Transition report press conference

Transition Report 2006 press conference, Monday 13 November 2006

MR WILLIAMS (Senior Manager, Press Office): May we welcome you to the press launch of the Transition Report for 2006. Erik Berglof, the Chief Economist, will make the introductory remarks and then this session will be open for your questions. Everybody has seen the report, the press release and the executive summary. There is a booklet with graphs and other indications.

There is a transmission embargo of 1700 GMT, or 5 o’clock this afternoon for the agencies and obviously anybody who is putting it on to the web or for broadcasting purposes.

MR ERIK BERGLOF (Chief Economist): Thank you and welcome to this year’s presentation of the Transition Report. This is my first Transition Report. That makes things much easier because it is really very good news that we have to give you.

This is news about a region that is growing, and growing faster than we anticipated earlier this year. It is also growing fast by international comparison. It is a region that is converging with Western Europe and within the region in the sense that the eastern part of the region is growing faster than the western part. This is a very general observation. The driver is, to a great extent, consumption. That means that people are improving their livelihoods; households have more to spend; and wages are going up. On the whole, this is a very positive message.

Of course, there are different regions, and I will go through them one by one. We talk about three sub-regions: the CIS and now, since this year, Mongolia; South-East Europe; and Central and Eastern Europe including the Baltics. These groups hide difference within them, and let us look at them one by one.

The CIS and Mongolia is the fastest growing part of our region. We think growth will approach 6.9 per cent compared to the region as a whole, which is 6.2 per cent for this year. Here raw material prices, particularly oil and gas, matter a great deal but countries that are not rich in resources are also doing very well; countries like Armenia, Georgia and Ukraine. In some cases this is because of improved commodity prices, but mostly it is through better and higher consumption and in some countries very strong remittance flows. These flows play an important role in some parts of the region, particularly the Caucasus and South-East Europe.

I will say a few words about Russia later, but in South-East Europe there has been a strong revival of some industries, particularly in the metal sector. We see expanding exports, strong domestic demand and strong credit growth. The financial sector is expanding very quickly in these countries. We estimate growth for this year at 5.9 per cent.

In Central and Eastern Europe and particularly the Baltics growth is very fast. In Central and Eastern Europe we see more of a levelling off of growth, but still higher than we had anticipated just six months ago. Here again, there is strong demand with strong exports driving growth and there is also a very active financial sector.

As you know, in the Transition Report we try to monitor what is going on in terms of reform. We look at a broad range of reforms that we think matter for the building of a market economy. We see an improvement, compared to last year at least, in terms of the speed of reform. In South-East Europe in particular, basically all the countries have had at least one improvement in one area. This is a positive development.

In Central and Eastern Europe, in order to get reform to come through, and particularly for the aspects at which we do not look closely – the macro aspects – we focus on what we call structural reform, things that bring about the market economy. The concerns we note in the report are about the ability to take difficult macro decisions, difficult decisions when it comes to fiscal discipline. Here we point to some concerns as we go forward.

In the CIS, most of the reforms come in the big countries, the richer countries. They come in areas that are not so much government driven but driven by market forces, particularly in the financial sector but also to some extent in telecoms.

Each year we have a theme for the Transition Report. This year we have chosen to focus on the financial sector. That is the sector where we have seen most reform during the last year, so it is appropriate to focus on this sector. When we focus, we try to take a slightly longer time perspective. There is quite a remarkable transformation of the financial sector in the region from just 15 years ago when these countries basically lacked a financial system. They had one mono bank doing both central banking and commercial banking; they were channelling resources without much intermediation. Those systems look very different today. They are extremely fast growing and much more diverse. They have a lot of foreign ownership, as you know, and so foreign banks have played an important role, particularly in Central and Eastern Europe, but increasingly in the CIS. These banks have played a very important role both in securing the stability of financial systems but increasingly also in transforming management in banks and also starting new banks and broadening the number of products offered. The foreign banks started by supporting the large corporates, but increasingly they have come to service households. A lot of the growth in consumer credit comes from the increased emphasis by banks on servicing the household sector.

Over time, small and medium sized enterprises have come to benefit from this as well, but still the challenge facing the financial systems is how this sector can give access to small entrepreneurs. Here foreign banks may be at an informational disadvantage. They are increasingly penetrating this segment but many firms are still outside the formal financial system. This is an issue and particularly the further east you go, the more of an issue it is and there small and medium sized firms are very much outside the official financial system.

