania Netherlands exceeded 10 percent of GDP. By contrast, current350 Equity 350 account balances improved sharply in Austria,300 445 300 Germany, and the Netherlands. 1999 2007 Average2250 250 The convergence in interest rates not only fueled private sector spending, it also boosted government200 200 primary spending. The interest rate compression150 150 provided a substantial windfall for countries like Italy and Greece, allowing these countries to reduce100 100 their overall de cits while increasing primary 50 50 spending (Figure 3.11). The boom in private sector 0 0 domestic demand fueled a surge in government tax revenue, which created further space to boost Italy Spain Latvia Ireland Austria France Greece Finland Estonia Belgium Bulgaria 1999 2007 Portugal Germany Lithuania Netherlands primary expenditure (Figure 3.12). As a result, countries in the periphery saw a sharp increaseSources: IMF, Balance of Payments Statistics database; and IMF,World Economic Outlook database. in primary expenditure between 2000 and 2007—even though this was not visible in headline1 For Ireland, 2001 instead of 1999 data have been used reflectinglack of data availability.2 15th and 85th percentile. scal balances at the time. 57
    • REGIONAL ECONOMIC OUTLOOK: EUROPEFigure 3.5 In general, the change in scal balances played onlySelected EU Countries: Cross-Border Mergers a modest part in increasing external imbalances.and Acquisitions for Selected Target Countries, The improvement in headline balances was the real2001–07 problem, because it disguised deterioration in the(Percent of completed deals)1 underlying scal situation. Interest savings and what 30 30 turned out to be the temporary revenues had been used to boost primary expenditure. Shocks external to the EU and euro area also 25 25 contributed to rising imbalances. The integration of China into the world economy bene ted Germany, which exported high-end machinery, but 20 20 hurt southern Europe (Chen, Milesi-Ferretti, and Tressel, forthcoming). The integration of CEE countries into Europe boosted German rms’ 15 15 productivity as they set up production platforms in the region, but competed with other countries’ exports (Marin, 2010). Similarly, the appreciation 10 10 of the euro between 1999 and 2008 had a bigger France Italy Germany Denmark Spain Total United Kingdom impact on some countries in the periphery, for which trade with countries outside the euro area is very important, than on countries in the core, for which trade with other euro area countries is moreSources: Thomson One Banker; and IMF staff calculations. important.51 Completed deals in which the target company and the acquirercompany are based in the Europe 15 area (Austria, Belgium, Denmark,Finland, France, Germany, Greece, Ireland, Italy, Luxembourg,Netherlands, Portugal, Spain, Sweden, and the United Kingdom). Dealsinclude only those that imply a change of control of the acquired company(20 percent of ownership), but exclude those in which the acquirer 5 The bulk of the appreciation of the CPI-based realalready had control before acquisition. effective exchange rate in Greece and Portugal was due to the nominal appreciation of the euro (Chen, Milesi-Ferretti, and Tressel, forthcoming). Figure 3.6 Euro Area: Current Account Balances in 2007 and Starting Positions in the 1990s 110 110 18 18 Real Incomes Netherlands Government Bond Rates Austria Greece Purchasing power parity per capita, 1990 105 105 Government bond rate, 1995 (percent) 16 16 France Germany 100 Belgium 100 95 95 14 14 (relative to Germany) Italy Finland 90 90 Italy 12 12 Portugal 85 85 Spain 10 10 80 80 Spain Finland 75 75 8 Ireland 8 Belgium Greece Ireland France Netherlands 70 70 Austria Germany 6 6 65 y = 1.7222x + 91.57 65 1.722x + 91.57 y = -0.35x + 9.0 R² = 0.7291 0.729 R² = 0.70 Portugal 60 60 4 4 -15 -10 -5 0 5 10 -15 -10 -5 0 5 10 Current account balance, 2007 (percent of GDP) Current account balance, 2007 (percent of GDP) Sources: IMF, World Economic Outlook database; IMF, International Financial Statistics; and IMF staff calculations.58
    • 3. FINANCIAL INTEGRATION, GROWTH, AND IMBALANCES Figure 3.7 Euro Area: Saving-Investment Balances, 2000–09 (Percent of GDP) 30 30 30 30 Surplus Countries Deficit Countries Total Total 25 25 25 25 20 20 20 20 Saving Saving Investment Investment 15 15 15 15 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 12 12 12 12 Surplus Countries Deficit Countries Households Households 10 10 10 10 8 8 8 8 6 6 6 6 Saving Saving Investment Investment 4 4 4 4 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 14 14 14 14 Surplus Countries Deficit Countries Corporate Corporate 12 12 12 12 10 10 10 10 8 8 8 8 Saving Saving Investment Investment 6 6 6 6 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 5 5 5 5 Deficit Countries 4 Surplus Countries 4 4 Government 4 Government 3 3 3 3 2 2 2 2 1 1 1 1 0 0 0 0 -1 -1 -1 -1 -2 -2 -2 -2 -3 -3 -3 -3 Saving Saving -4 -4 -4 -4 Investment Investment -5 -5 -5 -5 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Sources: Eurostat; and IMF staff calculations. Note: Surplus (deficit) countries are countries with a current account surplus (deficit) in 2007. Surplus countries include Austria, Belgium, Finland, Germany, and the Netherlands. Deficit countries include France, Ireland, Italy, Portugal, and Spain.The Crisis experienced the most severe retrenchment (Milesi-Ferretti and Tille, 2011). As risk aversionThe credit booms in Europe came to a sudden end among investors rose sharply and equity marketsin September 2008 after Lehman Brothers led for plunged, many advanced-country banks, whenbankruptcy. All types of capital ows reversed in confronted with liquidity and capital shortages,the fall of 2008, but cross-border banking ows sharply curtailed new lending or even deleveraged. 59
    • REGIONAL ECONOMIC OUTLOOK: EUROPE Table 3.1 Selected EU Countries: Sectoral Saving-Investment Balances, 2000–07 (Percent of GDP, unless otherwise indicated) Households Nonfinancial corp. Financial corp. General government Total S I Net S I Net S I Net S I Net S I Net 2007 Surplus countries 10.2 6.5 3.8 12.6 11.1 1.5 1.0 0.3 0.7 2.8 1.7 1.0 26.6 19.6 7.0 Netherlands 6.9 7.5 -0.5 17.0 9.3 7.7 1.5 0.4 1.2 3.4 3.3 0.1 28.8 20.4 8.4 Germany 11.5 6.2 5.3 11.4 10.5 0.8 0.7 0.1 0.6 2.4 1.4 1.0 26.0 18.3 7.6 Finland 3.9 7.7 -3.7 14.9 12.5 2.5 0.7 0.3 0.4 7.6 2.5 5.1 27.1 22.9 4.2 Austria 10.2 5.3 5.0 12.0 16.0 -4.0 2.3 0.7 1.6 2.6 1.1 1.4 27.2 23.2 4.0 Belgium 10.0 6.7 3.3 13.6 13.7 0.0 1.3 0.8 0.6 1.7 1.6 0.1 26.7 22.8 3.9 Deficit countries1 9.0 7.7 -1.0 6.8 12.8 -2.9 1.5 0.5 0.6 2.8 3.2 -0.4 20.0 24.2 -4.2 Italy 10.2 6.9 3.3 6.3 12.2 -5.9 1.3 0.4 0.9 2.3 2.3 0.0 20.1 21.9 -1.8 France 10.2 7.0 3.1 7.9 11.1 -3.2 0.8 0.8 0.0 1.1 3.3 -2.2 20.0 22.2 -2.2 Ireland 3.3 12.2 -8.8 9.3 9.8 -0.4 4.9 0.6 4.3 4.1 4.7 -0.5 21.7 27.2 -5.5 Spain 6.9 9.7 -2.8 5.2 17.2 -12.0 2.1 0.1 2.0 6.9 4.0 2.8 21.0 31.0 -10.0 Portugal 4.9 5.8 -0.9 5.6 13.6 -8.0 2.6 1.0 1.6 -0.5 2.4 -2.9 12.7 22.9 -10.2 Greece2 -1.1 9.4 -10.5 10.7 7.2 3.5 2.0 0.3 1.7 -2.5 2.8 -5.3 9.0 19.7 -10.7 Hard peg -6.3 4.8 -11.1 16.0 26.0 -10.0 1.3 0.1 1.1 6.0 5.4 0.6 16.9 36.3 -19.4 Lithuania -3.2 3.9 -7.1 13.9 21.5 -7.6 1.5 0.1 1.3 3.6 5.3 -1.7 15.8 30.9 -15.1 Estonia -0.9 8.5 -9.4 15.5 26.1 -10.6 -0.2 -0.1 -0.1 7.6 5.1 2.5 22.0 39.6 -17.7 Latvia -3.0 5.0 -8.0 12.4 29.1 -16.7 3.0 0.0 3.0 5.7 6.3 -0.6 18.1 40.4 -22.3 Bulgaria -14.9 3.5 -18.4 21.0 28.0 -7.0 0.7 0.4 0.3 7.6 4.9 2.7 14.3 36.8 -22.5 2000 Surplus countries 9.6 7.2 2.5 8.9 12.2 -3.3 1.5 0.7 0.8 2.4 2.0 0.4 22.4 22.0 0.4 Netherlands 6.9 7.0 -0.1 13.8 10.4 3.4 3.1 1.4 1.7 4.5 3.1 1.4 28.4 22.0 6.4 Germany 10.5 7.5 2.9 6.9 12.0 -5.1 1.2 0.5 0.7 1.6 1.8 -0.2 20.2 21.8 -1.6 Finland 4.4 6.6 -2.3 14.7 11.6 3.1 0.1 0.2 -0.1 9.3 2.4 6.8 28.5 20.9 7.6 Austria 8.9 5.7 3.1 11.3 16.0 -4.7 2.1 1.0 1.1 1.3 1.5 -0.2 23.6 24.3 -0.7 Belgium 10.6 5.9 4.8 12.5 13.8 -1.3 1.0 0.9 0.1 2.6 2.0 0.6 26.7 22.5 4.2 Deficit countries1 9.2 6.5 2.7 8.8 11.9 -3.1 1.2 0.6 0.6 2.0 2.9 -0.9 21.2 21.9 -0.7 Italy 9.9 6.5 3.4 8.6 11.3 -2.8 0.8 0.6 0.3 1.3 2.3 -1.0 20.6 20.7 -0.1 France 9.8 5.7 4.0 8.3 10.8 -2.5 1.4 0.8 0.5 2.1 3.1 -1.0 21.6 20.5 1.1 Ireland3 4.9 7.4 -2.5 9.4 8.9 0.6 2.2 0.4 1.8 3.9 4.3 -0.3 20.5 20.9 -0.4 Spain 7.5 7.4 0.1 10.3 15.3 -5.0 1.5 0.4 1.1 3.0 3.2 -0.1 22.3 26.3 -4.0 Portugal 7.5 8.8 -1.2 8.0 15.4 -7.4 1.7 0.7 1.0 0.5 3.7 -3.1 17.8 28.5 -10.7 Greece 2.4 11.5 -9.1 8.3 7.8 0.6 0.7 0.4 0.3 -0.2 3.6 -3.8 11.3 23.3 -12.0 Hard peg -1.1 2.2 -3.3 13.4 17.6 -4.2 1.8 0.7 1.1 3.1 2.6 0.5 17.2 23.0 -5.8 Lithuania 4.5 3.7 0.9 5.6 12.5 -6.9 1.3 0.4 1.0 1.5 2.4 -0.8 13.0 18.9 -5.9 Estonia 2.3 3.4 -1.0 16.0 21.2 -5.1 1.5 0.3 1.2 3.5 3.8 -0.3 23.4 28.7 -5.3 Latvia 1.5 1.4 0.2 14.4 19.9 -5.5 2.7 1.1 1.6 0.2 1.4 -1.1 18.9 23.7 -4.8 Bulgaria4 -9.3 0.8 -10.1 18.8 19.2 -0.4 1.6 0.8 0.8 6.1 2.9 3.2 17.3 23.8 -6.5 Change (2007 over 2000) (percentage points of GDP) Surplus countries 0.6 -0.7 1.3 3.7 -1.0 4.8 -0.5 -0.4 -0.1 0.4 -0.2 0.6 4.2 -2.4 6.6 Netherlands 0.0 0.4 -0.4 3.2 -1.1 4.3 -1.6 -1.1 -0.5 -1.1 0.2 -1.3 0.4 -1.6 2.0 Germany 1.0 -1.3 2.3 4.5 -1.4 5.9 -0.5 -0.4 -0.2 0.8 -0.3 1.2 5.8 -3.5 9.3 Finland -0.4 1.0 -1.5 0.2 0.9 -0.6 0.5 0.1 0.5 -1.7 0.0 -1.8 -1.4 2.0 -3.4 Austria 1.4 -0.4 1.8 0.7 0.0 0.7 0.2 -0.3 0.5 1.3 -0.4 1.6 3.6 -1.1 4.7 Belgium -0.6 0.9 -1.5 1.2 -0.1 1.3 0.4 -0.1 0.5 -0.8 -0.3 -0.5 0.1 0.3 -0.3 Deficit countries1 -0.2 1.3 -3.7 -2.0 0.9 0.2 0.2 -0.1 0.1 0.8 0.3 0.5 -1.1 2.3 -3.5 Italy 0.3 0.4 -0.1 -2.2 0.9 -3.2 0.5 -0.2 0.6 1.0 0.0 1.0 -0.5 1.2 -1.7 France 0.4 1.3 -0.9 -0.4 0.3 -0.7 -0.6 -0.1 -0.5 -1.0 0.2 -1.2 -1.6 1.7 -3.3 Ireland -1.6 4.7 -6.3 -0.1 0.9 -1.0 2.7 0.2 2.4 0.2 0.4 -0.2 1.2 6.3 -5.1 Spain -0.6 2.3 -2.9 -5.1 1.8 -6.9 0.6 -0.3 0.9 3.8 0.9 3.0 -1.3 4.7 -6.0 Portugal -2.6 -3.0 0.4 -2.4 -1.7 -0.6 0.9 0.3 0.6 -1.0 -1.2 0.2 -5.0 -5.6 0.6 Greece -3.5 -2.1 -1.4 2.4 -0.5 2.9 1.2 -0.1 1.3 -2.4 -0.8 -1.5 -2.3 -3.6 1.3 Hard peg -5.3 2.6 -7.9 2.5 8.4 -5.8 -0.5 -0.5 0.0 2.9 2.8 0.1 -0.3 13.3 -13.6 Lithuania -7.7 0.2 -8.0 8.3 9.1 -0.8 0.1 -0.2 0.4 2.1 2.9 -0.8 2.8 12.0 -9.2 Estonia -3.3 5.1 -8.4 -0.6 4.9 -5.5 -1.7 -0.4 -1.3 4.1 1.3 2.8 -1.4 11.0 -12.4 Latvia -4.5 3.6 -8.1 -2.0 9.2 -11.3 0.2 -1.1 1.4 5.5 5.0 0.5 -0.8 16.7 -17.5 Bulgaria -5.6 2.7 -8.3 2.2 8.8 -6.6 -1.0 -0.4 -0.5 1.5 2.0 -0.5 -3.0 13.0 -16.0 Sources: Eurostat; IMF, World Economic Outlook database; and IMF staff calculations. Note: S denotes gross saving; I denotes gross investment; Net = S minus I. Country group averages are weighted with 2000 and 2007 nominal GDP weights. 1 Excluding Greece. 2 2005. 3 2002. 4 2004.60
