Wiener Institut für Internationale Wirtschaftsvergleiche The Vienna Institute for International Economic Studies IDEAS Conference, Delhi 29 January 2012 Session on: Economic integration and its impact Current state and crisis of Europe’s model of integration Michael A Landesmann

 wiiw 2 Main Issues  What is at the root of the crisis in Europe?  Is the Euro-zone going to pull through? In which shape?  What is the predicament of Europe’s ‘periphery’?  Pitfalls in the ‘European integration model of growth and convergence’?  More generally: growth and catching-up in an era of financial market integration

 wiiw 3 What is at the root of the crisis in Europe? Why is EU more hit than other advanced economies?  No-bail-out clause plus constitution of the ECB makes the Euro-zone very vulnerable in times of very nervous financial markets; but the additional important ingredient is:  Pronounced developments of external imbalances within the Euro-zone, driven by financial market integration and – mostly – fast private sector debt accumulation  Policy-mechanisms to deal with these imbalances non-existent or in-effective: no established crisis management mechanism at EU/Euro level (ECB mandate, no pooling of debt responsibility; no fiscal stabilisation function); financial markets insufficiently (and nationally) regulated;  real exchange rates diverge persistently driven by capital inflows (interest rate convergence before the crisis); relative price adjustment very slow – hence, during the crisis, rebalancing through incomes;

 wiiw 4 Current state of the crisis in Europe  Banks very weak; no effective re-capitalisation; implicit liability of states – sovereign debt problem and feed-back processes; national segmentation of responsibility and differentiated vulnerability of countries persists – very slow move towards some ‘mutualisation of debt’  Austerity in fiscal policies, deleveraging processes (corporate, households, banks) generate stagnation; sustainability of debt of both private and public sectors judged (by markets) as unresolved; banking and sovereign debt crisis could further escalate  Any resolution in sight?

 wiiw 5 Policy master-plan?  Exclusive focus on fiscal consolidation: Germany sees this as a pre- condition for any move towards joint action/mutualisation on the debt problem and widening ECB’s mandate – focus to bring long-term public debt ratios down (constitutional amendments; tightening of fiscal control)  Recapitalisation of banks asked for, but happens through shrinkage of balance sheets – credit crunch  Some moves towards EU-wide regulatory and supervisory bodies; but lacking teeth so far; in the short-run more national segmentation of banking  Measures to monitor development of competitiveness in the future; details to be worked out; unlikely to be very effective  No growth strategy, except lip-service to change revenue and expenditure structures in ‘growth enhancing’ manner; plus liberalisation

 wiiw 6 Is the Euro-zone going to pull through? In which shape?  Economic issues: - recession(s) 2012/13; then medium-term stagnation/low growth - unfolding of fiscal consolidation; widening of ECB activity – important transitory role; slow build-up of EFSF/ESM (role vis-a-vis banking system and sovereign debt); Greek default – contagion effects – ‘ring-fencing’; access to capital markets will remain/become very problematic for a range of countries (IT,SP,PO,GR,HU, Ro, IRL,...); bank collapses and contagion a possibility  Political issues: - How are polities going to react? espec. in high austerity countries - Technocratic handling of the crisis; reaction against MerkMontozy; tensions in and towards inter-governmental processes; reactions in national polities and parliaments; field for populist/nationalist parties; little debate on alternative strategies

 wiiw 7 The predicament of Europe’s ‘periphery’  In many countries (Southern and Eastern periphery) high debt levels of private sectors (corporate and household sectors) – deleveraging processes; public sector debt has significantly increased  Foreign banks in retrenchment – credit constraints severe; cross-border banking goes through a process of re-nationalisation  Current accounts adjust strongly – mechanisms different in fix- and flex-exchange rate countries; big differences across countries in underlying strength of export sector; in a range of economies strong legacy of distorted tradable/non- tradable sector structures  FDI and inward capital flows sharply down – ‘catching-up model’ (‘downhill capital flows’) will have to be significantly rethought (stronger focus on industrial policy; emphasis on tradable sector; less reliance on fixed exch. regimes; EMU?)

