## _cr1598 ## Source details **Canonical URL:** [_cr1598](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2015/_cr1598.pdf) ## Other formats - [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2015/_cr1598.pdf.md) - [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2015/_cr1598.pdf.json) --- ### Summary and context - NMS-6 comprises Bulgaria, Croatia, Czech Republic, Hungary, Poland and Romania. - NMS-EA consists of Estonia, Latvia, Lithuania, Slovakia and Slovenia. - As of June 2014, no NMS-6 fulfills all adoption criteria; none is assessed as ready to join the euro at that stage. - Paper builds on the 2004 IMF study (Schadler et al, 2005), updates evidence, and addresses topics highlighted by the global financial crisis. ### Euro adoption: criteria, leeway, and institutional constraints - Adoption criteria (Treaty on European Union): 1. Legal = includes the statutes of the national central bank. 2. Fiscal = a government budgetary position without a deficit and debt level that are determined excessive. 3. Price stability = a rate of inflation which is close to that of, at most, the three best performing Member States in terms of price stability. 4. Exchange rate stability = observance of 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. 5. Interest rate stability = over a period of one year before examination, an average nominal long-term interest rate that does not exceed by more than 2ppt that of, at most, the three best-performing Member States in terms of price stability. - Key adoption steps under sovereign control: - Harmonizing the legal framework with euro area standards. - Applying for ERM2 entry. - Euro area institutions retain substantial discretion in admitting countries to ERM2. - Political and institutional uncertainty about the evolving euro-area framework provides a rationale for waiting before making an irreversible adoption decision. ### Monetary regimes in NMS-6 and monetary autonomy - Regime classifications and notable histories: - Bulgaria: Lev; Hard peg - currency board; Float until 1997. Currency board adopted in response to hyperinflation. - Croatia: Kuna; Soft peg - crawl-like arrangement; Dinar until 1994; soft peg to deutsche mark until euro introduction. - Czech Republic: Koruna; Other managed arrangement; peg to dollar/currency basket until 1997; inflation targeting; free float until 2013; classified as “other managed arrangement”. - Hungary: Forint; Floating - inflation targeting; various pegs and crawling pegs until 2008 with increasingly wide bands (15% 2001-08); classified as “floating”. - Poland: Złoty; Free floating - inflation targeting; various pegs and crawling pegs until 2000; classified as “free floating”. - Romania: Leu; Floating - inflation targeting; monetary based targeting with managed float until 2005; classified as “floating”. - Experience and valuation since 2004: - Monetary tightening and exchange rate appreciation helped contain credit booms in the mid-2000s. - After the 2008-09 crisis, monetary easing supported domestic demand. - During 2012–14, monetary policy helped offset imported disinflationary pressures. - Trade-off emphasis: - For floaters: replacement of monetary autonomy by macroprudential tools, fiscal policy, and scope for internal adjustment within the euro area. - For peggers: extent to which macro-prudential and regulatory tools remain usable after adopting the euro. ### Trade-offs: benefits and costs of euro adoption - Benefits (revisited since 2004): - Trade generation (evidence since 2004 shows trade generation has remained far below original expectations). - Improved country risk perception from deeper integration with the euro area, potentially lowering funding costs. - Elimination of currency mismatches — reducing vulnerabilities from euro-denominated loans and balance-sheet currency mismatches. - Costs: - Loss of monetary autonomy and exchange rate as shock absorber. - For countries that maintained monetary autonomy, ceding it could be costly for containing credit booms, stabilizing demand, and offsetting imported disinflation. - Quantitative staff estimates and contextual figures: - If the NMS-6 adopted the euro they would account for about 8 percent of the euro area’s GDP (14 percent on a PPP basis). - If convergence resumed as in the early 2000s, NMS-6 adoption could increase average euro inflation by up to 0.3 percentage points, implying a tighter ECB monetary stance and reduced nominal adjustment space for euro area members facing asymmetric shocks. ### Euro premium and country risk perception (empirical evidence) - Country risk perception indices used: - Institutional Investor’s country credit ranking (IIR); scale zero to 100 with 100 representing the least likelihood of default (IIR linearized and inverted in regressions). - Linearized version of Standard & Poor’s sovereign credit ratings (S&P). - Relationship: 4–5 points on the IIR scale correspond to one rating notch with S&P. - Main empirical findings (panel 2001–2013, annual γ estimates): - Through most of the 2000s, euro area membership provided a substantial country risk premium of 10–15 rating points on the IIR scale, and about two rating notches with S&P. - This premium has mostly vanished—entirely for the S&P index, and to a somewhat lesser degree for the IIR. - Decline in the premium started in 2010, suggesting the euro area crisis triggered investor reassessment. - Interpretation: - Euro adoption can reduce perceived risks via elimination of exchange rate risk and access to lender-of-last-resort in a global reserve currency; for weak-institution countries it can strengthen monetary-anchor credibility. - Conversely, membership can undermine perceived ability to handle country-specific shocks. ### Appendix I — Estimating the Euro Premium (method and selected regression results) - Sample and variables: - Panel of 34 European countries, annual observations 2001–2013. - Dependent variable C: expert assessment (IIR and linearized S&P). - Controls X: fiscal and external balances, public debt, per-capita-GDP, real GDP growth, unemployment, inflation, exchange rate regime, investment/GDP, NIIP, governance quality. - Euro dummy interacted with time to allow time-varying γ; EU membership dummy included. - Data sources: IMF WEO, governance quality as average of Kaufmann et al. (2002–12), exchange rate regime from Ilzetzki et al. (2011) extrapolated post-2010. - Main table summary (selected coefficients and statistics as reported): - Controls (examples with coefficient and t-value): - Real growth: 0.40 3.63*** ; 0.12 4.64*** ; 0.37 3.41*** - Unemployment rate: -1.03 -9.56*** ; -0.31 -12.16*** ; -0.84 -7.13*** - CPI inflation: -0.26 -3.92*** ; -0.68 -5.88*** ; -0.20 -2.46** - Gen. gov. debt: -0.17 -9.01*** ; -0.03 -6.62*** ; -0.14 -7.16*** - NIIP: 0.03 5.15*** ; 0.01 4.10*** ; 0.02 3.60*** - Governance quality (included in column 3): 18.08 5.63*** - Observations: 442 ; 442 ; 374 - Adjusted R2: 0.952 ; 0.952 ; 0.956 - Country F significance: F(33,359)=37.63 (0.000) ; F(33,359)=45.30 (0.000) ; F(33,292)=22.10 (0.000) - Significance notation: 1 (***), 5 (**), and 10 (*) percent level. - Robustness: - Pattern of a steep decline in the euro premium from 2010 persists across alternative specifications and dynamic panels. - Arellano-Bond GMM: estimated size of euro premium is on average smaller by about one-third. - Euroization and credibility: - Balance-sheet euroization data limited (11 new EU members 2006–2012). - Alternative correlations show a non-linear relationship: euroization becomes disproportionately more detrimental for country perception at higher levels of FX loan share. - The FX-specific credibility premium remains broadly stable over time, unlike the general euro premium which declined after 2010. - Euroization correlates strongly with governance quality; governance inclusion is necessary to avoid overstating the euroization link. ### Eliminating currency mismatches and financial stability implications - FX mismatches widespread in Central and Eastern Europe; balance sheet euroization (share of bank loans denominated in FX) is considerable in all NMS-6 except Poland and the Czech Republic. - Most FX debt is denominated in euro; euro adoption can eliminate sizeable currency mismatches (e.g., Baltic states and Slovenia). - Empirical findings: - For nearly fully euroized economies, euro adoption can eliminate a ratings malus of more than 10 IIR points. - The malus increases disproportionately with higher levels of euroization (non-linear impact). - Caveats: - In Poland and Croatia a significant part of FX loans are denominated in Swiss francs (CHF) rather than euro; in Hungary most CHF loans were converted into domestic currency with a de-facto conversion date of November 2014—so some currency mismatch would remain after euro adoption. - Value of ECB access was evident during the 2008/09 crisis when cross-border currency markets were impaired. ### Banking Union (BU): reforms, architecture, and implications for non-euro NMS-6 - Harmonization and Single Rulebook milestones: - ESFS established in 2011; CRD IV/CRR adopted mid-2013; BRRD and DGSD adopted mid-2014. - Single Supervisory Handbook and further harmonization work ongoing. - BU architecture and missing elements: - BU includes SSM and SRM; open to non-euro EU members. - Key missing elements: truly common fiscal backstop and a pan-European deposit guarantee scheme. - SRF will amount to €55 billion by 2024 and be fully mutualized by 2024; SRF borrowing against future levies intended next step. - ESM is acting as de facto common fiscal backstop but ESM direct recapitalization is not available to non-euro area BU participants (ESM Treaty open only to currency union members). - What opting into the BU entails for non-euro members: - Close cooperation with the ECB (Article 7 of SSM Regulation); national legislation required to work with ECB and SRB. - ECB assesses transposition into national law and can request additional information and a comprehensive assessment. - Non-euro opt-ins have representation on the Supervisory Board but not on the ECB Governing Council; draft SB decisions referred to Governing Council under a non-objection procedure. - Non-euro opt-ins would contribute to and have access to the SRF but would not automatically be eligible for ESM direct recapitalization or automatic ECB liquidity facilities. - ELA remains a national prerogative; ECB in supervisory capacity will determine bank solvency and thus ELA eligibility. - Modalities differing from euro-area members (key takeaways): - (i) Role in the SSM: non-euro countries are not members of the ECB’s Governing Council. - (ii) Fiscal backstop: non-euro opt-ins are not eligible for direct bank recapitalization from the ESM. - (iii) Liquidity support: non-euro opt-ins would not automatically have access to ECB liquidity facilities. - Safeguards: possibility of “reasoned disagreement” and exit; effectiveness of safeguards uncertain. - Macroprudential policy space and coordination: - CRR/CRD IV allows national authorities to set stricter requirements above micro-prudential minima; national authorities retain control over measures not specified in Union law (e.g., loan-to-value and debt-to-income ratios). - For CRR/CRD IV measures, BU participants must notify the ECB 10 working days prior; ECB may object and provide written explanation within 5 working days. - Asymmetry: ECB can strengthen measures under Union law but cannot compel loosening; NCAs can tighten but cannot loosen below ECB minimum. - Extent to which joining BU limits macroprudential space depends on final BU modalities. - Expected benefits and caveats for NMS-6: - Benefits when BU fully established: reverse financial fragmentation, lower funding costs for banks under SSM, eliminate home-host supervisor distinction, and sever sovereign-bank links. - For NMS-6 specifically: potential lower spillovers if euro area banks become safer; greater fungibility of liquidity could lower funding costs for cross-border groups and boost lending to faster-growing NMS. - Caveats: until SRF fully mutualized, local backstops remain important and loss of local control over liquidity and resolution could be costly. ### Opt-in attractiveness and trade-offs for NMS-6 (summary of considerations) - Direct participation in BU prior to euro adoption is generally less attractive for NMS-6 than for euro area countries due to unequal treatment and incomplete BU. - Key country characteristics affecting opt-in calculus: - Degree of real or financial integration with euro area. - Degree of economic flexibility. - Share of local bank assets owned by euro area banks. - Local supervisory standards and local backstops (DGS, fiscal space). - Policy space for monetary and fiscal policies. - Financial stability trade-offs: - Potential benefits: improved supervision quality, reduced regulatory arbitrage, better home-host coordination, access to SRF. - Potential costs: loss of local prudential flexibility, loss of control over cross-border capital/liquidity flows, risk of stricter solvency criteria and increased resolution incidence. - Macroeconomic considerations: - Joining BU could reduce ability to support credit access via prudential measures when country-specific circumstances call for supportive regulation. - Asymmetry in powers under the BU and uncertainty on heterogeneity acceptance by ECB complicate assessment. - When opt-in may not make sense: - Lack of equal treatment vs euro area members (representation, liquidity and fiscal backstops). - Lack of clarity and experience with operational modalities. - When opt-in may make sense: - If BU participation addresses specific challenges that outweigh BU shortcomings (e.g., improve supervision credibility, access larger industry-funded backstop). - Key BU facts and figures: - ECB directly supervises 120 significant banks—jointly comprising almost 85 percent of total euro area bank assets—and oversees NCAs’ supervision of the other 3500 less significant banks. - Significance thresholds include total assets exceeding €30 billion; total assets exceeding €5 billion and 20% of GDP; cross-border assets/liabilities ratio above 20%; receipt of ESM assistance; or being one of three most significant institutions. - SRF planned size: €55 billion (about 1 percent of covered deposits in the euro area); 60 percent mutualized after 2 years, 100 percent after 8 years (2024). - ESM direct bank recapitalization: up to €60 billion available (December 2014 decision) but not available for non-euro future BU participants. ### Pension systems, PAYG sustainability, and Pillar II evolution - PAYG pension concerns: - Most reforms imply a steep cut in pension benefits; replacement rates in some PAYG systems projected to fall below 20 percent compared to around 40 percent today. - Political reversals have occurred when benefit reductions took effect. - Projected PAYG pension spending (selected country time-series excerpts, percent of GDP under "With reforms"): - Bulgaria: 2010 9.9; 2020 9.2; 2030 9.6; 2040 10.1; 2050 11.1; 2060 11.1; ... 2060 21.2 - Croatia 2/: 2010 6.0; 2020 4.4; 2030 3.3; 2040 2.6; 2050 2.5; 2060 3.3; ... 2060 7.0 - Czech Republic: 2010 9.1; 2020 8.7; 2030 8.9; 2040 9.7; 2050 11.0; 2060 11.8; ... 2060 21.0 - Hungary: 2010 11.9; 2020 10.5; 2030 9.3; 2040 9.8; 2050 11.2; 2060 12.4; ... 2060 24.4 - Poland: 2010 11.8; 2020 10.9; 2030 10.9; 2040 10.3; 2050 10.0; 2060 9.6; ... 2060 35.5 - Romania: 2010 9.8; 2020 9.2; 2030 10.3; 2040 11.6; 2050 12.8; 2060 13.5; ... 2060 28.8 - Slovakia: 2010 8.0; 2020 8.6; 2030 9.5; 2040 10.6; 2050 12.2; 2060 13.3; ... 