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HomeDOCUMENTSCommittee Reports2010 Annual Session217 ESCEW 10 E bis - THE IMPACT OF THE FINANCIAL CRISIS ON CENTRAL AND EASTERN EUROPE

217 ESCEW 10 E bis - THE IMPACT OF THE FINANCIAL CRISIS ON CENTRAL AND EASTERN EUROPE

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ATTILA MESTERHAZY (HUNGARY)
RAPPORTEUR

I.  INTRODUCTION 

    A.  HOW THE CRISIS SWEPT THE REGION 

II.  ECONOMIC CONDITIONS 

    A.  DOMESTIC ECONOMIC STRUCTURES  
    B.  INTERNATIONAL TRADE  
    C.  MACROECONOMIC (IM)BALANCES: CURRENT ACCOUNTS AND CAPITAL FLOWS  
    D.  INTERNATIONAL ECONOMIC RELATIONS  
    E.  LABOUR, MIGRATION AND REMITTANCES 

III.  IMPLICATIONS FOR FISCAL AND MONETARY POLICY 

    A.  FISCAL POSITIONS BEFORE THE CRISIS 
    B.  MEASURES IN THE MIDST OF CRISIS 

IV.  THE LATVIAN AND BULGARIAN EXPERIENCES  

    A.  LATVIA  
    B.  BULGARIA 

V.  IMPACT ON MILITARY EXPENDITURE 

VI.  RECOMMENDATIONS AND CONCLUSION 

BIBLIOGRAPHY 

 

I. INTRODUCTION

1.  Economic conditions in the 20 countries comprising Central and Eastern Europe1 (CEE) underwent an exceptional deterioration during the recent global financial and economic crisis.  While largely spared from the initial credit-tightening that stemmed from the sub-prime mortgage market collapse in the United States during the first half of 2008, none of these transition economies were able to avoid financial and commercial contraction following the September 2008 implosion of Lehman Brothers.  Indeed, the latest estimates of real gross domestic product for 2009 indicate that only Albania, Belarus and Poland avoided economy-wide contractions, while the region’s GDP as a whole shrank by 6.2% year-on-year (IMF, 2010c) These contractions occurred after nearly a decade of economic progress which in several cases, was characterized by spectacular growth. This vertiginous reversal of fortunes quickly generated concerns about the region’s fundamental economic vitality, raised the spectre of social unrest and has posed questions about the future direction of political and economic reform in many of these countries (World Bank, 2010).  Fortunately, by early 2010, a modicum of stability had returned to the region, although serious problems persist.  Indeed, the region as a whole remains vulnerable to yet another global downturn should such a scenario unfold.

2.  The late but dramatic onset of crisis in the CEE can be attributed respectively, to the crisis’s origin in Western capital markets, as well as the region’s heavy dependence on external markets and foreign capital. The distant epicentre of the crisis initially allowed foreign investors to keep capital committed to CEE markets.  With the exception of the Baltic States, the region enjoyed positive returns through the first three quarters of 2008.  The CEE, however, did not go unscathed during the first phase of the crisis: from July 2007 to September 2008 credit creation and foreign capital flows to the region, predictably, began to slow, but initially without a serious impact on economic growth.  According to the European Bank for Reconstruction and Development (EBRD), “the main reason why these signs did not manifest themselves in declining output in most countries before the second half of 2008 was the continued expansion of exports” (EBRD, 2009).  Quarterly data from the Economist Intelligence Unit (EIU) bears this out.  Although lending rates in the region slowed markedly during the first three quarters of 2008, exports as well as imports only began to contract in the fourth quarter.  Unfortunately, when the full force of the financial crisis finally struck Central and Eastern Europe, it struck the region’s financial and real economies in a devastating fashion as well as foreign capital and demand in tandem.  Thus, from late 2008 onward, “economic activity contracted rapidly, with almost no lag” (EBRD, 2009: 11).

3.  The financial and economic crisis has also affected Central and Eastern Europe to a greater degree than most other developing and emerging regions (World Bank, 2010).  This is largely due to the CEE’s unique economic structures, history and geo-political position. Indeed, the Communist legacy of these countries puts them in a special analytical category, although with the passage of time, that Communist legacy has become less burdensome.  Following the collapse of the Communist bloc, the CEE countries operated below 1992 output levels for between five and ten years, and in many cases their transitions were marked by sustained economic recession. This was virtually inevitable as central planners had so profoundly misallocated capital and labour. Turning around decades of poor policy was inevitably going to be a painful process.  By the turn of the century, however, the prospect of joining the European Union (EU) had both hastened economic integration with advanced Western markets and served as a catalyst for critical structural reforms.  While liberal reforms assumed different forms in each of the new EU members (Bulgaria, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, Slovakia and Slovenia), all experienced substantial growth from 2000/01 onwards as barriers to intra-regional trade and finance were lowered and domestic economic structures were rationalized and rendered more internally logical and internationally competitive.

4.  The transition narrative for the other ten CEE countries, however, has been less consistent.  In the 1990s, most of South Eastern Europe continued to operate with relatively under-developed economies, which were further weakened by wars linked to the break-up of Yugoslavia and all the attendant problems that violence precipitated - corruption, closed borders and command economies.  Yet, with the return of stability to the Balkans, the region’s governments embarked upon substantial reforms designed to pave the way to eventual EU accession.   Meanwhile, the four Commonwealth of Independent States (CIS) countries in the CEE region – Belarus, Moldova, Russia and Ukraine2 – adopted rather different approaches to economic reform and external economic relations.  Within the CIS, the State has assumed a much larger role in national economic life than has been the case in other CEE countries. Here the vestiges of the command economy are more apparent; autonomous economic actors enjoy less space in which to operate and these markets are generally less open to global economic opportunities.

5.  This readily apparent diversity of economic experiences, cultures and structures has meant that the impacts of the global economic crisis and the policy responses have varied widely throughout the CEE.

A. HOW THE CRISIS SWEPT THE REGION

6.  It has been well documented that the initial credit crunch began in the United States’ subprime mortgage market in the summer of 2007. As liquidity plunged and the cost of short-term borrowing surged, investors in highly leveraged positions were compelled to ‘deleverage’. They did so by withdrawing capital from higher-risk investments either to pay off other obligations or to place it in safe havens like the US dollar or commodities markets.  This generated enormous price volatility across a broad range of assets and financial markets.  Volatility quickly spread to European capital markets as many major European banks were holding assets in US securities markets.  Although Western banks with a strong presence in Central and Eastern Europe withdrew capital from the region in order to shore up their balance sheets at home, capital outflows initially remained relatively minor through the first half of 2008. The Baltic States, however, were exceptions in this regard. Their stellar growth rates had been largely financed by large inflows of foreign capital, which generated a financial bubble that had already begun to deflate by late 2007.  In any case, with the collapse of several major US firms in September 2008 (Lehman Brothers, AIG and Bank of America) the initial credit crunch turned into a full-blown global financial and economic crisis throughout much of the region.

7.  As financial markets around the world roiled with uncertainty during Q4 2008, the CEE region underwent a so-called ‘sudden stop’ of bank lending (EBRD, 2009).  To make matters worse, this occurred as import demand in the West struck production schedules for CEE goods.  The scarcity of existing capital and rising risk premia for new capital had also triggered a sharp rise in borrowing costs for the region’s governments and private sector.  From 2007 to 2009 net investment in the CEE declined precipitously from a record US$255 billion to roughly US$20 billion – a drop of over 90% (UNECE, 2010).3  Goods and services exports declined rapidly in late 2008 and early 2009.  The UNECE (United Nations Economic Commission for Europe) reports that the CEE region’s value of exports contracted by 27.5% in 2009, while the total value of regional imports declined by an even greater 30% (UNECE, 2010).

