EU8+2 Regular Economic Report January 2007

Output growth gained further pace across the region in 2006 but is likely to moderate slightly in 2007, according to the World Bank’s latest EU8+2 (Includes Bulgaria, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, Slovakia, and Slovenia) Regular Economic Report. The report indicates that real GDP growth strengthened in the region, not least in Poland, Slovakia, and Romania, as dynamics improved further in the second half of the year, but the Baltic States, Slovenia, and Bulgaria also grew at an even stronger rate than the year before.

This occurred in spite of currency appreciation against the euro, and especially the dollar, in several countries, as well as some moderation in growth in the euro area. Meanwhile, oil prices declined significantly from September and further in early 2007. The report predicts that growth is likely to ease in most of the new member states in 2007 as growth slows in the euro area and output moves closer to potential.

Atendency towards higher inflation is emerging. While inflation remains well under control in Poland and the Czech Republic, other countries are struggling. In the Baltic countries and to some degree Bulgaria and Romania, strong wage and credit growth are leading to overheating and significant inflationary pressures. In other countries, weakening currencies in May and June 2006 contributed to higher price pressures later in the year, particularly in Hungary. Regulated price adjustments and indirect tax increases aggravated inflation in several countries.

“2007 will bring another round of regulated price increases for most EU8+2 countries, with the impact on inflation likely to be most pronounced in Hungary, the Czech Republic, Estonia, Lithuania, and Romania,” says Thomas Blatt Laursen, World Bank Lead Economist and the report’s lead author. “At the same time, the recent sharp decline in oil prices could help dampen inflationary pressures in 2007. The region’s fiscal policies were generally pro-cyclical in 2006, and the picture is not likely to change much this year.”

The previous EU8 Quarterly Economic Report series, published since March 2004, has been extended to include new EU member states Bulgaria and Romania in addition to the eight Central European and Baltic countries that joined the EU in 2004. The new EU 8+2 Regular Economic Report will be published three times a year. It will continue to monitor the macroeconomic and reform developments in the EU 8+2 countries and provide both an up-to-date summary of economic developments in the region and in-depth analyses of key current economic policy issues.

Fiscal deficits increased in most countries in the region despite strong growth and buoyant tax revenues, adding to concerns about overheating. Only Poland and Bulgaria managed to improve their structural fiscal balances. The fiscal easing was particularly dramatic in Hungary and Slovakia, with the deficit in Hungary reaching about 10 percent of GDP. For 2007, Hungary is planning strong fiscal consolidation, and Slovakia and Poland are similarly aiming for lower deficits. Most other countries in the region envisage further fiscal easing. Many of the countries are planning fiscal consolidation that will only bite in 2008-2009, but the credibility of these delayed plans is diluted because many countries will be entering pre-election periods.

Current account deficits increased in 2006 across the region, in some countries to worrisome levels. Buoyant domestic demand was associated with higher deficits, with export growth holding up well. While external deficits remained low in Poland, the Czech Republic, and Slovenia, they were close to or exceeded 10 percent of GDP elsewhere. Foreign direct investment covered the deficits of the Czech Republic and Poland, and most of the deficits in Hungary, Bulgaria, and Romania. The banking sector played the main role in financing deficits in the Baltic States.

Enthusiasm for early euro adoption has waned somewhat. While Slovenia joined the eurozone on January 1, 2007, most new member states are struggling to meet the entry conditions related to inflation, budget deficits, exchange rate stability, and legal compatibility. Most countries have dropped target dates for entering the eurozone. Slovakia is still aiming for January 2009, despite the very small margin planned in the fiscal deficit for 2007. Lithuania’s bid for January 2007 was rejected in Spring 2006 due to inflation concerns, and Estonia and Latvia have delayed their euro adoption plans for the same reasons. The Baltic States still aim to join as soon as possible but have acknowledged that this is unlikely before 2010. The other countries have indicated that euro adoption would not be feasible until sometime between 2010-2012, at the earliest.

Output growth is likely to moderate slightly in 2007

Real GDP growth strengthened not least in Poland, Slovakia, and Romania, but the Baltic States, Slovenia, and Bulgaria also grew even more strongly than the year before in spite of currency appreciation against the euro and the dollar. Meanwhile, oil prices declined significantly from September and further in early 2007. Growth is likely to ease somewhat in most new member states in 2007.

A tendency towards higher inflation is emerging

Most countries in the region are struggling to contain inflation. In the Baltics, Romania, and Bulgaria, strong wage and credit growth are leading to overheating and inflationary pressures. In other countries, currency weakening last year contributed to higher price pressures later in 2006. Another round of regulated price increases is expected in 2007, and the recent sharp decline in oil prices could help dampen inflationary pressures.

Fiscal policies will continue to be pro-cyclical

Fiscal deficits increased in most countries in the region despite strong growth and buoyant tax revenues, particularly in Hungary and Slovakia, with the deficit in the former reaching 10% of GDP. For 2007, Hungary is planning strong fiscal consolidation, and Slovakia and Poland similarly target lower deficits. Most other countries in the region envisage further fiscal easing.

Current account deficits increased in 2006

Bouyant domestic demand was associated with higher current account deficits, with export growth holding up well. While external deficits remained low in Poland, the Czech Republic, and Slovenia, they were close to or exceeded 10% of GDP elsewhere. FDI covered deficits in most countries, while the banking sector played a key role in financing deficits in the Baltic States and Romania.

Enthusiasm for early euro adoption has waned

Slovenia joined the eurozone from January 1, 2007, but most other countries are struggling to meet the entry conditions and have dropped specific targets dates for entering the eurozone. Euro adoption will not be feasible until at least 2010 in most places.

The main report (54 pages) may be found on the web site of the world bank.

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