Will catching-up continue smoothly in the “new” EU Members? Juergen Kroeger Director DG Economic and Financial Affairs European Commission 13 th Dubrovnik Economic Conference June 27 th to July 1 st, 2007, Disclaimer: The views expressed in this presentation are the author’s own and should not be regarded as stating an official position of the European Commission.

2 Outline 1.“New” MS: successful catching-up but imbalances 2.“Floaters”: mostly fiscal imbalances  situation and policy; 3.“Fixers”: private sector / financial imbalances  situation and policies; 4.Conclusions

3 STYLIZED FACTS OF SUCCESSFUL REAL CATCHING-UP Phase 1 : Upswing  Initially real expected rate of upturn has to be high  In order to avoid overheating monetary policy has to be used, not fiscal policy  Tight money in the upswing is necessary to  Contain inflation  Establish demand supply equilibrium  Help establishing inter temporal equilibrium  Appreciation reduces import costs  Current account deficit, covered by FDI, is a counterpart to fill the supply-demand gap.

4 STYLIZED FACTS OF SUCCESSFUL REAL CATCHING-UP Phase 2 : Consolidation  Higher investment increases the capital stock : Potential output rises  Domestic supply approaches domestic demand  The marginal real rate of return shrinks to the level of partner countries  Monetary policy is gradually easing  Net exports rising as exchange rate depreciates  Current account moving towards a sustainable level

5 1.“New” MS: successful catching-up but imbalances Growth and per-capita income figures indicate that catching- up has been successful…

6 1.“New” MS: successful catching-up but imbalances …but other indicators, esp. current account deficits, suggest potential problems ahead, in particular in “fixers”: “ Fixers”

7 1.“New” MS: successful catching-up but imbalances In some cases, FDI-financing of C/A-deficits is small and/or decreasing: “F I X E R S”

8 1.“New” MS: successful catching-up but imbalances C/A deficits are private sector-driven in “fixers”, while being more public sector-driven in “floaters”: “F I X E R S” “F L O A T E R S”

9 2. “Floaters”: mostly fiscal imbalances Room for fiscal consolidation and expenditure rationalization:

10 3. “Fixers”: mostly private sector / financial imbalances –Against a backdrop of negative real interest rates… “F I X E R S”

11 3. “Fixers”: mostly private sector / financial imbalances –…high growth in “fixers” predominantly driven by high domestic consumption, while external contribution negative: “F I x e r s” “F l o a t e r s”

12 3. “Fixers”: mostly private sector / financial imbalances –Although investment remains strong, it consists to a substantial extent of construction: “Fixers”

13 3. “Fixers”: mostly private sector / financial imbalances –And the share of the construction sector in GDP is quite large and growing: “Fixers”

14 3. “Fixers”: mostly private sector / financial imbalances –Unit labour cost developments do not bode well for external competitiveness: “Fixers”

15 3. “Fixers”: mostly private sector / financial imbalances –Credit growth is reaching staggering levels… “Fixers”

16 3. “Fixers”: mostly private sector / financial imbalances –…with credits to households growing particularly fast… (Y-o-y, end-2006)

17 3. “Fixers”: mostly private sector / financial imbalances –…and foreign currency lending often dominating: Foreign currency lending as a % of total outstanding credit, 2005

18 3. “Fixers”: mostly private sector / financial imbalances –While real estate prices are high… Source: Bank of Latvia

19 4. Conclusions Catching-up has been successful but there are signs of overheating in the “fixers” (and RO), which could hamper the efficient resource allocation and endanger smooth further real convergence; The remaining policy instruments of the “fixers” to cope with the situation are limited to fiscal policy and structural policies (in particular related to the financial sector); This could be a lesson for the “floaters” (see e.g. RO) not to peg their exchange rate too early or manage it too tightly and to contain balance sheet exposures to exchange rate movements;