## 4. EU and Balance of Payments Support to Hungary and Latvia

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### Introduction
- May 2004 enlargement: eight Central and Eastern European countries joined the EU (Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Slovakia, Slovenia).
- Enlargement scale:
  - population increased by 19 percent
  - area increased by 22 percent
  - economic output increase was about 9 percent
- Study purpose: assess impact of EU membership on NMS and OMS over five years, focusing on macroeconomic and financial stability and isolating effects of EU-level frameworks (Maastricht criteria, Stability and Growth Pact (SGP), Lisbon agenda, financial integration and prudential policies).
- Timeframe covers two sub-periods:
  - historically strong global growth (2004–07)
  - onset of the global financial crisis (2007–09)
- Key preview findings:
  - Increased economic and financial integration between OMS and NMS leading to rapid NMS growth that exceeded fundamentals.
  - Some improvement in macro-financial performance, with substantial cross-country differences.
  - Ongoing challenges: inflation control, fiscal adjustment, structural reform, financial stability.
  - EU-level support during crisis included the EU’s balance of payments facility and ECB reverse purchase (repo) arrangements with some NMS central banks.
  - Markets under-priced NMS risks prior to the crisis; repricing occurred during 2007–08 with spreads reflecting policy quality (lower inflation and deficits → substantially lower spreads).
  - Financial sector integration amplified crisis transmission; recommended responses include use of cross-border and EU-level arrangements and strengthening domestic tools (prudential policies, consumer protection, financial education).

*Source: IMF staff compilation from chapter "4. EU and Balance of Payments Support to Hungary and Latvia."*

### II. Macroeconomic and Financial Performance and Vulnerabilities

A. Economic and Financial Integration
- Integration timeline and drivers:
  - Integration predated May 2004 accession and deepened afterwards.
  - Foreign capital (FDI and portfolio) and foreign-owned banks from OMS played major roles in NMS financial transformation and shock absorption.
- Trade and cycle indicators:
  - Share of NMS exports in EU imports increased about 2.5 times between 1993 and 2008, with a doubling already before accession and continued growth after accession.
  - Degree of synchronization between NMS and euro area increased; correlations exceed those for Greece and Portugal.
  - About two thirds of NMS trade is with the euro area.
- Financial integration features:
  - Foreign-owned banks control a major part of NMS banking assets; foreign ownership shares in NMS banking systems rose substantially.
  - Convergence in nominal interest rates reduced risk premia until the crisis; crisis renewed cross-country differentiation in interest rates.
  - Rapid credit growth and financial deepening across NMS, with Baltic NMS showing especially high credit growth.
  - Local capital markets developed unevenly; equity and bond market integration increased but development was disparate.

B. Rapid Economic Growth
- Growth patterns:
  - Emerging Europe grew at rates second only to emerging Asia in early 2000s.
  - Convergence: poorer NMS tended to grow faster (negative relationship between initial PPP per-capita GDP and growth).
  - NMS GDP growth outpaced predictions from Europe-wide regression by 2.5 percentage points on average.
- Growth decomposition:
  - Growth driven primarily by total factor productivity (TFP); capital accumulation important; labor contribution smaller and sometimes negative due to emigration.
  - Average annual TFP growth rates vary among NMS, from 2 percent to 6 percent; earlier EU entrants had TFP ranges roughly 0.6 percent to 2.9 percent.
- Shares in world output:
  - NMS share in world output rose from about 1.5 percent in early 1990s to an estimated 2.1 percent in 2008.
  - OMS share fell from as high as 24 percent in 1989 to 20 percent in 2008.

C. Exchange Rates and Prices
- Nominal convergence achieved partly through nominal exchange rate appreciation relative to the euro and some higher inflation.
- IMF staff assessments: real exchange rate appreciation exceeded 1½ percent per year in most NMS during the last decade and was generally seen as equilibrium in most cases.
- During the crisis most NMS currencies depreciated rapidly.
- Average consumer inflation in the NMS was below the average of other emerging markets through 2007–08, though some NMS experienced credit-driven booms and accelerating prices.

D. Risks and Vulnerabilities
- Imbalances and exposures:
  - Rapid growth accompanied by large imbalances: domestic credit and demand booms, large capital inflows, rising external debt, large current account deficits in several NMS.
  - High share of foreign-currency lending (euros, Swiss franc, Japanese yen) created private sector balance-sheet exposure to exchange rate depreciation.
  - High ratios of short-term debt (remaining maturity) to foreign exchange reserves in several countries (Baltics among highest).
- Market perceptions and capital flows:
  - Pre-crisis “halo effect” compressed sovereign yields by some 50–100 basis points below fundamentals up to mid-2000s; halo dissipated in 2007–08 as spreads returned to or exceeded fundamentals.
  - Capital flow patterns: sizable FDI to Central Europe, bank loans to the Baltics, and portfolio investment; net capital flows charted as percent of GDP for 1999–2006.
- Crisis transmission:
  - Late 2008 sudden slowdown in capital flows; funding costs rose significantly and access was curtailed.
  - Two NMS—Hungary and Latvia—requested EU and IMF financial support during the crisis.

### III. Impact of EU Membership: Preliminary Evidence

- EU acquis adoption substantially altered legal, regulatory, and policy frameworks in NMS via Maastricht criteria, SGP, Lisbon agenda, Financial Services Action Plan, Lamfalussy process.
- EU frameworks emphasize rules-based policies, constraining discretionary policymaking and improving predictability.
- Measurement challenges:
  - Pre-existing reforms before 2004 accession.
  - Long gestation for benefits.
  - Difficulty constructing counterfactual.
  - Influence of the global boom-bust cycle during the five-year window.
- Econometric and empirical findings:
  - Evidence of a “growth bonus”: NMS GDP growth exceeded fundamentals-based predictions.
  - Some evidence of an “EU halo effect” in lower sovereign spreads pre-crisis that disappeared in 2007–08.
- Role of EU frameworks:
  - Maastricht criteria: set basic macroeconomic objectives.
  - SGP: provided fiscal discipline details.
  - Lisbon agenda: targeted structural reforms focused on growth and jobs.
  - Adherence to frameworks has been uneven; better adherence tends to correlate with lower spreads and more favorable outcomes.
- Policy implication: domestic governance frameworks and consistency with EU rules matter for translating EU membership into macroeconomic improvements.

A. EU Membership and Economic Growth (detailed findings)
- Regression and quantification:
  - Within Europe there is a strong negative relationship between PPP per-capita GDP in 2003 and average growth 2003–07.
  - NMS GDP growth was on average 2.5 percentage points higher than predicted by the Europe-wide regression.
  - Compared to world-wide regressions, NMS growth exceeded predictions by 3.2 and 3.0 percentage points for unweighted and weighted regressions, respectively.
  - Growth regression estimates attribute about 1.5 percentage points of higher NMS growth to factors associated with liberalization and integration.
- Sources of growth:
  - TFP main driver; capital accumulation also contributed; labor contribution smaller and negative in some cases due to emigration.
- Policy recommendations implied:
  - Pursue structural reforms that foster investment in high-productivity projects.
  - Encourage economic flexibility, public investment in education and infrastructure, and development of well-functioning financial markets to sustain productivity catch-up.
  - Maintain adherence to rules-based fiscal frameworks to sustain market confidence and lower sovereign spreads.

