Stuck In Transition

The EBRD Transition Report for 2013, published last November, was entitled Stuck in Transition? By the time of the EBRD Annual Meeting of 14-15 May 2014 the cosmetic question mark was no longer appropriate.

In 1991 the EBRD – European Bank for Reconstruction and Development – was set up in London in order to assist the post-socialist transition countries, and to promote their sustainable development as open market economies. Initially the EBRD operated in 28 countries: the 15 Republics from the Former Soviet Union, 6 countries from Central-Eastern Europe (Bulgaria, the Czech Republic, Hungary, Poland, Romania, Slovakia), 5 Republics from Former Yugoslavia, plus Albania and Mongolia.  Soon the Czech Republic was declared to have completed its transition and dropped out, but two additional members from the further split of Former Yugoslavia were added: Kosovo and Montenegro. Then 6 countries from Eastern and Southern Mediterranean were added, assimilated to transition economies because of similar problems of stabilization, re-structuring, and the change of their political and economic institutions: Cyprus; Turkey; Egypt, Jordan, Morocco, Tunisia. Today the EBRD has 35 countries of operation, and 66 shareholders. Next Libya is lined up for membership.

Since 1994 the EBRD has published in November every year a Transition Report, monitoring economic and institutional developments and constructing synthetic indices summarizing the progress of individual countries in various aspects of their transition process. In November 2013 their Transition Report was entitled: Stuck in Transition?, with a cosmetic question mark at the end. The Report acknowledged that since the mid-2000s the reform process seemed to have stagnated in transition countries, actually registering some reversals reflected in the “downgrading” of EBRD indices. The inflow of Foreign Direct Investment had slowed down and in some countries was reversed, also as a result of the end of US Monetary Easing pre-announced by Ben Bernanke. Economic growth, as a result of the 2008-2009 global crisis and the Eurozone Crisis of 2011-2012, had slowed down to well below pre-crisis levels: only 2% was expected in 2013. Productivity growth - under current policies and institutions – was going to be modest during the current decade and decline further in the next decade: therefore economic convergence with developed countries was at risk. Further economic reform meets social, political, human and capital constraints.

But for the EBRD Stuck In Transition? was only a rhetorical question. The preannounced end of US Monetary Easing did not materialise under Bernanke or his successor Janet Yellen. The Eurozone Crisis was countered by the ECB unorthodox new measures introduced by Mario Draghi. FDI was bound to resume its course. In November 2013 economic growth in the area was projected to accelerate to 2.7% in 2014. There was said to be a virtuous circle between democratization and institutional development, and between the progress of institutions and economic growth. For the EBRD all was well really in the Transition.

The question mark may or may not have been justified in November 2013, but by the time of the EBRD Annual Meeting in Warsaw on 14-15 May 2014 it undoubtedly was no longer appropriate. The virtuous circle between institutional development and economic performance would turn into a vicious circle if exogenous shocks adversely affected either factor. In 15 of the EBRD countries of operation, as a result of the global crisis, public opinion had turned against market reforms, especially in the more democratic countries, thus breaking the link between democratization and the development of institutions. “Private capital flows to the transition region as a whole had remained relatively low and a continuation of cross-border deleveraging was delaying the resumption of credit growth” (EBRD, May 2014). Turkey took a turn for the worse, with widespread political unrest and its violent repression, and associated economic slowdown. There were adverse political developments and serious new economic problems in Egypt. And above all the confrontation between Russia and Ukraine caused a slowdown in Russia (with consequent rouble devaluation and stock exchange fall) and a recession in Ukraine, which adversely affected other Central European countries, especially the Baltics and Serbia. The end of recession in Slovenia is not enough of a compensatory factor.

The latest EBRD growth forecasts for 2014 in the transition area have been cut back from 2.7% to 1.4%, and an improvement to 1.9% in 2015 was regarded as possible but problematic. The EBRD most likely outcome is near zero growth in Russia this year and minimal growth in 2015, and in Ukraine a 7% decline this year and stagnation next year. But the EBRD worst-case scenario is extremely worrying: the implementation of threatened economic sanctions against Russia would immediately precipitate a Russian recession, and bring growth in the whole area to a complete halt, with serious contagion implications for the entire global economy.

On 26 July in Saint Petersburg Professor Ruslan Grinberg, Director of the Institute of Economics of the Russian Academy of Sciances, convened a Founding Conference with the purpose of setting up a new Centre for the Economic and Socio-Cultural Development of the CIS and Central-Eastern Europe.  Against the background illustrated above a renewed focus on these countries, with their distinctive features due to the common Soviet-type starting model, is undoubtedly most opportune, timely, indeed absolutely necessary.

In brief, the Agenda of such a Centre ought to include a re-consideration of alternative models of capitalism other than the hyper-liberal, crony [“oligarch” in Russian] capitalism that has prevailed in the transition; re-thinking the role of the State in the transition process, re-vamping its functions in market regulation and the very creation of market institutions, infrastructure investment, the financing of research and innovation, the alleviation of poverty and unemployment and the guarantee of social peace.  On this last point the EBRD 2013 Report rightly lays great emphasis on the need for “economic inclusion” for the success of any market economy. Inclusion is understood as broad access to economic opportunities regardless of gender, social class and urban/rural background, especially for young adults. 

More generally, intellectual inspiration could be drawn from the comparative analysis of transition experiences to-date but also from recent publications including for instance Thomas Piketty’s Capital in the Twenty-First Century (2013), Mariana Mazzucato’s The Entrepreneurial State (2011) and Grzegoz Kolodko’s monumental work on transition and on globalization. Inter-disciplinarity is essential. We wish Professor Grinberg every success with his new venture.