2060 25.1 - Notes: 2/ For Croatia, numbers are for old age related pension spending only and do not include other pension payments from the PAYG scheme. - Net Present Value (NPV) of pension deficits (selected country excerpts, percent of GDP): - Bulgaria (Discount rate=1): 2010-2030 34; 2031-2060 79; 2010-2060 114. - Croatia 1/ (Discount rate=1): 2010-2030 -38; 2031-2060 -105; 2010-2060 -144. - Czech Republic (Discount rate=1): 7; 65; 72. - Hungary (Discount rate=1): 39; 87; 126. - Poland (Discount rate=1): 76; 48; 124. - Romania (Discount rate=1): 27; 10; 37. - Slovakia (Discount rate=1): 77; 176; 253. - Average (Discount rate=1): 30; 47; 78. - Columns for Discount rate=2 and Discount rate=0 also presented in source. - Policy directions to improve fiscal and social sustainability: - Align mandatory retirement age with longevity. - Reduce incentives for early retirement. - Pillar II (mandatory, pre-funded, private) systems — evolution and performance: - Adoption in NMS: Hungary (1998), Poland (1999), Bulgaria (2002), Croatia (2002), Romania (2007). Czech Republic did not make contributions mandatory. - Evidence on national savings: no systematic evidence that Pillar II systems increased national savings overall; Croatia, Estonia, Lithuania, Poland and Slovakia show sizeable increases around Pillar II introduction. - Transition costs largely financed by government debt; Pillar II investments in government securities are more than twice as high in the NMS than in other OECD private pension funds. - Fees and operating expenses: total fees fell from >2 percent of assets in 2006 to about 1¼ percent in 2011; operating expenses remain >50 percent higher than in other OECD countries. - Asset allocation: many Pillar II portfolios have a high share of government securities due to regulations and minimum domestic investment requirements; Baltic countries are main exceptions. - Pillar II reversals after 2008/09: - Baltic countries: temporary reversals; some have restored Pillar II. - Romania: delayed build-up. - Slovakia and Poland: significantly reduced size of Pillar II schemes with no declared restoration intention. - Hungary: eliminated its second pension pillar. - Bulgaria and Croatia: maintained second pillars throughout the crisis period. ### Drivers of Pillar II reversals (summary) - Fiscal pressures were an important trigger for reversing Pillar II reforms to stay within or return to EDP deficit ceilings. - Correlation evidence (univariate, small sample): - Countries with the largest second pillars (measured by contribution rate) had the largest reform reversals. - Regression examples presented: - Change of Pillar II Contribution Rate over 2007-13 vs Contribution Rate of Pillar II in 2007: y = -0.5389x + 4.2886, R² = 0.7304. - No evidence that reversals were related to poor investment performance; negative correlation of pre-crisis returns with reversals (dissolved/cutback funds were relatively more profitable). - No significant relationship between asset management fees and extent of reversals after 2008 for countries considered. - EU fiscal framework changes: - 2011 SGP reform increased flexibility vis-à-vis second pillar funds; ESA 2010 (entered September 2014) reduced some incentives to abolish Pillar II but did not eliminate them. - Policy recommendations: - For countries maintaining Pillar II: encourage more diversified investment portfolios and reduce administrative costs; transition costs should at least partly be absorbed by the budget. - For countries abolishing Pillar II: improve fiscal performance, increase public savings, strengthen incentives for voluntary third-pillar participation with quality controls and low-cost products. - Cross-cutting: align retirement age with longevity and reduce early retirement incentives. - EU fiscal framework: case for greater neutrality toward pension regime choice to avoid discouraging pre-funding of ageing costs. ### Export performance, quality, and structural reform priorities (NMS-6) - Export performance and convergence: - 2003–07: NMS grew at an average annual real rate of about 6 percent, 3 percentage points faster than EU 15; average income gap per capita (PPP) against EU 15 fell by about 10 percent until convergence stalled. - Since 1995 NMS-6 as a group experienced a spectacular increase in exports to the EU, with heterogeneity across countries. - Empirical analysis of value-added exports to the EU (sample 2003–11, NMS-10 excluding Croatia in regressions): - Dependent variable: value-added exports to EU scaled by GDP. - Structural explanatory variables in final specification: - Human capital: upper secondary or tertiary educational attainment. - Participation in continuous vocational training and skills upgrade. - Inactivity trap. - Relative minimum wage. - Foreign investment environment index (higher values = lower restrictions). - Control variables include supply-chain share, PPP GDP per capita, weighted partners’ growth, REER-ULC. - Key regression findings (selected coefficients and fit): - Upper secondary or tertiary educational attainment: 0.16** (column 1) ; 0.33*** (column 2). - Participation in continuous vocational training and skills upgrade: 0.15*** ; 0.14***. - Foreign investment environment: 1.0** ; 2.2***. - Share of exports processed by supply chain: 0.44*** ; 0.34***. - Observations: 73 ; 73. R-squared: 0.85 ; 0.85. - Shapley decomposition of one-standard-deviation improvements (Figure 3 reported shares): - Higher education: 27% - Vocational training and skills upgrade: 17% - Inactivity trap: 2% - Relative minimum wage: 7% - Real effective exchange rate (ULC-based): 4% - Foreign investment and ownership environment: 28% - Supply chain participation: 15% - Export quality (Henn, Papageorgiou, Spatafora 2013 and EU-market methods): - NMS-6 overall exports quality above 60th percentile compared to all countries. - Czech Republic close to 90th percentile overall. - Product-tiering: Czech Republic highest tier (61st–97th percentile); Croatia, Hungary, Poland next tier (40th–89th); Bulgaria and Romania third tier (24th–80th). - More than half of export products from NMS are in the bottom half of the EU quality ladder in some countries (share of products below 50th percentile: 62 percent in Poland; 52 percent in Hungary). - Price elasticity of quality estimated around 0.5 (Vandenbussche 2014) — quality upgrading likely raises price, profits, and market share. - Country-specific structural reform priorities (selected): - Bulgaria and Romania: broad-based reforms — human capital, secondary education, improve foreign investment regime, supply-chain linkages. - Poland: improve foreign ownership regime and deepen links in services-based supply chains. - Hungary: strengthen operating environment for foreign investors to reverse decline in contribution from foreign investment environment. - Czech Republic and Hungary: increase R&D spending, higher education, innovation; diversify exports outside the EU. - Services trade and Services Directive (SD): - Weighted average share of SD sectors in total services exports to EU: - NMS-6: 70 percent; Croatia: almost 90 percent; NMS-EA: 59 percent; Other EU: 62 percent. - Services exports in SD sectors grew on average 8 percent annually; implementation reduced average restrictions on services imports by about 30 percent since 2006, with variation. - Remaining barriers concentrated in professional and technical services (authorization, economic needs tests, licensing, territorial restrictions). - Policy recommendation: further liberalization of services trade within the EU, especially professional services, to boost NMS-6 exports. ### Cross-country findings on domestic bank promotion and funding costs (Box 6) - Domestic banks in all NMS-6 pay higher funding costs than foreign-owned peers; widest margins in Hungary, Bulgaria, and the Czech Republic. - Post-crisis deposit expansion and market-share dynamics: - Bulgaria: cumulative deposit growth 2009-2013 21.43; domestic banks share in total deposits 22.11; other indicators reported in source table. - Hungary: cumulative deposit growth 2009-2013 41.0; domestic banks share 47.0; indicators reported. - Poland: cumulative deposit growth 32.1; domestic banks share 40.2; indicators reported. - Czech Republic: cumulative deposit growth 1.7; domestic banks share 6.4; indicators reported. - Romania: cumulative deposit growth 13.5; domestic banks share 11.1; indicators reported. - Croatia: source table shows omissions/ellipses for some entries. - Interpretation: domestic banks in Bulgaria and Hungary may have benefited from a more favorable policy stance; gains in market share associated with paying a funding-cost premium. ### Conclusions and policy considerations (synthesis) - The rubric of euro adoption changed since the early adopters: - The substantial country risk premium available to early-2000s adopters (10–15 IIR points; about two S&P notches) has mostly vanished after 2010; its return depends on success of ongoing euro-area institutional reforms. - For countries with sizeable FX loan shares, important financial stability benefits from adopting the euro remain (eliminating currency mismatches, access to euro lender-of-last-resort). - Opt-in to the Banking Union prior to euro adoption: - Presents trade-offs: gains from improved supervision and common backstops vs loss of national control over prudential tools, liquidity ring-fencing, and unequal access to euro-area liquidity/fiscal backstops. - Decision depends on country characteristics, policy preferences, BU operational modalities, and clarity on future euro-area reforms. - Structural reform priorities to maximize gains from the EU single market: - Strengthen human capital (higher education, vocational training). - Improve foreign investment environment and supply-chain integration. - Target R&D and innovation for higher-quality exporters. - Further liberalize services trade within the EU, especially professional services. - Pension policy imperatives: - Align retirement ages with longevity and reduce early-retirement incentives. - For countries keeping Pillar II: improve diversification and reduce fees; absorb transition costs partly via fiscal space. - For countries that abolished Pillar II: strengthen public savings and incentivize voluntary schemes with low costs. - Waiting option: - Given evolving euro-area governance, incomplete BU elements, and remaining uncertainty over macroprudential and fiscal coordination, there is an “option value of waiting” before irreversible euro adoption or BU opt-in decisions. _Italic: IMF staff chapter text from _cr1598 (EURO ADOPTION—MACROECONOMIC BENEFITS AND CHALLENGES; and selected related sections) as provided in the supplied content unit._ ### 1. The 2004 IMF Study, and New Evidence on its Main Findings _________________________ 19 ### _cr1598 - 1. The 2004 IMF Study, and New Evidence on its Main Findings _________________________ 19 ### Summary and context - NMS-6 includes Bulgaria, Croatia, Czech Republic, Hungary, Poland and Romania. - NMS and NMS-EA definitions: NMS-EA consists of Estonia, Latvia, Lithuania, Slovakia and Slovenia. - In the latest reports from June 2014, no NMS-6 fulfills all adoption criteria, hence, none is assessed as ready to join the euro at this stage. - The paper follows and builds on the conceptual framework of the 2004 IMF study (Schadler et al, 2005), updating evidence and addressing topics highlighted by the global financial crisis. ### Leeway and institutional constraints for euro adoption - Key adoption steps under sovereign control: - Harmonizing the legal framework with euro area standards. - Applying for ERM2 entry. - Euro area institutions retain substantial discretion in admitting countries to ERM2. - Adoption criteria (as defined in the Treaty on European Union): 1. Legal = includes the statutes of the national central bank. 2. Fiscal = a government budgetary position without a deficit and debt level that are determined excessive. 3. Price stability = a rate of inflation which is close to that of, at most, the three best performing Member States in terms of price stability. 4. Exchange rate stability = observance of 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. 5. Interest rate stability = over a period of one year before examination, an average nominal long-term interest rate that does not exceed by more than 2ppt that of, at most, the three best-performing Member States in terms of price stability. ### Monetary regimes in NMS-6 (classification and evolution) - Bulgaria and Croatia: - Bulgaria: Lev; Hard peg - currency board; Float until 1997. Currency board adopted in response to hyperinflation. - Croatia: Kuna; Soft peg - crawl-like arrangement; Dinar until 1994, hyperinflation. Soft peg to deutsche mark until euro introduction. - Czech Republic, Hungary, Poland, Romania: - Czech Republic: Koruna; Other managed arrangement; Peg to dollar/currency basket until 1997. Inflation targeting; free float until 2013. Classified as “other managed arrangement” reflecting recent currency interventions. - Hungary: Forint; Floating - inflation targeting; Various pegs and crawling pegs until 2008 with increasingly wide bands (15% 2001-08). Classified as “floating”. - Poland: Złoty; Free floating - inflation targeting; Various pegs and crawling pegs until 2000. Classified as “free floating”. - Romania: Leu; Floating - inflation targeting; Monetary based targeting with managed float until 2005. Abandoned amid high inflation. Classified as “floating”. - Historical note: In the Baltics, euro adoption followed many years of unilateral hard pegs to the euro; Slovenia and the Slovak Republic maintained monetary autonomy until shortly before euro adoption. ### Trade-offs revisited: benefits and costs of euro adoption - Benefits identified (2004 study and revisited): - Trade generation that could translate into higher growth (evidence since 2004 shows trade generation has remained far below original expectations). - Improved country risk perception from deeper integration with the euro area that could lead to lower funding cost. - Elimination of currency mismatches (new focus since the 2004 study), reducing vulnerabilities from euro-denominated loans and related balance-sheet currency mismatches. - Costs identified: - Loss of monetary autonomy: ceding the ability to adapt monetary conditions and use the exchange rate as a shock absorber. - For countries with maintained monetary autonomy, ceding it could be costly; monetary tightening and exchange rate appreciation helped contain credit booms in the mid-2000s, monetary easing supported domestic demand after the 2008-09 crisis, and more recently easing helped offset imported disinflationary pressures. ### Evidence on the euro premium and country risk perception - Data and indices: - Country risk perception indices used: Institutional Investor’s country credit ranking (IIR) and a linearized version of Standard & Poor’s sovereign credit ratings (S&P). - Relationship between indices: 4–5 points on the IIR scale corresponding to one rating notch with S&P. - Estimation: - The relationship between perceived credibility and country characteristics was estimated for 34 countries during 2001–13; the euro premium was estimated for each year separately (see Appendix I in source). - Main empirical findings: - Through most of the 2000s, euro area membership provided a substantial country risk premium of 10–15 rating points on the IIR scale, and of about two rating notches with S&P. - This premium has mostly vanished—entirely for the S&P index, and to a somewhat lesser degree for the IIR. - The timing of the decline—starting in 2010—suggests that the euro area crisis triggered a reassessment among investors of the relative benefits and drawbacks of euro membership. - Interpretation: - Adopting the euro can reduce perceived risks through elimination of exchange rate risk and access to lender-of-last-resort facilities in a global reserve currency; for weak-institution countries it can strengthen the credibility of the monetary anchor. Conversely, it can undermine country risk perception if it reduces the ability to handle country-specific shocks. ### Monetary autonomy: experience and valuation since 2004 - For NMS that have maintained monetary autonomy, it has been helpful in containing macroeconomic imbalances: - Monetary tightening and exchange rate appreciation contained credit booms in the mid-2000s. - After the outbreak of the 2008-09 financial crisis, monetary easing supported domestic demand. - More recently, monetary policy helped offset imported disinflationary pressures. - Trade-offs differ by regime: - For floaters: key issues are extent to which monetary autonomy can be replaced by macroprudential tools and fiscal policy, and the scope for internal adjustment within the euro area. - For peggers: the question is the extent to which macro-prudential and other regulatory tools remain usable after adopting the euro. ### Policy considerations and timing - Uncertainty about the euro area’s evolving institutional framework provides a rationale for many NMS-6 to wait for final outcomes before taking an irreversible adoption decision. - The decision to adopt the euro entails economic trade-offs and political economy considerations; the paper refrains from recommending adoption or non-adoption and focuses on key macroeconomic tradeoffs. *Source: EURO ADOPTION—MACROECONOMIC BENEFITS AND CHALLENGES, IMF staff chapter prepared by Jiri Podpiera, Johannes Wiegand and Jiae Yoo (February 26, 2015).