COMMISSION STAFF WORKING DOCUMENT Accompanying the document REPORT FROM THE COMMISSION TO THE EUROPEAN PARLIAMENT AND THE COUNCIL CONVERGENCE REPORT 2014 (prepared in accordance with Article 140(1) of the Treaty on the Functioning of the European Union)
Date: 2014-06-04
Institutions: European Commission
Subjects: Bulgaria, Croatia, Czechia, Hungary, Lithuania, Poland, Romania, Sweden, economic convergence, economic disparity, economic reform, euro area, financial control, macroeconomics, price stability, public debt, stability programme













EUR-Lex - 52014SC0177 - EN











|



52014SC0177

COMMISSION STAFF WORKING DOCUMENT Accompanying the document REPORT FROM THE COMMISSION TO THE EUROPEAN PARLIAMENT AND THE COUNCIL CONVERGENCE REPORT 2014 (prepared in accordance with Article 140(1) of the Treaty on the Functioning of the European Union) /* SWD/2014/0177 final */









Convergence
Report 2014
                                                                                                                                                   
Member States
BG          Bulgaria
CZ          Czech Republic
HR          Croatia
LT           Lithuania
HU          Hungary
PL           Poland
RO          Romania
SE           Sweden
EA          Euro area 
EA-18    Euro area, 18 Member States
EA-17    Euro area, 17 Member States
before 2014
EU-28    European Union, 28 Member
States
EU-27    European Union, 27 Member
States before July 2013 (i.e. EU-28 excl. HR)
EU-25    European Union, 25 Member
States before 2007 (i.e. EU-27 excl. BG and RO)
EU-15    European Union, 15 Member
States before 2004
Currencies
EUR       Euro
ECU       European currency unit
BGN       Bulgarian lev
CZK       Czech koruna
HRK      Croatian kuna
LTL        Lithuanian litas
HUF       Hungarian forint
PLN        Polish zloty
RON       Romanian leu (ROL until 30 June 2005)
SKK       Slovak koruna
SEK        Swedish krona
DEM      Deutsche Mark 
USD        US dollar
SDR        Special Drawing Rights
Central Banks
BNB       Bulgarska narodna banka
(Bulgarian National Bank – central bank of Bulgaria)
ČNB       Česká národní banka
(Czech National Bank – central bank of the Czech Republic)
HNB       Hrvatska narodna banka
(Croatian National Bank – central bank of Croatia)
MNB      Magyar Nemzeti Bank (Hungarian
National Bank – central bank of Hungary)
NBP        Narodowy Bank Polski
(National Bank of Poland – central bank of Poland)
BNR       Banca Naţională a
României (National Bank of Romania – central bank of Romania)
Other abbreviations
AMR      Alert Mechanism Report
BoP        Balance of Payments
BPO        Business process outsourcing
BSE        Budapest Stock Exchange
CAR       Capital adequacy ratio
CBA       Currency board arrangement
CDS        Credit Default Swaps
CEE        Central and Eastern Europe
CIS         Commonwealth of Independent
States
CIT         Corporate Income Tax
CPI         Consumer price index
CR5        Concentration ratio
(aggregated market share of five banks with the largest market share)
EC          European Community
ECB       European Central Bank
EDP        Excessive Deficit Procedure
EERP     European Economic Recovery
Plan
EMI        European Monetary Institute
EMS       European Monetary System
EMU      Economic and monetary union
ERM II  Exchange rate mechanism II
ESA 95  European System of Accounts
ESCB     European System of Central
Banks
EU          European Union
Eurostat Statistical Office of the
European Union
FESE      Federation of European
Securities Exchanges
FDI         Foreign direct investment
FGS        Funding for Growth Scheme
FSA        Financial Supervisory
Authority
FSAP      Financial Sector Action Plan
GDP        Gross domestic product
HICP      Harmonised index of consumer
prices
HFSA     Hungarian Financial
Supervisory Authority
KNF       Komisja Nadzoru Finansowego
(Polish Financial Supervision Authority)
MFI        Monetary Financial
Institution 
MIP        Macroeconomic Imbalance
Procedure
MTO      Medium-term objective
NCBs     National central banks
NEER     Nominal effective exchange
rate
NIK        Najwyższa Izba Kontroli
(Poland's Supreme Chamber of Control)
NPL        Non-performing loans
OJ           Official Journal
OJL         Official Journal Lex
PIT         Personal Income Tax
PPS         Purchasing Power Standard
PPP         Purchasing Power Percentage
R&D       Research and development
REER     Real effective exchange rate
SITC      Standard International Trade
Classification
SKOK    Spółdzielcze Kasy
Oszczędnościowo-Kredytowe (Credit Union)
TEC        Treaty establishing the
European Community
TFEU     Treaty on the Functioning of
the European Union
ULC       Unit labour costs
VAT       Value added tax
VSE        Vilnius Stock Exchange
WSE       Warsaw Stock Exchange
ZSE        Zagreb Stock Exchange
Convergence
Report 2014  1
Convergence Report 2014 - Technical annex  3
1.     Introduction  5
1.1.     ROLE OF THE REPORT  5
1.2.     APPLICATION OF THE CRITERIA   6
1.2.1.    Compatibility of legislation  7
1.2.2.    Price stability  7
1.2.3.    Public finances 12
1.2.4.    Exchange rate stability  13
1.2.5.     Long-term interest rates 13
1.2.6.    Additional factors 13
2.     Bulgaria  17
2.1.     Legal compatibility  17
2.1.1.    Introduction  17
2.1.2.    Central Bank independence  17
2.1.3.    Prohibition of monetary financing and
privileged access 18
2.1.4.    Integration in the ESCB  18
2.1.5.    Assessment of compatibility  18
2.2.     PRICE STABILITY  18
2.2.1.    Respect of the reference value  18
2.2.2.    Recent inflation developments 19
2.2.3.    Underlying factors and sustainability of
inflation  19
2.3.     public finances  22
2.3.1.    Recent fiscal developments 22
2.3.2.    Medium-term prospects 23
2.4.     EXCHANGE RATE STABILITY  24
2.5.     LONG-TERM INTEREST RATEs  24
2.6.     ADDITIONAL FACTORS  25
2.6.1.    Developments of the balance of payments 25
2.6.2.    Market integration  27
2.6.3.    Financial market integration  29
3.     Czech Republic  31
3.1.     legal compatibility  31
3.1.1.    Introduction  31
3.1.2.    Independence  31
3.1.3.    Prohibition of monetary financing  31
3.1.4.    Integration in the ESCB  32
3.1.5.    Assessment of compatibility  32
3.2.     PRICE STABILITY  32
3.2.1.    Respect of the reference value  32
3.2.2.    Recent inflation developments 33
3.2.3.    Underlying factors and sustainability of
inflation  33
3.3.     public finances  36
3.3.1.    The excessive deficit procedure for the Czech
Republic  36
3.3.2.    Recent fiscal developments 36
3.3.3.    Medium-term prospects 37
3.4.     EXCHANGE RATE STABILITY  38
3.5.     LONG-TERM INTEREST RATEs  39
3.6.     ADDITIONAL FACTORS  39
3.6.1.    Developments of the balance of payments 40
3.6.2.    Market integration  41
3.6.3.    Financial market integration  43
4.     Croatia  45
4.1.     Legal compatibility  45
4.1.1.    Introduction  45
4.1.2.    Central bank independence  45
4.1.3.    Prohibition of monetary financing and
privileged access 45
4.1.4.    Integration in the ESCB  45
4.1.5.    Assessment of compatibility  45
4.2.     PRICE STABILITY  45
4.2.1.    Respect of the reference value  45
4.2.2.    Recent inflation developments 46
4.2.3.    Underlying factors and sustainability of
inflation  46
4.3.     public finances  48
4.3.1.    The excessive deficit procedure for Croatia   48
4.3.2.    Recent fiscal developments 49
4.3.3.    Medium-term prospects 50
4.4.     EXCHANGE RATE STABILITY  51
4.5.     LONG-TERM INTEREST RATEs  52
4.6.     additional factors  53
4.6.1.    Developments of the balance of payments 53
4.6.2.    Market integration  54
4.6.3.    Financial market integration  56
5.     Lithuania  59
5.1.     LEGAL COMPATIBILITY  59
5.1.1.    Introduction  59
5.1.2.    Central bank independence  59
5.1.3.    Prohibition of monetary financing and
privileged access 59
5.1.4.    Integration in the ESCB  59
5.1.5.    Assessment of compatibility  60
5.2.     PRICE STABILITY  60
5.2.1.    Respect of the reference value  60
5.2.2.    Recent inflation developments 60
5.2.3.    Underlying factors and sustainability of
inflation  61
5.3.     PUBLIC FINANCES  63
5.3.1.    Recent fiscal developments 63
5.3.2.    Medium-term prospects 64
5.4.     EXCHANGE RATE STABILITY  65
5.5.     LONG-TERM INTEREST RATES  66
5.6.     ADDITIONAL FACTORS  67
5.6.1.    Developments of the balance of payments 67
5.6.2.    Market integration  68
5.6.3.    Financial market integration  70
5.7.     Sustainability of convergence  71
6.     Hungary  77
6.1.     LEGAL COMPATIBILITY  77
6.1.1.    Introduction  77
6.1.2.    Central Bank independence  77
6.1.3.    Prohibition of monetary financing and
privileged access 77
6.1.4.    Integration in the ESCB  78
6.1.5.    Assessment of compatibility  79
6.2.     PRICE STABILITY  79
6.2.1.    Respect of the reference value  79
6.2.2.    Recent inflation developments 79
6.2.3.    Underlying factors and sustainability of
inflation  80
6.3.     PUBLIC FINANCES  83
6.3.1.    Recent fiscal developments 83
6.3.2.    Medium-term prospects 84
6.4.     EXCHANGE RATE STABILITY  85
6.5.     LONG-TERM INTEREST RATEs  86
6.6.     ADDITIONAL FACTORS  86
6.6.1.    Developments of the balance of payments 87
6.6.2.    Market integration  88
6.6.3.    Financial market integration  90
7.     Poland  93
7.1.     LEGAL COMPATIBILITY  93
7.1.1.    Introduction  93
7.1.2.    Central bank independence  93
7.1.3.    Prohibition of monetary financing and
privileged access 94
7.1.4.    Integration in the ESCB  94
7.1.5.    Assessment of compatibility  94
7.2.     PRICE STABILITY  94
7.2.1.    Respect of the reference value  94
7.2.2.    Recent inflation developments 95
7.2.3.    Underlying factors and sustainability of
inflation  96
7.3.     PUBLIC FINANCES  98
7.3.1.    The excessive deficit procedure for Poland   98
7.3.2.    Recent fiscal developments 98
7.3.3.    Medium-term prospects 99
7.4.     EXCHANGE RATE STABILITY  100
7.5.     LONG-TERM INTEREST RATEs  100
7.6.     ADDITIONAL FACTORS  101
7.6.1.    Developments of the balance of payments 101
7.6.2.    Market integration  103
7.6.3.    Financial market integration  104
8.     Romania  107
8.1.     Legal compatibility  107
8.1.1.    Introduction  107
8.1.2.    Central Bank independence  107
8.1.3.    Prohibition of monetary financing and
privileged access 108
8.1.4.    Integration in the ESCB  109
8.1.5.    Assessment of compatibility  109
8.2.     PRICE STABILITY  109
8.2.1.    Respect of the reference value  109
8.2.2.    Recent inflation developments 110
8.2.3.    Underlying factors and sustainability of
inflation  111
8.3.     PUBLIC FINANCES  113
8.3.1.    Recent fiscal developments 113
8.3.2.    Medium-term prospects 114
8.4.     EXCHANGE RATE STABILITY  115
8.5.     LONG-TERM INTEREST RATEs  116
8.6.     ADDITIONAL FACTORS  117
8.6.1.    Developments of the balance of payments 117
8.6.2.    Market integration  119
8.6.3.    Financial market integration  120
9.     Sweden  123
9.1.     LEGAL COMPATIBILITY  123
9.1.1.    Introduction  123
9.1.2.    Central Bank Independence  123
9.1.3.    Prohibition of monetary financing and
privileged access 123
9.1.4.    Integration in the ESCB  124
9.1.5.    Assessment of compatibility  125
9.2.     Price stability  125
9.2.1.    Respect of the reference value  125
9.2.2.    Recent inflation developments 125
9.2.1.    Underlying factors and sustainability of
inflation  125
9.3.     Public finances  128
9.3.1.    Recent fiscal developments 128
9.3.2.    Medium-term prospects 128
9.4.     Exchange rate stability  129
9.5.     Long-term interest rates  130
9.6.     Additional factors  131
9.6.1.    Developments of the balance of payments 131
9.6.2.    Market integration  133
9.6.3.    Financial market integration  134
LIST OF Tables
2.1.     Bulgaria - Components of inflation  20
2.2.     Bulgaria - Other inflation and cost indicators 21
2.3.     Bulgaria - Budgetary developments and
projections 23
2.4.     Bulgaria - Balance of payments 26
2.5.     Bulgaria - Product market integration  28
3.1.     Czech Republic - Components of inflation  34
3.2.     Czech Republic - Other inflation and cost
indicators 35
3.3.     Czech Republic - Budgetary developments and
projections 37
3.4.     Czech Republic - Balance of payments 41
3.5.     Czech Republic - Product market integration  42
4.1.     Croatia - Components of inflation  48
4.2.     Croatia - Other inflation and cost indicators 49
4.3.     Croatia - Budgetary developments and projections 50
4.4.     Croatia - Balance of payments 54
4.5.     Croatia - Product market integration  55
5.1.     Lithuania - Components of inflation  60
5.2.     Lithuania - Other inflation and cost indicators 62
5.3.     Lithuania - Budgetary developments and
projections 64
5.4.     Lithuania - Balance of payments 68
5.5.     Lithuania - Product market integration  69
6.1.     Hungary - Components of inflation  80
6.2.     Hungary - Other inflation and cost indicators 81
6.3.     Hungary - Budgetary developments and projections 83
6.4.     Hungary - Balance of payments 87
6.5.     Hungary - Product market integration  89
7.1.     Poland - Components of inflation  95
7.2.     Poland - Other inflation and cost indicators 96
7.3.     Poland - Budgetary developments and projections 98
7.4.     Poland - Balance of payments 102
7.5.     Poland - Product market integration  103
8.1.     Romania - Components of inflation  110
8.2.     Romania - Other inflation and cost indicators 112
8.3.     Romania - Budgetary developments and projections 114
8.4.     Romania - Balance of payments 118
8.5.     Romania - Product market integration  119
9.1.     Sweden - Components of inflation  126
9.2.     Sweden - Other inflation and cost indicators 127
9.3.     Sweden - Budgetary developments and projections 129
9.4.     Sweden - Balance of payments 132
9.5.     Sweden - Product market integration  133
LIST OF Graphs
2.1.     Bulgaria - Inflation criterion since 2008  19
2.2.     Bulgaria - HICP inflation  19
2.3.     Bulgaria - Inflation, productivity and wage
trends 21
2.4.     Exchange rates - BGN/EUR  24
2.5.     Bulgaria - 3-M Sofibor spread to 3-M Euribor 24
2.6.     Bulgaria - Long-term interest rate criterion  25
2.7.     Bulgaria - Long-term interest rates 25
2.8.     Bulgaria - Saving and investment 26
2.9.     Bulgaria - Effective exchange rates 26
2.10.   Bulgaria - Foreign ownership and concentration in
the banking sector 29
2.11.   Bulgaria - selected banking sector soundness
indicators 29
2.12.   Bulgaria - Recent development of the financial
system relative to the euro area   30
3.1.     Czech Republic - Inflation criterion since 2008  33
3.2.     Czech Republic - HICP inflation  33
3.3.     Czech Rep. - Inflation, productivity and wage
trends 34
3.4.     Exchange rates - CZK/EUR  38
3.5.     Czech Republic - 3-M Pribor spread to 3-M
Euribor 39
3.6.     Czech Republic - Long-term interest rate
criterion  39
3.7.     Czech Republic - Long-term interest rates 39
3.8.     Czech Republic - Saving and investment 40
3.9.     Czech Republic - Effective exchange rates 40
3.10.   Czech Republic - Foreign ownership and
concentration in the banking sector 43
3.11.   Czech Republic - selected banking sector
soundness indicators 43
3.12.   Czech Republic - Recent development of the
financial system relative to the euro area   43
4.1.     Croatia - Inflation criterion since 2008  46
4.2.     Croatia - HICP inflation  46
4.3.     Croatia - Inflation, productivity and wage
trends 47
4.4.     Exchange rates - HRK/EUR  51
4.5.     Croatia - 3-M Zibor spread to 3-M Euribor 52
4.6.     Croatia - Long-term interest rate criterion  52
4.7.     Croatia - Long-term interest rates 52
4.8.     Croatia - Saving and investment 53
4.9.     Croatia - Effective exchange rates 54
4.10.   Croatia - Foreign ownership and concentration in
the banking sector 56
4.11.   Croatia - selected banking sector soundness indicators 57
4.12.   Croatia - Recent development of the financial
system relative to the euro area   57
5.1.     Lithuania - Inflation criterion since 2008  60
5.2.     Lithuania - HICP inflation  61
5.3.     Lithuania - Inflation, productivity and wage
trends 62
5.4.     LTL - Spread vs central rate  65
5.5.     Exchange rates - LTL/EUR  65
5.6.     Lithuania - 3-M Vilibor spread to 3-M Euribor 66
5.7.     Lithuania - Long-term interest rate criterion  66
5.8.     Lithuania - Long-term interest rates 66
5.9.     Lithuania - Saving and investment 67
5.10.   Lithuania - Effective exchange rates 68
5.11.   Lithuania - Foreign ownership and concentration
in the banking sector 70
5.12.   Lithuania - selected banking sector soundness
indicators 71
5.13.   Lithuania - Recent development of the financial
system relative to the euro area   71
6.1.     Hungary - Inflation criterion since 2008  79
6.2.     Hungary - HICP inflation  79
6.3.     Hungary - Inflation, productivity and wage
trends 81
6.4.     Exchange rates - HUF/EUR  85
6.5.     Hungary - 3-M Bubor spread to 3-M Euribor 86
6.6.     Hungary - Long-term interest rate criterion  86
6.7.     Hungary - Long-term interest rates 86
6.8.     Hungary - Saving and investment 88
6.9.     Hungary - Effective exchange rates 88
6.10.   Hungary - Foreign ownership and concentration in
the banking sector 90
6.11.   Hungary - selected banking sector soundness
indicators 91
6.12.   Hungary - Recent development of the financial
system relative to the euro area   91
7.1.     Poland - Inflation criterion since 2008  95
7.2.     Poland - HICP inflation  95
7.3.     Poland - Inflation, productivity and wage trends 97
7.4.     Exchange rates - PLN/EUR  100
7.5.     Poland - 3-M Wibor spread to 3-M Euribor 100
7.6.     Poland - Long-term interest rate criterion  101
7.7.     Poland - Long-term interest rates 101
7.8.     Poland - Saving and investment 102
7.9.     Poland - Effective exchange rates 102
7.10.   Poland - Foreign ownership and concentration in
the banking sector 105
7.11.   Poland - selected banking sector soundness
indicators 105
7.12.   Poland - Recent development of the financial
system relative to the euro area   106
8.1.     Romania - Inflation criterion since 2008  110
8.2.     Romania - HICP inflation  110
8.3.     Romania - Inflation, productivity and wage
trends 111
8.4.     Exchange rates - RON/EUR  115
8.5.     Romania - 3-M Robor spread to 3-M Euribor 116
8.6.     Romania - Long-term interest rate criterion  116
8.7.     Romania - Long-term interest rates 117
8.8.     Romania - Saving and investment 117
8.9.     Romania - Effective exchange rates 118
8.10.   Romania - Foreign ownership and concentration in
the banking sector 121
8.11.   Romania - selected banking sector soundness
indicators 121
8.12.   Romania - Recent development of the financial
system relative to the euro area   121
9.1.     Sweden - Inflation criterion since 2008  125
9.2.     Sweden - HICP inflation  125
9.3.     Sweden - Inflation, productivity and wage trends 126
9.4.     Exchange rates - SEK/EUR  130
9.5.     Sweden - 3-M Stibor spread to 3-M Euribor 130
9.6.     Sweden - Long-term interest rate criterion  130
9.7.     Sweden - Long-term interest rates 131
9.8.     Sweden - Saving and investment 131
9.9.     Sweden - Effective exchange rates 132
9.10.   Sweden - Foreign ownership and concentration in
the banking sector 135
9.11.   Sweden - selected banking sector soundness
indicators 135
9.12.   Sweden - Recent development of the financial
system relative to the euro area   135
LIST OF Boxes
1.1.     Article 140 of the Treaty  6
1.2.     Assessment of price stability and the reference
value  8
1.3.     Excessive deficit procedure  10
1.4.     Data for the interest rate convergence  14
1.5.     The Macroeconomic Imbalance Procedure (MIP) 15
LIST OF Maps
No table of contents
entries found.
Report
1.1.      ROLE
OF THE REPORT
The euro was introduced on 1 January 1999
by eleven Member States. The decision ([1]) by the Council (meeting in 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]) and the European Monetary Institute (EMI), respectively ([4]). These reports, prepared in accordance with Article 121(1) TEC ([5]), examined whether the Member States satisfied the convergence
criteria and met the legal requirements.
Since then, Greece (2001), Slovenia (2007), Cyprus and Malta (2008), Slovakia (2009), Estonia (2011) and Latvia (2014) have
adopted 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 for such Member States. Denmark and the United Kingdom negotiated opt-out arrangements before the adoption of the Maastricht
Treaty ([6]) and do not
participate in the third stage of EMU. Until these Member States indicate that
they wish to participate in the third stage and adopt the euro, they are not
the subject of an assessment as to whether they fulfil the necessary
conditions. 
In 2012, the Commission and the ECB adopted
their latest regular Convergence Reports ([7]). At that time, none of the Member States assessed was deemed to
meet the necessary conditions for adopting the euro. 
On 5 March 2013, Latvia submitted a request
for a convergence assessment. Following the Convergence Report 2013 on Latvia
and on the basis of a proposal by the Commission, the Ecofin Council decided in
July 2013 that Latvia fulfilled the necessary conditions for adopting the euro
as of 1 January 2014 ([8]).
In 2014, two years will have elapsed since
the last regular reports were prepared. 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, Croatia, Lithuania, Hungary, Poland, Romania and Sweden. This Commission Staff Working Document is a
Technical Annex to the Convergence Report 2014 and includes a detailed
assessment of the progress with convergence.
The financial and economic crisis, along
with the recent euro-area sovereign debt crisis, has exposed gaps in the
current economic governance system of the Economic and Monetary Union (EMU) and
showed that its existing instruments need to be used more comprehensively. With
the aim of ensuring a sustainable functioning of EMU, an overall strengthening
of economic governance in the Union has been undertaken. Accordingly, this
Commission Staff Working Document makes references where appropriate to
procedures that help to strengthen the assessment of each Member States'
convergence process and its sustainability. In particular, it incorporates
references to the strengthened surveillance of macroeconomic imbalances (see
sub-section 1.2.6.).
The remainder of the first chapter presents
the methodology used for the 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 in which they appear in Article
140(1) (see Box 1.1). The cut-off date for the statistical data included in
this Convergence Report was 15 May 2014.
1.2.      APPLICATION
OF THE CRITERIA
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 sustainable
convergence by reference to the fulfilment of the four convergence criteria
dealing with price stability, public finances, exchange rate stability and long
term interest rates as well as some additional factors. The four convergence
criteria are developed further in a Protocol annexed to the Treaty (Protocol No
13 on the convergence criteria). 
1.2.1.   Compatibility
of legislation
In accordance with Article 140(1) of the
Treaty, the legal examination includes an assessment of compatibility between a
Member State’s legislation, including the statute of its national central bank,
and Article 130 and 131 of the Treaty. This assessment mainly covers three
areas. 
·       First, the independence of the national central bank and of the
members of its decision-making bodies, as laid down in Article 130, must be
assessed. This assessment covers all issues linked to a national central bank's
institutional financial independence and to the personal independence of the
members of its decision-making bodies. 
·       Second, in accordance with Articles 123 and 124 of the Treaty, the
compliance of the national legislation is verified against the prohibition of
monetary financing and privileged access. The prohibition of monetary financing
is laid down in Article 123(1) of the Treaty, which prohibits overdraft
facilities or any other type of credit facility with the ECB or the central
banks of Member States in favour of Union institutions, bodies, offices or agencies,
central governments, regional, local or other public authorities, other bodies
governed by public law, or public undertakings of Member States; and the
purchase directly from these public sector entities by the ECB or central banks
of debt instruments. As regards the prohibition on privileged access, the
central banks, as public authorities, may not take measures granting privileged
access by the public sector to financial institutions if such measures are not
based on prudential considerations. 
·       Third, the integration of the national central bank into the ESCB
has to be examined, in order to ensure that at the latest by the moment of euro
adoption, the objectives of the national central bank are compatible with the
objectives of the ESCB as formulated in Article 127 of the Treaty. The national
provisions on the tasks of the national central bank are assessed against the
relevant rules of the Treaty and the ESCB/ECB Statute. 
1.2.2.   Price
stability
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”. 
Since national consumer price indices
(CPIs) diverge substantially in terms of concepts, methods and practices, they
do not constitute 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 legal basis for 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
provided the basis for a change of the HICP index 
 (Continued on the next page) 
 Box (continued) 
base reference period from 1996=100 to
2005=100 ([10]).
As has been the case in past convergence
reports, a Member State’s average rate of inflation is measured by the
percentage change in 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 inflation of the three 'best-performing Member States in terms
of price stability' plus 1.5 percentage points. Accordingly, the reference
value is currently 1.7%, based on the data of Latvia (0.1%), Portugal (0.3%)
and Ireland (0.3%) over the 12-month period covering May 2013-April 2014.
Greece, Bulgaria and Cyprus were identified as outliers, as their inflation
rates deviated by a wide margin from the euro area average reflecting
country-specific economic circumstances (see Box 1.2)
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. This deserves particular attention in
the current juncture as the financial turmoil exposed unsustainable price
developments in many EU Member States, including euro area countries, in the
pre-crisis period.
Inflation sustainability implies that the
satisfactory inflation performance must essentially be due to the adequate
behaviour of input costs and other factors influencing price developments in a
structural manner, rather than reflecting the influence of cyclical or
temporary factors. Therefore, this Technical Annex also takes account of the role
of the macroeconomic situation and cyclical position 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 
 (Continued on the next page) 
 Box (continued) 
 (Continued on the next page) 
 Box (continued) 
developments have impacted on domestic
inflation. Similarly, the impact of administered prices and indirect taxes on
headline inflation is also considered.
From a forward-looking inflation
perspective, the report includes an assessment of medium-term prospects for
price developments. The analysis of factors that have an impact on the inflation
outlook – cyclical conditions, labour market developments and credit growth –
is complemented by a reference to the most recent Commission services' forecast
of inflation. That forecast can subsequently be used to assess whether the Member State is likely to meet the reference value also in the months ahead ([11]). Medium-term inflation prospects are also assessed by reference to
the economies' key structural characteristics, including the functioning of the
labour and product markets.
1.2.3.   Public
finances
The convergence criterion dealing with the
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 (see Box 1.3 for further information on the excessive deficit
procedure as strengthened by the 2011 reform of the Stability and Growth Pact).
The details of the excessive deficit procedure are defined in Regulation
1467/97 as amended in 2005 and 2011 (most recently under the
"Six-Pack") which sets out the way in which government deficit and
debt levels are assessed to determine whether an excessive deficit exists,
under article 126 of TFEU. The convergence  assessment in the budgetary area is
therefore judged by whether the Member State is subject to a Council decision
under 126(6) on the existence of an excessive deficit ([12]). 
Long-term sustainability of public finances
deserves particular attention at a time when the financial crisis has
significantly impacted on the fiscal positions and debt levels in many Member
States. In response to this, economic governance in the EMU was substantially
strengthened in 2011, which included, inter alia, the operationalisation
of the debt criterion in the Excessive Deficit Procedure ([13]).
1.2.4.   Exchange
rate stability
The Treaty refers to the exchange rate
criterion in the third 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”. 
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 not have devalued its currency’s bilateral central rate against the euro
on its own initiative for the same period” ([14]). Based on the Council Resolution on the establishment of the ERM II ([15]), 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. 
In its assessment of the exchange rate
stability criterion, the Commission takes into account developments in
auxiliary indicators such as foreign reserve developments and short-term
interest rates, as well as the role of policy measures, including foreign
exchange interventions, in maintaining exchange rate stability. 
A number of Member States have benefited
from balance-of-payments assistance programmes since 2008. In order to
determine whether international financial assistance constitutes evidence that
a country has faced severe tensions in its exchange rate, the Commission examines
the role played by official external financing during the assessment period on
a case by case basis. 
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 16 May 2012 to 15 May 2014.
1.2.5.   
Long-term interest rates
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 Protocol on
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, taking into account differences in
national definitions” (see Box 1.4).   
For the assessment of the criterion on the
convergence of interest rates, yields on benchmark 10-year bonds have been
taken, using an average rate over the latest 12 months. The reference value for
April 2014 is calculated as the simple average of the average long-term
interest rates in Latvia (3.3%), Portugal (5.8%) and Ireland (3.5%), plus 2
percentage points, yielding a reference value of 6.2%. 
1.2.6.   Additional
factors
The Treaty in Article 140 also calls for an
examination of other factors relevant to economic integration and convergence.
These additional factors include financial, product and labour market
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 section on price
stability.
The assessment of additional factors gives
an important indication of a Member State's ability to integrate into the euro
area without difficulties. As regards the balance of payments, the focus is on
the situation and development of the
external balance ([16]). Market
integration 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. 
Starting with the 2012 Convergence Report,
the convergence assessment is aligned with the broader "European
Semester" approach which takes an integrated and upstream look at the
economic policy challenges facing EMU in ensuring fiscal sustainability, competitiveness,
financial market stability and economic growth. 
The section on additional factors makes
reference to the surveillance of macroeconomic imbalances under the
Macroeconomic Imbalance Procedure, which was adopted in December 2011 as one of
the key elements of the legislative package (the "Six-Pack") to
enhance the governance structures in EMU, and integrates its results into the
assessment ([17]).
2.1.      Legal
compatibility
2.1.1.   Introduction
The legal basis for the Bulgarska narodna
banka (BNB – central bank of Bulgaria), the Law on the Bulgarian National Bank
(the BNB Law) of 1997, has not been amended since the 2012 Convergence Report.
Therefore, the comments provided in the 2012 Convergence Report are largely
repeated in this year's assessment.
2.1.2.   Central Bank independence
Article 14(1) of the BNB Law Bank does not
accurately mirror the grounds for dismissal of the Governor set out
exhaustively in Article 14.2 of the ESCB/ECB Statute.
Pursuant to Article 14(1) of the BNB Law, a
member of the BNB Governing Council, including the Governor, may be relieved
from office (1) "if he no longer fulfils the conditions required for the
performance of his duties under Article 11(4)", (2) "if he is in
practical inability to perform his duties for more than six months" or (3)
"if he has been guilty of serious professional misconduct".
Whereas the second ground for dismissal is
not provided in Article 14.2 of the ESCB/ECB Statute, the third dismissal
ground provided in Article 14(1) of the BNB Law narrows down the concept of
"serious misconduct" of Article 14.2 of the ESCB/ECB Statute to
"serious professional misconduct". In order to remove these
imperfections and limit interpretation problems, Article 14(1) of the BNB Law
should be amended.
Furthermore, the ground for dismissal
provided in the Conflict of Interest Prevention and Ascertainment Act of 2008
which has been applicable to the BNB Governor, Deputy Governors and the members
of the BNB Managing Board since December 2010 has to be brought in line with
Article 14.2 of the ESCB/ECB Statute. Article 33(1) in conjunction with Article
3(13) of the Conflict of Interest Prevention and Ascertainment Act provides that
the breach of its provisions and the existence of a conflict of interest are
grounds for dismissal. This incompatibility should be removed by specifying
that a dismissal of the Governor is only admissible if, as set out in Article
14.2 of the ESCB/ECB Statute, the breach of the duty is a lack of fulfilment of
the conditions required for the performance of the Governor's duties or is a
serious misconduct of which the Governor has been guilty.
Pursuant to Article 12(1) of the BNB Law,
the Governor shall be elected by the National Assembly. The National Assembly
has taken the view that it has the power to annul or amend its decisions,
including decisions under Article 12(1) of the BNB Law. The National Assembly
has substantiated this assertion by stating that pursuant to a Constitutional
Court decision of 26 February 1993, the Bulgarian Constitution does not
explicitly prohibit the National Assembly from amending or annulling its
decisions. Such understanding would allow the dismissal of the Governor under
conditions other than those mentioned in Article 14.2 of the ESCB/ECB Statute.
It should be ensured that the Governor, when properly elected or appointed, may
not be dismissed under conditions other than those mentioned in Article 14.2 of
the ESCB/ECB Statute.
Article 14(2) of the BNB Law Bank should be
amended. Article 14(2) of the BNB Law Bank stipulates that "where the
duties of a Governing Council member cease before the term of office has
expired, another person shall be elected/appointed for the outstanding
period of the term of office". As regards the Governor, this is not in
line with Article 14.2 of the ESCB/ECB Statute, pursuant to which the term of
office of a Governor shall be no less than five years.
Article 44 of the BNB Law should be amended
with a view to achieving compatibility with Article 130 of the TFEU and Article
7 of the ESCB/ECB Statute. Pursuant to Article 44 of the BNB Law, 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. It should be clarified that
this encompasses national, foreign and EU institutions or bodies.
2.1.3.   Prohibition of monetary financing and privileged access
Article 45(1) and (2) of the BNB Law are
not fully consistent with Article 123 of the TFEU and Article 21.1 of the
ESCB/ECB Statute and thus should be amended.
Article 45(1) of the BNB Law provides 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.
Article 45(1) of the BNB Law should be amended with a view to including all entities
mentioned in Article 123(1) of the TFEU and Article 21.1 of the ESCB/ECB
Statute. Furthermore, while the prohibition of monetary financing does not
allow the direct purchase of public sector debt, purchases on the secondary
market are not prohibited unless they qualify as a circumvention of the
objective of Article 123 of the TFEU. For this reason, the word ‘direct’ should
be inserted in Article 45(1) of the BNB Law.
Pursuant to Article 45(2) in conjunction
with Article 33(2) of the BNB Law, Article 45(1) of the BNB Law does not apply
to the extension of credits to state-owned and municipal banks in emergency
cases of liquidity risk that may affect the stability of the banking system.
The scope of this exemption should be amended to be fully consistent with the
wording of Article 123(2) of the TFEU and Article 21.3 of the ESCB/ECB Statute.

2.1.4.   Integration in the ESCB
Objectives
The objectives of the BNB are compatible
with the Treaty on the Functioning of the European Union. 
Tasks
The incompatibilities in the BNB Law are
linked to the following ESCB/ECB tasks:
·       definition of monetary policy and monetary functions, operations and
instruments of the ESCB (Articles 2(1), 3, 16(4 and 5), 28, 30, 31, 32, 33, 35,
38, 41 and 61 of the BNB Law);
·       conduct of foreign exchange operations and the definition of foreign
exchange rate policy (Articles 20(1), 28, 31, 32 of the BNB Law);
·       right to authorise the issue of banknotes and the volume of coins
(Articles 2(5), 16(9), 24 to 27 of the BNB Law);
·       non-recognition of the role of the ECB in the field of international
cooperation (Articles 5, 16(12) and 37(4) of the BNB Law);
·       ECB's right to impose sanctions (Article 61, 62 of the BNB Law).
There are also numerous imperfections
regarding:
·       non-recognition of the role of the ECB in the functioning of the
payment systems (Articles 2(4) and 40(1) of the BNB Law); 
·       non-recognition of the role of the ECB and the EU in the collection
of statistics (Article 4(1) and 42 of the BNB Law);
·       non-recognition of the role of the ECB and of the Council in the
appointment of the external auditor (Articles 49(4) of the BNB Law);
·       absence of an obligation to comply with the Eurosystem's regime for
the financial reporting of NCB operations (Article 16(11), 46 and 49 of the BNB
Law).
2.1.5.   Assessment of compatibility
The BNB Law and the Conflict of Interest
Prevention and Ascertainment Act are not fully compatible with Article 131 of
the TFEU as regards central bank independence, the prohibition of monetary
financing and the integration in the ESCB at the time of euro adoption.
2.2.      PRICE STABILITY
2.2.1.   Respect of the reference value
The 12-month average inflation rate, which
is used for the convergence assessment, was below the reference value at the
time of the last convergence assessment of Bulgaria in 2012. Average annual
inflation hovered around 2.5% between mid-2012 and mid-2013, before declining
to 0.4% by end-2013. In April 2014, the reference value was 1.7%, calculated as
the average of the 12-month average inflation rates in Latvia, Portugal and
Ireland plus 1.5 percentage points. The average inflation rate in Bulgaria during the 12 months to April 2014 was -0.8%, i.e. well below the reference value.
It is projected to remain well below the reference value in the months ahead.
2.2.2.   Recent inflation developments
The inflation rate in Bulgaria has fallen
significantly over the past two years, turning negative in the second half of
2013 and first months of 2014. The fall in inflation has been broad-based, but
largely driven by declining import prices as well as the appreciation of
Bulgaria's euro-fixed currency against its main trading partners in the
Balkans, decreases in administratively set energy prices, a good agricultural
harvest that led to lower food prices and weak domestic demand. The decline in
inflation over the past few years has not followed a smooth trend, as a
temporary increase in inflation above the euro area average was recorded in the
second half of 2012.  This was mainly reflecting the volatility in global
commodity prices. However, in addition to import price trends, the sharp
fluctuations in energy prices over 2012-13 were amplified by domestic factors.
Several administratively set energy price components recorded an increase in
2012, at that time coinciding with an upturn in global energy prices. In
contrast, the network charge on electricity was lowered by the government in
2013 in response to public protests against high energy bills. By chance, this
measure coincided with a period of global energy price decline. 
Core inflation (measured as HICP inflation
excluding energy and unprocessed food) declined steadily from somewhat above 1%
recorded in 2012 to -0.4% by the end of 2013 and -1.0% in April 2014. Headline
inflation was above core inflation till mid-2013, when it abruptly fell due to
temporary factors affecting both unprocessed food and energy. The components of
core inflation have trended downwards over the past few years, but especially
from early 2013. This was likely a reflection of both lower import prices
passing through to domestic prices and weak domestic demand, as consumers have
remained cautious in spending, in spite of strong growth in real wages over the
past years. Inflation of non-energy industrial goods continued to fall,
reaching a historically low level of -2.3% in early-2014. Services inflation
fell from over 3% in August 2012 to below -1% by early 2014, partly due to the
pass-through of lower import prices. Negative producer price inflation
confirmed the lack of cost pressures in 2013 and in the first months of 2014.
2.2.3.   Underlying factors and sustainability of inflation
Macroeconomic policy-mix and cyclical stance
The economic recovery has so far been weak
in Bulgaria, with exports rebounding, but domestic demand still sluggish. GDP
growth reached 1.8% in 2011, but has slowed to 0.6% in 2012 before picking up
slightly to 0.9% in 2013. According to the Commission services' 2014 Spring
Forecast, Bulgaria's GDP growth is expected to be more broad-based over
2014-15, with domestic demand forecast to reinforce the export-driven growth
momentum. The purchasing power of households has been buoyed by growth in real
wages in a low-inflation environment and consumer confidence appears to be
gradually firming. GDP growth is forecast to reach 1.7% in 2014 and 2% in 2015.
This relatively modest growth momentum would, however, imply a further slight
widening of the already negative output gap.
The fiscal stance, as measured by changes
in the structural balance, has shifted over recent years, but was overall
rather neutral for inflation. Following three years of strong consolidation,
the fiscal stance has been slightly expansionary in 2013, with some
discretionary expenditure increases after the parliamentary elections.
According to the Commission services' 2014 Spring Forecast, the structural
balance is projected to weaken slightly further in 2014, but to tighten
marginally in 2015. 
In the context of its currency board
arrangement to the euro, most standard monetary policy instruments are not
available to Bulgaria. In response to these limitations, the BNB has taken a conservative
approach towards bank regulation. Credit flow to the economy has remained
overall slightly positive, with modest growth in corporate credit compensating
for a slight decline in household credit. However, the second half of 2013 and
the first months of 2014 have been marked by a deceleration of credit growth.
Both deposit and lending interest rates have continued on a downward trend,
implying a gradual improvement in lending conditions and credit availability.
Nevertheless, credit availability may be limited for those sectors most
affected by the financial crisis as well as some corporate segments with higher
perceived risk, including start-up companies and SMEs. The subdued lending
activity and a risk-averse stance of households, confirmed by the rising
deposit stock, support the present low-inflation environment.