Transition economies: a worse nosedive than anticipated

“At the start of this year, the global economic crisis was hitting central and eastern Europe with unimaginable force. Any illusion that this region was somehow immune from the “western” credit crunch and the subsequent financial squeeze was definitively quashed. Output was declining at startling rates that would only become apparent much later in the Spring.”
“But the danger signs were everywhere. There was real risk of a genuine emerging market crisis – that financial systems in a number of countries would collapse entirely, that currencies would run out of control, that there could be sovereign defaults.” (Anthony Williams, EBRD Head of Media Relations, The road to a fragile recovery, 16 October 2009)

Now they tell us

I don’t remember the EBRD ever signaling any such danger. Slowdown, yes, in their forecasts for 2009 and 2010, that from optimistic growth expected in May 2008 got progressively worse to insignificant growth in January 2009 and an average 5.2% contraction for the 29 countries of EBRD operation in May 2009. I suppose it is part of the institutional duties of the EBRD not to encourage pessimistic expectations that may become self-fulfilling, but then we should note this for future reference and remember that, when the EBRD forecasts a significant slowdown, what they really mean is an impending disaster.

How was the disaster averted? “That this horror scenario didn’t happen – Anthony Williams continues – was a result partly of unprecedented international support, with the EU and organizations like the IMF providing huge macroeconomic packages that were flexible and tailored to specific country needs [to Latvia, as well as Hungary, Ukraine, Romania and other CEE]. Other IFIs, including the EBRD, stepped in to provide micro support to banking groups and corporates with little or no access to liquidity. Crucially western banks, a dominant force in financial sectors in many countries in central and eastern Europe, did not retrench as feared. The authorities in eastern Europe responded with policies aimed at dealing promptly and effectively with the crisis, even though those responses were in some cases immensely painful and politically unpopular.”

At least in Latvia, it is not at all clear that a systemic crisis has been averted. And evidence that western banks “did not retrench as feared” has not been provided by the EBRD; perhaps they will in due course, in their Transition Report 2009 due in November 2009 or elsewhere. Did western banks really not retrench at all, or on average? Did they retrench less than feared, and how much were they feared to retrench and by whom? Certainly not by the EBRD. And recently Swedbank, the largest Swedish lender in the Baltic region, “has threatened to scale back its presence in crisis-hit Latvia if the country goes ahead with controversial plans to limit the amount lenders can collect from mortgage-holders” (Stefan Wagstyl, 28 September 2009).

Otherwise, is everything fine now in transition economies? It might be in the Czech economy, which has been taken off the list of EBRD countries of operation because it no longer needs its credit – the first to deserve this upgrade – and, most annoyingly, off EBRD statistics. Not fine at all in the 28 EBRD remaining client countries (including Turkey since last year), where the average nosedive now expected for 2009 turns out to be more pronounced than the Bank anticipated in May 2009: a contraction of 6.3% instead of 5.2%, with Estonia, Latvia, Lithuania, Armenia and Ukraine expected to decline by well over 10%.

“Signs of positive growth in the third quarter of 2009 suggest that the recession is now bottoming out in many countries of the EBRD region. However, any upturn in 2010 is likely to be fragile and patchy.” (EBRD press report, 15 October 2009) For 2010 the EBRD now forecasts an average growth for the region of about 2.5%, which is 1% higher than it forecast in May 2009, but since it starts from a level which is now 1.1% lower than it was expected then, the higher growth forecast for 2010 actually masks a lower absolute level of GDP than previously anticipated. And “There are likely to be significant cross-country differences in output growth in 2010”, with Latvia, Lithuania, Hungary and Bulgaria expected to continue to contract until 2011. “It is also clear that the social costs of the global economic crisis are only likely to be felt in earnest next year, when corporate bankruptcies and unemployment will continue to rise”, said EBRD Chief Economist Erik Berglof (Ibidem)
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The same factors that transmitted the global crisis to transition economies – the contraction in world trade and tight credit conditions – are now causing its continuation. “The Institute for International Finance, a bankers’ group, estimates that in 2007 $382bn – more than 40 per cent of the financial flows into all emerging markets – went into CEE. The IIF forecast in June that even with all the extra support the IMF, the EU and the EBRD are putting into the region, this year’s figure would be about zero” (Stefan Wagstyl, FT, 28 September 2009).

Heterogeneity

Transition countries with a fixed exchange rate regime – excluding euro-zone members but including Bulgaria, Latvia or Lithuania – are facing a slower and more painful adjustment, the burden of which falls on wages and prices and therefore ultimately demand and employment. Other factors explaining country heterogeneity are the differences in their fiscal positions, the weakness of banking systems, and dependence on commodity exports. The full set of the EBRD October forecasts is reproduced below, or can be downloaded from the EBRD website ).

“Russia’s economy is expected to shrink by 8.5 per cent on a year-on-year basis in 2009, followed by a rebound in late 2009 and growth of about 3 per cent in 2010 year-on-year. Kazakhstan will suffer a much milder output decline this year (of about 1.5 per cent) but the recovery is expected to be weak, in the order of +1.5 per cent.”

“Relatively faster 2010 growth, in the order of between about 2 and 5 per cent is expected in some internationally competitive countries with relatively sound pre-crisis banking systems, such as Albania, Poland, Slovakia, and Slovenia.”

“Some commodity rich countries including Azerbaijan, Mongolia, Turkmenistan, and Uzbekistan, whose financial systems were smaller and less affected by the crisis, and whose growth is mostly driven by commodities, are also expected to grow faster in 2010, in the order of 5 per cent or more.”

“In Hungary, which was hit particularly hard at the start of the crisis, the crisis has been contained thanks to strong international support as well as sound domestic policies. However, its growth is expected to remain slow in 2010 due to necessary fiscal adjustment and a continued credit crunch. It is expected to show slightly negative growth next year, driven by a weak economy in late 2009 and early 2010” (EBRD press report, 15 October 2009, cited above).

Divergence?

The crisis spells – at least temporarily – a reversal in the convergence process that had accompanied EU enlargement. In 1999-2008 income per head in the EU (15) grew at an average yearly rate of 1.41%, and in the Euro-zone at 1.47%, while in the new member states it grew at 2.00% (Poland) or more (from 2.29% in Hungary to 4.17 in Romania). “Growth over the medium term in the EBRD region is also likely to be below the trend experienced over the last decade” (Erik Berglof, quoted). The crisis is reinforcing the heterogeneity of national performances among transition economies and within the EU.

