Beyond EMU

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					Beyond EMU

5 .................   Introduction

7..................   EMU: Lessons from the crisis

13................    Great Divergence in ‘New’ Europe during Great

21................    CEE public finances

25     ...........    Conclusions: Crisis pushes EMU in new daylight

27    ............    Country reports
                      28   .......   Hungary
                      32   .......   Poland
                      36   .......   Czech Republic
                      40   .......   Romania
                      44   .......   Bulgaria

51................    List of participants

The KBC group has a significant presence in the main countries of Central and Eastern Europe. The process of European
integration is having a catalytic effect on the economies of these countries. Not only economic, but also political devel-
opments in both the existing and candidate EU Member States are conspiring to set the pace for further integration.
To fully comprehend this process, analysts from KBC Bank, KBC Asset Management, KBC Ireland, ČSOB Czech Republic,
ČSOB Slovakia, Kredyt Bank Poland, Kredyt Bank Tfi Poland, K&H Hungary, and NLB Slovenia met to exchange ideas at
an annual conference that took place in Budapest this year.

Current events made the job of choosing this year’s key topic an easy one. The financial crisis and ‘the Great Recession’
revealed that many economies and financial markets were less robust than we thought. Tough questions on the appro-
priateness of monetary and fiscal policymaking in the past decade arose. It was also the first big stress test for the
Economic and Monetary Union, a project that is of crucial importance for the Central European countries destined to
adopt the euro. However, some important frailties of the EMU were revealed. The question, is therefore, whether or
not it is still a wise decision for Central European countries to aim for entry or at least to aim for fast entry?

The conference jump-started a detailed study, which has resulted in this report. In the first part of section one, we draw
a number of conclusions about the way the EMU functioned during the crisis. In the second part, the performance of
the Central European countries during the crisis is highlighted, with special attention given to the heterogenity of the
region and to the way policymakers reacted. In part three, the focus is on public finances. The Great Recession and
financial crisis have dealt a severe blow to public finances around the world. Within the EMU, the deterioration of
public finances in some countries has unleashed a wave of speculation on the markets that has rocked the EMU to its
foundations. How have the public finances of the Central European countries fared during the crisis? Part four contains
an overview of the areas discussed and our conclusions. The main question will be whether or not it is still appropriate
for Central European countries to aim for (fast) EMU entry.

In the second section, we present five country reports that paint a more detailed picture of the economic and political
developments in five Central European countries.

                                                                   Piet Lammens, Head of Market Research, KBC Bank
                                                        Greet Vander Roost, Senior Analyst KBC Group Chief Economist
                                                                                               Brussels, 27 April 2010.

EMU: Lessons from the crisis

“The financial crisis is demonstrating that in turbu-
lent financial waters it is better to be on a large
solid and steady ship than on a small vessel”
Jean Claude Trichet January 2009

There is little doubt that the recent cri-
sis has revealed that many economies
and financial systems right around the
world were far less ‘seaworthy’ than
we thought. This note assesses the per-
formance of the Eurozone through the
crisis in an attempt to assess how much
repair work needs to be done to the
‘good ship’ EMU. These results may
also provide pointers as to whether
European countries outside the sin-
gle currency area may find it more
or less attractive to continue to chart
their own economic course in the

How has the Eurozone fared?                                    Of course, stability matters for any number of economic
                                                               variables. It is usually suggested that participation in the
The scale and breadth of the recent financial crisis mean      single currency delivers significant stability benefits in rela-
that economies all around the globe have experienced a         tion to exchange rates and interest rates. It is self-evident
dramatic change in their fortunes of late. Inevitably, the     that exchange rate volatility against other participating
Eurozone suffered a significant weakening in activity and      economies has disappeared. However, the trade weighted
employment and severe problems in it’s financial markets.      value of the Euro became notably more volatile through
Perhaps, the Euro area’s founding fathers might have           the crisis. It may be that participation in EMU dampened
expected that membership of the single currency would          exchange rate fluctuations relative to the experience of
have provided a greater degree of shock absorption than        a freely floating currency but this might be regarded as
has been the case. However, the events of the past couple      a mixed blessing. Some countries with greater discretion
of years have emphasised forcefully the global essence of      over exchange rate policy might have sought to avoid the
economic activity and financial systems across the world       speed and scale of currency appreciation that the Euro
today. In these circumstances, there was little possibil-      experienced towards the end of 2008 and again in the
ity that ‘Fortress Europe’ could have markedly insulated       Autumn of 2009.
Eurozone members from the worldwide trauma of the
past couple of years. Instead, graph 1, which depicts the      The breadth and depth of Eurozone financial markets
trend in real GDP in the US, Japan and the Eurozone            would be expected to result in reduced volatility in inter-
through the past decade, emphasises the importance of          est rates. In addition, there is little doubt that the ECB
global factors in the business cycle.                          liquidity support assisted hugely in increasing the stability
                                                               of Eurozone money markets of late. But how do we assess
On this basis the trends in graph 1 might seem that the        the benefits to Eurozone countries? Euro area money mar-
Eurozone has navigated the crisis in a broadly similar         ket interest rates were far more stable (and lower) than
fashion and possibly slightly better than some other major     those in crisis countries such as Iceland but the evidence is
economies. Unfortunately, it remains too early to arrive       less clear-cut when comparisons are made with the money
at a definitive judgement. The trajectories of activity        market performance of a range of European Countries
shown in graph 1 might also be interpreted as pointing         outside the Eurozone or indeed, when account is taken of
to a sharper downturn and a correspondingly speedier           the sharp widening of Government bond spreads within
upswing outside of the Eurozone. The events of the past        the Eurozone. This is not to suggest that some significant
year or two argue that it is impossible to entirely insulate   widening wasn’t justified. Arguably a problem in EMU
an economy from global turbulence, but the real lessons        was that spreads had declined too far in the pre crisis
of the crisis will only be learned from the capacity of        period. However, spreads have been particularly unstable
various economies to respond and recover in a sustainable      of late, suggesting that EMU hasn’t delivered any signifi-
and reasonably speedy manner. It will be some significant      cant cushion of stability in this regard.
time before we can draw definitive conclusions in this
regard. However, we can look at a number of develop-           Was Eurozone policymaking better than
ments that suggest the period ahead will be challenging        elsewhere?
for the Eurozone.
                                                               Another important metric in the relative performance
What did EMU promise and what did it                           of the Eurozone through the crisis relates to the policy
deliver?                                                       response of the relevant authorities. The ECB acted swiftly
                                                               to inject additional liquidity into the financial system
The benefit most commonly associated with membership           when conditions deteriorated in 2007 but it resolutely
of the Eurozone is increased stability but stability can       refused to alter it’s monetary course until October 2008.
be measured in many ways. Opinion differs as to what           As Graph 2 illustrates, the ECB acted far later and some-
aspects of stability should be prized most highly. Clearly,    what more slowly than either the US Federal Reserve
for the European Central Bank, price stability is the over-    or the Bank of England. As noted previously, powerful
riding goal. Important as this may be, it is questionable      global forces meant that economic circumstances in the
how much significance should be attached to a narrow           Eurozone didn’t differ markedly from elsewhere. Judged
definition of price stability in current circumstances.        from this perspective, it may be that the ECB was relatively
Furthermore, there is little evidence that financial markets   slow to grasp the enormity of the problem facing the
took a markedly more benign view of the longer term            global economy. However, it must be emphasised that the
outlook for inflation in the Eurozone than elsewhere.          ECB succeeded in driving short term money market rates
So, the Eurozone doesn’t seem to have benefitted from          down to levels comparable with those in other zones.
a price stability-related dividend in relation to borrow-      Moreover, it should also be noted that the ECB succeeded
ing costs through the crisis period. This is because any       in communicating it’s message clearly to markets – a key
number of other influences on economic performance             task in such turbulent conditions. In this respect, it’s per-
have seemed much more important than price stability of        formance was notably better than in the pre-crisis period
late. As noted above, the experience of the Eurozone in        and, arguably, more consistent than signals coming from
terms of ‘real’ economic variables such as activity has not    some other central banks through the crisis.
been markedly more stable than elsewhere through the
period of the crisis.

                                                                          Graph 1 - Global influences more important
The crisis may highlight the comparably ‘narrow’ mandate                             than ‘Fortress Europe’
of the ECB, but the past year or two has also shown it                             (real GDP, Q1 2007 = 100)
to be a far more pragmatic institution than some of it’s
more severe critics might have envisaged. Unfortunately,
from a broader economic perspective, the absence of              100

a federal budgetary capacity in the Eurozone places a
particularly heavy burden on the ECB in terms of EMU             95
policymaking. A clear ‘fault line’ in Eurozone structures
has been the absence of mechanisms to mimic the capac-           90
ity of the Federal Government in Washington or National
Governments outside the Eurozone to implement decisive           85
and speedy policy actions across regions. In saying this,
two considerations must be borne in mind. First of all,          80                                             EMU
automatic stabilisers are much more important in many                                                           Japan
Eurozone countries than in the US. As a result the eco-
nomic downturn wasn’t notably worse in the single cur-            2001           03              05             07           09
rency area than it the ‘States. Second, it must be remem-
bered that the crisis has expressed frailties in economic
governance right around the world. So, it would be incor-
rect as well as unfair to suggest that problems that have
become evident in the Eurozone of late suggest the single                             Graph 2 - The ECB was slow
currency is uniquely flawed. That said, it does not seem                                     (policy rates)
unreasonable to suggest the infrastructure and instru-
ments available to policymakers in the Eurozone have                                                                  US
proven inadequate. The reality is that any union between          6                                                   UK
soverign states is fundamentally different to the relation-                                                           Sweden
ship between various regions in the one country. This is          5

because the distributions of pain and gain between coun-
tries matters hugely. While efforts were made to suggest a        4
coherent and co-ordinated European approach, the reality
is that significant responses in terms of budgetary policy
and support for the financial system were driven largely
by national considerations. Shortcomings in this respect
continue to cause major problems for the Eurozone as              1
current concerns in relation to Greece and a number of
other countries show.                                             0
                                                                   2005     06              07        08             09           10
Did EMU membership make things better or

The crisis has also cruelly exposed deep seated problems
in many Eurozone countries that hints at a structural flaw                       Graph 3 - Could EMU leave Greece?
in EMU. This centres on the extent to which membership
of the Eurozone allowed and possibly even encouraged
participating countries to become unduly complacent
about the domestic policy stance they adopted. Right              7
around the world it is clear that financial markets dramati-
cally underpriced risk prior to the crisis. In the case of the    6                                                                    -6
Eurozone, the disappearance of exchange rate volatility,
coupled with what were extremely low and relatively
stable borrowing costs saw increased capital flows into a         4
number of countries and a corresponding deterioration                              Greek government bond yield spread
in their current account positions. In this way, it could be                       (left-hand scale)                                   -10
argued that membership of EMU contributed materially                               Greek government balance
                                                                  2                (% of GDP, right-hand scale)
to the scale of budgetary and current account imbalances                                                                               -12
that has emerged in certain Eurozone countries. At very           1
least, it can be suggested that membership of EMU may
                                                                  0                                                                    -14
have encouraged and facilitated countries’ ability to run         1998    2000         02        04        06         08       10
policies that would have been less sustainable outside the
single currency area.

                                                                              Graph 4 - One story doesn’t fit all
This problem and the radical change in circumstances                          (real GDP, peak to current %-change)
since the crisis is clearly seen in graph 3 which shows a
dramatic drop in the Greek bond spread with Germany in            0

the early years of EMU and the insensitivity of this spread
to frequently troubling Greek budgetary developments
through most of the past decade. The profound change              -4
in the markets assessment of late is seen in the recent
blowout in bond spreads in spite of the announcement              -6
of extremely ambitious measures to reduce the Greek
deficit.                                                          -8

Current problems in terms of markedly weaker economic            -10
conditions and an uncertain and volatile outlook are pri-
marily concerns of the countries themselves but they also        -12

entail significant spill-over effects. It is worth noting that
neither the institutional framework of the Eurozone or

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the risk assessment of financial markets provided any early







warning of looming problems. Indeed, it was some time

into the crisis before financial markets began to focus on
potentially significant differences in the circumstances of      the Eurozone would bolster a country’s living standards.
various Eurozone countries. Instead, they initially bought       While economists might not regard this as inevitable,
into and propagated a ‘one story fits all’. With the nota-       there is broad agreement that ‘real’ convergence is hugely
ble exception of Ireland in late 2008 and early 2009,            important to the functioning of EMU. There have been
markets did not focus on significant divergences between         limits to the degree. The data in graph 5 suggests ‘real’
the experience and policy responses of various Eurozone          convergence (expressed in terms of GDP per capita) in
countries in the early stages of the crisis. It is only in the   recent years. More significantly, economic structures have
past six months that attention has been focussed on the          been slow to change. Unfortunately, the lack of greater
sustainability of (i) fiscal balances, (ii) competitive posi-    progress in the good years may mean a more dramatic
tions, and (iii) the credibility of exit strategies in various   reversal in the wake of the crisis. Large differences in
Eurozone countries.                                              the scale of adjustment now needed by various coun-
                                                                 tries in the wake of the crisis imply that there could be
Does one size fit all?                                           strong forces acting towards ‘real’ divergence for some
                                                                 time to come. Of course, most countries requiring major
As graph 4 indicates, there have been significant variations     adjustments would also face significant problems if they
in national economic performance across the Eurozone             were outside EMU. However, as noted, above it seems
since the onset of the crisis. Perhaps surprisingly, these       that participation in EMU did not strengthen and pos-
differences don’t reflect geographic proximity. So, for          sibly weakened the capacity to identify a need for and a
example, in terms of the drop in GDP, the experience of          capacity to take tough decisions. In addition, inside EMU
Portugal differs notably from that of it’s near neighbour.       countries are unable to use the exchange rate to assist in
Nor does size seem to matter in this regard. While the fall      the adjustment process. The fact that circumstances vary
in GDP is somewhat less than elsewhere in small countries        so widely between EMU countries implies internal strains
such as Malta, Cyprus, and Belgium, the particular weak-         are likely to persist within the Eurozone for some time.
ness of Ireland and Finland suggests small is not always         Mechanisms to deal with such problems have been found
beautiful. Clearly, these data suggest a range of diverse        wanting. This is very obvious from the extremely painful,
factors including the size of the construction and prop-         protracted and very public process to agree practical sup-
erty sectors, the importance of international trade as well      port for Greece. This speaks volumes as to how limited
as the nature and scale of the domestic policy response          the Economic element of Economic and Monetary Union
played key roles in the performance of national econo-           is. Belated if understandable concerns about ‘moral haz-
mies through the crisis. Broadly similar conclusions appear      ard’ imply the possibility of persistent strains within EMU
from a comparison of national employment trends. As in           in coming years. This also means much greater external
the case of activity, it could be that important institutional   intrusion in domestic economic policymaking here and
differences mean the pace of adjustment across countries         elsewhere in coming years.
varies considerably.
                                                                 What lies ahead?
Although one might expect significant regional differ-
ences in performance in any major economic zone, the             With hindsight, it is clear that domestic economic poli-
particularly sharp variation in GDP and job performance          cies in many countries within the Euro area were not
across Eurozone members since the crisis began raises            calibrated in a manner that provided an adequate cush-
important questions about the nature and extent of ‘real’        ion for the recent downturn. There is little question that
convergence in the Eurozone in the past ten years. This          political expediency and a degree of irrational exuber-
is important for a variety of reasons. In political circles,     ance combined in a manner that resulted in governments
there has been a strong assertion that membership of             running fiscal positions that the crisis has shown to be

