Fiscal Policy Consequences of the Crisis in Eastern Europe

The crisis in Eastern Europe has shown up the fragility of the accepted growth and transition model. This was based basically on four pillars:  financial integration, trade integration, value chain integration and institutional integration with the EU, the latter based on gradually adopting the tenets of the acquis communautaire. Different countries, depending on their geographical vicinity to the EU and other specifics, adopted this growth model to varying degrees.

Most spectacular, arguably, was financial integration which resulted in large parts of the financial sector, especially banks, in the region being owned by Western banks. In some neighboring countries, like the Czech Republic, Slovakia, the Baltics, Albania, Croatia, Romania, Poland and Hungary, more than 90% of bank assets are owned by foreigners. But also in Armenia, the Ukraine and the Kyrgyz Republic, more than 50% are owned by foreigners. While foreign bank ownership, on balance, cushioned the crisis (since they maintained their activity levels in the countries), it also brought additional problems, mainly by being conduits of financial crisis contagion and for very large shares of hard-currency denominated loans to unhedged borrowers (those without incomes in hard currency), which increased the real burden of debt significantly in countries which during the crisis had to devalue their currency. This, in turn increased the incidence of non-performing loans for the banks.

Trade integration was the second channel, exerting a strong pull on exports from these countries. Many countries saw it also as a sign of increasing maturity to be able to export to (rather demanding) EU markets – often at the expense of neglecting other, more traditional, historical channels of trade – frequently shunned because of previous political experience. Trade patterns differ among Eastern and Southern European countries, but EU exports and imports constitute a major share of most of these countries’ foreign trade.

This was enhanced by the third channel, i.e. integration into EU-dominated value chains: outsourcing of labor-intensive productions from EU core countries towards the South and East, but also Greenfield foreign direct investments promoted this process; examples are the  automobile and component industries in Slovakia and Hungary, machinery and other metal manufacturing operations in many countries, food chain investments in the Ukraine, and others. While these patterns enabled the countries to grow fast before the crisis, being pulled by the success of the major EU manufacturers in world markets, they also pulled these countries down when the automobile and investment industries in general fell into crisis.

Llast but not least, the drive of many of these countries towards EU accession, but also the policies of international financial institutions, like EBRD, which demand corporate governance standards and environmental and technical standards of the EU for many of their operations, led to significant institutional and legal change approximating the EU-relevant body of regulations. Again, inter-country differences exist.

These channels, especially the first three, were responsible for crisis contagion from West to East. The region suffered severe GDP losses in 2008/2009, in 2009 GDP for the region as a whole fell by -5.5%, in some countries, like the Baltics and Ukraine by more than 15%. For many of these countries, this has been already the second severe crisis in the course of only  20 years. This needs to be remembered when one observes the sometimes significant political upheavels resulting from the crisis. We in the “West” recall this as the worst crisis since World War II or since the Great Depression, but for our neighbours there is a much more recent devastating memory.

Recovery is slow: foreign capital flows, the drivers of very high growth, will remain low for a long time to come; EU growth to support export demand is forecast to be especially low; the value-chain integration has cost many jobs, but may resume once the recovery takes hold in the West. The upshot of all this is that in the future a rebalancing of the growth model implying less dependency on the West will be necessary: the region will have to rely much more heavily than before on domestic growth drivers than on foreign ones. This will result in lower growth than before the crisis, but – given the large catching up potential of these countries – can still be expected to be about twice that of the EU for many years to come. A more domestic/regional growth pattern may in the end be more “organic” and sustainable than the previous one. But this does not mean to abandon integration towards the EU, rather complementing it with more domestic growth. Attention to domestic and regional demand, complementary export drives into neighboring and third countries will be necessary to lessen EU dependency and to make up for lost FDI and financial flows from Europe.  Bringing larger parts of the grey economy into the open by reducing institutional and corruption-induced barriers to entrepreneurship, attention to tax compliance, but also efforts to upgrade the innovation potential of these economies, i.e. industrial and innovation policies, will be necessary. Measures to prevent capital flight from these countries should increase and complement scarce savings; confidence in the future socio-economic development may also lessen incentives of many, especially young, persons to seek employment abroad. This might in the medium run lessen the stringent human capital restrictions as a result of some of the best educated and most dynamic persons leaving the country.