* ### 11. As a result, the NMS-6 today face a different situation than the early euro ### _cr1598 - 11. As a result, the NMS-6 today face a different situation than the early euro ### Eliminating Currency Mismatches - FX (foreign currency) mismatches occur when households and corporations are indebted in foreign currency while assets and income streams are in domestic currency; currency depreciation can trigger upward revaluation of debt harming financial stability and activity. - FX indebtedness is widespread in Central and Eastern Europe; balance sheet euroization (proxied by the share of bank loans to the private sector denominated in FX) is considerable in all NMS-6 except Poland and the Czech Republic. - Most FX debt in the NMS is denominated in euro; euro adoption can therefore eliminate sizeable currency mismatches (as in the Baltic states and Slovenia). - Euro adoption also grants access to euro lender-of-last-resort facilities for banks with high euro-denominated assets and high euro funding needs. - Empirical findings: - Correlations show that for nearly fully euroized economies, euro adoption can eliminate a ratings malus of more than 10 IIR points. - The malus increases disproportionately with higher levels of euroization (non-linear impact). - Caveats: - In some economies (notably Poland and Croatia) a significant part of FX loans is denominated in Swiss francs rather than euro; in Hungary most CHF loans were converted into domestic currency with a de-facto conversion date of November 2014—so some currency mismatch would remain after euro adoption. - The value of ECB access was evident during the 2008/09 financial crisis when cross-border currency markets were impaired, especially for banks with sizeable FX assets but without a euro area parent bank. ### Advantages from Preserving Monetary Policy Autonomy and Exchange Rate Flexibility - Monetary policy autonomy allows setting monetary conditions aligned with the economy’s needs and enables the exchange rate to act as a shock absorber—helping stabilize domestic demand, contain inflation volatility, and manage credit developments. - The assessment considers three episodes in the past 10–12 years: - economic convergence (about 2003–07), - the financial crisis of 2008/09 and aftermath, - the period 2012–14 affected by disinflationary pressures from global commodity markets and the euro area. - Methodology: map a monetary conditions index (weighted average of real interest rate and real exchange rate; see Appendix II) against domestic demand volatility and related outcomes for (i) NMS that maintained monetary policy autonomy and (ii) NMS that used external monetary anchors (adopted euro or tied currencies to the euro/other baskets). - Key contrast: - Countries that maintained monetary autonomy tended to have tighter monetary conditions during convergence, often via nominal exchange rate appreciation rather than higher central bank interest rates. - Countries with fixed exchange rates tended to have fairly accommodative monetary conditions, resulting in stronger overshooting in domestic demand, larger credit and asset booms, and higher and more volatile inflation. ### Managing Convergence - Data points: - In 2003–07, the NMS grew at an average annual real rate of about 6 percent, 3 percentage points faster than the old EU member states (EU 15). - As a result, the average income gap per capita (PPP) against the EU 15 fell by about 10 percent until convergence stalled with the global financial crisis. - Policy insight: - Sustained higher growth requires a tighter monetary policy stance to avoid credit/housing booms, inflation, and external imbalances unless matched by tighter monetary conditions. - Fixed exchange rate regimes risk adopting a monetary stance too loose relative to fast-growing economies, with the risk increasing with the real income gap to the euro area. ### Managing Downturns - During the 2008/09 global financial crisis: - Monetary autonomy enabled central banks to cut policy rates and allow nominal exchange rate depreciation to act as shock absorbers. - Nominal depreciations were especially large in Poland and Romania, where domestic demand held up better than elsewhere. - In contrast, countries with fixed exchange rates tended to have to tighten monetary conditions to defend pegs, leading to larger demand contractions (though with exceptions, e.g., Bulgaria). - Note: In Hungary the scope for exchange rate depreciation was arguably constrained by the high share of FX loans. ### Offsetting Disinflationary Spillovers - Recent disinflationary pressures (global commodity prices and euro area disinflation, 2012–14) affected NMS asymmetrically: - Flexible exchange rate economies saw disinflation mostly in headline inflation. - Exchange rate pegging economies saw deflationary pressures creep into core inflation. - Econometric evidence (Iossifov and Podpiera, 2014; open-economy New Keynesian Phillips curve, 2004–14 panel): - The share of inflation variance explained by euro area developments is largest in Bulgaria and Croatia (both have tied their currencies to the euro, “ET”). - Inflation-targeting (“IT”) central banks have largely offset the deflationary impulse from the euro area with monetary policy. ### Impact of Euro Adoption on Macroeconomic Policy Frameworks - Euro adoption implies ceding monetary autonomy and subjecting members to stricter enforcement under the stability and growth pact; membership entails joining the Banking Union with transfer of most micro-prudential supervision authority and some macro-prudential aspects to the ECB. - Different implications depending on pre-adoption regime: - For NMS-6 that float and target inflation: monetary autonomy would need replacement by counter-cyclical fiscal policy, macro-prudential tools, and internal adjustment (wages). - For NMS-6 with currencies pegged to the euro: extent of usable macro-prudential policies within the euro area is a key issue (Bulgaria and Croatia have been heavy users of macro-prudential instruments). - Ongoing euro area reforms (fiscal and financial governance) are incomplete; final shape and implementation will determine policy space within the euro area and available common support. - Given uncertainty about reforms’ final outcomes, there is rationale for waiting before an irreversible euro adoption decision—the “option value of waiting” applies to irreversible policy choices. ### Conclusions - The parameters of the euro adoption debate have shifted: - The significant country risk premium that early 2000s adopters could expect has mostly vanished with the euro crisis; its return is uncertain and depends partly on success of ongoing euro area institutional reforms. - For countries with sizeable shares of foreign currency loans, important financial stability benefits from adopting the euro remain. - Quantitative and contextual points: - Staff estimates: if the NMS-6 adopted the euro they would account for about 8 percent of the euro area’s GDP (14 percent on a PPP basis). - If convergence resumed as in the early 2000s, NMS-6 adoption could increase average euro inflation by up to 0.3 percentage points, implying a tighter ECB monetary stance and reduced nominal adjustment space for euro area members facing asymmetric shocks. *Italic: IMF staff chapter text from _cr1598 - 11. As a result, the NMS-6 today face a different situation than the early euro* ### 30. The NMS that have maintained exchange rate flexibility and monetary policy ### The NMS that have maintained exchange rate flexibility and monetary policy autonomy ### Exchange rate flexibility and monetary policy autonomy: experience and benefits - During convergence, nominal currency appreciation supported more balanced growth and restrained credit and asset price booms. - In the crisis-induced downturn of 2008–09, depreciation and monetary loosening helped stabilizing demand and, more recently, prevented external deflationary pressure from spilling into domestic core inflation. ### Risks, policy constraints, and implications of euro adoption - If divergent growth patterns and volatility were to repeat, euro adoption would constrain macro-policy options, especially for economies with: - large income gaps vis-à-vis the euro area, and - a-synchronized business cycles vis-à-vis the euro area. - A large burden would be placed on other policy instruments to safeguard balanced growth, notably: - counter-cyclical fiscal policy—which, in turn, requires fiscal space, and - macro-prudential policies. - Structural reforms to boost growth potential and facilitate internal adjustment would also be key. - The uncertainty about future macroeconomic volatility provides rationale to wait for and analyze outcomes before taking an irreversible adoption decision. ### Countries that peg to the euro: differing balance of arguments - Countries that peg their currencies to the euro have already traded monetary autonomy and exchange rate flexibility for the euro as monetary anchor. - For the most part, their policy frameworks would not change materially upon adopting the euro. - An important remaining issue is the extent to which they could employ macro-prudential and other regulatory instruments also within the euro area. ### Ongoing European fiscal and financial reforms: implications for policy space - The scope for using fiscal policy and macro-prudential instruments is being re-defined in the context of ongoing reforms of the European fiscal and financial architecture. - Depending on the final shape of these reforms, this may or may not constrain policy space for euro area members. - The limited means of the NMS-6 to affect reform outcomes and the resulting uncertainty provide a rationale for delay and further analysis before euro adoption. ### Box 1 — The 2004 IMF Study: original assessment and subsequent evidence - 2004 study conclusions: - Key factor in favor of euro adoption: trade generation and higher growth; staff considered real GDP gains of 10 to 25 percent over 20 years plausible. - Adoption would reduce perceived credit risk and could reduce funding costs for NMS. - Risks noted: coping with asymmetric demand shocks without independent monetary policy; large and volatile capital inflows and lending booms; higher inflation due to the Balassa/Samuelson effect. - Preconditions for managing risks: fiscal space for countercyclical policies, wages and prices sufficiently flexible, and strong financial supervision. - Subsequent developments / new evidence: - Risk spread compression happened as anticipated in 2004, at least until the outbreak of the euro crisis. - Warnings of excessive asset and credit booms were well placed. - Recent estimates of trade and growth effects are much smaller than assumed in 2004 and range from nil (Havranek, 2010) to 2-3 percent of GDP (Baldwin, 2006). - Recent studies suggest trade generation is more related to EU entry than to euro adoption. - Demand volatility has been significantly larger than anticipated in 2004, especially after 2008/09; endogenous business cycle synchronization with euro adoption has not materialized, with signs of divergence and growing external imbalances. ### Box 2 — New Member States, euro adoption, and the Theory of Optimal Currency Areas (OCA) - Benefits of a currency union in principle: - capital market integration, lower terms-of-trade volatility, reduced exchange rate fluctuations, and import of monetary policy credibility for countries with weaker institutions. - Costs: - forgoing exchange rate flexibility and monetary policy autonomy to manage cyclical conditions. - To minimize costs, countries in a currency union should have: - synchronized business cycles and growth patterns (enhanced by intra-industry trade), - flexible non-monetary adjustment mechanisms (price and wage flexibility, cross-border labor mobility), and - risk sharing through integrated financial markets (cross-country asset holdings). - Empirical findings for NMS: - Business cycle synchronization of NMS with the euro area is in general lower than within the euro area, though Hungary, Poland, and the Czech Republic have higher synchronization with the euro area. - Wage flexibility in the NMS tends to be high. - Cross-border labor mobility increased, with substantial outward migration post-2009-2011, mostly younger and educated workers. - Cross-country risk sharing through financial market integration is low and reversed after the 2008/09 crisis: higher interest rate spreads and funding market segmentation along national lines. - Cross-border asset holdings are one-directional: euro area banks hold sizeable assets in NMS, and FDI and portfolio investment from euro area residents in NMS is much larger than vice versa. - As a result, domestic investment in the NMS is more sensitive to domestic saving than in EU15, and national consumption is closely correlated with GDP. - Overall assessment: - Significant structural differences and lack of integration with the euro area exist, but for NMS like the Czech Republic, Hungary, and Poland these do not seem larger than heterogeneity within the euro area itself. ### Box 3 — Economic and price convergence in Emerging Europe - Transition-era reforms led to economic convergence through trade and price liberalization, privatization, and adoption of advanced Europe’s legal frameworks. - Productivity and income per capita increased by 20 percent relative to the Euro Area countries by between 1995 and 2013. - Real exchange rate appreciation mechanisms: - Balassa-Samuelson effect: faster productivity growth for tradables than non-tradables during convergence; earlier estimates suggested 1-2 percentage points of consumer price inflation per year, but more recent studies find much smaller effects. - Podpiera effect: shifting production toward higher quality goods that come with price increases; underreporting in CPI indices can reflect as real exchange rate appreciation. Studies document rapid increases in prices in tradable sectors in NMS and calibrate models explaining rapid (2-3 percent a year) CPI-based real exchange rate appreciation during convergence. - Real exchange rate appreciation occurred partly through nominal exchange rate appreciation in countries with flexible exchange rate regimes; in exchange rate targeting countries it happened solely through higher inflation differentials. *Source: _cr1598 - 30. The NMS that have maintained exchange rate flexibility and monetary policy autonomy (IMF).