Financial Crisis in Eastern Europe

Jens Jungmann / Bernd Sagemann (Eds.) Financial Crisis in Eastern Europe GABLER RESEARCH Jens Jungmann Bernd Sagema...

Author: Jens Jungmann | Bernd Sagemann (Eds.)

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Jens Jungmann / Bernd Sagemann (Eds.) Financial Crisis in Eastern Europe

GABLER RESEARCH

Jens Jungmann Bernd Sagemann (Eds.)

Financial Crisis in Eastern Europe Road to Recovery With a foreword by Michael Müller-Wünsch and an epilogue by Dirk Schreiber

RESEARCH

Bibliographic information published by the Deutsche Nationalbibliothek The Deutsche Nationalbibliothek lists this publication in the Deutsche Nationalbibliografie; detailed bibliographic data are available in the Internet at http://dnb.d-nb.de.

1st Edition 2011 All rights reserved © Gabler Verlag | Springer Fachmedien Wiesbaden GmbH 2011 Editorial Office: Stefanie Brich | Heiko Ripper Gabler Verlag is a brand of Springer Fachmedien. Springer Fachmedien is part of Springer Science+Business Media. www.gabler.de No part of this publication may be reproduced, stored in a retrieval system or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the copyright holder. Registered and/or industrial names, trade names, trade descriptions etc. cited in this publication are part of the law for trade-mark protection and may not be used free in any form or by any means even if this is not specifically marked. Cover design: KünkelLopka Medienentwicklung, Heidelberg Printed on acid-free paper Printed in Germany ISBN 978-3-8349-2740-8

Foreword

At the end of the first decade of our new century the global economic system was buffeted by unexpected events. The global economy had not been prepared for such developments. At the outset the imminent disruption might have been discussed within the confined circles of political committees and intellectual societies, but never in depth by senior general management in the global business community or the public sector. But this global crisis is comprised of many regional jigsaw pieces and the events were triggered and accelerated by the so-called domino effect as a consequence of the interlinking and interlocking worldwide financial and trade systems. Nevertheless they need to remain fitted together if our global system is to function in the future too. In such circumstances we routinely tend to place our focus on regions like the US, mainland Asia, South America, Middle East or Western Europe. This book addresses an area of great economic interest in a manner never seen before. Eastern Europe is one of the jigsaw pieces and dominos which fall into the maelstrom of the global developments. Yet, this is also a very specific region with various culture differences on one hand and manifold different economic foundations on the other. The editors, Dr. Bernd Sagemann and Jens Jungmann, took the opportunity to combine their personal knowledge of this region with local knowledge gathered from experts on the ground to bring about a compelling and comprehensive status report with regard to Eastern Europe. The thorough analyses and the depth of each country description contained in the book provide an overview of the financial and economic potential and capabilities of the Eastern European region which has never been the case before. Therefore, we would like to thank the editors and the individual authors for their efforts and contributions in generating a valuable and enhanced understanding of this region, which along with the BRIC countries, is one of the most fascinating developing regions of our hemisphere. This book is a unique conception and should become a standard for the evaluation of the financial and economic status of the region for practitioners and likewise for the scientific community.

Foreword |

5

With the in-depth knowledge derived from these comprehensive essays, we should hopefully be more prepared for future economic developments, and events such as the global financial meltdown should no longer be such a surprise. I expect that many readers will appreciate the straightforward and accessible style with which this publication treats this complex matter. Berlin, December 2010

Prof. Dr.-Ing. Michael Müller-Wünsch

6

| Foreword

Preface

“The story of the boom and crash of 1929 is worth telling for its own sake. Great drama joined in those months with a luminous insanity. But there is the more somber purpose. As protection against financial illusion or insanity, memory is far better than law. When memory of the 1929 disaster failed, law and regulation no longer sufficed. For protecting people from the cupidity of others and their own, history is highly utilitarian.” John Kenneth Galbraith (The Great Crash 1929)

The end of a journey always comes back to its beginning. Why do financial crises occur? Do they have the same root causes? Are the solutions the same? Ten years after the Asian financial crisis 1997-98 ended, the US subprime crisis in autumn 2008 had plunged the world into a deep recession. The parallels to the previous regional and global crises, especially the great Depression of 1929-33, are obviously. The world financial crisis 2008-2010 has hit Central and Eastern Europe harder than the rest of the world – the Eastern Europe financial crisis resembles the Asian financial crisis of 1997-98 within the same fundamental problems of excessive inflows of short-term bank credits, enticed by pegged exchange rates, leading to large private foreign debt. This publication firstly gives a general overview about the great subprime credit crisis and its spill-over to Eastern Europe. Subsequently the countries Bulgaria, Czech Republic, Hungary, Lithuania, Poland, Romania, the Russian Federation, Serbia, Slovakia and Ukraine are analyzed with regard to their individual situation before this era, the impacts being faced, their attitudes and forces against the effects and their position afterwards, giving an outlook for the upcoming years. Special thanks are given to the authors of the country profiles and their lasting spur during editing. Particularly many thanks to Ms Agnieszka Ogórkiewicz and Mr Richard Scalé, Rödl & Partner, who both rendered the timely publication possible with their great commitment. Hamburg, December 2010

Bernd Sagemann

Jens Jungmann

Preface |

7

Overview

Foreword _____________________________________________________________ 5 Preface _______________________________________________________________ 7 Overview _____________________________________________________________ 9 List of Abbreviations ___________________________________________________ 11

The World Financial Crisis ____________________________________19 The Great Subprime Credit Crisis and its Impact on Eastern Europe __________ 21 Bernd Sagemann & Peter Reese

SpeciƂc Areas of Crisis in Eastern Europe _____________________63 Bulgaria: The Deferred Crisis ____________________________________________ 65 Minko Karatchomakov Czech Republic: Crisis Postponed – Navigation to Recovery ________________ 109 Rene Vazac Hungary: A Country Hit Hard __________________________________________ 177 Roland Felkai Lithuania: The Return of Opportunities __________________________________ 257 Tobias Kohler Poland: (Po)Land of Opportunity ________________________________________ 315 Jens Jungmann Romania: Politics do matter____________________________________________ 377 Joerg Gulden

Overview |

9

Russian Federation: The Rocky Road ___________________________________ 413 André Scholz Serbia: Serial Tensions amidst Recovery _________________________________ 471 Nicole Arnold Slovakia: Small Land of Big Changes ____________________________________ 517 Maroš Tóth Ukraine: Impact and Recovery from the Crisis________________________________581 Klaus Kessler

Epilogue __________________________________________________ 621 Financial Crisis in Eastern Europe: Road to Recovery ______________________ 623

Editors` Vita _________________________________________________________ 631 Authors` Vita ________________________________________________________ 633

10

| Overview

List of Abbreviations

ABS

Asset Backed Securities

AIG

American International Group

AMBAC

American Municipal Bond Assurance Corporation

ARM

Adjustable Rate Mortgage

ASEAN

Association of Southeast Asian Nations

AT

Austria

BA

Bratislava Region (Slovakia)

BB

Banskobystrický Region (Slovakia)

bbl

Barrell

BCPS

Bank Credit ti private sector

BG

Bulgaria

BKV

Budapesti Közlekedési Vállalat

BMI

Business Monitor International

bn, bln

Billion

BoA

Bank of America

BPO

Business Process Outsourcing

BRIC

Brazil, Russia, India, China

CDO

Collateralized Debt Obligations

CDS

Credit Default Swaps

CEE

Central Eastern Europe

CEFTA

Central European Free Trade Agreement

List of Abbreviations |

11

CESEE

Central East and South East Europe

éEZ

éeské energetické závody a.s.

CHF

Swiss Franc

CIS

Commonwealth of Independent States

CLN

Credit Linked Note

CMT

Constant-Maturity Treasury

CNB

Czech National Bank

CO2

Carbon dioxide

COMECON

Council for Mutual Economic Assistance

CPDO

Constant Proportion Debt Obligation

CPI

Consumer Price Index

CPPI

Constant Proportion Portfolio Insurance

CPT

Corporate profit tax

CR

Czech Republic

CRD

European Capital Requirement Directive

CSO

Czech Statistical Office

éSSD

Czech Social Democratic Party

CTP

Common Trade Policy

CZ

Czech Republic

CZK

Czech Crown

DE

Germany

e.g.

for example

EAGGF

European Agricultural Guidance and Guarantee Fund

EBRD

European Bank of Reconstruction and Development

EC

European Commission

ECB

European Central Bank

12

| List of Abbreviations

ECOFIN

Economic and Financial Affairs Council

EEC

European Economic Community

EERP

European Economic Recovery Plan

EGF

European Globalisation Adjustment Fund

EMU

Economic and Monetary Union

ERM

Exchange Rate Mechanism

ESA

European Space Agency

etc.

et cetera

ETI

Enabling Trade Index

EU

European Union

EUR

Euro

EURIBOR

European Interbank Offered Rate

FD

Federation

FDI

Foreign Direct Investment

FDIC

Federal Deposit Insurance Corporation

FED

Federal Reserve Board of Governors

FHLC

Federal Home Loan Corporation

FNMA

Federal National Mortgage Association

FR

France

FSSP

Financial Sector Support Programme

FX, f/x

Foreign Exchange

GDP

Gross Domestic Product

GE

General Electric

GSE

Government Sponsored Enterprises

HU

Hungary List of Abbreviations |

13

HUD

Department of Housing and Urban Development

HUF

Hungarian Forint

ICT

Information and Communication Technology

ICTY

International Criminal Tribunal for the former Yugoslavia

IFC

International Finance Corporation

IKB

Deutsche Industriebank AG

IMF

International Monetary Fund

Invega

Governmental guarantee institution

IR

Ireland

IRB

Investiêná a rozvojová banka

ITD

Hungarian Investment and Trade Development Agency

JPY

Japanese ¥en

KAMAZ

ÈÔÙÒÐÑ ÈÊÚÖÔÖÉÐÓäÕãÑ ÏÈÊÖÌ/ Kamskiy avtomobilny zavod

km

Kilometer

KR

Košický Region (Slovakia)

L´S-HZDS

ėudová strana - Hnutie za demokratické Slovensko

LHS

Left hand side

LIBOR

London Interbank Offered Rate

LTL

Lithuanian Litas

LVL

Latvian Litas

M&A

Mergers & Acquisitions

m, mln

Million

MALEV

Hungarian Airlines

14

| List of Abbreviations

MAV

Hungarian State Railways

MBS

Mortgage-backed securities

MERCOSUR

Mercado Común del Sur

MNB

Hungarian Central Bank

MNE

Multinational Enterprise

MPO

Ministry of Industry and Trade (Czech Republic)

MSZP

Magyar Szocialista Párt - Hungarian Socialist Party

MWh

Megawatt hour

MWt

Megawatt thermal

NAFTA

North American Free Trade Agreement

NATO

North Atlantic Treaty Organization

NBH

National Bank of Hungary

NBP

National Bank of Poland

NBR

National Bank of Romania

NBS

National Bank of Serbia

NBS

National Bank of Slovakia

NBU

National Bank of Ukraine

NERV

Národní ekonomická rada vlády

NES

National Employment Service

NL

The Netherlands

No.

Number

NR

Nitra Region (Slovakia)

NSZZ

Niezaleŏny Samorzâdny Zwiâzek Zawodowy „Solidarnoıä” – Independent and Self-Governing Trade Union Solidarnoıä

ODS

Civic democratic party

OECD

Organisation for Economic Co-operation and Development

List of Abbreviations |

15

OLAF

European Anti-fraud Office

OTC

over-the-counter

p.a.

per annum

p.p.

percentage points

PAYG

pay-as-you-go

PC

Partidul Conservator

PD-L

Partidul Democrat-Liberal

PE

Private Equity

PL

Poland

PLN

polish zloty

PO

Prešovský Region

PRIBOR

Fixing of Interest Rates on Interbank Deposits

PSD

Partidul Social Democrat

Q

Quarter

R&D

Research & Development

RHS

Right hand side

RO

Romania

RON

New Rumanian Leu

RPNM

Annual percentual rate of costs

RSD

Serbian Dinar

RUB

Russian Ruble

SDR

Special Drawing Rights (to and from SKK)

SEE

Southeast Europe

SEK

Swedish Krona

16

| List of Abbreviations

SIEPA

Serbia Investment and Export Promotion Agency

SLO

Slovenia

SME

Small and medium sized entities

SoDra

State Social Insurance Fund Board

SOFIX

Aktienindex der bulgarischen WP-Börse

SP

Spain

SPV

Special Purpose Vehicle

SR, SK

Republic of Slovakia

SSC

Shares Services

SSK

Slovakian crown

SzDSz

Szabad Demokraták Szövetsége - Alliance of Free Democrats

SZRB

Slovak Guarantee and Development Bank

TN

Trenêiansky Region (Slovakia)

TPCA

Toyota Peugeot Citroën Automobile

TT

Trnavský Region (Slovakia)

TWh

Terawatt hour

UAH

Ukrainian Hryvna

UDMR

Hungarian Democratic Union of Romania - Uniunea Democratà Maghiarà din România

UEFA

Union of European Football Associations

UK

United Kingdom

UNCTAD

United Nations Conference on Trade and Development

UNPR

National Union for the Progress of Romania – Uniunea Nationala pentru Progresul Romaniei

US

United States

List of Abbreviations |

17

USA

United States of America

USD

US-Dollar

VAT

Value added tax

VILIBOR

Vilnius Interbank Offered Rate

VUB

Všeobecná úverová banka

WTO

World Trade Organization

WW

World War

y-o-y

year-on-year

YTM

Yield to Maturity

ZA

Žilinský Region (Slovakia)

18

| List of Abbreviations

The World Financial Crisis

The Great Subprime Credit Crisis and its Impact on Eastern Europe Bernd Sagemann & Peter Reese

The Great Subprime Credit Crisis and its Impact on Eastern Europe |

21

“Collateralized debt obligations … have gotten much too sophisticated, are priced by extraordinary mathematical models, and are very difficult to value. I think people are going to be frightened to deal with those things for a long time. A lot of them are just going to disappear, because they’ve been tried; they don’t work.”1 Alan Greenspan, September 2007

1.

Introduction

The current global financial crisis is the worst the world has seen since the Great Depression during 1929-33. In 2008, clouds were gathering on the financial horizon. US house prices had peaked in 2006 and adjustable mortgage rates had risen, damaging the balance sheets of highly indebted households and undermining faith in mortgage-backed securities (MBS). It became evident that a variety of securitized assets, some quite highly leveraged, were far riskier than advertised. Prior to September 2008, global aggregate demand had remained robust. Trade was not in rapid decline. The biggest problem many countries were facing was the spike in commodity prices in the previous 18 months, peaking in the spring and the summer of 2008.2 The burst of the bubble and the following subprime credit crisis evolved into a global credit crunch with a prolonged impact on the financial architecture as well as the real economy worldwide. In particular in the Eastern European countries, emerging after the fall of the ‘iron curtain’ and some of them after joining the European Union, have been suffering considerably.

1 Kevin Phillips, Bad Money, 2008, p. 96. 2 Commission on Growth and Development, Post-Crisis Growth in Developing Countries, A Special Report of the Commission on Growth and Development on the Implications of the 2008 Financial Crisis, 2010, p. 5.

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| Bernd Sagemann & Peter Reese

J. Jungmann, B. Sagemann (Eds.), Financial Crisis in Eastern Europe, DOI 10.1007/978-3-8349-6553-0_1, © Gabler Verlag | Springer Fachmedien Wiesbaden GmbH

2.

The Great Subprime Credit Crisis and its Global Impact

The severe worldwide recession – which in most countries began to show up in 2008 – was triggered by the housing bubble in the USA. This kind of economic bubble affected a vast part of the US housing market. On the domestic level, US house prices more than doubled from 2000 to 2006 but started to decline from summer 2006 onwards. Between July 2006 and June 2009 the S&P/|Case-Shiller Home Price Index shows a price drop of about 33% for average US house prices. For 2008 only, the average US house prices fell by nearly 20% which is the largest annual decrease in the index history.3 As a result the average foreclosure rates among US homeowners more than tripled from about 1|million per month in 2006 to above 3 million per month in 2008. This caused severe losses for banks and investors which were exposed to the real estate market via subprime- and Alt-A mortgage loans, MBS or Collateralized Debt Obligations (CDO) and other securitized debt instruments which were financing the housing bubble. The extent of the losses resulting, led to a severe credit crisis which has become publicly known as ‘the subprime credit crisis’. The subprime credit crisis triggered unprecedented turmoil in the worldwide capital markets. The crisis started to become public for the first time on 4 March 2007 when HSBC announced a write-off of 11 billion USD in subprime related mortgage debt, which was followed by a series of banks and hedge funds that had to declare huge losses and were forced to recapitalize. In summer 2007 the crisis infected several money market funds which invested in structured credit securities and in consequence were impelled to close the fund. In 2008 the crisis developed further: firstly the collapse of Bear Stearns in March and later Washington Mutual, which were both taken over by JPMorgan. The crisis culminated in September 2008 when Lehman Brothers went bankrupt – the largest bank bankruptcy in history so far – and Merrill Lynch had to sell itself to the Bank of America (BoA). At the same time the two remaining American investment banks, Goldman Sachs and 3 The S&P/|Case-Shiller Home Price Indices measure the residential US housing market by tracking the changes in the value of the residential real estate market in 20 metropolitan regions across the US. To measure housing markets, the indices use the repeat sales pricing technique developed by Karl Case and Robert Shiller. This methodology collects data on single-family home re-sales, capturing re-sold sale prices to form sale pairs. Cf. Standard & Poor’s, S&P/|Case-Shiller Home Price Indices, 2009, http://www2.standardandpoors.com/spf/pdf/ index/CS_HomePrice_History_063055.xls (retrieved on 25 July 2009).

The Great Subprime Credit Crisis and its Impact on Eastern Europe |

23

Morgan Stanley, applied for a bank license and were seeking financial support from outside investors ending up selling stakes to Warren Buffet and Mitsubishi Financial Group respectively. In the following months several of the world’s largest banks and financial institutions had to be bailed out by the taxpayer and as a result were (partly) nationalized – among those banks Citigroup Corp., BoA, AIG, Royal Bank of Scotland, Halifax Bank of Scotland/|Lloyds TSB, Fortis, Dexia, Hypo Real Estate or Commerzbank. From the beginning of the crisis in 2007 until the first half of 2009 just in the US the total number of regional banks which had to declare insolvency and got under the receivership of the FDIC went up to 74.4 To many the burst of the global crisis has come up as a surprise, wondering how this severe global credit crisis could happen, how seriously and long lasting it would be and what implications were to come in the future for the financial industry and the world economy. Its background and furthermore its impact on other sectors of the financial markets and the broader financial industry when ultimately spilling over to other economies causing a global recession, are in the focus.

2.1.

The Causes of the Subprime Credit Crisis

The reasons for this crisis are varied and complex. The crisis can be attributed to a number of factors which emerged over several years and which were pervasive in both, the housing and the credit markets. This includes the inability of homeowners to make their mortgage payments, primarily due to risky mortgage products. Other reasons were, e.g. overstrained lenders and speculation as well as overbuilding during the boom period. High personal and corporate debt levels, financial products that distributed and concealed the risk of mortgage default also played a role. Finally monetary policy, international trade imbalances and government regulation, or the lack thereof, also fuelled the crisis.5 Further major catalysts of the subprime

4 Cf.|Federal Deposit Insurance Corporation, Failed Bank List, 2009. http://www.fdic.gov/bank/individual/failed/banklist.html (retrieved on 24 July 2009). 5 Cf.|J.E. Stiglitz, Commentary: How to prevent the next Wall Street crisis, 2008, http://edition.cnn.com/2008/ POLITICS/09/17/stiglitz.crisis/index.html (retrieved on 19 March 2009).

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| Bernd Sagemann & Peter Reese

crisis were the influx of huge amounts of money from the private sector, banks entering into the mortgage bond market and predatory lending practices of mortgage brokers, specifically the adjusted rate of mortgage loans.6 Ultimately moral hazard lay at the core of many of the causes.7 The credit crisis can be seen as the consequence of aggressive risk taking by several financial institutions. Banks increased their leverage up to levels indefensible in a severe downturn and thereby funded unsustainable economic growth. The reasons behind this dynamic were several widely held misconceptions: e.g. the strong creditworthiness of borrowers, reliable ratings and investors sophisticated enough to efficiently assess and price the risks of complex financial assets. Another underlying flawed assumption was that prices for houses in one region would be largely uncorrelated to prices of real estate in other regions and therefore the underlying risk could be adeptedly diversified.8 In addition, it was widely believed that rating agencies used the right models and correct assumptions and were able to produce reliable ratings reflecting the true risk of default of the underlying assets. Finally, it was assumed that credit risk was well distributed via innovative financial instruments to thousands of investors all over the world. This bundle of severe delusion and flawed assumptions caused the crisis by misleading regulators and central banks and by providing the wrong incentives to banks and investors. 2.1.1.

Politicians Assisted in Creating the Subprime Monster

Fannie Mae and Freddie Mac are the biggest underwriters of home mortgages in the US. These entities do not lend money directly to consumers but instead, they purchase loans from banks on the so called secondary market. The names of Fannie Mae and Freddie Mac are based on their corporate acronyms; FNMA (Federal National Mortgage Association) and FHLC (Federal Home Loan Corporation). Fannie Mae was founded in 1938, during the Great Depression, when millions of families could not become homeowners or faced losing their homes. In 1968 Fannie Mae was partially privatized, and in 1970 Freddie Mac was created as a wholly pri6 Cf.|Senator C. Dodd, Create, Sustain, Preserve, and Protect the American Dream of Home Ownership, 2007, http://dodd.senate.gov/?q=node/3731 (retrieved on 5 March 2009). 7 Cf. B. Brown, Uncle Sam as sugar daddy: The moral Hazard problem must not be ignored, 2008, http://www.marketwatch.com/story/moral-hazard-uncle-sam-as-sugar-daddy (retrieved on 24 July 2009). 8 Cf. R.J. Shiller, The Subprime Solution: How Today’s Global Financial Crisis Happened, and What to Do about It, 2008, pp. 34-38.

The Great Subprime Credit Crisis and its Impact on Eastern Europe |

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vate company to improve competition. Since then, both are privately owned by shareholders but regulated by the US Congress. They are also often referred to as Government Sponsored Enterprises (GSEs), due to the fact that they have been created to serve a public aim and are exempt from state and local taxes. In addition their securities generally benefit from a state guarantee. Therefore the GSEs are able to borrow money more cheaply than other banks. The state guarantee plus the tax advantage are an indirect federal subsidy. This advantage is estimated to be worth about 6.5 billion USD p.a. In return, the GSEs were expected to serve ‘public purposes’, including helping to make home buying more affordable. For many years there was significant political influence on this two major US mortgage banks to provide cheap refinancing of mortgages to other banks by purchasing so-called ‘affordable loans’ to the lower middle class. By expanding the type of loans they would buy, both were hoping to spur banks to provide more loans to people with less-than-stellar credit ratings. In 1992 – under the Clinton Administration – the Department of Housing and Urban Development (HUD) became the responsible regulator of Fannie Mae and Freddie Mac. The Clinton Administration had a clear political agenda to put more low-income and minority families into their own homes. In 1995 the HUD agreed to let Fannie Mae and Freddie Mac purchase affordable-housing credit which included loans to low-income borrowers. The idea was that this would spur granting of loans and increased lending would benefit many borrowers who did not qualify for conventional loans. The agency therefore required Fannie Mae and Freddie Mac to purchase far more ‘affordable loans’ made to these borrowers. Since then the GSEs have been supposed to buy a certain portion of ‘affordable’ mortgages each year made to underserved borrowers. In the 1990s the GSEs had already expanded homeownership for millions of families by reducing the requirements for down-payments. Nevertheless, in 1999 Fanny Mae was facing increasing pressure from the Clinton Administration to further expand mortgage lending to low- and moderate-income people and felt pressure from stockholders to maintain its phenomenal profit growth. For example, the HUD requested that by 2001 50% of the GSEs portfolio should be made up of loans to low and moderate-income borrowers. At the same time HUD was investigating allegations of racial discrimination in the automated underwriting systems used by the GSEs to determine the credit-worthiness of credit applicants. In addition, banks, thrift institutions and mortgage companies had been pressing Fannie Mae to help them grant more loans to subprime borrowers, whose incomes, credit ratings and savings were not good enough to qualify for conventional loans.

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| Bernd Sagemann & Peter Reese

This group of borrowers could only get loans from finance companies that charge much higher interest rates (premiums ranged from 3% to 4%). To continuously increasing homeownership rates among minorities and low income consumers Fannie Mae finally announced that it will further ease the credit requirements on loans purchased from banks and other lenders. The program included 24 banks in 15 regions and was intended to encourage the institutions to extend home mortgages to individuals whose credit would generally not be good enough to qualify for a conventional mortgage loan.9 For years the HUD stuck with an outdated policy allowing Freddie Mac and Fannie Mae to count billions of US-Dollars they invested in subprime loans as a public good that would foster affordable housing and which could be repackaged and refinanced based on public guarantees. Only every four years, HUD reviews the goals set to the GSEs to adapt them to market changes and neglects to examine whether borrowers could make the payments on the loans that Freddie and Fannie classified as affordable. From 2004 to 2006, the two GSEs purchased securities backed by subprime loans worth|434|billion USD, creating a market for more such lending.10 Through creating a secondary market for housing loans by purchasing mortgage loans from other banks or mortgage brokers, these banks provide loan originating institutions with ‘fresh money’ to make new loans and to dispose of the credit risk connected to the loans sold. The GSEs then repackage these loans as MBS, stamp them with a government guarantee and sell them to investors. In effect, they are acting as a bridge between mortgage lenders and capital market investors. Since the government guarantee assures that interest and principal will be paid – whether or not the original borrower pays – investors considered MBS from Fannie Mae and Freddie Mac as ‘safe’ investments comparable to treasury bonds. Because the GSEs partly passed their funding advantage on to the institutions that originated the loans, these parties could offer housing loans at very low rates. Almost all US mortgage lenders, from huge financial institutions like Citigroup or BoA to small, local banks, rely on the GSEs for low-cost funding for their mortgage business. The two GSEs are giants in the US housing system and used to guarantee or own roughly half of the about 12|trillion|USD US mortgage loan market. Today with 5.3|trillion USD in outstanding debts, Fannie Mae and Freddie Mac are financing approximately 40% of all US mortgages. 9 Cf.|S.A. Holmes, Fannie Mae Eases Credit To Aid Mortgage Lending, in: New York Times, 1999, p.|C2. 10 Cf.|C.D. Leonnig, How HUD Mortgage Policy Fed The Crisis: Subprime Loans Labeled, Afforable, in: Washington Post, 2008, p. A01.

The Great Subprime Credit Crisis and its Impact on Eastern Europe |

27

2.1.2.

Central Banks Fuelled the Crisis

Alan Greenspan was chairman of the United States Federal Reserve Board of Governors (FED) from 1987 to 2006. In his 18 years at the helm of the world’s most important central bank he became famous for fighting economic downturns and financial crises always with the same recipe: in the face of a crisis he sharply lowered the interest rates and as a result the monetary supply was overabundant. In addition to the political assistance via the GSEs the FED fuelled the real estate bubble, too. By keeping interest rates at or close to historically low levels the FED tried to support economic growth after the downturn that followed the burst of the internet bubble and after 11 September 2001. Probably one of the biggest misconceptions was that Alan Greenspan believed innovation and globalization were enhancing productivity and competition in a way that would be sufficient to permanently curb inflation for the next several years. Therefore the FED’s interest rate policy could be focussed more on economic growth by keeping interest rates at low levels for long periods without generating inflation or even expectations of inflation. As a result of this assumption it was widely believed that in the case that growth slowed down central banks could be expected to cut interest rates, encouraging more spending through more borrowing and hence spur growth. This role of the central demand manager has become part of what central banks are expected to do in a downturn. This role has been accepted by different central banks to a varying degree. The European Central Bank (ECB) still seems to be more reluctant to unilaterally support growth while neglecting the extension of monetary supply aggregates. The ECB at least partly seems to still follow the tradition of the Deutsche Bundesbank, which was renowned for its strict control of monetary supply. In the US the FED appeared to be less scrupulous about accepting the role of the national demand manager.11 Over his nearly two decades of incumbency at FED, Alan Greenspan always cut interest rates and expanded the monetary supply whenever a severe financial crisis (i.e. the stock market crash of October 1987, the Asian crisis or the combined internet and 9/11 crisis) was happening. Generally prices of financial assets are not normally distributed and extremely large changes occur much more often (and are followed more often by more extremely large changes in the same direction) than theory suggests. Modern capi11 Cf.|G. Cooper, The Origin of Financial Crises – Central Banks, Credit Bubbles and the Efficient Market Fallacy, 2008, p. 79.

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tal markets theory is based on the assumption that markets are efficient and prices follow a random path so that movements (returns) tend to be normally distributed. In the real world price distributions are showing much more extreme events or ‘fat tails’.12 Therefore, a deep recession or even depression could be expected to happen even much more often. Thanks to Greenspan’s standard policy of cutting rates and flooding the markets, all these crises did not develop into any long lasting economic disaster. Market participants learned this lesson well and were more and more relying on what has become known as the ‘Greenspan put’.13 In the aftermath of the dotcom-crash and 9/11 the FED not only tolerated the massive over-supply of cheap mortgage loans to home buyers. The FED even approved that homeowners could often use the cheap mortgages not only to buy a family home but to leverage-up their existing house and extract the equity to fund consumption – or invest in additional real estate and speculate on further price increases. This was regarded as an effective tool to stimulate the growth of the US economy, which is largely dependent on consumption.14 The FED was certainly aware of the existence of asset bubbles (i.e. in 1996 when Alan Greenspan questioned if there is ‘irrational exuberance’ in stock prices).15 Nevertheless, Greenspan was convinced that asset price bubbles would not seriously harm the long-term stability of the economic development or the financial system as a whole. Alan Greenspan claimed that “ […] we were not facing a bubble but froth – lots of small local bubbles that never grew to a scale that could threaten the health of the economy […]”.16 His successor, Ben Bernanke, was certainly also aware of the real estate bubble. Already in 2005 Bernanke commented that

12 Cf. D. Satyajit, Traders Guns & Money: Knowns and unknowns in the dazzling world of derivatives, 2006, p.|163. 13 Cf. N. Ferguson, The Ascent of Money: A Financial History of the World, 2008, pp. 164-169. 14 Cf. Alan Greenspan, Remarks by Chairman Alan Greenspan. At the annual convention of the Independent Community Bankers of America. 2003, http://www.federalreserve.gov/newsevents/speech/ 2003speech.htm (retrieved on 3 March 2009). 15 Cf. Alan Greenspan, The Age of Turbulence: Adventures in a New World, 2007, p. 231. 16 Alan Greenspan, The challenge of central banking in a democratic society. Remarks at the Annual Dinner and Francis Boyer Lecture of the American Enterprise Institute for Public Policy Research, 1996, http://www.federalreserve.gov/boarddocs/speeches/19961205.htm (retrieved on 5 March 2009).

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“ […] house prices have risen by nearly 25% over the past two years. Although speculative activity has increased in some areas, at a national level these price increases largely reflect strong economic fundamentals […]”.17 The belief that asset bubbles do not affect the long-term economic development may be based on the strong conviction of the FED, that over time asset prices are mean reverting in nature and do not create serious inflation. This may explain why the FED focuses on ‘core inflation’ instead of a wider definition of inflation when measuring the development of the Consumer Prices Index (CPI).18 The availability of cheap debt alone should normally not lead to a housing bubble of this magnitude. For a long time Americans have been buying houses with borrowed money. It is therefore hard to see why anybody should have believed that basic principles of borrowing had been repealed. From long experience home buyers, mortgage banks and investors should have known that home buyers shouldn’t take on mortgages whose payments they could not afford, and that enough money should be put down to be able to sustain a moderate drop in home-prices while still having positive equity on hand. Low interest rates should have reduced the mortgage payments but not the amount of equity, a homebuyer has to invest when asking for a mortgage.19 The reason for the crisis was a complete negligence of the traditional principles in the credit business. To some extent this was driven by the irrational exuberance of many individuals who saw house prices rising ever higher and decided that they should jump into the market and should not worry about how to cover the debt service. This attitude was mainly driven by the change in lending practice: home buyers were offered loans which required little or no down-payment and with monthly repayments that often were well beyond their ability to afford or would become unaffordable once an initial low teaser interest rate would reset. Much of this dubious lending was labelled ‘subprime’ but the phenomenon was much broader 17 Ben S. Bernanke, The Economic Outlook, 20 October 2005, http://www.whitehouse.gov/ cea/econoutlook 0051020.html (retrieved on 5 March 2009). 18 The concept of core inflation tries to measure only inflation that is not peripheral. This theory assumes that in particular food and fuel prices are peripheral as they are supposed to be mean-reverting, implying that these prices may go up in the short run but would tend to revert to equilibrium over the medium term. What matters are only prices of other products that will not tend to asymptotically move back towards a hypothetical normal but would tend to be sticky in the downward direction and hence all increases could be taken to be of a permanent nature. 19 Cf. P. Krugman, The return of depression economics and the crisis of 2008, 2009, p. 148.

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than that – it reached into the market for the Alt-A loans and even into the prime market. The problem wasn’t restricted to low-income or minority home buyers, many other borrowers were also taking on more debt then they could handle. So why did lenders relax the credit standards? One reason was the state-guaranteed refinancing provided by the GSEs, which – under pressure from politicians – refinanced and took over ever riskier loans from the banks originating the loans. To get rid of the exposure they basically invented the securitisation industry already back in the 1930s. Later, this business model was copied by investment banks. The reinforced competition further accelerated the growth of the credit bubble. Another motivation was that many lenders started to believe in this Ponzischeme of ever rising home prices. As long as home prices only went up, it didn’t matter much from a lenders point if a borrower could honour his or her payments. If the debt service is too high the borrower could take out a home-equity-loan to get more cash or just sell the home and pay-off the mortgage plus the interest due. As further incitement lenders did not worry about the quality of the loan any more because these were not put on their balance sheet. Instead they were sold to investors, who lacked the information and knowledge to understand what kind of credit quality they were buying. Investors rather relied on ratings, state guarantees or other kind of credit insurance. 2.1.3.

The Necessary Toolset

The invention and proliferation of a new form of innovative financial instruments, so-called ‘credit derivatives, provided the necessary toolset for building up the subprime credit bubble. Credit derivatives, which were developed in the 1990s, experienced a subsequent colossal growth. In only ten years the total market for credit derivatives grew on average by 80.2% p.a. from 180 billion USD in 1996 to 20.2 trillion USD in 2006. Credit Default Swaps (CDS) – which were originally intended to insure and transfer credit risk – account for 30% to 50% of all traded credit derivative contracts. This market exploded from an underlying notional amount of still less than|500|billion USD in 2000 to about 6.6 trillion USD in 2006.20

20 Cf. R. Barrett / J. Ewan, BBA Credit Derivatives Report, British Bankers Association, 2006, n.p. http://www.bba. org.uk/bba/jsp/polopoly.jsp?d=341&a=7673&view=purchase (retrieved on 10 March 2009).

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This growth is expected to go on. It is not just the size of the market that has continued to grow but also the diversity of products. Among others the expansion of index trades, and equity-linked products have created an unprecedented variety of traded products in the credit derivatives market. The ‘Times’ estimated that the nominal volume of all traded credit derivatives would reach| 62|trillion USD in 2008.21 By comparison the global GDP for 2008 is also forecasted to reach|62 trillion USD. To understand the factors for the subprime crises it is vital to figure out how these instruments work and how these have been used by the banks to transfer risk and synthetically leverage-up on- and off-balance sheet. Credit derivatives are defined as a class of derivative financial contracts whose value derives from the credit risk of an underlying bond, loan or other financial assets. In this way, the credit risk is with an underlying entity other than the counterparties to the transaction itself.22 The underlying entity is known as the ‘reference entity’. This reference entity may be a corporate, a sovereign or any other form of legal entity which has incurred debt. Credit derivatives are bilateral contracts between the protection buyer and protection seller (investor). Under a derivative contract the seller sells protection against the credit risk of the reference entity and receives a credit margin (‘premium’) from the buyer. The main market participants are banks, hedge funds, insurance companies, pension funds and corporations. Credit default products are the most commonly traded credit derivative products. Under these contracts the parties will define one or more credit events that trigger a payment from the investor to the protection buyer. The credit event is usually triggered when the reference entity goes into bankruptcy, fails to pay or defaults on any of its obligations (such as a bond or loan), faces an acceleration such as an obligation that is declared immediately due and payable following a default, faces a moratorium over its obligations or has to restructure its obligations. In contrast to standardized exchange traded derivatives, contracts where the parties assume credit exposure to a clearing house as the central counterparty, credit derivative contracts are highly customized and traded directly between 21 Cf. P. Hosking / M. Costello / M. Leroux, Dow dives as Federal Reserve lines up $75bn emergency loan for AIG, in: The Times, 2008, p. 4. 22 Cf. D. Satyajit, Credit Derivatives: CDOs and Structured Credit Products, 2005, p. 6.

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two interested parties. Therefore the parties to the contract are exposed to each others default risk. This type of bilateral contract is also referred to as over-thecounter (OTC-)|contract. There is no standardized exchange traded contract and no clearinghouse for credit derivatives at the moment. All contracts are traded OTC but normally the counterparties benefit from individually negotiated collateral and margin call agreements that help to reduce their counterparty risk. Given the fast growing volume of the credit derivatives market, the size of the associated counterparty exposure clearly has the potential to destroy the financial system. The counterparty-risk has become the Achilles heel of today’s financial markets. Insurance is worth nothing if the insurer cannot pay up. The huge involvement of large investment banks or of some insurance companies (e.g. AIG or a monoline insurer) in the credit-derivatives market is the main reason why there is such a public interest to bail them out. A fast and uncontrolled default of one of these counterparties could be sufficient to destabilize the whole financial system. The ultimate proof of this hypothesis was the default of Lehman Brothers on 15 September 2008. Lehman’s bankruptcy caused derangement in the markets because all its innumerable counterparties struggled to calculate their risk exposure and to cover their positions in the market again. This massive re-hedging of positions created huge price distortions, significantly increased the existing uncertainty in the markets and further contributed to illiquidity. Today, there are several initiatives supported by regulatory bodies to create transparent and regulated markets and clearinghouse solutions for the most commonly traded credit derivatives. Regulators have sought to establish a comprehensive clearinghouse solution for credit derivatives since 2004. These efforts took on new urgency during 2008’s financial turmoil and especially after the default of Lehman Brothers, after which several major banks disclosed that they had several thousand OTC credit derivative contracts with Lehman and suffered significant losses while trying to close out the underlying risk position or to find a new counterparty.23 Credit derivatives are fundamentally divided into two categories: funded credit derivatives as CDOs and unfunded credit derivatives such as CDS.24 23 Recognizing the huge business opportunity several leading derivatives exchanges and clearinghouses are about to fierce competition to establish a trading and clearing platform for standardized credit derivatives contracts based on the most commonly traded underlying reference entities. Atlanta-based Intercontinental Exchange (ICE) created, via its ICE Clear Europe unit, a European-regulated central counterparty for CDS transactions. NYSE Euronext and LCH. Clearnet as well as LSE, Eurex and others are also working hard to get into the market. 24 Cf. R. Barrett / J. Ewan, BBA Credit Derivatives Report, British Bankers Association, 2006, n.p., http://www.bba. org.uk/bba/jsp/polopoly.jsp?d=341&a=7673&view=purchase (retrieved on 10 March 2009).

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An unfunded credit derivative is a bilateral contract between two counterparties, where each party is responsible for making its payments under the contract itself without recourse to other assets, i.e. credit spreads and payments of cash or physical settlement amounts. The seller is not obliged to make any upfront payment to provide collateral or fund an underlying bond, loan, loan-portfolio or credit index. Under an unfunded credit derivative, the protection seller is only obliged to make a payment if the credit event occurs or other conditions to settle the contract are met. If the contract parties fail to stipulate a collateral agreement or margin calls, the buyer has full credit risk on whether the seller will be able to honour its obligation and provide the defined cash or physical settlement amount when the credit event is happening. With the introduction of unfunded products, credit derivatives have separated funding from credit. This has made the credit markets more accessible to players with relatively high funding costs (e.g. hedge funds) and made it cheaper to leverage credit risk.25 The most important unfunded credit derivative product is the single name CDS, which is set up as a bilateral contract that enables an investor to buy protection against the risk of default of a single asset issued by a specified reference entity. Following a defined credit event, the buyer of protection receives a payment intended to compensate the loss of the investment. In return, the protection buyer pays a fee.26 Other unfunded credit derivative products include: Total Return Swap, CDS on Asset Backed Securities (ABS), CDS on portfolios or indices (like the iTraxx index based on a portfolio of single name CDS), Credit Default Swaption, Credit Spread Option, Constant Maturity CDS (CMCDS), First to Default CDS. On the other hand funded credit derivatives are transactions where the credit derivative is fully or partially embedded in a bond or loan structure.27 A funded credit derivative therefore involves the protection seller making an initial payment (i.e. the purchase price of a CDO) which is used to settle any potential credit event. The advantage of this structure for the protection buyer as the seller of the CDO is,

25 Cf. D. O’Kane, Credit Derivatives Explained: Market, Products, and Regulations, 2001, p.|3. http://www.investinginbonds.com/assets/files/LehmanCredDerivs.pdf (10 January 2009). 26 Cf. ibid., p.|25. 27 Cf. Edmund Parker, Credit Derivatives, in: PLCFinance, 2008, p.|4. http://www.mayerbrown.com/london/article.asp?id=4234&nid=1575 (retrieved on 22 March 2009).

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not being exposed to the credit risk of the protection seller. Thereby the counterparty credit risk is to some extent collateralized. At the same time the investor provides the funding for the underlying bond, loan or loan portfolio as well. Funded credit derivative products include the following products: Collateralized Debt Obligation (CDO), Synthetic Collateralized Debt Obligation (Synthetic CDO), Collateralized Debt Obligation squared (CDO2), Credit Linked Note (CLN), Constant Proportion Debt Obligation (CPDO), Synthetic Constant Proportion Portfolio Insurance (Synthetic CPPI). So how did this new breed of derivative instruments foster the subprime crisis? Focusing on a bank which wants to enhance the return on its loan portfolio and free up some balance sheet by securitizing a certain portfolio of mortgage loans. Firstly the bank repackaged the loan-portfolio by selling it to a Special Purpose Vehicle (SPV).28 In a second step the SPV’s loan portfolio was then sliced into tranches of different seniority (first loss tranche, second loss tranche and different CDOs are assigned to each tranche). Finally the different CDO tranches were rated by at least one of the three major rating agencies and sold to yield hungry investors. Interest and principal payments are made in order of seniority. The so-called ‘super senior tranche’ or ‘senior tranche’ used to have a AAA+ or AAA rating and hence were considered to be the safest securities. The (super) senior tranches normally accounted for about 88% to 91% of the SPV’s total liabilities. The senior tranches of a CDO were often at times followed by so-called ‘mezzanine tranches’, which were subordinated to the senior tranches and therefore used to carry a lower but still high investment grade rating such as AA or BBB. Mezzanine tranches typically accounted for 4%-5% of the total financing volume. Finally there were the so-called ‘junior tranches’ or ‘equity tranches’ which were meant to absorb any first losses. Consequently these tranches used to have the lowest or even no-rating and therefore had to offer much higher returns (higher coupon payments or lower prices) to compensate for the significantly higher risk of default. A specific equity tranche would account for only between 3% and 7% of the total liabilities.

28 An SPV is a limited liability company created for the single purpose of holding and refinancing the loans outside the balance sheet.

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With CDOs banks could create massive leverage for investors, or even themselves. A 2% first-loss or equity-tranche of a CDO has a leverage of 50 times compared to the leverage ratios of ten to twelve times of a typical commercial bank.29 Equity tranches used to be bought by hedge funds which are yield avaricious and therefore seek to build-up massive leverage. With the proliferation of credit derivatives and the possibility to securitize and sell loan portfolios investment banks were enabled to provide ever increasing amounts of mortgage loans to homeowners (as well as leveraged loans to corporates or private equity firms) without having to keep the loans on their balance sheet and/|or having to bear the connected credit risk. To extend further loans banks did not need to raise funding via deposits from retail or institutional investors or the inter-bank market any longer. Instead of keeping the loans on their balance sheet they securitized them and sold the newly created financial assets to different investors. The most junior first-loss or equity-tranche was often bought by hedge funds while the AAA rated senior tranches were bought by pension funds and insurance companies. Hence the credit risk of the loan portfolio ultimately ended up with institutional investors or other banks. In this new business model the balance sheet was only needed for the comparatively short time interval from originating the loans until they were sold on. The balance sheets and therefore the minimum equity which was needed to satisfy regulatory requirements decreased while the return on equity was pushed up by the disproportionate high fee income from the securitization and sale of the structured securities (funded credit derivatives). More and more investment banks adapted this lucrative business model and the ‘raw-material’ gradually became a scarce resource. Therefore, banks were easing their own lending standards to generate more mortgage or consumer loans. Investment banks even started to look externally for ‘supply’ and finally found themselves in competition against each other to buy mortgage or consumer loan portfolios of retail banks. In return these retail banks were incentivised to relax their credit standards and started to accept lower credit qualities knowing that they could offload any newly originated credit exposure. Some investment banks even started to take over smaller mortgage or retail banks, to ensure access to further loans that could be securitized.

29 Cf. D. Satyajit, Traders Guns & Money: Knowns and unknowns in the dazzling world of derivatives, 2006, p.|291.

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The invention of ‘synthetic CDOs’ brought the solution to this supply problem. Instead of a portfolio of loans, a synthetic CDO is based on a portfolio of CDS. Therefore, this new instrument allowed banks to synthetically create fixed income assets independent from the underlying demand for or availability of loans. Hence the financial industry was able to meet investors demand for higher yielding fixed income assets. The result was a higher demand for the underlying CDSs which drove the prices for these kinds of credit guarantees down. The result was that CDS spreads were too low and did not properly reflect the inherent default risk of the underlying anymore. In theory, CDS could be created up to an unlimited amount. When selling a synthetic CDO, managers simply entered into even more CDS. This excessive demand for credit risk via CDS puts pressure on the risk premiums in terms of reduced CDS market spreads. After the real risk having become visible in 2007 – due to a wider recognition of the US subprime in the financial markets and effective default of the first CDO tranches – the demand for new CDOs dried up very fast and the secondary market for CDOs became totally illiquid. Thereby an important source of demand for new credit risk trickled away. After all, it is only logical that, with the likelihood of a recession and bond default rates increasing, more investors would rather buy insurance against such events while becoming more and more reluctant to take over additional risks by buying further CDOs (or alternatively by writing more CDS). More importantly, however, a CDS has become the product of choice for those investing in credit as an asset class. Five to ten years ago, the corporate-bond market was a lot less active. In most bonds there was little trading because they were often locked up in the portfolios of pension funds or insurance companies. The invention of the CDS increased the liquidity of the market and, crucially, enabled investors to take a ‘short’ position on a bond issuer. Traditionally, he is likely to buy a corporate bond, e.g. at 95%, and expecting the best to get the interest disbursed and the bond being repaid at par. At worst, the issuer could default and the buyer could be left with nothing. Nowadays, an investor who believes that credit conditions for a particular company will deteriorate has the option to buy a CDS on the bond, whether he owns the bond or not. The value of the CDS will rise if default becomes more likely.

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In this regard, the dominating credit index family iTraxx Europe deserves mentioning, which was created in 2004 by the merger of the DJ TRAC-X Europe 100 and iBoxx Diversified (iBoxx) indices.30 The creation of credit index products like the iTRAXX and the respective derivative contracts on this reference or underlying allows investors to bet on or hedge against the rise or fall of a standardized market portfolio of corporate bonds (or a certain segments of the market such as investment grade or high yield).31 As a result, CDS contracts have become such a useful instrument for hedge funds and trading desks of investment banks that it seems to be inconceivable that they will disappear again. Just as the future on the S&P 500 index is a key part of the equity market, the CDS on the iTRAXX has become central subject to the credit market. During a banking crisis, when the credit risk – on which CDS were written – materializes, many of these unfunded credit derivatives will need to be settled. If the counterparties, who wrote the CDS, cannot perform on their liabilities, this could have severe consequences, meaning after the initial default it is implied that the respective CDS buyers, who bought these instruments to insure against credit events, would be left without insurance and consequently would have to suffer further losses. Such losses could then drive these buyers into bankruptcy as well. The alarming conclusion is that the 62|trillion|USD CDS market might conceivably provide for an even bigger problem to come. Governments, central banks and regulators recognized this tremendous risk and – in order to prevent this from happening – already bailed out several ‘system critical’ large banks and other institutions world wide. One of the most prominent and probably the costliest institution which had to be saved with a total of 144 billion USD of tax-payers money was American International Group (AIG).

30 Cf. ibid. pp. 210-214. 31 iTraxx is the brand name for the family of credit default swap index products covering Europe, Japan and the rest of Asia. They form a large sector of the overall credit derivative markets. The indices are constructed on a set of rules with the overriding criterion, being that of liquidity of the underlying CDS. The iTraxx index family is owned, managed, compiled and published by the International Index Company (IIC), which also licenses market makers. CDS indices allow investors and portfolio managers to invest in or hedge against credit risk in a more efficient manner than by just using groups of single CDSs. They are standardised contracts and referenced to a fixed number of obligors.

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2.1.4.

The Case of AIG

With total assets of more than 1 trillion USD and revenues of 113 billion USD as per 2006, AIG used to be the worlds’ largest insurance company (by assets) and number ten on the Fortune 500 list of the largest US companies. In the 1990s AIG’s Financial Products unit in London entered into the market for credit derivatives. Because the underlying debt securities – mostly corporate issues and some mortgage securities – carried investment grade ratings, AIG was happy to book income in exchange for providing insurance. After all, the management apparently assumed that they would never have to pay any claims. By 2008, AIG had insured 513 billion USD in debt via CDS contracts including 78 billion USD mortgage related CDOs. Industry practice permits firms with very high credit ratings to enter into OTC derivatives contracts with limited or no collateral or margin payments. Since AIG itself used to be a highly rated company, it did not have to post collateral to its CDS counterparties. This made the contracts all the more profitable.32 On 16 September 2008, AIG suffered a serious liquidity crisis following the downgrade of its credit rating by at least two notches by the three top global rating agencies, who at the same time warned that more downgrades could follow. Moody’s Investors Service cut AIG’s rating from Aa3 to A2, a two-notch downgrade. Standard & Poor’s Ratings Services even lowered the rating to A-minus from AA-minus, a three notch reduction while Fitch Ratings reduced its credit standing also by two notches from AA-minus to A. This triple strike hit the insurer in a situation when it was struggling to find new sources of funding at a time of global financial turmoil which has brought two of the biggest investment banks to their knees. After this rigorous downgrade of its creditworthiness the company was contractually obliged to provide collateral to its trading counterparties, which led to a severe liquidity crisis. The London unit of AIG sold credit protection by writing CDS on CDOs that had declined in value. To prevent the company from collapsing, and in order for AIG to meet its obligations to post additional collateral to CDS trading partners, the FED announced the creation of a secured credit facility of up to 85 billion USD. The credit facility was secured by the assets of AIG subsidiaries. In addition the FED received warrants for a 79.9% equity stake and the right to suspend dividends to all

32 Cf. G. Morgensen, Behind Insurer’s Crisis, Blind Eye to a Web of Risk, in: New York Times, 2008, p.|A1.

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common and preferred stock previously issued.33 This heavily diluted AIG’s stockholders and the share prices of AIG’s common stock fell by more than 95% to just 1.25 USD. On the same day, AIG announced that its board accepted the terms of the Federal Reserve Bank’s rescue package and secured credit facility. This was the first step to what would become the largest government bailout of a private company in US history, though at the time still smaller than the bailout of Fannie Mae and Freddie Mac for 100 billion USD each a week earlier. AIG reported over 13.2 billion USD in losses in the first six months of 2008.34 The Financial Products division, headed by Joseph Cassano, had entered into credit default swaps to insure 441 billion USD worth of securities originally rated AAA. Of those securities, 57.8 billion USD had been structured debt securities backed by subprime loans. CNN named Cassano as one of the ‘ten most wanted culprits’ of the 2008 financial collapse in the US. When Lehman Brothers suffered a major decline in share price, investors began comparing the types of securities held by AIG and Lehman, and found out that AIG had valued its Alt-A and subprime mortgage-backed securities at 1.7 to 2 times the rates used by Lehman. On 14 September 2008, AIG announced it was considering selling its aircraft leasing division, International Lease Finance Corporation, in an effort to raise necessary capital for the company. The Federal Reserve engaged Morgan Stanley to determine, if there are systemic risks to a failing of AIG, and asked private entities to supply short-term bridge loans to the company. In the meantime, New York regulators have approved AIG for 20 billion USD in borrowing from its subsidiaries. On 16 September 2008, AIG’s stock dropped 60% at the market’s opening. The Federal Reserve continued to meet that day with major Wall Street investment firms to broker a deal to create a 75 billion USD line of credit to the company. Rating agencies Moody’s and Standard and Poor’s downgraded their credit ratings on AIG’s credit to concerns over continuing losses on MBS, forcing the company

33 Cf. FED, Federal Reserve Board, met with full support of the Treasury Department, authorities the Federal Reserve Bank of New York to lend up to USD 85|billion to the American International Group (AIG), 16 September 2008. http://www.federalreserve.gov/newsevents/press/other/20080 916a.htm (retrieved on 5 March 2009). 34 Cf. M.J. De La Merced / G. Morgensen, in: New York Times, 2008, p.|C1.

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to deliver collateral of over 10 billion USD to certain creditors. The ‘New York Times’ later reported the break-up of talks on Wall Street and AIG had to file for bankruptcy protection on Wednesday, 17 September 2008.35 Finally, on 22 October 2008, those creditors of Lehman Brothers, who bought credit default swaps from AIG as a hedge against an event of default of Lehman, settled those accounts. The net payments, amounted to only 5.2 billion USD, even though initial estimates of the amount of the settlement were between 100 billion USD and 400 billion USD. During December 2008, AIG paid| 18.7|billion USD to various financial institutions, including Goldmann Sachs and Société Général to retire obligations related to CDS. As much as 53.5 billion USD related to swap payouts are part of the bailout. Three months later, on 15 March 2009, under mounting pressure from Congress and after consultation with the Federal Reserve, AIG disclosed a list of major recipients of collateral postings and payments under CDS, guaranteed investment plans, and securities lending agreements. The total sum of these payments between 16 September and the end of 2008 was 107 billion USD which were entirely raised by the US tax payer. The major recipients of AIG’s collateral and insurance payments were large investment banks like Société Générale (11.9 billion USD), Goldman Sachs (12.9|billion USD), Deutsche Bank (11.8|billion USD), UBS (4.2|billion|USD) and Barclays (7.0|billion|USD). 2.1.5.

The Monolines

What US government guarantees are to the GSEs mortgage bonds, monoliner insurance companies are to CDOs. Monoline insurance companies are also referred to as ‘monoliner insurance’ or simply ‘monolines’ because they provide only one product, a guarantee. In contrast to protection via a CDS contract, where the protection seller receives a regular credit spread, monoline insurance of a bond issue is purchased through a one-time payment of an up-front premium. Not all bond issues qualify for insurance. Each insurer has its own credit criteria, although the categories reviewed are essentially the same as those used by the rating agencies. Issuers that meet certain credit criteria can purchase bond insurance policies from monolines. The insurance guarantees the payment of principal and interest in case an issuer defaults. 35 Cf. M.M. Grynbaum, A.I.G. Allowed to Borrow Money From Subsidiaries, in: New York Times, 2008, p. C8.

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Bond ratings are based on the credit of the insurer rather than the underlying credit of the issuer. A municipal bond insurance policy is intended to result in significant interest cost savings, depending on the issuer’s underlying credit and market conditions at the time of the bond sale. Interest cost savings are attributable to a higher bond rating – and hence lower credit spreads – as well as enhanced liquidity for insured bonds. Insurance regulations prevent property/casualty insurance companies, life insurance companies, and multiline insurance companies from offering financial guarantee insurance. The monoline industry claims that it has the advantage of a sole focus on capital markets.36 When the very first AAA monoline insurance, the American Municipal Bond Assurance Corporation (AMBAC), was founded in 1971 it was created to exclusively insure municipal bonds. From 1971 to 2007 the number of insured bond issues grew astronomically. In 1980, only 3% of all municipal bond issues were insured compared to approximately 60% in 2007. An estimated 2.5 trillion USD of such bonds are presently outstanding of which more than half are insured. With growing popularity of insurance, the number of insurers increased also. AMBAC was joined by several other triple-A rated insurers. In addition, insurance companies with lower ratings entered the market and offered to provide insurance for bonds that were too small, unusual or had credit conditions that did not meet the risk criteria of AAA insurers. Over time, due to the growing competition and because growth prospects and fees were attractive, many of the often privately held municipal bond insurers started to insure mortgage bonds and later also structured bonds such as CDOs as well.37 At the beginning of 2007, the credit ratings of the monolines came under review because they had too much exposure to bonds which were backed by subprime mortgages and were starting to suffer from higher default rates then it had been expected. This exposure threatened the claims paying ability of the monolines and ultimately resulted in rating downgrades. In 2007, there were seven insurers rated triple-A by Moody’s, Standard & Poor’s and Fitch. On 21 November 2008, Moody’s downgraded the ratings of the last two triple-A rated monolines, Assured Guaranty Corp and Financial Security Assurance Inc. In an effort to regain its public municipal bond business, on 18 February 2009, MBIA Insurance Corp. (MBIA Corp) 36 Cf. AFGI (o.J.), Advantages of the Monoline Structure, http://www.afgi.org/monoline.htm (retrieved on 5 March 2009). 37 Cf. N.N., A monoline meltdown? – A hedge fund stalks subprime’s next potential victim, in: The Economist, 2007, http://www.economist.com/finance/displaystory.cfm?story_id=9552987 (retrieved on 5 March 2010).

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split the company in two. Going forward all of its public insurance business is under its subsidiary MBIA Insurance Corp of Illinois which the company expects to rename National Public Financial Guarantee Corp. MBIA Corp. Therefore, by 2009 from the originally seven monoline companies there was not a single one left being triple-A rated. Many pension funds, insurance companies or other institutional investors are prohibited from investing into overly risky products by either internal rules (i.e. their association of incorporation) or by external laws and regulations. Often these investors are completely barred from investing into assets with a rating lower than single-A or BBB. Sometimes their maximum possible investment in lower rated assets is limited to a small percentage of their total portfolio. The potential to achieve a higher rating via an embedded credit guarantee from a monoline insurer or via a CDS contract written by AIG, a hedge fund or any other protection seller, increased the number of eligible investors. It may therefore be concluded that without the misperception about CDO ratings being true and reliable, the demand for such funded credit derivatives (now often referred to as ‘toxic waste’) would have been significantly lower and hence the astronomical growth of the market for CDOs would have been less explosive. 2.1.6.

The Low Interest Rate Environment and the Demand for Higher Yield

The low interest rate environment and the related over-supply of liquidity inflated several asset values and as a result the return of these assets fell to often historically lows. In such an environment different types of institutional investors got more and more desperate to generate higher returns. Managers of institutional and retail funds as well as hedge funds are under constant pressure to out-perform their respective benchmarks because they are operating in an industry dominated by economies of scale which forces all players to grow in size, seek to survive as a niche-player or ultimately leave the market. Hence asset managers are generally facing stiff competition to retain old and win new clients and to generate more and more assets under management. In the absence of any other transparent quality measure the relative out-performance of a respective fund therefore serves as the key marketing argument to attract new money. This pressure could be an incentive for fund managers to implement more risky investment strategies than the fund would otherwise pursue.

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Another reason is that many asset managers, especially hedge funds, are not only rewarded based on a fixed fee or a percentage of total assets. In addition they often claim a performance related fee that has to be paid on the out-performance over a certain minimum defined return. This mechanism naturally incentivises the asset manager to enter into excessively risky investments because in an up-side scenario the investor has to share the potentially huge out-performance with the manager while in a down-side scenario any losses are exclusively borne by the investor. Besides another type of investor is the life insurance and pension fund industry. These institutional financiers often have contractual commitments to deliver a guaranteed minimum return to their clients every year. Insurance companies and pension funds are usually investing in very liquid and very safe AAA-rated securities with long maturities like government bonds or covered bonds. Investments in lower rated asset classes, like investment grade corporate bonds or even high-yield bonds or equity, are normally restricted by law to a small percentage of the total portfolio and monitored by a regulator. In an environment of sustained low interest rates it may not be possible to generate the guaranteed annual yield any longer. Thus, the investment managers are under pressure to find well-rated investments which match the strict investment criteria but deliver a higher return than the traditionally available investment opportunities. In a low interest rate environment, investments in well rated, structured credit products like MBS or CDOs often provided a welcome remedy. It goes without saying that scale economies and the pressure to show better returns than the competitors also applied to the life insurances and pension fund industry. As a result insurance companies and pension funds have been major investors in mortgage backed structured credit. Furthermore, banks which have a limited international presence have to be named as a third type of CDO investors. These banks invest via credit derivatives into foreign credit portfolios to diversify their loan portfolio geographically while at the same time seeking to accelerate their balance sheet growth outside their limited geographic presence (i.e. banks from Ireland or Iceland). Other banks were lacking growth opportunities because they disposed only of a limited business model (i.e. the German Landesbanks or IKB). Due to competitive pressure or because management had the wrong incentive scheme, they were seeking to enhance their return on equity by investing directly into structured credit instruments or they were trying to add further leverage via so called Special Investment Vehicles (SIVs). The

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SIVs were held outside the balance-sheet so the amount of equity that the banks needed to contribute was minimized which allowed for much higher leverage than regulators would have allowed on balance sheet.38 2.1.7.

The Need to Deleverage

The credit crunch took place against a backdrop of the long-term rise in consumer indebtedness in the US. For years, US consumers have been living beyond their means. Between 1972 and 2008, US consumer indebtedness, as a share of GDP, grew from 60% to 120%. Even when one excludes mortgage debt, US consumers carry more than 2.5 trillion USD in consumer credit – up more than 50% from 1.6|trillion USD in 2000. Indeed, the explosion in mortgage lending was, in part, driven by consumers using the boom in housing prices to take on more debt in order to fuel further consumption, based on the theory that still higher prices later would pay for money borrowed today. The wide availability of cheap debt was a key factor fuelling the growth of the US economy, and, to the degree that the US economy has been an engine of global economic expansion, the growth of the world economy as well. US household consumption accounts for an unusually high – and unsustainable – 70% of US GDP. As a consequence, the savings rate of US households, barely above zero, has reached the lowest level since the Great Depression during these times. But, of course, it is not just consumer debt that has driven the growth of the US economy. Between 2000 and 2007, corporate and government debt also increased, causing total US debt to climb from 250% to 350% of GDP.39 Financial institutions used debt to boost returns.40 In parallel, outstanding debt of the total US financial sector grew from 10 trillion|USD in 2002 to 16|trillion|USD in 2007. Corporations used debt to fund global expansion. And, of course, the federal government increased its debt to increase spending while keeping taxes low. But debt cannot grow faster than income forever. The days of such extreme debtfuelled expansion in the US economy by leveraging households and financial institutions are definitively over. In the last years, both consumers and financial institutions need to deleverage. The only way to prevent this is a reallocation of leverage 38 Cf. P. Gumble, Subprime on the Rhine, in: Fortune, 2007, pp. 45-48. 39 By contrast, in the 30 years between 1950 and 1980, total US debt stayed between 125% and 155% of GDP. 40 The top five US investment banks, for example, increased their leverage from 21 times to 30 times between 2000 and 2007 in order to compensate for a sharp fall in their return on assets; this increase in leverage allowed them to boost their total asset base from 1.5 trillion USD to 4.3 trillion USD.

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to the state. This is exactly what happened during the years of crisis in the US as well as worldwide to governments – bailing out banks and other large and allegedly ‘system’ critical companies with guarantees and direct equity injections, thereby assuming their debt and transferring leverage to the public households. In addition, it could be seen that the central banks are buying corporate bonds and treasury bonds, funding the ongoing global public deficit spending initiative. The question is: who will help to deleverage the public households? The answer will most likely be ‘inflation and taxes’. 2.1.8.

The Fiction of the Strong US Borrower and Predatory Lending Practices

At least on the surface the fiction of having strong borrowers was perhaps the most reasonable of the several flawed assumptions that formed the basis for the subprime credit crisis. For years, credit losses had been (relatively) limited, so borrower creditworthiness did indeed appear to be strong. However, there has been a dangerous circularity to this logic. Lender and investor perception of healthy homeowner credits have driven spreads lower, causing marginal borrowers to appear to be more financially attractive than, in fact, they were. Thus, making it easier to justify providing them financing. This situation was further fuelled by the belief that financially constrained borrowers would be covered by ever-rising home prices via home equity release products. The unintended result was highly imprudent lending of subprime loans to people who could not afford the homes they were buying. Subprime loans are targeted towards borrowers with poor credit quality and generally carry a higher interest rate than conventional loans. Unfair, deceptive or fraudulent practices of some lenders or mortgage brokers during the loan origination process (‘predatory lending’) also played an important role in the development of the housing bubble. For example, certain loan products such as the Adjustable Rate Mortgage (ARM) have been structured and sold with teaser rates. For an ARM, as a mortgage loan, the interest rate on the note is periodically adjusted based on a variety of indices. Among the most common indices are the rates on one-year Constant-Maturity Treasury (CMT) securities or the London Interbank Offered Rate (LIBOR). Consequently, payments made by the borrower may change over time with the varying interest rate or alternatively, the term of the loan may change. For the borrower, adjustable rate mortgages may be less expensive, but at the price of bearing higher risk. In order to attract potential borrowers it was quite common to sell ARMs with ‘teaser periods’. These are relatively

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short initial fixed-rate periods (typically up to one year) when the ARM bears an interest rate that is substantially below the ‘fully indexed’ market rate. In some cases, the teaser rate was even 0%. The low teaser rate predisposes an ARM to sustain above-average payment increases later. Teaser rates are ‘Trojan horses’ as they aim to induce borrowers to view the cost of an ARM as being cheaper than it really is. After its expiration, the teaser rate is ‘reset’ and increased to a rate which normally is much higher than the prevailing market rate. Especially less educated low-income borrowers are often attracted by this kind of loan product and found out that they were unable to keep up with their payments only once the rate was reset. Another feature of the subprime and Alt-A loan market, which accounted for about 21% of loans outstanding and 39% of the mortgages issued in 2006, were the ‘stated income loans’. These loans were provided to home buyers without verification of their income, as they tend to overstate their income in order to obtain the desired loan amount and be able to purchase their dream-home. These products have also become known as ‘liar’s loans’. With the bursting of the housing bubble, the problem became visible for all. In 2008 US housing prices had fallen about 19%, not yet bringing the market back to long-term historic price levels. In late 2006, default rates on subprime loans were only 1%; a year later, they were at 10%. Meanwhile, Moody’s estimated that between 2004 and 2007 US banks made about 15|million high-risk mortgage loans and that a full two-thirds would ultimately end up in default. 2.1.9.

The Rating Agencies Were Driving through the Rear-view Mirror

The rating agencies played a critical role in the subprime industry. They certified that a certain mortgage backed structured security (i.e. a MBS or CDO tranche) which was based on a portfolio of repackaged mortgage loans, has a specific rating. For over a century, the oligopoly of the three large rating agencies Moody’s, Standard and Poor’s and Fitch have gathered and analyzed a wide range of financial, industry, and economic information to arrive at independent assessments on the creditworthiness of various entities, giving rise to the now widely popular rating scales.41 Until recently, the agencies focused the majority of their business on single-name securities (bond issues were the credit risk can be ascribed to a 41 i.e. investment grade ratings like AAA, AA, A, BBB followed by lower rating classes like BB, B, CCC, CC, C being called non-investment grade.

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single underlying borrower or reference entity). In recent years, the business model of credit rating agencies has expanded beyond their historical role to include the nascent field of structured securities. From the start, the market for structured securities evolved as a ‘rated’ market, in which the risk of tranches was assessed by the credit rating agencies. Issuers of structured securities were eager to have their new issues rated on the same scale as ‘single-name’ bonds so that institutional investors such as life insurance companies or pension funds (which often have investment policies subject to ratingsbased constraints) would be able to purchase the securities. By having these new securities rated, the issuers created the illusion of comparability with existing ‘single-name’ bonds. This provided access to a large pool of potential buyers for what otherwise would have been perceived as very complex derivative securities. Over the past decade, risks of all kinds have been repackaged to create vast quantities of triple-A rated structured securities with competitive yields – such as CDOs and all types of ABS. By 2007, there were 37,000 structured finance issues in the US alone with the top rating. Roughly 60% of all global structured securities were AAA-rated, in contrast to less than 1% of the corporate issues.42 Through offering AAA-ratings along with attractive yields during a period of relatively low interest rates, these securities were eagerly bought by investors around the world. In turn, securitization activities grew to represent a large fraction of Wall Street and rating agency revenues in a relatively short period of time. The 2005/06 structured securities issuance boom supported Wall Street banks to recover from the depressed revenue and compensation levels of the post-9/11 and internet bubble years. In 2006 Moody’s Corporation reported that 44% of its revenues came from rating structured finance products, surpassing the 32% of revenues from their traditional business of rating corporate bonds.43 It was widely believed that credit ratings could be relied upon to correctly reflect the risk of even the most complicated and opaque structured securities like synthetic CDOs or CDO2. This flawed assumption provided false comfort and misleading incentives to investors. With unprecedented access to data, computing power and analytical tools, investment banks and investors were assumed to be exceptionally sophisticated. Advanced financial technology meant that risk could be

42 Cf. J.D. Coval / J. Jurek / E. Stafford, The Economics of Structured Finance, 2007, p. 5. 43 Cf. G. Soros, The New Paradigm for Financial Markets – The Credit Crisis Of 2008 And What It Means, in: Public Affairs, 2008, p. 89.

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finely tailored to their specific needs. Blessed by rating agencies and – if needed – strengthened by credit insurance, this risk was assumed to be nearly bullet-proof. Consequently, the equity capital cushion applied against it was minimized. Because the agencies did not disclose their valuation models, assumptions and underlying statistics were nearly impossible even for institutional investors to analyze and validate the correct default risk of a certain CDO tranche. They had to rely on the rating as more or less the only way to determine the right risk premium or price for a certain package of securitized mortgage backed loan portfolio. Since rating agencies based their valuations on historical default rates, and their loss experience improved over time due to steady rising house prices, rating agencies became more generous in their valuations of all kinds of collateralized mortgage obligations. Because default probabilities were based on past statistical data the agencies were basically ‘driving through the rear-view mirror’, when applying and certifying a rating to a certain mortgage backed structured security.44 In addition, rating agencies had a significant incentive to provide benevolent ratings and not be too harsh to their major clients because a large part of their business was coming from only a few leading investment banks plus the two GSEs that specialized in purchasing, repackaging and selling of mortgage loans by issuing rated structured securities. This business process was also called ‘Warehousing’. Over the years, the three major rating agencies S&P, Moody’s and Fitch generated a constantly rising share of their total annual fee income by rating structured MBS. By 2006, the revenue Moody’s generated from rating structured credit products made up for about half of its total rating revenues.45 Credit rating agencies are under scrutiny for giving investment-grade ratings to securitization transactions (CDOs and MBSs) based on subprime mortgage loans. Higher ratings were justified by various credit enhancements including over-collateralization (pledging collateral in excess of debt issued), credit default insurance (monoliner), and equity investors willing to buy the most junior tranche of a CDO and bear the first losses. It is also being investigated as to whether conflicts of interest were involved, as rating agencies are paid by the investment bank that securitizes the loans and sells the exposure to investors. Internal rating agency emails, dated before the time when credit markets started to deteriorate, discovered and

44 Cf. ibid., pp. 82-84. 45 Cf. Buttonwood Column, Credit and blame to the agencies, in: The Economist, 2007, http://www.economist. com/displaystory.cfm?story_id=9769471 (retrieved on 6 March 2009).

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released publicly by US-congressional investigator’s, suggest that some rating agency employees suspected at the time that lax standards for rating structured credit products would produce negative results.46 On 11 June 2008, the US Securities and Exchange Commission proposed the following new rules designed to address perceived conflicts of interest between rating agencies and issuers of structured securities: Y

Prohibit a credit rating agency from issuing a rating on a structured product unless information on assets underlying the product was available.

Y

Prohibit credit rating agencies from structuring the same products that they rate.

Y

Require credit rating agencies to make all of their ratings and subsequent rating actions publicly available. This data is required to be provided in a way that facilitates comparisons of each credit rating agency’s performance. Doing this provides a powerful check against providing ratings that are persistently overly optimistic, and further strengthens competition in the ratings industry.

Y

Attack the practice of buying favourable ratings by prohibiting anyone who participates in determining a credit rating from negotiating the fee that the issuer pays for it.

Y

Prohibit gifts from those who receive ratings to those who rate them, in any amount over 25 USD.

Y

Require credit rating agencies to publish performance statistics for one, three, and ten years within each rating category, in a way that facilitates comparison with their competitors in the industry.

Y

Require disclosure by the rating agencies of the way they rely on the due diligence of others to verify the assets underlying a structured product.

Y

Require disclosure of how frequently credit ratings are reviewed; whether different models are used for ratings surveillance than for initial ratings; and whether changes made to models are applied retroactively to existing ratings.

46 Cf. U.S. House of Representatives Committee on Government Oversight and Reform, Committee Holds Hearing on the Credit Rating Agencies and Financial Crisis, 2008, http://oversight.house.gov/story.asp?ID=2250 (retrieved on 12 March 2009).

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Y

Require credit rating agencies to make an annual report of the number of rating actions they took in each rating class, and require the maintenance of an XBRL database of all rating actions on the rating agency’s web site. That would permit easy analysis of both, initial ratings and ratings change data.

Y

Require documentation of the rational for any significant out-of-model adjustments.

Y

Require the public disclosure of the information a credit rating agency uses to determine a rating on a structured product, including information on the underlying assets. That permits broad market scrutiny, as well as competitive analysis by other rating agencies that are not paid by the issuer to rate the product.47

The last requirement is designed to facilitate ‘unsolicited’ ratings of structured securities by rating agencies not compensated by issuers. 2.1.10. The Markowitz Hypothesis

Finally, market participants – the most prominent one being Alan Greenspan – believed that credit derivatives helped to widely distribute the credit risk from the exploding amount of US household debt globally among investors. Even if credit worsened, analytics failed and default rates of structured securities would rise above the expected levels, the absence of concentrated risk would prevent systemic problems. This belief, more than any other factor, explains why investors and even central banks, instead of being wary of asset bubbles, were under the impression that this time, it would be different. A few academics, analysts and investors – such as Warren Buffet and the International Monetary Fund’s (IMF) former chief economist Raghuram Rajan – warned that CDOs, other ABS as well as unfunded credit derivatives would spread credit risks and uncertainty about the value of the underlying assets more widely, rather than reduce risk through diversification. With the advent of the subprime crisis and its development into a global credit crunch, this view gained substantial credibility. Unfortunately, not only was homeowner credit suspect, but the market had misread this risk. The ensuing panic resulted in a self-accelerating deleveraging process because investors worldwide tried to unwind leveraged positions in the same instruments, which resulted in a further deterioration of market prices and forced 47 Cf. U.S. Securities and Exchange Commission, SEC Proposes Comprehensive Reforms to Bring Increased Transparency to Credit Rating Process, 11 June 2008, http://www.sec.gov/news/press/2008/2008-110.htm (retrieved on 5 March 2009).

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other investors to either also unwind their leveraged positions or post huge collateral volumes. This and the crash in asset prices finally led to a severe liquidity crisis. The safety net of risk analytics and ratings was seen to be an illusion. When investors realized that the risk was largely concentrated on bank balance sheets, their confidence in the financial system eroded rapidly. Credit rating agencies had failed to adequately account for extremely large risks when rating structured securities and funded credit derivatives. As discussed earlier, the main reason for this failure were that they relied on past data and their analytical models but did not adequately take into account correlation risk and the real world which is not normally distributed and tends to have fat tails.48 By 2000, the total pool of global fixed-income securities had reached 35 trillion USD. It had taken hundreds of years to get there. Yet it doubled over the next six years. One might ask: Why did global capital markets grow as fast as they did and why were they able to absorb all this (in retrospect) risky borrowing? The answer lies as much in investor demand for fixed-income securities that offered good returns as it does in the insatiable appetite of consumers for debt to fuel their spending. 2.1.11. Moral Hazard in the Financial System

It was already discussed that Alan Greenspan in his 18-year tenure at the FED lowered interest rates and increased money supply each time the global financial system was facing a crisis. Hence the FED assumed the function as lender-of-lastresort. This function had unfortunate adverse consequences because the banks learned that they could rely on the FED to provide financing in the event of crisis. This created a moral hazard type incentive, because banks were naturally more confident and willing to extend loans, knowing that they could rely on the central banks (or even the Government) to bail them out. Hence, banks were leveragingup their balance sheets to a much greater extend, accepting higher risks to generate higher returns.49 Leveraging-up was easier for US investment banks than for US commercial banks which were much more regulated.

48 These misperceptions often result from our desire to explain complex systems with abstract models. The tendency to rather rely on a simplifying model while at the same time to ignore extremely unlikely events – called black swan events – is at the heart of this credit crisis. Cf. Thaleb, N.N., The Black Swan: The Impact of the highly Improbable, 2007, pp. xvii-xviii. 49 Cf. G. Cooper, The Origin of Financial Crises – Central Banks, Credit Bubbles and the Efficient Market Fallacy, 2008, p. 58.

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To add leverage and generate returns some banks used credit derivatives which consumed less equity but helped creating an implicit leverage. Other banks created SIVs outside their balance sheet to circumvent regulation. After the bust of the dotcom bubble and 9/11, Greenspan publicly asserted that the FED Funds Rate would be kept low for the good of the economy. This meant that US treasury bonds would offer a low return for the foreseeable future. So Wall Street filled the void and created higher returns by packaging higher-yielding mortgage debt into (apparently) AAA-rated securities. A second layer of moral hazard was created because the lender-of-last-resort was expected to effectively support all banks alike independent of their size or risk policy. Depositors therefore considered all banks to be equally reliable. Hence a bank that followed a riskier investment or credit policy was not punished by investors withdrawing their funds or requesting substantially higher returns and the cost of funding remained the same. The normalization of this trend can be observed when comparing the credit spread that banks of different quality/rating had to pay before the crisis to the spreads they have to afford now to get funding. A third moral hazard-like problem was created by the incentives driving the mortgage originators (loan brokers and mortgage banks) and the distributors of the structured securities (GSEs and investment banks). Their rewards were not aligned with sound credit underwriting principles or the distribution of assets backed by solid collateral. Credit was no longer granted to creditworthy individuals and held on the balance sheet until maturity. The business model changed. Now credit was originated and warehoused only until it could be packaged into opaque securities and sold to investors. Brokers earned transaction fees of about 1.5% to 1.75% of the total size of a deal. That’s much more than the average 0.4% that banks charge to sell investment-grade bonds and about the same fee level as for junk bonds, which traditionally used to be the most lucrative.50 The seemingly unlimited investor demand driven by low interest rates inflated this bubble further. Many CDOs are valued on a mark-to-market basis and experienced substantial write-downs when market value more or less collapsed (depending of their respective seniority). Resulting from their misjudgements, the huge losses in asset values have forced banks to revisit all their assumptions. Driven by spiking defaults starting in CDS and high-risk subprime mortgages but now spreading via Alt-A to 50 Cf.|G. Cresci, Merrill, Citigroup Record CDO Fees Earned in Top Growth Market, Bloomberg, 30 August 2009, http://www.bloomberg.com/apps/news?pid=10000103&sid=a.FcDwf 1.ZG4&refer=us (retrieved on 10 March 2009).

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prime mortgages (and further to highly leveraged private equity deals, consumer and credit card loans and finally corporate debt), banks are tightening lending standards on all kinds of loans. Banks and rating agencies are clamping down on financial engineering and innovation, thereby reducing the flexibility of terms and instruments available to borrowers. Finally, a reduced ability to place debt with investors implies that banks have to hold more of it on their own balance sheets. At the same time, the capacity of their balance sheets is shrinking as they try to reduce their leverage while the rating cycle forces banks to hold more equity for a certain amount of debt because under the Basel II regime the risk weightings increase when ratings decrease. In the second half of 2007, the issuance of ABS fell by more than 75% compared with the first half of that year, and has virtually grounded to a halt in 2008/09. The closure of the market for securitized debt instruments prevented banks from passing on their credit exposure. Because they could not refinance and free up their balance sheets via the capital markets any more, banks equity was often ‘blocked’ by old commitments and so they were hampered in granting new loans. In addition, in 2008 the issuance of plain senior unsecured bank bonds had fallen by more than 75% from the steady levels of 2003-2007. Later that year even the market for covered bonds (collateralized with high grade mortgage loans or public debt) came to a halt. Finally, after the banks stopped lending towards each other via short term money market loans the central banks became the major source of refinancing for most banks that did not have a sufficient client deposit base. The refinancing problems explain the difficulties that many banks had to grant new longer dated loans. Thus, driven by more stringent lending practices, the lack of available refinancing sources and scarce equity capital, the ability of banks to grant new credit facilities to customers was very much constrained. If granted at all, due to higher cost of liquidity, scarce equity and higher risks, credit margins for new credit lines have substantially increased. Credit spreads for new commercial loans often expanded by more than 150-200 basis points (bp) for loans rated BBB and by more than 250-400|bp for borrowers rated below investment grade. One feature of the financial system that has been changing over recent years is the identity of the risk-takers. Traditionally, the lubrication for many markets came from investors and speculators. These people risked their own cash. By 2007, however, financial institutions had become more leveraged, committing even bigger parts of their own equity in order to increase the level of proprietary risk – thereby

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shifting what had once been investor risk onto the banking system itself. In other words, historic intermediaries had themselves become major holders of risk. This is particularly true for US broker houses but also for several European and to a minor extent for some Asian banks.

2.2.

How the Subprime Crisis Developed to a Global Credit Crunch

The crisis began in February 2007, when HSBC, the world’s largest bank at that time, informed the public that it will have to write-down its holdings of subprimerelated MBS by 10.5|billion USD. This was the first major subprime related loss to be reported. The second victim of the subprime crisis was New Century Financial which filed for Chapter|11 bankruptcy protection after it was forced by its backers to repurchase bad loans in April 2007, worth billions of US dollars. The year ended with about 45 US banks and mortgage companies either being shut down, suspending operations or being sold. This second part intends to depict the magnitude of the credit crisis and to show how the subprime crisis spilled over to other sectors of the financial markets affecting the global financial industry and other sectors and thereby ultimately drove the global economy into recession. 2.2.1.

The Magnitude of the Credit Crisis

Until March 2009 banks worldwide had already disclosed and written-off about 690|billion EUR (930 billion USD) in subprime related losses, roughly 60% of these were borne by American banks. In April 2009 the IMF estimated that total cumulated write-downs of global financial institutions could reach 4.1|trillion USD. New York University Professor Nouriel Roubini expected that “… credit losses could peak at a level of 3.6 trillion USD for US institutions …“ only, of which about half will have to be borne by banks and broker dealers. Given that the total equity of the US banks at the time was about 1.4 USD trillion, means that the whole US financial system will basically go insolvent.51 51 Cf. H. Meyer / A. Daya, Roubini Predicts U.S. Losses May Reach USD 3.6 Trillion, Bloomberg, 2009. http://www. bloomberg.com/apps/news?pid=20601087&sid=aS0yBnMR 3USk&refer=home (retrieved on 20 March 2009). Cf. IMF, Global Financial Stability Report, 2009, http://www.imf.org/external/np/tr/2009/tr042109.htm (retrieved on 20 March 2009).

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At a 1:12.5 ratio of capital to assets (tier 1 ratio of 8%), estimated losses of between 3.6|trillion USD to| 4.4|trillion USD would mean a 45 trillion USD to 55 trillion| USD decline in global credit capacity – a net contraction representing about 16.5% to 20% of current global credit levels. Given that roughly 4 USD of credit are necessary for every 1 USD growth in GDP, such a contraction would lead to a massive global economic slowdown directly reducing global growth by almost 4.7% to 5.7%, even before any second- and third-order effects take hold. 2.2.2.

How the Crisis in Subprime Debt Infected Other Markets

Since the beginning of the crisis the forecasted losses are constantly rising. One of the reasons is that market values of more and more asset classes have been affected by the accelerating fall of asset values over the last months. What started as a meltdown of a single asset class (mortgage backed loans and CDOs) in February 2007 soon affected other kinds of less liquid structured bonds to spill over to other forms of credit like leveraged loans and corporate bond spreads within a few months, to finally affect the equity market just about twelve months later. In the meantime the corporate bond market was closed for most of 2008 and only opened up from December 2008 for large companies with very strong investment grade ratings (at least BBB+ or better) which were willing to pay about ten times the credit spread they had been paying before the crisis. The crisis encouraged investors to take their money out of asset classes that were perceived to be risky like credit products or equities and put it into commodities (e.g. gold, silver) as ‘stores of value’. The other asset class which was not affected were government bonds from the most highly rated countries like the US or Germany. Government bonds from smaller less developed or from higher leveraged countries also suffered from widening spreads and illiquidity. By 2009 nearly every financial asset class was affected. The mounting losses reduce banks equity faster than they were able to recapitalize. Therefore they had to restrict balance sheet growth (lending) or even reduce their loan books and sell other assets to further deleverage their balance sheets. As the global recession affected nearly every borrower in a more or less dramatic way, banks and credit agencies were forced to continuously lower the individual ratings. The worsening of the average credit quality of the banks’ loan books brought forth to apply higher and higher equity capital ratios to cover the rise in risk weighted assets on their balance sheets as demanded by the Basel II accord.

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Finally, the cost at which banks are borrowing money exploded and some sources of refinancing were no longer available even to the strongest banks (i.e. the bond market or the inter-bank money market). Therefore, nearly every bank or financial institution faced more or less severe funding problems. What started as a crisis of subprime mortgage lending developed into a global credit crunch. Banks were not able to provide corporates with relatively cheap loans anymore and especially companies which were highly leveraged or relied on a capital-intensive business model faced problems to fund new debt or refinance existing debt that had to be rolled-over. Corporates with a robust and potentially profitable business model which had to rely on external funding – because they either had an insufficient operating free cash-flow or because they had to refinance existing debt – were forced to seek recourse to the equity markets to fund their operational needs. Others companies with a less viable and stable business model faced insolvency, even though sometimes they were profitable. As a result of the credit crunch companies tried to cut cost and lay-off people. Unemployment was rising dramatically and many private households were facing insolvency too. Hence banks faced massive additional write downs not only on corporate loans but also on consumer loans and credit card debt. With further falling house prices and rising unemployment prime mortgages default rates were displayed which were significantly higher than the historical average. Due to the size of the prime vs. the subprime market – which is about ten times bigger – the possible losses in the prime segment have the potential to exceed the expected losses from subprime mortgages many times. 2.2.3.

Hedge Funds and other Near-Banks

Beyond the uncertainties real banks have been facing, there was mounting concern around the so called shadow banking system: hedge funds, private equity funds (PE), and other near-banks and alternative investors. The evaporation of asset prices which was driven by rising default risk of nearly all market participants combined with an ongoing forced de-leveraging of banks and near-banks. Hedge funds in particular had been under huge pressure to sell off their investments in order to reduce their leverage or post additional collateral. These players usually invest in long-term and to a certain degree in relatively illiquid assets (like structured credit or commodities). At the same time they work with high amounts of short- to medium-term debt to leverage their investments. Unlike banks hedge funds are not regulated. Hence their ability to leverage is not limited

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and often they employ much higher leverage ratios as banks to maximize the potential return of their fund for the investors (plus the performance fee for the fund managers). Because of the high leverage ratios these investors are also commonly referred to as non- or near-banks. To receive financing, hedge funds normally have to pledge their assets as collateral. With the rapid decrease of all kind of asset values during the crisis they faced margin calls from their banks. In case these calls could not be met they were forced to sell the assets even into a falling market. This mechanism combined with the significant asset volumes controlled by hedge funds, contributed to and accelerate the rapid decrease of all kinds of asset prices during the crisis. By selling less affected asset classes to free-up urgently needed cash to post additional collateral and prevent a forced sale of another asset – which was rather illiquid or already lost most of its value – hedge funds helped tremendously to spill the crisis over from subprime CDOs and mortgage backed ABS to other asset classes. The fall in asset prices and the heightened risk aversion finally affected government bonds from smaller countries like Iceland, Ireland or Austria, where the banking industry represents a disproportionately large share of GDP. It also affected several Central- and Eastern European countries, which used to fund in hard currency and face difficulties to pay back their debt because their own currencies were falling rapidly. Even for larger countries like the UK significantly rising CDS spreads indicated a severe degradation of creditworthiness. CDS spreads for government bonds will tend to rise further as long as it is expected that the burden from bailouts, increasing social security budgets and economic stimulation packages for public households is rising. What began as a leverage crisis in one asset class has become a global credit crunch and turned into a very material insolvency problem even for certain governments as well.

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3.

The Impact of the Subprime Credit Crisis in Eastern Europe

The global financial crisis has hit Central and Eastern Europe harder than any other region of the world. In general, the financial crisis of 2008-10 resembles the East Asian crisis of 1997-9852. The fundamental problem then and now was excessive inflows of short-term bank credits, enticed by pegged exchange rates, leading to large private foreign debt.53

3.1.

The Rise and Fall of the Countries in the Region

After joining the European Union, foreign investment poured into the Eastern Europe countries, property values soared, housing markets boomed, and ordinary consumers found themselves with access to credit that was unthinkable during the dark days of communism.54 Until autumn 2008, the countries of the region had enjoyed a wonderful decade, with an average growth rate for the whole region of 7%-8% a year.55 The Baltic countries of Latvia, Estonia, and Lithuania, for example, boasted annual economic growth of nearly 10% in recent years56, thanks to three factors. First, in the 1990s these countries had undergone a successful transition to market economies, with

52 Dr. Bernd Sagemann, Die Stadtstaaten Hongkong und Singapur in der Asienkrise – Die Krisen und ihre Parallelen, 2009, pp. 284-298. 53 Anders Aslund, Implications of the crisis for Eastern Europe, 2009, http://www.iie.com/publications/papers/paper.cfm?ResearchID=1250 (retrieved on 31 August 2010). 54 Jeffrey White, Europe’s financial crisis is spreading eastward, CSMonitor.com, 28 October 2008, http://www.csmonitor.com/layout/set/print/content/view/print/236504 (retrieved on 31 August 2010). 55 Anders Aslund, Implications of the crisis for Eastern Europe, 2009, http://www.iie.com/publications/papers/paper.cfm?ResearchID=1250 (retrieved on 31 August 2010). 56 Jeffrey White, Europe’s financial crisis is spreading eastward, CSMonitor.com, 28 October 2008, http://www.csmonitor.com/layout/set/print/content/view/print/236504 (retrieved on 31 August 2010).

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deregulation, privatization, and financial stabilization. Second, they benefited from vast underutilized real and human capital. Third, their exports drove growth through international integration and a global boom.57 The economic growth strategy followed by the Eastern Europe economies in 1990s and 2000s can be described as foreign saving led growth in three senses: Foreign Direct Investments, cross-border lending and exports. In hindsight, it is relatively easy to see that when such high level of dependence on foreign savings takes place during increasing financial innovation and liberalization, and is coupled with simultaneous technological change in production that enables geographic dispersion without local linkages, financial and economic crisis in one or other form becomes an accident waiting to happen. It became a question of when, not if. Thus, it should not come as a great surprise that Eastern European countries became the epicentre for the World Financial Crisis. On the contrary, in the last two decades Eastern Europe seemed to epitomize the problems created during these years globally. On the one hand, there is the fast and furious industrial restructuring driven by massive inflow of Foreign Direct Investments; the rise of modularity in production means that large parts of restructured industry are oriented towards lower value added activities with low domestic linkages. On the other hand, equally transformative change in the banking sector essentially breaks the ties with domestic productive sector only to marry with help of enormous inflow of cross-border lending with domestic consumers. This led to loss of competitiveness through low productivity growth and through currency appreciations. All of this is accompanied by fragmented and hollowed out policy arena incapable of creating structural and innovation policies to further productivity growth. This kind of massive fragility in most Eastern European economies was bound to lead to depression-like events in 2009 as witnessed in the Baltic economies.58 The situation in April 2009 showed that some Eastern European countries have been implementing measures to meet criteria enabling them to join the Euro-zone and are therefore in relatively robust economic shape. Poland, for example, had relatively fairly healthy public finances and a low debt-to-GDP ratio and the Czech Republic had a strong banking system and low debt. Some of the countries of Eastern Europe, including the Czech Republic, Slovakia, and Poland, are in reasonable shape due to their more export-driven economies, which means that they need to 57 Anders Aslund, Implications of the crisis for Eastern Europe, 2009, http://www.iie.com/publications/papers/paper.cfm?ResearchID=1250 (retrieved on 31 August 2010). 58 Rainer Kattel, Financial and Economic Crisis in Eastern Europe, 2010, p. 14.

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borrow less. Broadly speaking, these countries have engaged less in lending in foreign currencies and have implemented tighter fiscal policies. Russia was handling the financial crisis without considering recourse to IMF funding, while Poland has been giving money to the IMF rather than receiving it, which demonstrates the strength of its position. The Czech Republic, Slovakia and Poland chose to keep their currencies floating against the euro, which means they can still devalue their own currencies and assist their exporters if the euro falls. But these countries are not immune to the crisis – the Polish zloty has dropped 30% against the euro in the past six months, making the worst-performing emerging-market currency.59

3.2.

The Role of the Government to Fight Back the Crisis

The government, including the Central Bank, has several roles in fighting a financial crisis like this global one. One is to prevent a complete failure of the financial system and to replace essential functions like credit provision until the normal channels reappear. That has been done quickly and aggressively in the advanced countries, with central banks playing a prominent part. The authorities injected capital into banks, furnished liquidity, and purchased a wide range of assets on a large scale. These interventions likely averted a far worse outcome, akin to a depression, in which banks and business fail in large numbers, for no other reason than a shortage of credit. A second role is to try to prop um economic activity and asset prices by filling the gap left by sidelined consumers and investors. In performing both these functions, the government’s role temporarily expands. It becomes a player as well as a referee on a much broader front. If successful, coordinated government action will mitigate the damage, even if it cannot eliminate it. As normal economic activity returns, the government withdraws. The aim is not to prevent the recession and the decline in asset prices but rather to prevent a destructive overshoot. Government action helps to resolve a costly co-ordination failure, in which private-sector efforts to deleverage thwart each other. Individual households, firms and banks know their cutbacks will hurt everyone else, but they also know that if they do not retrench, when everyone else does, they will go under. As a result, everyone retrenches, which is socially disastrous, even if it is privately rational. The government must, then, act as a ‘circuitbreaker’, interrupting the transmission of shocks from one part of the economy to 59 ACCA, Central and Eastern Europe and the financial crisis, 2009, p. 4.

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the other. Fiscal stimulus reduces deadlines in the real economy, boosting employment, income and credit quality. Restoring credit increases the bang a government gets for its stimulus buck. Interventions in the financial economy and the real economy are more effective in combination than in isolation.60 As the crisis erupted, excellent ad hoc cooperation developed between the IMF and the European Commission. The IMF had the staff, and procedures for handling a financial crisis, while the European Commission had neither, so it conceded and assisted instead. The European Commission has co-financed the IMF programs for Hungary and Latvia, and several European countries, notably Scandinavians, contributed substantial financing to the Latvian program.61 The World Bank, the European Bank for Reconstruction and Development, and the European Investment Bank have also played a substantial role in fighting the crisis. The bank recapitalization has been in the main focus of these international institutions. One of the greatest worries has been that the Western European banks that had bought most Eastern European banks would withdraw from the region. So far, no European bank has done so, and the peak of the crisis has hopefully passed. In Ukraine, 17 banks with subsidiaries in the country have even committed themselves to recapitalizing their Ukrainian subsidiaries with 2 billion USD in 2009. Exchange rate policy has become the bone of contention in the new stabilization programs. The pegs were clearly causes of the crisis, but that does not necessarily mean that they should be abandoned in the mid of the crisis. If a country devalues, its banks could be squeezed on all sides. The locals cost of the loans the banks had taken abroad would sharply rise, and many would default. Their domestic customers had taken loans in foreign currency would also be unable to repay them with revenues in the devalued currency.62 For the Eastern European economies this period has been and still is a tough time, navigating the crisis and (fiscal) challenges ahead, each of them managing these in their individual way.

60 Commission on Growth and Development, Post-Crisis Growth in Developing Countries, A Special Report of the Commission on Growth and Development on the Implications of the 2008 Financial Crisis, 2010, p. 8. 61 Anders Aslund, Implications of the crisis for Eastern Europe, 2009, http://www.iie.com/publications/papers/paper.cfm?ResearchID=1250 (retrieved on 31 August 2010). 62 Ibid.

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Specific Areas of Crisis in Eastern Europe

Bulgaria: The Deferred Crisis Minko Karatchomakov

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1.

Situation before the Crisis

In the first decade of the third millennium Bulgaria experienced a perceptible boost in economic activity alongside the other emerging economies of Eastern Europe. This period was however preceded by ten years of trial and error whilst establishing a functioning market economy in an environment of political disorientation, social disaffection and market disturbance.1

1.1.

Retrospective Overview

1.1.1.

The Decade of Downfall post 1989

During the first ten years after the collapse of the socialist command economy, Bulgaria faced a massive slowdown in economic development due to steadily decreasing or even ceased public investments that could not be compensated by private economic activity. Unfortunately, the general deterioration of the economic performance and the living standard was not caused solely by the transition into a market driven economy. The slowdown was additionally accelerated by the lack of clear objectives, by anti-reform pressures, by incompetent leadership and thus by erratic decisions. As a result GDP fell so dramatically that the level of economic output in 1989 could barely be restored by 2007.2 Having been ranked number 50 worldwide in 1985 by the criterion of market freedom, Bulgaria saw by 2000 a demotion to rank 1083 notwithstanding the advanced privatisation of the former oversized state industries. Eventually, following the exorbitant price rises of 1997 in which the level of inflation peaked at 1,058%4, the distress caused thereby cul-

1 Vasil Prodanov, ÈÏØÛàÐÚÍÓÕÐÇÚ ÉâÓËÈØÙÒÐ ×ØÍÝÖÌ (Bulgaria’s Destructive Transition), Le Monde diplomatique, Bulgarian edition, volume 10/2007, http://www.bg.mondediplo.com/article181.html (retrieved on 26 August 2010). 2 Ibid. 3 Economic Freedom Network, http://www.freetheworld.com/cgi-bin/freetheworld/getinfo.cgi (retrieved on 26 August 2010). 4 Commerzbank Report on Bulgaria, Bulgariens Hürdenlauf in die EU, 2003, p. 3, https://www.commerzbank.de/ media/konzern/engagement/oekonomie/europa/bulgarien/laenderbericht.pdf (retrieved on 26 August 2010).

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J. Jungmann, B. Sagemann (Eds.), Financial Crisis in Eastern Europe, DOI 10.1007/978-3-8349-6553-0_2, © Gabler Verlag | Springer Fachmedien Wiesbaden GmbH

minated in mass riots over the whole country which resulted in the reallocation of political power and, fortunately, lasting political stability. A radical reform package was immediately introduced and the country underwent an overall transformation. 1.1.2.

The Boom Decade

The beginning of the new millennium was then finally marked by a turning point in Bulgaria’s economic performance. The signs of recovery were, initially, the result of the consequent implementation of market orientated policies for overcoming the national economic crisis. In 2000 Bulgaria’s GDP grew by 5.8%, which was the most notable increase since 19905 and, moreover, an increase positioning Bulgaria at the top of the emerging Eastern-European economies. This was enabled by the comprehensive restructuring of the state portfolio. The shares in the manufacturing and service industry that had been concentrated in state hands were gradually reduced to 22% in 20006 and shifted towards the private sector. This all occurred against the background of a Currency Board prescribed by the International Monetary Fund as a condition for rendering financial aid and as a means of guaranteeing the volume of money in levs with foreign currencies. This also implied restrictive fiscal policy, which led to a reduction of the budget deficit to 1% in 2000.7 The fixed rate of exchange of the Bulgarian lev with the German mark at the beginning and the fixed rate with the euro from 1999 onwards turned out to be one of the effective measures as the inter-dependence of the Bulgarian lev with the weakened euro, at the time, guaranteed that, firstly, Bulgaria’s exports into the European Union would not be influenced by the fluctuation of the euro and, secondly, it cheapened Bulgaria’s exports into some third countries. From the 2000 onwards, the expectations of almost 70% of enterprises for

5 ËÍÕÞÐÇ ÏÈ ÐÒÖÕÖÔÐßÍÙÒÐ ÈÕÈÓÐÏÐ Ð ×ØÖËÕÖÏÐ ÒâÔ ÐÕÐÙÚÍØÙÚÊÖÚÖ ÕÈ ÜÐÕÈÕÙÐÚÍ (Economic Analyses and Forecast Agency of the Ministry of Finance), ÖÌÐàÍÕ ÌÖÒÓÈÌ ÏÈ ÐÒÖÕÖÔÐÒÈÚÈ ÕÈ âÓËÈØÐÇ ×ØÍÏ 2000 ËÖÌÐÕÈ. ÍØÐÇ ÒÖÕæÕÒÚÛØÕÐ ÖÉÏÖØÐ (Annual Report on Bulgaria’s Economy 2000. Series of Overviews of the Economic Activity), p. 1, http://www.aeaf.minfin.bg/bg/izdaniq/ Year_2000.pdf (retrieved on 26 August 2010). 6 Commerzbank Report on Bulgaria, Bulgariens Hürdenlauf in die EU, 2003, p. 43, https://www.commerzbank.de/ media/konzern/engagement/oekonomie/europa/bulgarien/laenderbericht.pdf (retrieved on 26 August 2010). 7 Cf. ibid., p. 1.

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order books to be constantly filled8 were positive and Bulgaria’s exports grew by 24.2% from 1999 to 2000.9 Domestic consumption was also finally able to achieve constantly positive growth rates too. Among the flanking measures, there are several crucial amendments that can be found in the financial legislation passed during the boom years regarding such areas as company and sole trader insolvency, corporate taxation or the issuance of licenses and permissions. While some of these measures were directly aimed at restrictions to enhance transparency in the private sector or to prevent the evasion of taxes, other measures were intended to liberalise the market and stimulate private activity. For example, some statutory licenses and permissions were completely abolished and tax rates were reduced.10 Most important, these measures together signalised that the time for green-field investments had come. This is evidenced by the financing structure of private investments: these were financed up to 50% through direct foreign investment.11 In the years following12 Bulgaria’s economy gained momentum and the attempts to close the gap separating Bulgaria from the former Socialist countries in Eastern Europe yielded further positive results. On 1 January 2007, after eleven years of negotiations, Bulgaria joined the European Community and the European Union. Though deemed not to have fulfilled the political requirements for accession13 such as combating organised crime and corruption to a satisfactory level or by guaranteeing an independent judiciary for investors and citizens, Bulgaria was attested to have a functioning market economy as set forth by the Copenhagen Criteria, mean-

8 Cf. ibid., p. 18. 9 Cf. ibid., p. 7. 10 Cf. ibid., p. 1., also p. 26, where the reduction of indirect taxation at the expense of the direct taxation is demonstrated. The revenue from taxation of the earnings had been gradually decreased from 15.7% to 8.22% whereas the revenue from value-added tax and special taxes levied on consumption grew from 30.32% to 39.01%. 11 Cf. ibid., p. 10. 12 Hence, we are not examining the dynamics of the economic performance until the outbreak of the World Financial Crisis. Instead, we are focusing on the status quo in 2007 in order to illustrate the general tendencies and the tone of the market in the year before the first signs of the crisis, even if abroad, became perceptible. 13 Cf. e.g. the European Press Review by BBC News of 27 September 2006, http://news.bbc.co.uk/2/hi/europe/5383762.stm (retrieved on 26 August 2010).

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ing macroeconomic stability and a ban on restrictive practices, distortion of competition and the abuse of dominant market positions combined with a guarantee that any violation of fair competition would be efficiently constrained.14 Another progression made in the course of negotiations with the European Union was the implementation of an efficient financial supervisory agency. The enforcement of the appropriate legislation was an achievement that was already praised in the very early reports of the European Commission on Bulgaria.15 A new Public Internal Financial law came into effect in 2001 which provided a special agency for financial control with the appropriate powers to perform ex-ante control in the public sector and to harmonise internal audit systems. Separately, the national audit office aligned, in consultation with the European Court of Auditors, Bulgaria’s legal audit framework with internationally accepted and EU-compliant standards.

1.2.

Financial Status of the Private Sector

Despite the changes in ruling parties that occurred in 2001 and 2005, the aims of maintaining solid financial discipline and growth-conducive environment remained unaltered. The mechanisms of financial supervision that were introduced in 2001 and subsequently strengthened, improved the confidence of investors in the banking system and likewise the mechanisms of inter-bank refinancing. The EU-compliant insolvency law also strengthened the confidence of banks in their debtors.

14 Presidency Conclusions of the Copenhagen European Council from 21 to 22 June 1993, http://www.europarl. europa.eu/enlargement/ec/pdf/cop_en.pdf (retrieved on 26 August 2010), cf. especially 7.B.iv). 15 Commission of the European Communities, Regular Report on Bulgaria’s Progress Towards Accession 2001, http://ec.europa.eu/enlargement/archives/pdf/key_documents/2001/bu_en.pdf (retrieved on 6 September 2010), p. 90 et seq.

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This inter-dependence formed the basis of the steady economic growth experienced by Bulgaria between 2001 and 2008 as demonstrated in the following picture: Picture 1: GDP growth as a percentage of the previous year’s growth p.a., source: Ministry of Economy and Energy, 2010. 7.0 6.0 5.0 4.0 3.0 2.0 1.0 0.0 2001

2002

2003

2004 Bulgaria

2005

2006

2007

2008

EU

In 2007 economic activity experienced a continued boom.16 The expectations of businesses to acquire more customers and orders exceeded, in the first quarter of the same year, the long-term level of expectations by circa 30%. These expectations were responsible for domestic local and foreign businesses increasing their investments by 29.6% compared with 200617, thus exceeding the investment increase in 2006 and thus also exceeding the 16.5% forecast. Akin to the dynamism of businesses in the area of investments, consumers also spent more income on consumption, increasing the previous year’s rate by 6.8%.

16 ÍÕÚâØ ÏÈ ÐÒÖÕÖÔÐßÍÙÒÖ ØÈÏÊÐÚÐÍ (Centre for Economic Development), ÖÒÓÈÌ ÏÈ ÐÒÖÕÖÔÐÒÈÚÈ ÕÈ âÓËÈØÐÇ ÒâÔ ÒØÈÇ ÕÈ ÚØeÚÖÚÖ ÚØÐÔÍÙÍßÐÍ ÕÈ 2007 ËÖÌÐÕÈ. ÍÏæÔÍ (Report on Bulgaria’s economy at the end of the third quarter of 2007. Summary), p.|1, http://ced.bg/publication.php?PublicationID=135 (retrieved on 26 August 2010). 17 Cf. ibid., p. 2 et f.v..

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The figures representing the increase of value added – a criterion that rather tends to cause economists concern as far as Bulgaria is concerned18 – denoted a positive development. While the weighted average value added grew to 8.2%, the growth of the value added in the financial sector reached the extraordinary rate of 40%. Up to that point in time, investor and consumer loans were being approved at such a rate and at such non-stringent conditions as never seen prior. The ease with which loan capital could be accessed motivated broad strata to expand their consumption that could not be covered by domestic products in the same ratio as it was growing.19 This increased imports dramatically and led to a trade deficit totalling 5 billion EUR in the course of the first nine months of the year. In spite of eclipsing the domestic production and services, the growing-import tendency was, to a great extent, the manifestation of foreign capital directly invested in Bulgaria. Seen against the background of issuing loans in Europe before the Financial Crisis, the pleasingly high level of foreign capital flows towards Bulgaria testified a strong ‘securitisation’ of the investment decisions with equity and loans. In 2007 the foreign direct investments amounted to 6.1 billion EUR and thus formed 19.9% of the GDP in that year.20 To express the relevance of these figures on a greater scale: the accrued amount of foreign direct investments in 2006 and 2007 exceeded the total of the investments made between 1990 and 2005. The allocation of the investments through the different sectors shows that approximately half of the amount invested in 2007 was invested in real estate, construction and tourism. There was a correlation between the financial resources to realise the construction projects on the one hand and the financial possibility of purchasing the real estate on the other as the banks were still willing to underpin the financial bases of these deals.

18 Cf. e.g. EUbusiness, Bulgaria needs higher productivity: World Bank, http://www.eubusiness.com/europe/bulgaria/1190642521.89/view (retrieved on 26 August 2010). 19 Cf. ÍÕÚâØ ÏÈ ÐÒÖÕÖÔÐßÍÙÒÖ ØÈÏÊÐÚÐÍ (Centre for Economic Development), ÖÒÓÈÌ ÏÈ ÐÒÖÕÖÔÐÒÈÚÈ ÕÈ âÓËÈØÐÇ ÒâÔ ÒØÈÇ ÕÈ ÚØeÚÖÚÖ ÚØÐÔÍÙÍßÐÍ ÕÈ 2007 ËÖÌÐÕÈ. ÍÏæÔÍ (Report on Bulgaria’s economy at the end of the third quarter of 2007. Summary), p.|3, http://ced.bg/publication.php?PublicationID=135 (retrieved on 26 August 2010). 20 InvestBulgaria Agency, Bulgarian Investment Review, April 2008, p. 3, http://www.investbg. government.bg/ upfs/45/spisanie_april.pdf (retrieved on 26 August 2010).

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However, the share of those industries and services that were independent of loan capital and therefore less likely to react in a volatile fashion to a shortage of external financing remained comparatively moderate. Already in 2007, there had been concerns expressed as to the prospects of such sectors as construction and real estate and, interdependent with these two sectors, the tourism branch to maintain the flow of equity and loans for financing the vast number of projects already commenced.21 Nevertheless, though mostly based on domestic capital flow, investments in real estate and construction remained prevailing, thus indirectly causing pressure to the negative trade balance.22 As productivity could not catch up with the turbulent development of income and, obviously, upward demand, the inflation rate in 2007 doubled to 13.1%.23 Nevertheless, the inflation increase did not have any dramatic impact on interest rates for credit in both euros and levs as would normally have been expected. Interest rates however did indeed, rapidly increase at the end of 2007, however, this remained a temporary fluctuation without any direct influence on the market confidence.24 Credit in the private sector, thus, remained stable and, except for signs of overheating, the crisis was not yet in sight.

21 Cf. ÍÕÚâØ ÏÈ ÐÒÖÕÖÔÐßÍÙÒÖ ØÈÏÊÐÚÐÍ (Centre for Economic Development), ÖÒÓÈÌ ÏÈ ÐÒÖÕÖÔÐÒÈÚÈ ÕÈ âÓËÈØÐÇ ÒâÔ ÒØÈÇ ÕÈ ÚØeÚÖÚÖ ÚØÐÔÍÙÍßÐÍ ÕÈ 2007 ËÖÌÐÕÈ. ÍÏæÔÍ (Report on Bulgaria’s economy at the end of the third quarter of 2007. Summary), p.|4, http://ced.bg/publication.php?PublicationID=135 (retrieved on 26 August 2010). 22 Cf. ibid., p. 4. 23 Cf. ibid., p. 4. 24 Cf. Bulgarian National Bank, Interest rates for new businesses crediting in the non-financial sector, retrieved at http://www.bnb.bg/Statistics/StMonetaryInterestRate/StInterestRate/StIRInterestRate/ index.htm (retrieved on 26 August 2010).

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1.3.

Financial Status of the Public Sector

In view of the laudable economic growth and the economic policy of the government, Bulgaria’s long-term credit rating was assessed at BBB in euros and BBB+ in levs.25 The basis of this assessment was the increase in monetary reserves at the Bulgarian National Bank which accrued to circa EUR 3.95 billion by 2007. The fact that the monetary reserve was rising despite the nation’s obligation to the European Union budget illustrates that the fiscal policy was solidly planned. A major reform of the taxation rates was expected to increase tax revenues by motivating businesses and individuals to come out of the black market and to declare their income for taxation under the new flat-rate tax. The flat rate was levied on both corporate and individual income and, amounting to only 10%; it was widely advertised to be the European Union’s lowest tax rate. The intention of the legislator was to combine the different advantages of the European Union, especially the guarantee of free movement of capital, goods and services, the safety of investments and tax rate competition against the background of similar principles of tax legislation. The reform came into force in the following year on 1 January 2008. Even if considered to be of a certain disadvantage to the low-income strata, the tax reform was meant to simplify the taxation system, to allow an accurate projection of the tax burden, to equalise all subjects of taxation and to yield similar positive effects for the business environment as in other countries that had introduced a flat tax in the previous years, e.g. Slovakia. Though the most important effect was the expansion of the scope for taking financial decisions in enterprises as the margin of net earnings that could be ploughed back into the business operation was notably broadened. Already before that, real levels of tax revenue corresponded to the tax revenue level planned. In 2007 the corporate tax revenues did not deviate from the government’s plan at all.26 The main accent in taxation was already evidently shifting to indirect taxes such as value added or excise tax and formed circa 70% of the government revenue. Even further increases of these taxes were planned in order to compensate for the decrease in direct tax revenue and, thus, raise the amount and volume of deposits and investments forming the basis of the capital stock of the 25 Cf. ÍÕÚâØ ÏÈ ÐÒÖÕÖÔÐßÍÙÒÖ ØÈÏÊÐÚÐÍ (Centre for Economic Development), ÖÒÓÈÌ ÏÈ ÐÒÖÕÖÔÐÒÈÚÈ ÕÈ âÓËÈØÐÇ ÒâÔ ÒØÈÇ ÕÈ ÚØeÚÖÚÖ ÚØÐÔÍÙÍßÐÍ ÕÈ 2007 ËÖÌÐÕÈ. ÍÏæÔÍ (Report on Bulgaria’s economy at the end of the third quarter of 2007. Summary), p.|6, http://ced.bg/publication.php?PublicationID=135 (retrieved on 26 August 2010). 26 Cf. ibid., p. 7.

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country. Public debt was reduced by around 10% and totalled 4.2 billion EUR. Although private debts payable to foreign creditors had increased, at that point in time there was no reason for major concern.27 To stabilise the positive balance of revenue and expenditure, the government was intending to carry on the privatisation of state-owned businesses. As a further step towards generating more revenue, the liberalisation of the market was planned to be continued through a simultaneous reform of the state administration as the latter was, and still is often complained about by entrepreneurs and foreign investors and blamed for restraining market freedoms and the potential for economic growth. For this purpose, there was no need to spend domestic public funds as the European Union provided funding for educational and qualification-raising measures for the public administration. Another step towards aligning the public finance standards with European Union standards was the decentralisation of the state administration. Besides establishing a special organisation empowered with coordinating competencies, the tax revenue principles were modified to reallocate the share of the state and of the municipalities in the state revenue. For this purpose, the act governing local taxes was appropriately amended to ascribe the revenue from patent tax to the municipalities. Moreover, to intensify the competition not only in the private but also in the public sector, the municipalities were transferred the competency to determine the level of the local taxes themselves. Thus, the structurally weak areas of the country should be provided access to the investors’ market. An incentive measure for investors, reciprocally, was the tendency to reduce the tax burden for companies investing in municipalities with extremely high unemployment rates. Thus, the government transformed the tax burden into a contribution for the development of certain municipalities listed by the Ministry of Economy and Energy in a special ordinance passed on an annual basis. Public expenditure for social security purposes followed the overall economic development. The wages and salaries in the public sector were increased on the basis of the inflation rate and the rate of economic growth. However, to perpetuate the formation of a solid capital stock and decelerate inflation, the growth of the individual income in the public sector was kept rather moderate. The contributions paid by the employers and the employees for the different sectors of the social insurance were decreased. The contributions to the unemployment insurance decreased by 2% and to the old-age pension insurance by 1%.28

27 Cf. ibid., p. 7. 28 Cf. ibid., p. 8.

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Simultaneously, the legislator codified in the code governing the social insurance the mechanism of gradual reallocation of the social insurance contributions burden towards the insured employees until parity of the contributions burden is reached. This development, however, cannot be seen isolated from the raising of the threshold designed to guarantee that the contributions of employees with an income above the threshold level remained constant despite their high income. As a result, the general social insurance relief provided for employers turned into an additional burden particularly for those of them owing contribution payments for the social insurance of employees with an income equal to or above the threshold. The expectation of the government was to draw back into the social insurance system all employers and employees who were offering or receiving services under undeclared employment contracts. The effect of these measures is rather questionable as many of the participants in the Bulgarian employment market cannot be encouraged to integrate into the social insurance system be it for the reason of avoiding official work or for the mere reason of avoiding any inclusion on a black list of those evading contributions to the social insurance system.

1.4.

Development Status of the Real Economy

1.4.1.

Development Status of the Bank Sector

The increase in the money volume circulating was a reflection of the boom in production, export, consumption and import. However, banks remained able to provide credit to the growing mass of corporate and individual debtors as the amount and volume of the deposits was simultaneously growing. Being the intermediate link between creditors and debtors, the banks operating in Bulgaria were rapidly gaining their customers’ trust as illustrated in the following picture:

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Picture 2: Deposits and Loans Volume (in million Bulgarian Levs), source: National Statistics Institute, 2010. 25,000 20,000 15,000 10,000 5,000 0 2005

2006 Deposits

2007

2008

Loans

The interest rates did not undergo any changes caused by domestic factors. The slight increase of the interest rates was, to a great extent, driven by the increase of the interest rates at the international markets and especially in the Euro-zone29. However, these fluctuations rather concerned the deposits and loans in euros and not those denominated in the domestic currency. The increased money volume in circulation also enlarged the balance sheets of the banks present in the Bulgarian financial market. This, in turn, enabled the banks to issue loans that were greater in volume.30 50% of the loans issued were granted to corporate customers.31 Although the portion of the bad loans was decreasing in 200732, the global tendencies33 led the Bulgarian National Bank to introduce some restrictions. In line with the National Bank’s new policy, the commercial banks were 29 Cf. ibid., p. 9. 30 Cf. ibid., p. 10. 31 Cf. ibid. 32 Cf. ibid. 33 Cf. ËÍÕÞÐÇ ÏÈ ÐÒÖÕÖÔÐßÍÙÒÐ ÈÕÈÓÐÏÐ Ð ×ØÖËÕÖÏÐ ÒâÔ ÐÕÐÙÚÍØÙÚÊÖÚÖ ÕÈ ÜÐÕÈÕÙÐÚÍ (Economic Analyses and Forecast Agency of the Ministry of Finance), ÐÕÈÕÙÖÊ ÙÍÒÚÖØ: ÖÞÍÕÒÐ Ð ÖßÈÒÊÈÕÐÇ #1/2008 (Financial Sector: Estimations and Expectations volume 1/2008), p. 3.

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obliged to maintain a capital reserve of 12% instead of the former 8% of their deposit base. This measure was intended to calm down a market that was seemingly heading towards overheating and, moreover, to bring lending down to a lower level guaranteeing the stability of the bank system. In particular, the mechanism of influence was two-fold: on the one hand, liquidity had to be withdrawn from the money market and, on the other hand, the loan costs for the banks had to increase to moderate the demand after cheap loans. 1.4.2.

Development Status of Other Sectors

The sectors where a booming development could be seen were in particular real estate and construction. As illustrated sub 1.2, these were the sectors with the easiest access to private capital. The increase of the value added in these sectors reached 11.6% on an annual basis.34 The real estate and construction sector attracted 14% of all investments although it contributed itself only 6% of the value added to the economy as a whole. This development was, however, inevitable as housing and production facilities throughout the country mostly originated from the time before 1989 and either did not provide sufficient space or it was not costefficient for them to be renovated and adapted to contemporary needs. Another boom area, however on a smaller scale, was the IT branch. The telecommunication market grew in 2007 by 10%35. At that point in time, Bulgaria had to catch up with the developed countries as far as broadband Internet access or UMTS were concerned. One of Bulgaria’s prospective sectors prior to the crisis was tourism. The growth rates were, compared to the real estate sector, somewhat low, however steady. In 2007 the number of visiting tourists increased by almost 7%36. The return on this moderate growth was, however, more than double as high: it reached 16%. The present tendency in tourism to attract rather all-inclusive tourists was and still is considered to be a temporary strategy for a limited time period until Bulgaria has established itself as a recognisable provider of high-quality tourist products. The new tourism concept is financed with funds of different national and regional programmes of the European Union, but is yet to be fully implemented.

34 Cf. ibid., p. 13. 35 Cf. ibid. 36 Cf. ibid., p. 14.

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The heavy industry sectors of major relevance in the national economy were stagnating. The energy market was indeed restructured in accordance with requirements of the European competition law, however the larger projects – such as the construction of a new nuclear power plant – were creating costs without contributing material progress towards earning yields. The plans for a comprehensive modernisation of the country’s infrastructure did not reach the stage of visible realisation either. Despite the joining of Bulgaria’s economy with the emerging markets of the other new European Union’s members, Bulgaria’s development however remained unidirectional. The efforts of the private sector were concentrated in the construction business to such an extent that other sectors were neglected. This imbalance could only be compensated by the increase of foreign direct investments that also covered areas such as high technologies, machine manufacturing, chemistry or the retail market.

2.

The Impact of the World Financial Crisis (2008/2009/2010)

In the course of the development of the World Financial Crisis, its impact on Bulgaria’s economy remained perceptible only to a limited extent. The signs that could be interpreted as a manifestation of the crisis in Bulgaria, however, seen isolated from the immediate reaction of the relevant capital markets, could hardly be said to be more than minor decreases in the economic indicators. Having been more actively integrated into the European single market in the preceding previous years, Bulgaria could not avoid the indirect consequences of the crisis. As the manifestation of any such consequences takes time, Bulgaria’s economy was considered to be robust enough to cope with the secondary difficulties arising out of the uncertainty of investors and creditors. This, unfortunately, could not remove the concern that Bulgaria would be involved in the global changes triggered by the financial crisis.

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2.1.

Outline of the Expansion of the Crisis in Bulgaria

The crisis was believed by experts to be imported and not home-made as Bulgaria’s economy did not have to cope with structural deficiencies that sooner or later would have caused the economy to implode.37 The crisis, in Bulgaria’s case, would only reach alarming proportions because the confidence of the international financial markets was suddenly lost and, for a long period of time, no particular efforts towards coping with the crisis on an international scale were made at its outset. That could reassure the markets and guarantee the allocation of capital at a healthy level. This led not also financing institutes to become more cautious and absent but also unsettled foreign investors who had given the strong impetus to Bulgaria’s economy in 2007 and 2008. The first sign of the crisis was the collapse of some of the equity markets in the region which, due to structural similarity, implied a similar collapse of the SOFIX. After the Slovak capital market lost 10% of its value, in the Ukraine the equity crash reached 80%.38 In Bulgaria, a similar development could already be forecasted at the time as the value of the SOFIX was showing a gradual decline post October 2007.39 The turnover at the SOFIX also experienced a dramatic reduction so that ultimately the national stock market mirrored the fate of the market in the Ukraine and the loss amounted to circa 70% on an annual basis.40 It could easily have been predicted that the stock market, as on the global scale, would be struck first. Besides being especially volatile and dependent on the sentiments of some of the more speculative investors, Bulgaria’s stock market was at a nascent stage and could not be treated by investors with the same degree of confidence as the wellestablished stock markets of the world. Just as in the equity markets in other Eastern European countries, Bulgaria’s stock market was not an exception to the rule that prime incentive for involvement in these markets was on the basis of highly speculative calculations and profit prospects.

37 Ivan Iskrov, The financial crisis and Bulgaria, a speech on 28 October 2008, http://www.fincity.bg/show. php?storyid=847 (retrieved on 26 August 2010). 38 Cf. ibid. 39 Cf. ibid. 40 Cf. ibid.

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The expectations of the stock market players, tracked in 2008, showed only vague signs of disappearing confidence. The aggregated values however revealed market apprehension.41 The greatest slowdown was, unsurprisingly, expected in the BG REIT index. Being an index created at the beginning of 2007 for fund-raising for the securitisation of the real estate sector, it suffered first from the deceleration of the economy and was expected to decrease for the first time since its initiation in the last quarter of 2007. The reasons given by the respondents for their cautious estimation with regard to all indices of the domestic stock market were, however, solely based on the expectation of reduced loan potential on the world markets and decreasing GDP growth on a global scale.42 Most surprising in their estimation of the stock market prospects were the banks – almost half of them were expecting further growth at the end of the year and the majority of those banks that were not that optimistic were reckoning at least with indices at the same levels the following year.43 These estimations were dramatically revised at the beginning of 2009. The banks above all others were expecting a decrease in the indices with the most marked fall predicted to occur in the BG REIT index.44 A great majority were still remaining optimistic though against the backdrop of a noticeable withdrawal of foreign shareholders from the Bulgarian stock market. Bearing in mind their share in the Bulgarian stock exchange market, the local investors could hardly be expected to invest at a level compensating for the withdrawal of foreign capital in the short run. This estimation was, however, mostly shared only by intermediate traders trading directly at the very stock market.45

41 Cf. ËÍÕÞÐÇ ÏÈ ÐÒÖÕÖÔÐßÍÙÒÐ ÈÕÈÓÐÏÐ Ð ×ØÖËÕÖÏÐ ÒâÔ ÐÕÐÙÚÍØÙÚÊÖÚÖ ÕÈ ÜÐÕÈÕÙÐÚÍ (Economic Analyses and Forecast Agency of the Ministry of Finance), ÐÕÈÕÙÖÊ ÙÍÒÚÖØ: ÖÞÍÕÒÐ Ð ÖßÈÒÊÈÕÐÇ #4/2008 (Financial Sector: Estimations and Expectations volume 4/2008), p.|7, http://www.aeaf. minfin.bg/bg/izdaniq/financial_survey_4_2008.pdf (retrieved on 26 August 2010). 42 Cf. ibid., p. 7. 43 Cf. ibid., p. 7. 44 Cf. ËÍÕÞÐÇ ÏÈ ÐÒÖÕÖÔÐßÍÙÒÐ ÈÕÈÓÐÏÐ Ð ×ØÖËÕÖÏÐ ÒâÔ ÐÕÐÙÚÍØÙÚÊÖÚÖ ÕÈ ÜÐÕÈÕÙÐÚÍ (Economic Analyses and Forecast Agency of the Ministry of Finance), ÐÕÈÕÙÖÊ ÙÍÒÚÖØ: ÖÞÍÕÒÐ Ð ÖßÈÒÊÈÕÐÇ #1/2009 (Financial Sector: Estimations and Expectations volume 1/2009), p.|5, http://www.aeaf. minfin.bg/bg/izdaniq/financial_survey_1_2009.pdf (retrieved on 26 August 2010). 45 Cf. ibid., p. 5.

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The bank lending proposals underwent a structural change. Whereas at the end of 2007 banks were first looking at the returns on an alternative investment opportunity before issuing a loan, by the end of 2008 the most crucial criteria became, inter alia, the competition on the supply side: banks were now rather tending to first take into account the number and offers of other competing banks and similar financial institutes and the National Banks restrictions on issuing loans that became effective in 2007.46 Similarly, the behaviour pattern of borrowers saw a change too. While at the beginning of 2007 potential borrowers were taking their decision in favour of a certain bank by the criterion of financial need, in 2008 the differences in prices and conditions became the crucial criterion: now more borrowers were looking for lenders with more favourable loan conditions or even for a bank alternative such as leasing companies or the stock market. The decisions of depositors in favour of a certain bank followed a similar pattern of decision-taking during the first year of the World Financial Crisis.47 The behaviour pattern of depositors remained unchanged under the circumstances of a global confidence crisis, quite on the contrary, the trust in the Bulgarian currency and the domestic bank system became even stronger despite the negative expectations in regard to the employment market.48

2.2.

Domestic Impact

2.2.1.

Private Sector Recession

The impact of the crisis on the private sector came with a delay. It had been predictable that the main impact would cause a recession of the economy due to a withdrawal of foreign capital from the country and the apprehensions of foreign direct investors.49 Experience had shown that, with fiscal or incentive measures implemented by the government, Bulgaria’s economy could maintain stability, though not the strong economic growth as seen in 2006 and 2007. An increase in unemployment and a decrease in demand and imports were expected to replace 46 Cf. ibid., p. 5, first chart. 47 Cf. ibid., p. 6. 48 Open Society, ÙÍáÈÕÍ ÏÈ ÒØÐÏÈ (Feeling of crisis), 30 April 2009, http://econ.bg/analysis86022/article160789/useshtane_za_kriza (retrieved on 26 August 2010). 49 Cf. Ivan Iskrov, The financial crisis and Bulgaria, a speech on 28 October 2008, http://www.fincity.bg/show. php?storyid=847 (retrieved on 26 August 2010).

