Transition report press conference

Transition Report 2005 press conference, Monday 14 November 2005

STEVEN FRIES: Good afternoon. It is a pleasure to have this opportunity to present to you and discuss with you our twelfth Transition Report. This is, I think, one of our more unique reports in that it draws on and benefits very significantly from our business environment and enterprise performance survey, which is a large-scale survey of businesses right across eastern Europe that we have conducted every three years together with the World Bank. The first round was in 1999, the second round in 2002 and the third round in 2005. I think this gives quite a unique insight into what is happening on the ground in terms of business development and business performance in the transition countries of eastern Europe. To make it even more interesting, we have run a benchmarking survey in a number of west European countries, Germany, Greece and Portugal, which helps us to put the transition economies in a broader context and a broader perspective.

I shall say a few words about the key findings from the survey in a moment,  but before I come to the key conclusions of the report let me say a little about the other aspects of this year’s Transition Report. As you may be aware, having seen previous reports and had an opportunity to at least glance through this year’s report, there is a chapter which updates our assessment on progress in transition and progress in structural and institutional reform across all 27 countries of the region where the EBRD operates and also takes a close look at the macroeconomic performance prospects and risks in the region.

To give you a few of the highlights in terms of progress in transition, it is quite interesting that we see a new driver of reform in the region, particularly in the countries of central Europe and south-eastern Europe, namely the EU process. The prospect of EU accession has been a key driver of reform. The most advanced countries, the new EU8 members, the countries of central Europe and the Baltic, took a bit of a pause in reform after having acceded to the EU. You may recall from last year’s report that this was a theme that we stressed quite strongly. Encouragingly, we saw a reinvigoration of reforms in the new EU8 members and we see this now being a market-driven process rather than an EU-driven process. It is driven by the need for better corporate governance, better business practices, better access to financial services that come with operating in a more globally challenging environment, deeper international integration within the European economy and growing competitive pressures worldwide. We now see reforms in that group of countries as being market-driven.

In south-east Europe we have seen the countries take a bit of a reform breather, with the notable exception of Serbia and Montenegro, which continued to move forward quite strongly despite a relatively weak coalition government.

In the CIS we have seen a number of countries move forward in reforms but largely in those countries where there have been key political changes, such as Georgia and Ukraine, and a shift in political orientation in Moldova, which have been key to underpinning forward movement in reform in those countries.

On the macro side, we have seen another good year for the transition countries, though not as good as in 2004 when the region as a whole grew by 6.6 per cent. In 2005 we are looking at a moderation of growth to around 5.3 per cent for all the countries of the region. 

As to a geographical breakdown, we still see the CIS countries as the strongest growth performers, forecasting growth for the CIS countries as a whole, including Russia, at around 6 per cent, in the countries of south-eastern Europe, Romania, Bulgaria, and so forth, at around 4.8 per cent and in those countries in central Europe and the Baltics, the new EU member states, at around 4.2 per cent. These are growth rates which we see as being largely in line with the potential rate of output growth, so these are rates that we think these countries can sustain over the medium term. 

Looking forward, it is important to realise the risks that the countries run from the macroeconomic perspective. We have detailed quite carefully in the report where we see the macroeconomic vulnerabilities and the other risks.  One issue we take quite a close look at is that of risks or vulnerabilities within the financial sectors in the region. We felt it was important to take a close look at this issue because of the rapid growth in domestic credit that we are seeing in all of the countries. Of course, the rapid expansion of domestic credit is part of the growth story, and it is a positive story, but at the same time we know from experience in other countries that episodes of rapid credit growth can be associated with subsequent bouts of financial instability or difficulties. Therefore the key issue we look at is how sustainable this credit expansion is. Part of it is just a natural catch-up process. We saw it in other countries, in Spain and Portugal, for example, when they acceded to the European Union. We took a close look at the nature of the risk to the financial sector both from a macro perspective and from a prudential perspective.

In terms of the key findings from the business environment survey, the story is largely a positive one for the region, in two senses. The first is that, since we first ran the survey in 1999, it being primarily a survey of local business, not foreign investors, there has been a sustained improvement in the business environment across a range of dimensions, from the predictability of business regulation to the effectiveness of tax administration, the ability to access financial services and various features of the institutional environment, such as confidence in the courts, the incidence of corruption and the significance of crime from a business perspective. In most but not all cases we see a significant improvement.