* ### Appendix I. Estimating the Euro Premium ### Appendix I. Estimating the Euro Premium ### Empirical strategy and data - Panel data regression for 34 European countries with annual observations for the period 2001–2013. - Estimated equation includes: - C: expert assessment of country perception. Two measures used: - Institutional Investor’s country credit ranking (IIR) — respondents grade each country on a scale of zero to 100, with 100 representing the least likelihood of default. - A linearized version of Standard & Poor’s sovereign credit ratings (S&P) — linearization assigns a value of 1 to an AAA rating, of 2 to AA+, and so on (foreign currency sovereign credit rating used). - X: vector of country characteristics including fiscal and external balances, public debt, per-capita-GDP, real GDP growth, unemployment rate, inflation, exchange rate regime, national investment as share of GDP, and the country’s international investment position (NIIP); and an indicator measuring institutional quality. - Euro: dummy variable equal to 1 if country i was member of the euro area in year t, 0 otherwise (interacted with a time dummy so γ varies over time). - EU: dummy variable capturing EU membership. - δ and θ: country/time dummies capturing unobserved, time-invariant country-specific factors and common time-specific factors. - Most data drawn from the IMF’s World Economic Outlook (WEO) database. - Governance quality: simple average of the Kaufmann et al. (2010) governance quality indices available for 2002–12. - Exchange rate regime: dummy for floating currencies (freely or managed) from Ilzetzki et al. (2011) until 2010 and extrapolated with IMF (2013a) thereafter. - Public debt data available for about 90 percent of observations; regression includes dummy for missing public debt observations. - Expectations variable: typically the expected outcome of variable for year t at the time when the WEO fall forecast is produced; concurrent values found to have greatest explanatory power. ### Main regression results (summary) - Table A1 (Panel Regressions, 2001–2013 / 2002–2012) — key coefficients and statistics (as reported): - Controls (coefficients and t-values): - Per-capita GDP: -1.8^(-5) -0.51 ; 0.1^(-5) 0.58 ; -1.7^(-5) -0.39 - Real growth: 0.40 3.63*** ; 0.12 4.64*** ; 0.37 3.41*** - Investment/GDP: 0.13 1.36 ; 0.04 1.74* ; 0.11 1.09 - Unemployment rate: -1.03 -9.56*** ; -0.31 -12.16*** ; -0.84 -7.13*** - CPI inflation: -0.26 -3.92*** ; -0.68 -5.88*** ; -0.20 -2.46** - Gen. gov. balance: -0.10 -0.95 ; -0.07 -2.69*** ; -0.00 -0.01 - Gen. gov. debt: -0.17 -9.01*** ; -0.03 -6.62*** ; -0.14 -7.16*** - External balance: 0.06 0.82 ; 0.04 2.42** ; 0.08 0.99 - NIIP: 0.03 5.15*** ; 0.01 4.10*** ; 0.02 3.60*** - Floating (dummy): 0.16 0.14 ; -0.50 -1.82* ; 0.72 0.56 - Governance quality (included in column 3): 18.08 5.63*** - Country fixed effects, time dummies, euro and EU membership dummies, dummy for missing gov. debt observations included (not reported individually). - Observations: 442 ; 442 ; 374 - Adjusted R2: 0.952 ; 0.952 ; 0.956 - Significance of country F: F(33,359)=37.63 (0.000) ; F(33,359)=45.30 (0.000) ; F(33,292)=22.10 (0.000) - Significance notation: 1 (***), 5 (**), and 10 (*) percent level. - Note: IIR index reported linearized and inverted in the table footnote. ### Findings on Euro and EU premia - Euro premia: - Estimates for the IIR index (column 1) and the S&P indices (column 2) are in general similar. - IIR tends to value euro area membership higher than S&P throughout. - The decline in the premium in the wake of the euro crisis is steeper for the S&P index than for the IIR. - The γ estimates measure the impact of euro area membership on country perception, holding country characteristics constant; γ is allowed to vary over time to track changes in the value of euro membership. - EU premia: - The premium for EU membership is generally insignificant, except for 2001/02 when EU membership displays modest positive significance with the IIR index. - The early-2000s pattern likely reflects improvement in investor perception of non-EU countries rather than deterioration for EU members. - Controls with strongest impacts on perceived credibility: - Unemployment and government debt have the strongest impact on perceived credibility. - Followed by inflation, growth, and the NIIP. - IIP (NIIP) puts most weight on stock variables; S&P assessments also place weight on flow variables (budget deficit, current account balance). - Governance quality is a strong determinant of credibility; its inclusion does not materially affect the pattern of the euro premium over time. ### Robustness and alternative estimators - Robustness checks: - Additional control variables tested, including covariates capturing global macro/liquidity conditions (e.g., the VIX index). - Dynamic panels estimated, notably the Arellano-Bond (1991) GMM estimator. - The basic pattern — a steep decline in the euro area premium from 2010 — persists across all specifications. - Arellano-Bond results: - With Arellano-Bond, the estimated size of the euro premium is on average smaller by about one-third. ### Euroization and perceived credibility - Data constraints: - Information on balance-sheet euroization available for only 11 new EU member states from 2006–2012 (in a few cases going back to 2004), preventing inclusion of euroization directly as a covariate in the full regression. - Alternative strategy: - Correlate: - (i) the NMS’ country fixed effects, and - (ii) a country’s estimated annual residual credibility premium - with the share of FX loans in total private sector loans. - Trade-offs: - Correlation (i) is unbiased if FX loans share is invariant over time (holds approximately for most countries) but is based on very few observations. - Correlation (ii) enlarges the sample but requires an orthogonality assumption between euroization and other covariates in the main regression, which may not hold and may introduce estimation bias of unknown direction. - Results (using model (3) residuals and fixed effects): - Correlation with euroization is marginally weaker for the residual credibility premium than for fixed effects, but the difference is small. - The richer sample from residual premiums allows extracting a non-linear relationship: - Euroization becomes disproportionately more detrimental for country perception the larger FX balance sheet mismatches are. - This FX-specific credibility premium appears broadly stable over time — in contrast to the general euro credibility premium, the FX-specific credibility premium has not vanished with the euro crisis. - Additional note: - Euroization correlates strongly with governance quality; inclusion of governance quality in X is necessary to avoid overstating the link between euroization and perceived credibility. *Source: _cr1598 - Appendix I. Estimating the Euro Premium* ### 2. In the aftermath of the crisis, the EU embarked on ambitious financial sector reforms ### 2. In the aftermath of the crisis, the EU embarked on ambitious financial sector reforms ### Harmonization and Single Rulebook - Objective: improve transparency and health of the financial system, strengthen and harmonize bank supervision and resolution, reduce market fragmentation, and minimize the cost to taxpayers of future bail-outs. - Two parallel tracks given euro area challenges: harmonization across the single market; and euro-area-specific common supervision/resolution (Banking Union). - European System of Financial Supervision (ESFS) established in 2011 and Single Rulebook developed (EC, 2013). - Components and milestones: - ESFS comprises the European Banking Authority (EBA), the European Systemic Risk Board (ESRB), European Securities and Markets Authority (ESMA), European Insurance and Occupational Pensions Authority (EIOPA), the Joint Committee of the European Supervisory Authorities (ESAs), and national supervisory agencies. - Capital Requirements Directive (CRD IV) and Capital Requirements Regulation (CRR) adopted in mid-2013 to harmonize capital definitions and implement Basel III. - Work ongoing on binding technical standards for CRD IV/CRR implementation and on other rulebook chapters, including harmonization and strengthening of deposit guarantee schemes. - Bank Recovery and Resolution Directive (BRRD) and Deposit Guarantee Scheme Directive (DGSD) adopted in mid-2014. BRRD introduces “bail-in” of bank liabilities (conversion of liabilities to equity). DGSD sets minimal requirements for national deposit guarantee schemes, ensuring they are funded ex ante and pay out in a timely manner. - Next step: development of a Single Supervisory Handbook and further harmonization of supervisory practices for uniform implementation of the Single Rulebook. ### Banking Union (BU) architecture and missing elements - BU builds on EU-wide reforms and includes the Single Supervisory Mechanism (SSM) and the Single Resolution Mechanism (SRM). BU is open to non-euro area EU member states. - Key BU elements not yet in place: - Truly common fiscal backstop and a common deposit guarantee scheme. - Single Resolution Fund (SRF) will be fully funded and mutualized only by 2024; SRF will amount to €55 billion by 2024. SRF borrowing against future industry levies is an intended next step. - Pan-European deposit guarantee scheme does not yet exist; only a voluntary mutual borrowing mechanism between national DGSs exists so far. - European Stability Mechanism (ESM) is acting as de facto common fiscal backstop for euro area banks but ESM bank recapitalization is not available to non-euro area BU participants (ESM Treaty open only to currency union members). ### What “opting into the BU” entails for non-euro area members - Participation means entering into close cooperation with the ECB (Article 7 of the SSM Regulation) and passing national legislation to work with the ECB and the Single Resolution Board (SRB). - Entry process: - ECB assesses the transposition into national laws and can request additional information and carry out its own comprehensive assessment. - Outcome of application not conditional on comprehensive assessment results, but ECB can use information requests and assessments as levers. - Exit option: - Non-euro area participating member states can suspend or terminate close cooperation with the ECB; the ECB can also suspend or terminate cooperation if the member is not fulfilling obligations. - Resolution actions prior to becoming a participating member would not be covered by the SRM. - Representation and decision-making differences: - After opting in, non-eurozone members have representation on the Supervisory Board (SB) on par with euro area member states, but do not sit on the ECB Governing Council. - SB drafts decisions that are referred to the ECB Governing Council, which may adopt them under a “non-objection procedure” or object. - Non-euro area members would be invited to send representatives to the Governing Council if the ECB contemplates an objection or if non-eurozone members disagree; a reconciliation process follows. A non-euro area member may notify the ECB it will not be bound by a decision (reasoned disagreement). If disagreement is not accepted, this can lead to suspension or termination of cooperation under Article 7. - After opting in, non-eurozone members have representation on the Single Resolution Board (SRB) and would contribute to and have access to the Single Resolution Fund (SRF). - Emergency Liquidity Assistance (ELA) and liquidity access: - ELA remains a national prerogative; rules apply to all EU members (ELA extended to solvent institutions). - For BU-participating states, the ECB in its supervisory capacity under the SSM will determine bank solvency and thus eligibility for ELA. - Non-euro area BU participating members would not be entitled to supplementary access to the ECB’s liquidity facilities automatically; any ECB liquidity provision via repo or swap lines to non-euro area members is granted on a country-by-country basis and subjugated to monetary policy considerations. ### Key takeaways on non-euro BU participation (as stated) - Modalities differ notably from euro-area members: - (i) Role in the SSM: non-euro countries are not members of the ECB’s Governing Council that adopts decisions drafted by the Supervisory Board. - (ii) Fiscal backstop: non-euro area opt-ins are not eligible for direct bank recapitalization from the ESM (acting as de facto common fiscal backstop). - (iii) Liquidity support: non-euro area opt-ins would not automatically have access to the ECB liquidity facilities. - Safeguards for non-euro area opt-ins include the possibility to present “reasoned disagreement” and to exit the BU, but effectiveness of these safeguards is uncertain. ### Sensitivities for NMS-6 (non-euro EU new member states) - NMS-6 context: chapter focuses on pros and cons of participating in the BU prior to euro adoption for NMS-6 that are EU members but not yet in the euro area. - Features making NMS-6 sensitive to unequal treatment in the BU: - Most banking systems dominated by euro area bank subsidiaries; subsidiaries often more important for local economies than for parent banking groups. Ability to influence parent-bank-related decisions is critical. - Removal of cross-border capital and liquidity barriers under BU could reduce local authorities’ ability to ring-fence, increasing importance of influencing parent bank activity via SSM decision-making. - Access to common liquidity and fiscal backstops is important because: - (i) many NMS-6 still have large external liabilities, though many NMS subsidiaries are now less reliant on foreign parent bank funding than before the crisis (see Box 1 in the staff report). - (ii) banks in NMS-6 typically have less bail-inable funding (other than uninsured deposits) than eurozone banking groups operating in the region. - NMS-6 are more likely to benefit from risk-sharing aspects of the SRF or other common backstop. - Uncertainty on safeguard effectiveness: - SSM is recent; no experience yet with process. Views differ on whether BU opt-in modalities sufficiently protect non-euro opt-ins’ interests. - Exit clause may be ineffective in practice due to potential negative reputational effects of exercising it. - Whether opt-ins would gain or lose influence over decisions regarding parent banks is complex and depends on operational modalities and practice. ### Macroprudential policy space and coordination - CRR/CRD IV gives national macro-prudential authorities a range of tools to set stricter requirements above micro-prudential minima; national authorities retain full control over measures not specified in Union law (e.g., loan-to-value and debt-to-income ratios). - All EU member states must notify the ESRB of changes in macroprudential stance; ESRB provides opinions but cannot enforce recommendations—members must explain measures questioned by ESRB (soft check-and-balance). - For BU members under the SSM: - National competent authorities (NCAs) can deploy macroprudential measures subject to notification to the ESRB. - For CRR/CRD IV measures, BU-participating states must notify the ECB of intent 10 working days prior to issuance. If the ECB objects, it supplies a written explanation within 5 working days which the national authority must consider. - ECB may apply stricter macroprudential requirements than national authorities irrespective of direct SSM supervision (subject to notification and timelines). - Asymmetry: ECB can strengthen measures under Union law but cannot compel loosening; NCAs can tighten but cannot loosen below ECB minimum. - Key takeaway: extent to which joining BU would limit macroprudential policy space—unless offset by lower shock likelihood or additional euro-area institutional support—needs assessment; current lack of clarity and experience with BU operational modalities complicates full assessment. ### Expected benefits and remaining caveats for NMS-6 - Main