Commission staff working document - Convergence Report 2010 - Accompanying document to the Report from the Commission "convergence Report 2010 " (Prepared in accordance with Article 140(1) of the Treaty) {COM(2010) 238 final}
Date: 2010-05-12
Institutions: European Commission
Subjects: Economic and Monetary Union, convergence criteria, coordination of EMU policies, economic convergence, report, single monetary policy

EN 

EN  

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EUROPEAN COMMISSION 

Brussels, 12.5.2010 
SEC(2010) 598 final 

COMMISSION STAFF WORKING DOCUMENT 

CONVERGENCE REPORT 2010 

Accompanying document to the 

REPORT FROM THE COMMISSION 

CONVERGENCE REPORT 2010 

(Prepared in accordance with Article 140(1) of the Treaty) 

{COM(2010) 238 final} 

 
  
 
 
 
 
 
 
 
European Commission 

Directorate-General for Economic and Financial Affairs 

Convergence Report 2010 

EUROPEAN ECONOMY 

xxx/2010 

 
 
 
 
 
 
ABBREVIATIONS 

Member States 

Bulgaria 
Czech Republic 
Estonia  
Latvia 
Lithuania 
Hungary 
Poland 
Romania 
Sweden 

BG 
CZ 
EE 
LV 
LT 
HU 
PL 
RO 
SE 
EU-27  European Union, 27 Member States 
EU-25  European Union, 25 Member States before 1 January 2007 (i.e. EU-27 excl. BG and RO) 

Currencies 

EUR   Euro 
ECU   European currency unit 
BGN  Bulgarian lev 
Czech koruna 
CZK 
Estonian kroon 
EEK 
Latvian lats 
LVL 
LTL 
Lithuanian litas 
HUF  Hungarian forint 
MFI  Monetary Financial Institution  
PLN 
RON  Romanian leu (ROL until 30 June 2005) 
Slovak koruna 
SKK 
SEK 
Swedish krona 
DEM  Deutsche Mark  
USD   US dollar 
SDR 

Special Drawing Rights 

Polish zloty 

Other abbreviations 

BoP 
Balance of Payments 
CBA  Currency board arrangement 
Credit Default Swaps 
CDS 
Central and Eastern Europe 
CEE 
Commonwealth of Independent States 
CIS 
Consumer price index 
CPI 
Concentration ratio (aggregated market share of five banks with the largest market share) 
CR5 
European Central Bank 
ECB 
Excessive Deficit Procedure 
EDP 
EMI 
European Monetary Institute 
EMU  Economic and monetary union 
ERM II  Exchange rate mechanism II 
ESA95  European System of Accounts 
ESCB  European System of Central Banks 
Eurostat Statistical Office of the European Communities 
FDI 
FSC 
GDP  Gross domestic product 
HICP  Harmonised index of consumer prices 

Foreign direct investment 
Financial Supervision Commission 

ii 

 
 
 
 
 
 
Information and communications technology 

ICT 
MTO  Medium-term objective 
NCBs  National central banks 
NEER  Nominal effective exchange rate 
Non-performing loans 
NPL 
PPS 
Purchasing Power Standard 
R&D  Research and development 
REER  Real effective exchange rate 
SGP 
TFEU  Treaty on the Functioning of the European Union 
TFP 
ULC   Unit labour costs 
VAT  Value added tax 

Stability and Growth Pact 

Total factor productivity 

iii 

 
 
ACKNOWLEDGEMENTS 

The Convergence Report and its Technical Annex were prepared in the Directorate-General for Economic 
and Financial Affairs. The main contributors were Zdeněk Čech, Anton Jevcak, Ewa Klima, Paul Kutos, 
Géraldine Mahieu, Laura Ruud, Sara Tägtström, Milda Valentinaite and Joachim Wadefjord.  

Other contributors were Benjamin Angel, Sean Berrigan, Piotr Bogumil, Lina Bukeviciute Georg Busch, 
Adriaan Dierx, Gatis Eglitis, Balazs Forgo, Malgorzata Galar, Olivia Galgau, Agne Geniusaite, Nikolay 
Gertchev, Gabriele Giudice, Oskar Grevesmuhl, Isabel Grilo, Zoltan Gyenes, Renata Hruzova, Fabienne 
Ilzkovitz, Barbara Kauffmann, Filip Keereman, Julda Kielyte, Daniel Kosicki, Bozhil Kostov, Baudouin 
Lamine,  João  Nogueira  Martins,  Olivia  Mollen,  Balazs  Parkanyi,  Julien  Rousselon,  Aleksander 
Rutkowski,  Dominique  Simonis,  Harald  Stieber,  Michal  Strojwas,  Ingrid  Toming,  Mariana  Tomova, 
Corina Weidinger Sosdean, Ralph Wilkinson and Markus Wintersteller.  

Statistical assistance was provided by Gerda Symens and André Verbanck.  

The  report  was  coordinated  by  Massimo  Suardi  and  approved  by  Servaas  Deroose,  Acting  Deputy 
Director General, and Marco Buti, Director General. 

Questions and comments may be referred to Géraldine Mahieu (geraldine.mahieu@ec.europa.eu). 

iv 

 
 
CONTENTS 

Convergence Report 2010 

Convergence Report 2010 - Technical annex 

1. 

Introduction 

1.1.  ROLE OF THE REPORT 

1.2.  APPLICATION OF THE CRITERIA 

1.2.1.  Compatibility of legislation 

1.2.2.  Price stability 

1.2.3.  Government budgetary position 

1.2.4.  Exchange rate stability 

1.2.5.  Long-term interest rates 

1.2.6.  Additional factors 

2. 

Bulgaria 

2.1. 

LEGAL COMPATIBILITY 

2.1.1. 

Introduction 

2.1.2.  Objectives 

2.1.3. 

Independence 

2.1.4. 

Integration in the ESCB 

2.1.5.  Prohibition of monetary financing 

2.1.6.  Assessment of compatibility 

2.2.  PRICE STABILITY 

2.2.1.  Respect of the reference value 

2.2.2.  Recent inflation developments 

2.2.3.  Underlying factors and sustainability of inflation 

2.3.  GOVERNMENT BUDGETARY POSITION 

2.3.1.  Developments 2004-2009 

2.3.2.  Medium-term prospects 

2.4.  EXCHANGE RATE STABILITY 

2.5. 

LONG-TERM INTEREST RATE 

2.6.  ADDITIONAL FACTORS 

2.6.1.  Developments of the balance of payments 

2.6.2.  Product market integration 

2.6.3.  Financial market integration 

3.  Czech Republic 

3.1. 

LEGAL COMPATIBILITY 

3.1.1. 

Introduction 

3.1.2.  Objectives 

3.1.3. 

Independence 

3.1.4. 

Integration in the ESCB 

3.1.5.  Prohibition of monetary financing 

3.1.6.  Assessment of compatibility 

3.2.  PRICE STABILITY 

3.2.1.  Respect of the reference value 

3.2.2.  Recent inflation developments 

3.2.3.  Underlying factors and sustainability of inflation 

3.3.  GOVERNMENT BUDGETARY POSITION 

3.3.1.  The excessive deficit procedure for the Czech republic 

1 

3 

5 

5 

7 

7 

7 

10 

12 

13 

14 

17 

17 

17 

17 

17 

18 

18 

18 

19 

19 

19 

20 

24 

24 

25 

27 

29 

30 

30 

31 

33 

35 

35 

35 

35 

35 

35 

36 

36 

37 

37 

37 

37 

41 

41 

v 

 
3.3.2.  Developments until 2009 

3.3.3.  Medium-term prospects 

3.4.  EXCHANGE RATE STABILITY 

3.5. 

LONG-TERM INTEREST RATE 

3.6.  ADDITIONAL FACTORS 

3.6.1.  Developments of the balance of payments 

3.6.2.  Product market integration 

3.6.3.  Financial market integration 

4. 

Estonia 

4.1. 

LEGAL COMPATIBILITY 

4.1.1. 

Introduction 

4.1.2.  Objectives 

4.1.3. 

Independence 

4.1.4. 

Integration in the ESCB 

4.1.5.  Prohibition of monetary financing 

4.1.6.  Assessment of compatibility 

4.2.  PRICE STABILITY 

4.2.1.  Respect of the reference value 

4.2.2.  Recent inflation developments 

4.2.3.  Underlying factors and sustainability of inflation 

4.3.  GOVERNMENT BUDGETARY POSITION 

4.3.1.  Developments 2004-2009 

4.3.2.  Medium-term prospects 

4.4.  EXCHANGE RATE STABILITY 

4.5. 

LONG-TERM INTEREST RATES 

4.6.  ADDITIONAL FACTORS 

4.6.1.  Developments of the balance of payments 

4.6.2.  Product market integration 

4.6.3.  Financial market integration 

5. 

Latvia 

5.1. 

LEGAL COMPATIBILITY 

5.1.1. 

Introduction 

5.1.2.  Objectives 

5.1.3. 

Independence 

5.1.4. 

Integration in the ESCB 

5.1.5.  Prohibition of monetary financing 

5.1.6.  Assessment of compatibility 

5.2.  PRICE STABILITY 

5.2.1.  Respect of the reference value 

5.2.2.  Recent inflation developments 

5.2.3.  Underlying factors and sustainability of inflation 

5.3.  GOVERNMENT BUDGETARY POSITION 

5.3.1.  The excessive deficit procedure for Latvia () 

5.3.2.  Developments 2004-2009 

5.3.3.  Medium-term prospects 

5.4.  EXCHANGE RATE STABILITY 

5.5. 

LONG-TERM INTEREST RATE 

5.6.  ADDITIONAL FACTORS 

5.6.1.  Developments of the balance of payments 

5.6.2.  Product market integration 

5.6.3.  Financial market integration 

vi 

41 

42 

44 

45 

46 

46 

47 

49 

51 

51 

51 

51 

51 

51 

52 

52 

53 

53 

53 

53 

58 

58 

58 

61 

63 

65 

65 

66 

68 

71 

71 

71 

71 

71 

72 

72 

72 

73 

73 

73 

74 

78 

78 

78 

79 

82 

84 

85 

85 

87 

89 

 
 
6. 

Lithuania 

6.1. 

LEGAL COMPATIBILITY 

6.1.1. 

Introduction 

6.1.2.  Objectives 

6.1.3. 

Independence 

6.1.4. 

Integration in the ESCB 

6.1.5.  Prohibition of monetary financing 

6.1.6.  Assessment of compatibility 

6.2.  PRICE STABILITY 

6.2.1.  Respect of the reference value 

6.2.2.  Recent inflation developments 

6.2.3.  Underlying factors and sustainability of inflation 

6.3.  GOVERNMENT BUDGETARY POSITION 

6.3.1.  The excessive deficit procedure for Lithuania () 

6.3.2.  Developments 2004-2009 

6.3.3.  Medium-term prospects 

6.4.  EXCHANGE RATE STABILITY 

6.5. 

LONG-TERM INTEREST RATE 

6.6.  ADDITIONAL FACTORS 

6.6.1.  Developments of the balance of payments 

6.6.2.  Product market integration 

6.6.3.  Financial market integration 

7.  Hungary 

7.1. 

LEGAL COMPATIBILITY 

7.1.1. 

Introduction 

7.1.2.  Objectives 

7.1.3. 

Independence 

7.1.4. 

Integration in the ESCB 

7.1.5.  Prohibition of monetary financing 

7.1.6.  Assessment of compatibility 

7.2.  PRICE STABILITY 

7.2.1.  Respect of the reference value 

7.2.2.  Recent inflation developments 

7.2.3.  Underlying factors and sustainability of inflation 

7.3.  GOVERNMENT BUDGETARY POSITION 

7.3.1.  The excessive deficit procedure for Hungary () 

7.3.2.  Developments 2004-2009 

7.3.3.  Medium-term prospects 

7.4.  EXCHANGE RATE STABILITY 

7.5. 

LONG-TERM INTEREST RATE 

7.6.  ADDITIONAL FACTORS 

7.6.1.  Developments of the balance of payments 

7.6.2.  Product market integration 

7.6.3.  Financial market integration 

8. 

Poland 

8.1. 

LEGAL COMPATIBILITY 

8.1.1. 

Introduction 

8.1.2.  Objectives 

8.1.3. 

Independence 

8.1.4. 

Integration in the ESCB 

8.1.5.  Prohibition of monetary financing 

8.1.6.  Assessment of compatibility 

93 

93 

93 

93 

93 

93 

93 

93 

94 

94 

94 

94 

98 

98 

98 

99 

101 

103 

104 

104 

105 

107 

109 

109 

109 

109 

109 

109 

110 

111 

112 

112 

112 

112 

116 

116 

116 

117 

120 

122 

123 

123 

124 

126 

129 

129 

129 

129 

129 

130 

130 

131 

vii 

 
 
8.2.  PRICE STABILITY 

8.2.1.  Respect of the reference value 

8.2.2.  Recent inflation developments 

8.2.3.  Underlying factors and sustainability of inflation 

8.3.  GOVERNMENT BUDGETARY POSITION 

8.3.1.  The excessive deficit procedure for Poland () 

8.3.2.  Developments 2004-2009 

8.3.3.  Medium-term prospects 

8.4.  EXCHANGE RATE STABILITY 

8.5. 

LONG-TERM INTEREST RATE 

8.6.  ADDITIONAL FACTORS 

8.6.1.  Developments of the balance of payments 

8.6.2.  Product market integration 

8.6.3.  Financial market integration 

9. 

Romania 

9.1. 

LEGAL COMPATIBILITY 

9.1.1. 

Introduction 

9.1.2.  Objectives 

9.1.3. 

Independence 

9.1.4. 

Integration in the ESCB 

9.1.5.  Prohibition of monetary financing 

9.1.6.  Assessment of compatibility 

9.2.  PRICE STABILITY 

9.2.1.  Respect of the reference value 

9.2.2.  Recent inflation developments 

9.2.3.  Underlying factors and sustainability of inflation 

9.3.  GOVERNMENT BUDGETARY POSITION 

9.3.1.  The excessive deficit procedure for Romania () 

9.3.2.  Developments 2004-2009 

9.3.3.  Medium-term prospects 

9.4.  EXCHANGE RATE STABILITY 

9.5. 

LONG-TERM INTEREST RATE 

9.6.  ADDITIONAL FACTORS 

9.6.1.  Developments of the balance of payments 

9.6.2.  Product market integration 

9.6.3.  Financial market integration 

10.  Sweden 

10.1.  LEGAL COMPATIBILITY 

10.1.1.  Introduction 

10.1.2.  Objectives 

10.1.3.  Independence 

10.1.4.  Integration in the ESCB 

10.1.5.  Prohibition of monetary financing 

10.1.6.  Assessment of compatibility 

10.2.  PRICE STABILITY 

10.2.1.  Respect of the reference value 

10.2.2.  Recent inflation developments 

10.2.3.  Underlying factors and sustainability of inflation 

10.3.  GOVERNMENT BUDGETARY POSITION 

10.3.1.  Developments 2004-2009 

10.3.2.  Medium-term prospects 

10.4.  EXCHANGE RATE STABILITY 

viii 

132 

132 

132 

133 

137 

137 

137 

138 

140 

142 

143 

143 

144 

146 

149 

149 

149 

149 

149 

150 

150 

151 

152 

152 

152 

153 

156 

156 

156 

157 

159 

161 

162 

162 

163 

165 

169 

169 

169 

169 

169 

169 

170 

170 

171 

171 

171 

171 

175 

175 

175 

177 

 
 
10.5.  LONG-TERM INTEREST RATE 

10.6.  ADDITIONAL FACTORS 

10.6.1.  Developments of the balance of payments 

10.6.2.  Product market integration 

10.6.3.  Financial market integration 

LIST OF TABLES 

2.2.1. 

2.2.2. 

2.3.1. 

2.6.1. 

2.6.2. 

Bulgaria - Components of inflation 

Bulgaria - Other inflation and cost indicators 

Bulgaria - Budgetary developments and projections 

Bulgaria - Balance of payments 

Bulgaria - Product market integration 

3.2.1.  Czech Republic - Components of inflation 

3.2.2.  Czech Republic - Other inflation and cost indicators 

3.3.1.  Czech Republic - Budgetary developments and projections 

3.6.1.  Czech Republic - Balance of payments 

3.6.2.  Czech Republic - Product market integration 

4.2.1. 

4.2.2. 

4.3.1. 

4.6.1. 

4.6.2. 

5.2.1. 

5.2.2. 

5.3.1. 

5.6.1. 

5.6.2. 

6.2.1. 

6.2.2. 

6.3.1. 

6.6.1. 

6.6.2. 

7.2.1. 

7.2.2. 

7.3.1. 

7.6.1. 

7.6.2. 

8.2.1. 

8.2.2. 

8.3.1. 

8.6.1. 

8.6.2. 

9.2.1. 

9.2.2. 

9.3.1. 

9.6.1. 

9.6.2. 

Estonia - Components of inflation 

Estonia - Other inflation and cost indicators 

Estonia - Budgetary developments and projections 

Estonia - Balance of payments 

Estonia - Product market integration 

Latvia - Components of inflation 

Latvia - Other inflation and cost indicators 

Latvia - Budgetary developments and projections 

Latvia - Balance of payments 

Latvia - Product market integration 

Lithuania - Components of inflation 

Lithuania - Other inflation and cost indicators 

Lithuania - Budgetary developments and projections 

Lithuania - Balance of payments 

Lithuania - Product market integration 

Hungary - Components of inflation 

Hungary - Other inflation and cost indicators 

Hungary - Budgetary developments and projections 

Hungary - Balance of payments 

Hungary - Product market integration 

Poland - Components of inflation 

Poland - Other inflation and cost indicators 

Poland - Budgetary developments and projections 

Poland - Balance of payments 

Poland - Product market integration 

Romania - Components of inflation 

Romania - Other inflation and cost indicators 

Romania - Budgetary developments and projections 

Romania - Balance of payments 

Romania - Product market integration 

10.2.1.  Sweden - Components of inflation 

10.2.2.  Sweden - Other inflation and cost indicators 

10.3.1.  Sweden - Budgetary developments and projections 

10.6.1.  Sweden - Balance of payments 

10.6.2.  Sweden - Product market integration 

178 

179 

179 

180 

181 

20 

21 

25 

31 

32 

38 

39 

42 

47 

48 

54 

55 

60 

66 

68 

74 

75 

79 

86 

88 

95 

96 

99 

105 

106 

113 

114 

117 

124 

125 

133 

134 

138 

144 

145 

153 

154 

157 

163 

165 

172 

173 

176 

179 

181 

ix 

 
 
 
 
LIST OF GRAPHS 

2.2.1. 

2.2.2. 

2.2.3. 

2.4.1. 

2.4.2. 

2.5.1. 

2.5.2. 

2.6.1. 

2.6.2. 

2.6.3. 

2.6.4. 

2.6.5. 

2.6.6. 

Bulgaria - Inflation criterion since 2004 

Bulgaria - HICP inflation 

Bulgaria - Inflation, productivity and wage trends 

Exchange rates - BGN/EUR 

Bulgaria - 3-M Sofibor spread to 3-M Euribor 

Bulgaria - Long-term interest rate criterion 

Bulgaria - Long-term interest rates 

Bulgaria - Saving and investment 

Bulgaria - Effective exchange rates 

Bulgaria - Recent development of the financial system relatively to the euro area 

Bulgaria - Foreign ownership and concentration in the banking sector 

Bulgaria - selected banking sector soundness indicators relatively to the euro area 

Bulgaria - Recent developments in bank credit to households and corporations relatively 

to the euro area 

2.6.7. 

Bulgaria - Share of foreign currency loans (as percentage of total loans to households / 

corporations) 

3.2.1.  Czech Republic - Inflation criterion since 2004 

3.2.2.  Czech Republic - HICP inflation 

3.2.3.  Czech Republic - Inflation, productivity and wage trends 

3.4.1. 

Exchange rates - CZK/EUR 

3.4.2.  Czech Republic - 3-M Pribor spread to 3-M Euribor 

3.5.1.  Czech Republic - Long-term interest rate criterion 

3.5.2.  Czech Republic - Long-term interest rates 

3.6.1.  Czech Republic - Saving and investment 

3.6.2.  Czech Republic - Effective exchange rates 

3.6.3.  Czech Republic - Recent development of the financial system relatively to the euro area 

3.6.4.  Czech Republic - Foreign ownership and concentration in the banking sector 

3.6.5.  Czech Republic - selected banking sector soundness indicators relatively to the euro 

area 

3.6.6.  Czech Republic - Recent developments in bank credit to households and corporations 

relatively to the euro area 

3.6.7.  Czech Republic - Share of foreign currency loans (as percentage of total loans to 

4.2.1. 

4.2.2. 

4.2.3. 

4.4.1. 

4.4.2. 

4.4.3. 

4.5.1. 

4.6.1. 

4.6.2. 

4.6.3. 

4.6.4. 

4.6.5. 

4.6.6. 

households / corporations) 

Estonia - Inflation criterion since 2004 

Estonia - HICP inflation 

Estonia - Inflation, productivity and wage trends 

EEK - Spread vs central rate 

Exchange rates - EEK/EUR 

Estonia - 3-M Talibor spread to 3-M Euribor 

Estonia - Interest rate indicator 

Estonia - Effective exchange rates 

Estonia - Saving and investment 

Estonia - Recent development of the financial system relatively to the euro area 

Estonia - Foreign ownership and concentration in the banking sector 

Estonia - selected banking sector soundness indicators relatively to the euro area 

Estonia - Recent developments in bank credit to households and corporations relatively 

to the euro area 

4.6.7. 

Estonia - Share of foreign currency loans (as percentage of total loans to households / 

corporations) 

Latvia - Inflation criterion since 2004 

Latvia - HICP inflation 

Latvia - Inflation, productivity and wage trends 

LVL - Spread vs central rate 

Exchange rates - LVL/EUR 

5.2.1. 

5.2.2. 

5.2.3. 

5.4.1. 

5.4.2. 

19 

19 

21 

27 

27 

29 

29 

30 

30 

33 

33 

34 

34 

34 

37 

37 

38 

44 

44 

45 

45 

46 

46 

49 

49 

50 

50 

50 

53 

53 

55 

61 

61 

62 

63 

65 

65 

68 

69 

69 

69 

69 

73 

73 

76 

82 

82 

x 

 
 
5.4.3. 

5.5.1. 

5.5.2. 

5.6.1. 

5.6.2. 

5.6.3. 

5.6.4. 

5.6.5. 

5.6.6. 

5.6.7. 

Latvia - 3-M Rigibor spread to 3-M Euribor 

Latvia - Long-term interest rate criterion 

Latvia - Long-term interest rates 

Latvia - Saving and investment 

Latvia - Effective exchange rates 

Latvia - Banking sector rescue measures relatively to the euro area 

Latvia - Recent development of the financial system relatively to the euro area 

Latvia - Foreign ownership and concentration in the banking sector 

Latvia - selected banking sector soundness indicators relatively to the euro area 

Latvia - Recent developments in bank credit to households and corporations relatively to 

the euro area 

5.6.8. 

Latvia - Share of foreign currency loans (as percentage of total loans to households / 

6.2.1. 

6.2.2. 

6.2.3. 

6.4.1. 

6.4.2. 

6.4.3. 

6.5.1. 

6.5.2. 

6.6.1. 

6.6.2. 

6.6.3. 

6.6.4. 

6.6.5. 

6.6.6. 

corporations) 

Lithuania - Inflation criterion since 2004 

Lithuania - HICP inflation 

Lithuania - Inflation, productivity and wage trends 

LTL - Spread vs central rate 

Exchange rates - LTL/EUR 

Lithuania - 3-M Vilibor spread to 3-M Euribor 

Lithuania - Long-term interest rate criterion 

Lithuania - Long-term interest rates 

Lithuania - Saving and investment 

Lithuania - Effective exchange rates 

Lithuania - Recent development of the financial system relatively to the euro area 

Lithuania - Foreign ownership and concentration in the banking sector 

Lithuania - selected banking sector soundness indicators relatively to the euro area 

Lithuania - Recent developments in bank credit to households and corporations 

relatively to the euro area 

6.6.7. 

Lithuania - Share of foreign currency loans (as percentage of total loans to households / 

7.2.1. 

7.2.2. 

7.2.3. 

7.4.1. 

7.4.2. 

7.5.1. 

7.5.2. 

7.6.1. 

7.6.2. 

7.6.3. 

7.6.4. 

7.6.5. 

7.6.6. 

7.6.7. 

corporations) 

Hungary - Inflation criterion since 2004 

Hungary - HICP inflation 

Hungary - Inflation, productivity and wage trends 

Exchange rates - HUF/EUR 

Hungary - 3-M Bubor spread to 3-M Euribor 

Hungary - Long-term interest rate criterion 

Hungary - Long-term interest rates 

Hungary - Saving and investment 

Hungary - Effective exchange rates 

Hungary - Banking sector rescue measures relatively to the euro area 

Hungary - Recent development of the financial system relatively to the euro area 

Hungary - Foreign ownership and concentration in the banking sector 

Hungary - selected banking sector soundness indicators relatively to the euro area 

Hungary - Recent developments in bank credit to households and corporations relatively 

to the euro area 

7.6.8. 

Hungary - Share of foreign currency loans (as percentage of total loans to households / 

corporations) 

Poland - Inflation criterion since 2004 

Poland - HICP inflation 

Poland - Inflation, productivity and wage trends 

Exchange rates - PLN/EUR 

Poland - 3-M Wibor spread to 3-M Euribor 

Poland - Long-term interest rate criterion 

Poland - Long-term interest rates 

Poland - Saving and investment 

8.2.1. 

8.2.2. 

8.2.3. 

8.4.1. 

8.4.2. 

8.5.1. 

8.5.2. 

8.6.1. 

83 

84 

84 

85 

85 

89 

89 

89 

90 

90 

90 

94 

94 

96 

101 

101 

101 

103 

103 

104 

104 

107 

107 

107 

108 

108 

112 

112 

114 

120 

120 

122 

122 

123 

123 

126 

126 

126 

127 

127 

127 

132 

132 

134 

140 

140 

142 

142 

143 

xi 

 
 
8.6.2. 

8.6.3. 

8.6.4. 

8.6.5. 

8.6.6. 

Poland - Effective exchange rates 

Poland - Recent development of the financial system relatively to the euro area 

Poland - Foreign ownership and concentration in the banking sector 

Poland - selected banking sector soundness indicators relatively to the euro area 

Poland - Recent developments in bank credit to households and corporations relatively 

to the euro area 

8.6.7. 

Poland - Share of foreign currency loans (as percentage of total loans to households / 

9.2.1. 

9.2.2. 

9.2.3. 

9.4.1. 

9.4.2. 

9.5.1. 

9.5.2. 

9.6.1. 

9.6.2. 

9.6.3. 

9.6.4. 

9.6.5. 

9.6.6. 

corporations) 

Romania - Inflation criterion since 2004 

Romania - HICP inflation 

Romania - Inflation, productivity and wage trends 

Exchange rates - RON/EUR 

Romania - 3-M Robor spread to 3-M Euribor 

Romania - Long-term interest rate criterion 

Romania - Long-term interest rates 

Romania - Saving and investment 

Romania - Effective exchange rates 

Romania - Recent development of the financial system relatively to the euro area 

Romania - Foreign ownership and concentration in the banking sector 

Romania - selected banking sector soundness indicators relatively to the euro area 

Romania - Share of foreign currency loans (as percentage of total loans to households / 

corporations) 

9.6.7. 

Romania - Recent developments in bank credit to households and corporations 

relatively to the euro area 

10.2.1.  Sweden - Inflation criterion since 2004 

10.2.2.  Sweden - HICP inflation 

10.2.3.  Sweden - Inflation, productivity and wage trends 

10.4.1.  Exchange rates - SEK/EUR 

10.4.2.  Sweden - 3-M Stibor spread to 3-M Euribor 

10.5.1.  Sweden - Long-term interest rate criterion 

10.5.2.  Sweden - Long-term interest rates 

10.6.1.  Sweden - Saving and investment 

10.6.2.  Sweden - Effective exchange rates 

10.6.3.  Sweden - Banking sector rescue measures relatively to the euro area effective amounts 

10.6.4.  Sweden - Recent development of the financial system relatively to the euro area 

10.6.5.  Sweden - Foreign ownership and concentration in the banking sector 

10.6.6.  Sweden - selected banking sector soundness indicators relatively to the euro area 

10.6.7.  Sweden - Recent developments in bank credit to households and corporations relatively 

to the euro area 

10.6.8.  Sweden - Share of foreign currency loans (as percentage of total loans to households / 

corporations) 

LIST OF BOXES 

1.1.1. 

1.2.1. 

1.2.2. 

1.2.3. 

Article 140 of the Treaty 

Assessment of price stability and the reference value 

Excessive deficit procedure 

Data for the interest rate convergence criterion 

143 

146 

147 

147 

147 

147 

152 

152 

154 

159 

160 

161 

161 

162 

162 

166 

166 

166 

167 

167 

171 

171 

173 

177 

177 

178 

178 

180 

180 

181 

182 

182 

182 

182 

182 

6 

8 

11 

14 

xii 

 
 
 
 
 
 
Convergence Report 2010 

(prepared in accordance with Article 140(1) of the Treaty) 

 
 
REPORT

2 

 
 
Convergence Report 2010 

Technical annex 

 
 
1. 

INTRODUCTION 

1.1. 

ROLE OF THE REPORT 

in 

of 

sustainable 

the  Council  (meeting 

The  euro  was  introduced  on  1  January  1999  by 
eleven  Member  States,  following  several  years  of 
successful  adjustment  efforts  to  achieve  a  high 
degree 
convergence.  The 
decision (1)  by 
the 
composition of the Heads of State or Government) 
on 3 May 1998 in Brussels on the eleven Member 
States  deemed  ready  to  participate  in  the  single 
currency  had,  in  accordance  with  the  Treaty 
(Article  121(4)  TEC) (2),  been  prepared  by  the 
Ecofin  Council  on  a  recommendation  from  the 
Commission.  The  decision  was  based  on  the  two 
Convergence Reports made by the Commission (3) 
the  European  Monetary  Institute  (EMI), 
and 
respectively (4). 
in 
accordance with Article 121(1) TEC (5), examined 
in  considerable  detail  whether  the  Member  States 
satisfied the convergence criteria and met the legal 
requirements. 

  These  reports,  prepared 

then,  Greece  (2001),  Slovenia  (2007), 
Since 
Cyprus  and  Malta  (2008)  and  Slovakia  (2009) 
have joined the euro. 

Those  Member  States  which  are  assessed  as  not 
fulfilling the necessary conditions for the adoption 
of the euro are referred to as "Member States with 
a derogation". Article 140 of the Treaty lays down 
provisions  and  procedures  for  examining  the 
situation of Member States with a derogation (Box 
1.1).  At  least  once  every  two  years,  or  at  the 
request  of  a  Member  State  with  a  derogation,  the 
Commission  and  the  European  Central  Bank 
(ECB)  prepare  Convergence  Reports  on  such 
Member States. Denmark and the United Kingdom 
the 
negotiated  opt-out  arrangements  before 

(1)  OJ L 139, 11.5.1998, pp. 30-35. 
(2)  The  numbering  of  Treaty  articles  cited  in  this  report 
corresponds to the one of the Treaty on the Functioning of 
the  European  Union  (TFEU)  except  when  explicitly 
mentioned. Article 121(4) TEC does no longer exist in the 
TFEU,  as  it  refers  to  the  first  countries  deemed  ready  to 
adopt the euro on 1 January 1999. 

(3)  Report 

on 

progress 

and 
recommendation  with  a  view  to  the  transition  to  the  third 
stage  of  economic  and  monetary  union,  COM(1998)1999 
final, 25 March 1998. 

convergence 

towards 

(4)  European  Monetary  Institute,  Convergence  Report,  March 

1998. 

adoption  of  the  Maastricht  Treaty (6)  and  do  not 
participate  in  the  third  stage  of  EMU.  Until  these 
Member  States 
to 
participate in the third stage and join the euro, they 
are not the subject of an assessment as to whether 
they fulfil the necessary conditions.  

they  wish 

indicate 

that 

In  2008,  the  Commission  and  the  ECB  adopted 
their  latest  regular  Convergence  Reports (7).  In 
parallel,  on  4  April  2008  Slovakia  submitted  a 
request  for  an  assessment  of  the  fulfilment  of  the 
necessary  conditions  to  adopt  the  euro  on  1 
January 2009. Following the Convergence Reports 
and on the basis of a proposal by the Commission, 
the  Ecofin  Council  decided  in  July  2008  that 
Slovakia  fulfilled  the  necessary  conditions  for 
adopting the euro as of 1 January 2009 (8). None of 
the  other  Member  States  assessed  was  deemed  to 
meet  the  necessary  conditions  for  adopting  the 
euro. 

services'  Working  Paper 

In 2010, two years will have elapsed since the last 
regular  reports  were  made.  Denmark  and  the 
United  Kingdom  have  not  expressed  a  wish  to 
enter  the  third  stage  of  EMU.  Therefore,  this 
convergence  assessment  covers  :  Bulgaria,  the 
Czech  Republic,  Estonia,  Latvia,  Lithuania, 
Hungary,  Poland,  Romania  and  Sweden.  This 
is  a 
Commission 
Technical Annex to the Convergence Report 2010 
and includes a detailed assessment of the progress 
with  convergence.  The  remainder  of  the  first 
for 
chapter  presents 
application  of  the  assessment  criteria.  Chapters  2 
to  10  examine,  on  a  country-by-country  basis, 
fulfilment  of  the  convergence  criteria  and  other 
requirements in the order as they appear in Article 
140(1).  The  cut-off  date  for  the  statistical  data 
included in this Convergence Report was 23 April 
2010. 

the  methodology  used 

(6)  Protocol  (No  16)  on  certain  provisions  relating 

to 
Denmark,  Protocol  (No  15)  on  certain  provisions  relating 
to  the  United  Kingdom  of  Great  Britain  and  Northern 
Ireland. 

(7)  European  Commission,  Convergence  Report  2008, 
COM(2008)  248  final,  7  May  2008;  European  Central 
Bank, Convergence Report May 2008, May 2008. 

(8)  Council  Decisions  of  8  July  2008  (OJ  L  195,  24.7.2008, 

(5)  The content of this article is now included in Article 140(1) 

pp.24-27).  

TFEU. 

5 

 
                                                           
                                                           
 
European Commission 

Convergence Report 2010 

Box 1.1.1: Article 140 of the Treaty

"1. At least once every two years, or at the request of a Member  State with a derogation, the Commission 
and the European Central Bank shall report to the Council on the progress made by the Member States with 
a  derogation  in  fulfilling  their  obligations  regarding  the  achievement  of  economic  and  monetary  union. 
These reports shall include an examination of the compatibility between the national legislation of each of 
these  Member States, including the statutes  of its national central bank,  and Articles 130  and 131 and the 
Statute of the ESCB and of the ECB. The reports shall also examine the achievement of  a high  degree  of 
sustainable convergence by reference to the fulfilment by each Member State of the following criteria: 

— the achievement of a high degree of price stability; this will be apparent from a rate of inflation which is 
close to that of, at most, the three best performing Member States in terms of price stability, 

—  the  sustainability  of  the  government  financial  position;  this  will  be  apparent  from  having  achieved  a 
government budgetary position without a deficit that is excessive as determined in accordance with Article 
126(6), 

—  the observance  of  the normal  fluctuation  margins  provided  for  by  the  exchange-rate  mechanism  of  the 
European Monetary System, for at least two years, without devaluing against the euro, 

— the durability of convergence achieved by the Member State with a derogation and of its participation in 
the exchange-rate mechanism being reflected in the long-term interest-rate levels. 

The four criteria mentioned in this paragraph and the relevant periods over which they are to be respected 
are  developed  further  in  a  Protocol  annexed  to  the  Treaties.  The  reports  of  the  Commission  and  the 
European Central Bank shall also take account of the results of the integration of markets, the situation and 
development of the balances of payments on current account and an examination of the development of unit 
labour costs and other price indices. 

2. After consulting the European Parliament and after discussion in the European Council, the Council shall, 
on  a  proposal  from  the  Commission,  decide  which  Member  States  with  a  derogation  fulfil  the  necessary 
conditions on the basis of  the  criteria set out in paragraph 1,  and abrogate the  derogations of the Member 
States concerned. 

The Council shall act having received a recommendation of a qualified majority of those among its members 
representing Member States whose currency is the euro. These members shall act within six months of the 
Council receiving the Commission's proposal. 

The qualified majority of the  said members, as referred to in the second subparagraph, shall be defined in 
accordance with Article 238(3)(a). 

3.  If  it  is  decided,  in  accordance  with  the  procedure  set  out  in  paragraph  2,  to  abrogate  a  derogation,  the 
Council shall, acting with the unanimity of the Member States whose currency is the euro and the Member 
State  concerned,  on  a  proposal  from  the  Commission  and  after  consulting  the  European  Central  Bank, 
irrevocably  fix  the  rate  at  which  the  euro  shall  be  substituted  for  the  currency  of  the  Member  State 
concerned, and take the other measures necessary for the introduction of the euro as the single currency in 
the Member State concerned." 

6 

 
 
 
 
 
Convergence Report 2010 - Technical annex 

Chapter 1 - Introduction 

1.2.  APPLICATION OF THE CRITERIA 

1.2.2.  Price stability 

In  accordance  with  Article  140(1)  of  the  Treaty, 
the  Convergence  Reports  shall  examine 
the 
compatibility  of  national  legislation  with  Articles 
130  and  131  of  the  Treaty  and  the  Statute  of  the 
European System of Central Banks (ESCB) and of 
the European Central Bank. The reports shall also 
examine  the  achievement  of  a  high  degree  of 
the 
sustainable  convergence  by  reference 
fulfilment of the four convergence criteria dealing 
with  price  stability,  the  government  budgetary 
position,  exchange  rate  stability  and  long  term 
interest  rates  as  well  as  some  additional  factors 
(Box  1.2.1.).  The  four  convergence  criteria  are 
developed  further  in  a  Protocol  annexed  to  the 
Treaty  (Protocol  No  13  on  the  convergence 
criteria).  

to 

1.2.1.  Compatibility of legislation 

between 

In  accordance  with  Article  140(1)  of  the  Treaty, 
the  legal  examination  includes  an  assessment  of 
compatibility 
a  Member  State’s 
legislation,  including  the  statute  of  its  national 
central  bank,  and  Articles  130  and  131  of  the 
Treaty  and  the  Statute  of  the  ESCB/ECB.  This 
assessment  mainly  covers  three  areas.  First,  the 
objectives  of  the  national  central  bank  must  be 
examined,  in  order  to  verify  their  compatibility 
with  the  objectives  of  the  ESCB  as  formulated  in  
Article  2  of  the  Statute  of  the  ESCB/ECB.  The 
ESCB’s  primary  objective  is  to  maintain  price 
stability.  Without  prejudice  to  this  objective,  it 
shall  support  the  general  economic  policies  in  the 
Union.  Second,  the  independence  of  the  national 
central  bank  and  of  the  members  of  its  decision-
making  bodies  (Article  130)  must  be  assessed. 
This  assessment  covers  all  issues  linked  to  a 
national  central  bank's  institutional  and  financial 
independence and to the personal independence of 
the members of its decision-making bodies. Third, 
the integration of the national central bank into the 
ESCB has to be examined, in order to ensure that 
the  national  central  bank  acts  in  accordance  with 
the  ECB’s  guidelines  and  instructions  once  the 
Member State concerned has adopted the euro. 

The  price  stability  criterion  is  defined  in  the  first 
indent  of  Article  140(1)  of  the  Treaty:  “the 
achievement of a high degree of price stability […] 
will  be  apparent  from  a  rate  of  inflation  which  is 
close to that of, at most, the three best performing 
Member States in terms of price stability”. 

Article  1  of  the  Protocol  on  the  convergence 
criteria  further  stipulates  that  “the  criterion  on 
price stability […] shall mean that a Member State 
has a price performance that is sustainable and an 
average rate of inflation, observed over a period of 
one  year  before  the  examination,  that  does  not 
exceed by more than 1.5 percentage points that of, 
at  most,  the  three  best  performing  Member  States 
in  terms  of  price  stability.  Inflation  shall  be 
measured by means of the consumer price index on 
a comparable basis, taking into account differences 
in national definitions”.  

legal  basis  for 

they  do  not  constitute 

Since  national  consumer  price  indices  (CPIs) 
diverge substantially in terms of concepts, methods 
and  practices, 
the 
appropriate means to meet the Treaty requirement 
that  inflation  must  be  measured  on  a  comparable 
basis.  To  this  end,  the  Council  adopted  on  23 
October  1995  a  framework  regulation (9)  setting 
the 
the  establishment  of  a 
harmonised  methodology  for  compiling  consumer 
price  indices  in  the  Member  States.  This  process 
resulted  in  the  production  of  the  Harmonised 
Indices  of  Consumer  Prices  (HICPs),  which  are 
used  for  assessing  the  fulfilment  of  the  price 
stability  criterion.  Until  December  2005,  HICP 
series  had  been  based  on  1996  as  the  reference 
period.  A  Commission  Regulation  (EC)  No 
1708/2005 (10)  provided  the  basis  for  a  change  of 
the  HICP  index  base  reference  period  from 
1996=100 to 2005=100. 

(9)  Council  Regulation  (EC)  No  2494/95  of  23  October  1995 
concerning  harmonised  indices  of  consumer  prices  (OJ  L 
257,  27.10.1995,  pp.  1-4),  amended  Regulations  (EC)  No 
1882/2003 and No 596/2009 of the European Parliament of 
the Council.  

(10)  Commission Regulation (EC) No 1708/2005 of 19 October 
2005 laying down detailed rules for the implementation of 
Council  Regulation  (EC)  No  2494/95  as  regards  the 
common  index  reference  period  for  the  harmonised  index 
of  consumer  prices,  and  amending  Regulation  (EC)  No 
2214/96. 

7 

 
                                                           
European Commission 

Convergence Report 2010 

Box 1.2.1: Assessment of price stability and the reference value

The numerical part of the price stability criterion implies a comparison between a Member State's average 
price performance and a reference value.  

A  Member  State’s  average  rate  of  inflation  is  measured  by  the  percentage  change  in  the  unweighted 
average of the last 12 monthly indices relative to the unweighted average of the 12 monthly indices of the 
previous period, rounded to one decimal.  

This measure captures inflation trends over a period of one year as requested by the provisions of the Treaty. 
Using the commonly used inflation rate – calculated as the percentage change in the consumer price index of 
the latest month over the index for the equivalent month of the previous year – would not meet the one year 
requirement.  The  latter  measure  may  also  vary  importantly  from  month  to  month  because  of  exceptional 
factors.  

The reference value is calculated as the unweighted average of the average rates of inflation of, at most, the 
three best-performing Member States in terms of price stability plus 1.5 percentage points. The outcome is 
rounded to one decimal. While in principle the reference value could also be calculated on the basis of the 
price performance of only one or two best performing Member States in terms of price stability, it has been 
existing  practice  to  select  the  three  best  performers.  Defining  the  reference  value  in  a  relative  way  (as 
opposed to a fixed reference value) allows to take into account the effects of a common shock that affects 
inflation rates across all Member States.  

As Article 140(1) of the Treaty refers to 'Member States' and does not make a distinction between euro area 
and other Member States, the Convergence Reports select the three best performers from all Member States 
– EU-15 for the Convergence Reports before 2004, EU-25 for the reports between 2004 and 2006 and EU-
27 for reports as of 2007.  

The notion of 'best performer' is not defined mechanically in the Treaty. It is appropriate to interpret this 
notion  in  a  dynamic  way,  taking  into  account  the  state  of  the  economic  environment  at  the  time  of  the 
assessment. In previous Convergence Reports, when all Member States had a positive rate of inflation, the 
group of best performers in terms of price stability naturally consisted of those Member States which had the 
lowest  positive  average  rate  of  inflation.  In  the  2004  report,    Lithuania  was  not  taken  into  account  in  the 
calculation of the reference value because its  negative rate of inflation, which  was due to country-specific 
economic  circumstances,  was  significantly  diverging  from  that  of  the  other  Member  States,  making 
Lithuania  a  de  facto  outlier  that  could  not  be  considered  as  'best  performer'  in  terms  of  price  stability 
(Lithuania's average 12-month inflation was at that time 2.3 percentage points below the euro area average 
12-month  inflation).  At  the  current  juncture,  characterised  by  exceptionally  large  common  shocks  (the 
global economic and financial crisis and the associated sharp fall in commodity prices), a significant number 
of countries face episodes of negative inflation rates (the euro area average inflation rate in March 2010 was 
only slightly positive, at 0.3%). In these circumstances, negative rates of inflation constitute an economically 
meaningful benchmark against which to assess countries' price stability performance. Conversely, excluding 
all  countries  with  negative  average  inflation  rate  from  the  potential  best-performers  in  terms  of  price 
stability  would  lead  to  an  artificially  high  reference  value,  disconnected  from  the  current  situation  of  the 
Member States in terms of price stability. At the same time, excluding from the best performers a country 
with an average inflation rate that is distant from the euro area average inflation by a very wide margin – in 
line  with  the  precedent  of  the  2004  Convergence  Report  –  seems  also  warranted,  as  including  it  would 
severely  affect  the  reference  value  and  thus  the  fairness  of  the  criterion.  In  March  2010,  this  leads  to  the 
exclusion  from  the  best  performers  of  Ireland,  the  only  Member  State  whose  average  inflation  rate  has 
deviated  by  a  wide  margin  from  that of  the  euro  area  and  other Member  States,  mainly  due  to  the  severe 
economic downturn. Table 1.1 lists the reference value in the Convergence Reports issued since 1998. 

(Continued on the next page) 

8 

 
 
 
 
 
Convergence Report 2010 - Technical annex 

Chapter 1 - Introduction 

Box (continued) 

Table 1:

Inflation reference value in previous and current Convergence Reports

Convergence Report

Cut-off month

adoption date

1998

2000

2002

2004

2006 May 

2006 December

2007

2008

2010

January 1998

March 2000

April 2002

August 2004

March 2006

October 2006

March 2007

March 2008

March 2010

Three best
performers 1) 2)

Austria, France, Ireland

Sweden, France, Austria

United Kingdom, Germany, France

Finland, Denmark, Sweden

Sweden, Finland, Poland

Poland, Finland, Sweden

Finland, Poland, Sweden

Malta, Netherlands, Denmark

Portugal, Estonia, Belgium 

Reference
value 3)

Euro area average
inflation rate 4)

2.7

2.4

3.3

2.4

2.6

2.8

3.0

3.2

1.0

1.5

1.4

2.4

2.1

2.3

2.2

2.1

2.5

0.3

1) EU15 until April 2004; EU25 between May 2004 and December 2006; EU27 from January 2007 onwards.

2) In case of equal rounded average inflation for several potential best performers, the ranking is determined on the basis of unrounded data.

3) Reference values are only computed at the time of Convergence Reports. All calculations of the reference value

    between the Convergence Reports are purely illustrative

4) Measured by the percentage change in the arthmetic average of the latest 12 monthly indices relative to the 

    arithmetic average of the 12 monthly indices of the previous period.

in 

inflation 

the  percentage  change 

As has been the case in past convergence reports, a 
is 
Member  State’s  average  rate  of 
measured  by 
the 
arithmetic  average  of  the  last  12  monthly  indices 
relative to the arithmetic average of the 12 monthly 
indices of the previous period. The reference value 
is  calculated  as  the  arithmetic  average  of  the 
average  rate  of 
three  best-
inflation  of 
performing  Member  States  in  terms  of  price 
stability plus 1.5 percentage points. 

the 

into  account 

Taking 
the  current  exceptional 
economic circumstances, over the 12 month period 
covering  April  2009-March  2010  the  three  best-
performing  Member  States  in  terms  of  price 
stability  were  Portugal  (-0.8%),  Estonia  (-0.7%) 
and Belgium (-0.1%), yielding a reference value of 
1.0%.  This  excludes  Ireland,  the  only  country 
whose average inflation rate (-2.3%) deviates from 
the euro area average by a wide margin, and which 
could hence not reasonably be regarded as a  best 
performer in terms of price stability (Box 1.2.1).  

The Protocol on the convergence criteria not only 
requires  Member  States  to  have  achieved  a  high 
degree  of  price  stability  but  also  calls  for  a  price 
performance  that  is  sustainable.  The  requirement 
of sustainability aims at ensuring that the degree of 
price  stability  and  inflation  convergence  achieved 
in previous years will be maintained after adoption 
of the euro.  

implies 

This 
performance  must  essentially  be  due 

the  satisfactory 

that 

inflation 
the 

to 

examines 

factors.  Therefore, 
the 

adequate behaviour of input costs and other factors 
influencing  price  developments  in  a  structural 
manner,  rather  than  reflecting  the  influence  of 
this  Technical 
temporary 
Annex 
the 
of 
role 
also 
macroeconomic  situation  and  cyclical  stance  in 
inflation performance, developments in unit labour 
costs  as  a  result  of  trends  in  labour  productivity 
and nominal compensation per head, developments 
in  import  prices  to  assess  how  external  price 
developments  have 
impacted  on  domestic 
inflation,  and  the  impact  of  administered  prices 
and indirect taxes on headline inflation. The issue 
of sustainability deserves particular attention at the 
current  juncture  where  the  fall-out  from  the 
financial  crisis  has  significantly  impacted  on 
inflation performance in many countries. 

From  a  forward-looking  perspective,  the  report 
includes  an  assessment  of  medium-term  prospects 
for inflation.  The analysis of factors that have an 
impact  on  the  inflation  outlook,  such  as  credit 
is 
developments 
complemented  by  a  reference  to  the  most  recent 
Commission  forecast  of  inflation.  That  forecast 
can  subsequently  be  used  to  assess  whether  the 
country is likely to meet the reference value also in 
the months ahead (11).  

conditions, 

cyclical 

and 

(11)  According  to  the  Commission  Spring  2010  Forecast,  the 
reference  value  is  forecast  to  stand  at  2.0%  in  December 
2010, with Lithuania, Czech Republic and Portugal as best 
performers  in  terms  of  price  stability.  Latvia  and  Ireland 
have been excluded from the best performers in December 

9 

 
                                                           
 
 
 
 
 
 
 
 
European Commission 

Convergence Report 2010 

1.2.3.  Government budgetary position 

the 
The  convergence  criterion  dealing  with 
government  budgetary  position  is  defined  in  the 
second  indent  of  Article  140(1)  of  the  Treaty  as 
“the  sustainability  of  the  government  financial 
position: 
this  will  be  apparent  from  having 
achieved a government budgetary position without 
a  deficit  that  is  excessive  as  determined  in 
accordance  with  Article  126(6)”.  Furthermore, 
Article  2  of  the  Protocol  on  the  convergence 
criteria states that this criterion means that “at the 
time  of  the  examination  the  Member  State  is  not 
the  subject  of  a  Council  decision  under  Article 
126(6) of the said Treaty that an excessive deficit 
exists”. 

The convergence assessment in the budgetary area 
is  thus  directly  linked  to  the  excessive  deficit 
procedure which is specified in Article 126 of the 
Treaty  and  further  clarified  in  the  Stability  and 
Growth Pact. The existence of an excessive deficit 
is  determined  in  relation  to  the  two  criteria  for 
budgetary  discipline  set  in  Article  126(2),  namely 
on  the  government  deficit  and  the  government 
debt.  Failure  by  a  Member  State  to  fulfil  the 
requirements under either of these criteria can lead 
to a decision by the Council on the existence of an 
excessive deficit, in which case the Member State 
concerned  does  not  comply  with  the  budgetary 
convergence  criterion  (for  further  information  on 
this procedure, see Box 1.2.2 (12)).  

2010 as their average inflation rate is forecasted to deviate 
from  the  euro  area  average  by  a  wide  margin,  being 
respectively  at  4.6  and  2.8  percentage  points  below  the 
euro  area  average  inflation.    The  forecast  of  the  reference 
value  is  subject  to  significant  uncertainties  given  that  it  is 
calculated  on  the  basis  of  the  inflation  forecasts  for  the 
three Member States projected to be the best performers in 
terms  of  price  stability  in  the  forecast  period,  thereby 
increasing the possible margin of error. 

(12)  The  definition  of  the  general  government  deficit  used  in 
this  report  is  in  accordance  with  the  excessive  deficit 
procedure, as was the case in previous convergence reports. 
In particular, interest expenditure, total expenditure and the 
overall balance include net streams of interest expenditure 
resulting  from  swaps  arrangements  and  forward  rate 
agreements.  Government  debt  is  general  government 
consolidated  gross  debt  at  nominal  value  (Council 
Regulation 479/2009). Information regarding the excessive 
deficit  procedure  and  its  application  to  different  Member 
States since 2002 can be found at: 

http://ec.europa.eu/economy_finance/sg_pact_fiscal_policy/exc

essive_deficit9109_en.htm. 

10 

 
                                                                                   
 
 
Convergence Report 2010 - Technical annex 

Chapter 1 - Introduction 

Box 1.2.2: Excessive deficit procedure

The  excessive  deficit  procedure  is  specified  in  Article  126  of  the  Treaty,  the  associated  Protocol  on  the 
excessive  deficit  procedure  and  Council  Regulation  (EC)  No  1467/97  on  speeding  up  and  clarifying  the 
implementation  of  the  excessive  deficit  procedure1,  which  is  the  “dissuasive  arm”  of  the  Stability  and 
Growth Pact. Together, they determine the steps to be followed to reach a Council decision on the existence 
of  an  excessive  deficit,  which  forms  the  basis  for  the  assessment  of  compliance  with  the  convergence 
criterion on the government budgetary position. 

Article  126(1)  states  that  Member  States  are  to  avoid  excessive  government  deficits.  The  Commission  is 
required to monitor the development of the budgetary situation and of the stock of government debt in the 
Member  States  with  a  view  to  identifying  gross  errors  (Article  126(2)).  In  particular,  compliance  with 
budgetary discipline is to be examined by the Commission on the basis of the following two criteria: 

“(a)  whether  the  ratio  of  the  planned  or  actual  government  deficit  to  gross  domestic  product  exceeds  a 
reference value [specified in the Protocol as 3 percent], unless: 

•  either the ratio has declined substantially and continuously and reached a level that comes close to the 

reference value; 

•  or,  alternatively,  the  excess  over  the  reference  value  is  only  exceptional  and  temporary  and  the  ratio 

remains close to the reference value; 

(b) whether the ratio of government debt to gross domestic product exceeds a reference value [specified in 
the Protocol as 60 percent], unless the ratio is sufficiently diminishing and approaching the reference value 
at a satisfactory pace”. 

According to the Protocol on the excessive deficit procedure, the Commission provides the statistical data 
for the implementation of the procedure. As part of the application of this Protocol, Member States have to 
notify data on government deficits, government debt, nominal GDP and other associated variables twice a 
year, namely before 1 April and before 1 October2. After each reporting date, Eurostat examines whether the 
data are in conformity with ESA953 rules and related Eurostat decisions and, if they are, validates them. 

The Commission is required to prepare a report if a Member State does not fulfil the requirements under one 
or  both  of  the  criteria  given  above  (Article  126(3)).  The  report  also  has  to  take  into  account  whether  the 
government deficit exceeds government investment expenditure and all other relevant factors. These include 
the  medium-term  economic  position  (in  particular,  potential  growth,  cyclical  conditions  and  the 
implementation  of  policies  under  the  Lisbon  agenda)  and  the  medium-term  budgetary  position  of  the 
Member State (in particular fiscal consolidation efforts in "good times", debt sustainability and the overall 
quality of public finances) as well as any other factors which, in the opinion of the Member State concerned, 
are  relevant.  Consideration  of  these  factors  is  relevant  –  subject  to  the  double  condition  that the deficit  is
close  to  the  reference  value  and  its  excess  over  it  is  temporary  –  for  the  following  steps  of  the  procedure 
leading  to  the  decision  on  the  existence  of  an  excessive  deficit.  In  the  context  of  this  decision  special 
consideration is foreseen for pension reforms introducing a multi-pillar system including a mandatory, fully-
funded pillar.4 

1   OJ L 209, 2.8.1997, p. 6. Regulation as amended by Regulation (EC) No 1056/2005 (OJ L 174, 7.7.2005, p. 5). 
2  

Council  Regulation  (EC)  No  479/2009  on  the  application  of  the  Protocol  on  the  excessive  deficit  procedure  (OJ  L
145, 10.06.2009, p1).  
European System of National  and Regional Accounts, adopted by  Council  Regulation (EC) No 2223/96 (OJ L 310
30.11.1996, p. 1). Regulation as last amended by Regulation (EC) No 400/2009 of the European Parliament and of the
Council (OJ L 126, 21.5.2009, p. 11). 
In all budgetary assessments in the framework of the excessive deficit procedure, the Commission and the Council
shall give due consideration to the implementation of pension reforms introducing a multipillar system that includes a
mandatory,  fully  funded pillar.  For  more  information,  see  "Public  Finances  in  EMU – 2007"  (Part  II,  Section  4.2)
European Economy No.3/2007.  

3  

4   

(Continued on the next page) 

11 

 
 
 
                                                           
 
European Commission 

Convergence Report 2010 

Box (continued) 

 The next step in the procedure is the formulation by the Economic and Financial Committee of an opinion 
on this report, which according to the Stability and Growth Pact must occur within two weeks of its adoption 
by  the  Commission  (Article  126(4)).  If  it  considers  that  an  excessive  deficit  exists  or  may  occur,  the 
Commission  addresses  an  opinion  to  the  Council  (Article  126(5)).  Then,  on  the  basis  of  a  Commission 
recommendation,  the  Council  decides,  after  an  overall  assessment,  including  any  observation  that  the 
concerned Member State may have, whether an excessive deficit exists (Article 126(6)). The Stability and 
Growth  Pact  prescribes  that  any  such  decision  has  to  be  adopted  as  a  rule  within  four  months  of  the 
reporting dates (1 April, 1 October). 

At  the  same  time  as  deciding  on  the  existence  of  an  excessive  deficit,  the  Council  has  to  issue  a 
recommendation  to the Member  State concerned with  a  view  to  bringing  that situation to an end within a 
given  period,  also  on  the  basis  of  a  Commission  recommendation  (Article  126(7)).  According  to  the 
Stability and Growth Pact, the Council recommendation has to specify when the correction of the excessive 
deficit  should  be  completed,  namely  in  the  year  following  its  identification  unless  there  are  special 
circumstances, and has to include a  deadline of six months at  most for effective  action to be taken  by the 
Member State concerned. The recommendation should also specify that the Member State concerned has to 
achieve a minimum annual improvement of at least 0.5% of GDP as a benchmark in its cyclically-adjusted 
balance net of one-off and temporary measures. 

If effective action has been taken in compliance with a recommendation under Article 126(7) and, compared 
with  the  economic  forecasts  in  this  recommendation,  unexpected  adverse  economic  events  with  major 
unfavourable  consequences  for  government  finances  occur  subsequent  to  its  adoption,  the  Council  may 
decide,  on  a  recommendation  from  the  Commission,  to  adopt  a  revised  recommendation  under  the  same 
article, which may notably extend the deadline for the correction of the excessive deficit by one year. 

Where it establishes that there has been no effective action in response to its recommendations, the Council 
adopts a decision under Article 126(8) on the basis of a Commission recommendation immediately after the 
expiry of the deadline for taking action (or at any time thereafter when monitoring of the action taken by the 
Member State indicates that action is not being implemented or is proving to be inadequate). The provisions 
of  Article  126(9  and  11),  on  enhanced  Council  surveillance  and  ultimately  sanctions  in  case  of  non-
compliance, are not applicable to Member States with a derogation (that is, those that have not yet adopted 
the euro), which is the case of the Member States considered in this report. 

When, in the view of the Council, the excessive deficit in the Member State concerned has been corrected, 
the  Council  abrogates  its  decision  on  the  existence  of  an  excessive  deficit,  again  on  the  basis  of  a 
Commission recommendation (Article 126(12)). 

1.2.4.  Exchange rate stability 

third 

The Treaty refers to the exchange rate criterion in 
the 
indent  of  Article  140(1)  as  “the 
observance  of  the  normal  fluctuation  margins 
provided  for  by  the  exchange-rate  mechanism  of 
the  European  Monetary  System,  for  at  least  two 
years, without devaluing against the euro”.  

not  have  devalued  its  currency’s  bilateral  central 
rate  against  the  euro  on  its  own  initiative  for  the 
same period” (13). Based on the Council Resolution 
on  the  establishment  of  the  ERM  II (14),  the 
European  Monetary  System  has  been  replaced  by 
the  Exchange  Rate  Mechanism  II  upon 
the 
introduction of the euro, and the euro has become 
the centre of the mechanism.  

Article  3  of  the  Protocol  on  the  convergence 
criteria  stipulates:  “The  criterion  on  participation 
in  the  exchange  rate  mechanism  of  the  European 
Monetary  System  (…)  shall  mean  that  a  Member 
State has respected the normal fluctuation margins 
provided  for  by  the  exchange-rate  mechanism  of 
the  European  Monetary  System  without  severe 
tensions  for  at  least  the  last  two  years  before  the 
examination. In particular, the Member State shall 

In  its  assessment  of  the  exchange  rate  stability 
criterion,  the  Commission  takes  into  account 

(13)  In  assessing  compliance  with  the  exchange  rate  criterion, 
the  Commission  examines  whether  the  exchange  rate  has 
remained  close  to  the  ERM  II  central  rate,  while  reasons 
for  an  appreciation  may  be  taken  into  account,  in 
accordance  with  the  Common  Statement  on  Acceding 
Countries  and  ERM2  by  the  Informal  ECOFIN  Council, 
Athens, 5 April 2003. 

(14)  97/C 236/03 of 16 June 1997, OJ C 236, 2.8.1997, p.5. 

12 

 
                                                           
 
 
in  auxiliary 

developments 
indicators  such  as 
foreign  reserve  developments  and  short-term 
interest  rates,  as  well  as  the  role  of  policy 
exchange 
measures, 
interventions, 
rate 
stability.  

in  maintaining  exchange 

including 

foreign 

rate, 

In  order 

international 

tensions  on 

its  exchange 

to  determine  whether 

For  the  first  time,  some  Member  States  have 
received 
balance-of-payments 
assistance  during  the  assessment  period  for  this 
this 
report. 
constitutes  evidence  that  a  country  has  faced 
severe 
the 
Commission  examines  several  factors,  including 
the  situation  that  led  to  the  need  for  official 
external  financing,  the  magnitude  and  financing 
profile  of  the  assistance  programme,  the  residual 
financing gap, the policy conditionality attached to 
it as well as developments in foreign exchange and 
financial  markets.  The  possible  impact  of  other, 
often 
financing 
official 
(multilateral  or  bilateral)  on 
arrangements 
exchange 
financial  market 
stability, 
performance and risk perceptions is also taken into 
account.  

precautionary, 

rate 

As  in  previous  reports,  the  assessment  of  this 
criterion  verifies  the  participation  in  ERM  II  and 
examines  exchange  rate  behaviour  within  the 
mechanism.  The  relevant  period  for  assessing 
exchange  rate  stability  in  this  Technical  Annex  is 
24 April 2008 to 23 April 2010. 

Convergence Report 2010 - Technical annex 

Chapter 1 - Introduction 

1.2.5.  Long-term interest rates 

the  Protocol  on 

The  fourth  indent  of  Article  140(1)  of  the  Treaty 
requires  “the  durability  of  convergence  achieved 
by  the  Member  State  with  a  derogation  and  of  its 
participation  in  the  exchange  rate  mechanism 
being  reflected  in  the  long-term  interest  rate 
levels”.  Article  4  of 
the 
convergence  criteria  further  stipulates  that  “the 
criterion  on  the  convergence  of  interest  rates  (…) 
shall mean that, observed over a period of one year 
before the examination, a Member State has had an 
average  nominal  long-term  interest  rate  that  does 
not  exceed  by  more  than  two  percentage  points 
that of, at most, the three best performing Member 
States in terms of price stability. Interest rates shall 
be measured on the basis of long-term government 
bonds  or  comparable  securities, 
into 
taking 
account differences in national definitions”.    

and 

the  criterion  on 

the  assessment  of 

For 
the 
convergence of interest rates, yields on benchmark 
10-year  bonds  have  been  taken,  using  an  average 
rate over the latest 12 months. For Estonia, which 
does not have a harmonised benchmark long-term 
government  bond  or  a  comparable  security, 
financial  market 
economic 
indicators 
fundamentals  provide  a  basis  for  a  qualitative 
assessment  of  the  fulfilment  of  the  long-term 
interest  rate  criterion  (Box  1.2.3).  In  line  with 
Article 4 of the Protocol (referring to 'at  most the 
the 
three  best  performing  Member  States'), 
reference value for March 2010 is calculated as the 
simple  average  of  the  average  long-term  interest 
rates in Portugal (4.2%) and Belgium (3.8%) plus 
2 percentage points, since Estonia does not have a 
harmonized  benchmark 
long-term  government 
bond  or  a  comparable  security  that  could  be  used 
for the calculation of the reference value 

13 

 
European Commission 

Convergence Report 2010 

Box 1.2.3: Data for the interest rate convergence criterion

The  fourth  indent  of  Article  140(l)  of  the  Treaty  requires  that  the  durability  of  nominal  convergence  and 
exchange rate stability in Member States should be assessed by reference to long-term interest rates. Article 
4 of the Protocol on the convergence criteria adds that these “Interest rates shall be measured on the basis of 
long-term  government  bonds  or  comparable  securities,  taking  into  account  differences  in  national 
definitions”. 

Article  5  of  the  Protocol  requires  that  the  Commission  should  provide  the  statistical  data  used  for  the 
application of the convergence criteria.  However, in the context of the interest rate criterion, the ECB has 
developed the criteria for harmonising the series of yields on benchmark 10 year bonds on behalf of Eurostat 
and collects the data from the central banks. The selection of bonds for inclusion in this series is based on 
the following criteria: 

• 

issued by central government; 

•  a residual maturity close to 10 years; 

•  adequate liquidity, which is the main selection criterion; the choice between a single benchmark or the 

simple average of a sample is based on this requirement; 

• 

fixed coupon; 

•  yield gross of tax. 

For thirteen Member States, the representative interest rates used in this report incorporate all of the above 
characteristics. For 10 Member  States, the residual  maturity of the benchmark bond  is below 9.5 years, in 
particular for Romania, Cyprus, Lithuania and Denmark with a residual maturity below 8 years. The market 
liquidity  for  government  bonds  of  Lithuania,  Cyprus  and,  to  a  lesser  extent,  Latvia  is  particularly  low, 
therefore  reducing  the  signalling  quality  of  those  indicators.  Except  for  Cyprus  for  which  primary  market 
yields  are  used  due  to  insufficient  development  of  the  secondary  market,  all  yields  are  calculated  on  the 
basis of secondary market rates. For Czech Republic, Germany, Spain and Malta a basket of bonds is used, 
while a single benchmark bond is used in twenty-two Member States.  

For Luxembourg, where no government debt securities with a maturity of close to ten years exist, a proxy 
based on a benchmark long-term bond issued by a private credit institution with a solid credit rating is used. 
The residual maturity of this benchmark bond is however now relatively low, close to 8.5 years.  

For Estonia, no appropriate harmonised series or proxy could be identified, primarily reflecting the very low 
level of Estonian government indebtedness. Instead, a weighted average interest rate for EEK-denominated 
new  loans  to  households  for  house  purchase  and  non-financial  corporations  other  than  bank  overdrafts  is 
included,  together  with  other  financial  market  indicators,  in  a  broad-based  qualitative  assessment  of  the 
fulfilment of the long-term interest rate criterion. 

Data  used  in  this  Report  can  be  found  on  Eurostat  (monthly  series  "EMU  convergence  criterion  bond 
yields").  

1.2.6.  Additional factors 

The  Treaty  in  Article  140  also  requires  an 
examination  of  other  factors relevant  to  economic 
integration  and  convergence.  These  additional 
include  financial  and  product  market 
factors 
integration and the development of the balance of 
payments. The examination of the development of 
unit labour costs and other price indices, which is 

also  prescribed  by  Article  140  of  the  Treaty,  is 
covered in the chapter on price stability. 

The  additional  factors  are  an  important  indicator 
that the integration of a Member State into the euro 
area  would  proceed  without  major  difficulties.  As 
regards  the  balance  of  payments,  the  focus  is  on 
the  situation  and  development  of  the  external 

14 

 
 
 
 
 
Convergence Report 2010 - Technical annex 

Chapter 1 - Introduction 

the  euro  area  are  not  subject 

balance  (15)  to  ensure  that  the  Member  States 
joining 
to 
unsustainable  external  imbalances.    Integration  of 
product markets is assessed through trade, foreign 
direct investment and a smooth functioning of the 
internal  market.  Finally,  progress  in  financial 
integration  is  examined,  together  with  the  impact 
of  the  financial  crisis,  the  main  characteristics, 
structures  and  trends  of  the  financial  sector  and 
compliance  with  the  acquis  of  the  Union  in  this 
area.  

(15)  The  external  balance  is  defined  as  the  combined  current 
and  capital  account  (net  lending/borrowing  vis-à-vis  the 
rest of the world). This concept permits in particular to take 
full  account  of  external  transfers  (including  EU  tranfers), 
which  are  partly  recorded  in  the  capital  account.  It  is  the 
concept closest to the current account as defined when the 
Maastricht Treaty was drafted. 

15 

 
                                                           
 
2. 

BULGARIA 

2.1. 

LEGAL COMPATIBILITY 

2.1.1.  Introduction 

The  Law  on 
the  Bulgarian  National  Bank 
(hereinafter  the  "Law  on  BNB")  constitutes  the 
legal basis for the Bulgarian National Bank (BNB) 
and deals with the BNB’s structure and functions. 
The  Law  was  adopted  by  the  38th  National 
Assembly  on  June  5,  1997  and  published  in  the 
Darjaven  Vestnik  (official  journal),  issue  46  of 
June  10,  1997.  The  last  amendment  was  made  in 
2009.  

Following  the  last  Convergence  Report  in  2008, 
the Bulgarian Government, in cooperation with the 
BNB, has prepared a draft law amending the Law 
on  the  Bulgarian  National  Bank  (draft  law).  The 
draft  law  aims  to  bring  legislative  requirements 
regarding 
regulatory 
the  Central  Bank’s 
framework in line with the provisions of the Treaty 
on 
the  European  Union 
(hereinafter  the  TFEU)  and  the  Statute  of  the 
ESCB and the ECB, which were pointed out in the 
Convergence  Report  of  May  2008.  All 
the 
comments made on the draft law – which is at an 
advanced  stage  of  the  legislative  procedure  –  are 
subject to its adoption by the Bulgarian Parliament.  

the  Functioning  of 

2.1.2.  Objectives 

The objectives of the BNB are compatible with the 
TFEU.  

2.1.3.  Independence 

There  are 
imperfections subsist.  

two 

incompatibilities  and 

some 

In  Article  14(1)  the  grounds  for  dismissal  for  the 
the  Governing  Council  do  not 
members  of 
accurately  mirror 
those  of  Article  14(2) 
ESCB/ECB  Statute.  Whereas  a  further  defining 
and  clarification  of  these  grounds  is  in  principle 
appreciated 
interpretation 
problems,  an  explicit  reference  to  Article  14(2) 
ESCB/ECB  Statute  should  be  included.  The  draft 
law would remove this imperfection. 

in  order 

limit 

to 

replacing  the  members  of  the  Governing  Council 
should  also  be  elected/appointed  for  a  term  of 
office  of  at  least  five  years.  The  draft  law  would 
remove this imperfection.  

Article  33(1),  read  in  conjunction  with  Article 
3(13), of the Law on the prevention and disclosure 
of  conflicts  of  interests  (hereinafter  the  "Law  on 
conflict  of  interests)  (adopted  on  October  31, 
2008) is incompatible with the TFEU, since it sets 
additional  grounds  for  the  dismissal  of  BNB's 
Governor, going beyond those covered by 14(2) of 
the ESCB/ECB Statute. 

including  decisions  concerning 

Article  12(1)  and  (2)  of  the  Law  provide  for  the 
National Assembly’s powers to elect the Governor 
and the Deputy Governors of the BNB. Following 
a recent case, the National Assembly claimed that 
it  has  the  power  to  annul  or  amend  its  previous 
the 
decisions, 
election of the Governor and Deputy Governors of 
the  BNB  taken  under  Article  12(1)  and  (2)  of  the 
Law. The National Assembly justified its claim on 
the  basis  of  a  Constitutional  Court  decision  of 
February  26,  1993  stating  that  the  Constitution 
does  not  contain  an  express  provision  prohibiting 
the  National  Assembly 
from  annulling  or 
amending  its  acts.  The  Law  should  remove  this 
incompatibility  and  ensure  that  the  Governor 
and/or  any  other  member  of 
the  Governing 
Council  of  the  BNB,  when  elected  or  appointed,  
shall not be dismissed under conditions other than 
the 
those  mentioned 
ESCB/ECB Statute, even if they have not yet taken 
up their duties.  

in  Article  14(2)  of 

Article  44  provides  that  the  members  of  the 
Governing  Council,  in  the  performance  of  their 
tasks,  shall  be  independent  and  shall  not  seek  or 
take any instructions from the Council of Ministers 
or  from  any  other  body  or  institution.  Neither  the 
Council  of  Ministers  nor  any  other  body  or 
institution  shall  give  instructions  to  the  members 
of the Governing Council. This provision does not 
correspond to the wording of the Article 130 of the 
TFEU and the Article 7 of the ESCB/ECB Statute 
(e.g.  Union  institutions  are  not  included)  and 
should therefore, be brought into line with it. The 
draft law would remove this imperfection. 

Article  14(2),  which 
cases  of 
replacement,  should  foresee  that  persons  who  are 

addresses 

17 

 
European Commission 

Convergence Report 2010 

2.1.4.  Integration in the ESCB 

The  incompatibilities  in  the  Law  on  the  BNB  are 
linked to the following ESCB/ECB tasks: 

• 

the absence of an obligation to comply with the 
Eurosystem's regime for the financial reporting 
of NCB operations (Article 16(11), 46 and 49). 

the  definition  of  monetary  policy  (Articles  3, 
30, 31, 32, 35, 38); 

2.1.5.  Prohibition of monetary financing 

There is still one imperfection.  

Article 45 (1) states that the BNB shall not extend 
credits and guarantees, including through purchase 
of  debt  instruments,  to  the  Council  of  Ministers, 
municipalities,  as  well  as  to  other  governmental 
and  municipal 
institutions,  organizations  and 
enterprises. The provision of Article 45(1) does not 
fully  correspond  to  the  wording  of  Article  123(1) 
of the TFEU and Article 21(1) ESCB/ECB Statute. 
Paragraph  1  should  include  all  entities  which  are 
mentioned  in  Article  123(1)  of  the  TFEU  and 
Article  21(1)  ESCB/ECB  Statute.  The  draft  law 
would remove this imperfection.  

2.1.6.  Assessment of compatibility 

As  regards  the  central  bank  integration  into  the 
ESCB  at  the  time  of  euro  adoption,  legislation  in 
Bulgaria, in particular the Law on the BNB, is not 
fully  compatible  with  Article  130  and  131  of  the 
TFEU  and  the  ESCB/ECB  Statute.  The  draft  law, 
subject to its entry into force would remove some 
of the existing imperfections. However, it does not 
cover  the  issues  related  to  the  integration  of  the 
BNB to the Eurosystem. 

The  law  on  conflicts  of  interests  contains  also 
provisions  which  are 
the 
independence of the BNB. 

incompatible  with 

• 

• 

• 

• 

• 

• 

the conduct of foreign exchange operations and 
the  definition  of  foreign  exchange  ratepolicy 
(Articles 20, 29, 30, 32, 35); 

the right to authorise the issue of banknotes and 
the  volume  of  coins  (Articles  2(5),  16,  24  to 
27); 

the  monetary 
functions,  operations  and 
instruments  of  the  ESCB  (Articles  16,  28,  30, 
31, 32, 35, 36, 37, 38, 41); 

the  financial  provisions  related  to  the  ESCB 
(Article 49 (1), (2)); 

the  ECB's  approval  before  participation  in 
international  monetary  institutions  (Articles  5, 
16); 

• 

the ECB's right to impose sanctions (Article 61, 
62). 

There are also numerous imperfections regarding: 

the non-recognition of the role of the ECB for 
the 
the  payment  systems 
functioning  of 
(Articles 2(4) and 40(1));  

the non-recognition of the role of the ECB and 
the  EU  for  the  collection  of  statistics  (Article 
4(1) and 42), 

the non-recognition of the role of the ECB and 
the  EU  for  the  withdrawal  from  circulation  of 
notes and coins (Article 16); 

the  Council 

the non-recognition of the role of the ECB and 
of 
fight  against 
for 
counterfeiting and the authentification of notes 
and coins (Article 27);  

the 

the  non-recognition  of  the  role  of  the  ECB  in 
the  field  of  international  cooperation  (Article 
37(4)); 

the non-recognition of the role of the ECB and 
of  the  Council  for  the  appointment  of  the 
external auditor (Articles 49 (4)); 

• 

• 

• 

• 

• 

• 

18 

 
 
 
2.2. 

PRICE STABILITY 

2.2.1.  Respect of the reference value 

the 

The  12-month  average  inflation  rate  in  Bulgaria, 
which is used for the convergence assessment, has 
been  above 
reference  value  since  EU 
accession. In March 2010 the reference value was 
1.0%,  calculated  as  the  average  of  the  12-month 
average  inflation  rates  in  Portugal,  Estonia  and 
Belgium  plus  1.5  percentage  points.  The 
corresponding inflation rate in Bulgaria was 1.7%, 
i.e.  0.7  percentage  points  above  the  reference 
value. The 12-month average inflation rate is likely 
to remain above but close to the reference value in 
the months ahead. 

Graph 2.2.1: Bulgaria - Inflation criterion since 2004

 (percent, 12-month mov ing av erage)

14

12

10

8

6

4

2

0
Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11

B ulgaria

Reference value

Note: The dots show the projected reference value and 12-month average inflation 
in the country in December 2010.
Sources: Eurostat, Commission services' Spring 2010 Forecast.

2.2.2.  Recent inflation developments 

After  several  years  of  fairly  volatile  inflation 
averaging  around  6.5%,  annual  HICP  inflation 
picked up strongly in 2007 on the back of buoyant 
domestic  demand  and  the  global  increase  in  oil 
prices.  High  wage  growth  drove  inflationary 
pressures,  both  from  the  supply  and  the  demand 
side.  Inflation  increased  over  a  broad  range  of 
categories,  with  the  surge  most  pronounced  in 
energy,  processed  and  unprocessed  food  and 
services.  Inflation  accelerated  further  in  2008  and 
reached its peak at some 15% in the middle of the 
year.   

The  outbreak  of  the  global  economic  crisis  in 
autumn  2008  marked  the  start  of  a  downward 
inflation  trend.  The  moderation  was  the  result  of 
several  factors.  First,  external  price  pressures 
stemming  from  high  agricultural  product  prices, 
booming  oil  and  other  commodities  prices  were 
relieved  when  the  crisis  hit  global  economic 
activity.  The  direct  effect  implied  lower  food  and 

Convergence Report 2010 - Technical annex 

Chapter 2 - Bulgaria 

energy  prices,  while  second-round  effects  worked 
through  a  downward  adjustment  of  Bulgarian 
producer  prices  as  imported  inputs  became  less 
costly.  As  the  domestic  economy  entered  into 
recession,  slower  wage  growth,  credit  constraints 
and  deteriorating  consumer  sentiment  dented 
consumption,  which  further  relieved  inflationary 
pressures.  

Finally, the disappearance of base effects added to 
the general moderation of inflation in the course of 
2009. As a result, annual HICP inflation receded to 
1.6%  in  December  2009.  Inflation  decelerated 
considerably in many HICP categories, whereas in 
some  categories,  notably  energy,  inflation  was 
negative throughout most of 2009.  

Inflation  picked  up  slightly  in  early  2010  on  the 
back  of  increasing  fuel  prices  following  the  oil 
price  rebound  and  a  hike  in  excise  duties  on 
tobacco  products.  In  March  2010,  annual  HICP 
inflation stood at 2.4%.  

Graph 2.2.2: Bulgaria - HICP inflation

 (y-o-y percentage change)

16

12

8

4

0

-4

2004

2005

2006

2007

2008

2009

B ulgaria

Euro  area

Source: Eurostat.

inflation  (measured  as  HICP 

Core 
inflation 
excluding  energy  and  unprocessed  food)  moved 
broadly  in  line  with  headline  inflation.    Core 
inflation  gathered  pace  in  the  course  of  2007 
before  reaching  a  decade-high  peak  of  14.5%  in 
June  2008.  The  upswing  in  core  inflation  was 
driven  by  a  sharp  increase  in  processed  food 
prices,  while  strong  wage  increases  and  buoyant 
domestic demand also accelerated inflation in non-
industrial  goods  and  services.  Core 
energy 
inflation  declined  significantly 
in  2009,  but 
the 
remained  above  headline 
adjustment  in  prices  of  services,  which  have  a 
relatively  high  weight  in  core  inflation,  was 
somewhat  less  pronounced  despite  the  ongoing 
economic  contraction.  Core  inflation  fell  below 
headline  in  early  2010,  when  energy  became  the 
main driver of headline inflation. 

inflation  as 

19 

 
 
 
European Commission 

Convergence Report 2010 

Table 2.2.1:

Bulgaria - Components of inflation

(percentage change)1)

weights  

in total   

2004

2005

2006

2007

2008

2009

Mar-10

HICP

Non-energy industrial goods

Energy

Unprocessed food 

Processed food

Services

HICP excl. energy and unproc. food
HICP at constant taxes 2)
Administered prices HICP

6.1

-0.1

9.0

4.1

11.5

4.6

5.9

4.9

8.9

6.0

2.2

12.8

10.8

1.4

6.7

3.6

6.0

7.9

7.4

2.6

5.2

5.4

7.6

4.4

5.1

6.3

18.5

13.4

6.5

8.1

5.4

5.8

7.8

8.2

7.2

5.8

12.0

6.0

12.5

10.9

17.2

12.7

12.0

11.3

10.6

2.5

2.9

-5.7

1.3

2.4

5.8

4.1

1.9

7.2

1.7

1.8

-3.3

-1.2

2.1

4.2

3.0

1.3

4.6

2010

1000

232

141

85

171

371

774

1000

151

1) Measured by the arithmetic average of the latest 12 monthly indices relative to the arithmetic average of the 12 monthly indices 

   in the previous period.

2) Last observation for HICP at constant taxes is February 2010

2.2.3.  Underlying  factors  and  sustainability  of 

inflation 

Macroeconomic  policy-mix  and  cyclical 
stance 

Following  several  years  of  buoyant  growth,  the 
Bulgarian economy continued to expand rapidly in 
2008  on  the  back  of  private  consumption  and 
extraordinarily  buoyant 
investment  demand. 
Despite  a  slowdown  towards  the  end  of  the  year, 
annual real GDP recorded a robust 6% growth.  

The  full  impact  of  the  global  financial  and 
economic  crisis  reached  the  Bulgarian  economy 
only  in  2009,  when  it  entered  into  recession  with 
this 
real  GDP  declining  by  5%.  Against 
background,  previously  accumulated  imbalances 
started  to  correct,  although  less  sharply  than  in 
some  other  countries  in  the  region.  Given  the 
lagged  process  of  adjustment  and  foreseen  fiscal 
consolidation,  growth  is  likely  to  remain  weak  in 
2010, 
in 
Bulgarian  export  markets.  The  Commission 
services'  Spring  2010  Forecast  projects  Bulgaria's 
economic  growth  to  be  close  to  zero  in  2010, 
followed  by  2.7%  growth  in  2011.  As  a  result  of 
the  deep 
the  Bulgarian  economy 
operated  below  its  potential  in  2009  and  is 
projected to stay below potential throughout 2010. 

largely  depending  on 

the  recovery 

recession, 

 Over the previous years Bulgaria achieved a high 
fiscal  consolidation  and  posted 
degree  of 
budgetary  surpluses,  but  fiscal  policy  loosened 
markedly  since  the  onset  of  the  recession.  The 
fiscal  stance,  as  measured  by  changes  in  the 
structural balance, was restrictive  in 2008, though 
not  sufficiently  strict  to  prevent  the  widening  of 
already large macroeconomic imbalances. In 2009, 
the fiscal balance worsened significantly amid the 

20 

rapidly  deteriorating  macroeconomic  situation, 
reflecting  both  discretionary  spending  and  weak 
revenues.  The  general  government  balance  turned 
into a deficit of 3.9% of GDP, and the fiscal stance 
became  expansionary  for  the  first  time  in  several 
years.  Projections  show  that  under  an  unchanged 
policy  assumption  the  general  government  will 
post deficits in 2010 and 2011, albeit smaller than 
in 2009.  

In  the  run-up  to  the  crisis,  monetary  conditions 
were accommodative in the context of the currency 
board  system.  Nominal  interest  rate  convergence 
and  rising  inflation  implied  negative  ex  post  real 
interest  rates,  which,  together  with  rising  income, 
encouraged  extensive  borrowing  by  the  private 
sector  during  2007-2008.  The  global  financial 
turmoil drastically changed the situation. As parent 
banks lowered funding to their subsidiaries, banks 
had  to  raise  funds  from  local  deposits,  which 
sparked  a  significant  increase  in  nominal  interest 
rates.  Falling  inflation  added  to  the  real  interest 
rate increase. In the meantime, rising uncertainties 
regarding  the  economic  prospects  in  Bulgaria  and 
lowered  credit 
worsening  credit  conditions 
demand. As a result, growth of credit to the private 
sector  slowed  from  more  than  30%  in  2008  to 
around 3% in early 2010. 

Wages and labour costs 

labour  market 

The  Bulgarian 
tightened 
significantly in the run-up to the financial crisis as 
a  result  of  a  buoyant  domestic  economy  and 
increasing  labour  demand  in  non-tradable  sectors. 
The  unemployment  rate  dropped  from  double 
digits  at  the  beginning  of  the  decade  to  around 
5½% 
rate  also 
increased. 

in  2008.  The  participation 

 
 
 
 
 
Convergence Report 2010 - Technical annex 

Chapter 2 - Bulgaria 

Table 2.2.2:

Bulgaria - Other inflation and cost indicators

2004

2005

2006

2007

2008

(annual percentage change)

20091)

20102)

20112)

HICP inflation

Bulgaria

Euro area

Private consumption deflator

Bulgaria

Euro area

6.1

2.2

4.4

2.0

Nominal compensation per employee

Bulgaria

Euro area

Labour productivity

Bulgaria

Euro area

Nominal unit labour costs

Bulgaria

Euro area

Imports of goods deflator

Bulgaria

Euro area

5.0

2.5

3.9

1.8

1.0

0.9

5.9

1.3

6.0

2.2

5.2

2.1

5.9

2.2

3.5

1.1

2.4

1.3

7.4

2.2

5.7

2.2

7.4

2.6

2.9

1.7

4.4

1.1

10.0

3.6

11.4

4.1

1) 2009 data (except HICP inflation) are estimates. 

2) Commission services' Spring 2010 Forecast.

Source: Eurostat, Commission services.

Graph 2.2.3: Bulgaria - Inflation, productivity and wage trends

(y-o-y % change)

20

16

12

8

4

0

-4

2004

2005

2006

2007

2008

2009

2010

2011

P ro ductivity (real GDP  per perso n emplo yed)

No minal co mpensatio n per emplo yee

No minal unit labo ur co sts
HICP  inflatio n

Source: Eurostat, Commission services' Spring 2010 Forecast.