    • 3. FINANCIAL INTEGRATION, GROWTH, AND IMBALANCES Figure 3.8 Selected EU Countries: Current Account Balances, 1999–2009 (Percent of GDP) 2 2 10 10 EU 27 Austria Germany 8 8 Netherlands 1 1 6 6 4 4 0 0 2 2 0 0 -1 -1 -2 -2 -2 -2 -4 -4 1999 2001 2003 2005 2007 2009 1999 2001 2003 2005 2007 2009 10 10 2 2 0 0 5 5 -2 -2 -4 -4 0 0 -6 -6 -8 -8 -5 -5 Belgium -10 -10 Finland -12 -12 -10 France -10 Greece Italy -14 Ireland -14 Spain Portugal -15 -15 -16 -16 1999 2001 2003 2005 2007 2009 1999 2001 2003 2005 2007 2009 15 15 4 4 Bulgaria Czech Republic 10 Estonia 10 Hungary 2 2 5 Latvia 5 Poland Lithuania Slovak Republic 0 0 0 0 -5 -5 -2 -2 -10 -10 -4 -4 -15 -15 -20 -20 -6 -6 -25 -25 -8 -8 -30 -30 -35 -35 -10 -10 1999 2001 2003 2005 2007 2009 1999 2001 2003 2005 2007 2009 Sources: IMF, World Economic Outlook database; and IMF staff calculations.In a change of strategy, they advised their In the euro area periphery, Ireland and Spainsubsidiaries and branches in emerging Europe that suffered wrenching private sector adjustments.new credit would henceforth need to be nanced Before the crisis, Ireland and Spain had bothsolely by increases in local deposits (Figure 3.13).6 experienced investment booms, which now collapsed. In Portugal and Greece, whose investment paths had been stable or declining,6 The effect was compounded by the freezing of the the impact of the crisis was initially less severe.international syndicated loans market, as well as a halt in Subsequent stress in the public sector affected themthe growth of direct cross-border loans. more (Figure 3.14, Table 3.2). 61
    • REGIONAL ECONOMIC OUTLOOK: EUROPE Figure 3.9 External Balances (Percent of GDP) 8 8 5 5 Current Account Current Account 6 6 0 0 4 4 -5 -5 2 2 -10 -10 0 0 -15 -15 -2 -2 -4 -4 -20 -20 Surplus countries Hard peg Deficit countries Central Europe -6 -6 -25 -25 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 1995 1997 1999 2001 2003 2005 2007 2009 8 8 5 5 Trade Balance Trade Balance 6 6 0 0 4 4 -5 -5 2 2 -10 -10 0 0 -15 -15 -2 -2 -20 -20 -4 -4 Hard peg Surplus countries Deficit countries Central Europe -6 -6 -25 -25 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 1995 1997 1999 2001 2003 2005 2007 2009 2 2 1 1 Income Balance Income Balance 0 0 1 1 -1 -1 -2 -2 0 0 -3 -3 -1 -1 -4 -4 Surplus countries -5 Hard peg -5 Deficit countries Central Europe -2 -2 -6 -6 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 1995 1997 1999 2001 2003 2005 2007 2009 Sources: IMF, World Economic Outlook database; and IMF staff calculations. Note: Surplus (deficit) countries are countries with a current account surplus (deficit) in 2007. Surplus countries include Austria, Belgium, Finland, Germany, and the Netherlands. Deficit countries include France, Greece, Ireland, Italy, Portugal, and Spain.The hard peg countries in emerging Europe, where exacerbated by a collapse in housing prices, andimbalances had been most pronounced, were also GDP contracted sharply, leading to a steep rise inhit hard.7 Domestic demand plunged, further concerned about their exposures and wanted to engineer a gradual slowdown, the real shock to the region came7 Although the adjustment in the Baltics had already in September 2008, after Lehman Brothers filed forstarted in the fall of 2007, when Swedish banks became bankruptcy.62
    • 3. FINANCIAL INTEGRATION, GROWTH, AND IMBALANCESFigure 3.10 Figure 3.11Euro Area 11: Current Account Imbalance Euro Area 11: Changes in General GovernmentIndicator, 1990–20091 Expenditure, 1995–2007(Percent of GDP) (Percentage points of GDP)6 6 15 Changes in general government 15 10 Greece 10 primary expenditure5 5 5 Portugal 5 Belgium4 4 Italy Ireland 0 0 Spain France -5 -53 3 Austria Netherlands -10 -10 Germany Finland2 2 -15 -15 -8 -7 -6 -5 -4 -3 -2 -1 0 1 2 Changes in general government interest expenditure1 1 Sources: IMF, World Economic Outlook database; and IMF staff calculations.0 0 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 Concerns about the public sector soon exacerbatedSources: IMF, World Economic Outlook database; and IMF staffcalculations. the crisis (Figure 3.15). The decline in domestic¹ Sum of the absolute values of current account balances in euroarea divided by aggregate GDP. demand contributed to a severe drop in government revenue, and scal balances deteriorated sharply. Risk premiums in the periphery surged, even in countriesunemployment. The CEE countries that during that had entered the downturn with low de cits andthe boom years had exible exchange rate regimes debt (Figure 3.16). A vicious circle emerged: whilesuffered a less severe recession. These countries the sovereign debt problems worsened as a result ofhad not experienced the same size credit boom and the scal costs of banking problems, the concernshad much lower current account de cits, and went about the public sector exacerbated the problems forthrough much smaller forced adjustments (IMF, the private sector and nancing costs for both went2010b). up in tandem (Figure 3.17). Figure 3.12 Selected EU Countries: Real Domestic Demand, Government Revenue, and Expenditure Growth, 2000–07 (Percent) 140 140 140 140 Domestic Demand versus Goverment Revenue Growth Revenue versus Expenditure Growth Real government expenditure growth Latvia Real government revenue growth 120 Estonia 120 120 120 Latvia 100 Lithuania 100 100 Estonia 100 80 80 80 Lithuania 80 Ireland 60 60 60 60 Spain Ireland Bulgaria 40 40 40 Spain 40 Greece Bulgaria Portugal 20 Portugal Belgium Greece Finland 20 20 Netherlands Finland 20 Italy France Italy France Austria Belgium Austria Netherlands 0 Germany 0 0 Germany 0 -20 -20 -20 -20 -20 0 20 40 60 80 100 120 140 -20 0 20 40 60 80 100 120 140 Real domestic demand growth Real revenue growth Sources: IMF, World Economic Outlook database; and IMF staff calculations. 63
    • REGIONAL ECONOMIC OUTLOOK: EUROPE Figure 3.13 Europe: Bank Exposure, 2003–10 3,500 3,500 1,000 Exposure of BIS-Reporting Banks to Emerging Europe, billions 1,000 Exposure of BIS-Reporting Banks to EA4, billions of U.S. dollars of U.S. dollars 900 900 3,000 3,000 800 Vis-à-vis all sectors 800 (exchange-rate adjusted) 2,500 2,500 700 Vis-à-vis all sectors 700 600 Vis-à-vis banks 600 2,000 2,000 (exchange-rate adjusted) 500 Vis-à-vis banks 500 1,500 1,500 400 400 1,000 1,000 300 300 Vis-à-vis all sectors 200 200 500 Vis-à-vis all sectors (exchange-rate adjusted) 500 Vis-à-vis banks 100 100 Vis-à-vis banks (exchange-rate adjusted) 0 0 0 0 Mar-03 Mar-04 Mar-05 Mar-06 Mar-07 Mar-08 Mar-09 Mar-10 Mar-03 Mar-04 Mar-05 Mar-06 Mar-07 Mar-08 Mar-09 Mar-10 200 700 200 700 Exposure of BIS-Reporting Banks to EA4 Exposure of BIS-Reporting Banks to EA4 180 Vis-à-vis all sectors, percent of 2010 GDP 180 Vis-à-vis banks, percent of 2010 GDP 600 600 160 Greece 160 Portugal 500 Greece 500 140 Spain 140 Portugal Ireland (right scale) Spain 120 120 400 400 Ireland (right scale) 100 100 300 300 80 80 60 200 60 200 40 40 100 100 20 20 0 0 0 0 Mar-03 Mar-04 Mar-05 Mar-06 Mar-07 Mar-08 Mar-09 Mar-10 Mar-03 Mar-04 Mar-05 Mar-06 Mar-07 Mar-08 Mar-09 Mar-10 Sources: Bank for International Settlements; IMF, World Economic Outlook database; and IMF staff calculations. Note: EA4 comprises Greece, Ireland, Portugal, and Spain.Why Was the Crisis So Severe? temporary and matched by the increased future capacity of the recipient countries to service theirWhy did the widening of current account debts. As exports subsequently grow, imbalancesimbalances culminate in such a severe crisis? In should decline.itself, the widening of external imbalances was not However, these large capital in ows fueled ansurprising. Capital can be expected to ow from unbalanced and unsustainable growth pattern:richer to poorer countries, where the marginalproductivity of capital is higher. Indeed, current • Growth in the current account de cit countriesaccount positions in the late 2000s were closely was increasingly driven by sectors such aslinked to both per capita income and interest construction and nancial intermediation withrate differentials before monetary integration small tradable components, while growth in(Figure 3.6).8 Nor are higher current account the surplus countries was tilted toward thede cits always a concern. To the extent that tradable sector, especially industry (Table 3.3).in ows are used to expand production, especially As a result, the surplus countries saw sizableexport capacity, current account de cits should be increases in their export-to-GDP ratios (Figure 3.18), while countries with small current8 Together, account de cits experienced much smaller per capita income and interest ratedifferentials in the early 1990s explain about 85 percent increases, and countries with very high currentof the variation in current account balances in the account de cits became even more closed inlate 2000s. the 2000s.64
    • 3. FINANCIAL INTEGRATION, GROWTH, AND IMBALANCES Figure 3.14 EA4: Saving-Investment Balance, 1999–2009 (Percent of GDP) 35 35 35 35 Greece Ireland 30 30 30 30 25 25 25 25 20 20 20 20 15 15 15 15 10 10 10 Saving 10 Saving Investment Investment 5 5 5 5 1999 2001 2003 2005 2007 2009 1999 2001 2003 2005 2007 2009 35 35 35 35 Portugal Spain 30 30 30 30 25 25 25 25 20 20 20 20 15 15 15 15 10 10 10 Saving 10 Saving Investment Investment 5 5 5 5 1999 2001 2003 2005 2007 2009 1999 2001 2003 2005 2007 2009 Sources: IMF, World Economic Outlook database; and IMF staff calculations.Table 3.2Selected EU Countries: Current Account Balances and Real Domestic Demand, 2003–10 Precrisis Vulnerabilities Adjustments During Crisis Change in Current Change in Real Domestic Current Account Balance, Real Domestic Demand Account Balance, 2007–10 Demand Growth, 2007–10 2007 (percent of GDP) Growth, 2003–07 (percent) (percent of GDP) (percent) Euro area countries with high current account deficits Greece -14.4 15.8 3.9 -10.0 Ireland -5.3 27.1 4.6 -22.9 Portugal -10.1 7.3 0.2 -1.0 Spain -10.0 20.7 5.5 -7.6 Hard peg Bulgaria -30.2 43.9 29.5 -11.3 Estonia -17.2 42.5 20.8 -29.3 Latvia -22.3 62.8 25.9 -35.4 Lithuania -14.6 53.1 16.4 -20.5Sources: IMF, World Economic Outlook database; and IMF staff calculations. 65