A dimension of the business environment that our survey looks at which portrays a deteriorating trend is that of labour regulation. Over the years businesses perceive labour regulation as an increasing constraint on their capacity to grow and to develop their business. Of course, labour regulation is a complex issue. It benefits workers and can afford them a degree of protection but it also constrains the flexibility and capacity of businesses to adjust. The key point here is that from a business perspective it is becoming an increasing obstacle.

The other perspective on the business environment that it is useful to note is the comparison with the more mature market economies in western Europe. Here we see some convergence towards, but not yet achieving, the levels of the quality of the business environment that we see in the more mature market economies that we have surveyed, which are Germany, Greece and Portugal.  There is more to do in terms of reform in these areas.

Lastly, the survey looks at the performance of businesses and the important contribution that different types of firms make to the growth story of the region, particularly the role of foreign-owned firms in boosting productivity as well as new entrants into the markets, new private businesses. In terms of the types of firms that are leading the growth charge in the region, those are the key ones that the survey has identified.

That is, by way of introduction, a quick overview of the key findings of the report on progress in transition from a macro perspective as well as some of the key findings from this year’s business environment and enterprise performance survey. My colleagues and I should be happy to answer any questions you might have.

VERONIKA REINIGER (Nepszabadsag Hungarian Daily): Hungary is one of only two countries which is criticised because obstacles to business have increased since 2002. Hungary was also heavily criticised by ECOFIN and the EU Commission because of the double deficits. I should be grateful if you would elaborate on EBRD's view on the state of the Hungarian economy and the obstacles to business that you mentioned.

STEVEN FRIES: It is important to hear what local businesses are saying in terms of the obstacles that they perceive. I think that what we see is the consequence of a relatively slow pace of structural and institutional reform in Hungary over the course of the past several years, with the exception of the financial sector, where I think the Hungarian Government has moved forward, certainly in improving the depth and quality of financial intermediation. What you see is perhaps the consequence of a lack of a strong reform drive in improving aspects of the administration of the judiciary in Hungary.

On the macro side, one of the issues we highlight on Hungary’s macroeconomic performance is the fiscal position and the reclassification of the budget deficit this year because of the accounting for the government’s investment programme. Properly accounted for, we are looking at a general government deficit of 6 per cent of GDP, which is well off the level required for accession to economic and monetary union and, before that, participation in ERM II. I think that from a fiscal perspective the Hungarian Government has a long way to go in terms of consolidating the fiscal position and moving on to the next phase of the European integration process, which is ERM II and accession to economic and monetary union. The challenges are clearly there from a macro perspective as well as with regard to improving public administration and economic governance. On the latter, that is the voice of Hungarian businesses. They do not see real improvement over the last three years and indeed they see some deterioration.

ANDREI MARAWSKI (La Tribune): How would you assess the situation in Poland?  We have a new government that has already sent strong signals, making the difference between productive investment and non-productive investment, saying that they will not look for a balanced budget but then again saying that they might delay the programme for entering the euro zone. Does the situation represent a major shift and something that could be followed by other governments?

STEVEN FRIES: Certainly the tone and the rhetoric of the new Polish government represents a shift. It is clearly more populist in its orientation. It has questioned the value of foreign direct investment, particularly in the retail sector but also elsewhere. It has perhaps questioned the pace of fiscal consolidation and indeed there has been some weakening of the zloty recently, reflecting what may be concerns about the pace of fiscal consolidation going forward. 

I would make a couple of points. The first is to emphasise the strong benefits that can be delivered from openness to investment in all forms, including investment from foreign businesses. One of the key findings from our Transition Report is that foreign businesses do bring in a lot in terms of higher levels of productivity and performance, so not welcoming foreign investment is really a forgone opportunity for the country and for the people who would have the opportunity to work in those businesses and earn the higher wages that higher productivity can deliver. It is important not to lose sight of the benefits of foreign investment and all that it can bring. It is not a cure-all but it brings certain benefits and should be welcomed.

