Analysis of economic situation in the countries of Central and Eastern Europe in the second quarter of 2007

The National Bank of Poland International Department International Comparative Studies Division Analysis of economic situation in the countries of Central and Eastern Europe in the second quarter of 7 November 7

Prepared by: Marcin Grela Adam Perz Approved by: Paweł Samecki This report has been prepared on the basis of various research sources, independent from the National Bank of Poland, for information purposes.

Executive summary The aim of this report is to present the economic situation of the NMS-9 1 group in 7 Q. The study covers the structure of economic growth, external imbalances, inflation, monetary policy and the situation on the labour market. The macroeconomic situation of new member states was compared with the situation of the emerging economies. The report also points to the change in export directions in individual NMS-9 and the change in the volume of foreign exchange reserves. The economic growth rate in the NMS-9 region remained high in 7 Q. However, as compared to the previous quarters, the real GDP growth rate decreased in the region. In 7 Q, it amounted to.%, as compared to.% in 7 Q1 and.% in the whole. The Baltic states and the Czech Republic (though to a much lesser extent) experienced the decrease in the GDP growth rate in recent four quarters, accompanied by the growth of inflation. A similar situation occurred in Hungary. In Slovakia, Romania and Bulgaria the opposite trends were observed. The increase in the GDP growth rate, especially in Romania and Slovakia, was accompanied by a substantial decrease in inflation. A significant increase in the GDP growth rate had been recorded also in Poland in the last four quarters, but inflation also significantly increased within that period. In almost whole NMS-9 region (except for Bulgaria and Slovakia) the real GDP growth rate in Q decreased as compared to the previous quarter. The decrease was the highest in Estonia and Hungary. The structure of economic growth in the NMS-9 group did not change significantly in the last quarter. In the Baltic states and Romania, the contribution of consumption to the economic growth was still high while the contribution of net exports 1 NMS-9 (New Member States): Poland, the Czech Republic, Slovakia, Hungary, Estonia, Lithuania, Latvia, Bulgaria, Romania. Weighted average for NMS-9. remained negative, despite a minor improvement. In other countries, the economic growth was driven almost equally by the consumption and investments. Figure 1.1. Real GDP growth rate and HICP inflation. Change between Q and 7 Q (average for preceding quarters) HICP HICP HICP 9 7 3 1... 1. 1. 1. 1. 1 HU 7 Q HU Q LT 7 Q CZ 7 Q LV 7 Q EE 7 Q LT Q CZ Q LV Q EE Q 1 1 1 PKB RO Q BG 7 Q BG Q SK Q RO 7 Q SK 7 Q 7 9 1 PKB PL Q PL 7 Q... 7 PKB Source: Eurostat 3

In 7 Q, the external imbalances for the NMS-9 group slightly increased as compared to the previous quarter. The current account deficit for this group of countries, calculated as the percentage of GDP, amounted to 11.% on average in 7 Q, as compared to 1.% in 7 Q1 3. As in previous periods, the current account deficit in most countries resulted from the goods trade deficit (except for the Czech Republic and Hungary in the last several quarters) and the negative balance on income. The high external imbalances, especially in the Baltic states, did not cause a significant decrease in the long-term debt ratings. Only in the case of Latvia, Fitch downgraded the rating from A- to BBB+ (foreign currency) and from A to A- (domestic currency). Table 1.1. FITCH credit rating for long-term debt denominated in foreign currencies September 3 7 Poland BBB+ BBB+ BBB+ BBB+ BBB+ A- Czech Republic BBB+ A- A- A A A Slovakia BBB- BBB A- A A A Hungary A- A- A- BBB+ BBB+ BBB+ Estonia A- A- A A A A Lithuania BBB BBB A- A- A A Latvia BBB+ BBB+ A- A- A- BBB+ Bulgaria BB BB+ BBB- BBB BBB BBB Romania BB- BB BBB- BBB- BBB BBB Source: FitchRatings Table 1.. FITCH credit rating for long-term debt denominated in domestic currencies 3 September 7 Poland A+ A+ A A A A Czech Republic A A A A+ A+ A+ Slovakia BBB+ A- A+ A+ A+ A+ Hungary A+ A+ A+ A- A- A- Estonia A+ A+ A+ A+ A+ A+ Lithuania A- A- A A A+ A+ Latvia A A A A A A- Bulgaria BB+ BBB- BBB BBB+ BBB+ BBB+ Romania BB BB+ BBB BBB BBB+ BBB+ Source: FitchRatings Between May 7 and August 7, the average inflation rate in NMS-9 increased. The average HICP growth rate within that period increased from.% to.%, i.e. by.9 3 Arithmetic average for NMS-9. percentage points. However, the changes of the price growth rate differed between the analysed countries. Inflation increased in Bulgaria, Romania, the Czech Republic and the Baltic states in the analysed period, and decreased in Poland, Slovakia and Hungary. The interest rates policy of central banks in 7 differed among the countries following the direct inflation targeting policy. The central bank interest rates in Poland and the Czech Republic have been raised since the beginning of 7; they have remained unchanged in Slovakia and have been cut in Hungary and Romania. Figure 1.3. Inflation and interest rates in NMS-9 applying the floating exchange rate policy between September and September 7. Interest rates Interest rates. 3. 3. SK 7 September PL 7 September PL September CZ 7 September CZ September SK September 1 3 HICP 9. 7. 7. HU September RO 7 September RO September HU 7 September 7 7 HICP Source: Eurostat In September 7, the central bank of Romania decided to raise its interest rates (cf. Chapter ). The inflation rate presented in the Figure concerns August 7.

