PBW REAL ESTATE FUND

These 3 countries are again experiencing strong growth, even more this year than last, after a period of low GDP growth due to the general situation in Europe.

The recovery is mainly due to a change in the exchange rate policy: these countries had been experiencing strong real appreciation of their currencies until 2001; in 2001 they changed their policies, either on their own or as a result of market forces, anyway with no currency protection; fairly strong depreciation of the currencies started in 2001. This increased their competitiveness (in export markets) and means that the current growth rate is sustainable.                      

Given this situation, I think that the most important reason to worry about these countries is the lack of savings. These 3 countries have substantial external deficits due to both the fall of the savings rate of households, which became very low, and also to the public deficits. The public deficits are themselves linked to a deliberate policy of reducing the tax burden: these countries have  reduced certain taxes fairly substantially. The fall in savings can be explained by the extremely fast growth of credit facilities. This is easy to understand given the very low debt level in the private sector, in particular for households. This (fall in the savings rate) may occur when it is necessary to build infrastructure and absorb the costs of EU entry, whilst the tax policy remains very aggressive. This leads to significant external deficits. I believe that this is the most important concern, and is linked with the Euro, not the EU, because, if no exchange rate crisis has yet arisen because of these external deficits, it is due, at least until recently,  to the privatisation (process) which attracted important flows of private capital into these countries; however since 2001 direct investment flows have weakened, and more and more external deficits have been funded by short-term debt rather than corporate investment. Short-term debt within these 3 countries has been growing over the past 2 to 3 years.

In some cases these debts relate to international corporations operating in Poland and funding themselves in Euros, for example, on the European market, but nevertheless the overall situation is financially unbalanced by low savings and external and budgetary deficits. This is significant, I believe: repetitive crises in countries that are moving or emerging occur when there are insufficient savings, and consequently the only way to keep this level of investment unchanged is to call upon external debt, which exposes these countries to additional risks of exchange rate stability. These 3 large countries of Central Europe are in this situation.

Of course, not all of them  face exactly the same problem: low savings have not discouraged a significant level of investment in the Czech Republic; in Poland and Hungary investment in fact is not very high for countries with their level of revenue: even when growth did not slow, this had a negative impact on the levels of savings. This means that one of the challenges of economic policy in these countries should be to increase savings rates.

This will not be easy to achieve in countries with such liberal economic policies, therefore tax policy cannot be used to compensate either external or budgetary balances.

Thus, if these countries were due to join the Euro Zone in the short term, this could be  insignificant: in the Euro Zone the external deficit of a country does not mean anything any more. No one cares about the external deficit of a French region. However, accession to the Euro has been postponed and will not be before 2009 in Poland and Hungary, whereas the markets believed it would be in 2006. Their uncertain ability to reduce their public deficits  from 6% to 3% of  GDP, makes accession in 2006 impossible. The main risk resulting from that could be that the financial markets will start focusing on external and public deficits and increase exchange rate volatility compared to that of one year ago. This is our concern. 

We have the experience of Latin America, where the countries have enormous potential for growth but have been permanently hindered by current account balance crises. There are no savings in these countries, therefore investments are made through external debt. This has led to crises of external debt which reduce GDP growth. The countries of Central Europe can not be trapped in the same way.

There are 2 issues : a purely legal one and an economic one. You know the legal one: a country joining the Euro Zone must have remained  within the fluctuation margins of the so called EMS2 for at least 2 years. For the time being only Hungary adheres to the EMS, neither the Czech Republic nor Poland are within the EMS margins. And then the public deficits must fall below the 3 % GDP hurdle. This is the reason why these countries have postponed the date of their accession to the Euro Zone. It is not possible to assess when Poland will put the PLN in the EMS. The margins of the EMS are now between + or – 15 %, but it is unlikely that they will be within these margins in 2005-2006; and then the real problem is the public deficit, of course, even though year after year they announce public deficits levels that they subsequently exceed.

Poland, unlike the Czech Republic, has the current difficulty that every economic sector is losing jobs; traditional sectors are progressively disappearing, which is rather normal in such a developing country. But the modern sectors of its economy are also disappearing because they were either privatized or sold to foreign corporations that increase productivity by laying off workers, so neither the traditional nor the modern sectors are creating jobs, therefore the rate of unemployment is reaching about 19 % and adding a heavy burden to public finances. These countries are having difficulties curbing public deficits. So, given these legal constraints, I believe that only after several years will these countries be able to join the Euro Zone.

Then, economically do they have to do it? On this topic, I believe that the consensus of opinion amongst economists is “no.” Given this level of development and its consequences, the nominal exchange rate must not be a pre-determined rate. And there, two major mechanisms exist:

-         industry in these countries is making great gains in productivity because it is modern, adopts international technologies, and distributes revenues. A part of these revenues is consumed in services, and this is obvious in Poland, where the services sector  is developing very quickly. The prices of services are thus increasing, and therefore it is offsetting the gains made in productivity in industry, because the revenues are consumed in services that cannot be imported, of course. As a result, inflation has impacted on the services sector. This means that inflation is higher than in countries that already have reached a high level of productivity in industry. The ECB is used to calculating the part of inflation due to this effect that comes in addition to normal inflation. Therefore these countries often have higher inflation than West European countries, but it is difficult for them to maintain their exchange rates.

