## rei0517

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### EXECUTIVE SUMMARY — Recent Developments and Outlook
- Growth has broadened across Central, Eastern, and Southeastern Europe (CESEE).
- Outside the Commonwealth of Independent States (CIS) and Turkey, growth remained strong, driven by accommodative policies.
- Russia and the rest of the CIS are exiting recession as firming oil prices lift activity; Turkey’s growth partially rebounded after a sharp drop following elevated political uncertainty.
- 2016 snapshots:
  - Outside the CIS and Turkey: growth was robust but softened in some countries in the second half of 2016; growth was mainly consumption driven while investment was generally weaker.
  - Several CESEE EU countries experienced slower absorption of EU structural funds at the start of the new cycle, weighing on activity.
  - CIS: started exiting recession supported by higher commodity prices; Russia estimated to have grown in the second half of 2016 with recovery in private consumption and an uptick in manufacturing; Ukraine’s recovery picked up; Belarus’s recovery remained elusive.
  - Turkey: activity slowed sharply in 2016Q3 but partially rebounded in 2016Q4; 2016Q4 rebound driven by consumption and net exports.
- Financial and credit developments:
  - Non-performing loan (NPL) ratios have declined significantly from post-crisis peaks but remain high relative to other emerging market economies.
  - A few CESEE countries are in the early expansion stage of the credit cycle; outside the CIS and Turkey, credit growth is accelerating (largely household lending); business lending more uneven.
  - Russia: credit growth picking up after stagnation; rest of CIS: credit contraction continued but slowed; Turkey: credit growth slowed then gradually recovered.
- Financial conditions tightened modestly since Fall 2016 with increases in long-term yields after U.S. yield curve steepening; EM sovereign spreads narrowed as U.S. election–related volatility abated.
- Tables and Figures reflect data as of April 28, 2017.

### Inflation, Labor Markets, and Slack
- Labor markets:
  - Unemployment rates have fallen to pre-crisis levels in many countries outside the CIS and Turkey.
  - Wage growth is strong; significant minimum wage increases occurred in many countries.
  - Labor shortages, especially for skilled workers, are acute in some economies (e.g., the Baltics and the CEE).
  - Unemployment rates remain high in SEE non-EU countries due to structural problems.
- Inflation patterns:
  - Outside the CIS and Turkey, headline inflation picked up from low levels; core inflation developments are mixed, with notable increases in the Baltics and the CEE.
  - SEE EU: inflation turned positive after VAT cut effects in Romania dropped out.
  - Russia: inflation is falling; Turkey and rest of CIS: inflation increasing reflecting exchange rate pass-through and higher commodity prices.
- Output gap classification ranges used in the analysis:
  - Positive gap: greater than 0.5 percent
  - Closed gap: between −0.5 and 0.5 percent
  - Small negative gap: between −1.5 and −0.5 percent
  - Negative gap: between −3 and −1.5 percent
- Country-level notes: Turkey and Russia appear somewhat below potential; Belarus, Bosnia and Herzegovina, and Ukraine have negative output gaps.

### Outlook and Risks
- Near-term prospects:
  - Strengthening global activity and supportive domestic macro policies underpin the outlook.
  - Outside the CIS and Turkey, growth projected to pick up, fueled by domestic demand and greater absorption of EU structural funds.
  - Russia’s recovery will support activity in other CIS and Baltic countries.
  - Turkey: growth expected to remain weak amid ongoing political and economic uncertainty.
- Selected projections and forecasts:
  - Russia’s GDP projected to expand by 1.4 percent in 2017.
  - Growth in Turkey expected at 2.5 percent in 2017.
  - Russia: inflation reaching 4.5 percent in 2017.
  - Rest of the CIS: inflation projected to be 10.6 percent in 2017.
  - Turkey: inflation forecast to be about 10 percent in 2017.
- Risks (tilted to the downside over the medium term):
  - Upside: stronger external demand (euro area, United States), firmer commodity prices, lower political uncertainty in Western Europe.
  - Downside: global shift toward protectionism, sudden tightening in global financial conditions, shocks in advanced Europe, wage increases harming competitiveness.

### Policy Priorities — General and Country-Specific
- General guidance for economies close to full capacity:
  - Begin macro policy normalization.
  - Priority: reduce cyclically adjusted fiscal deficits to achieve medium-term fiscal targets and lower vulnerabilities.
  - Where inflation is picking up, monetary policy should gradually withdraw accommodation.
  - A tighter fiscal stance would allow monetary policy to normalize more gradually in most inflation-targeters.
- Country-specific:
  - Turkey: tighten monetary policy further to lower inflation and reduce elevated external vulnerabilities.
  - Russia: continue monetary easing as inflation declines toward target while fiscal policy adjusts to lower oil prices.
- Medium-term challenge: boost potential growth and convergence via structural reforms (strengthen institutions; improve public sector efficiency, including restructuring state-owned enterprises and enhancing public sector investment management; improve labor supply via higher participation and reduced structural unemployment).

### Boxes and Key Figures (selected)
- Box 1. Turkey: Recent Developments and Near-term Outlook
- Box 2. Regional Spillovers from the Nascent Recovery in Russia
- Box 3. EU Funds Absorption—How Much of a Cyclical Boost Can Be Expected?
- Figures referenced include GDP Growth per Capita; Recovery breadth; WEO Output Gaps Estimates, 2017; Labor Markets; Inflation and Expectations; NPLs; Credit Cycle Positions; Credit Growth; Tables include CESEE: Estimates of Output Gaps, 2017 and Projections: Real GDP Growth and Inflation.