    • REGIONAL ECONOMIC OUTLOOK: EUROPEFigure 3.15 Figure 3.17Selected EU Countries: Change in Fiscal Selected EU Countries: Change in SovereignBalance, 2007–10 and Bank Credit Default Swap Spreads,(Percentage points of GDP) January 2010–March 2011 0 0 900 900 Average change in local senior 800 800 financial CDS (basis points) Portugal Ireland 700 700 -5 -5 600 Greece 600 500 500-10 -10 400 400 300 Netherlands 300 United 200 Kingdom 200-15 -15 Spain 100 Italy 100 Belgium 0 France 0-20 Germany -20 -100 Sweden -100 -200 0 200 400 600 800 1,000-25 -25 Change in sovereign CDS (basis points) Sources: Bloomberg L.P.; and IMF staff calculations. Note: Data points not labeled are for Austria, Denmark, Norway, and-30 -30 Switzerland.-35 -35 Italy Spain Latvia Ireland Austria France Greece Finland Estonia Belgium Bulgaria Portugal Lithuania Germany Netherlands nature and the failure to prevent bubbles. With competition rather limited, investorsSources: IMF, World Economic Outlook database; and IMF staff calculations. in the nontradable sector enjoyed rents unavailable in the tradable sector, which wasFigure 3.16 fully exposed to the harsh winds of globalSelected Countries: Five-Year CDS Spreads, markets. Pro tability in the nontradable sectorJanuary 2007–April 2011 jumped as asset price bubbles developed(Basis points) unchecked in key subsectors such as1,400 1,400 construction (Figures 3.22 and 3.23). Greece Ireland1,200 Portugal 1,200 • With incentives stacked toward the Spain Latvia nontradable sector, investment took off and1,000 1,000 Lithuania Germany foreign capital owed in. Beginning in 2002– 800 800 03, the share of FDI in the current account de cit countries declined while bank and 600 600 portfolio in ows surged (Figure 3.24). As the 400 400 capital stock in the nontradable sector grew, marginal productivity of capital declined over 200 200 time (Table 3.4). 0 0 Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 • This pattern of growth led to a steady wideningSource: Bloomberg, L.P. of current account balances, which resulted in large changes in net external asset positions• Strong growth in the nontradable sector, in (Figure 3.25)—an ultimately unsustainable turn, contributed to rising wages, which put trend. pro tability in the tradable sector under pressure (Figures 3.19, 3.20, 3.21) and made the current • As current account de cits widened, countries account de cit countries less attractive for FDI. became increasingly dependent on continuing capital in ows, and a sudden stop of capital• Investment in the nontradable sector received in ows could cause a large-scale nancial a further boost from its relatively closed disruption, with a severe impact on growth.66
    • 3. FINANCIAL INTEGRATION, GROWTH, AND IMBALANCES Table 3.3 Selected EU Countries: Growth in Value Added and Contribution by Sector, 2000–07 (Percent) Surplus Countries Deficit Countries Hard Peg Central Europe Total 13.0 14.8 63.2 34.0 Agriculture 0.0 -0.1 -0.7 0.6 Industry 4.3 1.8 14.1 14.4 Construction -0.6 1.3 6.8 1.1 Trade, transport, and communication 3.3 3.2 23.6 9.4 Financial intermediation, and real estate 4.5 5.7 14.6 6.3 Other services 1.6 2.8 4.8 2.6 Sources: Eurostat; and IMF staff calculations.Markets Underestimated Risks macroeconomic volatility had declined and the central problem of depression prevention, for allBefore the recent global crisis, markets tended to practical purposes, had been solved (the “Greatunderestimate these risks. This pattern was also Moderation”). Large capital ows seemed toobserved in countries with exchange rates pegged carry few risks when crisis was seen as a remoteto the euro in anticipation of early euro area entry. possibility.Risk premiums remained low, so current accountimbalances became wider and more persistent,thus contributing to large changes in net external Economic Policies Failed to Addressasset positions. Markets showed little concern until Imbalancesmid-2007, ignoring solvency risk and covering large nancing needs at low interest rates, which boosted Economic policies failed to suf ciently correctself-feeding bubbles in nontraded sectors. By failing market failures and check overoptimisticto demand higher risk premiums, markets failed to expectations.rein in this unhealthy development until it was toolate for a soft landing. This situation is not unique • With interest rates set at the euro area averageto the European debt crisis but follows a pattern and markets not differentiating betweenfamiliar from other crisis cases, including the Latin countries, the credit boom became dif cultAmerican debt crisis of the early 1980s, the Asian to stop once it had started. Indeed, as thecrisis of the late 1990s, and the U.S. subprime crisis economy heated up and in ation and wagesof the late 2000s. started to rise, high in ation led to negative real interest rates, further boosting demandOne reason markets underestimated risks may for credit (Figure 3.26). In emerging Europe,have been the expectation that euro area banks and and as discussed in the October 2010 Regionalgovernments would be bailed out. Markets found Economic Outlook, the new EU member statesit dif cult to imagine that the euro area countries that had xed their currencies to the eurowould not come to the rescue of members in at an early stage (Bulgaria, Estonia, Latvia,trouble—particularly given the interconnectedness and Lithuania) all experienced credit andof their banking systems. The regulatory domestic demand booms and very highenvironment also considered all sovereign bonds to current account de cits, while countries thatbe safe assets. retained greater monetary independenceYet the underestimation of risk was not con ned generally experienced less pronouncedto Europe. The belief was widely held that imbalances (Box 3.1). 67
    • REGIONAL ECONOMIC OUTLOOK: EUROPE Figure 3.18 Selected EU Countries: Exports of Goods, 1995–2009 (Percent of GDP) 50 50 50 50 Euro Area Emerging Europe 45 45 45 45 40 40 40 40 35 35 35 35 30 30 30 30 25 25 25 25 20 20 20 20 15 Surplus countries 15 15 Hard peg 15 Deficit countries Central Europe 10 10 10 10 1995 1997 1999 2001 2003 2005 2007 2009 1995 1997 1999 2001 2003 2005 2007 2009 Sources: IMF, World Economic Outlook database; and IMF staff calculations.Figure 3.19 Figure 3.20Euro Area: REER (ULC Manufacturing Based), Selected EU Countries: Appreciation of REER1995 2009 (ULC Manufacturing Based), 2000–071(Index, 1999 = 100) (Percent)120 120 50 50 40 40115 115 30 30110 110 20 20 10 10105 105 0 0100 100 -10 -10 -20 -20 95 95 -30 -30 Italy Spain Latvia BLEU² Ireland Austria France Finland Greece Estonia Lithuani Portugal Bulgaria Germany Netherlands 90 90 Surplus countries Deficit countries 85 85 1995 1997 1999 2001 2003 2005 2007 2009 Sources: European Commission; and IMF staff calculations.Sources: European Commission; and IMF staff calculations. 1 Real effective exchange rates are relative to the rest of EU27 and based onNote: Aggregation is weighted by GDP. quarterly data. 2 BLEU stands for Belgium-Luxembourg Economic Union.• However, other policy instruments to curb the periphery were, on average, not in worse domestic demand and excessive expansion of shape than in the core (with the exception the nontradable sector were used insuf ciently. of Portugal and Greece, Figure 3.27), this Tighter scal policy could have dampened situation primarily re ected savings on interest domestic demand.9 Although scal balances in payments and revenues that turned out to be temporary.9 It would also have created fiscal cushions that could • Stronger macroprudential regulation wouldhave been used during the subsequent downturn. have required nancial institutions to build up68
    • 3. FINANCIAL INTEGRATION, GROWTH, AND IMBALANCESFigure 3.21Selected EU Countries: Appreciation of REER Why Is Resolution of the Crisis(ULC Manufacturing Based) Versus Change So Protracted?in Corporate Saving to GDP, 2000–07 The boom-bust cycle in the euro area periphery 6 6 was not unique. During the boom years, countries Germany throughout the world experienced credit and asset 4 4 price escalations. Stark differences across regionsChange in corporate saving to GDP Netherlands also occurred in other monetary unions. In the 2 2 United States, Arizona, California, Florida, and (percentage points) Ireland Greece 0 Finland Austria Belgium 0 Nevada went through severe boom-bust cycles, France while other states were much less affected. -2 -2 Portugal Italy The crisis in Europe was prolonged by the -4 -4 incomplete integration of the nancial system and the absence of a centralized mechanism to -6 y = -0.17 + 0.33 Spain -6 deal with it. The result was a vicious circle in R² = 0.47 which sovereign debt and banking sector problems -8 -8 -20 -10 0 10 20 30 aggravated each other. Appreciation of ULC-Manufacturing REER (percent) Sources: European Commission; Eurostat; and IMF staff calculations. Financial Integration Is Incomplete Financial integration in the EU and the euro area is larger capital buffers and provisions in good still incomplete and uneven. Some elements of the times, which would have raised the cost of nancial system are highly integrated: capital ows capital and slowed the expansion of nancial cross borders with little impediment, and banks sector balance sheets, or at least made banks transact freely in the money market. But home less vulnerable in the subsequent bust.10 bias in portfolio allocations remains, securitizationWhile credit excesses, housing booms, is very much a national affair (for example, nocompetitiveness losses, and lack of scal discipline uniform mortgage contract exists), and cross-all played a role, their contributions were country border retail banking is virtually nonexistent—speci c. Greece suffered most from the lack of cross-border provision of retail nancial services scal discipline. Ireland and Spain experienced amounts to less than 1 percent of total loans. Aparta lack of political fortitude to use scal policy from some regional clusters, cross-border mergersand macroprudential tools to manage credit and and acquisitions are still limited in most Europeanhousing cycles.11 banking markets, with foreign acquisitions accounting for only 20 percent of banking activity, compared with 40 percent in other sectors.12 For the euro area as a whole, foreign bank10 During the boom years, many countries in emerging participation in domestic markets amounted toEurope strengthened prudential regulations to slow 27 percent in 2009 (Figure 3.28).credit growth. Although these measures had limitedeffectiveness in slowing credit, they resulted in thecreation of large capital and liquidity buffers, whichprotected the banks during the crisis of 2008–09. 