The Future of Growth in CESEE Presentation at EBRD London, 13 February 2018 Bas B. Bakker Senior Regional Resident Representative for Central, Eastern and Southeastern Europe
CESEE had a very deep crisis in 2008/09 15 GDP growth (Percent) 10 5 CE-5 Baltics CIS SEE EU SEE non-eu 0-5 -10-15 2000 2002 2004 2006 2008 2010 2012 2014 2016 2
albeit with significant cross-country differences 3
In most CESEE countries, GDP per capita is well above pre-crisis levels 4
Growth is not as high as in the pre-crisis years 15 10 5 0-5 Real GDP growth in CESEE excl. CIS (Percent) Max Average Min 2007 level -10-15 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 5
2 year average employment growth But employment growth in many countries is as high as during pre-crisis peaks. GDP growth vs. employment growth (Percent, 2 year average) 3 CE-5 2 SEE 2 1 0 Post-crisis 2013 2012 2017 2016 2015 2014 2002 2003 2007 2006 2005 2004 1 0-1 -2 Post-crisis 2015 2014 2013 2012 2017 2016 2007 2006 2005 2004 Pre-crisis 2003 2002 Pre-crisis -1-3 0 1 2 3 4 5 6 7 0 2 4 6 8 2 year average GDP growth 6
Unemployment is coming down rapidly and is now below pre-crisis levels 14 Cumulative Changes in Unemployment Rate (2008Q1=0, seasonally adjusted) 14 14 12 12 12 10 10 10 SRB 8 EST LTU 6 LVA 4 SVK HUN 2 POL 0-2 -4 2007 2010 2013 2016 CZE 8 HRV 6 4 SVN BGR 2 ROU 0-2 -4 2007 2010 2013 2016 8 6 4 2 0-2 -4 MNE BIH ALB* MKD 2017Q3: -12.2 2008 2010 2012 2014 2016 *For ALB 2012Q1=0 7
Despite this rapid fall, in 2014-16, inflation was very low in CESEE even lower than in Western Europe 8 CPI Inflation (Percent) 6 4 CESEE excl. CIS 2 Euro Area 0-2 2008 2009 2010 2011 2012 2013 2014 2015 2016
In 2017 inflation picked up 8 CPI Inflation (Percent) 6 4 CESEE excl. CIS 2 Euro Area 0-2 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018
Energy and food prices played key role in resurgence of inflation 40 Oil and Food Prices (Percent, Y/Y, 6 months moving average) 30 20 10 0-10 -20-30 -40-50 Oil Price Food and Beverage Price Index 2013 2014 2015 2016 2017 10
However, wage growth has also notably accelerated over the past two years 18 Nominal Wage Growth (Percent, Y/Y) 16 14 12 10 8 6 4 2017Q3 2015Q4 2 0-2 MNE BIH MKD SRB POL HRV LVA SVN CZE SVK LTU EST BGR HUN ROU 11
Outlook for Western Europe is for continued recovery and low interest rates 5 Real GDP Growth in Euro Area (Percent) 4.5 Euro Area Policy Rate and Its Forecast (Percent) 4 4.0 3 2 1 0-1 -2-3 -4 3.5 3.0 2.5 2.0 1.5 1.0 0.5 ECB Survey of Professional Forecasters -5 2000 2003 2006 2009 2012 2015 2018 0.0 2008 2010 2012 2014 2016 2018 12
This makes it likely that rapid growth will continue. Question: What will it imply for the labor markets? 3 Employment and Working Age Population Growth in CESEE (Excl. TUR and CIS, percent) 2 Employment growth 1 0-1 -2 Working Age Population Growth and UN projection -3 2005 2007 2009 2011 2013 2015 2017 13
According to WEO estimates, output gaps in most countries are now closed 14
Outside the labor market, there are no signs of overheating Inflation is modest Current account deficits remain low and capital inflows are low Credit growth does not much exceed GDP growth 15
Tightening labor markets and low inflation may continue to co-exist in the near future Much of inflation in CESEE depends on Food and energy prices Imported inflation Exchange rate appreciation in some countries may keep inflation low 16
Pre-crisis, inflation really picked up only in 2007-08, when oil shock added to tight labor markets 7 CPI Inflation in CESEE (Percent, excl. CIS) 6 5 4 3 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 17
Even if rapid growth of wages does not lead to pick-up of inflation, it may still affect the economy If firms absorb rising labor costs, profit margins will decline Decline of profit shares will Reduce investment Reduce competitiveness 18
Low inflation does not necessarily mean that growth is sustainable In pre-crisis years we overestimated potential output growth in advanced countries because core inflation remained low 3 2 1 0-1 -2 3.0 2.8 2.6 Output Gap in and Potential Output Growth in Advanced Economies: 1995-2006, percent Output Gap WEO Fall 2017 WEO Fall 2006 1995 1997 1999 2001 2003 2005 WEO Fall 2006 2.4 WEO Fall 2017 2.2 2.0 Potential Output Growth 1995 1997 1999 2001 2003 2005 19
