Has the Catching-up Process in Eastern Europe Ended?

The EBRD Transition Report 2009, published at the end of last year, shows a reduction in GDP for the whole EBRD region of -6.3% in 2009. Modest growth is forecast for 2010. This shows that world-wide the EBRD region was hit most strongly by the present crisis. Latvia  (-16%), Armenia and Ukraine (each -14%) were affected most, but Russia which accounts for more than 70% of the region’s GDP also shrank by 8.5%. While we in the Western countries talk about the most severe crisis since World War II or since the Great Depression, our co-citizens in the EBRD region are experiencing already the second deep crisis within the last 20 years. The celebrations of the Berlin Wall falling 20 years ago all seem to omit the deep economic and social crisis which hit the ex-Communist countries during the first half of the 1990’s. In many countries this amounted to “losing” half their GDP. This recurrence of a deep crisis might to some extent explain the deep frustration, the political fragility and the “reform-fatigue” in many of these countries.

The growth model of the ex-Communist countries after the change followed a similar pattern in all countries, if at different speed and intensity. “Shock therapy” propounded, among others, by Jeffrey Sachs and other Anglo-American advisers meant dismantling existing institutions, liberalizing prices and privatizing state-owned companies in as rapid a sweep as possible. While a minority of economists argued for a sequential strategy by first building market-based institutions and then liberalizing gradually, the “shock-and-awe” proponents found the ear of the newly elected or self-appointed politicians.

After a deep “adjustment recession” with devastating costs in terms of human fates, with dismantling of social institutions which had previously been supported by the state-run companies, with mass emigration to the West (frequently of the most innovative, best qualified persons), with “voucher” privatizations where most assets eventually ended up in the hands of “oligarchs” who had connections to or were themselves previously politically powerful persons, from the late 90’s strong GDP growth started to take hold. Most of the financial sector institutions (banks, insurance companies, stock exchanges, leasing companies) were taken over or founded by Western banks, a large part of the financing of private-sector companies, many of which were affiliates of Western firms, came whole-sale through the Western Banks, since savings in these countries were insufficient to fund the huge public and private sector investment requirements. Large current account deficits were the result, except for countries with large energy and mineral resources. The manufacturing industries in Central and Eastern Europe were closely linked to the supply networks of Western automobile, electrical and machinery industries, often founded as foreign direct investments by their mother companies. This resulted in a very strong export orientation of many of these countries (also those further to the East) towards the European Union. Also today, many of these countries have strong or nearly exclusive export ties to the EU – at the expense of a more stratified export portfolio.

The crisis in the EU countries (-4%) hit EU imports – and thus exporters – very strongly. Many countries experienced reductions in exports of more than 20% in 2009. Since the crisis is global, reductions in EU exports could not be compensated by increases in exports to other regions, also because no export marketing channels had been built up previously.

Today, the crisis in many of the EBRD countries of operation is not only an economic crisis, but also a social crisis with rocketing poverty rates, and a political crisis with weak governments, strongly divided political parties, with populists promising easy solutions and with xenophobic excesses.

It has become obvious that the previous, seemingly very successful growth model of the last decades is not sustainable. It has proven to be fragile, because it relied too much on (cheap) foreign financing, on the strength and resilience of the EU economy as a destination for exports, on increased industrial integration into the EU value chains. While this model – tying a whole region closely to the EU – still has validity for the future, its advantages will need to be complemented by a more “indigenous” and regional development model. And: a future growth model will have to have more modest goals. Growth rates of 5%-7% and more will not return in the decades to come. This implies that the speed of the catch-up of the EBRD region with the more advanced countries of the EU will slow down significantly.

Several factors explain this slower, more modest pace in the future:

–         External financing will be lower. Western banks are themselves struggling to repair their balance sheets, both in the West and the East; risk perceptions which had been “exuberant”, will overshoot and lead to a new risk aversion by external financiers. As a result, future financing will have to come more strongly from internal, domestic sources, supplemented by IFI financing and some selective external financing. Countries will also need to safeguard against capital flight and step up their efforts to enforce taxation and create incentives for savings.