12 The situation is different in many countries of11 During the boom years, Spanish banks were required emerging Europe, where foreign banks tend to dominateto build supplemental reserves to cover future loan the banking sector, reflecting a conscious decision bylosses (“dynamic provisioning”). While this helped to the governments to divest to Western banks becausebuild buffers, it was less successful in slowing credit domestic and state-owned banks repeatedly caused crisesgrowth. and slowed the transition process. 69
    • REGIONAL ECONOMIC OUTLOOK: EUROPE Figure 3.22 Selected EU Countries: Nominal House Prices, 2000:Q1–2010:Q3 (Index, 2000:Q1 = 100) 300 300 300 300 Surplus Countries Deficit Countries 250 250 250 250 200 200 200 200 150 150 150 150 100 100 100 100 Austria Germany Netherlands Italy France Spain 50 50 50 50 Belgium Finland¹ Ireland Portugal Greece¹ 0 0 0 0 2000:Q1 2001:Q1 2002:Q1 2003:Q1 2004:Q1 2005:Q1 2006:Q1 2007:Q1 2008:Q1 2009:Q1 2010:Q1 2000:Q1 2001:Q1 2002:Q1 2003:Q1 2004:Q1 2005:Q1 2006:Q1 2007:Q1 2008:Q1 2009:Q1 2010:Q1 Sources: Bank for International Settlements; national authorities; and IMF staff calculations. ¹For Finland (panel 1) and Greece (panel 2), 2006:Q1 = 100. Figure 3.23 Selected EU Countries: Profitability by Sector, 2000–07¹ (Index, 2000 = 100) 120 120 110 110 Germany Portugal² 115 115 105 105 110 110 Manufacturing 100 Manufacturing 100 105 105 100 100 95 95 Construction Construction 95 95 90 90 90 90 85 85 85 85 80 80 80 80 2000 2001 2002 2003 2004 2005 2006 2007 2000 2001 2002 2003 2004 2005 2006 120 120 120 120 Spain Ireland 115 115 115 115 Construction 110 110 110 110 Construction 105 105 105 105 Manufacturing 100 100 100 100 95 95 95 95 Manufacturing 90 90 90 90 85 85 85 85 80 80 80 80 2000 2001 2002 2003 2004 2005 2006 2007 2000 2001 2002 2003 2004 2005 2006 2007 Sources: EU KLEM database; and IMF staff calculations. ¹Profitability is computed as value added deflator minus wage rate plus gross value added per hours worked (or an inverse of labor productivity). ²Data for Portugal are for 2000–06.70
    • 3. FINANCIAL INTEGRATION, GROWTH, AND IMBALANCES Figure 3.24 Selected EU Countries: International Investment Position, 2000–09 (Billions of U.S. dollars) 1,500 1,500 1,500 1,500 Surplus Countries Low-Deficit Countries 1,000 1,000 1,000 1,000 Direct investment, net Other investment, net 500 500 500 500 Direct investment, net 0 0 0 0 Other investment, net -500 Portfolio investment, net -500 -500 -500 Portfolio investment, net -1,000 -1,000 -1,000 -1,000 -1,500 -1,500 -1,500 -1,500 2000 2002 2004 2006 2008 2000 2002 2004 2006 2008 0 0 0 0 -200 -200 -200 -200 Direct investment, net Direct investment, net -400 -400 -400 Portfolio investment, net -400 Other investment, net -600 -600 -600 -600 Other investment, net -800 -800 -800 -800 -1,000 -1,000 -1,000 -1,000 -1,200 Portfolio investment, net -1,200 -1,200 -1,200 -1,400 -1,400 -1,400 -1,400 High-Deficit Countries Central Europe -1,600 -1,600 -1,600 -1,600 2000 2002 2004 2006 2008 2000 2002 2004 2006 2008 Sources: IMF, International Financial Statistics; and IMF staff calculations. Note: Surplus (deficit) countries are countries with a current account surplus (deficit) in 2007. Surplus countries include Austria, Belgium, Finland, Germany, and the Netherlands. Low-deficit countries are countries with a 2007 current account deficit less than 5 percent of GDP and include France and Italy. High-deficit countries are Greece, Ireland, Portugal, and Spain.Perceptions of a lack of cross-border synergies uni ed legal framework is a clear obstacle butplayed a role, but differences in business and so is the desire to maintain national champions,regulatory environments seem to be important build niche activities, take advantage of regulatoryfactors explaining the incomplete nancial and supervisory arbitrage, and retain full nationalintegration in the euro area. The absence of a accountability for explicit and implicit guarantees 71
    • REGIONAL ECONOMIC OUTLOOK: EUROPE As a result, banking ows to the euro area Table 3.4 periphery during the boom years largely took the Euro Area: Output-Capital Ratios, 2000–07 form of debt rather than equity, which exposed (Percent) banks in the periphery to rollover risk. By contrast, Average¹ Marginal² in emerging Europe, with fewer implicit barriers to 2000 2007 2000–07 bank expansion, most of the bank ows went from Italy 0.44 0.39 0.16 parent banks to their local subsidiaries. Although Spain 0.44 0.37 0.23 nominally in the form of debt, in practice the ows Portugal 0.58 0.52 0.24 were more like equity—parent banks could not France 0.46 0.42 0.26 suddenly withdraw funding from their subsidiaries Netherlands 0.41 0.40 0.32 Germany 0.41 0.40 0.32 because such an action would lead to liquidity Belgium 0.39 0.38 0.32 shortages in the subsidiary and likely intervention Greece 0.43 0.40 0.34 by supervisors. The more stable funding structure Austria 0.38 0.37 0.35 bene ted banks in emerging Europe during the Ireland 0.65 0.62 0.56 crisis, and may have been one of the reasons that Finland 0.42 0.45 0.67 banking crises in the region were largely avoided. Sources: Organization for Economic Cooperation and Development, Economic Outlook database; and IMF staff calculations. ¹ Real GDP divided by total capital stock. Institutions Supporting the Single ² Change in real GDP divided by change in total capital stock. Financial Market Are Still Being Built The EU has fostered nancial integration byof the banking system. It is not surprising, relaxing constraints (for example, the singlethen, that the ef ciency bene ts conferred by passport for cross-border banking) andheightened competition in a single market have harmonizing various aspects of the nancialbeen limited at best and have recently suffered a system, and by adopting a common currency in thesetback (Box 3.2). euro area, but this process has been allowed to run Figure 3.25 Selected EU Countries: International Investment Position, 2000–07 (Percent of GDP) 150 150 800 800 Net International Investment Position Total External Liabilities 1308 700 700 100 100 2000 600 600 Change from 2000 to 2007 50 50 500 2007 500 400 400 0 0 300 300 -50 -50 200 200 -100 -100 100 100 2000 0 0 -150 Change from 2000 to 2007 -150 -100 -100 2007 -200 -200 -200 -200 Spain Italy Latvia Italy Greece Poland Hungary Portugal Bulgaria Estonia Lithuania Finland Ireland¹ Austria France Belgium Poland Latvia Spain Germany Lithuania Bulgaria Estonia Greece Germany Hungary Finland France Portugal Austria Belgium Ireland¹ Netherlands Netherlands Slovak Republic Czech Republic Slovak Republic Czech Republic Sources: IMF, International Financial Statistics; and IMF, World Economic Outlook database. Note: Net International Investment Position is defined as the difference between total external assets and total external liabilities. ¹ 2001 instead of 2000.72
    • 3. FINANCIAL INTEGRATION, GROWTH, AND IMBALANCESFigure 3.26 Figure 3.28Selected EU Countries: Inflation, June 2008 Selected EU Countries: Foreign Bank Presence(Year-over-year, percent) (Percent of assets) 100 10020 20 200018 18 90 2009 9016 16 80 8014 14 70 7012 1210 10 60 60 8 8 50 50 6 6 40 40 4 4 2 2 30 30 0 0 20 20 Latvia Bulgaria Lithuania Estonia Belgium Spain Greece Finland Austria France Italy Ireland Portugal Germany Netherlands 10 10 0 0 Germany Estonia Czech Republic Slovak Republic Luxembourg Romania¹ Bulgaria¹ Lithuania Malta Finland Poland Latvia Ireland Belgium United Kingdom Hungary Cyprus Slovenia EU27 Austria Portugal Greece Denmark EMU Italy Spain Netherlands France SwedenSource: Eurostat.Figure 3.27Selected EU Countries: Fiscal Balance, 2007 Source: ECB Report on EU banking structures, consolidated banking data. Note: Foreign bank presence is the total assets of foreign banks’ branches and(Percent of GDP) subsidiaries as a percent of the total assets of the banking sector. ¹ Data from 2005.6 65 5 guarantees of liabilities, bans on short selling, and4 4 proposals for bail-ins). Arrangements to deal with3 3 cross-border banks broke down over burden-2 2 sharing issues. Throughout the ongoing resolution1 1 of the crisis, the approach to banking sector0 0 problems has remained national.-1 -1-2 -2 EU policymakers have responded to the crisis by-3 -3 setting up new institutions. The European Systemic-4 -4 Risk Board (ESRB) will look into macroprudential-5 -5 risks to spot credit developments before they give Italy Spain Latvia Ireland Austria France Finland Greece Estonia Belgium Portugal Lithuania Germany Netherlands lead to unsustainable imbalances, while the new European Supervisory Authorities should strengthen and harmonize regulation and supervision.13Source: IMF, International Financial Statistics. But dealing effectively with interconnectedahead of the institutions necessary to support the nancial institutions operating in a single nancialsingle nancial market. No effective instruments market requires a pan-EU, or at least a eurowere put in place to detect and handle cross-border area-wide, approach, a step beyond the currentlyrisks or mitigate the buildup of imbalances nancedby cross-border nancial ows. 13 In the international context, various initiatives areAs a result, when the crisis hit, reactions were under way to make the banking sector safer, and progressmostly national, with no regard for the cross- is being made in setting up better cross-border tools forborder implications of such policies (for example, crisis management and resolution. 73