                                                                  Graph 5 - Limited real convergence gives way to divergence
unsustainable. We have suggested that membership of                            (GDP per capita, % of EU-15 level)
EMU may have contributed in this regard. Development
of adequate signalling mechanisms will be a key focus in                               Belgium
coming years.                                                   130                    Ireland
More significantly, the policy prescriptions envisaged for      120                    Spain
several countries imply that the correction of problems in      110
the areas of the public finances and competitiveness will
result in a strongly deflationary impulse for a number of       100

Eurozone countries. Importantly, there is no mechanism in       90
EMU that would act in the opposite direction to cushion
the blow. This implies that national policies in adjusting      80

countries will act towards increased ‘real’ divergence.

If the early years of EMU highlighted the benefits of EMU       60
                                                                 1990     93      96        99    2002   05      08
membership in terms of greater stability, access to easier
financing and a relatively expansionary fiscal policy, com-
ing years may see a greater focus on the costs of member-
ship. The mechanism by which countries are encouraged
or forced to adjust remains to be decided. In particular, it    seems inevitable that external influences both in terms
appears there is little early prospect of material non-crisis   of EU institutions and market forces will be notably more
assistance being provided to those countries directly or        intrusive in domestic policymaking of Eurozone mem-
indirectly through more expansionary policies elsewhere         bers in the future. So, the ‘costs’ of membership may
in the Eurozone. A further concern is emerging evidence         become much clearer. The precise nature and extent of
that points towards likely significant differences in the       such changes and related questions about the degree of
speed and substance of national responses in ‘problem’          support that will be provided to countries in difficulties
countries. This suggests various countries may be set on        represents a fundamental change in the framework and
rather different paths towards stability in coming years.       functioning of the Eurozone. This may alter both its future
Likely divergences in performance and policy settings           path and its attractiveness to countries outside the single
would be more acceptable within a large regional econo-         currency area. In this and many other respects, the major
my than in a group of countries where national political        consequences of the crisis on the Euro area have yet to
considerations continue to assume critical importance.          be felt.

It is very clear that existing mechanisms to limit national
budgetary divergences and the procedures set out in             Author:
the Stability and Growth pact have proven entirely inad-        Austin Hughes, KBC Ireland
equate. While an alternative has yet to be formalised, it

Great Divergence in ‘New’ Europe during Great Recession

At first glance, looking at only past CDS premiums development among the new Eastern
European EU members, one might think that the region faced a huge common negative
external shock that had exerted heavy downward pressure on all respective markets
and economies in 2009. In this article we try to show that such a simple conclusion
is far from true. Although the ten new Eastern European EU members were really
facing a symmetrical negative external shock after the fall of Lehman Brothers,
the reaction of the individual economies to this shock proved to be actually
very asymmetrical.

This may have reflected, above all, the different macroeconomic funda-
mentals with which the individual countries of the region entered the
global financial crisis and the deepest post-war recession in Europe. It
was, in the end, the macroeconomic stability of individual countries
(for instance expressed as their ability to meet the Maastricht conver-
gence criteria) in combination with the rate of dependence on exter-
nal financing (the ratio of loans in foreign currencies) that decided
among other things, how fast each of the economies and relevant
markets recovered from the drastic external shock. Moreover, the ini-
tial macroeconomic conditions of the respective states were a decisive
factor in a country’s ability to withstand the financial shock without
requesting official help abroad (from the IMF or the EU). And last but
not least, it also influenced the choices of the individual countries to
combat the recession through their own economic policies.

In a panicky reaction after the fall of Lehman Brothers, the markets
did tend to put Eastern European countries together in one basket.
But already early in 2009, it became evident that it would be a great
mistake to put the Polish economy, which appeared to be the only
one in the EU to grow in 2009, next to Latvia, which had to request
IMF help and recapitalise a part of its domestic banking sector. Thus,
paradoxically, this nasty crisis has perhaps finally given markets a reason
to also carefully distinguish between the new EU members, as they already
do between the old EU members.

                                                                                  Graph 1 - Sovereign risk premium - 5year CDS
The not so surprising de-coupling of real                                                         (basis points)
output in Eastern Europe in 2009
Understandably, the above-mentioned divergent develop-                                                                            Latvia
                                                                        1200                                                      Bulgaria
ment of risk premiums among new EU member states had                                                                              Romania
to reflect underlying fundamental developments. In this                 1000                                                      Estonia
respect, probably the most representative and also highly                                                                         Hungary
                                                                                                                                  Czech Rep.
contrasting indicator during the crisis was GDP develop-                800                                                       Slovakia
ment. It again showed that rather than taking a homo-                                                                             Lithuania

geneous view of the entire region, differentiation among                600
the individual countries was definitely required.
The Polish economy was unique in this regard, as it was
the only EU member to have noted positive growth in
2009. In addition to the fact that Poland entered the crisis
with good macroeconomic fundamentals, two one-off fac-                   June-2008        Dec-08         June-09            Dec-09
tors contributed to this unique result, having encouraged
the domestic economy and domestic demand at the time
of the external shock. First, the Polish economy continued
to profit from the good performance of the construc-
tion industry, which profits from the increasing inflow of
money from Brussels and preparations for the Euro 2012                         Graph 2 - GDP development during Great Recession
football championships. The Polish economy has also been                                       (Q3 2008 = 100)
positively influenced by the relatively favourable demo-
graphic outlook, based on the baby boom of the early
1980s, which was further boosted, at the time of the crisis,
by a massive return of Poles working abroad. At any rate,
had it not been for those two unique factors, which by the              100
way, will continue over the coming two years, demand in
Poland would have been weaker and the economy would
probably not have escaped the crisis.                                    90
At the other pole of performance among the new Eastern                                                         Lithuania
European EU countries were the Baltic States, Romania,                   80                                    Poland
and Hungary. It is no accident that three of these coun-                                                       Estonia
tries ended up under IMF supervision, which – together                                                         Czech Rep.
with the EU – provided them with the required bridging
loans. In the case of those countries, two negative effects               2006             07             08                 09
were obviously at work, both well-known from previous
financial crises in other emerging markets. A sudden credit
crunch combined simultaneously with a collapse in foreign
trade. The consequence was a drop in the output of those
economies by tens of percent, quite similar to the 1994
financial crisis in Mexico and the 1997 crisis in Southeast
                                                                               Graph 3 - Industrial production as % of GDP in 2008

On the other hand, we must note here that the growth                    Luxembourg
in nominal GDP denominated in euros in the affected                            Latvia
Eastern European countries amounted to an average of                         Greece
15% per year from 1996 to 2008. That rate, even if we                           Malta
 Table 1 - Domestic and External Rescue Operations in 2008 and 2009         Belgium
                   banking bailout   IMF or EU loans   ECB swap lines        Estonia
  Bulgaria                                                                  Bulgaria
  Czech Rep.                                                                 Austria
  Estonia                                                                    Poland
  Lithuania                                                                 Hungary
  Latvia                  X                 X                              Slovenia
  Hungary                                   X                X             Romania
  Poland                                                     X           Czech Rep.
  Romania                                   X                                        0%    5%      10%   15%       20%      25%    30%   35%

                                                                        Graph 4 - Twin deficits and borrowing in foreign currencies
take into account a very optimistic scenario of real and
price convergence, is unsustainable in the long term.
Clearly, unit labour costs will have to drop or stagnate in                                               25

                                                                Budget & C/A de cit as % of GDP in 2008
the Baltic States, Hungary, and Romania in the coming
years in order for those countries to become competitive,                                                 20
which will necessarily put a stop to or lead to a factual
negation of the convergence process in the countries con-
                                                                                                                                              Lithuania                 Latvia
cerned.                                                                                                   15

Some conundrum might explain why economies that were                                                                                       Hungary
not hit by the financial contagion in any dramatic way,                                                                Poland
and which had quite healthy fundamentals, still experi-                                                               Slovakia                     Slovenia

enced a deep decline in real output in 2009. An explana-                                                  5        Czech Rep.
tion of why, for example, the Czech, Slovak, or Slovenian
economies fell so significantly is provided by the similar
performance of the German economy in the crisis. Due                                                           0      10         20        30       40     50      60        70   80
to the high share of the export-oriented industry that                                                                                FX credit as % of GDP in 2007
lost orders overnight, the German economy experienced
the deepest drop since the Second World War. Hence,
it is quite obvious that the very similar structure of the
Czech, Slovak, and Slovenian economies (where industry
accounts for over 25% of GDP too), amplified by the
strong connection to German companies (due to the high
influx of direct foreign investments in recent years) meant    Graph 5 - Real effective exchange rates around Lehman’s collapse
                                                                            (deflated by CPI, September 2008 = 100)
that these small open economies were not able to avoid
a significant drop in production (like the German export
champion).                                                                                                                                         Slovenia
In any event, the confirmed synchronisation of the busi-                                                                                           Romania
ness cycle of the above-mentioned economies with the
performance of Germany, as a key country in the euro-           100
zone, should, at least, satisfy policy-makers in Slovakia
or Slovenia, as those countries only recently became            95

EMU members. The high correlation of real output with           90
German economy’s performance during the crisis could
be regarded as an indication that the Slovakian and             85
Slovenian economies represent an almost optimal cur-                                                                                                 Hungary
                                                                80                                                                                   Czech Rep.
rency area with this core eurozone country. At the same                                                                                              Slovakia
time, for the Czech Republic that experience can serve as                                                                                            Lithuania
                                                                                                          2006                   07                08              09
a message that the Czech economy need not fear enter-
ing the eurozone, because if the ECB policy stays under
the supervision of German policy-makers, there should be
limited risk of an asymmetric shock.

Initial stance of Fundamentals Defined Room
for Domestic Accommodative Policies

As we already mentioned, differentiation among the indi-
vidual Eastern European countries in terms of macroeco-
nomic fundamentals defined quite diverse possibilities to
apply pro-active macroeconomic management.

In terms of fiscal demand management, practically only
those countries which did not have a closed or dramati-
cally impaired access to capital markets during the peak
of the crisis could take such an advantage. That practically
only concerned the Czech Republic, Slovakia, Slovenia,
and in part also Poland. Those countries could afford to let
automatic fiscal policy stabilisers work, which, on the one
hand, deepened the deficits of the countries concerned,
but on the other mitigated the economic decline. If we
do not count the introduction of the scrapping bonus in

Slovakia and Romania, then the only country that has to a         FX positions, together with the temporary need of the
limited extent attempted an accommodative fiscal policy           Hungarian and Polish central banks to obtain euro liquid-
during the crisis was the Czech Republic. It was, however,        ity through swap-lines with the ECB, pointed to the fact
a very weak attempt (amounting to 1.5% of GDP) which,             that a concept of the optimal currency area cannot be
furthermore, had to be corrected during the course of the         taken just on simple assessment of how economies (differ-
year with the promise of a restrictive package, as the issu-      ent currency areas) respond to external shocks. In our view,
ance of the new government debt became very difficult in          this financial crisis revealed that the concept of an optimal
the conditions of a rapidly deepening public deficit.             currency area is too simple and it should be enriched with
                                                                  a financial dimension that would take into account the
While the attempt at a fiscal expansion proved to be              interconnectivity of financial sectors or major multina-
problematic in the new Eastern European EU countries,             tional companies across the economies concerned.
choices of the monetary policy were not much better off.
Here, however, we must realise that Slovakia and Slovenia         Would the Euro Help in the Crisis?
were already members of the eurozone in 2009 and that
the Baltic States and Bulgaria operate in the currency            At the end of this chapter, we cannot avoid the question
board regime (with a fixed link to the euro), so there            as to whether it would have been more advantageous
was no independent monetary policy in the case of those           for Eastern European countries to have been members of
countries. The possibility of battling the crisis with their      the eurozone during the crisis. There is probably no ques-
own monetary policy was thus only available to the Czech          tion about this with respect to the countries operating
Republic, Poland, Hungary, and Romania. In reality, how-          in the currency board, as these countries actually already
ever, only the first two countries mentioned could afford         import the ECB policy; but their banking sector cannot
to support their economy and financial system with a loos-        make full use of it. The Hungarian and Romanian bank-
ened monetary policy and implied (real) exchange rate             ing sector would undoubtedly also welcome easy access
depreciation at the time of the peak of the crisis. The high      to euro liquidity through ECB’s repo operations. The same
ratio of foreign-currency loans (whether private or gov-          is more than true for the Baltic economies which, having
ernment) in Hungary and Romania led the local central             fixed their currencies, had both disadvantages i.e. a strong
banks to fear that a subsequent depreciation of their cur-        currency (implicitly the euro) and high domestic interest
rencies would yet deepen the problems of debtors, which           rates as the market priced in a collapse of respective cur-
is why they preferred defending their currencies with high        rency boards. On the other hand, in the case of the Czech
interest rates. Even in the Czech Republic and Poland, the        Republic and Poland, it is not easy to make a judgement
CNB and the NBP could not decide entirely freely, as they         as to whether a potential membership in the eurozone
suddenly faced a well-known fear of floating phenom-              would have made it easier for them to face the financial
enon. This is because an unexpected problem occurred,             crisis and global recession. Firstly, the Polish economy
in the form of export companies that were ‘over-hedged’           operating with its own currency did not fall into recession
in their FX positions. They suddenly found themselves             at all; and secondly, the Czech economy did not perform
in significant mark-to-market FX losses once the previ-           that badly in the end, at least partly thanks to the weaker
ously strong domestic currency depreciated unexpectedly.          koruna (such a conclusion is possible, especially compar-
These losses than complicated their relations with banking        ing Czech performance to the development of the neigh-
institutions and created the risk of a further freeze on          bouring Slovak economy which adopted the euro shortly
loans in the corporate sector. Thus, the Polish and Czech         before the crisis).
export companies could not (at least in the short term -
until their hedged contracts matured), take advantage of          We must, however, note with respect to the above con-
the weaker currency to increase their competitiveness in          clusions, that any considerations as to whether eurozone
export markets.                                                   membership, and hence ECB policy, would have been a big
                                                                  advantage to any EMU outsiders from Eastern Europe, are
In our view, this negative experience of Czech and Polish         made on the basis of the implicit assumption that the rat-
exporters with the consequences of wrongly hedged                 ing of the given country would be sufficiently high for the