Wages and labour costs
The economic crisis has led to an extended
period of labour market distress, with the first signs of labour market
stabilisation visible only in the second half of 2013. Employment fell by about
2.5% in 2012 and was overall broadly flat in 2013. The unemployment rate peaked
at around 13% in 2013, while the working-age population has also declined due
to ageing and emigration. Despite these factors and wage restraint in the
public sector over 2010-12, nominal wage growth in the private sector remained
relatively high especially over 2009-2011, but has since then strongly
decelerated. The rapid wage growth in the initial crisis years was partly a
reflection of composition effects, continued wage convergence pressures, skills
shortages in some sectors and administrative increases of sectoral and
occupational wage floors. 
Labour productivity grew relatively
strongly between 2010 and 2012, as large cuts in employment boosted output per
employee, while output growth itself was sluggish. This phenomenon ended in
2013 with the stabilization of the labour market. Labour productivity is
projected to increase by around 1.5% in 2014 and 2015. The growth in nominal
unit labour cost (ULC) declined between 2009-2012, but it picked up again in
2013. ULC growth is projected to stabilise at around 2% in 2014-2015, with
upward pressure resulting from expected wage convergence. 
External factors
Given the high openness of the Bulgarian
economy, developments in import prices play an important role in domestic price
formation. Global energy and food prices are the most relevant for inflation,
given their relatively large share in the consumer basket and the high energy
intensity of the Bulgarian economy. Import prices (measured by the imports of
goods deflator), have been volatile over the past few years. Rebounding from
2009 lows, import prices increased markedly in 2010 and 2011. A somewhat lower
increase of about 4% was recorded in 2012, followed by a decline of similar
magnitude in 2013, reflecting lower global energy, food and some raw material
prices. Import prices are expected to continue declining also in 2014 given
i.a. that energy prices are forecast to moderate further over the year. This is
also expected to pass through to lower energy-related inflation. It should be
noted that Bulgaria depends on a single source of gas supply and negotiates gas
prices bilaterally, occasionally diverging from global price trends. 
The nominal effective exchange rate of the
lev (measured against a group of 36 trading partners) remained relatively
stable from early 2009 until late 2012. From November 2012, a noteworthy
appreciation trend can be observed, as some currencies of major trading
partners depreciated against the euro (Turkish Lira, Russian Rouble, Romanian
Leu), which contributed to lower import prices.
Administered prices and taxes
Administered prices ([18]) substantially influenced the consumer price inflation rate in
Bulgaria over the past few years, but indirect tax changes less so. The share
of administered prices in the HICP basket is relatively high in Bulgaria at
around 17%, compared to 13% in the euro area on average. The annual change of
administered prices turned from a 4.9% increase in 2012 to a decline of -1.1%
in 2013 on average, with higher decline in the second half of 2013. The
increase in administered prices in 2012 was most notably related to electricity
prices and to a lesser extent to hospital services. In contrast, responding to
public protests in early 2013 against high energy bills, the government
strongly lowered the administratively set electricity price in several steps in
2013 and the latest decrease took effect on 1 January 2014.
Administratively-set prices of healthcare were lowered, as well. Overall,
administered prices raised headline inflation in 2012 by about 0.5 percentage
points, but lowered it in 2013 by about 0.3 percentage points, albeit more
strongly towards the end of the year.
Indirect tax changes had on aggregate only
a minor effect on inflation over 2012-13. In 2012, a rise in excise duties on
diesel slightly increased energy prices, but on the other hand changes to VAT
legislation applicable to the tourism sector reduced services inflation by
about the same amount. In 2013, excise duties on diesel fuels were raised
again, but were lowered for natural gas used for heating, resulting in an
overall small negative effect on inflation. During the assessment period,
annual constant-tax HICP was on average at the same level as headline
inflation. 
Medium-term prospects
With the fading of base effects from energy
and food prices, inflation is forecast to slowly rebound over the second half
of 2014 to positive territory. The Commission services' 2014 Spring Forecast
expects annual average inflation to reach -0.8% in 2014 and to increase to 1.2%
in 2015, in line with the projected recovery in domestic demand and the
on-going convergence of prices towards the euro area average. 
Risks to the inflation outlook appear
broadly balanced, with the most significant risks related to global energy and
food price developments, given also their relatively large share in the
Bulgarian consumer basket. As a specific inflation risk factor, the
administratively lowered electricity network charges might not be sustainable
in the longer term. However, presently no change in policy has been announced
by the Bulgarian authorities.
The level of consumer prices in Bulgaria was at 47% of the euro area average in 2012. Over the long run, there is
significant potential for further price level convergence, in line with the
expected catching-up of the Bulgarian economy (Bulgaria's income level was at
about 44% of the euro area average in PPS terms in 2012). 
Medium-term inflation prospects will depend
on wage and productivity developments, as well as on global commodity price
trends. A prudent fiscal stance is expected to help contain inflationary
pressures. Tax policy is expected to have only a limited impact on inflation,
as the harmonisation of excise duties on liquid fuels has been finalised and
the excise rate harmonisation for tobacco is scheduled to be spread over
several years.
2.3.      public finances
2.3.1.   Recent
fiscal developments
On 22 June 2012, the Council decided to
abrogate the decision on the existence of an excessive deficit according to
Article 126 (12) TFEU, thereby closing the excessive deficit procedure for
Bulgaria ([19]). The
financial crisis impacted severely on public finances, leading to a budget
deficit of 4.3% of GDP in 2009. This was followed by a period of strong fiscal
consolidation over 2010-12, when the general government deficit declined from
3.1% of GDP to 0.8% of GDP. The improvement in the fiscal balance was largely
due to tight expenditure controls, as reflected in the fall of the
expenditure-to-GDP ratio to below 36% of GDP by 2012. In 2013, the deficit has returned
to 1.5% of GDP.
This was a weaker outcome than that
projected by the Bulgarian authorities in their previous convergence programme
submitted in April 2013, which targeted a deficit of 1.3% of GDP. The
underperformance was due to a combination of lower-than-expected tax revenues
and some expenditure increases. Additional spending was for specific social
programmes and for increasing pensions and wages of some public service
occupations.
Previously, pensions and the aggregate
public sector wage bill were frozen over several years. The above trends in
nominal fiscal deficit are similarly reflected in the estimate of the
structural balance. In structural terms, the deficit is estimated to have
deteriorated by around 0.5 pp. of GDP in 2013, indicating an expansionary
fiscal stance in that year after several years of contraction. 
Bulgaria's public debt is one of the lowest
among the EU Member States and financing conditions have remained favourable.
However, since public finances have been running a deficit since the 2009
economic crisis, the debt-to-GDP ratio has steadily increased from 16.2% in
2010 to 18.9% of GDP in 2013. 
2.3.2.   Medium-term prospects 
The 2014 Budget Law was adopted by
Parliament on 9 December 2013. The budget targets a general government deficit
of 1.8% of GDP in 2014, which would be higher than the outcome in 2013. There
are no major tax rate changes foreseen in the Budget, but the government expects
to boost revenue collection through improving tax collection. The increase of
the deficit is largely explained by a boost to public investment and some
additional expenditure for pensions and social measures.
The Commission services' 2014 Spring
Forecast projects the general government deficit at 1.9% of GDP in 2014,
improving marginally to 1.8% of GDP in 2015.  In structural terms, the deficit
is estimated to weaken slightly in 2014, but a consolidation would be under way
in 2015, based on a no-policy change assumption. The general government gross
debt is forecast to increase from 18.9% in 2013 to about 23% of GDP in 2015.
The 2014 Convergence Programme was
submitted on 17 April 2014. The programme aims at reducing the headline general
government deficit to 0.9% of GDP by the end of the programme period (2017).
The official targets for the general government budget balance have been
marginally revised down compared to the previous years' update, now targeting
-1.8% of GDP in 2014 and -1.5% of GDP in 2015. The small deviation of the
targets for 2014-2015 compared with the Commission services' 2014 Spring
Forecast is mainly due and an assumption of much stronger VAT and personal
income tax collection in 2014, which is, however, partly balanced by also assuming
much stronger investment expenditure growth in the same year.
Further details on the assessment of the
2014 Convergence Programme for Bulgaria can be found in the Commission Staff
Working Document, which accompanies the Commission Recommendation for a Council
Recommendation on the 2014 National Reform Programme of Bulgaria and delivering
a Council Opinion on the 2014 Convergence Programme of Bulgaria.
In March 2012, Bulgaria signed the Treaty
on Stability, Coordination and Governance in the EMU and declared its intension
to comply with the Title III Fiscal Compact already now. This implies an
additional commitment to conduct a stability-oriented and sustainable fiscal
policy. The TSCG will apply to Bulgaria in its entirety upon lifting its
derogation from participation in the single currency.
2.4.      EXCHANGE RATE STABILITY
The Bulgarian lev does not participate in
ERM II. The 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 is obliged to exchange monetary liabilities and euro at the
official exchange rate without any limit. The CBA was instrumental in achieving
macroeconomic stabilisation and serves as a key policy anchor. 
Over the past two years, the CBA operated
in a challenging environment, characterized by weak economic growth, weak
credit flow and contagion risks in the banking sector from Greece. However,
growing exports, strong public finances, an improving external funding position
of the banking sector and sizable reserve buffers have underpinned the
resilience of the CBA.
Bulgaria's
international reserves (around EUR 14 billion) covered around 163% of the
monetary base, about 100% of short-term debt ([20]), 42% of broad money (M3) and about 35% of GDP as of end-2013. A
high reserve coverage was deliberately built into the framework for Bulgaria's CBA, to cater for potential financial sector stress following the 1996-97
crisis.
The government keeps the bulk of its fiscal
reserve deposited in the BNB. International reserves remained rather stable
over the past two years and its fluctuation broadly followed the development of
the government's fiscal reserves and changes in the price of gold. 
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 operation of Bulgaria's CBA. Short-term interest rate differentials vis-à-vis the euro area continued to decrease
over the past two years. The 3-month spread declined gradually from around 200
basis points in spring 2012 to well below 100 basis points by early 2014. On
the other hand, Bulgarian overnight interbank rates were below those of the
euro area. 
2.5.      LONG-TERM INTEREST RATEs
For Bulgaria, the development of long-term
interest rates over the current reference period is assessed on the basis of
secondary market yields on a single benchmark government bond with a residual
maturity of close to but below 10 years.
The Bulgarian 12-month moving average
long-term interest rate relevant for the assessment of the Treaty criterion was
below the reference value at the 2012 convergence assessment. It declined from
above 5% in early 2012 to around 3.5% by mid-2013. In April 2014, the latest
month for which data are available, the reference value, given by the average
of long-term interest rates in Latvia, Portugal and Ireland plus 2 percentage points,
stood at 6.2%. In that month, the twelve-month moving average of the yield on
the Bulgarian benchmark bond stood at 3.5%, i.e. about 2.7 percentage points
below the reference value.
The long-term interest rate of Bulgaria has
been on a gradually declining trend since 2009. Bulgarian benchmark bond yields
fell significantly in the second half of 2012, with the calming of financial
tensions in the euro area, and in Greece in particular. However, 2013 was
characterized by some increase in the long-term interest rate, related to
political uncertainty around the elections in that year and an expected
monetary tightening in the USA. 
Spreads to the Bund declined by almost 200
basis points in the second half of 2012 and fluctuated around 190 basis points
in 2013, as the rise in Bulgaria's long-term interest rate broadly followed
that of Germany. The spread to the German benchmark bond was at around 200
basis points in April 2014 ([21]).
2.6.      ADDITIONAL FACTORS
The Treaty (Article 140 TFEU) calls for an
examination of other factors relevant to economic integration and convergence
to be taken into account in the assessment. The assessment of the additional
factors – including balance of payments developments, product, labour and
financial market integration – gives an important indication of a Member State's ability to integrate into the euro area without difficulties. 
In November 2013, the Commission published
its third Alert Mechanism Report (AMR 2014) ([22]) under the Macroeconomic Imbalance Procedure (MIP - see also Box 1.5). The AMR 2014 scoreboard showed that Bulgaria exceeded the indicative threshold in
two out of eleven indicators, one in the area of external imbalances (i.e. the
net international investment position) and one in the area of internal
imbalances (i.e. the unemployment rate). In line with the conclusion of the AMR
2014, Bulgaria was subject to an in-depth review, which found that Bulgaria
continues to experience macroeconomic imbalances, which require monitoring and
policy action.
2.6.1.   Developments of the balance of payments
Bulgaria's external balance (i.e. the
combined current and capital account) adjusted from high pre-crisis deficits to
close to balance by 2010 and reached a surplus of around 3% of GDP in 2013.
Both goods and services trade performed well, with the traditionally negative
goods balance being partly counterbalanced by the surplus on services. The income
account also improved in 2012, reflecting lower profits on FDI, but this
slightly reversed in 2013. The strongest improvement relative to 2011 came from
current transfers, reflecting an increasing absorption of EU funds and
remittances from Bulgarians working abroad. 
Mirroring the trends of the current
account, the savings-investment gap hovered close to balance from 2010 and rose
to about 2% of GDP in 2013. Gross national savings remained high by historical
standards, as companies continued to undergo balance-sheet adjustments and
households remained cautious in their spending, in spite of increasing incomes.
At the same time, gross fixed capital formation remained subdued as firms and
households have not recovered confidence amid a weak economic recovery.
Capacity utilisation in industry remains below the pre-crisis peak levels.
Competitiveness indicators showed a mixed
picture in the past two years. The ULC-deflated real-effective exchange rate
has appreciated significantly since mid-2012, largely due to the rising NEER.
On the other hand, HICP- and manufacturing sector ULC-based REERs remained more
stable (given that manufacturing sector records lower wage growth than in the
services sector while productivity growth is higher). Bulgaria has had an
improving market performance since the 2008 crisis. After a temporary dip in
2012, this trend resumed in 2013.
Moderate financial account outflows have
continued since 2010. Net FDI inflows have remained positive, but rather
subdued by historical standards since 2009. New investments went mainly to
productive sectors, including automotive and metals manufacturing and energy.
The slump in real estate activity was reflected by a sharp drop in FDI in this
sector. The banking sector has continued to reduce its foreign liabilities and
increased its assets abroad. Net portfolio outflows declined to close to zero
in 2013. Gross external debt declined significantly from around 108% of GDP at
end-2009 to about 94% by end-2013, supported by repayment of foreign debt by
the banking sector and non-financial corporate deleveraging. Similarly, the
improvement in the international investment position was reflected in a
reduction in net external debt, while the FDI stock has remained relatively
stable.
According to the Commission services’ 2014
Spring Forecast, the external surplus is projected to abate to around 2% of GDP
in 2014 and 2015, as a pick-up in domestic demand is expected to drive imports
while export growth remains overall robust. 
2.6.2.   Market integration
The Bulgarian economy is well integrated to
the euro area through trade and investment linkages. As a small open economy,
Bulgaria is characterised by a high ratio of trade openness. During the global
crisis, however, Bulgaria recorded a contraction of trade openness, as external
demand faltered, and both imports and exports contracted in real terms. In
recent years, due to the rebound of global trade, the declining trend in
openness to trade reversed, increasing from a low of 52% in 2009 to some 68% in
2012. 
Bulgaria's export specialisation is focused
on intermediate technology products. A breakdown of exported goods by product
category shows a predominance of labour and raw-material-intensive, low- and
medium-technology goods over high-technology goods. Mineral products (19%),
base metals (18%), and machinery and electrical equipment (14%) are the largest
export sectors in Bulgaria. Despite an increase in the share of high technology
products in exports until 2009 (reaching 4.6% of GDP), the trend seems to have
reversed in recent years, contributing to a high-tech trade deficit (i.e. trade
deficit in high-tech) of -3.8% in 2012.
Bulgaria experienced significant FDI
inflows during the pre-crisis period on account of low labour costs, an
excellent tourism potential and a lower risk perception associated with the
perspective of the country's EU accession. The main recipient sectors of FDI
were services (real estate and business activities, and financial
intermediation), construction and to a lesser extent manufacturing. FDI inflows
reached a high of 29% of GDP in 2007, but dried up considerably during the
global economic downturn, with just 3.7 % of GDP in 2012. However, in
particular due to the high accumulation rate experienced in the years before
the crisis, the FDI stock in Bulgaria is higher than the average for the other
non-euro area Member States. 
After the pre-crisis boom that ended in
2008, house prices in Bulgaria have been declining. The cumulated correction
between 2008 and 2012 reached 42% but the speed of the adjustment has declined
over time. In 2012, the real house price index fell by 7% (compared to 10% in
2011). Building permits fell sharply from 2007 to 2012, accumulating a huge 83%
decline. The latest available figures signal a trend reversal and the number of
authorisations to start building projects increased by 16% in 2013. Employment
and value added in the construction sector have decreased steadily since 2009. 
Concerning the business environment,
Bulgaria performs in general worse than most euro area Member States in
international rankings ([23]). Based on the
World Bank Doing Business indicators, the performance of Bulgaria deteriorated
in 2013 in the areas of starting a business, dealing with construction permits
and registering property, accessing electricity and protecting investors and
managing insolvency. On the other hand, there was a marked improvement in the
indicator related to trading across borders. Public administration as a whole
scores relatively poorly according to the World Bank's Worldwide Governance
Indicators ([24]). According
to the November 2013 Internal Market Scoreboard, Bulgaria had a transposition
deficit (0.6%) close to the 0.5 % target as proposed by the European Commission
in the Single Market Act (2011). 
The experience of 2008-13 shows that the
Bulgarian labour market adjusts to economic shocks by shedding labour rather
than by lowering wages ([25]). This
tendency is not entirely explained by institutional factors. Wage setting
appears relatively flexible in Bulgaria according to most labour market
institutional features (wage bargaining largely at firm level, relatively low
coverage of collective wage agreements, low union density, short duration of
wage bargaining contracts, limited wage indexation). While most institutional
features do not therefore seem to significantly limit labour market adjustment,
an exception appears to be a unique Bulgarian system of minimum social security
thresholds, which set a multitude of wage floors by industry and occupation,
potentially limiting downward wage flexibility in a crisis. 
While the Bulgarian labour market
demonstrated some flexibility during the downturn through shedding labour, it
appears less efficient in post-crisis reallocation and re-employment of labour.
In Bulgaria, active labour market and retraining policies to facilitate the
upgrading of the skills of the unemployed and their transition to new
employment are less developed. The Bulgarian labour market is also
characterised by persistent emigration. According to the National Statistics
Office data, net emigration was especially high during 2009-10, coinciding with
the period of the labour market crisis. However, while emigration was less
pronounced in other periods, it exceeded immigration flows also during the boom
years 2007-08 and since 2011 (last data is available from 2012). This suggests
that emigration is fundamentally driven by the large income gap with the other
EU Member States and domestic labour market cycles only affect the strength of
net emigration. Therefore, it cannot be expected that in Bulgaria cross-border
labour movements would symmetrically facilitate labour market adjustments both
over up- and downturns of the economic cycle.
2.6.3.   Financial market integration
Bulgaria's financial sector is well
integrated with the EU financial sector, in particular through a high level of
foreign ownership in its banking system. The share of foreign-owned
institutions in total bank assets has, however, declined during the crisis,
reaching 73% in 2012, as local banks were more active in the new environment.
Bank concentration, as measured by the market share of the five largest credit
institutions in total assets, has converged to the euro area average since EU
accession.  
Financial intermediation in Bulgaria is
mainly indirect, with domestic bank credit steadily around 70% of GDP since
2011. Rapid credit expansion ended by 2009 as changes in the international financial
environment constrained access to foreign funding and the economy started to
deleverage. The attractiveness of domestic deposit collection increased and
competition among banks led to high deposit rates in some periods. The banking
sector managed to substantially reduce its reliance on external funding. Credit
to the economy by the domestic banking sector has been flat since mid-2012. The
share of foreign-currency loans (predominantly in euro) in total declined
somewhat during the past two years and stood around 72% for non-financial
corporations and 39% for households at the end of 2013. Private sector debt of
132% of GDP in 2012 is somewhat below the euro area average (145% of
GDP) ([26]).
The Bulgarian financial system has proved
resilient to the international financial crisis. No banking system rescue
measure had to be taken by the government. Confidence in the currency board
arrangement is strong and international reserves remained at high level. The
banking system is fairly liquid and well capitalized, with a capital adequacy
ratio of 16.9% at the end of 2013. The quality of the loan portfolio is,
however, still deteriorating, with the share of non-performing loans reaching
16.9% at end-2013, as domestic recovery has been weak. Profitability of the domestic
banking sector has remained positive since EU accession.
The non-banking financial sector remains
underdeveloped relative to the euro area with a relatively small insurance
sector. The financial deepening of capital markets, which progressed
considerably during the economic boom, came to a halt since the financial
crisis. The capitalization of the stock market declined markedly since its
highs of 2007 and was down to less than 13% of GDP in 2013. The debt securities
market remains small in comparison with the euro area average and is mainly
used for financing a part of Bulgaria's relatively low public debt. 
Regulation and supervision of monetary
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, especially from the neighbouring countries. Bulgaria has a good track
record of implementing EU financial services directives.
3.1.      legal
compatibility           
3.1.1.   Introduction
Česká národní banka (ČNB – Czech
national bank) was established on January 1, 1993. Its main legal basis is the
Czech National Council Act No. 6/1993 Coll. on the Czech National Bank, adopted
on 17 December 1992 (the ČNB Law). 
Following the Convergence Report 2012, the
ČNB Law was amended by Law No. 227/2013 Coll. which was adopted on 20 June
2013. However, since there have been only limited amendments as regards the
incompatibilities highlighted in the Commission's 2012 Convergence Report, the
comments made in the latter are largely repeated in this year's assessment. 
3.1.2.   Independence
Article 9(1) of the ČNB Law prohibits
the ČNB and its Board from taking instructions from the President of the
Czech Republic, Parliament, the Government, administrative authorities,
European Union institutions, any government of a Member State of the European
Union or any other body. 
However, according to Article 3 of the
ČNB Law, the ČNB shall submit a report on monetary developments to
the Chamber of Deputies of the Parliament for review at least twice per year.
The Chamber of Deputies may ask for a revised report and in this case, the
ČNB will have to submit a revised version complying with the Chamber of
Deputies' requirements. This power of the Parliament to ask for amendments and,
thus, to influence the content of the ČNB's report on monetary
developments can affect the ČNB's institutional independence. For this reason,
Article 3 contradicts Article 9(1) and is considered as incompatible with
Article 130 of the TFEU and Article 7 of the ESCB/ECB Statute.
Further, Article 9(1) of the ČNB Law
needs to be adapted to fully reflect the provisions of Article 130 of the TFEU
and Article 7 of the Statute and consequently expressly prohibit third parties
from giving instructions to the ČNB and its Board members who are involved
in ESCB-related tasks.
The power for the Chamber of Deputies of
the Parliament to request modifications to the submitted earlier annual
financial report (Article 47(5) of the ČNB Law), could also hamper the
ČNB’s institutional (and possibly financial) independence. Thus, Article
47(5) of the ČNB Law constitutes an additional incompatibility which
should be removed from the Act.
Pursuant to Article 11(1) of the ČNB
Law, the Minister of Finance or another nominated member of the Government may
attend the meetings of the Bank Board in an advisory capacity and may submit
motions for discussion. Article 11(2) entitles the Governor of the ČNB, or
a Vice-Governor nominated by him, to attend the meetings of the Government in
an advisory capacity. With regard to Article 11(1) of the ČNB Law,
although a dialogue between a central bank and third parties is not prohibited
as such, it should be ensured that this dialogue is constructed in such a way
that the Government should not be in a position to influence the central bank
when the latter is adopting decisions for which its independence is protected
by the TFEU. The active participation of the Minister, even without voting
right, to discussions where monetary policy is set would structurally give to
the Government the opportunity to influence the central bank when taking its
key decisions. Therefore, Article 11(1) of the ČNB Law is incompatible
with Article 130 of the TFEU, as Member States have to take undertake not to
seek to influence the members of the decision-making bodies of the national
central bank. 
3.1.3.   Prohibition
of monetary financing
Article 34a(1) first half-sentence of the
ČNB Law prohibits the ČNB from providing overdraft facilities or any
other type of credit facility to the bodies, institutions or other entities of
the European Union, central governments, regional or local authorities or other
bodies governed by public law, other entities governed by public law or public
undertakings of the Member States of the European Union. The list of entities
does not fully mirror the one in Article 123(1) of the TFEU and, therefore, has
to be amended.
Moreover, the footnote in Article 34a(1)
ČNB Law should refer to Article 123(2) of the TFEU instead of globally to
Article 123 of the TFEU.
3.1.4.   Integration
in the ESCB
Objectives
Pursuant to Article 2(1) of the ČNB
Law, "in addition" to the ČNB's primary objective of maintaining
price stability, the ČNB shall work to ensure financial stability and the
safety and sound operation of the financial system and – without prejudice to
its primary objective – support the general economic policies of the Government
and the European Union. Article 2(1) of the ČNB Law needs to be amended
with a view to achieving compatibility with Article 127 TFEU and Article 2 of
the ESCB/ECB Statute. Compatibility with the ESCB's objectives requires a clear
supremacy of the primary objective over any other objective.
Tasks
The incompatibilities in this area,
following the TFEU provisions and ESCB/ECB Statute, include:
·       definition of monetary policy and monetary functions, operations and
instruments of the ECB/ESCB (Articles 2(2)(a), 5(1) and 23 to 26, 28, 29, 32,
33 of the ČNB Law);
·       conduct of exchange rate operations and the definition of exchange
rate policy (Articles 35 and 36 of the ČNB Law);
·       holding and management of foreign reserves (Articles 35(c), 36 and
47a of the ČNB Law);
·       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 of the ČNB
Law);
·       ECB's right to impose sanctions (Article 46a of the ČNB Law).
There are also some imperfections
regarding:
·       the absence of reference of the role of the ECB and of the EU in the
collection of statistics (Article 41);
·       non-recognition of the role of the ECB in the functioning of the
payment systems (Article 38 and 38a of the ČNB Law);
·       non-recognition of the role of the ECB and of the Council in the
appointment of the external audit of the ČNB (Article 48(2) of the
ČNB Law);
·       absence of an obligation to comply with the Eurosystem's regime for
the financial reporting of NCB operations (Article 48 of the ČNB Law);
·       non-recognition of the role of the ECB in the field of international
cooperation (Article 2(3) of the ČNB Law).
3.1.5.   Assessment
of compatibility
As regards the independence of the central
bank, the prohibition of monetary financing and the integration of the central
bank in the ESCB at the time of euro adoption, the ČNB Law is not fully
compatible with the compliance duty under Article 131 of the TFEU.
3.2.      PRICE
STABILITY
3.2.1.   Respect
of the reference value
The 12-month average inflation rate, which
is used for the convergence evaluation, was below the reference value at the
time of the last convergence assessment of the Czech Republic in 2012.
Following an upward trend since mid-2010, it peaked at above 3.5% in late 2012,
before declining gradually close to 1% in early 2014. In April 2014, the
reference value was 1.7%, calculated as the average of the 12-month average
inflation rates in Latvia, Portugal and Ireland plus 1.5 percentage points. The
corresponding inflation rate in the Czech Republic was 0.9%, i.e. 0.8 percentage
points below the reference value. The 12-month average inflation rate is
projected to fall well below the reference value in the months ahead.
3.2.2.   Recent
inflation developments
Annual HICP inflation in the Czech Republic
moved broadly in line with the euro-area average in the period between 2009 and
2011. It increased above the euro-area inflation in 2012, largely due to an
increase in the lower VAT rate while higher energy and food prices in global
commodity markets were also passed through into consumer prices. Despite
another VAT increase in January 2013, price growth significantly moderated
throughout 2013 as pressures stemming from energy prices gradually eased off and
growth in prices of services became subdued. Price developments in the services
sector reflected a sharp fall in prices of communication services and lower
increases in administered prices as compared to previous years. Lack of demand
pressures, reflecting the economic downturn, also contributed to the moderate
price growth. Annual HICP inflation hovered close to 0.3% in early 2014.
Core inflation (measured as HICP inflation
excluding energy and unprocessed food), averaged 1.7% in 2012-2013, reflecting
weak underlying price pressures in the real economy. Higher costs of key
intermediate inputs – energy and food commodities – together with changes in
VAT were the main drivers of price growth in processed food, and in 2012 also
in services. Prices of non-energy industrial goods have followed a declining
trend since 2002 on the back of intensifying competition on final markets and
sustained effectiveness gains on the part of producers of imported goods. In
2012-2013, their negative contribution to core inflation was mitigated by the
above-mentioned increases in indirect taxes and a weaker koruna. In 2012,
headline inflation exceeded core inflation by a wide margin as the hikes in
imported food and energy prices were not fully passed through into core
inflation. Producer price inflation for total industry decreased to 0.8% in
2013, confirming the moderation of cost pressures on the supply side. 
3.2.3.   Underlying
factors and sustainability of inflation
Macroeconomic policy-mix and cyclical stance
Following a moderate recovery in 2010-2011,
real GDP declined again in both 2012 and 2013 largely on account of falling
domestic demand. While private consumption expenditure was negatively affected
by declines in real disposable income of households, gross capital formation
fell due to recurrent cuts in public investment and decreased risk tolerance on
the part of businesses. As these factors gradually eased off, economic growth
resumed in the second quarter of 2013, albeit initially at a modest pace.
According to the Commission services' 2014 Spring Forecast, economic activity,
supported by a brightening outlook for the global economy, is expected to
strengthen, resulting in real GDP growth of 2% in 2014 and 2.4% in 2015. The
Czech economy is estimated to have operated well below its potential since 2009
and the output gap is projected to remain negative even in 2015.
The fiscal stance, as measured by changes
in the structural balance, has been restrictive since 2010. The headline
deficit decreased in 2010 and 2011 on account of improvements in both the
cyclical and structural components. The structural balance continued to improve
in 2012 as further consolidation was pursued, although the headline deficit was
temporarily pushed up by sizeable one-off expenditure measures (in particular
related to the adoption of the law on financial compensations to churches).
Fiscal adjustment in both 2012 and 2013 relied heavily on cuts in public
investment and increases in indirect taxes, which is likely to have accentuated
the economic downturn. Looking ahead, the fiscal stance is expected to loosen
in both 2014 and 2015.
Monetary policy, conducted within an
inflation targeting framework ([27]), was further loosened in 2012 in view of the subdued inflation
outlook and faltering recovery. The ČNB cut its main policy rate (the
2-week repo rate) by a cumulative 70 basis points to its technical 'zero bound'
(0.05%) between June and November 2012. Despite the accommodative monetary
policy stance, credit growth and the inflation outlook remained subdued. Having
fully exploited the interest rate channel, the ČNB began using the
exchange rate as an additional instrument for easing monetary conditions in
November 2013, which is likely to stoke up inflation in 2014.
Wages and labour costs
The labour market showed substantial
flexibility in accommodating lower labour demand during the economic downturn
of 2012 and 2013. Specifically, the rise in unemployment was limited by the
willingness of firms to cut working hours rather than jobs and by a persistent
shift from regular to self-employment. The unemployment rate peaked at 7% in
2012 and started to decline (in seasonally adjusted terms) in the second half
of 2013. Despite the unfavourable economic situation, the number of employed
persons continued to expand at a modest pace, supported by a growing supply of
part-time jobs and rising participation of older workers. Real wages fell in
both 2012 and 2013 as a consequence of modest nominal wage increases in this
period. The Czech population of working age is projected to continue shrinking
in coming years, which is set to weigh on employment growth going forward.
The labour hoarding behaviour on the part
of employers contributed to negative growth in productivity per worker in 2012
and 2013. As nominal compensation per employee continued to rise in 2012,
nominal unit labour costs (ULC) increased. ULC broadly stabilised in 2013 due
to the decline in nominal compensation per employee. This was to a large extent
related to the introduction of a second personal income tax bracket, in
anticipation of which part of compensations was paid out in the fourth quarter
of 2012, before the tax became effective. Labour productivity is expected to
increase again along with the firming economic recovery, thus dampening nominal
ULC growth in 2014 and 2015.
External factors
Given the size and openness of the Czech
economy, import prices have a sizeable effect on domestic price formation.
Import prices (measured by the imports of goods deflator) increased
considerably in 2012, largely on account of higher prices of
internationally-traded commodities, but their growth significantly decelerated
in 2013. As a result, energy and food prices increased significantly in 2012
before moderating by late 2013. The joint contribution of energy prices and
unprocessed food prices to HICP inflation averaged 1.2 percentage points in
2012 and 2013, accounting for about half of the average HICP increase in this
period. The key factor behind the projected increase in import prices in 2014
is a weaker nominal effective exchange rate of the koruna.
Inflationary impulses from the exchange
rate have been moderate up to late 2013. The koruna's nominal effective
exchange rate (measured against a group of 36 trading partners) depreciated by
less than 2% between the first quarter of 2012 and the third quarter of 2013.
However, following the ČNB's decision to intervene on the foreign exchange
market, the NEER dropped by about 6% in late 2013 and then remained broadly
stable in early 2014.
Administered prices and taxes
Changes in administered prices and indirect
taxes have played a significant role in determining headline inflation in
recent years. At the same time, the share of administered prices in the HICP basket
has declined in recent years to below 11% by 2014 ([28]), compared to 13% in the euro area.
Changes in administered prices were a
sizeable driver of inflation in 2012, but their growth moderated in 2013.
Developments in 2012 were affected by the ongoing deregulation of rents, hikes
in heat energy prices and changes in most administrative charges – in
particular in health care – on account of the increase in the lower VAT rate
(see below) and higher input prices of materials.
Similarly, the contribution of indirect
taxes to headline inflation was stronger in 2012 than in 2013 as it was
significantly influenced by changes in the value added tax in both years. While
the lower VAT rate was increased from 10% to 14% in 2012, affecting about a
third of the consumption basket, both VAT rates were raised by 1 pp. to 15%
(the reduced rate) and 21% (the basic rate) respectively in 2013. Another
significant tax change that affected both years concerned the excise duty on
tobacco, the rates of which were harmonised with the minimum rates imposed by
the EU Single Market rules. Constant tax inflation was thus substantially lower
than headline inflation in 2012 and 2013. HICP inflation is not expected to be
significantly affected by further changes in indirect taxes in 2014. 
Medium-term prospects
The fading out of past increases in
indirect taxes together with the large fall in regulated prices of electricity
are expected to keep inflation subdued in 2014. However, inflation is projected
to pick up in the second half of 2014 on account of the significant weakening
of the koruna in late 2013. Stronger domestic demand is then expected to stoke
up inflation in 2015. On this basis, the Commission services' 2014 Spring
forecast projects annual HICP inflation to average 0.8% in 2014 and 1.8% in
2015.
Risks to this inflation outlook are broadly
balanced. The main downside risk stems from weaker-than-expected economic
activity on account of a slower recovery in the euro area and other key trading
partners. On the upside, a stronger-than-expected recovery in domestic demand
would bolster nominal wages, and re-ignite demand pressures. 
The level of consumer prices in the Czech
Republic was at some 71% of the euro-area average in 2012, with the relative
price gap widest for services. This suggests potential for further price level
convergence in the long term. Income convergence has effectively stalled in the
post-crisis period as the income level reached 75% of the euro-area average in
PPS in 2012, compared to 76% in 2007.
Medium-term inflation prospects will
continue to be affected by productivity and wage developments as well as by the
functioning of product markets (e.g. energy and telecommunication prices).
Given the openness of the Czech economy and its limited resource base, commodity
prices and other external price shocks will continue to exercise significant
influence on domestic inflation. 
3.3.      public
finances
3.3.1.   The
excessive deficit procedure for the Czech Republic
On 2 December 2009, the Council decided
that an excessive deficit existed in the Czech Republic in accordance with
Article 126(6) of the Treaty on the Functioning of the European Union (TFEU)
and addressed recommendations to the Czech Republic in accordance with Article
126(7) with a view to bringing an end to the situation of an excessive
government deficit by 2013. In its recommendations, the Council invited the
Czech Republic to ensure an average annual fiscal effort of 1% of GDP over the
period 2010-2013. The Council established the deadline of 2 June 2010 for the
Czech government to take effective action to implement the deficit reducing
measures in 2010 as planned in the draft budget law for 2010 and to outline in
some detail the consolidation strategy that will be necessary to progress
towards the correction of the excessive deficit. On 13 July 2010, the Council
concluded that the Czech authorities had taken effective action to correct the
excessive deficit and that no additional steps in the excessive deficit
procedure were necessary at that stage ([29]). As the headline general government deficit was well below the 3%
of GDP threshold in 2013 and the Commission services' 2014 Spring Forecast
confirmed the durability of the correction, the European Commission is
recommending that the Council abrogate the decision on the existence of an
excessive deficit in the Czech Republic.
3.3.2.   Recent
fiscal developments
The severe economic downturn experienced by
the country in 2009 had a negative effect on public finances and caused the
general government deficit to widen from 2.2% of GDP in 2008 to 5.8% of GDP in
2009. The subsequent period has been marked by continuous efforts to correct
the excessive deficit and to bring public finances back on a more sustainable
path. The cumulative fiscal effort (measured by the change in the structural
balance) in the period from 2010 until 2013 amounted to about 5.5% of GDP. 
While the composition of the consolidation
packages varied from one year to another, two main budgetary items appear to
have driven the overall budgetary adjustment, namely indirect taxes and public
investment. Within the category of indirect taxes, both excise duties and VAT
were increased several times with an estimated cumulative fiscal impact of
almost 1.8% of GDP in the period 2010-2013. VAT rates increased from 5% and 19%
in 2010 to the current 15% and 21%. The sharp drop in public investment
averaged more than 13% annually over the period 2010-2013. The consolidation effort
affected also other expenditure and revenue categories, such as social
benefits, the public sector wage bill, intermediate consumption and the social
security contributions, albeit to a lesser degree. 
The general government deficit in 2013
reached 1.5% of GDP. This outcome was underpinned by consolidation measures of
0.7 pp. of GDP, of which about two thirds fall on the revenue side. The main
measures included increases in both the reduced and standard VAT rate by 1 pp.
and a lower indexation of pensions. A public investment retrenchment of 12%
year-on-year as well as higher property income reflecting strong performance of
some state-controlled companies were
also important factors contributing to the reduction of the headline deficit.
The revenue-to-GDP ratio increased by 0.6 pp. to 40.9% of GDP while the
expenditure-to-GDP ratio fell by 2.1 pp. to 42.4 % of GDP.
While still well below the 60% of GDP
threshold, the debt ratio increased from 38.4% of GDP in 2010 to 46% of GDP in
2013, mainly on account of high government deficits. 
3.3.3.   Medium-term
prospects
The budget for 2014 was adopted by the
Parliament on 19 December 2013. According to the Commission services' 2014
Spring Forecast, the general government deficit is expected to increase to 1.9%
of GDP in 2014 in an environment of improving macroeconomic conditions.
Government consumption is set to exhibit a relatively strong growth on account
of the planned increase in the public sector wage bill and in intermediate
consumption (total fiscal impact of approximately 0.2% of GDP). The forecast
also factors in a sharp increase in public investment as a strong rebound is
expected in EU-financed investment projects. The main deficit-reducing measures
include an increase in excise duties and one-off revenue from the sale of newly
released frequency ranges. Overall, total government expenditure will remain
broadly in line with nominal GDP growth. The revenue-to-GDP ratio is projected
to drop by 0.3 pp. to 40.6%. The structural balance is forecast to deteriorate
by about 1.1 pp. of GDP in the context of a narrowing output gap.
On unchanged policies, the headline deficit
is expected to widen to 2.4% of GDP in 2015 and the structural deficit is
forecast to deteriorate further to 1.9% of GDP. The debt-to-GDP ratio is
projected to remain broadly stable over the forecast horizon reaching 45.8% in
2015.
The 2014 Convergence Programme, covering
the period 2014-2017, was submitted by the Czech authorities on 28 April 2014.
The main goal of the programme´s budgetary strategy is to keep the general
government deficit below the 3% of GDP reference value in 2014-2017. The
recalculated structural balance is expected to reach -1% of GDP in 2014
according to the programme, implying that the Czech Republic should reach its MTO
this year. Following an overall assessment of the Czech Republic's budgetary
plans, with the structural balance as a reference, including an analysis of
expenditure net of discretionary revenue measures, there is a risk that the
structural deficit will exceed the MTO in 2015.
Further details on the assessment of the
2014 Convergence Programme for the Czech Republic can be found in the
Commission Staff Working Document, which accompanies the Commission
Recommendation for a Council Recommendation on the 2014 National Reform
Programme of the Czech Republic and delivering a Council Opinion on the 2014
Convergence Programme of the Czech Republic.
The Czech Republic has not signed the
Treaty on Stability, Coordination and Governance in the EMU by the time of this
assessment. 
3.4.      EXCHANGE
RATE STABILITY
The Czech koruna does not participate in
ERM II. Since the late 1990's, the ČNB has been operating under an
explicit inflation targeting framework combined with a floating exchange rate
regime, allowing for foreign exchange market interventions by the central bank.
The exchange rate of the koruna against the
euro experienced a prolonged nominal appreciation in the period following EU
accession, amid significant capital inflows that supported a sustained economic
catching-up. After reaching an all-time-high against the euro in mid-2008, the
koruna's exchange rate weakened considerably during the global financial crisis
in late 2008 and early 2009. The koruna recovered partly during 2009 and then
remained broadly stable, predominantly trading between 24 and 26 CZK/EUR from
early 2010 until late 2013.
