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Macroeconomic overview


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Macroeconomic overview

Executive summary

The transition countries have continued to show robust growth, driven in many places by strong domestic demand spurred by growth in credit and real wages. Domestic demand and high energy are however contributing to upward pressure on inflation throughout the region. Moreover, domestic savings are currently insufficient to cover investments, resulting in large persistent current account deficits, at a time when foreign direct investment is projected to taper off slightly from the levels in 2004-05. In 2006, several countries’ currencies have come under pressure in foreign exchange markets. This reflects a generally more critical assessment by foreign investors of vulnerabilities in emerging market economies. Further, central banks in the United States, the euro zone and Japan (the G-3) have recently raised their interest rates, making investments in the G-3 more attractive.

On the monetary side, central banks across the region have been trying to grapple with the problems of rapidly developing financial intermediation paired with rising inflationary pressures. Many central banks decided to raise policy interest rates, to introduce stricter regulations on minimum reserves or other anti-inflationary measures. Against this backdrop, fiscal policy has generally been too loose to stem domestic demand pressures effectively. The case for more restrictive fiscal policies becomes more pressing in view of the long-term implications of ageing populations, which will put significant pressures on public budgets in the future.

Central eastern Europe and the Baltic states

The economies of central eastern Europe and the Baltic states (CEB) have continued to grow strongly, driven mainly by domestic demand and also by export growth. However, demand pressure is combining with high energy and commodity prices to spur inflation and generate large current account deficits. The monetary authorities are focused increasingly on ensuring price and exchange rate stability. Nevertheless, fiscal policy is too expansive in some countries to cap domestic demand effectively.

Economic activity

Although real GDP growth in the region fell to [4.7] per cent in 2004 from [5.1] per cent in 2005, the decline was due largely to a 2 percentage point slowdown in Poland. The Baltic states, the Czech Republic and the Slovak Republic recorded growth rates of at least [6] per cent in 2005. In 2006, average real growth across the region is forecast to reach [5.4] per cent, reflecting to a large extent a recovery in Poland.

Rising private consumption in the Baltic states, the Slovak Republic and, to a lesser extent, in Poland, has been supported by real wage growth, with significant increases in unit labour costs. Low (real) interest rates and financial service innovations have meanwhile fuelled consumer credit, especially through credit cards and mortgage financing. The increasing presence of foreign banks has also had a major impact (see Box 2.1). Total real credit in the region grew on average by [21] per cent in 2005, and by over 50 per cent in Latvia and Lithuania. Increasing mortgage financing has also led to higher residential investment, while European Union (EU) funds have supported investment growth more generally.

Unemployment rates have come down in most countries (except in Hungary and Poland) since 2001. However, the overall level remains relatively high, and a significant proportion of the jobless have been out of work for a year or more, reducing the likelihood of re-employment (see Table 2.1). In 2005, the short-term unemployment (those out of work for less than a year) rate was lower than the eurozone average in six of the eight CEB countries. Many countries are experiencing labour shortages in fast-growing sectors of the economy, such as the construction sector in the Baltic states and the Slovak Republic’s automotive sector. Emigration of skilled labour (for example health care staff) has added to the shortages, although a couple of CEB countries (Czech Republic, Poland) are also benefiting from immigration into the low-skilled sector. These trends are contributing to strong wage pressures and may fuel further inflation.

<<Insert Table 2.1 about here – Unemployment rates in 2004 and 2005>>


Growth in domestic demand, combined with rising energy and food prices, have led to rising inflation since mid-2005 in the Czech Republic, Estonia, Lithuania and the Slovak Republic. In Hungary, Latvia and Poland, the upward inflationary trend started in the second quarter of 2006. Headline inflation exceeds the Maastricht inflation criterion in most CEB countries. Rising energy and food prices are largely responsible for this acceleration, as illustrated by the difference between the overall inflation rate and the “core” inflation rate (which excludes energy and food). In all CEB countries, core inflation is significantly below the overall inflation rate. However, higher energy and food prices can have an impact on other prices and wages, and in some countries (the Baltic states, for example), core inflation has been increasing in 2006 (see Chart 2.1).

<<Insert Chart 2.1 about here – Inflation and core inflation in selected countries>>

Foreign trade and FDI

Demand pressures in CEB are generating strong import growth and domestic savings are currently insufficient to cover investments, resulting in current account deficits. This is in contrast to most other emerging market countries in Asia or Latin America. Estonia, Latvia and the Slovak Republic registered current account deficits ranging between [8.6] per cent and [12.5] per cent of GDP in 2005, while Lithuania and Hungary had deficits of [7] to [8] per cent. In 2006, the current account deficits are likely to be even larger, reflecting rising private consumption. Real exchange rates have been appreciating since 2001 as a result of strong capital inflows and the resulting boost to productivity in the tradable sector relative to the non-tradable sector.