It is true that some of the factors making for vulnerability to external shocks – such as trade openness, economic and financial integration – are also factors that will reinforce recovery trends in an upturn. But there are other vulnerability factors – such as weak banking systems, fiscal over-stretching, or high private and public indebtedness made worse by mismatching of assets and liabilities – that need tackling before the global upturn can be expected to pull national economies out of recession or stagnation. And membership of a single currency area can make countries more resilient to a downturn but cannot be a cure after the event: a rush to a precipitous euro-zone enlargement today – necessarily preceded by a devaluation – apart from being against the Maastricht rules would not make any sense.

EBRD capital increase

Before the crisis the EBRD was confronted with demands from the US, its largest shareholder, to reduce the scale of its activities in transition economies. Now, as anticipated last May, the Bank is seeking a 50 per cent capital increase, an extra €10bn, from its shareholders – some 60 governments, including European Union members, the US and Japan – to compensate for the decline and reversal of capital inflows into the area. Thomas Mirow, the EBRD president, in a letter to shareholders warns that working with its current €20bn capital, the Bank would have to limit its annual lending to about €8bn in 2009-10 and reduce it to €6bn thereafter. “Activity would shrink while the recovery is still precarious,” while “raising the capital by €10bn to allow the bank [would] commit €9bn-€10bn annually, or €20bn in total extra funding in 2010-15. By mobilizing extra capital from private investors, the total additional funds raised could reach €60bn” (Stefan Wagstyl, FT, 28 September 2009). A final decision will be taken at the EBRD’s next annual meeting in Zagreb, in May 2010.

Mr Mirow states that “The region will need to change its growth model – away from reliance on easy finance and commodities, and towards the development of domestic financial markets, strong institutions and a diversified production base.” If conditions improve “further and faster than is currently expected”, the extra capital might not be needed and could be returned after a review in 2015. Not a chance, regardless.

The EBRD and Foreign Banks in Transition Economies

La lingua batte dove il dente duole. The tongue always finds the aching tooth. No-one can help thinking and talking about worries and fears, hoping to chase them away, almost to exorcise them. Clearly the EBRD is very worried about the possible withdrawal of funds by foreign banks from transition economies. Its officials keep talking about this, ambivalently both envisioning the dangers and denying them in the same breath. Economics can be controversial: if it is quite common for an economist to disagree with herself, it is even more common for an international financial institution, like the EBRD. But for an outsider this insistence is a very worrying signal indeed.

On 7 May 2009, inaugurating the newly founded EBRD blog, the Bank’s Chief Economist Erik Berglof strikes a pre-emptive attack: “Eastern European governments can … damage the international bank groups by preventing them from transferring profits or adjusting their exposures. The public pressures to interfere are great.” And in the EBRD Press Release on the same day, Berglof notes that “Over the past six months important bank bailout programmes in Western Europe have helped stabilise the international banks operating in Eastern Europe” and assumes “continued external engagement, particularly from the western parents of banks in the region”.

I pointed out, in a Comment, that in turn “international bank groups can damage Eastern European governments by the abrupt withdrawal of funds in a crisis.” And that the EC Spring forecasts 2009 tell a different story: “The repatriation of capital by foreign banks has been particularly abrupt in some cases. …the presence of EU banks in the region creates further potential negative spill-overs via the financial channel” (p.22). And “If a foreign bank with big exposure to the region—Swedish, Austrian or Italian—needs to raise more capital but finds that outsiders think its loan book is too risky, what happens? The price of rescue may be that it sheds a troubled foreign subsidiary. Signs of shareholder twitchiness are growing“ (The Economist, 26 February 2009). Not unnaturally, when capital becomes scarcer in the country of origin, foreign capital tends to go back home.

Berglof readily admitted the problem: “I do indeed think that there is a serious risk that some banks could decide to withdraw or be forced to withdraw from the region. We should not kid ourselves, the forces on the banks to retrench are extraordinary - some deleveraging and adjustment to lower credit demand is unavoidable and essentially healthy.” He actually strengthened the point adding that “The current situation has elements of a prisoners’ dilemma where the banks as a collective want to stay involved, but in the short-term an individual bank has incentives to be the first to withdraw.” But he relied on the “Vienna Initiative” (illustrated in his post) and other forms of concerted and conditional support by international financial institutions.

On 14 May 2009, at the Bank's Economic Policy Forum, EBRD President Thomas Mirow took comfort from the fact that, in the “spectacular slump which now seems to suggest that the only way is down” – and which he regards as exaggerated as “the earlier spectacular success when the only way seemed to be up” – “we did not see the withdrawal of any of the leading western banking groups who own most of the financial sector in eastern Europe.” This he attributes to “the fact that financial integration generally went along with long term commitments, particularly on the part of international banking groups”. “A measure of the progress achieved so far is the fact that the danger of large-scale retrenchment or withdrawal of western parent banks from eastern Europe has been averted and seems more unlikely now than only a few months ago”(my Italics throughout).

The trouble is that on 11 May two other EBRD officials, Piroska Nagy and Stephan Knobloch, in an excellent post on the EBRD Blog, on “BIS data on cross-border flows” produced substantial and disquieting evidence of the seriousness of cross border outflows. In the last quarter of 2008 BIS-reporting banks significantly reduced their asset holding across major world regions ($1.8 trillion or 5.4% of their stock). In absolute terms advanced countries were hit harder ($1.3 trillion), but in relative terms emerging markets did worse. So far the EBRD region was the least affected, but the decline ($57 billion) was “still very significant”.

