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Public Policies Can Steer Eastern Europe to Sustainable Growth

Warsaw, Poland: low wages, well educated populations made eastern Europe attractive to outside investors in mid-2000s (photo: Andrej Rybczynski/Corbis)

POST-CRISIS EASTERN EUROPE

Public Policies Can Steer Eastern Europe to Sustainable Growth

By Bas B. Bakker and Anne-Marie Gulde
IMF European Department

August 10, 2010

  • Domestic demand will likely stay weak as consumers continue to rein in spending
  • Future growth will need to come from exports rather than domestic demand
  • Balanced macroeconomic policies, wage moderation can help prevent overheating

Eastern Europe seems poised for recovery.

Exports are rebounding and domestic demand is showing signs of stabilizing. The IMF predicts the region will grow by 3.3 percent in 2010.

Still, emerging Europe cannot return to business as usual. Future growth—especially in countries that had built up large imbalances during the boom years of the mid-2000s—must rely more on capital flows into the tradables sector and less on flows into the nontradables sector. In these countries, exports are recovering but domestic demand will likely stay weak as consumers continue to rein in spending to pay off debt.

Eastern Europe was hit hard by the global crisis. The region grew very rapidly in the decade and half that preceded the world economic downturn but, in 2009, GDP declined by 6 percent.

Economic theory predicts that capital should flow from richer to poorer countries. That is what happened in eastern Europe. Capital flows to the region had always been high, but from 2003 onwards, they accelerated even further. Western European banks began to invest vigorously in eastern Europe’s growing markets—and in the ensuing competition, credit conditions loosened and growth became unbalanced. Capital inflows went largely to sectors such as real estate, construction, and banking that did not produce tradable goods—boosting domestic demand but not supply. That led to a surge in imports, unprecedented current account deficits, and overheating economies.

In the fall of 2008, the capital inflows came to a sudden stop. The decline in capital inflows caused a sharp drop in domestic demand. Domestic demand contracted most in countries that previously had the biggest increases in domestic demand, the large current account deficits, and the highest raise in the credit-to-GDP ratio. In countries without large imbalances, domestic demand held up better.

New export markets

Private sectors in countries that experienced the boom must develop new markets for exports of manufactured goods and services, which will require restructuring of their economies. That is no mean task, but it is achievable. Restructuring will be helped by market signals that will change as profits in the nontradables sector shrink and investments seek more promising venues.

But the process may be difficult. Even in the tradables sector, new projects may have to fight for much scarcer financing. Inflows will remain reduced as western banks struggle to rebuild their balance sheets and risk-adjusted returns in emerging Europe seem less attractive.

Public policies can play a role as well in steering eastern Europe toward a more sustainable growth path. More balanced macroeconomic policies and wage restraint can help prevent the overheating that pulls resources from the tradables to the nontradables sector. Fiscal policy in particular could play a much more active role—saving money when revenues are growing instead of increasing spending and boosting public wages. This may mean that during boom times small fiscal surpluses are not sufficient—that large surpluses are needed.

Policymakers may prefer to spend in boom times, but the payoff of saving is that a large fiscal buffer will reduce the need to cut expenditure sharply during a recession—as several countries had to do during this crisis.

Preventing overheating is important, because manufacturing competitiveness in many emerging European economies deteriorated during the boom. For example, according to EU data, Latvia’s unit labor costs in manufacturing rose 90 percent relative to its trading partners between 2003 and 2008. Some other countries—notably Bulgaria, Estonia, and Romania—also experienced a sharp appreciation of their real exchange rate.

Tighter fiscal policy

Tighter fiscal policy will help moderate wage growth. Over time, wages will catch up with those in western Europe. But if the catch-up goes hand in hand with productivity increases in manufacturing, it need not impede competitiveness nor discourage investors.

But emerging Europe should not compete on low wages alone—and will find it difficult to do so. Other emerging markets have even lower wages now and, as workers emigrate to western Europe, wages will rise in emerging Europe. Instead, the region should aim to produce increasingly sophisticated products. Structural reforms, including those that bolster the business climate, could help, as would improving education and, in some nations, fighting corruption.

Foreign capital inflows can also play an important role, if they are aimed at enhancing supply, especially in the external trade–oriented sector. Such investment would support growth, transfer technology, and help contribute to an improvement of labor force skills.

Some countries in the region are already following this model. In the Czech and Slovak Republics, growth during the boom was much more balanced, credit growth more restrained, and current account deficits small—and exports played an important role. Although this strategy produced growth more muted than in some of their neighbors before the crisis, their recessions were much less deep. As a result, over a longer horizon, these two countries have grown faster than countries that had a domestic demand boom.