IMPLICATIONS FOR CYCLICAL POLICIES 20
This would be the good time to create fiscal space and reduce structural deficits Particularly given that debt is much higher than pre-crisis levels. 100 90 General Government Debt (Percent of GDP) 80 70 60 2017 50 40 2007 30 20 10 0 EST UVK BGR CZE LVA LTU ROU MKD BIH SVK POL ALB SRB MNE HUN SVN HRV UKR 21
Unfortunately, many countries are reverting to pro-cyclical loosening 3 2 General Government Structural Balance (Percent of GDP) 2016 1 0-1 -2-3 2018-4 -5-6 ROU POL HUN SVN HRV EST SRB SVK BGR LVA LTU BIH CZE 22
Monetary policy will only be an option in countries with floating exchange rates They can let exchange rate appreciate They can raise interest rates Countries with fixed exchange rates or the euro have the most challenges: Nominal interest rates are likely to stay low (in line with ECB rates) Real interest rates will then decline as inflation/wages pick up 23
Pre-crisis, countries with floating exchange rates found it easier to keep inflation low 12 CPI Inflation (Percent) 10 Fixers 8 6 4 Floaters 2 0 2004 2005 2006 2007 2008 2009 2010 2011 2012 Note: Fixers include BGR, EST, HRV, LVA, LTU, SVN and SVK. Floaters include CZE, HUN, POL and ROU. 24
and were able to mitigate the boom-busts. 10 Real GDP Growth (Percent) 8 6 4 2 0-2 -4-6 Fixers Floaters -8 2000 2002 2004 2006 2008 2010 2012 Note: Fixers include BIH, BGR, EST, HRV, LVA, LTU, SVN and SVK. Floaters include ALB, CZE, HUN, POL, ROU and SRB. 25
IMPLICATIONS FOR STRUCTURAL POLICIES 26
Potential output growth is well below pre-crisis levels. Potential Output and GDP Growth (Percent) 6 CE-5 GDP growth, 3 year moving average 8 SEE EU GDP growth, 3 year moving average 12 10 Baltics GDP growth, 3 year moving average 5 6 8 4 3 Potential output growth 4 2 Potential output growth 6 4 2 0 Potential output growth 2 0-2 -4 1 2002 2005 2008 2011 2014 2017-2 2002 2005 2008 2011 2014 2017-6 2002 2005 2008 2011 2014 2017 27
Why has potential GDP growth slowed? TFP growth has slowed That means same investment yields less output increase Lower return on investment leads to decline of investment, further reducing growth 28
To understand this, let s look at Solow- Swan growth model In Solow-Swan growth model, long-term growth depends on n+g n=growth of working age population g=growth of labor augmenting technological progress (which is equal to TFP growth/labor share) 29
According to Solow-Swan, in long term, GDP growth does not depend on investment rate Higher investment rate without increase in n+g will initially lead to higher GDP growth rate But as capital-output ratio rises, growth rate falls back to old level (Of course investment rate does matter for income levels) (Government investment may boost TFP and be better for growth than government consumption) 30
What would we expect to happen if n+g slows down? Lower GDP growth If investment rate unchanged, capital-output ratio will rise and return on capital will drop Investment will likely fall in response to drop in returns, which will further reduce GDP growth (in the short term) So we would expect both lower growth and lower investment This is precisely what happened. 31
n+g has slowed down 12 Working Age Population + Labor Augmenting Technological Growth (Percent, 5 year moving averages) 10 8 6 4 2 CE5 Baltics SEE EU 0-2 SEE non-eu -4 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 32
Much of this reflects lower TFP growth 6 TFP Growth (Percent, 5-year moving average) 5 4 3 SEE non-eu Baltics SEE EU 2 1 CE-5 0-1 -2 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 33
But working age population growth has come down as well 0.5 Working Age Population Growth (Population ages 15-64 years, 5 year moving average) 0.0-0.5-1.0 SEE non-eu CE-5 SEE EU -1.5 Baltics -2.0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 34
Output growth has slowed and investment rates are lower 10 GDP growth (Percent, 3 year moving average) 33 Investment Rate (Percent of GDP, 3 year moving average) 8 6 31 29 Baltics SEE EU 4 2 0 CE-5 Baltics SEE EU SEE non-eu 27 25 23 21 CE-5-2 19 SEE non-eu* -4 17-6 2002 2004 2006 2008 2010 2012 2014 2016 15 2002 2004 2006 2008 2010 2012 2014 2016 *Excl. MKD 35
