Fast, but sustainable? Challenges and policy options for the catching-up process of central and eastern European countries
Speech by Jürgen Stark, Member of the Executive Board of the ECB
delivered at the Economic conference on central, eastern and south-eastern Europe
Frankfurt am Main, 1 October 2007
Ladies and gentlemen,
I hope that you have all enjoyed the dinner so far. Before we move on to the dessert, it is my great honour and pleasure to welcome you tonight at the 2nd Economic conference on central, eastern and south-eastern Europe. I understood that it would be a challenge to ask for your attention after a long day of interesting and fruitful discussions on convergence issues in Europe. I have therefore decided to focus my speech tonight on something that is perhaps a little spicier than our desserts. The topic of my speech is “Fast, but sustainable? Challenges and policy-options for the catching-up process of central and eastern European countries”. While I will concentrate on central and eastern European (CEE) countries that are Member States of the European Union (EU) – given that this region lies in the area of my responsibility – I am confident that some of the key points I discuss tonight will also be of interest to countries in south-eastern Europe.
Since the fall of the Iron Curtain 18 years ago the Central and Eastern Europe countries have made remarkable progress with regard to improving their standards of living. Their income levels have been gradually converging towards those of the euro area. Yet, as we all know, there continues to be a substantial gap in their income per capita relative to the euro area. Thus, one main policy challenge for the central and eastern European countries is to maintain a strong and sustainable process of catching up with the euro area. That said, the current situation in several countries shows how difficult it is to follow a convergence path that is simultaneously fast and sustainable. In fact, a number of countries currently face substantial as well as rising domestic and external imbalances that may ultimately threaten the sustainability of their catching-up process.
Against this background, a number of important questions arise. What are the available policy options for these countries? What role does the underlying exchange rate regime play in the convergence process? In particular, are certain exchange rate regimes and monetary policy frameworks better suited to ensuring sufficiently stable macroeconomic conditions to make the ongoing catching-up process in the central and eastern European countries sustainable?
Possible lessons to be drawn from former cohesion countries
Before looking in more detail at the central and eastern European countries, it might be useful to take a quick look at the catching-up experience of the former cohesion countries, namely Greece, Ireland, Portugal, and Spain, that are today part of the euro area. What can we learn from their experiences on their way to joining the euro? In this context, it is important to recall that there are a number of similarities, but also important differences between the cohesion countries at the time when they joined the European Union and the central and eastern European countries today. The main similarity is the relatively low GDP-per-capita level at the time of EU accession. Consequently, the cohesion countries also underwent a strong catching-up process in the 1990s, which resulted in high growth and inflation differentials with the more mature EU economies. Moreover, the former cohesion countries also experienced strong credit growth and large current account imbalances.
However, one important difference is that all four cohesion countries were able to make use of their monetary and exchange rate policy to adjust for emerging imbalances. Despite the fact that most cohesion countries participated in the exchange rate mechanism for two or more years, they were able to cushion the inflationary impact of real convergence by allowing the nominal exchange rate to appreciate. Another important difference is that the former cohesion countries had a different time horizon for their catching-up process compared with that currently envisaged for the CEE countries. For all of the cohesion countries, the time span between adopting the acquis communautaire, entering the EU, becoming part of the single market, participating in the exchange rate mechanism and eventually joining the euro area was over a decade. This might help to explain why the catching-up process in the cohesion countries appears to have been somewhat smoother than current experiences in some central and eastern European countries.
Current macroeconomic and financial challenges
Against this background, let me now briefly outline the main macroeconomic and financial challenges faced by the countries in central and eastern Europe. When grouping the countries according to their underlying monetary and exchange rate regimes, it seems that the countries with hard pegs – i.e. Bulgaria, Estonia, Latvia and Lithuania – experience rather similar macroeconomic and financial patterns. In recent years, these patterns have appeared to differ significantly from those faced by countries with more flexible exchange rates, namely the Czech Republic, Hungary, Poland, Romania and Slovakia. To give you a striking example of macroeconomic performance depending on the underlying exchange rate regime, the countries with hard peg regimes have recently experienced a very rapid catching-up process, with cumulative real GDP growth standing on average at 18% in the past two years, which is almost twice as fast as the growth rates observed in the countries with flexible regimes. To some extent, this might also reflect the fact that the income level in the fixed exchange rate countries is on average still somewhat lower compared with the countries with flexible rates. Likewise, inflation in the countries with hard peg exchange regimes was almost one and a half times higher in the past two years compared with the countries with flexible regimes.
The macroeconomic and financial developments in the CEE countries are puzzling in the sense that they are neither in line with economic theory, and nor do they reflect the empirical findings that are usually observed in other catching-up economies, including the cohesion countries in the 1990s. Let me explain this in more detail. While in the central and eastern European countries the economic performance differs substantially depending on the exchange rate regime, most theoretical models do not support the view that the choice of exchange rate regime should have an impact on macroeconomic performance. In turn, the empirical literature on the impact of the exchange rate regime on inflation basically suggests that countries with hard pegs usually display a better inflation performance compared with countries with floating exchange rates. This can be largely explained by the disciplinary device of the anchor currency and greater confidence, which should result in lower inflation volatility. Likewise, the empirical literature finds a link, although it is somewhat weaker, between the exchange rate regime and growth performance: Output growth is assumed to be weaker in countries with fixed regimes compared to countries with floating exchange rates. This is explained by higher productivity growth in countries with floating regimes as a result of faster growth in external trade, while productivity growth in fixed regimes might sometimes be reduced by the limited adjustment mechanism and thereby lower economic efficiency. However, these findings are countered by the current macroeconomic performance of the central and eastern European countries, as growth and inflation have been particularly high for a number of years in countries with fixed peg exchange regimes. What are the implications of these findings? In principle, it could be seen as an indication that, for some of these countries, the current situation might not be sustainable. This makes it all the more necessary to look more deeply at the macroeconomic developments and challenges ahead.