*Prepared by a staff team consisting of Ahmed El Ashram and Yan Sun, with input from country teams, and research assistance from Cristina Batog and Vizhdan Boranova. The team was led by Laura Papi and Emil Stavrev, under the general guidance of Jӧrg Decressin. Approved by Poul M. Thomsen. May 11, 2017.*

### Bond markets, fund flows, and financial conditions
- EMBIG spreads have narrowed; flows to bond and equity funds recovered in 2016–17 (chart timeframe: Jun-13 to Apr-17; time windows Oct. 31, 2016 to Apr. 28, 2017 and Oct. 31, 2016 to Nov. 30, 2016).
- Key region labels used in charts: POL HUN ROU UKR TUR HRV RUS SRB EMs; UKR TUR POL RUS SVK HUN ROU CZE LVA LTU BGR SRB EMs; SRB RUS HRV EM; LatAm; TUR EM; Global EM EUR UKR EM Asia; HUN POL.
- Forces shaping outlook:
  - Pick-up in global activity, improving euro area outlook, and anticipated U.S. fiscal stimulus expected to increase external demand for CESEE.
  - Firming commodity prices support CIS recovery and raise headline inflation globally.
  - Russia turnaround will have favorable spillovers through trade, investment, and financial channels.
- Monetary policy expectations:
  - CESEE EU inflation targeters (Czech Republic, Hungary, Poland, Romania): monetary policy remains accommodative; markets expect modest tightening or no change (Poland) one year ahead.
  - Czech National Bank removed exchange rate floor in early April.
  - Russia: interbank rates expected to ease further after easing in stance.
  - Turkey: average funding rate increased since early 2017 by about 350 basis points; markets expect interbank rates to increase modestly.
- Fiscal stance and EU funds absorption:
  - Fiscal policy projected neutral or expansionary in most countries; expansionary stances expected in Bulgaria, Croatia, Estonia, Hungary, Romania (including recently announced tax rate cuts).
  - Given largely closed output gaps, structural fiscal deficits will remain sizable for many countries.
  - Russia: fiscal consolidation process expected to continue to adjust to lower oil revenue.
  - EU Structural and Investment Funds absorption envisaged to pick up and boost activity in EU members; higher absorption likely to have a strong cyclical impact.
  - Empirical evidence: "the first-year multiplier is between ½ and 2/3 and the long-term impact could be as high as three in a cyclical downturn."
- Near-term financial outlook:
  - Financial conditions expected to remain favorable given gradual monetary policy normalization in advanced economies and ECB accommodative stance.
  - Growth set to pick up in the Baltics, the CEE, and most SEE non-EU countries; Bulgaria and Romania projected to slow moderately after strong 2016.

### Regional inflation, growth, potential, and vulnerabilities
- Divergent inflation trends expected to continue near term: headline and core inflation projected to pick up outside CIS and Turkey, but core inflation generally to stay below target for remainder of 2017.
- Medium-term potential growth:
  - Potential growth expected to be significantly lower than pre-crisis levels for most CESEE countries due to weaker productivity growth and lower investment.
  - Rapid re-accelerating convergence is more challenging; aging populations and declining workforces (except Turkey) weigh on long-term output potential; outward migration contributes to workforce declines.
- Vulnerabilities to rapid tightening of global financial conditions:
  - Past episodes triggered sizable capital outflows; credit spreads widened; exchange rates depreciated generally by less than in other emerging markets (except Turkey).
  - External liabilities:
    - Other than in the CIS and Turkey, elevated external liabilities (about 100 percent of GDP) are main source of vulnerability; bulk is FDI and intercompany lending.
    - Many countries have significant euro-denominated external liabilities; Hungary’s U.S. dollar debt largely swapped into euros.
    - Turkey and the CIS vulnerable to higher U.S. dollar funding costs due to high shares of U.S. dollar–denominated liabilities.
    - Turkey: external funding largely U.S. dollar denominated, sourced from portfolio flows and cross-border bank borrowing with limited FDI; loss of sovereign investment grade increases vulnerability.
    - Russia: low external debt and large U.S. dollar export proceeds mitigate high share of dollar liabilities.
    - Rest of CIS: high external debt and significant cross-border borrowing increase vulnerability.
  - Balance sheet mismatches:
    - Corporate mismatches large in Croatia, Hungary, Russia, Turkey, Ukraine.
    - Financial sector FX mismatches elevated in Bosnia and Herzegovina and Serbia.
    - High dollar credit to private sector in CIS and Turkey implies sharp U.S. dollar appreciation would generate significant corporate losses.
    - Hungary and Russia: corporate U.S. dollar exposures reportedly hedged by U.S. dollar export proceeds; Croatian corporate debt largely euro denominated.
  - Relative vulnerability indicators: Turkey and CIS (excluding Russia) may be most vulnerable due to elevated current account deficits, large external-debt-refinancing needs, and low reserves coverage.
  - Limited fiscal space and still-high public debt increase vulnerability in Croatia, Hungary, Ukraine, and some SEE non-EU countries.

### CESEE EU — Wage growth, inflation pass-through, and competitiveness
- Wage dynamics:
  - Annual real wage growth in CESEE EU countries has averaged about 4.5 percent since 2014, outstripping labor productivity growth by about 2 percentage points per year.
  - Industry surveys indicate labor shortages increased significantly since 2013, implying persistent wage pressures.
- Pass-through estimates:
  - For CESEE EU, 1 percentage point higher wage growth would increase core or headline inflation by about 0.06–0.08 percentage points in the short term and 0.3 percentage point in the long term.
  - A 1 percentage point increase in euro area inflation would raise headline or core inflation in CESEE EU economies by 0.2–0.3 percentage point in the short term and 1.5 percentage points or more in the long term.
- Competitiveness effects:
  - So far, strong wage growth had limited impact on inflation due to low commodity prices, low imported inflation from the euro area, and compressed profit margins.
  - Real effective exchange rate deviations from the 2000–15 average are mixed; several countries in ±5–10 percent range; Bulgaria, Estonia, Latvia exceed 20 percent.
  - Non-oil current account balances relatively stable; export market shares broadly unchanged for many CESEE countries in 2014–16, with Baltic countries showing modest erosion since 2014.
- Risk: If energy prices and euro area inflation rebound, the offset that muted wage-driven inflation may disappear; higher energy prices would produce sharper rebound in headline inflation and squeeze profit margins in commodity-importing countries.

