By Timothy Ash
It remains a close call as to whether the economies of central Europe will be in a position to join EMU at the target date of 2009-2010
The transformation of the economies in central and eastern Europe over the past 15 or so years has been remarkable. The contrast with the difficult days of the early 1990s, when shock economic therapy had laid bare great tracts of their industrial heartlands, is stark.
Across the region, real growth in gross domestic production (GDP) averaged more than 5% in 2003 and 2004, nearly double that of the eurozone economies (see table).
What is more striking, however, is that all the economies surveyed, except Macedonia, posted real GDP growth in 2004. The high flyers were Russia, Ukraine and Kazakhstan, which benefited from favourable terms of trade for commodities, and the small, open Balkan states, which have capitalized on recent foreign direct investment to retain their mantle as Transition Tigers.
Laggards struggle
The laggards were the bigger, more developed economies, such as the Czech Republic, Hungary, Poland, Slovenia and Croatia. All have struggled to maintain growth above 5% in recent years, reflecting perhaps a higher base, political instability – in the Czech Republic and Poland in particular – and problems in meeting the challenges of Economic and Monetary Union (EMU). Hungary continues to battle against twin deficits.The different growth trends highlight that, while all the countries are struggling with the transition from planned to market economies, the macroeconomic issues they face differ across the region. The economies can be grouped into three categories.
For Russia, Ukraine and Kazakhstan, the biggest challenge remains that of managing large foreign exchange inflows, associated with the maintenance of large current account surpluses, or in the case of Kazakhstan, an oil boom spurred by massive inflows of foreign direct investment attracted to the primary production sector.
With a relatively underdeveloped financial system and a limited range of monetary tools at the disposal of their central banks, the authorities in all three countries
have struggled to control foreign currency inflows, and to counter “Dutch disease” or the harmful effects of large increases in a country’s income. Money supply and inflation have both risen.
Russia has been more successful than Ukraine and Kazakhstan because it has managed to run large budget and primary budget surpluses, and accumulate about $27 billion in an oil windfall fund (the stabilization fund). This surplus sterilizes the inflows associated with the primary production boom and provides a kitty to fund debt buy-backs, which helps improve public sector debt dynamics over the longer term.
Ukraine has been less successful in that, despite posting record high rates of GDP growth in 2004 (12.1%), it ran a budget deficit (3%-4% of GDP) and failed to build up reserves. As a result, inflation has risen. Much of this fiscal irresponsibility may be attributed to politically expedient promises made in the run-up to last year’s presidential election campaign.
Hopes for Yushchenko
It is hoped that the new Yushchenko administration will rein in its fiscal policy quickly and that Ukraine moves to a more flexible exchange rate regime, to allow appreciation, which would help drive down inflation.
A similar prescription is probably apt for Russia but, given expected foreign exchange appreciation, the hope is that such an exchange rate policy is also accompanied by far-reaching structural reform to let the economy compete at appreciated exchange rate levels. On this we have been encouraged by the recent initiative to monetize social benefits, and plans to cut the statute of limitations from 10 to three years, but progress in energy sector restructuring has been less positive.
In central Europe the key challenge remains the need to tighten fiscal policy to meet the demands of EMU. Arguably a prime reason for the modest real GDP growth trend in central Europe has been the inability or, in some cases, the unwillingness of governments in the region to address deep-seated problems in public finance.
Fiscal deficits have expanded greatly in recent years, reaching 12.9% of GDP in the Czech Republic in 2003, and 9.6% of GDP in Hungary in 2002. Although both were cut in 2004, their deficits, and those of Poland, have stuck at about 5% of GDP, well short of the EMU target of 3% of GDP.
In March the Council of Economics and Finance Ministers of the European Union (EcoFin) relaxed the rules of the EU’s Stability and Growth Pact which means it will be easier for the first-tier accession states to meet the Maastricht criteria.
However, the concern is that governments in the region either do not adequately understand the challenge in terms of reforming public finance or do not have the political capital to instigate the required reforms. Therefore, it remains a close call as to whether the economies of central Europe will be in a position to join EMU at the target date of 2009-2010.
And, while, the desirability of early EMU membership is still open to question, it is beyond doubt that removing the uncertainty over reform of public finance will be positive, both for market and business development in the region.
Balancing act
Perhaps the biggest challenge facing second- and third-round EU accession states is the need to balance the growth in domestic credit with the need to ensure that the balance of payments remains sustainable. Rates of domestic credit growth have been quite phenomenal in recent years, particularly in the Balkans, and this trend is also extending to Russia and Ukraine as financial markets develop and deepen.
Household credit growth has been increasing at an annualized rate of 30-70% across the region. The fact that this has come in parallel with the expansion in current account deficits (record highs in Romania in 2004) has set alarm bells ringing. However, it should be noted that the expansion is from a very low base. Household credit-to-GDP is about 20-25% of GDP in Bulgaria and Romania – about one quarter the level in developed market economies.
Fewer delinquents
Delinquency rates among borrowers are also low, reflecting the fact that per capita household debt levels remain low. The fact that banking sectors are generally foreign-owned, and so western-standard credit screening is being applied, is encouraging. However, the rush for market share among lenders might affect delinquency rates, as could a general growth slowdown.
The plus is that financial markets are finally beginning to fulfil their natural role of channelling capital to the most productive uses. Current account deficits are rising, but in the cases of Bulgaria and Romania they are still well funded via foreign direct investment.
In addition, the maintenance of large current account deficits has been a characteristic of many transition economies, and simply reflects the need to import in the short run to fund growth and development over the longer term. There may also be a measurement problem with GDP, as high informal sector activity understates GDP, relative to the current account deficit.
Timothy Ash is managing director, emerging markets fixed income research, at Bear Stearns International in London