Is the transition countries reliance on foreign capital a sign of success or failure?

Is the transition countries reliance on foreign capital a sign of success or failure? Christoph Rosenberg IMF Regional Office for Central Europe and the Baltics UNECE FfD Regional Consultation Expert Meeting Geneva, May 13, 28

Outline Convergence in the CEE countries the role of foreign capital External imbalances: the flip-side of rapid convergence - Some reassuring trends -Concerns Policy Conclusions

Growth in Emerging Europe is expected to slow in near term, due to global spillovers 12 1 Annual GDP growth (percent) 8 6 4 2 CE4 World Baltics Euro area Bulgaria & Romania -2-4 -6-8 1997 1998 1999 2 21 22 23 24 2 26 27 28p 29p Source: WEO April 28.

Nevertheless, the region has been converging very fast Convergence in Emerging Europe and in the Rest of the World, 22 6 Average growth of PPP per capita GDP, 22 6 2 1 1 MD UA BA AL BY RO TR MK LV RS LT BG HU EE RU SK PL 6 7 8 9 1 11 12 CZ ln(ppp per capita GDP), 22 Rest of the world Europe Linear (rest of the world) Linear (Europe) HR 2 1 1

Productivity improvements and capital accumulation (from abroad) have been key Emerging Europe: Growth Accounting, 22 6 (Percent per year) 1 8 Total factor productivity Labor Capital 1 8 6 6 4 4 2 2-2 -2 Macedonia, FYR Czech Rep. Hungary Poland Croatia Serbia Romania Moldova Slovak Rep. Bulgaria Albania Russia Bosnia and Herz. Ukraine Lithuania Belarus Estonia Latvia

The flip-side of this are high current account deficits, especially high in the Baltics and South-Eastern Europe Current account deficit (in percent of GDP) 1 Emerging Asia - Latin America Central Europe -1 Baltics -1 Bulgaria & Romania -2 2 1 2 3 4 6 7 8p 9p Source: IMF WEO April 27.

These are closely related to financial deepening 7 6 Change in credit to private sector 22-27 (in ppt of GDP) Change in external private debt 22-27 (in ppt of GDP) 4 3 2 1 N.A. -1 EE LV BG LT RO HU SI CZ PL SK Sources: National authorities; and IMF staff calculations.

External imbalances: some reassuring trends Most of the deterioration of C/A balances is driven by an increase in investment Emerging Europe: Contributions to Current Account Deficit, 23 7 (Percent) 2 2 1 Increase in investment to GDP Decline in savings to GDP Change in current account deficit to GDP 2 2 1 1 - -1-1 Bulgaria Latvia Serbia Ukraine Romania Lithuania Estonia Belarus Turkey Moldova Albania Croatia Russia Poland Macedonia, FYR Slovak Republic Hungary Czech Republic Bosnia and Herz. 1 - -1-1

External imbalances: some reassuring trends and financed by FDI (and borrowing from foreign parent banks) C/A minus net FDI, 22-26 average (percent of GDP) 2 1 Current account balance/gdp 1 (Current account less net foreign direct investments)/gdp - -1-1 -2 Russia Ukraine Poland Macedonia, FYR Belarus Czech Rep. Albania Turkey Slovak Rep. Hungary Moldova Lithuania Romania Serbia Bulgaria Estonia Bosnia and Herz. Latvia

External imbalances: some reassuring trends EU transfers (mainly structural and agricultural funds) are an increasingly important part of the balance of payments EU Funds, average annual commitments, 24-6, 27-13 financial perspectives (percent of GDP) 6.. 24-6 avg 27-213 avg 4. 3. 2. 1.. Latvia Lithuania Estonia Poland Slovakia Hungary Czech Republic Slovenia EU8 average

External imbalances: some reassuring trends Exchange rate appreciations do not explain high C/A deficits Appreciation in real effective exchange rate, 23 7 Emerging Europe: Change in Current Account Balance and Real Effective Exchange Rate Appreciation, 23 7 (Percent) 6 4 3 2 1-1 BG LV RO UA RS LT TR RU EE MD AL PL HR BY -2-2 -2-1 -1-1 Change in current account balance/gdp, 27 CZ MK SK HU BA 6 4 3 2 1-1

External imbalances: some reassuring trends and lack of competitiveness is not a problem Emerging Europe: Percentage Change in Export Market Shares in the World Economy, 22 6 1/.7.7.6.6...4.4.3.3.2.2.1.1.. Moldova Croatia Hungary Macedonia, FYR Turkey Ukraine Lithuania Bulgaria Latvia Russia Belarus Czech Rep. Romania Poland Albania Estonia Slovak Rep. Bosnia and Herz. Serbia

External imbalances: some reassuring trends The EU halo effect : markets continue to reward EU membership Risk premium: difference from fundamentals Residuals including country fixed effects (in basis points) -4-2 2 4 Jan1 Jan2 Jan3 Jan4 Jan Jan6 Jan7 Jan8 CEECs Latam excl. Argentina East Asia Other EMs