### Policy recommendations (detailed)
- General macro framework (outside CIS and Turkey):
  - Macroeconomic policies should adjust to advanced cyclical recovery and reduce vulnerabilities.
  - Fiscal policy should bear the brunt of macroeconomic adjustment, allowing monetary policy to withdraw accommodation gradually.
  - Fiscal tightening needed in many countries given advanced cyclical position, relatively large cyclically adjusted deficits, and need to preserve competitiveness and rebuild policy room.
  - Fiscal consolidation should be accompanied by improving expenditure quality and revenue composition.
- Monetary policy for inflation targeters:
  - Remain accommodative but prepare to normalize gradually if underlying inflation moves up persistently.
  - Phase out unconventional measures (e.g., credit support schemes in Hungary) in an orderly way.
  - Gradual conventional tightening may be needed to contain inflation pressures; faster tightening if high wage growth causes inflation to rise more rapidly than expected.
- Financial sector:
  - Continue balance sheet repair and further NPL reduction.
  - Implement Regional NPL Action Plan measures where applicable; enhance prudential oversight; strengthen debt enforcement and insolvency frameworks; deepen markets for distressed debt.
- Country responses to recent shocks:
  - Russia: continue monetary easing as inflation expectations fall toward central bank target; continue medium-term fiscal consolidation focusing on durable adjustment.
  - Turkey: further monetary tightening necessary to lower inflation and reduce external vulnerabilities; use fiscal space judiciously while pursuing credible medium-term consolidation.
- Structural reforms (regional):
  - Strengthen institutions and public sector efficiency, including SOE restructuring and stronger public investment management.
  - Implement active labor market policies to increase participation and boost labor supply; consider immigration policy per IMF (2016a).
  - Improve investment climate and reduce labor market rigidities to lower SEE non-EU unemployment.
  - Russia: rekindle structural reform agenda to diversify growth toward non-energy tradables, reduce administrative pressures, improve labor mobility.
  - Turkey: improve business climate (institutional stability and quality), increase domestic private savings, address labor market rigidities to reduce informality, better integrate refugees.

*International Monetary Fund, CESEE REI SPRING 2017 (excerpts from chapter: Key forces shaping the outlook and outlook summary)*

### Box 1 — Turkey: Recent Developments and Near-Term Outlook
- Cycle and activity:
  - Turkey at a different point in the cycle: activity and credit growth slowed sharply in 2016 amid increased political and economic uncertainty.
  - Security concerns reduced tourism; surge in imports weakened current account.
  - Inflation high and volatile; unemployment rising.
- Revisions and ratios:
  - Nominal and real GDP growth revised upward by an average of 2.7 percentage points over 2011–15.
  - Revision lowered public and external debt-to-GDP ratios by as much as 5 and 9 percentage points, to 28 percent and 46 percent of GDP, respectively.
  - 2015 current account deficit now 3.8 percent of GDP, about 0.7 percent of GDP lower than before revision.
  - Fiscal deficit improved by 0.2 percent of GDP.
- External vulnerabilities:
  - External financing requirements high at 23 percent of GDP.
  - Turkish lira slid by more than 25 percent against the dollar since end-June 2016.
  - Sharp depreciation led to higher inflation and pressure on corporate balance sheets and banks’ asset quality; foreign currency loans exceed 20 percent of GDP.
  - Capital flows recovered since end-February 2017; credit spreads and bond yields fell.
- Policy measures late 2016:
  - Fiscal/administrative: temporary tax cuts; corporate and SME loan guarantees; measures to reduce domestic use of foreign currency including collecting public sector FX receivables in lira.
  - Monetary/liquidity: central bank increased policy rate and lowered FX reserve requirements to support FX liquidity.
- Near-term outlook:
  - Subdued: near-term growth projected to remain below potential.
  - Political uncertainty and less favorable global financial conditions expected to keep borrowing costs elevated.
  - Imbalances expected to persist with inflation above target and external debt rising.
  - Offsetting factors: weaker lira may benefit net exports; fiscal incentives may support investment.

*Prepared by Ahmed El-Ashram, with inputs from Plamen Iossifov.*

### Annex B — Impact of EU Funds on Growth in the CESEE EU Countries (methodology, results, implications)
- Sample and period:
  - Panel regression for 11 CESEE EU countries (Bulgaria, Croatia, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, Slovak Republic, Slovenia) over 2008–15.
- Estimation equation (symbols preserved):
  - g_it = α + β ESIF_it + Σ γ_j z_it−j + Σ δ_j X_it−j + μ_i + λ_t + ε_it
  - ε_it = μ_i + λ_t + ν_it
- Estimator: Arellano and Bond dynamic panel GMM (Arellano and Bover 1995); robust standard errors corrected for finite sample bias.
- Collinearity note: correlation between change in EU funds absorption and change in government investment is very low (0.08); correlations with private investment and total investment are −is 0.3 and −0.27, respectively.
- Key reported impact multipliers:
  - "The results show that the impact multiplier of the EU funds is between ½ and 2/3."
  - The EU funds’ impact spans more than one period—consistent with multiyear project implementation.
- Selected coefficients from Table B1 (dependent variable: real GDP growth):
  - real GDP growth (t-1):
    - (1) 0.315 *** (0.0662)
    - (2) 0.492 *** (0.107)
    - (3) 0.509 *** (0.0805)
    - (4) 0.316 *** (0.0860)
    - (5) 0.448 *** (0.0986)
  - Change in EU funds absorption (t):
    - (1) 0.645 *** (0.157)
    - (2) 0.478 *** (0.182)
    - (3) 0.647 *** (0.150)
    - (4) 0.477 ** (0.194)
    - (5) 0.663 *** (0.142)
  - Change in EU funds absorption (t-1):
    - (1) 1.176 *** (0.203)
    - (2) 1.009 *** (0.278)
    - (3) 1.005 *** (0.227)
    - (4) 1.284 *** (0.266)
    - (5) 1.143 *** (0.196)
  - Change in EU funds absorption (t-2):
    - (1) 1.719 *** (0.177)
    - (2) 1.234 *** (0.204)
    - (3) 1.294 *** (0.177)
    - (4) 1.737 *** (0.218)
    - (5) 1.364 *** (0.175)
  - Change in Gross Capital Formation (Private Sector):
    - (1) -0.00452 (0.153)
    - (2) 0.0149 (0.146)
    - (3) -0.397 *** (0.124) [t-1]
    - (4) -0.372 *** (0.129) [t-1]
    - (5) -0.129 ** (0.0592) [t-2]
    - (5) -0.0935 (0.0902) [t-2 in another spec]
  - Change in Gross Capital Formation (Government):
    - (3) 0.768 *** (0.292)
    - (4) 0.621 *** (0.237)
    - (3) 0.533 (0.384) [t-1]
    - (4) 0.447 (0.424) [t-1]
    - (3) 0.0351 (0.409) [t-2]
    - (4) -0.119 (0.480) [t-2]
  - Change in Total Gross Capital Formation (specification 5):
    - (5) 0.221 (0.138)
    - (5) Change in Total Gross Capital Formation (t-1) -0.293 ** (0.130)
    - (5) Change in Total Gross Capital Formation (t-2) -0.0277 (0.0980)
- Additional table metadata preserved exactly as presented:
  - Observations6666666666
  - Number of countries11 11111111
  - Robust standard errors in parentheses.
  - Significance notation: *** p<0 .0 1 , ** p<0 .0 5 , * p<0 .1
- Implications:
  - Short-run and dynamic effects of changes in EU funds absorption are sizable and positive across specifications (immediate t coefficients 0.477 ** to 0.663 ***; larger lagged effects up to 1.719 *** at t-2).
  - Government gross capital formation positive in some specifications; private sector gross capital formation shows negative and sometimes significant lagged coefficients in some specifications.
  - Empirical findings consistent with EU-funded projects producing multiyear growth impacts.