Financing current account deficits has not yet caused significant problems in CEB (see Chart 2.2) as foreign direct investment and, to a lesser extent, net portfolio investments continue to be strong. Following steep increases in 2004 and 2005, net FDI is projected to decline in 2006 (to US$22.5 billion in 2006 from US$27.6 billion the previous year). A drop in net FDI into Estonia, Hungary, and particularly the Czech Republic, is being partially offset by increases into Latvia, Lithuania, Poland, the Slovak Republic and Slovenia. In Estonia, Hungary, Latvia and Lithuania the FDI coverage of the current account deficit in 2006 is forecast below 50 per cent, making these countries more vulnerable to a sudden reversal of capital flows. FDI not only provides long-term financing but can also add to export capacities and may therefore help to lower the trade deficit. Substantial investment in the automotive industry in the Czech Republic has contributed in this respect to a decline in the current account deficit, and similar positive effects are anticipated in the Slovak Republic. Other countries, such as Hungary and Poland, recorded a rising share of portfolio investment inflows in 2004 and 2005. However, relatively high net portfolio inflows can make countries more vulnerable to a sudden reversal of capital flows when adverse economic and financial developments occur abroad or at home.

<<Insert Chart 2.2 about here – Net FDI coverage of current account deficits>>

During 2006, several countries’ currencies have come under pressure in foreign exchange markets. This reflects a generally more critical assessment by foreign investors of vulnerabilities in emerging market economies. Further, central banks in the United States, the eurozone and Japan (the G-3) have recently raised their interest rates, making investments in the G-3 more attractive. The Hungarian forint, the Polish zloty and the Slovakian koruna have depreciated by 12, 6 and 2 per cent respectively against the euro between 01 January and 30 June 2006, although there has since been some reversal. In the case of the Slovak koruna, the National Bank intervened heavily in the currency market between May and June 2006 to support the currency. Nominal exchange rates remain fixed in the Baltic states, which maintain currency boards, and also in Slovenia, which has already set its permanent entry rate of the tolar to the euro in advance of formal adoption of the euro on 1 January, 2007.

Domestic policies

Policy-makers are facing significant challenges in the conduct of monetary and fiscal policy, and central banks in CEB have had to take strong measures to ensure price and exchange rate stability. In the Czech Republic, Hungary, Latvia, Lithuania and the Slovak Republic, central banks have all increased their interest rates since January 2006. The central bank of Poland is the only country in the region to have decreased its main interest rate over this period, but from a strictly restrictive stance. This came on the back of a stronger than expected decline in inflation and a more favourable inflation outlook. On 31 January 2006, the Central Bank of Slovenia initially dropped its rate (to bring it closer to eurozone levels prior to euro adoption in 2007), but has since increased it twice in response to inflationary pressures. In Estonia and Latvia, the central banks have introduced stricter regulations on minimum reserves and other anti-inflationary measures.

On the fiscal side, average general government deficits across the region were [1.8] per cent of GDP in 2005, compared with a 2.7 per cent target. The better-than-expected deficit outcomes across the region mainly reflect a strong macroeconomic environment and overcautious target-setting rather than an improvement in the underlying structural budget balance. The case for more restrictive fiscal policies, which have generally been too loose to stem domestic demand pressures effectively, becomes more pressing in view of the long-term implications of ageing populations, which will put significant pressures on public budgets in the future (see Box 2.2). Among the countries in the region Hungary stands out as the only country that missed all original fiscal targets by a wide margin in the past four years. The December 2004 update of the convergence programme foresaw a decline in the deficit by 1.2 per cent of GDP, while ultimately the fiscal deficit increased from [5.4] to [6.1] per cent of GDP in 2005. The persistent fiscal difficulties have been reflected in declining investor sentiment and downgrades by the main rating agencies.

South-eastern Europe

South-eastern Europe (SEE) continued to grow robustly during 2005 and the first half of 2006. The region is benefiting from an industrial revival and expanding export opportunities while the prospects of EU accession are attracting record inflows of foreign capital. Inflation is generally subdued but rapid credit growth and high levels of public spending are posing challenges for governments and central banks. Continued large current account deficits may be problematic in the future should remittances from workers living abroad and foreign direct investment slow down.

Economic activity

Real GDP growth in SEE was [5] per cent in 2005 and is projected to increase slightly to [5.5] per cent in 2006. Serbia had the strongest growth rate at [6.3] per cent, while Albania, Bosnia and Herzegovina and Bulgaria all recorded growth in excess of 5 per cent.