In the Baltic states and Bulgaria which apply the fixed exchange rate policy the market interest rates have increased significantly during 7. It was particularly visible in Latvia where 3-month RIGIBOR increased from.% to 1.7%, i.e. by. percentage points, between January and September 7, including by 3. percentage points in September alone. Taking into account the inflation rate in the Baltic states and Bulgaria, it is worth noticing that despite the growth of nominal interest rates, the real interest rates in those countries remain at an exceptionally low level. rate in NMS-9 at the end of 7 Q amounted to.% and was lower by.9 and 1. percentage points, respectively, than in March 7 and December. The average wages in NMS-9 increased by 1.% in 7 Q, as compared to the corresponding period of the previous year. The increasing growth rate of wages in the countries of the analysed region was the main reason behind the increasing ULC growth rate. Figure 1.. Inflation and interest rates in NMS-9 applying the fixed exchange rate policy between September and September 7. 1 1 LV 7 September 1 Interest rates LT 7 September EE 7 September LV September BG 7 September LT EE BG September September September 1 1 HICP Source: Eurostat Similarly to previous quarters, also 7 Q was characterised by the improvement of the situation on the labour market in NMS-9. The economic growth supported the increase in employment and the decrease in unemployment. Wages also increased and were the main reason for the increasing growth rate of unit labour costs (ULC). The average employment growth rate in 7 Q amounted to.% in NMS-9 and was lower by. and. percentage points, respectively, as compared to 7 Q1 and the whole. The increase in employment was accompanied by the decrease in unemployment. The average unemployment

1. The NMS-9 economic situation as compared to the emerging economies The years - saw a worldwide acceleration in economic growth. In, the global economy grew by.%. The emerging economies grew faster in the period. The average GDP growth amounted to.% in in the NMS-9 group and to 7.% in the rapidly developing countries. In 7 Q, the economic growth rate in NMS-9 was lower than in the emerging markets and amounted to.% and.%, respectively. Figure 1.1. Annual GDP growth rate A relatively small foreign trade volume in developing countries as compared to NMS-9 results from the inclusion of large economies (China, India, Russia, Indonesia and Brazil) in the group of the emerging economies. A significant part of production in the large economies goes to domestic markets. Thus, the exports to GDP ratio is lower than in on average much smaller economies of NMS-9. Figure 1.. Foreign trade volume, percentage of GDP. 1 1 1 93 9 99 17 1 11 13 117 9 7 3 1 7,7 7, 7,3,,,,3,,,,3,,9,7,,3 3, 3,1,7,9, 1 3 7 Q1 World Emerging NMS-9 7 Q 7 9 3 7 1 1 3 7 Q1 World Emerging NMS-9 Sources: IMF IFS, Eurostat, EcoWin Economic. 7 Q Sources: IMF WEO, Eurostat, EcoWin Economic. In recent years, the global foreign trade volume also increased as compared to the value of global production 7. Starting from the total value of exports and imports of NMS-9 was higher than the total GDP value in those countries. In, the foreign trade volume of the NMS-9 region represented 11% of the GDP, while in 7 Q this figure increased to 117%. In comparison with the emerging economies and the world average, the NMS-9 region was characterised by the largest openness of the economies. Argentina, Brazil, Chile, China, the Philippines, India, Indonesia, Malaysia, Mexico, Russia and Turkey called Emerging in the Chart; according to the IMF classification, those countries are classified as the emerging countries. They were selected as a representative comparable group for NMS-9 countries due to their significant impact on the growth of the world economy and a similar level of GDP per capita. 7 Foreign trade volume understood as the total of exports and imports. The average current account balance decreased along with the increase in the foreign trade volume of NMS-9. The average deficit in the NMS-9 region amounted to 1.% of the GDP in and increased to 11% in 7 Q. In the same period, the emerging countries reported a current account surplus of 3.% and 3.% of the GDP in and 7 Q, respectively. The surplus on the current account in the group of developing countries results from the export-oriented direction of the emerging economies, mostly Asian ones. In addition, some of the countries included in this group (Russia, Indonesia) are the global exporters of commodities. The recent growth of the world prices of commodities had a significant impact In the case of the emerging countries and NMS-9, it is calculated as a relation of the total of exports and imports of all countries from a given group to the total GDP of all the countries from that group.

on the improvement of the foreign trade balance in those countries. Figure 1.3. balance, percentage of GDP 9. - - - - -1-1 -1 1, 1 -,9 -,9,,7, 3 -, Emerging,9-7,9-7, 3, 3, 3, -1, NMS-9 7 Q1 Sources: IMF WEO, EcoWin Economic, Eurostat. -1, 7 Q1-11, Despite the recent economic growth acceleration, no worldwide inflation growth was observed. The average inflation in NMS-9 amounted to.% in 7 Q and was lower than in the emerging countries. Figure 1.. Annual average inflation rate 1 9 7 3 1.1 7. 7. 1. 3..1.9..1..7..3.. 3. 3. 3. 3. 3. 3.3 3 7 Q1 World Emerging NMS-9 7 Q.1. The economic growth acceleration had a positive impact on the improvement of the situation on the labour market in the emerging countries. In 7 Q, the average unemployment rate amounted to 7.% in the emerging countries and to.% in NMS-9, which demonstrated the improvement of the unemployment rate as compared to previous years. The unemployment rate in the NMS-9 region became lower than in the group of the emerging economies. Sources: IMF WEO, Eurostat. Figure 1.. Unemployment rate 1 1 1 13. 1.7 11. 11. 1. 9.1 9.....1 7.7......3 7.37. 7.. 1 3 7 Q1 7 Q World Emerging NMS-9 Sources: ILO, Eurostat, national statistics offices. 9 Calculated as arithmetic average for a given group of countries. 7

