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International Seminar for Experts
“Catching up after Enlargement”
Cicero Foundation
October 14-15, 2004
Fiscal Policy Challenges Facing the New
Member States in a Period of Large Capital
Inflows & Substantial Investment Requirements
Armin Riess
European Investment Bank
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
7
6
5
4
Long-run CEE growth potential 4-5%
EU-15 potential
3
2
1
0
CZ
SL
HU
SK
PL
BU
RO
Source: European Commission, Economic Forecast, Spring 2004
ES
LA
LI
Consumer price inflation (in %), 2004
12
10
8
6
4
2004 CEE average
EU-15/eurozone target
2
0
LI
PL
CZ
ES
SL
LA
BU
Source: European Commission, Economic Forecast, Spring 2004
HU
SK
RO
Public debt in CEE & EU-15 (% of GDP), 2004
120
100
80
Maastricht 60% criterion
60
40
20
Source: European Commission, Economic Forecast, Spring 2004
ES
LA
LI
RO
SL
CZ
BU
SK
PO
HU
LU
IRE
UK
DK
FI
ES
SWE
NL
POR
FR
A
GER
BEL
GR
IT
0
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
8
(% of GDP, 1999-2003 average)
6
CEE average 3.9%
4
EU15 average 2.3%
2
LI
RO
SK
PL
ES
BU
HU
LA
SL
CZ
UK
AT
BEL
GER
DK
IT
FI
FR
SWE
ES
NL
PT
GR
IRE
LU
0
Source: European Commission (2003 Spring Forecast) and IMF (Staff Appraisal Reports)
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)
20
15
10
5
0
CZ
HU
LI
PO
2000
RO
2050
Source: European Commission; Occasional Paper 4, July 2003
SL
EU
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)
(2001-2003 average for CEE, peak inflow periods otherwise )
14
12
10
8
1998-9
1996-9
1987-91
6
4
2
Source: IMF (Staff Appraisal Reports); Begg et al. (2002)
Sp
Po ain
rt
ug
a
G l
re
ec
e
SK
CZ
LA
LI
RO
BU
ES
SL
PL
H
U
0
Capital inflows & current account deficits
(in % of GDP, 2001-2003 average)
14
12
10
Current account deficit
Capital inflows
8
6
4
2
0
-2
HU
PL
SL
ES
Source: IMF (Staff Appraisal Reports)
BU
LI
RO
LA
CZ
SK
Why do large capital inflows occur?
 Higher returns on physical investment
 Expected trend appreciation of currency
(Balassa-Samuelson effect)
Why are capital inflows a mixed blessing ?
What’s 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
Fiscal deficit & exchange rate regime
(% of GDP, 2001-2003 average)
5
“Flexible” exchange rates
3
Hard currency pegs
1
-1
ES
BU
LI
LA
Source: IMF (Staff Appraisal Reports)
SL
RO
SK
CZ
HU
PL
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’