The Boom-Bust in the EU New Member States: The Role of Fiscal Policy JVI Lecture, Vienna, January 21, 216 Bas B. Bakker Senior Regional Resident Representative for Central and Eastern Europe
Outline The boom-bust in CESEE Fiscal policy and the boom-bust Concluding thoughts 2
The Boom-Bust in CESEE 3
Pre-crisis, income levels in CESEE converged rapidly with Western Europe Average annual GDP growth (percent) GDP per capita level relative to Germany (percent) Slovenia Czech Rep. Estonia Slovakia Hungary Lithuania Latvia Croatia Russia Poland Romania Bulgaria Montenegro Belarus Serbia Macedonia Ukraine Bosnia Albania Moldova 22 Convergence 22-7 2 4 6 8 4
fueled by strong capital inflows. 3 25 2 15 Portfolio FDI Other, including banks Total Cumulative Net Capital Inflows, 23 8* (Percent of 23 GDP) 1 5-5 *As the boom in the Baltic states ended in 27, data for the Baltic states refer to 22 7 in percent of 22 GDP. 5
Western European banks were an important source of capital flows 6 Exposure of BIS-reporting banks to CESEE vis-a-vis all sectors (exchange-rate adjusted) Quarterly changes (percent of region's GDP), rhs 5 8 Changes in exposure of BIS-reporting banks (percent of 215 GDP) 5 Outstanding amount (USD billion) 4 6 4 3 2 3 2 1-1 4 2-2 29-15 23-8 1-2 -4 23 25 27 29 211 213 215-3 -6 Baltics SEE EU CE5 SEE non-eu 6
Bank flows fueled a credit boom Change in ratio of private sector credit to GDP, 23 8 6 5 4 3 2 1 Change in external position of western banks and in private sector credit Albania Macedonia Czech Rep. Russia Belarus Turkey Poland Ukraine Moldova Bosnia and Herzegovina Slovak Republic Hungary Romania Croatia Lithuania Bulgaria Latvia Estonia -1 1 2 3 4 5 6 Change in ratio of external position of western banks to GDP, 23 8 7
which boosted domestic demand. Real domestic demand growth, 23 8 14 12 1 8 6 4 2 Domestic Demand and Private Sector Credit Growth, 23 8 1 (Annual percentage change) Poland Slovakia Croatia Moldova Macedonia Bosnia Czech Republic Hungary Serbia Russia Turkey Romania Estonia Bulgaria Belarus Latvia Ukraine Lithuania Albania Montenegro 1 2 3 4 5 6 7 8 Real private sector credit growth, 23 8 8
Rapid credit growth was associated with rapidly rising current account deficits 3 percent per annum 1 2 Real credit growth 5 1-1 -2 Current account balance percent of GDP -5-3 2 21 22 23 24 25 26 27-1
Current account deficits in some countries reached very high levels -5-1 -15 22-7 averages External imbalances Czech Rep. Macedonia Slovakia Serbia Belarus Poland Moldova Romania Albania Credit boom Kosovo Croatia Hungary Annual increase in private credit percent of GDP Slovenia Bulgaria Lithuania Estonia Current account balance percent of GDP Bosnia and Latvia Herzegovina 5 1 15
But views differed on how to interpret these imbalances Abiad, Leigh, and Mody (27): "International Finance and Income Convergence: Europe is Different Current account deficits are benign. Capital flowing from rich to poor countries Bakker and Vladkova-Hollar (26): Asia 1996 and Eastern Europe 26: Deja-vue all over again? 11
In September 28, Lehman Brothers defaulted Global risk aversion spiked Western European banks came under financing pressure As a result they suddenly stopped sending large amounts of capital to CESEE 9 8 7 6 5 4 3 Volatility index on S&P 5 Domestic demand collapsed just when exports dropped because of global recession 2 1 Jan-7 Jul-7 Jan-8 Jul-8 12