. Economic growth The economic growth rate in NMS-9 in 7 Q decreased in comparison with previous periods. The real GDP growth rate in the region amounted to.% in 7 Q, as compared to.% in 7 Q1 and.% in. Except for Bulgaria and Slovakia, the GDP growth rate in the remaining countries from the group decreased as compared to the previous quarter. The decrease was the largest in Estonia (-. percentage points) and in Hungary (-1. percentage points). As in previous years, the structure of economic growth in the NMS-9 group was diversified, which provided the basis for a division into the following groups: A. the Baltic states and Romania characterised by a high individual consumption growth rate and a large foreign trade deficit in the last quarters; B. Poland, the Czech Republic, Slovakia and Bulgaria characterised by a more balanced growth; C. Hungary the country struggling with a growing economic slowdown. Figure.1. Real GDP growth rate in NMS-9 1 Q3 Q Q1 Q Q3 Q Q1 Q Q3 Q 7 Q1 7 Q NMS-9 EE, LT, LV, RO PL, CZ, SK, BG HU Source: Own analysis on the basis of: Eurostat, EcoWin, Economic, national statistical offices. A. The economic growth rate in the Baltic states and Romania decreased further in 7 Q. In all countries, the real GDP growth rate decreased as compared to 7 Q1, and in Estonia the decrease amounted to as much as. percentage points (from 1.1% to 7.%). The average growth rate in those countries amounted to.% in 7 Q, as compared to 7.% in Q1 and.% in. The decrease was mainly the result of the drop of the contribution of consumption and net exports. A positive sign seems to be the increase in the contribution of investment outlays to the economic growth in the abovementioned group of countries. Consumption remained the main driver of the economic growth in those countries. The contribution of the consumption growth rate into the economic growth was the largest and amounted to 1. percentage points in 7 Q. However, it marked the decline, as compared to 11. percentage points in 7 Q1. The contribution of consumption was considerably larger in the subsequent quarter than the average economic growth rate in this group of countries. The decline of the consumption growth rate had the largest impact on the slowdown of the economic growth rate in the Baltic states and Romania in the last quarter. At the same time, the contribution of gross investment outlays to the economic growth in this group of countries increased. It amounted to.1 percentage points in 7 Q, as compared to.% in 7 Q1 and.1% in. Another common feature of this group of countries is a large, negative contribution of net exports to the economic growth. Although the contribution of net exports to the economic growth in 7 Q increased to -7.1 percentage points, compared to -. percentage points in 7 Q1, it was still significantly lower than in (-. percentage points). The improvement of the net exports contribution to the economic growth as compared to was visible only in Estonia.

In Lithuania and Latvia, the reason for deteriorating foreign trade balance was mainly an increase in the imports growth rate which in those countries is over 1 percentage points higher than the exports growth rate. The deficit grew even more in Romania but it was due to a significant decline in the exports growth rate in the last quarter (from 1.9% in 7 Q1 to.% in 7 Q). Table.1. Decomposition of economic growth in Central and East European countries, - (percentage points) Bulgaria 1 1 - -1-1 Q3 Q Q 1 Q Q3 Total consumption Change in inventories GDP Q Q1 Latvia Q Q 3 Q 7 Q 1 7 Q Gross fixed capital formation Net exports 7 3 1-1 Q3 Q Q1 Czech Republic Q Q3 Total consumption Change in inventories GDP Q Q1 Q Lithuania Q3 Q 7 Q1 7 Q Gross fixed capital formation Net exports 1 1 - -1-1 Q3 Q Q1 Q Q3 Total consumption Change in inventories GDP Estonia Q Q1 Q Hungary Q3 Q 7 Q1 7 Q Gross fixed capital formation Net exports 3 1 1 - -1-1 - Q3 Q Q1 Q Q3 Total consumption Change in inventories GDP Q Q1 Poland Q Q3 Q 7 Q1 7 Q Gross fixed capital formation Net exports 1 1 - -1-1 Q3 Q Q1 Q Q3 Q Q1 Q Q3 Q 7 Q1 7 Q Total consumption Gross fixed capital formation Change in inventories Net exports GDP Romania 1 - - - Q3 Q Q1 Q Q3 Q Q1 Q Q3 Q 7 Q1 7 Q Total consumption Gross fixed capital formation Change in inventories Net exports GDP Slovakia 1 - - Q3 Q Q1 Q Q3 Total consumption Change in inventories GDP Q Q1 Q Q3 Q 7 Q1 7 Q Gross fixed capital formation Net exports 1 1 - -1-1 Q3 Q Q1 Q Q 3 Total consumption Change in inventories GDP Sources: Eurostat, EcoWin, national statistical offices. In 7 Q, the Baltic states were characterised by a different import structure than other countries from the NMS-9 group. The imports of consumption goods and products amounted to approximately % of total imports in those countries in 7 Q, which market a decrease of 3 percentage points as compared to the previous quarter. The share of consumer imports in the Baltic states is still significantly higher than in other NMS-9; it amounted to 1% in the same period. The foreign trade deficit which remains on a high level in the Baltic states and Romania (1% of the GDP in 7 Q) may be still Q Q 1 Q Q 3 Q 7 Q1 7 Q Gross fixed capital formation Net exports 1 1 1 - - - Q3 Q Q1 Q Q3 Total consumption Change in inventories GDP Q Q1 Q Q3 Q 7 Q1 7 Q Gross fixed capital formation Net exports attributed to strong internal demand, mainly consumer demand, despite its weakening in 7 Q. In addition, high inflation rate in the Baltic states translated into the strengthening foreign exchange rate in those countries. The real effective exchange rate (REER) in 7 Q strengthened by 1.1% in Estonia,.9% in Lithuania and 1.% in Latvia, which could have also contributed to the decrease in competitiveness of those economies and the weakening of exports. The increasing foreign trade deficit in Romania, which amounted to almost 1% of GDP in 7 Q, as compared to 1% in Q1 and 11.% in resulted from the decline in the exports growth rate. In Q, it fell by over 9

