Speeches & Transcripts

Regional Policy Forum on “Growth Strategies after the Crisis”

June 24, 2011

Philippe H. Le Houerou Remarks for the Center of Excellence in Finance (CEF) forum Ljublijana, Slovenia

As Prepared for Delivery

Ladies and Gentlemen, it is a privilege for me to address you this morning.  I would like to personally thank the Center of Excellence in Finance (CEF) for organizing this important and timely forum.  I would also like to congratulate the Center on its ten year anniversary.  I am also pleased to see so many friends and colleagues from CEF member countries. I am looking forward to discussing with all of you some of the challenges and policy options facing the CEF member countries during the recovery from the global economic crisis and beyond.

Before talking about the future, I want to discuss some of the elements that contributed to the significant pre-crisis growth in the CEF countries. The CEF countries benefitted greatly from what I like to call “the good neighborhood effect.” All of the CEF countries have either joined the EU – Slovenia, Romania, and Bulgaria -- or aspire to join the EU – the countries of the Western Balkans, Croatia, Turkey and Moldova. The benefits of European integration for these countries have been a key to convergence in income and consumption levels since 2000. In many ways during the past two decades, Europe has invented a convergence machine. In 2000, the average per capita income for CEF countries was slightly less than $3000. By 2007 it was over $7,500.
This convergence has been driven in part by the integration of trade in Europe. About 62% of merchandise exports originated and ended up in Europe (EU25) in 2009. Europe is a final destination for 65% of exports from the CEF countries.

This trade integration has been accompanied by very large financial flows. Credit growth in the CEF countries and throughout Central, Eastern and Southeastern Europe was fueled by financial flows from parent banks primarily in Western Europe. As an example, in the pre-crisis years direct lending from parent banks was a substantial percentage of total credit to the economy in many CEF countries. In 2008, it was over 40% in Montenegro and Serbia and over 25% in Bulgaria and Croatia. Overall, private sector credit growth in the CEF countries averaged over 55 percent in 2007 and fueled a massive increase in real estate prices. As a result, household debt increased in many countries. For examples, in 2008 household debt totaled more than 40% of GDP in Croatia and more than 20% in Bulgaria and Slovenia.

These same benefits of European integration that helped the CEF countries will now pose challenges going forward. The “neighborhood effect” that benefitted the CEF countries in the pre-crisis years will now be a challenge as Western Europe is expected to be the slowest growing region in the post-crisis years.

Starting from the global context, we project that global economic growth in 2011 will be lower than it was in 2010  at about 3.2 percent and only slightly better in 2012 and 2013 at around 3.6 percent.  And for Western Europe, we see economic growth in the next three years at just under two percent.

Against this backdrop of a more difficult external context, many CEF countries also face the challenge of cleaning up their banking sector, reducing their fiscal deficits, and a deep trend of a shrinking labor force and an ageing population. The average labor force participation ratio in the CEF counties is less than 65% of the working age population. And the problem will become worse. Over the next three decades, all of Europe’s labor force will shrink by a quarter. And within this same time period, more than a quarter of all Europeans will be older than 65. Obviously, these demographic dynamics have far reaching implications for policy makers in the CEF countries.

In the interest of time, I’d like to focus my remarks today on two challenges facing CEF countries in the post-crisis world: The structural dimension of fiscal adjustment and improving competitiveness.

First, the size of government, fiscal adjustment and reforms in the social sector.

The fiscal deficits in CEF countries averaged more than 5% in 2009 and 4% in 2010. This fiscal pressure will intensify the urgency to complete long-delayed reforms to pensions, social safety nets, health and education.

To address this issue frontally, CEF countries have much bigger governments than other countries with similar GDP per capita. The median value of government spending for CEF countries in 2008 was about 40% of GDP. This is close to the EU15 median of 46% and much higher than the 29% in Latin America and the 25% in Emerging Asia.

The main driver for such large public spending is not the public investments needed for growth, but social spending. Total spending on pensions, social safety net schemes, health, and education averaged slightly over 21% of GDP in 2009 for CEF countries.