Labour shortages led to wage growth far exceeding 
productivity  gains.  Growth  in  compensation  per 
employee  accelerated  to  19%  in  2008  with  wage 
dynamics  largely  driven  by  the  private  sector, 
although  public  sector  wage  increases  were  also 
significant. At the same time, productivity growth 
remained  broadly  stable  at  around  3%,  lagging 
behind 
in  other  catching-up 
economies, despite exceptionally high FDI inflows 
to  the  economy.  As  a  result  of  high  wage  and 
moderate labour productivity growth, nominal unit 
labour costs (ULC) increased significantly. 

the  rates  seen 

In 2009, pressures in the labour market eased and 
the  unemployment  rate  rose  to  around  8%  in  late 
2009.  Wage  growth  remained  quite  resilient  and 

7.6

2.1

6.8

2.3

17.9

2.7

3.3

1.1

14.2

1.6

7.3

1.3

12.0

3.3

11.0

2.9

19.3

3.4

2.7

0.0

16.2

3.4

10.8

4.1

2.5

0.3

1.7

-0.1

8.7

2.0

-2.2

-2.0

11.1

4.0

-13.7

-7.5

2.3

1.5

1.5

1.4

4.7

1.3

1.2

1.8

3.5

-0.5

6.8

3.9

2.7

1.7

1.9

1.5

4.0

1.5

2.0

1.3

1.9

0.1

1.7

1.6

lower 

somewhat 

broad-based  in  comparison  to  regional  peers, 
suggesting 
labour  market 
flexibility, despite a relatively decentralised wage-
setting  process.  Nominal  wages  rose  by  around 
11% in 2009 despite the government's decision to 
freeze  public  wages.  To  be  sure,  uncertainties  on 
the  quality  of  private  sector  wage  data  remain 
high,  given  a  significant  share  of 
the  grey 
economy.   

Labour  productivity  turned  negative  in  2009  as 
industrial production plunged and the non-tradable 
sector  shrank  sharply.  Against  this  background, 
nominal unit labour costs continued to increase at 
brisk  pace.  ULC  growth  is  expected  to  decelerate 
in  2010  on  the  back  of  slower  wage  growth  and 
moderate further in 2011. However, it will remain 
the highest among the non-euro area new Member 
States  and  well  above  euro  area  ULC  growth, 
which  may  lead  to  a  loss  in  cost  competitiveness 
and contribute to higher inflation.   

External factors 

the  high  openness  of 

Given 
the  Bulgarian 
economy,  developments  in  import  prices  play  an 
important role in domestic price formation. Import 
prices  rose  sharply  in  2005-2008,  but  recorded  a 
steep  annual  decrease  of  14%  in  2009.  Annual 
growth in import prices is expected to turn positive 

21 

 
 
 
 
 
 
European Commission 

Convergence Report 2010 

again  in  2010,  although  imported  inflation  is 
assumed to moderate considerably as compared to 
the previous years. 

percentage points to average annual HICP inflation 
in 2008. 

in 

Energy  and  food  prices  have  been  a  major 
component of imported inflation in the recent past, 
in  particular  in  view  of  the  large  weight  of  these 
categories 
the  Bulgarian  HICP  basket. 
Accelerating  energy  and  food  inflation  during  the 
first  half  of  2008  was  followed  by  moderating 
price growth in the second half of the year, while 
inflation in those goods categories turned negative 
in  2009.  The  correction  was  mostly  a  result  of 
declining  global  food  and  commodities  prices, 
although  some  domestic  factors,  such  as  a  good 
harvest in Bulgaria in 2008, also contributed to the 
downward 
food  prices.  Sizeable 
disinflation  in  transport  services  reflected  the 
indirect effect of lower fuel prices. 

trend 

in 

The  depreciation  of  the  currencies  of  some  trade 
partners 
(Romania,  Poland,  Czech  Republic, 
Hungary,  Turkey)  between  September  2008  and 
March  2009  led  to  an  appreciation  of  the  lev  by 
some  4%  in  nominal  effective  terms  (measured 
against  a  group  of  35  trade  partners),  but  this 
development  appears  to  have  had  a  minor  impact 
the 
on 
depreciation  of  the  US  dollar  compressed  import 
prices  of  energy  products  and  commodities 
throughout 2009.  

import  prices.  More 

importantly, 

Administered prices and taxes 

inflation 

Adjustments  in  administered  prices  and  indirect 
taxes  have  been  an  important  determinant  of 
Bulgarian 
recent  years.  The 
in 
contribution  of  administered  prices  to  headline 
inflation, with a weight of around 16% in the HICP 
basket, was nonetheless uneven over time. In 2008 
annual  increases  in  administered  prices  picked  up 
and  reached  11%,  while  a  7%  increase  was 
recorded  in  2009,  i.e.  well  above  2009  headline 
inflation.  

The  categories  of  goods  and  services  with 
administratively  controlled  prices  that  contributed 
most to increase in headline inflation in 2008 were 
electricity  and  public  transport (16).  Increases  in 
administered  prices  contributed  around  1.6 

(16)  For  the  purpose  of  this  report,  other  notable  administered 
prices in Bulgaria include heating, water supply, sewerage 
collection,  postal  services,  hospital  services,  education, 
social protection and insurance connected with transport. 

22 

In 2009 a shift in the trend of administered prices 
occurred.  In  particular,  the  effect  of  an  electricity 
price hike in 2008 faded in the middle of the year 
and  the  contribution  of  electricity  prices  to  HICP 
inflation  became  negative.  The  effect  of  an 
increase  in  heating  prices  that  took  place  in 
January  was  to  a  great  extent  offset  by  the 
subsequent suspension of central heating prices in 
Sofia. The positive contribution of higher prices in 
passenger  transport,  water  supply  and  sewerage 
services  categories  also  considerably  lessened  in 
the  second  half  of  2009.  However,  the  effect  was 
partially  compensated  by  increased  contributions 
of  some  other  categories  of  services.  Overall, 
changes  in  administered  prices  added  around  1.1 
percentage  points  to  annual  HICP  inflation  in 
2009. Administrative price inflation is estimated to 
add  about  0.4  percentage  points  to  headline 
inflation in 2010. 

indirect 

inflation 

to  HICP 

tax  changes,  which 
A  number  of 
contributed 
in  2008  and 
afterwards,  have  been  undertaken  in  line  with  tax 
harmonisation  requirements  within  the  EU.  This 
notably  reflects  a  continuous  increase  in  excise 
duties  on  tobacco  products,  which  is  estimated  to 
have  contributed  0.3  and  0.7  percentage  points  to 
average  annual 
in  2008  and  2009, 
respectively.  It  is  expected  to  add  1  percentage 
point to inflation in 2010.  

inflation 

Medium-term prospects 

After a sharp decline in the course of 2009, HICP 
annual  inflation  is  expected  to  pick  up  again 
gradually  during  2010.  The  first  months  of  2010 
indicated  a  turnaround  in  energy  and  transport 
prices. The revival of Bulgaria's economic growth, 
expected in the second half of 2010, will add to the 
rebound  of  inflation,  in  particular  in  services  and 
processed  food.  As  the  intra-year  increase  of 
inflation  in  2010  starts  from  a  low  base,  the 
Commission  services'  2010  Spring  Forecast 
projects annual average inflation to remain broadly 
stable  at  2.3%  in  2010,  and  to  rise  moderately  to 
2.7% in 2011.  

Risks  to  the  inflation  outlook  appear  broadly 
balanced.  A  stronger  economic  recovery,  faster 
expansion  of  bank  credit  or  marked  pick-up  of 
global  commodity  prices  would  raise  inflationary 

 
                                                           
pressures. 
adjustments would have disinflationary effects.  

Conversely, 

downward 

wage 

The  level  of  consumer  prices  in  Bulgaria  was  at 
48%  of  the  euro  area  average  in  2008.  This 
suggests significant potential for further price level 
convergence  in  the  long  term,  as  income  levels 
(38%  of  the  euro  area  average  in  PPS  in  2008) 
increase towards the euro area average. 

Medium-term  inflation  prospects  in  Bulgaria  will 
hinge  upon  wage  and  productivity  trends.  The 
wage level in Bulgaria remains low in comparison 
to  the  euro  area.  The  previously  widening  gap 
between  wage  and  productivity  growth  has 
lessened  as  a  result  of  the  economic  crisis  and  is 
expected  to  narrow  further  over  the  short-term 
horizon. However, efforts are needed to close this 
gap  in  a  sustained  manner,  so  as  to  minimise  the 
risk of excessive wage growth once the economic 
recovery takes hold. Further structural measures to 
improve the business environment and to facilitate 
the effective allocation of labour market resources, 
mainly  by  shifting  labour  from  non-tradable  to 
tradable  sectors,  will  play  an  important  role.  A 
prudent  fiscal  stance  will  also  be  essential  to 
contain inflationary pressures. 

Convergence Report 2010 - Technical annex 

Chapter 2 - Bulgaria 

23 

 
European Commission 

Convergence Report 2010 

2.3.  GOVERNMENT BUDGETARY POSITION 

2.3.1.  Developments 2004-2009 

Bulgaria's  general  government  balance  improved 
markedly  in  the  years  before  the  outbreak  of  the 
global  economic  and  financial  crisis.  Over  the 
period  2004-2008, 
fiscal  balance  was 
the 
consistently  maintained  in  surplus,  amounting  to 
1.7% of GDP on average and ranging from close to 
balance budget in 2007 to a surplus of 3% of GDP 
in 2006. For most of the period the total revenue-
to-GDP  ratio  increased,  while  expenditure  as  a 
share of GDP was kept under restraint. Before the 
economic  downturn  the  revenue-to-GDP  ratio 
never  fell  below  39%  of  GDP,  while 
the 
expenditure-to-GDP  ratio  exceeded  40%  of  GDP 
only in 2007 as a result of a one-off cancellation of 
Iraqi debt. The reductions in corporate income tax 
rates  in  2007,  the  introduction  of  a  10%  flat-rate 
personal  income  tax  since  the  beginning  of  2008 
and  the  policy  of  reducing  the  social  security 
contributions  since  2006  appear  to  have  led  to  a 
considerable shrinkage of the grey economy. They 
also shifted additionally the tax burden from direct 
to indirect taxes, which account for more than 40% 
of general government revenue. In line with lower 
public  debt, 
interest  expenditures  decreased 
steadily  and  the  primary  balance  reached  2¾%  of 
GDP 
in  2008.  Current  primary  expenditures 
decreased by over 3% of GDP relative to 2004 to 
around  31%  of  GDP  in  2008.  At  the  same  time 
capital  expenditure  gradually  increased  to  around 
7% of GDP in 2009. The budgetary outturns were 
planned 
than 
consistently 
throughout  the  years  before  the  crisis,  mostly  due 
to higher than expected revenue and the favourable 
macroeconomic  environment.  This  reflects  also 
traditionally very conservative revenue projections 
as  well  as  the  impact  of  the  economic  cycle.  In 
addition,  maintaining  buffers  on  the  expenditure 
side  has  provided  for  a  certain  fiscal  flexibility 
during the budgetary execution phase.  

initially 

better 

Favourable  economic  conditions  aided 
fiscal 
consolidation  in  most  of  the  period  before  the 
global  economic  downturn.  The  improvement  in 
the  general  government  balance  was  underpinned 
by  buoyant  revenue  growth,  especially  as  regards 
indirect  tax  revenues  thanks  to  rapidly  expanding 
domestic  demand.  Revenue  growth  might  have 
been  even  stronger  had  the  revenue  windfalls  not 
been used to lower personal and corporate income 
tax rates as well as social contribution rates.  

24 

In  2009,  this  changed  as  the  global  economic 
downturn  took  a  toll  on  public  finances.  The 
the  general 
budgetary  surplus  vanished  and 
government  budget balance  swung  from  a  surplus 
of 1.8% of GDP at the end of 2008 to an estimated 
deficit  of  around  4%  of  GDP.  The  budgetary 
under-performance  was  mostly  due  to  lower  than 
expected  revenues,  reflecting  composition  effects 
due  to  falling  domestic  demand  as  well  as  more 
subdued  inflation.  Policy  efforts  were  geared 
toward  fiscal  consolidation  and  the  government 
adopted  measures,  aimed  at  limiting  non-interest 
expenditure  and 
tax  compliance. 
improving 
However,  they  were  not  enough  to  offset  the 
significant  revenue  shortfall  and  the  worsening  of 
the fiscal position in 2009. 

in 

Developments 
the  structural  balance  (i.e. 
cyclically-adjusted  balance  net  of  one-off  and 
other temporary measures) were broadly similar to 
those  in  the  headline  balance,  except  for  2007 
when the one-off cancellation of Iraqi debt led to a 
negative  structural  balance.  The  fiscal  stance,  as 
measured  by  the  change  in  the  structural  balance, 
had been tight from 2004 to 2006 as well as from 
2007  to  2008.  In  2009,  the  structural  balance 
turned negative under the impact of the economic 
crisis  and  the  fiscal  stance  was  expansionary 
despite 
consolidation  measures 
undertaken in the second half of the year. Thus, in 
2004-2009 the underlying fiscal position has been 
either counter-cyclical or broadly neutral. 

fiscal 

the 

The government debt-to-GDP ratio has followed a 
downward  trend,  decreasing  from  around  38%  in 
2004  to  14%  in  2008. In 2009,  however,  the  debt 
ratio  increased  by  around  1  percentage  point  as  a 
result of the negative impact of the global financial 
crisis  on  the  primary  balance  which  turned  into  a 
deficit.  In  the  period  prior  to  the  crisis,  the 
reduction in the debt ratio was mainly due to high 
primary  surpluses,  strong  GDP  growth,  and 
substantial  privatization  revenues.  The  high  debt-
reducing  stock-flow  adjustments  of  around  5-6% 
of  GDP  over  the  period  reflect  mainly  valuation 
effects  and 
large  privatization  receipts.  The 
accumulated  net  financial  assets,  mainly  in  the 
form of government fiscal reserves with the central 
to  carry  out  early  debt 
bank,  were  used 
repayments. 

 
Table 2.3.1:

Bulgaria - Budgetary developments and projections
Outturn and forecast 1)

2004

2005

2006

Convergence Report 2010 - Technical annex 

Chapter 2 - Bulgaria 

(as % of GDP unless indicated otherwise)

2007

2008

2009

2010

2011

General government balance

- Total revenues

- Total expenditure

of which: 
- interest expenditure

- current primary expenditure

- gross fixed capital formation

p.m.: Tax burden

Primary balance

Cyclically-adjusted balance

One-off and temporary measures
Structural balance 3)
Structural primary balance

Government gross debt

p.m: Real GDP growth (%)

p.m: Output gap

p.m: GDP deflator (% change)
Convergence programme 2)

General government balance

Primary balance
Structural balance 3) 4)
Government gross debt

p.m. Real GDP (% change)

1.6

41.3

39.7

1.8

34.1

2.9

34.0

3.4

0.6

0.0
0.6

2.4

37.9

6.6

2.8

5.1

1.9

41.2

39.3

1.7

33.3

4.2

34.6

3.6

0.8

-0.1
0.9

2.6

29.2

6.2

3.1

3.8

3.0

39.5

36.5

1.4

30.8

4.2

34.0

4.4

1.6

-0.1
1.8

3.2

22.7

6.3

3.8

8.5

0.1

41.5

41.5

1.0

32.3

4.8

34.6

1.1

-1.5

0.0
-1.5

-0.5

18.2

6.2

4.4

7.9

1.8

39.1

37.3

0.8

30.9

5.7

33.8

2.7

0.0

0.0
0.0

0.8

14.1

6.0

5.1

11.4

2008
1.8

2.7

0.2

14.1

6.0

-3.9

36.9

40.7

0.8

34.7

4.8

31.5

-3.1

-2.9

0.0
-2.9

-2.1

14.8

-5.0

-2.7

4.6

2009
-1.9

-1.3

-0.7

14.7

-4.9

-2.8

36.8

39.7

0.8

34.0

4.5

30.9

-2.0

-1.1

0.0
-1.1

-0.3

17.4

0.0

-4.9

1.5

2010
0.0

0.9

1.9

14.6

0.3

-2.2

36.8

39.1

0.9

33.5

4.5

30.7

-1.4

-0.7

0.0
-0.7

0.1

18.8

2.7

-4.1

2.1

2011
0.1

1.0

1.7

14.5

3.8

2012
0.1

1.1

1.0

14.4

4.8

2013
n.a.

n.a.

n.a.

n.a.

n.a.

1) Commission services’ Spring 2010 Forecast (taking into account the data from April 2010 EDP notification). 
2) With April 2010 EDP notification the bulgarian authorities have changed the estimation for 2009 general government balance to 
     a deficit of 3.9% of GDP and the fiscal target for 2010 to a deficit of 2.0% of GDP.

3) Cyclically-adjusted balance excluding one-off and other temporary measures.

4) Commission services’ calculations on the basis of the information in the programme.

There are no one-off and other temporary measures in the programme.

Sources: Commission services, January 2010 update of Bulgaria's Convergence Programme and April 2010 EDP Notification.

2.3.2.  Medium-term prospects 

The 2010 budget was adopted by the Parliament in 
December  2009.  On  the  revenue  side,  there  were 
no  major  changes  in  the  tax  laws,  except  an 
increase  in  the  excise  tax  rates  for  tobacco, 
kerosene and electricity for industrial production in 
line with the EU harmonisation requirements. The 
impact  on  revenue  of  a  reduction  in  social 
contribution  rates  by  2  percentage  points  was 
partially  offset  by  an  increase  in  the  mandatory 
minimum  insurable  income.  On  the  expenditure 
side,  wages  and  intermediate  consumption  in  the 
general  government  sector  are  set  to  remain 
unchanged  at  the  2008  level.  Gross  fixed  capital 
formation  is  planned  to  remain  constant  as  a 
percentage  of  GDP.  These  expenditure-reducing 
measures  more  than  compensate  the  increase  by 
0.2%  of  GDP  in  pensions  for  widowers  and  the 
elderly in 2010.  

According  to  the  January  2010  update  of  the 
convergence  programme  and  the  April  2010  EDP 
notification  the  authorities  will  target  a  headline 
deficit  of  2%  of  GDP  in  2010  and  a  balanced 
general government budget balance for 2011. The 
Commission services' spring 2010 forecast projects 
that the budget deficit will be contained below the 
reference value of 3% of GDP in the medium term 
and  is  expected  to  improve  in  structural  terms  by 
1¾pps  in  2010  and  ½pps  in  2011.  Therefore,  the 
fiscal  stance  is  estimated  to  be  restrictive  both  in 
2010 and in 2011. 

foreseen 

With  regard  to  the  long-term  sustainability  of 
public  finances  in  Bulgaria,  achieving  higher 
primary  surpluses  over  the  medium  term,  as 
already 
the  programme,  would 
contribute  to  reducing  further  the  risks  to  the 
sustainability  of  public  finances  which  were 
assessed  in  the  Commission  2009  sustainability 
report  as  low.  The  government  gross  debt  is  at  a 
low  level  and  the  medium-term  debt  projections 

in 

25 

 
 
 
 
 
 
measures  and  the  strong  political  commitment  to 
fiscal  discipline  are  expected 
to  partially 
compensate  the  risks  stemming  from  the  slightly 
favourable  assumptions  on  growth  and  revenue 
collection.  In  the  short-  to  medium-term  the 
programme  foresees  ambitious  structural  reforms 
that  aim  to  strengthen  the  sustainability  of  public 
finances  and  at  the  same  time  to  underpin  the 
economic recovery."  

The  Council  invited  Bulgaria  to  (i)  continue 
implementing  strict  fiscal  policies  and  adopt 
further  consolidation  measures  to  achieve  the 
programme  target  for  2010  with  a  view  to 
sustaining the on-going adjustment in the external 
imbalances;  and  (ii)  strengthen  the  efficiency  of 
public  spending  by  vigorously  implementing  the 
planned  structural  reforms  in  the  area  of  public 
administration, healthcare, education. 

European Commission 

Convergence Report 2010 

until 2020 that assume GDP growth rates will only 
gradually  recover  to  the  values  projected  before 
the  crisis  and  tax  ratios  will  return  to  pre-crisis 
levels  show  that  the  budgetary  strategy  envisaged 
in the programme would be enough to decrease the 
debt-to-GDP ratio and to allow to reach a net asset 
position by 2020 (17). 

2010 

update 

January 

The 
of  Bulgaria's 
convergence  programme  was  submitted  to  the 
European  Commission  and  the  Council  on  30 
January  2010.  It  covers  the  period  2009-2012 (18) 
and  was  envisaging  a  frontloaded  towards  the 
beginning of the programme adjustment towards a 
targeted  balanced  headline  budget.  The  medium-
term  objective  (MTO)  for  the  budgetary  position 
presented  in  the  programme  was  a  surplus  of  ½ 
percent  of  GDP  in  structural  terms,  which  was  to 
be  achieved  from  2010  onwards.  The  planned 
structural  balance  of  almost  2%  of  GDP  in  2010 
was  significantly  larger  than  the  MTO.  However, 
the  2009  budget  deficit  estimation  was  revised 
with  the  April  2010  EDP  notification,  defining  a 
new fiscal consolidation path from a lower starting 
point. The authorities already adopted a new anti-
crisis  and  fiscal  consolidation  package  that  is 
expected  to  bring  the  deficit  below  the  reference 
value  of  3%  of  GDP  in  2010.  It  includes  a  broad 
range of measures on both the expenditure and the 
revenue side. Depending on their effectiveness and 
the 
the  macroeconomic 
environment,  an  increase  of  the  VAT  rates  may 
also  be  considered  later  in  the  year.  The  fiscal 
target  for  2011  remains  unchanged  and 
the 
government  plans  to  achieve  a  balanced  general 
government budget. 

improvement 

of 

summarised 

the  Council 

In  its  April  2010  Opinion  on  the  convergence 
programme, 
its 
assessment as follows: " The overall conclusion is 
that  the  programme's  aim  to  maintain  a  sound 
budgetary  position,  reflected  in  planned  general 
government  balanced  budgets, 
is  considered 
adequate  at  the  current  economic  juncture  and  in 
view of the need to contain the economy's external 
consolidation 
imbalances. 

undertaken 

The 

(17)  More  details  on 

the  determinants  of 

long-term 
sustainability of public finances can be found in Bulgaria: 
Macro  Fiscal  Assessment  –  An  analysis  of  the  January 
2010  update  of  the  convergence  programme,  section  5.2. 
(http://ec.europa.eu/economy_finance/about/activities/sgp/
main_en.htm). 

the 

(18)  The successive updates of the convergence programme and 
the  assessments  by  the  Commission  and  the  Council  of 
them 
at: 
be 
http//ec.europa.eu/economy_finance/about/activities/sgp/m
ain_en.htm. 

found 

can 

26 

 
                                                           
 
2.4. 

EXCHANGE RATE STABILITY 

The Bulgarian lev does not participate in ERM II. 
The  central  bank  of  Bulgaria  (BNB)  pursues  its 
primary  objective  of  price  stability  through  an 
exchange rate anchor in the context of a Currency 
Board  Arrangement  (CBA).  Bulgaria  introduced 
its CBA on 1 July 1997, pegging the Bulgarian lev 
to  the  German  mark  and  subsequently  to  the  euro 
(at  an  exchange  rate  of  1.95583  BGN/EUR). 
Under  the  CBA,  the  BNB’s  monetary  liabilities 
have  to  be  fully  covered  by  its  foreign  reserves. 
The  BNB 
to  exchange  monetary 
liabilities  and  euro  at  the  official  exchange  rate 
without  any  limit.  The  CBA  was  instrumental  in 
achieving  macroeconomic  stabilisation  and  serves 
anchor. 
as 
Graph 2.4.1: Exchange rates - BGN/EUR

is  obliged 

policy 

key 

a 

Convergence Report 2010 - Technical annex 

Chapter 2 - Bulgaria 

Tightening  liquidity  conditions  in  the  Bulgarian 
banking  system  encouraged  the  BNB  to  relieve 
pressures  by  releasing  part  of  the  accumulated 
foreign  reserve  buffer.  In  particular,  the  BNB 
allowed 50% of commercial banks’ cash in vaults 
to  be  recognized  as  reserve  assets  and  eased 
commercial  banks’  access  to  reserves  with  the 
BNB.  The  minimum  required  reserves  were 
reduced  from  12%  to  10%  as  from  December 
2009.  The  minimum  required  reserves  on  funds 
attracted by banks from abroad were lowered from 
10%  to  5%  as  from  January  2010,  while  reserve 
requirements  were  no  longer  imposed  on  central 
and  local  government  deposits.  In  addition,  the 
government  withdrew  part  of  its  sizeable  deposit 
finance  budgetary 
held  with 
expenditures.  As  a  result  of  the  measures  taken, 
foreign 
reserves  declined  by  20%  between 
September 2008 and July 2009. 

the  BNB 

to 

(monthly av erages)

2.1

2.0

1.9

1.8

2004

2005

2006

2007

2008

2009

Source: ECB and EcoWin.

The  BNB  does  not  set  monetary  policy  interest 
rates.  The  domestic  interest  rate  environment  is 
directly  affected  by  the  monetary  policy  of  the 
euro  area  through  the  operations  of  Bulgaria's 
CBA. 

The  CBA  operated  in  an  environment  of  higher 
risk  perceptions  since  the  onset  of  the  financial 
crisis,  amidst  a  generally  higher  global  risk 
aversion  and  a  worsening  economic  situation  in 
Bulgaria.  Nevertheless,  sizable  reserve  buffers 
underpinned the resilience of the CBA. 

international  reserves  almost 

Bulgaria's 
twice 
exceed the monetary base and cover around half of 
broad  money  M3.  A  high  reserve  cover  had  been 
deliberately built into the framework for Bulgaria's 
CBA,  to  cater  for  potential  financial  sector  stress 
following  the  1996/97  crisis.  Over  the  years  the 
reserves  steadily  increased,  reaching  a  peak  of 
close to 15bn EUR in September 2008.  

The  return  of  confidence  in  the  banking  system 
and one-off factors, such as allocation of additional 
IMF  special  drawing  rights,  led  to  a  partial 
recovery  of  foreign  exchange  reserves  in  autumn 
2009. However, as the fiscal position continued to 
deteriorate, the government decided to draw again 
on the accumulated fiscal reserve, bringing official 
foreign  reserves  down  to  about  12bn  EUR  in 
March 2010. 

The  rapid  accumulation  of  short-term  private 
external  debt  over  recent  years  has  amplified 
country  risk.  The  ratio  of  the  country's  foreign 
reserves  to  short-term  debt  declined  from  about 
300%  in  2004  to  92%  in  mid-2009.  Rising  short-
term  debt  was  the  major  factor  behind  this 
reserves  also 
deterioration  but 
the 
contributed  as  crisis 
ratio 
improved  to  100%  as  of  end-2009,  mostly  on  the 
back of temporarily rising reserves.   

fall 
intensified.  The 

in 

Graph 2.4.2: Bulgaria - 3-M Sofibor spread to 3-M Euribor

 (basis points, monthly v alues)

500

400

300

200

100

0

2004

2005

2006

2007

2008

2009

Source: Eurostat.

27 

 
      
 
 
European Commission 

Convergence Report 2010 

Short-term  interest  rate  differentials  vis-à-vis  the 
euro area narrowed strongly between late 2004 and 
early  2007,  suggesting  a  sustained  drop  in  the 
country  risk  premium.  In  the  context  of  global 
financial  market  uncertainties,  spreads  widened  to 
around 200 basis points in late 2007 and remained 
broadly  stable  till  October  2008.  Tighter  liquidity 
and heightened risk perception with regard to new 
Member  States  in  autumn  2008  further  increased 
short-term  interest  rate  spreads,  which  reached 
in  March  2009  and 
some  490  basis  points 
remained  at  around  470  basis  points  during  the 
first  half  of  the  year.  Despite  a  clear  decline  in 
Bulgaria's  short-term  interest  rates  since  autumn 
2009, the differential with euro area rates remains 
elevated  in  comparison  to pre-crisis  levels.  At  the 
cut-off date of the report it stood at about 360 basis 
points. 

28 

 
 
Convergence Report 2010 - Technical annex 

Chapter 2 - Bulgaria 

2.5. 

LONG-TERM INTEREST RATE 

Long-term  interest  rates  in  Bulgaria  used  for  the 
convergence examination reflect secondary market 
yields  on  a  single  benchmark  government  bond 
with a maturity below but close to 10 years.  

Graph 2.5.1: Bulgaria - Long-term interest rate criterion
 (percent, 12-month mov ing av erage)

12

10

8

6

4

2

0
Jan-04

Jan-05

Jan-06

Jan-07

Jan-08

Jan-09

Jan-10

B ulgaria

Reference value

Source: Commission services.

The  Bulgarian  12-month  moving  average  long-
term interest rate relevant for the assessment of the 
Treaty  criterion  has  been  gradually  increasing 
since 2007. In summer 2009 the long-term interest 
rate  surpassed  the  reference  value  and  stayed 
above  it  since  then.  In  March  2010,  the  latest 
month  for  which  data  are  available,  the  reference 
value,  given  by  the  average  of  long-term  interest 
rates  in  Portugal  and  Belgium  plus  2  percentage 
points,  stood  at  6%.  In  that  month,  the  12-month 
moving average of the yield on ten-year Bulgarian 
benchmark bond stood at 6.9%, i.e. 0.9 percentage 
points above the reference value. 

Graph 2.5.2: Bulgaria - Long-term interest rates

 (percent, monthly v alues)

10

8

6

4

2

0

2004

2005

2006

2007

2008

2009

Source: Eurostat.

B ulgaria

Euro  area

Spreads  of  Bulgaria's  long-term  interest  rates  vis-
à-vis  the  euro  area  widened  gradually  from  about 
30 basis points in 2007 to around 110 basis points 
in  late  2008,  reflecting  the  increasing  inflation 
differential  and  broader  concerns  about 
the 
overheating of the Bulgarian economy. Long-term 
interest spreads widened further in 2009, reaching 
350  basis  points  in  the  first  half  of  the  year  as  a 
result  of  lower  global  risk  appetite  and  increasing 
country risk premia.  

Spreads  started  to  narrow  in  the  second  half  of 
2009  on  returning 
investors'  confidence  and 
declined to around 220 basis points in March 2010. 
A strong fiscal position and relatively low level of 
the 
government  debt  has  arguably 
divergence  of  Bulgaria's  long-term  interest  rates 
vis-à-vis the euro area compared to some regional 
peers. 

limited 

29 

 
 
 
 
 
European Commission 

Convergence Report 2010 

2.6.  ADDITIONAL FACTORS 

2.6.1.  Developments  of 

the  balance  of 

payments 

the 

trade  deficit 

Bulgaria’s  external  deficit  (i.e.  the  deficit  on  the 
combined  current  and  capital  account)  widened 
persistently  over  the  last  decade,  reaching  some 
29% of GDP in 2007, before contracting to 8% of 
GDP  in  2009  as  a  consequence  of  the  financial 
crisis.  The  main  driver  behind  the  surge  of  the 
external  deficit  was  the  trade  gap.  The  negative 
trade  balance  in  goods  increased  sharply  over 
2005-2008  amid  buoyant  domestic  demand.  In 
in  goods  narrowed 
2009, 
significantly  on  the  back  of  an  abrupt  contraction 
in domestic demand as the decline in imports was 
deeper than in exports. Trade in services remained 
in  small  surplus  over  2004-2009  thanks  to  solid 
growth  of 
tourism  revenues.  Relatively  high 
remittances  were  a  supportive  factor  for  the 
external  balance.  In  contrast,  the  surplus  in  the 
income  balance  declined  steadily  and  the  income 
account turned negative since 2006 due to growing 
earnings  of  foreign  companies  and  an  increasing 
external debt servicing burden.  

large  FDI 

inflows  and  other 

Bulgaria's external deficit was principally financed 
by 
investment 
liabilities,  notably  bank  credit  (particularly  since 
2007).  In  contrast,  portfolio  investment  flows  in 
recent  years  were  insignificant  and  negative. 
Between 2004 and its peak in 2007 the balance on 
the  financial  account  soared  to  more  than  45%  of 
GDP, but it declined sharply in the last quarter of 
2008,  revealing  the  country’s  vulnerability  to 
changes  in  investors'  sentiment.  In  2009  FDI 
inflows  halved,  while  other  investment  flows 
recorded  an  even  higher  contraction,  mostly  as  a 
result of lower property investments. Nevertheless, 
the  financial  account  in  2009  more  than  fully 
covered the current and capital account deficit.  

Graph 2.6.1: Bulgaria - Saving and investment

(in percent of GDP at market prices)

50

40

30

20

10

0

2004

2005
Gro ss natio nal saving

2006

2007

2008

2009

Gro ss capital fo rmatio n at current prices; to tal eco no my

Source: Eurostat, Commission services.

30 

a 

saving-investment  perspective, 

From 
the 
widening  of  the  external  deficit  was  essentially  a 
reflection  of  an  investment  boom  driven  by  FDI 
inflows  and  credit  growth.  FDI  was  mostly 
concentrated  in  the  non-tradable  sector,  notably 
financial  intermediation,  construction,  real  estate, 
wholesale  and  retail  trade.  Since  the  unfolding  of 
the  financial  crisis,  private  investment  in  these 
sectors shrank significantly, leading to a narrowing 
of  the  saving-investment  gap  in  2009.  Absorption 
of  EU  structural  funds  is  expected  to  increase  in 
2010  and  partially  compensate  the  fall  of  private 
FDI.  In  contrast  to  investment  dynamics,  the 
savings  to  GDP  ratio,  which  was  on  a  slightly 
increasing  trend  since  2006,  further  increased  in 
2009. 

Graph 2.6.2: Bulgaria - Effective exchange rates

 (v s. 35 trading partners;  monthly av erages;

  index numbers, 2004 = 100)

150

140

130

120

110

100

90

80

2004

2005

2006

2007

2008

2009

NEER

REER, HICP d eflated

REER, ULC d eflated

Source: Commission services.

and 

cost 

price 

competitiveness 
External 
deteriorated  to  some  extent  in  the  run-up  to  the 
financial  crisis.  The  real-effective  exchange  rate 
(ULC-deflated) has appreciated sharply since mid-
2006,  on  the  back  of  buoyant  wage  growth  amid 
moderate  productivity  gains.  Despite  that,  the 
share  of  Bulgaria's  exports  in  world  markets 
continued  to  increase.  The  real  appreciation  was, 
less  accentuated  when 
over 
deflated  by  consumer  prices.  The  ULC-deflated 
real-effective exchange rate of the lev continued to 
appreciate in 2009, on the back of still robust wage 
growth.  

longer-run, 

the 

Over  recent  years  Bulgaria  has  accumulated  large 
external  debt.  Between  2004  and  2009  gross 
external  debt  increased  from  64%  to  111%  of 
GDP. The rapid accumulation of external debt was 
a  result  of  expanding  private  debt,  which  now 
makes up almost 90% of total external debt, while 
public external debt was reduced sharply over the 
same  period  due  to  fiscal  discipline.  The  share  of 
short-term  external  debt  increased  over  time, 
although much of this is intra-group debt. In 2009 

 
 
 
Convergence Report 2010 - Technical annex 

Chapter 2 - Bulgaria 

Table 2.6.1:

Bulgaria - Balance of payments

Current account

Of which: Balance of trade in goods

                 Balance of trade in services

                 Income balance 

                 Balance of current transfers

Capital account
External balance 1)
Financial account

Of which: Net FDI

                Net portfolio inflows
                Net other inflows 2)
                Change in reserves (+ is a decrease)

Financial account without reserves

Errors and omissions

Gross capital formation

Gross saving

External debt

International investment position

2004

-6.6

-14.9

3.3

1.2

3.7

0.8

-5.8

4.4

11.4

-2.1

2.7

-7.5

12.0

1.3

23.1

17.3

63.7

-27.6

2005

-12.4

-20.1

3.7

0.3

3.7

1.1

-11.3

15.6

14.7

-4.7

7.1

-1.5

17.1

-4.3

28.0

16.5

70.9

-46.9

2006

-18.4

-22.0

3.7

-2.7

2.7

0.7

-17.7

21.0

24.1

1.2

1.7

-6.0

27.0

-3.3

31.7

13.1

82.0

-60.8

2007

-26.8

-25.1

4.1

-8.2

2.4

-2.0

-28.9

36.4

30.6

-1.8

17.7

-10.1

46.4

-7.5

36.8

14.3

100.4

-86.4

(percentage of GDP)

2008

-24.0

-25.2

3.9

-5.2

2.4

0.8

-23.2

31.4

18.2

-2.2

17.4

-2.0

33.4

-8.2

38.3

15.4

108.7

-101.8

2009

-9.4

-12.1

4.6

-4.7

2.8

1.4

-8.0

8.3

9.8

-1.8

-1.6

1.9

6.4

-0.3

26.2

17.9

111.3

-109.6

1) The combined current and capital account.

2) Including financial derivatives.

Sources: Eurostat, Commission services and Bulgarian National Bank.

the  ratio  of  short-term  debt  to  GDP  stabilised  at 
around  34%  and  remained  broadly  unchanged  in 
early 2010. 

Bulgaria's external deficit remains large compared 
to  other  new Member  States,  but  it  is  expected  to 
further narrow in 2010-10, supported by a recovery 
of  export  growth.  Over  the  medium  term,  further 
adjustment  in  the  external  imbalance  will  depend 
crucially  on  the  ability  of  the  Bulgarian  economy 
to re-orient resources to the tradable sector and to 
bring  wages  back  in  line  with  productivity  and 
enhance both price and non-price competitiveness.   

the  ratio  of  extra-EU-27  trade  of  goods  to  GDP 
remained  stable  in  the  latter  two  years  of  the 
period.  The  crisis  decreased  trade  openness  in 
2008, especially with EU partners.  

Bulgaria  is  a  small  open  and  highly  integrated 
economy  in  terms  of  trade  and  FDI  with  the  EU-
27. EU accession undoubtedly played a role in this 
result.  Trade  volumes  with  other  neighbouring 
countries  are  also  of  significant 
importance, 
mainly  linked  to  geographical  proximity  (Balkan 
countries)  and  the  strong  reliance  on  energy 
imports from Russia.  

2.6.2.  Product market integration 

structural 

Bulgaria's  trade  openness  ratio  increased  over  the 
last  years  and  is  well  above  the  EU-27  average. 
The evolution in trade openness in the first half of 
the  decade  was  driven  by  major  macroeconomic 
and 
trade 
reforms, 
liberalisation.  These  reforms,  undertaken  in  the 
run-up  to  EU  accession,  have  focused  on  price 
liberalisation,  the  removal  of barriers  to  trade  and 
investment, and the reduction of state control over 
businesses. Over the period 2004-2008, the ratio of 
intra-EU-27  trade  in  goods  to  GDP  increased, 
though  there  was  a  slight  decline  in  2008,  while 

including 

31 

 
 
 
 
 
European Commission 

Convergence Report 2010 

Table 2.6.2:

Bulgaria - Product market integration

Trade openness 1) (%)
Extra-EU trade in goods GDP ratio 2) (%)
Intra-EU trade in goods GDP ratio 3) (%)
Intra-EU trade in services GDP ratio 4) (%)
Export in high technology 5) (%)
Technological balance 6) (%)
Total FDI inflows GDP ratio 7) (%)
Intra-EU FDI inflows GDP ratio 8) (%)
FDI intensity 9)
Internal Market Directives 10) (%)
Value of tenders in the O.J. 11)
Time to start up a new company 12)

Bulgaria

2003

:

18.3

27.5

:

2.9

-3.1

10.5

:

:

:

:

:

2004

2005

2006

2007

64.1

20.2

29.2

10.3

2.5

-3.2

13.8

11.5

5.3

:

:

32.0

64.0

19.1

30.5

9.9

2.9

-3.8

14.4

10.7

5.9

:

:

32.0

68.6

21.0

32.8

10.3

3.3

-3.5

24.7

20.6

10.4

:

:

32.0

76.3

24.9

36.3

11.0

3.5

-3.4

29.7

25.4

12.8

0.8

8.5

32.0

2008

73.7

24.9

34.2

10.4

:

:

19.2

16.5

8.8

0.4

8.7

32.0

 1) (Imports + Exports of goods and services / 2 x GDP at current market prices) x 100 (Foreign Trade Statistics, Balance of Payments).

 2) (Extra-EU-27 Imports + Exports of goods / 2 x GDP at current market prices ) x 100 (Foreign Trade Statistics).

 3) (Intra-EU-27 Imports + Exports of goods / 2 x GDP at current market prices ) x 100 (Foreign Trade Statistics).

 4) Intra-EU-27 trade in services (average credit and debit in % of GDP at current prices) (Balance of Payments).

 5) Taken directly from Eurostat's databases: Exports of high technology products as a share of total exports.

 6) (Exports - imports in high tech) / GDP at current prices x 100, since 2007 the data based upon SITC Rev. 4 (earlier SITC Rev. 3).

 7) Total FDI inflows (in % of GDP at current prices).

8) Intra-EU-27 FDI inflows (in % of GDP at current prices).

9) FDI intensity (average intra-EU-27 inflows and outflows in % of GDP at current prices).

10) Percentage of internal market directives not yet communicated as having been transposed, in relation to the total number.

11) Public procurement - Value of public procurement which is openly advertised  (in % of GDP).

12) Time to start a new company (in days), Doing Business World Bank.

Sources: Eurostat, Commission services.

Bulgaria's exports are mainly composed of low and 
medium-low  technology  goods.  In  2007,  trade  in 
goods  revealed  a  comparative  advantage  in  raw 
material  goods  (lead,  wood  and  copper)  and 
labour-intensive  goods.  Revealed  comparative 
advantages  in  goods  such  as  power  generating 
machinery  and  steel  products  also 
improved 
compared to 2003, which reflects some upgrading 
of exports towards medium-low technology goods. 
Moreover,  the  share  of  exports  with  a  high 
technological  content  has  been  increasing  since 
2004 and, consequently, the relatively large deficit 
of the technological balance slightly decreased. In 
the  longer  term,  there  seem  to  be  favourable 
prospects  for  the  economy  to  move  further  away 
from 
towards  higher 
value-added sectors and services. So far, as a very 
economy, 
energy-intensive 
Bulgaria's 
raw 
materials and investment goods.  

imports  were  dominated  by 

labour-intensive  sectors 

catching-up 

and 

The  increase  of  FDI  inflows  in  recent  years  has 
been very strong, although Bulgaria has suffered a 
drop in capital inflows since 2008, like other new 
Member States. On average over the period under 
review,  the  ratio  of  FDI  inflows  to  GDP  was  the 
highest among the new Member States, essentially 
fuelled  by  intra-EU  FDI  inflows,  suggesting  that 
the  country  has  ample  capacities  in  attracting 

32 

low 

labour  costs,  and  progress 

foreign  investors.  EU-27  Member  States  account 
for more than 90% of total FDI, with around 70% 
of  total  inward  FDI  coming  from  the  euro  area 
countries.   A stable macroeconomic environment, 
relatively high GDP growth, low production costs, 
in 
including 
implementing  reforms  were  important  drivers  for 
the  FDI  accumulation  in  Bulgaria.  The  further 
relaxation of foreign ownership barriers, which are 
mainly  related  to  restrictions  on  privatisation  of 
state-owned  enterprises 
such  as 
electricity,  gas  and  water,  could  bring  additional 
FDI inflows.  

sectors 

in 

The dominant part of FDI inflows in Bulgaria went 
to  sectors  focused  on  serving  local  market  needs 
and  barely  contributed  to  enhancing  the  country's 
export  capacity,  except  in  a  few  sectors  such  as 
mining  and  metal  industries.  Initially,  the  biggest 
share of FDI in manufacturing was in investment-
intensive sectors for the production of intermediate 
goods,  including  oil  refinery,  chemicals,  metals 
fast  growing 
for 
and  various 
construction industry. Gradually, emphasis shifted 
towards the services sectors, namely real estate and 
business 
financial 
(about 
intermediation  (about  25%)  and  the  processing 
industry  (12%).  In  a  longer-term  perspective,  the 
low share of FDI in manufacturing in general and 

services 

inputs 

30%), 

the 

 
 
 
 
 
Convergence Report 2010 - Technical annex 

Chapter 2 - Bulgaria 

the focus on labour-intensive and low value-added 
sectors  are  a  cause  for  concern.  Shortage  of 
workers  with  mid-level  skills  might  also  hinder 
investment in medium-high technology sectors.  

A number of measures were adopted in Bulgaria to 
improve  the  business  environment,  such  as  the 
introduction  of 
impact  assessments  for  new 
legislation,  the  creation  of  an  electronic-based 
commercial registration, the adoption of the single 
the 
form  payment  scheme  at  borders  and 
establishment  of  one-stop-shops  at  all  levels  of 
administration.  A  target  to  reduce  administrative 
burden for businesses by 20% before 2012 was set, 
based on the common methodology agreed by the 
Commission.  In  2009,  significant  progress  was 
achieved with the reduction of the start-up capital 
for commercial companies (to a symbolic 1 euro), 
which is expected to reduce entry barriers for new 
market entrants. However, there are still problems 
of  over-regulation, 
in  obtaining 
authorisations, 
time-consuming  settlements  of 
contractual  and  legal  disputes,  and  continued 
corruption.  Finally,  the  transposition  of  Internal 
Market directives in Bulgaria was very prompt. In 
2009,  the  country  has  no  directives  overdue  by 
more than two years. 

long  delays 

capitalisation,  which  was  rising  during  the  boom, 
declined  considerably  during  2008  and  reached 
18% of GDP at the end of 2009. The bond market 
remains  a  source  of  funding  primarily  for  the 
government. Even though there has been progress 
in 
financial 
intermediation,  there  is  still  room  for  further 
financial deepening. 

development 

direct 

the 

of 

Graph 2.6.3: Bulgaria - Recent development of the  

financial system relatively to the euro area
(in percentage of GDP)

180
160
140
120
100
80
60
40
20
0

BG, 2004

BG, 2009

Euro area,
2004

Euro area,
2009

Debt securities

Sto ck market capitalisatio n

Do mestic bank credit

Source: Eurostat, Bulgarian National Bank, FESE.

The  banking  sector  has  remained  relatively 
competitive, as evidenced by a CR5 concentration 
ratio (20)  of  57%.  Concentration  has  increased 
during the recent years and, while being above the 
EU average, it is still below the average of the new 
EU  members.  The  share  of  bank  assets  owned  by 
foreign institutions remains very high at 83%. 

2.6.3.  Financial market integration 

 Bulgaria's  financial  sector  is  broadly  integrated 
into  the  EU  economy.  The  main  channels  of 
integration  were  rapid  bank  credit  expansion  as 
well  as  a  high  level  of  foreign  ownership  of  the 
banking system. Compliance with the acquis of the 
Union  in  the  field  of  financial  services  has  been 
fully achieved (19). 

100

80

60

40

20

0

Bulgaria's  financial  system  has  not  been  heavily 
affected  by  the  international  financial  crisis.  No 
banking sector rescue measures were taken by the 
government.  Confidence  in  the  currency  board 
arrangement  was  preserved  and 
international 
reserves  remained  at  a  high  level.  Owing  to  the 
its  public 
relatively  conservative  stance  of 
finances, 
the  Bulgarian  government  avoided 
external financing pressures. 

Indirect  financial  intermediation  is  predominant, 
with  domestic  bank  credit  amounting  to  almost 
73%  of  GDP  at  the  end  of  2009.  Equity  market 

Graph 2.6.4: Bulgaria - Foreign ownership and 

concentration in the banking sector
(in percent, weighted av erages)

BG, 2004

BG, 2008

Euro area,
2004

Euro area,
2008

Co ncentratio n in the banking secto r (CR5 ratio )

Share o f fo reign institutio ns as % o f to tal assets

Source: ECB, Structural indicators for the EU banking sector, January 2010.

Even though the quality of banks' loan portfolios is 
worsening,  banks'  capitalisation  remains  strong 
and no liquidity tensions have been manifest. Non-
performing  loans (21)  started  to  increase  in  2009 
and  reached  about  6%  at  the  end  of  the  year. 
Profits for 2009 remained solid, as evidenced by a 
return  on  equity  of  about  8%.  Banks  managed  to 
maintain  a  high  capitalisation  with  a  capital 
adequacy ratio of 17% as of December 2009. 

(19)  All Financial Services Action Plan (FSAP) Directives were 
transposed,  and  good  progress  has  been  made  with  the 
transposition  of 
the  Post-FSAP  Directives.  See: 
http://ec.europa.eu/internal_market/finances/actionplan/ind
ex_en.htm#transposition. 

(20)  The  CR5  concentration  ratio  is  defined  as  the  aggregated 
market  share  of  the  five  banks  with  the  largest  market 
share. 

(21)  Non-performing loans are loans  where principal or interest 

arrears payments have been past-due over 90 days. 

33 

 
                                                           
 
 
                                                           
European Commission 

Convergence Report 2010 

Graph 2.6.5: Bulgaria - selected banking sector soundness 
20

indicators relatively to the euro area

%

15

10

5

0

-5

BG, 2004

BG, 2009

Euro area,
2004

Euro area,
2008

Return on equity

Capital adequacy

No n performing lo ans

Note: For 2008, EU-27 non performing loans for are a proxy for EA.
Source: ECB, Bulgarian National Bank, EC calculations.

The growth in the banking segment of the financial 
system  is  most  apparent  through  the  dynamics  of 
domestic  credit.  Bank  credit  has  grown  at  an 
annual average of 32% since 2005, with a peak of 
almost  60%  in  2007.  Since  then,  credit  expansion 
has  decelerated,  especially  throughout  2009,  but 
has  remained  positive,  as  shown  by  a  7%  y-o-y 
growth rate at the end of December 2009. 

Graph 2.6.6: Bulgaria - Recent developments in bank credit to 

households and corporations relatively to the euro area

(in percentage of GDP)

60

50

40

30

20

10

0

Dec-04 Dec-05 Dec-06 Dec-07

Dec-08 Dec-09

Ho useho lds, B G
No n-financial co rpo ratio ns, B G
Ho useho lds, Euro  area
No n-financial co rpo ratio ns, Euro  area

Source: ECB, Eurostat.

While  the  credit  expansion  tended  to  privilege 
households  between  2004  and  2006,  the  trend 
changed  in  2007.  Loans  to  corporations,  which 
reached  47%  of  GDP  in  2009,  remained  higher 
than  loans  to  households  (29%  of  GDP).  This 
compares  to  the  euro  area  averages  of  52%  and 
55%  of  GDP  respectively.  Households  still  prefer 
to  contract  loans  in  the  domestic  currency,  even 
though the share of foreign currency credit rose up 
to one-third at the end of 2009. Corporations have 
a  marked  and  increasing  preference  for  foreign 
currency credit, the share of which stood at 75% at 
the end of 2009.  

34 

Graph 2.6.7: Bulgaria - Share of foreign currency loans

(as percentage of total loans to households / corporations)

80

70

60

50

40

30

20

10

0

Dec-04

Dec-05 Dec-06

Dec-07 Dec-08

Dec-09

Co rpo ratio ns

Ho useho lds

Source:  Bulgarian National Bank and own calculations.

The financial deepening of capital markets, which 
progressed  considerably  during 
the  economic 
boom,  came  to  a  halt  since  the  financial  crisis. 
Despite  an  increase  in  the  leading  stock  market 
index by 19% in 2009, overall equity capitalisation 
declined by about 5%. Liquidity, which has always 
been  limited,  decreased  by  about  two-third  if 
measured by total turnover on all market segments. 
Financial intermediation, wholesale and retail trade 
and  transport,  storage  and  communication  are  the 
economic sectors with the highest capitalisations. 

The  development  of  the  non-banking  financial 
intermediaries, which was buoyant until 2007, was 
significantly affected by the stock market decline. 
The  net  assets  of  pension  funds  stagnated  in 
nominal  value  and  fell  to  about  3%  of  GDP.  The 
assets of collective investment funds decreased by 
almost 50% between 2008 and 2009 and fell below 
1% of GDP. Securitisation of receivables and real 
estate  assets  remains  low,  as  evidenced  by  total 
assets  of  about  2%  of  GDP.  Assets  managed  by 
life and non-life insurance companies, which were 
significantly 
the  downturn, 
continued  to  grow  and  reached  respectively  about 
its  dynamic 
1%  and  4%  of  GDP.  Despite 
expansion  prior  to  the  financial  crisis,  the  non-
banking sector remains underdeveloped relative to 
the euro area. 

less  affected  by 

the  monetary 
Regulation  and  supervision  of 
financial  institutions  is  conducted  by  the  BNB. 
Since 1 March 2003, all players in the non-banking 
financial  sector  and  the  capital  markets  are  under 
the supervision of a single regulator, the Financial 
Supervision  Commission 
(FSC).  The  FSC 
cooperates strongly with the BNB, as well as with 
international  partners, 
the 
neighbouring countries. 

especially 

from 

 
 
 
 
3.  CZECH REPUBLIC 

3.1. 

LEGAL COMPATIBILITY 

3.1.1.  Introduction 

The  Czech  National  Bank  (CNB)  was  established 
on  January  1,  1993,  following  the  division  of  the 
State  Bank  of  Czechoslovakia.  Its  creation  was 
based  on  the  Czech  National  Council  Act  No. 
6/1993, adopted on December 17, 1992.  

Even though the Act on CNB was amended several 
times  since  the  last  Convergence  Report,  no 
relevant  amendments  to  the  Act  were  introduced 
with  regard  to  the  incompatibilities  mentioned  in 
2008.  Consequently,  comments  from  2008  are 
largely repeated in this year's assessment. 

3.1.2.  Objectives 

No  incompatibilities  with  the  TFEU  exist  in  this 
area.  

3.1.3.  Independence 

There  are  a  couple  of    incompatibilities  and  an 
imperfection  with  respect  to  the  TFEU  and  the 
ESCB/ECB Statute.  

According  to  Article  3(1)-(4)  of  the  Act  on  the 
CNB,  the  CNB  shall  submit  a  report  on  the 
monetary development to the Chamber of Deputies 
of  the  Parliament  for  review.  The  Chamber  of 
Deputies  may  ask  for  a  revised  report  and  in  this 
case,  the  CNB  will  have  to  submit  a  revised 
version complying with the Chamber of Deputies' 
requirements.  

This legal possibility for the Parliament to ask for 
amendments and, thus, to influence the content of 
the CNB's report on the monetary development can 
affect the central bank's institutional independence. 
For  this  reason,  it  is  considered  as  incompatible 
with Article 130 of the TFEU and Article 7 of the 
ESCB/ECB Statute.  

of 

the 

Parliament 

What  is  more,  the  possibility  for  the  Chamber  of 
Deputies 
request 
modifications  (Article  47(5)),  to  the  submitted 
earlier  annual  financial  report,  could  also  hamper 
the  central  bank’s 
institutional  (and  possibly 
independence.  Thus,  Article  47(5) 
financial) 

to 

constitutes  a  further  incompatibility  which  should 
be removed from the Act.  

As  regards  the  personal  independence  of  the 
CNB's  decision  making  bodies,  Article  6(11)-(13) 
provides  for  grounds  of  dismissal,  which  are  not 
exactly corresponding to those of Article 14(2) of 
further 
the  ESCB/ECB  Statute.  Whereas  a 
clarification  of  these  grounds  is  in  principle 
appreciated 
interpretation 
problems, an explicit reference to Article 14(2) of 
the ESCB/ECB Statute should be included.  

in  order 

limit 

to 

3.1.4.  Integration in the ESCB 

The  incompatibilities  in  this  area,  following  the 
TFEU provisions and ESCB/ECB Statute, include:  

• 

• 

• 

• 

• 

• 

the  obligation  to  consult  the  ECB  (Articles 
5(2)(a) and 37); 

the  definition  of  monetary  policy  (Articles 
2(2)(a), 5(1) and 23); 

the conduct of foreign exchange operations and 
the  definition  of  foreign  exchange  policy 
(Article 35a,b); 

the  holding  and  management  of 
reserves (Article 1(4) and Article 35(c)(d); 

foreign 

the  non-recognition  of  the  competences  of  the 
ECB  and of  the  Council on  the banknotes and 
coins (Article 2(2)(b), Articles 12 to 22); 

the  monetary 
functions,  operations  and 
instruments of the ECB/ESCB (Articles 23, 25, 
26, 26a, 28, 29, 29a, 32, 33, 36); 

• 

the  ECB's  right  to  impose  sanctions  (Article 
46b) 

There are also some imperfections regarding: 

• 

• 

the absence of reference of the role of the ECB 
and  of  the  EU  for  the  collection  of  statistics 
(Articles 41 and 46b); 

the non-recognition of the role of the ECB for 
the functioning of the payment systems (Article 
38); 

35 

 
European Commission 

Convergence Report 2010 

• 

• 

• 

the non-recognition of the role of the ECB and 
of  the  Council  for  the  appointment  of  the 
external audit of the CNB (Article 48(2)); 

the absence of an obligation to comply with the 
Eurosystem's regime for the financial reporting 
of NCB operations (Article 48); 

the  non-recognition  of  the  role  of  the  ECB  in 
the  field  of  international  cooperation  (Article 
40). 

3.1.5.  Prohibition of monetary financing 

An  incompatibility  and  an  imperfection  exist  in 
this area.  

3.1.6.  Assessment of compatibility 

independence  and 

As  regards  the  central  bank  integration  into  the 
ESCB  at  the  time  of  euro  adoption,  the  central 
bank's 
the  prohibition  on 
monetary  financing,  the  legislation  in  the  Czech 
Republic  -  in  particular  the  Act  on  the  CNB  and 
the  Act  on  the  Financial  Arbitrator,  is  not  fully 
compatible with Article 130 and 131 of the TFEU 
and the ESCB/ECB Statute. 

the 

including 

Under  Article  1(2)  of  Act  No.  229/2002  on  the 
Financial  Arbitrator,  the  CNB  is  required  to 
the 
latter's  activities, 
support 
payment of expenses of associated persons, as well 
as  the  salary  and  specified  emoluments  of  the 
Arbitrator  and  its  Deputy.  This  law  was  amended 
in  2004  and  2006;  however,  this  practice  has  not 
been abandoned. It constitutes a form of financing 
of obligations pertaining to the public sector which 
infringes  the  prohibition  of  monetary  financing 
(Article  123  of  the  TFEU,  Article  21  of  the 
ESCB/ECB Statute).  

According to Article 30(2) of the Act on the CNB, 
the CNB is not allowed to provide returnable funds 
or  any  other  financial  support  to  the  Czech 
Republic or its bodies or to any other authority and 
body  governed  by  public  law,  with  the  exception 
of  public  banks.  The  wording  of  this  provision 
constitutes  an  imperfection.  It  is  rather  extensive 
and does not take fully into account Article 123(2) 
of  the  TFEU.  It  provides  de  facto  a  wider 
exemption than the one foreseen in Article 123(2) 
of the TFEU, which exempts publicly owned credit 
institutions  only  'in  the  context  of  the  supply  of 
reserves by central banks'. 

36 

 
 
 
 
Convergence Report 2010 - Technical annex 

Chapter 3 - Czech Republic 

3.2. 

PRICE STABILITY 

in  January  2010,  though  it  remained  at  muted 
levels. 

3.2.1.  Respect of the reference value 

Graph 3.2.2: Czech Republic - HICP inflation

 (y-o-y percentage change)

inflation  and 

The 12-month average inflation rate for the Czech 
Republic,  which  is  used  for  the  convergence 
assessment,  sharply  increased  above  the  reference 
value  after  November  2007.  The  difference 
between  12-month  average 
the 
reference value narrowed again significantly in the 
course of summer and autumn 2009. From January 
2010  onwards,  12-month  average  inflation  was 
below  the  reference  value.  In  March  2010,  the 
reference  value  was  1.0%,  calculated  as  the 
average of the 12-month average inflation rates in 
Portugal, Estonia and Belgium plus 1.5 percentage 
points.  The  corresponding  inflation  rate  in  the 
Czech  Republic  was  0.3%,  i.e.  0.7  percentage 
points  below  the  reference  value.  The  12-month 
average inflation rate is likely to remain below the 
reference value in the months ahead. 

Graph 3.2.1: Czech Republic - Inflation criterion since 2004

 (percent, 12-month mov ing av erage)

7

6

5

4

3

2

1

0
Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11

Czech Republic

Reference value

Note: The dots show the projected reference value and 12-month average inflation 
in the country in December 2010.
Sources: Eurostat, Commission services' Spring 2010 Forecast.

3.2.2.  Recent inflation developments 

Annual  HICP  inflation  in  the  Czech  Republic 
remained  broadly  in  line  with  euro  area  levels, 
albeit  somewhat  more  volatile,  until  mid-2007. 
Inflation  picked  up  temporarily,  though  very 
sharply,  in  the  course  of  the  second  half  of  2007 
and  2008.  This  was  a  combined  result  of  rising 
energy  and  food  prices,  pushed  up  further  by 
indirect 
tax  changes  and  administered  price 
increases  and  by  the  weakening  koruna  in  the 
second half of 2008. When the impact of cost-push 
factors  ebbed  away  and  as  the  Czech  economy 
entered  recession,  HICP  inflation  dropped  rapidly 
to an average of 0.6% in 2009. Headline inflation 
picked  up  slightly  in  the  first  quarter  of  2010, 
partly  reflecting  upward  changes  in  indirect  taxes 

8

6

4

2

0

-2

2004

2005

2006

2007

2008

2009

Czech Republic

Euro  area

Source: Eurostat.

in 

this 

though 

concealed 

developments 

taxation.  A  decline 

inflation  (measured  as  HICP 

Core 
inflation 
excluding  energy  and  unprocessed  food)  moved 
broadly  in  tandem  with  headline  inflation  since 
substantial 
2007, 
divergences 
index 
of 
subcomponents. Core inflation was notably pushed 
up  by  a  sharp  increase  in  processed  food  and 
services prices in 2008, reflecting both the spike in 
global  commodity  prices  and  upward  changes  in 
indirect 
in  non-energy 
industrial goods prices acted partly as an offset, on 
the  back  of 
the  price-dampening  effect  of 
exchange rate appreciation in the first half of 2008. 
In  2009,  core  inflation  eased  significantly,  with 
declines in annual rates recorded across the major 
categories.  The  sharp  fall 
inflation, 
dropping  into  negative  territory  in  the  fourth 
quarter of 2009, suggests that underlying price and 
cost  pressures  stemming  from  the  real  economy 
have decreased on the back of the severe downturn 
in  economic  activity.  The  available  data  also 
suggest 
inflation  expectations  are  well-
that 
anchored at low levels.  

in  core 

3.2.3.  Underlying  factors  and  sustainability  of 

inflation 

Macroeconomic  policy-mix  and  cyclical 
stance 

The  Czech  economy  is  estimated  to  have  fallen 
well below potential in 2009, following a period of 
brisk  expansion  of  economic  activity  in  the  years 
after  EU  accession.  Annual  real  GDP  growth 
dropped  from  around  5.4%  on  average  in  2005-
2008  to  -4.2%  in  2009,  suffering  notably  from  a 
collapse  in  external demand amid  the  intensifying 
global crisis. The contraction of the economy was 

37 

 
 
 
European Commission 

Convergence Report 2010 

Table 3.2.1:

Czech Republic - Components of inflation

(percentage change)1)

weights  

in total   

2004

2005

2006

2007

2008

2009

Mar-10

HICP

Non-energy industrial goods

Energy

Unprocessed food 

Processed food

Services

HICP excl. energy and unproc. food
HICP at constant taxes 2)
Administered prices HICP

2.6

-1.7

3.7

1.7

3.9

4.9

2.5

1.8

4.5

1.6

-2.2

6.4

0.2

0.6

3.5

0.9

1.4

3.7

2.1

-2.0

9.7

0.3

1.0

3.1

0.9

1.4

4.0

3.0

-0.4

2.2

3.1

7.6

3.2

3.1

2.4

4.7

6.3

-0.2

11.0

2.1

11.0

7.6

5.8

4.3

13.6

0.6

-2.4

2.7

-1.8

0.7

2.5

0.5

0.6

6.9

0.3

-2.5

2.6

-1.9

0.0

2.1

0.2

0.2

6.2

2010

1000

268

134

76

197

325

790

1000

142

1) Measured by the arithmetic average of the latest 12 monthly indices relative to the arithmetic average of the 12 monthly indices 

   in the previous period.

2) Last observation for HICP at constant taxes is February 2010

indicators  for 

also driven by an investment plunge on the back of 
a  worsening  economic  outlook  and  tighter  credit 
conditions.  Available 
the  first 
quarter  of  2010  suggest  that  the  Czech  economy 
stages  a  muted  recovery.  Real  GDP  growth  is 
expected  to  pick  up  moderately  to  1.6%  in  2010 
and 2.4% in 2011, reflecting particularly a rebound 
in  foreign  demand.  Subdued  wage  growth  and 
fiscal  consolidation  measures  should  weigh  on 
domestic  demand.  Accordingly,  Commission 
services'  estimates  suggest  a  large  and  negative 
output gap over the medium term. 

The  fiscal  stance,  as  measured  by  changes  in  the 
structural  balance,  was  expansive  in  2008  and 
2009. The increase in the headline deficit in 2009 
reflected  a  deterioration  in  both  the  cyclical  and 
the structural component, with the latter mirroring 
mainly the impact of fiscal stimulus measures. The 
fiscal  stance  is  expected  to  be  restrictive  in  2010 
amid  the  efforts  of  the  Czech  government  to 
correct growing budgetary imbalances. 

Monetary  policy,  conducted  within  an  inflation 
targeting framework (22), was recently loosened in 
view  of  easing  inflation  pressures  in  the  midst  of 
the sharp economic downturn. The Czech National 
Bank  (CNB)  lowered  its  key  rate  by  a  total  275 
basis  points  to  1.0%  between  August  2008  and 
December  2009.  The  depreciation  of  the  koruna 
between  mid-2008  and  early  2009  contributed  to 
an  easing  of  monetary  conditions.  Ex  post  real 
interest rates remained at a low level, though they 
picked  up  from  negative  territory  on  the  back  of 
sharp  disinflation  during  the  second  half  of  2008. 
Credit  growth  to  the  Czech  economy  dropped 

(22)  As  from  January  2010,  the  inflation  target  of  the  Czech 
National  Bank  is  defined  as  annual  consumer  price  index 
growth  of  2%  (with  a  tolerance  band  of  ±  1  percentage 
point). 

38 

sharply  in  2009,  on  the  back  of  unfavourable 
cyclical  conditions  and  tightened  bank  lending 
standards. 

Wages and labour costs 

to 

labour  market  reacted  markedly 

The 
the 
economic  downturn,  with  employment  falling  in 
2009.  The  unemployment  rate  picked  up  from  a 
15-year low of 4.4% in 2008, suggesting very little 
slack  in  the  labour  market,  to  just  below  7%  in 
2009. Annual growth in nominal compensation per 
employee  shrunk  from  around  6%  recorded  in 
2006-2008 to some -0.8% in 2009, and a moderate 
increase is expected this year. Labour productivity 
growth  fell  sharply  in  2009,  amid  very  low 
investment activity and contracting GDP, though it 
is projected to regain its momentum in 2010 in line 
with  the  recovery  of  the  economy.  As  a  result, 
growth  in  nominal  unit  labour  cost  (ULC)  is 
expected  to  drop  into  negative  territory  in  the 
course of 2010.  

Graph 3.2.3: Czech Republic - Inflation, productivity and wage 

(y-o-y % change)

12

9

6

3

0

-3

-6

2004

2005

2006

2007

2008

2009

2010

2011

P ro ductivity (real GDP  per perso n emplo yed)

No minal co mpensatio n per emplo yee

No minal unit labo ur co sts
HICP  inflatio n

Source: Eurostat, Commission services' Spring 2010 Forecast.

 
                                                           
 
 
 
 
 
Convergence Report 2010 - Technical annex 

Chapter 3 - Czech Republic 

Table 3.2.2:

Czech Republic - Other inflation and cost indicators

2004

2005

2006

2007

2008

(annual percentage change)

20091)

20102)

20112)

HICP inflation

Czech Republic

Euro area

Private consumption deflator

Czech Republic

Euro area

2.6

2.2

3.3

2.0

Nominal compensation per employee

Czech Republic

Euro area

Labour productivity

Czech Republic

Euro area

Nominal unit labour costs

Czech Republic

Euro area

Imports of goods deflator

Czech Republic

Euro area

5.7

2.5

4.1

1.8

1.5

0.9

1.4

1.3

1.6

2.2

0.8

2.1

4.9

2.2

5.2

1.1

-0.3

1.3

-1.1

3.6

1) 2009 data (except HICP inflation) are estimates. 

2) Commission services' Spring 2010 Forecast.

Source: Eurostat, Commission services.

2.1

2.2

1.4

2.2

5.9

2.6

4.8

1.7

1.1

1.1

0.2

4.1

3.0

2.1

2.9

2.3

6.3

2.7

3.4

1.1

2.9

1.6

-1.4

1.3

6.3

3.3

5.0

2.9

6.3

3.4

1.2

0.0

5.1

3.4

-3.6

4.1

0.6

0.3

0.4

-0.1

-0.8

2.0

-3.1

-2.0

2.4

4.0

-3.3

-7.5

1.0

1.5

0.7

1.4

2.3

1.3

3.6

1.8

-1.2

-0.5

0.8

3.9

1.3

1.7

1.1

1.5

3.7

1.5

2.1

1.3

1.6

0.1

1.1

1.6

The wage negotiation process in the private sector 
is  decentralised,  with  wage  setting  largely  at  the 
enterprise  level.  In  2009,  the  main  drag  on  total 
wage  growth  stemmed  from  the  private  sector, 
while  available  data  point  to  public  sector  wage 
growth  remaining  higher  than  in  the  rest  of  the 
economy.  Looking  ahead,  nonetheless,  there  are 
some  encouraging  signs  of 
improved  wage 
discipline  in  the  public  sector.  In  particular,  the 
2010  budget  foresees  a  broad  public  sector  wage 
freeze. Given the muted wage increases in both the 
public  and  private  sectors  expected  in  the  near 
term,  the  labour  market  situation  should  not 
present a risk to the inflation outlook. 

External factors 

this category in the HICP basket. Fuel prices rose 
markedly during the first half of 2008 on the back 
of  mounting  oil  prices.  Following  a  significant 
downward  correction  in  global  commodity  prices, 
fuel  inflation  remained  in  negative  territory  for 
most of 2009; it picked up only towards end-2009 
and  in  early  2010  due  to  a  rebound  in  oil  prices. 
Electricity  and  gas  prices  followed  a  broadly 
similar  profile,  although  with  a  lag  and  a  varying 
degree  of  pass-through  from  global  prices.  As  a 
result,  the  total  contribution  of  energy  prices  to 
HICP 
from  around  1.5 
percentage  points  in  2008  to  some  0.4  percentage 
points 
in  2009.  Food  prices  have  exerted 
significant  downward  pressure  on  inflation  since 
mid-2009,  though  their  volatility  was  muted  as 
compared to energy prices. 

inflation  decreased 

into 

integration 

the  world 

For  the  Czech  Republic,  given  the  high  openness 
economy, 
and 
developments  in  import  prices  play  a  key  role  in 
domestic  price  formation.  Import  prices,  as 
measured  by  the  imports  of  goods  deflator  in  the 
national  accounts,  were  supportive  to  disinflation 
in  recent  years,  declining  over  the  period  2007-
2009.  

Energy prices have been an important determinant 
of  import  prices  in  the  Czech  Republic,  in 
particular  in  view  of  volatile  prices  of  primary 
commodities  and  a  comparatively  large  weight  of 

Import price dynamics in the Czech Republic have 
been  significantly  influenced  by  exchange  rate 
fluctuations of the koruna. The appreciation of the 
koruna,  by  about  14%  in  nominal-effective  terms 
between  early  2007  and  mid-2008,  helped  to 
impulses 
the 
moderate 
from  global  commodity  markets. 
emanating 
Subsequently, 
the  koruna  nominal  effective 
exchange rate depreciated by around 10% between 
mid-2008 and early 2009, acting partly as an offset 
to  the  downward  cost-push  exerted  by  falling 
commodity prices.  

inflationary 

strong 

39 

 
 
 
 
 
excluded  in  the  context  of  fiscal  consolidation 
efforts.  Conversely,  a  protracted  recession  of  the 
Czech  economy  and  further  appreciation  of  the 
koruna  on  the  back  of  an  improved  balance  of 
payments  outlook  would  have  disinflationary 
effects.  

The  level  of  consumer  prices  in  the  Czech 
Republic  was  at  some  70%  of  the  euro  area 
average in 2008, with the relative price gap widest 
for  services.  This  suggests  some  potential  for 
further price level convergence in the long term, as 
income levels (about 74% of the euro area average 
in  PPS  in  2008)  increase  gradually  towards  the 
euro area average. 

Medium-term  inflation  prospects  in  the  Czech 
Republic will notably hinge upon productivity and 
wage  developments  as  well  as  on  the  functioning 
of  product  markets  (e.g.  energy  prices).  A  robust 
policy 
inflation 
framework,  which  anchors 
expectations  at  a  low  level,  should  be  preserved. 
Over the longer term, a prudent fiscal policy stance 
as well as the effective allocation of labour market 
resources  will  also  play  a  role  in  alleviating 
inflationary  pressures  in  the  context  of  catching-
up.  

European Commission 

Convergence Report 2010 

Administered prices and taxes 

In  particular,  upward  changes 

Changes  in  administered  prices  and  indirect  taxes 
have  been  an  important  determinant  of  inflation 
dynamics  in  the  Czech  Republic  over  recent 
years (23). 
in 
administered prices, with a weight of around 14% 
in  the  HICP  basket,  have  exerted  a  permanent 
upward  pressure  on  inflation.  The  contribution  of 
indirect taxes to headline inflation was particularly 
strong  in  2008  and  early  2010,  notably  mirroring 
the  Czech 
fiscal 
government.  

consolidation 

efforts  of 

Annual  increases  in  administered  prices  fell  from 
13.6%  in  2008  to  6.9%  in  2009,  though  the 
positive  gap  vis-à-vis  headline  inflation  remained 
broadly constant (partly on account of an increase 
in  regulated  rents  in  2009).  The  adjustments  in 
indirect taxes in 2008 comprised an increase in the 
preferential  VAT  rate  (from  5%  to  9%),  the 
introduction of an environmental tax and a hike in 
tobacco excise duties. In January 2010, VAT rates 
(both base and reduced rate) as well as a number of 
excise  duties  (on  tobacco,  beer,  spirits  and  motor 
fuels)  were  increased;  the  first-round  effect  of 
these  indirect  tax  changes  is  estimated  to  have 
contributed  by  around  1  percentage  point  to  the 
increase  in  annual  headline  inflation  in  January 
2010.  

Medium-term prospects 

HICP inflation is expected to remain low in 2010, 
on  the  back  of  muted  economic  activity.  The 
changes  in  indirect  taxation  in  January  2010  and  
expected  increases  in  energy  and  commodity 
prices  will,  nonetheless,  keep  annual  inflation  in 
positive  territory.  Growth  in  nominal  unit  labour 
costs is expected to remain muted in 2010-2011, in 
in  economic 
line  with  a  moderate  recovery 
activity.  On  this  basis,  the  Commission  services' 
Spring  2010  Forecast  projects  annual  HICP 
inflation  to  average  1.0%  in  2010  and  1.3%  in 
2011. 

Risks  to  this  inflation  outlook  appear  broadly 
balanced.  The  main  upside  risks  relate  notably  to 
the  possibility  of  a  higher-than-expected  rebound 
in  economic  growth  and  related  upward  pressure 
on  producers'  margins.  No  major  changes  to 
indirect  taxes  are  foreseen  over  the  next  years, 
though  further  upward  adjustments  cannot  be 

(23)  For the purpose of this report, administered prices notably 
include  regulated  utility  prices,  public  and  social  services, 
public transport and some prices in the housing area. 

40 

 
                                                           
3.3.  GOVERNMENT BUDGETARY POSITION 

3.3.1.  The  excessive  deficit  procedure  for  the 

Czech republic 

In December 2009, the Council adopted a decision 
stating  that  the  Czech  Republic  had  an  excessive 
deficit, based on a planned deficit of 6.6% of GDP 
in  2009.  At  the  same  time,  the  Council  issued 
recommendations  to  correct  the  excessive  deficit 
by  2013.  In  particular,  the  Czech  Republic  was 
recommended  to  implement  the  deficit  reducing 
measures  in  2010  as  planned  in  the  draft  budget 
law  for  2010;  ensure  an  average  annual  fiscal 
effort  of  1%  of  GDP  over  the  period  2010-2013; 
and  specify  the  measures  that  are  necessary  to 
achieve  the  correction  of  the  excessive  deficit  by 
and 
conditions 
2013, 
accelerate the reduction of the deficit if economic 
or  budgetary  conditions  turn  out  better  than 
currently expected. The next step in the procedure 
is the assessment of effective action upon expiry of 
the deadline of 2 June 2010. 

permitting, 

cyclical 

The  Czech  Republic  has  previously  been  the 
subject of an excessive deficit procedure, in which 
the  existence  of  an  excessive  deficit  was 
established  in  July  2004.  Subsequent  budgetary 
developments 
the 
to 
procedure in June 2008. 

the  abrogation  of 

led 

3.3.2.  Developments until 2009 

The headline fiscal position improved significantly 
during the economic boom phase that preceded the 
crisis. With real GDP growth averaging almost 6% 
over  the  period  2004-2007,  the  dynamism  of 
government  revenue  allowed  a  decline  in  the 
government deficit from 3% to below 1% of GDP. 
Over the 2004-2008 period of positive output gaps 
fiscal  policy  provided  pro-cyclical  stimulus  to 
economic activity. The structural deficit (cyclically 
adjusted  deficit  net  of  one-offs)  increased  from 
1.9%  of  GDP  in  2004  to  4.5%  of  GDP  in  2008. 
Good  economic  times  were  thus  not  exploited  to 
make  progress  with  fiscal  consolidation.  The 
decline  of  government  revenue  during  the  crisis 
exposed  the  vulnerable  underlying  fiscal  position. 
Public finances started to deteriorate at the end of 
2008,  when  the  economy  entered  into  recession, 
bringing the deficit to 2.7% of GDP. In 2009, the 
government deficit reached 5.9% of GDP. 

Convergence Report 2010 - Technical annex 

Chapter 3 - Czech Republic 

General  government  expenditure  fell  from  around 
45%  of  GDP  in  2004  to  43%  of  GDP  in  2008. 
Government  consumption  grew  at  a  lower  pace 
than nominal GDP while social benefits increased 
markedly  and  kept  pace  with  the  high  nominal 
GDP  growth  rates.  Reforms  of  the  social  benefits 
system introduced in 2008 curbed the fast growing 
mandatory  spending.  The  expenditure-to-GDP 
ratio  surged  to  around  46%  of  GDP  in  2009, 
reflecting  the  fall  in  real  GDP,  the  operation  of 
automatic stabilisers and discretionary measures to 
stimulate  economic  activity 
including  public 
investment.  The  revenue-to-GDP  ratio  declined 
from around 42% of GDP in 2004 to around 40% 
of GDP in 2009. The sizeable revenue loss in 2009 
the  economic  downturn  and 
was  caused  by 
discretionary measures.  

to 

is  due 

The 2009 government deficit was targeted at 1.6% 
of  GDP  in  the  November  2008  update  of  the 
Convergence Programme. The deficit turned out to 
be  4.3  percentage  points  of  GDP  higher.  The 
worse-than-targeted  deficit 
the 
unprecedented scale of the crisis and its impact on 
public  finances.  While  the  budget  assumed  a 
positive real GDP growth at 3.7%, the outturn was 
recession  of  4.2%.  Around  half  of 
a 
the 
in  2009  can  be 
the  deficit 
deterioration  of 
attributed  to  the  effect  of  automatic  stabilisers. 
Discretionary  fiscal  stimulus  measures  amounted 
to some 2% of GDP. The main measures included 
cuts  in  social  security  contributions,  increases  in 
public  infrastructure  investment,  financial  support 
to 
support 
employment. Most measures implemented in 2009 
were  temporary  and  cushioned  against  the  effects 
of  the  crisis,  mainly  through  providing  support  to 
businesses. 

and  measures 

businesses 

to 

The  government  debt-to-GDP  ratio  remained 
broadly  stable  between  2004  and  2008.  While 
structural  deficits  remained  high  over  the  period, 
an increase in the level of debt was avoided thanks 
to favourable "snow-ball" effects and privatization 
revenues.  The  large  general  government  deficit  in 
2009 contributed to a large increase in the debt-to-
GDP ratio which exceeded 35% of GDP, up from 
30% of GDP in 2008.     

41 

 
 
European Commission 

Convergence Report 2010 

Table 3.3.1:

Czech Republic - Budgetary developments and projections
Outturn and forecast 1)

2005

2006

2004

2007

(as % of GDP unless indicated otherwise)

2008

2009

2010

2011

General government balance

- Total revenues

- Total expenditure

of which: 
- interest expenditure

- current primary expenditure

- gross fixed capital formation

p.m.: Tax burden

Primary balance

Cyclically-adjusted balance

One-off and temporary measures
Structural balance 2)
Structural primary balance

Government gross debt

p.m: Real GDP growth (%)

p.m: Output gap

p.m: GDP deflator (% change)

Convergence programme
General government balance

Primary balance
Structural balance 2) 3)
Government gross debt

p.m. Real GDP (% change)

-3.0

42.2

45.2

1.2

36.7

4.8

37.5

-1.8

-2.4

-0.5
-1.9

-0.7

30.4

4.5

-1.5

4.5

-3.6

41.4

45.0

1.2

36.4

4.9

37.2

-2.4

-3.9

-1.2
-2.7

-1.6

29.7

6.3

1.0

-0.3

-2.6

41.1

43.8

1.1

35.7

5.0

36.7

-1.5

-4.0

-0.1
-3.9

-2.8

29.4

6.8

3.9

1.1

-0.7

41.9

42.6

1.2

35.2

4.7

37.3

0.5

-2.9

0.0
-2.9

-1.7

29.0

6.1

6.0

3.4

-2.7

40.2

42.9

1.1

35.3

4.9

35.5

-1.6

-4.5

0.0
-4.5

-3.4

30.0

2.5

4.8

1.8

2008
-2.1

-1.0

-3.7

30.0

2.5

-5.9

40.3

46.1

1.3

38.4

5.4

34.6

-4.6

-5.1

0.3
-5.4

-4.1

35.4

-4.2

-2.2

2.7

2009
-6.6

-5.3

-6.1

35.2

-4.0

-5.7

41.4

47.0

1.7

38.6

5.6

35.3

-3.9

-4.7

0.2
-4.9

-3.2

39.8

1.6

-2.7

0.1

2010
-5.3

-3.5

-4.1

38.6

1.3

-5.7

41.7

47.4

2.1

38.5

5.7

35.6

-3.6

-4.8

0.1
-4.9

-2.8

43.5

2.4

-2.5

0.6

2011
-4.8

-2.8

-3.7

40.8

2.6

2012
-4.2

-2.0

-3.5

42.0

3.8

2013
n.a.

n.a.

n.a.

n.a.

n.a.

1) Commission services’ Spring 2010 Forecast.

2) Cyclically-adjusted balance excluding one-off and other temporary measures.

3) Commission services’ calculations on the basis of the information in the programme. One-off and other temporary

measures in the convergence programme of February 2010 are 0.2% of GDP in 2009; deficit-decreasing; and -0.1% of GDP 

in both 2010 and 2011 deficit increasing.

Sources: Commission services and February 2010 update of Czech Republic's Convergence Programme.

3.3.3.  Medium-term prospects 

Faced  with  a  severe  deterioration  of  the  deficit  in 
2009,  the  Czech  authorities  decided  to  start  fiscal 
consolidation  already  in  2010.  As  a  result,  some 
stimulus  measures  were  withdrawn  earlier  than 
planned  and  a  sizeable  consolidation  package 
(more  than  1.5%  of  GDP  according  to  the 
authorities)  was  adopted  as  part  of  the  2010 
budget. Permanent discretionary measures adopted 
in  2007-2008  and  implemented  in  2009,  such  as 
cuts in social contributions paid by employees and 
a reduction of the CIT to 19%, remain in place.  

real  estate 

Consolidation  in  2010  relies  mostly  on  revenue 
side  measures.  These  include  increases  in  VAT, 
taxes.  Early 
excise  duties  and 
withdrawal 
social 
temporary 
contributions  combined  with  an  increase  of  social 
security  ceilings  for  high-income  earners  will 
provide 
revenues. 
additional  boost 
Consolidation  measures  on  the  expenditure  side 

cuts 

an 

of 

in 

to 

are  more  modest.  Main  measures  include  cuts  in 
social  benefits  and  unused  possibility  of  pension 
indexation  in  2010.  The  consolidation  package 
also  foresees  a  freeze  of  the  public  sector  wage 
bill.  While  most  changes  on  the  revenue  side  are 
conceived  as  permanent,  measures  on 
the 
expenditure side expire at the end of 2010. 

According  to  the  February  2010  update  of  the 
convergence  programme,  the  Czech  authorities 
target a deficit of 5.3% of GDP in 2010 while the 
Commission services' spring 2010 forecast predicts 
a deficit of 5.7% of GDP. The fiscal stance in 2010 
is  restrictive,  as  the  primary  structural  balance  is 
projected  to  improve  by  around  1  p.p.  in  2010 
according to the Commission services' spring 2010 
forecast.  

Fiscal  projections  after  2010  are  subject 
to 
considerable  uncertainty.  Based  on  a  no-policy-
change  assumption, 
the  Commission  services' 
spring  2010  forecast  foresees  no  improvement  of 
the  deficit  in  2011,  as  no  additional  consolidation 

42 

 
 
 
 
 
to 

last  update  of 

measures have been approved so far. Nevertheless, 
the  Czech  authorities  plan  to  continue  fiscal 
consolidation  after  2010  and  to  bring  the  deficit 
below  the  3%  of  GDP  threshold  by  2013,  in  line 
with the Council recommendations of 2 December 
2009.  According 
the 
the 
convergence  programme,  the  general  government 
deficit  is  projected  at  4.8%  of  GDP  in  2011  and 
4.2%  of  GDP  in  2012.  Expenditure  cuts  account 
for  three  quarters  of  the  overall  consolidation 
effort.  However,  the  consolidation  strategy  does 
not  provide  sufficiently  concrete  measures  on  the 
expenditure  side  in  2011  and  2012  and  no 
information 
is  provided  on  deficit-reducing 
measures in 2013.  