*Source: IMF staff compilation from chapter "4. EU and Balance of Payments Support to Hungary and Latvia."*

### Box 1 — Estimating the Impact of EU Membership on Output Growth (summary)

- Econometric specification (sample of 106 developed and developing economies in 1996–2007):
  - Real GDP per capita growth = 11.14 (2.95)** –1.43( 4.51)*** initial real GDP per capita – 7.03 (-3.89)*** age dependency rate + 0.12(3.89)*** investment/GDP +0.02(1.78)* university enrollment ratio – 0.014(- 2.32)** inflation rate +0.62(3.01)** index of economic freedom in 1995 +0.85(3.98)*** change in the index of economic freedom during 1995–2005 +0.98(1.82)* dummy variable for NMS + 0.67(1.69)* dummy variable for Africa.
- Statistical notes:
  - ***, **, and * denote statistical significance at the 1, 5, and 10 percent level, respectively.
  - Number of observations is 106.
  - Adjusted R2 is 0.62.
- Key coefficient interpretations:
  - Dummy variable for NMS: 0.98(1.82)* suggests NMS per capita GDP grew faster by about 1 percent per annum than explained by included determinants.
- Estimated “growth bonus” associated with EU membership: about 1 percentage point of the GDP growth rate (residual after controls).
- Broader integration impacts include effects on trade, investment, cross-border production chains, know-how, and migration; cross-border labor mobility cited as beneficial for convergence.

*Source: _wp0968 - Box 1. Estimating the Impact of EU Membership on Output Growth_*

### Box 2 — Euro Area Accession: Experiences of Slovenia and Slovakia (summary)

- Slovenia:
  - Adopted the euro in January 2007.
  - Achieved sustained robust growth with small external imbalances and public debt; gradual lowering of inflation and interest rates to euro area levels.
  - PPP-based per capita income reached about 80 percent of the EU average in 2006.
- Slovakia:
  - Entered ERM2 in November 2005 and the euro area in January 2009.
  - Met all the Maastricht criteria; 2007–09 budget framework aimed at meeting Maastricht fiscal deficit criterion in 2007 and achieving further consolidation thereafter.
- Common success factors:
  - Ability to satisfy Maastricht criteria simultaneously.
  - High degree of political commitment and broad public support for euro adoption.
- Fiscal stability and Maastricht fiscal criterion:
  - General government balances in the NMS were generally worse than in other emerging markets and somewhat lower than in the OMS.
  - The fiscal deficit Maastricht criterion has been the second most challenging for the NMS (after inflation), with the NMS missing it about 40 percent of the time.
  - Average 2004–08 general government balance varied from +1.6 to -6.5 percent of GDP across individual NMS.
  - Empirical analyses suggest Maastricht fiscal criterion and SGP provide an effective rules-based framework; the "3 percent anchor" is crucial for anchoring expectations and monitoring.
- Structural policies and Lisbon Agenda:
  - Lisbon objectives included raising employment from 61 percent to 70 percent by 2010 and raising growth to an average real rate of 3 percent.
  - Progress uneven; agenda relaunched in 2005 with focus on labor market reforms.
  - Faster-reforming NMS had better unemployment records and were better placed for job-creating growth.
  - Labor markets in the NMS are more flexible than in the OMS but less flexible than in non-EU emerging markets.
  - Goods markets relatively well integrated; internal market in services remains fragmented.
- Financial integration and stability:
  - EU membership influenced NMS financial sectors through regulatory harmonization and market integration.
  - Share of foreign-controlled banking assets increased substantially in NMS.
  - Financial soundness five years post-entry: mixed assessment — no systemic failures but outlook challenging; rapid credit growth and foreign-currency lending heightened vulnerabilities.
  - Market-based indicators showed increased correlation of NMS bank health with OMS bank health.
- Prudential supervision:
  - EU regulatory framework adoption improved regulation and supervision in NMS, with quality higher than comparable non-EU emerging markets.
  - Gaps remain; ongoing initiatives include FSAP updates, Lamfalussy implementation, MoUs, and directives on winding-up/liquidation and disclosure.

*Source: _wp0968 - Box 2. Euro Area Accession: Experiences of Slovenia and Slovakia_*

### Box 3 — Quality of Regulatory and Supervisory Frameworks in NMS (summary)

- Methodology:
  - Observance of Basel Core Principles (BCP), Insurance Core Principles (ICP), and IOSCO principles measured on a 0–100 scale (nonobserved to fully observed).
  - Focus on supervisory implementation.
- Results:
  - Level of observance in NMS higher than in comparable non-EU emerging markets; difference insignificant in banking, significant in insurance and securities.
  - OMS observance higher by 13–18 percentage points on average compared with NMS; OMS observance less uneven (standard deviation 4–10 percentage points lower).
  - Cross-border ownership concentrated in a few OMS banks (Austria, Italy, Sweden, Belgium, France), especially pronounced in the three Baltic countries dominated by Swedish bank affiliates.
- Areas for improvement:
  - Banking: supervision of other risks, connected lending, money laundering, supervisory objectives, autonomy, powers, resources, remedial measures, consolidated supervision.
  - Insurance: market conduct, internal controls, derivatives and off-balance-sheet items, supervisor organization, corporate governance, assets, onsite inspection, licensing, cross-border operations.
  - Securities: enforcement powers, compliance programs, prudential requirements, powers/resources, operational independence and accountability.
- Crisis-related policy guidance:
  - Short-run: contain the crisis and limit adverse impact.
  - Medium-run: strengthen financial stability arrangements while preserving integration benefits.
  - Banking strategy: realistic loss recognition; triage of banks into sound, viable needing recapitalization/restructuring, and unviable; prompt recapitalization/restructuring of viable banks; resolve unviable banks with differentiation between non-systemic and systemic; ring-fence impaired assets.
  - Cross-border group management: joint recapitalizations, supervisory colleges, joint reporting, contingency planning, avoidance of nationalization of host activities, and signals to preserve cross-border responsibilities.
  - Household and corporate debt: targeted debt restructuring where needed; avoid blanket debt forgiveness.
- Lessons on EU arrangements:
  - Cross-border risks require stronger home-host cooperation and possible joint responsibility frameworks.
  - Limitations existed in ECOFIN principles and June 2008 MoU; harmonization incomplete at crisis onset.
  - Need for better tools for bank failure management and coordination to prevent spillovers from unilateral crisis measures.
- Policy recommendations:
  - NMS should be proactive in EU reform debates (De Larosière Group report).
  - Consider systems of joint responsibility and accountability for financial stability.
  - Strengthen coordination among prudential agencies and establish colleges of supervisors.
  - Enhance central bank–supervisor cooperation and integrate financial stability into macroeconomic policy.
  - Continue regulatory convergence with OMS and improve consumer protection and financial education.