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the market mood of the boom years. The impact of the crisis was, indeed, also expected to reduce the trade deficit, however this reduction would only be a statistical figure without any positive consequences as the general mood of the market would hardly provide for circumstances under which the diffidence of foreign market players could be compensated by domestic economic activity and intensified exports to strengthen the national position in international trade. The reason for that is the structure of Bulgaria’s economy whereby foreign investors own the vast majority of the industries producing competitive products and, at the same time, became reasonably apprehensive under the circumstances of investment risk and uncertainty. Further consequences of the crisis were deemed to be a decrease in the pricing level causing stagnation in the development of wages and salaries and the inflation rate as well.50 Nevertheless, Bulgaria encountered the crisis with the shield of stable fiscal conditions and confidence in the financial market. Though highly dependent on the foreign capital basis of its banks, the bank system continued functioning and the restrictions that had to be made were rather moderate. The monetary reserve of the Bulgarian National Bank provided the guarantee of maintaining, firstly, the credit rating prior to the crisis as well as, secondly, financial certainty. Following picture demonstrates the deferred effect of the crisis on Bulgaria’s economy as a whole and by composition: Picture 3: GDP between 2007 and 2009 by composition in billion levs, source: National Statistics Institute, 2010. 50.000 45.000 40.000 35.000 30.000 25.000 20.000 15.000 10.000 5.000 0

GDP totalincluding corrective factors Governmental expenditure Financial services Trade and other Services Construction Industry Agriculture

2007

50 Cf. ibid.

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2008

2009

As can be seen, the impact on the overall GDP was insofar negative as it returned to its level of 2007. The only sector that could expand its contribution to the national economy was that of the financial services whereas the sector that had to suffer the most was the construction sector due to both withdrawal of investors and harder accessibility of financial resources. The financial shield formed by the monetary reserve prevented scenarios as they developed in Latvia, Hungary or, at a later stage, Romania. The monetary supply could be guaranteed without having to be expended on any bank saving measures as it was the case in Latvia or, even more prominent, in the USA and Germany. The financial stability of the country led indeed to a recession, however not to a dramatic extent. The data presented above, however, represent only the development of the GDP until 2009. As the World Financial Crisis unfolded, the effect on Bulgaria’s economy was at first deferred. The drop in economic output did not spread itself over a long period but appeared in a condensed form in 2009 and 2010. In 2009 the GDP shrank by 5%. During the first quarter of 2010 the GDP also decreased by 3.6%.51 The downward curve seems now to have been only of a temporary nature: already in the second quarter of 2010 the decline decelerated to only 1%.52 The deceleration of the slump was registered in all sectors of the economy: services, manufacturing industry and agriculture. The service sector, however, is having the greatest impact on the negative numbers for GDP. A positive factor which has countered the general fall in GDP is the increase in exports measured against the background of reduced imports, thus generating a lower trade balance deficit.53 The factor causing a drop in GDP on the expenditure side of the balance sheet is falling consumer spending. Manufacturing industry showed the most pleasing numbers which helped to bolster the economy during the crisis: the decrease in the manufacturing industrial sector amounted to less than 1%.54 This, however, was not a stable trend after reaching the bottom at the end of 2009, showing an overall decline of -7.5%.55 As 51 ÍÕÚâØ ÏÈ ÐÒÖÕÖÔÐßÍÙÒÖ ØÈÏÊÐÚÐÍ (Centre for Economic Development), ÖÒÓÈÌ ÏÈ ÐÒÖÕÖÔÐÒÈÚÈ ÕÈ âÓËÈØÐÇ ÒâÔ ÒØÈÇ ÕÈ æÓÐ 2010 ËÖÌÐÕÈ. ÍÏæÔÍ (Report on Bulgaria’s economy at the end of July 2010. Summary), p. 1, http://ced.bg/event.php?EventID=166&year=2010 (retrieved on 26 August 2010). 52 Cf. ibid., p. 1. 53 Cf. ibid. 54 Cf. ibid. 55 Cf. ibid.

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explained above, the construction industry had overheated the market and it was predictable that it would be hit the hardest after its exorbitant performance in the previous year and the sudden and drastic (in comparison to other sectors) collapse in growth reflected this. However, this collapse can be viewed relatively. Firstly, the sector saw extreme growth in the previous decade and, secondly, after completion of a large number of construction projects, demand to a degree had been satisfied. The growing export of industrial goods however has already begun to compensate for the vacuum left behind from the boom of the construction sector so that the overall prospects are developing towards a gentler decline in GDP and, at the latest in 2011, Bulgaria will probably join the other economies that are on the way to recovery. Exports were slightly growing already at the end of 2009 and at the beginning of 2010 the growth rate reached 5.9%.56 This increase can be traced back to the export of goods which increased during the first quarter of 2010 by more than 10%.57 The production of goods returned to its historic level at the end of 2009 and is generating increasing turnover from the domestic market. The prospects for exporting these goods to external countries were rather better during the period of a strong US dollar; however exports will have to be promoted if they are to reach the level they achieved before the outbreak of the crisis. A positive sign in this regard is the 26% increase in export of machinery and spare parts for European and Asian countries, and the 20% increase of raw materials that were exported during the first months of 2010.58 Imports have shown a recovery after the five quarters of strong decline but the low level is still contributing to a better trade deficit balance. The goods being imported more intensively are raw materials and resources for the domestic manufacturing industry which will most probably provide a good fillip to Bulgaria’s exports. This shows that Bulgaria’s economy is gaining speed again and that the deferred outbreak of the crisis has not resulted in a deferred recovery. Bulgaria is not only following the general trend of recovery in the European Union but is also demonstrating an improved competitiveness in industrial manufacture. This development, unfortunately, may only be a short-term effect because the governments of the European Union are cutting back on public expenditure which may trigger a reduction in demand.

56 Cf. ibid., p. 2. 57 Cf. ibid. 58 Cf. ibid., p. 3.

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The decrease in the service sector can also be explained to a great extent by the impact of the construction sector’s collapse. A service sector that is closely related to it is the real estate services sector which depends on project development and, even more than the construction itself, on the market sentiment. Forming a part of the service sector, it impacted unfavourably the whole service sector output during 2009 and in the first half of 2010. Another sector that follows the development of construction is the tourism sector. The hotels and restaurant trade saw a decrease of turnover of more than 8% tool.59 Similarly, the sector of communications and transport contributed to the negative balance of the service sector. Following picture represents the development of people engaged as entrepreneurs or employees in the country’s economy shortly before and at the beginning of the crisis: Picture 4: Development of the economic activity of the population, source: National Statistics Institute, 2010. 4,000 3,500 3,000 2,500 2,000 1,500 1,000 500 0 2007

2008

2009

Inhabitants engaged in economic activity

Employed inhabitants

The changes in real growth and capitalisation of businesses also had their impact on the employment rate. This can also be indirectly seen in the decrease of the consumption share in the GDP expenditure. At the beginning of 2010, households spent 8% less than at the end of 2009 and continued cutting outgoings in 2010, spending still 7.3% less in the second quarter of the year than in the first quarter.

59 Cf. ibid., p. 2.

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The picture demonstrates that unemployment increased in comparison with 2007. However, as 2007 was a boom year with climbing wages and salaries combined with a large number of new start-ups, the decrease can be deemed a typical cyclical manifestation of the economy’s fluctuation. Moreover, the number of people engaged in any kind of economic activity, but not as an employee increased slightly compared to 2007 suggesting that the impact of the crisis on entrepreneurship may have been positive. The background of this development can be seen in the efforts of the government to introduce incentive measures for the re-qualification of dismissed employees. The unemployment growth rate decreased in the course of the first half of 2010, however the unemployment rate itself still remains high and the expectations of businesses are for a continuing decrease in employment60. The level of unemployment, however, does not cause many concerns against the background of the European Union as the national and the union level of unemployment are comparable. The only part of the population suffering from a higher unemployment rate is the youth. In this regard, Bulgaria does not have as many employment opportunities when compared with the average for the European Union.61 The peak of unemployment was reached in February when it amounted to 10.26%. 2.2.2.

Governmental Involvement

Bulgaria’s market attractiveness was documented in a report of the World Bank of 201062: Bulgaria was ranked number 81 out of 183 economies by the criterion of Doing Business. In other regards, such as investors’ protection, however, Bulgaria did far better, its rank was 38. Behind these figures, there are complex developments that have taken place in recent years. Corrupt and stolid administration were continued to be blamed for Bulgaria’s lack of attractiveness in the Eastern European region even after the accession to the European Union. Efforts were said to be made, however the results were not perceptible for a long time. Eventually, in 2008 the trade register was modernised and its functioning electronic version was introduced together with an obligation for all traders and companies to re-enrol themselves in the new register system. This accelerated the launch of new companies and enabled smaller and 60 Cf. ibid., p. 4. 61 Cf. ibid. 62 World Bank, Doing Business. Measuring Business Regulations. Bulgaria, http://www.doingbusiness.org/ ExploreEconomies/?economyid=30 (retrieved on 26 August 2010).

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foreign investors especially to set foot in the Bulgarian market more quickly. Moreover, Bulgaria launched a Corporate Governance Code that provided for an opportunity to do business on a more transparent basis. Another measure that gained in importance during the crisis was the act encouraging investors to do business in Bulgaria. The state engaged by passing this act in the provision of individual administrative services and shortening the deadlines for administrative services. Furthermore, the state provided for an opportunity of a facilitated acquisition of land property or rights in rem and of tax concessions. Nevertheless, 65% of the businesses were complaining that the regulatory regimes are opaque and non-transparent. The main areas where action is deemed necessary are named to be the old regulatory basis, the lack of a national strategy on levying taxes and fees, the lack of transparency and the weak institutional control.63 The government, nevertheless, refrained from alienating foreign investors by raising the tax rates. The solid fiscal basis formed in the pre-crisis years gave Bulgaria an opportunity to wait for the end of the crisis without changes of legislation to the disadvantage of investors.

2.3.

Foreign Impact

The biggest casualty of the crisis, however, was foreign investment. The deterioration in the flow of investment to the country in 2009 amounted to 14%. This, fortunately, did not shock the country after the abrupt downfall of foreign direct investments in 2007 compared with 2006 that amounted to 67.6% The underlying implication of these figures, however, should not be overestimated because in the dramatic growth of 2006, there were transactions included with a non-recurring effect so that the potential for maintaining the level of foreign direct investments in the years after 2006 could hardly be sustained. The following pictures illustrate the development of foreign direct investments throughout the boom years. The first of them illustrates only Bulgaria’s success in attracting foreign direct investments whereas the second one shows Bulgaria’s success in attracting foreign in-

63 Cf. ÍÕÚâØ ÏÈ ÐÒÖÕÖÔÐßÍÙÒÖ ØÈÏÊÐÚÐÍ (Centre for Economic Development), ÖÒÓÈÌ ÏÈ ÐÒÖÕÖÔÐÒÈÚÈ ÕÈ âÓËÈØÐÇ ÒâÔ ÒØÈÇ ÕÈ æÓÐ 2010 ËÖÌÐÕÈ. ÍÏæÔÍ (Report on Bulgaria’s economy at the end of July 2010. Summary), p. 4, http://ced.bg/event.php?EventID=166&year=2010 (retrieved on 26 August 2010).

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vestments compared to the progress made by other Eastern European Economies. The third picture reveals the origin of the investments and the fourth one their designation. Picture 5: Development of foreign direct investments in EUR billions, source: Bulgarian National Bank, 2009. 10,000 9,000 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1,000 0 1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

Picture 6: The Growth of the Foreign Direct Investments in Eastern Europe as a percentage of the GDP; source: Bulgarian National Bank, Bank Austria Credit-Anstalt, 2009. 25

20

15

10

5

2008

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2009

ia Slo ve n

La t via

Tu rke y

ary

Slo va kia

Re Cz

ech

Hu ng

lic pu b

nd Po la

ne Uk

rai

ia Ro ma n

a rbi Se

-5

Bu lg

ari a

0

Picture 7: Share of the foreign direct investments by origin, accrued values 1996-2009; source: Bulgarian National Bank, 2009. 18% 16% 14% 12% 10% 8% 6% 4% 2%

us si a R

It a ly

H

un g

ar y

SA U

s C

yp ru

an y G er

m

K U

ec e G re

s la nd et he r N

Au st ria

0%

Picture 8: Allocation of the foreign direct investments, source: Bulgarian National Bank, 2009. 25%

20%

15%

10%

5%

th er O

Te le co m

En er gy

on st ru ct io n C

Tr ad e

Fi na nc e

M an uf ac tu ri n g

R

ea lE st at e

0%

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The performance of the foreign direct investments can be traced to a large extent back to the financial crisis and the crisis of the real economy. The uncertainty as to which banks were endangered by a collapse and whether their restructuring would be supported by the governments of the G20 is the main factor that plausibly explains the abrupt refrain of the investors from realisation of projects in Bulgaria. The crisis of the Greek public debt and the pressure on Greek banks was the next factor that weakened Bulgaria’s economy without any reasonable grounds. The 30% share of Greek banks in the Bulgarian lending market and their 25% share in the deposits market led analysts to predict a collapse of the Bulgarian financial market.64 Similar comments about a potential risk were also spread in the media by representatives of the European Bank for Reconstruction and Development.65 These statements caused rumours about Bulgaria’s financial stability to the advantage of neighbouring countries where Greek banks hold shares in the market that are just half as high as their share in the Bulgarian market.66 The Minister of Finance of the present government relied on assurances from the Bulgarian National Bank that it would make sure deposit monies from businesses and individuals would not leave the domestic market towards Greece. Although the Governor of the Bulgarian National Bank reassured that deposits would not be directed to Greece, the danger that Bulgaria’s crediting market could rapidly shrink were not convincingly countered so that Moody’s predicted it would be highly likely that, notwithstanding the budgetary discipline, Greece’s problems would be transferred to Bulgaria.67 The performance of the foreign direct investments denoted a further remarkable downfall after the end of 2010. The accrued amount of capital that had flowed into the country by May 2010 totalled EUR 253 million. As a percentage of GDP for the according period, it formed only 0.7%. This means that the potential of the foreign direct investments to boost the economy and thus both raise the capital stock and the living standards of the population may have already been used up to a great 64 Cf. The statements of the Minister of Finance and the Governor of the Bulgarian National Bank, “Does crisis in Greece make Bulgarian bank system vulnerable?”, http://www.bnr.bg/sites/en/Economy/ Pages/1003GreekCrisisandBanks.aspx (retrieved on 26 August 2010). 65 Cf. The statement of the president of the European Bank for Reconstruction and Development in “EBRD sees Greek bank impact on Balkans”, http://www.reuters.com/article/idUSLDE6441YY20100505 (retrieved on 26 August 2010). 66 Cf. The statements of the Minister of Finance and the Governor of the Bulgarian National Bank, “Does crisis in Greece make Bulgarian bank system vulnerable?”, http://www.bnr.bg/sites/en/Economy/ Pages/1003GreekCrisisandBanks.aspx (retrieved on 26 August 2010). 67 Cf. ibid.

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extent. After the main flow of outsourcing processes circumvented Bulgaria in the late 1990s and the first five years of the new millennium, the country could only make any reasonable efforts to catch up with the other Eastern European countries between 2006 and 2008. It would be highly speculative to forecast that no more outsourcing of manufacturing or services will take place in the coming years to the extent it did in the boom years. However, to the East of Bulgaria, there are other emerging markets that also offer attractive investment conditions for particular personnel-intensive processes. The Caucasian and Middle-Asian states could outrival Bulgaria as it has to obey to strict requirements of the European Union pertaining to environment or competition protection. What is more, Bulgaria has exhausted the potential of tax cuts as the status of the public finances in 2010 signifies. Bulgaria will have to spend vast amounts of public money to hugely improve its infrastructure and reform its underfinanced educational system and its ailing healthcare system. Further investments to create high-quality infrastructure are highly recommendable because otherwise the country will lose investors whose operations entail the intensive transportation of goods and, in tourism, where a large number of visitors prefer to travel through the country under their own steam. To carry out all these necessary infrastructure projects, Bulgaria, fortunately, can rely on guaranteed financing from the European Union. However, the investments into the future of the society will have to be carried by the population, i.e. with tax revenues. And yet, Bulgaria still has opportunities to attract foreign direct investments. The nature of company business requires a high level of confidence in the market. Still offering somewhat low production costs, Bulgaria, theoretically, only needs to enhance the framework for doing business. The enhancement has partially taken place, however, mostly as new acts of law and not as efficient implementation of existing law. A stricter approach in the state administration and a clear vision for attracting foreign investments are expected to enhance Bulgaria’s chances for attracting new investors or motivating present investors to expand their engagement in Bulgaria.

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3.

Challenges and Coping with the Financial Crisis

3.1.

Fiscal Measures

The main mechanisms of influencing the crisis were believed by the Governor of the Bulgarian National Bank to be under the control of the Bank and the government.68 However, accruing a budget surplus to fill up the monetary reserve was not deemed to be a sufficient measure in the crisis. For this purpose, the budget contained measures for immediate restructuring in order to avoid or postpone payments from the foreign currency reserve. This means in particular that the headline large projects that would not lead to an increase of productivity in the economy had to be postponed or cancelled, and among these projects was and still is the construction of a new nuclear power plant. The effect of the nuclear power plant’s integration into the electricity grid is an arbitrary point: while some advocates of the project state that it would enhance Bulgaria’s electricity supplier position in the Balkans, opponents of the project predict that the costs would not allow the electricity to be priced at an attractive level to be exported. Moreover, the nuclear plant is said to become even a reason for an increase in electricity prices in the domestic market. These verbal protests were, unfortunately, not taken that seriously by the government. It signed in its last year a great deal of cost-intensive contracts in sectors that do not generate any earnings yet or at all, such as the construction of the nuclear power plant or military equipment for governmental needs. These decisions impacted the budget situation in 2009, however, at first only invisibly. Not taking any particular anti-crisis measures at that moment perpetuated the influence of the crisis on the real economy but, indeed, without any shock for the economy. In fact, the economy would not experience an immediate shock as the financial stability was guaranteed by the currency board and was additionally sustained by the monetary reserve that had been constantly growing in the prior years. The currency board in particular guaranteed the stability of the Bulgarian currency throughout the whole period of fluctuation of the major convertible currencies such as the dollar.

68 Cf. Ivan Iskrov, The financial crisis and Bulgaria, a speech on 28 October 2008, http://www.fincity.bg/show. php?storyid=847 (retrieved on 26 August 2010).

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In the midst of the World Financial Crisis the legislative and executive power changed. After a period of a boom, which unfortunately was also a boom of the corruption that could not be combatted efficiently, the political preferences began to change so that a new political movement based on citizens’ initiative and joined by several politicians from older parties and experts came into power. While some of the voters were disappointed by the previous government and wished a change hoping that a new political power would not carry the taint of corrupt interdependencies and lobbyists, others merely expected a more rapid increase of the living standards for the broader mass of the population. In any case, the change came at a time when the crisis had certainly reached Bulgaria so that the new government was facing enormous expectations to not only take efficient measures that would raise the living standard as expected but also to cope with the impact of the crisis. The first months of the new government were unfortunately used not to elaborate an immediate anti-crisis programme but rather to seek confrontation with the political parties which had previously been in power. The work of the new ministers was, at first, aimed at revealing any incorrect, unfair, corrupt or even criminal practices of the administration of the previous government. This was, however, to some extent a requirement of the European Union. The OLAF service of the European Union had been giving hints that funds of the European Union had been misappropriated for a long time before the change in government came into effect so that the new government had first to take measures to unfreeze the vast funds that Bulgaria could not use for co-financing projects in agriculture or regional development. The first positive effect of the new government’s work was to initiate investigation and prosecution and, thus, successfully unfreeze these funds. However, the crisis was still not over by that time and the statistics were showing a rather pessimistic picture. The main priority of the government before the end of 2009 was to follow the fiscal aim of not exceeding the budget deficit limit of 3% in order to qualify for the introduction of the euro in the approaching years. In the years prior to the outbreak of the crisis, governmental lending assumed the form as depicted:

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Picture 9: Crediting by/of the state, source: National Statistics Institute, 2010. 2.000 1.500 1.000 500 0 -500

2006

2007

2008

2009

-1.000 -1.500 -2.000 -2.500 -3.000

Issued credit (+) / received credit (-)

In 2009, the government was, for the first time for several years, unable to repay national debt or finance the social insurance or expend the budgetary surplus for other public purposes. Bulgaria had to take borrow from the Bulgarian National Bank, which completely counterbalanced the surplus accrued between 2006 and 2008. The exact correlation of revenue and expenditure during the year had also to be reorganised. First, to demonstrate what that correlation was in the boom years, the below illustration depicts the budget balance from 2004 to 2008:

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Picture 10: Performance of budgetary surplus generation, source: Bulgarian National Bank, 2009. 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 2004

2005 Expenditute

2006

2007

2008

Surplus

In 2009 the budget had to be financed with funds over and above the budgetary revenue. The budgetary deficit for 2010 is calculated to be 3.9%. This surprise for the government and for the European statisticians led the government to consolidate the next year’s budget in line with the performance of the economy and the expectations of low figures in the real economy. They did not need long to wait for the first results: in the first quarter of 2010 the budget entailed a moderate surplus and a slight deficit in the second quarter. On a consolidated basis, though, the deficit totalled 0.68 billion EUR in May 2010, which is still a deceleration in the growth of the deficit, compared with 2009. The deficit is a result of low revenues. In May 2010 the revenue deviated from the planned level by more than 15%69. Though the level of expenditure, for political reasons, exceed the budgetary plan by 2.4% in May 2010. The revenue from direct taxes such as value added tax or consumption taxes deviated from the planned figures by circa 20%70 although measures for fighting tax fraud had been introduced. 69 Cf. ÍÕÚâØ ÏÈ ÐÒÖÕÖÔÐßÍÙÒÖ ØÈÏÊÐÚÐÍ (Centre for Economic Development), ÖÒÓÈÌ ÏÈ ÐÒÖÕÖÔÐÒÈÚÈ ÕÈ âÓËÈØÐÇ ÒâÔ ÒØÈÇ ÕÈ æÓÐ 2010 ËÖÌÐÕÈ. ÍÏæÔÍ (Report on Bulgaria’s economy at the end of July 2010. Summary), p. 7, http://ced.bg/event.php?EventID=166&year=2010 (retrieved on 26 August 2010). 70 Cf. ibid.

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In the previous years, as it became well known, the customs information system was not connected to the information and control system of the tax authorities and the Ministry of Finance. The decrease can, additionally, be traced back to the altered demand for goods and another measure that was introduced to lighten the burden of businesses: the term for refunding the value added tax paid by a business was shortened, which negatively influenced the accrued revenue of that year. In general, the basis of the budget for 2010 is a reduction in expenditure. At the beginning of the third quarter of 2010 the budget was updated on the basis of new market information and negative expectations for the remaining quarters of the year. The main issue and reason for the budget’s update was, however, the proposition to reduce the minimal amount of the monetary reserve from 3.15 billion EUR to 2.25 billion EUR.71 In addition, the expenditure in the previous year’s budget had to be increased by the original 0.7% of the year’s GDP to 4.8% on a cash basis or, respectively, to 3.9% on an expenditure basis72. The legislator updated the budget mostly for the purposes of enabling further cuts in expenditure. With a possible indirect impact on the real economy, the public funds for wages and salaries in the state sector and, inter alia, the capital costs are to be reduced by up to 4.5%.73 At the same time, the expenditure for public health care is to be increased by more than 14%.74 This is the result of the government’s decisive measure to commence the reform of the ailing public health care system and not wait for the crisis to pass. To avoid social pressure, the costs for old age pensions were not reduced as was the case in Romania or, temporarily, in Latvia. However, the age for retiring is to be raised after long disputes with employee representatives. In addition the social insurance period, in which payments to the oldage insurance system are made, is to be extended by several years depending on the gender and the role. Early retirement is to be restricted as much as possible to concentrate the funds at the disposal of the government for higher pensions in the future and to pay them on the principle of equality after a certain age. Whether these cosmetic steps alone can guarantee the raising of old age pensions in the future as hoped for, is debatable. For this purpose, a reform of the further pillars of the pension system needs to be implemented. At the moment the progress of any such reform is at the discussion stage although the future of the old age pensions is seen in a self contributory system and not in a pay as you go state system. 71 Cf. ibid. 72 Cf. ibid. 73 Cf. ibid., p. 8. 74 Cf. ibid.

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As a further measure, the reserve for unforeseen and other special interventions was increased five times from 137 million EUR to 710 million EUR.75 This reserve is to cover expenses for structural reforms in different sectors and other measures resolved upon by the government. It shall be solely at the government’s discretion as to how to proceed with these funds and whether or not to draw on them. Against the background of cuts in expenditure throughout the European Union, Bulgaria’s decision to increase the budgetary funds allocated to some sectors has caused analysts to express suspicions that such a step would be perceived negatively not only by the member countries in the European Union but also by investors. The treaty violation proceedings because of the deficit exceeding the 3% threshold have already been initiated, however, governments throughout the European Union, be it long standing or new members, do not seem to be particularly concerned when proceedings are initiated for the first time in a number years. The proceedings are likely to be lost by Bulgaria if it realises the plan to commence a deeper reform of the state administration and the health care system because the budget hole cannot be filled up by any other means than fighting tax fraud. Such measures have also been introduced and are aimed at sectors where businesses are generally run off the record and do not declare their actual turnover and earnings. However, these measures have, by now, remained restricted to the hotel and restaurant industry so that the results are not sufficient to fill the 3 % budget deficit gap. In 2010, the Ministry of Finance finally presented a list of 60 measures to cope with the crisis actively. The measures were discussed and agreed upon by the government as well as the employers’ and the employees’ representatives. A list of those measures envisaged for strengthening fiscal stability is as following: Y

acquisition of additional internal and external financial resources;

Y

acceleration of the sale of CO2 emission rights to an amount of up to 50 million tonnes through the national green investment system;

Y

privatisation of minority shares through the Bulgarian Stock Exchange;

Y

liberalisation of the investment regime of the Silver fund (an institution sustaining and guaranteeing old age pensions with budget monies invested by using capital market instruments) and of other private capital-based old-age pension funds to allow them to invest in Bulgarian low-risk financial instruments;

75 Cf. ibid.

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Y

temporary suspension of the special VAT and duty free regime of public authorities;

Y

establishment of public registers for rented state and municipal property;

Y

amendment to the legal basis enabling the prolongation of rental contracts of the state. Offer for long-term rent of agricultural land to be paid in advance and an offer for public sale of agricultural land;

Y

introduction of a final tax on the income from monetary or real prizes received in games where the prize is determined by chance;

Y

change in the taxation of insurance payments;

Y

increase of the coefficient of advance payments on the corporate tax sum from 1 to 1.1;

Y

increase the state’s dividend from trade companies from 50% to 80%;

Y

forwarding 50% of the state or municipality-dominated companies’ income from rent;

Y

increase of the tax on dwellings with a tax value above 150,000 EUR and on automobiles with a tax value over 35,000 EUR by 100%; increase of 200% for tax on private yachts and jets;

Y

reduction of the payment period for work disability from 75 to 30 days;

Y

adoption of a time-plan for accelerated launch of a comprehensive e-government akin to the e-government of the European Union aiming at improving the business climate, optimising the administration, reducing corruption and increasing the transparency and efficiency of public expenditure.

Y

reduction of all taxes for the use of e-government services;

Y

outsourcing of state orders to private agents;

Y

launch of concessions on the road infrastructure;

Y

reduction of the state assistance to political parties by 15%;

Y

10% reduction of the current cost of authorities in charge of operations financed with funds from the state budget except for such operations that are delegated by the state. This does not apply to salaries and other remunerations in authorities that have optimised the number of their personnel;

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Y

reduction of the state and municipal budgets by the amount of the value of representative garments and official clothing (the cost to employees in the public sector for representative garments and clothing had previously been subsidised);

Y

adoption of a time plan for the repayment of the accounts payable due for performed orders and contracts in full amount;

Y

refunding of value added tax and consumption taxes within the shortened period of time;

Y

accelerated payment of the amounts due to beneficiaries of European Union funds; acceleration of the current programmes and launch of new projects in accordance with the operational programmes and the national plans for the purpose of maximal exploiting the European Union’s funds; increase of the advance payments to 40% of the due amount;

Y

launch of public registers for the sums due for performed orders and contracts with public authorities or European projects;

Y

commitment of the agents performing orders and contracts with the state to pay the due wages, salaries, contributions to social insurance as well as accounts payable to business partners as soon as the state has transferred the due amount;

Y

immediate amendment of the tax legislation to ensure that, during the time needed by the state to pay the refundable amounts of value added tax or consumption taxes, no interest or punitive payments shall be due for the creditors of the refundable amounts and that their access to European projects shall not be denied;

Y

simplification and shortening of the insolvency proceedings;

Y

monthly publications by the Ministry of Finance of the performance of the revenue and expenditure part of the budget and of an analysis including the amount of value added tax payable or refundable; monthly publications of detailed data on servicing the state debt including an economic analysis; monthly publication of detailed data on the monetary reserve and its composition; quarterly collection of information by the Ministry of Finance on the financial results of all commercial companies in which the state or municipalities hold the majority of the shares including the balance sheet and a report on their revenue and expenditure;

Y

increase in the personnel of the State Agency for Financial Supervision by ten experts for conduction of audits in some major commercial companies.

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3.2.

Macroeconomic Stimulation Measures

In the list of 60 measures to cope with the crisis actively, the Ministry of Finance included also a set of measures for strengthening the real economy. The measures were, similar to those designed to stabilise the fiscal background of the national economy, discussed and agreed upon by the government as well as the employers’ and the employees’ representatives. In the following, the list of the envisaged measures is provided: Y

increase in the capital base and attracted foreign resources of the Bulgarian Development Bank via a bond issue. Proceeds to be directed to an extent of not less than 60% to small and medium businesses. Analysis of the utilisation of the state Post facilities network in smaller towns and villages for the purposes of the Bulgarian Development Bank;

Y

establishing and activation of the CO2 share trade system. Determination of the accountability and the tax treatment of CO2 trade deals throughout the European Union;

Y

amendment to the Investment Promotion Act aimed at reduction of the thresholds for issuance of class A and class B investment certificates for activity in high-technology sectors as defined by Eurostat and for investments in municipalities with unemployment equal to the country’s average or above this level;

Y

introduction of a minimal threshold for investments in the areas of scientific research, education, medical healthcare, IT and arts; determination of the conditions for the issuance of certificates and for the promotion of projects having priority in any sector of the economy;

Y

strengthening of the municipal autonomy in levying taxes;

Y

definition of a single base for the calculation of waste fees which should be the amount of waste generated;

Y

facilitation of the issuance of entry clearance for Russian and Ukrainian citizens;

Y

launch of a mechanism for the increase of the minimal wages taking into account social and economic parameters;

Y

abolition of the maximum level for damage recovery payments in the case of unemployment and definition of the amount of damage recovery as 60% of the previous socially insured income; introduction of an obligation for unemployed persons to enrol at the Unemployment Agency’s office within seven days after the employment relationship is terminated;

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Y

making efforts for the temporary limitation of the increase in state-regulated prices of goods and services of public interest;

Y

establishment of a mechanism for guaranteeing the capital investments of socially insured persons in funds for additional old-age insurance which are deposited in commercial banks;

Y

measures in the framework of the operational programme for human resources and co-financed from the state budget for sustaining the employment in endangered enterprises by introducing flexible working time, a specific holiday for economic reasons; guaranteeing the employees’ rights to be recovered the damage of dismissal;

Y

providing additional monies for subsidised employment in accordance with the National Employment Plan;

Y

enhancement of the employees’ mobility by establishing a mechanism by the state and its social partners for monitoring the sectoral and territorial allocation of qualified employees;

Y

prolongation of the time period during which an employer may temporarily, until the end of 2011, engage an employee in the performance of a different job in the same or a different company for 45 to 90 days per year under the condition that the employee consents to the prolongation;

Y

restriction of the employment market access for persons from third countries save for highly qualified persons;

Y

establishment of mechanisms for providing a first job to young people educated in the framework of the operational programme for the development of human resources;

Y

amendment of the legal base governing competition to guarantee loyal competition and preventing distortion of the market through monopolist pressure on the suppliers of goods and services, as introduced in other European Union countries;

Y

a detailed review of the enterprises endangered by cessation of their activity due to violation of requirements of environment law of the European Union and analysis of the opportunities for the state to render assistance admissible under European law;

Y

collection of information from the National Revenue Agency on unpaid wages and salaries and providing aggregated data by activities and by regions quarterly;

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Y

use of the legal option for the Minister of Labour and Social Policy to expand the effect of the collective labour contracts of the particular sectors on the basis of mutual consent reached at the councils for trilateral cooperation of the particular sectors.

4.

Outlook for the Coming Years

4.1.

Pro-cyclical and Anti-cyclical Effects

The 60 measures adopted by the government have not yet yielded measurable results. However they can be expected to accelerate Bulgaria’s emergence from the cycle of the crisis because the core element of these measures is the promotion and encouragement of the private sector activity and the limitation of the government’s commitment to mere control or providing assets that it already has at its disposal. These measures should boost all sectors of the economy: from construction, which experienced a dramatic collapse, to industry, which is already performing comparatively well. The construction sector is expected to profit from the sale of unused shares in CO2 emissions as the income is envisaged to be invested in a vast project for the modernisation of the Socialist built housing estates. It will also be to the advantage of all private sector players if the government keeps its plan to refund value added tax and consumption taxes within the legally prescribed terms as this will increase the operational working capital of businesses. This promise of the government seems, judging by the complaints of businesses, to be evidently a mere manifestation of goodwill rather than an intention to reorganise the budget in such a manner that it could fit the plan to pay refundable amounts within the time period set forth legally. The positive effect of earlier refunding could however, be negated by the obligation to make monthly advance corporate tax payments on a 1.1 coefficient basis. The increase of 10% on a monthly basis leads to an annually accrued amount of 1.2 additional advanced payments which means that a thirteenth advance monthly payment is to be made. Even if refundable, the corporate tax is an annual tax so that refunding will take place with a delay and not on a monthly basis.

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The decision to increase the state’s dividend in state-owned and state-dominated businesses can be judged similarly. The increase will lead to additional revenue for the government and will broaden its basis to make more expenses during the crisis instead of giving the business an opportunity of reinvestment. The restructuring of the burden of social insurance payments to the disadvantage of sick or dismissed employees represents the third kind of measure that does not only cause a positive change but may have a negative impact, too. However, in the particular case of saving public money with regard to short term illness or periods of short unemployment, the negative impact is of minor importance, since in many cases of absence from work due to illness, benefit fraud is suspected and cutting the financial aid during unemployment normally encourages the unemployed individual to make more efforts to re-enter the labour market. As in Bulgaria’s present situation, there are funds that have been raised by the European Union to support projects that normally the state is involved in, the government has intensified its programme for investment in infrastructure of national importance. The projects that are to be realised in the coming years pertain to the motorway system, the modernisation of the main railroad corridors for express transportation of goods from Bulgaria’s seaports or airports into the country or further abroad and the Sofia metro. These measures are also a burden for the public purse, however, the monetary value of the positive effect on the national economy is expected to exceed the government obligations under these projects. The projects create jobs or maintain existing jobs and, in the long run, should generate earnings through the profitable use of the infrastructure.

4.2.

Fiscal Prospects

The commentary about the reliability of the state’s budget deficit plans as stated by analysts76 remains the one single exception to the rule that the government’s forecasts are based on solid research. Taking this into account, the budget should generate in 2011 a surplus again.77 The government is pursuing, furthermore, the aim of accession to the euro area so that there are strong arguments to assume that, even under circumstances of only moderate economic growth, a deficit in the budget is not planned for 2011 to 2013. The rating outlooks have furthermore sta76 Cf. UniCredit, Economics & FI/FX Research for the third quarter of 2010, p.|10, http://www.bankaustria.at/informationspdfs/CEE-QU_3-10.pdf (retrieved on 26 August 2010). 77 Cf. ibid., p. 13.

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bilised. Unfortunately, some reforms in the public sector must go into implementation in the up and coming years and their feasibility is not guaranteed by this year’s budget. If the economy does not return to a robust growth rate, there will be barely sufficient government money to accomplish the reform of the social insurance and the healthcare system. Under these circumstances, the gross foreign debt is not expected to be reduced in 2010 or 2011.78 However, it has to be remarked that the Bulgarian government’s debt is still under strong control and has remained at a laudable level reaching only 20% of GDP.79

4.3.

Prospects for the Real Economy

The real economy gives some reason to believe that it is on the way to recovery and positive GDP growth is expected for the third quarter of 2010 as well. At the moment it is being driven by export80 but Bulgaria’s export is not considered to have the potential to compensate for the stagnation in the internal demand if economy is to grow at a more healthy and sustainable pace. The consumer sector, unfortunately, is forecasted to remain weak especially as there is still pressure on wages and salaries81 and insolvency risk remains higher than usual. The conditions for funding are reported to show a deteriorating tendency. Domestic banks have increased the interest demanded on loans by around a fifth from an average of 7.02% in 2009 to 8.53% in 2010.82 The rate is possibly dependent of course on the risk of a bad loan.83 External funding is stagnating as a consequence of the European sovereign debt crisis and is not a real alternative under these circumstances.84 Loans for households have as a result, shown a decrease. The conditions for lending are expected to improve when there is certainty that the average level of foreign direct investments stabilises at a certain level and, additionally, the competition for extending loans in euro intensifies so that external funding becomes a cheaper alternative to funding by local banks. 78 Cf. ibid. 79 Cf. ibid. 80 Cf. ibid. 81 Cf. ibid. 82 Cf. ibid. 83 Cf. ibid., pic. 15. 84 Cf. ibid.

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Following pictures depict the expectations for GDP growth, the pressure on the labour market for employees (unemployment) and employers (average wages), for foreign direct investments and for the gross foreign debt that, together, compose the cornerstones of the 2011 forecast for a moderate recovery. Bulgaria will remain attractive due to its low production costs, however, these low costs may not be the decisive factor for launching an operation where the competition eliminates market players with low productivity. As foreign investments will not broaden the basis for the government to freely determine its economic and fiscal policy to the same extent as in the pre-crisis years, the challenge before Bulgaria is to maximise the use of the available European Union’s funds and to engage as many investors as possible in the exploitation of these funds. Also to promote the export sector, to generate a higher GDP, more revenue for the budget and more income for households. Both equity investing and applying for European funding offer excellent opportunities for existing and future investors to engage as suppliers, partners or consultants of Bulgarian businesses. Picture 11: GDP growth forecast, in billion EUR, source: UniCredit, 2010. 36 35.5 35 34.5 34 33.5 33 2009

2010

2011

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Picture 12: Average wages growth in EUR, source: UniCredit, 2010. 325 320 315 310 305 300 295 290 2009

2010

2011

Picture 13: Unemployment rate as a percentage, source: UniCredit, 2010. 11.5% 11.0% 10.5% 10.0% 9.5% 9.0% 8.5% 8.0% 2009

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2010

2011

Picture 14: Foreign direct investments in billion EUR, source: UniCredit, 2010. 3.5 3 2.5 2 1.5 1 0.5 0 2009

2010

2011

Picture 15: Gross foreign debt in billion EUR, source: UniCredit, 2010. 38

112 110

37.5

108

37

106 36.5 104 36

102

35.5

100

35

98 2009

2010 EUR billion

2011 Percentage of GDP

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1.

Situation before the Crisis

The years 2007 to 2009 will go down in the history of the world economy as the years of the great global economic crisis of our times. Unfortunately, without the benefit of hindsight, we may not be able to fully appreciate its scope, depth or consequences. The only thing that can reliably be said about the crisis today is that it is the largest economic recession that the young Czech Republic has gone through these past ten years. Before proceeding to a detailed analysis of the economic development that has led to the economic crisis, it could be useful to search for the parallels in the history of crises long past. The most obvious comparison would be with the Great Depression of the 1930’s. Hoping that this is a reasonable simplification, we would like to distinguish between two basic types of crises, i.e. between the financial (or fiscal) crisis and the economic crisis. The historical experience shows that economic difficulties tend to be triggered by the meltdown of the financial markets, liquidity shortfall in the banking system or currency fluctuations. In other words, the infection usually starts in the financial markets and then goes on to spread through the entire economy. However, given the initial unfolding of the crisis in the Czech Republic, we have come to the conclusion that the impact of the current financial crisis on the Czech economy was primarily second-hand. As late as at his press conference of 9 February 2009, the Czech President Václav Klaus commented on the financial crisis, its influence on the Czech economy in 2008 and the ambitious fiscal stimulus packages then introduced by Nicolas Sarkozy in France and Barack Obama in the USA by saying that “a recovery from an untreated case of cold takes seven days and a recovery from a treated case of cold takes one week.“1 There are several important similarities between the existing crisis and the Great Depression of 1929-1933. The real impact of the Wall Street Crash of 1929 transpired at a symbolic rather than an economic level. The actual causes of both economic recessions went deeper than what finally surfaced on the financial markets. And in both instances (1929 and 2007), the bursting of the financial bubbles, however dramatic, need not have had to spill over to the real economy, if handled otherwise.

1 In the third quarter of 2008, the industrial production of the Czech Republic still appeared to grow, albeit slowly (0.8 %), Source: Czech Statistical Office (www.czso.cz).

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J. Jungmann, B. Sagemann (Eds.), Financial Crisis in Eastern Europe, DOI 10.1007/978-3-8349-6553-0_3, © Gabler Verlag | Springer Fachmedien Wiesbaden GmbH

And while the Czech stock markets immediately plummeted on news of New York and London stock market crashes, the real economy initially appeared unaffected.1 In the meantime, however, foreign investors began to lose confidence and the volume of investments skydived as they decided to play safe. The money supply faltered. That in turn sapped consumers’ confidence and gradually stalled the growth of the entire economy. The small open economy of the Czech Republic thus more or less ‘contracted’ the crisis in consequence of the general slump in demand for Czech products on foreign markets. Nevertheless, since the Czech Republic did not adopt euro before the crisis, it could at least partially mitigate some of that impact through normal currency rate fluctuations. Let us now go back to our comparison with the Great Depression. Another common feature of both the 1930s and the existing global economic crisis is that both recessions were preceded by an overheating of the economy. The ‘Roaring Twenties’ stock-market bubble was driven mostly by the excess of capital gains flowing from post-WWI investments in European economies and from WWI reparations, combined with the USA policy of restraining European exporters from investing in its domestic markets (protectionism). The overheating that led to the financial and economic crisis of today was caused mostly by the vocal US government support of affordable home ownership ‘for everyone’, which was to be accomplished by subprime lending. Excessive money supply fuelled a housing market boom and encouraged debt-financed consumption. The securitisation of credit instruments accompanied by detrimental changes in household payment habits, and unrealistic ratings by credit rating agencies also significantly contributed to the current financial crisis. The inevitable freezing of the market with so-called toxic assets gave rise to a wave of insolvencies and bankruptcies. Unlike in the Great Depression, where the prices stopped falling only as late as in 1932, in our current crisis the price slump ended much faster. But the impact on international financial institutions was devastating; the crash mostly affected those who were directly involved in mortgage lending and derivatives investment. Czech banks, on the other hand, managed to overcome the financial crisis without any crashes, mostly due to the painful recovery process following the Czech currency crisis of 1997 and 1998, and due to the strict supervision and surveillance exercised by the Czech National Bank.

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1.1.

Methodology

Most economic experts share the sentiment that the gross domestic product and the empirical monitoring of its fluctuations constitute the most suitable indicator of economic development. While it is virtually impossible to gain a comprehensive insight of the day-to-day evolvement of the economy in its complexity, GDP facilitates the understanding in a broader context. And while the knowledge of the health of the domestic economy may not be gleaned just from an analysis of macroeconomic indicators inferred from national accounts, such an analysis still promotes better understanding of complex correlations between highly aggregated economic indicators, and provides an easy-to-understand perspective of the past development and current state of the Czech economy. For this reason, this analysis is based on the combination of both approaches, depending on whichever perspective may give us a better view of the issues that we try to describe. Whenever the character of a particular industry and the available figures allow, a year-onyear comparison, a commentary or an informative chart is provided. Unless noted otherwise, this paper is based on data and figures released by the Czech Statistical Office, Ministry of Labour and Social Affairs and Ministry of Industry and Trade.

1.2.

Economic Development

1.2.1.

The Lean Years of Economic Transformation

The free market economy of the Czech Republic is a product of a large-scale economic transformation of the Czechoslovak Socialist Republic after 17 November 1989 and the major political changes in December 1989. The transformation from a state-owned and state-planned economy to an open and free market economy was not without its bumps and turns, and in fact, initially leads to a major economic slump. The transformation entailed transfer of state-held resources to private businesses and the sale of state-owned assets to foreign investors.2 The initial wave of transformation and the consequent GDP freefall were driven mostly by the desire to accomplish the economic liberalisation as fast as possible. The price liberalisation resulted in an unprecedented rise in consumer price index. This was fol2 In the first post-communist years, privatization often involved management buy-outs by former socialist-era managements, often with disappointing results, both due to management’s inability to cope with the pitfalls of free market economy and due to so-called tunneling frauds. The impact of such MBO’s on GDP development is yet to be researched.

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lowed by a speedy liberalisation of foreign trade and the ensuing Czech currency devaluation. Together with restrictive fiscal policies, such measures ended up in the inevitable decline of domestic demand, with all the expected effects on GDP and the economy. The economical development was also detrimentally affected by the collapse of the Council for Mutual Economic Assistance (Comecon) and the associated decline in demand for Czech products, which coincided with the economic recession in the Western Europe, inhibiting attempts at reorientation of Czech exports. The demand for Czech products dived again when the Czechoslovak market collapsed in consequence to the break-up of the Czech and Slovak Federation. According to the estimates released by the Czech Statistical Office, the break-up of Czechoslovakia alone reduced the GDP by at least 2%. The Czech economy was battling the various adverse economic influences as late as in 1995, when the real GDP was almost 6% lower than at the end of 1989.3 Despite the cost-saving measures introduced to cope with the first wave of the flood, fiscal and currency crisis of 1997, at the turn of the millennium, the economic growth finally managed to rise above the pre-transformation levels. However, it can be said without fear of contradiction that the transformation of the Czech economy up until the year 1995 proceeded without any fundamental flaws, even though there were certain difficulties and missteps that had to be overcome. The economy was steered to free market conditions without any major detrimental impact on the welfare of the population. The progress of the reforms stuttered in the late years of the decade. A gap widened between high domestic demand and low domestic supply, and the volume of domestic investments diminished. Massive foreign investments unbalanced the economy beyond the zone of comfort and shifted the balance of current account deficit relative to GDP. In the years 1997 to 1998, the domestic economy experienced its first real crisis, albeit partially still in consequence to transformation efforts.4 This crisis is frequently referred as the Czech currency crisis or Czech banking crisis, and is further analysed in chapter 2.

3 Czech Statistical Office, Zdroje HDP a jejich užití v letech 1995 až 2005, 2006, p. 3. 4 Not all reforms were brought to a successful conclusion at that time; the banking sector reforms and selected pricing adjustments were postponed.

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1.2.2.

The Fat Years Before the Crisis

The statistics reveal that in the decade from 1999 to 2008 the Czech Republic experiences its first ten fruitful years. The gross domestic product at fixed prices grew continually from the crisis of 1997-1998, as attested both by GDP and other similar indicators, and by the development of the average gross salary. The inflation remained low throughout this period: Picture 1: Time series of GDP, real wages and inflation 1996 -2009; source: Based on data released by the Czech Statistical Office (www.czso.cz), 2010 25% 20% 15% 10% 5% 0% -5%

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

-10% GDP f.p.

Real w ages

Inflation

The picture shows constant GDP growth since 1999. Initially, the growth was accompanied by short spells of deceleration (2001 to 2002). Then the growth continued to rise steadily every year. The performance of the economy improved with investments in modern technologies and product innovation. The effective domestic supply outstripped the domestic demand, and the excess production was selling well on foreign markets, thus reducing the foreign trade imbalance. The reduced growth figures from 2001 and 2003 were caused mostly by the second wave of floods. It may be interesting to analyse the principal causes of the favourable economic development in the past ten years. The main factors affecting the gross domestic product are contemplated in the following.

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Credit Availability

An important characteristic of the domestic economic development over the last dozen years is the caution exercised by Czech banks after the banking crisis in 1997/1998. This credit caution played a major role in the rapid GDP growth decline in period 2000 to 2002, when the banks practically froze their lending activities (with the GDP still growing in this period, though) in order to accomplish recovery before the bank privatization planned and later carried out by the social-democratic government. The second cause of the 2000-2002 credit freeze entailed the administrative measures adopted by the Consolidation Bank in order to prepare Czech banks for privatisation. According to the analyses prepared by the Czech Statistical Office, the Czech banks used this period to create sufficient provisions and reserves. In 2003, the reserves were high enough to outstrip the banks’ risk aversion, and the banks gradually relaxed their tight credit policies. The statistics from this period indicate a close correlation between the volume of credits and nominal GDP growth, which continued until 2009. The stimulation effect of good credit availability on the Czech economy was particularly noticeable in the period from 2004 to 2007, when the volume of corporate credit grew by about 16% each year.5 Picture 2: Comparison of change in GDP at market prices and change in volume of bank credits; source: Based on data released by the Czech Statistical Office (www.czso.cz), 2010 30% 20% 10% 0% -10%

2004

2005

Change in GDP at market prices

2006

2007

2008

2009

Change in volume of bank credits

Interest Rates

According to the available statistics, there exists a demonstrable correlation between a GDP growth at market prices and year-on-year changes in quarterly interest rates of the Czech currency in the years 2001 to 2009. Theoretically, declining 5 Dubská, Drahomíra, Podnikatelské prostįedí a ekonomický rŃst éeské republiky, 2010, p.|2.

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interest rates should induce GDP growth, since the lower cost of credit is expected to stimulate investment and lead to lower costs of business operations, resulting in higher profits. However, this correlation can only be established for 2002 and 2007. One of the reasons why this correlation does not always apply to the domestic market, is the independence of the currency and interest rate policies of the Czech National Bank on the government’s growth projections. The other reason is the relatively low value of interest rates. Moreover, most Czech companies are owned or co-owned by foreign investors, whose financial resources also originate abroad. On the other hand, investors often prefer Czech inter-bank rates (at least since 2006) to EURIBOR. For this reason, foreign parent and affiliate companies are often funded by Czech capital.6 Picture 3: Comparison of GDP and inter-bank interest rate development; source: Based on data released by the Czech Statistical Office (www.czso.cz), 2010. 10% 8% 6% 4% 2%

-4%

2002

2003

2004

2005

1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q

1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q

0% -2%

2006

2007

2008

2009

2010

-6% PRIBOR 3M

GDP change

Income Tax

The impact of income tax rates on the GDP is expected to follow the same logic as the impact of interest rates fluctuations. An income tax certainly tends to be an important consideration for foreign investment decision-makers. The proponents of economic liberalism, in particular, promote the idea that lower income tax rates have a direct beneficial impact on the GDP. However, the data reported by the Czech Statistical Office regarding the development of nominal GDP and tax rates show no such correlation. The combination of reduced tax rates and GDP growth appeared in the short period between 2004 and 2007, but the national budget still 6 According to the Czech National Bank Act, CNB’s main mission is the stability of currency.

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registered significant deficit. Rather than reduced tax rates, the true reasons behind the economic growth in the period from 2004 to 2007 include the accession of the Czech Republic to the EU and the beneficial influence of prospering foreign markets on Czech exports. Picture 4: Development of Corporate Income Tax Rates and GCP 1996-2009; source: Based on data released by Czech Statistical Office (www.czso.cz), 2010. 45% 40% 35% 30% 25% 20% 15% 10% 5% 0% -5% -10%

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Corporate income tax rate

GDP at s.c.

Qualification and Skills

Perhaps more importantly, foreign investments are influenced by an assessment of production costs and the somewhat hard-to-measure level of skills and qualification of local labor. According to EUROSTAT, the Czech Republic is second only to Slovenia in the per-capita number of workshop engineers, machinists and skilled mechanics, surpassing even countries such as France, Germany or Austria. Similar correlation exists with regard to secondary school education rates, albeit to the detriment of university education. While only approximately 15% of the Czech population has a university degree, in Germany the numbers are more than 10% higher, although admittedly, college-level education used to be lumped under secondary education in the Czech Republic, because the Czech education system did not recognize bachelor’s degrees.

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Picture 5: Percentage of machinists and skilled mechanics; source: Based on data released by EUROSTAT, 2010, http://appsso.eurostat.ec.europa.eu/nui/show.do?dataset=cens_ reisco&lang=en (retrieved on 25 August 2010). 7% 6% 5% 4% 3% 2% 1% 0% SLO

CZ

BG

IR

SP

FR

HU

DE

SK

RO

AT

PO

NL

The Czechs also have a long and continuing tradition of industrial endeavour and Bohemia used to rank among the most developed regions of the Austrian monarchy. This may be one of the reasons why the working skills and qualifications of local workers still tend to rank high in comparison with other investment considerations. Speculation aside, the strong inflow of foreign investments at the turn of millennium in domestic processing and manufacturing industry was certainly driven by the profitable combination of good skills and qualifications and low wage levels of Czech employees, and acted as a major competitive advantage that influenced foreign investors’ decisions. Wages

Unfortunately, the low level of wages that used to attract investors to Czech Republic is now becoming a thing of the past. Even though the gross wages development closely follows the development of nominal GDP, meaning that wages grow as fast (or as slow) as GDP, wages have been growing at one of the fastest rates of all EU Member States. The cost of labour in the Czech Republic increased by 80% from 2000 to 2008. The average labour-cost increase in Germany in the same period (according to EUROSTAT) did not rise above 5%. There are two basic explanations for this development. Firstly, the initial payroll levels in the Czech Republic were significantly lower than in Germany, which means that even an 80% increase still does not bring the Czech Republic to German payroll levels. Secondly, in EUROSTAT, the numbers in Czech currency are converted to euros using the ever stronger CZK/EUR exchange rate, meaning that the relative increase in euros

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is much higher than the relative increase in Czech crowns. Whatever the reason, the fact remains that the increasing cost of Czech labour in euros remains a major problem for all Czech-based employers operating at high payroll to total costs ratio. Labour Productivity

The following picture reveals that in the period from 2004 to 2006 the labour productivity growth outstripped the growth of real wages. Unfortunately, it is impossible to determine what was is the exact impact of the slump in demand for Czech products in 2007 on the adjusted labour productivity index, although it is safe to assume that at that time the labour productivity still grew faster than real wages (as it should in healthy economy). Our detailed analysis of labour productivity growth (see below) appears to corroborate our findings on aggregated figures. Picture 6: Comparison of three Selected Economic Indicators; source: Based on data released by the Czech Statistical Office (www.czso.cz), 2010. 8% 6% 4% 2% 0% -2%

2002

2003

2004

2005

2006

2007

2008

2009

-4% Labor productivity

Real w ages

PRIBOR 3M

Investment Incentives

Investment incentives used to be one of main instruments exercised by the Czech government in order to attract foreign investors. The most common incentives included tax relief, direct payments for every new job, compensation for training and retraining costs, gratuitous or discounted lease of operating premises, such as by way of industrial parks. In the Czech Republic, the availability of government-sponsored investment incentives is region-based. For example, while no incentives are available in (relatively wealthy) Prague, the largest proportion of in-

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vestment incentive is spent in the nearby Central Bohemian Region. From 1998 to January 2010, the Czech Republic distributed investment incentives in the total value of 530.9 billion CZK, which corresponds to almost one eighth of the GDP in 2009. Most incentives were used to support investments by German companies (over 25% of all incentives), while one eight of all incentives were used by domestic investors.7 Investment incentives are targeted at several industries, but the automotive industry incentives certainly prevail. In fact, due to the auto industry incentives, the Czech Republic manufactured as many cars as the much larger and more populous Italy (with all the favourable and adverse effects this may bring) in 2008. Unfortunately, the dependence of the Czech industry on automotive production cycle is strong enough to be considered an addiction (see the picture below). Consequently, through investment incentives, the Czech governments have substantially shaped the future of the domestic economy, and, in turn, the depth and the development of the economic crisis. Picture 7: Comparison of Car Production and GDP Development; source: based on data released by the Czech Statistical Office (www.czso.cz), 2010.

Change in motor vehicle production

3.Q 0 9

1.Q 0 9

3.Q 0 8

1.Q 0 8

3.Q 0 7

1.Q 0 7

3.Q 0 6

1.Q 0 6

3.Q 0 5

-30% -40%

1.Q 0 5

0% -1%

3.Q 0 4

-10% -20%

1.Q 0 4

2% 1% 3.Q 0 3

10% 0% 1.Q 0 3

3%

3.Q 0 2

4%

20%

1.Q 0 2

5%

30%

3.Q 0 1

40%

-2% -3%

GDP at market prices

National Debt

Regrettably, the otherwise fairly positive economic figures are spoiled by the soaring public borrowing and national debt (despite its short-term beneficial impact on GDP as it stimulated public and private spending). Enormous as it is, the 7 Czechinvest and own calculations.

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national debt may still be perceived as tolerable when viewed from the perspective of the past and projected GDP growth. Less tolerable is the fact that the national debt continued to rise even in the times of substantial GDP growth. Picture 8: Comparison of GDP, Public Budget Deficit and National Debt Development; source: Based on data released by Czech Statistical Office (www.czso.cz), 2010. 10% 5% 0% -5%

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

-10% -15% -20% -25% -30% -35% Public deficit/GDP

National debt/GDP

GDP at s.c.

GDP Growth Analysis

It could be illuminating to inspect the economic development in the pre-crisis years from the perspective of GDP growth analysis. In 2004, the growth was driven mostly by gross domestic investments, or as referred to today, by gross capital formation (incl. inventory). The impact of the foreign trade growth was partially eliminated by the lower consumption expenditure. In 2005, the year-on-year GDP growth accelerated to 6.4% to reflect the rising foreign trade balance at fixed prices and final consumption expenditure. Unfortunately, the gross capital formation amounted to mere 0.1% in 2005 due to slipping inventory numbers. In 2006, the effect of the foreign-trade balance and the final consumption expenditure figures evened out; the GDP was also favourably influenced by the high level of investments. The change in the foreign-trade balance accounts for higher exports in that period. In 2007, the impact of final consumption expenditure surpassed the impact of gross domestic investments and the stagnating trade balance figures. For more details, see the following illustrative picture:

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Picture 9: Development of gross investments, foreign trade balance and final consumption, source: Ministry of Industry and Trade, Analýza vývoje ekonomiky éR a odvøtví v|pŃsobnosti MPO za rok 2007, 2008.

7.5% 5.5% 3.5% 1.5% -0.5% 2004 -2.5%

2005 Gross investments

1.2.3.

2006 Foreign trade balance

2007 Final consumption

Bountiful Years Just Before the Crisis

Shortly before the crisis, the economy was growing fast allied with a minimal inflation rate. In 2004, real wages grew slower than the GDP to the benefit of the domestic economy. From 2005 to 2007, the economic growth surpassed the 5% level that indicates a healthy economy, and even outstripped the GDP growth of the neighbouring countries (with the exception of Slovakia and the Baltic countries). The financial sector also appeared reasonably fit. The inter-bank interest rates were steadily declining and the domestic three-month PRIBOR was lower than EURIBOR.

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Picture 10: Time series EURIBOR 3M and PRIBOR 3M; source: Based on data released by the Czech Statistical Office (www.czso.cz), 2010. 5% 4% 3% 2% 1% 0% 2004

2005

2006

EURIBOR 3M

2007

2008

PRIBOR 3M

1.2.3.1 2007 – The Best Year Ever

Ironically, the first year of the world financial crisis became the year when the Czech economy accomplished its highest GDP growth in recent history. Even though some of the new EU Member States recorded higher growth figures, the domestic growth was still fairly respectable. The figures were construed as a clear indication that the Czech Republic and its neighbours8 were gradually closing the gap between their economies and the economies of the more developed EU Member States. For example, while the GDP of the Czech Republic grew by 6.5% in 2007, the EU average amounted to 2.9%. According to the data released by CSO and EUROSTAT, the Czech per-capita GDP at purchasing power parity amounted to 82% of the EU average in 2007. No wonder that after several good years, domestic consumption expenditure finally become one of the chief driving forces behind the GDP growth. Compared to the past, the domestic gross fixed capital formation grew by 6.1%. Car pool investments grew by 8.6% and machinery and equipment investments by 7.9%. Speaking of the favourable macroeconomic indicators, it is also worth noting that the trade balance shifted again in 2007, and the exports outstripped the imports. The difference between the exports and imports was fairly insubstantial, though, with exports growing by 14.5 % and the imports by 13.7 % – an indication that the Czech economy was (and still is) import-intensive. The economic experts welcomed the then record-breaking trade balance surplus and the fact that the 8 In 2007, both the Czech and the Slovak economy recorded record-breaking GDP growth. In the Czech Republic, the real GDP growth amounted to 6.5%, in Slovakia to 10.4%.

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Czech Republic was the only new EU Member State that actually recorded trade surplus in 2007. Approximately 80% of the domestic foreign trade was with EU Member States, the trade with Germany constituted one third of the total domestic foreign trade turnover. The trade balance with Slovakia, which used to be the principal foreign trade partner of the Czech Republic after the break-up of the Federation, dropped to mere 9%. And while the Czech economy registered trade surplus with other EU Member States, it also recorded a trade deficit with the rest of the world – meaning that our domestic imports with non-EU countries surpassed our exports. The disproportion was caused chiefly by the import of mineral fuels. Machinery and motor vehicles remained the principal domestic export articles, accounting for more than 50%. The industry numbers in 2007 also indicated growth in high added-value production (automotive industry, electrical engineering industry, IT industry). More than 60% of the entire production was designated for export. It might be worth describing the overall structure of the Czech economy at this point. In 2007, industry accounted for almost one third of the domestic GDP, services for more than one half. Compared to the past, the building industry remained at about 6%, while the agriculture dropped to less than 3%. For details, see our chart below: Picture 11: Structure of Czech Economy; source: Based on data released by the Czech Statistical Office (www.czso.cz), 2010. Industry 16.3%

Building

3.7%

2.8%

10.1%

Agriculture

6.4%

Other services 42.5%

Commerce and hotels 13.7% 15.0%

32.0%

Transport and communications Banking Production Services

Manufacturing accounted for 27.5% of the total 32% figure for the entire industry. The remaining 5.5% can be attributed mostly to mining (black and brown coal), related production and electric power distribution.

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The construction industry registered a solid 6.7% growth in 2007, which indicates that the growth of the domestic economy was not one-sided. The growth in the construction industry was driven mainly by large-scale industrial and administrative development projects and by continuing intense residential development. In 2007, the number of new finished apartments grew by 38%. However, the number of new residential development projects stagnated. Direct foreign investments in 2007 amounted to 9.3 billion USD, that is 6.4 billion USD in reinvested profits and 2.8 billion USD in new investments. Rather than industry proper, direct foreign investments were targeted mostly at real property and construction development, services to manufacturing industry and financial intermediation. At the same time, there was a capital outflow of more than 1.4 billion USD in long-term credit payments, dividends and reductions of the capital stock. The aptness of the ‘fruitful-year’ reference is also attested by the fact that the labour productivity outperformed real wage growth. In 2007, the average wages in the manufacturing industry grew by 4.5% in year-on-year comparison, the labour productivity grew by 6.6%. However, our analysis of the labour productivity numbers reveals that the growth was also partially driven by rising employment levels9 (of about 2%), which means that the adjusted labour productivity remained approximately the same as the real wage expenditure (the labour productivity growth gradually came to a halt in late 2007). The productivity stagnation that followed is usually blamed on the shortage of trained employees in certain highly-qualified engineering professions. Similar skill shortage was observed in other, lower-profile technical professions. The rising employment figures in certain industries meant that in 2007 the general unemployment rate dropped below the 1998 level for the first time in a decade. Lower unemployment and higher real wages also made the household consumption expenditure one of the chief driving forces behind the economic growth in 2007. Increased consumption was also motivated by more readily available loans, broader consumer product range, and increasing retail chain competition. The sales revenues were on the rise despite higher sales margins. Interestingly, the growth in food and foodstuff prices was somewhat compensated by lower prices of non-foodstuff products, mostly due to the rising comparative strength of the Czech currency in relation to EUR and USD. Unfortunately, growing consumption also brought about stagnation in the volume of savings, which has remained virtually unchanged over the past ten years. 9 This includes both the employment of formerly unemployed persons and the increase in the number of economically active persons abroad; the total number of economically active persons dropped, though.

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The good impression left by such economic figures was somewhat spoiled by public fiscal deficits. Even though the public debt was some thirty percent lower than originally planned, it still increased, as did the gross external (foreign) debt of the Czech Republic (from 37% in 2008 to 38% in 2007). Although the value of foreign exchange reserves in Czech crowns (held by the Czech National Bank) kept falling, their value in US dollars increased. In absolute numbers, Czech foreign exchange reserves correspond to approximately three months of trade imports, which is held to be adequate.10 Due to the rising CZK/EUR exchange rates, the income (and particularly wages) converted to euros appeared to increase rapidly, even though the nominal increase in CZK was much less substantial. This change was chiefly due to the favourable foreign trade developments. Picture 12: Comparison of CZK/EUR Development and Import/Export Balance; source: Based on data released by the Czech Statistical Office (www.czso.cz), 2010. 36 34 50

32 30

0 2001

2002

2003

2004

2005

2006

2007

-50

2008

28 26 24

-100

CZK/EUR at 31/12.

Trade Balance in CZK Billion

100

22 -150

20 Trade balance

Annual average CZK/EUR

Unfortunately, these favourable developments were soon to be interrupted by the onset of the economic crisis. The above picture reveals that the trade surplus growth ended already in 2008, mostly in response to the emerging global economic crisis and due to the fact that the strong currency inflated the prices of Czech products. The domestic economy was also facing the risk that it could lose its competitive advantage of cheap and well-qualified work force, in which case companies with low profit margin and high labour-cost ratio would withdraw their investments. 10 Ministry of Industry and Trade, Analýza vývoje ekonomiky éR a odvøtví v|pŃsobnosti MPO za rok 2007.

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But strong Czech currency helped the economy to keep tight rein on inflation. The decline in the prices of imports absorbed the growth of domestic consumer prices (especially the foodstuffs and utilities), and the fuel prices. While consumer prices growth remained at about 5%, the average inflation rate was only about 3%. Low inflation levels have been acting as an important stabilizer of the Czech economy over the past fifteen years. 1.2.3.2 Downsides of High Economic Growth

Favourable economic figures are not always accompanied by favourable development in other areas. Unfortunately, the progress in the enforceability of law appears to follow the opposite direction. For example, the duration of bankruptcy and settlement litigations has substantially increased over the past few years. While in 2004 only one in four of all bankruptcy lawsuits were older than five years, in 2008 it was almost one half (44%).11 More than one quarter of bankruptcy lawsuits were still unsettled after more than seven years of litigation. This is particularly disturbing in view of the fact that in Belgium, Netherlands or Ireland, to name just a few countries of comparable size, average bankruptcy litigation lasts about six months. It is also much easier for businesses to file bankruptcy in those countries than in the Czech Republic. The recovery ratio of bankruptcy lawsuits in the Czech Republic is also very low – creditors recover only about 19% of all their filed claims, because the owners usually manage to transfer the solvent and unimpaired assets from the insolvent businesses either before the start or in the course of the bankruptcy proceedings. The inadequacy of Czech insolvency laws may also be illustrated on the lack of correlation between the number of new bankruptcy lawsuits and GDP development. In fact, large corporations appear virtually immune from bankruptcy, which seems to affect only small and medium-sized companies most of the time. The arrival of the recent world economic crisis changed this situation somewhat, when the number of bankruptcies increased in response to falling GDP. Company formation procedures used to be so protracted and complicated that it gave rise to ‘turnkey businesses,’ i.e. new empty-shell businesses sold by professional promoters and company formation agencies. Recently we have seen improvements in the administrative law that eliminates at least some problems, but ‘turnkey companies’ tend to be quite popular even today.

11 Dubská, Drahomíra, Podnikatelské prostįedí a ekonomický rŃst éeské republiky, 2010, p. 1.

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It is therefore hardly surprising that the Czech Republic tends to occupy some of the lowest ranking positions on the Corruption Perception Index published by the Transparency International of all EU Member States (usually the eighth to third worst ranking)12.

2.

The Impact of the World Financial Crisis (2008/2009/2010)

2.1.

Economic Development in 2008, 2009 and 2010

2.1.1.

So Far So Good – Year 2008 and the Onset of Global Crisis

In 2008, the financial crisis first started to affect the real economy. As shown in the following picture, which is based on data released by the EUROSTAT, the impact of the global crisis on Central European markets was still rather difficult to discern in early 2008. But while the Central European economies were flourishing (despite currency fluctuations), the German economy was already in deep recession, and the 2.1% slump in German GDP in the last quarter 2008 still constituted one of the best results of all old EU Member States. Countries like Slovakia, Poland and the Czech Republic with their relatively reasonable national debt appeared to be in good shape and fared well against the first wave of the crisis. The deceleration at the end of the year 2008 and start of year 2009 was caused mostly by the demand shock, i.e. the sudden slump in foreign demand, combined with growing domestic consumption. Hungary and Baltic countries experienced the first sign of problems at a much earlier date – in 2007, because their high public debt already severely disrupted their internal and external economic stability (see the next picture). 13

12 éeská republika, Transparency International, available at http://www.transparency.cz/doc/cpi2009_cz.xls, and http://www.transparency.cz/index.php?lan=cz&id=16&pom_id=87 (retrieved on 11 August 2010). 13 Local data are translated to euros at current exchange rate, which means that slight fluctuations in the opposite directions are possible.

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Picture 13: Comparison of Economic Development of CR and its Neighbours, source: Based on data released by EUROSTAT: http://appsso.eurostat.ec.europa.eu/nui/setupModifyTableLayout.do, 2010. 10% 5%

0 1Q 1

9 3Q 0

9

9 2Q 0

3Q 0

9

8 3Q 0

1Q 0

8 2Q 0

8

8 1Q 0

4Q 0

7 -5%

4Q 0

0%

-10% -15% -20% CZ

SK

HU

PL

DE

Throughout 2008, the Czech economy appeared reasonably fit even though the GDP growth started to slow down, mostly due to the demand shock and diminished household consumption. The first true warning signs entailed the slump in trade balance in the month of October, followed by a decline in production numbers. The GDP still continued to grow, mostly due to the large nominal increase in domestic consumption. But real increase in domestic consumption was unfortunately affected by large inflation figures, which were in turn driven up by an increase in the reduced VAT rate from five to ten percent, by substantial housing price increases due to deregulation or rent and by rising natural gas and electric power prices. The combined effect of such changes meant that the Czech Republic suddenly had one of the fastest rising inflation rates in the EU – despite the fact that high commodity prices made headlines all over the globe. The foregoing macroeconomic figures are not the only proof of the small and open character of the Czech economy. The numbers about the revenue produced by foreign-controlled companies in correlation to total industry revenues are perhaps even more illuminating. According to the information released by the Ministry of Industry and Trade, in 2008 foreign-controlled companies produced more than 63% of the total industry revenues, and employed almost one half of all people working for the industry (46.1%). Despite the emerging crisis, the volume of direct foreign investments into Czech economy was still encouraging, even though the proportion of re-invested earnings increased. The capital stock investments were

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still comparable with years 2006 and 2007; investments came mostly from Germany, followed by Cyprus. It will probably not come as a surprise that the largest investments were targeted at financial intermediation and real property sectors.14 Picture 14: Total Direct Investments in éR in 2007; source: Based on data released by MPO, 2010.

B

NL

DE

AT

LUX

S

CH

USA

os tatní

FRA

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

The dominating presence of the Netherlands in the above picture deserves a short comment. The low tax burden available in the Netherlands motivated many investors from countries such as Germany or Austria, as well as many Czech investors to transfer their headquarters to the Netherlands, which is why so many Netherlands-based companies appear as direct investors in the statistics. For the same reason, the hitherto low investments from Cyprus appear to be on rise. Czech currency underwent some major developments in 2008. The domestic currency appreciation in comparison to the two principal reserve currencies peaked in summer, when the Czech crown improved by 11% compared to euro and by almost one quarter compared to US dollar. This was followed by a slow but steady decline in relative value, which continued in 2009. It is interesting to compare how the Czech currency and foreign-export figures evolved over time. Picture 15: Comparison of Average Monthly CZK/EUR Rates and Year-on-Year Export Figures; source: Based on data released by CNB and www.czsu.cz, 2010.

10% 0% -10%

Jan

Feb

Mar

Apr

May

Jun

Jul

Aug

Sept

Oct

Noc

-20% Change in Czech exports

Dec

22.000 23.000 24.000 25.000 26.000 27.000

CZK/EUR

14 Ministry of Industry and Trade, Analýza vývoje ekonomiky éR a odvøtví v|pŃsobnosti MPO za rok 2008.

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CZK/EUR

Export changes

20%

The fundamental numbers show seemingly inexplicable strengthening of Czech currency in the face of declining export. Only after the summer holidays did the Czech currency start to move hand in hand with the exports, gradually making Czech products more affordable and competitive. Despite the slower growth, the total Czech trade balance ended up in surplus, even though the surplus was lower than in 2007. The favourable development in the second quarter of the year was mostly influenced by a new Hyundai manufacturing plant which opened in Nošovice (Silesia), higher production of the TPCA plant in Kolín (joint venture of Toyota, Peugeot and Citroën), and the high production output by the Hitachi plant in northern Bohemia and Foxconn in Pardubice. It almost seemed plausible in summer 2008 that the trade surplus could bring record-breaking numbers, but everything changed at the end of the year, when the domestic currency strengthened again in witness of increased supply of foreign currencies on the EUR/CZK and USD/CZK markets. Favourable annual figures at the end of year 2008 for industry and foreign trade were also confirmed by the developments of the labour market. The average recorded unemployment rate dropped by 1.1% to a virtually unprecedented 5.5%. Since the year-on-year employment figures increased by 1.2% and there was a substantial rise in nominal wages (somewhat held back by high inflation), the productivity of labour stagnated. In June, the registered unemployment rates dropped to the lowest ever figures in recent history. However, the labour market was already partially overheated at the time, since the salary negotiations were based on the excellent economic results in 2007 and did not account for the fast market and economic changes brought about by the emerging crisis of 2008. The labour market data tallied with the foreign trade figures; the trade surplus in July 2008 corresponded to the aggregate trade surplus of two or three previous months. The picture would not be complete if we failed to mention the growth of building industry, which amounted to 0.6% on average, with the public-funded infrastructure investments growing by 11% and residential development by 8%. Unfortunately, the commercial development projects decelerated by 6%. Small contractors dealt with the situation by improving their efficiency and productivity, which made them competitive with larger companies, and thus helped them avoid substantial downswing. In short, if the financial crisis had not affected the real economy, year 2008 would have been a very good year for the Czech Republic. The public fiscal stability was still reasonably good; all substantial macroeconomic indicators in the ear-

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ly months of the year were excellent. The economy approached its short-term optimum and was in black numbers. This would make the impact of the crisis in the subsequent year even harder to swallow. 2.1.2.

2009 – The First Year of Crisis

As seen in the first picture in chapter 2.2., which depicts the GDP development over the last fourteen years, year 2009 was the first year of economic recession, with three consecutive calendar quarters recording falling GDP figures. Picture 16: Comparison of Average Monthly CZK/EUR Rates and Year-on-Year Export Figures; source: Based on data released by the Czech Statistical Office (www.czso.cz), 2010. 10%

760 750

5%

740 0%

730

GDP change

GDP in 2000 in CZK bn

770

720 -5%

710

GDP in 2000

GDP change

After a decade of constant growth, the Czech economy suddenly recorded the first year with a real GDP decline of about 4%. This was the largest economic recession in the recent history of the Czech Republic (see the introductory picture). In principle, though, the domestic economic development only followed that of the entire Europe. The Euro-zone overcame the recession in the third quarter of 2009, and stagnated in the last quarter of the year, as did the Czech Republic. Compared to its neighbours, the recession experienced by the Czech economy was less steep than in Slovakia, but more substantial than in Poland. In fact, Poland is the only EU Member State, which appears to have avoided the recession altogether. Compared to the Czech Republic, Poland is much less import dependent and benefits from higher domestic consumption, which keeps the external fluctuations under better control, provided that the public debt is held at bay.

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What is the chief culprit of the crisis according to Czech companies? A survey organized by the Czech National Bank reveals that Czech companies blame lower demand (52.1%), worse customer payment habits (34.4%) and the difficulties in obtaining funding for their operations through standard financial channels (27.2%). The main defence mechanisms exercised by Czech companies include budget costs (89%), lower production volume (49%), lower margins (40%) and prices (34%).15 These responses also answer to the question about the correlation between the fiscal and economic crisis – in the Czech Republic, the crisis spread in consequence to the combined effect of the demand shock and consumption reduced to the detriment of coerced savings. The Czech domestic industry production fell by 13.4% in 2009; in the first months of the year, the figures declined by up to 20%. In the second six months, the freefall gradually halted but uncertainties remained, until in December the production numbers began to rise again. The recession persisted for 14 months. The most affected industries included machinery and equipment production and metalworking industry – some of the most traditional Czech industries. The automotive industry, which exports two thirds of its production, was affected by the crisis at the start of the year before the introduction of a scrappage program in Germany and in later in other neighbouring countries. As noted later in the text, the Czech government also introduced a scrappage program but never came to implement it in practice. However, the Czech automotive industry and all its subcontractors managed to benefit from the scrappage bonuses offered by other countries. The only industry branch that was not affected by the crisis was the foodstuffs industry. Household consumption was the only beneficial contributor to GDP growth. The crisis was naturally accompanied by corresponding developments in payment habits. According to the Confederation of Industry of the Czech Republic, 92% of 1,600 respondents reported deterioration in payments habits at the end of the second quarter of 2009. In December 2009, worse payments habits were reported by 80% of respondents. In the first quarter of 2010, payment habits deterioration was reported by 61%, 4% reported improvement and 33% respondents reported no change.16 Worse payment habits are dangerous for the economy, because they lead to secondary insolvency, thus exposing companies to insolvency risk. The existence of secondary insolvency also reduces the quality of trade relationships between the companies involved. 15 Singer, Miroslav, Insolvence z|pohledu éNB, 2010. 16 Confederation of Industry and Trade, http://www.spcr.cz/cz/ankety/anketa_spcr_cerven.doc, http://www.spcr. cz/files/anketa_12_2009.doc; http://www.spcr.cz/files/cz/ankety/anketa_spcr_duben_2010.doc (retrieved on 15 August 2010).

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There exists a statistical correlation between the development of payment habits in the Czech industry and quarterly GDP development. Based on the business cycle surveys organized by the Czech Statistical Office (CSO), June 2009 was the worst month of crisis from the perspective of payment habits, when 92% of respondents cited deteriorating payment habits as the most significant detrimental issue affecting their business. The general trend has been changing ever since September 2009, but the improvement is not substantial. However, the CSO’s assurance about the close correlation between payment habits and GDP development is certainly good news.17 It means that the solvency and payment habits are (and hopefully will be) improving along with the GDP growth. An interesting revelation can also be gleaned from a 2009 survey organized by the Hamburg-based EOS Group. Based on the analysis of this survey carried out by éeská exportní garanêní a pojišĹovací spoleênost, CSO came to a conclusion that German companies are considerably more disciplined when making payments to other German companies than in paying, for example, their Czech counterparts (contractors, suppliers). Such issues have also amplified the impact of the world economic crisis on to the Czech Republic. In early November 2008 and then throughout the year 2009, the volume of corporate credit facilities plummeted. However, the decline was not caused solely by increasing wariness on the part of banks and their declining willingness to give credit. The nosediving demand and severe production cutbacks meant that companies had no need for the same volume of operating capital as in the years of prosperity. This observation is supported by the data released by factoring and leasing companies. These alternative capital funding providers recorded their largest year-on-year turnover fall-off, as confirmed both by the Secretary General of the Czech Leasing and Financial Association, Jiįí Pulz,18 and by its Report on the Condition and Development of Non-Banking Leasing Credit and Factoring Market in the Czech Republic. But in the first quarter 2010, the factoring companies registered with the Association of Factoring Companies of the Czech Republic, reported a 4.7% increase compared to the first quarter of 2009. The recovery of the economy still does not appear to have affected the market of leases for movable assets, which records 19.6% decline in the year-on-year comparison.19 17 Drahomíra Dubská, Podnikatelské prostįedí a ekonomický rŃst éeské republiky, 2010, chapter 6 – Payment Habits, p. 2. 18 Vlastimil RŃžiêka, Leasingový trh zaznamenal nejprudší meziroêní propad, http://realit.cz/clanek/leasingovy-trhzaznamenal-nejprudsi-mezirocni-propad (retrieved on 12 August 2010). 19 Czech Leasing and Financial Association, http://www.clfa.cz/statistiky/2010_1q_zprava.doc, http://www.clfa. cz/statistiky/zprava_o_stavu_trhu_2009.doc (retrieved on 12 August 2010).

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On the other hand, according to a survey organized by the Confederation of Industry in December 2009 of 1,600 Czech companies, three fifths of all respondents believe that the availability of credit has deteriorated. Still, this is a slightly better result than provided by the same survey from June 200920, even if the difference is rather small. More than one half of all respondents agreed that the availability of operating credits, in their own experience, is very good. In the area of investments, the availability of credit still appears problematic. Gross investments, or rather their decline, were one of the principal holdbacks of GDP growth. This component of the gross domestic product was falling ever since the second half of the preceding year and in 2009 this unfortunate tendency still continued. Reduced inventory thus remains the only benefit of the decline in gross investments. The construction industry fared reasonably well, with a slight, one-percent decline. The industry was driven chiefly by large-scale infrastructure projects funded by the state and European budgets; other branches of the construction industry were in decline. The number of freshly completed apartments grew, nevertheless. Some may explain this development by reference to higher average wages and higher unemployment. We believe, though, that these figures are caused chiefly by the long delay between the closing of a purchase contract and the actual apartment completion, final inspection and handover. The reason for an increase in the average wages is slightly dismal, even if logical – rising unemployment rates due to mass redundancy of low-paid blue-collar workers with so-called variable wages. Nominal wages growth stalled in response to the crisis, a much welcome change compared to the preceding year’s development, but real wages (especially in comparison to euro) still rose due to low inflation. We believe that in the long run this development is detrimental to the interests of domestic economy. While the common wage-earning population may welcome rising wages with open arms, investors, especially those with low added-value investments and high labour cost ratio, have been gradually turning away from the Czech Republic, and have started transferring their manufacturing facilities to more affordable markets.

20 Confederation of Industry and Trade, http://www.spcr.cz/cz/ankety/anketa_spcr_cerven.doc, http://www.spcr. cz/files/anketa_12_2009.doc, http://www.spcr.cz/files/cz/ankety/anketa_spcr_duben_2010.doc (retrieved on 12 August 2010).

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Picture 17: Evolution of registered unemployment rate; source: based on data published by MPSV, 2010. 10% 9% 8% 7% 6% 5% D ec

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Unlike in most other markets, there have been virtually no transactions in the merger and acquisition market in the Czech Republic during the recent crisis. While mergers and acquisitions tend to be much more common during economic prosperity, so-called forced acquisitions tend to be almost as frequent in the time of crisis. Most often, these entail recovery or remedial takeovers of a competing or complementary business, often for a fraction of its value in the times of prosperity, or sale of redundant segments which do not contribute to the core business of the company. However, in the Czech economy, there were no substantial forced sales in 2009, if we are not accounting for the usual bankruptcy and insolvency proceedings. The Czech Statistical Office proposes an explanation21 that Czech banks tend to support their corporate clients despite deteriorated fundamental figures (through credit facilities, credit restructuring, postponement of payments etc.) It can also be explained by the fact that while bankers usually receive a bonus for every closed credit transaction (irrespective of the debtor’s ability to repay the debt), they also may lose their bonus if the debtor defaults and they have to recognize an allowance for such impaired debt. This may explain why the volume of toxic credits and their growth rate is not as significant as might be expected. On the other hand, there has been a steady growth in the volume of direct Czech investments abroad, as revealed by the business cycle surveys organized by the Confederation of Industry in 2009. Even though the relative increase is not sub-

21 Drahomíra Dubská, Podnikatelské prostįedí a ekonomický rŃst éeské republiky, CSO Prague, 2010, chapter 10 – Mergers and Acquisitions, p. 1.

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stantial (from 1% of Czech companies to 8%), Czech National Bank’s statistics appear to confirm these data (see our picture below). According to most commentators, the increase is the result of recent investments made by éEZ22 in the Balkans.

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Picture 18: Evolution of Czech Direct Investments Abroad; source: Based on data released by CSO (www.czso.cz), 2010

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Increase in volume of investments

Direct foreign investments in the Czech economy have declined but still remain in positive numbers. Despite almost a 50% drop in the total volume of investments, direct capital stock investments increased. The volume of re-invested profits remains high. Unfortunately, we have also seen a large outflow of other capital investments. From the regional perspective, there has been a large outflow of capital stock investments back to the Netherlands (more than 1 billion EUR), particularly in comparison to recent years (see our picture for the year 2007). Interestingly, the largest decline in capital stock investments occurred in the mineral mining industry, in particular in black and brown coal mining. In spite of the crisis, capital stock investments from German investors are on the rise; however, direct investments from Austria, Belgium and the USA still prevail. It is hardly surprising, seeing the impact of the crisis on the German economy, that there have been precious little investments to manufacturing industry or industry as a whole, and that investments are instead targeted at real property and trade operations. The economic prosperity of a small and open economy like the Czech Republic is largely dependent on its export skills and capabilities. This is of particular importance in view of the high proportion of manufacturing industry in our domestic exports, particularly motor vehicles and machinery. In fact, the importance of industry for our economy is even higher than for Germany (CR 30%, Germany 26%). At the same time, the service sector is on the rise, as is the number of companies 22 Abbreviation éEZ refers to éeské energetické závody a.s., electric power manufacturer and electricity provider controlled by the state.

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producing high added-value, which is certainly good news. Rising average wages and consequently also rising cost of labour (especially when converted to euros) deserve mention as some of the most worrying trends of the Czech economy today. On the one hand, this problem could be solved by adopting Euro as the Czech legal tender, which would stabilize wage growth in euros compared to slow nominal wage growth in Czech crowns. However, the currency also played an important role at the end of 2008 and in early 2009 as a buffer that helped keep the fiscal crisis at bay, and it helped restart the exports. Our experience from the 2007-2010 crisis shows that fiscal and economic stability very much depends on the domestic and foreign public debt and foreign currency exposure. Without stabilization and improvement – in particular with respect to public budget deficit – any future or the continuing economic crises will have much more severe impact on the Czech economy. 2.1.3.

Development in the First Quarter of 2010

The first favourable data from the end of 2009 and from the first quarter of 2010 hint at the slow but steady improvement. The recovery is driven by good foreign trade numbers, i.e. by the rising foreign demand. In the first quarter of 2010, the GDP grew by 1.1% according to CSO, an improvement that may also have been caused by the low comparative figures from the same quarter of 2009. Household consumption figures, which contributed to the substantial GDP slump in the second half of year 2009, still act as an impediment to faster growth, as does the continuing decline in the volume of investments.

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Picture 19: Evolution of Czech Export and Industry Levels; source: Based on data released by CSO (www.czso.cz), 2010 120% 110%

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The picture shows that the growth is driven primarily by exports, mostly in response to the recovering German economy as our principal trade partner. Despite the favourable GDP figures in 2010, some of the industries were still in decline. For example, building industry fell by one fifth during the first six months of 2010, mostly due to long winter and lower number of jobs on the market. Retail sales continue to slump along with the household demand, which is held back by consumers’ concerns about their economic future. It is no wonder, then, that the price level rose only slightly, despite the administrative intervention regarding transportation costs. Falling consumer demand is also partially driven by the rising unemployment and slower growth in nominal wages. Worryingly, in spite of still very low foreign trade surplus, the CZK is again on rise.

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29 28.5

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Picture 20: Evolution of CZK/EUR rate and Trade Surplus/Deficit; source: Based on data released by CSO (www.czso.cz), 2010.

2010 Average monthly CZK/EUR rate

In conclusion, the Czech economy has been performing increasingly better since third quarter of 2009. The recovery still appears fragile and the future developments are uncertain, as they depend on the economic prosperity of our main foreign trade partners. At this time, it is predicted that GDP will grow by 1.6 in 2010 and by 2.3% in 2011 (provided that the inflation rate remains at 1.6% throughout 2010 and at 2.5% in 2011)23.

2.2.

Banking and Financial Crisis in the Czech Republic

2.2.1.

Development of Czech Banking System

The 2008-2010 financial crisis had a very small impact on the banks operating in the Czech Republic. The government saved billions of CZK in bailout costs and the banks’ clients did not lose their savings. It must be said, though, that the Czech Republic had its major banking crisis already in the 1990’s, with several major banks going bust. The bailout and restructuring costs of the 1990’s banking crisis are estimated at more than 170 billion CZK. Such an expenditure is not dissimilar from the 23 Ministry of Finance, Department of Fiscal Policy, Makroekonomická predikce éeské republiky, July 2010, p. 5.

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amounts spend by the USA and European governments in the present economic crisis (in proportion to the size of the economies).24 Before proceeding in our analysis of the current economic crisis, we would therefore like to shed some light on the circumstances of 1990’s the Czech banking crisis.25 To explain the causes and timing of the Czech banking crisis, we must first discuss the transformation of the Czech economy in the post-socialist era. In the 1990s, problems with subprime lending and overvaluation of assets haunted virtually all banks owned by the domestic capital whether founded during the socialist era or after the Velvet revolution. The enormous outbreak of enterprising activities, huge public pressure and shortcomings in government regulation meant that banks were not able to avoid the subprime lending trap.26 Large banks managed to offload their old subprime debts to the Consolidation Bank, purging their portfolios from socialist-era loans and credits by way of Consolidation Program I, which reduced the volume of old subprime credits in the banking sector (net of Consolidation Bank) to 24 %.27 Consolidation Program I also aimed to rid the banks of their old debts and to replenish their capital through government bonds.28 Despite the fairly conservative credit policy exercised by most Czech banks, the relative volume of subprime credits continued to increase throughout the period 1997-1998. As to the causes of this development, these included the banks’ inability to satisfy their debts from the sale of securities and charges over book debts, or the fact that the banks overestimated the value of their assets. In 1999, subprime loans constituted up to 40% of new loans granted by large banks or up to 50% of total loans granted by small banks. On average, approximately 32% of all loans granted by the banking sector were subprime.29 24 Jan Šmíd, Banky v éeské republice postihla krize jen minimálnø, http://www.vstricnabanka.cz/banky-v-ceskerepublice-postihla-krize-jen-minimalne-127.html (retrieved on 20 August 2010). 25 Renata Pražáková, Co dølají zkrachovalé banky?, http://www.finance.cz/zpravy/finance/23459-co-delaji-zkrachovale-banky-/ (retrieved on 20 August 2010). 26 Bankovní krize v|éR, http://bankovnictvi-finance.studentske.eu/2008/04/bankovn-krize-v-r.html (retrieved on 20 August 2010). 27 Ibid. 28 Zbynøk Revenda, Įešení špatných nových úvørŃ a dalších problémŃ bank od roku 1993, http://nb.vse.cz/kbp/ TEXT/Grant_krize_2a.pdf (retrieved on 20 August 2010). 29 Bankovní krize v|éR, http://bankovnictvi-finance.studentske.eu/2008/04/bankovn-krize-v-r.html (retrieved on 20 August 2010).

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The new uncollectible or impaired debts mostly included privatization-related loans. The bankers often gave credit under the automatic assumption that privatization projects were going to succeed and that entrepreneurs would be able to repay their debts. Sometimes the projects failed. The situation was exacerbated by the fact that the largest wave of privatization loans dated back to 1992 when banks’ expectations about the forthcoming changes in real property and debt enforcement laws proved overly optimistic. The legislation did not allow the banks to foreclose the client’s real property without the client’s consent, and even if the client signed preliminary consent with automatic foreclosure in the event of default, the client could still revoke the consent at any time. In other words, without the property owner’s consent, the debt was virtually uncollectible.30 As to other causes which lead to the subprime crisis, the lack of qualified and experienced bank experts also played a major role, as did the aggressive business strategy of banks’ managements. Many bank managers also appeared to believe, perhaps out of habit of thought from the socialist era, that the government would always step-in in case of problems (in particular with respect to credits granted to state-owned or state-controlled companies). The bank regulation rules (on capital adequacy, liquidity, risk exposure, credit classification etc.) were still in the state of formation. Bank supervision, either by CNB or bank owners, was not always adequate.31 In their attempts to penetrate the credit market, new (small) banks in particular often gave credit to high-risk companies and individuals (moral hazard). Sometimes the debtors intentionally decided not to repay their loans, capitalizing on inadequate legal protection available to creditors.32 The Czech National Bank coped with the subprime lending crisis in three basic ways – by placing the failing banks into receivership (and other associated measures such as the revocation of banking license), by way of Consolidation Program II and by way of so-called Stabilization Program. The situation of Agrobanka was dealt with as a special case. The government was paying for the Consolidation Bank losses since 1996, but finally decided to proceed with a major intervention

30 Miroslav Tuêek, Revue Proglas 3/2001 / Bankovnictví devadesátých let, http://www.cdk.cz/rp/clanky/15/bankovnictvi-devadesatych-let/ (retrieved on 20 August 2010). 31 Zbynøk Revenda, Įešení špatných nových úvørŃ a dalších problémŃ bank od roku 1993, http://nb.vse.cz/kbp/ TEXT/Grant_krize_2a.pdf (retrieved on 20 August 2010). 32 Ibid.

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in 1998. Two years later, in 2000, the state pitched in again to deal with the problems faced by one more large, privately-held bank, Investiêní a poštovní banka. Two small banks lost their licenses in 2003.33 The generous bailout policy virtually released Czech banks from their dependence on the problems of the Czech economy. Foreign investors into the privatized banking sector did not have to worry about collecting unpaid debts from insolvent debtors. They did not have to exercise their extensive experience and international contacts to restructure problem-ridden Czech companies. The government magnanimously took up the burden of responsibility for all their problems and concentrated hundreds of billions worth of impaired debts in the hands of the Czech Consolidation Agency.34 Our 1990’s experience confirms that banking crises tend to be caused by a very complex set of problems, including, but not limited to subprime loans, imprudent security investments, difficulties in coping with plummeting real estate prices (overvaluation of assets), or inexperienced management.35 Some fifteen banks filed bankruptcy or liquidation in the Czech Republic from 1995 to 2003. But when the banking system in the USA and Europe all but collapsed in 2008-2010, and many US and Western European banks had to file bankruptcy or had to be bailed out by the local governments or central banks (e.g. USA: Lehman Brother, Germany: Hypo Real Estate, Island: Glitnir etc.)36, the Czech Republic was virtually unaffected. Apart from the government interventions in late 1990’s, which made Czech banks stronger than ever, there are several other reasons why the domestic banking system never became a victim to the global 2008-2010 banking crisis. The Czech banks never took up trading in complex derivative instruments. The proportion of toxic assets (such as investments in Icelandic banks and other high-risk as-

33 Zbynøk Revenda, Įešení špatných nových úvørŃ a dalších problémŃ bank od roku 1993, http://nb.vse.cz/kbp/ TEXT/Grant_krize_2a.pdf (retrieved on 20 August 2010). 34 Jiįí Weigl, Ohlédnutí za problémy privatizace êeského bankovnictví, http://www.klaus.cz/clanky/731 (retrieved 20 August 2010). 35 Bankovní krize v|éR, http://bankovnictvi-finance.studentske.eu/2008/04/bankovn-krize-v-r.html (retrieved on 20 August 2010). 36 Helmut Steuer, Staat übernimmt Islands Glitnir-Bank, http://www.handelsblatt.com/unternehmen/banken-versicherungen/staat-uebernimmt-islands-glitnir-bank;2051319 (retrieved on 20 August 2010).

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sets) held by Czech banks was negligible – less than 1% of all assets. The Czech banks are well capitalized and remain profitable despite the crisis.37 The domestic banking sector does not constitute a risk to the domestic financial sector. The 1990’s experience also made the domestic banks more wary of unknown and untested products and financial innovations. The conservative approach also helped the banks to keep adequate liquidity at the start of the global crisis (the banks have sufficient resources to lend money out of primary deposits) and helped them retain a small default rate on their credits. The banks also did not grant large volume of foreign currency credits, which made them insulated from the fluctuations on currency risk hedging markets. The capitalization of the domestic banking sector is also adequate on account of the Bank Act, which lays down a compulsory ratio between capital and capital reserves, and bank’s assets or liabilities. At the end of March 2010 (and for the first time since 2002), all Czech banks had a total capital adequacy ratio of more than 10% (the law sets forth 8% as the minimum). This indicates that Czech banks with their comfortable capital cushion are resilient against credit and market exposures.38 As on 31 December 2009, thirty nine banks were licensed to operate in the Czech Republic either as public limited companies or as structural units of foreign banks.39 The largest banks are owned by foreign equity. 2.2.2.

Interest Rate Development

One of the principal tasks and one of the chief monetary policy instruments of the Czech National Bank is to regulate money supply through interest rates in order to keep the inflation low and stable. The following chapters present an overview of the main characteristics of the Czech banking and financial sectors that contributed to the stability of the domestic banking sectors and that protected the Czech banking sector from the impact of the global financial crisis. As set forth in the Czech National Bank Act Section 2 (Act 6/1993 Sb.), the Czech National Bank is required to maintain price stability. Without prejudice to its primary objective, CNB is also

37 Miroslav Singer, Globální krize a êeská ekonomika oêima éNB, www.cnb.cz (retrieved on 15. August 2010). 38 Jan Frait, Zpráva o finanêní stabilitø 2009/2010, www.cnb.cz (retrieved on 15 August 2010). 39 éeská národní banka, www.cnb.cz (retrieved on 20 August 2010).

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expected to support economic policies of the government leading to sustainable economic growth. The Czech National Bank proceeds in compliance with the principles of open market economy.40 The monetary policy instruments applied by CNB in the monitored period evolved thus: Picture 21: CNB´s Interest Rates; source: Own picture based on data released by CNB (www. cnb.cz), 2010. 5% 4% 3% 2% 1%

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Repo rate is the interest rate at which the CNB repurchases government securities from commercial banks. It is one of the principal monetary policy instruments whereby the Czech National Bank regulates the money supply available on the market. Lombard rate is the rate of interest at which the Czech National Bank lends funds to domestic commercial banks. Discount rate is the rate charged by CNB to commercial banks on their deposit facilities (liquidity surplus). The monetary policies countered the adverse effects of the business cycle: higher rates in 2007-08 held the inflation and overheating pressures under control, lower rates in 2009 mitigated the adverse impact of freefalling foreign demand.41 As other central banks all over the world, CNB lowered the interest rates during the 20082010 crisis to affect the inflation. The policy of increasingly lower interest rates may be at its end, though.42 40 Act 6/1993 on Czech National Bank, http://www.cnb.cz/miranda2/export/sites/www.cnb.cz/cs/legislativa/zakony/download/zakon_o_cnb.pdf (retrieved on 22 August 2010). 41 Miroslav Singer, Hospodáįská krize a êeská ekonomika, www.cnb.cz (retrieved on 16 August 2010). 42 Miroslav Singer, Globální krize a êeská ekonomika oêima éNB, www.cnb.cz (retrieved on 15 August 2010).

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The following table shows the differences between the paces at which EURIBOR decreased compared to the domestic PRIBOR. Picture 22: Comparison EURIBOR vs. PRIBOR, source: www.cnb.cz, www.sdw.ecb.europa.eu, 2010. PRIBOR 3M annual average

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2.2.3.

Credit Availability

Czech banks were not affected by credit availability problems that played havoc with some other economies. The total volume of credit facilities given to businesses declined only as late as in August 2009 (for the first time since 2005). However, the growing volume of subprime credits resulting from rising numbers of insolvent businesses has certainly affected the bank’s willingness to give credit. In 2008 and 2009, there was a definite slump in the business credit dynamics, in particular owing to a decline in short-term facilities, caused mostly downswings in production and operating credit demand. 43 We believe that the banks’ policy is based on sound estimates of risks involved in additional subprime lending, since they are already coping with the rising risk of defaults in business credit facilities granted in the years of economic boom preceding the onset of the current economic crisis. The proportion of business subprime credits is on the rise ever since 2008 (about 3%); in spring 2010, it amounted to approximately 7.5% and still remains high. The proportion of subprime credits given to export-oriented business increased more steeply during the crisis than those granted to the entire business credit sector. The existing risk surcharge is still fairly high and we do not expect any substantial drop in the cost of credits in the foreseeable future.

43 Jan Frait, Zpráva o finanêní stabilitø 2009/2010, www.cnb.cz (retrieved on 15 August 2010).

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2.2.4.

Czech Currency Development

The Czech Republic is not a member of the European Monetary Union and holds on to its own legal tender. The new Czech government is apprehensive of setting forth a binding deadline for euro adoption, because it fears that fast euro adoption could accelerate inflation. In a small open economy like the Czech Republic, the official currency acts as one of the principal macroeconomic variables. Its fluctuations are closely related to interest rates set down by the Czech National Bank. Over the last ten years, the comparative strength of the Czech crown to euro has been steadily rising. It is a result of a complex set of many internal and external factors, including, but not limited to, the outcome of the economic transformation and the long-term changes on the supply side of the economy. Picture 23: Development of CZK/EUR Rate; source: Based on data released by CNB at www.cnb.cz, 2010. 40.00 35.00 30.00 25.00 20.00 2000

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This trend was interrupted by currency bubbles in years 2001 to 2004, and in years 2008 to 2009.44 The first of these bubbles came to pass when CNB reduced the interest rate at a slower rate than ECB. During the 2008-2009 crisis, the foreign exchange volatility increased. In late 2008, the Czech currency rate weakened in response to the Lehman Brothers crash, the onset of the financial crisis and foreignmedia campaign. This trend lasted until February 2009, when it suddenly reversed. The Czech crown rate has been steadily growing ever since.

44 Miroslav Singer, Vývoj kurzu koruny, nedávný hospodáįský vývoj a aktuální otázky mønové politiky, www.cnb.cz (retrieved on 16 August 2010)

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Over the past ten years, the CZK has strengthened also in correlation to the USD.45 Picture 24: Development of CZK/USD Rate; source: Based on data released by CNB at www. cnb.cz, 2010. 40 35 30 25 20 15 2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

Jun 10

CZK/USD at 31/12

Without euro as the legal tender, Czech exporters must account for foreign exchange risks whenever they trade their goods or services in euros. As the Czech crown strengthens, their profit declines, and sometimes a profitable transaction may even turn into a loss-maker. On the other hand, weaker CZK promotes exports, because it makes the goods and services cheaper on foreign markets. The strengthening CZK may also adversely impact the profit and the cash-flow of Czech companies that take foreign currency loans from a foreign creditor. Perhaps this is why foreign-currency credits constitute only 20% of the total volume of business credit facilities. 2.2.5.

Maastricht Criteria

This is an assessment of how the Czech Republic observes the four euro convergence criteria, also known as Maastricht criteria, as set forth in Article 140 of the Treaty on the Functioning of the European Union and in detail in the Protocol on the Convergence Criteria46 and Protocol on Excessive Deficit Procedure.47

45 Foreign exchange rates http://www.cnb.cz/cs/financni_trhy/devizovy_trh/kurzy_devizoveho_trhu/prumerne_ mena.jsp?mena=USD (retrieved on 20 August 2010). 46 Protocol (No.13) on the Convergence Criteria, http://www.zavedenieura.cz/cps/rde/xbcr/euro/Protokol_13.pdf (retrieved on 19 August 2010). 47 Protocol (No.12) on Excessive Deficit Procedure, http://www.zavedenieura.cz/cps/rde/xbcr/euro/Protokol_12. pdf (retrieved on 19 August 2010).

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According to EU Convergence Reports,48 the progress made by the Czech Republic over the years with respect to its obligations regarding the achievement of economic and monetary union developed as follows: Picture 25: The observance of Maastricht criteria in Czech Republic, source: Convergence Reports, 2008-2010, 2010. Criterion

Price stability

Government finance

Exchange rate

Long-term interest rates

2004

;

:

:

;

2006

;

:

:

;

2008

:

:

:

;

2010

;

:

:

;

Year

The table shows that in the long run, the Czech Republic has observed only the long-term interest rate criterion, not least because of the fact that the difference between ECB and CNB rates has been null for some time already. We do not expect any major future problems in this regard. More difficult to achieve is the price stability criterion, which the Czech Republic failed in 2008 in response to the pro-inflation shock caused mostly by rising indirect taxes and deregulation of prices. With the economic recession, the inflation substantially declined and continued to be fairly stable throughout the early months of 2010, despite additional increase in indirect taxes. With the forthcoming recovery of economy, a small increase in inflation can be expected in 2011. In the long run, Czech Republic is expected to fulfil this criterion. The sustainability of government finances has not been accomplished at any time during the monitored period. Ever since 2004, the Czech Republic has been reported in the Council Decision on the Existence of an Excessive Deficit, and received two recommendations on measures to adopt in order to observe the finances sustainability criterion (i.e. the government deficit and government debt criteria). 48 European Commission, European Economy No 1/2006, http://ec.europa.eu/economy_finance/publications/publication497_en.pdf (retrieved on 19 August 2010). Convergence Report 2008, http://ec.europa.eu/economy_finance/publications/publication12574_en.pdf (retrieved on 19 August 2010). Convergence Report 2010, http://ec.europa.eu/economy_finance/publications/european_economy/2010/pdf/ ee-2010-3_en.pdf (retrieved on 19 August 2010).

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However, we expect that the government deficit will continue to rise in 2010 and 2011, and that the government debt will continue to remain at the level set forth by the criterion. It is impossible to evaluate the fulfilment of the exchange rate criterion, because the Czech Republic is not a member of the ERM II exchange rate mechanism and its Czech crown exchange rates are not subject to the official parity grid. The compatibility of the domestic economy with Euro-zone economies and the consistence of the economic policies in place will help the Czech Republic in complying with this criterion in the future.49 2.2.6.

Stock Market Developments

Despite high fluctuations on the Czech stock market, not unlike on the stock markets elsewhere in the world, the impact of the domestic stock market on the Czech economy, and thus also on the Czech banking and financing sectors, is fairly limited. The number of companies that collect capital on the Czech stock market is also very small. The development of the Px index of the Prague Stock Exchange closely followed the evolution of other European indices, as confirmed by the Survey of the Czech Economy and MIT Sectors, published by the Ministry of Industry and Trade. In 2007, the Prague Stock Exchange copied the major stock markets and recorded an extraordinary PX index increase of 14.2%. The mortgage lending crisis of 2008 caused large-scale turbulences on all stock markets. Low money supply reduced the appeal of new stocks and the stock market indices plummeted. The Prague Stock Exchange experienced the worst year in its fifteen-year history, with PX skydiving by 52.7% as at 31 December 2008, and the total volume of transactions by 1.8% (compared to 5.1% increase in 2007). In 2009, the trading was still largely influenced by the global economic crisis. It was not until the second quarter of 2009 when the prices in both the world and Prague stock exchange market started to rise. It was an extremely volatile year, and

49 Ministry of Industry and Trade, Analýza vývoje ekonomiky éR a odvøtví v|pŃsobnosti MPO za rok 2007, http:// www.mpo.cz/dokument35578.html (retrieved on 19 August 2010). European Commission, A Convergence Report 2010, http://ec.europa.eu/economy_finance/publications/european_economy/2010/pdf/ee-2010-3_ en.pdf (retrieved on 19 August 2010).

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even though the growth was strong in the second and third quarters, at the end of the year 2009, the PX index still remained at about 42% under its historical best in October 2007. The year 2010 continues to be fairly volatile from the stock market perspective. However, the trading on the Prague Stock Exchange grew substantially, at a faster rate than Western-European and US indices such as S&P 500, NASDAQ Composite and Dow Jones IA. In the perspective of the existing public debt crisis, a deceleration and increased uncertainty is expected within the short term. However, it is believed that in the long run, the Prague Stock Exchange will continue to grow in response to weak euro. 50

2.3.

Mortgage Lending Crisis in the Crisis

This chapter deals with the development of the Czech mortgage lending markets and with the impact of the US mortgage lending crisis on the economy of the Czech Republic. To start with, we would like to note that the Czech Republic did not experience a mortgage lending crisis, and that the impact of the US mortgage lending crisis on the Czech economy was fairly limited. We will describe in this chapter the basic differences between the Czech and US mortgage markets and the reasons as to why the Czech Republic was spared the difficulties that afflicted so many other economies. It goes without saying that mortgage lending acts as a significant driver of economic development and growth. For this reason, developed mortgage market appears to be one of the defining features of developed market economies today, and there exists an apparent correlation between the fluctuations of the mortgage market and the economic growth. On the one hand, mortgage markets are affected by the economic development; on the other hand, economic development is influenced by changes and situation on the mortgage market.51

50 Ministry of Industry and Trade, Analýza vývoje ekonomiky éR a odvøtví v|pŃsobnosti MPO, http://www.mpo.cz/ dokument76395.html (retrieved on 19 August 2010). 51 Vøra Doubravská, Hypoteêní financování nemovitostí v|éR a dopad americké hypoteêní krize na hypoteêní trh v|éR, 2010, pp. 8, 13.

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2.3.1.

Mortgage Loans in the Czech Republic

There are two types of mortgage loans available on the market – specific and non-specific loans. Unlike other types of loans, mortgage loans are secured by a pledge or collateral attached to a real property. A mortgage can be taken up to finance private ownership of residential property or to finance commercial activities. Residential mortgage loans are subsidized by the government and the mortgagor is entitled to certain state-funded benefits52. In the Czech Republic, mortgage loan interests may be deducted from the tax base. A private borrower may deduct up to CZK 12,000 in interests (net of state subsidy) from his or her income tax base every year. 2.3.2.

Mortgage Market Evolution from 1995 to 2007

The history of mortgage markets in the Czech Republic dates back to year 1995, when commercial banks acquired their first mortgage licenses from the Czech National Bank, which entitled them to issue mortgage bonds. In 1995, the public awareness of the mortgage market was still very low, the interest rates high (about 15%), and the size of the mortgage market consequently fairly small. There were attempts at changing this situation through state-subsidized contributions, but these efforts were met with a mixed reception. Situation on the mortgage market started to improve after the year 2000 with declining interest rates and stabilization of Czech currency. Year 2003 witnessed the highest demand for mortgage loans, mostly in response to falling interest rates, which made mortgages affordable to a much wider cross-section of the population. However, the demand for mortgages was not driven solely by favourable interest rates. The purchasing power of the population also played a major role in this development, as did the growing numbers of people who wanted to own their home instead of just leasing it, whether for fear that the real property prices would substantially rise upon the Czech Republic accession to the EU or for fear of rent deregulation.53 The interest rates continued to fall throughout 2004. Many banks even adjusted their interest rates several times during that year in response to their competitors’ skydiving interest rates.54

52 František Pavelka / Dagmar Bardová, Opltová Radka, Úvørové obchody, 2001, p. 76. 53 Vøra Doubravská, Hypoteêní financování nemovitostí v|éR a dopad americké hypoteêní krize na hypoteêní trh v|éR, 2010, pp. 38-39. 54 Ibid., p. 39.

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In 2005, the clients’ preferences respecting the fixation period changed. While in the past, clients preferred one-year interest rate fixation, ever since 2005 longer fixation periods become the standard, usually in the range from five to ten years. The popular demand for mortgages continued to grow in 2006 despite rising interest rates. Year 2007 was the most successful year of mortgage lending so far, with every twentieth inhabitant repaying a mortgage loan. As to the average size of mortgage loans, it amounted to about two million CZK. The rising number of mortgages is closely related to ongoing deregulation of rents. Higher average wages have also contributed to this phenomenon, with increasingly higher number of people becoming eligible. Despite the rising interest rate, mortgage markets jumped up also just before the expected VAT-rate increase from 5% to 9%.55 2.3.3.

Impact of the Crisis on the Mortgage Market and Latest Developments

In response to the looming financial crisis, Czech banks tightened up their lending terms, namely by restricting the total sum of loan principle to 70-85% of the value of the mortgaged property. Income confirmations became standard. In developer projects, the client’s own contribution increased to 40% and in re-sale projects even to 50%.56 In 2007, interest rates continued to increase. In fear of increasingly higher rates, new clients began fixing their interest rates at three to five year periods, unlike in times of lower interest rate, when one-year fixation prevailed.57 In 2008, the mortgage market fell rapidly by about 20%, with the number of mortgage loans plummeting to levels prevailing in years 2005 and 2006. The number of new residential projects also dropped to its seven-year minimum. The demand for medium and small-sized apartments slumped accordingly.58 The first signs of market recovery appeared in the last quarter of 2009, but the number and volume of mortgages still rose slowly owing to the impediment of high interest rates. The deteriorating availability of mortgage loans caused stagnation in demand for residential property. Decline was recorded with respect to all fixation 55 Ibid., pp.40-42. 56 Aneta Mitková Bc., Hypoteêní krize v USA a její dopad na trh hypoték v éeské republice, 2009, pp.|74-75. 57 Vøra Doubravská, Hypoteêní financování nemovitostí v|éR a dopad americké hypoteêní krize na hypoteêní trh v|éR, 2010, p. 66. 58 Aneta Mitková Bc., Hypoteêní krize v USA a její dopad na trh hypoték v éeské republice, 2009, pp.|75, 77.

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periods, although the most marked slump occurred in one-year interest fixation mortgages. Three-year fixed loans accounted for 37% of the total volume of mortgage loans in 2009, five-year fixed mortgages accounted for 42%. A total of 44,402 mortgage contracts were closed in 2009 (at a total worth of CZK 74.389 billion). Although this may seem high, this amount still represents a noticeable 36.6% decrease compared to year 2008 or almost 50% decrease compared to year 2007.59 Picture 26: Mortgage loans from 2006 to 2009 (CZK thousands); source: Fincentrum Hypoindex, 2010. 1st Quarter

2nd Quarter

3rd Quarter

4th Quarter

Sum total

2006

18,255

26,347

25,598

28,743

98,943

2007

28,588

47,151

33,120

36,623

15,482

2008

26,426

34,605

31,517

24,733

117,281

2009

17,674

22,459

16,870

17,386

74,389

Despite falling interest rates, the mortgage market continues to decline in 2010, with a 7% year-on-year drop in volume. Highest price reductions occurred in threeyear fixation loans.60 The following picture sums up the development in the number of new mortgage loans in the period from 2002-2010. The picture shows the pronounced peak in demand in 2007, followed by steep decline. As at 2010, the Czech Republic has returned to year 2002 levels.

59 Vøra Doubravská, Hypoteêní financování nemovitostí v|éR a dopad americké hypoteêní krize na hypoteêní trh v|éR, 2010, pp. 68-69. 60 Ibid., pp. 70-71.

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Picture 27: Development of New Mortgage Contracts from 2002 to 2010; source: Based on data released at http://www.mmr.cz/Bytova-politika/Statistiky-Analyzy/Statistiky-z-oblasti-bytove-politiky-(1)/Hypotecni-uvery/Hypotecni-uvery-(2002-2008), 2010. 100,000 90,000 80,000 70,000 60,000 50,000 40,000 30,000 20,000 10,000 0 2002

2003

2004

2005

2006

2007

2008

2009

2010

Recently, there has been an increasingly worrying rise in credit and loan delinquencies. Operating credit facilities appear to be the most affected part of the banks’ portfolios, where payments that are more than 90 days past due constitute 11.42% of the entire volume of operating credits on the market. The volume of household defaults on loan instalments is also on the rise, mostly due to increasing unemployment levels. In total, household loan delinquencies affect approximately 5% of loans; the situation is better with respect to loans used to fund residential property ownership. From 2000 to 2009, the Czech household indebtedness increased eightfold. While in 2000 households owed ‘only’ 121.5 billion CZK, in 2009 the total household debt amounted to 973.5 billion CZK. Compared to Czech households, the relative indebtedness of households in Euro-zone countries (loans to gross income ratio) still remains twice as high.61 In response, Czech banks now check and inspect the reliability and solvency of prospective borrowers much more carefully than they did in the past, focusing on details such as age, sex, number of children, marital status, profession, education or even whether the borrower has a permanent or fixed-term employment contract. The better the client’s creditworthiness, the more favourable interest rate he or she will receive, and vice versa. Creditworthiness rating can be raised by an addition of

61 Vøra Doubravská, Hypoteêní financování nemovitostí v|éR a dopad americké hypoteêní krize na hypoteêní trh v|éR, 2010, pp. 78, 79.

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guarantor. Banks have also started using credit registers, which collect information on how credit applicants repay their other debts or what were the applicants’ payment habits with respect to their past loans or credits.62 Refinancing and debt restructuring have become increasingly popular products as they allow borrowers to take advantage of lower interest rates. The ratio between the mortgage loan and the value of the mortgage property has also changed. It is now much less common for the mortgage to cover the entire value of the mortgaged property, and there are only a few banks left that still offer this option, even if the one hundred percent cover is determined based on the bank’s own appraisal rather than market value. So-called one hundred percent mortgages are also given at a higher interest rate. The most common mortgage terms available on the market today are limited to 85% of the real property value. However, the safest policy is to make certain that the value of the property exceeds the mortgage by at least 30%.63

3.

Challenges and Coping the Financial Crisis

3.1.

Anti-crisis Measures in the Czech Republic

The political landscape of the Czech Republic has been exceedingly unstable from the very onset of the economic crisis. The political stage has been strongly polarized and hostile. Instead of searching for viable and sustainable economic solutions, its protagonists wasted precious time by coarse personal attacks, populist demagogy and catch-all politics. In the fairly short period from the end of year 2007 until today, the Czech Republic had four distinct governments, each of which coped with the economic crisis in its distinct manner. The turbulent political development is described in the following chapter. And while even the previous

62 Radek Kyml, Analýza vývoje hypoteêních úvørŃ v|éR, Praha, 2010, p. 50. 63 Vøra Doubravská, Hypoteêní financování nemovitostí v|éR a dopad americké hypoteêní krize na hypoteêní trh v|éR, 2010, pp. 79, 80.

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governments to a certain degree attempted to produce and implement their own anti-crisis measures, we believe that only the measures recently introduced by Petr Neêas’s new government deserve a detailed analysis.64

3.2.

Political Landscape of the CR during the Economic Crisis

The first indications of the upcoming economic crisis were noted by Mirek Topolánek’s first cabinet that remained in office from 4 September 2006 to 9 January 2007. This minority government was composed solely of ODS65 and independent members and failed to win the vote of confidence in the Chamber of Deputies. |This cabinet operated as an interim government only, that is, as a cabinet with limited powers and practical authority. Mirek Topolánek was re-appointed a prime minister on 8 November 2006 and started the process of assembling a new government from members of ODS, KDUéSL66 and Strana zelených67. The majority centre-right cabinet was sworn in on 9|January 2007 and won the parliamentary vote of confidence on 19 January 2007. This cabinet also proved to be short-lived, though. Two years later, on 24 March 2009, the opposition managed to overthrow the government during the Czech Republic’s Presidency in the Council of the European Union, amidst the raging economic depression. Jan Fišer’s successor cabinet took up their duties soon thereafter.68 Jan Fišer’ interim government was set up by éSSD69, ODS, Strana zelených and originally also by KDU-éSL as a caretaker cabinet to carry out the executive duties in the period from the no-confidence voting in spring 2009 to the intended early

64 The text that follows is based on the Government’s Policy Statement of|3 August 2010 and other public-domain government documents, documents released by the Chamber of Deputies of the Parliament of the Czech Republic, and from daily and professional periodicals. 65 ODS – Civic Democratic Party, founded by the acting President Václav Klaus, usually referred to as a centre-right political party. 66 KDU-éSL – Christian and Democratic Union – Czechoslovak People’s Party. 67 Strana zelených – Green Party. 68 Until then, Jan Fišer held the office of the president of the Czech Statistical Office. 69 éSSD – Czech Social Democratic Party, the main opposition party that overthrew Mirek Topolanek’s government with the help of the Communist Party and dissenting members of the Green Party.

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election in autumn 2009. However, the Constitutional Court’s ruling cancelled the autumn elections and Jan Fisher’s interim government went on to rule until the general elections in May 2010. On 25 June 2010, Jan Fisher handed in his resignation to President Václav Klaus, who charged Jan Fisher’s government to carry out their duties until the appointment of Petr Neêas’s government on 13 July 2010. éeská sociálnø demokratická strana (éSSD) as the main opposition party managed to grab a tight victory in the general elections. But much to its chagrin, it was unable to find a willing coalition partner and form a government. The acting centre-right coalition government, lead by the prime minister Petr Neêas, was created from three political parties, Obêanská demokratická strana (ODS), TOP 0970 and Vøci veįejné71 holding six, five, and four ministerial offices respectively. The economic crisis and rising public debt acted as the principal underlying element of the election campaigns of all three parties forming the incumbent coalition, and their success in the election was largely affected by the looming Greek bankruptcy. The government has 15 departments, which makes it the smallest cabinet in recent history. The Government Policy Statement was approved on 4 August 2010, and the cabinet won the confidence vote of the Chamber of Deputies on 10 August 201072. In his keynote speech, the prime minister summarized this cabinet’s main mission as “budget responsibility, rule of law and fight against corruption.” It needs to be said, though, that the political instability did not affect the progress of the economic crisis in the Czech Republic in 2009 and 2010. After twenty years since the Velvet Revolution, the social and political landscape of the Czech Republic now appears sufficiently developed that such a political instability does not have a substantial impact on the economic situation.

70 Right-wing conservative party. 71 Vøci veįejné – Public Affairs. A party a with centre-right political program, formed shortly before the May 2010 elections. 72 Government of the Czech Republic, Programové prohlášení Vlády éeské republiky, 4 August 2010.

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Picture 28: GDP and government change, source: Based on data released by CSO (www.czso. cz), 2010.

10% 8% 6% 4% 2% 0%

Q106 Q2 06 Q3 06 Q4 06 Q107 Q2 07 Q3 07 Q4 07 Q108 Q2 08 Q3 08 Q4 08 Q109 Q2 09 Q3 09 Q4 09 Q110

-2% -4% -6%

1. Topolanek's government

3.3.

2. Topolanek's government

Topolanek's government overthrow n

Fišer's caretaker government

Summary and Comments on Selected Anti-crisis Measures

The recovery formula proposed by Petr Neêas’s cabinet combines direct anti-crises measures with deeper, society-wide reforms that failed to be brought to life by previous political representations, either due to their political impotence or fear of short-term adverse response from the public. It is a well-known fact that throughout its existence, the Czech Republic has been afflicted with the bane of weak and unstable governments. Most anti-crisis measures introduced by Petr Neêas’s cabi-

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net were originally framed by the government’s advisory body known as NERV73, a think-tank composed of political and economic experts who were selected based on their qualifications and expertise rather than political affiliation. NERV’s proposals and conclusions that are going to guide the acting government’s policy are described below. The global economic crisis and the plummeting gross domestic product helped reveal long-neglected budget deficit problems and the threats posed by the ever rising mandatory spending, as well as the need for long-due pension, welfare and health system reforms. At the time being, the Czech Republic’s total public spending surpasses its total income by about 80 billion CZK a year – a structural deficit that needs to be addressed by explicit and direct government policies. Government consumption also constitutes a major problem, in particular with respect to budget-sponsored payroll expenditure and the operating costs of the government. The government likewise plans to monitor the cost efficiency of state agencies and is determined to close down redundant projects and institutions. The incumbent government currently intends to cut those costs by 20%. Despite its many adverse consequences, the economic crisis thus appears to have convinced the general public of the dire need of large-scale reforms that were being postponed for lack of courage and determination. The acting government claimed allegiance to budget responsibility, and made a commitment to lead the country out of the economic crisis and put to a halt the rising public debt. At the same time, the government promised not to cope with the consequences of the economic crisis to the detriment of a particular social class or group. Due to the formidable length of the policy statement, and in view of the purpose of this publication, we decided to summarize only the most fundamental issues, and the measures scheduled in the following two areas: Y

Anti-crisis measures in general government economic policy,

Y

Changes in the pension system and their anti-crisis consequences.

73 Nerv is an abbreviation for “Národní ekonomická rada vlády“ (Government’s National Economic Council“). It is also a play on words meaning simply ‘a single nerve’, i.e. an enclosed, cable-like bundle of peripheral axons (the long slender projections of neurons).

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3.4.

Anti-Crisis Measures in Government Economic Policy

3.4.1.

Anti-Crisis Measures Adopted by Previous Government

Before we proceed to a discussion of measures proposed by the incumbent government, we would like to mention some major incentives implemented by previous governments that had immediate stimulating effect on businesses suffering from the onslaught of the economic crisis:74 Social security discount – this incentive was proposed with the aim to protect up to tens of thousands jobs held by low-income workers. Employers could apply for a social security discount on behalf of all employees whose wages exceeded 115% of the official average wage (27,100 CZK at that time). The discount had to be calculated individually for every employee, maximum eligible discount amounted to 630 CZK per one employee and month. The discount was granted for workers employed for at least one calendar month and could not have been claimed by bankrupt or insolvent employers. Tax deductions – according to the accompanying report of the Czech Ministry of Finance, this incentive aimed to encourage tax payers to expedite their intended acquisitions of PPE assets from 3-5 year tax-depreciation class by reducing the standard tax depreciation period. These favourable tax depreciation terms applied to tools, machinery, office equipment, agricultural and building machinery, selected machines, cars and trucks. However, the shorter depreciation period applied only to assets purchased from the beginning of 2009 until the end of the second quarter 2010, and could only be used to purchase brand-new assets. The policy also applied to acceleration of lease periods in finance leases, which fundamentally also constitute an acquisition of assets. Depreciation of assets with three-year depreciation period was reduced to twelve months; depreciation of assets with five-year depreciation period was reduced to 25 months (60% of the acquisition cost in the first year and 40% in the second year). According to the accompanying report,75 ac-

74 Government of the Czech Republic, Strategie pįipravenosti a akcelerace rŃstu“ of 2 December 2008, http://www. vlada.cz/assets/media-centrum/predstavujeme/Strucne-o-Narodnim-protikrizovem-planu.pdf (retrieved on 13 August 2010), CR Government – Východiska z krize – 38 spoleêných opatįení vlády, odborŃ a zamøstnavatelŃ, http://www.vlada.cz/scripts/detail.php?id=68067&tmplid=50 (retrieved on 26 July 2010). 75 Accompanying report of the Ministry of Finance attached to amendment act 586/1992 Sb.,on taxes, available a http://www.psp.cz/sqw/text/tiskt.sqw?O=5&CT=768&CT1=0 (retrieved on 26 July 2010).

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celerated depreciation exercised by approximately 60% of taxpayers would reduce the tax revenues of the state budget by approximately 9.4 billion CZK in 2010 and by additional 3.6 billion CZK in 2011. VAT deduction for cars – from April 2009, businesses and sole proprietors may buy any car used for business purposes net of VAT. Under previous regulation, the VAT discount applied only to commercial vehicles such as lorries. This measure had a substantial favourable impact on aging company car fleets and also considerably boosted the domestic automotive industry with its fundamental contribution to gross domestic product. Income tax advance – the Parliament approved an amendment act releasing sole proprietors and businesses with five or less employees from their duty to pay income tax prepayments for the duration of the crisis. Flat-rate tax deductions – To support sole proprietors and small businesses, the government raised allowable flat-rate reduction, with ensuing income tax savings. Per-child tax relief – The per-child relief, i.e. the discount that natural persons may deduct from the final tax liability per each child they raise has increased by 924 CZK p.a., and every tax payer was entitled to claim per-child relief for all his or her children. The per-child relief may be claimed by one parent only, the higher discount can be deducted as from tax year 2010. Child allowance was also temporarily raised to support the purchasing power of families with children. Insolvency act amendment – another attempt at anti-crisis policy applicable to businesses. This amendment aimed to promote various business rescue and revitalization measures in order forego bankruptcy and liquidation. A recent amendment intends to cancel the legal duty of debtors to file an insolvency petition in case of insolvency, which should give debtors additional time for resolving their situation in the best way possible. The government will also wait with the payment of statutory taxes and levies charged on behalf of employees and for the duration of restructuring process it will not demand late charges on social security payments. This amendment aims to prevent a wave of fast bankruptcies and mass redundancies. It is estimated that this proposal could save up to 70,000 jobs. Scrappage program – is a good example of how political disputes may affect economy and environment. In order to prevent a slippage in the volume of production in automotive industry, many governments (in Germany, Slovakia, Austria or France, for instance) introduced a scrappage program as one of their anti-crisis incentive. In the Czech Republic, the enactment of the Waste Act was accompanied

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by prolonged discussions about the benefits of scrappage program between the automotive industry lobby and left-wing opposition on the one hand and the fragile right-wing government on the other hand. President Václav Klaus is probably the most vocal critic of the scrappage program in the Czech Republic; in fact, he even vetoed the Scrappage Program Act in 2009. The Chamber of Deputies overrode his veto, though, and the government is now entitled to launch the scrappage program at its discretion. The new government does not intend to introduce any such program. At the same time, the Czech Republic benefited from the scrappage programs introduced abroad, especially in Germany, France and Slovakia. While during the first two quarters of the last year the domestic economy slipped, the decline in trade exports and industry production slowed down and then even reversed to modest growth in the late months of the year 2009. This development was substantially influenced by improvements in German economy caused by rising demand for cars following the introduction of German scrappage program. The gross domestic product also started to increase as from the Q3 of year 2009. In fact, trade surplus for year 2009 grew by 85 billion CZK in year-on-year comparison, achieving the record-breaking amount of 152 billion CZK. This trade surplus was also greatly influenced by the German scrappage program. In the Czech Republic, Hyundaibrand car exports increased almost tenfold (from 11,945 in 2008 to 114,664 in 2009), while TPCA Czech grew by decent 2.61% and ŠKODA AUTO by 1.81%)76. It is hardly a surprise that the representatives of the Czech automotive industry welcomed foreign scrappage programs with open arms. 3.4.2.