*IMF staff analysis as presented in Annex B of the CESEE REI Spring 2017 report.*

### EXECUTIVE SUMMARY

### EXECUTIVE SUMMARY

### A. Recent Developments: The Recovery Has Broadened
- Growth has broadened across Central, Eastern, and Southeastern Europe (CESEE).  
- Outside the Commonwealth of Independent States (CIS) and Turkey, growth has remained strong, driven by accommodative policies.  
- Russia and the rest of the CIS are finally on the road to recovery, with firming oil prices lifting activity.  
- Growth in Turkey has rebounded partially after dropping sharply in the wake of elevated political uncertainty.  
- In 2016:
  - Outside the CIS and Turkey, growth was still robust, but softened in some countries in the second half of 2016; growth was mainly consumption driven while investment was generally weaker.  
  - Several CESEE EU countries experienced slower absorption of EU structural funds at the start of the new cycle, weighing on activity.  
  - The CIS countries started exiting the recession, supported by higher commodity prices. In Russia, the economy is estimated to have grown in the second half of 2016, with a recovery in private consumption accompanied by an uptick in manufacturing. Ukraine’s recovery picked up some steam as macroeconomic imbalances were reduced. Belarus’s recovery remained elusive.  
  - In Turkey, activity slowed sharply in 2016Q3 but partially rebounded in 2016Q4; the slowdown reflected lower investment following increased uncertainty after the failed coup attempt and weaker tourism activity, while the 2016Q4 rebound was driven by consumption and net exports.  
- High-frequency indicators (e.g., PMIs) suggest activity is picking up in 2017 in CEE countries and continuing to recover in Russia; Turkey’s economy continues to stabilize after the 2016Q3 contraction.  
- The cyclical recovery appears largely complete in much of the region; many economies are beginning to operate close to full capacity, though estimates of output gaps are subject to wide margins of error.  
  - Turkey and Russia appear somewhat below potential; Belarus, Bosnia and Herzegovina, and Ukraine have negative output gaps.  
- Credit and bank balance-sheet repair:
  - Non-performing loan (NPL) ratios have declined significantly from post-crisis peaks in many CESEE economies, though they remain high relative to other emerging market economies.  
  - A few CESEE countries are in the early expansion stage of the credit cycle.  
  - Outside the CIS and Turkey, credit growth is accelerating (driven largely by lending to households); lending to businesses has been more uneven.  
  - In Russia, credit growth is picking up after stagnation; in the rest of the CIS, credit contraction continued but slowed; in Turkey, credit growth slowed in response to shocks but is gradually recovering.  
- Foreign-owned bank sales in the region have not had adverse impact; international banks are increasingly looking to expand CESEE operations as profitability improves.  
- Financial conditions have tightened modestly since Fall 2016: yields on long-term local and foreign currency bonds have increased following the steepening of the U.S. yield curve in late 2016. As U.S. election–related volatility abated, EM sovereign spreads narrowed (notably in Russia and Ukraine), ETF and mutual fund flows recovered, and equity markets continued to post gains.  
- Tables and Figures reflect data as of April 28, 2017.

### B. Inflation, Labor Markets, and Slack
- Labor markets have tightened in most of the region:
  - Unemployment rates have fallen to pre-crisis levels in many countries outside the CIS and Turkey.  
  - Wage growth is strong; significant increases in minimum wages occurred in many countries.  
  - Labor shortages, especially for skilled workers, have become acute in some economies (e.g., the Baltics and the CEE).  
  - Unemployment rates remain high in the SEE non-EU countries, reflecting structural problems such as incomplete reforms, weak investment climates, infrastructure gaps, and low FDI inflows.  
- Inflation developments:
  - Outside the CIS and Turkey, headline inflation has picked up from low levels, driven by higher commodity prices and base effects; core inflation developments are more mixed, with more notable increases in the Baltics and the CEE.  
  - In the SEE EU, inflation turned positive after the impact of value-added tax cuts in Romania dropped out.  
  - Surveys suggest an increase in inflation expectations in CESEE EU countries.  
  - In Russia, inflation is falling; in Turkey and the rest of the CIS, inflation is increasing, reflecting exchange rate pass-through of recent depreciations and higher commodity prices.  
- Output gaps:
  - A variety of estimates suggest many economies are close to full capacity (see CESEE: WEO Output Gaps Estimates, 2017; Table 1).  
  - Ranges used: (1) Positive gap: greater than 0.5 percent; (2) Closed gap: between −0.5 and 0.5 percent; (3) Small negative gap: between −1.5 and −0.5 percent; (4) Negative gap: between −3 and −1.5 percent.