8.  In a region highly dependent on foreign markets, it did not take long for these contractions to translate into severe hardship.  Unemployment soared with job losses greatest in the higher valueadded sectors.  For the 15 countries with available statistics, the unweighted average of official unemployment rose from 9.5% to 12.6% from the first quarter (Q1) of 2009 to Q1 2010 (EIU, 2010). These numbers, however, masked important regional differences.  For example, the three Baltic States saw their unemployment rates more than double from 6.3% in 2008 to 16.8% in Q1 2010 (unweighted average).  While there are now signs of recovery throughout the CEE region, unemployment has increased across the region, a development which generates both fiscal and political tensions. 

9.  It is important to note where these job losses occurred.  Across the region industrial production and construction fell faster than any other sector and, accordingly, these sectors have shed the greatest number of workers.  While this follows logically from tightening export markets and credit availability, it means many skilled workers were among the most severely affected by the crisis.

10.  Indeed, the economic fallout leapt almost seamlessly from financial to export markets to industrial production.  Eventually no sector of the labour market was spared. National governments scrambled to cope with the crisis and to reignite the economic dynamism that defined the region over the past decade. Some began to correct the deficiencies that had left them so vulnerable in the recent global downturn.  The optimal policy responses throughout the European continent and in North America, however, were not always obvious and remain the subject of some dispute.  On the one hand, the collapse in private consumption and investment has fuelled calls for Keynesianstyle fiscal expansion to fill the gap in aggregate demand.  On the other hand, soaring debts have pointed to the need for fiscal austerity in order to reinvigorate the supply side of national economies, bolster foreign investor confidence, and to put national budgets on a sustainable foundation.  In fact, a mix of these policy goals has generally been adopted. The policy responses have been strongly conditioned by the particular economic frameworks in place as these countries entered the crisis and by the fiscal resources that were available to national governments at the onset of the crisis. 


II. ECONOMIC CONDITIONS

A. DOMESTIC ECONOMIC STRUCTURES

11.  Over the past two decades various Central and Eastern European countries have variously undergone ‘shock therapy’ reforms, backlashes against liberalisation, war and strife in the Balkans, political and economic integration with the EU, WTO and NATO, the introduction of or tightening links to the euro, revivals of State control, and ‘colour revolutions’. No two national experiences have been identical and the past two decades have perhaps only exacerbated the heterogeneity in the CEE.  It was inevitable that the global crisis would strike countries operating in such variegated landscapes in very different ways. It was also inevitable that the policy responses to that crisis would diverge markedly.

12.  While the entire region has suffered as a result of the financial crisis and the precipitous decline in foreign demand, the Baltic States, Ukraine, Moldova and Russia underwent the steepest contractions in real GDP in 2009, ranging from a 7.9% decline in Russia to a staggering 18.0% fall in Latvia.  At the other end of the spectrum, Poland and Albania avoided contractions, growing by 1.8 and 3.0% respectively, while the Belarusian economy remained almost stagnant with a real increase of 0.2% (EIU, 2010).  Interestingly, the capacity of these economies to weather the financial storm hardly correlates with the EBRD’s transition scores - a rating system designed to gage the overall degree of transition toward free-market liberal systems.  The three Baltic States, for example, fare quite well in each transition category with average scores ranging from 3.7 to 3.93 of a possible 4; Poland received a lower score of 3.78.  These measures of economic modernisation and policy liberalisation are second only to Hungary (3.96) and Slovakia (3.78).4  In contrast, Albania, Moldova, Russia and Ukraine score at or slightly above the 3-point mark (from 3.0 to 3.07).5  These disparities roughly correlate with the 2009 rankings of political liberalisation that are published annually by Freedom House as well as the Heritage Foundation’s economic freedom rankings.  At first glance, variation in these countries’ respective capacities to weather the financial and economic crisis does not seem to relate to the degree of market liberalization. 

13.  Moreover, while a large and diverse internal market generally seems to bolster resilience (IMF, 2009c), this alone seems insufficient to galvanise recovery.  Although the Russian economy is over three times the size of Poland’s, Russia’s seemingly inexorable embrace of ever greater State intervention and persistently poor relations with foreign investors has characterised national economic policymaking in recent years.  In 2009 the Russian economy shrank by 7.9% (EIU, 2010).   Poland, which has a relatively large internal market although hardly the size of Russia, performed the best in the EU over the initial 18 months of the crisis. Its macro- and micro-economic policies seem to be a critical part of the explanation.  The relative wealth of a society (measured by GDP per capita) also appears to bear only a minor relation to resilience in the face of crisis.  While Ukraine and Albania’s average incomes are the second and third lowest in the region (approximately US$7,000), Albania had the highest growth on the continent, while Ukraine’s ranked second worse, with a drop of 15.3% in 2009. 

14.  The relative starting positions of these economies are also of some import.  Standard growth theory asserts that, ceteris paribus, economies with lower levels of capital and income per worker will grow more quickly than more advanced economies when capital is suddenly made available, until all economies reach their ‘steady state rate of growth’ (Solow, 1956).  In the CEE this ‘catchup’ effect can be observed in Albania, which started at a significantly lower level of GDP per capita than its neighbours, but not in Moldova where the average income level was comparable to Albania’s in 1992 but which has subsequently lagged behind (IMF, 2009a).  In terms of cumulative GDP growth since 2003, IMF projections for 2010-2014 suggest that relatively poorer countries in the 1990s, such as Ukraine, Moldova and Russia, will outperform Poland. While Albanian growth will trail that of Poland, it is set to achieve cumulative growth in 2010 higher than that of Estonia, Latvia and Lithuania - countries where average income has grown rapidly over the past decade.  Surprisingly, the situation was not so different before the crisis.  In 2007 and 2008 Poland and Albania grew at their lowest pace since 2003, and the Baltic States were outperformed by Ukraine, Moldova and Russia.  Looking at cumulative growth since 1993, however, paints a different picture with Ukraine and Moldova growing the least in the CEE, while the fastest growing economy up to 2008 was Albania, followed by Estonia and Latvia, which only enjoyed average levels of GDP per capita throughout the 1990s.  All of this suggests that some of Europe’s poorer countries have grown more rapidly, and that some of this growth, for example, in Albania seem to be linked to progressive institutional reforms (SET, 2010) rather than a simple ‘catch-up’ mechanism.  In other words, government policies and institutions matter.

15.  In the final analysis the degree of liberalisation, economic size and the ‘catch-up effect’ of lower initial per capita income do not fully explain the region’s diverse growth patterns and the differentiated impacts of the crisis.  These structural factors certainly play an important role in setting the context for successful economic performance, but clearly the specific context in each country is quite varied.  This report will now discuss these different contexts and, in so doing, will highlight elements that have shaped the contours of a crisis that has severely undercut Central and Eastern European growth.

B. INTERNATIONAL TRADE

16.  A common feature of the CEE region is its dependence on external markets for domestic growth and prosperity.  Trade with Western Europe and Russia is crucial for all CEE economies.  Important differences emerge, however, with respect to their dependence on foreign finance.  The dizzying influx of foreign capital to the region in the years before the crisis ultimately generated large macroeconomic imbalances.  These capital inflows not only underwrote new and essential investment but also funded a consumption boom and current account deficits that were, in many cases, unsustainable (EBRD, 2009).  While the countries with more open financial structures posted impressive growth rates in the early 2000s (i.e., the Baltic States), these were also the economies hardest hit by the precipitous retrenchment of foreign capital and credit.  For those States operating in closed or tightly restricted capital markets, the crisis was transmitted through the contraction of export markets, while reduced financial inflows had a relatively smaller impact.

17.  In the eight years before the crisis, the CEE had posted exceptional rates of growth, especially when compared to their relatively dismal economic performance in the 1990s. Real GDP growth rates of 6 to 10% were common across the region in the middle part of this decade (IMF, 2010c). Increasing industrial output propelled much of this growth, particularly in those countries with the most ‘catching-up’ to do, including Albania, Belarus, Bulgaria, Latvia, Lithuania and Ukraine.  During this same period exports expanded even more quickly and consistently than industrial production, with only Ukrainian exports undergoing real declines prior to the crisis (EBRD, 2009).6  This growth was obviously welcomed and generally seen as a sign of the region’s increasing modernisation and resilience. 