Because spending on pensions is the biggest percentage of government social spending in many CEF countries, pension reform is the highest priority. This is true in Europe as a whole, as well as in CEF countries where pension outlays near or exceeds 10% of GDP in Bosnia, Croatia, Macedonia, Moldova, Montenegro, Serbia, and Slovenia. Progress has been made in the past couple of years, and almost all of the CEF countries have introduced some pension reforms since the crisis. Most reforms include a mix of decreasing benefits, increasing contributions, and increasing the retirement age. But they are far from complete. CEF countries, except Turkey, Albania, and Kosovo, are aging much faster than most other countries around the world. As a result, even taking into account recent reforms, our projections show a deteriorating fiscal situation in many countries over the next few decades

In addition to pensions, social safety net spending also consumes a significant percentage of GDP. It varies among the CEF countries. For example it was over 3.5% in Croatia in 2009 and was slightly more than 1% in Montenegro, Bulgaria, and Moldova.  There are significant opportunities for making these programs more efficient by targeting the poorest and reducing overlaps. In Bulgaria, Macedonia, Turkey, Moldova and Bosnia, our latest data shows that less than 50 percent of total benefits are received by the poorest quintile.

In health and education, there are significant opportunities to improve the quality and efficiency of services. Both health and education also consume a great deal of public resources in many CEF countries.
Education spending averaged slightly less than 5 percent of GDP in CEF Countries. We believe that savings can be achieved without compromising quality. For example, there are too many teachers in many countries. In Romania, Moldova, Croatia, Bulgaria and Serbia, the student-teacher ratio is slightly more than 15 to 1.

Health spending also consumes a substantial amount of government resources. In 2008, health spending averaged about 5 percent of GDP in CEF countries. Given the aging of the population, this fiscal pressure is also likely to increase. Again, there are opportunities for improving efficiency. For example, hospital beds often are unoccupied. And those that stay in hospitals, stay for far longer than in high income countries. In Bulgaria and Bosnia, our latest data shows that the occupancy rate for hospital beds is less than 65%, which is lower than the 77% for Western Europe. And in both of these countries, patients stay for almost 10 days on average compared to the Western European average of less than 7 days. Another issue with health spending is that there are often large percentages of the population that do not contribute to universal health insurance schemes. In Bosnia, Montenegro and Macedonia between 40 and 50 percent of the population contributes. In these countries, war veterans and workers in the informal sector, who register as unemployed, decrease revenues for health systems.

The World Bank is seeing a significant increase in demand from our client countries in the region to assist on structural reforms in pensions and social safety net schemes. The majority of our budget support operations now have some pension or social safety net reform component. We are working or have completed lending and technical assistance projects focused on social assistance and pension reform in Albania, Bosnia, Bulgaria, Croatia, Kosovo, Macedonia, Montenegro, Romania, Serbia, Turkey and several other countries in the Emerging Europe region.

The same is true in health, where, for example, we have a project in Turkey to support the expansion of coverage of health insurance to the poor (equity) and reforms to provider payment systems (efficiency).  In Montenegro, a health project is supporting the introduction of a new payment system for hospitals, based on productivity rather than inputs (efficiency).  It also supported the introduction of capitation payments for primary care physicians.  The Serbia Health Project also supports similar changes.  A Romania project, currently under preparation (a results-based financing loan), will supports hospital restructuring and rationalization.

In education, policy based loans in Romania, Serbia and Bulgaria have encouraged school consolidation and there is a new project under preparation in Moldova  which will do the same.

The second major theme that I want to discuss today is the need to improve competitiveness.

The competitiveness agenda has come back very strongly in all of Europe for good reasons.  In the post-crisis world with low growth in Western Europe and a dramatic rise in the growth in China, India and the other BRIC countries, the CEF countries will need to dramatically improve their competitiveness.

Competitiveness is, of course, a multi-dimensional concept linked to macroeconomic policies, including exchange rate management, but also structural issues such as productivity, governance, investment climate, infrastructure, skills as well as long-term issues of demographics.

The competitiveness agenda is also closely linked to the fiscal agenda that I discussed previously. Reforms in social spending will free up much needed resources for public investments in infrastructure. These reforms will also improve labor force participation, improve incentives to work, and getting the right skills to compete.