Moreover, within Emerging Europe: 1) the decline was concentrated on a few countries: Russia, Turkey, Ukraine, as well as Poland, the Czech Republic, and Slovenia; 2) the decline happened in the most financially integrated countries, not necessarily in countries with weaker fundamentals, “with large outflows both from countries that have already been hard hit by the crisis (Ukraine) and countries that have been resilient so far (Poland)”. “This is in line with earlier crisis experiences which showed that investors withdraw liquidity not only from countries with weaker fundamentals but also from markets in the same region that are deeper and more liquid” (Nagy and Knobloch, Ibidem). Thus asset outflows in the last quarter of 2008 were 15.5% of the stock in Russia, 9.4% in Ukraine, 8.2% in Poland, 7.5% in Turkey (which is also a country of operation for the EBRD), 7.2% in the Czech Republic, 4.1% in Moldova. In absolute terms, the outflow was $33bn in Russia, $12bn in Turkey, $11bn in Poland, $4bn in the Czech Republic and in Ukraine.

Data refers to all cross-border loans, deposits, and securities held by bank offices located in one of the 41 BIS-reporting countries. This includes assets held vis-a-vis all economic sectors, i.e. private and public, or bank and non-bank. BIS uses the category "developing" countries; this note uses "emerging" countries instead.

“Looking forward, – Nagy and Knobloch conclude – similar trends are expected to have continued – if not deepened - in Q1 of 2009. De-leveraging is an inevitable part of banks’ balance sheet adjustment in the context of the global financial crisis.” While the average picture is reassuring, for the individual countries where the phenomenon is concentrated it is intensely worrying.

But this is not the end of the story. If the post by Nagy and Knobloch pulls the rug from under their President and the Chief Economist, Piroska Nagy adjusts her aim with another post, on “The ‘invisible hand’ of advanced country central banks in emerging markets”, while EBRD senior economist Ralph De Haas writes another post “In defense of foreign banks”.

Piroska Nagy notes that “most emerging market economies have limited policy room to deliver massive counter-cyclical crisis response”, but “there is an invisible channel through which advanced country quantitative easing can benefit emerging markets”, trickling down to subsidiaries of international banking groups. She regards the “invisible hand” of the European Central Bank as particularly important.

I would argue that the ECB hand is, indeed, invisible, because it is not there. The ECB is notorious for not having the function of Lender of Last Resort, which rests with the national Central Banks for their national banks, leaving open the thorny and often unanswerable question of bank nationality. True, the ECB is often said to have functions of ELA - “Emergency Liquidity Assistance”, understood as lesser responsibilities than those of Lender of Last Resort – except that the IMF uses the two expressions interchangeably. Willem Buiter worries about who would re-capitalise the ECB if it went bankrupt; I worry about the impossibility of the ECB ever going anywhere near bankruptcy as a result of its non-existant operations as Lender of Last Resort, with Eurozone banks going bust instead.

And anyway, quantitative easing does not seem to work in the Eurozone, as banks are still reluctant to lend; why should liquidity trickle down into Emerging Europe. Furthermore I have heard other promises, for instance of prosperity trickling down, but I have also come across trickling up. Quantitative easing by the ECB and national Central Banks in Europe is much more likely to spill-over into a commodity price boom than into Emerging Europe.

Finally, in his post In defense of foreign banks, Ralph De Haas distinguishes between cross-border foreign bank lending, which he recognises does shrink during the crisis, and local lending which he regards as generally more stable. He refers to a 2004 study which he co-authored to argue that in central eastern Europe “reductions in cross-border credit were generally met by increases in lending by foreign bank subsidiaries”. But that was then and this is now, and much worse than then; and in any case foreign and local funds are not perfect substitutes, for local funds do not help the stability of the currency.

So, now we know. The EBRD President, its Chief Economist, the Senior Adviser to the Chief Economist and her co-author, and at least another Senior Economist, go to considerable lengths to tell us that there might be trouble ahead, but to reassure us that all is under control, and that foreign banks will behave selflessly, readily and adequately to support and stabilise credit in Emerging Europe. Excusatio non petita accusatio manifesta, as it were.

Clearly they are all worried stiff, and so they should be. I wonder if there is an agreed plan for providing Emergency Liquidity Assistance to one of the Currency Boards of Emerging Europe if it went bust; there should be one. Or two.

Eastern Europe: from Slowdown to Nosedive

On 15-16 May next the EBRD – European Bank for Reconstruction and Development, founded in 1991 to assist the post-socialist transition of Central-Eastern Europe – will hold its Annual Meeting in London. The Bank “could be set for a big increase of its €20bn capital to help deal with the economic crisis” (Stefan Wagstyl, EBRD considers big rise in capital, FT, 7 May 2009 http://www.ft.com/cms/s/0/5c560d04-3b35-11de-ba91-00144feabdc0.html). The case for capital increase is greatly strengthened by the publication, on 7 May just before the Meeting (http://www.ebrd.com/new/pressrel/2009/090507gdp.pdf), of the latest EBRD forecasts for 2009-2010 for all the 28 transition countries where it operates plus Turkey which was added in October 2008.

On average, in these 29 countries the EBRD forecasts a 5 per cent contraction in real GNP. Such nosedive comes after the growth slowdown from 6.9 per cent in 2007 to 4.2 per cent in 2008, and is followed by a modest recovery of 1.4 per cent, anticipated for the second half of 2010. The peak of unemployment is yet to come. These forecasts are much more pessimistic than the EBRD own forecast of January 2009, of imperceptible but positive growth at 0.1 per cent, itself a significant deterioration with respect to the November 2008 forecasts of 3.0 per cent growth, which in turn had been slashed from 5.7 in May 2008.

The latest EBRD figures are also – on average but not for Central Europe – worse than the most recent growth forecasts by the IMF, in the World Economic Outlook of April 2009, on Crisis and Recovery (http://www.imf.org/external/pubs/ft/weo/2009/01/pdf/text.pdf). The European Commission Spring Forecasts 2009 (European Economy 3/2009, 4 May 2009, https://webmail.london.edu/exchweb/bin/redir.asp?URL=http://ec.europa.eu/economy_finance/publications/publication15048_en.pdf) are much more optimistic about Russia (only -3.8 per cent in 2009) but more pessimistic about Hungary and Poland, and otherwise only marginally different. The forecasts of UN/DESA Monthly Briefing on the World Economic Situation and Prospects (http://www.un.org/esa/policy/publications/wespmbn/sgnote_8.pdf), published on 7 May 2009, the same day as the EBRD forecasts, are consistently slightly more optimistic (The next set of forecasts, by the UN World Economic Situation and Prospects Update as of mid-2009, is to be released on 26 May 2009).

