Prospects and Challenges for Economic Growth in the South Caucasus and other Transition Economies C. Felipe Jaramillo The World Bank Tbilisi, Georgia, February 1, 2007

1. Growth record since Recent trends in Transition Economies: The South Caucasus Economies

ECA – Real GDP Growth (%)

ECA – Index of Real GDP (1990=100)

GEORGIA ARM AZE CIS

Transition, reforms and growth Substantial progress was achieved by CEB -- markets have responded favourably to previous reforms. Reform in CIS countries has been slower and less ambitious – but growth has picked up in recent years in reforming countries (and oil exporters) With a positive external environment, most countries have enjoyed strong growth in , leading in some cases to “reform complacency” Source: EBRD

2. Recent Economic Trends in Transition Economies – EU 8+2 EU 8: Poland, Czech, Hungary, Eslovenia, Slovakia, Latvia, Estonia, Lithuania +2: Romania, Bulgaria

Short-term performance in EU8+2 remains very positive External environment – remained broadly favorable (some slowdown, but falling oil prices) Financial markets in the region recovered firmly from the May-June 2006 turmoil supported by overall strong fundamentals Capital inflows translated into strong appreciation trends Bullish stock markets -- record highs Outlook: remains positive, with some EU8+2 countries vulnerable to sudden corrections

Growth gained further steam Real GDP Growth (% yoy) Strong growth momentum maintained in 3Q Increasingly driven by vibrant domestic demand Stimulated by strong credit expansion and wage growth (the Baltics and Romania/Bulgaria) Growth likely to slow down in 2007 in line with euro-zone and closing output gaps

External imbalances mount… Current account balances have worsened in most economies (except HUN and POL) --- on the back of widening trade deficits exacerbated by real exchange rate appreciation The largest external imbalances (the Baltics, Slovakia and Bulgaria/Romania) are generated in the private sector translating into booming private sector credit Current account deficit (% of GDP)

Increasing inflationary pressures Inflationary pressures intensified in most countries Related to rapid output growth and closing of output gaps, labor market tightening, rapid credit expansion and pro-cyclical fiscal policies In response to increasing pressures, somewhat balanced by appreciation trends, most EU8+2 followed the ECB tightening cycle Contribution to CPI inflation (perc. points)

Fiscal consolidation rather slow Sizeable increase in fiscal deficit in 2006 projected in Hungary (to about 10% of GDP) and Slovakia Structural fiscal balances deteriorated in most countries (except Poland and Bulgaria) Fiscal position likely to worsen in 2007 in the Czech Republic, Estonia, Bulgaria and Romania. Major adjustment only in Hungary Concern: Fiscal policy may be exacerbating the imbalances of the current expansion cycle

Structural reforms largely stalled Some further progress on privatization, but strategic sectors remain state-controlled Little progress on further enhancing labor market flexibility (labor taxes, mobility) Limited progress in other areas of business environment, incl. the functioning of the judiciary in the newest member states Public finance reforms stalled (but ambitious plans in Hungary) Governance remains a problem in most countries

3. What is happening in the South Caucasus?

Georgia Strong growth performance in recent years explained by pickup in reforms, solid fiscal management and growing positive market sentiment

Strong fiscal mgmt – fast revenue growth

Strong pickup in FDI – beyond pipeline

And more diversified FDI sources

Has weathered well export restrictions

Georgia – emerging challenges Some signs of overheating (inflation pick up, growing external imbalances, rapid credit growth) Challenge of continuing to boost trade and diversify products and partners

Armenia Impressive fifth year of double digit growth – fueled by continued reforms and strong macro-fiscal management Fueled by private sector – consumption and investment (FDI and remittances)

Armenia – emerging challenges Rapid credit growth from a small base Appreciation pressures and external competitiveness challenge

Azerbaijan Very high growth since 2003 derived from large oil exports

Azerbaijan Risk of “Dutch disease” Deteriorating fiscal position – fast growth of expenditures Rapid credit growth Inflationary pressures and real appreciation Faltering reform efforts?

Challenges and emerging issues in South Caucasus economies Avoiding reform fatigue

Challenges and emerging issues in South Caucasus economies Dealing with appreciation pressures – micro and regulatory reforms to boost competitiveness Need to address trade bottlenecks -- continue to expand and diversify export supply and markets Challenges of financial development

The End Prospects and Challenges for Economic Growth in the South Caucasus and other Transition Economies C. Felipe Jaramillo The World Bank Tbilisi, Georgia, February 1, 2007