Prospects: Short and Long Vladimir Gligorov

Contents Changing monetary regime European challenges (changing policy framework) The Balkans: the adjustment problem

Changing Monetary Regime Interest rate hike is all but certain, but the timing is uncertain The uncertainty is fuelling the volatility of the exchange rates inter alia FED wants to normalise, to change the monetary regime, i.e. go to above 3 per cent rate in two years or so, but does not want to start the process and have to reverse course (as happened to ECB and Bank of Sweden, and also to the FED in 2007) However, the FED does not want to remain passive and miss the change in expectations because of too much dependency on the past data – it needs to get ahead of the curve at some point

Effects of Changed Monetary Regime Effects on the euro area: mostly positive, assuming non-perverse exchange rate reaction In part because lower euro does the work of the ECB for it (in terms of boosting inflation) Emerging markets challenged (if the history of past changes in monetary regimes are to go by) In part because of oil and commodity prices remaining depressed while currencies are devaluing

European Challenges Policy framework will continue to evolve, albeit slowly Public and intra-euro foreign debts will push for banking union and some elements of a fiscal union Risks of disintegration will increase as EU continues to underperform in supply of the basic public goods: security, justice, and welfare Assuming preserved political stability, or sustainable instability, growth prospects will continue to improve, however slowly

New Europe Convergence growth returns in the East and even in the South Mostly on the basis of export performance and better debt profiles in Central European and Eastern Balkan EU member states Especially in countries with strong exporting sectors

The Balkans The Balkans still face the adjustment problem due to, in part, rigid price and policy structure and low openness Examples: Greece and Croatia (slow export and investment recovery) Alternative examples: Serbia and Bulgaria (export recovers, but not investments) And political instability

Consumption, Deleveraging, and Investment Investment decline everywhere Consumption persistence Both of households and of governments Trade and current account deficits closing i.e. savings increasing (deleveraging) (all the data is from EUROSTAT, so some smaller Balkan countries are not covered, but they do not differ substantially)

Gross Fixed Capital Formation/GDP

Gross Capital Formation/GDP

Government’s Final Consumption/GDP

Household Final Consumption/GDP

Final Consumption/GDP

Consumption Beats Investment Final consumption (as a share of GDP) holds up (in smaller EU states and those in the South) Investment plunges Household consumption less volatile than government Consumption of households especially strong in the Balkans

Export Growth Exports have grown strongly in the crisis But less in Greece, Croatia, Spain, Portugal While much more in other Balkan countries and also in the Baltics Why? Basically because of the pre crisis loss of competitiveness and the post-crisis difference in the readiness to adjust

Exports/GDP

Imports/GDP

Exports, euro

Export and Import Growth, 2014/2008

Exports/GDP and GDP growth

Foreign Trade There is striking differentiation in export performance Where Southern EU countries (including Croatia) do worse or much worse than Balkan and Baltic countries One lesson: small economies can increase exports even if external demand is not improving and is even deteriorating (they are price takers) So, there is a supply problem in the export performance

Manufacturing On the supply side the problem is low share of the tradable sector In particular of manufacturing Both in Southern Europe and the Balkans

Manufacturing Value Added, % GDP

Growth, Manufacturing, Exports More open economies, in terms of exports to GDP, grow faster Higher share of manufacturing supports exports It helps to manufacture in order to grow (here exports of goods and services)

Growth and Exports

Growth and Manufacturing/GDP ( ), smaller less industrialised countries

Growth and Manufacturing/GDP ( ), EU plus some candidate countries

Manufacturing/GDP and Exports/GDP ( )

The Adjustment Problem If there is a loss of competitiveness and rigid exchange rate regime Adjustment has to go via decline of imports to achieve improvement in the current account, and with: Real exchange rate depreciation Decline in wages, and Increase in unemployment

Current Account

Exchange Rate and Employment Real depreciation especially strong in Greece and Croatia, but also in Spain and Portugal (this is USD REER ULC based against the rest of the world) Employment decreases and unemployment increases again more or less in the same group of countries

Real Effective Exchange Rates, 2010=100

Employment rate, 15-64

Employment rate, 25-54

Unemployment rate

Wages Nominal wages mainly held up But grew very slowly or not at all in Southern European and Balkan countries So, with inflation, mostly shared among this group of countries, that is reflected in the real exchange rate depreciation Increased unemployment serves to sap the growth of wages Serbian wages are given separately in euro to correct for the unusually high inflation In a number of countries wages have continued to increase, i.e. if there was no or little loss of competitiveness before 2009 (e.g. Poland and Romania)

Wages (nominal)

Wages (real, in euro)

Wages (nominal)

Productivity and Competitiveness Productivity improved in majority of the countries, though notably not in Greece, Hungary, Macedonia and not much in Croatia and Slovenia Unit labour costs adjusted in countries with overvalued real exchange rates before the crisis Higher wage share in GDP is not correlated with higher growth rates

Real Labour Productivity (2010=100)

Nominal Unit Labour Costs ( )

Wages and GDP

Public Debt/GDP Apart from Greece, Croatia and Serbia stand out There is a steep trend line in the chart showing the path of Croatian public debt Projections for are from the EU

Gross Public Debt/GDP

Legitimacy Risk In Macedonia and now in Montenegro, but also in Kosovo and Bosnia and Herzegovina there is either acute or chronic issue of legitimacy What is meant by that? Take the Montenegrin case first, and then the Macedonian one Finally the case of Bosnia and Herzegovina

Prospects for Growth Assumptions and Potential (this mostly applies to the Balkan less open economies) Slow growth of household final consumption, e.g. 1 percent No growth in government final consumption Strong increase in investment Faster growth of exports than imports Potential growth rate for countries like Croatia, Serbia, and most other less open economies, is about 3 percent – in next 5 years or so Assuming adjustment is accomplished by the end of that period with no dramatic changes in the external environment, potential growth rate could be somewhere between 4 and 5 percent as long as employment rates reach the levels characteristic for more developed economies in Europe

Conclusions Monetary regime is changing – interest rates are going to get detached from zero Energy and commodity prices should stay low EU and euro area, barring major destabilisation, should benefit from the changed monetary regime and low import prices Central European countries should benefit from sustainable overall policy framework and from increased prospects for exports Balkan countries and others that face sustainability issues will have to transit to more sustainable macroeconomic conditions with slower potential growth of up to 3 percent in next 5 years or so