Several factors have underpinned the economic revival of SEE since 2000. The first is a recovery in industrial growth, influenced in large part by a strong inflow of foreign investment into key industries. In some industries, once-moribund enterprises have been regenerated by substantial investments – for example, in the metals sector in Bosnia and Herzegovina, FYR Macedonia and Serbia. In the larger EU accession candidates – Bulgaria, Croatia and Romania – industrial production has also been influenced significantly by foreign direct investment (FDI). A second factor is strong domestic demand, fuelled by credit growth. From a low base, credit has been expanding very rapidly in SEE (by [20] per cent in 2005) and the resulting consumer demand has prompted an increase in imports. A third factor is the revival of export markets. Countries in the region now have duty-free access to the EU for most goods. Also, trade within SEE is recovering on the back of renewed links between former Yugoslav republics and a region-wide network of bilateral free trade agreements. The latter is being converted into a regional free trade accord, which should lead to further expansion of trade over the medium term. Despite these positive developments, however, unemployment is generally high across the region, especially in the Western Balkans.


Inflationary pressures have increased over the past year in SEE. The average inflation rate in the region in 2005 was low at [5] per cent. However, Serbia was a significant exception, with inflation rising to 17.5 per cent by the end of 2005 from 13.7 per cent in 2004. While higher energy prices have had an influence, the main causes of inflation in Serbia appear to be strong wage growth, rapid credit expansion, and, in some industries, a consolidation of monopoly power and protectionism that is keeping prices above world levels. In Bulgaria, inflation also rose in the first half of 2006, reaching almost 9 per cent on the back of higher fuel and food prices and an increase in excise taxes, although it has come down slightly since. In Romania (which, like Bulgaria, expects to join the EU next year) inflation is still above 6 per cent. Elsewhere in the SEE inflation remains at low single-digit levels.

In response to inflationary pressures, several countries rely on various types of fixed exchange rate regimes adopted over the years. Montenegro’s policy of unilateral adoption of the euro some years ago, when it was still part of the Federal Republic of Yugoslavia, has been successful in bringing about low inflation. However, this policy is not an option for other countries in the region; it is explicitly ruled out by the EU for countries either in accession negotiations or within the Stabilisation and Association Process. Most countries have a stable nominal regime, either through a currency board (as in Bosnia and Herzegovina and Bulgaria), a fixed peg exchange rate (as in FYR Macedonia) or a managed float (Albania, Croatia, Romania and Serbia).

Foreign trade and FDI

The SEE region continues to run high current account deficits, ranging in 2005 from [1.3] per cent of GDP in FYR Macedonia to [17.8] per cent in Bosnia and Herzegovina. In the latter case, strong doubts persist about the quality of the data. Nevertheless, a deficit of this magnitude, even if overstated, is a cause for concern, especially in a currency board regime. Bulgaria similarly has a currency board and a double-digit current account deficit (above 14 per cent of GDP in mid-2006). As noted above, SEE is generally experiencing strong export growth, all countries in the region having recorded expansion in excess of 7 per cent in 2005. However, this is being offset by rising demand for imports, reflecting not only higher consumption but also the significant investment needs of the region.

Large current account deficits are not a new development in the SEE region. Most countries in 2005 had strong inflows of investment-related capital, and all of them had a balance of payments surplus. FDI inflows to the region are at record levels, having risen from [US$9 billion] in 2004 to [US$ 12 billion] in 2005. They are on course to reach [US$ 12 billion] again in 2006. The inflows are related mainly to privatisation and acquisitions as the banking sectors of several countries (notably in Croatia, Romania and Serbia) have attracted great interest from foreign banks.

<<Insert Chart 2.3 about here – Net FDI in US$ billion>>

Two further considerations are likely to sustain the momentum of FDI in the short term. First, all SEE countries have been making significant progress in the EU accession process, sending a strong signal to investors that the region’s long-term future lies in European integration. The second factor is the region’s improved image. Most countries have received upgrades from the main international ratings agencies, again indicating an improved economic climate and increasing opportunities. Recognising this potential, foreign investors are prepared increasingly to disregard the region’s problematic past.

Domestic Policies

The main macroeconomic challenges facing policy-makers in SEE are on the fiscal side. While fiscal discipline has generally been maintained in 2005-06 across the region, government spending in several countries, such as Bosnia and Herzegovina, Croatia, Montenegro and Serbia, is too large relative to GDP and out of line with other countries and regions of similar economic size. In addition, although all countries in the region have major investment needs, government spending is weighted heavily towards current rather than capital spending. The region as a whole recorded an average general government deficit of 0.7 per cent of GDP in 2005 (see Chart 2.6) and, in general, fiscal discipline is being maintained in 2006.

