Author: Maciej Danielewicz

Editor-in-chief of Obserwator Finansowy

World Bank: The recovery in Central Europe in 2021 will be underpinned by, among others, interest rate policy in Poland

The recovery in Central Europe will be supported by a rebound in global trade and activity in the euro area, and by exceptional policy accommodation throughout 2021, including near-zero policy interest rates in Poland – says Franziska Ohnsorge, manager, Prospects Group at the World Bank.
World Bank: The recovery in Central Europe in 2021 will be underpinned by, among others, interest rate policy in Poland

Franziska Ohnsorge, World Bank (©World Bank)

The pandemic may provide momentum for automation and digitalization that can further promote emerging market and developing economies’ shift into higher-productivity activities in global value chains, especially if supported by investment in transport and digital connectivity – the economist adds.

Obserwator Finansowy: Can the COVID-19 pandemic provide an opportunity for the CEE countries to catch up with developed economies? What will support such a scenario and what will threaten it? What measures should developing countries take to move faster from the pandemic recession to the growth path?

Franziska Ohnsorge: Like most emerging market and developing economies, countries in Central Europe are expected to see a subdued recovery in 2021. Growth in Central Europe is envisioned to firm this year to 3.6 percent, on par with expected euro area growth. The recovery will be supported by a rebound in global trade and activity in the euro area, and by exceptional policy accommodation throughout 2021, including near-zero policy interest rates (Hungary, Poland).

However, this outlook is subject to heightened risks and depends critically on the path of the pandemic. If it takes longer than anticipated to bring the pandemic under control, tourism, in particular, may fail to recover promptly. A prolonged downturn in travel could yield much weaker growth outcomes, particularly in tourism-dependent economies (Central Europe, Turkey, the Western Balkans). Conversely, policies that increase the absorption of EU structural funds could boost investment and growth in Central Europe.

The heightened level of uncertainty around the global outlook highlights policy makers’ role in raising the likelihood of better growth outcomes while warding off worse ones. Limiting the spread of the virus, providing relief for vulnerable populations, and overcoming vaccine-related challenges are key immediate priorities. With weak fiscal positions severely constraining government support measures in many countries, an emphasis on ambitious reforms is needed to rekindle robust, sustainable, and equitable growth.

How has the pandemic changed the perception of risks arising from increased debt and the use of fiscal policy to support growth? Can emerging markets finance economic recovery with debt? Or conversely– can they afford to keep fiscal discipline?

Emerging markets and developing economies have responded to the pandemic with unprecedented stimulus to avert worse growth outcomes. Fiscal support packages in Central Europe have averaged 9 percent of GDP and have ranged from sizable discretionary measures to loan guarantees and other credit measures.

Fiscal support programs and output collapses combined have triggered a surge in debt levels in emerging market and developing economies. Government debt rose by 9 percentage points of GDP in emerging market and developing economies in 2020—the single largest one-year increase since the late 1980s when many of them were in debt crises. Even before the pandemic, however, a rapid buildup in these economies—dubbed the “fourth wave” of debt accumulation—had raised concerns about debt sustainability and the possibility of financial crisis. This surge in debt magnifies risks of financial market turmoil.

World Bank: NBP’s response – swift, large and effective in limiting the economic scarring effects of the pandemic

The deterioration in fiscal positions has made achieving fiscal sustainability more challenging. Providing a clear exit strategy for unwinding substantial support—alongside strengthening fiscal frameworks and debt transparency and efficiency—would help bolster credibility and keep borrowing costs contained. It would also put governments in a better position to address fiscal risks such as the realization of contingent liabilities, particularly those that arise from state-owned enterprises.

The trade-off between strengthening fiscal positions and continuing to provide support can be made more palatable through improvements on the part of both revenues and expenditures. On the revenue side, ensuring that the tax structure and statutory rates are efficient could help mobilize domestic revenues and soften the drag from fiscal consolidation. On the expenditure side, improving public investment efficiency, as well as the quality of public procurement, can ensure that expenditures yield high growth dividends and offset the impact of consolidation. Strengthening governance, for instance, could halve the expenditure losses generated by public infrastructure inefficiencies. Additionally, expenditures could be prioritized toward measures that bolster inclusive and sustainable growth and also help ensure fiscal sustainability, such as investment in human capital or priority sectors, including green technology.

In the medium term, in the exceptional circumstances faced by the CEE economies during the pandemic, what is the higher risk: elevated inflation or elevated unemployment?