    • REGIONAL ECONOMIC OUTLOOK: EUROPE Box 3.1 Why Did the Currency Board Countries in Emerging Europe Have Such Large Imbalances? Selected EU Countries: Composition of Growth, 2000–07 (Percentage points) 20 20 20 20 Change in Exports-to-GDP Ratio Change in Domestic Demand-to-GDP Ratio 15 15 15 15 10 10 10 10 5 5 0 0 5 5 -5 -5 0 0 -10 -10 -5 -5 -15 -15 -20 -20 -10 -10 Latvia Latvia Poland Poland Estonia Estonia Bulgaria Bulgaria Slovak Republic Slovenia Hungary Slovenia Hungary Lithuania Romania Romania Lithuania Czech Republic Czech Republic Slovak Republic Sources: IMF, World Economic Outlook database; and IMF staff calculations. As discussed in Chapter 3 of the October 2010 Regional Economic Outlook: Europe (IMF, 2010b) the large capital ows that went to emerging Europe in the years before the global economic crisis did not affect all countries equally. In some countries, current account de cits widened to over 15 percent of GDP and in ation reached double digits, while in others imbalances remained more contained. One important factor in these differences was the exchange rate regime. The largest imbalances occurred in new EU member states with hard currency pegs to the euro (Bulgaria, Estonia, Latvia, and Lithuania). In most new member states with more exible exchange rate regimes, imbalances were milder (the Czech Republic, Hungary, Poland, and the Slovak Republic). Imbalances were also less in countries with xed exchange rates that were not yet EU members (Bosnia and FYR Macedonia). Capital ows into these countries were lower, probably partly because of the memory and legacy of various con icts in the region, and partly because they were not yet in the EU). Why did imbalances in new member states with hard pegs become so much larger than in new member states with more exible exchange rate regimes? • From a demand perspective, a boom in domestic demand drove GDP growth in countries with xed exchange rates (see gure). These countries saw sharp increases in their domestic demand to GDP ratios, while the exports to GDP ratios increased much less. In countries with oating exchange rates, the growth pattern was more balanced. • From a supply perspective, GDP growth was driven to a large extent by the nontradable sector. Countries with more exible exchange rates had much stronger growth in manufacturing. These differences re ect differences in capital in ows. In the Baltics and Bulgaria, capital ows largely went to the nontradable sector, whereas in the countries with more exible exchange rates, a much larger share went to the tradable sector. Note: The main author of this box is Jeta Menkulasi.74
    • 3. FINANCIAL INTEGRATION, GROWTH, AND IMBALANCES When faced with large capital in ows, the xed exchange rate regime countries had few instruments at their disposal to stop the credit boom. Indeed, they experienced a vicious circle. As the economy heated up and wage growth and in ation increased, real interest rates dropped, further boosting demand for credit. Sharp wage increases led to a deterioration of the tradable sector’s competitiveness, which led to a reduction in the growth of exports. Countries with more exible exchange rates did not experience the same vicious circle— they could keep real interest rates higher by letting the nominal exchange rate appreciate, which mitigated the credit boom.planned coordination. There is little alternative • Third, it would have facilitated consolidationto harmonization of regulations and supervisory of the nancial sector typical in the aftermathpractices at the EU level and an approach to crisis of a crisis and helped avoid the tendency tomanagement and resolution that employs a pan- ring-fence national systems. ConsolidationEU backstop. Only then will location no longer is now occurring slowly, if at all, and oftenmatter for nancial institutions’ costs of and access within borders. In many cases, restructuringto funding, and only then will the nancial system has led to refocusing on the domestic marketbe decoupled from the sovereign, a link that in the and sales of foreign operations, thus reducingcurrent crisis has proved to be detrimental in both nancial integration. Similarly, nationaldirections. authorities, mindful of their taxpayers, are ring- fencing operations under their purview, thus diminishing the bene ts of the single market.More Complete Financial Integration • Finally, had a pan-EU supervisory regime beenWould Have Helped Resolve the Crisis in place, excessive exposures or expansions ofHow would this deeper integration forti ed by banking systems well beyond the scal capacityproper institutions have helped in resolving the of the sovereign may have been spotted and ill-crisis? considered unilateral policy moves avoided.• First, banks would have suffered less spillover Experience in the United States illustrates that more from sovereign debt trouble. Deposit guarantees centralized crisis resolution mechanisms and more or any other implicit guarantees would not have integrated capital markets can make a difference depended on the sovereign signature, which (Box 3.3). The United States also went through would have kept funding costs for banks in euro a severe boom-bust cycle, with large differences area periphery countries in check. across regions. Although the U.S. scal de cit is now higher than that of the euro area countries,• Second, it would have given the EU more and some individual states have come under options for dealing with weaknesses in the signi cant scal pressures, the U.S. capital market banking system. If domestic markets had been has not disintegrated along state lines. more open to foreign banks, national public sector policies for supporting and recapitalizing In sum, increased nancial integration will banks—which has perpetuated the adverse improve risk sharing and should help stabilize feedback between banks and sovereign—would national demand, contributing to the resolution not have been the only viable measures.14 of imbalances and helping prevent their reemergence. But it will need to be accompanied14 Achieving these changes would require rapid progresson the single regulatory rulebook for banks and on the establishment of a pan-European approach toharmonizing supervisory practices to eliminate multiple securitization, and more uniform consumer protectionreporting requirements. Standardization of products, regimes are also needed. 75
    • REGIONAL ECONOMIC OUTLOOK: EUROPE Box 3.2 Recent Developments in Bank Competition in Europe Globalization and nancial integration have changed the business environment in which banks operate. The impact has been profound in Europe, supported by the introduction of the euro, signi cant liberalization, and harmonization of nancial sector regulation as policymakers pursue the goal of a single market. A fully integrated nancial market promotes innovation and competition and ensures ef cient provision of nancial goods and services. At the same time, the global nancial crisis has made clear that harmonized and well-designed regulation and prudent supervision of the banking sector are indispensible for preventing excessive risk taking. The crisis took a heavy toll on European banks and required the introduction of bank support schemes to avoid disorderly bank failures that could have pushed the nancial sector into collapse. With advice from the ECB and the European Commission, national authorities implemented support schemes for their domestic banks. The Commission had to balance the need for state aid on the one hand with safeguarding competition and avoiding market segmentation along national borders on the other. Whether this has been achieved is a key question for policymakers. A competitive and suf ciently integrated banking sector should facilitate adjustment and the needed recapitalization, and cross-border restructuring through mergers and acquisitions is an essential element. The level of bank competition can be measured in various ways. Historically, inferences about the level of competition relied on structural characteristics such as concentration ratios for the largest banks, or overall pro tability. However, high capital returns may simply re ect high ef ciency instead of monopolistic rents. Moreover, structural features could be less relevant in gauging market competition in very open, globally integrated, and highly contestable markets. Unrestricted entry and exit of rms, including those from abroad, may force banks to act competitively even if their numbers are small. Indeed, Claessens and Laeven (2004) show for a large cross-country sample that being open to new entry is the most important competitive pressure; they nd no evidence that banking system concentration is negatively associated with competitiveness. The H-statistic (H) developed by Panzar and Rosse (1987) is a widely used measure for competitive behavior that relies on market contestability and potential competitors. It focuses on the degree to which changes in the costs of inputs lead to subsequent changes in revenues. Under a monopoly, an increase in input prices will increase marginal costs and reduce equilibrium output and total revenues (H < 0). Under perfect competition, an increase in input prices will be fully passed on to the output price (H = 1). Positive values less than 1 imply some degree of monopolistic competition. Estimation results for the periods 1995–2000, 2001–07, and 2008–09 show the following:1 • In the period shortly after the introduction of the euro (2001–07), competitive bank behavior broadly converged across euro area member countries to a lower overall level and closer to the U.S. level. • In the aftermath of the nancial crisis, several European countries and the euro area as a whole saw a further small but statistically signi cant deterioration in their levels of banking competition. However, the overall deterioration in competition in Europe appears no worse than the deterioration in the United States. The nding that large and nancially integrated countries or regions tend to exhibit less competitive behavior than smaller regions exhibit is in line with other studies, including Bikker and Spierdijk (2008), who also nd Note: The main author of this box is Thomas Harjes. 1 Postcrisis estimates only provide preliminary evidence in view of the limited number of observations and the fact that structural changes in the aftermath of the crisis may have distorted the long-term market equilibrium in some countries, which could invalidate the H-statistic.76
