Will Emerging Europe Adjust Safely To Less Benign Times?

Most economies in emerging Europe have been growing at a rapid clip in recent years, some reaching growth rates second only to emerging Asia. This rapid convergence with the rest of Europe has been fueled in part by large capital inflows and exceptionally benign financial conditions. Now, however, the surge in global financial turbulence and weakening global growth are casting doubt on whether the recent pace of convergence is sustainable. The IMF's April 2008 Regional Economic Outlook for Europe discusses these risks, and recommends policies to address them and ensure that emerging Europe is prepared for more difficult times ahead.

In the IMF's view, rapid growth in emerging Europe is based on strong fundamentals—productivity improvements and increases in the capital stock. Convergence with the living standards in the rest of Europe is therefore expected to continue throughout the region. But high resource utilization and rising external vulnerabilities imply a slowing of the pace. Estimates suggest that most countries can sustain annual growth rates clustered around the 4 to 6 percent range. This is still consistent with fast catch up, but well below the rates of up to 10 percent seen in the past couple of years.

High external imbalances could foreshadow volatility ahead, with risks of a hard landing in some countries. It is true that large current account deficits are an expected feature of convergence in a highly integrated region, and that the high levels of foreign direct investment across the region are reassuring. But the IMF's analysis suggests that many current account deficits, primarily in the Baltics and in Southeastern Europe, now are well above estimates justified by fundamentals. In these cases there is a risk of abrupt adjustment: high levels of external debt are vulnerable to movements in exchange rates and interest rates, growth fluctuations, and changes in investors' appetite for emerging markets.

The region has so far been resilient to the global financial turbulence, but that should not lead to complacency: global growth is projected to slow and contagion risks loom large. The financial turmoil has begun to affect the cost and availability of financing. Sovereign and private bond spreads are rising, short-term cross-border financial flows are moderating, and credit growth is slowing in some countries. In short, Europe's financial systems are still being tested, and a more severe credit squeeze is a distinct possibility. Together with the slowing of export markets, this could lead to a retrenchment of foreign bank capital inflows to emerging Europe. What is currently a moderate slowdown could quickly turn into a bumpy landing.

Although countries differ in how vulnerable they are, tighter macroeconomic and financial policies will be essential in most cases to address imbalances and ensure a soft landing. Fiscal policies should take on a more active role in managing domestic demand, particularly in countries where fixed exchange rate regimes do not allow tightening of monetary policies. Measures to strengthen the financial sector—including assigning larger risk weights for foreign currency lending to unhedged borrowers and placing limits on loan-to-value and debt service-to-income ratios—will create buffers to help the economy deal with shocks.

Besides the more immediate need to adjust policies to slower world growth and more demanding financial markets, the region's long-term strength will be determined by progress in structural reforms. Such reforms will allow laggards to catch up and fast growers with large imbalances to narrow current account deficits and build up capacity to service external debt. Reforms that reduce the role of the state in the economy and improve the business environment can increase the region's ability to deal with shocks. By strengthening investors' confidence, this will also help sustain high growth rates.