Access to credit will also be a major challenge for companies in the post-crisis period. With the exception of Turkey and Serbia, credit growth averaged about 4% in CEF countries in 2010. Companies will have to adjust to an environment that is much different than the pre-crisis years of easy credit.

But today I want to briefly focus on two aspects of the competitiveness agenda, namely, the business environment and skills.

Based on our 2011 doing business ranking, there are opportunities for improvement in many CEF countries. The ease of doing business for CEF countries ranges from 38 to 119, with a median of 74, among the 183 countries worldwide.
For example, the costs of starting a business  are higher in the CEF countries than in other countries in Emerging Europe; the time needed to register property in CEF countries is longer ; and the tax system is more burdensome . Other problematic areas include property registration, contract enforcement, governance and corruption.

The good news is that we are seeing increasing efforts aimed at improving this situation. Over 60% of our budget support operations now contain reforms in the business environment, ranging from a total revamping of the commercial code in Turkey, improving customs and tax processes in Kosovo, and improving business regulation procedures  and simplification in Serbia.

I also want to briefly touch on quality of governance and corruption as a core part of the competitiveness agenda. The doing business rankings and other major governance surveys point to this as one of the major concerns for many CEF countries. The Transparency International 2010 Corruption Perception Index for the CEF counties ranges from 27 to 110 among 178 countries worldwide, with a median of 71.  In order to be competitive, the CEF countries need to focus on addressing corruption and improving the quality of governance to support a level playing field for enterprises. In fact, we are working with several CEF countries to improve the quality of their public administration. We also see increased demand to improve delivery of services, including in Romania and Bulgaria. And in the last two years, a number of our budget support operations have had some component related to improving the tax administration or civil service. Other areas supported include improvements in budgeting and procurement to decrease the opportunities for graft.

The second area within competitiveness that I want to touch on is the need to improve skills. One thing that surprised me two years ago was a survey of 10,000 firms in Emerging Europe, including the CEF countries. This survey highlighted that skills – That I considered to be one of the positive legacies of socialism – as the key bottleneck to competitiveness and growth.

In terms of skills, the socialist legacy is particularly visible in low-income countries in the region, which have the highest secondary enrollments in the world for their income level. Tertiary enrollments, which have grown rapidly in the past two decades, are also high relative to similar income levels. Despite this, almost 30% of firms in Emerging Europe considered skills to be the most important impediment to their growth.

Although the situation varies by country, two problems related to quality seem particularly acute in the region -- too many students are failing and education systems have difficulties imparting problem-solving skills. World Bank data for all of Emerging Europe show that there is a large percentage of 15-year-olds who have such poor numeracy and literacy skills that their future success in the modern workplace is questionable.

The quality of higher education is also a major issue. Enrollments at the tertiary level used to be tightly controlled and reserved for the few, best performers. In the past two decades, however, enrollments have doubled, tripled, or quadrupled, but without the benefit of quality assurance mechanisms. As a result, in many cases the expansion of the system has not been accompanied by growing quality.
The World Bank has been involved in a number of projects in CEF countries that focus on skill building in a broad sense. They support skill building through early childhood education, improvements in the quality of secondary and vocational education and improvements in tertiary education.

In Moldova, the Bank, in partnership with the global partnership on Education for All, is supporting improvements in access and quality of pre-school education.  The Turkey secondary education project is supporting improvements in secondary and vocational education, and a new project is under discussion to expand access and quality of pre-school education.  New projects in Montenegro and Macedonia are supporting improvements in tertiary education.  An important strand of our work in countries with significant Roma populations has been to encourage school attendance and completion by the Roma.  In Macedonia this is through a conditional cash transfer program from which Roma will benefit, in Bulgaria grants to local communities will increase participation by Roma in early childhood education, in Serbia, school grants will allow schools to improve retention of Roma students.  

In conclusion, many CEF governments have started tackling the issues of competitiveness and the structural dimensions of fiscal adjustment. However, to achieve significant post-crisis growth in a more challenging global environment these reforms will need to continue. Technical solutions are known, but it is critical that the political will to reform does not waver. The alternative is the danger of being caught in what we call the middle income trap.

Thank you for your time. I am looking forward to hearing your views.