<<Insert Chart 2.4 about here – Government expenditures and deficits>>

On the monetary side, central banks across the region have been trying to grapple with the problems posed by the take-off of financial intermediation and credit growth. The main tools available to address this have been bank reserve requirements and interest rates. Reserve requirements have been raised substantially in Bosnia and Herzegovina, Croatia and Serbia, while the Romania’s Central Bank has had to raise interest rates on several occasions since mid-2005. Nevertheless, the banking system in the region has become progressively stronger. Not only have established foreign banks entered the markets in all countries, but supervisory powers have been strengthened and are enforced more rigorously (link with Box 2.1).

Commonwealth of Independent States and Mongolia

The Commonwealth of Independent States (CIS) and Mongolia have continued to reap the benefits of high energy and commodity prices, reflecting the strength of global demand for the region’s natural resources. The growth in domestic demand has been fuelled by a combination of accelerating credit, higher employment and real wages, remittances from workers living abroad, a booming construction sector and, in 2006, expansionary fiscal policies. Inflation is still high in several countries, contributing to a further real appreciation of domestic currencies.

Economic activity

The economy of the CIS and Mongolia grew by [6.6] percent on a weighted average basis in 2005. This was lower than the 8 per cent recorded in 2004 but higher (for the seventh year in a row) than the growth rate in CEB or SEE. The region is projected to grow at almost [7] per cent in 2006, reflecting continued buoyancy in key commodity prices (see Chart 2.5). Azerbaijan in particular has become one of the fastest-growing economies in the world due to the major expansion of its oil sector. Real GDP in Azerbaijan rose by [26] per cent in 2005 and by just over [36] per cent year-on-year in the first half of 2006. In Ukraine real growth is likely to double in 2006 from the relatively depressed rate recorded in 2005, following a rebound in international steel and metal prices and strong domestic demand. In the region’s largest economy, Russia, real GDP growth remained strong at [6.4] per cent in 2005 (only slightly below the levels in the previous two years) and this trend is continuing in 2006. As Chart 2.5 illustrates, the correlation between the oil price increase and the increase in CIS growth rates has been particularly strong since 1999 until 2004, suggesting an important link between oil prices and growth. However, from 2005 on, this correlation has weakened. This could be an indication that oil-rich countries are making efforts to manage their resources better by saving oil revenues in funds, but it may also point to the limits of growth given the capacity constraints in the region and the current state of structural reforms.

<<Insert Chart 2.5 about here – Oil price and weighted average real growth>>

A key source of growth has been private consumption, which has risen particularly strongly in the non-resource-rich countries such as Armenia, Georgia and Ukraine. The increase has been spurred by rising real wages, higher employment growth, rapid credit growth and robust inflows of remittances from workers living abroad. Real wage growth across the region, for instance, averaged [15.9] per cent in 2005 and is running at about the same rate in 2006. In many cases, public sector wage growth has contributed to an economy-wide rise in real wages. Moreover, the increasing use of financial products, such as credit cards and mortgages, has fuelled consumer credit growth. Total real credit increased on average by [20] per cent in the region in 2005 and by more than [50] per cent in Armenia and Kazakhstan.

Gross fixed investment growth has also been a significant factor in real GDP expansion, particularly in resource-rich countries. The relative importance of fixed investment growth has been declining in Russia, Azerbaijan and Kazakhstan following the completion of major hydrocarbon investments, such as export pipelines. However, in Uzbekistan the economy has been benefiting from new Russian and Chinese investment in the oil and gas sector during 2006. A recovery in investment is also underlying the rebound in real GDP growth in Ukraine this year. There has also been a notable rise in residential investment growth in most countries of the region, with the construction sector benefiting from a housing boom bolstered by rising personal incomes, mortgage credits, tax exemptions and relatively low real interest rates. Moreover, oil and gas exporting countries, such as Azerbaijan, Kazakhstan and Russia, have seen strong growth in the services sector, especially those related to the domestic mining industries.


High inflation levels continue to affect many CIS countries. Annual consumer price inflation in the region averaged 10 percent in 2005 and is expected to fall only modestly in 2006. This reflects rising costs for producers and strong demand from domestic consumers. Energy and commodity prices are at record levels and are adversely affecting non-resource-rich countries. For example, in Armenia – the country with the lowest inflation rate in the region in 2005 – rising energy prices have been the primary cause of the rise in inflation from [‑0.2] per cent at the end of 2005 to [6.7] per cent year-on-year in July 2006. However, even the resource-rich countries – Azerbaijan, Kazakhstan, Mongolia, Russia, Turkmenistan and Uzbekistan) – have been experiencing persistently high or rising inflationary pressures. Energy-related revenues and income flows have boosted domestic spending while central bank purchases of foreign exchange have not been offset by an equivalent sale of government securities. This has resulted in rapid growth of money supply, in many cases exceeding nominal GDP growth. Given the relatively underdeveloped domestic money and capital markets this has contributed to the increase in financial asset prices across the region.

