Long-Term Challenges and Policies

Chapter 1: Economic Outlook

In Europe and Central Asia, overlapping shocks from the pandemic and Russia’s invasion of Ukraine have exacerbated the slowdown in long-term growth prospects and created difficult policy choices. These shocks have reversed earlier progress made toward the achievement of the Sustainable Development Goals. More than ever, policy makers will need to ensure social safety nets are robust and well targeted to balance the need for fiscal sustainability with that of providing support to vulnerable populations. ECA’s economies also need to emphasize spending on growth-enhancing investments to help support the digital and green transitions. For some energy exporters, higher commodity prices represent an opportunity to invest windfall gains in measures that yield long-term growth dividends and promote diversification, which will help these economies adapt to the green transition. Long-standing structural issues related to weak institutions and an incomplete market transition will also need to be addressed to reignite productivity growth.

Strengthening Social Protection to Meet New Challenges in an Inclusive and Adaptive Manner

Robust social safety nets can underpin a productivity-driven recovery from the pandemic and the ongoing cost-of-living crisis if they facilitate the reallocation of labor to more productive employment. These social safety nets should be inclusive and adaptive and should extend coverage to diverse groups of workers and communities that are adversely affected by the cost-of-living crisis and the technology, globalization, demography, and climate change–driven transitions of the labor markets.

Labor market deregulation, technological change, and trade integration are already reshaping employment patterns across ECA. Conventional social protection systems, built around employment-based insurance schemes, may fail to provide adequate coverage as old jobs disappear and novel work arrangements spread rapidly. In addition, over the past two decades, job tenure in EU countries shrunk, particularly for vulnerable groups of the working population, including youth, women, and low-skilled workers. These vulnerable groups are therefore particularly adversely affected by the secular decline in traditional jobs and the shift toward more flexible employment standards. Expected large-scale reallocation of labor across sectors triggered by the transition to a green economy will also test the capacity of many social protection systems to handle that transition smoothly. Technological change and global competition put a premium on the private sector’s agility and quick adjustment to ever-changing consumer preferences for new products and services and would entail a higher frequency of transitions between jobs. Against this backdrop, equitable social protection systems should strengthen the protection of vulnerable workers during the green transition without stalling job creation in the green economy.

Formidable challenges confront the systems of social protection in ECA, especially when many governments are already facing increasing fiscal headwinds. Agile, fair, and pro-growth social safety nets need to enhance preparedness and responsiveness to big shocks (such as the COVID-19 pandemic, an influx of ● 31

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refugees on the scale triggered by the war in Ukraine, or the cost-of-living crisis); catch up with a rapid transformation of European labor markets, which creates new disparities and vulnerabilities in different segments of the labor force; and prepare for the labor market disruptions that are expected to result from the green energy transition.

Building a modern social protection system. Unreformed employment-based, risk-sharing safety nets structured around job protection risk making social protection less inclusive and could leave an increasing share of the labor force unprotected as the ongoing transformation of the ECA labor markets gathers pace. Demographic challenges, such as aging population, falling birth rates, and immigration; increasing job turnover; and proliferation of nonstandard employment, driven by technological change, globalization and regulatory reforms, undermine the ability of traditional pillars of social protection (such as pay-as-you-go pension systems and employer-based provision of social benefits) to respond effectively to shocks and support the labor market transition to a green economy. A modern social protection system should mitigate the shorter-term impacts of shocks, facilitate longer-term economic recovery and economic growth, and support the job reallocation that the green transition will require.

Optimal social protection policy should respond to shocks and long-term changes in the labor market affecting incomes and jobs, such as, for example, the COVID-19 pandemic, the energy price shock, and technology-driven automation of jobs. Optimal social policy should ensure welfare protection of broad groups of the population as well as support sustainable growth without hindering the reallocation of labor to more productive sectors of the economy. Publicly financed policies, such as a guaranteed minimum income, a negative income tax scheme, or a universal basic income program, would shield most people from substantial welfare losses regardless of their labor market status. At the minimum, income support programs should be means-tested, to ensure they reach the poorest and those who face an adverse shock. Social protection systems can also be made more adaptive by setting out in advance the rules that would guide any changes, such as modifications to eligibility criteria, system procedures, and benefit amounts that a sudden shock would necessitate. Such policies could be the base of an equitable social protection system.

Job losses and transitional unemployment should be insured by national unemployment income support programs instead of employer-provided arrangements, which are suboptimal from a risk-pooling perspective. Generous severance payments, for example, may distort firms’ labor choices, by deterring formal hiring. Broad unemployment income support programs, financed from mandatory individual savings and complemented by public funding, are less distortionary and more protective.