    • 3. FINANCIAL INTEGRATION, GROWTH, AND IMBALANCESsome deterioration in competitive behavior over time for Europe’s banks. They argue that banks in largeand integrated nancial markets are pushed by rising capital market competition and tend to shift fromtraditional intermediation to more sophisticated and complex products associated with less pricecompetition. However, the further deterioration in competitive pricing observed in the aftermath of thecrisis is unlikely to yet re ect structural market changes and evolving bank business models. Instead,signi cant bank losses and the subsequent need for recapitalization may have temporarily limited competitivepressures. Finally, little evidence yet suggests that national support schemes in Europe have further hinderedcompetition. Nevertheless, the European Commission and other regulatory agencies should continue toinsist on bold restructuring and balance sheet repair in instances in which state aid has been granted witha view toward maintaining a level playing eld for healthy and competitive banks with sound businessmodels. Bank Competition Measured by H-Statistic over Time 1995–2000 2001–2007 2008–2009 Change Before and After Before and After EMU Crisis Standard Standard Standard Standard Standard Country/region H-Statistic H-Statistic H-Statistic H H Error Error Error Error Error (1) (2) (3) (4) (5) (6) (7)=(3)–(1) (8) (9)=(5)–(3) (10) Austria 0.58 0.04 0.60 0.03 0.71 0.10 0.02 0.04 0.10 0.11 Finland 0.80 0.10 0.55 0.06 0.65 0.05 -0.25** 0.12 0.10 0.08 France 0.64 0.01 0.58 0.02 0.63 0.05 -0.05*** 0.02 0.04 0.05 Germany 0.43 0.01 0.45 0.01 0.36 0.02 0.02 0.02 -0.09*** 0.02 Greece 0.82 0.08 0.52 0.06 0.39 0.10 -0.3*** 0.10 -0.13 0.11 Ireland 1.02 0.16 0.75 0.07 0.59 0.13 -0.27 0.17 -0.17 0.14 Italy 0.88 0.01 0.59 0.01 0.50 0.03 -0.29*** 0.02 -0.09*** 0.03 Netherlands 0.90 0.16 0.41 0.06 0.61 0.08 -0.49*** 0.16 0.20** 0.10 Portugal 0.71 0.04 0.68 0.05 0.85 0.17 -0.03 0.07 0.17 0.18 Spain 0.70 0.03 0.80 0.03 0.51 0.05 0.09** 0.04 -0.29*** 0.06 United 0.51 0.04 0.65 0.03 0.62 0.05 0.14*** 0.04 -0.03 0.05 Kingdom United States 0.31 0.01 0.43 0.00 0.27 0.01 0.12*** 0.01 -0.16*** 0.01 Euro area 0.70 0.01 0.52 0.01 0.44 0.01 -0.18*** 0.01 -0.07*** 0.01Source: IMF staff calculations. For more detail, see Sun (forthcoming).Note: *** and ** indicate significance at the 1 and 5 percent level, respectively. 77
    • REGIONAL ECONOMIC OUTLOOK: EUROPE Box 3.3 Crisis Resolution and Financial Integration in the United States Like Europe, the United States experienced large United States: Housing Boom-Bust, 2000–10 regional differences in 180 House Purchase Price Appreciation 180 the housing boom-bust. (Percent) 150 150 California, Florida, Nevada, 2000 to peak quarter and Arizona went through 120 Peak quarter to September 2010 120 the most severe cycles. 90 90 In these states, housing prices more than doubled 60 60 from 2000 to their peak, 30 30 and then declined sharply— in Nevada by more than 0 0 50 percent. In other states, -30 -30 the amplitude of the cycle -60 was not as large. These -60 District of Columbia New Hampshire North Carolina Massachusetts South Carolina Pennsylvania New Mexico New Jersey North Dakota South Dakota Rhode Island Mississippi Connecticut New York West Virginia Delaware Maryland Tennessee Minnesota Michigan Nebraska Kentucky Oklahoma Arkansas Missouri Louisiana California Colorado Washington Georgia Montana Virginia Arizona Alabama Nevada Hawaii Vermont Oregon Wisconsin Kansas Wyoming Florida Illinois Indiana Alaska Texas Maine Iowa Idaho Ohio Utah differences in the housing boom-bust were associated with stark differences in the severity of the recession 2 2 ( rst three gures). Between Change in GDP in Construction (Percentage points of GDP) late 2006 and late 2010, 1 1 the unemployment rate rose by 10 percentage 0 0 point in Nevada, and only ½ percentage point in -1 -1 North Dakota.1 Differences in unemployment rate -2 2000 to 2006 -2 levels were similarly stark— 2006 to 2009 ranging from 4 percent -3 -3 in North Dakota to New Hampshire North Carolina Massachusetts South Carolina Pennsylvania District of Columbia New Mexico Alaska New Jersey North Dakota South Dakota Rhode Island Mississippi Connecticut New York West Virginia Delaware Minnesota Maryland Tennessee Michigan Kentucky Nebraska Oklahoma Arkansas Colorado Louisiana Missouri California Washington Georgia Virginia Montana Arizona Alabama Nevada Oregon Hawaii Vermont Wisconsin Wyoming Kansas Florida Indiana Illinois Maine Texas Iowa Idaho Ohio Utah 14½ percent in Nevada. However, unlike in Europe, nancial markets in the Sources: Bureau of Economic Analysis; Federal Housing Finance Agency; and IMF staff calculations. United States remained fully integrated. Some states experienced sometimes severe scal pressures,2 but there were no concerns that these pressures would affect the nancial sector or reduce market access for the private sector, and there was no differentiation in private sector nancial market access by state. Note: The main author of this box is Lone Christiansen. 1 North Dakota also bene ted from an oil industry boom. 2 In California, the recession’s negative effect on revenues together with the strict balanced budget provision led to the issuance of IOUs in lieu of some payments in the summer of 2009. The budget approval process was further complicated by the requirement of a two-thirds super majority of votes to pass the budget bill.78
    • 3. FINANCIAL INTEGRATION, GROWTH, AND IMBALANCES United States and Selected EU Countries: Boom and Bust, 2003–09 20 Percentage Change in House Prices and Real GDP, 2006–09 20 10 10 Change in Unemployment Rates and Real GDP, 2006–09 9 9 Unemployment rate, Dec. 2006-09 North Dakota Nevada 15 Wyoming 15 Florida Oklahoma 8 Rhode Island 8 Michigan South Dakota Alabama California 7 7 (percentage points) 10 10 Illinois Real GDP South Carolina Idaho District of Columbia Iowa Tennessee Washington Nebraska 6 Georgia North Carolina New Jersey 6 Utah Mississippi Ohio Delaware Oregon 5 District of Columbia Kansas West Virginia Alaska Colorado Montana 5 5 Arizona Indiana Missouri Kentucky Massachusetts West Virginia 5 Maryland Virginia Arkansas Texas New York Hawaii Pennsylvania Washington Wyoming Oregon Pennsylvania Connecticut New Mexico Utah Massachusetts Hawaii Connecticut Idaho Vermont Wisconsin 4 Wisconsin Virginia Maryland TexasMississippi 4 Missouri 0 California Minnesota New Hampshire Indiana Maine Alabama Kentucky South Carolina 0 Louisiana New Hampshire Maine Montana New Jersey Delaware Illinois New Mexico New York North Carolina 3 Minnesota Vermont Colorado Iowa Oklahoma 3 Arizona Louisiana Alaska Georgia Ohio Tennessee Arkansas -5 Florida Rhode Island -5 2 Kansas Nebraska 2 Nevada South Dakota y = 0.2408x + 3.2761 Michigan 2 1 y = -0.2471x + 5.0762 North Dakota 1 R = 0.3407 2 R = 0.4595 -10 -10 0 0 -60 -50 -40 -30 -20 -10 0 10 20 -10 -5 0 5 10 15 20 House prices Real GDP, 2006− 09 (percent) 8 Real GDP growth 8 (Percent) 6 6 4 4 2 2 0 0 -2 -2 -4 -4 Average annual growth, 2003−08 -6 Average annual growth, 2003−08, European countries -6 2009 -8 -8 2009, European countries -10 -10 Michigan Louisiana Ohio Rhode Island Missouri Maine South Carolina Pennsylvania Illinois New Hampshire Indiana New Jersey West Virginia Massachusetts Kentucky Georgia Minnesota Vermont Wisconsin Tennessee New Mexico Delaware Alaska Mississippi Arkansas District of Columbia Maryland Nebraska Alabama Kansas Virginia Florida Colorado Montana South Dakota Oklahoma New York California Connecticut North Carolina Texas Hawaii North Dakota Washington Iowa Arizona Wyoming Utah Nevada Idaho Oregon France Belgium Spain Finland Ireland Sources: Bureau of Economic Analysis; Bureau of Labor Statistics; Federal Housing Finance Agency; IMF, World Economic Outlook database; and IMF staff calculations. Note: Annual house prices are based on averages of seasonally adjusted quarterly indices. Unemployment rates are seasonally adjusted.This marked difference between the United States and Europe is likely the result of the different nancialsector crisis resolution mechanisms, the better integration of capital markets, and the larger role of the federalgovernment. With much smaller state debts, and with bail-out responsibility assigned to the federal level, concernsabout the public nances of individual states do not spill over to the private sector.• In Europe, individual countries were responsible for rescuing insolvent banks, while in the United States, nancial bailouts took place at the federal level.3 Thus, in Ireland bank support weighed on public nances, while in the United States the bailouts of AIG and investment banks were done at the federal level rather than by the state where the bank was headquartered.• In the United States, failing banks often are taken over quickly by other banks—including from other states— while in Europe such takeovers of problem banks have been uncommon.3 The federal government stepped in to save Bank of America, Wells Fargo, U.S. Bancorp, PNC Financial, and a host ofothers. In September 2008, the Treasury was given authority to use $700 billion under the Troubled Asset Relief Programto purchase assets, make equity investments and loans, and provide asset guarantees in a range of nancial institutions andmarkets. At the height of the crisis, the Treasury also guaranteed more than $3 trillion in assets to prevent runs on moneymarket mutual funds. The Federal Deposit Insurance Corporation extended the coverage of insured deposits to $250,000,provided an unlimited guarantee of transactions deposits, and guaranteed new bank debt issues. The Federal Reserve provideda range of liquidity support to depository institutions, securities dealers, select foreign central banks, and key markets, andconducted unconventional large-scale asset purchases to support the housing sector and the economy. See IMF (2010c). 79