Existing Anti-Crisis Measures

The following text debates the basic anti-crisis solutions introduced by the incumbent government of the Czech Republic in the document “Exit Strategy – Plan of Short-Term Measures to Cope with the Crisis and Its Consequences”77. At the recent talks with the representatives of businesses and employees (Economic and Social Consensus Council, also known as the Tripartite Commission), the government managed to reach common ground with its partners on almost forty fundamental proposals that are expected to accelerate economic growth whilst preserv76 Ministry of Industry and Trade, Analýza, vývoje ekonomiky éR a odvøtví v pŃsobnosti MPO za rok 2009, http:// download.mpo.cz/get/39149/46523/558694/priloha001.pdf (retrieved on 16 August 2010). 77 Czech Republic Government – Východiska z krize – 38 spoleêných opatįení vlády, odborŃ a zamøstnavatelŃ, http://www.vlada.cz/scripts/detail.php?id=68067&tmplid=50 (retrieved on 26 July 2010).

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ing the economic and social welfare of the Czech Republic. This proposal has been drafted in accordance with the guiding principles of the joint policy statement of the new coalition closed and signed after the general elections in May 2010, and acts as the basic foundation for the Government Policy Statement for years 20102014. The measures listed below therefore combine the proposals and policies introduced in both documents. The Exit Strategy lists a set of specific measures that are expected to reduce the adverse consequences of the existing economic crisis, stabilize the economic and social environment and restart the economic growth. One of its primary goals is to accomplish a balanced budget by year 2016. The purpose of the government plan is to identify the most pressing short-term problems faced by the domestic economy and determine an exit strategy to help overcome the impact of the global economic crisis on our economy. The main measures proposed in the Government’s Exit Strategy include: 1. To improve equality of economic opportunities, the government will introduce an ‘integrated control system’. This system will enable a closer cooperation of public authorities (tax authorities, trade licensing authorities, Czech Social Security Agency, Czech Trade Inspectorate, Czech Environment Inspectorate etc.) The cooperation will also include the interconnection of the relevant IT systems and databases. Care will be taken to eliminate duplication of administrative duties on the part of businesses. 2. The government proposes major public budget cuts and undertakes to reduce public spending. Although the general public may find such measures unpopular in the short term, the government believes that such measures are a matter of social responsibility. The government plans reducing the overall volume of salaries paid from the state budged by 10% and intends not to index such salaries for inflation for the period of three years. This measure will not affect teachers, whose work is believed to have been severely undervalued for a long time already. At the same time, the existing pay rate system that is based on the years of services served will be replaced by a modern system that will motivate civil servants through performance incentives. The government will come up with a Civil Service Act aimed at improving the efficiency of the Civil Service rather than just at reasserting the social welfare benefits and immunity or impunity of civil servants. The reduction in the volume of salaries available for Civil Service shall not affect healthcare professionals whose pay is not determined by the constraints of the

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state budget but rather by payments into the public health insurance system. At the same time, replacement of the existing pay rate system is planned also for the healthcare system. Other anti-crisis measures and public reforms in the area of public finances include: –

a 10% salary reduction for all constitutional authorities, taxation of all flat-rate reimbursements and compensations;

–

a 50% reduction in state contributions for political parties for the period of three years;

–

a 10% reduction of all welfare benefits, no indexing for inflation for the upcoming three years; –

Pension benefits will be indexed for inflation in 2011;

–

Birth and funeral allowance will be cancelled altogether.

3. The government will step up the efforts to prevent unemployment benefits abuse by analysing legal regulations for loopholes (legal audit of the balance between the flexibility and security of employment) and by introducing improved control mechanism to minimize such abuse. 4. The government recommends developing a ‘tax collection statistics’ program that will collect the data from tax returns and health and social insurance payments. The government would also like to carry through the idea of ‘Single Collection Point’ and streamline the tax collection system. The ‘Single Collection Point’ will be a government agency that will collect the income tax, social security and health insurance (calculated from a single pay base using a single form template), and distribute the relevant amount to the account of the target institutions. This collection system will reduce the costs of tax collection for both the state and the tax payers by a substantial margin. 5. The poor condition of domestic public budgets makes the reduction of taxes in upcoming years patently impossible. Instead, the executive branch of the government will concentrate on the simplification of taxes and on streamlining the tax collection process. The government will come up with a new income tax act that will incorporate the following new approaches to domestic taxation: –

The Czech Ministry of Finance will bring forth a proposal on the harmonisation of tax and insurance bases. The proposal will be a part of the plan to

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reduce the difference between the taxation of employees and the self-employed persons; –

The government will carry out an objective analysis of the taxation system in order to eliminate unnecessary tax exceptions and exemptions. The tax concessions will continue to exist in the following areas: –

Support for research and development;

–

Support for families with children;

–

Support for people in need;

–

Support for people who take responsibility for their housing arrangements;

–

Support for people who take responsibility for their education;

–

Support for people who plan for their old age and retirement.

The broadly criticized tax concessions for employee benefits are going to be replaced by a single tax relief for a transport between residence and place of employment in the form of tax base deduction. The deduction will be the same for all taxpayers. 6. The government intends to support families with children and wants to give women an option to resume their careers soon after their birth of their child or children. According to the Policy Statement, the government wants to make the costs of child care and domestic services tax deductible. The maximum tax deduction under this new form of tax relief will be limited, and the costs will be deductible only up to twelve years of age of the child. This measure is also expected to help create substantial number of new jobs in the area of child care and domestic services. 7. The new government would like to promote broader and more substantial involvement of private investors in research and development programs. For this reason, the government will set up an ‘incremental tax deduction’ for research and development investments. At the moment, private investors may deduct twice the amount of their research and development investment.78 The government will propose increasing the deduction by additional 20% for investments in domestic universities or Academy of Sciences.

78 For the first time as a normal cost, for the second time as a special deductible item in the tax return.

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8. To improve tax payers’ legal certainty, the government intends to introduce a duty on the part of the tax authorities to provide, at a tax payer’s request, a binding opinion on a construction of tax laws. This will involve the establishment of a new government agency that will be obliged to issue binding legal opinions on tax-related issues. The state will provide this service for a fee, but it will also responsible for the correctness of the answer. 9. The government intends to cancel so-called transactional taxes (inheritance tax, donation tax, real property transfer tax), making the revenue from such transactions subject to normal income taxation. Next of kin exemptions will apply. 10.The state will continue to monitor and supervise transfer pricing policies applicable to sale of goods and provision of services within business combinations. 11.The government will reopen the discussion on the Act on Abuse of Substantial Market Power in Sale of Agricultural and Foodstuff Products. The government will also include the issue of agricultural subsidies in the list of its European policy priorities. The government intends to continue in the development of the Farmer’s Portal in order to simplify the administration of agricultural subsidies. Special incentive programs will be created for agricultural entrepreneurs, including, for example, long-term preferential-rate credits. 12.The government will analyse the impact of so-called ‘Kurzarbeit’ on the labour market. The government will continue to support education and retraining programs. 13.The government will analyse the system of welfare services and its funding, in particular the issue of staffing needs of Employment Offices and the financing of unemployment projects. 14.The government has agreed to carry out a thorough analysis of the existing system of family welfare benefits and the beneficial effect of child allowance and parental allowance, in order to assure that the terms of allowances, their size and duration fulfil the true purpose for which they are granted. The government may replace child allowance by higher income tax deduction or tax bonus. Apart from the apparent motivational impact, such measures would produce additional administrative savings. Welfare system is not intended as an alternative to work. The new government (as its predecessors) will fight the abuse of welfare system and illicit work by consistent and thorough monitoring and strict sanctions. In addition, the government will introduce new structural changes to the welfare system to assure that unemployment benefits will be withheld from or reduced for those, who

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–

hand in their notice, or end their employment by mutual agreement, or are fired for breach of discipline;

–

have been granted adequate severance pay;

–

fail to do at least twenty hours of community service per week, unless they attend a retraining program during that time.

15.It was decided to review the expediency and efficiency of public budget spending and to carry out an audit of the management of public budget resources. The rules on the compensation of board members who exercise ownership rights on behalf of the government will also be subject to revision. An interdepartmental commission already started work on alternative compensation models for the management and board members of companies in which the state holds more than a 33% interest and in the state-owned companies. 16.The government has decided to extend its support to commercial and consumer loans offered by licensed banks. On the other hand, the government will put in place a thorough and rigorous monitoring of consumer credit facilities provided by non-banking companies (by way of a consumer loan bill presented to the Parliament). 17.The Czech Republic has an open, export-oriented economy. The government would therefore like to prepare a detailed Export Strategy covering the period until the year 2016. The government also intends to reinforce the financial position of export insurance company EGAP, a.s., a specialized state-owned credit insurance company that insures credits connected with exports of goods and services from the Czech Republic against political and commercial risks. The government will also support éeská exportní banka, a.s. (éEB), a specialized state-owned bank set up to support exports. The government will expand the credit limit of both institutions so that they can offer their services also to small and medium businesses. The Government Policy Statement mentions the need for a society-wide debate about the replacement of Czech crowns with euros. However, euro may not be adopted without long-term government budget discipline and balanced public budgets. The new cabinet made explicit its intention to agree with the opposition on the exact date for Euro-zone accession, which would require extensive legislative and administrative changes.

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18.The government intends to revise the terms of investment incentives (by virtue of tax holidays, new job bonuses, purchase price discounts for land and premises used for new investments etc.). In view of the changed economic situation, the government would like to lay down a list of sectors exempt from government incentives. 19.The government recommends preparing a strategy that would guide the housing development in the area of tenements and flats for senior citizens and lowincome population (low-cost / council flats). 20.After many years, the government has finally made explicit its support for the completion of two additional blocks of nuclear power plant Temelín and for the restoration of power plant Prunéįov II. The government intends to cut back the excessive, unsystematic support for photovoltaic power plants. The government also intends to carry out a review of selected environmental laws and regulations and the relationship between environment protection, trade and industry (so-called ‘Ekoaudit’), and to identify the most problem-ridden environment protection regulations. It appears that in the future, the government will strive not to present bills that would protect the environment beyond what is required in the EU, if such bills could substantially endanger competitive ability of the Czech economy. The government would like to accelerate the drawing of funds from the Operational Program ‘Environment’, especially with respect to sewage treatment plants for large urban areas. 21.The government intends to carry out its international obligations set forth by EU policies with respect to electric power and thermal energy production from renewable resources. Laws and regulations will be approved to render rational support for new alternative power resources, accounting for their size and location (in particular to protect arable soil). A future system for calculating feedin tariffs will aim to support further development of environment-friendly power resources. 22.The government will prepare a white paper on the financing of transportation and transport infrastructure from year 2011 on, aimed at the management of the unfinished constructions ratio. The government will also present a plan for the implementation of specific PPP projects in the area of transport infrastructure; all new CZK 300-milion+ projects financed from the Structural Funds will be subject to a detailed government review. The government has decided to support activities to improve the navigability of the Labe river (the Elbe), in particular by building new locks and other structures. The government intends to support the completion of unfinished motorways and highways, and repairs of first class

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roads, and to connect such roads to the European road network. Funding will be provided by the introduction of electronic toll collection system for freight vehicles, which will replace the existing road tax system. The government allows for the possibility of private transport infrastructure investments provided that they do not raise public debt. 23.Based on the document “Analysis of Structural Funds as an Exit Strategy from the Economic Crisis”, the government intends to accept measures that will streamline and accelerate the withdrawal of resources from Structural Funds. Given the sorry statistics of the Czech Republic about its ability to utilize Structural Funds, this topic should be assigned a top priority, in our view. The government would also like to make use of the resources available from the European Globalization Adjustment Fund to overcome the consequences of the economic crisis. 24.Fight against corruption remains one of the main (proclaimed) priorities of the incumbent government. The government will continue in the implementation of the updated Government Anti-Corruption Strategy for years 2006–2011.79

3.5.

Pension Reform and the Crisis

As noted before, the necessity of a comprehensive pension reform predates the existing economic crisis, but despite long discussions, there has been no societywide consensus on how to accomplish such a reform. At the same time, the inception of a comprehensive pension reform may be the most important anti-crisis measure of all. It is not longer sustainable to continue with the existing pay-as-you-go, staterun pension system where benefits are paid directly from the current social security contributions and taxes. The government will therefore try to introduce a stageby-stage transformation to a more flexible and powerful hybrid retirement system. Y

The first stage – public awareness campaign – is expected to start without delay. The Czech Social Security Agency will send each social security payer a letter at the end of each calendar year, whereby it will inform the payer about the amount contributed during the year, and supplement a calculation of the tax payer’s future monthly retirement pension under the existing system. In the second stage, the government will proceed to a so-called hybrid system:

79 Czech Republic Government – Východiska z krize – 38 spoleêných opatįení vlády, odborŃ a zamøstnavatelŃ, http://www.vlada.cz/scripts/detail.php?id=68067&tmplid=50 (retrieved on 26 July 2010).

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Y

Pay-as-you-go (PAYG) – funded from the compulsory pension insurance, at 28% of the assessment basis

Y

Capital contributions – a plan member may also decide to make individual contributions to his or her plan, in which case the pay-as-you-go contribution will be reduced to 24 percentage points, and the plan member will be obliged to contribute at least additional 6% of the assessment base to his plan. If the plan member’s parents already receive retirement benefits, 2% from his or her assessment base will be sent directly to his or her parents’ accounts.

The government intends to compensate the expected shortfall in the revenues of the PAYG system from the revenues of the state-owned CEZ Group, or by raising indirect taxes, if necessary. Individual plan member accounts will be managed by a special agency established by the government in cooperation with the private sector. The purpose of the reform is simply to assure that the ever rising costs of the pension system do not bankrupt the entire state budget.

3.6.

Other Crisis Exit Options – Nerv

The primary task of the government’s National Economic Council (NERV), originally established by Prime Minister Mirek Topolánek, is to monitor financial markets and to seek out and propose measures that would help the Czech Republic restore and accelerate its economic growth. NERV is a think-tank of independent economic experts that meet every month, usually also inviting other experts and academics, to analyse and present economic measures for the government’s discussion and possibly implementation. According to the acting prime minister, in future NERV may also be asked to provide second, dissenting opinions on controversial economic measures introduced by the government. The areas of interest covered by NERV include: Y

Putting a stop to rising public debt;

Y

Pension reform;

Y

Fight against corruption;

Y

Country’s relationship with EU and acquis communautaire;

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Y

Preservation of the competitive ability (education reform, research and development reform, restructuring of infrastructure);

Y

Enterprise promotion.

3.7.

Conclusions, Challenges and the Lessons drawn from the Economic Crisis

The purpose of the foregoing text was to depict the anti-crisis measures as they evolved in our politically unstable environment and as they were implemented by different government cabinets and other state institutions. At the same time, largescale, macroeconomic anti-crisis measures were accompanied by equally-minded measures and policies implemented at the micro level – by businesses of all sizes. Managements had to put in place redundancy plans, had to cut down the salaries and wages, sell assets, reduce production, and generally strive to stay ahead of the curve, while balancing their cash-flows with the help of the increasingly hard-to-get bank credit. The variety and scope of such small-scale measures depends on a specific impact on individual branches of industry, and on the size and the financial situation of each business. An attempt at describing and comparing such measures in detail would certainly exceed the scope of this publication. Instead, we would like to remark on certain interesting, albeit general conclusions and recommendations: Y

Both the domestic crisis of 1997-2001 and the global crisis of 2008-2009 jointly indicate that certain industries are more vulnerable than others. This applies in particular to high labour-intensive industries with low-added value products or services80;

Y

It is important to focus one’s efforts on one key area, but it is fundamental to maintain flexibility within that single area. High flexibility proved an important competitive advantage for many businesses during the economic recession;

Y

Innovation is equally important. Businesses should not stop innovating and investing in new technologies even in hard times;

Y

Strategic decisions must be based on an ongoing, in-depth assessment of risks, threats and vulnerabilities, and the decision-making process must always account for any such risks and threats. A long period of growth made many businesses reckless, and careless about expenditures that produced inadequate or even no returns. To predict and avoid future difficulties, managements will have

80 Eva Kislingerová, Podnik v êasech krize, 2010, p. 197.

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to evaluate all occurrences that affected their business in 2006 and especially in 2007 and 2008. It is also necessary to make provisions for the fact that turbulence in the financial markets does not just spill over from one region to another, but may also have severe repercussions on the real economy.81 Y

In the times of crisis, a strong equity position tends to be the best and sometimes the only way to preserve financial stability. It may sound like a conventional wisdom, but it is always good to keep in mind, that businesses which invest into their own equity, and learn to rely on their own capital reserves rather than on banks’ willingness to give credit are in a much better position when the hammer strikes the anvil. A business with a strong financial position may even use the crisis to win a price war with its competition and gain larger market share.82

As to what the businesses expect from the government in the way of public anticrisis measures, a recent survey organized by PricewaterhouseCoopers has revealed that the most-frequently raised requests include financial system stability, taxation system stability, low administrative burden and more flexible employment law.83 According to the survey, the beneficial impact of such measures would surpass the benefits of any direct support and incentive programs that the government has to offer. To end with good news, the Czech business community also believes that the crisis had lower and less devastating economic impact on the Czech Republic than on other Central and Eastern European countries.

4.

Outlook for the Coming Years

The upcoming economic development of the Czech Republic depends not just on the evolution of global markets, but also on certain important issues that are somewhat specific to the Czech economy.

81 Ibid., p. 199. 82 Ibid., p. 200. 83 PWC Czech Republic, éeský prŃzkum názorŃ generálních įeditelŃ, http://www.pwc.com/cz/cs/ceo-survey/nejdulezitejsi-zjisteni-pruzkum-pro-cr.jhtml (retrieved on 3 August 2010).

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The home currency development is the first such specific issue. Since the Czech Republic has not adopted euro as its sole legal tender, the fluctuations of the CZK may substantially affect domestic exports. The strengthening of the home currency in the pre-crisis period fortunately did not have any grievous consequences, but strong CZK may still substantially affect our domestic economic growth in the future, in particular if the currency grows due to increased speculative demand that does not account for the true level of business activity, gross domestic product and employment levels. At the same time, in the first months of the economic depression in the Czech Republic at the end of year 2008, the gradually weakening CZK provided a vital boost to Czech exports. Regrettably, the favourable impact was lessened by the fact that the change did not come to pass until the onset of the economic crisis in our country. The openness and the small size of the economy also play an important role. Since the Czech economy is open in both directions, it may be unbalanced by a demand shock such as by a falling foreign demand or a commodity demand shock. Due to its diminutive size, the Czech economy also may not able to compensate for such an event by an increased domestic consumption as the neighbouring Poland would, for example. A resurrection of the economic depression on the part of our main business partners is therefore the principal risk that the Czech Republic faces today, since this could send the economy plummeting again, possibly even leading to a more enduring W-shaped economic recession. Domestic issues such as rising unemployment rates may also increase the credit risk in the household loans’ segment. That would raise the loan delinquency rates, and the ensuing consumer demand would slow down the recovery process, thus aggravating the situation in consumption-oriented industries. As noted earlier in the text, the Czech industry is dominated by the automotive and engineering segments. Any adverse economic in these two segments would therefore have substantial repercussions on the entire, otherwise fairly healthy Czech economy. Unfortunately, changes required to accomplish a more balanced industrial structure would take a very long time, and would have to be accompanied by government interventions. Interestingly, the Czech Republic has not been able to establish a correlation between the instability of the political landscape and the economic development. In the short period from 2007 to 2009 the country had four governments, one of which was overthrown during the Czech presidency of the Council of the Europe-

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an Union. And yet, in 2007 the Czech Republic accomplished its highest ever GDP growth, while the raging international economic crisis of 2008 first started to make its mark on the domestic economy at the very end of that year. However, a lack of governmental fiscal discipline may severely harm the economy. Unless the government adopts additional consolidation measures, the government debt in 2012 could rise up to 47% of GDP. The close relationship between the public finance system and the banking industry as the main public debt creditor could transform a mere fiscal threat into a full-blown money supply and credit crisis. The financial markets are also much less broad-minded when it comes to the funding of public debts of small rather than large economies.84 On the other hand, excessive government cuts could elicit unwanted demand shock, with all its adverse consequences on the economic growth. The past experience shows that governments sometimes tend to deal with their debts by using high inflation, which cuts down the comparative value of their debt. This is why the stability of currency acts as one of the key indicators of long-term economic growth. In the Czech Republic, the currency stability is monitored and guaranteed by the independent Czech National Bank, which has set its inflation target for the ensuing year at 2% with one percentage point margin in both directions. The expected PRIBOR values are equally low at 1.3%85 on average. Due to the rising old-age dependency ratio, government cuts will not be successful in the long-term if not accompanied by a major pension reform. An unreformed, pay-as-you-go pension system could slowly but unavoidably bankrupt the entire economy over the next thirty years. Consequently, a pension reform is probably the most important challenge that the Czech Republic will have to face in the ensuing years. In general, however, we remain cautiously optimistic about the short- and midterm prospects of the Czech economy, and the business cycle surveys organized by the Czech Statistical Office appear to support our view. According to the composite confidence indicator that measures overall business confidence in the economy, most businesses believe that we have finally overcome the economic crisis and the economy has started to grow.86

84 Jan Frait, Zpráva o finanêní stabilitø 2009/2010, CNB, 18 June 2010, p. 15. 85 Ministry of Finance, Fiscal Policy Department, Makroekonomická predikce éeské republiky, July 2010, p. 13. 86 Czech Statistical Office, Vybrané ukazatele éeské republiky, Prague, July 2010, p. 1.

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Hungary: A Country Hit Hard Roland Felkai

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1.

Situation before the Crisis

1.1.

Recent Historical Developments and their Effects on the Economy

Until its EU accession Hungary – from an economic point of view – had always been considered a role model for all other accession candidates among the CEE. However, in the following years it lost its distinguished position and fell behind other new member countries. The reasons for this development towards a country with serious problems, as Hungary is now being regarded by many economic analysts, may be found in a reluctant and hesitant approach by any post-accession government to bring about necessary structural reforms, but also in the impact of the world financial and economic crisis on Hungary which we would like to describe in the present chapter. In order to get a better understanding of Hungary’s situation in the current crisis it can be helpful to take a look at the country’s most recent historical developments and their effects on the basic economic data in general, as well as on its labour market in particular. At the turn of the nineties, radical political, economic and social changes took place in the central and eastern European countries, including Hungary.1 The most fundamental moments of the events referred to as regime change were the abolition of the one-party system and the establishment of political pluralism, the preponderance of private ownership instead of the dominance of social – state and co-operative – ownership, and the transition from a planned economy to a market economy. The changes occurred very fast from a historical perspective, though in practice not from one day to the next, but as a result of a longer process. Its key points were the events of 1989-1990, though these were preceded by very important changes and followed by even more significant ones. In the last 20 years there have been considerable socio-economic changes in Hungary, determined among others by its international engagement – such as the country’s accession to NATO in 1999 then EU accession in 2004.

1 Hungarian Central Statistical Office, Hungary 1989-2009, 2010, p. 7.

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J. Jungmann, B. Sagemann (Eds.), Financial Crisis in Eastern Europe, DOI 10.1007/978-3-8349-6553-0_4, © Gabler Verlag | Springer Fachmedien Wiesbaden GmbH

The radical changes of the economy and society in 1989-1990 resulted in essential changes in the labour market as well. The major feature of this was the end of full employment and the appearance of unemployment, which became constant.2 In the first half of the 1990s, the accumulated structural and efficiency problems, the loss of the Eastern European markets, the economic decline and the transition to market economy all resulted in the explosive growth of unemployment. The peak of this process was in 1993, when more than half a million people were unemployed and the unemployment rate amounted to 12.1%. Following the start of economic growth, unemployment fell continuously by more than half, to 5.7% by 2001 as a whole. Between 2002 and 2009, except 2007, unemployment increased more or less each year. In the years following the regime change, employment declined considerably mainly due to the economic transformation. As it will be described in more detail in the following paragraphs in 2008 and 2009, in connection with the effects of the world economic crisis on the labour market, employment began to decrease again, and the employment rate which was low in international comparison all the time, fell in 2009 again to the level ten years earlier (55.4%). Along with the transformation of the economic structure, there was a significant shift in proportion in the structure of industries over 20 years. The proportion of goods producing sectors in employment decreased gradually, while that of different services aiming at meeting the growing consumer demands increased. In the second half of the 1980s and at the turn of the decade the socio-economic problems accumulated for decades became evident and increasingly broke to the surface in Hungary and in all the countries of the central and eastern European region. The dissolution of the COMECON had a considerable impact on the change of external conditions, since with this market grouping taking 42% of Hungarian exports and supplying 40% of imports the Hungarian economy was truly shocked by its breakup.3 The gross domestic product (GDP) fell by 18% between 1989 and 1993, to the level registered in the second half of the 1970s, while the number of employed persons declined by almost one and a half million.

2 Ibid., pp. 10-11. 3 Ibid., pp. 30-35.

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A further problem was that the capital needed for production and its modernisation was not available. Significant amounts of foreign capital arrived in the country through privatisation as well, in addition, privatisation mobilised the domestic capital. Picture 1: Volume of gross domestic product, source: Hungarian Central Statistical Office 1989–2009, 2010, p. 30.

In the middle of the decade economic restrictions were made and real income and consumption were reduced to improve the balance of production and use, and the Hungarian economy was put on a path of stable growth from 1997. External trade was refocused: the European Union became the main trading partner of Hungary, while the majority of capital investments also came from Western Europe. Picture 2: Volume of GDP and investments, source: Hungarian Central Statistical Office 19892009, 2010, p. 32.

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The government measures started in the second half of 2006 – aiming to reduce the extremely high general government deficit, primarily through lowering demand – brought about the deceleration of the dynamics of increase. As a result, the gross domestic product rose only by 1.1% in 2007. Restructuring was largely over by the turn of the millennium. The GDP period of 2006-2009 was characterised by stagnation and decrease. The role of the foreign direct investment (FDI) was a determining factor in the economic development of Hungary after the political rebound. In this regard Hungary was the first among the states changing regime in the region in 1989 to open its economy for FDI. The stock value of FDI expanded rapidly at the beginning of the nineties. Over the decade one of the main forms of capital inflow was privatisation, in the frame of which 4.6 billion EUR of investments were realized between 1991 and 1997. From 1997 – in addition to green-field investments – reinvested earnings played an increasing role. The stock of foreign direct investment exceeded 10 billion EUR at the end of 1996 for the first time, and its value was increasing until 2007, when it amounted to 67.0 billion EUR. The share of the service sector increased to reach 54% in 2007. The result stemmed first of all from significant investments made in real estate, renting and business activities and in trade and repair. As the following table shows, in the period between 1997 and 2000 dynamic, two-digit increases were recorded both in imports and exports, which went on after the slowdown in 2001. This trend was broken by the global economic crisis that started at the end of 2008, owing to which the volume of both exports and imports fell considerably. Picture 3: Volume of external trade; (1989=100), source: Hungarian Central Statistical Office, Hungary 1989–2009, 2010, p. 32.

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Based on the figures of the Hungarian Central Statistical Office4 the main financial data of Hungary the following progress may be described after the opening of its economy towards the western markets. Previous COMECON countries accounted for a considerable part of Hungary’s exports and imports, from the beginning of the 1990s the focal point of the trade increasingly moved to countries of the European Economic Community and the gradually enlarging European Union. Although back in 1989 and 1990 the Soviet Union was Hungary’s most important external trade partner. Germany took this position afterwards, which it has retained since. In 1995, the first year when the time series were compiled according to the new methodology, a deficit of 1.3 billion EUR was observed. The deficit grew almost continuously afterwards, largely as a consequence of the deterioration of the balance of incomes, though in a few years the deficit of the balance of goods increased at a higher rate than that of incomes. The balance of services was typically in surplus. In 2007 the substantial improvement of the balance of goods was nearly completely offset by the increase in the net outflow of incomes. Industry showed a moderate increase after 1993 and a more dynamic one after 1997 with a slight slowdown at the turn of the millennium, but even so it doubled in volume by 2007 compared to 1989. The economic transformation exerted a significant impact on industry. Foreign direct investment and technological innovation played a main role in how the export competitiveness of this sector improved. A new and large section of foreign direct investment was the construction of shopping centres. Before the regime change there were very few shopping centres in the country, but their number increased dynamically at the beginning of the 1990s, similarly to that of the hypermarkets that have a very large floor area. Today there are four significant hypermarket chains in Hungary, which had 136 hypermarkets in 2008. However, between 2005 and 2007 the increase of sales was higher than that of incomes; the people financed this difference by loans. The issuance of loans for private persons started to expand in Hungary in 2001 as a subsidy on loans for habitation purposes had been introduced by the government. As a result of the state subvention, the number of loans increased enormously. Due to the sudden indebtedness of the households with the supported loans the government introduced stricter requirements for the state subsidy in 2003. After the withdrawal of the habitation subsidy policy the financial institutions had to 4 Ibid., pp. 36-38.

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look for other profitable products. Therefore banks chose to widen their range of products with the issuance of foreign currency loans. 5 These loans became even cheaper for the customers than the state supported loans. As a result, in Hungary, within the entire domestic loan portfolio the share of foreign exchange loans grew incessantly during the past five years, with the largest share of growth seen in the foreign exchange loans provided to households. Among all household loans, in the middle of 2007 the share of foreign exchange loans reached over 50%. The granting of mortgage based loans is recently one of the most successful sectors in the whole bank sector. Although the Hungarian mortgage market is rather small in European compensation, it is the largest market among the newly joined member states of the EU. In 2007 the debt ratio in Hungary in proportion to the incomes was at the end of 2007 13%, which is considerably higher than the average of the EU of 10.5%.6 Picture 4: Percentage of GDP/Household sector net savings position; Average of 2002–2006; as a percentage of GDP, source: Hungarian National Bank, Analysis of the Convergence Process, March 2008, 2008, p. 51. 3.0 2.0 1.0 0.0 -1.0 -2.0 -3.0

Czech Republic

Estonia

Latvia

Lithuania

Hungary

Poland

Slovakia

-4.0 -5.0 -6.0 -7.0

5 Cf. Szilvia Czéhner, A magyar jelzáloghitelezés jelene és kihívásai: intézményi háttér és az amerikai hitelpiaci válság hatása (The present and challenges of the Hungarian mortgage loans: institutional background and the impacts of the US loan market crisis). Thesis. Budapest Corvinus University 2008. p. 23. 6 Erdész Levente, Az amerikai buborék kipukkadása és a világgazdaság megfertĩzése. (The blow-out of the American bubble and the infection of the global economy.) Thesis. Budapest Corvinus University, 2009.

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As shown above in Hungary the risk of unmanageable credit growth in regional comparison is moderate, and – compared to other new EU Member States – neither the equilibrium loan portfolio, real estate prices, nor the savings position of households show signs of any remarkable risk. Picture 5: Volume of retail sales*; (1989=100), source: Hungarian Central Statistical Office 1989–2009, 2010, p. 46.

1.2.

Political Situation – A Prime Minister “Under Pressure”

Ferenc Gyurcsány, a Hungarian politician and wealthy entrepreneur returned to politics in 2002 as the head strategic advisor of Péter Medgyessy, the previous Prime Minister (PM). From May 2003 until September 2004 Gyurcsány was a minister responsible for sports, youth and children. He became the president of the socialist party MSZP in Gyĩr-Moson-Sopron County in January 2004, serving until September 2004. In the summer of that same year it seemed that there were larger problems in his relationship with the current PM Péter Medgyessy, so he resigned as minister. In a week, problems in the coalition led to the resignation of Medgyessy, and MSZP voted Gyurcsány to become the sixth prime minister of Hungary as he was acceptable for the coalition partner, SZDSZ. Gyurcsány was reappointed prime minister after the 2006 parliamentary elections, with his coalition taking 210 of the available 386 parliamentary seats, and making him the first prime minister to stay in office for a consecutive election period after a general election since 1990.

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Since his 2006 election victory he has introduced austerity measures to tackle Hungary’s budget deficit that had grown to become 10% of GDP by the end of 2006. These austerity measures have been constantly criticized by the main opposition party, Fidesz, on the one hand as being too harsh on the people, and on the other hand by conservative economists for not going far enough to reduce government spending on social benefits, including pensions. Ferenc Gyurcsány has been the first prime minister since the fall of communism to try to introduce a health care reform in order to rationalize and modernize the national health care system. His efforts for a renewed and more efficient health care however, have been undermined mainly by his own party, as many socialist party members regard this reform as a threat to the communist era achievement of free and equal health care service for all. On 17 September 2006, an audio recording surfaced, allegedly from a closeddoor meeting of the Prime Minister’s party MSZP, held on 26 May 2006, shortly after MSZP won the election. On the recording, Gyurcsány admitted that his government had been lying to the people for the last one and a half to two years. Despite public outrage, the prime minister refused to resign, and a series of demonstrations started near the Hungarian Parliament, swelling from 2,000 to about 8,000 demonstrators each day calling for the resignation of Gyurcsány and his government for several weeks.

1.3.

Economic Situation

1.3.1.

State Budget Deficit

The government debt, including debt assumptions and repo operations, grew by 880 billion HUF (or 6.0%) to 15,586 billion HUF in 2007. The smaller than originally planned growth was the result of the decreasing financing needs and the positive balance of certain special net financing requirement items. The debt/GDP ratio (debt ratio) expresses the economic burden of public debt in comparison to the country’s economic performance. Following an economic decline after the political transformation the debt ratio reached its highest value by 88.7% in 1993. The debt ratio started to decrease following the economic stabilization in the middle of the 1990’s until 2001, at which point it started to rise again. The rising trend of government debt stopped in 2007, as the debt ratio, fell from 61.8% in 2006 to 61.3% in 2007.

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The HUF denominated debt, which amounted to nearly three-quarters of the total, grew by 551 billion HUF (or 5.2%) to 11,104 HUF billion in 2007. Long-term domestic bonds amounted to 56% of the total government debt. The 8,738 billion HUF domestic bond portfolio consisted of 37 bond series, i.e. the average series size was 236 billion HUF. 10 bond series had an outstanding volume of more than 400 billion HUF (1.6 billion EUR). For the sake of comparison, the year before the same bond portfolio was worth 7,772 billion HUF and consisted of 40 bond series, with an average size of 194 billion HUF, and only 7 series were larger than 400 billion HUF. Thus, the concentration of the marketable bond portfolio continued in 2007. The gross foreign currency debt of the central government increased by 348 billion HUF in 2007 and amounted to 4,473 billion HUF (17.6 billion EUR) at the end of the year (28.7% of the gross government debt). Exchange rate movements increased the value of the foreign currency debt by 14 billion HUF in 2007.7

7 Dr. Álmos Kovács / Imréné Karácsony / Ferenc Szarvas, Debt Management Report 2007, 2007, p.|24.

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May 2007 10,997.3 313.3 63.5 249.8 10,684.0 10,156.7 7,683.8 1,825.0 648.0 527.3 4,331.0 785.6 682.8 102.8 95.2 7.6 3,545.4 3,545.4 3,545.3 0.1

Jun 2007 11,087.1 252.1 79.0 173.1 10,835.0 10,307.7 7,761.5 1,902.3 644.0 527.3 4,352.1 869.7 768.8 101.0 93.5 7.5 3,482.4 3,482.4 3,482.3 0.1

Jul 2007 11,070.8 252.1 79.0 173.1 10,818.7 10,292.2 7,834.1 1,830.0 628.1 526.4 4,433.7 883.2 780.3 102.9 95.3 7.6 3,550.5 3,550.5 3,550.4 0.0

Aug 2007 11,030.6 252.1 79.0 173.1 10,778.5 10,256.2 7,947.4 1,712.8 596.1 522.3 4,505.6 907.7 803.4 104.3 96.6 7.7 3,597.9 3,597.9 3,597.9 0.0

Sep 2007 11,006.9 159.1 79.0 80.0 10,847.8 10,325.5 8,064.8 1,679.1 581.6 522.3 4,437.8 886.6 783.6 102.9 95.3 7.6 3,551.2 3,551.2 3,551.1 0.0

Oct 2007 10,997.7 201.1 121.0 80.0 10,796.6 10,275.1 8,059.7 1,643.9 571.5 521.5 4,526.8 932.4 829.3 103.1 95.5 7.6 3,594.4 3,594.4 3,594.3 0.0

Nov 2007 11,125.0 201.1 121.0 80.0 10,923.9 10,402.4 8,172.5 1,665.6 564.3 521.5 4,568.2 940.9 836.9 104.0 96.3 7.7 3,627.3 3,627.3 3,627.2 0.0

Dec 2007 11,103.8 145.7 145.7 0.0 10,958.1 10,465.4 8,245.3 1,664.9 555.2 492.7 4,472.6 846.5 838.8 7.7 0.0 7.7 3,626.1 3,626.1 3,626.1 0.0

24.7

25.6

25.4

25.3

25.5

25.0

25.1

27.3

18.9

19.0

19.0

9.1

9,690.4 1,933.4

9,720.7 1,877.4

9,977.8 1,817.8

9,936.9 1,882.3

10,036.0 1,923.8

10,191.1 2,000.7

10,190.5 1,928.6

10,182.5 1,803.7

10,266.2 1,763.6

10,225.1 1,730.1

10,359.6 1,747.2

10,402.9 1,749.1

14,950.8 15,182.7 15,213.5 15,139.5 15,353.7 15,464.1 15,529.5 15,563.5 15,463.5 15,543.4 15,712.1 15,585.5

Foreign exchange debt is recorded at themed exchange rate of the NBH at the end of the month.

Marketable HUF debt (1.2.1.1 + 1.2.1.2 + 1.2.2) 1.2.1.2 Discount T-bills at face value

Total central government debt

other debt

** From 2010 it consists the outstanding amount of the Premium Government Bond.

*

Apr 2007 10,848.9 250.3 0.5 249.8 10,598.6 10,071.3 7,622.6 1,787.0 661.7 527.3 4,265.2 775.5 674.4 101.2 93.7 7.5 3,489.7 3,489.7 3,489.7 0.1

14,926.2 15,157.1 15,188.1 15,114.2 15,328.3 15,439.2 15,504.4 15,536.2 15,444.6 15,524.5 15,693.1 15,576.4

Mar 2007 10,892.4 250.3 0.5 249.8 10,642.1 10,114.0 7,721.8 1,727.9 664.3 528.1 4,295.6 785.9 684.2 101.7 94.2 7.5 3,509.7 3,509.7 3,509.6 0.1

TOTAL

Feb 2007 10,740.8 356.4 0.5 355.9 10,384.4 9,856.3 7,408.8 1,783.8 663.7 528.1 4,416.3 808.0 703.4 104.6 96.9 7.8 3,608.3 3,608.3 3,608.2 0.1

Jan 2007 10,711.6 356.4 0.5 355.9 10,355.2 9,826.8 7,326.2 1,835.8 664.8 528.4 4,214.6 818.3 712.4 106.0 98.1 7.9 3,396.3 3,396.3 3,396.2 0.1

1. Forint denominated debt 1.1 Loans 1.1.1 Foreign loans 1.1.2 Domestic loans 1.2 Government Securities 1.2.1 Public issues 1.2.1.1 Bonds 1.2.1.2 Discount T-bills 1.2.1.3 Retail securities ** 1.2.2 Private placements (bonds) 2. Foreign exchange denominated debt * 1.1 Loans 1.1.1 Foreign loans 1.1.2 Domestic loans 1.1.2.1 Raised from National Bank of Hungary 1.1.2.2 Other loans 1.2 Government Securities 1.2.1 Issued abroad 1.2.1.1 Foreign currency bonds 1.2.1.2 Kingdom of Hungary 1924 issues

Picture 6: Central Government gross debt, source: Government Debt Management Agency Plc./ofƂcial online schedule.

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1.3.2.

Inflation

According to the Annual Business Report and Financial Statements of the National Bank of Hungary8 the trends in inflation rate in Hungary were influenced by the following parameters in 2007. In 2007, the annual consumer price index varied in the range of 6.4% to 9%. Following a peak in March, it decreased steadily until October, when it reversed and edged up consistently until the end of the year. Average annual inflation rose to 8% from 3.9% in the previous year, while average core inflation increased from 2.3% to 5.3%. Thus, in the course of the year, year-on-year inflation exceeded the 3% inflation target significantly every month. As a result, the primary objective of the central bank could not be achieved in 2007. In the summer of 2006, the Government announced the details of its austerity package. This also made it clear that fiscal adjustments would push inflation up significantly in 2007, mainly through a significant increase in income and social taxes, and regulated prices. Increasing oil prices in the global markets and a sharp rise in the price of unprocessed food as from the summer of 2007 also contributed to an accelerating inflation. Picture 7: Breakdown of inflation into components, source: Hungarian National Bank, Annual Report, Business Report and Financial Statements of the Magyar Nemzeti Bank 2007, 2007, p. 17.

8 Hungarian National Bank, Annual Report, Business Report and Financial Statements of the Magyar Nemzeti Bank 2007, 2007, p. 17.

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Picture 8: The consumer price index and its components; (Percentage change, year on year), source: Hungarian National Bank, Annual Report, Business Report and Financial Statements of the Magyar Nemzeti Bank 2007, 2007, p. 17. 2005

2006

2007

annual average

2007 Q1

Q2

Q3

Q4

Core inflation

2.1

2.3

5.3

5.8

5.8

5.2

4.6

Unprocessed food

4.3

17.8

13.7

16.1

9.3

12.3

17.0

Fuel and energy

8.6

7.8

2.2

2.4

0.9

-1.8

7.5

Regulated prices

6.1

3.7

14.7

15.3

17.6

15.6

10.1

CPI

3.6

3.9

8.0

8.5

8.6

7.7

7.1

1.3.3.

GDP growth

From 2000 gross domestic product (GDP)9 has increased relatively evenly, at a rate of around 4% in Hungary. From the use side, however, both consumption and gross capital formation grew by leaps and bounds in the space of a few years, domestic use exceeding economic potential at an accelerating rate. Government measures started in 2006 aiming at restoring the economic equilibrium and reducing demand effects resulted in the considerable slowdown of the growth dynamic, and GDP was only 1.3% higher in 2007 than in the previous year. Picture 9: Growth of GDP and same factors of domestic use; (2000=100), source: Hungarian Statistical Office, Hungary in Figures 2007, Budapest, 2008, p. 18.

9 Hungarian Statistical Office, Hungary in Figures 2007, 2008, pp. 18-20.

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Since 2006 the structure of the use side of GDP has been different in many respects from that observed in the past ten years. As a result of structural reform efforts and budget adjustments, the economic development structure in previous years, reliant upon the three pillars of investment growth, consumption and exports, transformed from 2006 onwards. With the narrowing of domestic use factors, it was progressively exports that drove increases. 1.3.4.

Foreign Direct Investment (FDI)

Picture 10: Major data on countries having the highest stocks of direct investment; source: Hungarian Central Statistical Office, Hungary at the end of 2007, 2009, p. 56. Ranking

Investor country

Billion HUF

End of 2006 = 100.0

Share of total stock of investments, %

1.

Germany

3,728.8

100.1

24.6

2.

Netherlands

2,157.6

113.8

14.2

3.

Austria

1,967.2

125.4

13.0

4.

Luxembourg

860.4

133.3

5.7

5.

France

784.1

121.5

5.2

6.

USA

747.5

138.4

4.9

7.

UK

396.2

47.2

2.6

8.

Belgium

370.2

118.9

2.4

9.

Cyprus

361.0

182.6

2.4

10.

Italy

250.4

104.0

1.7

At the end of 2007 the stock of foreign capital operating in Hungary was 15.2 trillion HUF, 10% more than one year before. Germany remained the most important investor country, although the value of its investments was unaltered compared to that recorded at the end of 2006.10

10 Hungarian Central Statistical Office, Hungary 2008, 2009, pp. 56-57.

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Among the countries in the rankings, the United Kingdom, the fourth most important investor country in 2006, dropped three places, which was essentially the consequence of capital withdrawal in 2007 from the management activities of holding companies. At the end of 2007 the ten most important investor countries possessed more than three quarters of the total capital stock. The largest proportion, 36% of foreign capital stock invested in Hungary, operated in manufacturing. The capital stock operating in manufacturing grew by 10% in 2007, which means an acceleration of the pace of increase compared to the previous year. However, in case of the services sector, the growth fell significantly: a rise of 1.8 HUF trillion was recorded in 2006 as against 0.5 trillion HUF in 2007. The key branch of services was represented by real estate, renting and business activities, where a fifth of the total capital stock operated. This was followed by wholesale and retail trade, and repair. In 2007 5.3% more enterprises with foreign direct investment (FDI) operated in Hungary than in the previous year, and their number (27,200) was higher than ever before. Based on the regional location of enterprises with FDI, Central Hungary, and Budapest within that, has a dominant role. 1.3.5.

Unemployment Rate

In the period before the crisis the employment situation of the country shows the following developments. According to the figures of the Yearbook of the Hungarian Central Statistical Office, “Hungary in Figures”11 there was no essential change in the labour market of Hungary in 2007. The number of employed and unemployed people was nearly the same as the year before. It is mainly people whose highest level of education is primary school who have poor employment perspectives. Another reason for the relatively low employment rate is that atypical forms of employment are not widespread in Hungary, e.g. less than 4% of employees work in part-time jobs.

11 Hungarian Statistical Office, Hungary in Figures 2007, 2008, pp. 8-9.

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Picture 11: Number of employed persons by industries, 2007, source: Hungarian Statistical Office, Hungary in Figures 2007, 2008, p. 8. Industries

Change between 2000 and 2007 %

Persons thousand

Of which: share of females %

Agriculture

-28.4

182.9

23.0

Industry

-8.3

950.8

37.5

Construction

23.7

330.5

7.0

Trade and repair

8.9

591.5

53.2

Hotels and restaurants

16.2

156.1

56.6

Transport, storage, communication

-3.7

301.7

25.8

Financial intermediation

-0.6

83.8

67.9

Real estate, renting and business activities

38.3

282.9

45.9

Public administration, health, education, other community service activities

2.9

1,046.0

66.3

1.8

3,926.2

45.4

National economy, total

Unemployment decreased slightly in 2007 compared to the year before. The unemployment rate grew in the age groups 30-34, 40-44, and 50-59, while it improved in the other age groups. Within this, the rate for young people saw the highest decrease, however, it is still the highest among all the age groups. Female unemployment had been below male unemployment for many years, equalling it in 2004 and surpassing it since then. In Hungary there have always been regional discrepancies with regard to employment rates. This means that the situation for people looking for jobs is much better in Western Hungary and in the region around the capital Budapest, while this cannot be said for the rural areas of northern, north-east or south-east Hungary where often structural weaknesses make it difficult to find a job.

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1.3.6.

Exchange Rate Development vis-à-vis the Euro

According to the data issued by the Hungarian Central Bank (the MNB) the annual average HUF/EUR exchange rate in 2007 was 251.3 HUF compared to 264.2 HUF in 2006, due to the significant depreciation of the forint exchange rate against the euro, which took place during the year. The revaluation reserves due to exchange rate changes did not show notable changes compared to the end of 2006 because neither the revaluated foreign exchange amounts, nor the difference between the official forint exchange rate and the average cost rate showed significant changes compared to the end of the previous year. On 31 December 2007, the amount of the revaluation reserves was 49.9 billion HUF, which represents only a slight increase of 0.3 billion HUF compared to the end of 2006.12 Picture 12: Changes in the forint exchange rate (1 January 2006–31 December 2007), source: Hungarian National Bank, Annual Report, Business Report and Financial Statements of the Magyar Nemzeti Bank 2007, 2007, p. 34.

The fundamental aim of Hungarian monetary policy was to prevent the feedthrough of temporary inflationary shocks into inflation expectations, thereby avoiding the emergence of lasting inflation effects. The cycle of interest rate increases in 2006 was followed by significant uncertainties in 2007. The Government’s measures engineered to curb demand, improved the external balance, reduced the fiscal 12 Hungarian National Bank, Annual Report, Business Report and Financial Statements of the Magyar Nemzeti Bank 2007, 2007, pp. 34-35.

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deficit and the country’s external borrowing requirement simultaneously and contributed to a better country risk rating. The negative impact of fiscal adjustments, however, left Hungarian monetary policy facing a dilemma. The underlying reason for this was that the austerity measures led to slowdown in economic growth, which could have justified a more lax monetary policy, and rising inflation, which would then call for a tighter policy. In the central bank’s opinion, there was considerable uncertainty as to the impact of lower demand on inflation, the tapering off of the inflationary effect of one- off shocks and trends in inflation expectations.13 After the second quarter in 2007, the MNB detected unmistakeable improvement in the economic climate. However, in August 2007 the Hungarian economy underwent new, mainly global shocks, with the aftermath shaking the economy until the end of the year. A rapid increase in food and oil prices weakened downside risks and strengthened upside risks to inflation. Money market turbulence attributable to the US sub-prime crisis exerted its effect indirectly through its impact on the forint’s expected risk premium, ultimately leading to a weaker HUF/EUR exchange rate. As the Hungarian banking system did not have any direct exposure to the US subprime market, capital market woes did not exert any substantial influence on the domestic markets and there were no major liquidity constraints. 1.3.7.

Social Situation – Demonstrations Against the Government

After the aforementioned (chapter 1.1) 2006 comment from Prime Minister Gyurcsány had been revealed, in which he admitted that his governing party had been lying about the real facts of the country, the acceptance of the government within Hungarian society fell to a low. Hundreds went out into the street and demanded the resignation of the Prime Minister. Several riots broke out, including the occupation of the national television building. In 2007 the demonstrations continued; as a consequence none of the measures of Gyurcsány’s government were welcomed by society at large and the execution of an austerity package evidently could not be carried out.

13 Ibid., pp. 18-19.

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1.3.8.

First Signs of a Crisis

As mentioned before, the subprime crisis (being a banking crisis in the first place) initially had no direct effect on the Hungarian banking system since most of the Hungarian banks did not have direct links to the highly speculative markets that would break down during the subprime crisis. However, it can be observed that, when the global economic crisis developed from this global banking crisis and spread over the world economies in 2008 Hungary was in an unfavourable and weak position due to its poor economic performance at the time, its still high state budget deficit and forint volatility as described in the abovementioned paragraphs.

2.

The Impact of the World Financial Crisis (2008/2009/2010)

2.1.

The Year 2008

2.1.1.

Political Situation – Missing Awareness of the Crisis’ Depth

According to leading politicians and economic experts taking effective measures against the crisis was complicated because neither the political circles, nor society itself realised (or they even denied believing) the severity of the crisis and its potential effects on the Hungarian economy. Árpád Kovács, former Head of the State Audit Office of Hungary, stated in an interview, e.g. that the Office tried to call the attention of the government to the adverse status of the Hungarian state economy and additionally the serious effects of the global crisis, but according to him: “… risks and disorders of adaptability just as the fact that some part of the political elite as well as Hungarian people and small and medium-sized enterprises have no idea of the development of worldwide processes have been demonstrated by us in conferences and statements. Even in autumn 2008, after Lehman Brothers filed for bankruptcy, politicians of the government party asked me why I was so pessimistic.” Kovács said the political atmosphere, even on the budget debate regarding the year 2009, in November 2008 had been determined by this attitude, too. The government party did simply not want to accept that this wouldn’t be a financial crisis

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195

only. But it would turn into an economical and later into a social crisis, which would sweep them away if no changes were made.14 2.1.2.

Economic Situation – High Deficit and the Hungarian Forint “Under Attack”

The same analyst as mentioned above describes the close to bankruptcy situation of the Hungarian economy with the following reasons. In his opinion, in Hungary, there had been an economic crisis without the global economic crisis, too. The country had been balanced a long time by the international glut of money only, whereas credits had been granted uncounted by foreigners. Making use of these credits it had still seemed to be manageable to become net indebted instead of having had a positive saving rate. He made clear that this was a problem, but in spite of these warnings there had been no significant reactions from part of the government.15 András Simor, Head of the National Bank of Hungary, also sees one of the main reasons for the Hungarian economic crisis in the foreign currency credits, the risks of which, according to Simor had been pointed out by the National Bank of Hungary several times and in several places, for years. But, as he said, “at that time nobody but the National Bank was interested in the risks and necessary restrictions of foreign currency credits – not the banks, the clients, the government, the financial audit nor the politicians.” Every initiative of the MNB encountered huge resistance. Even at the beginning of 2008, as the National Bank had warned market actors against granting Yen credits, some banks had answered, the National Bank shouldn’t instruct them what to do, they had been fully aware of risks they were taking. After efforts lasting for months, the MNB could only have a very soft recommendation accepted by co-authorities.16 The then Minister of Economy and later from April 2009 next Prime Minister, Gordon Bajnai, was blamed several times that the government played down the potential effects of the global economic crisis on the Hungarian economy at the beginning. On 6 October 2008, one month after the bankruptcy of Lehman Brothers 14 Árpád Kovács in: József Péter Martin / István Várkonyi / Álomcsĩd – Interjúk a válságról (“Dream bankruptcy – Interviews on the crisis”), 2010, p.|112. 15 András Simor in: ibid., p. 110. 16 Ibid., p. 118.

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had been revealed, Bajnai held a short speech in Parliament in which he said – particularly with regard to the situation of the Hungarian banking system – that Hungary’s economic situation was stable and Hungary could face severe international economic circumstances with reasonable certainty. However, he also added that Hungary had to take it into account that due to this crisis; much more severe economic circumstances were still to come worldwide and – also unavoidable – in Hungary in the following months or maybe years. However, the speech hasn’t been warning enough for consciousness of the direct effects of the global crisis on Hungary, so that as a country Hungary could more effectively prepare to challenge the crisis.17 A few days later, on 9 October 2008 the Hungarian economy was hit directly by the global crisis when a speculative attack was made on the majoritarian state owned bank OTP and on the forint, and the market of government securities came to a standstill. Bajnai admits that already before the speculative attack on OTP shares, upcoming problems could be perceived, the situation had become worse day by day. In his opinion, at that time, it had been hard to recognize how huge the problem was, though. He said that ”a couple of days passed by until we took up the tread and realised that we have to fight, fight for our lives and suffer unavoidable losses. However, on 9|October 2008 we exactly knew that Hungary became a target and got attacked.” According to Bajnai the global economic crisis results from the progress that “if there is less money in the world, consumption abates, credit possibilities are restricted, investments decrease, market becomes restricted.” Additionally to the global crisis, as Bajnai said, Hungary had to face three problems at the same time. First of all authenticity problems, as 2001-2006 prosperity was financed – simplified – continuously and in an increasing extent from budget deficit and indebtedness. Secondly the lack of growth. Finally there was the problem of a high foreign currency debt rate caused mainly by private and business borrowing. According to Bajnai the latter problem could be traced back to economic-political failures. He stated that “the politics as starting already from 2001 led to a wave of house building

17 Gordon Bajnai in: József Péter Martin / István Várkonyi. Álomcsĩd – Interjúk a válságról (“Dream bankruptcy – Interviews on the crisis”), 2010, pp. 12-17.

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and purchasing which resulted in increasing credit requests. Because of rising forint interests due to an undisciplined economic policy, market actors incurred debts more and more in foreign currency.”18 State Budget Deficit

In 2008 the government debt, including repo operations, grew by 2,518 billion HUF (16.2%) to 18,104 billion HUF from end-2007. In addition to the increased financing requirement of the central government, the relatively large rise in the debt was caused by the loans drawn from the IMF/EC package (a large part of which was not used for financing but was deposited in foreign currency), the exchange rate difference due to the conversion of debt in foreign currency to forints and other items such as the balance of repo transactions at the end of the year. 1,035 billion HUF of the increase was actually used for financing, while a significantly larger amount –1,484 billion HUF – was deposited with the NBH in foreign currency. The actual economic burden of government debt as expressed by the debt/GDP ratio (debt ratio) peaked at 88.7% in 1993, after the economic decline following the end of the centrally planned economy. From the mid 1990s the debt ratio decreased rapidly – thanks to the stabilisation of economic policy – until 2001, when it began to grow again. After a slight improvement in 2007, the indicator increased again in 2008. According to preliminary data, the debt ratio grew from 61.3% at the end of 2007 to 68.4% at the end of 2008. However, excluding the 1,484 HUF foreign currency deposits so as to obtain a figure that is comparable with previous years, the debt ratio in 2008 was only 62.8%; this means that GDP-proportional debt would have increased by 1.5% (see picture).19

18 Ibid., pp. 12-17. 19 Dr. Almos Kovács / Imréné Karácsony / Ferenc Szarvas, Debt Management Report 2008, 2008, p.|24.

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Mar 2008 11,476.4 145.7 145.7 11,330.7 10,839.0 8,588.0 1,718.5 532.5 491.7 4,663.5 951.4 943.5 0.0 0.0 7.9 7.9 3,712.1 3,712.1 3,712.1

Apr 2008 11,409.4 145.7 145.7 11,263.7 10,772.0 8,531.6 1,712.5 527.9 491.7 4,555.4 928.1 920.4 0.0 0.0 7.7 7.7 3,627.3 3,627.3 3,627.2

May 2008 11,385.8 145.7 145.7 11,240.1 10,748.3 8,508.9 1,712.3 527.2 491.7 4,379.8 880.1 827.7 0.0 0.0 7.3 7.3 3,499.8 3,499.8 3,499.7

Jun 2008 11,454.2 145.5 145.5 11,308.7 10,817.8 8,505.8 1,778.9 533.2 490.9 4,506.6 706.1 706.1 0.0 0.0 0.0 0.0 3,800.5 3,800.5 3,800.5

Jul 2008 11,289.5 145.5 145.5 11,144.0 10,653.1 8,521.9 1,594.2 537.1 490.9 4,403.0 696.1 696.1 0.0 0.0 0.0 0.0 3,706.9 3,706.9 3,706.8

Aug 2008 11,287.9 145.5 145.5 11,142.4 10,653.3 8,421.1 1,703.6 528.6 489.1 4,560.5 741.1 741.1 0.0 0.0 0.0 0.0 3,819.4 3,819.4 3,819.4

Sep 2008 11,322.3 145.6 145.5 11,176.7 10,688.5 8,424.3 1,723.7 540.5 488.2 4,650.3 751.4 751.4 0.0 0.0 0.0 0.0 3,899.0 3,899.0 3,898.9

Oct 2008 11,281.0 183.6 183.5 11,097.4 10,664.2 8,538.1 1,588.1 538.0 433.2 5,000.0 813.6 813.6 0.0 0.0 0.0 0.0 4,186.4 4,186.4 4,186.4

Nov 2008 11,415.5 183.5 183.5 11,232.0 10,798.8 8,721.8 1,541.0 536.0 433.2 6,272.2 2,110.0 2,110.0 1,270.7 839.3 0.0 0.0 4,162.2 4,162.2 4,162.2

Dec 2008 11,250.6 219.9 219.9 11,030.7 10,599.7 8,570.6 1,482.4 546.6 431.0 6,774.8 2,529.4 2,529.4 1,755.5 773.9 0.0 0.0 4,245.4 4,245.4 4,245.4

15.4

15.3

5.3

5.1

5.0

4.9

6.9

7.1

7.6

56.5

78.5

10,644.9 1,778.0

10,798.2 1,801.2

10,735.8 1,801.9

10,712.9 1,799.8

10,775.6 1,871.4

10,607.0 1,685.6

Foreign exchange debt is recorded at themed exchange rate of the NBH at the end of the month.

10,587.0 1,798.5

10,613.8 1,796.1

10,636.2 1,820.5

10,559.4 1,679.5

10,696.0 1,638.6

16,476.5

1,267.7

10,484.0 1,580.1

16,620.3

1,483.6

15,853.6 15,932.1 16,155.1 15,970.0 15,770.7 15,965.8 15,697.4 15,855.4 15,979.7 16,288.6 17,744.2 18,103.9

19.1

15,834.5 15,916.6 16,139.9 15,964.7 15,765.6 15,960.8 15,692.5 15,848.5 15,972.7 16,281.0 17,687.7 18,025.4

Feb 2008 11,325.7 145.7 145.7 11,180.0 10,687.5 8,460.7 1,691.7 535.0 492.5 4,591.0 838.6 830.6 0.0 0.0 8.0 8.0 3,752.4 3,752.4 3,752.3

** From 2010 it consists the outstanding amount of the Premium Government Bond.

*

Central government net debt Memo items: Marketable HUF debt (1.2.1.1 + 1.2.1.2 + 1.2.2) 1.2.1.2 Discount T-bills at face value

Out of the international loan program, amount is placed at the NBH as a deposit or at domestic banks as loans.

Total central government debt

other debt

TOTAL

1. Forint denominated debt 1.1 Loans 1.1.1 Foreign loans 1.2 Government Securities 1.2.1 Public issues 1.2.1.1 Bonds 1.2.1.2 Discount T-bills 1.2.1.3 Retail securities ** 1.2.2 Private placements (bonds) 2. Foreign exchange denominated debt * 1.1 Loans 1.1.1 Foreign loans 1.1.1.1 Loan from IMF and EU 1.1.1.2 Other 1.1.2 Domestic loans 1.1.2.1 Other loans 1.2 Government Securities 1.2.1 Issued abroad 1.2.1.1 Foreign currency bonds

Jan 2008 11,277.1 145.7 145.7 11,131.4 10,638.8 8,378.7 1,715.6 544.5 492.7 4,557.4 843.0 835.1 0.0 0.0 7.9 7.9 3,714.4 3,714.4 3,714.4

Picture 13: Central Government Debt Gross, source: Government Debt Management Agency Plc./ofƂcial online schedule.

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Inflation Average inflation in 2008 amounted to 6.1%. As a result of the declining trend observed in the second half of the year, inflation, which had been at 6.9% in the first quarter, fell to 4.3% in the fourth quarter. Average annual inflation fell to 6.1% from 8% in the previous year, while average annual core inflation declined from 5.3% to 5.2%. In the course of the year, year-on-year inflation exceeded the medium-term objective of 3% every month, and, apart from the last month of the year, it also fell outside the ±1% tolerance band. As a result, the primary objective of the MNB was not achieved in 2008.20 The difference between actual inflation and the inflation target of the MNB was predominantly attributable to cost shocks of a global origin beyond the control of monetary policy. These shocks were primarily the result of developments in oil and food prices. Food and oil prices started to increase extremely quickly and in an unforeseeable manner in the summer and autumn of 2007, respectively. Picture 14: The consumer price index and its components; (percentage change, year on year), source: Hungarian National Bank, Annual Report, Business Report and Financial Statements of the Magyar Nemzeti Bank 2008, 2008, p. 19. 2006 2007 2008 2008 annual average

Q1

Q2

Q3

Q4

5.2

5.2

5.8

5.6

4.2

13.7

5.8

13.8

11.3

2.1

-4.1

7.8

2.2

9.9

14.8

13.3

12.8

-1.3

3.7

14.7

7.9

6.9

7.1

8.5

9.1

3.9

8.0

6.1

6.9

6.8

6.3

4.3

Core inflation

2.3

5.3

Unprocessed food

17.8

Fuel and energy Regdulated prices CPI

The inflation of market services and tradable goods shows that in 2008 there was no considerable improvement compared to the previous year, even in sectors only indirectly affected by cost shocks and which can be influenced by monetary policy to a greater extent.

20 Hungarian National Bank, Annual Report, Business Report and Financial Statements of the Magyar Nemzeti Bank 2008, 2008, pp. 18-19.

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GDP Growth

Gross domestic product of Hungary decreased by 2.3% in the fourth quarter of 2008 and by 2.5% when adjusted for calendar effects, compared to the corresponding period of the previous year. The value added of commodity producing branches (agriculture, industry and construction) grew by 1.3% in the fourth quarter. The performance of the industry decreased by 8.5%, while instead of the trend previously observed in the value added of construction, it raised by 2.7% mainly due to some works of great value in highway construction and utility projects realized at the end of the year.21 The gross value added of services decreased by 4.2% in the fourth quarter of 2008. Among services, the highest decline can be observed in the performance of financial intermediation, real estate, renting and business activities (-7.8%) because of the unfavourable market processes. Looking at the expenditure side of GDP in the fourth quarter of 2008, final consumption of households decreased by 3.3%. This was due to the strong decrease of household final consumption expenditure by 4.4%. Final consumption of government diminished by 9.5%, due to the high level of previous year’s basis, when funds had to be provided in order to bear the cost of the Gripen fighter airplanes that had been procured for the Hungarian Airforce. Actual final consumption decreased by 4.2%. Domestic use in 2008 decreased by 2.6%. Picture 15: Gross domestic product (GDP); (seasonally and calendar effects adjusted and reconciled data, volume indices, previous quarter=100.0), source: Hungarian Statistical Office, First release (release date: 11 March 2009), 2009, p. 2.

21 Hungarian Statistical Office, First release (release date: 11 March 2009), 2009, pp. 1-4.

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Industry was 3.4% lower and services total decreased by 0.6%. Household consumption expenditure decreased by 1.8%. The social transfers in kind from government decreased by 0.8%. The actual final consumption of government went down by 1.3%, actual consumption decreased by 2.5%. Exports declined by 6.5%, while imports by 7.3%. The volume of gross domestic product decreased by 1.3% when adjusted for seasonal and calendar effects, compared to the corresponding period of the previous year. Foreign Direct Investment (FDI)

The single biggest FDI contributor in Hungary in 2008 was Germany (13.9 billion EUR or 22.2%). Other major investors included Austria (9.1 billion EUR or 14.5%), the Netherlands (8.4 billion EUR or 13.4%), Luxembourg (6.7 billion EUR or 10.7%), France (3.8 billion EUR or 6.1%) and the USA (2.6 billion EUR or 4.1%). Altogether the EU provided 75% of all FDI in Hungary in 2008.22 Picture 16: Breakdown of FDI stock (at end-2008); By country of origin, source: Ministry for National Development and Economy, Economic Policy and Analysis Department, Overview of foreign direct investment in Hungary, 2010, p. 1.

Other countries 20%

Austria 13% Belgium 3% Cyprus 3% France 6%

Japan 10% USA 4% Germany 19%

Netherlands 12% Luxembourg 10%

22 Ministry for National Development and Economy, Economic Policy and Analysis Department, Overview of foreign direct investment in Hungary, 2010, p. 1.

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More than 60% of all FDI was attracted by services (40 billion EUR or 63.7%); the leading sectors here were wholesale and retail trade (8.8 billion EUR or 14%), transport and communication (5.9 billion EUR or 9.4%), real estate sector (5.7 billion EUR or 9.2%), as well as banking sector (5.5 billion EUR or 8.8%). Manufacturing accounted for 27.7% (17.4 billion EUR). Unemployment Rate

2008 was a year with considerable and unfavourable changes in the labour market: the number and share of employed people fell significantly, while that of unemployed increased perceptibly. This meant at the same time that in respect of EU Member States, the labour market position deteriorated. Regional differences in the country have been invariably significant and growing. The unemployment rate in 2008 was 7.9%, which was the highest value after 1998. As a consequence, the number of economically active (employed or unemployed) population aged 15-64 fell by 0.7% to some 4.1 million.23 Picture 17: Distribution of the population aged 15–64, source: Hungarian Central Statistical Office, Hungary 2008, 2009, p. 13.

The level of employment was low in international comparison, and the lag behind the EU-27 average has increased from 6.2 to 9.2 percentage points (p.p.) since the turn of the millennium. In the background of the very low employment rate 23 Hungarian Central Statistical Office, Hungary 2008, 2009, pp. 13-15.

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compared to EU, those people having primary educational attainment only had the worst employment opportunities; among them, in Hungary 27% were employed as opposed to the 48% in the EU in 2008. In case of people with secondary or tertiary educational attainment, the lag behind the EU average was smaller in 2008 (7.3 p.p. and 4.4 p.p., respectively). Another reason for low employment is that atypical forms of employment are not really common in Hungary. In 2008, the proportion of part-time employment and employees with fixed-term labour contract increased slightly. The proportion of employees working in part-time jobs was 4.3%, which equalled the rate in the Czech Republic. The EU-27 average, however, was 17.6%. The gender composition of employed persons changed significantly in 2008, the number of employed men fell by 33,000 over the year, while that of employed women decreased to a smaller extent, by 15,000. Out of 100 employed persons 54 were males and 46 were females. Employment rate was 63.0% for men and 50.6% for women. In the sectoral structure of employment, the weight of service branches increased in a manner that the number of 15-64 year-old people employed in the sector did not practically change, while this number fell slightly in industry and agriculture. The headcount decrease was 35,000 in industrial branches and 9,000 in agriculture over the year. The labour market status of regions changed to some extent, which resulted in the increase of the regional differences within the country. Among the population aged 15-64, the employment rate was the highest (62.7%) and unemployment rate the lowest (4.6%) in Central Hungary. Here, beside the unchanged level of employment rate, the unemployment rate even fell by 0.2 p.p. compared to the previous year. The labour market situation was the worst in Northern Hungary, since the employment rate diminished by 1.3 p.p. there, and the rate of unemployment grew by 1.1 p.p. among the economically active population. Thus, the employment rate was the lowest (49.5%) and the unemployment rate the highest (13.4%) in this region. The other five regions were characterized by a decreasing employment rate and – except for Western Transdanubia – an increasing unemployment rate. The increase of regional disparities is shown by the fact that the difference between the region with the lowest and the region with the highest unemployment rate rose from 7.5 p.p. to 8.8 p.p. over the year.

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Picture 18: Labour market trends in the regions (among population aged 15–64 years, in %), source: Hungarian Central Statistical Office, Hungary 2008, 2009, p. 15. Employment rate

Unemployment rate

Regions

2007

2008

2007

2008

Central Hungary

62.7

62.7

4.8

4.6

Central Transdanubia

61.8

60.3

5.0

5.9

Western Transdanubia

63.4

62.1

5.0

5.0

Southern Transdanubia

51.2

51.0

10.0

10.3

Northern Hungary

50.8

49.5

12.3

13.4

Northern Great Plain

50.5

49.9

10.9

12.0

Southern Great Plain

55.2

54.5

7.9

8.8

National average

57.3

56.7

7.4

7.9

Exchange Rate Development vis-à-vis the Euro

Income arising from exchange rate changes is primarily determined by the difference between the official exchange rate and the cost rate, which nearly quadrupled by 31 December 2008, growing to 12.7 HUF/EUR from 3.25 HUF/EUR at the end of the previous year. The depreciation of the official forint exchange rate, which was observed at the beginning of 2008, was soon followed by a strong appreciation in the first half of the year after the intervention band was eliminated (26 February 2008). The HUF exchange rate was subject to substantial depreciation pressure in October, when in only a few days it lost more than 10% against the EUR, but the pressure abated when the Central Bank raised the base rate and a substantial loan amount was granted under the credit facility agreement with international organisations (IMF, EU, World Bank). Overall, the HUF depreciated by 4.5% against the EUR during the year, and the exchange rate stood at 264.78 HUF/EUR on 31 December 2008. 24

24 Hungarian National Bank, Annual Report, Business Report and Financial Statements of the Magyar Nemzeti Bank 2008, 2008, p. 37.

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Picture 19: Changes in the forint exchange rate (1 January 2007-31 December 2008), Hungarian National Bank, Annual Report, Business Report and Financial Statements of the Magyar Nemzeti Bank 2008, 2008, p. 37.

2.1.3.

Social Situation

According to Árpád Kovács, former Head of the State Audit Office of Hungary, the crisis had – besides the economic – its social reasons as well. The corruption and the lack of awareness of global events could be seen in local politics and the local business economy as well. The disappointment with regard to the interests and health of the small and medium-sized businesses was also evident in local mayor’s offices.25 This means that on a local as well as at the state level the leaders’ general attitude was myopic and handled the corruption based relationships as an accepted way of governance.

25 Árpád Kovács in: József Péter Martin / István Várkonyi, Álomcsĩd – Interjúk a válságról (“Dream bankruptcy – Interviews on the crisis”), 2010, p.|107.

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2.2.

The Year 2009

2.2.1.

Political Situation – New PM with Dwindling Support for Strict Austerity Measures

Gordon Bajnai, a 41-year-old former investment banker, became a minister in Ferenc Gyurcsány’s government cabinet in July 2007, in the Ministry of Local Government and Regional Development. After the coalition partner SZDSZ, the Alliance of Free Democrats, left the government coalition in May 2008, he took over the newly-formed Ministry of National Development and Economy. In March 2009, Prime Minister Ferenc Gyurcsány resigned, announcing that he would hand over his position to a new premier with a higher support of the parties of the Hungarian Parliament. SZDSZ opposed most candidates for the post proposed by the Hungarian Socialists. Although Bajnai was reluctant to become the new Prime Minister, after a week, with no tangible results in sight, and having been asked by the majority of party stakeholders, who also assured him of their support of the needed austerity measures, he took the job. Securing the backing of both parties, Bajnai became Prime Minister on 14 April 2009. The Hungarian Parliament elected Bajnai as Hungary’s Prime Minister with comfortable majority of the votes. In his first speech as Prime Minister, he promised drastic measures to stop the negative spiral of the Hungarian economy, and to ease the burden of the international crisis. He also stated that he would remain in power as long as he had the solid majority of Parliament behind his austerity package, but would not stay longer than a year and not run for a new election period. Bajnai was succeeded by Viktor Orbán and his rather conservative Fidesz government in May 2010. After that Bajnai retired from politics and returned to the business life. Leading Hungarian political and economical analysts describe the political situation in 2009 as follows: In 2009 the crisis escalated worldwide, but the Hungarian government still wouldn’t accept its effects on Hungary and still didn’t communicate the necessary measures, accordingly. The unexpectedly deep recession and the tighter fiscal policy that was necessitated by it created the situation in which Gyurcsány stepped down as Prime Minister to be replaced by the economical expert Bajnai in spring 2009. The timing may have been precipitated by the fact that long-standing rifts in the governing party were by then accompanied by signs of the government’s growing international isolation. For

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example, when Gyurcsány more or less unilaterally proposed a huge 200 billion EUR stabilisation package for the recently acceded countries during an EU summit that was called to discuss the economic crisis in early 2009, it was rejected not only by the old Member States who were supposed to provide the funding but also by the new Member States who would have benefited from the proposal but who believed that solidarity with Hungary at the time would have sent the wrong message. With dwindling support, Gyurcsány probably felt that political background for a quick and effective crisis management could be more successfully secured by a new prime minister. There were arguments against calling elections ahead of time: elections are time-consuming, whereas the adjustment could not wait, and it was questionable whether the opposition was politically and technically ready to govern, as they had declared that the sacrifices requested by the government in connection with the management of the crisis were not necessary. The program finally adopted by the government of Prime Minister Bajnai, which was formed in April 2009, was based on various elements included in the proposals made in 2008 by the Reform Alliance and a white paper that was prepared by the Ministry of Finance in early 2009 on the basis of pessimistic assumptions and that was rejected by the government at that time.26 After the change of government, three major reforms were quickly introduced in pensions, taxes, and social aid, and a 3.8% budget deficit next year – one of the smallest in Europe had been expected. In a ‘Newsweek’ interview in 2009 Bajnai showed optimism and stated that bank interest rates were significantly below precrisis levels. He referred to the opinion of JPMorgan, according to which Hungary might be the first of the Polish-Czech-Hungarian trio to introduce the euro, and to the analysts of Merrill Lynch who said Hungary might come out of the crisis in the strongest fiscal position of all OECD countries. Bajnai believed that Hungary had “become a frontrunner in terms of fiscal stability.”27 He further said: “Hungarians are used to crisis, and so far we have avoided meltdowns. Last October, when the crisis hit us, Hungary was seen as a risk because a significant number of people had foreign-currency loans and the potential of our economy had been reduced by a lack of reform. But we were one of the first countries to turn to the IMF and the European Commission. And that put the floor under the risk of financial free fall.”28 26 Gabor Karsai / Andras Vertes, Ki a válságból, de hova be… (Out of the crisis, but whereto…), in: Dr. Peter Sándor / Dr. László Vass, A Magyarország politikai évkönyve® 2009 Digitális könyv (Political year-book of Hungary of 2009, digital book), 2010, p. 217. 27 Gordon Bajnai, We Have Become a Frontrunner, 27 November 2009 – Newsweek online, http://www.newsweek.com/2009/11/26/gordon-bajnai-we-have-become-a-frontrunner.html, (retrieved on 16 August 2010). 28 Ibid.

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Bajnai took over an economy that was expected to contract by 6 percent in 2009 and kept afloat by a 25.1 billion USD IMF-led lifeline. Foreign investors were declining to finance Hungary’s high budget and current account deficits, and the forint’s weakness kept threatening hundreds of thousands of families who took out foreign currency mortgages. Bajnai had to cut government spending to rescue the budget, keep within IMF guidelines and regain investor confidence, and he was facing dissent from every possible side. Furthermore, he had a difficult task in coping with the then ruling socialists, since he needed their votes, although quite a view members of MSZP were having a problem with him, because of the necessary cuts in welfare spending that he announced would be rejected by the socialists’ traditional voter base. Analysts at that time expected Bajnai to have limited time to act – and they were right. The campaign for the spring 2010 election was soon to be initiated. Bajnai said pensions, public sector bonuses, maternity support, mortgage subsidies, energy subsidies and public transport subsidies would have to be cut and even structural reforms were also important, e.g. in public administration, the health care and education. However, he then had no time to further work out concrete and detailed plans how such reforms could be implemented. 2.2.2.

Economical Situation

State Budget Deficit

The deficit of the central government amounted to 918.6 billion HUF (about 3.4 billion EUR) in 2009. The net balance of transfers from the EAGGF fund of the European Union (EU) worth 34.4 billion HUF decreased the net borrowing requirement. Privatisation revenues amounted to 1.1 billion HUF, which also decreased the financing requirement. Thus, the total net borrowing requirement amounted to 883.1 billion HUF in 2009. Net issuance was 910.4 billion HUF; out of which net HUF-denominated issuance was -774.4 billion HUF and net foreign currency denominated issuance was 1,684.8 billion HUF. 1,124.8 billion HUF was placed at the National Bank of Hungary and other banks in the form of foreign currency deposits or loans at the end of December. The total amount of other liabilities decreased by 58.4 billion HUF in 2009.29

29 Government Debt Management Agency Pte. Ltd., Government Securities market, quarterly report, Fourth quarter 2009, 2009, p. 1.

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| Roland Felkai Feb 2009 11,228.1 219.9 219.9 11,008.2 10,577.3 8,493.7 1,552.3 531.4 430.9 7,531.2 2,924.8 2,924.8 2,046.2 878.6 4,606.4 4,606.4 4,606.4 0.1

Mar 2009 11,947.4 980.6 980.6 10,966.8 10,536.7 8,418.6 1,592.9 525.2 430.1 8,426.1 3,622.7 3,622.7 2,699.6 923.1 4,803.4 4,803.4 4,803.3 0.1

Apr 2009 11,744.9 1,383.9 1,383.9 10,361.1 9,931.0 7,834.2 1,577.1 519.7 430.1 7,405.8 2,939.5 2,939.5 2,111.7 827.8 4,466.3 4,466.3 4,466.3 0.0

May 2009 11,742.9 1,301.7 1,301.7 10,441.2 10,011.0 7,796.0 1,705.8 509.3 430.1 7,262.0 2,888.2 2,888.2 2,061.7 826.5 4,373.7 4,373.7 4,373.7 0.0

Jun 2009 11,439.9 1,036.1 1,036.1 10,403.8 9,974.6 7,779.0 1,695.1 500.5 429.2 7,222.4 3,092.7 3,092.7 2,246.6 846.1 4,129.7 4,129.7 4,129.7 0.0

Jul 2009 11,214.4 1,022.9 1,022.9 10,191.5 9,762.2 7,660.5 1,621.2 480.5 429.2 7,751.1 3,445.9 3,445.9 2,620.6 825.3 4,305.2 4,305.2 4,305.2 0.0

Aug 2009 10,968.5 1,022.9 1,022.9 9,945.5 9,518.1 7,388.8 1,649.4 479.9 427.4 7,908.1 3,512.6 3,512.6 2,670.0 842.6 4,395.5 4,395.5 4,395.5 0.0

Sep 2009 11,095.9 1,015.7 1,015.7 10,080.2 9,653.6 7,532.2 1,658.9 462.5 426.6 7,848.7 3,480.0 3,480.0 2,648.2 831.8 4,368.7 4,368.7 4,368.7 0.0

Oct 2009 11,103.2 1,006.2 1,006.2 10,097.0 9,670.4 7,456.4 1,762.5 451.6 426.6 7,905.0 3,501.7 3,501.7 2,660.7 841.0 4,403.3 4,403.3 4,403.3 0.0

Nov 2009 10,574.8 401.9 401.9 10,172.9 9,746.3 7,523.9 1,785.7 436.7 426.6 8,443.4 4,043.5 4,043.5 3,273.3 770.2 4,399.9 4,399.9 4,399.9 0.0

Dec 2009 10,476.2 438.7 438.7 10,037.5 9,613.2 7,519.2 1,647.3 446.6 424.3 8,468.5 4,114.5 4,114.5 3,351.7 762.8 4,354.0 4,354.0 4,354.0 0.0

100.9

73.9

54.9

47.5

13.1

16.1

12.6

10.6

11.3

13.2

20.1

10,476.9 1,654.4

10,480.5 1,617.2

2,081.2

10,441.6 1,703.6

18,366.2

1,538.9

9,841.4 1,684.4

17,666.7

1,507.0

9,931.9 1,822.3

17,545.3

1,131.2

9,903.3 1,805.6

17,544.3

1,105.7

9,710.9 1,728.3

17,875.9

Foreign exchange debt is recorded at themed exchange rate of the NBH at the end of the month.

1,446.8 17,413.4

1,588.5 17,385.4

9,465.6 1,761.8

17,768.6

1,120.6

9,617.7 1,759.9

17,838.3

1,116.8

9,645.5 1,868.0

17,901.6

1,117.9

9,736.2 1,892.7

17,999.9

1,031.4

9,590.8 1,747.4

17,840.1

1,124.8

18,973.9 18,860.2 20,447.3 19,205.6 19,052.4 18,675.5 18,981.6 18,889.2 18,955.2 19,019.5 19,031.3 18,964.9

85.8

18,888.1 18,759.3 20,373.5 19,150.8 19,004.9 18,662.4 18,965.5 18,876.6 18,944.6 19,008.2 19,018.2 18,944.8

Jan 2009 11,238.6 219.9 219.9 11,018.7 10,587.8 8,528.0 1,521.5 538.3 431.0 7,649.5 2,920.6 2,920.6 2,046.7 873.9 4,728.9 4,728.9 4,728.8 0.0

** From 2010 it consists the outstanding amount of the Premium Government Bond.

*

Central government net debt Memo items: Marketable HUF debt (1.2.1.1 + 1.2.1.2 + 1.2.2) 1.2.1.2 Discount T-bills at face value

Out of the international loan program, amount is placed at the NBH as a deposit or at domestic banks as loans.

Total central government debt

other debt

TOTAL

1. Forint denominated debt 1.1 Loans 1.1.1 Foreign loans 1.2 Government Securities 1.2.1 Public issues 1.2.1.1 Bonds 1.2.1.2 Discount T-bills 1.2.1.3 Retail securities ** 1.2.2 Private placements (bonds) 2. Foreign exchange denominated debt * 1.1 Loans 1.1.1 Foreign loans 1.1.1.1 Loan from IMF and EU 1.1.1.2 Other 1.2 Government Securities 1.2.1 Issued abroad 1.2.1.1 Foreign currency bonds 1.2.1.2 Kingdom of Hungary 1924 issues

Picture 20: Central Government Debt Gross, source: Government Debt Management Agency Plc./official online schedule.

Inflation

Average annual inflation was 4.2% in 200930 At the beginning of the year, the consumer price index approached the 3% target; however, it exceeded 5% in the second half of the year. Picture 21: Inflation target and inflation developments, source: Hungarian National Bank, Annual Report, Business Report and Financial Statements of the Magyar Nemzeti Bank 2009, 2009, p. 18.

Picture 22: The consumer price index and its components (Percentage change, year-on-year), source: Hungarian National Bank, Annual Report, Business Report and Financial Statements of the Magyar Nemzeti Bank 2009, 2009, p. 19. 2007

2008

2009

annual average

2009 Q1

Q2

Q3

Q4

Core inflation

5.4

5.2

4.1

3.3

3.2

5.1

5.1

Unprocessed food

13.7

5.8

5.0

3.1

11.1

3.9

1.7

Fuel and energy

2.2

9.9

-5.2

-11.5

-9.9

-5.0

5.5

Regulated prices

19.7

8.7

8.0

8.1

8.0

8.6

7.1

CPI

8.0

6.1

4.2

3.0

3.6

5.0

5.2

Note: As a result of the restructuring of certain sub-components in 2009, the time series of inflation may differ, even on a retrospective basis, from those published in previous years. 30 Hungarian National Bank, Annual Report, Business Report and Financial Statements of the Magyar Nemzeti Bank 2009, 2009, pp. 18-19.

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The most significant conclusion drawn from inflation data for 2009 is the fact that inflation inertia – a typical trend in recent years – has clearly broken. This is distinctly reflected in the deceleration in the price dynamics of market services (excluding tax changes). While the price index of services fluctuated between 5% and 6% in previous years, in 2009 it fell close to 3%, excluding the effect of indirect tax increases. GDP Growth

Based on the volume of GDP the performance of the Hungarian economy decreased from the fourth quarter of 2008.31 In 2009, GDP was 6.3% (after calendar adjustment 6.2%) lower than one year earlier. Within the year it fell by about 6%-7% in the first three quarters, and at a somewhat lower pace, by 4.0% in the last three months of the year compared to the low base. Picture 23: GDP growth, source: Hungarian Statistical Office, Hungary in Figures 2009, 2010, p. 42. Change in volume compared Distribution, to the previous year Industries 2009 a) 2007 2008 2009 Total GDP

100.0

1.0

0.6

-6.3

Agriculture, hunting and forestry, fishing

3.0

-21.3

54.3

-17.5

Industry

24.9

6.0

0.4

-15.9

Construction

4.8

-6.7

-3.6

-3.0

Trade and repair, hotels and restaurants

13.0

4.0

-2.5

-8.5

Transport, storage and communication

8.2

5.1

0.8

-4.3

Financial intermediation, real estate, renting and business activities

23.6

0.5

-1.5

0.8

Public administration, education, health and social work

17.7

-3.9

-2.0

-1.0

Of which

31 Hungarian Central Statistical Office, Statistical report, January 2010 Summary, 2010, pp. 1-2.

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Industries

Distribution, 2009 a)

Change in volume compared to the previous year 2007

2008

2009

4.8

3.0

-5.8

-1.0

93.0

-1.2

0.7

-11.5

Actual final consumption of households

64.7

-1.6

-0.6

-6.7

Actual final consumption of government

9.8

-4.3

-0.3

1.0

Actual final consumption of, total

74.5

-2.0

-0.6

-5.7

Gross fixed capital formation

20.0

1.6

0.4

-6.5

Other community, social and personal service activities Total domestic use of GDP Of which

a)

In case of production, total of branches, at basic prices = 100.0; in case of use, total GDP = 100.0.

After the moderate changes in previous years the volume of domestic use fell sharply, by 11.5% in 2009, its value accounting for 93% of GDP. The share of net exports rose from 1% to 1.5% in the previous two years to 7%. The marked change was caused by the joint impact of balance-improving and demand-reducing measures and the global economic fall. 2009 was already the third year that the actual final consumption of households has decreased, but the rate of decline was 6.7%, much higher than the former 0.51.5%. While earlier on the source of domestic use exceeding production was the import surplus of external trade in goods and services, this changed for an export surplus from 2007. In 2009 its amount rose to 1.8 trillion HUF. The change occurred dominantly in the trade in goods.

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Picture 24: GDP and its main components of use (2000=100), source: Hungarian Statistical Office, Hungary in Figures 2009, 2010, p. 42.

From production side the performance of goods-producing branches was down by 14.4%, while that of services at an essentially lower rate, by 2.3%. The determining factor of the global decline was the 16% fall of the gross value added by industry, which is closely related to global economic processes. The output of construction decreased by 3% on an annual level within which the volume of building erection was lower than in the previous year. Meanwhile the volume of civil engineering works rose – primarily as a consequence of road and motorway constructions, construction of public utilities and power lines, railway reconstructions and works related to metro line 4. The performance of agriculture declined by 17.5% in 2009 compared to the outstandingly high base one year before. In 2009 a decrease could be observed throughout almost all branches. A slight growth (+0.8%) was recorded only in financial intermediation and real estate activities. However, it has to be admitted that these branches had suffered a significant decrease in the previous year.32

32 Hungarian Statistical Office, Hungary in Figures, 2009, Budapest, 2010, pp. 42-43.

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Picture 25: Export (+) and import (-) surplus as a proportion of GDP, source: Hungarian Statistical Office, Hungary in Figures 2009, 2010, p. 43.

The recently processed detailed data on external merchandise trade for 2009 show the considerable fall of both exports and imports: as an impact of the global economic crisis the volume of exports was down by 12%, while that of imports fell by 17% throughout the year. The price level of external trade, measured in HUF, was influenced by the exchange rate of the forint as well as foreign exchange prices. From January to December 2009 the forint depreciated by 13% against the major currencies, within which by 12% against the euro and by 18% against the US dollar. Foreign Direct Investment (FDI)

Data from 200833 shows the effect of the global economic crisis on FDI. Its inflow of 3.1 billion EUR was considerably lower than the 4.4 billion EUR posted in 2007. Reinvestments slumped as a result of the global financial crisis, while other capital flows were negative following an increase in reverse intra-company loans and repayment of debt to parent firms by Hungarian subsidiaries of multinational organisations. This trend continued in 2009 even though the inflow of equity capital increased compared to 2008, reinvestments and reverse intra-company loans decreased inflows significantly. 33 Hungarian National Bank, ITDH Zrt. Hungary: The Logical Choice, 2010, http://www.itdh.com/engine. aspx?page=Itdh_Foreign (retrieved on 25.08.2010).

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Picture 26: FDI inflow to Hungary 2001-2009 Q3, in EUR million, source: Hungarian National Bank 2009, ITDH Zrt. Hungary: The Logical Choice, 2010, http://www.itdh.com/ engine.aspx?page=Itdh_Foreign (retrieved on 9 August 2010).

In the second and third quarter 2009, FDI stock that had decreased in 2008, increased again, and reached 60 billion EUR.

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Picture 27: FDI inflow to Hungary 2001-2009 Q3, in EUR million, source: Hungarian National Bank 2009, ITDH Zrt. Hungary: The Logical Choice, 2010, http://www.itdh.com/ engine.aspx?page=Itdh_Foreign, (retrieved on 9 August 2010).

FDI stock in Hungary in 2009 by sector may be described as follows: The manufacturing sector now accounted for more than one third of foreign investment in Hungary. By contrast, manufacturing was the main target of almost all investments in the early 1990s. Since then, however, services have gained ground, partly because privatisation in the services sector began later than in manufacturing. According to Ernst and Young’s CEE Attractiveness Survey of 200934, investments in services doubled in Hungary between 2004 and 2008 in terms of the number of projects.

34 Patrick Gounelle / Marc Lhermitte, Ernst & Young, European attractiveness survey 2009, http://www.ey.com/ IE/en/Newsroom/News-releases/Press-release-2009---European-attractiveness-survey-2009 (retrieved on 9 August 2010).

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Picture 28: FDI inflow to sectors in Hungary 2004-2008, source: Hungarian National Bank 2009, ITDH Zrt. Hungary: The Logical Choice, 2010, http://www.itdh.com/engine. aspx?page=Itdh_Foreign, (retrieved on 9 August 2010). Other; 3%

Manuf acturing; 36%

Services; 56%

Electricity, gas and water supply; 5%

In 2008, Hungary was the target of 21% of all services investments in CEE, although the automotive industry was the best performer as far as the number of jobs created is concerned.| As in other CEE countries, investors from the EU-15 countries historically account for the overwhelming majority of investments in Hungary – 79% according to the Hungarian National Bank in 2009. This dominance is explained by geographical proximity and historical links. Once again, Germany was by far the most important country of origin with 25% of all FDI, followed by the Netherlands (14%) and Austria (13%). The United States – like in the year before – was the largest non-European investor (5%). Many investments made through the Netherlands and other European countries also originate from the US. Although, most investments arrived from the European Union in 2009, Germany – at that time also deeply affected by the crisis – performed very poorly in the first quarter 2009. It produced the second lowest FDI figure since 2001.

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Picture 29: FDI stock by country of origin, source: Hungarian National Bank 2009, ITDH Zrt. Hungary: The Logical Choice, 2010, http://www.itdh.com/engine.aspx?page=Itdh_ Foreign (retrieved on 9 August 2010). Other; 23%

Germany; 25%

Italy; 2% Switzerland; 1% Belgium; 2% Netherlands; 14%

Norway; 1% Luxembourg; 6% USA; 5% France; 5%

Austria; 13%

UK; 3%

Reinvested earnings played a dominant role in foreign direct investment, amounting to more than half of all investments in Hungary in 2009. Reinvestments in the services sector had increased significantly in recent years. According to Ernst and Young’s CEE Attractiveness Survey of 200935, half of the investors already present in Hungary were considering to further develop their activities in the country. In recent years, however, the share of reinvestments has decreased against total inflow. According to PricewaterhouseCoopers36, FDI inflows to the CEE region decreased by 50% in 2009, while the real estate sector, which accounted for one quarter of all investments to the region, declined by 71%. As already shown above, FDI inflow to Hungary was already on the decrease in 2008, falling by about 30% to 3.1 billion EUR. Hungary had recently been the focus of more small and medium investments due the increasing number of projects realised in the services sector. Between 2004 and 2008, investments in the services sector doubled (Ernst and

35 Patrick Gounelle / Marc Lhermitte, Ernst & Young, European attractiveness survey 2009, http://www.ey.com/IE/ en/Newsroom/News-releases/Press-release-2009---European-attractiveness-survey-2009 (retrieved on 9 August 2010). 36 Hungarian Investment and Trade Development Agency, The Logical Choice http://www.itdh.com/engine. aspx?page=Itdh_Foreign, ITDH Zrt. Hungary: Budapest, 2010 (retrieved on 9 August 2010).

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Young, Hungary Attractiveness Survey, 2009) 37. This shift in the distribution of capital inflows resulted in lower annual FDI in the short term. The interest of foreign investors was still strong in the areas of shared services, ICT, logistics, tourism and biotechnology. Surprisingly, ITD Hungary had also received several inquiries from the automotive sector. However, the economic crisis had already slowed down the decision-making processes of companies as they grew more cautious. Against this background, more than 20 promising decisions had been delayed from the previous year. As far as announced investments were concerned, the number of projects declined by 48% regionally (see table below) in 2009, but Hungary still performed better than some other CEE countries. According to the analysts of PWC this development may result in a quicker rebound in FDI inflows over the next couple of years. Unemployment Rate

As a consequence of the economic crisis, the number of employed people in Hungary in 2009 was significantly lower, while that of unemployed people considerably higher than in the previous year when disadvantageous labour market trends characterized the last quarter of the year. Though both the decrease of employment rate and the increase in unemployment rate was lower than the ones characteristic of the majority of EU Member States, the relative labour market position of Hungary did not change essentially. In terms of employment rate, except Malta, Hungary took the last place among EU Member States, while considering unemployment rate Hungary could improve four places in ranking (19th place) of EU countries over the year.38 Due to the shutdown of factories and headcount decrease originating from the economic crisis, as from 2008 the number of unemployed had grown significantly. According to the labour force survey, the number of unemployed people aged 15-64 was in 2009 on annual average 27.8% more than one year earlier. Unemployment rate rose from 7.9% (in 2008) to 10.1% which has been the highest value since 1995.

37 Patrick Gounelle / Marc Lhermitte, Ernst & Young, European attractiveness survey 2009, http://www.itdh.com/ resource.aspx?ResourceID=itdh_attractivenesssurvey20091 (retrieved on 9 August 2010). 38 Hungarian Statistical Office, Statistical reflection 9/2010 Labour market situation, 2009, pp. 1-2.

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Picture 30: Changes of unemployment rate by quarters, Q1 2007 – Q4 2009, source: Hungarian Statistical Office, Statistical reflection 9/2010 Labour market situation, 2009, p. 1.

The economic activity of the age-group 15-24 further decreased in 2009, and, at the same time, their unemployment rate deteriorated significantly (it grew from 19.9% to 26.5%). As a consequence of the crisis, the number of unemployed increased, first of all in manufacturing (men were typically hit harder). The number of those who lost their jobs in construction and in wholesale and retail trade grew as well. Exchange Rate Development vis-à-vis the Euro

In 2009 the official exchange rate of the forint fluctuated in a very wide range, between 264.17 HUF and 316 per EUR. In the first quarter 2009 the exchange rate depreciated markedly; it was much weaker than the average cost rate, then it started to strengthen as of April and was already moving within a narrower band in the second half of the year. Furthermore, in March, pursuant to the decision of the Monetary Council, in addition to the usual volume of foreign currency sales, the MNB started to lead the net EU funds to the market, which resulted in outstand-

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ing exchange rate gains at the given exchange rate levels. This explains the fact that the foreign exchange rate of 136.7 billion HUF in 2009 was several times larger than that of 2008. 39 Picture 31: Changes in the forint exchange rate (2008-2009), source: Hungarian National Bank, Annual Report, Business Report and Financial Statements of the Magyar Nemzeti Bank 2009, 2009, p. 37.

Summary of the Symptoms of the Crisis in Hungary in 2009

Excerpts from the “Political year-book of Hungary in 2009” show quite clearly how hard the economic crisis affected Hungary in 2008 and 2009 – not only in an economic but also in a political and social point of view. It seems that the heavy impacts of this crisis were not even predicted to be so bad on Hungary, so the crisis hit Hungary hard and in a way took the country by surprise. Hungarian consumers became more cautious and lots of companies had to struggle for their survival. The key factors of the decline in consumption in Hungary in 2009 included the weak la-

39 Hungarian National Bank, Annual Report, Business Report and Financial Statements of the Magyar Nemzeti Bank 2009, 2009, p. 37.

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bour market as described above, the freeze or reduction of nominal salaries in the public sector, and in general, the sudden increase of debt service on loans and the limited availability of new credit. For the politicians as well as for the Hungarian society at the end of 2009 it was clear that the global recession was considerably deeper than what was expected at the end of 2008 (although the rebound started sooner than anybody expected). The Hungarian economy showed far worse figures then any of the expectations would have predicted. Lower wages, a drastic drop in consumption and weaker profitability obviously reduced the government’s tax income. Both the IMF and the EU understood the situation and accepted that a realistic target figure for the deficit, even with tough mid-year adjustments (including certain structural reforms), was ‘only’ 3.9%. Preliminary calculations showed that this target could be achieved. On the other hand, primarily due to the reduction of domestic demand, the unexpectedly large recession resulted not only in a dramatic improvement in the external balance but in fact the total elimination of net external financing, and of a surplus.40 The crisis also caused a marked change in consumer attitudes. Growing risks, the unavailability of easy credit and higher debt service on existing loans led to a cautious approach that, on one hand, resulted in weaker consumption and, on the other hand, served as an incentive for savings. According to a study from Gábor Karsai and András Vértes in the “Political yearbook of Hungary in 2009”41 the progress of the economy in 2009 showed the following picture. The majority of Hungarian companies still faced a shortage of demand and liquidity problems at the end of 2009. The number of voluntary and compulsory liquidation procedures markedly increased, yet remained fairly low in international comparison, and still more companies were established than went bankrupt. The vulnerability of the Hungarian financial system to the global crisis was low, but it was still deeply affected by the crisis due the credit boom caused by cheap money. Nevertheless, banks fared relatively well in 2009, which was partly due to the cooperation between foreign parent banks and Hungarian monetary authorities. Financial GDP actually grew in 2009, as banks were able to recharge increasing costs to customers. The ratio of delinquent debts tripled, but banks managed 40 Cf. Gábor Karsai / András Vértes, Ki a válságból, de hova be… (Out of the crisis, but whereto…), in: Dr. Péter Sándor / Dr. László, Vass, A Magyarország politikai évkönyve® 2009 Digitális könyv (Political year-book of Hungary in 2009, digital book / database). 41 Cf. ibid.

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to cover their losses and comply with their obligation to make provisions. As a result of increasing risks associated with corporate credit granting, banks demanded higher securities and offered loans with shorter terms. Repayments of the majority of consumer loans remained on schedule, and where problems were encountered, loan payments were typically rescheduled. In the first half of 2009, Hungary financed its sovereign debt from the IMF-EU loan rather than from the market. To this point, Hungary drew down 70% and used 45% of the EUR 20 billion credit line. The reserves of the National Bank of Hungary grew to previously unseen levels. The benefit of being indebted in a foreign currency is that the IMF-EU loan is cheap, but it increases foreign exchange exposure. For this reason (and because it could obtain market financing), Hungary decided not to draw down additional instalments. Hungary successfully issued EUR and USD bonds in July 2009, and the Greek crisis did not have a long-standing negative effect on the evaluation of the Hungarian economy either. In fact, Hungary’s adjustments are quoted by many as an example for countries that are just beginning to face a large budget deficit. The balance of external and internal payments was very favourable in 2009. The ESA deficit was 3.9%, one of the lowest in the EU. The current account and the capital account showed a surplus of 1.5 billion EUR after a deficit of 6.5 billion EUR in 2008, which represents an improvement of 8 billion EUR, almost 9% of the GDP, over the course of a year! The domestic use of GDP fell by 11.5%, a rate that exceeded the decline in industrial output. From a macroeconomic perspective, this served as the background for the spectacular improvement in the external balance.42 2.2.3.

Social Situation – People Angry about Corruption Scandals

In Hungary the economy is heavily affected by corruption, yet its measures cannot be defined precisely. The corruption related scandals evoked stronger public attention in the period of the crisis. These scandals certainly did not help to restore people’s confidence and trust in their leaders, be it on a local, regional or national governmental level! A prominent example for such scandal is the BKV (Public Transport Company of Budapest, i.e. a state owned company). While the country was still in the middle of a severe economic crisis BKV managers allegedly did everything to enrich themselves and people close to them – at the cost of the general public. 42 Ibid.

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Salary and severance pay issues had pervaded BKV to such an extent that local politicians have also been caught in the line of fire. Among other cases the police are presently investigating over 800 BKV contracts for irregularities related to excessive pay, and amongst other defendants the former head of the BKV and the mayor of a city centre district of Budapest have been imprisoned on remand within the scope of an extensive crime investigation. If we look at the number of similar scandals in Hungary throughout the past few years one could say that there seems to be a prevailing tendency in the country for such scandals. Some commentators like John Horvath43 even argue that the problem of outrageous salaries in Hungary wasn’t limited to just business enterprises but extended all the way through the civil service and even to the head of the National Bank of Hungary who makes four times as much as his American counterpart. The author raised even further criticism when he stated, that “one may argue that the head of the National Bank of Hungary, Andras Simor is also linked to the activities of offshore enterprises. Not only was Simor embroiled in a scandal in which he transferred a large portion of his wealth to an offshore account in Cyprus, but nearly everyone within the government is tainted in one way or another by an offshore scandal of sorts. This includes the Finance Minister, Peter Oszko whose previous job was as a ‘tax optimization’ consultant. In other words, he helped clients avoid paying taxes in Hungary through various offshore schemes including the former Prime Minister, Gordon Bajnai, himself. His association with an offshore company called ‘Wallis International’ was involved in the bankruptcy a few years ago of a major poultry processing plant that ruined the livelihood of hundreds of farmers, ultimately leading several to commit suicide.”44 However, Prime Minister Bajnai stated in his interview regarding the reasons behind the crisis of the country’s economy that the Hungarian society, as well as the politics weren’t aware of crisis. It resulted therein that the necessary measures couldn’t have been undertaken by the government either. Therefore, in his opinion harder measures were not considered to be possible and necessary on a political level – partly due to the aforementioned general lack of awareness of crisis, partly due to the unforeseeable nature of the crisis’ depth and temporal extension. Not only the Hungarian government and all European countries but also the IMF and

43 John Horvath, In Hungary the Financial Crisis has picked up a Second Wind, 23 December 2009, http://www. heise.de/tp/r4/artikel/31/31771/1.html (retrieved on 18 August 2010). 44 Ibid.

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the European Commission adjusted their estimations, GDP expectations and deficit forecasts continuously. The Prime Minister admitted, more effective measures would have been necessary to cope with the crisis in time: ”We cut off the leg of the patient in pieces. Maybe it would have been better to cut it off in one piece – the pain could have been less”.45 According to some commentators, in 2009 a social explosion was threatening Hungary after the austerity measures of a rather unpopular government had been announced together with the scandals of the governing politicians. As described later in more detail, in 2009 Hungary had to turn to IMF and EU for a loan to avoid state bankruptcy. However, as further commented by John Horvath, “IMF loans to countries come with strings attached. These strings make up a package known as structural adjustment. This is accomplished through massive cuts in public spending, especially in the areas of education and health. As a result, these sectors are left open to privatization and exploitation by big business since schools and hospitals are in desperate need of funding that governments no longer can or are willing to provide. Although the Hungarian government had tried to fulfil the dictates of the IMF in this latest budget through a drastic set of cuts in spending, it’s obvious that it hasn’t gone far enough. In particular, its failure to introduce a comprehensive form of property tax that would target the poor has once again irritated the IMF.”46 However, Hungarian governments have always been hesitant to carry out necessary, but unpopular measures. For years Hungary had promised to introduce a comprehensive form of property tax but has always failed to do so, mainly because of the public backlash it would cause. The reason for such hesitant attitude lies clear at hand: the Hungarian political culture is characterized by two blocks of political parties permanently fighting each other with sometimes subjective argumentation. A broad parliamentary consensus in specific political issues is unthinkable, and taking unpopular measures – even if an objective spectator might see that they were necessary and reasonable – is quite hard to ‘sell’ to the electorate who would turn to the opposition party to “help them out of the situation” in the next general elections.

45 Gordon Bajnai in: József Péter Martin / István Várkonyi, Álomcsĩd – Interjúk a válságról (“Dream bankruptcy – Interviews on the crisis”), 2010, p. 19. 46 John Horvath, In Hungary the Financial Crisis has picked up a Second Wind, 23 December 2009 http://www.heise.de/tp/r4/artikel/31/31771/1.html (retrieved on 18.08.2010).

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The high unemployment rate in 2009 had a severe impact on the government’s tax revenue. But it was not only the decreased tax revenue that made the government’s job even more difficult, but also the fact that those individuals who lost their job would turn to the state to claim welfare benefits, unemployment aid, or early pension. The same commentator as mentioned above was quite right in his worrying evaluation of Hungary’s socio-economic situation in 2009 when he pointed out that even for the physically and mentally handicapped government support had been cut back drastically to the extent that many programs which helped handicapped people integrate into the workforce would have to be scrapped, leaving many without support and, in effect, without a chance to work. The same could be said for almost all key government programs. As another example of the alarming condition of state funded social and health care institutions he mentioned Hungary’s network of ambulance services that was in such an overloaded state that it could be described as being on the brink of collapse by the end of 2009. Furthermore, Budapest’s transport authority BKV – shaken from a huge scandal as already mentioned above – was more or less bankrupt in 2009 and could only be saved at the last minute by an emergency cash injection. The Hungarian State Railways (MAV) and even the recently reacquired Hungarian Airlines (MALEV), had similar severe problems to operate both of which were (and still are) unable to function without extra government support. On the local level, municipalities which had already been struggling to survive over the years have also been considered to be close to bankruptcy and have had difficulties to provide even basic services without taking on debts. All this has not only led the government in 2009 to be hugely unpopular, but has also led to a noticeable rise in anti-global and anti-multinational sentiment. This was clearly expressed in the southern town of Pecs where the municipality took control of the city’s water works, shutting out the French company Suez by force. As elsewhere, many have woken up to the realisation that not everything should be left in the hands of private enterprise. It is obvious that news such as the latter, certainly did not contribute to re-gaining the confidence of urgently needed foreign investors to Hungary.

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2.3.

The Year 2010 – Current Situation

2.3.1.

Political Situation – New Confidence among Politicians / No Comparison to Greece

After the enormous unpopularity of the former government, the results of the Hungarian parliamentary elections in spring 2010 could easily be predicted: the conservative party, FIDESZ, led by Prime Minister candidate Viktor Orbán won the elections with an overwhelming two-thirds parliamentary majority. Orbán has since enjoyed high support among the Hungarian public, but he has had to come to terms with fighting the negative effects of the crisis for Hungary’s economy in the first place. His main concern is the high state budget deficit that may lead to investors losing confidence in Hungary and in the worst case turning away. Consequently, to regain investors’ and lenders’ confidence that the country’s economic policies are sound and reliable is one of the most important tasks of the new government, as Orbán has uttered several times in various public statements. The new government’s new economic rescue package trims state spending and levy a hefty new tax on banks to help close the government’s budget gap.47 In June 2010, shortly after taking over the government, the communication of the new leaders resulted in the fall of the euro to a four-year low. ‘Wall Street Journal online’ reported that Lajos Kosa, vice president of Fidesz said that Hungary was in a Greek-style sovereign-debt crisis. Additionally, the prime minister’s spokesman, Peter Szijjarto, roiled markets by saying the economic situation was severe and that Hungary wasn’t likely to meet budget-deficit targets prescribed by the IMF. Szijjarto said at a news conference that Hungary’s new government was “ready to avert the Greek road”, but he added that “there is nobody in the country apart from the previous government who still says the budget deficit of 3.8% of gross domestic product can be reached.” That is the IMF’s target for this year. His remarks exacerbated fears in financial markets, where investors were worried that the new government could soon announce worse news from Hungary’s treasury.48 The market promptly reacted to these statements and Hungary’s currency and stock market plummeted.

47 Wall Street Journal, Hungary Plans Bank Tax, Budget Cuts to Soothe Markets in: Wall Street Journal online Economy, 9 June 2010, http://online.wsj.com/article/NA_WSJ_PUB:SB10001424052748704764404575286283092092988. htm (retrieved on 16 August 2010). 48 Charles Forelle / Veronika Gulyas / Margit Feher, Hungary’s Economic Woes Punish Euro, Roil Markets, in: Wall Street Journal online, 5 June 2010, http://online.wsj.com/article/NA_WSJ_PUB:SB100014240527487 04764404575286283092092988.html (retrieved on 16 August 2010).

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These comments were symptomatic of conflicting pressures on the government and the different audiences it is trying to appease. According to Financial Times online with key municipal elections in October, the ruling Fidesz was desperate not to upset voters, as it feared they might shift their allegiance to Jobbik, a far-right party hostile to foreign capital. But Hungary is seeking to win greater flexibility from international lenders at the very moment the IMF, and especially the EU, are focused on demonstrating the need for fiscal responsibility. The government has been in damage-control mode since then, with officials coming out to insist that Hungary would stick to its agreements with the International Monetary Fund and the European Union, which stepped in to bail out the heavily indebted country in 2008. Fidesz said however, that the severe austerity measures imposed by the previous government were unnecessary. Prime Minister Orbán said Hungary deserved better terms from lenders. But Orbán’s address indicated that he had reformulated his plans for fiscal easing in the face of opposition from EU leaders, the IMF and markets already spooked by the situation in Greece and fearing contagion effects. Orbán said, “Hungary is not standing on its own feet, but is living off loans.” He said the government had to decrease its reliance on borrowing and to cut government spending by about 120 billion forint, or about 1.3% of the planned 2010 budget.49 He also said the country wouldn’t seek to ‘renegotiate’ the terms of its debt. Instead of calling for the immediate, broad changes to the tax system which his party had suggested, Orbán put forward a plan to shift toward a flat tax on incomes, starting in about two years. He called for an immediate cut in the corporateincome tax, but only for smaller companies. Orbán further said he expected to raise 200 billion HUF, or nearly 840 million USD, from levies on financial institutions. Those banks now pay about 13 billion HUF in taxes each year, he said. He said the planned banking tax would stay in place for three years. Details of how the new tax would be assessed are still being discussed. According to ‘Wall Street Journal’ most analysts say that the new flare-up of Hungarian debt worries in 2010 was nothing more than “a storm in a teacup”. So a comparison of Hungary in 2010 with the situation in Greece being on the brink of state bankruptcy would not be possible for the following reasons: 49 Cf. Hungary Plans Bank Tax, Budget Cuts to Soothe Markets, in: Wall Street Journal online, 9 June 2010, http:// online.wsj.com/article/NA_WSJ_PUB:SB10001424052748704764404575286283092092988.htm (retrieved on 16 August 2010).

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Y

First of all, Hungarian officials rapidly backtracked from their earlier comments, with the prime minister’s chief of staff saying Hungary would stick to strict spending limits and wasn’t at any risk of default. Top European official JeanClaude Juncker, Prime Minister of Luxembourg, said he’s not worried about Hungary.

Y

The numbers bear this out: Hungary’s central bank sees a budget deficit of 4.5% – a fraction of the double-digit deficits afflicting Greece, Ireland and even the United Kingdom. Hungary’s total public debt is also roughly 75% of its overall economic output, which is around the EU average, while Greece’s is far higher and well over 100% of GDP.

Y

Hungary also hasn’t even tapped out the cash from the multibillion rescue package it received in 2008 from the European Union and IMF.50 2.3.2.

Economical Situation – First Signs of a Slight Recovery?

The protection offered by the availability of the IMF and EU loan, as well as expectations that it would be extended into next year, has been an important source of reassurance for investors. Hungary’s public debt is equivalent to about 80% of its GDP, the highest level in central Europe. Its budget deficit this year is expected to be about 3.8% of GDP. State Budget Deficit

The deficit of the central government amounted to 606.6 billion HUF (about 2.3 billion EUR) in the first three months of 2010. The net balance of transfers from the European Union (EU) worth 127.8 billion HUF decreased the net borrowing requirement. Privatisation revenues amounted to 30.0 billion HUF, which also decreased the financing requirement. Thus, the total net borrowing requirement amounted to 448.8 billion HUF in the first quarter. Net issuance was 453.1 billion HUF; out of which net HUF-denominated issuance was 76.9 billion HUF and net foreign currency denominated issuance was 376.2 billion HUF. 1,211.9 billion HUF was placed at

50 Neil Shah, Is Hungary the New Greece?, in: Wall Street Journal online, 7 June 2010, http://blogs.wsj.com/ marketbeat/2010/06/07/is-hungary-the-new-greece/?KEYWORDS=hungary+next+greece, 19.08.2010).

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(retrieved

on

the National Bank of Hungary and other banks in the form of foreign currency deposits or loans at the end of March. The total amount of other liabilities increased by 90.0 billion HUF in the first quarter.51 Picture 32: General Government Debt Gross, source: Government Debt Management Agency Plc./official online schedule.

1. Forint denominated debt 1.1 Loans 1.1.1 Foreign loans 1.2 Government Securities 1.2.1 Public issues 1.2.1.1 Bonds 1.2.1.2 Discount T-bills 1.2.1.3 Retail securities ** 1.2.2 Private placements (bonds) 2. Foreign exchange denominated debt * 1.1 Loans 1.1.1 Foreign loans 1.1.1.1 Loan from IMF and EU 1.1.1.2 Other 1.2 Government Securities 1.2.1 Issued abroad 1.2.1.1 Foreign currency bonds

TOTAL other debt

Total central government debt Out of the international loan program, amount is placed at the NBH as a deposit or at domestic banks as loans. Central government net debt Memo items: Marketable HUF debt (1.2.1.1 + 1.2.1.2 + 1.2.2) 1.2.1.2 Discount T-bills at face value

Jan 2010 10,461.9 438.7 438.7 10,023.2 9,598.9 7,626.3 1,522.9 449.6 424.3 8,890.1 4,147.2 4,147.2 3,386.9 760.3 4,742.9 4,742.9 4,742.9

Feb 2010 10,547.4 438.7 438.7 10,108.7 9,684.4 7,631.1 1,606.7 446.6 424.3 8,871.5 4,143.9 4,143.9 3,385.6 758.3 4,727.6 4,727.6 4,727.6

Mar 2010 10,554.4 438.7 438.7 10,115.7 9,692.3 7,815.0 1,436.5 440.8 423.5 8,746.6 4,085.4 4,085.4 3,345.1 740.3 4,661.2 4,661.2 4,661.1

Apr 2010 10,470.5 438.7 438.7 10,031.8 9,608.3 7,642.0 1,529.8 436.5 423.5 8,741.5 4,082.3 4,082.3 3,344.2 738.1 4,659.2 4,659.2 4,659.2

May 2010 10,572.5 485.2 485.2 10,087.3 9,663.7 7,705.3 1,520.5 438.0 423.5 9,109.5 4,291.8 4,291.8 3,531.8 760.0 4,817.8 4,817.8 4,817.7

Jun 2010 10,677.4 485.2 485.2 10,192.2 9,769.6 7,800.4 1,534.9 434.3 422.6 9,478.2 4,465.9 4,465.9 3,678.4 787.5 5,012.3 5,012.3 5,012.3

19,352.0 19,418.9 19,301.0 19,212.0 19,682.0 20,155.7 41.7

96.4

110.1

111.1

251.3

314.8

19,393.7 19,515.4 19,411.2 19,323.1 19,933.4 20,470.5 1,164.4 18,229.3

1,225.3

1,211.9

1,218.9

1,318.8

1,214.8

18,290.0

18,199.3

18,104.2

18,614.6

19,255.7

9,662.1 1,697.3

9,674.9 1,511.9

9,595.2 1,609.6

9,649.2 1,589.4

9,757.9 1,593.6

. 9,573.6 1,608.5

*

Foreign exchange debt is recorded at themed exchange rate of the NBH at the end of the month.

** From 2010 it consists the outstanding amount of the Premium Government Bond.

Inflation

Following an increase in the second half of 2009, annual inflation stagnated at around 6% – i.e. well above the medium-term inflation target – in the first months of 2010, while annual core inflation showed a slight, but gradual decline.52

51 Government Debt Management Agency Pte. Ltd., Government Securities market, quarterly report, first quarter 2010, 2010, p. 1. 52 Hungarian National Bank, Quarterly Report on Inflation, June 2010, 2010, pp. 31-35.

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In the first quarter of 2010, core inflation was more than 0.3 percentage point (p.p.) lower than expected. The difference was mainly caused by the lower-thanexpected price dynamics of alcohol and tobacco products, while the pricing of industrial products and market services, which determine the medium-term disinflation trend, was in line with MNB’s expectations. In each month of 2010 the price increases in the market services sector at the beginning of the year were lower than the historical ones. As a result of subdued domestic demand, companies remain unable to carry out any significant price increases. GDP Growth

Gross domestic product of Hungary increased by 0.1% in the first quarter of 2010 and by 0.2% when adjusted for calendar effects, compared to the corresponding period of the previous year. According to seasonally adjusted data, the economic performance rose by 0.9% as compared to the previous quarter. This might be the first signs of a slight recovery.53 Picture 33: Percentage change of GDP (as compared to the same period of previous year), source: Hungarian Statistical Office, First release (release date: 9 June 2010), 2010, p. 1.

53 Hungarian Statistical Office, First release (release date: 9 June 2010), 2010, pp. 1-4.

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According to the unadjusted figures, the economic performance has stagnated after the fifth quarter of decline compared to the corresponding period of the previous year. Picture 34: Volume change of gross domestic product, the corresponding period of previous year=100.0, source: Hungarian Statistical Office, First release (release date: 9 June 2010), 2010, p. 2. 2009 Denomination

2010

1Q

2Q

3Q

4Q

1Q

Agriculture, forestry, fishing

85.1

77.7

83.0

84.5

95.3

Mining and quarrying, manufacturing and electricity

80.3

79.5

84.4

92.6

103.3

of which manufacturing

78.0

78.5

84.5

92.8

104.2

Construction

96.9

100.5

96.8

94.5

91.3

Services total; of which

98.0

97.2

97.4

98.3

99.3

Trade, repair, hotels and restaurants

92.6

92.5

88.6

92.5

96.2

Transport, storage and communications

95.4

93.2

96.6

97.8

102.0

Financial intermediation and real estate activities

100.3

99.0

101.2

102.4

100.8

Public administration, education, health and social work

100.0

98.9

101.2

102.4

100.8

Other community, social and personal service activities

97.6

102.4

100.1

96.1

101.0

GDP, total (at purchaser´s price)

93.3

92.5

92.9

96.0

100.1

There was a 0.8% increase in the fields of financial intermediation, real estate, renting and business activities. Within this, the moderate decrease of real estate is worth mentioning: it is in line with the last quarters’ decline in construction output. In terms of external trade improving, the balance of external trade was plus 478 HUF billion, while terms of trade were getting better. Not only the volume of exports but imports increased substantially, by 13.7% and 11.6%, respectively.

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External trade contributed to GDP growth by +2.4 p.p. The export and import of finished products increased by 15.2% and 14.4%. The export of services again increased by 6.6%, and the import of services diminished by 1.7%. Picture 35: Percentage change of GDP, seasonally and calendar adjusted data (as compared to the previous period), source: Hungarian Statistical Office, First release (release date: 9 June 2010), 2010, p. 5.

Foreign Direct Investment (FDI)

The stock of foreign direct investment (FDI) in Hungary in 2010 exceeds 64 billion EUR, which is among the highest in the Central and Eastern European region in per capita terms. Most FDI has flown into services and competitive manufacturing (transport equipment, electrical equipment). Of the total FDI stock in Hungary, 75% came from the EU and 22% from Germany. The highest FDI inflow in form of equity capital came from Russia (786 million EUR) to Hungary in 2009. This was due to the acquisition of Mol shares by Surgutneftegas (from OMV). The second biggest investor was the Netherlands (578 million EUR) and the third was Switzerland (323 million EUR). Other major investors include Luxembourg (225 million EUR), Romania (90 million EUR), Hong Kong

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(89 million EUR) and Singapore (60 million EUR). However, the balance of inflow from Austria was -505 million EUR (mainly due to the Mol transaction mentioned above). In 2010 non-debt creating FDI is expected to be around 2.5 billion EUR. However experiences suggest that the amount of other capital is hard to predict in a meaningful way. In the medium term an average of 4 billion EUR of total FDI inflow annually is expected, which can be significantly influenced by large scale transactions.54 Unemployment Rate

In the first quarter of 2010 the number of unemployed people aged 15-74 was 498,000, that is 95,000 more than a year before. Unfortunately, these numbers didn’t show a decrease compared to the same period of the previous year. The unemployment rate was 11.8%, which was 2.1 p.p. higher than a year before. The unemployment rate for males increased by 2.6 p.p., for females by 1.7 p.p. In this quarter, the number of people in employment aged 15-74 was 3,719,000. In the given period, 61.9% of the population aged 15-64 years, and within this, 64.5% of the population aged 15-61 was present in the labour market. In the period January to March 2010, the average number of people in employment aged 1564 years was 3,688,000, that is 48,000 fewer than in the previous year. The employment rate calculated for this age-group was 54.5%, 0.6 p.p. less than in the same period of the previous year.55 In the second quarter of 2010 the number of unemployed persons aged 15-74 grew by 18% to 473,000 compared to the last year which resulted 1.5 p.p. higher, i.e. 11.1% unemployment rate. This means 72,000 more unemployed people than a year before, while it was a rate of 9.6% a year before and 1.8% in January-March 2010. The unemployment rate in the second quarter of 2010 decreased by 0.7% compared to the previous three months. In the second quarter, the number of people in employment aged 15-74 was 3,779,000, that is 0.5 p.p. fewer than in the corresponding period of the previous year, but it outnumbered the value of the previous three months by 21,000 (March-

54 Ministry for National Development and Economy, Economic Policy and Analysis Department, Overview of foreign direct investment in Hungary, 2010, pp. 1-2. 55 Hungarian Statistical Office, Employment and unemployment, First release (release date: 28 April 2010), 2010, pp. 1-4.

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May 2010). In the observed period, the number of employed men aged 15-64 years was 2,001,000 with an employment rate of 60.3%, while 1,747,000 women were employed and their employment rate amounted to 50.6%.56 Picture 36: The change in the unemployment rate and the number of employed people aged 15-74 compared to the same period of the previous year, source: Hungarian Statistical Office, First release (release date: 28 July 2010), Employment and unemployment, 2010, p. 1.

Exchange Rate Development vis-à-vis the Euro

Central European countries reacted to the Greek debt crisis in a more sensitive manner than other emerging regions.57 Since the beginning of the year, currencies in the region had appreciated by some 3-6% against the euro, before depreciating to a similar extent with the exacerbation of the situation in Greece. Exchange rates practically moved together in the whole period, although at certain times the zloty and the forint outperformed the average. In early May 2010, however, these two currencies suffered the greatest loss.

56 Ibid., p. 1. 57 Hungarian National Bank, Quarterly Report on Inflation, June 2010, 2010, pp. 39-41.

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Picture 37: Changes in the exchange rates of Central European currencies against the euro, source: Thomson Reuters, Hungarian National Bank, Quarterly Report on Inflation, 2010, p. 39.

The exchange rate of the forint against the euro appreciated considerably at the beginning of the period, remaining in the 262-268 HUF band until the end of April, before weakening to nearly 283 HUF, as a consequence of the decline in global risk appetite following escalation of the Greek debt crisis. Following the announcement of the European stability package, the forint – moving together with the currencies of the region – strengthened, but did not leave the exchange rate band of 270-280 HUF against the EUR. According to an analysis of the ‘Financial Times’, in Hungary in 2010 70% of all outstanding consumer and business debt is denominated in foreign currency, of which the vast majority is in Swiss francs. In Hungary foreign currency loans were hugely popular before the global financial crisis because of their comparatively low interest rates, and for the 1.7 million Hungarians who hold them – in a population of just ten million – the swings of the currency markets have a direct impact on their pockets.

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While foreign exchange rates were broadly stable, none of this posed a problem. But as the Swiss franc has appreciated against the forint in recent weeks, Hungarian borrowers are feeling the pinch. With some borrowers starting to fall behind on their mortgages, the government estimates that 10-15% of foreign exchange loans are in ‘endangered territory’. One of the first things Hungary’s government did upon winning the election was to ban issuance of forex loans. Swiss franc lending had in any case ground to a near standstill and, crucially, the law does not affect existing borrowers, many of whom have long term mortgages with. To help these people, the government is thought to be considering setting up a national asset fund to buy real estate, turning homeowners into renters and converting their forex loans into domestic currency. Nevertheless, stress tests conducted by the MNB in April revealed that there would be only a limited need for new capital if the forint stayed near present levels.58 In what is becoming a test case of the bloc’s commitment to austerity, Brussels bluntly criticised the short-term nature of many of Hungary’s budget proposals and pressed Budapest to provide more detail on structural reforms. It also warned about the need to respect central bank independence and to reconsider the size and structure of a 200 billion HUF (892 million USD, 688 million EUR, 586 million £) bank tax. The breakdown of the talks was a “further indication the new Fidesz government favours populist policies over fiscal discipline and reform”, said David Oxley, emerging markets economist at ‘Capital Economics’. “This is a dangerous game to play at a time when the Euro-zone is mired in a sovereign debt crisis” commented the ‘Financial Times online’.59 IMF and EU financial support provides an important psychological cushion for investors and its withdrawal, albeit temporarily, may presage a period of renewed financial market volatility. Although Hungary’s economic situation is not critical – it currently has no need to draw on the remainder of its 20 billion EUR (26 billion USD, 17 billion £) stand-by facility – it remains precarious, given its reliance on foreign funding and comparatively high public debt.

58 Chris Bryant, Hungary’s forex challenge, in: Financial Times online, 15 July 2010, http://www.ft.com/cms/ s/0/06118bc2-902e-11df-ad26-00144feab49a.html (retrieved on 16 August 2010). 59 Chris Bryant, Hungary’s mixed messages sow confusion, in: Financial Times online, 19 July 2010, http://www. ft.com/cms/s/0/7f18cdc8-935d-11df-bb9a-00144feab49a.html (retrieved on 16 August 2010).

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Most recently MNB policymakers voted to keep interest rates on hold. But analysts said further rate cuts were now out of the question and that monetary policy might have to tighten prematurely if the currency sold off further.60 2.3.3.

Social Situation – Positive Aspects out of the Crisis?