-         the other argument, with the same conclusion, is a lower level of prices for goods. A basket of consumer goods in one of these countries compared to the same basket of the same goods in countries of Western Europe, Germany for example, is on average half the price. So commercial integration and mobility of employment will involve a progressive convergence of the prices of goods, as happened in Ireland, Spain, and  Greece. If prices rise or even double, that is not inflation: it means that they are getting closer to the level of prices in Western Europe; it is not possible to determine the exchange rates, otherwise the competitiveness should be divided by 2 : during the period of price convergence, the nominal exchange rate must be depreciated. Ireland or Spain, for example, which successfully joined the EU, have until recently been implementing continuous depreciation policy for their currencies versus DM, a strong depreciation in order to avoid the convergence of prices and revenues causing a drop in competitiveness.

Growth is stronger in these countries because of competitiveness offsets, because revenues are distributed, prices converge, and inflation is therefore stronger than in West European countries. Should the exchange rate be set, competitiveness would fall and the margins of exporting companies would be reduced. In fact it is a very bad idea for these countries to enter the Euro Zone as long as they have not to a large extent closed their technology gap and their level of prices has not converged towards our prices. In Ireland this process lasted 10 years; it is not possible in 6 months. So I believe that a large majority of economists are opposed in the interest of these countries,  to their accession to the Euro Zone

 The CE Governments know this. But let us imagine that countries with 6 or 7% of external public  deficits announce to the markets, “We shall not enter the Euro Zone before 2015”, then the risk of crisis would be very great.

They need to join the Euro Zone soon in order to reduce the cost of their external deficits, but on the other hand, from an economic point of view, it is a very bad idea. There is a real conflict of objectives in the exchange rate policies of these countries.

This question is a bit difficult. First of all, many journalists believe that May 1st is an event. Nothing will happen. As I said before, the peak of foreign direct investment into these countries was reached in 2000-2001; we have already experienced a drop on FDI in these countries because privatisations are over. The whole financial and economic integration has been done before. From a macro-economic point of view nothing happens on May 1st.

Second, these countries are small. The cumulative GDP of the 10 new members is equal to 5% of the EU-15 GDP, therefore it will not radically change the macroeconomic equilibrium. You read in the newspapers that “the enlargement of the EU with countries showing heavy external deficits will alter its image.” I drew several graphs with economic data, in the EU-15 on the one hand, and in the EU-25 on the other hand: a strong magnifying glass is necessary to see the difference.

So, as I said before, the major positive impact for these countries was the large FDI, which was very important, and the major risk will touch current account balances and a potential overvaluation of exchange rates.

Looking closely, in terms of exports, the economy of only one country has been affected: Germany. The export flows from Germany into these countries are 5 times higher than the flows from France and 20 times higher than from Spain. Thirty percent of German direct investments abroad were directed to Central Europe, compared to 3 % for France. France, Spain, and Italy have almost no economic or financial ties with Central Europe on the macroeconomic level. The macroeconomic situation in France, Italy, and Spain has not significantly changed with enlargement. But Germany had a significant impact. This is the only country for which Central Europe represents a significant part of its export flows and relocations. For France, Spain, and Italy it means a virtual total non-event from a macroeconomic point of view.

Another issue is hardly even discussed although we should mention it: the institutional price. I think that these countries have a stronger impact on France, Spain, and Italy through institutional difficulties than through financial flows or costs of foreign trade. These countries have strong fiscal policies: the corporate tax rate in Hungary is 16%, and 19% in Poland – Poland is about to cut it to 15 %, while it is 34% in France, and these countries have the right to vote on fiscal decisions, employment regulations, etc… where unanimity is required.

They have to play a part, essentially through fiscal policy, that gives them considerable weight and exerts strong pressure on the governments: France will not be able to keep its 34% corporate tax rate.

Germany has its commercial exchanges nearly in balance. Commercial balances are around 0, with a strong increase of flows in both directions. This is due to relocation, which is not so negative, because import and export flows are increasing at the same time, and both partners benefit equally, but considering other countries this process is quite marginal. 8% of the total export flow from Germany goes into Central Europe, and 2% of the total export flow from France goes to Central Europe. Spain and Italy don’t export at all to these countries. This is odd and regrettable, because these countries have substantial growth potential and France, Spain, and Italy are ignoring it. The feeling is that German industry has a strategy of specialisation and relocation which is not negative because it keeps a substantial, even massive, part of its industry in Germany. Trade flows today are the counterpart of investment flows. A country that has trade flows without investment flows does not exist. 50 % of foreign trade flows worldwide are intra-corporate flows: trade flows within the companies. If a country does not import from a country, it does not have a commercial activity with that country.

Any other effects ?

Many people talk about migratory flows, but in fact migratory flows are not coming from the 10 countries in the enlargement. Migratory flows in Europe are even out of the 10 countries of the enlargement, essentially the Balkans, Romania, and Bulgaria. Bulgaria loses ½% of its population each year through emigration. It is very impressive.

What is difficult for CE populations, especially in Poland, is that social protection has fallen significantly. Corporations do not abide by work regulations. Times are hard in Poland. I have colleagues who work with 40° fevers because if they do not work they are laid off. Working conditions have deteriorated and the level of social protection has decreased. Life is hard in these countries. In Poland 20% of the active population is unemployed.