The result was a sudden stop and then reversal of bank flows 6 Exposure of BIS-reporting banks to CESEE vis-a-vis all sectors (exchange-rate adjusted) Quarterly changes (percent of region's GDP), rhs 5 8 Changes in exposure of BIS-reporting banks (percent of 215 GDP) 5 Outstanding amount (USD billion) 4 6 4 3 2 3 2 1-1 4 2-2 29-15 23-8 1-2 -4 23 25 27 29 211 213 215-3 -6 Baltics SEE EU CE5 SEE non-eu 13
The result was a deep recession which was not projected by most observers Real GDP growth in 29 (percent) 1 5 WEO forecast October 28 Consensus forecast October 28-5 -1-15 -2 Albania Poland Belarus Macedonia BiH BiH Serbia Serbia Czech Czech Republic Republic Slovak Slovak Republic Republic Bulgaria Bulgaria Montenegro Montenegro Moldova Moldova Romania Hungary Croatia Russia Slovenia Estonia Ukraine Lithuania Latvia Romania Hungary Croatia Russia Slovenia Estonia Ukraine Lithuania Latvia Canada Canada United United States States Outturn France France Germany Germany United United Kingdom Kingdom Italy Japan Italy Japan 14
The larger previous capital inflows, the sharper the reversal Capital flows in the run-up and during Global Financial Crisis Change in capital flows in 29 (percent of average 25-9 GDP) 5-5 -1-15 -2-25 -3-35 -4 Slovenia Slovakia Czech Rep. Macedonia Croatia Bosnia and Poland Herzegovina Kosovo Albania Lithuania Hungary Romania Estonia Serbia Latvia Bulgaria Montenegro 2 4 6 8 1 12 14 16 Cumulative capital flows, 25-8 (percent of average 25-9 GDP) 15
Countries which had large domestic demand booms, now saw deep recessions Real GDP growth, 29 5-5 -1 Hungary Real Domestic Demand Growth and Real GDP Growth (Percent) Albania Poland Bosnia & Herzegovina Czech Rep. Croatia Turkey Macedonia, FYR Serbia Slovakia Moldova Bulgaria Russia Romania Estonia Lithuania Belarus -15 Ukraine -2 Latvia 2 4 6 8 1 12 14 Real domestic demand growth, 23-8 16
The IMF was quick to provide assistance 29 28 29 28 EU countries: EU member countries SBA program FCL program 28 29 29 29 21 211 21 21 Non-EU countries: SBA program EFF program PCL program Precautionary programs 17
In second half of 29, risk aversion declined sharply 9 Volatility index on S&P 5 (index) 7 CESEE average CDS spreads (basis points) 8 6 7 6 5 5 4 4 3 3 2 2 1 1 Jan-7 Jan-8 Jan-9 Jan-1 Jan-11 Jan-7 Jan-8 Jan-9 Jan-1 Jan-11 18
In 21, region started to grow again 1 Real GDP growth, 215 (percent y/y) 5 Baltics CE5 SEE EU SEE -5 CIS -1-15 27 28 29 21 211 212 213 214 215 19
The crisis was deep, but most countries have recovered to above pre-crisis levels (unlike the euro area periphery) GDP, 215 (percent change since 28) Poland Moldova Albania Macedonia Belarus Slovakia Ireland United Kingdom Germany Estonia Montenegro Czech Rep. Bosnia and Herz. France Lithuania Austria Romania Bulgaria Hungary Russia Latvia Serbia Spain Slovenia Portugal Italy Cyprus Croatia Ukraine Greece 2-3 -2-1 1 2 3
In per capita terms, growth has been faster although of course tepid by pre-crisis standards GDP and GDP per capita, 215 (percent change since 28) Poland Moldova Albania Macedonia Belarus Slovakia Ireland United Kingdom Germany Estonia Montenegro Czech Rep. Bosnia and Herz. France Lithuania Austria Romania Bulgaria Hungary Russia Latvia Serbia Spain Slovenia Portugal Italy Cyprus Croatia Ukraine Greece GDP per capita 21-3 -2-1 1 2 3
Fiscal policy during the crisis 22
The boom-bust was a private-sector phenomenon They were NOT the result of fiscal imbalances (with the exception of Hungary) The boom was hard to stop Countries took extensive macro-prudential measures They did not stop the credit boom They helped create buffers in the banking system 23