 Table 2 - Key Sovereign Ratings

                                          Currently                                        As at the end of 2007
                               Moody’s      S&P                Fitch           Moody’s             S&P             Fitch
  Bulgaria                         Baa3     BBB                BBB-              Baa3              BBB+            BBB
  Czech Rep.                        A1        A                 A+                A1                 A               A
  Estonia                           A1       A-                 A+               Baa1                A               A
  Lithuania                        Baa1     BBB                BBB                A2                 A               A
  Latvia                           Baa1     BBB                BBB                A2                A-              A-
  Hungary                          Baa1     BBB-               BBB                A2               BBB+            BBB+
  Poland                            A2       A-                 A-                A2                A-              A-
  Romania                          Baa3     BB+                BB+               Baa3              BB+             BBB
  Slovakia                          A1       A+                 A+                A1                 A               A
  Slovenia                         n.a.      AA                 AA               n.a.               AA              AA
  ECB rating treshold                       BBB-                                                    A-

ECB to accept the government bonds of the country con-
cerned as collateral on its repo operations. That, however,
taking into account the current uncertainty surrounding
the Greek fiscal tragedy, could not be taken as granted
for the future. Recall that sovereign ratings of some
member states are just above the ECB rating threshold for
accepting country’s government bonds to its repo opera-
tions and this is really an unpleasant fact for the countries
from the Eastern Europe, which consider the eurozone as
a future safe harbour for their domestic banking sectors.
Actually, the setting of the (rating) parameters of the
ECB’s policy rules for the acceptance of government bonds
as collateral in its repo operations can become a limiting
factor for a number of future EMU candidates. Even to the
extent that it could in the future substantially slow down
the process of EMU enlargement, because potential can-
didates might have a problem to win sufficiently strong
sovereign ratings.

Jan Cermak, CSOB Prague


• The global financial crisis/recession showed that the ten new EU member states, which the markets have labelled
Eastern or ‘New’ Europe, are macro-economically very heterogeneous, which was manifest not only in the differing
speeds of revival in individual markets and economies, but also in the differing needs to draw foreign financial assist-
ance, and in the possibilities of the individual governments in the region to fight the recession with their own policy.
In these respects the Polish and the Czech economies, which faced low macroeconomic imbalances at the beginning of
the crisis and were responsible for their own monetary policy, had the biggest room to act independently.
• The course of the financial crisis also drew attention to certain new phenomena that emphasised the hitherto unex-
pected dependence of Eastern Europe on the eurozone. Global de-leveraging brought in a temporary shortage of euro
liquidity in individual countries, which the respective central banks had to address with the ECB. Moreover, the sudden
weakening of fundamentally sound Central-European currencies gave rise to an unexpected problem, with the mark-
to-market FX losses of exporters. Hence, in the first stage, they were not able to profit from the weaker currency. Both
of these problems show that the theory of an optimal currency area should be enriched with a new (financial) dimen-
sion that would also take into account the financial links between companies and banks across currency zones.
• A relaxed ECB policy would certainly have been of benefit for many Eastern European countries, had they been – like
Slovakia and Slovenia – members of the eurozone. But only on the condition that the rating of those countries would
have met the ECB rules for the acceptance of collateral for their repo operations. These rules set by the ECB could
become a factor influencing the attractiveness of EMU membership in the eyes of Eastern European candidates.

Box 1 - Slovakia, the newcomer in the EMU
Did it perform better or worse than its Central European peers?

Economic situation
The Slovak economy boomed during the pre-crisis period, with real growth of about 10% in 2007. The economic
growth decelerated in the early stages of the crisis in 2008, but GDP still increased by about 6% for the whole year.
The hard landing in 2009 was no big surprise, but the crimp in growth of -4.6% in real terms was nevertheless a reality
check. Ahead of EMU entry, the crown appreciated substantially and the EMU entry rate was fixed at historical record
levels. Was the strong exchange rate a major driver behind the dismal economic performance during the crisis?

The crisis hit all sectors of the economy negatively, but manufacturing, services (tourism and financial services) and
the retail sector were hit the hardest.
The financial sector was pressured by the loss of its natural business (local currency) and fees from the international
payments within the Eurozone, an effect of euro adoption. On the other hand, deposits grew rapidly ahead of the
conversion date of 1 January 2009 and created a big liquidity buffer that shielded the sector from the worst effects
of the financial crisis. So the negative development in the financial sector was at least for a large part not related to
a loss of competitiveness vis-à-vis those countries who kept their currency. Obviously, the crisis played a role too, as
lower economic activity hit the banking revenues.

Is the competitive devaluation an advantage?
The negative impact of the appreciation of the EUR/SKK exchange rate (ahead of EMU entry) on economic activity
during the crisis is difficult to demonstrate or to verify directly. According to some economic studies, the full impact
of the stronger EUR/SKK exchange rate would affect the economy with a 12 to 18 months time lag. In that case,
the full impact would have become evident only in the second half of 2009 or early 2010. However at that stage,
the domestic economy started to recover, pulled along by the improved external demand. Are there broadly similar
developments in the revival of Slovak industry and its regional counterparts that have stayed outside EMU or has
Slovakia performed worse than its peers?

Industry and exports negatively affected
Slovakia’s main trading partners are Germany and the Czech Republic. We think that the steep decline in external demand
had a far greater effect than the loss of competitiveness vis-à-vis Czech crown that depreciated against the euro.

Looking at the development of industrial production, it is clear that the negative impact of the global crisis was felt
uniformly throughout the region. The currency depreciation of the HUF, PLN or CZK of course create price advan-
tages abroad, but in such adverse environment it seems that this price advantage is difficult to exploit.

Impact on retail sales
Slovaks travelled abroad for weekend shopping as the weaker exchange rate of other CE4 countries improved their
purchasing power. The Slovak retail chains were thus additionally hit, as the crisis itself already lowered demand.
When we compare the year-on year decrease of retail sales in Slovakia, the Czech Republic and Hungary, Slovakia is
the clear “loser”, with the biggest fall during 2009. However, the shopping tourism prevailed for only several months
and the trend started to reverse in early 2010.

Impact on tourism
The other sector that felt the negative impact of the crisis and the depreciation of neighboring currencies was
tourism. The Slovak mountain resorts recorded significantly lower visits from Czech and Polish customers, due in
particular to the strength of the euro against the CZK or PLN. The balance of travel services moved from a surplus
of more then € 400 million in 2007 to approximately € 150 million in 2009. However, the sector is not so important
for the Slovak economy!

The initial macroeconomic conditions were probably better in Slovakia then in other countries, a result of the prepa-
ration for EMU entry that needed the implementation of sound macro and structural policies. The currencies of the
regional counterparts have still a competitive advantage, but are losing it fast as their currencies are becoming again
stronger against the euro. On the other hand, the Eurozone membership is continuing to be catalyst for FDI inflow.
So, we conclude that Slovak hasn’t done much worse than its neighbours.

Marek Gabris, CSOB Bratislava

Box 2 - The IMF programme in Hungary

Hungary faced a severe balance of payments crisis in late 2008. The country was running on unsustainable external
and public debt paths, a high tax burden and fiscal overspending were hurting competitiveness and activity was low.
A currency and duration mismatch between the liabilities and assets side of banks’ balance sheets posed a significant
threat to financial stability at a time of shrinking liquidity.

The 20 billion EUR loan originated by the IMF, the EU and the World Bank covered the liquidity needs of the country
to roll over its large-scale foreign currency and public debt. However, the 2009 March downturn meant that Hungary
would face a deeper recession than envisaged in the original programme, thereby weakening the credibility of the
budget deficit target.

The Prime Minister resigned and the ruling Socialists replaced him with Mr Bajnai, the former minister of the econ-
omy. Before the inauguration, Bajnai asked for the signature of deputies for a programme of deep and painful cuts
totalling 3% of GDP. The 13th month pension bonus in the public sector was cancelled, the public wage bill was also
frozen for two years, family subsidies were reduced and pension rules tightened.

The government also hiked the VAT rate from 20% to 25% and cut payroll taxes and social contributions in order to
boost employment. Their combined effect was neutral for the budget.

The programme seems to have succeeded as the country avoided a full-blown balance of payments crisis, while the
economy started to recover from mid-2009. The external balance improvement even surpassed projections as all
domestic sectors moved to a better savings/investment ratio, which allowed the country to turn an 8% of GDP cur-
rent account deficit into a surplus within a year. The external debt was consequently able to decline faster, which
could decrease the vulnerability of the economy.

Years of external indebtedness will now be followed by years of debt reduction. The central bank initiated stricter
rules for household borrowing via tighter loan-to-value ratios, especially for foreign currency loans. The new growth
model will move away from the use of foreign capital and will use domestic savings instead, which may help lower
the interest income outflow, although low interest rates abroad have kept this amount down. One risk is that the
banking system will heal itself at a slow pace and that risk aversion in lending will become a drag on growth. Some
new regulation for banks may also be introduced over the next few years, either by the new government or at a
EU-wide level.

Improving competitiveness was also a key feature of the programme and the real depreciation of the exchange rate
could also have played a role here as it gave a quick boost to exporters. At the time of the super-weak currency
in March 2009, people from neighbouring countries travelled to Hungary for regular shopping to take advantage
of the price differences. Although this may have been a temporary boost to exports, as most of these goods were
imported before, it helped the country to establish a
foreign trade surplus more quickly.                                           Saving positions
                                                                                  (% of GDP)
A key lesson of Hungary’s crisis was that fiscal prudence
is not enough alone: the country carried out a major           5                           Hungary total (C/A)
fiscal overhaul after 2006, but avoiding excessive private                                 Corporate
credit growth is also important, especially if additional                                  Government
risks are incurred, like foreign currency depreciation or
a duration mismatch in funding. Lack of savings cannot
be replaced by external financing for long and it is just a
matter of time before the tide turns and markets require
the repayment of these loans. The price countries pay
for these repayments can be too high if something unex-
pected happens.

Gyorgy Barcza, K&H Budapest
                                                                    2006     07           08              09

CEE public finances

The global recession and the financial crisis have dealt a severe blow to public finances around the world. The stalling
of economic activity undermined government revenue and a more flexible policy, combined with automatic stabilis-
ers, led to increased public spending. The result has been rising public deficits and
a surge in debt (see graph 1). The recent crisis made also clear that during the
pre-crisis period, which has already been referred to unjustly as the “great
moderation”, too little attention focused on a country’s debt situation.
For instance, the government and/or households in countries such as the
US and Greece ran up towering debts. Although the CEE economies
also came under pressure during the crisis, the debt situation in most
of these countries is remarkably favourable compared to most of
the EMU-countries.

Thanks to their sound economic fundamentals, the Czech
Republic, Slovakia and Poland were able to adopt a flexible
policy, as a result of which their public deficit deteriorated
from -0.7%, -1.9% and -1.9% of GDP respectively in 2007 to
–6% of GDP in 2009 (see graph 2). The Hungarian govern-
ment, which is bound by stringent IMF conditions, was not
able to adopt an accommodating policy and recorded a
relatively small public deficit (-4%) last year. These figures
form a stark contrast with the high deficits in countries like
Ireland (-12.2%) and Greece (-12.7%). The past few months
financial markets have expressed their concerns about
the sustainability of the Greek public finances and the
government CDS-spreads surged. The Greek government
announced extra budgetary cuts in an attempt to temper
the rumours about the unsustainability of the Greek debt
and the eurozone-countries and the IMF made clear that
they provide a safety net. Looking at the CDS-spreads in the
CEE (graph 3), it is clear that the markets acknowledge the
fact that the CEE-public finances are better positioned.