The economic crisis had obviously the most hurtful consequences in 2009. However now, in 2010, certain positive trends could be found within everyday business operations. The joint survey of ‘Figyelĩ’, a Hungarian weekly journal, Lege Artis and Volksbank61 suggests that smaller companies may profit from the crisis, since after the initial shock, the sense of unity, loyalty and an innovative drive have strengthened within these companies. The need to switch from a well known, family-style conduct of business to the well structured operation of a medium enterprise presented recently quickly developing small and medium-sized enterprises (SMEs) with a huge challenge. The survey proves that this trend has been reinforced by the crisis of the real economy in the last 18 months. Long overdue but for various reasons evaded, organisational and attitude changes had to be finally implemented. The SME sector is a dominant factor of the Hungarian economy: it produces half of the GDP and employs 73% of employees in the country. Almost two thirds of the companies scrutinised reported a reduction in turnover last year and only 20% managed to grow. However, four fifths of respondents generated profit in 2009. 40% of managers have introduced changes to working hours or salaries. Obviously, this typically meant the reduction of both, although the survey has produced some surprising results. In the region of Central Hungary, for example, 17% of companies have introduced longer working hours or in Eastern Hungary salaries have been

60 Ibid. 61 Lege Artis Figyelĩ, We need a crisis, in: Figyelĩ.net, Nr. 30/2010, 29 July 2010, http://www.fn.hu/hetilap/20100726/nekunk_valsag_kell/ (retrieved on 4 August 2010). The survey of Figyelĩ, a HR consultant company, and Volksbank consists of two parts. A questionnaire-based survey was conducted by Lege Artis in May and June 2010 on a sample derived from the Üzlet & Siker (Business and Success) project database of Figyelĩ. The sample of 117 enterprises represents the entire SME sector (i.e. companies employing less than 250 persons) broken down to industries (services, industry, agriculture, trade) and regions (Central, Western and Eastern Hungary) as well. Besides, another focus group study was undertaken in June 2010 with the participation of managers of industrial and service undertakings.

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raised and decreased by the same amount of companies – i.e. by 20%. Two fifths of respondents reported redundancies, although there are significant regional differences in this area as well. In the last year, the dominant trend for managements was to centralise operation and exercise greater control over the business. They hoped this would help to overcome the crisis. Many have indicated, however, that the recession has made the lack of competent middle managers in Hungary clear. The top management and owners have to deal with far too many operative tasks. In a crisis managers were also open about the amount each employee earns for the company. “Pragmatism being the guiding principle we discussed financial matters openly. We have introduced financial transparency in the company” – describes the new practice of the owner of a service provider enterprise. “Solidarity has become stronger and workers are more focused on performance, they have realised the value of their job”, added a businessman. At the beginning of the recession Hungarian companies also continued to apply long standing methods. However, as the crisis deepened it has become clear that innovative ideas, new and different techniques and solutions are needed. In short, companies have to start taking risks. “I like changes. After the initial shock we started working and I was able to achieve without any problems what I have wanted to implement for 2-3 years, but what has always been blocked by resistance. We reconsidered administrative positions and restructured the whole organization,” a Hungarian businessman said in connection with the operation of his company during the period of crisis. The survey comes to the conclusion that the crisis has strengthened some Hungarian SMEs and their management. They have taken measures they had no strength to take in ‘peacetime’. For those who have ‘survived’ it the crisis has given faith and thus, they may be able to overcome new challenges more easily.62

62 Cf. We need a crisis. www.Fn.hu (Figyelĩ net).Nr. 30/2010 – 29 July 2010.

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3.

Challenges and Coping with the Financial Crisis

3.1.

Economic Policy Objectives

According to the Updated Convergence Programme of Hungary regarding 2009-201263, form January 2010, the objectives of Hungary’s economic policy is described as follows: In Hungary, in view of the fragile external position of the country, the negative effects of the crisis could not be mitigated by fiscal stimulus measures. The Government, to partially offset the declining revenues forecasted due to the repeated downward adjustments of the growth projections, adopted several decisions on budgetary expenditure cuts. As a consequence, while the general government deficit to GDP ratio will practically remain unchanged between 2008 and 2010, the structural balance, calculated based on the cyclical position of the economy, improves by almost two and a half percentage points. In the absence of any fiscal elbow room, reallocations within the budget as well as faster and more efficient use of EU funds promote in the short term economic stability, assistance to SMEs and their access to funding. Partly in response to the crisis management measures, the risk assessment of Hungary has improved considerably since the second half of 2009, reflected both in declining sovereign yields and in the stabilisation of the exchange rate. Thus, as global financial developments returned to normal, the financing of public debt from the market could be resumed. In view of market financing opportunities developing more favourably than foreseen, practically no funds available under the loan agreements with international institutions were drawn down in the second half of 2009 and the disbursement deadline for the credit facility was modified from the original date of March 2010 to the autumn of 2010.64

63 Government of the Republic of Hungary, Updated Convergence Programme of Hungary 2009-2012, 2010, p. 1. 64 Ibid., p 1.

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3.2.

Characteristics of the IMF/EU rescue package 2008

Hungary was the first country in the Central-East European region, which turned to IMF for rescue package and also received support from the EU, because the Forint showed extreme volatility in the short term in the former communist bloc countries of the European Union. Hungary approved of this support, which was a form of lending of last resort to the Hungarian economic and financial state, as Hungary was the most vulnerable economy in CEE due to its high level of outstanding loans and high budget and current account deficits and the trust in external overseas financing and the popularity of foreign currency loans among households. “There is totally irrational behaviour and malicious gossip on the market,” the ‘Wall Street Journal’s online’ edition quoted MNB Governor András Simor on 19 October 2008. “That’s why when this wave of the crisis affected us, the first thing we did was to call the EU and IMF and we said we think we’re OK, we’re on a sustainable path, but markets are irrational”, Simor said.65 “Finance Minister at that time, János Veres, said Hungary asked the International Monetary Fund (IMF) for talks, but this does not mean it will take loans from the IMF, Veres said. Based on the agreement, the content of the cooperation with the IMF could be anything, depending on the turn of events late, he added.”66 Hungary’s biggest financial problem at that time was that it had an excessive faith in foreign investors were to buy government bonds. The state debt agency rejected an auction of government bonds as bids failed to reach even half the 40 billion HUF offer. The central bank followed the situation on the markets and its measure may have given provisional backing to the forint and protected the financial sector, but the country needed to use the financial help offered by the International Monetary Fund to stabilize its markets in a permanent way. Hungary’s government and National Bank have taken a series of steps in those weeks to boost markets after the bond market seized up. They have lined up potential help from the IMF and the European Central Bank (ECB).

65 Budapest Business Journal, ECB help a last resort for Hungary – central banker, in: BBJ online, Monday 7:48, 20 October 2008, http://bbj.hu/index.php?id=44730 (retrieved on 2 August 2010). 66 Budapest Business Journal, Hungary organizes IMF support because of attack on forint, in: BBJ online, Monday 14:39, 13 October 2008, http://bbj.hu/index.php?id=44552 (retrieved on 2 August 2010).

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The Hungarian central bank had hiked the benchmark base rate by 300 basis points to 11.50% as of 22 October 2008 and made it clear that it was prepared to defend the forint. The central bank had signed a 5 billion EUR Forex swap line with the European Central Bank (ECB) and had also launched auctions where it buys government bonds in order to boost the bond market. The IMF revealed a statement on reaching an agreement with Hungary for a 15.7 USD billion loan program, while the European Union stood ready with an additional 8.1 USD billion in financing and the World Bank another 1.3 billion USD. The IMF loan is to be disbursed over 17 months. It is the biggest international rescue package for an emerging market economy since the start of the current global crisis and is the first for an EU-member country (IMF statement). Hungary’s first Letter of Intent as of 4 November 200867 covered the macroeconomic framework, fiscal policy, financial sector policies, and monetary and exchange rate policy. It included several tables on program-monitoring and economic targets, and ends with a technical memorandum of understanding that sets definitions and reporting standards for matters such as Hungary’s net foreign exchange reserves, gross foreign assets and liabilities, and the consultation mechanism on the twelve-month rate of inflation. According to the first Letter of Intent, the main objectives of the Hungarian Government are amongst others: to reduce the government’s financing needs and improve long-term fiscal sustainability, to maintain adequate capitalization of the domestic banks and liquidity in domestic financial markets, and to underpin confidence and secure adequate external financing. However there are quite a few obligations from the side of the government in the Letters of Intent, the program contains rather uncertain promises, like “The government is in the process of considering additional steps to improve the competitive position of the economy, which are fully consistent with the program.” The general government, deficit was only projected to fall to 3.4% of GDP (or 2.9% of GDP, adjusted for the EU’s Excessive Deficit Procedure purposes).68

67 Hungary’s Letter of Intent to IMF, 4 November 2008, p. 2. http://www.imf.org/external/np/loi/2008/hun/110408. pdf (retrieved on 24 August 2010). 68 Ibid., paragraph 8, p. 3.

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In the Letter of Intent of September 2009 the Hungarian Government expressed its commitment to the general government deficit ceiling of 3.9% of GDP (Maastricht definition) in 2009, it further affirmed its intention to bring the 2011 overall deficit of the general government below 3% of GDP, as required under the EU Excessive Deficit Procedure. The MNB remains committed to the inflation target of 3% over the medium term, while acting as needed to mitigate risks to financial stability.69 In December 2009, the commitment to reduce the general government deficit (Maastricht definition) was decreased from 3.9% to 3.8% of GDP in 2010. The commitment to reduce the general government deficit regarding 2011 remained maximum 3% of GDP. The MNB remained in December 2009 committed to the inflation target of 3% over the medium term.70 The last of the IMF’s Hungary reviews concluded in mid-July 2010 included no update of the commitments because the new Hungarian government refused to agree to further fiscal austerity or to the 2011 budget deficit goal, among other issues. An International Monetary Fund (IMF) mission, led by Christoph Rosenberg, held discussions with the Hungarian authorities in mid-July 2010 as part of the sixth and seventh reviews of the country’s Stand-By Arrangement.71 According to Rosenberg “the 2011 outlook envisages a continued pickup in real GDP growth – to the 2½2¾ range depending on the external environment and the strength of policies – and a further decline in inflation to the central bank’s target.” However, he added “at the same time, more remains to be done to cement these gains and put Hungary on a strong and sustainable growth path. In an environment of heightened market scrutiny of government deficits and debt levels, the fiscal deficit targets previously announced – 3.8% of GDP in 2010 and below 3% of GDP in 2011 – remain an ap-

69 Hungary´s Letter of Intent to IMF, 16 September 2009, paragraph 12, 15, pp. 4, 5, http://www.imf.org/external/ np/loi/2009/hun/091609.pdf (retrieved on 24 August 2010). 70 Hungary´s Letter of Intent to IMF, 4 December 2009. paragraph 16, 25, pp. 4, 7 http://www.imf.org/external/np/ loi/2009/hun/120409.pdf (retrieved on 24 August 2010). 71 IMF External Relations Department , Statement by the IMF Mission to Hungary, http://www.imf.org/external/ np/sec/pr/2010/pr10295.htm (retrieved on 24 August 2010).

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propriate anchor for the necessary consolidation process and debt sustainability, and should|be adhered to, but additional|measures will need to be taken to achieve these objectives.”72 The previous government in Hungary was anything but talking tough when it agreed to set budget guidelines that|it would follow|to get the funding that saved the country from default. According to ‘Wall Street Journal’, the new government headed by Orbán, sees the deal with the IMF and the EU as merely a loan agreement, refusing to recognize the elements of the plan that would limit its policy-making freedom. Accordingly, Orbán insists that the only commitment the country made was meeting this year’s budget deficit target of 3.8% of gross domestic product, and that the IMF should have no say in how Hungary reaches that goal. But an inspection of the country’s contracts with the IMF seems to suggest the list of commitments is much longer. European Economic and Monetary Affairs Commissioner Olli Rehn told Hungarian paper Vasarnapi Hirek that Hungary must reduce its budget deficit to below 3% of GDP next year and focus on sustainable economic growth.73

3.3.

Major Endeavours and Measures in 2008/2009/2010 to Fight the Negative Impacts of the Crisis

3.3.1.

Employment Policy

Reduction of employer’s social security contributions, the abolition of the lumpsum health contribution aims to reduce the employers’ burdens, and to support employers to keep or even improve workplaces and increase labour demand in spite of the crisis. In this regard, in 2009-2010 the employer’s social security contribution and other employers’ allowances have been decreased. There are several government measures aiming to increase the employment rate, and to stimulate the labour supply: the most important one is the ‘Pathway to Work’ programme. The programme aims to improve the situation of the unem72 Ibid. 73 Margit Feher, Braver Hungary Walks Tight Rope With IMF, 2010, http://blogs.wsj.com/new-europe/2010/09/01/ braver-hungary-walks-tight-rope-with-imf/?mod=rss_WSJBlog&mod=neweurope (retrieved on 1 September 2010).

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ployed people receiving unemployment benefit by reducing the effects of a high unemployment benefit against the willingness to work, e.g. by preparing the unemployed for job search. In this regard the government planned to review the pension system and the system of social benefits. The Government has further simplified the rules of ad hoc employment by abolishing paper based administration and the ‘temporary employment booklet’. With this measure the unregistered employment is expected to decrease, the labour market to whiten and the legal certainty of employees to strengthen. Additional to the above described measures the government planned also to encourage the employment of persons with limited working ability by implementing changes in the tax regime. To supplement long term and structural labour market incentives, in 2009 the Government allocated funds of about 50 billion HUF for programmes aiming to reduce, mainly in the short term, the labour market consequences of the economic crisis. Within this programmes from 2009 the Social Ministry introduced state aid packages in the form of a special fund employers could apply for, and aiming mainly to enable employers to retain workplaces and avoid job losses. The financial framework of the aid amounted to approximately 7.4 billion HUF in 2009.74 However, the state aid certainly could not solve the huge range of unemployment caused by the economic crisis in Hungary. As an example, General Electric (GE), Hungary received an unemployment aid package amounting to 650 million HUF, which only delayed redundancies, as despite the state aid GE had to cut 2,700 jobs after six months.75 In Hungary the demand for well qualified skilled workers remains a general problem even in the period of the crisis. In order to cope with this deficiency the restructuring of the vocational training and its fitting to the requirements of the current labour market has been necessary. In the framework of the modernisation of vocational training, a scholarship has been introduced as of 2010 for persons train74 Országos Foglalkoztatási Közalapítvány Kuratóriuma, Az Országos Foglalkoztatási Közalapítvány (OFA) pályázatot hirdet a foglalkoztatottság megĩrzésének támogatására a gazdasági visszaesés következtében átmenetileg nehéz helyzetbe jutott munkáltatóknál. http://www.ofa.hu/index.php?WG_NODE=WebPalyazatok&WG_ OID=PALf3ff174106c446f6c (retrieved on 26 August 2010). 75 Gazdaság / Gazdaságpolitika, A támogatás sem garancia. Gazdaság » Gazdaságpolitika. Egy fecske nem csinál nyarat alapon nem feltétlenül fog minden munkahelymegĩrzĩ támogatásban részesülĩ cég a General Electric Hungary Zrt. Sorsára jutni, 2009, http://www.vg.hu/gazdasag/gazdasagpolitika/a-tamogatas-sem-garancia-295685, (retrieved on 26 August 2010).

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ing skills with short supply in trade schools. The purpose of the measure is to assure that the structure of training, the number and qualifications of school leavers are more flexibly adapted to the needs of the economy and of the labour market. 3.3.2.

Major State Aids and Private Investment Projects in Hungary

In November 2008, a 1,400 billion HUF programme was announced making more favourable forms of financing available in the forms of micro-credit, investment credit, working capital credit, credit guarantees, venture capital fund and interest subsidy. Furthermore, tenders of the New Hungary Development Plan and the New Hungary Regional Development Programme provide significant non-refundable sources. As the updated Convergence Programme of Hungary for 2009-2012 also reports, besides the above mentioned state aid programme the following megaprojects by private investors will be implemented in Hungary in the near future: Y

The project of Daimler AG with a total value of almost 800 million EUR, which started in 2008 and according to which a new Mercedes car manufacturing plant is to be established in Kecskemét, may be described as the largest recent investment to Hungary;

Y

the Bosal group, one of the largest automotive suppliers, was also expanding its manufacturing capacity of its plant in Kecskemét in Hungary to meet growing demand for its innovative products;

Y

Audi, which plans for the long term, should continuously expand its activities, with investments of over 60 billion HUF in the next two years;

Y

the relocation of generator production of Bosch into Hungary;

Y

Hankook tires will also implement expansion projects of almost 50 billion HUF in the next two years.

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3.3.3.

Measures in 2010 Budget According to the Updated Convergence Programme of Hungary for 2009-2012

The updated convergence programme covers the period 2009 to 201276 and takes into account the 2010 budget adopted by Parliament on 30 November and the macroeconomic projection based on most recent information. The budget act approved by Parliament set the general government deficit at 3.8% of GDP for 2010. The measures introduced by the government in the updated Convergence Program regarding the budget for 2010 to assure the permanent reduction of public expenditure levels were quite indefinite: “In order to strengthen the sustainability of the pension system, the rules of pension indexation have changed as of 2010, thus the pension increase was in line with expected inflation. As a result of the abolition of the 13th month pension, the total pension expenditure will increase at a lower rate, by less than 2.5%. Social benefits will become more targeted and more effective. Child care benefits will be available for a shorter period and the maximum period of eligibility for the family allowance will be shortened by three years. In addition, the family allowance and social benefits linked to the old-age pension minimum will not be raised in 2010 either. The budget reckons further with the altered regulations resulting in an over 10% drop in sick pay expenditures. As a result of better targeting, housing subsidies will be reduced considerably, by about one quarter. Expenditures on meanstested gas and district heating subsidies will drop to about one third of the previous level. The subsidy is financed from the income tax payable by energy suppliers in 2010 for the last time (so-called ‘Robin Hood tax’).” The aforementioned measures should according to the Government result in social benefits other than in kind staying at previous year’s level and in-kind social transfers through market producers declining. Both components of social transfers will decrease as a percentage of GDP, by almost half a percentage point in aggregate. In addition to the above mentioned measures, the budgeting of the system of public institutions was also subject to strict cost controls: the wage scale in the public sector will not be increased in 2010 either and the 13th month salary will be abolished. Taking into account the financing of public work under the ‘Pathway to Work’ programme and the effects of the reduced contribution rates, expenditures on compensation of employees will decrease by half a percentage point of GDP. 76 Government of the Republic of Hungary; The updated convergence programme 2009-2012. http://ec.europa. eu/economy_finance/sgp/pdf/20_scps/2009-10/01_programme/hu_2010-01-29_cp_en.pdf (retrieved on 19 August 2010).

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The effects of the freezing and other withdrawals will be incorporated permanently into the expenditures of central budget chapters. For the expenditures of chapters financed from subsidies (i.e. not from own revenues or EU funds), the 2010 budget contains an almost 7% lower amount than the 2009 appropriations. Changes concerning local governments and public transport companies aim to further improve operational efficiency: the reduction of central budgetary transfers to the local governments will be supported by more flexible conditions for operation, but the appropriation also reckons with the effects of lower social contributions, the expected decrease in the number of pupils, the reallocation of certain task to central budgetary chapters, etc. (According to the 2010 budgetary forecast, the local government subsystem will respond to the reduction of central subsidies partly by efficiency gains and partly by a higher deficit.). Long distance public transport can be made more efficient by organisational and operational changes. The budget gives priority to projects co-financed by the EU in 2010 as well, thus investment expenditures may rise slightly after the decline in 2009. The tax restructuring started in the second half of 2009 and completed in 2010 has changed the structure of revenues: the weight of social contributions and taxes on income have decreased, the ratio of taxes on consumption has increased.

4.

Outlook for the Coming Years

As we can see Hungary was hit hard by the financial crisis and the government will have to keep on making great efforts to bring the country back on a recovery road. Some measures have already been implemented; others are still to come, e.g. the bank tax. How Hungary will develop throughout the next few years is not easy to predict in detail, but leading analysts have already made their comments on Hungary’s future. To predict a positive or a rather negative process of, either Hungary coming out of the crisis or instead staying in the crisis maybe even for years, depends also on the optimistic or pessimistic stance of the observer. What might be a good sign

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for hope is that the economy of Hungary’s biggest investor country and trade partner, Germany, seems to be recovering faster than expected with surprisingly good growth expectations for the year 2010. In the following we suggest that the recently issued forecasts of Business Monitor International (BMI) might be close to the possible outcomes.77 The overwhelming victory of Fidesz in April 2010’s parliamentary elections has substantiated political stability, but its policy agenda has been a little difficulty implementing. Should the Fidesz party help deliver a strong economic recovery for Hungary over the coming years, lowering poverty and unemployment rates, while also successfully implementing a host of structural reforms to the economy, this could help to both ease current ethnic tensions as well as stem the flow of support to more radical parties. Moreover, while the need for austerity measures to decrease the fiscal deficit would likely strip Fidesz of their overwhelming majority in parliament, getting Hungary’s economy back on track would boost their chances of gaining another term in office. Should Hungary become one of the best reformers in the region, foreign direct investment would pick up rapidly (much like Slovakia under the centre right coalition from 1998 to 2006), potentially allowing euro accession earlier than currently forecast. Successive governments, whether from the centre-right or centre-left, would help sustain this drive as the economic benefits are realised, following a path of rapid economic and political convergence with Western Europe. Business Monitor International studies show further that despite Hungary’s very poor medium-term economic outlook, the country’s long-term growth prospects remain reasonable, with real convergence with the Euro-zone forecast to resume beyond 2010. Indeed, between 2011 and 2014, real GDP growth is forecast to accelerate to an average 3.2% annually, from a paltry 0.6% for the previous five-year period. The key factor shifting economic momentum will be public policy, with the country’s long-stalled structural reform programme likely to receive a degree of renewed momentum after the general election in 2010. The shift from a minority to a Fidesz-led majority government following April 2010’s parliamentary election should help to improve the efficiency of policy formation. Although we caution that Fidesz may be little more proactive than the Socialists have been in pushing through economic liberalisation initiatives including reducing state involvement in the corporate sector, decreasing the corporate tax burden and the delivery of pub-

77 Business Monitor International Ltd., Hungary, Business Forecast Report, 2010 www.businessmonitor.com (retrieved on 25 August 2010).

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lic goods. Nevertheless, the interim crisis-management administration that took office in April 2009 is likely to take valuable steps in this direction, laying the ground for a full-length incoming government. Over the long run, likely policies – including increased private sector participation in the health services sector, a flat income tax and a reduction in social welfare expenditures – should serve to improve labour force participation and drive reasonably healthy domestic consumption growth. Indeed, we believe that the country’s chronically low employment rate, which has hovered at around 50.0% since 2004, will finally be boosted in the latter half of our ten-year forecast period, largely on the back of expected reforms. This is one of two key factors we have taken into account to justify our forecast for household expenditure growth to average a decent 2.4% annually from 2015 to 2019. Concerning euro-adoption, the second factor is the expectation for steadily declining interest rates, which will coincide with the long-term disinflationary trend we are forecasting. Indeed, we believe that 2008 will be the peak of the current monetary tightening cycle and, through the long term, expect the National Bank of Hungary’s policy rate to steadily converge with its European Central Bank counterpart by 2014. Both domestic and external economic variables after 2010 will be far more conducive toward achieving Maastricht targets and we expect the new administration to take advantage of these conditions. First, global supply side inflationary factors are forecast to begin subsiding markedly in 2009, alongside a forecast resurgence in the US dollar and concomitant decline in energy and soft commodity prices. Second, the expected upswing in growth, in part due to an expected recovery in the Euro-zone beginning in late 2010 as well as renewed consumer confidence will help to elevate government revenue growth at a time when fiscal reform initiatives should restrict the increase in expenditures. With the country’s economic recovery expected to start to take effect from 2011 onwards, Hungary will likely be in a positive position to enter into the European Exchange Rate Mechanism (ERM-2) in 2013 and fulfil all five of the Maastricht criteria by 2014. This will set the stage for adoption of the euro in 2015 at an expected conversion rate of 245.00 HUF/EUR. By 2014, Business Monitor International is forecasting annual average inflation to fall to 4.0%, while the general government fiscal deficit should also contract to 2.4% of GDP. At the same time, taking into account an expected improvement in foreign investment inflows and trade dynamics, owing to the government’s reforms

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and Euro-zone economic recovery, Hungary’s external accounts are also forecast to improve markedly. The current account deficit is expected to steadily improve through our ten-year forecast period, both on the back of improved export capacity as well as a steadily widening services surplus, which is likely alongside long-term development of the country’s tertiary industries. By 2014, the current account deficit is expected to total only 2.7% of GDP. Beyond 2014, Business Monitor International expects the Hungarian economy to continue benefiting from the macroeconomic stabilisation achieved through fulfilment of the Maastricht criteria, while the adoption of the euro should also help to bolster investor confidence and trade integration with the Euro-zone within the first one to two years of its use. As such, the EU convergence trends are expected to start to take hold again in the 2014-2018 period after having taken a severe knock as a result of the 2008-2010 recession.78 The article of ‘heise.de’ of December 2009 predicted on the coming social and economic effects of the crisis that with the pressure mounting on all sides, some feel that a social explosion is imminent. This doesn’t mean, however, that people will suddenly mobilize and force the government to abandon the IMF dictates and introduce true forms of economic stimulus, including making multinationals pay their fair share of the tax burden. Along these lines the future looks quite bleak for many Hungarians. Economic insecurity has given rise to political apathy on the one hand and extremism on the other. This, in turn, fuels the rise of radical movements, as exemplified by the rise of the right-wing Jobbik Party in Hungary. While all this may seem to be a Hungarian problem, it’s actually something which affects the entire EU. For one, it’s not only Hungary which is going through this process, but many other countries within the region as well. Not only this, more established EU member states are also feeling the pressure. Greece is a case in point. The economic failure of Hungary will no doubt have a lasting and negative impact on the rest of Europe. This is not only in terms of economics, but politics as well. The Jobbik’s uniformed paramilitary wing, the Hungarian Guard, has already been emulated elsewhere, such as in the Czech Republic, and in London a branch of the Jobbik has been established. Meanwhile, within the European parliament an alliance of nationalist parties was set up, among them the Jobbik, the British National Party, and the French National Front. 78 Ibid. p. 28.

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As long as Brussels prefers to look the other way while neo-liberalism wreaks havoc on the economies of Central and Eastern Europe, this situation will only become worse. Most Hungarians had high hopes when joining the EU, believing that membership would bring economic prosperity and a certain guarantee against government abuse. In both cases people have been disappointed to find out that they were wrong.79 One way in which countries such as Hungary can shield themselves from the devastating whirlwind of currency speculation and rising interest rates is to introduce capital controls so as to limit the ability of foreign funds to enter and flee a country easily. However, the IMF is against such controls arguing that it restricts economic freedom. Because of this, the Hungarian economy is forced into a nowin situation. It has to adhere to IMF dictates otherwise it won’t receive the cash it badly needs to avoid bankruptcy. In turn, concern over a looming currency attack provides a perfect excuse for why the government can’t undertake genuine stimulus measures even if it wants to. This no-win situation is compounded by the fact that a sudden devaluation of the Hungarian currency to more realistic levels would have a catastrophic effect on most people. Personal savings and property values would shrink, impoverishing many. Most Hungarians are quite aware of this: earlier this year when the Hungarian currency began to devalue at an alarming rate, people rushed to convert what they could into euros and US dollars. The rush was such that many exchange offices ran out of hard currency. This uneasy situation is also reflected in the fluid state of consumer prices. Prices in Hungary are anything but stable, and price stability is what lies at the heart of any properly functioning economy. Of most concern is the price of electricity and natural gas which have been increasing steadily throughout the year. With rising prices and falling real wages a growing number of people have begun to default on their utility bills. Some companies have responded by trying to make payment terms a little easier but this has been of little help.80 The economic policy of no Hungarian government can defy expectations of the international financial sector. The reason for this is that despite a significant strengthening of external and internal balance debts remain to be high (budget gross debt was approximately 78% of GDP and net foreign debt was 55.6% of 79 John Horvath, In Hungary the Financial Crisis has picked up a Second Wind, 2009, http://www.heise.de/tp/r4/ artikel/31/31771/1.html. (retrieved on 18 August 2010). 80 Ibid.

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GDP). Such debts are normally financed by financial and capital markets. Therefore, the new government will also be forced to pursue strict fiscal and income policy and keep the country on a path leading to a decreasing level of foreign debt and eventually a reduced level of budget debt. If the government failed to do so markets would stop financing Hungary. The situation of the Hungarian economy is mainly determined by global changes taking place in the world and in the European Union. Thus, the influence of the new government elections on economic processes in 2010 is likely to be weaker than generally expected (however, it may have a significant effect on the subsequent period). On the one hand, unlike 2006, the economic situation does not require immediate measures to restore the balance. Almost all international and domestic institutions agree that in 2010 – by ‘only’ disciplined government behaviour – a budget deficit of 4% of GDP can easily be achieved. On the other hand, unlike in 2002, the political force that is likely to form a government has no short term promises similar to that of the 100-day Program, which would have to be at least partially executed immediately. Real changes and priorities of the economic policy will mainly be apparent after the submission of the convergence programme and the budget for 2011. The ‘Political year-book of Hungary’ sees the country’s economic future to be connected with the introduction of the euro. Confrontation with international organisations is not a feasible alternative: not simply because of valid credit agreements and coordination regulations, but mainly because of the anticipated reaction of financial markets. The Hungarian government will be unable to pursue an effective demand stimulation economic policy after 2010 not only as a consequence of balance requirements, but also because in open countries domestic production can hardly be raised by only stimulating internal demand. In this situation only symbolic changes can be expected in the short term, e.g. a supplementary budget amending a lot of details but leaving the main structures intact. At the same time the government has to make a strategic decision still in 2010 (e.g. as part of an updated convergence programme) about whether it wanted to introduce the euro in the same term (effectively in 2014). This depends on domestic considerations as well as the attitude of the EU and the ECB, i.e. how much these institutions urge new member states to quickly join the Economic and Monetary Union, which itself is also experiencing internal troubles. Basically the government has to choose between a fast introduction of the euro (offering a reforming and serious perspective) and a ‘floundering’ economic policy (loosening up the budget to its possible limits and introducing slow changes). In theory, a distributing economic

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policy increasing budget deficit and debt and engaging in open confrontation with international organisations is also imaginable. This, however, would lead even in the short term to such consequences – devaluation, interest rate hike, higher inflation, persistent stagnation, capital flight – that realistically rule this option out. A programme for the rapid introduction of the euro in 2014 suggests the decrease of budget deficit and the level of budget debt, moreover, as a means of achieving these goals, the restructuring of the operation of public services (mainly local governments, education and health care) and spending cuts to finance significant tax reductions. At the same time economic growth and the accompanying expected significant increase of tax and contribution revenues would also not necessitate the nominal decrease of spending in every area. In our opinion even in the medium term this solution would serve the interests of the Hungarian economy and would give a real margin for serious enterprises. It would decrease the country’s financial vulnerability, improve its growth potential and increase employment in a sustainable and competitive way. However, a floundering economic policy that evades conflicts and balances tax reduction with higher budget deficit may also be feasible. This would justify a relatively stable, approximately 4% (and in the EU for years still relatively good) budget deficit with tax reduction and with the provision of necessary financial resources in a conflict-evading way. This economic policy would emphasize a patriotic-statist approach that will no doubt be central in the next government’s rhetoric. It would mean the financial assistance granted to Hungarian SMEs, Hungarian farmers and state-owned companies. Surprisingly, this would hardly improve the competitiveness of enterprises. However, there is a risk that growth and the standard of public services would be lower than otherwise as a consequence of extended government involvement, lower efficiency requirements and an excessive orientation of the supply towards state aspects instead of market demand. Moreover, the room for manoeuvre would be further restricted by a higher budgetary interest burden. What the Hungarian economy needs now above all is a period of calm development. It needs political powers and main economic, social and interest representation stakeholders to loudly or quietly reach an agreement about some common, long-term national objectives.81

81 Gabor Karsai / Andras Vertes; Ki a válságból, de hova be… (Out of the crisis, but whereto…), in: Dr. Péter Sándor / Dr. László, Vass; A Magyarország politikai évkönyve® 2009 Digitális könyv (Political year-book of Hungary of 2009, digital book), 2010, p. 217.

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According to the Prime Minister, the task of its party is to maintain the connection between the middle class and the more doubtful groups of society, to wholly renew the economic system of Hungary and to lead the country out of the crisis. To complete these tasks the central aim of the economic policy shall be the employment and creation of one million new workplaces in ten years. In his opinion only employment gives opportunity to rise and the more people work, the more successful the economy will become.82

82 Napi Gazdaság, Orbán megnevezte a legfontosabb feladatokat http://www.napi.hu/default.asp?cCenter=article. asp&nID=457254&place=kepnelkulivezeto1 (retrieved on 4 September 2010).

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Lithuania: The Return of Opportunities Tobias Kohler

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1.

Situation before the Crisis

1.1.

Lithuania’s Journey into the Global Economy from 1991 to 1999

As a former Soviet republic and a young nation which declared its independence at the beginning of the 1990s, Lithuania’s recent history has been quite eventful. This applies not only to political matters but also to the country’s economic development – away from the role of an integrated part of the Soviet planned economy to a liberal market economy structured according to the western model. After Lithuania’s independence the economy was subjected to radical changes. Hereby two major phases in economic development could be identified during the 1990s. The first phase, from 1991 to 1993, was characterised by a dramatic economic downturn caused by the breakdown of the economic system in place at the time. Already by 1991 the first reforms had been undertaken to introduce the free market and therefore allow Lithuania access to the world marketplace. This complex phase of reform was a painful process for Lithuania, as it coincided with sharp declines in all economic sectors. The second stage of reforms can be described as a phase of restoration and stabilisation and lasted from 1994 to 1999. During this period, the economy began to stabilise and from 1995 onwards the annual rate of economic growth started to increase year by year. The development of the Lithuanian economy during this period was not just a quantitative process related to output changes. In reality, this period was characterised by the transition from one economic system to another. It was accompanied in particular by the privatisation of former state enterprises and assets, as well as changes in the character of business relations. By 1994 the private sector generated 60% of GDP, 65% in the year 1995, 68% in 1996, and in 1997 already 70% of GDP. However, not only did the private sector play an ever increasing role in the economy throughout the 1990s but also the level of direct foreign investment grew significantly and also its share in GDP accordingly.1

1 Juozas Bivainis / Aruras Bucas, OECD, Corporate Governance in Lithuania 1999, 1999, p. 4.

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J. Jungmann, B. Sagemann (Eds.), Financial Crisis in Eastern Europe, DOI 10.1007/978-3-8349-6553-0_5, © Gabler Verlag | Springer Fachmedien Wiesbaden GmbH

Admittedly Lithuania also had to overcome economic crises during this time. For example, in autumn 1995 Lithuania experienced a banking crisis and in addition to that, the Russian economic crisis in summer 1998 had a severe impact on the Lithuanian economy. As a result of the Russian crisis the demand for Lithuanian exports dropped off markedly from the (for historical reasons) still very important Russian market and the former Soviet states. Many Russian importers were unable to pay for goods which had already been ordered and delivered. Furthermore, the country’s banking system was drawn into a serious situation as many Lithuanian banks had invested heavily in Russian government bonds. The Russian crisis had a serious impact on nearly all the main sectors of the Lithuanian economy. The drop-off in exports to the Eastern European countries resulted in a significant cooling off in economic growth in Lithuania. Therefore, the growth at the beginning of 1999 was much weaker than the one in the prior year. The 100 largest Lithuanian firms exported 15.2% less in the first half of 1999 in comparison to the same period a year earlier and their turnover fell by 14.8% at the same time. 20% of companies reported losses for the first half of 1999.2 The Russian crisis and the resulting fall in tax revenues were met by major cuts in government spending. For example, the government draft budget was amended during the crisis in 1999 and further savings of 450 million LTL were pencilled in. By the second half of 1999 growth in the economy could already be seen again.3

1.2.

The Preparations for Entry to the EU – From 2000 to 2004

After the short recession during 1999 brought about by the Russian crisis the Lithuanian economy grew continually and was based on a broader footing. Nevertheless, the upturn in growth was based primarily on two pillars: property and consumer spending. As a result of increasing construction activity, primarily in road building and the housing sector, more and more money started to flow in to different projects with the result that the construction sector became a major engine of growth.4 A high level of consumer appetite combined with rising household incomes plus falling unemployment led to acceleration in private consumption. In the 2 Ibid., p. 5. 3 Ibid., p. 6. 4 Paul Thomsen / G. Russell Kincaid, IMF Staff Report for the 2006 Article IV Consultation for Lithuania, 12 April 2006, p. 6.

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period from 2000 to 2002 the average wage increased by 5%. By June 2003 the rate of unemployment stood at 9.4% which was a four year low.5 Consumption was encouraged by the increasing availability of consumer credit and other forms of finance which were becoming increasingly accepted and popular among consumers. Exports grew at a strong pace despite the appreciation of the local currency. The balance of trade remained unchanged however as imports grew dramatically on the back of increasing private demand. The rate of inflation was at 0.9% in May 2003 according to the CPI Index. The growth in wages slowed down, and unit labour costs also declined, not only in retail, but in other areas as well. It is certainly true that Lithuania made tremendous strides from 1999 to 2004 in continuing towards the development of an open and competitive economy. The consolidation of the government finances, the growing economic robustness and a falling level of unemployment resulted in Lithuania fulfilling all the criteria for an entry into the EU.6 On 1 May 2004 Lithuania joined the EU. In addition, Lithuania joined the ERM II mechanism from 28 June 2004 in order to have the opportunity to introduce the euro in 2007. Since 2000 the amount of money in circulation has increased sharply due to the improved economic situation and a resumed confidence in the banking sector. At the end of 2001 – on the basis of increasing consumer confidence, low interest rates, greater competitiveness and a more efficient privatised banking sector – it was noticeable that considerably more credit had been released into the private sector. For example, in comparison to 2002, the amount of credit granted in 2003 increased by 35%.7 The economic boom in Lithuania carried on into 2004 unchecked. GDP growth increased to 6.75% primarily because of private consumer demand and increasing investment. Capacity utilisation in the manufacturing sector rose by 70%, the highest value since 2000.8

5 José Fajgenbaum / G. Russell Kincaid, IMF Staff Report for the 2003 Article IV Consultation for Lithuania, 28 July 2003, p. 6. 6 Ibid., p. 7. 7 Ibid., p. 10. 8 Paul Thomson / Carlos Muniz, IMF Staff Report for the 2004 Article IV Consultation for Lithuania, 9 March 2005, p. 5.

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1.3.

Development of Selected Economic Sectors from 2004 Onwards

1.3.1.

The Property Sector and Construction Industry

With a boom especially in the property and construction sector, Lithuania belonged to the group of the fastest growing economies in the EU prior to the outbreak of the global economic and financial crisis. In preparation for entry into the EU in 2004 as well as in the period shortly after, a number of state and private construction projects were continued and completed with the help of EU funds. 2006 saw a 21% increase in services provided by the construction sector in comparison to the previous year. In 2007 Lithuania was able to come up with a growth rate of 21.2% and further exceeded the previous year’s growth again. These growth rates contributed towards an increase in the construction industry’s share of GDP to 10.2% in 2007 (2006: 8.8%).9 The construction boom was not only clearly visible when you drove through Vilnius, Kaunas and Klaipeda. The three main economic centres based on the large number of building sites and newly completed construction projects, but also manifested it in property price increases. Between 2002 and 2006 the average price for an existing building in Vilnius grew by 275% and for newly completed structures by 162%. Construction projects were launched in all areas, but with a focus on housing. For example, between 1998 and 2003 there were on average around 5,000 housing construction projects per annum. This number grew particularly fast in the following years. From 2004 to 2006 an average of 6,700 housing projects were completed, 9,289 projects in 2007, 11,286 in the year 2008, and in 2009 around 9,400.10

9 Bundesagentur für Außenwirtschaft, Branche kompakt – Bauwirtschaft Litauen 2008. 10 Global Property Guide, Modest growth foreseen for Lithuania’s GDP in 2010 and 2011, 11 May 2010, http:// www.globalpropertyguide.com/Europe/Lithuania/Price-History (retrieved on 25 August 2010).

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Picture 1: Dwellings Construction 2000–2009; source: Statistics Lithuania, 2010, www.stat.gov.lt/en/ (retrieved on 25 August 2010). 20,000

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Foreign Trade

Foreign trade has also flourished in Lithuania. Varying products are not only exported to the neighbouring countries of Latvia, Estonia, Belarus and Russia, but also most notably to Western Europe. Lithuania’s most important trading partners are Russia, Poland, Germany, Latvia and the Netherlands.11 However, it is important to note that the external trade balance of Lithuania, as in most transition countries, is in deficit. In 2004 goods to the value of 7.45 billion EUR were exported and in the same time period 9.88 billion EUR of goods were imported, resulting in a trade deficit of 2.43 billion EUR. Main exports to Russia were motor vehicles (re-exports of motor vehicles), food products, electrical appliances (refrigerators), electronic parts, furniture and carpets. The main products exported to the EU nations were textiles, foodstuffs, chemical products, metal products and timber. From the EU, on the other hand, the major imported items included motor vehicles, computer equipment, machinery and capital equipment, textiles and foodstuffs. From Russia the main imports tend to be fuels such as gas and oil.12 11 Germany Trade & Invest, Litauens Außenhandel mit zweistelligen Steigerungsraten, 2008, p. 2. 12 Außenwirtschaft Österreich (AWO), Exportbericht Litauen, 2008, p. 9.

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Picture 2: Foreign Trade 2004 – 2009, source: Statistics Lithuania, 2010, www.stat.gov.lt/en/ (retrieved on 25 September 2010).

1.3.3.

Banking Industry and Bank Lending

Lithuania’s strong economic upswing is also attributed to high levels of bank lending to companies and private individuals. The immense economic turnaround was mainly fuelled by money from overseas. Thus, strong internal demand was generated, allied with a robust export sector. By 2004 the Lithuanian government had already been contacted by the IMF in connection with the credit driven growth and the IMF confronted them with the possible ramifications for the stability of the financial sector. By the end of 2004 59% of total credit had been issued in other currencies other than the Lithuanian litas (LTL). In order to have greater control of bank lending, government established a supervisory system and established a cooperation agreement with other northern states. Naturally the government took the view that there was a foreign currency conversion risk for a country on the road to euro adoption. Moreover, the maximum allowable share of the open position in foreign currency is under the Bank of Lithuania predetermined allowable13 limit, 25% of the total bank limit.14 13 Law on Banks: Article 48. Prudential Requirements for Banking Activities / Bank regulation: “Prudential Requirements for Banking Activities“, 2. September 2004; Article 3. 14 Paul Thomson / Carlos Muniz, IMF Staff Report for the 2004 Article IV Consultation for Lithuania, 9 March 2005, p. 23.

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Banks from Sweden, Norway and Denmark are in particular present in the Lithuanian market, whereby Swedish banks dominate. Between 2006 and 2008 Swedbank derived 40% of its profits from the Baltic states.15 According to data from the European Bank for Reconstruction and Development (EBRD) by the end of 2007 91.7% of balance sheet assets were in foreign hands.16 In the boom years of 2004 to 2008 bank lending was handled somewhat recklessly. As a result of rising incomes, screening of potential borrowers for credit worthiness was only partially undertaken, or if at all. The property boom was also propped up and supported during this time through on-going cheap lending. This development was encouraged as the result of an increasingly competitive banking market in which lending criterion were relaxed in order to gain market share. The outcome was that many Lithuanians were able to purchase flats or houses which they actually could not afford. 1.3.4.

Industry

Industrial production in Lithuania also grew particularly quickly from 2004 to 2008. Thus, the industrial companies sold 13.7 billion EUR worth of products in 2007 (excluding VAT and excise tax) and mining activities increased by 14% in 2007. The largest industrial sectors are motorised transport manufacture, trailer and semi-trailer manufacture, other forms of transport manufacture, radio, television and communication equipment and apparatus, textiles, metal products (except machinery and mechanical equipment), rubber and plastic products and intermediate goods and paper products. An important role is taken up by information technology and telecommunications. This sector includes information technologies such as computers, PCs, servers, network components, means of access, data communication solutions and infrastructure solutions, IT services and complex solutions (Internet, programming, etc.) and telecommunications services (fixed and mobile communications, etc.). In 2005, the number of mobile customers in Lithuania increased more than in any other nation (in comparison to other EU countries). In addition, Lithuania stands out among the countries in Central and Eastern Europe by the fact that it occupies a top position in the biotechnology sector, which benefits primarily from overseas investment. 15 Steuer, Helmut, Finanzkrise trifft Nordeuropa, in: Handelsblatt, 06.02.2008, http://www.handelsblatt.com (retrieved on 6 August 2010). 16 Fabian Nemitz, Germany Trade & Invest, Litauische Banken schreiben hohe Verluste, 2009, p. 1.

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1.4.

Economic Overview

1.4.1.

GDP and the Rate of Inflation

In the last ten years in Lithuania there has been a great deal of economic optimism. This is demonstrated particularly well based on a number of economic indicators. Gross domestic product (GDP) increased from 2000 to the EU accession of Lithuania in 2004 by an average of 6.7% per year. Even in 2008 GDP growth reached 3.2%. The rate of inflation until EU accession was stable at between 1.1% and 1.2%. After the country’s entry to the EU in 2004, however, the inflation rate sprung up to its highest level of 11.1% in 2008. Picture 3: Annual Inflation Rate 2000-2009; source: Eurostat, 2010, www.ec.europa.eu/eurostat (retrieved on 5 September 2010).

The increase in 2005 is explained in part by a surge in oil prices during that year. Moreover, after accession to the EU in May 2004 food prices rose: Food exports to the EU-15-zone rose due to the harmonisation in the area of trade, imports fell back on the other hand because of the EU Customs Union (EU external border with Russia and Belarus).17 17 Paul Thomsen / G. Russell Kincaid, IMF Staff Report for the 2006 Article IV Consultation for Lithuania, 2006, p. 8.

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A rise in the inflation rate was also a factor in Lithuania‘s failed accession to the monetary union in 2006. In addition, food prices continued to rise because of the summer drought. After all, these effects are responsible for around ¹/³ of the Harmonised Index of Consumer Prices.18 1.4.2.

Public Finances

Lithuania’s national debt is expected to reach 40% of GDP by 2010. Even though it is one of the smallest in the EU and compared with countries like Belgium or Italy, which have national debts greater than 100% of GDP, it still might look comparably small. The speed by which it is increasing annually poses a serious problem for Lithuania. This trend has worsened as a result of the financial crisis as is still to be shown. Picture 4: National debt 2000-2008; source: Statistics Lithuania: Quarterly Debt of General Government, www.stat.gov.lt/en/ (retrieved on 25 August 2010). 35 30 25 20 15 10 5 0 -5

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The increase in the public spending deficit has in part arisen as a result of higher costs in the old age pension system. Some unforeseen costs also occurred which could not be offset through the reforms in the tax system. A further reason for the 18 Paul Thomsen / G. Russell Kincaid, IMF Staff Report for the 2007 Article IV Consultation for Lithuania, 9 March 2007, p. 4.

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ever growing public spending deficit was the unexpected increase in imports.19 The public finances are also impacted by a civil administration which is riddled with inefficiency, an overbearing bureaucracy and a bloated management as well as a certain level of corruption when awarding public contracts. In addition, there were numerous decisions made by the government which were marked by a distinct lack of sustainability and caution. It meant, among other things, that no new reserves were created in the boom years and existing reserves of social insurance were used up completely –- often in favour of populist measures and prestige objects.

1.5.

Fiscal Situation

1.5.1.

Corporation Tax

Prior to the outbreak of the global financial crisis in 2007 the rate of tax on company profits (corporate income tax) was 15%. A reduced rate of tax applied to all companies that employed no more than ten workers and whose total annual turnover per annum did not exceed 500,000 LTL. For companies with an annual turnover of less than 100,000 LTL per annum and who in the rule employed less than ten staff, profits up to 25,000 LTL were not subject to corporation tax. Any amounts over and above this figure were taxed at 15%. 1.5.2.

Income Tax

In 2007 the rate of income tax stood at 27%. Allied to this was a reduced rate of 15%. This reduced rate was applied to dividend payouts, interest income, income from copyright agreements, rental income, income from property sale and individual business activities. All income not covered by the reduced tax rate was taxed at the 27 % tax rate. Most pertinent to this was in fact the income from gainful employment.

19 Paul Thomsen/ G. Russell Kincaid, IMF Staff Report for the 2007 Article IV Consultation for Lithuania, 9 March 2007, p. 6.

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1.5.3.

Value Added Tax

VAT stood at 18%, and the reduced rate at 5%. This reduced tax rate applied to public transport, books, pharmaceutical and medical goods, overnight hotel stays, raw and frozen meat or fish, as well as for sports, cultural and artistic events. 1.5.4.

Other taxes

Since 2007 there has also been a property tax, the level of which is fixed at local level. Within the framework of the Property Tax Law the rate varies between 0.3% and 1.0%. The rate at which the property tax is set is determined by a price band in which the asset falls. Every asset has its own basis of calculation according to the value of the asset.

1.6.

Labour and Social Policy in the Boom Years

1.6.1.

Wage Costs

Since the accession of Lithuania to the EU there has been a noticeable strong increase in gross wages. Wage growth of between 10% and 20% p.a. was typical. Also the minimum wage in Lithuania, which is independent of any branch tariffs, was increasing steadily. The sectors which had been experiencing the fastest growing wage rates were the construction industry, healthcare and social industry, trade, education and training and manufacturing industry.

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Picture 5: Average monthly gross wage in Lithuania in 2003 1Q-2008 1Q, source: Statistics Lithuania, quarterly data on earnings, www.stat.gov.lt/en/ (retrieved on 5 September 2010). 2500.0 2000.0 1500.0 1000.0 500.0

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1.6.2.

Unemployment Figures

The unemployment figures reflected particularly well the economic upturn in Lithuania. The unemployment rate in 2000 was 10.2%, 11.4% in the year of EU accession (2004), and in 2007 it had fallen to 4.3%. This is the lowest rate of unemployment in Lithuania’s recorded economic history. The economic recovery was thus reflected in rising levels of employment.

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Picture 6: Unemployment rate 2004 – 2009, % by year, Males and females, Urban and rural areas, Total by age (per cent), source: Statistics Lithuania, www.stat.gov.lt/en/ (retrieved on 5 September 2010).

1.6.3.

Social Security

The social security system in Lithuania is financed by contributions from insured persons and employers, taxes and other sources. In 2000 the general rate of contribution for social security was increased from 31% to 34.084%. Of this contribution rate of 34.084%, 30.98% is borne by the employer and 3% by the employee. There is no maximum upper limit (Social Security contribution assessment ceiling). An additional contribution of 0.1% of the salary is borne by the employers and paid into the Guarantee Funds for Insolvencies. The income being the basis for all calculations shall not be smaller than the statutory minimum salary. Old Age Pensions

The old age pension system in Lithuania was reformed in 2004. Alongside the pay as you go / contributory based pension system a second pillar was introduced. This reformed pension system consists of a flat rate and an earnings-related portion. The pension system is managed by ‘SoDra’ (State Social Insurance Fund Board) which also pays the pensions.

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Under the reformed model it is planned that a portion of the old age pension will be guaranteed by the state. The other part is to be considered as a supplementary pension for which the beneficiary is responsible. The future beneficiary may acquire shares in privately managed pension funds through his/her pension contributions. In 2004, the share that was paid to private pension funds was 2.5% (from a total of 25.9% for the full old age pension scheme), in 2005 it was 3.5%, in 2006 4.5% and in the year 2007 it was 5.5%. Alongside the reformed pension model, the pay as you go| /| contributory system has nevertheless been continued. Indeed, there were some changes, which proved advantageous for the older section of the population. Therefore, it is not surprising that most of the younger employees decided to take up the reformed model. In 2010 74% of Lithuanians had already chosen the reformed old age pension model.20 On 1 July 2007, a number of major changes to the pay as you go / contributory system came into force. Accordingly, people with a 30-year contribution period in the social security have an entitlement to a supplementary pension for old age or disability pension for each additional full year of pension insurance. The calculation is done individually by multiplying 3% of the basic pension by the number of full years of contributions in excess of 30 years. At the same time the basic pension was set at LTL 266 from 1 February 2007. The bonus for the pension contribution will probably benefit some 410,000 beneficiaries of the old age pension.21 The share of the pension and the surviving dependents pension is 26.2%. The employer bears 23.7% and the employee 2.5% of the cost. Maternity Benefits and Maternity / Paternity Leave

From 1 January 2007 the Maternity / Paternity leave pay was set at 85% of regular salary of the beneficiary. Since 1 July 2007 the amount of benefit increased to 100% from the end of pregnancy leave up to the child’s sixth month and 85% for the remaining period.

20 European Council, Annual progress report on the implementation of the national reform program of Lithuania 2009, p. 17. 21 MISSOC-Info 1/2008, Entwicklung der sozialen Sicherung in 2007 in Litauen, pp. 3, 4.

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On 1 January 2008 further changes were introduced. The claim period has been extended, so that now 100% of the mandatory salary of the beneficiary will be paid up until the first year of the child’s life and 85% will be paid up until the child’s second birthday. In addition, a more favourable method for the calculation of the maternity allowance was introduced.22 The share of the maternity allowance and the maternity / paternity leave in social security was 3.3% (3.4% by 2009). Of this 2.8% (2.9% by 2009) was borne by the employers and 0.5% by the employees. This system was introduced in particular to counteract the migration-related population decline. However, it has also led to widespread abuse as a consequence of false increases in income (e.g. by means of bogus employment contracts) in the calculation of the regular income relevant period, and thus a considerable strain on the social security system.

2.

The Impact of the World Financial Crisis (2008/2009/2010)

2.1.

Selected Economic Sectors

2.1.1.

The Property Sector and Construction Industry

The most apparent outcome of the world financial crisis upon the Lithuanian economy is the collapse of its construction and property sector. In 2007 and 2008 there were numerous cranes all around the capital of Vilnius, in particular in the city centre, in 2010 however only a handful can be seen. Equally, it can also be concluded on the basis of numerous half-finished buildings (including a large number of state-led projects such as the new sports stadium in Vilnius) in the city centre that the financial crisis has had a serious impact on the lives of Lithuanians. In particular in the housing sector the fatal effects of a burst property bubble are evident. Many Lithuanians bought overpriced apartments or houses, which were typically financed as a rule by borrowings of up to 75% loan to value and were secured by the banks primarily through the acquired property itself in anticipation of further price appreciation. Often these homeowners live in unfinished building complexes which due to the insolvency of the management company are no longer supplied 22 Ibid., pp. 1, 2.

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with electricity water and gas. Unfortunately, as it is often the case, the developer and the seller are insolvent and thus claims for compensation come to nothing. In addition, the monthly salary is sometimes not sufficient to cover the monthly interest and/or capital repayment as a consequence of short-time work or even unemployment. The corresponding increase in repayment defaults allied with a lack of adequate security has proved to be, again, an extra burden for the banks. The rapid construction boom came to an abrupt end and being a major pillar of the economy halted the major economic upturn. In 2009 the revenues in the construction industry fell significantly (by up to 50% in some instances), as a result of surging levels of default. The unemployment figures and insolvencies in the sector are without equal in the short history of the Lithuanian free market. 2.1.2.

Foreign Trade

Not only the domestic construction and property sector came to a standstill with the outbreak of the financial crisis. The Lithuanian export and import trade also slowed down significantly, as the main trading partners with Lithuania were themselves experiencing a major downturn. The neighbouring trading partner Latvia, for example, whose national bankruptcy was only hindered through an emergency loan of 7 billion EUR from the IMF. The collapse of the Latvian Parex Bank, which was also active in Lithuania, could only be avoided by means of a takeover by the Latvian state at a merely symbolic price of 1.00 LVL (ca. 0.70 EUR). In Germany as one of Lithuania’s largest trade partners, the banking sector too came under severe pressure in the course of the crisis and a number of banks required support from the state or were partly nationalised (including Commerzbank, Hypo Real Estate). Industrial production in Germany dropped dramatically, in particular in the car manufacturing sector and suppliers suffered accordingly including those active in Lithuania. As a result at the beginning of 2008 a so-called ‘scrappage scheme’ was introduced in Germany whereby buyers received a premium of 2,500 EUR (over and above what they may have received from the car dealer as part exchange) from government for the purchase of a new car. All these measures cost the German government a great deal of resources, which were then lacking for the promotion of foreign investment. As the global economic framework worsened the demand for products from Lithuania sank. Consequently Lithuanian exports declined dramatically which led to a further deterioration in the economic situation.

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2.1.3.

Banking Industry and Bank Lending

The financial crisis has had a devastating impact on the banking landscape in Lithuania. Unlike in other European countries, however, no banks in Lithuania had to be supported with financial help or nationalised. Nevertheless, most Lithuanian banks, which in the large part are owned by overseas banking groups, went into the red as a result of lax and generous lending policies. The group banking parent companies themselves were often also suffering from a lack of liquidity, and sought to bridge this issue by withdrawing funds from their Baltic subsidiaries. Over and above this the banking parents began to implement much stricter lending guidelines and forced through drastic cost cutting policies. In fact the guidelines for obtaining credit became so strict that at the highpoint of the crisis not only consumers but companies too found it almost impossible to fulfil the new criterion introduced by the banks. Faced with impending insolvency, scores of business have been accepting credit conditions (e.g. joint and several unlimited liability of partners including private property) that otherwise in a more benign economic climate would not have been accepted. These conditions will place a burden on society in the coming years and have a negative impact on the nation’s sustainable economic development. 2.1.4.

Industry and the Domestic Market

During the first six months of 2009 all the industry indicators showed a marked deterioration in comparison to the same six months in 2008. This situation was further aggravated by the weakness of the world economy, unfavourable economic and political developments in other countries, poor liquidity, difficulties in obtaining bank credit and the rising cost of raw materials. In the first half of 2009 industrial goods to the value of 23.1 billion LTL (excluding VAT and consumption tax) were sold, which corresponds to 72.1% of products sold in the same period one year earlier. 18.3 billion LTL worth of oil was refined, which represented 79.2% of the value refined in the previous year time frame. In the same time period mining and government subsidised processing of waste products fell to 65.8% of the level of the previous year, and the trade in industrial products reduced to 81.4% of the prior year numbers. Similarly, the trade in gas equipment, steam generators, electricity generators and air conditioners reduced to 93.3% of the prior year’s level. Just on the basis of the figures provided, it is easy to see why the Lithuanian economy contracted as much as it did.

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However, on the positive side the production of companies in the computer, electronic or optical sector grew by 21.8%. Also an increase in output of 3.7% was seen in the pharmaceutical sector. The first six months of 2009 saw a total trade deficit of 2.2 billion LTL. The deficit was 77.5% lower than in the equivalent time period of the previous year. If the figures for the first half of 2009 are compared with those of 2008, imports fell by 43.5% and exports dropped 31.0%. Disregarding mineral products exports fell by 26.8% and imports by 44.3%.23 The domestic market also experienced a dramatic tumble and consumer demand fell by around 17%. Excluding automotive sales and adjusted in real terms, overall consumer sales fell by nearly 22%. This was approximately the level achieved in 2005. This declining trend continued and from January to April 2010 there was again a decline of 13.7%. By way example new car registrations slumped by 67%. For the whole of 2010 the EU commission estimates a real fall of 5%.24

2.2.

Economic Overview

2.2.1.

GDP and the Rate of Inflation

In the current situation, it has proven to be a burden for Lithuania to couple the domestic currency to the euro via a fixed exchange rate (1 EUR = 3.4528 LTL). This was favourable to the nation as long as business between Lithuania and its trading partners prospered and all forms of products and services were exchanged. Credit and investment could be obtained from the west and domestic products could be exported without the risk of exchange rate fluctuations. However, should the demand for Lithuanian products from overseas markets drop, then export business to those countries collapses. A weakening of the national currency is the result, which manifests itself in devaluation. Though, if the local currency is pegged to the euro at a fixed rate, there is no option of a monetary

23 European Council, Annual progress report on the implementation of the national reform program of Lithuania 2009, p. 31. 24 Fabian Nemitz, Germany Trade & Invest, Wirtschaftstrends kompakt Litauen Jahresmitte 2010, 5 July 2010, p. 6; Vrubliauskiene, Lina, The Lithuanian Economy No. 2, Swedbank, 26 July 2010, p.|3.

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stabilising devaluation. When the stability of the currency can no longer be guaranteed, it can speed up a recession and pushes up inflation rates. And this was in fact the case in Lithuania, which saw a record inflation rate in 2008 of 11.1%. Despite all this, compared to the other two Baltic nations, Estonia and Latvia, Lithuania was initially the least affected by the crisis. In September 2008 Ũ more than a year after the collapse of investment bank Lehman Brothers Ũ the GDP growth in Lithuania was still impressive and at the end of that year amounted to 3.2%. In the same time period Latvia and Estonia had already recorded negative GDP growth rates of -4.6% and -3.6% respectively. Already during the course of 2009 the sharp drop in purchasing power and the resulting competition and price pressures resulted in stagnant and even declining consumer prices. It had the effect that the consumer price inflation has remained at a low level for quite some time. Thus, consumer prices increased between May 2010 and May 2009 by only 0.7%. However, this increase resulted from, in particular, the rising cost of tobacco and alcohol products (11.6%), higher prices on public transport (7.9%) and from an increase in the cost of educational services (13.5%). Nevertheless, soaring energy prices are expected for the whole of 2010 and also in 2001. Analysts from the SEB predict annual inflation of 0.5 % in 2010, 1.2% in 2011 and a rate of not more than 1.8% in 2012.25 2.2.2.

Public Finances

The public finances of Lithuania were already in a poor state prior to the financial crisis and the crisis has only worsened the situation. Government revenues have decreased by around 25 % and at the same time social security spending has increased as a consequence of rapidly rising unemployment. The reaction of the Lithuanian government given the vast scale of the slump in tax revenues was often incompetent and sometimes even counterproductive. While in 2009, consolidation measures of approximately 8% of GDP were undertaken, these measures could not prevent a budget deficit in 2009 which rose to 8.9% of GDP. In 2008 the public deficit stood at 3.2 % of GDP. The government has budgeted for a public spending deficit of 4% of GDP in 2010. However, according to a forecast carried out by the EU commission the public deficit is likely to end up at 8.4% of GDP.26

25 Jenny Nordgren, Country Risk Analysis Lithuania, SEB Merchant Banking, 9 June 2010, p. 4. 26 Fabian Nemitz, Germany Trade & Invest, Wirtschaftstrends kompakt Litauen Jahresmitte 2010, 5 July 2010, p. 3.

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2.3.

Employment and Social Affairs

2.3.1.

Wage Costs

One of the central problems of the Lithuanian economy during the boom period was a sharp increase in wages which was not matched by a corresponding improvement in productivity. The unit labour costs and the expected outlook for wages in the future were in many cases the reason why production locations were not established in Lithuania or they were continuing to be set up in the Far East to the benefit of Asian nations. This still represents an obstacle as to how Lithuania is perceived as a competitive location. In the third quarter of 2008, compared to the first quarter of 2009, average monthly wages had already fallen by around 126 LTL. Again, from the first quarter of 2009 to the first quarter of 2010 monthly wages fell by 162 LTL. Since their highpoint in the third quarter of 2008, monthly wages have now fallen by 288 LTL. Picture 7: Wages 2009-2010, source: Statistics Lithuania, quarterly data on earnings, 2010, www.stat.gov.lt/en/ (retrieved 15 September 2010). 2500 2000 1500 1000 500

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Wage index (increase compared same quarter of previous year), %

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2.3.2.

Job Market

When the numbers for the fourth quarter of 2009 are compared with the first quarter of 2010 a large spike in unemployment is evident. In the fourth quarter the unemployment rate was 15.6%. In the first quarter of 2010 it climbed to 18.1%. This represents an increase of 3% in the distance of one quarter. Nevertheless, Lithuania still has officially the lowest unemployment rate of the three Baltic states (first quarter 2010: Estonia 19.8%, Latvia 20.4%). Admittedly the statistics are not wholly reliable as many companies lay off workers officially in order to avoid social security and similar costs, yet employ those same people off the record. The industrial, construction, trade and service sectors all laid off a vast number of their employees within a short space of time. The principal reasons for these workforce redundancies were falling demand, company restructurings or insolvencies.27 In 2008 241,000 people were registered at the employment office as job-seekers. In comparison to 2007, it was an increase of over 29%. The highest number of new registrants was recorded in the last quarter of 2008. 2.3.3.

Child and Youth Poverty

The effects of the financial crisis also had an impact on the young. Prior to the crisis, Lithuania was already marked out as having some of the highest levels of child poverty in the EU. 25% of children live under the poverty line (101 EUR per person/month). In comparison: about 20% of the country’s adults live below the poverty line. Moreover, Lithuania is one of those countries in which most children who live below the poverty line are found in families with unemployed parents.28 As a consequence of the government’s cost cutting measures to combat the crisis, children and youth have been directly and indirectly impacted. For example social security payments and old age pensions were reduced. These measures have brought with them great risks to the fabric of Lithuanian society in which there is and has been a great deal of solidarity between the different age groups and generations. For example there are many households in which two or more generations are present. Grandparents can no longer support their grandchildren with money

27 European Council, Annual progress report on the implementation of the national reform program of Lithuania 2009, p. 51. 28 Eurochild, Impact of economic and financial crisis on children & young people, 9 October 2009, p. 3.

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or in other ways, since they themselves would have to go short in other areas. A compensating factor for the lack of state support for young people or their parents is now no longer available. In addition to the declining family support state benefits have also been cut. For example, free meals for children in primary school have been abolished. Similarly, the monthly child benefit of 50 LTL has been cut.29

3.

Challenges and Coping with the Financial Crisis

3.1.

Challenges of the Financial Crisis

3.1.1.

Pegged Exchange Rates

For all three Baltic nations the current system of pegged exchange rates for the local currency with the euro has proven to be fatal during the crisis. In contrast with Poland for example, a relaxation of the exchange rate by means of currency stabilising measures was not possible. In fact foreign exchange reserves are threatened with erosion as in the instance of a devaluation of local currency; the Bank of Lithuania is obligated to support the fixed exchange rate through foreign exchange sales. For this purpose they have to draw on central bank money which reduces the monetary base. Where necessary depreciation has to take place via an elevation of the exchange rate otherwise there is the danger of illiquidity in the country itself. It should be noted, however, that many Lithuanian companies and private individuals have borrowed euros, but have their salary paid in the national currency. By dint of abandoning the pegged currency system and elevation of the exchange rate, euro denominated loans become more expensive to service. This would result in further encumbrances and loan defaults. All three Baltic States have decided therefore to continue with the pegged exchange rate system to the euro. Estonia is to be the first of the countries to enter the Euro-zone on 1 January 2011.

29 Ibid., p. 2.

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3.1.2.

Inflation

Falling domestic demand, sinking foodstuff prices and minimal wage growth have led to a retreat in the inflation numbers in 2009. In July 2009 the rate of inflation for the whole year was predicted to be 2.6 %. From an inflation rate of 11.1% observed at the end of 2008, a decline was seen to 7.8% by July 2009. Most of the reduction is most likely explained by the slow grow rate of output prices for industrial goods and services. 3.1.3.

Job Market

Alongside the intensification of the crisis the demand for labour also contracted. In the first half of 2009 there were 42,500 positions open. Of those however 72.6% were fixed term positions. The demand for labour fell by 27% in comparison to the same time period a year earlier. The shake out in employment hit the unskilled and semi-skilled workers as well as low qualified employees hardest. As the economic situation deteriorated, more and more qualified personnel were impacted by measures to reducing staffing levels. Also of particular note was that the rate of unemployment among men grew at almost double the rate of women. In 2009 on average 41.8% of the unemployed were women and 58.2% were men. A year earlier this figures were almost exactly the other way round (men: 41.6%, women: 58.4%).30 The sectors most affected by job losses were construction, mining and quarrying, retail and the hotel industry. By contrast, employment in the IT sector and related industries as well as in agriculture was relatively safe.31

30 Statistics Lithuania, quarterly data on labour force, 2010, www.stat.gov.lt/en/ (retrieved on 15.09.2010). 31 Lina Vrubliauskiene, The Lithuanian Economy No. 2, Swedbank, 26 July 2010, p. 1.

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Picture 8: Unemployment rate in %: 4th quarter 2008 – 1st quarter 2010, Males and females, Urban and rural areas, Total by age (per cent), source: Statistics Lithuania, 2010, www.stat.gov.lt/en/ (retrieved 15 September 2010).

The problem of youth unemployment deserves special attention. Next to Spain the Baltic area belongs to the frontrunner for youth unemployment in Europe. For example, the youth unemployment rate during 2009 in Lithuania stood at around 30%. On the one hand, youth unemployment can be seen to be a structural problem. After independence from the Soviet Union a whole swathe of heavy industry disappeared in one go and thereby the demand for labour. On the other hand, many young people in Lithuania were choosing the wrong subjects and qualification areas. Even among academics there were high rates of unemployment because the art and humanities, including such subjects as philosophy, were attracting more students than engineering. The promotion of awareness among school leavers as to the importance of an application oriented education is becoming ever more relevant.32

32 Daniela Friedinger, Triste Aussichten im Baltikum, in: Wirtschaftsblatt.at, 18 August 2010, www.wirtschaftsblatt.at/archiv/triste-aussichten-im-baltikum-434504/index.do (retrieved on 10 September 2010).

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3.1.4.

Migration

A further issue posing a real problem for Lithuania is the high rate of emigration, which has led to net outward migration over a number of years. Various studies and research have shown that migration has a direct impact on a nation’s economic circumstances. This phenomenon can be seen until a country reaches a certain higher living standard. In this case, the emigration of workers and the so-called ‘high potentials’ stops and the number of people returning rises. However, certain peculiarities are special to Lithuania: the country had long been oppressed by either Tsarist or, following on from that, Soviet regimes, so that according to Lithuanian conception the nation is based on ethnic and cultural criterion. Therefore, the diaspora is a part of the national collective.33 In 2004 and 2005 there were particularly high levels of emigration from Lithuania. With the onset of economic recovery, the numbers emigrating slackened and the number of immigrants or migrants returning home increased steadily. With the deteriorating economic situation at the beginning of 2009 the number of emigrants also jumped noticeably34. However, the economic impact that Lithuanians living overseas have on the Lithuanian domestic economy, should not be underestimated. As an example, in 2007 Lithuanians living overseas transferred 870 million LTL back to Lithuania which was the equivalent of 2% of GDP in that year alone.35

33 Sebastian Gobert, Litauen – Du kannst mich mal!, in: cafebabel.com, 25 June 2009. 34 OECD, SOPEMI Country Notes 2009 Lithuania, http://www.oecd.org/dataoecd/42/49/44067898.pdf (retrieved on 12 September 2010). 35 Sebastian Gobert, Litauen – Du kannst mich mal!, in: cafebabel.com, 25 June 2009.

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Picture 9: International Migration by statistical indicator and year, Republic of Lithuania (Persons), source: Statistics Lithuania, 2010, www.stat.gov.lt/en/ (retrieved 12.09.2010).

Emigrants

20 09

20 08

20 07

20 06

20 05

20 04

20 03

20 02

20 01

24,000 22,000 20,000 18,000 16,000 14,000 12,000 10,000 8,000 6,000 4,000 2,000 0

Imigrants

The results from the micro census in 2001 showed that emigration at the beginning of the century was a temporary affair rather than a permanent relocation abroad. Thus, typically most Lithuanian migrants do not stay overseas for longer than one year. After accession of Lithuania to the EU, however, this changed matters somewhat, since there are no movement restrictions for workers within the EU, and this enabled workers to move freely within member states. In 2007, for example, 66% of Lithuanian emigrants migrated to EU Member States. The main destinations for emigrants are the United Kingdom, Ireland, Germany and Spain. Outside the EU they are the United States, Russia and Belarus.36 Emigrants have been predominantly male. Since 2003 however, there has been a sharp reduction in male emigration, so that at present more women than men are now emigrating. This could be an indicator for family reunifications, which can lead to long-term emigration. This assumption is supported by the fact that the total value of money transfers from migrants back to Lithuania has started to decline sharply.

36 OECD, SOPEMI Country Notes 2009 Lithuania, http://www.oecd.org/dataoecd/42/49/44067898.pdf (retrieved on 12 September 2010).

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Nevertheless, it is also noteworthy that the older generation of migrants return to Lithuanian at the end of their working life. In addition many Lithuanians who have studied abroad return to Lithuania after completion of their exams to begin their first job.37 3.1.5.

Banking System

In the first quarter of 2009, the Lithuanian banks slipped into the red. As a consequence lending to the public and sector was curbed. The volume of credit in the period January to August 2009 decreased by 7.7% to 66 billion LTL. As a comparison, from the back end of 2005 to the end of 2008 the volume of credit tripled from 26 billion LTL to nearly 71 billion LTL. Due to the deteriorating economic environment – particularly in transportation, real estate and construction – many debtors are now unable to repay their loans, leading to high credit loan default losses at the banks. Due to unrecoverable debt, the banks had to record higher provisions and slipped into the red for the first quarter of 2009 accordingly. SEB reported for the first nine months of 2009 a loss of 626.4 million LTL, Swedbank a loss of 592.3 million LTL and DnB Nord a 237.2 LTL million loss.38 These high losses were responsible for the reduced rate of lending to the private sector. The resulting lack of liquidity in the private sector alone (and also in connection with the necessary loss adjustments to receivables and property) led to an increasing number of bankruptcies. The stricter lending guidelines came about through changes in the underlying capital adequacy requirements backing the loans and as a result of the changes in the assessment of risk by banks. Thus the option of the inclusion of the anticipated annual profit in the equity basis was restricted. The risk valuation of property loans is now undertaken according to criterion which is in fact tighter than those provided for under Basel regulations. Furthermore, loans that were secured through commercial property were valued at 100% risk for the bank.39

37 Midaugas Butkus / Kristina Matuzeviciute, Emigration and remigration situation in Lithuania, Vadyba 2009, Vol. 14, Nr. 1, p. 32. 38 Fabian Nemitz, Germany Trade & Invest, Litauische Banken schreiben hohe Verluste, 28 October 2009. 39 European Council, Annual progress report on the implementation of the national reform program of Lithuania 2009, p. 16.

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To solve the distrust and the associated problems in the inter-bank market, the Bank of Lithuania corrected the liquidity loan process. The bank amended the capital ratio for Lithuanian bank reserves down from 6% to 4%. 3.1.6.

Insolvencies

A consequence of the development in bank lending was, as already indicated, an increasing number of insolvencies. In particular, the areas of manufacturing, construction, wholesale and retail trade as well as transportation were hit. The number of company insolvencies doubled in 2009 compared to 2008 and reached an unchartered level. At this point, it is also important to note that a functioning legal insolvency practice procedure does not exist in Lithuania. Not only are re-organisation and restructuring procedures the exception. Also the fact that the insolvency procedure rules rarely lead to even a partial satisfaction of the creditors’ claims, results in mistrust and blocks economic development. The reasons for this are varied as well as straightforward: most insolvencies are carried out via an insolvency practitioner who is chosen and paid by one or more of the interested parties and appointed on the according recommendation of the judge. A non-partisan administration, including equal treatment of all creditors, is therefore only the case in a few exceptions. The fact that a challenge by the insolvency practitioner as to the validity of transactions only occurs rarely in practise combined with a frequent reluctance of state authorities to investigate or to impose criminal law sanctions on preferential treatment of creditors and/or intentional transfer of assets prior to insolvency contributes to a destabilisation of the economy. Frequently encountered were the socalled ‘Phoenix cases’ in which all assets were transferred to a Newco (specifically created for this purpose) prior to the expected insolvency. The result being that the persons involved were able to carry on trading with the Newco, avoiding most of the negative consequences of the insolvency. Particularly disastrous were the affects regarding the time frame in which an insolvency application is to be submitted by the managing director. There are no clear guidelines as to submission and therefore companies, despite meeting the insolvency criteria, carry on for long periods, with the result that on application very few assets are left at the disposal of the creditors. In addition, in these cases usually a personal liability of the manager director is denied.

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Picture 10: Instituted and completed bankruptcy processes from 1993 - 2009, source: Statistics Lithuania, www.stat.gov.lt/en/ (retrieved on 12 September 2010). 2 000 2.000 1843

1 800 1.800 1 600 1.600 1.400 1.200 957

1.000 799

800

642

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600

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Instituted bankruptcy procedures

3.1.7.

106

Completed bankruptcy procedures

Downrating from Credit Rating Agencies

Due to the major downturn in Lithuania the BBB rating from Standard & Poor’s has fallen into danger. In spring of 2009 Lithuania managed to hold on to this rating. In the same time period the other two Baltic nations, Latvia and Estonia, were downgraded by the rating agencies. However, the downgrade was not as drastic as feared, so that Lithuania did not receive junk status (e.g. under BBB-).40 Fitch also downgraded the Baltic States. Estonia went from A- to BBB+, Latvia from BBB- to BB+ and Lithuania from BBB+ to BBB. Thus, only Latvia received junk status.41 These ratings led to the unfortunate situation that Latvia could no longer go to the credit market and obtain funds, and had to turn to the IMF in order get the required funding.

40 Edward Harrison, Baltics: Fitch downgrade and more downgrades to come, Roubini Global Economics, 13 April 2009, http://www.roubini.com/euro-monitor/256341/baltics__fitch_downgrade_and_more_downgrades_to_ come (retrieved on 25 August 2010). 41 Edward Harrison, Edward, More trouble in the Baltics as S&P downgrades, Roubini Global Economics, 11 August 2009, http://www.roubini.com/financemarkets-monitor/257474/more_trouble_in_the_baltics_as_s_p_downgrades (retrieved on 26 August 2010).

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3.2.

Challenges of the Financial Crisis

3.2.1.

Job Market

A number of measures were attempted in order to combat the crisis in the job market. Thus, employment measures and unemployment insurance were improved as well as measures for those who had lost their jobs. On 14 July 2009, parliament adopted the ‘law for employment initiative’ (official register 2009 n, No. 86-3638). The aim of the law is to mitigate the impact of the financial crisis on the unemployed, create means by which job positions can be maintained and to give a larger number of people the opportunity to participate in employment activities. The law should help companies cope better with the difficulties arising from the financial crisis and help to avoid disproportionate job losses. Those companies that announce layoffs as well as those introducing short-time working receive a free place on activities of the employment office regarding vocational training. In addition, companies offering social work during idle time receive a 50% subsidy from the employment office for the salaries payable. Equally the new legislative measures are also designed for the long term unemployed, in order to enable their return to the job market. Those who have been unemployed for two or more years receive the right to participate in schemes which encourage people to obtain work qualifications. Similarly, those who were not able to work because of family circumstances, such as raising children or home care will also be supported. In addition, in the course of 2010, numerous measures have been implemented to provide incentives for companies to create new jobs. For example, new regulations governing work from home were introduced and a relaxation of the restrictions regarding working hours to favour overtime arrangements and flexible working hours e.g. by expending the option to apply working time accounts to various activities. 3.2.2.

Taxation

The worldwide economic crisis has hit the still unstable and largely debt finance dependent economy of Lithuania unprepared and with serious implications for the public budget. Against this background, Lithuania has grasped at particular fiscal measures. The purpose of these measures is firstly to stimulate the economy and

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secondly to consolidate the public finances. The tax changes that are being discussed for this purpose stand in the middle of conflicting priorities and are also associated with painful cuts in government spending. This means that the government had to overcome considerable parliamentary and non-parliamentary opposition and will have to do so in the future. Meanwhile, however, a number of amendments to tax laws have been adopted. They have resulted, in part, in broad changes in the national taxation system. Mostly these changes were implemented by 1 January 2009 and in the following two quarters. On 1 August 2009 further tax laws were adopted. In addition, ongoing tax changes are to be adopted with effect from tax assessment period 2010. Further measures from the tax package are expected at the end of 2010. Corporate Income Tax

The rate of corporate income tax on company profits was increased with effect from 1 January 2009 from the previous rate of 15% to 20%. This tax increase was revoked as at 1 January 2010 so that corporate profits in the assessment period 2010 are again taxable at 15%. Furthermore, the tax relief for partnerships and sole proprietorships to the amount of 25,000 LTL was abolished. Also from now on, all companies, regardless of their legal form (with the exception of non-profit organizations) in which not more than ten workers are employed and whose income does not exceed 500,000 LTL are to be taxed at 5%. If a company‘s profit is paid out to natural persons and not taxed at the company level, the amount distributed is fully taxable at 20%. This ruling applies to profit distribution from tax year 2009 onwards. From 1 January 2010 interest paid to foreign companies is exempt from withholding tax in Lithuania if the foreign company has been registered or incorporated in any other way in a Member State of the European Economic Community (EEC) or in a country with which Lithuania has an appropriate double taxation agreement. Dividends paid by domestic companies are generally charged at 15% withholding tax. The dividends are usually exempt from taxation if a company holds not less than 10% of the shares for a period of more than twelve months. Within the assessment period for the 2010 tax year it is possible, under certain conditions, to transfer current tax losses from domestic and overseas companies to Lithuanian companies in the same group of companies.

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The ability to carry forward tax losses from 2010 onwards to all subsequent tax years is basically unlimited.42 The companies investing in fundamental technological upgrade are entitled to reduce the taxable corporate income by 50%. Such incentive is applicable for expenses incurred during the periods from 2009 till 2013. Farms and agricultural activities were not excluded from the taxation increases. Provided that 50% of their income is derived from agricultural activities and thus until now was tax exempt, these gains will be taxed at 5% for 2009, 10% in 2010 and 15% in 2011 and later. For the assessment periods from 2010 onwards, bad debts can be written off at a higher amount than previously permitted, even if no proofs of efforts to recover the claim or the non-recovery of the claim are submitted. Moreover, other conditions regarding the submission documentation, compliance with which previously was virtually impossible, have been made considerably easier. Income Tax

From 1 January 2009 the personal income tax is reduced to 15% for all kinds of income except dividends and other profits distribution that are subject to 20% rate. Also from 1 January 2009 the non-taxable amount is applicable only for employment income and is reduced proportionally to the increase of such income. For the monthly employment income of 3,150 LTL and more the non-taxable amount is not applicable. From 1 January 2010 when determining the taxable base for personal income tax, sole traders may make a standard professional expenses deduction equal to 30% of the total revenue achieved in the relevant tax year, without having to provide documentary proof in this connection. As at 1 January 2010 new rules on benefits in kind were introduced. They will apply in particular to employee loans and the use of company cars for private purposes.

42 Lithuanian Tax Administration, Pelno mokescio pakeitimai 2010 metais, http://www.vmi.lt/lt/?itemId=10814109 (retrieved on 21 June 2010).

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Value Added Tax

From 1 January 2009 the standard VAT rate was increased from 18% to 19% and with effect from 1 September 2009 it was increased to 21%. It was originally intended to abolish all reduced VAT rates from 1 January 2009. But the application of the reduced VAT rate of 9% for books and non-periodical publications and information as well as the 5% rate on pharmaceutical products and medical devices fully or partly reimbursed from the state fund has been extended until 31 December 2010. Until 31 August 2011 services for the provision of households with heating and hot water will be taxed at the reduced VAT rate of 9%. From 1 May 2010 the advanced VAT has to be paid to the state budget if the average of VAT amount payable into the state budget per calendar month for three successive months exceeded 10 million LTL (until 30 April 2010 this threshold was 100,000 LTL). Other Taxes

Since 1 January 2009 the following property assets are no longer subject to property tax: Y

Property used by a natural person to earn income from agricultural activity;

Y

property which is owned by legal entities or used by them, if more than 50% of the income of that person during that fiscal year is derived from agricultural activities.

Moreover, duty on tobacco products was increased to such an extent that those products are now five times more expensive than before. 3.2.3.

Social Security Insurance

From 1 January 2009 the list of income subject to the social security contributions has also been extended. Alongside the employment income such contributions are levied on the income of sportsmen and sportswomen, and sports performers, royalties earned, income of farmers and their partners (if certain criteria are met). The amount of the social security contributions depends on the kind of the income as well as the period for which they have to be paid as for some kind of income a transitional period has been foreseen during which the social security contributions will be increased gradually.

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From 1 January 2010 the calculation basis for the determination of social security contributions for individuals who carry out a sole trading activity, amounts to 50% of their income (without deduction of compulsory contributions for health insurance and social security contributions) which was achieved from their activities. This tax ruling also applies to the determination of the social security contributions on incomes earned by sportspeople, entertainers and income derived from agreements on copyright. The maximum amount of the assessment basis for the above persons is determined per calendar year (so-called ‘Social Security Contribution Assessment Ceiling’) using the following formula: 48 times the amount of ‘statutory insured income’ the government sets for each year. The ‘Social Security contribution assessment ceiling’ stands currently at 71,424 LTL (1,488 LTL x 48). Health Care and Health Insurance

The health sector and thus health insurance in Lithuania was subjected to radical cost savings. The budget of the state health services in 2008 amounted to 1.284 billion EUR. For 2009, an increase of 6.84% was predicted. At the end of 2008 however, the budget of the health system was reduced by 6.4% in response to the financial crisis. Consequently, in many areas of healthcare, savings had to be made. These savings were accomplished in two steps. Firstly, the salaries of the employees state health insurance system were reduced. The job evaluation scale on which their salary payments are based was lowered from 1.0 to 0.89. In addition, savings in the area of pharmaceutical drugs and medical devices have been made. Most of the country wide health facilities chose the strategy of reducing staff salaries. Downsizing through reduction in headcount was mostly avoided. Moreover, many mergers of various institutions were conducted. For example, the Health Information Centre merged with the Hygiene Institute, the Centre for Infectious Diseases with the AIDS Centre and the Agency for Alcohol Control with the Drug Control Facility, leading to a net reduction in staffing of 20%-30%.

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In 2009 the Health Department reduced the budget for health facilities by 22%. The expenditures on salaries and benefits were reduced by 10% and other purchases were reduced by 18%. The salaries for non-civil servant employees were reduced by 13.5%. The objective of this first round of cuts was to prevent a rise in unemployment. According to official announcements, this first round of cuts had no impact on access to health care for the insured, since the bulk of the savings had been achieved through salary reductions. But this statement must be doubted. In particular, there is the widespread practice whereby a sufficient and timely treatment is only undertaken if private payments are made by the patient to the personnel treating them. These practices are expected to have increased as a result of salary cuts. Secondly, the VAT on medical drugs was increased at first to 19% and then later raised to 21%. As a result the deficit in the health insurance fund was reduced. In addition, savings in hospital stays and the financing of the hospitals were initiated. The trade in medical drugs has been regulated and a pricing system was introduced which is designed to ensure that the price of imported drugs does not exceed the EU average. According to the principle of ‘higher sales volume – lower prices’ special prices for common medical drugs are to be negotiated with pharmaceutical companies.43 For 2010 a further round of cuts of circa 5% are planned. The impacts on the access to patient treatment are not presently foreseeable.

43 Danguole Jankauskiene, Visuomenes sveikata, The impact of the economic and financial crisis on the health care sector in Lithuania, 2009, p. 18.

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Picture 11: Reduction in the approved State Health Insurance Fund expenditure for different types of services in 2008 and 2009, source: Danguole Jankauskiene, Visuomenes sveikata, The impact of the economic and financial crisis on the health care sector in Lithuania, 2009, p. 18.

6.37%

Overall devrease in expenditure

6.40% 6.23%

85%

4.00%

Personal health services Compensations for medications and medical aids Compensations for stays in sanatoria and rehabilitation centres Medical aids and cetralized purchasing expenditure orthopaedic aids

10.00% 9.00%

4.00%

Expenses for health services programmes Administrative expenses

Indeed savings in the health system are not just reflected in this area. In addition, the basis of calculation for compulsory contributions to health insurance has changed. From 1 January 2010, the so-called ‘passive income’ (e.g. dividends, interest, transfer of property) is not subject to compulsory contributions to health insurance. For 2009 a corresponding contribution of 6% was paid on such income by fully tax liable persons resident in Lithuania. The basis for the determination of the compulsory contributions for health insurance for individuals with sole trading activities will be in future the basis also for the calculation of social security contributions (i.e. 50% of generated taxable income). The contribution for health insurance that covers medical care amounts to 9% of gross salary. Of this 6% is borne by the employee and 3% by the employer.

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Old Age Pension Scheme

The reformed pension scheme was subject to a significant change. It was namely decided that the amounts transferred to the private pension funds were no longer to amount to 5.5% but only 2% (to be transferred via SoDra). The regulations originally provided for a contribution of 5.5%, which was to be increased to 6% from 2012 to 2014 and again reduced to 5.5% in 2015. Those measures were aimed at improving SoDra’s tight financial situation. As a consequence of their implementation the household costs of SoDra are expected to fall by about 604 million LTL in 2011. Additionally, the reduction to 2% should be transitory only and the contribution rates should rise again to 5.5% in 2011. Between 2012 and 2014 it is planned to increase the contributions to the private pension funds to 6% in order to make up for the said reduction to 2%. However, the contributions will not be increased to 5.5% in 2011. Eventually it was resolved that in 2011 2% would also be transferred to the private pension funds. No wonder then that the resolution of the parliament was contested before the constitutional court. The plaintiffs claim that the reduction of contribution rates constitutes a violation against the trust protection principle deeply rooted in EU law.44 The pension insurance contributions amount to 26.3%, of which 3% are paid by the employee and 23.6% by the employer. 3.2.4.

Law

Company Law

Not only budget cuts and social security savings were undertaken to counteract the recession. There have also been numerous changes to company law aimed at reducing the time and bureaucratic burden associated with company formation as well as enabling amendments to company incorporation documents. The present regulations reduce the time required for company registration from five to three working days after the submission of all necessary documents to the registration authorities and payment of the registration fee.

44 Verslo zinios, Nr. 144 (3296), 2010, p. 3

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Additionally, the obligation to specify the company registered office in the foundation deed was abolished, as a result of which it is no longer required to amend the company deed whenever the company’s registered office is relocated. Another change concerns the abolition of the duty to file the specimen signatures of authorised company representatives with the registration authorities, in force till the end of 2009. At present, the registration authorities must be provided with a complete list of shareholders of a legal entity. All companies established prior to 1 March 2010 had to lodge the above list of shareholders by 1 October 2010 to satisfy this requirement. Certificates issued by the registration authorities have also been changed as a measure to adapt the relevant legal provisions to those binding in Germany and Poland. The registration certificate has been abolished and substituted by a register excerpt, which contains more information and is cheaper to produce. New principles for the appointment and dismissal of management board members have been adopted. They allow the company’s manager to resign pursuant to the joint stock company law. The manager of the company has to be dismissed by a resolution of the organ by which he/she had been appointed (management board or shareholders’ meeting). If a decision of the management board or shareholders’ meeting is not taken within 15 days after the application of the resignation the contract ends the next day after that period expires. If the repeated shareholders’ meeting does not take place the contract ends as well, as of the following day. The procedure for establishing a sole trader business has been made much simpler. Since the beginning of 2010 such enterprises can be registered via the Internet. The relevant documents are then generated automatically and furnished with an electronic signature. The obligation to have the foundation document notarised no longer applies. Labour Law

Starting from June 2010, employers and employees are allowed to conclude teleworking contracts. The purpose of this amendment is to flexibly organise the work processes and to reduce the work-related costs. Teleworking contracts can be concluded both for tasks which can be performed at home without any problems and those which require the use of telecommunications equipment. The new regulations also set forth the cases in which the employer is entitled to demand overtime. They include measures taken by the company to prevent an accident or its outcome in a situation when due to an unexpected accident or illness

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the outstanding work cannot be completed within the schedule, or by clean-up work, loading and unloading operations in transport companies as well as in cases stipulated in the employment contract. However, the employer’s right to demand overtime from individual employees is restricted. The overtime may not exceed four hours per day and 120 hours in a year. This total limit can be extended to 180 hours if the employment contract provides that. It has become easier to conclude contracts of employment for a specified period. The duration of contracts of employment and contracts for a specified work may now be limited to a period of up to five years. If an employment contracts has been concluded for a newly created job position, its maximum lifetime may not exceed two years or the deadline of 31 July 2012. The total number of fixed term employment contracts may constitute at most 50% of all employment contracts concluded in a given enterprise. Also newly included is the possibility to suspend the contract of employment for up to three months. Pursuant to the said provisions the employee is entitled to discontinue the performance of his main tasks and responsibilities as provided for in the employment contract for a period of up to three months if the employer either has not fulfilled the obligations he was charged with by virtue of the law, contract of employment or collective bargaining agreement or has not paid the compensation to the employee for over two months. In such a case the employee must inform the employer in writing on his suspending the performance of the tasks and responsibilities three days in advance. As a consequence of the suspension, the employee is exempt from the obligation to perform work and receives no remuneration. If the employment contract is suspended for justified reasons, the employer must pay the employee a monthly compensation in the amount equal to the minimum wage. If the reasons for suspension prove to be unsubstantiated, the employee has to pay damages to the employer. As from 2010 it is additionally possible to keep summarised work time records provided that such a need exists in an enterprise and the opinion of the company workers’ representative has been duly accounted for and such an option has been otherwise set forth in the collective bargaining agreement. Summing-up: the liberalisation of Lithuanian labour law, though the introduction was delayed, has provided the employers and employees with new and urgently needed opportunities allowing them to react flexibly to economic changes and to help stimulate the now poorly performing business and labour market.

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Introduction of Private Bankruptcy

The plans for the near future include the introduction of private bankruptcy, i.e. insolvency proceedings for natural persons. Although the plan is still subject of dispute among the political circles, Lithuanian government has already adopted a basic resolution providing for the introduction of this procedure. According to Dainius Kreivys, Minister of Economic Affairs, the bankruptcy regulations should apply to persons who already have debts and to new debtors. The plans provide for the possibility to initiate the insolvency proceedings by the creditor or by the debtor. All insolvency cases and involved persons shall be made public. The insolvency proceedings shall not apply to individuals who are still solvent or who have caused their insolvency intentionally. Neither shall they be initiated if ten years have lapsed since the insolvency beginning. The purpose of introducing the private insolvency is to give consumers the opportunity to release themselves from debts and to live an orderly life. The consumers are considered a fundamental constituent of a sound internal market, as they are those who can boost consumption. The basic prerequisite for the success of these measures is establishing such financial terms and conditions which can be fulfilled by the party to the proceedings. Latvia, where the debtor is obliged to pay the monthly minimum wages to the insolvency administrator, can be cited here as a cautionary example: in reality no honest debtor can afford such proceedings. On the other hand, the proceedings should not put unacceptable burden on the creditor, since this could trigger a domino effect leading to the creditor’s economic difficulties. 3.2.5.

Further Measures

Governmental financial support for enterprises

In order to counteract the credit crunch for enterprises, the government has launched a relevant financial support programme. The support is to be rendered through microloans, small and big loans, and guarantee refunds. Pursuant to the ‘Act on Development of Small and Medium Size Enterprises’, the government has made available to the banks the financial funds to be granted to companies in the form of loans. The loans are granted in Lithuanian litas for a period of four years and are subject to an interest rate of 5.5% p.a. The maximum loan amount is 175,000 LTL. The loans can be awarded only to Lithuanian enter-

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prises operating in the wholesale trade, construction, insurance, finance and legal services industries as well as agricultural holdings which have been duly entered in the register. The purpose of microloans and small loans is to keep the investment opportunities open to enterprises and to refund the investment expenses incurred by them. The loans are liable to interest rate calculated according to the six-month VILIBOR (inter-bank offered rate). The above rate is then reduced by 0.5% and increased by the bank‘s margin. The medium size enterprises are supported through small loans granted from the EU subsidies. In this case the maximum loan amount is 350,000 LTL. The loan interest rate depends on the region in which the borrower is based. For borrowers from Vilnius, Kaunas and Klaipeda, Lithuania’s largest cities, the interest rate is calculated according to the three-month VILIBOR less 1% and increased by the bank’s margin. The margin may, however, not exceed 2.2%. The interest rate binding for companies from other locations is the three-month VILIBOR less 2% plus the banks margin (the maximum interest rate being 2.2%). In addition to that, the so-called ‘open loan funds’ have been introduced. They are available to banks granting loans to small and medium size enterprises. A bank applies for a loan from the government. In case of positive check results the loan amount is transferred to the bank and from the bank to a company. The maximum loan amount is 1.5 million LTL, of which 25% has to be secured by the bank‘s share capital. The loan repayment period is 60 months, which, however, may be extended by twelve months. The loan interest rate is determined using the three-month VILIBOR plus 0.1% and the bank’s margin (the rate may not, however, exceed 3%). Lithuanian enterprises receive loans also from the European Investment Fund. The loans can be granted by banks which have concluded agreements with the European Investment Found. However, such loans have to be secured by 50% of the banks‘ share capital. The maximum loan amount may not exceed 1% of the bank’s total loan volume. The loan repayment period is 120 months. Each borrower may take out only one loan. In the event the bank demands further guaranties securing the loan, such guaranties can be provided by INVEGA (a governmental guarantee institution). INVEGA provides a guarantee of up to 80% of the loan amount. The remaining loan amount is to be secured by the borrower through the establishment of lien.

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Research and Development

The Lithuanians economic potential must be enhanced through the research and development measures. To this end changes have been introduced with respect to corporate income tax. Enterprises investing in new technologies, including communications solutions and IT hardware and software, can classify up to 50% of the related expenses as tax-deductible costs. Moreover, government has launched an innovation programme aimed at supporting the research and development activities. The Ministry of Economic Affairs has promised to aid 21 projects in this area (Official Journal 2008, No. 87-1125). The aid is mainly sourced from the financial funds amounting to 36.6 million LTL made available through the EU structural funds for laboratories and research centres. In 2008, the Ministry of Economic Affairs allocated 255,000 LTL for enterprises working on research development projects in collaboration with scientific research centres.45 Foreign Direct Investments

In the crisis period, foreign direct investments were an important and reliable financial source which mitigated the effect of the crisis. According to calculations as at 1 April 2009, the value of foreign direct investments totalled 32.31 million LTL, which means an increase of 2.6% as compared to the beginning of 2009. The most significant direct investments were reported for production (23.1%), real property, leasing and other sectors (16.5%), financial agency/brokerage (16.4%), transport, warehousing and telecommunications (14.6%), as well as whole and retail sale (13.7%). Accordingly, the expected recovery will at its starting point also rely mostly on foreign financial resources. Planning and building of industrial and business parks are other measures undertaken to stimulate direct investments. The industry parks in Siauliai, Kedainiai district, Marijampole municipality as well as in the free trade zone of Klaipeda were completed in 2009. The investments were financed from EU funds. In the near future investors will be offered a total of 614.75 hectares of land for investment purposes. At the moment four private investment projects are under way, which are expected to bring in up to 300 million LTL and create 200 jobs.46 45 European Council, Annual progress report on the implementation of the national reform program of Lithuania 2009, p. 25. 46 European Council, Annual progress report on the implementation of the national reform program of Lithuania 2009, p. 25.

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Picture 12: Foreign direct investments at the beginning of the year by statistical indicator and year, Republic of Lithuania, source: Statistics Lithuania, 2010, www.stat.gov.lt/en/ (retrieved on 24 September 2010). 40,000 35,000 30,000 25,000 20,000 15,000 10,000 5,000

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In March 2010, “fDiMarkets.com“, the website publishing the data on foreign direct investments worldwide, announced 28 foreign investments to be launched in Lithuania in 2009. The investments brought over 3.5 million LTL and 5,300 new jobs to the country.47 The Lithuanian Minister of Economic Affairs, Dainius Kreivys has set the goal of doubling the foreign direct investments in Lithuania within five years. According to the Lithuanian Statistical Office, the foreign direct investments amounted to 2,893 EUR per capita in 2009. Lithuanian government expects this to rise to 5,200 EUR per capita. In 2010 the Swedish SEB-Group intends to expand its activity in Lithuania by establishing new branch banks, IT divisions or customer service centres. These will be the bank’s first organisational units performing not customer service but solely internal company functions. In this way, 150 jobs will be created. Another investor is Western Union, which is going to establish a ‘Global Operations Centre of Excellence’ in Lithuania and thus create 200 work places. 47 Financial Times, Crossborder Investment Monitor, 2010, http://www.fdimarkets.com (retrieved on 25 September 2010).

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The Barclays Group opened 2009 a new information technology centre in Vilnius. In the same year, IBM and the government signed a letter of intent providing for establishing a joint research facility in Lithuania. Moog Medical, a US manufacturer of medical equipment, has moved parts of its production, research and development to Lithuania. The total value of the investment is 4 million EUR. The same is planned by Systemair, a leading manufacturer of ventilation equipment based in Sweden and Gruppo Sopena, the Spanish manufacturer of aluminium components.48 Renewable Energy and Energy Saving Programmes

In 2009, measures aimed at the development of renewable energy sources and energy saving were undertaken with the support of the EU structural funds. Those measures comprised 216 agreements for a total of 540.69 million LTL providing for the renovation of public buildings, improvement of efficiency of energy production, modernisation of power supply lines and central heating. The improvement of energy efficiency of public buildings constitutes one of the central issues of the energy saving programme. Most programme-related costs are covered from the EU structural and cohesion funds. Total EU subsidies to be granted between 2007 and 2013 amount to 1.07 million LTL. The subsidies will cover the renovation of 375 public buildings altogether.49 Up to now, renewable energy has played a very minor role in Lithuania. Until 31 December 2009 most of electricity in Lithuania has been produced from nuclear power. Besides that, fossil fuels, such as shale oil and gas, have constituted important energy sources. After the power plant Ignalina went offline on 31 December 2009 pursuant to the requirements set out in the EU accession treaty, Lithuania changed from an energy exporter to an energy importer. Due to political failures, the energy market was not prepared for that change. As a result, the competition among electricity suppliers is very limited and the monopoly position of the well-established suppliers keeps the energy prices high. The high price levels are also caused by a strong dependence of the Lithuanian power industry on gas and oil supplies from Russia, where pricing is often determined by political interests. 48 Alfa.lt, Kubilius: Western Union is yet another result of consistent, 2010, http://www.alfa.lt/ straipsnis/10363038/?Kubilius..Western.Union.is.yet.another.result.of.consistent=2010-05-28_19-13 (retrieved on 28 May 2010). 49 European Council, Annual progress report on the implementation of the national reform program of Lithuania 2009, p. 38.

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For this reason the development of renewable energy sources is one of the vital goals of Lithuanian politics. The development of renewable energy sources should lead to the reduction of Lithuania’s dependence on suppliers of fossil fuels (including particularly Russia). On the other hand, it will allow significant reduction of greenhouse gas emission. The first achievements in the development of renewable energy sources have already been reported. Between 2007 and 2008, the use of renewable energy increased by 5% to altogether 9.1% of the total energy consumption. In 2008, the production of electricity from renewable energy sources grew by 4% to 4.3%.50 At present, a large number of onshore wind parks are being built or planned. These large-scale projects enable not only the Lithuanian construction companies to survive in a period of an almost complete stagnation of the construction sector. But the projects are also a profitable opportunity for foreign providers of high-tech and specialist products (wind power plants) as well as the related services (such as deep foundation or construction of foundations). Also the erection of an ultra-modern waste incineration plant with the capacity of 34 tons per hour in Klaipôda offers an alternative option to traditional energy sources. It is, at the same time, a step toward solving the waste disposal problem. EU subsidies

Lithuania has become the ‘European Champion’ with regard to the use of EU subsidies. EU subsidies are an important funding source for investments in Lithuania. The value of EU subsidies in the 2010 national budget amounted to about 2.3|billion EUR. The EU funds are used mainly for infrastructure projects and for the improvement of energy efficiency. They are granted primarily a part of cohesion and regional development funds. Until 2013, Lithuania is expected to receive about 4.1 billion EUR for infrastructure alone. The funds will be spent on, among others, the extension of Via Baltica, the main road corridor between the three Baltic countries, and the Rail-Baltica rail transport project. The three Baltic countries are among the biggest recipients of EU subsidies in the field of environmental technology. The main objectives of subsidies include the improvement of drinking water supply to the population, environment-friend-

50 Ibid., p. 40.

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ly treatment of sewage produced by industry and households as well as the establishing of a centralised recording system for sewage production and treatment. At present, two large waste incinerating plants are being planned in Lithuania.51 Lithuania has also applied several times to the European Commission for granting support from the EU globalisation funds. On 30 November 2009, the European Commission approved Lithuania’s application for support through the European Globalisation Adjustment Fund (EGF). The resources obtained from the fund will provide support in the amount of 258,163 EUR to 480 workers dismissed from the manufacturer of electrical equipment Snaigô and its sub-suppliers UAB Jugos kabeliai and UAB Hoda. On 18 January 2010 the Commission approved Lithuania’s application for funds to help 806 construction workers to find employment after redundancy. The EGF has appropriated approximately 1.2 million EUR for this purpose. Additionally, following a separate application, the EGF will lay out a total of 1,185,569 EUR to support 491 clothing industry workers and 636 furniture industry workers.52 Until 2013 Lithuania will receive up to 1.1 billion EUR from the EU social fund to create workplaces for highly qualified staff, support social integration and adult education, support research workers in achieving the desired qualifications as well as to improve the efficiency of public administration. Apart from this, the EU provides financial support for infrastructure projects. Those projects include the extension of the seaport Klaipôda. Along a distance of 1 km new docks as well as roads and railway sidings providing access to them are being built. The value of the construction plan amounts to 723 million LTL, the major part of which has been subsidized from the EU funds. Worth mentioning is also the modernisation of the power plant at Lietuvos Elektrine in Elektrenai, for which EUR 360 million has been appropriated. The project financing parties include the European Bank for Reconstruction and Development.53

51 Fabian Nemitz, Germany Trade & Invest, Wirtschaft in den baltischen Staaten stabilisiert sich, 8 March 2010. 52 Europäische Kommission, Beschäftigung, soziale Angelegenheiten und Chancengleichheit, 2010, http:// ec.europa.eu/social/main.jsp?langId=de&catId=326&newsId=678&furtherNews=yes (retrieved on 25 August 2010). 53 Fabian Nemitz, Germany Trade & Invest, Wirtschaftstrends kompakt Litauen Jahresmitte 2010, 5 July 2010.

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Issue of Government Bonds

Counteracting the crisis has not been the only purpose for which Lithuania has obtained the EU funds. Lithuania has been active on the bond market on several occasions and has issued government bonds since the beginning of 2009. The demand for the Lithuanian bonds was strong, which, however, could have been caused by a high coupon rate set between 6.75% and 9.375% p.a. It should be pointed out here that the bond issues were negatively affected by the financial situation in Latvia and later by the Greece crisis. At the same time, the Baa1 rating according to Moody’s still lies within the investment grade band. Through the participation in the bond market Lithuania has raised about 7.6 million EUR of liquid funds. The long repayment periods (till 2020) allow long-term planning. Budget Cuts

One of the most significant challenges to be coped with by Lithuania in connection with the crisis both in the past and in the future is putting the budget in order. As already mentioned, Lithuania’s national debt is rapidly increasing. The financial recession has worsened the budget situation. The national debt more than doubled from the first quarter of 2008 (15.3 billion LTL)54 to the first quarter of 2010, the new indebtedness amounting to 32.7 billion LTL (or 9.47 billion EUR).55 Picture 13: Quarterly Debt of General Government, source: Statistics Lithuania, www.stat.gov.lt/ en/ (retrieved on 25 September 2010). 35,000 30,000 25,000 20,000 15,000 10,000 5,000

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In order to curb the growing debt, Lithuanian government and parliament have undertaken diverse measures aimed at restructuring the national budget. In the first step, salaries of politicians, judges, civil servants and government employees were reduced in two stages, the first of which involved the cutting of the salary calculation base from 490 LTL to 475 LTL. The reduction included also remuneration bonuses. The salaries of government employees, judges, civil servants and politicians were cut by 3.7% to 12%. These measures are supposed to save approximately 2 million LTL personnel costs per month. In the second reduction stage the salary calculation base was again lowered, this time from 475 LTL to 450 LTL, which corresponds to a reduction of 5.3%. The bonuses were reduced by 7.5% in the case of top-ranking officials and to 10% in the remaining cases. Substantial cuts had also to be made in the salaries of politicians and ministry employees. For instance, the monthly remuneration of the undersecretary of the Ministry of Finance was cut by 3,264 LTL. Picture 14: Salary – Ministry of Finance, source: Ministry of Finance-Lithuania, 2010. 14,000 12,000 10,000 8,000 6,000 4,000 2,000 0 2008 Deputy minister

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By virtue of the resolution adopted by the Lithuanian government on 19 August 2009 (Law Journal 2009 No. 100-4185) the monthly base salary being the point of reference for the assessment of salaries paid to public administration employees was reduced from 128 LTL to 122 LTL. The resolution pertained also to the base hourly rate, which was therefore lowered from 0.76 LTL to 0.73 LTL. Moreover, the bonuses received by top-ranking officials were reduced by 30%, and that paid to other officials – by 10%. Equally savings were made in arts and culture. The savings in the culture sector comprised the halving of the budget of the event ‘Vilnius – European Capital of Culture’ 2009 to only 11 million EUR. The equal amount was spent by Linz, the second European Capital of Culture, on staff salaries alone.56 Picture 15: Wages and salaries at current prices by quarter, LQ Public administration; services for social sphere and community activities (LTL million), source: Statistics Lithuania, www.stat.gov.lt/en/ (retrieved on 25 September 2010).

56 Matthias Kolb, Eine verpasste Gelegenheit, in: Berliner Zeitung, 6 August 2009, http://www.berlinonline.de/berliner-zeitung/archiv/.bin/dump.fcgi/2009/0806/seite3/0004/index.html (retrieved on 15 August 2010).

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IMF

Unlike its neighbour Latvia, Lithuania survived the economic crisis without the help of the International Monetary Fund (IMF). So far, the Lithuanian government has managed to solve the problems caused by the crisis on its own, without resorting to IMF loans. As the above data shows, Lithuania was able to receive loans on the international markets also during the crisis. The loans were granted at an expensive lending rate, meaning they will pose a burden to the national budget and will limit its resources in the future.

4.

Outlook for the Coming Years

4.1.

Accession to the Monetary Union

Lithuania has already been planning to join the monetary union since its accession to the EU. On 27 June 2004 Lithuania joined the European Exchange Rate Mechanism II, originally with the intention to introduce the euro as from 1 January 2007. However, this plan was abandoned in 2006 due to exceeding the admissible inflation rate of 2.7% by 0.1%. As a result of the financial crisis and the ensuing problems with the public finances, inflation rate and the GDP, the date of the introduction of the euro, already put off to 1 January 2010, was again postponed. According to estimates of the four major banks in Lithuania, namely SEB, Swedbank, DnB Nord and Nordea, Lithuania will be able to join the Euro-zone by 2014. Lithuania’s Prime Minister Andrius Kubilius has emphasized that a significant budget deficit reduction planned for 2012 will allow for achieving a deficit under 3% and that therefore the plan to join the monetary union is plausible.

4.2.

Current Economic Data and Forecasts

The economic situation observed during the year 2010 gives grounds for the hope that the climate for investments will significantly stabilise by the year-end. Lithuania will, however, be far from reaching the level reported for 2008. According to the estimates of the EU Commission Lithuania’s GDP will decrease by 1.8%.

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Most market observers and analysts also expect a marginal one-digit drop. Much more optimistic was the forecast of the Lithuanian Ministry of Finance, according to which the GDP should significantly increase. In the meantime, the forecast for 2010 was corrected downwards to 1.6%. In 2011, the GDP is expected to rise to 2.8%. In the view of the Minister of Finance, Ingrida Simonyte, Lithuania is not likely to achieve the growth rates of 8%-10% in the long term. The optimistic forecasts speak of a growth rate of 4% in 2011.57 In the opinion of the Ministry of Finance, exports will have the strongest influence on the economic growth. The second most important growth factor will be EU-subsidised investments.58 According to the Lithuanian statistical office, the economy reported a growth in the first quarter of 2010. After incurring a net loss of 3.1 billion LTL in the last three quarters of 2009, in the first quarter of 2010 the Lithuanian economy reported a gross profit of 703.6 million LTL. In comparison to the three last quarters of 2009, the share of enterprises generating the profit increased from 43.7% to 45%.59 The EU Commission points to the continuing deep insecurity over the future economic trends and restrictive lending terms imposed by the banks as the reasons for the stagnation in the investment market. Since May 2009, symptoms of improvement in the business climate have been observed. Lending costs have in the meantime also returned to the level prevailing before the recession. Therefore, some banks have announced the relaxing of the terms for granting loans. This may stop or prevent the insolvency of many companies, as loans are more easily available to entrepreneurs. In 2010 a drop in private consumption is expected. The EU Commission assumes a drop by effectively 5% since the situation on the labour market will remain tense. Although a small decrease in the unemployment is forecast, it will hardly relieve the labour market in view of the unemployment rate of 18.1% reported for the first quarter of 2010. It is expected that the employment rate in the whole year 2010 will amount to 16.7% (2011: 15.5%; 2012: 13.9%; 2013: 12.3%). 57 Hannes Gamillscheg, Skepsis trotz Aufschwung, in: Die Presse, 19 August 2010 http://www.berlinonline.de/berliner-zeitung/archiv/.bin/dump.fcgi/2009/0806/seite3/0004/index.html (retrieved on 21 August 2010). 58 Verslo zinios, Nr. 146 (3298), 2010, p. 5 59 Milda Seputyte, Lithuanian Companies return to profit as decline slowed, in: Bloomberg Businessweek, 17 June 2010, http://www.bloomberg.com/news/2010-06-17/lithuanian-companies-returned-to-profit-in-first-quarteras-decline-slowed.html (retrieved on 15 August 2010).

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Also Swedbank assumed in its analysis that the inflation rate had reached its climax in the first half-year of 2010 and would decline to about 16% by the yearend. According to the analysis, the wages and salaries will again decrease by 5% in 2010.60 The new workplaces will be evenly distributed in the export sector, mainly in production and logistics industries, as well as in the financial and insurance business and IT sector. In contrast, the construction industry will be rather reluctant to employ new staff. In reality, in this sector there is an increasing use of temporary workers.61 The domestic demand has been negatively affected by the reduced wages and salaries, the insecurity about the future economic situation, high interest rates on older loans as well as saving measures undertaken by the government. For the reasons already described above, energy prices jumped about 30% at the beginning of 2010.62 As Ferran Tarradellas Espuny, the speaker of the EU Commission’s energy department, put it, the Baltic region is a kind of an energy island which is connected with the EU electricity network by a line from Tallin to Helsinki (‘Estlink’). According to the estimations of the Lithuanian government, the electricity line which is planned to be established between Lithuania and Sweden (440 kilometres) by 2016 and between Lithuania and Poland by 2015 will partially solve the problem. In order to protect their independence with respect to the use of electricity, the three Baltic countries and Poland are planning to jointly construct a new nuclear power plant in Lithuania between 2018 and 2021.63 However, the preparations for the construction are far from promising so that the project completion will in all probability be delayed. As far as international trade is concerned, exports and imports decreased in 2009. In 2010 a rise is expected for both sectors, and so far this forecast has indeed been confirmed by the numbers. Exports have probably risen by about 17% in the first quarter 2010. For the full year a rise of 5% is expected. In terms of imports, an increase of around 3% is forecasted.

60 Lina Vrubliauskiene, The Lithuanian Economy No. 2, Swedbank, 26 July 2010, p. 3. 61 Ibid. 62 Rasa Lukaityte, A.Sekmokas: 2011 m. elektros kaina gali ir kiek mažôti, www.delfi.com (retrieved on 12 January 2010). 63 Petras Vaida, Lithuania’s Chernobyl-type reactor Ignalina closure may mean economic pain, The Baltic course, 20 November 2009, http://www.baltic-course.com/eng/energy/?doc=20678.

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The Lithuanian imports and exports are strongly dependent on the economic situation of its trade partners. If the economic situation improves in the Euro-zone and in Russia, a corresponding upturn is sure to arrive in Lithuania as well.64 According to most recent economic polls, the majority of the enterprises with foreign capital assessed are more optimistic about their future profits and sales than in 2009.

4.3.

Developments and the Outlook for Individual Industries

Currently, it can be concluded that the economic situation has now stabilised at a modest level. The sharp downturn in the second half of 2009 was halted, mainly due to higher exports. In contrast, private consumption is still weak. Turnover in the retail sector has fallen in the first quarter of 2010 by 14.5% compared to the already poor previous year.65 The paper and pulp, timber, textile and food sectors already have a large rebound behind them. Even the metal sector can claim a slight upturn after a strong final quarter of 2009. The chemical industry has already recorded an upswing in the second quarter of 2009. Similarly, the rubber and plastic industry has been able to return to the black in the first quarter of 2010. In contrast, the manufacturing sector has again experienced a downturn in the first quarter of 2010.66 The upswing in the areas of rubber and plastic, textiles as well as timber is thanks to the high export share of the products. In contrast, the recovery in the chemical, food and paper industry is not so simple to explain, because these products are mainly consumed by the domestic market (approximately 60%).67 According to Prime Minister Kubilius, more of the world‘s leading high-tech companies and innovators will come to Lithuania and open up their service centre there. Currently, Barclays, IBM, Fermento and Western Union are present in Lithua-

64 Fabian Nemitz, Germany Trade & Invest, Wirtschaftstrends kompakt Litauen Jahresmitte 2010, 5 July 2010. 65 Jenny Nordgren, Country Risk Analysis Lithuania, SEB Merchant Banking, 9 June 2010, p. 1. 66 Lina Vrubliauskiene, The Lithuanian Economy No. 2, Swedbank, 26 July 2010, p. 4. 67 Ibid., p. 4.

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nia with service centres, and other prominent companies should also follow suit. After undertaking successful reforms, Lithuania now represents a superb location for research & development as well as for service centres.68 In order to meet the energy shortage in Lithuania, a 400 km gas transmission line from Poland to Lithuania is planned. To this end, at the beginning of August 2010, an agreement was signed between the Polish gas pipeline operator Gaz-Systema SA and the Lithuanian utility company Lietuvos Dujos. The project will be implemented in accordance with the EU strategy for the connection of gas transportation systems and it is of strategic importance for the integrity of the whole EU gas market. The costs of the investigation and feasibility study will therefore be 50% funded by the EU Commission. The other half of the costs will be split between the two company groups involved. According to preliminary calculations, the pipeline will cost around EUR 290 million.69 Even the banks are beginning to replace bad news with positive messages. Thus, the Swedish SEB published on 13 July 2010 its quarterly results for the second quarter of 2010 and the head of SEB, Mrs Falkengren, said at the press conference with reference to the Baltic States: “There are several signs that an economic recovery has now been initiated.” This was also reflected in the overall performance of the bank: operating income for the second quarter climbed to 2.6 billion SEK, which represented a quadrupling of the previous year‘s result. The interest income on the other hand, fell to 4.1 billion SEK from 5.4 billion SEK a year earlier. However, SEB, the second largest bank in the Baltics after Swedbank has had to cope with credit losses, and they reported losses in this area alone of 619 million SEK (first quarter: 1.9 billion SEK), but which were however much less than experts had expected.70

68 Permanent Representation of Lithuania to the European Union, Prime Minister Kubilius: Lithuania is capable to win in global competition, 23 June 2010; Lina Vrubliauskiene, The Lithuanian Economy No. 2, Swedbank, 26 July 2010, p. 4. 69 Ria Novosti, Litauen und Polen prüfen Möglichkeiten für die Verbindung ihrer Gaspipelines, in: Baltische Rundschau, 7 August 2010, http://www.baltische-rundschau.eu/2010/08/07/litauen-und-polen-prufen-moglichkeiten-fur-verbindung-ihrer-gaspipelines/ (retrieved on 10 August 2010). 70 Helmut Steuer, Schwedische SEB steigert Gewinn deutlich, in: Handelsblatt, 13 July 2010, http://www.handelsblatt.com/unternehmen/banken-versicherungen/quartalsbericht-schwedische-seb-steigert-gewinn-deutlich;2617887 (retrieved on 15 September 2010).

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As mentioned prior, currently the banks have to cope with credit losses resulting from bad loans. For example 20% of loans can be classified as non-performing loans. However, since the end of the year, a measure of stabilisation has been noted, which is based mainly on fewer bad loans in the company sector. The number of bad loans in the consumer and private household sector however continues to rise. This is primarily due to the increase in unemployment, the decline in wages and the tough public spending consolidation process. For these reasons, a further rise in loan defaults in this sector is expected in the future.71 In August 2010 two positive announcements confirmed optimistic outlooks stating that investors are becoming increasingly aware of the regained attractiveness of the Baltic States. Finland based Vicus Capital announced it will invest 60 million EUR in retail stores and real estate development projects throughout the Baltic area. Furthermore, the US fast-food chain McDonald‘s is going to spend a total of 20 EUR million in growing their presence in the Baltic States, whereby the number of restaurants in Estonia, Latvia and Lithuania shall be raised to 35.

4.4.

Conclusion

If the indicators can be trusted it seems the worst is over for the Lithuanian economy. Many after effects, however, remain visibly persistent – particularly high unemployment, low purchasing power and the high proportion of non-performing loans. The reforms that were launched in the face of economic downturn, came too late, were often not sufficiently coordinated among the participating government agencies and lacked rigour. This is particularly true with regard to the reforms of the social security system and especially in connection with the health sector, which remains in relation to the quality of care in the EU somewhat in its tail lights. The measures to cut red tape in company law are now moving in the right direction, but were overdue even before the crisis. The company tax system has regained its high level of attractiveness and Lithuania has fulfilled, (aside from the purely national benefits) most of the requirements to play a leading role within the framework of a tax optimised structure and has – at least in theory – the makings of an EU tax haven. It still remains a mystery as to

71 Jenny Nordgren, Country Risk Analysis Lithuania, SEB Merchant Banking, 9 June 2010, p. 3.

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why this fact is still seen as an insider tip, and the official presentation of the benefits of Lithuania as a business location are largely neglected, whereby significant potential to attract new interest is squandered. Perhaps it is because this competitive advantage is actually sometimes not achievable in practice. This is typically due to the lack of experience in international tax matters within the tax authorities and also as a result of bureaucratic and inflexible management. Here in particular it now seems that considerable resistance has now been overcome (e.g. introducing the possibility of an agreement with the tax authorities to agree a tax rate, if the cost of an exact determination would be disproportionally high, and simplified write down possibilities for bad debts), so that the progression also in this field is cautiously optimistic. The next step, which is urgently needed, is to create clear normative rules both for the taxation of project syndicates with foreign participation and with regard to the methods for sharing of expenses and revenues between the foreign parent and Lithuanian tax establishment. In industrial and labour law the right approach has also been pursued (flexible working hours and overtime rulings, temporary work contracts), but important issues have not been addressed and should be on the agenda at the next round of reforms. These outstanding issues refer to the disproportional and differentiating notice of termination rules for employers and workers, the reduction or abolition of the statutory redundancy payments for unemployment, the limitation of unrestricted carry-over of untaken holiday and respective compensation claims, all of which lead to high costs for employers and discourage recruitment. Lithuania appears to be a favourable production location when the development in wages is evaluated, however, the official statistics provided by the government must be treated with a degree of caution as many companies, under pressure to reduce costs, employ staff officially at the notional minimum wage but then payout a considerable portion of staff wages off the record. Manufacturing sites and office space are now available on favourable terms due to the construction boom of recent years and therefore in many areas there is a prevailing excess of supply. For the retail sector demand is still evident and is only slowed by the low purchasing power of consumers. Consumer demand has been increasing in 2010 after a sharp decline in 2009, but is still at the average level of 2005. The return of confidence in business can only be brought about via a painful but certainly much needed fundamental reform of insolvency law. This requires firstly, practical arrange-

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ments for an independent insolvency administration in whose hands effective tools can be placed for the accumulation of bankrupt estates and the subsequent liquidation or reorganisation. This has to be combined with a clear timeframe for the due diligence and registration duties and the appropriate consequences for violations (personal liability of directors and shareholders; criminal prosecution). Numerous companies and projects are to some extent still battling against significant financing difficulties caused by the crisis, and present an attractive and low priced opportunity for an acquisition or an initial entry into the market. Particularly in the sales area there are currently possibilities to take over at a stroke whole sales & distribution networks which cover the entire Baltic region and beyond. However, it is necessary to carry out in advance a comprehensive risk assessment and market analysis, as during the boom times in many cases such business models were also implemented but proved not to be viable in realistic market conditions. The principle remains that when selecting business partners and designing legal relationships due care and attention should be taken. In summary it can be concluded that Lithuania had lost some of its attractiveness as an investment location prior to the crisis. High unit wages, low productivity and only a partially attractive legal system coupled with an increasingly unattractive tax environment. The economic and financial crisis has corrected a large number of negative developments in an overheated economy and allowed urgent necessary reforms to be implemented which, without the threat of a catastrophic scenario, would otherwise not have been politically possible. For all the human tragedy that is inevitable with such a crash, it has to be recognised, from a Lithuanian perspective, that the economic development during the crisis was a return to earth. For many investors now is the moment to take the initiative and, understanding and learning from the relapse in the years prior to the boom, take this to mean what it really signiƂes: The Return of Opportunities!

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Poland: (Po)Land of Opportunity Jens Jungmann

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1.

Situation before the Crisis

1.1.

Poland – Location, Political System

Poland is located in the centre of Europe and this fact alone should be enough to demonstrate the potential of the country. Poland is bordered by Germany to the west (along the Nysa KĜodzka and the Odra Rivers), by the Czech Republic and Slovakia to the south (mountain borders) as well as by Ukraine, Belarus and partially Lithuania to the east. A Russian enclave known as the Kaliningrad Oblast runs along a small part of the Polish border to the north. The rest of the northern border stretches along the sandy coast of the Baltic Sea.

Picture 1: Basic information on the Republic of Poland Area

312,679 km2

Population

38,135 thousand

Capital city

Warsaw, 1.702 m people

Administrative division

16 provinces, 314 districts, 2,478 communes

Legislative power

Sejm (460 Members of Parliament), Senate (100 senators)

Executive power

President (five-year term of office), Council of Ministers (four-year term of office)

Judicial power

Supreme Court, common courts of law, administrative courts, courts-martial

Time zone

GMT +1

Currency

Zloty (PLN) = 100 grosz (gr.)

Average life expectancy

79.7 for women, 71.0 for men

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J. Jungmann, B. Sagemann (Eds.), Financial Crisis in Eastern Europe, DOI 10.1007/978-3-8349-6553-0_6, © Gabler Verlag | Springer Fachmedien Wiesbaden GmbH

1.2.

Economic Situation of Poland before the Financial Crisis

The Polish economy has been developing very dynamically since the beginning of the transformation in 1989. The last 20 years in Poland have seen significant political and economic changes, the most important of which include: Y

1991 – opening of the Warsaw Stock Exchange;

Y

1994 – the National Privatisation Programme;

Y

1995 – denomination of the Polish zloty;

Y

2004 – accession to the European Union;

Y

2007 – accession to the Schengen Area.

Poland’s accession to the European Union in May 2004 did not only initiate the economic revival, but also provided the impetus for accelerated growth, as the first symptoms of recovery could be noticed already in 2002. The subsequent years saw further economic development of the country, which encompassed the entire economy. The growth in that period followed in particular in agriculture, industry, construction and services. It may be easily concluded that the impetus for development of these sectors came from Poland’s membership in the European Union. An increased inflow of foreign direct investments (FDI), which followed Poland’s accession to the European Union in 2004, was one of the most significant factors stimulating the Polish economic development between 2004 and 2008. Membership in the European Union was a clear signal for foreign investors that doing business in Poland would be stable and predictable. Apart from Poland’s accession to the European Union, the encouragement for the investors to locate foreign direct investments in Poland was drawn from the following: Y

favourable assessment of the situation across Central Europe;

Y

Poland’s improved rating;

Y

strong performance of Polish companies, which translated into an increase in capital reserves from profits earned in companies under direct lending;

Y

comparative advantage of Poland over the ‘old European Union’ Member States in labour intensive production.1

1 G. Ancyparowicz, WpĜyw bezpoırednich inwestycji zagranicznych na wzrost polskiej gospodarki w okresie poakcesyjnym, 2009.

