Fiscal Policy Challenges Facing the New Member States in a Period of Large Capital Inflows & Substantial Investment Requirements Armin Riess European Investment Bank International Seminar for Experts Catching up after Enlargement Cicero Foundation October 14-15, 2004

Main questions Public debt & fiscal deficits that countries can afford? Role of public investment and other expenditure? Role of balance of payments position (notably capital inflows)?

What do we need to examine? Key features of CEE economies Public debt sustainability Mixed blessing of capital inflows

Real GDP growth projection (in %), 2004 Source: European Commission, Economic Forecast, Spring 2004 EU-15 potential Long-run CEE growth potential 4-5%

Consumer price inflation (in %), 2004 Source: European Commission, Economic Forecast, Spring CEE average EU-15/eurozone target

Public debt in CEE & EU-15 (% of GDP), 2004 Source: European Commission, Economic Forecast, Spring 2004 Maastricht 60% criterion

Key features of CEE economies -Summary- Real economic growth:CEE > EU15 Inflation:CEE > EU15 Nominal economic growth:CEE > EU15 Public debt:CEE < EU15

Public debt sustainability (ad hoc criteria) Keep public debt/GDP-ratio constant ! Debt/GDP should converge to 60% (Maastricht) ! Debt/GDP should fall to zero (Stability & Growth Pact) !

Debt dynamics Change in debt/GDP ratio = fiscal deficit/GDP ratio – nominal GDP growth debt/GDP ratio

Fiscal deficit that leaves debt/GDP unchanged Nominal GDP growth 4%5%7% Fiscal deficit (in % of GDP) Debt in % of GDP 20%0.8%1.0%1.4% 40%1.6%2.0%2.8% 60%2.4%3.0%4.2%

Where does public investment fit into this picture? Fiscal deficit can be higher if … … public investment is large today, but expected to fall in the future. Is public investment high in CEE?

Public investment in CEE & EU-15 (% of GDP, average) Source: European Commission (2003 Spring Forecast) and IMF (Staff Appraisal Reports) EU15 average 2.3% CEE average 3.9%

What about other public expenditure? High investment today can justify higher fiscal deficit, but … … other government expenditure may be low today relative to their future level. Example: public pension expenditure

Public pension expenditure in selected CEE countries (in % of GDP) Source: European Commission; Occasional Paper 4, July 2003

Public debt sustainability - Summary - Debt sustainability does not imply the same fiscal deficit for all countries Some government expenditure (investment) may justify higher fiscal deficits, others (pensions) call for fiscal restraint Public debt sustainability is one thing, macroeconomic stability is another

Capital inflows (in % of GDP) ( average for CEE, peak inflow periods otherwise ) Source: IMF (Staff Appraisal Reports); Begg et al. (2002)

Capital inflows & current account deficits (in % of GDP, average) Source: IMF (Staff Appraisal Reports) Capital inflows Current account deficit

Higher returns on physical investment Expected trend appreciation of currency (Balassa-Samuelson effect)

Whats good: Investment finance higher growth Too much of a good thing: Overheating of economy (inflation) Credit boom & banking sector stability Excessive currency appreciation & competitiveness

How to cope with large capital inflows? Banking sector stability Effective prudential regulation & supervision Overheating of economy Revaluation of exchange rate/exchange rate flexibility Fiscal austerity

Source: IMF (Staff Appraisal Reports) Hard currency pegs Flexible exchange rates Fiscal deficit & exchange rate regime (% of GDP, average)

Conclusion Fiscal policy assessment requires a country-by-country approach Coping with dark side of capital flows is key (fiscal) policy challenge Fiscal policy challenges other than those concerning the bottom line