                                                                                                   Graph 1 - Major shift to right below
Governments need to go on a diet

The increased deficit will push up the level of public debt in                                       2007                                       2009
the Czech Republic, Slovakia and Poland by 10-12%-points
between 2007 and 2010, which is comparable to the                                             FN
                                                                                     4   DK
increase in debt in Germany and Austria. In Hungary the                                        SW

debt level would increase 18%-points of GDP. However,                                2        SP

                                                                 De cit (% of GDP)
                                                                                     0      NL     GE
the debt levels in Greece and Ireland will increase by 30                              Czech Rep.AU           BE
                                                                                                                         IT      FN
and 49%-points respectively. The divergent starting points                      -2          Poland
                                                                                   Slovakia UK    PT
                                                                                                  FR                                  DK               GE
of the debt level put debt in the Czech Republic, Poland                        -4                                 GR                                   Hungary
                                                                                                         Hungary                               AU
and Hungary at 40%, 57% and 84% of GDP respectively in                          -6                                                 Slovakia NL                    BE
2010 (see graph 4). In the EMU only Slovakia and Finland                        -8                                            Czech Rep. Poland
would be able to keep debt below 60% in 2010.                            -10
The efforts required in the Central European countries to                -14
                                                                                                                                           IR     UK
get their public finances back under control are consider-                 20              40       60      80 100 120 20        40         60         80     100 120
                                                                                                               Debt level (% of GDP)
ably less than in certain EMU countries. Based on cautious
projections for economic growth, inflation and interest
rates, budgetary measures worth 4.6%-points of GDP in
Poland, 3.4 in the Czech Republic and 0.5 in Hungary will be
required to stabilise debt by 2020. The measures required
in Greece and Ireland are about 10%-points of GDP. Thanks                                Graph 2 - Global crisis hit public finances hard
to a lower base, public debt in the CEE countries will then                                      (government balance, % of GDP)
stabilise at much lower levels than in most EMU countries.
In 2020, the debt level would remain below 60% in the
Czech Republic and reach some 70% in Poland and 80% in             6                                                                              2007
Hungary. In the EMU only Slovakia and Finland would keep           4
its debt below 80%. The situation in Greece and Ireland will       2
mean public debt levels of 164% and 114% respectively.             0

Ageing costs and potential growth disturb
long term outlook                                                -4


An important factor for the long term sustainability of the      -8
public finances is the cost of ageing. In the CEE-4 the share    -10
of elderly in the total population is growing faster than in     -12
the EU-15. This will impose an extra burden on public expen-
ditures if policies are not reformed. The projected change                                                            ly                                    nd UK ece
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is around 6% of GDP for the Czech Republic and Slovakia,

4% for Hungary and -1.1% for Poland (see graph 5). The
remarkable negative figure for Poland is mainly thanks to
the pension reform. Since 2000 public pension expenditures
have decreased substantially, whereas the trend in the
                                                                              Graph 3 - 5 year sovereign CDS spreads CEE versus PIGS
other countries is upwards. The Polish pension expenditures
are decreasing although neither the benefit level is excep-
tionally low nor the contribution level is exceptionally high.                                       CEE                                   PIGS
In fact the reform of the pension system brought about a         700                                                                                               450
                                                                                         Poland                               Spain
change towards contributions in individual accounts, allevi-                             Czech Rep.                           Portugal
                                                                                         Hungary                                                                   400
ating the Polish government from future liabilities.             600
                                                                                                                              Greece                               350
Additionally, the long term outlook for the Central European                                                                                                       300
debt dynamics is troubled by the outlook for potential           400                                                                                               250
growth in the region (see graph 6). In converging countries
potential growth is usually higher than in developed coun-       300                                                                                               200

tries due to the gains in labour productivity. In the CEE-4                                                                                                        150
potential growth amounts over 4% in 2010, almost double                                                                                                            100
of the EU-15 growth level. But as the countries are converg-     100
ing, labour productivity growth is declining towards the
same level as in the EU-15. However, the demographic out-        0                                                                                                     0
                                                                  2008                              09              10 2008            09                    10
look for the CEE-4 countries is remarkably more negative
than in the EU-15. Decreasing employment growth results

                                                                                          Graph 5 - Projected change in age-related expenditures 2010-
in a lower potential GDP growth in the CEE-4. By 2050 it                                                              2060
would decline below 1%, in contrast to 1.5% in the EU-15.                                                          (% of GDP)

60% debt level no issue for Czech Republic
With the possibility of membership of the EMU in the off-
ing, the Maastricht debt criterion is obviously significant.                                4
Based on conservative assumptions, the Czech Republic’s
debt will very likely remain below the 60% of GDP set in                                    2
the Treaty if the government reduces the deficit gradu-
ally. Based on similar assumptions, public debt in Poland                                   0
would increase to 70% and in Hungary to around 80%
(see graph 7). The Polish government will most probably                                            Pensions
                                                                                           -2      Health care
take the firmest action, because under the Polish constitu-                                        Long-term care
tion austerity measures kick in as soon as the level of debt                                       Unemployment bene ts and education
exceeds 60% by 2020. A recently published plan proposes                                         EU-15    Belgium    Poland   Czech Rep. Slovakia    Hungary
improving the primary deficit by 4.6%-points over three
years, which would keep the Polish debt level below 60%.
In Hungary, public debt had already risen above 60% in
2005, and the recent crisis pushed it over the 80% mark.
Based on conservative forecasts for growth, inflation and
interest rates, budgetary measures worth 3.9%-points of                                     Graph 6 - Potential growth in CEE is set to decline due to
GDP will be required to bring debt back to 60%. Again                                                         dempgraphic outlook
the three CEE countries are in a much better position than
most EMU countries. The Greek effort would amount to                                        5
                                                                                                                             Labour productivity growth
25%-points of GDP and in Belgium the required effort is                                                                      Employment growth
estimated to be 14%-points of GDP.                                                                                           Potential GDP-growth

There is not, however, an “ideal” debt level for all countries.
Because of the exchange-rate risk and short track record,                                   2
the level of debt acceptable to the markets is lower in the
CEE countries than in the EMU countries. This is also clearly                               1
reflected in the interest rate spreads with German rates.
Despite the Czech Republic’s sound budgetary situation,                                     0
the rate spread with Germany is similar to the Portuguese
rate spread. The Polish rate spread is even close to the                                   -1

Greek spread, which has risen dramatically, and Hungary’s
spread is even higher. There is, therefore, considerable                                          2010       2020        2030           2040        2050
scope for a narrowing of spreads in the long term.

Greet Vander Roost, Group Chief Economist Department,
KBC Brussels

 Graph 4 - UK and PIGS countries require substantially higher                             Graph 7 - Required effort to bring back debt level to 60% is
              efforts to stabilize debt by 2020                                              substantially higher for the EU-15 countries by 2020
                                                                                             (budgetary effort, change in primary balance in %-points)
  12                                                                                180    30
                    Budgetary effort (change in primary balance in %-points)
                    Debt level in 2020 (% of GDP)
     8                                                                              120
                                                                                    80     10

     4                                                                              60
     2                                                                                      0

     0                                                                              0      -5
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Conclusions: Crisis pushes EMU in a new daylight
The eurozone seems to have managed the crisis as good as some other major economic areas. But, as the world is still
licking its wounds and the recovery is in full development, it might be too early to assess the capacity of economies to
respond and recover in a sustainable and reasonably speedy manner. It may be too soon to draw definitive conclusions
but it is clear that the eurozone faces serious challenges.

The crisis revealed several imbalances within the EMU, namely diverging evolutions on labour markets and government
finances, imbalances on current accounts and major differences in competitiveness. During the ‘good’ pre-crisis years,
these imbalances have been growing beneath the surface. In fact, membership of the eurozone allowed and possibly
even encouraged participating countries to be unduly complacent about the domestic policies they adopted. First of all,
monetary policy in the EMU was not suitable for all member-countries, resulting in low real interest rates that lead to
a credit boom, overconsumption and an overheating economy. The fixed currency in combination with low borrowing
costs boosted capital flows resulting in a deterioration of the external position of some countries. Financial markets
paid little attention to government finances during the pre-crisis years. Low government bond yields, with little dis-
crimination between the EMU-members, discarded all incentives for governments to keep their finances healthy. As a
result, Greek government debt is currently on an unsustainable path and a rescue plan is waiting to kick in. Additionally
there are major differences within the eurozone concerning the level of real convergence and the evolution of com-
petitiveness. Germany proved to be the competitiveness-champion, whereas Ireland and Italy lost a lot of ground the
past ten years. The fixed exchange rate leaves no other option than to adjust internally which promises to be a long
term process.

Taking the above issues into consideration, there is no clear answer to the question ‘better in or out’, but there are
some recommendations and discussion points that need to be highlighted:
- Before entering the EMU, a high level of nominal and real convergence is necessary. Entering too soon is an ideal
  ground for growing imbalances and loss of competitiveness. During the converging-process the exchange rate is an
  important tool to prevent the economy from overheating.
- For some countries the prospect of EMU-entry could act as some sort of shock therapy to force important reforms.
  The remaining issue is whether the level of convergence after the shock therapy is high enough to avoid building up
  imbalances once the country would join the EMU. Additionally there is the problem of moral hazard; a country that
  was able to enter might be reluctant to continue with the necessary reforms.
- The Maastricht-criteria proved to be inadequate. Instead of a set of quantitative measures, there is a need for a broad
  assessment of economic and political maturity. First of all, focussing on a limited set of criteria could in fact bring
  other factors in distress, or could leave other imbalances out of scope. Secondly, the candidate-country should have
  reached a political maturity that is appropriate (e.g. absence of corruption).
- EMU-entry should not be regarded as a goal, but is actually the continuation of a journey. Even inside the EMU
  continued reform and flexibility is necessary to keep the economy in balance and to remain competitive. Instead of
  ‘entry-criteria’ there is a need for ‘inside-criteria’ that are imposed and controlled by an independent organism. In this
  regard it would also be useful to implement an EMU-statistical office that gathers and verifies the official statistics.
  This would ensure greater consistency between the data that is collected and could maybe prevent major revisions or
- The crisis revealed another flaw in the EMU, namely the lack of a political union. During the crisis the EMU did not
  succeed in organizing and coordinating decisive and speedy policy action across the region. The Economic element
  of the ‘Economic and Monetary Union’ is limited. Strong mechanisms or institutions to deal with internal strains are
  missing. This is at the moment demonstrated by the protracted and difficult process to agree practical support for

The past crisis puts EMU in a different light. The early years emphasised the benefits of membership, whereas coming
years will focus on the costs of membership. The fact that circumstances vary so widely within the eurozone, implies
that internal strains are likely to persist for some time.

Greet Vander Roost,
Piet Lammens
Austin Hughes
Jan Cermak
Gyorgy Barcza

Country reports


       Czech Republic



 • Economy recovering slowly from the crisis, modest
   growth in 2010 possible
 • External balance improves sharply and current account
   turns into surplus
 • New government may stick to supply-side economics
 • Tax cuts, bureaucracy, employment and efficient spend-
   ing could be priorities

 The Hungarian economy has been slowly emerging from its deepest crisis since 1990. The economy could already post
 limited growth in 2010, while external and public debt ratios could return to sustainable paths.
 The 2010 election brought strong support for a new centre-right government, whose most important challenge will
 be to carry out a pro-growth strategy and maintain the recently established balance. The IMF programme will run
 until October, so that new measures could be monitored by international institutions. This package will probably
 focus on corruption, bureaucracy, employment, more efficient public spending and a multi-year tax reduction pro-
 The banking system has also been healing itself by setting aside earnings for capital rebuilding and by reducing
 holdings of higher-risk-assets. The improvement of macro- and financial vulnerabilities will however be slow, so the
 country will remain vulnerable for many years to come. The new growth model will probably build on domestic sav-
 ings instead of external financing, which could accelerate this process as well.
 Better competitiveness and strong growth could be the only way out of indebtedness, and a stable political back-
 ground could allow politicians to focus more on this over the next four years.

Macro developments and economic outlook                      Future growth could also be influenced by the new govern-
                                                             ment’s fiscal policies, which may include a large-scale tax
Economy recovering from deep recession                       cut from 2011. On the other hand, domestic demand has
                                                             remained depressed and has not yet shown any sign of
Hungary was hit hard by the Great Recession and the          pick-up, which could pose a threat to the recovery process.
economy contracted 6.3% in 2009. Heavily indebted pri-
vate and public sectors together with low competitiveness                          Graph 1 - GDP growth
due to the high tax burden left the economy vulnerable                               (y/y change in %)
to the financial crisis.                                      6

The minority government – with the assistance of the          4
IMF – decided on a deep and painful austerity package
in spring 2009, which helped the economy to improve its       2
external and fiscal balance in the midst of the recession.
However, while this package put an additional drag on         0
domestic demand last year, the export sector began to
recover from mid-2009 and the economy slowly turned
This year’s outlook is for a small, 0.5% expansion, which    -6
could be followed by a more visible acceleration to
around 3% in 2011.                                           -8
                                                               2006     07         08       09       10    11

Longer-term prospects could hinge on the new govern-            to around 4.7% of GDP, so a higher deficit figure could
ment’s policies to boost competitiveness, which is a weak       disappoint the markets. The IMF and the EU will also
point stemming from bureaucracy, inefficient government         have a say on the issue as the IMF programme ends later
spending financed by high taxes.                                in October, while the current convergence programme
                                                                promises a sub-3% deficit for 2011. The IMF will also pub-
Hungary’s economy has been in a vicious circle of high          lish two more reviews on Hungary, the next one probably
taxes, low activity and widespread tax evasion for decades.     in May, and these could limit a possible increase of the
The new government’s key challenge will be to reverse it        deficit target unless the IMF agrees to such a change, for
and build sustainable public finances. Over-spending has        example in exchange for structural changes.
been the root cause behind the troubled tax system as the
high level of expenditures – consolidated expenditures          Early comments suggest that the new government may
around 50% of GDP – required the use of all possible kinds      stick to supply-side economics and may try to improve
of taxation to generate sufficient revenues.                    competitiveness via more efficient public spending and
                                                                a multi-year tax cutting programme. Fighting corruption
The examples of the fiscal overhaul in Slovakia and Poland      and bureaucracy could also be key issues as recent scan-
are promising. Both countries lowered expenditures and          dals have focused public attention on these areas.
taxation and saw an acceleration of growth afterwards.
                                                                Markets recovering strongly
Hungary has room for such turnaround as its expenditure
and revenue ratios to GDP are 10%-points higher than its        Markets received the 2009 austerity package well and the
regional peers. The new government will likely conclude         return to a sustainable external balance and sustainable
a new program with the IMF that will most likely limit the      fiscal deficits – together with the improving global back-
growth of spending in real terms. Fidesz leader Mr Orban        drop – was followed by a sharp bond rally over the last
said that corporate tax burden could be reduced to the          12 months.
regional level in a 4-years time span, while it may take
6-years for labour taxes.                                       The large foreign trade surplus allowed the currency to
                                                                stabilise around the 265-275/€ level. The currency’s fair
Politics and the budget deficit cycle                           value based on the price-income convergence path was
                                                                estimated between 250.00 and 260.00/€, but the high for-
Fidesz was able to secure a two-thirds majority, which          eign currency debt led to a depreciation during the crisis.
allows them to reform the municipal sector and amend            The current recovery phase thus allows the currency to get
the constitution.                                               closer to its equilibrium level.