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As a result of the above circumstances, the value of FDIs attracted to Poland between 2004 and 2007 was substantially higher than in the five years preceding the accession of Poland to the European Union, totalling nearly 51 billion EUR. For instance, the main investors in 2006 were Luxembourg (24%) and Germany (18%). The FDI inflow to Poland decreased in 2008 and totalled only 9.972 million EUR. It was 42% less than in 2007. The majority of the funds came from Germany and accounted for 16% of the total foreign direct investments.2 Between 2004 and 2008 that country’s foreign direct investment totalled in aggregate ca. 62 million EUR3. The following figure presents the FDI inflows to Poland between 2003 and 2008. Picture 2: FDI inflow to Poland in the years 2003-2008 (in EUR mln); source: Narodowy Bank Polski (National Bank of Poland – NBP), 2008. 1st Q

2nd Q

3rd Q

4th Q

1st – 4th Q

2003

1,443

824

536

1,264

4,067

2004

3,958

2,765

1,526

1,988

10,237

2005

2,131

1,119

1,831

3,249

8,330

2006

3,900

1,999

1,202

8,640

15,741

2007

4,212

2,781

4,361

5,320

16,674

2008

3,443

3,410

2,671

1,446

10,970

When analysing the impact of the FDIs in Poland in the post-accession period, it should be pointed out that foreign investors concentrated their activity in regions with relatively well-developed infrastructure, leaving out barely urbanised and low-labour cost regions. No wonder that in 2007 61% of foreign-capital dominated companies operated in Mazowieckie, Dolnoılâskie, İlâskie and Wielkopolskie Provinces. The influence of the foreign direct investments on the Polish economic situation was manifested in stimulating investment activity among domestic producers, both those collaborating with and those competing with companies owned by foreigners. Polish business, threatened by bankruptcy or a hostile take-over, tried to catch up with the technological advancement in order to cut costs and improve

2 NBP, Zagraniczne inwestycje bezpoırednie w Polsce w 2008 roku, 2010. 3 G. Ancyparowicz, KapitaĜ zagraniczny w Polsce po akcesji Unii Europejskiej, 2009.

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quality. Facing that challenge stimulated the demand for investments as companies installed more energy-efficient production lines and purchased the most up-to-date licences and know how.4 Another significant aspect of the inflow of the foreign direct investments in the context of the Polish economy was the foreign investors’ contribution to popularisation of the work organisation and staff management methods. They have tightened the discipline and improved the labour productivity among the Polish entrepreneurs. The improved labour productivity among the Polish entrepreneurs is evidenced by an increase in the labour productivity ratio, which rocketed between 2002 and 2008 by as much as about 60%.5 Summing up the Polish economic situation before the first signs of the global financial crisis appeared in 2008, it is the dynamic development between 2004 and 2007, which overlapped with Poland’s accession to the EU, and which is worth particular attention. The improved welfare of the Polish society between 2000 and 2007 is evidenced by a two-and-half-fold increase in the gross domestic product per capita. The most significant factors accelerating the economic growth in Poland include the increased inflow of foreign direct investments and the actions to restructure and modernise the Polish economy, undertaken before the country joined the European Union. Those actions resulted in, among other things, the inflow of new technologies raising competitiveness of the goods manufactured in Poland and the increased labour productivity in the construction, trade and industry sectors. A detailed analysis of the construction, trade and industry sectors before the financial crisis reached Poland is discussed in the following sections. 1.2.1.

Construction

The construction sector in Poland, like in other EU Member States, is the economy’s driving force. At the same time, the construction sector is highly sensitive to economic and social phenomena due to the production cycles characteristic for that industry which usually last several years and make the construction companies operate in a constantly changing environment. This means that the construction sector in Poland operates in unstable market conditions6.

4 Ibid. 5 Ibid. 6 Z. Bolkowska / E. Szwarc, Budownictwo polskie w latach 1990-2007, 2008.

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The most significant macroeconomic factors determining the business activity in the construction include: Y

current account balance;

Y

inflation;

Y

monetary policy.7

A current account balance showing a long-term deficit may limit the construction demand; volatile and hardly-foreseeable inflation renders the credit risk assessment difficult for construction companies, whereas high inflation causes price volatility on the construction market, which in turn misleads both customers and producers. Monetary policy works in different directions. On one hand, a rigorous monetary policy, construed as low inflation and the current account deficit at the level accepted by domestic investors, may prompt the construction demand. On the other hand, low inflation accompanied with relatively high interest rates may contribute to low construction demand and low construction activity.8 The strong correlation between the national economic situation and the construction branch is evidenced by the analysis of the pace of the economic growth in Poland in the period from 2000 to 2010. The slower economic growth between 2000 and 2003 was accompanied by a considerable slowdown in the construction sector in that period. When analysing the situation in the Polish construction branch before the global financial crisis, two sub-periods may be singled out. The period from 2000 to 2003 was a time of a slowdown in the Polish construction, while the years from 2004 to 2007 saw a considerable increase in the sales of construction and assembly production. The development in the construction market between 2000 and 2007 was determined by the drop in GDP growth in the period from 2000-2003 and by the economic recovery which began in early 2004. It is worth pointing out that Poland’s economic performance substantially improved as a result of its accession to the European Union in 2004, which prompted a significant inflow of foreign direct investments.

7 E. Zawadzki, Budownictwo polskie przed przystâpieniem do Unii Europejskiej, 2002. 8 Ibid.

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The years 2000-2003 saw a slowdown in the economy, which considerably affected the situation in the construction market. Construction production volume in large companies plunged in that period by about 25%. The drop in the production of small companies, carrying out mainly repair and modernisation work, was less serious and somewhat alleviated the effects of the construction sector slowdown.9 According to the construction sector experts, the slowdown in the Polish construction branch between 2000 and 2003 was caused chiefly by: Y

a decrease in the investment scope;

Y

removal of the majority of reliefs and allowances supporting the construction sector;

Y

growing competitiveness of foreign companies;

Y

fierce competition among domestic companies leading to bankruptcy of some construction companies.10

The downturn in the Polish construction sector between 2000 and 2003 was primarily visible in employment and profitability areas. The employment dropped in companies hiring more than nine workers from 523,000 in 2000 to 354,000 in 2003. Picture 3 presents the negative net financial result and the negative return on sales achieved between 2001 and 2003 in the construction sector. Picture 3: Financial results in the construction sector between 2001 and 2003; source: Central Statistical Office, 2010. Specification Return on sales in % Net financial result in PLN m

2001

2002

2003

-1.2

-2.6

-0.6

-636.3

-1,179.8

-245.2

The period from 2004 to 2007 saw the construction sector stepping in the path of fast growth. Poland’s accession to the European Union had a considerable impact on the development of the construction branch in that period. It entailed an increased inflow of foreign direct investments significantly affecting the construction sector trends. However, a slower recovery of the construction sector, as compared to other branches, needs to be pointed out. The first symptoms of econom-

9 Z. Bolkowska / E. Szwarc, Budownictwo polskie w latach 1990-2007, 2008. 10 Ibid.

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ic recovery in other sectors could be observed as early as 2003, while the revival in the construction branch followed a year later. Nevertheless, the growth rate in construction between 2005 and 2007 was higher in comparison with other branches. Apart from the general trend in the domestic economy, other factors significant for improvement in the construction branch include: Y

an increase in demand for investment constructions;

Y

more efficient use of the EU aid funds;

Y

infrastructure and construction development priorities adopted under the Lisbon Strategy;

Y

the challenge to combat the housing shortage.11

The construction sector’s structure by type between 2004 and 2007 was dominated by fast development of the so-called infrastructural and road construction with concurrent stagnation in the finishing work and residential construction. The employment, industry profitability and increasing gross wages and salaries reflected the good condition of the construction branch in the years 2004-2007. The fall in the average employment in the construction levelled off in 2004 and 2005 whereas it turned into a sound growth in 2006. Despite that tendency, the employment in construction companies was insufficient to complete an ever larger number of orders. This was a consequence of difficulties in finding workers caused by, among other things, economic migration and poor wage increase. The profitability also clearly improved. Starting from 2004, the construction sector began to achieve increasingly better net financial results with the concurrent increase in the return on sales. Two tendencies need to be pointed out in the summing-up of the construction sector situation in Poland before the global financial crisis: the downturn of 20002003, and the strong construction boom after 2004. The latter started with stable prices and was followed by a slow increase in the construction production prices due to employment and material barriers. 1.2.2.

Trade

Trade is an indicator of a country’s welfare, an incentive for economic development. Foreign trade creates opportunities to contract various services, buy goods at competitive prices with a wide range of products offered. Foreign trade, i.e. the 11 Ibid.

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relation between exports and imports, is contemporarily related to the division of labour and high specialisation of goods production. Such an arrangement of the foreign trade allows for the maximised use of the available goods, assuming that a state pursues the proper trade policy. The year 2004 brought about significant changes in the Polish international trade exchange, chiefly due to Poland’s accession to the European Union. By joining the EU, Poland has delegated national competences in trade policy to the Community level. The common trade policy (CTP) encompasses autonomic activities as well as statutory activities, i.e. contracts with non-EU countries or other international law entities. The Community’s exclusive competences include trade in goods and services.12 The following figures present the situation of the Polish imports at the end of 2004 after joining the EU. Picture 4: Structure of Polish imports in 2004; source: Central Statistical Office, 2010. Germany; 24.2%

Other; 42.2%

Italy; 7.9%

Russia; 7.3% France; 6.7% Netherlands; China; 4.6% 3.5% Czech Republic; 3.6%

12 H. Bâk, Gospodarka w Unii Europejskiej, Wybrane zagadnienia rynku wewnötrznego, 2009.

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The situation of the Polish exports at the end of 2004 after joining the EU was structured as follows: Picture 5: Structure of Polish exports in 2004; source: Central Statistical Office, 2010. Germany; 30.0%

Other; 33.3%

France; 6.1% Begium; 3.2% Sweden; 3.5% Russia; 3.8%

Italy; 6.0% Czech Republic; 4.3%

Netherlands; 4.3%

United Kingom; 5.5%

The comparison of the above pictures shows that Poland’s major trade partner is, both in the case of imports and exports, Germany with a 24.2% and 30% share respectively. The evaluation of Poland’s economic situation before the crisis is based on the balance of trade ratio. In the years 2000-2007 before the global downturn, the Polish economy experienced periods of exports in excess of imports (trade surplus) as well as the opposite (trade deficit). The trade surplus (2000-2003 and 2005) is favourable from the economy perspective. High production of goods purchased by foreign customers helps maintain jobs and contributes to development of the national economy. In the years of the negative balance of trade (2004, 2006, 2007) the situation is adverse as the goods are either too expensive or of poor quality and find no foreign customers. By group of countries – in the first eleven months of 2006, the share of Central and Eastern

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Europe in the Polish exports increased by 0.7 percentage points (p.p.) against the same period in 2005, while the share of developed countries dropped by 0.4 p.p. In the case of imports, the share of developing countries grew by 2.4 p.p. and of the Central and Eastern European countries by 1.2 p.p., with the concurrent fall of the share of developed countries by 3.6 p.p., in particular of the EU Member States (by 3.0 p.p.). 77.5% of total export was destined to the EU, while imports from the Member States accounted for 62.8% of the total imports. As in the previous years, Germany was Poland’s major partner in the period from January to November 2006, with 27.3% share in exports and 23.8% share in imports. The exports increased by 14.6% while the imports by 13.3% against the same period in 2005. In the case of Russia, the period from January to November 2006 saw exports growing by 14.5% and imports by 33.4%. Russia’s share in total exports dropped by 0.1 p.p. to 4.3%, and increased in imports by 1.2 p.p. to 9.9%. The growing significance of imports from China needs to be pointed out, as the share in Poland’s total imports rose by 0.7 percentage point to 6.1% with the majority of that increase attributable to imports of white goods, furniture and footwear. Exports to Ukraine and the Czech Republic grew considerably, chiefly due to a significant rise in exports of electromechanical and metallurgical products, both accounting for a large share in the total exports13. The most important internal conditions affecting the Polish trade in 2007 include the continued high growth of domestic demand of around 8%, steady appreciation trend of the Polish zloty (PLN) against the two major currencies with nearly 3% increase against EUR and almost 11% against USD, as well as an increase in unit labour costs. In 2007 the real estate market slumped, industrial production and employment growth slowed down, and access to credit certainly became more difficult for households and businesses, which substantially hindered the US economic growth in 2008. In 2007, exports and imports of Euro-zone countries increased respectively by 5.9% and 5.4% against the previous year, while in 2006 the growth rate was more than 2 p.p. higher. The year 2008 saw a further slump in exports from that area, mainly due to the anticipated economic slowdown in the United States and other non-EU developed countries, and gradual appreciation of EUR against USD and JPY which hindered the price competitiveness of EU exporters. After the shortterm economic slowdown in Germany in 2005 (GDP growth of mere 0.9%), the Polish major trade partner experienced a clear revival in GDP growth in 2006 and 2007 when it rose by 2.9% and 2.5%, respectively. At the end of 2006, the eco13 Ministerstwo Finansów, Analiza sytuacji gospodarczej Polski w 2007 roku, 2010.

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nomic growth in that country was encouraged by private consumption and investments in residential construction. As a consequence, domestic demand jumped from 0.3% in 2005 to 1.9% in 200614. 1.2.3.

Industry

The situation in Poland before the dawn of the global economic crisis can be split into two stages. The first one refers to the period before Poland joined the European Union. At the time of transformation in which Poland inherited the obsolete structures of the old Polish industrial sector the expectation arose of a significant economic upturn. The Treaty of Accession itself brought in hope for the opening of the European markets and increased foreign investments in Poland. To be able to compete with foreign businesses, the Polish manufacturing companies needed funds for investments to improve their technology parks and the quality of the products offered. After Poland joined the European Union, which took place in 2004, the economy started to thrive as a result of the accession, which could be substantiated with 5.3% increase in the gross domestic product (GDP) and 12.6% growth in the sold production of industry. In 2005, the economic development slowed down and the figures reported for the GDP as well as for the sold production of industry were respectively 3.5% and 3.7%.15 The upward trend continued in the years 2006 and 2007, as the sold output of industry rose by 11.2% in 2006 and in 2007 – by 9.5%16. Till 2007 the outlook for the Polish industry was very optimistic as the indices reflecting the condition of the sector confirmed its intense development. Picture 6 shows the total sold production of industry by month, in the years 2006-2008.

14 Ministerstwo Finansów, Ocena handlu zagranicznego Polski w 2007 r. (na podstawie danych wstöpnych), 2008. 15 Ministerstwo Gospodarki, Polska 2007. Raport o stanie gospodarki, 2007. 16 Ministerstwo Gospodarki, Polska 2008. Raport o stanie gospodarki, 2008.

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Picture 6: Relative changes in the sold production of industry by month in the years 20062008; source: Central Statistical Office (GUS), 2010. 25% 20% 15% 10% 5% 0% -5%

Jan Feb Mar Apr May Jun Jul Aug Sept Oct Nov Dec

-10% -15% 2006

2007

2008

Analysing the condition of the industry in individual years on the basis of the picture above, the year 2006 should be noted as a period of a significant growth in the sold production of industry, whereas a distinct downward trend may be observed for the same index, as from the year 2007. In the years 2000-2007, the figures reported for the industry structure reflected the most intense growth of 169% in the production of radio, television and telecommunication equipment and devices. The next largest branches of industry, where the growth indices were very satisfactory, included manufacture of office equipment and computers as well as manufacture of motor vehicles, trailers and semi-trailers (165.7% and 162.7%, respectively). The smallest increase in production in the years 2000-2007 was reported for manufacture of metals (15.8%) as well as for manufacture of other transport equipment (20.4%). The figures for the same period disclosed also a decrease in the sold production of industry. Falls in output were visible in, among others, manufacture of coke and refined petroleum products and manufacture of clothing as well as fur and leather goods.17

17 GĜówny Urzâd Statystyczny, MaĜy Rocznik Statystyczny Polski 2008, 2008.

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Picture 7 presents the relative changes in the sold production of industry for individual types of goods. Picture 7: Relative changes in the sold production of industry by type of goods in the years 2006-2008; source: Central Statistical Office, 2010. 35.0% 30.0% 25.0% 20.0% 15.0% 10.0% 5.0% 0.0% intermediate goods

capital goods

consumer durables

2006

2007

consumer nondurables

energy goods

2008

The largest increase in the sold production of industry in a breakdown into main industrial groupings occurred in the years 2006 and 2006 with respect to production of the consumer durables. The year 2006 reported 30.3% growth, whereas the figures for the year 2007 showed 25.9% increase. For the sake of comparison, the growth in production of consumer durables amounted in 2008 to merely 7.8%. The relative changes in the production of capital goods in 2007 were disclosed at the level of 15.6%, as against 17.3% in the previous year. An increase in the production of intermediate goods in 2007 remained at a level similar to that for the year 2006 and showed increases of 12.0% and 11.9%. In the case of intermediate goods, the downward movement in 2008 was significant, as the figure plummeted to 0.8%. The least change in the period 2006-2008 was reported for the production in the grouping of goods related to energy (respectively for the years 2006, 2007 and 2008: 5.2% 1.4% and 2.1%).

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1.3.

Financial Situation in Poland

The political transformation in Poland brought in a free-market economy. In December 1989, the inflation rate hit a level of 585.8%.18 However, due to the changes (commonly referred to as the ‘Balcerowicz Plan’) aimed at cutting inflation and including the Polish currency in the group of convertible currencies19, the Polish economy started to gradually operate as one of the free-market economies. The profound economic changes in Poland, as launched in 1989, brought about a steady inflation rate that was kept comparatively low in the first years of the 21st century, which brought about a stable economic situation in Poland. The years 2005-2006 covered a period in which the inflation rate in Poland was the lowest, as compared to other ‘new’ EU Member States. The years 2000-2007 were the time of growing indebtedness in the public finance. The upward trend of the public debt growth against GDP is notable. In 2000, the public debt accounted for 36.8% of GDP, whereas in 2007 it consumed 48.7%. Summing up the condition of the public finance in Poland in the period from 2000 to 2007, it should be underlined that despite the unfavourable upward trend of the public debt share in GDP, Poland still met the convergence requirements set forth in the Treaty on European Union, according to which the ratio of the public finance debt against GDP should not exceed 60%.

1.4.

Labour Market

As from the moment Poland joined the European Union, the situation on the labour market gradually improved. The economic revival, which partially resulted from the accession to the EU, contributed to increased employment. The following figures show the unemployment rate in the years 2001-2007.

18 GĜówny Urzâd Statystyczny, Roczne wskaōniki cen towarów i usĜug konsumpcyjnych w latach 1989-2010, 2010. 19 Rada Ministrów, Program gospodarczy – gĜówne zaĜoŏenia i kierunki. ZaĜoŏenia zaakceptowane przez Radö Ministrów 9 paōdziernika 1989, 1989.

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Picture 8: Unemployment rate in the years 2001-2007 (%); source: Central Statistical Office, 2010. unemployment (%)

2001

2002

2003

2004

2005

2006

2007

17.5

20.0

20.0

19.0

17.6

14.8

11.2

Analysing the Polish labour market before the global financial crisis, it may be noted that the unemployment rate in Poland was clearly on a decrease as from 2004, i.e. upon the Polish accession to the structures of the European Union. The key determinants of the fall in the unemployment rate after Poland joined the EU involved an increased inflow of foreign direct investments as well as labour-related migration of the Poles. That was in the main the result of new opportunities of gainful employment which arose outside the domestic borders upon joining the European Union. The FDI inflow to Poland in 2005 created 37,745 new jobs, which helped Poland to take up the leading position among the European countries as regards the number of new workplaces created by foreign investors20. Another key factor to contribute to the decrease of the unemployment rate in Poland after 2004 refers to labour-related migration. This was possible due to opening of the labour markets by such countries as the United Kingdom, Ireland and Sweden. Opening of the markets by the aforementioned states brought about a change of the destination countries targeted by labour-related migration of the Poles, mainly the United Kingdom and Ireland. It is difficult to determine the size of migration of the Polish workers due to different methods applied to register the persons employed in the EU Member States. The migration for the period from May 2004 to January 2007 may be, however, estimated to reach 1,120 thousand migrant workers.21 Migrant Poles were in the main those leaving for gainful purposes with the intention to come back to Poland as well as young, well-educated persons who wished to live a higher standard. Migration of specialists or highly qualified persons, in particular the medical service personnel, was found to be considerable too.22

20 Ernst & Young, Ernst & Young o atrakcyjnoıci krajów, 2006. 21 ZespóĜ Doradców Strategicznych Rady Ministrów, WspóĜczesne migracje z i do Polski Szanse i zagroŏenia, 2008. 22 Urzâd Komitetu Integracji Europejskiej, Cztery lata czĜonkostwa Polski w UE, 2008.

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Opening of the British and Irish markets resulted not only in a decreased unemployment rate in Poland but contributed also to a growth of wages and salaries. The increase in wages and salaries was accompanied with growing work productivity due to rising competitiveness and adoption of work organisation methods resulting from the inflow of FDIs.23 In addition to many positive changes on the Polish labour market, the negative ones should be noted, which include the following: Y

large differences in the unemployment rates, depending on the region and originating from the non-uniform economic growth;

Y

occurrence of the so-called ‘structural unemployment’;

Y

poor mobility of the Poles;

Y

low effectiveness of vocational and continuous education and training;

Y

comparatively low professional activity;

Y

migration of some young and qualified personnel;

Y

relatively high unemployment rate among women, the elderly and the youth.24

Summing up the situation on the Polish labour market in the years 2000-2007, it is necessary to point to the positive trend downwards as regards the unemployment rate as from 2004 as well as to a significant increase in work productivity for the same period. A negative aspect of the Polish labour market, as underlined by the European Commission in the report for 2008, involved in the main a relatively high unemployment rate among the elderly, youth and women as well as low professional activity in comparison with other EU Member States25.

23 GĜówny Urzâd Statystyczny, Przeciötne miesiöczne wynagrodzenie w gospodarce narodowej w latach 19502009, 2010. 24 Urzâd Komitetu Integracji Europejskiej, Cztery lata czĜonkostwa Polski w UE, 2008. 25 Council of the European Union, Joint Employment Report 2007/8, 2008.

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2.

The Impact of the World Financial Crisis (2008/2009/2010)

2.1.

Macroeconomic Consequences of the Economic Crisis in Poland

After several years of fast growth a period of economic slowdown has arrived. Since the second half of 2007 the US economy – the driving force of the world economy – has been gripped by the real estate crisis and the financial market turmoil. The first problems occurred in the subprime mortgage market, namely the excessive liberalisation in granting credit to low-income earners. As a consequence, the real estate prices plummeted and translated into troubles of the banking sector: Lehman Brothers investment bank went bankrupt and the FED agreed to take over Fannie Mae and Freddie Mac. The global crisis destabilised the EU economy, including Poland. Almost all Member States experienced negative growth in the second half of 2008 and at the beginning of 2009. The negative consequences of the crisis reached Poland as late as in the second half of 2008. That was several months after the breakdown became apparent in the world’s leading economies due to the fact that the EU Member States are not only Poland’s major trade partners but its key foreign investors as well. The deteriorating economic performance made the total FDIs fall to 11.3 billion PLN (by 32%) in 2008. However, it needs to be pointed out that while the said economies went into recession, the Polish economy just slowed down, though substantially. The comparatively better situation of our country came from a relatively high internal demand and, paradoxically, to a rather low share of foreign trade as a share of GDP. Poland remained resistant to the world crisis for quite long. Yet, as the global economy continued its downward slide, the crisis started to gradually affect the Polish economy as well. Initially, the global financial market turmoil was limited in Poland mainly to the capital market, but later swept across all major segments of the national economy.26 The impact of the world financial crisis on the Polish economy is mostly of indirect nature and comes mainly through credit and trade channels. In the aftermath of the global recession, Polish banks re-assessed risks and, as a consequence, tightened their credit policies. Thus, credit became less available and the cost of raising capital on the capital market increased for households and companies, which 26 Narodowy Bank Polski, Polska wobec ıwiatowego kryzysu gospodarczego, 2009.

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affected, among others, the construction industry. However, it should be stressed that the Polish construction sector was the only one in the Visegrad Group (an informal name of the alliance of CEE countries, namely the Czech Republic, Slovakia, Poland and Hungary, as used since 1991) that gas not collapsed since the onset of the world economic crisis, but merely stagnated. It was not until the first months of 2010 when the relative changes in the sold production of construction companies reported a downslide, though experts point also to bad weather (not conducive to building work) as one of the reasons underlying that occurrence.27 An analysis of the labour market after the first signs of the economic stagnation in Poland resultant from the world financial crisis shows that the number of the employed ceased growing as from 2009. At the beginning of 2009 the rising unemployment rate was the most significant problem of the Polish labour market. The number of the registered unemployed as at the end of March 2009 stood 3.3% higher than in March a year earlier, and the unemployment rate rose by 0.3% in the comparable period.28 The unemployment rate in March 2010 reached as much as 12.9% and was 1.8 percentage points higher than in March 2009. Lower economic activity caused by the world crisis contributed to deterioration of the labour market between January and March 2010. The labour market situation further worsened also as a result of the inclement weather at the beginning of 2010 which hindered activities in the construction.29 The financial standing of Polish businesses was seriously affected by depreciation of the PLN in the second half of 2008, which caused huge losses due to currency options purchased earlier by companies. The consequences of those transactions translated into poor results in the financing activities of non-financial corporations at the turn of 2008. Other factors restraining the development of the Polish economy include recession of the Euro-zone economies which are Poland’s major trade partners. Recession in the EU Member States translated into lower demand for Polish products. This adversely affected Polish exports, in particular the most export-oriented segment of the Polish economy namely the industrial sector.30

27 GĜówny Urzâd Statystyczny, Dynamika produkcji przemysĜowej i budowlano – montaŏowej w styczniu 2010 r., 2010. 28 GĜówny Urzâd Statystyczny, Analiza sytuacji gospodarczej Polski w 1 kwartale 2009 roku, 2010. 29 Ibid. 30 Narodowy Bank Polski, Polska wobec ıwiatowego kryzysu gospodarczego, 2009.

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In the context of other CEE countries, the consequences of the global economic crisis seem to be mildest in Poland. Poland, as the only country in the region, reported economic growth in the first half of 2009 at the estimated rate of 1.0%. Small (as compared to other countries in the region) openness of the economy, and the minor share of machinery and equipment in tangible exports (as compared to the Czech Republic, Slovakia or Hungary) are among the reasons experts quote to explain the continued growth of the Polish GDP. The following sections present the consequences of the world economic crisis for the most significant sectors of the Polish economy. 2.1.1.

Construction

In macroeconomic terms, in Poland the year 2008 was not significantly different from 2007. In comparison to 2007, the economic growth rate fell just insignificantly from 6.8% to 5.1%, which shows that the global crisis had little impact on the Polish economic situation in 2008. The relatively good condition of the Polish economy in 2008 permeated into the construction sector which continued to disclose strong upward trend, even despite the drop against the previous year. The relative changes in the sale of construction and assembly production, in fixed prices, totalled 9.2% in 2008 against 17.8% a year earlier31. The upward trend in the construction in 2008 continued to stimulate the relatively sharp price rise in that sector, which totalled 4.8% against 7.4% in 2007. At the same time, it is worth pointing out that the difference between total inflation and the inflation in the construction decreased from 4.9% in 2008 to just 0.6% in 2009. In terms of employment and wages and salaries, the construction sector continued its upward trend. The average employment in the construction sector, with companies hiring more than nine people in 2008, was 11.7% higher in 2008 than it was in 2007 and remained at the same level of 11.5% against the year before. The wage and salary growth rate in that sector remained high in 2008 and amounted to 10.7%.32 Profitability of the construction business also reported good results, as evidenced by net turnover profitability ratio of 5%.33 31 GĜówny Urzâd Statystyczny, MaĜy Rocznik Statystyczny Polski 2010, 2010. 32 GĜówny Urzâd Statystyczny, Budownictwo – wyniki dziaĜalnoıci w 2008 r., 2009. 33 GĜówny Urzâd Statystyczny, MaĜy Rocznik Statystyczny Polski 2009, 2009.

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When analysing the structure of the construction sector, it is worth noting that the share of private construction in the total number of completed buildings dropped from 90.3% in 2007 to 88.8% in 2008. In addition to private construction, residential construction deserves noting due to its high growth rate. In 2008, a total of 165,189 new flats were completed, which stands for 23.6% increase in comparison to the previous year. Picture 9 presents the structure of the Polish construction sector in 2008 in form of a graph. Picture 9: Structure of the Polish construction sector in 2008; source: Central Statistical Office, 2010. 4.6%

non-residential buildings

3.6% 31.2%

transport infrastructure

15.8%

residential buildings pipelines, telecommunication lines comprehensive industrial constructions

17.5% 27.3%

civil engineering constructions

2009 was the year in which the first signs of the adverse influence of the global crisis in Poland appeared. The economic growth rate clearly plummeted and was reported at a level of 1.8%, i.e. 3.3% less than in 2008. Comparing the performance of the Polish economy with those of other countries, it needs to be stated that the former proved relatively resistant to the world financial crisis. The slowdown of economic growth in Poland, caused by the global financial crisis, had a considerable impact on the Polish construction branch in 2009. The growth in sales in the construction sector declined substantially against 2008 and amounted to 2.2%. Major macroeconomic factors, being a corollary of the global financial crisis and at the same time determining the slowdown in the construction growth in 2009, included: Y

lower investment growth;

Y

deteriorating financial situation among non-financial corporations;

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Y

difficulties in obtaining credit.

In addition to the above macroeconomic factors, the lower growth in the construction sector was contributed to also by such barriers as rising labour costs, scarcity of qualified workers, relatively high costs of building materials and insufficient demand. As far as construction production structure in 2009 is concerned, the number of civil engineering constructions rose by 16.9% while that of completed flats slipped by 3.1% against the previous year.34 The slump in the construction in 2009 restrained the growth of wages and salaries as well as of average employment. The increase in average monthly gross wages and salaries in the construction was reported at the level of 4.4% and was lower than the growth in wages and salaries in the entire economy (5.5%). The average paid employment rate went down to 3.0% in 2009. It is worth pointing out that despite the recession in the national economy, the construction sector disclosed relatively high net turnover profitability of 5.5%, achieved mainly by optimising the administration expenses, reducing employment and managing equipment more efficiently. Furthermore, 2009 witnessed a clear slide in the construction and assembly production prices. In comparison to the previous year, prices in the construction sector went up just 0.2%, chiefly due to falling demand in the construction market with a concurrent decrease in prices of building materials35. Initial estimates of GĜówny Urzâd Statystyczny (Central Statistical Office) for the first quarter of 2010 indicate 3.0% growth of the Polish GDP. Such a performance illustrates the relative robust nature of the Polish economy in the face of the world financial crisis and it is one of the best in Europe. Among the construction companies with more than nine employees, the construction and assembly production in fixed prices decreased by 6.1% against the increase of 1.4% in the same period last year. Poor results for the first quarter led to the clear fall in production in the first half of 2010.36 However, it must be add-

34 Ministerstwo Gospodarki, Analiza sytuacji gospodarczej Polski w 2009 roku, 2010. 35 Ministerstwo Gospodarki, Polska 2009. Raport o stanie gospodarki, 2009. 36 GĜówny Urzâd Statystyczny, Informacje o sytuacji spoĜeczno-gospodarczej kraju. I póĜrocze 2010, 2010.

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ed that the main reason underlying the slump in the construction sector in the first quarter was not as much the worldwide recession but rather the bad weather in that period.37 The recession in the first half of 2010 spread across all construction fields. The sale related to buildings, specialised construction activities as well as civil engineering construction dropped by respectively 6.7%, 6%, and 5.1%.38 18.3% slump in the number of flats completed in the first quarter, as compared to the previous year, is also worth noting.39 Despite the poor performance in the construction branch in the first half of 2010, certain signs of improvement in the sector appeared. They refer first of all to 16.1% increase (against the previous year figures) in the number of flats under construction40, 4.1% increase in the construction and assembly production in June 2010 (against the previous month)41, the favourable business climate among the construction companies which anticipated 4.7% and 5.2% growth rate in, respectively, 2010 and 201142, as well as the positive evaluation of the order book in July 2010.43 Among the major obstacles to development, construction companies still point to the relatively high labour costs, red tape, growing competition on the market and insufficient demand.44 Summing up the condition of the Polish construction branch between 2008 and June 2010, attention should be paid to the considerable impact of the world economic crisis on the stagnation in the construction sector, which culminated in 2009. However, it is worth emphasising that the Polish construction branch remained relatively resistant to the negative macroeconomic conditions, which may be evidenced with streamlining of the activities among the construction companies, as a result of which a high construction profitability ratio was maintained.

37 Ministerstwo Gospodarki, Analiza sytuacji gospodarczej Polski w I kwartale 2010 r., 2010. 38 GĜówny Urzâd Statystyczny, Informacje o sytuacji spoĜeczno-gospodarczej kraju. I póĜrocze 2010, 2010. 39 Ministerstwo Gospodarki, Analiza sytuacji gospodarczej Polski w I kwartale 2010 r., 2010. 40 Ibid. 41 GĜówny Urzâd Statystyczny, Informacje o sytuacji spoĜeczno-gospodarczej kraju. I póĜrocze 2010, 2010. 42 KPMG, Budownictwo w Polsce. Pierwsza poĜowa 2010 roku, 2010. 43 GĜówny Urzâd Statystyczny, Informacje o sytuacji spoĜeczno-gospodarczej kraju. I póĜrocze 2010, 2010. 44 KPMG, Budownictwo w Polsce. Pierwsza poĜowa 2010 roku, 2010.

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The good climate prevailing among the construction companies in Poland, unlike those in the Czech Republic or Slovakia, is another positive sign in the Polish construction branch, which may indicate the gradual recovery of the sector, as the businesses anticipate a sharp increase in construction and assembly production in 2010 and 2011. Experts believe that the steady improvement in the economic situation, in the form of greater availability of investment credit and an increased demand, will help pull the construction industry out of recession. 2.1.2.

Trade

Just like the economic slowdown of 2001-2003, the present financial crisis has also contributed to a reduced total inflow of the direct investment made by western investors. Developed countries were the first to experience that drop in 2008. According to the preliminary estimates of the United Nations Conference on Trade and Development (UNCTAD), 2009 witnessed a decline in FDI inflows across all regions of the world. The decline affected, though to a various extent, all major forms of investment and capital investment components, re-invested profits as well as loans granted by investors. Yet, foreign direct investment flowed into Poland at a relatively stable level, especially given the length of the financial crisis and the situation in some neighbouring countries.

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The picture below presents forecast capital expenditures on trade by industry. Picture 10: Forecast capital expenditures in Poland in 2008-2010; source: Central Statistical Office, 2010. 45.0 40.0 35.0 30.0 25.0 20.0 15.0 10.0

0.0 -5.0 -10.0

Jan 08 Feb 08 Mar 08 Apr 08 May 08 Jun 08 Jul 08 Aug 08 Sept 08 Oct 08 Nov 08 Dez 08 Jan 09 Feb 09 Mar 09 Apr 09 May 09 Jun 09 Jul 09 Aug 09 Sept 09 Oct 09 Nov 09 Dez 09 Jan 10 Feb 08 Mar 08 Apr 08 May 08 Jun 08 Jul 08

5.0

-15.0 -20.0 -25.0 -30.0 TOTAL

Food products

Textiles, Clothing, Footw ear

Household goods total (rtv, household goods and others)

Motor vehicles

The reduced growth rate of capital expenditures on trade in 2008 and 2009 is clearly visible in the analysis of the forecast capital expenditures in Poland between 2008 and 2010. A slow upward trend in the forecast capital expenditures on individual branches of the trade sector may be observed as from the beginning of the second quarter of 2009, except for the white goods industry where the growth rate of foreign investments plunged as from the fourth quarter of 2009. The situation in the foreign trade deteriorated in 2009. According to the Central Statistical Office, total exports fell by 9 p.p. during 2009, which indicates a significant slowdown in comparison with 2008 when they grew at the rate of 7.3%. On

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the other hand, imports dropped by about 14.2% in contrast to 8.4% increase in 2008. Changes in foreign trade activity of companies, as observed in 2009 and at the beginning of 2010, occurred amidst considerable currency fluctuations.45 Analysis of the general business climate index depicts the impact of the economic crisis on retail trade. It is a comprehensive index calculated as an arithmetic mean of responses to the questions about the current and anticipated economic situation. The business climate is perceived as ‘good’ when the index is above zero. Otherwise, the climate is considered ‘bad’. The picture below presents the results of a monthly analysis of the general business climate in retail trade from January 2008 to July 2010. Picture 11: General business climate index for retail trade from 2008 to 2010; source: Central Statistical Office, 2010. 30.0 25.0 20.0 15.0 10.0 5.0

-5.0

Jan 08 Feb 08 Mar 08 Apr 08 May 08 Jun 08 Jul 08 Aug 08 Sept 08 Oct 08 Nov 08 Dez 08 Jan 09 Feb 09 Mar 09 Apr 09 May 09 Jun 09 Jul 09 Aug 09 Sept 09 Oct 09 Nov 09 Dez 09 Jan 10 Feb 08 Mar 08 Apr 08 May 08 Jun 08 Jul 08

0.0

-10.0 -15.0 -20.0 TOTAL

Food products

Textiles, Clothing, Footwear

Household goods total (rtv, household goods and others)

Motor vehicles

45 Instytut Nauk Ekonomicznych PAN, Gospodarka Polski. Prognozy i opinie, 2010.

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The above figures point to the gradual, long-term deterioration of the retail trade business climate from May 2008 until February 2009 in almost all the branches under analysis. The run upwards in the business climate, which started in March 2009, was interrupted again in August 2009 and was hindered until December 2009. According to a survey by the Central Statistical Office, retail trade entrepreneurs pointed to a short-term improvement of the business climate from January to April of the following year. Yet, the recent months showed a decline in all indices including the main one which, despite the drop, reported a positive value of 1.4 at the end of July 2010 and indicates a good business climate in the retail trade sector. In 2009 Polish trade with the EU as well as worldwide fell. A downward drift in trading followed both in exports and imports by, respectively, 17.6% and 25.6%. The poor results of the Polish foreign trade were tied closely to the impact of the economic crisis which dampened import demand so markedly and suddenly that it caused an unprecedented plunge in turnover on all markets from November 2008 to the end of 2009. The favourable balance of trade in 2009, resultant from a smaller drop in exports, confirms the above state of affairs. The European integration helped eliminate the trade deficit with the EU Member States, so characteristic for the pre-accession period. In spite of the recession in 2009, the balance of trade in goods with EU countries improved and rose from 2.3 billion EUR in 2008 to 11.9 billion EUR in 2009. Imports declined by 23.7 billion EUR, which is more than the drop in exports by 13.4 billion EUR. The EU share in Polish exports increased from 77.8% in 2008 to 79.3% in 2009, whereas the share in imports fell from 61.9% in 2008 to 61.4% in 2009. The upward trend of the EU share in Polish exports, accompanied by the downward trend in imports, may be inferred from the data for January 2010, whereby the EU share in total Polish exports amounted to 79% and the share in imports from the EU accounted for 57.3% of Poland’s total import. It is worth pointing out that the index downslides for Poland were significantly smaller than in other CEE countries. For instance, the value of Estonian exports in the period from January to November 2009 dropped against the same period of 2008 by 25%, in Latvia by 30% and in Lithuania by 22%. At the same time, Polish exports fell by 18%. Imports in other countries of the region reported also downslides that were greater than in Poland – in Latvia by 40%, in Estonia by 35%, and in Poland by 27%. Poland maintained a relatively high level of trade with the recession-ridden countries. Since January 2010 total exports have risen by 1.8% (January 2010 against January 2009), whereas exports to non-European countries have grown by 15.6%. Since imports fell more significantly than exports, the bal-

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ance of trade in Poland grew considerably from the level of -17.7 billion EUR in 2008 to -3.4 billion EUR in 2009. The well-established position of Polish exporters on the common market contributed to the export results for 2009 being ahead of expectations. Foreign trade worked towards stabilisation of the Polish economy. Generally speaking, despite the decline in indices, trade influenced favourably the economy which had been impacted adversely by the world financial crisis. The major EU export and import partners of Poland continue to be: Y

Germany with 26.1% share in total exports and 22.4% share in total imports;

Y

Italy with 6.9% share in total exports and 6.8% share in total imports;

Y

France with 6.9% share in total exports and 4.6% share in total imports;

Y

United Kingdom with 6.4% share in total exports and 3.0% share in total imports46. Trade in goods with four major trade partners of Poland fell:

Y

by 21.4% in the case of Germany;

Y

by 15.8% in the case of Italy;

Y

by 18.6% in the case of France;

Y

by 14.4% in the case of the United Kingdom.

The balance of trade in goods with all four key export partners in the EU improved: Y

in the case of Germany: from -3.6 billion EUR to 1.6 billion EUR;

Y

in the case of Italy: from -2.3 billion EUR to -0.4 billion EUR;

Y

in the case of France: from 0.5 billion EUR to 1.7 billion EUR;

Y

in the case of the United Kingdom: from 2.7 billion EUR to 3.1 billion EUR.

The share of the balance of trade in goods in the total Polish exports grew in 2009 (against 2008) with the following trade partners: Y

with Germany: from 25% to 26.1%;

Y

with Italy: from 6.0% to 6.9%;

Y

with France: from 6.2% to 6.8%;

Y

with the United Kingdom: from 5.8% to 6.4%.

46 Study developed on the basis of data of the Central Statistical Office.

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The share in exports of the single most important trade partner, namely Germany, was greater in 2008 by 1.1 p.p. and amounted to 26.1%, whereas in the case of imports its share was smaller by 0.6 p.p. and stood at 22.4%. The balance surplus reached 7.0 billion PLN against the deficit of 12.6 billion PLN in 2008. The increase in the balance of trade in goods was caused by more favourable PLN exchange rate against EUR and GBP, and at the same time implied strengthening of the position of Polish exporters on Western European markets. Trade with China and India also developed in a positive manner – exports rose by ca. 20% and 18% respectively, whereas imports fell by 15%. Poland’s trading with the USA and Japan increased insignificantly. If compared with the data for January 2009, in 2010 Polish exports to NAFTA members, ASEAN countries and MERCOSUR countries grew by respectively 22.9%, 17.8% and 5.7%. Analysis of the data for the year 2009 shows an unfavourable trend in trade with Russia, which, according to forecasters, is supposed to reverse in 2010. The year 2009 saw a dramatic fall in trade with Russia when exports amounted to merely 3.6 billion EUR in 2009 against 6 billion EUR in 2008, whereas imports reached the level of 9.2 billion EUR and 13.9 billion EUR respectively. The trade deficit with Russia, the seventh largest export market for Poland, also shrank from -7.8 billion EUR in 2008 to -5.6 billion EUR in 2009. Similar trends were observed in trading with Ukraine and Belarus. The poor results on transactions with the countries in Eastern Europe were caused by widespread protectionist actions undertaken by their governments. According to the periodical WTO protectionism reports, Russia is among the countries most willingly to employ restrictive trade policy measures in connection with the financial crisis. Since Russia is not a WTO member state, it is particularly easy for that country to undertake such measures.47 The results obtained in the first months of 2010 promise the growth rate to remain at the level similar to that of the second half of 2009, which amounts to 1.7%. An assessment of the economic situation in the analysed period needs to account for the consequences of the global financial crisis, as spread worldwide. In this context Poland’s performance was exceptionally good, since Poland, as the only country in Europe and one of the few countries in the world, escaped the recession.

47 Ministerstwo Spraw Zagranicznych, Departament Polityki Ekonomicznej, Ekonomiczno – spoĜeczne efekty czĜonkostwa Polski w Unii Europejskiej, GĜówne wnioski w zwiâzku z 6-tâ rocznicâ przystâpienia Polski do UE, 2010, http://polskawue.gov.pl (retrieved on 23 July 2010).

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2.1.3.

Industry

The financial crisis affected the Polish economy with varying intensity. Although the economic performance was generally poor, it turned out that some sectors of the industrial economy appeared more or less resilient to the crisis. While the production in some branches dropped against the previous periods, in some other ones it withstood the aftermaths of the crisis and continued to grow. However, taking into account the Polish industry sector as a whole, it may be concluded that the recession followed and the growth indices reported negative values in the years of the global economic crisis. According to the figures presented by the Central Statistical Office, the sold output of industry related to the whole sector saw a 3.3% increase still in 2008, as compared with the previous year. At the same time, it needs to be underlined that the growth ratio was nonetheless lower than the one in the year 2002.48 Taking into account the annual indices for the year 2009, it may be stated that the value by which the sold output in industry decreased against the previous year was 3.5%. Picture 12 presents a detailed analysis of the growth rate of the sold production of industry for particular branches in the years 2006-2009. Picture 12: Relative changes in the sold production of industry by branch in the years 20062009; source: Central Statistical Office, 2010. 2006

2007

2008

2009

Total sold production of industry

11.6%

10.7%

3.6%

-3.5%

mining and quarrying

-2.6%

0.5%

3.3%

-12.8%

manufacturing

13.8%

12.4%

4.0%

-3.0%

electricity, gas, steam and hot water generation and supply

1.2%

1.6%

-1.7%

-4.9%

water supply, sewerage and waste management and remediation activities

6.7%

3.1%

12.2%

2.5%

2008 brought about a breakthrough in Polish industry. Based on the estimates of the Central Statistical Office it was evident that the upward trend for the sold production of industry reversed in the second half of 2008, and specifically in its fourth

48 Ministerstwo Gospodarki, Analiza sytuacji gospodarczej Polski w 2008 roku, 2009.

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quarter. In that period, the total sold output of industry without seasonal adjustment declined by 6.3% in comparison with a similar period of the previous year. The downward trend was the case almost throughout the entire year 2009. The economic breakdown which affected also the companies in the industry sector is reflected by the business climate index for manufacturing. The period of stable and perceptible upward business tendency lasting from 2003 to 2008 was followed by an economic breakdown which resulted in negative values for business climate in manufacturing. The index continued to report negative values throughout the entire year 2009. As far as the key industrial goods are concerned, the most considerable changes affected the energy producers. The business climate index plummeted to the lowest value in March 2009, when it reported the level of 47.6%. At the same time, it should be pointed out that the relative changes in the group of the energy industry were bigger than in other groups. The business climate index shown for consumer goods producers dropped to the minimum level of 7.7% in February. It might be well assumed that the economic crisis in Poland affected the businesses operating in the food and beverage sector to the smallest extent. In this case, the business climate index during the downturn disclosed positive figures, wherein its lowest value (0.2) was reported for March 2009.49 Picture 13 presents the changes in the business climate index in manufacturing for the years 2000-2010. Picture 13: Business climate index in manufacturing for the years 2000-2010; source: Central Statistical Office, 2010.

Analysing the condition of the industry sector in the era of the global financial crisis, it is the comparatively high correlation between the Polish economic performance measured by the GDP growth and the value of the total sold output of industry, as shown in picture 14, which is worth noting. 49 Study developed on the basis of the data of the Central Statistical Office.

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Picture 14: Quarterly changes in the sold production of industry and gross domestic product in the years 2007-2009; source: Central Statistical Office, 2010. 15%

10%

5%

0% I

II

III

IV

I

2007

II

III

IV

2008

I

II

III

IV

2009

-5%

-10%

-15%

Total sold production of industry (without seasonal adjustment) Produkt krajowy brutto (ceny stale)

The analysis of the picture above discloses a relatively tight correlation between the changes in GDP and the growth rate of the sold output of industry in the years 2007-2009. This correlation shows that the situation in the Polish industry deteriorated in line with the decrease in the gross domestic product. The interdependence between these two indices demonstrates explicitly the moment in which the economic breakdown occurred. It happened in the fourth quarter of 2008 when the sold output of industry dropped significantly and the gross domestic product started to decrease sharply. The signs of downturn in both the indices appeared already a bit earlier, i.e. in the third quarter of 2008. The GDP grew in the first quarter of 2009 to the value of 0.7% in comparison with the same period in the previous year, whereas the changes in the sold production of industry increased by 10% against the corresponding period of the previous year. For the sake of comparison, the relative changes in the GDP and the sold output of industry in the first quarter of 2007 disclosed the values of, respectively, 7.5% and 12.2%, against the equivalent periods in the previous year.50

50 Study developed on the basis of the data of the Central Statistical Office.

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The downturn in the sold output of industry affected in the main the branch of electricity, gas, steam and hot water generation and supply. The sold output of industry in this branch in the first quarter of 2008 grew by 11.3%, whereas the fourth quarter reported 14.8% decrease of the same, as compared with the similar period of the previous year. Although mining and manufacturing reported little change, the fourth quarter, in which the sold production dropped, was a turning point for these two branches. Picture 15 presents the downward trend of the quarterly changes in the sold output of individual industries. Picture 15: Relative changes in the sold production by industry and quarter in 2008; source: Central Statistical Office, 2010. 20.0% 15.0% 10.0% 5.0% 0.0% -5.0%

sold production of mining and querying

sold production of manufacturing

sold production of electricity, gas, steam and hot water generation and supply

sold production of water supply, sewerage and waste management and remediation activities

-10.0% -15.0% -20.0% 1Q

2Q

3Q

4Q

Although the industry growth rate clearly levelled off in the view of the global crisis, the outlook for this sector seems optimistic, even though its condition depends to a large extent on the global as well as national economy. The gradual revival of the industry and its recovery from the recession may be substantiated by, among others, an increased business climate index for manufacturing. It has disclosed positive values since the beginning of 2010. Another sign to confirm the upward trend in the Polish industry is the growth rate of the sold output of industry. It was disclosed in the first and second quarter of 2010 at the level of, respectively, 9.5% and 11.7% in comparison with similar periods of the previous year.51

51 Study developed on the basis of data of the Central Statistical Office.

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2.2.

Economic Crisis and the Financial Situation in Poland in the Years 2008-2010

The condition of the Polish economy in the years 2008-2010, as compared with those of the Euro-zone Member States as well as with other countries of the region, seems positive. Poland is the only country among the EU Member States to report economic growth. The reaction of the Polish economy to the crisis, contrary to all reasonable expectations, confirms its sustainable development. The financial breakdown made the drawbacks of the financial supervision particularly distinct in many countries, at the same time confirming the reasonability of Polish regulations. As a result, in 2009 Poland was the country of the highest growth rate in Europe. Picture 16 shows the GDP growth rate by quarter in the years 2008-2010. Picture 16: GDP growth rate in the years 2008-2010 (y-o-y), source: Central Statistical Office, 2010. 2008

2009

2010

1Q

2Q

3Q

4Q

1Q

2Q

3Q

4Q

1Q

6.3

6.1

5.2

3.2

0.7

1.1

1.8

3.3

3.0

5.1

1.8

-

The period of an intense economic growth, which was characteristic for all key sectors such as services, industry and construction and which started in 2004, continued till the mid-2008. Then, the upward trend slowed down and the growth rate decreased year over year (y-o-y) to 3.2% in the last quarter, whereas during the entire year 2008, the growth rate reported the value of 5.1% y-o-y. Further decrease in the GDP rate was visible especially in the first half of 2009 when the growth rate disclosed the y-o-y figures for the first and second quarters at the respective levels: 0.7% and 1.1%. In the second half of 2009, the GDP astonished the majority of the financial analysts. In the fourth quarter of 2009, the index grew by 3.3% y-o-y, as compared to 1.8% for the third quarter.52 In 2008, the main driving force of the growth was domestic demand. The entire year reported high values for individual consumption expenditure, which resulted in the main from the favourable changes on the labour market (increased employment as well as growth in wages and salaries). In 2009, upon three quarters of a negative outcome on GDP, in the fourth quarter the domestic demand brought in 52 GĜówny Urzâd Statystyczny, Wybrane kwartalne wskaōniki makroekonomiczne, 2010.

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a positive stimulus equalling the drop in the first three quarters (0.9 p.p.). According to the analysis of the Central Statistical Office, the main contributor to the GDP growth in the fourth quarter was, nonetheless, the foreign demand (net export), which contributed to the economic growth by 2.2 p.p.. The effects of the crisis, perceptible already in 2008, referred to the public finance which deteriorated. Any economic slowdown brings in a decrease in taxrelated inflows and an increase in individual categories of public expenditure. In the years 2008-2010, this common pattern was perfectly visible. In 2008, the deficit in the general government sector reached 46,889 million PLN, i.e. 3.7% of GDP against 1.9% of GDP in 2007. A year later, the deficit in the general government sector increased to the level of 95,730 million PLN, which accounted for 7.1% of GDP, whereas the public debt totalled 684,365|million PLN|, i.e. 51.0% of GDP.53 According to the forecast by the Ministry of Finance, in the year 2010 the deficit in the said sector is to level off and remain similar in figures to those in the year 2009, when it totalled 97,033 million PLN, i.e. 6.9% of GDP, whereas the public debt is to amount to 755,043|million PLN|, i.e. 53.5% of GDP. The deteriorating public finances postponed the moment in which Poland was able to adopt the common currency, i.e. euro. The precondition to join the Eurozone is to meet the convergence criteria set forth in Art. 121.1 of the Treaty on European Union signed in Maastricht. Taking into account the figures of the public finance sector, as reported for 2008, on 24 June 2009 the European Commission reopened the excessive deficit procedure for Poland, which had been closed in 2008 in view of the figures disclosed for the year 2007. Under the amendment to the Convergence Implementation Plan, the assumed deficit in the general government sector is to diminish not earlier than after 2010, and in 2011 it will total 5.9% of|GDP with the subsequent drop to 2.9% of GDP in the year 2012.

2.3.

Labour Market

The most significant economic factors to shape the labour market in Poland include the economic growth rate as well as the increasing investments. The sharp upward trend of the economic growth disclosed as from 2004 was maintained also in 2008, although the last quarter of that year reported an economic slowdown. Yet, the aftermaths of the global crisis on the financial market were limited in their 53 GĜówny Urzâd Statystyczny, DĜug publiczny sektora finansów publicznych i deficyt budŏetowy w 2009 r., Warsaw 2010.

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scope that year and did not significantly affect employment with companies. The fourth quarter of 2008 saw only a minor fall in the number of people employed with companies (by 1.3%) as well as an increase in the unemployment rate by 0.6%, as compared with the previous quarter. As a result of the global financial crisis and the economic recession that followed, the employment in Poland ceased to grow from 2009. At the beginning of 2009, the main problem relating to the Polish labour market was the rising unemployment rate. The number of the registered unemployed as of the end of March 2009 was by 3.3% higher than in the same month of the previous year, whereas the unemployment rate rose by 0.3% in the similar period.54 The global economic slowdown aggravated the situation on the labour market till the first quarter of 2010. The labour market situation further worsened also as a result of inclement weather in the first months of 2010, which hindered business activity especially in the construction sector.55 The unemployment rate in March 2010 rose already up to the level of 12.9% and was 1.8% higher than in March 2009 and at the same time the highest level since the first quarter of 2007, when it reached the level of 14.3%. In the second quarter of 2010, the situation of the unemployed began to improve and the unemployment rate dropped by 2.3 p.p. against the first quarter of 2010, and reported the value of 10.6%. As a consequence of Poland’s accession to the EU, which resulted in easy access to the labour markets of the EU-15 Member States, the number of the Polish citizens going abroad for gainful purposes in the recent years was on a continuous increase. However, in 2008, significant changes in the migration trend of the Poles were observed. In 2008, the economic situation of the countries in Western Europe, such as the United Kingdom, Ireland, Germany or Spain, which were targeted by many migrant Poles, significantly deteriorated. A fall in production, accompanied with bankruptcy of businesses, contributed to a considerable increase in the unemployment on the local markets. As a result, the demand for migrant workers declined. In the United Kingdom and Spain, the deteriorating labour market and the fears regarding competitiveness on the part of the migrant workers, who used to be hired on worse remuneration and social terms than the natives, incited numerous social protests. As a result, Polish citizens found the search for work abroad increasingly difficult.

54 GĜówny Urzâd Statystyczny, Analiza sytuacji gospodarczej Polski w 1 kwartale 2009, 2009. 55 GĜówny Urzâd Statystyczny, Analiza sytuacji gospodarczej Polski w 1 kwartale 2010 roku, 2010.

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The year 2008 witnessed a phenomenon of migration of the Polish workers from the EU Member States, which had been severely affected with the economic recession, to other EU countries where the demand for foreign labour was still high. A report by a Polish organisation Zjednoczenie Polskie w Wielkiej Brytanii (Federation of Poles in Great Britain)56 shows that some of the Poles left the United Kingdom and migrated to Norway or the Netherlands. The deterioration of the situation in the EU-15 Member States drove many Polish citizens to come back to Poland. They might also have been driven by the stable growth in the average wages and salaries in the national economy of Poland throughout the entire economic slowdown. In the second quarter of 2010, the average wages and salaries amounted to 3,403.65 PLN57 and were higher by 14% as compared with the beginning of 2008 as well as by 26% bigger than the average wages and salaries in 2007.

3.

Challenges and Coping with the Financial Crisis

In 2009 Poland commemorated the 20th anniversary of changes in the political system and in the economy, as well as the fifth anniversary of accession of Poland to the European Union. The main topic of that time did not, however, focus on those events but on the global economic crisis whose earliest aftermaths for the Polish economy were observed already in the year 2008, whereas their greatest impact was perceptible in the year 2009. The main challenge faced by the Polish public institutions in the era of crisis was to mitigate the negative effects of the global recession upon the individual sectors of the national economy as well as to maintain the highest possible rate of the economic growth. The actions aimed at managing the crisis in Poland were undertaken on multiple levels and were not limited to just measures implemented nationally. They were pursued also within the European Union whose Member States include

56 Ministerstwo Gospodarki, Polska 2008, Raport o stanie gospodarki, 2008. 57 GĜówny Urzâd Statystyczny, Przeciötne zatrudnienie i wynagrodzenie w sektorze przedsiöbiorstw w czerwcu 2010 r., 2010.

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Poland. The most significant undertakings as regards both the economy and legislation aimed at alleviation of the negative impact of the global financial crisis on the condition of the Polish economy are presented in|sections|3.1.-3.3.

3.1.

Rescue Package for the EU Economy

The actions to counteract the crisis in the European Union were undertaken already in the fourth quarter of 2008. On 7 October, the Economic and Financial Affairs Council (ECOFIN) undertook to launch any and all measures as necessary to improve the condition and stability of the financial system in order to restore the confidence in the financial sector and its proper operation. It was also determined that although the decisions on public intervention must be taken on the national level, they should be coordinated and carried out based on a number of the shared principles of the European Union.58 On 28 November 2008, the European Commission presented a rescue package for the EU| Economy (European Economic Recovery Plan – EERP). Its execution was estimated to consume 200 billion EUR|, i.e. 1.5% of the EU GDP. This amount was to include 170 billion EUR sourced from the budgets of the Member States (ca. 1.2% of the EU GDP) and 30 billion EUR obtained from the EU funds (ca.|0.3% of the EU GDP). The strategic objectives of the plan include in particular: Y

swift stimulation of the market demand and confidence;

Y

downsizing the social costs of the economic recession;

Y

creation of stimulation in the European economy during its return to quick and competitive global growth;

Y

facilitation of transition of the EU economy to low carbon economy.59

Y

In response to the global economic crisis and the recommendations set forth in the EERP, on 30 November 2008 the Polish government put forward the socalled ‘Plan Stabilnoıci i Rozwoju’ (Stability and Development Plan), which summarised the measures undertaken so far by the National Bank of Poland as well as by the government to counteract the consequences of the global financial crisis and which announced further anti-crisis actions. The key objectives of the adopted Stability and Development Plan include the following:

58 Ministerstwo Gospodarki, Polska 2009. Raport o stanie gospodarki, Warsaw 2009. 59 Ibid.

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Y

ensuring the stability of public finance due to assurances and guarantees granted to the financial institutions which incur credits on the inter-bank market;

Y

stimulating the consumer and investment demand;

Y

supporting medium- and large-sized companies which pursue projects strategic for the Polish economy;

Y

protecting the labour market.60

3.2.

Actions of the Polish Government to Counteract the Consequences of the Economic Crisis

The government of the Republic of Poland has undertaken a number of actions to alleviate the impact of the global economic recession upon the Polish economy. The fundamental ones include the government anti-crisis plan, anti-crisis package as well as the aid for the housing loan repayment. 3.2.1.

Government’s Anti-Crisis Plan

In response to the rescue package of the European Union, in November 2008 the Polish government adopted the ‘Plan stabilnoıci i rozwoju – wzmocnienie gospodarki Polski wobec ıwiatowego kryzysu finansowego’ (Stability and Development Plan – Reinforcing the Polish Economy in the Face of the Global Financial Crisis) aimed at ensuring the stability of the public finance and the financial system as well as at maintaining the economic growth. The government’s anti-crisis plan has been supplemented with the adopted and pursued package of measures of the Minister of Economy, intended directly to mitigate the impact of the economic recession. The measures taken by the Ministry of Economy to ensure stability and development are targeted, first of all, to increase the consumer and investment demand as well as support entrepreneurship to stabilize the economy in the era of the crisis as well as provide for its return to the path of the fast economic growth. The anti-crisis plan of stability and development provides for 91.3 billion PLN to be supplied to the Polish economy in the years 2009-2010. The plan offers for a set of solutions, the most vital ones including reinforcing the system of assurances and

60 Narodowy Bank Polski, Polska wobec ıwiatowego kryzysu gospodarczego, 2009.

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guarantees as well as credits for small- and medium-sized companies, speeding up investments co-financed from EU funds as well as investments in renewable energy sources and telecommunications. The plan provides for the limit of assurances and guarantees to be increased by 40 billion PLN in 2009 and an additional lending activity to be launched in the amount of 20 billion PLN for the small- and medium-sized companies. The assumptions refer as well to speeding up investments co-financed with the EU funds in the amount of 16.8 billion PLN and an advance payment to be obtained from the European Commission in the amount of 3 billion PLN. Moreover, the plan foresees additional payments to investments in renewable sources of energy in the amount of 1.5 billion PLN to be provided by ‘Narodowy Fundusz Ochrony İrodowiska i Gospodarki Wodnej’ (National Fund for Environmental Protection and Water Management). The major legislative measures under the stability and development plan by the government are presented below. The stability and development plan included amendments to the Act on Assurances and Guarantees Granted by the State Treasury and Particular Legal Persons as well as to the Act on the National Economy Bank. The amendments of the aforementioned acts were intended to help the business mainly of the micro- and smallsized companies to meet the requirements set forth by the banking sector while applying for credit.61 They also increased the volume of the granted assurances and guarantees as well as made the assurance business standards uniform. At the same time, some of the responsibilities of Bank Gospodarstwa Krajowego (National Economy Bank) have been defined in detail, which is to streamline the procedures binding so far.62 Following the joint declaration of the EU Member States made on 7 October 2008 at the ECOFIN session, on 23 October 2008 the Polish Sejm adopted a bill amending the Act on the Bank Guarantee Fund. Having been signed by the President, the Act entered into force on 13 December 2008. At present, the repayment of deposits made by the Poles is guaranteed to the amount of 50.000 EUR, i.e. ca. 200.000 PLN. Moreover, it will be possible for the fund to incur loans from the State Treasury. The amendment has introduced the possibility for the Council of Ministers to issue a regulation, upon consulting the President of Narodowy Bank 61 Biuro Analiz Sejmowych, Opinia do rzâdowych projektów ustaw: o poröczeniach i gwarancjach udzielanych przez Skarb PaĞstwa oraz niektóre osoby prawne oraz o zmianie niektórych innych ustaw (druk nr 1639), o zmianie ustawy o Banku Gospodarstwa Krajowego oraz niektórych innych ustaw (druk 1638) z dnia 9 marca 2009 roku, 2009. 62 Ibid.

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Polski (National Bank of Poland) and Komisja Nadzoru Finansowego (Polish Financial Supervision Authority), under which it will be possible to determine the upper limit of the guaranteed deposits to be temporarily higher than the one set forth in the act concerned. Another legislative measure aimed at mitigation of the consequences of the financial crisis consisted in amending the Personal Income Tax Act by way of another act which abolished taxation of allowances granted by the trade unions and those financed by the Company Social Benefit Funds, as well in making the value of social benefits in kind and monetary benefits sourced in this respect from the Company Social Benefit Fund exempt from personal income tax. Further amendments to the Personal Income Tax Act and the Corporate Income Tax Act introduced bigger tax reliefs as regards investments (up to 100,000 EUR) made by newly established companies, where the new regulations have been in force since 22 May 2009. The new legislation provides also for the possibility to recognise the expenses related to research and development conducted by companies as tax-deductible costs. The legislators also amended the Act on Assurances and Guarantees granted by the State Treasury in order to reinforce the system of assurances and guarantees for the small- and medium-sized companies to widen their access to external financing sources. The act entered into force on|15|May|2009. The Act on Committee on Financial Stability has also been adopted which, in the case that the crisis worsens, is to facilitate the competent key authorities to undertake the swift and co-ordinated actions. The Act on Committee on Financial Stability dated 7 November 2008 (‘Journal of Laws’, No 209, item 1317) took effect on 13 December 2008. According to the legislative assumptions, the aim of the Committee’s operation is to ensure efficient co-operation as regards supporting and maintenance of the stable national financial system by way of exchanging information, opinions and evaluations of the situation in the financial system in Poland and abroad as well as through co-ordination of actions in this respect (art.|1|item 2 of the said act). The members of the Committee include the Minister of Finance, the President of the National Bank of Poland, the Chairperson of the Financial Supervision Authority, who are headed by the Minister of Finance. The Committee’s responsibilities include in particular the following: assessment of the situation in the domestic financial system and on the international markets as well as ensuring the proper information flow between the Committee’s members as regards significant events and trends which might threaten the stability of the domestic financial system; development and adoption of collaboration procedures in the case the stabil-

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ity of the domestic financial system is threatened as well as co-ordination of the activities undertaken by the Committee members in the case a threat to the stability of the domestic financial system arises. Another key legislative instrument under the anti-crisis plan was to adopt the Act on Granting the Support for Financial Institutions by the State Treasury (on 12|February|2009) in order to provide the Minister of Finance with the possibility to support the financial institutions whose liquidity has been affected. According to this act, the financial institutions include national banks, credit unions, investment funds, brokerage houses, national insurance companies and pension funds. Under the said Act, the financial institutions may apply for financial support to be granted in the following forms: state guarantees (this form of support is accessible exclusively for the national banks), loans of treasury securities, sale of treasury securities with deferred payment, sale of treasury securities by instalment as well as sale of treasury securities under offer addressed to specified financial institutions. According to the original wording of the act, the support under the principles stipulated therein could be granted no longer than till 31 December 2009. On 13 January 2010, an amendment took effect to extend the possibility to apply for such support by the financial institutions till the end of 2010. To sum up, it should be stated that the government’s anti-crisis plan was a prelude to a truly significant legislative thrust which introduced multiple amendments of law and established new instruments to make Poland ready to fight the financial crisis. 3.2.2.

Anti-Crisis Package

As a result of transformation of the financial crisis into the economic breakdown, in 2009 actions were undertaken to develop an anti-crisis package which was to be addressed to entrepreneurs affected by the recession. The outcome of such work is the Act of 1 July 2009 on Mitigating the Consequences of the Economic Crisis for Employees and Employers (‘Journal of Laws’, No. 125 item 1035, hereafter: the Anti-Crisis Act), which is fundamental to the anti-crisis package. The act took effect on 22 August 2009 and is to remain in force till the end of 2011. Prior to that, on 17 August 2009, the European Commission resolved that the state aid provided under the regulations of the said act was in compliance with the common market. Therefore, it was possible to apply the state aid regulations as from the day on which the Anti-Crisis Act took effect.

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The main objective of the act is to sustain the economic performance, curb the growth of unemployment as well as protect the society against the consequences of budget-related problems. Due to the fact that some of the regulations of the Anti-Crisis Act interfere with the employees’ rights and legislative assumptions, particular provisions of the bill were consulted with the Trilateral Commission for Social and Economic Affairs (Trójstronna Komisja do Spraw SpoĜeczno-Gospodarczych), whose abbreviated name is the Trilateral Commission. The Trilateral Commission is a platform of social dialogue for reconciliation of the interest of employees, employers and the public good. The members of the Trilateral Commission include the government officials appointed by the Prime Minister, representatives of the recognized trade union organisations as well as the representatives of the recognised organisations of employers. At present, the Trilateral Commission members representing the trade unions include NSZZ ‘Solidarnoıä’ (Solidarity), Ogólnopolskie Porozumienie Zwiâzków Zawodowych (National Alliance of Trade Unions) and Forum Zwiâzków Zawodowych (Trade Union Forum). The employers are represented by Polska Konfederacja Pracodawców Prywatnych (Polish Confederation of Private Employers), Konfederacja Pracodawców Polskich (Confederation of Polish Employers), Zwiâzek RzemiosĜa Polskiego (Polish Craft Association) as well as the Business Centre Club.63 The consultation was not short of the tension between the employers and the representatives of the trade unions. The latter were of the opinion that the introduced solutions made the position of the employees too weak due to the possibility of announcing economic downtime (a novelty in the Polish law), limitation of the working time and exclusion of one of the Labour Code regulations under which the contract of employment for a definite period is lawfully deemed concluded for an indefinite period if made for the third time. The Anti-Crisis Act may be regarded as a set of instruments to support entrepreneurs and the employees they employ, which undergo financial difficulties resultant from the financial and economic crisis, in a way so as to enable them get through the crisis and avoid redundancies or even some worse scenario, i.e. bankruptcy. Such instruments, whose details are presented further in this section, include regulations aimed at greater flexibility of the employee’s working time, financial support for the employer as well as co-financing of training courses, post-graduate education and grants for the employees employed with those companies which meet the criteria to benefit under the Anti-Crisis Act.

63 Based on data sourced from the Ministry of Labour and Social Policy.

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The key assumption of the Anti-Crisis Act was to direct the financial aid to entrepreneurs in a straightforward manner affected by the financial and economic crisis. In this way, the act provides for a number of conditions which, only if met jointly, entitle the given entrepreneur to exploit the tools which are provided for therein and which are instrumental in determining just those entrepreneurs who have been financially experiencing a hard time due to the crisis. It should be pointed out, however, that some of its provisions refer to all entrepreneurs with no distinction between those, as set forth by the act, who ‘suffer temporary financial difficulties and those who do not suffer the same’. To be entitled to use the state aid under the statutory aid schemes it is necessary for the entrepreneur to obtain the status of the so-called ‘entrepreneur undergoing temporary financial difficulties’. To obtain such a status, the entrepreneur is required to meet jointly the following conditions. The first one requires that the turnover (construed as sales) with a given entrepreneur drops by at least 25%, wherein such a drop should be measured by quantity or value within three consecutive months after 1 July 2008 against the corresponding three months but in the period from 1 July 2007 to 30 June 2008. The above condition is to make the entrepreneurs who have suffered a drop in the turnover due to the prevailing economic crisis distinct from those who experienced a turnover decrease in no relation to the recession. It is also material that the Polish legislator adopted the date of 1 July 2008 as the cut-off point, which results from the fact that the European Commission accepted that date in, among other things, the Commission’s Communication dated 22 January 2009 (‘Official Journal of the European Union’ 2009/C 16/01). Under another condition for the act to apply, the given entrepreneur must not be in arrears with payment of tax liabilities, social insurance contributions and health insurance premiums as well as with the contributions to the Guaranteed Employee Benefit Fund and the Labour Fund. The act assumes, however, two exemptions from the above requirement. The requirement is deemed met when the indebted employer has concluded an agreement on repayment of the debt and pays the instalments on a timely basis or is provided with a deferred payment date or when the social insurance contributions or health insurance premiums or the contributions to the Guaranteed Employee Benefit Fund or to the Labour Fund, which are in arrears, refer to the period falling due after 1 July 2008.

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In order to direct the aid exclusively to the entrepreneurs whose chance for remedy of their financial standing is real, it has been resolved that the potential beneficiary of the aid schedules must not meet the conditions of declaring bankruptcy. The act refers to the Bankruptcy and Rehabilitation Law, under which the debtor’s insolvency, i.e. a state in which the debtor fails to meet his financial obligations, is deemed the condition to declare bankruptcy. A debtor who is a legal person or an organisational unit without any legal personality upon whom a separate act confers a legal capacity, is deemed insolvent also when his obligations are in excess of the value of his assets, even if he is current in discharge of those obligations. Another condition arises immediately from the principles of granting the state aid, as set forth in the Commission’s Communication dated 22 January 2009 which determines the temporary community-based legal frame for the Member State to grant aid, under which the access to the financing in the time of the financial and economic crisis is made easier (‘Official Journal of the European Union’, 2009/C 16/01). Item 4.2.2 c) of the Communication stipulates that the aid may be granted exclusively to companies which ’were not in difficulty’, i.e. whose financial situation was not difficult. In order to determine the difficult financial situation, the Guidelines of the European Commission refer to previous Guidelines of the Commission dated 1 October 2004 as well as to the Commission Regulation (EC) No. 800/2008. Additionally, a given entrepreneur is required to develop a recovery plan under which the financial standing of the entrepreneur is likely to improve, and which would cover a year starting from the first day of the month following the day on which the aid available under the act was applied for. It is worth pointing out that entrepreneurs who have received the state aid from the Labour Fund for ensuring equipment or additionally equip a workplace for a referred unemployed person are not entitled to apply for the means under the act concerned, unless at least twelve months have passed from the date of decision on granting such an aid. As assumed by the Polish legislators, the above conditions are deemed met upon presentation of a relevant certificate. The certificate is issued at the entrepreneur’s request, and its standard form is specified in the relevant regulation to the act. The certificate is issued by the Head of Local Office of the Guaranteed Employee Benefit Fund (Biuro Terenowe Gwarantowanych İwiadczeĞ Pracowniczych). The entrepreneur who has obtained the certificate is considered an ‘entrepreneur undergoing temporary financial difficulties’.

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The Anti-Crisis Act provides for two types of the aid instruments. The first one is addressed exclusively to ‘entrepreneurs undergoing temporary financial difficulties’. The other type is addressed to all entrepreneurs who are employers. The aid instruments addressed to ‘entrepreneurs undergoing temporary financial difficulties’ include the following forms: a subsidy to the employee’s wage or salary during the so-called ‘economic downtime’, a subsidy to the employee’s wage or salary in the case his/her working time is reduced, subsidies to employee’s social insurance contributions in the part paid for by the employer, a possibility to re-negotiate terms of repayment of dues to the Guaranteed Employee Benefit Fund, as well as subsidies to training courses and post-graduate education. Subsidies to the employee’s wage or salary during the so-called ‘economic downtime’ may be obtained up to the amount of the unemployment benefit and for the period of six months. The unemployment benefit amounts to 717 PLN per month in the first three months of the entitlement to such a benefit, and 563 PLN per month in subsequent months of the entitlement. An ‘economic downtime’ has been defined for the purposes of the Anti-Crisis Act and is construed as non-performance of work by a ready-to-work employee at the entrepreneur undergoing temporary financial difficulties caused by economic reasons not attributable to the employee. The subsidy in the case of reduced working time may amount to maximum 70% of the unemployment benefit. It needs to be emphasized that working hours stipulated in an employment contract must not be reduced for a period longer than 6 months and by more than half of the regular work time basis. Of importance is also the fact that the option to reduce working hours may be introduced to a collective labour agreement, or upon an agreement with trade unions. As regards subsidies for purposes of training (for a maximum period of six months) or post-graduate education (for a maximum period of twelve months), it should be underlined that they may be granted to an employee if the entrepreneur undergoing temporary financial difficulties has created a relevant training fund. The subsidies are granted on terms specified in an agreement between the district governor (starosta) and the entrepreneur, provided that the training or post-graduate studies are justified by current or future needs of the employer. The subsidy amount per person equals 80% of the training-related costs or post-graduate education costs, wherein the legislators have stipulated the maximum amount of the subsidy at 300% of the average wage and salary in the preceding quarter, as announced by the President of the Central Statistical Office and valid as at the date of agreement.

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According to the communication of 12 May 2010 by the President of the Central Statistical Office (Monitor Polski No. 39, item 548), the average wages and salaries for the first quarter of 2010 amounted to 3,316.38 PLN. The provisions of the Anti-Crisis Act as regards flexibility of the employee’s working hours are very important and often applied by entrepreneurs. It is material that every entrepreneur who is an employer may follow those regulations, regardless of whether he is (or not) undergoing temporary financial difficulties. The provisions of the Anti-Crisis Act aim at improving conditions of running a business activity by making labour law regulations substantially more flexible. The anti-crisis instruments applicable to all entrepreneurs include: the option to extend the settlement period up to twelve months (pursuant to the Labour Code the basic settlement period is four months), the option to set up individual working time in order to provide for flexible hours to start and end work, the option to set up individual working schedule with flexible work start and end hours upon request of an employee who looks after a child under the age of 14 or who looks after a family member requiring personal care. The first two instruments involve a necessity to enter into an agreement with the trade unions or with the employees’ representatives. All of the said instruments let the employer make the working hours more flexible and better adjusted to the needs of the company whose production at the time of crisis is vulnerable to declines or unusually sharp fluctuations. The aforementioned regulation is of paramount importance for industries contingent upon weather conditions, especially as regards the construction sector in which the workload in winter is normally much lower. With the aim to protect employees’ right to remuneration, the legislators have introduced a significant restriction as regards flexibility of working hours, according to which in each month of the extended settlement period the employee is duly entitled to the minimum remuneration for work. In addition, a restriction that the individual working hours must not violate the employee’s right to a period of rest specified in the Labour Code has been introduced with respect to the individual working time regulations, whereby the employer may define different hours to start and end work while escaping the definition of overtime, as set forth under the Anti-Crisis Act. Of utmost importance and somewhat controversial is the provision of the AntiCrisis Act excluding the statutory regulation under which the contract of employment for a definite period was lawfully deemed concluded for an indefinite period, if made for the third time. The excluded regulation protected employees against successive contracts for a definite period, which are easier to terminate than the

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contracts for an indefinite period. Although the Anti-Crisis Act stipulates that the total time of employment on the basis of employment contracts for a definite period must not exceed 24 months, the common criticism is directed at the lack of any sanctions for the employers who have failed to observe that restriction. To sum up, it should be affirmed that the Anti-Crisis Act includes a vast range of tools helping companies overcome the crisis. Some urge the regulation on concluding employment contracts for a definite period to be introduced to the Labour Code permanently. It must be admitted that entrepreneurs have not widely used the instruments intended for those who hold certificates of undergoing temporary financial difficulties. According to the information by the Ministry of Labour and Social Policy on the level of implementation of the Act of 1 July 2009 on Mitigating the Consequences of the Economic Crisis for Employees and Employers, as at 9 August 2010 only 162 entrepreneurs have filed applications for subsidies provided for in that Act64. Given that the Act has been in force for almost a year, the aforementioned percentage of entrepreneurs seems exceptionally low. On one hand, this may indicate that Poland is tackling the crisis pretty well, whereas, on the other hand, doubts may arise whether the criteria set for the entrepreneurs undergoing temporary financial difficulties are not too stringent and thus prevent them from using means from the Guaranteed Employee Benefit Fund to subsidize the employees’ wages and salaries, or from the Labour fund to subsidize training courses and post-graduate studies. The small volume of the granted support is also reflected by the total amount of the aid paid out between the moment the Act entered into force and the date of the Ministry’s information (9 August 2010), which is 5,809,898.69 PLN. 65 The aid in the form of subsidies to training courses, grants and post-graduate education has enjoyed even less interest. The number of employees covered with agreements on subsidising employee training courses amounted to 491 persons, wherein all of them have received subsidies for training courses, while the aid for post-graduate education has not been granted at all. The amount earmarked for subsidies to training courses and grants totalled 887,875.99 PLN. 66 Taking into account that the government originally set aside around 1.5 billion PLN for the state aid under the Anti-Crisis Act, the actual support volume must be deemed negligible.

64 Ministerstwo Pracy i Polityki SpoĜecznej, Informacja o wnioskach zĜoŏonych do Funduszu Gwarantowanych İwiadczeĞ Pracowniczych na podstawie ustawy z dnia 1 lipca 2009r. o Ĝagodzeniu skutków kryzysu ekonomicznego dla pracowników i przedsiöbiorców wg stanu na dzieĞ 9 August 2010 r., 2010. 65 Ibid. 66 Ibid.

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In contrast, according to the data of the State Labour Inspectorate (PaĞstwowa Inspekcja Pracy) as of 30 June 2010, the regulations on flexible working hours have enjoyed much greater interest, which, most certainly, has been so because all entrepreneurs were entitled to apply them. 764 instances of extending the settlement period have been reported to the District Labour Inspectorates (Okrögowy Inspektorat Pracy), and the majority, i.e. 538 employers, have extended the settlement period up to the maximum of twelve months.67 Vast majority of entrepreneurs who have decided to make the working time more flexible operate in the processing industry (425 employers).68 3.2.3.

State Aid in Repayment of Housing Loans

The Act of 19 June 2009 on the State Aid in Repayment of Certain Housing Loans Granted to Persons Who Have Lost Jobs (‘Journal of Laws’, No. 115 item 94) is considered an additional component of the anti-crisis package. The said act became effective on 5 August 2009. Although the direct beneficiaries of the aid granted in the form of loan subsidies are individuals, it must be emphasised that the support clearly addresses banks or other institutions granting housing loans. The aid in repayment of housing loans is, to a certain extent, a remedy for the financial crisis of the banking sector. Being free from the concerns related to poor repayment of mortgages by individuals who have lost their jobs or who had to discontinue their business activity, the banks are not in need to reduce the lending activity to consumers and persons (natural and legal), which is to stimulate the economy and fuel its growth. The act sets out the terms of granting the temporary repayable state aid to natural persons who are obliged to repay a housing loan and who have lost their jobs, as well as the terms of using and repaying the aid. The aid is affected through Bank Gospodarstwa Krajowego (National Economy Bank), whereas the means and handling costs are financed by the Labour Fund. The act effectiveness is limited in time and applications for granting the aid in the form of housing loan subsidies may be submitted until the end of December 2010. Since the subsidies to housing loan instalments under repayment are addressed to people who have lost their jobs as a result of the economic crisis, the act is very precise in defining the target group of this aid schedule. Pursuant to the act, the 67 PaĞstwowa Inspekcja Pracy, Informacja dotyczâcâ stosowania przepisów ustawy z dnia 1 lipca 2009 r. o Ĝagodzeniu skutków kryzysu ekonomicznego dla pracowników i przedsiöbiorców (Dz. U. Nr 125, poz. 1035), 2010. 68 Ibid.

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aid may be granted to a borrower who is obliged to repay a housing loan and who has lost the job after 1 July 2008. According to the act, a job is construed as employment or any paid work, including any business activity which is carried out and subject to entering in the register of economic activity if a given entrepreneur hires no employees. Under the act, discontinuation of a business activity equals a lost job. Inclusion of entrepreneurs who perform business under self-employment in the group of beneficiaries of the said act follows the intention to expand the group of the aid recipients, which results from the fact that a significant number of natural persons affected by the crisis have not worked under an employment contract but pursued a sole proprietorship. It is also the resemblance to the situation of the individuals who have lost their employment or other paid work, which has been pointed to by the Funds Department of the Ministry of Labour and Social Policy, where such a resemblance has become an argument justifying provision of the aid to individuals who are self-employed, as it is the only source of income which may be lost by either group69. It is also required that a borrower be at the same time the owner or co-owner of the apartment under the mortgage with respect to which the aid is to be provided. The amount of aid depends on the total of the principal and interest instalment. The aid is granted up to the amount of 1,200 PLN being one instalment and for a maximum period of twelve months. It is irrelevant whether the housing loan was granted in Polish zloty or in a foreign currency, which is exceptionally important since mortgage loans have been granted in the main in Swiss francs (CHF). The aid amount and schedule of its disbursement is set forth in the decision on the form in which the aid is to be granted. The decision is issued on the basis of information provided in the statement by the lending institution. The amount of the aid for repayment of the housing loan is determined as at the date of the decision on the basis of the lending institution statement, and is constant throughout the entire period of disbursement, i.e. it should not change when the aid is under payment. Neither are changes to the amount of the housing loan instalment admitted. If during the aid payment the actual instalment amount changes, then the borrower is required to pay the difference in the case the aid does not cover the instalment amount; in a reverse situation, the bank is expected to appropriate the excess payment for the next instalment.70 69 Ministerstwo Pracy i Polityki SpoĜecznej, Komentarz Departamentu Funduszy Ministerstwa Pracy i Polityki SpoĜecznej do wybranych artykuĜów ustawy z dnia 19 czerwca 2009r. o pomocy paĞstwa w spĜacie niektórych kredytów mieszkaniowych udzielonych osobom, które utraciĜy pracö, 2009. 70 Ibid.

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Similar to the Anti-Crisis Act, the aid provided for under the Act on State Aid in Repayment of Certain Housing Loans Granted to Persons Who Have Lost Jobs did not enjoy much interest. According to the information of the National Economy Bank as of April 2010, only 1,145 unemployed were aided in repayment of mortgage via the agency of the Labour Office, whereas the government estimated that about 50,000 unemployed might benefit from such aid and therefore earmarked 230.6 PLN million in the Labour Fund. According to the Labour Office employees, the interest in the aid is poor due to restrictive criteria of its granting. Nonetheless, the very fact of adoption of such an act had a positive influence on the mortgagegranting institutions as they were certain that even if the borrowers lose their jobs they will be provided with financial support to repay the incurred credits.

3.3.

Counteracting the Crisis in Poland

Apart from the Polish government, which adopted legislative measures to mitigate the negative consequences of the global financial crisis, state-based institutions in Poland also responded to the deepening stagnation of the economy. Sections 3.3.1 to 3.3.3 describe the most significant steps undertaken by Narodowy Bank Polski (National Bank of Poland) and Rada Polityki Pieniöŏnej (Monetary Policy Council) as well as Komisja Nadzoru Finansowego (Financial Supervision Authority). 3.3.1.

Actions of the National Bank of Poland and the Monetary Policy Council

The key anti-crisis measure adopted by Narodowy Bank Polski (National Bank of Poland – NBP) was the launch of two programmes: the so-called ‘Pakiet Zaufania’ (Confidence Package) and ‘Pakt na rzecz rozwoju akcji kredytowej w Polsce’ (Lending Activity Stimulus Pact in Poland). The Confidence Package was introduced in Poland in October 2008. Its main objective was to stabilise the situation on the inter-bank market by maintaining liquidity of the banking sector in the Polish and foreign currencies, extending insurance coverage and reducing the level of reserve requirement.71 The NBP’s actions under the Confidence Package focused on:

71 Narodowy Bank Polski, Polska wobec ıwiatowego kryzysu gospodarczego, 2009.

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Y

carrying out liquidity-providing open market operations not limited by amount and falling due up to six months, despite excessive liquidity of the banking sector;

Y

carrying out bilateral FX swap operations in USD, EUR and CHF to help commercial banks obtain funds in foreign currencies;

Y

extending the scope of securities acceptable by the NBP to help banks find refinancing sources.

The other programme of the National Bank of Poland, namely the Lending Activity Stimulus Pact in Poland, was somehow a reaction to the stricter criteria of granting credit, which effectively reduced the amount of credit granted, especially in the sector of non-financial corporations. That programme, unlike the Confidence Package which was the NBP’s unilateral initiative, aims at creating a multilateral collaboration platform. The idea of collaboration between the central bank and commercial banks involves the National Bank of Poland as a provider of liquidity to commercial banks in exchange for intensified actions to boost lending by the commercial banks. Measures initiated by the Polish central bank under the Lending Activity Stimulus Pact in Poland are focused on the following: Y

extension of the repo operations time limit to twelve months;

Y

introduction of discount credits;

Y

purchase of bonds issued by banks in open market operations by the NBP.

The above actions target at, among other things, providing banks with a new source of long-term financing and facilitating liquidity management as well as providing a source of re-financing for newly-granted credits. Initially, the NBP’s actions to boost the amount of credit failed to meet expectations. However, according to a recent survey by ‘Open Finance’, as encompassing 16 banks, the number of mortgages granted in the first quarter of 2010 rose for the first time in ten quarters and was 23.5% higher than the figure for the previous year. This may indicate a gradual improvement in the banks’ lending activity and a positive trend in reassessment of risks related to granting credit. Certain measures to mitigate the consequences of the global financial crisis have been taken also as a part of the monetary policy. As an example, the Monetary Policy Council (Rada Polityki Pieniöŏnej), which is a body responsible for implementation of the national monetary policy in Poland, reduced the interest rates

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at the beginning of the third quarter of 2008. The interest rate reduction, started at the beginning of the third quarter of 2008, constituted a response of the council to the first signs of the economic recession around that time. Four reductions of interest rates between January 2009 and June 2009 provided evidence that the council was actively involved in softening the monetary policy in 2009. Further intervention in the interest rate level was discontinued as from July 2009 when some promising signs for the Polish economy appeared and the changes made until that time were found sufficient and conducive to the return of the Polish economy to the path of growth. The only evidence of the council’s activity in 2010 related to introduction, at the beginning of the year, of the discount rate for bills of exchange accepted from banks for discount by the National Bank of Poland.72 The measures undertaken by the Monetary Policy Council within the monetary policy caused, among other things, a reversal of depreciation of the PLN against EUR and USD, which had followed from mid-2008 to the first quarter of 2009 and been a consequence of withdrawal of foreign investors from the Polish market. The currency performance in the first quarter of 2010 confirms appreciation of the Polish zloty. In comparison to the previous year, the values of euro and US dollar, as expressed in the Polish currency, dropped by 11.1% and 16.2% respectively.73 3.3.2.

Actions of the Financial Supervision Authority

In view of the symptoms of the financial crisis, as appearing in the world, also Komisja Nadzoru Finansowego (Financial Supervision Authority) has taken actions with the aim to prevent destabilisation of the Polish financial system. The Financial Supervision Authority is a public administrative body which supervises the banking sector, the capital market, the insurance and pension market as well as electronic money institutions. The main actions on the part of the Financial Supervision Authority, taken to suppress spreading of the crisis in Poland, was to provide liquidity to the Polish banks, and in particular to prevent possible cash outflow from ‘daughter-companies’ to ‘mother-companies’ within international capital groups, as well as to strengthen their capital base.74

72 Ministerstwo Gospodarki, Analiza sytuacji gospodarczej Polski w 2009 roku, 2010. 73 Ministerstwo Gospodarki, Analiza sytuacji gospodarczej Polski w I kwartale 2010 r., 2010. 74 Urzâd Komisji Nadzoru Finansowego, Polski rynek finansowy w obliczu kryzysu w latach 2008-2009, 2010.

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According to information from the Financial Supervision Authority75, the following actions have been taken to counteract the crisis: limitation of growth in the portfolio of foreign-currency-indexed loans, adoption of a liquidity resolution, supervision of intra-group transactions, tightening of the concentration limits for banks, limitation of the risk related to concentration of deposits of insurance companies, retention of profits at banks (and, selectively, at insurance companies), limitation of the role played by subordinated loans in bank capitals, introduction of a mechanism to recognise bonds under bank capitals, assessment of total option position and valuation, restrictions in recommendations for banks using derivative instruments. As far as the supervision of intra-group transactions is concerned, the Financial Supervision Authority Office has introduced, as from 13 October 2008, the obligation to report, on the daily and formal basis, the transactions within the financial groups.76 Under this obligation, the form of the concluded transactions was checked against consistence with the content thereof as well as against compliance with the bank operation security rules in view of the binding legal regulations and supervision standards. In order to tighten concentration limits for banks, on 17 December 2008 the chairperson of the Financial Supervision Authority adopted resolution no. 382/2008 which came into force on 1 January 2009, and changed the concentration limits applicable to the Polish banks. The change referred to the involvement in foreign ‘mother-companies’ as well as in equity-related entities registered in Poland, and repealed the so far binding exceptions from general regulations introduced under the European Capital Requirement Directive – CRD77. It should be stated here that the anti-crisis actions of the Financial Supervision Authority, accompanied with measures taken by the National Bank of Poland, the Ministry of Finance and the Monetary Policy Council, contributed substantially to stabilisation of the Polish financial system.

75 Ibid. 76 Ibid. 77 Ibid.

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4.

Outlook for the Coming Years

The most fundamental long-term strategic goal of the Polish economic policy should be to attain and maintain the standards of living by the Poles, which would be comparable to those enjoyed by the most developed EU Member States and have a similar level of social security. In the years 2004-2008 Poland already managed to make up for some of the development backlog against the EU developed countries. However, the worldwide economic crisis slowed the economic growth between 2008 and 2010. The sections 4.1-4.5 present an outlook for the Polish economy in the nearest future and the most significant driving forces to speed up the economic growth and narrow the gap in the standard of living in Poland and the ‘old’ European Union Member States.

4.1.

‘Polska 2030 – Wyzwania rozwojowe’ Report

Despite the current overwhelming crisis, continuation of the reforms launched after 1989 should remain the top priority in Polish economic policy. With the above in mind, ZespóĜ Doradców Strategicznych Premiera Rzeczpospolitej Polskiej (Board of Strategic Advisors to the Prime Minister of the Republic of Poland) has published a report titled ‘Polska 2030. Wyzwania rozwojowe’ (Poland 2030. Development Challenges). It is instrumental to work on ‘DĜugookresowa Strategia Rozwoju Kraju’ (Long-Term National Development Strategy) – a document to be developed and implemented under the requirements of the European Union. The purpose of that report is to determine a new direction of development. Such a new direction, given 20 years of transformation and continued EU membership, which has been the driving force of the economic activities until recently, seems indispensable, as the two incentives that have set the direction so far are no longer sufficient. At the time of the global crisis, a long-term strategy and a vision of development of the Polish economy in the coming years seems absolutely necessary. The crisis will be and is an opportunity for those countries that are distinct with their ability to modernise and introduce economic reform. Poland sees the crisis as its chance for a change. However, Polish measures to be undertaken as a part of the economic reforms must be consistent with the actions undertaken within the EU, as all Member States have pledged to follow the Lisbon Strategy intended to make the Community the world’s most competitive economy.

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The report on challenges faced by Poland points to the following: Y

maintaining long-term economic growth and improving competitiveness of the Polish economy;

Y

unfavourable changes in the age structure of the Poles, which may entail a significant increase in costs of retirement benefits in the future;

Y

the need to enhance the professional activity of the Poles and the continuing education;

Y

the energy and climate security;

Y

development of the intellectual capital and growing effectiveness of higher education;

Y

the need to reduce differences in the pace of development of individual regions of Poland;

Y

streamlining of the actions undertaken by the state administration and improvement of the legislative processes;

Y

development of civil society.78

The above quoted report makes up a multi-angle analysis of the challenges Poland has been facing. Although its authors highlighted ten key points, the biggest growth-generating factor in the long run seems to be strengthening of the research and development sector in Poland. The above assumption may be substantiated with the main goal of ‘Strategia Rozwoju Kraju na lata 2007-2013’ (2007-2013 National Development Strategy), under which the outlays on research and development are to be increased up to respectively 1.5% and 2.0% of GDP in 2010 and 2015.79 The 2007-2013 Operational Programme ‘Innowacyjna gospodarka’ (Innovative Economy), presented by the Ministry of Regional Development, emphasises the importance of research and development for stimulation of the economic growth. The programme’s key priority was to increase expenditures on research and scientific work financed under the European Regional Development Fund.80

78 Rada Ministrów, Polska 2030. Wyzwania rozwojowe, 2009. 79 Ibid. 80 Ministerstwo Rozwoju Regionalnego, SzczegóĜowy opis priorytetów Programu Operacyjnego Innowacyjna Gospodarka 2007-2013, 2009.

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Research and development in Poland should focus mainly on the science sector in order to increase its competitiveness. On one hand, it is necessary to develop the research base and personnel. On the other hand, it is required that the already existing resources be earmarked for research in disciplines that are crucial for the national development. Furthermore, the role played by scientific research in the economic growth must rise, e.g. by promoting co-operation among companies, business institutions and research and development (R&D) centres. The need to enhance the employment of R&D outcomes by business units, including intensified transfer of state-of-the-art technological, product and organisational solutions, is also becoming a priority. The biggest potential in this respect rests with the regions with scientific centres that are able to generate new knowledge and technologies, as well as with an economic base that provides for absorption and commercial exploitation of such knowledge and technologies.81 It is worth noting, however, that the efficiency of research and development aimed at boosting innovation of the Polish economy depends in the main on the pace of the information society’s growth.

4.2.

Euro 2012 – European Football Championship

The European Football Championship Euro 2012, preparation of which is currently well under way, is one of the top short-term priorities for Poland and the Poles. Granted the right to host the Euro 2012, this alone was a good reason for celebration among the Polish people. In addition to the sports and cultural aspects, hosting of such an event brings in naturally measurable benefits for the country’s economy. According to a study developed by the Ministry for Economy, the key results of organising the Euro 2012 will include: Y

speeding up the increase in gross expenditures on fixed assets from 16.7% in 2006 to the average level of 22-25% in the period from 2008 to 2012;

Y

speeding up the domestic demand growth from about 6% in 2006 to the average level of around 7.5-8% in the period from 2008 to 2012;

Y

speeding up the individual consumption growth.

Looking at the economic aspect of the European Football Championship to be hosted by Poland, it should be emphasized that the biggest benefits drawn from that event are to be reaped by the construction and tourism sectors. Both contrac81 Ministerstwo Rozwoju Regionalnego, Strategia rozwoju kraju 2007-2015, 2006.

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tors and material suppliers will gain substantial profits. During the event, most profits will go to the hotel industry, as well as food manufacturers and retailers. Advertising agencies may also anticipate higher revenues. The Ministry for Economy expects 21.4|million tourists to visit Poland in 2012, which is significantly more than in e.g. 2006 (15.7 million) and is to translate into a considerable increase in revenues in the tourism sector, which are currently estimated to reach 12.5 billion USD in 2012. The organisation of the Euro 2012 affects various aspects of the Polish economy. The necessity to modernise the obsolete road and communications infrastructure, which has been a major obstacle for the inflow of foreign direct investments, should result in a FDI boost in subsequent years. Investments in the infrastructure modernisation should also improve the labour market, as new jobs are to be created. The right to host such a remarkable event, as granted to Poland, will also strengthen the country’s prestige, which is, in turn, expected to be followed by an increased interest in the Polish market on the part of the foreign capital, including both portfolio capital (e.g. shares in construction companies) as well as direct investors. The flow of foreign investments between 2007 and 2012 is estimated to rise by an average of 3 billion EUR against the average level in the last three years (a forecast by the Ministry for Economy). Given the positive aspects of hosting the Euro 2012, attention should be also paid to potential negative scenarios. The first one involves a possible increase in consumer prices, whereas the second one may lead to a deficit in the current account due to lower exports caused by a revival of the internal demand with concurrent appreciation of the Polish zloty.82

4.3.

Investment Attractiveness of Poland

As a result of the United Nations Conference on Trade and Development (UNCTAD), the World Investment Report was prepared, according to which Poland did not escape the fall in investment, which was estimated to reach 22% in USD. To compare, FDI in the Czech Republic dropped by almost 60%, in Romania by 55%, and in Spain by as much as by 80%. The UNCTAD report shows that Poland continues to be the biggest beneficiary of FDI in the region with over 11 billion USD in 82 Ministerstwo Gospodarki, WpĜyw EURO 2012 na rozwój polskiej gospodarki, 2008.

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2009 (similar figures were provided by the National Bank of Poland). For the sake of comparison, the value of investments that flew to the Czech Republic was just 2.7 billion USD, while the figures for Slovakia and Hungary reported disinvestment of respectively 50 million USD and 5.6 billion USD. According to a recent survey, in the next three years Central and Eastern Europe will become the third most attractive region for foreign investments after China and India, whereas the modern services will develop most resiliently. Changes brought by the 2008/2009 crisis involve gradual alterations in the investment structure in favour of the service sector (BPO/SSC). Such a phenomenon is especially evident in Europe. Poland has become the second (after Ireland) major destination on the Old Continent for investments in this sector, even though many potential investors admit that a few months ago they did not take Poland into account while considering a place for investment.83 The service centre industry in Poland may become one of the most important driving forces of the economic growth. Such centres aim at downsizing the costs of business operations by gathering groups of employees highly specialised is comparatively narrow fields, thus obtaining the synergy effect. Setting up of service centres in Poland is encouraged by the high level of qualifications among Polish employees combined with increasingly better command of foreign languages. Service centres in Poland take the form of BPO centres or shared service centres (SSC). The former operate as external entities while the latter function within a corporate structure. The services provided by such centres in Poland include mainly the following: Y

information technologies;

Y

call centres specialised in passive collection of orders or active contact with customers;

Y

financial accounting;

Y

payroll accounting;

Y

research and development.84

The potential of the service centre sector is best evidenced by the fact that out of 300 centres on the market at the end of 2007 one half was set up after 2001. It is worth noting, however, that they are usually located in large cities. 83 Ernst & Young, Ernst & Young’s 2010, European attractiveness survey. 84 Biuro badawczo-analityczne DiS, Przeglâd 300 miödzynarodowych centrów usĜug, 2008.

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4.4.

Polish Presidency of the Council of the European Union – 2011

The presidency, also known as the ‘chairmanship’, is more of a function than of an institution. The formula of the presidency of the European Union (earlier the European Communities), reflects the overall logic of the integration process. Entrusting European Union presidency to its individual Member States on equal terms, regardless of their potential or status, has always been a part of the broadly understood community-based approach. The crisis will be, most certainly, the greatest challenge during the Polish presidency and, therefore, it is necessary to be aware that the problems resulting there from are hard to predict and solve. In many aspects, the Polish presidency will fall due in the worst time possible, taking into account recovering from the crisis: the EU GDP will be significantly lower (even by 7%), budget revenues will decrease, output markets will deteriorate, the Member States will struggle against high unemployment and probable social unrest all of which will make governments suffer the political consequences of the crisis. Moreover, the temporary effects of the increased public investment policy, based on the logic of fiscal impetus, will fade away. The rational enthusiasm in the Poles’ attitude towards the European Union is not unconditional. Therefore, it is required that in addition to strengthening the position of Poland as a solid and reliable partner, the pre-presidency campaign reinforce proEuropean attitudes among the Polish society. At the same time, the existing high support for the European Union in Poland and the trust vested in its institution allows to presume that Polish citizens will be well conscious of the presidency and its importance. It needs to be added that among the nations of the European Union, the Poles are some of the strongest supporters of the common foreign, defence and security policy towards non-EU countries as well as of further enlargement of the European Union.85 Poland is to take over the presidency of the Council of the European Union as from July 2011.

85 Urzâd Komitetu Integracji Europejskiej, Prezydencja Polski w UE, 2009.

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4.5.

Europe 2020: New Economic Strategy for Europe as an Opportunity for Poland?

Poland and Europe expect a time of changes. The crisis has undone the effects produced during the many years of economic and social progress and revealed structural weakness of the European economy. Europe 2020 sets out a vision of the European social market economy of the 21st century. The strategy is aimed at recovery from the crisis and preparation of the European economy for the challenges of the next decade. Five headline targets have been agreed to show where the European Union should be by 2020: Y

employment rate of the population aged 20-64 should rise up to 75%;

Y

3% of the EU GDP should be invested in R&D;

Y

the ‘20/20/20’ energy and climate targets should be met;

Y

the number of early school leavers should be reduced to 10% and at least 40% of the younger generation should have higher education;

Y

the number of people living at risk of poverty should be reduced by 20 million.86

Both the European Union and the Member States will be involved in implementation of the above quoted headline projects. It is, therefore, worth noting that the guidelines of the new EU strategy are compliant in many areas with the development priorities set out in programme ‘Polska 2030’ (Poland 2030), e.g. in education and scientific research.87 The new strategy is to replace the Lisbon Strategy adopted in 2000, which has not brought the required effects (it aimed at making Europe the most dynamic and competitive economic block in the world, which would develop faster than the United States). In the context of the forthcoming actions, Poland and other EU countries should, in the first place, learn their lessons from the global economic crisis. No EU Member State is capable of handling alone the threats posed by a global recession similar to the one which started in 2008.

86 Komisja Europejska, Europa 2020, 2010. 87 Rada Ministrów, Polska 2030. Wyzwania rozwojowe, 2009.

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Romania: Politics do matter Joerg Gulden

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1.

Situation before the Crisis1

1.1.

Country Profile

Romania lies on the Black Sea coast of South-eastern Europe. The country is divided by the Carpathian Mountains and the Transylvanian Alps into three historically and physically different regions: Wallachia, Moldova and Transylvania. It is bordered by Bulgaria to the south, Serbia and Hungary to the west and the Ukraine and the Republic of Moldova to the north. Lying at the outer rim of the European Union with three neighbouring countries that are not EU Member States adds some additional aspects to the country compared to the more central member states. The political system is a parliamentary representative democracy with a two chamber parliament and the sole executive powers being with the government, headed by the prime minister. The current main political parties are Y

PD-L (Partidul Democrat-Liberal);

Y

PSD (Partidul Social Democrat);

Y

PC (Partidul Conservator) – currently in an alliance with PSD under the name Alianķa PSD+PC;

Y

National Liberal Party (Partidul Naķional Liberal);

Y

UNPR – National Union for the Progress of Romania (Uniunea Nationala pentru Progresul Romaniei);

Y

UDMR – Hungarian Democratic Union of Romania (Uniunea Democratà Maghiarà din România);

Y

Greater Romania Party (Partidul România Mare);

Y

Minor parties, noticeable amongst them 18 parties of ethnic minorities that have a seat in the Chamber of Deputies guaranteed by the constitution.

1 The following chapter describes the economic and social pre-crisis situation in Romania, the impact of the financial crisis, the anti-crisis measures from a Romanian as well as an economic outlook for the decade to come. Unless stated otherwise, all data have been taken from official publications issued by the National Bank of Romania, the National Institute for Statistics and the World Bank. Parts of this chapter are excerpts of periodical publications issued by Business Monitor International, London, and the four International Monetary Fund staff reports on the Reviews under the Stand-By Arrangement issued from 2002 to 2010 by IMF, Washington.

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J. Jungmann, B. Sagemann (Eds.), Financial Crisis in Eastern Europe, DOI 10.1007/978-3-8349-6553-0_7, © Gabler Verlag | Springer Fachmedien Wiesbaden GmbH

The current government is formed by a minority coalition formed by PD-L, UDMR and UNPR but has to rely on independent deputies to pass legislation. Although most of the independents have reconfirmed their support for the government ahead of the June 2010 no confidence vote, the majority is unstable. The following table shows the political and geographical key data of the country: Picture 1: Country Profile, source: own data. Area

238,391 km2

Population

21,498 thousand

Capital city

Bucharest, 1.94 m people

Form of Government

Parliamentary representative democracy

Legislative power

Bicameral Parliament, 137-seat Senate, 330-seat Chamber of Deputies

Executive power

Prime Minister and council of Ministers

Judicial power

Supreme Court, common courts of law, administrative courts, martial courts

Head of State

President Traian Basescu

Head of Government

Prime Minister Emil Boc

Presidential Elections

Last: 22/11/2009 first round; 06/12/2009 second round Next: 2014

Parliamentary Elections

Last: 30 November 2008 Next: November 2012

Key Treaties / Relations

Member of EU, WTO, NATO, IMF, Council of Europe, OSCE and ILO

Ongoing Disputes

None

Time zone

GMT +2

Currency

New Romanian Leu (RON) = 100 Bani

Average life expectancy

71.3 years

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1.2.

The Lost Decade 1990-2000

Romania began the transition from Communism in 1989 with a largely obsolete industrial base and a pattern of output unsuited to the country’s needs. In the years after the revolution, Romania underwent a long period of economic transition to a market economy. Compared to its Central and Eastern European neighbours, this process has been neither smooth nor particularly well-managed, and included two periods of economic recession and financial scandals during the 1990s. The Romanian economic development can be said to be highly influenced by political stability as “policies often fell prey to electioneering and the instability of coalition governments”.2 In general, the transition to a market economy proved extremely painful compared to other transition states. By 1992, grain production was only ²/³ of the 1989 level, GDP had fallen by 30%, industrial production had fallen 47% and inflation had reached 300%. Growth returned weakly in 1993, with GDP increasing 1%, but then gained some momentum, rising 3.9% in 1994, 6.9% in 1995 and 4% in 1996. In 1997, the government entered into an arrangement with the IMF for a standby agreement supported by a credit line of 430 million USD, but the agreement was suspended because of the government’s slowness in implementing agricultural reform. At the end of 1997, GDP had fallen -6.6% and inflation had soared to 151.4%. The 1997 / 1998 crisis produced a further contraction of 7.3% of GDP for the year, with domestic savings and investment rates dropping significantly. Inflation, however, under new government restraints, moderated to 40.6%. Despite an austerity budget for 1999, inflation increased to 54.8% and the GDP contracted 3.2% for the year. As shown in the following figure, one full decade after the revolution, the GDP on purchasing-power-parity had not reached 1989 levels and inflation was – although no longer at hyperinflationary levels of the first half of the decade – still at a high level. Coming from a close to no-debt situation in 1989, showing at that time the best debt-to-GDP ratio in Central and Eastern Europe, the budget deficit was one of the few comparably positive economic indicators, being on a moderate level of 5.45% of GDP.

2 International Monetary Fund, Staff Report for the 2002 Article IV Conclusion, 2002.

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Picture 2: Key Economic Data 1989 – 1999, Data: World Bank, own graphics.

As a conclusion, at the end of 1999 Romania compared unfavourably with the other CEE transformation states with respect to inflation, GDP, FDI, privatization, the perception of corruption, the overall trust in the political system and the business climate, the 1990s can truly be considered to be a lost decade for the country.

1.3.

Economic Growth and Social Change

1.3.1.

The Turn-Around 2000-2004

With growing confidence in the political system in connection with the year 2000 presidential and parliamentary elections, the picture started to change. Following the election-triggered boom in domestic demand in late 2000 and early 2001, the authorities implemented a program of budget restraint, energy price adjustments and attempted to firm up wage controls. This dampened domestic demand and reduced the current account deficit.

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On the other hand, export and GDP growth were among the highest in the region, reflecting the fruits of private investments in export-oriented consumer goods industries over the last few years and the gains in competitiveness from the 1999 depreciation. During these years, GDP grew by 5% p.a. in average, mainly driven by exports and FDI. This resulted in a higher employment rate, reduced poverty and the establishment of middle-class with higher consumption rate but also increasing loans to private households. Inflation, reaching high double figures in the late 1990s and being still at a 45% yearly average in 2000, had steadily declined and was close to single-digit figures in the 2005 forecasts. Picture 3: GDP Growth and Inflation decrease 1999-2004, source: World Bank, own graphics.

The government raised fiscal discipline and improved the general governmental deficit from 4.5% in 1999 to 2% of GDP in 2003. Moreover, investment picked up, supported by expansion in credit to the private sector. The decline in employment, characterizing the 1990s, has bottomed out, and the unemployment rate has stabilized for the time being at about 8.5%, a moderate level for a transition economy.

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Overall, the progress in Romania’s macroeconomic indicators during the 20002004 period was remarkable and prepared the ground for the rapid development towards EU accession standards.3 The overall improvement of the Romanian economy resulted in a successful conclusion of the 2001 IMF arrangement in October 2003 – the first time after five successive failures in the 1990s. Despite those successes, the structural reforms were still showing a mixed picture. Although a couple of measures have been taken to encourage privatisation, the privatisation record was still the worst compared with other CEE countries. The IMF stated in 2002 that “a crucial component of the program continues to be a reduction in the quasi-fiscal deficit of state-owned enterprises. The implementation of the government’s wage and employment programs for 2002 and 2003 will be of key importance both for improving enterprise profitability and for the success of the disinflation strategy.”4 Despite the fact that the private sector share in GDP has increased close to 70% of GDP in 2003, the number of state-owned enterprises was still amounting to more than 1,100 in 2004.5 The negative financial position of the most of these enterprises indirectly influenced the budget deficit as they were relying on governmental support, World Bank estimations showing that indirect subsidies to state enterprises amounted to around 7% of GDP.6 1.3.2.

Accession boost and growing imbalances 2005-2008

The November 2004 elections showed no clear victory, but after a series of alliance changes and fraud claims, finally the strictly pro EU ‘Justice and Truth’ (Dreptate ĵi adevàr) alliance led the government. One key pledge in the run-up to the elections was the acceleration of economic reform. In the first meeting of the new government tax cuts and the introduction of a 16% flat tax regime was announced. Although, according to IMF estimations, the new tax regime resulted in state revenue declines in the amount of 1.5% of GDP, the flat tax regimes was defended by Prime Minister Càlin Popescu-Tàriceanu as the base for promoting entrepreneurship, accelerating growth and to encourage less government spending and there3 European Commission, Progress towards Meeting Economic Criteria for Accession, 2004. 4 International Monetary Fund, News Brief No. 02/91, 2002. 5 Dimitris Papadimitrou / David Phinnemore, Romania and the European Union, 2008. 6 World Bank, Romania: Restructuring for EU Integration – the Policy Agenda, 2005.

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fore having an overall positive economic effect. The new government succeeded in showing an image of managerial competence, but the initial results were rather poor. Yearly GDP growth for 2005 dropped to 4.1% from 8.3% in 2004 and both IMF and EU expressed serious concerns on the on-going pro-cyclical fiscal policy and successive rises in public sector wages. These led to an increase of domestic consumption and slowed down the disinflationary trends of the foregoing years, resulting in an yearly average inflation rate of 8.6%, being considerably higher than the NBR target rate of 6.0%. Although growing consumption led to higher VAT revenues, the relaxation of fiscal policy in the second half of 2005 had a negative effect on the budget deficit. Trade deficit and current account deficit were widening as well, but the year has also shown strong capital inflows from FDI and EU funds and an increase in capital market liberalisation. While the November 2005 ‘EC Monitoring Report’ was held comparably restrained by stating that the country “has broadly maintained macroeconomic stability, even if the policy mix turned less prudent and raised concerns about the sustainability of recent stabilisation achievements”7, the dispute with the IMF was by far more harsh. It escalated in November 2005 and led to the suspension of the 2004’s 1 billion USD Stand-By agreement after criticising the government’s wage policy and branding the 2006 budget as unrealistic.8 The ‘IMF March 2006 staff report’ stated that macroeconomic conditions deteriorated significantly in 2005. Growth slowed to 4.1% in 2005, with agricultural output falling as a result of floods and industrial output growth slowing due in part to the abolition of global textile quotas. Domestic demand, on the other hand, grew strongly reflecting a sharp increase in private consumption – supported by significantly lower direct taxes, higher wages, and faster credit growth. The credit expansion has contributed to a widening in the current account deficit to 8.7% of GDP in 2005, and also led to inflationary pressures. As a result, and despite the significant appreciation of the RON, disinflation slowed considerably: CPI inflation was 8.4% (y-o-y) in March 2006. Despite the arguable economic politics, the Tariceanu government showed achievements in other fields. It managed to close all chapters of ‘acquis communautaire’ and finally the accession treaty was signed on 25 April 2005.

7 European Commission, Romania: 2005 Comprehensive Monitoring Report, 2005. 8 Dimitris Papadimitrou / David Phinnemore, Romania and the European Union, 2008.

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As in the EU-10 countries, this fuelled economic development dramatically and led to strong growth in industrial output, rapid industrial domestic output price increases in local currency highly increased construction activity, increased retail sales activity, turnover and employment growth in some services sectors. 2006 was an overall positive year with slightly higher GDP growth rate of 4.6% compared to 2005’s 4.1% – and end-of-period inflation fell to 4.9% from 8.6% in 2005. The inflation performance has been indeed impressive. In addition to prudent monetary and fiscal policies through November 2006, disinflation benefited from the postponement of administered-price increases, favourable agricultural prices, and currency appreciation. On the other hand, pro-cyclical public-sector wage policies exacerbated domestic-demand pressures. Such policies – influenced by trade unions and a fragile political envronment – led to a substantial real increase in government wages, outpacing those of the private sector. The original wage allocation proved insufficient given average increases of 9-15%. Although the authorities had committed to freeze vacant positions (except EU accession-related hiring) to offset wage overruns, government employment increased by 3.5%. Moreover, on account of retroactive wages for teachers and judges due to legal settlement, and payment of bonuses, the wage bill increased even higher. On a positive note, the government exercised prudence in the minimum wage (6.5%) and controlled the wage bill of state owned enterprises. Following the EU accession on 1 January 2007, Romania has enjoyed massive capital inflows and strong GDP growth in 2007 and until the third quarter of 2008. GDP grew by 6.3% in 2007, but agriculture was adversely affected by a drought (non-agricultural output expanded at a robust 7.4%). Despite healthy export growth, the current-account deficit widened markedly from 10.4% of GDP in 2006 to 14% of GDP in 2007, reflecting booming domestic demand, strong credit growth, and pro-cyclical fiscal and incomes policies. The fiscal deficit (cash basis) in 2007 increased to 2.25% of GDP, sharply up from a deficit of 0.5% of GDP. Higher agricultural and energy prices as well as excess demand contributed to more than a doubling of headline inflation from May 2008 (3.8%, y-o-y) to May 2008 (8.5%, y-o-y). The exchange rate depreciated sharply after the turmoil in international financial markets started in August 2007, but has stabilized since February 2008. In response to inflation rising well above its target range, the National NBR increased its policy rate several times from October 2007 (7.0%) to May 2008 (9.75%).

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The boost continued in 2008, showing a final real GDP growth of 7.1% despite the first signs of decline in the fourth quarter. For the first time in a decade, the growth of exports exceeded import growth, leading to an improvement of the current account deficit from -12.2% of GDP in 2007 to -10.1% in 2008. Picture 4: Imports, exports and current account balance 2005-2008, source: IMF, own graphics.

Parallel, pressure on inflation grew with an average yearly CPI increase of 7.8% compared to 4.8% in 2007. The fiscal deficit enlarged to 4.8% of GDP against 3.1% in the prior year, mainly due to further increases in the public wage bill, social transfers and pension payments. Overall, the development in the years 2005 to the beginning of the crisis in late 2008 were showing impressive growth but also the build-up of significant internal and external imbalances.

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2.

The Impact of the World Financial Crisis (2008/2009/2010)

2.1.

Crisis – Sudden and Fierce

Until November 2008, the Romanian authorities were rather optimistic that the impacts of the financial crisis would have rather indirect effects on the economy. The hit came sudden and fierce. Capital inflows suddenly died up, exports began to plummet and country risk indicators skyrocketed as the country was perceived to be among the most vulnerable to the downturn. Real GDP dropped by 13% (quarter-on-quarter, annualized) in the fourth quarter of 2008, compared with the precrisis average growth rates of 9%, due to a sharp contraction of domestic demand and a devaluation of the leu (RON) against the euro from October 2008 to early 2009, this putting pressure on household, corporate and bank balance sheets. Picture 5: Devaluation of the leu against the euro, source: National Bank of Romania, own graphics.

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The banks, fortunately entering the crisis well capitalized and not holding significant amounts of derivatives linked to the global mortgage loan system, faced rising non-performing loans, a dried up inter-bank market liquidity and limited access to external funding. The large pre-crisis fiscal imbalances put the government into a weak position for an effective response. Romania’s external trade contracted sharply in 2009. The collapse in global trade and capital flows was hard to take for the FDI and export dependant country and the following sharp contraction in domestic demand led to a decline in imports of close to 35% (y-o-y) during the first three quarters of 2009, almost double the rate of decline in exports in the same period. The effect was an external adjustment to the current account deficit reducing to 4.5% of GDP compared to the 13.5% peak in 2007, this being amongst the largest adjustments of the new EU Member States. Picture 6: Stall of Foreign Trade and Recovery, source: Raiffeisen Research, 2010.

As global trade started to recover in late 2009, Romanian trade did alike, with export growth outpacing import growth again.

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2.2.

Structural Problems Revealed

Not a direct effect of the crisis but revealed by the sharp contraction of the economy, the structural problems in Romania became visible immediately. Romania’s impressive annual GDP growth averaging 6.2% between 2002 and 2007 had gone hand in hand with rising external imbalances. The current account deficit widened from 3% to 14% of GDP in the same period, the fifth highest among EU-10 countries. The rapid expansion of financial intermediation, combined with steadily increasing income expectations had fuelled a domestic demand boom, for both consumption and investment, leading to a rapid increase in imports. A negative income balance, linked to profit repatriation by direct investors and interest payments was offset by current transfers (including mainly remittances and EU funds). Financial intermediation has played a key role in channelling international capital flows to Romanian residents. Between end-2002 and November 2008, domestic credit to the private non-financial sector tripled from 11% to 39% of GDP, against a background of fierce competition amongst largely foreign-owned banks. The latter have benefited from ample liquidity injections by their parent companies until the beginning of 2008. Whereas the rising external deficits have been mainly driven by the private sector, public sector net lending has also contributed to an increasing degree, with deficits rising from 1.2% of GDP in 2005 to more than 3% in 2008. Between 2000 and 2006, FDI was the principal financing source, covering around 75% of the current account deficit (picture 2). However, from 2007 onwards, FDI inflows dropped to roughly ½ of the deficit, as the privatization programme of state-owned enterprises was coming to an end. Also the composition of FDI inflows has changed. The share of equity inflows (including privatization receipts) shrank from 59% in 2004 to 13% in 2007, while inter-company loans have become more prominent, rising from 13% to 52% in the same period. The difference, i.e. reinvested earnings, stayed roughly constant. The rest of the current account deficit was more than covered by ‘other investment’, being mainly loans and currency deposits. The capital account has remained slightly positive and stood at 0.7% of GDP in 2007, partly reflecting the inflow of EU funds. Significant privatization receipts and the NBR foreign exchange reserve requirements for credit institutions have also led to a fast accumulation of reserve assets. The increasing importance of FDI intra-company loans and other investment has resulted in a steady increase in external debt from 30% of GDP in 2000 to 52% of GDP in August 2008.

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While medium- to long-term debt as a percentage of GDP has only risen slightly over the past years, short term debt increased eightfold from 2% of GDP in 2000 to 16% of GDP in 2008, entailing increased short-term debt roll-over risks. Moreover, the coverage of short term debt by foreign exchange reserves has rapidly declined in the last few years, but appeared to stabilize in 2008 around roughly 90%. Yet slightly less than half of these reserves represent commercial banks’ foreign exchange reserve requirements and are as such to be considered as contingent shortterm net drains on official reserves. The domestic counterpart of rapidly increasing external debt has been the acceleration of bank lending to households and enterprises. The stock of private nonfinancial sector credit tripled from 11% of GDP at the end of 2002 to 39% of GDP in November 2008, leading to annual credit growth oscillating around 55% over the last three years. As the growth rate of domestic deposits remained subdued at roughly 30% over the last three years, the loan-to-deposit ratio increased rapidly from 0.7 (end-2004) to 1.4 (in November 2008), which is slightly above the EU average of 1.2. In the same period, the foreign currency loan to deposit ratio even reached 2.2. The fast-paced increase in domestic lending has been mainly driven by foreign exchange denominated loans, thanks to their lower interest rates (which were on average 3,5 percentage points (p.p.) below interest rates on RON-denominated loans) and low perceived currency risk in a context of sustained RON appreciation until mid-2007. This brought the total share of foreign currency denominated loans to 56% in November 2008, i.e. above the EU-10 countries average of 44%. The high share of foreign exchange denominated loans and the particularly high loan to deposit ratio in foreign currency underscored balance sheets’ vulnerability to increased exchange rate volatility. As a conclusion, Romania’s growth model has implied large external imbalances and has relied on increasing volumes of foreign capital inflows. With the intensification of the international financial crisis, access to domestic and external capital sources by banks has been constrained, leading to a sharp drop in domestic credit growth; consumer and investor confidence were weakening; higher exchange rate volatility posed significant balance sheet risks to households and unhedged companies and weaker demand from the Euro-zone weighed on export performance. The initial fiscal starting position and external imbalances together with the high spending on wages in the public sector and state-owned enterprises, as well as the pension burden left no room for expansionary fiscal policy.9 9 European Commission, Romania: unwinding imbalances – need for fiscal consolidation, Brussels, 2009.

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Under these circumstances, the financial crisis was a sudden and fierce challenge for the stability of the Romanian economy, with limited scope for the Romanian government to react.

3.

Challenges and Coping with the Financial Crisis

3.1.

Late Recognition and Shiftless Reactions

When the Financial Crisis started in the United States, culminating in the meltdown of the mortgage lending system and the banking crisis of September 2008, Romania’s economy was still booming. This might explain the fact that the Romanian government and the relevant authorities seemed not to recognise the severe impact of the crisis on the Romanian economy that arose in late 2008. The governmental position in late 2010 was “What crisis? A rather nervous attack than an economic crisis.” 10 The position of the National Bank of Romania was still one of optimism by December 2008 and the feeling was that Romania would not be severely affected by the crisis. The “fundamentally sound banking system and a lack of exposure to toxic financial assets” were the base for the assumption, that the effects would be limited to indirect effects like constraints of external financing, decline in FDI inflow, decreasing foreign demand and an increasing foreign exchange rate volatility.11 Romanian real estate market was considered not at all to be confronted with a crisis, as it was just beginning to grow and it would take about 20 years to become saturated.12 Nevertheless, after the European Commission expressed concern regarding the need for anti-crisis measures, Prime Minister Popescu-Tàriceanu asked his ministers on 17 November 2008 to start thinking about measures to support the national 10 Radu Ĵerban, Pensions under the Recession Burden, in: The Romanian Economic Journal No.35, 2010. 11 Mugus Isarescu, Romania in the Context of the Financial Crisis, presentation held on 10 December 2010, Bucharest, 2010. 12 Ruxandra Ciulu, Crisis Inversion Strategies – Theory or Reality in Romania, 2009.

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economy and to have them ready by the following cabinet meeting; the Prime Minister never mentioned the word ‘crisis’. The proposed plan of measures was going to inject some 10 billion EUR into the economy, including tax incentives, such as a 10 p.p. cut in social security contributions, tax exemptions for reinvested dividends and a 5% tax bonus for the timely payment of taxes. However, as soon as it was appointed in December 2008 after the elections in November, the new government found that the budget deficit for the 2008 financial year was in excess of 5%, as a result of overdue payments accumulated by the previous government. In response to the concerns and proposals (put forward by the social partners), the government invited them to a meeting at the Ministry of Public Finance on 12 January 2009. The parties to these discussions agreed to appoint joint working groups representing the trade unions, employer organisations, the government and the financial services sector; these working groups were given the task of drafting an anti-crisis programme by 22 January 2009. After the cabinet meeting on 5 February 2009, the new Prime Minister Emil Boc stated that 32 anti-crisis measures were to be attached to the draft budget act and forwarded to parliament for debate, amongst them: Y

investments worth 10.2 billion EUR – or 20% of all budget spending and 7% of GDP – for infrastructure works;

Y

the allocation of an extra 2 billion EUR to pay for the outstanding debts of the previous government;

Y

tax exemptions for reinvested profits, effective from the second quarter of 2009;

Y

support for small and medium-sized enterprises (SMEs) through a guarantee fund for the loans granted to SMEs and through the capitalization of two banks;

Y

improved mechanisms for absorbing European funds, accelerated fund drawing procedures, the promotion of public-private partnerships and the elimination of bureaucracy;

Y

an extension of the unemployment benefit period by three months, as well as an exemption from taxes and charges for technical unemployment benefit;

Y

co-funding of 50% towards continuing vocational training for unemployed people and employees;

Y

legislation regarding the minimum welfare pension;

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Y

consultation with the social partners on matters related to pay increases and the law regarding standard principles of wage formation for public servants;

Y

a moratorium for 2009 on the salaries of high-ranking civil servants and public officers, affecting about 7,000 persons;

Y

capitalization of CEC-Bank and Eximbank;

Y

continuation of the ‘Rabla’ car scrapping program, which, unlike the previous years, provided for the acceptance of cars up to ten years old and the increase of the amount granted from 3,000 RON to 3,800 RON;

Y

including the revenue of the institutions and government agencies in the consolidated state budget.

The initial 2009 anti-crisis measures have to be seen in the light that the government came into power just at the moment of the sudden macroeconomic shock and the overall perception of Romanian authorities was slowly changing from ‘what crisis’ to severe concerns about the economy. As mentioned before, the imbalances built up in the years of growth significantly limited the government’s possibilities to react to the sudden stop in capital inflows and the deterioration in trade, government revenues and domestic demand. From this point of view the measures taken were understandable but they were by no means sufficient.

3.2.

Politics under Supervision: Romania and the IMF

The authorities soon realized that the proposed action plan was not suitable to counteract the impacts of the crisis and that external assistance was needed in order to prevent a meltdown of the economy. Therefore, the government approached the IMF and the EU for financial assistance in March 2009. In a rapid reaction, IMF, EU and World Bank in principle agreed upon a 20 billion EUR bailout package in April. On 4 May 2009 the Executive Board of the IMF approved a 24-month Special Drawing Right (SDR) 11.4 billion (about 12.9 billion EUR) Stand-By Arrangement for Romania in order to support the Romanian government’s economic program. The approval made SDR 4.37 billion (about 4.9 billion EUR) immediately available and the remainder in instalments subject to quarterly reviews. The Stand-By Arrangement was combined with other multilateral financial

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support, the total international financial support package will amount to 19.9 billion EUR, with the EU providing 5 billion EUR, the World Bank 1 billion EUR, and the EBRD, the EIB, and the IFC a combined 1 billion EUR. The funding was accompanied with stringent warranties and from then on those warranties dominated Romanian economic politics. Key to the program was a reversal of the sharp increase in public spending that caused the large deficit to accumulate even during a period of strong economic growth. Short-term budget cuts were to be combined with fiscal policy reforms to place the public finances on a more sustainable path. The effects of the fiscal adjustment and budget reforms were to be cushioned by boosting social safety net spending and safeguarding capital spending. Banking sector measures were also be implemented to ensure that banks remain sufficiently strong to weather the economic downturn. Specific program objectives included: Y

reducing the fiscal imbalance to bring the deficit back under 3 percent of GDP by 2011;

Y

maintaining adequate capitalization of banks and liquidity in domestic financial markets;

Y

bringing inflation within the target range of the National Bank of Romania (NBR) by end-2009 and maintain it there;

Y

securing adequate external financing and improve confidence.