Secondly, on the macro side, in contrast to Hungary where we saw a widening of the fiscal deficit over the course of the past year, we have seen some modest improvement. In Poland this is primarily a growth-driven phenomenon, not driven by changes in fiscal policy. I think that, looking forward, the key thing is to maintain the gradual strategy of fiscal consolidation and the ultimate accession to economic and monetary union that the government and the Central Bank had previously set out for the country. I think those aims are achievable in the Polish context. They require tough political choices, particularly on government spending, but I think it would ultimately deliver more growth and more confidence in the Polish economy.

GABRIEL PARTOS (BBC World Service): Mr Fries, last year’s report referred to a reform pause in central Europe, which was understandable given that they had just joined the EU. This year you are talking about a similar pause in south-eastern Europe, which makes less sense to me, given that they are still accession countries in some cases or indeed candidate countries. What is your explanation for the fact that, with the exception of Serbia and Montenegro, they are not proceeding with reforms as quickly as they should be?

STEVEN FRIES: I think it is rather similar to what we observed in the EU8 countries. The pace of reform was quite strong in the run-up to agreeing a formal accession timetable and meeting all the requirements of the acquis and associated structural and institutional reforms that are picked up with our transition indicators. Certainly, a lot more needs to be done in the two countries that are set to join in 2007, Romania and Bulgaria, particularly in the area of governance, the functioning of the courts and the quality of public administration, and indeed those are not so much issues picked up in our transition indicators, which essentially look at market liberalisation, privatisation and certain areas of institutional reform, but are broader challenges in terms of legal reform and of the quality of public administration and governance, law and order issues and the fight against corruption, and so on, in both of those countries, which are key challenges going forward. Clearly, there is no room for complacency in those countries. 

PAUL HANNON (Dow Jones): A theme in some of the areas you have talked about so far is the reluctance of the new members of the European Union to do very much to advance the date at which they will ultimately join the euro zone.  All across the region it seems as if elected governments are unwilling to make any sort of sacrifices and certainly to toy with their popularity in pursuit of that goal. This is very much in contrast to what used to be perceived as an extremely attractive thing for them to be involved with. Do you think that the problems that the core euro zone, Germany, Italy and France, are having have in any way made people think again about the benefits of becoming a member of that currency area?

STEVEN FRIES: I think that the reasons for the reluctance to move more quickly in the large central European countries towards meeting the requirements for participation in ERM II and accession to economic and monetary union are largely domestic and reflect the tough political choices that need to be made in order to achieve the fiscal consolidation that is required to satisfy the deficit criterion under the Maastricht Treaty. I think the issues you refer to in the EU15 member countries are really of secondary order of importance to the political decisions that governments in central Europe are making. Certainly my view, and I think the view of most forward-looking commentators and government officials in the region, is that economic and monetary union could deliver significant benefits to these countries over the lung run, and I think what you are seeing is a weighing of long-term benefits in terms of lower transaction costs in the economy, increased trade potential, greater financial stability and less exposure to volatility emanating from exchange-rate risk. All of those can deliver real economic benefits over the medium to long term but to get there tough political choices have to be made in the short term, and I think it is the reluctance to make those tough political choices that is holding back the pace of progress in this area in central Europe.

PAUL HANNON (Dow Jones): As a forward-looking commentator, when do you see any of the big three actually joining the euro zone?

To follow up on the point that what is happening within the currency area is not having an effect, if you make a choice there are two sides: one is the cost and the other is the benefit. If the benefit is not easily marketable to your voters, will that not affect how easy it will be for you to convince them that the pain in the short term is worth it? I was wondering whether the lack of an apparent return in the existing euro zone was making it more difficult for these guys to justify short-term pain in order to achieve … To achieve what exactly? If the evidence from the existing 12 is anything to go by, it is not exactly a simple case to put, is it? There are not any definitive riches at the end of the rainbow here.