The  long-term  budgetary  impact  of  ageing  is 
clearly above the EU average, mainly as a result of 
a relatively high increase in pension expenditure as 
a  share  of  GDP  over  the  coming  decades.  The 
budgetary  position  in  2009,  as  estimated  in  the 
programme,  compounds  the  budgetary  impact  of 
population  ageing  on 
the  sustainability  gap. 
Achieving  primary  surpluses  over  the  medium 
term  and  undertaking  reforms  of  pension  and 
health  care  systems  with  a  view  of  containing  the 
future 
these  expenditures  would 
contribute to reducing the risks to the sustainability 
of  public  finances  which  were  assessed  in  the 
Commission  2009  Sustainability  Report  as  high. 
An  expert  advisory  group  of  the  Minister  of 
Finance  and  the  Minister  of  Labour  and  Social 
Affairs  was  established  in  January  2010  with  the 
aim of preparing alternative proposals for pension 
reform. These will be finalised by the end of May 
2010 and conveyed to the new government. 

increase 

in 

summarised 

the  Council 

In  its  April  2010  Opinion  on  the  convergence 
programme, 
its 
assessment as follows: " The overall conclusion is 
that  the  budgetary  strategy  of  the  Czech  Republic 
for 2010 is appropriate and in line with the Council 
Recommendation under Article 126(7) TFEU. The 
fiscal  strategy  for  the  following  years  lacks 
ambition and fiscal targets are subject to risks both 
on the revenue and expenditure side. In particular, 
the  expenditure  targets  are  not  backed  up  by 
specific measures from 2011 on and the favourable 
macro-economic  assumptions  put  some  doubt  on 
the revenue projections for 2012. Moreover, while 
the target date for bringing the government deficit 
below  3%  of  GDP  (2013)  is  in  line  with  the 
Council  Recommendation,  it  is  not  possible  to 
the 
fully  assess 
the  budgetary  strategy  as 
the 
programme  does  not  provide  details  on 

Convergence Report 2010 - Technical annex 

Chapter 3 - Czech Republic 

the  correction  of 

that  are  necessary 

consolidation  measures 
to 
achieve  the  planned  significant  adjustment  in  that 
year.  Therefore,  more  information  on  the  broad 
strategy  underpinning 
the 
excessive  deficit,  including  in  particular  2013, 
would  be  welcome.  With  respect  to  the  fiscal 
framework,  there  are  noticeable  weaknesses  in 
several 
in  budgetary 
in  particular 
procedures,  enforcement  of 
the  medium-term 
budgetary  framework.  Furthermore,  the  long-term 
budgetary impact of ageing is clearly above the EU 
average  which  remains  a  concern  for  long-term 
sustainability  of  public  finances  and  points  to  the 
need  for  reforms  in  the  areas  of  pensions  and 
healthcare."  

areas, 

that  are  necessary 

The  Council  invited  the  Czech  Republic  to:  (i) 
implement  the  2010  budget  rigorously  and  avoid 
expenditure  slippages;  in  line  with  the  Council 
Recommendation  under  Article  126(7),  target,  in 
the context of the 2011 and 2012 budgets, a larger 
budgetary  adjustment  than  the  one  planned  in  the 
programme  and  specify 
the 
the 
measures 
excessive  deficit  by  2013  at  the  latest;  (ii)  take 
action  to  improve  budgetary  procedures  and  to 
enforce and monitor more rigorously the medium-
term budgetary targets; in particular, avoid upward 
revisions  of  expenditure  ceilings  beyond 
the 
revisions  permitted  by  the  budgetary  rules;  (iii) 
implement  the  necessary  reforms  in  order  to 
improve  the  long-term  sustainability  of  public 
finances. 

in  more  detail 
to  correct 

43 

 
Short-term  interest  rate  spreads  vis-à-vis  the  euro 
area hovered close to zero in 2004-2005 and turned 
negative  in  2006-2007  and  the  first  half  of  2008, 
reflecting  notably  the  past  track  record  of  low 
inflation  and  prolonged  appreciation  pressures  on 
the  Czech  currency.  The  3-month  interest  rate 
differential against the euro area narrowed rapidly 
and  turned  positive  in  the  course  of  the  fourth 
quarter  of  2008  amid  the  intensifying  global 
financial  crisis  and  substantial  cuts  in  the  ECB 
policy  rates.  The  Czech  central  bank  (CNB) 
introduced 
repo 
instrument  in  October  2008,  with  the  aim  to 
prevent  potential  transmission  of  turbulences  in 
foreign  financial  markets  to  the  Czech  financial 
sector.  

liquidity-supplying 

a  new 

In  2009  and  early  2010,  short-term  interest  rate 
differentials  against  the  euro  hovered  at  around 
100 basis points, and fell to about 75 basis points 
at the cut-off date of this report. The CNB lowered 
the  key  policy  rates  broadly  in  tandem  with  the 
ECB  over  recent  quarters,  but  tight  liquidity 
conditions in the Czech money market kept short-
term  spreads  up. The  main  refinancing rate of  the 
CNB stood at 1.0% in April 2010, i.e. at the same 
level as the ECB reference rate. Foreign exchange 
reserves hovered at an equivalent of around 3 to 4 
months of imports in recent years. 

European Commission 

Convergence Report 2010 

3.4. 

EXCHANGE RATE STABILITY 

The Czech koruna does not participate in ERM II. 
Since  the  abandonment  of  the  currency  peg  in 
1998, the monetary policy regime has moved to an 
explicit  inflation  targeting  framework.  The  Czech 
Republic operates a floating exchange rate regime, 
with  the  central  bank  abstaining  from  currency 
interventions, 
instrument  remains 
the 
though 
available in principle. 

Graph 3.4.1: Exchange rates - CZK/EUR

(monthly av erages)

35

30

25

20

2004

2005

2006

2007

2008

2009

Source: ECB and EcoWin.

The  exchange  rate  of  the  koruna  experienced  a 
long  period  of  sustained  nominal  appreciation 
between  EU  accession  in  2004  and  mid-2008, 
interrupted  only  for  a  brief  period  in  early  2007. 
The koruna's exchange rate strengthened to an all-
time-high  against  the  euro  in  July  2008.  A 
remarkably strong weakening impetus set in during 
the  second  half  of  2008  amid  the  intensifying 
global financial crisis. The Czech koruna corrected 
part  of  its  losses  in  2009  and  early  2010,  amid 
heightened  currency  volatility,  reflecting  some 
moderation 
in  global  risk  aversion  and  an 
improving  external  balance.  During  the  two  years 
before  this  assessment,  the  koruna  depreciated 
against the euro by 1.1%. 

Graph 3.4.2: Czech Republic - 3-M Pribor spread to 3-M Euribor

 (basis points, monthly v alues)

150

100

50

0

-50

-100

-150

2004

2005

2006

2007

2008

2009

Source: Eurostat.

44 

 
      
 
 
Convergence Report 2010 - Technical annex 

Chapter 3 - Czech Republic 

Graph 3.5.2: Czech Republic - Long-term interest rates

 (percent, monthly v alues)

6

4

2

0

2004

2005

2006

2007

2008

2009

Source: Eurostat.

Czech Republic

Euro  area

Yields  on  Czech  government  bonds  broadly 
mirrored those of the euro area between early 2005 
and mid-2008, with spreads in either direction not 
exceeding  around  50  basis  points.  The  favourable 
inflation  outlook,  amidst  the  trend  appreciation  of 
the  nominal  exchange  rate,  played  the  key  role  in 
narrowing  the  long-term  spread  vis-à-vis  the  euro 
area.  Long-term  interest  rate  spreads  widened 
abruptly  amid  the  intensification  of  the  global 
financial crisis in the second half 2008. The yields 
on  Czech  government  bonds,  nonetheless,  stayed 
less affected as compared to its regional peers. The 
interest  rate  differential  vis-à-vis  the  euro  has 
narrowed since mid-2009, down to around 40 basis 
points in March 2010, reflecting notably the cuts in 
the  central  bank's  key  rates  as  well  as  the 
comparatively strong fundamentals of the country.  

3.5. 

LONG-TERM INTEREST RATE 

Long-term  interest  rates  in  the  Czech  Republic 
used  for  the  convergence  examination  reflect 
secondary market yields of a basket of bonds with 
a maturity of around 10 years. 

Graph 3.5.1: Czech Republic - Long-term interest rate criterion

 (percent, 12-month mov ing av erage)

12

10

8

6

4

2

0
Jan-04

Jan-05

Jan-06

Jan-07

Jan-08

Jan-09

Jan-10

Czech Republic

Reference value

Source: Commission services.

The  Czech  12-month  moving  average  long-term 
interest  rate  relevant  for  the  assessment  of  the 
Treaty  criterion  has  stayed  below  the  reference 
value over the entire assessment period. In March 
2010, the latest month for which data are available, 
the reference value, given by the average of long-
term interest rates in Portugal and Belgium plus 2 
percentage  points,  stood  at  6.0%.  In  that  month, 
the  twelve-month  moving  average  of  the  yield  on 
ten-year Czech benchmark bond stood at 4.7%, i.e. 
1.3 percentage points below the reference value. 

45 

 
 
 
European Commission 

Convergence Report 2010 

3.6.  ADDITIONAL FACTORS 

Graph 3.6.2: Czech Republic - Effective exchange rates
 (v s. 35 trading partners;  monthly av erages;

  index numbers, 2004 = 100)

170

160

150

140

130

120

110

100

90

80

2004

2005

2006

2007

2008

2009

NEER

REER, HICP d eflated

REER, ULC d eflated

Source: Commission services.

Competitiveness indicators for the Czech Republic 
show  a  rather  mixed  picture  over  recent  years.  A 
large fraction of real exchange rate fluctuations has 
been  due  to  swings  in  the  nominal  effective 
exchange  rate  of  the  koruna.  The  sharp  nominal 
depreciation  in  the  second  half  of  2008  led  to  a 
strong  weakening  in  the  koruna's  real  effective 
exchange  rate  deflated  both  by  HICP  and  unit 
labour costs. These gains in competitiveness were 
partly  offset  by  the  appreciation  of  the  koruna  in 
2009  and  in  the  first  quarter  2010.  The  solid 
competitive  position  of  the  Czech  economy  was 
also  reflected  in  market  share  increases  over  past 
years,  although  the  gains  were  more  muted  in 
2008-2009.  

in 

The  significant 
the  external 
improvement 
balance  of  the  Czech  Republic  suggests  that 
financing constraints pose no major problems. The 
financial account surplus significantly narrowed in 
2008-2009,  averaging  just  below  1%  of  GDP, 
down from 3.1% in 2007. The decline was largely 
driven  by  lower  FDI  inflows,  reflecting  both  a 
decrease  in  foreign  investment  in  the  Czech 
Republic  and  an  increase  in  Czech  investment 
abroad.  Over  the  medium  term,  the  external 
balance would be further supported by progress in 
fiscal  consolidation.  Preserving  competitiveness 
will hinge upon structural policies geared towards 
ensuring  a favourable  investment  climate  for both 
domestic  and  foreign  investment,  including  an 
educated workforce and flexible labour market, as 
well  as  on  wage  and  productivity  developments. 
The global economic crisis has also shown that the 
vulnerabilities related to sectoral concentration, for 
the  Czech  Republic  in  the  automotive  industry, 
may  pose  some  risks  to  the  external  position  in 
going ahead. 

3.6.1.  Developments  of 

the  balance  of 

payments 

The  external  balance  (i.e.  the  combined  current 
and  capital  account)  of  the  Czech  Republic 
improved  from  a  deficit  of  2.6%  of  GDP  in  2007 
to  a  moderate  surplus 
in  2008-2009.  The 
narrowing  of  the  external  shortfall  over  the  past 
two  years,  amid  divergent  trends  in  individual 
subcategories,  was  notably  reflecting  a  higher 
trade  surplus  and  a  narrowing  deficit  on  the 
income  balance.  The  pick-up  in  the  merchandise 
trade  surplus  in  2009  resulted  from  a  markedly 
deeper  decline  of  imports  than  exports,  helped  by 
positive  terms  of  trade.  Net  income  outflows  fell 
on  the back of  a  decline  in  profits  related  to  FDI. 
The favourable  developments  in  the  trade balance 
and  the  income  balance  were,  nonetheless,  partly 
offset  by  a  shrinking  of  the  surplus  of  trade  in 
services (mirroring a fall in receipts on travel and 
transport  in  the  midst  of  the  global  economic 
crisis). 

Graph 3.6.1: Czech Republic - Saving and investment
(in percent of GDP at market prices)

30

20

10

0

2004

2005
Gro ss national saving

2006

2007

2008

2009

Gro ss capital fo rmatio n at current prices; total eco nomy

Source: Eurostat, Commission services.

investment,  while 

In  terms  of  the  saving-investment  balance,  the 
increase  in  the  external  deficit  between  2005  and 
2007  was  mainly  accounted  for  by  an  increase  in 
domestic 
the  saving  ratio 
remained  broadly  stable.  Since  2008,  both  saving 
and  investment  ratios  to  GDP  decreased  sharply; 
the  private  saving-investment  gap  fell  amid  the 
economic  downturn  and  balance  sheet  adjustment 
in  the  financial  and  non-financial  sectors,  though 
the  rising  government  deficit  partly  acted  as  an 
offset.  

46 

 
 
 
Convergence Report 2010 - Technical annex 

Chapter 3 - Czech Republic 

Table 3.6.1:

Czech Republic - Balance of payments

Current account

Of which: Balance of trade in goods

                 Balance of trade in services

                 Income balance 

                 Balance of current transfers

Capital account
External balance 1)
Financial account

Of which: Net FDI

                Net portfolio inflows
                Net other inflows 2)
                Change in reserves (+ is a decrease)

Financial account without reserves

Errors and omissions

Gross capital formation

Gross saving

External debt

International investment position

1) The combined current and capital account.

2) Including financial derivatives.

2004

2005

2006

2007

2008

2009

(percentage of GDP)

-5.3

-0.5

0.6

-5.6

0.2

-0.5

-5.8

6.1

3.6

1.9

0.9

-0.2

6.4

-0.4

27.5

22.0

37.6

-30.7

-1.3

2.0

1.2

-4.8

0.2

0.2

-1.2

2.1

9.3

-2.7

-1.4

-3.1

5.2

-0.9

25.7

23.9

39.3

-28.7

-2.4

2.0

1.4

-5.2

-0.6

0.3

-2.2

2.8

2.8

-0.8

0.9

-0.1

2.9

-0.7

26.8

24.7

38.2

-34.6

-3.2

3.4

1.4

-7.2

-0.8

0.6

-2.6

3.1

5.1

-1.6

0.1

-0.5

3.6

-0.5

27.0

24.4

40.6

-41.8

-0.7

2.8

1.8

-4.8

-0.5

0.8

0.2

0.6

1.0

-0.2

0.9

-1.1

1.7

-0.8

25.3

21.9

40.4

-38.2

-1.1

5.1

0.7

-6.5

-0.4

1.1

0.1

1.1

0.7

3.2

-1.2

-1.7

2.7

-1.1

21.5

20.5

44.7

-45.2

Note: Loans for direct investment that are included in the gross external debt are currently reported in net terms by the CNB. 
Sources: Eurostat, Commission services and Czech National Bank.

3.6.2.  Product market integration 

the 

has 

trade 

expanded 

continuously 

the  progress  of 

less  pronounced, 

The  Czech  Republic  is  one  of  the  most  open 
economies  in  the  EU-27.  Trade  openness  slightly 
increased  over  the  period  under  review.  Trade  in 
and 
goods 
in 
significantly,  while 
services  was 
latter 
in  2008, 
representing  only  10%  of  exports 
reflecting an increasing specialisation of the Czech 
economy  in  manufacturing  goods.  The  growing 
openness  ratio  has  not  given  rise  to  major  trade 
imbalances,  since  it  reflected  a  simultaneous 
increase  in  both  exports  and  imports.  Trade 
openness  in  2008,  although  still  high,  decreased 
slightly  as  a consequence of  the global  crisis,  due 
to a sharper drop in foreign trade than in domestic 
production.  

The  orientation  of  the  Czech  Republic's  foreign 
trade  is  mostly  towards  the  EU-27,  which  is  an 
indication  that  economic  integration  of  the  Czech 
economy  into  the  EU  is  well  advanced.  The 
average  2004-2008  intra-EU  trade  in  goods  ratio 
was  almost  five  times  higher  than  the  extra-EU 
trade  in  goods  ratio.  Trade  integration  has  been 
particularly close with the neighbouring countries, 
in  particular  Germany  (around  30%  of  both 

exports  and 
imports),  Slovakia  and  Austria. 
However, a gradual shift in the orientation of trade 
from  the  EU-15  Member  States  towards  the  new 
Member  States,  the  CIS  countries,  and  Asia  is 
observed.  On  the  import  side,  the  main  trading 
partners are also from the EU-27, although Russia 
remains an important energy supplier. 

A  key  development  in  the  composition  of  Czech 
exports  over  the  last  decade  has  been  the  shift 
towards  high  technology  and  higher  value-added 
goods.  The  proportion  of  high 
technology-
in  Czech  exports  doubled, 
intensive  goods 
accounting  for  more  than  10%  of  total  exports  in 
2008.  As  a  result,  the  technological  trade  balance 
of  the  Czech  Republic  improved  over  the  last 
years.  Looking  at  categories  of  goods  based  on 
factor  intensities  shows  that  the  share  of  labour-
intensive  goods 
total  exports  decreased 
substantially,  while  the  share  of  capital-intensive 
goods increased. This evolution in trade reflects a 
shift  in  the  production  structure  of  the  Czech 
economy  away  from  primary  and  semi-finished 
goods and increasingly towards more sophisticated 
parts  and  components,  which  can  be  associated 
with the catching-up process and the absorption of 
technology  through  strong  FDI  inflows.  It  also 
shows  that  the  labour  cost  advantage  is  gradually 

in 

47 

 
 
 
 
 
European Commission 

Convergence Report 2010 

Table 3.6.2:

Czech Republic - Product market integration

Trade openness 1) (%)
Extra-EU trade in goods GDP ratio 2) (%)
Intra-EU trade in goods GDP ratio 3) (%)
Intra-EU trade in services GDP ratio 4) (%)
Export in high technology 5) (%)
Technological balance 6) (%)
Total FDI inflows GDP ratio 7) (%)
Intra-EU FDI inflows GDP ratio 8) (%)
FDI intensity 9)
Internal Market Directives 10) (%)
Value of tenders in the O.J. 11)
Time to start up a new company 12)

Czech Republic

2003

2004

2005

2006

2007

:

11.4

43.4

:

12.4

-2.1

2.3

:

:

:

:

:

71.8

10.3

53.0

5.6

13.7

-2.0

4.5

3.7

2.1

9.6

0.4

40.0

70.9

10.2

51.8

6.2

11.7

-1.2

9.4

8.9

4.4

2.5

2.7

40.0

74.9

11.1

54.8

6.3

12.7

-1.0

3.8

3.4

2.3

1.6

5.2

40.0

77.9

11.9

57.1

6.5

14.1

-0.6

6.0

4.7

2.7

3.4

4.1

24.0

2008

75.5

12.6

53.8

6.9

:

:

5.0

4.3

2.5

1.4

5.3

17.0

 1) (Imports + Exports of goods and services / 2 x GDP at current market prices) x 100 (Foreign Trade Statistics, Balance of Payments).

 2) (Extra-EU-27 Imports + Exports of goods / 2 x GDP at current market prices ) x 100 (Foreign Trade Statistics).

 3) (Intra-EU-27 Imports + Exports of goods / 2 x GDP at current market prices ) x 100 (Foreign Trade Statistics).

 4) Intra-EU-27 trade in services (average credit and debit in % of GDP at current prices) (Balance of Payments).

 5) Taken directly from Eurostat's databases: Exports of high technology products as a share of total exports.

 6) (Exports - imports in high tech) / GDP at current prices x 100, since 2007 the data based upon SITC Rev. 4 (earlier SITC Rev. 3).

 7) Total FDI inflows (in % of GDP at current prices).

8) Intra-EU-27 FDI inflows (in % of GDP at current prices).

9) FDI intensity (average intra-EU-27 inflows and outflows in % of GDP at current prices).

10) Percentage of internal market directives not yet communicated as having been transposed, in relation to the total number.

11) Public procurement - Value of public procurement which is openly advertised  (in % of GDP).

12) Time to start a new company (in days), Doing Business World Bank.

Sources: Eurostat, Commission services.

eroding  and  that  the  Czech  exports  will  have  to 
move further away from labour-intensive goods.  

The  Czech  export  structure  concentrates  on  a 
limited  number  of  manufacturing  goods,  with 
transport 
machinery,  automotive  and  other 
equipment  accounting  for  50%  of  total  exports. 
The  particular  importance  of  the  car  industry  is 
reflected  in  the  composition  of  imports  and 
exports,  with  motor  vehicles  and  related  products 
being  the  largest  categories.  Finally,  as  a  highly 
integrated economy in the international production 
chain,  there  is  a  high  share  of  intermediate  goods 
in  total  Czech  imports,  while  exports  have  a  high 
imported content. 

The  Czech  Republic  has  been  an  attractive  place 
for  FDI  for  some  time.  The  country  enjoys  a 
central  location  in  Europe.  It  emerged  from  the 
transition process with a strong industrial base and 
a  highly  skilled  and  relatively  cheap  labour  force, 
as  well  as  a  high  quality  infrastructure.  FDI  has 
benefited  from  government  incentives  introduced 
in the 1990s to support green-field and brown-field 
investments 
and 
acquisitions),  initially  targeted  at  manufacturing 
and  then  at  all  sectors.  Macroeconomic  stability 
has  also  been  an  essential  factor  and  EU 
membership provided a further stimulus to foreign 

(privatisations,  mergers 

48 

(financial 

intermediation), 

investors. In 2008, the stock of FDI was equivalent 
to  approximately  40%  of  GDP,  a  comparatively 
high level among regional peers. The bulk of total 
inward  FDI  stock  originates  in  the  EU-27  (95%), 
including a high share from the euro area (66%). In 
terms  of  sectors,  the  FDI  stock  was  focused  on 
services 
and 
manufacturing  (notably  automotive,  chemicals, 
petroleum,  electricity,  gas  and  water).  FDI 
generated  positive  spill-over  effects,  namely 
advances  in  productivity,  technical  expertise  and 
business  competence,  through  the  transfers  of 
technology  and  know-how 
to 
domestic  enterprises  and  through  the  augmented 
human capital base. In the medium term, continued 
FDI inflows will remain essential to sustain strong 
economic growth. 

foreign 

from 

In  the  last  years,  important  measures  have  been 
adopted  to  improve  the  business  environment  in 
the  Czech  Republic,  in  particular  in  promoting 
better  regulation,  which  has  contributed  to  a 
reduction  in  administrative  burden  and  red  tape. 
Some progress has also been made to improve the 
ease of doing business owing to the establishment 
of  one-stop-shops  and 
the  adoption  of  new 
procedures for closing down businesses. In 2007, a 
new insolvency act came into force, which should 
in  particular  shorten  the  length  of  bankruptcy 

 
 
 
 
 
Convergence Report 2010 - Technical annex 

Chapter 3 - Czech Republic 

proceedings. More recently, several reforms in the 
area  of  e-government  have  been 
introduced, 
including  online  communication  with  the  public 
administration  and  the  establishment  of  electronic 
information registers. Finally, the ongoing process 
of  integration  could  also  be  facilitated  by  the 
improved  transposition  of  the  EU  Internal  Market 
directives. In 2008, the transposition deficit in the 
Czech  Republic  was  above  the  1%  EU  target  and 
also higher than the EU-27 average. This persistent 
to  a  heavy 
is 
transposition  deficit 
transposition  process  which  can  postpone  the 
whole process considerably.  

related 

3.6.3.  Financial market integration 

The  Czech  Republic’s  financial  sector  is  well 
integrated  into  the  EU  financial  sector.  The  main 
channel  of  integration  is  a  high  degree  of  foreign 
ownership of financial intermediaries. Compliance 
with  the  acquis of  the  Union  in  the  field  of 
financial services is fully achieved (24). 

In  response  to  signs  of  financial  market  tensions 
amid intensification of the global crisis, the Czech 
National  Bank  widened  the  range  of  liquidity-
providing  operations.  The  deposit  insurance  was 
raised  to  EUR  50.000,  in  line  with  a  commitment 
taken at EU level. Apart from these measures, the 
Czech  government  did  not  need  to  undertake  any 
substantial  measures  to  safeguard  financial  sector 
stability. 

the 

The Czech financial system remains heavily bank-
based  with  87%  of 
total  assets  under 
management  belonging  to  the  credit  institutions. 
Domestic  bank  credit  relative  to  GDP  picked  up 
from 40% in 2004 to 58% in 2009, in line with the 
developments  seen  in  other  larger  new  Member 
States,  although  it  remained  below  euro  area 
levels. Stock market capitalisation relative to GDP 
remained  broadly  stable  between  2004  and  2009, 
amounting to about 23% in 2009. Total amount of 
outstanding  bonds  has,  nonetheless,  more  than 
doubled, amounting to about 45% of GDP by end-
2009.  However,  both  ratios  remain  well  below 
euro area levels. 

Graph 3.6.3: Czech Republic - Recent development of the  

financial system relatively to the euro area
(in percentage of GDP)

180
160
140
120
100
80
60
40
20
0

CZ, 2004

CZ, 2009

Euro area,
2004

Euro area,
2009

Debt securities

Sto ck market capitalisatio n

Do mestic bank credit

Source: Eurostat, Czech National Bank, FESE.

The Czech banks, of which around 96% belong to 
foreign groups and of which the five biggest have 
achieved  a  combined  market  share  of  nearly  two 
thirds  (the  CR5  ratio),  are  dedicated 
to  a 
conservative  retail-orientated  business  model.  The 
banks  finance  their  lending  activities  primarily 
through  domestic  deposits  and  displayed  a  sound 
loan to deposit ratio of around 77% by end-2009. 

Graph 3.6.4: Czech Republic - Foreign ownership and 

concentration in the banking sector
(in percent, weighted av erages)

120

100

80

60

40

20

0

CZ, 2004

CZ, 2008

Euro area,
2004

Euro area,
2008

Co ncentratio n in the banking secto r (CR5 ratio )

Share o f fo reign institutio ns as % o f to tal assets

Source: ECB, Structural indicators for the EU banking sector, January 2010.

Overall, profitability of the Czech banks remained 
stable  through  the  business  cycle.  The  average 
return-on-equity  ratio  rebounded  to  23%  in  the 
third  quarter  of  2009,  i.e.  close  to  the  levels 
observed  in  2003-2008  and  the  capital  adequacy 
ratio (CAR) increased from about 11% in 2007 to 
14% in 2009(25). The NPL ratio (26) stood at 5% in 
September 2009, i.e. at the lowest level among the 
new  Member  States  (though  above 
the  EU 
average). Nonetheless, provisioning for these NPL 
fell  to  59%  in  2009,  down  from  77  %  in  2003 
(when NPLs also stood at 5%). 

(24)  For  further  information  on  compliance  with  the  financial 

services directives please refer to 

http://www.cnb.cz/m2export/sites/www.cnb.cz/en/fi

nancial_stability/fs_reports/fsr_2008-2009/FSR_2008-
2009.pdf 

http://ec.europa.eu/internal_market/finances/actionplan/index_e

(26)  Loans in default, i.e. loans in the substandard, doubtful and 

n.htm#transposition 

loss categories as a share of total gross client loans. 

(25)

49 

 
                                                           
 
 
                                                           
 
European Commission 

Convergence Report 2010 

Graph 3.6.5: Czech Republic - selected banking sector 

Graph 3.6.7: Czech Republic - Share of foreign currency loans

soundness indicators relatively to the euro area

(as percentage of total loans to households / corporations)

22

19

17

14

12

10

7

5

2

0

Dec-04 Dec-05 Dec-06 Dec-07

Dec-08 Oct-09

Co rpo ratio ns

Ho useho lds

Source: Czech National Bank and own calculations.

The  Prague  stock  market  remains  relatively  less 
developed  in  terms  of  total  market  capitalisation 
compared  to  the  euro  area.  It  enjoys  strong  ties 
with  the  Wiener  Börse,  its  main  shareholder,  as 
well  as  with  the  Budapest  and  Ljubljana  stock 
the  Czech  debt 
exchanges.  The  growth  of 
securities  market  over  recent  years  can  be 
attributed  to  several  private  issues  which  were 
virtually non-existing before 2004.  

Non-banking  financial  institutions  in  the  Czech 
Republic are in an early stage of development. The 
insurance companies, the pension schemes, and the 
investment funds manage 7 %, 4 %, and 2 % of the 
total financial sector assets respectively. Their total 
assets under management amounted to about 6 %, 
2 % and 2 % of GDP in 2008, whereas banks total 
assets under management add up to some 59 % of 
GDP.  The  Czech  National  Bank  supervises  the 
banking  sector,  the  capital  market,  the  insurance 
and  pension  scheme  industry  and  credit  unions. 
rules 
The  CNB 
safeguarding the stability of these sectors. 

lays  down  and  enforces 

%

30

25

20

15

10

5

0

-5

CZ, 2004

CZ, 2009

Euro area,
2004

Euro area,
2008

Return o n equity

Capital adequacy

No n perfo rming lo ans

Note: For 2008, EU-27 non performing loans for are a proxy for EA.
Source: ECB, IMF, EC calculations.
The  Czech  households  and  enterprises  exhibit  a 
relatively  low  share  of  indebtedness  as  compared 
to the euro area, but it remains broadly comparable 
to the levels prevailing in some other new Member 
States.  Annual  credit  growth  to  the  private  sector 
fell  from  just  above  20%  in  2007-2008  to  around 
1% by end-2009, amid considerable differences in 
to  non-financial 
individual 
corporations decreased sharply by about 9% year-
on-year 
seventh 
consecutive  month  of  negative  credit  growth  in 
this  sector.  Loans  to  the  private  households  grew 
through  2009,  though  at  a  more  moderate  pace 
than a year ago, and expanded by about 12% year-
on-year by end-2009.  

in  December  2009, 

sectors.  Loans 

the 

Graph 3.6.6: Czech Republic - Recent developments in 

bank credit to households and corporations relatively to 
the euro area (in percentage of GDP)

60

50

40

30

20

10

0

Dec-04 Dec-05 Dec-06 Dec-07

Dec-08 Dec-09

Ho useho lds, CZ
No n-financial co rpo ratio ns, CZ
Ho useho lds, Euro  area
No n-financial co rpo ratio ns, Euro  area

Source: ECB, Eurostat.

The low level of domestic interest rates as well as 
abundant  domestic  liquidity  made  lending  in 
foreign  currencies  less  attractive.  Lending  in  a 
currency other  than  the koruna  is  very  limited  for 
private  households  and  stable  at  around  18%  of 
total  loans  for  companies.  Hence,  the  Czech 
the 
financial 
to 
vulnerabilities 
currency 
mismatch.  

less  exposed 
a 
from 

is 
stemming 

system 

50 

 
 
 
4. 

ESTONIA 

4.1. 

LEGAL COMPATIBILITY 

by  an  explicit  reference  to  Article  130  of  the 
TFEU. 

4.1.1.  Introduction 

4.1.4.  Integration in the ESCB 

Eesti Pank was originally founded on February 24, 
1919 and was restored as Estonia’s central bank on 
reform  was 
January  1,  1990.  A  monetary 
implemented  in  1992  based  on  the  establishment 
of a currency board linked to the DEM, and to the 
euro as from 1999. The Eesti Pank Act (hereinafter 
the  Act)  was  adopted  on  May  18,  1993  and  last 
amended on April 22, 2010.  

With respect to the amended Act the imperfections 
identified in the Convergence Report of 2008 have 
been removed.  

A series of provisions have been amended so as to 
take  account  of  the  TFEU  requirements  and  the 
respective  roles  and  competences  of  the  ECB, 
ESCB and the EU.  

The decision-making bodies of Eesti Pank are the 
Governor of the Central Bank and the Supervisory 
Board. The President of the Republic appoints the 
Governor  on  the  proposal  of  the  Supervisory 
Board. The Governor is in charge of organisational 
compliance with the operations of the ESCB. 

This concerns in particular, Article 9(2)(9) (design 
the  national  side  of  euro  coins);  14(1) 
of 
(recognition  of  the  general  competence  of  the 
ESCB/ECB  with  regard  to  the  tasks  listed by  that 
Article);  Section  34  (collection  of  the  statistical 
data).   

Following the assessment of the last Convergence 
Report,  the  Estonian  Government,  in  cooperation 
with  Eesti  Pank,  has  prepared  amendments  to  the 
Act  on  the  Eesti  Pank,  which  was  adopted  by 
Riigikogu (Parliament) on April 22, 2010. 

4.1.2.  Objectives 

The  objectives  of  the  Eesti  Pank  are  compatible 
with the TFEU.  

With respect to the amended Act, Article 4(4) was 
repealed,  in  order  to  remove  an  imperfection 
related  to  the  secondary  objective,  as  defined  by 
the TFEU. 

4.1.3.  Independence 

No  incompatibilities  with  the  TFEU  and  the 
ECB/ESCB Statute exist in this respect.    

Article 9(5) of the Act has been amended so as to 
comply with the prohibition on governments from 
seeking  to  influence  national  central  banks  in  the 
pursuit  of  the  missions  for  which  it  protects  their 
independence. The permanent right to speak of the 
Minister of Finance, in former Article 9(5) was not 
compatible  with  the  institutional  independence  of 
the  Eesti  Pank  and  thus,  with  Article  130  of  the 
TFEU  and  Article  7  of  the  ESCB/ECB  Statute. 
The amended Act has removed this incompatibility 

As  regards  the  incompatibilities  identified  in 
Article 111 of the Estonian Constitution, Estonia's 
Parliament initiated a Constitutional review by the 
Supreme  Court  of  the  Eesti  Pank  Act  on  January 
25,  2006.  The  Supreme  Court  indicated  on  May 
11, 2006 that the Eesti Pank Act will be compliant 
with  the  Constitution  after  the  introduction  of  the 
the 
in  Estonia,  since  Article  111  of 
euro 
Constitution shall no longer be applicable as of the 
abrogation of the derogation of Estonia. While the 
formal  ruling  of  the  Supreme  Court  does  not  in 
itself remove the formal incompatibilities raised in 
the  Commission's  2004  Convergence  Report,  it 
nevertheless provides legal clarity, in particular on 
the 
the 
inapplicability  of  Article  111  after 
introduction  of  the  euro  in  Estonia.  A  formal 
amendment of this Article of the Constitution is no 
longer required. 

The Currency Law and the Law on the Security of 
the  Estonian  kroon  were  repealed  by  the  Law  on 
the  Introduction  of  the  Euro,  which  was  adopted 
by  Riigikogu,  April  22,  2010  with  effect  from  the 
date  of  the  introduction  of  the  euro  in  Estonia. 
Consequently, 
(notably 
related  to  the  ECB's  exclusive  right  to  authorise 
the  issue  of  banknotes  and  the  ECB's  role  in  the 
conduct of foreign exchange operations and in the 
definition  of  the  foreign  exchange  policy)  have 
been removed.  

incompatibilities 

the 

51 

 
European Commission 

Convergence Report 2010 

4.1.5.  Prohibition of monetary financing 

the  amended  Act 
Following 
incompatibilities or imperfections identified. 

there  are  no 

Article 16 of the Act, has been repealed and thus, 
removes 
to 
the 
Article 123 of the TFEU. 

incompatibility  corresponding 

4.1.6.  Assessment of compatibility 

is  fully 
The  Eesti  Pank  Act,  as  amended 
compatible with Article 130 and 131 of the TFEU 
and the ECB/ESCB Statute.  

The Currency Law and the Law on the Security of 
the  Estonian  kroon  was  repealed  and  replaced  by 
the Law on Introduction of euro, with effect from 
the date of the introduction of the euro foreseen on 
1 January 2011.  

As  regards  the  central  bank  integration  into  the 
ESCB at the date of euro adoption, Article 111 of 
Estonia's  Constitution  is  not  formally  compatible 
with the requirements of the TFEU and the ESCB 
Statute.  However,  the  ruling  of  May  11,  2006  of 
the  Constitutional  Review  Chamber  of  Estonia's 
Supreme  Court  provides  sufficient  legal  certainty 
without 
the  need  for  further  amendment  of 
Estonia's Constitution.  

52 

 
 
  
 
Convergence Report 2010 - Technical annex 

Chapter 4 - Estonia 

4.2. 

PRICE STABILITY 

4.2.1.  Respect of the reference value 

The  12-month  average  inflation  rate  for  Estonia, 
which is used for the convergence assessment, has 
been  below  the  reference  value  since  December 
2009. Estonia's 12-month average inflation peaked 
at  above  10%  in  the  second  half  of  2008  and 
declined  steadily  thereafter.  In  March  2010,  the 
reference  value  was  1.0%,  calculated  as  the 
average of the 12-month average inflation rates in 
Portugal, Estonia and Belgium plus 1.5 percentage 
points. The corresponding inflation rate in Estonia 
was  -0.7%,  i.e.  1.7  percentage  points  below  the 
reference value. The 12-month average inflation of 
Estonia  is  likely  to  remain  below  the  reference 
value in the months ahead.  

Graph 4.2.1: Estonia - Inflation criterion since 2004

 (percent, 12-month mov ing av erage)

12

10

8

6

4

2

0

due  to  one-off  factors  (substantial  increases  in 
excise duties and strongly rising global commodity 
prices).  In  late  2008,  inflation  declined,  driven by 
an  abrupt  fall  of  commodity  prices  and  the 
downward  impact  of  the  recession.  Consequently, 
Estonia recorded negative annual inflation rates in 
the  second  half  of  2009.    Estonia's  year-on-year 
inflation  turned  positive  in  March  2010.  Positive 
inflation  rates  resulted  mainly  from  hikes  in 
administered  price  both  in  January  (excise  duties, 
electricity) and March (electricity) 2010, and from 
increases  in  global  energy  prices,  which  also 
affected  heating  energy  prices  in  March.  Higher 
domestic  and  imported  vegetables  prices,  partly 
due  to  the  cold  winter,  also  contributed  to  the 
March inflation reading. 

Graph 4.2.2: Estonia - HICP inflation

 (y-o-y percentage change)

12

9

6

3

0

-3

2004

2005

2006

2007

2008

2009

-2
Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11

Source: Eurostat.

Esto nia

Euro  area

Esto nia

Reference value

Note: The dots show the projected reference value and 12-month average inflation 
in the country in December 2010.
Sources: Eurostat, Commission services' Spring 2010 Forecast.

4.2.2.  Recent inflation developments 

Following  average  inflation rates  of  around 4–5% 
between  mid-2004  and  2006,  Estonia's  year-on-
year HICP inflation (27) picked up in 2007, driven 
by  domestic  demand  pressures.  While  upward 
pressures  from  the  overheating  of  the  economy 
started to ease in the course of 2008, inflation still 
accelerated (to above 11%) in the first half of 2008 

instances  of  non-compliance  with 

(27)  In  the  context  of  compliance  monitoring  and  quality 
assurance,  Eurostat  has  been  reviewing  the  statistical 
practices  used  to  compile  the  HICP  in  Estonia  against 
HICP methodology and other guidelines and good practices 
in  the  field  of  consumer  price  indices.  Eurostat  concluded 
the  HICP 
that 
methodology  are  limited  and  unlikely  to  have  a  major 
impact  in  practice  on  the  HICP  annual  average  rates  of 
change. The Estonia data pass all standard HICP validation 
tests  –  they  are  internally  consistent  and  aggregate 
correctly.  Estonian  HICP  data  should  be  considered 
comparable  to  the  HICPs  of  other  EU  countries.  The 
compliance report published in March 2010 is available at 
http://epp.eurostat.ec.europa.eu/portal/page/portal/hicp/met
hodology/compliance_monitoring 

inflation  (HICP  excluding  energy  and 
Core 
unprocessed  food)  broadly  followed  the dynamics 
of  the  economic  cycle,  but  was  also  affected  by 
increases in excise duties. Strong domestic demand 
triggered  an  increase  in  core  inflation  in  2006–
2007, while the economic contraction led to a fast 
deceleration  in  particular  in  2009  and  early  2010. 
Inflation  of  both  industrial  goods  and  services 
prices  peaked  in  early  2008  and  declined  rapidly 
thereafter. A surge in global agricultural prices and 
excise  duties  increases  on  alcohol  and  tobacco 
resulted in an increase in processed food prices in 
2008, followed by a gradual decline in 2009.  

4.2.3.  Underlying  factors  and  sustainability  of 

inflation 

Macroeconomic  policy-mix  and  cyclical 
stance 

in  other  EU  countries, 

As 
inflation 
developments  have  been  strongly  affected  by 
weakening economic activity from 2008. Domestic 
late  2007  and  started 
demand  stabilised 

recent 

in 

53 

 
 
                                                           
 
European Commission 

Convergence Report 2010 

Table 4.2.1:

Estonia - Components of inflation

(percentage change)1)

weights  

in total   

2004

2005

2006

2007

2008

2009

Mar-10

HICP

Non-energy industrial goods

Energy

Unprocessed food 

Processed food

Services

HICP excl. energy and unproc. food
HICP at constant taxes 2)
Administered prices HICP

3.0

-0.5

8.4

-0.6

5.6

3.3

2.5

2.3

3.5

4.1

0.2

13.6

3.0

4.2

3.7

2.6

3.6

6.0

4.4

1.9

8.3

6.5

3.4

5.2

3.5

4.3

6.1

6.7

2.6

8.0

7.8

7.8

9.6

6.5

6.5

9.2

10.6

2.4

23.8

9.4

17.1

10.1

8.8

8.7

21.9

0.2

0.5

-3.5

-3.2

2.1

1.3

1.2

-1.4

9.3

-0.7

0.4

-1.5

-4.2

-0.7

-0.3

-0.1

-2.4

4.5

2010

1000

281

133

93

201

292

774

1000

98

1) Measured by the arithmetic average of the latest 12 monthly indices relative to the arithmetic average of the 12 monthly indices

   in the previous period.

2) Last observation for HICP at constant taxes is February 2010

contracting  in  2008,  after  a  period  of  overheating 
and  increasing  capacity  constraints  in  2006–2007. 
The  downturn  was  aggravated  by  the  global 
financial  and  economic  crisis,  which  triggered  a 
deep 
started  end-2008.  The 
subsequent rapid adjustment in product and labour 
markets led to a general decline of prices in 2009.  

recession 

that 

Recent  developments  indicate  that  the  recession 
bottomed  out  in  late  2009,  but  the  recovery  is 
likely  to  remain  subdued  in  the  context  of  the 
current  uncertain  global  economic  outlook.  The 
Commission  services'  estimates  suggest  that  the 
output gap of the Estonian economy turned sharply 
negative  in  2009  and  that  growth  will  remain 
significantly below potential in 2010. 

The  Commission  services'  Spring  2010  Forecast 
projects  Estonia's  economic  growth  to  be  close  to 
1%  in  2010,  and  close  to  4%  in  2011.  The  initial 
positive impact to growth is likely to emerge from 
strengthening  external  demand  and  from  a  turn  in 
the inventory cycle. The recovery of consumption 
is  projected  to  remain  more  subdued,  limiting 
upward pressures on domestic prices. 

public 

finances 

involved 

consolidation 

Estonia  maintained  a  prudent  fiscal  policy  stance 
during the crisis. The fiscal policy response to the 
a 
weakening 
comprehensive 
effort,  which 
contributed 
to  downward  price  adjustment. 
Measured  by  the  structural  balance,  the  fiscal 
stance  tightened  considerably  in  2009,  while  it  is 
projected  to  be  expansionary  in  2010.  However, 
the  estimates  are  subject  to  high  uncertainties 
given 
economic 
exceptionally  volatile 
environment. 

the 

2009,  with  (ex  post)  short-term  real  interest  rates 
increasing  along  with  falling  inflation.  Tighter 
lending  conditions  since  2008,  together  with  the 
recession  and  an  uncertain  global  economic 
outlook,  constrained  credit  growth,  which  turned 
negative in 2009.   

Wages and labour costs 

reaching 

The reversal of labour market conditions in 2008–
2009  significantly  eased  wage  pressures 
in 
Estonia.  By  end-2009,  the  unemployment  rate 
more than tripled to 15% from its historical lows in 
mid-2008, 
those 
registered after the Russian crisis of the late 1990s. 
A 
substantial  and  broad-based  employment 
reduction across economic sectors (in particular in 
construction  and  manufacturing)  eased 
labour 
supply  constraints,  which  had  led  to  a  surge  in 
wages in the preceding years.  

levels  exceeding 

The  growth  of  unit  labour  costs  started  to  ease 
from  a  high  level  in  2008,  along  with  contracting 
economic  activity.  Following  exceptionally  high 
wage  growth  in  particular  in  2007,  growth  in 
nominal  compensation  per  employee  eased  to 
around  10%  in  2008,  i.e.  to  a  level  prevailing  in 
2004–2005. 
In  2009,  growth  of  nominal 
compensation  per  employee  entered  negative 
territory,  adjusting 
the  changed 
rapidly 
macroeconomic  environment.  At  the  same  time, 
labour  productivity  declined  already  in  2008,  and 
fell  further  in  2009  amid  the  economic  downturn. 
Consequently, nominal unit labour costs continued 
to  increase  in  2008,  though  at  a  lower  pace  than 
before, and recorded a slight increase also in 2009. 

to 

Monetary  conditions  tightened  significantly  in  the 
context  of  Estonia's  currency  board  system  in 

54 

 
 
 
 
 
Convergence Report 2010 - Technical annex 

Chapter 4 - Estonia 

Table 4.2.2:

Estonia - Other inflation and cost indicators

2004

2005

2006

2007

2008

(annual percentage change)

20091)

20102)

20112)

HICP inflation

Estonia

Euro area

Private consumption deflator

Estonia

Euro area

3.0

2.2

2.0

2.0

Nominal compensation per employee

Estonia

Euro area

Labour productivity

Estonia

Euro area

Nominal unit labour costs

Estonia

Euro area

Imports of goods deflator

Estonia

Euro area

12.2

2.5

7.3

1.8

4.6

0.9

1.0

1.3

4.1

2.2

3.6

2.1

10.8

2.2

7.3

1.1

3.3

1.3

2.8

3.6

1) 2009 data (except HICP inflation) are estimates. 

2) Commission services' Spring 2010 Forecast.

Source: Eurostat, Commission services.

4.4

2.2

5.3

2.2

14.2

2.6

4.3

1.7

9.4

1.1

4.8

4.1

6.7

2.1

7.4

2.3

24.8

2.7

6.4

1.1

17.3

1.6

3.2

1.3

10.6

3.3

9.2

2.9

9.8

3.4

-3.7

0.0

14.1

3.4

6.7

4.1

0.2

0.3

-0.8

-0.1

-3.0

2.0

-4.6

-2.0

1.7

4.0

-7.3

-7.5

1.3

1.5

0.9

1.4

-3.3

1.3

3.7

1.8

-6.7

-0.5

4.2

3.9

2.0

1.7

2.1

1.5

1.3

1.5

2.2

1.3

-0.9

0.1

1.9

1.6

Graph 4.2.3: Estonia - Inflation, productivity and wage trends

(y-o-y % change)

27
24
21
18
15
12
9
6
3
0
-3
-6
-9

2004

2005

2006

2007

2008

2009

2010

2011

P ro ductivity (real GDP  per perso n emplo yed)

No minal co mpensatio n per emplo yee

No minal unit labo ur co sts
HICP  inflatio n

Source: Eurostat, Commission services' Spring 2010 Forecast.

A highly flexible labour market was conducive to 
the fast downward adjustment in nominal wages in 
2009.  The recently  revised Labour  Code, together 
with generally decentralised wage setting, allowed 
the private sector to react rapidly to changes in the 
macroeconomic  environment.  Public  sector  wage 
growth  somewhat  lagged  developments  in  the 
private sector, both in the years of strong economic 
growth  and  during  the  subsequent  downward 
fiscal 
adjustment.  However, 
consolidation  in  2009  also  implied  a  considerable 
employment  reduction  as  well  as  nominal  wage 
cuts  in  the  public  sector  (by  16%  year-on-year  in 
the  public  administration  in  the  fourth  quarter  of 
2009).    

substantial 

the 

The  Commission  services'  Spring  2010  Forecast 
projects  wages  to  continue  falling  in  Estonia  in 
2010, and to increase only slightly in 2011, along 
with  the  economic  recovery.  As  productivity  is 
projected  to  recover  in  line  with  the  rebound  of 
economic  activity,  this  would  imply  decreases  in 
unit  labour  costs  in  2010–2011.  Altogether,  wage 
pressures  on  consumer  prices  are  likely  to  remain 
subdued in the foreseeable future.  

External factors 

Consumer prices in Estonia continue to be strongly 
affected  by  global  commodity  prices  and  import 
prices  in  general.  A  high  degree  of  openness  and 
the  smallness  of  the  economy  imply  that  the 
impact of external price developments on domestic 
price  formation  is  higher  than  the  euro  area 
average.  Estonia's  import  prices,  as  measured  by 
the  imports  of  goods  deflator  in  the  national 
accounts,  increased  at  fast  rates  since  2005  and 
peaked in 2008, broadly following the dynamics of 
global oil prices.  

The increase in global oil prices triggered a surge 
in Estonia's energy prices – in particular in 2008 –, 
while  also  feeding  into  prices  of  other  goods  and 
services.  An  increase  in  excise  duties  on  motor 
fuels  in  January  2008  also  contributed  to  high 
energy prices. Energy prices fell  in  Estonia  in  the 

55 

 
 
 
 
 
 
European Commission 

Convergence Report 2010 

first half of 2009, but increased slightly thereafter, 
along  with  the  dynamics  in  global  oil  prices.  In 
2008, global agricultural prices also peaked at their 
highest level of the last decade, adding to headline 
inflation.  The  impact  of  developments  in  global 
commodity  prices  on  inflation  tends  to  be  fairly 
strong, given a relatively high share of energy and 
food products in total consumer expenditures. 

Exchange  rate  developments  had  a  minor  impact 
on  Estonia's  import  prices  in  2004–2009,  as  the 
nominal  effective  exchange  rate  of  the  kroon 
remained broadly stable. The kroon appreciated in 
nominal  effective  terms  only  during  December 
2008  (by  some  2%),  and  remained  broadly 
unchanged throughout 2009. The nominal effective 
appreciation  was  triggered  by  a  weakening  of  the 
currencies  of  some  main  trading  partners  (incl. 
Sweden and the UK), and it reversed in early 2010 
in  line  with  the  depreciation  of  the  euro  (notably 
vis-à-vis US dollar and Swedish krona).  

Administered prices and taxes 

Increases  in  administered  prices  (28)  and  indirect 
taxes  had  a  significant  effect  on  consumer  prices 
during  the  reference  period.  The  share  of  goods 
prices, 
and 
however, remained  at  only  one-tenth  of  total 
consumer expenditures.  

services  with 

administered 

energy,  which 

In  2008,  administered  prices  added  more  than  1.5 
percentage  points  to  headline  inflation,  while  in 
2009  their  impact  was  around  0.5  percentage 
points. The main contributor was an increase in the 
reflected 
price  of  heating 
developments  in  global  oil  prices.  Additionally, 
electricity  prices  were  increased  considerably,  in 
particular in 2009, while water and waste handling 
prices were also revised upwards, both in 2008 and 
2009. In early 2010, heating energy and electricity 
prices  were  increased  further,  with  an  estimated 
impact  on  annual  headline  inflation  of  below  0.5 
percentage points.  

0.5  percentage  points.  Both  in  2008  and  2009, 
headline inflation was mostly affected by increases 
in  excise  duties  on  alcohol  and  tobacco,  the  latter 
in  order  to  finalise  the  harmonisation  of  indirect 
tax  rates  with  EU  minimum  requirements.  Higher 
excise  duties  on  motor  fuels  and  natural  gas,  as 
well  as  some  higher  state  fees  (e.g.  notary  fees), 
are  estimated  to  have  had  limited  effects  on  2009 
inflation.   

Another  significant  contributor  to  2009  headline 
inflation  was  an  increase  in  the  value  added  tax 
rate  by  two  percentage  points  in  July  2009. 
Additionally, preferential value added tax rate was 
increased,  while  the  scope  of  its  application 
narrowed.  The  estimated  impact  of  the  VAT  rate 
increase  was  about  0.5  percentage  points,  which 
was  lower  than  expected,  as  weak  domestic 
demand  and  strong  competition  among  retailers 
triggered  only  a  partial  pass-through  of  the  tax 
increase.  

is  estimated 

The  impact  of  indirect  taxes  on  headline  inflation 
to  remain  significant, 
in  2010 
exceeding  one  percentage  point  in  case  of  full 
pass-through.  This  includes  a  full  year  impact  of 
the  VAT  rate  increase  in  July  2009 of  around  0.5 
percentage  points  and  the  impact  of  higher  excise 
duties  on  motor  fuels,  alcohol  and  tobacco, 
applicable  partly  from  July  2009  and  partly  from 
January 2010. 

Medium-term prospects 

Estonia's  consumer  price  inflation  is  likely  to 
remain  subdued  in  2010,  reflecting  the  ongoing 
downward  nominal  wage  adjustment  and  strong 
competition  among  retailers.  Fiscal  consolidation-
driven  surges  in  indirect  taxes  will  temporarily 
contribute significantly to annual inflation, broadly 
offsetting the impact of downward wage pressures. 
The  Commission  services'  Spring    2010  Forecast 
projects Estonia's HICP inflation to reach 1.3% in 
2010, and 2.0% in 2011.  

The impact of hikes in indirect taxes on consumer 
price inflation remained moderate in 2008, but was 
significant  in  2009,  reflecting  fiscal  consolidation 
measures  on  the  revenue  side.  In  total,  the  tax 
measures  are  estimated  to  have  added  close  to  2 
percentage  points  to  headline  inflation  in  2009, 
while  in  2008  their  contribution  had  been  below 

The  main  risk  to  inflation  developments  is  linked 
to  global  commodity  prices,  in  particular  the 
dynamics of global energy prices. Higher transport 
costs  and  energy  prices  tend  to  feed  into  a  wide 
range  of  consumer  goods.  On  the  downside,  a 
delay of the economic recovery may put additional 
downward pressures on prices.  

(28)  For the purpose of this report administered prices include, 
inter  alia,  regulated  utility  prices,  public  transport  and 
postal services.  

Estonia  has  shown  strong  convergence  in  price 
levels  towards  the  euro  area  average  over  recent 

56 

 
                                                           
Convergence Report 2010 - Technical annex 

Chapter 4 - Estonia 

years.  The  level  of  consumer  prices  in  Estonia 
stood  at  75%  of  the  euro  area  average  in  2008. 
This suggests some potential for further price level 
convergence in the long term, as Estonia's income 
levels  (at  about  62%  of  the  euro  area  average  in 
PPS in 2008) rise towards the euro area average. 

and 

Medium-term  inflation  prospects  will  inter  alia 
depend  on  the  evolution  of  wage  setting  and 
productivity  developments.  Continued  flexible 
labour  markets  together  with  competitive  price 
formation in product markets will be key for price 
stability.  Price  developments  will  also  depend  on 
maintaining  a  prudent 
fiscal  policy  stance, 
including  cautious  wage  setting  in  the  public 
sector,  to  keep  domestic  demand  in  line  with 
inflation 
fundamentals 
help 
expectations  at 
the 
combination  of  factors  that  drove  buoyant  credit 
expansion  in  the  past  (pent-up  credit  demand, 
accelerated  financial  deepening  and  integration, 
rapid  risk  spread  compression)  is  not  expected  to 
recur.  Nevertheless,  continued  vigilance 
in 
managing  credit  growth  will  be  important  to 
prevent the re-emergence  of credit-driven demand 
pressures as the recovery takes hold. These factors 
imply  that  the  prospects  for  the  sustainability  of 
low inflation are overall favourable, provided that 
supportive policies are maintained.  

anchor 
levels.  Moreover 

low 

57 

 
  
 
 
European Commission 

Convergence Report 2010 

4.3.  GOVERNMENT BUDGETARY POSITION 

4.3.1.  Developments 2004-2009 

buoyant 

supported 

the  private  sector, 

Estonian  public  finances  were  in  surplus  until 
revenue 
by 
2007, 
accompanying strong domestic demand-led growth 
and  an  emerging  asset  price  bubble.  Reflecting  a 
rapid  expansion  of 
the 
expenditure-to-GDP ratio remained very low, 34% 
of  GDP  on  average  in  2004-2007.  However,  this 
masked  strong  growth  in  expenditure  over  these 
years in both nominal and real terms, partly due to 
a  routine  recourse  to  mid-year  supplementary 
budgets. In parallel, tax cuts were adopted. Overall 
this 
the  structural 
balance (cyclically-adjusted balance net of one-off 
and  other 
temporary  measures)  by  over  3 
percentage points of GDP between 2004 and 2007. 
A large part of windfall revenue was nevertheless 
saved, contributing to the accumulation of sizeable 
fiscal  buffers  and  securing  a  net  asset  position  of 
the  government  sector.  Estonia  thus  entered  the 
downturn  from  a  comparatively  strong  fiscal 
position.   

to  a  worsening  of 

led 

fiscal 

buffers 

The downturn represented a combination of a turn 
of the domestic cycle and the impact of the global 
financial crisis. In 2008 the abrupt deterioration of 
the  economic  environment  led  to  a  worsening  of 
the  nominal  budgetary  position  by  5.3  percentage 
points  of  GDP,  with 
the  structural  balance 
declining by 3¼ percentage points. The previously 
accumulated 
prompt 
consolidation efforts implemented from the second 
half  of  2008  onwards  enabled  the  government  to 
finance  the  deficit  in  2008  and  2009  mainly  by 
reducing  assets  and  recourse 
to  non-market 
borrowing,  thereby  avoiding  the  need  to  rely  on 
market  financing  at  a  time  of  high  global  risk 
aversion.  However,  it  soon  became  clear  that 
unless fiscal policy reacted further to the widening 
of  public  deficits  due  to  the  ongoing  recession, 
fiscal reserves would eventually run out. 

and 

A  further  major  consolidation  of  public  finances 
was  thus  implemented  in  2009.  This  limited  the 
general  government  deficit  to  1.7%  of  GDP, 
compared  to  the  deficit  of  2.7%  the  year  before. 
The outcome was in line with the December 2008 
update  of  the  convergence  programme,  despite  an 
unforeseen  15%  decline  in  nominal  GDP  and  an 
estimated increase in the cyclical component of net 
borrowing  of  around  4½  percentage  points  of 

58 

GDP.  On  the  revenue  side,  the  consolidation 
measures included increases in several tax rates, as 
well  as  some  temporary  measures  with  limited 
negative  domestic  demand  effect  to  offset  the 
transitory impact on the budget of the exceptional 
contraction  of  economic  activity.  This  allowed 
nominal  revenue  to  be  maintained  at  broadly  the 
level of the previous year. Consolidation measures 
also  included  a  reduction  in  general  government 
expenditure,  including  by  reducing  the  wage  bill, 
and  containing  growth  in  social  benefits.  The 
structural balance as estimated by the Commission 
services  improved  by  around  3¾%  of  GDP  in 
2009. 

the 

assets, 

Since  the  deficits  in  2008  and  2009  were  partly 
financed by running down previously accumulated 
financial 
in  general 
government debt, mainly in the form of borrowing 
local 
in 
from 
governments,  bank  borrowing,  was  relatively 
limited,  from  debt  of  an  all-time  low  of  3.8%  of 
GDP in 2007 to 7.2% by end-2009.  

the  EIB  and, 

the  case  of 

increase 

4.3.2.  Medium-term prospects 

The  2010  state  budget,  covering  revenue  and 
expenditure  of  the  central  government,  including 
intra-government 
transfers,  was  adopted  by 
Parliament  on  9  December  2009.  The  main 
measures  on  the  revenue  side,  compared  to  the 
previous year, are increases in excise tax rates for 
alcohol,  tobacco,  fuel  and  electricity,  including 
changes  agreed  as  a  result  of  the  parliamentary 
discussion.  The  2010  budget  also  foresees  further 
cuts in operational expenditure, against an increase 
in  general  government  investment,  implying  a 
broadly  stable 
level  of  nominal  expenditure. 
Additional measures to improve the fiscal position 
amount to around 0.7% of GDP in 2010, while the 
full-year  impact  of  consolidation  decisions  that 
entered  into  force  from  the  second  half  of  2009 
provides  an  additional  improvement  of  2.5%  of 
GDP.  However,  this  improvement  is  offset  by  a 
further  projected  decline  in  tax  bases  and  decline 
in non-tax revenue. 

The  January  2010  update  of  the  convergence 
programme targets a general government deficit of 
2.2%  of  GDP in  2010.  This  is  close  to  the  deficit 
projected in the Commission services' spring 2010 
forecast.  Given 
the  still  exceptionally  high 
negative output gap, one-off measures adopted for 
2010 are of a similar magnitude of those for 2009, 

 
but would significantly decline in 2011, reflecting 
the expectation of improving cyclical conditions. 

taking 

improve 
should  be 
account 

The  fiscal  stance  in  2010  as  measured  by  the 
change in the structural balance is estimated in the 
Commission  services'  forecast  as  expansionary. 
The structural deficit would increase to marginally 
in  2010  and 
thereafter. 
above  2% 
treated 
this  estimate 
However, 
cautiously, 
the 
into 
exceptionally  volatile  economic  environment 
implies that calculation of the cyclical components 
of  the  deficit  (using  standard  elasticities)  is  less 
firmly  based.  More  obviously,  the  consolidation 
achieved through cuts in government consumption 
in  2009  and  2010,  in  particular  a  reduction  in  the 
government  sector  wage  bill,  contributes  to  the 
price  and  wage  adjustment  in  the  economy, 
improving thus the competitive position. 

that 

The  long-term  budgetary  impact  of  ageing  is 
significantly  lower  than  the  EU  average.  The 
current  ratio  of  gross  debt  in  Estonia  is  very  low 
and  maintaining  sound  government  finances,  in 
line with the budgetary plans over the programme 
period, would contribute to limiting the risks to the 
sustainability  of  public  finances  which  were 
assessed  in  the  Commission  2009  Sustainability 
Report as low. Medium-term debt projections that 
assume  GDP  growth  rates 
to  recover  only 
gradually  to  the  values  projected  before  the  crisis 
and  tax  ratios  to  return  to  pre-crisis  levels  show 
that  the  budgetary  strategy  envisaged  in  the 
programme,  taken  at  face  value,  would  be  more 
than sufficient to stabilise the debt-to-GDP ratio by 
2020 (29). 

The  most  recent  update  of  the  convergence 
programme,  covering  the  period  2009-2013,  was 
adopted by the Estonian government on 28 January 
2010. The main goal of the programme's budgetary 
strategy  is  to  maintain  a  budgetary  position  better 
than the Treaty reference value and to achieve the 
MTO,  defined  in  the  programme  as  a  structural 
balance,  by  the  end  of  the  programme  period  in 
2013, when the headline and primary balances are 
both projected to reach a surplus position. 

In  its  April  2010  Opinion  on  the  convergence 
programme of Estonia, the Council concluded that 

(29)  More  details  on 

the  determinants  of 

long-term 
sustainability  of  public  finances  can  be  found  in  Estonia: 
Macro  Fiscal  Assessment  –  An  analysis  of  the  January 
2010  update  of  the  convergence  programme,  section  5.2. 
(http://ec.europa.eu/economy_finance/about/activities/sgp/
main_en.htm). 

the 

Convergence Report 2010 - Technical annex 

Chapter 4 - Estonia 

of 

the 

economic 

Estonia  had  implemented  a  decisive  consolidation 
of  public  finances  in  2009  against  a  significant 
situation, 
deterioration 
contributing  to  the  ongoing  adjustment  in  the 
economy  and  aiming  at  supporting  a  smooth 
participation in ERM II, while striving to avoid an 
excessive  deficit  situation.  The  economy  was 
emerging from a severe recession at the time of the 
assessment, while average growth was projected to 
remain  considerably  lower  over  the  medium  term 
than  in  the  upswing  and  peak  years  of  the  recent 
cycle.  The  Council 
that 
consolidation 
in  2009  already 
constituted  a  major  adjustment  of  public  finances 
to the expected lower growth in the medium term, 
although achieving stricter expenditure control and 
improving the medium-term budgetary framework 
remained  work-in-progress. 
Council 
commended 
for  appropriately 
the  authorities 
ambitious targets set in the programme – a gradual 
decline in the general government headline deficit 
from  2010  and  reaching  a  surplus  position  in  line 
with the MTO by the end of the programme period 
– while noting that these budgetary outcomes were 
subject to downside risks in the short and medium 
term. 

implemented 

concluded 

also 

The 

In the light of the assessment, the Council invited 
Estonia  to  ensure  that  the  general  government 
deficit  remains  below  3  %  of  GDP,  to  take  the 
necessary measures to underpin the targeted return 
to  the  MTO  and  to  strengthen  the  medium-term 
budgetary framework. 

59 

 
                                                           
European Commission 

Convergence Report 2010 

Table 4.3.1:

Estonia - Budgetary developments and projections
Outturn and forecast 1)

2004

2005

2006

(as % of GDP unless indicated otherwise)

2007

2008

2009

2010

2011

General government balance

- Total revenues

- Total expenditure

of which: 
- interest expenditure

- current primary expenditure

- gross fixed capital formation

p.m.: Tax burden

Primary balance

Cyclically-adjusted balance

One-off and temporary measures
Structural balance 2)
Structural primary balance

Government gross debt

p.m: Real GDP growth (%)

p.m: Output gap

p.m: GDP deflator (% change)

Convergence programme
General government balance

Primary balance
Structural balance 2) 3)
Government gross debt

p.m. Real GDP (% change)

1.6

35.6

34.0

0.2

29.9

3.8

31.3

1.9

1.2

-0.8
2.0

2.2

5.0

7.2

1.5

3.6

1.6

35.2

33.6

0.2

29.4

4.0

30.1

1.8

0.3

0.0
0.3

0.5

4.6

9.4

4.3

5.5

2.5

36.5

34.0

0.2

28.7

4.7

31.0

2.7

0.0

0.9
-0.9

-0.7

4.5

10.0

8.3

7.6

2.6

37.4

34.8

0.2

28.7

5.2

32.3

2.8

-0.7

0.4
-1.1

-0.9

3.8

7.2

11.0

10.2

-2.7

37.1

39.9

0.2

33.2

5.3

32.2

-2.5

-4.1

0.2
-4.3

-4.1

4.6

-3.6

4.5

6.7

2008
-2.8

-2.5

-4.7

4.6

-3.6

-1.7

43.6

45.4

0.3

39.6

4.9

36.1

-1.4

1.3

1.9
-0.6

-0.2

7.2

-14.1

-10.1

-0.6

2009
-2.6

-2.3

-1.1

7.8

-14.5

-2.4

43.4

45.8

0.4

38.9

5.6

36.6

-2.0

0.2

2.3
-2.1

-1.6

9.6

0.9

-8.6

-1.0

2010
-2.2

-2.0

-1.5

10.1

-0.1

-2.4

41.7

44.1

0.4

37.3

5.4

35.3

-1.9

-0.9

0.9
-1.8

-1.4

12.4

3.8

-4.8

1.9

2011
-2.0

-1.7

-0.9

13.0

3.3

1) Commission services’ Spring 2010 Forecast.

2) Cyclically-adjusted balance excluding one-off and other temporary measures.

3) Commission services’ calculations on the basis of the information in the programme. One-off and other temporary

measures taken from the programme (1.2% in 2009, 1.9% in 2010 and 0.6% in 2011; all deficit-reducing).

Sources: Commission services and January 2010 update of Estonia's Convergence Programme.

2012
-1.0

-0.6

-0.1

14.2

3.7

2013
0.2

0.7

0.4

14.3

4.0

60 

 
 
 
 
 
 
 
4.4. 

EXCHANGE RATE STABILITY 

The  Estonian  kroon  entered  ERM  II  on  28  June 
2004 and has been participating in the mechanism 
for almost six years at the time of the adoption of 
this report. The ERM II central rate was set at the 
parity  rate  prevailing  in  the  existing  currency 
board  arrangement,  with  a  standard  fluctuation 
band of +/-15%. Upon ERM II entry, the Estonian 
authorities  unilaterally  committed  to  maintain  the 
currency 
the 
mechanism.  In  line  with  this  commitment,  there 
has been no deviation from the ERM II central rate 
since the kroon's participation.  

arrangement  within 

board 

Graph 4.4.1: EEK - Spread vs central rate

 (as percent, daily v alues)

1.0

0.5

0.0

-0.5

-1.0

Jun-04

Jun-05

Jun-06

Jun-07

Jun-08

Jun-09

Source: Commission services, ECB and EcoWin.

Estonia  has  been  operating  a  currency  board 
arrangement  since  the  reintroduction  of  the  kroon 
in  1992,  with  the  kroon  initially  pegged  to  the 
Deutsche mark. The peg was switched to the euro 
as  of  1  January  1999.  The  currency  board 
arrangement  has  been  backed  up  by  generally 
prudent fiscal policies, open markets and a broadly 
flexible economy. Since its inception, the currency 
board  arrangement  has  served  as  a  key  policy 
anchor and enjoyed wide popular support.  

the  reference  period, 

The  exchange  rate  did  not  experience  severe 
tensions  during 
though 
several  financial  market 
indicators  suggest  a 
temporary  increase  in  risk  perceptions  in  the 
context  of  the  global  financial  crisis.  Financial 
market risk perceptions vis-à-vis Estonia improved 
again  markedly  since 
late  2009,  along  with 
increasing  risk  differentiation  across  the  countries 
in the region by investors.  

Foreign exchange reserve buffers remain robust in 
the  currency  board 
in 
Estonia, 
arrangement 
all  domestic 
liabilities of the central bank have to be backed by 

line  with 
requirement 

that 

Convergence Report 2010 - Technical annex 

Chapter 4 - Estonia 

foreign  exchange  reserves  or  gold.  The  main 
domestic liabilities of the central bank are currency 
in  circulation  and  banks'  holdings  in  the  central 
bank (mainly related to the reserve requirement of 
the  banks).  The  law  guarantees  full  convertibility 
of the kroon at the parity rate and permits the issue 
of  new  cash  only  against  a  corresponding  change 
in  reserves.  Foreign  exchange  reserves  of  the 
central bank covered some 115% of the monetary 
base at end of March 2010.  

Graph 4.4.2: Exchange rates - EEK/EUR
(monthly av erages)

16.0

15.8

15.6

15.4

15.2

15.0

ERM II

2004

2005

2006

2007

2008

2009

Source: ECB and EcoWin.

The foreign exchange reserves held by the Bank of 
Estonia  surged  in  October  2008  and  returned  to  a 
somewhat  lower  level  thereafter,  comparable  to 
that  of  mid-2008.  Foreign  exchange  reserves 
continue  covering  about  40%  of  the  economy's 
short-term  external  debt,  which  is  dominated  by 
banks' liabilities to their foreign parent banks. The 
banks  have  also  significant  external  claims  on 
foreign  banks,  mainly  related  to  cross-border 
banking  groups.  In  February  2009,  the  Bank  of 
Estonia concluded a precautionary agreement with 
the  central  bank  of  Sweden  (Riksbank).  The 
arrangement  aimed  at  broadening  the  Bank  of 
Estonia's  capabilities  to  provide  liquidity  to  the 
largely  Swedish-owned  financial  sector  if  needed, 
cross-border 
the 
in 
supervisory 
been 
had 
strengthened  already  in  the  years  preceding  the 
crisis.  The  additional  liquidity  channel  was  not 
used,  and  the  arrangement  was  not  extended  in 
2010.  

enhanced 
that 

context  of 

cooperation 

interest 

rates.  The  domestic 

The Bank of Estonia does not set monetary policy 
rate 
interest 
environment  is  directly  affected  by  the  monetary 
policy  of  the  euro  area  through  the  operation  of 
Estonia's currency board arrangement. Changes in 
euro  area  money  market  interest  rates  directly 
transmit  to  Estonia's  financial  markets,  where 
liquidity  is  held  mainly  in  euro,  due  to  close 
international linkages. 

61 

 
 
 
European Commission 

Convergence Report 2010 

Kroon  money  market  volumes  are  very  limited, 
mainly  reflecting  hedging  activities  of  foreign 
firms  with  kroon  exposure.  The  spreads  of  kroon 
money  market  quotations  vis-à-vis  the  euro  area 
more  than  tripled  at  end-2008  and  subsequently 
narrowed again since end-2009 to below 120 basis 
points at the cut-off date of this Report. 

Graph 4.4.3: Estonia - 3-M Talibor spread to 3-M Euribor

 (basis points, monthly v alues)

600

500

400

300

200

100

0

-100

2004

2005

2006

2007

2008

2009

Source: Eurostat.

62 

 
 
                                                                                                                                                                                                
  
4.5. 

LONG-TERM INTEREST RATES 

The  convergence  criterion  on  long-term  interest 
rates  is  not  directly  applicable  to  Estonia,  as  no 
appropriate  benchmark 
long-term  government 
bonds or other comparable securities are available 
for the assessment. The absence of bonds reflects a 
very  low  level  of  gross  public  debt  and  prudent 
fiscal  policies,  which  led  to  budget  surpluses  in 
2002–2007. Therefore, it does not as such preclude 
Estonia  from  fulfilling  the  long-term  interest  rate 
criterion.  

financial  market 

While the linkages between long-term bond yields 
indicators  are 
and  other 
surrounded by significant uncertainties, alternative 
indicators  may  reflect  developments  relevant  for 
the  durability  of  convergence.  Hence,  they  should 
be  included  in  a  broader  qualitative  assessment 
provided that they are interpreted with appropriate 
caution.   

in 

financial  market 
several 
Developments 
indicators suggest a sizeable temporary increase of 
risk perceptions towards Estonia during the global 
crisis,  followed  by  a  significant  easing, 
in 
particular  since  late  2009.  The  rise  of  risk 
perceptions at the height of the crisis reflected both 
a  global  deterioration  of  investor  sentiment  vis-à-
vis  Central  and  Eastern  European  economies  and 
particular  regional  factors  (including  concerns 
about  possible  spillovers  from  Latvia).  The  rapid 
reversal of the temporary surge in risk perceptions 
concerning  Estonia,  which  has 
implied  a 
in  Estonia's  relative 
improvement 
significant 
financial  market  performance  within  the  group  of 
new  Member  States,  appears 
indicate  a 
resumption  of  market  confidence  in  the  country's 
fundamentals,  backed  up  by  a  determined  policy 
response to the crisis.    

to 

Among  financial  market  indicators,  interest  rates 
on  kroon-denominated  loans  to  households  and 
the 
non-financial  corporations  peaked  during 
crisis,  after  a  steady  increase  in  previous  years. 
Interest rates returned to their early-2008 levels in 
late  2009.  However,  these  interest  rates  include 
private sector credit risk and are dominantly driven 
by market conditions in the banking sector, which 
is  not  generally  the  case  for  in  government  bond 
yields. Also, Estonia's kroon-denominated lending 
market  is  very  limited  and  mainly  based  on 
variable  interest  rates  (with  mark-ups  set  over 
short-term  money  market  rates),  thus  failing  to 

Convergence Report 2010 - Technical annex 

Chapter 4 - Estonia 

provide a representative sample for a broader long-
term  convergence  assessment.  Retail 
lending 
market  transactions  are  mainly  denominated  in 
euro, resulting from close international linkages.  

Graph 4.5.1: Estonia - Interest rate indicator

 (percent, monthly v alues)

12

10

8

6

4

2

0

2004

2005

2006

2007

2008

2009

Note: New definition as of Oct-05; Weighted average interest rate on new 
EEK-denominated loans to households and non-financial corporations .
Source: Eurostat.

by 

reflect 

definition 

Kroon-denominated  money  market  quotations, 
which 
short-term 
developments,  surged  strongly  during  the  crisis. 
Short-term  spreads  rose  in  line  with  the  broader 
regional trend and peaked at 5.6 percentage points 
in March 2009. By March 2010, the spread vis-à-
vis euro area money market interest rates returned 
to  below  1.2  percentage  points,  comparable  to 
levels  of  mid-2008.  Estonia's  kroon-denominated 
money  market  reflects  mainly  limited  hedging 
activities  of  foreign  firms  with  kroon  exposure, 
rather  than  liquidity  conditions  in  the  banking 
sector.  

Sovereign  credit  ratings  and  credit  default  swap 
spreads  –  indicators  of  the  risks  of  holding 
Estonian  public  sector  debt  –  also  signalled  an 
increase  in  risk  perceptions  during  the  global 
crisis.  Despite  Estonia's  continuously  very  low 
general  government  gross  debt  and  significant 
fiscal  reserves,  credit  default  swap  (CDS)  spreads 
peaked at above 700 basis points in February 2009. 
In addition, two credit rating agencies downgraded 
Estonia's  sovereign  credit  rating  in  2009,  affected 
by 
in  neighbouring 
countries.  

adverse  developments 

increased 

Financial  markets' 
differentiation 
between  countries  in  the  region,  coupled  with  the 
government's  strong  fiscal  consolidation  in  2009, 
contributed  to  a  decline  in  risk  perceptions  for 
Estonia in particular since late 2009. CDS spreads 
narrowed  more  strongly  than  those  of  Member 
States with higher credit risk and returned to their 
mid-2008  levels  of  below  100  basis  points  in 
March 2010. They are currently lower that that of 

63 

 
 
European Commission 

Convergence Report 2010 

several euro area  members. Credit rating agencies 
revised  their  sovereign  credit  outlook  for  Estonia 
from negative to stable in early 2010.  

reinforced 

in  Estonia.  Estonia 

In  a  broader  perspective, 
the  durability  of 
convergence, as required by the long-term interest 
rates  criterion,  is  supported  by  continued  prudent 
policies 
the 
credibility  of  its  commitment  to  sustainability-
oriented  policies  by  maintaining  strict  policy 
discipline  in  the  context  of  the  global  financial 
crisis. Flexible wage and price setting mechanisms 
enabled  rapid  downward  adjustment  of  domestic 
costs,  providing  support  to  price  stability  and 
external  competitiveness.  External 
imbalances 
have  reversed  rapidly  over  the  last  year.  Public 
debt  remains  by  far  the  lowest  in  the  EU,  and 
substantial  fiscal  consolidation  contributed 
to 
enhancing  the  sustainability  of  public  finances, 
including by maintaining fiscal reserves.  

Altogether, while financial market indicators point 
to an increase in risk perceptions vis-à-vis Estonia 
at the height of the crisis, their development during 
the  reference  period,  as  well  as  a  broader 
assessment  on  the  durability  of  convergence, 
would  support  a  positive  assessment  on  Estonia's 
fulfilment of the long-term interest rate criterion.   

64 

 
4.6.  ADDITIONAL FACTORS 

4.6.1.  Developments  of 

the  balance  of 

payments 

surplus 

in  2009.  The 

Estonia's  external  imbalances,  which  had  built  up 
during  the  boom  years,  started  unwinding  rapidly 
with the turn of the economic cycle in 2008, while 
the  global  crisis  precipitated 
the  necessary 
economic adjustment. The external deficit (i.e. the 
combined  current  and  capital  account  deficit) 
declined  by  half  in  2008,  and  turned  into  a 
significant 
strongest 
correction  took  place  in  the  balance  of  trade  in 
goods,  where  the  deficit  declined  to  less  than  5% 
of  GDP  in  2009,  compared  to  deficits  of  18%  of 
GDP in 2006–2007. At the same time, the already 
substantial  trade  surplus  in  services  increased 
further, driven by transport services. The deficit of 
the income balance narrowed in 2009, as profits in 
companies  with 
foreign  ownership  declined. 
Positive  net  capital  transfers  increased  in  2009, 
reflecting higher inflows of EU structural funds in 
the 2007–2013 financial perspective.  

High  external  trade  imbalances  of  Estonia  in  the 
preceding  years  were  primarily  driven  by  strong 
import  demand,  rather  than  by  weak  export 
growth.  Estonia's  export  market  share  surged 
temporarily  in  2005–2006  mainly  due  to  intense 
transit  trade  in  motor  fuels,  while  it  returned  to 
somewhat  lower  levels  in  2007–2008  after  the 
transit  trade  contracted.  However,  real  effective 
exchange  rates  deteriorated  in  2006–2007,  as 
Estonia's  prices  and  labour  costs  increased  faster 
than  those  of  its  trade  partners.  That  said,  real 
appreciation  based  on  unit 
in 
manufacturing  was  somewhat  less  pronounced 
than  that  based  on  ULC  in  the  whole  economy, 
which  reflected  particularly  fast  wage  growth  in 
the  non-tradables  sector.  In  2009,  the  downward 
adjustment  of  wages  led  to  a  depreciation  of  the 
real  effective  exchange  rate  (deflated  by  unit 
labour costs), and contributed to restoring Estonia's 
cost competitiveness. 

labour  costs 

Convergence Report 2010 - Technical annex 

Chapter 4 - Estonia 

Graph 4.6.1: Estonia - Effective exchange rates

 (v s. 35 trading partners;  monthly av erages;

  index numbers, 2004 = 100)

150

140

130

120

110

100

90

80

2004

2005

2006

2007

2008

2009

NEER

REER, HICP d eflated

REER, ULC d eflated

Source: Commission services.

the  real  effective  exchange  rate 
Conversely, 
deflated  by  consumer  price  inflation  remained 
broadly  stable  in  2008–2009,  reflecting  inter  alia 
high  inflation  due  to  surges  in  administered  price 
and  indirect  taxes.  Strengthening  competitiveness, 
together  with  increasing  the  value  of  exports,  has 
become  increasingly  relevant  for  gaining  market 
and support the rebalancing of the economy. 

The  current  account  deficit  up  to  2008  was 
financed  by  strong  capital 
inflows,  mainly 
channelled 
the  foreign-owned  banks, 
through 
which fuelled imports. In 2009, subdued domestic 
demand,  aggravated  by  the  global  downturn, 
reduced the need for foreign financing, as reflected 
in  net  capital  outflows.  Banks  returned  excess 
liquidity  to  their  parent  banks,  as  retail  credit 
financing 
demand  declined  under 
conditions  and  an  uncertain  global  outlook.  A 
general  decline  in  profits  also  reduced  reinvested 
earnings, 
foreign  direct 
resulting 
investment inflows.   

tightened 

lower 

in 

Graph 4.6.2: Estonia - Saving and investment
(in percent of GDP at market prices)

50

40

30

20

10

0

2004

2005
Gro ss natio nal saving

2006

2007

2008

2009

Gro ss capital fo rmatio n at current prices; to tal eco no my

Source: Eurostat, Commission services.

Improved  access  to  credit,  provided  by  foreign-
owned  banks  at  favourable  conditions,  fuelled 
gross capital formation in Estonia up to 2008, and 
led to a significant negative saving-investment gap 
in 2004–2008. Solid general government surpluses 
up to 2007 contributed to narrowing the gap, while 

65 

 
 
 
European Commission 

Convergence Report 2010 

Table 4.6.1:

Estonia - Balance of payments

Current account

Of which: Balance of trade in goods

                 Balance of trade in services

                 Income balance 

                 Balance of current transfers

Capital account
External balance 1)
Financial account

Of which: Net FDI

                Net portfolio inflows
                Net other inflows 2)
                Change in reserves (+ is a decrease)

Financial account without reserves

Errors and omissions

Gross capital formation

Gross saving

External debt

International investment position

2004

-11.3

-16.2

9.2

-5.3

0.9

0.7

-10.6

12.0

5.7

6.0

2.5

-2.3

14.2

-1.4

33.1

21.7

77.0

-86.5

1) The combined current and capital account.

2) Including financial derivatives.

Sources: Eurostat, Commission services and Bank of Estonia.

strong investment demand, including in real estate, 
deepened  the  gap  in  the  years  of  overheating.  In 
2009,  investment  activity  declined  considerably, 
while  private  savings  increased,  reversing  the  gap 
into positive net savings.         

High net capital inflows through foreign banks up 
to  2008  also  increased  the  economy's  external 
debt.  Banks'  external  debt  liabilities  (mainly  to 
parent  banks)  continue  to  constitute  more  than 
50% of total external debt. Triggered by a decline 
in domestic demand, external debt fell in absolute 
terms  in  2009,  while  its  ratio  to  GDP  continued 
increasing as GDP contracted. The same dynamics 
were  reflected  in  the  international  investment 
position, which  deteriorated in  relation  to GDP  in 
2009.  The  stock  of  foreign  direct  investment  in 
Estonia  declined  in  2008–2009,  mainly  reflecting 
lower  investment  in  financial  intermediation,  and 
real estate and business activities.  

The  Commission  services'  Spring  2010  Forecast 
projects  Estonia's  external  balance  to  remain  in 
surplus in 2010–2011, with exports growing faster 
than imports in 2010 and at broadly the same rate 
in  2011.  Over  the  medium  term,  the  external 
balance  will  depend  on  further  enhancing  and 
upgrading  the  economy's  export  capacity  and  on 

66 

2005

-10.0

-13.9

7.5

-4.1

0.4

0.8

-9.2

8.2

15.7

-15.8

11.1

-2.8

11.0

1.0

33.8

23.7

86.5

-85.2

(percentage of GDP)

2006

-16.9

-18.1

6.0

-5.2

0.4

2.2

-14.7

14.2

4.2

-8.0

21.6

-3.6

17.8

0.5

38.7

22.5

97.5

-74.6

2007

-17.8

-17.8

6.1

-6.8

0.7

1.0

-16.8

15.7

4.6

-2.3

13.9

-0.6

16.2

1.1

40.2

21.3

111.0

-74.3

2008

-9.4

-11.7

7.4

-6.3

1.2

1.0

-8.4

8.9

3.7

3.1

5.2

-3.1

12.1

-0.6

29.7

19.5

118.5

-75.3

2009

4.6

-3.7

9.6

-2.9

1.6

2.8

7.4

-6.6

1.1

-10.5

2.8

0.0

-6.6

-0.8

19.4

24.1

126.8

-81.8

the 

resources 

ensuring  sustainable  developments  in  domestic 
demand.  The  ongoing  economic  adjustment 
supports 
into 
re-allocation  of 
tradables  sectors,  which  needs  to  be  enhanced  by 
appropriate  policies.  Continued  strengthening  of 
flexible  labour  markets  and  ensuring  an  attractive 
business climate are necessary to underpin foreign 
direct  investment  inflows.  Ensuring  consistency 
between wage and productivity developments will 
remain  key  for  both  sustainable  domestic  demand 
and external balances.  

4.6.2.  Product market integration 

the  successful 

As  a  small  and  very  open  market  economy, 
Estonia  has  experienced  an  increasing  degree  of 
trade openness over the last years. This was mainly 
driven  by 
trade  re-orientation 
towards the EU, especially since Estonia joined the 
EU in 2004. It was also fuelled by the recovery of 
trade  flows  with  the  CIS  countries.  In  2008,  the 
degree  of  trade  openness  (almost  80%)  was  the 
highest among the small new Member States. The 
orientation  of  Estonia's  foreign  trade  is  mostly 
towards  the  EU-27,  which  is  a  sign  of  a  robust 
process  of  economic  integration  being  underway. 
The  average  2004-2008  intra-EU  trade  in  goods 
ratio was almost three times higher than the extra-

 
 
 
 
 
Convergence Report 2010 - Technical annex 

Chapter 4 - Estonia 

share  of  total  FDI  went  into  the  services  sector 
(notably in financial intermediation) with the bulk 
coming  from  the  neighbouring  countries  (Finland 
and  Sweden)  while  a  fifth  of  total  FDI  went  into 
the manufacturing sector. 

Overall,  important  efforts  have  been  made  to 
improve the business environment, which will also 
ease the process of integration. Ongoing efforts, in 
particular the creation of the one-stop-shop and the 
acceleration  of  registration  proceedings  contribute 
to  improving  the  regulatory  framework  and  to 
reducing administrative costs, which should further 
enhance  business  dynamism.  Reforms 
in  the 
Labour  Law  aim  to  facilitate  the  transfer  of 
resources  to  the  more  productive  or  export-
oriented  sectors,  as  well  as  to  foster  productivity. 
Concerning  the  transposition  of  the  EU  Internal 
Market  directives,  Estonia's  transposition  deficit 
has  recently  improved  and  is  now  below  the  1% 
EU target.  

EU trade in goods ratio. Trade integration has been 
particularly pronounced with the Baltic region and 
the  neighbouring  countries  such  as  Finland, 
Sweden, as well as Germany. Trade flows with the 
EU  have  also  been  supported  by  the  currency 
board arrangement ensuring stable exchange rates. 
Trade  with  extra-EU  partners  remains  important 
with  Russia,  followed  by  Norway  and  the  US. 
Estonia  plays  a  role  of  quasi-transit  country  for 
Russia,  notably  with  respect  to  vehicles  and 
mineral  products,  with  very  limited  processing 
before  re-exporting.  However,  quasi-transit  trade 
with  neighbouring  Russia  started  declining  in 
2007, after Estonia's political tensions with Russia 
and the development of Russian ports on the Baltic 
Sea.  

the 

total)  and 

The  composition  of  Estonia's  trade  in  goods  has 
evolved over  the  last  decade,  but  it  still  shows  an 
export pattern dominated by raw materials (a third 
of 
labour-intensive  products. 
Estonia's  manufacturing  exports  in  2007  show 
revealed  comparative  advantages  in  furniture  and 
telecommunications  equipment.  Since  2004,  the 
share  of  labour-intensive  products  in  exports  has 
declined,  while  the  share  of  capital-intensive 
products  as  well  as  of  research-intensive  exports 
has increased. This change reflects the progressive 
evolution  of  Estonia's  labour  skills  and  cost 
competitiveness  conditions.  The  deterioration  of 
cost competitiveness affected particularly the low-
skilled  intensive  sectors  and  hindered  export 
growth  in  sectors  such  as  textiles  and  in  specific 
sub-sectors  of  machinery.  Over  the  period,  there 
was  a  gradual  shift  in  Estonia's  exports  from  low 
technology  exports  to  medium-to-low  technology 
exports,  such  as  chemicals,  and  there  are  some 
favourable prospects for an increase in medium-to-
high  technology  exports.  However,  the  share  of 
exports  in  high  technology  goods  is  still  much 
lower  than  the  EU-27  average.  In  addition,  low 
export  unit  values  indicate  that  Estonia's  trade 
specialisation is in rather low quality products.   

