By Ajai Chopra

When the global financial crisis spread to emerging Europe in the last quarter of 2008, memories of the Asian crisis of the late 1990s sprang back to life. Would emerging Europe face the same chaotic currency depreciations, mass defaults of banks and companies, double-digit output losses and social unrest that beset several Asian countries back then?

Nine months into the crisis, it is clear that emerging Europe as a whole is not following Asia’s script. But it is also clear that the crisis is evolving differently across countries.

The Baltic countries (Estonia, Latvia and Lithuania) are suffering output declines that already exceed those of the Asian crisis (see chart below).


By contrast, a milder version of the crisis is unfolding in central Europe (by which I mean the Czech Republic, Hungary and Poland, commonly referred to as the CE3) despite a much deeper global downturn than what we saw during the Asian crisis.

Why have the CE3 and the Baltic countries experienced such different fates? An important part of the explanation might be the interplay between balance sheet vulnerabilities from borrowing in foreign currencies and the evolution of exchange rates during the crisis.

Before laying out this argument in more detail, however, I want to stress that the CE3 and the three Baltic economies—all of which joined the European Union in May 2004 and have yet to adopt the euro—are far from homogeneous groups.

For example, within the CE3, macro-financial vulnerabilities before the crisis were most pronounced in Hungary with its high level of public and external debt. In contrast, the Czech Republic and Poland were less exposed to swings in investor sentiment because of sounder fundamentals.

Similarly, important differences exist within the Baltics. For example, Estonia’s pre-crisis fiscal position was stronger than that of its two neighbors. Lithuania had a lower level of external debt, while Latvia’s position was weaker on both counts.

These are just some examples of the differences between these six countries. There are many more, but it would be impossible to do justice to all of them in a short blog post (which is already longer than my other posts). Therefore, readers interested in macro-financial vulnerabilities and economic policies of individual countries should consult the latest IMF country reports, press releases, and articles on the Czech Republic, Estonia, Hungary, Latvia, Lithuania, and Poland, The focus in this blog will be on broadly common regional characteristics and stylized facts that seem relevant for how the crisis is playing out.

With this said, let’s consider the CE3 and the Baltics in turn.

Prior to the crisis, the CE3 resembled Asia in many ways. Current account deficits ranged from 3 percent to 8 percent of GDP (see chart below). Moreover, households and companies in Hungary (and to a lesser extent in Poland) had borrowed heavily in foreign currencies  and were therefore vulnerable to a sharp depreciation in the exchange rate.


Yet unlike the experience in Asia, exchange rate depreciations at the start of the crisis in the CE3 countries soon slowed. Since March 2009, the forint, zloty, and koruna have actually been regaining value, with central banks even leaning against the wind to rein in appreciation and rebuild reserves (see chart below). The modest depreciations have meant that serious distress for foreign-currency indebted corporations and households has been avoided, thus mitigating the adverse impact on jobs and growth that was seen in Asia because of balance sheet adjustments.


But why were the depreciations modest? A part may just have been luck, but there are well-identified factors at play as well.

  • First, in contrast to the soft pegs in Asia, the CE3 currencies were floating, and were arguably only moderately overvalued. The initial depreciations by some 10-20 percent may have been just enough to restore a sense of competitive valuation.
  • Second, the CE3 economies never suffered a full “sudden stop” of capital inflows as in Asia. Wholesale funding markets dried up, but western European parent banks maintained credit lines to their central European subsidiaries. (See also my previous blog post on bank coordination in Europe). In addition, bank supervision and capital levels in emerging Europe have been better than in Asia in the 1990s, helping limit financial sector strains.
  • Third, the task for external financial assistance was therefore mostly limited to replacing temporarily impaired wholesale funding markets. Hungary—the economy most dependent on wholesale and securities funding, given the large amount of government bonds held by non-residents—received a $25 billion emergency financing package from the IMF and other institutions. Poland also secured a $21 billion precautionary arrangement under the IMF’s flexible credit line to support market confidence. But in contrast to Hungary, the Polish authorities have not tapped IMF funds to replace market funding.
  • And fourth, EU membership may have instilled confidence in the region’s long-term stability and catch-up potential due to an accelerated convergence process.

This begs the question of why the Baltics have not been similarly “lucky.” Perhaps the key reason is that they entered the crisis saddled with much larger imbalances. Current account deficits not only dwarfed those in central Europe, but also those in Asia in the late 1990s (see chart below). Hard currency pegs and expectations of early euro entry had helped attract large capital inflows, but these often fed real estate bubbles, caused heavy exchange rate overvaluations, and fostered a substantially larger accumulation of foreign-currency  denominated private debt than in any other region (for an analysis of sectoral balance sheets see, for example, Chapter III of the “Selected Issues” papers prepared for the 2009 Article IV consultation with Estonia).


Faced with such imbalances, governments in the Baltic countries understandably feared the disruptions that a nominal devaluation could cause. Instead, they decided to embark on a course of “internal devaluation”—restoring competitiveness through wage and price declines rather than through a currency devaluation. Indeed, wages in the private sector are falling fast, thanks to the flexibility of these economies.

In addition, it has been necessary to bring government spending in line with the countries’ reduced means. In Lithuania, for example, measures to reduce the fiscal deficit have exceeded 7 percent of GDP in 2009 alone. Latvia is faced with an even greater challenge and as my colleague Anne-Marie Gulde said in a recent interview, “In deciding to maintain the peg, the authorities have chosen a path that puts a heavy burden on fiscal policy in the short term. But even without the end goal of euro adoption to drive policy decisions, Latvia would have faced a very difficult policy environment and would over time have needed to bring expenditures in line with revenues.”

Inevitably, though, the collapse in output in Baltic countries and the need for strong fiscal measures to address underlying budget weaknesses have fed on each other, complicating the task of policymakers.

Sustained effort will be required for the strategy of internal devaluation to succeed, and it will need to be accomplished in a way that minimizes further pressure on economic activity and protects the most vulnerable groups in society at a time already marked by painful adjustment. But because of the prior overheating and major imbalances in the Baltics, balance sheet strains and output losses are unavoidable, with or without a currency devaluation.

This blog post has put forward some preliminary views on the interplay between balance sheet vulnerabilities and the evolution of exchange rates to explain the different trajectory of the current crisis across countries in emerging Europe, compared with the unfolding of the Asian crisis in the late 1990s. It is by no means the last word on the subject—researchers will undoubtedly examine these issues in detail in the coming years. But perhaps this contribution can spark a first round of debate and your views are welcome

Next week, John Lipsky, the IMF’s First Deputy Managing Director, will be blogging from Jackson Hole. He’ll give us his views about what’s next for the global economy. If policies have accomplished their main goal—overcoming the recession—what should policymakers do next? As I mentioned in my blog, one key factor in deciding post-crisis policies is potential output, something John also plans to discuss. So do check back with us on Monday.