motivation for BU: reverse financial fragmentation, raise credibility of euro area bank supervision, eliminate home-host supervisor distinction for cross-border banks, and sever sovereign-bank links. - Expected benefits when BU fully established: - Lower bank compliance costs and removal of barriers to cross-border activity. - Lower funding costs for banks under SSM supervision. - For NMS-6 specifically: - If euro area banks become safer and more conservative under consistent BU supervision, likelihood of negative spillovers from euro area to NMS-6 will be lower. - Greater fungibility of liquidity within the euro area could lower funding costs for cross-border banking groups and help boost lending to faster-growing/higher-return NMS. - Home-host interactions may become simpler under a single supervisor, but key question remains whether SSM will treat bank exposures to counterparties inside and outside the BU differently. *Source: _cr1598 - 2. In the aftermath of the crisis, the EU embarked on ambitious financial sector reforms* ### 16. At present, direct participation in the BU prior to euro adoption is generally less ### _cr1598 - 16. At present, direct participation in the BU prior to euro adoption is generally less ### Attractiveness of Banking Union (BU) participation prior to euro adoption - Direct participation in the BU prior to euro adoption is generally less attractive for the NMS-6 than for euro area countries, given that the BU remains incomplete and non-euro area members do not enjoy the same treatment as the euro area members. - Euro area members can rely on ECB liquidity facilities and the ESM; non-euro area NMS do not have either, making early BU participation less attractive despite similar decision-making powers ceded to the supranational level.10 - Removal of barriers to cross-border transfer of capital and liquidity would reduce the required capital and liquidity buffers at the subsidiary level.9 ### Key considerations determining whether an NMS-6 country is better off in the BU - Decision depends on country characteristics, policy preferences and BU operational modalities (see Box 5 referenced in source). - Country characteristics affecting preferences and trade-offs include: - Degree of real or financial integration with the euro area (columns 1 and 3 in Table 1). - Degree of economic flexibility (column 2). - Share of local bank assets owned by euro area banks (column 4). - Local supervisory standards (column 5). - Local backstops (local DGS (column 6) and fiscal policy space (column 8)). - Policy space for monetary and fiscal policies (columns 7 and 8). - NMS-6 risk-sharing preferences depend on exposure to common versus asymmetric shocks: less integrated economies are more likely to face asymmetric shocks and may value common backstops more. - NMS-6 policy preferences influence desired stringency of prudential standards; willingness to opt in depends on perceived similarity between national preferences and SSM preferences. - Joining the BU may affect macroprudential and monetary policy space for opt-ins. ### Financial stability (FS) — potential benefits of joining the BU - Improve the overall quality/stringency of supervision: - If SSM sets micro-prudential standards at least as strict as current national standards and distances supervision from local vested interests, banks would be safer and FS risks lower. - New members with less stringent supervisory standards and weaker local backstops would benefit more (Table 1, Columns 5, 6, and 8, Ranks: Low).11 - Limit negative externalities from actions of current BU member banks: - Participation could reduce regulatory arbitrage and macroprudential leakages; SSM ensures compliance via centralized supervision and harmonized practices. - Benefits larger for countries with strong financial links to the euro area and significant presence of BU member banks (Table 1, Columns 3 and 4, Ranks: High), and for those with less stringent supervisory standards and weaker local backstops (Table 1, Columns 5, 6 and 8, Ranks: Low). - Better access to information and improved home-host coordination through direct participation in the SSM: - Direct participation provides greater access to supervisory information on cross-border banks and the ability to participate in SSM/SB decision-making processes, though representatives act in their personal capacities for the good of the Union.13,14,15 - New members with strong financial links to the euro area and significant presence of BU member banks would benefit (Table 1, Columns 3 and 4, Rank: High). ### Financial stability — potential costs or limitations of joining the BU - Limits ability to use prudential tools for country-specific shocks: - Some local flexibility under the Single Rulebook could be lost after joining the SSM, including “good” discretion to tailor measures to local conditions. - If SSM prudential requirements are stricter than warranted by local conditions, this could increase bank closures or lower recovery values (“less of ‘good forbearance’”). - This concern is most relevant for countries relatively less integrated with the euro area and more exposed to asymmetric shocks (Table 1, Columns 1 to 4, Ranks: Low), and for supervisors with greater capacity to intervene (Table 1, Column 5, Rank: High). - Loss of control over cross-border capital and liquidity flows: - After joining the BU, local supervisors lose control over liquidity requirements at the subsidiary level (though they retain ability to set large exposure limits16). - If negative externalities are not fully eliminated, loss of ring-fencing ability may be perceived as increasing FS risk, especially where euro area banks’ subsidiaries dominate local markets (Table 1, Columns 3 and 4, Ranks: High) and where supervisors have strong intervention capacity (Table 1, Column 5, Rank: High). ### Cost of financial distress and resolution — potential benefits of joining the BU - Increases efficiency and reduces cost of bank resolution: - SRM complements BRRD by ensuring winding down of large cross-border banks is orderly and “least cost” on a consolidated basis; positive for hosts of euro area bank subsidiaries (Table 1, Column 4, Rank: High). - Provides access to common, industry-funded backstop (SRF): - Access to SRF gives NMS banks a larger backstop without adding to sovereign fiscal burden. - Benefits larger for countries more likely to be hit by asymmetric shocks and those with weaker local backstops.17 - These benefits are limited until the SRF is fully mutualized: national contributions to the SRF will be gradually mutualized over the course of the next eight years. ### Cost of financial distress and resolution — potential costs or limitations - Loss of local control over resolution process without commensurate supra-national risk-sharing: - Until the SRF is fully mutualized, resolution decisions at BU level may not fully account for available financing, which remains largely local DGS and local fiscal backstops. - Risk that SSM applies stricter solvency criteria than warranted by local conditions, raising incidence of resolution under the BU. - This is most relevant for countries with strong supervision (Table 1, Column 5, Rank: High), those where subsidiaries of cross-border banks to be resolved by SRM have significant market share (Table 1, Column 4, Rank: High), and countries with less adequate local backstops (Table 1, Columns 6 and 8, Ranks: Low).18 ### Macroeconomic considerations and policy space - Joining the BU could reduce national policymakers’ ability to support access to credit through prudential measures when country-specific circumstances call for more supportive financial regulation. - Asymmetry in powers under the BU: - National prudential norms can only be stricter than the floor set by the ECB. - The ECB may strengthen macroprudential policies, but cannot compel loosening. - It is unclear how much heterogeneity the ECB will accept while ensuring level playing field and preventing regulatory arbitrage. - This concern is most relevant for less integrated economies facing different cyclical conditions (Table 1, Columns 1 to 4, Ranks: Low) and for supervisors with greater intervention capacity (Table 1, Column 5, Rank: High). *International Monetary Fund. Content extracted from chapter/section titled: At present, direct participation in the BU prior to euro adoption is generally less.* ### 19. All BU members, including those in the eurozone, retain some policy instruments (for ### _cr1598 - 19. All BU members, including those in the eurozone, retain some policy instruments (for ### National policy instruments and coordination within the Banking Union (BU) - All BU members retain national policy instruments (examples cited: taxes and subsidies, housing policies) that could be used to offset BU-level measures. - Non-euro area BU members additionally retain sovereignty over monetary and exchange rate policies prior to euro adoption. - In the BU context, national policies would need to be coordinated with prudential measures taken both at the national and BU level. - Independent monetary policy can serve as an additional tool to manage shocks and potentially allow a non-euro area BU member to benefit from BU upsides while mitigating downsides. - Perspective: BU members without independent monetary policy will be at a disadvantage relative to their inflation-targeting peers (Table 1, Column 7, Rank: Low). ### Trade-offs and country-specific considerations for NMS-6 opt-in decisions - Key takeaway: Some NMS-6 may opt in for non-economic reasons (e.g., enhance quality and credibility of bank supervision, distance supervision from local vested interests, access larger common industry-funded backstops). - Opt-in decision is complex and depends on country characteristics, policy preferences, and BU modalities. - Illustrative trade-offs: - Less integrated economies with the euro area (example countries cited: Bulgaria, Croatia) - Trade-off between access to a larger industry-funded common backstop (SRF) and loss of flexibility to deal with country-specific shocks. - Upside of SRF fully materializes only once SRF is fully mutualized; downside assessment requires clarity and experience with BU operational modalities. - Economies where euro area banks dominate local banking systems (examples cited: Czech Republic, Croatia) - Trade-off between direct participation in SSM deliberations (better access to information, influence on parent-bank decisions) and ceding control over intra-group cross-border capital and liquidity flows (ability to ring-fence). - Value depends on whether negative externalities from euro area cross-border banks would be effectively eliminated under the BU. - Countries with monetary and exchange rate flexibility - Need to assess how centralization of micro- or macroprudential powers under the BU affects ability to conduct monetary policy/lender-of-last-resort functions. - Non-eurozone BU opt-ins could, in principle, use monetary/exchange rate flexibility to offset tighter BU-level macroprudential requirements, but this could create tensions requiring resolution. ### How one NMS opt-in may affect others - An opt-in by one NMS could influence others if it creates a competitive advantage for the joining NMS and makes others worse off versus the status quo; this requires assuming a limited pool of capital/funding from euro area banks (not seen as plausible). - Other interrelated factors (Kisgergely and Szombati, 2014) include: - BU-membership may be used by international capital market participants as a signaling device of lower systemic risk, possibly disadvantaging opt-outs. - Potential dominance of BU-centric views in EBA and ESRB operations could marginalize NMS positions. ### Evidence on foreign banks’ allocation drivers - Host country risk profile, growth potential, and banking system soundness are dominant factors in foreign banks’ asset allocation decisions. - CESEE bank lending survey findings: - Foreign banks have broadly similar views on the Czech and Slovak banking systems despite one being in the euro area/BU and the other not. - During the crisis, euro area banks scaled back regional exposure but differentiated across countries by risk profiles: - NMS-6 with relatively higher asset quality and profitability (examples: Poland, Czech Republic) attracted additional foreign funding. - Countries with higher FX-currency mismatches, NPLs and lower profitability experienced significant outflows. ### Conclusions and conditions affecting attractiveness of early BU opt-in for NMS-6 - The opt-in calculus for NMS-6 is complex and must weigh economic, political, and evolving European financial architecture factors. - For NMS-6 that set euro adoption dates (example: Romania), early BU opt-in is a matter of phasing institutional adjustments. - For others, opt-in requires careful consideration of country characteristics, policy preferences/space, and clarity on BU implementation. - When opting into BU may not make sense: - BU design: lack of equal (or fully equivalent) treatment of euro area and non-euro area BU members (representation in the SSM, access to common liquidity and fiscal backstops) tilts against early opt-in and favors waiting until euro adoption. - BU modalities: lack of clarity and experience with operational modalities (coordination between SSM and local supervisors; coordination between national and BU prudential policies and national monetary policies) favors waiting. - When countries may still opt in: - If BU participation addresses specific challenges that outweigh BU shortcomings (examples: enhance supervision quality/credibility; access larger industry-funded common backstop). - Opting in would be more attractive if: - Mechanisms ensure NMS-6 concerns about unequal treatment of opt-ins vs euro area members are fully addressed. - Greater clarity on BU operational modalities (shaping opt-ins’ policy space and expected support from common euro area institutions) is provided. ### Key elements and modalities of the Euro Area Banking Union (selected facts and figures) - Single Supervisory Mechanism (SSM) - ECB directly supervises 120 significant banks—jointly comprising almost 85 percent of total euro area bank assets—and oversees NCAs’ supervision of the other 3500 less significant banks in the euro area. - Significance assessment criteria include: - a) total assets exceeding €30 billion; - b) total assets exceeding €5 billion and 20% of GDP of a Member State; - c) cross-border assets or liabilities ratio above 20%; - d) request for, or receipt of, direct public financial assistance from the ESM; - e) one of the three most significant credit institutions in a participating Member State. - Single Resolution Mechanism (SRM) and Single Resolution Fund (SRF) - SRF eventual planned size: €55 billion (about 1 percent of covered deposits in the euro area). - SRF mutualization timeline: national compartments initially; 60 percent mutualized after 2 years, building to 100 percent after 8 years, in 2024. - From January 2016, SRM can draw upon SRF to resolve banks under BRRD. - ESM Direct Bank Recapitalization - Up to €60 billion available for direct bank recapitalization by the ESM (December 2014 decision). - ESM recapitalization not available for future non-euro area BU participants (ESM Treaty open only to currency union members). - SSM governance and decision-making - Supervisory Board (SB) within the ECB: chair, vice-chair (also on ECB Executive Board), single representative from each participating Member State plus four ECB representatives. - Draft decisions by SB referred to ECB Governing Council; regular draft decisions passed by simple majority; regulatory decisions with SSM-wide import passed by qualified majority (Article 26 of the SSM Regulation). - SRM governance and decision-making - Single Resolution Board (SRB): chair, vice-chair, three other full-time