18.  In the years following the 1998 Russian crisis, some 50 million people moved out of poverty in Eastern and Central Europe, the former Soviet Union and Turkey. This was driven by rising incomes and particularly increasing real wages among the working poor. The recent crisis, however, has put these gains at risk. According to a recent World Bank Study, in 2010 there will be 11 million more people in poverty in the region and another 23 million people living just above the international poverty line relative to pre-crisis projections (Sugawara et. al.). In other words, roughly one fifth of those who recently escaped poverty will have returned to it. Countries where households have been overly dependent on the construction sector and remittances will suffer the most. Secondary effects on social safety nets and education could have even longer-term effects.

19.  The expansion of exports, by definition, increased the region’s reliance on external markets, especially with regard to Western European markets.  From 2006 until 2008 a majority of the CEE countries were exporting of goods and services at a level equivalent to more than half of their GDP, revealing a remarkable degree of openness.  Indeed, the CEE is significantly more dependent on external markets than other emerging market regions.  (Darvas and Veugelers, 2009) The Czech and Slovak Republics, Estonia and Hungary led the region in export dependence, with each posting gross export values equivalent to approximately 80% of GDP.  These four cases also demonstrate the downside risks of export dependence (at least in a recessionary world), as the Czech and Slovakian economies contracted by over 4% in 2009 despite strong fundamentals.  Hungary’s weaker fiscal position and Estonia’s credit-fuelled growth, by contrast, exacerbated their steep declines.  As discussed above, a significant domestic market can be most helpful when international markets are deteriorating.  For example, although Albania does not have a large internal market, it is less open to trade and finance than other transition countries. Unlike the rest of the region, it maintained an admirable growth rate in 2009.  Obviously, interdependence can sometimes generate additional losses during downturns, but this hardly justifies even temporary protectionist measures. Over the long run, openness brings a welter of economic benefits and should continue to be encouraged.

20.  While most of the CEE economies have seen exports rise as a share of GDP, one group, led by Russia, has had quite a different experience.  Despite the strong growth of the Russian economy from 2000 to 2008, gross exports of goods and services declined over this period from 44 to 31% of GDP-equivalence.  Only Belarus, Moldova and Ukraine have experienced similar declines in the export share of GDP since 2000 – all of which are members of the CIS (Commonwealth of Independent States). These countries are all relatively distant from Western markets, have some common institutional structures and political norms, and are less advanced in their transition toward liberal market structures and open societies.  These factors tend to reinforce existing trade and policy patterns within the CIS.  The CIS’s greater dependence on volatile primary resource exports is also a factor as this tends to discourage the kind of product diversification that might deepen their trading positions.  Moreover commodity crisis fell substantially during the crisis. Yet, for all their similarities, these economies have reacted in different ways to the global crisis.  Ukraine, for example, contracted by 15.2% against declines of 7.9% in Russia, 6.5% in Moldova, and a 0.2% increase in Belarus (UNECE, 2010).  In terms of net exports, Moldova suffered trade deficits of over 50% of GDP in 2007-08 (by far the largest in the CEE); Belarus had smaller trade deficits approaching 5%; Ukraine’s trade was balanced over the 2000-08 period, while Russia enjoyed consistently large trade surpluses stemming from its role as a major energy supplier.  Thus, even within this sub-group sharing several important characteristics, major differences are evident.

C. MACROECONOMIC (IM)BALANCES: CURRENT ACCOUNTS AND CAPITAL FLOWS

21.  The high volume of Central and Eastern European exports has been a critical factor in the region’s impressive growth over the past decade.  The pattern of rapid, trade-driven growth followed by a crash in many ways mirrors the East Asian experience during the 1990s (BIS, 2009).  Yet, the CEE is distinct insofar as many of these countries have experienced unprecedented levels of current account deficits largely due to the ubiquity of finance-led growth patterns. This was not the case in Asia (EBRD, 2009). Although current account deficits often reflect developing economies’ requirements for imported capital and capital goods, sustained and rising current account deficits can undermine macroeconomic stability when failing to bolster productivity growth (IMF, 2009d).  They also put downward pressure on currencies and, if the exchange rate is not allowed to depreciate, can potentially generate fundamental internal disequilibria. On the other hand, depreciation can push up inflation and increase the cost of debt denominated in foreign currencies; it is precisely for that reason that governments sometimes resist depreciation despite the potentially positive effect it can have on the trade balance (IMF, 2009d). When maintaining a fixed exchange rate, however, there is no choice but to adjust internally which can mean real wage cuts, increasing unemployment and reduced consumption. In retrospect, the vulnerability that deepened the crisis in the CEE is not surprising given that the average regional current account deficit was 5% of GDP (10% if one excludes Russia) for several years before the crisis.

22.  The Asian financial crisis of 1997-98 revealed that even when coupled with strong growth, large and sustained current account deficits leave economies vulnerable to swift reversals of capital inflows, which directly impinge on both growth and investor confidence (BIS; IMF, 2009d).  Likewise, significant current account deficits stemming from large capital inflows were crucial factors in the early and precipitous contractions in Estonia, Latvia and Lithuania, as most foreign finance fled at the first signs of uncertainty (World Bank, 2010).  Current account deficits in the Baltic region were among Europe’s largest and most unsustainable.  At their peak in 2007, the Estonian, Latvian and Lithuanian current account deficits stood at 17.8, 22.3 and 14.6% of GDP, respectively; two years later, these deficits had been completely reversed, and the three Baltic States had become the only current account surplus countries apart from Russia and Hungary in the CEE (IMF, 2010c).

23.  Current account deficits, however, only partially account for the region’s economic vulnerability.  Russia’s large surpluses, for example, did little to stem its contraction of 7.9% in 2009.  Moreover, while in 2008 Bulgaria and Montenegro posted the region’s largest current account deficits of 24 and 52% respectively, in 2009 their economies declined by 5.0 and 3.1%, relatively modest contractions compared to the Baltic States (IMF, 2010c). 

24.  These narratives reveal significant differences between the boom and bust cycles in Central and Eastern Europe this decade and what transpired in East Asia eleven years prior.  First, the recent current account deficits and economic contractions in the CEE are much greater than those observed in East Asia in 1997-98 (EBRD, 2009).  Secondly, unlike East Asia in the 1990s, the CEE has been a net importer of goods and services this decade. While the Czech Republic, Hungary, Slovenia and Ukraine shifted from net exporter to net importer positions, Russia held the only consistent net trade surplus position from 2000 to 2008.  For the remainder, net imports ranged from below 5% of GDP (Belarus, Poland, Slovakia) to around 20% (Albania, Bulgaria, the former Yugoslav Republic of Macedonia, Latvia, Serbia) and to over 40 and 50% of GDP in the most extreme cases (Bosnia and Herzegovina, and Moldova).  Again excluding Russia from the calculation, the CEE saw aggregate net exports fall from -4.97% of GDP in 2006 to -5.76% in 2007, finally reaching its nadir in 2008 with net exports accounting for -6.25% of GDP (UNECE, 2010).  Clearly the economic success of the CEE was not simply rooted in export growth, domestic reform, finance driven growth and domestic consumption have also been key factors here (IMF, 2006).

25.  Over the past decade, gross capital inflows to most emerging market economies (EMEs) increased rapidly.  In a recent study of the potential sources of financial instability, the Bank for International Settlements reported that gross inflows into East Asia reached 15% in 2007, 5 percentage points higher than the pre-1997-98 peak, whereas the CEE region enjoyed gross capital inflows of over 20% of GDP. Spurred by closer integration with the European Union, these huge inflows were largely intermediated by foreign-owned banks, which reduced solvency risks while increasing credit risks (BIS, 2009).  In other words, foreign banks’ large capital bases ensured that subsidiaries had access to affordable capital, but the decision-makers’ distance from local market conditions and lending practices weakened their oversight capabilities. Credit risk proved an important factor in the rapid collapse of Central and Eastern Europe, as demonstrated by the steady increase in the proportion of non-performing loans (World Bank, 2010).  Although delayed payments and defaults are to be expected in downturns, the data on CEE arrears demonstrates patterns symptomatic of a more acute problem (EBRD, 2009; BIS, 2009; World Bank, 2010).

