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07/22/2010

Public Finances in Eastern Europe: How Frightening is it?

DZ Bank Emerging Markets Research, Frankfurt.

This article appeared in the June 2010 issue of Current Economics with permission of the author.

Key Concepts: Budget Deficits | Public Debt | Debt Servicing Costs |

Key Economies: Eastern Europe |

EMU Periphery Exposed to Difficulties in Public Finances

Debt servicing costs have risen dramatically across developed economies. Budget revenues have fallen, expenditures have risen and the nationalization of banks has also added to the stock of public debt. Even if interest rates stay very low in most developed states, debt servicing will continue to bite into a large chunk of public revenues. By 2011 this will result in a situation in which a number of countries, including the US, Greece, Ireland and Italy, will spend 10% or more of their public revenues on debt servicing, according to forecasts from the European Commission. The consequences are far reaching and potentially dangerous. Confronting continuously rising debt servicing entails the question whether or not state finances remain sustainable. Market judgements on this can be quick and severe, as has been aptly demonstrated in the Greek case: without the money of the European Union (EU) and the International Monetary Fund (IMF) Greece would have been insolvent by now. In addition, downgrades by major credit rating agencies have raised concerns about debt in Portugal and Spain.

The most salient characteristic of public finances at the European Monetary Union (EMU) periphery is the considerable rise in debt servicing costs, particularly in Greece and Ireland. Greece exhibits a particularly poisoning mix of unsustainable public finances, with public debt having reached 115% of GDP in 2009 and projected to rise further to 119% by 2011. With such a high debt-to-GDP ratio, the cost of debt servicing may be as much as 15% of budgetary revenues (or close to 6% of GDP). The corresponding ratios in Ireland are less frightening, but the public debt-to-GDP ratio is still set to rise from 64% in 2009 to 87% in 2011. In Portugal and Spain, public debt-to-GDP ratios are set to increase from 77% and 53% to 91% and 73%, respectively.

How Affected is the Eastern Periphery of the EU?

The Eastern periphery of the EU has also suffered from a deterioration in public finances. Countries in the region most exposed to difficulties appear to be Bulgaria, Hungary, Latvia, Lithuania and Romania. Hungary has traditionally struggled with high debt servicing costs and this created a particularly difficult situation when the global financial crisis escalated in 2008-09. Falling real GDP levels amid the crisis also made the sustainability of otherwise conservatively managed public finances questionable in Latvia and Lithuania. Although Bulgaria had mostly pursued stability-oriented fiscal policies in preceding years, false data provided by the previous government created a lack of confidence and raised questions about the actual state of public finances. Romania has witnessed a particularly fast rise in debt servicing costs as its budget deficit has escalated in recent years and the markets have grown increasingly reluctant to finance it. As a result, in the cases of Hungary, Latvia and Romania, the debt service-to-total revenue ratio is set to reach more than 6% in 2011 according to European Commission forecasts, a comparable level to the fiscally most vulnerable EMU member states. However, public debt-to-GDP ratios remain significantly below that of the EMU periphery with the exception of Hungary, where it is expected to peak at 79% in 2010 and start decreasing next year. (The Czech Republic, Poland and Slovakia exhibit relatively low, albeit rising public debt-to-GDP ratios. Their ratios of debt servicing-to total revenues remain below 5% of total revenues with the exception of Poland where it could reach close to 8% by 2011.)

Chart 1: Interest Payments Rise in EMU Periphery (Debt Servicing as a % of Total Revenues)

Rising interest payments in the euro zone periphery

Source: European Commission


However, it is not only the size of public debt and interest expenditures states incur that matter, but also the structure of their debt. Peripheral countries with public debt predominantly held by foreign investors are more at risk than those in which government bonds are held by local residents, as foreigners tend to liquidate their assets more promptly under financial strain. Hence, a high ratio of net financial savings of households to public debt can, to some extent, mitigate adverse external effects, and this seems to be the case in Hungary. On the other hand, the Baltic States fare particularly badly in this measure and this is an important reason for the grave difficulties Latvia has been facing amid the global financial crisis. Statistics show that the EMU periphery can also rely on scarce domestic household savings. While the Eastern periphery of the EU appears to be in a similar situation, its generally lower public debt-to-GDP ratios mean that this is somewhat less of a problem.

Yet the crisis showed that peripheral countries with lower public debt-to-GDP ratios can swiftly become exposed to severe consequences at times of market turmoil. Hence, following Hungary, Latvia and Romania also resorted to the help of the EU and the IMF in 2008-09 to ensure solvency. Their cases appear to be different from one another, as well as to those of Bulgaria and Lithuania.