When such measures are in place, governments can adapt their social protection policies to rapidly changing labor market conditions by implementing regulatory reforms that gradually remove restrictions on firms’ hiring and dismissal practices. Uniformly enforced regulations protecting workers, irrespective of their work arrangements, against abuses by employers and hazardous working conditions will guarantee that more flexible labor markets will enhance workers’ welfare.

Chapter 1: Economic Outlook

Social protection systems will need to address the challenges of the post-pandemic labor market and the green transition. When entire sectors or types of jobs disappear, employment-based insurance schemes cannot provide adequate protection to the affected groups of the population. Policies to encourage human capital accumulation, employment assistance programs, and other active labor market policies—such as skills training, entrepreneurial support, and intermediation—can be helpful to smooth adjustments to changing labor markets and ongoing economic transformations. Evidence shows that sectoral employment programs can be particularly effective when they provide training for transferrable skills and help match individuals with jobs in high-wage sectors. The private sector could play a role in subsidizing training in sector-specific skills.

Successful implementation of modern social protection systems will increasingly rely on the use of digital tools to manage the massive amounts of labor market data and monitor people’s welfare. Countries in ECA need to harness digitalization to improve their capacity to deliver services effectively and target vulnerable populations better. Much stronger cooperation and information sharing between government agencies is required to set up an integrated system that responds quickly to the fast-changing landscape of work.

Protecting refugees. The wave of refugees from Ukraine to neighboring ECA countries, especially Poland, dwarfs previous crises—more than 7 million Ukrainian refugees are estimated to be present in Europe (UNHCR 2022b). While the majority of them will eventually return to their home country, this will not happen soon and will be conditional on the outcome of the conflict. As a result, it will be critical for host countries to mobilize resources to ensure public service delivery and effective absorption of migrants in the short- and medium-term. The main difficulty is designing policies that will allow seamless integration of the refugees into the host country economies and enable the ECA region to take advantage of the gains generated by labor mobility and address the costs (World Bank 2019). This also applies to the integration of internally displaced people within the borders of Ukraine.

On the upside, compared to previous waves of immigration in Europe, Ukrainian refugees could have better integration prospects into European labor markets. A relatively high share of the refugees are well educated, and many have already stayed or worked in the host countries. Many refugees have a good degree of familiarity with the host country labor markets because of information sharing in social networks and sizable Ukrainian immigrant communities that were already present in the EU before Russia’s invasion of Ukraine (Eurostat 2022). The previous wave of Ukrainian migrants to Poland, for example, helped alleviate demographic pressures and bolstered Polish growth by an estimated 0.3 to 0.5 percentage point per year. The current wave could help alleviate labor shortages and lift long-term growth in the EU (Kammer et al. 2022; Strzelecki, Growiec, and Wyszyński 2022). The overall impact on the EU labor force of the inflows of Ukrainian refugees is estimated at 0.5 percent by the end of 2022, with Czechia, Poland, and Estonia experiencing the largest gains of about 2 percent (OECD 2022b).

Since many Ukrainian refugees are children, disruption to education could have lasting negative impacts on the future labor market outcomes and social ● 33

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integration potential of refugee children and youth. Therefore, ensuring adequate access to schooling poses another formidable challenge for the host countries, which need to integrate a large number of refugee students into their education systems and provide social and emotional support to refugee youth.

Securing a Sustainable Future

In the medium term, the green transition would help reduce the region’s dependence on fossil fuel imports while also supporting energy security. The current juncture provides an opportunity to put in place effective policies that encourage more efficient consumption of energy—similar to the experience of the United States in the 1970s, when surging energy prices prompted policy makers to impose and tighten fuel efficiency standards on cars and home appliances and lower speed limits (World Bank 2022d). Since then, per capita energy consumption has fallen sharply and oil consumption even more so. It is thus essential for policy makers today to continue carbon reduction efforts and utilize the current energy price shocks to embolden the transition to net zero emissions.

Efforts can be made to incentivize a shift away from fossil fuel consumption, such as by encouraging electric power transport and renewable energy generation. Given reduced fiscal space, it is even more essential that green investments generate the greatest value toward achieving the objectives embedded in the European Green Deal. Policies and incentives must shift away from perpetuating the use of fossil fuels, toward renewable energy sources and improvements in energy efficiency. Higher domestic production of renewable energy coupled with increased energy efficiency will contribute to lowering fossil fuel consumption and imports, achieving greater energy independence in EU member states and other economies, and nurturing the green transition.

Key national policies can include creating climate-smart regulatory frameworks, introducing carbon pricing policy instruments (once prices have fallen and stabilized), addressing building efficiency standards, and strengthening land use regulations. In energy exporters, prudent management of resource rents involves avoiding inefficient and distortive energy subsidies, and instead increasing export diversification, strengthening long-term growth prospects, and building resilience to external shocks.