26.  In sustainable growth patterns consumption trends are smoother than the more volatile trends in income growth.  This, however, was not the case during the CEE’s boom years.  From 2003 until 2008, only the economies of Bulgaria, Croatia, Hungary, Poland, the Slovak Republic and Slovenia grew more quickly than the rate of private consumption growth. In the other ten economies with available data, people consumed increasingly more than they earned – a trend made possible through consumers’ ever-easier access to credit - oftentimes denominated in foreign currencies. Through the current crisis, these six countries generally performed better than Estonia, Latvia, Lithuania, Moldova, Romania, Russia and Ukraine, all of which underwent a significantly higher expansion of private consumption over GDP. Moreover, much of the credit to households and to businesses was euro-denominated, considerably increasing credit risks linked to exchange rate movements (World Bank, 2010).  Unsurprisingly, exposure levels tended to be greater in countries with a larger foreign-bank presence. 

27.  This phenomenon was particularly evident in the Baltic States, Moldova and Romania. Consumption in Albania and Belarus expanded more quickly than GDP, but these countries suffered comparatively less than the Baltic States, Moldova, Romania, Russia and Ukraine where consumption rates increased at an even quicker pace.  One explanation for this is that, for various reasons, Albania and Belarus are more insulated from international capital markets (EBRD, 2009). Russia and Ukraine represent another exception as both had generated large current account surpluses prior to the crisis, but this offered insufficient protection in the face of unsustainably rising private consumption (particularly for Ukraine where private consumption grew annually by roughly 10 percentage points more than did GDP).  In sum, while much of the inflowing foreign capital was destined for fixed capital formation (the fastest growing component of investment across the region), those countries that indulged in unsustainable rates of private consumption growth were particularly vulnerable when the global economy turned downward.

28.  As a final note, the IMF recently highlighted the fact that certain Foreign Direct Investment (FDI) (i.e., those between parent banks and their subsidiaries) flows are far more volatile than previously thought. Such capital flows conform to patterns more akin to short-term debt than to long-term investments (IMF, 2010). While fixed capital investments were comparatively more stable, remittances appear to have contracted the least.

D. INTERNATIONAL ECONOMIC RELATIONS

29.  The remarkable growth in the CEE over the past decade was also driven by the region’s mounting integration with international institutions, and with the European Union in particular.  Some of the countries that have acceded to the EU since 2004, however, have faced serious institutional problems. In some cases there were difficulties in properly employing available EU structural and cohesion funds. But with strong support and encouragement from the European Commission (EC) and with capable domestic leadership, the absorption capacity of these economies increased markedly from 2007 onwards (Euractiv, 2008).  These funds combined with fundamental institutional reforms, which were an essential element of the accession process, enabled growth and stability in the region (Schnabl, 2009).  Membership in liberal inter-governmental organisations and even associate status with them has been a primary catalyst for pro-growth reform. Currently, Bosnia and Herzegovina, Croatia, the former Yugoslav Republic of Macedonia, Montenegro and Serbia have each signed and are implementing EU Stabilisation and Association Agreements, which have driven economic reforms in a manner to encourage institutional and policy convergence. 

30.  The Commonwealth of Independent States plays a similar role in trying to unify regional policies, although liberal reform has hardly been a top priority for that body.  Led by Russia, this political and economic group also engages Belarus and Moldova along with Ukraine, which has not ratified the CIS Treaty but which participates as a full member.  Despite attempts to strengthen the CIS, it has yet to establish inter-governmental institutions with clear policy goals that support the members in times of need.  Its orientation, moreover, is not nearly as liberal as that of the EU or other regional institutions like ASEAN (Association of Southeast Asian Nations) or NAFTA (North American Free Trade Agreement), nor does the CIS have established legal relations regulating the convergence of policies.

31.  Most CEE countries are also members of the IMF and the WTO.  WTO membership has provided a crucial economic advantage to it newer European members, as it has both advanced domestic reforms needed to bolster international competitiveness and helped open markets for these countries’ exports.  Indeed, the accession of Estonia and Latvia in 1999, and Lithuania in 2001, was an important factor in the Baltic export boom of the past decade.  Bosnia and Herzegovina, Montenegro and Serbia have all been working hard to join the WTO, and each is now approaching the final stages of accession talks (WTO, 2010).  In contrast, Russia, Belarus, Bosnia and Herzegovina, Montenegro and Serbia are continuing in the accession processes.  While there had been conflicting signals regarding Russia’s drive for membership, President Medvedev had appeared to win the internal struggle over whether Russia ought to join the organisation sooner rather than latter (FT, 2009).  President Obama endorsed this goal at a USRussian summit in June 2010 and vowed to make progress on the outstanding technical issues that the US government believes need to be resolved before Russia can be admitted. (Kaufman)  However, the outcome of Russia’s entry to the WTO remains uncertain given Prime Minister Putin’s continued commitment to protectionist measures, most recently in the automotive industry (FT, 2010d). The apparent difference between Russia’s two leaders in this regard is revealing.

32.  Participation in IMF programs has also helped vulnerable CEE countries to weather the downturn. The IMF has been instrumental in supporting the economies that were in free fall at the height of the financial crisis through the disbursement of loans necessary to cover current account deficits and to restore international investor confidence.  The IMF granted emergency assistance to Belarus, Bosnia and Herzegovina, Hungary, Latvia, Poland, Romania, Serbia and Ukraine.  With the exception of Poland, each country was extended a Stand-By Agreement (SBA), which has long been the central lending facility of the IMF. Stand-By Agreements are designed to help recipient countries address macroeconomic imbalances and, in particular, large current account deficits.  The loans, however, are disbursed in tranches, with each new issuance released if and only if the recipient country reforms its fiscal and macroeconomic policies in accordance with the conditions established in the agreement.

33.  This ‘conditionality’ incentivizes governments to take what are often unpopular decisions, which are nonetheless needed to restore economic stability.  In Latvia, both emergency assistance and fiscal consolidation were inescapable.  The SBA funded by the IMF, the EU and Scandinavian governments imposed requirements for tax hikes and wage cuts to curb a runaway budget deficit (FT, 2010a).  The programme has proven a tempting target for the opposition parties appealing to popular resentment.  However, when tough austerity measures become the criteria for bailouts, the pressure on governments is somewhat eased. In some cases, however, the IMF can become the target of government wrath as has occurred in Hungary, where the current government has put a halt to bail-out loan talks after the IMF claimed Hungary was not acting with sufficient alacrity to make durable cuts in State spending. (Fairclough)  In Ukraine, the Stand-By Agreement proceeded on course from November 2008 until the presidential electoral campaign inspired a series of populist spending measures. Following the establishment of the new government, the IMF formally approved a new Stand-By Agreement on 28 July 2010 worth US$15.2 billion over two and a half years (EIU Country Report, 2010). Although IMF conditionality has long been a contentious issue, there is little doubt that the quick delivery of emergency funds was fundamental in keeping, for example, the Latvian currency peg from breaking and in covering Ukraine’s foreign loan payments – two outcomes that would have seriously exacerbated the social and economic fallout of the financial crisis. The IMF has thus helped to ensure policy stability in the region through its role as the lender of last resort, while both the WTO and the EU have provided a longer-term context for advancing macro- and micro-economic reforms.