    • REGIONAL ECONOMIC OUTLOOK: EUROPE Box 3.3 (concluded) • In the United States, state debt is relatively low—in 2008, federal debt held by the public was about 2½ times as large as debt issued by states.4 Constitutional and statutory provisions in many states limit debt issuance, and most states are governed by balanced budget provisions (last gure, top panel).5 • In the United States, the borrowing exibility and safe haven status of the federal government provides a backstop for the individual states during bad times. A sizable part of the federal stimulus went to states, helping to prevent sharp spending cuts at the state level. More broadly, unlike in Europe, the much larger role of the central scal authority in the United States may have a stabilizing effect on individual states. Spending by the federal government is about as large as spending of individual states (last gure, lower panel). United States and Selected EU Countries: United States and Selected EU Countries: Unemployment Rates, 2006–10 Debt and Expenditure, 2008 (Percent of GDP) 14 14 Change in Unemployment Rates, December 2006–10 (Percentage points) 45 45 12 12 Debt Outstanding 40 40 10 10 35 35 8 8 30 30 6 6 25 25 4 20 20 4 15 15 2 2 10 10 0 0 5 5 -2 -2 0 0 North Carolina Massachusetts Pennsylvani New Jersey New York New Mexico South Dakota Hawaii Mississippi Maryland Virginia Kentucky Michigan Arizona Georgia Missouri Illinois Delaware Oregon Nevada Netherlands North Dakota Connecticut Nebraska Kansas Iowa Arkansas Texas Alaska Minnesota Maine Montana Louisiana Indiana Colorado Rhode Island Florida Ireland New Hampshire Ohio Utah Idaho Austria Spain Vermont Oklahoma Tennessee Alabama California South Carolina West Virginia Wyoming Washington Wisconsin District of Columbia New Mexico New Jersey Pennsylvania New York Hawaii Georgia Maryland Michigan Delaware Virginia Arizona Nevada Kentucky Iowa North Carolina Mississippi North Dakota Arkansas Missouri Oregon Illinois Louisiana Rhode Island Massachusetts U.S. federal gov1 Idaho Maine Connecticut New Hampshire Texas Colorado Florida South Carolina South Dakota Utah Minnesota Nebraska Kansas Ohio Indiana Montana Alaska Vermont Oklahoma Tennessee Alabama California District of Columbia Wyoming West Virginia Washington 25 25 Wisconsin Unemployment Rates, December 2010 60 60 (Percent) Expenditure 20 20 50 50 40 40 15 15 30 30 10 10 20 20 5 10 10 5 0 0 New Jersey Pennsylvania New York New Mexico Nevada Maryland Hawaii U.S. federal gov. Delaware Virginia Illinois Iowa Arizona Kentucky Michigan Mississippi Connecticut Texas Colorado Missouri Georgia Oregon North Carolina Massachusetts Arkansas South Carolina Germany Belgium South Dakota New Hampshire Kansas Florida Indiana Minnesota Utah Nebraska Louisiana Maine Ireland North Dakota Idaho Ohio Rhode Island Montana Alaska Spain France Vermont District of Columbia Tennessee California Alabama Oklahoma Wyoming Washington West Virginia Wisconsin 0 0 New Jersey New Hampshire New York Hawaii New Mexico Pennsylvania Michigan Virginia Maryland Arizona Missouri Mississippi Georgia Kentucky Iowa Delaware Arkansas Oregon Nevada Connecticut Illinois Netherlands North Dakota Nebraska South Dakota Kansas Minnesota Montana Indiana North Carolina South Carolina Rhode Island Florida Maine Utah Louisiana Massachusetts Alaska Texas Colorado Idaho Austria Ireland Spain Ohio Vermont Alabama California Oklahoma Tennessee Wyoming Washington West Virginia District of Columbia Wisconsin Sources: Bureau of Economic Analysis; dXdata; IMF, World Economic Outlook database; Sources: Bureau of Labor Statistics; Eurostat; and IMF staff calculations. and IMF staff calculations. Note: Unemployment rates are seasonally adjusted. ¹ Fiscal year basis. Debt held by the public (IMF, 2010d). 4 By 2010, outstanding federal debt had increased to 60 percent of GDP, suggesting that the ratio increased even further. No data on 2010 individual state debt are available yet. 5 Some of these provisions are implicit rather than explicit: “some balanced budget requirements are based on interpretations of state constitutions and statutes rather than on an explicit statement that the state must have a balanced budget” (National Conference of State Legislatures, 2010).80
    • 3. FINANCIAL INTEGRATION, GROWTH, AND IMBALANCESBox 3.4How Far Have Current Account Imbalances Adjusted?To gauge how far rebalancing has come since the onset of the nancial crisis, the macroeconomic balanceapproach is used to compare actual current account balances with “equilibrium” current accounts, which aredetermined as a function of fundamental factors.1 This notion of “equilibrium” measures levels of the currentaccount that are consistent with underlying macroeconomic conditions and does not explicitly address thesustainability of current account positions.A simple empirical model was used, based on the Consultative Group on Exchange Rate Issues methodology.2In this model, current accounts as ratios to GDP are determined as a function of the initial net foreign assetposition, the scal balance, the per capita growth rate, the level of per capita GDP, the oil trade balance, and keydemographic features (see Annex for technical details). This approach con rms that current accounts moved awayfrom their equilibrium values in the period immediately before the global crisis ( rst gure, rst and second panels).During 2001–04, most actual current account balances were not signi cantly different from their estimatedequilibrium values. Re ecting comparatively older populations (and, in some cases, natural resources andimportance as nancial centers) a number of countries, including Austria, Belgium, Denmark, Germany, and theNetherlands were in surplus, whereas countries in the southern periphery of the euro area (Greece, Portugal,and Spain) were showing a modest de cit, and new EU member states (notably the Baltics, Hungary, Romania,and the Slovak Republic), characterized by much lower GDP levels, displayed somewhat larger de cits. Thisjuxtaposition is consistent with convergence theory, according to which capital should ow downhill to equilibrateits relative return (Abiad, Leigh, and Mody, 2007).Subsequently, during 2005–08, current accounts moved away from their estimated equilibrium values in asigni cant number of cases. De cits in the periphery of the euro area and new member states became largerthan could be explained by equilibrium models. In the periphery of the euro area, the gaps between the de citsand their estimated equilibrium intervals ranged from about 1 percent of GDP in Portugal to nearly 5 percentof GDP in Spain. Among the new member states, the gaps ranged from about 1 percent of GDP in Estonia andLithuania to more than 9 percent of GDP in Bulgaria. Overoptimistic expectations of rapid income convergencetogether with underestimations of risk and policies that supported the allocation of resources to the nontradablesector, underpinned these developments (see main text). Conversely, in a few countries (notably Germany)surpluses began to exceed equilibrium values. While these diverging current account developments were notmirror images inside the euro area or the EU, they were nanced largely by intra-euro area or intra-EU capital ows (Chen, Milesi-Ferretti, and Tressel, forthcoming).Current accounts began moving back toward equilibrium as a consequence of the global crisis. The return of riskaversion and risk differentiation sharply curbed cross-border capital ows. The resulting contraction in privateand public domestic demand led to an acute reduction of current account de cits. Current account balancesin surplus countries also narrowed as exports declined and domestic demand held up better than in the de citcountries.Note: The main author of this box is Irina Tytell.1 Two other approaches to determining sustainable current account balances exist. One is a reverse “early warning” typeexercise that links the probability of a crisis to the degree of imbalance and derives “safe levels” of current accountimbalances. This approach is based on historical observations of the association of imbalances with subsequent crises.Another approach is based on evaluating the current account balance that stabilizes the net foreign asset position of thecountry in question (see Lee and others, 2008).2 See Lee and others (2008); and also Jaumotte and Sodsriwiboon (2010); Barnes, Lawson, and Radziwill (2010); and Decressinand Stavrev (2009). 81
