Their economies’ new openness set them up for a fall, but the stars of the former Soviet bloc will rise again.
Erik Berglof, Chief Economist, European Bank for Reconstruction and Development 25 December 2008
Over the past several years under difficult domestic circumstances, the countries of Eastern Europe have moved away from centrally planned economies and embraced globalization, inviting Western companies and financial institutions to invest. Unfortunately, when the global financial crisis hit, this very openness turned these transition countries into unwitting victims of the contagion.
In the financial sector, stock markets have plunged, currencies have been put under pressure and several countries have experienced rapid capital outflows. Growth in the region has decelerated from 7.5 percent in 2007 – the highest level since transition to market economies began – to a likely 6.3 per cent in 2008. The slowdown is coming from the rapid decline of key export markets, more expensive credit and the shutdown of traditional lending channels. The countries are struggling not just because of the crunch at local banks, but also because of the increasingly important parent banks, foreign financial institutions that are facing dismal prospects at home and abroad. Countries are also hit directly through lower credit ratings and speculation against their currencies.
The focus of policymakers has quickly shifted from containing inflationary pressure to protecting domestic financial institutions and mitigating the impact on the real economy. The scale of the crisis is potentially overwhelming for individual governments, but within their limitations, most countries have taken appropriate policy responses.
What is clear is that the general level of risk and the likelihood of a significant slowdown have risen substantially. Rapid credit growth in many transition countries in recent years has raised questions about the quality of bank portfolios and internal risk management systems. While tighter policy and stricter prudential regulations are required to bring about more sustainable rates of credit expansion, the deterioration in the overall financing environment could result in far more severe contractions than have been predicted.
The crisis is a challenge to the East European growth model that has relied on extreme levels of openness to trade and capital flows. Economists have to go back the United States in the 19th century to find a similar example of growth. The large current account deficits have been financed primarily by foreign direct investments. Cross-border financial integration has been unprecedented, with most Eastern European banks controlled by foreign parents. This model, having generated economic growth and institutional change, made these countries more resilient.
What made these countries vulnerable as the crisis intensified was the exposure of the private sector to movements in foreign exchange. Foreign currency borrowing has increased everywhere in the economy. Car loans in Swiss francs and mortgages in Japanese yen have been common. These excesses were often promoted by foreign banks and ignored by the regulators in their home countries; local regulators were essentially powerless, and instruments available to monetary authorities to stem the rapid growth of overall credit were limited by the strong influence of the foreign banks. It was also symptomatic that Hungary, the country where these practices have perhaps been most wide spread, was the first to be hit by the crisis.
The crisis is also a challenge to the European transition model based on rapid institutional change supported by the external anchor of European enlargement. However, as with the basic growth model, the problem is not in the model itself, but in its implementation.
Major Risk
The prospect of joining the European Union drove the remarkable changes in Central and Eastern Europe. That prospect now supports the implementation of difficult economic and political reforms in Southeast Europe as documented in the annual Transition Report from the European Bank for Reconstruction and Development (EBRD). The stronger the admission prospects and the closer in time for membership, the greater the leverage. Even some countries of the former Soviet Union, like Ukraine and Moldova – or Turkey, where potential EU membership is far into the future – are playing an important role in promoting change. What made Hungary vulnerable was capital liberalization with huge foreign exchange exposure, large fiscal imbalances and inflation that prevented the country from joining the euro zone.
A major risk of the global financial crisis is that the attention of policymakers will be diverted from the long-term growth challenges. Over the medium term, the scope for the transition economies to sustain high growth remains substantial. A large body of empirical research suggests that the countries that have implemented key market-enabling and market-deepening reforms – such as price liberalization, privatization and financial sector reform – have reaped benefits in terms of growth.
The challenges now are to implement the often more difficult and protracted market-sustaining reforms (such as competition policy, governance and company restructuring) that are essential for long-term growth, while trying to surmount the shorter-term pressures coming from the international economic situation. Failure to keep inflation under control and to ensure the stability and functioning of the financial system will make it hard, if not impossible, to effectively implement policies aimed at raising the long-term growth potential of a transition economy.
“Car loans in Swiss francs and mortgages in Japanese yen have been common. These excesses were often promoted by foreign banks and ignored by the regulators in their home countries; local regulators were essentially powerless.”