The Stand-By Agreement shifted the political behaviour almost instantly. Under the pressure of the program’s warranties, the government – against strong political opposition and public mass protests – started a stringent austerity programme. Major components of the programme have been: Y

introduction of the Fiscal Responsibility Law, limiting the number of budget revisions to be conducted in a single year and sets fiscal rules on public expenditure, personnel costs and the country’s budget deficit in March 2010;

Y

amendments to banking and winding-up laws in order to enhance the bank resolution framework;

Y

introduction of legislation and internal regulations needed for implementation of tax administration reforms;

Y

preparing the legislation for the unified wage law, with the purpose of keeping wages in the public sector on a sustainable path;

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Y

expenditure cuts in order to bring the fiscal deficit to 6.8% of GDP which corresponds to the initial 6.5% target before the revision of the 2010 GDP forecasts: –

25% cut in total wages, bonuses and other compensations paid to all public sector employees (amounting to 1% of GDP 2010);

–

15% cut in pensions and other social transfers (amounting also to 1% of GDP) – this part of the law has been cancelled by a vote of the constitutional court end of June 2010 – the minimum wages and pensions remained unchanged and the guaranteed minimum income scheme was exempted from the 15% cut in social spending in order to protect the more vulnerable members of society;

–

cuts in transfer payments to local governments (0.3% of GDP);

–

reduction of heating subsidies (0.03% of GDP);

–

temporary freeze of early retirements;

–

strict controls on new disability pensions;

–

reduction of public workers by 20,000 in a first step in 2010;

Y

on the revenue side, the measures were rather limited and consisted basically on the broadening of the tax base in personal income and social security and the introduction of a turnover tax on medical distributors;

Y

fiscal Strategy for 2011-2013 in compliance with the Fiscal Responsibility Law, incorporating a fiscal deficit target of no more than 4.4% of GDP in 2011, eliminating the 13th salary paid to public sector employees, limiting the wage bill to 39 million RON and setting a maximum of 1,290,00 total public employees at the beginning of 2011;

Y

work on the local public finance law in order to strengthen fiscal discipline of local governments;

Y

reinforced tax administration efforts to effectively fight tax evasion and improving the management of growing tax arrears as well as tightening control over the largest taxpayers: –

related to VAT, introduction of common minimum standards for registration and removal from records of taxpayers who carry out intra-community trade;

–

establish collateral controls for intra-community acquisition of products with increased risk of tax fraud;

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–

review of the conditions for transferring shares/equity in companies, as well as those governing the liability of administrators, shareholders and third parties in order to combat the risk of fraud;

–

amendment to the legal framework governing the trading of duty-free goods;

–

improvements to the legislation related to electronic cash-registers;

Y

restructuring measures on state-owned enterprises including encouragement of privatisation;

Y

preparing the long term pension reform;

Y

reform of the Public Health Care System;

Y

introduction of patient service fees from 2011;

Y

cutting the number of hospital beds to 9,200;

Y

revision of the labour code;

Y

introduction of the new Education Law;

Y

0n the Financial Market side, raising of the target coverage ratio for ex-ante financing by to 2%;

Y

commitment to keeping inflation within the target band of 2.5% – 3.5%.

On 25 June 2010, the Constitutional Court ruled on the package of expenditure cuts approved by parliament. The court accepted the legality of the 25% cut in public sector wages and the cut of 15% in most social transfers, but rejected the constitutionality of the 15% reduction in pensions. This decision created a gap of 0.7% of GDP to achieve the 6.8% of GDP deficit target. In a quick response, the cabinet decided on compensatory measures and approved an emergency decree to increase the standard VAT rate from 19% to 24% with immediate effect. The lengthy debate on the no-confidence vote and the fiscal package has delayed the pension reform legislation, but the implementation in 2011 seems to be still in reach. Overall, under the pressure of the Stand-By Agreement waivers, the Romanian authorities showed quick responses and, at least at the moment full commitment to the modalities of the Agreement even against massive oppositional and public protests.

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4.

Outlook for the Coming Years

4.1.

Short Term: Recovery – Visible but Fragile

Although Romanian growth has shown improvement since the second quarter of 2009, an urgent need for the government to rein in its budget deficit has resulted in a programme of drastic fiscal austerity that will almost certainly result in renewed recessionary forces. Current forecasts expect this policy-induced economic weakness to result in a full-year 2010 real GDP contraction of 1.9% and for it to persist into the first half of 2011. The full-year 2011 growth is estimated at just 2.1% – well below the 6.8% average rate of expansion seen over 2004-2008. Analysts expect this momentum to be sustained and expect the domestic economy to go into a double-dip growth scenario through the second half of 2010 and into 2011 While the Romanian economy appears to be slowly edging out of recession according to the GDP development in the second and third quarter, it is unlikely, that a sustainable recovery will be seen until the second half of 2011. In the short run, the drastic fiscal austerity that is being implemented by the Romanian government – as required by the IMF Stand-By Agreement – to depress aggregate demand and result in a modest contraction in GDP through the coming quarters. As illustrated in the GDP by expenditure picture below, government consumption has had a fairly neutral impact on growth since the economy entered recession. This is unlikely to be the case going forward, given the sharp expenditure cuts the government must implement through the latter stages of 2010. It is to be expected that this will not stay and that government consumption impact will be a 0.4 p.p. drag on real growth in 2010.

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Picture 7: Real GDP Growth by expenditure, percentage point contribution, source: BMI, 2010.

Beyond this, fiscal austerity will weigh heavily on private consumption. Indeed, while private consumption contributed 7.0 p.p. (y-o-y) to the second quarter’s growth showing, analysts expect it to make only a 0.4 p.p. contribution to headline real GDP growth in 2010. The government’s decision to implement a 25% public sector wage cut and a 5.0 p.p. increase in VAT while also cutting government payroll numbers and pension payments will undoubtedly have a detrimental effect upon private consumption growth. Job losses in the public sector will mean that Romania’s unemployment rate (7.4% in August 2010) remains elevated thus also limiting consumption growth.

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Picture 8: Unemployment Rate (%), source: BMI, 2010.

Furthermore, lower public sector earnings and pension cuts together with the layoffs and the sharp increase in the price of goods resulting from the VAT hike will only serve to depress private consumption through the coming quarters. Even without the drag of recent fiscal austerity measures, the latest retail sales figures make plain the weak nature of Romania’s recovery – with the retail sales index excluding automotive fuel up a not impressive 1.8% year-to-date in May, with the May reading still down 5.7% on a y-o-y basis.

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Picture 9: Development of Retail Sales, source: BMI, 2010.

As stated earlier, under the conditions of the IMF Stand-By Agreement, Romania will face a tough road of fiscal consolidation through the coming quarters as the government implements drastic austerity in an attempt to correct its budgetary overspend. While the country’s low outstanding debt load will help ensure the sovereign’s solvency, there are challenging times ahead for Romania. The economy is likely to remain weak into the medium term on account of the unavoidable austerity, with the resultant political instability likely to delay the return of investor confidence in the sovereign. Although Romania ran a relatively conservative budgetary position prior to the global financial crisis, its government must now deliver a programme of fiscal austerity that will almost certainly ensure the domestic economy is mired in recession through the remainder of 2010 and into 2011. The austerity measures will contribute to the effect that the Romanian economy will contract by 1.9% in 2010 rather than the initial IMF forecasts of 0.5%, and the expansion in 2011 is estimated to be around an unglamorous 2%.

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While Romania’s budget deficit averaged just 1.7% of GDP in the five years of 2002-2007 and general government debt was a very modest 12.6% of GDP at end2007, government now faces the challenge of a budget deficit that ended 2009 at a distressing 8.3% of GDP. This tremendous budget deficit is very much the result of the harsh 7.1% contraction in domestic economic activity seen in 2009 due to the slump in global trade and the equally sharp drop FDI inflows into Romania resulting from the global financial crisis. The 20 billion EUR IMF Stand-By Agreement of March 2009 moderated the severity of the domestic downturn, but Romania nevertheless remains fiscally dependent on this outside assistance. Picture 10: Fiscal Balance, source: BMI, 2010.

As the above figures illustrate, Romania’s government finances quickly descended into deficit from 2008 onwards, as tax revenues slipped and expenditure commitments continued to edge higher. The situation remains precarious, with the budget deficit coming in 13.5% (y-o-y) higher at 9.03 billion RON in the first quarter of 2010.

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As per its IMF commitments, the Romanian government is now implementing severe austerity measures aimed at correcting this substantial fiscal imbalance. Indeed, while Romania has so far received 10.7 billion EUR in support from the IMF, further funding is contingent upon the government making progress on the fiscal front. With Romania unable to finance itself adequately from capital markets at the moment due to investor fears over the sustainability of its budget deficit (government has repeatedly refused to sell debt at yields above 7%, ensuring debt auctions fail to receive anywhere near full bid coverage), government has little choice but to follow an IMF-led path of fiscal rebalancing. These measures will prove effective in curbing the government’s budget deficit, with the VAT hike bolstering revenues and the cut in public sector wages helping to curb expenditure. Picture 11: Budget Deficit in% of GDP, source: BMI, 2010

While the period of austerity will prove extremely challenging for most Romanians, it can be expected that the policy action will help reduce the budget deficit to 6.0% of GDP in 2010, down from 8.3% in the year prior, and put the sovereign on

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a path towards fiscal sustainability. The budget deficit is forecasted to fall to 3.0% of GDP by 2014 – in line with the EU’s deficit limit – helped along by an uptick in growth from mid of 2011 onwards. Given this expected consolidation, the view of Romania’s long-term fiscal position is fairly optimistic. For one thing, the pension reform and public sector cuts currently being introduced by the government will help redress the long-term structural imbalance to be found in the Romanian economy. The latter has currently six million pensioners and 1.3 million public sector workers, compared with just over 3.7 million working in the private sector. Picture 12: Government Debt, in% of GDP, source: BMI, 2010.

Furthermore, as the above figure illustrates, even with Romania’s near-term fiscal overspend, the government debt will remain relatively modest due to the financial prudence exercised during the boom years. Outstanding government debt is forecasted to peak at just 35.4% of GDP in 2015 – a serviceable level of government debt. Therefore, it seems unlikely that there is great risk of a credit event hitting holders of Romanian sovereign debt.

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Despite relatively favourable long-term fiscal dynamics, investor confidence has yet to be restored in sovereign debt. The government has repeatedly failed to successfully auction meaningful levels of leu-denominated debt through mid-2010 due to most investors’ unwillingness to receive a yield lower than 7%. For example, on 13 September 2010, government raised only 372 million RON from a 1 billion RON auction of one-year debt yielding 7%, after again rejecting all bids above the 7% mark. In addition to unsuccessful bond auctions, the low confidence in the sovereign debt is very much reflected in the elevated level of credit default swaps on its debt. The political fallout of the tough austerity programme is likely to further influence investor confidence. Protests against spending cuts swept Romania on 15 September 2010, with further unrest highly likely as austerity continues to bite. With support for the government being increasingly eroded by this dynamic, investors will likely remain wary, given the collapse of the previous coalition government in October 2009 (after the withdrawal of Social Democratic Party participation) due to the threat such a development would pose to fiscal consolidation. The current centrist government has already faced a no-confidence vote in June 2010, surviving by a relatively narrow margin. With the oppositional PSD threatening to again table a no-confidence vote against the government in parliament, investments in Romanian sovereigns will be rather limited. Therefore, government will likely need IMF support well into the medium term until domestic economic and political conditions begin to show improvement. Monetary policy will have a vigilant eye on inflation. The rate of consumer price inflation was accelerating to 7.6% (y-o-y) in August 2010, compared with 4.1% (yo-y) in June 2010. The surge in consumer price inflation (CPI) seen through July-August is not reflective of excessively loose monetary conditions, but rather a one-time adjustment to the government’s VAT rate. The government hiked VAT in July to help plug the hole in its fiscal accounts, raising the rate charged on general goods to 24% from 19% previously, which had the obvious effect of causing yearon-year CPI to shift upwards. The impact of the government’s decision to hike VAT is shown in the below figure, with the headline rate of year-on-year CPI jumping beyond the NBR’s 2.5-4.5% target band. This overshoot is extremely unlikely to correct until well into the medium term (unless wider monetary condition become strongly deflationary). It will be twelve months (from July 2010) before this VAT hike no longer influences year-onyear CPI – at which point the headline rate of inflation should drop markedly.

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Picture 13: Headline CPI Growth and NBR target band, source: BMI, 2010.

Although, with the Romanian economy still struggling to gain momentum due to on-going fiscal austerity, the NBR will rather likely delay the beginning of monetary policy tightening. The NBR will also keep its policy rate on hold at 6.25% until the second half of 2011, at which point the domestic economy should have begun to show recovery. Although year-on-year CPI will remain elevated from August’s 7.6%, it has to be stated that underlying inflationary pressures are not particularly strong. The increase in the rate of VAT caused month-on-month CPI to jump to 31.0% month-onmonth annualised in July but, with the VAT increase already included in the level of consumer prices, month-on-month annualised CPI returned to just 2.8% in August. This figure is more reflective of Romania’s actual rate of CPI inflation due to monetary factors. With this in mind, there is little reason for the NBR to tighten monetary policy in order to stem inflation. Indeed, such a move would merely compound the precarious state of the Romanian economy. Policymakers at the NBR have acknowledged

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that this is the case and retained a dovish tone on the recent surge in headline CPI. The bank’s governor, Mugur Isarescu, has stated he sees little need for monetary tightening given that the cause of high inflation ‘isn’t monetary’. With the global economy on the way to recovery, the investment climate will again be important for Romania’s ability to attract foreign capital inflows. Corruption was and is estimated to be a plague over the medium term. This assumption is being underlaid by a 20 July report by the European Commission (EC) criticising the country’s lack of progress on the issue. Change for the better is needed in order to improve Romania’s business environment which, despite the nation’s EU entry, remains weak compared with the wider region. Among the newer EU entrants and potential accession candidates, Romania has proven to be somewhat of a straggler. In the Transparency International’s 2009 Corruption Perceptions Index, Romania was valued with a 3.8 score out of possible 10.0, with a lower score indicating a higher level of perceived corruption. This was amongst the poorest results in the region, only Serbia (3.5/10.0) showed a worse corruption perception level. Picture 14: Corruption perception level, source BMI, 2010.

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This is far from encouraging, considering the institutional reforms expected to accompany harmonisation to EU standards. Indeed, in its 20 July report, the EC actually accused Romania of being in clear breach of its accession commitments due to Bucharest’s failure to properly instigate reforms in order to clamp down on corruption. In particular, the EC noted that substantial improvements are required in protecting against conflict of interest and corruption in public requirement and criticised the fact that corruption trials remain lengthy with only a few judgements against prominent politicians having yet reached a first instance decision. Furthermore, the EC expressed concern that, even when convictions are achieved, there is a tendency to issue low and suspended penalties that do not effectively deter impropriety. Corruption is prevalent at all levels of Romanian society and likely to remain so until further reforms are instigated by Bucharest. Without concrete reforms Romania’s business environment will remain affected by corruption, this deterring muchneeded foreign investment – particularly in areas directly related to public tenders. Romanian authorities are not likely to rapidly instigate far reaching reforms to tackle the issue of corruption unless the EC applies further pressure beyond its 20 July report. In fact, progress actually appears to have stalled in months. The Constitutional Court rejected a government law to further empower the National Integrity Agency on 19 July on the basis that measures requiring public figures to declare their financial interests would represent a breach of their right to a private life. Additionally, the senate has also shown reluctance to strengthen graft laws, voting against measures to do so in July 2010. Concrete progress to materialise cannot be expected for some time, given the apparent resistance to reform shown by parts of both the legislature and the judiciary. In particular, the weak position of the ruling government, which faces extremely unfavourable economic challenges due to a sizeable fiscal deficit, will most likely undermine any attempts to tackle graft. Indeed, it is likely that the EC will have to apply further pressure, potentially threatening to sanction economic aid payments to Romania (a measure used against Bulgaria in 2008, when it saw 500 million EUR of farming subsidies halted due to fraud), before any renewed drive on graft will materialise. In turn, Romania’s business environment is set continue to demonstrating regional underperformance well into the medium term.

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4.2.

Long Term Perspectives

Over a long term, Romania faces three major challenges to assure sustainable economic growth. First, the resolution of the macroeconomic imbalances generated in the period before the crisis must be assured by proper policies. The external adjustment by the crisis has abruptly corrected external imbalances, but additional action is needed to eliminate the fiscal imbalance and prevent a re-emergence of competitive problems and a not sustainable current account. Second, as with other new EU Member States, Romania has the medium-term perspective of accession to the Euro-zone. This will require nominal convergence with the Maastricht criteria. Third, nominal convergence should be accompanied by real convergence, this means sustainable growth to lift livings standards closer towards EU average In order to successfully deal with those challenges, Romania has to improve the flexibility of the economy and increase its growth potential through structural reforms related to labour, product and investment markets. Investment has to be increased primarily in infrastructure. Under the condition that those challenges are accomplished, the longer-term outlook remains relatively favourable. Although the 7-8% rates of growth posted during the credit boom years are unlikely to be seen again, the assessment for the economy, especially compared to the likes of neighbouring Bulgaria are still optimistic. A real GDP growth to average 4% during 2010-2020, compared with 5.1% over the course of 1999-2008 seems to be realistic. The following dynamics build the ground for these expectations: Y

private sector debt burden appears to be manageable;

Y

banking sector remains comparably robust;

Y

exchange rate remains flexible while euro adoption will be delayed;

Y

large consumer market.

Unlike some of its more heavily indebted peers in emerging Europe (notably Bulgaria, Ukraine, Hungary and the Baltic states), Romania’s credit boom did not translate into an untenable private sector debt position. In particular, private sector external debt stands at around 30% of GDP compared with over 80% in Bulgaria.

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The more limited deleveraging requirement will free up capital for domestic consumption and productive investment, rather than channelling funds into debt servicing and repayments, which is otherwise an inefficient use of resources. Alongside the fairly manageable debt dynamics of the private sector in general, the limited degree of leverage in the banking sector as a further factor supporting Romania’s longer-term economic outlook has to be highlighted. With banking sector leverage around 10:1 and given an absent funding gap (deposits fully cover outstanding loans), domestic banks are well placed to support credit creation over the longer term, which in turn will fuel activity through the wider economy. Again, this is in stark contrast to elsewhere in Central and Eastern Europe, where pervasive banking sector leverage and deteriorating asset quality, coupled with limited financial sector reform so far, will have a significant bearing on credit growth over the medium to longer term. Romania’s flexible exchange rate regime will be supportive of economic growth going forward. The sharp depreciation of the Romanian leu towards the tail end of 2008 and early 2009 has bolstered the competitiveness of the export sector, with exchange rate flexibility helping to correct economic distortions over the longer term. Meanwhile, neighbouring Bulgaria, which has rigidly held onto the currency board arrangement, faces internal devaluation and potentially severe debt deflation. It will ultimately anchor the economy onto a lower growth path going forward. As a member of the EU, Romania is obliged to adopt the euro at some point. Though, with the impact of the crisis, it is most unlikely that this will happen significantly before 2020. Finally the relatively large domestic consumption base in Romania is a reason to expect a return to healthy rates of economic growth over the longer term. The consumer market is the largest in South-eastern Europe (in current US dollar terms) and the fourth largest in emerging Europe (behind Russia, Turkey and Poland), with Romania also being the fifth most populous country of the major Central and Eastern European states. With the limited level of household debt and income per capita being the second lowest in the EU (ahead of Bulgaria), there is clearly significant room for growth over the longer term, especially as Western European retailers continue to exploit more profitable opportunities away from their home markets. As such, Romania’s economic model will remain geared towards internal demanddriven growth over the longer term. Although there is room for healthy economic growth over the longer term, a number of key risks that could dampen Romania’s economic outlook have to be highlighted. Chief among these is the fragile domestic political environment. Since

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the transition from communism in the 1990s, Romania has been plagued by unstable coalitions, which have frequently collapsed and disrupted economic policy and reform. This will likely remain an enduring risk for going forward, with the potential for further serious political schisms severely impacting the ability of any administration to get to grips with far-reaching structural reforms. As a result, the quality of Romania’s political and economic institutions will continue to suffer, in turn weighing on investor risk perceptions and efficient resource allocation over the longer term. Allied to this, pervasive corruption across all echelons of society will most likely remain a major hindrance to market transparency and long-term economic growth. Romania’s population dynamics also points to looming economic constraints in the long term. Picture 15: Population profile by gender, source: BMI, 2010.

While a fairly young population will be supportive of consumer spending, the population is in long-term structural decline as a result of a low fertility rate and emigration. In case of the former, Romania’s total fertility rate is around 1.39, below the 2.1 replacement level. In the meantime, membership to the EU has seen many of the country’s better-skilled workers migrate to labour markets elsewhere in the EU in search of better pay and employment opportunities.

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With these trends unlikely to reverse going forward, the shrinking population will reduce economic capacity, while a failure to raise the birth rate or attract migrant workers will leave an ageing population and rising dependency ratio. Both dynamics will pose significant challenges to economic growth over the longer term. Finally, there is the question of whether eventual euro adoption will be a blessing or a curse. Although accession to the Euro-zone will eliminate exchange rate risks (attracting foreign investment and deepening trade integration), it will also strip the National Bank of Romania of its ability to control interest rates in response to changing economic conditions and the fiscal cycle. Given the misalignment of political and economic cycles in the Euro-zone, the inability to adjust interest rates removes a vital policy lever for the Romanian authorities and could see significant economic distortions build up over the longer term. With inability to competitively devalue vis-à-vis other Euro-zone members, Romania will need to significantly improve the competitiveness of domestic industries in order to compete effectively in foreign markets. Picture 16: Productivity levels in CEE, source: BMI, 2010.

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However, since Romania has failed to sufficiently raise productivity in line with the EU average thus far, there is a risk euro adoption could force a long and protracted period of internal devaluation. As a conclusion, the already existing macroeconomic imbalances were revealed by the financial crisis and limited the scope for effective counteraction by the Romanian government. Under the warranties of the Stand-By Agreement with the IMF, the Romanian authorities had to swiftly introduce severe austerity measures, focusing primarily on cost cutting rather than on broadening the tax base. First steps towards rebalancing have been taken by limiting public wages and a pension reform is at least within reach, but the reliance on external funds will stay active in the short term. The main question is whether the political system will be able to make the shift from a short-term focus on the behaviour and whims of the electorate and vested interests to a sustainable stable policy-making approach in order to allow room to take advantage of the opportunities the country almost certainly offers.

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Russian Federation: The Rocky Road André Scholz

Russian Federation: The Rocky Road |

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1.

Situation before the Crisis

Between 1999 and 2008, Russia was one of the fastest growing economies in the world. The global economic crisis which began in the USA in August 2007 and then spread and intensified in September 2008 left few countries unaffected. Russia, however, fared particularly badly. Like much of the world, Russia was hit by a serious economic crisis in late summer of 2008. Before the crisis, the Russian economy expanded dynamically thanks to record export levels and a lively banking market. In the years 2003-2007, the Russian economy boomed with annual GDP growth averaging 7.5%. Due to high real growth and a strong real appreciation of RUB, Russia’s nominal GDP had increased five-fold since 2002; GDP per capita approached 12,000 USD in 2008 (Picture 1). However, the economic boom and RUB appreciation were mainly driven by rising commodity prices and massive inflows of foreign capital, which were temporary factors. Picture 1: Strong economic performance over recent years, source: Deutsche Bank Research, Central Bank of Russia, International Monetary Fund, OECD, Russian Statistical Agency 2009, p. 3 Nominal GDP GDP per capita

USD bn USD

Population

1995

2000

2005

2006

2007

2008

313

260

765

989

1,294

1,677

2,110

1,770

5,340

6,940

9,120

11,860

Million Domestic savings % of GDP Domestic % of GDP Investment

148

147

143

143

142

141

28.8

34.9

28.8

28.1

27.0

28.0

25.4

16.9

17.7

18.5

21.1

21.9

GDP growth (real)

% y-o-y

n.a.

10.5

6.4

7.7

8.1

5.6

Industrial production growth

% y-o-y

-4.6

8.7

5.1

6.3

6.3

2.5

Crude oil production

m tons

307

324

470

481

491

488

Natural gas production

bn m3

595

584

641

656

651

664

%

8.9

10.7

7.6

7.2

6.1

7.7

Unemployment rate (official)

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J. Jungmann, B. Sagemann (Eds.), Financial Crisis in Eastern Europe, DOI 10.1007/978-3-8349-6553-0_8, © Gabler Verlag | Springer Fachmedien Wiesbaden GmbH

The spectacular growth in the last years before the crisis masked but did not eliminate the acute problems of the Russian economy accrued during the last decade. The main problems were: Y

Energy efficiency ranking among the lowest in the world and lagging far behind the developed countries. One of the main reasons was cross subsidization within and between sectors, which has declined from 5% to 3% of GDP but is still unjustifiably high.

Y

Low labour productivity, amounting to 36% of the US level and roughly 72% of China’s.

Y

Low official share of small and medium-sized enterprises in GDP, which has remained flat at 17% in recent years, thus demonstrating the illiberal character of the Russian economy.

Y

Corruption, being to a large extent a natural consequence of a lack of economic freedom and the state’s excessive influence on business.

Y

Social spending, especially on pensions, posing an excessive burden on the state budget. The consolidated budget spending is exceptionally high. Public spending, after declining in 2004-06, started to grow again in 2007 and reached 41% of GDP in 2009. Given Russia’s level of development, sustainable growth is hardly possible with such high spending. Russia still does not have a private pension system: only 2% of the population have transferred part of their pensions to non-state funds.

Y

Finally, excessive employment in the government sector making up for the incompetence of the bureaucracy. The number of government officials has grown by at least 25% since 2000. Overall, 16% of Russia’s population is employed in the public sector.1

1.1.

Russia’s Economy Rising

The Russian economy has gone through turmoil during the last two decades. In the 1980s the Soviet economy suffered from stagnation and in 1989-91, the Soviet economic system collapsed. Russia’s GDP officially plummeted by 44% by 1998. The real decline however was probably only half that because an extensive unregistered economy developed after socialism. From 1999 to 2007, the Russian econ1 Anders Aslund / Sergei Guriev / Andrew Kuchins, Russia after the Global Economic Crises, 2010, p.|xii.

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omy grew rapidly by an average of 7% a year. Because of the sharp real appreciation of the rouble, however, Russian GDP measured in current US dollars expanded by an amazing average of 27% a year over the same period, from 196 billion USD in 1999 to 1.75 trillion USD in 2008. According to the International Monetary Fund (IMF), Russia was before the crisis the eighth largest economy in the world, measured by GDP in current dollars, coming just before Spain and after Italy. If GDP is measured in purchasing power parity, Russia was already the sixth largest economy, after Germany but ahead of the United Kingdom and France.2 In a 2003 paper on the BRICs (Brazil, Russia, India and China), Goldman Sachs projected that in less than 40 years these four economies together would likely be larger than the combined Group of Six (G-6) nations.3 With a cautiously projected average annual growth of only 3.9%, Russia would overtake Italy in 2018, France in 2024, the UK in 2027 and Germany in 2028. By 2030, Russia would be the fifth largest economy in the world. Factors causing Russia’s economic dynamism in addition to abundant energy resources are sound macroeconomic policies, an open economy, substantial investment and high levels of education. Russia’s weaknesses are its institutions, governance and the rule of law. Among the BRICs, Russia had by far the highest GDP per capita in both current dollar and purchasing power parity terms: In 2008 these were 12,000 USD (four times that of China) and approximately 16,000 USD, respectively – about ¹/³ of those of the 15 old members of the European Union.4 Russia’s higher income level is also evident in superior social indicators. In most regards, Russia is slightly more advanced than Brazil and Mexico but head and shoulders above China and India. Most impressive, increasing numbers of young Russians are opting for higher education. Another indication of Russia’s strength is its swiftly growing middle class. According to the Russian research institute Centre for Strategic Research, over 30% of Russians can now be considered middle class. The development of Russian consumers makes the country all the more attractive to US exporters of merchandise and services.

2 International Monetary Fund (IMF), World Economic Outlook database, 2008; Peterson Institute for International Economics, Russia’s Economic Revival: Past Recovery, Future Challenges, 2009, p. 40, www.piie.com (2010). 3 Dominic Wilson / Roopa Purushothaman, Dreaming with BRICs: The Path of 2050, Goldman Sachs Global Economics Paper 99, 2003, p. 6. 4 International Monetary Fund (IMF), World Economic Outlook database, 2008, p. 5.

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But to understand Russia’s economic problem, it is necessary to comprehend the cause of its growth over the last two decades. They fall into three categories: transformation to capitalism, the use of free capacity and structural change, and energy rents. 1.1.1.

Transformation to Capitalism – Breaking down the Soviet System

The main reason for the growth has been European and capitalist convergence, which Russia has enjoyed thanks to the hard-fought introduction of a market economy in the 1990s. The transition to market economy consisted of deregulation, privatization and financial stabilization. But the most important step was to liberalize prices and trade to create a market economy, allowing economic decisions to be freely made by individuals and independent firms. Prices are predominantly free and subsidies are small. No state planning committee tells enterprises what to produce or to whom to sell. Transactions are overwhelmingly monetized. In 1996 Russia was a full-fledged market economy.5 Another feature of a free market economy is the dominance of private enterprise. From 1992 to 1997 Russia undertook the largest privatization in the world history. According to the European Bank of Reconstruction and Development (EBRD), the private sector contributed 70% of GDP from 1997 to 2004, although, contrary to the trend in other transformation countries, that share fell to 65% in 2005. But essentially Russia owes all its economic growth to the expansion of the private sector which has taken place in recent years. From 1998 to 2002, Russia undertook a profound tax reform and adopted a liberal tax system, cutting the number of taxes sharply, reducing tax rates and introducing a flat personal income tax of only 13%, while decriminalizing many tax violations. As a result, Russians started paying taxes and public expenditures hovered around a moderate 35% of GDP. The recovery was coupled with remonetisation as Russia enjoyed a credit boom.6 Russia’s structural reforms continued until 2002. Among the last important reforms were a comprehensive judicial reform allowing businessmen to pursue lawsuits against either other businessmen or the government (and the number of lawsuits has been constantly growing) and the adoption of a land code permitting 5 Anders Aslund, Russia´s Capitalist Revolution: Why Market Reform Succeeded and Democracy Failed, 2007, pp. 278-280. 6 Institute for International Economics, Russia’s Economic Revival, Past Recovery, Future Challenges, 2009, p. 41, www.piie.com (retrieved on 30 August 2010).

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private ownership of agricultural land. New laws on licensing, certification, permits and inspections eased restrictions on small enterprises and a new customs code simplified the former very complicated customs procedures. Another very important factor stimulating Russia’s growth after the Soviet era is the country’s fast integration into to the world economy: Total exports surged from 42 billion USD in 1992 to 472 billion USD in 2008.7 Much of the increase came from the rising oil prices, but Russia’s economy has been diversifying: The share of oil and gas in the country’s export has fallen to 60% from 90% in the late 1980s. 1.1.2.

Structure Changes and Free Capacity

The second main reason for the high growth has been the huge free capacity in production, infrastructure and human capital as well as significant structural changes since the collapse of communism. With the rise of the new capitalist service sector, a large-scale structural change spurred growth. The service sector expanded from 33% of GDP in 1989 to 57% in 2007. Even so, Russia’s industrial sector is still large by international standards, contributing 38% of GDP in 2006, compared with 27% in the Euro-zone.8 Russia’s structural changes are best illustrated with a brief review of its major industries. Economic growth took off with recovery in the privatized heavy export industries, oil and metals. In its wake, some related sectors recovered, notably mining, chemical industry and partially heavy machine building. With rising personal incomes, housing construction and retail trade expanded significantly and are proliferating throughout the country. A few industries that initially lagged behind are now evolving and will contribute to Russia’s growth in the next years. Agriculture is reviving slowly but steadily. Old state and collective farms are redistributed gradually to huge agricultural enterprises with some hundred thousand hectares of land, because, so far, much of this land has lain fallow. But these companies are having serious trouble finding skilled management and labour staff. The agricultural revival started in grain production and pig farming, but Russia’s cattle and dairy industry remains miserable. The country’s burgeoning poultry industry has one of the

7 Central Bank of Russian Federation, Statistics, 2009, www.cbr.ru (retrieved on 25 August 2010). 8 World Bank, World Development Indicators, 2009, http://devdate.worldbank.org (retrieved on 25 August 2010).

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strongest protectionist lobbies, whereas grain producers favour free exports. In the 1980s the Soviet Union imported an average of 38 million tons of grain each year, but in 2005-2006 Russia exported 11-12 million tons of grain a year.9 Another rising sector is the automotive industry. Russia still imports more cars than it produces because the old soviet car producers have impeded the development of new domestic companies. But it is forecasted that Russia will overtake Germany as the biggest car purchaser in Europe, with some 3.5 million cars. Moreover, most large car producers in the world either have established or are about to establish production in Russia and the country’s automotive output will likely expand spectacularly. Similarly, Russia’s forestry industry has been a laggard because of late reforms, but with huge resources and domestic demand it is set to develop fast. The most recent structural changes include the 7% a year rise in the number of registered enterprises. It is true that Russia remains dominated by big enterprises, their share however is not as large as it is commonly perceived. With five million registered enterprises and 3.4 million registered individual entrepreneurs, Russia has a total of 8.4 million firms.10 Small and medium sized enterprises contribute 45% of GDP, compared with about ²/³ in Western Europe. Summing up, Russia’s systemic and structural changes represent a gigantic catch-up to capitalist convergence that all post-communist reform countries have experienced. The average annual real growth in former Soviet states from 2000 to 2009 was 9%, but it reached only about 7% in Russia, so Russia has actually been comparatively less dynamic than its cohort. The growth leaders were Azerbaijan, Armenia, Estonia, Kazakhstan and Latvia.11 1.1.3.

Energy Sector

The third and probably the main factor behind Russia’s growth is the oil price windfall since 2004. As international oil prices took off, a dominant theme in the Russian economic debate became the danger of an ‘energy curse’ for the Russian economy. The curse actually encompasses several problems, such as overvalua9 Institute for International Economics, Russia’s Economic Revival: Past Recovery, Future Challenges, 2009, p. 42, www.piie.com (retrieved 30 August 2010). 10 Federal State Statistics Service online database, 2008, www.gks.ru (2010). 11 European Bank of Reconstruction and Development, Economic Statistics and Indicators, 2008, www.ebrd.com (2010).

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tion of the currency, the government ignoring reforms and rent seeking. After the Russian financial crash of 1998, the authorities were greatly concerned with any overvaluation of the exchange rate that would price out other exports, the so-called ‘Dutch disease’. As a consequence, talent has been focused on making money in the energy sector and the development of other industries has been neglected, not least because Russian labour has been uncompetitive with its high salaries. Another curse is that abundance of energy revenues (that has boosted the country’s budget surplus current balance and currency reserves) makes it difficult to motivate policymakers and the population to pursue and accept economic reforms that often entail hardship in the short term. As a result, Russia has made no economic or social reforms worth mentioning for the past eight years as the government focused on the distribution of oil rents rather than on the improvement of policy. The last energy curse is that the concentrated energy revenues facilitate the concentration of both political power and rent seeking. This is the cause of the extreme and rising corruption in Russia. As a consequence, Russia’s business environment is poor and it is getting worse. The state bureaucracy impedes efficient economic activity and adds to the cost of doing business in the form of time spent dealing with arbitrary regulations and the payment of bribes. 1.1.4.

Putin’s Reforms

Russia’s economic success could not be solely attributed to high oil and commodities prices. It is essential to recognize the contribution of economic reforms undertaken during Putin’s first term. Three important reforms stand out in their contribution to growth. First, the tax reform of 2001 improved incentives to work and decreased tax evasion. Second, liberalizing the procedures for corporate registration and licensing and limiting inspections improved the climate for small business and entrepreneurs. Third, conservative macroeconomic policy and financial sector reform lowered interest rates and fuelled an investment and consumption boom. In a 2009 study Yuriy Gorodnichenko, Jorge Martinez-Vazquez and Klara Sabririanova-Peter provided microeconomic evidence on the real benefits of introducing the flat income tax.12 They studied a representative panel of Russian households and showed that the tax reform increased labour supply and lowered tax evasion. In 2001 Russia became the first large economy to adopt a flat tax. The Tax Code of 2001 replaced a progressive rate structure with a flat tax rate of 13%. The study 12 Yuriy Gorodnichenko / Jorge Martinez-Vazquez / Klara Sabririanova-Peter, Myth and Reality of Flat Tax Reform: Micro Estimates of Tax Evasion and Productivity Response in Russia, Journal of Political economy 117, no. 3, 2009, p. 504.

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found that the flat tax reform was instrumental in decreasing tax evasion in Russia and that a part of greater fiscal revenues in 2001 and several years beyond can be linked to increased voluntary tax compliance and reporting. The study also found that the productivity effect on the real side of the economy was positive, although smaller than the tax evasion effect.13 Another study14 in 2007 followed a representative panel of 1,600 small businesses in 20 regions of Russia over five years – before and after the major deregulation reforms. Between 2001 and 2004, Russia simplified procedures and reduced red tape associated with entry regulation (registration and licensing) and regulation of existing businesses (inspections). The laws introduced clear measurable limits to the regulatory burden. In particular, the new laws required that registering a business should involve a visit to just one government agency and take at most one week, that each inspecting agency should inspect a business no more than once in two years and that licenses should be valid for at least five years. In addition, about 90% of business activities that previously had required licenses became exempt. The authors of the study found that this elimination of administrative barriers resulted in the growth of small business – in terms of both number and employment. They also found that the impact of the reform varied greatly across regions. The deregulation was more successful in regions with transparent government, independent media, powerful industrial lobby, low corruption and stronger fiscal autonomy. The study15 by Erik Berglof and Alexander Lehmann provides evidence on the contribution of the financial sector to economic growth in Russia. They argue that there is sound evidence of strengthening of the links between finance and the real sector in Russia. Russian data show that financial development had a beneficial impact on corporate finance, corporate growth and broader economic growth. Early reforms had lasting impact, but it took until 2001 for bank credit to the private sector to show strong and sustained growth.

13 Andreas Aslund / Sergei Guriev / Andrew Kuchins, Russia after the global Economic Crisis, 2010, p. 15. 14 Evgeny Yakovlev / Ekaterina V. Zhuravskaya, Deregulation of Business, CEPR Discussion Paper DP6610, 2007, p. 9. 15 Erik Berglof / Alexander Lehmann, Sustaining Russia’s Growth: The Role of Financial Reform, Journal of Comparative Economics 37, no. 2, 2008, p. 198.

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1.2.

Overdependence on Oil and Gas

Oil and gas have shaped Russia since the first discoveries of oil in Baku in the 19th century. These resources were of critical importance for the Soviet economy. From early on, the fact that oil and gas were domestically produced allowed the command economy to develop without the imperative of a balance of payments constraint to limit waste and inefficiency. One of the alleged policy failures of the Russian leadership is the failure to diversify the economy so as to reduce its dependence on oil and gas. According to official statistics, oil and gas production, like other parts of Russia’s mining sector, did not make a major direct contribution to GDP growth in 2005-2008. Instead, the service sectors, particularly trade, real estate, construction and finance, enjoyed double-digit growth. However, the importance of oil and gas should not be underestimated. Closely related sectors accounted for about 60% of manufacturing, transport services benefited from oil and gas shipment, and trade benefited from mining companies that sold their output at notional transfer prices to parent companies (or subsidiaries) that are located in tax havens within the Russian Federation and are statistically classified as trading companies. Further, rising commodity prices leveraged capital inflows, which financed private consumption and investment, and generated business for the financial and real estate sectors. Finally, since 2005 taxation has siphoned off most of the oil sector’s profits above 25 USD per barrel for the federal budget or Russia’s sovereign wealth funds. In the case of the budget, the funds fuel state consumption and investment. Russia has, as such, made insufficient progress with diversifying its economy away from oil and gas by generating non-oil growth. The key reasons are the conditions for doing business in Russia, which are widely believed to be unfavourable. This is reflected in established international business surveys. According to the World Bank’s Doing Business Index, Russia fell to rank 120 (out of 181 countries) in 2009 compared to rank 112 in 2008. According to the Index of Economic Freedom, published by the Wall Street Journal and Heritage Foundation, Russia is the 146th freest out of 179 countries.16 Russia has changed in many respects over the past ten years, but commodity exports have remained the lifeblood of the Russian economy. Crude oil and gas account for ²/³ of exports. Another 30% is composed of metals, chemicals, timber and agricultural products. A continued increase in export prices over 2003-08 improved Russia’s terms of trade by more than 120%. As a result, its merchandise trade sur16 Deutsche Bank, Deutsche Bank Research. 2009, p. 3.

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plus increased from around 50 billion USD to 180 billion USD. This kept the Russian economy highly liquid and increased the confidence of investors in the capacity of Russian borrowers to service their rising stock of liabilities.17 Picture 2: Rising oil prices improved external balances, source: Deutsche Bank Research, Central Bank of Russia, Institute for International Finance, IMF, 2009, p. 5 1995

2000

2005

2006

2007

2008

USD bn

7.0

46.8

84.6

94.7

77.0

102.3

% of GDP

2.2

18.0

11.1

9.6

5.9

6.1

Trade balance

USD bn

19.8

60.2

118.4

139.3

130.9

179.7

Exports of goods

USD bn

82.4

105.0

243.8

303.6

354.4

471.6

% y-o-y

22.3

39.0

33.1

24.5

16.8

33.1

USD bn -62.6

-44.9

% y-o-y

24.1

13.5

28.8

31.0

36.0

30.6

Terms of trade

% y-o-y

6.0

49.0

16.7

11.4

3.4

21.1

World oil price (average)

USD/ bbl

17.0

28.2

53.4

64.3

71.1

97.0

Urals oil price (average)

USD/ bbl

n.a.

27.5

50.3

61.0

69.1

95.1

Exchange rate

RUB/USD

4.6

28.2

28.8

26.3

24.5

29.4

Real effective exchange rate

Index (eop)

92.2

75.0

102.2

111.2

118.6

122.5

Foreign direct investment (net)

USD bn

1.5

-0.5

0.1

6.6

9.2

17.9

Portfolio investment (net)

USD bn

-2.4

-13.2

-11.4

15.7

6.9

-34.0

Official reserves (gross)

USD bn

18.0

28.0

182.0

303.7

478.8

427.1

Current account balance

Imports of goods

-125.4 -164.3 -223.5 -291.9

17 Ibid., p. 4.

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Total external debt

1995

2000

2005

2006

2007

2008

USD bn 132.7

160.0

257.2

310.6

465.4

483.5

% of GDP

42.4

61.6

33.6

31.4

36.0

28.8

USD bn

11.8

18.7

43.5

56.7

108.0

79.8

% of reserves

65.5

66.7

23.9

18.7

22.6

18.7

of which private sector

USD bn

7.6

31.4

175.1

261.9

419.0

450.7

of which banks

USD bn

4.7

9.0

50.1

101.2

163.7

164.7

of which short term

While the global crisis has exacerbated Russia’s economic difficulties, the origins of the Russian crisis are not entirely economic. Foreign investors began pulling out of Russia in the summer of 2008 following then President Putin’s clumsy threats against companies alleged to owe back taxes. The outflow accelerated in the aftermath of Russia’s invasion of Georgia in August 2008. By the end of 2008, over 130 billion USD had been pulled from the country, the largest annual figure since the government began compiling statistics on capital flows in the mid-1990s.

1.3.

Financial Situation

Russia was awash with cash. The government’s reserve fund, created to cushion the economy from a fall in oil prices, stood at 140 billion USD and the National Welfare Fund (NWF), intended mainly to solve the looming pension crisis, held another 30 billion USD. The NWF, though not yet officially a ‘sovereign wealth fund’, was already among the ten largest such funds, rivalling the Brunei Investment Agency. A combined Russian sovereign wealth fund would rival Singapore’s Temasek Holdings (the sixth largest in the world) and lag just behind the China Investment Corporation. The Russian stock market was doing well. According to the World Bank’s World Development Indicators, the ratio of market capitalization to GDP in Russia was 117%, just slightly below the Organization for Economic Cooperation and Development (OECD) average (120%) and above France and Korea

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(both 107%). While it was below India and China (both 150%), Russia was ahead of Brazil (103%), the Euro-zone (85%) and upper middle income countries (86% on average). Russian private and state-owned companies were expanding abroad extensively, often buying stakes in large foreign companies. A survey of Russian multinational enterprise (MNEs) showed a dramatic internationalization of Russian firms.18 The top 25 Russian companies held 59 billion USD in assets abroad, which made Russia the third largest investor among emerging markets in 2006 in terms of foreign direct investment (FDI) outflows, following Hong Kong and Brazil and the second largest in terms of outward FDI stock. Importantly, Net Foreign Direct Investment position turned positive since 2000 onwards, while net private capital inflows soared from almost zero in 2000 back to over 80 billion USD in 2007 (picture 3). The rise of FDIs is an important structural development in the Russian capital account that is likely to reduce its vulnerability to ‘sudden stops’ compared with the previous period. International experience and recent research show that countries with higher share of FDI and equity-like investments (compared with bond, bank loans, and trade credits) in total capital flows typically experience lower volatility and risk of ‘sudden stops’, i.e., massive capital outflows. Nevertheless, the level of FDIs to Russia remains lower in comparison to that reported for China, India, and Brazil, for example.19 Picture 3: Net capital inflows and direct investment, source: Zeljko Bogetic / Karlis Smits / Nina Budina / Sweder van Wijnbergen, Long-Term Fiscal Risks and Sustainability in an Oil-Rich Country, 2010, p.|13. Direct Investment, USD bn

Net private capital inflows, incl. errors and omissions, USD bn

40

60

20

40

0

20

-20

0

-40

-40

20 07

20 06

20 04 20 05

20 03

20 02

20 01

19 99 20 00

19 98

19 97

19 95 19 96

-20

19 94 19 95 19 96 19 97 19 98 19 99 20 00 20 01 20 02 20 03 20 04 20 05 20 06 20 07

80

19 94

100

60

-60 Net FDI

DI abroad

FDI in Russia

18 Skolkovo Moscow School of Management and the Columbia Program of International Investment. 19 Zeljko Bogetic / Karlis Smits / Nina Budina / Sweder van Wijnbergen, Long-Term Fiscal Risks and Substainbility in an Oil-Rich Country.

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Russian companies had nearly 200 billion USD in foreign sales and employed 130,000 people abroad. Foreign assets, sales and employment each had than doubled since 2004.20 1.3.1.

The Banking System Vulnerabilities are Rising

In recent years before the crisis, resistance to nominal appreciation in the face of upward pressure on the real exchange rate, with financial conditions, offered the banks a one way bet. In this environment, attempts to sterilize capital inflows led to high domestic interest rates while exchange rate pressure is up towards an appreciation. With ample global liquidity and low global interest rates, Russia’s banks and corporations were able to borrow cheaply abroad, earn high interest rates by lending at home and expected to make additional capital gain on their foreign exchange exposure.21 Time and again, as observed among other oil exporters that did not accept the real exchange rate consequences of their spending plans, this resulted in rising bank fragility. The high foreign exchange exposure that resulted threatened to wipe out large parts of bank equity and a substantial part of deposits if and when oil prices unexpectedly fall and the anticipated currency appreciation evaporates and rapidly turns into depreciation. However the banking sector entered the global financial crisis in a relatively strong position. At the end of 2008, Russia’s banks enjoyed relatively sound financial indicators, with strong solvency (average capital adequacy ratio of 15.5%), high profitability, low non-performing loans (2.5% of total loans) and adequate liquidity.22

1.4.

Did the Growth Decade of 1999-2008 Benefit the Average Russian?

Yes, it did! Contrary to widespread opinion, growth did trickle down to both the middle class and the poor, not just benefiting the rich or very rich parts of society. The real incomes in 1999-2008 increased by a factor of 2.5 (picture 4). Real wages more than tripled. For example the mobile phone market grew from virtually zero to 20 Andreas Aslund / Sergei Guriev / Andrew Kuchins, Russia after the global Economic Crisis, p. 43. 21 Zeljko Bogetic / Karlis Smits / Nina Budina / Sweder van Wijnbergen, Long-Term Fiscal Risks and Sustainability in an Oil-Rich Country, 2010, p. 27. 22 Ibid., p. 11.

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more than 100%. Moscow real estate prices went up from about 700 USD /m² at the end of 1999 to 6,000 USD in the summer of 2008.23 The financial system grew manifestly in terms of size and sophistication. For example, the credit to GDP ratio increased from about 10% to about 40% reflecting a boom in both retail and corporate lending.24 Unemployment went down by more than half; from 12.9% in 1999 to 6.3% in 2008. The poverty rate went down from 29% in 1999 to 13% in 2008. The poverty gap (the income that would suffice to bring all the poor to the minimum living standards) decreased from 4.9% of the total households’ income in 1999 to 1.2% in 2008. Moreover, self-assessed life satisfaction rose significantly.25 Even inequality had not increased. Dmitriy Stolyarov and Klara Sabirianova-Peter show that inequality might have even slightly decreased from the Gini coefficient of 0.42 in 1999 to 0.38 in 2005.26

23 Date from Real Estate Market Indicators, www.irn.ru. 24 Andreas Aslund / Sergei Guriev / Andrew Kuchins, Russia after the global Economic Crisis. 25 Russian Monitoring Survey, RLMS, 2009; Sergei Guriev / Ekaterina Zhuravskaya, (Un)Happiness in Transition, Journal of Economic Perspectives 23, No 2, 2009, pp. 143-168. 26 Yuriy Gorodnichenko / Dmitriy Stolyarov / Klara Sabirianova-Peter, Inequality and Volatility Moderation in Russian: Evidence from Micro-Level Panal Date on Consumption and Income, Review of Economic Dynamies 13, No. 1, 2010, pp. 209-237.

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Picture 4: Russian Average Monthly Wage (Period Average, in US Dollars), source: Bank of Finland Institute for Economics in Transition; Russian analytical digest 65/09, 2009, p. 12. www.bof.fi/bofit_en/seuranta/venajatilastot (retrieved on 14 August 2010).

1.4.1.

Domestic Credit

Domestic credit growth, which had increased from an annual rate of 15% in 2000 to around 44% in 2004, began to slow in 2008. Indeed, while these rates of domestic credit expansion were significant, the total stock of domestic credit relative to GDP was only somewhere between 20–25% in 2008. Thus the lending boom in Russia was not as extreme as those that took place in parts of central and east Europe. Furthermore, while there was certainly evidence of a boom in property prices in some parts of Russia, especially in Moscow and some of the larger provincial cities, mortgage lending constituted only around 20% of total lending to households at the end of 2007. By international standards, this was modest. Indeed, domestic credit to households as a whole moved from a mere 1% of GDP in 2002 to only 9% in 2007. Unlike other emerging economies (and some advanced economies), the period of economic growth in Russia had not been caused by an unsustainable boom in lending to Russian households. If anything, the relatively underdeveloped banking system in Russia had impeded this avenue of growth. Of mild concern was the foreign currency-denominated nature of around 20% of mortgage

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lending. While this would be important in the event of any depreciation of the rouble, the extent of foreign currency-denominated lending in Russia’s overall household lending was comparatively meagre. In July 2008 top Russians officials presumed that Russia would escape the international financial crisis and even be a safe haven.

2.

The Impact of the World Financial Crisis (2008/2009/2010)

2.1.

General Impact

Now fast forward to the fall of 2008. Refuting all calming statements, judging by data from the Russian Ministry of Economy27, the impact of the World Financial Crisis hit the Russian Federation for the first time in May of 2008. GDP grew by 8.5% in the first and slowed to 7.5% in the second quarter of 2008 and continued its downward slide in the following months. The general economic negative trend was spearheaded by a drastic worsening of the investment climate due to a tightening of the credit market and an increase in base rates. The drop in investments was accompanied by a drastic slowdown in construction activities. While construction grew by a whopping 28.9% during the first quarter, this figure plummeted to a mere 6.4% in August. In the first eight months of 2008, GDP remained relatively stable due to the vitality of industrial production, which grew by 7.6% compared to the corresponding period in 2007, as well as retail, which showed an increase of about 15% during this period of time. The same cannot be said about the energy sector, which suffered from lower demand and sinking prices. The high relevance of this factor becomes obvious if one considers the dependence of the Russian economy on the energy sector. The following picture breaks down the structure of Russian exports. About 2/3 consist of oil and gas, about 90% of resources in general.

27 Russian Ministry of Economy, Osnovnie tendencii social’no-economicheskovo razvitia v janvare-avguste 2008 g.

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Picture 5: Russian Export 2007/08, source: Russian Ministry of Economy, Osnovnie tendencii social’no-economicheskovo razvitia v janvare-avguste 2008 g, 2008, p. 8. 80% 70%

68.6% 64.2%

60% 50% 40% 30%

26.0%

23.3%

20% 5.6%

10%

4.9%

0% Fuels and Energy

Other resources 2007

2.2.

Machines and equipment

4.2%

3.2%

other goods

2008

Russian Specifics

Even if the above-said does not show anything which could not at all have been expected considering the global economic situation in 2008 and Russia’s role as oilexporting country, Russia’s economic crisis was not quite like the crises around the world. Under the influence of the global recession, some long-term serious problems became visible, previously having laid hidden under the veil of steady economic growth and rising real wages. There is a wide consensus among Russian economists that the inception of the recession in Russia can be dated back to the nineties and would have taken place even if there had not been a worldwide meltdown. In particular, growth in the construction and manufacturing sector completely ceased by the end of 2007. The existence of a bubble in crucial sectors like construction and retail, which provide jobs for about a quarter of the overall work force, could be proven by the high share of borrowed funds in these parts of the economy, amounting to 80% by 2008. Most of the borrowed funds came from abroad. Another circumstance holding back Russia’s economy is its frightening inefficiency. Labour productivity is low, only 36% of the US level and roughly 72% of China’s. Russia’s energy efficiency is the lowest in the world. This is largely a consequence of cross-subsidization between and within sectors, which lessen the necessity to act prudently and responsibly.

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The incompetence of the bureaucracy has been ‘remedied’ by an increase in its staff. Since 2000, the number of government employees rose by a quarter. By now, 16% of Russia’s population are on the government’s payroll. At the same time, the government’s influence is weighty. Public spending amounts to 41% of GDP, mainly due to excessive social spending, especially on pensions. After a failed reform in 2001, Russia still to this day does not have a functioning private pension system, although its population undergoes the same demographic changes, such as aging, as many nations of the Western world. Finally, there is the bad reputation concerning the Russian investment climate and the rule of law. A very vivid demonstration of that problem was the reaction of investors to a remark Vladimir Putin made about the Russian steel company Mechel at a conference in Nizhny Novgorod on 24 July 2008. The picture on the left shows the Russian Prime Minister and other officials on their way to that conference, where they were going to meet with the metal producers. Vladimir Putin uttered only five sentences about Mechel and its billionaire chief executive: “We have a respected company, Mechel,” he said. “By the way, we invited the owner and director of the company, Igor Vladimirovich Zyuzin, to today’s meeting, but he suddenly got sick. Meanwhile, it is known that in the first quarter this year the company exported raw materials at half the domestic, and world price. And what about the margin of tax for the government?” Source: NY Times, 2008.

He continued: “Of course, sickness is sickness, but I think Igor Vladimirovich should get better as quick as possible; otherwise we’ll have to send him a doctor to clear up all these problems.” Instantly, the reminiscence of the destruction of Yukos oil company in 2004 surfaced and made the Russian stock market plunge 5% the following day. In the meantime, Vladimir Putin’s words cost Mechel’s shareholders about 1.2 billion USD a sentence. Mechel, which closed the day before at 36.61 USD in New York, tumbled 13.77 USD on 24 July 2008, to close at 22.84 USD. The company, which responded on the following day, gained 3.36 USD to close at 26.20 USD.

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“There is a good deal of understandable anger in the market towards Russia,” Roland Nash, head of research at the Renaissance Capital brokerage in Moscow, commented on Putin’s words and their consequences.“Political risk is rising.” Considering this lack of trust, it is not surprising that from May to October 2008, the Russian stock market plunged by no less than 80% and the balance of payment deteriorated due to investors pulling out their capital. Russia took countermeasures and used up much of its reserves, which had peaked in August 2008 at 598 billion USD, the third largest in the world after China and Japan. The balance of payment took a sharp turn in 2008. After three years of capital moving into Russia and financing crucial parts of its economy, the sum flowing abroad in 2008 exceeded the value flowing into the country over the three previous years. Because of these developments, Fitch lowered Russian foreign and local currency ratings from BBB+ to BBB, or two rankings above junk. The reduction followed a similar move by Standard & Poor’s, which in December of 2008 became the first agency to downgrade Russia in a decade. The fact that the share of small and medium-sized enterprises in GDP remained flat at a relatively low 17% for several years leading up to the crisis was proof of the illiberal overall character of the Russian economy, the excess involvement of the government and the presence of large corporations. Due to these economic players’ lack of flexibility, the Russian economy was not able to adapt and react to the changing circumstances in the proper way. Its GDP fell by 10.4% in the first half of 2009. The GDP drop was mostly caused by a deterioration of net investment, which dropped by 17% in 2009. Furthermore, construction activity in 2009 dropped by 16% compared to the previous year. The construction slowdown was, for the most part, caused by cancellations of projects to put up production sites. The construction of homes decreased in 2009 only by 6.7%. After plummeting by 18.4% from January to September 2009, it stabilized quickly in the fourth quarter and became one of the key factors of the stabilization of GDP. Production in 2009 faced a decrease of 10.8% compared to the year before. For the most part, this was caused by a stumbling industry (-16% in 2009). This, on the other hand, can be traced back to a lower demand for investment-related goods: a drop in the production of means of transportation and transportation equipment by 38%, of electronic and optic equipment by 31.6%, and of machines and their equipment by 28.4%. However, production picked up courage quickly and started growing again in quarters three and four, by 2.8% and 1.5% respectively.

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The gross domestic product of the Russian Federation not seasonally adjusted (1), seasonally adjusted (2) with the gross domestic product of the year 1995 being 100%. Picture 6: GDP 2006-09, source: Russian Ministry of Economy, Osnovnie tendencii social’noeconomicheskovo razvitia v janvare-avguste 2010 g, 2010, p. 10. 200%

1

2

190%

180%

170%

160%

150%

140% 1 2 3 4 5 6 7 8 9 101112 1 2 3 4 5 6 7 8 9 101112 1 2 3 4 5 6 7 8 9 101112 1 2 3 4 5 6 7 8 9 101112 2006

2007

2008

2009

A problem child of the crisis was the Russian auto industry. In June 2008, The Economist described “Russia’s booming car market” as a place where “you just need someone to count the money”. In November, the market slowed to its lowest since January 2007. According to analysts, the market drop was linked to a collapse in auto loan programs and general uncertainty among consumers, and the market would slide back into its condition of the 1990s unless auto loans recovered. The government supported domestic auto makers by an increase in tariffs on imports, leading to an expected 7.5-8% price increase for foreign cars. GAZ and KAMAZ were the first auto makers to cut production in September and October of 2008. GAZ cut its truck production by 23.4% in September 2008; in October, the company announced a shutdown of the main assembly line due to a decrease in demand for its most successful line, the GAZelle truck. KAMAZ had been reporting financial difficulties since September. In October, KAMAZ reduced working hours by a third, from a six-day to a four-day working week. KAMAZ urgently requested a 15 billion rouble state-backed loan and took a private loan from Citigroup at 9% over prime rate. In December Daimler AG acquired the first 10% in KAMAZ stock, citing ‘perfect storm’ as a good time acquisition. AvtoVAZ disclosed emergency measures on 16 October 2008, when Igor Sechin held an industry-wide anti-crisis brainstorming session in Togliatti, the company’s headquarter. AvtoVAZ reported a stockpile of a 100,000 unsold cars (two months’ output). The company received government assistance of 1 billion USD in the shape of a Vneshtorgbank loan. AvtoFramos, a Moscow-based manufacturer of Renault Logan, declared that instead of a planned weekly New Year holiday, the plant would stop for a month, Russian Federation: The Rocky Road |

433

12 December 2008 to 12 January 2009. Trade unions asserted that AvroFramos had practiced short-time stoppages in November; the plant administration refuted these statements. According to the unions, unsold stock reached 8,000 cars, a month’s output of the plant. Amtel-Vredestein closed two of its tire plants due to cash flow problems. Consumer confidence was undermined by the crisis to a smaller extent than investment and industrial production. The decrease in retail revenue in 2009 amounted to 5.5%. After a dive in the first quarter, retail stagnated with little up-and-down movement for the rest of the year. The stabilization was carried by lower inflation and growing real disposable income, which added 1.9% in 2009. At the same time, real wages decreased by 2.8%. Their downward movement started at the end of 2008 and continued until mid-2009. The discrepancy between real disposable income and real wages can be explained by a drop in arrears of wages by 23.7%. The number of people unemployed rose by 1.5 million and averaged by about 6.4 million or 8.4% of the employable population. These figures peaked in February and started evening out subsequently. Exports in 2009, according to estimates of the Ministry of Finance, amounted to 303.3 billion USD, which constitutes a drop of 35.7% as a result of lower prices for raw goods at the beginning of the year. At the same time, the drop in physical deliveries totalled only 3.5%. Starting April, export volumes strengthened again because of a recovering oil price (from 43.5 USD a barrel in the first to 74.1 USD a barrel in the fourth quarter). The import of goods totalled, according to estimates 192.7 billion USD, which was 34% less than in 2008. Here, the main reason was a lower physical influx rather than price fluctuations. However, currency issues played a role. Especially the strengthening of the RUB contributed to a recovery of the import level starting June 2009. While the fact that global growth gained momentum was reflected in a rebound of external trade, Russia was lagging behind. Export and import activity around the world rebounded in both volume and value terms, with import volume growth in developing countries surging to a 65% annualized rate of growth in the fourth quarter of 2009. That was the eight consecutive month of double-digit growth. Export volumes also surged 64% in the same period. In December 2009, developing country trade volumes exceeded the previous peak recorded in April 2008 for the first time. Regarding high-income countries, the pace of recovery was slower. With

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weaker domestic demands, import volumes in these countries remained 15% below the levels of April 2008. However, in the Russian Federation, import volumes remained sharply compressed in December 2009, at 24% below April 2008. The net outflow of capital amounted to 52 billion USD in 2009. Over the course of the year, the direction the capital flow changed many times. In quarters one and three, there was a relatively strong outflow of capital, about 34 billion USD each quarter in the context of debt amortization by the banking sector and the acquisition of foreign assets. In quarters two and four, an influx of funds could be observed (5 billion USD in the second and 12 billion USD in the fourth), mainly because of a lowered demand for foreign assets on the part of the banks and for foreign currency on the part of the population. The volatility of the capital flows reflected shifts in oil prices and market expectations for the rouble. However, improving investor sentiments for the global economy and increased risk tolerance toward emerging markets, adding to that the recovery of the Russian economy in the second half of 2009 – facilitated capital inflows to Russia at the end of 2009. The currency reserves of the Bank of Russia, as a result of operations in the context of the balance of payments, increased in 2009 by 3 billion USD. In the last quarter, as a consequence of capital inflow and a higher balance of payments surplus, reserves increased by 28 billion USD. The deficit of the federal budget for the year 2009 amounted, on the basis of preliminary calculations by the Ministry of Finance, 2326.1 billion RUB or 6% of GDP compared to a 1707.5 billion RUB surplus (4.1% of GDP) in the previous year. Public revenue in 2009 added up to 7336 billion RUB or 18.8% of GDP compared to 9274.1 billion RUB and 22.3% of GDP in 2008. Expenditures amounted to 9662.2 billion RUB or 24.8% of GDP. In the first half of 2010, the Russian GDP grew by 4.2%, with construction and trade contributing to the growth and industry holding it back. Accordingly, net investment started picking up steam in March, and continued its growth, adding 7.4% in June 2010 compared to June 2009.

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Picture 7: Net Investment, source: Russian Ministry of Economy, Osnovnie tendencii social’noeconomicheskovo razvitia v janvare-avguste 2010 g, 2010, p. 7. ɤ ɚɩɢ ɬɚɥ

420% 380% 340% 300% 260% 220% 180% 140% 100%

1 2 3 4 5 6 7 8 9 101112 1 2 3 4 5 6 7 8 9 101112 1 2 3 4 5 6 2008

2009

2010

The figure above shows the development of the net investment in the Russian Federation from January 2008 until June 2010, seasonally adjusted (1) and not adjusted (2). The level from January 1995 being 100% (y-axis).

2.3.

Impact of Crisis Policies

Although the coping with the financial crisis will be discussed in detail below, the impact of the financial crisis in Russia cannot be abstracted from the measures undertaken by the Russian government and their consequences. Although it is said that the Russian government reacted adequately for the most part, there are certain policies it is heavily criticized for. For example, the subsidization of inefficient companies because of fears of protest in the face of massive layoffs distorted the market equilibrium and hindered the cleansing power of bankruptcy. A textbook example of how much damage to economic growth a policy of supporting nearly bankrupt companies can do is provided by the Japanese economic crisis of the 1990s. Previously, the Japanese economy had experienced three decades of steady growth. While the real estate bubble was intact, land under the Emperor’s palace in Tokyo cost more than all of the land in the state of California. The bubble burst and was followed by a ten-year-long economic crisis. The question arises: why did the stagnation last so long and why did banks continue lending to companies facing bankruptcy. The answer to the second question is almost obvious. The banks did not want to admit their mistakes. If the bankrupt debtors had stopped paying, the banks would have been forced to recognize losses, which would have led to bankruptcy of the banks themselves. Instead, lenders decided to keep half-dead companies alive artificially, e.g. gave new loans so that debtors could pay the interest on the old ones.

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But there is also another reason. The government set the goal to support and save as many small and medium-sized businesses as possible by means of loans and put pressure on the banks to lend easily. The Japanese government achieved its goal of keeping bankruptcies low. However, it paid a high price. At the beginning of 2000, a whopping 30% of all Japanese businesses were so-called ‘zombies’, i.e. companies that were not able to survive without external support. The highest density of ‘zombies’ could be found in sectors in which businesses were not bothered much by international competition, like construction, retail, and services. Massive layoffs could be prevented in these sectors. However, very few new jobs were created subsequently and productivity dropped considerably as another significant effect of the Japanese government’s policy of supporting ‘zombies’. In sectors where the number of zombies grew by 5% per year, productivity added 2% in the same period, but in sectors where the number of ‘zombies’ increased by a fifth production fell in average by 5% per year. A noteworthy observation could be made on healthy companies, which were doing business as competitors of the ‘zombies’. It became obvious that the mere existence of zombies created obstacles to the growth of healthy companies. In sectors where employment was supported artificially, the growth and the number of new jobs significantly lagged behind. ‘Zombies’ not only concentrated banks’ and taxpayers’ money on themselves, but also attracted the skilled workforce by artificially high wages. If Japan had allowed ‘zombies’ to go bankrupt, the investment volume would have been higher by 4% to 36% depending on the sector. It is not surprising that the Japanese economy grew only 0.5% in the 1990s, while, for example, the GDP of the United States added an average of 2.6% p.a. in the same period. The Russian government runs the risk of repeating the mistake of the Japanese. While support to the unemployed did start in 2009 through retraining and relocation, the support to inefficient enterprises was an order of magnitude higher. The direct support to the unemployed (increased unemployment benefits and support of regional active labour market policies) amounted to 74 billion RUB, which equals 3 billion USD or a quarter of 1% of GDP. The support to businesses was 675 billion RUB or 20 billion USD. This sum was used to about equal parts for ‘targeted’ and ‘general’ support (373 billion RUB and 302 billion RUB, respectively). The former sum was used to provide assistance to specific industries and, in most cases, to specific enterprises. Most of the ‘general’ support (282 billion RUB out of 302 billion RUB) was used to reduce the corporate profit tax rate. While on the surface,

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this support seems to be general, it disproportionately benefited certain enterprises – mostly Gazprom and a few other raw material exporters which remained profitable even during the crisis. Picture 8:

Production output (December 2008 equals 100%), source: Russian Ministry of Economy, Osnovnie tendencii social’no-economicheskovo razvitia v janvare-avguste 2010 g, 2010, p. 6.

113,0 111,0 109,0 107,0 105,0 103,0 101,0 99,0 97,0 Feb Mrz Apr Mai Jun 09 09 09 09 09

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Aug Sep Okt Nov Dez Jan 09 09 09 09 09 10

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Picture 9: Retail revenues (seasonally adjusted, December 2008), source: Russian Ministry of Economy, Osnovnie tendencii social’no-economicheskovo razvitia v janvare-avguste 2010 g, 2010, p. 5. 101,0 100,0 99,0 98,0 97,0 96,0 95,0

Ja n Fe 0 9 b M 09 rz A 09 p M r0 ai 9 Ju 09 n Ju 09 l A 09 ug Se 0 9 p O 09 kt N 09 ov D 09 ez Ja 09 n Fe 1 0 b M 10 rz A 10 pr M 10 ai Ju 10 n Ju 10 l1 0

94,0

The comparison of the two pictures above illustrates some consequences of the partly misguided Russian anti-crisis policies. Another move by the Russian government, namely raising tariffs, was widely seen as a step in the wrong direction. The aim of this policy was clear – protecting the domestic market from foreign competition. However, the effect was one of lower trade and a sinking of the standard of living due to a reduction in the supply with foreign goods. Also, there would have been another way of protecting the domestic market, which even carried less political risk, namely depreciating the rouble. On the one hand, while an abrupt devaluation would have been risky and could have

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triggered a panic, a gradual depreciation could have started earlier and gone faster than it did. The depreciation would have made Russian goods cheaper in comparison to the ones offered in US dollars and in this way would have propped up Russian exports. Picture 10: Consumer Price Index (in relation to the according month of the previous year), source: Russian Ministry of Economy, Osnovnie tendencii social’no-economicheskovo razvitia v janvare-avguste 2010 g, 2010, p. 9. 16,0 14,0 12,0 10,0 8,0 6,0 4,0 2,0

Ja n Fe 0 9 b M 0 rz 9 A 09 p M r0 ai 9 Ju 09 n Ju 09 l A 09 ug Se 0 9 p O 09 k N t0 ov 9 D 09 ez Ja 09 n Fe 1 0 b M 1 rz 0 A 10 p M r1 ai 0 Ju 10 n Ju 10 l1 0

0,0

On the other hand, billions of US dollars in reserves could have been saved or used more directly, if the Russian Central Bank would not have thrown them into the fight against the sinking rouble. Many critics stress the excessive centralization in Russia’s political system, which contributed to poor economic measures. The regime’s ideology would place conservation of power and loyalty to the ruling class higher than the common good. Given this characterization, it is surprising that the government did not nationalize major banks and companies and did not bury the Russian economy in inefficiency, just as it doomed the Soviet Union. The reason the government of the Russian Federation, all in all, performed well during the economic crisis was its instinct of self preservation. For the first time in many years, the political and economic system faced a serious threat. It was necessary for the ones wishing to stay in power to prevent an economic collapse. The government was woken up and energized by the crisis and shifted more decisionmaking power to competent people, who knew about and could do something for the country. The relatively pro-market members of the government obtained a louder voice and their advice was, at least to some extent, subsequently implemented. The global economic crisis forced the Russian government to endorse sensible policies in order to fend off disaster.

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However, as the oil prices recovered, the Russian government regained confidence and moved from correct economic measures back to trying to preserve the status quo. As a consequence, an opportunity to create a foundation for a newly structured, modernized, investor-friendly economy and long-lasting economic power was missed.

3.

Challenges and Coping the Financial Crisis in Russia

After two years into the global economic crisis, it is still not clear how events will ultimately play out. It has been a dramatic time for all countries, including Russia. Prior to the start of the crisis, many people in Russia thought that they were ‘decoupled’ from what happened in the leading Western economies. But as shown here in previous chapters the Russian economy was heavily impacted. In the third quarter of 2008, the world financial crisis and the bursting of the asset bubble hit Russia with a double shock. Oil prices collapsed, which had a colossal direct impact, and capital was withdrawn from Russia in the flight to safety. These shocks, which exposed the full extent of Russia’s dependence on commodity prices and capital inflows, triggered a deep recession, almost exactly ten years after the 1998 ‘Russian crisis’. Both of these shocks were primarily due to events abroad. It is important to stress this point, because some observers have argued that Russia’s crisis was home grown. Eventually, Russia’s structures and policies determined how the shock played out in Russia, but the shock itself was external.28 At first glance, this crisis seems similar to what happened a decade earlier, as oil prices in 1998 plunged in response to the Asian Crisis in 1997. Back then Russia suffered a financial crisis with near-catastrophic consequences, including a twofold real devaluation and a default on domestic debt. But the current crisis differs significantly from the one ten years ago. Then, Russia’s inability to deal with its own fiscal crisis allowed the external shock to have the particular effects it did. In 2008, Russia was fiscally prepared for an external shock; something that spared the country from a much worse outcome than it might otherwise have suffered. Russia’s

28 Clifford G. Gaddy / Barry W. Ickes, Russia after the Global Financial Crisis, Eurasian Geography and Economics. 2010, 51, No.3, p. 281.

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output, employment, and real wage losses during current Great Recession, while sizable, were lower than feared early in the crisis – in part due to the large anti-crisis policy response.

3.1.

Monetary and Exchange Rate Policies

It is important to note that the Russian government behaved more prudently than its citizens during the booming years of 2002-2008, where private consumption was unsustainably high and collapsed with the crisis.29 It pursued a number of sensible policies, especially in the early years. The most important were aimed at collecting taxes to the federal centre. Former President Putin and his closest and most important associate in this endeavour, Minister of Finance Aleksey Kudrin, implemented fiscal reforms, especially improvements in tax administration. Their first priority, however, was to decrease Russia’s sovereign debt. It was the boom in oil prices which began in early 2004 that allowed Russia in January 2005 to pay off the entire balance of its debt to the IMF – three and a half years ahead of schedule. At the same time Russia began to build reserves, in the form of foreign currency assets accumulated in an oil stabilization fund based loosely on the Norwegian model. According to data of the central bank, Russia’s currency reserves grew by 55 billion USD in 2005, 120 billion USD in 2006, and 170 billion USD in 2007, bringing the total to nearly 600 billion USD by mid-2008. Only China and Japan had more.30 These fiscal savings, accumulated over the last decade, allowed the government to react to current crisis and introduce sizeable, discretionary fiscal stimulus measures without significant deterioration in its debt-to-GDP ratio. Without the stabilization fund, the impact of the crisis would have clearly been much more severe. Monetary and exchange rate policies of the government were aiming at easing monetary conditions and higher exchange rate volatility. In mid-2008, the RUB came under pressure and started to depreciate. The central bank intervened to smooth the impact of the capital outflows on the exchange rate and provide Russian enterprises and households with much needed foreign exchange. Thereby it lost official reserves in the amount of 170 billion USD by December 2008 and an-

29 Jürgen Conrad, Private sector external debt rose from 48 billion USD in 2002 to 451 billion USD in 2008, in: Deutsche Bank Research, 11 December 2009, p. 4. 30 Clifford G. Gaddy./ Barry W. Ickes, Russia after the Global Financial Crisis, Eurasian Geography and Economics. 2010, 51, No.3, p. 288.

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other 40 billion USD in January 2009.31 This loss constituted a decline of 35%, cumulatively, and appeared to be the result of a serious policy mistake when it happened. However, it was perhaps the price the authorities had to pay to ensure an orderly deleveraging of private-sector external debtors without major bankruptcies, avoid massive deposit runs that could have brought the banking sector under additional serious stress, and avoid any resemblance of the 1998 Russian crisis that could have led to a significant loss of political capital. It is notable that the authorities did not introduce capital account restrictions even when outflows accelerated strongly and stabilisation was not in sight. Despite massive sales of currency reserves, the depreciation of the RUB continued until February 2009, partly due to a shift of bank deposits from RUB to foreign currency. It weakened by 34% versus the USD and the real effective rate depreciated by 19%.32 After this controlled devaluation the RUB stabilized and appreciated again by 13% against the USD. It floats today in a corridor against a basket comprising 55% USD and 45% EUR. Before the crisis, when oil prices were rising and the balance of payment surpluses was large, the central bank kept the corridor on an upwards trajectory. Between end-2002 and mid-2008 the RUB gained 36% against the USD encouraging foreign borrowing. Given a high inflation discrepancy, the real appreciation was even more obvious. In 2006 the effective RUB rate surpassed its level before the 1998 crisis. This real appreciation undermined the competitiveness of the non-commodity sector, increasing the commodities share in exports and driving import absorption as domestic manufacturers lost market shares. Picture 11: Rouble has stabilised after controlled devaluation, source: Deutsche Bank Research; IMF, 2009, p. 6.

31 Jürgen Conrad, Russia in the financial crisis and beyond, in: Deutsche Bank Research, 11 December 2009, p. 6. 32 Ibid., p. 6.

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In the first seven months of 2009, Russia’s external sector had stabilized. The merchandise trade surplus averaged 7.7 billion USD per month, the same level as in the fourth quarter of 2008, although much lower than before the crisis.33 The capital account was more volatile, with strong net outflows in the first quarter 2009 and net inflows in the second quarter. In sequence with that, official reserves declined sharply in January 2009 but quickly recovered to 412.6 billion USD| during the second quarter. Picture 12: Export driven by oil price, source: Deutsche Bank Research; Central Bank of Russia; IMF, 2009, p. 5.

While the external stabilisation can be partly explained by policy changes, including a decision to widen the exchange rate band in January 2009, which helped to defuse devaluation expectations, it is perhaps mainly attributable to the oil price recovery. In fact, falling oil prices in early July triggered another spell of RUB weakness, reflected in declining reserves. At the end of April 2009 the central bank started to loosen monetary conditions and exercise more flexible exchange rate policies – aimed to facilitate the recovery of credit. With higher oil prices putting an upward pressure on the RUB, the central bank can increase its foreign exchange reserves to avoid an excessive appreciation of the currency that might undermine the economic recovery. In general, the global financial crisis has taken its toll on Russia‘s financial sector, with severe pressures on financial institutions. The response of authorities to the crisis has been mainly successful. A systemic banking crisis has been averted, the liquidity crunch eased and depositor confidence re-established. Despite fears of widespread, large defaults, both the banking sector and non-financial corporations have for the most part serviced their debt obligations. No major defaults on 33 Jürgen Conrad, Russia in the financial crisis and beyond, in: Deutsche Bank Research, 11 December 2009, p. 5.

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foreign debt obligations by banks or corporate entities occurred in 2009. The domestic bond market also continued functioning throughout the crisis. With total external payments of banks and corporations of about 130 billion USD due in 2009 (about 10% of GDP), payments and rollovers were orderly.34 However, the crisis has also highlighted serious weaknesses. Although the central bank has been loosening monetary conditions, the impact on credits has been limited so far. The refinancing rate has been cut eleven times from 13% in April 2009 to 8.5% today, reflecting a deceleration of inflation35. These gradual decreases in policy and bank lending rates to corporates and households have not yielded any significant changes in lending volumes. The accumulation of credit to enterprises, which doubled in the two years preceding the crisis (picture 13), declined in the first three quarters of 2009 and remained flat in the fourth quarter. The same trends are observed for credits to private households. Moreover, if the existing stock of credits were adjusted for non-performing and restructured loans – estimated to account for 5% and 25% of total loans – there would be a considerable decline in net credits to the economy in the second half of 2009. So, despite the improved liquidity, credit risk remains very high, and the banks continue to be extremely risk-averse. The banking sector is cautious in new lending because of fears over asset quality and the need to provision for losses in an environment of high credit risk. Picture 13: Stock of credits to companies and households in 2007-09, source: Russian Economic Report 21, 2010, p. 12, www.worldbank.org.ru (retrieved on 25 August 2010). 15,000 13,000 11,000 9,000 7,000 5,000 3,000 1,000 Feb

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Credits to companies in rubles and foreign currency, bln rubles

34 World Bank in Russia, Russian Economic Report, No. 21, March 2010, p. 11. 35 Ibid.

April

Russian banks are also far too dependent on foreign sources of funding. The loan-deposit ratio rose from 126% in 2005 to 149% in late 2008, which reflects an increased reliance of banks on external foreign borrowing. Rising non-performing loans (now estimated by one of the banking associations to reach 25% of total loans by the end of 2010) alarm those in both corporations and banks. By the end of 2009, lending – particularly for small and medium businesses and households – had fallen dramatically as the economic crisis undermined the credit-worthiness of many formerly solvent borrowers. At a time when banks needed more capital, the securities markets (both at home and abroad) had fallen in value and bankers faced the prospect of raising capital when equity prices remained low by historical standards.36 So, liquidity conditions remain fairly tight, while the inter-bank market continues to be constrained by escalating problems with non-performing loans and worsening balance sheets of banks. With the crisis deteriorating – and the anti-crisis measures starting to be functioning – now is the time to re-emphasize the reform challenge to build an increased capacity and soundness in financial markets. A comprehensive and coordinated programmatic approach is mandatory. Necessary consolidation of the banking sector will likely occur due to recently increased capital levels. However, a new framework is needed to provide for an orderly reorganization of deposit taking institutions in case of bankruptcy. An improved corporate insolvency system would provide effective mechanisms for corporate rehabilitation to allow viable companies to keep operating. Prudential regulation and supervision of banks should be strengthened to follow international practices, particularly consolidated supervision of large financial groups. Aligning operational risk management and other forms of corporate governance of banks with international standards is also desirable. Improved disclosure of financial product information to retail customers is as well recommended as are easy-to-use redress mechanisms and other areas of consumer protection in financial services. Further reforms on credit information systems as well as collateral laws and registers, particularly for movable collateral (such as company inventories and receivables) would also help banks increase credit to businesses and households.

36 Ibid., p.12.

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3.2.

Fiscal Policies to Preserve Social Peace, not Infrastructure

Besides targeting the financial sector the government has boosted spending on social welfare initiatives, including public works schemes, temporary employment and paid furloughs for workers. The anti-crisis public expenditure measures in 2009 were focusing mainly on wages, pensions, and social assistance targeting the broad middle class. These social expenditure increases, however broadly applied, were timely. A considerable increase in social expenditures occurred already in the first quarter of 2009 when the economy contracted the most. The increase in the minimum wage on 1 January 2009, plus increased outlays in education and health where a significant part of expenditures consisting of compensation for employees affected by an increase of the minimum wage. This approach helped limit the impact on real incomes and, therefore, on household consumption. But an increase in expenditures on supporting real economy were mainly concentrated in the third and fourth quarter of 2009, coinciding not with the decline but with a gradual recovery phase of GDP. Most fiscal stimulus measures were introduced according to budget plans but executed largely in the second half of 2009. Approximately 98.4% of all budgeted anti-crisis fiscal expenditure measures were executed in 2009. Only a few remained unexecuted – particularly consumer credits for purchasing new cars (only 187.7 million RUB were executed compared with 2 billion RUB budgeted), state support for airlines (only 6.1 billion RUB were executed relative to 11 billion RUB budgeted), and support for the auto industry for which 38 billion RUB were budgeted (executed at the rate of 91.8%). Furthermore, the federal budget provided 77.7 billion RUB for labour market measures and subsidies to the regions; these funds were executed with 89.7% rate due to implementation capacity constraints in the regions. In 2010, the government plans to introduce more modest anti-crisis fiscal measures to support the real sector and the labour market in the amount of 0.5% of GDP.

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Picture 14: The Phasing of the Expenditure Stimulus: Changes in Consolidated Budget Expenditures, quarterly (year on year) in percentage of GDP, 2008-2010 Q1, source: World Bank in Russia, Russian Economic Report, No. 22, 2010, p. 11.

While this fiscal policy prevented a repeat of the chaotic devaluation of 1998 and therefore preserved short-term social stability, it forced Russia to rapidly spend its reserves. Much of the spending came also out of the Reserve Fund that was set up to cushion the economy from potential shocks. Though Russia had accumulated the world’s third largest store of foreign reserves in the years leading up to the crisis, it spent over 400 billion USD during the first months of the crisis, principally bailing out politically connected companies (and defending the RUB). About half that sum went to propping up industries hit the most, including auto manufacturing, metallurgy, the banking sector, and the defence industry (picture 14). As described above, another 200 billion USD in reserves was wiped out by the central bank’s attempts to preserve the value of the RUB in the face of large-scale capital flight. Although the size of Russia‘s anti-crisis fiscal measures was adequate in comparison to the West, their structure and implementation could have been more effective. Tax cuts and broad pension and wage increases rather than targeted measures made the response package more expensive than otherwise. Also the relative lack of focus on infrastructure and targeted social assistance made the overall output multipliers lower than otherwise. And it appears that most expenditure measures were implemented in the second half of 2009, while the deepest growth con-

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traction was in the first half of the year. Hence, the fiscal stimulus focused on the non-financial sector could not substantially mitigate the contraction in early 2009.37 For instance, with a bumpy recovery and weak demand conditions, unemployment remained high in the first quarter of 2010. By the end of March, unemployment increased to 8.6% from 8.2% at the end of 2009, reflecting uncertain economic recovery and seasonal reductions in employment in the winter months (picture 15). Although the unemployment rate in April dropped to 8.2% because of a rise in seasonal employment (the number of employed increased by 700,000) and the labour productivity turning positive, the real wages continue to outpace productivity.38 Picture 15: Unemployment rate, World Bank in Russia, Russian Economic Report, No. 22, 2010, p. 6.

37 World Bank in Russia, Russian Economic Report, No. 21, March 2010, p. 14. 38 World Bank in Russia, Russian Economic Report, No. 22, June 2010, pp. 4-5.

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Picture 16: Main macroeconomic indicators 2006-10, World Bank Russian Economic Report 22, 2010, p. 5. 2006 2007 2008 2009 2010 Jan – Dec Jan – Dec Jan – Dec Jan – Dec Jan – Apr

Apr

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Unemployment (%, ILO definition, e-o-p) a)

Data for the 1st quarter of 2010.

Poverty is another important indicator for measuring the success of anti-crisis fiscal policies. The Russian government’s interventions aimed at a broader middle class, rather than only the poor and contributed to a reduction in projected poverty rate in the second half of 2009 (picture 16).39 Using revised unemployment data, household survey data, and national poverty lines, it is estimated that without the government’s policy interventions (including the increase in pensions, wages, and unemployment benefits and modest increases in social assistance and labour market programs), the likely headcount poverty rate for Russia could have reached 17.4% at the end of 2009. In particular, the scale-up of wages, pensions and other benefits introduced in 2009 (while it may have less desirable fiscal consequences), have mitigated the decline in the average household consumption per capita. Taking into account these interventions, poverty rate is now likely to end around 14% by the end of 2009 and 12.5% in 2010, a return to the pre-crisis level, a year earlier than previously expected. 39 World Bank in Russia, Russian Economic Report, No. 21, March 2010, p. 23.

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Picture 17: Projected impact of the crisis on the poverty rate, 2008-2011, Distribution of Russian Population by income groups, source: World Bank Staff estimates based on aggregate output forecast and household survey date on employment and incomes, Russian Economic Report, No. 21, 2010, p. 23. 100% 90%

1.2%

1.3%

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Picture 18: Crisis Projected Poverty Rates in %, source: World Bank Staff estimates based on aggregate output forecast and household survey date on employment and incomes, World Bank in Russia, Russian Economic Report No. 22, 2010, p. 20.

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Following the sizeable expenditure increases in 2009, the government now aims to gradually withdraw the fiscal stimulus and strengthen the fiscal position in the medium term. The 2010 budget includes a planned adjustment of around 1.8% of GDP; but the planned 46% increase in pensions by end of 2010 would result in new expenditure pressures. In addition to the scheduled increase of pensions, a re-evaluation of Soviet era pension contributions will result in an increase in pension levels. In April 2010, the basic pension was already raised by 6.3% in addition to the scheduled increase in January 2010. In the first quarter of 2010, a gradual withdrawal of fiscal stimulus measures began as expected – expenditures to support various sectors of economy were reduced by 1% of GDP, compared with the previous year. The proposed budget amendment is likely to result in a lower deficit due to higher oil and non-oil revenues but part of this windfall will be spent on additional expenditures. Even so, the latest official estimates expect the federal deficit to be lower (at 5.4% of GDP) than in the original budget (6.8%).40 Despite the gradual climb in oil prices to over USD 70 per barrel the Russian government is confronting the necessity of running a budget deficit until at least 2012. In an effort to improve expenditure outcomes and support adjustment, the Kremlin approved in May 2010 a comprehensive program. The program introduces ambitious steps to overhaul the budget process. By 2012, the budget will be transformed into a ‘program budget’ consisting of specific programs grouped into seven key areas linked to Russia’s development objectives and particular monitoring frameworks. Such a reform will eventually make it possible to link allocated funds to target indicators with timelines for their implementation to improve expenditure monitoring, efficiency, and service delivery. Looking to the rest of 2010, while a fiscal consolidation is necessary, there is a risk that a significant part of the adjustment will again fall on the much needed infrastructure maintenance expenditures. In 2010, public expenditures on transport are estimated to fall by 0.6% of GDP from the (already) low level of 2.5% of GDP in 2009. Public infrastructure, long recognized as a key to regional and economic development, represents a primary channel for the government to promote competitiveness, international and inter-regional interconnectivity, and productivity growth. Inadequate maintenance is identified as one of the reasons for the deterioration of transport infrastructure in Russia. Lower allocations for improving the existing road infrastructure, combined with emphasis on new construction, are therefore likely to result in additional cuts in maintenance expenditures. The World Bank’s preliminary estimates from an ongoing public expenditure review suggest a funding gap 40 World Bank in Russia, Russian Economic Report, No. 22, June 2010, p. 12.

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for road network maintenance alone of about 1.2% of GDP per year. Adequate provision for maintenance is cost effective and markedly cheaper than addressing a mounting backlog of maintenance and new investments later on. The focus of fiscal policies on people’s incomes has helped mitigate the social impact of the crisis, but at the expense of greater rigidity in infrastructure expenditures. Evidence from other countries indicates that the discretionary capital expenditures could have much larger fiscal multipliers if they especially address acute infrastructure bottlenecks. The state of Russia’s transport infrastructure is very poor for a middle income country and has been declining due to underinvestment in maintenance and rehabilitation. Here lies an enormous challenge for the next years. According to the just released ‘2010 Enabling Trade Index’ (World Economic Forum), Russia ranks 48th on the availability and quality of transport infrastructure (measured by the state of infrastructure across all modes of transport in each country, as demonstrated by the density of airports, the percentage of paved roads, and the extent to which they are congested, as well as the transhipment connections available to shippers from each country). While the quality of transport infrastructure in Russia varies significantly across different modes of transport – and different parts of the country – the road infrastructure is estimated to have deteriorated the most. According to the World Economic Forum’s 2010 Enabling Trade Index (ETI), Russia’s railway infrastructure quality ranks 33rd in the world, relatively good but still significantly behind the Western European levels to which the country aspires. But its ranking on the quality of road infrastructure is 111th, among the world’s worst; this – in a vast country that is heavily resource-intensive and that depends on transport of goods and services for its exports. The quality of port and air infrastructure is also comparatively poor – Russia ranks 82nd and 87th, respectively. These differences are also evident in comparing the asset deterioration in recent years, by transport modes. According to Rosstat, the asset deterioration rate reached 48% for air transport, roads and maritime port infrastructure in 2008. The deterioration in railways was much lower – 24%. A recent survey of quality of the federal road network indicates that majority of roads do not meet the minimum riding quality requirements.41 In general it can be stated, the Kremlin’s intervention to cope with the crisis has been successful in preserving social peace and preventing a return to the worst moments of earlier crises, such as hyperinflation or widespread unemployment. The decision to accumulate large reserves during the boom years appears in particular to have paid off. By deploying a fairly substantial stimulus package, the Russian 41 Ibid., p. 13.

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government has managed to cushion the worst short-term consequences of the crisis. However, the biggest share of governmental expenditures went to the existing, large, often state-owned enterprises with little going to small and medium-size and new enterprises or infrastructure.

3.3.

Structural Weaknesses, uneven Geographical Impact

During the first stage of the crisis, the Russian state came under enormous pressure to use its reserves to bail out a wide variety of politically connected firms. As in the west, large sums were transferred to failing industrial enterprises (and major banks). This economic crisis has been moderately severe within Russia, and the impact of unemployment and underemployment is concentrated in particular industries that have been hit especially hard – including metallurgy, construction, and manufacturing. While the economy seems to be gradually recovering by the end of 2010, the crisis exposed several structural weaknesses that could hold back growth even after the worst has passed. Firstly, it has reminded of the fact how thoroughly dependent Russia is on oil and gas. From the middle of 2008 to early 2009, Russia plunged deeper than nearly any other major economy in the world as measured by indicators of total output, industrial production, or stock market values. It has since rebounded strongly in some respects. Yet, if one takes a longer view, it must also be recognized how much the Russian economy grew in the years before the crisis. Over the past five or ten years, even with the negative effect of the current crisis, Russia has outperformed all other countries, including the other fast-growing BRIC countries. Both sides of the phenomenon – the pre-crisis boom followed by the huge collapse – have the same cause, namely, Russia’s dependence on world oil markets. Russia grew thanks to oil; Russia fell because of oil. This structural dependence on the flow of rents from oil (and gas) dates back for decades and cannot be overcome through a temporary fiscal policy package. These recent shocks, positive and negative, are by no means the first and will not be the last. Russia’s biggest problem for the future is not high-frequency volatility but the fundamental uncertainty of the price level over the longer term.42

42 Clifford G. Gaddy / Barry W. Ickes, Russia after the Global Financial Crisis, Eurasian Geography and Economics. 2010, 51, No.3, p. 307.

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Secondly, Moscow has had to spend heavily out of its reserves to prop up failing industries and expand social services to those thrown out of work or otherwise affected by the downturn. By intervening to prop up a basically uncompetitive economic model, the Kremlin may well be setting the stage for slower growth in the future.43 It also encouraged the recipients of government bailouts to use the money for currency speculation, rather than rescuing troubled businesses. One particularly difficult legacy for Russia has been the uneven demographic impact of the crisis. While the two major urban centres of Moscow and St. Petersburg have weathered the storm relatively well, heavy industrial regions such as the Urals, as well as medium-sized cities lacking the concentrated wealth of the two capitals but nonetheless connected to the global supply chain have been especially hit hard.44 For instance, recent statistics indicate that unemployment in rural areas declined more than in urban areas. According to Rosstat, unemployment in rural areas fell to 11.3% in April 2010 from 13.4% in January 2010. During the same period, urban unemployment dropped to 7.1% from 7.8%. Despite rising vacancies, the slow recovery of large, labour intensive sectors such as retail trade and construction is limiting employment growth in the cities. The unemployment rate remains very uneven throughout Russia, with the highest reported for North Caucasus – 16.8%, and the lowest for the Central District – 5.2% (picture 19). Rosstat statistics indicate a positive trend in unemployment dynamics in almost all regions in April 2010. But the improvement is uneven, reflecting different rates of economic recovery in the regions, as well as differences in the structure of regional economies and seasonal employment. The economic recovery is likely to have a limited impact on labour markets with modest employment growth likely to prevail in the medium term.

43 Jeffrey Mankoff, Internal and External Impact of Russia`s Economic Crisis, Russie.Nei.Visions, No. 48, March 2010, p. 8. 44 N. Zubarevich., The Crisis in Regional Perspective, Pro et Contra, Vol. 12, No. 5-6, September-December 2008, p. 12.

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Picture 19: Geographic distribution of unemployment, percent, source: World Bank in Russia, Russian Economic Report, No. 22, 2010, p. 7. 20.0

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The areas causing the most concern for the Kremlin are the roughly 460 socalled ‘monotowns’, or single-factory towns, which grew up in the Soviet period around single enterprises. Monotowns are urban settlements with economic bases dominated by a single industry or core enterprise. In a massive drive for industrialization and urbanization, Soviet planners created them at ‘rational’ locations, in their minds a contrast with the chaotic and wasteful patterns of the capitalist economies. After World War II, Russia‘s planned settlements grew rapidly, many in geographically inhospitable areas to the north and east of Central Russia. The main principle was the spatial division of labour, which meant maximum regional specialization in some types of production within the autarkic national economy, underpinned by military, strategic, political, bureaucratic, and economic rationales. There is no firm consensus on what constitutes a monotown or on how many monotowns there are. The most authoritative study, “Monotowns and Core Enterprises”, commissioned in 1999–2000 by the Ministry of Economy, classified 467 cities and 332 smaller towns as monotowns – roughly two in five of Russia’s cities,

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with a population of 25 million, or a sixth of Russia’s people.45 With about 900 core enterprises, they produced more than 30% of industrial output. Nearly 2/3 of them are in manufacturing, fuels, metallurgy, food processing, and timber and pulp. So, the problems of monotowns in Russia – competitiveness, diversification, technological upgrading, jobs – are largely the problems of Russia‘s urban-based manufacturing. Today, these monotowns are often no longer globally competitive. Given the danger of social unrest if one or two of these enterprises shut down, the Kremlin and regional authorities have sought to keep them open at all cost. They have pumped in large amounts of budgetary funds to keep loss-making uncompetitive factories open. The most notorious recipient of bailout funds has been AvtoVAZ, which employs over 100,000 workers and has held debt of over 2 billion USD. To keep AvtoVAZ running, Prime Minister Putin promised to inject more than 1.7 bil-

45 Two examples of monotowns, see: World Bank in Russia, Russian Economic Report, No. 22, June 2010, pp. 2122. Togliatti has a population of more than 700,000, and is Russia‘s largest monotown. It is home to the VAZ auto works, Russia‘s largest car maker, directly contributing about 1% of GDP. VAZ employed about 106,000 at the end of 2008, and most other enterprises in Togliatti are tied to VAZ. As a result of the economic crisis, VAZ was in financial difficulties in early 2009. Industrial output fell by 44%, wages and employment decreased, and workers were forced into vacations or part-time employment. In September 2009, 27,600 VAZ employees were laid off, and further restructuring may be necessary. The company’s best prospects are an alliance with Renault to manufacture Renault, Nissan, and Lada cars. Dalnegorsk has 40,000 people, 524 kilometres from Vladivostok and 36 kilometres from the Sea of Japan. In 1897, a mining expedition discovered valuable lead and zinc ores in this area. By World War II, the town developed a complex plant producing tin. Today’s products include boron-containing substances like borax and other cleaning pastes. Two enterprises, GHK Bor and OAO GMK Dal’polimetal are currently subsidiaries of OOO UK Russian mining company (RGRK) that started operations in 2005 and took over these enterprises in 2005 and 2009 respectively. About 60% of the population depends on these companies for jobs and incomes. OAO GMK Dal’polimetal was first founded as an enterprise in 1897 and has currently about 2000 employees producing zinc and lead concentrates. GHK Bor was founded in 1958. During Soviet times, Bor employed 10,000 people, but in January 2009 employment was 3,421. Including their family members, about 12,000 people depend on GHK Bor that produces mainly boric acid colemanite. Dalnegorsk’s narrow specialization is linked to the limited job opportunities, falling living standards, a shrinking tax base, and deteriorating infrastructure. The enterprises have been in arrears for electricity, and the regional government has given them subsidies. Bor wants to sell its heating and energy facilities to Dalnegorsk or a local utility. Dalnegorsk’s town budget is vulnerable to the crisis at these core enterprises, and the social infrastructure (schools, nurseries, cultural facilities) is suffering as well. GHK Bor owes the city 50 million RUB.

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lion USD into the company in the fall of 2009, despite opposition from the Finance Ministry. The ministry argued there was little sense pouring such sums into a company that had not demonstrated the ability to produce a competitive product.46 Similarly, the aluminium conglomerate Rusal was quietly bailed out by the Kremlin after Putin had publicly upbraided its owner, the oligarch Oleg Deripaska, on television for idling his firm’s operations in Pikalevo, a monotown of 22,000 near St. Petersburg, producing cement, aluminium, and potash. In 2009, the social discontent led to public protests. When the plant was closed, there were no prospects for work, and there was no assistance. The company stopped paying its bills, and heat and hot water were shut off. The residents blocked an important federal highway, prompting the Prime Minister to intervene. Disaffected residents in other monotowns have tried to emulate Pikalevo. Such industrial bailouts are perilous in Russia, more than in the west, because they act as an obstacle to the process of ‘creative destruction’. That, in macroeconomic terms, is needed to make Russia’s industrial sector more competitive. The impact of the crisis in monotowns cannot be boiled down to a single ‘problem’. In fact, it has multiple dimensions: fiscal, social, and economic. Enterprises still providing social services have curtailed them, including central heating, critical in a northern country with cold climate. The collapse of the tax base tied to the core enterprises has curtailed municipal finance and basic services. The revenues from personal income tax – the major source of municipal revenues – have suffered from unemployment and falling wages. This has reduced the incomes (and the tax payments). Regional tax revenues from the personal income tax (shared by the regional and municipal budgets) have also been falling, as well as the corporate profit tax (shared by the regional and federal budgets), and the corporate property tax. The challenge for monotowns is gigantic. Most of them have narrow and inflexible structures including obsolete physical capital, crumbling infrastructure, and an immobile population. The cause lay in the legacy of Soviet planning that created the monotowns and their economies. That system worked as long as relative prices were controlled to reflect domestic planning priorities rather than international relative scarcities, but it collapsed in the face of market realities when prices were liberalized. It is likely that only a few of the enterprises can compete in international markets although no systematic analysis of their viability has been made. Anyway, many of them are vulnerable to commodity price volatility. Many produce the wrong products in the wrong places. Economically unviable monotowns are similar to the once booming mining towns that became ghost towns. 46 RIA-Novosti, AvtoVAZ Carmaker Could Get Additional State Support – Putin, 3 December 2009.

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Under the watchword ‘modernization’, President Medvedev has used the crisis to promote the idea of weaning Russia from its reliance on state corporations (monotowns) and the sale of natural resources in favour of creating an economy based on innovation and high technology. One of the critical obstacles for the success of Medvedev’s campaign will be the fate of the state corporations. These conglomerates – including among others the arms exporter Rostekhnologii, nanotechnology firm Rosnano, and Olimpstroi, in charge of constructing facilities for the 2014 Olympic Games in Sochi, as well as the energy giants Gazprom and Rosneft – were established or strengthened during Putin’s presidency as a means of enhancing the state’s control of key sectors of the economy, and at least incidentally to provide a revenue stream for favoured state officials. These firms have proven much less effective in terms of adding value to the Russian economy than the private sector, which still accounts for 65% of Russia’s GDP.47 Few state firms are profitable, and many are deeply indebted, in part as a result of foreign loans taken out to pay for currency speculation. Many of them also enable corruption, as their overseers engage in large-scale asset-stripping.48 In the early stages of the crisis, the Kremlin also encouraged some of the firms to take on even more debt in order to buy out failing rivals at risk of foreign takeovers. Similarly, the state bailed out selected, politically connected private companies from the state treasury to prevent the seizure of their assets by foreign creditors. Many firms appear to have siphoned off such bailout money to pay dividends, without resolving their debts – which collectively amounted to 294 billion USD at the beginning of July 2009.49 In Russia, such debts practically never result in companies undergoing any bankruptcy proceedings; they merely continue to lose money. President Medvedev has called for the state corporations to be gradually wound down and transferred to private ownership. However, since many of these firms are controlled by important political players, true privatization would also disrupt the existing political constellation. Privatization could also, of course, be done in a way that preserves many features of the existing system, much as in the early 47 Jeffrey Mankoff, Internal and External Impact of Russia`s Economic Crisis, Russie.Nei.Visions, No.|48, March 2010, p. 13. 48 For a detailed analysis of the cultural heritage within the Red Economy (former or current state-owned enterprises) and the New Russian Economy (companies founded since 1991) and its strong impact on the behaviour of managers and workers with regard to modernization, see: Markus Liemich, Transfer von Unternehmenskultur. Eine empirische Untersuchung am Beispiel des deutsch-russischen Joint Ventures ‘Mobile TeleSystems’, 2000. 49 Jeffrey Mankoff, Internal and External Impact of Russia`s Economic Crisis, Russie.Nei.Visions, No.|48, March 2010, p. 13.

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1990s when privatization was often used as a cover for managers to seize control of their companies.50 It is also uncertain whether foreigners will be allowed to participate, and which companies will actually be privatized. However, it is certain that the pressure to maintain state control of firms in ‘strategic’ sectors of the economy, such as state oil major Rosneft – which now produces about 44% of Russia’s oil – is intense.

4.

Outlook for the Coming Years

After a decade of solid economic growth, Russia is now facing numerous acute challenges. A temporary economic slowdown is inevitable because of the global recession and falling process of commodity exports. Russia’s very high real estate prices are already rapidly declining, which will hurt the weak banking system. The domestic demand will be constrained as well. Three scenarios appear plausible over the next twelve years: an inertia scenario, a reform (or innovation) scenario, or a crisis scenario.51 The inertia scenario presumes no major new reforms and average annual growth of 3.5% to 4%. The only growth drivers would be capitalist convergence, improved development and better allocation of human capital, continued economic restructuring and some remonetisation. Russia’s resource wealth is so substantial that such a strategy can deliver moderate growth for a long time to come, and the higher world energy prices will be, the more likely such a choice.52 The reform scenario implies that the Russian government faces its main challenges and carries out the required reforms. First, Russia should accede to the WTO and improve its legal standards. Second, the Kremlin needs to introduce transparent procurement procedures for major investments. Third, property rights must be reinforced and re-nationalization stopped to ease the problems in banking and energy production. With this scenario, an average growth of 6.5% p.a. is feasible, but it is very far from Russia’s current economic policy.53 The first problem is limited 50 M. Goldman, The Piratization of Russia: Russian Reform Goes Awry, 2007, pp.103-104. 51 Peterson Institute for International Economics, Russian economic Revival, 2009, p. 54. 52 Ibid. 53 Ibid.

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capacity of reformers; Reformers in government are scarce and rent seekers abundant. The second problem is limited commitment to reform. Even if reformers have a chance to implement a specific reform package, the resource-curse logic implies such a window of opportunity may not last long. 54 Finally, a crisis scenario, Russian officials do not discuss the possibility of outright systemic crisis, but the grounds for such a scenario are substantial. Russia is very sensitive to commodity prices, as commodities accounted for about 85% of Russia’s exports.55 Fast economic growth in post-crisis Russia will be very difficult. Russian economic growth will slow down because of both external and – most importantly – internal reasons. Lower worldwide economic growth will almost certainly result in lower oil prices than in the pre-crisis decade. It is reasonable to expect such slower growth as the world’s largest economies will have to increase taxes to pay for the expenditures to support their economies during the crisis and as there is an unprecedented increase worldwide in anti-market sentiment and policies.56 On the 13th Annual St. Petersburg International Economic Forum 2009, President Dmitri Medvedev said that the anti-crisis economic decisions of 2008 were successful. Russia continues lobbying for reform of the international financial institutions, and creating reserve currencies as an alternative to the US dollar. Finally, Medevedev rebuked protectionism and supported lowering taxes as part of the growth stimulus.57 Both ideas, that is raising the rouble to the status of an international reserve currency and building an internationally competitive financial sector in Moscow, may seem unrealistic at the moment but if pursued with persistence over a long period of time they may be successful. As s reserve currency, the rouble may well be in demand as it represents a good hedge against rising oil prices.58 Russia’s internal problems relate to the ‘resource curse’. The return of high oil prices had important implications for the Russian economy: If oil prices remain high, Russia will probably delay much needed economic reforms. The ‘low hanging fruit’ of basic economic reform and prudent macroeconomic policies has al54 Anders Åslund / Sergei Guriev / Andrew Kuchins, Russia After the Global Economic Crisis, 2010, p.|34. 55 Peterson Institute for International Economics, Russian economic Revival, 2009, p. 55. 56 Anders Åslund / Sergei Guriev / Andrew Kuchins, Russia After the Global Economic Crisis, 2010, p.|29. 57 Ibid., p. 28. 58 Ibid., p. 35.

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ready been picked. Future economic growth requires building political and economic institutions – such as constraints on the executive branch, improving the rule of law, lowering corruption, improving protection of property rights, contract enforcement, and competition. Such institutions are difficult to build in every society. But in Russia it is especially problematic as the ruling elite are not interested in building such institutions. ‘The resource curse’ provides an explanation: All other things being equal, resource-rich economies tend to grow at slower rates.59

4.1.

Investment in Oil

In the medium to longer term, the quantity of oil and gas produced becomes a key issue for maintenance of the rent flow. This requires investment in new reserves, primarily located in Eastern Siberia. Development of these new reserves raises a whole new cost dimension. The eastern oil is in regions that are colder, more remote, and geologically more complex. Obtaining the new reserves requires large, non-discrete investments. Because the investments are irreversible, Russia is exposed to a huge risk if prices return to low levels. If Russia cannot diversify this risk, it will not be able to make the investments necessary to sustain current levels of production.60 This point is central to thinking about Russia’s future relationship with the global economy. Higher oil prices will increase Russia’s fiscal revenues and likely lower the fiscal deficit of the consolidated government. Given these trends, fiscal deficit could be reduced to only 3% of GDP in 2010 and the budget could be balanced in 2011. This does not, however, take into account additional funds needed to finance the growing deficit of the pension fund, which could add 0.5-1.0 p.p. to the overall deficit. But even with additional social spending, if oil prices stay at current levels the overall deficit of the consolidated government could be entirely financed from the Reserve Fund, which on 1 March 2010 was 1.7 trillion RUB, or 3.8% of GDP. This would, in turn, reduce the need for external borrowing that was built into the budget. The downside risks associated with high volatility of oil prices and global demand will remain.61 59 Ibid., p. 29 60 For a discussion of the challenges associated with the renewal of Russia’s petroleum resource base, and of the experience in development of the key oil and gas deposits on Sakhalin, see Moe / Kryukov (2010) and Bradshaw (2010) in this issue. 61 Cf. The World Bank in Russia, Russian Economic Report, No. 22, 2010, p. 18.

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The simulations presented below are based on the current World Bank’s average oil price projection for 2009-2012 and real price of 60 USD per barrel in years after 2013 (picture 20). This oil price assumption is based conservatively on expert oil view of long term oil prices (World Bank’s Prospects Group 2010). But it is relatively more optimistic than the short term oil price assumption used by Russian government – 41 USD per barrel (Urals) in 2009 and 50 USD per barrel (Urals) in 2010. The price of gas is assumed to be correlated to oil price movements. The baseline scenario for oil and gas extraction profile is based on the relatively conservative scenario presented in the Government of Russia 2020 strategy document.62 Picture 20: Russia’s oil and gas production volume: government strategy 2020 and oil price assumption for projections, source: World Bank staff estimates, oil and gas extraction profile based on the Government of Russia economic development strategy, 2010.

62 Zeljko Bogetic / Karlis Smits / Nina Budina / Sweder van Wijnbergen, Long-Term Fiscal Risks and Sustainability in an Oil-Rich Country/ The Case of Russia, 2010, p. 20.

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Picture 21: Long-term fiscal revenues from oil and gas in billions of USD 2008, source: World Bank staff estimates, 2010.

4.2.

GDP

Russia‘s real GDP is likely to grow by about 5% to 5.5% in 2010, followed by a 3.5% growth in 2011. Consumption, particularly household consumption, will be the main factor driving economic growth in 2010, especially towards year-end. The future contribution of net exports to aggregate growth and the pace of economic growth in 2011 will very much depend on the ability of the banking sector to provide longer term credits to enterprises to facilitate growth in fixed investment.63 Picture 22: Outlook for Russia 2010-2011, source: World ank projections, 2010. World growth, % Oil prices, average, USD/bbl

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63 The World Bank in Russia, Russian Economic Report, No. 21, 2010, p. 18

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Looking into medium term, with the current growth profile and possible growth of 3.5% in 2011 and 2012, real GDP in Russia will reach pre-crisis levels only at the end of third quarter of 2012. Picture 23: Medium term of GDP growth, source: World Bank projections, 2010.

Russia’s recovery is taking place in the context of a gradual but fragile global recovery. The fallout from the crisis will probably change the landscape for finance and growth over the next decade. Global real GDP, which fell by 2.2% in 2009, is expected to grow by 2.7% in 2010 and 3.5% in 2011. Real GDP in high-income countries, which declined by 3.3% in 2009, is expected to increase slowly – by 1.8% in 2010 and 2.3% in 2011. World trade volumes, which fell by a staggering 14.4% in 2009, are projected to expand by 4.3% this year and 6.2% in 2011. While this is the most likely scenario, considerable uncertainty clouds the outlook. Depending on consumer and business confidence in the next few quarters and the timing of fiscal and monetary stimulus withdrawals, global growth in 2011 could be as low as 2.5% or as high as 3.4%.64 Given the outlook for oil prices and global demand, we expect a gradual deterioration in the current account in 2010-2011, while the capital account is likely to improve. If oil prices remain at their current levels, the surplus on the external current 64 The World Bank in Russia, Russian Economic Report, No. 21, 2010, p. 18.

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account will fall to about 32 billion USD in 2010 (about 2% of GDP) and further to 19 billion USD in 2011, mostly due to a rebound in imports associated with income growth and the real appreciation of the rouble. The capital account is projected to improve to a surplus of 30 billion USD in 2010 and 50 billion USD in 2011, reflecting an increase in non-debt capital inflows, lower debt repayments, and an improvement in the borrowing capacity of banks and non-financial corporations. The exchange rate is likely to remain volatile in the short-term with upward pressure on the rouble if the oil price remains close or above 80 USD a barrel – and downward pressure if the oil price decreases below 70 USD a barrel.65

4.3.

Fiscal Debt

With access to external borrowing gradually improving, larger banks or corporations should be able to finance or rollover their debt obligations in 2010. According to the CBR, banks will have to pay about 34 billion USD in 2010 and corporations about 70 billion USD, both in principal and interest payments, which is lower in the aggregate by 30 billion USD than in 2009. However, smaller and medium size companies will continue to experience difficulties in accessing credit on terms that would make their projects profitable.66 Picture 24: External debt Service (USD Billion), source: World Bank Russia Economic Report 21, 2010.

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65 Ibid., p. 18. 66 Ibid., p. 22.

4.4.

Labour Markets

The economic recovery is likely to have a limited impact on labour markets with modest employment growth likely to prevail in the medium term. Unemployment is expected to stay around 9% in the first quarter 2010, with some improvement throughout the year, mostly a result of higher seasonal employment. Going forward, most countries in the region, including Russia, will likely experience moderate job growth recovery with sustained high unemployed rates. In fact, employment levels are expected to recover at a rate significantly lower than GDP growth recovery in a number of countries in Europe and Central Asia region. In fact, for reasons discussed above, it is possible that both supply and demand shocks and policy changes (large increases in minimum wages) and the labour market (such as the rise of unemployed and mismatch of unemployed and job vacancies) have ratcheted up the level of unemployment, making it difficult to reduce it in the short term. This will make for an environment of a relatively jobless recovery. Only when the economic growth becomes more broad based and robust, it is likely to see sustained improvements in the labour market, probably in 2011. Tight credit conditions and high unemployment continuing to weigh down on household income and wages are unlikely to improve fast enough to provide large and sustained boost to consumption.67 Picture 25: Jobless Growth Recovery Likely: Average Annual employment and GDP growth forecast in ECA, 2010-2011, source: IMF (WEO), World Bank staff estimates (data for Russia), 2010.

67 Ibid., p. 19.

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Picture 26: Projected impact of the crisis on the poverty rate, percentage of people with income level below minimum subsistence, 2007-2011, source: World Bank staff estimates based on aggregate output forecast and household survey data on employment and incomes, 2010.

To alleviate demographic and labour market imbalances and support the recovery of domestic demand and growth, Russia should improve its internal and external migration policy while addressing the broader economic and social concerns of both Russia and Central Asia. Specific policy issues could be addressed to unleash the productive potential of migration in Russia and the CIS countries.68

4.5.

Population and Immigration

Another significant problem is the pension system. The Russian population is aging and shrinking, leading to a decrease in the number of working-age people and contributions. In a no-reform scenario, the replacement rate of the public system is projected to decline to about 17% in 2030, far below the current level of about 26%, which is already widely perceived as inadequate and implies that many state pensions will be below the subsistence level. The pension reform that started in 2001 is not adequate to address these challenges.69

68 Ibid., p. 24. 69 Anders Åslund / Sergei Guriev / Andrew Kuchins, Russia After the Global Economic Crisis, 2010, p.|37.

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Picture 27: Russia: Historic and Projected total population, 1989-2030, source: Rosstat, UN, and World Bank LDB, 2010.

Picture 28: Russia: Replacement rate of natural decrease in population by net migration inflows in %, source: Rosstat, 2010.

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Picture 29: Projected changes in total population and distribution of population by groups (2010-30), source: Rosstat, 2010.

If these trends continue, Russia will need more than 12 million immigrants to compensate for the labour force decline within the next 20 years unless major, unforeseen changes occur in the structure of the main population groups. Therefore, Russia needs to consider far-reaching steps to improve its attractiveness for migrants and inspire renewed inflows of both skilled and unskilled labour.70 A key objective of Russia’s economic strategy for 2020 is also to increase living standards, which will require long-term growth of around 6.5%. But the current economic landscape is different from that after 1998, and capacity constraints are likely to become binding very soon. So, labour will play an important role in the post-crisis recovery, especially in an economy that is expected to lose 1% of its working-age population annually in the next decade. None of the high-performing economies reached this optimal growth scenario in such circumstances.71 One of the most important challenges for Russia is increasing its labour stock (both skilled and unskilled) on the back of changing demographic patterns; migrants will play a key role.72

70 The World Bank in Russia, Russian Economic Report, No. 21, 2010, pp. 24-25. 71 Mikhail Dmitriev, Long-Term Economic Consequences of the Aging Population in Russia. Background paper for Russia Human Development Report 2009, Centre for Strategy, 2009. 72 The World Bank in Russia, Russian Economic Report, No. 21, 2010, p. 28.

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Serbia: Serial Tensions amidst Recovery Nicole Arnold

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1.

Situation before the Crisis

For Serbia, like for other emerging economies in (South) Eastern Europe, the first decade of the third millennium was marked by a perceptible boost. However, these ten years are characterized by efforts to establish a functioning market economy in an environment of political uncertainty, regional tensions, social scepticism and market disturbance.

1.1.

Political and Historical Turmoil

Observing the history of the Balkan States they have continuously faced turbulent times with regard to political as well as economic development. Under communist partisan leader Josip Broz (Tito) the country was structured in six federation republics including Croatia, Bosnia and Herzegovina, Slovenia, Serbia, Montenegro and Macedonia, so-called Socialist Federal Republic of Yugoslavia. At first, Tito’s death in 1980 signalled the end of the Federal Republic which was secondly backed by empowering Slobodan Miloševiä at the end of the same decade, riding a wave of nationalist sentiment. Within the coming years, negotiations over how to resolve Yugoslavia failed and in June 1991 Slovenia and Croatia declared their independence, followed by Macedonia a few months later and Bosnia and Herzegovina in 1992. Serbia opposed this moves and actively participated in wars and conflicts in Bosnia and Croatia during the years 1992-1995. Serbia and Montenegro declared themselves a new state in April 1992 and adopted the Constitution of the Federal Republic of Yugoslavia. Ten years later, after months of negotiations between the two countries and mediation by the EU, the ‘Belgrade Agreement’ was signed – constituting a looser union between the republics with the intention to promote stability within the region and make further progress towards European integration. As opinion in Montenegro was divided, this was just left as an aspiration and the republic exercised its right for a referendum on independence, bringing the state union between Serbia and Montenegro to an end in June 2006. During these times, the politic regime was replaced, at first by Vojislav Kostunica together with the Democratic Party in 2000, bringing new reforms. As a stabilization of the situation could not be reached and organized crime came up, new

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elections brought president Boris Tardic to power. Since then, political turbulences were tamed and his position was confirmed by re-election for a second mandate in 2008.

1.2.

Recovering Years before the Crisis

1.2.1.

Economic Situation

The aforementioned political developments influenced Serbia’s economy markedly. During the 1990s Serbia has been going through recovery from conflict and isolation facing an ongoing transformation from the planned economy while targeting a fully functioning market economy. Its favourable economic position was heavily impacted by the turbulences during 1992-1995 and the NATO bombing in 19991 left the Serbian economy in a desolate state. During this decade it lost spacious ground relative to other CEE countries. After the ousting of Miloševiä in 2000, basically all successive governments have introduced reforms to liberalise the market, undertaken privatizations and followed a tight monetary policy even though the political situation was uncertain to a great extent.

Macroeconomic Developments

The economy showed fast growth averaging 5.3% and a steady increase of the GDP since 2000 boosted by inflows and expansionary policies. After periods of stagnation in the 1980s, further decline in the 1990s and the collapse at the end of the century it seems that Serbia is getting its way up, moving in the right direction.

1 Cf. Michael Dobbs, NATO’s Latest Target: Yugoslavia’s Economy, in: Washington Post, 25 April 1999, p. A1.

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Picture 1: GDP development 2000-2007; source: IMF World Economic Outlook 2010, 2010. 10%

45,000 40,000

8%

35,000 30,000

6%

25,000 20,000

4%

15,000 10,000

2%

5,000 0

0% 2000

2001

2002

GDP (USD mln)

2003

2004

GDP per capita (USD)

2005

2006

2007

GDP growth rate

The high growth rates were a welcome side effect of structural reforms and privatization, primarily driven by domestic demand and linked to an extensive boom as well as increases in real wages and credit growth.

Balance of Payments and Trade

In autumn 2007 Serbia seemed on the way to becoming more closely integrated within the region and globally: it ratified the Central Eastern Free Trade Agreement2 (CEFTA) which created a regional free trade area of the South East European countries and offering as well access to other Eastern European and Central Asian countries under bilateral agreements. Additionally Serbia has a preferential status in free exports to the EU and USA.3 Beside the former Yugoslav Republics, major trading partners are Russia, Italy, Germany, France and its neighbouring EU states Hungary, Bulgaria and Romania. Notably, the relationship to Russia is deeply rooted by the fact, that Serbia enjoys one of the little number of free trade agreements with the Federation, even though this is yet not exploited to its full potential.

2 Further states include Croatia, Bosnia, Montenegro, Macedonia, Albania, Moldova, Kosovo. 3 Serbia Investment and Export Promotion Agency (SIEPA), Investing in Serbia, http://www.siepa.sr.gov.yu/site/ en/home/1/investing_in_serbia/liberalized_trade/ (retrieved on 25 August 2010).

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Serbia experienced an ongoing increase in trade figures between 2000 and 2007 from 4.9 billion USD to 27.4 billion USD. Even though the macroeconomic and investment climate was still fragile at this time, the value could again be significantly increased compared to 2006: Exports reached 8.82 billion USD, 37.3% higher than in 2006, and imports in the amount of 18.55 USD billion correspond to a growth of 40.8% over the previous year. Picture 2: External Trade 2000-2007; source: Statistical Office of the Republic of Serbia, 2010. 2000

2001

2002

2003

2004

2005

2006

2007

Exports (bn USD)

1,558

1,721

2,075

2,477

3,523

4,553

6,428

8,825

Imports (bn USD)

3,330

4,251

5,614

7,333 10,753 10,575 13,172 18,554

Trade Balance (bn USD) Exports/ Imports (%)

-1,772 -2,540 -3,539 -4,856 -7,230 -6,022 -6,744 -9,729 46.8

40.4

37.0

33.8

32.8

41.1

48.8

47.6

In general, the above developments indicate obvious improvements in the economy presumably triggered by the ongoing privatization programme. However, at this time it could be expected that any further possible increase in exports will most probably be offset by higher imports, driven by stronger investment and consumer demand. In total the negative trade account is likely to show only marginal improvements on the near future. Trade is one main driver of the balance sheet and contributes to Serbia’s current account deficit. To a great concern, this has been growing since 1998 from 500|million USD to a current volume of over 6.3 billion USD. The extensive increase recorded in 2007 could be explained by the faster pace in growth of imports than exports and by higher commodity prices, as the country is obliged to pay for importing energy and food stuffs.4 Basically financed through the large amount of FDI and foreign borrowing the sustainability of the current account deficit is highly dependent upon sustainable high export growth.

4 Wiener Institut für Internationale Wirtschaftsvergleiche, wiiw Forecast for Central, East and Southeast Europe, and China: The Big Boom is Over, but Growth Remains Strong, 2008, http://www.wiiw.ac.at/pdf/FC2_presse_ eng.pdf (retrieved on 25 September 2010).

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Picture 3: Current account deficit (in billion USD), International Monetary Fund, World Economic Outlook, 2009. 0 -1

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

-2 -3 -4 -5 -6 -7

Foreign Direct Investment

Serbia has been focussing on attracting FDI with high priority during the last years. The country is highly competitive, offering financial and tax incentives to companies willing to invest5 as well as a spacious free-trade area with access to a far greater market than just the Serbian one. Eligible businesses are mainly in the fields of manufacturing, internationally marketable service sectors, research and development. To attract foreign investors, a favourable tax policy has been implemented, offering comparable low tax rates and exemption for ten years in some cases6 as well as tax credits or reduced tax rates.7 Besides, Serbia developed several incentives in 2006, including cash grants for creation of a significant number of new jobs. After attracting remarkable 3.3 billion EUR of FDI in 2006, the cumulative level sharply decreased to 1.8 billion EUR in 2007, which was even not lower than in 2005. This development could be explained by the slower pace privatization following the elections at the beginning of 2007 and a half-year delay in forming 5 Cf. Serbia Investment and Export Promotion Agency (SIEPA), Investment Incentives, http://www.siepa.gov.rs/ site/en/home/1/investing_in_serbia/investment_incentives/ (retrieved on 15 September 2010). 6 E.g. investment > EUR 7.5 billion or at least 100 employees on indefinite contracts. 7 Cf. Serbia Investment and Export Promotion Agency (SIEPA), Tax System, http://www.siepa.gov.rs/site/en/ home/1/brief_guide/serbia_on_your_location_list/tax_system/ (retrieved on 25 August 2010).

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the government. However, according to the European Bank for Reconstruction and Development (EBRD), Serbia is still ranked fourth in Southeast Europe after Bulgaria, Romania and Croatia in 2007. Picture 4: Foreign Direct Investment in Serbia, source: Ministry of Finance, Bulletin May 2010, 2010, p.|14. 2001 2002 2003 2004 2005 2006 2007 2008 FDI net in million EUR

184

500 1,194

774 1,250 3,323 1,821 1,824

Foreign direct investments have been the necessary backbone on the growth path. Due to the lack of domestic savings, FDI helped the economy to realize catchup potential and keep consumption high. This attractive situation was untenable from economic perspective and visualized in large current account deficits.

Tax Regime

Burdened by idiosyncrasies, the tax system underwent several changes at the end of the 1990s and beginning of the 2000s. Finally a new tax law was adopted on 1 January 2005 introducing VAT and the redefined CIT. Serbia’s tax regime is highly conducive to foreign investment, underlining the fact Serbia to become striking destination for international investors. Harmonized with the EU tax system, Serbia offers attractive tax rates: a corporate profit tax rate, set at 10%; VAT of 18% and a lower rate of 8%8, salary tax (12%) and social contributions – all of them among the lowest in Central and Eastern Europe. Additional incentives to attract FDI can be summarized as follows9: Y

Tax Credits –

20% of investments in fixed assets; if less than 50% of the total tax liability; can be carried forward up to ten years

–

80% of investments in fixed assets for specific sectors; unused part can be carried forward for ten years

–

40% of investments in fixed assets for SMEs; if less than 70% of the total tax due

8 For basic food, newspapers, utilities etc.. 9 Tax regime in Serbia, source: Belgradenet, 2010, http://www.belgradenet.com/business/taxes.html

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Y

Tax Holiday –

10 years exemption from corporate profit tax, starting from the first year of taxable profit reported, if (a) investment in fixed assets > 600 million RSD, (b) > 100 new full-time employees during investment period

–

Y

5 years exemption from corporate profit tax for concession-related investments, starting on the day of completion

Tax Exemption –

Y

Exemption of corporate profit tax before completion of concession investment

Others

Y

–

100% of gross salaries and related employee contributions for the employment of new workers; available for two years; number is to be kept during this period

–

Carrying forward tax losses and offsetting against future gains over ten years

–

Up to 25% accelerated depreciation for ecological investments, education, staff training, scientific research and computer hardware

Double Taxation –

Tax credit in Serbia if profit has already been taxed abroad

–

Tax Credit in Serbia if personal income tax has already been paid abroad (DTT)

Labour Market Flows

The economic transition has brought deep changes in the labour market of Serbia. It is characterized by rigidities and high unemployment. The new Labour Law ratified in 2005 provides considerable protection to employees from dismissal and has been criticised by some international institutions for being insufficiently flexible.10 The International Monetary Fund states that labour market institutions discourage employment11, which continues to fall even as output rises. 10 European Bank for Reconstruction and Development, Strategy for Serbia, 2007, p. 16. 11 International Monetary Fund, Serbia and Montenegro – 2006 Article IV Consultation and Post-Program Monitoring Serbia: Concluding Statement of the Mission, 2006, http://www.imf.org/external/np/ms/2006/062706.htm (retrieved on 26 August 2010).