*Source: Box 3. Quality of Regulatory and Supervisory Frameworks in NMS (excerpt).*

### Box 4 — EU and Balance of Payments Support to Hungary and Latvia (summary)

- Context and timeline:
  - Hungary among the first emerging markets hit by the global financial crisis; short stress in March 2008 and financing conditions deteriorated sharply in mid-October 2008.
  - Latvia experienced a sharp downturn in output growth and external funding pressures in 2008.
- Hungary: causes and institutional interaction:
  - Key vulnerabilities: high debt levels, balance sheet mismatches, increased investor differentiation as global liquidity declined.
  - Article 119 of the Treaty Establishing the European Community requires consultation with the European Commission and the EU economic and financial committee for non-euro area members before seeking assistance.
  - Prior to Hungary no operating procedures had been developed for EU–IMF interaction; the Hungary process (see IMF, 2008b) could become a reference for similar cases.
- Latvia: policy needs and programmatic requirements:
  - Maintaining exchange rate parity and band would require exceptionally strong domestic adjustment policies, sizeable external financing, and broad political consensus.
- Broader implications:
  - EU membership provided access to the EU’s balance of payments facility and ECB repo arrangements with some NMS central banks.
  - Crisis amplified heterogeneity across NMS and increased dispersion of sovereign spreads.
  - Market “EU halo effect” that compressed spreads disappeared during the crisis.
- Policy priorities for NMS:
  - Deliver sound fiscal policies.
  - Achieve high productivity growth.
  - Ensure flexible labor and product markets.
  - Short run: contain the crisis and limit adverse impact.
  - Medium run: strengthen financial stability frameworks while safeguarding integration benefits.
  - Domestic tools: prudential policies, financial education, consumer protection.
  - Given high integration, NMS authorities need close cooperation with OMS, use cross-border and EU-level arrangements, and be proactive in debates on improving arrangements.

*Source: Box 4, _wp0968 - Box 4. EU and Balance of Payments Support to Hungary and Latvia_*

### APPENDIX II — Crisis Response Measures in Selected NMS (selected items)

Monetary Policy and Exchange Rate Policy — Liquidity measures and interest rates
- Czech Republic:
  - launched regular liquidity-supplying repo operations with government bonds used as collateral
- Hungary:
  - Interest rate: MNB raised the interest rate by 300 bps to 11½ % on October 22; policy rate cut by 50 bps on November 24.
  - Liquidity measures:
    - Reserve requirement reduced from 5 to 2 %
    - Establishment of a foreign exchange swap facility, supported by a repo facility with the ECB amounting to €5 bn
    - Establishment of an auction facility to purchase government bonds from market makers
    - Creation of two new facilities to inject forint liquidity into the banking system: a 2-week refinancing window at a fixed price and 6-month tender with no fixed price
    - Loosening of collateral requirement
- Poland:
  - Interest rate: 25 bps rate cut on the main policy rate on November 27.
  - Liquidity measures:
    - Weekly EUR/CHF swap operations with SNB
    - NBP offering USD and EUR swaps for banks
    - Range of collateral for Lombard credit broadened and haircuts reduced
    - Participation in weekly EUR/CHF foreign exchange swap operations of the SNB and the Eurosystem

Financial Sector Policies — Deposit insurance, guarantees, recapitalization, and household support
- Czech Republic:
  - Deposit insurance increased from € 25,000 (at 90 %) to € 50,000 for all deposits.
  - Daily monitoring of banks’ liquidity positions and exposures.
- Hungary:
  - Deposit insurance/debt guarantee:
    - Government plans to establish a precautionary Refinancing Guarantee Fund ($2.8 bilion)
    - Legal increase in deposit insurance coverage of retail deposits from HUF 6 million to HUF 13 million (in line with EU agreements)
    - Political pledge to provide a blanket guarantee on all deposits
  - Bank recapitalization:
    - Government plans to establish a precautionary Capital Base Enhancement Fund ($2.8 billion).
  - Asset purchases/market support: discussions on mitigating household balance sheet risks from foreign currency loans (extend duration, convert fx-based loan to a forint loan at no extra charge, transitional installment reduction).
- Poland:
  - Deposit insurance/debt guarantee:
    - Bank Guarantee Fund law amended to increase deposit guarantee from EUR 22,500 to EUR 50,000 and eliminate coinsurance
    - Draft law to guarantee interbank lending submitted to parliament
    - Government set aside 40 billion zloty for these guarantees
  - Bank capital injection: increase capital of state-owned BGK bank by 2 billion zloty

Fiscal Policy — Tax, expenditure, and stimulus measures
- Czech Republic:
  - Tax/revenue: tax cuts previously envisaged for 2009 canceled; commitment not to change the tax code in ways that lower net revenues.
  - Expenditure/public investment:
    - Primary government expenditure reduced by 2 percentage points of GDP
    - Overall deficit target for 2009 cut to 2½ percent of GDP
    - Announcement of an economic stimulus package
    - Fiscal responsibility law passed by parliament
- Hungary:
  - Tax/revenue: excise tax on alcohol and luxury car raised to finance budget reserve for social assistance to the poor.
  - Expenditure/public investment: accelerate EU fund spending (PLN 7 billion beyond 2009 budget and PLN 3 billion advance from the EU).

International Financial Support
- Hungary:
  - (i) Hungary reached agreement on a 17-month stand-by arrangement of SDR 10.5 billion ($15¾ billion, €12½ billion) from the IMF, with the first tranche of SDR 4.2 billion
  - (ii) EU approved a €6½ billion loan, with an additional €1 billion coming from the World Bank

*Source: _wp0968 - APPENDIX II. CRISIS RESPONSE MEASURES IN SELECTED NMS COUNTRIES*

### References .............................................................................................................

### _wp0968 - References

### Tables
- 1. Macroeconomic Performance in the NMS and Other Emerging Market Economies ...................... 43
- 2. Explaining Spreads on Sovereign Bonds ......................................................................................... 44
- 3. Explaining Inflation Performance .................................................................................................... 45
- 4. Explaining Fiscal Performance......................................................................................................... 46
- 5. Explaining Structural Reforms ......................................................................................................... 47
- 6. Lisbon Scorecards ............................................................................................................................ 48
- 7. Prudential Supervision in NMS and Other Countries ...................................................................... 49
- 8. Financial Soundness Indicators in NMS and Other Countries ......................................................... 50

### Figures
- 1. Growth Performance in the NMS and Other Economies ................................................................. 51
- 2. Financial Market Vulnerability Indicators in the NMS, 2006–08 .................................................... 52
- 3. Performance vis-à-vis Maastricht Criteria, 2004–08........................................................................ 53
- 4. NMS: Export Share in the World Market, 2000–07......................................................................... 54
- 5. Emerging Europe: Market Indicators in the Crisis ........................................................................... 55

### Boxes
- 1. Estimating the Impact of EU Membership on Output Growth......................................................... 17
- 2. Euro Area Accession: Experiences of Slovenia and Slovakia.......................................................... 22
- 3. Quality of Regulatory and Supervisory Frameworks in NMS ......................................................... 31

*Source: _wp0968 - References*

### 4. EU and Balance of Payments Support to Hungary and Latvia......................................................... 40

### 4. EU and Balance of Payments Support to Hungary and Latvia

### Introduction
- May 2004 enlargement: eight Central and Eastern European countries (Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Slovakia, Slovenia) joined the EU.
- Enlargement scale: population increased by 19 percent and area by 22 percent; economic output increase was about 9 percent.
- Study purpose: assess impact of EU membership on NMS and OMS over five years, focusing on macroeconomic and financial stability and isolating effects of EU-level frameworks (Maastricht criteria, Stability and Growth Pact (SGP), Lisbon agenda, financial integration and prudential policies).
- Timeframe covers two sub-periods: historically strong global growth (2004–07) and the onset of the global financial crisis (2007–09).
- Key preview findings:
  - Increased economic and financial integration between OMS and NMS leading to rapid NMS growth that exceeded fundamentals.
  - Some improvement in macro-financial performance, with substantial cross-country differences.
  - Ongoing challenges: inflation control, fiscal adjustment, structural reform, financial stability.
  - EU-level support during crisis included the EU’s balance of payments facility and ECB reverse purchase (repo) arrangements with some NMS central banks.
  - Markets under-priced NMS risks prior to the crisis; repricing occurred during 2007–08 with spreads reflecting policy quality (lower inflation and deficits → substantially lower spreads).
  - Financial sector integration amplified crisis transmission; NMS should use cross-border and EU-level arrangements and strengthen domestic tools (prudential policies, consumer protection, financial education).