Chart 2: Debt Servicing Costs Are on the Rise in CEE (Debt Servicing as % of Total Revenues)

Debt servicing costs rising in Central and Eastern Europe

Source: European Commission


Hungary: Can Public Debt Begin to Decline?

A severe recession in 2009 slowed the fiscal adjustment in Hungary that started in 2006, when the general government deficit was 9.3% of GDP. Despite the difficulties entailed during the global financial crisis, the deficit remained at a comparatively low level of 4% last year. This was only possible by imposing considerable spending cuts as the 6.3% drop in GDP slashed tax revenues. The cyclically adjusted structural primary balance got closer to equilibrium and is forecast to reach a surplus of 1.2% in 2010 if the budget deficit amounts to 4% of GDP, according to the projection of the central bank. The reason behind the improvement is that a cyclical upturn will increase tax revenues, while part of the stabilisation measures will structurally reduce expenditures over the longer term. Yet, despite the improving primary balance, public debt jumped to 78.6% of GDP by the end of 2009, from 72.9% a year earlier, due to a drop in nominal GDP and the large loan package from international lenders. Technically, the latter increases debt until it starts to be repayed, since a part of the withdrawn international loan is unused as currency reserves at the central bank (MNB). (Hungary has withdrawn EUR 14.1bn from the 20bn which was offered by the IMF, EU and the World Bank at the end of 2008. EUR 4.8bn has not been spent, partly staying in deposits at the MNB and partly lent to banks who will repay it in 2010-11.) While repaying this part of the international loan should not be problematic, it will decrease both public debt and currency reserves. Thus, cyclical and technical factors seem supportive of returning public debt to a declining path in the coming years.

Chart 3: Net Financial Saving of Households in CEE has Stayed at Comparable Levels to Those of EMU Periphery Countries

Household savings in Eastern Europe

Source: MNB (based on Eurostat)


Institutional and political underpinnings of a responsible fiscal policy line have also improved in recent years. The so-called Fiscal Responsibility Act was adopted at the end of 2008, restricting budget spending through the regulation of the real (i.e. inflation adjusted) value of the public debt stock that cannot increase from 2012. Hence, with real growth returning from 2010, the law also stipulates a decreasing debt-to-GDP ratio over a medium term horizon.

Moreover, in contrast to earlier announcements, the new centre-right government has pledged to uphold the 3.8% of GDP budget deficit target for 2010 and below 3% for 2011, set by its predecessor. To attain this, Prime Minister Viktor Orban has recently announced a series of fiscal austerity measures. These include a sizeable cut in spending on state administration (to save HUF120bn) and an extra tax levied on banks and other financial service providers (HUF 200bn annual revenue). Whether these targets can be achieved however, does not seem to be clear at the moment. On the other hand, a flat 16% personal income tax will be introduced from 2011, implying a considerable reduction in personal income tax revenues that should be counter-balanced by the increased tax burden of low-income earners. In addition, corporate tax of small and medium-sized enterprises (SMEs) up to an annual revenue of HUF 500 million will be cut to 10%, but this should not entail a sizeable revenue drop to the budget as this group of companies typically claims minimal profits.

Should the budget deficit fall to 3.8% of GDP in 2010 and below 3% in 2011, government debt should begin to decline by 2011. Deducting the interest payment on government debt of 3.8% of GDP would result in a balanced primary budget in 2010 and a primary surplus of 0.8% of GDP in 2011. Assuming 1.4% GDP growth for 2010 and 3% for 2011, in line with our base scenario, and forward-looking real interest rates in the range of 2.5%-3% on public debt, the overall debt stock should fall to about 77.5% of GDP, from the current 78.6% in our calculation, by the end of 2011.

Given that net financial assets of Hungarian households in 2008 reached 59% of GDP according to Eurostat data, a significant part of public debt had to be, by definition, financed from external sources: external debt of the government reached 35% of GDP in 2008. However, a marked - although probably only temporary - improvement in the financing ability of households amid the crisis and a cut back of investment by corporations, (also reflected in a sharp current account adjustment), enabled the budget to be refinanced from the IMF-EU-World Bank package and domestic sources. This fact is demonstrated by the nominal stock of public debt held by foreign investors that in essence has not increased since 2009. Meanwhile, government bond yields have fallen considerably, with the 1-year Treasury bill yields falling from above 12% in Q1 2009 to about 5.25% recently. In addition, a USD 2bn international bond issuance was successful at the beginning of 2010. Hence, the likelihood of one of the most indebted CEE countries attaining a sustainable public debt trajectory is realistic. Yet refinancing of the state should rely much more on domestic sources so that vulnerability of the economy is minimised.