On 7 November 2013, the ČNB began
using the exchange rate as an additional instrument for easing monetary
conditions in view of projected price developments indicating an undershooting
of the inflation target for a protracted period of time. The ČNB announced
that it would intervene on the foreign exchange market to weaken the koruna, so
that its exchange rate against the euro was close to 27, and clarified that it
regarded this commitment as one-sided, allowing the exchange rate to float
freely on the weaker side of this level. The announcement and initial market
interventions proved to be effective as the koruna swiftly weakened from below
26 CZK/EUR to above 27 CZK/EUR and then continued to trade close to 27.4 CZK/EUR
in early 2014. During the two years before this assessment, the koruna
depreciated against the euro by almost 11%. 
International reserves increased to about
EUR 34 billion in the fourth quarter of 2012 and then remained broadly stable
for three quarters. The reserve level jumped up to above EUR 40 billion (27% of
GDP) in late 2013, largely as a result of the ČNB's foreign exchange
market interventions.
After having increased during the global
financial crisis, the 3-month interest rate differential against the euro
declined gradually in late 2009 and throughout 2010, partly reflecting the cuts
in policy rates of the ČNB. Short-term interest rate spreads vis-à-vis the
euro area turned negative in 2011 as the ECB temporarily tightened its policy
stance, but returned to positive territory in 2012 following rate cuts and
massive liquidity injections through 3-year long-term refinancing operations in
the euro area. The 3-month interest rate differential declined to below 50
basis points in late 2012 as the ČNB cut its key policy rate to 0.05% in
November 2012 and then continued to further converge to zero during 2013 and in
early 2014. At the cut-off date of this report, the 3-month spread vis-à-vis the
euro area was just some 4 basis points. 
3.5.      LONG-TERM
INTEREST RATEs
Long-term interest rates in the Czech
Republic used for the convergence examination reflect secondary market yields
on a single benchmark government bond with a residual maturity of about 10
years. 
The Czech 12-month average long-term
interest rate relevant for the assessment of the Treaty criterion was below the
reference value at the time of the last convergence assessment of the Czech
Republic in 2012. It peaked in the aftermath of the global financial crisis at
4.9% in late 2009 and then declined gradually to 2.1% by mid-2013. It increased
somewhat in early 2014. In April 2014, the latest month for which data are
available, the reference value, given by the average of long-term interest
rates in Latvia, Portugal and Ireland plus 2 percentage points, stood at 6.2%.
In that month, the 12-month moving average of the yield on the Czech benchmark
bonds stood at 2.2%, i.e. 4 percentage points below the reference value. 
After the global financial crisis,
long-term interest rates in the Czech Republic followed a protracted downward
trend, declining from above 5% in mid-2009 to below to below 2% in late 2012.
At the same time, the spread against the German long-term benchmark bond narrowed
to below 100 basis points, reflecting the ČNB's policy rate cuts as well
as the gradual stabilisation in euro-area financial markets. Long-term spreads
remained broadly stable in 2013, oscillating around 50 basis points, as yields
increased somewhat in both the Czech Republic and Germany. The spread against
the German benchmark bond widened to about 70 basis points in early 2014 ([30]).
3.6.      ADDITIONAL
FACTORS
The Treaty (Article 140 TFEU) calls for an
examination of other factors relevant to economic integration and convergence
to be taken into account in the assessment. The assessment of the additional
factors – including balance of payments developments, product and financial market
integration – gives an important indication of a Member State's ability to
integrate into the euro area without difficulties. 
In November 2013, the Commission published
its third Alert Mechanism Report (AMR 2014) ([31]) under the Macroeconomic Imbalance Procedure (MIP - see also Box
1.5). The AMR 2014 scoreboard showed that that the Czech Republic exceeded the
indicative threshold in one out of eleven indicators, i.e. the net
international investment position. In line with the conclusions of the AMRs
2012-14, the Czech Republic has not been subject to in-depth reviews in the
context of the MIP.
3.6.1.   Developments
of the balance of payments
The Czech Republic’s external balance (i.e.
the combined current and capital account) gradually improved from a deficit of
above 3% of GDP in 2010 to a surplus of 0.5% of GDP in 2013. The adjustment was
mostly on account of growing surpluses in the merchandise trade balance as
imports (dampened by weak domestic demand) slowed down faster than exports. In
contrast, trade in services recorded only a moderate surplus of around 1.5% of
GDP on average in 2011-2013, falling short of the levels reached in previous
years. Favourable developments in the trade balance were partly offset by
deficits in the income balance, which continued to burden the current account
as net income transfers reached a new low of -8% of GDP in 2013. The external
balance was also supported by the increased capital account surplus. 
In terms of the savings-investment balance,
the improvement in the external account over 2012-2013 was aligned with lower
borrowing needs of the general government. Overall, gross capital formation
declined from almost 25% of GDP in 2010 to some 22% of GDP in 2013, while
savings hovered around 21% of GDP over 2011-13. The saving-investment gap of
the private sector remained broadly unchanged (as a percentage of GDP), but its
structure was impacted by the 2012-2013 economic downturn. Households, facing
reductions in their real spending power, reduced investment purchases while savings
of non-financial corporations were constrained by their falling gross operating
surplus.
Export performance deteriorated somewhat in
2013 after having improved for more than a decade. This was partly due to
one-off factors such as a sizeable fall in revenue from tourism and in exports
of computers and electronics, while the pace of exports to non-EU markets
slowed down considerably as well. External price and cost competitiveness, as measured
by the ULC- and HICP-deflated real effective exchange rates, improved
considerably in late 2013, reflecting a substantial NEER depreciation.
Mirroring the improvement in the external
balance, the financial account balance turned negative in 2012 and then
remained broadly stable in 2013. The net inflow of FDI remained positive, but
diminished in 2013 largely on account of outflows of foreign funds from
domestic non-financial corporations. The net portfolio inflows, which turned
into a surplus in the aftermath of the 2008 crisis, also remained positive,
increasing to almost 2.5% of GDP in 2013. The largest adjustment was recorded
in other investment flows and international reserves, which mainly reflected
foreign exchange operations of the ČNB in late 2013. Gross external debt
increased gradually to 54% of GDP in 2013. Nevertheless, the net international
investment position improved somewhat in 2013.
According to the Commission services' 2014
Spring Forecast, the external balance is expected to continue increasing in
2014-2015 as the export performance should be supported by favourable external
environment. 
3.6.2.   Market
integration
The Czech economy is highly integrated into
the euro-area through trade and investment linkages. Trade openness of the
Czech Republic remains very high. Although it declined markedly during the
global crisis, it rebounded in recent years to reach 75% of GDP in 2012.
Trade is predominantly conducted with the
neighbouring euro-area Member States, also in relation to their significant
foreign direct investment presence. The share of intra-euro-area trade in goods
expressed in percentage of GDP is high and has been further increasing in
recent years, reaching almost 48% in 2013. The evolution of Czech exports was
mainly driven by a few sectors over the past years, namely machinery and
electrical equipment (37% of overall exports), vehicles, aircraft, vessels
(18%) and metals (10%). A rising share of high-technology products in total
exports, combined with a high-tech trade deficit that closes only gradually,
points to the significance of outward processing trade. Exports of
high-technology products have increased over the past years (e.g. computers),
but the technologically more advanced components are produced abroad.
The Czech Republic has attracted a high
share of FDI in the tradable sector thanks to its geographical proximity to EU
core markets, relatively good infrastructure and highly educated labour force.
FDI inflows mainly originate in the EU, with the Netherlands, Germany, and
Austria accounting for more than two thirds of the total stock. From a sectoral
perspective, FDI was directed mainly to a few sectors, namely automotive, real
estate, finance and insurance (accounting for more than 50% of the total
stock). Recently, an increase of FDI in the renewable energy sector has been
evident.
Since 2008, house prices in the Czech
Republic have followed a declining trend, with the cumulated fall in the
2008-2012 period amounting to 10%. In 2012, the deflated house price index
decreased by 4%. Between 2008 and 2012, the number of authorisations to start
work on building projects declined by 47%, which was nonetheless lower than the
fall experienced at EU-28 level. Despite the evolution of building licenses,
residential investment has remained broadly stable at around 4% of GDP in the
past years. The share of employment in the construction sector has also
remained unchanged at around 9%. On the other hand, value added in the
construction sector has fallen by 11% since 2009 (in real terms).
As far as the business environment is
concerned, the Czech Republic has experienced a deterioration of the scores
received in international rankings in recent years which thus remain in general
worse than for most euro-area Member States ([32]). In particular, the Czech Republic performs poorly on protecting
investors, suffers from high tax compliance costs and there is also a scope for
improvement in obtaining construction permits. According to the 2013 Internal
Market Scoreboard, the Czech Republic reduced its deficit in the transposition
of EU directives to a record low of 0.2% in 2012. An amendment to the Public
Procurement Act was adopted in late 2013. The new amendment appears to go
against the changes adopted in 2012 by removing some of the transparency
safeguards and loosening the public procurement rules.
Since protection of permanent employees
against collective and individual dismissals is relatively strict (above the
euro-area-OECD countries' average according to the 2013 OECD employment
protection indicator), companies prefer adjusting wages and working hours to
downsizing in case of a moderate distress. Net migration flows have not been
significant in recent years, with the exception of pre-crisis years 2007-08,
when considerable net immigration was registered.
3.6.3.   Financial
market integration
The Czech financial sector remains highly
integrated into the EU financial sector. The main channel of integration is
through a high degree of foreign ownership of financial intermediaries. The
Czech banks, of which around 90% belong to foreign groups, operate a
conservative retail-orientated business model. Bank concentration, as measured
by the market share of the largest five credit institutions in total assets,
remained above the euro-area average over the past years, but it has fallen by
4 percentage points since 2010.
By end-2013, the total assets held by the
banking sector accounted for almost 128% of GDP. Loans constitute about 60% of
total bank assets. While credit to non-financial companies remained just above
21% of GDP between 2007 and 2013, loans to households grew from 20% to 30% of
GDP over the same time period. As a result, the level of private sector
debt ([33]) increased
from 61% of GDP in 2007 to 72% of GDP in 2012, remaining significantly below
the euro-area average of 145%. On the other hand, deposits account for some 69%
of banking sector liabilities. Czech banks thus act as net creditors to their
foreign parents, a distinguishing feature within the region.
The capital adequacy of banks measured by
standard regulatory ratios is somewhat higher than in the euro area. The
average capital adequacy ratio stood at 16.6% in June 2013. Non-performing
loans (6.7% in June 2013) are some 1.5 percentage points above the euro-area
average. Profitability has held up remarkably well during the financial crisis.
In June 2013, the average return on equity (RoE) amounted to 15.4%, more than
three times the euro-area average and only 3 percentage points below the
end-2007 RoE. A conservative business model and low funding costs have helped
to preserve the high profitability of Czech banks.  
Similarly to most regional peers, the Czech
financial system remains heavily bank-based, with banks holding about three
quarters of its total assets under their management. The remaining quarter is
equally shared between the insurance sector, including the pension schemes, and
other financial intermediaries, including auxiliaries.
The Prague Stock exchange enjoys strong
ties with the Vienna, Budapest and Ljubljana stock exchanges as the CEE Stock
Exchange Group holds a controlling stake in all four of these stock exchanges.
Prague's stock market capitalisation stood at 15% of GDP by end-2013, which was
about half of its 2007 level and far below the euro-area average of 74%. The
total amount of outstanding debt securities increased by about 50% between 2007
and 2013 and amounted to some two thirds of Czech GDP by end-2013. As far as
its composition is concerned, some 63% was issued by government institutions,
22% by banks, 13% by non-financial corporations and 2% by insurance companies. 
Since 1993 the Czech National Bank
supervises the financial market in the Czech Republic. It regulates and
enforces the rules for the banking sector including credit unions, the capital
market, the insurance and pension-savings industry. The Czech Republic has
implemented all EU financial services directives. The implementation of the
last two, the prospectus directive and the alternative investment fund managers
directive (AIFMD), is currently being examined by the Commission services.
4.1.      Legal
compatibility
4.1.1.   Introduction
The main legal rules governing the Croatian
National Bank (Hrvatska Narodna Bank – HNB) are laid down in Article 53 of the
Constitution of the Republic of Croatia  ([34]) and the Act on the Croatian National Bank ([35]). The Act was amended in 2013 with a view to Croatia entering the
European Union on 1 July 2013. The Act provides for specific rules applying to
the HNB as of EU accession of Croatia and a specific chapter for rules applying
to the HNB as of the moment the euro becomes the official currency of the
Republic.
4.1.2.   Central
bank independence
The principle of independence of the HNB is
laid down in Article 53 of the Constitution and in Articles 2 (2) and 71 of the
Act. Article 71 of the Act contains a specific reference to the principle of
Central Bank independence as enshrined in the Treaty, stating that the HNB
shall be independent in achieving its objective and carrying out its tasks
under the Act in accordance with Article 130 of the TFEU. As regards the rules
on a possible removal of the HNB Governor from office, Article 81 of the Act
makes a specific reference to the relevant wording of Article 14 (2) of the Statute.
No incompatibilities and imperfections
exist in this area.
4.1.3.   Prohibition
of monetary financing and privileged access
No incompatibilities and imperfections
exist in this area. The rules on prohibition of lending to the public sector
pursuant to Article 78 of the Act include a specific reference to the
prohibition of monetary financing as laid down in Article 123 of the TFEU.
4.1.4.   Integration
in the ESCB
Objectives
The objectives of the HNB are laid down in
Articles 3 and 72 of the Act and are fully compatible with the objectives
applying to the European System of Central Banks pursuant to Article 127 of the
TFEU.
Tasks
The provisions under chapter VIII of the
Act define the tasks the HNB has to carry out as integral part of the European
System of Central Banks pursuant to the rules of the TFEU and the Statute. No
incompatibilities exist with regard to these tasks. The Commission understands
that the competence of the HNB Council to decide on the HNB's membership in
international institutions pursuant to Article 104 (11) of the HNB Act is
without prejudice to the ECB's powers in the field of international cooperation
involving tasks entrusted to the ESCB under Article 6.1 of the Statute.
4.1.5.   Assessment
of compatibility
The Constitution and the Act on the
Croatian National Bank are fully compatible with Articles 130 and 131 of the
TFEU.
4.2.      PRICE
STABILITY
4.2.1.   Respect
of the reference value
The 12-month average inflation rate, which
is used for the convergence assessment, increased from slightly above 2% in
early 2012 to 4% in April 2013, but has declined strongly thereafter. In April
2014, the reference value was 1.7%, calculated as the average of the 12-month
average inflation rates in Latvia, Portugal and Ireland plus 1.5 percentage
points. The average inflation rate in Croatia during the 12 months to April
2014 was 1.1%, i.e. 0.6 percentage point below the reference value. It is
projected to remain below the reference value in the months ahead.
4.2.2.   Recent
inflation developments
Inflation in Croatia has fluctuated over
the past two years, reflecting mainly cost pressures, such as volatile energy
and food prices, combined with increases in administered prices and indirect
taxes, while demand-side pressures have remained low. With energy and food
products accounting for close to half of the consumption basket, annual
inflation exceeded 4% during the second half of 2012 and remained relatively
high until early 2013.  Inflation slowed down significantly from spring 2013 as
global energy price pressures and the impact of earlier hikes in administered
prices gradually faded and disinflationary effects from the protracted
recession more than offset increases in indirect taxes. From October 2013,
declining electricity prices due to market liberalisation further contributed
to the slowdown in inflation. Annual inflation turned slightly negative in
spring 2014.
After following a gradual upward trend from
mid-2012 to early 2013, core inflation (measured as HICP inflation excluding
energy and unprocessed food) declined from autumn 2013, falling about 2
percentage points to below 1% by early 2014. The increase in core inflation
until early 2013 was mainly driven by processed food prices, but mitigated to
some extent by the slowdown of inflation of non-energy industrial goods. From
autumn 2013, pressures from processed food and services prices receded, driving
down core inflation to 0.5% in April 2014. Over the past two years, core
inflation was on average 1 percentage point below headline inflation,
reflecting the impact of global energy prices, combined with changes in
administered prices and taxes. By contrast, headline inflation fell below core
inflation from the second half of 2013. Producer price inflation (total
industry) dropped significantly, to -3% at year-end 2013 from 7% a year
earlier, confirming the decrease in price pressures. 
4.2.3.   Underlying
factors and sustainability of inflation
Macroeconomic policy-mix and cyclical stance
The global financial crisis halted
Croatia's credit-driven growth model and exposed deep-rooted structural
problems, including an uncompetitive tradable sector and a significant private
debt overhang. Economic activity contracted during 2012-2013, extending the
recession to five years and the cumulative decline in output to 12%. The latter
is mostly attributable to a contraction in domestic demand. Net exports
contributed positively to GDP growth, reflecting ongoing compression of
imports. The Commission services' 2014 Spring Forecast projects real GDP to
decline by 0.6% in 2014, also reflecting the impact of fiscal consolidation,
before expanding by 0.7% in 2015. Croatia's economy is estimated to have
operated well below potential since 2009. 
The fiscal stance, as measured by changes
in the structural balance, appears to have been restrictive in 2012 and 2013.
However, given the protracted recession, estimates of the structural balance
are surrounded by substantial uncertainties. In addition, specific transactions
such as the assumption of debt of some public and state-owned enterprises (e.g.
shipyards) affected the structural deficit in 2010 and 2011, since, although
exceptional, they were not considered as one-offs. Nevertheless, the
estimations suggest that the structural deficit remained large, at 3.5% in
2013. Fiscal consolidation measures, as defined in the March revision of the
2014 budget, and an additional package of measures in April, are expected to
contribute to its gradual narrowing to 2.3% by 2015.
The HNB maintains an accommodative monetary
policy stance, with continued high liquidity provision to the banking sector.
Tight macro-prudential policies in the past have built high reserve and liquidity
buffers in the financial system, some of which were gradually released in the
course of the crisis. However, the high degree of financial euroisation
constrains the scope of domestic monetary policy, while its effectiveness is
limited by the shallow domestic money market and relatively high concentration
in the banking sector. The transmission of the historically low short-term
rates to lending rates has been limited so far, in particular for longer-term
loans. Nevertheless, supply does not appear to be the main constraint to
credit, as the largest banks have comfortable levels of capital and liquidity.
Demand for loans is weak because of high indebtedness and deleveraging needs of
the private sector. This has resulted in a slight contraction of credit to the
private sector since mid-2012.
Wages and labour costs
The protracted recession has taken a toll
on the labour market. Employment dropped by 13% in the period 2008-2013 and the
unemployment rate doubled to above 17%. Job losses were most pronounced in the
manufacturing sector, construction and trade, while the lack of adjustment in
the public sector and the slow process of restructuring of state-owned
companies may have dampened the decrease in employment. Growth in nominal gross
wages decreased with the onset of the crisis to 2.3% on average since 2009.
Real wages stagnated during five consecutive years.
Labour productivity grew on average close
to 2% annually during 2010-2013 as a result of the decrease in employment.
Nominal unit labour costs (ULC) increased moderately at 0.4% on average over
the same period. Looking ahead, ULC growth is expected to remain contained. 
External factors
Inflation developments in Croatia are
sensitive to external price developments, due to the small size of the economy
with limited diversity in domestic production and a strong dependency on
imports. The high share of energy and food products in the consumption basket
implies a particularly high vulnerability to fluctuations in global commodity
prices. Import prices (measured by the imports of goods deflator), rose
markedly in 2012, but grew at a much slower pace during 2013, contributing to
the disinflationary trend. Import prices developed broadly in line with
inflation in the euro area, which supplies the bulk of imported goods.
The nominal-effective exchange rate (NEER)
of the kuna (measured against a group of 36 trading partners) has appreciated
by about 1% during the past two years. A marginal nominal depreciation against
the euro was counterbalanced by a strengthening against the US dollar, the
Russian rouble and the Chinese yuan – the currencies of Croatia's most
important non-euro-area trading partners. The temporary increase of the NEER
during summer 2013 was related to the strong tourism season. Exchange rate
fluctuations over the past two years appear to have been too small to have
exerted a significant impact on prices. However, the temporary depreciation of
the kuna against the US dollar in mid-2012 contributed to the increase in
energy prices at that time.
Administered prices and taxes
Eurostat has not yet published a list of
administered prices in Croatia according to the common EU methodology. However,
in 2012 and 2013, there were changes in some prices of goods and services that
could be considered as administered. During the first half of 2012, prices were
raised for utilities such as electricity, gas and water supply and some other
communal services, notably public transportation and heating. The fading out of
the impact of these changes contributed to lower inflation in 2013. 
The most important change to indirect taxes
was the increase in the standard VAT rate from 23% to 25% in March 2013.
Further changes were introduced from January 2014, when the intermediate rate
was increased from 10% to 13%. In line with tax harmonisation requirements
within the EU, but also due to the need to increase budget revenues, there were
some changes in excise taxes. The tax on tobacco was raised in November 2012
and in June 2013. Excises on motor fuels were gradually increased in 2012-2014,
while excises on motor vehicles were lowered for the more
environmentally-friendly cars in 2013. Eurostat's constant-tax inflation
measure (HICP-CT) is not yet available for Croatia. 
Medium-term prospects 
HICP inflation is expected to remain low in
the context of weak domestic demand, unfavourable labour market developments
and high deleveraging needs of the private and the public sector. Wage growth
will likely remain subdued in view of the need to increase export
competitiveness, further reducing cost price pressures. The Commission
services' 2014 Spring Forecast projects the average HICP inflation rate to fall
to 0.8% in 2014, before increasing slightly to 1.2% in 2015. 
Risks to the inflation outlook are slightly
on the downside. Disinflationary pressures could emerge from protracted weak
labour market developments if the recovery turns out weaker than expected.
Private sector deleveraging could also remain a stronger drag. The main upside
risk is a shock to global commodity prices, to which Croatia is particularly
exposed. The impact of the expected fiscal consolidation is ambiguous: while
further increases in indirect taxes and administrative prices imply upside
risks, expenditure cuts may have disinflationary effects through further
reducing private demand. 
In Croatia, the level of consumer prices
stood at 69% of the euro-area average in 2012. This suggests potential for
further price level convergence in the long term, as income levels (around 57%
of the euro-area average in PPS in 2012) rise towards the euro-area average. 
Medium-term inflation prospects will depend
on wage cost and import price dynamics, also in relation to the extent of spare
capacity in the economy. Efforts to increase productivity and employment in the
tradable sector will be important in determining the outcome. Failure to
improve competitiveness and engineer a rebalancing of the economy towards more
export-driven growth, while reducing the overall level of indebtedness, may
imply weak economic prospects and subdued inflation in the medium-term. High
foreign exchange exposure of the public and the private sector and the
commitment to avoid excessive exchange rate volatility determine the central
bank's room for manoeuvre.
4.3.      public
finances
4.3.1.   The
excessive deficit procedure for Croatia 
On 28 January 2014, the European Council
decided that an excessive deficit existed in Croatia in accordance with Article
126(6) of the Treaty on the Functioning of the European Union (TFEU). The
Council issued a set of recommendations to Croatia in accordance with Article
126(7) TFEU with a view to bringing to an end the situation of an excessive
deficit by 2016. In particular, the Council invited the Croatian authorities to
gradually reduce the general government deficit to 4.6%, 3.5% and 2.7% of GDP
in 2014, 2015, and 2016, respectively, consistent with an annual improvement in
the structural balance of 0.5%, 0.9% and 0.7% of GDP, respectively, in the
three years. The Council established the deadline of 30 April 2014 for
effective action to be taken. 
To limit risks to the adjustment, Croatia
was recommended to (i) carry out a thorough expenditure review with the
objective to rationalise wage, social security and subsidy outlays and to
provide sufficient fiscal space for the implementation of growth-enhancing
expenditure, including co-financing of EU-funded projects; (ii) further improve
tax compliance and increase the efficiency of tax administration; and (iii)
improve the institutional framework for public finances, including through
enhancing multi-annual budgetary programming, strengthening the role and
independence of the Fiscal Policy Committee, and ensuring compliance with
fiscal rules. In addition, the Council invited the Croatian authorities to
implement structural reforms, notably addressing labour market rigidities and
an unfavourable business environment and improving the quality of public
administration, with a view to raising potential GDP growth.
4.3.2.   Recent
fiscal developments
Croatia’s fiscal situation deteriorated
rapidly with the onset of the global financial crisis, as cyclical factors
interacted with entrenched structural weaknesses. Declining revenues and the
lack of more decisive corrective reaction by the authorities determined
subsequent adverse trends in the public deficit and debt. Recurrent assumptions
by the government of debt of SOEs, such as the now privatised shipyards, also
added to the general government deficit and debt. The deficit peaked at 7.8% of
GDP in 2011, came down to 5% of GDP in 2012 and remained at that level in 2013.
In 2013 the government revised the budget
twice, in April and December, responding to higher expenditures relative to
plan and unexpected revenue shortfalls. In particular, corporate income tax
receipts came in weaker than expected after the introduction of a tax break on
reinvested profits. Revenues were also adversely impacted by the change in the
VAT collection system, in the context of entering the customs union. 
Meanwhile, total expenditures increased, chiefly due to higher social expenditures,
including a 1%-of-GDP clearance of arrears of the health sector, and growing
interest expenditures. 
The expenditure-to-GDP ratio peaked at
above 48% in 2011, before declining to below 46% in 2012-2013. The
revenue-to-GDP ratio increased slightly during the past two years, from above
40% in 2011 to 41% in 2013. 
Public debt surpassed 67% of GDP in 2013,
up from 56% of GDP 2012 and 37% of GDP in 2009. Debt dynamics reflected
persistently high budget deficits, coupled with weak economic activity and some
calling of guarantees. In 2013, the debt level was also affected by the bond
issuance in the U.S. market in November to pre-finance debt roll-over needs in
early 2014. 
4.3.3.   Medium-term
prospects
The 2014 Budget Law was adopted by
Parliament on 4 December 2013, targeting a general government deficit of 5.5%
of GDP according to the national methodology ([36]). The main measures on the revenue side were an increase in the
intermediate VAT rate from 10% to 13% and a further alignment of the tobacco
excise tax. In response to the recommendations by the Council with a view to
correcting the excessive deficit, the Parliament passed a budget amendment in
March 2014, with consolidation measures totalling close to 2% of GDP, at face
value, in 2014. The measures are distributed roughly half-half between the
revenue and expenditure sides. An additional set of measures amounting to 0.4%
of GDP was endorsed in April 2014. 
The Commission services' 2014 Spring
Forecast, which takes into account the amended budget and additional measures,
projects the general government deficit to decline to 3.8% of GDP in 2014 and
3.1% of GDP in 2015 (according to ESA 95 standards). The cumulative change
in the structural balance in 2014 and 2015, as compared to 2013, is estimated
at 1.2 percentage points. General government gross debt is forecast to increase
from about 67% of GDP in 2013 to above 69% of GDP in 2015.   
The 2014 Convergence Programme was
submitted on 24 April 2014. It confirms the government's commitment to reduce
the deficit to below 3% of GDP by 2016, as recommended by the Council. In
particular, the general government deficit is targeted to gradually decline
from 4.9% of GDP in 2013 to 2.5% of GDP in 2017. The deviation of the targets
for 2014-2015 compared to the projections in the Commission services' 2014
Spring Forecast is mainly a consequence of the more favourable macroeconomic
scenario underlying the Programme and a different assessment of the envisaged
measures and their estimated impact. 
Further details on the assessment of the
2014 Convergence Programme for Croatia can be found in the Commission Staff
Working Document, which accompanies the Commission Recommendation for a Council
Recommendation on the 2014 National Reform Programme of Croatia and delivering
a Council Opinion on the 2014 Convergence Programme of Croatia.
Croatia has not signed the Treaty on
Stability, Coordination and Governance in the EMU by the time of this assessment.
4.4.      EXCHANGE
RATE STABILITY
The Croatian kuna does not participate in
ERM II. The HNB conducts its monetary policy within a flexible inflation
targeting regime with the exchange rate as the main nominal anchor to achieve
the price stability objective. Maintaining a broadly stable exchange rate of
the kuna against the euro is also important from a financial stability
perspective, given the high degree of balance sheet euroisation of both the
public and private sectors. The exchange rate regime can be characterised as a
tightly-managed float. The HNB does not defend a target rate or band for the
kuna's exchange rate against the euro, but aims to counter excess volatility.
The HNB has also not announced a numerical inflation target, which allows a higher
degree of discretion in conducting monetary policy, including with a view to
maintaining the overall stability of the financial system.
The kuna's exchange has remained broadly
stable over the past two years, with movements between 7.4 and 7.7 against the
euro. The marginally weaker trend path has reflected weak domestic economic
developments and unfavourable external conditions. Subdued growth, a slowdown
in capital inflows and monetary policy easing by the HNB were compounded by the
fluctuations of the euro against other major currencies and financial market
tensions affecting the CEE region and emerging markets more generally. The
latter were particularly pronounced during late 2011 and early 2012, as
deleveraging pressures mounted on euro area parent banks, and during
summer/autumn 2013, amid the prospect of an earlier end to the Federal
Reserve's asset purchase programme. Notwithstanding the medium-term trend, the
kuna experienced some intra-year volatility, mainly related to developments in
the tourism sector. The currency tended to strengthen during the summer months
and weakened during the low season.
Croatia's international reserves stood at
EUR 12.9bn at year-end 2013, equivalent to around 29% of GDP and covering
about 100% of short-term external debt ([37]). In terms of monetary aggregates, international reserves covered
around 173% of the monetary base. Croatia continued to accumulate international
reserves during the past few years, although at a slower pace compared to the
pre-crisis period. Continued growth in reserves partly reflects international
issuances of sovereign bonds.
The HNB does not actively use interest
rates as a monetary policy tool, given the weak transmission channel in a shallow
domestic money market. However, the HNB uses liquidity and reserve requirements
to steer short-term rates. From early 2010, money market liquidity remained
abundant, which was reflected in a decline in short-term interest rates. The
domestic benchmark rate Zibor remained on average about 130 basis points above
the 3‑month Euribor during the past two years. Higher rates between
mid-2011 and early 2012 were related to the winding-up of a smaller bank in
November 2011, a temporary increase in the reserve requirement rate, and
interventions by the HNB on the foreign exchange market. At the cut-off date of
this report, the 3-months spread vis-à-vis the euro area stood at 50 basis
points.
4.5.      LONG-TERM
INTEREST RATEs
The long-term interest rate in Croatia used
for the convergence examination reflects the secondary market yield on a single
benchmark government bond with a residual maturity of about six years. In the
absence of a kuna-denominated sovereign bond with longer maturity, yield
developments have to be interpreted with great caution. 
The Croatian 12-month moving average
long-term interest rate used for the assessment of the Treaty criterion
gradually declined from a peak of 6.9% in July 2012 to around 4.6% in late
2013, before increasing slightly from early 2014. In April 2014, the last month
for which data are available, the reference value, given by the average of
long-term interest rates in Latvia, Portugal and Ireland plus 2 percentage
points, stood at 6.2%. In that month, the 12-month moving average of the yield
on the Croatian benchmark bond stood at 4.8%, i.e. 1.4 percentage points below
the reference value. However, the comparability of the benchmark rate with the
reference value is constrained by the relatively short residual maturity of the
bond. 
The monthly long-term interest rate
remained above 7% in early 2012, following a sharp increase in late 2011 amid
heightened risk perception towards the CEE region. It fell rapidly during the
second half of 2012 and the beginning of 2013 to around 4.3%, as financial
market confidence improved and investors searched for yield, amid ample
liquidity in the banking system. Between June 2013 and January 2014, the
long-term interest rate increased to around 5%, driven by growing risk aversion
towards emerging markets, the deterioration of the fiscal outlook, and
subsequent downgrades of Croatia's long-term sovereign rating to sub-investment
grade by the three major credit rating agencies. In April 2014, the long-term
interest rate (6-year maturity) stood at 4.4% and the spread vis-à-vis the
German benchmark bond (10-year maturity) at 300 basis points. The six-year
interest rate spread vis-à-vis the similar-maturity German benchmark bond stood
at 370 basis points in April 2014. 
On the basis of additional indicators, such
as CDS spreads or the long-term ratings of the sovereign, there appears to be
room for further convergence of Croatia's credit status. In particular,
Croatia's sovereign rating is low compared to the euro area, and the negative
outlook assigned by two rating agencies indicates the possibility of further
downgrades. The cost of insuring sovereign debt against non-payment remained
elevated, including in relation to countries with comparable ratings. Five-year
CDS spreads stood above 300 basis points in early 2014, the highest among the
CEE countries. 
4.6.      additional
factors
The Treaty (Article 140 TFEU) calls for an
examination of other factors relevant to economic integration and convergence
to be taken into account in the assessment. The assessment of the additional
factors – including balance of payments developments, product and financial
market integration – gives an important indication of a Member State's ability
to integrate into the euro area without difficulties.
In November 2013, the Commission published
its third Alert Mechanism Report (AMR 2014) ([38]) under the Macroeconomic Imbalance Procedure (MIP - see also Box
1.5). The AMR 2014 scoreboard showed that Croatia exceeded the indicative
threshold for three out of eleven indicators, two in the area of external
imbalances (i.e. the net international investment position and export market
shares) and one in the area of internal imbalances (i.e. unemployment). In line
with the conclusion of the AMR 2014, Croatia was subject to an in-depth review,
which found that Croatia is experiencing excessive imbalances, which require
specific monitoring and strong policy action. In particular, policy action is
required in view of the vulnerabilities arising from sizeable external
liabilities, declining export performance, highly leveraged firms and fast-increasing
general government debt, all within a context of low growth and poor adjustment
capacity. 
4.6.1.   Developments
of the balance of payments
Croatia's external balance (i.e. the
combined current and capital account) adjusted from very large and rising deficits
until 2008 to near balance in 2012 and reached a surplus of 1.2% of GDP in
2013. The improvement was mostly on account of merchandise trade, as imports
dropped with the contraction in domestic demand. Strong surpluses in the
services account, due to the importance of the tourism industry, have pushed
the overall external balance into a surplus. The income account deficit
remained broadly unchanged until 2012, reflecting a comparable contraction of
outflows and inflows, but declined significantly in 2013 as a result of lower
profitability of direct equity investments.
The large and increasing savings-investment
gap during 2006-2008 (about -7% of GDP on average) was eliminated by 2013,
against the backdrop of the protracted recession and the slowdown of capital
inflows. Gross national savings dropped from above 22% of GDP in 2008 to 19% in
2013, reflecting rising borrowing needs by the public sector, while the private
sector adjusted its balance sheets after strong credit expansion in the
pre-crisis period. Gross fixed capital formation collapsed during 2009-2010 and
has not recovered since then. In 2013, it stood at below 19% of GDP.
Competitiveness indicators for Croatia
reveal a mixed picture in the past years. After deteriorating during the
pre-crisis period, some improvement has taken place in the past few years. The
ULC-deflated real-effective exchange rate (REER) depreciated by about 7% in the
period 2010 to early 2014, although from a high level, supported by both NEER
and ULC developments. The improvement in the ULC-deflated REER masks important
divergences between sectors. In the manufacturing sector, the ULC-deflated REER
appreciated by about 10% in 2009-2010 and only started to improve gradually
from mid-2011, depreciating by about 5% through to early 2014. The
HICP-deflated REER depreciated during 2010 and 2011, but appreciated
thereafter, partly due to increases in indirect taxes and administered prices.
Croatia's export performance has deteriorated during the past years, reflecting
low competitiveness, in particular in the manufacturing sector. 
Mirroring the improvement in the external
balance, the surplus in the financial account declined strongly from 2008, to
below 1% in 2013. The net FDI balance recovered somewhat in 2011 and 2012, but
fell again in 2013. Net inflows of portfolio investment continued to increase
towards the end of the observed period, as the government financed part of its
debt on external markets. On the other hand, net other inflows turned negative
from 2012 due to deleveraging of the private sector, in particular the
financial sector. Gross external debt has been hovering at slightly above 100%
of GDP since 2009, peaking at 105% of GDP in 2013. The relative stability hides
diverging trends in the public and the private sector. While the former
increased its external indebtedness since the onset of the crisis, the latter
reduced it. The decline in the private sector's foreign exposure was most
pronounced in the banking sector. Private sector deleveraging has been
supportive for rebalancing of the net international investment position, which
improved moderately since 2010, although the negative balance remains
substantial. 
According to the Commission services’ 2014
Spring Forecast, the external account is projected to remain in surplus in 2014
and 2015, as domestic demand remains subdued while exports benefit from
improving demand in the EU, Croatia’s key export market. 
4.6.2.   Market
integration
The Croatian economy is integrated into the
euro area through trade and investment linkages. The degree of trade openness
stood at 43.4% of GDP in 2012, which is low given the small size of the
Croatian economy. It is also lower than in the pre-crisis years as a result of
import compression and poor export performance. Intra-euro-area trade in goods
accounted for slightly over half of total trade in goods or 14.9% of GDP in
2012. There remains significant room for deepening trade integration with the
euro area.
The poor export performance is mainly due
to the depressed state of goods exports. During the past decade, they stagnated
at 22% of GDP, whereas in the CEE EU Member States, goods exports expanded from
46% to 62% of GDP in 2000-2012. Goods exports account for about half of total
exports, with sizeable shares for machinery, electrical, chemical and mineral
products. Services exports have fared slightly better, mainly due to strong
growth in the tourism sector. In 2012, tourism accounted for two thirds of
services exports and one third of total exports. Maintaining high growth in the
tourism sector may become gradually more challenging, as the potential to
expand beyond summer tourism seems limited. The share of high-technology
exports stood at 7.4% of total exports in 2012, a slight expansion from
2007-08. The high-tech trade balance remains in negative territory, but has
improved slightly during the past few years. 
Total FDI inflows to Croatia in percent of
GDP slowed down significantly in 2010 and have recovered moderately to 2.4% in
2011 and 2012. During the past decade, FDI was mainly directed into the
banking, real estate and retail sectors, which may not attract similar levels
of investment in the near term, as the credit-driven growth model seems to have
run its course. Croatia has failed to attract FDI in the tradable sector and is
weakly integrated into global supply chains. Relatively high costs and an
unfavourable business environment appear to be the main obstacles to attracting
FDI. 
From the early 2000s to the peak of 2007,
house prices followed an upward trend, increasing by 47% in real terms. The
correction between 2007 and 2012 reached 24%. The real house price index showed
a 2% decrease in 2012, which accelerated to 18% in 2013. In the past six years,
the number of building permits granted fell substantially, by 27% in 2012 and
by 20% in 2013. Furthermore, real value added in the construction sector has
decreased substantially, at an annual average rate of 12% between 2009 and
2012. The share of construction in total value added was 5% in 2012, down from
9% in 2008.
With regard to the business environment,
Croatia performs worse than most euro area Member States in international
rankings ([39]). The
business environment is marked by multiple shortcomings, notably a high
regulatory burden, inefficiencies in the administration of construction permits
and property registration, an inefficient justice system, prolonged litigation
and bankruptcy procedures and weak protection of investments. Public
administration as a whole also performs relatively poorly according to the
World Bank's Worldwide Governance Indicators ([40]).  
Activity and employment rates are low
compared to the euro-area average, which is partly related to underlying
institutions and policies such as early retirement schemes, pension eligibility
criteria, and the tax-benefit system. Furthermore, a comparatively high share
of workers is employed in the non-tradable sector, including the government
sector and SOEs, which may slow down the necessary employment reallocation. At
the same time, high long-term unemployment risks reducing the potential
employability of the labour force once the economy recovers. Anecdotal evidence
suggests that brain-drain pressures may become an issue as a consequence of
joining the Single Market. 
4.6.3.   Financial
market integration
The financial sector in Croatia is highly
integrated with the EU financial sector, with foreign ownership of financial
institutions exceeding 90% of total assets. Market concentration is high, as
the largest five banking institutions account for 76% of banking sector assets,
slightly higher than in 2007.
Financial intermediation in Croatia is
mainly indirect, with domestic bank credit just above 70% of GDP, out of total
lending of 100% of GDP at end-2013. Strong credit expansion during the boom
years has given way, during the current recessionary period, to rapid
deleveraging, especially in the corporate sector. With increased risk aversion
by the private sector, deposit volumes have increased and deposit funding has
become cheaper for Croatian banks. This has led to an improvement in the
loan-to-deposit ratio and has also enabled the large banks to reduce their
reliance on parent bank funding. Outstanding credit to non-financial
corporations and households was lower than in the euro area, at 33% and 38% of
GDP, respectively, in 2012. The share of foreign-currency-denominated loans
stood at 73% of total loans at end-2013, with the majority denominated in euro
(64% of total loans) and a smaller share in Swiss franc (9% of total loans,
mostly housing loans). Private sector debt stood at 132% of GDP in 2012,
somewhat below the euro area average. Cross-border loans by foreign parent
banks to the corporate sector have played a significant role in the expansion
of private sector debt between 2005 and 2010.  