Improvements to financial systems have come about very much in response to improvements in the institutional environment, in terms of both regulation and supervision and basic legal structures that can support things like mortgage lending and allow collateral to be used in financial transactions. There has been a remarkable transformation of the financial sector, which has responded very well to the growth needs of the region.

Let me end with a few words about Russia because Russia is very important to the region and to the Bank. As you know, Russia is changing in many directions at once. We may all feel some ambivalence about some of these changes but we need to step back a bit when we look at them and think about what Russia was just five or six years ago. In this regard, no one would have expected the turnaround in terms of growth, very strong macro management and the ability to control these very large revenues that they have gained from the increase in oil and gas and commodity prices in general.

One thing often overlooked is the dramatic improvement in business in Russia. There have been strong management improvements with a new generation of managers coming in to these companies. There have been improvements in corporate governance, perhaps not always to very high levels, but there are clear improvements. There are strong productivity improvements, particularly in some sectors exposed to competition from abroad. There are record levels of foreign direct investment into Russia. We expect foreign direct investment to double this year from a level last year that was already very high by Russian standards. We should remember that foreign direct investment in Russia has been very limited in the past.

That is the good news. Perhaps the less good news is that the state sector has not managed to transform itself to the same extent. When we looked at structural reform in Russia, in the bank and non-bank sectors, there have been upgrades in parts of the financial system. Much of the growth we have seen comes from earlier reforms in the early years of the Putin administration. We may now see a reluctance to implement further reform in the state sector. To some extent, we also see more state interference. Of course, one does have concern about an unreformed state interfering. This is more understandable in the resource sector. These are fundamentally Russian choices. When that extends further, there is reason for concern. This is so particularly now after Russia has been in a phase of building reserves and creating the resources to invest and to meet the huge needs of the Russian economy in terms of infrastructure, education, health and so on. With an unreformed state sector, one with serious problems in terms of preparing and implementing investment, there are reasons to be concerned.

As Russia tries to get these investments implemented and is entering an election period, it is going to be particularly important by trying to support Russia in its efforts to build a better infrastructure. The Bank can play an important role in this by trying, in various ways, to support the private sector’s involvement in these transactions and the creation of transparency in procurement, and by trying to prevent corruption and so on in these large investments. On the whole, we are optimistic that Russia will manage to sustain its growth over the next few years. We think this will be important for the region as a whole, and it is important for the Bank.

MR TONY WILLIAMS (Senior Manager, Press Office): For the sake of structure, it might be better at the beginning to have questions and discussion about the Transition Report itself, the improvement that Erik talked about in the process of transition and transformation and the reasons why the Bank has revised significantly upwards its forecast for 2006 since the earlier report in May, and then to get on to the financial sector and any other questions outside of that. That will keep questions in one particular area at any one time.

MS NINA KOEPPEN (Dow Jones): As just mentioned, you have significantly upgraded your forecast for 2006. I have two points. You have not given us any programme for 2007. Secondly, why exactly have you upgraded your forecast? Is that because of stronger domestic demand? Is it both strong domestic demand and stronger FDI or are there other factors? Could you expand?

MR ERIK BERGLOF (Chief Economist): The upgrades are driven very much by the large economies in our region: Russia, Romania, and Poland to some extent. I would say that largely this is consumption driven and consumption has grown more than we anticipated in these countries. In Russia, this is further strengthened by the strong inflow of foreign direct investment which, by historic standards, is really remarkable.

You ask about 2007?

MR SAM FANKHAUSER (Director Policy Studies and Sector Strategy, Office of the Chief Economist): The figure is around 6 per cent, similar to our 2006 forecast.

MS NINA KOEPPEN (Dow Jones): Would you call this a slow-down?

MR SAM FANKHAUSER (Director Policy Studies and Sector Strategy, Office of the Chief Economist): No.

MR ANDREW WALKER (BBC World Business Report): From the report, it looks as though, among the reform areas, competition policy seems to stand out as one where there has been least progress. Do you have any idea why this is proving so difficult?

MR ERIK BERGLOF (Chief Economist): We have had some improvements.

MR ANDREW WALKER: It does seem to be the area that gets the lowest scores when you put on the numbers.

MR ERIK BERGLOF (Chief Economist): Competition policy is extremely important in many of these countries but it is one of the areas that has, in the past, turned out to be most difficult. It was also very difficult in Central and Eastern Europe to go from having a competition policy formally in place to implementing it. This is an area that faces the strongest special interests in implementation. That is the main explanation.