members, and one representative from national resolution authorities of each participating member state. - Plenary SRB meets at least twice a year; may meet if more than €5 billion in SRF funds used in any 12 month period. - Macroprudential policy space under SSM and CRR/CRD IV - NCAs can deploy macroprudential measures subject to ESRB non-binding opinion; CRR/CRD IV measures require notifying the ECB 10 working days prior to decision; ECB may object and provide written explanation within 5 working days. - ECB may apply stricter macroprudential requirements than national authorities. - Pillar I measures: countercyclical capital buffer, additional capital buffers for systemic risk, systemic important institutions, capital conservation, leverage ratio, level of own funds; national authorities can set higher risk weights on real estate exposures and large exposures. - Pillar II measures: institution- or group-specific measures following supervisory review. - Liquidity provisions: liquidity coverage ratio and net stable funding ratio. - Limits on large exposures and intra financial sector exposures. - National macroprudential authorities retain control over measures not specified in Union law (examples: loan-to-value and debt-to-income ratios), subject to notification to ESRB and possible EU Council intervention. - Timeline notes - SSM enabling legislation adopted October 2013; ECB Comprehensive Assessment undertaken in preparation. - SRM enabling legislation adopted April 2014; SRM began operating January 2015. - SRF adopted by intergovernmental agreement May 2014; gradual mutualization to 100 percent by 2024. - Harmonization of liquidity requirements in 2015 and leverage ratio by 2018 (as noted for national unilateral setting until harmonization). *Source: _cr1598 - 19. All BU members, including those in the eurozone, retain some policy instruments (for* ### Box 6. Cross-Country Differences in Policymakers’ Relative Preference for Promoting ### Box 6. Cross-Country Differences in Policymakers’ Relative Preference for Promoting Domestic Banks ### Policymakers' revealed preference and measurement approach - Policymakers' revealed preference for promotion of domestically-owned banks is inferred from the extent to which domestic banks are allowed to gain market share despite above-average funding costs. - The cost of funding is estimated as the ratio of interest expenses to the average interest-bearing liabilities (the latter proxied by the difference between total liabilities and equity). - Source data: ECB Consolidated Banking Data and Fund staff calculations. ### Empirical findings for NMS-6 (high-level) - Domestic banks in Bulgaria and the Czech Republic, and to a lesser extent Poland and Hungary, rapidly expanded their deposit base in the post-crisis period. - Domestic banks in Bulgaria and Hungary have the largest market shares relative to other NMS-6 countries, whereas in the Czech Republic the market share of domestic banks remains marginal. - In all NMS-6 countries, domestic banks have higher funding costs than their foreign-owned peers. - The widest funding-cost margins between domestic and foreign-owned banks are recorded in Hungary, Bulgaria, and the Czech Republic. ### Country-specific observations and interpretation - Bulgaria: - Rapid expansion of domestic banks’ deposit base in the post-crisis period. - Domestic banks have one of the largest market shares among NMS-6. - Domestic banks pay a funding-cost premium over foreign-owned banks. - Hungary: - Domestic banks have one of the largest market shares among NMS-6. - Domestic banks pay a funding-cost premium; the size of the premium is likely driven by foreign-owned banks’ interest rate margin policies in response to the government-mandated cost of restructuring of FX-denominated debt. - Czech Republic: - Domestic banks expanded deposits rapidly in the post-crisis period, but the market share of domestic banks remains marginal. - Domestic banks exhibit a funding-cost premium; margins among the widest in NMS-6. - Poland: - Domestic banks expanded deposits post-crisis to a lesser extent than Bulgaria and the Czech Republic; domestic banks have somewhat larger market share gains than some peers. - Domestic banks pay higher funding costs than foreign peers. - Romania: - Mixed performance: domestic banks’ deposit growth and funding-cost dynamics differ from other NMS-6; domestic banks also pay higher funding costs than foreign peers. - Overall interpretation: - Results suggest that domestic banks in Bulgaria and Hungary might have benefitted from a more favorable policy stance compared to their foreign-owned peers. Gains in market share in recent years are associated with domestic banks paying a bigger premium in funding costs over foreign-owned banks. ### Data table and metrics reported (as in source) - Reported indicators and labels in the source: Cummulative Growth Rate of Deposits 2009-2013; Share of domestic banks in total bank deposits; Average cost of funding 2009-2013; Return on equity avg 2008-2013. - Raw country-level panel (excerpted labels as presented in the source): - Bulgaria 21.43 22.11 0.71 33.4 27.4 10 6.0 4.7 2.9 1.8 5.9 5.7 0.2 - Czech Republic 1.7 6.4 4.6 167.1 25.1 142.0 2.4 1.4 0.9 9.3 14.1 -4.8 - Hungary 41.0 47.0 6.0 14.3 -10.6 24.9 5.5 3.3 2.1 8.5 -6.6 15.0 - Poland 32.1 40.2 8.1 79.9 35.8 44.1 3.0 2.6 0.5 11.4 9.2 2.2 - Romania 13.5 11.1 -2.4 -7.9 29.6 -37.5 4.4 3.9 0.5 2.4 0.1 2.3 - (Croatia row in source shows ellipses/omissions) - Notes: the table in the source presents cumulative deposit growth 2009-2013, shares of domestic banks in total deposits, average cost of funding 2009-2013, and return on equity averages for 2008-2013; exact column alignments and some entries in the source are presented with ellipses for Croatia. *Source: ECB Consolidated Banking Data and Fund staff calculations.* ### 4. At the same time, most reforms imply a steep cut in pension benefits, calling into ### _cr1598 - 4. At the same time, most reforms imply a steep cut in pension benefits, calling into ### PAYG pension systems: fiscal and social sustainability - Most reforms imply a steep cut in pension benefits, raising concerns about the social—and therefore political—sustainability of PAYG systems. - For some NMS-6 PAYG systems, the replacement rate of income in retirement is projected to fall below 20 percent, compared to around 40 percent today. - Some countries have already reversed recent reforms in response to political pressures that increased when benefit reductions started taking effect (Schwarz and Arias, 2014). ### Projected PAYG pension spending (selected time series excerpts, in percent of GDP) - With reforms / Without reforms framework: "With reforms" refers to projected spending under currently legislated reforms (baseline in the EU Ageing Report). "Without reforms" refers to pension spending if parameters were kept constant at 2010 levels. - Representative country-level figures from the spending time series (selected years shown in the source): - Bulgaria: 2010 9.9; 2020 9.2; 2030 9.6; 2040 10.1; 2050 11.1; 2060 11.1; ... 2060 21.2 - Croatia 2/: 2010 6.0; 2020 4.4; 2030 3.3; 2040 2.6; 2050 2.5; 2060 3.3; ... 2060 7.0 - Czech Republic: 2010 9.1; 2020 8.7; 2030 8.9; 2040 9.7; 2050 11.0; 2060 11.8; ... 2060 21.0 - Estonia: 2010 8.9; 2020 7.7; 2030 8.2; 2040 8.1; 2050 8.0; 2060 7.7; ... 2060 16.8 - Latvia: 2010 9.7; 2020 7.3; 2030 6.5; 2040 6.3; 2050 6.4; 2060 5.9; ... 2060 21.0 - Lithuania: 2010 8.6; 2020 7.6; 2030 8.4; 2040 9.6; 2050 10.8; 2060 12.1; ... 2060 17.2 - Hungary: 2010 11.9; 2020 10.5; 2030 9.3; 2040 9.8; 2050 11.2; 2060 12.4; ... 2060 24.4 - Poland: 2010 11.8; 2020 10.9; 2030 10.9; 2040 10.3; 2050 10.0; 2060 9.6; ... 2060 35.5 - Romania: 2010 9.8; 2020 9.2; 2030 10.3; 2040 11.6; 2050 12.8; 2060 13.5; ... 2060 28.8 - Slovakia: 2010 8.0; 2020 8.6; 2030 9.5; 2040 10.6; 2050 12.2; 2060 13.3; ... 2060 25.1 - Notes: - 2/ For Croatia, numbers are for old age related pension spending only and do not include other pension payments from the PAYG scheme. - Different tax treatment on pension and non-pension income will affect income replacement rate net of taxes; in some countries (e.g. Hungary), the replacement rate can be higher because pensions are not taxed. ### Net present value of pension deficits (Table 2 excerpts, in percent of GDP) - Table 2 presents Net Present Value (NPV) of pension deficits for periods 2010-2030, 2031-2060, and 2010-2060 under multiple discount rates. Selected country NPV entries: - Bulgaria: Discount rate=1: 2010-2030 34; 2031-2060 79; 2010-2060 114. Discount rate=2: 2010-2030 31; 2031-2060 55; 2010-2060 86. Discount rate=0: 2010-2030 29; 2031-2060 38; 2010-2060 67. - Croatia 1/: Discount rate=1: 2010-2030 -38; 2031-2060 -105; 2010-2060 -144. Discount rate=2: 2010-2030 -34; 2031-2060 -74; 2010-2060 -108. Discount rate=0: 2010-2030 -30; 2031-2060 -53; 2010-2060 -83. - Czech Republic: Discount rate=1: 7, 65, 72. Discount rate=2: 6, 44, 50. Discount rate=0: 6, 30, 36. - Estonia: Discount rate=1: 16, -13, 4. Discount rate=2: 15, -9, 7. Discount rate=0: 14, -6, 8. - Latvia: Discount rate=1: 51, 66, 116. Discount rate=2: 46, 47, 93. Discount rate=0: 42, 34, 77. - Lithuania: Discount rate=1: 14, 61, 75. Discount rate=2: 13, 41, 55. Discount rate=0: 12, 29, 41. - Hungary: Discount rate=1: 39, 87, 126. Discount rate=2: 36, 59, 95. Discount rate=0: 33, 41, 74. - Poland: Discount rate=1: 76, 48, 124. Discount rate=2: 70, 35, 105. Discount rate=0: 65, 25, 90. - Romania: Discount rate=1: 27, 10, 37. Discount rate=2: 25, 7, 33. Discount rate=0: 24, 5, 29. - Slovakia: Discount rate=1: 77, 176, 253. Discount rate=2: 69, 122, 191. Discount rate=0: 63, 86, 149. - Average: Discount rate=1: 30, 47, 78. Discount rate=2: 28, 33, 61. Discount rate=0: 26, 23, 49. - Source note: Discount rate=1, Discount rate=2, Discount rate=0 columns are presented in the source table; figures are in percent of GDP. - 1/ For Croatia, only old age related pension spending is included. PAYG balance including other pension payments will be smaller. ### Policy directions to improve fiscal and social sustainability - Two areas with significant reform potential: - Align the mandatory retirement age with longevity. - Reduce incentives for early retirement. - Rationale: - Several NMS-6 countries continue to have relatively generous early retirement incentives and special pension regimes for privileged groups, resulting in a high share of relatively young beneficiaries. - Gains from these reforms could be used to improve fiscal sustainability, increase social sustainability of replacement rates, or both. ### Pillar II (mandatory, pre-funded, private) pension schemes: history and rationale - Pillar II systems channel contributions into privately held accounts to finance supplementary pensions from accumulated savings. - Adoption history in the NMS: - Hungary (1998), Poland (1999), Bulgaria (2002), Croatia (2002), Romania (2007). - Czech Republic: did not make contributions mandatory; instead strengthened tax incentives for voluntary savings. - Conceptual objectives: - Generate additional pension income by raising national savings (only effective if national savings increase and not offset by public sector dis-saving). - Risk diversification via returns on capital and potential for foreign asset investment. - Boost ownership, labor market participation, and capital market development by linking pension income to contributions. ### Performance of Pillar II systems: empirical findings - Overall assessment caveats: - Hard to identify clear-cut, comparable metrics of success; national savings affected by many factors; young funds often show initially elevated fees and limited diversification. - Evidence on national savings: - No systematic evidence that Pillar II systems increased national savings. - Only Croatia, Estonia, Lithuania, Poland and Slovakia show a sizeable increase in national savings as a share of GDP around Pillar II introduction dates. - Observation consistent with governments offsetting private saving increases via higher fiscal deficits. - Social security contributions and public dis-saving: - Upon Pillar II introduction, PAYG contributions were typically cut to the same degree as Pillar II contributions were levied. - Exceptions where governments matched individual contributions: Estonia (from the outset) and Lithuania (only recently). - Financing transition costs: - Large holdings of government bonds by many Pillar II funds suggest transition costs were largely covered with debt financing rather than fiscal consolidation. - Pillar II investments in government securities are more than twice as high in the NMS than for private pension funds in other OECD countries. - Investment returns and risk: - Prior to the 2008/09 financial crisis, gross investment returns on Pillar II funds were generally modest and typically exceeded real returns from domestic long-term government bonds in most cases; crisis erased pre-crisis gains. - Long-term horizon of funds makes assessment against short-term benchmarks problematic. - Fees and operating expenses: - Total fees for Pillar II funds fell from an average of more than 2 percent of assets in 2006 to about 1¼ percent in 2011. - Operating expenses remain more than 50 percent higher than in other OECD countries. - As a rule of thumb cited: one percent of assets spent in fees and other charges reduces life-time pension earnings by about 20 percent (Barr (2000) referenced in source). - Asset allocation and diversification: - Only a few countries diversified away from domestic risk; overall Pillar II portfolios have a high share of government securities. - Baltic countries are a main exception due to low levels of public debt. - Regulations in many countries enforce a high share of risk-free assets and a minimum domestic investment requirement, biasing portfolios toward government securities, bank deposits, and cash. ### EU fiscal framework, Pillar II transition costs, and reversals - Eurostat reclassified Pillar II to the private sector in 2004, which increased recorded fiscal deficits because Pillar II contributions no longer counted as fiscal revenue; transition costs became visible. - 2005 SGP reform and subsequent rules: - Full exemption requests for transition costs were turned down in 2005. - European Council allowed limited adjustments to the deficit for a maximum of five years on a degressive linear scale, provided the deficit remained "close to the reference value". - Preventive arm: net cost of systemic pension reforms with an impact on long-term fiscal sustainability could be partially taken into account when determining a country’s medium-term objective (MTO). - Shortcomings of exemptions: - Ceiling for deficit allowance understood to be at most ½ of a percent of GDP, whereas average Pillar II transition costs pre-crisis were about one percent of GDP, and much higher for countries with large second pillars (e.g., Poland and Hungary). - Exemption period (five years) far shorter than actual transition period (which can last 40–50 years); no allowance under the debt criterion. - Pillar II reversals after the 2008/09 crisis: - Several reversals occurred, sometimes temporary: - Baltic countries: temporary reversals; currently in process of or have finished restoring Pillar II systems. - Romania: delayed somewhat the build-up of its second pillar. - Slovakia and Poland: significantly reduced size of their Pillar II schemes with no declared intention of restoration. - Hungary: eliminated its second pension pillar altogether. - Bulgaria and Croatia: maintained their second pillars throughout the crisis period without major parameter changes. - Reasons cited for reversals: disappointing financial performance and high private management fees. _Italic: Source — Fund staff synthesis of the IMF chapter content provided in the supplied PDF content unit._ ### 