The Global Financial-Economic Crisis and Emerging Europe:

Determinants, Effects, and Political Risks

Introduction

Emerging Europe was, on average, the worst performing region during the GFEC

This presentation examines: (1) why the economies of emerging Europe

performed so badly; and (2) what effects this is likely to have on the future

development of the economies of the region, i.e., has the crisis changed the future economic trajectory of the region?

(3) how is this likely to shape the political risk environment in the near future?

Summary 1. Convergence: pre-crisis performance in

comparative perspective 2. Crisis: impact of the crisis on the economies of

the region in terms of ‘growth reversals’, plus determinants of poor performance in comparative perspective

3. Recovery: how strong and of what type? 4. Challenges: what is likely to be different about the

post-crisis growth models, and what will the drivers of growth be?

5. Political risks: how is the crisis likely to shape the future political risk environment?

Convergence Average GDP growth over 2000-2007 was among the

fastest in the region and the world…

Convergence …leading to progress in convergence with EU per capita

income levels…

Convergence What explained this level of performance?

Institutional reforms of 1990s – most countries become market economies by 2000, except Belarus, and several Central Asian economies.

Facilitating a more rational allocation of resources than under socialism - growth in tradables, services, etc., with a corresponding decline in the share of heavy industry.

Liberalization of domestic economies and transnational sectors sees rapid integration of region within global economy through high trade openness (e.g., ratio of foreign trade to GDP increased faster than anywhere else, EE has a greater share of global exports than China).

Undervalued real exchange rates compensate for institutional weaknesses (Rodrik, 2008), boosting competitiveness in 1990s and early 2000s.

Prospect of EU accession helped boost trade and investment ties between core EU economies and CEE, e.g., FDI penetration, foreign bank ownership, other capital flows, etc.

Convergence: growth models

1995-1999 2000-2004

Convergence

Convergence

Convergence

Convergence Signs of overheating before crisis?

Increased capital flows (not a region-specific phenomenon over this period) lead to real effective exchange rate appreciation from mid-2000s onwards

While competitiveness is only marginally affected (exports still grew at a fast pace), growth models switch from transition emphasis on services and tradables sector growth to a a rise in domestic consumption and investment based on rapid growth in imports of goods and capital (unlike east Asia)

Components of GDP growth over period sees declining contribution of net exports to growth

This is justified as a natural element of convergence, with expansion in residential investment, services, etc., considered desirable given the socialist legacies

Growth rates reach record levels in some countries, but evidence of overheating (e.g., CA balances, inflation, credit growth, house prices, etc) in many cases

Crisis ‘Growth reversal’ during GFEC among the worst in

the world…

Crisis …notwithstanding considerable intra-regional

variation

Crisis What explains the severity of growth reversals?

• A number of hypothesized determinants:• 1. Financial vulnerabilities: large and persistent current

account deficits; excessive expansion of domestic lending; foreign currency exposure, etc.

• 2. Trade vulnerabilities: dependence on raw materials (some CIS), or EU-oriented manufactures; unsophisticated export structures; excessive trade openness; export of labour (remittances), etc.

• 3. Institutional vulnerabilities: perhaps poor rule of law, corruption, policy instability, absence of financial sophistication (!), accounted for region’s poor performance?

Crisis

The severity of growth reversals: determinants • To test the strength of these explanations, the size of the

growth reversal is regressed on 23 independent variables, each attempting to measure financial, trade, or institutional vulnerabilities.

• As well as looking for relationships within the EE region, regressions including as many other countries for which data are available are also carried out.

• Consequently, region-specific factors can be identified. • Large number of specifications are considered; here only

significant findings are presented.

Crisis Bivariate regressions of growth reversals on hypothesized determinants in emerging Europe…

Variable Coefficient p-value Observations Adj. R2

Average annual GDP growth, 2000-07 (per cent) -0.946 0.000 25 0.145

GDP per capita, log, PPP, 2007 -2.239 0.000 25 0.049

FDI stock, 2007 (per cent of GDP) -0.011 0.000 24 0.002

FDI stock change, 2000-07 (per cent of GDP) -0.002 0.000 23 0.000

Remittances, average, 2003-2007 (per cent of GDP) -0.054 0.000 25 0.003

Private sector financial balance, average, 2003-07 (per cent of GDP) 0.273 0.002 25 0.065

Primary and resource-based exports, 2007 (per cent of industrial exports) -0.981 0.000 23 0.001

Sophistication of export basket (ExpY), average 2005-07 0.000 0.000 22 0.003

Medium- and high-tech export capabilities, average (2005-07) -10.067 0.000 22 0.017

Stock of private sector credit, 2007 (per cent of GDP) -12.674 0.000 25 0.121

Private sector credit growth, 2003-07 (per cent of GDP) -18.269 0.000 25 0.151

Stock of external debt, 2007 (per cent of GDP) -0.082 0.000 25 0.148

External debt growth, 2000-07 (per cent of GDP) -0.082 0.110 24 0.196

Share of foreign banks in banking assets, 2005 (per cent of total assets) 0.024 0.000 23 0.010