*Italic: Source: IMF staff compilation from chapter "4. EU and Balance of Payments Support to Hungary and Latvia."*

### II. Macroeconomic and Financial Performance and Vulnerabilities

A. Economic and Financial Integration
- Integration predated May 2004 accession and deepened afterwards.
- Foreign capital (FDI and portfolio) and foreign-owned banks from OMS played major roles in NMS financial transformation and shock absorption.
- Trade integration evidence:
  - Share of NMS exports in EU imports increased about 2.5 times between 1993 and 2008, with a doubling already before accession and continued growth after accession.
- Business cycle synchronization:
  - Degree of synchronization between NMS and euro area increased; correlations exceed those for Greece and Portugal.
  - About two thirds of NMS trade is with the euro area.
- Financial integration metrics:
  - Foreign-owned banks control a major part of NMS banking assets; foreign ownership shares in NMS banking systems rose substantially (charted comparisons vs. OMS).
  - Convergence in nominal interest rates reduced risk premia until the crisis; crisis renewed cross-country differentiation in interest rates.
  - Rapid credit growth and financial deepening across NMS, with Baltic NMS showing especially high credit growth.
  - Local capital markets developed unevenly; integration of equity and bond markets increased but market development was disparate across countries.

B. Rapid Economic Growth
- Emerging Europe (including NMS) grew at rates second only to emerging Asia in early 2000s.
- Convergence documented: poorer NMS tended to grow faster (negative relationship between initial PPP per-capita GDP and growth).
- NMS GDP growth outpaced predictions from Europe-wide regression by 2.5 percentage points on average.
- Contribution to growth decomposition:
  - Growth driven primarily by total factor productivity (TFP); capital accumulation important; labor contribution smaller and sometimes negative due to emigration.
  - Average annual TFP growth rates vary widely among NMS, from 2 percent to 6 percent; earlier EU entrants had TFP ranges roughly 0.6 percent to 2.9 percent.
- Global share changes:
  - NMS share in world output rose from about 1.5 percent in early 1990s to an estimated 2.1 percent in 2008.
  - OMS share fell from as high as 24 percent in 1989 to 20 percent in 2008.

C. Exchange Rates and Prices
- Nominal convergence included price level convergence mainly via nominal exchange rate appreciation relative to the euro and some higher inflation.
- IMF staff assessments: real exchange rate appreciation exceeded 1½ percent per year in most NMS during the last decade and was generally seen as equilibrium in most cases.
- During the crisis, most NMS currencies depreciated rapidly.
- Average consumer inflation in the NMS was below the average of other emerging markets through 2007–08, though some NMS experienced credit-driven booms and accelerating prices.

D. Risks and Vulnerabilities
- Rapid growth accompanied by large imbalances in several NMS: domestic credit and demand booms, large capital inflows, rising external debt, large current account deficits in several NMS.
- Currency mismatches: high share of foreign-currency lending (euros, Swiss franc, Japanese yen) created private sector balance-sheet exposure to exchange rate depreciation.
- Short-term debt risk: high ratios of short-term debt (remaining maturity) to foreign exchange reserves for several countries (charted; e.g., Baltic countries among highest).
- Favorable market assessment pre-crisis (a “halo effect”) compressed sovereign yields by some 50–100 basis points below fundamentals up to mid-2000s; evidence suggests this halo dissipated in 2007–08 as spreads returned to or exceeded fundamentals.
- Capital flow patterns: sizable FDI to Central Europe, bank loans to the Baltics, and portfolio investment; net capital flows charted as percent of GDP for 1999–2006.
- Crisis impact: late 2008 sudden slowdown in capital flows; funding costs rose significantly and access was curtailed.
- Two NMS—Hungary and Latvia—requested EU and IMF financial support during the crisis.

### III. Impact of EU Membership: Preliminary Evidence

- EU acquis adoption substantially altered legal, regulatory, and policy frameworks in NMS, notably via Maastricht criteria, SGP, Lisbon agenda, Financial Services Action Plan, Lamfalussy process.
- EU frameworks emphasize rules-based policies, constraining discretionary policymaking and improving predictability.
- Measuring EU membership impact is challenging due to:
  - Pre-existing integration and reforms predating 2004 accession.
  - Potential long gestation for benefits (decades).
  - Difficulty constructing a plausible counterfactual.
  - Influence of unusual global boom-bust cycle during the five-year window.
- Econometric findings (summary):
  - Evidence of a “growth bonus”: NMS GDP growth exceeded fundamentals-based predictions.
  - Some evidence of an “EU halo effect” in lower sovereign spreads pre-crisis that disappeared in 2007–08.
- Role of EU frameworks:
  - Maastricht criteria: set basic macroeconomic objectives.
  - SGP: provided fiscal discipline details.
  - Lisbon agenda: targeted structural reforms focused on growth and jobs.
  - Adherence to frameworks has been uneven; better adherence tends to correlate with lower spreads and more favorable outcomes.
- Policy implication highlighted: domestic governance frameworks and consistency with EU rules matter for translating EU membership into macroeconomic improvements.

A. EU Membership and Economic Growth (detailed findings)
- Convergence evidence: within Europe, strong negative relationship between PPP per-capita GDP in 2003 and average growth 2003–07; NMS growth rates were higher than predicted by Europe-wide regressions.
- Quantified growth differentials:
  - NMS GDP growth was on average 2.5 percentage points higher than predicted by the Europe-wide regression.
  - When compared to world-wide regressions, NMS growth exceeded predictions by 3.2 and 3.0 percentage points for unweighted and weighted regressions, respectively.
  - Growth regression estimates attribute about 1.5 percentage points of higher NMS growth to factors associated with liberalization and integration (see Box 1 referenced in text).
- Sources of growth decomposition:
  - TFP was the main driver of NMS growth; capital accumulation also contributed; labor’s contribution was smaller and negative in some cases due to emigration.
- Policy recommendations implied by findings:
  - Pursue structural reforms that foster investment in high-productivity projects.
  - Encourage economic flexibility, public investment in education and infrastructure, and development of well-functioning financial markets to sustain productivity catch-up.
  - Maintain adherence to rules-based fiscal frameworks to sustain market confidence and lower sovereign spreads.