The EBRD is an institution suffering from three existential problems. It is supposed to lend to the private sector in transition economies, at commercial rates, but if it does this its existence does not make any difference. It is a public financial institution whose raison d’être is the inefficiency of public financial institutions. And we will know that it has fulfilled its mission only if and when it is liquidated.

In fact, before the crisis, the EBRD government-shareholders (about 60) were considering reducing the scale of its activity – perhaps also because of the EBRD own over-generous assessment of transition progress in its yearly Transition Reports. Now an expansion is being considered instead because of both the envisaged large scale of the recession in its countries of operation, and the need to fill the gap abruptly left by the drop in current capital inflows into the area.

There is no reason to believe that the pessimism of the latest EBRD forecasts has been exaggerated in order to strengthen the case for the Bank’s capital increase. EBRD Chief Economist Erik Berglof says that "There are downside risks to these predictions. But now there is also upside potential. Our underlying outlook assumes continued external engagement, particularly from the western parents of banks in the region." (http://www.ebrd.com/new/pressrel/2009/090507k.htm) Such an engagement on the part of foreign parent banks in the area is an over-optimistic assumption (see below). If anything, the withdrawal of foreign parent banks from transition economies is precisely what strengthens the case for an EBRD major capital increase in the near future, already before the review of the EBRD capital is due in 2012.

Within the aggregate forecasts given above, the heterogeneous group of 29 countries naturally exhibits a highly diversified economic performance. In Central Europe and the Baltics in 2009 Poland fares best, with zero growth. At the other end of the range, all three Baltics are contracting by more than 10 per cent: Estonia (already in recession at -3 per cent in 2008) at -10.5, Lithuania -11.8, Latvia -13.2. Hungary is doing rather poorly: after stagnation at 1.1 per cent in 2007 and 0.5 per cent in 2008, its GNP is poised to fall by 5.0 per cent, with zero growth next year. On average this area’s GDP is expected by the EBRD to decline in 2009 at 2.9 per cent, and to resume growth at only 0.2 per cent in 2010. In the April 2009 World Economic Outlook the IMF was even more pessimistic, with a 3.7 per cent GNP decline, but more optimistic for Russia and the rest of the Commonwealth of Independent States.

EBRD forecasts for South-eastern Europe show a slightly better performance: on average growth rates in 2007-2010 follow the pattern (in per cent): 6.3, 6.6, -2.2, 0.4; in 2009 Romania is worst with -4.0. Eastern Europe and the Caucasus (meaning the non Asian members of the Commonwealth of Independent States, not counting Russia) in the same years exhibit actual and predicted growth of: 9.9, 5.0, -6.2, 1.3; Ukraine is expected to contract by 10.0 per cent this year and grow at a zero rate next year. Central Asia is the least affected area, with GNP growth rates of 9.2, 5.0, 0.4, 3.0 in 2007-2010. Finally, Russia is seriously affected: 8.1 and 5.6 in 2007, 2008; - 7.5 in 2009, the result of an even deeper fall in the first quarter and an expected improvement in the rest of the year; the green shoots of recovery are forecast by the EBRD at 1.0 per cent in 2010.

All these countries have either completed their transition to the market economy and their re-integration into the world economy and especially Europe (the ten new member states of 2004 and 2007, with Slovenia and Slovakia already members of the Eurozone), or have made steady and very substantial progress in that direction. What makes them so vulnerable to the pandemic financial and real crisis?

Initially, when the global crisis involved only the financial sector, transition countries – regardless of EU membership – seemed to be fairly resilient. Then, as the crisis impacted the corporate sector, they began to slowdown, and by the end of 2008 and the first quarter of 2009, when domestic consumption began to be affected, they went from slowdown to nosedive.
In general the current financial crisis confronted all emerging and developing countries – including transition economies – with two shocks: “a ‘sudden stop’ of capital inflows driven by global deleveraging, and a collapse in export demand associated with the global slump” (Atish R. Ghosh et al., IMF 2009)[1]. But there are different aspects and intensities, specific to country groups, discussed both in the IMF Staff Position Note just quoted and in other papers[2].

1. Home made sub-primes. The USA sub-primes crisis of August 2007 touched only marginally the transition economies. But a large amount of domestic loans, mostly for house-purchase finance but also in the enterprise sector – and in the government sector – were originally denominated in foreign currency because the national currency a) involved much higher interest rates and b) had been stable or (with the exception of countries with a successful Currency Board: Bulgaria, Estonia and Lithuania) appreciating. All these loans, amounting to $250 billion in Central Eastern Europe (Auer and Wehrmuller 2009)[3] promptly became sub-prime, as soon as the domestic currency began to depreciate for the reasons indicated below. Thus Polish borrowers in Swiss Francs in the last quarter of 2008 and the first quarter of 2009 have seen their zloty liabilities rise by 31 per cent due to the revaluation of the SF with respect to the Polish zloty.

Auer and Wehrmuller estimate that in the 10 EU member states from Central Europe total losses from private and public debt re-valuation amount to about $60bn, under 5 per cent of GDP in most countries but as much as 18 per cent and 8 per cent in Hungary and Poland respectively. The expectation that the state will ultimately bear the cost of bailing out the debtors, plus the cost born by the state on its own debt, has dramatically raised the spread on Credit Default Swaps for the eight countries for which data are available out of the ten new Member States (Auer and Wehrmuller, cit.).

The problem is serious: in 2007 in eight countries the foreign currency-denominated debt in the non-financial private sector exceeded 50% of total non-financial sector debt: Ukraine, Romania, Bulgaria, Lithuania, Hungary, Georgia, Estonia, Latvia; over 60% in the last four of these, almost 90% in Latvia (Connelly, 2009, p.23).