18. To gauge why countries unwound second pillar reforms, we correlate the size of the ### _cr1598 - 18. To gauge why countries unwound second pillar reforms, we correlate the size of the ### Drivers of Pillar II reform reversals - Small sample caveat: results are based on a small number of observations; analysis is univariate. - Fiscal pressures were an important trigger for reversing Pillar II reforms, including the need to stay within—or return to—the EDP’s deficit ceilings. - Contribution rate and reform reversal correlation: - Countries with the largest second pillars—as measured by the Pillar II contribution rate—had the largest reform reversals. - Pillar II funds with contribution rates of up to 5 percent—triggering a loss in fiscal revenue of ½-1 percent of GDP—did in general survive the financial crisis and its aftermath. - Incentives to divert contributions: - Large amounts of contributions channeled into the second pillar provided a strong incentive to divert second pillar contributions to the budget to reduce the headline fiscal deficit. - Preventive arm (MTO) treatment: - Net cost of systemic pension reforms with an impact on long term fiscal sustainability could be partially taken into account when determining a country’s medium-term objective (MTO). ### Empirical patterns and asset-related factors - No evidence that reform reversals were related to poor investment performance. - There is a negative correlation of pre-crisis returns with reform reversals—Pillar II funds that were dissolved or cut back were relatively more profitable. - No significant relationship between asset management fees and the extent of Pillar II reversals after 2008 for the countries considered. - Selected figure statistics shown in the source (visual correlations): - Regression: y = -0.5676x -0.5992, R² = 0.1589 (Change of Pillar II Contribution Rate over 2007-13 vs Weighted Avg Real Return (2005-07)). - Regression: y = -0.0583x + 2.0141, R² = 0.0402 (Change of Pillar II Contribution Rate over 2007-13 vs Administration Fees (pct. of total assets, 2006)). - Regression: y = -0.5389x + 4.2886, R² = 0.7304 (Change of Pillar II Contribution Rate over 2007-13 vs Contribution Rate of Pillar II in 2007). - Budgetary cost depiction: - The source presents “Budgetary Cost of Second Pension Pillars (Percent of GDP)” with country-specific averages before and after the crisis for listed countries (graphical). ### The EU fiscal framework post-crisis - 2011 SGP reform increased flexibility vis-à-vis second pillar funds: - Deficit exemption: the regressive scale for the deficit allowance under the EDP was eliminated and made permanent but remains subject to tight approval restrictions and the size of the exemption remains limited. - MTOs: net cost of systemic pension reforms can be partially taken into account when defining—or allowing a temporary deviation from—a country’s adjustment path toward its MTO. - ESA 2010 (entered into force September 2014): - Under ESA 2010, lump-sum transfers of assets from the second pension pillar fund to the general government sector have no longer a direct impact on the general government budget balance, somewhat reducing the incentive to abolish Pillar II funds in the context of the EDP. - Note in source: it does not eliminate the incentive entirely because (i) increase in higher social security contributions from re-integrating the second pension pillar into the budget continues to lower the recorded fiscal deficit, (ii) pillar II asset transfers continue to reduce recorded government debt and (iii) interest savings as a result of debt reduction also continue to lower the recorded fiscal deficit. - Remaining shortcomings and distortions: - Preventive arm: Improvements in fiscal sustainability from pension reforms are only partially recognized in MTOs; little relation appears between existence of a second pillar fund and a country’s MTO. - Corrective arm: adjustment to the deficit criterion for second pillars remains small and subject to many conditions; no flexibility is allowed when assessing compliance with the debt ceilings — framework continues to discriminate against large second pension pillars. - Frequent ad hoc changes, complexity, and discretion in application trigger substantial policy uncertainty. - Illustration (poland vs germany): - While Germany’s headline fiscal balance was almost 4 percentage points stronger than Poland’s in recent years, both countries’ pension-adjusted balances were, on average, almost identical — reflecting cost-saving parametric reforms to Poland’s PAYG system and the existence of its second pillar. - Pension-adjusted balance concept referenced: pension-adjusted balance (PABF) developed by Soto et al. (2011) and applied using data from the EC’s 2012 ageing report. ### Conclusions and policy recommendations - Long-term challenge: Securing fiscally and socially sustainable pension systems remains a challenge; with currently legislated parameters, most NMS-6 PAYG systems will pay much lower pensions in the future, creating a risk of old-age poverty. - Options to avoid lower pensions absent retirement age increases: - Accept higher fiscal burdens, or - Increase savings ahead of time to generate additional income for future pensions. - Recommendations for countries maintaining a second pillar: - Strengthen Pillar II fund performance by encouraging more diversified investment portfolios and further reducing administrative costs. - Transition costs of second pillars should at least in part be absorbed by the budget, requiring more fiscal space. - Recommendations for countries abolishing second pillars: - Cope with ageing costs by improving fiscal performance and increasing public savings. - Strengthen incentives for participation in a third, voluntary pillar; ensure design includes sufficient quality control and availability of simple savings products with low administrative costs. - Avoid generous tax breaks for voluntary schemes as mostly higher earners use them. - Cross-cutting reform: - Align retirement age more closely with longevity and reduce incentives for early retirement to ease the trade-off between fiscal and social sustainability. - EU fiscal framework neutrality case: - There remains a case for rendering the EU’s fiscal framework more neutral toward a country’s choice of pension regime. - Full neutrality is difficult because it would arguably require moving away from the headline deficit as the main assessment tool; however, efforts toward neutrality are worthwhile to avoid discouraging countries from pre-funding ageing costs. *Italic: Source — CEE New Member States Policy Forum, INTERNATIONAL MONETARY FUND (excerpt from the supplied content).* ### Appendix II. Evolution of Pillar II Systems and Contribution Rates ### Appendix II. Evolution of Pillar II Systems and Contribution Rates ### Evolution of Pillar II systems and contribution rates (selected entries from table) - Bulgaria - Jan-02: SSC of PAYG participants 16.0% ; Pillar II SSC 11.0% ; Pillar II contribution 5.0 % (universal funds) ; Total no change 5/ - 2011-14: 17.8% ; 12.8% ; 5.0 % (universal funds) - Croatia - Jan-02: mandatory for those borne after 31/12/1961 ; SSC total 20.0% ; PAYG SSC 15.0% ; Pillar II SSC 5 % 3/20% ; no change - Czech Republic - Jan-13: voluntary, but upon entry no withdrawal from Pillar II ; SSC total 28.0% ; PAYG SSC 25.0% ; Pillar II SSC (3+2)% ; 7/(28+2)% ; likely to be abolished (merged into Pillar III) - Hungary - Jan-98/1998: 31.0% ; 25.0% ; 6.0% ; 31.0% ; Abolished - 1999-2000: 30.0% ; 24.0% ; 6.0% ; 30.0% - 2001: 28.0% ; 22.0% ; 6.0% ; 28.0% - 2002-03: 26.0% ; 20.0% ; 6.0% ; 26.0% - 2004-06: 26.5% ; 18.5% ; 8.0% ; 26.5% - 2007: 29.5% ; 21.5% ; 8.0% ; 29.5% - 2008-10: 33.5% ; 25.5% ; 8.0% ; 33.5% - 2011: 34.0% ; ..0.0% ; .. - 2012: 37.0% ; ..0.0% ; .. - Poland (4/ Jan-99) - up to 2010: 19.5% ; 12.3% ; 7.3% ; 19.6% ; partially abolished - investments in instruments other than (domestic) government bonds remain - 2011-12: 19.5% ; 17.2% ; 2.3% ; 19.5% - 2013: 19.5% ; 16.7% ; 2.8% ; 19.5% - Romania - Jan-07 / 2007: 31.3% ; 29.3% ; 2.0% ; 31.3% ; restoration in progress - 2008: 31.3% ; 29.3% ; 2.0% ; 31.3% - 2009: 31.3% ; 29.3% ; 2.0% ; 31.3% - 2010: 31.3% ; 28.8% ; 2.5% ; 31.3% - 2011: 31.3% ; 28.3% ; 3.0% ; 31.3% - 2012: 31.3% ; 27.8% ; 3.5% ; 31.3% - 2013: 31.3% ; 27.3% ; 4.0% ; 31.3% - Estonia - Jan-02 up to Jun-09: 20.0% ; 16.0% ; (4+2)% ; 2/(20+2)% ; fully restored - Jul-09 to Dec-10: 20.0% ; 20.0% ; (0+2)%(20+2)% - 2011: 20.0% ; 19.0% ; 3.0%(20+2)% - 2012: 20.0% ; 16.0% ; (4+2)%(20+2)% - Latvia (4/ Jul-01) - up to 2006: 20.0% ; 18.0% ; 2.0% ; 20.0% ; partially restored - 2007: 20.0% ; 16.0% ; 4.0% ; 20.0% - 2008 to Apr-09: 20.0% ; 12.0% ; 8.0% ; 20.0% - May-09 to Dec-12: 20.0% ; 18.0% ; 2.0% ; 20.0% - 2013: 20.0% ; 16.0% ; 4.0% ; 20.0% - 2014: 20.0% ; 14.0% ; 6.0% ; 20.0% - Lithuania - Jan-04 / 2004: 26.3% ; 23.8% ; 2.5% ; 26.3% ; partially restored - 2005: 26.3% ; 22.8% ; 3.5% ; 26.3% - 2006: 26.3% ; 21.8% ; 4.5% ; 26.3% - 2007: 26.3% ; 20.8% ; 5.5% ; 26.3% - 2008: 26.3% ; 20.8% ; 5.5% ; 26.3% - 2009H1: 26.3% ; 23.3% ; 3.0% ; 26.3% - 2009H2-2011: 26.3% ; 24.3% ; 2.0% ; 26.3% - 2012: 26.3% ; 24.8% ; 1.5% ; 26.3% - 2013: 26.3% ; 23.8% ; 2.5% ; 26.3% - 2014 (note 6/): 26.3% ; 24.3% ; (2+1+1)%(26.3+1+1)% - Slovakia - Jan-05 up to sept 2012: 18.0% ; 9.0% ; 9.0% ; 18.0% ; partially reversed - 2013 (note 6/): 18.0% ; 14.0% ; 4.0% ; 18.0% Notes (from table footnotes and annotations) - SSC to finance pensions only. - 4 ppt of mandatory SSC of the state are redirected to Pillar II. Individuals add 2 ppts of supplementary individual contributions. - Initial plan was to increase rate to 10 percent by 2009 but initial law never set a schedule for the increase to take place. - Notionally defined contribution systems. - In 2000, a second pillar-type system for workers in hazardous occupations was introduced with the aim to provide for early retirement. The 2002 reform introduced a mandatory second pillar for all employees. - Contributors to the second pillar were also allowed to leave and return to PAYG. - 2 percent supplementary contributions by individuals. - Additional scheme annotations in the table text: mandatory for those borne after specific dates (e.g., 31/12/1959; 31/12/1971; 31/12/1968; after 1971 with voluntary cohorts specified), plans to increase Pillar II from 2017, 2014-17: rate may rise to 8 % to make up for reduced revenue, plan to increase Pillar II to 6 percent in 2016 and to 7.5 percent in 2020 (partially financed from non-SSC revenues and additional individual contributions), plan to increase to 6 % in 0.5 steps, 1 from individuals, 1 from other state budget resources. ### Summary of export performance and policy findings (NMS-6) - High-level summary bullets - Since 1995, NMS-6 as a group has experienced a spectacular increase in exports to the EU, but there is considerable heterogeneity across countries. - The Czech Republic, Hungary and Poland have steadily increased exports to the EU as a share of GDP, while Bulgaria and Romania lag. - Structural and institutional factors (human capital, labor skills, foreign investment environment, wage competitiveness) are highly significant in explaining export performance to the EU. - Quality improvement of exports is important for sustained income convergence; Romania and Bulgaria show the largest room for quality improvement, while Hungary and Czech Republic show the least room for improvement among the NMS. - Policy priorities should be mindful of initial conditions: for countries specializing in lower-end products, priorities include better foreign investment regime and stronger links with supply chains; for countries specializing in higher-quality products, priorities include higher education and R&D spending. - Further liberalization of services trade within the EU can significantly boost exports; NMS-6 benefits from the EU Services Directive but barriers remain in professional and technical services. ### Empirical analysis: determinants of value-added exports to EU (sample and approach) - Sample and dependent variable - Sample: ten NMS for the period 2003-11 (Croatia excluded from regression due to data limitations). - Dependent variable: value added exports to the EU scaled by GDP (preferred over gross exports to remove re-exports and imported inputs). - Structural explanatory variables included (final specification) - Human capital: upper secondary or tertiary educational attainment; participation in continuous vocational training and skills upgrade. - Labor market efficiency: inactivity trap; minimum wage relative to gross average wage. - Foreign investment environment: index of prevalence of foreign ownership and regulatory sentiment (higher values indicate lower degree of restrictions). - Participation in supply chains: share of exports processed through upstream and downstream supply chains. - Gravity and control variables included - PPP GDP per capita; weighted distance from export partners; population; weighted real GDP growth of trading partners; real effective exchange rate (ULC-based); time dummies and euro area crisis dummy (time dummies and crisis dummy were insignificant). ### Estimation results and quantitative findings (Table 1 and Figure 2 summary) - Regression specifications (panel OLS; two dependent variable versions) - Column 1: value added exports to the EU in percent of a country’s own GDP. - Column 2: distance of value added exports from the NMS-10 average. - Key coefficient estimates (structural variables, selected) - Upper secondary or tertiary educational attainment: 0.16** (column 1) ; 0.33*** (column 2) - Participation in continuous vocational training and skills upgrade: 0.15*** ; 0.14*** - Inactivity trap: -0.09*** ; -0.03* - Relative minimum wage: -0.08** ; -0.16*** - Foreign investment environment (higher values indicate lower degree of restrictions): 1.0** ; 2.2*** - Control variables (selected) - Share of exports processed by supply chain: 0.44*** ; 0.34*** - PPP GDP per capita: 0.0 ; 0.0 - Weighted real GDP growth of trading partners: 0.06 ; 0.13 - Real effective exchange rate (ULC-based): -0.03 ; -0.07** - Population: 0.57 ; -0.68 - Goodness of fit and observations - Observations: 73 ; 73 - R-squared: 0.85 ; 0.85 - Standard errors in parentheses; significance: *** p<0.01, ** p<0.05, * p<0.1. - Interpretation of quantitative results - The five structural variables are all statistically highly significant and together capture more than 80 percent of the explained variance in both specifications. - The strongest impact on value added exports comes from human capital—particularly continuous participation in vocational training and skills upgrade (one-standard-deviation improvement leads to the largest increase in exports in the levels specification). - In the specification using distance from group average, foreign investment environment shows the largest impact, with higher education and skills also contributing strongly. - Participation in supply chains is the second-most important factor for increasing exports. - Higher REER-ULC reduces exports by eroding competitiveness; REER-ULC is significant in some specifications. - PPP GDP per capita, weighted distance, weighted GDP growth in partners and population are statistically insignificant in the preferred specification, possibly because supply chain participation captures much of the gravity effect. - Time dummies and a euro area crisis dummy were statistically insignificant. ### Policy implications and priorities (derived from analysis) - Strengthen human capital and on-the-job skills upgrading - Policies to increase participation in continuous vocational training and skills upgrade can yield strong increases in value-added exports. - Improve foreign investment environment - Reforms that lower restrictions and improve sentiment toward foreign ownership can have large positive impacts on exports, especially relative to peers. - Deepen integration into supply chains - Policies that facilitate links with global and EU supply chains (trade facilitation, infrastructure, regulatory clarity) can substantially increase exports. - Maintain wage competitiveness for low-skilled labor while addressing inactivity traps - Reducing disincentives to work (inactivity trap) and addressing relative minimum wage pressures can improve export performance. - Targeted approach to export quality - For economies specializing in lower-end products, prioritize FDI attraction and supply chain integration to access technology. - For economies specializing in higher-quality products, prioritize higher education and R&D to sustain quality improvements. - Services liberalization - Further liberalization of services trade within the EU, particularly in professional and technical services, offers significant potential to boost exports for NMS-6. *Italic: Source: Appendix II. Evolution of Pillar II Systems and Contribution Rates; CEE New Member States Policy Forum (selected sections and Table 1) as provided in the supplied content.