34.  Poland’s recent dialogue with the IMF has differed from those conducted by its neighbours.  Like Ukraine, Poland’s exchange rate was allowed to float freely, but the government has pursued sound macroeconomic policies and strong regulatory oversight. Its current account deficit stood at a manageable 5% of GDP in 2008 (IMF, 2009e). Currency depreciation endowed it with a degree of flexibility that fixed-exchange rate regimes did not enjoy (i.e. the Baltic States, Bulgaria and eurozone members). Poland also qualified for the IMF’s new ‘Flexible Credit Line’ (FCL) facility - a preemptive and optional loan that aims to restore confidence in the recipient’s economy (IMF, 2009f). Remarkably, Poland did not draw on the Special Drawing Rights SDR13.69 billion available before the contract expired in May 2010.  Poland and the IMF have now rolled-over the loan for another year (until July 2011), but it seems unlikely that Poland will need to access these emergency funds.

E. LABOUR, MIGRATION AND REMITTANCES

35.  The social impact of the global crisis, of course, has been enormous.  Falling real wages and rising unemployment have placed enormous burdens on both the people of the region and national institutions.  The shock has curbed what were often unsustainable levels of consumption, but those suffering job losses as a result are among the greatest victims of the crisis.  In addition to job losses, remittances coming into poorer countries and poorer communities have declined as the labour markets in host countries have also tightened.  Thus, with worsening prospects at home and abroad, many potential migrants are staying at home, while some of the diaspora return home looking for work in their communities. Unfortunately data on migration flows during the crisis remain imprecise. There are nevertheless signs that migration from the region decelerated or, in some cases, may have reversed.  All of these factors have increased demands for government social support.  Yet, government finances have deteriorated to such an extent that, in many cases, social services have not been able to keep pace with the rising demand for them.  While there is little evidence of a broad ideological shift against liberal capitalism either in the public or in national political parties, mounting public anger cannot be discounted, and this could set back reform processes (World Bank, 2010).  High unemployment could also increase criminal activity, which obviously has high social and economic costs.

36.  Job losses in part of Central and Eastern Europe have already reached unprecedented levels.  Based on the EIU’s estimates for 14 of the CEE countries,7 the number of officially unemployed persons increased from about 9.33 million in 2008 to 12.05 million in 2009 – a 30% jump in one year. The largest increases have been in the Baltic States.  In 2007, the unemployment rates were, respectively, 4.7, 6.0 and 4.3% in Estonia, Latvia and Lithuania; these figures for Q12010 reached 14.4, 20.4 and 15.6% – a three-fold increase in people actively looking for work (EIU, 2010).  Quarterly data from the Economist Intelligence Unit shows that unemployment rates in the CEE rose in each quarter in 2009 and have continued upward in the first two quarters of 2010.  A recent World Bank study (Arvo Kuddo) suggested that from 2008 to 2009 the official unemployment rate would skyrocket in the Czech Republic, Slovakia, Ukraine (an increase of > 30%), Russia (> 40%) and Moldova (> 60%).  While the rest of the region fared slightly better, there is clearly a risk that part of this rise in joblessness may become structural rather than cyclical, which will place greater long-term burdens on CEE governments and societies. The young working population and marginal groups, such as minorities and immigrations, have been hit hardest (Kuddo, 2009), a factor which could also increase the risk of social unrest in Central and Eastern Europe.

37.  Unemployment surveys cover only those persons who are registered as actively looking for work. They exclude those who have given up the search or who have never registered. To better fathom changes in the job market, therefore, it is useful to also look at total employment figures.  In the 11 countries with available data (the EU members plus Croatia), total employment fell in every country at the beginning of 2009.  While employment levels began to increase as Western stimulus measures kicked in the second and third quarters of 2009, the sluggish growth of export markets and the launching of fiscal consolidation measures led to decreases in total employment in Q4 2009 and Q12010 (Eurostat).

38.  While these absolute declines are stark, of even greater concern are the sector-specific declines.  Sectoral data for the CEE EU members reveals that the manufacturing sector has been the hardest hit.  Despite the slight rebound in total employment in mid-2009, employment in manufacturing has been declining in every country in almost every quarter: from Q1 2009 to Q1 2010, Czech Republic, Estonia, Latvia, Hungary, Slovenia and Croatia each had one quarter in which manufacturing employment increased – all other quarters showed reductions in the number of employed people.  In aggregate, this amounts to 705,000 fewer manufacturing jobs in Q12010 compared with the beginning of 2009 – or a loss of 1.8 million manufacturing jobs since Q12008.  As the manufacturing sector in these countries accounts for a greater share of employment than any other sector, it is a critical generator of wealth for the CEE countries and its workers (Eurostat).

39.  Adding to the social and economic consequences of greater unemployment and reduced wages are, respectively, the reversal of migration flows and declining remittances, which are a particularly important source of foreign exchange earnings in a number of CEE countries.  With fewer people moving to the advanced economies (particularly to Western Europe) and with increasing numbers returning to the CEE, competition for jobs and for social support has been a source of some social, political and economic tensions.

40.  Remittance flows to Central and Eastern European countries declined from their 2008 peak of US$57.2 billion to US$46.7 billion in 2009 – a drop of 18.3% (World Bank, 2010).  This is a significant reversal given the 20 to 30% year-on-year growth of remittance inflows during the preceding decade.  While this is indeed a heavy loss for many people in Central and Eastern Europe, the 2009 remittance receipts are still significantly higher than the US$38.8 billion received in 2006. In Serbia, Albania, Moldova and Bosnia and Herzegovina, remittances are economically crucial as they account for over 10% of GDP in each country.  It is important to note that remittances tend to flow to the lower echelons of society and thus provide an important degree of social support, even when not accounting for a large share of a given national economy.  For example, in 2008 inflowing remittances generated a mere 0.4% of Russia’s GDP (the lowest in the region), but this provided an extra US$6 billion in household income.


III. IMPLICATIONS FOR FISCAL AND MONETARY POLICY

41.  For obvious reasons the condition of public sector finances has deteriorated during the crisis.  Across the board, CEE governments have recorded their largest deficits in years. In several cases these represented the largest deficits since the initiation of transition.  They are not unique in this as most Western governments are also experiencing very serious fiscal pressures arising out of the global crisis, falling revenues and rising outlays linked to automatic stabilisers and stimulus packages.  In aggregate, the CEE’s deficit level rose from -1.8% of GDP in 2008 to 5.3% in 2009.  This is particularly worrisome as the region’s real GDP declined by approximately 6.2%.  Increasing expenditure is largely due to the onset of ‘automatic stabilisers’ including unemployment benefits and social services that kick in as an economy turns downward.  Although CEE countries have engaged in some discretionary spending to bolster demand, such countercyclical efforts are limited by thin reserves and borrowing limits which reduce the fiscal space for maneuver.

A. FISCAL POSITIONS BEFORE THE CRISIS

42.  A central question all governments in Europe and North America must address today is: what government policies can most quickly put national economies on a sustainable growth path?  Of course, there are no easy answers to this question.  Rapid and sustainable growth depends on a multitude of factors, many of which are non-economic. These include institutional histories, social cleavages and political cultures.  Some serious faults have been identified in certain government policies during the ‘good times’ (IMF, 2010a), and there are discussions about which particular policies would have been more appropriate at particular points throughout the business cycle (Lewis, 2009). Indeed, the unprecedented nature of the financial and economic crisis has triggered a renewed appraisal of the foundation of macroeconomic policies which, among other things, has resurrected Keynesian approaches (IMF, 2009d; BIS, 2009).  Many analysts, including those from the IMF, now agree that fiscal policy should have, and could have, been tighter during the boom years.  Had greater prudence been exercised, governments would have had more fiscal space to combat the economic and social consequences of the crisis as it broke.  Of course, this is also true for a number of Western countries burdened with sustained fiscal deficit problems, but their ability to borrow internationally provides some fiscal flexibility that transition countries simply do not enjoy.

43.  Some critics (e.g. Darvas, 2009) have blamed many CEE governments and others in the OECD for pursuing pro-cyclical fiscal policies – that is, for over-zealously expanding government spending during periods of growth – which subsequently limited their capacity to engage in discretionary spending when it was truly needed during the downturn.    However, a recent study by John Lewis (2009) tests the cyclicality of CEE governments’ fiscal policies with real time data.8  Lewis’s empirical testing demonstrates that “the total response of fiscal policy is roughly the same size as external estimates of automatic stabilisers”, which suggests that the stance of discretionary policy is, on the whole, acyclical (Lewis, 2009).  Regardless of these spending trends, budget deficits were common during the boom years and, as a result, many governments squandered an opportunity to build up stronger financial positions during the boom.

