Fiscal Policy Challenges Facing the New Member States in a Period of Large Capital Inflows

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International Seminar for Experts Catching up
after Enlargement Cicero Foundation October
14-15, 2004

• Fiscal Policy Challenges Facing the New Member
  States in a Period of Large Capital Inflows
  Substantial Investment Requirements

Armin Riess European Investment Bank
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Main questions

• Public debt fiscal deficits that countries can
  afford?
• Role of public investment and other expenditure?
• Role of balance of payments position (notably
  capital inflows)?

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What do we need to examine?

• Key features of CEE economies
• Public debt sustainability
• Mixed blessing of capital inflows

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Real GDP growth projection (in ), 2004
Long-run CEE growth potential 4-5
EU-15 potential
Source European Commission, Economic Forecast,
Spring 2004
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Consumer price inflation (in ), 2004
2004 CEE average
EU-15/eurozone target
Source European Commission, Economic Forecast,
Spring 2004
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Public debt in CEE EU-15 ( of GDP), 2004
Maastricht 60 criterion
Source European Commission, Economic Forecast,
Spring 2004
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Key features of CEE economies - Summary -

• Real economic growth CEE gt EU15
• Inflation CEE gt EU15
• ? Nominal economic growth CEE gt EU15
• Public debt CEE lt EU15

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Public debt sustainability(ad hoc criteria)

• Keep public debt/GDP-ratio constant !

• Debt/GDP should converge to 60 (Maastricht) !

• Debt/GDP should fall to zero
• (Stability Growth Pact) !

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Debt dynamics
Change in debt/GDP ratio
fiscal deficit/GDP ratio
nominal GDP growth debt/GDP ratio
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Fiscal deficit that leaves debt/GDP unchanged
Nominal GDP growth Nominal GDP growth Nominal GDP growth
4 5 7
Fiscal deficit (in of GDP) Fiscal deficit (in of GDP) Fiscal deficit (in of GDP)
Debt in of GDP
20 0.8 1.0 1.4
40 1.6 2.0 2.8
60 2.4 3.0 4.2
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Where does public investment fit into this
picture?

• Fiscal deficit can be higher if

• public investment is large today, but expected
  to fall in the future.

• Is public investment high in CEE?

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Public investment in CEE EU-15 ( of GDP,
1999-2003 average)
Source European Commission (2003 Spring
Forecast) and IMF (Staff Appraisal Reports)
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What about other public expenditure?

• High investment today can justify higher fiscal
  deficit, but

• other government expenditure may be low today
  relative to their future level.

• Example public pension expenditure

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Public pension expenditure in selected CEE
countries (in of GDP)
Source European Commission Occasional Paper 4,
July 2003
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Public debt sustainability - Summary -

• Debt sustainability does not imply the same
  fiscal deficit for all countries

• Some government expenditure (investment) may
  justify higher fiscal deficits, others (pensions)
  call for fiscal restraint

• Public debt sustainability is one thing,
  macroeconomic stability is another

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Capital inflows (in of GDP)(2001-2003 average
for CEE, peak inflow periods otherwise )
1998-9
1996-9
1987-91
Source IMF (Staff Appraisal Reports) Begg et
al. (2002)
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Capital inflows current account deficits(in
of GDP, 2001-2003 average)
Capital inflows
Current account deficit
Source IMF (Staff Appraisal Reports)
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Why do large capital inflows occur?

• Higher returns on physical investment
• Expected trend appreciation of currency
  (Balassa-Samuelson effect)

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Why are capital inflows a mixed blessing ?

• Whats good
• Investment finance ? higher growth

• Too much of a good thing
• Overheating of economy (inflation)
• Credit boom banking sector stability
• Excessive currency appreciation competitiveness

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How to cope with large capital inflows?

• Banking sector stability
• Effective prudential regulation supervision
• Overheating of economy
• Revaluation of exchange rate/exchange rate
  flexibility
• Fiscal austerity

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Fiscal deficit exchange rate regime ( of
GDP, 2001-2003 average)
Flexible exchange rates
Hard currency pegs
Source IMF (Staff Appraisal Reports)
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Conclusion

• Fiscal policy assessment requires a
  country-by-country approach
• Coping with dark side of capital flows is key
  (fiscal) policy challenge
• Fiscal policy challenges other than those
  concerning the bottom line