The banking system appears to have adequate
levels of liquidity and is highly capitalized. The overall capital adequacy
ratio stood at 21% at the end of 2013, significantly above the euro-area
average. Profitability has been high and remained positive until end-2013, but
rising non-performing loans and increasing provisioning reduced it by 70%
year-on-year in 2013. The quality of the loan portfolio is deteriorating rapidly,
with the share of NPLs reaching 15.6% at end-2013. A particular concern has
been the rapid rise in NPLs in the corporate sector, which reached 27% at
end-2013. The coverage ratio increased slightly during 2013 to 46%, but remains
below historical levels and below the average of the CEE region.
The non-banking financial sector is well
developed relative to other CEE countries, and non-banking institutions play a
fairly important role in financial intermediation. In 2012, they accounted for
roughly 40% of GDP or one fourth of financial institutions' assets. Pension
funds, with total assets of about 16% of GDP, are the biggest players, and
their size has more than doubled since 2008. The insurance sector has also been
growing, but its size, measured by total premium to GDP of about 10% in 2012,
is comparable to the euro-area average. Investment funds have also increased
their assets, since 2008 by 40%, and their total assets account for about 5% of
GDP. Leasing and factoring are another important group in the non-banking
financial sector with total assets fairly high (almost 9% of GDP), despite
their modest reduction in business since 2008.
Capital markets in Croatia are less
developed than in the euro area, but among the most developed in the CEE
region. In 2007 the Zagreb Stock Exchange (ZSE) merged with Varaždin Stock
Exchange, resulting in a single Croatian capital market, leading in the region
by market capitalization and trading volume. Initially, trading volumes were
very high at 111% of GDP, but have shrunk in the course of the crisis and are
now more in line with those of other CEE countries. Currently, the ZSE includes
stocks of 378 companies, with market capitalization of around HRK 180 billion,
corresponding to 55% of GDP. Conversely, debt markets are not very developed. 
The Croatian National Bank (HNB) is the
supervisory authority for credit institutions while HANFA, the Croatian
Financial Services Supervisory Agency, is in charge of the supervision of
non-bank financial institutions, including insurance and leasing companies,
investment firms, and asset and pension fund management companies. During 2013
the Council for Financial Stability was established with members from HNB,
HANFA, the Ministry of Finance and the State Agency for Deposit Insurance and
Bank Rehabilitation for the implementation of macro-prudential policy. In
principle, the transposition of all directives related to financial services
should have taken place before the accession of Croatia to the European Union.
The relevant legislation is currently under examination by the Commission services,
including the Alternative Investment Fund Managers Directive (AIFMD), for which
the transposition date was July 2013.
5.1.      LEGAL
COMPATIBILITY
5.1.1.   Introduction
The Bank of Lithuania was
established                                              originally in 1922 and
was re-established in March 1990. Its legal status is defined in Article 125 of
the Lithuanian Constitution of 1992. The Law on the Bank of Lithuania
(hereinafter 'the BoL Law') lays down the tasks and functions of the Bank of
Lithuania ([41]). The BoL
Law was amended several times and most recently through Law No XII-765 of 23
January 2014 ([42]).  
5.1.2.   Central
bank independence
Pursuant to a recent amendment ([43]) to the Law on the National Audit Office, now clearly defines the
scope of control conducted by the National 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 Statute of the ESCB and of the
ECB. According to the amended law, the National Audit Office may perform an
audit of the activities of the Bank of Lithuania, with the exception of the
execution of tasks of the European System of Central Banks and the Eurosystem.
The law foresees that the National Audit Office shall take into account the
independence of the Bank of Lithuania and shall not give instructions to the
Bank of Lithuania, Board of the Bank of Lithuania or its members in carrying
out its functions related to the performance of the tasks of the European
System of Central Banks and the Eurosystem. 
On 24 January 2014, the Lithuanian
Constitutional Court declared that the amendments from 2006 to Article 125 of
the Constitution were unconstitutional given that the amendments were not
carried out in line with the appropriate legislative procedure applying to
amendments to the Constitution. The amendments of 2006 brought the Constitution
in line with the principle of central bank independence as they revoked the
BoL's exclusive right to issue currency and clarified the legal basis for the
right to dismiss the BoL governor in line with Article 130 of the TFEU and
Article 14.2 of the Statute.
The Constitutional Court clarified in its
ruling that the declaration of unconstitutionality of the amendments does not
mean that the previous version of Article 125 of the Constitution re-enters
into force. Therefore, the Constitution does not provide for the exclusive
right of the BoL to issue the currency. Furthermore, the Court stated that the
constitutional commitment of Lithuania to eventual full participation in the
Economic and Monetary Union implies the application of the independence
guarantee to the BoL set by the law of the European Union. Against this
background, the Commission understands that the Seimas' vote of non-confidence
against state officials appointed by the latter as enshrined in Articles 75 and
84 (13) of the Constitution cannot constitute a ground for dismissal of the BoL
governor in addition to the grounds for dismissal provided by Article 14.2 of
the Statute and as replicated in Article 12 of the BoL Law. The Commission
understands that the Court's jurisprudence forms the official constitutional
doctrine which has the same legal value as the Constitution itself. On the
basis of this understanding, the Constitution is compatible with the principle
of central bank independence as enshrined in the TFEU and the Statute.
5.1.3.   Prohibition
of monetary financing and privileged access
There are no incompatibilities and
imperfections in the Lithuanian laws with regard to the prohibition of monetary
financing and privileged access as enshrined in Article 123 and 124 of the
TFEU.
5.1.4.   Integration
in the ESCB
Objectives
The objectives of the Bank of Lithuania are
compatible with the TFEU.
Tasks
There are no incompatibilities and
imperfections in the Lithuanian legislation with regard to the tasks of the
ESCB and the ECB and the correct spelling of the euro.
5.1.5.   Assessment
of compatibility
The Lithuanian Constitution, the BoL Law
and the Law on the National Audit Office, as amended, are fully compatible with
Articles 130 and 131 of the TFEU.
5.2.      PRICE
STABILITY
5.2.1.   Respect
of the reference value
The 12-month average inflation rate for
Lithuania, which is used for the convergence evaluation, was above the
reference value at the time of the last convergence assessment in 2012. Since
early 2012, average inflation has been on a steady downward trend, dropping
from 4.2% in February 2012 to below 1% at the beginning of 2014. In April 2014,
the reference value was 1.7%, calculated as the average of the 12-month average
inflation rates in Latvia, Portugal and Ireland plus 1.5 percentage points. The
corresponding inflation rate in Lithuania was 0.6%, i.e. 1.1 percentage points
below the reference value. The 12-month average inflation is projected to
remain below the reference value in the months ahead.
5.2.2.   Recent
inflation developments
In previous years, Lithuania's inflation
rate moved within a broad range, reflecting in particular large variations in
the inflation contributions of services, food and energy, which together
represent around 75% of the HICP basket. Changes in administered prices and
taxation further amplified inflation volatility. Annual HICP inflation peaked
at above 12% in mid-2008 and then decreased rapidly throughout 2009 as the
economy moved into recession. Following a marginal year-on-year decline in the
price level in early 2010, annual inflation increased on the back of higher
commodity prices to 5% in May 2011. Annual inflation has thereafter broadly
followed a declining trend, induced by lower inflation of energy and processed
food prices, which was also supported by continuing wage restraint in the
economy. After having stabilised at around 0.5% in the second half of 2013,
annual inflation dropped to some 0.3% in early 2014.
Core inflation (measured as HICP inflation
excluding energy and unprocessed food) has been less volatile than headline
inflation in recent years, highlighting the strong effect of rising commodity
prices on inflation. Core inflation peaked at above 2.5% in late 2012 and then
declined during the first half of 2013 to 1.1% in July 2013. At the same time,
the gap between core and headline inflation narrowed due to particularly low
inflation of energy prices. In fact, energy inflation has steadily decelerated
since 2011 and turned negative in 2013. It stood at ‑2.5% in early 2014.
Since June 2013 the core inflation rate has exceeded headline inflation levels
as it remained slightly above 1% in early 2014. Inflation of service prices
mirrored the overall declining trend albeit at a slower pace. It has fallen
since 2012 to reach 1.5% in April 2014. Non-energy industrial goods inflation
was already relatively low and has remained so in recent years with 1.1% in
2012, 1.0% in 2013 and 0.6% in early 2014. Annual average producer price
inflation for total industry decreased from 5.1% in 2012 to -2.3% in 2013 and
stood at -4.2% in March 2014, suggesting that pipeline price pressures remain
subdued.
5.2.3.   Underlying
factors and sustainability of inflation
Macroeconomic policy-mix and cyclical stance
Real GDP growth was around 7% on average
between 2005 and 2008, but a sharp contraction of almost 15% followed in 2009.
GDP growth turned positive in 2010 before reaching 6% in 2011 and 3.7% in 2012.
Initially driven by rapid export growth, the recovery has increasingly relied
on domestic demand through growth in both private consumption and investment.
In the second half of 2013, the contribution of net exports turned negative and
domestic consumption became the main growth driver, leading to a GDP growth
rate of 3.3% for 2013. The output gap, which turned negative in 2009, is
estimated to close in 2016. According to the Commission services' 2014 Spring
Forecast, real GDP growth is projected to remain 3.3% in 2014 and to accelerate
to 3.7% in 2015.
The fiscal stance, as measured by changes
in the structural balance, was tightened over 2012 and 2013 in line with the
gradual recovery in domestic demand. The structural deficit is estimated to
have remained just above 2% of GDP in 2013. A further gradual tightening of the
fiscal stance is foreseen for 2014 and 2015. 
Monetary conditions have been accommodative
in recent years in the framework of the currency board arrangement within ERM
II. Short-term interest rates have remained close to levels observed in the
euro area since end-2010. Credit conditions stabilised in the aftermath of the
global financial crisis and banks have sufficient liquidity. However, lending
conditions, in particular to SMEs, construction and the real estate sector,
remain tight, while private sector demand for credit is still weak as
deleveraging pressures persist.
Wages and labour costs
The Lithuanian labour market demonstrated a
high degree of flexibility during the crisis, supported by a decentralised wage
bargaining process. Unemployment has gradually declined from its post-crisis
peak of almost 18% in 2010 to below 12% in 2013. Employment started to grow
again in the second quarter of 2010 and has been on a modest upward trend since
then. 
Nominal compensation per employee declined
in 2009 but recovered strongly in the following years. The public sector wage
freeze, which was implemented during the crisis, was partially reversed in 2013
and the minimum wage was raised by 25% to LTL 1,000 in January 2013, inducing a
pick-up in growth of compensation per employee. As a result, nominal unit
labour cost growth, which turned positive in 2011, increased to 3.8% in 2013 as
productivity growth declined gradually between 2010 and 2013. 
According to the Commission services' 2014 Spring
Forecast, growth of nominal unit labour costs should decline again to below 2%
in 2014 and to 2% in 2015, reflecting a pick-up in labour productivity growth.
Nevertheless, high structural unemployment and emerging skill mismatches in
some labour market segments could lead to emerging wage pressures.
External factors
As a small and open economy, Lithuania is
highly sensitive to external developments, a factor further exacerbated by the
large weight of energy and food prices in the HICP basket. Mirroring trends in
world energy and food prices, import prices (measured by the imports of goods deflator)
surged in 2010 and 2011. Import price growth moderated in 2012 and turned
negative in 2013, largely caused by a stabilisation and subsequent drop in
world oil and food prices. Accordingly, the contribution of energy prices to
HICP inflation became negative (0.2pps) in 2013 while unprocessed and processed
food contributed 0.4pps and 0.3pps respectively. The nominal effective exchange
rate of the litas (measured against a group of 36 trading partners) has
followed a mild appreciation trend since mid-2012. As a result, it had a
slightly dampening impact on domestic price developments. 
Administered prices and taxes
Adjustments in administered prices ([44]) and indirect taxes have been important determinants of inflation
in Lithuania in recent years. Increases in administered prices, with a weight
of around 17% in the HICP basket (compared to 13% in the euro area)
significantly exceeded HICP inflation in the past. The average annual increase
in administered prices declined from almost 16% in 2009 to below 7% in 2010 and
some 6.8% in 2012, when it was mainly driven by rising prices of gas, heat
energy and passenger rail transport. In 2013, administered prices grew at 1.1%,
i.e. below headline inflation. This trend is forecast to continue in 2014, with
negative growth of administered prices and a stabilisation thereafter. Notably,
decisions to reduce heating prices were taken in 2012 and 2013 with a
considerable downward impact on inflation in 2013 and 2014.
The standard VAT rate has not been raised
since September 2009 and stands at 21%. Excise duties on cigarettes, alcoholic
beverages and diesel fuel have been repeatedly increased since 2009, but are
estimated to have had only a marginal impact on average annual inflation in the
respective years. Further increases in excise duties were introduced at the
beginning of 2014, in line with applicable EU regulations. Reduced VAT rates
for periodicals and for some passenger transportation services were introduced
in 2013, while reduced VAT rates for residential heating and some medicines
were extended. In the absence of major tax revisions, the HICP at constant tax
rates has developed very much in line with actual inflation rates, dropping
from slightly above 4% in 2011 to 1.2% in 2013 and further to 0.6% in spring 2014.
No further VAT rate revision has been announced for the immediate future.
Medium-term prospects
The favourable outlook for primary
commodity price developments suggests that the inflation contributions of
energy and food products could continue to be low or even negative in 2014. At
the same time, domestic price increases should remain modest. Inflation
expectations remain well anchored. According to the Commission services' 2014
Spring Forecast, average annual inflation is thus projected to remain broadly
stable in 2014 at about 1.0% and increase moderately to 1.8% in 2015.
Risks to the inflation outlook appear to be
broadly balanced. Upside risks are mainly related to a possible rise of global
commodity prices, with the overall impact amplified by the relatively large
weight of commodities in the consumption basket, as well as increasing wage
pressure resulting from a tightening labour market. The output gap is set to
close in 2016 and the unemployment rate is at its estimated natural level.
Additionally, skill mismatches can be observed in some sectors of the economy,
possibly contributing to an acceleration of wages going forward. Downside risks
to inflation could emerge from a delayed economic recovery of Lithuania's main
trading partners leading to a protracted period of low commodity prices and
weaker-than-expected growth in Lithuania.
5.3.      PUBLIC
FINANCES
5.3.1.   Recent
fiscal developments
On 21 July 2013, the Council decided to
abrogate the decision on the existence of an excessive deficit according to
Article 126 (12) TFEU, thereby closing the excessive deficit procedure for
Lithuania ([45]).
The economic crisis had severe
repercussions on Lithuania's public finances, as the headline general
government deficit rose from 1.0% of GDP in 2007 to 9.4% of GDP in 2009,
despite substantial consolidation measures of around 8% of GDP adopted during
2009. Due to further consolidation measures adopted in subsequent years, the
general government deficit declined to 7.2% of GDP in 2010 and 5.5% of GDP in
2011. The consolidation measures were taken mostly on the expenditure side,
including cuts in public sector wages followed by a wage freeze, temporary cuts
in pensions as well as a reduction of selected social benefits. In addition,
transfers to the second pillar pension funds were lowered. On the revenue side
the government increased the standard VAT rate by 3pp and eliminated some tax
exemptions.
In 2012 Lithuania’s general government
deficit narrowed to 3.2% of GDP. Progress was in large part due to expenditure
restraint and improvements in tax compliance, supported by solid economic
growth. However, the outcome fell short of reaching the target of 3.0% of GDP
set in the 2012 convergence programme, mainly because state-owned enterprises
only paid half of the expected dividends to the budget, sales of carbon rights
fell considerably short of plan and local governments encountered a deficit
higher than expected. 
In 2013, fiscal consolidation was supported
by a healthy collection of direct taxes, in particular corporate income tax,
which compensated for a shortfall in indirect tax collection, while expenditure
growth at central government level was contained. In addition, fiscal results
of local governments turned out to be better than expected. Overall, the
general government deficit reached 2.1% of GDP in 2013, i.e. 0.4pps less than
targeted in the 2013 Convergence Programme.
The structural deficit (the
cyclically-adjusted balance net of one-offs and other temporary measures) as
calculated by the Commission decreased gradually from some 7.2% of GDP in 2009
to around 2.1% in 2013.
The expenditure-to-GDP ratio has declined
steadily over the last years due to lower spending on personnel, goods and
services and social transfers. It decreased from 42.2% in 2010, to 34.4% in
2013. The revenue-to-GDP ratio declined as well, falling from 35% in 2010 to
32.2% in 2013, mainly due to slow nominal growth in indirect tax revenue,
despite the recovery of domestic demand and government's efforts to improve tax
compliance.
While remaining well below 60% of GDP, the
debt-to-GDP ratio deteriorated to 39.4% in 2013 from only 15.5% in 2008 as a
result of high government deficits and high interest on new debt incurred
during the crisis.
5.3.2.   Medium-term
prospects 
The Lithuanian Parliament adopted the 2014
budget on 12 December 2013 targeting a general government deficit of 1.9% of
GDP along with a medium-term budgetary framework for 2014-2016. The general
government budget deficit is planned at 0.9% of GDP in 2015 and a surplus of
0.1% of GDP is foreseen for 2016. Consolidation in the 2014 budget is based on
further expenditure restraint, in particular maintaining the partial public
sector wage freeze for the fifth year. In October 2013 the government had to
partially reverse public wage cuts following a judgement of the Constitutional
Court. In 2014, cuts of state and other specific pensions have been reverted.
On the revenue side, excise taxes on tobacco and alcohol increased as of spring
2014. The government also plans to collect more revenues by stepping up tax
collection efforts, especially for VAT. 
Taking into account these measures and
robust growth in domestic demand, the Commission services' 2014 Spring Forecast
projects a deficit of 2.1% of GDP in 2014. In 2015, the state budget
expenditure rule is expected to contain the increase in total expenditure. The
government deficit is therefore forecast to fall to 1.6% of GDP in 2015. The
overall fiscal stance in 2014, as measured by the change in the structural
balance, is expected to result in a moderate consolidation of 0.2pps and is
expected to become more restrictive in 2015. The general government debt is
expected to increase from 39.4% of GDP in 2013 to around 41.4% of GDP in 2015,
due to foreseen pre-financing for the redemption of a Eurobond in February
2016. 
In March 2012, Lithuania signed the Treaty
on Stability, Coordination and Governance in the EMU. This implies an
additional commitment to conduct a stability-oriented and sustainable fiscal
policy. The TSCG will apply to Lithuania in its entirety upon lifting its
derogation from participation in the single currency.
5.4.      EXCHANGE
RATE STABILITY
Lithuania entered ERM II on 28 June 2004
and has thus been participating in the mechanism for almost ten 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 within the mechanism.
Since then, and in line with this commitment, there has been no deviation from
the central rate.
The Bank of Lithuania began operating under
a 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. The litas exchange rate did not
experience tensions during the reference period. 
Under the currency board arrangement all
domestic liabilities of the Bank of Lithuania have to be backed by foreign
exchange reserves or gold. International reserves increased from below EUR 5bn
at the beginning of 2011 to above EUR 6bn at the end of 2011 thanks to strong
FDI inflows and successful international sovereign bond issuance. They remained
close to this level throughout 2012 and 2013, with relatively small
fluctuations mainly reflecting short-term changes in government deposits.
International reserves covered on average around 130% of the monetary base
during 2012-2013, well above the required 100% statutory minimum. The ratio of
international reserves to GDP stood at 17.6% and they covered around 80% of
short-term debt by the end of 2013([46]). 
The Bank of Lithuania does not set monetary
policy interest rates. The domestic interest rate environment is directly
affected by monetary conditions in the euro area through the operations of
Lithuania's currency board arrangement. 
The 3-month interest rate differential
against the euro peaked in mid-2009, reflecting elevated risk premia during the
period of heightened financial market tensions. After dropping sharply during
the second half of 2009 and in early 2010, short-term interest differentials
vis-à-vis the euro area remained below 50 basis points in 2011. Short-term
spreads widened again to above 50 basis points in 2012 as monetary policy
loosening in the euro area was not fully reflected in local interbank rates.
Spreads narrowed considerably by mid-2013, falling to below 20 basis points in
August 2013 as local money market conditions further improved. At the cut-off date
of this report, the 3-month spread vis-à-vis the euro area amounted to about 10
basis points.
5.5.      LONG-TERM
INTEREST RATES
The long-term interest rate in Lithuania
used for the convergence examination reflects the secondary market yield on a
single benchmark government bond with a residual maturity of around 9 years. 
The Lithuanian 12-month moving average
long-term interest rate relevant for the assessment of the Treaty criterion
peaked at some 14% at the end of 2009. It declined to around 5.2% in early 2011
and remained rather stable until the beginning of 2012. It was below the
reference value at the time of the last convergence assessment in 2012. Since
then it declined further during 2012 and 2013. In April 2014, the latest month
for which data are available, the reference value, given by the average of
long-term interest rates in Latvia, Portugal and Ireland plus 2 percentage
points, stood at 6.2%. In that month, the 12-month moving average of the
Lithuanian benchmark bond stood at 3.6%, i.e. 2.6 percentage points below the
reference value.
Long-term interest rates remained fairly
stable at just above 5% from March 2010 until the beginning of 2012. Afterwards
they gradually declined to below 4% by mid-2013, reflecting improved investor
sentiment towards the country supported by increased sovereign credit ratings
as well as a relatively low domestic inflation. Although the long-term
litas-denominated government bond market is relatively shallow, the government
issued debt securities with original maturity of up to 10 years in 2012 and
2013. The Lithuanian long-term interest spread vis-à-vis the German benchmark
bond ([47]) stood at
around 180 basis points in early 2014.
5.6.      ADDITIONAL
FACTORS
The Treaty (Article 140 TFEU) calls for an
examination of other factors relevant to economic integration and convergence
to be taken into account in the assessment. The assessment of the additional
factors – including balance of payments developments, product, labour and
financial market integration – gives an important indication of a Member
State's ability to integrate into the euro area without difficulties. 
In November 2013, the Commission published
its third Alert Mechanism Report (AMR 2014) ([48]) under the Macroeconomic Imbalance Procedure (MIP - see also Box
1.5). The AMR 2014 scoreboard showed that Lithuania exceeded the indicative
threshold for two out of eleven indicators, one in the area of external
imbalances (i.e. the net international investment position) and one in the area
of internal imbalances (i.e. the unemployment rate). In line with the conclusions
of the AMRs 2012-14, Lithuania has not been subject to in-depth reviews in the
context of the MIP.
5.6.1.   Developments
of the balance of payments
After recording a substantial surplus in
2009, Lithuania's external balance (i.e. the combined current and capital
account) deteriorated again in 2010, reaching a deficit of 1.2% of GDP in 2011,
despite strong export growth combined with solid gains in market shares, as the
parallel recovery in domestic demand boosted imports. After reaching surpluses
in 2010-2011, the current account moved to a deficit of 3.7% of GDP again in
2011 as domestic demand rebounded, although it improved again and was close to
balance in 2012 and moved to surplus in 2013. The current account is set to
post moderate deficits in 2014 and 2015.
Lithuania's deficit in international trade
of goods fell by almost 10pp to 3.3% of GDP in 2009 as the sharp recession
suppressed demand for imports. Subsequently, a slow recovery of imports
combined with a good export performance kept the balance of trade in goods at
significantly lower levels compared to pre-crisis years (-4.8% of GDP in 2010
and -5.8% of GDP in 2011). In 2012, the deficit was at 2.8% of GDP and widened
only slightly in 2013. Lithuania's surplus in services increased from 1.6% of
GDP in 2009 to 3.7% of GDP in 2013. The income account moved to surplus in
2009, reflecting mainly loan-loss provisions made by foreign-owned banks, and
returned to deficit from 2010 onwards when foreign-owned banks regained
profitability. Current transfers and the capital account have consistently
recorded significant surpluses reflecting positive net inflows from EU funds
and migrant remittances.
The saving-investment gap has narrowed
since 2011 and in 2013 savings exceeded the investment. Gross national savings
increased in 2010 amid the uncertainty regarding the prospects of the economy
and has been on a gradual upward trend since then. While the household savings
rate fell somewhat in 2012 and 2013, after a peak in 2010, the evolution in the
government savings rate was less negative as reflected in an improving fiscal
balance, while corporate savings increased substantially. Following a steep
fall in 2008-2009, investment activity rebounded in 2010 and very strongly in
2011 but declined again in 2012. It started to recover in 2013. Investment as
share of GDP declined significantly in 2009 and has remained at much lower
levels than before the crisis. 
A significant decline in the real-effective
exchange rate in 2009-2011, in particular when deflated by ULC, gave a strong
boost to Lithuania's cost competitiveness. Since 2012 labour costs started to
rise and the REER began to increase. Nevertheless, Lithuania continued
substantially improving its export performance since 2010. Following a mild
upward trend, the ULC-deflated REER appreciated by about 6% and HICP-deflated
by about 3% between mid-2012 and April 2014, while NEER appreciated by about
4%. 
Mirroring the improvement in the external
balance, the financial account moved closer to balance by 2011. Lithuania has
attracted positive net inflows of foreign direct investment since 2010, albeit
at an uneven pace in 2011-2013, while also recording substantial net portfolio
investment, mainly thanks to successful sovereign external debt issuance. Net
outflows of other investment were particular high in 2009 and 2010 when foreign
banks started to deleverage and external loan liabilities in the banking sector
shrank significantly. Since then net outflows continued at a slower pace in
line with deleveraging.
Net FDI inflows recovered after a collapse
in 2009 and peaked at 3.2% of GDP in 2011, helped by better financial results
in the banking sector. However, net FDI subsided to 0.7% in 2012 and recovered
only somewhat in 2013. The net international investment position improved from
its lowest level in 2009 (-57.3% of GDP) to -45.7% of GDP by end-2013. Total
gross external debt declined to about 67% of GDP at the end of 2013 after
peaking at around 84% in 2009. 
According to the Commission services' 2014
Spring Forecast, the external surplus is expected to shrink gradually in 2014
and 2015 as the positive impact of stronger external demand is foreseen to be
offset by a parallel increase in the impact of domestic demand growth.
5.6.2.   Market
integration
The Lithuanian economy is well integrated
into the euro area through trade and investment linkages. Trade openness of
Lithuania remains very high, almost 84% in 2012, and is substantially above the
euro-area average. The economic crisis affected Lithuania's trade openness
negatively, but the ratio quickly recovered in recent years.  
Around 40% of Lithuania's trade was with
the euro area countries in 2012 ([49]). Lithuania's main euro area trading partners were Germany, Latvia,
Estonia and the Netherlands, while Russia, Poland, the United Kingdom and
Belarus remained important non-euro-area export markets.
Low-to-medium-technology goods continue to
predominate in Lithuania's exported goods. While before the economic crisis a
gradual shift to exports of high-technology products could be observed,
accounting for 7.3% of total exports in 2007, this share declined to a low of
5.8% in 2012. The highest share in total exports of goods was that of mineral
products with 24%, while the share of machinery and electrical equipment was
only 11%, significantly below the levels recorded in other non-euro area Member
States.
The stock of inward FDI amounted to some
36% of GDP in 2012, up from 34% in 2009, with the main FDI inflows originating
in Sweden, Poland, Germany and the Netherlands. Despite a relatively favourable
business environment and moderate taxes, Lithuania has been struggling to
attract higher FDI inflows. Following the crisis, total FDI inflows in percent
of GDP fell in 2009 and have been recovering in recent years.
House prices declined sharply between 2007
and 2009 (by 34% in real terms) and remained broadly stable thereafter. The
real house price index decreased by 3.2 % in 2012. Investment in dwellings
followed the same evolution. After a 47% fall between the 2008 peak and 2010,
residential investment has remained unchanged at 1.8% of GDP for the last three
years. The share of construction in total value added almost halved between
2008 and 2010 and has remained at just over 6% since then. Consistent with the
above developments, employment in construction experienced a sharp fall in 2009
and 2010 (of 26% and 29%, respectively). The situation improved in 2012, with
an increase in employment of 5% (construction making up 7% of total
employment). Construction activities are expected to revitalize, as building
permits picked up in 2012 after a sharp fall of 61% between 2007 and 2009. The
number of building licenses granted increased by 38% in 2012 and by 19% in
2013.
Concerning the business environment,
Lithuania performs broadly in line with the average of euro area Member States
in international rankings ([50]). The
government has taken actions to cut administrative burden, and some progress
was made on the time necessary to start a new company. According to the November
2013 Internal Market Scoreboard, Lithuania had a transposition deficit (0.6%),
close to the 0.5 % target as proposed by the European Commission in the Single
Market Act (2011).
The Lithuanian labour market has proved to
be highly flexible as demonstrated by nominal wage adjustment during the
economic cycle. While the decentralised wage-setting system supported a rapid
wage increase during the boom years, it also allowed a considerable downward
wage adjustment during the subsequent recession in 2009 and 2010. Since then,
wages have moved broadly in line with productivity.
Since joining the EU, Lithuania has
experienced a net outflow of workers demonstrating a high degree of mobility
within the EU. Emigration has tended to flow to EU countries with strong
cyclical demand for additional labour. As the post-crisis recovery of
Lithuania's economy has so far been stronger than in most EU Member States, net
emigration has come down significantly, reflecting both decreasing gross
emigration and a rise of re-immigration. 
5.6.3.   Financial
market integration
Lithuania’s financial sector is highly
integrated into the EU financial system. Foreign ownership amounted to about
90% of total assets at the end of 2012, held mainly by a few large subsidiaries
and branches of Nordic banking groups. It increased compared to 2007, primarily
due to the liquidation of the domestic Snoras bank in December 2011. The
banking sector is highly concentrated, with the five largest institutions
accounting for almost 84% of total assets.
The size of Lithuania's financial sector is
small compared to the euro-area average, with banks constituting the largest
segment. Deleveraging triggered by the financial crisis has reduced the loan
portfolio: credit to corporations fell from 31% of GDP in 2007 to 22% of GDP in
2013 while credit to households declined from 25% to 21% of GDP, respectively.
Consolidated private sector debt fell from 85% of GDP in 2009 to 63% of GDP in
2012 and is significantly below the euro-area average. Facilitated by the litas'
peg to the euro, euro-denominated lending is prevalent for both households and
corporations. The share of foreign-currency loans amounts to 74% in the
corporate, 76% in the residential and 41% in the consumer portfolio ([51]). The gradual reduction of foreign-currency loans after the crisis
has not fundamentally altered the exchange rate risk of the private sector. 
The capital adequacy ratio (CAR) of the banking
sector improved substantially from around 10% in 2007 to 17% in 2013. At the
same time, Lithuania made significant progress in resolving the stock of
non-performing loans that peaked above 20% following the 2009 recession. The
NPL ratio has decreased to 10% in mid-2013, helped by prudent bank provisioning
policies and some adjustments to the regulatory framework. Apart from
write-offs of defaulted loans, the improvement in asset quality resulted also
from a return to debt servicing by borrowers as their financial standing
improved. After losses in 2009 and 2010, Lithuanian banks have posted annual
profits since 2011. Although return on equity has not come back to its
pre-crisis level, at 10% in 2013 it was above the euro-area average.
Following the financial crisis, banks in
Lithuania have become increasingly self-funded, accumulating local deposits and
decreasing liabilities towards their foreign parent banks. This is a common
trend for many banking markets in Central, Eastern and South-Eastern Europe,
including those in the euro area. The change in funding structure is
illustrated by the fall in the loan-to-deposit ratio from 210% in 2009 to 120%
in 2013. The share of non-resident deposits in banking sector liabilities is
low (below 3%) and these deposits are well-diversified in terms of country of
origin ([52]).
Non-bank financial intermediaries play a
relatively minor role in Lithuania's financial system.  In 2012, total assets
of eleven insurance companies amounted to less than 3% of GDP while ten leasing
companies held assets worth about 5% of GDP. Assets of pension funds, in
particular the 2nd pillar funds, were growing continuously in recent years,
reaching 4.3% of GDP. Recent amendments of the legal framework may facilitate
development of investment funds, whose assets correspond to 1.6% of GDP. Credit
unions have expanded, featuring double digit annual growth rates even during
the crisis, but despite their number ([53]) they have remained relatively small players in the market with
assets corresponding to about 2% of GDP ([54]).
The Vilnius Stock Exchange (VSE) belongs to
the NASDAQ OMX group and uses a single trading platform together with other
exchanges in the Baltic-Nordic region. Stock market capitalisation fell from
24% of GDP in 2007 to 9% of GDP in 2013, reflecting both limited stock supply
by domestic companies and feeble investor demand. Overcoming these constraints
is challenging in a relatively small capital market. Due to an increasing level
of central government debt, the outstanding stock of debt securities reached
31% of GDP in 2013. 
Since 2012, the Bank of Lithuania (BoL) is
the single authority exercising micro-prudential supervision. It has been
proactive in identifying and addressing risks in the financial sector. After
the liquidation of Snoras bank, launched at the end of 2011, in January 2013
the BoL revoked licences of two credit unions in the framework of tightening
oversight of this market segment. In February 2013, it resolved ailing Ukio
bank on concerns about asset quality and risk management practices. Ukio bank's
good assets were transferred to another domestic bank, Siauliu bank, supported
by an equity participation of the EBRD. The BoL interventions contributed to
protecting financial stability in the long term while preserving depositor
confidence in the short term. According to a draft law proposed in 2013, the
Bank of Lithuania will also assume responsibility for development and
implementation of macro-prudential policy. Lithuania has a good track record in
implementing EU financial services directives.
5.7.      Sustainability
of convergence
This concluding section draws together
elements that are key for gauging the sustainability of Lithuania’s convergence
vis-à-vis the euro area. The analysis reviews sustainability from a number of
angles:
First, the sustainability dimension is
inherent in the individual convergence criteria themselves. This holds most
explicitly for the price stability criterion, which includes the requirement of
a “sustainable price performance”. The fiscal criterion (EDP) also involves a
forward-looking aspect, providing a view on the durability of the correction of
fiscal imbalances. While the exchange and interest rate criteria are, by
construction, backward-looking, they aim at capturing an economy’s ability to
operate durably under conditions of macroeconomic stability, hence indicating
whether the conditions for sustainable convergence following euro adoption are
in place.
Second, the assessment of additional
factors (balance of payments, product and financial market integration)
required by the Treaty broadens the view on sustainability of convergence and
allows for a more complete picture, complementing the quantitative criteria. In
particular, a sound external competitiveness position, effectively functioning
markets for goods and services and a robust financial system are key
ingredients to ensure that the convergence process remains smooth and
sustainable.
Third, the convergence assessment should be
informed by the results and findings of enhanced policy co-ordination and
surveillance procedures (MIP, fiscal governance). The aim of these new
governance instruments is not to add to the existing requirements for euro
adoption, but to make full use of the more comprehensive analysis undertaken
under the new surveillance tools in assessing sustainability of convergence.
While individual elements drawn from the new governance framework (e.g. related
to AMR scoreboard indicators) are included in the relevant chapters on
convergence above, this section uses the new framework to provide a more
integrated view of the sustainability dimension.
Any assessment of the sustainability of
convergence has limits and must be based on a judgement of the likely future
evolution of the economy. In particular, as experience has shown, the
sustainability and robustness of the convergence process after euro adoption is
to a significant extent endogenous, i.e. it depends on a Member State’s
domestic policy orientations after it has joined the euro area. Therefore,
while the assessment of sustainability is an essential element in determining a
Member State’s readiness to adopt the euro based on initial conditions and
existing policy frameworks, the outcome of such a sustainability assessment
must ultimately be conditional and can only be validated by the adoption of
appropriate policies over time. In this respect, the on-going strengthening of
governance mechanisms in EMU will have a major part to play in ensuring that
such policies are implemented by the Member State after euro adoption. 
The analysis below looks at sustainability
from five different perspectives: price stability; fiscal performance and
governance; macroeconomic imbalances; competitiveness and market functioning;
and financial stability.
Price stability
Lithuania’s present inflation rate is below
the reference value, and while the inflation rate is projected to rise from the
current levels, it is expected to remain moderate over the forecast horizon.
Going beyond the headline view, a sustainable price performance implies that
the respect of the reference value reflects underlying fundamentals rather than
temporary factors. The analysis of underlying fundamentals (e.g. cyclical
conditions and policy stance, wage and productivity developments, imported
inflation, administered prices – see section 2.2) and the fact that the reference
value has been met by a comfortable margin support a positive assessment on the
fulfilment of the price stability criterion.
In Lithuania, the level of final
consumption prices of private households stood at around 63% of the euro-area
average in 2012. This suggests a potential for further price level convergence
in the long term, as income levels (around 67% of the euro-area average in PPS
in 2012) rise towards the euro-area average. To the extent that this is an
equilibrium phenomenon, it does not imply a loss of price and cost
competitiveness, but the process needs to be managed carefully so as to detect
and counteract the emergence of excessive price pressures at an early stage.
Longer-term inflation prospects will hinge
in particular on wages growing in line with productivity. As Lithuania is still
a catching-up economy, wages are expected to grow at a faster rate than in most
advanced euro area members. However, risks to price stability from catching-up
related price adjustment are limited by the recently demonstrated flexibility
of the labour market and wage-setting mechanisms which should ensure that
labour costs are aligned with productivity. They are also contained by the
country's significant progress in implementing the EU services directive and
low market entry costs, which keep competitive pressures high, as witnessed by
the recent new entries in the retail market. A shortage of well-qualified
labour in the medium term could drive up wages relative to productivity.
Addressing the remaining bottlenecks will be important in limiting any
tightening of the labour market. Diversification of supplies and more
competitive markets would also support favourable price developments in the
energy sector. 
The productivity growth required to ensure
a smooth catching-up in the price level will largely depend on improvements in
the business environment and progress in attracting new investment. Increased
market competition should also support favourable price developments (and there
is no evidence that Lithuania would fare worse in this respect than the euro
area average). 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 fundamentals and help anchor inflation
expectations. Finally, if commodity prices rise again in the medium term,
Lithuania would be particularly affected due to the composition of its consumer
basket, low energy efficiency and high material input share in production. In this
context, efforts to improve the energy efficiency of the economy, in particular
for buildings and in the transport sector, should be further prioritised, as
also indicated in the annual European Semester exercise.
Fiscal performance and governance
The 2014 Convergence Programme covering the
period of 2014-2017 was submitted on 23 April 2014. The budgetary strategy
outlined in the programme is to adjust the structural budgetary position
towards achieving the medium-term budgetary objective (MTO) in 2015. The MTO
itself is set at the level of minus 1% of GDP. In terms of nominal targets,
this strategy implies a headline deficit of 1.9% of GDP in 2014, with the
deficit declining further to 0.9% in 2015 and the budget turning to a surplus
in 2016-2017. The headline budgetary deficit targets for 2014 and 2015 are
below the projections in the Commission services' 2014 Spring Forecast, with
deficits of 2.1% of GDP in 2014 and 1.6% of GDP in 2015, respectively.
Further details on the assessment of the
2014 Convergence Programme for Lithuania, including the assessment of the
long-term budgetary impact of ageing, can be found in the Commission Staff
Working Document, which accompanies the Commission Recommendation for a Council
Recommendation on the 2014 National Reform Programme of Lithuania and
delivering a Council Opinion on the 2014 Convergence Programme of Lithuania.
Lithuania has put in place a number of
fiscal governance measures, which should support the longer-term commitment to
sound public finances. In March 2012, Lithuania signed the Treaty on Stability,
Coordination and Governance in EMU (TSCG) and the respective ratification law
was approved by Parliament in September 2012. This implies an additional
commitment to conduct stability-oriented and sustainable fiscal policies. This
development is important to ensure that Lithuania’s medium-term budgetary
framework, which specifies revenues and expenditure of the national budget for
three years, is complemented with binding targets and a clear connection between
the medium-term targets and the annual budgets. Currently, a draft legislative
package including a constitutional law on the sustainability of general
government sector finances in accordance with the Fiscal Compact is being
discussed by Parliament. These laws should enforce multi-year fiscal discipline
in accordance with the requirements of the Treaty on Stability, Coordination
and Governance in the Economic and Monetary Union. It is anticipated that the
National Audit Office would be charged with the functions of an independent
Fiscal Council and its legal independence would be strengthened.
The transposition of the TSCG into national
law would furthermore support existing legislation, in particular the Law on
Fiscal Discipline, adopted in 2007 and applied since 2013. It is based on
provisions of the Stability and Growth Pact, links an expenditure ceiling to
revenues and sets as an objective a balanced budget in the medium term as well
as long-term sustainability. However, it lacks a binding medium-term expenditure
framework. 
In addition, amendments of the National
Budget law to implement Council Directive 2011/85/EU on requirements for
budgetary frameworks of the Member States targeting a balanced or surplus
position over the cycle are coming into full force for the 2014 budget planning
and execution process. These amendments increase the government's
accountability for the implementation of the multiannual fiscal targets;
however, the new law is not yet tested. 
Overall, existing legal commitments as well
as legal acts currently under preparation to strengthen Lithuania's fiscal
framework are important elements to ensure that the commitment to fiscal
discipline will be sustained over time. In addition, the fiscal framework will
also benefit from continuous efforts to strengthen governance mechanisms in
EMU, which should ensure appropriate implementation by the Member State after
euro adoption.
