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IMFSurvey Magazine: Countries & Regions

Emerging Europe Closes Income Gap with Advanced Europe

Korean electronics plant in Wroclaw, Poland: business-friendly environment has led to wave of new investment in emerging Europe (photo: Yonhap)

EUROPEAN UNION'S NEW MEMBERS

Emerging Europe Closes Income Gap with Advanced Europe

By Athanasios Vamvadakis
IMF European Department

August 1, 2008

  • Emerging Europe's catching up largely driven by strong fundamentals
  • But growth in recent years has been above potential, likely to ease
  • Structural reforms could raise potential growth, ensure smooth catching up

Europe's emerging economies have been growing fast.

The region's annual real GDP growth has averaged close to 6 percent in the last five years, accelerating the recovery that started in the late 1990s. Growth has been particularly rapid in the Baltics, followed by South-Eastern and Central-Eastern Europe.

Compared with other emerging economies, only emerging Asia has been growing faster in the current decade. This performance has allowed emerging Europe to start closing its large income gap with the advanced European economies. But the region still has far to go. Even if growth continues at the average rate of the past five years, it would take 20 years for Central and Eastern Europe to catch up with Western Europe.

Intraregional differences

The new EU members in the Baltics and in most of Central-Eastern Europe have made substantial progress on the structural front, reducing the role of the state in the economy and creating a business-friendly environment that has led to a wave of new investment, including foreign direct investment. They are also very open to international trade, and have labor markets that are more flexible than those of the euro area.

In contrast, and despite recent progress, South-Eastern Europe has fallen behind on reforms compared with the rest of emerging Europe, partly because many of the countries have yet to join the EU and so have not benefited fully from the EU harmonization process. That said, these countries' lower incomes per capita could facilitate fast growth once the right policies are put in place.

Sound policies

Although macroeconomic policies could do more to address overheating concerns in some countries, they have been broadly conducive to the region's catching up. Partly due to cycle-driven revenues, most countries have relatively low fiscal deficits, or even small surpluses, and low levels of government debt.

Independent central banks across the region have also improved their credibility in safeguarding macroeconomic stability. But rising inflation, primarily driven by developments in commodity markets, poses new challenges.

Can it continue?

Although Central and Eastern Europe will likely continue catching up with Western Europe, growth is expected to slow down in 2008-09. In fact, the region has been growing at rates faster than even its strong fundamentals seem to justify.

Estimates from an empirical growth model that quantifies the impact of such fundamentals on growth suggest that although potential growth is high throughout emerging Europe, actual growth rates have been even higher in recent years in all countries but Hungary. The difference is the largest in the Baltics, and primarily in Latvia, followed by South-Eastern Europe and by Central-Eastern Europe. On average, the region is estimated to have grown about 2 percent faster than its potential during 2003-07.

Risks ahead

The catching-up process may prove volatile in countries with large external imbalances. Current account deficits, although not inconsistent with regional convergence, are well above estimates justified by fundamentals, making those countries subject to risks of an abrupt adjustment. High levels of external debt are also a source of vulnerability.

Moreover, the recent speed of financial deepening in the region has been extreme—indeed, it has been slowing during 2008. The pace of credit expansion relative to economic growth has exceeded that in other emerging economies, especially if lending by nonbank financial institutions and direct borrowing from corporates and, increasingly, households abroad is included in addition to bank lending.

Structural reforms key to growth

Together with sound macroeconomic policies, further progress in structural reforms will be key to ensure smooth catching up in emerging Europe.

The estimates from the growth model suggest that such progress could substantially increase potential growth rates across the region, in some cases even above current growth rates. If countries manage to reform at the same pace as in the current decade—a pace that has been relatively fast for the new EU members but slow for the rest of the countries in the region—they could increase potential growth by an average of about 1½ percent annually.

Non-EU members could increase potential growth by more than 2 percent if they match the reforms achieved by the new EU members. Reforms to increase the flexibility of the economies of emerging Europe would also facilitate the transfer of resources toward the tradable sector, thereby helping to reduce external imbalances.

Comments on this article should be sent to imfsurvey@imf.org


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