Over  the  period  2005-2007,  Estonia  attracted 
strong  FDI  inflows  (around  10%  of  GDP),  well 
above the EU-27 average. FDI inflows contributed 
to  enhancing  Estonia's  export  capacity, 
in 
particular  in  the  electronic  sector,  but  only  to  a 
limited  extent.  Estonia’s  trade  specialisation  in 
low-technology  and  low-skilled  processed  goods 
was initially influenced by large investments from 
Sweden  and  Finland,  and  by  subcontracting 
arrangements in the machinery sector (12% of total 
imports and 15% of total exports in 2008). A large 

67 

 
 
European Commission 

Convergence Report 2010 

Table 4.6.2:

Estonia - Product market integration

Trade openness 1) (%)
Extra-EU trade in goods GDP ratio 2) (%)
Intra-EU trade in goods GDP ratio 3) (%)
Intra-EU trade in services GDP ratio 4) (%)
Export in high technology 5) (%)
Technological balance 6) (%)
Total FDI inflows GDP ratio 7) (%)
Intra-EU FDI inflows GDP ratio 8) (%)
FDI intensity 9)
Internal Market Directives 10) (%)
Value of tenders in the O.J. 11)
Time to start up a new company 12)

Estonia

2003

:

15.5

40.2

:

9.4

-3.9

9.4

:

:

:

:

:

2004

2005

2006

2007

78.3

13.9

45.3

13.5

10.0

-4.2

8.0

6.1

4.0

5.0

2.7

72.0

84.1

14.8

49.8

14.0

10.3

-5.1

20.6

20.1

11.8

1.3

7.1

72.0

87.7

20.4

49.2

13.3

8.0

-3.5

10.8

10.6

8.4

1.1

7.4

35.0

79.7

15.5

46.8

12.8

7.8

-1.9

12.8

12.8

9.8

1.0

7.4

35.0

2008

78.5

14.7

45.5

13.1

:

:

8.2

6.7

5.6

1.1

8.2

7.0

 1) (Imports + Exports of goods and services / 2 x GDP at current market prices) x 100 (Foreign Trade Statistics, Balance of Payments).

 2) (Extra-EU-27 Imports + Exports of goods / 2 x GDP at current market prices ) x 100 (Foreign Trade Statistics).

 3) (Intra-EU-27 Imports + Exports of goods / 2 x GDP at current market prices ) x 100 (Foreign Trade Statistics).

 4) Intra-EU-27 trade in services (average credit and debit in % of GDP at current prices) (Balance of Payments).

 5) Taken directly from Eurostat's databases: Exports of high technology products as a share of total exports.

 6) (Exports - imports in high tech) / GDP at current prices x 100, since 2007 the data based upon SITC Rev. 4 (earlier SITC Rev. 3).

 7) Total FDI inflows (in % of GDP at current prices).

8) Intra-EU-27 FDI inflows (in % of GDP at current prices).

9) FDI intensity (average intra-EU-27 inflows and outflows in % of GDP at current prices).

10) Percentage of internal market directives not yet communicated as having been transposed, in relation to the total number.

11) Public procurement - Value of public procurement which is openly advertised  (in % of GDP).

12) Time to start a new company (in days), Doing Business World Bank.

Graph 4.6.3: Estonia - Recent development of the  financial 

system relatively to the euro area
(in percentage of GDP)

180
160
140
120
100
80
60
40
20
0

EE, 2004

EE, 2009

Euro area,
2004

Euro area,
2009

Debt securities

Sto ck market capitalisatio n

Do mestic bank credit

Source: Eurostat, Bank of Estonia, Nasdaq OMX, Estonian CSD.

The  growing  domestic  bank  credit  reflects  the 
credit  expansion  of  the  post-accession  economic 
boom,  driven  mainly  by  construction  activity. 
Mortgages  and  loans  to  real  estate  business 
account  for  about  two  thirds  of  total  credit  to  the 
private  sector.  The  total  credit  to  GDP  ratio  has 
converged  fairly  closely  towards  the  euro  area 
average.  

Sources: Eurostat, Commission services.

4.6.3.  Financial market integration 

Estonia's  financial  sector  is  well  integrated  with 
the  broader EU  financial  sector, which  is testified 
by  cross-border  ownership  links,  convergence  of 
market trends and the role of the euro in domestic 
financial 
fully 
implemented the acquis of the Union in the field of 
financial  services  and  new  directives  have  been 
transposed in the national law systematically (30).  

transactions.  Estonia 

has 

The  Estonian  financial  sector  is  heavily  bank-
based,  which  is  typical  of  smaller  economies. 
Between  2004  and  2009,  the  role  of  banks  in 
financial 
further,  while 
capitalisation of the stock market fell significantly. 
The  share  of  debt  securities  in  total  assets  of  the 
financial sector remained marginal, although it has 
slightly increased. 

intermediation  grew 

(30)  See: 

http://ec.europa.eu/internal_market/finances/actionplan/ind
ex_en.htm#transposition. 

68 

 
                                                           
 
 
 
 
 
Graph 4.6.4: Estonia - Foreign ownership and 

concentration in the banking sector

(in percent, weighted av erages)

120

100

80

60

40

20

0

EE, 2004

EE, 2008

Euro area,
2004

Euro area,
2008

Co ncentratio n in the banking secto r (CR5 ratio )

Share o f fo reign institutio ns as % o f to tal assets

Source: ECB, Structural indicators for the EU banking sector, January 2010.

Compared  to  the  euro  area  and  to  the  peer 
countries  in  the  region,  the  Estonian  banking 
market  is  strongly  concentrated,  with  the  five 
largest banks holding about 95% of the total assets 
(CR5  ratio).  The  Estonian  financial  sector  is 
almost  entirely  foreign  owned.  Nordic  banks  are 
the  strategic  investors  in  the  Estonian  banking 
sector  as  well  as  in  most  non-bank  financial 
institutions.  

Graph 4.6.5: Estonia - selected banking sector soundness 
30

indicators relatively to the euro area

%

20

10

0

-10

-20

-30

EE, 2004

EE, 2009

*

Euro area,
2004

Euro area,
2008

Return o n equity

Capital adequacy

No n perfo rming lo ans

Note: For 2008, EU-27 non performing loans for are a proxy for EA.
*Subsidiaries only. Source: ECB, Bank of Estonia, Estonian FSA, EC calculations.

The banking sector has felt the negative impact of 
economic  recession.  The  share  of  non-performing 
loans increased above 6% by the end of 2009 (31), 
compared  to  very  low  levels  in  previous  years. 
Increased  loan-loss  provisions  had  a  negative 
impact  on  banks'  profits,  previously  among  the 
highest  in  the  EU.  In  2009,  banks  recorded 
significant  losses  illustrated  by  a  negative  return 
on  equity  ratio.  At  the  same  time,  banks  were 
increasing  their  capital  buffers,  mainly  Tier  I 
funds.  As  a  result,  the  capital  adequacy  ratio 
increased  to  22%  as  of  end-2009,  well  above  the 
required minimum and also the euro area average. 
The  evolution  of  banking  soundness  indicators 
corresponded to trends prevailing in the euro area, 
although featuring higher amplitudes. 

(31)  Loans  overdue  for  more  than  60  days  as  %  of  total 
portfolio of loans to non-financial sector. Data for Q3 2004 
and Q3 2009 (Graph 4.6.5). 

Convergence Report 2010 - Technical annex 

Chapter 4 - Estonia 

In  the  last  few  years,  financial  leverage  of 
households  and  corporations  converged  rapidly 
towards  the  euro  area  averages.  The  fast  credit 
growth came to a halt in 2008 when the economic 
downturn  spurred  a  deleveraging  process.  In  the 
course of 2009, the outstanding credit volumes fell 
both for households (from EUR 7.6 to 7.4 billion)  
and non-financial companies (from EUR 7.2 to 6.9 
billion), but given the even stronger drop in GDP, 
the respective credit to GDP ratios still increased. 

Graph 4.6.6: Estonia - Recent developments in bank credit 

to households and corporations relatively to the euro area

(in percentage of GDP)

60

50

40

30

20

10

0

Dec-04 Dec-05 Dec-06 Dec-07

Dec-08 Dec-09

Ho useho lds, EE
No n-financial co rpo ratio ns, EE
Ho useho lds, Euro  area
No n-financial co rpo ratio ns, Euro  area

Source: ECB, Eurostat.

Driven by the price differential and the perception 
of  low  currency  risk  linked  with  the  Estonia's 
currency  board  arrangement,  loans  in  foreign 
currency – mainly the euro – dominate in lending 
to households and non-financial firms. Their share 
–  already  high  five  years  ago  –  further  increased 
for  both  sectors,  made  up  mainly  by  loans  with 
long-term maturities. 

Graph 4.6.7: Estonia - Share of foreign currency loans

(as percentage of total loans to households / corporations)
100
90
80
70
60
50
40
30
20
10
0

Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 Dec-09

Co rpo ratio ns

Ho useho lds

So urce: B ank o f Esto nia and o wn calculatio ns.

Estonia's  financial  markets  are  well  integrated  in 
the EU markets. Regarding market infrastructures, 
the  Tallinn  stock  exchange  belongs 
the 
NASDAQ  OMX  group  and  uses  a  single  trading 
platform  together  with  other  exchanges  in  the 
Baltic-Nordic region. Recently, an increasing share 
of  payments  and  securities  settlements  has  been 
done through the TARGET2 system. Nonetheless, 

to 

69 

 
 
 
                                                           
 
 
European Commission 

Convergence Report 2010 

Estonian financial markets remain relatively small 
and volatile. The capitalisation of the Tallinn stock 
exchange  reached  its  peak  in  summer  2007  but  it 
has  fallen  back  to  its  2004  level  since  then.  This 
resulted from the sharp decline of stock prices and 
from  some  delistings.  Given  the  lack  of  central 
the  debt  securities  market 
government  debt, 
consists  mainly  of  corporate  bonds.  In  the  period 
2004-2009, most new issues were by non-financial 
companies,  and  to  a  lesser  extent  banks  and  non-
residents.  The  bulk  of  the  bonds,  especially  since 
mid-2008, were denominated in foreign currencies. 
relatively 
The  money  market 
given 
underdeveloped 
liquidity 
the 
management  of 
largest  banks  has  been 
the 
centralised in the parent banks. 

remains 
that 

institutions  other 

Financial 
than  banks  are 
relatively  less  developed.  Leasing  and  factoring 
companies  play  a  relatively  important  role  with 
assets equal to 14% of GDP. The insurance sector 
is still at an early stage of development, with total 
premiums  of  insurance  companies  accounting  for 
only 2% of GDP in 2009. Some Estonian insurers 
were involved in cross-border business in the other 
Baltic  states.  Total  assets  of  investment  and 
pension  funds  equalled  about  11%  of  GDP  in 
2009.  Both  the  funds  and  insurance  companies 
invest a large share of their assets on EU markets 
(e.g.  76%  of  total  funds'  assets  in  September 
2009).  

is  carried  out  on  a 
Financial  supervision 
consolidated  basis  by 
the  Estonian  Financial 
Supervision  Authority.  Given  the  high  share  of 
intensive 
cross-border  business, 
cooperation  with  supervisory  authorities  in  the 
relevant 'home' and 'host' countries. 

is  an 

there 

70 

 
 
5. 

LATVIA 

5.1. 

LEGAL COMPATIBILITY 

5.1.1.  Introduction 

The  Bank  of  Latvia  was  founded  in  1922  and  re-
instated  in  1991,  under  the  Law  on  the  Bank  of 
Latvia.  This  Law  was  last  amended  in  October 
2009. 

Since no substantial changes have been introduced 
into the Law on the Bank of Latvia, the comments 
from  the  2008  Convergence  Report  are  largely 
repeated in this year's assessment. 

5.1.2.  Objectives 

There  are  no  incompatibilities  but  there  is  one 
imperfection. 

The  wording  of  the  Bank  of  Latvia’s  primary 
objective  (Article  3)  does  not  fully  reflect  Article 
127(1) of the TFEU and thus, should be brought in 
line with it. 

5.1.3.  Independence 

Several  incompatibilities  and  some  imperfections 
with the TFEU and the ESCB/ECB Statute exist in 
this area.  

Article  17  of  the  Law  on  the  Bank  of  Latvia 
provides  for  the  possibility  of  the  central  bank's 
liquidation upon a resolution of the Parliament.  

exactly correspond to those stated in Article 14(2) 
of  the  ESCB/ECB  Statute.  Article  22  needs  to  be 
adapted to be fully compliant with Article 14(2) of 
the ESCB/ECB Statute. 

The lack of inclusion of the right of judicial review 
before the Court of Justice of the EU, in case of the 
further 
Governor's  dismissal, 
imperfection.  

constitutes 

a 

Article  28(5)  of  the  Law  provides  that  if  the 
Governor  of  the  Bank  of  Latvia  is  absent,  his  or 
her  rights  and  obligations  are  exercised  by  the 
Deputy Governor or by the person appointed by an 
express  order.  This  provision,  to  the  extent  that  a 
person who is not a member of the Bank of Latvia 
the 
Council  can  be  appointed 
Governor’s  duties, 
the 
requirement of central bank independence. Article 
28  of  the  Law  needs  to  be  adapted  to  be  fully 
compliant with Article 14(2) of the Statute. 

to  exercise 
incompatible  with 

is 

According  to  Article  13,  the  Bank  of  Latvia  shall 
be independent in the adoption of its decisions and 
their  implementation  in  practice.  It  shall  neither 
seek nor take instructions from the Government or 
any  other  institution. It  shall  not  be  subject  to  the 
decisions and regulations adopted by these bodies. 
the 
This  provision  does  not 
requirements  of  Article  130  of  the  TFEU  and 
Article  7  of  the  ESCB/EC  Statute  (e.g.  Union 
institutions are not explicitly included). Article 13 
should therefore be brought into line with it.  

fully  match 

the 

In  view  of  the  principle  of  the  central  bank's 
independence  and  its  legal  integration  into  the 
ESCB, this provision is considered as incompatible 
with  the  TFEU  and  the  ESCB/ECB  Statute.  This 
measure  would 
institutional 
infringe 
independence  of  the  central  bank,  as  a  third  party 
would  be  allowed  to  decide  on  its  winding  up, 
while not being even legally obliged to provide for 
a  succeeding  institution.  Liquidation  could  also 
only  take  place  after  a  bankruptcy,  which  pre-
supposes  that  the  State  would  have  failed  to 
guarantee 
the  central  bank  has  enough 
financial resources to ensure the tasks entrusted to 
it by the TFEU (financial independence).  

that 

The grounds for dismissal of the Governor and the 
other  members  of  the  Council  (Article  22)  do  not 

to 

the 

regard 

financial 

With 
independence, 
according  to  Article  181  of  the  Law,  the  Bank  of 
Latvia transfers to the state budget, within 15 days 
following the approval of the annual report by the 
Council,  part  of  its  profit  calculated  by  applying 
the  tax  rate  for  residents  under  the  Law  on 
corporate income tax and a payment for the use of 
state  capital  in  the  amount  of  50%  of  the  profit. 
What  is  more,  Article  19  provides  that  the  profits 
are transferred to the reserve capital of the Bank of 
Latvia  after  the  part  of  its  profits  specified  in 
Article  181  of  the  Law  is  transferred  to  the  State 
budget.  This  provision,  as  it  stands  now,  reduces 
significantly the capacity of the Bank of Latvia to 
decide  the  level  of  its  reserves,  which  limits  its 
financial 
the 
operations in Articles 181 and 19 indicates that the 
contribution to the State budget is very significant 

independence.  The  sequence  of 

71 

 
European Commission 

Convergence Report 2010 

and is deducted before any transfer of profit to the 
reserve  capital  of  the  Bank  of  Latvia.  The  law 
should  be  amended  with  a  view  to  increasing  the 
financial independence of the Bank of Latvia. 

5.1.5.  Prohibition of monetary financing 

An incompatibility exists in this area. 

5.1.4.  Integration in the ESCB 

The incompatibilities in this area are linked to the 
following ESCB/ECB tasks: 

• 

the  possibility  for  the  Parliament  to  liquidate 
the Bank of Latvia (Article 17); 

According  to  Article  36,  the  Bank  of  Latvia  shall 
not  be  entitled  to  issue  credits  to  the  Government 
and  to  buy  Government  securities  on  the  primary 
market.  The  scope  of  the  public  sector  entities 
covered  in  this  Article  needs  to  be  significantly 
extended to be consistent with the list contained in 
the Article 123 of the TFEU. 

• 

the definition of monetary policy (Articles 26); 

5.1.6.  Assessment of compatibility 

• 

• 

• 

• 

• 

the conduct of foreign exchange operations and 
the  definition  of  foreign  exchange  policy 
(Article 4); 

the  holding  and  management  of 
reserves (Article 5); 

foreign 

the 

time  of  euro  adoption, 
the  central  bank  and 

As  regards  the  central  bank  integration  into  the 
the 
ESCB  at 
independence  of 
the 
prohibition  on  monetary  financing,  the  legislation 
in  Latvia  -  in  particular  the  Law  on  the  Bank  of 
Latvia  -  is  not  fully  compatible  with  Article  130 
and 131 of the TFEU and the ESCB/ECB Statute. 

the right to authorise the issue of banknotes and 
the volume of coins (Articles 4 and 34); 

. 

the  monetary 
instruments of the ESCB (Article 38); 

functions,  operations  and 

the  non-recognition  of  the  role  of  the  ECB  in 
the  field  of  international  cooperation  (Article 
7). 

There are also some imperfections regarding: 

• 

• 

• 

• 

the non-recognition of the role of the ECB and 
the  EU  for  the  collection  of  statistics  (Article 
39 and 40); 

the non-recognition of the role of the ECB for 
the functioning of the payment systems (Article 
9); 

the rules for publishing balance sheets and the 
absence  of  an  obligation  to  comply  with  the 
Eurosystem's regime for the financial reporting 
of NCB operations (Article 15); 

the non recognition of the role of the ECB and 
the  Council  for  the  appointment  of  external 
auditors  and  lack  of  a  clear  definition  of  the 
scope  of  control  performed  by  the  audit 
commission,  whose  members  are  approved  by 
the State Audit Office (Article 43). 

72 

 
 
 
5.2. 

PRICE STABILITY 

5.2.1.  Respect of the reference value 

The  12-month  average  inflation  rate  for  Latvia, 
which is used for the convergence assessment, was 
above  the  reference  value  between  May  2004, 
when  Latvia  became  an  EU  Member  State,  and 
February 2010. In March 2010, the cut-off date for 
this report, the 12-month average inflation rate fell 
below  the  reference  value  for  the  first  time.  The 
difference  between  Latvian  12-month  average 
inflation  and  the  reference  value  increased  after 
accession  and  remained  well  above  the  reference 
value  in  subsequent  years.  Between  spring  2007 
and autumn 2008, the gap with the reference value 
widened rapidly, to close to 12 percentage points. 
The  difference  has  been  falling  rapidly  and 
continuously  since  then.  In  March  2010,  the 
reference  value  was  1.0%,  calculated  as  the 
average of the 12-month average inflation rates in 
Portugal, Estonia and Belgium plus 1.5 percentage 
points. The average inflation rate in Latvia during 
the  12  months  to  March  2010  was  0.1%,  i.e.  0.9 
percentage points below the reference value, and it 
is likely to remain well below the reference value 
in the months ahead. 

Graph 5.2.1: Latvia - Inflation criterion since 2004

 (percent, 12-month mov ing av erage)

16

12

8

4

0

-4
Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11

Latvia

Reference value

Note: The dots show the projected reference value and 12-month average inflation 
in the country in December 2010.
Sources: Eurostat, Commission services' Spring 2010 Forecast.

5.2.2.  Recent inflation developments 

Since  late  2004  and until  recently,  HICP  inflation 
in Latvia was among the highest in the EU against 
a  background  of  very  rapid  real  GDP  growth, 
increasing capacity constraints and strong demand 
pressures feeding into inflation. 

Convergence Report 2010 - Technical annex 

Chapter 5 - Latvia 

Graph 5.2.2: Latvia - HICP inflation

 (y-o-y percentage change)

20

15

10

5

0

-5

2004

2005

2006

2007

2008

2009

Latvia

Euro  area

Source: Eurostat.

In the course of 2007 and early 2008, inflationary 
pressures  became  even  more  entrenched  amidst 
clear  signs  of  a  wage-price  spiral  and  upward 
adjustments  in  inflation  expectations.  Headline 
HICP  inflation  increased  sharply  to  10%  on 
average in 2007 and further to above 15% in 2008. 
In  response  to  the  financial  crisis  and  a  sizeable 
weakening in domestic demand in mid-2008, price 
dynamics  reversed  sharply.  Driven  by  strong 
disinflationary  forces  in  the  economy  reflecting 
collapsing  domestic  demand,  falling  wages  and 
declining  import  prices,  HICP  inflation  has  been 
decreasing  rapidly  since  its  double-digit  peak  in 
turned 
mid-2008.  Year-on-year 
negative  in  October  2009  and  on  average  in  2009 
HICP inflation fell to 3.3%. In March 2010, HICP 
inflation  stood  at  -4.0%.  Core  inflation  –  defined 
inflation  excluding 
as  year-on-year  headline 
energy and unprocessed food – has moved largely 
in  tandem  with  headline  inflation  and  stood  at 
-4.2% in March 2010.  

inflation  rates 

imports 
the 

The  mounting  inflationary  pressures  in  2007  and 
early 2008 were reflected in all core categories of 
the HICP, with the exception of non-energy goods 
which  benefited  from  cheaper 
in  a 
strong 
globalising  economy.  Similarly, 
disinflation  process  that  began  in  mid-2008  has 
been  broad  based,  led  by  food  products  and 
energy.  However,  increases  in  the  VAT  rate  and 
for  alcoholic 
taxes,  notably 
other 
beverages  and  tobacco,  and  administered  service 
prices,  in  particular  those  related  to  health  and 
social  care,  have  prevented  consumer  price 
inflation  from  falling  even  more.  To  some  extent, 
the  higher  indirect  taxes  and  administered  service 
prices  reflect  the  government's  efforts  to  restore 
public finances to health. 

indirect 

73 

 
 
 
European Commission 

Convergence Report 2010 

Table 5.2.1:

Latvia - Components of inflation

(percentage change)1)

weights  

in total   

2004

2005

2006

2007

2008

2009

Mar-10

HICP

Non-energy industrial goods

Energy

Unprocessed food 

Processed food

Services

HICP excl. energy and unproc. food
HICP at constant taxes 2)
Administered prices HICP

6.2

3.9

10.4

4.7

8.3

5.6

5.8

5.8

6.7

6.9

2.6

12.2

10.0

7.4

6.9

5.5

6.7

5.1

6.6

1.6

12.6

9.3

7.6

6.7

5.1

6.2

11.8

10.1

3.3

10.4

12.3

14.4

12.9

9.7

9.8

16.6

15.3

2.7

27.3

13.7

27.4

15.4

13.8

13.6

31.8

3.3

0.0

4.0

0.4

6.8

4.7

3.5

-1.9

17.6

0.1

-1.5

-0.6

-4.3

4.1

0.6

0.7

-3.4

6.3

2010

1000

253

141

105

203

299

755

1000

127

1) Measured by the arithmetic average of the latest 12 monthly indices relative to the arithmetic average of the 12 monthly indices

   in the previous period.

2) Last observation for HICP at constant taxes is February 2010

5.2.3.  Underlying  factors  and  sustainability  of 

inflation 

Macroeconomic  policy-mix  and  cyclical 
stance 

by 

domestic 

the  crisis, 

Before 
real  GDP  growth  was 
exceptionally  strong,  averaging  around  11% 
between  2005  and  2007,  the  highest  in  the  EU, 
demand. 
boosted 
exuberant 
Commission  services'  estimates  suggest 
that 
buoyant  growth  led  to  a  strongly  positive  output 
gap  in  the  period  2006-2008.  Double-digit  output 
growth  came  to  an  end  with  the  global  financial 
crisis.  The  adjustment  process  in  Latvia  was 
initially  rather  steady  but  its  pace  accelerated 
significantly  in  the  course  of  2008,  reflecting  in 
particular  a  contraction  of  private  consumption. 
The 
demand  was 
compounded by a sharp increase in risk aversion in 
global  financial  markets  and  a  large  export  shock 
and  Latvia  suffered  an  unprecedented  loss  of 
output in early 2009.  

domestic 

collapse 

in 

correction 

the  massive 

already 
Despite 
experienced  and  some  signs  of  stabilisation, 
domestic  demand  is  expected  to  continue  to 
contract  due  to  the  deleveraging  process  in  the 
financial sector, the weakness of the labour market 
and  the  massive  ongoing  fiscal  consolidation 
process.  The  domestic  cost  adjustment,  together 
with  efforts  to  shift  economic  resources  to  the 
tradable  sector,  should  contribute  to  placing  the 
economy  on  a  stronger  footing  for  a  sustainable 
export-led  recovery  from  end-2010.  Real  GDP  is 
nevertheless  expected  to  contract  by  3.5%  on 
average  in  2010  and  before  reverting  to  positive 
growth  rates  in  2011,  however  far  from  sufficient 
to close the significantly negative output gap.  

74 

In  reaction  to  the  emerging  signs  of  slowing 
economic  and  credit  activity,  the  Bank  of  Latvia 
proceeded  to relax  some  of  the  measures  that  had 
been  introduced  in  2007  to  contain  credit  growth. 
Reserve  requirements  for  bank  liabilities  above 
two  years  were  reduced  in  several  steps  during 
2008  to  3%,  while  the  reserve  ratio  for  all  other 
liabilities included in the reserve base was reduced 
to 5%. In order to further encourage credit growth, 
stimulate  longer-term  funding  of  banks  and  ease 
money market liquidity conditions, the refinancing 
rate  was  cut  from  6%  to  4%  in  the  first  half  of 
2009  and  to  3.5%  in  March  2010.  In  the  same 
period,  the  deposit  facility  rate  was  reduced  from 
3% to 0.5% in an attempt to support activity in the 
lats  interbank  market  and  to  encourage  banks  to 
channel  available  financial  resources  into  the 
economy. However, the tight exchange rate peg to 
the  euro,  the  high  degree  of  euroisation  and 
integration  with  the  European  financial  system 
constrain  the  scope  and  effectiveness of  monetary 
policy.  Against  a  background  of  an  increasing 
share of non-performing loans, a repricing of risk, 
limited  business  opportunities  and  weak  demand 
for new loans, the Bank of Latvia's measures have 
had little discernible effect on bank lending to the 
private sector. 

During the years of overheating, fiscal policy was 
not  sufficiently  used  to  counter  domestic  demand 
pressures  and  public  finances  did  not  accumulate 
buffers  for  the  contraction  phase  of  the  business 
cycle.  In  response  to  the  challenges  posed  by  the 
severe  recession,  the  Latvian  authorities  begun  an 
ambitious  correction  of  the  significant  structural 
deficit  with 
tight 
implementation  of  the  2009  budget,  achieving  a 
general  government  deficit  of  9.0%  of  GDP.  In 
2010, the budget includes additional consolidation 
measures in amount of about 4% of GDP. Further 

preparation 

and 

the 

 
 
 
 
 
Convergence Report 2010 - Technical annex 

Chapter 5 - Latvia 

Table 5.2.2:

Latvia - Other inflation and cost indicators

2004

2005

2006

2007

2008

(annual percentage change)

20091)

20102)

20112)

HICP inflation

Latvia 

Euro area

Private consumption deflator

Latvia 

Euro area

6.2

2.2

7.1

2.0

Nominal compensation per employee

Latvia 

Euro area

Labour productivity

Latvia 

Euro area

Nominal unit labour costs

Latvia 

Euro area

Imports of goods deflator

Latvia 

Euro area

14.5

2.5

7.4

1.8

6.6

0.9

8.2

1.3

6.9

2.2

8.7

2.1

25.1

2.2

8.9

1.1

14.8

1.3

12.3

3.6

1) 2009 data (except HICP inflation) are estimates. 

2) Commission services' Spring 2010 Forecast.

Source: Eurostat, Commission services.

6.6

2.2

6.0

2.2

23.2

2.6

7.0

1.7

15.2

1.1

9.6

4.1

10.1

2.1

10.3

2.3

35.1

2.7

6.2

1.1

27.2

1.6

5.7

1.3

15.3

3.3

15.6

2.9

14.5

3.4

-5.4

0.0

21.0

3.4

9.2

4.1

3.3

0.3

3.2

-0.1

-11.9

2.0

-5.1

-2.0

-7.1

4.0

-6.7

-7.5

-3.2

1.5

-3.3

1.4

-8.0

1.3

4.0

1.8

-11.5

-0.5

6.7

3.9

-0.7

1.7

-0.6

1.5

1.0

1.5

2.5

1.3

-1.5

0.1

1.7

1.6

sizeable  budgetary  measures could  still  be needed 
in  subsequent  years 
the  Maastricht 
criterion by 2012. 

to  meet 

labour productivity in the years ahead, leading to a 
visible improvement in nominal unit labour costs.  

Wages and labour costs 

The development of wages and unit labour costs in 
the years before the global financial crisis reflected 
the  impact  of  buoyant  economic  activity  on  a 
labour  market  which  had  become  increasingly 
to 
tight.  Large-scale  emigration  contributed 
shortages  in  many  segments  of  the  labour  market 
and  skills  mismatches  compounded  the  problem. 
Nominal  unit 
in  Latvia 
accelerated  notably  from  2003  and  onwards  in 
response  to  a  sharp  pick-up  in  compensation  per 
employee, as wage growth outstripped high labour 
productivity 
legalisation  of 
wages may have added some upward distortion to 
the figure).  

labour  costs  (ULC) 

increases  (though 

In the course of 2008 and 2009, the labour market 
clearly  reacted  to  the  severe  economic  slowdown, 
with  unemployment  increasing  rapidly  and  hours 
worked  and  wages 
result, 
compensation of employees per head fell markedly 
in 2009 and is expected to continue falling in 2010, 
with  the  driver  shifting  from  hours  worked  to 
nominal wage reduction. The fall in compensation 
per employee is expected to outpace the decline in 

falling.  As  a 

Measures  to  scale  down  public  sector  wages  and 
the  large  adjustment  of  the  labour  market  are 
expected  to  support  the  necessary  correction  of 
economy-wide wages and labour productivity, and 
are  therefore  essential  to  improve  Latvia's  cost 
competitiveness and economic performance.  

Against  the  backdrop  of  a  decentralised  wage-
setting  system,  the  role  of  the  public  sector  in 
economy-wide  wage  setting  is  limited,  but  not 
insignificant.  In  2009,  public  wages  adjusted  at  a 
faster  pace  than  in  the  private  sector,  as  fiscal 
consolidation  efforts  concentrated  on  correcting 
the  large  excesses  of  the  boom  years.  The 
adjustment  in  the  public  sector  wage  bill  is 
expected to continue in 2010, reflecting the further 
consolidation measures that entered into force after 
the  June  2009  supplementary  budget.  While  the 
ongoing  nominal  wage  correction  in  the  private 
sector  is  expected  to  become  more  pronounced, 
supporting  downward  pressures  on  prices  and 
costs,  the  effect  of  high  unemployment  could  be 
reduced  by  a  fall  in  the  participation  rate  and  by 
higher outward migration. 

75 

 
 
 
 
 
European Commission 

Convergence Report 2010 

Graph 5.2.3: Latvia - Inflation, productivity and wage trends

Administered prices and taxes 

(y-o-y % change)

40

30

20

10

0

-10

-20

2004

2005

2006

2007

2008

2009

2010

2011

P ro ductivity (real GDP  per perso n emplo yed)

No minal co mpensatio n per emplo yee

No minal unit labo ur co sts
HICP  inflatio n

Source: Eurostat, Commission services' Spring 2010 Forecast.

External factors 

Following  several  years  of  buoyant  growth  rates, 
import prices (as measured by the import of goods 
deflator  in  the  national  accounts)  rose  further  on 
average  in  2008,  largely  driven  by  increasing 
world  energy  prices  in  the  first  half  of  the  year. 
The subsequent sharp drop in global energy prices 
in the second half of the year, together with falling 
prices  on  imported  foodstuffs  and  other  tradable 
goods such as clothing and footwear, was reflected 
in  a  strong  fall  of  import  prices  in  2009.  The 
contribution of energy prices to HICP inflation fell 
from above 3.5 percentage points by mid-2008 to a 
small negative contribution at the end of 2009. 

The  nominal  effective  exchange  rate  of  the  lats, 
measured  against  a  group  of  35  trade  partners, 
remained  fairly  stable  between  2005  and  2007, 
reflecting  subdued  movements  in  the  euro,  the 
anchor  currency  since  January  2005,  vis-à-vis 
Latvia's major trading partners. Towards the end of 
2008,  concomitant  with  the  intensification  of  the 
global  financial  crisis,  the  currencies  of  many  of 
Latvia's main trading partners depreciated vis-à-vis 
the  euro  amidst  a  general  flight  to  quality.  As  a 
result,  between  October  2008  and  July  2009,  the 
nominal  effective  exchange  rate  of 
lats 
appreciated  by  approximately  4.5%,  which 
reinforced  the  impact  on  inflation  of  falling 
the 
international 
subsequent 
improvement  of  financial  market 
confidence,  starting  in  mid-2009,  the  nominal 
effective  exchange  rate  of  the  lats  has  been 
depreciating gradually. 

prices.  With 

commodity 

the 

In  Latvia,  increases  in  administered  prices (32) 
(which  account  for  almost  13%  of  the  HICP 
basket) and indirect taxes have noticeably added to 
headline  HICP  inflation  over  the  last  few  years. 
Following EU accession, along with the legislative 
amendments establishing a broader basis for VAT, 
the  excise  tax  rates  on  tobacco  and  fuel  were 
gradually  increased  to  harmonise  the  rates  in 
compliance with the EU legislation.  

rose 
in  2006  and  2007 

The  contribution  to  annual  headline  HICP  from 
from  1½-2 
higher  administered  prices 
percentage  points 
to 
approximately  3  percentage  points  in  2008,  in 
response  to  inter  alia  rising  energy  tariffs  and 
higher public transport fees. In 2009, administered 
prices added about 2 percentage points to headline 
HICP  inflation,  to  a  large  extent  reflecting  rising 
prices  for  public  services,  notably  for  hospital 
services  and  public  transport.  Tariffs  for  gas  and 
heat  energy  were 
in  2009,  partly 
reduced 
mitigating  the  impact  from  rising  administered 
services prices. Given that state financing has been 
reduced  in  the  areas of health  and  social  services, 
no  substantial  decline  in  these  prices  is  to  be 
expected in the near future.  

Changes  in  indirect  taxes  have  exerted  upward 
pressure  on  consumer  price  inflation  in  Latvia 
since  EU  accession.  This  trend  continued  in  2008 
and 2009, when upward adjustments in excise tax 
rates  of  notably 
tobacco  and  alcohol  added 
positively  to  headline  annual  inflation.  In  January 
2009,  the  VAT  rate  on  all  goods  and  services 
increased by 3 percentage points, estimated by the 
Latvian  authorities  to  have  added  roughly  2 
percentage points to annual headline inflation. 

Medium-term prospects 

Inflation  performance  in  2010  will  largely  be 
driven by domestic demand-side factors, including 
notably the outlook for wages and unemployment. 
The  severe  recession,  which  has  led  to  a  rapid 
increase  in  unemployment,  a  fall  in  hours worked 
per  employee  and  to  a  nominal  reduction  of  full-
time  equivalent  gross  wages,  will  be  reflected  in 
further  declining  headline  inflation  in  the  near 
term.  Supply-side 
to  some  degree, 
factors, 
including  world  energy  prices  and  administered 

(32)  For the purpose of this report, administered prices include 
inter alia regulated energy prices, public transport, hospital, 
medical  and  paramedical  services,  refuse  and  sewage 
collection, water supply and postal services. 

76 

 
 
                                                           
prices are likely to restrain deflationary pressures, 
mainly  due  to  base  effects.  The  Commission 
services' Spring 2010 Forecast expects the average 
HICP  inflation  rate  to  fall  to  -3.2%  in  2010, 
compared to 3.3% in 2009.  

The  inflation  outlook  is  associated  with  several 
near-term  risks.  Downside  risks  to  the  inflation 
outlook  are  primarily  linked  to  further  reductions 
in  real  personal  income,  which  would  depress 
to 
further. 
domestic  demand 
developments  in  global  commodity  prices,  upside 
risks  are  associated  with 
the  considerable 
uncertainty  about  the  impact  on  prices  of  further 
potential 
increases  or  higher 
administered  prices,  which  may  be  required  for 
fiscal consolidation purposes.  

addition 

indirect 

tax 

In 

The  level  of  consumer  prices  in  Latvia  stood  at 
almost 70% of the euro area average in 2008. This 
suggests  some  potential  for  further  price  level 
convergence  in  the  long  term,  as  income  levels 
(around  53%  of  the  euro  area  average  in  PPS  in 
2008) rise towards the euro area average.  

Convergence Report 2010 - Technical annex 

Chapter 5 - Latvia 

are 

and 

falling 

encourage 

that  wages 

incomes  and 

The  effects  of 
rising 
unemployment on domestic demand and economic 
activity  at  large  are  likely  to  be  visible  for  yet 
some  time  to  come  and  contribute  to  subdued 
consumer  price  inflation  over  the  medium  term. 
Falling  consumer  prices  facilitate  coping  with 
the 
lower  nominal  wages 
reorientation  of  the  economy  towards  external 
markets.  Such  a  shift  of  the  economy's  structure 
requires 
realigned  with 
productivity, a process that is ongoing. While it is 
still  too  early  to  conclude  that  the  necessary 
realignment  of  wages  and  productivity  has  been 
fully  attained,  some  factors  suggest  a  return  to 
positive inflation over the coming years. First, the 
scope  for  price  and  wage  reduction  in  Latvia,  a 
small  and  open  economy  with  a  high  share  of 
imports  in  consumption,  is  limited  by  the  free 
movement  of  goods  and  labour  within  the  Single 
Market.  Outward  migration  has  intensified,  partly 
limiting  a  further  rise  in  the  unemployment  rate. 
Looking  ahead,  the  number  of  people  working 
abroad  could  rise  further,  especially  once  the 
economic  situation  in  the  EU  recovers.  At  some 
point,  outward  migration  would  contribute  to 
upward  wage  pressures.  Second,  surveys  of 
inflation  expectations  suggest  that  the  ongoing 
consumer  price  deflation  in  Latvia  could  be 
relatively short-lived. 

77 

 
European Commission 

Convergence Report 2010 

5.3.  GOVERNMENT BUDGETARY POSITION 

5.3.1.  The  excessive  deficit  procedure 

for 

Latvia (33) 

the 

time, 

same 

Council 

In  July  2009,  the  Council  adopted  a  decision 
stating  that  Latvia  had  an  excessive  deficit,  based 
on  a  notified  deficit  of  4.0%  of  GDP  in  2008.  At 
the 
issued 
recommendations  to  correct  the  excessive  deficit 
by  2012  and  established  a  deadline  of  7  January 
2010 for effective action to be taken. The Council 
recommended  Latvia  to  ensure  an  average  annual 
fiscal  effort  of  at  least  2¾%  of  GDP  over  the 
period  2010-2012,  strengthen  fiscal  governance 
and  transparency  (improvement  of  the  budgetary 
framework,  reinforcement  of  the  Ministry  of 
Finance's  spending  controls),  as  well  as  financial 
market regulation and supervision. On the basis of 
a  Commission  Communication, 
the  Council 
concluded  on  16  February  2010  that  Latvia  had 
taken  action 
representing  adequate  progress 
towards  the  correction  of  the  excessive  deficit 
within  the  time  limits  set  by  the  Council.  The 
procedure is therefore held in abeyance.  

The  Commission  continues  to  closely  monitor 
budgetary  developments  in  Latvia  in  accordance 
with  the  Treaty  and  the  SGP,  and  the  criteria  set 
out  in  the  context  of  the  medium-term  financial 
assistance from the EU. The conditions attached to 
this  assistance  are  consistent  with  the  Council 
recommendations under the EDP. 

5.3.2.  Developments 2004-2009 

The  general  government  balance,  after  recording 
limited  deficits  (not  exceeding  1%  of  GDP)  over 
the period 2004-2007, deteriorated dramatically in 
2008 and the first half of 2009. This deterioration 
paralleled  the  reversal  of  the  earlier  boom  led  by 
domestic  demand  and  property  inflation  and  the 
shift  into  severe  recession  as  Latvia's  economic 
and financial crisis deepened, leading to an appeal 
in  late  2008  for  international  financial  assistance. 
The deficit is now estimated to have reached 4.1% 
of  GDP  in  2008  and  9.0%  in  2009.  The  revenue 
fell 
ratio  peaked 
significantly  in  the  two  following  years,  as  tax 
bases were eroded by the economic downturn even 

in  2006  at  37.7%,  but 

(33)  All documents related to the excessive deficit procedure for 
Latvia 
at: 
be 
http://ec.europa.eu/economy_finance/sgp/deficit/countries/l
atvia_en.htm 

found 

can 

78 

expenditure 

conditions).  The 

more  rapidly  than  nominal  income.  The  ratio 
dropped  to  34%  of  GDP  in  2009,  despite  higher 
non-tax revenues (less directly linked to short-term 
cyclical 
ratio 
increased  sharply  in  2008  and  2009,  as  the 
economy  moved  into  a  severe  contraction  and,  to 
mid-2009, expenditure also increased in real terms 
(notably, there were very large pension increases at 
end-2008). In 2009 the ratio reached 43%, despite 
the  impact  of  June  2009  consolidation  measures  - 
almost fully on the expenditure side - amounting to 
4.4% of GDP.  

The impact of the crisis has been massive. In 2009 
tax revenues collapsed, falling in nominal terms by 
one quarter compared to 2008. On the expenditure 
side,  the  limited  automatic  stabilisers  resulted  in 
additional  spending  in  comparison  with  2008  of 
around  1%  of  GDP.  Discretionary  measures 
included current expenditure cuts amounting to 4% 
of  GDP  and  those  regarding  fixed  investment  to 
2%  of  GDP.  Despite  their  extent,  these  cuts  were 
outweighed  by  revenue  losses  and  higher  interest 
payments, and by a huge denominator effect due to 
the  collapse  of  GDP.  The  extent  of  the  toll  the 
crisis  took  on  Latvian  public  finances  explains 
why the 2009 outcome was so far from the original 
official  deficit  target  of  5.3%  set  in  the  January 
2009  convergence  programme.  The  unexpected 
severity  of  the  downturn  led  international  lenders 
to agree with the Latvian authorities in June 2009 
on a revised medium-term fiscal adjustment path. 

the 

The  structural  balance  (i.e.  the  cyclically-adjusted 
balance  net  of  one-off  and  other 
temporary 
measures)  worsened  progressively  throughout  the 
period  2004-2009,  reflecting  essentially  the  pro-
cyclical  fiscal  stance  during  the  boom  years 
preceding 
(slight) 
crisis.  The 
deterioration  of  the  structural  balance  recorded  in 
2009 should be viewed taking into account that the 
exceptionally volatile economic environment from 
2008  may 
to  standard  elasticities  not 
sufficiently  capturing  the  impact  of  the  extreme 
downturn;  the  primary  structural  fiscal  balance  in 
2009 improved by 0.5% of GDP.  

further 

lead 

Fiscal  policy  has  a  prominent  stabilisation  role  to 
play  in  Latvia,  given  the  limited  scope  for 
monetary policy to stabilise the economy under the 
fixed  exchange  rate  regime.  Given  Latvia's  pro-
cyclical fiscal stance in the overheating period, its 
MTO  of  a  1%  structural  deficit  was  never 
achieved.  An 
the  structural 
balance could have proved feasible, despite catch-

improvement 

in 

 
                                                           
Convergence Report 2010 - Technical annex 

Chapter 5 - Latvia 

2006

2007

2008

2009

2010

2011

(as % of GDP unless indicated otherwise)

Table 5.3.1:

Latvia - Budgetary developments and projections
Outturn and forecast 1)

2004

2005

General government balance

- Total revenues

- Total expenditure

of which: 
- interest expenditure

- current primary expenditure

- gross fixed capital formation

p.m.: Tax burden

Primary balance

Cyclically-adjusted balance

One-off and temporary measures
Structural balance 2)
Structural primary balance

Government gross debt

p.m: Real GDP growth (%)

p.m: Output gap

p.m: GDP deflator (% change)

Convergence programme
General government balance

Primary balance
Structural balance 2) 3)
Government gross debt

p.m. Real GDP (% change)

-1.0

34.7

35.8

0.7

30.8

3.1

28.5

-0.3

-1.3

0.0
-1.3

-0.6

14.9

8.7

1.0

7.0

-0.4

35.1

35.5

0.5

30.0

3.1

29.0

0.1

-1.5

0.0
-1.5

-1.0

12.4

10.6

4.1

10.2

-0.5

37.7

38.1

0.4

30.6

4.6

30.4

0.0

-3.2

0.0
-3.2

-2.7

10.7

12.2

9.7

9.9

-0.3

35.4

35.7

0.3

28.6

5.7

30.5

0.0

-4.5

0.0
-4.5

-4.2

9.0

10.0

15.3

20.3

-4.1

34.4

38.6

0.6

32.4

4.8

28.9

-3.5

-6.4

0.0
-6.4

-5.8

19.5

-4.6

8.3

15.4

2008
-4.1

-3.4

-6.7

19.5

-4.6

-9.0

34.0

43.0

1.6

36.4

3.9

26.3

-7.4

-6.3

0.6
-6.9

-5.3

36.1

-18.0

-9.8

-0.7

2009
-10.0

-8.7

-7.6

34.8

-18.0

-8.6

36.2

44.8

2.4

37.4

4.1

26.3

-6.2

-5.7

1.0
-6.7

-4.3

48.5

-3.5

-10.7

-6.3

2010
-8.5

-6.1

-5.5

55.1

-4.0

-9.9

34.5

44.4

2.9

36.6

4.0

25.9

-6.9

-8.3

0.7
-9.0

-6.1

57.3

3.3

-5.6

-1.0

2011
-6.0

-2.7

-3.9

59.1

2.0

1) Commission services’ Spring 2010 Forecast.

2) Cyclically-adjusted balance excluding one-off and other temporary measures.

3) Commission services’ calculations on the basis of the information in the programme. 

There are no one-off and other temporary measures in the programme.

Sources: Commission services and January 2010 update of Latvia's Convergence Programme.

2012
-2.9

0.3

-1.8

56.8

3.8

2013
n.a.

n.a.

n.a.

n.a.

n.a.

the  boom  phase, 

up needs, if public wage increases had been more 
firmly controlled and public investment prioritised. 
During 
fiscal  policy  and 
budgetary  process  clearly  lacked  a  firm  multi-
annual  anchor,  particularly  for  expenditure  that 
was increased in tandem with windfall revenues in 
numerous  supplementary  budgets.  Consequently, 
rapid  economic  growth  was  not  appropriately 
exploited to design sounder fiscal policies.  

Given increased deficits, recent debt developments 
also  show  a  rapid  increase,  although  from  a  very 
low  starting  base.  The  debt  ratio  reached  36%  of 
GDP in 2009, compared with only 9% in 2007. An 
additional  factor  augmenting  the  debt  ratio  has 
been recent financial injections of around 1½% of 
GDP  linked  to  the  effective  nationalisation  of 
Parex  Bank,  and  a  far  smaller  injection  into  the 
already publicly-owned Mortgage and Land Bank. 
Moreover, 
support  and  guarantees 
provided  to  Parex  total  almost  8%  of  GDP. 
International  financial  assistance,  provided  under 
favourable  interest  rate  conditions,  is  available  to 

liquidity 

Latvia in the form of a coordinated package of up 
to EUR 7.5 billion over the period to end-2011 and 
policy 
is 
Council 
conditionality 
recommendations. (34)  

comprehensive 

accompanied 

with 

line 

by 

in 

5.3.3.  Medium-term prospects 

is  planned 

to  remain  severely 
Fiscal  policy 
restrictive  in  the  medium-term,  given  the  absence 
of  room  for  fiscal  manoeuvre  and  the  need  to 
correct economic imbalances, in line with the exit 
strategy  advocated  by  the  Council  for  Latvia, 
anchored  on  correcting  the  excessive  deficit  by 
2012.  The  2010  State  budget  adopted  by 
Parliament  on  1  December  2009  entails  a  further 
discretionary  consolidation  effort  amounting  to 
over  4.2%  of  GDP,  as  set  in  the  context  of  the 

(34)  Contributions  from  the  EU,  either  multilaterally  under  the 
EU Balance of Payment facility (€3.1 billion) or bilaterally 
from several EU Member States, total €5.3 billion, with the 
remaining part provided by the IMF (around €1.7 billion), 
the  World  Bank  (€400  million)  and  the  EBRD  (€100 
million). 

79 

 
                                                           
 
 
 
 
European Commission 

Convergence Report 2010 

level 

income 

the  balance 

balance of payments assistance and endorsed in the 
Council Recommendation to Latvia of 7 July 2009. 
The  consolidation  is  distributed  fairly  evenly 
between  expenditure  and  revenue.  Among  the 
revenue  measures  are  the  increase  of  the  personal 
income  tax  rate,  various  reforms  that  make  the 
tax  and  social  contribution 
personal 
systems  more  neutral,  as  well  as  additional 
taxation  of  real  estate,  progressive  taxation  of  car 
usage,  and  increased  excise  duties  on  gas  and 
tobacco.  On  the  expenditure  side,  the  2010  State 
budget  introduced  significant  expenditure  cuts 
based to a large extent on structural reforms, while 
at  general  government 
is 
expected  to  benefit  from  wage  cuts  in  local 
government  and  targeted  reductions  of  various 
social allowances. There is no significant recourse 
to  one-off  measures (35).  Despite  the  very  large 
consolidation  effort  associated  with  the  2010 
budget,  the  forecast  2010  deficit  is  slightly  above 
the  previously  agreed  ceiling  of  8.5%  of  GDP 
recommended  by  the  Council,  reflecting  some 
weakness 
the 
Commission  services'  calculations,  the  structural 
balance  is  expected  to  improve  by  only  0.2%. 
However,  current  estimates  of  structural  balances 
need  to  be  interpreted  with  great  caution,  given 
significant  uncertainties  around  potential  growth 
and output gap estimates and that the exceptionally 
volatile  economic  environment  may 
to 
standard  elasticities  not  sufficiently  capturing  the 
impact  on  the  budget  of  the  extreme  downturn 
experienced by Latvia.   

revenues.  According 

lead 

in 

to 

The  deficit  for  2011,  on  the  assumption  of 
unchanged  policy,  would  reach  9.9%  of  GDP, 
notably  due  to  increased  interest  payments,  lower 
non-tax revenues and particularly lower dividends 
(assuming  current  high  pay-out 
ratios  will 
normalise),  and 
increased  second-pillar  social 
contributions (provided the authorities follow their 
initial timetable in that regard).  

The  fiscal  path  presented  by  the  authorities  in  the 
2010  convergence  programme,  submitted  last  29 
January  and  assessed  as  broadly  plausible,   
matches that recommended by the Council to aim 
for a deficit below 6% of GDP in 2011 and achieve 
the  correction  of  the  excessive  deficit  by  2012  at 
the  latest.  The  Latvian  authorities  have  already 
outlined several additional fiscal steps, including a 
broad  review  of  social  insurance  benefits  and 

(35)  The increase in table 5.3 is due to the fact that the decrease 
of second-pillar social contributions, decided last year, did 
not have a full year impact in 2009. 

80 

further 
the  profile  of 

pension  systems,  the  goal  being  to  preserve  their 
future  sustainability  and  adequacy.  Although 
general  government  gross  debt  (36%  of  GDP  in 
2009)  still  remains  well  below  the  60%  of  GDP 
reference value,  it  is  projected  to  increase sharply 
financial  sector 
and,  depending  on 
international 
interventions  and 
financial  assistance,  could  exceed  this  reference 
value.  According  to  the  Commission  services' 
recalculation of the structural balance according to 
the  commonly  agreed  methodology,  the  medium-
term  budgetary  objective  (MTO)  of  a  structural 
deficit of 1% of GDP will not be achieved within 
the  programme  period.  In  view  of  the  new 
methodology and given the most recent projections 
and debt level, the MTO itself nevertheless reflects 
the objectives of the Stability and Growth Pact.  

Overall,  the  budgetary  strategy  set  out  for  the 
coming years in the 2010 convergence programme 
has  been  assessed  as  consistent  with  the  Council 
recommendations  under  Art.  104(7)  TEC  and  the 
deficit  targets  set  in  the  framework  of  balance  of 
payments  assistance.  This  reflects  the  authorities' 
ambition to comply with the Maastricht criteria in 
2012  and  join  the  euro  area  by  2014.  There  is  a 
risk  of  budgetary  outcomes  worse  than  planned 
given the amount of remaining fiscal adjustment to 
be undertaken and not yet backed by fully-defined 
measures.  Although  this  risk  is  counter-balanced 
by  the  binding  commitments  given  under  the 
international  financial  assistance  agreements  and 
the authorities' record to date in meeting these, this 
reinforces  the  need  to  improve  the  budgetary 
framework,  as  planned  in  the  course  of  2010. 
Latvia  has  consequently  been  invited  to  fully 
implement  the  2010  budget,  prepare  a  menu  of 
options allowing the adoption of a 2011 budget in 
accordance  with  the  consolidation  needs,  and 
adopt later a 2012 budget also complying with the 
targeted fiscal path; Latvia has also been invited to 
carry  out 
to 
implement a social benefits reform in the course of 
2011,  and  to  improve  fiscal  governance  notably 
thanks  to  an  appropriate  fiscal  discipline  law,  a 
binding  medium-term  budgetary  framework,  and 
strengthened  mechanisms 
the  grey 
economy; economic growth should be fostered by 
ensuring  that  the  available  EU  structural  funds 
reach the real economy.  

thorough  analysis  needed 

tackle 

the 

to 

The long-term budgetary impact of ageing is lower 
than  the  EU  average.  However,  the  budgetary 
position  in  2009,  as  estimated  in  the  programme, 
compounds  the  budgetary  impact  of  population 

 
                                                           
Convergence Report 2010 - Technical annex 

Chapter 5 - Latvia 

ageing  on  the  sustainability  gap.  Reducing  the 
primary  deficit  over  the  medium  term  would 
contribute to reducing the risks to the sustainability 
of  public  finances,  which  were  assessed  in  the 
Commission 2009 Sustainability Report as high. 

81 

 
European Commission 

Convergence Report 2010 

5.4. 

EXCHANGE RATE STABILITY 

The  Latvian  lats  entered  ERM  II  on  2  May  2005, 
i.e. it had spent more than five years in ERM II at 
the time of the adoption of this report. The central 
rate was set at the parity at which the lats had been 
re-pegged from the SDR to the euro on 1 January 
2005 (LVL 0.702804 per EUR 1), with a standard 
fluctuation band of ±15%. Upon ERM II entry, the 
authorities  unilaterally  committed  to  maintain  a 
tighter  fluctuation  margin  of  ±1%  around  the 
central  rate.  During  the  two  years  preceding  this 
assessment,  the  official  EUR/LVL  exchange  rate 
did  not  deviate  from  its  central  rate  by  more  than 
±1%, in line with the Latvian authorities' unilateral 
commitment, but the EUR/LVL exchange rate was 
nevertheless subject to episodes of severe tensions, 
as 
the  evolution  of  additional 
indicators. 

reflected 

in 

Graph 5.4.1: LVL - Spread vs central rate

 (as percent, daily v alues)

1.5

1.0

0.5

0.0

-0.5

-1.0

-1.5

Apr-05

Apr-06

Apr-07

Apr-08

Apr-09

Apr-10

Source: Commission services, ECB and EcoWin.

Following  a  volatile  2007,  when  occasional 
rumours about an upcoming devaluation of the lats 
triggered  sudden  but  temporary  depreciations  vis-
à-vis  the  euro,  2008  saw  sustained  weakening 
pressures on the lats within the narrow fluctuation 
margins.  The  lats  came  under  heavy  pressures  in 
autumn 2008 when, against a background of large 
and  increasing  macro-imbalances,  markets  grew 
increasingly  concerned  over  the  sustainability  of 
the peg and the likelihood that contingent financial 
sector liabilities would have to be absorbed by the 
government.  Latvia  was  downgraded  by  rating 
agencies,  Eurobond  and  CDS  spreads  increased 
substantially,  interbank  market  rates  rose,  and 
capital outflows from the banking system surged.  

Faced with growing liquidity strains in the banking 
system  the  Bank  of  Latvia  (BoL)  responded  by 
providing  liquidity,  part  of  which  came  from 
requirements. 
lowering  minimum 

reserve 

82 

However,  the  authorities'  initial  responses  to 
stabilise  a  large  domestic  bank  failed  to  stem  the 
capital  outflows  and  the  BoL  was  forced  to  sell 
roughly one-quarter of its international reserves in 
currency exchanges by the year-end. Subsequent to 
the  agreement  in  late  December  2008  to  provide 
Latvia with a coordinated package of international 
financial  assistance,  totalling  up  to  €7.5  billion 
over 
financial  market 
to  2011, 
conditions improved in January 2009 and pressures 
on  the  exchange  rate  eased  and  interbank  market 
rates declined.  

the  period 

Graph 5.4.2: Exchange rates - LVL/EUR
(monthly av erages)

0.8

0.7

0.6

0.5

ERM II

2004

2005

2006

2007

2008

2009

Source: ECB and EcoWin.

instability,  a 

The  exchange  rate  peg  came  under  renewed 
pressure  in  the  first  half  of  2009  amid  waves  of 
political 
sharply  deteriorating 
economic outlook and contracting credit. Tensions 
culminated  in  June  when  short-term  interbank 
market  rates  temporarily  rose  to  above  30%, 
reflecting the system-wide lat liquidity shortage, a 
general  loss  of  confidence  among  banks  in  the 
financial soundness of competitor banks, as well as 
mounting  uncertainty  about 
the  authorities' 
capacity  to  sustain  the  exchange  rate  regime. 
While  the  peg  was  successfully  defended,  gross 
foreign  assets  were  depleted  by  more  than  one-
third  between  end-February  and  end-June  as 
capital  outflows  from  the  banking  system  (largely 
associated  with  loan  repayments  to  foreign  parent 
banks, repayments of syndicated loans by domestic 
outflows) 
banks 
continued unabated, keeping the lats in the weaker 
half  of  the  fluctuation  band.  Only  after  the 
European  Council's  support  of 
the  Latvian 
authorities' supplementary budget in mid-June and, 
in  particular,  following  the  disbursement  of  the 
EU's  second  loan  tranche  in  July  (as  part  of  the 
international  loan  package)  did  financial  market 
conditions  improve  visibly.  The  lats  strengthened 
vis-à-vis  the  euro  and  interventions  in  the  foreign 

non-resident 

deposit 

and 

 
 
    
 
exchange  market  in  support  of  the  lats  became 
redundant.  

alia 

inter 

reflecting 

In  the  second  half  of  2009  and  up  to  the  cut-off 
date of this report, pressures on the exchange rate 
were  largely  absent  and  international  reserves 
gradually 
stabilised, 
moderating  capital  outflows  from  the  banking 
sector,  stabilising  non-resident  deposit  flows  and 
the  sharp  reversal  of  the  current  account  into 
the  significant 
surplus.  Helped  notably  by 
disbursements  from  the  international  assistance 
package,  the  liquidity  situation  in  the  banking 
system improved while investor concerns linked to 
a  change  in  the  exchange  rate  regime  eased. 
Notwithstanding  some  volatility  in  October  2009, 
mainly  related  to  uncertainties  about  the  2010 
budget 
economic 
stabilisation,  renewed  commitments  from  foreign 
banks  to  maintain  overall  exposure  to  Latvia,  and 
the  approval  in  December  2009  of  a  strong  2010 
budget  strengthened  confidence  and 
reduced 
financial  market 
further.  Credit  rating 
agencies subsequently revised the country outlook 
from negative to stable. 

negotiations, 

signs 

risks 

of 

Graph 5.4.3: Latvia - 3-M Rigibor spread to 3-M Euribor

 (basis points, monthly v alues)

2000

1500

1000

500

0

2004

2005

2006

2007

2008

2009

Source: Eurostat.

Convergence Report 2010 - Technical annex 

Chapter 5 - Latvia 

Reflecting  these  developments,  interbank  market 
interest rates and yields on Treasury bills declined 
substantially  while  bid-ask  spreads  and  CDS 
spreads  narrowed.  On  23  April  2010,  the  3M 
interbank  interest  rate  spread  between  RIGIBOR 
and  EURIBOR  had  fallen  to  around  140  basis 
points,  substantially  lower  than  its  peak  of  20 
percentage  points  in  June  2009.  While  the  lats 
continuously  traded  on  the  weaker  side  of  its 
central  rate  vis-à-vis  the  euro  towards  the  end  of 
2009  and  onwards,  reflecting  the  gradual  fall  in 
short-term  interest  rates  and  the  growing  excess 
liquidity in the banking system, the Bank of Latvia 
intervened  only  in  very  limited  amounts  in  the 
foreign  exchange  market  to  support  the  lats. 
Boosted by international assistance inflows, at the 
end  of  March  2010,  the  reserve  coverage  ratio 
stood above 260% of the monetary base. 

83 

 
 
 
in  2004, 

Following  EU  accession 
long-term 
interest  spreads  vis-à-vis  the  euro  area  initially 
declined,  and  even  became  negative  in  the  spring 
of 2006 before trending upward. In the second half 
of  2008  and  in  2009,  Latvia's  long-term  interest 
rate rose markedly and the spread to the euro area 
widened considerably, reacting to adverse changes 
in  sentiment  among  investors  and  rating  agencies 
towards  the  country  amid  the  economic  and 
financial  crisis.  The 
rate 
differential  peaked  at  above  10  percentage  points 
in  November  2009,  reflecting  sharply  rising  risk 
premia  (including  for  exchange  rate  risk,  credit 
risk  and  liquidity  risk)  and  subsiding  demand  for 
LVL-denominated 
rising 
the  exchange  rate  regime. 
uncertainty  about 
Thereafter,  as  signs  of  economic  stabilisation 
became  visible,  market  conditions  improved  and 
inflation  expectations  eased  the  yield  differential 
narrowed somewhat and stood around 7 percentage 
points in March 2010. 

long-term 

securities 

interest 

amid 

European Commission 

Convergence Report 2010 

5.5. 

LONG-TERM INTEREST RATE 

For  Latvia,  the  development  of  long-term  interest 
rates  over  the  reference  period  (April  2009  to 
March 2010) is assessed on the basis of secondary 
market  yields  on  a  single  benchmark  bond  with  a 
maturity of close to, but above, 9 years. 

Graph 5.5.1: Latvia - Long-term interest rate criterion

 (percent, 12-month mov ing av erage)

14

12

10

8

6

4

2

0
Jan-04

Jan-05

Jan-06

Jan-07

Jan-08

Jan-09

Jan-10

Latvia

Reference value

Source: Commission services.

The  Latvian  12-month  moving  average  long-term 
interest  rate  relevant  for  the  assessment  of  the 
Treaty  criterion  rose  above  the  reference  value  in 
December  2008  and  the  difference  vis-à-vis  the 
reference  value  has  increased  continuously  since 
then. In March 2010 the reference value, given by 
the average of long-term interest rates in Portugal 
and  Belgium  plus  2  percentage  points,  stood  at 
6.0%.  In  that  month,  the  twelve-month  moving 
average  of  the  yield  on  the  Latvian  benchmark 
bond  stood  at  12.7%,  i.e.  more  than  6  percentage 
points above the reference value.  

Graph 5.5.2: Latvia - Long-term interest rates

 (percent, monthly v alues)

16

14

12

10

8

6

4

2

0

2004

2005

2006

2007

2008

2009

Latvia

Euro  area

Source: Eurostat.

84 

 
 
 
5.6.  ADDITIONAL FACTORS 

5.6.1.  Developments  of 

the  balance  of 

payments 

In  the  pre-crisis  years,  the  booming  economy  led 
to  marked  widening  of  deficits  on  the  external 
balance  (i.e.  the  combined  current  and  capital 
account), to above 20% of GDP in both 2006 and 
2007. The shortfall in merchandise trade accounted 
for  the  largest  part  of  the  deficits  but  also  the 
balance  on  income  weakened  gradually,  partly 
reflecting  sizeable  reinvested  earnings  by  foreign 
companies  (underlining  the  profitability  of  past 
foreign direct investment).  

In  the  course  of  2008,  the  Latvian  economy 
adjusted  rapidly  to  the  recession  that  hit  the 
country. The overall external balance turned into a 
sizeable  surplus  in  2009,  almost  12%  of  GDP, 
reflecting a sudden stop of capital flows following 
the  international  financial  crisis  and  marking  a 
swift turnaround compared to the situation of only 
a  year  earlier,  when  the  external  balance  still 
showed  a  double-digit  deficit.  This  remarkable 
shift  was  the  result  of  a  combination  of  factors, 
including  an  improvement  in  the  trade  balance, 
mainly due to a fall in imports that was much more 
rapid than that of exports (merchandise exports fell 
sharply  but  exports  of  services  developed  more 
income 
favourably),  positive  figures  on 
account  resulting  from  losses  of  foreign  investors 
(in particular in the banking sector, including loan 
loss provisions) and advanced payments by the EU 
structural  funds.  The  balance  on  the  capital 
account  remained  in  surplus,  reflecting  almost 
exclusively EU funding for capital investment. 

the 

large 

the  concurrent 

In  comparison  to  most  other  new  Member  States, 
Latvia  experienced  a  very  strong  catch-up  related 
investment  and  consumption  boom  in  pre-crisis 
years,  with 
savings-
investment  gap  reflecting  both  substantial  capital 
inflows  and  decreasing  national  savings  in  2006 
and  2007.  Since  then,  faced  with  scarce  credit, 
limited  business  opportunities  and  a  debt 
overhang, the private sector sharply increased their 
saving which more than compensated for the rising 
deficit in the government sector.  

Convergence Report 2010 - Technical annex 

Chapter 5 - Latvia 

Graph 5.6.1: Latvia - Saving and investment
(in percent of GDP at market prices)

50

40

30

20

10

0

2004

2005
Gro ss natio nal saving

2006

2007

2008

2009

Gro ss capital fo rmatio n at current prices; to tal eco no my

Source: Eurostat, Commission services.

of 

several 

Following 
deterioration, 
years 
competitiveness  indicators  began  to  improve  in 
2009 supported by disinflation and wage cuts. The 
real  effective  exchange  rate,  measured  both  by 
consumer  prices  (HICP)  and  unit  labour  costs 
(ULC),  showed  little  improvement  until  late  2008 
or early 2009 when the effects of the measures to 
scale  down  public  sector  wages  and  the  huge 
adjustment of the labour market gradually became 
visible. Both the HICP-adjusted and ULC-adjusted 
real effective exchange rates peaked by early 2009 
and  recent  developments  suggest  a  gradual  but 
in  price  and  cost 
accelerating 
competitiveness, 
the  ULC-
adjusted measure.  

in  particular  for 

improvement 

and 

years 

Wages,  consumer  price  inflation  and  unit  labour 
costs  are  projected  to  develop  favourably  in 
comparison to major trading partners over the next 
external 
further 
two 
competitiveness.  Exports  have  picked  up  in  the 
largest  product  groups  and  market  shares  in  some 
foreign  markets 
in  Latvia's  neighbourhood 
rebounded in 2009, in particular in markets where 
national  currencies  depreciated  strongly  towards 
the end of 2008. 

support 

Graph 5.6.2: Latvia - Effective exchange rates

 (v s. 35 trading partners;  monthly av erages;

  index numbers, 2004 = 100)

200

180

160

140

120

100

80

2004

2005

2006

2007

2008

2009

NEER

REER, HICP d eflated

REER, ULC d eflated

Source: Commission services.

In  the  years  preceding  the  international  financial 
crisis, the financing of the external deficits mainly 

85 

 
 
 
European Commission 

Convergence Report 2010 

Table 5.6.1:

Latvia - Balance of payments

Current account

Of which: Balance of trade in goods

                 Balance of trade in services

                 Income balance 

                 Balance of current transfers

Capital account
External balance 1)
Financial account

Of which: Net FDI

                Net portfolio inflows
                Net other inflows 2)
                Of which International financial assistance

                Change in reserves (+ is a decrease)

Financial account without reserves

Errors and omissions

Gross capital formation

Gross saving

External debt

International investment position

2004

-12.9

-20.2

4.4

-2.0

5.0

1.1

-11.8

11.6

3.8

1.6

9.1

-2.9

14.5

0.2

33.0

20.2

93.3

-49.4

1) The combined current and capital account.

2) Including financial derivatives.

Sources: Eurostat, Commission services and Bank of Latvia.

reflected  strong  inflows  of  other  investment, 
largely linked to intra-group bank funding and the 
growth in non-resident deposits. In both 2006 and 
2007,  net  other  investment  inflows  accounted  for 
more than 20% of GDP.  

When  the  international  financial  turmoil  escalated 
in  the  second  half  of  2008,  the  banking  system’s 
heavy  reliance  on  foreign  funding  in  combination 
with  years  of  unsustainably  high  credit  growth 
(largely  directed  to  non-tradables  such  as  real 
estate)  and  large  current  account  deficits  raised 
concerns  about  the  health  of  the  financial  system, 
the  exchange  rate  regime  and  external  debt 
sustainability. The global liquidity crisis prevented 
the  private  and  public  sectors  from  accessing 
international private capital markets and obtaining 
the  foreign  currency  needed  to  ease  the  mounting 
liquidity  strains  in  the  banking  system.  In  late 
2008,  the  Latvian  authorities  made  a  request  for 
EU  medium-term  financial  assistance  under  the 
Balance  of  Payment  facility  for  non-euro  area 
countries and for a Stand-By Arrangement with the 
IMF,  as  part  of  a  coordinated  package  of 
international financial assistance and accompanied 
by  comprehensive  policy  conditionality  so  as  to 
fiscal 
restore  balance-of-payments  viability, 

86 

(percentage of GDP)

2005

-12.5

-18.9

3.8

-1.1

3.7

1.3

-11.2

13.1

3.6

-0.8

13.5

-3.3

16.3

-1.9

34.4

21.9

99.4

-58.7

2006

-22.5

-25.6

3.3

-2.7

2.4

1.2

-21.3

20.6

7.5

0.2

22.9

-9.9

30.5

0.6

39.7

17.2

114.0

-69.0

2007

-22.3

-23.9

3.5

-3.2

1.3

2.0

-20.4

21.2

6.8

-2.3

20.1

-3.4

24.6

-0.8

40.4

17.9

127.6

-74.2

2008

-13.0

-17.6

4.0

-1.6

2.2

1.5

-11.5

13.3

3.0

1.1

7.3

4.1

1.9

11.4

-1.8

31.5

18.5

128.5

-78.1

2009

9.4

-6.5

6.2

6.4

3.3

2.4

11.8

-12.6

0.4

1.5

-9.5

12.3

-4.9

-7.7

0.8

19.0

27.6

154.7

-81.6

sustainability and economic growth. So far, Latvia 
has received EUR 2.7 billion of loans from the EU 
under the Balance of Payment facility.  

in 

sector 

Latvia's  financial  account  balance  turned  negative 
in  the  first  half  of  2009  as  private  sector  capital 
flows  reversed  abruptly.  For  the  year  as  a  whole 
the  financial  account  deficit  amounted  to  close  to 
13%  of  GDP,  largely  driven  by  a  reversal  in  the 
balance  of  other  investment  that  turned  sharply 
negative  for  the  first  time  since  2003.  This 
deterioration  reflected  decreasing  foreign  debt 
obligations 
(largely 
the  banking 
associated  with  loan  repayments  to  foreign  parent 
banks, repayments of syndicated loans by domestic 
banks  and  non-resident  deposit  outflows)  as  well 
as  an  increase  in  resident  deposits  abroad.  More 
recently, 
have 
moderated including a stabilisation of non-resident 
deposit  outflows.  At  less  than  0.5%  of  GDP,  net 
foreign  direct  investment  (FDI)  flows  remained 
positive  in  2009,  but  considerably  lower  than  the 
peak levels in 2006 and 2007. The bulk of inward 
FDI in 2009 reflected investment in equity capital 
and  other  capital,  i.e.  recapitalisations  of  foreign-
affiliated  banks,  which  was  large  enough  to 

financial 

outflows 

account 

 
 
 
 
 
outweigh  outward  FDI,  mainly  associated  with 
losses of foreign-owned companies. 

The  deterioration  in  the  external  balance  sheet 
positions  in  the  pre-crisis  years  notably  mirrored 
trends  in  the  private  sector.  In  recent  years, 
however, it is mainly public debt that underlies the 
rising  level  of  gross  debt,  reflecting  large  fiscal 
deficits. Overall, total gross external debt has been 
on a rapidly increasing trend for the last decade. It 
reached almost 155% of GDP in 2009 and is likely 
to  rise  further  in  2010  mainly  due  to  government 
budget  deficits.  Due 
substantial  equity 
liabilities, the net international investment position 
is likely to remain negative over the medium term. 
However,  the  pace  of  the  decline  in  inflation  and 
underlying  domestic  drivers  (such  as  ULC) 
suggests  a  relatively  flexible  price  formation 
process  that  should  help  unwind  past  imbalances 
and  future  current  account  surpluses  should 
gradually reduce Latvia's external vulnerabilities. 

to 

by 

(such 

factors 

external 

The  outlook  for  the  balance  of  payments  is 
as 
influenced 
developments in  global  commodity  prices  and  the 
strength  of  external  demand),  but  also  crucially 
depends  on  prospects  to  improve  the  competitive 
position  and  attract  investment  to  the  tradable 
sector. The external balance is projected to remain 
in  surplus  over  the  forecast  period,  reflecting 
sustained 
transfers  from  EU  funds,  subdued 
imports and further losses of foreign banks due to 
the  prolonged  weakness  in  the  economy.  Future 
growth needs to come from the tradable sector but 
Latvia's  capital  stock  remains  heavily  skewed 
towards non-tradables, such as real estate. Even if 
there  has  been  a  long-term  trend  of  rising  world 
export market shares and  significant improvement 
has  taken  place  in  the  product  composition  of 
exports,  the  export  structure  is  still  heavily  tilted 
towards  low-to-medium  tech  and  labour  intensive 
traditional  industries.  Going  forward,  the  main 
challenges  for  Latvia  will  be  to  attract  new 
investment, in particular in the tradable sector, also 
by  fully  taking  advantage  of  the  EU  structural 
funds  available  to  it,  and  raise  productivity  levels 
which  are  still  much  lower  than  in  the  more 
competitive EU countries. 

Convergence Report 2010 - Technical annex 

Chapter 5 - Latvia 

trade  with  the  EU-27,  in  particular  with  the  other 
new Member States. The strong economic  growth 
in  the  CIS  economies,  with  which  Latvia  has 
traditionally strong trade links, was also a positive 
factor.  However,  the  degree  of  trade  openness 
remains  lower  than  that  of  Estonia  and  Lithuania, 
suggesting  that  there  is  scope  for  further  trade 
growth.  There  was  a  temporary  reduction  in 
Latvia's  trade  openness  in  2007,  as  a  result  of 
buoyant  domestic  consumption.  After  the  severe 
economic  recession  in  2008-2009,  which  led  to  a 
sharp drop in both imports and exports, the degree 
of openness is expected to increase again.  

Over  the  period  under  review,  Latvia's  trade 
integration  increased  most  with  the  neighbouring 
Baltic  countries  but  with  the  rest  of  the  EU-27 
countries  as  well,  such  as  Germany,  Sweden  and 
the United Kingdom. Trade also increased with the 
CIS  countries,  in  particular  Russia,  where  robust 
economic  growth  was  a  major  driver  of  the 
stronger  demand.  The  orientation  of  Latvia's 
foreign  trade  is  mostly  towards  the  EU-27.  In 
2008, Lithuania and Estonia followed by Germany 
were  Latvia's  most  important  trading  partners  on 
the export side. On the import side, Germany was 
the most important trading partner, in particular for 
the  acquisition  of  technologies  and  capital  goods, 
followed  by  Russia  as  a  main  energy  supplier  of 
oil and natural gas.  

for 

textiles 

advantage 

the  composition  of  Latvia's 
As  mentioned, 
exported  goods  by  product  category  reveals  a 
comparative 
raw  materials 
(particularly  wood)  and  labour-intensive  products. 
However,  the  shares  of  these  two  segments  have 
shrunk.  The  wood  and 
industries, 
traditionally  the  most  important  export  sectors, 
were  hit  by  acute  labour  shortages  and  large 
domestic  cost  increases  related  to  rapid  wage 
growth  between  2004  and  2008.  In  contrast,  the 
shares  of  capital-  and 
technology-intensive 
products  have  increased,  especially  since  2005. 
The export product structure of Latvia has become 
more  diversified  over  the  past  decade,  with 
products  such  as  chemicals,  basic  metals,  and 
machinery  and  transportation  equipment  gaining 
shares in total exports. 

5.6.2.  Product market integration 

Latvia’s  trade  openness  ratio  has  been  growing 
gradually  in  recent  years,  especially  after  EU 
accession. This upward trend was the result of the 
trade  liberalisation  process  and  the  increase  in 

87 

 
European Commission 

Convergence Report 2010 

Table 5.6.2:

Latvia - Product market integration

Trade openness 1) (%)
Extra-EU trade in goods GDP ratio 2) (%)
Intra-EU trade in goods GDP ratio 3) (%)
Intra-EU trade in services GDP ratio 4) (%)
Export in high technology 5) (%)
Technological balance 6) (%)
Total FDI inflows GDP ratio 7) (%)
Intra-EU FDI inflows GDP ratio 8) (%)
FDI intensity 9)
Internal Market Directives 10) (%)
Value of tenders in the O.J. 11)
Time to start up a new company 12)

Latvia

2003

:

8.3

27.7

:

2.8

-3.2

2.7

:

:

:

:

:

2004

2005

2006

2007

50.6

9.5

30.5

5.2

3.2

-2.9

4.6

3.2

1.6

7.0

1.8

16.0

54.4

10.4

32.4

6.1

3.2

-2.8

4.4

2.8

1.6

1.1

9.8

16.0

55.5

10.9

33.0

6.3

4.2

-3.0

8.3

6.1

3.1

0.5

13.8

16.0

51.9

9.9

30.9

6.1

4.6

-2.4

8.1

7.0

3.8

0.6

12.3

16.0

2008

50.0

10.5

28.1

6.1

:

:

3.7

2.9

1.7

0.5

9.5

16.0

 1) (Imports + Exports of goods and services / 2 x GDP at current market prices) x 100 (Foreign Trade Statistics, Balance of Payments).

 2) (Extra-EU-27 Imports + Exports of goods / 2 x GDP at current market prices ) x 100 (Foreign Trade Statistics).

 3) (Intra-EU-27 Imports + Exports of goods / 2 x GDP at current market prices ) x 100 (Foreign Trade Statistics).

 4) Intra-EU-27 trade in services (average credit and debit in % of GDP at current prices) (Balance of Payments).

 5) Taken directly from Eurostat's databases: Exports of high technology products as a share of total exports.

 6) (Exports - imports in high tech) / GDP at current prices x 100, since 2007 the data based upon SITC Rev. 4 (earlier SITC Rev. 3).

 7) Total FDI inflows (in % of GDP at current prices).

8) Intra-EU-27 FDI inflows (in % of GDP at current prices).

9) FDI intensity (average intra-EU-27 inflows and outflows in % of GDP at current prices).

10) Percentage of internal market directives not yet communicated as having been transposed, in relation to the total number.

11) Public procurement - Value of public procurement which is openly advertised  (in % of GDP).

12) Time to start a new company (in days), Doing Business World Bank.

Sources: Eurostat, Commission services.

the 

While 
technological  content  of  Latvia's 
exported  goods  shows  a  predominance  of  low 
technology 
technology 
and  medium-to-low 
products,  there  has  been  some  improvement.  The 
rapid  growth  of  the  CIS  market,  where  Latvia  is 
traditionally  present,  supported  this  process,  since 
this  trade  shows  a  more  favourable  product 
composition  of  Latvia's  exports  reflecting  past 
industrial  links.  As  a  result,  in  2008,  Latvia's 
exported  goods  in  terms  of  factor-intensity  were 
more  similar  to  those  of  the  other  two  Baltic 
States.  

total 
Services  represent  around  one-third  of 
exports,  consisting  mainly  of 
transportation 
services,  financial  services  and  tourism.  Services 
exports  have  increased  somewhat  faster  than 
exports of goods, reflecting a general shift towards 
the service sector in the economy. Compared to the 
neighbouring  countries,  Latvia  has  been  rather 
successful  in  this  respect,  benefiting  from  its 
geographical  location  as  the  centre  of  the  Baltic 
States and a connection between the CIS countries, 
in particular Russia, and the West.       

FDI  flows  to  Latvia  accelerated  in  2004  with  EU 
accession  and  were  further  encouraged  by  the 
privatisation  process  and  an  improved  business 
environment. However, the stock of inward FDI as 

88 

a percentage of GDP in 2007 was still considerably 
lower in Latvia than in Estonia, but higher than in 
Lithuania.  FDI  mainly  originates  from  the  EU-27 
(more  than  75%)  but  the  share  of  the  euro  area 
amounts  to  only  one-half  of  that  share  because, 
apart from Germany, the main investing countries 
in Latvia are not in the euro area (Estonia, Sweden 
and  Denmark).  The  role  of  FDI  in  increasing 
Latvia's  export  performance  remains 
limited, 
except  in  the  field  of  forestry,  since  the  largest 
sawmills  and  pulp  producing  companies  originate 
in Scandinavia. However, the largest shares of the 
FDI  stock  are  in  services,  led  by  financial 
intermediation  (28%),  real  estate,  renting  and 
business  activities  (22%)  and  trade  and  repair 
services 
in 
manufacturing  (11%)  and  transport,  storage  and 
communication (7%) are much lower.  

shares  of  FDI 

(14%).  The 

Important efforts have been made in Latvia in the 
past years to improve the business environment, in 
particular  in  terms  of  enforcing  contracts,  trading 
across  borders  and  obtaining  credit.  Company 
registration  has  been  simplified  however  further 
progress has to be made to improve the regulatory 
framework and to reduce the administrative burden 
on  businesses  in  terms  of  dealing  with  licences, 
employing  workers, 
registering  property  and 
closing  a  business.  The  process  of  integration  has 

 
 
 
 
 
Convergence Report 2010 - Technical annex 

Chapter 5 - Latvia 

also been facilitated by the improved transposition 
of  the  EU  Internal  Market  directives,  with  a 
transposition  deficit  in  Latvia  which  is  below  the 
1% EU target and well below the EU-27 average. 

5.6.3.  Financial market integration 

Latvia's financial sector is well integrated into the 
broader  EU  economy.  The  main  channels  of 
integration  have  been  the  important  market  share 
of  foreign-owned  banks  and  the  participation  of 
the domestic stock exchange into the OMX Group 
of  Nordic  exchanges.  Compliance  with  the  acquis 
of  the  Union  in  the  field  of  financial  services  has 
been fully achieved. (36) 

Latvia's financial system has been heavily affected 
by  the  international  financial  crisis.  Outflows  of 
non-resident  deposits,  which  are  a  substantial 
segment  of  Latvian  banks'  deposit  base,  led  to 
liquidity  tensions  in  some  banks.  Consequently, 
banking sector rescue measures were taken both by 
the  government  and  the  Bank  of  Latvia,  totalling 
2.1%  of  GDP  in  state-sponsored  recapitalisations 
and  4.6%  of  GDP  in  liquidity  support.  Parex 
Banka,  the  largest  domestic  bank  of  systemic 
importance,  was  nationalised  in  November  2008. 
financial 
Against 
difficulties,  the  Latvian  government  requested  an 
international  assistance  program.  Besides,  in  the 
framework of the European Banking Coordination 
Initiative,  parent  institutions  of  foreign  banks 
operating in Latvia acknowledged their support to 
the  economic  stabilisation  program 
through 
commitments  to  keep  their  exposure  to  Latvia 
broadly unchanged.  

the  background  of 

rising 

Indirect  intermediation  is  predominant  in  Latvia, 
with  domestic  bank  credit  amounting  to  almost 
73%  of  GDP  at  the  end  of  2009.  Banks'  assets 
account  for  97%  of  the  entire  financial  sector 
Equity capitalisation has been heavily impacted by 
the economic  and financial crisis and it decreased 
to  7%  of  GDP  by  2009,  slightly  lower  than  its 
2004  level.  Similar  developments  have  occurred 
on  the  bond  market,  on  which  attracted  funds 
account  for  less  than  6%  of  GDP.  Hence,  with 
the  Latvian 
to  direct 
respect 
financial  sector  has  made 
in 
convergence to the EU averages. 

little  progress 

intermediation, 

Graph 5.6.4: Latvia - Recent development of the  financial 

system relatively to the euro area
(in percentage of GDP)

180
160
140
120
100
80
60
40
20
0

LV, 2004

LV, 2009

Euro area,
2004

Euro area,
2009

Debt securities

Sto ck market capitalisatio n

Do mestic bank credit

Source: Eurostat, Bank of Latvia.

Concentration  in  the  banking  sector  has  been 
rising,  as  evidenced  by  a  CR5  concentration  ratio 
(37) of 70%, which is above the average both in the 
euro area and in the new Member States. The share 
of  bank  assets  owned  by  foreign  institutions  has 
been  rising  and  reached  68%  in  2008.  Following 
the  rescue  measures  taken  by  the  government  in 
late  2008,  17%  of  the  banking  sector  is  state-
owned. 

Graph 5.6.3: Latvia - Banking sector rescue measures 

relatively to the euro area

(effectiv e amounts in percentage of GDP)

10

8

6

4

2

0

Graph 5.6.5: Latvia - Foreign ownership and 

concentration in the banking sector
(in percent, weighted av erages)

80
70
60
50
40
30
20
10
0

Latvia

Euro area

LV, 2004

LV, 2008

Euro area,
2004

Euro area,
2008

Recapitalisatio n

Liability guarantees

A sset relief

Liquidity suppo rt

Note: data for December 2009.
Source: European Commission.

Co ncentratio n in the banking secto r (CR5 ratio )

Share o f fo reign institutio ns as % o f to tal assets

Source: ECB, Structural indicators for the EU banking sector, January 2010.

The  quality  of  banks'  loan  portfolios  has  been 
deteriorating  quickly  and  substantially,  even 

(36)  All Financial Services Action Plan (FSAP) Directives have 
been transposed, and good progress has been made with the 
transposition  of 
the  Post-FSAP  Directives.  See: 
http://ec.europa.eu/internal_market/finances/actionplan/ind
ex_en.htm#transposition. 

(37)  The  CR5  concentration  ratio  is  defined  as  the  aggregated 
market  share  of  the  five  banks  with  the  largest  market 
share. 

89 

 
 
                                                           
 
 
 
                                                           
European Commission 

Convergence Report 2010 

though  banks'  capitalisation  has  remained  robust 
due  to  repeated  capital  injections.  The  economic 
in  a  surge  of  non-
downturn  has  resulted 
performing  loans, (38)  which  have  reached  about 
16%  of  banks'  loan  portfolio  by  December  2009. 
Despite substantial losses, as shown by a return on 
equity  of  -42%  in  2009,  banks  managed  to  stay 
well capitalised, with an average capital adequacy 
ratio of about 15%. 