2. External imbalances. Connelly (2009, cit.) considers twenty countries which he labels “Emerging Europe” (the EBRD 29 minus Turkey, Albania; Bosnia & Herzegovina, Macedonia, Montenegro, Serbia; Tajikistan and Turkmenistan; Mongolia). He notes that “Emerging Europe is the only emerging market region to collectively run a current account deficit”: apart from Azerbaijan, Kazakhstan and Russia in 2008 all the other countries in this group have current account deficits, of which seven over 10 per cent of GDP: Bulgaria at -21.2 per cent, Georgia -20.6, Moldova -15.3 Lithuania -13.9, Romania -13.3, Latvia -12.1, Estonia -11.2.

Sustained current account deficits lead naturally to higher external debt. But it cannot be argued that the current account deficits were the result of fiscal profligacy. Between 2000 and 2008 the number of countries running a government surplus increased from one (Russia) to five (with the addition of Azerbaijan, Belarus, Bulgaria, Kazakhstan), while the deficits of another 13 countries out of the twenty reviewed by Connelly fell below 3 per cent. Thus the growth of external debt is clearly due, on average, primarily to the private sector. Yet the expected emergence of contingent liabilities and costly bail-outs reduces governments’ credibility anyway. Darvas and Pisani-Ferry (2009)[4] establish a significant correlation between the cost of credit default swaps (CDS), the insurance against default on government debt, and current account deficits. Moreover, non-Eurozone members pay a higher insurance cost, rising very much faster over time: “the crisis management in the euro area has had the unintended consequence of putting non euro-area new member states at disadvantage”. Probably, without the credibility bestowed by the euro, floating rates lead to overshooting devaluation, while fixed rates lose competitiveness to the country that maintains them and provide adverse shocks when the peg sooner or later must be altered.

3. Primary product exporters – primarily Russia, Azerbaijan and Kazakhstan – until mid-2008 were in a position to run current account surpluses and accumulate foreign reserves. But in 2008 oil, gas, cotton and metals fell in price. Foreign reserves were used – wasted, we could say to some extent – to support overvalued exchange rates and to bail out financial institutions and productive enterprises. The Central Bank of Russia foreign reserves (including gold) fell from $476.4bn in 2007 to $427.1bn in 2008 and $383.9 at the end of April 2009, plus another $32bn lost by the Stabilisation Fund in the first quarter of 2009 (https://webmail.london.edu/exchweb/bin/redir.asp?URL=http://www.bof.fi/bofit_en/seuranta/venajatilastot/index.htm , though other sources report larger losses). The EC Spring Forecasts 2009 (cited) are more optimistic than the EBRD yet expect a Russian budget swinging sharply from a hefty surplus to large deficits, of respectively 6.5% and 2.7% of GDP in 2009, due to the reduction in commodity prices and in economic activity, plus the large fiscal stimulus packages. Russia is also forecast to see major falls in both its trade and current account surpluses, respectively to 5.1% and 6.3% of GDP in 2009, and 1.4% and 2.7% in 2010.

4. Fall or reversal of FDI and portfolio investment inflows. “With net private capital flows to emerging market (and developing) countries projected to decline from an inflow of US$600 billion in 2007 to an outflow of US$180 billion in 2009, EMEs [Emerging Market Economies] are facing a severe credit crunch. Particularly affected are the countries with large current account deficits – many of which had asset price and credit booms” (Ghosh et al., 2009, p.6). Transition economies had been able to attract large and growing capital inflows thanks to privatisations at attractive prices, high interest rates net of devaluation cover or even plus revaluations, and production de-localisation thanks to low wages. These attractions have weakened, and the recession has made inflows even less attractive.

“The region [i.e. Donnelly’s Emerging Europe defined above] faces an aggregated adjusted gross external financing requirement of approximately $460bn, or around $930bn if short-term is added… The deterioration in the outlook for private capital flows to emerging markets makes ‘roll-over’ of these loans extremely unlikely, with the Institute of International Finance (IIF) projecting a fall in private capital flows to the region from around $254bn in 2008 to only $30bn in 2009” (Connelly 2009, p.4).

In these circumstances devaluations are unavoidable but steering a course between floating and pegging is hard, as we have seen above. Higher interest rates are unlikely to bring back capital in a recession. Controls on capital flows will at best stop capital flight but not bring it back, and can be counterproductive. Official financing is therefore badly needed, by the IMF in the first instance with doubling access limits, Flexible Credit Lines, and Stand-By arrangements. With additional resources, support for debt re-structuring can come from national governments, for instance converting foreign currency loans to domestic currency and compensating banks for losses, maybe only partly.

5. Foreign Banks withdrawing funds. At the inception of the transition an under-capitalised and largely insolvent state banking system was partly cleansed of what today are labelled toxic assets, re-capitalised, privatised mostly to foreign banks, and new banks were promoted, also mostly foreign. By 2006, foreign ownership in the ten New Member States, excluding Slovenia (at 22 per cent), ranges from 74 per cent in Latvia to 98 per cent in Estonia (EBRD, Transition Report 2006). Foreign banks were to provide capital and know how, and through access to foreign parent banks provide foreign exchange and in practice access to lending of last resort in the country of origin.

Today the EBRD Chief Economist still relies on “the continued external engagement, particularly from the western parents of banks in the region” (cited above). And Darvas and Pisani-Ferry (2009, cited) still argue that “Several factors have mitigated the impact of the crisis on non euro area NMS [New Member States]: … [among other things] western European ownership of NMS banks (by indirectly stabilizing their NMS subsidiaries)…” (emphasis added).

Yet the EC Spring forecasts 2009 tell a different story: “The repatriation of capital by foreign banks has been particularly abrupt in some cases. For instance, in Ukraine real GDP growth is projected to decline by 9½% in 2009, due to a severely curtailed access to external financing, which has triggered the conclusion of a stand-by arrangement (SBA) with the IMF…”. “The significant and broad-based slowdown in the CIS could have direct growth effects in Central and Eastern Europe, and the presence of EU banks in the region creates further potential negative spill-overs via the financial channel” (p.22, emphasis added). “Paradoxically, it is precisely this characteristic – strong foreign banking presence – that renders EE countries (except for the CIS) region, much more vulnerable to the present financial turmoil” (Uvalic 2009, p.4)[5]. In turn, foreign parent banks risk downgrading as a result of the declining profitability and the losses on their operations in Eastern Europe; conversely, EE countries depend on their continued financial health.