According to the EBRD/World Bank Life in Transition Survey in 2006, many people in the region have found transition to be a very difficult experience but have remained optimistic about the future. There are good grounds for such optimism. Most transition countries have continued to make economic progress and have largely sustained the momentum of reforms necessary to reinforce growth. Nevertheless, events that have originated outside the region, combined with shortcomings in policy and institutions within it, now pose major risks of instability and recession. Furthermore, implementation of more complex market-sustaining reforms will be essential.
Finding resources and political will to implement these reforms will prove exceedingly difficult in the current environment. Many people associate the current problems in the region’s financial systems as evidence of the weaknesses of the market economy. Indeed, in many countries there is a serious risk that economic reforms could be reversed and achievements over the past two decades could be undone. Supporting the reform agendas through benchmarking and deeper analysis is more important than ever.
The challenge of sustaining long-term growth in the transition region raises questions about the respective roles of government and the private sector. Many governments have, at one time or another, actively pursued various forms of industrial policy. Although the experience has often been quite negative, some recent instances show that there can be justification for selective industrial policy — something that goes beyond the implementation of so-called “horizontal” policies affecting all participants in the business environment. Targeted or “vertical” policies can, for example, be deployed to address failures in markets.
Baltic R&D
There are several areas where intervention may be warranted in some transition countries, particularly in financing innovative activities, helping to form clusters of economic activity and building the key capabilities needed to diversify and improve product quality. Among West European countries, Finland has promoted itself as an attractive location for internationally competitive companies. It has put a national innovation system (NIS) at the center of its science and technology policy and directed increased public research and development spending towards commercially viable projects.
In the transition region, the three Baltic states have dramatically increased their R&D activity in the past decade and are moving toward this type of model. However, to avoid the pitfalls that clearly exist, such vertical industrial policy should avoid targeting specific products and instead focus on activities that are, in so far as possible, subject to the disciplines of market competition and private sector participation. Moreover, recent experience in the transition countries shows that the way in which such interventions are designed will be critical to their success or failure.
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Global Financial Crisis: Eastern Edge
Their economies’ new openness set them up for a fall, but the stars of the former Soviet bloc will rise again.
Erik Berglof, Chief Economist, European Bank for Reconstruction and Development
25 December 2008
Over the past several years under difficult domestic circumstances, the countries of Eastern Europe have moved away from centrally planned economies and embraced globalization, inviting Western companies and financial institutions to invest. Unfortunately, when the global financial crisis hit, this very openness turned these transition countries into unwitting victims of the contagion.
In the financial sector, stock markets have plunged, currencies have been put under pressure and several countries have experienced rapid capital outflows. Growth in the region has decelerated from 7.5 percent in 2007 – the highest level since transition to market economies began – to a likely 6.3 per cent in 2008. The slowdown is coming from the rapid decline of key export markets, more expensive credit and the shutdown of traditional lending channels. The countries are struggling not just because of the crunch at local banks, but also because of the increasingly important parent banks, foreign financial institutions that are facing dismal prospects at home and abroad. Countries are also hit directly through lower credit ratings and speculation against their currencies.
The focus of policymakers has quickly shifted from containing inflationary pressure to protecting domestic financial institutions and mitigating the impact on the real economy. The scale of the crisis is potentially overwhelming for individual governments, but within their limitations, most countries have taken appropriate policy responses.
What is clear is that the general level of risk and the likelihood of a significant slowdown have risen substantially. Rapid credit growth in many transition countries in recent years has raised questions about the quality of bank portfolios and internal risk management systems. While tighter policy and stricter prudential regulations are required to bring about more sustainable rates of credit expansion, the deterioration in the overall financing environment could result in far more severe contractions than have been predicted.
The crisis is a challenge to the East European growth model that has relied on extreme levels of openness to trade and capital flows. Economists have to go back the United States in the 19th century to find a similar example of growth. The large current account deficits have been financed primarily by foreign direct investments. Cross-border financial integration has been unprecedented, with most Eastern European banks controlled by foreign parents. This model, having generated economic growth and institutional change, made these countries more resilient.