Macroeconomic imbalances
The assessment of convergence also draws on
the surveillance of macroeconomic imbalances under the Macroeconomic Imbalance
Procedure (MIP - see also Box 1.5), embedded in the broader "European
Semester" approach to enhance the governance structures in EMU, and
integrates the MIP results into the analysis. The Commission published its
third Alert Mechanism Report (under the cycle for 2014) in November 2013. 
The related scoreboard update shows that
Lithuania breaches the indicative threshold in two out of eleven indicators,
one in the area of external imbalances (i.e. net international investment
position) and one in the area of internal imbalances (i.e. unemployment). Both
indicators are moving towards the indicative thresholds. Based on the
conclusions of the last three reports, Lithuania was not subject to an in-depth
review in the context of the MIP. 
The AMR from November 2013 notes that after
accumulation of imbalances prior to the crisis in 2009 Lithuania's external
competiveness has improved substantially. The process of internal adjustment
included wage and employment cuts, fiscal consolidation, deleveraging in the
private sector, and growth-enhancing structural reforms.
Competitiveness, labour and product market
functioning
Standard indicators of cost
competitiveness, such as real effective exchange rates (REER) and relative unit
labour costs, are now below the indicative thresholds set under the scoreboard
for monitoring external imbalances under the MIP. From 2008 to mid-2012, the
REER deflated by unit labour costs depreciated by about 20%, but it started to
appreciate slowly since then as wage growth picked up in 2013. The current
level of the REER is considered sustainable, as the country has steadily gained
market shares over the past years. However, the REER estimates do not include
Russia, which is one of the major trade partners of Lithuania. The latest
projections suggest that the Lithuania's current account will remain slightly
in deficit in 2014-2015 while the overall external balance (current and capital
accounts) will be slightly positive for the same period.
The Lithuanian labour market demonstrated a
high degree of flexibility during the crisis. Job seekers also showed high
mobility within the EU as emigration increased substantially in the process of
structural adjustment flowing to EU countries with high demand for additional
labour. More recently, the robust post-crisis recovery and steady pace of job
creation have not only reduced emigration but raised significantly the number
of (re-)immigrants in Lithuania.
Underpinned by a decentralised wage-setting
system, considerable wage adjustment took place in Lithuania over 2009 and 2010
and wages moved broadly in line with productivity afterwards. In 2014-2015,
wages are projected by the Commission services' 2014 Spring Forecast to remain
consistent with productivity. Vacancy rates remain among the lowest in the EU,
indicating that at the aggregate level labour supply is adequate. Nevertheless,
regional differences and skills mismatches on specific labour market segments
keep structural unemployment relatively high. The latest statistics show that
youth unemployment, though still high, has moved slightly below the EU average.
Long-term unemployment declines in line with total unemployment rate, while
still remaining a major challenge. All these structural deficiencies on the
labour market amount to a significant loss in potential output and pose risks
of excessive wage adjustments; they need to be properly addressed by active
labour market policies and education reforms, as stipulated in the Commission
and Council country-specific recommendations.
Lithuania has achieved significant progress
in liberalising its markets and integrating its trade of goods and services
within the Single Market. Much of the structural adjustment related to this
process has been already completed. However, challenges still remain and are
being addressed in the context of the country-specific recommendations issued
by the Commission and the Council. The recommendations emphasise the importance
of enhancing energy efficiency and energy interconnections with other EU Member
States and furthering a reform of state-owned enterprises. 
The process of further structural
adjustment needs to be supported by flexible resource allocation and
well-functioning markets. Moreover, some social policy indicators are still significantly
below the euro area average, which poses additional risks to the full
completion of the convergence process. However, on balance, the size of the
economic restructuring and convergence progress in the past several years
suggest that the country's institutional capacity and market maturity are
already sufficient to address remaining challenges.
On balance, there is sufficient ground for
a positive assessment of Lithuania's competitiveness prospects going forward.
The relative flexibility of the labour market and the advanced integration and
liberalisation of product markets create favourable conditions for the economy,
while remaining weaknesses should be addressed to further reduce the risk of
imbalances. 
Financial stability
The integration of the domestic financial
sector into the EU financial system is substantial, mainly thanks to a high
level of foreign ownership of the banking system. The relative size of
Lithuania's financial system is small compared to the euro area average, not
least due to the post-crisis private sector deleveraging process, which is just
coming to an end. The foreign-owned segment of the financial sector proved
resilient to the economic and financial crisis, benefitting from substantial
support from parent banks, while two domestic banks and several domestic credit
unions were closed in an orderly fashion. Financial supervision has been
tightened in line with international supervisory regulations; prudential
indicators of the banking system are met with a significant margin. 
Looking ahead, it is essential to ensure
that credit is used to finance sound and productive investments by enterprises,
including SMEs.  The prospects of a re-emerging lending boom are reduced as
Lithuania's financial supervision has responded to the experience of the past
crisis and tightened banking sector regulation, while closing overexposed
domestic credit institutions (see section 5.6.3). Nevertheless, in view of the
expected price level convergence, real interest rates may ceteris paribus
be lower for Lithuania than for the euro area average, which needs to be
counteracted both by a prudent macro stance and appropriate supervisory
practices. An appropriate and timely use of macro-prudential policies will also
be important in limiting any undesirable consequences related to excessive
credit growth.
The long-term outlook for financial
stability in Lithuania is favourable, assuming that the prudent business model
of the banks and the proactive attitude of the supervisor are maintained.
Furthermore, the assumption of responsibility for macro-prudential policy by
the Bank of Lithuania should also be a supportive factor. The close cooperation
with the Swedish, Norwegian and Danish authorities on cross-border supervision
and crisis management are expected to continue in the banking union with the
ECB as the new supervisor of Lithuania's largest banks after euro adoption by
Lithuania. 
Conclusion 
Overall, a broad-based look at underlying
factors suggests that sufficiently strong conditions are in place for Lithuania
to be able to maintain a robust and sustainable convergence path in the medium
term, thus supporting a positive assessment. However, significant challenges
remain, and policy discipline will need to be maintained in a determined manner
to fully exploit the benefits of participation in the euro area and minimise
risks to the convergence path going forward. The on-going strengthening of
governance mechanisms in EMU will be a supportive factor in this respect.  
6.1.      LEGAL
COMPATIBILITY
6.1.1.   Introduction
The main rules governing the National Bank
of Hungary (Magyar Nemzeti Bank, hereafter: MNB) are laid down in Article 41 of
the new Hungarian Fundamental Law ([55]) and Act CXXXIX 2013 on the MNB (hereafter: MNB Act). The MNB Act
has been subject to frequent changes including some recasts over recent years.
The currently applicable MNB Act took effect on 1 October 2013, providing for
the MNB to become responsible for macro-prudential policy and, further to the
dissolution of the Hungarian Financial Supervisory Authority, micro-prudential
supervision of the Hungarian financial sector. The MNB law was amended last on
13 February 2014 ([56]) with regard
to certain supervisory tasks of the MNB and related enforcement rights.
6.1.2.   Central
Bank independence
Frequent amendments to the Central Bank Act
of a Member State can create instability in the Central Bank's operations.
Therefore, a stable framework that provides a solid basis for a Central Bank to
function is essential for central bank independence.
Pursuant to Section 176 of the MNB Act, the
MNB has become the legal successor of the liabilities of the former Hungarian
Financial Supervisory Authority (HFSA), which ceased to exist on 1 October
2013. This legal succession also implies the transfer of all employees from the
HFSA to the MNB pursuant to Section 183 of the MNB law. The principle of
central bank independence pursuant to Article 130 of the TFEU implies that the
MNB must have sufficient financial resources to perform its ESCB and
ECB-related tasks, in addition to its national tasks. The tasks transferred
from the HFSA to the MNB must not affect its ability to carry out these tasks
from an operational and financial point of view.
Further to this principle, the MNB should
be fully insulated from all financial obligations resulting from any HFSA
activities. Contractual relationships in the period prior to 1 October 2013
including, amongst others, all employment relations between any new MNB staff
member and the former HFSA can be continued only with the proviso that the
continuation does not impinge on the MNB's independence and its power to fully
carry out its duties under the Treaty. Against this background, Section 176 and
183 of the MNB Act have to be aligned to the principle of central bank
independence as enshrined in Article 130 of the TFEU.
According to Section 9 (7) of the MNB Act,
the Governor and the Deputy Governors shall take an oath before the President
of the Republic upon taking office with the words required by Law XXVII of 2008
as amended on the oath and solemn promise of certain public officials. The Law
requires making an oath with words "I, ….(name of the designated public
officer), hereby make an oath to be faithful to my home country, Hungary and to
its Fundamental Law,  I will comply   with other laws, and make sure other
citizens comply with it also, I will fulfil my duties arising from my position
as a … (name of the position) in order to promote the development of the
Hungarian nation […]". The oath does not contain a reference to the
Central Bank independence enshrined in Article 130 TFEU. What is more, the
Fundamental Law contains only an indirect reference to EU law. Since the
Governor and the Deputy-Governors as members of the Monetary Council are involved
in the performance of ESCB related tasks, any oath should make a clear
reference to the Central Bank independence under Article 130 of the TFEU.
Therefore, the oath is an imperfection with the institutional independence of
the MNB and the wording of the oath should be adapted to be fully in line with
Article 130 of the TFEU.
6.1.3.   Prohibition
of monetary financing and privileged access
Pursuant to Section 36 of the MNB Act and
subject to the prohibition of monetary financing set out under Section 146 of
the MNB Act, the MNB can provide an emergency loan to credit institutions in
the event of any circumstance arising in which the operation of a credit
institution jeopardizes the stability of the financial system. In order to
comply with the prohibition on monetary financing of Article 123 of the TFEU,
it should be clearly specified that the loan is granted against adequate
collateral to ensure that the MNB would not suffer any loss in case of debtor's
default.
Pursuant to Section 37, the MNB may grant loans
to the National Deposit Insurance Fund in emergency cases, subject to
prohibition of monetary financing under Section 146 of the Act. Though the Act
adequately reflects conditions for central bank financing provided to a deposit
guarantee scheme a specific requirement should be included to ensure that the
loans granted to the National Deposit Insurance Fund are provided against
adequate collateral to secure the repayment of the loan. Therefore, Section 37
is incompatible with the prohibition on monetary financing as laid down in
Article 123 of the TFEU.
Article 177(6) of the MNB Act provides for
state compensation to the MNB of all expenses resulting from obligations which
exceed the assets the MNB has taken over from the HFSA. The law does not
contain any provisions on the procedure and deadlines on how the state shall
reimburse the MNB of the expenses. Therefore, the reimbursement under Article
177(6) of the MNB Act is not accompanied by measures that would fully insulate
the bank from all financial obligations resulting from any activities and
contractual relationships of the HFSA originating from prior to the transfer of
tasks. In case of a substantial time gap between the costs arising to the MNB
and the reimbursement by the state pursuant to Article 177(6) of the MNB Act,
the reimbursement would result in an ex-post financing scheme. Should the
expenses incurred at the MNB exceed the value of assets taken over from the
HFSA, such a scenario would constitute a breach of the prohibition of monetary
financing laid down in Article 123 of the TFEU. In order to comply with the
prohibition of monetary financing, Sections 176 and 183 of the MNB Act should
be amended in order to insulate the MNB by appropriated means from all
financial obligations resulting from the HFSA's prior activities or legal
relationships and obligations including those deriving from the automatic
further employment of HFSA staff by the MNB.
6.1.4.   Integration
in the ESCB
Objectives
Article 3(2) of the MNB Act determines
that, without prejudice to the primary objective of price stability, the MNB
shall uphold to maintain the stability of the financial intermediary system, to
increase its resilience, to ensure its sustainable contribution to economic
growth and support the economic policy of the government. The objective laid
down in Article 3(2) of the MNB Act is reduced to supporting the economic
policy in Hungary. The Article has to be aligned to the secondary objective of
the ESCB enshrined in Article 127 (1) of the TFEU and Article 2 the Statute of
the ESCB in order to embrace the support of the general economic policies in
the entire EU rather than in Hungary only.
Tasks
The MNB Act contains a series of
incompatibilities with regard to the following ESCB/ECB tasks:
·       definition of monetary policy and the monetary functions, operations
and instruments of the ESCB (Sections 1 (2) 4, 16 – 20, 159 and 171 of the MNB
Act);
·       conduct of foreign exchange operations (Sections 1(2), 4(3), (4) and
(12), 9 and 159(2) of the MNB Act) and the definition of foreign exchange
policy (Sections 1(2), 4(4) and (12), 22 and 147 of the MNB Act);
·       competences of the ECB and of the Council for banknotes and coins
(Article K of the Fundamental Law and Sections 1(2), 4(2) and (12), 9, 23, 26
and 171(1) of the MNB Act);
There are also some imperfections in the
MNB Act regarding the:
·       non-recognition of the role of the ECB in the functioning of the
payment systems (Sections 1(2), 4(5) and (12), 9 and 159(2) of the MNB Act);
·       non-recognition of the role of the ECB and of the EU in the
collection of statistics (Section 1(2), 30(1) and 171(1) of the MNB Act);
·       non-recognition of the role of the ECB in the field of international
cooperation (Sections 6(1), 15 and 144 of the MNB Act));
·       absence of an obligation to comply with the Eurosystem's regime for
the financial reporting of NCB operations (Article 12(4)(b) and Law C of
2000/95 (IX.21.) in conjunction with Government Decree 221/2000 (XII.19.));
·       non-recognition of the role of the ECB and the Council in the
appointment of external auditors (Sections 6 (1) (c), 15 and 144 of the MNB
Act).
6.1.5.   Assessment
of compatibility
As regards central bank independence of the
MNB, the prohibition on monetary financing and the integration of the MNB into
the ESCB at the time of euro adoption, existing Hungarian legislation is not
fully compatible with the Treaties and the Statute of the ESCB and the ECB
pursuant to Article 131 of the TFEU.
6.2.      PRICE
STABILITY
6.2.1.   Respect
of the reference value
The 12-month average inflation rate, which
is used for the convergence evaluation, has been above the reference value at
the time of the last convergence assessment of Hungary in 2012. Average annual
inflation increased to 5.7% by December 2012 and has been decreasing ever since
then. In April 2014, the reference value was 1.7%, calculated as the average of
the 12-month average inflation rates in Latvia, Portugal and Ireland plus 1.5
percentage points. 
The average inflation rate in Hungary
during the 12 months to April 2014 was 1.0%, i.e. below the reference value. It
is projected to remain below the reference value in the months ahead.
6.2.2.   Recent
inflation developments
Inflation has moved in a quite wide range
in Hungary in recent years, mainly reflecting the evolution of energy and food
prices, which together represent about 46% of the HICP basket. Administrative
measures and taxation also contributed significantly to inflation volatility.
HICP inflation increased until September 2012, peaking above 6%, driven up by a
bad harvest, a weaker exchange rate and several tax changes. Inflation fell
sharply in January 2013, with the fading-out of the effect of earlier indirect
tax hikes and the start of a series of utility price reductions. The latter
temporarily decreased inflation in 2013 and early 2014, with administered price
inflation running well below the headline level. A decline in market energy and
food prices also supported disinflation in late 2013, as did weak domestic demand
and historically low inflation expectations. On the other hand, excise duty
increases and some other government measures (most notably the introduction of
the financial transaction duty) had a substantial upward effect. Annual HICP
inflation declined to 0.6% by end-2013 and stood at -0.2% in April 2014.  
 
Core inflation (measured as HICP inflation
excluding energy and unprocessed food) only partly followed the evolution of
HICP inflation. It recorded a large decline (1.3 pp.) in January 2013, when the
effect of the 2012 VAT hike dropped out of the index. Then it declined further
to below 2% by early 2014. Processed food inflation, although trending down
from its peak in 2012, remained elevated in the assessment period, mainly due
to the policy measures affecting tobacco prices. The least volatile components
of core inflation (industrial goods prices and services) contributed to
disinflation. Industrial goods inflation turned negative in August 2013 and remained
so until the end of the assessment period, despite the weakening exchange rate.
Services inflation was depressed by the slack in the labour market, while it
was lifted by financial services prices, following the introduction (and
increase) of the financial transaction duty in 2013. The annual producer price
inflation decreased from around 7% in the first half of 2012 to close to -2% in
early 2014, due to falling energy prices as well as contained domestic demand.
6.2.3.   Underlying
factors and sustainability of inflation
Macroeconomic policy mix and cyclical stance
After a short-lived recovery in 2010 and
2011, the Hungarian economy fell into recession again as GDP contracted by 1.7%
in 2012, partly on account of a severe drought. Economic activity recovered in
2013 with GDP growth at 1.1%, mainly driven by an improved performance of the
agriculture and construction sectors, while industry also contributed
positively to economic growth. Investment turned positive, mainly as a result
of public investment, but gross fixed capital formation of the corporate sector
also started to accelerate on the back of a speeding-up in the absorption of EU
funds and the central bank's extended Funding for Growth Scheme (FGS, providing
subsidized lending to SMEs). A sharp decline in inflation contributed to
increasing households' real disposable income, but the still high unemployment
and ongoing deleveraging continued to drag on consumer spending. As a result,
the output gap remained wider than -3% of potential GDP in both 2012 and 2013.
Based on the Commission services' 2014 Spring Forecast, real GDP growth is
expected to reach 2.3% in 2014 and 2.1% in 2015, driven by a further pick-up in
domestic demand, while the contribution of net exports is projected to be
neutral. Although gradually closing, the output gap is expected to remain
negative throughout the forecast horizon.
The fiscal policy stance, as measured by
changes in the structural balance, was substantially tightened in 2012 (by over
3 percentage points of GDP), mostly on account of revenue measures (reflecting
around 2/3 of the improvement). While it remained broadly neutral in 2013, it
is projected by the Commission services' 2014 Spring Forecast to be loosening
gradually over the forecast horizon by 1.5 percentage points, due to increasing
expenditures. 
Monetary policy, conducted within an
inflation targeting framework ([57]), has been loosened significantly since 2012, in view of weak
underlying inflation pressures and a negative output gap. Starting from a
relatively tight level in August 2012, the base rate was reduced in 21
consecutive steps by 4.5 percentage points till April 2014 to 2.5%. The MNB
reduced the pace of the cuts from 25 to 20 bps in mid-2013 and later to 15 and
then to 10 bps. In addition to rate cuts, the MNB further loosened the monetary
policy stance through the FGS, which was introduced as a new instrument,
primarily to foster lending to SMEs ([58]). Nevertheless, general credit conditions remained tight toward
both corporates and households in the last two years, reflecting negative net
lending flows and contributing to disinflationary effects. The first allocation
of the FGS scheme temporarily relieved tight credit supply constraints toward
SMEs in Q3 2013, but net lending to corporates was again negative in the
following two quarters.
Wages and labour costs
The Hungarian labour market is relatively
flexible, with decentralized wage setting and a low coverage of collective
agreements. The labour market reacted rather swiftly to the sharp economic
downturn in 2008, with compensation per employee declining over 2009 and 2010
reflecting wage cuts in the public sector as well as substantial wage
moderation in the private sector. The unemployment rate reached 10.9% in
2011-12 before decreasing to 10.2% in 2013. 
Compensation per employee started to
increase in 2011 and a further pick-up in wages contributed to a ULC increase
of around 4% in 2013, after Hungary experienced ULC growth of around 2.5% in
2011-2012. Labour productivity growth remained rather subdued at below 1% in
2013. ULC growth is forecast to decelerate to around 2% in 2014 and 2015. This
pattern primarily reflects the projected pace of nominal wage growth of around
3.5%, while productivity growth is expected to pick-up slightly to around 1.5%
in 2014 and 2015.
External factors
Given the high degree of openness of the
Hungarian economy, developments in import prices play an important role in
domestic price formation. The impact of lower energy and agricultural commodity
prices on headline inflation is accentuated by their relatively high weight in
the HICP basket. Growth of import prices (measured by the imports of goods
deflator), had an inflationary impact in 2012, while the disinflationary impact
started to dominate in 2013. 
Import price dynamics have been significantly
influenced by exchange rate fluctuations. After having depreciated by around
4.5% on average in 2012 relative to 2011, the forint's nominal effective
exchange rate (measured against a group of 36 trading partners) weakened
further around 1% in 2013. Looking ahead, the growth of import prices is
expected to remain supportive of a low-inflation environment in Hungary,
pending no further weakening of the exchange rate.
 Administered prices and taxes
The share of administered prices ([59]) in the HICP basket is relatively high in Hungary at around 17%,
compared to the euro area average (13%). From 2004 to 2011, the growth rate of
administered prices was significantly higher than headline inflation, reaching
on average almost 10%. After an increase of 5.1% in 2012, administered prices
declined by 4.8% in 2013, chiefly on account of three waves of cuts in
regulated energy and other utility prices introduced as of January, July and
November. These measures had an overall effect on the inflation rate of over -1
pp. for 2013 and entail − as a full-year effect − an additional
reduction in the inflation rate of around 1 pp. for 2014. A further round of
utility price cuts is due to be introduced as of April, September and October
2014, which could decrease the annual HICP by an additional 0.2 pp. in 2014 and
2015. Overall, administered prices lowered headline inflation by about 0.1 pp.
in 2012 and 1.3 percentage points in 2013.
Changes in taxation related to fiscal
adjustment measures have also had a substantial impact on inflation. In January
2012, the general VAT rate was increased from 25% to 27%, which together with
several rounds of excise duty hikes increased annual HICP inflation by 2.2 pp.,
as measured by the constant-tax index (HICP-CT). The contribution of indirect
tax changes to HICP inflation dropped to 0.5 pp. in 2013 and it mostly
reflected excise duty hikes on alcohol, tobacco and liquid petroleum gas.
Tobacco products contributed overall by about 0.7 pp. to headline inflation in
2013, as they were also affected by an increase in the guaranteed profit margin
of retailers. Although not accounted as an indirect tax measure in HICP, the
introduction of the financial transaction duty on banking transactions
triggered a significant rise in financial services prices, which contributed to
inflation by around 0.5 pp. in 2013. 
Medium-term prospects
The historically low inflation figures over
the past year have been driven to a large extent by the influence of one-off or
volatile factors (regulated utility price cuts and declining agricultural and
market energy prices). Core inflation stood at a moderate level, below 2% in
early 2014, reflecting the effect of a still negative output gap. The latter is
expected to close gradually, but to remain negative throughout the forecast
horizon. Therefore once the effects of one-off factors fade away, inflation is
expected to converge towards the central bank's 3% target. Accordingly, the
Commission services' 2014 Spring Forecast projects HICP inflation to average
1.0% in 2014 and 2.8% in 2015.
Risks to the inflation outlook appear to be
broadly balanced. Upside risks to the projection relate mainly to a
stronger-than-expected recovery and a possible weakening of the exchange rate.
At the same time, if the global inflation environment weakens further and the
potential downside risks related to deleveraging materialise, this could
rapidly translate into lower inflation.
The level of consumer prices in Hungary
stood at about 59% of the euro area average in 2012. As in other new Member
States, the remaining gap vis-à-vis the euro area is larger for services than
goods. This suggests that there is scope for further price level convergence in
the long term, as income levels (around 62% of the euro area average in PPS in
2012) rise towards the euro area average.
Medium-term inflation prospects will depend
strongly on wage and productivity developments, notably on efforts to avoid
excessive wage increases in the non-tradable sector and on the success with
anchoring inflation expectations at the central bank's 3% target. 
6.3.      PUBLIC
FINANCES
6.3.1.   Recent
fiscal developments
On 21 June 2013, the Council decided to
abrogate the decision on the existence of an excessive deficit according to
Article 126 (12) TFEU, thereby closing the excessive deficit procedure for
Hungary ([60]). The
consequences of the financial crisis hit also public finances, leading to a
budget deficit of 4.6% of GDP in 2009, albeit a number of important structural
steps (e.g. pension reform) in the framework of the EU/IMF financial assistance
programme limited the deterioration. Despite a lacklustre recovery in
2010-2011, and a renewed recession in the following year with a GDP decline of
1.7%, the headline general government deficit was brought down to 2% of GDP in
2012, on the back of an over 3 pp. structural improvement. This was achieved
against the backdrop of numerous consolidation measures skewed toward the
revenue side, which was also reflected in the increase in the tax burden by
close to 2 pp. from the previous year (see Table 6.3). 
The 2012 budget targeted a deficit of 2.5%
of GDP on the basis of a 0.5% growth assumption. However, the constantly
deteriorating macroeconomic outlook throughout 2012 implied important revenue
shortfalls, while some expenditure overruns also occurred, altogether amounting
to 1¾% of GDP. These adverse impacts were more than offset by the following
deficit-reducing measures and developments: (i) the full cancellation of the
budgeted extraordinary reserves of 1.1% of GDP ([61]), (ii) a better-than-expected local government sector's balance by
0.7% of GDP in the context of the reallocation of responsibilities from local
to the central government levels, (iii) within-the-year corrective measures of
0.3% of GDP enacted by the government, and (iv) higher-than-budgeted one-off
revenues of 0.2% of GDP related to the further transfer of assets from the
private to the public pension pillar. The expenditure-to-GDP ratio temporarily
fell from 50% in 2011 to 48.6% in 2012, before returning to around 50% in 2013,
partly explained by changes in absorption of EU funds.
The April 2013 Convergence Programme
contained a deficit target of 2.7% of GDP for 2013. Last year's outturn was
2.2% of GDP, which implies a stabilisation in the structural balance. Compared
to the budgeted figures, revenues turned out to be overall lower by about 0.5%
of GDP, even after including the impact of the June 2013 tax-increasing
measures of 0.4% of GDP, such as higher financial transaction duties and
sectoral taxes on the energy and telecommunication companies, and after
substantially higher-than-expected social security contributions. The lower tax
revenues partly stem from lower-than-expected inflation, but are also linked to
the overestimation of the budgetary impact of selected tax measures (e.g. the
introduction of the financial transaction duty). In net terms, expenditure
slippages amounted to 0.35% of GDP, which, inter alia, reflected the brought-forward
introduction of a new compensation scheme in the education sector and other
extra wage-related payments as well as higher-than-budgeted outlays on goods
and services. In total, the above-mentioned revenue shortfalls and expenditure
overruns amounting altogether to 0.85% of GDP were more than offset by the
cancellation of the extraordinary budgetary reserve buffer of 1.3% of GDP. 
Gross general government debt decreased
from 82.1% of GDP in 2011 to 79.8% in 2012, primarily reflecting the sizeable
multi-year fiscal corrective package, but an important appreciation of the
forint by some 7% compared to its end-2011 level also contributed to the debt
reduction. The debt-to-GDP ratio further declined by around half percent of GDP
in 2013, mainly on account of the end-year reduction in the state cash deposits
as well as the accelerated utilisation of the transferred pension assets for
refinancing debt obligations.
6.3.2.   Medium-term
prospects 
The 2014 budget was adopted by Parliament
on 17 December 2013. It targets a deficit of 2.9% of GDP, i.e. a slight upward
revision compared to the 2.7% of GDP target laid down in the 2013 Convergence
Programme. On the revenue side, the budget contains notably the extension of
the family tax allowances (0.15% of GDP) as well as the full-year impact of the
distance-based road-toll (0.2% of GDP) introduced from mid-2013. On the
expenditure side, it incorporates in particular the planned further increase of
wages in the public education sector. These elements are projected to be partly
offset by a nominal freeze of public wages in most areas of the public sector,
the enhancement of tax administration and the effect of economic recovery. In
addition, the implementation of specific investment projects of 0.4% of GDP is
legislated to be conditional on the realisation of one-off revenues from the
sale of telecommunication licences. Finally, in order to counterbalance
potential unforeseen adverse developments, an extraordinary budgetary reserve
of over 0.3% of GDP was established (on top of the standard general reserve of
close to 0.4% of GDP).
The Commission services' 2014 Spring
Forecast projects the current year's deficit to reach 2.9% of GDP, i.e.
identical with the official target. The better-than-expected budgetary outturn in
2013 has only a limited base effect. Compared to the budgeted figures, tax
revenues are projected to be lower by around 0.3% of GDP due to a
lower-than-expected inflation as well as a more cautious assessment of measures
aiming to enhance tax administration. The forecast is based on the assumption
that the extraordinary reserve buffer (0.3% of GDP) will not be spent.  The
debt-to-GDP ratio is forecast to increase again to over 80% in 2014, mainly due
to the revaluation of the FX component, reflecting the recent HUF depreciation.

The 2014 Convergence Programme was
submitted on 30 April. It aims at a nominal deficit trajectory below the Treaty
reference value, which would bring down the deficit to 1.9% of GDP by the end
of the programme period. It represents an upward shift in the deficit path
compared to the 2013 Convergence Programme, e.g. for 2016, the deficit target
is currently set at 2.5% of GDP opposed to the target of 1.3% of GDP in last
year’s Convergence Programme. This revision is mainly linked to the projected
change in the official medium-term macroeconomic scenario, in particular to the
reduced nominal GDP growth path. For 2015, the Commission services' 2014 Spring
Forecast projects the achievement of the deficit target of 2.8% of GDP. However,
while the authorities' forecast presented in the 2014 Convergence Programme
calculates with a still remaining extraordinary reserve of around 0.3% of GDP,
the Commission services assumes that no reserve buffer will be left (similarly
to 2014). The programme envisages a gradual, but continuous decrease in the
government debt-to GDP ratio, from 79.2% in 2013 to 74.7% in 2017.
Further details on the assessment of the
2014 Convergence Programme for Hungary can be found in the Commission Staff
Working Document, which accompanies the Commission Recommendation for a Council
Recommendation on the 2014 National Reform Programme of Hungary and delivering
a Council Opinion on the 2014 Convergence Programme of Hungary.
In March 2012, Hungary signed the Treaty on
Stability, Coordination and Governance in the EMU. This implies an additional
commitment to conduct a stability-oriented and sustainable fiscal policy. The
TSCG will apply to Hungary in its entirety upon lifting its derogation from
participation in the single currency.
6.4.      EXCHANGE
RATE STABILITY 
The Hungarian forint does not participate
in ERM II. Between mid-2001 and early 2008, the MNB 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. On 26 February 2008, the exchange
rate bands were abolished and a free-floating exchange rate regime was adopted
that however allows for foreign exchange interventions by the Central Bank. The
move aimed at helping the MNB to better control inflation by removing possible
conflicts between maintaining the exchange rate band and the inflation target,
thereby more firmly anchoring inflation expectations. 
The forint exchange rate against the euro
has been volatile in recent years. The forint depreciated after the
parliamentary elections in spring 2010, but it gradually recovered to the
previous level by April 2011. It then weakened some 15% to the euro in the second
half of 2011, in the context of the euro area sovereign debt crisis and the
controversial early-FX-mortgage loan repayment scheme. From early 2012 to
August 2012 the forint appreciated against the euro, amid a pick-up in global
risk appetite and expectations about a potential new international financial
assistance package to Hungary. The forint was broadly stable against the euro
in the second half of 2012, but fell to 303 HUF/EUR in March 2013, with
uncertainties around the Cyprus macroeconomic assistance programme and
speculations about monetary policy under the new MNB management. Supported by
increased investor interest in EU financial assets and improvements in the
macroeconomic situation, the forint strengthened to around 293 HUF/EUR in May
and has remained relatively stable in the range of 290-300 HUF/EUR for the rest
of 2013, except for some days ahead of the Fed's September meeting and in late
December. The forint has remained at levels over 300 HUF/EUR in the first
months of 2014, with temporary pressures linked mainly to emerging market
developments triggered by expectations of a gradual normalisation of US
monetary policy, the continuation of the domestic monetary easing cycle, as
well as the political crisis in Ukraine. During the two years before this
assessment, the forint depreciated against the euro by about 4%.
International reserves peaked close to EUR
39bn in late 2011 and since early 2012 have hovered broadly around EUR 35bn, at
a level two times higher than that of the 2006-2008 pre-crisis period.
Fluctuations were mainly due to major sovereign debt management steps and to
the uneven payment of EU funds. In particular, after the early repayment of the
IMF liabilities from the 2008-2010 programme (Hungary repaid around EUR 5bn to
the IMF in 2013), international reserves fell to around EUR 31bn in August and
September 2013. However, reserves were replenished to EUR 34.7bn by
end-November by large EU-funds transfers and a USD-denominated bond issue by
the government. At the end of 2013, international reserves corresponded to
about 35% of the full year 2013 GDP. 
Short-term interest rate differentials
vis-à-vis the euro area increased from October 2011 to summer 2012, reaching
around 680 basis points in August 2012, as domestic monetary policy was
tightened in the context of deteriorating financial market sentiment, while
policy rates were reduced in the euro area. In August 2012, the MNB started a
rate-cutting cycle which initially lowered the policy rate by 25 basis points
per month. The pace of monthly reductions was scaled back to 20 bps in August
2013, to 15 bps in January 2014 and to 10 bps in March, reducing the key policy
rate overall from 7% to 2.5%. As Hungarian interbank market rates closely
followed the path of the policy rate, the short-term interest rate differential
to the euro area reflected the changes in the base rate. At the cut-off date of
this report, the 3-month spread vis-à-vis the euro area reached around 230
basis points. 
6.5.      LONG-TERM
INTEREST RATEs
For Hungary, the development of long-term
interest rates is assessed on the basis of secondary market yields on a single
benchmark bond with a residual maturity close to but below 10 years. 
The Hungarian 12-month moving average
long-term interest rate relevant for the assessment of the Treaty criterion has
been above the reference value at the time of the 2012 convergence assessment.
It was rising in 2012 till July, when it reached 8.4%, and has been falling
since then until the cut-off date. In April 2014, the latest month for which
data are available, the reference value, given by the average of long-term
interest rates in Latvia, Portugal and Ireland plus 2 percentage points, stood
at 6.2%. In that month, the twelve-month moving average of the yield on the
Hungarian benchmark bond stood at 5.8%, 0.4 percentage points below the
reference value. 
The monthly long-term interest rate of
Hungary has been on a declining trend since early 2012, when it peaked at
around 9.5%. With improving financial market confidence and a global search for
yields, the long-term rate fell to around 5% by May 2013. Afterwards, with
changing expectations about the forthcoming scaling back of the quantitative
easing by the Fed, long-term yields temporarily rose during the summer of 2013
and in early 2014, but have fluctuated generally around their April 2013 level.
Long-term spreads vis-à-vis the German benchmark bond stood at some 410 basis
points in April 2014 ([62]).
6.6.      ADDITIONAL
FACTORS
The Treaty (Article 140 TFEU) calls for an
examination of other factors relevant to economic integration and convergence
to be taken into account in the assessment. The assessment of the additional
factors – including balance of payments developments, product and financial
market integration – gives an important indication of a Member State's ability
to integrate into the euro area without difficulties. 
In November 2013, the Commission published
its third Alert Mechanism Report (AMR 2014) ([63]) under the Macroeconomic Imbalance Procedure (MIP - see also Box
1.5). The AMR 2014 scoreboard showed that Hungary exceeded the indicative
threshold in four out of eleven indicators, two in the area of external
imbalances (i.e. the net international investment position and export market
shares) and two in the area of internal imbalances (i.e. the public sector debt
and unemployment rate). In line with the conclusion of the AMR 2014, Hungary
was subject to an in-depth review, which found that Hungary continues to
experience macroeconomic imbalances, which require monitoring and decisive
policy action.
6.6.1.   Developments
of the balance of payments
The external balance of Hungary (i.e. the
combined current and capital account), turned into a surplus in 2009, which has
gradually increased each year since then, reaching 6.5% of GDP in 2013. Since
2011, the improvement has reflected higher goods and, to a lesser extent,
services trade surpluses. The balance of current transfers has also improved,
while the deficit of the income balance decreased in 2013 for the first time
since 2009. The growing surplus of the capital account reflects higher
absorption of EU funds.
Hungary's savings-investment surplus
increased in 2012 and 2013. The savings rate in the economy declined from 2011
to 2012 as the county experienced a recession. Both the household and the
enterprise sector's savings rate were lower than in previous years while the
government sector's corresponding indicator stagnated. However, the decline in
the investment rate exceeded that of savings, resulting in an improved net
lending position. In 2013 the household savings rate increased while it
declined further in the corporate sector. Overall investment as a share of GDP
has declined  between 2010 and 2012, but remained stable in 2013, reflecting
positive real growth in gross fixed capital formation for the first time since
2008.
Despite some volatility, price and cost
competitiveness indicators of Hungary have been broadly stable in the last
years. The nominal depreciation of the forint in the second half of 2011 was
reflected in the real-effective exchange rates deflated by HICP or ULC, which
were corrected in early 2012 and have remained broadly stable since then.
Hungary's export performance improved over recent years, in particular in 2013.
Mirroring a continuous external surplus,
the financial account has been in deficit since 2009. Net FDI inflows were 2.2%
of GDP in 2012 (mostly due to the automobile sector and recapitalisation in the
banking sector), but decreased to 0.6% of GDP in 2013. Net portfolio investment
inflows reached 1.9% of GDP in 2012 and rose to 3.2% in 2013, while international
reserves were quite stable despite large repayments of institutional financial
assistance loans. This, coupled with the fast deleveraging of the banking
sector resulted in a sharp decline in external debt, by about 6% and 10% of GDP
in 2012 and 2013. Consequently, gross external debt to GDP declined
significantly from around 135% at end-2011 to about 119% by 2013. The net
international investment position improved from its lowest level in 2009
(-117.2% of GDP) to -93% of GDP by 2013.
The balance-of-payments assistance granted
to Hungary by the EU and the IMF in autumn 2008 expired in late 2010. Of the
EUR 5.5 bn disbursed by the EU, EUR 3.5 bn are still outstanding. EUR 2 bn are
due on 7 November 2014, while an amount of EUR 1.5 bn is due on 6 April 2016. The
IMF loan had been reimbursed by 2013. Although Hungary asked for precautionary
balance of payments assistance from the EU and the IMF in November 2011, as the
country's financial market situation has stabilised, this request has been
withdrawn in January 2014.
According to the Commission services'
Spring Forecast, the external surplus is expected to decrease from 6.1% of GDP
in 2014 to 5.7% in 2015. This reflects a deterioration in the trade balance due
to a pick-up in the economy as well as a lower level of EU funds by the end of
the forecast horizon. 
6.6.2.   Market
integration
The Hungarian economy is highly integrated
to the euro area through trade and investment linkages. Its degree of trade
openness has increased rapidly since EU accession, from 67% in 2005 to 91% in
2012, reflecting the deeper integration of the Hungarian economy into
continental and global supply chains. Intra-euro area flows dominate both
directions of trade, accounting for 55% of trade in goods. Outside the euro
area, the main trading partners are Russia, Romania, Poland and the Czech
Republic. 
Hungary’s export of goods is heavily tilted
towards high- and medium-high technology products. However, the economic crisis
affected the share of high technology products, which came down from over 22%
of total exports in 2010 to just 17% in total exports in 2012. The high-tech
trade surplus narrowed to just 1% in 2012, but the share of machinery and
electrical equipment is over 40% in total exports in 2012, the highest among
non-euro area Member States. 
FDI inflows to Hungary decreased during the
economic crisis, but have strongly rebounded in the recent years, reaching a
high 11.1% of GDP in 2012. However, this primarily reflected a steep jump in
capital in transit and the recapitalisation of the financial sector due to
losses, and not the effect of increased new investment activities. Without the
former two factors, FDI inflows amounted to around 2½% of GDP in 2012, only
slightly higher than in previous years. Inward FDI (filtered from the effect of
capital in transit and recapitalisation in the financial sector) stood at 1¾%
of GDP in 2013. In 2012, the largest FDI investors in terms of stocks were
Germany, Luxembourg, the Netherlands and Austria. Around 45% of the total net
FDI stock is allocated in the manufacturing sector, suggesting that FDI plays a
pivotal role in enhancing Hungary’s export capacity and contribute
significantly to the integration of the Hungarian economy with the euro area.
In the past five years, real house prices
have fallen by a third in Hungary. In particular, in 2012 house prices
decreased 9% (and 8% in 2011). During this period of house price decline,
building permits were also cut by 77% between 2007 and 2012. The housing market
remained depressed also in 2013, as indicated by a 29% fall in the number of
housing permits compared to the previous year. Investment in dwellings has also
been falling steadily in the last years. It stabilised at over 2% of GDP in
2011-2012, halving the 2007-2009 levels. Value added in the construction sector
decreased by 22% between 2008 and 2012. The share of construction in total
value added stood at 4% in 2012. 
Concerning the business environment,
Hungary performs in general worse than most euro area Member States in
international rankings ([64]). It ranks
particularly low in terms of the legal and regulatory framework, which is
complex and unstable due to frequent and sometimes ad-hoc modifications ([65]). Finally, according to the 2013 Internal Market Scoreboard,
Hungary's transposition deficit of EU Directives went down to 0.5% in 2012
which is on par with the target proposed by the European Commission in the
Single Market Act (2011). 
The Hungarian labour market can be
considered as rather flexible in terms of employment protection, according to
the 2013 OECD employment protection indicator for permanent workers (Hungary
scored well below the euro-area-OECD countries' average). The crisis experience
has confirmed that the private sector reacts flexibly to profitability
pressures both in terms of wages and employment. Nevertheless, there are
certain weaknesses affecting the functioning of the labour market. The major
problem seems to be the persistently low level of private sector employment,
which is linked to both demand and supply side constraints but also reflects
inefficient government intervention. From the demand side, private sector
employment is hindered by a low level of productivity growth and capital accumulation.