STEVEN FRIES: At first glance your argument is that the sluggish performance of the euro zone is not much of an inducement for the new member states to adopt the euro, but I think you might need to take a more nuanced look at the issue. I think the sluggish growth in the euro zone is due to a number of factors and not primarily to the single currency itself. The need for a structural reform agenda in the EU15 in order to make the economies more flexible and more dynamic and to increase the pace of adjustment in those countries is well known. I think that the slow growth in the EU15 is really due to the structural obstacles to growth in those countries. I do not think you would want to simply extrapolate for the EU8 that accession to economic and monetary union could not deliver strong benefits. I think the obvious counter example would be to look at the Baltics. They have been running currency boards, having not quite adopted the euro as a currency, but they have run credibly pegged exchange-rate regimes and have been able to grow quite fast and to converge at a very brisk rate to the EU15. If you took a close look at these issues, I think you would still sensibly conclude that, despite the clear structural problems in the EU15, the EU8 could benefit from participation in the euro, for the reasons I set out, namely the classic benefits from monetary union.

PAUL HANNON (Dow Jones): What is your view with regard to the timing?

STEVEN FRIES: As fast as politics allow, really. I think that sensible observers would say 2010 to 2012. Clearly, the pace of fiscal consolidation will be a gradual one, for the political reasons that we have already discussed.

ANDRZES SWIDLICKI (Polish News Agency): In your report you emphasise the need to commercialise and privatise segments of the health service, if not the whole health service. How important is this issue in terms of prioritisation? Should it take precedence over other reforms or should it be done simultaneously? How important is the whole issue for the region?

STEVEN FRIES: I think the key idea here is the importance of delivering better value for money in terms of public expenditure. Clearly, the size of government in Poland and other central European countries is quite large when government revenue and government spending is looked at as a share of GDP, but it is not at all clear that governments are able to deliver the quality and level of service that would go along with having such a large role of government in the overall economy. I think the key challenge here is to step up and improve the delivery of public services in health, education and other key areas which we know are important from the longer-term perspective of the countries. I think that that is the key idea here: it is a priority, it has a fiscal dimension in that greater efficiency in spending on health and education can support greater fiscal consolidation, but there is also an improved public service delivery perspective on these issues. And a key challenge is to improve the organisation and delivery of service to meet the real needs of the Polish people and people throughout the region.

GABRIEL ROZENBERG (The Times): You said that labour constraints, skill shortages and labour-market regulation are considered more of an obstacle in mature market economies than in most transition countries. What lessons can western Europe be taught by these transition economies? What are the areas in which the countries in central and eastern Europe are ahead of the pack? Is it not time for the EBRD to extend its remit to helping larger economies, such as maybe Germany, France or Italy, move into a flexible market framework?

STEVEN FRIES: There are a number of institutions that would encourage the EU15 to move to more flexible economic frameworks. It is certainly a direction that we think is appropriate, but obviously that is not the primary remit of the EBRD. 

The key point in the report is to understand that labour regulation has two dimensions to it. One is the cost side, which is that it does constrain the flexibility of businesses. When we ask local businesses across the region whether this holds back their growth potential, the answer is, yes, and increasingly so. That is what the 2002 and 2005 surveys have told us. When running the survey in the more mature economies in the EU15, they say it is even more of a problem than businesses in the EU8 countries say it is. The business perspective is that it is perceived as a constraint that holds back growth. The other side of that is the labour-protection side and the assurance that it could be regarded as providing workers with greater job security and stability. 

On the other side of the coin, the point I would emphasise is that it is important to look not only at job security but also at job creation and the importance of creating new jobs in an economy that is flexible and open to international competition. Here I do think there is a lesson to be learned from the countries of the region with somewhat more flexible labour markets.  That being said, there are clearly rigidities in the labour markets, particularly in central Europe, and high levels of structural unemployment.

ANDRE MARAWSKI (La Tribune): Let us talk about Ukraine. It is now almost a year after the so-called orange revolution. There was initially great excitement on the part of observers, but then the observers began to become upset. There was a much publicised privatisation in the steel industry in Ukraine. There have thus been ups and downs. How would you assess the situation? What is the correct analysis?

STEVEN FRIES: I think the situation in Ukraine is a mixed one. I think that to some extent it is an opportunity forgone. A new government came into power with strong popular support and a mandate for change: better governance, less corruption, more transparency. At the same time, it was clear that the government struggled to put forward a coherent and comprehensive reform strategy. There were disagreements within the government that limited its capacity to move forward strongly. There has recently been a change in government and there is now perhaps the potential to unblock the situation, although we are looking at a new round of elections in Ukraine in 2006 so I think the ambitions for change going forward should be rather modest.