44.  Interestingly, most CEE governments fared better in this area than the EU-27 average.  EU member States are obliged to keep government finances in line with the Stability and Growth Pact (SGP) criteria, in which deficits are to remain below 3% of GDP and total government debt is to be no higher than 60% of GDP. Only Bulgaria, Estonia (up to 2008), and Russia ran consistent budget surpluses during the five years leading up to the crisis (EBRD, EIU).  The stories behind these surpluses, however, vary considerably.  Impressive structural reforms in Estonia and Bulgaria, for example, reinforced their austere fiscal posture – policies that are essential to sustainability in small States with open economies and tightly pegged currencies (see below).  Russia’s budgetary surpluses were, by and large, the product of the high oil and gas prices, which account for a significant proportion of Russian exports and government revenues. Bosnia and Herzegovina also ran budgetary surpluses up to 2006.  However, this position began to weaken during the political stalemate following the parliamentary elections in Bosnia’s entity Republika Srpska held in October 2006.  Bosnia and Herzegovina’s finances rapidly deteriorated in 2007 and 2008 perhaps because the weakened influence of the EU’s High Representative removed an “external” source of fiscal discipline in that divided country.  While perhaps an extreme example, Bosnia’s recent history demonstrates how expedient policymaking can negatively affect a State’s long-term economic stability in a very short amount of time.

45.  The remaining 16 CEE countries ran deficits as well and the bulk of these were above the 3% floor.  As discussed in the previous section, the attraction of EU membership provides positive incentives for economic reforms, yet these seem to wane once membership is secured.  Indeed, although several CEE government budgets relaxed in recent years, this is not associated with entry into the EU but appears to begin once entry is ‘in the bag’ (Lewis, 2009).  Similarly, this was shown to be the case for the Czech Republic, Poland and Hungary in the years prior to NATO accession (Berger et al., 2007).  However, the deficits of the Czech and Slovak Republics were significantly reduced in 2007 and 2008, which somewhat eased the budgetary burden during the crisis.  In contrast, since 2003 Albania, Poland and Hungary each ran deficits well in excess of the -3% benchmark (EBRD, 2009; EIU).  Since 2006, Hungary has had a general government debt exceeding 60% of GDP.  For Belarus, Moldova, and Ukraine – where the desire to join the EU is less clear – government finances have been conditioned somewhat by financing and reform agreements with the IMF, with only Ukraine running consistent, albeit modest, deficits prior to the crisis.

46.  By comparison, in 2008 the EU-27 average government deficits stood at -2.3% of GDP, while the average debt load was 63.2% (equivalent figures were slightly worse for the euro-zone).  The latest data shows that the unweighted average of balances for EU members  in the CEE was 2.5% in 2008 and only 0.7% for the non-EU members.9  More impressive is the region’s average debt level, which stands at a mere 26.5%, with only Albania (55.9%) and Hungary (72.6%) as significant outliers.  On the whole, CEE government deficits before the crisis (including non-EU members) were lower than those of the advanced economies of Europe, North America and Japan.  Indeed, several of the EU’s southern members generated particularly high levels of debt in the run up to the crisis, in part, because their position in the eurozone significantly reduced interest spreads, and this encouraged significant capital inflows. These inflows proved unsustainable once the crisis struck.  As these governments lack the flexibility to devalue their currencies to kick start growth, they are compelled to choose between painful domestic austerity or the high-risk option of (partial) default.  To date the former solution has been chosen and Europe has scrambled to make the second option untenable.

47.  A similar dynamic is also apparent among some eurozone aspirants although they, theoretically, are in a position to devalue their currencies before joining.  However, this course has been avoided in the Baltic countries and in Bulgaria in favour of the long-term stability that eurozone membership should bring (Soros). In several countries very tight austerity measures have recently been introduced to address fiscal shortfalls as quickly and stringently as possible. Indeed, the discretionary fiscal space available to the CEE is much reduced because their access to foreign finance is now significantly restricted.  The unfortunate lesson is that despite high levels of growth, stability, and the myriad benefits of NATO and EU membership, the CEE governments will likely remain more fiscally austere than advanced economies as they face a greater need to assuage market foreign investors’ perceptions of default risk.

B. MEASURES IN THE MIDST OF CRISIS

48.  During 2009 most of the region’s governments, save Bulgaria, implemented expansionary fiscal and monetary measures aimed at buoying aggregate demand (Darvas, 2009).  Fiscal policy expansions came in the form of support for the most vulnerable, and for the unemployed in particular.  However, many countries provided credit to businesses, finance for infrastructure projects and income tax reductions (Darvas, 2009). There is not sufficient space here to assess all of these spending programmes.  What can be said is that due to the limited fiscal space the extra spending measures have generally been offset by consolidation measures. Consolidation was generally implemented through public-sector wage and/or hiring freezes, consumption tax increases as well as cuts in any other ‘non-essential’ areas.  The silver lining is that the forced consolidation will further structural reforms needed to put national budgets on a more sustainable foundation (IMF, 2009b).  There are concerns among some economists that European leaders have moved too quickly to embrace austerity and that there is a general risk of inducing a double dip recession should Europe’s governments radically reduce expenditure at what is still a economically vulnerable moment.  Indeed, the timing of the withdrawal of stimulus measures has been a matter of great debate this year. Clearly, each country must consider its unique circumstances, but it is crucial to recognise that, across the world, weak demand remains a fundamental hindrance to a strong recovery.

49.  Banking system insolvency has also been a concern. Following the European Commission directive, 12 CEE countries10 increased government-guaranteed deposit insurance. The EU members raised insurance to the recommended €50,000 level, while Albania and Croatia doubled and quadrupled deposit guarantees, respectively. Liquidity injections and bank re-capitalisation policies were also introduced, although at levels lower than in the more mature open-market economies. This was largely due to the prominent position of foreign-owned banks in the CEE (EBRD, 2009).  Of the six countries that engaged in banking sector support, Russia and Ukraine offered the largest and most direct support to their respective banking systems. This is not particularly surprising as both are among the CEE countries with the lowest shares of foreignowned banks and two of the highest shares of state-owned banks (EBRD, 2009). Bosnia and Herzegovina and Montenegro are small, relatively open economies but with significant foreign-bank presence (foreign banks owned 84.6% and 95% of banking assets in 2008). Yet, their liquidity injection (and, for Bosnia and Herzegovina, bank recapitalisation) programmes were implemented under the IMF and other international bodies in order to reduce widespread uncertainty.  Finally, Hungary and Latvia stand out as the most advanced economies of the six; yet their fiscal positions entering the crisis were particularly weak.  Although Latvia had strong fundamentals in 2008, its banking system was seen as more vulnerable than its neighbours, in part because foreign banks owned only 65.7% of Latvian assets, against 91.8 and 98.1% in Lithuania and Estonia respectively. Furthermore, Latvian state-owned banks accounted for almost 20% of banking assets in 2008, second to only Belarus and Russia.

50.  Indeed, the clear and committed support of foreign institutions, including the IMF, the EIB and foreign-owned banks operating in the CEE, played decisive roles in the crisis (EBRD, 2009).  The European Bank for Reconstruction and Development helped stabilise the region’s banks by orchestrating an orderly deleveraging process among the region’s banks which helped avoid a panic. The EU provided low interest loans to help countries maintain repayment schedules and the IMF provided vitally needed credit without imposing the kind of conditionality that proved problematic in past crises.

