Petar Goshev: South Eastern European countries' competitiveness and
challenges on the road to EU
Introductory speech by Mr Petar Goshev, Governor of the National Bank of the Republic of
Macedonia, at the international conference "Competitiveness of the South Eastern European
countries and challenges on the road to EU", organized by the National Bank of the Republic
of Macedonia, Skopje, 30 May 2008.
* * *
Honored guests,
Dear friends,
I wish you a very warm welcome to the Conference of the National Bank of the Republic of
Macedonia on the
Competitiveness of the South Eastern European Countries and
Challenges on the Road to the EU. Similarly to the several conferences and workshops
organized by our Bank in the recent years, this one will also seek to develop a discussion on
a very important topic for the countries in transition striving to reach the income level of the
EU member states. Although real convergence is not directly in the focus of interest of the
monetary authorities, the unbreakable tie between the nominal and real convergence makes
this topic extremely important also from a viewpoint of the monetary policy. Therefore, at this
Conference we will try to analyze once again the achievements of the new EU member
states, particularly their experience, their successes, but also their failures regarding
competitiveness of their economies on the road to EU and EMU membership. I am
convinced that South Eastern European countries, that is EU candidate and potential
candidate countries, will have an opportunity to broaden their knowledge about what to do
and what to avoid on the road to EU. At the same time, we will also share the experiences
about the challenges that the South Eastern European countries face with on their way to the
real convergence.
The transformation of the Central and Eastern European countries and their final
membership in the EU is one of the most remarkable events in human history. Never
before had so many countries and people made so many changes in such a short time.
During the 1990s, we witnessed a complete renewal of entire systems and institutions,
implementation of structural reforms, but also establishing new ways of living and thinking.
What is important for us here is that these changes were happening simultaneously with a
huge rise of income and living standards in general. Although not a perfect indicator for the
remarkable changes, the comparison of GDP per capita in the beginning of transition and
now shows a clear picture of the progress. In 1993, the group of 10 new EU member states
had a GDP per capita that was 37.2% of the euro-zone level at that time, but in 2007 this
indicator reached 56.4%.1 Certainly, not all transition countries were moving with the same
speed, and not all of them reached the same level of income. Among this group of countries,
the three Baltic countries were moving the fastest. In 2007 they had an average GDP per
capita of 56.8% of the average level in the euro-zone (it was 28.2% in 1993). Although the
process of income growth is present also in South Eastern Europe, its pace is slower. For the
period 1996-2007, convergence was made to the income per capita in the countries of the
euro-zone by 8.2 percentage points (from 20.8% to 28.9%).2 What is clear from these
comparisons is that the achievements are huge, but also that much more remains to be done
in order to reach the level of old EU members.
Why the speed of real convergence of the new EU member-states and of the candidate
and potential candidate countries is different, is one of the frequently discussed
questions. Taking classical theory of growth as a starting point, income actually depends on
the factors of production and technological growth, meaning that the reasons for the
differences should be sought in these factors. According to research, the productivity rise
was mostly due to what we call "total factor productivity", that is improvements that can be
attributed neither to capital nor to labor, but to specific organizational, technological and
institutional changes that result in productivity rises and GDP growth. In the past few years,
the new EU member-states register trends of positive influence also of the labor to the
economic growth, while among the SEEU countries this contribution is still mainly negative.3
Structural and institutional reforms also had key influence on the accelerated productivity
growth. Transition indicators of the EBRD that are commonly used for assessment of the
reforms indicate that the new member-states have already reached the level of the
developed countries in the fields of privatization, price liberalization, trade and foreign
exchange systems (although they are still lagging behind with respect to the enterprises
restructuring, competition protection, banking reform and liberalization of the interest rates
and financial markets and institutions, as well as the overall infrastructure).4 On the other
hand, these indicators clearly point to the fact that the SEEU countries, are significantly
lagging behind with the reforms in all these areas, except price liberalization and to a certain
extent trade and foreign exchange systems.