Fall in TFP is a global problem 1.5 TFP growth (Percent, 5 year moving average) 1.0 0.5 USA 0.0-0.5 EU15-1.0 2000 2002 2004 2006 2008 2010 2012 2014 2016 36
Why has global TFP growth slowed? 37
Several interrelated factors have played a role Measurement issues may have played a role, but most of TFP slowdown seems genuine Weak corporate balance sheets, combined with tight credit conditions, have undermined TFP growth, partly by constraining investment in intangible assets in distressed firms. An adverse feedback loop of weak aggregate demand, investment, and capital-embodied technological change seems to have afflicted the advanced economies. Elevated economic and policy uncertainty may have further weakened TFP growth, partly by tilting investment away from higher-risk, higher-return projects. 38
What can be done to boost TFP growth Address several problems Limited access to financial services (e.g. for SMEs) Infrastructural gaps Inefficient legal systems and other government services 39
Improve institutions, especially judiciary Judicial Independence, 2015 Impartial Courts, 2015 Below 25 percentile Between 25 and 75 percentile Above 75 percentile Source: World Economic Forum. Note: Worldwide distribution excluding LICs 40
Institutional reforms provide large efficiency gains Better institutions hold the promise of retaining emigration of skilled workers Effective protection of property rights provides stronger incentives for investment Institutions affect innovation and productivity through enhanced trust, cooperation, commitment, and contract enforcement 41
TFP matters, because CESEE is still poorer than Western Europe 70 60 50 Real GDP per capita (Percent of Germany) CE-5 Baltics 40 30 SEE EU CIS 20 SEE non-eu 10 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 42
Continued convergence will necessitate faster TFP growth Faster TFP growth will not only raise GDP growth directly; it also increases the return on investment Increasing capital/labor without higher TFP will boost capital output ratio and lower return on capital 43
Capital-output ratios in many CESEE countries are no longer low compared with Western Europe 3.5 Capital Output Ratio (Percent) 3.0 DEU EST 2.5 2.0 HRV BGR 1.5 2000 2002 2004 2006 2008 2010 2012 2014 2016 44
Employment to population ratio in 2016 (Percent) Even though capital per worker is still low. Capital per Worker vs. Employment to Population Ratio 50 45 40 MDA RUS UKR POL SRB BGR ROU LTU SVK EST SWE CZE LVA HUN SVN HRV DEU DNK NLD AUT GBR PRT FIN FRA IRL BEL ESP 35 30 ALB MKD MNE BIH TUR GRC ITA 25 20 0 100 200 300 400 500 600 700 Capital per worker in 2014 (Thousands of PPP dollars) 45
Concluding thoughts CESEE has done very nicely in recent years with strong growth and rapidly declining unemployment The challenge will be to continue this rapid growth Labor markets have tightened, and are likely to tighten further if strong growth continues If TFP growth does not pick up, growth cannot continue at this pace 46
Thank you
Supplemental slides
Solow-Swan rehash Output depends on the capital stock, employment, and labor-augmenting technological progress: Y t = K t A t L t 1 The labor force grows at rate n: The rate of technological progress is g: L t = L(0)e nt A t = A(0)e gt The capital stock is determined by investment minus depreciation: ሶ K t = sy t δk(t) 49
Long-run equilibrium Long-Run Equilibrium Path The growth rate of capital is: dy Y dk K = n + g = n + g The capital output ratio is: K Y = s n + g + δ The return on capital is: r = Y K = (n + g + δ) s 50
Labor augmenting technological progress can be deduced from TFP growth In the Solow-Swan framework we have: Taking logs and differentiating we get: Y t = K(t) (e gt L t ) 1 dy Y = dk K + 1 dl L + 1 g Total factor productivity growth is typically derived as: g TFP = dy Y dk K 1 dl L It follows that: g = g TFP 1 51
Raising K/L without raising TFP will lead to decline in return on capital Y t = K t α A t L t 1 α Return on capital depends on capital output ratio r = α K Y Capital output ratio depends on capital labor ratio and TFP K Y = (K L )α 1 A Low K/L does not necessarily mean low K/Y it can also mean low TFP 52