Pre-crisis lessons and post-crisis challenges for SEE economies. Christos Papazoglou Bank of Greece

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1 Pre-crisis lessons and post-crisis challenges for SEE economies Christos Papazoglou Bank of Greece

2 A comparative analysis of three regions in Emerging Europe: SEE, CE4 and the Baltics Contents A Closer look at the pre-crisis growth experience: It looks similar, but is it? The impact of the crisis: Similar shocks but different impact across countries. Lessons from the pre-crisis experience and challenges for the post-crisis period: How the reemergence of imbalances can be avoided and the bet for sustainable growth can be won.

3 Common pre-crisis experience: Strong output growth Average GDP Growth , 7, 6, 5, 4, 3, 2, 1,, Bulgaria Romania Croatia Serbia Albania FYROM Turkey Baltics CE4

4 .and credit growth Credit levels to private sector (percent of GDP) Bulgaria Romania Croatia Serbia Albania FYROM Turkey Baltics CE

5 which benefited from large capital inflows Net capital inflows, cumulative (Percent of 27 GDP) 14, 12, 1, 8, 6, 4, 2,, Bulgaria Romania Croatia Serbia Albania FYROM Turkey Baltics CE4

6 Thus the boom combined: GDP growth, capital inflows and credit Capital Inflows and Real GDP Growth, Credit growth and Real GDP Growth, ,5 7,5 7, Baltics 7, Baltics Real G DP g ro w th 6,5 6, 5,5 5, 4,5 4, Albania Croatia FYROM Romania Turkey Serbia CE4 Bulgaria R e a l G D P g r o w th 6,5 6, 5,5 5, 4,5 4, Romania Turkey Serbia CE4 Croatia FYROM Bulgaria 3,5 3,5 3, Capital inflows 3, Credit to GDP

7 Despite that, the growth drivers differ GDP Growth components, (Percent) Bulgaria Romania Croatia Serbia Albania FYROM Turkey Baltics CE4 Consumption Investment Exports Imports

8 Growth rate in SEE and the Baltics was unbalanced Negative contribution of net exports Contribution of net exports and domestic demand to average annual real GDP growth, Hungary Slovak Rer. Czech Rep. Poland Turkey FYROM Net exports Croatia Albania Estonia Domestic demand Latvia Serbia Lithuania Bulgaria Romania

9 In particular Most economies in SEE and the Baltics received large capital inflows, while domestic demand appeared to have been the main driving force of growth. In contrast, the CE4 received more moderate inflows and exports had a strong contribution to growth.

10 But let s have a closer look The pre-crisis growth model relied on the idea of closer cooperation with developed Europe (EU). It consisted of three components: 1. The first was of political nature as it aimed at political, legal as well as regulatory integration with the EU. The other two were of economic nature as emphasis was put in economic integration with the EU. In particular, they aimed at boosting growth through: 2. Trade liberalization and trade integration with the EU 3. Financial integration by relying on foreign capital markets, attracting debt inflows and FDI and by allowing the entry of foreign (European) banks.

11 Although the model was more or less common, it did not lead to homogeneous results as a number of countries showed increasing signs of vulnerability In particular, Capital flows in many instances did not have the right composition and the right direction and did not contribute enough in fostering competitiveness. Growth relied mostly on domestic demand leading to the emergence of internal and external imbalances. The external imbalances were further augmented, as weak external competitiveness affected adversely export performance. The entry of foreign banks to the extent that encouraged FX lending and contributed to rising loan-to-deposit ratio generated banking sector fragilities.

12 But lets look at the impact of capital inflows Strong inflows do not necessarily improve competitiveness. It is important to know: The composition of these inflows and the importance of FDI inflows The sectoral composition of FDI inflows The distribution of bank loans as most inflows fueled rapid bank credit expansion

13 In most countries, the majority of the inflows were indeed FDI Capital inflows, cumulative 27 (Percent 27 GDP) Bulgaria Romania Croatia Serbia Albania FYROM Turkey Baltics CE4 FDI inflows/gdp Debt inflows/gdp

14 But the FDI/GDP ratio varies across countries FDI Stock, 27 (percent of GDP) Bulgaria Romania Croatia Serbia Albania FYROM Baltics CE4 Tradable Sector Non-tradable Sector