Graph 5.6.6: Latvia - selected banking sector soundness 

%

indicators relatively to the euro area

LV, 2004

LV, 2009

Euro area,
2004

Euro area,
2008

30

20

10

0

-10

-20

-30

-40

-50

Return on equity

Capital adequacy

No n performing lo ans

Note: For 2008, EU-27 non performing loans for are a proxy for EA.
Source: ECB, Financial and Capital Market Commission, EC calculations.

The growth in the banking segment of the financial 
system  is  most  apparent  through  the  dynamics  of 
domestic  credit.  Bank  credit  has  grown  at  an 
annual average of 34% since 2005, with a peak of 
63% 
in  December  2005.  Credit  expansion 
continued  throughout  2006  and  started  to  slow 
down in mid-2007, coming to a halt in May 2009. 
By December 2009, domestic credit has contracted 
by about 15% y-o-y. 

Households  and  non-financial  corporations  have 
been  equally  benefiting  from  the  new  bank  loans 
during  the  boom  years.  Credit  to  corporations, 
which  reached  52%  of  GDP  in  2009,  remained 
slightly  higher  than  credit  to  households,  which 
stood  at  47%  of  GDP.  Convergence  to  euro  area 
averages,  respectively  at  52%  and  55%  of  GDP, 
has been fully achieved with respect to lending to 
corporations. 

(38)  Non-performing loans are loans where principal or interest 

arrears payments have been past-due over 90 days. 

90 

Graph 5.6.7: Latvia - Recent developments in bank credit 

to households and corporations relatively to the euro area

(in percentage of GDP)

60

50

40

30

20

10

0

Dec-04 Dec-05 Dec-06 Dec-07

Dec-08 Dec-09

Ho useho lds, LV
No n-financial co rpo ratio ns, LV
Ho useho lds, Euro  area
No n-financial co rpo ratio ns, Euro  area

Source: ECB, Eurostat.

households 

corporations 

show 
and 
Both 
consistently  high  preferences  for  borrowing  in 
foreign currency. Euro-denominated loans reached 
respectively  90%  and  95%  of  households  and 
corporations'  debt  vis-à-vis  banks.  Taking  into 
account the liquidity tensions in the monetary and 
banking  system  in  late  2008,  the  risks  associated 
with unhedged borrowing are strong. 

Graph 5.6.8: Latvia - Share of foreign currency loans

(as percentage of total loans to households / corporations)

100
90

80
70
60

50
40
30
20

10
0

Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 Dec-09

Co rpo ratio ns

Ho useho lds

Source: Bank of Latvia  and own calculations.

Despite its integration in the OMX Group and the 
NOREX  cooperation  which  includes  the  stock 
markets  in  Copenhagen,  Helsinki,  Stockholm, 
Reykjavik,  Tallinn  and  Vilnius,  the  Riga  Stock 
Exchange has not played yet a decisive role in the 
financing  of  the  economy.  However,  against  the 
background  of  high  foreign  investment  and  the 
strong  bank  credit  expansion  from  the  past,  this 
could  hardly  be 
interpreted  as  a  sign  of 
inefficiency.  The  debt-securities  market  remains 
dominated by government issuances and represents 
only  a  limited  source  of  funding  for  private 
companies. 

The  low  level  of  development  of  the  capital 
markets  accounts  for  the  very  small  size  of  the 
non-banking  financial  sector.  Even  though  net 
assets of pension funds grew from 1.4 million lats 

 
 
                                                           
 
 
Convergence Report 2010 - Technical annex 

Chapter 5 - Latvia 

in  2004  to  93  million  lats  in  2009,  they  still 
account for less than 1% of GDP. Assets managed 
by  investment  companies  are  negligible  at  22 
million  lats.  Assets  managed  by  life  and  non-life 
insurance  companies,  respectively  at  below  1% 
and  about  2% of  GDP,  are  still  very  low,  even  in 
comparison to other new member states. 

Regulation  and  supervision  of  all 
financial 
institutions  is  carried  out  by  the  Financial  and 
Capital  Market  Commission  (FCMC).  In  the 
context  of  the  international  financial  assistance 
programme,  financial  sector  supervision  has  been 
strengthened  considerably.  Cooperation  with  the 
Baltic  and  Nordic  countries  has  been  further 
enhanced. 

91 

 
 
6.1.4.  Integration in the ESCB 

No incompatibilities and imperfections exist in this 
area. 

6.1.5.  Prohibition of monetary financing 

No incompatibilities and imperfections exist in this 
area. 

6.1.6.  Assessment of compatibility 

All  incompatibilities  and  imperfections  identified 
in  the  2004  Convergence  Report  have  been 
removed  already  in  2006,  confirmed  by  the 
Convergence Report in 2008.  

However, following the amendments of Article 23 
of  the  Law  on  the  Bank  of  Lithuania  and  Article 
14(4)  of  the  Law  on  the  State  Audit  Office,  there 
the 
imperfections  with 
are 
requirements for central bank independence. 

respect 

two 

to 

6. 

LITHUANIA 

6.1. 

LEGAL COMPATIBILITY 

6.1.1.  Introduction 

The  Bank  of  Lithuania  started  to  operate  in  1922 
and was re-established in March 1990. The Law on 
the  Bank  of  Lithuania,  as  last  amended  on 
December 10, 2009, constitutes the legal basis for 
the establishment of the Bank of Lithuania. 

The  Law  on  the  Bank  of  Lithuania  and  other 
legislation concerning the Bank of Lithuania were 
considered  fully  compatible  in  the  Convergence 
Report 2008.  

6.1.2.  Objectives 

The  objectives  of  the  Bank  of  Lithuania  are 
compatible with the TFEU. 

6.1.3.  Independence 

There  are  two  imperfections  with  regard  to  the 
independence of the Central Bank. 

Following the amendment of the Law on Bank of 
Lithuania (Law No. XI-510), Article 23 introduced 
a  new  rule  on  the  allocation  of  the  Bank  of 
Lithuania profits. This provision, as it stands now, 
reduces  significantly  the  capacity  of  the  Bank  of 
Lithuania to decide the level of its reserves, which 
limits its financial independence. The sequence of 
the  operations  in  Articles  23(3)(1)-(3)  indicates 
that  the  contribution  to  the  State  budget  is  very 
significant  and  is  deducted  before  any  transfer  of 
profit  to  the  reserve  capital  of  the  Bank  of 
Lithuania. The law should be amended with a view 
to  increasing  the  financial  independence  of  the 
Bank of Lithuania. 

legal  certainty  reasons 

Article 14(4) of the Law on the State Audit Office 
(Law  No  XI-497)  explicitly  empowers  the  State 
Audit  Office  to  perform  the  audit  in  the  Bank  of 
is 
Lithuania.  For 
recommended  to  clearly  define  in  the  legislation 
the scope of control conducted by the State Audit 
Office,  without  prejudice  to  the  activities  of  the 
Bank  of  Lithuania's  independent  external  auditor 
competences,  as  provided  in  Article  27(1)  of  the 
ESCB/ECB Statute. 

it 

93 

 
 
 
European Commission 

Convergence Report 2010 

6.2. 

PRICE STABILITY 

deflationary  trend,  year-on-year  inflation  turned 
negative in January 2010.   

6.2.1.  Respect of the reference value 

Graph 6.2.2: Lithuania - HICP inflation

 (y-o-y percentage change)

The 12-month average inflation rate for Lithuania, 
which  is  used  for  the  convergence  assessment, 
remained  above  the  reference  value  in  2008  and 
2009, although the gap vis-à-vis the reference has 
been  gradually  closing  since  late  2008.  In  March 
2010  the  reference  value  was  1.0%,  calculated  as 
the average of the 12-month average inflation rates 
in  Portugal,  Estonia  and  Belgium  plus  1.5 
percentage points. The corresponding inflation rate 
in  Lithuania  was  2.0%,  i.e.  1  percentage  point 
above  the  reference  value.  The  12-month  average 
inflation  is  expected  to  fall  below  the  reference 
value in the months ahead. 

Graph 6.2.1: Lithuania - Inflation criterion since 2004

 (percent, 12-month mov ing av erage)

12

10

8

6

4

2

0

-2
Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11

Lithuania

Reference value

Note: The dots show the projected reference value and 12-month average inflation 
in the country in December 2010.
Sources: Eurostat, Commission services' Spring 2010 Forecast.

6.2.2.  Recent inflation developments 

After a period of moderate inflation, annual HICP 
inflation in Lithuania picked up significantly in the 
second  half  of  2007  as  a  result  of  rising  global 
food  and  energy  prices,  as  well  as  mounting 
capacity 
pressures 
intensified in the first half of 2008 on the back of 
robust wage and demand growth. Inflation reached 
a peak of 12% in June 2008. 

Inflationary 

constraints. 

The  sharp  drop  in  global  commodity  prices  in 
autumn  2008  relieved  inflationary  pressures  on 
transport and food stuffs. However, the Lithuanian 
economy was  initially little affected by the global 
crisis  and  inflation  in  other  HICP  categories 
persisted throughout autumn 2008. Inflation started 
to decelerate strongly from early 2009, when credit 
contracted  and  economic  activity  fell.  While 
increases  in  import  prices,  indirect  taxes  and 
administered  prices  partially  offset  the  general 

94 

14

12

10

8

6

4

2

0

-2

2004

2005

2006

2007

2008

2009

Lithuania

Euro  area

Source: Eurostat.

inflation. 

remained  below  headline 

Core  inflation  (measured  as  HICP  excluding 
energy  and  unprocessed  food)  moved  in  tandem, 
It 
but 
significantly  declined  in  2009  as  the  fall  in 
domestic  demand  had  a  pronounced  impact  on 
non-energy industrial goods and to a lesser extent 
food.  Available 
on  services  and  processed 
indicators  point  to  shrinking  non-food  retail  trade 
and  catering  activities,  suggesting  that  low  core 
inflation will persist in the near term. 

Compared  to  the  euro  area,  inflation  in  Lithuania 
has  been  volatile,  reflecting  the  sensitivity  of  the 
Lithuanian  economy  to  external  price  shocks, 
especially  via  the  energy  sector  and  variations  in 
food prices, which together have a relatively large 
weight  (of  around  47%)  in  the  Lithuanian  HICP 
index. 

6.2.3.  Underlying  factors  and  sustainability  of 

inflation 

Macroeconomic  policy-mix  and  cyclical 
stance 

After  years  of  strong  economic  growth,  the 
Lithuanian  economy  was  hit  by 
the  global 
financial  crisis.  In  autumn  2008  the  cost  of 
borrowing  increased  amid  the  global  liquidity 
squeeze. Tighter financing conditions and a fall in 
external demand contributed to a slowdown of real 
economic  activity  in  late  2008  and  a  severe 
contraction in the first half of 2009. The recession 
bottomed  out 
in  mid-2009,  but  growth  has 
remained  fragile  amid  weak  global  economic 
the  Commission 
environment.  According 
services'  2010  Spring  Forecast,  the  Lithuanian 
economy  will  still  contract  by  around  0.6%  in 

to 

 
 
 
Convergence Report 2010 - Technical annex 

Chapter 6 - Lithuania 

Table 6.2.1:

Lithuania - Components of inflation

(percentage change)1)

weights  

in total   

2004

2005

2006

2007

2008

2009

Mar-10

HICP

Non-energy industrial goods

Energy

Unprocessed food 

Processed food

Services

HICP excl. energy and unproc. food
HICP at constant taxes 2)
Administered prices HICP

1.2

-0.2

2.7

2.3

2.4

-0.3

0.7

0.5

-1.2

2.7

-0.7

7.2

6.4

1.4

3.3

1.3

2.5

4.2

3.8

-0.1

7.6

8.0

2.7

4.8

2.4

3.8

6.2

5.8

-0.2

6.8

8.6

10.5

6.8

5.2

5.5

9.7

11.1

1.8

17.9

15.3

15.8

12.2

9.3

10.1

17.0

4.2

0.2

8.2

3.1

5.8

5.8

3.7

0.2

15.8

2.0

-1.4

6.3

-1.8

5.1

2.7

1.8

-1.2

10.4

2010

1000

267

136

115

221

260

749

1000

126

1) Measured by the arithmetic average of the latest 12 monthly indices relative to the arithmetic average of the 12 monthly indices 

   in the previous period.

2) Last observation for HICP at constant taxes is February 2010

2010  and  rebound  by  3.2%  in  2011.  The  strength 
of  the  recovery  will  largely  depend  on  external 
demand,  whereas 
income, 
financing  constraints  and  fiscal  consolidation 
measures may weigh on domestic demand.  

falling  domestic 

The  recession  led  to  the  emergence  of  a  negative 
output gap, following several years of output well 
above  potential.  Commission  services'  estimates 
suggest  that  the  output  gap  of  the  Lithuanian 
economy will remain negative in 2010 and 2011. 

tax 

Lithuania's general government deficit increased in 
2007  and  2008,  indicating  a  clearly  pro-cyclical 
fiscal  stance.  The  new  government  that  was 
formed  at  the  end  of  2008  took  a  number  of 
measures  to  achieve  fiscal  consolidation  in  the 
2009  budget.  Together  with  two  supplementary 
budgets adopted in 2009, fiscal austerity packages 
for  the  year  totalled  around  8%  of  GDP.  They 
increases  and  a 
included  spending  cuts, 
temporary  reduction  of  transfers  to  second  pillar 
pension  funds.  Nevertheless,  given  the  sharp 
economic downturn the general government deficit 
increased  to  8.9%  of  GDP  in  2009  despite  the 
immense  fiscal  effort.  Commission  calculations 
under  the  commonly  agreed  methodology  suggest 
that 
the  structural  balance  also  deteriorated, 
implying  an  expansionary  fiscal  stance.  However, 
the  estimate  of  consolidation  based  on 
the 
structural  balance  should  be  treated  with  extreme 
caution, given its reliance on output gap estimates 
which are far from robust in current circumstances. 
The fiscal stance is expected to become restrictive 
in  2010  as  a  result  of  further  fiscal  consolidation 
efforts. 

In the pre-crisis period, monetary conditions were 
accommodative  in  the  framework  of  the  currency 
II.  High 
board  arrangement  within  ERM 

profitability  of  the  corporate sector  and optimistic 
expectations  about  household 
income  growth 
encouraged  banks  to  ease  lending  constraints.  At 
the  same  time  fierce  competition  drove  lending 
interest  rates  down  in  both  euro  and  litas.  Credit 
growth  surged,  boosting  private  consumption  and 
investment.  

Credit conditions worsened significantly in autumn 
2008  as 
the  financial  crisis  deepened.  The 
corporate sector was affected particularly severely, 
aggravating  the  contraction  of  economic  activity. 
Since  autumn  2009,  improving  sentiment  with 
regard  to  the  Baltic  countries  and  ample  liquidity 
in  the  market  led  to  a  sharp  decline  in  lending 
rates, but credit standards remained very tight and 
the deleveraging process continued in early 2010. 

Wages and labour costs 

The  Lithuanian  labour  market  reacted  swiftly  to 
changing economic circumstances. Since the onset 
of the crisis, nominal wages in both the private and 
public sectors declined by around 10% over a year, 
with the most pronounced reductions registered in 
the  non-tradable  sectors.  The  decline  in  private 
sector  wages  was  somewhat  faster  as  it  started 
already  in  the  fourth  quarter  2008,  while  cuts  in 
public sector wages were implemented since 2009 
as  the  government  intensified  efforts  to  stabilise 
public finances. Wages are expected to fall further 
in 2010, in particular in the public sector, although 
emigration  may  to  some  extent  limit  the  scope  of 
adjustments.  The  wage  bargaining  process  in 
Lithuania is highly decentralised. 

95 

 
 
 
 
 
European Commission 

Convergence Report 2010 

Table 6.2.2:

Lithuania - Other inflation and cost indicators

2004

2005

2006

2007

2008

(annual percentage change)

20091)

20102)

20112)

HICP inflation

Lithuania 

Euro area

Private consumption deflator

Lithuania 

Euro area

1.2

2.2

-0.3

2.0

Nominal compensation per employee

Lithuania 

Euro area

Labour productivity

Lithuania 

Euro area

Nominal unit labour costs

Lithuania 

Euro area

Imports of goods deflator

Lithuania 

Euro area

10.9

2.5

7.4

1.8

3.3

0.9

-0.5

1.3

2.7

2.2

1.7

2.1

11.5

2.2

5.2

1.1

6.0

1.3

9.0

3.6

1) 2009 data (except HICP inflation) are estimates. 

2) Commission services' Spring 2010 Forecast.

Source: Eurostat, Commission services.

3.8

2.2

4.0

2.2

16.7

2.6

5.9

1.7

10.1

1.1

8.8

4.1

5.8

2.1

6.4

2.3

13.9

2.7

6.9

1.1

6.5

1.6

4.9

1.3

11.1

3.3

9.7

2.9

12.9

3.4

3.3

0.0

9.3

3.4

9.1

4.1

4.2

0.3

4.5

-0.1

-7.5

2.0

-8.7

-2.0

1.2

4.0

-10.6

-7.5

-0.1

1.5

0.5

1.4

-2.4

1.3

3.2

1.8

-5.5

-0.5

6.3

3.9

1.4

1.7

1.3

1.5

1.5

1.5

3.0

1.3

-1.4

0.1

2.5

1.6

Graph 6.2.3: Lithuania - Inflation, productivity and wage trends

(y-o-y % change)

16

12

8

4

0

-4

-8

-12

2004

2005

2006

2007

2008

2009

2010

2011

P ro ductivity (real GDP  per perso n emplo yed)

No minal co mpensatio n per emplo yee

No minal unit labo ur co sts
HICP  inflatio n

Source: Eurostat, Commission services' Spring 2010 Forecast.

As  a  result  of  the  downturn  and  the  restructuring 
efforts  in  both  the  private  and  public  sector, 
unemployment increased from a record low of 4% 
in 2007-2008 to 14% in 2009, easing labour supply 
constraints.  

Labour productivity is expected to rebound swiftly 
in 2010 and 2011 after a GDP contraction-induced 
fall  in  2009.  Nominal  unit  labour  costs,  which 
remained  broadly  unchanged 
  are 
projected to decline  markedly in 2010 and further 
in 
cost 
competitiveness and fostering export-led growth.  

Lithuania's 

improving 

in  2009, 

2011 

External factors 

For  Lithuania,  a  small  and  very  open  economy, 
developments  in  import  prices  play  a  key  role  in 
domestic  price  formation.  Import  prices,  as 
measured  by  the  imports  of  goods  deflator  in  the 
national  accounts,  rose  relatively  sharply  in  the 
period  between  2005  and  2008  but  decreased 
significantly in 2009.  

Energy and food prices were a major component of 
imported  inflation  in  the  recent  past,  in  particular 
in  view  of  the  large  weight  of  these  categories  in 
the  Lithuanian  HICP  basket.  Energy  prices  were 
highly  volatile  over  the  period  2007-2009  due  to 
oil  price  fluctuations  in  international  markets  and 
gas  price  revisions  by  Russia  (Lithuania's  sole 
supplier). Food prices were less volatile, though in 
2007 and 2008 they recorded significant increases 
in line with global agricultural price developments, 
adding to headline inflation in Lithuania.  

Exchange  rate  developments  had  a  limited  effect 
on  Lithuania's  import  prices  in  the  period  2004-
2007,  as  the  nominal  effective  exchange  rate 
remained  broadly  stable.  The  nominal  effective 
exchange  rate  appreciated  by  around  4%  between 
September 2008 and March 2009, as the currencies 
of some important trade partners (Poland, Sweden, 
UK)  depreciated.  This  development  appears  to 

96 

 
 
 
 
 
 
Convergence Report 2010 - Technical annex 

Chapter 6 - Lithuania 

have  had  only  a  minor  impact  on  Lithuania's 
headline inflation rate.  

VAT hike, together with increases in excise duties 
are  expected  to  add  about  1.1  percentage  point  to 
annual HICP inflation in 2010. 

In  particular, 

The high degree of openness had a significant anti-
inflationary  effect  in  Lithuania  over  the  recent 
years. 
low-cost 
countries  helped  to  hold  down  import  price 
inflation  for  non-energy  industrial  durables  and 
semi-durables. 

imports 

from 

Administered prices and taxes 

in  Lithuania 

in  administered  prices (39)  and 
Adjustments 
indirect taxes have been important determinants of 
inflation 
in  recent  years.  The 
contribution of administered prices, with a weight 
of  around  13%  in  the  HICP  basket,  to  headline 
inflation increased significantly in 2008 and 2009, 
when they rose by 17% and 16%, respectively. The 
contribution  of  indirect  taxes  also  increased  in 
2009, mirroring fiscal consolidation efforts. 

In 2008 and 2009, marked increases were recorded 
in  the  prices  charged  for  natural  gas,  heating 
energy  and  passenger  transport.  The  increases 
mostly  reflected  trends  in  import  prices  and 
abolition  of  preferential  VAT  rates  for  certain 
in 
categories  of  goods.  Overall 
administered  prices  contributed  with  around  one-
fifth  of  average  annual  inflation  in  2008  and 
around a half in 2009. A surge in electricity prices 
following the closure of the Ignalina nuclear power 
plant in early 2010 together with other increases in 
administered  prices    are  estimated  to  add  around 
0.8 percentage point to 2010 inflation.  

increases 

indirect 
rising  HICP 
line  with 

tax  changes,  which 
A  number  of 
inflation,  were 
to 
contributed 
undertaken 
tax  harmonisation 
in 
requirements  within  the  EU.  Excise  duties  on 
alcohol, tobacco products and temporarily on fuels 
were raised in the course of 2009. The changes in 
excise duties are estimated to have raised headline 
annual  inflation  by  about 0.3  percentage points  in 
2008  and  0.7  percentage  points  in  2009.  The 
standard  VAT  rate  was  raised  twice  in  the  course 
of 2009, from 18% to 19% in January and to 21% 
in  September.  The  first  increase  is  estimated  to 
have  increased  annual  average  inflation  by  about 
0.5 percentage points and the second by around 0.2 
percentage  points.  The  lagged  effect  of  the  2009 

(39)  For  the  purpose  of  this  report,  administered  prices  in 
Lithuania include water supply, refuse, sewerage collection 
and  other  related  services,  electricity,  gas,  heat  energy, 
certain  categories  of  passenger  transport,  postal  services, 
education and social protection. 

Medium-term prospects 

Lithuania's inflation is likely to remain subdued in 
2010 reflecting strong downward unit labour costs 
adjustment,  restrictive  fiscal  policy  and  fierce 
competition among retailers. Inflationary pressures 
will mainly stem from external factors, notably rise 
in energy and global food prices. On this basis, the 
Commission  services'  2010  Spring  Forecast 
expects average HICP inflation to fall to -0.1% in 
2010  and  to  remain  modest  at  around  1.4%  in 
2011. 

Risks to the inflation outlook are broadly balanced. 
Downside risks are associated with a slower global 
or  domestic  recovery.  This  would  result  in  lower 
import  prices  and/or  personal 
income  (albeit 
emigration  may  slow  down  the  wage  adjustment 
process).  In  contrast,  a  stronger-than-expected 
increase  in  commodity  prices  on  international 
markets  would 
inflationary 
pressures.  Large  exchange  rate  fluctuations  of  the 
euro against the dollar could amplify the impact on 
Lithuanian inflation via energy prices. 

intensify 

likely 

The level of consumer prices in Lithuania stood at 
almost 62% of the euro area average in 2008. This 
level 
for 
suggests  potential 
convergence  in  the  long  term,  as  income  levels 
(around  57%  of  the  euro  area  average  in  PPS  in 
2008) rise towards the euro area average. 

further  price 

Medium-term  inflation  prospects  depend  on  the 
course  of  fiscal  policy  and  wage  developments. 
Rebalancing  the  economy  towards  the  tradable 
sector,  avoiding  a  pro-cyclical  fiscal  stance  once 
the economy is set on a recovery path and stepping 
up  structural  reforms  will  be  essential  to  keep 
inflation  in  check  and  ensure  sustained  growth.  It 
is  equally  necessary  to  improve  the  business 
environment  in  order  to  attract  more  FDI  and 
support  the  job  creation  process,  while  keeping 
wage growth in line with productivity gains. 

97 

 
                                                           
European Commission 

Convergence Report 2010 

6.3.  GOVERNMENT BUDGETARY POSITION 

6.3.1.  The  excessive  deficit  procedure 

for 

Lithuania (40) 

In  July  2009,  the  Council  adopted  a  decision 
stating  that  Lithuania  had  an  excessive  deficit, 
based  on  a  notified  deficit  of  3.2%  of  GDP  in 
2008.  Although  close  to  the  reference  value,  the 
excess  was  considered  neither  exceptional  nor 
temporary.  At  the  same  time,  the  Council  issued 
recommendations  to  correct  the  excessive  deficit 
by  2011  and  established  a  deadline  of  7  January 
2010  for  effective  action  to  be  taken.  In  its 
subsequent assessment, the Commission found that 
Lithuania had taken effective action. Moreover, the 
developments in the economic outlook implied that 
unexpected  adverse  economic  events  with  major 
unfavourable  effects  for  government  finances  had 
occurred  in  Lithuania  in  the  meantime.  Following 
this  assessment,  in  February  2010,  the  Council 
issued  new  recommendations  (on  the  basis  of  a 
recommendation from the  Commission) to correct 
the  excessive  deficit  by  2012.  In  particular,  the 
annual fiscal effort is required to average 2¼% of 
GDP  over  the  period  2010-2012,  and  fiscal 
be 
governance 
should 
strengthened  by  enhancing 
the  medium-term 
budgetary  framework,  enforceable  expenditure 
ceilings  and  improved  monitoring  of  the  budget 
execution.  The  next  step  in  the  procedure  is  the 
assessment  of  effective  action  upon  expiry  of  the 
deadline of 16 August 2010. 

transparency 

and 

6.3.2.  Developments 2004-2009 

After  recording  rather  limited  deficits  over  the 
period  2004-2007,  not  exceeding  1.5%  of  GDP, 
the  general  government  balance  deteriorated  in 
2008 and in particular 2009 as the domestic bubble 
burst and the global economic crisis hit the country 
hard.  The  fiscal  deficit  reached  3.3%  of  GDP  in 
2008 and deteriorated further to an estimated 8.9% 
fiscal 
for 
consolidation  undertaken  by 
the  government 
during  this  year.  The  revenue  ratio  increased  by 
2.5pp  of  GDP  in  2004-2008,  reflecting  the  strong 
revenue  growth  as  well  as  increasing  inflows  of 
EU funds. As economic growth collapsed in 2009, 
the revenue ratio decreased slightly to 34.1%. The 

significant 

despite 

2009, 

the 

(40)  All documents related to the excessive deficit procedure for 
Lithuania 
at: 
http://ec.europa.eu/economy_finance/sgp/deficit/countries/l
ithuania_en.htm  

found 

can 

be 

98 

expenditure  ratio  remained  very  low  till  2007,  at 
an  average  of  33.8%  of  GDP.  In  2008,  a  year  of 
parliamentary  elections,  it  rose  to  37.4%  of  GDP, 
due to considerable expenditure overruns on public 
sector  wages  and  social  transfers.  In  2009,  as  the 
economy  moved  into  a  severe  contraction,  the 
expenditure ratio reached 43.0% of GDP, against a 
16.9%  decline  in  nominal  GDP,  notwithstanding 
the  impact  of  the  fiscal  consolidation  measures, 
amounting 
the 
expenditure side. Total current expenditure in 2009 
remained at a similar level in nominal terms. 

to  8%  of  GDP, 

largely  on 

if 

also 

significant 

funds.  On 

the  expenditure 
implemented 

The  economic  crisis  had  an  extensive  impact  on 
the  public  finances  in  2009.  Reflecting  the  rapid 
economic  downturn,  budget  revenue  has  fallen 
sharply:  tax  revenues  collapsed  in  nominal  terms 
by nearly one fifth compared to 2008. This decline 
could  have  been  more 
the 
implemented  an  overall 
government  had  not 
revenue-raising comprehensive tax reform. Current 
transfers  increased  due  to  improved  absorption  of 
EU 
the 
side, 
substantial 
government 
expenditure cuts, including in public sector wages, 
as  the  limited  automatic  stabilisers  resulted  in  an 
increase  of  expenditure  of  around  2%  of  GDP 
compared  to  2008,  while  interest  payments  added 
another  0.4%  of  GDP. 
In  general,  current 
expenditure  increases,  planned  in  2008,  were 
counterbalanced  by  consolidating  discretionary 
measures  in  2009.  Based  on  a  more  optimistic 
growth  scenario,  the  original  target  set  in  the 
January  2009  update  of 
the  convergence 
programme  was  of  a  deficit  of    -2.1%.  The 
magnitude  of  the  crisis  explains  why  the  2009 
outcome is so far from the original official deficit 
target,  despite  the  decisive  measures  taken  by  the 
government during the year. 

The  structural  balance  (the  cyclically-adjusted 
balance  net  of  one-offs  and  other  temporary 
measures)  started  to  decline  in  2005  reaching         
-5.6% in 2008, indicating in the latter years a pro-
cyclical  fiscal  stance  in  a  period  of  very  strong 
growth.  Despite  the  rapid  economic  growth  until 
2008,  the  government  has  not  set  ambitious 
budgetary  targets  and  windfall  revenues  mainly 
fiscal 
spent 
consolidation.  The  structural  balance  deteriorated 
further in 2009 (to -7.1%); however, this estimate 
should  be  treated  cautiously,  taking  into  account 
economic 
that 
environment implies that calculation of the cyclical 

instead  of  achieving 

exceptionally 

stronger 

volatile 

the 

 
                                                           
Table 6.3.1:

Lithuania - Budgetary developments and projections
Outturn and forecast 1)

2004

2005

2006

Convergence Report 2010 - Technical annex 

Chapter 6 - Lithuania 

(as % of GDP unless indicated otherwise)

2007

2008

2009

2010

2011

General government balance

- Total revenues

- Total expenditure

of which: 
- interest expenditure

- current primary expenditure

- gross fixed capital formation

p.m.: Tax burden

Primary balance

Cyclically-adjusted balance

One-off and temporary measures
Structural balance 2)
Structural primary balance

Government gross debt

p.m: Real GDP growth (%)

p.m: Output gap

p.m: GDP deflator (% change)

Convergence programme
General government balance

Primary balance
Structural balance 2) 3)
Government gross debt

p.m. Real GDP (% change)

-1.5

31.8

33.3

0.9

28.4

3.4

28.3

-0.6

-2.5

0.0
-2.5

-1.5

19.4

7.4

3.4

2.5

-0.5

32.8

33.3

0.8

28.8

3.4

28.5

0.3

-1.8

0.0
-1.8

-1.0

18.4

7.8

4.7

6.6

-0.4

33.1

33.6

0.7

28.3

4.1

29.4

0.3

-2.1

0.0
-2.1

-1.4

18.0

7.8

6.2

6.5

-1.0

33.8

34.8

0.7

28.0

5.2

29.7

-0.3

-3.7

-0.6
-3.1

-2.4

16.9

9.8

10.1

8.5

-3.3

34.2

37.4

0.6

31.3

5.0

30.3

-2.6

-5.7

-0.1
-5.6

-5.0

15.6

2.8

9.0

9.7

2008
-3.2

-2.6

-8.6

15.6

2.8

-8.9

34.1

43.0

1.0

37.5

3.9

29.1

-7.9

-6.7

0.4
-7.1

-6.1

29.3

-15.0

-8.2

-2.3

2009
-9.1

-7.8

-7.5

29.5

-15.0

-8.4

34.1

42.5

1.6

35.7

4.7

27.8

-6.8

-6.1

0.7
-6.8

-5.2

38.6

-0.6

-8.6

-2.0

2010
-8.1

-6.2

-6.8

36.6

1.6

-8.5

33.2

41.7

1.9

34.6

4.7

26.9

-6.6

-6.8

0.0
-6.8

-4.9

45.4

3.2

-6.4

1.2

2011
-5.8

-3.6

-4.5

39.8

3.2

2012
-3.0

-0.6

-1.7

41.0

1.2

2013
n.a.

n.a.

n.a.

n.a.

n.a.

1) Commission services’ Spring 2010 Forecast.

2) Cyclically-adjusted balance excluding one-off and other temporary measures.

3) Commission services’ calculations on the basis of the information in the programme. One-off and other temporary measures

 taken from the programme (0.5% of GDP in 2008, 0.2% in 2009, 0.3% in 2010; all deficit-reducing; and 0.3% in 2011 and 0.3% in 2012; 

all deficit-increasing). 

Sources: Commission services and February 2010 update of Lithuania's Convergence Programme.

components  of 
the  deficit 
elasticities) is less firmly based.  

(using 

standard 

The general government debt ratio, after declining 
steadily  from  19½%  in  2004  to  15½%  in  2008 
increased  to  an  estimated  nearly  30%  in  2009. 
Interest  payments  gradually  decreased  from  0.9% 
of GDP in 2004 to 0.6% of GDP in 2008. In 2009, 
interest  expenditure  jumped  to  1.0%  of  GDP  due 
to higher financing needs and interest rates. 

6.3.3.  Medium-term prospects 

The  2010  budget  was  approved  by  Parliament  on 
10  December  2009,  along  with  a  medium-term 
budgetary  framework  for  2010-2012.  The  main 
measures 
in 
expenditure of around 4% of GDP, particularly in 
government current spending, including the public 
sector  wage  bill,  and  social  benefits,  with  some 
the  most  vulnerable 
progressivity 

include  further  substantial  cuts 

to  protect 

groups. However, net interest on public debt, is set 
to  increase.  On  the  revenue  side,  changes  are 
limited to a reduction in the corporate income tax 
rate by 5 percentage points, after it was raised only 
in  January  2009,  and  some  increases  in  non-tax 
revenue.  The  2010  budget  also  reflects  the  full-
year 
expenditure 
revenue 
consolidation measures implemented in the second 
half  of  2009.  The  share  of  non-tax  revenue  in  the 
programme  is  projected  to  increase  substantially, 
mainly  related 
to  higher  absorption  of  EU 
structural funds.  

impact  of 

and 

The  government  targets  a  general  government 
budget  deficit  of  8.1%  of  GDP  in  2010.  The 
Commission services' spring 2010 forecast projects 
a  somewhat  higher  deficit  of  8.4%  of  GDP, 
reflecting  a  more  cautious  assessment  of  the 
recovery. The deficit is forecast to increase slightly 
to  8.5%  in  2011;  while  tax  revenue  is  set  to 
recover,  this  is  outweighed  by  the  ending  of  a 
temporary suspension of part of the transfers to the 
second pillar pension funds.  

99 

 
 
 
 
 
 
implemented 

contributing  to  the  ongoing  adjustment  in  the 
economy  and  supporting  smooth  participation  in 
ERM II and the correction of the excessive deficit. 
The economy is currently emerging from a severe 
recession,  while  average  growth  is  projected  to 
remain  considerably  lower  over  the  medium  term 
than  in  the  peak  years  of  the  recent  cycle.  The 
consolidation 
in  2009  already 
constitutes  a  major  adjustment  of  public  finances 
to the expected lower growth in the medium term. 
Stricter  expenditure  control  and  a  strengthened 
medium-term budgetary framework would support 
the  needed  further  consolidation.  The  programme 
targets a gradual decline in the general government 
headline  deficit 
the 
correction  of  the  excessive  deficit  by  2012  as 
recommended  by  the  Council,  although  these 
budgetary  outcomes  are  subject  to  downside  risks 
over the whole programme period." 

from  2010,  aiming  at 

The  Council 
to  consider 
invited  Lithuania 
additional corrective measures in 2010 if necessary 
to achieve the envisaged consolidation, in addition 
to  implementing  rigorously  those  planned  in  the 
budget  and  to  specify  the  necessary  measures  to 
underpin fully the adjustment over the programme 
period recommended by the Council under Article 
126(7).  Lithuania  was  also  asked  to  implement 
planned  social  security  system  reforms,  including 
pension  reform,  so  as  to  reduce  the  high  risks  to 
long-term  sustainability  of  public  finances  and 
strengthen fiscal governance and transparency. 

European Commission 

Convergence Report 2010 

The  overall  fiscal  stance  in  2010,  as  measured  by 
the change in the structural balance, is expected to 
be  mildly  restrictive,  showing  an  improvement  of 
⅓  percentage  point.  However,  this  seems  to 
significantly  underestimate 
the  government's 
consolidation efforts totalling around 4% of GDP. 
The  structural  primary  balance  shows  a  stronger 
improvement  of  around  1  percentage  point,  as 
interest  expenditure 
increase.  This 
is  set 
estimate  of  consolidation  based  on  the  structural 
balance should again be treated with caution, given 
its  reliance  on  output  gap  estimates  which  are  far 
from 
in  current  circumstances.  The 
restrictive  fiscal  stance  is  an  appropriate  response 
and in line with the European Economic Recovery 
Plan. 

robust 

to 

coming 

decades.  Medium-term 

With regard to the sustainability of public finances 
in  the  long-term,  Lithuania  appears  to  be  at  high 
risk. The long-term budgetary impact of ageing is 
slightly  above  the  EU  average,  mainly  due  to  the 
projected  increase  in  pension  expenditure  during 
the 
debt 
projections  until  2020  which  assume  that  GDP 
growth  rates  will  only  gradually  recover  to  the 
values  projected  before  the  crisis  and  tax  ratios 
will  return  to  pre-crisis  levels  show  that  the 
budgetary  strategy  envisaged  in  the  programme, 
taken  at  face  value,  is  not  enough  to  stabilise  the 
debt ratio by 2020 (41). 

16  February 

The latest update of the Convergence Programme, 
submitted on 26 February 2010, covers the period 
2009 to 2012. The main aim  of the programme is 
the  correction  of  the  excessive  deficit  by  2012, 
within  the  deadline  recommended  by  the  Council 
programme 
on 
substantially 
the  medium-term 
objective  (MTO)  for  the  budgetary  position  to  a 
structural  surplus  (e.g. 
the  cyclically-adjusted 
temporary 
deficit  net  of  one-off  and  other 
measures)  of  0.5%  of  GDP,  but  the  MTO  is  not 
achieved within the programme period. 

2010.  The 

strengthens 

the  Council 

In  its  April  2010  Opinion  on  the  Convergence 
Programme, 
its 
assessment  as  follows:  "The  overall  conclusion  is 
that 
decisive 
consolidation of public finances in 2009 against a 
significant deterioration of the economic situation, 

implemented 

summarised 

Lithuania 

a 

(41)  More  details  on 

the  determinants  of 

long-term 
sustainability of public finances can be found in Lithuania: 
Macro  Fiscal  Assessment  –  An  analysis  of  the  February 
2010  update  of  the  convergence  programme,  section  5.2. 
(http://ec.europa.eu/economy_finance/about/activities/sgp/
main_en.htm). 

the 

100 

 
                                                           
 
 
6.4. 

EXCHANGE RATE STABILITY 

Lithuania entered ERM II on 28 June 2004 and has 
been participating in the mechanism for almost six 
years at the time of the adoption of this report. The 
ERM  II  central  rate  was  set  at  the  parity  rate 
prevailing  under 
the  existing  currency  board 
arrangement,  with  a  standard  fluctuation  band  of 
±15%.  Upon  ERM  II  entry, 
the  authorities 
unilaterally  committed  to  maintain  the  currency 
board 
this 
commitment, there has been no deviation from the 
central  rate  since  the  litas  started  participating  in 
ERM II. 

the  mechanism.  In 

line  with 

in 

Graph 6.4.1: LTL - Spread vs central rate

 (as percent, daily v alues)

1.0

0.5

0.0

-0.5

-1.0

Jun-04

Jun-05

Jun-06

Jun-07

Jun-08

Jun-09

Source: Commission services, ECB and EcoWin.

The  Bank  of  Lithuania  began  operating 
its 
currency  board  in  April  1994,  with  the  litas 
initially  pegged  to  the  US  dollar  at  4  LTL/USD. 
The litas peg was changed to the euro in February 
2002  at  the  prevailing  market  rate  of  3.4528 
LTL/EUR.  

Graph 6.4.2: Exchange rates - LTL/EUR
(monthly av erages)

3.8

3.6

3.4

3.2

ERM II

2004

2005

2006

2007

2008

2009

Source: ECB and EcoWin.

The litas exchange rate did not experience tensions 
risk 
reference  period, 
during 
perceptions  temporary  increased  in  the  context  of 
the global financial crisis.  

though 

the 

Convergence Report 2010 - Technical annex 

Chapter 6 - Lithuania 

that 

requirement 

Foreign  exchange  reserve  buffers  remained  very 
solid in Lithuania, in line with the currency board 
all  domestic 
arrangement 
liabilities of the central bank have to be backed by 
foreign exchange reserves or gold. Official foreign 
exchange reserves covered on average 144% of the 
monetary  base  during  2008-2009,  well  above  the 
required  100%  statutory  minimum.  The  coverage 
ratio further improved in early 2010 and in March 
2010, it stood at 165% of the monetary base.  

Foreign  exchange  reserves  during  the  last  three 
years  covered  on  average  64%  of  short-term 
external  debt.  As  short-term  debt  was  gradually 
replaced by  long-term  debt  in  the  course of 2009, 
reserves  to  short-term  debt  ratio  surpassed  the 
historic  average  and  in  the  end  of  2009  stood  at 
84%, signalling a significant risk reduction. 

Graph 6.4.3: Lithuania - 3-M Vilibor spread to 3-M Euribor

 (basis points, monthly v alues)

800

700

600

500

400

300

200

100

0

2004

2005

2006

2007

2008

2009

Source: Eurostat.

The  central  bank  of  Lithuania  does  not  set 
monetary  policy  interest  rates.  The  domestic 
interest rate environment is directly affected by the 
monetary  policy  of  the  euro  area  through  the 
operations  of  Lithuania's  CBA.  Changes  in  euro 
area  money  market  interest  rates  directly  transmit 
to Lithuania's financial markets, where liquidity is 
the 
managed  predominantly 
significant  presence  of  foreign  banks  in  the 
Lithuanian banking system. 

in  euro,  due 

to 

financial  crisis,  partly  due 

Short-term  interest  rates  on  the  litas  interbank 
market have been highly volatile since the onset of 
the 
to  market 
shallowness. Short-term interest differentials vis-à-
vis the euro area temporarily widened in late 2007 
as a result of the liquidity crisis in global markets. 
They  declined  at  the  beginning  of  2008  and 
remained  below  100  basis  points  up  to  October 
2008.  

101 

 
 
      
 
 
European Commission 

Convergence Report 2010 

The  deterioration  in  investors'  sentiment  towards 
the Baltics affected interbank lending in the Baltic 
markets  and  led  to  markedly  higher  short-term 
interest rates. Combined with the ECB's policy rate 
cut,  this  development  resulted  in  a  widening  of 
spreads  with  the  euro  area  to  almost  700  basis 
points in late 2008. The Bank of Lithuania reacted 
promptly  to  liquidity  pressures  by  reducing  the 
minimum reserve requirement on bank liabilities to 
4%  from  6%,  which  helped  to  reduce  short-term 
interest  rates  by  around  2  percentage  points  in 
early 2009.  

improved 

Lithuania's  short-term  interest  rates  rose  sharply 
again  in  June  2009  amid  heightened  investor 
concerns  on  the  Baltics.  In  the  second  half  of  the 
year, 
liquidity  conditions,  upward 
revisions in rating outlooks and returning investor 
confidence  led  to  a  rapid  decline  in  Lithuania's 
short-term interest rates. At the cut-off date of the 
report  the  3-month  spread  vis-à-vis  the  euro  area 
stood  at  about  80  basis  points,  one  of  the  lowest 
spreads among non-euro area countries. 

102 

 
 
Convergence Report 2010 - Technical annex 

Chapter 6 - Lithuania 

6.5. 

LONG-TERM INTEREST RATE 

given  the  absence  of  trading  throughout  most  of 
2009.  

reflects 

examination 

convergence 

The  long-term  interest  rate  in  Lithuania  used  for 
the 
the 
secondary  market  yield  on  a  single  benchmark 
government bond with a maturity of 6 years, due to 
the  absence  of  a  suitable  alternative  bond  with 
longer  maturity.  This  stands  in  contrast  to  the 
common practice of comparing 10-year, or close to 
local-currency  denominated 
10-year,  maturity 
government bonds with the reference value. 

Graph 6.5.1: Lithuania - Long-term interest rate criterion
 (percent, 12-month mov ing av erage)

14

12

10

8

6

4

2

0
Jan-04

Jan-05

Jan-06

Jan-07

Jan-08

Jan-09

Jan-10

Lithuania

Reference value

Source: Commission services.

The  Lithuanian  12-month  moving  average  long-
term interest rate relevant for the assessment of the 
Treaty  criterion  stayed  below  the  reference  value 
during 2004 – 2008. Since 2009 it has been above 
the  reference  value.  In  March  2010,  the  latest 
month  for  which  data  are  available,  the  reference 
value,  given  by  the  average  of  long-term  interest 
rates  in  Portugal  and  Belgium  plus  2  percentage 
points,  stood  at  6%.  In  that  month,  the  12-month 
moving average of the Lithuanian benchmark bond 
stood  at  12.1%,  i.e.  6.1  percentage  points  above 
the reference value.  

This  result  must  be  interpreted  with  great  caution 
as  the  long-term  litas-denominated  government 
bond  market  is  extremely  shallow.  Notably,  the 
calculation  of  the  Lithuanian  12-month  moving 
average  long-term  interest  rate  value  for  the  year 
2009 is largely affected by a small number of  very 
low-volume  trades,    executed  in  January  2009 
when  pressures  in  the  Baltic  markets  were  very 
high.  The  yield  rose  to  14.5%  and  strongly 
impacted the average long-term interest rate as no 
new trades took place till December. Trades in late 
2009  and  early  2010  started  to  drive  the  average 
long-term interest rate down, but the impact of the 
previous hike in early 2010 has not yet faded away 

Graph 6.5.2: Lithuania - Long-term interest rates

 (percent, monthly v alues)

16

14

12

10

8

6

4

2

0

2004

2005

2006

2007

2008

2009

Source: Eurostat.

Lithuania

Euro  area

the  global  financial  crisis.  An 

The  sharp  increase  in  long-term  interest  rates  in 
early 2009 to some extent reflects the country risk 
premium, which rose considerably since the onset 
of 
improved  
macroeconomic outlook, the successful issuance of 
long-term euro- and dollar-denominated bonds and 
litas-
a  revival  of  risk  appetite  compressed 
denominated  long-term  government  bond  yields 
markedly  in  late  2009  and  early  2010.  The 
Lithuanian  long-term  interest  spread  vis-à-vis  the 
euro area at the cut-off date of the report stood at 
around 150 basis points. 

103 

 
 
 
European Commission 

Convergence Report 2010 

6.6.  ADDITIONAL FACTORS 

6.6.1.  Developments  of 

the  balance  of 

payments 

Lithuania’s  external  balance  (i.e.  the  combined 
current and capital account) has undergone a sharp 
correction  during  the  crisis,  adjusting  from  a 
deficit 10% of GDP in 2008 to a surplus of 7% of 
GDP in 2009. The external deficit in the pre-crisis 
period was mainly driven by the merchandise trade 
gap,  which  had  widened  as  a  result  of  buoyant 
domestic  demand.  Trade  in  services  and  current 
transfers  remained  in  surpluses  over  recent  years, 
in  2008. 
these  surpluses  narrowed 
although 
However,  the  deficit  on  the  income  balance  fell 
slightly  in  2008  as  profits  of  foreign  companies 
shrank.  

In  2009,  when  domestic  demand  contracted  and 
wages  fell,  the  merchandise  trade  gap  narrowed 
rapidly,  while  the  services  surplus  tripled.  Net 
current  transfers  doubled  and  the  surplus  on  the 
capital account also increased, partly as a result of 
better  EU  funds  absorption.  Furthermore,  the 
previously  highly  negative  income  account  turned 
to balance.  

The  primary  driver  behind  the  increasing  saving-
investment  gap  in  the  run-up  to  the  crisis  was  a 
surge  in  investment  activity  financed  by  private 
sector  borrowing  and  FDI,  while  the  domestic 
saving  ratio  remained  rather  stable.  Gross  capital 
formation  shrank  markedly  in  2009  when  bank 
credit  flows  to  the  private  sector  turned  negative 
and  FDI  flows  moderated.  As  a  result  savings-
investment gap became positive in 2009.   

Graph 6.6.1: Lithuania - Saving and investment
(in percent of GDP at market prices)

40

30

20

10

0

2004

2005
Gro ss national saving

2006

2007

2008

2009

Gro ss capital fo rmatio n at current prices; total eco nomy

Source: Eurostat, Commission services.

The  external  competitiveness  of  the  Lithuanian 
economy  appears  to  have  remained  solid  during 
2004-2008  as  the  share  of  Lithuanian  exports  in 
world  trade  continued  increasing  despite  rapid 

104 

increases 

in  manufacturing 

REER  appreciation.  The  ULC  rise  had  a  limited 
direct effect on the external competitiveness since 
remained 
wage 
moderate  compared  to  sharp  increases  in  non-
tradable  sectors.  The  real-effective  exchange  rate 
deflated by consumer price inflation as well as by 
unit  labour  costs  started  to  decline  from  early 
2009.  The trend continued in early 2010 implying 
cost  competitiveness  gains  of  the  Lithuanian 
economy.  

Graph 6.6.2: Lithuania - Effective exchange rates

 (v s. 35 trading partners;  monthly av erages;

  index numbers, 2004 = 100)

130

120

110

100

90

80

2004

2005

2006

2007

2008

2009

NEER

REER, HICP d eflated

REER, ULC d eflated

Source: Commission services.

Lithuania's  external  deficits  up  to  2008  were 
financed  by  strong  capital 
inflows,  mainly 
channelled  through  foreign-owned  banks.  Net 
foreign  direct  investment  (FDI)  also  played  a 
significant,  but  less  important  role,  while  net 
portfolio 
largely 
flows  were  negligible  and 
negative.  In  2009,  net  FDI  remained  positive,  but 
bank external credit markedly contracted, as banks 
revised  lending  policies  in  the  region,  tightened 
credit  standards  and  returned  excess  liquidity  to 
parent banks.  

Total gross external debt had been on an increasing 
trend  for  a  number  of  years  but  stabilised  from 
end-2008 as a result of rapid repayment of private 
debt,  which  fully  offset  the  increase  in  public 
borrowing. The external debt to GDP ratio slightly 
deteriorated  as  the  economy  contracted  and  stood 
at  around  86%  of  GDP  at  the  end  of  2009.  Net 
external  debt 
lower  but  still 
is  significantly 
sizeable at close to half of gross external debt. 

The  Lithuanian  economy  has  undergone  radical 
changes since the onset of the financial crisis. The 
accumulated  macroeconomic  imbalances  quickly 
unwound  and  the  current  account  turned  into 
surplus.  Flexible  wage  and  price  setting  enabled 
rapid downward adjustment of domestic costs and 

 
 
 
 
Convergence Report 2010 - Technical annex 

Chapter 6 - Lithuania 

2005

-7.1

-11.3

4.1

-2.4

2.5

1.3

-5.8

6.0

2.6

-1.0

7.1

-2.7

8.7

-0.2

23.9

16.8

50.7

-42.8

2006

-10.6

-13.9

3.6

-2.7

2.4

1.2

-9.5

10.4

5.1

-0.8

11.1

-4.9

15.3

-0.9

26.3

16.0

60.2

-49.2

2007

-14.5

-15.0

1.6

-4.1

3.0

1.7

-12.8

12.9

3.6

-0.8

13.0

-3.0

15.9

-0.1

30.9

15.8

71.9

-56.1

(percentage of GDP)

2008

-11.9

-12.0

1.1

-3.3

2.3

1.8

-10.1

10.4

3.2

-0.3

5.1

2.4

7.9

-0.3

27.0

15.1

71.6

-52.2

2009

3.8

-2.9

2.2

0.4

4.1

3.4

7.2

-7.2

0.4

2.6

-10.4

0.2

-7.4

0.0

12.5

15.0

86.2

-58.7

trade 

in  goods  declined 

The  orientation  of  Lithuania's  foreign  trade  is 
mostly  towards  the  EU-27,  which  is  a  sign  of  a 
well-advanced integration process. Although intra-
EU 
in  2008  after 
increasing earlier in the period, the average 2004-
2008 intra-EU trade in goods ratio was more than 
1½  time  higher  than  the  extra-EU  trade  in  goods 
ratio.  Intra-EU  trade  in  services  has  remained 
relatively  stable  in  recent  years  but  generally 
increased over the period reflecting an increase of 
market services in the overall economy.  

and 

accounting 

More than 60% of Lithuania's exports of goods are 
directed  to  EU-27  countries,  with  the  Baltic 
neighbours 
for 
Poland 
approximately one third of total flows. Lithuania's 
exports to the EU have a broad geographic spread 
with  the  main  trading  partners  being  Germany, 
France,  Denmark, 
the 
Netherlands  and  Sweden.  As  regards  extra-EU 
trade,  exports  to  the  CIS  have  increased  by  an 
average annual rate of 60% in nominal terms since 
2004.  Currently,  the  CIS  and  particularly  Russia, 
Belarus and Ukraine represent approximately 25% 
of Lithuania's total exports. 

the  United  Kingdom, 

Table 6.6.1:

Lithuania - Balance of payments

Current account

Of which: Balance of trade in goods

                 Balance of trade in services

                 Income balance 

                 Balance of current transfers

Capital account
External balance 1)
Financial account

Of which: Net FDI

                Net portfolio inflows
                Net other inflows 2)
                Change in reserves (+ is a decrease)

Financial account without reserves

Errors and omissions

Gross capital formation

Gross saving

External debt

International investment position

2004

-7.7

-10.6

3.6

-2.7

2.0

1.3

-6.4

5.6

2.3

0.9

1.9

0.5

5.1

0.8

22.7

15.2

42.3

-34.5

1) The combined current and capital account.

2) Including financial derivatives.

Sources: Eurostat, Commission services and Bank of Lithuania.

provided  support  to  price  stability  and  external 
competitiveness.  According  to  the  Commission 
services' 2010 Spring Forecast, Lithuania's current 
account  is  expected  to  remain  in  surplus  in  2010 
and 2011. 

Over the medium term, the achieved improvement 
in  the  external  balance  needs  to  be  supported  by 
continued  efforts  of  fiscal  consolidation,  policies 
fostering  job  creation  and  productivity  growth  as 
well  as  a  reorientation  of  resources  towards 
tradable sectors. 

6.6.2.  Product market integration 

to 

Lithuania  is  a  small  open  economy,  with  a  high 
degree  of  openness,  which  has  been  generally 
increasing over recent years, and is well above the 
EU-27  average.  The  accession 
the  EU 
contributed  to  extremely  rapid  integration  where 
trade  was  successfully  re-oriented  towards  EU 
partners.  This  positive  performance  is  usually 
explained  by  Lithuania's  relatively  diversified 
export  structure.  However,  despite  robust  export 
growth,  Lithuania's  trade  deficit  widened  over  the 
past years, reaching its peak in 2008 as a result of 
increasing imports.  

105 

 
 
 
 
 
European Commission 

Convergence Report 2010 

Table 6.6.2:

Lithuania - Product market integration

Trade openness 1) (%)
Extra-EU trade in goods GDP ratio 2) (%)
Intra-EU trade in goods GDP ratio 3) (%)
Intra-EU trade in services GDP ratio 4) (%)
Export in high technology 5) (%)
Technological balance 6) (%)
Total FDI inflows GDP ratio 7) (%)
Intra-EU FDI inflows GDP ratio 8) (%)
FDI intensity 9)
Internal Market Directives 10) (%)
Value of tenders in the O.J. 11)
Time to start up a new company 12)

Lithuania

2003

2004

2005

2006

2007

:

18.3

26.2

:

3.0

-3.0

1.0

:

:

:

:

:

57.1

16.8

31.2

4.7

2.7

-3.3

3.4

:

:

1.0

2.4

26.0

62.6

19.9

32.7

5.3

3.2

-3.4

4.0

:

:

0.4

3.6

26.0

65.9

20.5

35.1

5.7

4.7

-2.3

6.0

9.9

5.4

0.3

4.2

26.0

62.5

17.6

35.5

5.9

7.3

-1.0

5.2

3.7

2.5

0.6

4.2

26.0

2008

67.5

23.8

33.9

5.8

:

:

3.9

2.9

1.7

0.6

3.6

26.0

 1) (Imports + Exports of goods and services / 2 x GDP at current market prices) x 100 (Foreign Trade Statistics, Balance of Payments).

 2) (Extra-EU-27 Imports + Exports of goods / 2 x GDP at current market prices ) x 100 (Foreign Trade Statistics).

 3) (Intra-EU-27 Imports + Exports of goods / 2 x GDP at current market prices ) x 100 (Foreign Trade Statistics).

 4) Intra-EU-27 trade in services (average credit and debit in % of GDP at current prices) (Balance of Payments).

 5) Taken directly from Eurostat's databases: Exports of high technology products as a share of total exports.

 6) (Exports - imports in high tech) / GDP at current prices x 100, since 2007 the data based upon SITC Rev. 4 (earlier SITC Rev. 3).

 7) Total FDI inflows (in % of GDP at current prices).

8) Intra-EU-27 FDI inflows (in % of GDP at current prices).

9) FDI intensity (average intra-EU-27 inflows and outflows in % of GDP at current prices).

10) Percentage of internal market directives not yet communicated as having been transposed, in relation to the total number.

11) Public procurement - Value of public procurement which is openly advertised  (in % of GDP).

12) Time to start a new company (in days), Doing Business World Bank.

Sources: Eurostat, Commission services.

While a breakdown of exported goods by product 
category  reveals  the  continued  predominance  of 
low-to-medium  technology  goods  in  Lithuania,  a 
gradual  shift  to  high  technology  goods  is  taking 
place.  However,  raw  materials  (mainly  petroleum 
labour-intensive  products 
and  fertilisers)  and 
(furniture,  textiles,  etc.)  still  dominate  Lithuania's 
exports.  Mineral  products  also  constitute  a  large 
share  of  Lithuanian  exports  to  other  recently-
acceded  Member  States  due  to  its  large  share  of 
refined  oil.  This 
is  confirmed  by  revealed 
comparative  advantage  ratios  in  products  such  as 
peat, fertilisers and fibres. The share of "difficult-
in 
to-imitate" 
Lithuania's export has increased substantially over 
the  last  few  years,  mainly  due  to  high  investment 
in the chemical and plastics industry. At the same 
time, the increase in the share of exported capital-
intensive goods recorded in recent years is mainly 
due to rising re-exports of road vehicles to the CIS 
countries.  Compared  with  other  New  Member 
States, 
to  growth  of  high 
technology  manufacturing  has,  however,  been 
quite limited. 

research-intensive 

the  contribution 

products 

The share of total FDI in GDP has been decreasing 
since  2006  and  is  below  that  of  the  EU  average. 
Intra-EU FDI has also seen a substantial reduction 
over  the  same  period.  The  most  frequently  cited 

106 

causes of the relatively muted attractiveness of the 
country  with  respect  to  FDI  relate  to  red  tape, 
corruption and the uncompleted land reform, while 
the  inefficiency  of  the  public  bureaucracy  is  also 
found to be problematic. To a large extent, the FDI 
has  flowed  into  non-tradable  sectors  such  as 
financial 
transport, 
communication,  electricity,  gas  and  water  supply. 
Nevertheless,  a  high  share  of  the  FDI  stock 
(approximately  40%  in  2008)  is  located  in  the 
manufacturing  sector,  with  a  large  share  in  the 
manufacture  of  petroleum  products.  The  top  three 
countries  of  origin  for  FDI  are  Sweden,  Denmark 
and Poland.  

intermediation, 

retailing, 

to 

respect 

lack  of 

transparency 

indices.  However, 

With 
the  business  environment, 
Lithuania generally ranks well in terms of business 
lengthy 
competitiveness 
procedures  for  licences,  procedures  for  territorial 
planning,  a 
in  public 
procurement  rules  and  late  payments  by  public 
authorities are all cited as problems in Lithuania's 
business  environment.  Hence,  Lithuania  has  been 
the 
their 
proportionate  use  of  accelerated  or  negotiated 
procedures,  which  permit  shorter  time-frames  for 
tendering  and  can  limit  the  number  of  entities 
which are able to bid. Initiatives to develop Better 
in 
Regulation  policies  are  still  quite  recent 

in  Europe 

country 

leading 

in 

 
 
 
 
 
Lithuania  as  a  Better  Regulation  Programme  was 
only adopted in February 2008. Finally, as regards 
the transposition of EU Internal Market directives, 
Lithuania  is  the  best  performing  Member  State 
with the lowest transposition deficit rate. 

6.6.3.  Financial market integration 

Lithuania’s financial system is well integrated into 
the  broader  EU  financial  system.  The  main 
channels of integration are a high degree of foreign 
ownership  of  financial  intermediaries  associated 
with  substantial 
foreign  currency  borrowing. 
Compliance  with  the  acquis  of  the  Union  in  the 
field  of  financial  services  has  been  broadly 
achieved (42).  

interventions  with  regard 

Continued 
involvement 
foreign  private  bank 
during  the  financial  crisis  reduced  the  need  for 
to  financial 
public 
assistance.  Consequently,  in  contrast  to  the  euro 
area,  banking  sector  rescue  measures  were  not 
applied in Lithuania. 

the 

increasing 

The  size  of  Lithuania's  financial  system  is  still 
quite  small  compared  to  the  euro-area  average  in 
terms  of  the  financial  sector  assets,  but  financial 
development  has  progressed  over  recent  years. 
Reflecting 
level  of  central 
government  debt,  outstanding  debt  securities 
reached  33%  of  GDP  at  the  end  of  2009,  still  far 
below euro area levels. Stock market capitalisation 
also  remained  relatively  small  and  decreased 
further  to  12%  of  GDP  at  the  end  of  2009,  while 
bank  credit  increased  rapidly  to  76%  of  GDP, 
which is still lower than in other Baltic States and 
about half of the euro-area level. 

Graph 6.6.3: Lithuania - Recent development of the  

financial system relatively to the euro area
(in percentage of GDP)

180
160
140
120
100
80
60
40
20
0

LT, 2004

LT, 2009

Euro area,
2004

Euro area,
2009

Debt securities

Sto ck market capitalisatio n

Do mestic bank credit

Source: Eurostat, Bank of Lithuania, Nasdaq OMX.

(42)  For  further  information  on  compliance  with  the  financial 

services directives please refer to 

http://ec.europa.eu/internal_market/finances/actionplan/index_e

Convergence Report 2010 - Technical annex 

Chapter 6 - Lithuania 

The  Lithuanian  financial  sector  is  heavily  bank 
based,  which  is  typical  for  smaller  economies. 
Lithuania's banking system is fully privatised since 
2002  and  is  quite  concentrated,  with  a  CR5(43) 
ratio  of  81%.  Foreign  ownership  progressively 
increased to represent 85% of total assets in 2009. 
the  Lithuanian 
Scandinavian  banks  dominate 
banking system. 

Graph 6.6.4: Lithuania - Foreign ownership and 

concentration in the banking sector
(in percent, weighted av erages)

100

80

60

40

20

0

LT, 2004

LT, 2008

Euro area,
2004

Euro area,
2008

Co ncentratio n in the banking secto r (CR5 ratio )

Share o f fo reign institutio ns as % o f to tal assets

Source: ECB, Structural indicators for the EU banking sector, January 2010.

Due  to  the  strong  economic  downturn  in  the 
region,  the  share  of  non-performing  loans  picked 
up from the end of 2008 and reached 19% in 2009, 
exceeding  the  level  in  the  euro  area (44).  After 
years of high profits, the banking system recorded 
losses  in  2009.  Yet,  the  average  capital  adequacy 
ratio  in  the  banking  sector  increased  somewhat 
compared  to  2008  and  reached  14%  in  2009  (and 
stayed  somewhat  above  the  level  in  the  euro 
area)(45).  

Graph 6.6.5: Lithuania - selected banking sector soundness 

%

indicators relatively to the euro area

08

21

16

11

6

1

-4

LT, 2004

LT, 2009

Euro area,
2004

Euro area,
2008

Return o n equity

Capital adequacy

No n perfo rming lo ans

Note: For 2008, EU-27 non performing loans for are a proxy for EA.
Source: ECB, Bank of Lithuania, EC calculations.

(43)  The  CR  5  concentration  ratio  is  defined  as  the  aggregate 
market  share  of  the  five  banks  with  the  largest  market 
share. 

(44)  The  definition  of  non-performing  loans  of  the  Bank  of     
Lithuania  is  substantially  tighter,  as  it  includes  non-
impaired  loans  overdue  more  than  60  days  and  all  the 
impaired loans. 

(45)  According to Lietuvos Bankas, the CAR reached 14.2% in 

n.htm#transposition 

the fourth quarter of 2009. 

107 

 
 
                                                           
 
 
                                                           
financial crisis. Government debt remained mainly 
denominated  in  euro  and  was  concentrated  in 
longer  term  maturities  of  above  two  years.  The 
Vilnius Stock Exchange (VSE) performed strongly 
following the EU entry, yet stock indices declined 
during the period of financial markets turmoil and 
started  to  recover  from  mid-2009.  The  investor 
base has substantially broadened since VSE joined 
OMX,  offering  access  to  the  Nordic  and  Baltic 
securities  markets,  and  harmonized  market 
practices and rules. 

of 

and 

importance 

concentration 
the 

foreign  ownership 
High 
cross-border 
highlight 
cooperation 
supervisory 
to  ensure  adequate 
structures in safeguarding financial stability as the 
financial  system  develops  and  integrates  further 
with the EU. The securities market is regulated and 
supervised  by  the  Securities  Commission  of  the 
Republic of Lithuania while the Bank of Lithuania 
supervises  credit  institutions.  Both  institutions  are 
co-operating 
the  supervision  of 
individual sectors. Moreover, cooperation between 
the  Baltic  and  Nordic  countries  is  particularly 
intensive,  with  Memoranda  of  Understanding 
supporting  enhanced 
the 
supervision  of  specific  institutions  and  crisis 
management arrangements. 

information  sharing, 

improve 

to 

European Commission 

Convergence Report 2010 

Graph 6.6.6: Lithuania - Recent developments in bank credit to 

households and corporations relatively to the euro area

(in percentage of GDP)

60

50

40

30

20

10

0

Dec-04 Dec-05 Dec-06 Dec-07

Dec-08 Dec-09

Ho useho lds, LT
No n-financial co rpo ratio ns, LT
Ho useho lds, Euro  area
No n-financial co rpo ratio ns, Euro  area

Source: ECB, Eurostat.

to 

Reflecting  financial  deepening,  domestic  lending 
to  the  private  sector  expanded  strongly  over  the 
past  years,  but  the  share  of  loans  to  the  corporate 
sector  and  households  in  relation  to  GDP  is  still 
below  the  euro-area  average.  As  a  result  of  the 
the  private  sector 
financial  crisis,  credit 
contracted over the course of 2009. The corporate 
sector  was  particularly  badly  hit  with  credit 
contracting significantly from its peak level in end-
the  sharp  GDP 
2008.  Despite 
contraction, 
to  GDP  ratio  further 
increased  in  2009,  with  credit  to  households 
remaining  lower  than  credit  to  corporations.  The 
share  of  euro  denominated  loans  increased  since 
2007 and is prevailing in most sectors.  

the  credit 

that,  due 

to 

Graph 6.6.7: Lithuania - Share of foreign currency loans

(as percentage of total loans to households / corporations)
80

70

60

50

40

30

20

10

0

Dec-04

Dec-05 Dec-06

Dec-07 Dec-08 Dec-09

Co rpo ratio ns

Ho useho lds

Source: Bank of Lithuania and own calculations.

Insurance  companies,  investment  funds,  leasing 
companies  and  pension  funds  are  still  at  a  rather 
early  stage  of  development.  However, 
the 
development  of  second  and  third  pillar  pension 
funds  accelerated  after  the  pension  reform.  At  the 
end  of  2008,  14  management  companies  operated 
in  the  Lithuanian  securities  market,  managing  30 
pension  funds  of 
insurance 
contributions,  and  6  funds  of  the  supplementary 
voluntary  pension  accumulation.  The  importance 
of  capital  markets  increased  in  relation  to  the 

the  State  social 

108 

 
 
 
 
7.  HUNGARY 

7.1. 

LEGAL COMPATIBILITY 

7.1.1.  Introduction 

The  Magyar  Nemzeti  Bank  (MNB)  originally 
started  its  operations  in  1924  and  restarted  to 
operate as a Central Bank in 1987. Act LX of 1991 
on the MNB, which was adopted in October 1991, 
re-instated the bank’s independence, and was later 
repealed  by  Act  LVIII  of  2001  on  the  MNB  (the 
Act).  The  legal  basis  for  the  operations  of  the 
MNB  contained  in  the  Act  has  been  amended 
several  times  since  the  last  Convergence  Report 
2008.  Further  relevant  provisions  can  be  found  in 
the MNB’s Statutes, which were lastly amended in 
2010.  

Since no substantial changes have been introduced 
into  the  Act  and  in  the  Statute  of  the  MNB,  the 
comments from the 2008 Convergence Report are 
largely repeated in this year's assessment. 

7.1.2.  Objectives 

The secondary objective of the MNB (Article 3(2)) 
refers  to  the  general  economic  policy  of  the 
Government,  while  it  should  make  a  reference  to 
the  general  economic  policies  in  the  Union,  with 
the latter taking precedence over the former, as it is 
provided under Article 127 of the TFEU. 

in  the  performance  of  ESCB  related  tasks,  the 
wording  of  the  oath  to  be  sworn  by  them  is 
incompatible  with  the  institutional  independence 
of  the  MNB  and  thus  needs  to  be  adapted  to 
comply with Article 14.3 of the ESCB Statute.  

Article  50(5)  provides  for  the  Governor's  right  to 
appeal to the Hungarian Labour Court in case of a 
proposal  of  dismissal.  Such  a  proposal  may  be 
submitted 
the  Republic 
the  President  of 
according to Article 50(6). This provision does not 
foresee  the  right  of  judicial  review  before  the 
Court of Justice of the EU.  

to 

With  regard  to  financial  independence,  Article 
46/A(b)  of  the  Act  allows  the  shareholder  to 
establish  the  MNB's  balance  sheet  and  profit  and 
loss  statement.  The  State,  as  the  shareholder 
(Article  46(4)),  is  represented  by  the  Minister  for 
Finance.  The  authority  and  influence  of  the  State 
(Minister  of  Finance)  to  establish  the  MNB's 
balance  sheet  and  profit  and  loss  statement  are 
incompatible  with 
the  principle  of  financial 
independence.  What  is  more,  following  Article 
65(1), the Minister for Finance as shareholder may 
also decide to pay out a dividend from the profit or 
the  accumulated  profit  reserves,  which  constitutes 
a  further  incompatibility  with  the  principle  of 
financial  independence.  Hence,  Article  46/A(b) 
and  Article  65(1)  should  be  adjusted  accordingly 
to remove those incompatibilities. 

7.1.3.  Independence 

7.1.4.  Integration in the ESCB 

are 

There 
imperfection identified.  

two 

incompatibilities 

and  one 

The  incompatibilities  in  the  Act  derive  from  the 
following ESCB/ECB tasks: 

According  to  Article  49(7)  Monetary  Council 
members – including the Governor- must make an 
oath  or  a  solemn  promise  and  sign  a  document 
before  the  Hungarian  President  with  the  words 
required  by  Law  XXVII  of  2008  on  the  oath  and 
solemn  promise  of  certain  public  officials.  The 
Law  requires  making  an  oath  with  words:"(…)  to 
be faithful to the home country, to the Republic of 
Hungary  and  to  its  people,  to  comply  and  ensure 
compliance  with  the  Constitution,  together  with 
other laws, (…) to fulfil the duties arising from my 
position  as  a  (name  of  the  position)  in  order  to 
promote  the  development  of  the  Republic  of 
Hungary  and  the  application  of  the  Constitution". 
Since the Monetary Council members are involved 

• 

• 

• 

• 

the definition of monetary policy (Articles 4(1), 
6, 7, 12, 13, 49 and 60(1)(a)); 

the conduct of foreign exchange operations and 
the  definition  of  foreign  exchange  policy 
(Articles  4(4), 7d, 11(2)(3), 17 and 61(2)); 

the  holding  and  management  of 
reserves (Article 4(3) and 61(2) ); 

foreign 

the competences of the ECB and of the EU for 
banknotes  and  coins  (Articles  4(2),  31,  31A, 
32, 34, 60(1)(d-g), 60(2)(b)); 

109 

 
European Commission 

Convergence Report 2010 

• 

• 

• 

the  monetary 
functions,  operations  and 
instruments  of  the  ESCB  (Articles  5-7,  9,  10, 
60(1)(b-c), 61(1)(3)); 

the  financial  provisions  related  to  the  ESCB 
(Article 45(2- 3)) 

the  ECB's  right  to  impose  sanctions  (Article 
29C and 29D). 

implies 

integration  requirement  also 

the 
The 
removal  of  incompatibilities  in  the  Statutes  of  the 
MNB.  Several  provisions  of  the  Statute  do  not 
respect the prerogatives of the ESCB/ECB notably 
relating  to  monetary  policy  (Articles  4.1,  5.2.1) 
and to the financial provisions related to the ESCB 
(Articles 3.2.2, 3.2.3 and 6.2.).  

Article  32/D  of  the  Constitution  of  Hungary  Act 
attributes  the  competence  for  monetary  policy  to 
the MNB without taking into account the ESCB’s 
role.  This  constitutes  a  further  incompatibility  in 
the area of integration into the ESCB. 

There  are  also  some  imperfections  in  the  Act 
regarding: 

• 

• 

• 

• 

• 

the non recognition of the role of the ECB for 
the 
the  payment  systems 
functioning  of 
(Articles 4(5), 26 and 27); 

the non recognition of the role of the ECB  and 
of  the  EU  for  the  collection  of  statistics 
(Articles 4(6), 28, 60(1)); 

the  non  recognition  of  the  role  of  the  ECB  in 
the  field  of  international  cooperation  (Article 
41(4)) ;  

the absence of an obligation to comply with the 
Eurosystem's regime for the financial reporting 
of NCB operations (Article 46A(b)); 

the non recognition of the role of the ECB and 
the  Council  for  the  appointment  of  external 
auditors (Articles 45(3), 46A(c)). 

7.1.5.  Prohibition of monetary financing 

In 
this  area,  some 
imperfection subsist.  

incompatibilities  and  an 

Under  Article  14  of  the  Act  on  the  MNB,  the 
Central  Bank  is  allowed  to  extend  emergency 
the  event  of 
institutions 
loans 

to  credit 

in 

110 

circumstances which jeopardize the stability of the 
financial systems. 

In  order  to  comply  with  the  prohibition  on 
monetary  financing  of  Article  123  of  the  TFEU 
and  to  be  considered  as  an  'emergency  liquidity 
assistance',  a  loan  should  only  be  allowed  under 
the  following  conditions:  the  credit  institution 
should  be  solvent,  the  loan  should  be  short-term, 
cover urgent and unforeseen liquidity needs and be 
sufficiently  secured  by  adequate  collateral.  A 
penalty  rate  should  preferably  be  required.  These 
conditions have not been taken fully into account.  

The Act in Article 16(1) specifies the list of public 
sector  entities  to  which  the  MNB  may  not  grant 
overdraft facilities or other types of credit facility. 
This  list  however,  is  not  fully  compatible  with 
Article 123 of the TFEU, since it extends the type 
of entities covered by the Act.  

is  more, 

in  Article  16(3) 

What 
the  credit 
institutions owned by the State, local governments, 
any  other  budgetary  organs,  Union  institutions  or 
bodies, and central governments, regional, local or 
other  administrative  organs  of  other  Member 
States  are  exempted  from  the  general  prohibition 
to provide credit facilities. This Article is not fully 
compatible  with  the  prohibition  on  monetary 
financing, since it contains a wider exemption than 
foreseen  by  Article  123(2)  of  the  TFEU,  which 
only exempts publicly owned credit institutions “in 
the  context  of  the  supply  of  reserves  by  central 
banks”.  

Article  16(4)  defines  the  concept  of  indirect 
ownership.  This  provision  appears  to  be  already 
regulated in Article 16(2) reflecting Article 8(1) of 
Regulation  3603/93  defining  the  term  “public 
undertaking”  by  means  of  the  degree  of  public 
such  undertakings.  A 
sector 
clarification  with  regard 
interrelation 
between the two Articles would be welcome. 

influence  on 

the 

to 

According  to  Article  71(3),  the  MNB  may  grant 
loans  to  the  National  Deposit  Insurance  Fund  in 
emergency  cases.  This  provision  is  related  to 
Article  16(1)  and  paragraph  119  of  Law  CXII  of 
1996 on the Credit Institutions (as last amended by 
Law  CL  of  2009)  which,  inter  alia,  regulates  the 
financing  of  the  fund.  Though  the  Act,  in  its 
Article 16(1), explicitly refers to Article 123 of the 
further 
TFEU 
clarification is recommended, so to ensure that the 
loans  granted  to  the  National  Deposit  Insurance 

and  Regulation  3603/93 

a 

 
Convergence Report 2010 - Technical annex 

Chapter 7 - Hungary 

Fund  are  provided  against  adequate  collateral. 
Consequently,  since  not  all  conditions  are  taken 
fully  into  account  when  providing  an  'emergency 
liquidity  assistance'  by  the  Central  Bank,  the 
Article  71(3)  remains 
the 
prohibition on monetary financing, as foreseen by 
the Article 123 of the TFEU.  

incompatible  with 

7.1.6.  Assessment of compatibility 

As regards central bank integration into the ESCB 
at the time of euro adoption, independence as well 
as the prohibition on monetary financing, existing 
Hungarian legislations, in particular the Act on the 
MNB, the Statutes of the MNB, the Constitution of 
Hungary  and  the  Credit  Institutions  Act,  are  not 
fully  compatible  with 
the 
ESCB/ECB Statute. 

the  TFEU  and 

111 

 
 
European Commission 

Convergence Report 2010 

7.2. 

PRICE STABILITY 

7.2.1.  Respect of the reference value 

The 12-month average inflation rate, which is used 
for  the  convergence  assessment,  has  been  above 
the  reference  value  since  EU  accession.  After  it 
declined  gradually  from  almost  8%  in  December 
2007  to  below  3.8%  in  October  2009,  average 
annual  inflation  picked  up  again  in  November 
2009.    In  March  2010,  the  reference  value  was 
1.0%,  calculated  as  the  average  of  the  12-month 
average  inflation  rates  in  Portugal,  Estonia  and 
Belgium  plus  1.5  percentage  points.  The 
corresponding inflation rate in Hungary was 4.8%, 
i.e.  3.8  percentage  points  above  the  reference 
value. The 12-month average inflation rate is likely 
to  remain  well  above  the  reference  value  in  the 
months ahead. 

Graph 7.2.1: Hungary - Inflation criterion since 2004

 (percent, 12-month mov ing av erage)

8

6

4

2

0
Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11

Hungary

Reference value

Note: The dots show the projected reference value and 12-month average inflation 
in the country in December 2010.
Sources: Eurostat, Commission services' Spring 2010 Forecast.

7.2.2.  Recent inflation developments 

Inflation  has  been  very  volatile  in  Hungary  in 
recent  years,  mainly  reflecting  the  evolution  of 
energy  and  food  prices,  which  together  represent 
more  than  40%  of  the  HICP  basket.  Changes  in 
administered  prices  and  taxation  further  amplified 
inflation 
significant 
volatility.  Furthermore, 
increases  in  unit  labour  costs  have  also  exerted 
upward pressure on inflation in recent years.  

tradables.  In  July  2009,  an 

to  rise  again  in  the  first  half  of  2009,  driven  by 
unprocessed  food  and  industrial  goods  prices  as  a 
weaker exchange rate was being passed into prices 
of 
in 
consumption  taxes  induced  a  further  jump  in 
consumer  prices.  As  a  result,  annual  HICP 
inflation  remained  elevated  at  around  5.8%  in  the 
first quarter of 2010. 

increase 

Graph 7.2.2: Hungary - HICP inflation

 (y-o-y percentage change)

9

6

3

0

-3

2004

2005

2006

2007

2008

2009

Hungary

Euro  area

Source: Eurostat.

the 

inflation  (measured  as  HICP 

inflation 
Core 
excluding  energy  and  unprocessed  food)  largely 
followed  the  evolution  of  headline  inflation,  with 
processed  food  prices  exhibiting 
largest 
volatility.  Prices  of  services  were  the  main  driver 
of core inflation, reflecting significant increases in 
unit  labour  cost  in  this  sector  which  were  further 
accentuated  by  frequent  tax  and  administrative 
Inflation  of  non-energy 
price 
industrial  goods  broadly  followed  a  downward 
trend  up  to  2006,  but  accelerated  significantly  in 
the  course  of  2007,  mostly  due  to  indirect  tax 
hikes.  As  the  one-off  impact  of  these  measures 
faded  out,  non-energy  industrial  goods  inflation 
dropped 
in  2008  before  accelerating  again 
gradually in 2009.   

adjustments. 

7.2.3.  Underlying  factors  and  sustainability  of 

inflation 

Macroeconomic  policy-mix  and  cyclical 
stance 

Annual  HICP  inflation  peaked  at  9%  in  March 
2007  as  a  result  of  a  surge  in  energy  and  food 
prices,  accentuated  by  increases  in  indirect  taxes 
and  administered  prices  in  the  context  of  fiscal 
consolidation.  Consumer  price  growth 
then 
broadly  followed  a  downward  trend  until  January 
2009  as  inflation  in  food  and  energy  prices 
gradually  receded  and  the  inflationary  impact  of 
one-off  measures  also  faded  out.  Inflation  started 

Real GDP growth averaged more than 4% between 
2002  and  2006  but  it  started  to  decline  in  2007, 
mainly as a result of a reversal in the fiscal policy 
stance (leaving net exports as the main contributor 
to  GDP  growth).  The  declining  growth  path  was 
accentuated  by  the  strong  negative  impact  of  the 
global  financial  market  turmoil  on  the  Hungarian 
economy,  which  required  the  adoption  of  further 
fiscal  consolidation  measures  in  2009  and  also 

112 

 
 
 
Convergence Report 2010 - Technical annex 

Chapter 7 - Hungary 

Table 7.2.1:

Hungary - Components of inflation

(percentage change)1)

weights  

in total   

2004

2005

2006

2007

2008

2009

Mar-10

HICP

Non-energy industrial goods

Energy

Unprocessed food 

Processed food

Services

HICP excl. energy and unproc. food
HICP at constant taxes 2)
Administered prices HICP

6.8

2.7

10.5

4.5

8.3

8.5

6.4

5.0

12.5

3.5

1.1

7.6

5.0

0.8

5.5

2.7

3.3

8.4

4.0

-0.4

7.1

15.7

4.1

4.3

2.5

5.3

6.5

7.9

3.7

13.6

11.5

10.3

7.1

6.7

6.6

19.1

6.0

1.3

12.1

4.5

10.9

5.1

5.1

5.9

10.2

4.0

3.5

2.1

6.3

4.4

4.5

4.1

2.2

7.2

4.8

4.2

4.9

5.7

4.5

5.1

4.7

2.0

6.8

2010

1000

252

147

74

215

312

779

1000

176

1) Measured by the arithmetic average of the latest 12 monthly indices relative to the arithmetic average of the 12 monthly indices

   in the previous period.

2) Last observation for HICP at constant taxes is February 2010

weakened 
the  country's  export  performance, 
resulting in a broad-based real GDP contraction of 
6.3%  in  2009.  As  a  result,  a  significant  negative 
the 
output  gap  opened  up.  According 
Commission  services'  Spring  2010  Forecast,  real 
GDP  is  expected  to  stagnate  in  2010  and  then 
increase  by  around  2.8%  in  2011,  on  the  back  of 
robust  export  expansion,  later  followed  by  a 
recovery in domestic consumption. 

to 

thus  also  contributed 

Fiscal policy has been restrictive since 2007. After 
deteriorating  markedly  in  2005  and  2006,  the 
structural  general  government  balance  improved 
continuously  over  the  next  three  years.  The 
fiscal  stance  constrained  domestic 
restrictive 
demand  and 
to  an 
improvement  in  the  external  balance,  while  at  the 
same time the associated indirect tax hikes had an 
upward  impact  on  prices.  During  2009,  further 
significant 
fiscal  adjustment  measures  were 
adopted  to  restore  investor  confidence  in  the 
Hungarian economy. Moreover, a broadly budget-
neutral reshuffling of the tax revenue structure was 
implemented,  with  a  lower  tax  burden  on  labour 
compensated  by  higher  consumption  taxes,  which 
again  exerted  an  upward  pressure  on  consumer 
prices.  Measured  by  changes  in  the  structural 
balance,  the  fiscal  stance  is  expected  to  remain 
then  become 
broadly  neutral 
expansionary in 2011.  

in  2010  and 

Monetary  policy  was  relatively  tight  in  the  recent 
period,  mainly  to  counter  excessive  financial 
market  volatility,  with  3-month  real  interest  rates 
above  2%  from  August  2008  until  October  2009 
despite  declining  economic  activity.  The  policy 
rate  was  cumulatively  increased  by  100  basis 
points in autumn 2008 due to higher inflation and 
an  increased  risk  premium  on  forint  assets.  In 
October 2008, the central bank increased the main 

turmoil(46).  Following 

policy  rate  by  300  basis  points  in  an  attempt  to 
stabilise  the  exchange  rate  in  the  midst  of  the 
financial  market 
the 
granting  of  Balance  of  Payments  assistance  by 
institutions(47)  and  given  some 
international 
tentative signs of financial market stabilization, the 
central  bank  lowered  the  policy  rate  by  200  basis 
points over the next three months. However, after 
short-term interest rates started to increase and the 
forint  to  depreciate  further,  the  rate-cutting  cycle 
was  interrupted.  It  was  re-launched  again  in  July 
2009  as  the  central  bank  gradually  lowered  the 
main  policy  rate  by  400  basis  points  in  9  months 
amid apparent financial market stability. The credit 
channel  was,  however,  hindered  by  the  necessary 
balance  sheet  adjustment  of  the  private  sector  as 
the  stock  of  loans  from  credit  institutions  to  the 
non-financial private sector declined in 2009. 

Wages and labour costs 

inflation 

in 
Between  2002  and  2008,  wage 
Hungary  was  high  and  well  above 
labour 
productivity  growth, notably in  the  service sector. 
The  resulting  rapid  increase  in  unit  labour  costs 
negatively  affected  inflation  and  external  cost 
competitiveness.  While  Hungarian  labour  market 
institutions 
flexible,  with 
relatively 
decentralized private sector wage setting and a low 
coverage  of  collective  agreements,  the  high  wage 
growth  was  partly  driven  by  wage  settlements  in 

are 

(46)  On  16  October  2008,  the  Magyar  Nemzeti  Bank  and  the 
European  Central  Bank 
they 
established an agreement on repurchase transactions, which 
will provide the MNB with a facility to borrow up to EUR 
5 billion. 

jointly  announced 

that 

(47)  On 28 October 2008, the European Union, the International 
Monetary  Fund  and  the  World  Bank  agreed  on  a  EUR  20 
billion  assistance  package  for  Hungary,  of  which  up  to 
EUR 6.5 billion was made available under the EU Balance 
of Payments facility. 

113 

 
                                                           
 
 
 
 
European Commission 

Convergence Report 2010 

Table 7.2.2:

Hungary - Other inflation and cost indicators

2004

2005

2006

2007

2008

(annual percentage change)

20091)

20102)

20112)

HICP inflation

Hungary

Euro area

Private consumption deflator

Hungary

Euro area

6.8

2.2

4.5

2.0

Nominal compensation per employee

Hungary

Euro area

Labour productivity

Hungary

Euro area

Nominal unit labour costs

Hungary

Euro area

Imports of goods deflator

Hungary

Euro area

10.9

2.5

6.4

1.8

4.3

0.9

-1.0

1.3

3.5

2.2

3.8

2.1

7.1

2.2

3.8

1.1

3.2

1.3

1.5

3.6

1) 2009 data (except HICP inflation) are estimates. 