51.  Finally, extraordinary measures have been taken by many countries attempting to defend their currency’s exchange rate.  Bulgaria, Croatia, Estonia, Hungary, Latvia, Lithuania and Romania’s pegged currencies came under immense pressure due to the sudden reversal of capital flows.  In February 2009, the cost of insuring these governments’ five-year bonds against default each rocketed above 600 basis points (peaking at almost 1,200 bps for Latvia).  Defending currency pegs required that their central banks expend a significant proportion of their foreignexchange reserves. For those countries with large outstanding debts denominated in foreign currency, devaluation was not seen as a desirable option, compelling governments to engage in austerity measures to defend the exchange rate. This was particularly the case in the Baltic States which saw growth, wages and employment plummet as a result.   Even more costly was Russia’s failed defence of its managed float: after spending one third of its enormous stockpile of reserves, sterilisation measures were ultimately abandoned and the rouble was allowed to depreciate by 20% (Darvas, 2009).  Ukraine also failed to defend its managed float, but when the default-insurance market spread surpassed 5,000 basis points the country shifted to a free-floating policy under the auspices of an IMF Stand-by Agreement.  Of course, those countries with floating currencies (i.e., Czech Republic and Poland) were not obliged to defend costly pegs, and resulting depreciated currencies will bolster exports in 2010 and 2011.


IV. THE LATVIAN AND BULGARIAN EXPERIENCES

A.  LATVIA

52.  This Committee has had the opportunity to visit both Latvia and Bulgaria this year and will visit the Czech Republic after this report goes to press. The Latvian case is particularly interesting as it suffered Europe’s greatest economic contraction. After contracting by 4.2% in 2008, Latvia’s gross domestic product shrunk by an astounding 18% in 2009 and will likely fall another 2.3% in 2010 before finally returning to growth in 2011 (IMF, WEO).  In the decade preceding the crisis, Latvia and the other Baltic States were the fastest growing economies in Europe.  Latvia consistently recorded real growth rates of over 10%.  Rising levels of trade and investment during a global era of easy credit fed expectations for future growth.  As foreign capital flowed in and credit rapidly expanded, prices edged upwards. Inflation reached nearly 18% by mid-2008 (BoL presentation).  But wage levels were rising far more quickly than workers’ productivity rates (Vilipisauskas, Rose-Roth).  Average nominal wages more than doubled between 2000 and 2008, while productivity rose by less than 50% (BoL). Cheap euro-denominated credit fuelled what proved to be an unsustainable pace of wage hikes. Yet it was politically difficult to advocate a slow down in credit expansion in the face of the country’s unparalleled growth. Indeed, credit bubbles are easiest to detect after they have burst; but there were nevertheless clear signs of trouble. The current account deficit rose nearly fourfold, from 6.6% of GDP in 2002 to 22.3% in 2007.  Paradoxically, as the economy lost its competitive advantage in labour costs terms, economic growth c, , , , ontinued to soar as credit-fuelled consumption and investment compensated for the worsening trade balance. This, of course, was not sustainable and was a central factor in the country’s economic collapse.

53.  Along with Estonia and Lithuania, Latvia had been considered to be on an inside track for euromembership.  The Bank of Latvia had dedicated itself to maintaining a stable exchange rate with the euro (at 0.703 lats/1 €).  For all intents and purposes, this deprived it of exercising an independent monetary policy.  When the crisis struck, however, foreign capital fled the country - a development that immediately squeezed businesses and consumers who had relied on cheap credit.  Had the exchange rate been flexible, the central bank would have been in a position to lower the interest rate or engage in quantitative easing to increase the availability of credit.  Under a fixed exchange rate regime, however, there is no leeway to do so.  The Bank of Latvia was determined to maintain the pre-crisis exchange rate despite the massive ‘internal devaluation’ that resulted. This was a key factor in the plummeting growth and soaring unemployment that ensued, but the authorities felt that given the high level of foreign currency-denominated debt, a devaluation would have had more adverse effects over the long run and rendered eventual euro membership all the more elusive.

54.  The Governor of the Bank of Latvia argued that devaluation would have damaged the country’s credibility and increased the level of bankruptcies.  Moreover, it would have generated fewer incentives for improving productivity and still would not have been sufficient to reverse the huge current account deficit (NATO PA, spring).  In effect, Latvia’s decision to maintain its fixed exchange rate required a high degree of suffering over the short term in order to lay the foundations for longer-term growth.  There are some signs that this shock therapy strategy is beginning to work.  This summer the EBRD revised its growth forecast upwards (from  3.0% to 2.0% for 2010), and the Economist Intelligence Unit notes that since January 2010 year-on-year industrial output has been increasing at respectable rates. And, as of June 2010 the Latvian economy reached industrial output levels equivalent to peak output in 2008 (EIU, 6 July 2010) and there are signs that its competitiveness is being restored.

55.  The response to the economic collapse in Latvia was further hindered by restricted fiscal leeway.  Latvia had been running relatively minor budgetary deficits in the years before the crisis, but even in 2008 falling tax revenue and increasing demands for social services generated a deficit equivalent to 4% of GDP. To support the overwhelmed social system and to regain some economic stability Latvia turned to the IMF, the EU and the Scandinavian governments in December 2008 for a €7.5 billion rescue package (FT, 2010a).  Under the agreement, Latvia’s budget deficit was set to reach 8.5% of GDP in 2010. This gave it leeway to provide some protection for the poorest and to finance active labour market policies and temporary jobs programmes (IMF, 2010d).  The World Bank has also offered support for these emergency programmes (World Bank, 2010b).  This unprecedented Stand-by Agreement runs until the end of 2011. But with the pick up in economic activity, the Latvian government now feels that it can avoid drawing upon the rescue capital put up by Scandinavian donors. This would be a very welcomed sign of a stable recovery.

B. BULGARIA

56.  Bulgaria experienced less of a downturn than Latvia over the course of the global economic crisis, but it has had to cope with other structural problems posing important potential barriers to long-term economic growth. Although the country underwent a rapid transition to prepare itself for EU membership, the problems of corruption and persistent inadequacies in its judicial system have been of great concern to the European Union and to Bulgaria’s domestic reformers. In other areas, its reforms have been more successful and, as a result, the country was less vulnerable than it otherwise would have been as the global economy slowed.  Even prior to joining the Union in 2007, Bulgarian public finances remained within the bounds of the SGP (Stability and Growth Pact). Indeed, the State was generating budgetary surpluses and public debt had begun to fall (reaching 14.1% of GDP in 2008).  Like Latvia, Bulgaria has pegged to the euro and that peg was maintained during the recent crisis.  This policy helped encourage significant capital inflows during the past decade but credit conditions were significantly tight in Bulgaria due to regulatory measures arising out of the 1997 financial crisis. During the boom years, Bulgaria’s GDP grew by a relatively moderate 6 to 7% and it underwent a comparatively minor but nonetheless very painful contraction of 5% in 2009 (IMF, 2010c).

57.  Bulgaria’s fiscal caution is rooted in the inflationary crisis in 1997 (BNB Meeting). The economic havoc that resulted informed successive governments’ efforts to rein in spending and ensure as much stability and predictability as possible.  Although pegging the currency to the euro deprived the central bank of monetary autonomy, tight financial regulation helped rein in the banks.  For example, when credit growth reached 45% in 2007 the authorities responded by increasing the capital adequacy ratio to 17% - far higher than the Basel II requirements (BNB Meeting).  This capital buffer proved very useful in 2008 and 2009 as foreign investment dried up. Capital inflows fell by 54% from 2008 to 2009, but domestic capital stocks generated through these regulatory measures helped keep the economy from falling off a cliff (UNECE, 2010). Bulgaria was hardly unique in this regard. The Czech Republic is another country that ensured that its banking practices and its budget were operating on a sustainable basis.  (The Economist, 20 March 2010)

58.  The government also maintained an admirable degree of fiscal discipline in the years before the crisis. This, in turn, accorded it a degree of flexibility in the recent downturn. The budget deficit for 2010 is estimated at 4% of GDP – the first time in over a decade that Bulgaria’s shortfall will exceed 3% (EIU, 2010). Yet infrastructure and social outlays have partly counteracted some of the worst aspects of the crisis and headed off potential social disruptions that the downturn might have otherwise induced. Bulgaria, however, continues to confront competitiveness challenges.  A large share of Bulgaria’s exports is in the textile sector and it is directly competing with China and other low-cost East Asian producers (BNB Meeting). Corruption continues to burden the national economy and weakens the effectiveness of the State. Addressing this will be essential to improving the country’s competitiveness and Committee members learned that doing so has become a top priority of the current government. 
 