MR ANDREW WALKER (BBC World Business Report): Special interests are preventing implementation.

MR ERIK BERGLOF (Chief Economist): Yes, and the hope is that the emergence of a stronger sector of small and medium sized enterprises, for example, can create political pressure that will further promote this implementation. We know that in Eastern Europe this is one of the most difficult areas to make rapid progress.

MR SAM FANKHAUSER (Director Policy Studies and Sector Strategy, Office of the Chief Economist): Part of that is perhaps inbuilt into the way we measure these things because we are looking for a track record with good application of competition policy. The systems are probably all right now, certainly in Central Europe, but by definition you have to wait a couple of years to look at the track record and see whether those agencies are doing what we want them to do.

MR GABRIEL PARTOS (BBC World Service): I think the reforms in Central Europe are still on hold and have been for at least two years now since EU accession. I wonder if there is any danger that this might also happen in post-accession countries, in the cases of Bulgaria and Romania. What needs to be done to avoid that?

MR ERIK BERGLOF (Chief Economist): As a general observation, there is always concern that the very strong pace of change that happened immediately before accession may be hard to sustain once you are inside the EU. In the cases of Bulgaria and Romania, they are subject to additional pressures that the previous accession countries were not. Part of their accession agreements will help with these pressures. Remember that these economies have been doing very well. They are still lagging in some reform elements. My prediction is that there will be continued improvement in those two countries.

MR ANDREW SWIDLICKI (Polish News Agency): If the reforms in Hungary are really the success you claim them to be in your report, because Hungary ranks very highly, why is there such a crisis in that country?

MR ERIK BERGLOF (Chief Economist): One should distinguish between the structural reforms that we measure and the macro economic and fiscal decisions that have to be made, which are more of a distributional nature. They are about divisions of income and wealth at the current time and also between current and future generations. These decisions are not really about reform as such; they are more about distribution issues. In Hungary that is an important part but there is also a political element that we do not measure which is to do with the political process that led to these protests. If you look at the structural reforms that Hungary has implemented, it is indeed a great success story.

I am told the question was about Poland but I thought you said Hungary.

MR ANDREW SWIDLICKI (Polish News Agency): Yes. You are welcome to elaborate a bit more on Poland.

MR DANIEL BASES (Reuters): From reading through the report and sitting here, you are giving a very positive view of things. We are upgrading our growth forecast. You put a very positive overlay on this but actually I feel, reading through it, that a lot of negative issues are coming forth in terms of financing, current account deficits and general economic trends. They do not all seem to be so positive. I wonder if this is going to come off the rails. We have this great growth that is energy and commodity driven in some of the countries, but there is also what seems to be a growing differentiation between the regions. Things seem to be a bit more critical in the report than what I am hearing in the comments. I wonder if I am reading this incorrectly.

MR ERIK BERGLOF (Chief Economist): The basic message in the report is that there is convergence in growth and reform in the region but with some slow-down in some aspects of reform in the CIS. The way I read the message in the report is very positive. Of course there are concerns, and those differ from region to region. In Central and Eastern Europe the concerns are more of a macro nature and the fact that the region is enjoying a period of very strong liquidity, while at the same time having problems implementing some of the difficult decisions in terms of fiscal discipline. That is a concern but the growth story is very strong.

It seems that, despite the political problems, the economies are doing very well in terms of generating growth and improving the livelihood of the people. It is natural for you to look for things that concern you over the long term. The basic message for Central and Eastern Europe is positive. In South-East Europe the overall story is very positive. We see strong growth and structural reform in all the countries. I have tried to provide a balanced picture of these areas. For Russia, on the whole I think we should acknowledge the many improvements and the very rapid ongoing change in Russian business, whilst not closing our eyes to some of the areas where we need more reform, particularly if we are going to sustain this high level of growth and also support the desire of the Russian Government to improve the infrastructure, health and education in the Russian economy.

The basic message is that Russia is growing at a rate that we could not have anticipated previously and which we would not have anticipated just five years ago. We need to see more reform supporting this growth.

MS JASNA PARO (Croatian TV): Where would you place Croatia among the countries in the region? Is EBRD one of the biggest investors in Croatia? Is that going to continue? What is the situation?

MR ERIK BERGLOF (Chief Economist): The basic story in Croatia is also very positive. It is one of strong growth and it is consumption driven. You may see some concerns in the report in terms of the pace of reform and the commitment to further privatisation. We are concerned about that but, on the whole, Croatia is on the path to EU accession. This is a powerful driver of reform, as we know from the past. The basic story in Croatia is quite positive as well.

