The implications for the real sector and the long-run growth prospects of SEE Francesco CONTESSO Advisor European Commission DG Economic and Financial Affairs Directorate D: International economic and financial relations, global governance 3 rd Bank of Greece Workshop on the Economies of Eastern European and Mediterranean Countries Eastern European and Mediterranean Countries Athens, 18 May

Outline 1. WB’s recovery from the 2008 financial crisis 2. The importance of the EU market for the WB 3. The impact of the euro-area sovereign debt crisis 4. Prospects and conclusions 2

1. WB’s recovery from the 2008 financial crisis 3

Pre-crisis growth patterns ( ) 1. High real GDP growth (5-7% on average)… 2. …boosted by strong credit growth and domestic demand as well as pro-cyclical fiscal policies… 3. …with strong reliance on external public and private financing, both in the form of FDI and foreign debt …leading to high domestic and external imbalances (large trade and current account deficits)… 5. …and strong investment growth in the non- tradable sectors rather than in tradables. 4

Vulnerabilities and crisis impact High dependence on foreign financing made countries vulnerable to risk of reversal  crisis led to lower capital inflows and slowing credit activity and deleveraging Foreign savings were mainly used to finance domestic consumption smoothing  crisis led to sharp falls in domestic demand Capital allocation biased towards non- tradable sector (construction, retail, financial sector)  crisis led to sharp real sector adjustments and output losses 5

Impact of 2008 crisis and recovery …  Uneven impact across the countries…  Three main channels: Trade External financing Remittances  Relevance of EU integration? 6

Economic linkages of WB with EU (1)  High degree of trade integration, but differences across countries  Remittances play a particular role in many countries 7

Economic linkages of WB with EU (2)  Strong financial integration  Foreign ownership  Important for stable financial sector  But potential funding risks (not part of this presentation) 8

3. The impact of the euro-area sovereign debt crisis 9

First signs of adverse impact on real output…  Deceleration of growth since the second half of 2011  Croatia remains in recession 10

…exports on a downward trend…  All countries in the region experience drop in exports  Clearly indicating loss in external demand  Only partly “price”- driven 11

…imports still not affected much…  Imports have been stable throughout 2011  Partly driven by peaks in commodity prices in the first half  …and domestic demand 12

…industrial production is falling …  Sharp drop of industrial production by the end of 2011  Most affected countries: BH, FYROM, SR  HR rather stable  In all countries, industrial production is below pre-crisis levels 13

…employment growth turns negative in some countries…  In HR and SR, employment declines since 2009  In most other countries, employment declines in  Temporary recovery in 2011  Again deterioration in late 2011 and

4. Prospects and conclusions 15

Spring 2012 Commission Forecast (11 May 2012) Outlook is towards slow recovery…  After a weak first half year economic activity will gain momentum in second half of  Underlying factors: - Decelerating and uncertain global growth (China, USA, Japan) - High energy prices - Need to rebalance public finances and financial sector weighs on growth in some Member States  EU: zero growth in 2012, 1¼ % in 2013 EA: -¼ % in 2012, 1% in

Growth perspectives are uneven within EU…  Countries which relied on credit/debt financed growth suffer most (EL, ES, PT, IT, SL, EE, LV)  Crisis-hit financial sectors are brakes on growth (IR, UK, FI) 17 Expansion/Contraction: real GDP per capita, (cumulated growth rates)

EU as trend setter for Western Balkan  In general, the Western Balkan countries follow growth profile of their main trading partner, the EU.  Main transmission mechanism: external demand, international (and domestic) financing conditions  Outlook for HR and SR is more pessimistic than for FYROM and ME  HR and SR have higher exposure to trading partners with low growth, are more dependant on foreign financing and suffer from delayed reforms 18

Unemployment likely to remain high …  In most Western Balkan countries, unemployment is significantly higher than in EU  Low growth in 2012 will lead to stagnation in unemployment in  Stronger growth in 2013 should allow a reduction in unemployment  In FYROM and SR, unemployment will remain above 20% of labour force  High unemployment reflects structural weaknesses and high informal sector 19

External imbalances persist …  Overall, external imbalances are likely to remain. Lower export growth is largely offset by lower domestic demand (low wage growth, restrained investment)  In ME and Serbia, current account deficits are expected to remain high Financing depends largely on FDI inflows and transfers  In FYROM and HR, current account deficits are likely to increase slightly, but will remain below 5% of GDP 20

Inflation likely to moderate in most Western Balkan countries …  After high, partly energy driven inflation, CPI increases are expected to remain moderate in 2012 and 2013, benefitting from lower import prices  In ME, tax increases might raise inflation in In Serbia, after a peak in 2011, lower energy prices and a strong anti-inflationary policy mix should contribute to CPI increases below 5% 21

Public finances under pressure …  In HR and SR, weak economic growth and a rigid spending structure are likely to keep deficits close to -5% of GDP.  In FYROM, the government is expected to maintain its low deficit approach.  In ME, the authorities have announced a deficit reduction strategy, which should bring the deficit below 2% in

Public debt likely to increase …  Low growth and persistent deficits are likely to raise debt levels.  In HR and SR, debt levels are approaching the 60% mark.  In ME, the policy of decreasing deficits should lead to a reduction in the debt ratio by  In FYROM, increased reliance on foreign credits will lead to a continued increse in the debt level. 23

Prospects and conclusions  Main transmission mechanism of sovereign-debt crisis to the Western Balkan are lower exports and in particular more constrained access to (foreign) financing.  This puts in question the Western Balkan growth model, which strongly relied on foreign sources.  The region’s growth potential is impeded by structural weaknesses (labour market rigidities, low institutional capacities, weak rule-of-law, etc. negatively affecting business environment) 24

Prospects and conclusions (cont.)  Quality and sustainability of convergence requires Supply side structural reforms to attract (foreign) investment and increase productivity Supply side structural reforms to attract (foreign) investment and increase productivity Shift from non-tradable to tradable sectors Shift from non-tradable to tradable sectors Improvement of public finances' quality Improvement of public finances' quality 25

Thank you for your attention 26