Originally posted in German at Makroskop
Translated and edited by BRAVE NEW EUROPE
It is astonishing that people in Western Europe rarely speak about the countries that stumbled into a new economic system after the fall of the Berlin Wall and have since been swimming in the great European economic stream in very different ways and with varying degrees of success. Even more astonishing is the fact that in the past ten years, i.e. after the global financial crisis and since the beginning of the euro crisis, almost nothing has been heard about these nations, although the latter crisis in particular has been a decisive turning point for many countries.
This applies especially to the eastern borders of the European Union, rather than to the countries closer to the Western core. Bulgaria and Romania, for example, are reported on when cases of corruption are uncovered or when the outcome of elections surprises the West, because these countries are having great difficulty establishing stable governments. But the fact that these two nations, in particular, have not yet overcome the crisis triggered ten years ago and are making little economic progress hardly impinges on Western consciousness. There is a reluctance to admit that there is no easy way for such countries to adjust to a market economy.
Crisis without end, but strong consumption
Economic development over the past ten years has been very similar in both countries (Graphs 1 and 2). Investment, which was very dynamic in the first decade of the century, has fallen sharply in both countries since then.
After that, there was an interruption in investment activity that has not yet been overcome. In 2013 and 2016, for example, corporate investment spending in both countries declined or remained constant, which is very unusual for such a country after a recession and in the wake of a slight upward trend.
Private consumption also remained weak in both countries in the first few years after the crisis, but has recently picked up much more strongly in Romania than in Bulgaria. With a real private consumption growth rate of ten percent last year, Romania has set a mark that is difficult to understand in view of the weak increase in investment. Although private consumption in Bulgaria rose despite similarly weak investment activity, it rose much less than in Romania.
Wages are rising robustly
This can be understood by looking at income developments in both nations (Graph 3). Nominal wages are growing at a considerable rate – in Romania last year at over fifteen percent. Quarterly data show that this year, too, they are continuing at a similar pace. In Bulgaria growth rates of almost ten percent were also achieved in the past quarters, but in the past year as a whole the figure was “only” seven percent.
Inflation remained relatively moderate compared to nominal wage growth (Graph 4). In Bulgaria, the inflation rate in 2017 equalled that in the euro area, i.e. around two percent. In the course of this year, inflation at the consumer level rose to around 3.5 percent.
The GDP deflator in Romania rose much more strongly, namely by a good five percentage points, as early as 2017, although consumer inflation was still below 2 percent (Graph 5). Over the course of this year, consumer-level inflation in Romania has risen to close to five percent and in Bulgaria it has been three percent in recent months.
Behind moderate inflation with strong nominal wage increases in both countries, productivity dynamics differ (Graph 6). While per capita productivity in Romania has risen at a significant pace since 2010, productivity development in Bulgaria has remained rather weak. As a result, real wages in Romania have risen significantly faster than productivity over the past two years, but after a long period of wage moderation since 2008, this seems absolutely justifiable from the domestic side.
The situation is different in Bulgaria. Here, real wages have been rising steadily for several years without any noticeable acceleration in productivity growth. Thus, after years of wage restraint, a new phase has started, which poses the question how long will companies hold steady and not react by increasing prices.
The fact that companies are not reacting with increased prices may be due to the fact that they are internationally active, operating with high (Western) productivity and thus with extremely high profit margins (or a large price margin below the international markets). However, there may also be a competitiveness problem among the original Bulgarian companies that prevents them from raising prices more robustly.
Foreign trade crisis ahead?
That it may be lack of competiveness is supported by the fact that the real exchange rate has risen more strongly in both countries since 1999 than in Germany, which we have taken here for comparison. But the appreciation is also enormous when measured against other euro-zone countries ( Graph 7).
The picture is almost exactly the same when comparing unit labour costs in international currency with those in Germany (Graph 8). A huge gap has arisen here, which will become a major problem for both countries trying to catch up.
Romania improved its competitiveness slightly for several years after its 2008 economic crisis, which was an overvaluation crisis, but the trend is now very clearly turning back towards deterioration. In Bulgaria, there has been no correction even after the crisis, and the real appreciation has accelerated since 2012.
In any case, these curves signal a major future problem for both nations. The high nominal wage increases are less of a problem for the domestic economy than for the external economy, as both countries have opted for an absolutely fixed exchange rate to the euro. Obviously, companies are now beginning to pass on the sharp rise in unit labour costs by increasing prices, which they have not done so far for the domestic market. For domestic companies, this means that they are trying to restore their profitability, after a time in which profits were depressed by high wage increases. The weak investment activity is certainly an expression of this.
It should be noted that both countries have undergone an enormous adjustment crisis when, after the global financial crisis, they were forced to reduce wages (as in Romania) or increase them less (as in Bulgaria) and massively curb internal consumption and imports because of huge current account deficits and the loss of international competitiveness. Graph 9 shows that since then both countries have had significantly lower current account deficits (Romania) or even slight surpluses.
However, this seeming stability in external economic relations conceals the fact that both nations continue to face enormous problems with regard to foreign trade because they have never made up for the enormous real appreciation of wages, i.e. the considerable loss of competitiveness. The extremely weak investment activity must be seen as a direct consequence of this fact. In this respect, policymakers are being deceived by the apparent normality of external balances and are thus preventing countries from prospering in the medium and long term.
In the second part of this article you will be able to read what pointers our analysis gives in terms of economic policy and what chances there might be, under these monetary conditions, of achieving a turnaround by means of a change in policy.