*Italic: Source: IMF staff compilation from chapter "4. EU and Balance of Payments Support to Hungary and Latvia."*

### Box 1. Estimating the Impact of EU Membership on Output Growth

### Box 1. Estimating the Impact of EU Membership on Output Growth

### Econometric growth specification
- Estimated on a sample of 106 developed and developing economies in 1996–2007, following methodologies used by Schadler and others (2005) and Vamvakidis (2008).
- Estimated specification:
  - Real GDP per capita growth = 11.14 (2.95)** –1.43( 4.51)*** initial real GDP per capita – 7.03 (-3.89)*** age dependency rate + 0.12(3.89)*** investment/GDP +0.02(1.78)* university enrollment ratio – 0.014(- 2.32)** inflation rate +0.62(3.01)** index of economic freedom in 1995 +0.85(3.98)*** change in the index of economic freedom during 1995–2005 +0.98(1.82)* dummy variable for NMS + 0.67(1.69)* dummy variable for Africa.
- Statistical notes:
  - ***, **, and * denote statistical significance at the 1, 5, and 10 percent level, respectively.
  - Number of observations is 106.
  - Adjusted R2 is 0.62.
  - Heteroscedasticity-consistent t-statistics are in parentheses.

### Key regression findings and numeric estimates
- Constant and explanatory coefficients (with t-statistics and significance):
  - Constant: 11.14 (2.95)**.
  - Initial real GDP per capita: –1.43( 4.51)***.
  - Age dependency rate: –7.03 (-3.89)***.
  - Investment/GDP: 0.12(3.89)***.
  - University enrollment ratio: 0.02(1.78)*.
  - Inflation rate: –0.014(-2.32)**.
  - Index of economic freedom in 1995: 0.62(3.01)**.
  - Change in index of economic freedom during 1995–2005: 0.85(3.98)***.
  - Dummy variable for NMS: 0.98(1.82)*.
  - Dummy variable for Africa: 0.67(1.69)*.

### Interpretation: determinants of faster growth
- The estimates imply that, other things being equal, faster per capita growth is associated with:
  - Relatively low initial income level.
  - Low dependency ratio.
  - Large investment share (investment/GDP).
  - Low inflation rate.
  - Relatively educated population (higher university enrollment ratio).
  - Higher index of economic freedom and improvements in that index over 1995–2005.
- The NMS dummy coefficient (0.98(1.82)*) suggests that NMS per capita GDP grew faster, by about 1 percent per annum, than can be explained by the included determinants—interpreted as a possible “growth dividend” related to transition after the early 1990s collapse.
- A similar positive dummy for African countries (0.67(1.69)*) reflects higher GDP growth in 1996–2007 than in previous decades for Africa; continuation of these effects is uncertain.

### Estimated “growth bonus” associated with EU membership
- Even after adjusting for identifiable growth determinants, the analysis finds a residual “growth bonus” associated with EU membership, estimated at about 1 percentage point of the GDP growth rate.

### Broader integration impacts (not estimated in the box)
- The economic integration of the NMS into the EU had other impacts not studied in detail here, including effects on trade and investment flows, cross-border production chains, know-how, and migration.
- Example: cross-border labor mobility provides benefits in terms of faster and smoother convergence (as found by Bems and Schellekens (2008) in a general equilibrium study).

*Source: _wp0968 - Box 1. Estimating the Impact of EU Membership on Output Growth*

### Box 2. Euro Area Accession: Experiences of Slovenia and Slovakia

### Box 2. Euro Area Accession: Experiences of Slovenia and Slovakia

### Euro area accession: country experiences and drivers
- Slovenia adopted the euro in January 2007.
- Slovenia's initial conditions and macroeconomic policies enabled:
  - sustained robust growth with small external imbalances and public debt;
  - gradual lowering of inflation and interest rates to euro area levels;
  - PPP-based per capita income reached about 80 percent of the EU average in 2006, putting Slovenia on a par with Greece and above Portugal.
- Slovakia entered ERM2 in November 2005 and entered the euro area in January 2009.
  - A coalition government following June 2006 elections committed to adopting the euro in January 2009.
  - The 2007–09 budget framework aimed at meeting the Maastricht fiscal deficit criterion in 2007 and achieving further fiscal consolidation thereafter.
  - Slovakia met all the Maastricht criteria.
- Common factors contributing to successful accession:
  - willingness and ability to satisfy all the Maastricht criteria simultaneously;
  - high degree of political commitment to euro adoption and broad public support (Slovenia recorded the highest levels of support for the euro of all EU countries; Slovakia above the EU average in public support and self-assessed knowledge of the euro).
- Note on public support: high public support or awareness does not automatically ensure adoption (Eurobarometer survey weakly correlated with meeting the inflation criterion), but it facilitates successful adjustment.

### Fiscal stability and the Maastricht fiscal criterion
- General observation:
  - General government balances in the NMS were generally worse than in other emerging markets and somewhat lower than in the OMS.
  - The fiscal deficit Maastricht criterion has been the second most challenging for the NMS (after inflation), with the NMS missing it about 40 percent of the time.
- Cross-country variation:
  - The average 2004–08 general government balance varied from +1.6 to -6.5 percent of GDP across individual NMS.
- Role of the EU framework and the Stability and Growth Pact (SGP):
  - Empirical analyses suggest the Maastricht fiscal criterion and the SGP provide a rules-based framework effective in combating politically-motivated fiscal distortions.
  - The "3 percent anchor" appears crucial in anchoring expectations and monitoring.
- Econometric analysis (replicating Annett (2006)) summarized:
  - Estimated equation (notation preserved): b is the fiscal balance, d is debt, y is the output gap, p is a dummy for the election year, g is a dummy for the form of fiscal governance, s the economy’s size, σ is its economic volatility, n is a dummy variable for new member states, ε is an error term, i and t denote country and year, respectively, and βs are the estimated coefficients.
  - Findings from the estimates for NMS:
    - Smaller economic size makes countries more amenable to external influences over fiscal policy.
    - Growth volatility in the NMS has been relatively higher (standard deviation of growth over the past 10 years being twice that of the OMS), and higher growth volatility is associated with greater likelihood to follow fiscal rules.
    - Predominant reliance on fiscal commitment in most NMS makes them more amenable to comply with SGP rules.
- Market and credibility effects:
  - Countries that follow fiscal rules more closely are likely to see lower bond spreads.
  - Introducing or tightening numerical fiscal rules tends to reduce yields on long-term government securities through a credibility effect or induced fiscal improvements.