1 percentage points compared to 7 Q1, while the imports growth rate decreased by 3 percentage points. As a result the contribution of net exports to the economic growth in Romania decreased from -7. percentage points to -9. percentage points. Such a significant decline in the exports growth rate might have been caused by the strong appreciation of the domestic currency, which had continued since mid-, though in previous quarters it did not have an impact on the decrease in the exports growth rate. In 7 Q, REER strengthened by only 1%, and by over % since June. Also in Romania, the deterioration of the foreign trade balance might have resulted from the increasing domestic demand, where the decreasing contribution of consumer demand was replaced, as in the Baltic states, by the increase in investment demand. The threats faced by the Baltic states and Romania did not diminish in 7 Q. The structure of the economic growth, which is still based on consumption and the increasing external imbalances may be the signs of the overheating of the said economies, which may be demonstrated by the decrease in the GDP growth rate that has been recorded in Estonia and Romania from the beginning of 7. Additional factors which point to such a possibility include: a strained situation on the labour market (the decreasing share of unused labour force and a very high rise of wages, exceeding % now), a high growth rate of loans for private sector and a relatively high inflation rate. In the Baltic states there are limited possibilities of the monetary policy s impact on the alleviation of the overheating of the economy. B. After the period of sustained growth since the beginning of, in 7 Q the average economic growth rate in Poland, Czech Republic, Slovakia and Bulgaria decreased. Those economies grew by.% in 7 Q, as compared to 7.% in 7 Q1. The real GDP growth rate increased slightly in Bulgaria and Slovakia, while in the Czech Republic and Poland the economic growth rate decreased. Since 7 Q1 the average economic growth rate in this group of countries has reached the same level as in the Baltic states and Romania. Economic growth in Poland, the Czech Republic, Bulgaria and Slovakia was more balanced and did not rely on the increase in consumption to a large extent. The decrease in the GDP growth rate in 7 Q was wholly the result of the decrease in the contribution of consumption. The contribution of the total consumption growth rate to the economic growth declined in all the abovementioned countries and amounted on average to 3.9% in 7 Q, as compared to.7 percentage points in 7 Q1. In addition, the individual consumption growth rate in the last quarter was lower than the GDP growth rate in all the countries from the group, as in previous quarters 1. The contribution of investment outlays to the economic growth of Poland, the Czech Republic, Slovakia and Bulgaria in 7 Q did not change as compared to Q1 and amounted to 3. percentage points. The contribution of the investment outlays growth rate did not change despite a large decrease in the investment growth rate in the analysed group of countries. It resulted from a largely seasonal nature of investments. The contribution of investment outlays in Q1 each year is lower than in the following quarters. In 7, it amounted to 1% of GDP in Q1 and to % of GDP in Q in the analysed group of countries. The contribution of investment outlays to teconomic growth was particularly high in Poland and Bulgaria. Despite the decrease from the previous quarter, it exceeded the contribution of total consumption in those countries, and the investment growth rate remained over % (almost 3% in Bulgaria). The Czech Republic and Slovakia were characterised by a lower growth rate and contribution of investments. 1 In Q and 7 Q1, the total consumption growth rate slightly exceeded the GDP growth rate only in Bulgaria. 1

Figure.. Real effective exchange rate in NMS-9 between January and June 7, index = 1 (increase means appreciation) 17 1 1 1 13 1 11 1 9 11 1 1 9 9 m1 m 1 13 13 1 1 11 11 1 1 9 9 m1 m m9 m1 m m9 m1 m m9 m1 7 m 7 CZ PL SK HU m7 m1 m1 m m7 m1 m1 m m7 m1 m1 7 m 7 EE LT LV BG m1 m m7 m1 m1 m m7 m1 m1 m Source: Own analysis on the basis of IMF IFS, Eurostat, central banks. The contribution of net exports to the economic growth of Poland, the Czech Republic, Slovakia and Bulgaria increased slightly in 7 Q. It amounted to -1.7 percentage points as compared to -1.9 percentage points in Q1. However, it meant RO the decrease as compared to when the input amounted to -.9 percentage points. The foreign trade balance improved only in the Czech Republic and Bulgaria, as compared to the previous quarter. The Czech Republic was the only country in the group with a surplus in the trade in goods and services and the positive contribution of net exports to the GDP growth rate. A positive contribution of net exports to the economic growth was also recorded, as in the previous four quarters, in Slovakia, where, however, the foreign trade deficit was recorded. The exports and imports growth rate both decreased in all countries from the group. In all those four countries, REER strengthened during 7 Q1. The appreciation was small in Bulgaria and the Czech Republic (.3% and 1% respectively) and significantly higher in Poland and Slovakia (.% and.7% respectively). The strong appreciation of domestic currency may partly explain the deterioration of the foreign trade balance in Poland and Slovakia in the last quarter. C. In 7 Q, Hungary, as in previous quarters, experienced a decrease in the real GDP growth rate. The GDP growth rate decreased from.7% in 7 Q1 to 1.% in 7 Q and was at the lowest level from among the countries of the region. It was the fifth consecutive quarter in which the economic growth rate in Hungary decreased. 11 Contrary to previous quarters, the decrease was not the result of the lower internal demand growth rate but mainly the decrease in the net exports contribution to the GDP growth rate. In 7 Q, the total consumption growth rate decreased to -3.3% from -1.7% in the previous quarter and the contribution of the consumption growth rate to the GDP growth rate amounted to -. percentage points (-. percentage points in Q1). The contribution of investment outlays increased and amounted to almost. percentage points as compared to -.% in Q1. The gross investment outlays growth rate significantly increased in 7 Q to over 1%, though it was negative in the previous quarters. Contrary to previous 11 In Q1, the real GDP growth rate in Hungary amounted to.9%. 11

quarters when net exports were the only category with positive contribution to the GDP growth rate, this contribution decreased significantly in the last quarter (from percentage points in Q1 to. percentage point in 7 Q), which was decisive for the further decline of the economic growth rate in Hungary. The decrease in the net exports contribution resulted first of all from the decline of the exports growth rate (17.% in Q1 and 1.% in 7 Q). This, in turn, might have been influenced by the strengthening REER which grew by 3.% in the last quarter. The economic growth forecasts for NMS-9 from 7 point to a possible decline of the economic growth rate. According to the European Commission 1, the average GDP growth rate 13 for NMS-9 in 7 will amount to.3% and in to.%. The IMF projects that in the same years the average economic growth rate will amount to.% and.% respectively, and Wiener Institut für Internationale Wirtschaftsvergleiche (WIIW) forecasts that the said figures will stand at.% and.9%. It is worth noticing that in 7 all abovementioned institutions revised upward their forecasts of the GDP growth rate for the two coming years. The projections show a decrease in the economic growth rate in the majority of NMS- 9 (except for Bulgaria) in 7 and. The decrease in the economic growth rate will result from the forecast economic slowdown in the euro area which is the main trade partner of NMS-9. According to the forecast, the decrease in the GDP growth rate will be the largest in the Baltic states. It is also projected that in, the GDP growth rate in Hungary will increase for the first time since. 1 The forecasts come from June 7. The interim forecasts of the European Commission of August 7 include only Poland from among NMS-9. According to the Commision, the economic growth rate in Poland in 7 will be higher than forecast in spring and will amount to.%, as compared to.1% projected in June 7. The Commission explains the higher GDP growth rate in 7 by unexpectedly good performance of the Polish economy in 7 Q. 13 The arithmetic average of forecasts for all countries. According to this method, the average GDP growth rate in amounted to 7.% in NMS-9. 1