2) Commission services' Spring 2010 Forecast.

Source: Eurostat, Commission services.

4.0

2.2

3.4

2.2

5.3

2.6

3.3

1.7

1.9

1.1

8.0

4.1

the  public  sector,  which  influenced  private  sector 
behaviour,  as  well  as  by  sizeable  minimum  wage 
increases.  

Graph 7.2.3: Hungary - Inflation, productivity and wage trends

12

(y-o-y % change)

8

4

0

-4

2004

2005

2006

2007

2008

2009

2010

2011

P ro ductivity (real GDP  per perso n emplo yed)

No minal co mpensatio n per emplo yee

No minal unit labo ur co sts
HICP  inflatio n

Source: Eurostat, Commission services' Spring 2010 Forecast.

as 

employment 

programmes 

larger  drop 

economic  downturn 

The  labour  market  reacted  rather  swiftly  to  the 
employment 
sharp 
decreased  by  some  2.5%  in  2009,  with  public 
sector 
somewhat 
dampening  a 
in  private  sector 
employment. Growth of nominal compensation per 
employee  came  to  a  halt,  reflecting  wage  cuts  in 
the  public  sector  as  well  as  a  reduction  in  social 
security  contributions.  At  the  same  time,  rising 
unemployment  hindered  wage  growth 
the 
this  downward 
private  sector.  However,  as 
adjustment  did  not  fully  match  the  drop  in  labour 
productivity  implied  by  the  decline  in  economic 

in 

7.9

2.1

6.2

2.3

6.7

2.7

1.3

1.1

5.4

1.6

-4.4

1.3

6.0

3.3

5.6

2.9

6.5

3.4

1.9

0.0

4.5

3.4

2.7

4.1

4.0

0.3

4.4

-0.1

-0.2

2.0

-2.8

-2.0

2.7

4.0

0.5

-7.5

4.6

1.5

4.2

1.4

-0.3

1.3

0.9

1.8

-1.2

-0.5

-0.4

3.9

2.8

1.7

2.3

1.5

3.7

1.5

2.0

1.3

1.7

0.1

2.2

1.6

activity,  growth  of  nominal  unit  labour  costs 
remained positive. ULC growth is expected to turn 
negative  in  2010,  improving  Hungary's  external 
competitiveness,    as  labour  productivity  should 
gradually recover while nominal compensation per 
employee  is  likely  to  continue  declining  amid 
weak  labour  market  conditions.  ULC  growth  is 
however projected to  pick up again in 2011 as the 
sharp 
in  nominal  compensation  per 
employee  is  expected  to  outpace  the  productivity 
gains.   

increase 

External factors 

its 

the  Hungarian 
the  high  openness  of 
Given 
economy  and 
the  world 
into 
integration 
economy,  developments  in  import  prices  play  an 
important  role 
in  domestic  price  formation. 
Growth  of  import  prices,  as  measured  by  the 
imports of goods deflator in the national accounts, 
had  a  disinflationary 
in  2007  but 
contributed  to  consumer  price  increases  in  2008 
and 2009.  

impact 

Import  price  dynamics  have  been  significantly 
influenced by exchange rate fluctuations. Nominal 
effective  exchange  rate  depreciation  of  more  than 
20%  between  July  2008  and  March  2009  led  to  a 
rapid  increase  in  import  prices  in  the  second  half 
of  2008.  At  the  same  time,  the  surge  in  oil  and 

114 

 
 
 
 
 
 
through 

natural  gas  prices  between  early  2007  and  mid-
2008  was  gradually  passed 
into 
administered  energy  prices.  The  impact  of  higher 
energy  prices  on  headline  inflation  was  further 
enhanced  by  their  relatively  high  weight  in  the 
HICP  basket.  After  peaking  in  early  2009,  import 
prices  decreased  somewhat  throughout  the  rest  of 
the  year  as  the  exchange  rate  strengthened  again 
and  commodity  prices  stabilised  far  below  their 
2008 peaks.   

Administered prices and taxes 

of 

rate 

administered 

than  headline 

The share of administered prices in the Hungarian 
HICP is around 18% (48). From 2004 to 2009, the 
prices  was 
growth 
significantly  higher 
inflation, 
contributing  on  average  some  1.7  percentage 
points  to  HICP  inflation.  Sectors  that  contributed 
the  most  to  administered  price  inflation  were 
energy,  services  related  to  housing  as  well  as 
transportation.  This  was  mainly  the  consequence 
of  global  commodity  price  growth,  reductions  in 
subsidies as well as substantial investment needs in 
certain  regulated  sectors.  In  2009,  administered 
prices  increased  by  7.2%,  driven  by  higher  prices 
of  electricity,  water  supply,  refuse  and  sewerage 
collection. Administered price inflation is expected 
to  decrease  somewhat  in  2010,  mostly  thanks  to 
lower regulated energy price growth. 

Changes in taxation related to fiscal consolidation 
have  also  had  a  substantial  impact  on  inflation 
since  2006.  In  July  2009,  the  average  VAT  rate 
was raised again, as the VAT rate for around 85% 
of  the  consumer  basket  increased  from  20%  to 
25%, while the VAT rate for approximately 8% of 
the  basket  declined  from  20%  to  18%.  Due  to 
weak  demand  conditions,  retailers  were  only  able 
to  pass  through  an  estimated  60%  of  the  VAT 
increase  to  consumers  in  the  short  term,  thus 
reducing  its  inflationary  impact  to  around  1 
percentage  point  in  both  2009  and  2010.  Excise 
duties  have  also  been  increased  gradually  to 
support  fiscal  consolidation  efforts  and  also  in 
order to reach the minimum level of excises duties 
on  cigarettes  required  in  the  EU.  Increases  in 
excise  duties  on  fuel,  alcoholic  beverages  and 
tobacco products  became  effective  in  January  and 
July  2009  and  in  January  2010.  Excise  tax  hikes 
are  estimated  to  contribute  some  0.2  percentage 

(48)  For the purpose of this report, administered prices include 
regulated  energy  prices,  public  and  social  services,  postal 
services,  public  transport,  pharmaceutical  and  medical 
products,  telecommunications  services,  recreational  and 
sporting activities and some prices in the housing area. 

Convergence Report 2010 - Technical annex 

Chapter 7 - Hungary 

points to headline inflation in 2009 and around 0.6 
percentage points in 2010. 

Medium-term prospects 

Inflation  is  expected  to  drop  below  the  3%  target 
of the National Bank of Hungary in the second half 
of 2011. The fading-out of the inflationary impact 
of one-off measures adopted in 2009 should be the 
main  driver  of  the  disinflationary  process,  while 
the  substantial  negative  output  gap  is  likely  to 
further constrain underlying inflationary pressures. 
As a result, according to the Commission services' 
Spring  2010  Forecast,  inflation  is  projected  to 
average 4.6% in 2010 and 2.8% in 2011. 

recovery 

Risks to inflation appear to be broadly balanced. A 
slower-than-expected 
domestic 
demand  would  likely  heighten  the  disinflationary 
impact  of  the  negative  output  gap.  On  the  other 
hand,  potential  second  round  effects  from  recent 
tax  increases  or  higher  growth  of  commodity 
prices could slow the pace of disinflation.   

of 

The  level  of  consumer  prices  in  Hungary  was  at 
some 65% of the euro area average in 2008. As in 
other new Member States, the remaining gap vis-à-
vis the euro area is larger for services than goods. 
This  suggests  potential  for  further  price  level 
convergence  in  the  long  term,  as  income  levels 
(about  59%  of  the  euro  area  average  in  PPS  in 
2008) rise towards the euro area average.  

Medium-term 
inflation  prospects  will  depend 
strongly  on  wage  and  productivity  developments, 
to  avoid  excessive  wage 
notably  on  efforts 
increases in the service sector and to prevent skill 
mismatches,  in  particular  for  the  low-skilled. 
Further fiscal consolidation will also be important 
to stem inflationary risks, especially when cyclical 
conditions improve. 

115 

 
                                                           
European Commission 

Convergence Report 2010 

7.3.  GOVERNMENT BUDGETARY POSITION 

7.3.1.  The  excessive  deficit  procedure 

for 

Hungary (49) 

became  more  difficult  to  meet,  reflecting  the 
investors'  concerns  about  the  sustainability  of  the 
the  high  current  account 
budgetary  position, 
deficit, and the drop in potential growth, therefore 
necessitating  both  a  stronger  policy  response  and 
significant external official assistance.   

the  examination 

in  2003.  Since 

In July 2004 the Council decided that an excessive 
deficit  existed  in  Hungary,  recorded  at  5.9%  of 
GDP 
in 
Convergence Report 2008, the most recent Council 
Recommendation  under  Article  104(7)  TEC  was 
adopted on 7 July 2009, establishing a deadline for 
taking effective action by 7 January 2010 in order 
to  put  an  end  to  the  existing  excessive  deficit  as 
rapidly  as  possible  and  by  2011  at  the  latest.  In 
particular,  Hungary  should  ensure  a  deficit  not 
exceeding  3.8%  of  GDP  in  2010,  rigorously 
implement the necessary consolidation measures to 
ensure  a  continued  reduction  of  the  structural 
deficit  and  a  renewed  decline  of  the  headline 
deficit,  with  an  increased  reliance  on  structural 
measures,  and  spell  out  and  adopt  additional 
measures  ensuring  a  cumulative  fiscal  effort  of 
0.5% of GDP over 2010 and 2011. 

On the basis of a Commission Communication, the 
Council concluded in February 2010 that Hungary 
had  taken  action  representing  adequate  progress 
towards  the  correction  of  the  excessive  deficit 
within  the  time  limits  set  by  the  Council.  The 
procedure  is  therefore  held  in  abeyance.  The 
closely  monitor 
Commission 
budgetary developments in Hungary in accordance 
with  the  Treaty  and  the  SGP,  and  the  criteria  set 
out  in  the  context  of  the  medium-term  financial 
assistance from the EU. 

continues 

to 

7.3.2.  Developments 2004-2009 

Between  2004  and  2006,  the  budgetary  deficit 
increased  from  6.4%  to  9.3%  of  GDP  due  to  an 
increase in the expenditure ratio of 3¼ pp. of GDP. 
The  mid-2006  fiscal  policy  reversal,  which  was 
aimed  at  correcting 
the  existing  economic 
imbalances and restraining the accumulation of the 
public debt, reduced the budget deficit to 3.8% of 
GDP by 2008. This adjustment was based slightly 
more  on  the  revenue  side  (3 pp of  GDP  against  a 
reduction  of  2½  pp  of  GDP  on  public  spending) 
and  was  incomplete  when  the  global  financial 
crisis  hit  in  late  2008.  Gross  financing  needs 

(49)  All documents related to the excessive deficit procedure for 
at: 

Hungary 
http://ec.europa.eu/economy_finance/sgp/deficit/countries/
hungary_en.htm  

found 

can 

be 

the  weight  of  consumption 

The  general  government  deficit  slightly  increased 
to  4.0  %  of  GDP  in  2009,  from  3.8%  of  GDP  in 
2008.  This  was  achieved  in  spite  of  the  strong 
economic  deterioration  associated  with  the  global 
economic  downturn  and  its  large  unfavourable 
budgetary  effects.  Specifically,  the  revenue  ratio 
increased  by  0.4  pp.  to  45.8%  of  GDP  due  to 
several  factors.  First,  the  absorption  of  EU  funds 
increased  from  0.6%  of  GDP  in  2008  to  1.7%  of 
GDP  in  2009.  Second,  the  decline  in  nominal 
revenues  turned  out  to  be  less  in  2009  than  what 
would  have  been  expected  applying  standard 
elasticities. Third, the multi-annual tax reshuffling 
aiming  to  lower  the  tax  burden  on  labour  and 
increase 
taxes 
generated extra revenue of about 0.2% of GDP in 
2009, rather than being totally neutral. Finally, the 
property  income  ratio  was  about  0.1%  of  GDP 
higher  than  in  2008,  notably  due  to  higher 
dividends  from  state-owned  enterprises.  With 
regard  to  the  expenditure  ratio,  it  increased  by 
0.5pp.  of  GDP  to  49.8%.  It  mainly  reflects  the 
denominator  effect  associated 
the  sharp 
deterioration  of  nominal  GDP  and  the  increasing 
absorption  of  EU  funds  complemented  by  the 
national  co-financing  requirement.  However,  such 
deterioration  was  mitigated  by  several  factors. 
First, 
and 
restructuring  measures  of  around  1¾%  of  GDP, 
including  reform  steps  in  the  pension  and  social 
benefit systems and saving measures in the public 
wages 
transfers.  Moreover, 
expenditures,  related  to  subsidies  and  gross  fixed 
capital  formation  (in  particular  from  national 
sources), were also reduced. 

authorities 

adopted 

saving 

social 

and 

the 

to 

negative 

Given  the  lack  of  fiscal  space  and  the  fragility  of 
the financial market situation, the authorities were 
only  in  a  position  to  support  the  economic 
recovery  by  taking  measures  that  did  not  have  a 
significant 
In 
particular, the EU co-financed projects represented 
in 2009 a unique opportunity for the authorities to 
implement stimulus measures as a response to the 
economic crisis by allocating more funds to labour 
market projects aiming at keeping employment and 
the  maximum  advance 
temporarily 

increasing 

budgetary 

impact. 

116 

 
                                                           
Table 7.3.1:

Hungary - Budgetary developments and projections
Outturn and forecast 1)

2004

2005

2006

Convergence Report 2010 - Technical annex 

Chapter 7 - Hungary 

(as % of GDP unless indicated otherwise)

2007

2008

2009

2010

2011

General government balance

- Total revenues

- Total expenditure

of which: 
- interest expenditure

- current primary expenditure

- gross fixed capital formation

p.m.: Tax burden

Primary balance

Cyclically-adjusted balance

One-off and temporary measures
Structural balance 2)
Structural primary balance

Government gross debt

p.m: Real GDP growth (%)

p.m: Output gap

p.m: GDP deflator (% change)

Convergence programme
General government balance

Primary balance
Structural balance 2) 3)
Government gross debt

p.m. Real GDP (% change)

-6.4

42.3

48.7

4.4

39.5

3.5

37.4

-2.0

-7.1

0.2
-7.3

-2.9

59.1

4.9

1.5

5.4

-7.9

42.2

50.1

4.1

40.6

4.0

37.5

-3.8

-8.7

0.4
-9.1

-5.0

61.8

3.5

1.8

2.1

-9.3

42.6

51.9

3.9

41.8

4.4

37.2

-5.4

-10.9

-0.3
-10.6

-6.7

65.6

4.0

3.6

3.9

-5.0

44.8

49.8

4.1

40.2

3.6

39.8

-0.9

-6.4

-0.9
-5.5

-1.4

65.9

1.0

3.0

5.9

-3.8

45.4

49.2

4.2

41.0

2.9

40.0

0.4

-5.1

-0.4
-4.7

-0.5

72.9

0.6

2.7

3.8

2008
-3.8

0.4

-4.6

72.9

0.6

-4.0

45.8

49.8

4.7

41.3

2.7

39.1

0.7

-2.2

-0.1
-2.2

2.6

78.3

-6.3

-4.0

4.9

2009
-3.9

0.5

-1.6

78.0

-6.7

-4.1

44.7

48.8

4.5

40.5

2.7

38.0

0.5

-2.1

0.2
-2.3

2.2

78.9

0.0

-4.3

2.6

2010
-3.8

0.5

-1.5

79.0

-0.3

-4.0

44.2

48.1

4.1

40.2

2.4

37.4

0.1

-3.0

0.0
-3.0

1.1

77.8

2.8

-2.1

2.2

2011
-2.8

1.0

-1.5

76.9

3.7

2012
-2.5

1.2

-2.5

73.6

3.8

2013
n.a.

n.a.

n.a.

n.a.

n.a.

1) Commission services’ Spring 2010 Forecast.

2) Cyclically-adjusted balance excluding one-off and other temporary measures.

3) Commission services’ calculations on the basis of the information in the programme. One-off and other temporary measures 

taken from the programme (0.4% of GDP in 2008, 0.1% in 2009; all deficit-increasing; 0.2% in 2010; deficit-decreasing; 

and 0.0% in 2011 and 2012).

Sources: Commission services and January 2010 update of Hungary's Convergence Programme.

payment  to  EU-financed  projects  from  25%  to 
40%. 

7.3.3.  Medium-term prospects 

increase  of 

the  headline  deficit 
The  slight 
represents  a  structural  effort  of  2½  pp  of  GDP  in 
2009.  Over  the  period  2004-2009,  the  decline  of 
the structural deficit attained 5¼% of GDP. 

However,  debt  has  followed  a  continuously 
increasing path, reaching almost 80% of GDP, 20 
pps.  higher  than  in  2004.  This  partly  reflects  the 
efforts  by  the  government  to  support  banks 
through  recapitalisation  (0.1%  of  GDP)  and 
liquidity support (around 2% of GDP) as well as a 
strengthening of international reserves, which was 
financed from the international financial assistance 
provided by the EU and the IMF. 

According  to  the  latest  convergence  programme, 
submitted on 29 January 2010, the main goal of the 
medium-term  budgetary  strategy  is  to  reduce  the 
general  government  deficit  from  3.8%  of  GDP  in 
2010  to  below  3%  by  2011,  therefore  putting  an 
end  to  the  existing  excessive  deficit,  in  line  with 
the  Council  revised  recommendations  of  7  July 
2009. Additionally, the authorities aim to achieve a 
further  improvement  of  the  headline  deficit  to 
2.5%  in  2012  in  line  with  the  medium-term 
objective  (MTO)  of  a  deficit  of  1.5%  of  GDP. 
More in detail, for 2010, Parliament adopted on 30 
November a budget in compliance with the general 
target  of  3.8%  of  GDP, 
government  deficit 
underpinned by a number of legal decisions on the 
specific  announced  measures,  which  include  the 
freeze of the public sector wage bill, the reform in 
the pension system, saving measures in the area of 
social benefits as well as reduction of the level of 
housing  subsidies  and  gas-  and  district-  heating 
supports.  It  also  encompassed  reserves  amounting 

117 

 
 
 
 
 
 
European Commission 

Convergence Report 2010 

to  HUF  206  billion  (0.8%  of  GDP).  The  budget 
aims  at  respecting  a  strict  management  of  central 
budget  chapters  (notably  thanks  to  the  newly 
established  Treasurers 
lower 
expenditures  of  the  local  governments  reflecting 
the  reduced  transfers  from  the  central  budget  as 
well  as  the  more  efficient  operation  of  the  long 
distance public transport.  

system) 

and 

The Convergence programme already incorporated 
that revenue could turn out lower than expected in 
the budget by ⅓% of GDP as implied by last year's 
worst  outcome.  It  also  foresaw  higher-than-
budgeted  expenditure  of  0.1%  of  GDP  linked  to 
the  additional  subsidy  to  the  Budapest  transport 
company.  This  was  compensated  by  (i)  lower-
than-budgeted  net  interest  expenditures  of  0.15% 
of  GDP,  (ii)  a  one-off  revenue  of  ¼  %  of  GDP 
from  the  shift  of  the  eligible  employees  and 
pensioners  from  the  private  pillar  into  the  public 
pension  system,  and  (iii)  a  freezing  of  0.2%  of 
budgetary reserves.  

The Spring forecast foresees a deficit that is 0.3% 
of GDP higher than the deficit target in the budget 
and the convergence programme for the following 
reasons:  On  the  one  hand,  further  expenditure 
slippages are likely to occur linked to the currently 
re-nationalized  airline  company  MALEV  and  the 
fact  that  the  planned  reduction  of  the  subsidy  for 
the  long-distance  public  transport  system  is  not 
structural  measures; 
fully  underpinned  by 
furthermore,  further  slippages  are  foreseen  as  the 
new  Treasurers'  system  may  not  be  sufficient  to 
fully ensure the control of the expenditures by line 
ministries  against  the  background  of  substantial 
cuts  in  the  past.  Revenue  shortfalls  are  expected 
due  to  the  Constitutional  Court's  decision  of 
revoking  the  general  value-based  property  tax 
adopted by the Parliament and due to the fact that 
the  projected  income  from  the  sale  of  (mobile-
telephone)  licences  seems  to  be  overestimated.   
On  the  other  hand,  budgetary  reserves  of  around 
½% of GDP are still available and could be frozen. 
The government also announced that it could make 
contingency expenditure cuts of 0.2% of GDP to at 
least partly compensate for adverse developments, 
but based on the no-policy change assumption this 
has not been incorporated in the forecast. 

All  in  all,  the  2010  Commission  services  Spring 
forecast  foresees  a  general  budget  deficit  of  4.1% 
terms  can  be 
in  structural 
of  GDP,  which 
characterised as broadly neutral.  

118 

Concerning  2011  and  2012,  the  revenue  ratio 
should  further decline,  linked  to  (i)  the  increasing 
weight of net exports, which makes growth less tax 
reach,  (ii)  the  lags  between  the  contraction  of  the 
economy  and  its  negative  impact  on  revenue,  and 
(iii)  the  adoption  in  2009  of  a  reduction  of  the 
income tax burden as of 2011 that would increase 
the  deficit  by  0.6%  of  GDP.  The  acceleration  of 
the  absorption  of  the  EU  funds  may  only  partly 
offset  these  developments,  leaving  an  overall 
decline in the revenue ratio of 0.8% of GDP. 

on 

the 

the 

(e.g. 

targets, 

expenditure 

fiscal  policy  has 

Therefore,  in  order  to  achieve  the  medium-term 
deficit 
to 
counterbalance the declining revenue to GDP ratio 
the 
and  expected  additional  outlays 
compensation of the loss of the national bank) with 
measures 
side.  The 
convergence programme broadly lists a number of 
possible expenditure measures that would underpin 
the  targeted  deficit  reduction  in  2011  and  2012. 
They  refer  mainly  to  a  further  real  wage  decrease 
in the public sector, an additional decline of social 
benefits  in  real  terms  and  strict  discipline  of  the 
management at the budget chapters. However, the 
bulk  of  these  measures  has  not  been  specified  in 
detail  and  concrete  decisions  in  this  respect  have 
not  been  taken.  Based  on  the  programme  data 
recalculated by the Commission services according 
to  the  commonly  agreed  methodology,  after  the 
strongly  restrictive  fiscal  stance  in  2009  and  the 
previous  two  years,  the  budgetary  stance  in 
Hungary  turns  broadly  neutral  in  2010  and  2011 
and expansionary in 2012. 

in 

the 

increase 

Medium-term  debt  projections  until  2020  that 
assume  GDP  growth  rates  will  only  gradually 
recover  to  the  values  projected  before  the  crisis 
and  that  tax  ratios  will  return  to  pre-crisis  levels 
show that the budgetary development envisaged in 
the  programme,  taken  at  face  value,  would  be 
enough to stabilise the debt ratio by 2020. Pension 
reforms  implemented  in  2009  are  estimated  to 
reduce 
age-related 
expenditure, which after this reform is projected to 
be  clearly  below  the  EU  average.  The  budgetary 
position  in  2009  improved  from  the  starting 
position  of  the  previous  convergence  programme. 
Thus,  the  budgetary  impact  of  population  ageing 
on 
largely 
mitigated.  Ensuring  high  primary  surpluses  over 
the  medium  term  and  implementing  the  pension 
reform  rigorously,  as  already  foreseen  in  the 
programme,  will 
long-term 
sustainability risks of public finances, which were 

the  sustainability  gap  has  been 

reduce 

future 

the 

 
Convergence Report 2010 - Technical annex 

Chapter 7 - Hungary 

of 

implementation 

if  needed;  (ii)  specify 

In  view  of  the  above  the  Council  recommended 
Hungary  on  26  April  2010  to:  (i)  ensure  that  the 
3.8%  of  GDP  deficit  target  for  2010  is  achieved 
through  tight  expenditure  control  as  well  as 
through  a  possible  freezing  of  budgetary  reserves 
contingency 
and 
the 
the 
expenditure  cuts 
measures  underlying  the  budgetary  targets  from 
2011  onwards  and  stand  ready  to  strengthen  the 
fiscal  effort  to  ensure  that  the  deficit  is  brought 
below 3% of GDP  in  2011 and  is  reduced  further 
thereafter;  and  (iii)  improve  the  quality  of  public 
finances by preparing and adopting a 2011 budget 
in  full  compliance  with  the  fiscal  framework  and 
by  supporting  expenditure  moderation  through  a 
further  reform  of  public  administration  and  by 
addressing the situation of loss-making enterprises 
through structural reforms. 

assessed  in  the  Commission  2009  Sustainability 
Report  as  medium.  After  the  validation  of  the 
projections based on the 2009 pension reforms by 
the Economic Policy Committee in February 2010, 
the updated sustainability calculations indicate that 
the sustainability risk is low. 

in  2012.  According 

and  2011 
to 

The Council's overall conclusion was that, despite 
the  sharp  economic  contraction  in  2009  in  the 
context  of  the  financial  crisis,  the  budget  deficit 
was  stabilised.  Following  the  strongly  restrictive 
fiscal  stance  in  2009  and  the  previous  two  years, 
the  budgetary  stance  in  Hungary  would  turn 
and 
broadly  neutral 
in  2010 
expansionary 
the 
programme, this should lead to a correction of the 
excessive  deficit  by  2011  and  attaining  the  MTO. 
The  government  gross  debt-to-GDP  ratio  was 
expected  to  continue  its  upward  movement  up  to 
2010  and  start  declining  again  in  2011,  bringing 
the  debt  back  on  a  downward  path.  However,  the 
budgetary  path  only  foresaw  a  small  structural 
improvement  in  2010,  none  in  2011,  and  a 
deterioration  in  2012.  Moreover,  this  path  was 
subject  to  considerable  downside  risks,  especially 
in  the  outer  years.  In  2010,  the  elimination  of  the 
property  tax  and  the  downward  risks  notably 
linked  to  the  additional  financing  need  of  the 
public  transport  could  be  compensated  to  some 
extent  by  the  freezing  of  budgetary  reserves  and 
contingency  expenditure  cuts  of  0.2%  of  GDP. 
Regarding the outer years, risks were linked to the 
fact  the  macroeconomic  scenario  presented  in  the 
programme  was  slightly  favourable  and  that  the 
bulk  of  the  measures  underlying  the  budgetary 
path was unspecified and not adopted. Against this 
background, the correction of the excessive deficit 
in 2011 in line with the recommendation of 7 July 
2009  under  Article  104(7)  of  the  TEC  and  the 
subsequent  further  consolidation  was  not  ensured 
and  it  would  be  necessary  to  specify  the  savings 
measures  and  strengthen  the  consolidation  efforts 
from  2011.  While  the  programme  presented  the 
main  elements  of  the  new  fiscal  framework, 
enhanced compliance needed to be ensured. 

119 

 
European Commission 

Convergence Report 2010 

7.4. 

EXCHANGE RATE STABILITY 

The Hungarian forint does not participate in ERM 
II.  Between  mid-2001  and  early  2008, 
the 
Hungarian  central  bank  operated  a  mixed 
framework that combined an inflation target with a 
unilateral  peg  of  the  forint  to  the  euro,  with  a 
fluctuation band of +/-15%. The central parity was 
devalued  once  in  June  2003,  from  276.1  to  282.4 
HUF/EUR, following a period of appreciation that 
culminated  in  the  currency  reaching  the  strong 
edge  of  the  fluctuation  band  in  January  2003.  On 
26  February  2008,  the  exchange  rate  bands  were 
abolished and a free-floating exchange rate regime 
was  adopted.  The  move  aimed  at  helping  the 
central bank to better control inflation by removing 
possible  conflicts  between  maintaining 
the 
exchange rate band and the inflation target, thereby 
more firmly anchoring inflation expectations.  

Graph 7.4.1: Exchange rates - HUF/EUR

(monthly av erages)

310

300

290

280

270

260

250

240

230

In line with the general improvement of the global 
financial  market  situation,  the  forint  started  to 
recover  in  early  March  2009  and  followed  an 
appreciating 
trend  until  end  of  July  2009. 
Thereafter,  the  exchange  rate  remained  broadly 
stable,  despite  a  gradual  loosening  of  monetary 
this 
policy.  During 
assessment, the forint depreciated against the euro 
by 4.6%. 

two  years  before 

the 

reflected 

has  mainly 

The  recent  evolution  of  official  international 
reserves 
successive 
disbursements  of  Balance  of  Payments  assistance 
from  international  organisations.  After  hovering 
between  EUR  16  and  18  billion  for  almost  three 
years,  the  stock  of  international  reserves  jumped 
by  some  EUR  5  billion  in  November  2008  and 
then  gradually  increased  to  above  EUR  30  billion 
in summer 2009, broadly ensuring full coverage of 
short-term external debt (excluding intra-company 
debt  liabilities).  International  reserves  remained 
broadly stable in late 2009 as the improved global 
financial  market  situation  as  well  as  increased 
investors'  confidence  in  the  country  led  to  a 
stabilisation  of  private  capital  flows.  Against  this 
background,  Hungary  decided  not  to  ask  for 
further  disbursements  from  the  committed  official 
international  Balance  of  Payments  assistance.  A 
successful USD 2 billion bond issuance in January 
2010 then led to a further increase in international 
reserves. 

2004

2005
Source: ECB and EcoWin.

2006

2007

2008

2009

Graph 7.4.2: Hungary - 3-M Bubor spread to 3-M Euribor

 (basis points, monthly v alues)

significant 

The  forint  started  to  strengthen  gradually  against 
the  euro  from  mid-2006  onwards,  as  the  adoption 
of 
fiscal  consolidation  measures 
improved investors' perception of Hungary. After a 
moderate  weakening 
forint 
appreciation  resumed  at  an  accelerated  pace  from 
March 2008, with the currency being supported by 
three  successive  policy  rate  hikes  by  the  central 
bank.  

during 

2007, 

1200

1000

800

600

400

200

0

2004

2005

2006

2007

2008

2009

Source: Reuters EcoWin.

The  exchange  rate  peaked  in  July  2008  before 
depreciating  substantially  in  the  subsequent  three 
months,  as  the  Hungarian  economy  turned  out  to 
be  particularly  vulnerable  to  the  global  financial 
market  turmoil.  The  granting  of  Balance  of 
Payments  assistance  by  international  institutions, 
coupled  with  a  sharp  tightening  of  monetary 
policy,  led  to  a  temporary  stabilization  of  the 
exchange rate in late 2008, but forint depreciation 
continued in early 2009.  

The  strong  commitment  to  fiscal  consolidation 
made  in  the  summer  of  2006  initiated  a  steady 
downward  path  in  short-term  interest  rate  spreads 
vis-à-vis  the  euro  area,  lasting  until  December 
2007  when  3-month  spreads  narrowed  below 
2.7%.  Short-term  spreads  then  started  to  widen 
again,  due  to  higher  interest  rate  expectations  on 
the  back  of  a  worsened  inflation  performance. 
Spreads surged to above 7% at the end of October 

120 

 
      
 
 
2008,  following  a  3  percentage  point  increase  in 
the  main  policy  rate  by  the  central  bank  in 
response to intense financial market turmoil. After 
remaining  volatile  but  broadly  stable  despite  four 
policy rate cuts over the next three months, money 
market  spreads  continued 
further, 
June  2009. 
above  8.4% 
peaking 
Subsequently,  improved  sentiment  and  the  re-
launching  of  the  policy  rate-cutting  cycle  set 
spreads  on  a  steep  downward  path  as  they 
continuously narrowed to about 5.4% at the cut-off 
date of this Report. 

to  widen 

in 

at 

Convergence Report 2010 - Technical annex 

Chapter 7 - Hungary 

121 

 
 
 
Graph 7.5.2: Hungary - Long-term interest rates

 (percent, monthly v alues)

14

12

10

8

6

4

2

0

2004

2005

2006

2007

2008

2009

Source: Eurostat.

Hungary

Euro  area

Long-term  interest  rates  peaked  at  above  11%  in 
March  2009  and  then  started  to  decline  gradually 
in line with the improving global financial market 
situation  coupled  with  the  adoption  of  additional 
fiscal  consolidation  measures,  stabilising  below 
8% by end-2009. As a result, spreads vis-à-vis the 
euro  area  decreased  to  less  than  400  basis  points 
by end-March 2010.  

European Commission 

Convergence Report 2010 

7.5. 

LONG-TERM INTEREST RATE 

the  development  of 

For  Hungary, 
long-term 
interest rates over the reference period (April 2009 
to  March  2010)  is  assessed  on  the  basis  of 
secondary  market  yields  on  a  single  benchmark 
bond  with  a  maturity  of  below  but  close  to  10 
years.  

the 

Hungarian  ten-year  government  bond  yields  have 
been  above 
reference  value  since  EU 
accession,  reflecting  high  risk  premia  in  view  of 
perceived  weak  macroeconomic  fundamentals. 
The  12-month  moving  average  long-term  interest 
rate  relevant  for  the  assessment  of  convergence 
increased substantially between end 2007 and mid-
2009,  but  it  has  been  on  a  decreasing  path  since 
August  2009.  In  March  2010,  the  reference  value 
for the long-term interest rate criterion, defined by 
the average of long-term interest rates in Portugal 
and  Belgium  plus  2  percentage  points,  stood  at 
6.0%.  In  that  month,  the  twelve-month  moving 
average  of  the  yield  on  the  Hungarian  benchmark 
bond  had  reached  8.4%,  2.4  percentage  point 
above the reference value.  

Graph 7.5.1: Hungary - Long-term interest rate criterion
 (percent, 12-month mov ing av erage)

12

10

8

6

4

2

0
Jan-04

Jan-05

Jan-06

Jan-07

Jan-08

Jan-09

Jan-10

Hungary

Reference value

Source: Commission services.

After remaining broadly stable in a range between 
6.5%  and  7%  since  late  2006,  long-term  interest 
rates  started  to  increase  in  November  2007  and 
surged  to  over  9%  in  October  2008.  The  upward 
trend  initially  reflected  lower  global  risk  appetite 
vis-à-vis  emerging  markets,  but  later  increasingly 
also  specific  concerns  about  Hungarian  financial 
stability.  Following  the  granting  of  Balance  of 
Payments  assistance  by  international  institutions, 
long-term interest rates dropped temporarily before 
increasing  even  further  in  early  2009  amid  a 
continued deterioration in investors' sentiment.  

122 

 
 
 
7.6.  ADDITIONAL FACTORS 

7.6.1.  Developments  of 

the  balance  of 

payments 

After  several  years  of  sizeable  deficits,  Hungary's 
external  balance  (i.e.  the  combined  current  and 
capital  account) started  to  improve  gradually  in 
2007,  as  export  performance  strengthened  due  to 
buoyant  global  growth  while  ongoing  fiscal 
consolidation  constrained  domestic  demand  and 
thus import growth. Having stabilised in 2008, the 
external  deficit  contracted  sharply 
in  2009 
swinging into surplus. The adjustment was largely 
induced by a drop in domestic demand resulting in 
lower  imports,  as  the  fall-out  from  the  financial 
crisis and further fiscal consolidation measures had 
a 
impact  on  private 
consumption and investment. The improvement in 
the  external  deficit  was  broad-based,  as  an 
increased  surplus  of  the  goods  and  services  trade 
balance was accompanied by a lower deficit of the 
primary  income  balance  and  higher  net  current 
transfers.  The  surplus  on  the  capital  account  also 
increased due to higher absorption of EU funds. 

substantial  negative 

Graph 7.6.1: Hungary - Saving and investment
(in percent of GDP at market prices)

30

20

10

0

2004

2005
Gro ss national saving

2006

2007

2008

2009

Gro ss capital fo rmatio n at current prices; total eco nomy

Source: Eurostat, Commission services.

Unlike most new Member States, Hungary did not 
experience  a  pronounced  catching-up  related 
investment  boom,  but  the  savings-investment  gap 
mainly reflected a decrease in government savings 
up  to  2006.  A  significant  reduction  in  the  public 
deficit,  which  more  than  compensated  lower 
private  savings,  led  to  an  improvement  of  the 
external deficit in 2007. In contrast, the subsequent 
large  correction  of  the  external  balance  in  2009 
was  induced  by  an  increase  in  private  savings 
combined  with  a  drop  in  total  investment,  as  the 
financial  crisis  led  to  a  substantial  adjustment  of 
private  sector  balances  while  government  savings 
declined again.  

Convergence Report 2010 - Technical annex 

Chapter 7 - Hungary 

Competitiveness  indicators  for  Hungary  show  a 
mixed  picture.  Continuous  increases  in  the  export 
market share up to 2008 were sustained by a shift 
from  mature  European  and  US  markets  to  fast-
growing  emerging  markets.  However,  Hungary 
underperformed  most  of  its  peers  with  respect  to 
the  value  of  exports.  This  might  reflect  the 
specialization of Hungary in some products whose 
prices have tended to decline over time (e.g. office 
machines and telecommunication equipment).  

Graph 7.6.2: Hungary - Effective exchange rates

 (v s. 35 trading partners;  monthly av erages;

  index numbers, 2004 = 100)

160

150

140

130

120

110

100

90

80

2004

2005

2006

2007

2008

2009

NEER

REER, HICP d eflated

REER, ULC d eflated

Source: Commission services.

The  real  effective  exchange  rate,  measured  by 
HICP or ULC, appreciated sharply in the first half 
of 2008 and then weakened markedly in the second 
half of 2008 and in early 2009 as a consequence of 
significant 
depreciation. 
Favourable  relative  ULC  developments  in  2009 
implied  that  the  real  effective  exchange  rate 
appreciated less in ULC terms than in HICP terms 
since March 2009.  

effective 

nominal 

FDI  coverage  of  the  external  deficit  declined 
substantially  from  almost  80%  in  2005  to  around 
20%  in  2008,  partly  also  due  to  higher  outward 
FDI. At the same time, growing equity investment 
abroad caused net portfolio flows to turn negative 
in  2007.  As  a  result,  other  investment,  notably 
banks'  external  borrowing,  became  the  major 
source  of  external  financing  in  2007.  Total  gross 
external debt has thus been on a rapidly increasing 
trend,  reaching  almost  100%  of  GDP  in  2007, 
while the net international investment position was 
also negative and elevated.  

rapid  accumulation  of 
liabilities  by 

The  increase  in  external  debt  reflected  persistent 
substantial public financing requirements, but also 
foreign-exchange 
the 
denominated 
and 
companies 
households.  The  large  dependence  on  external 
funding 
a 
in  autumn  2008 
balance-of-payments  crisis 

availability 

resulted 

in 

123 

 
 
 
European Commission 

Convergence Report 2010 

Table 7.6.1:

Hungary - Balance of payments

Current account

Of which: Balance of trade in goods

                 Balance of trade in services

                 Income balance 

                 Balance of current transfers

Capital account
External balance 1)
Financial account

Of which: Net FDI

                Net portfolio inflows
                Net other inflows 2)
                Of which International financial assistance

                Change in reserves (+ is a decrease)

Financial account without reserves

Errors and omissions

Gross capital formation

Gross saving

External debt

International investment position

2004

2005

2006

2007

2008

2009

(percentage of GDP)

-8.3

-3.5

0.6

-5.2

-0.2

0.1

-8.2

9.6

3.3

6.6

1.6

-1.9

11.5

-1.4

26.4

17.3

67.3

-85.1

-7.2

-2.5

1.3

-5.7

-0.3

0.7

-6.5

8.4

5.0

4.0

3.9

-4.4

12.9

-1.9

23.9

15.8

75.7

-90.6

-7.2

-2.3

1.4

-5.9

-0.3

0.6

-6.6

9.2

1.1

5.7

3.6

-1.1

10.3

-2.7

24.0

16.5

90.3

-6.6

0.2

1.0

-7.3

-0.5

0.7

-5.9

7.8

3.4

-1.6

6.2

-0.1

7.9

-1.9

23.5

17.0

97.8

-105.1

-101.5

-7.0

0.0

0.9

-7.2

-0.7

1.1

-5.9

8.7

1.4

-2.4

17.0

6.6

-7.3

16.0

-2.8

0.2

4.3

1.6

-6.0

0.3

1.3

1.6

-0.8

1.1

-3.6

7.7

8.7

-6.0

5.2

-0.8

23.4

16.2

116.5

-100.9

18.5

18.9

140.0

-115.9

1) The combined current and capital account.

2) Including financial derivatives.

Sources: Eurostat, Commission services and Magyar Nemzeti Bank.

necessitating  official  external  financial  assistance 
as private foreign capital inflows were inhibited by 
the  global  financial  market  turmoil.  The  majority 
of  the  pre-committed  financial  resources,  some 
EUR  14.2  billion,  was  disbursed  in  late  2008  and 
throughout 2009 following positive assessments of 
fulfilment of the policy conditionality associated to 
successive  tranches  of  the  assistance.  As  a  result, 
external debt increased sharply to 140% of GDP in 
2009.  In  view  of  the  improved  external  financing 
situation,  the  authorities  have  not  requested  a 
further disbursement of pre-committed funds since 
September 2009. 

Despite  an  improvement  of  the  trade  balance 
following  a  strong  growth  of  export,  the  external 
balance  is  expected  to  deteriorate  again  in  2010 
due  to  a  larger  deficit  of  the  primary  income 
balance  as  the  profitability  of  foreign-owned 
companies is likely to recover somewhat.  

7.6.2.  Product market integration 

The  degree  of  trade  openness  in  Hungary  has 
increased consistently since accession to the EU in 
2004,  driven  by  successful  trade  re-orientation 
towards  the  EU  and  ongoing  integration  into  the 

broader EU economy. Intra-EU trade in goods and 
services  has  been  increasing  consistently  over  the 
period  under  review.  At  the  same  time,  the 
successful  extension  of  export  markets  to  the  fast 
growing  economies  of  Eastern  Europe  and  Asia 
has  supported  the  further  opening-up  of  the 
economy and has contributed to the steady growth 
in  both  intra-  and  extra-EU  trade  in  goods.  The 
comparison  with 
the  EU-27 
suggests  that  the  process  of  integration  with  the 
EU  is  already  well  advanced.  The  average  2004-
2008  intra-EU  trade  in  goods  ratio  was  almost 
three times higher than the extra-EU trade in goods 
ratio.  

the  average  of 

Trade  with  the  rest  of  the  EU-27  dominates  both 
trade,  accounting  for  80%  of 
directions  of 
Hungary's  total  exports  and  70%  of  its  imports. 
Germany  accounts  for  approximately  one  quarter 
of both exports and imports and remains the most 
important trading partner of Hungary, followed by 
Italy,  France  and  Austria,  each  accounting  for 
approximately  5%.  The  new  Member  States 
account for 20% of total exports and 15% of total 
imports. On the import side, outside of the EU-27, 
Russia is a significant supplier of energy products 

124 

 
 
 
 
 
Convergence Report 2010 - Technical annex 

Chapter 7 - Hungary 

Table 7.6.2:

Hungary - Product market integration

Trade openness 1) (%)
Extra-EU trade in goods GDP ratio 2) (%)
Intra-EU trade in goods GDP ratio 3) (%)
Intra-EU trade in services GDP ratio 4) (%)
Export in high technology 5) (%)
Technological balance 6) (%)
Total FDI inflows GDP ratio 7) (%)
Intra-EU FDI inflows GDP ratio 8) (%)
FDI intensity 9)
Internal Market Directives 10) (%)
Value of tenders in the O.J. 11)
Time to start up a new company 12)

Hungary

2003

2004

2005

2006

2007

:

14.2

40.0

:

22.3

0.0

2.5

:

:

:

:

:

66.6

13.8

42.6

6.5

21.9

-0.4

4.4

2.5

1.7

2.0

1.3

52.0

69.7

14.5

44.2

7.2

19.7

-0.9

7.0

6.7

3.7

0.7

6.8

52.0

79.4

17.3

50.7

7.8

20.3

1.5

6.5

5.6

3.5

0.9

6.8

80.8

17.8

51.1

8.1

21.4

1.6

4.2

2.7

2.3

1.2

4.5

2008

82.5

18.8

51.3

8.4

:

:

3.0

3.5

1.3

0.6

5.2

38.0

38.0

16.0

 1) (Imports + Exports of goods and services / 2 x GDP at current market prices) x 100 (Foreign Trade Statistics, Balance of Payments).

 2) (Extra-EU-27 Imports + Exports of goods / 2 x GDP at current market prices ) x 100 (Foreign Trade Statistics).

 3) (Intra-EU-27 Imports + Exports of goods / 2 x GDP at current market prices ) x 100 (Foreign Trade Statistics).

 4) Intra-EU-27 trade in services (average credit and debit in % of GDP at current prices) (Balance of Payments).

 5) Taken directly from Eurostat's databases: Exports of high technology products as a share of total exports.

 6) (Exports - imports in high tech) / GDP at current prices x 100, since 2007 the data based upon SITC Rev. 4 (earlier SITC Rev. 3).

 7) Total FDI inflows (in % of GDP at current prices).

8) Intra-EU-27 FDI inflows (in % of GDP at current prices).

9) FDI intensity (average intra-EU-27 inflows and outflows in % of GDP at current prices).

10) Percentage of internal market directives not yet communicated as having been transposed, in relation to the total number.

11) Public procurement - Value of public procurement which is openly advertised  (in % of GDP).

12) Time to start a new company (in days), Doing Business World Bank.

Sources: Eurostat, Commission services.

(more  than  6%  of  total  imports)  and  China 
represents almost 7% of total imports.  

The main feature in the composition of Hungary's 
exports  is  the  very  significant  share  of  high 
technology  goods.  Accounting  for  21%  of  total 
exports on average during the period under review, 
it  is  one  of  the  highest  in  the  EU-27.  This 
specificity  is  also  highlighted  by  the  strong 
revealed  comparative  advantage  of  Hungary  in 
information and communication technology (ICT). 
As  a  result,  the  technological  trade  balance  is 
positive  since  2006  and  increasing.  Other  fairly 
competitive  sectors  in  Hungary  include  motor 
vehicles,  chemicals  and  pharmaceuticals,  agro-
industries, as well as energy. Looking at categories 
of  goods  based  on  factor  intensities  shows  that 
Hungary has a comparative advantage in research-
intensive products, especially in those classified as 
"easy-to-imitate"  but  to  a  lesser  extent  in  those 
classified  as  "difficult-to-imitate".  Hungary  has  a 
relative disadvantage in industries that require high 
inputs  of  labour  and/or  raw  materials.  So  far, 
Hungary has been able to increase its market share 
at  a  similar  pace 
the  other  catching-up 
economies  in  the  region.  Nevertheless,  declining 
cost  competitiveness, due  to  both high  labour  and 
capital  costs,  may 
increasingly  affect  export 
performance.  In  addition,  the  high  ICT  and  high 

to 

technology  content  (mostly  cars  and  electronic 
devices) of products makes exports more sensitive 
to the business cycle as demand for such products 
grows  faster  than  average  in  good  times,  but  also 
declines  faster  in  bad  times.  On  the  import  side, 
Hungary  focuses  mainly  on  intermediate  goods 
(needed for exports) and energy products.  

Hungary’s rapid trade expansion over the last two 
decades  has  crucially  relied  upon  the  available 
skilled  labour  force  and  the  sustained  inflow  of 
FDI  since  a  very  early  stage  in  its  transition 
process  and  a  very  high  inflow  of  FDI  into  high 
technology  sectors.  This  has  played  an  important 
role  in  the  quick  restructuring  of  the  Hungarian 
economy  and  in  boosting  export  performance. 
Although  the  ratio  of  total  FDI  inflows  to  GDP 
peaked  in  2005,  the  stock  of  FDI  amounted  to  a 
high of 79% of GDP in 2007, ranking second only 
to  Slovakia  among  the  new  Member  States.  The 
EU-27  is  the  main  source  of  FDI  inflows  to 
Hungary.  

With  respect  to  the  business  environment,  some 
progress  has  been  achieved,  notably  for  business 
start-ups,  with  a  reduction  in  time  and  costs  for 
starting-up  a  company.  However,  there  has  only 
been 
the  area  of  better 
regulation,  as  well  as  in  the  use  of  impact 

limited  progress 

in 

125 

 
 
 
 
 
European Commission 

Convergence Report 2010 

assessments and consultation tools when designing 
new legislation. Finally, the transposition deficit of 
EU Internal Market directives in Hungary was well 
below the 1% EU target in 2008 and no directives 
were  overdue  by  two  years  or  more  thus  this  is  a 
positive record. 

7.6.3.  Financial market integration 

Hungary's  financial  sector  is  well  integrated  into 
the  broader  EU  economy.  This  integration  is 
visible  in  the  high  level  of  foreign  ownership  of 
the  banking  system  as  well  as  in  the  participation 
of the Budapest Stock Exchange (BSE) in the CEE 
Stock  Exchange  Group.  Compliance  with  the 
acquis  of  the  Union  in  the  field  of  financial 
services has been fully achieved (50). 

Graph 7.6.3: Hungary - Banking sector rescue measures 

relatively to the euro area

(effectiv e amounts in percentage of GDP)

10

8

6

4

2

0

Hungary

Euro area

Recapitalisatio n

Liability guarantees

A sset relief

Liquidity suppo rt

Note: data for December 2009.
Source: European Commission.

The  international  financial  crisis  exposed  the 
weaknesses of the Hungarian financial system. The 
high-risk  perception  of  the  country  triggered  a 
seizing-up of the domestic bond market in October 
2008.  With  liquidity  becoming  scarcer  and  the 
drying  up  of  the  foreign  exchange  swap  market, 
the financial downturn swiftly filtered through the 
banking system. The excessive risk-taking both by 
banks and borrowers lead to a steady worsening of 
the  quality  of  banks'  loan  portfolio.  Against  this 
background,  the  Hungarian  government,  assisted 
by the IMF and the European Union, put in place a 
safety  net  addressing  the  short  and  medium  term 
liquidity needs of financial institutions. Also in this 
context,  using  the  framework  of  the  European 
Banking  Coordination 
the  parent 
institutions of the six main foreign banks operating 
in  Hungary  committed  to  keep  their  exposure  to 
the country. 

Initiative, 

(50)  For  further  information  on  compliance  with  the  financial 

services directives please refer to 

http://ec.europa.eu/internal_market/finances/actionplan/index_e

Hungary has one of the better developed financial 
sectors  among  the  new  EU  member  countries.  In 
the  few  years  preceding  the  crisis,  the  banking 
sector has been expanding at a very dynamic pace 
mainly 
through  rapid  credit  growth.  Indirect 
intermediation  is  predominant  with  bank  credit 
amounting  to  almost  70%  of  GDP  in  2009.    As  a 
result  of  high  central  government  issuance,  the 
total  value  of  outstanding  fixed  income  securities 
was equivalent to over 54% of GDP in 2009. Stock 
market capitalisation has been heavily impacted by 
the  outbreak  of  the  financial  crisis  and  stood  at 
some  23%  of  GDP  in  2009,  down  from  the  34% 
level reached in 2007.  

Graph 7.6.4: Hungary - Recent development of the  

financial system relatively to the euro area
(in percentage of GDP)

180
160
140
120
100
80
60
40
20
0

HU, 2004

HU, 2009

Euro area,
2004

Euro area,
2009

Debt securities

Sto ck market capitalisatio n

Do mestic bank credit

Source: Eurostat, National Bank of Hungary, FESE.

system 

With  over  half  a  dozen  similar-sized  players  the 
Hungarian  banking 
is  not  highly 
concentrated.  By  assets,  the  top  five  players 
account  for  a  share  of  55%  (CR5  ratio)  with  the 
largest  bank  having  a  20%  share.  This  moderate 
concentration  ratio  has  been  rather  stable  since 
2002.  The  share  of  bank  assets  owned  by  foreign 
institutions  through  subsidiaries  reached  60%  at 
the end of 2008, up 5 percentage points since late 
2004.  

Graph 7.6.5: Hungary - Foreign ownership and 

concentration in the banking sector
(in percent, weighted av erages)

70
60
50
40
30
20
10
0

HU, 2005

HU, 2008

Euro area,
2004

Euro area,
2008

Co ncentratio n in the banking secto r (CR5 ratio )

Share o f fo reign institutio ns as % o f to tal assets

Source: ECB, Structural indicators for the EU banking sector, January 2010.

Notwithstanding  the  severity  of  the  crisis  in 
Hungary,  the  level  of  non-performing  loans (51) 
remains among the lowest in the new EU Member 

n.htm#transposition 

(51)  Loans overdue for more than 90 days 

126 

 
 
                                                           
 
 
                                                           
States (close to 6% in November 2009). This level 
is expected to increase in 2010, but the Hungarian 
banking  system  remains  profitable  and  well 
capitalized. With a capital adequacy ratio of some 
13%  in  December  2009  and  a  return  on  equity  of 
almost 10% in 2009 the challenges going forward 
appear manageable.  

Graph 7.6.6: Hungary - selected banking sector soundness 

40

30

20

10

0

-10

%

indicators relatively to the euro area

HU, 2004

HU, 2009

Euro area,
2004

Euro area,
2008

Return o n equity

Capital adequacy

No n performing loans

Note: For 2008, EU-27 non performing loans for are a proxy for EA.
Source: ECB, National Bank of Hungary, Hungarian FSA, EC calculations.

A  key  component  of  growth  in  the  Hungarian 
banking  sector  has  been  domestic  lending.  Before 
in  2009,  credit  expansion  was 
decelerating 
particularly  buoyant  in  the  household  segment. 
Lending  to  households  reached  31%  of  GDP  in 
2009,  roughly  the  same  level  as  lending  to 
corporations.  Household  debt  in  percentage  of 
GDP  is  not  particularly  high  in  an  EU  wide 
comparison;  however,  two-third  of  this  debt  is  in 
foreign  currencies,  with  a  large  majority  of  loans 
in Swiss franc. 

Graph 7.6.7: Hungary - Recent developments in bank credit to 

households and corporations relatively to the euro area

(in percentage of GDP)

60

50

40

30

20

10

0

Dec-04 Dec-05 Dec-06 Dec-07

Dec-08 Dec-09

Ho useho lds, HU
No n-financial co rpo ratio ns, HU
Ho useho lds, Euro  area
No n-financial co rpo ratio ns, Euro  area

Source: ECB, Eurostat.

The share of credit in forint has steadily decreased 
since 2003 and reached less than 40% at the end of 
2008.  Since  then,  the  steep  depreciation  of  the 
forint in 2009 and the drying-up of liquidity on the 
interbank  foreign  exchange  swap  market  has 
inversed this trend and domestic currency loans are 
the 
becoming 
stock  of  foreign  currency  loans  is  high  and 
exposure of the private sector to exchange risk will 
remain substantial in the years to come. 

increasingly  popular.  However, 

Convergence Report 2010 - Technical annex 

Chapter 7 - Hungary 

Graph 7.6.8: Hungary - Share of foreign currency loans

(as percentage of total loans to households / corporations)

80

70

60

50

40

30

20

10

0

Dec-04

Dec-05 Dec-06

Dec-07 Dec-08 Dec-09

Co rpo ratio ns

Ho useho lds

Source: National Bank of Hungary and own calculations.

prices 

decreased 

ties  with 

The  Budapest  Stock  Exchange  (BSE)  has  not 
played  a  decisive  role  in  the  financing  of  the 
economy.  Despite  strong 
its  main 
shareholder,  the  Wiener  Börse  and  the  integration 
with  Prague  and  Ljubljana  stock  exchanges,  it 
remains a dynamic but local market place. Falling 
stock 
total  market 
capitalisation of the BSE to 23% of GDP in 2009. 
However, 
trading 
platform  and  a  well  diversified  product  range  for 
investment  in  spot  and  derivatives  markets.  An 
important  segment  of  the  market  is  the  debt 
securities 
is  dominated  by 
the 
government 
turnover. Issuance by non-financial corporations is 
negligible. 

issues  representing  96%  of 

the  BSE  offers  a  modern 

section,  which 

the 

The  share  of  financial  assets  held  by  financial 
intermediaries  other  than  banks  has  been  slowly 
but steadily decreasing. Following the outbreak of 
the  financial  crisis  investment  companies  and 
assets managers were hit by losses suffered on the 
capital market and by withdrawals of capital. Their 
share in total assets thus declined from about 10% 
in  2007  to  around  8%  in  2008.  Leasing  and 
insurers  as  well  as  pension  and 
factoring, 
healthcare  funds  represented  around  20%  of 
financial  institutions'  assets  in  2008,  broadly  in 
line with previous years. 

the 

financial 

international 

The  framework  for  regulation  and  supervision  of 
all financial institutions has been reviewed in 2009 
and  considerably  strengthened  in  the  background 
of 
assistance 
programme.  The  Hungarian  Financial  Services 
Authority  (HFSA)  has  been  given  a  status  of  an 
autonomous body and the cooperation between the 
HFSA,  the  central  bank  and  the  Ministry  of 
Finance has been institutionalised in the Financial 
Stability  Council.  Furthermore  the  HFSA  has 
extended  its  cross-border  cooperation  to  insure 

127 

 
 
 
 
European Commission 

Convergence Report 2010 

adequate 
international Hungarian financial system. 

supervision 

the 

of 

increasingly 

128 

 
 
8. 

POLAND 

8.1. 

LEGAL COMPATIBILITY 

8.1.1.  Introduction 

The Act on the Narodowy Bank Polski (the Act on 
the  NBP)  was  adopted  in  1997  and  was  last 
amended in 2008 and 2009. 

No  amendments  to  the  Act  on  the  NBP  were 
introduced  with  regard  to  the  incompatibilities 
the  Convergence  Report  2008. 
mentioned 
Consequently,  comments  from  2008  are  repeated 
in this year's assessment. 

in 

8.1.2.  Objectives 

There is one incompatibility and one imperfection. 

Article  9(3)  of  the  Act  on  the  NBP  foresees  that 
the  President  of  the  NBP  shall  assume  his/her 
duties  after  taking  an  oath  before  the  Parliament. 
In this oath it is referred to the observation of the 
provisions  of  the  Polish  Constitution  and  other 
laws, the economic development of Poland and the 
well-being of its citizens.  

to 

to  contributing 

As stated in Article 127(1) of the TFEU, the ESCB 
shall  support  the  general  economic  policies  in  the 
Union  with  a  view 
the 
achievement of the Union's objectives as laid down 
in the TFEU. The President of the NBP is neither 
obliged,  in  his  oath  to  take  into  account  the 
objectives  of  the  ESCB  in  the  performance  of  his 
duties, nor to follow the interest of the euro area as 
a  whole.  This  practice  clearly  contradicts  the 
TFEU  once  Poland's  derogation  to  the  euro  is 
lifted.  The  provision  is  therefore  considered  as 
incompatible with Article 127(1) of the TFEU.  

Moreover, the provision does not take into account 
Article 14(3) of the ESCB/ECB Statute stating that 
the  national  central  banks  are  an  integral  part  of 
the  ESCB  and  shall  act  in  accordance  with 
guidelines and instructions of the ESCB.  

Article  3(1)  sets  the  objectives  of  the  NBP.  It 
refers to the economic policies of the government 
while  it  should  make  reference  to  the  general 
economic  policies  in  the  Union,  with  the  latter 
taking precedence over the former. This constitutes 

an  imperfection  with  respect  to  Article  127(1)  of 
the TFEU. 

8.1.3.  Independence 

In 
this  area, 
imperfections subsist.  

several 

incompatibilities  and 

The Act on the NBP does not prohibit the NBP and 
members  of  its  decision-making  bodies  from 
seeking or taking outside instructions; it also does 
the  Government  from 
not  expressly  prohibit 
seeking  to  influence  members  of  NBP  decision-
making  bodies  in  situations  where  this  may  have 
an impact on NBP's fulfilment of its ESCB-related 
tasks.  This  lack  of  clear  reference  constitutes  an 
incompatibility with Article 130 of the TFEU and 
Article 7 of the ESCB/ECB Statute.  

Article  23(1)2)  provides  that  the  NBP  has,  inter 
alia, to submit draft monetary policy guidelines, to 
report  on  their  implementation  and  the  NBP's 
Council  decisions  to  the  Government.  This  body 
has therefore the opportunity to exert influence on 
the monetary and financial policy of the NBP. This 
practice  constitutes  an  incompatibility  in  the  area 
of independence. 

The  grounds  for  dismissal  of  the  NBP's  President 
(Articles  9(5)),  of 
the  members  of  NBP 
Management  Board  (Article  17(2b)  and  of  the 
members  of  the  Monetary  Policy  Council  (Article 
in  Article  14(3)  do  not  exactly 
13(5))  and 
correspond  to  those  of  Art.  14(2)  ESCB/ECB 
Statute.  The  grounds  for  dismissal  listed  in  those 
Articles are in addition to the grounds provided by 
Art. 14(2) ESCB/ECB Statute.  

to 

in  order 

Whereas a further clarification of these grounds is 
in  principle  appreciated 
limit 
interpretation  problems,  an  explicit  reference  to 
Article  14(2)  ESCB/ECB  Statute  should  be 
included  in  Article  198  of  the  Constitution  of  the 
Republic  of  Poland.  The  lack  of  inclusion  of  the 
right  of  judicial  review  in  case  of  the  President's 
dismissal constitutes a further imperfection. 

According 
to  Article  203(1)  of  Poland’s 
Constitution,  the  Supreme  Chamber  of  Control  is 
entitled to examine the NBP's activities as regards 
its  legality,  economic  prudence,  efficiency  and 
diligence. This provision of the Constitution needs 

129 

 
European Commission 

Convergence Report 2010 

to be adapted in order to respects Article 130 of the 
Treaty and Article 7 of the ECB/ESCB Statute.  

8.1.4.  Integration in the ESCB 

The  incompatibilities  in  the  NBP  Act  in  this  area 
are linked to the following ESCB/ECB/EU tasks:  

• 

• 

• 

• 

• 

• 

• 

• 

the  absence  of  a  general  reference  to  the  NBP 
as an integral part of the ESCB and to 
subordination to the ECB’s legal acts; 

its 

the definition and implementation of monetary 
policy  (Articles  227(1)  of  the  Constitution, 
Articles,  3(2)(5),  12(1),  12(2),  21,  23,  38-50a, 
and 53 of the Act on the NBP); 

the conduct of foreign exchange operations and 
the  definition  of  foreign  exchange  policy 
(Articles 3(2)(3), 17(4), 24, and 52); 

the  holding  and  management  of 
reserves (Articles 3(2)(2),  52); 

foreign 

the right to authorise the issue of banknotes and 
the volume of coins (Articles 4, 33, 37); 

the definition of the monetary unit (Articles 31 
and 32); 

the  monetary 
functions,  operations  and 
instruments  of  the  ESCB  (Articles  12(2)1-3, 
12(2)6,  38,  39,  40,  41,  42(4)-(7),  44,  47  and 
48); 

the competences of the ECB and of the EU for 
banknotes  and  coins  (Article  227(1)  of  the 
Constitution and Articles 4,  31 to 37 of the of 
the Act on NBP) 

Article  227  of  the  Polish  Constitution  does  not 
reflect  that  monetary  policy  decisions  as  well  as 
foreign exchange policies shall be adopted at euro 
area  level  once  Poland's  derogation  is  lifted. 
Moreover, the NBP shall exercise its responsibility 
for  issuing  the  national  currency  as  part  of  the 
ESCB. This provision is incompatible with Article 
127(2)  of 
the 
ESCB/ECB  Statute,  Article  219  of  the  TFEU  as 
well  as  with  Article  128 of  the  TFEU  and Article 
16 of the ESCB/ECB Statute.  

the  TFEU;  Article  12(1)  of 

Article  69(1)  of  the  NBP  Act  foresees  that  NBP 
accounts  are  examined  by 
independent 
auditors.  The  Act  does  not  take  into  account  that 

the 

the auditing of a central bank has to be carried out 
by independent external auditors recommended by 
the  Governing  Council  and  approved  by  the 
Council.  It  is  incompatible  with  Article  27(1)  of 
the ESCB/ECB Statute. 

What is more, the powers of the Supreme Chamber 
of Control to control the activities of the NBP, as 
laid  down  in  Article  203(1)  of  the  Constitution, 
should  be  clearly  defined  to  respect  the  activity 
performed  by  an  independent  external  auditor, 
appointed  in  accordance  with  Article  27(1)  of  the 
ESCB/ECB  Statute.  There  are  also 
some 
imperfections regarding: 

• 

• 

• 

• 

• 

the non recognition of the role of the ECB for 
the 
the  payment  systems 
(Articles 3 (2)(1)) 

functioning  of 

the non recognition of the role of the ECB and 
of the EU for the collection of statistics (Article 
3 (2)(7) and 23) 

the  non  recognition  of  the  role  of  the  ECB  in 
the  field  of  international  cooperation  (Article 
5(1) and 11(3)) ;  

the absence of an obligation to comply with the 
Eurosystem's regime for the financial reporting 
of NCB operations; 

the non recognition of the role of the ECB and 
of  the  Council  for  the  appointment  of  the 
external  auditor  of  the  NBP  (Article  69(1)). 
The  powers  of  the  Supreme  Chamber  of 
Control  to  control  the  activities  of  the  NBP 
should be without prejudice to the activities of 
NBP's  independent  external  auditors,  as  laid 
down  in  Article  27(1)  of  the  ESCB/ECB 
Statute; 

• 

the non recognition of the obligation to consult 
the ECB for certain acts (Article 21(4)). 

8.1.5.  Prohibition of monetary financing 

Article  42  of  the  NBP  Act  in  conjunction  with 
relevant  provisions  of  Law  on  banking,  allow  to 
the  NBP  to  extend  refinancing  loans  to  banks  in 
order  to  replenish  their  funding  and  also  extend 
refinancing  to  bank  for  the  implementation  of  a 
bank 
rehabilitation  programme.  The  current 
wording of those provisions could be interpreted as 
allowing  for  an  extension  of  refinancing  loans  to 
rehabilitation  proceedings 
banks  experiencing 

130 

 
Convergence Report 2010 - Technical annex 

Chapter 8 - Poland 

leading  to,  in  some  cases,  insolvency.  Thus, 
effective  preventive  measures 
explicit 
safeguards  should  be  provided  in  the  law,  in 
particular  in  Article  42  of  the  Act  to  avoid 
incompatibility with Article 123 of the TFEU. 

and 

8.1.6.  Assessment of compatibility 

the 

time  of  euro  adoption, 
the  central  bank  and 

As  regards  the  central  bank  integration  into  the 
the 
ESCB  at 
the 
independence  of 
prohibition  on  monetary  financing,  the  objectives 
of the monetary policy, the legislation in Poland, in 
particular the Act on the National Bank of Poland 
and  the  Constitution  of  Poland  are  not  fully 
compatible  with  Article  130  and  131  TFEU  and 
the ESCB/ECB Statute. 

131 

 
 
supply), 

increases 

deteriorating  economic  situation.  This  reflected 
inter  alia  a  surge  in  food  prices  (partly  due  to 
in 
decreasing  domestic 
administered  prices  (notably  of  electricity  and 
gas), higher excise taxes as well as the effect of the 
strong weakening of the zloty in the second half of 
the 
2008  and  early  2009.  Since 
disinflationary effect of low domestic demand has 
contributed  to  a  moderate  decline  in  year-on-year 
HICP  inflation,  which  reached  2.9%  in  March 
2010. 

late  2009, 

Graph 8.2.2: Poland - HICP inflation

 (y-o-y percentage change)

6

4

2

0

-2

2004

2005

2006

2007

2008

2009

P o land

Euro  area

Source: Eurostat.

in  2008, 

inflation  (measured  as  HICP 

Core 
inflation 
excluding energy and unprocessed food) increased 
gradually  in  the  course  of  2007  and  remained 
elevated 
largely  reflecting  a  sharp 
increase in prices of processed food in conjunction 
with  the  global  shock  to  agricultural  commodity 
prices. Strong domestic demand also contributed to 
price  pressures  across  a  wide  range  of  categories, 
notably 
in 
administered prices and excise taxes as well as the 
effect  of  zloty  depreciation  offset  the  dampening 
effect (notably on market services) stemming from 
weakening  demand.  However,  the  latter  effect 
gained  some  strength  in  the  last  months  of  2009 
and early 2010. 

in  services. 

In  2009, 

increases 

European Commission 

Convergence Report 2010 

8.2. 

PRICE STABILITY 

8.2.1.  Respect of the reference value 

The  12-month  average  inflation  rate  for  Poland, 
which  is  used  for  the  convergence  assessment, 
remained  below  the  reference  value  from  autumn 
2005 to early 2008. After having stayed very close 
to  the  reference  value  in  the  first  half  of  2008,  a 
sizeable  positive  gap  opened  up  in  the  following 
months.  In  March  2010,  the  reference  value  was 
1.0%,  calculated  as  the  average  of  the  12-month 
average  inflation  rates  in  Portugal,  Estonia  and 
Belgium,  plus  1.5  percentage  points.  The 
corresponding  inflation  rate  in  Poland  was  3.9%, 
i.e.  2.9  percentage  points  above  the  reference 
value. The 12-month  average  inflation  is  likely  to 
stay  above  the  reference  value  in  the  months 
ahead. 

Graph 8.2.1: Poland - Inflation criterion since 2004

 (percent, 12-month mov ing av erage)

5

4

3

2

1

0
Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11

P o land

Reference value

Note: The dots show the projected reference value and 12-month average inflation 
in the country in December 2010.
Sources: Eurostat, Commission services' Spring 2010 Forecast.

8.2.2.  Recent inflation developments 

Inflation  in  Poland  has  been  somewhat  volatile 
over  the  last  years,  reflecting  in  particular  the 
sensitivity of the Polish economy to external price 
shocks  and  exchange  rate  fluctuations  as  well  as 
variations  in  food  prices,  which  have  a  relatively 
large  weight  (of  around  30%)  in  the  Polish  HICP 
index.  

HICP  inflation  picked  up  significantly  in  the 
second half of 2007 on the back of rising food and 
energy  prices  as  well  as  rising  domestic  demand 
and  unit  labour  costs.  Annual  headline  inflation 
reached 4.5% on average in the first quarter 2008, 
the  highest  level  since  end-2004.  It  remained 
above  4%  for most  of  2008,  before  the  decline  in 
fuel and food prices in the world markets led to a 
temporary  drop  in  the  last  quarter  of  2008. 
Inflation  stayed  elevated  in  2009  despite  the 

132 

 
 
 
Convergence Report 2010 - Technical annex 

Chapter 8 - Poland 

Table 8.2.1:

Poland - Components of inflation

(percentage change)1)

weights  

in total   

2004

2005

2006

2007

2008

2009

Mar-10

HICP

Non-energy industrial goods

Energy

Unprocessed food 

Processed food

Services

HICP excl. energy and unproc. food
HICP at constant taxes 2)
Administered prices HICP

3.6

1.6

6.2

5.9

5.0

2.3

2.8

3.1

2.4

2.2

-0.1

6.2

3.0

1.9

2.2

1.2

1.6

2.8

1.3

-1.7

4.8

0.8

0.9

2.8

0.6

1.1

4.9

2.6

0.0

4.3

4.4

4.3

2.7

2.0

2.1

3.7

4.2

-0.3

8.5

2.8

7.9

4.4

3.6

3.5

6.4

4.0

0.2

5.9

7.1

5.7

4.5

3.3

3.2

6.9

3.9

0.5

6.1

6.2

5.5

4.3

3.3

3.4

5.7

2010

1000

280

130

94

202

293

775

1000

134

1) Measured by the arithmetic average of the latest 12 monthly indices relative to the arithmetic average of the 12 monthly indices 

   in the previous period.

8.2.3.  Underlying  factors  and  sustainability  of 

inflation 

Macroeconomic  policy-mix  and  cyclical 
stance 

After  a  period  of  rapid  growth  over  2003-2008 
(averaging  some  5%),  Polish  real  GDP  growth 
decelerated  in  2009.  However,  notably  thanks  to 
its comparatively sound fundamentals at the onset 
of  the  crisis,  the  cushioning  impact  of  sizeable 
exchange rate depreciation, the policy response to 
the downturn and a relatively closed economy, the 
Polish  economy  weathered  the  global  crisis  better 
than its regional peers, being the only EU country 
recording  positive  real  GDP  growth  (of  1.7%)  in 
2009. The output gap turned nevertheless negative 
in 2009 following several years of largely positive 
output  gaps.  Real  GDP  growth 
is  projected 
according  to  Commission  services'  2010  Spring 
Forecast to moderately rebound in 2010 and 2011, 
leading  to  some  widening  of  the  negative  output 
gap. 

fiscal  policy 

Robust real GDP growth led to a strong reduction 
of  general  government  deficits  during  2004-2007, 
with a mildly restrictive fiscal stance, as measured 
by changes in the structural balance, in most years. 
However,  the  structural  deficit  remained  elevated. 
turned  markedly 
stance 
The 
expansionary  in  2008,  reflecting  a  reduction  in 
social  contributions,  increases  in  personal  income 
tax  reliefs  and  generous  indexation  of  social 
benefits  and  pensions.  Fiscal  expansion  continued 
in  2009,  with  a  cut  in  personal  income  tax  and 
increases in social transfers and public investment. 
The 
implies  a 
moderately  restrictive  fiscal  stance  in  2010  and 
2011.  

structural  deficit  projection 

inflation 

targeting 

After  a  significant  tightening  between  early  2007 
and  mid-2008,  monetary  policy,  conducted  within 
framework (52),  was 
an 
subsequently  loosened  following  the  deterioration 
of  the  economic  situation.  The  National  Bank  of 
Poland (NBP) lowered its reference rate by a total 
of  250  basis  points  to  3.5%  between  November 
2008  and  July  2009.  In  addition,  the  minimum 
reserve  requirement  was  reduced  from  3.5%  to 
3.0%  in  May  2009.  The  NBP  also  took  several 
measures  to  improve  the  functioning  of  the 
interbank  market  as  part  of  the  "Confidence 
Package"  in  early  2009  (notably  extension  of  the 
repo 
maturity  of 
operations,  expansion  of  the  range  of  assets  that 
may  serve  as  collateral  for  access  to  liquidity-
providing  operations  and  introduction  of  foreign 
exchange  swaps  enabling  banks  to  obtain  foreign 
currencies  from  NBP,  notably  though  repurchase 
and swap agreements signed by the NBP, with the 
European  Central  Bank  and  the  Swiss  National 
Bank (53)). 

liquidity-providing 

zloty 

The  subsequent  reduction  in  money  market  rates, 
with  real  short-term  interest  rate  close  to  zero  or 
even  negative,  was  not  fully  reflected  in  the 
interest rates charged by commercial banks as the 
latter  increased  loan  margins.  In  addition,  due  to 
the  deteriorating  economic  outlook  and  higher 
costs  of  financing,  banks  significantly  tightened 
lending  conditions  and  reduced  their  offer  of 
foreign-denominated  loans.  The  lower  supply  of 
loans  together  with  a  reduced  demand  for  credit 
(most notably from enterprises) led to a significant 
slowdown of  credit growth  in  the  course  of 2009, 

(52)  The  inflation  target  is  set  at  2.5%  with  a  permissible 

fluctuation band of +/- 1 percentage point. 

(53)  As a result of the reduced demand for liquidity provided by 
these  operations  and  improved  conditions  in  the  Swiss 
franc  funding  market,  EUR/CHF  foreign  swaps    were 
discontinued after 25 January 2010.  

133 

 
                                                           
 
 
 
 
European Commission 

Convergence Report 2010 

Table 8.2.2:

Poland - Other inflation and cost indicators

2004

2005

2006

2007

2008

(annual percentage change)

20091)

20102)

20112)

HICP inflation

Poland 

Euro area

Private consumption deflator

Poland 

Euro area

3.6

2.2

3.0

2.0

Nominal compensation per employee

Poland 

Euro area

Labour productivity

Poland 

Euro area

Nominal unit labour costs

Poland 

Euro area

Imports of goods deflator

Poland 

Euro area

1.9

2.5

4.1

1.8

-2.1

0.9

4.9

1.3

2.2

2.2

2.1

2.1

1.7

2.2

1.4

1.1

0.3

1.3

-4.2

3.6

1) 2009 data (except HICP inflation) are estimates. 

2) Commission services' Spring 2010 Forecast.

Source: Eurostat, Commission services.

1.3

2.2

1.2

2.2

1.8

2.6

2.9

1.7

-1.1

1.1

2.8

4.1

particularly  for  corporations  and  housing  loans, 
following a period of vigorous growth over 2006-
2008. 

Wages and labour costs 

The  labour  market  situation  reacted,  albeit  with  a 
lag, to the economic slowdown after several years 
of  improvement.  The  weakening  demand  for 
labour,  together  with  higher  labour  supply  as  a 
result  of  increased  labour  participation,  translated 
into an increase in the unemployment rate to about 
8.2%  in  2009,  from  a  seven-year  low  of  7%  in 
2008.  

Graph 8.2.3: Poland - Inflation, productivity and wage trends

12

(y-o-y % change)

9

6

3

0

-3

2004

2005

2006

2007

2008

2009

2010

2011

P ro ductivity (real GDP  per perso n emplo yed)

No minal co mpensatio n per emplo yee

No minal unit labo ur co sts
HICP  inflatio n

Source: Eurostat, Commission services' Spring 2010 Forecast.

134 

2.6

2.1

2.4

2.3

4.9

2.7

2.3

1.1

2.6

1.6

0.8

1.3

4.2

3.3

4.2

2.9

8.1

3.4

1.2

0.0

6.9

3.4

0.3

4.1

4.0

0.3

2.7

-0.1

3.7

2.0

1.3

-2.0

2.4

4.0

9.3

-7.5

2.4

1.5

2.4

1.4

3.2

1.3

2.7

1.8

0.5

-0.5

-1.5

3.9

2.6

1.7

2.6

1.5

4.4

1.5

2.7

1.3

1.7

0.1

2.0

1.6

In  2009,  the  fall  in  labour  demand  led  to  a  lower 
growth  of  nominal  compensation  per  employee, 
after  several  years  of  rapid  increases.  This  helped 
to narrow, but not close, the gap with productivity 
growth,  which  dropped 
in  2008  and  2009 
reflecting  the  GDP  slowdown.  As  a  result,  the 
growth  rate  of  nominal  unit  labour  costs  (ULC) 
moderated in 2009 from the high levels reached in 
the context of the previous tightening of the labour 
market.  The  Commission  services'  2010  Spring 
Forecast  projects  the  growth  rate  of  unit  labour 
cost  to  further  decrease  in  2010  and  remain 
moderate  in  2011,  as  wage  growth  will  further 
adjust 
slowdown  while 
economic 
productivity growth is expected to rebound due to 
a more rapid recovery of output than employment. 

the 

to 

Wage  negotiations  in  the  private  sector  are  rather 
decentralised  and  flexible,  with  wage  setting 
mostly  at  the  enterprise  level,  though  centralised 
bargaining  applies  to  public  wages  and  to  some 
key sectors of the economy still dominated by state 
enterprises. The slowdown of wage growth in 2009 
was  primarily  private  sector-driven  while  public 
sector wage growth is expected to further decrease 
in 2010.  

 
 
 
 
 
 
External factors 

into 

integration 

For  Poland,  given  the  increasing  openness  and 
the  globalising 
deepening 
economy,  developments  in  import  prices  play  an 
important role in domestic price formation. Import 
prices,  as  measured  by  the  imports  of  goods 
deflator  in  the  national  accounts,  rose  relatively 
moderately  between  2006-2008,  but  surged  in 
2009,  largely  on  account  of  the  increase  in 
commodity  prices  and  the  depreciation  of  the 
zloty. 

Energy  and  food  prices  have  been  a  major 
component of imported inflation in the recent past, 
in  particular  in  view  of  the  large  weight  of  these 
categories  in  the  Polish  HICP  basket.  Energy 
prices  rose  sharply  between  mid-2007  and  mid-
2008, reaching a year-on-year increase of close to 
10%  in  mid-2008,  led  by  the  strong  increase  in 
crude  oil  prices  in  world  markets.  Administered 
energy  and  gas  prices  followed  a  broadly  similar 
profile, although with a lag and a varying degree of 
the  pass-through  from  global  prices.  After  having 
moderated  in  the  course  of  2009,  energy  prices 
started  to  rise  markedly  again  at  the  end  of  2009, 
led by the pick-up of crude oil prices amidst signs 
of  improvement  of  the  world  economy.  After  the 
strong  increase  in  2007-2008  driven  by  global 
agricultural price developments, the annual growth 
of  food  prices  moderated  strongly  in  the  second 
half  of  2008;  it  rose  moderately  again  in  2009, 
the  decreasing  domestic 
essentially  reflecting 
supply  of  food  products  (particularly  sugar,  meat 
and some vegetables). 

Import price dynamics over recent years were also 
affected by the evolution of the exchange rate. The 
sustained  appreciation  of  the  zloty  helped  to 
moderate 
impulses 
emanating  from  international  commodity  markets 
from  the  second  half  of  2007  to  mid-2008,  while 
the  subsequent  sharp  depreciation  of  the  zloty 
drove up import price inflation in 2009. 

inflationary 

strong 

the 

Administered prices and taxes 

Adjustments  in  administered  prices  and  indirect 
taxes have been an important determinant of Polish 
inflation  in  recent  years.  The  contribution  of 
administered  prices  to  headline  inflation,  with  a 
weight  of  around  13%  in  the  HICP  basket,  has 
been  uneven  over  time.  Annual  increases  in 
administered  prices  reached  on  average  about 
3¾% in 2004-2007, before surging to some 6% in 

Convergence Report 2010 - Technical annex 

Chapter 8 - Poland 

2008-2009,  contributing  about  0.7  percentage 
points to inflation in 2008-09.  

Marked  increases  in  consumer  prices  for  gas  and 
electricity  over  recent  years  broadly  reflected 
trends  in  prices  of  imports.  Other  main  upward 
changes  to  administered  prices  occurred  in  the 
categories  of  passenger  transport  and  sewage 
collection (54).  

indirect 

tax  changes,  which 
A  number  of 
contributed to the acceleration of HICP inflation in 
2004 and afterwards, have been undertaken in line 
with  tax  harmonisation  requirements  within  the 
EU. This notably reflects a continuous increase in 
tobacco  excise  duties,  which  is  estimated  to  have 
added an average 0.25 percentage points to annual 
headline  inflation  between  2006  and  2009.  In 
2009,  excise  duties  on  LPG  and  on  alcohol 
products  were  increased,  which  are  estimated  to 
have  increased  headline  inflation  by  about  0.2 
percentage points. Tax increases on cigarettes and 
fuel  oil  and  administered  prices  (notably  an 
increase  of  about  5.8%  of  electricity  prices  for 
households)  are  estimated 
to  add  some  0.7 
percentage points to inflation in 2010. 

Medium-term prospects 

Inflation  is  expected  to  be  relatively  low  in  2010 
and  2011,  reflecting  the  negative  output  gap 
following  the  crisis,  subdued  increase  in  unit 
labour cost and the expected lower growth of food 
and  energy  prices.  Inflation  is  however  likely  to 
increase  somewhat  in  the  course  of  2011,  pushed 
by a rebound in economic activity and, to a lesser 
extent,  in  unit  labour  costs.  The  Commission 
services' Spring 2010 Forecast projects inflation to 
average 2.4% in 2010 and 2.6% in 2011.  

Risks  to  inflation  appear  to  be  broadly  balanced. 
Upside risk mainly stem from higher commodities 
prices  and  a  higher-than-expected  increase  in  unit 
labour  costs.  On  the  other  hand,  slower-than-
expected  GDP  growth  connected  with  a  delayed 
recovery  in  main  trading  partners  and  a  further 
appreciation  of  the  zloty  on  the  back  of  an 
improved  balance-of-payments  outlook  would 
have disinflationary effects. 

(54)  For  the  purpose  of  this  report,  other  notable  administered 
prices in Poland include postal services, rental for housing, 
social  housing 
fees,  water  supply  and  subsidized 
pharmaceutical products. 

135 

 
                                                           
European Commission 

Convergence Report 2010 

The  level  of  consumer  prices  in  Poland  was  at 
some  66%  of  the  euro  area  average  in  2008.  This 
level 
for 
suggests  potential 
convergence  in  the  long  term,  as  income  levels 
(about  52%  of  the  euro  area  average  in  PPS  in 
2008) increase towards the euro area average. 

further  price 

Medium-term  inflation  prospects  in  Poland  will 
hinge upon wage and productivity trends as well as 
on  the  functioning  of  product  markets.  Further 
structural  measures  to  increase  labour  supply  and 
facilitate  the  effective  allocation  of  labour  market 
resources will play an important role in alleviating 
wage  pressures,  in  particular  in  light  of  the 
continued  expansion  of  FDI-related  production 
capacities.  On  product  markets,  there  is  scope  to 
enhance the competitive environment, especially in 
some  segments  of  the  telecommunications  and 
energy sectors. At the macro level, a prudent fiscal 
stance  will  be  essential  to  contain  inflationary 
pressures. 

136 

 
8.3.  GOVERNMENT BUDGETARY POSITION 

8.3.1.  The  excessive  deficit  procedure 

for 

Poland (55) 

In  July  2009,  the  Council  adopted  a  decision 
stating that Poland had an excessive deficit, based 
on  a  deficit  of  3.9%  of  GDP  in  2008  notified  in 
April 2009 (which was revised to 3.7% in the April 
2010  notification).  At  the  same  time,  the  Council 
issued  recommendations  to  correct  the  excessive 
deficit  by  2012  and  established  a  deadline  of  7 
January 2010 for  effective  action  to be  taken. For 
the  period  2010-2012,  the  Council  recommended 
Poland to ensure an average annual fiscal effort of 
least  1¼%  of  GDP.  Poland  was  also 
at 
recommended 
its  medium-term 
budgetary  framework,  as  well  as  to  improve  the 
implementation 
monitoring 
throughout the year. 

to  strengthen 

budget 

the 

of 

on 

and 

current 

information 

In  February  2009,  the  Council  concluded  that, 
the 
based 
recommendation  under  the  European  Economic 
Recovery  Plan  to  provide  fiscal  stimulus  in  2009, 
it  appears  that  Poland  has  taken  effective  action 
towards correcting the excessive deficit within the 
time  limit  set  by  the  Council.  The  procedure  is 
therefore  held  in  abeyance.  The  Commission 
continues 
budgetary 
developments  in  Poland  in  accordance  with  the 
Treaty and the SGP. 

closely  monitor 

to 

8.3.2.  Developments 2004-2009 

The general government deficit in Poland has been 
higher  than  the  3%  of  GDP  threshold  since  2002, 
except  for  2007  when  it  temporarily  decreased  to 
1.9% of GDP following several years of real GDP 
growth above potential. In 2008 Poland recorded a 
deficit of 3.7% of GDP, despite still high economic 
growth  (5%)  and  a  clearly  positive  output  gap, 
showing 
to 
consolidate  public  finances.  Although  Poland  was 
the only EU country to avoid a recession in 2009, 
the general government deficit increased further to 
7.2%  of  GDP  according  to  the  February  2010 
ratio 
convergence  programme.  The 
declined  from  39½%  of  GDP  to  37½%  in  2009, 
reflecting the effect of the crisis and cuts in social 
contributions  and  personal  income  tax  introduced 

times  were  not  used 

that  good 

revenue 

(55)  All documents related to the excessive deficit procedure for 
Poland  can  be  found  at:  http://ec.europa.eu/economy_ 
finance/sgp/deficit/countries/poland_en.htm. 

Convergence Report 2010 - Technical annex 

Chapter 8 - Poland 

in  2007-2009.  The  expenditure  ratio  increased 
from 42.2% in 2007 to 44.5% in 2009. 

According to Commission estimates, the structural 
balance (cyclically-adjusted balance net of one-off 
and  other  temporary  measures)  deteriorated  by 
about 2½ percentage points in 2009, bringing it to 
around 7¼% of GDP. The underlying fiscal deficit 
had  declined  in  the  years  2004-2007  from  around 
6% of GDP to about 3% of GDP, to a large extent 
the  positive  effects  of  a  partial 
reflecting 
implementation of a consolidating reform package 
(the  “Hausner  plan”).  However,  the  pro-cyclical 
loosening  of  fiscal  policy  in  2008  before  the  start 
of  the  crisis,  including  a  partial  reversal  of  some 
reforms,  and  the  worsening  of  the  government 
balance in 2009 brought back the underlying fiscal 
position back to its 2004 level.  