What made these countries vulnerable as the crisis intensified was the exposure of the private sector to movements in foreign exchange. Foreign currency borrowing has increased everywhere in the economy. Car loans in Swiss francs and mortgages in Japanese yen have been common. These excesses were often promoted by foreign banks and ignored by the regulators in their home countries; local regulators were essentially powerless, and instruments available to monetary authorities to stem the rapid growth of overall credit were limited by the strong influence of the foreign banks. It was also symptomatic that Hungary, the country where these practices have perhaps been most wide spread, was the first to be hit by the crisis.
The crisis is also a challenge to the European transition model based on rapid institutional change supported by the external anchor of European enlargement. However, as with the basic growth model, the problem is not in the model itself, but in its implementation.
Major Risk
The prospect of joining the European Union drove the remarkable changes in Central and Eastern Europe. That prospect now supports the implementation of difficult economic and political reforms in Southeast Europe as documented in the annual Transition Report from the European Bank for Reconstruction and Development (EBRD). The stronger the admission prospects and the closer in time for membership, the greater the leverage. Even some countries of the former Soviet Union, like Ukraine and Moldova – or Turkey, where potential EU membership is far into the future – are playing an important role in promoting change. What made Hungary vulnerable was capital liberalization with huge foreign exchange exposure, large fiscal imbalances and inflation that prevented the country from joining the euro zone.
A major risk of the global financial crisis is that the attention of policymakers will be diverted from the long-term growth challenges. Over the medium term, the scope for the transition economies to sustain high growth remains substantial. A large body of empirical research suggests that the countries that have implemented key market-enabling and market-deepening reforms – such as price liberalization, privatization and financial sector reform – have reaped benefits in terms of growth.
The challenges now are to implement the often more difficult and protracted market-sustaining reforms (such as competition policy, governance and company restructuring) that are essential for long-term growth, while trying to surmount the shorter-term pressures coming from the international economic situation. Failure to keep inflation under control and to ensure the stability and functioning of the financial system will make it hard, if not impossible, to effectively implement policies aimed at raising the long-term growth potential of a transition economy.
“Car loans in Swiss francs and mortgages in Japanese yen have been common. These excesses were often promoted by foreign banks and ignored by the regulators in their home countries; local regulators were essentially powerless.”
According to the EBRD/World Bank Life in Transition Survey in 2006, many people in the region have found transition to be a very difficult experience but have remained optimistic about the future. There are good grounds for such optimism. Most transition countries have continued to make economic progress and have largely sustained the momentum of reforms necessary to reinforce growth. Nevertheless, events that have originated outside the region, combined with shortcomings in policy and institutions within it, now pose major risks of instability and recession. Furthermore, implementation of more complex market-sustaining reforms will be essential.
Finding resources and political will to implement these reforms will prove exceedingly difficult in the current environment. Many people associate the current problems in the region’s financial systems as evidence of the weaknesses of the market economy. Indeed, in many countries there is a serious risk that economic reforms could be reversed and achievements over the past two decades could be undone. Supporting the reform agendas through benchmarking and deeper analysis is more important than ever.
The challenge of sustaining long-term growth in the transition region raises questions about the respective roles of government and the private sector. Many governments have, at one time or another, actively pursued various forms of industrial policy. Although the experience has often been quite negative, some recent instances show that there can be justification for selective industrial policy — something that goes beyond the implementation of so-called “horizontal” policies affecting all participants in the business environment. Targeted or “vertical” policies can, for example, be deployed to address failures in markets.
Baltic R&D
There are several areas where intervention may be warranted in some transition countries, particularly in financing innovative activities, helping to form clusters of economic activity and building the key capabilities needed to diversify and improve product quality. Among West European countries, Finland has promoted itself as an attractive location for internationally competitive companies. It has put a national innovation system (NIS) at the center of its science and technology policy and directed increased public research and development spending towards commercially viable projects.
In the transition region, the three Baltic states have dramatically increased their R&D activity in the past decade and are moving toward this type of model. However, to avoid the pitfalls that clearly exist, such vertical industrial policy should avoid targeting specific products and instead focus on activities that are, in so far as possible, subject to the disciplines of market competition and private sector participation. Moreover, recent experience in the transition countries shows that the way in which such interventions are designed will be critical to their success or failure.
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