Foreign trade and FDI

Continued high energy and commodity prices led to a small current account surplus in 2005 in the CIS countries and Mongolia, but there was wide variation across countries (see Chart 2.6). Russia and Turkmenistan recorded surpluses of [11.0] and [7.4] per cent of GDP respectively in 2005, due mainly to high prices for minerals and metal products. Uzbekistan’s surplus increased to just over [10] per cent of GDP on the back of favourable gold and cotton prices. In non-resource-rich economies, the combination of record import prices for energy and commodities and a marked rise in import demand (reflecting the buoyancy of domestic consumption and investment) led to substantial current account deficits of between [5] and [8] per cent of GDP in 2005. Moreover, Ukraine’s current account is expected to swing into deficit in 2006 for the first time since 1998.

Remittances from workers living abroad have continued to bolster economies across the region, especially in those countries with deficits, although it is possible that these deficits are overstated because of under-recording of remittances. Many expatriate workers from Armenia, Georgia, the Kyrgyz Republic, Moldova, and Tajikistan regularly send home earnings amounting to well over 5 per cent of GDP each year (see Transition Report Update 2006).

<<Insert Chart 2.6 about here – Current account balances>>

On the capital account side, net foreign direct investment (FDI) in the region in 2005 stood at US$ [13.3] billion, almost unchanged from the previous year. However, it is likely to fall to US$ [8.8] billion in 2006, mainly reflecting the one-off effect of Ukraine’s record privatisation revenues in 2005, which included the sale of Kryvorizhstal to Mittal Steel. Russia is increasingly a source for FDI directed to other countries in the region. Russian companies have accumulated substantial cash reserves and are increasingly investing abroad, motivated by portfolio diversification, vertical integration (and in part for political motives). This process in likely to intensify following the capital account liberalisation in July.

The ratio of external debt to GDP is receding in most countries, either through an explicit strategy of debt repayment to reduce external dependence (as in Azerbaijan, Russia and Uzbekistan) or by debt relief agreements with bilateral and/or multilateral creditors (as in Georgia, the Kyrgyz Republic, Moldova and Tajikistan).

Domestic policies

The strong growth enjoyed across the CIS and Mongolia (although from a low base) has brought increasing prosperity but also significant policy dilemmas. Monetary authorities in resource-rich countries may seek to manage the strong inflow of foreign currency and prevent the currency from appreciating in nominal terms in order to protect the competitiveness of non-energy/non-commodity export industries. On the other hand, a stronger currency can help to dampen inflationary prices by making imports cheaper. This is a difficult balancing exercise, made more problematic by the lack of sufficiently developed domestic money and capital markets. This makes the impact of interest rate changes on the real economy less effective. As inflation rates have risen, several countries (including Azerbaijan, Kazakhstan and the Kyrgyz Republic) have increased their main interest rates or introduced more direct measures of controlling the money supply (as in Kazakhstan), although the effectiveness of these measures remains to be seen.

In this situation, restrictive fiscal policy would be crucial in supporting monetary policy to stem inflationary pressures. The CIS countries and Mongolia recorded on average a fiscal surplus of [0.5] per cent of GDP in 2005, compared with a deficit of [0.3] per cent the previous year. However, a slight deterioration in fiscal balances is forecast for 2006, which would be avoidable if the growth dividend from continued buoyant economic activity was used to reduce the deficit. Resource-rich countries like Kazakhstan and Russia are largely managing the fiscal windfall with restraint. Russia’s Oil Stabilisation Fund is a good example in this respect of how budgetary surpluses can be put aside for use in possible future downturns. The fund is estimated to reach US$ 84 billion by the end of 2006. The fund is expected to reach US$ 84 billion by the end of 2006. However, in general fiscal policy across the region remains too loose to support strong counter-inflation measures.

Medium-term outlook and vulnerabilities

The medium-term outlook for the transition countries is one of continued growth, reflecting sustained progress in structural reforms and increasing integration into the world economy. However, growth rates similar to those achieved in recent years cannot be assured, and important risks remain. CEB prospects are increasingly tied in with performance in the eurozone, while SEE, the CIS and Mongolia still face substantial reform hurdles.


