World Bank: Inflationary Pressures and Growth Slowdown Predicted In Most New EU Member States

World Bank report also reviews implementation of Common Agricultural Policy

WARSAW, May 31, 2007―Output growth gained further pace across the 10 new European Union member states in 2006, but is likely to slow down in 2007, according to the latest World Bank EU8+2 Regular Economic Report. Growth accelerated in Estonia, Latvia, Poland, Slovakia, Slovenia, and Romania, while it remained largely unchanged in the Czech Republic, Lithuania, and Bulgaria. Only Hungary experienced a slowdown on the back of its fiscal austerity program. The region’s overall strong performance reflected the favorable external environment of robust global growth, low interest rates, and positive emerging market sentiment. In some countries, however, booming domestic demand is leading to an overheating of the economy, and current growth rates are unlikely to be sustainable. Growth is expected to slow across the region in 2007, with exception of Poland, Slovakia, and Bulgaria.

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The report notes that strong output growth was associated with rising employment and declining unemployment rates, not least in Poland and Slovakia. The services sector accounted for most new jobs (except in the Czech Republic), though the construction sector was also an important contributor in several countries. Meanwhile, labor force participation rates declined in Poland, Lithuania, Slovakia, and the Czech Republic (contributing to lower unemployment), while the opposite was true in Estonia, Hungary, Latvia, and Bulgaria. Tightening labor markets drove real wage growth well into double digit rates in the Baltic countries and Romania during 2006. The outflow of labor from the new EU member states (NMS) continues but may be slowing slightly.

This latest report repeats the warning of the previous edition on inflationary pressures, which are mounting in several countries in the region, with output above potential, tightening labor markets, and rapid credit growth. Inflation is rising rapidly in the Baltic countries, not least in Latvia, and is also trending upward in Poland and the Czech Republic, with monetary policy now biased toward tightening. In Hungary, inflation may have spiked under the influence of large administered price increases, with weaker demand and strong forint appreciation supporting a reversal of the trend. Currency appreciation has also been associated with declining inflation in Slovakia and Romania, and interest rates are on a downward path. While a strong fiscal position has helped ease inflationary pressures in Bulgaria, fiscal policy has not sufficiently helped contain inflation and real appreciation pressures in other countries.

Thomas Blatt Laursen, World Bank Lead Economist in Warsaw, who is heading the team preparing the report, observes: “Most countries in the region are not taking adequate advantage of the strong growth to improve public finances. The picture is not expected to change significantly in 2007, although Hungary will make an important dent in the very large deficit recorded in 2006, and Poland will continue its gradual adjustment process. Slovakia aims to bring its deficit just below the 3 percent of GDP threshold needed to adopt the euro from 2009 as planned. The need for a more ambitious fiscal policy is particularly acute in Latvia, but Bulgaria and Romania also can hardly afford the fiscal easing envisaged this year.” Laursen notes that most countries in the region are taking steps toward improving the quality of their public finances, although most recent initiatives have not been terribly ambitious.

“Reform momentum in the region has generally waned owing to post-accession reform fatigue, unstable political situations, and weak administrative capacity,” says Laursen. “Although small steps are taken now and then to improve the business environment, more complex public administration, legal, and labor market reforms are proving elusive, and renewed momentum is needed to sustain the process of rapid real convergence.”

The authors of the report point out that current account deficits widened further, reaching very high levels in the most vulnerable countries. While exports continued to grow strongly across the region, booming domestic demand raised current account deficits to 15 percent of GDP or higher in Latvia, Estonia, and Bulgaria. Meanwhile, the current account deficit narrowed significantly in Hungary. With FDI inflows much lower than current account deficits in the Baltic States, external debt levels increased further, as was the case in Bulgaria. Meanwhile, external positions remained strong in the Czech Republic and Poland, where growth was more balanced. There is little doubt that Latvia is the most vulnerable country in the region, but the situation also warrants monitoring in Estonia, Lithuania, Bulgaria, and Romania.

SPECIAL TOPIC: Support to Agriculture and Rural Development in the EU8+2

The report’s Special Topic reviews the impact of EU integration and the Common Agricultural Policy, which have led to substantial increases in agricultural income. According to the authors of the report, “The variation in income growth is as pronounced as the diversity in agricultural structures across the region. With the relative dominance of (semi-)subsistence farming in many NMS, labor productivity lags far behind the EU15 average.”

Laursen notes that “All NMS have opted for the highest allowed eligibility threshold, thus promoting farm consolidation and efficiency, but most NMS have opted to implement top-ups close to the maximum permitted level of 30 percent of EU15 average support, discouraging restructuring and consolidation in agriculture and at a significant budgetary cost.”

The report concludes that the EU8+2 agriculture and rural development challenges cannot be addressed by agricultural policy alone. For effective sector restructuring to take place, non-agricultural support policies and institutions have a role to play. Reliance on the provision of direct payments to secure farmer incomes would slow down structural change, as it would discourage farmers from restructuring, consolidating, or modernizing their farms.

For more information, please visit http://www.worldbank.org/eca/eu10rer

Source: World Bank