As a result of weak demand and subdued energy prices, inflation in emerging market and developing economies has fallen below central bank targets, on average, since May 2020. Nevertheless, the fall in inflation in EMDEs has been less broad-based than in advanced economies, reflecting the effects of sharp currency depreciations as well as rising domestic food prices in some countries. Whereas underlying inflationary pressures in most EMDEs are likely to remain subdued amid persistently soft demand, negative output gaps following the collapse in activity may not be as sizable as currently envisioned due to the pandemic’s damage to potential growth. This could eventually fuel a pickup in inflation.

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In addition, the global unemployment rate increased by about 2 percentage points in the first half of 2020 alone. The longer unemployment remains high, the more pronounced the associated human capital losses will be. Longer unemployment spells may discourage workers from remaining in the labor force, which could appreciably erode skills given steep job losses. Such deskilling may lower future earnings and dent human capital. As a result of human capital losses and an investment collapse, COVID-19 could further reduce potential growth—sustainable, full-employment growth—in emerging market and developing economies over the next decade, in the absence of reforms to boost underlying drivers of long-term growth.

What economic activities can be envisaged in the event of a negative scenario for the development of the pandemic in 2021 – if, for example, vaccination takes longer than anticipated or new, more contagious mutations of the virus develop?

In a downside scenario, the vaccine rollout might be delayed by one to two quarters and it may take longer to bring the pandemic under control. In such a scenario, economic activity would remain depressed, as households fear contact-intensive services, including recreation and tourism, and grapple with stringent social-distancing measures. Firms—facing pandemic-control policies, a bleak outlook for consumer demand, and elevated uncertainty—would curtail investment and hiring plans. Financial conditions would tighten markedly through 2021, as financial market sentiment would deteriorate in tandem with a string of unexpected vaccine delays and insufficient control of the pandemic, and as corporate and bank balance sheets would deteriorate over prolonged weakness in  demand and forbearance requirements. While accommodative monetary policy could keep financial crises at bay, fiscal sustainability concerns would limit the size of additional fiscal stimulus, leading to insufficient income support to the unemployed and struggling small- and medium-sized firms. In such a scenario, global growth might be 1.6 percent in 2021—less than half that in the baseline scenario (4 percent).

Is the economic model with the CEE region as Germany’s subcontractor, whose exports, in turn, strongly depend on demand from China, stable in the long term? Should Poland, for example, try to find its place in other value chains, in other parts of the globe?

Notwithstanding early concerns, global value chains have proven unexpectedly resilient with global goods trade rebounding to pre-pandemic levels. The pandemic may provide momentum for automation and digitalization that can further promote emerging market and developing economies’ shift into higher-productivity activities in global value chains, especially if supported by investment in transport and digital connectivity. Over time, supply chains may be restructured in ways that increase their diversity and resilience. For Central Europe, this could open new opportunities in global value chains that have promoted trade, foreign direct investment, and knowledge transfer.

Is fiscal policy combined with unconventional monetary policy the new normal? What would have to happen for central banks to raise interest rates significantly as they have significantly cut them?

Governments and central banks have provided unprecedented policy support to avert worse growth outcomes. In Central Europe, for example, fiscal support measures amounted to 9 percent of GDP, reflecting sizable discretionary measures and loan guarantees and other credit measures.

Central banks across advanced economies and emerging market and developing economies have also responded to the economic and financial market shocks induced by the COVID- 19 pandemic with broad-based cuts in short-term policy rates, which in many economies are now at, or close to, their effective lower bounds. To stabilize financial markets, 18 EMDE central banks expanded their remit by starting asset purchase programs, often for the first time. These novel tools appear to have helped stabilize financial markets. While appropriate in the midst of a deep recession, the prolonged use of these tools could dampen investor confidence and risk de-anchoring inflation expectations in countries with weak institutions if central bank credibility is undermined by extended funding of large fiscal deficits.

 – Interview by Maciej Danielewicz

 

Franziska Ohnsorge is Manager of the Prospects Group in the World Bank. Prior to joining the World Bank, Ms. Ohnsorge worked at the International Monetary Fund (IMF) and in the Office of the Chief Economist of the European Bank for Reconstruction and Development (EBRD). She has published on a range of topics in policy and academic publications. She holds a PhD in Economics from the University of Toronto.

Franziska Ohnsorge, World Bank (©World Bank)

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