Box 1 Export directions in the NMS-9 region In recent years, NMS-9 recorded a very fast growth of foreign trade. The average real exports growth rate amounted to 1.9% in this group between 1999 and, and to 13.% between and. Figure 1. Foreign trade of NMS-9, percentage of GDP 1 1 199 1999 1 3 Exports Exports+imports Source: Eurostat The countries of old European Union (EU-1) have been the main trade partner of NMS-9 for many years. Between 1999 and, exports to EU-1 accounted for over % of the total exports of the NMS-9 region. Exports to EU-7 in the same period accounted for approximately % of total exports. Paradoxically, from, i.e. from the accession of the majority of NMS-9 to the European Union, the share of exports to EU-1 has begun to decrease. In 3, it accounted for 7.7% of the total exports of those countries, while in it fell to.%. At the same time, the increase in trade within NMS-9 has been observed. In the same period, the share of exports within NMS-9 increased from 13.7% to 17.9% of total exports. Nevertheless, this increase did not compensate the decrease in the share of exports to EU-1. Between 3 and, the share of exports to EU-7 fell from.1% to 79.1%. A relative decrease in exports to EU-7 may be explained by the fast growth of exports to eastern neighbours. Between 3 and, the share of exports to Russia and Ukraine increased from 3.% to.3% of total exports. Exports to Asian countries (China, India, Japan and Korea) also slightly increased. 13

Figure. NMS-9 exports to EU-7, percentage of total exports. 19 1 17 1 1 1 13 1 11 1 1999 1 3 NMS-9 (left-hand axis) EU-7 (right-hand axis) 3 1 79 7 77 Source: Eurostat There are groups of countries within the NMS-9 region whose mutual foreign trade is significantly higher than trade with other NMS-9. However, these tendencies have not emerged in recent years but have been present for a long time and seem to result from historical links. The only change is a slight increase in the intensity of the tendencies after. The Baltic states are the most characteristic group. The share of the Baltic states exports within the group amounted to 1.% of the total exports of those countries in and was over three times higher than to other NMS-9. It marked a growth of over percentage points since 3, while the share of exports to EU-1 in the same period decreased by almost 13 percentage points. The value of trade within that group, including trade with other NMS-9, increased significantly faster than trade with EU-1 in recent years. The annual exports growth rate within the Baltic states group between 3 and amounted to 31% on average (3% to other NMS-9) and merely to.% to EU-1. Poland, the Czech Republic, Slovakia and Hungary form a somewhat different group. In these countries, foreign trade within the group was also larger than that with other NMS-9 and accounted for around % of the trade with the countries of the region (in the share of exports within the abovementioned group of countries amounted to 1.7%, while exports to other NMS-9 amounted to 3.7% of total exports). However, taking into account the fact that the total GDP of these countries accounted for 7% of the GDP of the whole region in recent years, those proportions seem to be more balanced than in the Baltic states, where the trade between these countries accounted for around 7% of the value of the trade with NMS-9, while their total GDP amounted to only 7.% of the total GDP of the NMS-9 region. As in the Baltic states, also in Poland, the Czech Republic, Slovakia and Hungary the increase in exports to NMS-9 was significantly higher than to EU-1 and amounted to 3.% and 11.%, respectively, on average between and. 1

The directions of foreign trade in Bulgaria and Romania resemble the situation in the Baltic states. Foreign trade between these countries accounted for approximately 33% of total foreign trade with NMS-9 in recent years (twice more than the ratio of the GDP of those countries to the region s GDP). In the case of Bulgaria and Romania, the share of exports to NMS-9 has increased since, while the share of exports to the old EU countries has significantly decreased. Figure 3. Foreign trade between Bulgaria and Romania as percentage of total foreign trade Figure. Foreign trade between Estonia, Lithuania and Latvia as percentage of total foreign trade 3. 3. 1. 1. 1999 1 3 19 1 17 1 1 1 13 1 11 1 1999 1 3 7 3 1 BG RO (left-hand axis) UE-1 (right-hand axis) EE LT LV (left-hand axis) UE-1 (right-hand axis) Figure. Foreign trade between the Czech Republic, Poland, Slovakia and Hungary as percentage of total foreign trade 1 1 13 1 11 1 1999 1 3 7 7 CZ HU PL SK (left-hand axis) UE-1 (right-hand axis) Source: Eurostat 1

3. External imbalances In 7 Q, the external imbalances for the NMS-9 group slightly increased as compared to the previous quarter. The current account deficit, calculated as a percentage of GDP for the said group of countries, amounted to 11.% on average in 7 Q, as compared to 1.% in 7 Q1. As in previous quarters, the current account deficit in the majority of the countries resulted from the deficit in the trade in goods (the Czech Republic and Hungary have been exceptions for several quarters) and a negative income balance. All NMS-9 recorded a surplus in the services account which also has not changed as compared to the previous quarters. The current transfers balance in the majority of the countries (except for the Czech Republic and Slovakia) was positive. Current transfers had a significant impact on the current account deficit in Poland, Romania, Lithuania and Latvia, where it amounted to from. to.% of GDP. In other countries, the current transfers balance did not exceed 1%. The following groups of countries were distinguished taking into account the amount and structure of the current account deficit: A. the Baltic states, Bulgaria, Romania despite a decrease in 7 Q, the current account deficit was still the highest in this group of countries and resulted mainly from a deficit in the trade in goods; B. Poland, the Czech Republic, Slovakia and Hungary countries with a relatively lower deficit which, however, increased significantly in 7 Q. In this group of countries the income account balance remains the main reason for the current account deficit. Figure 3.1. balance in the NMS-9 group between and 7, as percentage of GDP. - - - - -1-1 -1-1 - -1-1 - - -3 1 1 - -1-1 - - -3 CZ PL SK HU Q3 Q Q1 Q Q3 Q Q1 Q Q3 Q 7 Q1 7 Q Q3 Q Q1 Q Q3 Q Q1 Q Q3 Q 7 Q1 7 Q Q3 Q Q1 Q Q3 Q Q1 Q Q3 Q 7 Q1 7 Q EE LT LV BG Source: Own analysis on the basis of Eurostat and national central banks. RU 1