15 and so does the sectoral composition of FDI In the SEE and the Baltics most FDI went to non-tradables, while in CE4 it was more evenly distributed. Sectoral distribution of FDI, Bulgaria Romania Croatia Serbia Albania FYROM Baltics CE4 Tradable Sector Non-tradable Sector

16 Higher FDI to non-tradables is associated with the credit boom FDI in non-tradables and credit growth 6 Change in private credit /GDPGDP SVK ROM SERB LVA LTU FYROM CZE POL ALB HUN CRO EST BUL y =,642x + 16, NontradableFDI/GDP

17 And, in turn, the distribution of bank credit favored the non-tradable sector Distribution of bank loans, 28 (percent) Bulgaria Romania Croatia FYROM Turkey Baltics CE4 Tradeables Real estate Other non-tradeables

18 As a result, domestic demand was affected the most 14 Domestic Demand and Private Sector Credit Growth (Annual average percentage change) Real domestic demand growth Croatia CE4 Serbia Turkey FYROM Baltics Bulgaria Romania Albania Real private sector credit growth

19 .. and thus it became the main driver of growth in SEE and the Baltics Domestic Demand Growth and GDP Growth (Annual average percentage change) y = x Real GDP growth Albania Serbia Turkey CE4 FYROM Croatia Bulgaria Baltics Romania Real domestic demand growth

20 Higher demand led to wage increases Gross monthly earnings increase, (Percent) Bulgaria Romania Croatia Serbia Albania FYROM Turkey Baltics CE4

21 Leading to real exchange rate appreciation Real Effective Exchange Rate, (CPI deflated, 25=1) Romania Bulgaria Baltics Turkey CE4 Croatia FYROM Serbia Albania

22 ...undermining exporting performance REER (based on ULC) and Exports Czech R. Hungary Slovak R. Bulgaria Poland Romania Croatia Estonia Latvia Turkey Romania -1 Change in manufacturing unit labor cost based REER

23 Despite the favorable external conditions, exports did not increase in all cases Exports to GDP CE4 Baltics Turkey FYROM Albania Serbia Croatia Romania Bulgaria /8 2/4

24 Higher exports require bigger share of FDI into tradables FDI in tradables and export performance EST SVK CZE HUN Export/GDP SERB ALB LVA LTU ROM POL FYROM CRO BUL y = 3,5162x + 12, TradableFDI/GDP

25 As it improves the technological content of exports Technological content of exports, Bulgaria Romania Croatia Baltics CE4 Euro area Low tech-resource based Low-tech medium-tech high-tech

26 Thus, it is not surprising that, Countries with larger REER appreciation showed more pronounced resource reallocation towards non-tradables 8 6 Bulgaria Latvia Net shift to non-tradables (real) Romania Estonia Slovenia Lithuania Croatia Hungary Poland Slovakia Czech Republic Change in manufacturing ULC based REER (percent)

27 And this is largely explained by a drop in the share of manufacturing in GDP 8 Share of manufacturing on real GDP Czech Republic Slovenia Poland Estonia Lithuania Slovakia Bulgaria Hungary Croatia Romania Latvia Change in manufacturing ULC based REER (percent)

28 Reflecting the increase in the non- tradable sector in SEE and the Baltics 8 Net increase in non-tradables, 23-8 (percentage points) Bulgaria Latvia Romania Lithuania Croatia Hungary Poland Slovakia Czech R.

29 Thus, it is fair to say that Most economies in SEE and the Baltic states received large capital inflows that mostly went into non-tradables fuelling domestic demand In contrast, the CE4 received more moderate inflows, whose distribution was more balanced, as a large part went into non-tradables contributing to export-driven growth. This, in turn, explains the unevenness in the magnitude and the nature of the various vulnerabilities that emerged. That is, the countries accumulated different degrees of external and internal imbalances.