 wiiw 8 Economic Integration and Emerging Economies: general issues emerging from the crisis  International financial markets integration can strongly accentuate the possibility of external and internal imbalances  Exchange rate regimes are very important in this context  Catching-up processes can be seriously derailed due to the build-up of imbalances  Impact on distorting economic structures (domestic savings behaviour, capital allocations across tradable/non-tradable sectors, asset prices, competitiveness – real exchange rates, etc.)  The setting for catching-up economies in (EU)rope is special: affects not only EU members but also economies in the neighbourhood (e.g. Balkans)

 wiiw 9 The European integration model of catching-up  targeted at ‘deep integration’ with the EU/Euro area  associated with very far-reaching internal and external liberalization (trade, capital transactions, financial market integration, labour mobility)  benefits: ‘downhill’ capital inflows, trade integration, ‘technology’ transfer; institutional convergence  the model worked - ‘convergence process’ – but emergence of severe structural imbalances in important groups of European EMEs; heterogeneity of pre- and post-crisis experience of European EMEs

 wiiw 10 Growth – GDP at constant prices Average annual growth rates, , in %

 wiiw 11 European periphery and comparisons with other emerging economies  CE-5: Czech Republic, Hungary, Poland, Slovakia and Slovenia  BB-5: Bulgaria, Romania (SE-2); Estonia, Latvia, Lithuania (B-3)  WB-6: Albania, Bosnia and Herzegovina, Croatia, Former Yugoslav Republic of Macedonia, Montenegro and Serbia;  EU-Coh: Greece, Portugal, Spain  Asia-6: Indonesia, Korea, Malaysia, Philippines, Taiwan and Thailand  Latam-8: Argentina, Brazil, Chile, Columbia, Ecuador, Mexico, Peru and Uruguay

 wiiw 12 Composition of the current account of the balance of payments, Note: ASIA-6 excl. Taiwan. Source: IMF International Financial Statistics and IMF WEO October 2010.

 wiiw 13 Net private financial flows in % of GDP, Source: IMF Balance of Payments Statistics. ASIA-6 excl. Taiwan. LATAM-8 ASIA-6MENA-6 EU-COH CE-5 SEE-2 B-3 WB-6 TR

 wiiw 14 Credit to the private sector (%GDP, )

 wiiw 15 Financial integration - Changes in: (i) assets plus liabilities; (ii) credit to private sector in % of GDP (percentage point change), Note: Assets and liabilities: EU-COH: %; WB-6: %. Source: IMF International Financial Statistics. ASIA-6 excl. Taiwan, MENA-6 excl. Lebanon.

 wiiw 16 External debt: public and private (% of GDP), 2008 Note: ASIA-4 excl. PH, TW. MENA-4 excl. LB, SY. B-3 excl. FYROM, BA, RS. Source: World Bank, World Databank.

 wiiw 17 External debt: public and private (% of GDP), 2008 Note: ASIA-4 excl. PH, TW. MENA-4 excl. LB, SY. B-3 excl. FYROM, BA, RS. Source: World Bank, World Databank.

 wiiw 18 CESEE: GDP growth was well above the interest rate before the crisis Nominal interest rate on government debt and nominal GDP growth (%), Note: Interest rate = government interest expenditures / previous year gross debt.

 wiiw 19 Debt in % of GDP Gross external debtPublic debtPrivate debt Source: wiiw Annual Database incorporating Eurostat statistics.

 wiiw 20 Debt in % of GDP Gross external debtPublic debtPrivate debt Source: wiiw Annual Database incorporating Eurostat statistics.

 wiiw 21 Foreign bank ownership, (assets owned by foreign banks as % of banking system assets) Note: ASIA-6 excl. Taiwan, MENA-6 excl. Syria. Source: from Claessens et al (2008). B-3 SEE-2 WB-6 CE-2 LATAM-8 MENA-6 Turkey ASIA-6

 wiiw 22 Industrial Production - Index 1993=100, 2000, 2008 Note: ASIA-6 excl. Taiwan. B-SEE excl. Bosnia and Herzegovina, Montenegro and Serbia. Source: World Bank.