The boom would have been mitigated by rising risk premia Rising risk premia would have been automatic stabilizer (increased financing costs would have slowed credit growth) Problem was that risk premia fell during boom 24
Nevertheless, fiscal policy did contribute to the boom-bust Fiscal policy was very pro-cyclical: Public expenditure grew very rapidly during the boom years Fiscal policy was very contractionary during the bust. 25
During boom years most but not all countries had low debt and deficits 8 Public sector balance and debt, 27 (percent of GDP) Kosovo Maastricht area General government balance 6 4 2-2 -4 Latvia Russia Estonia Belarus Lithuania Bulgaria Bosnia and Herz. Czech Rep. Ukraine Slovakia Romania Slovenia Montenegro, Rep. of Macedonia, FYR Moldova Serbia Croatia Poland Albania Hungary -6 1 2 3 4 5 6 7 Public debt 26
However, public expenditure was growing rapidly Domestic demand boom led to public revenue boom Revenue boom led to public expenditure boom Unfortunately, much of the revenue boom turned out to be temporary While the increase in expenditure had a more permanent character. 27
Thus, in countries where private demand grew rapidly, public demand did so too. Domestic demand and government expenditure during the boom years Real expenditure growth, 23 8¹ 14 12 1 8 6 4 2 Bosnia & Herzegovina Hungary Albania Poland Croatia Czech Rep. Serbia Estonia Macedonia Slovakia Turkey Moldova Bulgaria Romania Russia Lithuania Ukraine Latvia Belarus Montenegro 2 4 6 8 1 Real domestic demand growth, 23 8¹ 28
Example: Bulgaria Bulgaria: 3 percent surplus in 27 and 28 looks very prudent Revenue increased by 3 percent in 28 so did expenditure! 29
The end of the domestic demand boom led to a sharp decline of revenue Dynamics of real tax revenues -5-1 -15-2 -25-3 -35-4 Tax revenues dynamics in 29 recession (percent y/y) Estonia Latvia Romania Lithuania Croatia Bulgaria Czech Rep. Hungary Slovakia Slovenia Poland -4-35 -3-25 -2-15 -1-5 5 Change in domestic demand 3
Financial sector support further added to fiscal pressures. 6 5 4 Fiscal cost of banking crises 27-11 (percent of GDP) FX loans to large banks Liquidity Recapitalization 3 2 1 Hungary Ukraine Latvia 31
Risk premia rose sharply 14 5-year CDS spreads (basis points) 12 1 8 Latvia 6 4 2 Jan-7 Jul-7 Jan-8 Jul-8 Jan-9 Jul-9 Romania Hungary Note: 5-yr CDS spreads at 6 basis points translate into 1 percent probability of default over the next 5 years, assuming 4 percent recovery rate. 32
Particularly in countries with high projected deficits 14 Imbalances and 5-year CDS spreads Peak CDS spreads in 29 (basis points) 12 1 8 6 4 2 Estonia Latvia Lithuania Romania Poland = CA deficit at 1 percent of GDP in 28 Serbia Hungary Croatia Slovak Rep. Bulgaria -8-7 -6-5 -4-3 -2-1 1 2 Forecast of 29 fiscal balance in April 29 (percent) 33
Projections of potential output were revised sharply as well Estimates of Real and Potential GDP (index, real GDP in 27=1) Estonia Hungary 34
And estimates of pre-crisis structural deficits were increased sharply Revisions of 27 cyclically-adjusted fiscal balance 4 Spring 28 2-2 latest -4-6 -8 HUN LVA ROU SVK LTU EST POL SVN CZE BGR 35
Strong financial pressures led to upfront adjustment. Discretionary fiscal measures in 29-1 (percent of GDP) 15 1 5-5 Long-term interest rates and fiscal adjustment Poland Croatia Bulgaria Romania Hungary Latvia Albania Lithuania 4 6 8 1 12 14 16 Long-term interest rate in 29 36 (percent)