Fiscal Policy Consequences

Debt levels in the region are much lower than in the West (see table 1). But budget deficit ratios (relative to GDP) are grosso modo as high as in the EU. Macroeconomic conditions keep putting pressure on the fiscal position: private sector deleveraging in the face of excessive private debt levels reduce tax revenues and lead to higher government expenditures, as do automatic stabilizers. Medium-term fiscal frameworks need to be designed so that budgets can benefit from the expected recovery. They would also help the assessment by financial markets of the credibility of budget consolidation efforts. Short-term considerations need to be balanced with more medium-term ones. Rating agency and financial market risk perceptions of these countries exert additional pressure to reduce deficits as financing costs become prohibitive and also crowd out more productive public expenditures. IMF programs for some countries help relieve short-term budget problems, but require stringent medium-term measures to constrain budget dynamics. The demographic ageing situation in many countries is even less favourable than in the demographics-challenged EU countries. In addition, “new” challenges, like environmental targets, educational efforts and the frequently inadequate social sectors also exert medium-term pressures.

Table 1: Deficit and Debt Situation 2009 in the EBRD Region

  Deficit to GDP  Debt to GDP
CentralE/Baltics -6.2 40.4
Southeast Europe -4.5 33.2
East Eur/Caucas -8.0 29.3
Russia -6.2 7.5
Centr Asia -5.0 30.1
Mem: EU -6.8 73.6
Mem: Eurozone -6.3 78.7


While high deficits and deteriorating debt levels would militate for fast and radical budget consolidation (which was already put in effect by the Baltic countries), effective demand considerations and the need to strengthen the future growth potential of these countries would argue in favour of a more delayed and measured approach. However, especially the small countries with weak industrial bases, are heavily dependent on financial market assessments and have little choice in this respect. The situation is a bit less stringent for larger countries, giving them more fiscal space.

The fiscal policy task for policymakers is daunting: rebalancing the growth model because of lower external financing and FDI-driven know-how transfer, a restructuring of tax systems towards more growth orientation, containing pressures on public expenditures in light of large infrastructure needs and the need to spend more on education and innovation, the fixing of socially and economically very important health and pension systems – all these tasks need to be fulfilled at a time when the major export market, the EU, is itself in a very fragile recovery mode.

However, relative to the previous crisis after the breakup of the Socialist system, the present one seems better manageable, since countries have, after all, made many important steps towards functioning market economies, albeit incomplete ones. The crisis has shown the importance of strong institutions in mitigating the effects of the crisis. While much has been achieved, many countries are still plagued by inadequate institutions. In addition, the political divisions in many countries are growing during the crisis. This frequently prevents joint actions, supported by large majorities in the parliaments and the population from being taken. The crisis has also brought forward in many groups nostalgia for the collapsed communist/socialist system, especially in more remote regions, away from the capitals, and among the less well educated, as well as among pensioners and persons on social assistance. There is a real danger that much progress made with transition so far may keep being stalled, also because of widespread reform fatigue. It is of utmost social and political importance to bring back into the workforce as many people as possible, as quickly as possible. Given the very high rates of unemployment, policymakers also need to consider public works programs[1] and the use of labor intensive methods of production. Some international financial institutions, as well as the European Union, might need to reassess their prescribed procurement rules, in order to enable firms to bid with low productivity, but high labor content methods.

[1] I owe this idea to Eduard Hochreiter


1 Comment

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

One response to “Fiscal Policy Consequences of the Crisis in Eastern Europe

  1. Pingback: Fiscal Policy Consequences of the Crisis in Eastern Europe « Föhrenbergkreis Finanzwirtschaft

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