Institutional quality, 2007 -5.390 0.000 24 0.121

Financial sophistication, 2007 -4.399 0.000 24 0.092

Current account balance, average 2003-07 (per cent of GDP) 0.230 0.003 25 0.040

Government net lending/borrowing, average 2003-07 (per cent of GDP) -0.368 0.000 25 0.023

Central government gross debt, average 2003-07 (per cent of GDP) 0.219 0.000 25 0.328

Trade openess, 2007 (per cent of GDP) -0.008 0.000 25 0.001

Net exports, average 2005-07 (per cent of GDP) 0.056 0.276 22 0.014

Dependent variable: Growth reversal

Crisis …multivariate models confirm these are the only two significant and robust explanatory variables for emerging Europe sample….

Covariate Model

CovariateCoefficent

Primary and resource-based exports, 2007

(per cent of industrial exports)

Private sector credit growth,

2003-07 (per cent of GDP) Observations R 2

None (1) -2.769 -36.633 *** 23 0.32

FDIstck (2) 0.017 -2.091 -37.555 *** 23 0.33

Δ FDI (3) 0.02 -1.363 -37.468 *** 23 0.33

Remit (4) -0.234 -2.247 -40.325 *** 23 0.37

PFSB (5) 0.007 -2.75 -36.425 ** 23 0.32

ExpY (6) 0.021 -3.959 -34.264 ** 21 0.3

MHTex (7) -20.454 -5.702 -36.980 *** 23 0.35

CredStk (8) -6.834 -4.548 -29.603 23 0.33

ExtDbt (9) 0.024 -2.444 -42.196 ** 23 0.33

Δ ExtDbt (10) -0.022 -3.876 -31.292 * 23 0.33

FBO (11) 0.054 1.607 -37.539 * 23 0.36

InstQ (12) -1.081 -2.466 -33.922 ** 22 0.34

FinSph (13) -2.231 -5.127 -31.92 ** 22 0.33

CAB (14) 0.015 -2.87 -36.337 ** 23 0.32

GvtB (15) 0.036 -3.086 -36.914 ** 23 0.32

GvtStk (16) 0.151 * 0.249 -24.235 * 23 0.44

HdPg (17) 3.231 -3.835 -45.670 ** 23 0.34

Openess (18) 0.012 -2.219 -37.272 *** 23 0.33

Note:

Crisis …multivariate models confirm these are the only two significant and robust explanatory variables for emerging Europe sample….

(1) (2) (3) (4)

FDI stock, 2007 (per cent of GDP) 0.001 0.013 0.004

Primary and resource-based exports, 2007 (per cent of industrial exports) 0.484

Private sector credit growth, 2003-07 (per cent of GDP) -23.248 -23.212 -24.346 * -24.352 *

Share of foreign banks in banking assets, 2005 (per cent of total assets) 0.005 -0.001 -0.005

Institutional quality, 2007 -2.085 -1.430

Central government gross debt, average 2003-07 (per cent of GDP) 0.140 0.140 0.151 * 0.150 **

Trade openess, 2007 (per cent of GDP) 0.031

Observations 23 23 23 23

R2

0.45 0.44 0.44 0.44

Note:

Dependent variable: Growth reversal

Crisis …with global regressions exhibiting similar results….

(1) (2) (3) (4) (5)

GDP per capita, log, PPP, 2007 -1.427 *** -2.681 *** -2.772 *** -1.465 * -1.766 ***

Private sector financial balance, average, 2003-07 (per cent of GDP) 0.057 0.082 0.253 *** 0.226 ***

Private sector credit growth, 2003-07 (per cent of GDP) -0.092 * -0.082 -0.457 *** -0.512 ***Financial sophistication, 2007 1.789 ** 1.062Current account balance, average 2003-07 (per cent of GDP) 0.142 * 0.116Central government gross debt, average 2003-07 (per cent of GDP) 0.053 *** 0.049 *** 0.039 *** 0.041 ***Institutional quality, 2007 0.917 1.45 *Sophistication of export basket (ExpY), average 2005-07 -0.000443 *

CIS dummy -2.127Transition dummy -6.249 ***

Observations 139 144 114 90 90

R2

0.39 0.37 0.38 0.43 0.38

Note:

Dependent variable: Growth reversal

Crisis What does this statistical analysis mean?

• For individual countries, not a lot – each case has its own characteristics (e.g., remittances in Armenia and Moldova)

• But, it does suggest that, on average, many common explanations are not as important as some argue: Trade vulnerabilities largely unimportant (open v. closed,

sophisticated [ExpY] v. basic, raw materials [Saudi Arabia v. Russia], etc)

Most financial vulnerabilities insignificant (FDI stock, foreign bank ownership, external debt, currency pegs, current account balances, etc)

Institutional quality of little importance, in EE

• In short, rate of pre-crisis credit growth and pre-crisis government stock of debt are two most important factors in explaining severity of growth reversals

Crisis And the crisis could have

been worse for emerging Europe

• Vienna Initiative (public-private agreement to stem capital flows).