Chart 4: CDS Spreads at the EMU Periphery Have Widened...
CDS spreads at the EMU periphery
Chart 5: ...With CEE Following Suit with a Lag
CDS spreads in Eastern Europe

Baltic Blues: the Worst Has Passed

In the years of high growth preceding the global financial and economic crisis, Latvia used to run relatively balanced budgets, with small deficits of below 1% of GDP. Fiscal revenues and expenditures both amounted to approximately 35% of GDP. Almost 60% of total revenues came from taxes, while 50% of all expenditures were taken up by the compensation of public sector employees and social benefits. State investments had a share of slightly above 10% in total expenditures, while interest payments were almost negligible. Alongside small deficits and a high rate of nominal GDP-growth, the stock of public debt decreased to just 9% of GDP by the end of 2007. As the crisis hit in the last quarter of 2008, financial difficulties began to mount. At the end of 2008 the Latvian government had to bail out one of the country’s largest commercial banks (Parex Banka), resulting in a huge increase in fiscal spending. Meanwhile, the collapse of (the real estate boom driven) domestic demand led to the most severe recession since the break up of the former Soviet Union. This led to a rapidly shrinking tax base and thus a sharp fall in nominal tax revenues. The budget deficit deteriorated to 4.1% of GDP in 2008 and, as the economy contracted by 18% in 2009, the deficit widened to 8.9% of GDP. In fact, this huge deficit reflected heroic efforts from the Latvian government to keep the country afloat. Even at the end of 2008 the Latvian government applied for IMF help and worked out a strict fiscal austerity program to avoid a threatening default. Had it not been for deep cuts on the expenditure side, the budget deficit could have reached 15-16% of GDP in 2009. The stock of public debt - reflecting the increasing budget deficit, the loan from the IMF and other institutional creditors and the marked fall in nominal GDP - rocketed to 19.5% of GDP by the end of 2008, and further to 36.1% by the end of 2009.

Under the current circumstances, fiscal austerity should remain in place. The economy will contract further in 2010 (by almost 3% in real terms and by about 8% in nominal terms). For the GDP-proportionate budget deficit to be unchanged, an additional correction amounting to more than 4% of GDP would be needed this year. According to official plans, this correction will be more balanced between the revenue and expenditure sides of the budget. Tax rates should inevitably be raised, as the share of tax-related revenues fell to just above 50% of total revenues in 2009. On the expenditure side, further cuts are needed in the compensation of public employees and social benefits, since interest payments on the higher debt stock will unavoidably rise. Yet, if these corrective measures prove to be successful, our baseline forecasts suggest that the budget deficit can be gradually reduced to 8.5% of GDP this year and to 6% by 2011. In the context of the agreement between Latvia and the IMF (and also recognizing the huge improvement in Latvia’s total external financing needs as illustrated by its markedly positive current account balance) we see no severe financing difficulties for Latvia, even with such high budget deficits. But the stock of public debt, of course, will increase further and may reach 52% of GDP by the end of 2011. However, it is expected to gradually moderate from 2012, as the rate of nominal GDP-growth should surpass that of the expected budget deficits. Thus, with disciplined fiscal policy Latvia may fulfil its aim and apply for Euro accession around 2014-15.

Similarly to Latvia, Lithuania also ran small budget deficits before 2008, but for almost identical reasons its budget deteriorated significantly as the recession began. Expenditure growth unmatched by revenue growth led to a 3.3% GDP proportionate deficit in 2008, and as GDP declined by close to 15% last year, tax revenues decreased to a formidable extent. For illustration, revenues from personal income and wealth taxes almost halved in nominal terms from 2008 to 2009. Without the harsh correction on the expenditure side that is estimated to have reached 8% of GDP last year the budget deficit could have rocketed to 16-17% of GDP. Yet a dramatic cut in state investments helped keep the deficit at 8.9% of GDP in 2009. This deficit and the more than 17% contraction of nominal GDP quickly drove the stock of public debt, which stood at a historic low of 15.6% of GDP at the end of 2008, to 29.5% come the end of 2009. As the banking sector in Lithuania was somewhat less vulnerable to external shocks than that of Latvia, there was no need for bailing out banks and thus the financing of the budget deficit was not at such a high risk. As a result, while Lithuania was also tipped to be one of the countries that should seek IMF-assistance, it was finally able to manage without incurring external obligations.

