Impact of the Eurozone crisis on CEE/SEE – short term and long term consequences

PERC TU Economist network workshop

Kiev

4 October 2012

Béla Galgóczi

bgalgoczi@etui.org

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Eurozone crisis 2010-2012: fundamental questions on the nature and construct of integration within EMU and the EU

The question is not anymore just about debt and competitiveness, but about the basic principle of integration, the extent of fiscal intervention, sovereignty and democracy

To illustrate this, three questions from national perspective:

Why Slovakia (with an income level of 1/3 of Greece) should finance a Greek bailout?

Why and to what extent the German taxpayer has responsibility for Greece and who represents him?

Can heads of the Eurozone interfer into the sovereignty of Greece (tell what to do..)?

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Conflicting objectives in the post-crisis period

All three questions can be justified from a national perspective, but can have fatal consequences for the Eurozone as a whole (and then of course back to the national level).

Although Slovakia was right to say, this is not the Euro-zone we entered, this is not an excuse. The letter of the Maastricht Treaty did not include such scenario, but an implicit commitment of limited fiscal sovereignty was there from the beginning. Now this will be more explicit and some sort of a shared fiscal authority (if not necessarily a full fiscal union) will appear.

In that case a bailout (even in form of guarantee) involves interference into fiscal sovereignty (tell Greece what to do..)

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What does this mean for CEE/SEE?

Even if the EMU is in a deep crisis it is still attractive for any small CEE economy to join (compared to being outside, it is still a safe-heaven)

All the more so that most CEE-s do not have a fundamental competitiveness problem (like PT or GR) where exchange rate could help (see later)

CEE is fully docked in on the German export machine, it is fully integrated into German value chains (has also a trade surplus with Germany) – ‘backyard’ of Eurozone centre

But they have large foreign exchange private loans.. (see graph and the case of Estonia)

We have to keep in mind:

- CEE and SEE countries are not yet out of the crisis

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Just to keep in mind…

Developments in unemployment for youth and adults, 2008Q2 and 2011Q2

Note: youth: 15-24 years, adults: 25-64 years.Source: Eurostat (2011j).

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One immediate consequence: the burden of foreign loans

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Short term consequences of the EMU crisis on CEE/SEE

Short term consequences arise from the market turbulences

Any country with less solid finances and with a level of high external financing is affected (more difficult debt financing, spreads on interest rates go up, bond markets dry up, exchange rates under pressure

These are very concrete threats and can bring state finances on brink of collapse, with depreciating currencies debt burden of household grows (domestic demand and GDP falls > a vicious circle can be launched)

No country can afford to go against the markets - Hungary! - the IMF again around the corner (and it is still the better option…)

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The story of two countries in brief: Hungary and Latvia

Two different cases, but the same lesson: an enduring overdosis of austerity kills the economy and poses a threat also to democracy.

Hungary: longest period of austerity (started at the end of 2006!) – in 2010 it led to a landslide victory of a populist party with the election promise of ‚down with austerity‘.

Right at the beginning ‚Brussels‘ made the new government clear: no tolerance with expansionary fiscal policy. Answer of the government: unortodox economic policy with chaotic results (including the infringement of basis democratic rights), including also the most brutal Labour Code in the EU.

By 2012: the IMF is again around the corner.

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The story of two countries in brief: Hungary and Latvia

Latvia was the first EU country to turn to the IMF in 2008 and has carried out a robust austerity programme with the adjustment course of ‚internal devaluation‘.

Since 2007, the country has lost 30% of ist GDP, but in 2011 it showed 5.9% growth (highest in EU).

Hence the early conclusion of the EU Commission: ‚austerity works!‘, Latvia put as example to south-EU crisis states.

BUT: the country suffered a 30% fall in GDP (and wages and pensions), it suffered a migration exodus, but still unemployment is 17%.

Well, it had 5.9% GDP growth last year, BUT precisely because from 2010 it abandoned austerity. Seeing the GDP in free fall, the IMF was flexible enough to accept a budget deficit of 12%.

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Mid term threat: a looming EMU recession will again effect the export sector

- Although FDI dependence was questioned in the 2009 crisis, FDI led export sector is still the strongest element of CEE economies.