Over the medium-term, real GDP growth should remain robust, although a slight slowdown is forecast from 2007. Export growth is likely to continue, but domestic demand is expected to remain the key source of economic growth. High energy and commodity prices and strong domestic demand could put further pressure on inflation. Central banks in CEB may have to raise domestic interest rates in the short term, even though this could have an adverse effect on domestic growth. The substantial current account deficits in the region need to be monitored carefully, especially as global liquidity has declined and foreign investors are paying more attention to macroeconomic fundamentals. An additional uncertainty is the increasing competitive pressure from Asian producers. These factors highlight the need for responsible fiscal policy, although political expediency suggests that further deficit reductions are unlikely in the short term.

With the exception of Slovenia, the CEB countries face growing uncertainty about to the timing of their adoption of the euro (see Table 2.2). Two years after joining the EU, convergence momentum has slowed down significantly. The Baltic states are struggling to meet the Maastricht inflation criterion and both Estonia and Lithuania have postponed adoption of the euro beyond their target date of January 2007. Although Latvia still intends to adopt the single currency in January 2008, it has the highest inflation rate in the EU.

<<Insert Table 2.2 about here – Comparison of euro adoption plans>>

Of the remaining countries, the Slovak Republic was most clearly on track to adopt the euro (in 2009) until rising inflation and policy statements by the new government on   fiscal priorities raised doubts about this schedule. In 2005, Poland was also aiming for euro adoption in 2009, but this no longer appears to be a government priority. The Czech Republic is fulfilling all Maastricht criteria except the exchange rate criterion, post-election political uncertainty has curbed the enthusiasm for a quick euro adoption. Although Hungary has not officially revised its plan for euro adoption in 2010, it has the highest fiscal deficit in the EU. Given the scale of fiscal consolidation required and the political difficulties facing the government, adoption by that date is unlikely.


Prospects for SEE over the medium term are favourable within a wide margin of uncertainty. Overall, growth is projected to match present levels, driven by continuing strong domestic demand and a probable expansion of exports. Increased stability in the region and the prospects of EU accession are encouraging record inflows of investment. Although these inflows are likely to decline as privatisation programmes are completed, their benefits will be longlasting. The main policy considerations should be on the fiscal side. Governments in all SEE countries will face sustained pressure for extra spending, especially on infrastructure deficiencies.

Two principal challenges for the region in the medium term are the goal of EU membership for all SEE countries and the lasting settlement of unresolved conflicts. With regard to EU accession there is a risk of a split between countries for which membership is either imminent or likely in the short term (Bulgaria, Romania and Croatia - SEE-3) and the rest of the region (SEE-5). The SEE-3 countries are likely to benefit substantially from considerable EU assistance, which should translate in the coming years into enhanced infrastructure and improved public administration. For the remaining countries, EU aid will be concentrated into a new instrument, the IPA (Instrument of Pre-Accession). While funding under this programme will be significant, there is a risk that the SEE-5 will lag behind. More generally, these countries are vulnerable to the growing sense of “enlargement fatigue” among existing EU member states. To maintain reform momentum, it is vital for all SEE countries that they have the prospect of full EU membership over the medium term.

Regarding the political environment, the main unresolved issue is the status of Kosovo. The general economic situation in the province is precarious and unlikely to improve significantly while a stalemate continues. Talks brokered by the United Nations are under way to try and resolve the impasse but a compromise satisfying all sides remains elusive. Nevertheless, it is most unlikely that SEE will see any repeat of the conflicts of the 1990s. The countries of the region have since become far more integrated and interdependent, which should provide a safeguard against future upheaval.

CIS and Mongolia

GDP growth rates in the CIS and Mongolia over the medium term should be similar to those expected this year, implying continued convergence with the other transition regions. Global demand for energy and commodities, especially from the growing economies of Asia, is likely to stay buoyant. While principally benefiting the resource-rich economies, this trend will also help countries like Ukraine and Armenia which depend on exports of non-precious metals or semi-precious stones and metals.

Private consumption will remain a key source of economic momentum. Across the region, credit is growing rapidly as financial services develop, but this also raises concerns about future financial stability. High energy and commodity prices in the global market, coupled with strong domestic demand fuelled by real wage growth, will continue to put upward pressure on the inflation rate, although the upward impetus from energy and commodity price increases on inflation is likely to come down in 2007 (see Chart 2.7).

<<Insert Chart 2.7 – Commodity prices>>

The persistent strength of economic growth across the region has made some countries complacent about the need for further reform and fiscal discipline. As Chapter 1 demonstrated, the CIS and Mongolia continue to lag behind in terms of structural reform and this is likely to lead to low productivity increases. This becomes all the more important given the pressure that ageing populations will put on public finances (see Box 2.2). Delaying reforms of the social welfare system will mean a greater eventual adjustment burden in the future and could jeopardise macroeconomic stability.