Recently the EBRD made one of its larger investments, worth a total of €432.4 million, in UniCredit subsidiaries across eight eastern European countries, to provide medium and long-term debt and equity financing through UniCredit subsidiaries in support of SMEs, lease finance and energy efficiency projects. [6] This is precisely the kind of contribution that the EBRD can make to the region’s recovery, especially if its relatively modest resources of €20bn were to be raised by 50-100 per cent.

6. Reduction in external demand. Current projections for 2009 indicate for the first time since the last War a decline in world output (-2 per cent according to the IMF) and a much larger decline in world trade, by as much as 13% (WTO), thus reducing for the first time since the War the most common measure of globalisation, the ratio between world exports and world GNP. A sizeable de-globalisation episode is taking place. Output contraction and trade are larger in the EU, with which transition economies have grown to be increasingly integrated, with EU trade shares of the order of 60-90 per cent for the New Member States and South-Eastern Europe, all characterised by high foreign trade openness, higher than that of most old members of the EU (see the table below, penultimate column). Such openness makes the transition economies opportunities of “de-coupling” from downturns in the EU rather limited (Connelly, cit., p.5). Lower trade shares involve a slowdown in manufacturing and extractive industries, and in internal demand especially in construction and financial services.

7. Differences in initial positions and policy response. “Some [countries] were ripe for a homegrown crisis associated with the end of unsustainable credit booms or fiscal policies; others were just bystanders caught in the storm” (Ghosh et al., 2009, cit., p.3; “… the majority were just innocent bystanders”, p.2).

Uncharacteristically, the IMF has recommended, to advanced economies experiencing the global recession, easing monetary policy and lower interest rates. It has also “called for a timely, large, lasting, diversified fiscal stimulus that is coordinated across countries with a commitment to do more if the crisis deepens” (Ghosh et al., 2009, p.19-20). Naturally the IMF now is forced to recommend the same policies to transition economies in crisis, though with stronger warnings about the possible side effects: “Much of the spending and revenue policy advice for advanced economies remains relevant for EMEs [Emerging Market Economies], once scaled down for their small fiscal space” (Ibidem, emphasis added).

Thus transition economies and other EMEs are reminded that looser monetary policies involve dangers of exchange rate devaluation and consequent adverse effects on balance sheets. That it is dangerous to exceed the “policy space” and especially the “fiscal space” of a country, jeopardizing policy credibility and sustainability. Changes should be gradual (however strange this now may sound coming from the IMF) and sustainable; abrupt and non sustainable changes can be particularly costly and disruptive (see Ghosh et al., 2009).

Clearly an expansionary fiscal policy “ is likely to be more effective in stimulating aggregate demand if the economy is relatively closed to trade flows, uses monetary policy to prevent or limit the appreciation of the currency, has substantial spare capacity, has a high proportion of credit-constrained households or firms, and has a sustainable public debt position” (Ibidem, p.21). Which is fair enough, except that transition economies and other EMEs are most unlikely to satisfy these ideal preconditions.

A short digression on the euro. The question here is whether early membership of the Euroarea might assist recovery in the New Member States, of which only Slovenia and Slovakia are already members. The IMF now recommends it, speaking out of turn because it is not for the IMF to recommend anything to Europe other than possibly an application to join the Euroarea on the part of those new members that meet the Maastricht conditions for membership.

Small open economies would probably gain from being part of a large currency area in times of crisis, although Slovakia (not yet a member until 1 January 2009) and the Czech Republic have done rather well being outside it. Unilateral adoption of the euro is ruled out by the EU for both members and candidates; Currency Boards reduce the probability of a crisis at the cost of making the crisis catastrophic if and when it happens (as in Argentina); European Currency Boards are not yet out of the danger zone. The European Central Bank role as Lender of Last Resort is remarkably undetermined and left to informal arrangements with Eurozone members; non-members with hyper-fixed links to the euro (unilateral euroisation or Currency Boards) might be left high and dry in times of crisis.

The EU could have well admitted at least a few other New Member States to the Euroarea, by somewhat loosening the Maastricht criteria for fiscal and monetary convergence, and the two-year membership of the Exchange Rate Mechanism II. The Maastricht criteria for fiscal convergence are in theory looser than those of the so-called Growth and Stability Pact (GSP, which involves not only a 3% ceiling to government deficit but a stricter zero per cent over the cycle) applying to all EU members regardless of Euroarea membership. In practice however the GSP strictures and the associated penalties were considerably relaxed in March 2005, and further loosened during the current crisis, whereas Maastricht criteria for joining the euro have been very strictly enforced. It is unreasonable to subject countries that grow much faster than the Eurozone members and have relatively low ratios between public debt and GNP to the same fiscal stringency of stagnant and highly indebted Euroarea members (like Italy), moreover rigidly and inflexibly applied only to prospective members.

Lithuania was left out of the euro only because its inflation exceeded the average inflation of the three least inflationary EU members by 1.6% instead of the 1.5% prescribed by the Maastricht Treaty – not exactly an enlightened or rational behaviour, especially considering that two of those three least inflationary countries were not Euroarea members.

“The EU can certainly be criticised for clinging to criteria ill-suited to catching-up countries and the case for reforming them is strong” (Darvas and Pisani-Ferry, 2009, cited). See also Nuti 2006. [7] Be that as it may, the middle of a recession is not the best time to change or, worse, bend the rules as drastically as it would be required by early admission of all or most New Members to the Euroarea. End of digression.

The heterogeneity of country experiences is pithily and efficiently synthesised by one-liners from two sources. The first is a table on Fourteen ways to slowdown from The Economist, 26 February 2009 (http://www.economist.com/world/europe/displaystory.cfm?story_id=1318459).