3 1-1 - -3-1 1 - -1-1 - - -3-3 - - - - -1 Table 3.1. deficit structure, -7, percentage of GDP. Bulgaria Czech Republic Goods Income Goods Income Goods Income Q3 Q Q1 Q Q3 Q Q1 Q Q3 Q 7 Q1 7 Q Latvia Services Current transfers Q3 Q Q1 Q Q3 Q Q1 Q Q3 Q Poland 7 Q1 7 Q Services Current transfers Q3 Q Q1 Q Q3 Q Q1 Q Q3 Q 7 Q1 7 Q Services Current transfers - - - - -1-1 1 - -1-1 - - 1 - -1-1 - - Goods Income Goods Income Goods Income Q3 Q Q1 Q Q3 Q Q1 Q Q3 Q 7 Q1 7 Q Lithuania Services Current transfers Q1 Q Q3 Q Q1 Q Q3 Q 7 Q1 7 Q Romania Services Current transfers Q3 Q Q1 Q Q3 Q Q1 Q Q3 Q 7 Q1 7 Q Services Current transfers Source: Own analysis on the basis of Eurostat and national central banks. 1 1 - -1-1 - - -3 - - - - -1 - - - - -1-1 -1-1 -1 Q3 Q Q3 Q Q3 Q Goods Income Goods Income Goods Income Estonia Q1 Q Q3 Q Q1 Q Q3 Hungary Q1 Q Q3 Q Q1 Q Q3 Slovakia Q1 Q Q3 Q Q1 Q Q3 Q 7 Q1 7 Q Services Current transfers Q 7 Q1 7 Q Services Current transfers Q 7 Q1 7 Q Services Current transfers A. The Baltic states, Romania and Bulgaria continued to report the highest current account deficit. Such a situation continues despite a significant decrease in the deficit in the majority of the countries from the group (except for Romania). In 7 Q, the deficit amounted to 17.% of GDP on average in this group of countries, as compared to % in 7 Q1. As in previous quarters, the deficit was the highest in Latvia and Bulgaria, where it amounted to 3.% and 19.% of GDP, respectively. In this group of countries, the current account deficit resulted mainly from a large deficit in trade in goods. It amounted to % of GDP in 7 Q and did not change significantly in comparison with the previous quarter. Thus, the decrease in the current account deficit was the result of other balance of payments categories, mainly the balance of services which in Q had an average surplus of.1% of GDP, as compared to the surplus of 1.% of GDP in the previous quarter, and improved in all countries. In addition, in the last quarter the balance on incomes deteriorated in the Baltic states, Bulgaria and Romania, while the surplus on the current transfers account increased. The main sources of the financing of the current account deficit in the Baltic states, Bulgaria and Romania included other investments, i.e. mainly loans for the banking sector. The average influx of other investments for the abovementioned group of countries amounted to 1.% of GDP in 7 17

Q. Direct investments and portfolio investments recorded a lower position on the financial account (9.3% and -1.% of GDP, respectively). Only in Bulgaria the influx of direct investments was higher in 7 Q than the influx of other investments. B. The current account balance in Poland, the Czech Republic, Slovakia and Hungary deteriorated significantly in 7 Q. The average deficit in that group of countries amounted to.1% of GDP in Q, as compared to 1.9% of GDP in 7 Q1 and.1% in. The current account balance deteriorated most significantly in the Czech Republic and Slovakia, where the deficit calculated as a percentage of GDP increased by. percentage points and 7.3 percentage points, respectively, in Q as compared to Q1. As in previous quarters, the largest part of the current account deficit was due to the deficit on the income account, whose increase in 7 Q (7.% of GDP as compared to 3.9% in the previous quarter) accounted for the largest part of the total deficit increase. The balance of trade in goods also deteriorated, to the largest extent in the Czech Republic. 3 1-1 - -3 3 3 1 1 - -1 1 1 - -1-1 Table 3.. Structure of the financial account balance, -7, percentage of GDP. Bulgaria Czech Republic Q3 Q Q3 Q Q1 Q FDI Other investments FDI Other investments FDI Other investments Latvia Q3 Q Q1 Q Q3 Q 7 Q1 7 Q Portf olio investments Q3 Q Q1 Q Q3 Q Q1 Q Q3 Q 7 Q1 7 Q Poland Portfolio investments Q1 Q Q3 Q Q1 Q Q3 Q 7 Q1 7 Q Portfolio investments 1 1 - -1 3 1 1 - -1 1 1 - Q3 Q FDI Other investments FDI Other investments FDI Other investments Q3 Q Q1 Q Q3 Q Q1 Q Q3 Q 7 Q1 7 Q Lithuania Portfolio investments Q1 Q Q3 Q Q1 Q Q3 Q 7 Q1 7 Q Romania Portfolio investments Q1 Q Q3 Q Q1 Q Q3 Q 7 Q1 7 Q1 Portfolio investments Source: Own analysis on the basis of Eurostat and central banks data. - - - 3 3 1 1 - -1-1 3 1-1 - -3 Q3 Q FDI Other investments FDI Other investments FDI Other investments Estonia Q3 Q Q1 Q Q3 Q Q1 Q Q3 Q 7 Q1 7 Q Hungary Portfolio investments Q Q1 Q Q3 Q Q1 Q Q3 Q 7 Q1 7 Q Slovakia Portfolio investments Q1 Q Q3 Q Q1 Q Q3 Q 7 Q1 7 Q Portfolio investments 1

As in other countries from the region, other investments were the main source of the financing of the current account deficit in Poland, the Czech Republic, Slovakia and Hungary. As in 7 Q1, also in Q the net influx of other investments amounted to.1% of GDP, while in the whole their balance was negative. The share of other investments in the financing of the current account deficit was still considerably lower than in the Baltic states. Apart from Slovakia, in all other countries the influx of foreign direct investments decreased. It was the most visible in Hungary where the balance of FDI amounted to -.% of GDP in Q, as compared to.7% in Q1 and 3.1% in. The balance of portfolio investments slightly increased in the abovementioned group of countries due to the significant increase in their influx in the Czech Republic and Slovakia. According to current account forecasts, its balance will remain negative in the following years in all those countries. According to the European Commission, the current account deficit at the end of 7 and in all the countries should be slightly lower than in 7 Q. The IMF forecasts that the deficit in the next two years will be higher than today only in Estonia, while in other countries the current account balance should slightly improve. 19