From the supply side, skill mismatches, and in particular a high share of
low-skilled workers, seem to be a persistent problem. In this respect,
recurrent substantial increases in minimum wages could decrease the demand for
low-productivity workers. Both domestic and international labour mobility is
rather low in Hungary, although the latter has increased recently. Domestic
labour mobility is hindered by a weakly functioning rental market as well as
high commuting costs in underdeveloped regions.
6.6.3.   Financial
market integration
Hungary's financial sector is well
integrated into the EU's financial system. This integration is noticeable in
the share 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. Most of Hungary's major banks are subsidiaries or branches of
EU-headquartered financial institutions. The exception is the country's largest
lender in terms of assets, OTP. The share of bank assets owned by foreign
lenders has somewhat declined (to 51.7% in 2012 down from 55.5% in end-2007) as
foreign groups have been steadily deleveraging their Hungary-based business
since 2010. 
Bank
concentration, as measured by the market share of the largest five credit
institutions in total assets, is above the euro-area average and has been
rather stable since EU entry. 
Hungary has one of the best-developed
financial sectors in CEE. Total assets of the banking sector were worth EUR 108
billion in 2012 (around 110% of GDP). Indirect intermediation is predominant in
Hungary, with domestic bank credit amounting to almost 50% of GDP in 2012, down
from 61% in 2007. In the few years preceding the 2008-09 global financial
crisis, the banking sector had been expanding at a fast pace, mainly thanks to
rapid credit growth fuelled among others by ample liquidity supplied by parent
banks. In the past three years bank lending to households and to the
non-financial private sector fell compared to levels recorded back in 2009. In
2012 banks' total assets were shrinking by 6.1% y-o-y, with household loans
decreasing by a considerable 11.7% and corporate loans down by 5.6%. The
deleveraging of the private sector continued throughout 2013. Nevertheless,
banks in Hungary continue to be heavily exposed to wholesale and
foreign-currency funding and parental support constraints. Furthermore, given
the high share of foreign-currency-denominated loans, with a large majority in
Swiss franc, the exposure of the private sector to exchange rate risk is to
remain substantial in the years to come. The aggregate private sector debt of
around 131% of GDP in 2012 was somewhat below the euro area average (145% of GDP)
([66]).
The Hungarian banking system remains
well-capitalized, with a record-high capital adequacy ratio of 17% in mid-2013.
However, the return on equity in the first half of 2013 was a mere 1.8%. Banks'
profitability in the recent years has been suppressed by losses related to the
early-FX-mortgage repayment scheme and the heavy tax burden imposed on the
financial sector. Moreover, loan portfolio quality has been continuously
deteriorating since the 2008-09 crisis. Non-performing loans reached 14.7% of the
loan book by mid-2013. 
The
share of financial intermediaries other than banks and credit cooperatives in
total assets of the Hungarian financial system declined after 2008. Following
the outbreak of the financial crisis investment funds were hit by losses
suffered on the capital market and by withdrawals of capital, but inflows have
picked up strongly in 2012 and 2013. The pension funds industry suffered a
major setback in 2011 after the second-pillar pension funds were transferred to
the state social security system.
The
stock exchange does not play a decisive role in the financing of the economy.
The market capitalisation of the BSE equalled just about 15% of the 2013 GDP,
around half of its 2007 level. The activity of both national and international
trading members declined significantly. As a result of high central government
issuance, the total value of outstanding fixed income securities amounted to
some 95% of GDP in 2013. Private sector bond issuance followed a pan-European
growth trend and represented about 7% of GDP in 2012.
As of 1 October 2013 the Hungarian financial
market supervision framework was changed. The new framework opts for an
integrated supervisory structure where the competence for both macro- and
micro-prudential supervision as well as consumer protection in the financial
services area is consolidated within the central bank. Hungary complied with
the transposition of EU financial services legislation.
7.1.      LEGAL
COMPATIBILITY
7.1.1.   Introduction
The Act on the Narodowy Bank Polski (the
NBP Act) was adopted on 29 August 1997. The consolidated version that includes
all amendments to the NBP Act was published in Dziennik Ustaw of 2013, item
908. The NBP Act has not been amended since the 2012 Convergence Report.
Therefore, the comments provided in the 2012 Convergence Report are largely
repeated in this year's assessment. 
7.1.2.   Central
bank independence
The NBP Act does not explicitly prohibit
the NBP and members of its decision-making bodies from seeking or taking
outside instructions; it also does not expressly prohibit the Government from
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. The
absence of such a reference constitutes an incompatibility with respect to Article
130 of the TFEU and Article 7 of the ESCB/ECB Statute.
Article 23(1)(2) provides that the NBP's
President has, inter alia, to submit draft monetary policy guidelines to the
Council of Ministers and the Minister of Finance. This procedure provides the opportunity
for the government to exert influence on the monetary and financial policy of
the NBP and thus, constitutes an incompatibility in the area of independence,
with Article 130 of the TFEU and Article 7 of the ESCB/ECB Statute.
Article 9(3) of the NBP Act foresees that
the President of the NBP shall assume his/her duties after taking an oath
before the Parliament. This oath refers 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. The President of the NBP acts in dual capacity as a
member of NBP’s decision-making bodies and of the relevant decision-making
bodies of the ECB. Article 9(3) of the NBP Act needs to be adapted to reflect
the status and the obligations and duties of the President of the NBP as member
of the relevant decision-making bodies of the ECB. Moreover, the oath does not
contain a reference to central bank independence as enshrined in Article 130 of
the TFEU. The oath as it stands now, is an imperfection and should be adapted
to be fully in line with the TFEU and the ESCB/ECB Statute.
The wording of the grounds for dismissal of
the NBP's governor as enumerated in Article 9(5) of the NBP Act could be
interpreted as going slightly beyond those of Article 14.2 ESCB/ECB Statute.
This imperfection should be removed to bring Article 9(5) of the Act fully in
line with Article 130 of the TFEU.
The Law on the State Tribunal provides for
suspension of the Governor from his duties following a procedure which is
incompatible with the principle of central bank independence and Article 14.2
of the Statute of the ESCB and of the ECB. Pursuant to the second sentence of
Article 11(1) of the Law on the State Tribunal read in conjunction with Article
3 and Article 1(1)(3) of the very law, the Governor of the NBP can be suspended
as a result of an indictment by the Parliament even before the State Tribunal
has delivered its judgment on the removal from the office. The procedure
violates the principle of central bank independence and Article 14 (2) of the
Statute given that the latter has to be understood as allowing for removal on
grounds of serious misconduct only if the Governor has been guilty as
established by a court decision ('guilty'). A suspension from office on grounds
of serious misconduct and further to parliamentary indictment deprives the
Governor of the possibility to continue exercising the duties until a court has
found the governor guilty of serious misconduct pursuant to Article 14.2 of the
Statute. Therefore, this procedure breaches the Statute and Article 130 of the
TFEU.
According to Article 203(1) of Poland’s
Constitution, the Supreme Chamber of Control (Najwyższa Izba Kontroli
(NIK)) is entitled to examine the NBP's activities as regards its legality,
economic prudence, efficiency and diligence. The NIK controls are not performed
in the capacity of an independent external auditor, as laid down in Article
27.1 of the ESCB/ECB Statute and thus, should be clearly defined so as to
respect Article 130 of the Treaty and Article 7 of the ECB/ESCB Statute. The
relevant provision of the Constitution is therefore, incompatible and needs to
be adapted in order to respect the ECB/ESCB Statute. 
7.1.3.   Prohibition
of monetary financing and privileged access
Article 42 in conjunction with Article
3(2)(5) of the NBP Act allow the NBP to extend refinancing loans to banks in
order to replenish their funding and also extend refinancing to banks for the
implementation of a bank rehabilitation programme, subject to conditionality
under Article 42(4) of the same Act. Against this background, the current
wording of Article 42(3) and (4) can be interpreted as allowing an extension of
refinancing loans to banks experiencing rehabilitation proceedings which
however could end in insolvency of the banks concerned. Effective preventive
measures and more explicit safeguards should be provided in the NBP Act to
clarify compatibility with Article 123 of the TFEU.
7.1.4.   Integration
in the ESCB
Objectives
Article 3(1) of the NBP Act 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 and Article 2 of the
ESCB/ECB Statute.
Tasks
The incompatibilities in the NBP Act and in
the Polish Constitution in this area are linked to the following ESCB/ECB/EU
tasks:
·       definition and implementation of monetary policy (Articles 227(1)
and (5) of the Constitution, Articles, 3(2)(5), 12, 23, 38-50a, and 53 of the
NBP Act);
·       holding of foreign reserves; management of foreign exchange and the
definition of foreign exchange policy (Articles 3(2)(2),   3(2)(3),  17(4)(2),
24 and 52 of the NBP Act);
·       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 NBP Act).
The NBP shall exercise its responsibility for issuing the national currency as
part of the ESCB.
·       appointment of independent auditors - Article 69(1) of the NBP Act
foresees that NBP accounts are examined by the independent auditors. The NBP
Act does not take into account that 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. 
There are also some imperfections
regarding:
·       non-recognition of the role of the ECB in the functioning of the
payment systems (Articles 3(2)(1) of the NBP Act);
·       non-recognition of the role of the ECB and of the EU in the
collection of statistics (Article 3(2)(7) and 23 of the NBP Act);
·       non-recognition of the role of the ECB in the field of international
cooperation (Article 5(1) and 11(3) of the NBP Act);
7.1.5.   Assessment
of compatibility
As regards the independence of the central
bank, the prohibition on monetary financing and the central bank integration
into the ESCB at the time of euro adoption, the legislation in Poland, in
particular the NBP Act and the Constitution of the Republic of Poland are not
fully compatible with the compliance duty under Article 131 of the TFEU.
7.2.      PRICE
STABILITY
7.2.1.   Respect
of the reference value
The 12-month average inflation rate for
Poland, which is used for the convergence evaluation, was above the reference
value at the time of the last convergence assessment of Poland in 2012. Average
annual inflation declined gradually from above 4% in mid-2012 to below 1% by
late 2013. In April 2014, the reference value was 1.7%, calculated as the
average of the 12-month average inflation rates in Latvia, Portugal and Ireland
plus 1.5 percentage points. The corresponding inflation rate in Poland was
0.6%, i.e. 1.1 percentage points below the reference value. The 12-month
average inflation rate is likely to remain below the reference value in the
months ahead.
7.2.2.   Recent
inflation developments
Annual inflation remained relatively stable
until mid-2012 and then decelerated substantially, reflecting, inter alia, the
impact of international energy prices and, to a lesser degree, food prices.
Weakening domestic demand exerted downward pressure on prices of services,
while non-energy industrial goods prices benefited from a stable exchange rate
and weak inflationary pressure in the global markets.
More specifically, annual HICP inflation
posted only a marginal decline from 4.1% in January 2012 to 3.8% in September
2012, due to favourable base effects (energy) and decelerating inflation of
imported industrial goods. It fell rapidly in late 2012 and during the first
half of 2013, posting the lowest annual increase on record of 0.2% in June.
Apart from favourable commodity price developments, this strong disinflation
also reflected an abrupt decrease in the prices of telecommunication services.
HICP inflation increased again to 0.9% in the third quarter of 2013, partly on
account of a pick-up in annual growth of unprocessed food prices and a sharp
one-off increase in waste removal fees in July 2013. As a result, annual HICP
inflation averaged 0.8% in 2013. In early 2014, annual inflation remained below
1%.
Until the end of 2012, core inflation
(measured as HICP inflation excluding energy and unprocessed food) evolved
broadly in line with HICP inflation, albeit at a lower level. Core inflation
declined gradually from above 3% in early 2012 to below 1% by mid-2013,
stabilising during the second half of 2013. The smaller decline compared to
headline inflation reflected relatively more persistent inflation of services
and processed food prices while prices of non-energy industrial goods fell in
2013. In the absence of cost pressures, annual average producer price inflation
for total industry also turned negative, averaging -1.3% in 2013.
7.2.3.   Underlying
factors and sustainability of inflation
Macroeconomic policy-mix and cyclical stance
Real GDP growth declined to 1.6% in 2013,
down from 2% a year earlier, well below estimates of potential output growth of
around 3¼%. Growth was mainly supported by net exports. The output gap is thus
estimated to have narrowed considerably in 2012 before turning negative in
2013. According to the Commission services' 2014 Spring Forecast, real GDP
growth is projected to rebound to 3.2% in 2014 and 3.4% in 2015, implying a
stabilisation of the negative output gap.
After a counter-cyclical fiscal contraction
in 2011, the fiscal stance, as measured by changes in the structural balance,
was further tightened in 2012 and in 2013. Fiscal consolidation is expected to
resume in 2014-2015 as Poland is committed to ensuring a timely correction of
its excessive deficit. 
Monetary policy, conducted within an
inflation targeting framework ([67]), was last tightened in May 2012 when annual inflation was near its
peak. In line with the subsequent disinflation trend, the Monetary Policy
Council (MPC) cut its main policy rate steadily from 4.75% in early November
2012 to 2.5% in July 2013. The MPC then kept the policy rate unchanged during
the second half of 2013 and in early 2014. 
Wages and labour costs
Wage negotiations in the private sector are
rather decentralised and flexible, with wage setting taking place mostly at the
enterprise level, although collective bargaining has a stronger impact on wage
formation in sectors dominated by state enterprises, such as mining. The
unemployment rate has increased marginally in 2012 and 2013 as total employment
stagnated.
Despite lower labour productivity growth,
the temporary economic rebound of 2010-2011 was still partly reflected in
growth of compensation per employee in 2012, implying higher nominal ULC
growth. In 2013, the continued weakening of aggregate economic activity
translated into more limited wage increases. As a result, nominal ULC increased
by less than 1%. ULC growth is expected to remain contained in 2014 before
picking up in 2015 as growth of compensation per employee should accelerate
faster than labour productivity growth.
External factors
Although external trade represents a lower
share of GDP in Poland than in regional peers, prices of imported goods and
services play an important role in domestic price formation. Import prices
(measured by the imports of goods deflator) surged in 2011, driven by a
substantial depreciation of the nominal effective exchange rate (measured
against a group of 36 trading partners). Import prices continued to rise in
2012, mainly as a result of higher global commodity prices, before broadly
stabilising in 2013. The import deflator is forecast to increase somewhat in
2014, mainly on account of an expected pick-up in global economic activity and
thus price pressures.
Administered prices and taxes
Increases in administered prices ([68]), with a weight of around 14% in the HICP basket (compared to 13%
in the euro area), significantly exceeded HICP inflation in recent years. The
average annual increase in administered prices remained above 5% in 2012,
driven by increases in tariffs for gas, electricity and heating as well as
increasing local fees (housing, public transport). It fell to 1.7% in 2013, on
the back of a cut in regulated gas prices for households in January 2013 and a
decrease in the price of electricity in July 2013, though their effect was
somewhat counterbalanced by an increase in waste management fees. Administered
prices should continue increasing at a moderate pace in 2014, mainly due to
limited growth of electricity and gas prices.
The impact of tax measures on the overall
consumer price developments was marginal in 2012 and 2013 as constant tax
inflation lingered only some 0.2-0.3 percentage points below headline
inflation. A marginally positive inflation contribution from higher excise
duties on alcohol is expected in 2014. 
Medium-term prospects
Looking ahead, price inflation is expected
to increase only gradually on account of a negative output gap. The
deflationary impact of one-off measures (lower prices of telecommunication
services) effective in 2013 should largely fade out in 2014. The Commission services'
2014 Spring Forecast projects HICP inflation to average 1.1% in 2014 and 1.9%
in 2015. 
Risks to the inflation outlook appear to be
broadly balanced. Stronger exchange rate depreciation, driven by a gradual
withdrawal of monetary stimulus in the US and associated capital outflows from
emerging markets, could result in higher consumer price growth. On the other
hand, the outlook for global growth and related price pressures remains
fragile. 
The level of consumer prices in Poland was
close to 56% of the euro-area average in 2012. This suggests potential for
further price level convergence in the long term, as income levels (about 62%
of the euro-area average in PPS in 2012) increase towards the euro-area
average.
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 to
facilitate the effective allocation of labour market resources will play an
important role in alleviating potential wage pressures, resulting inter alia
from negative demographic developments. As to product markets, there is scope
to enhance the competitive environment, especially in the services and energy
sectors. At the macro level, a prudent fiscal stance will be essential to
contain inflationary pressures.
7.3.      PUBLIC
FINANCES
7.3.1.   The
excessive deficit procedure for Poland
On 7 July 2009, the Council decided in
accordance with Article 104(6) of the Treaty establishing the European
Community (TEC) that an excessive deficit existed and addressed recommendations
to Poland, in accordance with Article 104(7) TEC with a view to bringing an end
to the situation of an excessive government deficit by 2012. 
On 21 June 2013, the Council concluded that
Poland had taken effective action but adverse economic events with major
implications on public finances had occurred, and issued revised recommendation
under Article 126(7) TFEU, in which it recommended that Poland should put an
end to the excessive deficit situation by 2014. The Council established the
deadline of 1 October 2013 for Poland to take effective action. 
On 10 December 2013, the Council
established in accordance with Article 126(8) TFEU that Poland had not taken
effective action. It adopted a new recommendation under Art.126 (7) TFEU,
according to which Poland should bring an end to the excessive deficit
situation by 2015 in a credible and sustainable manner. Moreover, Poland should
reach a headline deficit target of 4.8% of GDP in 2013, a deficit of 3.9% of
GDP in 2014 and of 2.8% of GDP in 2015 (excluding the impact of the assets
transfers due to the reversal of the pension reform which have been
subsequently enacted in December 2013). For 2014 this is consistent with an
improvement of the structural balance of 1% of GDP and 1.2% of GDP for 2015,
based on the Commission services' 2013 Autumn Forecast. The Council established
the deadline of 15 April 2014 for Poland to take effective action and to report
in detail the consolidation strategy that is envisaged to achieve the
targets. ([69]) 
7.3.2.   Recent
fiscal developments
The headline general government deficit
declined gradually from 7.8% of GDP in 2010 to 3.9% in 2012 before increasing
again to 4.3% in 2013.
In 2012, the deficit reduction was driven
by the fall in government expenditures. On the revenue side, an unexpected fall
in indirect tax revenues (by 0.3% of GDP) offset the new structural
consolidation measures, notably an increase by 2 percentage points of the
disability contribution rate, a new tax on copper and silver extraction, a
continued freeze in PIT thresholds and some changes in excise duties. On the
expenditure side, the improvement was mostly due to the sharp cut in public
investments. Moreover, the government maintained the freeze in the wage fund of
public sector employees and decreased the complementary direct payments to
farmers in the framework of the Common Agricultural Policy. 
In 2013, the deficit increased mainly due
to a weak performance of revenues related to slow economic growth. General
government revenues were nevertheless positively affected by the full-year
carry-over effect of measures taken in 2012 (an increase in the disability contribution
rate and the new mining tax) and of keeping the nominal PIT thresholds
unchanged. The total expenditure-to-GDP ratio fell thanks to a cut in public
investments. Notwithstanding some structural expenditure measures (a continued
freeze of wages of most central government employees, the start of a gradual
increase in retirement age and an amendment to the 2013 state budget containing
expenditure cuts), current expenditures grew slightly more than the nominal
GDP.
The debt-to-GDP ratio remained below but
close to 60% of GDP as a result of persistent general government deficits. It
slightly fell from 56.2% in 2011 to 55.6% in 2012 and then rose to 57% in 2013.
7.3.3.   Medium-term
prospects 
In 2014-15, the general government budget
balance will be affected by the reversal of the systemic pension reform. It
includes the following asset transfers from the second, private pension pillar
to the first one: a one-off transfer of assets worth about 9% of GDP in 2014 as
well as annual transfers of assets of persons who retire within 10 years,
starting in 2014. Under current accounting rules (ESA95), such asset transfers
are treated as general government revenue. Under the new rules, which will come
into force in autumn 2014 (ESA2010), such transfers will not count as revenue
anymore.
As a result, according to the Commission
services' 2014 Spring Forecast the general government budget balance is
projected to turn into a surplus of 5.7% of GDP in 2014 under ESA95, while it
is set to post a deficit of 3.6% with the asset transfers from the second
pension pillar not treated as revenue. Apart from the reversal of the pension
reform, the main measures with a positive and permanent effect on the general
government balance in 2014 include changes in VAT and excise duties, a continued
freeze in PIT thresholds, a partial public wage freeze and a gradual increase
in the retirement age. Expenditure savings will be partially offset by the
costs of a legislated extension of maternity leave and other increases in
social spending. 
In 2015, due to the one-off nature of the
large improvement in 2014, the general government budget balance is expected to
turn negative again, posting a deficit of 2.9% of GDP under ESA95. Excluding
the asset transfers due to the reversal of the pension reform, the deficit is
projected to reach 3.1% of GDP in 2015.
The structural deficit is estimated in the
Commission services' 2014 Spring Forecast to gradually improve, from 3.8% of
GDP in 2013 to 2.4% of GDP in 2015. 
The general government debt-to-GDP ratio is
forecast to fall to 49.2% in 2014, mainly as a result of the transfer of
pension fund assets, before increasing to 50% in 2015. The projected debt
figures are, however, subject to considerable uncertainty in view of possible
valuation effects of the sovereign debt denominated in foreign currency due to
exchange rate fluctuations.
The 2014 Convergence Programme was
submitted on 23 April 2014. It confirms the government's commitment to bring
the deficit below the EDP reference value of 3% of GDP by 2015 and sets a 2018
deadline to achieve the Medium Term Objective of a structural deficit of not
more than 1% of GDP. The nominal balance is expected in the programme to reach
a surplus of 5.8% of GDP in 2014 and a deficit of -2.5% of GDP in 2015 under
ESA95. These projections are more optimistic compared to Commission services'
2014 Spring Forecast, in particular due to a more optimistic macroeconomic
scenario underpinning these budgetary projections. 
Further details on the assessment of the
2014 Convergence Programme for Poland can be found in the Commission Staff
Working Document, which accompanies the Commission Recommendation for a Council
Recommendation on the 2014 National Reform Programme of Poland and delivering a
Council Opinion on the 2014 Convergence Programme of Poland.
In March 2012, Poland signed the Treaty on
Stability, Coordination and Governance in the EMU. The TSCG will apply to
Poland in its entirety upon lifting its derogation from participation in the
single currency.
7.4.      EXCHANGE
RATE STABILITY
The Polish zloty does not participate in
ERM II. Since April 2000, Poland operates a floating exchange rate regime, with
the NBP preserving the right to intervene in the foreign exchange market, if it
deems this necessary, in order to achieve the inflation target. 
Following a sharp depreciation in the
second half of 2011 – which induced foreign exchange market interventions by
the NBP – the zloty's exchange rate against the euro partially recovered in
early 2012. The zloty thereafter broadly stabilised and predominantly traded in
the range of 4.1-4.3 PLN/EUR until early 2014. Compared to April 2012, the
exchange rate of the zloty against the euro was thus basically unchanged in
April 2014. 
After remaining broadly stable at around
EUR 75 billion in 2011, international reserves increased throughout 2012 to
some EUR 85 billion in early 2013. Afterwards, the reserve level declined again
gradually to about EUR 77 billion (20% of GDP) by end-2013.
Short-term interest rate differentials
vis-à-vis the euro area widened in late 2011 and during the first eight months
of 2012, as the ECB loosened its policy stance while rates on the Polish money
market increased somewhat. After peaking at above 470 basis points in August
2012, short-term spreads declined to below 250 by mid-2013 reflecting
considerable monetary policy easing by the NBP which gradually cut its key
reference rate by 225 basis points between November 2012 and July 2013. At the
cut-off date of this report, the 3-month spread vis-à-vis the euro area
remained closed to 240 basis points. 
7.5.      LONG-TERM
INTEREST RATEs
Long-term interest rates in Poland used for
the convergence examination reflect secondary market yields on a single
benchmark government bond with a residual maturity of close to but below 10
years. 
The Polish 12-month average long-term
interest rate relevant for the assessment of the Treaty criterion was exactly
at the reference value at the time of the last convergence assessment in 2012.
It declined gradually from close to 6% in late 2011 to about 4% by end-2013. In
April 2014, the latest month for which data are available, the reference value,
given by the average of long-term interest rates in Latvia, Portugal and
Ireland plus 2 percentage points, stood at 6.2%. In that month, the 12-month
moving average of the yield on the Polish benchmark bond stood at 4.2%, i.e. 2
percentage points below the reference value.
Long-term interest rates declined from
above 6% in early 2011 to below 4% by end-2012, reflecting improved investor
sentiment towards the country as well as a substantial fall in domestic inflation.
Long-term interest rates increased again during the second half of 2013 as risk
appetite in global financial markets dwindled. As a result, long-term interest
rate spreads vis-à-vis the German benchmark bond hovered around 270 basis
points in early 2014 ([70]).
7.6.      ADDITIONAL
FACTORS
The Treaty (Article 140 TFEU) calls for an
examination of other factors relevant to economic integration and convergence
to be taken into account in the assessment. The assessment of the additional
factors – including balance of payments developments, product and financial
market integration – gives an important indication of a Member State's ability
to integrate into the euro area without difficulties. 
In November 2013, the Commission published
its third Alert Mechanism Report (AMR 2014) ([71]) under the Macroeconomic Imbalance Procedure (MIP - see also Box
1.5). The AMR 2014 scoreboard showed that Poland exceeded the indicative
threshold for two out of ten indicators, both in the area of external
imbalances (i.e. the current account balance and the international investment
position). In line with the conclusions of the AMRs 2012-2014, Poland has not
been subject to in-depth reviews in the context of the MIP.
7.6.1.   Developments
of the balance of payments
Poland’s external balance (i.e. the
combined current and capital account) remained in deficit in 2012, but it
narrowed considerably due to a lower trade deficit. The improvement in the
trade balance was driven by sustained export growth, fuelled by increasing
geographical diversification of exports and a low cost base, and subdued
imports, reflecting sluggish domestic demand growth. The external balance
turned positive in 2013, reflecting a further improvement in the trade balance,
which shifted into a surplus as exports continued to grow while lacklustre
growth of domestic demand dampened imports. At the same time, the negative
balance of primary income and the positive balance of current transfers
remained broadly stable in 2011-2013. 
As far as the saving-investment balance is
concerned, gross national saving (as a percentage of GDP) decreased in 2012.
The decrease was driven by falling gross saving by the private sector, in
particular households, which was only partially offset by higher government
saving. Gross national saving remained stable in 2013, despite a substantial
decline in government saving, as households started to increase their savings
again. At the same time, after a temporary increase in 2010-2011, domestic
investment activity (as a percentage of GDP) decreased in 2012 and 2013, on the
back of decreasing investment spending by the corporate and government sectors.
Overall, the corporate sector investment-to-GDP ratio in Poland is one of the
lowest in the EU and compares unfavourably to its peers.   
Poland's external competitiveness appears
to have remained solid in recent years as confirmed by its continuously
improving export performance. After a substantial nominal and real depreciation
in the second half of 2011, the real effective exchange rate appreciated
somewhat in 2012, in line with the change in the nominal effective exchange
rate. It remained broadly stable over 2013.  
On the financing side of the balance of
payments, net inflows of foreign direct investment (FDI), which covered almost
50% of the current account deficit in 2011, declined substantially in 2012,
mostly as a result of lower direct investment in Poland, and then turned
marginally negative in 2013. Due to rapidly increasing holdings of government
debt securities by non-residents, net inflows of portfolio investment were the
main source of foreign financing between 2009 and 2012. Portfolio investment
flows were broadly balanced in 2013 as non-residents' holdings of government
debt securities stabilised. Net inflows of other investment and financial
derivatives have remained relatively low in recent years, mainly due to lower
external borrowing by the private sector.
Total gross external debt increased from
63% of GDP in 2011 to 73% of GDP in 2013, while the negative net international
investment position also widened considerably. The stability of the balance of
payments was supported by the IMF's Flexible Credit Line arrangement, which was
initially granted in May 2009 and renewed in January 2011 and January 2013,
when it was increased and extended for another two years.
According to the Commission services' 2014
Spring Forecast, the external balance is expected to remain broadly stable in
2014 before deteriorating somewhat in 2015 as imports are foreseen to outpace
exports.
7.6.2.   Market
integration
Poland's economy is well integrated to the
euro-area through both trade and investment linkages. Following a decrease in
2008-2009 as a result of the crisis, trade openness increased further in the
following years, reaching some 47% of GDP in 2012, a higher percentage than for
some euro-area Member States. The share of extra-euro-area trade in goods, as
percent of GDP, has increased in recent years, reflecting the increase in
competiveness on the international stage, while the share of intra-euro-area
trade has remained broadly stable over the period under review. The share of
intra-euro-area trade in services has increased somewhat, spurred by business
process outsourcing activities.
The composition of Polish exports in goods
has evolved towards medium-to-high technology goods, though the share of
traditional industries (e.g. metal products, food, mineral fuels, chemicals,
furniture) remains high. In 2012, the export structure was dominated by
machinery and electrical equipment (24%) as well as vehicles, aircraft and
vessels (14%), reflecting the presence of multinational corporations in these
sectors which lead to technology transfers and contribute to export
competitiveness. The high-tech trade deficit, which was historically around
2.5%, has come down in 2012 to just 2% of the GDP, reflecting an increase in
exports with high technological content. This evolution is slow, partly due to
the limited inflow of FDI into high technology sectors, as well as low domestic
R&D spending, weak links between research institutes and the private sector
and relatively low quality of the research institutional framework.
FDI inflows mainly originated in Germany,
the Netherlands, France and Luxembourg, which together provided over 50% of the
FDI stock at the end of 2012. The significant size and growth of the domestic
market as well as a good access to large regional markets are pointed out as
main reasons for the attractiveness of the country for FDI.
According to Eurostat, real house prices in
Poland declined by over 20% between 2008 and 2012. In 2012, the year-on-year
decline amounted to 6%. Investment in dwellings has remained stable at around
3% of GDP for the past six years. Value- added in construction increased
steadily in real terms since 2005, but seems to have come to a halt in 2012.
After falling significantly during the crisis years, building permits
stabilised but a double digit decline (11% y-o-y) re-appeared in 2012,
indicating that construction activity may be subdued in the coming years.
Concerning the business environment, Poland
performs in general worse than most euro-area Member States in international
rankings. Two legislative packages were adopted in 2011 aimed at reducing the
number of procedures and administrative obligations imposed on businesses,
including by replacing administrative certificates with declarations, and to
reduce information obligations. These changes, among others, have contributed
to a slight increase in the scores recorded by Poland in international rankings
([72]). According
to the 2013 Internal Market Scoreboard, Poland has yet to attain the 1%
threshold deficit in the transposition of EU directives. 
One of the strengths of the Polish economy
is its endowment with a high-quality labour force and the regulatory set-up of
the labour market. The labour force is relatively skilled, labour taxes are
comparatively low, though not for the low skilled, and labour laws provide for
a sufficient degree of flexibility. In particular, protection of permanent
employees against collective and individual dismissals is (according to the
2013 OECD employment protection indicator) below the euro-area-OECD countries'
average while collective wage bargaining usually takes place at the company
level, allowing for a flexible wage adjustment process. 
However, this legal framework did not
prevent the development of a segmented labour market with a high share of
temporary employment, which might hinder productivity growth and human capital
formation. Moreover, existing special retirement schemes, in particular for
farmers, inhibit internal labour migration and reallocation of labour from
low-productivity sectors. Moreover, outward migration flows, especially after
EU accession, were substantial, while non-EU immigration is limited by the
existing restrictions on long-term immigration. Finally, the low quality and
applicability of higher education and poor access to good quality
apprenticeships and work-based learning aggravates the mismatch between the
supply of skills and labour market needs, especially for non-tertiary education
graduates.
7.6.3.   Financial
market integration
Poland's financial sector is well
integrated within the overall EU financial system. In 2012, over 63% of the
Polish banking sector's assets were owned by foreign financial institutions,
predominantly headquartered in EU Member States. Among the top ten banks
operating in Poland in 2013 just two are domestic, seven are subsidiaries of
major European banks and one belongs to a US financial institution.
Concentration in the Polish banking sector has remained close to the euro-area
average. The share of total assets owned by the five largest lenders amounted
to 47% after a number of mergers were finalised in 2012/13. 
With an aggregated asset size close to EUR
340 billion (end-2013) Poland has the biggest and one of the most developed
banking sectors among the new EU Member States. However, rising uncertainties
and slower economic growth in the past year were also reflected in the pace of
the banking sector's balance sheet expansion, with credit to the non-financial
private sector increasing by 3.8% in 2013. Nonetheless, when looking at the
longer-term trend, credit to the private economy was equivalent to 51% of GDP
in 2013, compared to 39% in 2007. The share of foreign-currency denominated
loans remains significant, particularly in the mortgage loan segment where
every second housing loan is denominated either in Swiss franc or euro.
Nevertheless, the share of FX loans has been gradually declining as most banks
dropped FX mortgages from their offer already back in 2009. Private sector
debt ([73]) remained
close to 75% of GDP in 2012, significantly below the euro-area average of 145%.

The capitalisation of banks continued to
improve reaching a capital adequacy ratio (CAR) of 15.3% in mid-2013. At almost
11%, the return on equity (ROE) remained considerable in the first half of
2013, double the euro-area average. The non-performing loans ratio followed the
euro-area trend and deteriorated during the crisis to about 6½% in 2009-2010,
up from 3.9% in 2007, before dropping to 6% in June 2013.
Non-banking institutions such as private
pension funds, asset management companies and insurance companies play a
relatively important role in financial intermediation in Poland and represent
about 30% of the aggregated assets of all domestically-based financial
institutions at the end of 2012. The private pension funds launched in 1999 are
the biggest players in this category with assets totalling about EUR 64 billion
(end-2012) and also belong to the biggest domestic institutional investors.
Their size is, however, set to shrink by about half in mid-2014 as a result of
new rules concerning the distribution of pension assets between the public
pay-as-you-go scheme and private pension funds. The insurance sector has also
been growing, but its size is still far below the euro-area average. It remains
dominated by three major players controlling about 75% of the insurance premia.
Investment funds have rapidly expanded through 2012 and 2013 increasing in size
by 28% and 15%, respectively, on the back of the good stock market performance.

Stock market capitalisation represented 36%
of GDP in 2013, down from a pre-crisis record high of 46% of GDP in 2007. Both
domestic and international investors have access to the Warsaw Stock Exchange
(WSE), the latter owning almost half of WSE's capitalisation. The WSE has so
far not taken part in the European stock exchange consolidation process. The
debt securities market, amounting to some 64% of GDP in 2013, is the largest
and most liquid in the region. It is dominated by government bonds (over 90%
share) while corporate bonds account for about 7% of the outstanding amounts.
Since 2006, the supervision of the
financial sector has been consolidated within the Polish Financial Supervision
Authority (KNF). In 2013, the scope of KNF's supervision was expanded to also
cover credit unions (SKOK), which suffered from comparatively low capital ratios.
Nonetheless, their total assets make up only a small part of the total
financial sector balance sheet. The KNF actively cooperates with its peers in
the European System of Financial Supervisors and has signed memoranda of
understanding with the home authorities of local foreign-bank subsidiaries.
Poland achieved full compliance with the EU financial services legislation and
implemented on time most of the subsequent directives.
8.1.      Legal
compatibility
8.1.1.   Introduction
The Banca Naţională a României
(BNR – central bank of Romania) is governed by Law No. 312 on the Statute of
the Bank of Romania of 28 June 2004 (hereinafter 'the BNR Law') which entered
into force on 30 July 2004.
The BNR law has not been amended since the
Convergence Report 2012. Therefore, the comments provided in the Convergence
Report 2012 are largely repeated in this year's assessment. Government
Emergency Ordinance 90/2008 on the statutory audit of the annual financial
statements and of the consolidated annual financial statements has been amended
with a view to achieve compatibility with Article 123 TFEU.
8.1.2.   Central
Bank independence
As regards central bank independence, a
number of incompatibilities and imperfections have been identified with respect
to the TFEU and the ESCB/ECB Statute. 
According to Article 33(10) of the BNR Law,
the Minister of Public Finances and one of the State Secretaries in the
Ministry of Public Finances may participate, without voting rights, in the
meetings of the BNR Board. Although a dialogue between a central bank and third
parties is not prohibited as such, this dialogue should be constructed in such
a way that the Government should not be in a position to influence the central
bank's decision-making in areas for which its independence is protected by the
Treaty. The active participation of the Minister, even without voting right, in
discussions of the BNR Board where BNR policy is set could structurally offer
to the Government the possibility to influence the central bank when taking its
key decisions. Against this background, Article 33(10) of the BNR Law is
incompatible with Article 130 of the TFEU. 
Article 3(1) of the BNR Law needs to be
amended with a view to ensuring full compatibility with Article 130 of the TFEU
and Article 7 of the ESCB/ECB Statute. Pursuant to Article 3(1) of the BNR Law,
the members of the BNR's decision-making bodies shall not seek or take
instructions from public authorities or from any other institution or
authority. First, for legal certainty reasons, it should be clarified that the
BNR's institutional independence is protected vis-à-vis national, foreign and
EU institutions or bodies. Moreover, Article 3 should expressly oblige the
government not to seek to influence the members of the BNR's decision-making
bodies in the performance of their tasks.
The BNR Law should be supplemented by rules
and procedures ensuring a smooth and continuous functioning of the BNR in case
of the Governor's termination of office (e.g. due to expiration of the term of
office, resignation or dismissal). So far, Article 33(5) of the BNR Law
provides that in case the Board of BNR becomes incomplete, the vacancies shall
be filled following the procedure for the appointment of the members of the
Board of BNR. Article 35(5) of the BNR Law stipulates that in case the Governor
is absent or incapacitated to act, the Senior Deputy Governor shall replace the
Governor. 
Pursuant to Article 33(9) of the BNR Law,
the decision to recall a member of the BNR Board (including the Governor) from
office may be appealed to the Romanian High Court of Cassation and Justice.
However, Article 33(9) of the BNR Law remains silent on the right of judicial
review by the Court of Justice of the European Union in the event of the
Governor's dismissal provided in Article 14.2 of the ESCB/ECB Statute. This
imperfection should be corrected.
Article 33(7) of the Law provides that no
member of the Board of BNR may be recalled from office for other reasons or
following a procedure other than those provided in Article 33(6) of this Law.
Law 161/2003 on certain measures for transparency in the exercise of public
dignities, public functions and business relationships and for the prevention
and sanctioning of corruption and the Law 176/2010 on the integrity in the
exercise of public functions and dignities define the conflicts of interest
incompatibilities applicable to the Governor and other members of the Board of
the BNR and require them to report on their interests and wealth. For the sake
of legal certainty, it is recommended to remove this imperfection and provide a
clarification that the sanctions for the breach of obligations under those Laws
do not constitute extra grounds for dismissal of the Governor of the Board of
BNR, in addition to those contained in Article 33 of the BNR Law.
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 establishment,
management and use of the public sector’s financial resources, including BNR's
financial resources, and to audit the performance in the management of the
funds of the BNR. Those provisions constitute an imperfection and thus, for
legal certainty reasons, it is recommended to define clearly in the Law the
scope of audit by the Court of Auditors, without prejudice to the activities of
the BNR’s independent external auditors, as laid down in Article 27.1 of the
ECB/ ESCB Statute.
Article 43 of the BNR Law provides that the
BNR must transfer to the State budget an 80% share of the net revenues left
after deducting expenses relating to the financial year, including provisions
for credit risk, and any losses relating to previous financial years that
remain uncovered. Such a procedure could, in certain circumstances, be seen as
an intra-year credit, which negatively impacts on the financial independence of
the BNR. A Member State may not put its central bank in a position where it has
insufficient financial resources to carry out its ESCB tasks, and also its own
national tasks, such as financing its administration and own operations.
Article 43(3) of the BNR Law also provides that the BNR sets up provisions for
credit risk in accordance with its rules, after having consulted the Ministry
of Public Finance. The central bank must be free to independently create
financial provisions to safeguard the real value of its capital and assets.
Article 43 of the BNR Law is incompatible with Article 130 of the TFEU and
Article 7 of the ECB/ ESCB Statute and should, therefore, be adapted, to ensure
that the above arrangements do not undermine the ability of the BNR to carry
out its tasks in an independent manner. 
8.1.3.   Prohibition
of monetary financing and privileged access
According to Article 26 of the BNR Law, the
BNR  under exceptional circumstances and only on a case-by-case basis may grant
loans to credit institutions which are unsecured or secured with assets other
than assets eligible to collateralise the monetary or foreign exchange policy
operations of the BNR. It cannot be excluded that such lending results in the
provision of solvency support to a credit institution that is facing financial
difficulties and thereby would breach the prohibition of monetary financing and
be incompatible with Article 123 of the TFEU. Article 26 of the BNR Law should
be amended to avoid such a lending operation.