What key challenges are the CEE countries currently facing? The countries with hard peg exchange regimes are currently faced with three main challenges:
First, inflation is increasing sharply in the countries with hard peg regimes amidst signs of overheating in the form of labour shortages and strong upward pressures on wages. Growth in unit labour costs has increased dramatically over the past year, mainly driven by strong wage increases. Wage increases have been particularly strong in the construction sector, reflecting labour market bottlenecks, which are aggravated by substantial outflows of migrants.
Second, the very strong credit growth in past years of well above 40% was to a large extent supported by very favourable financing conditions, including negative real interest rates. Strong credit growth has boosted private domestic demand, inflation and imports. As a result of this, house prices have also boomed, in particular, in the Baltic countries, where they have on average doubled since 2004.
Third, the countries with hard pegs face substantial external imbalances – the four-month moving average of the current account deficit increased strongly over the past two years to around 17% of GDP. The deficit largely stems from robust private consumption growth. Together with high external debt ratios and high foreign currency borrowing, external imbalances of this magnitude make the countries vulnerable to external and financial shocks.
The key challenges for countries with flexible exchange rates – which are currently undergoing a somewhat slower catching-up process – are as follows:
First, fiscal policy has been very loose, with fiscal deficits standing on average at above 4% of GDP. Fiscal consolidation efforts have been limited in the past and a number of countries are in an excessive deficit situation.
Second, inflationary pressures continue to be more muted, but are likely to increase once the catching-up process gains momentum and will pick-up more strongly than in the past. For a credible monetary policy, this implies standing ready to tighten monetary policy in order to ensure price stability at a time of stronger growth.
This brings me to the key question regarding what policy options are available to address the macroeconomic and financial challenges. I basically see four areas for possible policy intervention: fiscal policy, structural policy, supervisory and prudential policy and, last, but not least, monetary and exchange rate policy. It goes without saying that the available policy options differ across countries and need to be carefully examined on a case-by-case basis.
On the fiscal side, consolidation efforts need to be intensified, in particular, in the countries with floating exchange rates, and the efficiency of public expenditure improved. Countries with hard peg regimes, in particular, should not only avoid pro-cyclical positions, but in some cases, their cyclical situation may warrant a quite substantial increase in their budget surpluses in order to contribute to reigning in domestic demand. In this context, it is worth keeping in mind that any assessment of the fiscal stance is highly uncertain given the difficulties involved in disentangling the trend from the cycle. As there is some evidence that the size of structural budgetary improvements seems to be constantly overstated, additional prudence is required in the conduct of fiscal policy. Moreover, it is important to prevent wage pressures in the public sector from spilling over into the private sector and to bring the provisions of the tax-benefit system more into line with the requirement to avoid labour market bottlenecks and allow for sufficient flexibility within the economy.
As regards structural policy, there are several ways to improve the supply side conditions and to enhance economic flexibility in the product and labour markets. These measures aim, for example, at improving the wage formation process, fostering labour mobility between sectors and regions and enhancing competition in product markets. To reduce pressures on the housing market, a lower level of regulation, as well as lower tax incentives, might be warranted.
Supervisory and prudential polices can also play a complementary role in reducing strong credit growth and ensuring financial stability. Supervisory action can cover a wide range of measures, from “softer” measures, like moral suasion, to more intrusive ones, such as laying down additional requirements for risk management.
The availability of monetary and exchange rate policy options obviously differs depending on the underlying exchange rate regime.
The ultimate question for a country is which monetary policy and exchange rate regime is best suited to ensuring a fast and stable convergence process. Let me stress at this point that the relevant question to discuss is not a general discourse about the pros and cons of fixed versus flexible exchange rates – we should not try to apply this more academic debate to the central and eastern European countries as a whole. In the same vein, I also do not buy the opposing argument that I hear from time to time, namely that rushing into the euro would solve all the problems experienced by the central and eastern European countries. Rather, the relevant question to ask is whether any exchange rate system is better suited for a country to cope with the country-specific challenges arising from real convergence. Obviously, this can only be assessed on a country-by-country basis.
Irrespective of the exchange rate regime, the central and eastern European countries still need to implement all necessary reforms in the areas of fiscal, structural and prudential policies. In fact, these policies should be seen as complementary to the monetary and exchange rate policy.
Let me conclude. The central and eastern European countries are currently faced with substantial challenges as far as their catching-up processes are concerned. Even if an early adoption of the euro seems unrealistic at the present juncture for most countries, it would be wrong to assume that the current problems can be easily solved by joining the euro area before a fully sustainable level of convergence has been achieved. In the end, it is more important for the CEE countries to further build on their impressive achievements than to run the risk of facing additional problems if they enter monetary union too early in their convergence process. A sustainable level of convergence is in the interests of both the applicant country and the euro area as a whole.
Notwithstanding the need for high standards for the convergence process, it should be kept in mind that the enlargement of the euro area is an on-going process. The countries of central and eastern Europe have already made substantial progress on their way towards adopting the euro. ERM II has been greatly expanded since 2004, with seven Member States currently participating in it. Moreover, a number of countries have already joined or are about to join the euro area since the launch of the euro in 1999. Thus, there is no reason to assume that the door might one day be closed. If the right policies are applied, I am confident that the central and eastern European countries will master the challenges of convergence in the years ahead.
Thank you for your attention and I wish you a sweet dessert and a fruitful and enjoyable second day of the conference tomorrow!