The ruling Socialists came in second with close to 20% of       The next phase could be the return of inflationary pres-
the vote, while their far-right wing Jobbik was third with
                                                                                   Graph 2 - Budget deficit
17%. The fourth party to cross the 5% threshold for entry
                                                                                         (% of GDP)
into Parliament was the liberal LMP. Politics will however
play a key role until the local elections due in October.         0

                                                                  -1                                               Forecast
Hungary has a doubtful track record concerning fiscal def-
icits in election years. Parties used to spend 3-4% of GDP
before or after the elections in order to boost popularity,       -3
not just for the spring Parliamentary elections, but also for     -4
the municipality elections in the autumn.

The outgoing government emphasises that the 2010                  -6
budget deficit target of 3.8% of GDP could be maintained          -7
with prudence. On the other hand, the new ruling party
Fidesz says that the budget contains a number of risks and
that the deficit could be between 4.5% and 6.5% of GDP.           -9
                                                                                    Election years
                                                                            1994        98           2002     06         10
The consensus among economists sees a smaller slippage

sures in the second half of the year, when employment is      even though the latter fell by nearly 20%. Manufacturing
expected to rise again, which may put an end to the weak      – especially machinery – saw the biggest decline, so it
purchasing power of households. Inflation rose to over        was no surprise that this sector rebounded the most after
6% after the government raised VAT from 20% to 25% in         3Q09.
July 2009, but net core inflation remained low at around
2%. On this basis, the central bank started a gradual eas-    On top of this, the banking sector also needs to improve
ing of monetary policy in the summer of 2009, when the        its balance sheet. The heavy borrowing by households in
base rate was 9.5%. Rate cuts have lowered it to a new        euros and Swiss francs in previous years made it difficult
record low of 5.5% by March and money markets are             for the banks to fill the gap between forint-denominated
looking for additional cuts to below the 5.0% level.          liabilities and foreign currency denominated assets. Their
                                                              capital adequacy position was then weakened by the
Structural developments                                       sharp increase in non-performing loan ratios. The sector
                                                              responded by rebuilding a more than enough capital
Sustainable external and public debt paths                    adequacy ratio of 13% by end-2009 as banks set aside
                                                              earnings and reduced risk-weighted assets.
Hungary’s main challenge during the crisis was to establish
sustainable external and public debt paths. The IMF pro-      The central bank began stimulating lending by purchasing
gramme aimed at reversing the trend of the external debt      mortgage-backed securities, while the state development
path as early as 2010 and establishing a declining public     bank offered guarantees and refinancing for SMEs. Credit
debt path a year later in 2011. So far, this seems likely,    demand nevertheless remained low, which could slow the
although this year’s budget deficit revision poses a risk.    recovery process, and the new government has promised
                                                              to introduce additional measures to help the recovery.
Of course, the key elements behind these goals are the
maintenance of a gradual decrease in the budget deficit
over the coming years and balanced household and corpo-
rate savings/investment ratios.

Domestic demand fell at a double digit rate last year due
to higher unemployment, lower real wages and higher
savings. This helped imports to fall more than exports,

                 Graph 3 - Saving positions                                Graph 4 - Public debt and external debt
                        (% of GDP)                                                       (% of GDP)

  5                                                           160
                                Hungary total (C/A)
                                Government                    140


                                                                                                    Public debt
                                                                                                    External debt

 -10                                                           0
       2006      07           08               09              1995   97       99    2001    03    05       07      09   11

European integration and the EMU                              Overall, the 2010-2014 government term could establish a
                                                              more sustainable growth path for Hungary and this could
Maastricht criteria achievable in the medium term             bring euro adoption closer. However, vulnerabilities stem-
                                                              ming from indebtedness will disappear only over a very
Talks about ERM II entry and euro adoption became less of     long period of 10-20 years, while recent tensions may also
an issue after the Greek crisis as many fear that Hungary     raise some concerns about the pros and cons of the com-
could witness something similar if it joins the common cur-   mon currency.
rency too early. The association of entrepreneurs suggest-
ed that Hungary should wait till real income converges to
at least 80% of the eurozone average.                         Gyorgy Barcza, K&H Budapest

The new government has not yet indicated what the
new deficit path could be. The current convergence pro-
gramme targets a deficit of 2.9% of GDP for 2011, while
the pessimistic end of the latest indications from Fidesz
(6.5% of GDP) and a gradual 1pp yearly reduction would
point to a sub-3% deficit level in 2014, implying the adop-
tion of euro in 2016.

Inflation is currently standing at 5.9% Y/Y (2010 March)
and is expected to get close to 3% by the year-end, when
the effect of last year’s VAT hike will drop out of the
index. The 2009 budget deficit was 4.0% of GDP, higher
than the 3% criterion level, but one of the better results
in the EU27. Public debt rose to 80% of GDP in 2009,
higher than the 60% level, but a declining path may also
be enough to fulfil the requirements, which would come
about automatically if the deficit is maintained at a low
level and the economy accelerates to 2-3% GDP growth.

Key data
                                        2004       2005       2006      2007       2008      2009      2010F      2011F
 Real GDP growth (%)                      4.9       4.2        3.9        1.5       0.5       -6.,4      0.5        3.5
 Inflation (annual, %)                    6.8       3.6        3.9        8.0       6.1        6.1       4.5        3.5
 Budget balance*                         -6.3       -4.5      -8.7       -5.8       -3.4      -4.0       -5.5      -4.5
 Public debt*                            59.0      62.0       66.0       66.0      73.0       78.0      79.0       77.0
 Current account*                        -8.8       -7.3      -5.8       -5.4       -6.0       0.5       1.0       -0.5
 FDI inflow*                              3.5       4.9        2.0        1.0       2.4        1.0       1.5        1.5
Source: NBH, CSO, K&H
* % of GDP

 • Strong domestic demand and resilient construction navi-
   gated the Polish economy through the crisis
 • Poland faces slowing domestic demand and high struc-
   tural deficits
 • No rate increases before Q4 2010
 • Euro adoption likely to be postponed beyond 2015

 Poland withstood the financial crisis reasonably well. Thanks to solid domestic demand, fiscal stimulus and a good per-
 formance by the construction industry, the economy displayed the greatest resilience of any EU country. Nevertheless
 it faces two challenges. At the beginning of 2010 domestic consumption should slow due to higher unemployment.
 Secondly and more importantly, Poland needs to start combating the high structural deficit. This may be particularly
 difficult in the light of the 2011 elections and the 2012 European football championship.

Macro developments and economic outlook                          ries, which did not come to a halt until late 2009. Foreign
                                                                 trade, thanks to the high import dependency of exports,
Irrespective of the rapid deceleration of growth in 2009,        did not affect GDP to any great extent. On the supply side,
Poland has been feeling the real impact of the crisis on its     export-oriented industry, logically enough, performed the
economy to a lesser extent than most of Europe, and it is        worst. Nevertheless, construction fared surprisingly well
the only economy of the EU to have shown positive growth         despite its cyclical nature – its sales rose by almost 5% in
in 2009. Thus the convergence story (Poland’s catching up
with the developed countries) even accelerated.
                                                                                     Graph 1 - GDP growth
                                                                                       (y/y change, in %)
Private consumption in particular worked as a stabiliser,
as its weight in overall GDP is greater (65% of GDP) than         30
in the other Central European countries. Consumption              25
was reasonable (+3% y/y), owing to the fairly slow rise in
unemployment, which also stems from the fact the Polish
economy is less open, with a greater proportion of agricul-       15
ture and a lower proportion of cyclical industry in relation      10
to GDP. In addition, Poland benefited from its positive
demographic trends, which contributed to the increase in
the number of persons in employment, despite the rise in           0

unemployment. Poland also benefited from the reason-              -5
able level of fiscal expansion (see fiscal trends), which also    -10        GDP
had a greater multiplier effect, due to Poland’s less open                   Household consumption
economy.                                                                     Investement
                                                                    2004     05       06        07     08       09
The deceleration of the GDP growth rate was primarily due
to the fall in investment and the elimination of invento-

real terms in 2009. This is probably a result of the rising    Structural developments
inflow of funds from Brussels and the start of preparations
for the 2012 European Football Championship.                   The Polish labour market developed surprisingly well
                                                               in 2009. More people were employed in Poland at the
Solid fundamentals with clear fiscal risks                     end of 2009 than before the crisis (in early 2008). The
                                                               primary reason is the favourable demographic trend,
The Polish economy should also perform well in 2010,           which explains how the rise in unemployment and the
and we believe that its growth rate may accelerate to          increase in the overall number of people in employment
2.8%. However, the growth structure is likely to change.       can co-exist in this country. Poland, unlike most European
The persistent deterioration of labour market conditions       countries, experienced a baby boom in the 1980s, and this
should curb private consumption in the first half of the       is now a new source for the labour force.
year. This will be counterbalanced by the continuing fiscal
expansion and particularly by the recovering exports and       Construction has counterbalanced industry
inventory rebuilding. In addition, after the winter break,
Poland should continue to benefit from the good per-           Remarkably, people from this group of the population
formance of its construction sector with the preparations      have succeeded in finding jobs during the crisis, and thus
for the 2012 European Football Championship going into         unemployment rose no more than slightly. The main rea-
higher gear. The Polish economy may also benefit from          son has been the good performance of the construction
the favourable demographic outlook, driven by the baby         sector, where almost 200,000 people have found jobs since
boom of the early 1980s and boosted by the return home         the beginning of the crisis. This was enough to counterbal-
during the crisis of many Poles employed abroad.               ance the layoffs, to which industrial exporters in particular
                                                               had to resort. We believe that the success of construction
First hike no earlier than Q4 2010                             is based on the preparatory work associated with Poland’s
                                                               hosting the 2012 European Football Championship. In
Relatively fast GDP growth should eventually oblige            addition, the preparatory work has been supported by the
the the National Bank of Poland to raise interest rates.       adequate inflow of funds from Brussels.
Nonetheless, the central bank need not do so soon.
Inflation risks should be curbed by the reasonably strength-   However, our outlook for the first half of the year remains
ening Polish zloty – supported by strong fundamentals          cautious. A greater percentage of the population is now
and attractive carry. In addition, domestic inflationary       employed in construction. This can make the labour mar-
pressures should be weak in 2010 due to reduced house-         ket more cyclical, with a greater effect of seasonal layoffs.
hold consumption. We do not therefore expect the first         Furthermore, this will be augmented by the unusually
monetary tightening until late 2010.
                                                                            Graph 2 - Total number of employed
                                                                                      (Q1 2008 = 100)






                                                                     2008                          09

tough winter. While significant declines in the number           gence programme, due to the lack of specific austerity
of jobs may be temporary, they should curb the strong            steps planned for 2011 and 2012 and an over-optimistic
domestic demand. The first poor data of early 2010 from          growth forecast. Even if the constitutional safeguard were
the retail sector and the rise in unemployment to 13%            to be activated over the course of time (i.e. automatic
provide evidence of this.                                        expenditure cuts when the debt exceeds 55% of GDP),
                                                                 there would still be a risk of failure or legislative changes
Fiscal trends and accession to the EMU                           should the government fail to handle the economy
Poland’s main weakness relates to public finances.
Notwithstanding the relatively moderate impact of the            Furtheremore the recent tragedy of the Polish air crash,
crisis on the Polish economy (1.8% growth), the 2009 defi-       in which several top officials including President Lech
cit was close to 7% of GDP. If nothing changes, the country      Kaczynski and Central Bank governor Slawomir Skrzypek
is also set to post similarly poor figures this year and next.   died, may shift the attention away from the resolution of
The level of the structural deficit is a whopping 6% of          fiscal problems. We are therefore afraid that adoption of
GDP, and without proceeding to the necessary reforms,            the euro by Poland could be postponed to a later date.
Poland will hardly push its deficit to within the bounds
required by the EU for the adoption of the euro.
                                                                 Honza Bures, CSOB Prague
Political will to face structural deficits appears

Although the current government, unlike the previous
conservative one, positions itself as clearly EU-friendly,
Prime Minister Donald Tusk himself sees no chance for the
country to adopt the euro before 2015. Even this would
require a reduction of the government deficit to less than
3% by 2013 – in itself a challenging task. An election will
be held in Poland in 2011, while a year later the country
hosts the European Football Championship. In addition,
Brussels castigated the latest version of Poland’s conver-

              Graph 3 - GDP and deficit in 2009                                       Graph 4 - Inflation
                           (in %)                                                           (in %)

 3                                                                6
                                  Change in real GDP
 2                                Government de cit                                                          CPI
                                                                                                             Core CPI
 1                                                                5

 -6                                                               1
 -8                                                               0
         Poland              EU              Eurozone             2008                     09                       10

Key data
                                                                    2004              2005              2006    2007   2008   2009   2010F   2011F
  Real GDP growth (%)                                                 5.3               3.6               6.2    6.7    4.8    1.8     2.8     3.6
  Inflation (annual, %)                                               3.5               2.1               1.0    2.5    4.2    3.8     2.5     2.6
  Budget balance*                                                    -4.5              -4.1              -3.6   -1.9   -3.6   -6.9    -7.3    -7.0
  Public debt*                                                       45.7              47.1              47.7   45.0   47.2   51.7    57.0    62.0
  Current account*                                                   -4.0              -1.2              -3.0   -5.2   -5.1   -1.9    -2.5    -3.0

Source: Kredyt Bank, Polish Central Statistical Office, Polish Ministry of Finance, National Bank of Poland.
* % of GDP

Czech Republic
 • Recession has ended, but economy will need several
   years to recover fully
 • Unemployment trend still negative, inflation subdued
 • Budgetary position weakened, external trade posts
   record surplus
 • No euro adoption until 2016

 After a deep decline, primarily stemming from subdued foreign demand, the Czech economy is returning to moder-
 ate and uncertain growth. Both production and exports are starting to show surpluses, while foreign trade is post-
 ing a new record-breaking surplus every month. In view of weak domestic demand, inflation remains very low, well
 below the central bank’s target. Interest rates and yields also remain low, but are not preventing the koruna from
 resuming its appreciation. The budget management has worsened because of the recession, with the deficit having
 approached 6% of GDP last year. We need to wait for May’s parliamentary election to see how the Czech Republic
 will tackle its budget deficits. Nevertheless, given the outlook for public finances, the adoption of the euro does not
 appear realistic before the end of 2015.