### C. Outlook: Near Term Favorable, Risks Tilted to the Downside
- Near-term prospects are favorable:
  - Strengthening global activity and continued supportive domestic macroeconomic policies underpin the outlook.  
  - Outside the CIS and Turkey, growth is projected to pick up, fueled by domestic demand and greater absorption of EU structural funds.  
  - The recovery in Russia will support activity in other CIS and Baltic countries.  
  - In Turkey, growth is expected to remain weak amid ongoing political and economic uncertainty.  
- Risks to the outlook are two sided but tilted to the downside, notably over the medium term:
  - Upside potential: stronger external demand (higher growth in the euro area and the United States), a firmer recovery in commodity prices (helping the CIS), and lower political uncertainty following key elections in Western Europe.  
  - Downside risks: a global shift toward inward-looking policies and protectionism, a sudden tightening in global financial conditions, new shocks in advanced European economies, and further wage increases that could hurt competitiveness.

### D. Policy Priorities
- In countries with largely closed output gaps, macroeconomic policy normalization needs to begin:
  - Priority: start reducing still relatively large cyclically adjusted fiscal deficits to achieve medium-term fiscal targets and lower vulnerabilities.  
  - Where inflation is picking up on a sustained basis, monetary policy will need to gradually withdraw accommodation.  
  - A tighter fiscal stance would allow monetary policy to normalize more gradually in most inflation-targeters, helping maintain gains in competitiveness.  
- Country-specific guidance:
  - Turkey needs to tighten monetary policy further to lower inflation and reduce elevated external vulnerabilities.  
  - Russia can continue with monetary easing as inflation declines toward the central bank’s target and fiscal policy adjusts to lower oil prices.  
- Main medium-term policy challenge: boost potential growth and income convergence with structural reforms:
  - Gains from past reforms are largely exhausted and speeding up convergence is more challenging.  
  - Required reforms include strengthening institutions; improving public sector efficiency (including restructuring state-owned enterprises and enhancing public sector investment management frameworks); and improving labor supply by raising participation rates and reducing structural unemployment.

### E. Boxes, Figures, and Further Analysis (selected)
- Box topics included in the source:  
  - Box 1. Turkey: Recent Developments and Near-term Outlook  
  - Box 2. Regional Spillovers from the Nascent Recovery in Russia  
  - Box 3. EU Funds Absorption—How Much of a Cyclical Boost Can Be Expected?  
- Key figures and tables referenced in the source include, among others:
  - Figure 1. GDP Growth per Capita  
  - Figure 2. The Recovery Has Broadened in the Region  
  - Figure 3. CESEE: WEO Output Gaps Estimates, 2017  
  - Figure 4. Labor Markets Have Tightened in Most of the Region  
  - Figure 5. Inflation and Inflation Expectations Have Risen  
  - Figure 6. Non-performing Loans are Falling  
  - Figure 7. CESEE: Credit Cycle Positions  
  - Figure 8. Credit Growth is Recovering  
  - Table 1. CESEE: Estimates of Output Gaps, 2017  
  - Table 2. Projections: Real GDP Growth and Inflation

*Prepared by a staff team consisting of Ahmed El Ashram and Yan Sun, with input from country teams, and research assistance from Cristina Batog and Vizhdan Boranova. The team was led by Laura Papi and Emil Stavrev, under the general guidance of Jӧrg Decressin. Approved by Poul M. Thomsen. May 11, 2017.*

### 1. Change in Foreign Currency Sovereign Bond Yields

### 1. Change in Foreign Currency Sovereign Bond Yields

### Bond market developments and fund flows
- EMBIG spreads have narrowed, and flows in bond funds have recovered.
- Cumulative flows to exchange-traded and mutual funds investing in emerging market bonds & equities (May 2013=100) showed a recovery in 2016–17 after earlier episodes of outflows (chart timeframe: Jun-13 to Apr-17).
- Time windows shown in underlying charts: Oct. 31, 2016 to Apr. 28, 2017 and Oct. 31, 2016 to Nov. 30, 2016, indicating bond yield and spread changes over those periods.
- Country group and region labels in the charts include: POL HUN ROU UKR TUR HRV RUS SRB EMs; UKR TUR POL RUS SVK HUN ROU CZE LVA LTU BGR SRB EMs; SRB RUS HRV EM; LatAm; TUR EM; Global EM EUR UKR EM Asia; HUN POL.

### Key forces shaping the outlook
- A pick up in global activity portends better prospects for CESEE, while stronger commodity prices will underpin the recovery in the CIS.
- Activity has strengthened in advanced economies, notably in advanced Europe, and some major emerging economies since the October 2016 World Economic Outlook.
- In 2017, an improving euro area outlook based on a cyclical recovery in global manufacturing and trade, and stronger U.S. growth reflecting an anticipated fiscal stimulus, are expected to increase external demand for the CESEE countries.
- The firming of commodity prices is supporting the recovery in Russia and the rest of the CIS countries, and is raising headline inflation globally.
- A turnaround in Russia will have favorable spillovers to other CIS and Baltic countries through trade, investment, and financial channels.

### Monetary policy and interest rate expectations
- Monetary policy is expected to continue being accommodative in several of the CESEE EU countries and gradually ease in Russia.
- For the CESEE EU inflation targeters (Czech Republic, Hungary, Poland, and Romania), monetary policy remains accommodative and markets expect only modest tightening or no change in the case of Poland one year ahead.
- The Czech National Bank phased out an unconventional instrument by removing the exchange rate floor in early April.
- In Russia, following the recent easing in the monetary policy stance, interbank rates are expected to ease further.
- In Turkey, after the increase in the average funding rate since early 2017 (by about 350 basis points), markets expect interbank rates to increase modestly.
- Figure reference: Real policy rate and market expectations of interest rate change (In percent, as of April 28, 2017). Notes: Real policy rate = nominal rate minus one year-ahead inflation forecast from the April 2017 WEO; implied rate change = the 1-year ahead interbank interest rate swap rate minus current interbank interest rate; Turkish funding = weighted average cost of the Central Bank of the Republic of Turkey funding.