The 2009 deficit outturn estimated in the February 
2010  convergence  programme  (7.2%  of  GDP)  is 
worse  than  projected  in  the  spring  and  autumn 
2009  Commission  services’  forecasts  (6.6%  and 
6.4%  GDP  respectively),  and  much  higher  than 
projected  in  the  December  2008  convergence 
programme  (2.5%  of  GDP).  Real  GDP  growth  in 
2009  turned  out  to  be  2  percentage  points  lower 
than projected in the December 2008 convergence 
programme,  and  nominal  GDP  growth  0.9 
percentage point lower than projected. The decline 
in the revenue ratio (by about 2 percentage points) 
in  2009  resulted  not  only  from  the  growth  slow-
down  but  also  from  the  dramatic  shift  in  its 
composition and the impact of tax cuts. Despite the 
announced  measures 
to  contain  government 
expenditure,  overspending  also  contributed  to  the 
higher  deficit:  expenditure  outturn  (as  percentage 
of  GDP) 
the  February  2010 
in 
convergence  programme  was  about  1  percentage 
point  higher  (net  of  the  denominator  effect  of 
lower  GDP)  than  planned  in  the  December  2008 
programme.  

reported 

Despite  high  average  real  GDP  growth,  gross 
public debt increased from 45.7% of GDP in 2004 
to  50.7%  of  GDP  in  2009  according  to  the 
February  2010  convergence programme.  The debt 
increases  resulted  mainly  from  high  deficits, 
except for 2004, when there was a significant debt-
decreasing  stock-flow  adjustment  thanks  to  large 
privatisation 
considerable 
appreciation  of  the  zloty,  and  2008,  when  there 
was  a  significant  debt-increasing  stock-flow 
adjustment  due  to  the  large  depreciation  of  the 
Polish  currency.  Despite  the  existing  temporary 

receipts 

and 

a 

137 

 
                                                           
European Commission 

Convergence Report 2010 

Table 8.3.1:

Poland - Budgetary developments and projections
Outturn and forecast 1)

2004

2005

2006

2007

2008

2009

2010

2011

(as % of GDP unless indicated otherwise)

General government balance

- Total revenues

- Total expenditure

of which: 
- interest expenditure

- current primary expenditure

- gross fixed capital formation

p.m.: Tax burden

Primary balance

Cyclically-adjusted balance

One-off and temporary measures
Structural balance 2)
Structural primary balance

Government gross debt

p.m: Real GDP growth (%)

p.m: Output gap

p.m: GDP deflator (% change)

Convergence programme
General government balance

Primary balance
Structural balance 2) 3)
Government gross debt

p.m. Real GDP (% change)

-5.7

36.9

42.6

2.8

36.0

3.4

31.8

-2.9

-5.9

0.0
-5.9

-2.8

45.7

5.3

0.4

4.1

-4.1

39.4

43.4

2.8

36.2

3.4

33.1

-1.3

-4.0

0.0
-4.0

-1.2

47.1

3.6

-0.4

2.6

-3.6

40.2

43.9

2.7

36.4

3.9

34.1

-1.0

-4.0

0.0
-4.0

-1.3

47.7

6.2

0.9

1.5

-1.9

40.3

42.2

2.3

35.0

4.2

34.8

0.4

-2.8

0.0
-2.8

-0.5

45.0

6.8

2.4

4.0

-3.7

39.6

43.3

2.2

35.6

4.6

34.4

-1.5

-4.6

0.0
-4.6

-2.3

47.2

5.0

2.2

3.0

2008
-3.6

-1.4

-4.4

47.2

5.0

-7.1

37.4

44.5

2.6

35.6

5.3

31.9

-4.5

-6.9

-0.3
-7.2

-4.6

51.0

1.7

-0.6

3.7

2009
-7.2

-4.8

-7.1

50.7

1.7

-7.3

38.7

46.0

2.9

35.9

6.3

31.9

-4.5

-6.5

0.2
-6.3

-3.5

53.9

2.7

-2.1

2.2

2010
-6.9

-4.2

-6.6

53.1

3.0

-7.0

39.2

46.2

3.0

34.9

7.4

31.9

-4.0

-5.7

0.0
-5.7

-2.6

59.3

3.3

-3.4

2.4

2011
-5.9

-3.1

-5.8

56.3

4.5

1) Commission services’ Spring 2010 Forecast.

2) Cyclically-adjusted balance excluding one-off and other temporary measures.

3) Commission services’ calculations on the basis of the information in the programme.

There are no one-off and other temporary measures in the programme.

Sources: Commission services and February 2010 update of Poland's Convergence Programme.

2012
-2.9

-0.2

-2.9

55.8

4.2

2013
n.a.

n.a.

n.a.

n.a.

n.a.

scheme  for  anti-crisis  capital 
injections  and 
guarantees in the banking sector in Poland (with a 
ceiling  of  about  2.8%  of  GDP),  there  were  no 
significant interventions in that sector. Poland does 
not  seem  to  have  big  contingent  liabilities  related 
to  the  crisis.  Total  amount  of  guarantees  slightly 
exceeded  4%  of  GDP  in  2009  according  to  the 
February 2010 convergence programme. 

8.3.3.  Medium-term prospects 

start 

limited 

Faced  with  a  large  deterioration  of  the  deficit  in 
2009  and  given  the  Council  Recommendation  to 
reach the 3% of GDP deadline by 2012, the Polish 
authorities  decided 
fiscal 
to 
consolidation in 2010. The consolidation measures 
announced in the 2010 budget include an increase 
in excise and quasi-excise duties (on cigarettes and 
fuel) with a deficit-reducing impact of about 0.2% 
of GDP and a limit on wage and salary growth in 
the central government, leading to savings of about 
0.3% of GDP (if nominal GDP growth turns out as 
projected  in  the  February  2010  update  of  the 

convergence programme). Moreover, following the 
adoption  of  the  budget,  on  29  January  2010,  the 
Prime  Minister  and  the  Minister  of  Finance 
presented a package of reforms titled “The Plan for 
the  Development  and  Consolidation  of  Finances” 
with  the  overall  net  impact  of  ¼%  of  GDP, 
concentrated in 2012. 

The  February  2010  update  of  the  convergence 
programme  assumes  a  0.3  percentage  point 
reduction  of  the  deficit  ratio  to  6.9%  of  GDP  in 
2010, while the Commission services' spring 2010 
forecast  predicts  a  deficit  of  7⅓%  of  GDP,  the 
difference  being  fully  explained  by  the  projected 
developments  on  the  revenue  side.  The  fiscal 
stance  in  2010  is  moderately  restrictive,  as  the 
structural  balance  is  projected  to  improve  from  -
7.2%  of  GDP  in  2009  to  around  6⅓%  of  GDP  in 
2010  according 
the  Commission  services' 
forecast. 

to 

The foreseen worsening of government finances in 
2010,  according  to  the  Commission  services' 

138 

 
 
 
 
 
spring  2010  forecast,    mainly  reflects  an  increase 
in government expenditure, in particular a surge in 
the public investment ratio (by 1 p.p. of GDP) and 
higher  intermediate  consumption.  The  former will 
however  be  to  large  extent  financed  by  more 
capital 
the  EU.  Negative 
developments on the expenditure side are not fully 
counterbalanced by increased revenues (by 1⅓ pp. 
of  GDP)  driven  by  a  much  higher  absorption  of 
EU  funds  and  an  increase  in  excise  and  quasi-
excise duties.  

transfers 

from 

announced 

consolidation  measures 

Fiscal  projections  after  2010  are  subject 
to 
considerable  uncertainty.  Based  on  a  no-policy-
change  assumption, 
the  Commission  services' 
spring  2010  forecast  foresees  only  a  modest 
improvement of the deficit in 2011 to 7% of GDP 
as 
are 
negligible.  Nevertheless,  according  to  the  last 
update  of  the  convergence  programme,  the  Polish 
authorities  plan  to  continue  fiscal  consolidation 
after 2010 and to bring the deficit below the 3% of 
GDP  threshold  by  2012,  in  line  with  the  Council 
recommendations  of  7  July  2009.  The  general 
government  deficit  is  notably  projected  to  decline 
by 3 percentage points of GDP between 2011 and 
2012.  The  planned  consolidation  foreseen  after 
2010 is mainly expenditure-based. Social transfers 
other  than  in  kind  are  planned  to  fall  by  1.3 
percentage  points  in  2011-2012,  the  public  wage 
bill  by  0.8  percentage  point  and  intermediate 
consumption  by  0.7  percentage  point.  Public 
investment  is  planned  to  increase  further  in  2011, 
to  a  large  extent  because  of  the  increasing 
absorption  of  EU  funds  and  preparation  of 
infrastructure  for  the  2012  European  football 
championship. It would then drop considerably (by 
1.4  percentage  point  of  GDP)  in  2012.  On  the 
revenue  side,  direct  taxes  are  expected  to  yield  1 
percentage point of GDP more in 2012, compared 
to 2010.  

The  long-term  budgetary  impact  of  ageing  is 
significantly  below  the  EU  average,  reflecting  the 
projected  decrease  in  public  pension  spending. 
However, the budgetary position in 2009 causes a 
marked  sustainability  gap  over  the  long  term. 
Ensuring  higher  primary  surpluses  over 
the 
the 
in 
medium 
programme,  would  contribute  to  reducing  risks  to 
the  sustainability  of  public  finances  which  were 
assessed  in  the  Commission  2009  Sustainability 
Report as medium. 

term,  as  already 

foreseen 

Convergence Report 2010 - Technical annex 

Chapter 8 - Poland 

summarised 

risks,  both  on 

the  programme  are  subject 
the 

In  its  April  2010  Opinion  on  the  convergence 
programme, 
its 
the  Council 
assessment  as  follows:  "The  overall  conclusion  is 
that  while  Poland  is  planning  to  correct  its 
excessive deficit by 2012 in line with the Council 
recommendation  under 
the  excessive  deficit 
procedure,  the  fiscal  adjustment  is  considerably 
backloaded,  most  of  the  deficit  reduction  being 
projected to take place in 2012, and deficit targets 
to  significant 
in 
revenue  and 
downside 
expenditure side. In view of the recovery projected 
by  the  authorities  from  2010  and  the  large 
structural  government  deficit  a  more  frontloaded 
fiscal consolidation strategy would be appropriate. 
Risks to fiscal targets reflect favourable real GDP 
growth  assumptions, 
sizeable 
sufficiently  concrete  measures  in  support of  fiscal 
targets  from  2011  on,  a  history  of  current 
expenditure  slippages  compared  to  plans  and 
impact  of 
to 
strengthen  the  fiscal  framework,  in  particular 
backed  by  expenditure  rules,  are  welcome.  With 
respect  to  the  "temporary"  expenditure  rule  a 
higher  degree  of  ambition  would  be  appropriate, 
notably  in  terms  of  the  share  of  government 
finances covered by the rule." 

the  electoral  cycle.  Intentions 

lack  of 

the 

The  Council  invited  Poland  to:  (i)  implement  the 
2010  budget  rigorously,  under-execute  primary 
current  expenditure  plans  wherever  possible  and 
allocate  windfall  revenue  to  deficit  reduction;  (ii) 
strengthen  the  planned  budgetary  adjustment  in 
2011 in order to achieve the recommended average 
annual  fiscal  effort  of  1¼  %  of  GDP  in  line  with 
the  Article  104  (7)  Recommendation  ,  and  stand 
ready  to  adopt  further  consolidation  measures  in 
2011 and 2012, in case risks related to the fact that 
the  programme  scenario  is  more  favourable  than 
the  scenario  underpinning  the  recommendation 
under Article 104(7) TEC materialise; (iii) proceed 
with strengthening the fiscal framework, including 
through  introduction  of    an  expenditure  rule 
covering a larger share of the general government 
primary  expenditure  than  the  "temporary"  rule 
presented  in  the  Convergence  Programme,  with 
appropriate  monitoring 
enforcement 
mechanisms.  This  would  require  to  reduce  the 
share of statutory spending in total expenditures.  

and 

139 

 
 
 
European Commission 

Convergence Report 2010 

8.4. 

EXCHANGE RATE STABILITY 

it  gradually  moved 

The  Polish  zloty  does  not  participate  in  ERM  II. 
While in the earlier stages of transition Poland had 
followed  an  exchange-rate  based  stabilisation 
towards  greater 
strategy, 
exchange  rate flexibility  in  the  late  1990s. Poland 
adopted  a  direct  inflation  targeting  framework  in 
1998  in  combination  with  a  crawling  peg.  Since 
April  2000,  Poland  operates  a  floating  exchange 
rate  regime,  with  the  central  bank  generally 
abstaining from currency interventions, though the 
instrument remains available in principle. 

Graph 8.4.1: Exchange rates - PLN/EUR
(monthly av erages)

5.0

4.5

4.0

3.5

3.0

2004

2005

2006

2007

2008

2009

Source: ECB and EcoWin.

The zloty has exhibited high volatility over the last 
years. Following a depreciating trend during 2002-
2003, the zloty's exchange rate appreciated steadily 
between  2004  and  mid-2008,  amid  favourable 
market  sentiment  sparked  by  EU  accession, 
improved  fundamentals  of  the  economy  and  an 
upsurge  in  capital  inflows  (stemming  from  both 
FDI  and  EU  funds).  The  impact  of  a  generalised 
increase  in  risk  aversion  of  investors  during  the 
financial  crisis  and  the  deterioration  in  sentiment 
vis-à-vis  emerging  markets  led  to  a  substantial 
depreciation  of  the  zloty.  The  depreciation  was 
amplified  by  the  exercising  of  foreign  exchange 
option  contracts.  The  zloty  weakened  by  about 
30%  against  the  euro  between  end-July  2008  and 
its lowest point in mid-February 2009.  

The persistent currency weakness of Poland and its 
neighbours  led  the  central  banks  of  Poland, 
Hungary, Czech Republic and Romania to issue a 
coordinated  statement  in 
the  second  half  of 
February. At that time the Polish government also 
intervened 
euro-
denominated EU funds against zloty to support the 
currency.  Soon  afterwards,  Poland  was  granted 
access  to  an  IMF  Flexible  Credit  Line  facility  of 

exchanged 

verbally 

and 

140 

$20.5 bn, which it treated as precautionary. As this 
facility  was  conditional  on 
strong  ex-ante 
economic  fundamentals,  it  provided  a  positive 
signal to markets by suggesting IMF endorsement 
of  Poland's  policies, 
together  with  potential 
additional reserves in case of a deterioration of the 
global environment.  

These  actions,  together  with  improved  market 
sentiment vis-à-vis emerging markets, inverted the 
trend.  Market  perceptions 
zloty's  depreciation 
about  zloty  undervaluation  may  also  have  helped 
supporting  the  currency.  Since  March  2009,  the 
zloty  has  been  on  a  broadly  appreciating  path, 
although  amid  large  volatility,  notably  supported 
by  the  successful  placement  of  a  large  supply  of 
bonds and high demand from foreign investors. In 
order  to  curb  what  was  judged  as  an  excessively 
fast  appreciation  of  the  zloty,  the  NBP  and 
verbal 
government 
interventions  in  early  April  2010,  while  the  NBP 
intervened on the foreign exchange market for the 
first time since it allowed the zloty to trade freely 
together  with 
in  April  2000.  These  actions 
heightened  risk  aversion 
to  some  mild 
weakening  of  the  zloty  in  early  April.  During  the 
two  years  before 
the  zloty 
depreciated against the euro by 12%.  

this  assessment, 

officials 

resorted 

led 

to 

The  weakening  pressures  in  the  foreign  exchange 
market  were  reflected  to  some  extent  in  the 
evolution  of  foreign  exchange  reserves,  which 
temporarily  decreased  in  the  second  half  of  2008 
and  in  the  first  half  of  2009  but  rebounded 
thereafter.  At  the  end  of  2009,  foreign  exchange 
reserves  amounted  to  some  95%  of  short-term 
external debt at original maturity. 

Graph 8.4.2: Poland - 3-M Wibor spread to 3-M Euribor

 (basis points, monthly v alues)

500

400

300

200

100

0

2004

2005

2006

2007

2008

2009

Source: Eurostat.

Short-term  interest  rate  differentials  vis-à-vis  the 
euro area started to widen from a very low level of 
about 50 basis points in early 2007 as the National 

 
      
 
 
Bank of Poland (NBP) initiated a tightening cycle. 
The financial crisis and the ensuing lack of mutual 
trust  among  financial  institutions  contributed  to  a 
further widening of spreads. The more rapid easing 
of  the  monetary  stance  in  the  euro  area  than  in 
Poland  and  diverging  expectations  by  market 
participants on the path of the policy rate in Poland 
compared to the euro area led to a further widening 
of  the  interest  rate  differential  at  the  end  of  2008 
and  in  mid-2009.  Since  then,  short-term  interest 
rate differentials vis-à-vis the euro area have been 
broadly  stable,  averaging  some  340  basis  points, 
still  above 
to 
remaining liquidity constraints. At the cut-off date 
of this Report, they stood at about 320 basis points. 
The main refinancing rate of the NBP was at 3.5% 
in April 2010, i.e. 250 basis points above the ECB 
reference rate.  

the  pre-crisis 

testifying 

level, 

Convergence Report 2010 - Technical annex 

Chapter 8 - Poland 

141 

 
Graph 8.5.2: Poland - Long-term interest rates

 (percent, monthly v alues)

8

6

4

2

0

2004

2005

2006

2007

2008

2009

Source: Eurostat.

P o land

Euro  area

to 

initially 

rates  started 

interest 
in  mid-2007, 

From  a  relatively  low  level  of  about  5%,  Polish 
increase 
long-term 
gradually 
reflecting 
expectations  of  further  tightening  of  monetary 
policy  and,  from  the  second  half  of  2008,  a  rapid 
increase  in  risk  aversion  associated  with  a  broad 
sell-off  of  emerging  markets'  assets.  As  a  result, 
long-term  interest  rate  spreads  vis-à-vis  the  euro 
area  gradually  widened  and  exceeded  200  basis 
points  in  November  2008.  Thereafter  long-term 
interest  rates  dropped,  albeit  temporarily,  amid 
improved sentiment towards emerging markets and 
expectations of further cuts in the Polish reference 
rate.  The  worsening  economic  outlook  in  Central 
and  Eastern  Europe  led  to  a  new  deterioration  of 
risk perception in the region in early 2009 and an 
ensuing widening in spreads. Since then long-term 
interest  spreads  vis-à-vis  the  euro  area  have 
broadly stabilized at around 240 basis points.  

European Commission 

Convergence Report 2010 

8.5. 

LONG-TERM INTEREST RATE 

Long-term  interest  rates  in  Poland  used  for  the 
convergence examination reflect secondary market 
yields  on  a  single  benchmark  government  bond 
with a maturity below but close to 10 years. 

Graph 8.5.1: Poland - Long-term interest rate criterion

 (percent, 12-month mov ing av erage)

12

10

8

6

4

2

0
Jan-04

Jan-05

Jan-06

Jan-07

Jan-08

Jan-09

Jan-10

P o land

Reference value

Source: Commission services.

The  Polish  12-month  moving  average  long-term 
interest  rate  relevant  for  the  assessment  of  the 
Treaty  criterion  stayed  below  the  reference  value 
from  November  2005  to  December  2009.  Since 
then  it has been  slightly  above  it. In  March 2010, 
the  latest  month  for  which  data  are  available,  the 
reference value, given by the average of long-term 
interest  rates  in  Portugal  and  Belgium  plus  2 
percentage  points,  stood  at  6.0%.  In  that  month, 
the 12-month moving average of the yield on ten-
year Polish benchmark bond stood at 6.1%, i.e. 0.1 
percentage point above the reference value. 

142 

 
 
 
 
8.6.  ADDITIONAL FACTORS 

8.6.1.  Developments  of 

the  balance  of 

payments 

the  combined 
Poland’s  external  balance  (i.e. 
current  and  capital  account)  has  been  in  deficit 
since  1996,  albeit  at  relatively  moderate  levels. 
The  deficit  peaked  at  some  4%  of  GDP  in  2008, 
mainly  reflecting  a  worsening  trade  balance  as 
imports were buoyed by solid growth in domestic 
demand.  In  2009,  falling  domestic  demand  and  a 
price-driven shift in the composition of imports in 
favour  of  domestically  produced  goods  led  to  a 
markedly  deeper  decline  of  imports  than  exports, 
resulting in a sharp narrowing of the trade deficit. 
Similarly,  the  balance  of  trade  in  services,  which 
had  been  in  surplus  since  2005,  further  improved 
in  2009.  As  a  result,  the  external  account  was  in 
equilibrium in 2009. The negative income balance 
has  narrowed  since  2007  mainly  due  to  lower 
investment  income  by  foreign  companies.  Wages 
repatriated  by  Polish  citizens  working  abroad  and 
EU  transfers  (partly  accounted  for  in  the  current 
account, and partly as capital transfers) have been 
a  supportive  factor  for  the  external  balance  in 
recent  years,  with  combined  current  and  capital 
transfers amounting to about 3% of GDP in 2009.  

In  terms  of  the  saving-investment  balance,  the 
increase  in  the  external  deficit  between  2005  and 
2008  mainly 
reflected  an  acceleration  of 
investment  activity,  while  the  fall  of  the  latter 
largely  explained  the  2009  drop  in  the  external 
deficit.  The  domestic  saving  ratio  has  been  on  a 
slightly  increasing  path  over  the  last  years,  with 
increasing  fiscal  and  corporate  surpluses  partly 
offset by lower household savings.  

Graph 8.6.1: Poland - Saving and investment
(in percent of GDP at market prices)

30

20

10

0

2004

2005
Gro ss national saving

2006

2007

2008

2009

Gro ss capital fo rmatio n at current prices; total eco nomy

Source: Eurostat, Commission services.

In  spite  of  the  strong  appreciation  of  the  zloty's 
real  effective  exchange  rate  between  2004  and 
mid-2008  (by  about  45%  deflated  by  ULC), 

Convergence Report 2010 - Technical annex 

Chapter 8 - Poland 

external competitiveness appears to have remained 
solid, with Poland continuing to gain market share. 
The  real  appreciation  was  mainly  driven  by  trend 
nominal appreciation, but was over the longer-run 
slightly  less  accentuated  when  deflated  by  unit 
labour  costs  (particularly  when  using  labour  costs 
in  the  manufacturing  sector)  than  by  consumer 
price  inflation.  The  sharp  nominal  depreciation  at 
the end of 2008 led to a strong depreciation of the 
zloty's  real  effective  exchange  rate,  reaching  in 
early  2010  a  level  broadly  comparable  to  that  of 
mid-2007.  This  improvement  in  external  cost 
competitiveness  contributed  to  mitigate  the  effect 
of  the  external  demand  shock  on  Polish  export 
growth. 

Graph 8.6.2: Poland - Effective exchange rates

 (v s. 35 trading partners;  monthly av erages;

  index numbers, 2004 = 100)

140

130

120

110

100

90

80

2004

2005

2006

2007

2008

2009

NEER

REER, HICP d eflated

REER, ULC d eflated

Source: Commission services.

External  financing  has  remained  broadly  resilient, 
although the main source of financing has evolved 
over  time.  Net  inward  foreign  direct  investment 
(FDI) inflows, albeit being at a relatively low level 
compared  to  other  new  Member  States,  were 
largely  sufficient  to  finance  external  deficits  in 
2004-2007,  alleviating  possible 
sustainability 
concerns.  They  were  mainly  directed  towards 
export-oriented  manufacturing 
services 
(mainly  business  activities,  real  estate,  trade  and 
financial  intermediation).  FDI  inflows  moderated 
in  2008  and  2009,  with  the  onset  of  the  financial 
crisis. The major source of financing in 2006-2008 
was intra-group bank and corporate lending.  

and 

Despite the financial crisis, the Polish government 
successfully  issued  foreign-denominated  bonds  in 
2009  and  non-resident  holdings  of  government 
bonds  recovered  significantly  after  a  substantial 
drop in 2008, notably supported by the confidence 
impact of the IMF Flexible Credit Line granted in 
May  2009,  on  which  the  Polish  authorities  have 
not  drawn  so  far.  These  large  portfolio  inflows, 
together with large deposits from parent banks, led 

143 

 
 
 
European Commission 

Convergence Report 2010 

Table 8.6.1:

Poland - Balance of payments

Current account

Of which: Balance of trade in goods

                 Balance of trade in services

                 Income balance 

                 Balance of current transfers

Capital account
External balance 1)
Financial account

Of which: Net FDI

                Net portfolio inflows
                Net other inflows 2)
                Change in reserves (+ is a decrease)

Financial account without reserves

Errors and omissions

Gross capital formation

Gross saving

External debt

International investment position

2004

2005

2006

2007

2008

2009

(percentage of GDP)

-4.0

-2.2

0.0

-3.2

1.5

0.5

-3.5

2.9

4.6

3.7

-5.0

-0.3

3.3

0.6

20.1

15.9

51.2

-46.2

-1.2

-0.9

0.2

-2.2

1.6

0.3

-0.9

2.4

2.3

4.0

-1.3

-2.6

5.0

-1.4

19.3

18.0

43.7

-44.3

-2.7

-2.0

0.2

-2.8

1.9

0.6

-2.1

3.1

3.2

-0.9

1.5

-0.7

3.8

-1.0

21.1

18.1

49.7

-46.4

-4.7

-4.0

1.1

-3.8

2.0

1.1

-3.6

6.1

4.3

-1.3

6.1

-3.0

9.1

-2.4

24.4

19.3

54.9

-52.9

-5.1

-4.9

1.0

-2.6

1.5

1.1

-3.9

8.1

2.2

-0.5

5.7

0.7

7.4

-4.1

23.7

18.7

45.8

-47.6

-1.6

-1.0

1.1

-3.2

1.5

1.6

0.0

4.9

2.0

3.6

2.6

-3.4

8.2

-4.9

20.2

18.6

64.8

-62.7

1) The combined current and capital account.

2) Including financial derivatives.

Sources: Eurostat, Commission services and National Bank of Poland.

to  an  increase  of  foreign  exchange  reserves  by 
about 3.5% of GDP in 2009.  

8.6.2.  Product market integration 

the  successful 

Poland's  degree  of  trade  openness  has  been 
increasing  since  2004,  although  it  experienced  a 
slight  decline  in  2008  compared  to  the  previous 
year  as  a  result  of  the  crisis.  Compared  to  other 
countries  of  a  similar  size,  trade  openness  in 
Poland is rather low. It has however just surpassed 
the  EU-27  average  over  the  5-year  period.  The 
evolution  of  Poland's  trade  has  been  initially 
driven  by 
trade  re-orientation 
towards the EU. The ongoing integration with the 
EU was also the main factor shaping Polish foreign 
trade  in  the  recent  years.  The  average  2004-2008 
intra-EU  trade  in  goods  ratio  was  almost  three 
times  higher  than  the  extra-EU  trade  in  goods 
ratio.  The  increase  in  trade  has  been  due  to  both 
increasing  exports  and  imports  since  accession, 
without 
macroeconomic 
significant 
imbalances.  Both  extra-  and  intra-EU  trade  in 
goods  have  increased  as  have  intra-EU  trade  in 
services  but  the  former  has  been  much  stronger 
than  the  latter;  the  tourism  sector  remains  quite 
underdeveloped.  

any 

Total gross external debt has remained lower than 
for  a  number  of  regional  peers,  at  around  50%  of 
GDP  between  2004  and  2008  (which  was  also 
broadly  the  level  of  the  negative  net  international 
investment position). Debt increased to about 65% 
larger 
of  GDP 
government  external  borrowing  and  higher 
intercompany 
three-quarters  of 
external  liabilities  are  long-term  debt,  emanating 
(largely 
mostly 
intercompany and intra-group bank loans).  

in  2009,  mainly 

loans.  About 

reflecting 

private 

sector 

from 

the 

in 

further  progress 

its  export  structure 

Over the medium term, the external balance would 
fiscal 
be  supported  by 
consolidation.  Preserving  the  competitiveness  of 
the Polish economy will hinge upon its capacity to 
further  upgrade 
towards 
research-intensive  and  high-technology  industries. 
In addition, increase in labour market participation 
would  contribute  to  increase  potential  growth 
while a more flexible labour market would ensure 
an  adequate  reallocation  of  labour  towards  fast-
thereby 
growing 
supporting the recovery.  

the  economy, 

sectors  of 

144 

 
 
 
 
 
Convergence Report 2010 - Technical annex 

Chapter 8 - Poland 

Table 8.6.2:

Poland - Product market integration

Trade openness 1) (%)
Extra-EU trade in goods GDP ratio 2) (%)
Intra-EU trade in goods GDP ratio 3) (%)
Intra-EU trade in services GDP ratio 4) (%)
Export in high technology 5) (%)
Technological balance 6) (%)
Total FDI inflows GDP ratio 7) (%)
Intra-EU FDI inflows GDP ratio 8) (%)
FDI intensity 9)
Internal Market Directives 10) (%)
Value of tenders in the O.J. 11)
Time to start up a new company 12)

Poland

2003

:

7.0

21.1

:

2.7

-2.5

2.2

:

:

:

:

:

2004

2005

2006

2007

37.7

7.3

25.2

3.9

2.7

-2.8

5.1

4.7

2.5

2.9

2.6

31.0

36.7

7.3

24.2

3.9

3.2

-2.5

3.4

2.8

1.6

0.9

7.6

31.0

40.7

8.4

26.4

4.4

3.1

-2.4

5.7

5.0

3.6

0.9

5.2

31.0

42.1

8.7

27.2

4.7

3.0

-2.6

5.5

4.6

2.6

1.7

5.8

31.0

2008

41.8

9.1

26.5

4.6

:

:

2.7

2.7

1.5

2.0

7.2

31.0

 1) (Imports + Exports of goods and services / 2 x GDP at current market prices) x 100 (Foreign Trade Statistics, Balance of Payments).

 2) (Extra-EU-27 Imports + Exports of goods / 2 x GDP at current market prices ) x 100 (Foreign Trade Statistics).

 3) (Intra-EU-27 Imports + Exports of goods / 2 x GDP at current market prices ) x 100 (Foreign Trade Statistics).

 4) Intra-EU-27 trade in services (average credit and debit in % of GDP at current prices) (Balance of Payments).

 5) Taken directly from Eurostat's databases: Exports of high technology products as a share of total exports.

 6) (Exports - imports in high tech) / GDP at current prices x 100, since 2007 the data based upon SITC Rev. 4 (earlier SITC Rev. 3).

 7) Total FDI inflows (in % of GDP at current prices).

8) Intra-EU-27 FDI inflows (in % of GDP at current prices).

9) FDI intensity (average intra-EU-27 inflows and outflows in % of GDP at current prices).

10) Percentage of internal market directives not yet communicated as having been transposed, in relation to the total number.

11) Public procurement - Value of public procurement which is openly advertised  (in % of GDP).

12) Time to start a new company (in days), Doing Business World Bank.

Sources: Eurostat, Commission services.

The orientation of Poland's foreign trade is mostly 
towards the EU-27, and half of Polish exports flow 
to euro area countries, which is a sign of a process 
of  economic  integration  being  well-advanced. 
Trade integration has been particularly pronounced 
with the neighbouring countries. Germany remains 
the main trading partner of Poland, accounting for 
around 25% of exports, with Italy and France each 
absorbing  about  7%  of  Polish  exports.  However, 
there  has  been  a  small  reduction  in  the  relative 
importance of the euro area over the last few years. 
This  was  partly  due  to  strong  GDP  growth  in 
Russia  which  fuelled  the  demand  for  Polish 
exports  and  increased  trade  with  the  Central  and 
Eastern  European  region.  On  the  import  side,  the 
main  trading  partners  are  also  from  the  EU-27, 
although  Russia  remains  an  important  energy 
supplier.  Competitively  priced  Asian  goods  have 
also  been  winning  a  larger  share  of  the  Polish 
market,  a  pattern  that  is  observed  in  many  EU 
countries. 

The  composition  of  Polish  exports  has  evolved 
towards medium-to-high technology goods though 
the  share  of  traditional  industries,  such  as  metal 
products,  food,  mineral  fuels,  chemicals  and 
furniture,  remains  high.  The  share  of  high 
technology exports in Poland is also far below the 
EU-average.  Although  having  stabilised  in  recent 

years, the technological trade deficit remains high. 
This  can  be  explained  by  the  relatively  limited 
inflow  of  FDI  into  high-technology  sectors  in 
Poland  and  its  slow  absorption,  which  is  partly 
caused  by  low  domestic  R&D  spending,  weak 
links  between  research  institutes  and  the  private 
sector,  and  the  relatively  low  quality  of  the 
research institutional framework.  

Looking  at  categories  of  goods  based  on  factor 
intensities  shows  that  there  has  been  a  substantial 
change  in  the  sectoral  specialisation  of  Polish 
exports  since  1995.  The  shift  has  been  from 
labour-  and  resource-intensive  goods,  such  as 
clothing,  wood  and  furniture,  fish  processing  and 
mineral  fuels,  to  capital-  and  research-intensive 
goods,  such  as  cars  and 
television  screens. 
However,  in  a  medium  term  perspective,  the 
evolution of competitiveness in Poland will largely 
depend  on  its  capacity  to  upgrade  its  export 
structure,  by  continuing  to  reorient  it  towards 
capital-intensive and high-technology industries. 

in 

Poland’s  accelerated  expansion 
trade  was 
substantially  influenced  by  increased  FDI  inflows 
(mainly  originating  from  the  euro  area),  which 
played  an  important  role  in  the  gradual  quality 
upgrading of Polish exports. In 2008, the stock of 
FDI was equivalent to approximately 25% of GDP, 

145 

 
 
 
 
 
European Commission 

Convergence Report 2010 

in 

low 

than 

share 

comparatively 

a 
the 
neighbouring  countries.  There  has  been  a 
significant drop in FDI inflows between 2007 and 
2008  due  to  the  financial  crisis  despite  Poland 
showing  strong  economic  growth  in  2008  and 
maintaining  positive  economic  growth  in  2009. 
The top three sources of FDI are the Netherlands, 
Germany  and  France.  The  reasons  that  make 
Poland  attractive  for  FDI  are  the  growth  and  size 
of the domestic market, along with access to large 
regional  markets.  The  'second  round'  effect  of 
integration  with  international  production  chains 
also plays a key role with foreign investors. FDI in 
services  has  also  increased  due  to  the  high  skill 
levels  and  relatively 
labour  costs.  A 
significant  share  of  FDI  has  been  located  in 
“special  economic  zones”  benefiting  from  special 
tax  cuts  and  other  types  of  state  aid,  which  have 
been established since mid-1990s. The destination 
of  inward  FDI  is  mainly  real  estate  and  business 
activities, manufacturing, financial intermediation, 
and trade and repairs. 

lower 

a 

and 

lack 

procedures 

five  Member  States 

As  regards  the  business  environment,  limited 
progress has been made in the recent years. A one-
stop-shop for starting up a business was introduced 
in  2009  but  a  number  of  weaknesses  including 
of 
complicated 
communication  between  all  public  institutions  is 
making  it  more  than  "one-stop".  Poland  is  one  of 
only 
that  has  already 
transposed the Parliament and Council directive on 
improving  the  effectiveness  of  review  procedures 
concerning 
the  award  of  public  contracts. 
Nevertheless,  an  internal  report  deems  the  open 
overly 
procedures 
transparency  and  having 
formalised, 
unnecessarily 
Finally, 
concerning  the  transposition  of  the  EU  Internal 
Market  directives,  Poland  has  one  of  the  highest 
transposition deficits in the EU, well above the 1% 
EU  target,  along  with  a relatively  high number  of 
incorrectly transposed directives. 

be 
to 
lacking 
high 

time-consuming, 

prerequisites. 

8.6.3.  Financial market integration 

Poland's financial sector is well integrated into the 
EU  economy.  This  integration  is  present  in  the 
high  degree  of  foreign  ownership  of  financial 
institutions  as  well  as 
increasingly 
international  role  of  the  Warsaw  Stock  Exchange. 
Compliance  with  the  acquis  of  the  Union  in  the 

the 

in 

146 

field  of  financial  services  has  been  fully  achieved 
(56).  

Poland's financial system has shown resilience and 
avoided serious problems since the outbreak of the 
international  financial  crisis.  To  support 
the 
stability  of  the  sector,  the  Polish  government  has 
put  in  place  a  safety  net  addressing  the  short  and 
medium 
financial 
institutions. The total value of the state-sponsored 
scheme  is  EUR  4.8  billion.  The  scheme  expires 
mid-2010 and has not effectively been used. 

liquidity  needs  of 

term 

While the banking network in Poland is relatively 
weak  in  comparison  with  the  EU  average,  its 
capital market is one of the most developed among 
the new Member States. Capitalisation of the stock 
market  reached  44%  of  GDP  in  2007,  before  it 
decreased to 31% in 2009 following the downward 
trend  of  global  indices.  Between  2000  and  2008, 
the  share  of  banks  in  total  assets  of  the  financial 
sector was diminishing, a tendency stopped by the 
outbreak of the crisis. Compared to the euro area, 
the  Polish  financial  system  is  still  in  an  early 
development stage, although all markets have been 
converging.  

Graph 8.6.3: Poland - Recent development of the  financial 

system relatively to the euro area
(in percentage of GDP)

180
160
140
120
100
80
60
40
20
0

PL, 2004

PL, 2009

Euro area,
2004

Euro area,
2009

Debt securities

Sto ck market capitalisatio n

Do mestic bank credit

Source: Eurostat, National Bank of Poland, FESE.

Concentration  in  the  Polish  banking  sector  is 
relatively 
the  CR5 
low  as  evidenced  by 
concentration  ratio (57)  of  about  44%,  one  of  the 
lowest  among  the  new  Member  States.  The 
number of banks is high, totalling 69 in 2009 and 
privatisation  of 
is  still 
underway  with  17%  of  banks'  assets  under  state 
control. The share of bank assets owned by foreign 
institutions  through  branches  and  subsidiaries  has 
been steadily rising and reached 72% in 2009.  

the  banking  system 

(56)  All Financial Services Action Plan (FSAP) Directives have 
been transposed, and good progress has been made with the 
the  Post-FSAP  Directives.  See: 
transposition  of 
http://ec.europa.eu/internal_market/finances/actionplan/ind
ex_en.htm#transposition. 

(57)  The  CR5  concentration  ratio  is  defined  as  the  aggregated 
market share of five banks with the largest market share. 

 
 
                                                           
Graph 8.6.4: Poland - Foreign ownership and 

concentration in the banking sector
(in percent, weighted av erages)

80
70
60
50
40
30
20
10
0

PL, 2004

PL, 2008

Euro area,
2004

Euro area,
2008

Co ncentratio n in the banking secto r (CR5 ratio )

Share o f fo reign institutio ns as % o f to tal assets

Source: ECB, Structural indicators for the EU banking sector, January 2010.

Graph 8.6.5: Poland - selected banking sector soundness 

20

%

indicators relatively to the euro area

15

10

5

0

-5

PL, 2004

PL, 2009

Euro area,
2004

Euro area,
2008

Return on equity

Capital adequacy

No n performing lo ans

Note: For 2008, EU-27 non performing loans for are a proxy for EA.
Source: ECB, Polish FSA, EC calculations.

The  capitalisation  of  the  banking  sector  is  at  a 
healthy  13%  and  the  overall  profitability  of  the 
sector maintained a return on equity of about 12% 
in  2009.  However,  the  quality  of  banks'  loan 
portfolio has been deteriorating recently, with non-
performing  loans (58)  reaching  their  2006  level  of 
close to 8% at the end of 2009. 

Graph 8.6.6: Poland - Recent developments in bank credit 

to households and corporations relatively to the euro area

(in percentage of GDP)

60

50

40

30

20

10

0

Dec-04 Dec-05 Dec-06 Dec-07

Dec-08 Dec-09

Ho useho lds, P L
No n-financial co rpo ratio ns, P L
Ho useho lds, Euro  area
No n-financial co rpo ratio ns, Euro  area

Source: ECB, Eurostat.

Lending  has been  a  key  component  in  the growth 
of the Polish banking sector. Domestic credit to the 
private  sector  grew  on  average  by  30%  in  2007 

(58)  Irregular  loans:  at  banks  applying  Polish  accounting 
standards: loans classified as substandard (overdue above 1 
month),  doubtful  (3  months),  loss  (6  months)  loans;  at 
banks applying IFRS: impaired loans, as recognized by the 
bank  on  the  base  of  objective  circumstances  (NBP 
definition). 

Convergence Report 2010 - Technical annex 

Chapter 8 - Poland 

and  2008.  Since  mid-2009,  credit  expansion 
strongly  decelerated,  reaching  about  6%  y-o-y  in 
December 2009. The deceleration was particularly 
noticeable  in  domestic  credit  to  the  corporate 
sector, which recorded a negative growth of about 
-4% 
to 
in  end-2009,  while  credit  growth 
households  fell  to  12%  y-o-y  in  end-2009.  The 
share  of  domestic  credit 
the  households   
remains modest for EU standards, at about 33% of 
Polish GDP. Lending to the corporate sector had in 
December  2009  a  share  of  17%  of  the  GDP.  The 
share of bank credit in foreign currencies was also 
lower than the average among new Member States. 
This  share  shrank  through  2009  to  reach  37%  for 
households and 25% for the corporate borrowers at 
the end of the year.  

to 

Graph 8.6.7: Poland - Share of foreign currency loans

(as percentage of total loans to households / corporations)

45

40

35

30

25

20

15

10

5

0

Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 Dec-09

Co rpo ratio ns

Ho useho lds

Source:  National Bank of Poland and own calculations.

indices, 

the  falling 

including  16  foreign 

the  number  of 
Despite 
companies  listed  on  the  Warsaw  Stock  Exchange 
(WSE)  continued  to  increase  to  486  at  the  end  of 
2009, 
listings.  Foreign 
investors' stake in the WSE capitalisation exceeds 
40%.  The  WSE  has  so  far  not  taken  part  in  the 
European  stock  exchange  consolidation  process, 
but  its  announced  privatisation  will  open  some 
prospects in this regard. The debt securities market 
is  the  largest  and  most  liquid  in  the  region.  It  is 
dominated by government bonds (over 90% share); 
corporate  bonds  account  for  only  3%  of  the 
outstanding  amounts.  In  the  money  market,  in 
2008 and 2009 one could observe a growing share 
of short-term securities issued by the government, 
which was similar to the trend in the euro area. 

a 

relatively 
institutions  play 
Non-banking 
important  role  in  financial  intermediation.  Their 
total  assets  reached  the  level  corresponding  to  a 
half  of  the  bank  assets  in  2007,  before  it  fell  to 
some  37%  at  the  end  of  2009,  largely  due  to  the 
shrinking assets of investment funds. The pension 
funds introduced in 1999 are the biggest players in 

147 

 
 
 
 
                                                           
 
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Convergence Report 2010 

this  group  and  also  one  of  the  biggest  domestic 
institutional  investor,  stimulating  the development 
of the bond and equity market. Insurance business 
has  been  growing  fast,  but  its  size  measured  by 
total  premium  to  GDP  (about  5%  in  2008)  is  still 
far  from  the  euro  area  average.  Credit  unions 
(SKOK) have been expanding, but their total assets 
make up only for a small part of the total assets of 
the financial sector. Credit unions collect deposits 
and grant loans at the local level. Under the current 
legislation  SKOK  are  not  part  of  the  banking 
system and are not supervised by the regulator. 

As  a  result  of  the  reform  started  in  2006, 
supervision  of  the  financial  sector  has  been 
consolidated with the Polish Financial Supervision 
Authority  (PFSA).  The  PSFA  takes  part  in  the 
European  cooperation  of  supervisors  representing 
the  'host'  countries'  interests.  Following  the  EU 
recommendations, a Financial Stability Committee 
has  been  established  to  coordinate  work  on  crisis 
management. 

148 

 
 
 
 
9. 

ROMANIA 

9.1. 

LEGAL COMPATIBILITY 

9.1.1.  Introduction 

legal  basis  for 

The 
the  Banca  Naţională  a 
României  (BNR)  is  contained  in  Law  No.  312 
  BNR 
of June  28,  2004  on 
(hereinafter  "the  Law  on  BNR").  The  Statute  of 
BNR entered into force on July 30, 2004.  

the  Statute  of 

No  amendments  to  the  Law  on  BNR  were 
introduced  with  regard  to  the  incompatibilities 
mentioned 
the  Convergence  Report  2008. 
Consequently,  comments  from  2008  are  repeated 
in this year's assessment. 

in 

9.1.2.  Objectives 

The  secondary  objective  of  BNR  (Article  2(3)) 
refers to the general economic policy of the State. 
It  should  contain  a  reference  to  the  general 
economic  policies  in  the  Union,  with  the  latter 
taking precedence over the former. 

9.1.3.  Independence 

In  this  area,  a  number  of  incompatibilities  and 
imperfections  exist  with  respect  to  the  TFEU  and 
the ESCB/ECB Statute.  

Article 37(3) obliges BNR to take into account the 
opinion  of  the  Ministry  of  Public  Finance  when 
drawing  up  the  models  of  the  annual  statements. 
This  provision  offers  an  opportunity  for  a  third 
party to influence ex ante the models of the BNR's 
annual  statements  and  will  thus  negatively  affect 
the  BNR's 
is 
incompatible with Article 130 of the TFEU.  

independence.  The  provision 

According  to  Article  40(1)-(2),  the  BNR  should 
take  into  account  the  opinion  of  the  Ministry  of 
Public  Finance  when  issuing  its  regulations  on 
accounting  activities.  Furthermore, 
it  should 
consider the Ministry's opinion when recording its 
economic and financial operations.  

the  content  of 

The provision allows a third party to influence ex 
the  BNR's  accounting 
ante 
regulations as well as its records of economic and 
financial  operations,  thus  affecting  negatively  the 

BNR's institutional independence. The provision is 
incompatible with Article 130 of the TFEU.  

to 

Article  3(1)  provides  that,  in  the  performance  of 
their  tasks,  the  members  of  the  BNR's  decision-
making  bodies  shall  not  seek  or  take  instructions 
from  public  authorities  or 
from  any  other 
the 
institution  or  authority.  With  respect 
principle  of  independence  (Article.  130  of  the 
TFEU,  Article.  7  of  the  ECB/ESCB  Statute),  this 
provision  is not  complete.  It  should  be  added  that 
public  authorities  or  any  other  institutions  or 
authorities  shall  also  respect  this  principle  and 
abstain  from  influencing  the  members  of  the 
BNR's  decision-making  bodies.  Moreover,  this 
Article  seems  to  limit  the  prohibition  on  giving 
instructions  to  national  authorities.  The  provision 
constitutes an imperfection with respect to Article 
130 of the TFEU and Article 7 of the ECB/ ESCB 
Statute. 

In  Article  33(9)  it  is  foreseen  that  the  decision  to 
recall  from  office  a  member  of  the  NBR’s  Board 
may  be  appealed  to  the  Romanian  High  Court  of 
Cassation  and  Justice,  while  Article 14(2)  of  the 
ESCB/ECB Statute provides for a right of judicial 
review  by  the  Court  of  Justice  of  the  EU  in  the 
event  of  the  Governor's  dismissal.  The  provision 
constitutes  therefore  an  imperfection  with  respect 
to Article 14(2) of the ESCB/ECB Statute.  

in 

for 

transparency 

public 
and 

the  prevention 

The  Law  on  the  establishment,  organisation  and 
functioning  of  the  National  Agency  for  Integrity 
(No  144/2007)  and  the  Law  on  certain  measures 
the  exercise  of  public 
for 
business 
dignitaries, 
and 
functions 
and 
relationships 
sanctioning  of  corruption  (No  161/2003)  contain 
rules  on  the  incompatibilities  and  conflicts  of 
interest  applicable  to  the  Governor  and  members 
of  the  Board  of  BNR.  For  the  sake  of  legal 
certainty, 
to  provide  a 
recommended 
clarification  that  the  sanctions  provided  for  the 
breach  of  obligations  under  those  Laws  do  not 
constitute  extra  grounds  for  dismissal  of  the 
Governor or other members of the Board of BNR, 
in addition to those contained in Article 33 of the 
Law on BNR.  

is 

it 

149 

 
 
European Commission 

Convergence Report 2010 

According  to  Articles  21  and  23  of  the  Law 
concerning the organisation and functioning of the 
Court  of  Auditors  (No  94/1992),  the  Court  of 
Auditors is empowered to control the management 
and  use  of  the  public  sector’s  financial  resources, 
including  BNR's  financial  resources,  and  to  audit 
funds  of  BNR.  Those 
management  of 
provisions constitute an imperfection and thus, for 
legal  certainty  reasons,  it  is  recommended  to 
define  clearly  in  this  Law  the  scope  of  audit 
performed  by  the  Court  of  Auditors,  without 
prejudice  to  the  activities  of  BNR’s  independent 
external auditors, as laid down in Article 27(1) of 
the Statute. 

the 

9.1.4.  Integration in the ESCB 

The incompatibilities in the Statute of the BNR are 
linked to the following ESCB/ECB tasks: 

• 

• 

• 

• 

• 

• 

the  definition  of  monetary  policy  (Articles 
2(2)a, 19, 20 and 33(1)(a); 

the conduct of foreign exchange operations and 
the  definition  of  foreign  exchange  policy 
(Articles 2(2)a,(d-e), 9(1) and 9(2)(a-b), 10, 19, 
and 33(1)(a); 

the  holding  and  management  of 
foreign 
reserves (Articles 2(2)(d-e), 9(2)(c) 30 and 31); 

the right to authorise the issue of banknotes and 
the volume of coins (Articles 2(2)(c), 12 to 18); 

the  monetary 
functions,  operations  and 
instruments  of  the  ESCB  (Articles  5,  7,  8  and 
22(3)); 

the non recognition of the role of the ECB and 
of  the  Council  for  regulating,  monitoring  and 
controlling 
transactions 
foreign 
(Articles 10 and 11); 

currency 

• 

the  ECB's  right  to  impose  sanctions  (Article 
57).  

  There are also imperfections regarding:  

• 

the non recognition of the role of the ECB and 
the  EU  for  the  collection  of  statistics  (Article 
49);  

• 

the  need  to  consult  the  ECB  for  certain  acts 
(Article 3.2);  

150 

• 

• 

• 

the non recognition of the role of the ECB and 
of  the  Council  for  the  appointment  of  an 
external auditor (Article 36);  

the absence of an obligation to comply with the 
Eurosystem's regime for the financial reporting 
of NCB operations (Articles 37(3) and 40); and 

 the lack of reference to the role of the ECB for 
payment  systems 
(Articles  2(2),  22  and 
33(1)(b)). 

9.1.5.  Prohibition of monetary financing 

According to Article 26 of the Law on the Statute 
of  the  BNR,  the  BNR  may  grant  loans  to  credit 
institutions  that  are  either  unsecured  or  secured 
with  assets  under  exceptional  circumstances  and 
only on a case-by-case basis.  

In  order  to  comply  with  the  prohibition  on 
monetary  financing  of  Article  123  of  the  TFEU 
and  be  considered  as  an  'emergency  liquidity 
assistance',  a  loan  should  only  be  allowed  under 
the  following  conditions:  the  credit  institution 
should  be  solvent,  the  loan  should  be  short-term, 
cover urgent and unforeseen liquidity needs and be 
sufficiently  secured  by  adequate  collateral.  A 
penalty  rate  should  preferably  be  required.  These 
conditions have not been taken fully into account. 
The  provision  is  therefore  incompatible  with  the 
prohibition on monetary financing.  

The  Articles  6.1  and  29(1)  of  the  law  foresee  the 
prohibition on direct purchases by the BNR of debt 
instruments issued by the State, national and local 
public  authorities,  régies  autonomes,  national 
corporations,  national  companies  and  other 
majority  state-owned  companies.  Article  6.2 
extends  this  prohibition  to  the  debt  instruments 
issued by other bodies governed by public law and 
public  undertaking  of  other  EU  Member  States.  
Article  7(2)  of  the  law  prohibits  the  BNR  from 
granting  overdraft  facilities  or  any  other  type  of 
credit facility to the State, central and local public 
service 
authorities, 
undertakings, 
national 
companies  and  other  majority  state  owned 
companies. Article 7(4) extends this prohibition to 
other  bodies  governed  by  public  law  and  public 
undertakings  of  member  States.  These  provisions 
do not cover the full list of cases mentioned in the 
Article 123 of the TFEU (the Union institutions are 
for 
therefore 
instance  missing) 
incompatible with the TFEU.  

autonomous 
national 

public 
societies, 

and 

are 

 
Convergence Report 2010 - Technical annex 

Chapter 9 - Romania 

Article 43 of the Law provides that the BNR shall 
transfer to the State on a monthly basis 80% of its 
net  revenues  after  deduction  of  the  expenses 
related to the financial year and the uncovered loss 
of the previous financial year. This provision does 
not  rule  out  the  possibility  of  an  intra-year 
anticipated profit distribution under circumstances 
where  the  BNR  would  accumulate  profit  during 
the first half of a year, but suffer losses during the 
second half. The adjustment would be done by the 
State  only  after  the  closure  of  the  financial  year 
and  would  thus  imply  an  intra-year  credit  to  the 
State,  which  would  breach  the  prohibition  on 
monetary  financing.  The  provision  is  therefore 
incompatible with the Article 123 of the TFEU.  

9.1.6.  Assessment of compatibility 

the 

time  of  euro  adoption, 
the  BNR  as  well  as 

As  regards  the  central  bank  integration  into  the 
the 
ESCB  at 
independence  of 
the 
prohibition  on  monetary  financing,  the  legislation 
in Romania, in particular the Law on the BNR, is 
not  fully  compatible  with  Article  130  and  131  of 
the TFEU and the ESCB/ECB Statute. 

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Convergence Report 2010 

9.2. 

PRICE STABILITY 

quarter  of  2010,  Romanian  inflation  remained  at 
these elevated levels, averaging 4.6%.  

9.2.1.  Respect of the reference value 

Graph 9.2.2: Romania - HICP inflation

 (y-o-y percentage change)

15

10

5

0

-5

2004

2005

2006

2007

2008

2009

Ro mania

Euro  area

Source: Eurostat.

inflation  (measured  as  HICP 

Core 
inflation 
excluding  energy  and  unprocessed  food)  moved 
broadly  in  tandem  with  headline  inflation  in  the 
course  of  2008,  averaging  7.6%  for  the  year  as  a 
whole.  In  2009,  core  inflation  remained  high  (at 
6.6% for the year as a whole) – also in comparison 
to  headline  inflation  –  as  price  developments 
showed  persistent  inflationary  pressures  across  all 
categories with the exception of unprocessed food. 
Elevated  inflation  in  the  processed  food  category 
mainly  reflected  upward  adjustments  in  tobacco 
excise  duties.  Persistent  increases  in  the  prices  of 
some  service  categories  suggest,  in  view  of  the 
sharp 
that  underlying 
inflationary pressures may be also stemming from 
labour  and  product  market  rigidities.  Inflation  in 
non-energy  industrial  goods  remained  well  in 
positive territory in 2009, partly on account of the 
lagged  impact  of  the  significant  weakening  of  the 
leu  in  2008.  The  available  data  also  suggest  that 
high inflation may have become entrenched amidst 
signs of elevated inflation expectations.  

economic  downturn, 

The 12-month average inflation rate for Romania, 
which is used for the convergence assessment, has 
been above the reference value since EU accession 
in 2007. The difference between 12-month average 
inflation  and  the  reference  value  had  somewhat 
narrowed  by  mid-2007,  but  it  increased  again 
thereafter. In March 2010, the reference value was 
1.0%,  calculated  as  the  average  of  the  12-month 
average  inflation  rates  in    Portugal,  Estonia  and 
Belgium  plus  1.5  percentage  points.  The 
corresponding inflation rate in Romania was 5.0%, 
i.e.  4.0  percentage  points  above  the  reference 
value. The 12-month  average  inflation  is  likely  to 
stay well above the reference value in the months 
ahead. 

Graph 9.2.1: Romania - Inflation criterion since 2004

 (percent, 12-month mov ing av erage)

16

14

12

10

8

6

4

2

0
Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11

Ro mania

Reference value

Note: The dots show the projected reference value and 12-month average inflation 
in the country in December 2010.
Sources: Eurostat, Commission services' Spring 2010 Forecast.

9.2.2.  Recent inflation developments 

large  negative  supply  shocks 

Following  a  period  of  successful  disinflation, 
annual  HICP  inflation  bottomed  out  at  just  below 
4%  in  the  second  quarter  2007.  Subsequently, 
inflation  accelerated  sharply  between  mid-2007 
and  mid-2008 on  the back of  rising  food  and  fuel 
prices.  In  July  2008,  annual  headline  inflation 
peaked  at  a  three-year  high  of  9.1%.  When  the 
in 
effect  of 
commodity  prices  ebbed  away,  HICP  inflation 
resumed  a  downward 
trend  until  mid-2009. 
However,  inflation  remained  elevated  despite  the 
sharp economic decline, hovering at or just below 
5% in the second half of 2009. The large gap vis-à-
vis euro area headline inflation reflected inter alia 
increases in Romanian tobacco excise duties (both 
in  2009  and  2010),  higher  fuel  prices  (from  the 
fourth  quarter  2009  onwards)  as  well  as 
persistently  high  inflation  in  services.  In  the  first 

152 

 
 
 
Convergence Report 2010 - Technical annex 

Chapter 9 - Romania 

Table 9.2.1:

Romania - Components of inflation

(percentage change)1)

weights  

in total   

2004

2005

2006

2007

2008

2009

Mar-10

HICP

Non-energy industrial goods

Energy

Unprocessed food 

Processed food

Services

HICP excl. energy and unproc. food
HICP at constant taxes 2)
Administered prices HICP

11.9

8.1

19.4

3.2

14.5

13.3

12.2

10.9

16.6

9.1

6.6

17.6

10.2

5.1

8.3

6.3

8.1

6.6

4.1

11.9

4.0

6.6

6.5

5.8

5.4

13.7

10.6

4.9

2.6

5.9

1.2

7.9

5.4

5.5

4.2

5.3

7.9

3.0

9.9

7.1

10.9

8.2

7.6

7.1

7.8

5.6

4.1

4.0

3.4

7.3

8.5

6.6

4.0

7.1

5.0

3.8

3.4

2.0

7.9

6.8

6.2

3.4

5.1

2010

1000

230

169

155

274

171

676

1000

174

1) Measured by the arithmetic average of the latest 12 monthly indices relative to the arithmetic average of the 12 monthly indices

   in the previous period.

2) Last observation for HICP at constant taxes is February 2010

9.2.3.  Underlying  factors  and  sustainability  of 

inflation 

Macroeconomic  policy-mix  and  cyclical 
stance 

The Romanian economy is estimated to have fallen 
well  below  potential  during  the  global  economic 
crisis.  Economic  growth  abruptly  dropped  from 
around  7%  on  average  in  2006-2008  to  -7.1%  in 
2009, on the back of plummeting domestic demand 
amid  a  sharp  deceleration  in  credit  growth  and 
investment  inflows.  Available  data  and  indicators 
for  the  first  quarter  of  2010  suggest  a  shallow 
recovery  for  the  Romanian  economy.  Real  GDP 
growth is projected to rebound moderately to 0.8% 
in  2010  and  3.5%  in  2011,  reflecting  notably  a 
pick up in domestic demand components with the 
exception  of  public 
spending.  Accordingly, 
Commission  services’  estimates  suggest  a  large 
and negative output gap over the medium term.  

Romanian  public  finances  suffered  from  a  high 
structural  deficit  at  the  onset  of  the  global  crisis, 
following  largely  pro-cyclical  policies  during  the 
boom  years  around  the  EU  accession.  The  fiscal 
stance,  as  measured  by  changes  in  the  structural 
balance, became broadly neutral in 2009 reflecting 
in  particular  external  financing  constraints  in  the 
midst of the intensifying global financial crisis. In 
view  of  planned  consolidation  efforts  of  the 
Romanian government, a restrictive fiscal stance is 
projected for the years 2010 and 2011. 

Romanian  monetary  policy,  conducted  within  an 
inflation  targeting  framework (59),  was  recently 

loosened in view of an improved inflation outlook 
and  some  signs  of  stabilisation  in  the  domestic 
financial  markets. The National Bank of Romania 
(BNR)  lowered  its  key  rate  by  a  total  375  basis 
points to 6.5% between February 2009 and March 
2010.  The  depreciation  of  the  leu  between  mid-
2008  and  early  2009  contributed  to  an  easing  of 
monetary  conditions.  Ex  post  real  interest  rates 
remained  elevated  during  the  crisis,  though  they 
decreased  somewhat  in  early  2010,  as  a  result  of 
the  fall  in  nominal  interest  rates  amid  persistently 
high  inflation.  Credit  growth  in  the  Romanian 
economy  decelerated  abruptly  in  the  course  of 
2009  on  the  back  of  unfavourable  cyclical  and 
financial conditions.  

Wages and labour costs 

The labour market situation has reacted, albeit with 
a  lag,  to  the  sharp  economic  downturn.  The 
unemployment rate picked up to 6.9% in 2009, up 
from  a  ten-year  low  of  5.8%  in  2008.  Annual 
growth  in  nominal  compensation  per  employee 
decreased  from  very  high  levels  of  above  20%  in 
2007-2008  to  around  3%  in  2009,  and  a  further 
decline  is  expected  this  year.  In  2009,  labour 
productivity  growth  fell  into  negative  territory  on 
the back of contracting output. Productivity growth 
is  projected  to  regain  some  limited  momentum  in 
2010, fostered partly by restructuring and staff lay-
offs.  As  a  result,  growth  in  nominal  unit  labour 
costs  (ULC)  is  projected  to  decline  in  the  period 
ahead. 

(59)  The National Bank of Romania has set inflation targets  in 
terms of annual consumer price index growth at 3.5% (with 
a tolerance band of ± 1 percentage point) for end-2010 and 

at 3.0% (with a tolerance band of ± 1 percentage point) for 
end-2011. 

153 

 
                                                           
                                                                                   
 
 
 
 
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Convergence Report 2010 

Table 9.2.2:

Romania - Other inflation and cost indicators

2004

2005

2006

2007

2008

(annual percentage change)

20091)

20102)

20112)

HICP inflation

Romania

Euro area

11.9

2.2

Private consumption deflator

Romania

Euro area

12.7

2.0

Nominal compensation per employee

Romania

Euro area

Labour productivity

Romania

Euro area

Nominal unit labour costs

Romania

Euro area

Imports of goods deflator

Romania

Euro area

13.7

2.5

10.3

1.8

3.1

0.9

8.7

1.3

9.1

2.2

6.9

2.1

28.6

2.2

5.8

1.1

21.6

1.3

-3.6

3.6

1) 2009 data (except HICP inflation) are estimates. 

2) Commission services' Spring 2010 Forecast.

Source: Eurostat, Commission services.

6.6

2.2

4.9

2.2

12.4

2.6

7.1

1.7

4.9

1.1

-1.2

4.1

4.9

2.1

4.8

2.3

22.0

2.7

5.9

1.1

15.2

1.6

-9.2

1.3

7.9

3.3

9.5

2.9

24.2

3.4

7.6

0.0

15.4

3.4

17.2

4.1

5.6

0.3

3.3

-0.1

3.1

2.0

-6.2

-2.0

9.9

4.0

2.7

-7.5

4.3

1.5

4.0

1.4

2.3

1.3

2.5

1.8

-0.2

-0.5

1.7

3.9

3.0

1.7

3.3

1.5

2.5

1.5

2.6

1.3

-0.1

0.1

1.6

1.6

Graph 9.2.3: Romania - Inflation, productivity and wage trends

(y-o-y % change)

30

25

20

15

10

5

0

-5

2004

2005

2006

2007

2008

2009

2010

2011

P ro ductivity (real GDP  per perso n emplo yed)

No minal co mpensatio n per emplo yee

No minal unit labo ur co sts
HICP  inflatio n

Source: Eurostat, Commission services' Spring 2010 Forecast.

Romania  has  been  long  lacking  discipline  in  the 
area  of  public  wages,  as  public  sector  wages  rose 
above the trend in the overall economy in the last 
few  years.  The  Romanian  wage-setting  process  is 
largely  decentralised,  though  wage  agreements  in 
the  public  sector  continue  to  play  an  important 
signalling  role  for  private  sector  wages.  Looking 
ahead,  there  are  encouraging  signs  of  restoring 
wage  discipline  in  the  public  sector.  In  particular, 
the 2010 budget includes a reduction of the public 
wage  bill  by  freezing  public  wages  along  with  a 
number  of  structural  changes  to  reduce  public 
sector employment.   

154 

External factors 

For  Romania,  given  the  increasing  openness  and 
deepening  integration  into  the  world  economy, 
developments  in  import  prices  play  an  important 
role in domestic price formation. Import prices, as 
measured  by  the  imports  of  goods  deflator  in  the 
national  accounts,  have  been  supportive 
to 
disinflation  in  2006  and  the  first  part  of  2007.  In 
2008,  annual  growth  in  import  prices  picked  up 
strongly  on  the  back  of  the  effective  depreciation 
of the leu. The annual increase in import prices is 
estimated to have been muted in 2009. 

by 

exchange 

influenced 

Import  price  dynamics  in  Romania  have  been 
significantly 
rate 
fluctuations  of  the  leu.  The  leu  nominal  effective 
exchange  rate,  measured  against  a  group  of  36 
trade partners, depreciated by around 28% between 
mid-2007  and  early  2009.  The 
leu  broadly 
stabilised  in  the  course  of  2009,  reflecting  some 
moderation 
in  global  risk  aversion  and  an 
improving external balance. In the area of services 
prices,  the  linking  of  telecommunication  tariffs  to 
the  exchange  rate  of  the  leu  against  the  euro 
induced a sharp pick-up in consumer prices for this 
category in 2008 and 2009.  

Energy  prices  have  been  an  important  component 
in 
in 
in 

the  recent  past, 

imported 

inflation 

 
 
 
 
 
 
Convergence Report 2010 - Technical annex 

Chapter 9 - Romania 

an increased supply of domestic food products) is 
unlikely  to  be  repeated.  A  further  moderation  in 
unit labour costs is expected in 2010-2011, due to 
the  lagged  impact  of  the  economic  downturn.  On 
this  basis,  the  Commission  services'  Spring  2010 
Forecast projects annual HICP inflation to average 
4.3% in 2010 and 3.0% in 2011. 

in  view  of 

the  recent  recovery 

Risks  to  the  inflation  outlook  appear  broadly 
balanced.  The  main  upside  risks  include  external 
in 
factors, 
international energy prices, and further increases in 
administered  prices  (notably  of  gas  and  other 
utilities).  No  major  changes  to  indirect  taxes  are 
foreseen  over  the  next  years,  though  further 
upward  adjustments  cannot  be  excluded  in  the 
context of fiscal consolidation efforts. Conversely, 
a  slower-than-expected  recovery  of  the  Romanian 
economy  and  possible  appreciation  of  the  leu  on 
the  back  of  an  improved  balance-of-payments 
outlook would have disinflationary effects.  

The  level  of  consumer  prices  in  Romania  was  at 
some  58%  of  the  euro  area  average  in  2008,  with 
the  relative  price  gap  widest  for  services.  This 
suggests significant potential for further price level 
convergence  in  the  long  term,  as  income  levels 
(about  44%  of  the  euro  area  average  in  PPS  in 
2008)  increase  gradually  towards  the  euro  area 
average. 

Medium-term  inflation  prospects  in  Romania  will 
notably  hinge  upon  a  robust  policy  framework, 
which would help anchor inflation expectations at 
a  lower  level,  as  well  as  on  the  functioning  of 
product  markets.  Aligning  wage  growth  with 
productivity  developments  will  be  crucial 
to 
safeguard  both  competitiveness  and  a  sustainable 
inflation  performance;  a  prudent  fiscal  policy 
stance  will  be  essential,  including  in  view  of  the 
strong  signalling  role  of  public  wages  in  the 
Romanian economy. Advancing structural reforms 
to  step  up  competition,  especially  in  product 
markets  and  some  segments  of  the  retail  sector, 
would also help to contain inflationary pressures. 

particular  in  view  of  volatile  prices  of  primary 
commodities and a large weight of this category in 
the  Romanian  HICP.  Fuel  prices  rose  markedly 
during the first three quarters of 2008 on the back 
of soaring global oil prices; following a subsequent 
drop, they picked up only towards end-2009 due to 
a rebound in global oil prices. The annual increase 
in  natural  gas  prices  fell  into  negative  territory 
from  July  2009  onwards,  following  cuts  in  gas 
tariffs in the course of the first half of 2009. As a 
result,  the  total  contribution  of  energy  prices  to 
HICP 
from  around  1.6 
percentage points in 2008 to around 0.7 percentage 
points in 2009.  

inflation  decreased 

Administered prices and taxes 

Adjustments  in  administered  prices  and  indirect 
taxes  have  been  an  important  driver  of  Romanian 
inflation  in  recent  years  (60).  Administered  prices, 
added  to  headline  inflation,  particularly  in  2009. 
The  contribution  of  indirect  taxes  also  picked  up 
recently  and  reflected,  inter  alia,  adjustments  in 
view of  the  EU  tax  harmonisation  (i.e.  excises  on 
fuels 
fiscal 
consolidation 
the  Romanian 
government. 

tobacco 
efforts 

products) 

and 

and 

by 

Annual  increases  in  administered  prices  reached 
7.8%  in  2008  and  about  7.1%  in  2009.  The 
widening  of  the  positive  gap  vis-à-vis  headline 
inflation in 2009 largely mirrored persistently high 
inflation  in  some  administered  utility  prices  (e.g. 
water  supply  and  sewage  collection)  as well  as  in 
administered  energy  prices,  mirroring  notably  the 
lagged  effects  of  the  pass-through  from  higher 
commodity prices. In 2009 and early 2010, upward 
adjustments  in  excise  duties  heavily  impacted  on 
headline  HICP 
the 
subcategory  of  tobacco  products  is  estimated  to 
have  contributed  by  around  2.7  percentage  points 
to annual headline inflation in January 2010. 

In  particular, 

inflation. 

Medium-term prospects 

HICP inflation is expected to moderate in 2010, on 
the  back  of  muted  economic  activity  and  in  line 
with the tapering-off of the price increases related 
to  substantial  excise  duty  hikes.  Conversely,  the 
strong  disinflation 
food 
category in the course of summer 2009 (reflecting 

the  unprocessed 

in 

(60)  For the purpose of this report administered prices include, 
inter alia, regulated utility prices, cultural services and part 
of  public  transport.  The  share  of  administered  prices  in 
Romania's HICP basket amounted to around 17% in 2010.  

155 

 
                                                           
European Commission 

Convergence Report 2010 

9.3.  GOVERNMENT BUDGETARY POSITION 

9.3.1.  The  excessive  deficit  procedure 

for 

Romania (61) 

the 

time, 

same 

the  Council 

In  July  2009,  the  Council  adopted  a  decision 
stating  that  Romania  had  an  excessive  deficit, 
based on a notified deficit of 4% of GDP in 2008. 
At 
issued 
recommendations  to  correct  the  excessive  deficit 
by  2011  and  established  a  deadline  of  7  January 
2010  for  effective  action  to  be  taken.  In  its 
subsequent assessment, the Commission found that 
Romania had taken effective action. Moreover, the 
developments in the economic outlook implied that 
unexpected  adverse  economic  events  with  major 
unfavourable  effects  for  government  finances  had 
occurred  in  Romania.  Following  this  assessment, 
issued  new 
in  February  2009, 
recommendations  to  correct  the  excessive  deficit 
by  2012.  In  particular,  the  annual  fiscal  effort  is 
recommended  to  average  1¾%  of  GDP  over  the 
period  2010-2012,  fiscal  governance  should  be 
strengthened  and  the  announced  draft  pension 
reform  should  be  adopted  and  implemented.  The 
Commission 
closely  monitor 
budgetary developments in Romania in accordance 
with the Treaty and the SGP.  

the  Council 

continues 

to 

9.3.2.  Developments 2004-2009 

The  general  government  deficit 
increased 
throughout the 2005-2009 period reaching 8.3% of 
GDP  last  year.  The  worsening  of  the  deficit  in 
2005-2008, when real GDP growth averaged 6.4%, 
was  due  to  an  expansionary  fiscal  policy  stance 
which  is  reflected  in  the  deterioration  of  the 
structural deficit (the cyclically-adjusted deficit net 
of  one-offs  and  other  temporary  measures)  which 
reached 7.7% of GDP by 2008. The worsening of 
the fiscal deficit in 2009 reflects the effects of the 
crisis on government finances. 

The  revenue-to-GDP  ratio  increased  from  32.3% 
in 2005 to 33.5% in 2007 following an increase in 
both direct and indirect tax revenues as a result of 
a  favourable  evolution  in  earnings  and  corporate 
profits  as  well  as  of  a  strong  increase  in  private 
consumption.  However,  the  revenue-to-GDP  ratio 
deteriorated  to  32.8%  in  2008  and 32.1%  in  2009 

(61)  All documents related to the excessive deficit procedure for 
Romania 
at: 
http://ec.europa.eu/economy_finance/sgp/deficit/countries/r
omania_en.htm 

found 

can 

be 

156 

mainly  because  of  a  sharp  fall  in  revenues  on  the 
back of a sharp contraction in economic activity – 
real  GDP  fell  by  7.1%  in  2009  against  a  positive 
growth of 7.3% in 2008. The expenditure-to-GDP 
ratio  increased  continuously  throughout  the  2005-
2008  period,  from  33.5%  in  2005  to  37.6%  in 
2008.  This  was  in  large  part  the  result  of  rises  in 
current  spending,  in  particular  compensation  of 
employees  and  social  benefits  (pensions  were 
to  100%  wage  growth).  The 
being 
to 
expenditure-to-GDP  ratio 
40.4%  in  2009,  despite  measures  taken  to  control 
government  spending,  such  as  cuts  in  goods  and 
services  spending  and  the  restructuring  of  state 
agencies.  

increased  further 

indexed 

fiscal 

included 

financial 

The  economic  downturn  hit  Romania  hard  and  in 
March  2009  the  authorities  made  a  request  for 
assistance (62).  Policy 
multilateral 
consolidation 
conditionality 
measures aimed at decreasing the budget deficit to 
5.1%  of  GDP  in  2009.  The  urgent  need  for  fiscal 
consolidation  meant  that  only  a  very  limited 
number  of  stimulus  measures,  mainly  aimed  at 
supporting  businesses,  were  taken,  amounting  to 
0.2%  of  GDP.  They  included  the  exemption  of 
reinvested profits from tax, a temporary waiver on 
social  security  contributions  for  workers  on 
"technical  unemployment"  and  extending 
the 
scope of the "Rabla" programme for scrapping old 
cars. However, a sharper than anticipated recession 
in  the  first  half  of  2009  resulted  in  a  further 
worsening  of  the  fiscal  position.  Part  of  this 
deterioration  in  the  economic  conditions  was 
accommodated  by  revising  the  deficit  target  to 
7.8%  of  GDP,  which  allowed  partial  operation  of 
automatic  stabilisers.  The  government  deficit  in 
2009 missed that target by 0.5% of GDP. Despite 
the  efforts  made  by  the  government  to  reduce 
current spending, in particular by taking a series of 
one-off  measures  such  as  the  10-day  furlough  for 
all public sector employees, and windfall revenues 
(reimbursement  of  subsidies), 
there  was  a 
significant  build-up  of  payment  arrears  in  the 
health sector and at the local authority level at the 
end of the year. As a result the government deficit 
reached 8.3% of GDP in 2009. 

(62)  The package of international financial assistance amounted 
to a total of EUR 20 billion over the period to 2011. On 5 
May  2009,  the  EU  Council  adopted  a  decision  to  make 
available  to  Romania  medium-term  financial  assistance  of 
up to EUR 5 billion. The EU assistance for Romania comes 
in  conjunction  with 
(Stand-by-
loans  of 
Arrangement of EUR 13 billion), the World Bank (EUR 1 
billion) and the EIB and the EBRD (EUR 1 billion).  

IMF 

the 

 
                                                           
 
                                                           
Convergence Report 2010 - Technical annex 

Chapter 9 - Romania 

(as % of GDP unless indicated otherwise)

2007

2008

2009

2010

2011

Table 9.3.1:

Romania - Budgetary developments and projections
Outturn and forecast 1)

2004

2005

2006

General government balance

- Total revenues

- Total expenditure

of which: 
- interest expenditure

- current primary expenditure

- gross fixed capital formation

p.m.: Tax burden

Primary balance

Cyclically-adjusted balance

One-off and temporary measures
Structural balance 2)
Structural primary balance

Government gross debt

p.m: Real GDP growth (%)

p.m: Output gap

p.m: GDP deflator (% change)

Convergence programme
General government balance

Primary balance
Structural balance 2) 3)
Government gross debt

p.m. Real GDP (% change)

-1.2

32.3

33.5

1.4

27.0

3.0

27.7

0.2

-2.3

0.0
-2.3

-0.8

18.7

8.5

4.0

15.5

-1.2

32.3

33.5

1.1

27.5

3.9

28.5

-0.1

-2.2

0.0
-2.2

-1.1

15.8

4.2

4.2

12.2

-2.2

33.1

35.3

0.8

27.8

5.1

29.1

-1.3

-4.1

-0.6
-3.5

-2.7

12.4

7.9

7.6

10.6

-2.5

33.5

36.0

0.7

28.4

5.7

29.8

-1.8

-4.7

-0.1
-4.7

-3.9

12.6

6.3

8.8

13.5

-5.4

32.8

37.6

0.7

30.0

5.5

28.0

-4.7

-8.2

-0.5
-7.7

-7.0

13.3

7.3

9.5

15.2

2008
-5.5

-4.8

-8.5

13.6

7.3

-8.3

32.1

40.4

1.5

32.7

5.4

27.4

-6.8

-7.8

0.5
-8.3

-6.8

23.7

-7.1

-1.5

2.7

2009
-8.0

-6.5

-7.5

23.0

-7.0

-8.0

31.9

39.9

1.9

32.5

5.4

26.7

-6.2

-6.9

0.2
-7.1

-5.2

30.5

0.8

-3.5

4.6

2010
-6.3

-4.5

-5.2

28.3

1.3

-7.4

31.3

38.8

2.1

30.6

5.4

26.8

-5.4

-6.4

0.0
-6.4

-4.4

35.8

3.5

-3.5

4.0

2011
-4.4

-2.6

-3.2

29.4

2.4

2013

2012
-3.0

-1.6

-2.1

29.7

3.7

1) Commission services’ Spring 2010 Forecast.

2) Cyclically-adjusted balance excluding one-off and other temporary measures. One-off and other temporary measures are: 0.6% of G

3) Commission services’ calculations on the basis of the information in the programme. 

Sources: Commission services and March 2010 update of Romania's Convergence Programme.

The  debt-to-GDP  ratio  improved  from  18.7%  in 
2004  to  12.6%  in  2007  because  of  a  combination 
of lower implicit interest rates, high nominal GDP 
growth,  privatisation  receipts  and  foreign  debt 
valuation 
the  nominal 
related 
appreciation of the leu. However, the debt-to-GDP 
ratio  has  been  on  a  sharply  increasing  trend  since 
2008  due  to  the  high  budget  deficits  and  reached 
23.7% in 2009.  

effects 

to 

9.3.3.  Medium-term prospects 

The 2010 budget adopted by Parliament in January 
2010 targets a deficit of 6.3% of GDP. In line with 
the  balance-of-
the  policy  conditions  under 
the  planned 
payments 
adjustment  is  mainly  expenditure  driven:  the 
measures  imply  expenditure  cuts  of  around  2.2% 
of GDP. Moreover, there are also measures aimed 

support  programme, 

at  raising  revenue  by  about  ½  %  of  GDP.  On  the 
expenditure  side,  measures  consist  of  further 
reductions in the public sector wage bill (including 
a nominal freeze in public wages), a pension freeze 
and cuts in goods and services expenditure. On the 
revenue side, excise taxes will be raised and a tax 
on  medical  distributors  will  be  introduced.  The 
budget  also  includes  the  one-off  positive  effect 
from 
tax  arrears  (the 
Rompetrol bond), representing about ½% of GDP. 

the  reimbursement  of 

The 2010 government deficit target was confirmed 
in  the  March  2010  update  of  the  convergence 
programme.  However,  the  Commission  services' 
Spring  2010  forecast  predicts  a  deficit  of  8%  of 
GDP.  The  higher  deficit  predicted  by 
the 
Commission services is due to the fact that it now 
appears  that  the  measures  included  in  the  2010 
budget will not be sufficient to achieve the agreed 
budgetary  target  because  of:  (i)  the  base  effect 
from  the  higher  2009  deficit;  (ii)  lower  GDP 

157 

 
 
 
 
 
 
 
 
 
 
 
in 

in 

line  with 

the  convergence  programme 

is 
projected 
appropriate  and 
the  Council 
Recommendation  under  Article  126(7)  TFEU. 
However, full implementation of the consolidation 
measures foreseen for 2010 is essential to reach the 
deficit target. In addition, the programme does not 
sufficiently  specify  the  consolidation  measures  to 
be  taken  in  2011  and  2012.  The  Romanian 
Government  has  made  the  commitment  to  take 
contingency  measures,  if  needed,  to  reach  the 
2010.  Moreover, 
for 
deficit 
implementation  of  the  fiscal  governance  reforms 
decided upon within the context of the EU balance 
of  payments  assistance  programme  to  Romania 
should help in achieving the budgetary targets for 
the  adoption  and 
2011  and  2012.  Finally, 
implementation of the draft pension reform will be 
crucial in improving the long-term sustainability of 
public finances." 

target 

set 

The  Council  invited  Romania  to:  (i)  rigorously 
implement  the  fiscal  consolidation  measures  for 
2010  agreed  as  part  of  the  balance-of-payments 
support  programme  and  take  further  corrective 
action, if needed, to achieve the 2010 target for the 
general government deficit; specify, in the context 
of the Medium-Term Budgetary Framework, to be 
prepared by end May 2010, the fiscal consolidation 
measures  necessary  to  achieve  the  programme 
budgetary  targets  in  2011  and  2012;  (ii)  improve 
the 
and 
implementing  the  fiscal  responsibility  law  and  in 
particular  take  into  account  the  analysis  of  the 
Fiscal Council in the design and conduct of fiscal 
policy; (iii) adopt and implement the draft pension 
to  significantly 
law  which  would  contribute 
improve  the  long-term  sustainability  of  public 
finances.   

framework 

adopting 

fiscal 

by 

European Commission 

Convergence Report 2010 

growth in 2010, which is now expected to be 0.5% 
lower than assumed when drafting the budget, and 
(iii)  the  fact  that  the  government  is  only  expected 
to  receive  around  half  of  the  initially  expected 
revenue from the Rompetrol bond.  

Policies aimed at fiscal consolidation are expected 
to  continue  in  2011  with  a  view  to  reaching  a 
deficit  of  3%  of  GDP  in  2012.  In  particular,  the 
consolidation  measures  taken  to  control  the  2010 
budget should also help bring down deficits in later 
years.  This  explains  the  current  projection  of  a 
continued  decline  in  the  general  government 
deficit from 8% of GDP in 2010 to 7.4% in 2011. 
More  rapid  progress  in  bringing  down  the  deficit 
and achieving the 2012 deadline for the correction 
of the excessive deficit would require the adoption 
of additional consolidation measures. 

The fiscal stance in 2010 and 2011 is restrictive, as 
the structural balance is projected to improve from 
-8.3%  of  GDP  in  2009  to  -6.4%  of  GDP  in  2011 
according to the Commission services' forecast. 

compounds 

programme, 

the  medium 

term,  as  foreseen 

The  long-term  budgetary  impact  of  ageing  is 
clearly above the EU average, mainly due to a high 
projected  increase  in  pension  expenditure.  The 
budgetary  position  in  2009,  as  estimated  in  the 
convergence 
the 
budgetary  impact  of  population  ageing  on  the 
sustainability  gap.  Reducing  the  primary  deficit 
the 
over 
convergence  programme,  and  implementing  the 
draft  pension  reform  agreed  together  with  the 
international financial institutions in the context of 
the balance-of-payments assistance programme for 
Romania, which is aimed at curbing the substantial 
increase 
expenditures,  will 
contribute to reducing the risks to the sustainability 
of  public  finances  which  were  assessed  in  the 
Commission  2009  Sustainability  Report(63)  as 
high. 

age-related 

in 

in 

In  its  April  2010  opinion  on  the  convergence 
its 
programme, 
assessment  as  follows:  "The  overall  conclusion  is 
that  taken  at  face  value,  the  consolidation  path 

the  Council 

summarised 

(63)  In  the  Council  conclusions  from  10  November  2009  on 
sustainability  of  public  finances  "the  Council  calls  on 
Member States to focus attention to sustainability-oriented 
strategies  in  their  upcoming  stability  and  convergence 
programmes"  and 
the  Commission, 
further  "invites 
together  with  the  Economic  Policy  Committee  and  the 
Economic  and  Financial  Committee,  to  further  develop 
methodologies for assessing the long-term sustainability of 
public  finances  in  time  for  the  next  Sustainability  report", 
which is foreseen in 2012. 

158 

 
                                                           
 
9.4. 

EXCHANGE RATE STABILITY 

The  Romanian  leu  does  not  participate  in  ERM 
II (64).  Romania  has  been  operating  a  de  jure 
managed  floating  exchange  rate  regime  since 
1991,  though  moving  gradually  from  a  very 
strongly managed float – including through the use 
of administrative measures until 1997 – to a more 
flexible  one.  In  2004,  the  National  Bank  of 
Romania  (BNR)  increased  the  flexibility  of  the 
exchange rate and moved to a regime characterized 
by 
interventions.  Since  2005, 
Romania  has  been  operating  a  direct  inflation 
targeting  framework  combined  with  a  floating 
exchange  rate  regime.  The  BNR  has  stressed, 
nonetheless, that all instruments for the conduct of 
monetary  and  exchange  rate  operations  remain 
available 
currency 
in 
interventions. 

principle, 

including 

frequent 

less 

The  leu's  exchange  rate  fluctuated  widely  in  the 
course  of  the  2000s.  Between  late  2004  and  mid-
2007 the leu registered a broad appreciation trend 
amid  capital 
inflows  sparked  by  economic 
catching-up  and  prospects  of  EU  accession 
(facilitated by full capital account liberalisation in 
September  2006).  After  reaching  a  five-year  high 
in  mid-2007,  the  leu's  exchange  rate  fell  strongly 
in  the  midst  of  the  first  signs  of  turbulences  in 
global  financial  markets.  Also,  country-specific 
factors  appear  to  have  played  a  role  in  view  of 
increased  investors'  concerns  about  the  widening 
imbalances 
the  Romanian  economy.  The 
depreciating  trend  from  late  2007  was  only 
interrupted in the course of the first half of 2008.  

in 

A  further  significant  weakening  impetus  was 
triggered  in  autumn  2008  amid  the  intensification 
of  the  global  financial  crisis  and  rising  investor 
concerns  about  large  and  increasing  domestic 
macroeconomic 
imbalances.  Romania  was 
downgraded  by  major  rating  agencies,  CDS 
spreads  on  sovereign  debt  increased  substantially 
rates  surged.  Following 
and  money  market 
agreement in early 2009 to provide Romania with 
a  coordinated  package  of  international  financial 
assistance, 
financial  market  pressures  eased 
somewhat and the Romanian leu broadly stabilised 
in  the  course  of  2009.  The  lower  short-term 
volatility  of  the  leu  appears  to have  reflected –  in 

(64)  On 1 July 2005 the Romanian Leu (ROL) was replaced by 
the  new  leu  (RON),  with  a  conversion factor  of  1  RON  = 
10,000  ROL.  For  convenience,  however,  the  text  of  this 
report  consistently  refers  to  leu,  meaning  ROL before and 
RON after the conversion. 