Macro developments and economic outlook                      encourage Western European economies, notably the
                                                             scrapping bonuses. After growing by more than 20% last
Economy will need several years to recover from              year, the German new car market will be in for a decel-
downturn                                                     eration, which will also affect Czech manufacturers. The
                                                             main factor likely to determine this year’s direction of the
The Czech economy fell by 4.2% last year, much more          economy will be foreign demand, as we cannot expect
than during the previous recession of the late 1990s. The
rate at which the economy declined in late 2008 and early                         Graph 1 - GDP growth
2009 was exceptional. The economic downturn made                                         (in %)
itself felt as long ago as late 2008, when industrial new
orders started to disappear rapidly; nonetheless, it was      10
at the beginning of last year that the economy dropped                                                   y/y change
dramatically, with GDP falling by 4.1% q/q. Thus industry,                                               q/q change
after the years of driving economic growth, became the         6
main curb on the economy. The economy started to sta-
bilise slowly in the subsequent quarters of last year. The     4

introduction of what is known as the bonus for scrapping       2
cars in Germany, which greatly improved demand for cars
made in the CR, encouraged the economy significantly.          0

The latest figures clearly confirm that the recession in
the CR has already ended, and has been followed by a           -4
period of a modest upswing. Favourable data are coming
from the export-oriented industry in particular. However,      -6
                                                                2006         07           08             09
the picture of the returned upswing is qualified by the
risks that could stem from the expiration of schemes to

any positive stimuli from domestic demand. Household             heading towards the 10% mark. Although we believe
consumption will probably continue to be muted, due to           that for seasonal reasons the unemployment rate may
wage stagnation, combined with the rise in unemploy-             temporarily dip below 9.5%, unfortunately no change in
ment. Cuts in public budgets will lead to a reduction of         the trend has been evident thus far. This year’s economic
government consumption, and we do not expect invest-             growth will not be strong enough to generate a sufficient
ment to rise either. Unused capacity and poor prospects          number of new jobs and thus ensure a permanent decline
for foreign demand are strongly curbing private invest-          in unemployment. The recession not only made itself felt
ment. Only the public sector, supported by EU Funds, will        in the increased unemployment rate but also influenced
therefore be able to maintain its huge investments, which        wage developments. Although average wages rose by 4%
will primarily go into infrastructure. Thus GDP may grow         in real terms last year, this was no more than an apparent
by approximately 1.5% this year, while we anticipate that        increase, driven by the lay-offs of low-income staff. This
it will be largely fuelled by the generation of inventories,     is reflected by the decline in the median wage, which
which dropped significantly last year. In spite of this rela-    accordingly provides a truer picture of the labour market.
tively favourable outlook, a W-shaped recovery, as also          We also anticipate similar developments this year, when
envisaged by the Czech National Bank (CNB), remains a            the average wage is likely to fall even in real terms.
realistic scenario.
                                                                 Weak demand curbs inflation
Trade balance shows record-breaking surplus
                                                                 The recession has significantly curbed inflationary pres-
The CR’s foreign trade posted a record-breaking surplus          sures in the Czech economy. Thus year-on-year inflation
of almost CZK 152 bn (EUR 5.7 bn) last year. While the           has been below the CNB’s target since the beginning of
drop in exports (-13.8%) was enormous, it was more than          last year. Not even this year, for which the inflation target
counterbalanced by the decline in overall imports by the         has been reduced to 2%, will the central bank have any
CR of over 17%. The fall in imports was fuelled not only         obvious problem in hitting its target. Inflation is currently
by cheaper raw materials and poor domestic demand,               just 0.6% y/y and remains not only below the target but
but also by the reduction in export activities by domestic       also below the CNB’s latest forecast. While inflation is
firms, which use imported raw materials and components           likely to climb to slightly above the central bank’s target
in their production. In addition, the introduction of the        in the second half of the year, this will be primarily due
scrapping bonus in some European countries significantly         to the low comparative baseline and to administrative
curbed the fall in exports in the second half of the year.       measures, i.e. the VAT and excise duty increases carried
However, the improvement in the trade balance is likely          out this year. Fuel prices, which shadow oil and petrol
to come to a halt this year: firstly, domestic demand will       price developments in global markets, continue to pose a
no longer fall as rapidly as last year; and secondly we          risk to inflation. On the other hand, weak demand, along
should anticipate an increase in raw material prices. We
                                                                                 Graph 2 - Inflation and CNB’s target
are therefore expecting a moderate reduction of the                                             (in %)
trade surplus by approximately CZK 20 bn. The impact on
the current account will be negligible, as this year’s deficit    8
may rise to approximately 1.3% of GDP, from last year’s                                                             Outlook
1.0%. This deficit will continue to be easily covered by the      6
inflow of foreign capital.
Structural developments                                               CNB's target

Drop in contracts involves quick lay-offs
The unusually fast decline in the contracts of indus-
trial and construction firms led businesses to reduce the                    CNB's repo rate
                                                                 -2          In ation
number of agency workers rapidly as well as to cut their                     In ation forecast
core workforce. Thus the unemployment rate went up                           Net in ation
from 6% to 9.2% last year alone (Dec. 2009 vs. Dec. 2008),       -4
                                                                   2007              08          09            10
consequently hitting a five-year high. And the beginning
of this year saw no change either, with unemployment

with the strengthening koruna, should counteract the rise         European integration and the EMU
in inflation.
                                                                  Economic slowdown has worsened the govern-
Czech Koruna: strengthening again after a sharp                   ment’s budgetary position
                                                                  The economic slump has also negatively influenced the
After the rapid depreciation that accompanied the inten-          Czech government’s budgets. After three years of encour-
sification of the global financial crisis and the growth of       aging results, the fiscal deficit once again topped 3%
risk aversion, the Czech koruna relatively quickly recov-         of GDP, surging to 5.9% in 2009, more than double the
ered and started regaining its former strength. At the            deficit registered in 2008. The budgets were affected by
beginning of April this year, the Czech currency again            a decrease in corporate taxes, insurance contributions,
moved closer to the threshold of 25 CZK/EUR and we                and VAT, and also by an increase in social expenditure.
expect the koruna to break through this level this year.          Consequently, the CR has far exceeded the limit set by the
Working to the benefit of the koruna will be very favour-         Maastricht Treaty or the SGP; on the other hand, however,
able developments in the current account of the balance           and despite the high deficit, the general public debt of
of payments and an increase in the inflow of foreign capi-        the country remains well below the Maastricht limit.
tal. Furthermore, the CR has been successful in obtaining
EU funds and, in addition, the country is becoming an             The CR will therefore have to start dealing with the
active issuer of government Eurobonds. Therefore, it is           structural deficit of the state budget over the next two
hard to find arguments against the koruna, the only pos-          years: a problem which, until last year, was comfortably
sible exception being the unpredictable aversion to risk,         offset – and perhaps slightly masked – by strong eco-
although this should gradually decline as the economy             nomic growth. Thus budgetary reform will once again be
improves. We therefore expect the koruna to continue to           on the agenda and will probably have to focus on both
appreciate and that the pace of this appreciation will be         sides of the state budget, i.e. not only expenditure but
even more rapid than the central bank’s latest forecast.          also revenue. Nevertheless, we will have to wait until
                                                                  the parliamentary election at the end of May before we
                                                                  know in which direction the reform efforts are heading. In
                                                                  any case, it is clear that the election will not result in any
                                                                  changes to this year’s budgetary outlook. Therefore, the
                                                                  current strategy of government debt financing will con-

             Graph 3 - General government deficit                                                    Graph 4 - Convergence
                          (% of GDP)

 0                                                                                       90

 -1                            -0.7
 -2                                                                                      75
                                                                  Price level (EU=100)

                       -2.6                                                              70
 -3                                   -2.7
 -4                                                                                      60

                                                                                         55                                    2004
                  De cit                                                                 50
                  Maastricht                        -5.5
 -6                                          -5.9                                        45
 -7                                                                                      40
      2004   05        06      07     08     09     10F    11F                             40   50       60            70         80           90
                                                                                                     GDP per capita (EU=100)

tinue to apply, under which the Ministry of Finance will
have to borrow roughly CZK 280 billion this year to cover
its debt servicing and the planned deficit; however, the
government’s issuing activity on the bond market has not
been very strong so far and so we may speculate that the
government will rely on obtaining the necessary financing
in the second half of the year by issuing Eurobonds.

Rather weak issuing activity in the first half of the year
combined with the previous decrease in yields on the
European market is one of the reasons why bond yields
remain at relatively very low levels. However, gradual
economic recovery abroad may be expected to give rise to
inflationary expectations, thereby pushing yields higher,
which will also have an impact on the Czech market.

The government budget therefore remains the main
obstacle preventing the Czech Republic from adopting
the euro or entering into the ERM-2 in the near future.
Consequently, we do not expect the debate on the adop-
tion of the euro to not come into the spotlight until the
commencement of the public finance reform measures,
which will be totally in the hands of the new government.
However, we think that the Czech Republic is unlikely
to qualify for the euro before 2015 and 2016 therefore
remains the earliest year when the single currency might
be adopted.

Petr Dufek, CSOB Prague

Key data
                                       2004       2005       2006   2007   2008   2009   2010F   2011F
 Real GDP growth (%)                     4.5       6.3        6.8    6.1    2.5   -4.2     1.5     2.5
 Inflation (annual, %)                   2.8       1.9        2.5    2.8    6.3    1.0     1.7     2.0
 Budget balance*                        -3.0       -3.6      -2.6   -0.7   -2.7   -5.9    -5.5    -5.0
 Public debt*                           30.1      29.7       29.4   29.0   30.0   35.4    41.0    44.0
 Current account*                       -5.2       -1.3      -2.4   -3.2   -0.6   -1.0    -1.3    -1.3
  FDI inflow*                            4.5       9.4        3.8    6.0    3.0    1.4     1.5     1.8

Source: CNB, CSO, CSOB
* % of GDP

 • In 2009, the Romanian economy experienced a hard
   landing as the credit crisis overturned the credit-driven
   growth model
 • External assistance from the EMU and the EU helped
   stabilise the economy and restore market confidence.
   However, growth in 2010 and 2011 will still be very
 • The country is still targeting EMU entry in 2015, but
   in the wake of recent developments in the EMU and
   Romania, this call looks highly premature.

 During the second half of 2008, an era of superb growth in Romania came to an end. In addition, several factors that
 had contributed to the strong growth performance of the previous years from then on conspired in a negative way.
 The economy experienced a hard landing and tumbled into a deep recession. The country had to look for external
 assistance. The downturn probably bottomed out at the end of last year. A gradual recovery is expected to take place
 this year. However, the extremely favourable context of the pre-2008 era will not return soon. In cooperation with
 the IMF and the EU Romania is implementing structural reforms, including a big effort to repair government finances.
 This austerity plan will slow the real convergence towards the level of other EU countries in the year(s) to come. The
 still low level of convergence with the rest of the EU/EMU also raises questions about the case for an ‘early’ adoption
 of the euro.

