Atendency towards higher inflation is emerging.
While inflation remains well under control in Poland and the Czech Republic, other countries are struggling. In the Baltic countries and to some degree Bulgaria and Romania, strong wage and credit growth are leading to overheating and significant inflationary pressures. In other countries, weakening currencies in May and June 2006 contributed to higher price pressures later in the year, particularly in Hungary. Regulated price adjustments and indirect tax increases aggravated inflation in several countries.
“2007 will bring another round of regulated price increases for most EU8+2 countries, with the impact on inflation likely to be most pronounced in Hungary, the Czech Republic, Estonia, Lithuania, and Romania,” says Thomas Blatt Laursen, World Bank Lead Economist and the report’s lead author. “At the same time, the recent sharp decline in oil prices could help dampen inflationary pressures in 2007. The region’s fiscal policies were generally pro-cyclical in 2006, and the picture is not likely to change much this year.”
The previous EU8 Quarterly Economic Report series, published since March 2004, has been extended to include new EU member states Bulgaria and Romania in addition to the eight Central European and Baltic countries that joined the EU in 2004. The new EU 8+2 Regular Economic Report will be published three times a year. It will continue to monitor the macroeconomic and reform developments in the EU 8+2 countries and provide both an up-to-date summary of economic developments in the region and in-depth analyses of key current economic policy issues.
Fiscal deficits increased in most countries in the region despite strong growth and buoyant tax revenues, adding to concerns about overheating. Only Poland and Bulgaria managed to improve their structural fiscal balances. The fiscal easing was particularly dramatic in Hungary and Slovakia, with the deficit in Hungary reaching about 10 percent of GDP. For 2007, Hungary is planning strong fiscal consolidation, and Slovakia and Poland are similarly aiming for lower deficits. Most other countries in the region envisage further fiscal easing. Many of the countries are planning fiscal consolidation that will only bite in 2008-2009, but the credibility of these delayed plans is diluted because many countries will be entering pre-election periods.
Current account deficits increased in 2006 across the region, in some countries to worrisome levels.
Buoyant domestic demand was associated with higher deficits, with export growth holding up well. While external deficits remained low in Poland, the Czech Republic, and Slovenia, they were close to or exceeded 10 percent of GDP elsewhere. Foreign direct investment covered the deficits of the Czech Republic and Poland, and most of the deficits in Hungary, Bulgaria, and Romania. The banking sector played the main role in financing deficits in the Baltic States.
Enthusiasm for early euro adoption has waned somewhat.
While Slovenia joined the eurozone on January 1, 2007, most new member states are struggling to meet the entry conditions related to inflation, budget deficits, exchange rate stability, and legal compatibility. Most countries have dropped target dates for entering the eurozone. Slovakia is still aiming for January 2009, despite the very small margin planned in the fiscal deficit for 2007. Lithuania’s bid for January 2007 was rejected in Spring 2006 due to inflation concerns, and Estonia and Latvia have delayed their euro adoption plans for the same reasons. The Baltic States still aim to join as soon as possible but have acknowledged that this is unlikely before 2010. The other countries have indicated that euro adoption would not be feasible until sometime between 2010-2012, at the earliest.
CREDIT EXPANSION IN EMERGING EUROPE
The Special Topic looks at the rapid expansion of credit in “Emerging Europe” and associated vulnerabilities. Rapid credit expansion has not yet weakened banking systems in the region, but the situation warrants close monitoring. In some countries, an outright credit boom has contributed to large macroeconomic imbalances, potential asset market bubbles, and significant vulnerabilities that call for a more determined policy response.
The authors state that the overall efficiency, profitability, and capitalization of banks in the EU8+2 countries are all in line with banks in the eurozone, and non-performing loans do not yet show mounting vulnerabilities. The credit expansion reflects a natural process of financial deepening, and credit-to-GDP ratios are mostly in line with levels of per capita income. Foreign banks, which arguably have better management and oversight, hold a dominant position in virtually all EU8+2 countries. However, there are also important risks. An excessive growth rate of credit in some countries is contributing to overheating and large external imbalances, especially in the Baltic countries and to some extent Romania and Bulgaria. The concentration of new credit in the household sector for consumption and housing contributes little to long-term growth potential while creating conditions for asset price bubbles. Maturity and currency mismatches are increasing, especially for foreign currency mortgage credit. Indirect ownership structures may isolate some of the parent banks from their related local operations. Enhanced supervision, and in some countries tighter prudential regulations, are warranted, while a stronger response is called for where rapid credit growth is associated with mounting macroeconomic risks—including avoiding pro-cyclical fiscal policies and considering fiscal measures to discourage household borrowing.
