1. Economic Update New Growth Gradients, New Risks Europe and Central Asia Region The World Bank Office of the Chief Economist Poverty and Economic Management Sector Management Unit Human Development Sector Management Unit Private and Financial Sector Management Unit Annual Meetings Washington DC, September 23, 2011

2. ECA was hit hardest GDP Growth Projections, % 2

3. Main points 1.Economic recovery is underway, but it is slow Growth rates are about 2/3 of the pre-crisis rates 2.Job creation is lagging 1 in 8 workers are jobless, 3 in 10 young adults are unemployed The employed are working fewer hours 3.Public finance buffers have shrunk Public debt to GDP ratios are over a third higher than 2007 Fiscal consolidation has become necessary 4.Private finance has stabilized Credit is slowly picking up in most ECA countries Banking flows have been stable in Central and Southeastern Europe, but not among the oil and commodity exporters in the East 5.Risks are growing because of Southern Europe The Eurozone is the region’s biggest trade partner Greek and Italian banks operate in ECA, and Austrian, Swedish and French banks both in ECA and in the Eurozone’s troubled periphery 3 ECA Economic Update September 2011

4. Europe was hit harder in 2009 o Most countries had negative growth rates o And in some cases real GDP declines were in double digits Real GDP growth in 2009, % 4

5. Real GDP growth in 2010, % 5 Quicker pick-up in the East in 2010

6. 2011 has been good, so far o Growth projections are encouraging, even if lower than mid-year o All ECA countries are expected to grow this year Real GDP Growth in 2011 (projection), % 6

7. 2012 could be a good year too Real GDP Growth in 2012 (projection), % 7

8. 2011 GDP compares well with 2007 GDP is below its 2007 level in only 8 out of 30 ECA countries The Eastern part of ECA has fared better than the West Deviations of 2011 real GDP from the 2007 level 8

9. But the recovery signals a lower growth gradient The loss of income relative to pre-crisis trends is striking There has been a noticeable reduction in growth prospects Deviations of 2011 real GDP from the 1997-2007 trend for 2011 9

10. Unemployment rates (percent, latest available) Youth unemployment rates in select ECA countries (percent, Q1 2011) o Unemployment increased during the crisis; 1 in 8 are unemployed o Youth unemployment is a concern; 3 in 10 young adults are unemployed Job loss remains a big concern 10 Source: Employment Monitor-- http://go.worldbank.org/B8MMAI31I0

11. Percentage point change in unemployment rates in select ECA countries between Q1 2010 and Q1 2011 (or latest available quarter) o Unemployment has dropped since the early 2010 peak o Only a few exceptions: Bulgaria, Croatia, Slovenia, Moldova and Hungary Some jobs are returning 11 Source: Employment Monitor-- http://go.worldbank.org/B8MMAI31I0

12. The crisis hit public finances o Pre-crisis: structural fiscal imbalances masked by revenue over-performance o During the crisis: sharp fiscal deterioration in most ECA countries Fiscal balance in 2007 and 2010, percent of GDP 12

13. Fiscal consolidation is now a priority o Public debt increased during crisis and buffers are in some cases exhausted. o In most other countries buffers are limited Public debt in 2007 and 2010, percent of GDP 13

14. 5-year credit default swap spreads and public debt (Eurozone and ECA countries) Markets are now looking more closely at fiscal vulnerabilities Average in 2008August 2011 14

15. Immediate challenge: Systematic fiscal consolidation, not ad hoc expenditure cuts Markets are paying more attention to fiscal vulnerabilities now Growth remains weak in emerging Europe Oil rich countries better off, though fiscal reserves have fallen Needed: pro-growth expenditure measures Long-term challenges: Aging will add to the fiscal pressures in health care and pension expenditures Public service delivery, and public employment, and social security Broader tax base in oil-rich countries Restored ability to use automatic stabilizers Needed: long-term fiscal sustainability, fiscal space for investments and better quality of public services Austerity ahead 15

16. Banking flows stable in the west, but declining towards the east o Western European banks have maintained exposures in and near the EU o But developments in the East mimic those in Asia during the 1997-98 crisis Source: BIS locational statistics. Note: The Asian crisis equals 100 in June 1997; based on exchange rate adjusted flows. Banking claims in ECA (Quarterly data; September 2008 = 100) 16

17. Credit slow to recover, but good signs before recent uncertainty o Decline from pre-crisis levels was sharp—but necessary o Some encouraging signs—now only five countries still in negative territory Annual private sector credit growth, June 2011, year-on-year 17

18. Main risk? Spillovers o Rescue packages have not assured markets and uncertainty has spread to other vulnerable countries (Spain and Italy) Credit Default Spreads, as of September 5, 2011 18

19. Transmission channels are both financial and real o Financial: Direct effect through parent banks in Greece and Italy and indirect effects through banks exposed to GIIPS (Austria, France, Germany) o Trade: A cycle of declines in export demand o Contagion: Policy coordination challenges in the Eurozone Source: BOPS, WDI. *2009 data for Bosnia and Herzegovina, Macedonia and Turkey. 2008 data for Albania and Azerbaijan. EU10 + 1: Bulgaria, Croatia, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, Slovakia and Slovenia. W. Balkans: Albania, Bosnia and Herzegovina, Macedonia and Serbia. MI CIS (middle-income CIS): Belarus, Kazakhstan, Russian Federation and Ukraine. LMI CIS (low-income and lower middle-income CIS): Armenia, Azerbaijan, Georgia, Kyrgyz Republic and Moldova. Foreign Claims on ECA countries by sector and type, 2010 19

20. Financial channel—direct effects o Greek banks are important in the Balkans; Italian banks in Central Europe o A fire sale of emerging Europe assets would compromise the recovery Importance of GIIPS banks in ECA countries, 2010 Sources: Bankscope, Bankers almanac, Central Banks, Banks' Annual Reports. Note: Data only include banks with at least 50% ownership in the respective subsidiaries. 20

21. Financial channel—indirect effects o Some banks in emerging Europe have limited exposure in GIIPS (Sweden and Austria), but interconnectedness in funding markets could trigger problems o As would be the case from weaker economic prospects in Europe Source: EBA. Note: Based on Stress test in 2011H1. SI: Slovenia, AT: Austria, BE: Belgium, CY: Cyprus, DK: Denmark, FR: France, DE: Germany, GR: Greece, IE: Ireland, IT: Italy, NL: Netherlands, PT: Portugal, ES: Spain, SE: Sweden, GB: United Kingdom. Net direct positions in GIIPS sovereign debt for European banks with subsidiaries or branches in ECA 21

22. Trade channel o 2011 was expected to result in export levels above those reached in 2008, but recovery of exports has so far been slow o And now a slowdown in global activity has increased downside risks Value of exports in 2010 and 2011 (2008 = 100) 22

23. Conclusion 23 ECA Economic Update September 2011 1.Economic recovery is slowing nearer the Eurozone Growth rates are about 2/3 of the pre-crisis rates 2.Joblessness remains high A slow recovery means that jobs will not return soon without reform 3.Treasuries are weaker now than they were in 2007 Public debt to GDP ratios are over a third higher than before the last crisis 4.Private financial flows are stable Credit is slowly picking up in most ECA countries and banking flows were recovering in Central and Southeastern Europe 5.Risks are growing again because of Southern Europe The Eurozone is the region’s biggest trade partner, Greek and Italian banks own banking assets in the region, and Others (Austria, France and Sweden) active in the region also have exposure in the Eurozone’s troubled periphery.