### EU membership and structural policies (Lisbon Agenda and reforms)
- Lisbon Agenda objectives and mechanism:
  - Launched in 2000; objectives included raising employment rate from 61 percent to 70 percent by 2010 (20 million extra jobs) and raising growth to an average real rate of 3 percent.
  - Based on an "open method of coordination" with National Reform Programs (NRPs) and annual monitoring by the EU Council.
- Assessment of the Lisbon Agenda:
  - Progress has been uneven; significant progress at EU level but threatened by the financial crisis.
  - Employment rose since 2000 but is turning; youth joblessness remains high; access to secondary education improved but completion remains an issue; effective retirement age increased but still below 60 in a third of EU countries.
  - After evaluation led by Wim Kok, the Agenda was relaunched in 2005 with focus shifted from quantitative targets to specific policy actions, prioritizing labor market reforms.
- Empirical findings on structural reform drivers:
  - Updated analysis of Debrun and Annett (2004) indicates:
    - Factors explaining likelihood of reform in the NMS are not fundamentally different from OMS and non-EU OECD countries.
    - Smaller countries tend to be more reformist.
    - Countries with better fiscal performance tend to perform better on structural reforms, highlighting fiscal policy’s central role.
- Labor market and product market observations for the NMS:
  - Faster-reforming NMS have had better unemployment records and been better placed for job-creating growth.
  - Labor markets in the NMS are more flexible than in the OMS but less flexible than in non-EU emerging markets:
    - employment protection legislation less restrictive in NMS than OMS;
    - minimum wages lower, collective bargaining less centralized, unemployment benefits less generous in NMS.
  - Variation across NMS: Baltic countries show wages more responsive to productivity and unemployment than Central European NMS.
  - Goods markets relatively well integrated in EU; internal market in services remains fragmented, with sluggish productivity growth in services and uneven competition in network industries (telecoms, energy).
  - In many NMS, quasi-monopolies still dominate natural gas import/transport/distribution; Services Directive implementation (to be fully implemented by end-2009) could help catch-up.
- Interaction between reforms and crisis impact:
  - Some NMS that scored highly on structural indicators experienced the largest increases in spreads during the crisis (e.g., some Baltics), while Slovenia, Czech Republic, and Poland (with relatively lower scores) were least affected — suggesting pre-crisis macroeconomic and financial imbalances may matter more than reform extent in crisis resilience.

### EU membership, financial integration, and financial stability
- Financial integration trends:
  - EU membership influenced NMS financial sectors via financial integration policies and financial stability arrangements.
  - Integration started before accession as NMS aligned regulatory/supervisory systems, removed capital controls, and attracted OMS financial institutions.
  - Share of foreign-controlled banking assets increased substantially in the NMS and exceeds that in the rest of the world (chart cited).
- EU-wide integration drivers:
  - Monetary union (1999) and the Financial Services Action Plan (1999–2005) drove historic integration among OMS.
  - Cornerstones included the Capital Requirements Directive (CRD), Solvency II Directive, and Markets in Financial Instruments Directive (MiFID); CRD and MiFID are in effect; Solvency II discussions continue.
  - Lamfalussy framework (2001) and Level 3 Committees (CEBS, CESR, CEIOPS) aim to facilitate rule-making and consistent application; December 2007 ECOFIN launched a road map to reinforce these committees.
- Financial soundness five years post-EU entry:
  - Mixed overall assessment: NMS banks held up relatively well during the global financial crisis with no systemic failures or generalized depositor runs, but the outlook remained challenging.
  - Financial integration contributed to risk build-up via loosened financial constraints, capital inflows, credit growth, and asset price increases; rapid credit growth accompanied by growing share of foreign-currency-denominated loans in some NMS.
  - Key potential adverse outcomes from risk build-up: overheating, loss of competitiveness, prolonged sluggish growth, shocks to expectations and income, "sudden stops", interest rate and exchange rate instability, and asset price corrections — some of which were materializing at the time of writing.
- Financial soundness indicators and vulnerabilities:
  - Positive indicators:
    - NMS banks have been highly profitable with returns on assets and equity exceeding advanced economies and other emerging markets.
    - Nonperforming loan ratios below other emerging markets and declining over time.
  - Concerns:
    - Profitability measures and nonperforming loan ratios were propped up by rapid loan growth and are likely to worsen as the crisis affects loan performance and banks’ revenues.
    - NMS banks are on average less capitalized than their emerging market counterparts.
    - Evidence that relatively weak banks expanded rapidly.
    - An important issue is the willingness and ability of parent OMS banks to inject additional capital and sustain intra-group credit lines.
- Market-based indicators and cross-border correlation:
  - Market-based indicators suggest NMS bank health became closely correlated with OMS bank health.
    - Correlation coefficient of OMS and NMS bank distance to default was 0.82 for May 2004–November 2008 (0.71 if August 2007 onward excluded), up from 0.26 in January 1999–April 2004.
    - For comparison, corresponding correlations were 0.62 and 0.42 for OMS and U.S. banks, and 0.65 and 0.37 for OMS and Asian banks.
  - Distance to default measures for both OMS and NMS fell close to or below zero in late 2008 and early 2009.
  - There is important cross-country heterogeneity in bank soundness within the NMS.
- Prudential regulation and supervision:
  - EU membership required adoption of the EU regulatory framework (e.g., CRD and other FSAP Directives), leading to improved regulation and supervision in NMS.
  - IMF assessments indicate regulatory and supervisory frameworks in NMS were of higher quality than in comparable non-EU emerging markets (especially insurance and securities regulation), attributable to EU harmonization.
  - Within the EU, OMS regulation and supervision were of significantly higher and more even quality than in the NMS, though OMS supervision faced complex systems and exposed inadequacies during the global crisis.
  - Gaps in NMS supervisory systems remain and need further evolution to meet new challenges.
  - Ongoing initiatives addressing gaps include FSAP updates, Lamfalussy process implementation, improved cross-border cooperation via MoUs, and other EU measures (e.g., directives on winding-up/liquidation, disclosure recommendations, anti-money laundering improvements).

*Source: _wp0968 - Box 2. Euro Area Accession: Experiences of Slovenia and Slovakia*

### Box 3. Quality of Regulatory and Supervisory Frameworks in NMS

### Box 3. Quality of Regulatory and Supervisory Frameworks in NMS

### Methodology
- Regulatory and supervisory quality is measured using countries’ observance of internationally accepted standards in banking, insurance, and securities regulation.
- Relevant standards:
  - Basel Core Principles for Effective Banking Supervision (BCP)
  - Insurance Core Principles (ICP) by the International Association of Insurance Supervisors (IAIS)
  - IOSCO’s Objectives and Principles of Securities Regulation
- Extent of observance of each core principle is measured on a scale from 0 (nonobserved) to 100 (fully observed).
- Compliance scores focus on supervisory implementation (not only “regulations on the books”) and have been used in previous research.

### Results
- Main comparative finding:
  - The level of observance in the NMS countries was higher than in comparable non-EU emerging markets.
  - The difference was insignificant in banking supervision and regulation, but significant in insurance and securities.
- Within the EU:
  - The level of observance in the OMS countries was significantly higher by 13–18 percentage points on average compared with NMS.
  - Observance in OMS was less uneven: standard deviation being 4–10 percentage points lower on average.
- Interpretation:
  - Differences can be attributed to harmonization of regulatory frameworks within the EU and to banking regulation showing less cross-country variation than insurance and securities.
- Cross-border ownership and concentration:
  - Most foreign banks in NMS are branches or subsidiaries of a handful of banks from a subset of the OMS, especially Austria, Italy, and Sweden, but also Belgium and France.
  - Concentration is particularly strong in the three Baltic countries, where the system is dominated by affiliates of Swedish banks.
- Concentration implication:
  - High concentration is associated with increased potential for contagion through financial interlinkages.