Convergence Report 2010 - Technical annex 

Chapter 9 - Romania 

addition  to  the  positive  effects  associated  with 
international  financial  assistance  to  Romania  – 
some  signs  of  easing  global  market  conditions  as 
well  as  domestic  factors  (e.g.  tight  liquidity 
management  in  the  money  market  by  the  BNR). 
Financial  market  pressures  re-emerged  towards 
end-2009, mainly on account of domestic political 
uncertainties.  In  early  2010,  domestic  financial 
market conditions improved and the leu's exchange 
rate  recorded  a  moderate  appreciation,  mirroring 
notably  an  easing  of  external  financing  pressures 
as  well  as  the  approval  of  the  austerity  2010 
budget.  During 
this 
assessment, the leu depreciated against the euro by 
12.9%. 

two  years  before 

the 

Graph 9.4.1: Exchange rates - RON/EUR

(monthly av erages)

4.5

4.0

3.5

3.0

2.5

2004

2005

2006

2007

2008

2009

Source: ECB and EcoWin.

Fluctuations  in  the  level  of  foreign  exchange 
reserves  over  recent  years  reflected  notably  the 
liquidity  management  of 
the  banking  sector, 
foreign exchange operations by the government as 
well as changes in investor sentiment. In 2009, the 
level  of  the  foreign  exchange  reserves  remained 
robust,  amounting  to  about  120%  of  short-term 
external  debt  by  year-end.  International  reserves 
were  notably  boosted  by  the  disbursements  of 
international  financial  assistance,  though  cuts  in 
minimum  reserve  requirements  on  banks'  foreign 
exchange  denominated  liabilities  acted,  to  some 
extent, as an offset.  

159 

 
                                                           
    
 
The short-term interest rate differential eased only 
gradually  in  the  course  of  2009,  partly  reflecting 
improved  conditions  on  the  Romanian  money 
market.  Short-term  rates  decreased  further  in  the 
first quarter 2010 to 4.7% on 23 April 2010, in line 
with a rapid decline in the BNR's key policy rates 
and an abundant liquidity on the interbank market. 
The  main  refinancing  rate  of  the  BNR  was  at 
6.50%  in  April  2010,  i.e.  550  basis  points  above 
the ECB reference rate.  

European Commission 

Convergence Report 2010 

Graph 9.4.2: Romania - 3-M Robor spread to 3-M Euribor

 (basis points, monthly v alues)

2250

2000

1750

1500

1250

1000

750

500

250

0

2004

2005

2006

2007

2008

2009

Source: Reuters EcoWin.

Short-term  interest  rate  differentials  vis-à-vis  the 
euro  area  started  to  widen  swiftly  in  the  second 
half  of  2007,  from  a  low  of  just  above  200  basis 
points.  The  increase  in  money  market  spreads 
reflected, to some extent, higher key policy interest 
rates  of  the  BNR.  The  deepening  of  the  financial 
crisis  in  the  autumn  2008  and  the  ensuing lack  of 
liquidity drove short-term spreads further up. This 
can  be  attributed  to  heightened  risk  aversion 
among financial institutions on the back of macro-
financial  risks  as  well  as  to  the  central  bank's 
policy actions inducing tighter liquidity conditions.  

160 

 
 
 
 
Convergence Report 2010 - Technical annex 

Chapter 9 - Romania 

the 

interest 

long-term 

By  mid-2007,  long-term  interest  spreads  vis-à-vis 
the euro declined to a record low of just above 200 
basis  points.  A  decreasing  country  risk  premium, 
appreciation  of  the  leu  and  declining  monetary 
policy  rates  contributed  to  driving  yields  down. 
Subsequently, 
rate 
differential  vis-à-vis  the  euro  showed  a  relatively 
muted increase before widening abruptly amid the 
intensification  of  global  financial  crisis  in  late-
2008. The widening spread between Romanian and 
euro  area  benchmark  bonds  largely  reflected 
increasing  country  and  currency  risk  premia, 
though  the  comparatively  low  liquidity  of  the 
Romanian bond market has also been contributing 
to the yield differential. Long-term interest rates in 
Romania  have  been  very  volatile  since  end-2008; 
the  long-term  spread  vis-à-vis  the  euro  picked  up 
to  nearly  800  basis  points  in  August  2009,  before 
narrowing  again  to  about  350  basis  points  in 
in  spreads 
March  2010.  The  recent  decline 
reflected in particular expectations of a narrowing 
policy  rate  differential  between  Romania  and  the 
euro  area  as  well  as  some  easing  in  domestic 
market conditions.  

9.5. 

LONG-TERM INTEREST RATE 

Long-term  interest  rates  in  Romania  used  for  the 
convergence examination reflect secondary market 
yields for a basket of three benchmark bonds with 
a  maturity  of  below  but  close  to  10  years. 
However,  the  limited  number  of  Romanian  long-
term  bonds  issued  and  the  illiquidity  of  the 
secondary  market  pose  some  difficulties 
in 
interpreting the data. 

Graph 9.5.1: Romania - Long-term interest rate criterion
 (percent, 12-month mov ing av erage)

12

10

8

6

4

2

0
Jan-04

Jan-05

Jan-06

Jan-07

Jan-08

Jan-09

Jan-10

Ro mania

Reference value

Source: Commission services.

The  Romanian  12-month  moving  average  long-
term interest rate relevant for the assessment of the 
Treaty  criterion  has  stayed  above  the  reference 
value  since  EU  accession  in  January  2007.  In 
March  2010,  the  latest  month  for  which  data  are 
available, the reference value, given by the average 
of long-term interest rates in Portugal and Belgium 
plus  2  percentage  points,  stood  at  6.0%.  In  that 
month,  the  twelve-month  moving  average  of  the 
yield  on  the  Romanian  benchmark  bond  stood  at 
9.4%, 
the 
reference value.  

i.e.  3.4  percentage  points  above 

Graph 9.5.2: Romania - Long-term interest rates

 (percent, monthly v alues)

14

12

10

8

6

4

2

0

2004

2005

2006

2007

2008

2009

Source: Eurostat.

Ro mania

Euro  area

161 

 
 
 
 
European Commission 

Convergence Report 2010 

9.6.  ADDITIONAL FACTORS 

9.6.1.  Developments  of 

the  balance  of 

payments 

Romania's  external  deficit  reached  a  peak  of 
12.8% of GDP in 2007, before narrowing to 11.1% 
of  GDP  in  2008.  The  rapid  widening  of  the 
external  deficit  in  2005-2007  reflected  largely  a 
worsening  in  the  trade  balance  as  imports  were 
buoyed  by  solid  growth  in  domestic  demand.  In 
2008,  the  Romanian  external  deficit  started  to 
show signs of downward adjustment as a result of 
the  deceleration  in  domestic  demand  and  a  price-
driven shift in the composition of imports in favour 
of  domestically  produced  goods.  This  continued 
into  2009  on  the  back  of  an  abrupt  contraction  of 
domestic demand, with a markedly deeper decline 
of  imports  than  exports  resulting  in  a  rapid 
narrowing  of  the  merchandise  trade  deficit.  The 
balance  of  trade  in  services  remained  broadly 
neutral  over  recent  years.  The  negative  income 
balance  has  narrowed  since  2007,  notably  on  the 
back of lower repatriation of investment income by 
foreign  companies.  Conversely,  wages  repatriated 
by  Romanian  citizens  working  abroad  have  been 
supportive  a  factor  for  the  external  balance  in 
recent  years,  though  their  positive  contribution 
decreased  in  2009  on  the  back  of  the  global 
economic crisis. 

Graph 9.6.1: Romania - Saving and investment
(in percent of GDP at market prices)

40

30

20

10

0

2004

2005
Gro ss natio nal saving

2006

2007

2008

2009

Gro ss capital fo rmatio n at current prices; to tal eco no my

Source: Eurostat, Commission services.

In  terms  of  the  saving-investment  balance,  the 
increase  in  the  external  deficit  between  2005  and 
2007  was  mainly  accounted  for  by  a  rapid 
acceleration of domestic investment activity, while 
the  saving ratio was on  a  slightly  increasing path. 
The  private 
sharply 
decreased  amid 
the  economic  downturn  and 
balance sheet adjustment in the financial and non-
financial  sectors,  though  the  rising  deficit  of  the 
government sector acted partly as an offset. 

saving-investment  gap 

162 

The  real  effective  exchange  rate  appreciated 
strongly between 2004 and mid-2007, on the back 
of  trend  nominal  appreciation  of  the  leu  and 
positive  differentials  in  relative  consumer  prices 
and  unit  labour  costs  vis-à-vis  main  trading 
partners.  More  recent  developments  suggest  an 
competitiveness 
improving  price 
situation. This has been mainly due to the nominal 
effective depreciation of the leu since the onset of 
the  financial  crisis,  though  the  weakening  of  the 
real exchange rate deflated by unit labour costs has 
been 
recorded 
substantial market share gains since EU accession, 
including in the course of 2009. 

pronounced.  Romania 

cost 

less 

and 

Graph 9.6.2: Romania - Effective exchange rates

 (v s. 35 trading partners;  monthly av erages;

  index numbers, 2004 = 100)

240

200

160

120

80

40

2004

2005

2006

2007

2008

2009

NEER

REER, HICP d eflated

REER, ULC d eflated

Source: Commission services.

In  the  years  preceding  the  international  financial 
crisis,  the  Romanian  external  deficit  was  largely 
covered  by  net  foreign  direct  investment  inflows 
(partly  related  to  large-scale  privatisations).  In 
2007, the share of FDI in financing of the external 
shortfall  dropped  to  around  45%  reflecting  both 
lower  direct  investment  inflows  and  sizeable 
increase  in  the  current  account  deficit.  Net  other 
inflows,  mainly  linked  to  intra-group  funding  of 
foreign-controlled  Romanian  banks,  picked  up 
strongly and reached 11% of GDP in 2007.  

The  sizeable  external  shortfall  (coupled  with  high 
credit growth, in large part denominated in foreign 
currencies)  raised  concerns  about  external  debt 
sustainability  amid  the  intensifying  global  turmoil 
in late 2008. Tightening market conditions made it 
increasingly  difficult  for  the  government  to  cover 
growing  refinancing  needs.  In  early  2009,  an 
agreement to provide Romania with a co-ordinated 
package  of 
financial  assistance 
totalling up to EUR 20 billion was reached. More 
than half of the pre-committed financial resources 
were disbursed throughout 2009 and in early 2010 
following positive assessments on the fulfilment of 

international 

 
 
 
Convergence Report 2010 - Technical annex 

Chapter 9 - Romania 

Table 9.6.1:

Romania - Balance of payments

Current account

Of which: Balance of trade in goods

                 Balance of trade in services

                 Income balance 

                 Balance of current transfers

Capital account
External balance 1)
Financial account

Of which: Net FDI

                Net portfolio inflows
                Net other inflows 2)
                Of which International financial assistance

                Change in reserves (+ is a decrease)

Financial account without reserves

Errors and omissions

Gross capital formation

Gross saving

External debt

International investment position

1) The combined current and capital account.

2) Including financial derivatives.

2004

2005

-8.4

-8.7

-0.3

-4.2

4.9

0.8

-7.5

6.1

8.4

-0.7

6.3

-7.9

14.0

1.4

23.7

17.9

35.2

-26.9

-8.6

-9.8

-0.4

-2.9

4.5

0.7

-7.9

7.5

6.6

1.0

6.6

-6.7

14.2

0.4

23.3

14.4

38.7

-29.0

Sources: Eurostat, Commission services and National Bank of Romania.

2006

-10.5

-12.1

0.0

-3.3

5.0

0.0

-10.5

9.6

8.9

-0.2

6.3

-5.4

15.0

0.9

26.5

15.9

42.1

-37.7

2007

-13.4

-14.3

0.3

-3.3

3.9

0.7

-12.8

13.5

5.7

0.4

11.0

-3.6

17.0

-0.7

31.0

17.3

47.0

-43.5

(percentage of GDP)

2008

-11.6

-13.6

0.5

-2.7

4.3

0.4

-11.1

12.6

6.7

-0.4

6.3

0.1

12.6

-1.5

31.3

18.6

51.8

-49.4

2009

-4.5

-5.9

-0.3

-1.8

3.5

0.5

-4.0

5.2

3.8

0.4

2.0

7.7

-1.1

6.2

-1.2

25.1

20.8

67.9

-61.1

the  policy  conditionality  associated  to  successive 
tranches of the assistance.  

External  financing  pressures  eased  somewhat  in 
early-2010,  in  line  with  the  rapid  improvement  in 
the  external  balance.  Romania's  financial  account 
surplus  shrank  to  5.2%  of  GDP  in  2009,  from 
12.6%  of  GDP  a  year  earlier.  The  decline  was 
largely  driven  by  a  significantly  lower  surplus  in 
the  balance  of  other  investment  (reflecting  a 
reversal in private capital flows), though inflow of 
international  assistance  partly  acted  as  an  offset. 
Net FDI inflows fell considerably to just below 4% 
of  GDP  in  2009,  with  the  bulk  of  inward  foreign 
direct  investment  reflecting  reinvested  earnings. 
International  reserves  increased  by  an  equivalent 
of  around  1%  of  GDP  in  2009,  partly  due  to  the 
disbursement  of  international  financial  assistance, 
though some reserve outflows occurred on account 
of 
in  minimum  reserve 
requirements  on  banks'  liabilities  denominated  in 
foreign currencies. 

the  substantial  cut 

Total  gross  external  debt  has  been  rapidly 
increasing  over  recent  years  and  reached  around 
68%  of  GDP  in  2009.  In  the  pre-crisis  years,  the 
worsening  in  external  balance  sheet positions was 

largely  driven  by  borrowing  channelled  through 
the banking sector. With the recent deterioration in 
the  fiscal  balance,  it  is  mainly  public  debt  that 
underlies  the  rising  level  of  gross  external  debt, 
notably  mirroring  disbursements  of  international 
financial  assistance.  In  2010,  the  government's 
heavy  borrowing  needs  are  expected  to  weigh 
further on the rising external debt. 

Over the medium-term, the external balance would 
be supported by progress in fiscal consolidation as 
well as by the continued support in the framework 
of the international financial assistance. Preserving 
competitiveness  of  the  Romanian  economy  will 
hinge  upon  structural  policies  geared  towards 
ensuring  a  favourable  investment  climate  and  on 
investment, 
to 
tackling 
including  upgrading  infrastructure  and  improved 
absorption of EU structural funds. 

impediments 

foreign 

9.6.2.  Product market integration 

Romania's  trade  openness  has  been  rather  stable 
over the past years. Compared to other countries of 
a similar size, trade openness in Romania is rather 
low. The evolution of Romania's trade in the recent 
years  has  been  driven  by  the  perspective  of  EU 

163 

 
 
 
 
 
relatively 

three  countries,  namely  Austria,  the  Netherlands 
and Germany. The prospect of EU membership has 
been one of the main drivers for attracting FDI to 
Romania,  together  with  the  privatisation  of  major 
state-owned  enterprises,  a 
stable 
macroeconomic  environment  and  rising  living 
standards.  Although  the  share  of  FDI  stocks  in 
GDP  is  still  one  of  the  lowest  in  the  EU  (30%  of 
GDP  in  2008),  annual  net  inflows  well  exceeded 
the  average  performance  of  the  recently  acceded 
EU  Member  States.  FDI  inflows  have  been 
instrumental 
industrial 
speeding  up 
transformation process and have contributed to the 
strong  growth  of  the  domestic  services  sector, 
especially  in  financial  intermediation.  The  largest 
destination  of  FDI  remains  the  manufacturing 
sector  with  an  increase  in  higher  value-added 
segments  like  furniture  and  transport  equipment, 
indicating  a  shift  in  the  sectoral  composition  of 
FDI  inflows  from  the  traditional  labour-intensive 
sectors towards higher value-added production.  

the 

in 

European Commission 

Convergence Report 2010 

accession.  The  average  2004-2008  intra-EU  trade 
in  goods  ratio  was  more  than  double  that  of  the 
extra-EU trade in goods ratio.  

Three  quarters  of  Romania's  external  trade  flows 
are  with  other  EU-27  Member  States,  with 
Germany, Italy and France accounting for roughly 
40% of both imports and exports of goods. Outside 
the  EU,  Romania's  main  export  destinations  are 
Turkey  and  Russia,  accounting  for  10%  of  total 
exports.  On  the  import  side,  the  main  trading 
partners  outside  the  EU  are  China  (5%  of  total 
imports)  and  Turkey  (4%).  Interestingly,  and  in 
contrast to several other countries in the region, the 
geographical  breakdown  of  exports  has  remained 
broadly stable since 2000. 

Romania  shows  a  pattern  of  rather  low-  and 
medium-low  technology  exports.  Between  2000 
and  2008,  the  Romanian  economy  underwent  a 
profound  transformation,  which  is  reflected  in  the 
structure  of  its  external  trade.  The  share  in  total 
exports  of  labour-intensive  and  relatively  low 
value-added manufacturing goods, such as textiles 
and leather goods, declined from over 30% in 2000 
to  below  15%  in  2008,  as  a  result  of  increasing 
price  competition,  inter  alia  from  Asian  markets. 
At  the  same  time,  the  relative  importance  of 
capital-intensive products in total exports, such as 
machinery  and  transport  equipment,  increased 
steadily  from  approximately  20%  in  2000  to  over 
35%  in  2008.  This  shift  towards  greater  export 
specialisation  in  products  with  a  higher  value-
added  content  is  confirmed  by  the  evolution  of 
Romania's 
advantage; 
labour-intensive  goods 
gradually  away 
(despite  a  continuing  high  level)  and  increasingly 
towards  capital-intensive  and  difficult-to-imitate 
research-intensive  goods.  Trade  in  manufacturing 
goods 
reveals  a  comparative 
advantage in equipment for electricity distribution, 
steel  and  ferrous  waste.  The  share  of  high 
technology  exports  in  total  exports  remains  low, 
suggesting that the economic restructuring process 
in  Romania  is  still  at  an  early  stage.  So  far,  as  a 
very  energy-intensive  and  catching-up  economy, 
Romania's 
imports  have  been  dominated  by 
energy, raw materials and capital goods.  

in  2007  also 

comparative 

revealed 

from 

Between 2004 and 2008, Romania benefited from 
very large net FDI inflows, which were equivalent 
to  an  average  of  almost  7%  of  GDP  per  annum. 
inflows, 
the  main  source  of  FDI 
EU-27 
accounting  for  approximately  80%  of  total  FDI, 
with around 50% of total inward FDI originating in 

is 

164 

 
Convergence Report 2010 - Technical annex 

Chapter 9 - Romania 

Table 9.6.2:

Romania - Product market integration

Trade openness 1) (%)
Extra-EU trade in goods GDP ratio 2) (%)
Intra-EU trade in goods GDP ratio 3) (%)
Intra-EU trade in services GDP ratio 4) (%)
Export in high technology 5) (%)
Technological balance 6) (%)
Total FDI inflows GDP ratio 7) (%)
Intra-EU FDI inflows GDP ratio 8) (%)
FDI intensity 9)
Internal Market Directives 10) (%)
Value of tenders in the O.J. 11)
Time to start up a new company 12)

Romania

2003

2004

2005

2006

2007

:

10.1

24.9

:

3.3

-2.9

3.7

:

:

:

:

:

41.9

11.3

25.8

:

3.1

-3.2

8.5

:

:

:

:

29.0

39.7

11.7

22.6

3.9

3.1

-2.9

6.5

6.7

3.3

:

:

28.0

39.7

11.6

22.5

4.1

3.8

-2.9

9.2

8.6

4.4

:

:

11.0

37.8

9.2

23.2

4.0

3.5

-2.6

5.8

5.2

2.6

0.8

7.3

11.0

2008

38.2

9.7

22.4

4.6

:

:

6.8

6.1

3.1

0.4

7.4

14.0

 1) (Imports + Exports of goods and services / 2 x GDP at current market prices) x 100 (Foreign Trade Statistics, Balance of Payments).

 2) (Extra-EU-27 Imports + Exports of goods / 2 x GDP at current market prices ) x 100 (Foreign Trade Statistics).

 3) (Intra-EU-27 Imports + Exports of goods / 2 x GDP at current market prices ) x 100 (Foreign Trade Statistics).

 4) Intra-EU-27 trade in services (average credit and debit in % of GDP at current prices) (Balance of Payments).

 5) Taken directly from Eurostat's databases: Exports of high technology products as a share of total exports.

 6) (Exports - imports in high tech) / GDP at current prices x 100, since 2007 the data based upon SITC Rev. 4 (earlier SITC Rev. 3).

 7) Total FDI inflows (in % of GDP at current prices).

8) Intra-EU-27 FDI inflows (in % of GDP at current prices).

9) FDI intensity (average intra-EU-27 inflows and outflows in % of GDP at current prices).

10) Percentage of internal market directives not yet communicated as having been transposed, in relation to the total number.

11) Public procurement - Value of public procurement which is openly advertised  (in % of GDP).

12) Time to start a new company (in days), Doing Business World Bank.

Sources: Eurostat, Commission services.

have 

priorities 

less  and 

identified 

Relatively  good  progress  has  been  made 
in 
improving the business environment. On the basis 
of  an  inventory  of  authorisations  and  permits 
focusing  on  property 
registration,  business 
operations  and  construction  works,  the  Romanian 
for 
authorities 
simplification  or  elimination  of  authorisations.  In 
addition,  the  concept  of  the  one-stop-shop  is 
increasingly  being  applied.  A  reform  of  the 
bankruptcy  legislation  has  been  proposed  aiming 
to shorten business closure procedures to one year 
or 
to  possibly  enable  out-of-court 
corporate  restructuring  negotiations.  However, 
Romania  still  ranks  in  the  lower  half  among  the 
EU-27  Member  States  in  terms  of  the  business 
environment.  The  key  remaining  problems  are 
high  administrative  burdens  and  red  tape,  such  as 
in  obtaining 
onerous  regulation, 
authorisations  and  legal  insecurity.  This  also 
includes  labour  regulation  rigidities,  in  particular 
concerning  working  hours,  and  hiring  and  firing 
procedures. In addition, there are still problems in 
the  areas  of  competition,  the  functioning  of  the 
judicial  system  and  corruption,  to  be  associated 
with 
public 
administration  and 
legislation.  Finally,  as  a 
recently  acceded  country,  Romania  has  a  good 
score in transposing EU Internal Market directives 
and its transposition deficit is far below the 1% EU 

general  weaknesses 

long  delays 

the 

of 

target. The country has also no directives overdue 
by more than two years. 

9.6.3.  Financial market integration 

Since EU accession, the Romanian financial sector 
has  been  increasingly  integrated  into  the  EU 
financial  sector.  Romania  has  complied  with  its 
duties  to  transpose  the  FSAP  directives  and  has 
made good progress in transposing the post FSAP 
directives.  The  country  has  still  to  fully  transpose 
the  amended  directive  on  deposit  guarantee 
schemes  and  the  directive  on  payment  services  in 
the internal market.(65) 

taken  by 

The Romanian financial sector has weathered well 
the financial crisis so far. In the banking sector, no 
the 
rescue  measures  have  been 
government.  The  nine  largest  parent  banks  with 
subsidiaries  in  Romania,  which  have  participated 
in  the  European  Banking  Co-ordination  Initiative, 
have  complied  with 
to 
recapitalize  their  Romanian  affiliates  in  line  with 
the  stress  test  performed  by  the  National  Bank  of 
Romania.  

their  commitments 

(65)

http://ec.europa.eu/internal_market/finances/actionpl

an/index_en.htm#transposition. 

165 

 
                                                           
 
 
 
 
 
European Commission 

Convergence Report 2010 

Graph 9.6.3: Romania - Recent development of the  

financial system relatively to the euro area
(in percentage of GDP)

180
160
140
120
100
80
60
40
20
0

RO, 2004

RO, 2009

Euro area,
2004

Euro area,
2009

Debt securities

Sto ck market capitalisatio n

Do mestic bank credit

Source: Eurostat, National Bank of Romania, FESE.

Although  domestic  bank  credit  has  expanded 
significantly  in  the  period  2004-2009,  its  stock 
remained  considerably  below  the  euro  area  level. 
Stock market capitalisation almost tripled between 
2004 and 2009 from 6% to 16% of GDP, but it still 
remained  below  the  euro  area  level.(66)  The 
Bucharest  Stock  Exchange  index  (BET)  fell  by 
roughly  70%  in  2008  and  trading  decreased 
sharply.  The  market  of  debt  securities  has  been 
dominated by government issuances of T-bills and 
issuance  of  corporate  and 
bonds,  while 
municipal  bonds  has  been  limited.  The  latter 
development is also confirmed by the total value of 
bonds traded at Bucharest Stock Exchange, which 
amounted to only EUR 62 mn in 2008.  

the 

Graph 9.6.4: Romania - Foreign ownership and 

concentration in the banking sector
(in percent, weighted av erages)

100

80

60

40

20

0

RO, 2004

RO, 2008

Euro area,
2004

Euro area,
2008

Co ncentratio n in the banking secto r (CR5 ratio )

Share o f fo reign institutio ns as % o f to tal assets

Source: ECB, Structural indicators for the EU banking sector, January 2010.

Bank concentration slightly declined between 2004 
and  2008,  as  the  market  share  of  the  largest  five 
credit  institutions  in  total  assets  (CR5  ratio) 
decreased from 60% in 2004 to 54% in 2008. Bank 
concentration  in  Romania  is  among  the  lowest  in 
the  new  Member  States,  but  higher  compared  to 
both the euro area and the EU. Foreign ownership 
in the Romanian banking sector – one of the main 
channels of financial integration with the EU – has 
also  been  considerably  higher  than  in  the  euro 
foreign  owned  credit 
area.  The  assets  of 

institutions  in  total  assets  of  credit  institutions 
increased from 62% in 2004 to over 88% in 2008.  

trend,  as  non-performing 

Although  asset  quality  has  deteriorated,  sufficient 
capital  buffers  have  been  maintained  by  credit 
institutions. Capital adequacy, albeit lower than in 
2004, remained at a comfortable level in December 
2009  (about  14%)..  Asset  quality  has  followed  a 
deteriorating 
loans 
amounted to about 15% in December 2009(67).The 
profitability  of  the  Romanian  banking  sector 
improved  significantly  in  2008  compared  to  the 
previous  years,  mainly  due  to  a  higher  operating 
income  generated  by  intense  credit  activity  and 
leveraging.-.  In  2009,  losses  induced  by  loan  loss 
provisioning  impacted  sharply  profitability,  with 
the return on equity (ROE) declining to below 3% 
compared to roughly 17% in 2008.  

Graph 9.6.5: Romania - selected banking sector soundness 

25

20

15

10

5

0

-5

%

indicators relatively to the euro area

RO, 2004

RO, 2009

Euro area,
2004

Euro area,
2008

Return o n equity

Capital adequacy

No n perfo rming lo ans

Note: For 2008, EU-27 non performing loans for are a proxy for EA.
Source: ECB, National Bank of Romania, EC calculations.

loans 

currency 

important  role 

to  corporations 

lending  has  played 

an 
Foreign 
increasingly 
in  private  sector 
lending over the last couple of years. The share of 
FX 
to 
corporations  increased  only  marginally  between 
January  2007  and  end-2009,  but  the  share  of  FX 
loans  to  households  in  total  loans  to  households 
went  up  from  about  40%  to  roughly  60%  in  the 
same period.  

loans 

total 

in 

(66)  Stock  market  capitalisation  refers  to  the  capitalisation  of 

the Bucharest Stock Exchange.  

(67)  Non-performing  loans  are  defined  as  the  unadjusted 
exposure  of  loans  and  interest  classified  as  doubtful  and 
loss to total classified loans and related interest, excluding 
off-balance sheet items.  

166 

 
 
 
                                                           
 
                                                           
Convergence Report 2010 - Technical annex 

Chapter 9 - Romania 

No  changes  have  taken  place  concerning  the 
structure of financial supervision, as Romania has 
maintained  a  sectoral  model  of  supervision. 
Compared with 2004, both the banking supervisor 
(i.e.  National  Bank  of  Romania)  and  the  non-
banking financial sector regulators have intensified 
bilateral and multilateral cross-border cooperation. 
The  National  Bank  of  Romania  has  continued  to 
strengthen  bilateral  cooperation  with  other  EU 
banking  supervisors,  by  signing  further  bilateral 
banking 
memoranda 
supervision, for instance with Portugal and Cyprus. 
Furthermore,  all  financial  sector  regulators  signed 
the  2008  memorandum  of  understanding  on 
cooperation  between  the  financial  supervisory 
authorities, central banks and ministries of finance 
of the EU member states on cross-border financial 
stability.  

understanding 

on 

of 

Graph 9.6.6: Romania - Share of foreign currency loans

(as percentage of total loans to households / corporations)
70

60

50

40

30

20

10

0

Jan-07

Dec-07

Dec-08

Dec-09

Co rpo ratio ns

Ho useho lds

Source: National Bank of Romania and own calculations.

In  comparison  with  the  euro  area,  Romania  lags 
considerably  behind  concerning  the  evolution  of 
bank  credit  to  the  private  non-financial  sector. 
While  bank  credit 
to  both  households  and 
corporations  as  percentage  of  GDP  increased 
between 2004 and 2008, it is still markedly below 
the  levels  registered  in  the  other  new  Member 
States.  

Graph 9.6.7: Romania - Recent developments in bank credit to 

households and corporations relatively to the euro area

(in percentage of GDP)

60

50

40

30

20

10

0

Dec-04 Dec-05 Dec-06 Dec-07

Dec-08 Dec-09

Ho useho lds, RO
No n-financial co rpo ratio ns, RO
Ho useho lds, Euro  area
No n-financial co rpo ratio ns, Euro  area

Source: ECB, Eurostat.

The global economic downturn has also put a drag 
on  the  non-bank  financial  sector.  In  the  insurance 
sector,  the  growth  rate  of  gross  written  premiums 
slowed  down  in  2008  compared  to 2007  and  then 
slightly  declined  (by  -1.1%)  in  2009  compared  to 
the  previous  year.  Insurance  penetration  (gross 
written  premiums  as  a  percentage  of  GDP)  in 
Romania reached about 2% in 2008, which is one 
of  the  lowest  levels  in  the  EU.  In  2007,  Romania 
introduced  a  private  pension  system  comprising 
two  pillars:  the  mandatory  private  pension  funds 
(pillar  II)  and  the  voluntary  private  pension  funds 
(pillar  III).  The  net  assets  of  both  pillar  II  and 
pillar  III  pension  funds  followed  a  positive  trend, 
as  they  more  than  doubled  by  end-2009  as 
compared to 2008.  

167 

 
 
 
 
10. SWEDEN 

10.1.  LEGAL COMPATIBILITY 

10.1.1. Introduction 

The  position  of  the  Riksbank  as  a  Central  Bank 
dates  back  to  1897  when  the  first  Riksbank  Act 
was  adopted  concurrently  with  a  Law  giving  the 
Riksbank the exclusive right of issuing banknotes.  

The legal basis for its establishment is contained in 
both  the  Instrument  of  Government  (Swedish 
Constitution)  and  the  Sveriges  Riksbank  Act 
adopted  in  1988.  The  Sveriges  Riksbank  Act  was 
amended in 2004, 2006 and 2007. 

to 

No  amendments 
the  Riksbank  Act  were 
introduced  with  regard  to  the  incompatibilities 
mentioned 
the  Convergence  Report  2008. 
Consequently  comments  from  2008  are  largely 
repeated in this year's assessment. 

in 

10.1.2. Objectives 

Chapter  1,  Article  2  of  the  Riksbank  Act  should 
include  a  reference  to  the  secondary  objective  of 
the  ESCB,  while  the  promotion  of  a  safe  and 
efficient  payment  system  should  be  subordinated 
to  the  primary  and  secondary  objectives  of  the 
ESCB. 

10.1.3. Independence 

by  the  Riksbank.  Such  procedure  is  incompatible 
with  the  prohibition  on  giving  instructions  to  the 
Central Bank, pursuant to Article 130 of the TFEU 
and  Article  7  of  the  ESCB/ECB  Statute  and  thus 
should be adapted accordingly. 

In  Chapter  10,  Article  4,  it  is  foreseen  that  the 
Parliament  approves  the  central  bank's  profit  and 
loss  account  and  its  balance  sheet  and  that  it 
determines  the  allocation  of  the  Central  Bank's 
profit.  This  practice  impinges  on  the  financial 
independence  of  the  Riksbank  and  constitutes  an 
incompatibility. The right of the Parliament should 
be  limited  to  giving  an  approval  on  the  Central 
Bank's  decision  on  the  profit  allocation.  The 
Parliament  should  not  be  involved  in  the  relevant 
central bank's decision-making process.  

According  to  Chapter  8,  Article  14(2)  of  the 
Instrument  of  Government,  the  Parliament  may 
direct  the  Riksbank  in  an  act  of  law  within  its 
sphere of responsibility under Chapter 9 (financial 
power).  This  provision  does  not  respect  the 
principle of the Central Bank's independence in the 
performance  of  its  tasks  conferred  upon  by  the 
TFEU and the ESCB/ECB Statute and is therefore 
considered as incompatible.  

10.1.4. Integration in the ESCB 

The  incompatibilities  in  the  Riksbank  Act  are 
linked to the following ESCB/ECB tasks: 

There exist some incompatibilities in this area.  

• 

In Chapter 3, Article 2 of the Riksbank Act and in 
Chapter  9,  Article  13  of  the  Instrument  of 
Government,  the  prohibition  on  the  members  of 
the Governing Council and the Executive Board to 
seek  or  take  instructions  only  covers  monetary 
policy issues. As the provisions do not provide for 
their independence in the performance of the other 
ESCB  related  tasks,  the  principle  of  the  central 
bank's  institutional  independence  is  not  respected. 
therefore  considered  as 
Both  provisions  are 
incompatible  with  Article  130  of  the  TFEU  and 
Article 7 of the ESCB/ECB Statute. 

• 

• 

• 

the  absence  of  a  general  reference  to  the 
Riksbank  as  an  integral  part  of  the  ESCB  and 
to  its  subordination  to  the  ECB’s  legal  acts 
(Chapter 1, Article 1); 

the  definition  of  monetary  policy  (Chapter  1, 
Article 2 and Chapter 6, Articles 2, 3 and 5); 

the conduct of foreign exchange operations and 
the  definition  of  foreign  exchange  policy 
(Chapter 7, Articles 1, 2, 3, 4 and 7); 

the right to authorise the issue of banknotes and 
the  volume  of  coins  (Chapter  5,  Articles  1,  2 
and 3); 

Chapter  6,  Article  3  of  the  Riksbank  Act  obliges 
the  Riksbank  to  inform  the  minister  appointed  by 
the Swedish Government about a monetary policy 
decision of major importance, prior to its approvals 

• 

the definition of the monetary unit (Chapter 5, 
Article 1); 

169 

 
European Commission 

Convergence Report 2010 

• 

• 

• 

the  monetary 
functions,  operations  and 
instruments of the ESCB (Chapter 6, Articles 5 
and 6 and Chapter 11, Articles 1 and 2); 

financial  provisions  related 
(Chapter 10, Article 4); 

to 

the  ESCB 

the  ECB's  right    to  impose  sanctions  (Chapter 
11, Articles 2a, 3 and 5). 

implies 

integration  requirement  also 

the 
The 
removal  of  incompatibilities  in  the  Instrument  of 
Government,  notably  in  Chapter  9,  Articles  12 
(responsibility 
currency  policy 
matters),  13  (responsibility  for  monetary  policy 
decisions)  and  14  (right  to  issue  coinage  and 
banknotes).  

for  general 

Furthermore,  Articles  1  to  4  of  the  Law  on  the 
the 
Exchange  Rate  Policy,  which  confirms 
responsibility  for  general  currency  policy  matters 
(foreign  exchange  policy)  to  the  Government, 
constitute  a  further  incompatibility.  This  law  will 
have to be amended, so as to reflect the ECB's and 
Council's roles in this respect from the date of the 
adoption of the euro in the country. 

are 

There 
regarding: 

furthermore 

some 

imperfections 

• 

• 

• 

• 

the non-recognition of the role of the ECB and 
of  the  EU  for  the  collection  of  statistics 
(Chapter 6, Articles 4(2) and Article 9; 

the non-recognition of the role of the ECB for 
the functioning of payment systems (Chapter 6, 
Article 7); 

the non-recognition of the role of the ECB and 
of  the  Council  for  the  appointment  of  an 
external auditor; 

the  non-recognition  of  the  role  of  the  ECB  in 
the  field  of  international  cooperation  (Chapter 
7, Articles 5 and 6). 

10.1.5. Prohibition of monetary financing 

Two imperfections exist in this area.  

Under  Chapter  6,  Article  8  of  the  Sveriges 
Riksbank  Act,  the  Riksbank  may,  in  exceptional 
circumstances,  grant  credits or  provide guarantees 
on  special  terms  to  banking  institutions  and 

170 

Swedish companies that are under the supervision 
of the Financial Services Authority.  

In  order  to  comply  with  the  prohibition  on 
monetary  financing  of  Article  123  of  the  TFEU 
and  to  be  considered  as  an  'emergency  liquidity 
assistance',  a  loan  should  only  be  allowed  under 
the  following  conditions:  the  credit  institution 
should  be  solvent,  the  loan  should  be  short-term, 
cover urgent and unforeseen liquidity needs and be 
sufficiently  secured  by  adequate  collateral.  A 
penalty  rate  should  preferably  be  required.  These 
conditions have not been taken fully into account.  

In  the  provision,  some  conditions  are  not  taken 
fully  into  account  (e.g.  the  provision  of  adequate 
collateral  is  missing).  It  constitutes  therefore  an 
incompatibility  with  the  prohibition  on  monetary 
financing  as  foreseen  by  the  Article  123  of  the 
TFEU.  

In  Chapter  8,  Article  1(2),  it  is  provided  that  the 
Riksbank shall not extend credits or purchase debt 
instruments directly from the State, another public 
body  or  an  institution  of  the  EU.  According  to 
Article  1(3),  second  sentence,  the  Riksbank  may 
grant credit to and purchase debt instruments from 
financial institutions owned by the State or another 
public body.  

Both  paragraphs  do  not  fully  comply  with  the 
wording  of  Article  21(1),  (3)  of  the  ESCB/ECB 
Statute  and  constitute  imperfections.  Paragraph  3 
should  define  more  clearly  the  entities  concerned. 
In  paragraph  4,  second  sentence,  it  should  be 
added that, in the context of the supply of reserves 
by  central  banks,  these  publicly  owned  credit 
institutions should be given the same treatment as 
private credit institutions. 

10.1.6. Assessment of compatibility 

As regards the prohibition on monetary financing, 
the independence of the central bank as well as its 
integration  into  the  ESCB  at  the  time  of  euro 
adoption,  the  legislation  in  Sweden,  in  particular 
the  Sveriges  Riksbank  Act,  the  Instrument  of 
Government (part of the Swedish Constitution) and 
the Law on the Exchange Rate Policy, is not fully 
compatible with Articles 130 and 131 of the TFEU 
and the ESCB/ECB Statute.  

 
 
Convergence Report 2010 - Technical annex 

Chapter 10 - Sweden 

10.2.  PRICE STABILITY 

10.2.1. Respect of the reference value 

The  12-month  average  inflation  rate  for  Sweden, 
which is used for the convergence assessment, has 
until recently been well below the reference value, 
but moved above the reference value in July 2009 
as  disinflation  was  less  pronounced  than  in  other 
Member  States.  In  March  2010,  the  reference 
value  was  1.0%,  calculated  as  the  average  of  the 
12-month  average  inflation  rates  in  Portugal, 
Estonia  and  Belgium  plus  1.5  percentage  points. 
The  corresponding  inflation  rate  in  Sweden  was 
the 
2.1%, 
reference  value.  The  12-month  average  inflation 
rate  is  likely  to  fall  below  the  reference  value  in 
the months ahead. 

i.e.  1.1  percentage  points  above 

Graph 10.2.1: Sweden - Inflation criterion since 2004

 (percent, 12-month mov ing av erage)

5

4

3

2

1

0
Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11

Sweden

Reference value

Note: The dots show the projected reference value and 12-month average inflation 
in the country in December 2010.
Sources: Eurostat, Commission services' Spring 2010 Forecast.

10.2.2. Recent inflation developments 

expectations  have 

Since 1995, the Riksbank targets the domestic CPI 
with the aim to keep inflation at 2% ± 1 percentage 
point.  While 
there  have  been  periods  when 
inflation has deviated significantly from the target, 
remained  well 
inflation 
anchored and  in  line with the  target  since  the  late 
1990s. The difference between HICP and domestic 
CPI can occasionally be relatively large, reflecting 
mainly  the  non-inclusion  of  interest  costs  for 
owner-occupied homes in the HICP. This has been 
the case during the past year when significant cuts 
in  the  Riksbank's  repo  rate  contributed  to  a  rapid 
fall in CPI inflation. 

From late 2007 until September 2008 inflation rose 
rapidly, peaking at a 15-year high of 4.2%. A large 
part  of  the  increase  was  due  to  sharp  increases  in 
food  and  energy  prices  on  world  markets.  Rising 
domestic cost pressures also contributed, albeit to a 

lesser  extent,  resulting  from  a  sharp  drop  in 
productivity growth in 2007 and 2008.  

At the end of 2008, inflation began to fall quickly 
in connection with the steep downturn in economic 
activity  and  as  a  result  of  the  slowdown  in  food 
and  energy  prices.  The  decline  continued  until 
September  2009  when  inflation  bottomed  out  at 
1.4%.  Since  then,  inflation  has  picked  up  again, 
partly  reflecting  base  effects  due  to  falling  oil 
prices the year before and stood at 2.5% in March 
2010.  

Core  inflation  (measured  as  HICP  excluding 
energy  and  unprocessed  food)  slowed  between 
spring  2008  and  early  2009  but  picked  up  again 
subsequently,  reflecting  the  impact  of  previous 
krona weakening together with a large increase in 
unit  labour  costs  over  the  last  three  years.  The 
increase  has  broad-based  and  includes  both  the 
prices of services and non-energy industrial goods. 
The  rate  of  price  increases  for  processed  food 
surged  from  2007  to  late  2008  but  has  since  then 
levelled off.  

Graph 10.2.2: Sweden - HICP inflation

 (y-o-y percentage change)

6

4

2

0

-2

2004

2005

2006

2007

2008

2009

Sweden

Euro  area

Source: Eurostat.

10.2.3. Underlying  factors  and  sustainability  of 

inflation 

Macroeconomic  policy-mix  and  cyclical 
stance 

After several years  of  strong  growth,  the Swedish 
economy  began  to  slow  down  in  2007  as  exports 
were  affected  by  subdued  international  demand. 
The  global  financial  crisis  and  the  contraction  of 
world trade aggravated the downturn and real GDP 
growth  plummeted  in  late  2008  (averaging  -0.2% 
for  the  year  as  a  whole).  The  Swedish  economy 
had stabilised somewhat by mid-2009 but fell back 
again  in  the  last  quarter.  The  only  source  of 
strength  came  from  household  consumption  while 

171 

 
 
 
European Commission 

Convergence Report 2010 

Table 10.2.1:

Sweden - Components of inflation

(percentage change)1)

weights  

in total   

2004

2005

2006

2007

2008

2009

Mar-10

HICP

Non-energy industrial goods

Energy

Unprocessed food 

Processed food

Services

HICP excl. energy and unproc. food
HICP at constant taxes 2)
Administered prices HICP

1.0

-1.2

3.3

-0.6

0.3

2.5

0.8

0.9

3.8

0.8

-1.3

5.6

0.2

-0.7

1.6

0.2

0.7

2.6

1.5

-0.4

6.9

2.6

0.1

1.3

0.5

1.4

1.5

1.7

0.6

0.5

2.2

3.7

2.1

1.8

1.3

2.1

3.3

-0.1

9.5

6.5

7.6

2.2

2.3

2.7

2.1

1.9

1.5

-0.8

3.3

2.7

2.6

2.3

1.8

2.8

2.1

1.9

0.9

1.5

2.5

2.6

2.3

1.9

2.9

2010

1000

286

110

63

135

406

827

1000

132

1) Measured by the arithmetic average of the latest 12 monthly indices relative to the arithmetic average of the 12 monthly indices

   in the previous period.

2) Last observation for HICP at constant taxes is February 2010

industrial  production, 
investment  and  exports 
remained  at  depressed  levels.  Overall,  real  GDP 
contracted by 4.9% in 2009.  

A  gradual  recovery  is  expected  as  household 
consumption  continues  to  recover  and  exports 
strengthen  on  the  back  of  more  rapid  global 
growth.  The  Commission  services'  2010  Spring 
Forecast projects real GDP to grow on average by 
1.8% in 2010 and by 2.5% in 2011. The output gap 
is  expected  to  remain  highly  negative  during  the 
coming years. 

In  response  to  the  aggravation  of  the  global 
financial  crisis  in  September  2008,  the  Riksbank 
conducted  a  highly  expansionary  monetary  policy 
in  order  to  alleviate  the  effects  of  the  economic 
downturn  and  to  attain  the  inflation  target.  The 
Riksbank  cut  its  repo  rate from  4.75%  in October 
2008  to  the  present  level  of  0.25%  in  July  2009, 
i.e.  75  basis  points below  the  ECB  reference  rate. 
The  cut  in  interest  rates  together  with  higher 
inflation  led  to  a  fall  in  real  interest  rates,  which 
became negative in early 2009. The Riksbank also 
implemented  various  extraordinary  measures  in 
order  to  enhance  the  functioning  of  financial 
markets,  ease  the  supply  of  credit  and  reduce 
various risk premia. These are now gradually being 
phased  out  as  financial  markets  are  functioning 
more  smoothly  again.  The  sharp  depreciation  of 
the  krona  triggered  by  the  aggravation  of  the 
financial  crisis  in  September  2008  implied  a 
conditions. 
further 
However,  since  March  2009 
the  krona  has 
appreciated and recovered a large part of its earlier 
depreciation.  

loosening  of  monetary 

Lending  to  non-financial  companies  has  slowed 
down since the end of 2007 and exhibits negative 
growth  since  the  end  of  2009.  This  is  likely  the 

172 

expression of a weaker demand for credit and thus 
a result of the recession rather than a lack of credit. 
However,  low  interest  rates  have  contributed  to 
rapid  credit  expansion  in  the  household  sector 
since  mid-2009  after  a  few  years  of  declining 
growth.  Credit  growth  has  mainly  reflected  an 
increased  volume  of  loans  for  housing  purposes, 
and house prices have picked up significantly after 
a brief fall in the autumn of 2008.  

Sweden entered the recession in 2008 with strong 
public  finances.  After  several  years  of  tightening, 
fiscal  policy  became  more  expansionary  in  2009 
and the general government balance moved from a 
surplus  of  2.5%  of  GDP  in  2008  to  a  deficit  of 
0.5%  in  2009.  According  to  the  Commission 
services' 2010 Spring Forecast, a further loosening 
of the fiscal policy stance (measured by change in 
structural  balance)  is  expected  for  2010,  with  the 
deficit  expected  to  widen  to  2.1%  of  GDP.  In 
2011, the deficit is expected to narrow to 1.6% of 
GDP.  The  expansionary  economic  policy  has 
supported  the  economic  recovery  and  helped  to 
dampen  the  fall  in  output  and  employment  and  to 
avoid  an  unnecessarily  long  period  of  inflation 
undershooting the target. 

Wages and labour costs 

an 

through 

(primarily 

Following a reform of the wage bargaining system 
in  1997 
Industrial 
Agreement  signed  by  the  social  partners  in  the 
industrial sector, later replicated for other areas of 
the  labour  markets  and  confirming  the  role  of  the 
export  industry  as  wage  leader)  the  outcomes  of 
wage bargaining rounds since the late 1990s were 
generally  favourable  and  contained  moderate 
nominal  wage 
increases  coupled  with  high 
productivity  growth,  limiting  the  increases  in  unit 
labour costs up to 2007. 

 
 
 
 
 
Convergence Report 2010 - Technical annex 

Chapter 10 - Sweden 

Table 10.2.2:

Sweden - Other inflation and cost indicators

2004

2005

2006

2007

2008

(annual percentage change)

20091)

20102)

20112)

HICP inflation

Sweden

Euro area

Private consumption deflator

Sweden

Euro area

1.0

2.2

0.9

2.0

Nominal compensation per employee

Sweden

Euro area

Labour productivity

Sweden

Euro area

Nominal unit labour costs

Sweden

Euro area

Imports of goods deflator

Sweden

Euro area

4.0

2.5

4.9

1.8

-0.8

0.9

0.7

1.3

0.8

2.2

1.2

2.1

3.1

2.2

3.0

1.1

0.1

1.3

5.1

3.6

1) 2009 data (except HICP inflation) are estimates. 

2) Commission services' Spring 2010 Forecast.

Source: Eurostat, Commission services.

1.5

2.2

1.0

2.2

2.1

2.6

2.5

1.7

-0.4

1.1

3.9

4.1

1.7

2.1

1.1

2.3

5.1

2.7

0.4

1.1

4.7

1.6

-0.5

1.3

3.3

3.3

2.8

2.9

1.7

3.4

-1.1

0.0

2.8

3.4

4.1

4.1

1.9

0.3

2.2

-0.1

1.7

2.0

-2.9

-2.0

4.8

4.0

-1.1

-7.5

1.7

1.5

1.9

1.4

2.1

1.3

2.7

1.8

-0.5

-0.5

-2.0

3.9

1.6

1.7

1.9

1.5

2.5

1.5

2.2

1.3

0.3

0.1

2.0

1.6

than 

The 2007 wage bargaining round took place during 
a  strong  economic  upswing  and  the  agreed  wage 
in 
increases  were  considerably  higher 
previous  rounds  during  the  2000s.  However, 
economic  conditions  deteriorated  more  rapidly 
than  expected  in  the  following  years.  The  sharp 
drop  in  demand  caused  companies  to  quickly  cut 
down  production,  productivity  growth  weakened 
substantially and nominal unit labour costs soared 
in  2007-2009.  Unemployment  rose  from  an 
average level of 6.2% in 2008 to 9.3% in February 
2010.  Growth  of  nominal  compensation  per 
employee slowed down markedly in 2008, largely 
due  to  a  decrease  in  overtime  pay  and  other 
in 
variable 
compensation 
the 
slowdown  in  productivity  growth  became  more 
pronounced,  implying  a  sharp  upturn  in  nominal 
unit labour costs.  

remained  moderate 

In  2009,  growth 

supplements. 

but 

In  2010,  wage  agreements  for  around  80%  of  all 
employees will be renegotiated. At the time of this 
assessment, wage agreements have been signed for 
a  large  part  of  the  industrial  sector.  So  far,  the 
agreements   have been low compared to outcomes 
of  previous  bargaining  rounds  and  also  cover  a 
shorter  period  than  the  usual  three  years,  with 
many  agreements  expiring 
in  early  2012. 
According  to  the  Commission  services'  2010 
Spring  Forecast, 
the  growth  of  nominal 
compensation  is  expected  to  increase  to  2.1%  in 
2010  and  to  2.5%  in  2011.  This,  together  with  a 
strengthening of productivity growth, implies a fall 
in  nominal  unit  labour  costs  of  0.5%  in  2010  and 
broadly unchanged ULC in 2011. 

Graph 10.2.3: Sweden - Inflation, productivity and wage trends

(y-o-y % change)

9

6

3

0

-3

-6

2004

2005

2006

2007

2008

2009

2010

2011

P ro ductivity (real GDP  per perso n emplo yed)

No minal co mpensatio n per emplo yee

No minal unit labo ur co sts
HICP  inflatio n

Source: Eurostat, Commission services' Spring 2010 Forecast.

173 

 
 
 
 
 
 
Sweden was about 115% of the EU-27 average in 
2008, compared to about 130% in the late 1990s. 

Medium-term prospects 

Inflation is expected to remain moderate during the 
next few years as ample spare capacity is expected 
to  hold  down  price  and  wage  increases.  The 
Commission  services'  2010  Spring  Forecast 
projects average annual HICP inflation to decrease 
from  1.9%  in  2009  to  1.7  and  1.6%  in  2010  and 
2011  respectively.  Recent  surveys  confirm  that 
inflation expectations remain well-anchored. 

Risks  to  the  inflation  outlook  appear  broadly 
balanced. Although wage agreements signed so far 
indicate  moderate  nominal  wage 
increases, 
uncertainties remain as to the final outcome of the 
wage  bargaining  round,  with  strikes  in  the  paper 
and pulp sector. There is also the risk of wage drift 
in  those  sectors  of  the  economy  which  have  been 
less  affected  by  the  crisis..  The  downside  risks  to 
inflation  are  linked  to  the  negative  effect  on 
economic  activity  in  case  of  a  housing  market 
correction,  following  the  recent  rapid  increase  in 
household borrowing and house prices.  

European Commission 

Convergence Report 2010 

External factors 

Import prices, as measured by the import of goods 
deflator in the national accounts, picked up in 2008 
by  an  average of  4%. Higher  world  market  prices 
of  oil  and  agricultural  products  were  the  major 
drivers of imported inflation. In addition, prices of 
increased  substantially,  partly 
service 
because of a weaker krona. In 2009, import prices 
decreased, and they are expected to continue to fall 
in 2010 on the back of subdued international prices 
and the strengthening of the krona. 

imports 

Energy prices in the HICP slowed down markedly 
towards  the  end  of  2008  and  fell  by  0.8%  on 
average  in  2009.  Annual  food  price  inflation 
slowed down to 3.5% in 2009, which is a halving 
of the rate of increase compared to 2008. 

Administered prices and taxes 

Administrative prices account for 13% of the total 
HICP basket. The most important item is rents (9% 
of total HICP), which are considerably regulated in 
Sweden. (68)  

inflation 

in  March  2010.  The  pick-up 

Administrative price inflation picked up from early 
2007 onwards after being on a declining path since 
in  administrated 
2003.  Year-on-year 
prices  increased  from  around  1%  in  late  2006  to 
2.5% 
in 
administrative prices was due to a sharp increase in 
actual rents, municipal charges related to dwelling 
and prices for other services in respect of personal 
transport  equipment.  A  dental  reform  containing 
increased  subsidies  contributed  to  a  temporarily 
slowdown in administrative prices from mid-2008 
and  one  year  ahead.  In  late  2009,  the  increase  in 
administrative prices once again picked-up. 

Several  fiscal  measures  had  a  direct  impact  on 
inflation in 2008 and 2009, but their effects largely 
cancelled  each  other  out.  The  fiscal  changes 
included  increased  dental  subsidies,  increases  in 
energy  tax,  a  re-introduction  of  the  tax  deduction 
for  building  repairs  and  reconstruction  and  a 
termination of subsidies on eco-fuel driven cars. 

A larger and more integrated internal market in the 
EU  and  increased  imports  from  countries  outside 
the EU have contributed to push the Swedish price 
level downwards. The level of consumer prices in 

(68)  For the purpose of this report, administered prices include 
actual  rents  for  housing,  water  supply,  gas,  refuse  and 
sewerage  collection,  and  medical,  dental,  hospital  and 
postal services. 

174 

 
                                                           
  
10.3.  GOVERNMENT BUDGETARY POSITION 

10.3.1. Developments 2004-2009 

The  general  government  balance  improved  until 
2007, peaking at 3.8% of GDP. With the onset of 
the crisis, it has subsequently deteriorated, with the 
surplus shrinking to 2.5% of GDP in 2008 and an 
estimated deficit of 0.5% of GDP in 2009. During 
the period of strong GDP growth, the expenditure 
ratio fell by almost 3 percentage points to 52.5% of 
GDP  over  the  2004-2007  period,  before  rising 
again  to  almost  56%  in  2009.  Despite  substantial 
tax  cuts  as  from  2007,  the  revenue  ratio  has  held 
steady at around 56% of GDP until 2009. 

The  difference  between  the  new  and  the  previous 
update of the convergence programme is estimated 
at 3.3% of GDP and is mainly explained by worse-
than-expected 
expenditure 
developments  and  only  to  a  lesser  extent  a  worse 
starting  position  by  end  2008.  In  particular, 
revenue developments are estimated to have fallen 
short,  as  taxes  on  labour  income  fell  along  with 
hours worked. 

revenue 

and 

The  deterioration  in  the  government  balance  of  3 
percentage  points  compared  to  2008  reflects  the 
effect of automatic stabilisers as the economy went 
deeper into recession towards the end of 2008 and 
a  series  of  discretionary  fiscal  packages  of 
approximately 1¾% of GDP in 2009.  

With  the  exception  of  the  election  year  of  2006, 
the  structural  balance  has  been  above  the  1%  of 
GDP  surplus  target  during  the  2005-2009  period. 
Strong  growth  before  the  crisis  facilitated  fiscal 
consolidation. 

Government  gross  debt  fell  from  around  51%  in 
2004  to  around  38%  in  2008,  mainly  thanks  to 
fiscal  surpluses  but  also  to  privatisation  receipts. 
As  a  result  of  the  government  balance  swinging 
into  deficit  in  the  wake  of  the  recession,  the  debt 
ratio increased to about 42% in 2009.  

The  government  has  put  in  place  a  guarantees 
scheme  for  bank  borrowing  of  a  maximum  of 
SEK1500  billion  (or  roughly  50%  of  GDP).  By 
end-2009,  SEK271  billion  of  debts  were 
guaranteed, but none has ever been called. In 2009, 
the state also participated to the amount of SEK5.6 
billion  (or 0.2%  of GDP)  in  the  stock  issuance  of 
Nordea,  which  it  partly  owns,  using  part  of  the 

Convergence Report 2010 - Technical annex 

Chapter 10 - Sweden 

capital injection programme's SEK 50 billion. This 
does  not  affect  the  government  net  financial 
position, as it also increases its assets. 

10.3.2. Medium-term prospects 

in-work 

The 2010 Budget Bill was presented to Parliament 
in  September  2009  and  adopted  by  Parliament  in 
November  2009.  The  main  measures  on  the 
revenue  side  consist  of  a  fourth  step  in  the  so 
tax  credit  scheme,  with  an 
called 
estimated  impact  on  the  government  balance  of 
0.3% of GDP. A reduction in the taxes on pensions 
adds a further 0.1% of GDP to the stimulus. On the 
expenditure side, measures include additional state 
transfer  to  the  municipalities  of  about  0.3%  of 
GDP and additional resources to crime control and 
judicial  system,  education  and  training  activities 
and  measures  to  support  the  growth  of  small 
enterprises amounting to about 0.1% of GDP each. 

The  government  foresees  the  general  government 
deficit to widen to 3.4% of GDP in 2010, which is 
significantly  worse  than  the  Commission  spring 
forecast, which foresees a deficit of around 2% of 
GDP.  Tax  revenues  have  developed  in  a  much 
stronger  way  than  foreseen  a  couple  of  months 
ago, partly thanks to buoyant private consumption 
underpinned  by  increasing  consumer  confidence 
and an improvement in the employment outlook. 

The  planned  fiscal  stance  as  measured  by  the 
change  in  the  recalculated  structural  balance, 
meaning  the  cyclically-adjusted  balance  net  of 
one-off  and  other 
is 
expansionary,  with  the  structural  deficit  widening 
by 1.6 percentage points. Given the relatively low 
fiscal  and  macro-financial  risks,  this  is  deemed 
appropriate. 

temporary  measures, 

175 

 
 
 
European Commission 

Convergence Report 2010 

Table 10.3.1:

Sweden - Budgetary developments and projections
Outturn and forecast 1)

2004

2005

2006

(as % of GDP unless indicated otherwise)

2007

2008

2009

2010

2011

General government balance

- Total revenues

- Total expenditure

of which: 
- interest expenditure

- current primary expenditure

- gross fixed capital formation

p.m.: Tax burden

Primary balance

Cyclically-adjusted balance

One-off and temporary measures
Structural balance 2)
Structural primary balance

Government gross debt

p.m: Real GDP growth (%)

p.m: Output gap

p.m: GDP deflator (% change)

Convergence programme
General government balance

Primary balance
Structural balance 2) 3)
Government gross debt

p.m. Real GDP (% change)

0.8

56.1

55.3

1.6

50.7

2.9

48.7

2.4

0.0

0.5
-0.5

1.1

51.2

4.1

1.3

0.2

2.2

57.2

55.0

1.6

50.1

3.0

49.6

3.9

1.0

0.0
1.0

2.7

2.5

56.5

54.2

1.7

49.2

3.1

49.0

4.2

0.3

0.0
0.3

2.0

3.8

56.0

52.5

1.8

47.5

3.1

48.1

5.6

1.6

0.0
1.6

3.3

50.9

45.9

40.5

3.3

2.2

0.9

4.1

3.8

1.7

2.6

3.9

3.0

2.5

55.5

53.1

1.7

48.1

3.3

47.0

4.1

1.4

0.3
1.1

2.8

38.3

-0.2

1.8

3.2

2008
2.5

4.2

1.2

38.0

-0.2

-0.5

55.7

56.5

1.2

51.6

3.6

47.1

0.4

1.9

0.0
1.9

2.8

42.3

-4.9

-4.3

1.9

2009
-2.2

-0.9

0.3

42.8

-5.2

-2.1

53.9

56.2

1.1

51.3

3.6

45.5

-1.2

-0.2

0.0
-0.2

0.7

42.6

1.8

-3.3

2.4

2010
-3.4

-2.2

-1.3

45.5

0.6

-1.6

53.2

55.0

1.1

50.2

3.6

45.0

-0.7

-0.5

0.0
-0.5

0.3

42.1

2.5

-1.8

2.1

2011
-2.1

-0.8

-1.5

45.6

3.1

2012
-1.1

0.4

-2.1

45.2

3.8

2013
n.a.

n.a.

n.a.

n.a.

n.a.

1) Commission services’ Spring 2010 Forecast.

2) Cyclically-adjusted balance excluding one-off and other temporary measures.

3) Commission services’ calculations on the basis of the information in the programme. One-off and other temporary

measures taken from the programme ( 0.3% in 2008 deficit-increasing).

Sources: Commission services and January 2010 update of Sweden's Convergence Programme.

The  long-term  budgetary  impact  of  ageing  is 
clearly  lower  than  the  EU  average  and  the  large 
assets accumulated by the public pension schemes 
will  help  finance  part  of  the  increase  in  pension 
expenditure.  The  budgetary  position  in  2009 
contributes to the reduction of gross debt. Ensuring 
primary  surpluses  over  the  medium  term  and 
implementing appropriate structural reforms would 
contribute to limiting the risks to the sustainability 
of  public  finances  which  were  assessed  in  the 
Commission 2009 Sustainability Report as low. 

appropriately  continuing  to  be  expansionary  in 
2010. However, there are medium-term risks to the 
fiscal balance, and there is a need to ensure that the 
government  balance  improves  once  the  recovery 
gains momentum 

In view of the above assessment and also given the 
need to ensure sustainable convergence, Sweden is 
invited  to  ensure  that,  once  the  recovery  is  on  a 
firm footing, progress is made towards meeting the 
medium-term objective for public finances. 

The  2009  update  of  the  Swedish  convergence 
programme was submitted on 29 January 2010 and 
maintains  the  MTO  of  a  fiscal  surplus  of  1%  of 
GDP over the cycle. 

The  overall  conclusion  is  that  the  budgetary 
position  is  sound.  Large  surpluses  in  good  times 
allowed  fiscal  policy  to  play  an  active  role  in  the 
downturn,  not  only  by  boosting  demand  in  the 
short term but also by strengthening the economy's 
long-term  growth  potential.  The  fiscal  stance  is 

176 

 
 
 
 
 
 
Convergence Report 2010 - Technical annex 

Chapter 10 - Sweden 

10.4.  EXCHANGE RATE STABILITY 

Graph 10.4.2: Sweden - 3-M Stibor spread to 3-M Euribor

 (basis points, monthly v alues)

The Swedish krona does not participate in ERM II. 
Sweden  pursues  a  floating  exchange  rate  regime 
and inflation targeting since the early 1990s.  

The  krona  weakened  gradually 
from  2007 
onwards.  This  was  in  line  with  past  experience, 
with downward pressure on the krona emerging at 
appetite. 
times  of  decreasing  global 
Subsequently,  the  krona's  exchange  rate  has  been 
highly volatile. 

risk 

Graph 10.4.1: Exchange rates - SEK/EUR
(monthly av erages)

11.5

11.0

10.5

10.0

9.5

9.0

8.5

2004

2005

2006

2007

2008

2009

Source: ECB and EcoWin.

financial  crisis 

The  aggravation  of 
in 
the 
September 2008 and the sharp deterioration in the 
global  economic  outlook  had  a  significant  impact 
on  the  foreign  exchange  market.  The  krona  as  a 
small  currency  weakened  substantially  when 
investors  turned  to  currencies  perceived  as  more 
liquid and secure. Concerns about developments in 
the  Baltic  countries  and  the  Swedish  banks'  large 
exposure  towards  the  region,  reflected  in  a rise  in 
CDS spreads, also contributed to the weakening of 
the  krona,  as  did  a  negative 
rate 
differential  vis-à-vis  the  euro  area.  The  krona 
depreciated from around 9.4 SEK/EUR to a low of 
11.6  SEK/EUR  in  March  2009.  Since  then,  the 
krona has reversed a large part of its losses on the 
back  of  a  stabilisation  in  financial  markets  and 
signs of global economic recovery. The krona has 
also been supported by a narrowing of the interest 
rate  differentials  vis-à-vis  the  euro  area.  On  23 
the  negative  spread  was  0.11 
April  2010, 
the  krona  has 
percentage  points.  Overall, 
depreciated against the euro by 3% during the last 
two years.  

interest 

80

60

40

20

0

-20

-40

-60

-80

2004

2005

2006

2007

2008

2009

Source: Eurostat.

the  Riksbank  strengthened 

The  level  of  foreign  currency  reserves  has  varied 
during  the  last  years  due  to  temporary  liquidity 
assistance  in  foreign  currency,  particularly  US 
dollars,  provided  by  the  Riksbank  to  Swedish 
banks  and  increased  international  commitments. 
The  value  of  reserves  in  Swedish  kronor  has  also 
been  affected  by  the  depreciation  of  the  krona.  In 
2009, 
its  foreign 
exchange  rate  reserves  by  borrowing  foreign 
currency  through  the  Swedish  National  Debt 
Office.  The  level  of  foreign  exchange  reserves 
increased from around SEK 200 billion before the 
crisis to SEK 340 billion in early 2010. Reflecting 
Sweden's  high  degree  of  financial  integration,  the 
Riksbank  entered  into  a  range  of  temporary 
agreements  with  other  central  banks,  including 
swap  agreements  with  other  G-10  members 
(Federal  Reserve,  ECB),  swap  agreements  in 
conjunction  with  international  financial  assistance 
(Latvia, Iceland) and  a precautionary  arrangement 
with Estonia in the context of financial stability co-
operation. All agreements have now expired. 

177 

 
  
  
 
  
Long-term  interest  rates  in  Sweden  followed  the 
global  trend  of  declining  yields  in  2007  and  the 
beginning  of  2008.  Yields  bottomed  out  in  early 
2008, when rising inflation expectations started to 
push  up  long-term  interest  rates.  During  the  most 
acute phase of the financial crisis in the autumn of 
for 
2008, 
government  bonds,  which  pushed  down  interest 
rates. In early 2009, long-term interest rates began 
to  rise  again,  as  the  economic  outlook  improved 
and investors in financial markets gradually shifted 
towards more risky assets.  

their  demand 

increased 

investors 

Spreads vis-à-vis euro-area long-term interest rates 
were  close  to  zero  until  late  2007  but  turned 
negative  in  2008,  reaching  a  low  of  minus  100 
basis points around the turn of the year 2008/2009. 
Spreads  subsequently  narrowed  but  still  remain  at 
around minus 45 basis points. 

Graph 10.5.2: Sweden - Long-term interest rates
 (percent, monthly v alues)

6

4

2

0

2004

2005

2006

2007

2008

2009

Sweden

Euro  area

Source: Eurostat.

European Commission 

Convergence Report 2010 

10.5.  LONG-TERM INTEREST RATE 

Long-term  interest  rates  in  Sweden  used  for  the 
convergence  examination  are  secondary  yields  on 
a  single  benchmark  government  bond  with  a 
maturity of around 10 years. 

Swedish  long-term  interest  rates  have  been  below 
the  reference  value  since  EU  accession.  In  March 
2010,  the reference value  given by  the  average of 
long-term  interest  rates  in  Portugal  and  Belgium 
plus  2  percentage  points  stood  at  6.0%.  The 
twelve-month  moving  average  of  the  yield  on  a 
ten-year  Swedish  benchmark  bond  stood  at  3.3%, 
i.e.  2.7  percentage  points  below  the  reference 
value. 

Graph 10.5.1: Sweden - Long-term interest rate criterion
 (percent, 12-month mov ing av erage)

12

10

8

6

4

2

0
Jan-04

Jan-05

Jan-06

Jan-07

Jan-08

Jan-09

Jan-10

Sweden

Reference value

Source: Commission services.

178 

 
  
  
Convergence Report 2010 - Technical annex 

Chapter 10 - Sweden 

Table 10.6.1:

Sweden - Balance of payments

Current account

Of which: Balance of trade in goods

                 Balance of trade in services

                 Income balance 

                 Balance of current transfers

Capital account
External balance 1)
Financial account

Of which: Net FDI

                Net portfolio inflows
                Net other inflows 2)
                Change in reserves (+ is a decrease)

Financial account without reserves

Errors and omissions

Gross capital formation

Gross saving

External debt

International investment position

2004

2005

2006

2007

2008

2009

(percentage of GDP)

7.3

6.4

1.6

0.6

-1.3

0.0

7.3

-8.0

-3.5

-6.7

1.9

0.3

-8.3

0.6

16.4

23.1

139.1

-24.4

6.9

5.4

2.1

0.7

-1.3

0.1

7.0

-8.1

-4.5

0.0

-3.4

-0.2

-7.8

1.0

17.2

23.4

158.6

-20.9

8.4

5.2

2.6

1.9

-1.2

-0.7

7.8

-8.0

1.0

-5.1

-3.5

-0.4

-7.6

0.2

18.2

26.8

158.6

-12.9

8.4

3.5

3.6

2.4

-1.1

-0.1

8.3

-2.0

-2.3

3.5

-3.3

0.1

-2.1

-6.3

19.7

28.8

175.4

-1.6

9.5

3.7

3.7

3.5

-1.3

-0.2

9.4

4.4

1.3

-6.0

9.2

0.0

4.5

-13.8

19.6

29.1

196.6

-14.1

7.3

3.2

3.7

1.7

-1.2

-0.1

7.2

-10.4

-5.3

9.3

-10.6

-3.8

-6.6

3.1

15.9

23.2

205.2

-19.7

1) The combined current and capital account.

2) Including financial derivatives.

Sources: Eurostat, Commission services and the Riksbank.

10.6.  ADDITIONAL FACTORS 

10.6.1. Developments  of 

the  balance  of 

payments 

The  Swedish  external  balance (i.e.  the  combined 
current  and  capital  account)  has  been  in  surplus 
since  1994,  reflecting  in  particular  strong  exports 
of  goods.  The  share  of  exports  in  GDP  has 
increased  from  around  30%  in  the  early  1990s  to 
around  50%  at  present.  Another  factor  behind  the 
stronger external balance has been the reduction of 
interest  payments  on  external  debt  following  the 
consolidation of central government finances in the 
mid-1990s.  The  external  surplus  increased  from 
around 4% of GDP in the early 2000s to a level of 
7-8% of GDP since 2003. The surplus is expected 
to  decrease  somewhat  over  the  coming  years  but 
remains high in a historical perspective.  

While  the  surplus  in  the  current  account has  been 
stable  for  a  number  of  years,  there  has  been  a 
marked 
the  different 
components  due  to  increasing  globalization.  The 
surplus  on  trade  in  goods  has  declined  while  the 
previous deficit in services has swung to a surplus.    

redistribution  between 

The  large  surplus  in  the  current  account  implies 
that domestic savings exceed domestic investment 
and that Sweden has a corresponding net financial 
outflow.  Domestic  savings  have  to  a  high  degree 
financial  savings  and 
been  channelled 
investment abroad.  

into 

amid 

Total  gross  external  debt  has  increased  rapidly 
over  the  last  years  and  reached  200%  of  GDP  in 
2009.  The  net  international  investment  position 
remained  moderately  negative, 
some 
fluctuations. The expansion of cross-border capital 
flows  during  the  last  decade  has  resulted  in  large 
gross  stocks 
investment 
position. Hence, fluctuations in market values have 
had a large impact on the investment position and 
developments in recent years have been influenced 
by  volatile  asset  prices  and  exchange  rates  during 
the financial crisis.  

international 

the 

in 

179 

 
 
 
 
 
 
European Commission 

Convergence Report 2010 

Graph 10.6.1: Sweden - Saving and investment
(in percent of GDP at market prices)

40

30

20

10

0

2004

2005
Gro ss national saving

2006

2007

2008

2009

Gro ss capital fo rmatio n at current prices; total eco nomy

Source: Eurostat, Commission services.

With regard to external competitiveness, the krona 
has experienced sharp swings in both nominal and 
terms  since  2004.  After  an 
real  effective 
improvement  in  competitiveness  in  late  2008,  the 
real  effective  exchange  rate,  measured  both  by 
consumer  prices  (HICP)  and  unit  labour  costs 
(ULC), has subsequently increased.  

Graph 10.6.2: Sweden - Effective exchange rates

 (v s. 35 trading partners;  monthly av erages;

  index numbers, 2004 = 100)

120

110

100

90

80

2004

2005

2006

2007

2008

2009

NEER

REER, HICP d eflated

REER, ULC d eflated

Source: Commission services.

10.6.2. Product market integration 

The openness and level of integration with the EU 
of the Swedish economy has continued to increase 
steadily in the years to 2008, and is well above the 
EU  average.  Both  extra-  and  intra-EU  trade  in 
goods increased over the period 2004-2008 but the 
latter  stabilised  in  the  final  two  years.  Intra-EU 
trade in services also increased over the period but 
remains considerably lower than intra-EU trade in 
goods.  Sweden's  main  trading  partners  are  other 
EU-27  Member  States,  particularly  Germany  and 
its  Scandinavian  neighbours.  From  a  long-term 
perspective, intra-EU trade has increased its share 
of  total  Swedish  trade  with  regard  to  imports, 
whereas  it  has  dropped  slightly  with  regard  to 
exports.  Both  changes  have  been  matched  by 
corresponding  changes  in  the  shares  of  Asia  and 
North America. 

180 

The  composition  of  trade  in  goods  reflects  the 
features  of  Sweden's  manufacturing 
main 
in  mainly 
industries,  which  are  concentrated 
capital-intensive  sectors,  particularly  in  high  and 
medium-high  technology  industries,  though  the 
technological balance declined somewhat between 
2006  and  2007.  The  strength  of  high  technology 
products is confirmed by the revealed comparative 
advantage  in  products  such  as  power-generating 
machinery  and  parts,  and  motor  vehicles. 
However,  the  use  of  raw  materials,  such  as  paper 
and wood products, and fish processing continue to 
play an important role.  

Total  FDI  inflows  have  been  generally  increasing 
over  the  period  with  a  rapid  increase  in  total 
inflows  in  2008.  The  same  is  true  for  intra-EU 
FDI.  Approximately  three-quarters  of  total  FDI 
emanates  from  other  Member  States  but  the  main 
source is from the euro area with two-thirds of the 
total coming from there. Specifically the countries 
are  the  Netherlands,  the  UK  and  Luxemburg 
however,  the  data  is  somewhat  biased  as  many 
to  register  holding 
Dutch  companies  choose 
companies  in  Sweden.  The  rise  in  FDI  can  be 
attributed  to  a  business-friendly  climate  and  an 
adopted 
macroeconomic 
framework. Almost half of the inward FDI stock is 
in  the  manufacturing  sector,  which  is  clearly 
export-oriented. The other main prominent sectors 
of foreign FDI are the utilities sector, goods trade 
and financial services. 

stability-oriented 

to 

provide 

information 

Regarding  the  business  environment,  "Start-Up 
Offices"  (Nystartskontoren)  have  been  introduced 
by the Government in an effort to reduce exclusion 
and  to  create  more  jobs.  At  these  offices  support 
and coaching is available in one place for starting 
and  running  a  business.  A  website  has  also  been 
created to make the start-up process more coherent 
entrepreneurs 
and 
considering  starting,  running,  developing  and 
closing  down  a  business.  While  Sweden 
is 
fulfilling  the  EU  law  requirements  on  public 
some 
procurement, 
indications  that  there  is  room  for  improvement. 
The  value  of 
tenders  had  been  decreasing 
somewhat during the 2004-2007 period but picked 
up  again  in  2008.  However,  a  study  by  the 
to  a 
Swedish  Competition  Authority  pointed 
some 
facts.  Firstly, 
number  of  disturbing 
government 
entities 
and 
completely disregard their obligation to follow the 
rules  on  public  procurement 
the 
government  has  indicated  that  financial  penalties 

are  nevertheless 

therefore 

agencies 

public 

there 

 
  
  
Convergence Report 2010 - Technical annex 

Chapter 10 - Sweden 

Table 10.6.2:

Sweden - Product market integration

Trade openness 1) (%)
Extra-EU trade in goods GDP ratio 2) (%)
Intra-EU trade in goods GDP ratio 3) (%)
Intra-EU trade in services GDP ratio 4) (%)
Export in high technology 5) (%)
Technological balance 6) (%)
Total FDI inflows GDP ratio 7) (%)
Intra-EU FDI inflows GDP ratio 8) (%)
FDI intensity 9)
Internal Market Directives 10) (%)
Value of tenders in the O.J. 11)
Time to start up a new company 12)

Sweden

2003

:

10.5

19.2

:

13.1

0.6

1.6

:

:

1.6

3.6

:

2004

2005

2006

2007

41.3

11.0

20.3

5.6

14.1

0.8

1.7

0.0

1.7

2.0

3.3

43.8

11.8

21.3

5.9

14.2

0.8

2.8

2.5

3.8

0.9

3.2

46.3

12.4

22.6

6.2

13.4

0.8

6.9

4.3

4.0

1.3

3.1

47.8

12.1

23.3

6.8

13.8

0.6

5.8

4.6

3.1

1.0

3.1

2008

49.5

13.0

23.3

7.1

:

:

8.6

8.7

6.1

0.9

3.6

15.0

15.0

15.0

15.0

15.0

 1) (Imports + Exports of goods and services / 2 x GDP at current market prices) x 100 (Foreign Trade Statistics, Balance of Payments).

 2) (Extra-EU-27 Imports + Exports of goods / 2 x GDP at current market prices ) x 100 (Foreign Trade Statistics).

 3) (Intra-EU-27 Imports + Exports of goods / 2 x GDP at current market prices ) x 100 (Foreign Trade Statistics).

 4) Intra-EU-27 trade in services (average credit and debit in % of GDP at current prices) (Balance of Payments).

 5) Taken directly from Eurostat's databases: Exports of high technology products as a share of total exports.

 6) (Exports - imports in high tech) / GDP at current prices x 100, since 2007 the data based upon SITC Rev. 4 (earlier SITC Rev. 3).

 7) Total FDI inflows (in % of GDP at current prices).

8) Intra-EU-27 FDI inflows (in % of GDP at current prices).

9) FDI intensity (average intra-EU-27 inflows and outflows in % of GDP at current prices).

10) Percentage of internal market directives not yet communicated as having been transposed, in relation to the total number.

11) Public procurement - Value of public procurement which is openly advertised  (in % of GDP).

12) Time to start a new company (in days), Doing Business World Bank.

Sources: Eurostat, Commission services.

introduced 

to  address 

will  be 
this  problem. 
Secondly,  there  are  also  concerns  about  the 
prevalence  of  public  procurement  cartels,  where 
suppliers divide up the market among themselves. 
Finally,  the  transposition  of  EU  Internal  Market 
directives  has  been  improving  over  the  period 
under  review  and  Sweden  has  a  transposition 
deficit below the 1% EU target and below the EU 
average. 

10.6.3. Financial market integration 

The  integration  of  Sweden's  financial  sector  into 
the broader EU sector relates mainly to links with 
other  Nordic  countries  and  the  Baltic  States.  The 
main channels of integration are the ownership of 
financial intermediaries in the Nordic/Baltic region 
and transforming the Swedish stock exchange into 
the OMX Group of Nordic stock exchanges, which 
was  subsequently  bought  by  a  US  exchange. 
Sweden  adopted  the  acquis  of  the  Union  in  the 
field  of  financial  services  in  connection  to  its 
accession to the EU in 1995 and the transposition 
of 
systematically 
accomplished (69). 

subsequent 

legislation 

is 

Liability  guarantees  was  the  main  type  of  the 
measure  provided  by  the  Swedish  authorities  in 
relation  to  the  financial  crisis.  They  amounted  to 
8.5%  of  the  GDP  and  thus  exceeded  the  level  in 
the  euro  area,  whereas  the  recapitalisation  was 
subdued  and  significantly  below  the  euro  area 
level.  

Graph 10.6.3: Sweden - Banking sector rescue measures 

relatively to the euro area

(effectiv e amounts in percentage of GDP)

10

8

6

4

2

0

Sw eden

Euro area

Recapitalisatio n

Liability guarantees

A sset relief

Liquidity support

Note: data for December 2009.
Source: European Commission.

Sweden’s  financial  sector  is  very  well  developed, 
both in size and sophistication and corresponds to 
its advanced stage of economic development. The 
share  of  credit  institutions  in  total  assets  reached 
68%  at  the  end  of  2009.  The  equity  market 
capitalisation  decreased  compared  to  2007  and 

(69)  See: 

http://ec.europa.eu/internal_market/finances/actionplan/ind
ex_en.htm#transposition. 

181 

 
                                                           
 
                                                                                   
 
 
 
 
 
European Commission 

Convergence Report 2010 

stood at 110% of GDP which is in all cases above 
the euro-area average. 

Graph 10.6.4: Sweden - Recent development of the  

financial system relatively to the euro area

(in percentage of GDP)

180
160
140
120
100
80
60
40
20
0

SE, 2004

SE, 2009

Euro area, 2004 Euro area, 2009

Debt securities

Sto ck market capitalisatio n

Do mestic bank credit

Source: Eurostat, Statistics Sweden, Nasdaq OMX.

The  banking  sector  is  dominated  by  four  large 
banks,  which  are  also  active  in  other  Nordic 
countries,  the  Baltic  States,  Poland  and  Germany. 
The share of assets of foreign banks only reached 
9%  in  2008  but  has  increased  compared  to  2002. 
Mortgage 
relatively 
institutions  also  play  a 
important role  in  the  Swedish  banking  system,  by 
providing  about  40%  of  the  total  lending.  In  the 
period  from  2004  to  2008,  the  Swedish  banking 
system became increasingly concentrated. In 2008, 
the  Swedish  banking  system's  concentration  level 
stood 62% (measured by CR5 ratio) and was thus 
significantly higher compared to the euro area. (70) 

Since  mid-2007,  the  profitability  of  the  major 
banks, measured as return on equity, has declined 
following four years in which it increased. In 2008, 
it  amounted  to  12  per  cent  compared  to  negative 
rates  in  the  euro  area.  Yet,  the  average  capital 
adequacy  ratio  in  the  banking  sector  was  slightly 
below the euro area level and stood at about 11% 
in 2008. 

Lending  by  Swedish  monetary  and  financial 
institutions  to  the  domestic  non-financial  sector 
has picked up alongside economic growth in recent 
years  and  the  level  of  loans  to  companies  and 
households  in  relation  to  GDP  is  slightly  higher 
than for the euro-area average. The annual rate of 
domestic credit growth slowed down to 7% at the 
end  of  2009  mainly  due  to  a  decline  in  corporate 
lending,  which  stagnated  in  2009.  In  comparison, 
credit  to  households  has  been  less  impacted,  with 
its annual growth rate of 13% at the end of 2009. 
Foreign  currency  loans  to  the  private  sector  are 
very 
in  Sweden.  Households  borrow 
almost  exclusively  in  domestic  currency,  while 
corporations  took  around  10%  share  of  foreign 
currency loans. 

limited 

Graph 10.6.7: Sweden - Recent developments in bank credit to 

households and corporations relatively to the euro area

70
60
50
40
30
20
10
0

Graph 10.6.5: Sweden - Foreign ownership and 

concentration in the banking sector
(in percent, weighted av erages)

(in percentage of GDP)

100

80

60

40

20

0

SE, 2004

SE, 2008

Euro area,
2004

Euro area,
2008

Co ncentratio n in the banking secto r (CR5 ratio )

Share o f fo reign institutio ns as % o f to tal assets

Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 Dec-09

Ho useho lds, SE
No n-financial co rpo ratio ns, SE
Ho useho lds, Euro  area
No n-financial co rpo ratio ns, Euro  area

Source: ECB, Structural indicators for the EU banking sector, January 2010.

Source: ECB, Eurostat.

Graph 10.6.6: Sweden - selected banking sector soundness 

20

15

10

5

0

-5

%

indicators relatively to the euro area

SE, 2004

SE, 2008

Euro area,
2004

Euro area,
2008

Return on equity

Capital adequacy

No n performing lo ans

Note: For 2008, EU-27 non performing loans for are a proxy for EA.
Source: ECB, Swedish FSA, EC calculations.

Graph 10.6.8: Sweden - Share of foreign currency loans

(as percentage of total loans to households / corporations)
14

9

5

0

Dec-04 Dec-05 Dec-06 Dec-07

Dec-08 Dec-09

Co rpo ratio ns

Ho useho lds

So urce: Statistics Sweden, Sveriges Riksbank and o wn calculatio ns.

(70)  The  CR5  concentration  ratio  is  defined  as  the  aggregate 
market  share  of  the  five  banks  with  the  largest  market 
share. 

The  equity  market  is  comparatively  large  and 
liquid  and  plays  a  significant  role  in  financing 

182 

 
 
 
 
                                                           
 
 
Convergence Report 2010 - Technical annex 

Chapter 10 - Sweden 

Sweden  has  a  single  financial  supervisor  since 
1991,  when  the  Financial  Supervisory  Authority 
(FSA)  was  created  by  the  merger  of  the  Private 
Insurance  Supervisory  Service  and 
the  Bank 
Inspection  Board.  Given  the  complexity  of  highly 
developed financial systems and the importance of 
Swedish banks in the Baltic markets, the Swedish 
FSA  participates  actively  in  EU  co-operation  and 
conducts  on-site  investigations  at  branches  of 
Swedish  companies  located  in  other  EU  Member 
States. Cooperation between the Baltic and Nordic 
intensive,  with 
countries 
Memoranda 
supporting 
of  Understandings 
enhanced  information  sharing,  the  supervision  of 
specific 
institutions  and  crisis  management 
arrangements. 

particularly 

is 

Swedish  companies.  The  main  trading  activity 
takes  place  at  the  Stockholmsbörsen,  but  the 
investor  base  has  significantly  expanded  via  the 
OMX  group.  The  fixed-income  securities  markets 
are  also  well  developed  and 
internationally 
integrated, although they remain substantially less 
liquid  than  the  major  euro  denominated  markets. 
Most bonds are denominated in domestic currency, 
but  there  are  also  significant  amounts  of  debt 
securities in foreign currency, with shares broadly 
equally  split  between  the  euro  and  other  foreign 
currencies. 

Sweden  has  also  a  well-developed  insurance, 
pension  and  investment  fund  industry.  Assets 
under management by investment funds amounted 
to  EUR  92  million  or  28%  of  GDP  at  the  end  of 
2008.  This  includes  savings  from  the  Premium 
Pension System (PPM) which has been reclassified 
insurance 
from 
companies to follow Eurostat standards. Moreover, 
investments  from  insurance  companies  amounted 
to  EUR  212  million  at 
the  end  of  2008, 
respectively, 65% of GDP. 

the  social  security  sector 

to 

183