MR VITALY MAKARCHEV (Itar-Tass): I have a feeling that your Bank and you yourself feel quite comfortable about the rise of interference of the Russian state in various areas of the national economy. Is that correct or not?

MR ERIK BERGLOF (Chief Economist): I tried to say exactly the opposite because we have not seen the same extent of change in the state sector as we have seen in the business world in Russia. There is reason for concern that the government is expanding. Choices about the pace at which resources should be constructed over time are fundamentally Russian choices, but there are other signs of industrial policy that directly interfere in individual sectors about which we are concerned.

MS NINA KOEPPEN (Dow Jones): You acknowledge that there is going to be an increase in 2006 over 2005, but at the same time you are also saying that foreign direct investment is incredibly high. I am sure that the investors putting their money into Russia probably notice the same thing about what is going on. Does that mean that foreign direct investment levels will plummet?

MR ERIK BERGLOF (Chief Economist): No, I think foreign direct investment here is a sign of a basic positive trend in Russian business and that those investors taking their money to Russia now see bright prospects for investing in Russia. I tried to emphasise the problem of implementing the very large investments that the Russian Government now wants in terms of infrastructure, building roads and railways, better water systems and so on for the Russian population. There are great needs but these investments are difficult to implement. We know that they are particularly vulnerable to corruption and so on. The Russian Government faces serious challenges. They need to involve the private sector. I think our Bank can be helpful in trying to bring about these investments in the best interests of the Russian people.

MR ANDREW WALKER (BBC World Business Report): Taking up the question about investment, do you think the behaviour of the Russian Authorities is having a negative impact on domestic investment?

MR ERIK BERGLOF (Chief Economist): Domestic investment is picking up in Russia as well. There are huge needs for investment. We see that most industries in Russia face very serious capacity constraints. There is very old machinery and equipment. The signs are that investment is picking up and that Russian business is both improving its management but also investing in new equipment.

MR DANIEL BASES (Reuters): On the EU question, the report mentions in one or two places that there has to be some kind of anchor that the EU offers and if that is taken away, that might reduce the reform process. That leaves open the question of what the alternative might be. I wonder if you could elaborate and say if any alternatives are being thought about and if they would really be effective. Is this about basically crossing your fingers and hoping for the best?

MR ERIK BERGLOF (Chief Economist): Are you referring to alternative anchors that the EU could provide, other than membership, or other anchors in the EU process?

MR DANIEL BASES (Reuters): Perhaps there are other anchors in the process. As you mentioned, there is a fear that there might be fatigue in accession. That is the point.

MR ERIK BERGLOF (Chief Economist): Are you referring to countries that have already joined or countries in the process of joining? I still think that the EU anchor is very powerful in the candidate countries and beyond. There are countries about which there is more doubt as to whether the EU anchor will, in the long term, have the same impact, as in Ukraine where in the near term there are no real prospects. There are other anchors for these countries. We have some tentative good news for Russia that some kind of agreement on WTO has been reached with the Americans, which was the last hurdle in the bilateral part of the WTO negotiations. There are other anchors but no anchor is remotely as powerful as the EU anchor. I do not see any signs of it.

There is a concern beyond Croatia for countries further down that may possibly become candidates. There is scepticism about the European Union further extending membership that could have an effect. So far, we have not really seen that manifested in the pace of reform. We see countries in the next cohort – Serbia is doing very well as one of them – that are the leading reformers in the whole EBRD region.

MR ANDREW SWIDLICKI (Polish News Agency): On the question of EU funds, do you think that those newly admitted countries to the EU will be able to make the best use of EU funds, since there is, as you point out, corruption, barriers to business and insufficient competition and other obstacles?

MR ERIK BERGLOF (Chief Economist): The problem is the same as I mentioned in Russia in the sense that when you try to invest a lot of resources over a short period of time, the capacity to absorb these investments is important and it differs a lot between countries. Poland has done much to put this capacity in place. We know from the EU experience that the ability of countries to absorb investment differs. There is the experience of Greece compared to that of Ireland and so on. In my view, it will be important to put in place new and innovative frameworks to absorb these investments. From the Bank’s point of view, we are involved in several new and innovative ways of trying to involve the private sector and the banking sector and so on to make sure that the return on this investment is as high as possible.