### Areas for improvement (by sector)
- Banking:
  - Supervision of other risks
  - Connected lending
  - Issues related to money laundering
  - Supervisory objectives, autonomy, powers, and resources
  - Remedial measures
  - Consolidated supervision
- Insurance regulation:
  - Market conduct issues
  - Internal controls
  - Derivatives and off-balance-sheet items
  - Organization of the supervisor
  - Corporate governance
  - Assets
  - Onsite inspection
  - Licensing
  - Cross-border business operations
- Securities regulation:
  - Enforcement powers
  - Compliance program
  - Capital and other prudential requirements
  - Powers, resources, capacity
  - Operational independence and accountability

### Financial sector policy challenges presented by the global financial crisis
- Short-run and medium-run objectives:
  - Short run: contain the crisis and limit its adverse impact.
  - Medium run: strengthen financial stability arrangements to ensure continued benefits from financial integration.
  - Close cooperation between OMS and NMS is essential.
- Strategy toward the banking system in the crisis:
  - Realistic loss recognition.
  - Forward-looking assessment of soundness and viability of banks, accounting for likely losses from the recession.
  - Triage of banks into:
    - Sound institutions
    - Viable institutions needing recapitalization and/or restructuring
    - Unviable institutions
  - Prompt action to recapitalize and restructure viable institutions (use private capital where possible).
  - Prompt action to resolve unviable institutions, differentiating between non-systemic and systemic ones (close or wind down non-systemic; nationalize in whole or part systemic, with view to restructuring).
  - Ring-fencing of impaired or difficult-to-value assets.
- Cross-border group management:
  - Requires close cooperation and attention to interests of all countries involved.
  - Possible supportive measures:
    - Joint recapitalizations at the group level in return for commitments to maintain activities in all participating countries.
    - Home and host authorities sending a strong joint signal that cross-border banks have responsibilities to all countries where they operate.
    - Asking banks to report periodically to a joint body of home and host authorities (e.g., supervisory college) on fulfillment of commitments and problems.
    - Authorities should signal determination to behave responsibly, avoid nationalization of host activities or directing credit flows to specific national markets, and refrain from obstructing free flow of funds across borders.
    - Contingency planning for solvency problems at the group level.
- Household and corporate debt:
  - Some debt restructuring might be needed for highly indebted households and firms.
  - Any scheme should be targeted and tailored to:
    - Reduce short-term debt servicing costs of temporarily distressed borrowers.
    - Reduce overall debt levels of overindebted consumers.
    - Restructure or resolve overindebted companies.
  - Blanket debt forgiveness should be avoided because it is not cost-efficient, creates moral hazard, undermines credit culture, and risks undermining confidence of foreign banks in NMS markets.

### Lessons for reforming financial stability frameworks
- Cross-border nature of financial risks:
  - Financial risks have become cross-border, notably within the EU’s integrating financial market.
  - For most NMS, the crisis initially had an imported character via linkages with the OMS; homegrown vulnerabilities then exacerbated the crisis and fed back to OMS banks.
- Limitations of EU home-host arrangements:
  - Containing build-up of financial risks is difficult where foreign bank presence is extensive.
  - National authorities often lacked effective powers to contain risks because subsidiaries and branches were largely under home country supervisors’ control.
  - Cooperation with home country supervisors was not always flawless; scope to adjust prudential requirements to local circumstances was limited by harmonization.
  - Some NMS supervisors called for greater host country control.
- Bank failure management:
  - Bank failures occurred across both old and new member states; authorities wished for better tools and frameworks to handle failures cost-effectively.
  - Balance is needed between public interest and legal rights of shareholders and creditors; better mechanisms are required to prevent, manage, and resolve bank failures cost-effectively.
- Complexity of cross-border group failures:
  - Failures can cause tensions between home and host countries, impeding cost-minimizing solutions.
  - Examples from EEA cases:
    - Cases where home country support accompanied demands to prioritize domestic lending.
    - Cases where problems exceeded home country capacity to support (Icelandic banks).
    - Fortis: burden-sharing agreement fell apart within two days; operational integration was undone.
    - Dexia: stabilized by cooperative effort including burden-sharing by Belgian, French, and Luxembourg authorities and private shareholders.
  - For NMS, main challenge is determining extent to which foreign banks in their borders can benefit from home country support versus relying on less resourceful hosts.
- Spillover effects from uncoordinated crisis measures:
  - Unilateral crisis measures (e.g., deposit guarantees) by some EU member states triggered reallocation of funds toward guaranteed forms of debt, tightening funding for banks elsewhere and creating vulnerabilities.
  - Lack of coordination created negative market confidence effects.
  - Coordination improved over time as EU institutions sought to limit competitive distortions.
  - When state backing is large, governments’ resources and credit ratings become major determinants of bank soundness, potentially disadvantaging locally-owned banks in NMS.
- Political dynamics in crisis decision-making:
  - Crisis decisions move to the political level, subject to politicians’ incentives, making follow-through on non-binding ex-ante commitments difficult.
  - Governments took charge as public balance sheet usage became necessary, reducing relevance of technocrats’ prior understandings and experience.
- Shortcomings of EU cross-border financial stability arrangements:
  - Non-binding ECOFIN crisis management principles and June 2008 MoU proved of limited value in managing the crisis.
  - Practical difficulties in coordinating through elaborate cross-country structures during domestic crises.
  - Decision-makers had limited incentives to work toward common EU objectives enshrined in principles and MoUs.
  - Lack of a neutral “arbiter” or “referee” to overcome differences and monitor adherence to ex-ante commitments.
- Timing and incompleteness of EU arrangements at crisis onset:
  - ECOFIN principles had been in place for about a year; MoU adopted in June 2008; Capital Requirements Directive fully effective since January 1, 2008.
  - Harmonization of prudential regulations and supervisory practices was far from complete; many aspects still under review.

### Policy implications and recommended institutional responses
- NMS should be proactive in debates on EU reforms (notably following the “De Larosière Group” report) to ensure their interests are taken into account.
- Consider system of joint responsibility and accountability for financial stability to reconcile home and host interests.
- Strengthen coordination among prudential agencies with authority relevant to national financial stability, including in non-crisis times.
  - Two dimensions of financial stability challenge:
    - Stability of entities that straddle across countries (addressed largely through cooperation between home and host authorities, and colleges of supervisors).
    - Stability of countries with financial systems consisting of institutions of different nationalities (needs stronger mechanisms).
  - Proposal: establish “colleges of supervisors” or analogous bodies bringing together all supervisors that oversee significant parts of a national financial system.
- Enhance cooperation between central banks and supervisors, and integrate financial stability considerations into macroeconomic policies:
  - Central banks are well placed to take macrofinancial and systemic dimensions into account but need access to all relevant information.
- Continue regulatory and supervisory convergence with OMS, recognizing this is a moving target as global prudential frameworks evolve.
- Use consumer protection policies as a pillar of financial stability where feasible (consumer protection remains largely a national responsibility).
  - Effective enforcement can be challenging where judicial and administrative systems have deficiencies.
  - Boost financial education as a complement to prudential improvements.