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With regard to the structure, almost 2/3 of the employment is in the private sector. Generally, there is a large potential labour supply as only about 50% of the population in working-age is employed, but at the same time the educational attainment shows that a lot needs to be done to improve labour force. Nearly 70% have secondary school education or higher, but the share of higher education graduates (9.56%) or those with additional qualifications (4.32%) is low. Picture 5: Working-age persons (15-64 years) by educational attainment, source: Statistical Office of the Republic of Serbia, Labour Force Survey 2008, 2008, p. 47.

9,56%

4,32% 1,03% 5,25%

Without educational attainment Primary School non-completed 23,95%

Primary School Secondary School High School

55,89%

Faculty, academy and higher schools

Employment levels did not match the upturn in output during the economic boom years. The official unemployment rate since 2000 shows an ongoing increase peaking at nearly 21% in 2006, while the employment rate goes down, basically justified by the wave of privatizations. That year more than 53% of the total number unemployed were long term unemployed.12 Picture 6: Unemployment rate, source: Labour Force Survey April 2010, Statistical Office of Serbia, 2010. 2000 2001 2002 2003 2004 2005 2006 2007 Unemployment rate 12.9% 12.2% 13.3% 14.6% 18.5% 20.8% 20.9% 18.1%

12 According to the National Employment Service (NES) long-term unemployment refers to the unemployment longer than two years. International Organization of Migration, Labour Market Survey, Third Review, NATO/PFP Trust Fund Project, 2007, p. 10.

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The slight downturn shown in 2007 mainly resulted from the new Law of Health Insurance and Law on Health Care, having to transfer data on all persons – other than working population – from the National Employment Service to the Republic Health Insurance Bureau.13 In any case, unemployment rate is significantly higher than in other transition countries14 and especially far behind the average unemployment rate in EU countries (7.6%). Taking into consideration the large informal number of employees, real unemployment is most probably much lower. At end-2007 labour market indicators showed a positive change: new employment rose 12.2% year-on-year (y-o-y) of which 45.7% gained new employment and 54.3% changed jobs, vacancy growth rate fell 3.7% y-o-y and unemployment drifted down.15 Economic development during the last years was accompanied by a nominal wage growth of 20% to 30% y-o-y, indicating a loss of competitiveness. Although average wages decreased since end-2006, year-on-year growth was high, in both industrial and public sector wages. Picture 7: Average net wages in nominal and real terms (y-o-y growth, in %), source: National Bank of Serbia, Inflation Report 2007, 2007, p. 42. Average net wages

Average net wages in the public sector

35%

35%

30%

30%

25%

25%

20%

20%

15%

15%

10%

10%

5%

5%

0%

0% I

II

III

IV

I

2004

II

III

2005

in nominal terms

IV

I

II

III

2006

IV

I

II

III

I

2007

in real terms

II

III

IV

I

2004

in nominal terms

II

III

2005

IV

I

II

III

2006

IV

I

II

III

2007

in real terms

13 Cf. National Bank of Serbia, Inflation Report 2007, 2007, pp. 43-44. 14 Cf. International Organization of Migration, Labour Market Survey, Third Review, NATO/PFP Trust Fund Project, 2007, p. 10. 15 Cf. National Bank of Serbia, Inflation Report 2007, 2007, p. 44.

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The fact, that growth in real wages in the industry sector widely equals productivity, may lead to the conclusion that movements do not significantly affect inflation. Moreover, in correlation to inflation, public sector wages could cause pressure on prices. 1.2.2.

Financial Situation

Frequent elections in Serbia led to a lack of any kind of fiscal policy and had a pro-cyclical effect on the economy. After a long period of neither notable activity in credit markets nor mobilization of resources for new investments in the 1990s, the banking sector launched a period of major advanced reforms. The banks were faced with a lack of liquidity and insolvency due to non-profit oriented business conduct and mismanagement in the former years. The National Bank of Serbia started a privatization programme to reduce the number of state-owned banks. These changes resulted in a reduction in the total number of banks from 2001 until 2008 by 61% to only 34, the proportion of state ownership moved from 36% (2001) to nearly 10% (2008) with less than 20% of assets in foreign ownership.16 These structuring was backed by tight deliberated regulation, aimed at curbing excessive credit growth during the ongoing economic expansion and meaning a countercyclical use of prudential ratios and limits.

Inflation

Serbia’s macroeconomic disorder in the 2000s is clearly underlined by high inflation. The government managed to bring back the hyperinflation of the 1990s to 12% in 2003, but after this time no marginal further downtrends have been achieved until 2006. As a result, the National Bank of Serbia (NBS) shifted to an inflation-targeting regime in September that year, after it was previously focused on managing the exchange rate. Estimations have foreseen an average annual inflation with only single-digit figures for the first time in 2007. Fuelled by the summer drought and a sharp fall of the dinar against the euro on growing fears of violence in Kosovo, inflation increased during 2007, intermittent to double-digit figures, but levelled at 6.8% finally.

16 Jandra Zenic Zeljkovic, UNCTAD, Serbian experience in regulating the infrastructure services, 2010, p. 3.

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Picture 8: Inflation rate in Serbia from 2000–2007 (%, year average); source: Statistical Office Serbia, Statistical Year Book of Serbia 2008, 2008. 100.0 90.0 80.0 70.0 60.0 50.0 40.0 30.0 20.0 10.0 0.0 2000

2001

2002

2003

2004

2005

2006

2007

The, until then, declining trend in the key policy rate of the NBS reversed in August 2007 and the rate was raised from 9.5% to 9.75% p.a.. Thus, giving a fillip to the sale of NBS securities in the open market, resulting in liquidity withdrawals, in contrast to the months before, when used for reserving money creation. However, compared to the EU and USA, interest rate differences remain high and continue to encourage capital inflows.

Bank Lending

Starting in 2003 Serbia has shown a years-long period of continuous growth. After hitting a record high growth rate in August 2007, lending to households came to a halt one month later in due course of prudential measures by the NBS. In order to curb credit expansion these include a limited repayment period and a lower ratio of gross household spending to share capital from 200% to 150%. Nevertheless, 2007 saw a further increase of 40% in bank lending. At that time, loans account for about 47.5% (653 billion RSD) of the total banking assets. Lending to enterprises (58.7%) and households (38.4%) dominate in the composition of lending, while the growth of the banks’ loan portfolio for households has been higher then for the enterprise sector.17 Comprising only a low share in GDP – compared to neighbouring countries – private sector loans leave considerable space to expansion. 17 World Bank, Bank lending to small and medium enterprises – The Republic of Serbia, p. 8, 10.

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Picture 9: Sources of financing the growth of Bank credit to private sector, source: National Bank of Serbia, Statistical Bulletin September, 2009. 2003 2004 2005 2006 2007 BCPS growth rate (EUR)

19.1

26.9

41.6

26.9

39.8

Financing the growth of BCPS Bank claims to the public sector and NBS

-2.7 -10.0 -29.4 -61.4 -16.1

Bank deposits

13.3

14.0

30.5

43.8

Net foreign liabilities

2.2

24.2

30.3

30.3 -10.9

Other net liabilities

6.3

-1.3

10.2

14.2

45.9

21.0

By 2007, encouraged by the appreciation of the local currency in the previous year, the banking sector is already highly ‘euroized’. The majority of both credits and debits are in foreign currency which leaves Serbia in a risk situation in case of sharp currency depreciation.

Foreign Exchange Reserves

One of the roles of the NBS is to manage and safeguard the foreign exchange reserves of the Republic. Thus, in line with the Balance of Payments Manual18, which include international claims by the NBS that beside others may be used to bridge the financial gaps between international inflows and outflows as well as (in-) direct regulation by means of interventions on the foreign exchange market with the aim of influencing the foreign exchange rate. Serbia is in the fortunate position of having enhanced its foreign exchange reserves markedly. Between 2002 and 2007 the inflows contributed to an increase of around 8|billion EUR entirely created against net foreign assets and to a great extent paid in by more than 2.3 million19 Serbs living abroad. According to World Bank data in 2007 around 4.9 billion USD was supplied by these emigrants, being more than double of the amount of direct FDI in this year.20 Further input comes from foreign securities and exchange rate differentials as well as purchase of foreign exchange,

18 Prepared by the International Monetary Fund in 1993. 19 World Bank, Migration and Remittances Factbook, Serbia, 2008, n.p. 20 Ibid.

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strong capital inflows. These circumstance enabled Serbia to complete the early repayment of debt obligations to the IMF (232 million USD)21 as well as settlement of other maturing debts. At the same time, the amount covers the financial debt. Picture 10: Foreign Exchange Reserves (in billion Euro), source: National Bank of Serbia, Statistical Bulletin July 2010, 2010, p. 72. 12 10 8 6 4 2 0

2002

2003

2004 National Bank

2005

2006

2007

Commercial Banks

The reserves mainly consist of securities (60.62%) and deposits abroad (35.24%)22, with further investment in 2007 in bonds, bearing low market and credit risk (AAA). Accordingly, the monetary policy was very tight in relation to credit expansion. As a substantial amount of reserve money was created against net foreign assets, the NBS tried to neutralize it by opposing movements in net domestic assets, and thereby causing a slowdown in bank lending activity. At the same time, the banking sector showed very strong prudential ratios, while the NBS was targeting to further influence foreign exchange supply and demand, primarily via its interest rate policy, and indirectly steer the dinar exchange rate towards a more sustainable course over the longer term.

21 National Bank of Serbia, Annual Report 2007, 2008, p. 78. 22 Ibid., p. 79.

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1.3.

Having Broken the Back on the Growth Path?

Since the self-chosen separation of Montenegro and the independence of the Republic of Serbia, the country has continued its growth path and the economy has been slowly recovering. Reforms have been delayed due to political tensions between the coalition partners and the as yet unresolved Kosovo conflict. However, helped by a diversified economic structure, Serbia’s GDP in 2007 is higher than that of its regional neighbour states and the steady growth rate indicates that the economy is clearly catching up to comparable Eastern European countries. Having said this, Serbia is still not approaching the figures of other SEE countries that started transition process more than decade ago. Average GDP growth for the period 2001-2006 was 5.3% in Serbia, compared to 6.5% in SEE countries.23 Even if indicating a continuing equal average GDP growth at this stage, it will be possible to reach the GDP level from 1989 no sooner than 2015. Until then, its recent growth has been driven by consumption, aided by readilyavailable credit for companies and individuals and supported by an ongoing inflow of foreign investments. Now, imbalances are widening. Pointing out, that the main driver for the development in Serbia is domestic demand and, only to a lower degree, investments the country faces further challenges on its growth path. Rapid wage increases, government spending and strong domestic demand underlying this situation are putting severe upward pressure on inflation, which in the course of 2007 predominantly reached double-digit figures again. Finally, these developments have not been followed by competitiveness and export growth yet, and Serbia seems to have lost the opportunity to revive. The contribution of exports to GDP is very low and the private sector is undersized. The strong wage growth and appreciation of the dinar do not contribute to the competitive capability. In the case foreign debt grows robustly and in a stronger manner than the reserves and depending on the developments in the global financial markets – which is obviously somewhat cloudy by now – Serbia could face more severe liquidity problems in the long-term. Macroeconomic stability was strengthened by 2007, establishing an improved business climate with relative stability and predictability. However, the functioning of market mechanisms which allow efficient allocation of resources is still troubled

23 International Organization of Migration, Labour Market Survey, Third Review, NATO/PFP Trust Fund Project, 2007, p. 6.

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by the large proportion of administered prices, an undersized private sector, market transformation, inflexible labour market regulation and heavy involvement of the state sector in the production of private goods. With regard to the labour market it is one of the most important challenges to increase employment and create new jobs by establishing a favourable environment for employment-friendly economic growth. This requires a consistent economic policy, multi-sector job agenda, reforms in the field of education and vocational education, completion of privatization and restructuring process as well as encouraging investment climate.24 The financial system is relatively robust before the crisis because of though prudential measures undertaken by the National Bank of Serbia. Well capitalized banks, a low share of risky assets and solid f/x reserves bring Serbia in a favourable pre-crisis position. Notwithstanding, there are also some weaknesses, which may become key risks to financial stability: the large current account deficit, a high dependence on capital inflows, roll-over risks for direct cross-border lending and a high ‘euroization’ of the economy indicating vulnerability to balance sheet risks as a consequence of sudden depreciation. At this stage, the economy turns out to be less bright than it appears at first glance. It could be thought that Serbia might build a sustainable economic foundation and adjust in an orderly manner but, it will take a number of years before having a decent investment climate and persistent balances. However, the current patchy domestic policy mix of loose fiscal, tight monetary and so far slow-moving structural policies would further raise concerns over external stability.25

24 International Organization of Migration, Labour Market Survey, Third Review, NATO/PFP Trust Fund Project, 2007, p. 17. 25 Cf. International Monetary Fund, Serbia – 2007 Article IV Consultation, Concluding Statement of the Mission, November 2007.

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2.

The Impact of the World Financial Crisis (2008/2009/2010)

2.1.

Contamination of Serbia

At the time, Serbia being in the state of slow recovery, the World Financial Crisis emerged from a property bubble and a credit boom in the USA and soon spilled over to other (European) countries. Bad debts soared, the creditors – not only banks or investment funds – suffered big losses and this went on to cause a ripple effect on individuals in the financial market. The World Financial Crisis has added fuel to depreciation, declining commodity prices and upward trends in real interest rates, plunged economic activity and decelerated trade. In Serbia the first effects showed off in late 2008. As a result of its rather low but increasing integration with regional and global markets together with its long term macroeconomic position, the country was attacked by the recent crisis, but evolving through various channels and under different circumstances. Besides, Serbia was frequently cited as being one of the economies thought to be at most risk from the economic and financial turbulences. Primarily it is due to its considerable current account deficit, financed by large capital inflows, government expenditures and inflation, which made the country vulnerable to crisis. The lack of financing implied slower development, shrinking demand in the market lead to lower exports and a decrease in output resulted in lower public revenues. Developed countries experienced the financial crisis mainly through a decline of the market stability, while Serbia expects the beginning of an economic crisis due to overheated demand. At first sight, it was a liquidity crisis through contagion and drop of confidence in the market which turned into a solvency crisis, when the receding economy compounded the financial turbulence. But, the real economy of the country will not be unscratched either.

2.2.

Economic Crisis

2.2.1.

Macroeconomic Developments

Due to a reduction in foreign investment to a trickle and the lack of demand in the world markets to the country’s products accompanied by falling sources of finance, the country suffered economic meltdown, resulting in a deferred effect on

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the GDP. Growth in 2007 was healthy 6.9%, but as a result of the economic crisis this pace slowed down to 5.5% during 2008 and GDP fell by 3.0% in 2009 compared to the previous year.26 For 2010 an expansion of the Serbian economy was projected of 2.0%, with low base effects and a tentative recovery in external demand conditions helping the manufacturing sector in particular. In the first and second quarter 2010 the growth rates came back to 0.6% and 1.8% and give evidence to reach the meanwhile adjusted target of 1.5% by the end of the year. But, the wider uncertain economic environment and the possible spill-overs of the Greek crisis have cast a shadow over these prospects and make exports and investments remain difficult. Investments, remittances, industrial production, foreign exchange reserves and employment rates started a trend downwards and growth slowed down. Expansionary fiscal policies, including plans for a 70% increase of pensions, on top of external trade deficits growing at record levels, call into question the ability of the country to finance the needs, that in turn increase their vulnerability and that presumably lead to a possible financial crisis. 2.2.2.

Balance of Payments and Trade

Serbia entered the Crisis with a double-digit current account deficit (% of GDP). Within the first three quarters of 2008, the government argued that they were immune to the turbulences, as the overall balance of payments ran a surplus and was only in some categories showing marginal downward trends27. However, the export-oriented economy began to slump down in autumn 2008 due to the slid in the world commodity prices, resulting in thousands of employees losing their jobs. The government realized their situation worsening, but still insisting that the effects of the crisis would be least felt in Serbia in comparison to other regional European economies. Trade flows have slowed down considerably since then and private capital inflows have nosedived. Exports plunged in 2009 by about 24% and imports slumped 28% against previous year’s level as its main trading partners in the EU are facing recession. Sharpest declines in trade were recorded for intermediate and capital goods, reflecting the slow-down in domestic as well as trading partner manufacturing activity. Only trade in consumer goods dropped less.

26 International Monetary Fund, World Economic Outlook 2010, 2010, p. 159. 27 Cf. National Bank of Serbia, Inflation Report 2008, 2008, p. 31.

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During 2009 the current account deficit narrowed, as imports declined by falling demand, exports during that time picked up and the inflow from remittances improved. During 2010 these developments persisted and as per July the trade account deficit narrowed by 9.7% year-on-year. Showing an increase of exports (19.6%) exceeding imports growth (5.1%), the export – import ratio equalled 57.4% and was higher if compared to the same period last year (50.7%).28 For the upcoming five years a further growth of 10% to 15% is being aimed to iron out the deficit or reduce it to an acceptable level.29 But indicators prove that the economic activity within the first half of 2010 was somewhat fragile. To further encourage trade and investments, Serbia lately enlarged its market by signing further free-trade agreements with Norway, Switzerland, Iceland and Liechtenstein. On 1 September 2010, the free-trade agreement with Turkey was set into force, focussing especially the textile industry. The market for the Serbian economy is now extended to more than 800 million people providing as well further advantages for foreign investors. 2.2.3.

Foreign Direct Investment

The globally worsened economic cycle – even when just estimated – everywhere led very shortly to a sharp tightening in external financing conditions, increasing cost for financing as well as reduced appetite – either willingness or ability – for bank financing. International investors became increasingly risk averse and capital inflows to Serbia by credit and FDI slowed down markedly or reversed. As in terms of the country structure, investors from the European Union top the list, accounting for about 70% of the total FDI influx as well as US investments30 – but for those investing more indirectly due to their companies investing through European affiliates – it was just a matter of time before the roots pass their way to Serbia.

28 Cf. Statistical Office of the Republic of Serbia, External Trade Statistics, July 2010. 29 Cf. Aleksandar Vasovic, Serbian 2010 growth may top 2pct-trade minister, 8 September 2010, http://www.guardian.co.uk/business/feedarticle/9256119 (retrieved on 16 September 2010). 30 Cf. Serbia Investment and Export Promotion Agency (SIEPA), Strong FDI Figures, 2010, http://www.siepa.gov.rs/ site/en/home/1/investing_in_serbia/strong_fdi_figures/ (retrieved on 15 September 2010).

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In 2008, Serbia could still record 1.8 billion EUR but by 2009 FDI has slowed to a trickle around 1.3|billion EUR 31. Due to declining demand, uncertainty about firm’s economic future and the markets’ stability Greenfield investments are at a near standstill and many projects announced for 2009 have been rescheduled to 2010. E.g. Fiat’s plan to invest in Serbia, concluded in 2008, was delayed in realization due to the global financial turbulences. Nevertheless, it revitalized interest in the country. During the last months of 2009 several foreign investment could be initiated: Fiat finally shifts production to Serbia with 143 million USD investment in a Joint Venture together with the Serbian state, Gazprom spends 550 million USD for a majority share in state-owned oil and gas industry NIS with additional 670 million USD investment promised by 2012, Slovenian car component supplier Elrad ws as well as Italian textile manufacturer Fiorentino extend and modernize their assets. For 2010 Serbia expects a minimum of 2 billion USD foreign investments – calculated on the side of conservatism, according to SIEPA.32 During January and July 2010 investments volume amounted to 671.4 million EUR (net FDI: 499.6 million EUR)33 already, 90 projects in the sectors automotive, textile, furniture, electronic and construction, IT and communication are on the way. 2.2.4.

Labour Market Flows

By 2010 Serbia has reached its target of halving poverty, but unemployment is still high.34 After a relaxation in the labour market during 2008, unemployment constantly increased again. According to the Labour Force Survey conducted in April 2010, the unemployment rate rose from 14.0% in October 2008 to 19.2% in April 2010, its increase being particularly pronounced since October 2009 add up to 2.6%.35

31 Ministry of Finance, Bulletin May 2010, 2010, p. 14. 32 Germany Trade & Invest, Investoren weiter an Serbien interessiert, 17 August 2010, https://www.gtai.de/DE/ Content/__SharedDocs/Links-Einzeldokumente-Datenbanken/fachdokument.html?fIdent=MKT201008168004 &source=DBNL&sourcetype=NL (retrieved on 13 September 2010). 33 National Bank of Serbia, Serbia: Foreign Direct Investment, January – July 2010 by Country in Cash, 17 August 2010,

http://www.nbs.rs/export/internet/english/80/ino_ekonomski_odnosi/platni_bilans/fdi_by_country_

cash.xls (retrieved on 13 September 2010). 34 Sida, Opportunities for EU cooperation, but nationalism remains strong, 2010, http://www.sida.se/English/ Countries-and-regions/Europe/Serbia-/Developments-in-Serbia-/ (retrieved on 6 September 2010). 35 Statistical Office of the Republic of Serbia, Labour Force Survey 2010, p. 5.

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For end-2010 unemployment is estimated to be in the range of 20%.36 These developments in the labour market could be explained by a deceleration of impacts from the real economy reaching on it and a so far too slow and not adequate economic recovery. Even as the ministry expects by January 2011 new jobs will be created and living standard improved, experts are claiming that the reality and economic indicators that would confirm this statement are absent or minimal.37 During 2008 and 2009 net wages slowed down further or just slightly increased, picking up at the beginning of 2010. As of the third quarter of 2008 wages show a much lower partially negative growth – in both real and nominal terms. After moderate positive rates at the beginning of 2010, growth slowed down again in the second quarter without expectation of a significant upward trend for the months to come. Picture 11: Average net wages – total and public sector (seasonally adjusted, y-o-y growth, in %), source: National Bank of Serbia, Inflation Report 2010, 2010, p. 36. 4% 3% 2% 1% 0% -1% -2% -3% -4% II

III

IV

I

2008

II

III

IV

2009

I

II 2010

in nominal terms - public sector

in real terms - public sector

in nominal terms

in real terms

36 Ministry of Finance, Bulletin May 2010, 2010, p. 14. 37 Cf. T.N. Ðakoviä, Government convinced that crisis is over, business people waiting new wave, in: Blic online, 10 September 2010, p. 1f., http://english.blic.rs/In-Focus/6879/Government-convinced-that-crisis-is-over-businesspeople-waiting-new-wave (retrieved on 16 September 2010).

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Public wages showing a slower growth, as in this sector, a freezing or stepwise cut has been determined for 2010 and for the coming years a semi-annual indexation will be introduced, based on CPI inflation.38

2.3.

Financial Crisis

2.3.1.

Attempt to the Financial Sector

The banking sector constitutes a major part of the macro economy, comprising nearly 90% of the total assets of the financial sector in Serbia, representing 71% of GDP39 and therefore comprising a major economic pillar for the country. The financial market is considered less developed, trading sophisticated financial instruments or subprime mortgage-lined toxic assets to a lower extent but ‘euroized’ to a high degree. First signs of the influences of the World Financial Crisis have been corrections in the stock market, increasing sovereign spreads, reduced capital inflows and a depreciation of the dinar. A rise in lending rates, restricted access of the corporate sector to cheap cross-border loans, and a shortened supply of foreign exchange occurred due to a sharp drop in prices of securities.

Inflation

High government spending in the previous years has fuelled inflation which could not at all be restricted by the bank’s tightening monetary police. Inflation rate nearly doubled in 2008 rising up to a peak of 12% at the end of that year. High inflation expectations for the upcoming months motivated by the escalation of the World Financial Crisis, together with descending price rigidity neutralized the effect of higher interest rates and the stronger dinar, as well as the indirect effects of lower prices and agricultural products and world oil prices.40 Since March 2009 inflation is below 10% but is still one of the highest rates compared to the rest of the Balkans. During the last months of 2009 inflation rate was brought down to nearly 38 International Monetary Fund, Statement by an IMF Mission to Serbia, Press release No. 10/2010, 2010, http:// www.imf.org/external/np/sec/pr/2010/pr10218.htm (retrieved on 10 September 2010). 39 Cf. International Monetary Fund, Financial Sector Assessment Program Update, Republic of Serbia, Basel Core Principles for effective banking supervision, March 2010, p. 4. 40 National Bank of Serbia, Inflation Report 2008, 2008, p. 7.

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zero. This was contributed by the fast-paced exchange rate depreciation, increased indirect taxes and higher-than-anticipated market adjustments in prices according to purchasing power. These factors neutralized the mitigating effect of slowing activity and decelerating nominal wage growth which inducted reduced consumer spending. Continuing disinflation has allowed a gradual easing of Serbia’s monetary policy. Nevertheless, vigilance is called for, given the still unanchored inflation expectations and the potential for increased pass-through of recent exchange rate depreciation. For the time being inflation descended noticeably, creating an opportunity to durably stabilize price growth, even if in a low single-digit range. The inflation rate by August 2010 showed 6.6%, hitting the target by the NBS. Even being again the highest figure of the past twelve months, it has improved continuously and concerns about external financing have abated. Inflation is projected to be within the band at least until end of 2012. Picture 12: Actual and target inflation with a tolerance band for the period 2009-2012, based on information by source: Memorandum of the National Bank of Serbia on Setting Inflation Targets for the Period 2010–2012, source: National Bank of Serbia, 2009. 14.0%

12.0%

10.0% 10.0%

8.0%

8.0%

6.0%

6.0%

4.5%

4.0%

4.0%

2.0%

8 9 10 11 12 1 2 3 4 5 6 7 8 9 10 11 12 1 2 3 4 5 6 7 8 9 10 11 12 1 2 3 4 5 6 7 8 9 10 11 12 1 2 3 4 5 6 7 8 9 10 11 12

0.0% 2008

2009

2010

Inflation rate

Target

2011

Tolerance band

2012

Tolerance band

In order to react to mounting inflationary pressures the NBS raised the key policy rate after a series of rate cuts since end-2006. In the first quarter of 2008, after two revisions by 75 basis points (b.p.) it was further increased by 300 b.p. to 14.5%

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p.a. by the end of March and 15.75% in the second quarter of 2008.41 In October another raise to 17.75% was agreed, followed by downward revisions in 2009 as well as April and May 2010. Latest revision in August led to 8.5% as at present. As the ECB has increased its reference interest rate from 4% to 4.25% this is also being reflected in the interest rates of (European) banks in Serbia for domestic loans in euro. At this moment it could already be expected that banks will increase their interest rates, mainly for housing and short-term loans in euro with variable rates.

Bank Lending

During the credit crisis the banking sector showed remarkable stagnating credit – and rising risks margins. Lending activity fell sharply from the pre-crisis level, but still levelled positive in real terms. As a result of the bank run, corporate and household spending came to a halt in late 2008. Together with increasing deposit, loan and interest rates created an arriving credit crunch. 2009 a further slowdown was recorded. End-2009, continuing at the beginning of 2010 lending activity picked up, showing trends of growth driven by higher volumes and not only by the depreciation of the dinar. The real quarterly lending growth rate42 the second quarter doubled over the first quarter to reach 4.7% and 12.5% y-o-y, corporate and household lending rose by 4.1% and 5.8% respectively43 – yet no strong sign of recovery.

41 Cf. Ibid., p. 17. 42 It was adjusted by the effects of the exchange rate and inflation. 43 National Bank of Serbia, Inflation Report August 2010, 2010, p. 23.

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Picture 13: Quarterly growth rates of lending, source: National Bank of Serbia, Inflation Report August 2010, 2010, p. 23. 20%

15%

10%

5%

0% II -5%

III

IV

I

2008 Loans to economic orgnizations

II

III 2009

Loans to households

IV

I

II 2010

cross-border loans

Becoming more difficult during these times is the ability to obtain additional f/x sources in order to support a continuous lending or trading, by 2009 the banking sector was provided with lower f/x reserve requirements to obtain liquidity. Besides, having large capital buffers built up in former years to cover shortages, the situation could be weathered. In contrast, indirect credit risks stemming from high loan ‘euroization’ (approximately 70%) are elevated and displayed in increasing non-performing loan ratios to 6.5% in spring 2009.44 However, these developments did not fundamentally effect the stability of the banking sector – the capital adequacy ratios remained far above the minimum required by Basel Accords.

Foreign Exchange Reserves

As one of the first reactions in 2008, international banks started withdrawing liquidity. Taking this as a sign triggering consumer fears about a banking crisis, panic withdrawals of over 1.4 billion USD followed, representing 20% of total deposits. Both let to a drop in f/x reserves in 2008. The banks had to honour deposits and regain consumer trust and managed to bring savings back to 8 billion USD in November 2009, exceeding the pre-crisis level. 44 Cf. International Monetary Fund, First Review Under the Stand-By Arrangement, May 2009, p. 33.

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Serbia’s substantial currency reserves have been a big supportive nest egg during the financial crisis. By injecting around 2 billion EUR up to February 2009, the NBS was able to maintain liquidity and assist to stabilize the dinar exchange rate. Overall reserves remained relatively steady on a profound level at an average of around 10|billion EUR. Picture 14: Foreign Exchange Reserves in million euro, source: National Bank of Serbia, Statistical Bulletin July 2010, 2010, p. 72. 14 12 10 8 6 4 2 0 2007

2008 National Bank

2009

2010*

Commercial Banks

* estimated

Interest in the market is as well shown by foreign-owned banks which generally maintained, or even increased, their exposure to Serbia. Even if the National Bank of Serbia intervened in the foreign exchange market to limit volatility from time to time, the international reserve positions remains on a good level. 2.3.2.

The Serbian Dinar – Implications for a Currency Crisis

Serbia experienced combined banking and currency disturbance. The induced loss of investor confidence influenced the financial and stock markets negatively. The respectively reduced inflows of foreign funds and a weakened demand for the Serbian dinar head severe effects on the local currency. During 2008 the dinar strengthened against the EUR as well as the USD backed by a stable inter-bank f/x market and f/x resources contributed by interest rate differentials. After its high in August 2008, the dinar began depreciating due to global turbulences and lost over 10% of its value against the euro in October 2008, nearly 496

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25% by early 2009. On the one hand, it was a welcome correction to the large external imbalance and supportive to competitiveness, on the other hand, this led to a slump in foreign exchange exposures and a rising debt burden due to foreign-currency denominated credit without proper hedging. Even private lending collapsed and in turn choked consumption. The National Bank intervened substantially in the currency market to obviate excessive swings, maintain liquidity and orderly markets. The situation had stabilized during 2009 but further pressure came up in May 2010. The strengthening in depreciation is mainly ascribable to the impact of regional factors: investor’s sentiment towards the country turned due to the maelstrom of the Greek crisis and its spill-over to the rest of the region, economic tensions in the Euro-zone and major concerns over the financial situation in the CESEE, accompanied by limited deposit withdrawals from Greek subsidiaries. The gap between foreign exchange savings and demand let the NBS intervening heavily during the next two months. In the third quarter 2010 the dinar (RSD) caught up again, remaining at a less volatile level. Even now showing a stabilized performance after the depreciatory trend since November 2009, it has traded within the all-time low area of 99.50 RSD/EUR since February 2010. Picture 15: Movements in RSD/EUR exchange rate and NBS FX interventions, source: Inflation Report 2010, National Bank of Serbia, 2010, p. 25.

The NBS continued its floating exchange rate regime during these times and did not intervene to its maximum extend against the volatility of the RSD by using the reserves. In the case of Serbia, it has proven that the fluctuation levels of the market

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and in most of the cases could not be controlled due to manifold drivers. The resultant relatively high volatility of the RSD has finally helped to absorb external attacks and been supportive to the economic balancing during the crisis. By now it is questionable if the National Bank of Serbia will continue its direct intervention on the foreign exchange market and follow the previous target to limit losses beyond the psychologically relevant sticking point of 100.00 RSD/EUR. 2.3.3.

Financial Positioning

It has to be said, that all in all, the Serbian financial sector has proved resilient, as the involvement in financial products related transactions was limited so far, and foreign banks’ exposures have remained stable despite the current lowering of exposure limits under the Bank Co-ordination Initiative45. High capital adequacy ratios and liquidity available could help financial institutions to withstand or at least provide a buffer to the spill-overs of the liquidity and currency crisis. Another reason is that all operating banks are founded as joint stock companies and most negative effects could be mitigated with a cushion created during the booming time of expansion, e.g. high capitalization and obligatory reserves. However, additional risks signalling financial instability arose mainly due to conservative monetary policies from the previous years and the high share of foreign denominated loan. Serbia’s external financing position could now be strengthened and the reserve position became comfortable. The NBS has taken over the responsibility for revision of foreign as well as domestic banks and significantly improved the intensity of a risk-based monitoring as well as inspections and adopted early warning systems. Notwithstanding these positive developments, Serbia remains vulnerable to adverse financial spill-overs from the region. Radovan Jelašiä, Governor of the NBS, derives comfort out of the crisis and believes that the situation adjusted according to market provisions.46 The further lowering of real money market interest rates and widening of the depreciation gap of the real exchange rate gave the monetary policy in the second quarter of 2010 an even more expansionary edge.47 45 European Bank Co-ordination Initiative, Full Forum Meeting in March 2010, http://europa.eu/rapid/pressReleasesAction.do?reference=IP/10/335&type=HTML (retrieved on 3 September 2010). 46 Mathias H. Walther, Rückhalt hinter den Kulissen, in: Bundesministerium für wirtschaftliche Zusammenarbeit und Entwicklung, Ost-West Contact, 2010, p. 14. 47 National Bank of Serbia, Inflation Report August 2010, 2010, p. 9.

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3.

Challenges and Coping with the Financial Crisis

3.1.

Serbia on the Tightrope Walk

During 2007-2010 the development of Serbia has been restrained by serial events, essentially the independence of Kosovo, parliamentary and presidential elections, the promotion of EU accession. Alongside, the continuous challenges Serbia is facing from regional tensions, the World Financial Crisis has put a great burden on the country, challenged with neither a ready-made solution nor a best possible scenario. The crisis and its impact have been unprecedented during any phase and so has been the policy response. The main challenges during the crisis for the Serbian economy and society have been and to a great extent still are, whether to limit the depreciation of the dinar out of concern for inflation and balance sheet effect or saving f/x reserves for more difficult times and let external imbalances self-adjust, to intervene in advance to recession, credit crunch and falling inflation or putting more efforts on combating capital flight and inflationary consequences, to carefully cast away susceptibilities and external imbalances, changing to a looser monetary policy or set stabilizers to support economic recovery. Furthermore, choosing respective measures by keeping in mind the dependency to price and exchange rate movements while trying to act as precautionary as possible. At the same time having to be prepared for upcoming challenges by non-predictable developments abroad and move further on the way of transformation and development. Adequate financial resources, which have been generated by foreign bank operations in former years, need to be maintained in order to avoid serious influence in production and consumption and ensure financial sector solidity. Additionally, a lack of foreign direct investment could result in major economic instability, as then the absence of major inflows could no longer balance the current account deficit. Moreover, Serbia is walking the tightrope of aiming to protect the country against major impacts while at the same time not rising protectionism in favour of domestic organizations and harm foreigners/exporters. The drop in market confidence and the high dependency of Serbia on the European economies expose the vulnerability to a regional contagion and at the same time made it necessary to not only focus on home country but following problems in EU. Serbia, in the state of an emerging economy and not yet EU Member State also had to face and resolve problems on its own, when the EU focus was mainly on Euro-zone issues.

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At a first glance the disruption was expected to be overcome by strong discipline48, but when the impact from the global crisis turned into a local financial crisis, Serbian government called for several international institutions to provide assistance.

3.2.

Financial Aid from the IMF

The International Monetary Fund (IMF) has broadly extended its country focus for financial assistance. Being mainly active in the emerging economies the recent crisis has led the IMF turn to Europe. Reconditioning its lending, IMF provides more flexible loans with larger disbursements, reducing number and scope of conditions and focussing on most vulnerable areas affected by the crisis.49 In 2009, as one effect, the government found itself with a large hole in its budget and with a declining but still significant trade deficit. Outflows of foreign capital, declining foreign trade and the depreciation of the dinar caused massive imbalances. In order to stabilize the situation, restore confidence in the economy and reassure foreign investors, Serbia – besides other CESEE countries – sealed a stand-by agreement with the IMF. To avoid a balance-of payments crisis, the initially provided 370 million EUR (January 2009) stand-by loan was augmented in May 2009 to 3 billion EUR, which would be made available over two years. The IMF-led rescue includes financial support from the European Union’s bail-out fund as well as project aid from the World Bank and the European Bank for Reconstruction and Development. Supporting the government program and enabling a counteraction to the crisis, key objectives and policy actions are on the one hand tightening the fiscal stance of Serbia until end of 2010 and on the other hand strengthening the inflation-targeting framework while maintaining a managed floating exchange rate regime. Linked with the ‘Vienna Agreement’, exposures and capitalization of commercial banks should be secured and foreign currency reserves strengthened.

48 Cf. wieninternational.at, Serbia aims to survive the financial crisis by exercising discipline, 20 November 2008, http://www.wieninternational.at/en/node/11331 (retrieved on 13 September 2010). 49 Cf. International Monetary Fund, IMF and Serbia: looking beyond the crisis, 2010, p. 7.

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Serbia is committed to fiscal restraint, support for the banking sector, fiscal moderation and reduction in public spending, e.g. 18-month wage freeze for public sector workers, tax increases and price caps to control inflation. This declaration shall give confidence to international lenders and donors to release their funds and to help bring the Serbian economy forward. Since the programme was launched, Serbia showed a substantial deterioration of its external and financial environment. Quid pro quo, the authorities have raised fiscal deficit targets for 2009 and 2010 and taken further fiscal measures, received commitment from foreign banks and investors and requested additional financial support from other financial institutions, all in line with the IMF. After IMF conducting reviews of Serbia’s economic performance and fulfilment of key indicators set, four tranches50 totalling to 1.8 billion EUR have been disbursed until September 2010.

3.3.

Contribution from the European Economy

The tremendous impact of the crisis on Europe let the European Authorities focus their support on home countries. In first instance, European financial aid was provided to prop up banks in the Euro-zone and neither geared for those in emerging economies nor non-EU countries. 3.3.1.

European Union

Serbia, being on the way to EU accession, could avail of the opportunity to benefit from EUR 100 million under the Instrument of Pre-accession Assistance51 (IPA) for general budget support given by the European Commission (EC), agreed on 31 July 2009. The aid is meant to help with the stabilisation of the country, assist in economic recovery and ease social consequences of the crisis. In addition, this support shall help the country to follow its EU integration process besides coping with the crisis. The disbursement is executed to take place in two instalments, each worth 50 million EUR, in autumn of 2009 and in the first half of 2010, subject to the 50 1 May 2009: 804 million EUR; 2 December 2009 (postponed from August): 349.6 million EUR; 3 February 2010: 350 million EUR; 4 June 2010: 383.2 million EUR. 51 The IPA is focussing on providing financing for projects in countries which are on the way to EU accession. See also: European Parliament, http://www.delscg.ec.europa.eu/code/navigate.php?Id=752 (retrieved on 20 August 2010).

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fulfilment of the conditions in the program. It requires full compliance with the IMF agreement and further specific conditions to be met before the disbursement of the assistance, e.g. short-term reform in public finance management, integration with the EU, meeting political as well as economical criteria and European standards, assurance of implementation and enforcement of recently adopted laws on competition and state aid control, maintenance and development of Serbia’s administrative capacity of relevant institutions and bodies for EU integration. The financial package is to ensure: Y

availability of funds for public and private sector operators to secure the flow of investments into the economy;

Y

assistance in the reform of banking sector supervision and regulation, aimed at achieving financial stability for the business environment;

Y

that policy-making focuses on measures enhancing the competitiveness of the economy by connecting the education and vocational training systems to the private sector and helping then to generate employment and, investment, thus sustaining growth.52

In response to the economic crisis, Serbia was also granted a loan by the EC amounting to a maximum of 200 million EUR, provided in two instalments during 2010. This so-called ‘macro-financial aid’ is only granted in exceptional cases. It is complementing the already existing support by IMF and World Bank and requires strict compliance with the conditions set. 3.3.2.

European Investment Bank

The fact that the European Investment Bank53 (EIB) has been providing financial support for several projects in Serbia since years, brought up the call by Serbia for support during the World Financial Crisis. In order to combat this situation, the EIB launched a programme for Serbia including a 1.4|billion EUR plan for recovery of the economy and paving the way to closer integration to the EU. Lent on by Serbian commercial banks, the money may cover up to 100% of the project costs and is available for SMEs and local authorities as well as investments in the follow52 Cf. European Commission, EU genehmigt EUR 100 Mio. Budgethilfe für Serbien und EUR 85 Mio. zur Bewältigung der Finanzkrise in der Region des westlichen Balkans und der Türkei, 2009. 53 The European Investment Bank was created in 1958 by the Treaty of Rome. Its capital is contributed by 27 member countries, providing long-term lending to underpin the member states towards integration, development, economic and social solidarity.

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ing sectors: industry, infrastructure, energy, environmental protection, knowledge economy, health, education and services.54 The amount may be granted for financing up to 50% of the individual costs during the period 2009-2010. In May 2009, the first tranche of a 250 million EUR loan for small and medium sized entities was dispensed via the National Bank of Serbia. Further loans have been concluded for e.g. construction of a bridge (115 million EUR) and a highway (384 million EUR), research and development in the public sector (200 million EUR), education (50 million EUR), special projects of SMEs (45 million EUR). 3.3.3.

European Bank for Reconstruction and Development

Assistance by the EBRD during the financial crisis is just a few of numerous projects, as the bank is one of the major investors in Serbia. The commitment in 2009 was largely extended worth 423 million EUR as a response to the strong impact of the crisis.55 Current projects include industry, energy, financial institutions, commerce and agribusiness, municipal environmental infrastructure and transport. The bank contributed equity investments to one of the important Serbian banks Komercijalna Banka (48 million EUR) and Serbia’s largest private agribusiness company Victoria Group (40 million EUR) to help to survive the time of crisis.56

3.4.

Anti-crisis Measures by the Government and the Policy Response to the Crisis

Prime Minister Mirko Cvetkovic openly stated that Serbia did not erect any measures subsequently after realizing what would happen, but wanted first to see how other nations reacted in times of crisis.57 Shortly after this statement, the Serbian government established a working group and in addition prepared and adopted several measures. Even so the full extend of the contagion was unpredictable. This is, to be in the position of monitoring the effects continuously and promptly reacting to every new aspect. 54 Cf. European Investment Bank, EIB´s EUR 1.4 billion financial crisis plan for closer relations with EU – Signature of first EUR 250 million loan for SMEs and the new Framework Agreement, 2009, p. 1. 55 Cf. European Bank for Reconstruction and Development, Serbia, 2010, p. 1. 56 Cf. Ibid., p. 1. 57 Cf. SEEbiz, Government’s anti-crisis measures prove efficient, 10 April 2009.

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3.4.1.

Financial Sector Policy

The first plan was adopted for the protection of the banking sector in October 2008. Guarantees for foreign currency savings encouraged the people to regain confidence and have been increased from 3,000 EUR to 50,000 EUR, accompanied by the abolishment of savings tax until end-2009.

Credit Stimulus Package

The exceptional situation at the beginning of the year 2009 called for innovative solutions to support activity in the capital market and restoring the integrity of key instruments of monetary policy became more important. In this regard, an encouragement of the banking sector was intended by the credit stimulus package of the government launched in February 2009. The program focussed interest on subsidies, co-financing, and partial credit guarantees. At the same time, NBS lowered the reserve requirement base by the amount of loans under the program, raised the ceiling on retail loan-to-capital ratio, and abolished down payment requirements for households as well as reserve requirements on new foreign borrowing.58 Since March 2010, the minimum reserve for credits placed by corporate banks is modified to 5% (RSD-loans) and from 45% to 25% for f/x loans. Further credit support programmes have been initiated which boost credit in the market. According to the IMF, these markets are now functioning more normally and programes shall be gradually phasing out.59 Additionally long-term lending (3-5 years repayment period) was provided to businesses by the National Development Fund and commercial banks valuing approximately 170 million EUR.

Financial Sector Support Programme

In May 2009, the so-called ‘Financial Sector Support Programme’ (FSSP) was put in place. Voluntary and open to all banks this is to ensure external financing and liquidity. The FSSP requires banks to

58 Cf. International Monetary Fund, Republic of Serbia: Stand-By Arrangement – Second Review Mission, Aide Mémoire, 2009. 59 International Monetary Fund, IMF Reaches Staff-Level Agreement on Fifth Review of Stand-By Agreement with Serbia, 2010.

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Y

obtain specific commitments from parent bank groups to keep their exposures vis-à-vis Serbia at end-2008 levels until end of 2010, subject to review at end2009;

Y

keep sufficient level of capitalization and liquidity;

Y

participate in a stress test exercise based on IMF methodology and downside scenario;

Y

facilitating voluntary conversion of f/x and f/x-linked loans into RSD loans;

Y

restructuring of loans, requiring e.g. the extension of remaining loan maturity by at least twelve months or 20%, reduced monthly instalments, and in return;

Y

granting participating banks access to liquidity (RSD or f/x swap).60

To counteract the increasing inflation, NBS implemented a key interest rate and changes to targeting CPI inflation instead of core inflation in 2009. In the next step, the key interest rate was reduced gradually from 17.75% at the beginning of 2009 to 9.5% at the end of the year. A further three steps followed in March, April and May 2010, each 50 bp.61 Capital outflows by foreign banks could be avoided by the ‘Vienna Agreement’ through which ten international banks, operating in Serbia, committed their engagement and capital stock at constant level at least until 2010.62

Inflation-targeted regime

Effective as of 1 January 2009, NBS switched to inflation targeting monetary policy.63 In line with the strategies from the government the National Bank set targeted inflation rates for the period 2009-2012 gradually declining. This should support long-term macroeconomic developments, defend against of potential negative impact on the competitiveness of the economy and bringing the country in a position to ease the pressure on the nominal exchange rate.

60 Cf. International Monetary Fund, Financial Sector Assessment Program Update, Republic of Serbia, Crisis Management Framework, Technical Note, March 2010, p. 6. 61 Cf. National Bank of Serbia, Inflation Report 2010, 2010, p. 18. 62 See also Vienna Agreement, http://www.wipo.int/export/sites/www/treaties/en/classification/vienna/pdf/trtdocs_wo031.pdf (retrieved on 30 September 2010). 63 See also: National Bank of Serbia, Memorandum on Inflation Targeting as a Monetary Strategy.

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The inflation target is defined as a point with a tolerance band watched continuously. It represents a clear sign of the level of inflation that the central bank strives to achieve. The width of the tolerance band reflects interest in the stabilisation of economic activity and leaves a comfort zone for the flexibility of monetary policy in the period ahead without any detriment to its credibility. Thus, just causing short-term volatility of inflation, but not requiring a monetary policy reaction. Besides, the target is symmetrical, which provides a leeway to the NBS to communicate effectively if the target is missed in either direction. As it is not possible to keep inflation on target each and every month, the target set reflects the monetary policy’s medium-term focus. These measures let to prop up the Serbian economy and stabilize the inflation level. 3.4.2.

Governmental package of measures

Secondly, in January 2009, a package of measures worth around 1.2 billion EUR was set up for cushioning the consequences of the crisis, increased to 1.5 billion EUR in May 2010. The framework defined by the government in this context states partially restrictive and partially stimulating measures: restrictive with regard to the decrease of spending in an organized way and not through inflation and drastic devaluation of the national currency, stimulative to avoid recession and maintain GDP growth continuity.64 The (stimulating) measures in the area of economy and financials are set as follows: Y

Increasing liquidity of the economy through –

issuing sovereign guarantees for the amount of 40 billion RSD to the benefit of the National Bank of Serbia which would approve loans to banks which would then offer loans to businesses on favourable terms;

–

incentive loans from the Development Fund in the amount of 18.7 billion RSD;

–

international loans for infrastructure development: a) World Bank – 388 million USD b) EIB – 540 million EUR c) EBRD – 150 million EUR

64 Government of the Republic of Serbia, The Economic Crisis and its impact on the Serbian economy, Framework of Measures, 2008, p. 7.

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Y

Y

Y

–

favourable loans for the development of small and medium size enterprises (APEX loans) in the amount of 250 million EUR;

–

in cooperation with the NBS, implement the package of measures which would cause the high liquidity in the banking sector to spill over into the economy.

Increasing exports through –

providing working capital under favourable terms for effecting export related activities;

–

a higher level of export contracts insurance;

–

eliminating customs and duties barriers;

–

financial support to product certification;

–

supporting exporters in finding new markets in countries which are not as hard hit by the crisis, i.e. those maintaining a high growth rate.

Increasing domestic demand through the implementation of infrastructure projects – targeting the most vulnerable sectors: construction industry, construction materials, metal and metal products industry: –

corridor 10;

–

corridor 7;

–

reconstruction and streamlining of infrastructure within public enterprises;

–

construction of co-op apartments;

–

development of rural infrastructure.

Increasing investments by creating a favourable business climate –

Regulatory guillotine – building permits, issuing consents, removing red tape;

–

Reviewing the possibility of allowing free-of-charge use of land and infrastructure, as well as tax breaks for manufacturing capacities employing more than 100 people – applied to Greenfield and Brownfield investments (property of companies which are undergoing the restructuring process and are located outside the Greater Belgrade Area);

–

Privatization – instalments payment option for all methods of capital or property sale;

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Y

Y

–

Utility infrastructure – creating regulations and institutional preconditions for the modernization of public utility enterprises;

–

Opening the market for the construction of new production capacities in the energy sector.

Decreasing the fiscal burden –

Interest write-off for unpaid taxes and contributions if they are now settled on regular basis.

–

Past remaining obligations for health care will be frozen if the current ones are regularly paid and they will finally be written-off after five years of regular payment of the current obligations.

Increasing the trade in securities –

Abolishing capital gain tax when trading in securities,

–

Abolishing taxes on the absolute rights transfer when trading in securities.

Other measures within the financial sector have been defined by the National Bank of Serbia as mentioned above and are an integral part of the Republic of Serbia Government set of measures. The (restrictive) state administration related measures focus on the overall level of public spending but also some individual components, to contribute the boost of the economy. In more detail: Y

508

Direct Beneficiaries of the Budget –

The budget is generally restrictive with a 1.5% GDP deficit.

–

The salaries of budget recipients are planned restrictively – salary growth is allowed only up to the level of the projected inflation (the stock is higher by approximately 8% as compared to the last year).

–

The pensions were planned restrictively and in 2009 they remain at the same level.

–

The social entitlements in the stock increase to the level of the projected inflation.

–

The expenses for business trips and services (except with beneficiaries where expenses are unavoidable) have been decreased by 8% in actual amount, as compared to the last year.

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Y

–

The subsidies have been limited to 84% of the nominal amount for last year. The control over the use of subsidies is introduced, i.e. a special spending regime is introduced in the institutions which are subsidies beneficiaries. In addition, control over the use of special purpose subsidies is introduced in particular the control of effects of incentive subsidies. In case of unspecified purpose spending, the contract is terminated and funds are withdrawn for reinvestment, while in case of inadequate results the subsidies model is altered.

–

Introducing stimulating and punitive measures for the purpose of reducing grey economy.

–

Improving the efficiency of office and rental space utilization owned by the Republic of Serbia.

–

Enabling the privatization of the communal land for development.

–

A more responsible approach to state revenues (revenue agency, funds, public and utility companies) within the executive, bankruptcy and liquidation procedures (in particular in those cases where the property has already been sold off).

–

Improving the system of human resources management at the level of the whole state administration – no increase of the number of employees.

–

Increasing the capacity of the budget inspection.

–

More restrictive rulebooks on the use of service cars for budget beneficiaries.

Companies and Organizations where the Republic of Serbia has the Majority Ownership –

Regulating and stipulating the maximum compensation for managing and monitoring board members.

–

Regulating and stipulating the criteria for the salaries of managing directors – motivation scheme for increasing business efficiency.

–

Introducing restrictive mechanisms for the dismissal of managers in case of deviation from business and financial plans.

–

Salaries of employees are planned restrictively – the salaries increase only up to the level of projected inflation.

–

No new employees.

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–

Improving the efficiency of office/residential space and car use. Termination of new procurements and using rent-a-car services for passenger cars over 1.500 cm3 capacity.

–

Cutting expenses for representation, business trips, fairs, professional development, part time employment and piece work contracts, etc..

–

Cutting all other costs which are not directly linked to the business activities of the company.

–

Decreasing subsidies – linking subsidies to increased business efficiency.

–

More efficient and controlled public tender procedures.

–

Quarterly planning of and reporting on business and financial results.

–

Dislocation of the company’s/organization’s head office for the purpose of cutting costs and achieving a more even regional development, wherever possible.

–

Giving recommendation to local self government units to implement a similar string of measures to companies/organizations operating at the local level.

For the third part, the general population sector, the measures mean an adjustment to the current revenues in particular: Y

Employment

Y

–

Companies which receive incentive funds are under the obligation not to reduce the number of employees.

–

Increasing the effectiveness of the Employment Bureau in the area of retraining and new jobs search.

Social welfare –

Social spending is on the same level as in 2008.

–

Targeting socially vulnerable categories (amendments to the Law on Social Protection) – to assist those in need through better identification of socially vulnerable categories, to a greater extent than before.65

65 Government of the Republic of Serbia, The Economic Crisis and its impact on the Serbian economy, Framework of Measures, 2008, pp. 9-13.

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The government is forced to stick consequently to a belt-tightening economic route. Therefore the reform programme set up for the period 2008 until 2011 implies not only the removal of unsynchronised administrative regulations, but also the strengthening of mechanisms for controlling new regulations. The main contents are: Y

boosting liquidity of companies;

Y

securing exporting abilities;

Y

sustaining domestic demand;

Y

subsidization of credits, e.g. for cars, real estate;

Y

infrastructural measures, e.g. bridges, roads, railways.

The most important measures are the subsidization of credit and interest for both investors and consumers which in fact are made available by the state but lent on by banks. Special additional programmes have already been developed in the meantime, e.g. subsidize house building credit and providing favourable conditions for investments in agricultural and construction machines. A scrapping premium for cars of 1,000 EUR was brought up in 2009 to support the sales of Fiat Punto. Initially for only 5,000 cars, it was extended twice in the same volume.66 To soften the adverse consequences of the World Financial Crisis for persons with lower income, the authorities agreed on a 6.5 billion RSD (approximately 685 million EUR) aid for one-off payments to public employees, pensioners, poor municipalities as well as to increase targeted social assistance. Lately, the government provided a comprehensive pension law, effective as of April 2011, including both revised index formula and parametric reforms. In this context the crisis could function as a kind of catalyser for the Serbian economy, bringing about changes which are overdue. Nevertheless, it is obvious, that the government’s recovery plan is mainly based and depending on (financial) assistance from other organizations.

Privatization

A privatization programme has transferred state-owned companies to the private sector. The programme was set initially for the period from 2000/01 until 2009. During this time 1,721 socially owned enterprises have changed ownership and poured substantial cash in the budget. Having missed the finalization of the pro66 Cf. Germany Trade & Invest, Konjunkturprogramme weltweit – Chancen in der Krise, 2010 (without page).

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gramme in time, it was unveiled in 2008 as a three-year programme worth 44 billion USD encompassing the state communications company, an electricity utility, the national airline JAT and a pharmaceutical company. The privatization process for the around 250 remaining socially owned enterprises typically concluded by auctions and tenders67, welcoming as well foreign participation.

Tax Reform

Recently the government discussed several ideas of tax reform, including reduction of income taxes and contributions and an increase in excise to boost production, exports and employment. The government stresses, that such reform could also help to shift from one economic growth model to another, adding that this is also influenced by the competitiveness of the workforce, the reduction of administrative obstacles and an efficient judiciary.68 By now, the tax reform has not been ratified and is also not awaited before 2011, as along with the decrease of income taxes additional sources of income are to be found in order to not affect the revenues in total.

3.5.

Further Assistance by the World Bank

The World Bank has disbursed approximately 3 million USD to Serbia since 2000 so far. In the past years the country has been benefiting from another 388|million USD loan for the construction of ‘Corridor 10’ and a Development Policy Loan of 100|million USD for budget support, with advantageous terms: both loans were granted for a period of 20 years with a grace period of eight years and the interest rate in the amount of six-month LIBOR plus a variable interest margin of 0.17%.69 Until 2011 credit by the World Bank will total to around 900 million USD.

67 E.g. for sale of a stake in state-run telephony provider Telekom Serbje expected in the 4th quarter of 2010. 68 N.N., Reform of tax system to boost production, employment, in: Serbia Today, 29 April 2010. 69 Cf. Alexandra Popovic, World Bank grants assistance for development of Serbia’s e-government, 28 June 2010, http://www.i-policy.org/2010/06/world-bank-grants-assistance-for-development-to-serbias-e-government.html (retrieved on 15 September 2010).

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4.

Outlook for the Coming Years

4.1.

Potential for Serbia as an EU Member State

Serbia has benefited from EU autonomous measures since 2000 and developed to a potential candidate for EU accession. Already in 2005 the EU commission stated in its report, that Serbia had made sufficient progress in meeting the prerequisites and developing capacity to negotiate a Stabilisation and Association Agreement. After several rounds of talks on official and technical issues, the agreement was signed on 29 April 2008 in parallel with the Interim Agreement on trade and traderelated issues. However, both agreements are kept frozen from implementation on the EU part, as Serbia does not yet fully co-operate with the International Criminal Tribunal for the former Yugoslavia (ICTY) and would not be picked up until done so. Nevertheless, even being forced to follow crisis management since 2008 and shifting priorities in this regard, the EU accession remains the main target for the government. The adoption of legislative changes and the privatization process have brought Serbia more closely to compliance with the European Union. Serbia decided to start implementation of the provisions with the result that the access of EU exporters – its main trading partners – to Serbia improved substantially since 2009. In December 2009 the Council decided to unblock the Interim Agreement on trade and trade-related issues and the Visa liberalisation entered into force, which subsequently lead to the submission of Serbia’s application for EU membership on 22 December 2009. In June 2010 it has finally been decided by the EU to ratify the Stabilisation and Association Agreement which is one further important step to access the European Union. Needless to say, that assimilation is highly dependent on the willingness of EU-enlargement which is currently less distinctive. Latest proceedings show, that the EU General Affairs Council is likely to verify the membership application. An assessment by the European Commission is being initiated in October 2010, after discussion on foreign ministers’ meeting. Serbia’s convergence process with the more developed states of Western Europe is likely to continue apace over the long term. Including an underlying harmonization of legal and regulatory framework, the continuing convergence process with the EU and the final goal of membership will be supportive to increase the pace of reform and being a fundamental factor for driving growth of the economy producing wealth in the mid-term.

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The candidacy is only one step on a long way but it draws up a new picture of Serbia: without corruption and with an efficient jurisdiction, stable systems, consumer protection, social projects etc. as in other European countries.

4.2.

Navigating Challenges Ahead – Outlook 2015

The transformation progress and the favourable international economic and political situation have been put under pressure by the World Financial Crisis and posed serious challenges to the Serbs. Having dared Serbia to cope the crisis it could be named a blessing in disguise, as promoter for overdue reforms, political stabilization and economy moving towards Europe. In the past years, Serbia’s reform process has made a noteworthy progress but until now just helped to lay the basis for economic recovery. Realistically no other convincing alternative to this extended reform strategy exists. Serbia has demonstrated its willingness to move towards the EU and its recovery has been more hesitant than expected. Thanks to a responsible policy of the government and the National Bank – implementing adequate anti-crisis measures – in its kind ‘traditional’ and ‘innovative’ – thoughtful and prompt Serbia has not been suffering the effects of the financial crisis like other states in the region. A banking crisis could be averted, the rate of exchange could be stabilized, f/x reserves now exceed pre-crisis levels, the current account deficit is in check and inflation has improved. As private demand remains weak, exports seem to be picking up and the trade balance continues to strengthen. GDP decline was limited and the IMF expects real GDP to grow by 1.5% in 2010, 3.0% in 2011 and 5.0% in 201570, which would mean nearly pre-crisis level. While the worst of the economic downturn seems to have passed now, Serbia is still in an unsettled and vulnerable position. Several global leading indicators give positive signals and economies are in a gradual recovery mode, adjusting growth projections for 2010 up. In the case of Serbia the current slow pace of recovery may turn out to be only temporary. The core views for Serbia through the medium-term remain unchanged, Serbia still faces both domestic and international challenges, including accelerating a stalled reform agenda while mitigating the impacts of the financial crisis, combating corruption, reforming legislative systems and opposing Kosovo’s independ70 International Monetary Fund, World Economic Outlook 2010, 2010, p. 159.

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ence. Tough risks are titled to the downside, reflecting possible fallout from the current regional developments and therefore the account deficit is expected to remain contained. Policy discussions are focussed on near- and medium-term challenges in line with the IMF-Agreement and the fiscal strategy. Fiscal spending in the next years would have to be reduced to an absolute minimum. With a total budget deficit of 51.8 billion RSD 71 by end of June the level is higher than expected. The fiscal deficit target is announced to reach 4,75% of GDP for 2010, gradually declining to 4% (2011), 3,5% (2012) and 1.8% (2013) and 1% (2015)72 of GDP is estimated, underlying the assumption of a gradual real GDP growth in this years and the reform program to be set into force. Beside this it remains uncertain as to how Serbia will suffer further following the impact of the Greek crisis which significantly put pressure on the capital inflows in the country. While inflation expectations are still elevated, the remaining weak demand will keep it in check. Risks are depending on better-than-projected developments with regard to a possibly outsized hatch of depreciation, recovery of domestic demand and leveraged consumer prices. As long as the Euro-zone is expected to remain in deflation, deleveraging and with a growth on a low level, a robust ‘v-shaped’ recovery remains firmly off the cards.73 On the one side Serbia is showing a 1.5% economic growth which means a first sign for recovery, but on the other side having in mind the previous year’s drop this is not sufficient to talk about coming out of the crisis. Action is needed to kick-off a growth model addressing deeper challenges. Facing the symptoms of the recent crisis in Serbia, it becomes obvious that the road ahead is focussing on an export-led growth, an increase in savings and a trimming interconnection to the euro. Further structural reforms by the government will therefore mainly determine Y

further privatization to boost exports and domestic savings through higher corporate savings;

Y

improvements in the business environment;

Y

increasing competition to reduce margins and rents in non-tradable sectors;

71 Recorded in the second quarter of 2010. 72 Cf. National Bank of Serbia, Inflation Report 2010, 2010, p. 31. 73 Cf. Business Monitor, Serbia, Montenegro and Kosovo Business Forecast Report Q3 2010, 2010, Summary.

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Y

an upgraded infrastructure to ease movement of goods/services and increase public investment;

Y

a strengthened procurement process, injecting more competition.74

Boosting export will require a functioning solid banking sector and provision of particular financial instruments as a compulsory fundament. The measures taken and agreements arranged account for regained confidence in the market and banking sector. In the future a more balanced and adequate risk sharing will help to avert further jeopardizing financial stability. The country will be strongly depending on FDI and loans alongside ongoing reforms. If used wisely the current account deficit should be self-corrective over the long-term. A cut-back on public expenditure has already been agreed and will come into force as of April 2011, to achieve a more efficient administration an eGovernment project has just been launched in September 2010. The current plans and steps set into force show that Serbia is already thinking about the time after the crisis. Not to forget, that further recovery is possible only through strong demand in the rest of the world – for Serbia mainly indicated by the prospects in the EU. The regional tensions leave risks of adverse spill-overs and together with a weaker growth outlook for the Euro-zone the speed of recovery is dampened. Nevertheless, the signs stand for a rebalancing of Serbia’s economy, based on investment- and export-driven developments rather than on domestic demand and will underpin Serbia’s shift to a more sustainable growth.

74 Cf. Republic of Serbia, Letter of Intent to IMF, June 2010, Pos. 26-28.

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Slovakia: Small Land of Big Changes Maroš Tóth

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1.

Situation before the Crisis

1.1.

Political and Economic Background of the Slovak Republic before the Global Crisis

In order to understand the situation in which Slovakia found itself at the time of the outbreak of the global financial crisis, we must realise that we could only start talking about the introduction of both plural democracy principles and a market economy after the regime change in November 1989, while the independent Slovak economic policy only started to be conducted from 1 January 1993, i.e. after the separation of Czechoslovakia. Since the Slovak economy went through the process of both economic and political transformation simultaneously, it is not possible to assess these two aspects of development separately; we could even say that the interconnection of politics and the economy at the time of transformation is much closer than in the long standing democracies. In this|case, we talk about the politicisation of economy1, the degree of politicisation being different in various periods and strongly fluctuating, depending on the extant political situation at the time in question. For this reason, it is necessary to explain, at least briefly, the overall social and political climate in which the Slovak economy developed in the given period. Changes of political representation in the country meant an almost immediate impact on the change of economic objectives and especially on the means of achieving them, and thus, notable changes of economic policy as such took place. The beginning of the independent existence of the new state was politically and, of course, economically without question impacted by the authoritarian style of government of the then Prime Minister Vladimír Meêiar. Despite the fact that in the current parliamentary elections in June 2010, his party LS – HZDS did not obtain a sufficient number of votes to get into Parliament2, a|lot of significant political and economic topics that polarised Slovakia in the past and are still polarising it have their roots in the years of the so-called ‘Meêiar era’. These discussions include the need for economic or political reforms and questions of the operation and supervi1 Karol Morvay, Odpoêet vlády (programové vyhlásenie vlády vs. realita) – Ekonomika (Summary of Government’s Actions (Government’s Policy Statement vs. Reality) - Economy). http://www.infovolby.sk/index.php?base=data/ parl/2010/analyzy/odpocet/1275476107.txt (retrieved on 28 August 2010). 2 The party LS – HZDS received 4.32% of votes – a| minimum of 5% of votes were required to get seats in Parliament.

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J. Jungmann, B. Sagemann (Eds.), Financial Crisis in Eastern Europe, DOI 10.1007/978-3-8349-6553-0_10, © Gabler Verlag | Springer Fachmedien Wiesbaden GmbH

sion of secret services, privatisation, minority policy or economic and foreign-policy orientation of the Slovak Republic. With a|certain amount of simplification we could assert that the basic characteristics of the conditions of the Slovak economy (that were prevailing at the onset of the global crisis) were already being formed in this period. The ‘Meêiar era’ was marked by an increased level of corruption, concentration of power and its abuse by the contemporary political and economic elites. This period was characterised by deterioration of both the conditions for the existence of democratic structures in the country and conditions for the functioning of independent press and other mass media. In this period, there was open speculation about the interconnection of the political and economic elites with organised crime and with the misuse of the secret services to the advantage of the ruling politicians. The state authorities and institutions trampled on the elementary principles of the rule of law, even though in its constitution, the Slovak Republic declared itself to be a|state respecting the rule of law from its inception. Coarse nationalism, contributing to a radical worsening of bilateral relationships with neighbouring countries, could be observed to an increased extent – even in statements of top political representatives. These postures of the Slovak government, hardly acceptable in democratic countries, gradually led to an increasing political isolation of the Slovak Republic within Europe. In this period, Slovakia was not a|member of EU or NATO; on the contrary, Russia was the preferred political partner of the political representation at the time. Particularly well known is the statement of the then President of Russia, Boris Jelcin, who said to Vladimír Meêiar during his visit to|Moscow at the time before the Slovak parliamentary elections that ‘he really hoped so much that it would be Meêiar who will win the election’. Of course, the political isolation of Slovakia was also strongly reflected in the economic area. The political representation at that time did not provide sufficient guarantees for foreign capital standard investments. Therefore, compared to other countries of the so-called ‘Visegrad Group’ (V4)3, Slovakia was clearly lagging as

3 The establishment of V4 as it is known today goes back to 15 February 1991, when the heads of states or governments of Czecho-Slovakia (Václav Havel), Hungary (József Antall) and Poland (Lech Walesa) met in Visegrad to renew the cooperation among these four nations (after the disintegration of Czecho-Slovakia also countries) in order to support the process of European integration and transformation of economies. Accession of V4 countries to the European Union, which was approved in referendums in these states, took place on 1 May 2004. The only institution of the Visegrad Group is the International Visegrad Fund based in Bratislava, established in 1999.

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far as the amount of foreign investment was concerned. Even though the government officially declared that it was interested in both foreign capital and entry to the OECD, its practical measures were in conflict with these declarations. Another reason for lagging behind was the fact that during the privatisation of the national property, the so-called ‘domestic capital-formation class’ – a| limited group of entrepreneurs who were politically and economically connected with the ruling establishment and providing a relatively low rate of their own capital – was clearly preferred at the expense of foreign investors. Besides that, the so-called ‘Act on Strategic Companies’ was adopted in 1995. On its basis many important Slovak companies were excluded from privatisation, including banks and the so-called ‘natural monopolies’. In 1995, the government of Vladimír Meêiar stopped the second wave of voucher privatisation and decided to adopt the so-called ‘bond compensation scheme’. Subsequently, in the name of support of the domestic capital-formation class, the state property was sold off for a|fraction of its market or book value, usually to subjects politically selected beforehand. These politically related privatiers often had absolutely no experience with the management of these types of enterprises or with their activity in the relevant markets. The privatiers repaid some part of the purchase price by bonds cheaply purchased from national citizens. Apart from that, it was possible, having often met only some formal conditions, to apply for a|reduction of the purchase price by the amount of investments in the privatised company. Yet the support for this kind of privatisation went even further, because the major Slovak banks, at that time, were more or less controlled by the state as well, and provided easy credit for these privatiers to finance these acquisitions. Many of the loans provided were not paid back after the privatised enterprises had been tunnelled4 by their owners and later on, important banks (weakened also by this irresponsible credit policy) had to be stabilised at the expense of the state budget, i.e. the tax-payers. 4 The word tunnelling appeared in the specialized English economic literature somewhere around 2000 for the first time and the biggest credit for its popularization can probably be given to Andrei Shleifer, Rafael La Porta, Florencio Lopez-de-Silanes, Simon Johnson and Robert Vishny and their two articles “Tunneling and Investor Protection” and “Corporate Governance” published in ‘American Economic Review’ and ‘Journal of Financial Economics’ in 2000. ‘Tunnelling’ is the term used regularly for a|vast financial fraud,|where the management siphons off the company’s financial resources to other companies usually owned by the management on a|large scale. Of course, this siphoning off of the funds is usually not direct (it would often be too risky), but e.g. by means of deals strongly disadvantageous for the ‘tunnelled’ company. It can also take the form of various omissions in administration of entrusted property, from which the friendly companies eventually gain benefit.

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Privatisation conducted this way is also one of the reasons why in essence no stock market has developed in Slovakia until now – the volume of trades at the Bratislava Stock Exchange is almost negligible compared to stock exchanges| in neighbouring countries. Indeed, there is not the capacity for a|sufficient number of economically and politically independent entities for which the stock market would be an area for fair competition. If a Slovak company wanted to place its shares at the stock market, it usually did it at the Warsaw or Prague Stock Exchange. Both are substantially bigger, more developed and liquid. The economic growth at the end of the 1990s was largely induced by excessive government consumption and by institutions established| by the government to finance its needs or by various infrastructure projects which were often motivated politically, even at the cost of conditions extremely unfavourable for the state. Picture 1: Government consumption in % of GDP; source: Eurostat, Statistical Office of SR; www.oecd.org/dataoecd/5/51/2483816.xls (retrieved on 15 September 2010). 70% 65% 60% 55% 50% 45% 40% 35% 30% 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 Slovakia

USA

Germany

Investments in long-term projects, such as motorway construction, were largely financed by medium-term or even short-term loans which were increasingly more expensive and unfavourable, due to the overall situation of Slovakia. At that time, Slovak Republic was only able to borrow on international markets at high interest rates. They fully reflected the risk margin for the economic and political instability of the country in this period.5

5 At the end of October 1998, the price of bonds of SR issued in German marks with the maturity in 2003 corresponded to the yield which was 8.2% p.a. higher than the yield on German bonds.

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Another result of the large expansion in government spending was the fact that the domestic banks, instead of concentrating on their primary task, i.e. providing credit for domestic business projects of high quality, often preferred the more simple and less risky alternative: investments in government securities. This way, the state actually pushed businesses out of the market, since the capital allocated this way could not be used for providing credit to business projects. On the other hand, in general the biggest banks which were controlled by the state’s nominees. They provided credit to politically related business subjects even without sufficient liability and with very dubious business plans. Moreover, law enforcement was not functional or very limited during this period. The legislation in force did not provide enough means for creditors to assert their rights. This gradually led to a substantial increase in default loans; in 1998 their volume exceeded 30%, which, again, led to even more distrust of the Slovak banks towards the domestic business entities. With respect to limited finance sources, businesses not connected to the ruling political parties suffered from an acute lack of credit. Or the credit in this period was only provided at extremely high interest rates6, which again suppressed the already fragile growth of the private sector. As it was impossible to get credit under reasonable conditions, a|lot of sound and functioning companies ended up in financial difficulties and some of them eventually went bankrupt. The undercapitalised private sector was not able to create a|sufficient number of jobs to reduce the high unemployment rate. The latter subsequently increased the demands for government spending connected with providing at least the minimum social security for many of the unemployed. Paradoxically, there was also a|lot of over-employment in many huge state controlled and inefficient enterprises or entire sectors in this period. This artificially maintained employment, even in the already privatised enterprises, was often a silent part of the ‘price for political support’ in privatisation. The difficult economic situation in which the government of Vladimír Meêiar left Slovakia ahead of the parliamentary elections in autumn 1998 – the growing state budget deficit, increasing unemployment, increasingly negative trade balance current account, shrinking foreign exchange reserves, rapidly devaluating currency and a high level total debt – all this meant the necessity for rapid and effective measures from the newly elected government, regardless of who it would be. 6 The average interest rate on drawn loans was 23.5% p.a. in October 1998, according to data by NBS, http:// www.nbs.sk/sk/statisticke-udaje/udajove-kategorie-sdds/urokove-sadzby/priemerne-urokove-miery-z-uverovobchodnych-bank/rok-1998 / English:. www.nbs.sk/sk/statistic-data/data-categories-sdds/interest-rates/average-interest-rates-of-commercial-banks-on-loans/year-1998 (retrieved on 25 August 2010).

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1.2.

Democratic Forces Gain Political Power after Parliamentary Elections in 1998 – Positive Turnaround in among others Economic Policy

After the parliamentary elections in autumn 1998, the Meêiar era of the 1990s, marked with the economic and political isolation of Slovakia within Europe, was replaced by the government of a|broad left-right coalition excluding HZDS.7 The head of this cabinet, also labelled as the ‘Government of Change’, was the Prime Minister Mikuláš Dzurinda – until then the unofficial leader of the Meêiar opposition. In the political area, the coalition parties unanimously agreed on the need of a|radical change of the political climate in the country. With respect to this unanimous position and the constitutional majority that the parties of the then government coalition achieved in the parliamentary elections of 1998, rapid advancements in the democratisation process became evident. The apparent efforts of the new political forces to normalise disrupted relationships not only with neighbouring countries, but also at international level, as such was evident as well. With regard to the economy, opinions varied and the leftist parties of the government coalition especially declared unwillingness to embark on structural reforms of the economy. The unifying element of the common adversary – to defeat the Meêiar’s government – did not work in this case, because by definition and because of the position in the political spectre, the individual parties of the government coalition had completely different views on the methods of solving the difficult or even critical situation in which the Slovak economy found itself at the tail end of the 1990s. Occasionally this also resulted in contradicting opinions on the further direction of economic development in Slovakia after the undertaking of the necessary consolidation measures to rescue the ruined economy. The process of preparing the country for joining the OECD, which had been almost halted before the approaching elections at the end of 1998, was renewed. The objective was to catch up with the other countries of V4 (Poland, Hungary and Czech Republic), which were already members of this elite club, as soon as possible. However, admission was subject to the conditions of liberalisation of the Slovak economy and its opening to the world – this, however, required the adoption of a lot of measures to prepare the economy for this step.

7 The parties forming the government in 1998-2002: SDK, SDė, SMK and SOP; while SDK itself was a|coalition of parties DÚ, KDH, DS, SDSS and SZS.

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During the first year after the so-called first government of Mikuláš Dzurinda was formed, the necessary remedial measures, most of which were adopted as early as May 1999, first led to both higher inflation (especially by increasing the regulated energy prices, adopting import charges, increasing excise taxes) and higher unemployment and|reduction of real wages.8 At the same time, the growth of GDP temporarily slowed down. The consolidation measures, together with the fading effects of the previous government’s economic policy even led to the increase of debt-toGDP ratio of the Slovak Republic in the short term. However, the first positive effects started to appear gradually and the macroeconomic equilibrium started to be restored as well. Already by 2000 a recovery in the economy was discernable, interest rates fell and|a stabilization of the exchange rate of the Slovak crown was observed. An influx of direct foreign investments started, foreign debt stopped growing and inflation slowed.9 Picture 2: Gross public debt of Slovak Republic during 1993-2009 (% of GDP); source: Ministry of Finance of SR, Statistical Office of SR, Hrubý dlh verejnej správy, 2010. 60% 47.5%

50%

43.3%

40% 30% 20%

50.2% 48.9%

30.8%

28.3%

33.5% 34.4%

42.4% 41.5% 35.7%

34.2% 30.5% 29.3% 27.7%

24.8% 21.9%

10% 0% 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Naturally, these first stabilisation measures also met with positive response at the international economic level. In December 2000, Slovakia became a|member of the OECD, after almost six years of long admission procedures. Already in its report from 2000, the European Commission, when evaluating the ability of Slovakia to fulfil the basic criteria of the candidate countries for joining the European Union (the so-called ‘Copenhagen criteria’), which include the existence 8 Real wages dropped by 3.1% in 1999 and 4.9% in 2000. 9 The inflation, which was at the|single-digit level from 1995 to 1998, increased to 14.2% in 1999 and it reached the top in March 2000 – 16.6%. Then it started to fall gradually and|in February 2002 the year-to-year growth of consumer prices was only 4.3%.

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of a functional market economy and the ability to face the competition and market forces within the EU, stated that: “The government policy focused on macroeconomic stabilization has yielded the expected results. Slovakia can be considered a|functional market economy”10. The rating agency Standard & Poor´s increased Slovakia’s rating at the end of 2001, reclassifying the country in the investment level from which Slovakia dropped out just before the election in September 1998. This meant that a|clear signal about the readiness of the Slovak economy for an increased inflow of foreign investments was sent out to the international economic community.

1.3.

Period 2002-2007: Slovakia – Economic Tiger in CEE Area

To a|large extent the surprising results of the parliamentary elections in 2002, in which the conservative-liberal and right-wing political parties won (also thanks to the fragmentation of nationalist and socialist political forces), signalled the period of the most rapid and relatively sustainable development of the Slovak economy from the birth of the independent state in 1993. Only the second government of Mikuláš Dzurinda during 2002-200611 can be labelled as the government consisting of exclusively pro-European and pro-reform democratically oriented parties. In this period, the government started the process of an entire set of radical structural economic reforms with the view to increase the competitiveness of the Slovak economy within the European economic area. These reforms were also viewed very positively by the foreign media. “In six years Slovakia has gone from the ugly sister to the darling of Central Europe,” said Jake Slegers, director of the American Chamber of Commerce branch in Slovakia. “People now talk about the ‘Slovak model’ and the ‘Tatra Tiger’”12.

10 Ministry of Finance of Slovak Republic, Alternatívy rastu slovenskej ekonomiky (Alternatives of the growth of Slovak economy) Newsletter Verejná správa, volume 14/2002, http://www.civil.gov.sk/archiv/casopis/2002/1420mi. htm (retrieved on 15 September 2010). 11 On 8 October 2002, the coalition agreement was officially signed in Bratislava by the President of SDKÚ Mikuláš Dzurinda, president of SMK Béla Bugár, president of KDH Pavol Hrušovský and president of ANO Pavol Rusko. 12 Matthew Reynolds, Once a Backwater, Slovakia Surges , in: The New York Times, 28 December 2004, http://www.nytimes.com/2004/12/28/business/worldbusiness/28slovakia.html (retrieved on 25 August 2010):

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Besides the economic reforms in Slovakia, further political changes with the objective of deepening democratisation of society and public life were under way. The appropriateness and success of the new political trend was confirmed by both the admission of the Slovak Republic to NATO on 29 March 2004 and to the European Union on 1 May 2004. In this period, Slovakia became a|successful and internationally respected country. Of course, these landmarks in the geopolitical placement of Slovakia in the European and transatlantic structures were viewed very positively by foreign investors for whom they were a|signal to finally classify Slovakia among the countries of central and eastern Europe that met not only economic, but also political criteria. Ongoing economic reforms, privatisation of important, mainly telecommunication, petrochemical and power supply companies, abundance of qualified and still relatively cheap workforce compared to other Eastern European countries, as well as positive perception of the country by foreign investors brought about a|gradual increase in direct foreign investments (DFI) in this period. Even though the development of DFI in the economy of SR grew in the period to 1999, its total volume was far behind the contemporary needs of the Slovak economy, suffering from the lack of domestic capital. Picture 3: Influx of direct foreign investments to the Slovak Republic; source: National Bank of Slovakia, Priame zahraniêné investície (direct foreign investments), 2008. 4.000 3.500

in mil. EUR

3.000 2.500 2.000 1.500 1.000 500 0 -500

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A substantial part of this direct foreign investment went into the car production and the electrical engineering industry. Extensive investments in the car producing industry, including the gradual arrival of contractors for the existing car producers in Slovakia13 even resulted in Slovakia becoming the country with the largest number of cars produced per capita worldwide in 2007. The media even used comparisons like “Slovakia – Detroit of Central Europe”14. However, this type of relatively one-sided orientation in one sector also meant significant negatives later on, at the time of the crisis. A|lot of new jobs were created in this period in both the industrial and construction sector reacting to the beginning boom in real estate. This also led to a gradual reduction in the rate of unemployment – one of the biggest problems not only in the past, but also in present day Slovakia. In some sectors of the economy, a lack of qualified workers even started to become apparent. This trend culminated in 2008, when the historically lowest rate of 9% of unemployment in the era of independent Slovakia was achieved. The positive development in this respect was only halted by the onset of the crisis. Picture 4: Unemployment in SR (%); source: Statistical Office of SR, 2010, www.statistics.sk (retrieved on 15 August 2010). 20% 15% 10% 5% 0% 2003

2004

2005

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13 Currently, the following car producers have their production plants in Slovakia: VW in Bratislava, Peugeot Citroen in Trnava and|Kia Motors in Žilina. 14 TASR (Slovak Press Agency), President of the Slovak Republic hosted the senior Government Minister of the Republic of Singapur, Goh Chok Tonga, on 27 November 2006, http://www.prezident.sk/?rok-2006&news_ id=3441 (retrieved on 20 August 2010).

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With respect to the size of the Slovak market, the majority of Slovak industrial production was intended to be exported; export achieved a|record-breaking growth as well. The growth was not only in absolute numbers, but the openness of the economy increased as well. The share of export and|import in GDP increased from 143% in 2000 to 173% in 200715. Slovakia thus became the most open economy among the V4 countries. The most important foreign trade partners of Slovakia were and still are mainly the states of the European Union16 and the biggest foreign partners from among the individual countries are the Federal Republic of Germany and the|Czech Republic. Picture 5: Foreign trade development in SR (billion EUR); source: Statistical Office of SR, 2010 www.statistics.sk; Ministry of Economy of SR, 2010, www.economy.gov.sk (retrieved on 15 September 2010).

60 50 40 30 20 10 0 -10

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The growth of the Slovak economy in 2002-2007, encouraged mainly by investment, growing household consumption and foreign trade, attracted attention at both the European and global level. The positive news arriving from economy culminated in the beginning of 2008, when the official statistics from the record15 M. Bruncková / G. Machlica, Odhad rovnovážneho výmenného kurzu, (Estimate of a balanced exchange rate) July 2008, Ekonomická analýza 14 (Economic Analysis 14), Financial Policy Institute of the Ministry of Economy of SR, July 2008, p. 21. 16 Out of SR’s total export in 2007, the export to EU-27 countries accounted for 86.7% and import for 68.9%.

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breaking year of 2007 or from its last quarter were gradually published. According to the data of the Statistical Office of SR, the rate of growth of the gross domestic product (GDP) went from 8.5% in 2006 to the level of 10.4% in fixed prices. Slovakia was effectively the fastest growing economy in 2007 not only within the group of V4 countries, but also in the entire European Union (EU). The average growth of GDP of all 27 countries was 2.8% in the same year. Despite the continuous strengthening of the exchange rate of the Slovak crown, export of goods retained certain dynamics of growth. This was connected mainly with the launch of new production capacities and increase of production in the car producing (PeugeotCitroen, KIA Motors) and| electrical engineering sector (Sony, Samsung). At the same time, the dynamics of import growth decreased, mainly due to the decrease in the import of technology for the investment projects being built. This resulted in a|substantial reduction of the total trade balance deficit in 2007.17 Picture 6: Gross Domestic Product of SR (billion EUR); source: Statistical Office of SR, own calculations, 2010, www.statistics.sk (retrieved on 15 August 2010). 70 60 50 40 30 20 10 0 2003

2004

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Gross domestic product in current prices Gross domestic product in nominal prices

17 Ministry of Economy of the Slovak Republic, Výsledky zahraniêného obchodu SR v roku 2007 a v I. polroku 2008 (Foreign trade statistics of SR for 2007 and the first half of 2008), http://www.economy.gov.sk/vysledky-zahranicneho-obchodu-sr-v-roku-2007-a-v-1--polroku-2008-6895/128580s (retireved on 25 August 2010).

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A lot of similarly positive news and data rightfully aroused mostly positive expectations and hopes in the entire economic environment in connection with another important step in the economic life of both the country and its inhabitants: the introduction of the common European currency.

1.4.

Euro Adoption in Slovak Republic

One of the most important factors influencing the economic situation in Slovakia was the process of preparation and subsequent adoption of euro. The preparations for euro adoption in Slovakia started even before the Slovak Republic joined the European Union. On 16 July 2003 SR’s government led by Prime Minister Mikuláš Dzurinda approved a|document referred to as ‘Strategy of adopting the euro in the SR’ and concerted action of the Slovak government and the National Bank of Slovakia in regard to the Euro-zone entry of Slovak Republic. In July 2005, the Slovak government approved the fundamental document describing the sequence of steps necessary for the adoption of euro – ‘National Euro Changeover Plan for the Slovak Republic’, which was subsequently updated in 2007 and 2008. The plan defined specific tasks, their deadlines and responsible bodies for all areas affected by the preparations for the adoption of new currency. Part of the plan was the introduction of obligatory dual pricing (in koruna as well as in euro) for natural persons prior to, as well as, after the adoption of the single currency. The National Euro Changeover Plan for the Slovak Republic assumed 1 January 2009 as the date of the euro adoption. With this deadline, the Slovak government essentially identified a|specific time frame, within which it proposed to fulfil the obligation contained in the Treaty of Accession of Slovak Republic into European Union. At the same time, the deadline illustrated the efforts towards meeting

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the so-called ‘Maastricht criteria’18, the fulfilment of which presents the mandatory condition for obtaining approval on the Euro-zone entry from the Economic and Monetary Union (EMU) via European Commission or at the Economic and Financial Affairs Council (ECOFIN) meeting. Another condition for the introduction of the single European currency, besides fulfilment of the convergence criteria, is also a|minimum two year participation in the exchange rate mechanism (ERM II). En route to realizing this long-term goal, on 28 November 2005 Slovakia joined the ERM II. The Slovak currency SKK became a| part of this mechanism with fluctuation margins of +/-15% around the central rate, which upon the entry was defined at the level of 38.4550 SKK/EUR. After some initial hesitation, the government – led by Prime Minister Robert Fico and established based on the parliamentary elections of 2006 – definitively acknowledged the obligation of its predecessor to adopt all necessary measures in order for Slovakia to enter the Euro-zone as at 1 January 2009. After a period of relative uncertainty, which significantly affected the exchange rate of the Slovak koruna as well, this was a binding signal to Europe that the trend started by the previous government (at least in the economic sector) was to be continued. Considering the rapid strengthening of the exchange rate of SKK to EUR, on 19 March 2007 the central rate was re-adjusted to the level of 35.4424 SKK/EUR, thereby redefining the fluctuation margins as 30.1260 SKK/EUR to 40.7688 SKK/ EUR.

18 Convergence criteria also known as the Maastricht (convergence) criteria are the criteria set for European Union member states in order to adopt the euro as their currency. 1. Public finance: The criterion for the management of public finance involves 2 areas: The deficit of public finance may not exceed 3% GDP and total public debt may not exceed 60% GDP. 2. Inflation criterion: Average inflation measured by HICP for the preceding 12 months may not exceed the average of three countries with the best achievements in the area of price stability by more than 1,5 percentage point.| 3. Stability of long-term interest rates: The average long-term interest rate for the preceding 12 months may not exceed the average of interest rates of the three countries used for inflation criterion by more than 2 percentage points. 4. Exchange rate stability: The national currency must be part of the exchange-rate mechanism (ERM II) for minimum two years before the evaluation. During that period the national currency may not be devaluated on the initiative of the country, the currency may not vary from the agreed fluctuation margins, has to float close to the central rate and the development of the exchange rate must be without any marked tensions.

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In September 2007, the Slovak government approved the Act No. 659/2007 Coll. on the Introduction of the euro in the Slovak Republic and on amendments to certain acts, the so-called ‘Umbrella Act’, as a statutory regulation of the obligations of specific subjects before and after the introduction of euro. Picture 7: Fulfilment of the Maastricht criteria by the Slovak Republic; source: Eurostat, MF|SR, NBS, 2008. Criterion

Reference Value

March 2008

Fulfillment

Deficit of public finance (% of GDP)

3,0

2,2

;

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60,0

29,4

;

Inflation rate (%)

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2,2

;

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6,5

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;

Exchange rate stability Two years prior to evaluation the Participation in

;

national currency has to join the ERM II since exchange rate mechanism

November 2005

(ERM II)

In the Convergence Report assessing the readiness of the country, dated 7 May 2008, the European Commission recommended the admission of Slovakia into the Euro-zone as of 1 January 2009. Based on the assessment of Slovakia’s progress when fulfilling the convergence criteria as well as on the assessment of the European Central Bank (ECB), the EC arrived at the conclusion that the legislation of SR including the Statute of the National Bank of Slovakia (NBS) meets the necessary requirements. Also the other four convergence criteria in regard to inflation, deficit of public finances, stability of long-term interest rates as well as stability of the exchange rate have been fulfilled by Slovakia in a sustainable manner. The exchange rate of the Slovak koruna (SKK) on foreign exchange markets continued to strengthen also due to the influence of these official assessments, therefore leading to the second strengthening of the central rate at the end of May 2008, this time to the level of 30.1260 SKK/EUR. Hence, Slovakia became the first country to twice adjust its central rate within the ERM II. This step prompted extensive debates in economic as well as political circles about the possibility that the definitive exchange rate for Slovakia could be fixed to be even stronger than the latest de-

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termined central rate. This also would have been an unprecedented step, because until then all countries joined the Euro-zone with an exchange rate equalling the central rate of the respective currency towards euro. These speculations were also supported by the development on the foreign exchange markets, when shortly after announcing the new central rate the exchange rate of koruna reached a|historic peak of 30.080 SKK/EUR. These debates came to a definitive end on 8 July 2008, when the definitive exchange rate was approved by the Economic and Financial Affairs Council (ECOFIN), consisting of ministers of finance of member states of European Union: at the level of the last fixed central rate of 30.1260 SKK/EUR. Picture 8: Development of nominal exchange rate SKK/EUR; source: Wikipedia19, 2010.

The replacement of the Slovak koruna by the single European currency (Euro) as of 1 January 2009 signified the completion of Slovakia’s integration into the European economic and monetary union. At the same time it represented the most important integration step since the entry of Slovakia into European Union (EU). 19

19 Created with gnuplot, http://www.ecb.int/stats/exchange/eurofxref/html/index.en.html (retrieved on 18 August 2010).

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The preparation process of Slovak economic for the adoption of euro, as well as the actual entry into the Euro-zone has significantly influenced the extent and manner in which the economic crisis developed in Slovakia.

2.

The Impact of the World Financial Crisis (2008/2009/2010)

2.1.

End of 2008 – First Signs of Crisis in Slovakia – only a Slow-down of Growth?

Although the first symptoms of the crisis all around the world were noticeable as early as 2007 Ũ the most visible symptom probably the collapse of the investment bank Lehman Brothers in October 2008 Ũ Slovakia only truly started to be affected by the crisis at the end of 2008. As a matter of fact, through autumn and in the first days of December 2008 respectively, official bodies such as the Ministry of Finance or the National Bank of Slovakia published forecasts of the development of Slovak economy, admitting only a|marginal influence of the world financial and economic crisis on the economic development of Slovak republic.20 The Minister of Finance and the Prime Minister Róbert Fico alike both gave at that time rather optimistic forecasts and statements21, admitting a|certain influence of the world crisis on the development of Slovak economy, which however should lead only to some slowing down of the expected growth of Slovak economy. According to forecasts published at the end of December 2008, the growth of GDP was to slow down to 4.6% compared to the originally expected 6.5%. No scenario counted with the possibility (not even from the political opposition or independent economical analysts), that the world crisis could impact the Slovak economy in such profound ways as to cause a real drop of GDP. 20 Mid-term forecast of macroeconomic factors of NBS dated 5 December 2008 – In its quarterly forecast the National Bank of Slovakia has lowered the estimate of the growth of real GDP in 2009 to 4.7%, in the third quarter a|growth of 6.6% was still estimated. 21 „The deficit may even be reduced under two percent“, the Prime Minister declared after the government has approved the national budget for 2009, which still assumed an economic growth of 6.5%. „We can still be the fastest developing economy, despite the world crisis“, Fico stated.

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Such optimism Ũ almost overblown from the current point of view Ũ was understandable to a|certain degree. At that time the predictions could be based only on existing data on the development of Slovak economy as well as on the character of the world crisis. The statistical data for the third quarter of 2008 did not yet reflect the signs of the onset of the crisis in SR. The real GDP continued to grow at the level of 6.6%, while the real growth between quarters slowed down only gradually Ũ from 9.7% in the first quarter to 1.6% in the fourth quarter of 2008. Further indicators, such as sales and industrial production for the third quarter also showed no sign of a|slow-down in economic development. In the labour market a positive development prevailed as well, with the unemployment rate gradually falling to a|record-breaking level of 9% in the third quarter of 2008. This truly positive development was mostly the result of an increase in production of big foreign investors as well as their local sub-contractors. The development of wages in selected industries did not experience any significant changes as well, since the growth of the average monthly real wage during the first three quarters of 2008 exceeded the level of 3%.

2.2.

Beginning of 2009 – the Negative Impact of the Crisis Exceeds even the Most Pessimistic Scenarios

By the time of the fourth quarter of 2008, the downturn in the economic activity in the Slovak economy was already noticeable, with the most visible GDP drop in the Slovak economy in the first three quarters of 2009. At that time, the Slovak economy experienced in particular the full impact of the decrease in foreign demand after Slovak products. The automotive industry and related industries, such as transportation, were affected the most. Since this industry is predominant in Slovakia, the impact of the crisis on Slovakia in the first half-year of 2009 was truly agonising.

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Picture 9: Development of GDP in current prices during 2008 – 2010 (billion EUR); source: Statistical Office of SR, 2010. 10

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The fall of GDP in the first quarter of 2009 was also influenced by industrial production downtimes due to the so-called ‘gas crisis’, when the supply of natural gas from Russia through the Ukrainian transit route was initially severely limited and later even completely interrupted for more than two weeks, starting on 6 January 2009. The supply cut-off was the consequence of the Russia – Ukraine gas dispute regarding the price for Russian supplied gas to Ukraine, the payment of debts from previous periods, as well as prices for the transit of this gas to the territory of third countries. Since Slovakia is dependent on gas supplies from the East, this situation, rather inconceivable until that point, disturbed the economic activity of the country to a|considerable degree. At the same time, the beginning of 2009 was affected by a|rapid decrease of retail sales of Slovak shops. In addition, psychological factors too played certain negative parts in this area – the understandable degree of distrust against the new currency or apprehension as to how the euro will influence the increase of prices in shops. However, the value of the conversion exchange rate of the Slovak koruna has emerged as a|more important factor. The SKK/EUR rate of exchange, as already determined by the first half of 2008 meant that after the introduction of euro, goods from neighbouring states were much cheaper for Slovak consumers than

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goods from the domestic market. In the second half of the year, especially as a result of the panic in worldwide financial markets resulting from the on-going world and financial crisis, the currencies of neighbouring countries outside the Euro-zone gradually weakened against the euro. Therefore, especially in the regions neighbouring Poland, Hungary and Czech Republic, a so-called ‘mass shopping tourism’ emerged. The possibility of unproblematic cross-border movement also played a part in this situation, since all these countries together with Slovakia were part of the so-called ‘Schengen agreement’22. Therefore, at the beginning of 2009 the situation forced the employers to announce the first mass lay-offs, affecting especially the less-developed regions. However, there was also a positive side to such visible decrease of demand due to crisis. The fears of the public in regard to the expected increase of inflation related to the euro adoption were not fulfilled. Apprehension prevailed especially under the influence of reports from other countries which already had adopted the euro – the dramatic increase of inflation in Slovenia, where the euro was adopted in 2007, was perceived rather negatively from this point of view. Therefore, an unexpected situation had occurred. Under the threat of continued sales decrease, in many cases the vendors were forced to substantially lower their prices after euro adoption in order to increase their ability to compete with prices from neighbouring countries. The until then predominant monitoring of the euro introduction or the gas crisis in the Slovak media was also more and more urgently pushed aside by the topic of the world crisis and its consequences for the Slovak economy and population. These changes in the economic development were so fast and unexpected, that macroeconomic forecasts prepared and published within several months at most, still predicted a|completely different development. This was also the case by the comparison of macroeconomic forecasts by the Ministry of Finance of SR dated September 2008 and September 2009. Picture 10: GDP growth forecast; source: Ministry of Finance of SR, 2008, 2009. GDP real growth, %

2009

2010

2011

Forecast September 2008

6,5

6,1

5,8

Forecast September 2009

-5,7

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4,1

Difference

-12,2

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-1,7

22 These countries joined the Schengen Area on 21 December 2007.

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Even the European Commission forecasts at the start of 2009 were based on the assumption that Slovakia would be the fastest growing economy of the European Union in 2009. In the forecast published on 19 January 2009 the European Commission (EC) lowered the expected rate of Slovakia’s economic growth to 2.7% for 2009 and to 3.1% for 2010, while expecting a|growth of GDP on the level of 7.1% for 2008. „Despite everything, in this year Slovakia should be the fastest growing economy of the entire European Union (EU)”, Andrea Elscheková-Matisová, head of representation of European Commission in Slovakia, commented on the EC report. Picture 11: European Commission forecast – economic growth, V4 countries (19 January 2009); source: European Commission, 2009. 2009

2010

2011

Slovakia

- 5,8

1,9

2,6

Czech Republic

- 4,8

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Poland Hungary

Back then, one of the possible reasons for optimism in regard to the impact of the crisis on the Slovak economy was also the course of the world crisis. At least in the beginning, the world crisis appeared to be mostly a|financial crisis, affecting the banking sector in particular, penetrating the real economy only later and morphing into an economic crisis. However, as detailed in the following text, the banking sector of Slovakia at the beginning of the crisis in 2008 was in a|different position to the banking sectors in comparable European economies.

2.3.

Banking Sector

2.3.1.

Banking Sector before the Onset of Crisis

One of the most important processes, which occurred in the Slovak economy until now was the transformation and the subsequent privatisation of the banking sector. The discussion in regard to the privatisation of Slovak banks and their restructuring has been in progress since the establishment of the independent Slovak Republic. At first, even in this area there was a|visible effort to privatise the Slovak banks in the same way as other sectors of economy – in favour of the so-called

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‘domestic capital-generating class’. However, the privatisation or establishment of several smaller banks by Slovak business groups soon showed the incapability and inexperience of local players in this sector. A|situation threatened, in which the privatised banks would be (although not always directly) owned by their biggest creditors, therefore creating room for further uncontrolled lending and a subsequent collapse. Therefore, in later years, the idea of privatisation with the backing of foreign investors with the capital and know-how necessary started to emerge once more. However, such a standard solution for the instability of Slovak banks, which at that time already faced existential problems, did not have the necessary political support of the coalition in power, led by HZDS. The constant postponing of the necessary decisionmaking had very disadvantageous consequences for the entire Slovak economy. Imbalance on the financial market – especially the lack of lending sources for businesses together with extreme interest rates affected the entire Slovak economy. Essentially, this critical situation started to be solved only after the first government led by Mikuláš Dzurinda came to power. Meanwhile, the|significant delay in restructuring increased the amount of uncollectible bank loans which had to be rush-solved up to 105 billion SKK, with the total costs of their restructuring almost reaching 124 billion SKK.23 The restructuring incurred high costs for the state, which impacted the budget deficit and the total public debt respectively in a|significant way. Nonetheless, without the restructuring of the banking sector, the privatisation of banks by prominent foreign investors would be out of the question. The goal of restructuring of the biggest banks (Všeobecná úverová banka, a.s. (VUB), Investiêná a rozvojová banka (IRB) and Slovenská sporiteĘĢa, a.s.) was for the rate of capital adequacy of banks to reach the international standard of 8% and for the share of classified receivables on the total bank receivables to fall under 20%.24 This goal was achieved by two operations: Y

In the first step the capital requirements of banks were strengthened Ũ by increasing the equity by SKK 180,9 billion in total.

Y

Subsequently, a part of at risk credit (more than SKK 105 billion) was transferred from bank portfolios to specialised state-founded financial institutions.25

23 Using the current exchange rate of SKK/EUR more than EUR 4 billion. 24 National Bank of Slovakia, Annual report 2000, Bank supervision in 2000, http://www.nbs.sk/_img/Documents/_ Publikacie%5CVyrocnaSprava%5CSVK2000%5CVS2000_kap03.pdf (retrieved on 25 August 2010). 25 Konsolidaêná banka, š.p. ú, and|Slovenská konsolidaêná, a. s.

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Following the completion of the restructuring, the privatisation of the most important Slovak banks by prominent foreign investors (mostly European banking groups) commenced. The privatisation of banks with state-owned shares started essentially at the beginning of 2001. Slovenská sporiteĘĢa, a. s. was privatised as the first among the biggest Slovak banks, with the Austrian group Die Erste obtaining an 87.18% share. After the approval of the government, the Italian financial group IntesaBci became the new owner of the almost 95% share on the equity26 of VÚB, a. s., Bratislava, the biggest Slovak bank at that time.27 Picture 12: Shares of shareholders from various countries on the foreign capital in the banking sector of SR as of 30 June 2001*; source: SME, 2001. 1.95 1 12.5

36.9 10.3

9.1

8.3

7.95 12

Austria Great Britain U.S.A.

Italy Germany France

Czech Republic Holland Other

* Situation before the definitive entry of IntesaBci into VUB

26 Beside the 68.6% state-owned equity stake, the government of SR included in the purchase offer also a|25% share from multinational institutions EBOR and IFC, which entered the ownership structure of the bank as early as January 2001. 27 Zdroj: Tkáêová Dana Ing., Bankový Sektor Slovenskey Republiky-Vývoj, Reštrukturalizácia a Privatizácia, Biatec, volume 10/2001, 2001 pp.17-19.

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Due to the restructuring of banks, an|advantageous environment for the subsequent restructuring of the entire business environment was created at the same time, because only healthy, well-capitalised banks could help solving the complicated problems of the domestic entrepreneurs in a| more significant manner. On the other hand, a|long-term healthy development of the banking sector is not possible without a|healthy business environment. In the following years, this interactive relationship proved its qualities when the Slovak economy, including the banking sector, experienced significant continuous growth interrupted only by the onset of the world crisis. 2.3.2.

Banking Sector at the Time of the World Crisis

As opposed to the US banking sector and the banking sector in the majority of European countries, the banking sector in Slovakia was and still is in relatively good shape. The published data on the growth rate of loans granted, on the relative stability of interest rates not only for newly-granted loans, but even on the inter-bank market of that time, as well as data on the profitability of individual banks and the entire banking sector for 2008 clearly indicated that in 2008, the crisis only marginally affected the Slovak banking sector. The profitability of the Slovak banking sector increased continually from 2000, when the main part of the restructuring of the banking sector was completed. For 2008, the sector achieved a net profit exceeding 0.5 billion EUR, which meant that profit was approximately four times higher than in 2000 and was at the same time at approximately the same level as in the pre-crisis year 2007. Even in 2008, no losses or declines in profit occurred to the extent of those experienced by banks in USA and by other Euro-zone countries already in 2008.

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Picture 13: Development of Slovak banking sector during 2000-2008; source: NBS, 2009.

40 35.2

35 30

30

26.4 24.9

Billion EUR

25

21.7

23.2

21

18.8

20

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15

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2000

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10 5 0

profits of banking sector* volume of deposits*

volume of credits*

* deposits and credits as of 31.12., profit for calendar year.

The commendable state of the banking sector at the beginning of the financial crisis in 2008 was indicated also by a|relatively high year-on-year growth of lending to enterprises and households in comparison to the capital adequacy of banks. In the second half of 2008, this growth reached approximately 20%, even if on a month-on-month basis a gradual slow-down of lending activities could already be perceived. The comfortable position of the Slovak banking sector despite the circumstances at the time was caused by the concurrence of several factors: Y

conceivably the most important factor was that the very financially intensive and state assisted restructuring related to the global recovery of the banking sector happened at the end of the last decade of the 20th century and that this main phase was completed during 2000–2001;

Y

after the recovery, almost the entire banking sector was privatised in favour of foreign banking capital;

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Y

the banking sector profited from the continuous growth of the entire Slovak economy and at the same time its profitability grew as well;

Y

bank lending was rather conservative, the criteria of banks regarding the creditworthiness of clients were relatively strict;

Y

Slovak banks focused mostly on the domestic market, that due to appropriate business assets as well as the growth of purchasing power of the population provided sufficient room for the allocation of resources (in particular the growth of housing loans was remarkable);

Y

the participation of Slovak banks in the so-called ‘toxic assets’ was limited due to their reduced activity at the international level, which usually were realised on the level of their parent or holding company.

However, beginning in 2009, the influence of the global crisis on the development of the Slovak economy started to affect the financial numbers of Slovak banks in a more significant way. The volume of uncollectible loans for the banks started to grow due to growing financial problems and illiquidity among clients. Since December 2008, the banks had to create provisions at an increased rate, which also naturally affected their profits28, and led to a decline in lending respectively. Among the main reasons for the stagnation of the growth in lending in the Slovak economy at that time were also the following facts: Y

On the part of banks as lenders a|further tightening of criteria for loan granting took place, e.g. a more|detailed evaluation of the current and expected creditworthiness of the credit applicants. Other sectors such as property development and sub-contractual work for the automotive industry had and still have to overcome the limited appetite of the banks for these sectors.

Y

In the case of mortgage lending the banks stopped granting the (until now rather common) 100% re-financing against the value of the property.29

Y

At the same time, the banks needed to allocate a|larger share of resources for the creation of provisions for loans already granted.

28 When mentioning the decrease of profits of banks it is of course not possible to omit the fact that due to the introduction of the single European currency, the volume of transactions in this area decreased. Therefore, a|certain decrease was probably to be expected regardless of the ongoing economic crisis. 29 According to the legal regulations a|mortgage loan could refinance a maximum of 70% of the value of the property, however, the banks offered their clients the possibility to refinance the residual value using consumer loans etc.

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Y

Companies as credit applicants experienced a|rather significant reduction of investing activities due to unclear future development, leading to a reduced interest in investment loans.

Y

The population faced a similar situation, when especially in the lower-income groups the apprehension with regard to job retention and the related increased cautiousness with debts prevailed. However, the granting of loans to the general population maintained on the whole its growth trend even in 2009.

Y

Considering the real drop in property prices, the financially more robust section of the population postponed its purchases and the related funding through mortgage loans in favour of the expected further growth of property prices. However, in the last two quarters of 2009, especially since the beginning of 2010, a|fast increase in the granting of mortgage housing lending is evident.

Even though the impact of the economic crisis on the statistical indicators of Slovak banks is clear, this impact does not have such a significant scope as in other European countries. Neither in the past nor at present did the Slovak banking sector as a whole (or individual Slovak banks) require state bailouts. The sector is able to generate profits and at the same time maintain liquidity and functionality, i.e. to provide loans to households as well as the business sector without greater limitations30. This is confirmed also by the latest data for the first half of 2010 as well as by evaluations by the representatives of the National Bank of Slovakia. „We expect that the banking sector and especially the more important institutions within the system should be able to cope with the development, but also with a possible substantial worsening of development in comparison to the expectations”, emphasised Slavomír ŠĹastný, member of the Bank Board of the National Bank of Slovakia (BR NBS), at a|press conference on 12 April 2010.31

30 Juraj Franek, Financial Policy Institute, Ministry of Finance of Slovak Republic, Bankový sektor na Slovensku vs. finanêná a hospodárska kríza, 2009. 31 NBS: ZiskovosĹ bánk sa vlani prepadla na polovicu, ich situácia je však stabilná, (NBS: The bank profits for the last year have dropped by half, however, the situtation remains stable) TASR 12 April 2010, http://www. finance.sk/spravy/finance/31833-nbs-ziskovost-bank-sa-vlani-prepadla-na-polovicu-ich-situacia-je-vsakstabilna/?MailcenDivLogin=1 (retrieved on 25 August 2010).

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2.4.

Labour Market

2.4.1.

Development of the Enemployment Rate During Crisis

The Slovak labour market was hit far harder by the negative consequences of the world crisis than the banking sector. The period of the economic crisis is characterised, among others, by a|reduced demand for labour. That is heavily outbalanced by the labour supply, leading to the natural consequence of an|imbalance reflected in the increasing unemployment rate. The natural reaction of SR’s government to this situation was the adoption of measures in order to maintain employment and reduce the number of eradicated jobs respectively, since the creation of new productive jobs stagnated (and in principle still stagnates). The development of the unemployment rate in Slovakia (in %) from 2007 until the first half of 2010 is showed in the following graph: Picture 14: Unemployment rate development during 2007-2010; source: Statistical Office of SR, 2010. 14 13

% unemployment

12 11 10 9 8 7 6 Jan

Feb

Mar

April

May

Jun

Jul

Aug

Sept

Oct

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Dec

month 2007

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Of interest in the development of the labour market is the fact that the advantage of a|higher level of education started to show (e.g. the total number of employed persons decreased by 106,000 in the third quarter of 2009). However, in the same quarter the number of employees with university education increased by 14,700.32 In 2010, the registered unemployment rate increased in comparison to the previous year (e.g. compared to the situation in July 2009 the registered unemployment rate increased by 0.2% in July 2010), while in 2009 the average unemployment rate was 11.44%. According to the data SR’s Statistical Office published in July 2010, the average unemployment of this year is 12.59%. Of course, to some extent this comparison is not precise enough, since complete data for 2010 are not yet available. The government of SR has strived to alleviate the imbalance between the labour supply and demand for labour, among other things by adopting several measures supposed to absorb the impact of the existing legislative barriers. One such barrier in the area of labour-law legislation was present also in the case of limited possibilities and insufficient flexibility when reacting to the fluctuations in the volume of orders. Since employers are obliged to assign the employee work during the entire duration of his employment, the employers were forced to cancel jobs affected by the temporary deficit of orders. The executive reacted with relative flexibility, adopting a|legal regulation according to which: if the employee is not able to perform work due to serious operational reasons, such as a drastic drop off in order levels, the employer may grant the employee time off for the time span of this order shortage, compensated by wages. After the end of the work prevention period caused by the order shortage the employee shall continue to work off the granted time without entitlement to wage, since it was provided during the time off. Currently, this regulation, also called the ‘flexi-time account’33, is limited to the period from 1 March 2009 until 31 December 2012, when the mentioned imbalance is supposed to last.

32 K. Morvay, Zhodnotenie vývoja na trhu práce v|roku 2009 a|výhĘad na 2010, published on the HPI website www. hpi.sk, 21 February 2010. 33 This instrument of personnel policy was used for the first time by the company Volkswagen Slovensko even before its adoption in form of respective legal norms. Based on the success of this model, the flexi-time account was subsequently introduced also into the Slovak Labour Code.

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2.4.2.

Development of Average Wage During Crisis

Currently, the growth of the average nominal wage is stagnating or slowingdown respectively. An important factor influencing its growth even in the time of crisis in 2009 was the fact, that in most cases, unskilled or semi-skilled jobs with lesser or below-average financial remuneration were cancelled. At the same time, the nominal wages in public administration grew despite the crisis. This was to a certain degree due to a|certain momentum and inflexibility in the wages area in reaction to the ongoing crisis. Another considerable factor was also the approaching parliamentary elections of the first half of 2010 with the public administration employing a numerous group of potential voters. The following graph shows the development of the average nominal wage in the Slovak economy from 2006 until now (in EUR)34: Picture 15: Wages (in EUR), source: based on data of the Statistical Office of SR, 2010. 800

745

750

725

723

700 669

650

623

600 2006

2007

2008

2009

2010

In 2009, the real nominal wage underwent a slight growth or respectively maintained approximately the same level, mainly due to the decline in the growth of consumer prices (inflation). In 2009, the average nominal monthly wage in the 34 Data for the first quarter of 2010 published by SR’s Statistical Office. According to these data the average nominal monthly wages decreased to 725 EUR/month. However, in a|year-on-year comparison with 2009 the wages increased, since the growth index of the nominal wages reached 102,1. This apparent contradiction can probably be explained by the fact, that data for the first quarter do not include the possible nominal wage increases or bonuses usually paid out in the second half of the calendar year.

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economy increased by 3% in a year-on-year comparison against the previous year reaching 744. 50 EUR. However, annual inflation was well under 2%35. Therefore, real wages increased by 1.4%36. Nonetheless, the signs of a crisis were evident. In contrast to 2008, the growth of the nominal wage slowed-down by 5.1 percentage points (p.p.) and the growth of the real wage by 1.9 p.p.. This tendency persisted even in the first half of 2010. A|detailed overview is shown in the following graph: Picture 16: Growth of nominal and real wages during 2008-2010; source: Statistical Office of SR, 2010. 112

110

109.5

110 108

105.8

106

108.8

104.7

104.6

104.8 103.5

102.5

102.8

104 101.7

102 100 98

101.3

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101.6

96

Real wage index

10 1Q

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Nominal wage index

2.5.

Development on the Real Estate Market and in the Area of Mortgage Loans (Mortgage Banking)

2.5.1.

Real Estate and its Development

The steady economic growth especially after 2002 has naturally influenced the growth of property prices as well. In particular in the last years before the financial crisis, the entry of foreign investors to the Slovak market,|radical improvement of 35 In 2009, the inflation has reached 1.6% according to the Statistical Office of SR. 36 Statistical Office of Slovak Republic, Priemerná mesaêná mzda zamestnanca národného hospodárstva v 4. štvrĹroku 2009, (Average monthly wages of employees in the national economy in 4th quarter of 2009), 04.03.2010, http://portal.statistics.sk/showdoc.do?docid=20986 (retrieved on 25 August 2010).

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conditions and the availability of mortgages for housing (together with an undersaturated market) accelerated prices upwards. The property market at that time can most definitely be described as a seller’s market. In the time before the onset of the crisis, virtually any kind of residential or commercial project could be fully sold, or at least reserved in full usually within the starting phase. During this period, finished new flats were practically unavailable as buyers usually financed a|substantial part of the value of a purchased property in the form of an advance payment even before the start of construction. It was not unusual for buyers to pay in advance payments (bound of course to individual construction stages) up to 90% or more of the total price of the property even before its completion. Until around 2000-2001, certain projects were even being realised, various dubious developers declared bankruptcy using fraudulent, but due to the state of the legislation difficult to sanction methods, after collecting the so-called ‘advance payments’ (often more than 50% of the total value of the property) and disappeared without even starting the construction or repaying the collected money. Such cases together with the necessity to solve the urgent question of housing caused various anomalies in the residential market. Prices of older flats, built during the socialist era, increased alongside the prices of new flats. In some periods older flats even exceeded the prices of new ones, despite being rather worn down and barely complying with modern requirements. The development of real estate prices from 2005 until 2007 showed slight growth of prices in all monitored segments. The real estate bubble in Slovakia peaked in the last months of 2007 and first months of 2008. The average prices of housing property in Slovakia peaked in the third quarter of 2008, reaching the level of 1.549 EUR/m2. Compared to 2005, the prices were higher by 80% and compared to 2001 even by 160%. However, in the last quarter of 2008 real estate prices already started to fall.

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Picture 17: Basic and year-on-year index of residential property prices during 2002-2010 (year 2002 = 100); source: NBS, 2010. 300 250 200 150 100 50 0 2002 2003 2004 2005 2006 2007 2008 2009 2010 Basic index

Year-on-Year index

Aside from the real demand for new housing, the price bubble in the real estate market was supported also by demand for real estate for the purpose of a|so-called ‘secure investment’. Such activities were fuelled by the generally spread opinion, often supported by the media, that „it is not possible to suffer loss with an investment in property“. This argument was also propped up by surveys. Historical comparisons showed a|constant growth of real estate prices, interrupted only for short periods of time such as during the first months after Slovakia’s entry into the EU in 2004. However, these short-lived periods of stagnation or a|slight reduction of prices are to be understood only as|logical corrections and a reaction to the periods of increased price growth prior to such events. The determining factor supporting the increase of property prices especially in 2007 and 2008 was also inflation. It was expected by the population in relation to the announced introduction of the euro in 2009. It is difficult to estimate what part of these speculative transactions in the property market was due to the purchase for the purpose of laundering money from illegal activities or the so-called ‘grey economy’ respectively, in an effort to by-pass the regulation upon euro introduction. A|development similar to the development of the housing market could be observed also in the area of commercial property, i.e. office space and shopping centres. Based on previous global trends, constructions of so-called ‘multifunctional

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objects’, including all three of these segments were projected. After the initial uncertain beginnings and tentative undertakings, Slovakia became the target for investments of the major overseas development companies, in particular during the last years following up to the crisis (2005-2007). The competition in the small Slovak market included even at that time already strong domestic developers and financial groups. The media covered announcements of even bigger and more luxurious projects of multifunctional objects or even whole residential quarters. The capital intensity of these projects, heavily covered by the media, amounted quite often to hundreds of millions of euros.37 With the onset of the crisis many of the augured projects were stopped, mothballed or even cancelled completely. For some of the projects from this group onset of crisis could even be considered as fortunate. At the time of the real-estate bubble projects were being prepared and even realised, which under normal circumstances would never have reached the planning stage. In the period from the end of 2008 and during 2009 the developers concentrated in particular on the completion of projects started before the crisis, where the degree of completion for economic reasons prevented their simple preservation. Considering the number and the size of projects finished in such way, even in 2010 no radical shift in the ratio of demand and offer and therefore no rapid growth of property prices can be expected. The statistical data offer several clues38, stating the average price per square meter of residential property at a level of 1.297 EUR/m2 in the last quarter of 2009 and at 1.296 EUR/m2 in the second quarter of 2010. Nonetheless, on a| year-onyear basis, the prices of houses and flats decreased by 8.3%. However, this decrease between individual quarters was only minimal. The prices reverted back to 37 “Twin City multifunctional complex - The total investment costs related to this project are approximately 17 billion SKK (more than 500 billion EUR), which makes the Twin City centre the most significant development project not only in Slovakia, but also in the whole of Central and Eastern Europe.” Slavomír Jankoviê, Twin City, http:// www.hbreavis.sk/en/projekt/twin-city-1 (retrieved on 23 August 2010). “After three years of planning and three and a half years of construction, Ballymore fully opened EUROVEA, a 450 million EUR investment in Bratislava and Slovakia’s largest mixed-use development to date. The new city quarter, spread over an area of more than 230,000m², is now complete and fully open to the public”. Source: “Ballymore fully opens Central Europe‘s biggest development” 28.|April|2010, http://www.europe-re.com/system/main.php?pageid=2616&articleid=16048 (retrieved on 23 August 2010). 38 NBS, Statistic data on average prices of flats and houses, published quarterly by the National Bank of Slovakia based on NARKS data offer a|reasonably detailed overview of the real estate market. However, they monitor only the advertised prices and these are often much higher than the actual realised price, definitely agreed between the seller and the buyer.

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the level reached in the second half of 2007. However, it is worth noting that the trend of falling total average prices for residential property has slowed down somewhat, and we can probably talk about a plateauing of total prices. Some segments or regions even experienced even a|slight price growth, however compensated by a decrease in other segments or regions39. According to the data published by the NBS at the beginning of August 2010 the slight decrease of property prices continued even in the second quarter of 2010 with the average value of real estate at circa 1.293 EUR/m2. Picture 18: Development of prices of flats and houses during 2008 – 2009, source: NBS, using the NARKS data, 2010. 1,800 1,619

1,600

1,600

1,555 1,521 1,447 1,372

1,400 1,266

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1,200

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1,180

1,000 1Q 2008 2Q 2008 3Q 2008 4Q 2008 1Q 2009 2Q 2009 3Q 2009 4Q 2009

Flats

2.5.2.

Houses

Mortgage Financing in Slovakia – Fast Growth before the Crisis and Swift Reactions to the Immediate Situation at the Time of Economic Crisis

The improved access of the private as well as business sphere to bank financing to such investments was the|necessary pre-condition and accelerator of growth in the property market. 39 NBS, Monthly bulletin, April 2010, 2010, pp.|11-12.

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A legislative framework for mortgage loans did not exist in Slovakia until March 1996. Subsequent and as a result of the respective amendment of the Act on Banks40, this change enabled Slovak banks to provide those services. However, mortgage banking did not expand on a|larger scale until the introduction of state aid. Upon introduction of mortgage banking in Slovakia the price of funds for mortgage banking was approximately 20% p.a., resulting in very expensive mortgages and unacceptable conditions for the clients41. In 1999, interest rates on mortgage loans for natural persons ranged from 13.5% p.a. to 17.5% p.a. However, the developments in the capital market gradually stabilised and the rationale for state aid for mortgage loans disappeared. In 2003, interest rates ranged between 5.6% p.a. and 9.95% p.a. The amount of the state support for mortgage loans decreased each year42 and the process gradually aimed at the elimination of state aid. Retrospectively, it can be summarised that „the introduction of the state aid led to a|significant participation of mortgage financing in the financing of housing construction. In 1999, when state aid was introduced, mortgage loans of approximately 600|million SKK| were granted in the area of residential development, in 2002 they had already reached the level of 9.3|billion SKK| and in the first half of 2003, mortgage loans of 15.5|billion SKK| were granted“.43 Particularly in the period prior to the expansion of mortgage loans property became the subject of interest for speculators with| sufficient cash capital. Those speculators were able to realise high net gains before the completion of the respective property, when the property became eligible for a common building or mortgage loan. In the period before or shortly after the completion the price of the same flat was often higher by lofty double figure percentage points compared with the price at the time of project proposal and introduction. This in consequence reduced the number of potential customers who had sufficient financial means to purchase such property. However, this development also illustrated the serious and acute lack of new property in the residential market prior to the onset of the world economic crisis. 40 Act on Banks No. 21/1992 Coll. 41 Július Golej, Analysis of Mortgage Market in Slovakia, Nehnutel´nosti a Byvanie Vedecký êasopis, III. Volume / 2. Issue, 2008, p. 27. 42 The amount of the government compensation of mortgage loans ranged from 6% p.a. and in 1999 up to 2.5% p.a. Since 1 July 1 2003 a|flexible compensation of mortgage loans was introduced. 43 Bonifikácia hypoúverov sa má obmedziĹ na sociálne bývanie (State compensation of mortgage loans shall be limited to housing for social cases); 28 July 2003, http://ekonomika.etrend.sk/ekonomika-slovensko/bonifikaciahypouverov-sa-ma-obmedzit-na-socialne-byvanie.html (retrieved on 25 August 2010).

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In connection with the onset of the world crisis in the second half of 2008 and especially in the first half of 2009, new lending for housing experienced a distinctive drop. While the total volume of new loans for housing decreased in the first half of 2009 by a|third, classic mortgage loans experienced an even more significant drop.44 The reasons for this were two sided. On one hand, the banks significantly tightened their conditions and volumes for the granting of loans in connection with the negative development of economy. On the other hand, the demand for these loans in a time of general insecurity due to the economic situation started to show signs of a|rapid fall. However, already by the second half of 2009 lending for housing purchases had recovered and this trend continued through 2010, thus resulting only in a slowdown in growth when a year-on-year comparison of total volume of loans granted is made45. A greater appeal for this type of lending was driven by lower property prices and by lower interest rates charged by Slovak banks. According to data published by the National Bank of Slovakia and the European Central Bank (ECB), the new mortgage loans granted by Slovak banks in the middle of 2010 had the lowest interest rates. Despite this, in terms of mortgages Slovakia was the most expensive country in the Euro-zone at that time. While the average interest rate for fixed rate mortgages was 2.55%, the Slovak banks granted the same loans at an average interest rate of 4.76%|p.a. A|similar situation occurred also with the annual percentual rate of costs (RPNM) which more closely reflects the actual cost of a|loan, by including not only the interest rate but also the applicable bank charges. A|mortgage in the Euro-zone in May 2010 was on average granted for 3.58%|p.a., while at the same time mortgage loans in Slovakia were on average granted for 5.71%|p.a.46

44 Tlaêová konferencia poštovej banky (Press conference of the Poštová banka), Poštová banka, 7 April 2010; p. 4; http://www.pabk.sk/_img/Documents/ine%5CAko%20sa%20rok%20krizy%20podpisal%20pod%20oblast%20 byvania%20a%20jeho%20financovanie.pdf (retrieved on 4 September 2010). 45 In May 2010, new loans in the amount of 382,984 EUR thousand were granted, surpassing the until then recordbreaking month in volume of granted loans – September 2008. 46 When comparing the RPMN (annual percentual rate of charge) the cheapest mortgages were granted in Slovakia in December 2005, when the amount of RPMN reached 5.47%, especially due to lower charges for the keeping of loan accounts or other bank charges.

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Picture 19: Annual percentual rate of charge for new loans for households – loans for real estate purchase (%); source: NBS, 2010, http://www.nbs.sk/sk/statisticke-udaje/menova-a-bankova-statistika/urokova-statistika/bankova-urokova-statistika-uvery (retrieved on 25 September 2010). 7.50 7.00 6.50 6.00 5.50

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annual percentual rate of charge

In this respect the Slovak banks give prominence to refinancing costs and generally have a higher risk profile for domestic clients, since Slovak customers earn in comparison with customers from Western Europe substantially less, but do not apply for substantially lower mortgages. For this reason the instalment on the mortgage for purchase of a|similar property typically form a much bigger part of the average Slovak wage than for the average Western European customer.47

47 N.N., „Slovensko má najdrahšie hypotéky v|eurozóne“, (Slovakia has the most expensive mortgages ithin eurozone), 24 August 2010, 2010, http://peniaze.pravda.sk/slovensko-ma-najdrahsie-hypoteky-v-eurozone-f37-/sk_ phypo.asp?c=A100824_ 152426 _sk_phypo_p59 (retrieved on 5 September 2010).

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3.

Challenges and Coping with the Financial Crisis

When evaluating the impact of the global economic crisis in Slovakia and the reactions to it, it is necessary to take account of the fact that after a|few years of rapid economic growth, neither the public nor the political elites were willing to admit that this period was simply over and it would be necessary to take unpopular measures. As the repercussions of the crisis became apparent during the second half of the election campaign of the government led by|Róbert Fico, the effort to play down the possible impacts of the crisis on citizens (or voters), at least at a rhetorical level, was particularly evident. Therefore, the measures taken by the government during|the first months of the crisis were to a|great extent determined by the pursuit of success in the parliamentary election in June 2010. Despite such efforts the election success and the chance to form a new government evaded Róbert Fico and his party. Instead, a|radical political change took place, when for the first time in Slovak history a woman, Iveta Radiêová, became head of the government, consisting of right-wing and|mostly liberal political parties. In response to the first manifestations of the global financial and economic crisis, the Slovak government undertook a|set of measures in three phases (November|2008 to April|2009) in order to reduce the impact of the crisis. These measures were initially intended to ensure the stability of the financial sector; later on, their scope was extended to include the financing of businesses, strengthening of demand, reducing unemployment rates and restricting the negative social impacts of the crisis. One of the measures taken was the establishment of the Monitoring Committee of the Impacts of Economic Crisis on Businesses which started to operate in|November 2008. Its task is to monitor the financial and economic impact of the crisis on the business sector in Slovakia and to propose specific measures intended to minimize the negative impacts. The Committee members are representatives of economic ministries, the National Bank of Slovakia, the Statistical Office of the Slovak Republic, organizations associating small, medium-size and large enterprises, trade unions and|municipalities. The Monitoring Committee of the Economic Crisis Impacts on Businesses is a|platform for the discussion about|possibilities of improving the situation in the business sector during the global economic crisis.

