Conference on Competitiveness of the South Eastern European Countries: Challenges on the Road to EU, organized by the National Bank of the Republic of Macedonia, Skopje on May 30, Growth and Economic Policy: Are There Speed Limits to Real Convergence? István P. Székely and Maxwell Watson European Commission St Antonys College Oxford Oxford

03/06/2014 Székely-Watson Are there speed limits to real convergence? 2 EU accession accelerated real convergence, both with the EU and within RAMS

03/06/2014 Székely-Watson Are there speed limits to real convergence? 3 Convergence started earlier and has been faster in the Baltic countries

03/06/2014 Székely-Watson Are there speed limits to real convergence? 4 …though with vulnerabilities accumulating

03/06/2014 Székely-Watson Are there speed limits to real convergence? 5 Significant potential to absorb modern technology

03/06/2014 Székely-Watson Are there speed limits to real convergence? 6 But there are other important factors that also drive macroeconomic developments

03/06/2014 Székely-Watson Are there speed limits to real convergence? 7 Factors Determining Potential Growth: Theoretical and Empirical Findings Institutional quality Institutional quality Educational attainment Educational attainment Financial convergence Financial convergence Domestic savingsDomestic savings FDIFDI Private creditPrivate credit Size and efficiency of government Size and efficiency of government

03/06/2014 Székely-Watson Are there speed limits to real convergence? 8 Real versus financial convergence Real convergence (productivity shock in tradables) Financial convergence (reducing credit constraints)

03/06/2014 Székely-Watson Are there speed limits to real convergence? 9 Financial convergence can also increase vulnerabilities The B-S effect may be present and important in certain periods and countries, but not always The B-S effect may be present and important in certain periods and countries, but not always Removal of credit constraints leads to a strong real appreciation in the short-run, but to a more depreciated currency in the long run Removal of credit constraints leads to a strong real appreciation in the short-run, but to a more depreciated currency in the long run The two processes may thus seem similar in the short run, but are rather different in the long run The two processes may thus seem similar in the short run, but are rather different in the long run The readjustment is not without problems, especially with nominal rigidities and other market imperfections The readjustment is not without problems, especially with nominal rigidities and other market imperfections

03/06/2014 Székely-Watson Are there speed limits to real convergence? 10 Financial Convergence: Potential Vulnerabilities

03/06/2014 Székely-Watson Are there speed limits to real convergence? 11 The importance of allocation and efficient use of resources Efficiency of government (quality of public finance) Efficiency of government (quality of public finance) Quality of labor and capacity to innovate versus expenditure on or time spent in education Quality of labor and capacity to innovate versus expenditure on or time spent in education The important difference between tradable- nontradable versus productive-nonproductive The important difference between tradable- nontradable versus productive-nonproductive Allocative efficiency (quality of private institutions) Allocative efficiency (quality of private institutions)Implications: Large government is not necessarily wrong but … Large government is not necessarily wrong but … Faster credit growth enhances the growth potential only if … Faster credit growth enhances the growth potential only if … Reliance on foreign savings can speed up real convergence only if …, and the financial convergence that is involved needs policy attention Reliance on foreign savings can speed up real convergence only if …, and the financial convergence that is involved needs policy attention

03/06/2014 Székely-Watson Are there speed limits to real convergence? 12 Policy Priorities Overarching goal: raise potential growth Key role of government in assuring stable financial setting assuring stable financial setting reducing distortive activities reducing distortive activities enhancing human/physical capital enhancing human/physical capital addressing incentives (including moral hazard) addressing incentives (including moral hazard) …thus maximising gains from financial integration

03/06/2014 Székely-Watson Are there speed limits to real convergence? 13 Containing Vulnerabilities Key is to contain adjustment risks – e.g., from unbalanced financial development (factors that bias credit towards households) unbalanced financial development (factors that bias credit towards households) rigidities (including balance sheet exposures) rigidities (including balance sheet exposures) inadvertent fiscal errors during boom (from output gap or revenue elasticity) inadvertent fiscal errors during boom (from output gap or revenue elasticity)

03/06/2014 Székely-Watson Are there speed limits to real convergence? 14 A Risk-Return Strategy Lay analytical foundation through improved understanding of shocks to economy With diagnostic uncertainty, address risk (adjustment vulnerabilities) and returns (potential growth) Strong complementarity across policies to achieve this, including growth-oriented fiscal consolidation Great opportunities, but some constraints and trade-offs…

03/06/2014 Székely-Watson Are there speed limits to real convergence? 15 The EU Convergence Context Opportunities from trade and investment integration, institutional strengthening via acquis Environment also accelerates financial integration… History teaches us this can enhance good outcomes, but also heighten risk of policy failures Also concerns about policy traction: at best, qualified monetary autonomy, and foreign-owned banks

03/06/2014 Székely-Watson Are there speed limits to real convergence? 16 Interactions & Trade-Offs Policies are not powerless, but interactions, while mutually reinforcing, may not always have conventional sign (depreciation) interactions, while mutually reinforcing, may not always have conventional sign (depreciation) policy restraint may have strong sectoral effects policy restraint may have strong sectoral effects questions extend to regime design, not just calibration questions extend to regime design, not just calibration inter-temporal trade-offs: may raise short-run volatility inter-temporal trade-offs: may raise short-run volatility This argues for quantified scenarios, incorporating productivity variants/balance sheet risk/policy interactions/adjustment channels