MR GABRIEL PARTOS (BBC World Service): On the earlier question about reform fatigue, could you single out for us the key reform or reforms that should be getting under way in Central Europe and indeed to what extent would these be linked to a greater capacity to absorb EU funds?

MR ERIK BERGLOF (Chief Economist): If we look at structural reform as focused on in our measurement of reform, the remaining reforms in Central and Eastern Europe are primarily related to infrastructure and these are exactly the areas that these funds from the EU are meant to target. That is why reform in this area is particularly important. There is a link between the need to get further progress and the prospect of these large inflows of funds over the next few years.

MR SAM FANKHAUSER (Director Policy Studies and Sector Strategy, Office of the Chief Economist): There is a little box in the report which personally I find fascinating, which looks at differences within countries in terms of the extent to which reform has reached the whole of a country, not just the capital city. You will see from that that the huge challenge is to move away from the capital city, which generally is doing all right, to the regions of a country. Basically, the more rural the region, the higher the number of ethnic minorities and the more difficult they have found it to gain the benefits of transition. There is a huge challenge to level out the benefits of transition across the whole country.

MR TONY WILLIAMS (Senior Manager, Press Office): Are there any further questions on transition? Shall we go on to the special theme of the financial sector?

MS NINA KOEPPEN (Dow Jones): On the question of financials, you spoke in one section of the report about the growing importance of private equity finance. You showed us how much the sector has been growing over recent years. I wonder if you could forecast the coming year.

MR ERIK BERGLOF (Chief Economist): I could not give you a specific forecast. The forecast is always that this will rapidly increase. Very large funds in the last two years have gone into this sector. We certainly expect this to continue, assuming there is the same broad macro environment. Importantly, you can see from that chapter that the level of funds and the results are closely tied to the general institutional environment, quality of the law and enforcement, and that funds that went in at an early stage of transition took much longer to break even and the time to exit was much longer. Over time, we are seeing improvements. We think we can take these lessons to the rest of our region. Private equity is an important complement to the banks in these economies because banks tend to have an arm’s length, more distant relationship to firms. Private equity is a way to achieve managerial change and restructure companies. We think that could be a useful tool.

MS NINA KOEPPEN (Dow Jones): You have pointed out that domestic participation is really thin. How do you see this developing?

MR ERIK BERGLOF (Chief Economist): We have discussed this. We think that this is a major weakness of the private equity industry so far. It is important to try to build on this. We would very much like to be part of that as a financial institution and to support local initiatives. It is true, as a general point, that much of the growth in the region has been supported and financed by savers in other parts of the world. The level of foreign direct investment has been very high, particularly in Central and Eastern Europe. Of course, there are savings from other parts of the world. In general, building savings internally and particularly for these types of investment is very important.

MR VITALY MAKARCHEV (Itar-Tass): You said in your report that Azerbaijan has become the fastest growing economy in the world and you use a figure of 25 to 26 per cent. Is this your own calculation or that of the World Bank?

MR ERIK BERGLOF (Chief Economist): It is the growth rate of the country. It is their own.

MR VITALY MAKARCHEV (Itar-Tass): Is that supplied by Azerbaijan?

MR ERIK BERGLOF (Chief Economist): In all these countries there is uncertainty about the exact number, particularly in a country like Azerbaijan. You may want to take these very high numbers with a grain of salt. On the whole, it is clear that Azerbaijan’s economy is growing very rapidly and it is driven by the very high prices for oil and gas.

MR SAM FANKHAUSER (Director Policy Studies and Sector Strategy, Office of the Chief Economist): The forecast is our own EBRD forecast but is not very different from that of other people. There is a table in the report that compares our forecast with others.

MR ANDREW WALKER (BBC World Business Report): It is your forecast but these are the country’s figures for historic prices?

MR ERIK BERGOF (Chief Economist): Yes. I thought you were referring to last year’s growth.

MS JASNA PARO (Croatian TV): May I ask a question specifically about Croatia? When you were giving the overall picture, you said that there are still some areas of concern. Can you state some of those?

MR ERIK BERGLOF (Chief Economist): I have mentioned the area of privatisation. We have not seen great commitment over the last few years to further privatisation. That is an important area where we think that there are many opportunities for collaboration between the private and public sectors in infrastructure. It is important to see a stronger commitment by the Croatian Government to that.

MR TONY WILLIAMS (Senior Manager, Press Office): Thank you very much for coming. Erik Berglof and Alan Rousso will be around for a few minutes if you have further questions.