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From measures which were taken or already started in 2008, among others the following were positively evaluated: Y

the simplification of the duties of some groups of businesses to provide health care for employees;

Y

the introduction of a bonus for employees on low or minimum wages;

Y

the introduction of deposit protection|up to 100% including smaller enterprises;

Y

the decision to provide funds for the Slovak Guarantee and Development Bank (SZRB) and Export-Import Bank (EximbankA) in order to improve the access of small and medium-size enterprises to financing.48

The individual anti-crisis measures taken already by Fico’s government, some of which are still being implemented and will come into effect by end of 2010, can be substantially divided into three basic areas: Y

Measures concerning finance and economy

Y

Measures concerning business

Y

Measures concerning employment

In the following we would like to describe in more detail, measures that provoked the most response among experts and the public, or received the most attention in the media for other reasons.

3.1.

Measures Concerning Finances and Economy

Perhaps the most extensive and from the business point of view|the most closely monitored measures were the tax measures. Between 2008 and 2010, a|number of amendments to the tax laws were passed within the adopted packages of anticrisis measures. Their primary objective was the effort to reverse the negative impact of the global economic crisis on the Slovak economy by reducing the tax burden of businesses and citizens. Besides these changes, a|number of amendments of legislation in the area of taxes were made, not publicly declared to be direct anticrisis measures. But with their focus on reducing the administrative burden of businesses, on the equalisation of rules in taxation and on the support of the development of business activities, they had the potential to act effectively as measures with anti-crisis nature. 48 Ministry of Economy of the Slovak Republic, National Reform Programme of the Slovak Republic for 2008–2010, Implementation Report 2009, 2009, p. 12.

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The most important measures adopted with the intended or induced effect of reducing the impacts of the global economic crisis on the Slovak economy included: Y

Y

558

Concerning Value Added Tax: –

Shortening of the period for the refund of excessive VAT deductions, which enables, if certain conditions are met (e.g. the non-existence of tax, customs and similar liabilities towards the state), those concerned to apply for the refund of an excessive deduction within 30 days after the end of the taxation period in which the excessive deduction of VAT was made (Otherwise it is necessary to wait till the end of the following taxation period, i.e. the next month or calendar quarter, and| calculate the excessive deduction together with the tax obligation, if there is any, and only when this is not possible, the excessive deduction or its part that cannot be included will be refunded within 30 days).

–

Introduction of the system of group VAT-registration of financially, economically and|organizationally interconnected entities, which enables the members to invoice mutual taxable transactions within the group without VAT.

–

Cancellation of the restriction in claiming input VAT deduction for the purchase or leasing of passenger cars and their equipment.

–

Introduction of the so-called ‘reduced tax rate’ of 6% for the sale of specific agricultural primary products ‘from the farmhouse’ (milk, honey, meat, fish...).

Concerning Income Tax: –

Introduction of tax relief for enterprises carrying out research and development.

–

Cancellation of the planned introduction of the rule of so-called undercapitalization, under which the interest from loans received from specified related persons, would not be allowed as a|deduction for tax purposes; this concerns those loans that exceed six times the amount of the beneficiary’s equity. This measure enables unlimited financing of enterprises from funds within conglomerate groups without the need to search for alternative sources from unconnected entities.

| Maroš Tóth

–

Increase of the entry price of tangible and intangible assets, transfer of asset entries into depreciation groups with shorter period of depreciation, introduction of component depreciation (depreciation of individual separable parts of assets).

–

Increase of the personal allowance between 2009 and|2010.

–

Introduction of simplified tax accounting for small businesses.

–

Extension of the period for filing tax returns for the previous taxation period, and thus also for the payment of the tax, by three months or, in case of overseas income, by no less than six months if the taxpayer decides to do so (all that is necessary for the extension of the period is to file the|notice to the taxation authority; it is not necessary to apply for the extension of the period).

–

Extension of the period during which the tax loss produced can be amortised from five to seven years.

It is quite difficult to evaluate the direct impact of the above measures on the elimination of the effects of the global economic crisis on the Slovak economy. Nevertheless, the effectiveness of many of the intended measures on the business environment was reduced by obstacles in their practical implementation (e.g. in administration, etc.). Measures with the most significant impact are thus considered to be especially those concerning the classification and depreciation of assets or claiming of deductions in their procurement. Cancellation of the planned introduction of the undercapitalisation rule was an important measure as well. In the area of taxation of natural persons, the increase of the personal allowance could help to maintain overall private consumption of those population groups that were not affected by the increase of unemployment. Considering the fact that the global economic crisis also had negative influence on the public revenues of the Slovak Republic, besides the above measures, various laws were amended in the tax regime in the period 2008-2010. The objective being, to secure budget revenues, by means of increased taxation of business. For example tightening the rules for the use of adjusting entries allowed as a|deduction for tax purposes, introduction of the obligation to impose tax on liabilities that have been due for more than three years, increase of fines and sanctions for the breach of obligations in the area of tax (introduction of minimum sanctions independent of the European Central Bank interest rates), etc. can be considered as such measures. The efforts to secure additional tax revenues of the state also became evident in the increased number of tax controls, as well as in the increase of the number of decisions issued by tax authorities, the main goal of which was to sanction taxable

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subjects for the breach of obligations for years for which the right to impose taxes would soon expire. Many of the above measures eventually made the already difficult position of many companies even worse. The measure that would certainly make it to the top rating positions in the opinion polls or eventually became the symbol of the government anti-crisis measures was the so-called ‘car scrapping subsidy’ (‘šrotovné’): Like a|number of other countries, Slovakia adopted a|car allowance rebate system, the ‘car scrapping subsidy’, i.e. subsidy for the purchase of new passenger cars for those who have their old car scrapped. The government launched the program in spring 2009 after the sales of new cars slumped in the beginning of the year due to the economic crisis. Those who scrapped their car (which had to be older than ten years) became eligible for the subsidy. Funds of 55.25 EUR million were earmarked for the program which corresponded to 44,200 scrapped vehicles in the first and second round. Subsidies of 1.500 EUR were paid out in the first round and in the second round (which was not initially envisaged) they were reduced to 1.000 EUR. The advantages of the car scraping subsidy san be summarised as follows: Y

promotion of new car sales;

Y

improvements in road safety and|environmental aspects, as the car scrapping subsidy helped refresh the obsolete car fleet;

Y

the registration fees increased the general government revenue;

Y

the overall contribution to the public finances resulting from the difference between the subsidy paid out and the amount of the VAT received from the sale of new cars.

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Picture 20: Age of scrapped cars; source: Automotive Industry Association of the Slovak Republic - ZAP SR, 2010, www.zapsr.sk (retrieved on 25 August 2010). 3,683

4,920

4,842

8,655

cars of 25 years and older

cars from 20 to 25 years

cars from 15 to 20 years

cars from 10 to 15 years

Disadvantages might include the fact that the car scrapping subsidy cannot be considered a|systemic anti-crisis solution. Even though the demand for new cars increased in the short term, the sale of used cars was halted at the same time. A|shortfall in VAT collection is likely to occur in 2010 and 2011 due to the fact that those who were interested in buying a new car in the coming years moved their purchase forward to 2009. A| lot of discussion in this respect was also going on concerning the|amount of the total financial effect of the car scrapping subsidy on public finances. However, the numbers generated were completely different on the part of opponents and supporters of the measure, and were dependant on what variables were taken into account for calculation and how the results were interpreted. Even though one of the reasons for the adoption of car scrapping subsidy scheme was claimed to be an effort to promote the creation of new jobs or protection of the existing ones, such a|direct effect is hard to imagine. Most allowanc-

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es were spent on automobiles that were imported into the country.49 On the other hand, we cannot omit to say that besides Slovakia, the ‘car scrapping subsidy’ was also adopted in other countries that are export markets of car producers or contractors producing in Slovakia, so at least partially an opposite effect occurred, i.e. the car scrapping subsidy schemes in these countries increased the sales of cars and components made in Slovakia and the preservation of domestic jobs was indirectly supported. To some extent the argument that Slovakia should make a|gesture of solidarity to other countries that introduced the car scrapping subsidy had some weight as well. From the point of view of politicians, the introduction of the car scrapping subsidy was also influenced by the fact that the measure was widely publicised in the media and acclaimed by a|large part of the population – or voters! The ‘Program for Promotion of Biomass and Solar Energy Use in Households’, an objective of which is to promote installation of biomass boilers and solar collectors for heating and water heating for houses and flats, is of a similar nature. The program provides subsidies for solar collectors and biomass boilers. With respect to the high initial investment in these environmentally friendly sources of energy, which restricts their wider use, these subsidies can help reduce the investment costs to an acceptable amount. The declared ‘Thermal Insulation Program Support’ is worth attention as well, because of its extent. Under specified conditions, it is possible to receive financial aid for an apartment building thermal insulation from the State Housing Development Fund. The aid is available in two basic forms: Y

the granting of credit for this purpose under advantageous conditions;

Y

non-repayable financial contribution.

This program quite effectively supports the trend of energy saving and could have positive effects on the energy consumption of households in the long term.

49 SITA – The introduction of car scrapping subsidy in Slovakia has helped foreign car producers much more than the domestic ones. The results are based on an analysis by UniCredit Bank which claims that in March 2009, the percentage of cars made in Slovakia and bought by consumers was about 15%. Last year the share was 13.2% during the same month. “If we put it simply, we could say that 85% of the car scrapping subsidy supported mainly the production abroad”, said bank analyst Dávid Dereník.

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3.1.1.

Stabilization Aid for Banks

A new Act no. 276/2009 Coll. modified the conditions under which the state can grant the so-called ‘stabilization aid for a bank’ that finds itself in an unfavourable financial situation due to the global financial crisis. The goal of the stabilisation aid is to reduce the transfer of global financial crisis impacts from the banking sector to Slovak economy and to strengthen the conditions for preserving the stability of the financial system as a|whole. However, it should be stressed that this legal norm is more of a|preventive nature, as none of the Slovak banks got into existential problems as a|result of the financial crisis. 3.1.2.

The Program of Providing Help to Citizens who are Defaulting on Housing Loans

The Slovak government adopted a ‘Subject Plan for the program of providing help to citizens who are defaulting on housing loans’ as a|result of the economic crisis. It should prevent people who have lost their jobs because of the crisis to lose their homes as well. Although, the above measure received a|lot of publicity from government representatives as well as the media, this tool is actually not used in practice for various reasons, such as the relatively strict criteria or administrative demands. Since 1 December 2009, the ‘Act on Some Measures Related to Strategic Companies’ is in force. Under this act, the Slovak Republic has the pre-emptive right to purchase the property of so-called ‘strategic companies’, the property of which is subject to bankruptcy. The goal of this measure is primarily to preserve the operation of a|strategic company in order to prevent the situation in which the basic needs of the population (e.g. supplies of water, gas, heat, etc.) would not be secured as a|result of the economic problems of such a|company. It is one of the most widely discussed measures, mainly because of arguments whether it was just an|intentional legislative initiative meant to protect specific companies that found themselves on the brink of bankruptcy50. Another measure related to the strategic companies is the duty of the insolvency practitioner of the strategic company to ensure the operation of the company and to prevent unjustified mass lay-offs. Since the above measures have been adopted in connection with the global financial and economic crisis, they are only temporary and the applicable provisions will expire on 31 December 2010.

50 Especially the company Novácke chemické závody, a.s. was cited in this connection.

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3.2.

Measures Concerning Business

In order to support business, conditions the applicants for investment aid have to meet became softer for a|transitional period. It means in practice: In case of applications for investment|subsidies filed before 31 December 2010, the minimum limits required for their granting (e.g. the total value of the investment, the share of new acquired production and technology equipment from the total value of the specified acquired long-term tangible and long-term intangible assets) are reduced by one half. Understandably, this measure substantially extends the range of investment projects that can compete to receive the investment aid. As far as contributions to health and social insurance funds are concerned, the following measures bringing temporary reduction of the contribution burden on enterprises should be noted in particular: Y

The amount of contribution to the Reserve Fund of Solidarity is reduced from the existing 4.75% of the assessment base to 2% for self-employed persons. This measure is effective from 1 April 2009 to 31 December 2010.

Y

The period of paying the employer’s accident insurance contributions at a|single rate of 0.8% of the assessment base was extended to 31 December 2011.

3.3.

Measures Concerning Employment

With respect to the fact that Fico’s government often described itself as a|leftwing and socially oriented government, much attention, at least at the declaratory level, was paid to the preservation employment. These measures include: 3.3.1.

New contributions in order to preserve existing jobs and create new employment

A|number of new cash benefits provided by the Offices of Labour, Social Affairs and Family in order to contribute to the preservation of the existing jobs and to create new ones were introduced. Requirements for awarding the status of a social enterprise were temporarily moderated. Social enterprises are eligible to receive contributions of up to 50% of the total labour cost calculated from the average monthly wage of an employee in the economy of the SR from the first to third quarter of the|calendar year before the calendar year in which the contribution is provided.

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The status of a|social enterprise can be awarded to a|legal or natural person, who: Y

provides employment to people who were disadvantaged job seekers before entering the employment relationship (particularly graduates, the long-term unemployed, people more than 50 years old, disabled citizens, aliens who have been granted asylum, etc.) at the rate of at least 30% from the total number of employees;

Y

provides support and help in finding a|job in the open labour market to employees who were disabled job seekers before entering the employment relationship;

Y

uses at least 30% of the finances received from the income in the scope of activities that remain after the payment of all expenditures in the scope of activities for the relevant taxation period according to the tax return for the creation of new jobs or improving the working conditions every year;

Y

is listed in the register of social enterprises maintained by the Central Office of Labour, Social Affairs and Family.

In connection with the global economic crisis, the conditions for the purpose of awarding the status of a|social enterprise according to the above points 1–3 are considered to be met if the legal or natural person applies for granting the status of social enterprise before 31 December 2010. 3.3.2.

Contribution for the Graduate Practice

As a result of a more difficult employment market for graduates, access to the Contribution for the Graduate Practice was simplified. In order to be eligible for the Contribution for the Graduate Practice, from 1 November 2009 to 31 December 2010 the job seeker is not required, besides meeting other conditions, to be on file in the register for at least three months, but the entitlement to the contribution already applies from the date when the decision of listing in the register becomes effective, as long as other specified conditions are met.

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3.3.3.

Contribution for Self-Employment

From 1 December 2009 to 31 December 2010, the job seeker is not required to be on file in the register of job seekers for at least three months in order to be entitled to the ‘Contribution for Self-Employment’. The entitlement to this contribution begins, as long as other specified conditions are met, already from the date when the decision of listing in the register of job seekers becomes effective. Such simplification of the conditions only applies to job seekers who are less than 25 years old, who completed the continual professional training in a full-time form of study less than two years ago and haven’t started a regularly paid employment yet.51 Most of these government measures have the character of contributions, benefits or other forms of financial support, as is evident from the above summary. The previous government tried to use these measures partly to boost demand in the economy, whereas their possible adverse impact on the national budget or public finances was not considered to be a|substantial limiting factor. This resulted in the growth of public spending together with the reduction of GDP. That meant a|very rapid growth of the gross public debt in 200952 and this|unhealthy tendency also carried over into the first months of 2010. In that period of time the state budget deficit, according to the data published by the Ministry of Finance of the SR, amounted to 2.44|billion EUR| as of 30 June 2010, i.e. almost 2/3 of the planned annual deficit of 3.75|billion EUR. Compared to last year, the state budget deficit thus increased more than two times and the|Finance Ministry estimated in June an increase in the expected deficit of the public finances (the state budget is their substantial component) from the planned 5.5% of GDP to 6.98%. In an international comparison, however, the position of Slovakia is not even critical and the|government measures taken so far were received positively at the international level. In its assessment from 18 June 2010, the European Commission assessed the measures taken by a|group of countries, including Slovakia, in response to the Council’s recommendations from 2 December 2009 in connection with the elimination of their excessive general government deficit.53 The Com51 N.N., Opatrenia na boj s globálnou ekonomickou krízou. (Measures for fighting the global economic crisis) Ústredný portál verejnej správy http://portal.gov.sk/Portal/sk/Default.aspx?CatID=39&aid=2159 (retrieved on 20 August 2010). 52 The total gross public debt of the SR achieved 35.7% HDP in 2009. 53 In this recommendation, Slovakia was asked to start the consolidation of public finances in 2010 in line with its national plans and to eliminate the excessive deficit (above 3% of GDP) by 2013.

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mission stated: “The Slovak authorities have implemented several deficit reducing measures in 2010, which are expected to result in a sizeable improvement of the structural balance amounting to 1.2% of GDP.” Whether this forecast was correct is obviously a|question for the future, but its attainment does not mean that the problems connected with the crisis will be solved. The government that was established as a|result of the parliamentary election in June 2010 is thus faced with a|truly daunting challenge: it tries to stimulate the economy through suitable anti-crisis measures and, at the same time,|tries to reverse the trend of increasing national debt, as the government has resolved in its Policy Statement, where the consolidation of public finances is one of the priorities. Due to the fact that the Slovak Parliament only passed the government’s Policy Statement on 10 August|2010, the definitive package of specific measures that will be put into practice is not yet available. However, at least some of the objectives concerning the economic policy can be identified in the government’s Policy Statement. 3.3.4.

Public finances

It is a|substantial objective of the Government of the Slovak Republic to reduce the public finances deficit to below 3% of GDP in 2013, so that Slovakia can fulfil its commitments towards the EU following on from the Stability and Growth Pact. Most of the measures necessary to reduce the deficit will be effective from 2011. Currently, there are feverish discussions about the ways of achieving this objective both at a political level and in the media. As a|matter of fact, the 1,6|billion EUR| by which the deficit is to be cut next year can only be achieved by a|set of measures on both sides of the budget Ũ on both the revenue and expenditure side. The government declared that it would maintain the flat income tax and not increase its rate. The potential increase in income tax rate can only be connected with the cancellation or reduction of some contributions. The government will audit the existing exceptions in the Income Tax Act and other|acts on taxes with the view to significantly reduce their number.

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The government has resolved to pass a|substantial reform and simplification of the contribution system with the goal of making the system more effective. A|longterm objective is the introduction of a so-called ‘contribution bonus’54 if the situation of public finances makes it feasible. The government also declared that it would simplify the tax return and other reports and reduce the number of forms and reports. A plan to simplify the payment system, especially by eliminating stamp fees and introducing the possibility|to pay in cash or by payment cards at the offices, was announced as well. 3.3.5.

Business Environment

The government announced that it would abolish legislation attempting to regulate the market environment unsystematically and affect the results of voluntary agreements, such as the Chain Stores Act, Strategic Companies Act or selected provisions of the Commercial Code, etc. The government declared the effort to facilitate business, reduce red tape in all its phases – registration, business activity, business closure or transfer of business activities to another person. Through introduction of information technologies in the state and public administration, the government wants to eliminate multiple requests for information, documents and data from businesses. An intention to interconnect public registers – taxes, social affairs, healthcare, cadastre, etc. – and analyze the possibility|of assigning single identification to business entities with the goal of reducing red tape was declared as well.

54 This problem was addressed in more detail by Richard Sulík, President of the Freedom and Solidarity Party (Sloboda a|Solidarita – SaS), currently the Speaker of the National Council of the Slovak Republic. SaS wanted most of the 13 contributions to the Social Insurance Agency and health insurance agencies to be substituted with two contributions – 9% social insurance and 9% health insurance contribution. These would be calculated from the so-called super-gross wage, where the employer’s insurance contributions are added to the employee’s gross wage. At the same time, each citizen would be entitled to a|basic benefit from the state – the contribution bonus at the level of the subsistence minimum – currently 185 EUR. The workers’ contribution bonus would be reduced by the amount equal to ten percent of their income. SME, SAS vraj nepresadila odvodový bonus (SAS allegedly did not push the contribution bonus), 2010, http://ekonomika.sme.sk/c/5432316/sas-vraj-nepresadilaodvodovy-bonus.html#ixzz0y0dYazXt (retrieved on 24 August 2010).

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The government said that strategic enterprises would not be privatised. However, it would support all actions to make the operation of selected enterprises with the state’s|participation more effective. This includes the denationalization of heating plants or remaining shares in enterprises with the government’s influence, for example in the bus transport. 3.3.6.

Investments and|Regional Development

In its Policy Statement, the government observed that investments came to Slovakia unevenly and what is more important: their growth had slowed down under the influence of the economic crisis and|a deteriorating business environment. In order to remove regional differences within the European Union, it is necessary to continually support the growth of investments also within Slovakia, especially in lagging regions. Therefore, the government set the goal to make the rules for providing investment aid clearer, so as to support the creation of jobs in areas with a high unemployment rate,| the increase of value added in industry and| the transfer of the latest knowledge into practice. As one of the possibilities to assist in the achievement of this goal, the Policy Statement claims that the government will carry out pilot reference projects for lagging regions and regions with high unemployment rates in order to attract investments, in cooperation with the incoming or existing investors.

3.4.

Regional Differences and their Elimination – Even a Bigger Challenge after the Impact of the Global Crisis

The difficulty of the challenge that the government is faced with in the area of eliminating regional differences is more closely documented in the following text. It describes the significant differences in how the crisis was felt in|Bratislava and in the western part of Slovakia Ũ in comparison to its impact in other regions, especially in Slovakia’s south and east. The capital city’s dominance and edge over other regions Ũ whether in terms of income s, job opportunities, influx of foreign investments or overall standard of living Ũ became even bigger as a consequence of the global crisis.

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3.4.1.

Regional Differences in Unemployment and|Average Wages during the Crisis

Even though the national level of unemployment in Slovakia substantially decreased during the period before the crisis, this fact was not reflected in all regions of Slovakia to the same extent. Before and during the crisis, the highest rates of unemployment were in the eastern regions (Prešov region, Košice region) and|partly in central Slovakia (Banská Bystrica region). The differences in the unemployment rates between the regions of western Slovakia (especially the Bratislava region) and the above regions|with a high percentage of unemployment was caused mainly by the influx of foreign investments into Western Slovakia and the according job generation brought about by it. Government of the Slovak Republic tried to react to the given situation with consistent program budgeting, with a|new act on the support of regional development, extending the rights and responsibilities of self-government and by using the state financial aid or directly through the financial support of the construction of industrial parks.55 The|faster increase in unemployment in eastern and central Slovakia can also be connected with the fact that before the crisis, many of the inhabitants worked in Western Slovakia or abroad (especially in the Czech Republic) in the construction sector or industrial production. However, if these workers did not officially change their permanent place of residence and then lost their jobs due to the crisis, it showed in the statistics of labour offices in the regions that they come from.56 The development of unemployment in the individual regions of Slovakia during the crisis can be observed in the following graph, derived from the data of the Statistical Office of the Slovak Republic:

55 Sibyla Pavel, Regionálne rozdiely vláda neznížila (The government failed to reduce regional differences), in: Trend, 2 April 2010, http://ekonomika.etrend.sk/ekonomika-slovensko/regionalne-rozdiely-vlada-neznizila.html (retrieved on 13 September 2010). 56 Ibid.

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Picture 21: Unemployment rate in %; source: Statistical Office of the Slovak Republic, 2010. 22

Bratislava Region

20

Trnava Region

Unemployment rate in %

18

Trenþín Region

16 14

Nitra Region

12

Žilina Region

10 8 6

Banská Bystrica Region

4

Prešov Region

2

Košice Region

0

2006

2007

2008 year

2009

SR in total

Naturally, the different level of unemployment or employment in the individual regions is connected directly with the level of wages achieved in these regions. The overall increase in average wages proportionally determines the increase in differences among regions with higher and lower average wage. The Bratislava Region clearly dominates the level of average wages, which is also evident from the following graph.

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Picture 22: Wages in EUR; source: Statistical Office of SR, 2010, http://portal.statistics.sk/showdoc.do?docid=1802 (retrieved on 19 September 2010). 1000 950

Bratislava Region Trnava Region

900 850 800 750

Trenþín Region

700 650 600 550 500 450 400

Žilina Region

Nitra Region

Banská Bystrica Region Prešov Region Košice Region SR in total

2006

2007

2008

2009

year

3.4.2.

Real Estate

The regional differences within Slovakia were also evident in the property sector due to the differing levels of purchasing power within the population and these significant differences had been visible for quite a while before the onset of the crisis. In the capital city of Bratislava, numerous large projects for housing, shopping centres and office business could already be noticed by the turn of the millennia. In other regions, especially in the east and south of Slovakia, more significant projects only started to appear during the last four-five years prior to the onset of the crisis. These announced projects were usually connected with the arrival of a significant foreign investment in the given region, which was accompanied by expectations of demand for more housing. However, these expectations did not always fully meet reality. The supply of new flats in the regions was often confronted with insufficient purchasing power of the population and that is why a|lot of projects that were planned in the given region in connection with the arrival of foreign investors were not carried out at all or were carried out to a|much smaller extent than originally planned. However, as a|result of the general real estate boom especially between 2005 and 2008, the gradually widening supply of mainly new shopping centres, as well as housing properties, could also be observed in regions outside Bratislava. Howev-

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er, in the residential market the supply did not always meet the requirements of the future customers for the overall size and the corresponding adequate price of the properties. This disproportion between the character of the supply and the requirements of those interested in a new housing became even deeper with the onset of the crisis. When it began the construction of new flats in the regions was practically limited to finishing projects started already prior to its onset. Picture 23: Development of prices of residential property according to regions during 2002-2010 (in EUR/m2); source: NBS, on the basis of NARKS data, 2010. 2,500 2,000 1,500 1,000 500 0 2002

2003

2004 BA ZA

2005

2006 TT BB

2007 NR KE

2008

2009

2010

TN PO

After the beginning of the crisis, huge differences between the property prices of the individual regions still existed in Slovakia. The average price for one square meter of a property in the cheapest Nitra Region at the end of 2009 was only about 1 /3 of the price for the same space in Bratislava. In this way, these numbers relativise the above differences in incomes or average wages in the individual regions to a|certain extent. The indicator of economic availability of housing57 points out the fact that the inhabitants of the Bratislava region can only afford to buy 0.55m2 of a|flat from their average monthly wage, whereas the inhabitants of the Nitra Region can afford no less than 0.88m2 of a|flat. The order of regions according to this parameter is thus reverse to the order in case of average wages. The lower property prices and the official growth of wages for 2009 also increased the indicator of economic availability of housing everywhere in Slovakia. However, this growth 57 Economic availability of housing indicates what part of a|property (in m2) people can afford from their gross monthly wages.

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is relative, since especially in the first half of 2009, the group of people who could at least consider buying a|property at the given time narrowed as a repercussion of the crisis.58

4.

Outlook for the Coming Years

The introduction of the euro in the|Slovak Republic on 1 January|2009 provided a|possibility to verify various theories and hypotheses on the|reaction of economy to such a| step in practice. However, the case of Slovakia is a| unique situation, where the economy tries to react at the exact time it is being attacked by the impacts of the global economic crisis. It is probably still too early to evaluate this step as positive or negative; in the future, this process will certainly become a|subject of studies and researches which will have statistical data for a|longer period at their disposal. It will be certainly interesting to evaluate whether as an after-effect of the introduction of the euro the impact of the crisis was more painful for the Slovak economy or the opposite – it is this measure that will help the Slovak economy to cope with the crisis. However, the introduction of the euro cannot be judged only from the point of view of its influence on overcoming the crisis, as the consequences to the economy are long-lasting and they will|be active even after the end of the global economic crisis. However, it is necessary to take account of the fact that after the introduction of the single currency, Slovakia is no longer able to react to the economic situation by means of an independent policy in monetary issues and the European policy of the European Central Bank (ECB) must be followed in this respect. Considering the fact that the Slovak economy is one of the smallest in the European Union59 and, at the same time,|it is characterized by a|high degree of functional openness. It should be noted that even in case of optimal measures taken by the government and NBS, it cannot be expected that Slovakia will cope with the crisis independently of world developments, and especially| the developments in 58 Poštová banka, Tlaêová konferencia poštovej banky (Press conference of the Poštová banka), 7 April 2010, http://www.pabk.sk/_img/Documents/ine%5CAko%20sa%20rok%20krizy%20podpisal%20pod%20oblast%20 byvania%20a%20jeho%20financovanie.pdf (retrieved on 25 August 2010). 59 The Slovak Republic had a|population of 5,42 million as of|1 January 2010.

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the|European Union. The relatively small domestic market is not able to absorb the goods and services produced in Slovakia to the extent that would make it possible to consider more extensively the domestic incentives for the recovery of an entire economy. Even the best measures of the Slovak government can therefore only to a|marginal degree reduce the impacts of the global crisis and|prevent their disproportional distribution on various classes of population, regions, or various segments of economy. Recovery of the considerably export-oriented economy depends directly on the recovery of the demand in the most important customer markets of Slovak producers. These include European countries led by|Germany, with its market being the destination of more than one fifth of total Slovak exports in 2009.60 Picture 24: Biggest customer countries in 2009 (%); source: Statistical Office of the SR, 2010. Italy; 6.1%

Poland; 7.2%

Austria; 5.8%

Hungary; 0,063

Germany; 20.1%

Others; 25.4%

France; 7.8%

Russia; 3.6% Great Britain; 0,048

Czech Republik; 0,129

From this point of view, notable positive news is feeding through, as the Eurozone, according to Eurostat, achieved a|growth rate of 1% in the second quarter of 2010. In a year-to-year comparison with the second quarter of 2009, GDP of the Euro-zone even grew by|1.7%. For the above reasons, the information about the development of Germany’s economy is particularly favourable for the Slovak economy. Germany, according to the data published by Eurostat, saw a| year-to-year growth of GDP of 3.7% in the second quarter of 2010. 60 Statistical Office of the Slovak Republic, Celkový vývoz a|celkový dovoz podĘa ekonomických zoskupení (Total export and total import according to economic groups), http://portal.statistics.sk/showdoc.do?docid=21403 (retrieved on 4 September 2010).

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This positive trend can also be felt immediately in the Slovak economy which, compared to last year, even grew by|4.6% according to an express estimate of the Statistical Office of the Slovak Republic in the second quarter of 2010. This was the fastest growth in the European Union in the given period. In this case, the close relationship between the extent of the openness of the economy and the global economic situation, where any positive or negative movement on the global scale is usually also reflected even more strongly in the Slovak economy, proved to be genuine. Therefore, in the case of general economic recovery, a high level of functional openness of the Slovak economy will probably be an advantage. Of course, when evaluating the data|on|economic growth, we must take the baseline for the comparison that we work with into account: As already stated in the previous text, the first half of 2009 was very difficult in Slovakia and the impact of the crisis was perhaps somewhat more marked than in the neighbouring countries. Picture 25: The fastest growth of GDP in the EU; source: investujeme.sk, 2010, http://investujeme.sk/clanky/hdp-rastlo-v-druhom-kvartali-o-4-7-stalych-a-o-4-9-a-beznychcenach/ (retrieved on 25 September 2010). 5% 4% 3% 2% 1% 0% Slovakia

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Germany

Sweden

Estonia

Czech Republic

An unanswered question still remains whether these positive numbers already mean the first signs of a|turn and|indication of an approaching end of the global economic crisis or only a|short break in the sequence of unpleasant news Ũ and the crisis will strike again with a|new intensity. Analysts are currently concerned especially about the uncertainty regarding the development of the economies in|the USA and| China. If the existing risks regarding these two giant world economies prove to be true, it is obvious that the adverse impacts would be felt in the Slovak economy within a|short space of time. However, from the current point of view, we can be delighted that positive news (at least for now) is arriving and by some|measures, even exceed the predictions about growth of the Slovak economy for 2010, published for example by the Institute of Financial Policy at the Ministry of Finance of the Slovak Republic. These predictions were also evaluated as realistic by the Committee for Macroeconomic Forecasts61 at its session on 9 June 2010.

61 As part of the effort to achieve more transparency and objectiveness of macroeconomic forecasts, MF SR approached eight independent institutions (ING Bank, Tatra banka, SLSP, INFOSTAT, VÚB, SAV, NBS, éSOB) that attain good results in this field and founded the Committee for Macroeconomic Forecasts. The committe holds a|meeting regularly two times a|year, before the drafting of baselines and finalization of the state budget draft and flexibly as needed before the preparation or update of the convergence programme of SR. The objective is to discuss the provisional forecasts of MF SR that can be subsequently modified following the prevailing opinion in the committe. The results also include the overall evaluation of the character of the forecast of MF SR, i.e. whether it is conservative, realistic or optimistic. Ministry of Finance of Slovak Republic, Výbor pre makroekonomické prognózy, 14 September 2010.

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Picture 26: Forecast of macroeconomic development of SR in 2010 – 2013 (selected indicators); source: IFP, 2010, http://www.finance.gov.sk/Default.aspx?CatID=112 (retrieved on 15 September 2010). No.

Indicator

1. GDP; in current prices 2. HDP; real growth 3. Average monthly wage in economy (nominal growth) 4. Average monthly wage in economy (real growth) 5. Average employment growth, according to ESA95 6. Average unemployment rate, according to VZPS 7. Consumer price index (average growth) 8. Harmonised index of consumer prices (HICP) 9. Current account balance 10. Gross fixed capital formation (real growth) Export of goods and services 11. (real growth) Import of goods and services 12. (real growth)

unit

2008* 2009* 2010

billion € % %

2011

2012

2013

67,22 6,2

63,33 -4,7

65,38 3,2

69,77 3,8

75,11 4,5

81,07 4,6

8,1

3,0

1,9

4,5

5,7

6,2

%

3,3

1,3

0,5

1,5

2,1

2,2

%

2,8

-2,4

-1,4

0,7

1,3

1,4

%

9,6

12,1

13,6

12,7

12,3

11,3

%

4,6

1,6

1,4

3,0

3,6

3,9

%

3,9

0,9

1,0

2,8

3,5

3,7

% GDP

-7,0

-3,2

-3,5

-3,9

-3,5

-2,2

%

1,8

-10,5

6,7

3,8

4,4

3,3

%

3,2

-16,5

12,8

9,2

7,0

6,6

%

3,1

-17,6

13,5

8,7

6,1

7,7

* actual numbers.

It is obvious from the above forecasts that the Slovak economy (the growth of which can already be observed in 2010) should have recovered all the losses in economic growth by 2011 and overhaul in absolute terms the economic output from the last peak in 2008. This growth of the Slovak economy, supported mainly by the growth of both export and import of goods and services, will be (with some delay) followed by the unemployment numbers: new jobs will be created slowly and the level of unemployment will gradually decrease. However, according to this forecast, the unemployment rate won’t fall to the pre-crisis level of 2008 until 2013. Yet this fact, which is unfortunate if viewed isolated, has a positive twist to it (also confirmed by the latest statistical data): the labour productivity is going to grow and, according to forecasts, it should keep growing together with the growth of econo-

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| Maroš Tóth

my. Here it should be noted that the reaction in the labour market at the time of the crisis clearly highlighted out the structural weakness of the job market crystallising a low labour efficiency which was only justified through the low unit cost of labour. From the long-term point of view, it is obvious that the continuous success of the Slovak economy in international competition cannot be based solely on low costs, but mainly on quality and advanced level of the goods produced and services provided. Thus, it will be necessary to reassess the current structure of the economy which is focused on a|relatively limited range of sectors, where the dominant part is played by the automotive and|electrical engineering industry. It must be an objective of economy policies to greatly increase the proportion of sectors with a|high level of added value, which are threatened by these fluctuations to a|much lesser extent. From the above forecast it is clear that because of the higher expected rate of both import and export in relation to|GDP, the openness of the economy will keep growing. This obviously also means difficulties in the form of a future reappearance of the situation where this type of extremely open economy reacts unfavourably to fluctuating external economic events. However, with respect to the size (or rather ‘small size’) of the Slovak economy, this process is probably irreversible, despite the expected strengthening of the domestic demand in connection with the growth of the standard of living. The question as to how and to what extent the society will cope with the substantial economic differences between the most developed and underdeveloped regions remains a big unknown. Nowadays, nobody probably doubts the fact that this process will be difficult in terms of finances and time. The global crisis will most likely increase the regional differences to a greater extent. From the longer-term point of view, the ongoing global financial and economic crisis cannot be viewed entirely in a bad light. Apart from its negative consequences, the crisis has been helpful in introducing equilibrium in the economy and adjusting the expectations of those involved in the individual markets to become more realistic. At the same time, it has helped liberate the market from issues that distorted it through their ill-formed influences and which engendered an environment for the crisis to emerge. In this context, the term market must be viewed in the widest sense of the word. As the ongoing global crisis has not only forced the individual governments, regulation authorities, financial and industrial conglomerates, to revise their seemingly unshakeable attitudes and established objectives, it has also had the same effect

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on individuals, who will correct (at least subconsciously) their behaviour based on this experience Ũ and reassess the importance that they attach to the various social, material and spiritual values in their lives.

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| Maroš Tóth

Ukraine: Impact and Recovery from the Crisis Klaus Kessler

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1.

Situation before the Crisis

1.1.

Economic Environment in Ukraine

The Ukrainian economy was on the rise immediately prior to the global financial crisis. The average annual growth rate was 7.5% in the country’s national economy since 2000 up till the third quarter of 2008. Respectively, the government was practicing rather moderate tax policies with the budget deficit going above 1.5% of the GDP only once (i.e. in 2004, the year of the presidential elections). Country’s external debt was also decreasing. Considerable demand of international markets generated by dramatically growing developing economies had facilitated Ukraine’s export, which also showed record-breaking growth rates. On the negative side, significant growth of imports resulted in negative foreign balance which has been forming in Ukraine since 2006. However, extensive inflows of foreign capital largely covered cash-flow deficit (for instance, net annual DFI inflow to the Ukrainian economy averaged 8 billion USD during 2005-2008). It enabled the National Bank of Ukraine to accumulate foreign currency reserves of 37 billion USD as of the end of September 2008. In 2003 Ukraine ranked 6 to its GDP growth rate (9.6%) among the 28 European and Asian economies hit by the post-socialist market transformation, and it managed even to make it to the top line in 2004 (12.1%). Although it retreated to the second-last place in the rating according to that indicator (2.7%) just a year later, in 2005, the situation has been steadily improving in subsequent years. Picture 1: GDP growth rates in Ukraine in 2000-2008; source: State Committee of Ukraine, 2010, http://www.ukrstat.gov.ua (retrieved on 14 August 2010). 2000 2001 2002 2003 2004 2005 2006 2007 2008 Overall GDP growth, %

5.9

9.2

5.2

9.6

12.1

2.7

7.1

7.3

5.5

Before the crisis Ukraine’s banking sector with 184 banks shown accelerated growth. Assets of the Ukrainian banks grew from 603 billion UAH up to 926 billion UAH (55% growth) in one year only and equalled 97.5% of the nation’s GDP – higher than anywhere else in the CEE. Notably, top ten banks were controlling in fact about 50% of all assets in the banking sector. At the same time the lending volumes were growing at dramatic rates and loan funding became available to borrowers on quite liberal terms and conditions (absolute lending volumes grew from 492 billion UAH to 792 billion UAH). Deposit portfolio was growing as well, having increased by

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J. Jungmann, B. Sagemann (Eds.), Financial Crisis in Eastern Europe, DOI 10.1007/978-3-8349-6553-0_11, © Gabler Verlag | Springer Fachmedien Wiesbaden GmbH

almost 30%. In addition, foreign capital was expanding pro-actively to Ukraine’s banking sector. Non-Ukrainian banks accounted for more than 50% of the overall banking assets. The banking sector attracted 43% of the 2008 foreign investments to the Ukrainian economy. Increase in net income of banks reached 7.5 billion UAH. Banking income breakdown before the crisis was as follows: interest income accounted for 77.10%; commission fees for 14.67% and other incomes for 8.24%. Corporate loans accounted for 46.93% of the total interest income; retail loans for 32.65%; income on securities for 2.5%; income on transactions with subsidiaries – for 12.88%; placements with other banks – for 4.9% and other transactions – for 0.13%. The above impressive progress was achieved by the banking system during the period when the nation’s economy was generally on the rise, inflation rate was high and consumption was increasing at truly dramatic rates. Thus, the GDP grew 6.7% during January to September 2008 whereas the income of the population increased by 13.4% during the first half of that year. As the nation’s balance of payments demonstrated a positive pattern and therefore domestic market offer exceeded demand for foreign currencies, in May 2008 the official UAH to USD exchange rate fell by 3.96%, reaching the level of 4.85 UAH for 1 USD at the end of August 2008. As discussed above, Ukraine’s economy was growing at a stable rate throughout five years prior to the financial crisis. The industrial sector was growing throughout the pre-crisis years – registering higher growth rates in exports-oriented industries. More specifically, production growth was accelerating stepwise in the exportsoriented industries starting in early 2008 and capital concentrations were shifting in the economy to the raw materials production and exports-oriented industries from all other industries (in particular via the banking system). Thus, the production grew 3.5% in metallurgy and 5.2% in chemical industry during first seven months of 2008, ensuring rather high overall growth rates of the total industrial sector (7.3%). The portion of profitable enterprises grew in total during same seven months (from 65.1% during January to July 2007 up to 66.9% during January to July 2008), and therefore, the overall income obtained by the industrial sector was 71.7% higher than during similar 2007 period. The highest profitability growth was registered in the coke production and oil refining (5.7-fold), in the extractive industry (2.2-fold) and in chemical and petrochemical industry (2.5-fold).

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The highest borrowing growth rates were reported for the agriculture (135.1%), coke production and oil refining (132.5%), mechanical engineering (132.1%), chemical and petrochemical industry (130.6%). In the beginning of 2008 Ukraine’s economy was still attractive investment target for foreign investors. The overall foreign capital inflow to Ukraine’s economy during first half of 2008 was 2.7-fold of that for the first half of 2007. The investments were flowing mainly to the most attractive industries and sectors: agriculture (149.7%), financial sector (142.1%), coke production and oil refining (123%). As a consequence of the above trends, production of raw materials, components and fuel accounted for more than 2/3 of Ukraine’s overall industrial production. Socially oriented products made only 20% of the overall industrial production. The light industry became almost extinct to all practical purposes (1999: 1.6%; 2008: 0.9%). The growth was accelerating a little in the mechanical engineering industry (by 18% annually on average); however, its portion in the overall industrial production is|approximately 11% – lower than in the developed economies. Only 2/3 of the industrial goods were produced by the domestic industrial sector; the remainder had to be imported. The exports were comprised mainly of raw materials and fuel with low procession levels – as opposed to the imports comprised of hi-tech products with advanced procession levels and consumer goods. As discussed in the above, such foreign trade structure caused a steady decrease of Ukraine’s imports/exports liquidity ratio (from 1.126 in 2004 down to 0.8 in 2008). The nation managed to cover its increasing balance of trade deficit, attracting external funding, and as result Ukraine’s gross external debt – expressed as percentage of the nation’s exports of goods and services – grew from 74.2% in 2004 up to 120.6% in 2008.

1.2.

Political Instability and Tax Burden

Extreme political instability has been one of Ukraine’s characteristics since 2004 – the year of the Orange Revolution and election of Mr. Yuschenko to the presidential office. The lack of consolidation in the political circles has delayed or made totally impossible the reforms required by Ukraine to secure business transparency and stability as well as tax reforms. Consequently, business environment has become increasingly bureaucratized. In 2009 the World Bank Group rated Ukraine 142 among the 183 countries according to Doing Business Ranking.

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| Klaus Kessler

No significant progress was made in the taxation sphere. According to the World Bank Group, the overall tax burden on corporate income in Ukraine was 57.2% in 2008 – as opposed to the average of 44.5% in the developed economies. The International Finance Corporation (IFC) produced Paying Taxes 2008 report at the end of 2008 which is intended to compare the convenience of national tax systems using three main criteria – the number of taxes to be paid, overall tax burden and the time spent on procedures related to payment of taxes. Ukraine was rated 181 – second last (with the closing line given to Belarus). The IFC survey found 99 separate taxes in Ukraine. The procedures related to their payment consumed 848 hours annually. The 2008 state budget revenues were two-fold of the overall income obtained by businesses. Withholding taxes on payroll have reached 68% of the net earnings. VAT has become the largest problem in terms of tax payment procedures. The arrears on outstanding VAT reimbursements grew 1.5-fold during 2009 and reached round 20 billion UAH. Additionally the largest portion of the VAT budget was accounted for by VAT on imports (34%) rather than VAT on domestic sales (5.7%) – which fact makes VAT a kind of additional customs duty on imports.

1.3.

Conclusions

With reference to the foregoing, it can be summarized that before the financial crisis overall GDP growth (a key macro-economic indicator) has been positive since 2000. However, notwithstanding this fact, Ukraine’s macro-economic climate had been unstable during 2000-2008 – because no solutions were suggested for the first-priority tasks to implement the strategies which would promote social-economic growth of sound quality and at good rates – such as strategies to create incentives and to overcome the existing negative aspects: disproportions in the structure of the national industrial sector; its primary orientation on exports of products with low procession levels; crucial dependence on imported energy; unfavourable investment and innovation climate; imperfect legislative framework; low payment capacity of domestic market players; underdeveloped pricing and tariff regulation tools; obsolete technologies in the industrial sector and slow modernization; brain drain; continuing parliamentary and political instability. In view of the above, Ukraine’s annual macro-economic indicators demonstrating stable eco-

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585

nomic growth during 2000-2008 should be interpreted as the reflection of the global economic growth generating international demand for Ukraine’s products with low procession levels (mainly in metallurgy) rather than the consequence of any conscious government policies existing in the country.

2.

The Impact of the World Financial Crisis (2008/2009/2010)

2.1.

Consequences of the Financial Crisis on the Ukrainian Economy

As a consequence of the worldwide financial and economic crisis the Ukraine has been hit particularly hard. The Ukrainian economy displayed two different systematic patterns during 2008. While an actual growth rate of 6.7% was measured up until September 2008, from October and the following months of November and December there was a record fall. Alone in November 2008 GDP fell by 14.4% in comparison to the previous year and industrial production fell by a total of 29%. As a result of the dramatic deterioration of all the major indicators the total actual GDP growth rate for 2008 was in fact only a meagre 2.1%. Along with the shrinking real economy came a major deprecation of the exchange rate. The monthly high in the middle of December was over 9 UAH per USD, which was significantly above the rate of circa 4.5 UAH per USD in the middle of the year. These events have exposed the existing imbalance of the Ukrainian economy. One of the reasons for the high sensitivity of the Ukrainian economy to the crisis was the high dependence on a non-diversified export sector. Exports represent a share of around 50% of GDP in Ukraine and Ukrainian exports increased annually by 25% from 2003 to the end of the first half of 2008. However the scope and span of goods and products exported from Ukraine is not broad. For example, the share of metallurgical and chemical exports is circa 40%. Other important Ukrainian export products are agricultural products and foodstuffs (24.0%), machinery (12.6%) and minerals (9.8%). Geographical diversification of Ukrainian exports is also lacking. Only a few CIS States and some Western

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| Klaus Kessler

European nations comprise the most important trading partners of the Ukraine and Russia, Turkey, Poland, Italy, Belarus and Germany are the most important buyers of Ukrainian export products, together representing more than 50% of total exports. Picture 2: Main Ukrainian Export goods in 2009, source: National Bank of Ukraine, 2010, http://www.nbuv.gov.ua (retrieved on 9 August 2010). 9

7.2

41.2

10.5

16.2 16 Metallurgical products 41,2 Investment 16 Food 16,2 Minerals 10,5 Chemicals 9 Other 7,2

The economic crisis continued in to 2009 and economic activity fell off to such an extent that GDP decreased by 14% which was significantly worse than the falls in output experienced by neighbouring countries. Total exports fell by 40% and industrial production dropped by circa 22%. Only by the end of 2009 inflation sank from 20% to 12.3%. As expected the unemployment rate increased from 6.9% at the end of 2007 to 9.2% by the end of 2009. Unemployment has only risen moderately, as mentioned above, because salaries and wages have reacted relative flexibly to the financial crisis. Real wages sank by 10% accordingly. Throughout the crisis the public finances have come under increasing pressure. The budget deficit in 2009 stood at between 5.4% and 10.6% depending on which public spending is included. The IMF provided a prop up loan of 16.4 billion USD, from which three tranches had been drawn down by the end of 2009.

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Owing to the major devaluation of the Hyvnia (UAH) imports fell at a faster rate than exports in 2009. The current account deficit prior to the beginning of the crisis could largely be balanced. The bottom of the crisis appears to have been reached however by September 2009. Thus, the decline in industrial production by May 2009 was still a fall of 32% as compared to the prior year, but by August 2009 the figure was 23%. What is more the chemical and metal industry has been greatly boosted by the increase in demand on international markets. The recovery of the world economy also had a positive impact on the economic prospects for Ukraine. As the Ukrainian economy is closely linked to global developments, the improved outlook of the global economy has had a reassuring effect on the Ukraine. In view of the presidential elections in January 2010 the political risks rose from the third quarter of 2010, which in turn threatened the economic stabilisation. To keep the campaign pledges, unpopular steps which were previously agreed with the IMF such as increasing energy prices have not been realised. Moreover, despite the difficult budget situation, political efforts have been made to increase the minimum wage and improve other social benefits. As a consequence the cooperation with the IMF ceased in October and the payment of the last tranche of the loan agreed in 2008 has been postponed for the time being. A reaction to this political instability was a decline in the value of the UAH in September 2009 despite positive signs of an improving domestic economic outlook. The experts viewed the devaluation of the UAH as a consequence of expectations of the population that renewed political instability in the country would occur in advance of the presidential elections and further devalue the UAH. Consequently, the demand for foreign currencies rose. In this respect, the Ukrainian economy remained in a paralysed state until January 2010. It appears that all the business sectors as well as overseas investors are adopted a waiting position while events unfolded. The political and formal obstacles which had prevented further stabilisation measures and the planned adoption of the budget in late 2009 have now been eliminated with the accession to office of the new government in early 2010. Thus, the new budget was first adopted on 27 April 2010. However according to the opinions of experts the budget was unrealistic; government revenues were overestimated and public spending underestimated.

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| Klaus Kessler

Despite this, a slight increase in growth in the Ukrainian economy was recorded. According to information provided by the National Bank GDP grew by 5% in the first quarter in comparison to the first quarter of 2009. The new government estimates GDP growth will be 3.7% for the whole of 2010. The foreign demand for the core Ukrainian export products including metal, chemicals and agricultural products increased in the first and second quarter of 2010. The new government saw the need to resume negotiations with the IMF with regard to providing further funding. After meeting all the loan conditions which the IMF placed upon the new Ukrainian government the first tranche was paid out according to schedule on 28 July 2010. Shortly after the payment of the first instalment there was a positive reaction from the rating agencies, whose assessments are very important for the international capital markets. For example, Standard & Poor upgraded Ukraine’s debt rating from B to B+. The rating agency Fitch also reacted positively and pitched in with an upgrade from B- to B after the outcome of the negotiations with the IMF.

2.2.

Banking Sector Developments in the Ukraine during the Economic Crisis

In the three year period 2005 to 2008 the bank sector in Ukraine experienced strong growth rates. The portion of overseas capital to total capital in the sector grew very strongly. Total assets expanded greatly. The rapid development of bank assets was due to very high credit growth, in particular concerning credit lending to private households. Thus, encouraging a boom in consumer consumption financed by credit, while the mortgage loans made to private individuals made property purchases possible.

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Picture 3: Share of foreign capital to total capital in the Ukrainian banking sector; source: National Bank of Ukraine, 2009, http://www.nbuv.gov.ua (retrieved on 11 August 2010). 40% 35% 30% 25% 20% 15% 10% 5% 0% 2005

2006

2007

2008

The economic and financial crisis of 2008 impacted the banking sector in the Ukraine severely. The major impact was on the liquidity of the banks. Thus most Ukrainian banks have suffered from liquidity and solvency problems since 2008. For most banks therefore the pent-up and hidden risks came to the fore with the arrival of the crisis. Active lending to households was made possible by the use of foreign credit funding (syndicated loans, Euro bonds). Accordingly, the external debt of the banking sector rose dramatically from 2.7 billion USD in early 2005 to 39.4 billion USD by late 2008. Since the drawdown of foreign loans was mainly in foreign currency meant that either the bank or their client became exposed to an exchange rate risk. It should also be noted that over 50% of the loans granted to customers were in foreign currency. Thereby most of the foreign loans were granted for terms of between three and five years with the right of early termination for the lender. As the banks assumed that there would be automatic roll-over and renewal of the credit lines they did not factor in the risk of early termination. Concurrently the Ukrainian banks granted mainly long term credit to private households. This led to increased liquidity risk.

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| Klaus Kessler

After the crash of the international credit markets and the early termination of foreign credit lines from the lenders the banks in Ukraine had a serious problem on their hands. They needed to get new financing and at the same time overcome the liquidity problems. To settle these foreign debts the Ukrainian banks had to make use of much more expensive foreign credit lines. This meant also that the banks increased the rates of interest for credit already granted and introduced more rigorous requirements for borrowers. At the same time there was a run on the banks with depositors rushing to withdraw their savings. The National Bank attempted to stabilise the situation by imposing a moratorium on the withdrawal of savings from the banks. Despite these measures the banks could not prevent a loss of faith in banking institutions. According to information provided by the National Bank savings held by Ukrainian banks in local currency reduced by 25% and foreign currency savings fell by 19%. As a consequence of the recession the volume of distressed and non-performing loans increased dramatically. In total the entire banking sector reported a loss of 7 billion UAH in the first quarter. In comparison, profit in the same period last year amounted to 2.1 billion UAH. In order to prevent an impending collapse of the banking sector further emergency measures were taken. To calm the fears of depositors, the National Bank significantly raised the level of the deposit protection scheme at the end of 2008. The next measure the National Bank undertook was the intervention in distressed banks. In addition the Government began to formulate the measures for preparing the re-capitalisation of the banks. The 2009 budget provided 44 billion UAH for the re-capitalisation of the banks. The re-capitalisation of foreign banks in the Ukraine was carried out by their own parent entities and without the intervention of the Ukrainian State. The presence of the various overseas banks in Ukraine had a stabilising effect on the Ukrainian banking sector. According to the estimations of a number of Ukrainian experts the Ukrainian banking sector survived the crisis without severe losses only thanks to the foreign capital which sat with most of the banks. Further sources of foreign capital to overcome the crisis were the world banks, the European Bank for Reconstruction and Development (EBRD) as well as bi-lateral development banks. In 2009, the sharp rise in distressed loans emerged as one of the biggest challenges in the banking system. Further to data provided by the National Bank the value of distressed or problem loans was 6.8% of the total loan book. This meant a

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tripling of distressed loans since the beginning of 2009. It is also highly likely that the actual number is much higher. Experts estimate that distressed or problem loans are somewhere between 20% and 30% of total loans. Due to the on-going problems in the banking sector, lending in the economy throughout 2009 and 2010 could not swing into momentum. A sustainable recovery out of the crisis can only take place if there is sufficient funding for the real economy.

2.3.

The Deep Fall of the Ukrainian Construction Industry

After the collapse of construction demand the construction sector has suffered far worse than other sectors of the Ukrainian economy. The Ukrainian construction sector is a particularly important part of the Ukrainian economy. Officially the construction industry represents 4.1% of GDP. The wealth creation contribution of the sector is probably much greater however, due to the high levels of illegal employment and illegal earnings. The construction industry experienced a huge upswing from 2002 to 2008 on the back of the sustained economic boom during this period. This construction boom rode on the ever increasing real salaries and the corresponding demand for flats and apartments. The high demand for housing was caused by the existing shortage at the time and the replacement requirement due to the poor construction standards in the old Soviet built buildings. Because private households had very little capital many individuals and families financed by means of mortgage borrowing. Increasing property prices locked in investors who saw property as a relatively safe investment which promised good returns also. This led to a speculation bubble which resulted in prices rising by 560 % from 2002 to 2008. At the same time the amount of housing increased by 72 %.

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| Klaus Kessler

Picture 4: Development of the construction sector in Ukraine; source: State Committee of Ukraine, 2010, http://www.ukrstat.gov.ua (retrieved on 11 August 2010). 30

20

10

0

2003

2004

2005

2006

2007

2008

2009

-10

-20

-30

-40

-50 Economic growth Construction sector

During the boom period in the sector the construction industry also exhibited serious structural problems. The high level of concentration within construction sector, the proximity of large local construction companies to local decision makers and the non-transparent land allocation prevented free competition in the building industry. Prices and building costs have risen far greater than building output and construction quality accordingly. Already during the course of 2008 the sector experienced a sharp falloff in construction activity. The onset of the financial crisis resulted in a free fall for the construction sector. 2008 was a particularly black year for the construction industry which, among a few others, was the sector hardest hit by the crisis.

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The crisis brought about a fall in property prices and this development fed through into 2009 as well as the first two quarters of 2010. Picture 5: Price movements for owner occupied flats and apartments in Kiev 2009–2010; source: Estate Agency ‘Obolon’, 2010, http://www.domik.net/ (retrieved on 12 August 2010). 1,850 1,800 1,750 1,700 1,650 1,600 1,550 1,500

10 01 .0 6. 20

10 01 .0 4. 20

10 01 .0 2. 20

09 01 .1 2. 20

09 01 .1 0. 20

01 .0 8. 20

09

1,450

Price in USD

The measures undertaken by the state in order to overcome the crisis in the construction sector were not achieved due to the general short of funds. The construction sector is still currently sitting in a deep recession. Most construction projects have been frozen for an unknown period of time which is primarily due to the lack of financial backing. The banks appetite for lending to the construction sector in order to finance building activities and the acquisition of housing is very limited. Therefore signs of recovery in the sector in the following months are very unlikely.

2.4.

Measures to Overcome the Economic Crisis

As a consequence of the crisis, by the middle of October 2008 the Ukrainian had to go cap in hand to the IMF with a request for credit. The conditions set with the granting of emergency funding by the IMF made a whole row of negotiations with the Ukrainian government necessary. The subsequent acts of Parliament through

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the rapid adoption of the so-called ‘Anti-Crisis Law’ on 31 October 2008, and further decisions of the government and the National Bank opened the way for approval by the IMF of a 16.4 billion USD loan. The first tranche of 4.5 billion USD from the IMF loan was paid over on 10 November 2008. The granting of the IMF loan was reliant upon the adherence to a number of conditions (“conditionality”). The single most important condition was the retention of a flexible exchange rate system and over and above this, the strengthening of independence for the National Bank. In the financial sector, the Government undertook to draw up a working mechanism for the recapitalization of banks, and increase the level of the deposit insurance scheme. In addition, the problem of the ailing Ukrainian Prominvest Bank had to be solved, which was achieved through the acquisition of 75% of the bank’s shares by a Russian investor. A key point also concerned the progressive release of subsidised energy prices for industry and households. The strict fiscal and exchange rate policy of the National Bank by the end of 2008 had a stabilising impact on the Ukrainian economy. Thus in the fourth quarter of 2008 a significant devaluation of the UAH took place, which was urgently needed in order to restore external balance. Thanks to the IMF credit the worst effects of the international economic crisis in late 2008 were avoided by the Ukraine. However, 2009 was not expected to be any easier. The deep economic and financial crisis in Ukraine continued unabated in to 2009. After a whole raft of important adaptation measures to the IMF programme were adopted by the government at the end of 2008, these measures had to be implemented during 2009. However as most of the crisis measures constituted unpopular acts, political support was lacking for the implementation in 2009 as a result of the upcoming presidential elections in January of the following year. The crisis was aggravated in 2009 by the long-time political conflict between Prime Minister Julia Timoschenko and President Viktor Yushchenko. As an outcome of the open confrontation between the two senior politicians a number of important decisions were delayed or left out completely. And of course both leaders built pledges into their presidential election campaign which obviously did not promote economic reforms.

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The payment of the second tranche at the beginning of 2009 was delayed because the government budget for 2009 was economically unrealistic and allowed for a larger public deficit. After agreement with the IMF the budget deficit for 2009 was limited to 4% of GDP. The indirect result of the relatively tight monetary policy guided by the National Bank in 2009 was the stabilisation and underpinning of the UAH, which remained at a value of about 8 UAH/USD during that year. On the basis of a number of monetary policy measures it was possible to reduce the rate of inflation considerably despite the large devaluation in 2008. The inflation rate fell from 22.3% at the end of 2008 to 12.3% in late 2009. As a consequence of this downward trend in prices the UAH has been relatively stable since the end of the second quarter of 2009. This positive trend to lower levels of inflation also calmed the population somewhat which was reflected in the indicators. While the population was still panic buying foreign currency at the exchange rate offices during the first quarter of 2009, the number of sellers of foreign currency exceeded the number of buyers. Picture 6: Changes in the exchange rate (UAH/USD), source: Reuters, 2010, http://for-ua.com (retrieved on 16 August 2010). 10 9 8 7 6 5 4 3

01 .06 .20 08 01 .07 .20 08 01 .08 .20 08 01 .09 .20 08 01 .10 .20 08 01 .11 .20 08 01 .12 .20 08 01 .01 .20 09 01 .02 .20 09 01 .03 .20 09 01 .04 .20 09 01 .05 .20 09 01 .06 .20 09

2 1 0

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The tight policy of the National Bank at the end of 2008 and beginning of 2009 led to a large volume of critique from all sides of the political spectrum and put the National Bank under a huge amount of pressure. This showed that the independence of the National Bank needed to be reinforced. One of the most important policy conditions of the IMF for the granting of the loan, the stabilisation of the non-transparent state monopoly Naftogas, remained however unrealised in 2009. The stabilisation of Naftogas would require demanding structural reforms in the energy sector. To carry out such reforms in a politically divided nation in the run up to the presidential elections would be nigh on impossible. As the central issues such as pensions and energy pricing were left untouched by the political establishment the resulting government budget deficit was particularly high. Depending on how the numbers are measured the budget deficit was between 5.4% and 9.0% of GDP. In the autumn of 2009 the economic situation tensed again. In October 2009 the IMF mission in Kiev tested to see if the requirements for the payment of the fourth tranche of 3.8 billion USD, to be made in November 2009, were indeed fulfilled. As a result of the mission the fourth tranche of the IMF credit was suspended. The main reason for the suspension of the fourth tranche was the irresponsible fiscal policy which led to the high public sector budget deficit. In particular, the agreement on 1 September 2009 to increase gas prices for households and business was not carried out. Concurrently a new law was passed raising the minimum wage and the old age pension. Although this new law would result in an increased budget deficit, it was passed through parliament despite protest from the IMF. Since the IMF program was exploited for electioneering purposes in the run up to the presidential elections in January 2010, the IMF understandably held a “wait and see” position, while the outcome of election was being decided. In 2010 the Ukrainian government restarted negotiations with the IMF. During the course of the negotiations the IMF made it known that a continuation of the ongoing cooperation would not be possible without the fulfilment of the clear conditions. Thus the IMF asked for fundamental reforms in four key areas: fiscal policy, energy sector, monetary policy and the banking sector. After a drawn-out delay the political policy makers finally accepted the requirements of the IMF: Consequently, a credit line of 15.2 billion USD was agreed on 3 July 2010 with a maturity of 29 months.

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To fulfil the requirements of the IMF a number of important measures had to be met prior to the dispensation of the loan. Thus a number of adjustments to the budget had to be made. In this manner a public sector budget deficit of up to 5.5% of GDP was agreed for 2010, 3.5% in 2001 and 2.5% in 2012. In order to close the structural deficit of Naftogas, it was decided to increase the gas tariff for the population and the heating companies by 50% on 1 August 2010. In the area of monetary policy the independence of the National Bank was also strengthened. This measure should ensure price stability index in the future and allow the implementation of a low inflation policy. The recapitalisation of the bank sector is to be completed by the end of 2010 and banking supervision to be sharpened at the same time. According to the opinions of the experts a landmark decision for the future economic development of the Ukraine was achieved as a result of the agreement with the IMF. This should bring certain stability to the weak recovery and provide for lasting economic growth in the Ukraine.

3.

Challenges and Coping with the Financial Crisis

Ukraine was more vulnerable than other emerging markets to the detrimental effects of the financial crisis. It has faced number of challenges in process of coping the financial crisis due to both the economical and political factors. Starting from 2003 through 2007 year, Ukraine had one of the fastest growing economies among its neighbours and even from January to September 2008, when the USA and EU countries had already felt detrimental effects of the financial crisis, Ukraine continued to enjoy good economic results. The master factor of Ukrainian economy growth was booming domestic demand and strong exports growth in the years 2000-2007. Ukrainian economy is an export-oriented one and its growth was stimulated by increasing demand at the world markets. Ukraine’s exports mainly consist of metallurgical and chemical products, whose prices have declined sharply since September 2008. This decrease, coupled with significant economic slowdown in the rest of the world, has resulted in the dramatic decline of Ukrainian exports.

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Moreover, falling domestic demand has contributed to Ukraine’s poor economic performance. The domestic demand was based on a booming amount of bank loans, large increases in wages, rising profitability of enterprises, and a strong inflow of foreign investments. Since September 2008, however, these drivers have been rapidly vanishing, leading to a sharp reduction in domestic demand. The dramatic decline of Ukrainian exports and falling domestic demand in complex with the banking sector weakness are the key economic challenges in process of coping the financial crisis in Ukraine. Besides pure economical factors, political instability in the country made the country extremely vulnerable to the financial crises. A split in the democratic coalition, confrontation between the President, the Prime Minister and the Parliament has cast absence of the consistent policy in coping the financial crisis. The numerous political disputes complicated talks for a multibillion-dollar loan from the International Monetary Fund to stabilize the country’s struggling financial system. Though, despite the political instability Ukrainian Parliament together with the government was able to adopt and implement some anti-crisis measures summarised below.

3.1.

Anti-Crisis Measures in Banking and Finance Sectors

Starting from 2006 through 2008, the bank loans in Ukraine grew by 70%, supported by increase in money supply and borrowings from abroad. The high rates and growth in number of bank loans led to high levels of non-performing assets. The global financial crisis has battered Ukraine’s banking sector and caused its currency falling sharply. The first strokes of the financial crisis in Ukraine’s banking sector were connected to difficulties in accessing borrowings from abroad by Ukrainian banks. This was followed by mass depositors’ demands on pre-term repayment of deposits, leading to intensive cash outflows in the banking system. 3.1.1.

Prevention of pre-term Deposits Repayment

In order to eliminate intensive cash outflows in the banking system, on 11 October 2008 the National Bank of Ukraine (NBU) adopted a Resolution “On Additional Measures Concerning Banking Activity” No. 319 obliging the banks to re-

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pay money placed on deposits to their clients only after termination of the deposit agreements. Therefore, the depositor’s right to demand pre-term repayment of deposit was restricted. Imposition of moratorium on pre-term repayment of deposits caused panic and decrease of cash inflows from individuals and entities in the banking system in October-November 2008 by approximately 29 billion UAH. In December 2008 the NBU adopted Resolution “On Certain Issues of the Banking Activity” No. 413 that prolonged restriction on pre-term repayment of deposits but obliged the banks to arrange all necessary measures in order to increase the amount of deposits. As a result, by the end of 2008 banks increased interest rates by 1-2% for short-term deposits. Such measures attracted new depositors and kept then existing depositors from pre-term repayment. Moreover, in order to increase cash inflows from individuals, Ukrainian government has improved guarantees for repayment of the deposits. It increased guaranteed amount of compensation to the individuals in the event of a bank insolvency by more than ten times compared to such compensation amount before the crisis. 3.1.2.

Lending Activity

Ukrainian banks reacted to the difficulties in accessing borrowings from abroad and intensive cash outflows in the banking system by attempting to increase interest rate under the bank credit facilities granted to their clients. In January 2009 the amendments to the Civil Code of Ukraine and to the Law of Ukraine “On Banks and Banking Activity” prohibiting unilateral alteration by the banks of the credit agreements entered with the clients were introduced. In particular, the banks were prohibited from increasing an interest rate under credit agreements or decreasing it under bank deposit agreements (except for call deposits). Furthermore, the Law of Ukraine “On Amending Certain Laws of Ukraine with the Purpose of Overcoming Negative Impacts of the Financial Crisis” set forth provisions related to credit restructuring. Until 31|December|2010 commercial banks are entitled to restructure credits granted to individuals. Such restructuring applies to: (a) credits granted before 1 October 2008; (b) credits with the nominal value not exceeding 1|million UAH|or its equivalent in foreign currency. The restructuring methods include: prolongation of the term for the credit repayment of up to two years; extension of the credit agreement validity period; alteration of the interest calculation mechanism so that monthly interest payments would not exceed 35% of the aggregate monthly income of the borrower’s family.

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The Law of Ukraine “On Amending Certain Laws of Ukraine with the Purpose of Overcoming Negative Impacts of the Financial Crisis” released borrowers from paying any penalties applicable due to borrower’s untimely performance of credit agreements that occurred before the restructuring date. Moreover, pursuant to the Law of Ukraine “On Amending Certain Laws of Ukraine with the Purpose of Overcoming Negative Impacts of the Financial Crisis” a moratorium for the period from 2009 to 2010 on foreclosure of mortgaged residential property was established. The moratorium applies only if the following conditions are met: (a) the mortgaged property is the only residence of the mortgagee; (b) there is not more than a two month delay in interest payments; and (c) the debt is restructured as agreed by the bank and the borrower. In order to overcome foreign currency deficit, the Law of Ukraine “On Amending Certain Laws of Ukraine with the Purpose of Overcoming Negative Impacts of the Financial Crisis” limited the right of banks to grant foreign currency credits to individuals unless such credits were attracted for payment for services rendered by non-residents in relation to medical treatment and education abroad. In this case, credit had to be granted by Ukrainian banks through direct transfer of funds to the account of the medical or education institution, provided that the respective supporting documents are submitted by the borrower. Certain limitations were also introduced with respect to alteration of loans with non-resident lenders. The Law of Ukraine “On Amending Certain Laws of Ukraine with the Purpose of Overcoming Negative Impacts of the Financial Crisis” introduced limitations with respect to early repayment of loans by Ukrainian borrowers to non-resident lenders. The Law prohibited early repayment of loans granted to Ukrainian borrowers in foreign currency from non-resident lenders even when a relevant loan agreement provided for a possibility of early repayment of such loan. Furthermore, the Law prohibited alteration of the loan agreement with non-resident which would reduce the term of loan repayment. These provisions were effective until May 2010. 3.1.3.

Refinancing of Banks

During the months of October-December 2008 the NBU started implementing extraordinary measures on refinancing of commercial banks. Refinancing costs of commercial banks in October-December 2008 reached up to 105.4 billion UAH which is 42 times more than annual refinancing costs in the year 2007. Within this period of time the refinancing procedure lacked transparency. Most of the banks

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had no free access to refinancing funds. The NBU distributed refinancing funds between the limited number of banks and choice of banks was based solely on NBU’s discretion. Most of the refinancing funds granted during the months of OctoberDecember 2008 were not sufficiently secured and use of such funds by commercial banks was not monitored by the NBU. Such commercial banks often used the refinancing funds not for restoration purposes but for trading on currency markets. A need for obtaining a multibillion-dollar loan from the International Monetary Fund forced Ukrainian government to add some transparency to NBU refinancing procedure and to adopt relevant regulations. On 1 January 2009 the Budget Law for 2009 year came into force and its provisions deprived the NBU of its right to adopt decisions on refinancing unilaterally. From then on the refinancing procedure had to be done in the order approved jointly by the NBU and the Cabinet of Ministers of Ukraine. On 29 January 2009 the NBU and the Cabinet of Ministers of Ukraine adopted Regulation “On Refinancing of Banks During the Financial Crisis” that provided for appointment of the authorized representative of the Cabinet of Ministers of Ukraine to coordinate granting of funds to commercial banks’ refinancing. The above Regulation inter alia established the rate for refinancing and requirements regarding monitoring of refinancing activities. 3.1.4.

Recapitalization of Banks

Another anti-crisis measure used in coping the financial crisis in the banking sector was recapitalization of commercial banks requiring financial recovery. Recapitalization policy was adopted under the pressure from the side of International Monetary Fund; this was one of condition precedents of the stand by loan facility granted by the International Monetary Fund. The legislative ground for implementation of bank recapitalization policy was adopted by December 2008. However, Ukrainian government started to implement recapitalization only in February 2009 when the deadline for reporting before the International Monetary Fund was approaching. Recapitalisation procedure provided for acquisition by the state of a majority stake of shares of a commercial bank requiring financial recovery in exchange for funding and increase of the bank’s statutory capital. The key requirements of recapitalisation procedure included approval of recapitalisation proposal presented

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by NBU by the bank’s shareholders or its temporary administrator, reorganization of the bank into open joint stock company, acquisition of at least 50% + 1 share by the state in the course recapitalisation. Recapitalization procedure as well as refinancing procedure lacked transparency. Many procedures have been significantly shortened to accelerate the process of recapitalisation. For example, the term for obtaining a permit from the Antimonopoly Committee of Ukraine for concentration in banking sector has been reduced from 30 days to 5 working days. The time allowed for claiming decisions of the bank’s shareholders meeting concerning recapitalisation has been reduced to one month. As a result of recapitalization the government acquired control over thee banks: Rodovid Bank -99.97% of the state-owned shares, Kyiv Bank -99.94% of the stateowned shares and Ukrgazbank -81.58% of the state-owned shares. Such anti-crisis measure as recapitalization of banks is criticised as an ineffective one. The main argument is that the costs of recapitalization are generally higher than the cost of liquidating a bank and repayment of debts to its creditors. For instance, according to the Ministry of Finance of Ukraine, recapitalization of Ukrprombank will require at least 9 billion UAH and at least 2 billion UAH for refinancing. The costs of liquidation of this bank shall not exceed 7 billion UAH that will be used for repayment of deposits to its clients. 3.1.5.

Currency Regulation

The global financial crisis caused sharp devaluation of Ukrainian currency. In order to mitigate financial risks related to devaluation of Ukrainian currency, individuals and entities started converting their capital into hard currency. Increased demand for hard currency coupled with difficulties in accessing borrowings from abroad by Ukrainian banks created foreign currency deficit at Ukrainian currency market. In December 2008 the NBU adopted Resolution “On Certain Issues of the Banking Activity” No. 413 that obliged the banks to sell advances payments in a foreign currency returned to the residents of Ukraine in the instances when non-residents failed to perform their obligations under contracts for import operations.

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On 20 November 2009 the NBU attempted to limit speculation on the foreign currency exchange market and to prevent the use of Ukraine’s banking system for money laundering by means of introducing amendments to the NBU Regulation “On Approval of Instruction on Procedure of Organization and Carrying Out Currency Exchange Transactions on the Territory of Ukraine” No. 502. The amended NBU Regulation No. 502 bared Ukrainian banks from selling to one person within one banking day foreign currency in the amount exceeding the equivalent of 80,000 UAH (approximately 10,000 USD). Moreover, the NBU Regulation No. 502 established requirements regarding identification of persons carrying out currency exchange transactions for more than 15,000 UAH (approximately 1,800 USD) each. Furthermore, the amended NBU Regulation No. 502 bared Ukrainian banks from revising established foreign currency exchange rate in the course of the same banking day. The foreign currency exchange rate had to be established by the head of the bank’s board of directors. The other bank managers were not authorized to establish foreign currency exchange rates. Moreover, the NBU established the maximum level of margin for currency exchange transactions on the cash market. No bank’s commission was allowed for the sale and purchase of foreign currency for local currency. This limitation should have prevented money laundering and limit speculations with foreign currency. The government attempted to fight hard currency deficit by tightening the archaic rule on the mandatory timeframe for receipt by Ukrainian companies of foreign currency proceeds from sales (in case of export contracts) or goods (in case of import contracts). This rule was initially designed in early 1990s for prevention of capital flight. The Law of Ukraine “On Amending Certain Laws of Ukraine with the Purpose of Overcoming Negative Impacts of the Financial Crisis” reduced the period of foreign currency receivables transfer to accounts of Ukrainian residents from 180 to 90 calendar days starting from the date when a customs export declaration is obtained (in case of export of works or services, intellectual property rights– from the date when the respective acceptance act is signed by the parties). In case of breach of this 90-day rule, a Ukrainian party was subject to a rather severe penalty of 0.3% of the amount of the delayed payment or delivery for each day of the delay.

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3.2.

Anti-Crisis Measures in Housing Construction Sector

During 2005-2008 construction activity grew steadily. However, construction sector was the first one to experience detrimental impact of the financial crisis in Ukrainian banking sector. The vast majority of housing construction projects was financed by individuals that obtained funds for purchasing housing from bank under mortgage lending. The system of housing finance featured significant weakness: the households made prepayment through construction financing funds to construction companies or property developers before construction had been started. The weakness of this system became obvious when due to the crisis in banking sector, developers were not able to secure a constant inflow of cash from new households and thus had no way to finance further construction process. As a result of crisis in banking sector, new households were not able to obtain mortgage lending and developers did not have money to complete unfinished constructions. Furthermore, construction companies faced additional pressure from the supply side. The prices for construction materials exploded in 2008 due to significant increases in the prices for gas, electricity and transport. In 2008 Ukrainian Parliament adopted the Law of Ukraine “On Prevention of Global Financial Crisis Impact on Development of Construction Sector and Housing Construction”. The anti-crisis policy was based on two pillars: measures on reducing costs of construction and stimulation of demand for residential premises. However, until August 2009 Ukrainian government had not taken any actions on implementation of anti-crisis measures in construction sector. In August 2009 the Cabinet of Ministers of Ukraine adopted a resolution providing for state financing of residential premises acquisition. During August 2009 the government granted 1.1 billion UAH for the purchase of 4,238 apartments. However, at the overall scale such measures had no essential effect in coping crises in construction sector.

3.3.

Crisis Related Alteration to Foreign Investment Regime

Financial crises brought Ukrainian legislation on foreign investments back to the year 2004. The Law “On Amending Certain Laws of Ukraine with the Purpose of Overcoming Negative Impacts of the Financial Crisis” restored the burdensome

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rule on mandatory conversion of monetary foreign currency investments to statutory capitals of Ukrainian companies into local currency through investment accounts opened in Ukrainian banks. This rule also extended to purchasing corporate rights (shares) in Ukrainian companies since purchase of corporate rights (shares) is recognised to be an investment. Furthermore, the Law “On Amending Certain Laws of Ukraine with the Purpose of Overcoming Negative Impacts of the Financial Crisis” established a requirement of mandatory state registration of foreign investments. Before adoption of the above law, the state registration of foreign investments was not mandatory and remained at the discretion of the investor. The requirement on mandatory conversion of monetary foreign currency investments into local currency and mandatory state registration of foreign investments created additional obstacles to foreign investments in Ukraine. In May 2010 mandatory requirements regarding conversion of monetary foreign currency investments into local currency and mandatory state registration of foreign investments were abolished.

3.4.

Anti-Crisis measures in Labour Market

The financial crisis forced many companies to take radical anti-crisis measures in order to survive. Cutting of labour costs was one of at the measures applied by such companies. As a consequence, unemployment rate raised dramatically in Ukraine. In January of 2009 the Law of Ukraine “On Introduction of Amendments to Certain Laws of Ukraine in Relation to Decreasing the Impact of the Global Financial Crisis in the Sphere of Employment of the Population” was passed. The Law limited the right of employees dismissed “upon mutual consent of the parties” or “at one’s own accord without good reason” to claim unemployment benefits from the state employment authority before the 91st day of their dismissal. This amendment significantly reduced the motivation of employees to resign “upon mutual consent of the parties” or “at their own accord without good reason”. Trying to protect Ukrainian residents from increasing level of unemployment, the state employment centre reduced the number of employment permits issued to foreign nationals. The procedure of work permit obtainment for foreign nationals became more complicated and time consuming. These measures, however, had no positive effect in coping with increased unemployment.

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3.5.

Anti-Crisis alteration of Tax and Customs Legislation

The Law “On Amending Certain Laws of Ukraine with the Purpose of Overcoming Negative Impacts of the Financial Crisis” introduced some alterations to the Law of Ukraine “On Corporate Profit Tax”. Starting from 1 January 2009, banks could treat 100% of the aggregate amount of debt to cover possible losses from loan transactions as deductible expenses. Certain non-banking financial institutions could treat 80% of all losses provisions as tax deductible. Before alteration of the Law of Ukraine “On Corporate Profit Tax”, the maximum amount of provisions was limited to 10% of the aggregate amount of debts for banks, and 15% for non-banking financial institutions. Furthermore, cash method of tax accounting was introduced: banks’ income derived from credit transactions accrued in 2009 (retrospectively) and 2010, but not actually received as of 1 January 2011 had to be recorded in tax accounts as taxable income upon its actual receipt only. In addition to the above, under alterations introduced by the Law “On Amending Certain Laws of Ukraine with the Purpose of Overcoming Negative Impacts of the Financial Crisis”, sale or other type of disposal of the collateral by banks and other financial institutions became VAT exempt. Certain amendments were also introduced to the Law of Ukraine “On Personal Income Tax”. The most significant one related to release of legal entities (including banks) from acting as tax agents for individuals in relation to the deemed income earned by such individuals from uncollectible debt write-offs where limitation period had expired. In March 2009 Ukrainian government introduced additional duty on imported goods in the amount of 13%. The purpose of imposing such additional duty was to improve the balance of payments in connection with the global financial crisis. Later on Ukrainian government reversed its prior decision by cancelling the 13% import duty for all products except of refrigerators and automobiles. It should be noted that imposition of a 13% was not only an ineffective measure in coping the financial crisis but also was in conflict with the requirements of the World Trade Organization.

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4.

Outlook for the Coming Years

Ukraine is facing one of the most challenging and complicated periods of two and a half years since its independence. The tough unpopular reforms and accumulation of all the efforts to host the European community at the Football Tournament, if properly executed, may turn Ukraine to prosperity and sustainability for years to come just before the next parliamentary election scheduled in the fall 2012. In the middle of 2010, Ukraine’s economy was set up to working hard towards implementing reforms to meet the requirements of the IMF providing borrowing of 15 billion USD for 2.5 years under the new Stand-By Program signed in July 2010. The first tranche of 1.9 billion USD disbursed the same month outlined Ukraine’s commitment to directing its economy to sustained and balanced growth under supervision of the IMF consultants. The key measures included tightening of fiscal instruments, limitation of state spending, reforms in gas sector and pension system and completion of bank recapitalization. Therefore, the next two and half years, from middle of 2010 to end of 2012, of the Ukrainian economy development will demonstrate how serious Ukraine is towards moving from oligarch corrupt schemes to market-based economy. Interestingly, another key factor encouraging investors to participate in and monitor Ukrainian market is Ukraine’s preparation for and hosting UEFA EURO 2012 during the pick of stand-by program implementation.

4.1.

Defining Potential

The long-awaited reforms, which are essential to increasing Ukraine’s competitiveness and helping to overcome the recession that the economy is experiencing and allowing the country to take advantage of global growth trends are currently underway. Ukraine is counting on its major advantages to help in recovery. Ukraine has large mineral resources, and ranks as the fifth leading producer of iron ore that makes steel a precious source of recovery (the signs of which were shown in the spring 2010) as soon as steel global demand moves up. Ukraine’s arable land of 32 million hectares is fertile and largely underutilized to be recognised as an undeniable advantage in a period marked by the risk of global food shortage and dramatic climate change. Moreover, Ukraine has higher level of educational attainment than many other emerging economies, and a market of 45 million of population with considerable needs of infrastructure and capital goods to be satisfied.

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Another great potential considered by the experts is Ukraine’s ratification of the Kyoto Protocol and resources to produce renewable energy to reduce its dependency on imported fossil fuels including natural gas.

4.2.

Renewable Energy Opening Up New Fields for Investments?

Ukraine is a participant of the Kyoto Protocol and subject to its emission limits within the first budget period (2008-2012). Although Ukraine has been below the 1990 Kyoto Protocol baseline due to the closing of a large number of inefficient and heavily energy consuming industrial plants in 1990’s, reduction of transmission losses, and the introduction of efficiency measures in the consumer sector, to participate in sales of carbon emission credits, it is also getting eager to benefit from the Kyoto Protocol’s incentives to develop non-carbon energy source to position itself better for the possibility of more stringent limits, which may apply in the future. Despite the tragedy at Chernobyl Ukraine seems open to greater use of nuclear power as a means of meeting Kyoto targets. Currently, there are 15 nuclear power units operating in Ukraine and accounting for 48% of Ukraine’s total electrical generation. It is also planned to build eleven new reactors by 2030. European Bank for Reconstruction and Development (EBRD) has lent 215 million USD to Ukraine for reconstruction and completion of K2-R4 reactors with implementation of high nuclear safety standards and electricity market reforms.1 Moreover, although the development of renewable energy projects is hampered by the difficulty of securing financing and unclear legislation, greater efficiency and development of a range of renewable energy technologies seems to become a part of Ukrainian businesses’ strategy. Already, as of July 2010, Ukraine has 5 companies selling wind energy, 2 companies selling biomass energy, and 58 companies selling hydro energy produced by small hydroelectric power plants.2 These companies produce approximately 1% of the electric energy in Ukraine comparing to

1 Ubilava, Mariam, Development of Non-Carbon Energy Power Projects in Ukraine, Kazakhstan and Russia, 2010, http://www.climate.org/topics/clean-energy/non-carbon-power-russia.html, http://www.climate.org (retrieved on 14 August 2010). 2 Interview with Yaroslav Petrov, Associate with Asters Ukraine, Incentives for Investment in the Ukrainian Alternative Energy Industry, 2010, p. 7, http://www.kyivpost.com (retrieved on 6 August 2010).

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2009 renewable energy production figure of 18% of global electricity supply.3 However, the Renewable Energy Agency estimates that annual renewable energy use will grow to 100 TWh by 2030 to substitute already 7.3% of total energy supply.4 The wind energy potential alone is considered to be large enough to generate about 70 MWh5 per year or estimated 50% of Ukraine’s electricity by 2050.6 Picture 7: Projected Use of Renewable Energy Sources in Ukraine by 2050, mtce; source: Geletukha et al., Energy Supply in Ukraine: Outlook to 2050 // Green Energy, #4(12), 2003.

The renewable energy analysts confirm that several ambitious projects amounting to more than 1 billion USD of investments are under way in Ukraine.7 Furthermore, one of the private investments committed to the development of renewable energy projects includes 300 million EUR of DTEK, the energy subsidiary of the System Capital Management group, owned by Ukrainian billionaire Rinat Akhmetov, to construct a 200 MWt wind power plant in Zaporozhya Oblast in 2011-2014

3 REN21, Renewables 2010 Global Status Report (Paris: REN21 Secretariat), 2010, http://www.ren21.net/globalstatusreport/g2010.asp (retrieved on 15 July 2010). 4 Institute for Economic Research and Policy Consulting, German-Ukrainian Agricultural Policy Dialogue; Overview on Renewable Energy in Agriculture and Forestry in Ukraine, 2010, p. 9, http://ier.kiev.ua, (retrieved on 16 August 2010). 5 World Wind Energy Association, Ukraine can cover its energy needs completely based on renewable energy, 2006, http://www.wwindea.org (retrieved on 16 August 2010). 6 Ubilava, Mariam, Development of Non-Carbon Energy Power Projects in Ukraine, Kazakhstan and Russia, 2010, http://www.climate.org/topics/clean-energy/non-carbon-power-russia.html, (retrieved on 14 August 2010). 7 Oksana Faryna, Green energy struggles to grow, 2010, p. 9, http://www.kyivpost.com (retrieved on 6 August 2010).

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years.8 Considering the development of alternative energy as a strategically important direction of the business, Dnipropetrovsk –based Concord-Group, Beten International and Smart Holding have already announced their plans to build wind power plants with a total capacity of over 1.000 MWt, while Austrian company Activ Solar is planning to operate with an 8,5 MWh solar power plant in Crimea. The National Electricity Regulatory Commission of Ukraine has been stimulating renewable energy supply development by providing special prices (“green tariffs”) for electricity supplied by the renewable energy plants. The green tariff is set to be approved based on the energy resource individually for each plant, is supposed to be higher than the price generally used for purchasing electricity from traditional resources and is set until 2030. Therefore, wider use of renewable energy sources like hydro, geothermal, solar, biomass and wind will allow Ukraine to reduce its dependency on increasingly expensive imported fossil sources like coal, oil and gas, thus, improving energy security. Additionally, it will have economic and social benefits of creating new businesses and jobs and declining of greenhouse gas emissions and local air pollutants that enables Ukraine to plan establishing of significant amount of wind, solar and geothermal power generation by 2020.

4.3.

Boosting of Investments and Integrating with the European Community due to Hosting UEFA EUR 2012?

Ukraine’s winning of participation in hosting UEFA EURO 2012 together with Poland has triggered enormous expectations for boosting investments of foreign and domestic origin to sports, transportation and tourism infrastructure. It also provided a great opportunity of the Ukrainian state and Ukrainians to demonstrate their will for further integrating with the European community. However, the anticipated preparation for the hosting slowed during 2008-2009 years due to depletion of project financing caused by the international financial market crisis and local political uncertainty. During the implementation of the course of recovering from the financial and political instability and in order to meet the UEFA EURO 2012 goals, the new government of Ukraine approved a new State Target Programme for the preparation for and holding EURO 2012 in Ukraine in May 2010. The Programme stated the total amount of financing to reach approximately 15 billion EUR, of which 3.1 8 Ibid.

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billion EUR were planned for allocation by the state in 2010-2011 years.9 Overall public spending during the five years leading up to the games is forecasted to reach the equivalent of 6.5% of 2010 GDP, including loan guarantees10. Currently, it is predicted that incentives promised by the updated State Target Programme become crucial factors to attract approximately over 8.4 billion EUR of foreign and domestic investments for construction and renovation of more than thirty stadiums and training bases with two sports arenas meeting the requirements of FIFA and UEFA to hold competitions of any level, airports, roads and hotels in hosting cities - Kyiv, Donetsk, Lviv and Kharkiv. The tax contribution to the budget by the end of 2012 is expected at the level of 3 billion EUR.11 Picture 8: Euro 2012: Approved Budget (Billions of UAH); source: International Monetary Fund, Public Services, Ukraine – Request for Stand-By Arrangement and Cancellation of Current Arrangement Staff Report; Staff Supplement; Press Release on the Executive Board Discussion, 2010, p. 9, http://www.imf.org (retrieved on 6 August 2010). 2008 Public projects State budget State guarantees Local budgets Private projects TOTAL

3.6 3.1 ... 0.5 6.9 10.5

2009 3.7 3.1 … 0.6 10.0 13.7

2010

2011

25.2 10.1 13.6 1.5 23.8 49.0

2012

31.1 12.0 16.2 2.8 28.3 59.4

7.5 6.9 … 0.6 2.4 9.9

Total 71.1 35.3 29.8 6.0 71.3 142.4

Therefore, if Ukraine successfully accomplishes its part of preparation and hosting UEFA EURO 2012, it will receive not only tangible benefits of modern infrastructure to exploit but also recognition of its level of management, economic development, and business-government relations that may signal growing opportunity for integration with the European Union.

9 Olexander Martinenko / Victoria Papenkova, Ukraine: New State Target Programme for EURO 2012 in Ukraine is Adopted, 2010, p. 1, http://www.montaq.com (retrieved on 14 June 2010). 10 International Monetary Fund, Public Services, Ukraine – Request for Stand-By Arrangement and Cancellation of Current Arrangement Staff Report; Staff Supplement; Press Release on the Executive Board Discussion, 2010, p. 9, http://www.imf.org (retrieved on 6 August 2010). 11 New priorities of State program – infrastructure development, investments, UEFA rules, Information Centre “Ukraine – 2012”, by information of Vice Prime Minister of Ukraine press service, 2010, p. 1.

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4.4.

Obtaining the IMF Loan to Deal with Local Reforms and External Market Risks?

It is expected that renewed cooperation with the IMF in 2010 under the 2.5 year stand-by program of 15 million USD will help Ukraine to enact structural changes to achieve the following macroeconomics: 1. from 6.5% to 3.5% and 2.5% of GDP for overall government deficit (including the consolidated budget, the Pension Fund and oil and gas monopoly Naftogas Urkainy) in 2010, 2011 and 2012 respectfully; 2. below 35% of GDP for public debt by 2015; 3. deficit free Naftogas Ukrainy starting 2011 due to domestic gas tariff increases; 4. core inflation below 10% by 2012.12 Still, it is not strongly visible whether unpopular measures essential for the nation’s long-term stability including increase of the pension age by five years, hike of domestic gas tariffs for households and utilities companies by 50% in April 2011, hampering of salary growth in public sector, adopting transparent tax code will be implemented in full without stepping back.

4.5.

Increasing other Institutional and Commercial Borrowing?

The signing of the new stand-by program in July 2010 was set to unlock new foreign borrowings to Ukraine including 610 million EUR of budget support financing from the European Union and 800 million USD from the World Bank to be disbursed the same year. Analysts expect the disbursement of funds continues on the way of reforms showing positive economical effect. Long-term financing from international financial institutions will allow the government to reduce its need to borrow in the commercial financial market that would be beneficial for the state budget and the government debt sustainability. However, further government borrowings would push Ukraine’s total public debt to 40% of GDP by the end of 2010 from 35% of GDP13 achieved in 2009 that could still be considered as a moderate 12 International Monetary Fund, Public Services, Ukraine – Request for Stand-By Arrangement and Cancellation of Current Arrangement Staff Report; Staff Supplement; Press Release on the Executive Board Discussion, 2010, http://www.imf.org (retrieved on 6 August 2010). 13 Kyiv Post Staff Writers, IMF deal to unlock USD 1.6 billion EU, World Bank funding, Macroeconomic Briefs, 2010, p. 1, http://www.kyivpost.com (retrieved on 30 July 2010).

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level compared with many of Ukraine’s neighbouring European countries (the public debt of EU member countries under the Pact on Stability and Economic Growth should not exceed 60%). By 2015, Ukraine must ensure that its public debt is back to the figure of less than 35% of GDP.14 Ukraine’s strong “yes” to reforms in the middle of 2010 has echoed upgrading of its sovereign long-term foreign and local currency debt ratings to B from B- by Fitch15 and to B+ from B by Standard & Poor’s credit agencies. The outlooks are stable.16 The forecast of the rating may be increased to positive based on the reform development. Further rating upgrades will be very positive for the country and businesses to make new foreign borrowings from commercial lenders on more favourable terms. Yet, Ukraine may still act on 2010 summer situation to issue Eurobonds worth 2 billion UAH soon since the reduction of country risk levels provided an opportunity for the government to place new Eurobonds at a rate close to 7% similar to the yield of 6,437% on Ukraine’s outstanding dollar bonds due November 2016.17

4.6.

Export of Steel and Grain Still Key Factors of Boosting Ukraine’s Economy?

Ukraine will remain exposed to commodity price fluctuations in the global markets if it keeps large energy imports and low export diversification, in which steel and agricultural commodities account for 55% of exports. However, due to the same vulnerability of demand of steel and agricultural products and access to capital markets, Ukraine’s economy will expand faster than previously estimated as global demand recovers in 2010 and hopefully further. The World Bank upgraded GDP growth forecasts for Ukraine from 3.5% in 2010 to 4% in 2011 and 5% in 2012 with the comment that Ukraine is very sensitive to foreign demand18.

14 Capital Strategy, Monthly Macroeconomics Brief, #5(5), 5 August, 2010, p. 2. 15 Fitch Rating, 2010, http://www.fitchratings.com (retrieved on 11 August 2010). 16 Standard & Poor’s Rating, 2010, http://www.standardandpoors.com (retrieved on 30 July 2010). 17 Bloomberg Businessweek, Ukraine to Revisit Eurobond Plans as Rates Continue to Fall, Tigipko Says, 2010, p. 1, http://www.businessweek.com (retrieved on 2 August 2010). 18 Bloomberg Businessweek, Ukraine’s GDP to Rise 3.5% This Year, World Bank Says, 2010, p. 1, http://www.businessweek.com (retrieved on 1 July 2010).

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The growth in exports particularly of metallurgical products – steel prices and export volumes almost returned to record levels to support Ukraine’s metallurgical industry ranking amongst the top ten in the world in terms of size and exports. Despite the recent cooling of global metallurgical markets export of goods has been remaining unchanged and is expected to be supported by recovery of engineering product export. In agricultural sector, Ukraine is planning to introduce export quotes for the main crops of wheat, barley, corn and sunflower due to the climate changes towards colder winters and hotter summers. It is expected to be defined every year starting 2010 summer during the grain harvesting campaigns. The same change of the climate in Europe and Russia will be bringing the grain and flour product prices up that may benefit Ukraine in case it raises investments to its agricultural sector for technology upgrades. In overall, the economy grew 6.1% in the first five months of 2010 comparing to 7.5% of output expansion on annual average between 2000 and 2007 years. The government is planning to reach pre-crisis growth levels by the end of 201219. However, estimates of potential output of Ukraine are subject to large degree of uncertainty caused by structural breaks and lack of reliable data on capital stock and capacity utilization. Picture 9: Potential Growth and Output Gap (%); source: International Monetary Fund, Public Services, Ukraine – Request for Stand-By Arrangement and Cancellation of Current Arrangement Staff Report; Staff Supplement; Press Release on the Executive Board Discussion, 2010, p. 6, http://www.imf.org (retrieved on 6 August 2010).

19 Ibid.

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4.7.

Force of Mergers and Acquisitions, Cooperation and Privatization Coming Back?

It is expected that in 2010 and beyond the value of M&A transactions in Ukraine will increase to reach its highest level provided in 2007 by the end of 2011. According to the data of Mergemarket, a specialized informational agency, already in January – June of 2010, the volume went up to 17 transactions at the total amount of 1.7 billion USD that was four times higher than in the same period of 2009 (14 transactions for 430 million USD). The largest part of the merger volume at the beginning of 2010 was accounted by the acquisition of 50%+2 shares of the second Ukrainian metallurgical company, ISD, by Russian investors for 1 billion USD financed by Vnesheconombank (Russia). The majority of transactions involve medium- and large sized businesses in metallurgical, food and beverage, agriculture, telecommunications and financial sectors. It is predicted that M&A transactions in those sectors will continue further to achieve not less than 3 billion USD volume by the end of 2010.20 Moreover, opening opportunities of acquisitions in the Ukrainian agricultural industry developing on 32 million hectares of arable land together with reduction of grain supply in Europe and Russia due to climate changes might bring this sector to one of the leading positions among investors in the Ukrainian market in the near future. Another one of the most active sectors would be commercial real estate due to introduction of tax benefits to hotel development businesses as a part of UEFA EURO 2012 Incentive Programme and expected recovery of consumer spending. Furthermore, Ukraine is also seeking closer cooperation with Russia. One of the purposes is to support industrial companies such as aviation, defence industry, energy equipment building and shipbuilding. There are offered opportunities of establishing joint ventures between Russian companies and Ukrainian state aviation company Antonov OKB, and VAT Turboatom, the Ukrainian biggest turbine maker. The joint ventures will do sales, marketing and service.21 In one of the attempts to intensify economic growth, the government of Ukraine has been planning to sell state assets. The target assets include but are not limited to

20 Analytical Data Collection of Mergemarket, Phoenix Capital, Dragon Capital, Russians are buying Ukraine, 2010, http://realt.ua/Statti/0_Index.php?idn=60633&idr=262144 (retrieved on 9 September 2010). 21 Bloomberg Businessweek, Ukraine seeks Russian investment to boost industrial exports, 2010, http://www.businessweek.com (retrieved on 29 June 2010).

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1. the largest fixed phone service provider, OJSC Ukrtelecom, with net worth of about 1.2 billion USD; 2. majority of state shares in the engineering companies like OJSC Gorlovskiy Mashinostroitelny Zavod and OJSC Poltavskiy Zavod Gazorazryadnykh Lamp, 3. majority of state shares in energy-generating and energy-distributing companies like Donbassenergo and Zakhidenergo. It is expected that within the next five years the sale of the state assets will bring the state participation in the economy down, from current 37% to 20-25%.22

4.8.

Modelling New Tax Code and Paying off VAT Refund?

The new Tax Code of Ukraine is expected to be approved by the government by the end of 2010. Its key aspects include gradually cutting rates of value-added tax (VAT) from 20% to 17% and of corporate profit tax (CPT) from 25% to 20% by 1 January 2014, scrutinising limitations on individual entrepreneurship in terms of types of activity and tax rates, simplifying book-keeping, introducing tax breaks and extending authorities of the State Tax Administration as well as maintaining taxavoidance agreement with Cyprus. The Draft Tax Code approved in the first reading by the parliament in the summer 2010 has been widely criticised by the business community for dubious interpretation of norms, a large number of discriminatory and unfavourable provisions, and the potential to increase administrative pressure on business. Therefore, after significant amendments to be provided by the business community (the European Business Association and the American Chamber of Commerce are actively participating in recommendation drafting) and tax and legal consultants (from Kyiv offices of Ernst & Young and PricewaterhouseCoopers), the final version of the Tax Code will be adopted to welcome long-awaited much-needed comprehensive tax reform promoting tax efficiency, fairness, neutrality as well as effective tax administration and enforcement in Ukraine. Its impact on the Ukrainian economy and population sentiments will be more predictable after the approval of its final version available in the fall 2010.

22 Ibid.

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Additionally, the Ukrainian government has been looking for solutions to repay the VAT debt reaching the total amount of claims of 36 billion UAH (equivalent to 4.5 billion USD) as of June 201023. In the summer 2010, the government finally approved the issue five-year T-bills with a 5.5% coupon rate, which is less than half the market rate here defining at 13.5% of government bonds with similar duration traded at YTM) and semi-annual principal and coupon payments to convert 16,4 billion UAH (equivalent to 2, 1 USD) of the VAT refund arrears. The first tranche of 48. 5 UAH million (of three tranches planned) was issued to 705 companies with the lowest VAT refund claims.24 However, while the companies obviously would prefer to receive VAT refunds in cash and in full, the sooner the VAT bond issue is completed the faster it allows the recipients who have experienced the delay in refunds over 2008-2010 years to either sell or repo the bonds and raise long overdue funds for working capital and investment needs. Therefore, in the nearest future, the companies are expected to obtain the VAT bonds as a government issued instrument for the VAT refund to observe how the market would develop in hope to avoid speculative discounts at which the instrument is predicted to be traded in the first months.

4.9.

Banks on Earning Road Again?

Starting 2009 and going further to 2010-2012, Ukrainian banks have been implementing various instruments for cleaning up their balance sheets from non-performing loans in order to save their liquidity and continue lending without additional capital injections in compliance with the ratios set by the National Bank of Ukraine, the regulator of the Ukrainian banking system. The instruments include distressed debt trading and structural considerations. Distressed debts trading involving collection agencies and investors focused on distressed debt acquisitions has become one of the most popular trends in the Ukrainian banking market.

23 The Bleyzer Foundation (TBF), Ukraine – Macroeconomic Situation – June 2010, 2010, http://www.usubc.org/ site/sigmableyzer-macroeconomic-reports/ukraine-macroeconomic-situation-june-2010 (retrieved on 13 July 2010). 24 European Business Association News, Interview with Tomas Fiala, EBA Board Member and Managing Director of Dragon Capital, Ukraine, 2010, http://www.eba.com.ua (retrieved on 13 August 2010)

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Recently completed audits of the banks revealed that 61 banks having 59% of banking system assets will need approximately 4 billion EUR to cover the capital needs.25 Although funding constraints are gradually easing due to return of deposits in the banking system, the banks are still risk-averse to renew earning on lending. However, the certain growth in corporate and consumer lending is expected as soon as the NBU will substantially lower reserve requirements for foreign currency loans to companies without foreign currency revenues and continue gradually lowering the discount rate.

4.10. Hryvna Exchange Rate Getting Floating to Power Inflation? Renewed cooperation with the IMF could result in further gradual liberalization of NBU’s foreign exchange rate policy. Suggestions by the IMF shift to inflation-targeting solutions, first of all, would result in more flexible exchange rate. According to the IMF Country Report, the NBU will continue, on a daily basis, setting the official rate at the average transaction-weighted rate of the preceding day (with intraday adjustments if necessary to keep it within 2% of the market rate).26 It is also expected that the government and the NBU will promote the development of forward exchange market by end of March 2011. With the hike of gas tariffs and related increase of industrial output rates, growth of bread and flour product prices expected due to the summer drought in 2010 and mostly in 2011, the risk of higher than planned inflation might be offset by the NBU allowing UAH slightly appreciate in order to curb inflation. It is foreseen that the slight appreciation of UAH will be mostly positive for the population and banks while its negative impact on export industries (primarily steel and grain) will be eased by the improving consumption in the global markets.

25 International Monetary Fund, Ukraine – Request for Stand-By Arrangement and Cancellation of Current Arrangement Staff Report; Staff Supplement; Press Release on the Executive Board Discussion, Public Services, 2010, p. 8, http://www.imf.org (retrieved on 6 August 2010). 26 Ibid., p. 69.

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While Ukraine’s inflation rate dropped to 6.9% in June 2010, the lowest since June 2006, the World Bank forecasts the inflation rate at the end of 2010 to be 11.9% (due to increase of utility prices, gradual improvements in retail lending and consumer expectations) while the 2011 rate will be 9.5% to fall further to 8.1% in 2012.27

4.11. Consumers Supporting the Economy? Recovery of internal demand is limited by a rather moderate growth in disposable incomes and a lack of new retail loans. Decent real wage growth in 2010, a stable foreign exchange market and improving macroeconomic and political situations may positively affect population confidence and thus spending. If real incomes manage to sustain at least the current historically low growth rate (annual) of about 6%, they will reach pre-crisis level (in 2001-2007 real income growth was always in the two-digit ballpark) by the end of 2011.28 Although consumer expectations regarding the country’s economic growth prospects are reaching their highest level in the past four years and private consumption, which occupies approximately two thirds of the GDP, is reviving, analysts do not expect that it will add notable incremental growth to Ukrainian economy until the end of 2011.

4.12. Conclusion Therefore, Ukraine’s medium-term future looks considerably more promising than its recent past. The economy is expected to recover towards stability and efficiency to preserve confidence of international donors and foreign investors, if the opportunities started opening in 2010 are proper executed within a reasonable timeframe, in the next years, with an estimated boost in the upcoming two and half years and move towards European norms.

27 Bloomberg Businessweek, Ukraine’s GDP to Rise 3.5% This Year, World Bank Says, 2010, http://www.businessweek.com (retrieved on 1 July 2010). 28 Capital Strategy, Monthly Macroeconomics Brief, #3(3), 31 May, 2010, p. 1.

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Epilogue

Financial Crisis in Eastern Europe: Road to Recovery

»The only surprise about the economic crisis of 2008 was that it came as a surprise to so many.«1 Joseph Stiglitz

It would be easy to attribute a common thread to the experiences of the former Soviet bloc countries in the past two decades; post break-up euphoria, severe downturns in economic output as uncompetitive former state enterprises are faced with the realities of the market economy, a distinct improvement in the economic climate from the mid-nineties onwards, followed by overheated property markets and profligate consumer spending allied with easy credit as the Eastern European economies expanded robustly and rather carelessly after the turn of the new century and then subsequently an abrupt and rather severe slump precipitated by the banking crisis of 2008. However, such a swathing brush stroke would ignore the very different geographical, social, economic and traditional differences between the various countries at the time of the disintegration of the Soviet bloc and its former satellites and the period thereafter. Each nation had and has differing regional characteristics, shaped by the nations surrounding it and historical trading patterns which remained partly intact despite the abrupt circumstances after the division of Europe after the end of World War II. Hungary for example, was seen by the Western nations, as a somewhat more pro-market Soviet bloc country prior to the fall of the iron curtain, as the communist state apparatchik had already introduced some free market and economic reforms in the seventies and eighties prior to the fall of the iron curtain. Typical examples were the implementation of a number of joint ventures with western private industrial companies, and forms of private ownership and small scale enterprise were introduced. This was no doubt influenced by good and rather amicable relationships with Austria (and the city of Vienna) throughout the so-called ‘Cold War 1 Joseph Stiglitz, Freefall, 2010, p. 1.

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period’ and Austria acted as a good conduit for private enterprise and business interests. However subsequent to the radical changes in the political landscape Hungary fell somewhat by the wayside as the country was racked by political wrangling and a reluctance to face the fiscal challenges brought about by the introduction of the market economy. The recent decade has also seen an increase in political radicalism and stirrings of nationalistic reaction to outside influences (in particular the so called global organisations such as the IMF and discontent with what is seen as outside interests against which the Hungarian people are somewhat helpless). Nevertheless, the Hungarian people have historically always faced up to such challenges, and being a landlocked country surrounded by ever changing boundaries and political upheaval the people are nothing if not adaptable and the problems of the past decade seem to be behind them and the country is looking ever more attractive to overseas investors. Some might claim that Poland was the catalyst for change among the Soviet Blocs countries back in 1980 when the protests from the Gdansk shipyards, through the shipbuilders´ trade union Solidarnoıä, first came to the attention of the world and found the support of the western nations and the Catholic Church. Poland has a long and profound history as an independent nation bridging Western and Central Europe with Russia and the east. Nevertheless, at times Poland had to face belligerent neighbours and the nation has suffered as a result. However, the events of 1980 and the following years culminating in the fall of the Iron Curtain have been of a mixed blessing for Poland. The nation has experienced a great deal of migration of its younger people in search of better prospects elsewhere and its diaspora is spread worldwide but the combination of a favourable geographical location between Germany and Russia, a well-educated workforce, a long established trading history and a well-earned reputation as a hardworking people has allowed a deep change in the economic outlook of the nation. Throughout the 1990s and the decade after the turn of the century Poland has remained an attractive location for foreign investment. The key figure for investors has been the steady growth in productivity of the workforce and the increasing (but sometimes too slow) improvements in the country’s infrastructure. With a significant population and a broader scope of economic activity, including a confident and relatively solvent consumer sector in comparison to the smaller ex-Comintern nations, Poland has a come out of the recent upheavals in good shape reflected in the Zloty which has held up well against foreign currencies. Whether or not Poland will adopt the euro in the coming years is most probably a political rather than an economic question. Introduction of the euro will no doubt benefit foreign investment further and encourage even more trade with other European nations. However, on a po-

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litical level, a degree of fiscal independence at a monetary level allows Poland (at least to some extent), to make its own decisions in the future which are best suited to its requirements rather than the stipulations of the ECB. However, Poland is likely to adopt the euro in 2012/2013 and use of the euro in business is already widespread across the country. The Czech Republic seemed to have suffered most from the draconian influence of the Soviet Union on its satellite nations. As a committed member of the Warsaw Pact and a follower of the more stringent Communist model following the suppression of the 1968 uprising it seemed the Czech Republic (or as it was then Czechoslovakia) would struggle to adapt to the rigours of a market economy. However, the Czech Republic has turned out to be a shining star among the former Comintern countries, no doubt helped by its proximity to the substantial German market and undoubtedly a highly educated population with a strong tradition of engineering and technical expertise, This goes right back to the 19th century when the territory now within the confines of the Czech Republic underwent a dramatic industrial expansion. By comparison, after the comparatively harmonious break up of Czechoslovakia in 1993, Slovakia lost its way somewhat and found itself aligned strongly with the Russian Federation and shackled with a populous government which seemed more interested in lining the pockets of accomplices and confidants than providing accountable and competent government. This period in the economic and political wilderness and a certain international isolation started to be redressed at the beginning of the new decade as the political landscape and the populous came to the realisation that a re-integration and participation in the global economy were vital elements of the country’s future prosperity. This political and economic U-turn has been rewarded and the Slovak economy has now proven to be one of the most dynamic and foreign investment friendly in the whole of Eastern Europe. The fiscal regime has also demonstrated itself to be highly attractive to large foreign investors. Sensibly the country has also begun to look at broadening the scope of the economy in order to avoid an overreliance on large scale car manufacturing and the consequent swings in demand which might affect the Slovakian economy in the future. Lithuania for instance retained and carried on its close ties to the Scandinavian (particularly Sweden and Finland) countries despite its incorporation into the Soviet Union, as the Baltic people had always looked across the Baltic Sea for trade and cultural ties. As a small nation with a limited population and diminutive domestic market trying to find its feet in a rather brutal economic climate of the early nineties

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it sought close relations and, of course, investment from Sweden and Finland. Although hit sharply by the economic crisis of 2008 which also rolled into 2009, the government of Lithuania acted in a pragmatic manner throughout 2009. It introduced tax changes and took consolidation measures which partially restored confidence in the economy and provided a solid footing for the coming years. Russia has and always will be to some extent an enigma. In 1989, prior to the break-up of the Soviet Union, it was still the world’s second largest economy after the USA and was the leading and most powerful Eastern European nation. However, the collapse of the old state-run economy laid bare the real condition of the Soviet state led enterprises. Russia became to some extent a political and economic backwater for ten years as living standards fell and the country lurched from one crisis and conflict to the next, helped only by its endless natural resources. However, the “Wild West” economic policies of the nineties which enriched a small percentage of the population primarily at the cost of the majority of the populace have now been somewhat left behind. The recent governments of the Russian federation have attempted to introduce reform to simplify the tax system and reduce bureaucracy in order to encourage foreign investment outside the field of energy supply. This has to some extent been successful and was built on the back of a well educated population. Although, problems remain in encouraging the growth and establishment of small to medium sized companies which tend to reflect a more mature economy and facilitate distribution of wealth down through the population at large. There remains the issue of government corporatism and the link between the large (mainly energy) groups. The Russian political elite are still strong and company policy is still driven by non-economic decisions. Remarks from leading politicians still also tend to send waves of concern across national boundaries. Although, such outpourings should be taken with a pinch of salt as they tend to reflect the boisterous nature of Russian politics (aimed at a public audience) rather than any attempt to undermine reform. And yet, Russia is still a leading technological nation with a world renowned space program and a robust and export-oriented arms industry. It manufactures leading equipment which is sold worldwide and in many instances has a competitive edge over similar products from US, French, German and British arms industries. As the Russian administrative and tax regime becomes more transparent and companies participate less and less in the so-called ‘black economy’, tax revenues will continue to allow more latitude for social policy in order to improve the living standards and education assistance for the working population. What cannot be ignored is the potency and influence of Russia’s huge natural resources. Not only in the numbers; e.g. balance of trade, foreign reserves etc. but also in the geo-political sphere in which the leading industrial nations and

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the newly influential BRIC countries (of course including Russia) are determining foreign policy and strategy primarily with an eye on the sourcing of vital raw materials. Russia seems to hold all the good cards at the moment, but being an energy resource rich nation can also be a poisoned chalice. It can hide severe structural weaknesses and paper over holes in economic policy. Russia is acting with renewed confidence on the world stage but must continue with the, until now, successful economic reforms. They have started to pay dividends for the whole nation at large, rather than just the few. Bulgaria is located in the south-eastern corner of Europe and has strong links with the Balkan area and Greece. It is also geographically close to Turkey and the Ukraine as a consequence of its Black Sea coastline. From a Western European viewpoint Bulgaria has been an attractive tourist destination. Since the fall of the ‘iron curtain’ it also became a popular location for property investment. However, these images mask the real Bulgaria. The decline of heavy industry in the nineties and the taint and actual reality of high levels of government corruption resulted in a substantial free-fall in economic output well into the late nineties. All the usual standard indicators for social and economic ranking (including the corruption index) during this period, had Bulgaria wallowing in the lower division among the poorest South American and Central Asian nations. After the cataclysmic political events of the late nineties a kind of national unity was finally found. Bulgaria went on a new path of economic reform and progress which was only halted by the banking and economic crisis of 2008. Reforms included, among others, large scale privatisation, rationalisation of the government budget and reduction of the government spending deficit, a fixed rate of exchange with the then DM and subsequently with the euro, a crackdown on tax evasion, introduction of more efficient insolvency laws, the reduction of some tax rates and the abolition of state licencing. All these changes combined to form a solid environment for economic growth in the years after the turn of the century. Despite the strong economic growth in the years from 2002 to 2008, Bulgaria did not remain untouched by the 2008 crisis. The dangers of overreliance on foreign capital, whether for lending in the banking sector, ownership of the manufacturing sector, or for turnover and liquidity in the domestic stock market, became apparent as Bulgaria suffered the same shocks as other Eastern European through no fault of its own i.e. by simply being a player in the international economic arena. However, the monetary reserves of the Bulgarian National Bank allied with sensible and pragmatic fiscal policies and the absence of any significant banking collapses sustained the confidence of investors and the rating agencies in the Bulgarian economy. There is a cautious optimism about Bulgaria’s future outlook. Taking into consideration the geographical advantage that

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the country is a bridging point between the Middle East and Europe, it has relatively low labour costs, a geographical proximity to a number of major markets, a welleducated workforce, a pro-business legislative environment and, last but not least, a pleasant climate. Therefore, Bulgaria’s growth should return to pre-crisis levels provided that the government is able to sustain the development of the country’s infrastructure. The seductions and attractions of the free market were wholeheartedly embraced after the fall of the Iron Curtain by the ex-Comintern nations. However, the disciplines and sanctions of the market were unforgiving and a number of nations which we have discussed fell into difficulties early on and it took them several years to return to historical levels of output. The challenges of balancing government income and meeting the growing expectations of a free electorate have remained a problem to this day for most of the former Soviet Republics. Nevertheless, despite early criticism from the Western European nations (over high levels of corruption, bloated bureaucracy as a relic from the Communist era, opaque legal and tax systems, expensive populist policies rather the pragmatic approaches, fiscal profligacy and weak controls over financial lending) the Eastern European nations have reacted well to the crises. They introduced measures across the board to reduce government spending, attracted foreign investment, improved government transparency and stabilized currencies. In fact, one could say that these countries have reacted more resolutely and implemented far more change which will benefit the populace in the long term as opposed to the so-called advanced Western European nations such as France, Italy, the United Kingdom, Germany and Spain. They have struggled to battle against the vested interests of stakeholders who have proven to be particularly intransigent when it comes to necessary corrections such as the increase of the retirement age, reductions in social security spending, reduction of salaries in the public sector in order to balance the books, over-bloated and inefficient health systems and so on. It seems that the people of Eastern Europe have been (and still are) accustomed to change and hardship. Therefore, they are willing and able to take necessary measures (and pain) in order to restore financial and economic stability in the near and long term future. How this develops in the future will be interesting to see. The Western European countries will remain the ‘economic powerhouses’ in the coming years, but as Eastern Europe and Russia grows and develops at the rates predicted in 2010, the game of catch-up is likely to be completed within a decade or two. How the European Union and the political landscape will then look remains a matter of conjecture. The Eastern European nations are likely to become bolder in their demands for influence upon EU policy and increasingly reluctant to accept and adopt policy shaped by the old West European

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nations. The fulcrum of economic and political power will slightly shift over to Eastern Europe and this change will have an impact on economic, non-economic, social and political trends all over Europe. Hamburg, December 2010

Dirk Schreiber Financial Manager, Steinhoff Europe

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Editors` Vita

Jens Jungmann, Financial Auditor (PL & RO), CPA, CFE

The editor and author is one of the managing partners responsible for Rödl & Partner´s international business. As a CPA, CFE and a Polish and Romanian certified auditor Mr Jungmann has 20 years experience in advising enterprises from all industry sectors and of different sizes which operate in Central and Eastern Europe. Prior to his work in CEE, he started his professional career at a larger German audit firm. Thereafter, he was employed by one of the Big 4. His work took him to Dresden, Stuttgart, Boston, Poznan and finally to Warsaw. Mr Jungmann served for many years as a court-appointed expert witness in accountancy matters for the District Court in Poznan. For over seven years he was a member of the Audit Committee of the German-Polish Chamber of Industry and Commerce. Additionally, he acted as an employers´ representative in the Social Dialogue Committee in Wielkopolskie Province (Poland).

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Prof. Dr. Bernd Sagemann, LL.M., MBA, M.B.L.-HSG

The editor and author is Director at an international operating company in Germany and is responsible for the Accounting & Controlling division at headquarters as well as at the regional level. Prior to his current occupation he gained experience as Manager of Assurance and Corporate Finance at one of the Big 4 audit companies and subsequently as Head of Accounting / Finance at renowned businesses. After completing his education and training as a graduate in fiscal affairs as well as economics and macroeconomics studies, the author completed post-graduate studies in Financial Service Management at the University of Wales (MBA), law at the University of Münster (LL.M.) and European and International Business Law at the University of St. Gallen (M.B.L.-HSG). In the context of his vocational doctor thesis for Doctor of Philosophy at the University of Hamburg, he undertook a comprehensive review of the causes and effects of the Asian Crisis and their implications for the region. Alongside his daily business activities, the author is honorary professor at the FOM, University of Applied Sciences, and lectures primarily on Finance and Tax Law. Dr. Sagemann is engaged in scientific research in the origins of financial crisis as well as in the field of economic, legal and corporate development of the Southeast Asia Region and the People´s Republic of China, promulgating several publications about these objects of investigation.

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Authors` Vita

Nicole Arnold, LL.M.

The author is employed by an international operating company in Germany. After completing her studies in economics and international management, Ms Arnold passed a post-graduate study of law (LL.M.), focusing on M&A at the University of Münster. Besides this, she graduated as an International Certified Accountant (ICA) at the Frankfurt School of Finance & Management. She has gained experience in international markets during her field of work covering the automotive, real estate and service sector. Ms Arnold has worked in Spain and the United Kingdom before focusing in particular on eastern European markets. In her current position, she is responsible for the consulting and co-ordination of standardized operations within the Finance division. She coordinates with specialists and service providers in the area of corporate setup, (re)structuring and process development projects as well as conducting market entries from the financial, commercial, as well as legal and tax sides.

Dr. Roland Felkai

Dr. Roland Felkai, Graduate Economist, Master of Arts, born 1968 in Bremen/ Germany, studied economics at the Universities of Münster and London. He started his career in 1996 at the London office of a big-six-company and was seconded to Hungary in 1997 to build up a German Tax Desk in Budapest. In 1998 he became Managing Director of Rödl & Partner, Budapest and responsible for all service lines (audit, tax and legal services). Dr. Felkai has advised a significant number of investors in the last 13 years in tax planning opportunities, particularly in relation to M&A transactions. The author has published a wide range of papers on Hungarian and international tax law and is a lecturer at the University of Hamburg. He is also correspondent of the journals “European Taxation” and “Internationales Steuerrecht”.

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Joerg Gulden

Joerg Gulden, German Certified Tax Advisor, studied Economics and Organisational Science in Munich and Austin, Texas From 1994 to 1998 he was employed at a German audit firm in Dresden. After two years in a management consulting firm in Stuttgart, he changed to a major German based professional service firm. Since 2003, he is the Partner in charge of the firm’s activities in South-eastern Europe and the Middle East. Being specialised in international taxation and M&A, he has been advising numerous foreign investors including some of the Global Fortune 500 during their investment process into the region.

Minko Karatchomakov

Attorney at Law Minko Karatchomakov, lawyer (Germany), studied Bulgarian and German law in Sofia, Erlangen and Munich. After graduating from University Erlangen-Nürnberg, he absolved his post-graduate legal traineeship with the Higher Regional Court in Munich. Mr Karatchomakov has been with Rödl & Partner since 2007 and participated in the establishment of the Rödl & Partner’s Sofia office as a recognisable advisor of European corporate clients. Since 2009 he has held the position of head of the Bulgarian branch and has expanded Rödl & Partner’s activities to the city of Plovdiv. In 2010 he was appointed associate partner at Rödl & Partner. He advises investors, developers, traders and financial institutions in conducting business in Bulgaria or with Bulgarian partners in the area of M&A transactions, restructuring under company law, insolvency, employment, real estate transactions and renewable energy projects.

Klaus Kessler

Klaus Kessler, Attorney at law, Partner and Managing Partner of Rödl & Partner Ukraine Business, is responsible for the development and implementation of standards and procedures and the management of the offices in Kiev and Kharkov. Conjointly he provides legal consultation to companies with a focus on investments in Ukraine and the regions of South-Eastern Europe. As a member of Rödl & Partner’s international M&A Practice Group and as a consequence of his long M&A experience in Eastern Europe, Mr Kessler is responsible for M&A projects in this region.

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Prior to Rödl & Partner, the author worked as Junior Associate and Associate at two Munich based law firms with an international profile. During this time he was responsible for well-known clients in the field of patent, licence and trade mark law. He represented the clients in the federal patent court of Germany and handled international trademark and domain disputes before the European Trademark Office (HABM, Alicante) and WIPO (World Intellectual Property Organisation) in Geneva. Before to his time in Munich, he worked six months for San Francisco based law firm Ostermann and Partners. Mr Kessler studied Law at the University of Bayreuth and Munich. In addition, he attended courses at the University of California in San Diego for nine months. He received his admission to the German Bar in 1998.

Tobias Niklas Kohler

Tobias Niklas Kohler is Rechtsanwalt (Attorney-at-law) at the Landgericht München I (admitted April 2006) and Member of the Lithuanian Bar (July 2010). After completing his German high school diploma (Abitur) in 1996 he studied law in Munich. Between 2004 and 2007 he worked as a lawyer and attorney-at-law with the international multi-disciplinary professional services firm Rödl & Partner in Riga, Vilnius and Warsaw. Since March 2007 he has been head of legal and tax in Lithuania and since December 2007 head of the Rödl & Partner office in Vilnius. Today he is Partner and responsible for all legal, tax, audit and accounting services provided by Rödl & Partner in Lithuania. He advises investors, developers and trading firms in Lithuania and abroad in legal and tax aspects regarding national and international business transactions. Essentially he is focused on legal advisory and contract configuration regarding M&A, renewable energies, foreign direct investment, real estate transactions as well as structuring of transactions under tax and company law. He has published a number of articles on various tax issues as well as on leasing law and on debt management in the Baltic States. Furthermore he contributed to numerous compilations and publications on tax law and the investment environment in the Baltic States.

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Peter Reese

The author is currently working as Managing Director at the BNP Paribas Corporate & Investment Banking unit based in Frankfurt. As Senior Banker he is responsible for a number of large German corporates (mostly DAX & MDAX listed companies). As such he is a trusted advisor to his clients especially for strategic and capital market related topics. After leaving high-school Mr Reese completed his bank trainee programme prior to enrolling at the University of Hamburg in 1988 where he studied Business Administration and Economics. His main areas of interest were banking and finance related topics with a special focus on capital markets theory as well as derivatives pricing and risk management. He also focused on Macroeconomics and within this subject field, in particular Monetary Policy. In addition he was very much engaged in the fields of Law & Economics, Microeconomics and Game Theory. In 1993 the author started his professional career with Dresdner Bank, subsequently working in several departments such as Market Risk Controlling, Corporate Finance - Equity Capital Markets and finally as Deputy-Head of a Treasury & Securities Advisory team. In 2000 he joined Solution42, a mobile billing software maker, as CFO. His main task was to prepare the company for an IPO. In 2001, after a successful trade sale to Portal Software (today part of Oracle), Peter went back to Dresdner Bank to become team-head Structured Finance in the Financial Engineering department. In 2004 he joined BNP Paribas as Senior Relationship Manager for large midcap companies.

André Scholz

André Scholz, Wirtschaftsprüfer/Steuerberater (German Certified Public Accountant/Certified Tax Advisor), Partner and Managing Partner of Rödl & Partner Russia/ CIS, is responsible for all group activities within the region containing the offices in Moscow, Saint Petersburg, Minsk, Kishinev, Almaty and Tbilisi. In addition he provides consulting services to companies with a focus on investment in Russia and the CIS. His core focus is the audit of financial statements translated from local accounting principles into IFRS or German Accounting Standards. As a member of Rödl & Partner’s International Audit Practice Group and in conjunction with his long experience as a Certified Public Auditor, Scholz is also responsible for the international quality assurance of audit practices. Prior to Russia/ CIS, he worked on international audit and consulting projects in Mid-/Eastern-Eu-

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rope and was based in Berlin. Between 1997 and 2000 he was responsible for the audit practice in Bratislava, Slovakia. Prior to this he worked for a German audit firm in Dresden. He studied Economics at the University of Applied Sciences in Mainz and is coauthor of commentaries on Russian Accounting Rules. Scholz is a member of the board of the German-Russian Chamber of Commerce and chairman of the Committee for Accounting and Taxes of the Chamber.

JUDr. Maroš Tóth, MBA

JUDr. Maroš Tóth, MBA, attorney-at-law and a partner in the international firm Rödl & Partner, completed his studies at the Pavol Jozef Šafárik University in Košice (Slovakia). He received his doctor of jurisprudence (JUDr.) in 2000 and after successfully concluding his studies at the ESCP-EAP European School of Management in Berlin (Germany) he was awarded the MBA title. From 2001 he has been involved as a commercial lawyer for Rödl & Partner, providing legal consulting services to clients and since 2008, is managing partner of Rödl & Partner Advokáti, s.r.o. Mr Tóth provides legal advice mostly in the area of commercial law including company law, civil law M & A projects, real estate law and financing.

Rene Vazac, MBA

Rene Vazac is Certified Public Accountant and Partner at the international law, tax advisory and audit firm Rödl & Partner. Since 1997 she has been responsible for managing the audit department of Rödl & Partner in the Czech Republic, in 2002 promoted to partner at Rödl & Partner. After completion of Business School in Prague, Ms Vazac successfully completed her studies at the Munich Ludwig Maximilian University. From 1992 to 1997 she worked as Project Manager at the Munich office of the audit firm BDO. She has been a member of the Czech Chamber of Certified Public Accountants since 1996 and has published numerous papers on accounting matters. From 2000 to 2002 she taught at the Department of International Management at the University of Applied Sciences Amberg-Weiden. She specialises above all in German and international accounting standards.

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