Box Foreign exchange reserves in the NMS-9 region In recent years, there has been a noticeable surge in the level of official reserve assets in the world. In the years 1-, the level of reserve assets increased over twofold from USD, billion to over USD, billion, while the increase has even been higher in developing countries. In the analogical period, the value of reserves in China increased almost fourfold and almost threefold in India. A similar trend was visible in NMS-9 as the increase in the level of official reserve assets has been significant there since. At the end of 1, the level of reserve assets in the countries under research amounted to USD billion and it increased to USD 17 billion at the end of. The surge was due, on the one hand, to transactions in the balance of payments (the surplus in the financial account for NMS-9 was higher than the current account deficit in the years -) and, on the other hand, to the currency translation and changes in valuation (depreciation of USD against the euro and other domestic currencies). The highest increase in reserves among NMS-9 took place in Romania, where they increased sixfold in the years 1-. In the analogical period, currency reserves increased by over % in Bulgaria, Slovakia and in the Baltic states. Despite the rapid increase in the level of currency reserves in Central and Eastern Europe in recent years, the reserves-to-gdp ratio has not changed considerably. In 1, reserve assets amounted to 17.% of GDP while the figure for is 1.%. The rise in reserves as compared to GDP in the NMS-9 group in the years 1- was definitely lower than the global rise, where the ratio increased from.% to 1.% in the analogous period. This was mainly due to the pace of economic growth that was faster than the global one, as well as to higher inflation in NMS-9 (see: Chapter 1). Figure 1. Official reserve assets in the NMS-9 group, USD billion 19 17 1 13 Figure. Official reserve assets in the world, USD billion 11 9 7 Source: EcoWin 1999 Q1 1999 Q Q3 1 Q Q1 Q 3 Q3 Q Q1 Q Q3 3 1 1999 Q1 1999 Q3 Q1 Q3 1 Q1 1 Q3 Q1 Source: EcoWin Q3 3 Q1 3 Q3 Q1 Q3 Q1 Q3 Q1 Q3 The increasing level of reserves in NMS-9 in recent years was accompanied by the increase in indebtedness that grew at an even faster pace. The short-term indebtedness of the NMS-7 group 1 increased twofold from USD 3 billion to USD billion since mid-3 until the end of. AS a result, the ratio of reserves to the short-term indebtedness has deteriorated in NMS-9 in recent years it was 39% in 3 Q for NMS-7 while it dropped to 19.% by the end of. The 1 NMS-9 states with Bulgaria and Romania excluded.

ratio increased only in Lithuania and Latvia, yet the level of their reserves compared to indebtedness was much lower than in the remaining economies of the NMS-9 group (see: Table 1). Analysing the ratio of reserves to short-term indebtedness in the NMS-9 group it becomes clear that for most of the countries the ratio is over 1% (the Greenspan-Guidotti Rule), which indicates that their situation is rather stable. Among the countries under research, the ratio is definitely the lowest in the Baltic states. Its value did not exceed the safety threshold of 1% in Estonia and Latvia while in Lithuania it reached 1% only in Q (see: Table 1). Implementing the policy of a fixed exchange rate, the Baltic states seem to be most vulnerable to fast loss of reserves. Thus, the relatively low level of reserves as compared to the level of their indebtedness (due to the rapid increase in their foreign debt) may not be enough to safeguard the stable growth of their economies in the future. Figure 3. The ratio of reserve assets to short-term foreign indebtedness in NMS-9, % Figure. Short-term foreign indebtedness in NMS-9, USD billion 1 1 3 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Sources: IMF IFS, Joint External Debt Hub 1 Table 1. Official reserve assets in NMS-9 The level of official reserve assets, USD billion Change, % 9 7 7 3 Q3 3 Q The level of official reserve assets, percentage of GDP Q1 Q Q3 Q Q1 Q Q3 Q Q1 Q Q3 Q The level of official reserve assets, percentage of short-term indebtedness 1 1 3 Q3 Bulgaria 3 117,, 3, 3,1* 1,1 Czech R. 13 311 117, 3,,9 79, 19,9 Estonia 3 7 3, 13, 1, 9,,7 Hungary 17 19 1,7 13, 11,3 1,9 1, Latvia 11 1 7,1 1, 1,, 3, Lithuania 19 773, 3,,9 99, 11,1 Poland 3 7, 1, 3, 73, 9, Romania 1 37 1, 1, 13, - - Slovakia 1 133 19,,1 3,1 1,3 1, Total 1 19 19, 17, 1, 39,1** 19,** * Q3 ** Excluding Bulgaria and Romania. Sources: Own calculations based on JEDH, Eurostat, IMF IFS 1 Joint External Debt Hub (JEDH) is a database created jointly by the World Bank, IMF, OECD and BIS, that gathers data on foreign indebtedness. 1

Charts,. The ratio of reserve assets to short-term foreign indebtedness for individual NMS-9, % 3 1 3 1 1 1 1 Q1 Q3 3 Q1 3 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 3 Q1 3 Q3 Q1 Q3 Q1 Q3 Q1 Q3 CZ HU PL SK EE LV LT Sources: IMF IFS, Joint External Debt Hub