Over the medium term, China is likely to have an increasing economic influence on the Central Asian states. Trade volumes between China and Central Asia have expanded significantly (particularly for Kazakhstan, the Kyrgyz Republic and Mongolia) and this trend should continue. Central Asia’s rich natural resources also hold considerable attraction for energy-hungry China, which is consequently becoming a significant investor in the region. China is already the main source of FDI for Mongolia, and to a lesser but increasing extent, Kazakhstan. In Uzbekistan, a large scale oil and gas exploration project involving of the National Petroleum Corporation of China is in the planning process. To gain more influence in the region but also to ease the transport of commodities, China is also providing state loans for transport projects in Kazakhstan, the Kyrgyz Republic, Tajikistan and Uzbekistan.

Box : Ageing, pension reforms and capital market developments[1]

The populations of the transition countries are growing older. This is reflected in the increase in the old-age dependency ratio - the ratio of the population aged 65 and above to the population aged 15 to 64. According to UN projections, this ratio is likely to rise continuously from the present level of less than 20 per cent to almost 40 per cent by 2050. The young-age dependency ratio – the ratio of the population aged below 15 to the population aged 15 to 64 - is expected to remain relatively stable at around 25 per cent throughout the period to 2050 (see Chart 1).

The rise in the old-age dependency ratio indicates longer life expectancy and fertility rates (the number of children per woman) below the rate of approximately 2.1 children per woman at which population size (in the absence of migration) remains stable. According to the UN projections, life expectancy in transition countries will increase from currently 69 to about 75 years in 2050. Male life expectancy will increase from about 64 years to 72 years, while female life expectancy will rise from 74 to 79 years. Fertility rates are expected to stay at low levels. In 2005, the average fertility rate was 1.5 (ranging from 1.15 in the Ukraine to 2.5 in Turkmenistan). Migration also influences old-age dependency ratios, but to a lesser degree. In a few countries (for example, Hungary, Slovenia and Russia) net immigration in the period to 2050 is expected to have a moderate positive impact on population size according to UN projections. In most cases, however, the impact is expected to be negative, in particular in Albania, Kazakhstan, Kyrgyzstan and Tajikistan. Although population projections are inherently prone to large margins of error given the long period of time that they cover, the trends identified by the UN are supported by other research (for example, by Eurostat for the CEB countries).

<<Insert Box 2.2 Chart 1 here>>

Public finances and pension reforms

Population ageing and the rise in the dependency ratio will have dramatic effects on the public finances. Public pension systems based on the pay-as-you-go (PAYG) principle, whereby current contributions are used to finance current pensions, will come under pressure as the ratio between the number of pensioners and the number of contributors rises. Public expenditure on health and long-term care is also set to increase as medical advances continue and the demand for services rises with the growing numbers of elderly people. Population ageing, meanwhile, has a negative effect on fiscal sustainability. All other things equal, revenue from taxes on labour decline because of the shrinking working-age population. Abstracting from other possible effects (e.g., the impact of a more experienced workforce on productivity) this decline of the workforce will also tend to reduce output in the economy.

The overall impact of these developments will be considerable, particularly on unreformed pension systems. Although there is no comprehensive research covering all transition countries, a study carried out by the European Commission and the Economic Policy Committee for the eight CEB countries has estimated that the projected impact on public expenditure by 2050 from a change in pension, health care and long-term care provisions varies from a fall of 4.4 percentage points of GDP in Poland to a rise of 10 percentage points of GDP in Slovenia by 2050. The forecast reduction in public expenditure for Poland is a result of the sweeping pension reforms undertaken since 1998. Slovenia and the Czech Republic, which have not significantly reformed their pension systems, will record the highest increase.

There are several reasons why these expenditure projections may underestimate the challenges faced by transition countries, especially those outside the EU which face a greater burden from ageing populations. First, the projections are based on fairly favourable assumptions about future labour market developments and the ability of the new EU members to move towards the economic standards of other member states. Secondly, the health expenditure projections focus only on the demographic impact rather than factors that such as new medical technologies, rising per capita demand for health services and increasing prices of health-related goods and services). Lastly, institutional weaknesses make the challenge of ageing populations even greater, because they lead to low rates of tax compliance and hence low rates of participation in public pension schemes.