–         The international division of labor within Europe and its Eastern neighbors – which has led to building up close supply chains in these countries – will slow down, both because jobs will be needed in the West and because some of the stronger environmental rules will favour “close-to-home” production for reasons of reliability and ecological footprint. This will force the EBRD region to invest more into technological advance, by means of R&D and investments into education.

–         Countries with flexible exchange rates and high rates of financing in hard currencies will have to struggle with strongly increased real burdens of debt as a result of devaluations. Non-performing loans are already increasing strongly, banks will have problems with their balance sheets – which again will impede their new lending to companies.

–         Countries with fixed exchange rates are struggling to maintain their pegs. Their adjustment mechanisms are severely restricted, the danger of the one or the other sovereign default is imminent. For these countries, credible exit strategies need to be developed with the help of international institutions. Severe and longer-lasting recessions are very likely.

–         Mineral and energy-resource rich countries have built up significant financial reserves in the past; but their insufficient diversification of their economies – mainly as a result of high raw material prices and of lacking political will – will lead to a rapid depletion of reserves. Faster and more directed diversification efforts are needed to safeguard the future development.

–         The high growth rates until 2007 have led to a vastly deteriorating income distribution in many countries. Thus, the purchasing power of the population is concentrated in very few hands and does not support mass consumption. Efforts towards a more equal distribution of income will increase both effective demand and higher savings, to be rechannelled into investment. A stronger local financial market should also help to decrease the high demand for (apparently) cheaper hard-currency loans.

–         Regulation must reduce the high risk of hard-currency loans for consumers and small and medium-sized enterprises which have no income in foreign currencies. Both information campaigns about the risk of devaluation, compulsory hedging instruments and regulatory limits – plus the help of international financial institutions – need to be installed, in order to shield average consumers from predatory financial adventurers.

–         Frequently it is not only the attractiveness of the high-income EU as export destination which led to a regional concentration risk of EBRD region’s exporters, but also political animosities from the past which prevented  more regional trade relations. Export diversification, complementarities from previous times, re-juvenation of old trade relations (e.g. between the previous Yugoslav republics or the republics of the Soviet Union) are needed to complement trade with the EU. If successful, this might also lead to higher-value-added production and export and more producer influence on prices.

It is futile for the EBRD region to hope for a revival of EU trade as a way out of the crisis. EU countries have run up huge budget deficits during the crisis and will have their hands full with their own problems. Growth prospects for the EU – which in their Lisbon strategy had been aiming for 3% – are closer to 1% for the next decade – which also dampens import demand. Whether a common EU recovery program (beyond what was agreed a year ago) will be enacted, is uncertain. A new advisory panel has been appointed which met in Madrid the first weekend in January.

On balance, the EBRD region will have to base its growth model of the future much more than hitherto on domestic and neighbourhood relations. This requires a strong impulse in terms of a change of economic policy direction, not away from the EU integration model, but in addition to it.

Macroeconomic policies to address the existing current account imbalances will have to be put in place; exchange rate regimes need to be re-evaluated; industrial policies (horribile dictu!!) will have to be devised; new trade channels need to be opened, closer to home; R&D policies will be required to set the basis for higher value production; regulatory regimes both with respect to competition rules, to public (network) services, and to financial markets will need to be devised – the latter together with international regimes; capital and tax flight efforts must be fought vigorously (including domiciliation of firms in tax havens), in order to secure the capital and revenue base for the build-up of a social sector; social sector policies must be developed in order to insure citizens against existential risks; incomes and labor market policies must counteract further labor emigration and the return of the diaspora (to rely on remittances for financing is not a sustainable option). In short, EBRD countries must – together with international financial institutions – engage in strong policy reform, in order to reduce the dependence of their countries on the EU. The EBRD region must put itself on its own two feet.



Filed under Crisis Response, European Union, Financial Market Regulation, Fiscal Policy, Socio-Economic Development

2 responses to “Has the Catching-up Process in Eastern Europe Ended?

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