. Inflation and the monetary policy Average inflation rose in the NMS-9 region in the period between May 7 and August 7. The average HICP growth rate increased from.% to.%, i.e. by.9 percentage points. However, the changes in the price growth rate were different for countries under analysis: A. in Bulgaria, Romania and the Czech Republic inflation increased in the period under research; B. in Poland, Slovakia and Hungary inflation decreased. A. Of all the analysed countries Bulgaria saw the highest inflation increase. Its yearly HICP growth rate increased from.% to 9.3%, i.e. by. percentage points in the period between May and August 7. In August 7 alone inflation grew by. percentage points, as compared to the previous month. Such a rapid increase in the HICP growth rate was mainly due to the increase in the growth rate of processed and unprocessed food prices. The analysis shows that the inflation growth in Bulgaria may have been attributed in 9% to the increase in the growth rate of both food categories (see: Table.1). Net inflation and the growth rate of energy prices were of little impact on inflation changes. The high growth rate of unprocessed food prices in recent months was caused by unfavourable weather conditions high temperature and most of all drought during the crops growing season. It is highly probable that the increase in the growth rate of unprocessed food prices was also conducive to the increase in the prices of processed food. The inflation growth was thus mainly due to negative supply shocks. Similar to Bulgaria, the supply factors influenced the increase in inflation in Romania in recent months. The HICP growth rate increased in the period between May and August 7 from 3.9% to.%, i.e. by 1.1 percentage point. The analysis shows that practically all of the inflation growth was due to the increase in the growth rate of unprocessed food prices. Similar to Bulgaria, in Romania this was also caused by unfavourable supply shocks heat waves and draughts, yet unlike Bulgaria, the increase in the growth rate of unprocessed food did not translate into the increase in the prices of processed food. In the period between October and May 7, both in Bulgaria and Romania the growth rate of (processed and unprocessed) food prices was conducive to the decrease in inflation, however the abnormal weather conditions reversed the trend. Similar to the Balkans, in the period under research the HICP growth rate also rose in all the Baltic states. The highest inflation surge was posted by Latvia as its inflation increased from 7.% to 1.%, i.e. by. percentage points in the period between May and August 7. Inflation in Lithuania is currently the highest among all the countries of the NMS-9 group as its HICP growth rate increased in the period under scrutiny by. percentage points and amounted to.% in August 7. Estonia s inflation increased only by. percentage points in the analysed period. The inflation increase in the Baltic states was demand-driven, contrary to the Balkan states. In the case of Latvia, the increase in the cumulative HICP growth rate by % can be explained by the increase in core inflation as well as in the growth rate of processed food prices. Lithuania s total input in inflation changes of both groups expressed as the percentage of inflation changes was 11%. In both the above-mentioned countries, the changes of the growth rate of prices of unprocessed food and energy had only slight impact on inflation. This confirms the assumption that supply factors did not influence inflation in recent months. In the Czech Republic, inflation increased in the period under analysis by. percentage points, which can be explained by the increase in the growth rate of processed food prices. 3

Box 3 The method of inflation decomposition employed in the analysis. The HICP index was used to compare the growth rates of prices of consumer goods and services in the analysed countries. The main reason behind such a choice was the common methodology of the index for all analysed countries, which made comparison easier. While decomposing the HICP growth rate, goods and services were divided into four sub-groups: unprocessed food, processed food, energy and the remaining goods and services called net inflation. The category of processed food includes the growth rate of alcohol and tobacco products prices. The reasons underlying the choice of this decomposition method were: Including goods and services characterised by significant price changes, i.e. unprocessed food and energy, in separate categories. The changes in the growth rate of prices in those categories are often linked with the so-called supply shocks, e.g. a global increase in oil prices or an increase in unprocessed food prices that is the effect of unusual weather conditions. Moreover, the prices of goods and services included in the energy category often undergo direct or indirect administrative control as price changes depend on changes in the excise duty rates or administrative decisions. Dividing the overall growth rate of food into processed and unprocessed food. The analysis confirmed that the price growth rates of those two groups behave in a different way. The prices of unprocessed food undergo the so-called supply shocks, while the prices of processed food are less vulnerable and depend mostly on the increasing or decreasing demand. Assigning net inflation a separate category, that is the approximation of the core inflation, in which price growth rate depends mostly on demand. The change in demand for goods and services included in the core group is certainly not the only factor shaping their prices. Factors connected with the cost of manufacturing or changes to the rates of indirect taxes are also important here.

Table.1. Decomposition of HICP growth rate in countries where inflation increased in the period between May and August 7. Input in inflation level Input in changes The end of the Average The beginning of percentag increase in the weights in Country Price category the increase in the e of HICP growth percentag the HICP growth rate inflation rate August e points period, % May 7 change 7 Total HICP. 9.3. 1 1 Net 3.3..7 1..3 Bulgaria Energy.. -.3 -.7 1.9 Czech Republic Estonia Lithuani a Latvia Romania Processed food 1.3 3..1. 19.1 Unprocessed food -.... 9.7 Total HICP... 1 1 Net 1.1. -.3-17.1. Energy.1.1. 1. 1. Processed food 1.1 1.. 1. 19. Unprocessed food..1 -.1 -. 7. Total HICP.9.1. 1 1 Net 3.7..3 1.. Energy...3 13.7 11. Processed food 1. 1.3.1 3. 19.1 Unprocessed food.7.3 -. -19.7 9.3 Total HICP... 1 1 Net 1. 1.. 3. 3. Energy.9.7 -.1 -. 13.3 Processed food 1.9.. 73.. Unprocessed food... 1.9 11. Total HICP 7. 1.. 1 1 Net 3.9.9 1... Energy..9. 9. 11. Processed food. 3. 1..9. Unprocessed food 1.1 1.3. 7.1 11.3 Total HICP 3.9. 1.1 1 1 Net 1.7 1.3 -. -3.9 3. Energy 1.3 1.1 -. -17.1 1. Processed food 1.7 1..1 1.3 7. Unprocessed food -.7. 1. 137. 1. Source: Own summary on the basis of Eurostat data. B. Out of NMS-9, insignificant inflation decreases were posted by Hungary, Poland and Slovakia in the period under analysis. In Hungary, inflation amounted to 7.1% in August 7 it was lower by 1.3 percentage points than in May. The analysis shows that the drop in the HICP growth rate was almost entirely due to the drop in the growth rate of energy prices (see: Table.). The decrease in energy prices was in turn related to the expiry of the so-called base effect. In August, the Hungarian government decided to make initial increases of regulated prices aimed at improving the situation in the public finance sector. In Poland, the yearly HICP growth rate amounted to.1% in August 7 and was lower by. percentage points than in May 7. The decrease in inflation was supplydriven and resulted from the decrease in the growth rate of unprocessed food and energy prices. It is difficult to explicitly establish the reasons behind the drop in inflation in Slovakia. The HICP growth rate amounted to 1.% in August and was lower by.3 percentage points than in May 7. The drop in inflation was influenced by the changes in price growth rates in all the analysed categories. Currently, inflation in Slovakia is the lowest in NMS-9. Surely, the situation in the Slovak labour