Some countries took very strong measures to contain rise in deficits 2 15 Discretionary fiscal measures, 29 12 (Percent of GDP) 1 5-5 -1-15 Latvia 29 21 211 212 Cumulative Lithuania Serbia Romania Bosnia & Belarus Ukraine Albania Moldova Montenegro Hungary Bulgaria Macedonia, FYR Poland Croatia Russia Kosovo Simple average Weighted average 37
Interest rates declined subsequently; recovery followed Interest rates and growth prospects in Lithuania, 28-1 15 1 Long-term interest rate 5-5 -1-15 GDP growth forecasts for 29 GDP growth forecasts for 21-2 Jan-8 Jul-8 Jan-9 Jul-9 Jan-1 Jul-1 38
Both revenue and expenditure contributed to deficit reduction Changes in budget structures, 28-14 (percent of potential GDP) Revenue changes Expenditure changes 39
Expenditure to GDP ratios have come down from crisis-peak but are not yet back to pre-crisis levels 5 Revenues and expenditures as percent of trend GDP 22-15 Baltics CEE SEE EU SEE non-eu 5 5 5 48 48 48 48 46 46 46 46 44 42 44 42 Expenditures 44 42 44 42 4 38 4 38 Revenues 4 38 4 38 36 36 36 36 34 34 34 34 32 32 32 32 3 22 26 21 214 3 22 26 21 214 3 22 26 21 214 3 22 26 21 214 Note: Averages are unweighted.
Fiscal deficits have declined to more modest levels Fiscal balance (percent of GDP) Change in fiscal balance, 29-15 (percent of GDP) Lithuania Latvia Slovakia Romania Poland Bosnia Czech Rep. Moldova Hungary Ukraine Slovenia Albania Estonia Croatia Serbia Bulgaria Cyclical improvement Stuctural improvement Macedonia Kosovo Belarus Montenegro -5 5 1 41
but adjustment is not yet over. Estimated remaining adjustment needs (percent of GDP) Gap to structural balance of -1 percent of GDP Gap to debt stabilizing primary balance 42
And public debt is no longer low Public debt (percent of GDP) Change in public debt, 27-15 (percent of GDP) Ukraine Slovenia Croatia Serbia Montenegro Latvia Romania Bosnia Slovakia Lithuania Belarus Moldova Albania Macedonia Czech Rep. Russia Bulgaria Hungary Estonia Poland Kosovo 37.8 4.9 45.5 53.3 38.8 4.4 44.8 73.3 37.1 4.6 2.4 28.6 75.3 1.8 51.1 21.4 76.7 69.9 81.8 89.3 94.4 Public debt in 215 (percent of GDP) -2 2 4 6 8 1 43
However, adjustment fatigue seems to have set in. 8 7 6 5 4 3 2 1 Estimates of 216 Fiscal Deficit by WEO vintage (percent of GDP) Estimates of 216 deficit as in: Fall 215 WEO Fall 214 WEO 44
Concluding thoughts The crisis in CESEE was in most countries a private sector boom-bust However, fiscal policy exacerbated the boombust During the boom, expenditure grew too rapidly, fueling overheating Temporary revenue boom was used for permanent increase in expenditure As a result, countries were forced to do fiscal adjustment in the midst of the crisis 45
Lessons for future crises If you want to use fiscal policy during a bust, you need to build up buffers during a boom When you have a very strong domestic demand boom, you may need to build up very large fiscal surpluses during good time, if you want to let stabilizers work during busts 46
But is that feasible? Question: can you run 5 percent of GDP or more surpluses? Can you recognize unsustainable booms in time? 47
What do you when there is a boom? Ask yourself where the boom is coming from and target the measures at the sources of the boom. Bear in mind that you may never get this right and, therefore, having some fiscal space in reserve is critical. 48
Most important lesson! Booms never last! However, they last longer than you think When they end, the crisis comes much faster than you think Be skeptical when someone tells you that this time is different 49
Thank you