V. IMPACT ON MILITARY EXPENDITURE

59.  As governments across the region consolidate their budgets through spending cuts and tax increases, there are concerns in NATO circles about the impact on military expenditure.  Even before the crisis, several countries of the former Yugoslavia had been scaling down their military budgets, as had the Czech Republic and Hungary; nevertheless the region’s overall military spending increased roughly 7 to 8% in the three years before the crisis struck (SIPRI, 2010).  The latest data from SIPRI shows that, as an unweighted average, military spending increased by 4.2% in 2008 and declined by 1.2% in 2009.  When considered as a proportion of GDP, however, the region’s large contraction in 2009 meant that military spending increased from 1.8% to 2.1% of GDP (with each country, save Montenegro, maintaining or increasing their proportional allocation).  It is important to consider that there is less flexibility to adjust defence spending in the short term so the impacts of the crisis on defence spending may only be evident later.

60.  Of course, these averages hide important differences within the diverse region which are driven by threat perceptions and strategic ambitions as much as by economic factors.  Bulgaria, Croatia, Estonia, Lithuania, Moldova, Montenegro, Romania, Serbia, Slovakia and Ukraine all cut real military spending by no less than 5.8% in 2009 (most cuts are in the 7 to 10% range).  Quite remarkably, Latvia and Russia both increased their respective defence budgets in 2008 and 2009.  In light of its large economic contraction, estimates are that Latvia’s military budget increased from 1.7% in 2007 to 2.6% of GDP in 2009. Russia’s spending increased from 3.5% to 5.0% (by far the largest proportional spending increase in the CEE since the Balkan wars).  This will obviously be of some concern to Russia’s neighbours.  Russia’s immense size means that total military spending in the region increased from US$90.8 billion in 2008 to US$93.1 billion in 2009 – with Russia accounting for over 65% of this figure.

See word document for table.


VI. RECOMMENDATIONS AND CONCLUSION

61.  In the aftermath of the worst global economic crisis since the Great Depression, it is crucial that all governments refrain from protectionist measures.  The longterm costs of protectionism far outweigh short-term and narrowly construed benefits.  In particular, nothing about the current crisis changes our understanding of open trade, the benefits of which include higher growth, increased consumer choice and international solidarity. 

62.  CEE governments will continue to face daunting social, political and economic challenges as a result of this crisis.  With this in mind, the region’s governments will need to recognise that fiscal consolidation is inevitable, but it must facilitate the kinds of structural reforms and investments that will encourage long-term growth as well as budgetary sustainability.

63.  Neither euro-membership nor flexible currency regimes will insulate countries from the impact of global crisis. Appropriate monetary policies ultimately hinge not only on the economic fundamentals, institutions and practices of each country, but also on their unique economic cultures and their political, diplomatic and economic priorities.

64.  Over the long run, governments in the CEE as well as those throughout the OECD must adjust their approach to fiscal policymaking to ensure that savings are generated during boom periods to provide the necessary funds needed to finance spending measures during downswings. Doing so will help moderate rather than exacerbate the business cycle.  This is not always easy to do, and institutional change as well as a frank public discussion about fiscal matters is essential. An important lesson of this crisis is that many governments have pursued pro-cyclical fiscal policies that triggered financial bubbles and ultimately deprived governments of the resources needed to deal with the bursting of the bubbles. This must change.  That said, most of the governments have managed very well in adjusting to new economic conditions, and some like Latvia and Hungary have had to make massive adjustments to deal with large current account and budget deficits.  In some respects, this response might be a model for more timid policymakers in the West who sometimes have been slow to react to these conditions. Finally, the courage and patient sacrifice of the people of many CEE countries should be recognized as they have endured difficult times with a remarkable degree of stoicism. These countries have generally maintained political and social stability as a result.  This is a testament to the strength of these democracies and their civil societies.

65.  Fiscal reforms should protect pro-growth programmes that improve human capital, encourage innovation, and build infrastructure.  Spending cuts, for example, should target inefficient State policies, while rationalizing pension plans and healthcare entitlements in order to make them sustainable over the long term, particularly given demographic trends. Much of the region needs to refine policies designed to cope with an ageing workforce, poor infrastructure and the emergence of powerful direct competitors in Asia. This makes reform all the more essential.  Some countries need to improve tax collection methods.  Any increased taxes ought to focus on consumption and natural resource use rather than penalising potential sources of growth.  Obviously, ensuring public health and high education standards should remain a priority, as both are essential to long-term economic success. Moreover, several countries could increase revenues through more progressive tax regimes, which might lower the burden on the most vulnerable segments of society.  Again, many such reforms are also needed more broadly throughout the OECD.

66.  A reconsideration of the secular benefits of full capital account liberalisation is in order. Short-term capital movements into and out of emerging economies can be highly destabilising, and some measure of control may be in order to help insulate fragile market structures from the whims of the international investor community. Transition governments must be mindful of the foreign currency-denominated debt that households are taking on. When this exceeds certain thresholds, the economy as a whole becomes highly vulnerable in a downturn.

67.  At the time of writing, it is not entirely clear if the world is headed for a second recession or if the current relatively weak rate of growth can be sustained. There are signs though that conditions for the poor could grow worse. Food prices, for example, are now rising and this hits the poor disproportionately.  The solutions to this particular problem must include multilateral measures and more open trade in food products. In this light, Russia’s decision to impose grain export restrictions will only exacerbate rather than improve the region’s food security and represents a step backwards for Russia’s food industry which has great potential to play an important role in world markets.

68.  Defence budgets are vulnerable in the kind of downturn that is coursing through Europe. New NATO members are going to be under strong political pressure to cut defence budgets. Generating some degree of savings may be necessary and one way to do so is to create new efficiencies through enhanced European defence integration and defence industrial co-operation. Of course, more open transatlantic defence trade and co-operation can be particularly helpful in this regard.

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1   These are Albania, Belarus, Bosnia and Herzegovina, Bulgaria, Croatia, Czech Republic, Estonia, Hungary, Latvia, Lithuania, the former Yugoslav Republic of Macedonia*, Moldova, Montenegro, Poland, Romania, Russia, Serbia, Slovakia, Slovenia and Ukraine.

  * Turkey recognises the Republic of Macedonia with its constitutional name.
2   Ukraine is technically not a member of the CIS, as the Ukrainian Parliament has not ratified the CIS Treaty.  However, it participates as a de facto full member.
3   These data are for the 17 reporting countries in the CEE.  Up-to-date data was not available for the former Yugoslav Republic of Macedonia, Montenegro and Serbia.
4   The Czech Republic is even more modernised according to the EBRD’s assessment, as it has ceased providing development assistance as of 2009. Therefore, the country is no longer part of the Transition Report.
5   Only Belarus (2.04), Bosnia and Herzegovina (2.78), Montenegro (2.85) and Serbia (2.89) rank lower than these three extreme cases.
6   The EBRD does not report this information for all countries. Omitted are Belarus, Bosnia and Herzegovina, the Czech Republic, the former Yugoslav Republic of Macedonia, Montenegro and Serbia.
7   Excluding Albania, Belarus, Bosnia and Herzegovina, the former Yugoslav Republic of Macedonia, Moldova and Montenegro.
8   That is, data that was actually available at the time of budget making, rather than the more accurate revisions that are generally used in econometric studies.
9   For non-EU members in the CEE Albania, Belarus and Montenegro are excluded, as the latest data from the EIU does not include their revised budgets.  With the EBRD’s data from November 2009, the non-EU member’s fiscal balance is -1.0% of GDP, unweighted.
10   Albania, Bulgaria, Croatia, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, Slovak Republic, Slovenia.

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