* ### 10. Our empirical findings identify country-specific policy priorities. We look at the ### _cr1598 - 10. Our empirical findings identify country-specific policy priorities. We look at the ### Structural factors shaping export performance to the EU (NMS-6) - Time period analyzed: 2003-11. - Decomposition of structural contributions (based on regression results in Table 1, column 2; Shapley value decomposition) — impact on value added exports to EU from a one-standard-deviation improvement in each factor (Figure 3): - Higher education: 27% - Vocational training and skills upgrade: 17% - Inactivity trap: 2% - Relative minimum wage: 7% - Real effective exchange rate (ULC-based) / Wage cost (as labor cost) appears in decomposition: 4% - Foreign investment and ownership environment: 28% - Supply chain participation: 15% - Regression coefficients are robust to alternative specifications (see Rahman and others (forthcoming) as cited). ### Country-specific empirical findings (relative to other NMS peers) - Czech Republic: - Above-average export performance relative to other NMS during 2003-11. - Positive contributors: vocational training and skills upgrade, higher education, favorable foreign investment environment, links with supply chains. - Labor market variables (wage cost and incentives to work) have not been a source of competitiveness. - Hungary: - Above-average export performance relative to other NMS during 2003-11. - Positive contributors: wage competitiveness, strong links with supply chains, foreign investment environment (but contribution from foreign investment environment has declined in recent years). - Negative contributors: vocational training and higher education. - Poland: - Improvement in export performance over time; gap relative to other NMS decreasing. - Positive contributors: higher education, competitive wages. - Drag: relatively lower participation in supply chains. - Foreign investment environment historically negative, but improvement in recent years and a pick-up in off-shoring and outsourcing of business services (McKenzie 2013) boosted exports since 2010. - Bulgaria and Romania: - Below-average export performance during 2003-11, with the gap relative to the NMS average worsening over time. - Policy priority: broad-based reforms, particularly in human capital and foreign investment environment. ### Export quality in NMS-6: levels and room for improvement - Methodology: - Global quality index using Henn, Papageorgiou, and Spatafora (2013): estimated relationship between export quality, export unit value, production cost, and distance from importers (quality defined within SITC 4-digit product groups; product-level exercise uses SITC 4-digit products with at least ½ percent world market share). - Alternative EU-market methodology: Di Comite, Thisse and Vandenbussche (2014) using firm-level cost data and a mark-up model. - Overall standings (Henn et al. based): - NMS-6 overall exports quality is above the 60th percentile compared to all countries. - Czech Republic: overall quality close to the 90th percentile. - Romania: 61st percentile overall; lags others. - Product-level tiers: - Highest tier: Czech Republic — quality ranges between 61st and 97th percentiles. - Next tier: Croatia, Hungary, Poland — quality ranges between 40th and 89th percentiles. - Third tier: Bulgaria, Romania — quality ranges between 24th and 80th percentiles. - Room for quality improvement: - Positive quality gaps (importer demand > exporter supply) observed for NMS at overall and product levels. - Significant room for improvement identified in specific product areas: - Textile products: Bulgaria, Croatia, Romania - Wood products: Romania - Paper products: Poland - Beverages and tobacco: Bulgaria, Poland - Footwear: Croatia - EU-market comparison (Di Comite et al.): - NMS-6 quality distribution concentrated at lower and middle parts of EU quality spectrum. - Share of products below the 50th percentile (relative to other EU countries) ranges between: - 62 percent in Poland - 52 percent in Hungary - Conclusion: more than half of export products from the NMS are in the bottom half of the quality ladder relative to EU peers. ### Quality–value relationship and implications - Export quality is positively correlated with export value in both EU and world markets for the NMS. - Vandenbussche (2014): estimated price elasticity of quality is around 0.5, implying quality upgrading is likely to enable firms to increase price, profits, and market share — indicating causality from quality to higher exports. - Demographics and comparative advantage: - NMS are not expected to rely on low labor costs or labor abundance as a long-term comparative advantage due to ageing populations; improving quality must be part of export-enhancement strategies. - Policy priorities for quality improvement by country group: - Bulgaria and Romania: - Improve foreign investment regime. - Boost secondary education. - Link with supply chains to acquire technology. - Czech Republic and Hungary: - Focus on improving environment for innovation. - Ramp up higher education and R&D spending (Box 1 referenced). - Diversify exports outside the EU and into new products given heavy GDP reliance on value added exports to the EU. ### Services exports: scope and policy opportunities - Overview: - Goods dominate NMS-6 exports to the EU; services are underrepresented. - Services sector contributes to two-thirds of EU GDP and creates 9 out of 10 jobs, but its share in intra-EU trade is low. - For NMS-6, share of services sector in value added exports is only a third and much less than in gross exports. - Croatia is the only NMS-6 country where services (mainly tourism) dominate exports to the EU. - Services Directive (SD) impact: - Most services exports from NMS-6 fall under sectors covered by the SD (travel, construction services, computer and information services, operational leasing, miscellaneous business services, royalties, education and other personal, cultural and recreational services). - Weighted average share of SD sectors in total services exports to EU: - NMS-6: 70 percent - Croatia: almost 90 percent - NMS-EA: 59 percent - Other EU: 62 percent - Post-SD growth: services exports from NMS-6 in SD sectors grew on average 8 percent annually and more in sectors most liberalized after the SD. - European Commission assessment (Montiagudi et al, 2012): implementation of the SD reduced average restrictions on services imports across products and countries by about 30 percent since 2006, with considerable variation. - Remaining barriers: - Significant restrictions remain, particularly on professional and technical services (authorization, economic needs tests, licenses, territorial restrictions, restrictions on multidisciplinary activities). - Liberalization under the SD fell short of expectations due to member-state leeway to retain pre-existing restrictions deemed necessary to protect public interest. - Comparative advantage in services: - Hungary, Bulgaria, Romania show comparative advantage in a higher number of services products than goods products (Annex II). - Czech Republic, Hungary, Poland, Romania hold comparative advantage in professional and technical services relative to other EU members. - Weighted average share of professional services in total SD exports ranges between 30–40 percent in these four countries. - Policy implication: further liberalization of services trade in the EU, especially professional services, would greatly help NMS-6 increase exports to the EU. ### Policy implications and priorities - Core message: - Structural reforms are key to maximizing benefits from unrestricted access to the EU single market. - Policy areas highlighted: - Higher education. - Skills upgrade / vocational training. - Wage-structure reforms to provide incentives to work (address inactivity trap and relative minimum wage dynamics). - Improve foreign investment environment and ownership conditions. - Institutional reforms to promote integration with global supply chains. - For higher-quality exporters (Czech Republic, Hungary): strengthen environment for innovation, increase R&D spending, and diversify beyond the EU. - For lower-quality exporters (Bulgaria, Romania): focus on foreign investment regime, secondary education, and supply-chain linkages to acquire technology. - Further liberalization of services trade in the EU, especially professional services, to exploit comparative advantages and raise services value added exports. *Source: Staff calculations and analysis in IMF staff chapter (NMS-6 empirical analysis, figures and tables cited within the text).* ### 21. Our analysis identifies some country-specific structural reform priorities that can help ### _cr1598 - 21. Our analysis identifies some country-specific structural reform priorities that can help ### Country-specific structural reform priorities - Bulgaria and Romania - Finding: Export performance has been persistently weak relative to other the NMS. - Priority reforms: broad-based reforms, particularly improvement in skills, education attainment, and foreign investment regime. - Quality gap: room for quality improvement is particularly large for Bulgaria and Romania. - Poland - Finding: Export performance has consistently improved over time to almost closing the gap with the NMS average. - Priority reforms: a more conducive foreign ownership regime and greater links in services-based supply chains. - Hungary - Finding: Contribution of the operating environment for foreign investors has declined in recent years. - Priority reforms: strengthen the operating environment to enhance integration with the EU. ### Relative comparative advantage in Professional and Technical Services (RCA and % of exports in sectors under SD) - Note: RCA is relative to total services gross exports. - RCA values (as presented): - Bulgaria 0.616 - Croatia 0.48 - Czech Republic 1.130 - Hungary 1.131 - Poland 1.136 - Romania 1.140 - Estonia 0.827 - Latvia 0.731 - Lithuania 0.423 - Slovak Republic 0.820 - Slovenia 0.516 ### Export quality and structural reform priorities - Finding: There is room for export quality improvement in all NMS-6, particularly with respect to other exporters to the EU market. - Relationship: Strong positive relationship between exports value and quality. - Recommended structural reforms to increase both exports and quality: - Improve human capital. - Improve labor market and business environment. - Tailored priorities by existing quality level: - Low-end quality producers (Bulgaria and Romania): accessing technology through improving foreign investment environment and greater links with supply chains. - Medium-level quality producers (Czech Republic and Hungary): improving skills and higher education, and innovation through higher R&D spending. - Mid-quality, highly EU-integrated producers (Czech Republic and Hungary): diversification in products and markets; increasing R&D expenditure and tertiary education to raise quality; diversification into new products to remain on an export-led growth path. ### Services trade and market access - Finding: A large part of services exports from the NMS fall under sectors covered by the Services Directive (SD). - Comparative advantage: A number of the NMS have comparative advantage in these products, including in professional services which remain most restricted. - Policy recommendations: - Further dismantling of restrictions by EU members, both advanced and emerging economies, to maximize benefits from the single market. - Renewed impetus to the SD through third-party review of principles of non-discrimination, necessity and proportionality to assess public interest may also help. ### Box: Czech Republic and Hungary — Lessons from Korea - Comparative insight: - Japan and Germany demonstrated a negative room for quality improvement since 1970 (they provided quality above that demanded by importers). - Korea joined this group in the early 2000s after steady improvement in quality. - Structural drivers observed for Korea: - Ramping up of R&D spending (percent of GDP) since 1990s, surpassing levels of Germany by early to mid-2000s. - Increase in share of labor force with tertiary education. - A friendly business environment (Doing Business ranking as of 2014; and higher use of talent index as of 2014). - Implication for Czech Republic and Hungary: - Need for significant improvement in education, R&D expenditure and business environment to pursue similar quality upgrade and movement up the value chain. ### Annex: Selected data appendix summary statistics (variables, obs., mean, std. dev., min., max., source) - Domestic value-added exports to EU (% of GDP) - No. of obs. 90 - Mean 17.95 - Std. dev. 5.21 - Min. 0.0 - Max. 29.5 - Source: World Input-Output Database; World Economic Outlook database, IMF; and IMF staff calculations - Upper secondary or tertiary educational attainment (% of population aged 20-24 years) - No. of obs. 90 - Mean 85.6 - Std. dev. 5.57 - Min. 75.0 - Max. 94.1 - Source: Eurostat - Participation in continuous vocational training and skills upgrade (% of total employed) - No. of obs. 77 - Mean 27.4 - Std. dev. 14.7 - Min. 13.3 - Max. 61.0 - Source: LAF database, European Commission - Inactivity trap 1/ - No. of obs. 86 - Mean 71.6 - Std. dev. 13.64 - Min. 2.0 - Max. 90.0 - Source: LAF database, European Commission - Relative minimum wage (% of gross average wages) - No. of obs. 80 - Mean 40.3 - Std. dev. 10.0 - Min. 23.5 - Max. 62.4 - Source: LAF database, European Commission - Foreign investment and ownership environment - No. of obs. 80 - Mean 6.7 - Std. dev. 1.2 - Min. 4.3 - Max. 8.9 - Source: Economic Freedom of the World 2013 Annual Report - Share of exports processed by supply chain (% of gross exports) - No. of obs. 90 - Mean 76.9 - Std. dev. 3.8 - Min. 67.7 - Max. 82.7 - Source: World Input-Output Database and IMF staff calculations - Weighted real GDP growth of trading partners - No. of obs. 90 - Mean 0.24 - Std. dev. 4.1 - Min. -11.6 - Max. 12.2 - Source: World Input-Output Database; World Economic Outlook database, IMF; and IMF staff calculations - Population - No. of obs. 90 - Mean 10.2 - Std. dev. 11.0 - Min. 1.3 - Max. 38.5 - Source: World Economic Outlook database, IMF - PPP GDP per capita - No. of obs. 90 - Mean 7312.75 - Std. dev. 183.87 - Min. 828.2 - Max. 29402.8 - Source: World Development Indicators database, World Bank - GDP weighted distance - No. of obs. 90 - Mean 2197.4 - Std. dev. 2288.7 - Min. 423.7 - Max. 9176.1 - Source: GeoDist database, CEPII; World Economic Outlook database, IMF; and IMF staff calculations *Source: IMF staff analysis as presented in the chapter.* --- _Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2015/_cr1598.pdf_