The process of accelerated income increases, that is the process of real convergence,
also initiated the process of nominal convergence. Nominal convergence about which
we, central bankers, speak the most, is consisted mainly of convergence of price levels, but
also of exchange rate changes, interest rates and budget deficits to EU levels. As an
empirical fact, rises in relative CPI usually move together with rises in relative GDP, and
emerging Europe was not immune to this trend. The CPI level in the new EU member states
in 1995 ranged from 29.2% of the EU-15 level in Lithuania to 44.9% of the EU-15 level in
Poland. In 2006, the CPI level ranged from 42.7% in Bulgaria to 71.8% in Slovenia, which
clearly shows fast price rises in these countries.5
It is obvious that the parallel processes of real and nominal convergence of countries in
transition pose numerous challenges for their economic policies in general and
particularly for their monetary policies. The process of real convergence creates
inflationary pressures through a number of channels, thus making it difficult to fulfill one of
the Maastricht criteria for entering the monetary union, and also the higher inflation
generates negative effects on the competitiveness of the domestic economy. The
BalassaSamuelson effect is one of the most frequently indicated channels through which real
convergence leads to higher inflation rates. According to this concept, the faster productivity
growth in the tradables sector compared to the non-tradables sector of a country will cause a
positive inflation differential and afterwards real appreciation - through the rise of
marketdetermined prices of non-tradable goods.6 Although there are certain dilemmas regarding its
importance, most estimates show that the contribution of this effect ranges between 1 and 3
percentage points of CPI inflation. Therefore, for countries with a fixed exchange rate regime,
such as almost all transition countries had in the beginning and quite a few of them now, the
higher inflation is reflected directly into real effective exchange rate appreciation. On the
other hand, countries with flexible exchange rate regimes also face their share of difficulties.
Since they allow their currencies to fluctuate (and usually try to target inflation), their
productivity growth is reflected first in higher nominal exchange rate, and consequently in
real effective exchange rate appreciation as well.
Besides the Balassa-Samuelson as a supply side effect, there were also factors on the
demand side which contributed to higher inflation in these countries during the transition
process. As productivity and income grow, people start spending relatively more on
nontradables and services, which are usually considered more luxurious and are therefore more
expensive. In addition, there were huge quality improvements in products and services,
which also contributed to price rises. Last but not least, as these countries were establishing
functional market economies, they had to allow for market rather than administrative
determination of prices. As prices were previously kept artificially low, these changes caused
additional inflationary pressures. The implementation of structural reforms that are
prerequisite for real convergence, also creates pressures on the fiscal policy, i.e. the budget
deficit and consequently inflation. Part of the costs for the economic reforms are financed
from EU pre-accession funds, whose utilization, although it does not imply direct increase of
the budget deficit and jeopardizing one of the nominal Maastricht criteria, still could have a
significant liquidity effect, creating inflationary pressures.
The combined effect of the of these factors on the supply side and on the demand side, is
reflected in the relatively high inflation in these countries, the average annual rate of which in
the period 1993-2007 in the countries of Central and Eastern Europe ranged from 6% in the
Czech Republic to 38.6% in Lithuania. (By mid-90s, in South Eastern Europe, and in Bulgaria
and Romania, there were frequent instances of extremely high inflation. In this group, in the
period 1998-2007, the average annual inflation rate ranged from 2.1% in Macedonia to
31.1% in Serbia).7 Such movements caused appreciation of the real exchange rate,
which was especially emphasized in the new member states. Thus in the period
19942006, the cumulative appreciation of the real effective exchange rate ranged from 8%
in Slovenia to 105.9% in Lithuania.8 Economic theory offers arguments that real exchange
rate appreciation is not dangerous as long as it reflects changes in the equilibrium real
exchange rate. However, policy makers in these countries, especially in the recent years, are
not really comforted by these theoretical discussions which consider that real appreciation is
only movement to equilibrium. What they are seeing in their countries are common signs of
overheating of the economy and loss of competitiveness, which deepens the external
imbalances. In the beginning of transition, current account deficits were understandable and
not too much cause for concern, as these countries were importing technology and
previously unavailable goods. However, the size of the deficits in the last several years
exceeds the level that is usually deemed sustainable. Thus, the current account deficit in the
new member states in the period 1996-2005 ranged from 5% to 7.7% of GDP, but in the last
two years it has been reaching 10.1% and 11.3% of GDP. The average current account
deficit in the SEEU countries in the same period is even higher, and it is estimated that in
2007 it will reach 16.3%.9 Even though deficits are projected to fall in some of the countries,
in general they remain a cause for concern in most of them. Besides the trade deficit which,
due to lower competitiveness and higher consumption, is one of the main causes for the
current account deficits, some of these countries are also experiencing deficits in the income
balance, which mainly reflects repatriation of profits from foreign direct investments.
Most certainly, such high current account deficits would not have been possible if there were
not such large and continuous capital inflows in transition countries, mainly in terms of FDI,
but also of portfolio and other types of investments. For example, in the period 1989-2007,
total FDI amounted to around 3,600 USD per capita in the new EU member states and
around 2,000 USD per capita in the SEEU countries.10 Again, in the earlier years of
transition, capital flows partially substituted for the insufficient savings in these countries and
allowed for the necessary transfer of technology and expansion of production. However,
there are concerns that, in the recent years, and particularly in the countries with fixed
exchange rates, capital inflows are dangerously adding to domestic demand, thus putting
further pressure on inflation and increasing imports.