 wiiw 23 Differences in the composition of FDI 23 Large part in manufacturing, infrastructure, trade in central Europe Large part in real estate, finance in Baltic region

 wiiw 24 Real exchange rate developments, 1995 to 2010 Appreciation hand-in- hand with catching-up in Central Europe Misalignment in the Baltics/Balkans Stable real X-rate in Asia post crisis

 wiiw 25 Growth - GDP at constant prices Average annual growth rates, , in % Source: IMF World Economic Outlook, October EBRD and wiiw Annual Database incorporating national statistics, Eurostat..

 wiiw 26 Summarizing some of the features of European EMEs  High growth prior to the crisis  High indicators for openness: particularly strong growth in international financial integration  Much greater role of foreign banks in European EMEs compared to other EMEs  Fast growth of credit to private sector in many European EMEs  Public debt situation not that different between European EMEs and other EMEs  Differences in industrial production growth and the build-up of export capacity in different EMEs  Clear link between private credit growth and current account deterioration; and hence foreign debt positions

 wiiw 27 Summary: Specific features of European EMEs  Opening of the capital account: a rule of the game in the EU; deep financial integration  Reliance on massive imports of capital; only 4 CESEE-countries could avoid skyrocketing external (private) debt  Bank credit: the overwhelming source of external funding  Financial integration: major channel for transmitting shocks (EU- Coh, B-SEE regions hit hardest by the crisis)  So far no meltdown of financial systems in CESEE - advantage of the presence of foreign banks?  Differentiation across CESEE economies linked to extent of build- up of industrial production and export capacity

 wiiw 28 Principal policy lessons:  In national and EU policy frameworks: neglect of private sector debt build-up relative to public sector  Financial market regulation severely underdeveloped; specific issue in CESEE region: high level of cross-border banking  Fixed exchange rate regimes bear high risks; but what are the options of highly euroized EU members and candidates?  Current situation characterised by very fragile banking system; protracted deleveraging processes; strong financial market pressure prevents use of fiscal space;  Consequence: ‘European integration model of growth’ requires severe re-shaping

 wiiw 29 Real exchange rate developments 2003=100, CPI deflated Source: IMF: International Financial Statistics, wiiw calculation.

 wiiw 30 Relationship between pre-crisis credit growth and current account balances Source: IMF World Economic Outlook. average CA/GDP Change in credit/GDP

 wiiw 31 Structural features: European and other EMEs LATAM-8ASIA-6MENA-6CE-5EU-COHB-SEE Credit/GDP, change from 2004 to 2008 (percentage points) Real interest rate average, Current account balance/GDP, 2007 (%) Gross external debt, 2009 (% of GDP) GDP growth, Source: wiiw calculations.

 wiiw 32 Structural features: the role of exchange rate regimes ‘Fixers’ and ‘floaters’ amongst the CESEEs CESEE floatCESEE fix Credit/GDP, change from 2004 to 2008 (percentage points) Real interest rate average, Current account balance/GDP, 2007 (%) Gross external debt, 2009 (% of GDP) GDP-growth, FDI to finance and real estate sectors, 2007 (per cent of total FDI stock) Change in unemployment rate from 2007 to 2010 (percentage points) Source: wiiw calculations.

 wiiw 33 GDP development, =100 Source: wiiw forecast and IMF World Economic Outlook, October WB-6 CE-5 SEE-2 B-3 EU-COH LATAM-8 ASIA-6 TR

 wiiw 34 GDP development, =100 Source: wiiw forecast and IMF World Economic Outlook, October WB-6 CE-5 SEE-2 B-3 EU-COH LATAM-8 ASIA-6 TR MENA-6

 wiiw 35 General government gross debt (% of GDP), Source: IMF World Economic Outlook.

 wiiw 36 Unemployment at high levels registered unemployment rates in % Source: wiiw Monthly Database. Latvia Lithuania Romania

 wiiw 37 Indicators - country groups: Pop, GDP, GDP per capita 2008 Population, total (mn) GDP (USD bn) GDP, PPP (USD bn) GDP per capita (USD) GDP, PPP per capita (USD) 2008 LATAM ASIA MENA EU-COH CE SEE B WB Turkey B-SEE Source: World Bank, World Databank, wiiw calculation.