Articles 6(1) and 29(1) of the BNR Law
prohibit the direct purchases by the BNR of debt instruments issued by the
State, national and local public authorities, autonomous public enterprises,
national corporations, national companies and other majority state-owned
companies. Article 6(2) of the BNR Law extends this prohibition to the debt
instruments issued by other bodies governed by public law and public undertakings
of other EU Member States. Article 7(2) of the BNR Law prohibits the BNR from
granting overdraft facilities or any other type of credit facility to the
State, central and local public authorities, autonomous public service
undertakings, national societies, national companies and other majority state
owned companies. Article 7(4) of the BNR Law extends this prohibition to other
bodies governed by public law and public undertakings of Member States. These
provisions do not fully mirror the entities listed in Article 123 of the TFEU
(amongst others, a reference to Union institutions is missing) and, therefore,
have to be amended. 
Pursuant to Article 7(3) of the BNR Law,
majority state-owned credit institutions are exempted from the prohibition on
granting overdraft facilities and any other type of credit facility under
Article 7(2) of the BNR Law and benefit from loans granted by the BNR in the
same way as any other credit institution eligible under the BNR's regulations.
The wording of Article 7(3) of the BNR Law is incompatible with the wording of
Article 123(2) of the TFEU, which only exempts publicly owned credit
institutions “in the context of the supply of reserves by central banks”, and
should be aligned.
As noted above in point 8.1.2., Article 43
of the BNR 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 made 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. This provision is, therefore, also
incompatible with the Article 123 of the TFEU and has to be amended. 
8.1.4.   Integration
in the ESCB
8.1.4.1 Objectives
Pursuant to Article 2(3) of the BNR Law,
the secondary objective of the BNR is to support the State’s general economic
policy. Article 2(3) of the BNR Law contains an imperfection inasmuch as it
should contain a reference to the general economic policies in the Union as per
Article 127(1) of the TFEU and Article 2 of the ESCB/ECB Statute, with the
latter Articles taking precedence over the BNR Law.
8.1.4.2 Tasks
The incompatibilities in the BNR Law are
linked to the following ESCB/ECB tasks:
·       definition of monetary policy and monetary functions, operations and
instruments of the ESCB (Articles 2(2)(a), 5, 6(3), 7(1), 8, 19, 20 and 22(3)
and 33(1)(a) of the BNR Law);
·       conduct of foreign exchange operations and the definition of foreign
exchange policy (Articles 2(2)(a) and (d), 9 and 33(1)(a) of the BNR Law);
·       holding and management of foreign reserves (Articles 2(2)(e),
9(2)(c), 30 and 31 of the BNR Law);
·       right to authorise the issue of banknotes and the volume of coins (Articles
2(2)(c), 12 to 18 of the BNR Law);
·       non-recognition of the role of the ECB and of the Council in
regulating, monitoring and controlling foreign currency transactions (Articles
10 and 11 of the BNR Law);
·       lack of reference to the role of the ECB in payment systems
(Articles 2(2)(b), 22 and 33(1)(b) of the BNR Law).
There are also imperfections regarding the:

·       non-recognition of the role of the ECB and the EU in the collection
of statistics (Article 49 of the BNR Law); 
·       non-recognition of the role of the ECB and of the Council in the
appointment of an external auditor (Article 36(1) of the BNR Law); 
·       absence of an obligation to comply with the ESCB/ECB regime for the
financial reporting of NCB operations (Articles 37(3) and 40 of the BNR Law);
·       non-recognition of the ECB's right to impose sanctions (Article 57
of the BNR Law).
8.1.5.   Assessment
of compatibility
As regards the independence of the BNR, the
prohibition on monetary financing and the BNR's integration into the ESCB at
the time of euro adoption, the legislation in Romania, in particular the BNR
Law, is not fully compatible with the compliance duty under Article 131 of the
TFEU. 
8.2.      PRICE
STABILITY
8.2.1.   Respect
of the reference value
The 12-month average inflation rate for
Romania, which is used for the convergence evaluation, at the last convergence
assessment of Romania in 2012 was well above the reference value. Average
annual inflation increased from below 3% in mid-2012 to 4.5% in mid-2013,
before declining sharply thereafter. In April 2014, the reference value was
1.7%, calculated as the average of the 12-month average inflation rates in
Latvia, Portugal and Ireland plus 1.5 percentage points. The corresponding
inflation rate in Romania was 2.1%, i.e. 0.4 percentage points above the reference
value. Romania's 12-month average inflation rate is projected to remain above
the reference value in the months ahead.
8.2.2.   Recent
inflation developments 
Romania has recorded volatile and elevated
inflation rates in recent years. Annual inflation peaked at 8.5% in May 2011
following an increase in the standard VAT rate in mid-2010 and a rise in food
prices. It fell significantly during the second half of 2011 and in early 2012
to a low of 1.9% in April 2012, mainly due to a favourable base effect
supported by a good harvest in 2011 and lower energy commodity prices.
Inflation picked up again in the second half of 2012 due to rising food prices,
the impact of which was exacerbated by the large share of food items in the
consumer basket, and the pass-through effects associated with the leu's
exchange-rate depreciation. Energy price increases following the roadmap to
phase out administratively-set prices also added to inflationary pressures,
especially by end-2012 and at the beginning of 2013. As a result, annual
inflation remained above 4% between September 2012 and June 2013. Weak domestic
demand and an abundant harvest induced considerable disinflation in the second
half of 2013 which was supported by the reduction in the VAT rate on bread and
flour from 24% to 9% in late 2013. In early 2014, annual HICP inflation thus
hovered around 1.6%.
Core inflation (measured as HICP inflation
excluding energy and unprocessed food) has been on a downward trend from 3.6%
in the first quarter of 2012 to 1.9% in the first quarter of 2014. The main
drivers were slowing inflation for services and processed food. The levelling
off in late 2012 was on account of the evolution in processed food prices,
which are correlated to overall food commodity prices. Annual average producer
price inflation for total industry decreased strongly to below 1% in 2013 and
turned negative in first quarter of 2014, in line with overall receding
inflation pressures.
8.2.3.   Underlying
factors and sustainability of inflation
Macroeconomic policy-mix and cyclical stance
The Romanian economy growth accelerated to
3.5% in 2013 and is estimated to continue to operate slightly above potential
in 2014 and 2015. A very weak harvest and the difficult external environment
resulted in a slowdown of GDP growth to only 0.7% in 2012. GDP growth increased
to 3.5% in 2013 on the back of a very good harvest and strong exports, while
domestic demand remained weak. According to the Commission services' 2014
Spring Forecast growth is set to slow, but to remain robust at 2.5% in 2014 and
2.6% in 2015, amid a gradual rebalancing of growth drivers towards domestic
demand. The output gap is estimated to have narrowed to 1.6% of GDP in 2013 and
it is expected to further decline over the forecast horizon.
The fiscal stance, as measured by changes
in the structural balance, has tightened in 2011-2013. Significant fiscal
adjustment measures have been adopted under the joint EU-IMF financial
assistance programme to bring public finances back on a sustainable path. The
pace of fiscal tightening has declined, from a structural adjustment of some
2¼% of GDP in 2011 and 1¼% of GDP in 2012 to ¾% in 2013. The structural
adjustment is expected to be limited in 2014-2015. 
The BNR, operating within an inflation
targeting framework ([74]), kept its
key policy rate stable at 5.25% from March 2012 until May 2013, amid
uncertainties related to a temporary spike in inflation due to rising food
prices and related to the liberalisation of certain categories of administered
prices. In view of an improved inflation outlook, it gradually cut the policy
rate by a total of 175 basis points between July 2013 and in February 2014, in
order to stimulate lending and domestic demand. It also reduced minimum reserve
requirements with the medium term goal to align them increasingly with ratios
prevailing in the rest of the EU. Nevertheless, the banking sector's loan
portfolio contracted in 2013 and credit growth remained negative at the
beginning of 2014.
Wages and labour costs
The labour market situation was
considerably affected by the economic downturn. After three years of continuous
decline, total employment grew in 2012 only to decrease somewhat again in 2013,
despite a strong pick-up in economic growth. It is expected to expand only
gradually in 2014-2015. The unemployment rate has fluctuated between 7.0% and
7.3% in recent years and is expected to remain at a similar level. 
Nominal compensation per employee declined
in the period 2009-2011, but recovered strongly in 2012 and 2013. Compensation
per employee is expected to increase further by around 5% in 2014-2015. Labour
productivity growth was negative in 2012 with employment recovering faster than
output. Labour productivity picked up in 2013 on the back of economic recovery
and decreasing employment. It is projected to increase by about 2% in 2014-15,
in line with a projected moderate pace of economic expansion accompanied by
sluggish employment growth. As a result, growth of nominal unit labour costs
(ULC) is expected to remain relatively moderate, at around 3% in 2014-2015.
External factors
Given its deepening integration into the
world and the EU economy, developments in import prices play an important role
in domestic price formation in Romania. Import price inflation (measured by the
imports of goods deflator) outpaced consumer price inflation in 2011-2012,
before turning negative in 2013.
Energy and food commodity prices have been
an important determinant of import price inflation in Romania, in particular
given the large weight of these categories in the Romanian HICP. Following a
substantial increase in 2011, the contribution of energy prices to HICP
inflation declined gradually to about 0.5 pp. in 2013 as primary commodity
prices remained broadly flat in 2012-2013. 
Fluctuations of the leu have only
moderately influenced import price dynamics in recent years. The nominal
effective exchange rate (measured against a group of 36 trading partners)
depreciated somewhat in mid-2012 reflecting volatile capital flows and
political uncertainty. It recovered again in late 2012 and early 2013 and then
remained broadly stable throughout 2013 and in early 2014.
Administered prices and taxes
Changes in administered prices and indirect
taxes have significantly contributed to inflationary pressures in Romania in
recent years. Administered prices have a somewhat larger weight in the HICP
basket of around 15% (compared to 13% in the euro area) ([75]). Annual inflation in administered prices decreased from 7.6% in
2011 to 5.3% in 2012 on the back of stable commodity prices and a favourable
base effect stemming from changes in taxation in 2011. It increased to 6.0% in
2013. The liberalisation of prices of gas and electricity for households
started in the second half of 2013. This is, ceteris paribus, expected
to put upward price pressure on energy and therefore on administered prices.
Relatively low international commodity prices however counterbalanced this
upward pressure in the second half of 2013. 
Increases in fuel and tobacco excise duties
contributed moderately to inflation in Romania in 2012 and 2013. As a result,
the constant tax-inflation measure remained below HICP inflation in 2012 and
during the first half of 2013. The reduction of VAT rates on bread and flour
contributed to the inversion of the trend in late 2013. By April 2014, annual
constant tax-inflation was some 0.1 pp. below HICP inflation. 
Medium-term prospects
According to the Commission services' 2014
Spring Forecast, annual inflation is projected to decelerate from 3.2% in 2013
to 2.5% in 2014, mainly due to falling food prices, reaching historical lows in
the first half of 2014. Inflation is expected to return to the upper part of
the central bank's target band (2.5%±1pp.) in the second half of the year. In
2015, a gradual recovery in domestic demand and continued price convergence
towards the EU average are expected to translate into higher annual average
inflation (3.3%). It should nevertheless still remain within the central bank's
target band.
Risks to the inflation outlook are broadly
balanced. Domestic demand might surprise on the upside leading to inflationary
pressures. Upside risks are also related to a possible rise of global commodity
prices, with the overall impact amplified by the relatively large weight of
commodities in the consumption basket. A gradual withdrawal of monetary
stimulus in the US and associated capital outflows from emerging markets might
exert some downward pressure on the exchange rate which would feed into higher
inflation. On the other hand, the continued need for banks to repair their
balance sheets might constrain credit flows. Low inflation in the euro area
might also spill-over via the extensive trade links with the Romanian economy.
Over the long run, there is significant
potential for further price level convergence, in line with the expected
catching-up of the Romanian economy (with income levels at about 46% of the
euro-area average in PPS in 2013). The level of consumer prices in Romania was
around 54% of the euro- area average in 2012, with the relative price gap
widest for services. 
Medium-term inflation prospects will hinge
upon productivity and wage developments as well as on developments in some
categories of administered prices. The liberalisation of electricity and gas
markets, as agreed under the joint EU-IMF financial assistance programme,
should, ceteris paribus, imply sizeable inflationary pressures during
2014-2018. The actual impact of such measures on inflation will also depend on
developments in global commodity prices and on further price liberalisation.
Anchoring inflation expectations at a low level will be also important going
forward. A prudent fiscal policy and continuation of structural reforms, reaffirmed
by the commitments of the Romanian authorities under the ongoing joint EU-IMF
assistance programme, should support sustainable convergence going forward. 
8.3.      PUBLIC
FINANCES
8.3.1.   Recent
fiscal developments
On 21 July 2013, the Council decided to
abrogate the decision on the existence of an excessive deficit according to
Article 126 (12) TFEU, thereby closing the excessive deficit procedure for
Romania ([76]). 
Since 2009, Romania benefited from
medium-term financial assistance from the EU provided in conjunction with a
stand-by arrangement by the IMF. Romania was able to regain market access
during the first financial assistance programme (2009-2011) and has treated the
second programme (2011-2013) as pre-cautionary. In July 2013, the authorities requested
a third financial assistance programme, also of pre-cautionary nature, which
was granted by the Council in October 2013 ([77]). The current programme, running until 2015, aims to support
Romania in reaching its medium-term budgetary objective in 2015, as recommended
by the Council ([78]), to improve
fiscal governance and to implement other structural reforms.
During the crisis, the headline government
deficit peaked at 9.4% of GDP in 2009. The authorities opted for a
front-loading of fiscal consolidation focused on the expenditure side, but also
involving some revenue measures. This included reduction of public wages,
reduction in social spending and an increase in the standard VAT rate and
helped the deficit to decline to 5.5% of GDP in 2011. Total expenditure
declined from 39.4% of GDP in 2011 to 35.0% in 2013. Since 2011, the
revenue-to-GDP ratio decreased from 33.9% to 32.7% in 2013.
In 2012, the deficit decreased further to
3.0% of GDP. This was mainly driven by measures on the expenditure side. Social
security spending was lowered by keeping pensions mostly flat and by
streamlining the social assistance programmes. Excises for tobacco and diesel
were raised to strengthen the revenue side. 2013 saw a further decline of the
headline deficit to 2.3% of GDP. Reductions in expenditure provided for the
adjustment of the deficit, including savings in social assistance.
Revenue measures included: i) the
introduction of a turnover tax for certain SMEs; ii) the introduction of a tax
on windfall gains related to the deregulation of gas prices; and iii) increases
of excises on tobacco and alcoholic beverages. These revenue measures were
offset by weak tax collection due to less tax-rich growth, the restructuring of
the tax administration agency and a reduction in the VAT on bread and flour.
The structural deficit decreased from 3.8% of GDP in 2011 to 1.7% in 2013
according to the Commission services' 2014 Spring Forecast.  
The debt-to-GDP ratio, which stood at 13.4%
in 2008, increased significantly as a result of high government deficits and
unfavourable effects from higher interest rates and stock-flow adjustments. It
has nonetheless stabilised below 39% in 2012-2013 thanks to the reduced deficit
and improved financing conditions. At the end of 2013, public debt stood at
38.4% of GDP.
8.3.2.   Medium-term
prospects 
The budget for 2014 was adopted by
Parliament on 4 December 2013 targeting a deficit of 2.2% of GDP. The
consolidation measures adopted are mainly on the revenue side and include: i)
an increase in excises on fuel; ii) the introduction of inflation indexation of
excise duties; iii) a base broadening of the property tax; and iv) an increase
in royalties on mineral resources other than oil and gas. Policies increasing
the expenditure include the indexation of pensions foreseen by law and a
limited and targeted rise in public sector salaries. The budget also allows for
a rise in expenditure related to the co-financing of EU funds to cater for
accelerated absorption. 
Taking these measures into account the
Commission services' 2014 Spring Forecast projects a deficit of 2.2% of GDP in
2014, in line with the authorities' target. In 2015, the nominal deficit is
expected to decrease further to 1.9% of GDP under a no-policy-change
assumption. Under this scenario, the policies implemented by the authorities
are expected to lead to a slight decrease in the expenditure-to-GDP ratio. It
is expected to decrease from 35.0% in 2013 to 34.7% in 2015. Revenue as a
percent of GDP is expected to increase slightly from 32.7% in 2013 to 32.8% in
2015. According to the Commission services' 2014 Spring Forecast, the
underlying fiscal position in 2014-2015, as measured by the change in the
structural balance (cyclically-adjusted balance excluding one-offs and other
temporary measures), is expected to remain unchanged. The debt-to-GDP ratio is
expected to increase to 40.1% of GDP in 2015. 
Romania submitted the 2014 Convergence
Programme on 5 May 2014.  The Programme aims to reach the MTO in 2015. The
Convergence Programme foresees a deficit of 2.2% of GDP in 2014, 1.4% of GDP in
2015, 1.3% of GDP in 2016 and 1.1% of GDP in 2017. The Commission services'
2014 Spring Forecast expects the deficit to slightly decrease to 2.2% of GDP in
2014 and further to 1.9% of GDP in 2015 under a no-policy-change assumption.
Further details on the assessment of the
2014 Convergence Programme for Romania can be found in the Commission Staff
Working Document, which accompanies the Commission Recommendation for a Council
Recommendation on the National Reform Programme 2014 of Romania and delivering
a Council Opinion on the 2014 Convergence Programme of Romania.
In March 2012, Romania signed the Treaty on
Stability, Coordination and Governance in the EMU and declared its intension to
comply with the Title III Fiscal Compact already now. This implies an
additional commitment to conduct a stability-oriented and sustainable fiscal
policy. The TSCG will apply to Romania in its entirety upon lifting its
derogation from participation in the single currency. The Fiscal Responsibility
Law was amended on 10 December 2013 with a view to comply with the
above-mentioned Treaty.
8.4.      EXCHANGE
RATE STABILITY 
The Romanian leu does not participate in
ERM II.  Romania has been operating a de jure managed floating exchange
rate regime since 1991 with no preannounced path for the exchange rate ([79]). De facto, the exchange rate regime moved gradually from a
strongly managed float – including through the use of administrative measures
until 1997 – to a more flexible one. In 2005, Romania shifted to a direct
inflation targeting framework combined with a floating exchange rate regime.
The BNR has, nonetheless, stressed that currency intervention remains available
as a policy instrument. 
After the global financial crisis in late
2008 and early 2009, the leu broadly stabilised and mostly traded between
4.1-4.3 RON/EUR from 2009 until late 2011. The lower short-term volatility of
the leu reflected – in addition to the positive effects associated with the
EU-IMF international financial assistance to Romania and easing global market
conditions – also operations by the BNR in the interbank as well as in the
foreign exchange market. The leu depreciated towards historical lows of above
4.5 RON/EUR in July 2012. It firmed somewhat in late 2012 and early 2013, as
foreign interest in leu-denominated assets increased following the
parliamentary elections in December 2012. The leu's exchange rate against the
euro temporarily depreciated in May-June 2013, reflecting heightened global
risk aversion, but the weakening was more moderate in comparison with other
regional peers operating under floating exchange rate regimes. The leu came
again under depreciation pressures in early 2014. During the two years before
this assessment, the leu depreciated against the euro by 1.9%.
The gross international reserves remained
robustly high in 2012 and 2013, amounting on average to around EUR 35bn,
despite gradual repayments of international financial assistance. Its
short-term fluctuations in recent years have mainly reflected changes in the
foreign exchange reserve requirements of credit institutions, as well as
foreign exchange operations by the government. The reserve level was at around
25% of GDP by end-2013.
Short-term interest rate differentials
vis-à-vis the euro area decreased to below 400 basis points by end-2011. They
widened again during 2012, as the ECB loosened its policy stance, while rates
on the Romanian money market increased substantially due to political
instability concerns. After peaking at above 580 basis points in late 2012,
short-term spreads declined gradually throughout 2013 to around 200 basis
points by end-2013, reflecting considerable monetary policy easing by the BNR
from July 2013 to February 2014 by reducing the key policy rate by 175bps. At
the cut-off date of this report, the 3-month spread vis-à-vis the euro area
increased to around 270 basis points. 
8.5.      LONG-TERM
INTEREST RATEs
Long-term interest rates in Romania used
for the convergence examination reflect secondary market yields on a single
government benchmark bond with a residual maturity of around nine years.
However, the limited number of Romanian long-term bonds issued and the
illiquidity of the secondary market may pose some difficulties in interpreting
the data.
The Romanian 12-month moving average
long-term interest rate relevant for the assessment of the Treaty criterion
stayed above the reference value at each convergence assessment since EU
accession in 2007. It peaked at 9.7% in the fourth quarter of 2009, but
gradually declined thereafter and hovered at just around 7% in 2011. It was
above the reference value at the time of the last convergence assessment of
Romania in 2012. Since then, it declined further to around 5.5% by the end of
2012 and floated around 5.3% over the most of 2013. In April 2014, the latest
month for which data are available, the reference value, given by the average
of long-term interest rates in Latvia, Portugal and Ireland plus 2 percentage
points, stood at 6.2%. In that month, the 12-month moving average of the yield
on the Romanian benchmark bond stood at 5.3%, i.e. 0.9 percentage points below
the reference value.
After having remained at just above 7% for
most of the period 2010-2011, long-term interest rates declined gradually to
below 5.5% in the second quarter of 2013, reflecting a reduced country risk
premium backed by a solid fiscal consolidation track record as well as a
gradual downward adjustment of the expected path of interbank rates and the
precautionary EU-IMF programme. They then remained broadly stable, hovering
between 5% and 5½% until early 2014. At the same time, the long-term spread
vis-à-vis the German benchmark bond declined from above 500 basis points in
late 2012 to below 350 basis points in late 2013 and it stood at around 380
basis points in April 2014 ([80]). 
8.6.      ADDITIONAL
FACTORS
The Treaty (Article 140 TFEU) calls for an
examination of other factors relevant to economic integration and convergence
to be taken into account in the assessment. The assessment of the additional
factors – including balance of payments developments, product, labour and
financial market integration – gives an important indication of a Member
State's ability to integrate into the euro area without difficulties. 
In November 2013, the Commission published
its third Alert Mechanism Report (AMR 2014) ([81]) under the Macroeconomic Imbalance Procedure (MIP - see also Box
1.5). The AMR 2014 scoreboard showed that Romania exceeded the indicative
threshold in two out of eleven indicators in the area of external imbalances
(i.e. the net international investment position and the current account
deficit). Romania currently benefits from a precautionary EU-IMF financial
assistance programme totalling up to about EUR 4 billion which is foreseen to
last until September 2015. Close surveillance related to this arrangement
implies that Romania is not subject to in-depth reviews in the context of the
MIP in order to avoid the duplication of surveillance procedures ([82]).
8.6.1.   Developments
of the balance of payments
Romania's external balance (i.e. the
combined current and capital account) improved markedly during the global
crisis. After having recorded a deficit of around 4% of GDP in 2009-2011 it
narrowed somewhat in 2012 and then shifted into a surplus in 2013. The
improvement in the external balance reflected a significant decline in the
trade deficit, due to strong export growth and mostly flat imports. The
negative net income balance widened in 2012-2103, reflecting an increase in
FDI-related profits. At the same time, the positive balance of current
transfers remained broadly stable. Finally, the capital account recorded an
increasing surplus due to improved absorption of EU funds.
Romania's saving-investment gap continued
to narrow from 4.5% in 2011 to 1.0% in 2013. Both gross savings and investment
declined somewhat in 2012. While savings increased again in 2013, investment
continued to decline, inducing the significant adjustment of the current
account balance. The need of the corporate sector to repair its balance sheets
appears to have been the main driver, while the savings-investment gap of the
public sector also continued to narrow.
External price and cost competitiveness
continued to improve in the first half of 2012, largely due to NEER
depreciation. Competitiveness then deteriorated somewhat in 2013, as NEER
appreciation was accompanied by relatively higher price and cost increases in
Romania compared to its main trading partners. Nevertheless, Romania managed to
increase its export market share considerably in 2013.
Romania has been a recipient of international
financial assistance since 2009. When the international financial turmoil
escalated in late 2008, the large external shortfall in combination with the
banking system's heavy reliance on foreign funding raised concerns about
external debt sustainability. The first two-year joint EU-IMF financial
assistance programme of around 18 billion euros was provided to Romania amid
tightening market conditions and growing government refinancing needs in 2009.
It was followed by two joint EU-IMF programmes, granted in 2011 and 2013.
Unlike the first programme, both subsequent programmes have been treated as
precautionary, and no funding has been requested so far.
External financing pressures eased further
in 2012-2013 amid improvement in the external balance and recovery in global
risk appetite. Net FDI inflows, which had fallen sharply in 2009-10, broadly
stabilised in 2011-13, averaging around 1.5% of GDP. Net portfolio inflows
increased gradually in recent years to nearly 3% of GDP in 2012 and 2013. The
success in attracting significant amounts of portfolio investment into
government securities also reflected the inclusion of Romania in a number of
international benchmark indices. Net other inflows turned negative in 2012 and
2013 due to repayments of international financial assistance. Gross external
debt rose in 2011-2012 to above 75% of GDP mainly driven by an increase of
public external debt. It declined to below 70% of GDP in 2013, due to a reduction
of banks' external debt and plateauing public external debt. The net
international investment position peaked at -68% of GDP in 2012. It has
declined to some –62% of GDP in 2013, on the back of the strong current account
adjustment and robust nominal economic growth. 
According to the Commission services' 2014
Spring Forecast, the external balance is expected to remain broadly balanced in
2014 and in 2015. Romania's external position is expected to benefit from a
higher absorption of EU funds. 
8.6.2.   Market
integration
Romania's economy is well integrated into
the euro area through both trade and investment. The trade openness of Romania
has increased significantly in the aftermath of the crisis, but is still
relatively low. Trade openness in 2012 stood at around 43% of GDP. Trade with
the euro area dominates, and in particular with Germany, Italy, France and the
Netherlands.
Romania's trade pattern reflects the
country's labour-cost advantages and price competitiveness. However, its trade
specialisation has changed to some extent in the recent years, taking advantage
from its increased integration with the EU economy and from substantial
technology transfers by companies from the euro-area Member States. The
cumulative share of a few sectors (namely machinery and electrical equipment,
vehicles, aircraft, vessels) increased significantly in recent years, reaching
almost 40% in 2012. However, the upward trend in the share of high-technology
products in exports reversed to just 6.3% GDP in 2012 in comparison with the
8.8% reached in 2011. This decline is explained to a large extent by the
relocation abroad of an important cell phone manufacturer. The high-tech trade
balance deficit declined significantly from 2007 to 2011, but experienced a
slight rebound in 2012. This is in part explained by reduced investment,
deleveraging and a significant fall in FDI inflows.
Due to wage competitiveness, favourable
corporate tax rates and a relatively large domestic market, Romania attracted
substantial FDI inflows in the years before the crisis. However, in the
aftermath of the crisis FDI inflows declined considerably. FDI inflows have
remained relatively low, at around 1.5% of GDP in 2011-2012. Despite a slight
recovery in 2013, they are expected to remain substantially below their
pre-crisis level. The FDI stock reached 56% of GDP in 2012, much lower than in
other non-euro area Member States. The main FDI inflows originate from
euro-area Member States, with the Netherlands, Austria and Germany accounting
for more than half of the FDI inflows in 2012. In terms of sectoral allocation,
the FDI stock was 31% in manufacturing, some 19% in financial intermediation
and insurance, and 9% in construction and real estate. In Romania, FDI has a
tendency to concentrate in the main metropolitan areas, with the Bucharest
region attracting more than two-thirds in 2012.
According to Eurostat, house prices have
followed a negative trend since 2008 (the first year with available data). In
particular, the real house price index halved between 2008 and 2012. The speed
of the adjustment has declined over time (from a 26% year-on-year decrease in
2009 to 9% in 2012). Investment in dwellings has been stable at around 3% of
GDP in the past five years. Building permits rose by 121% in the period
2003-2008. Since then, the number of licenses decreased by 38% in 2008-2012 and
remained unchanged in 2013. Real value added in the construction sector has
shrunk over the last years, after double-digit increases in the pre-crisis
period, and stands at 10% of total value added in 2012. Employment in the real
estate sector has fallen notably in the last years (by 14% in 2012 alone).
Concerning the business environment,
Romania performs, in general, worse than most euro-area Member States in
international rankings ([83]). In
particular, Romania has low ranks in trading across borders and in registering
property. According to the 2014 World Bank Doing Business report, the ease of
paying taxes and of opening a business has recently improved. According to the
November 2013 Internal Market Scoreboard, Romania had a transposition deficit
(0.6%), close to the 0.5 % target as proposed by the European Commission in the
Single Market Act (2011), which is on par with the EU average. Public
administration as a whole also performs relatively poorly according to the
World Bank's Worldwide Governance Indicators ([84]).
In terms of resilience during the crisis,
the capacity of the Romanian labour market to adjust has been improved. Since
the major reform of the social dialogue code in 2011, wage-setting is largely
decentralised, with only few multi-company wage agreements being in place.
Changes in the labour code implemented in 2011 affecting provisions regarding
fixed-term contracts, collective dismissals and individual redundancies,
working-time flexibility and temporary agency contracts, started to pay off.
Yet in terms of capacity to generate new jobs and income, labour market
continues to under-perform as it remains characterised by a low employment rate
(20-64 age group around 64% in 2012-2013), high youth unemployment (around 23%
in 2012-2013) and a low share of temporary and fixed-term employment contracts.
The 2011 reform of the labour and social dialogue code is being complemented by
only very limited active labour market policies and only hesitant reforms in
education and vocational training that aim to address skill mismatches. Due to
a limited recovery of employment in 2012-2013, the propensity to emigrate in
search of better job opportunities abroad is still strong among the Romania's
labour force: population at working age continued to decline faster than total
population in 2011-2012.
8.6.3.   Financial
market integration
The Romanian financial sector is highly
integrated into the EU financial sector, in particular through the strong
presence of foreign banks in Romania. The share of foreign-owned banks, mainly
euro area parent banks, in the total assets of the Romanian banking sector has
slightly increased and reached some 90% in 2012 compared to 88% in 2007.
Concentration in the banking sector, as measured by the market share of the
largest five credit institutions, declined marginally between 2007 and 2012,
but remained above the euro area average. 
After a rapid financial deepening in the
years before the onset of the financial crisis, credit activity in Romania has
weakened considerably since 2007, reflecting both demand and supply side
factors. Romania still lags considerably behind the euro area as regards bank
credit to the private non-financial sector (around 34% of GDP).
Foreign-currency loans have played an important role in lending to the private
sector, as the share of these loans increased steadily in the period 2007–2012
to roughly 67% of the total loans to households in 2012, i.e. up by roughly 14
percentage points compared to 2007 (though part of this increase is due to the
depreciation of the leu). Lending to non-financial corporates has also been
dominated by foreign-currency loans, albeit to a lesser extent.
Foreign-currency loans to corporates increased to 59% of total loans in 2012,
compared to 55% in 2007. However, recent trends show a decrease in
foreign-currency lending for both households and corporates, inter alia due to
the measures introduced by the National Bank of Romania to curb
foreign-currency lending to unhedged households and corporates, in particular
SMEs. Private sector debt declined from 124% of GDP in 2009 to 74% by end-2012.
The Romanian banking sector has remained
resilient and maintained sufficient capital buffers, notwithstanding the still
on-going deterioration in asset quality. The banking system has remained
well-capitalised, as capital adequacy at system level stood at roughly 14.7% at
the end of June 2013. The shareholders of banks have provided capital support,
if necessary, so that no public resources have been used for banking sector
rescue measures. Nonetheless, the deterioration in asset quality and the
increase in loan-loss provisions, inter alia due to two collateral audits
mandated by the banking supervisor in 2012 and 2013, have put a strain on
banking sector profitability. Consequently, return on equity declined from
22.5% in 2007 to 6.2% in mid-2013. Non-performing loans (90 days overdue) have
increased significantly compared to the pre-crisis period (i.e. from below 2% in
2007 to roughly 20% in mid-2013).
In spite of the recovery in economic
activity, Romania has continued to show a comparatively low penetration of
financial market services. In the insurance sector, gross written premiums
recorded a positive trend in 2012 as they increased by 5.6% compared to 2011.
Insurance penetration (i.e. the ratio between gross written premiums for life
and non-life insurance and GDP) in Romania stood at roughly 1.4 % of GDP in
2012, which is still one of the lowest in the EU. Notwithstanding the difficult
economic environment, the private pension system including mandatory pension
funds (Pillar II) and voluntary pension funds (Pillar III) introduced in
Romania in 2007 has recorded a positive trend. Total net assets of the Pillar
II pension funds increased from 0.2% of GDP in 2008 to 1.8% in June 2013. The
net assets of the pillar III pension funds also went up and reached around 0.1%
of GDP in June 2013. Furthermore, the private pension funds (mostly Pillar II
funds) are currently the largest domestic institutional investors on the
Romanian capital market, ahead of mutual investment funds and insurance
companies. 
Equity and debt markets in Romania have
remained comparatively underdeveloped. Stock market capitalisation has
continued to be very low as compared to the euro area and regional peers. The
stock market capitalisation of 11% of GDP in 2013 ranked Romania low among its
peers in Central and Eastern Europe. The stock market capitalisation gap
vis-à-vis the euro area has remained broadly unchanged amid high market
volatility, though the Romanian market largely moved in sync with global
markets. Debt securities markets have been dominated by issuances of government
debt (T-bills and bonds denominated in both RON and foreign currency), whereas
the issuance of corporate and municipal bonds has remained limited. 
Romania established in 2013 a single
regulator for the non-bank financial sector (i.e. Authority for Financial
Supervision – AFS), which replaced the former sectoral supervisory authorities
in the area of securities, insurance and pensions. Whereas the establishment of
a single regulator constitutes a first step towards a more efficient and
effective supervision of the non-bank financial sector, several aspects need
further improvement in order to bring the ASF in line with good international
practices. Romania has transposed roughly 93% of all post-FSAP directives into
national legislation as of mid-December 2013. As regards the Alternative
Investment Fund Managers Directive (AIFMD)([85]), Romania has partially notified its transposition to the
Commission services.
9.1.      LEGAL
COMPATIBILITY
9.1.1.   Introduction
The legal rules governing the Swedish
Central Bank (Riksbank) are laid down in the Instrument of Government (as part
of the Swedish Constitution) and the Riksbank Act from 1988. No amendments to
these legal acts were passed with regard to the incompatibilities and the
imperfection mentioned in the 2012 Convergence Report. 
9.1.2.   Central
Bank Independence
Article 3 of Chapter 6 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 approval by
the Riksbank. A dialogue between a central bank and third parties is not
prohibited as such, but regular upfront information of government
representatives about monetary policy decisions, especially when Riksbank would
consider them as of major importance, could structurally offer to the
government an incentive and the possibility to influence Riksbank when taking
key decisions. Therefore, the obligation to inform the minister about a
monetary policy decision of major importance prior to its approval by the
Riksbank limits the possibility for the Riksbank to independently take
decisions and offers the possibility for the Government to seek to influence
them. 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. Article 3 of Chapter 6 should be
reformulated in order to ensure that monetary policy decisions of major
importance are communicated to the minister, if ever, only after its approval
by the Riksbank and for information purpose only.
Pursuant to Article 2 of Chapter 3 of the
Riksbank Act and Article 13 of Chapter 9 of the Instrument of Government, the
prohibition on the members of the Executive Board to seek or take instructions
only covers monetary policy issues. The provisions do not provide for their
independence in the performance of ESCB-related tasks directly entrusted by the
Treaty. By means of broad interpretation through reference to the explanatory
memorandum to the Law (the memorandum extends the coverage to all ESCB tasks),
one could consider these tasks as tacitly encompassed by the prohibition.
However, the principle of the Riksbank's institutional independence cannot be considered
as fully respected from a legal certainty perspective as long as the legal text
itself does not contain a clear reference to them. Both provisions are
therefore considered as incompatible with Article 130 of the TFEU and Article 7
of the ESCB/ECB Statute.
Pursuant to Article 4 of Chapter 10 of the
Riksbank Act, the Swedish Parliament approves the Central Bank's profit and
loss account and its balance sheet and determines the allocation of the Central
Bank's profit. This practice impinges on the financial independence of the
Riksbank and is incompatible with Article 130 of the TFEU. The Parliament must
not be involved in the relevant decision-making process. Its right should be
limited to approving the Central Bank's decision on the profit allocation.
Legislative proposals to tackle the flaw have been submitted by the Swedish
legislator but still provide for a decisive role of the Parliament in profit
distribution and budget allocation, which are incompatible with the principle
of financial independence as enshrined in Article 130 of the TFEU.
Article 4 of Chapter 1 of the Riksbank Act
provides for the replacement of the Governor, in case of absence or incapacity,
by the Vice-Governors nominated by the General Council. To ensure smooth and
continuous functioning of the Riksbank in case of expiry of the term of office,
resignation, dismissal or other cause of termination of office, the Act needs
to remove this imperfection and provide for procedures and rules regarding the
successor of the Governor in case of termination of office.
9.1.3.   Prohibition
of monetary financing and privileged access
Under Article 8 of Chapter 6 of the
Riksbank Act, the Riksbank may, in exceptional circumstances, grant credits or
provide guarantees on special terms to banking institutions and 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 it should be clearly specified that the loan is granted against adequate
collateral to ensure that the Riksbank would not suffer any loss in case of the
debtor's default. Therefore, it constitutes an incompatibility with the
prohibition on monetary financing under Article 123 of the TFEU.
Pursuant to Article 1(2) of Chapter 8 of
the Riksbank Act, the Riksbank shall not extend credits or purchase debt
instruments "directly from the State, another public body or institution
of the European Union". The Article does not enumerate the entities
covered by the prohibition of monetary financing correctly. Therefore, Article
1 is incompatible with the wording of Article 123(1) of the TFEU and 21(1) of
the ESCB/ECB Statute.
According to the Article 1(4) of Chapter 8
of the Riksbank Act, the Riksbank may grant credit to and purchase debt
instruments from financial institutions owned by the State or another public
body. This provision of Article 1 does not fully comply with Article 123(2) of
the TFEU and Article 21.3 of the ESCB/ECB Statute because the exemption only
covers publicly owned institutions. For the sake of legal certainty 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. 
The provisions of Article 4 of Chapter 10
on the allocation of the Riksbank’s profit are supplemented by non-statutory
guidelines on profit distribution, according to which the Riksbank should pay
80% of its profit to the Swedish State, after adjustment for exchange rate and
gold valuation effects and based on a five-year average, with the remaining 20%
used to increase its own capital. Although these guidelines are not legally
binding and there is no statutory provision limiting the amount of profit that
may be paid out, such practice could constitute an incompatibility with the
principle on the prohibition of monetary financing under Article 123 of the
TFEU. For legal certainty reasons the law should ensure that the reserve
capital of Riksbank is left unaffected in any case and that the actual
contribution to the State budget does not exceed the amount of the net
distributable profit.
9.1.4.   Integration
in the ESCB
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.
Tasks
The incompatibilities of the Riksbank Act
with regard to the ESCB/ECB tasks are as follows:
·       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);
·       definition of monetary policy and monetary functions, operations and
instruments of the ESCB (Chapter 1, Article 2 and Chapter 6, Articles 2, 3 and
5 and 6, Chapter 11, Article 1 and 2a of the Act; Chapter 9, Article 13 of the
Instruments of Government);
·       conduct of foreign exchange operations and the definition of foreign
exchange policy (Chapter 7 of the Act; Chapter 8, Article14 and Chapter 9,
Article 12 of the Instruments of Government); Articles 1 to 4 of the Law on
Exchange Rate Policy;
·       right to authorise the issue of banknotes and the volume of coins
and definition of the monetary unit (Chapter 5 of the Act; Chapter 9, Article
14 of the Instruments of Government);
·       ECB's right to impose sanctions (Chapter 11, Articles 2a, 3 and 5).
There are furthermore some imperfections
regarding the:
·       non-recognition of the role of the ECB and of the EU in the
collection of statistics (Chapter 6, Articles 4(2) and Article 9);
·       non-recognition of the role of the ECB in the functioning of payment
systems (Chapter 1, Article 2; Chapter 6, Article 7);
·       non-recognition of the role of the ECB and of the Council in the
appointment of an external auditor;
·       non-recognition of the role of the ECB in the field of international
cooperation (Chapter 7, Article 6).
9.1.5.   Assessment
of compatibility
As regards the prohibition on monetary
financing, the independence of the Riksbank as well as its integration into the
ESCB at the time of euro adoption, the legislation in Sweden, in particular the
Riksbank Act and the Instrument of Government as part of the Swedish
Constitution, is not fully compatible with the compliance duty under Article
131 of the TFEU.
9.2.      Price
stability
9.2.1.   Respect
of the reference value
The 12-month average inflation rate, which
is used for the convergence evaluation, was below the reference value at the
time of the last convergence assessment of Sweden in 2012. In April 2014, the
reference value was 1.7%, calculated as the average of the 12-month average
inflation rates in Latvia, Portugal and Ireland, plus 1.5 percentage points.
The corresponding inflation rate in Sweden was 0.3%, i.e. well below the
reference value. Sweden's 12-month average inflation rate is likely to remain
well below the reference value in the months ahead. 