I think the one encouraging development in Ukraine is the reprivatisation of the Kryvorizhstal steelworks. Clearly, it was taken back into state ownership through a judicial process, so the rules of law and property rights were protected. The second sale of these assets, which were originally sold for about 800 million, took place about 18 months or two years later for 4.8 billion. Clearly, Yushchenko and the new government have delivered much better value for money for the Ukrainian taxpayer. It is certainly better from the fiscal perspective, with significant inflow of resources to the government coffers which can be used to meet other objectives. Looking forward, the steelworks have a strategic owner who, as we have seen in Kazakhstan and Romania, is likely to add real value to the operations of the company, rather than people who were selected not for their business acumen but for other, obvious reasons.

PAUL HANNON (Dow Jones): I understand that President Putin has just reshuffled his cabinet and people are looking forward to elections in 2007.  What do you think can now be accomplished in Russia in terms of diversifying away from natural resources? Has this period of high natural-resource prices been an entirely missed opportunity from that point of view? What will be the consequences in the next round of government by whoever succeeds Putin, if he genuinely is not going to stand again?

STEVEN FRIES: I would not characterise the period of high oil prices as a missed opportunity. At least looking back in Russia, to the government’s credit, they have largely saved the oil windfall gains that have accrued to the economy and, at least until now – I am not looking forward to the 2006 budget – they have allowed the natural resource wealth that has accrued to float into the government coffers in a prudent way. The fiscal position has been strong; there is a large surplus. Significant amounts of external debt have been paid down, which takes some of the pressure off for real appreciation of the currency, though those pressures are clearly still apparent in the Russian economy and increasingly a problem. If you look at the composition of growth in the Russian economy, at the sectors which are growing rapidly and those which are slowing down, you see a clear kind of Dutch disease story emerge, in the sense that the non-tradable sectors, the service sectors and the construction sector, are those that are growing at double-digit rates whereas the tradable sectors, manufacturing and other traded goods, are the ones that are slowing quite markedly. There are clear indications of real appreciation beginning to affect the competitiveness and diversification of the Russian economy. 

The key thing going forward is to continue to manage the natural-resource wealth in a prudent way and to implement reforms that help boost and improve the competitiveness of the Russian economy. Clearly, less uncertainty in the regulatory framework, better functioning courts, less bureaucratic red tape and all the issues that we emphasise in improving the business environment could help boost the competitiveness of Russian firms.

What is more worrying is the pressure to step up spending from the Russian budget for consumption, increased wages and pensions. It is clearly right that they rise with the real growth of the economy, but moderation needs to be exercised in those areas. The 2006 budget emphasises greater spending on health and education where there are clear social needs, but again this needs to be balanced from a macroeconomic perspective to ensure that it does not fuel and add to the competitiveness problems. There has been some talk of VAT rate cuts going forward and other types of policy changes that would fuel consumption rather than boost investment and competitiveness, and those are greater sources of concern. The eye firmly needs to be kept on the issue of competitiveness and diversification of the Russian economy. Going forward, it is crucial that policies remain as supportive as possible of that objective.

DANIEL BASES (Reuters): It is quite nice to have 5.3 per cent growth, but it is down over a percentage point for the year. Could you go into a little more detail, beyond just the fact that there is a global growth slowdown? The global growth slowdown may or may not be more protracted in this area. How would you balance it, by saying “Yes, it is slowing but it is not slowing as much”, or “It is slowing more than …”? I am trying to find out the details behind why it is slowing.

MR STEVEN FRIES: The key issue here is that much of the slowdown is concentrated in the CIS countries. We are forecasting growth of 6.1 per cent for the CIS countries this year; I think it was 7 per cent or 7.5 per cent last year. Much of the slowdown is concentrated in the CIS countries, including Russia. In Russia I think the story is the one I described in response to Paul Hannon’s question, where we see a slowdown in parts of the industrial sector due to the rising real appreciation of the rouble and loss of competitiveness. That is the key source of the growth slowdown in Russia and in Kazakhstan to some extent, as well.

The other key area of slowdown in growth was Ukraine, which went from double digit growth to 5 per cent growth in the current year. There is a combination of reining back some of the fiscal excesses that the previous government had committed in the run-up to the elections and some loss of growth in key export markets for Ukraine.