30 This is verified by looking, first, at internal imbalances, such as inflation 15, Inflation 1, 5,, -5, Bulgaria Romania Croatia Serbia Albania FYROM Turkey Baltics CE4-1, Average inflation 23-8 Infl infl.23

31 and asset prices, such as housing prices Real estate prices, Peak less 24 price (Percent change per annum) Bulgaria Romania Croatia Czech Rep. Hungary Poland Slovak Rep. Estonia Latvia Lithuania

32 As well as at external imbalances, such as current account deficits 5,, -5, -1, -15, -2, -25, -3, Current Account Balance (Percent of GDP) Bulgaria Romania Croatia Serbia FYROM Albania Turkey Baltics CE4 Current Account Balance 28 CAB28-CAB23

33 Credit growth was externally financed, mainly through foreign banks, leading to financial vulnerabilities The presence of foreign banks facilitated FX lending Foreign bank asset share and share of FX lending, 28 Share of foreign-currency loans 28, % of total loans TUR LAT SERB HUN POL FYR CRO BUL CZE ALB LIT ROM Asset share of foreign-owned banks 28, % SLV EST

34 FX loans constituted a large part of total loans Foreign Loans / Total Loans Bulgaria Romania Croatia Serbia Albania FYROM Turkey Baltics CE4

35 and bank loans increased faster than deposits as they were financed by other less stable sources Loan to Deposit Ratio Bulgaria Romania Croatia Serbia Albania FYROM Turkey Baltics CE4

36 Resulting in high leverage as deposit growth lagged behind credit growth Change in deposit and credit to GDP, (in percentage points) 6 EST Change in credit to GDP SVK 1 TUR CZE HUN POL ROM LTA LTH ALB HRV SRB FYROM BGR Change in deposit to GDP

37 These vulnerabilities made the countries of the region much less protected against the crisis The global crisis spilled over to emerging Europe through two main channels: The financial channel, as risk aversion rose sharply. Banks experienced funding pressures as many advanced country banks faced liquidity and capital shortages. Domestic demand was affected by the sharp drop in credit growth as foreign capital dried up. The collapse in global trade soon led to a large drop in exports.

38 That is, sharp reduction in capital inflows Reduction of net capital flows, (Percent of GDP) Bulgaria Romania Croatia Serbia Albania FYROM Turkey Baltics CE

39 Leading to a large decline in bank credit Bank credit to private sector, (percentage change) Bulgaria Romania Croatia Serbia Albania FYROM Turkey Baltics CE

40 and to domestic demand Real domestic demand growth, 29 5 Bulgaria Romania Croatia Serbia Albania FYROM Turkey Baltics CE

41 At the same time, exports fell considerably Reduction of real exports, (Percent) Bulgaria Romania Croatia Serbia Albania FYROM Turkey Baltics CE4

42 Output dropped everywhere but not evenly 15 Real GDP growth (annual percent change) Bulgaria Romania Croatia Serbia Albania FYROM Turkey Baltics CE

43 In particular, the crisis affected less the economies that: Had accumulated lower vulnerabilities and had lower external financing needs. Avoided, in other words, large capital inflows and/or succeeded more in directing them into the tradable sector. Had lower degree of financial fragilities by containing the build up of financial risks. Had lower degree of financial integration and lower export dependence, like some of the western Balkan countries.

44 Lessons from the crisis GDP growth that relies on credit booms, rapid domestic demand growth and large capital inflows into the non tradable sector is not sustainable On the other hand, in economies where growth is more balanced as it relies on exports and an expanding tradable sector, generally leads to lower imbalances. As a result, these economies are affected less by a crisis while recover faster as well

45 .continuation Policies toward countering capital inflows-driven credit booms are essential in promoting more balanced and sustainable growth But given that credit growth is harder to control when it is externally funded, what can be done? Better cooperation between home and host supervisors Discourage FX loans. Reduce unhedged FX borrowing

46 .continuation Greater reliance on domestic currency lending by increasing sources of domestic finance Other policy instruments must play a more active role. This is particularly true for fiscal policy and the need for building up fiscal buffers in good times Overall, careful analysis of the drivers of growth, asset pricing developments and competitiveness

47 Main Challenges for sustainable growth Direct more capital flows into tradables Build export capacity find new comparative advantages Achieve more balanced growth Encourage higher domestic savings Maintain competitiveness Speed up reforms Improve business operating environment

48 Thank you for your attention

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