Policies that aim to dismantle fossil fuel subsidies raise formidable politicaleconomy challenges and should be embedded with supportive frameworks to ensure success (World Bank 2020). Promoting transparency in price setting, such as through clearly stated thresholds or formulas to set energy prices, is crucial to ensuring that subsidy removals are de-politicized (Inchauste and Victor 2017). Additionally, avoiding larger, more disruptive price changes in favor of more frequent price adjustments in price setting formulas will help to avoid price shocks. In several countries, using supporting reforms to offset the removal of energy subsidies, such as through cutting the cost of other household public serves or increasing social benefits, has helped to build public support for energy subsidy reform; however, such an approach requires improved capacity to implement additional benefit programs and should be implemented once energy prices fall from current elevated levels (Inchauste and Victor 2017). Finally,

Chapter 1: Economic Outlook

awareness campaigns should be used to highlight the benefits of subsidy reforms and encourage public support (El-Katiri and Fattouh 2017).

Improving Institutions for a Robust Economic Recovery

Strengthening institutional quality is key for fortifying the foundation for a robust and sustained economic recovery from the pandemic and the war in Ukraine. Strong institutions and conducive business climates set the preconditions for sustained growth. They encourage private sector investment and innovation by minimizing expropriation risk, creating a stable and confidence-inspiring policy environment, lowering the costs of doing business, and encouraging participation in the formal sector where productivity tends to be higher (World Bank 2018, 2019a). Good governance also ensures competitive and flexible markets with limited market concentration, effective regulation, and efficient and equitable provision of public services, including health care, education, and public infrastructure (Acemoglu and Johnson 2005; Dort, Méon, and Sekkat 2014; Gwartney, Holcombe, and Lawson 2006).

Institutional change can raise investment and productivity growth directly by increasing private returns to productivity-enhancing investment in human and physical capital. Institutional reforms can also promote investment and productivity growth indirectly, by removing obstacles to other drivers of long-term growth, such as innovation, openness, competition, and financial development (Acemoglu and 2005; Botero, Ponce, and Shleifer 2012; Glaeser et al. 2004; Glaeser, Ponzetto, and Shleifer 2007). Thus, there is considerable scope for governments to stem or reverse drags on potential growth (such as from adverse demographics) by strengthening institutions, reducing corruption, dismantling regulatory barriers to doing business and entrepreneurship, and ensuring effective regulation that is conducive for the efficient working of competitive markets (Kilic Celik, Kose, and Ohnsorge 2020).

The potential benefits of institutional reforms are underscored by the fact that weak institutions and governance remain a substantial obstacle to sustained growth of investment and productivity in ECA’s countries. ECA’s economies may be unable to achieve the potential output growth envisioned over the next decade without strong commitment to institutional reforms. Pervasive corruption and large informal sectors are formidable constraints on the ability of private firms to invest, innovate, and close the productivity gap with the EU.

Weaker rule of law can generate an uneven playing field for the private sector when it comes to competing against the state, while unaddressed corruption can contribute to state capture. In turn, this could increase several downside risks, including those related to spillovers from impaired corporate balance sheets to public balance sheets—when realized, these events have historically led to large fiscal costs (Bova et al. 2016). Significant barriers remain, especially with battling corruption—most ECA countries rank below the EU average in the public institutions component of the Global Competitiveness Index, with sizable gaps in ethics and corruption.

Moreover, Enterprise Survey data indicate that institutional weakness may be hindering the private sector—firms highlight the obstacles related to meeting ● 35

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with tax officials and competition from informal firms, among other constraints. In many ECA economies, the share of firms using credit is lower than in the EU, which may suggest that a weak business environment is constraining firms’ ability to access financing. Weak business environments may also diminish complementarities between public and foreign direct investment and domestic investment (Kose et al. 2017). A poor business climate allows anticompetitive practices to flourish, perpetuates corruption, discourages innovation, and distorts the efficient allocation of factors of production (Aghion and Schankermann 2004; Bourles et al. 2013; Buccirossi et al. 2013).

In the nearer term, improving institutional quality can be complemented by measures that strengthen macroeconomic stability and resilience. Given the current macroeconomic policy challenges of the region to temper inflation while protecting against currency depreciation and depletion of reserves, it is imperative that policy makers also move to strengthen legislation for monetary policy and bank supervision in order to help raise the credibility of macroeconomic frameworks and reduce the cost of policies that aim to reduce inflation and maintain currency stability (Gill and Ruta 2022b). Exchange rate pass-through from depreciation to inflation tends to be smaller in countries with more credible, transparent, and independent central banks; inflation-targeting monetary policy regimes; and better-anchored inflation expectations (Ha, Stocker, and Yilmazkuday 2019; Kose et al. 2019).