- Core CEE countries have a very high export dependence (CZ, SK, HU over 80% of GDP), partially concentrated in cyclical branches (automobile; electronics)

- With a recession in the Eurozone and a slowdown in Germany this will again hit the engine of these economies

- There are no other engines (domestic demand weak (exception Poland) /also because indebtedness of population/, banking sector weak, government expenditures under pressure)

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There is still one advantage of CEE countries compared to southern EMU members (PT, GR)

Beside debt the other root of the Eurozone crisis was the

degrading competitiveness of the southern periphery

While Germany had no real wage growth in a decade, unit labour costs (ULC) fell, domestic demand remained low

ULC in other Eurozone countries surged (ES, GR, PT) they lost export competitiveness (+ GR and PT also have structural weakness)

Even if CEE countries had larger wage and ULC increases then the EMU periphery, they do not have a fundamental competitiveness problem (because wages are still low and the FDI led export sector is competitive)

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The last decade: higher wage dynamics in CEE then in both the core and periphery of EMU

Eurozone in 2010Now we examine CEE wage developments in the last decade, what were the drivers and what might be the consequences?

We show real wage developments in CEE countries and in Germany

Real wages that practically stagnated in Germany grew in CEE countries characteristically in the range of 35-75% with Romania outpacing all other countries with an increase of 115%

Then we show the development of unit labour costs for selected CEE-s, Germany and two crisis countries in the Eurozone, Greece and Portugal

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What does this mean for CEE/SEE

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Change of nominal unit labour costs relative to Germany

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Higher wage dynamics in CEE than in both the core and periphery of EMU Eurozone in 2010

Unit labour costs that consider the effect of productivity as well, are widely regarded as a measure of competitiveness

The claim in the Eurozone is that divergence in nominal unit labour costs (NULC) led to unsustainable imbalances as the gap between Germany and countries like Greece and Portugal widened to unsustainable levels

The above graph showed that while NULC-s grew by around 35% in Greece and Portugal, in CEE core countries it showed an increase between 80 and 90% and in the Baltic states between 150 and 230% (here Estonia was shown with 150%)

CEE countries had either fixed exchange rates to the Euro (Baltics + Bulgaria) or (real effective) appreciating exchange rates

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Higher wage dynamics in CEE not necessarily a loss of competitiveness

Increasing nominal ULC-s normally mean losing on competitiveness, as we see in case of the EMU periphery

Still in CEE, no comparable loss of competitiveness occurred, as trade balances, export performance and market share gains show (see European Commission documents, as Annual Growth Survey, 2011)

Part of the answer comes from the nature of transformation economies (wage levels are still a fraction of that of the EU15 as the third graph below shows). At the same time productivity increases in the exporting manufacturing branches are much above national average and this `productivity reserve` gives room for upward wage convergence

Change (in %) in real compensation, 2000-2011

Note: Simple average of annual %-change by groups of countries.Source: AMECO (2011).

Adjusted wage share (2000-2012)

Note: The adjusted wage share is measured as compensation per employee as percentage of GDP at current factor.Source: AMECO (2011).

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What does this mean for CEE/SEE

CEE countries even if their unit labour costs were growing relative to Germany, this did not cause a competitiveness problem, as ULC-s in the manufacturing sector are much lower (due to higher productivity via FDI)

Southern Europe not only loses competitiveness because of ULC trends, but because of structural reasons: they do not have the type of productive base (FDI bases export potential) than what CEE-s have

This is partially due to changing FDI patterns that favoured CEE to South Europe (SK versus PT).

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Danger for CEE economies

Lost convergence: convergence was taken for granted (and a big promise of European integration) – now it is on the reverse

Wage convergence is also under pressure: the ruling doctrine (not just by DG Ecfin, but my most national governments) is that LOW WAGES are the key to competitiveness and even if wages are low (IN CEE they are much LOWER then productivity when both are compared to EU27 average),

They should be CUT even more!!

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Lessons for the region

The impacts of Euro crisis has several dimensions for CEE/SEE

Current market turbulences may remain prolonged: this makes pressure on debt financing and exchange rate especially in the vulnerable countries

This together with a likely recession in the EMU worsens growth prospects

Financial instability may increase and a new round of IMF involvement can be the consequence

Accession chances for SEE are not directly affected but the general uncertainty in the EMU is not helpful (might lead to a slowdown of the process > less willingness for more heterogenity): it is hard to imagine now to talk about the accession of the Ukraine seriously!

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Longer term impact of the EMU crisis

EMU accession for further CEE countries does not seem to be attractive at the moment, although this would have a stabilising effect

Entry criteria are however likely to become stricter and the appetite for further enlargement in EMU is also shrinking

There is also an institutional problem, EU countries outside the EMU are not part of the decision making process although the results affect them

It is at least positive that CEE countries do not have a fundamental competitiveness problem as certain southern European crisis states have.

For the real economy, the dangers of the turbulences matter

With the slowing EMU export-led growth is again in danger

It is however important to have a competitive export potential – in CEE/SEE it is hard to imagine to have this without FDI

Europe used to be a synonym of ‚convergence‘, catching up for CEE countries: is this over now?