Fourteen ways to slowdown (italics=pegged to euro; underlined=in euro area)
....................GDP......S&P..........financing
.....................per.....credit...requirements
Country...person*..rating#..% of GDP°..Exports§............In a nutshell
Belarus...12,344.... B+...........7.3...........62.1.Autocratic, isolated, gained surprise IMF bailout
Bulgaria..12,372.....A...........29.4...........61.0 Strong finances back currency peg; sleaze rampant
Czech R...25,757....AA.......... 9.4...........80.1 Thrifty and solid but hit by export slowdown
Estonia...20,754....AA.........20.0 ..........72.0 Star reformer squeezes spending to stay afloat
Hungary.19,830.....A ..........29.9..........80.2 Currency crush could topple debt-heavy economy
Latvia.....17,801....BBB........24.3..........46.6 Clinging to currency peg amid turmoil & downturn
Lithuania.18,855....A+ ........27.1...........59.0 Painful spending squeeze to avoid worse
Poland....17,560.....A+.........13.2..........42.3 Regional heavyweight speeds up euro bid
Romania.12,698...BBB+.......20.2.........36.4 Spendthrift policies meet solid reality
Russia....16,161....BBB..........2.2...........31.7 Energy-based kleptocracy in denial about crisis
Serbia... 10,911......BB-........23.5..........22.2 Seeking more IMF help
Slovakia.22,242....AAA......12.5...........90.5 Smugly in euro-area, hit by car-factory slowdown
Slovenia.28,894...AAA..........-.............70.5 Self-satisfied, rich and still growing
Ukraine....7,634...CCC+......16.1..........45.0 No end in sight to political and economic chaos

* PPP$, 2008 estimate. # Standard & Poor’s, latest. ° Current account balance, principal due on public and private debts plus IMF debits, 2008 estimate. § Goods and services, % of GDP, 2008 estimate. Sources: IMF; Moody’s; Economist Intelligence Unit; The Economist.
From: Sarah Hanson, The whiff of contagion, The Economist, 26 February 2009. (Corrected in the 5 March 2009 issue).

The second source is the EC Spring Forecasts 2009 (cited), whose country chapters for transition economies (EU member states, candidate states and Russia) have the enlightening subtitles listed below:

Bulgaria: Vanishing budgetary surplus, external deficit remains large.
The Czech Republic: Output falls sharply driven by collapse in external demand.
Estonia: Adjusting to face gloomier years.
Latvia: Domestic demand and trade implode.
Lithuania: Deepening recession leads to wider fiscal deficits.
Hungary: Domestic financial crisis magnifies recession.
Poland: Mild recession knocking at the door.Romania: Growth contracts sharply.
Slovenia: Sharp falls in exports and investment point to competitiveness challenges.
Slovakia: Global downturn weighs on exports.
Croatia: a declining economy creates important fiscal challenges.
The Former Yugoslav Republic of Macedonia: Joining the general trend … albeit with a delay.
Turkey: Manufacturing faltering as exports decline.
Russian Federation: The first recession in a decade.

In the 1990s an unexpected, deep and protracted recession characterised the post-socialist transition of Central-Eastern Europe and the Former Soviet Union, with GNP decline ranging from 18 per cent in Poland over three years, to 65 per cent in Moldova over ten years. The decline may be slightly exaggerated especially at the top of the range, for well known reasons, but a reliable and unbiassed observer such as Bob Mundell reckons that the transition recession was not just deeper than the 1929 crisis, it was deeper than the recession that accompanied the Black Death in the 14th century, because then income fall was matched by population fall and living standards were preserved.

By comparison the current recession must be barely perceptible to the populations of transition countries. And at least this time they are benefiting not only from more generous assistance from the international community, but from more enlightened policies of monetary easing and low interest rates, fiscal subsidies and expansion, large scale state intervention – all policies diametrically opposite to the draconian hyper-liberal policies that contributed so much to aggravate the transition recession and the other costs of transition in the 1990s. Only two things have really changed since then: today the hyper-liberalism that inspired the course of transition in the 1990s has been thoroughly discredited by the global crisis associated with it, and the predicament of transition economies is vastly improved simply because they happen to share it with the advanced countries that control international financial organisations.

[1] Atish R. Ghosh, Marcos Chamon, Christopher Crowe, Jun. I. Kim, and Johnathan D. Ostry, “Coping with the Crisis: Policy Options for Emerging Market Countries”, IMF Staff Position Note, SPN/09/08, 23 April 2009, http://www.imf.org/external/pubs/ft/spn/2009/spn0908.pdf.
[2] . See for instance Richard Connolly, “Financial vulnerabilities in Emerging Europe: An overview”, Bank of Finland Institute of Transition-BOFIT Online No. 3, 4 May 2009, http://www.bof.fi/NR/rdonlyres/BA4C9028-D69D-45CB-ABF1-140ECB129E4C/0/bon0309.pdf.
[3] Raphael Auer and Simon Wehrmuller, $60 billion and counting: Carry trade-related losses and their effect on CDS spreads in Central and Eastern Europe, 29 April 2009 http://www.voxeu.org/index.php?q=node/3467 http://www.vox.eu/.
[4] Zsolt Darvas and Jean Pisani-Ferry, The looming divide within Europe, Breugel, 18 January 2009, http://www.eurointelligence.com/article.581+M5852b1b851d.0.html
[5] Milica Uvalic, “The impact of the global financial crisis on Eastern Europe”, Conference Paper, Bol (Croatia), 21-23 May 2009.
[6] “UniCredit is the largest banking group in the central and eastern European region, with over 4,000 branches in 19 countries. The group has invested around €10 billion of equity in central and eastern Europe and has around €85 billion of total customers loans in the region. Beside its own funding programs to its subsidiaries, it cooperates with international institutions including the EBRD in order to ensure continuing support to the local economies during these challenging times.” (from the EBRD website, http://www.ebrd.com/new/pressrel/2009/090507g.htm).
[7] D. Mario Nuti, "Alternative fiscal rules for the new EU Member States", TIGER-WSPiS Discussion Papers n. 84, Warsaw, 2006, http://www.tiger.edu.pl/publikacje/TWPNo84.pdf .