Macro developments and economic outlook                        unsustainable build-up of imbalances. The current account
                                                               deficit rose to more than 12% of GDP in 2008. Romanian
Model of credit-driven growth of domestic demand               wage cost growth outpaced productivity growth, under-
stalled                                                        mining the country’s competitive position. Inflation rose
                                                               to a peak of 8.4% in the first half of 2008. The real effec-
Over the years 2001/2008 real GDP growth in Romania            tive exchange rate of the leu rose by more than 35% from
averaged 6.2%. The process of EU entry triggered a strong      2000 to the end of 2007. Until 2004, the high inflation
growth dynamic with both domestic and external demand          was offset by a nominal decline of the leu. However, from
contributing to this self-reinforcing growth spiral.
                                                                Graph 1 - Net exports made a positive contribution to growth
                                                                                for the first time since 2003
In the run-up to EU entry and immediately afterwards in
2007, Romania attracted strong investment inflows. In           30
part these were aimed at establishing production/export
capacity. Part of this capital inflow also went to domesti-     20
cally oriented activities, including foreign investment in
the banking sector. However, in retrospect, these invest-
ments were not able to lay the groundwork for a model
of sustainable and balanced economic growth. Domestic
demand, rather than foreign demand, became an ever              -10
more important source of Romanian growth. From 2003
onwards, net exports made (large) negative contributions        -20
to Romanian growth. This strong dynamic of domestic
                                                                          Inventory (growth contribution, in %)
demand was supported by a sharp rise in disposable              -30       Net exports (growth contribution, in %)
                                                                          Domestic demand (growth contribution, in %)
income and high credit growth.                                            Real GDP growth (in %)
                                                                 2002    03      04      05      06      07      08     09
As was the case in many other countries, the protracted
credit-driven growth of domestic demand led to an

2005, the combination of a strong leu and persistent high        capital inflows from official creditors like the IMF and
inflation caused a steep rise in the countries’ real effective   the EU, but, a big part of these inflows was offset as the
exchange rate (REER). A strong currency, low real interest       domestic banking sector repaid (i.e. didn’t roll over) a part
rates, the availability of cheap foreign currency financing      of the mostly short-term credit from foreign creditors. This
and a pro-cyclical fiscal policy all reinforced the pattern of   development was partly the consequence of the delever-
uneven domestic growth.                                          aging of the financial sector globally as (foreign) financial
                                                                 institutions were less inclined to provide credit. However,
As was the case for several countries in a similar situation,    foreign parent companies of domestic banks maintained
the credit crisis put an abrupt break on this growth model.      the longer-term commitment to their activity in the coun-
Export demand dried up as the crisis hammered demand in          try. On the other hand, the repayment of foreign liabili-
Romania’s major export markets. On top of that, the avail-       ties was also due to a decline of domestic actors’ demand
ability of cheap (foreign) credit also dried up, reinforcing     for foreign funding via the banking sector. On the other
the downturn in domestic consumption and investment.             hand, there was still a decent positive inflow of funds via
The domestic sector also experienced negative balance            the credit provided by other private creditors (around 2%
sheet effects due to its exposure to foreign currency lend-      of GDP), e.g. via intercompany loans.
ing, adding to the negative spiral.
                                                                 At the start of 2009, the funding of the foreign debt was
In order to secure the financing of its external obligations     one of the key issues for Romanian policy-makers. For 2010
and its rising government budget deficit, the country            and 2011 one might expect the current account deficit
went in search of external assistance. In a joint effort, the    to rise again slightly as an (albeit moderate) rebound in
IMF, the EU, the Worldbank, the EIB and the EBRD agreed          domestic demand could reverse part of the implosion of
to put in place financial assistance totalling up to EUR 20      import demand seen in 2009. However, the growth in
bn. The availability of the funding was made conditional         domestic demand is expected to remain very moderate
on the implementation of a strict reform programme tar-          due to the budgetary austerity package to be implemented
geting areas of fiscal policy, structural reform and finan-      throughout the coming year. On top of that, exports are
cial supervision.                                                expected to rebound due the economic recovery in the EU
                                                                 and the rest of the world. Romania should be able to regain
Looking back on the 2009 economic performance, the               market share in the wake of the improved competitive posi-
external support was highly welcome as the collapse of           tion after the depreciation of the (real) effective exchange
economic activity in Romania was much more aggres-               rate of the leu since mid 2008. In this context, one might
sive than had been expected at the start of the crisis and       expect the current account deficit to rise only moderately
even when the IMF agreement was concluded in May.                to around 5% of GDP this year and next. Such a deficit
According to an initial estimate, Romanian economic              should be considered as sustainable for a country that is
growth declined by 7.1% in 2009. Domestic demand col-
                                                                            Graph 2 - Global downturn hammers Romanian
lapsed by over 14% on 2008.
                                                                                        export and production
                                                                                          (y/y change in %)
Structural developments                                            20

External deficit returns to a sustainable level

The flip-side of this implosion of domestic demand was              5
a sharp decline/improvement in the country’s current                0
account deficit. The trade balance improved sharply as
imports declined much more steeply than exports. The cur-
rent account deficit declined from 12.3% of GDP in 2008            -10

to around 4.0% last year. This sharp decline in the current        -15
account deficit was also an important factor for the return        -20            Industrial production Romania
to more sustainable levels of the foreign financing needs.                        Industrial production Germany
The current account deficit was more or less covered by
FDI, even as FDI flows fell sharply from 2008. The financial       -30
                                                                     2003               05                07       09
crisis caused several changes in the structure and financ-
ing flows of the external position. Romania received large

engaged in a long-term catch-up convergence process. The         economy. Increases in excise duties and regulated prices
financing of a deficit of this order should pose no problem      have had an upward impact on headline inflation since
in a relatively stable financial environment, even though        late last year. These will drop out of the equation later
the room for foreign financing via the banking sector will       this year, making it easier for inflation to return to within
be limited. FDI, inter-company loans and capital support         the NBR inflation target band. Inflation might therefore
from the EU should allow Romania to finance this gap.            decline toward the 3.5% level by the end of the year.
                                                                 Moderate growth in 2010 and 2011, rising unemploy-
Profound budgetary overhaul needed despite low                   ment, the implementation of the budget austerity plan
government debt                                                  and low credit growth should create a context for infla-
                                                                 tion to stay close to the NBR target in 2010 and 2011.
The budgetary austerity measures of the IMF assistance           Nevertheless, domestic rigidities and an asymmetric pass-
plan will be an important factor for the development of          through of currency depreciation/appreciation in the level
the Romanian economy in the period 2010-2012, espe-              of domestic prices might still slow the disinflation process.
cially as Romania still aims to fulfil the Maastricht criteria   Higher energy prices remain a risk factor for the relatively
as soon as possible in order to apply for euro adoption.         favourable inflation outlook.

In the pre-crisis era, Romanian government finances              Moderating inflationary pressures, easing pressures on the
appeared at first sight to be very healthy and on a sustain-     currency market and in global markets and an improve-
able path. The government deficit between 2002 and 2007          ment in investor confidence after the approval of the IMF/
was below the 3% mark and the government debt/GDP                EU support package allowed the NBR to ease monetary
ratio dropped to less than 20%. However, the economic            policy throughout 2009. The central bank reduced the
crisis showed that the Romanian government balance was           reserve requirements and gradually lowered its policy rate.
not really ‘sustainable’, even though these budget/debt          This process was temporarily interrupted during the last
parameters looked extremely ‘favourable’ in comparison           quarter of 2009. Political uncertainty due the presidential
with average EU levels. In retrospect, the composition/          elections and a temporary delay in the conclusion of the
structure of the Romanian budget turned out to be highly         second review of the Stand-By Arrangement caused a
pro-cyclical. The U-turn in the economic cycle caused            temporary flare-up of investor caution towards Romania.
the budget deficit to rise from -5.4% in 2008 to -8.3%           However, after the elections the president managed to
in 2009, despite the measures already implemented last           secure a majority in parliament. Tensions eased and since
year to reduce the public sector wage bill. According to         the start of the year the NBR has reduced the key rate
the February revision of the agreement with the IMF, the         further to 6.5% (It was at 10% last year in May when the
budget deficit is expected to be reduced to 5.9% this year.      IMF SBA was agreed). If the inflation environment were to
The achievement of this target might be challenging. The         remain favourable, there might be room for some addi-
implementation of the public sector wage reform and the
                                                                         Graph 3 - Decline of the leu improved Romania’s
reform of the pension system are far from assured from
                                                                                      competitive position
a political point of view and might face social resistance.
The government is still aiming to reduce the government           4.5
deficit to the 3% Maastricht criterion by 2012. However,
this is still a very long call that might be very difficult or    4.25
all but impossible to achieve.
Inflation and monetary policy
The sharp downturn in economic activity caused inflation
to decline to 4.7% by year-end 2009, down from 6.3% at
the end of 2008. Inflation was therefore still above the
3.5% +/- 1% band. The March 2010 level was reported
at 4.2%. Rather modest growth, the big output gap and             3.25

a stronger leu in a y/y perspective should help inflation
return to within the NBR target band later this year.               3
                                                                     2005      06        07        08        09        10
Measures to reduce public wage growth might have a
dampening effect on wage growth in other parts of the

tional, albeit moderate easing. Uncertainty over the imple-        highly challenging. Nevertheless, until now the govern-
mentation of the structural/budgetary measures and the             ment still intends to enter ERM II in 2012, so as to receive
country’s aim of joining the euro as soon as possible might        approval for EMU entry in 2014 in order to adopt the euro
make the NBR rather cautious about further rate cuts.              on January 2015. The developments over the previous two
                                                                   years have shown that the swings in the global economic
The improvement in the current account deficit, favour-            cycle might cause the prospects for realisation of the EMU
able capital flows and global investor risk appetite for           entry criteria to change and become unrealistic in very
high-yield assets are supportive for the Romanian curren-          short period of time. The 2014 evaluation point may still
cy. A moderately strong currency will also help Romania            be a long way off, but aside from the assessment as to
achieve the Maastricht inflation target. However, as exces-        whether it will be feasible to meet the Maastricht criteria
sive leu strength would weigh on the already very moder-           within the timetable set out by the government, a more
ate growth, one might expect the central bank to step in           fundamental question might be raised.
to slow a too aggressive rise of the leu. We see room for
the leu to appreciate gradually to the EUR/RON 4.05 area           Recent problems within the euro zone have more than
(from 4.14 currently) on a one-year horizon.                       ever fuelled the debate as to whether it is a good option
                                                                   for a country like Romania to enter the euro area while
European integration and the EMU                                   real convergence remains very low. The recent experi-
                                                                   ence of countries like Greece and Spain has illustrated
EMU entry: more than a distant dream                               the potential danger of (too) low real interest rates for
                                                                   economies that still have a big convergence gap to fill.
Romania has no EMU opt-out clause. So, according to the            The convergence in the standard of living might be driven
EU rules, Romania should try to enter EMU as soon as               by a credit-driven catch-up in domestic demand, while
possible. In order to introduce the euro, Romania needs            supply factors fail to track the productive gains in the
to meet the Maastricht criteria. Until 2007 it looked as           stronger countries of the union. After the recent crisis,
though meeting the Maastricht criteria on a five-year              Romanian policy-makers are probably well aware of the
horizon should be feasible, with the inflation target              risk of such an economic path to convergence. However,
the most difficult to achieve due to the strong growth/            as the real convergence gap between Romania and the
overheating of the economy. However, since 2007/2008               EU/EMU is still very wide, there is a real risk that a credit-
the outlook for the Romanian economy has completely                driven growth spurt could resurface at some point. Rather
changed. Inflationary pressures have eased, but infla-             than trying to make an assessment as to whether Romania
tion is still well above the Maastricht criterion. On top          will be able to adopt the euro in early 2015 or one or two
of that, low growth and deflationary tensions might put            years later, the real question is what level of real conver-
the reference point for the inflation target at a very low         gence is needed to start the preparations for EMU entry.
level in the next two to three years. Apart from the infla-        In this respect, Romania has still a long way to go. We are
tion target, meeting the budget deficit criterion is no            well aware that this assessment involves the implicit rejec-
longer the sure thing it was a few years ago. The govern-          tion of the Maastricht criteria as an appropriate frame-
ment debt level of 60% of GDP will not be a problem.               work for an evaluation of EMU entry.
By implementing the IMF SBA agreement and according
to the convergence plan, Romania still aims to reach the
3% Maastricht budget deficit target in 2012. This will be          Peter Wuyts, KBC Brussels

Key data
                                                     2004   2005   2006       2007       2008        2009      2010F      2011F
  Real GDP growth (%)                                 8.5    4.2    7.9        6.3         7.3       -7.1        1.0         3.0
  Inflation (annual, %)                              11.9    9.1    6.6        4.9         7.9        5.6        4.3         3.4
  Budget balance*                                    -1.2   -1.2    -2.2       -2.5       -5.4       -8.3        -6.0       -4.5
  Public debt*                                       18.7   15.8   12.4       12.6        13.3       23.7       27.0        32.0
  Current account*                                   -8.4   -8.6   -10.6      -13.6      -12.3       -4.4        -5.0       -5.5
  FDI inflow*                                         8.4    6.6    8.9        5.7         6.6        4.0        5.0         5.5
Source: Eurostat, EC, NBR, KBC estimates/forecasts
* % of GDP

 • Bulgaria has been hard hit, as the global crisis put an
   end to the boom years
 • Adjustment takes time as the rebalancing of the exter-
   nal position is incomplete
 • The economy should broadly stabilise in 2010, setting
   the stage for a more vigorous recovery in 2011
 • The return of a rapid catch-up process is unlikely unless
   the country takes firm reform action
 • The government has unexpectedly called off ERM-2
   entry. It may be appropriate in the aftermath of the
   crisis to reconsider fast EMU entry altogether

 The financial crisis aborted a decade of rapid economic growth in which living standards started to converge towards
 EU levels, even though the gap remains wide. The crisis brought the unsustainable nature of the previous boom to
 the fore and pushed the economy into a deep recession. In 2010 a broad stabilisation of the economy is likely, setting
 the stage for stronger growth in 2011. However, growth will remain well below the levels of the previous decade and
 living standards will converge much more slowly towards EU averages unless profound structural reforms are made.
 Bulgaria should not have undue problems qualifying for euro adoption on the basis of the Maastricht criteria, but
 recent developments and economic theory suggest that the country should not aim for fast EMU entry or at least that
 the authorities should wait to see what kind of EMU rises out the ashes of the financial crisis before contemplating
 EMU entry.