• ECB only indirectly important.

• As a result, currency turmoil of late 2008, early

2009 is avoided.

• But it does mean capital outflows were slower and more persistent.

Cross-Border Bank Lending to Emerging Markets

(In per cent of 2007 Q4 stocks)

Recovery

Recovery

Recovery Characteristics of recovery in emerging

Europe:• Export-led recovery - CEE benefit from German

expansion; CIS from higher commodity prices and return to growth in Russia

• ‘Credit-less’ recovery & restocking• Current accounts have narrowed rapidly• Sharp swing in private sector financial balances,

with much dampened consumption and investment

• Rates of growth generally anaemic

Recovery Regressions: what accounts for anaemic

recovery?• Size of pre-crisis credit expansion (EBRD, 2010)• Size of post-crisis credit growth• Size of fiscal stimulus – Russia, Poland• Benefits of REER depreciation• Commodity exports/total exports, 2008

Future challenges 1. Credit growth likely to be depressed:

• Debt overhang (NPLs yet to peak in many countries) in many countries/sectors likely to affect supply of and demand for credit.

• International conditions also unfavourable, e.g., increased capital ratios (Basel III) in parent banks, changing regulations, sovereign debt crises in Eurozone, potential reversal of central bank liquidity provision in advanced countries, etc.

2. Fiscal discipline required in future:• Not obviously a trigger for crisis in EE, but balances were

boosted by pre-crisis boom; need for readjustment to lower revenues.

• Moreover, balances have deteriorated in responses to contraction in domestic demand (even in Estonia, Bulgaria, Hungary).

Future challenges 3. Deteriorating demographic profile

• All sub-regions except Central Asia and Caucasus set for dramatic population decline over next 40 years.

• Dependency ratios also due to rise.• Implications for long-term fiscal balances, capacity for debt

servicing, domestic sources of investment (as savings diminish).

4. So, need to shift resources to tradables• Need to raise domestic investment in tradables sectos• Raise productivity (1/3 -1/2 EU) and capital levels (2/3 EU-

15)• Need for complementary policies, such as exchange rate

policy and financial market regulation• And to remove obstacles to investment and improve

business environment through structural policies, e.g., infrastructure, education, labour markets

Political risks 1. Effects of fiscal austerity :

• Most countries of the region are now tightening budgets, most severely in Baltic and SEE regions. But will also be the case in future as revenues contract from boom year peaks.

Can cause deterioration in public services, social welfare, and in quality of infrastructure, all of which will affect business environment.

Also, potential for social conflict over distribution of shrinking pie.

2. Demographic profile challenges: Fiscal austerity reduces scope for orderly solution to

worsening demographic profiles. As well as economic effects (i.e., effect on budgets), there is

the related threat of how the ‘age of ageing’ affects political mobilization, e.g., parties organized around age, onerous tax rates on the young, need for increased immigration, etc.

Political risks 3. Migration risks:

• Inward migration may be the only way to sustain economic growth in some cases – this poses risks in many cases, e.g., in Russia and Ukraine there are many negative attitudes towards groups that are likely to be the source of inward labour flows.

• Conversely, in countries where prospects look bleak, further emigration may be destabilizing, e.g., Baltic republics, Russian educated strata, etc.

4. Failure of structural transformation: Unless investment in tradables occurs, growth and living

standards are likely to be lower, but economic competition may also be reduced.

This could result in lower political competition, leading to greater corruption, tendencies toward autocracy, unaccountable government structures, etc.

Political risks 5. Successful structural transformation:

• But if structural transformation is successful in authoritarian regimes (Kazakhstan, Russia, Ukraine), there is the prospect of new groups challenging the status quo.

• In regimes that have minimal infrastructural power - i.e., increased state capacity through persuasion rather than coercion - new economic development may cause political instability.

6. Below trend growth reducing rent-seeking opportunities: Where elites rule through rent-sharing (Russia, Kazakhstan,

Ukraine, etc), any reduction in either commodity prices and/or economic growth rates, a shrinking rent base may cause distributional conflict.

Summary 1. Pre-crisis performance was among the best in the world, due in

large part to either capital inflows or rising commodity prices...

...but during the GFEC performance was the worst.

2. On average, severity of impact of GFEC a function of rate of pre-crisis credit growth and pre-crisis stock of public debt, although individual cases exhibit specific vulnerabilities.

3. Recovery is export-led, and subdued compared to pre-crisis trend, but events in Eurozone suggest a slower and more sustained convergence may be possible.

4. Future challenges include shifting resources to tradables as domestic demand likely to be lower with limited access to, and capacity to absorb, credit flows, and because of impending demographic trends.

5. Political risks are related to future fiscal developments, demographic challenges, migration patterns, and potential socio-economic development.