In addition, the rise in incomes, the presence of abundant foreign capital, the expansion of
the banking sector and sometimes negative real interest rates all contributed to rapid credit
growth in transition countries. Again, the rates of growth were almost unprecedented before,
and in 2007 they reached around 60% year on year in Bulgaria, Romania and around 40.6%
in Lithuania.11 After a previously suppressed consumption, the process of credit growth was
understandable and desirable for economic growth. However, the rates of growth are only
adding to demand pressures in these countries, and in combination with the other factors,
adding to the rise of inflation, rise of imports and further worsening of the current account
position.
Dear guests,
At the current time, these developments pose two particular challenges for the policy
makers in transition countries, one a short-term and the other a longer term.
The short term challenge is how to lower the risk of high current account deficits, which
can cause wider financial crisis, combined with a currency crisis in countries with
pegs and currency boards. Both the economic theory and the economic history are clear
that current circumstances are not the most favorable for these countries. Worsening current
account deficits are not sustainable and can not continue forever. The more they widen, the
bigger the pressure becomes for real exchange rate depreciation as a way of restoring
competitiveness. This of course can be a bit easier for countries with flexible exchange rates,
which can achieve it by nominal depreciation (and thus risk rise in inflation). However,
countries with fixed rates are sometimes forced to abandon their exchange rate regime, as
they do not have any other way out of real overvaluation of their currencies. Another risk in
the short term might be the contagion of financial crises from abroad, which would combine
with fragilities and thus prompt financial and economic difficulties in these countries.
The long-run challenges for transition countries are related to the
simultaneous
maintenance of competitiveness and nominal convergence. What is next for the new EU
member states is certainly achieving EMU membership and all of them agree that the
stability and opportunities of the single currency are their goal. While achieving this seemed
easier a few years ago, the prospects are somewhat worsened in the light of the recent
developments. The record high oil prices and the high food prices additionally augmented the
inflationary pressures in these countries. The high inflation in most of the transition countries
makes them breach the first of the four Maastricht criteria. What is even worse, the forecasts
for the next several years for most of the countries show they will probably not meet the
inflation criterion. This is particularly troubling for the countries on a fixed exchange rate
regime or currency board, which do not have the exchange rate flexibility as an instrument
for handling inflation.
Another part where there might be trouble is the exchange rate criterion. Now it is the floaters
that could have bigger difficulties, particularly if the current developments continue and
capital keeps to flow in these countries, thus making pressures for nominal appreciation. As
far as the budget deficit criterion and the interest rate criterion are concerned, it appears that
in these areas there will be less difficulties in fulfilling the Maastricht criteria, under the
assumption there will be maintenance and strengthening of fiscal discipline.
Of course, not all is bad and unreachable as far as Maastricht criteria are concerned. These
countries are not giving up and they stand ready to increase their efforts in order to achieve
their goals. While it appears that most transition countries have postponed their euro-zone
entry a little bit due to the abovementioned difficulties, there are also two remarkable success
stories from the transition countries. We already have Slovenia which has been in the
eurozone since last year. In addition, we have Slovakia which got a positive opinion by the
European Commission on fulfillment of criteria and is getting ready to adopt the euro in the
beginning of next year.
The remarkable success of the Central and Eastern European countries of achieving EU
membership after a thorough transformation and rapid growth of living standards
undoubtedly holds a lot of recommendations and lessons for the South Eastern European
countries. These countries had similar, maybe even more advanced starting positions than
the other transition countries, but South Eastern Europe is now lagging far more behind in
terms of progress towards the EU. However, we should bear in mind that the main reason for
this is definitively the political instability and war conflicts in the region, which understandably
prevented faster economic transformation and reforms. Luckily, it appears that political
support for EU accession and the determination to pursue EU membership, including all the
necessary economic and political reforms, are strengthening.
