With all eyes on the euro area, it is easy to forget that only a few years ago the emerging economies of Europe, from the Baltic to the Black Sea, went through a deep economic and financial crisis. This crisis is the topic of a new book that we will introduce to the public this week in Bucharest, London, and Vienna.
One lesson is that your best chance to prevent deep crises is forcefully addressing booms before they get out of hand. Another is that even crises that look abysmal can be contained and overcome— policies to adjust the economy and international financial support do work.
In the half decade leading up to the crisis, easy global financial conditions, confidence in a rapid catch-up with western living standards, and initially underdeveloped financial sectors spawned a tremendous domestic demand boom in the region. Western banking groups bankrolled the bonanza, providing their eastern subsidiaries with the funds to extend the loans that fueled the domestic boom.
Economic growth was impressive, but underneath there was much to worry about. Current account deficits were as high as 15-25 percent of GDP in the Baltic countries and Bulgaria; private sector credit surged, much of it denominated in foreign currency; housing prices boomed; and non tradable sectors, such as construction, became bloated. Governments also contributed to the problem, using buoyant taxes to fund rapid spending growth. While headline fiscal balances looked good, the underlying health of public finances deteriorated rapidly.
The crisis in emerging Europe was an accident waiting to happen. Time was up when Lehman Brothers defaulted in September 2008. As banking groups in Western Europe came under pressure, new funding for the subsidiaries in emerging Europe stopped. This pulled the rug out from under credit and domestic demand booms—just when the collapse of global trade pummeled the region’s exports.
The economy went into a tailspin, housing prices collapsed, and unemployment surged. The region’s economy contracted by 6 percent in 2009, but that is an average: some countries experienced recessions comparable to the Great Depression in the United States, though some with less extreme precrisis booms, more policy space, and better crisis management escaped more lightly.
But it could have been worse had governments not moved quickly to stabilize their financial systems and get their public finances back under control. The international community committed €100 billion of financing under IMF-supported programs to stave off regional financial meltdown. Western banks contributed by refraining from recalling previously provided financing in an effort coordinated under the Vienna Initiative.
One lesson the episode drives home is that countries are better off if they deal with domestic demand booms before they get out of hand.
- Policies to fight bad economic times should not only be preserved for bad times. Taking away the punch bowl in good times helps mitigate the build-up of imbalances and creates buffers to fall back on when fortunes turn. Fiscal policy should keep a lid on expenditure growth in boom periods, even if the government’s fiscal balance is in surplus and higher spending seems easily affordable.
- Keeping credit growth in check is critical. It requires more effective cooperation with bank supervisors in Western Europe, where emerging Europe’s banks are headquartered, and a tougher line on foreign-currency lending.
- Some countries in the region, such as Poland, implemented policies in this vein; it was rewarded with avoiding a recession in 2009 and achieving healthy growth in the subsequent years.
Another lesson is that determined adjustment after a crisis works. Many countries in emerging Europe implemented highly demanding adjustment policies, including reducing government debt and deficits, bank restructuring, labor cost reductions, and other measures to restore competitiveness. It is paying off. Currency and systemic banking crises were largely avoided. Growth in the region has bounced back—4½ percent in 2010-11—unemployment has started to come down; the repair of public finances and financial systems is well underway; and external flow imbalances have disappeared. Most encouraging is the renewed focus on exports. Estonia’s sales abroad, for example, now account for 100 percent of GDP, up from 70 percent of GDP in 2007.
Emerging Europe is not out of the woods yet. External debt is still high, fiscal repair has further to go, and the banks need to resolve a large stock of non-performing loans. Moreover, the crisis in the euro area poses new challenges considering its tight linkages with emerging Europe.
But the experience of emerging Europe should give hope to other countries that face tough adjustment challenges—including in the euro area. Risk premiums for sovereigns in emerging Europe are now often lower than those in Western Europe. Who could have imagined that in 2009? That year, emerging Europe was the sick man of Europe, but no longer.