Can Eastern Europe escape the eurozone crisis?
Countries in Eastern Europe have until now shown remarkable economic resilience, after being hit harder by the 2008–2009. But their economic future relies on a new model of growth, argues Jana Grittersova on Euroactiv.
Jana Grittersova is a professor at the University of California-Riverside and an Austrian Marshall Plan Foundation Fellow at the Johns Hopkins University School of Advanced International Studies.
“The eurozone crisis continues to cast a long shadow over the global economy. Until now, however, countries in Eastern Europe – some eurozone members, others not – have shown remarkable resilience, after being hit harder by the 2008–2009 global credit crisis than any other part of the world.
Ten-year government bond yields for countries like Poland and the Czech Republic are lower than for Italy and Spain.
Can Eastern Europe escape? It is looking doubtful, as storm clouds have gathered. In its latest economic forecast, the European Bank for Reconstruction and Development in London predicts that growth in Eastern Europe will slow from 4.6% in 2011 to 3.1 % in 2012 – assuming that Greece stayed in the eurozone. Hungary and Slovenia are likely to go into recession.
Trade, fiscal and financial channels make emerging Europe highly vulnerable to eurozone turmoil. The European Union is the primary destination of East European exports: 87% of Slovakia’s goods exports, for instance, go to other EU countries, and Germany alone absorbs one-third of Czech exports.
As demand in the eurozone falls, so do the prospects for East European exports. The damage could be particularly bad in certain sectors. Countries in which the cyclical car industry is sizable – the Czech Republic, Hungary, Poland, Slovakia and Romania – are vulnerable. Countries like Estonia, whose exports are concentrated in high-tech machinery niche markets, could fare better. Southeast European economies with fairly low export bases should be spared too.
Overall, Eastern European governments have been more fiscally prudent than much of Western Europe, reporting debt to gross domestic product ratios below 60%, which is one of the Maastricht Treaty’s criteria for admission to the eurozone. But Poland and Hungary may face fiscal problems without some belt-tightening.
The financial channel offers the most cause for concern. Eurozone banks own most banking sectors in emerging Europe, with the exception of Slovenia. Stronger funding constraints for eurozone banks will force them to withdraw liquidity from Eastern Europe, squeezing credit. Some eurozone banks may withdraw from the region altogether. Romania, Bulgaria and the Balkan countries could be hit particularly hard by any further escalation of the Greek crisis, since a number of Greek parent banks hold subsidiaries in these countries.
Banks are just one financial channel. In Southeastern Europe, declining workers’ remittances may also hold back growth. Greece is the main host country for Albanian migrants, for example; remittances from Greece represent 4% of Albania’s gross domestic product.
Parts of Eastern Europe are likely to fare better than others. Baltic experience suggests that reforms can succeed even in times of financial distress and that devaluation is not a panacea to regain competitiveness and restore growth.
When the global financial crisis hit, countries with currency boards – the Baltic states and Bulgaria – faced a challenge similar to that confronting southern eurozone countries now. They did not opt for devaluation, advocated by many commentators, but instead implemented substantial cuts in incomes and expenditures in public administration, health care, and education, known as “internal devaluation.”
The Baltics experienced deep economic contractions (an 18% drop in Latvia, 15% in Lithuania and 14% in Estonia), but they all managed to bounce back and see strong export-driven growth. Their projected growth figures are expected to outperform.
East European countries with flexible currency regimes were not forced to embark on austerity programmes. The Czech Republic, Hungary, Poland, and Romania all devalued their currencies. As a result, they saw less contraction in output. But depreciation, even though it might temporarily increase export competitiveness, may pose a challenge for banks that have granted foreign-currency denominated loans.
There is a continuing exchange rate risk associated with heavy consumer borrowing in foreign currencies. And due to fiscal problems in the eurozone, there is also a risk of increased volatility of exchange rates that can negatively affect trade and debt servicing.
Those countries that joined the eurozone in recent years – Slovakia and Slovenia – benefited from minimised shocks related to currency risks in a time of distress. Despite the turmoil, the EU continues to provide a protective umbrella, not only through joint financial programmes with the IMF but via transfers from the Union’s structural, agricultural support and cohesion funds, which compensate for the reduction in capital inflows. Annual net transfers from the Union’s funds to the Baltic countries should amount to 3.6% of their combined GDP in 2009−2013.
But have East European countries created conditions for long-term growth? Their growth model has relied on foreign ownership of manufacturing industries and financial sector. The main source of comparative advantage has been a combination of low taxes, relatively low labour cost and skilled population capable to assemble complex consumer durables designed in Western Europe.
Quick enhancements in productivity have been financed through foreign direct investments and integration into cross-border production networks. This economic model, relying on foreign capital, has been challenged by declining foreign investments.
Some countries responded to the crisis by making their economic models more efficient, implementing reforms that combined austerity and structural reforms, while retaining social safety nets. But long-term growth requires a new round of reforms to overhaul the current debt-driven model of growth.
The focus should be on generating domestic sources of competitiveness and productivity improvements. This would require more investments in research and innovation, allowing emerging Europe to move to higher-value-added sectors. Further reforms of labour markets and welfare systems are also necessary.
To sustain this new growth model, a new financing model relying on local currency capital markets and local sources of finance is needed.
Emerging Europe as a whole is better prepared to withstand the eurozone shock now than it was in 2008: countries’ economic fundamentals have largely strengthened; external positions have improved; exposure to foreign banks decreased; bank balance sheets are stronger. But its economic future relies on a new model of growth.”
Published with kind permission of Euroactiv