### Fiscal policy stance and EU funds absorption
- Fiscal policy is projected to be neutral or expansionary in most countries.
- Expansionary fiscal stances are expected in Bulgaria, Croatia, Estonia, Hungary, and Romania, including because of recently announced tax rate cuts in some of these countries.
- Given largely closed output gaps, structural fiscal deficits will remain sizable for many countries in the region.
- In Russia, the fiscal consolidation process is expected to continue to adjust to lower oil revenue.
- The absorption of the EU Structural and Investment Funds is envisaged to pick up pace and boost activity in the region’s EU members; higher absorption of EU funds is likely to have a strong cyclical impact on output in the CESEE EU members.
- Empirical evidence from the past cycle suggests "the first-year multiplier is between 
1
2
ൗ
 and 
2
3
ൗ
 and the long-term impact could be as high as three in a cyclical downturn."

### Financial conditions and near-term outlook
- Financial conditions are expected to remain favorable, given the expected gradual monetary policy normalization in advanced economies and the European Central Bank’s continued accommodative stance.
- Near-term growth prospects are favorable for the region. Other than in the CIS and Turkey, growth is expected to improve for most countries.
- Growth is set to pick up in the Baltics, the CEE, and most SEE non-EU countries, reflecting strong domestic and external demand, and for the CESEE EU members, a pickup in the absorption of EU funds.
- In Bulgaria and Romania, growth is projected to slow moderately after a very strong performance in 2016.
- Russia’s GDP is projected to expand by 1.4 percent in 2017 (higher than envisaged in October 2016).
- Growth for the rest of the CIS is also projected to improve and has been revised upward relative to October 2016 projections.
- Growth in Turkey is expected to remain weak at 2.5 percent in 2017 amid ongoing political and economic uncertainty.

_International Monetary Fund, CESEE REI SPRING 2017 (excerpts from chapter: Key forces shaping the outlook and outlook summary)_

### 1. Real GDP Growth                                                                     2. Inflation (period average)

### 1. Real GDP Growth                                                                     2. Inflation (period average)

### Regional inflation outlook and projections
- "The divergent inflation trends in the region are forecast to continue over the near term."
- Headline and, to a lesser extent, core inflation are projected to pick up outside the CIS and Turkey, but core inflation is expected to generally stay below target for the remainder of 2017.
- Russia: inflation is expected to continue to fall toward the central bank’s target, reaching 4.5 percent in 2017.
- Rest of the CIS: inflation is projected to decline, but remain elevated at 10.6 percent.
- Turkey: inflation is forecast to increase significantly above target to about 10 percent in 2017—reflecting in part the exchange rate pass-through.

### Growth, potential growth, and labor force trends
- "In the medium term, potential growth is expected to be significantly lower than pre-crisis levels for most CESEE countries."
- Post-global financial crisis: potential growth has declined substantially across the region, reflecting weaker productivity growth and lower investment rates.
- Re-accelerating convergence is more challenging because gains from past reforms are largely exhausted.
- Rapidly aging populations and a declining workforce (except for Turkey) will significantly weigh on the region’s long-term output potential and have considerable fiscal implications; outward migration contributes to workforce declines.

### Risks (tilted to the downside)
- Near-term upside risk: stronger external demand (notably the euro area and the United States), and potential political uncertainty subsidence in Western Europe.
- Near- and medium-term downside risks:
  - A global shift toward inward-looking policies and protectionism.
  - A sudden tightening in global financial conditions.
  - New shocks in advanced Europe (uncertainty associated with upcoming major elections and post-Brexit arrangements, including impacts on the EU budget).
  - Domestic risk: wages and inflation could accelerate more than projected, adversely affecting competitiveness.

### Vulnerabilities to rapid tightening of global financial conditions
- Past episodes (Taper Tantrum, U.S. election sell-off) triggered sizable capital outflows; credit spreads widened and, except in Turkey, exchange rates depreciated generally by less than in other emerging market economies.
- External liabilities and composition:
  - Other than in the CIS and Turkey, elevated external liabilities (about 100 percent of GDP) are the main source of vulnerability; a mitigating factor is that the bulk is FDI and intercompany lending.
  - Many countries have a significant share of external liabilities denominated in euros; Hungary’s U.S. dollar debt is largely swapped into euros.
  - Turkey and the CIS are vulnerable to higher U.S. dollar funding costs, given high shares of U.S. dollar–denominated liabilities.
  - In Turkey, external funding is largely U.S. dollar denominated and sourced from portfolio flows and cross-border bank borrowing with limited FDI; loss of sovereign investment grade increases vulnerability.
  - Russia: low external debt and large U.S. dollar export proceeds mitigate the high share of dollar liabilities.
  - Rest of the CIS: high external debt and significant cross-border borrowing increase vulnerability to external financing pressures.
- Balance sheet mismatches:
  - Corporate balance sheet mismatches are large in Croatia, Hungary, Russia, Turkey, and Ukraine.
  - Financial sector foreign exchange mismatches are elevated notably in Bosnia and Herzegovina and Serbia.
  - High dollar credit to the private sector in the CIS and Turkey implies a sharp U.S. dollar appreciation would generate significant corporate losses.
  - In Hungary and Russia, corporate U.S. dollar exposures are reportedly hedged by U.S. dollar export proceeds; Croatian corporate debt is largely euro denominated.
- Relative vulnerability indicators indicate Turkey and CIS (excluding Russia) may be most vulnerable due to elevated current account deficits, large external-debt-refinancing needs, and low reserves coverage.
- Limited fiscal space and still-high public debt increase vulnerability in Croatia, Hungary, Ukraine, and some SEE non-EU countries.