In analyzing the economic developments in the region of South Eastern Europe, some
notable differences with the CEE countries appear. South Eastern Europe has much lower
pace of reforms and lower growth rates. Related to this, capital inflows in the region have
been much smaller and have shown a much bigger dispersion among countries, ranging
from 834 USD per capita in Albania to 3,932 USD per capita in Croatia, cumulatively in the
period 1989-2007.12 Credit expansion has been high, but has still to reach rates and length
of the one seen in more advanced transition countries. Consequently, there have been less
demand pressures as well as comparatively lower inflation than in the other countries,
although inflation has been rising recently. Exchange rate regimes in the region are various,
ranging from currency board in Bosnia and Herzegovina to almost free float within inflation
targeting in Serbia. What is common is that during the transition process all these countries
dedicated particular attention to their exchange rate regimes and they were mostly using
fixed rates, which reflects their high trade openness and their efforts to establish strong
monetary authority.
Regardless of the exchange rate regime, the real exchange rate appreciation in the countries
in the region has been considerable, although maybe a bit lower when compared to the new
EU member states. As a result, these countries have been suffering from competitiveness
loss as well. This can be clearly seen in the movement of their current account deficits, which
are considerable in all of these countries. For instance, current account deficits in 2007 range
from 3.1% of GDP in Macedonia to 36.2% of GDP in Montenegro.13 However, SEEU
contains two distinct patterns of the structure of the balance of payments. The first is the
conventional one for the transition countries, where the current account deficit is covered
mostly with FDI and portfolio investments (e.g. Croatia). On the other hand, the second
pattern is consisted of huge trade deficits, which are covered much more by remittances from
abroad than by foreign investments (e.g. Macedonia, Albania). However, the dilemma
appears whether these high current account deficits are sustainable.
Regarding the economic history, despite the fact that in certain areas Macedonia was a
pioneer in the implementation of reforms in South Eastern Europe, under the influence of
negative external and domestic shocks it had relatively low rate of economic growth of
averagely 2.7% in the 1997-2007 period. This resulted in a relatively low level of real
convergence of 25.7% of GDP per capita in the euro-zone (23.6% in 1996). The use of the
exchange rate as an anchor for inflation expectations has been effective until now, producing
low and stable inflation rates. In circumstances of high import dependence and relatively
slow implementation of structural reforms aimed at increasing the export potential,
contributed to the maintenance of high trade deficit, which was mainly financed by high
private transfers.
However, the transition process in Macedonia is specific because of the relatively slower
process of real convergence and the
continuous real depreciation of the Macedonian
Denar. Namely, according to some research,14 there has been an absence of the
BalassaSamuelson effect in Macedonia, that is the productivity in the tradable sector compared to
foreign partners rises with relatively lower rates. This was a result of the absence of big
foreign companies and the loss of important foreign markets, particularly after the
independence. In such circumstances, the only way to maintain the competitiveness of the
Macedonian producers was the specialization and exports of lower quality products. These
developments did not generate inflationary pressures, which caused absence of real
appreciation that was evident in the other transition countries.
In the past several years, Macedonia is quickly moving closer to the more advanced
transition economies. Several years in a row we have achieved positive and stable growth
rates, equaling 5.1% in 2007, which is the highest growth rate since independence. Even
though economic growth rates are lower than the ones in Baltic countries as well as some of
the countries in the region, this is a sure sign for the acceleration of the process of real
convergence. This process is also supported by the foreign direct and portfolio investments
(6.3% of GDP in 2007) and the faster credit expansion, with annual growth rate of 39% in
2007. As far as nominal convergence is concerned, Macedonia is facing challenges that are
common for most of the economies in the region and elsewhere. Since the last quarter of
2007, we are having an acceleration of the inflation rate, which is mostly caused by the
global rise of food and energy prices. Therefore, the uncertainty regarding the movement of
these prices, as well as the expectations for pressures initiated by the process of real
convergence are the main challenges for monetary policy in the medium term.
Dear guests,
I hope that with my introductory speech I have identified issues that are in the focus of
interest of the economic policy-makers in the transition countries, and which I expect to be
further elaborated by the participants in the conference. Today we have with us guests with
diverse backgrounds. We have presenters from EU institutions, from old and more advanced
new EU new member states, as well as from the South Eastern European countries, which
are determined to work hard for European integration. I hope that we can share the
experience of the existing EU member states, including the more advanced transition
countries, in the process of EU and later EMU integration. I am sure that South Eastern
European countries have a lot to learn, both in terms of successful strategies and steps and
mistakes to avoid. I am also sure that our capability as central bankers to successfully face
the challenges of faster accession towards the EU and EMU will be enhanced by this and
similar conferences. The high quality of the speakers and the guests and the diversity of their
background make me an optimist that we will have a fruitful Conference, which will broaden
our knowledge with new experiences. I wish you a successful work in the Conference and to
the representatives from abroad I wish a very pleasant stay in Macedonia.
Thank you for your attention!