Macro developments and economic outlook                        The booming economy in recent years was driven by
                                                               massive capital inflows, mostly coming from the mature
Some longer-term developments                                  European economies, which were looking to exploit the
                                                               opening up of the Central European labour markets. The
In the five years preceding the Great Recession of 2009,       lower wage costs allowed many West European firms to
Bulgarian GDP grew by slightly more than 6% per annum          lower their production costs, enabling them to withstand
and the performance is still outstanding when consider-        the competition from Asian producers. The products made
ing the period since the Bulgarian crisis of 1996/97, which    in the Central European countries thus found their way
finally brought the difficult post-Communist era adjust-       back to the more mature European countries. The large
ment to an end. During these 11 years growth averaged          capital inflows however also generated a domestic credit-
5.15% per annum.                                               driven demand boom, resulting in strong GDP growth and
                                                               expanded employment. Consequently, the current account
Living standards have improved substantially since 1998.       deficits widened to extremely high levels (of around 25%
This improvement pops up in the Eurostat statistics on         of GDP in Bulgaria), housing bubbles popped up, high
the real convergence in the European Union. In 1997,           wage growth that exceeded productivity growth became
Bulgarian per capita GDP (on PPP metrics) amounted to          the norm and inflation rose to double-digit levels.
26.4% of the average EU-25 level, rising to 41.3% in 2008,
the latest figure available. While the improvement is          Deep recession in 2009......
impressive, living standards are still very low and together
with those in Romania are the lowest in the whole              The default of Lehman Brothers in the fall of 2008 provided
European Union. The improvement in living standards in         the signal that pushed the overheated Bulgarian economy
the past 12 years has not prevented the adverse develop-       over the cliff. Capital inflows fell dramatically, leading to
ment of demographics. Indeed, the population, currently        a contraction in domestic demand, while trade slowed
about 7.6 million, has shrunk by 1.1 million since 1990,       substantially due to the lack of trade finance and the
and while the pace of decline has slowed somewhat, it          deep recession experienced by the main trading partners.
remains negative.                                              Following growth of 6% in 2008, the economy contracted

by 5% in 2009. Looking to the drivers of the economy in         able, unless structural reforms are speeded up. The IMF
2009, private consumption fell by 6.2%, suffering from          focussed on the need for reforms in its March 2010 Article
higher unemployment, tighter credit (credit crunch) and         4 Consultation statement: the rebalancing from the non-
steep falls in housing prices. Overall investment, which        tradable to the tradable sector needs slower wage growth
had still surged by 20% in 2008, plunged by 27% in 2009         in the medium term. Rationalising public administration
on reduced capital inflows, idle production capacity as         and making it more efficient and effective is needed to
demand dropped, and lower housing investments. The              create room for expenditure on the supply side of the
trade flows shrank sharply, but as imports fell more than       economy, such as the improvement of infrastructure, edu-
exports, net exports actually contributed positively to GDP.    cation and training. Containing public wage growth could
                                                                help limit economy-wide wage growth and increase com-
...followed by a slow recovery in 2010                          petitiveness. The pension and health care systems need
                                                                urgent reform, while a renewed push for privatisation
For this year, a broad stabilisation of the economy is likely   would enlarge the role of the private sector.
and any growth in GDP in 2010 is likely to be modest.
The necessary adjustment – a rebalancing of the economy         To conclude, future growth will in the absence of further
towards the tradable sector from the non-tradable one           structural reform be lower than over the past ten years
– is not yet complete. Domestic demand will therefore           and the rise in living standards will slow, maintaining a
remain negative in 2010, but will probably just be offset       wide gap on standards throughout the European Union.
by (net) export growth and restocking. The recovery in
exports and inventories has already started, but domestic       Structural developments
demand is, as expected, providing a headwind.
                                                                High external private sector debt leaves country
The EU confidence surveys – the timeliest cyclical indica-      vulnerable
tors – show that while Bulgarian business and consumer
confidence (see graphs) is off the bottom, the cyclical         The very high current account deficits (25% of GDP), the
recovery is tepid and is lagging not only the improvement       low savings ratio and the double-digit inflation showed
in EU confidence as a whole but also all other Central          that the Bulgarian economy had structural problems.
European countries, including the hard-hit Baltic states.       The huge capital inflows and the apparently strong pub-
                                                                lic finances masked these imbalances until the Lehman
The Currency Board arrangement prevented the Bulgarian          default wake-up. The capital inflows will remain very
economy from improving its competitiveness via a weaker         modest this year, as the January-February figures show a
exchange rate, as some of its competitors were able to.         further decline, and while they might recover somewhat
Therefore, the adjustment needs to be done in the real          from the low levels during the crisis, they will remain well
sphere, which is more difficult and time-consuming.
                                                                                  Graph 1 - Business confidence
So Bulgarian firms will continue to shed labour and
                                                                           (standard deviation from the long-term average)
wage growth may have to slow further, hitting domestic
demand. Economic recovery in the main EMU trading                  3
partners, Germany and Italy, will probably be slow, while
closer to home, exports to Greece, the country’s second            2
largest export market, will be negatively affected by
the plunge in Greek demand due to the austerity policy             1

adopted by the Greek government. To conclude, trade will
be a positive driver of growth in 2010, but will not be able
to pull overall growth up sharply.                                 -1
                                                                                    Czech Republic
Stronger growth in 2011, but structural reform                     -2               Poland
needed to raise trend growth                                                        Romania
                                                                   -3               EU-27

In 2011, the Bulgarian economy may grow more strongly
again as the adjustment will have been completed.                  -4
                                                                    2007               08                09                  10
However, it is unlikely to return to the post-crisis growth
levels of about 6% – which in hindsight were unsustain-

below the levels reached in the boom years.                      and a prolongation of this expenditure trend, which still
                                                                 accelerated in the first half of 2009, would have led to
The external imbalance was due to the private sector in          large fiscal deficits. Despite the correction of fiscal policy in
Bulgaria, contrary to the situation in many other countries      the second half of 2009, the budgetary situation remains
like Greece, where the public sector is the main source          challenging in 2010, especially after the upward revision
of imbalance. The string of current account deficits accu-       of the 2008-09 deficits. Indeed, the government aimed at a
mulated in a sharply rising external debt, from 69.1% of         balanced budget in 2010 and beyond and we haven’t seen
GDP in 2004 to 114.4% of GDP in 2009, of which the lion’s        signals that the government has plans to adjust the fiscal
share is private sector debt. This leaves the country highly     deficit path. However, all in all, it is likely that the govern-
vulnerable to a debt crisis, which usually end up in large       ment will undershoot its target and report a budget deficit
part in a transfer of private sector to public sector debt.      in 2010 too. The revenue targets are too ambitious and
We suspect that the currency board arrangement facili-           some slippage in spending isn’t ruled out either.
tates the increase in private sector foreign debt, as house-
holds and firms often disregard the foreign exchange risk        Inflation under control, as output gap is wide
and look for lower interest rates than those for euro bor-
rowing. So the authorities should keep a close eye on such       The overheating of the economy pushed inflation to
external debt dynamics and prevent them from becoming            12.4% in 2008 before slowing sharply to 2.4% in 2009.
too important. Indeed, while the authorities might wish          Inflation is expected to remain around 2009 levels in the
to keep the currency board in perpetuity, there may be           years ahead. Core inflation (excluding energy, food and
occasions when a change in parity might help address             alcohol) slowed to 2.1% y/y in February from 7.9% y/y in
an adverse shock, but the existence of high foreign debt         February 2009. The wide output gap is keeping inflation
could make such an option unworkable.                            under control, with administrative prices and the gyra-
                                                                 tions of energy prices the only sources of price volatility.
The current account has already adjusted to some extent,
as the deficit fell from 23% of GDP in 2008 to 7.8% in           European integration and the EMU
2009. However, it would be better if some further adjust-
ment were made.                                                  The Bulgarian government aspires to fast entry into EMU
                                                                 and had planned an entry into ERM-2 exchange rate
Fiscal surplus shifts to deficit                                 mechanism, often called the waiting room to euro adop-
                                                                 tion, in mid-2010, leading to possible euro adoption in
The fiscal headline figures look impeccable with a debt to       early 2013. However, a few weeks ago, the Prime Minister
GDP ratio of only 14.7% in 2009. The Bulgarian government        announced that the demand for ERM-2 entry would be
ran a budget surplus (ESA 95 basis) in each of the five years    delayed, as “irregularities” by the previous socialist-led
before 2009, so as to offset (with only modest success) the
                                                                                    Graph 2 - Consumer confidence
impact of external deficits and capital inflows on the econ-
                                                                             (standard deviation from the long-term average)
omy. Indeed, despite these budget surpluses, the economy
overheated. In 2009, the public deficit of 1.9% still looked       2.5
very modest by international standards. However, a few             2.0
weeks ago, the Prime Minister unexpectedly revised the             1.5
2009 deficit from -1.9% to -3.7% of GDP and the 2008 sur-
plus from 1.8% of GDP to 0.3% of GDP. The Prime Minister
justified the revisions by saying that the previous socialist-
led government had left behind more than 150 unaccount-            0.0
ed for procurement deals. This could have an impact on the         -0.5
EMU strategy of the government (see below).                        -1.0
                                                                   -1.5           Czech Republic
At 3.7% of GDP, the 2009 budget deficit might look man-                           Poland
                                                                   -2.0           Romania
ageable, but it nevertheless points to the need for a restruc-                    EU-27
turing of fiscal policy in 2010, and not just because of the
external debt vulnerability: the adjustment is also needed         -3.0
                                                                      2007                08                09                 10
because the domestic-demand revenue boom has ended.
In 2007-2008, this boom was used to increase expenditure,

government had led to an underreporting of the 2009               countries to safeguard their competitiveness against the
deficit and an overreporting of the 2008 surplus. The             anchor country Germany and its satellites, which follow a
Finance Minister suggested recently that Bulgaria may             highly orthodox, ruthless policy focussed on cost efficiency.
apply for ERM-2 membership by the end of 2010.                    Entering such an EMU requires a similar kind of policy. In
                                                                  theory this is not impossible to implement, but it should be
We think that the EU authorities will do their utmost to          embedded in a country’s genes or in other words requires
convince Bulgaria not to apply in the short term, even if         a strong consensus concerning economic discipline that
the Maastricht criteria still govern the membership issue         usually takes decades to achieve. Is such a consensus
and Bulgaria could readily comply with all the criteria.          already in place in Bulgaria? We don’t think so. Political
Indeed, the fiscal criteria will have been fulfilled from         scandals, corruption, legal uncertainties and doubts about
2010 onwards; the currency board arrangement should               the judiciary are signs that the necessary maturity for a dif-
make it easy to comply with the FX stability criterion,           ficult stay inside the EMU is still largely absent. EMU entry
while the deep recession will keep inflation sufficiently in      is often seen by countries as a destination rather than a
check for the next few years.                                     journey. Countries should be aware that entry doesn’t
                                                                  mean the country enters the Promised Land, but that it
The financial crisis has however shown that the Maastricht        is only the start of a difficult journey that will eventually
criteria are totally inadequate for judging the readiness of      result in a better economic future for its citizens.
a country to thrive within the EMU zone. Countries with a
low level of convergence will find it very difficult to develop   Before the recent crisis, countries aspiring to entry could still
their economy harmoniously, as the low EMU interest rates         entertain the notion that entry meant that the other EMU
are inappropriate for such countries. Indeed, as the currency     countries would be ready to come to the rescue when things
is irrevocably fixed upon EMU entry (against the euro), the       went awry. Following the Greek drama, hoping for such an
appreciation of the real effective exchange of a country –        outcome would be reckless. The EMU is going through a
an inevitable by-product of real convergence – will push          difficult period and it is still unclear what kind of EMU will
inflation higher. Higher inflation and higher growth in the       prevail in the end. Especially for countries with a currency
context of very low nominal rates leads to negative real          board, it is tempting to exchange that regime for euro adop-
interest rates, credit booms and bubbles. The case of the         tion, as the currency board already sharply limits the use of
Baltic countries, but also Bulgaria, all with currency boards,    the currency and interest rates as an economic tool and the
is straightforward in this respect, but also inside the EMU,      euro offer still lower rates. However, the currency board
countries with far higher real convergence rates such as          arrangement still allows a currency re-alignment, whereas in
Greece or Spain are experiencing these kinds of problems.         the case of euro adoption there is no way back apart from a
                                                                  very costly re-introduction of a national currency.
The financial crisis brought also to the surface the fact
that current account deficits may grow for longer and             So, while there are plenty of arguments in favour of stay-
more radically within the EMU, thereby hiding a loss of           ing out of the EMU until real conversion is much more
competitiveness and delaying the necessary adjustment.            advanced, the uncertainties about the future nature of
However, once it comes, the adjustment needs to happen            EMU should at least convince Bulgarian policy-makers not
in the real sphere, which is incredibly difficult.                to push for a fast entry into EMU.

These developments also show how difficult it is for              Piet Lammens, KBC Brussels

Key data
                                           2004       2005        2006        2007       2008        2009       2010F       2011F
  Real GDP growth (%)                       6.6         6.2        6.3         6.2         6.0        -5.0         0.2        3.0
  Inflation (annual, %)                     6.1         5.0        7.3         8.4        12.4         2.8         2.2        2.5
  Budget balance*                           1.6         1.9        3.0         0.1         0.3        -3.7        -2.0        0.0
  Public debt*                             37.9        29.2       22.7        18.2        14.1        14.7        15.5       15.5
  Current account*                          -6.0      -11.2       -17.8      -29.3       -23.0        -7.8        -5.5        -6.5
  FDI inflow*                               8.4        11.1       17.7        21.0        18.0         7.8         5.0        6.0
Source: EC Commission, IMF, BNB, KBC
* % of GDP

List of participants

 KBC Bank Brussels                                                                   KBC Brussels
 Piet Lammens                      Peter Wuyts                 Joke Mertens          Edwin De Boeck         Greet Vander Roost
 Global head of market research    Senior analyst              Analyst               Chief Economist        Senior Economist     
 +32 2 417 59 41                   +32 2 417 32 35             +32 2 417 30 59       +32 2 429 59 50        +32 2 429 59 84

 KBC IIB Dublin
 Austin Hughes
 Chief economist
 +353 1 6646892

 KBC-CSOB Prague
 Petr Dufek                        Jan Cermak                  Martin Kupka
 Head of macro-economic research   Head of market research     Chief Economist             
 +420 2 61353122                   +420 2 61353578             +420 2 61353574

 KBC-CSOB Bratislava
 Marek Gabris
 Senior economist
 +421 2 59668400

 KBC-TFI Warsaw
 Antonik Jaroslaw
 Head of Research
 +48 22 5810154

 KBC-K&H Budapest
 Gyorgy Barcza
 Chief economist
 +36 1 3289989

 NLB Lublijana
 Sonja Mlakar                      Leon Hodoscek
 Financial markets analyst         Financial markets analyst     
 +386 1 4769134                    +386 1 4769159

 Steven Gardyn
 Fund manager
 +352 299 881 203


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