Coping with the fiscal effects of ageing populations requires comprehensive reforms of social security, principally pension systems but also health and long-term care provision and labour markets. Many transition countries – Bulgaria, Croatia, Estonia, FYR Macedonia, Hungary, Kazakhstan, Latvia, Lithuania, Poland, Russia and the Slovak Republic – undertook extensive pension reforms in the late 1990s and in the early years of the present decade. All of them have introduced a multi-pillar model, characterised by three basic elements: a mandatory pay-as-you-go “first pillar” that is to some degree linked to earnings; a mandatory funded “second pillar” that is essentially an individual savings account; and a voluntary funded “third pillar” that can take many forms (individual, employer sponsored, defined benefit, defined contribution). Most of the other transition countries that have not introduced a multi-pillar model have nevertheless undertaken parametric reforms of their PAYG system, i.e. altered important parameters of this system, for example, raising retirement ages, extending required contribution periods and strengthening the link between contributions and benefits.

The countries that have undertaken multi-pillar reform have kept a (reformed) public PAYG earnings-related scheme (see Table 1). Despite parametric reforms of the PAYG system, most transition countries retained the idea of a defined benefit (DB) scheme, where pensions are calculated as a fixed proportion of the individual’s earnings or final salary. Latvia, Poland, Croatia, Kazakhstan and to some extent Russia have transformed their public systems from a defined-benefit scheme into a notional defined contribution (NDC) system. In an NDC scheme, pensions are financed on a PAYG basis, but individual contributions generate future pension claims that are accumulated in each individual’s notional account. At the time of retirement, benefits are calculated in an actuarial way, reflecting individual contributions and the growth of the economy. In the end, the pension benefit is an annuity drawn from the notional accumulated capital sum.

<<Insert Box 2.2 Table 1 about here>>

Capital market development

As well as helping to improve fiscal sustainability, multi-pillar pension reforms can also stimulate capital market development in so far as the creation of mandatory pension schemes generates long-term savings. Managed by professional investors and with a long-term orientation, pension funds have the potential to create more competition to existing commercial and investment banks, to stimulate financial innovation, to promote greater market integrity and modern trading facilities and to encourage more robust regulation in the financial sector as a whole.

<<Insert Box 2.2 Table 2 about here>>

Within the transition region, experience shows that pension funds have the potential to generate a substantial amount of long-term savings. Accumulated savings are still small – about US$ 46 million in net assets under management, or 3 per cent of GDP (see Table 3) – but growing rapidly, on average by about 50 per cent per year in 2005. Given the small size of the assets under management, it is too early to assess conclusively the impact of mandatory pension funds on capital market development. Regarding increased competition for existing institutions, it appears that in the early stage of reform (in the Slovak Republic, for example) the introduction of the mandatory funded pillar provides a boost to the existing banking sector as most of the assets are still held by commercial banks. However, portfolios tend to get more diversified over time, even though the majority of assets remain in bonds.

In countries with small capital markets, where there are a limited number of investment opportunities and euro adoption is a medium term objective, pension funds invest predominantly in foreign currency. For example in Estonia and Lithuania over 80 per cent of the assets are invested this way (mostly in euro). This is a positive strategy for risk diversification but not necessarily for domestic capital market development. Pension fund market concentration is still high in many countries. In Bulgaria, for example, two companies managed almost 70 per cent of net assets in the pension system at the end of 2004. In Russia, the large number of funds competing for capital has led to a number of funds operating far below efficiency levels, resulting in high management costs. Nevertheless, the introduction of pension reform has in many countries been accompanied by a sequence of new legislation regarding the management of pension funds, indicating that the countries are well aware of the need for robust regulation in this area.

Annex: Tables and charts

Table 2.1: Unemployment rates in 2004 and 2005

Chart 2.1: Inflation and core inflation in selected CEB countries (July 2005 to July 2006)

Source: Eurostat

Note: HICP = Harmonized index of consumer prices

Chart 2.2: Net FDI coverage of current account deficit

Source: EBRD.

Note: Slovenia is not included due to negative net FDI in 2005.

Chart 2.3: Net foreign direct investment from 2000 to 2005

Source: EBRD

Chart 2.4: Government expenditures and deficits as a percentage of GDP in 2005

Source: EBRD

Chart 2.5: Oil price and weighted average real growth in the CIS and Mongolia, 1996-2006

Source: EBRD and Bloomberg

Chart 2.6: Current account balances in 2005 and 2006 as per cent of GDP

Source: EBRD

Table 2.2: Comparison of euro adoption plans in 2005 versus 2006

Chart 2.7: Selected commodity price indices, 2000-2010

Source: IMF

Box , Chart 1: Dependency ratios in transition countries (2005-2050)

Source: UN

Box , Table 1: Overview of multi-pillar reforms in transition countries

Box 2.2, Table 2: Volume and structure of assets held in mandatory (“second pillar”) pension funds in selected transition countries in million US$ at the end of 2005

This box is based on EBRD Working Paper No. xxx. …

Politica de confidentialitate



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