9.2.2.   Recent
inflation developments
HICP inflation in Sweden has been trending downwards
since end-2008. In recent years, inflation fell from an average of 1.4% in 2011
to 0.9% in 2012, before declining further to 0.4% in 2013. The decline in
inflation over the last two years was driven by the strengthening of the krona
and sluggish internal and external demand, and was broad-based across various
goods and services. Annual inflation was below its historical averages for all
main HICP components in 2013. HICP inflation stood, on average, at 0.0% in the
first four months of 2014.
 Core
inflation (measured as HICP excluding energy and unprocessed food) followed a
similar downward trend. It declined from 1.1% in 2011 to 1% in 2012 and 0.5% in
2013. The reversal of headline inflation towards core inflation in 2012
primarily reflects the abating impact of previously elevated energy price
inflation, which turned negative in 2013, bringing headline below core
inflation. Although unprocessed food price inflation reached 3.5% in 2013, its
impact on headline inflation was relatively minor due to its low weight in the
HICP. Producer price inflation was mostly negative since end-2011, with
occasional episodes of mildly positive figures (e.g. from October 2013 to
January 2014). 
9.2.1.   Underlying
factors and sustainability of inflation
Macroeconomic policy-mix and cyclical stance
Following the strong recovery of the
Swedish economy from the 2008-2009 recession, real GDP growth was sluggish in
2012 (0.9%) but started to pick up again in 2013, when real GDP grew at a rate
of 1.5%. Steady growth in domestic demand, supported by expansionary fiscal and
monetary policy, helped to sustain economic growth against the impact of the
weak external environment. Nonetheless, the negative output gap is estimated to
have increased over the past two years. According to the Commission services'
2014 Spring Forecast, real GDP growth will be gradually picking up from 2.8% in
2014 to 3.0% in 2015, leading to a narrowing of the negative output gap.
In the wake of a counter-cyclical fiscal
expansion, the fiscal stance, as measured by changes in the structural balance,
continued to be moderately expansionary in 2012 and 2013. The headline surplus
of 2011 turned into a moderate deficit in 2012 which increased in 2013. Stronger
GDP growth and the fiscal framework should help to reduce the headline deficit
as from 2015, with the fiscal stance projected to turn restrictive in 2014 and
2015.
Monetary policy, conducted within an
inflation targeting framework ([86]), was loosened significantly between 2011 and 2013. In response to
low inflationary pressures and sluggish economic growth, the Riskbank gradually
cut its main policy rate from 2% in autumn 2011 to 0.75% in December 2013.
Nevertheless, inflation has been below the target of 2% since 2011, due to the
weak international economic activity and dampened export price growth abroad.
The high level of private debt, and the associated potential financial and
macroeconomic risks, is perceived as implying certain limitations for the Riksbank's
monetary policy.
Wages and labour costs
The Swedish labour market proved to be
resilient during the period of sluggish growth. Employment grew by some 2% in
2011 and by around 1% in 2012 and 2013. In spite of the steadily growing
employment, the unemployment rate has remained at some 8% since 2011 due to an
increase in the labour force. Annual growth of nominal compensation per
employee increased to above 3% in 2012 but moderated to close to 1% in 2013.
Improved economic activity and the lower unemployment rate are likely to
translate into relatively higher wage increases in the forthcoming period, with
annual wage growth projected to average 2.7% in 2014 and 3.0% in 2015. 
Growth in labour productivity was moderate
in the last two years (0.2% and 0.5% in 2012 and 2013, respectively).
Accordingly, growth in nominal unit labour cost (ULC), which stood at some 3%
in 2012 and fell to 0.7% in 2013, is projected to hover around levels slightly
above 1% in 2014-2015. These developments point to relatively limited price
pressures from labour costs in the years ahead.
External factors
Given the high openness of the Swedish
economy, developments in import prices play an important role in domestic price
formation. Import price growth (measured by the imports of goods deflator) has
been negative since 2011. The decline can be explained by falling international
commodity price inflation, subdued demand in the EU and the appreciating krona.
Looking ahead, the import deflator is expected to return to a low but positive
growth path as from 2014, thus dampening external disinflationary pressures.
The nominal effective exchange rate of the
Swedish krona (measured against a group of 36 trading partners) was strong in
2012 and 2013. It increased markedly between early 2012 and early 2013, as the
krona benefitted from safe-haven flows, and remained broadly stable since then.
The strong nominal effective exchange rate significantly contributed to the
subdued inflation in Sweden in recent years.
Administered prices and taxes
Changes in administered prices ([87]) and indirect taxes significantly influenced Swedish inflation over
the past two years, albeit in opposite directions. The share of administered
prices in the HICP basket is 14% in Sweden (compared to 13% in the euro area).
Annual growth in administered prices fell from 3.1% in 2012 to 1.9% in 2013,
considerably lifting headline inflation in both years. To a large extent, this
was due to the increase in rents, which are subject to a high level of
regulation in Sweden and represent by far the largest component of administered
prices. At the same time, the price of medical services increased significantly
in the beginning of 2012, bringing medical service price inflation to
historical highs; passenger transport prices were raised as well. 
Tax changes, on the other hand, contributed
to a moderation in consumer price developments in 2012 and 2013. Although the
excise tax on tobacco was raised in the beginning of 2012, this rise was more
than offset by a reduction in the VAT rate for restaurant and catering services
as well as tax changes in the climate and energy area. The HICP-CT index (a
rough measure of inflation at constant tax rates) increased by 1.3% in 2012 and
by 0.7% in 2013, compared to increases in the HICP index of 0.9% and 0.4%,
respectively.
Medium-term prospects
On the back of a gradual pick-up in growth,
inflation is likely to increase only very moderately in the course of 2014. No
particular upward pressure is foreseen from any HICP component, and wage
developments are projected to remain moderate as resource utilisation is low.
Accordingly, the Commission services' 2014 Spring Forecast projects annual
average inflation at 0.5% in 2014 and 1.5% in 2015.
Risks to the inflation outlook appear to be
broadly balanced. Stronger economic growth in Sweden with faster-than-expected
wage growth, a rise in global commodity prices and a reversal of the recent
appreciation of the krona would raise inflationary pressures. Conversely, a
further appreciation of the krona or a downward correction of house prices
would have disinflationary effects. 
The level of consumer prices in Sweden
relative to the euro area gradually increased since Sweden joined the EU in
1995. In 2012, the Swedish price level was at some 126% of the euro-area
average, compared to 122% in 2011. At the same time, the income level in Sweden
continued to rise, reaching 126% of the euro-area average in PPS in 2012,
compared to 102% in 2009.
In the medium term, inflation is likely to
pick up as the recovery progresses and unemployment decreases further. With the
expected normalisation in demand, companies are projected to raise prices and
cautiously compensate for the subdued price levels in the last two years. On
the other hand, moderate wage developments, the ample spare capacity lingering
in the Swedish economy and strong international competition will dampen any
upward pressure on consumer price developments. Amid low inflationary
pressures, loose monetary conditions could prevail for a longer time, with a
possible further repo rate cut by the Riksbank foreseen in 2014.
9.3.      Public
finances
9.3.1.   Recent
fiscal developments 
After two years with small surpluses, the
general government balance turned into a deficit of 0.6% of GDP in 2012 which
widened to 1.1% in 2013. This reflected lacklustre growth and a number of
government measures to support the economy, which focused on corporate
taxation, active labour market policies and infrastructure investment. The
surplus in the structural balance narrowed from 0.3% of GDP in 2012 to 0.1% in
2013, reflecting the discretionary measures taken. The expenditure-to-GDP ratio
increased from 51.8% of GDP in 2012 to 52.6% in 2013, while the revenues-to-GDP
ratio increased by 0.3 pp. to 51.5% of GDP.
Nevertheless, Swedish public finances
remain robust. The budgetary outcome in 2013 (-1.1% of GDP) was better than the
deficit of 1.6% of GDP targeted in the 2013 Convergence Programme. 
The decline in the government debt-to-GDP
ratio over the previous years reversed in 2013. Gross government debt increased
from 38.3% in 2012 to 40.6% in 2013, mainly on account of an additional
borrowing of SEK 100 billion (EUR 11 billion) to strengthen the foreign
currency reserves of the Riksbank. 
9.3.2.   Medium-term
prospects
The 2014 Budget Bill, which was adopted on
18 December 2013, uses the fiscal space available to improve household
disposable income in a time of weak economic growth. The measures taken amount
to SEK 21 billion (EUR 2.4 billion), including notable income tax cuts. 
Consequently, according to the Commission
services' 2014 Spring Forecast, the general government deficit is projected to
reach 1.8% of GDP in 2014 and the structural balance is forecast to turn into a
deficit, reflecting the expansionary stance of fiscal policy. In 2015, the
nominal deficit is expected to decline to 0.8% on the back of the economic
recovery, with the structural balance improving. 
Gross government debt is expected to
increase further in 2014, reaching 41.6% of GDP, before falling back to 40.4%
of GDP in 2015. 
The medium-term budgetary strategy of the
2014 Convergence Programme aims at achieving the government's target of a
general government surplus of 1% of GDP over the cycle and a surplus of at
least 1% of GDP by 2018. Therefore, any new expenditure-increasing reform
proposed in the Budget Bills for both 2015 and 2016 will have to be funded
"krona for krona" by revenue and/or expenditure measures as already
exemplified in the proposed 2014 Spring Budget Bill. Until 2011, this
one-percent surplus target coincided with Sweden's Medium-Term Objective (MTO).
However, since 2012, the MTO is -1% of GDP, i.e. the minimum required. The
change is explained by a wish to separate the minimum fiscal requirements for
EU Member States from the more ambitious 1% surplus target set by the Swedish authorities.
The authorities rely on a set of indicators to measure the fulfilment of the
surplus target. According to the Commission's calculations based on the
Commission 2014 Spring Forecast, the structural balance for Sweden will be more
stringent than its MTO over the forecast horizon. 
Further details on the assessment of the
2014 Convergence Programme for Sweden can be found in the forthcoming
Commission Staff Working Paper, accompanying the Commission recommendation for
a Council Recommendation on the National Reform Programme 2014 of Sweden and
delivering a Council opinion on the Convergence Programme of Sweden.
In March 2012, Sweden signed the Treaty on
Stability, Coordination and Governance in the EMU (TSCG). This implies an
additional commitment to conduct a stability-oriented and sustainable fiscal
policy. The TSCG will apply to Sweden in its entirety upon lifting its
derogation from participation in the single currency.
9.4.      Exchange
rate stability
The Swedish krona does not participate in
ERM II. The Riksbank pursues inflation targeting under a floating exchange rate
regime. 
Following the strong depreciation of the
krona against the euro at the onset of the financial crisis in 2008, the krona
appreciated by some 35% between March 2009 and August 2012, reaching a
twelve-year high of 8.3 SEK/EUR in August 2012. While this appreciation was
also a correction of the krona's previous weakening, safe-haven flows, resulting
from the intensification of the euro-area sovereign debt crisis, significantly
contributed to it. Since then the krona has depreciated by some 7% against the
euro, averaging 8.9 SEK/EUR in the first four months of 2014. Overall, during
the two years before this assessment, the krona depreciated against the euro by
some 2%. 
Until mid-2012, the krona was also
supported by a significant widening of short-term interest rate differentials
vis-à-vis the euro area, which increased to around 170 basis points in August
2012. The increase in spreads was driven by a marked decline in euro-area
short-term rates as from mid-2011, reflecting a loosening of the euro-area
monetary policy stance and the provision of additional liquidity to the banking
system by the ECB. Between August 2012 and end-2013 short-term spreads declined
by some 100 basis points on the back of falling short-term rates in Sweden (as
the Riksbank cut its policy rate by 75 bps) and  largely unchanged rates on
euro-area money markets. At the cut-off date of this report, the 3-month spread
vis-à-vis the euro area had fallen below 60 basis points.
International reserves remained broadly
stable at around SEK 345 billion between Q4-2011 and Q4-2012. In December 2012,
the Riksbank decided to increase the foreign currency reserves by SEK 100
billion in the light of higher commitments to the IMF and to maintain its
readiness to provide the Swedish banking sector with liquidity in foreign
currency. Following this increase, official reserves remained broadly unchanged
throughout 2013, averaging SEK 430 billion. By the end of 2013, they covered
some 12% of GDP.
9.5.      Long-term
interest rates
Long-term interest rates in Sweden used for
the convergence examination reflect secondary market yields on a single
benchmark government bond with a residual maturity of close to but below 10
years.
The Swedish 12-month moving average
long-term interest rate, relevant for the assessment of the Treaty criterion,
gradually declined from above 4% in 2008, bottomed out at some 1.6% between
October 2012 and May 2013 and has been increasing again since then. It was
markedly below the reference value at the time of each past convergence
assessment. In April 2014, the latest month for which data are available, the
reference value, given by the average of long-term interest rates in Latvia,
Portugal and Ireland plus 2 percentage points, stood at 6.2%. In that month, the
12-month average of the yield on the Swedish benchmark bond stood at 2.2%, i.e.
4.0 percentage points below the reference value.
Long-term interest rates trended down from
above 3.3% in early 2011 to historically low levels of around 1.3% in mid-2012
on the back of falling domestic inflation, a gradual loosening of monetary
policy and safe-haven flows into Swedish government bonds. They subsequently
increased to 2.6% in September 2013. This increase reflected a reversal of
safe-haven flows following the OMT announcement by the ECB and, as from May
2013, a generalised increase in interest rates following heightened
expectations of a decrease in the pace of asset purchases by the US Federal
Reserve. Since October 2013, long-term interest rates have been declining, to
2.1% in April 2014. Long-term interest spreads vis-à-vis the German benchmark
bond, which had been very low in recent years, widened between end-2012 and
autumn 2013 and have fluctuated around 65 basis points since then. They stood
at some 60 basis points in April 2014 ([88]).
9.6.      Additional
factors
The Treaty (Article 140 TFEU) calls for an
examination of other factors relevant to economic integration and convergence
to be taken into account in the assessment. The assessment of the additional
factors – including balance of payments developments, product and financial
market integration – gives an important indication of a Member State's ability
to integrate into the euro area without difficulties. 
In November 2013, the Commission published
its third Alert Mechanism Report (AMR 201) ([89]) under the Macroeconomic Imbalance Procedure (MIP - see also Box
1.5). The AMR 2014 scoreboard showed that Sweden exceeded the indicative
threshold for three out of eleven indicators, linked to both external and
internal imbalances (i.e. the current account balance, export market shares and
private sector debt). In line with the conclusion of the AMR 2014, Sweden was
subject to an in-depth review, which found that Sweden continues to experience
macroeconomic imbalances, which require monitoring and policy action.
9.6.1.   Developments
of the balance of payments
The surplus on Sweden's external balance
(i.e. the combined current and capital account) has been on a declining trend
since 2007, falling from above 9% of GDP in 2007 to 6.6% in 2013. The decline
in the current account surplus is partly explained by a structural decrease in
Sweden's merchandise trade surplus; net exports declined markedly since the
mid-2000s due to the increased importance of the services sector in the Swedish
economy and due to increased international competition. The services trade
surplus remained slightly above 3% of GDP since 2010 and the income balance
increased somewhat, reflecting the continued strengthening of Sweden's net
international investment position. Current transfers have delivered a
relatively steady negative impact, reflecting Sweden's foreign aid and positive
net contributions to international organisations, as well as remittances
transferred by foreign workers in Sweden to their home countries.
Sweden's
large savings-investment surplus persisted in 2012 and 2013, reflecting high
net savings by the private sector, fiscal prudence and the low level of
residential investment. Gross national savings averaged some 25% of GDP in 2012
and 2013, little changed from previous years. While households have increased
precautionary savings following the 2008 financial crisis, corporate and
household saving had also risen as a result of reforms introduced in the 1990s,
such as the introduction of a pension plan of defined contributions. Gross
fixed capital formation declined in both 2012 and 2013, as firms postponed
investment in the uncertain economic environment. 
Indicators of cost competitiveness showed a
mixed picture in the past years. Both the ULC- and the HICP-deflated
real-effective exchange rate (REER), which have been moving very closely
together over the last two years, continued their gradual appreciation in 2012
and early 2013, peaking in March 2013. Since then, they have been trending
downwards, reflecting the decline of the NEER. Sweden's export performance
deteriorated in 2012 and 2013 as goods exports lost further ground to
international competitors. 
Sweden's financial account deficit declined
in 2012 to around 2% of GDP, from a deficit of 8.7% in 2011. Since 2009, the
negative financial account balance has reflected Sweden's role as a net FDI
investor abroad and foreign bank lender. Net portfolio inflows have been positive
since 2009 and increased further in 2013 driven by the refinancing of banks on
international capital markets. External reserves increased markedly in 2013, as
the Riksbank increased foreign currency reserves by SEK 100 billion to re-align
them with the exposure of Swedish banks to foreign capital markets. Gross
external debt to GDP continued to decline from 200% of GDP at end-2011 to 197%
of GDP at end-2013, mainly driven by the reduction in public debt. While
Sweden's mildly negative net international investment position remained broadly
stable in 2011 and 2012, it is estimated to have improved in 2013 on the back
of a sizeable current account surplus and favourable valuation changes.
According to the Commission services’ 2014
Spring Forecast, the external surplus is projected to continue its gradual
decline to some 6% of GDP in 2014 and 2015. The projected decline reflects the
fact that, compared to previous recoveries, net exports are expected to
contribute little or nothing to GDP growth.
9.6.2.   Market
integration
Sweden's economy is highly integrated into
the euro area through trade and investment linkages. Its openness had only
temporarily been reduced by the economic crisis in 2008-2009 and subsequently
recovered gradually. Intra-EA trade represents an important share of Swedish
exports. In 2012, 42% of Swedish goods exports were oriented to EA markets.
Sweden's main EA trading partners were 
Germany and Finland, while the UK, Denmark,
Norway and the US remained important non-EA export markets. There has been some
increase in the importance of exports to the BRICs, in particular China.
Between 2007 and 2012, the share of services in total Swedish exports increased
as a result of the increasing role of outsourcing services in the industry, but
remained stable in intra-EA trade. 
The composition of trade in goods reflects
the main features of Sweden's manufacturing industries, which are mainly
concentrated in capital-intensive sectors and high and medium-high technology
industries. Goods exports include traditional products, such as pulp and paper,
iron and steel, as well as more innovation-driven products such as machinery,
car parts, pharmaceuticals and communication appliances. The share of high
technology exports (mainly electronic and telecommunication equipment) was
broadly stable at 13% over the past two years.
While Sweden has traditionally been a
destination for FDI, total FDI inflows in percent of GDP decreased sharply
between 2008 and 2010 owing to increased economic uncertainty. Since then, they
have recovered only slowly, reaching some 3% of GDP in 2012. Approximately 60%
of total FDI emanates from the euro area.
After a temporary dip in 2008, house prices
resumed their upward trend in 2010 and stabilised thereafter. The annual
percentage change in the real house price index stood at -0.2 in 2012 (and 0.7
in 2011). Although house prices have not been growing extensively since 2010,
inefficiencies in the Swedish housing market continue to imply potential risks
for macroeconomic stability, in particular in case of potential house price
corrections ([90]). In
2010-2011, building permits recovered from their drastic decline in the
previous years, before falling again in 2012. The latest figures available
point to a renewed increase in building permits. Residential investment has
remained broadly constant at around 3% of GDP in the last years. The share of
construction in total value added has remained stable at around 5%.
Regarding the business environment, Sweden
performs well above the average of the euro-area Member States in international
rankings ([91]). The
Swedish economy is characterised by a business-friendly climate, a transparent
legal and regulatory framework, a skilled labour force, and a
stability-oriented macroeconomic framework. Transaction costs related to
starting or closing a business are relatively low. However, additional efforts
could be made to further simplify procedures for new firms ([92]).()Finally, according to the 2013 Internal Market Scoreboard, the
transposition of EU Internal Market directives further improved over the period
under review; in 2012, Sweden had an average transposition deficit of 0.1%, the
lowest in the EU.
The Swedish labour market, characterised by
constructive cooperation between social partners, produces relatively positive
labour market outcomes and is adequately flexible. The employment rate was
around 74% in 2012, one of the highest in the euro area. Unemployment is
comparatively low and the share of long-term unemployed is among the lowest in
the euro area. The wage-setting system is based on negotiations between
employee and employer confederations, with the majority of wage bargaining
taking place at firm level within the framework of sectoral agreements.
Individual salaries are generally set locally, allowing for differentiation
according to individual performances. Wages have been developing broadly in
line with benchmarks based on both internal labour market adjustment and
external competitiveness ([93]).
Sweden has a relatively high incidence of
flexible working time arrangements. While the employment protection of
permanent workers is comparatively high (close to the euro-area-OECD countries'
average, according to the 2013 OECD employment protection indicator), the
employment protection of temporary workers is comparatively low (roughly half
of the euro-area-OECD countries' average). Adjustment by labour mobility is
adequate, with a relatively low dispersion of regional unemployment rates. The
integration of low-skilled and foreign-born remains the key challenge for the
Swedish labour market since the employment rate of both groups is significantly
below the overall employment rate. 
9.6.3.   Financial
market integration
Sweden's financial sector is well
integrated into the EU financial sector, especially through inter-linkages in
the Nordic-Baltic financial cluster. The main integration channels are the
Swedish ownership of financial intermediaries in all countries of the region,
bank funding on international financial markets and consolidation of the
Stockholm stock exchange in the Nasdaq-OMX Group. The foreign exposure of
Swedish banks accounts for about half of their total lending and is mainly
directed towards Denmark, Finland, the US, Germany and the UK. Exposure to the
Baltic countries corresponds to around 5% of the aggregated loan book, but
plays a dominant role in the Estonian, Latvian and Lithuanian market. On the
other hand, foreign ownership in the Swedish market is relatively low (8.5% in
2012) and slightly declined in recent years. The Swedish banking sector is
dominated by four large banks and the market concentration is higher than in
the euro area. In 2012, the five largest banks held more than 60% of domestic
bank assets, compared to a euro-area average of 50%. 
 Total
assets of the Swedish banking sector, including foreign operations, amount to
about 400% of GDP, which is above the euro-area average. The structure of the
financial sector is similar to the euro area. Relative to GDP, the banking
sector assets and stock market capitalisation are higher in Sweden, while the
size of the debt markets is comparable. Loans constitute about 55% of total
bank assets. In recent years, loans to households have been gaining relative to
loans to non-financial corporations, increasing from 62% of GDP in 2007 to 78%
in 2013. In the euro area, this ratio increased only marginally, from some 54%
of GDP to 55% of GDP. The credit expansion exerted also upward pressure on
house prices, although they have not grown extensively since 2010. Following
the introduction of the 85% loan-to-value cap on new mortgages in 2010, the
Swedish Financial Supervisory Authority (FSA) took further steps to contain
growing household indebtedness, in particular through introducing a 15% risk
weight floor for mortgages and a recommendation for individual amortisation
plans in 2013. Corporate loans in Sweden remained close to 50% of GDP in 2013,
the same as in 2007. In the euro area, the ratio declined from 49% to 45% over
the same time span. Total consolidated private debt stabilised at around 210%
of GDP since 2010, significantly above the euro-area average of 145% of GDP ([94]).
The capital adequacy of Swedish banks
measured by standard regulatory ratios remains relatively high, with a capital
adequacy ratio of above 12% in mid-2013 (compared to some 15% in the euro
area). However, as Swedish banks apply low weights in their risk calculation,
due to low historical loss levels, the average ratio of capital to total
non-risk weighted assets is relatively low. The ratio of non-performing loans
stayed below 1% for a number of years (0.8% in 2013). The high asset quality,
cost-efficiency and market concentration support the profitability of Swedish
banks. In 2013, the average return on equity (RoE) was at 11.3%, almost double
the euro-area average. Among other factors that contributed to the good
performance of the Swedish banks are high leverage (linked with high private
indebtedness), diversified business models and low funding costs. 
Deposits account for only 30% of banking
sector liabilities in Sweden. Due to their large size relative to the economy,
Swedish banks are bound to rely extensively on market funding, half of which is
in foreign currency. This also results from the composition of savings, with a
relatively low share held as bank deposits and a high share placed in
securities, pension funds and insurance products. Sweden's safe haven status
during the euro area debt crisis led to substantial capital inflows and low
funding costs for banks. Since market financing tends to be more volatile than
funding via deposits, funding risk is an inherent challenge for the Swedish
banking sector ([95]).
The assets of non-bank financial
intermediaries account for about 45% of the total assets of financial
institutions, having increased over the past two years. Sweden has a developed
and relatively large insurance sector, including almost 300 domestic companies
and almost 40 foreign branches ([96]). Notwithstanding the number of undertakings, the sector is quite
concentrated, with the ten largest companies holding 85% of the market in 2012
(in terms of investment assets). Total premiums received in 2012 corresponded
to 7.1% of GDP, of which some three quarters were accounted for by life
insurances ([97]). The
insurance companies managed assets amounting to 89% of GDP. The assets under
management of the Swedish investment funds corresponded to 57% of GDP, while
the state pension funds' (AP Funds) total assets increased to 32% GDP.
Shareholding is widespread in Sweden,
making the equity market large and liquid. Households directly hold around 10%
of the listed shares and further 25% through investment funds as well as
insurance and pension schemes. Foreign investors hold about 40% of the stocks;
their participation has been increasing ([98]). Stock market capitalisation increased to 122% of GDP in 2013,
coming back to the pre-crisis level and exceeding twice the euro-area average.
NASDAQ OMX Stockholm is the dominant trading venue, sharing the same listed
companies with the stock exchanges in Helsinki, Copenhagen and Reykjavik
("Nordic list").  The value of the outstanding debt securities
increased from 134% of GDP in 2007 to 166% in 2013, in line with evolution of
the euro-area average. The long term debt market in SEK is dominated by
issuances of covered bonds by mortgage institutions (45% of the total) and
central government debt securities (30%). Banks rank third, although the bulk
of their issuance is done in foreign currencies on the international market ([99]). The issuance of corporate debt has increased since 2007, but
remains relatively limited, which is also the case for bonds issued by
municipals and county councils. The Swedish money market, accounting for about
one tenth of the bond market in terms of size, halved after the financial
crisis and has been recovering only slowly in recent years. Sweden has also
developed a foreign exchange market as well as markets for interest-rate and
forex derivatives.
Since 1991, the Swedish Financial
Supervisory Authority (FSA) has been the single micro-prudential supervisor for
the banking, securities and insurance sectors. In 2013, the government decided
to grant responsibility for macro-prudential oversight to the FSA as well, thus
concentrating micro- and macro-prudential tools in a single authority. The
Riksbank and the Ministry of Finance will remain involved in macro-prudential
policy in the areas of their competencies, not least through participation in
the Financial Stability Committee ([100]). Sweden has implemented most of the EU financial services
directives.
([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 towards convergence
and recommendation with a view to the transition to the third stage of economic
and monetary union, COM(1998)1999 final, 25 March 1998.
([4])  European Monetary Institute,
Convergence Report, March 1998.
([5])  The content of this article is now
included in Article 140(1) TFEU.
([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
2012, COM(2012) 257 final, 12 May 2010; European Central Bank, Convergence
Report 2012, May 2012.
([8])  Council Decision of 9 July 2013 (OJ L
195, 18.7.2013, p. 24–26).
([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 by Regulations (EC) No 1882/2003 and No 596/2009
of the European Parliament and 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.
([11]) Based on the Commission services' 2014
Spring Forecast, the inflation reference value is forecast to stand at 1.8% in
December 2014. 
([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/economic_governance/sgp/deficit/index_en.htm.
([13]) A directive on minimum requirements for
national budgetary frameworks, two new regulations on macroeconomic
surveillance and three regulations amending the Stability and Growth Pact and
complementing it with new enforcement mechanisms for euro area Member States
entered into force on 13 December 2011. Besides the operationalisation of the
debt criterion in the Excessive Deficit Procedure mentioned in Box 1.3, the
amendments introduced a number of important novelties in the Stability and
Growth Pact, in particular an expenditure benchmark to complement the
assessment of progress towards the country-specific medium-term budgetary
objective.    
([14]) 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.
([15]) 97/C 236/03 of 16 June 1997, OJ C 236,
2.8.1997, p.5.
([16]) 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 transfers), 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.
([17]) To avoid the duplication of
surveillance procedures, Member States under EU-IMF financial assistance
programmes  are not examined under the macroeconomic imbalances procedure and were
therefore not covered in the Alert Mechanism Report and in-depth reviews. Among
the Member States examined in this report, this concerns Romania.
([18]) According to the Eurostat definition, administered
prices in Bulgaria include inter alia electricity and other regulated
utility prices, pharmaceutical products, hospital services, part of public
transport and education. For details, see http://epp.eurostat.ec.europa.eu/portal/page/portal/hicp/documents_meth/HICP-AP/HICP_AP_classification_2011_2014_02.pdf
([19]) An overview of all excessive deficit
procedures can be found at: http://ec.europa.eu/economy_finance/ economic_
governance/sgp/deficit/index_en.htm
([20]) Based on estimated residual maturity
([21]) The reference to the German benchmark
bond is included for illustrative purposes, as a proxy of the euro area
long-term AAA yield.
([22]) http://ec.europa.eu/europe2020/pdf/2014/amr2014_en.pdf
([23]) For instance, Bulgaria ranks 58th (out
of 189 economies) on the World Bank's 2014 Ease of Doing Business Index and
57th (out of 148 economies) on the World Economic Forum's 2013-2014 Global
Competitiveness Index.
([24]) http://info.worldbank.org/governance/wgi/
index.aspx#home
([25]) Maiväli, M. and M. Stierle, ʻThe
Bulgarian labour market puzzle: Strong wage growth amidst rising
unemploymentʼ, Country Focus, Directorate-General for Economic and
Financial Affairs, European Commission, 2013.
([26]) Data on private sector debt are based
on consolidated ESA 95 data of non-financial corporations and households (and
non-profit institutions serving households) sectors' liabilities related to
loans and securities other than shares.
([27]) As from January 2010, the inflation
target of the ČNB is set as annual consumer price index growth of 2% (with
a tolerance band of ± 1 percentage point).
([28]) According to the Eurostat definition, administered
prices in the Czech Republic include inter alia regulated utility
prices, heat energy, public transport, pharmaceuticals, medical and social
services. For details, see http://epp.eurostat.ec.europa.eu/portal/page/portal/hicp/documents_meth/HICP-AP/HICP_AP_classification_2011_20
14 _02.pdf 
([29]) An overview of all ongoing excessive
deficit procedures can be found at: http://ec.europa.eu/economy_finance/
economic_governance/sgp/deficit/index_en.htm
([30]) The reference to the German benchmark
bond is included for illustrative purposes, as a proxy of the euro area long-term
AAA yield.
([31]) http://ec.europa.eu/europe2020/pdf/2014/amr2014_en.pdf
([32]) For instance, the Czech Republic ranks 75th
(out of 189 economies) on the World Bank's 2014 Ease of Doing Business Index
and 46th (out of 148 economies) on the World Economic Forum's
2013-2014 Global Competitiveness Index.
([33]) Data on private sector debt are based
on consolidated ESA 95 data of non-financial corporations and households (and
non-profit institutions serving households) sectors' liabilities related to
loans and securities other than shares.
([34]) Constitution as amended and published
in the Official Journal of the Republic of Croatia no. 56/90, 135/97, 113/2000,
123/2000, 124/2000, 28/2001, 55/2001 and 76/2010.
([35]) Official Journal of the Republic of
Croatia no. 75/2008 and 54/2013.
([36]) Government budgetary figures are not
fully aligned with ESA standards and cannot directly be compared with the
figures provided by the Commission.
([37]) Based on estimated residual maturity
([38]) http://ec.europa.eu/europe2020/pdf/2014/amr2014_en.pdf
([39]) For instance, Croatia ranks on 89th
(out of 189 economies) on the World Bank's 2014 Ease of Doing Business
Index and 75th (out of 148 economies) on the World Economic Forum's 2013-2014
Global Competitiveness Index.
([40]) http://info.worldbank.org/governance/wgi/index.aspx#
home
([41]) Law No I-678 of 1 December 1994.
([42]) Register of Legal Acts 2014-01-30, No.
2014-716, effective as of 31 January 2014.
([43]) Law No XII-766 of 23 January 2014,
Register of Legal Acts 2014-01-30, No 2014-712, entering into force on the day
the Council abrogates the derogation of Lithuania pursuant to Article 140 of
the TFEU.
([44]) According to the Eurostat definition, administered
prices in Lithuania inter alia include water supply, refuse and sewerage
collection, electricity, gas, heat energy, medical products and certain
categories of passenger transport. For details, see
http://epp.eurostat.ec.europa.eu/portal/page/
portal/hicp/documents_meth/HICP-AP/HICP_AP_
classification_2011_2014_02.pdf
([45]) An overview of all excessive deficit
procedures can be found at: http://ec.europa.eu/economy_finance/ economic_
governance/sgp/deficit/index_en.htm
([46]) Based on estimated residual maturity.
([47]) The reference to the German benchmark
bond is included for illustrative purposes, as a proxy of the euro area
long-term AAA yield.
([48]) http://ec.europa.eu/europe2020/pdf/2014/amr2014_en.pdf
([49]) Latvia – an important trading partner
of Lithuania - joined the euro area in 2014, which led to a further increase in
this ratio.
([50]) Lithuania ranks 17th (out of 189
economies) on the World Bank's 2014 Ease of Doing Business Index and 48th (out
of 148 economies) on the World Economic Forum's 2013-2014 Global Competitiveness
Index.
([51]) Bank of Lithuania supervisory data, end
2013. 
([52]) Bank of Lithuania (2013) Financial
Stability Review 2013
([53]) In 2012, there were 77 credit unions
with assets corresponding to 1.8% of GDP and one central credit union with
assets corresponding to 0.3 GDP.
([54]) Bank of Lithuania (2013) Financial
Stability Review 2013
([55]) The Fundamental Law came into effect on
1 January 2012 has been amended five times since.
([56]) Law XVI of 2014 published on 24
February 2014
([57]) Following a decision in August 2005,
the MNB pursues a continuous medium-term inflation target of 3% for the period
starting in 2007 with a permissible ex post fluctuation band of +/- 1
percentage point.
([58]) For more on the FGS, see e.g. the 4th
PPS Review Note:
http://ec.europa.eu/economy_finance/assistance_eu_ms/
documents/hu_efc_note_4th_pps_mission_en.pdf
([59]) According to the Eurostat definition, administered
prices in Hungary inter alia include water supply, refuse and sewerage
collection, electricity, gas, heat energy, pharmaceutical products and  certain
categories of passenger transport. For details, see http://epp.eurostat.ec.europa.eu/portal/page/portal/hicp/documents_meth/HICP-AP/HICP_AP_classification_2011_
2014_02.pdf
([60]) An overview of all excessive deficit
procedures can be found at: http://ec.europa.eu/economy_finance/economic_
governance/sgp/deficit/index_en.htm
([61]) The extraordinary reserves were
in-built security buffers with a specific regulation governing their potential
release: these could not be spent before September 30, 2012 and the government
could have decided on the use only if in the Autumn 2012 fiscal notification
the expected EDP deficit for 2012 would not exceed 2.5% of GDP.
([62]) The reference to the German benchmark
bond is included for illustrative purposes, as a proxy of the euro area
long-term AAA yield.
([63]) http://ec.europa.eu/europe2020/pdf/2014/amr2014_en.pdf
([64]) For instance, Hungary ranks 54th (out
of 189 economies) on the World Bank's 2014 Ease of Doing Business Index and
63rd (out of 148 economies) on the World Economic Forum's 2013-2014 Global
Competitiveness Index.
([65]) For a more detailed assessment see
section 4 of the 2014 in-depth review on Hungary.
([66]) Data on private sector debt are based
on consolidated ESA 95 data of non-financial corporations and households (and
non-profit institutions serving households) sectors' liabilities related to
loans and securities other than shares.
([67]) Since the beginning of 2004, the NBP has
pursued a continuous inflation target of 2.5% with a permissible fluctuation
band of +/- 1 percentage point.
([68]) According to the Eurostat definition, administered
prices in Poland include inter alia water supply, refuse and sewerage
collection, electricity, gas, heat energy and certain categories of passenger
transport. For details, see http://epp.eurostat.ec.europa.eu/portal/page/portal/hicp/documents_meth/HICP-AP/HICP_AP_classification_2011_20
14 _02.pdf
([69]) An overview of all ongoing excessive
deficit procedures can be found at: http://ec.europa.eu/economy_finance/
economic_governance/sgp/deficit/index_en.htm
([70]) The reference to the German benchmark
bond is included for illustrative purposes, as a proxy of the euro area long-term
AAA yield.
([71]) http://ec.europa.eu/europe2020/pdf/2014/amr2014_en.pdf
([72]) For instance, Poland ranks 45th (out of
189 economies) on the World Bank's 2014 Ease of Doing Business Index and 42nd (out
of 148 economies) on the World Economic Forum's 2013-2014 Global
Competitiveness Index.
([73]) Data on private sector debt are based
on consolidated ESA 95 data of non-financial corporations and households (and
non-profit institutions serving households) sectors' liabilities related to
loans and securities other than shares.
([74]) Year-end annual inflation targets of 3.0%
in terms of annual consumer price index growth (with a tolerance band of ± 1
percentage point) were set for end-2011 and end-2012. Starting in 2013, the BNR
follows a flat multi-annual inflation target of 2.5% (± 1pp.).
([75]) According to the Eurostat definition, administered
prices in Romania include inter alia regulated electricity and gas
prices, regulated utility prices, medical products, postal services and cultural
services and part of public transport. For details, see
http://epp.eurostat.ec.europa.eu/
portal/page/portal/hicp/documents_meth/HICP- AP/HICP_
AP_classification_2011_2014_02.pdf
([76]) An overview of all excessive deficit
procedures can be found at: http://ec.europa.eu/economy_finance/
economic_governance/sgp/deficit/index_en.htm
([77]) The precautionary international
assistance package provides for a total of EUR 4 billion, equally split between
EU and IMF. For further information on this and past programmes, see http://ec.europa.eu/economy_finance/
assistance_eu_ms/romania/index_en.htm
([78]) http://ec.europa.eu/europe2020/making-it-happen/country-specific-recommendations/index_en.htm
([79]) 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.
([80]) The reference to the German benchmark
bond is included for illustrative purposes, as a proxy of the euro area
long-term AAA yield.
([81]) http://ec.europa.eu/europe2020/pdf/2014/amr2014_en.pdf
([82]) http://eur-lex.europa.eu/LexUriServ/
LexUriServ.do?uri=OJ:L:2013:140:0001:0010:EN:PDF
([83]) Romania ranks 73rd (out of 189
economies) on the World Bank's 2014 Ease of Doing Business Index and 76th (out
of 148 economies) on the World Economic Forum's 2013-2014 Global
Competitiveness Index .
([84]) http://info.worldbank.org/governance/wgi/
index.aspx#home
([85]) http://eur-lex.europa.eu/legal-content/EN/ALL/
?uri=CELEX:32011L0061
([86]) Since 1995, the Riksbank has targeted
increases in the domestic CPI with the aim of keeping inflation at 2%.
([87]) According to the Eurostat definition,
fully administered prices in Sweden inter alia include water supply,
refuse and sewerage collection, hospital services and combined passenger
transport. Mainly administered prices inter alia include actual rents
for housing and medical services. For details, see http://epp.eurostat.ec.europa.eu/portal/page/portal/hicp/documents_meth/HICP-AP/HICP_AP_classification_2011_2014_02.pdf
([88]) The reference to the German benchmark
bond is included for illustrative purposes, as a proxy of the euro area
long-term AAA yield.
([89]) http://ec.europa.eu/europe2020/pdf/2014/amr2014_en.pdf

([90]) For a more detailed analysis, see
European Commission (2014), "Macroeconomic Imbalances - Sweden 2014",
European Economy. Occasional Papers. 186. March 2014.
([91]) For instance, Sweden ranks 14th (out of
189 economies) on the World Bank's 2014 ease of doing business index and 6th (out
of 148 economies) on the World Economic Forum's 2013-2014 Global
Competitiveness Index.
([92]) According to the 2014 World Bank Doing
Business Report the time to start a business in Sweden is 16 calendar days,
which is slightly longer than the EU average of 14 days.
([93]) The methodology for wage benchmarks is
published in European Commission (2013), "Benchmarks for the assessment of
wage developments", European Economy. Occasional Papers. 146. May
2013.
([94]) For a more detailed analysis, see
European Commission (2014), "Macroeconomic Imbalances - Sweden 2014",
European Economy. Occasional Papers. 186. March 2014.
([95]) ibid.
([96]) As at the end of 2012. Source: Sveriges
Riksbank (2013), The Swedish Financial Market.
([97]) Swiss Re Sigma (2013), World
Insurance in 2012.
([98]) 2012 data. Source: Sveriges Riksbank
(2013), The Swedish Financial Market.
([99]) Issues in foreign currencies are
typically converted in SEK via derivatives, primarily currency swaps.
([100])         The FSC (Financial Stability
Committee), established by a government decision of December 2013, will also
include the FSA and the Swedish National Debt Office. The first of its official
semi-annual meetings is foreseen for June 2014. The establishment of the FSC
formalises the inter-institutional cooperation on financial stability and
crisis management dating back to 2005.