### CESEE EU: Wage growth, inflation pass-through, and competitiveness
- Wage dynamics:
  - Annual real wage growth in CESEE EU countries has averaged about 4.5 percent since 2014, outstripping labor productivity growth by about 2 percentage points per year.
  - Industry surveys indicate labor shortages have increased significantly in several countries since 2013, implying persistent wage pressures.
  - Structural shortages of skilled labor (notably in CEE), possibly driven in part by emigration, may not be easily resolved by wage increases.
- Pass-through estimates (empirical evidence):
  - For CESEE EU countries, 1 percentage point higher wage growth would increase core or headline inflation by about 0.06–0.08 percentage points in the short term and 0.3 percentage point in the long term.
  - In contrast, a 1 percentage point increase in euro area inflation would raise headline or core inflation in the CESEE EU economies by 0.2–0.3 percentage point in the short term and 1.5 percentage points or more in the long term.
- Current effects on competitiveness:
  - So far, strong wage growth has had a limited impact on inflation, offset by low commodity prices, low imported inflation from the euro area, and compression in profit margins.
  - Deviations in the real effective exchange rate (based on unit labor costs in manufacturing) from the 2000–15 average are mixed; several countries are in the ±5–10 percent range, while Bulgaria, Estonia, and Latvia exceed 20 percent.
  - Non-oil current account balances have been relatively stable for most countries; export market shares appear broadly unchanged for many CESEE countries in 2014–16, though the Baltic countries show signs of modest erosion since 2014.
- Risk from commodity and euro area inflation rebound:
  - If energy prices recover and euro area inflation is sustained, the offset that has muted wage-driven inflation may disappear; with relatively high energy shares in CESEE EU CPI, higher energy prices would produce a sharper rebound in headline inflation and further squeeze profit margins in commodity-importing countries.
  - Given relatively weak productivity growth, continuing strong wage growth would likely add to pressures on both core and headline inflation.

### Policy priorities and recommendations
- General macro framework (outside the CIS and Turkey):
  - Macroeconomic policies should adjust to the advanced cyclical recovery and reduce vulnerabilities further.
  - Fiscal policy should bear the brunt of macroeconomic adjustment, allowing monetary policy to gradually withdraw accommodation.
  - Fiscal tightening is needed in many countries given advanced cyclical position, relatively large cyclically adjusted deficits, and the need to preserve competitiveness and rebuild room for policy maneuver.
  - Fiscal consolidation should be accompanied by enhancing expenditure quality and improving revenue composition.
- Monetary policy for CESEE EU inflation targeters:
  - Monetary policy should remain accommodative but may need to begin normalizing gradually if underlying inflation moves up persistently.
  - Inflation-targeting central banks (Czech Republic, Hungary, Poland, and Romania) should prepare to phase out unconventional measures (such as credit support schemes in Hungary) in an orderly way to avoid excessive tightening.
  - Gradual conventional tightening may be needed to contain inflation pressure and inflation expectations; faster tightening could be required if high wage growth causes inflation to rise more rapidly than expected.
- Financial sector policies:
  - Continue balance sheet repair and further reduction in NPLs.
  - Implement Regional NPL Action Plan measures where applicable; enhance prudential oversight to incentivize write-offs or restructurings; strengthen debt enforcement and insolvency frameworks; deepen markets for distressed debt.
- Country-specific guidance for recent shocks:
  - Russia:
    - Monetary policy can continue to ease as inflation expectations fall toward the central bank’s target; pace should consider pickup in activity and need to build credibility under the new inflation-targeting regime.
    - Continue ambitious medium-term fiscal consolidation to adjust to permanently lower oil prices, focusing on well-targeted and durable adjustment.
  - Turkey:
    - Further tightening of monetary policy is necessary to lower inflation and reduce elevated external vulnerabilities.
    - Judicious use of available fiscal space can cushion negative shocks but should be accompanied by credible medium-term consolidation plans.
- Structural reforms (regional priorities):
  - Strengthen institutions and improve public sector efficiency, including state-owned enterprise restructuring and stronger public investment management.
  - Implement active labor market policies to increase participation rates and boost labor supply given adverse demographics; consider immigration policy as discussed in IMF (2016a).
  - Improve the investment climate and reduce labor market rigidities to lower unemployment in SEE non-EU countries.
  - Russia: rekindle structural reform agenda to diversify growth toward the non-energy tradable sector, reduce administrative pressures, and improve labor mobility.
  - Turkey: improve business climate (institutional stability and quality), increase domestic private savings, address labor market rigidities to reduce informality, and better integrate refugees.

*Source: IMF World Economic Outlook Database; CESEE Regional Economic Outlook, Spring 2017 (selected chapter content).*

### Box 1. Turkey: Recent Developments and Near-Term Outlook

### Box 1. Turkey: Recent Developments and Near-Term Outlook

### Economic and financial cycle; activity and credit
- Turkey is at a different point in the economic and financial cycle from the rest of the region: activity and credit growth slowed sharply in 2016 against a backdrop of increased political and economic uncertainty.
- Security concerns have adversely affected tourism arrivals, and a surge in imports has weakened the current account.
- Inflation has been high and volatile, and unemployment has been rising.

### Recent national accounts revisions and fiscal/external indicators
- Nominal and real GDP growth were revised upward by an average of 2.7 percentage points over 2011–15.
- The revision lowered the public and external debt-to-GDP ratios by as much as 5 and 9 percentage points, to 28 percent and 46 percent of GDP, respectively.
- The 2015 current account deficit is now 3.8 percent of GDP, about 0.7 percent of GDP lower than before the revision.
- The fiscal deficit improved by 0.2 percent of GDP.

### External imbalances, exchange rate, and balance-sheet vulnerabilities
- External financing requirements are high at 23 percent of GDP given the still-large current account deficit and the banking and corporate sectors’ relatively high reliance on short-term external funding.
- The Turkish lira came under substantial pressure in recent months, sliding by more than 25 percent against the dollar since the end of June 2016.
- The sharp depreciation led to higher inflation and amplified pressures on corporate balance sheets and banks’ asset quality, given the high share of foreign currency loans (in excess of 20 percent of GDP).
- Capital flows have recovered since end-February 2017, with credit spreads and bond yields falling.