    • REGIONAL ECONOMIC OUTLOOK: EUROPE Box 3.4 (continued) Fiscal Adjustment and Current Account Balances (Percent of GDP) Estimated Ranges for Current Account Norms and Fiscal Balance Targets and Projections, averages over 2009–12 Actual Current Accounts 0 0 (Percent of GDP) -2 -2 Averages over 2001–04 15 15 -4 -4 10 10 5 -6 -6 5 0 0 -8 Stability program targets -8 -5 -5 IMF projections -10 -10 -10 -10 -12 -12 United Kingdom Ireland Spain Greece Portugal Latvia France Lithuania Poland Czech Republic Romania Netherlands Slovak Republic Slovenia Belgium Italy Germany Austria Denmark Luxembourg Hungary Finland Sweden Estonia Bulgaria -15 -15 Actual current account balance -20 -20 Czech Republic United Kingdom Estonia Greece Portugal Belgium Denmark France Germany Hungary Ireland Italy Latvia Lithuania Luxembourg Netherlands Poland Romania Slovak Republic Slovenia Spain Bulgaria Austria Finland Sweden Estimated Effects of Further Fiscal Adjustment on Current Accounts, averages over 2009–12 2.0 2.0 1.5 1.5 Averages over 2005–08 15 15 1.0 1.0 10 10 0.5 0.5 5 5 0.0 0.0 0 0 -0.5 -0.5 -5 -5 -1.0 -1.0 -10 -10 -1.5 -1.5 United Kingdom Greece Ireland Finland Czech Republic Slovenia Italy Belgium Bulgaria France Denmark Poland Lithuania Portugal Spain Romania Netherlands Estonia Hungary Latvia Germany Sweden Luxembourg Austria Slovak Republic -15 Actual current account balance -15 -20 -20 Bulgaria Latvia Spain Slovenia Greece Ireland Romania Estonia Portugal Lithuania Belgium Czech Republic Denmark Finland France Hungary Italy Luxembourg Netherlands Slovak Republic United Kingdom Poland Austria Germany Sweden Sources: IMF, World Economic Outlook database; and IMF staff calculation. Averages over 2009–12 Looking ahead using IMF World Economic Outlook 15 15 projections of current accounts for 2009–12, with 10 10 a few notable exceptions (Greece and Portugal), de cits are set to decline to levels compatible with 5 5 equilibrium values for the current account ( rst 0 0 gure, third panel).3 In Greece, policies are in place to further improve the external accounts under the -5 -5 -10 -10 3 Note that for the purpose of computing the equilibrium -15 -15 Actual current account balance values for this period it was assumed that countries follow -20 -20 sustainable scal policies. For the EU this means adherence Portugal Greece Slovenia Belgium Italy France Czech Republic Finland Luxembourg Netherlands Poland Romania Slovak Republic Spain United Kingdom Denmark Germany Austria Ireland Bulgaria Hungary Sweden Lithuania Estonia Latvia to targets of the Stability and Growth Program updates. In addition, to abstract from the potential in uence of output gaps on the estimates of the equilibrium current accounts, Sources: IMF, World Economic Outlook database; and IMFstaff calculation. the European Commission’s projections for potential growth were used rather than those for actual growth.82
    • 3. FINANCIAL INTEGRATION, GROWTH, AND IMBALANCES EU- and IMF-supported adjustment programs. For some countries, including Belgium, France, Italy, and Spain, a modest further improvement in the external accounts would be desirable. Strikingly, a number of countries in eastern Europe are set to run current account balances well above what would be consistent with fundamentals. The gaps between the de cits and their estimated equilibrium intervals are projected to range between about 2 percent of GDP in Bulgaria to 10 percent of GDP in Latvia. This possibly re ects a combination of private sector balance sheet repair currently under way, and still-heightened risk aversion toward the region, both of which may temporarily depress domestic demand. A subsequent recovery of domestic demand would likely bring current account balances back in line with equilibrium values. Similarly, a number of surplus countries are set to continue to run surpluses that exceed values justi ed by fundamentals. The ongoing fiscal adjustment could have sizable effects on current account balances in a number of countries. Fiscal deficits rose sharply in the aftermath of the global financial crisis and are currently being brought down to preserve sustainability of the public finances across the EU. In some countries (for example, Greece), projected fiscal deficits remain higher than targets stipulated in their most recent Stability and Convergence Programs (SCPs), while in other countries (for example, Germany) the situation is now reversed (second figure, first panel). A simulation based on the model mentioned above shows that additional adjustment to align projected fiscal balances to current SCP targets could be enough to bring Italy’s, France’s, and Belgium’s current account deficits within the normal range (second figure, second panel). In Greece, continued fiscal consolidation would further reduce, although not eliminate, remaining imbalances. At the same time, additional consolidation could further increase the current account balance in Ireland.by robust institutional arrangements and place to further improve the externalbackstops at the EU or euro area level. Finally, accounts under the EU/IMF-supported nancial integration will remain imperfect for adjustment programs.some time, so scal and structural policies To overcome the crisis decisively, adjustingwill also need to be implemented to facilitate imbalances is not enough: the most critical factoradjustment to shocks under a common in the longer term is restoring GDP growth inmonetary policy. the crisis-affected countries to secure lasting prosperity. Strong GDP growth would also make it easier to put public nances on aRestoring Growth and Preventing sustainable footing and improve the health ofFuture Excessive Imbalances banking systems.The crisis led to a sharp adjustment of earlier A sustainable recovery in crisis-affected countriescurrent account imbalances, and current account will require a growth pattern different frombalances in many countries are now close to that of the precrisis years, with a stronger role“equilibrium” (Box 3.4). Current account de cits for the tradable sector and exports, and a lessin Spain and Ireland declined signi cantly by 2010, prominent role for the nontradable sector, capitalwhile current account de cits in the Baltics and ows, and domestic demand. The previousBulgaria disappeared or turned into surpluses. growth pattern, which relied on large capitalLooking ahead, de cits are set to be reduced to in ows, led to pronounced boom-bust cycles.levels compatible with equilibrium values of the These cycles increased growth volatility but hadcurrent account, with a few notable exceptions no appreciable effect on average growth while(Greece and Portugal). In Greece, policies are in leaving a legacy of high external indebtedness 83
    • REGIONAL ECONOMIC OUTLOOK: EUROPE Figure 3.29 Selected EU Countries: Capital Inflows and GDP per Capita Growth, 2003–10 14 14 45 45 Sweden Growth of GDP per capita, 2003–10 Austria Slovak 12 12 40 Republic 40 Growth of GDP per capita, 2003–10 Finland Bulgaria Belgium Poland 10 10 35 35 Greece Germany 8 8 30 Netherlands 30 Romania Czech 6 6 Republic 25 Lithuania 25 4 France 4 Estonia Portugal 20 20 Latvia Slovenia 2 Spain 2 Italy 15 15 0 0 -2 -2 10 10 y = -0.5077x + 23.121 Hungary y = 0.4668x + 6.4144 5 R² = 0.0298 5 -4 R² = 0.2674 -4 Ireland -6 -6 0 0 -15 -10 -5 0 5 10 -14 -12 -10 -8 -6 -4 -2 0 Average current account balance, 2003–10 Average current account balance, 2003–10 (percent of GDP) (percent of GDP) Sources: The Conference Board Total Economy database, January 2011; IMF, World Economic Outlook database; and IMF staff calculations. Figure 3.30 means complete (Figures 3.30 and 3.31).15 In the Selected EU Countries: Growth of Real Exports euro area periphery, Ireland’s competitiveness of Goods and Services, Average 2010–11 has improved considerably, while Spain has (Percent) experienced a strong increase in exports. In 16 16 Greece and Portugal, export growth is still weak, 14 14 even though Greece has seen an improvement in 12 12 competitiveness. 10 10 8 8 Ultimately, growth and convergence will depend 6 6 on productivity increases. On this front, some 4 4 countries have performed poorly over the past 2 2 0 decade, despite ample access to foreign capital. 0 In Portugal, for example, labor productivity grew Greece Italy Portugal Ireland Belgium France Netherlands Spain Austria Latvia Germany Estonia Bulgaria Lithuania by much less than its starting position pointed it toward. Apparently it failed to put the large capital Sources: IMF, World Economic Outlook database; and IMF staff calculations. in ows it enjoyed to their best productive uses (Figure 3.32).and impaired competitiveness (Figure 3.29).Surplus countries could focus on removingobstacles to the expansion of their nontradable Better Policies Are Neededsectors. at the National LevelAfter a dif cult 2009, such a shift seems to Sustainable convergence in the EU will requirebe taking hold in the Baltic countries and better policies at the national level—policies thatBulgaria. Exports grew rapidly in 2010 and promote increases in efficiency and productivityso far in 2011, and competitiveness indicators and that prevent boom-bust cycles. To aimproved markedly, although the reallocation considerable extent, the current crisis arose fromof resources to the tradable sector is by no a failure to use national policies to manage local conditions. Therefore, policymakers need to rely 15 See also Chapter 2.84
    • 3. FINANCIAL INTEGRATION, GROWTH, AND IMBALANCES Figure 3.31 REER (ULC Manufacturing Based) (Peak = 100) 110 110 110 110 100 100 100 100 90 90 90 90 80 80 80 80 70 70 70 70 60 Estonia Latvia 60 60 Greece Spain 60 Lithuania Bulgaria Ireland Portugal 50 50 50 50 2005:Q1 2006:Q1 2007:Q1 2008:Q1 2009:Q1 2010:Q1 2005:Q1 2006:Q1 2007:Q1 2008:Q1 2009:Q1 2010:Q1 Sources: European Commission, Price and Cost Competitiveness Indicators; IMF, Information Notice System; and IMF staff calculations. Figure 3.32 Selected EU Countries: Labor Productivity 100 100 70 70 Labor Productivity Catch-up, 1999–2010 GDP per Hour 90 90 (2010 PPP dollars) Growth of GDP per hour, 1999–2010 60 60 Estonia 80 80 2010 Romania 50 1999 50 70 Latvia 70 Slovak Republic 60 Lithuania y = -1.313x + 74.11 60 40 40 R² = 0.628 50 Bulgaria Czech Republic 50 30 30 40 Hungary 40 Ireland 20 20 30 Slovenia 30 Poland Greece Sweden 20 Finland Austria Netherlands 20 10 10 Spain Germany France 10 10 Portugal Italy Belgium 0 0 Italy Poland