Yet further corrective measures are needed to avoid the widening of the budget deficit this year. These measures will mostly address the expenditure side (further cuts in public sector wages and social benefits), while only minor changes are going to take place on the revenue side. Lithuania’s economy will also contract in 2010 (albeit by less than that of Latvia), thus just to keep the GDP-proportionate budget deficit unchanged, the required expenditure cuts need to be close to 4% of GDP. Assuming that these austerity measures can be implemented without too many problems, the general government deficit may fall to 8.3% of GDP this year and to 6.5% in 2011. Even this (accounting also for our nominal GDP forecast) implies that the stock of public debt increases to 39% of GDP by the end of 2010 and then close to 44% by end-2011. Nevertheless, we see no major problems in financing these deficits (the external financing needs of Lithuania have improved a lot, just like that of Latvia due to a sizeable current account adjustment), meaning that Lithuania can also pursue its goal of admission to the Euro zone by 2014 or 2015 at the latest.

Bulgaria and Romania: Less Indebted, Yet More Vulnerable

Bulgaria and Romania constitute interesting cases in terms of public finances with difficulties different from other countries in the region. The first remarkable characteristic is their relatively low debt-to-GDP ratio. At end-2009 Bulgaria’s public debt was estimated at 16.2% of GDP at end-2009, while Romania’s debt added up to around 27.4%. Despite the relatively low public debt level, these ratios are sometimes difficult to tolerate by the market as structural risks, both economic and political ones, are perceived to be high. Although Bulgaria has had a decent fiscal track record in recent years, it suffered a credibility loss after the revelation on the practices of the previous Stanishev government that had provided false official data on the budget. In turn, Romania has had problems with refinancing its public debt since early 2009 and is engaged in an IMF stand-by agreement, implying very strict austerity measures whose implementation has caused a sequence of political difficulties up to now.

Domestic sources to refinance an increasing public debt stock appear limited in both countries. Although in Bulgaria public debt is fully covered by the net financing assets of households (54.3% of GDP), debt of non-financial companies added up to 122.6% of GDP at the end of 2008, leaving a financing gap to be fulfilled by external lenders. In fact, the record debt of the corporate sector makes total debt of the economy higher than the Eastern European average. Bulgaria intends to revise its current budget bill as the deficit increased more than expected in the first four months of the year. The revised bill is expected to contain a deficit target of 4.8% of GDP in cash based methodology for 2010 as a result of a reduction of revenues by BGN 2bn, and increased public spending. This would be rather close to our own deficit forecast that predicts a deficit of 5% for 2010, followed by 3% in 2011 as economic growth restarts. The revision of the budget will probably imply a slightly higher level of public debt that we expect to peak at around 20% of GDP in 2011-2012.

The financing situation in Romania became problematic in 2009 as the budget gap increased significantly while financing from market sources virtually froze. Hence, following Hungary and Latvia, Romania resorted to the assistance of the EU and the IMF to ensure solvency. From the beginning, Romania has had difficulties in meeting the deficit criteria set in the stand-by agreement that had to be fulfilled in a politically tense period, characterized by the presidential elections in late 2009. After President Bissau’s re-election, the new government established by Prime Minister Boc embarked upon a path of strict austerity measures. Criteria for the forthcoming tranches of IMF-EU financing include a 25% cut in public sector wages and a 15% cut in pensions and unemployment benefits. The IMF Executive Board will decide on disbursing the next tranche after these measures have been taken, which at the closing of our report seems likely but not certain.

In fact, after the Greek debt crisis the IMF changed gear and set more demanding requirements to stabilize state finances in Romania. According to the calculations of the Ministry of Finance, the public debt-to-GDP ratio is expected to increase from the current 29% of GDP to 36%-37% by end-2010, even if austerity measures are taken. The debt increase can be attributed to borrowing to cover the budget gap in 2010. Although current public debt is nearly covered by net financial assets of households (27.9% of GDP at end-2008), the dynamics of the debt level do not seem sustainable without drastic steps. Finance Minister Sebastian Vladescu claimed that without the currently discussed austerity package public debt would rise by about EUR 11bn in 2010 and by a further EUR 9bn in 2011, causing the country’s debt to reach approximately 50% of GDP (EUR 60bn) by end-2011. We assume that the Boc government will eventually be successful in implementing the required austerity measures and hence the budget deficit is forecast to decline to 7.2% of GDP in 2010 (ESA methodology), down from about 8.3% in 2009. For 2011 we forecast a deficit of 6.4%. Based on these figures, we project a significant increase in the public debt-to-GDP ratio in the coming years with a peak at around 45% in 2012.


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