DANIEL BASES (Reuters): You mentioned that Russia is the only country to be downgraded on a transition basis. Do you see that trend continuing? Do you see the beginning of a turn in the development of this country? How low will it go?

STEVEN FRIES: I think the picture that we portray of Russia in the report is a mixed one. There is clearly the downgrade but there is also the upgrade.  Let me start with the positive and then talk about the negative. 

The positive development in Russia was the movement in banking reform, in particular the implementation of the deposit insurance scheme, the relicensing of banks, the raising of prudential standards, the introduction of international accounting, and so forth. That is an area where the government clearly took a strong step forward. 

The area in which there was backtracking was in large-scale privatisation.  Here I am sure you all know very well the story of the taking back into state ownership of key assets of Yukos and their ultimately ending up in Rosneft.  The second element of the story is the re-establishment of majority state-ownership of Gazprom. Looking forward, there could be a third element of this story, namely the acquisition of Sibneft by Gazprom, which would take that private oil company back into majority state hands. In what is viewed as a strategic sector for the Russian economy there is clear movement towards greater state ownership and control and greater direct state command over the flow of resources in the economy.

Do I think that this is the beginning of a more widespread trend in Russia?  No, I think that where we see key elements of state control in the Russian economy is in the energy sector and in the banking sector, where state institutions still have a dominant role. Beyond what is considered to be strategic from that narrow perspective, I do not anticipate a wholesale reversal, taking more assets back into state ownership; but, that being said, I think that the moves we have seen are a step backwards for the Russian economy. There is clear evidence, particularly in the oil sector, that private Russian oil companies have been much more efficient and more productive, raising their productivity at a much more rapid rate than the state-owned companies are, and investing more. This is, in a sense, a lost opportunity for the Russians to make the most of their natural resource wealth. I think they are heading in a direction that will make this sector less efficient and less dynamic than it otherwise could have been.

DANIEL BASES (Reuters): If banking and oil are the key industries that are considered crucial to Russian policies going forward, is that to say that the reforms and the progress that we saw this year, which you highlighted in the report, are vulnerable to being undone?

STEVEN FRIES: No, I do not think they are vulnerable to being undone. I think the challenge for the banking sector going forward is to diminish the role of the dominant state institutions and to foster more competition, more efficiency and better delivery of service in the financial sector. I think that clearly the reforms we have seen so far will help improve competitive pressures within the banking sector itself. Sberbank no longer has a monopoly in terms of state deposit insurance, and that will create a more even playing field for attracting deposits and make the market more competitive. The points I would make about policies going forward are similar to the points I made on the energy sector. There is abundant evidence right across the region that private banks, foreign-owned banks, are really the engine of productivity gains and growth in a whole range of sectors, including the banking sector, and movement in that direction, with greater openness to foreign entry into the sector and ultimately privatisation of the state-owned banks, would be the right way to move forward. I think that the steps that have been taken so far are supportive of moving in that direction, and I do not think that they will be reversed.

PAUL HANNON (Dow Jones): I have a technical question about Russia and the report. You give a figure for private sector share of GDP in mid-2005 as 65 per cent, which you say is a drop from last year. Do you know what last year’s figure was?

A SPEAKER (Off microphone): It was 70 per cent.

PAUL HANNON (Dow Jones): So it has moved from 70 per cent to 65 per cent in one year.

SPEAKER: (Off microphone)  And that is the counterpart to the taking back into state ownership of key oil and gas assets.

PAUL HANNON (Dow Jones): Just to be clear, from this table it is the only country in the region where the share of the private sector has actually gone down.

SPEAKER (Off microphone): Yes. In the distant past it has happened in other countries.

PAUL HANNON (Dow Jones): But not over this year.

SPEAKER (Off microphone): … (inaudible) …

SAM FANKHAUSER: I should perhaps say that these figures come with a bit of a health warning. They do not have the same level of accuracy that you would expect with figures that come from national accounts. These are EBRD estimates.

PAUL HANNON (Dow Jones): But the direction is clear.

SAM FANKHAUSER: The direction is clear. We know, for example, what the share of Gazprom in the Russian GDP is. Five per cent is not a bad estimate.