### Policy measures announced in late 2016
- Fiscal and administrative measures: a package of temporary tax cuts; corporate and small and medium enterprise loan guarantees; measures to reduce domestic use of foreign currency, including by collecting public sector foreign exchange receivables in lira.
- Monetary and liquidity measures: the central bank increased the policy rate and lowered foreign exchange reserve requirements to support foreign exchange liquidity.

### Near-term outlook and risks
- The near-term outlook is subdued: near-term growth is projected to remain below potential in Turkey.
- Political uncertainty and less favorable global financial conditions are expected to keep borrowing costs elevated.
- Imbalances are expected to persist, with inflation remaining above target and external debt rising.
- Offsetting factors: net exports may benefit from a weaker lira, and fiscal incentives may help support investment.

*Prepared by Ahmed El-Ashram, with inputs from Plamen Iossifov.*

### Annex B. Impact of EU Funds on Growth in the CESEE EU Countries

### Annex B. Impact of EU Funds on Growth in the CESEE EU Countries

### Methodology and Model Specification
- Panel regression estimated for the 11 CESEE EU countries (Bulgaria, Croatia, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, Slovak Republic, and Slovenia) over 2008–15.
- Estimation equation (B1.1) (symbols preserved from source):
  - g_it = α + β ESIF_it + Σ γ_j z_it−j + Σ δ_j X_it−j + μ_i + λ_t + ε_it
  - where g is real GDP growth in percent; ESIF is the change in the EU funds in percent of GDP; z_it are control variables including changes in total gross capital formation, government gross capital formation, and private sector gross capital formation measured in percent of GDP.
- Disturbance term specification preserved:
  - ε_it = μ_i + λ_t + ν_it
  - contains both a country fixed effect μ_i and a time effect λ_t.
- Dynamic panel estimation: Arellano and Bond dynamic panel generalized method of moments (GMM) estimator (Arellano and Bover 1995) used; reported standard errors corrected for finite sample bias.
- Note on collinearity: "The correlation between change in EU funds absorption and change in government investment is very low (0.08). Reflecting weak total investment and decline in private investment, the correlations for change in EU funds absorption and private investment and total investment are −is 0.3 and −0.27, respectively. Therefore, collinearity is not a major concern for the estimation."

### Key Estimation Results and Interpretation
- Reported impact multipliers:
  - "The results show that the impact multiplier of the EU funds is between ½ and 2/3."
  - "The results also show that the EU funds’ impact spans more than one period—consistent with the fact that many EU-funded projects, for example, infrastructure projects, are generally multiyear endeavors."
- Table B1: Estimation Results for Equation (B1.1)
  - Dependent Variable: real GDP growth
  - Coefficients and robust standard errors (in parentheses) for specifications (1)–(5):
    - real GDP growth (t-1):
      - (1) 0.315 *** (0.0662)
      - (2) 0.492 *** (0.107)
      - (3) 0.509 *** (0.0805)
      - (4) 0.316 *** (0.0860)
      - (5) 0.448 *** (0.0986)
    - Change in EU funds absorption (t):
      - (1) 0.645 *** (0.157)
      - (2) 0.478 *** (0.182)
      - (3) 0.647 *** (0.150)
      - (4) 0.477 ** (0.194)
      - (5) 0.663 *** (0.142)
    - Change in EU funds absorption (t-1):
      - (1) 1.176 *** (0.203)
      - (2) 1.009 *** (0.278)
      - (3) 1.005 *** (0.227)
      - (4) 1.284 *** (0.266)
      - (5) 1.143 *** (0.196)
    - Change in EU funds absorption (t-2):
      - (1) 1.719 *** (0.177)
      - (2) 1.234 *** (0.204)
      - (3) 1.294 *** (0.177)
      - (4) 1.737 *** (0.218)
      - (5) 1.364 *** (0.175)
    - Change in Gross Capital Formation (Private Sector):
      - (1) -0.00452 (0.153)
      - (2) 0.0149 (0.146)
      - (3) -0.397 *** (0.124) [t-1]
      - (4) -0.372 *** (0.129) [t-1]
      - (5) -0.129 ** (0.0592) [t-2]
      - (5) -0.0935 (0.0902) [t-2 in another spec]
    - Change in Gross Capital Formation (Government):
      - (3) 0.768 *** (0.292)
      - (4) 0.621 *** (0.237)
      - (3) 0.533 (0.384) [t-1]
      - (4) 0.447 (0.424) [t-1]
      - (3) 0.0351 (0.409) [t-2]
      - (4) -0.119 (0.480) [t-2]
    - Change in Total Gross Capital Formation:
      - (5) 0.221 (0.138)
      - (5) Change in Total Gross Capital Formation (t-1) -0.293 ** (0.130)
      - (5) Change in Total Gross Capital Formation (t-2) -0.0277 (0.0980)
  - Observations6666666666
  - Number of countries11 11111111
  - Robust standard errors in parentheses.
  - Significance notation: *** p<0 .0 1 , ** p<0 .0 5 , * p<0 .1

### Implications and Findings
- Magnitude:
  - Short-run and dynamic effects of changes in EU funds absorption are sizable and positive across specifications:
    - Immediate (t) coefficients range from 0.477 ** to 0.663 *** across specifications.
    - Lagged effects (t-1 and t-2) are larger, with t-2 coefficients up to 1.719 *** in specification (1).
- Temporal profile:
  - The EU funds’ impact “spans more than one period,” consistent with multiyear project implementation (e.g., infrastructure).
- Controls:
  - Government gross capital formation shows positive coefficients in some specifications (e.g., 0.768 *** and 0.621 ***), indicating positive association with growth in those specifications.
  - Private sector gross capital formation shows negative and sometimes significant lagged coefficients in some specifications (e.g., -0.397 *** and -0.372 *** for t-1 in specifications shown), reflecting specification-specific results.

*IMF staff analysis as presented in Annex B of the CESEE REI Spring 2017 report.*

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_Source: https://www.imf.org/-/media/files/publications/reo/eur/2017/rei0517.pdf_