External imbalances: Concerns C/A deficits in some countries are much higher than supported by fundamentals Current Account Balances and Model Predictions (Percent of GDP) -2-4 -6-8 -2-4 -6-8 -1-12 Current account model predictions, emerging Europe -1-12 -14 Current account balances, emerging Europe, average 23-7 -14-16 -18 Latvia Estonia Bulgaria Romania Current account model predictions, Asia Lithuania Hungary Slovak Rep. Czech Rep. Poland Slovenia -16-18

External imbalances: Concerns External debt is growing and reserve coverage is insufficient in some countries External debt to GDP Change 22-27 3 Short-term debt / reserves, 27 4 3 3 2 2 1 2-1 1-2 1-3 -4-3 3 2 2 1 1 S e r b ia T u r k e y B o s n ia a n d H e r z. M o ld o v a R ussia Albania U k r a in e M acedonia B e la r u s B u lg a r ia Slovak R ep. C z e c h R e p. R o m a n ia P o la n d C r o a t ia Lithuania Latvia Hungary E s t o n ia Bosnia and Herz. Albania Macedonia, FYR Russia Hungary Serbia Moldova Ukraine Poland Czech Rep. Turkey Croatia Romania Bulgaria Slovak Rep. Lithuania Belarus Estonia 1/ Latvia

External imbalances: Concerns Although lending to emerging Europe is relatively a small share in the portfolio of banks in advanced Europe Relative Magnitudes of Funding Exposure for Emerging and Western Europe, June 3, 27 (Percent) 3 3 2 Exposure in percent of the country's banking sector assets Share in total claims on emerging Europe 3 3 2 2 2 1 1 1 1 Austria Source: BIS, IMF staff calculations. Germany Italy France Belgium Sweden Netherlands Switzerland United Kingdom Portugal Spain

External imbalances: Concerns it exposes the region to common-lender contagion risk Concentration of Emerging Europe Exposure to Western Europe, June 3, 27 (Percent) 1 1 9 9 8 8 7 7 6 6 4 4 3 3 2 2 1 1 AL BA RS BY SK HR RO MK MD CZ UA HU BG RU PL TR LV LT EE Austria Italy Germany France Sweden Netherlands Switzerland Other Source: Bank for International Settlements, Quarterly Review, December 27. Note: Country names are abbreviated according to the ISO standard codes. 1/ Emerging Europe exposure to western European banks is defined as the share of the reporting banks in each western European country in the total outstanding claims on a given emerging European country (both bank and nonbank sectors). For example, about 42 percent of Croatia's exposures to Western European reporting banks is owed to Austrian banks, 38 percent to Italian banks, 13 percent to French banks, etc. For the Baltic countries, 8 percent or more of exposures to the reporting banks is owed to Swedish banks.

External imbalances: Concerns Credit, mostly refinanced from abroad, is concentrated on households and nontradables 4 Credit to Nonfinancial Corporations, 2-27 4 3 Credit to Households, 2-27 3 3 3 Real estate and construction Other nontradables Tradables 3 3 3 2 Housing purposes Consumer and other 3 2 Credit (percent of GDP) 2 2 1 2 2 1 Credit (percent of GDP) 2 1 2 1 1 1 1 1 2 21 22 23 24 2 26 27 2 21 22 23 24 2 26 27

External imbalances: Concerns Since the onset of the global financial crisis, markets have differentiated between emerging market countries Argentina Latvia Iceland Ukraine Romania Bulgaria South Africa Estonia Lithuania Turkey Hungary Russia Mexico China Poland Brazil Slovakia Czech Republic Change in CDS July 17 May 6 (bps) 1 1 2 2 3 3 1 1 2 2 3 3 Iceland South Africa Romania Argentina Ukkraine Turkey Mexico Russia China Hungary Brazil Slovakia Poland Czech Republic Change in the EURO exchange rate July 17 May 6 (+= depreciation, percent) -2-1 1 2 3 4-2 -1 1 2 3 4 Source: Bloomberg, national statistics.

Particularly countries with large external imbalances face higher financing cost Emerging Europe: Bond Spreads and Current Account Deficits Cnange in EMBI spreads since January 1, 27 1/ 14 12 1 8 6 4 2 Latvia Bulgaria Lithuania Romania Slovak Republic Hungary Poland Czech Republic -2-2 -1-1 - Current account deficit in 27 (percent of GDP) 14 12 1 8 6 4 2 Source: IMF.

So, are large external imbalances a risk? Optimists: The EU s halo effect (about 1 bp) Favorable structure of financing (EU funds, remittances, FDI, low portfolio inflows) Presence of large EU banks Pessimists: Historical boom-bust evidence of large capital inflows Debt financing is potentially vulnerable to sudden stops and increased cost of refinancing (as is already been felt now) Foreign capital mainly goes to the non-tradable sector => questions about countries capacity to repay In the wake of the global credit crisis, markets are starting to punish countries with large imbalances

Policy Dilemma Large external imbalances should not surprise in an environment of rapid growth Policy challenge: how to reduce vulnerabilities without impeding the convergence process? Analytical challenge: how to distinguish natural convergence from overheating

Policy agenda Monetary policy: address inflationary pressures, but keep an eye on interest differentials which could induce short-term capital inflows Fiscal policy: let automatic stabilizers work if economy slows down, but no room for additional stimulus Financial sector supervision: watch crossborder exposures, encourage the build-up of capital buffers Prepare for euro adoption by creating flexible economies and sound institutions