### EU Membership and Macroeconomic Crisis Management
- Preliminary lessons on whether EU membership helped NMS manage the crisis:
  - EU membership does not eliminate possibility of a macro-financial crisis (illustrated by Hungary and Latvia).
  - Stabilization criteria and associated policy frameworks can limit but not eliminate major distress due to limitations, global shocks, and national policy implementation differences.
  - Cross-country policy differences have been reflected in sovereign spreads.
- Advantages of EU membership during the crisis:
  - EU’s balance of payments facility provided a safety cushion in situations of distress (capacity fell short of needs).
  - ECB repo arrangements with some NMS central banks have been helpful.
- Close linkages imply policy spillovers:
  - Measures in OMS (e.g., increased deposit insurance coverage) can trigger deposit withdrawals elsewhere in the EU, including NMS, arguing for close policy coordination between NMS and OMS in crises.
- Potential additional EU actions if crisis impact worsened:
  - If impact takes form of balance of payments problems: EU balance of payments support facility (tested in Hungary and Latvia).
  - If impact is temporary shortages of euro liquidity in non-euro area NMS: temporary reciprocal currency arrangements (swap lines) with the ECB could be helpful (benefit to NMS central banks: greater capacity to provide euro funding for term and overnight liquidity operations).
  - ECB must weigh risks involved against potential benefits such as reduced spillover risk into the euro area.

*Source: Box 3. Quality of Regulatory and Supervisory Frameworks in NMS (excerpt).*

### Box 4. EU and Balance of Payments Support to Hungary and Latvia

### Box 4. EU and Balance of Payments Support to Hungary and Latvia

### Context and timeline
- One of the first emerging markets to suffer from the fallout of the global financial crisis was Hungary.
- A short episode of financial stress occurred in March 2008, but Hungary’s financing conditions deteriorated sharply in mid-October 2008.
- Latvia started to experience a sharp downturn in output growth and external funding pressures in 2008.

### Hungary: causes of stress and institutional interaction
- Key vulnerabilities cited:
  - High debt levels.
  - Significant balance sheet mismatches.
  - Increased investor differentiation among emerging markets as global liquidity declined and risk aversion rose.
- Institutional procedure:
  - Article 119 of the Treaty Establishing the European Community requires a non-euro area member country to consult with the European Commission and the European Union’s economic and financial committee on its balance of payments needs before seeking assistance from other sources.
  - Prior to the recent events in Hungary, no operating procedures had been developed for interaction between the EU and the IMF.
  - The process as developed in the case of Hungary (see IMF, 2008b) could become a reference for similar future cases—i.e., EU member states that are not participating in the ERM II mechanism.

### Latvia: policy needs and programmatic requirements
- The Latvian authorities asked the IMF, together with the EU, to provide technical and financial support.
- The assessment emphasizes that maintaining Latvia’s exchange rate parity and band would require:
  - Exceptionally strong domestic adjustment policies.
  - Sizeable external financing.
  - Broad political consensus.

### Broader implications for NMS and EU-level support mechanisms
- EU membership provided NMS access to facilities that proved useful during the crisis, including:
  - The EU’s balance of payments facility, which provided a safety cushion in situations of distress.
  - Repo arrangements established by the ECB with some NMS.
- The crisis amplified heterogeneity across NMS, increasing dispersion of sovereign spreads and market differentiation among countries.
- Market perceptions that previously produced an “EU halo effect” and compressed sovereign spreads in many NMS disappeared during the global financial crisis.
- Lessons and policy priorities for NMS include:
  - The crisis elevated the premium on sound policies; adoption of EU-level frameworks has contributed to sound macroeconomic and structural policies, especially via:
    - The Maastricht criteria as anchors for macroeconomic policies.
    - The Stability and Growth Pact (SGP) implementing Maastricht fiscal criteria.
  - Domestic policy frameworks remain the crucial driver of economic performance; to prosper within the EU and as current or future euro-area members, NMS need to:
    - Deliver sound fiscal policies.
    - Achieve high productivity growth.
    - Ensure flexible labor and product markets.
  - In the short run, the main challenge is to contain the crisis and limit its adverse impact.
  - In the medium run, the challenge is to strengthen financial stability frameworks while safeguarding benefits of financial integration.
  - Important domestic tools include prudential policies, financial education, and consumer protection arrangements.
  - Given high integration between NMS and OMS banking systems, NMS authorities need close cooperation with OMS, use current cross-border and EU-level arrangements, and be proactive in debates on improving these arrangements.

*Source: Box 4, _wp0968 - Box 4. EU and Balance of Payments Support to Hungary and Latvia_*

### APPENDIX II. CRISIS RESPONSE MEASURES IN SELECTED NMS COUNTRIES

### APPENDIX II. CRISIS RESPONSE MEASURES IN SELECTED NMS COUNTRIES

### Monetary Policy and Exchange Rate Policy — Liquidity measures and interest rates
- Czech Republic
  - launched regular liquidity-supplying repo operations with government bonds used as collateral
- Hungary
  - Interest rate: MNB raised the interest rate by 300 bps to 11½ % on October 22, in response to increased financial market pressures. The policy rate was cut by 50 bps on November 24.
  - Liquidity measures:
    - Reserve requirement reduced from 5 to 2 %
    - Establishment of a foreign exchange swap facility, supported by a repo facility with the ECB amounting to €5 bn
    - Establishment of an auction facility to purchase government bonds from market makers
    - Creation of two new facilities to inject forint liquidity into the banking system: a 2-week refinancing window at a fixed price and 6-month tender with no fixed price
    - Loosening of collateral requirement
- Poland
  - Interest rate: 25 bps rate cut on the main policy rate on November 27.
  - Liquidity measures:
    - Weekly EUR/CHF swap operations with SNB
    - NBP offering USD and EUR swaps for banks
    - Range of collateral for Lombard credit has been broadened and haircuts reduced
    - Participation in the weekly EUR/CHF foreign exchange swap operations of the SNB and the Eurosystem

### Financial Sector Policies — Deposit insurance, guarantees, recapitalization, and household support
- Czech Republic
  - Deposit insurance/debt guarantee: Announced deposit insurance increase from € 25,000 (at 90 %) to € 50,000 for all deposits.
  - Regulatory measures: Daily monitoring of banks’ liquidity positions and exposures.
- Hungary
  - Deposit insurance/debt guarantee:
    - Government plans to establish a precautionary Refinancing Guarantee Fund ($2.8 bilion)
    - Legal increase in deposit insurance coverage of retail deposits from HUF 6 million to HUF 13 million (in line with EU agreements)
    - Political pledge to provide a blanket guarantee on all deposits
  - Bank recapitalization: Government plans to establish a precautionary Capital Base Enhancement Fund ($2.8 billion).
  - Asset purchases/market support: Discussions ongoing on a plan to mitigate the balance sheet risks of households from their exposure to foreign currency loans by:
    - extending duration of the loan
    - converting fx-based loan to a forint loan at no extra charge
    - transitionally reducing the installments if unable to service the existing loan
- Poland
  - Deposit insurance/debt guarantee:
    - The Bank Guarantee Fund law has been amended to increase the level of deposit guarantee from EUR 22,500 to EUR 50,000 and eliminate coinsurance
    - Draft law to guarantee interbank lending submitted to parliament
    - The government has set aside 40 billion zloty for these guarantees
  - Bank capital injection: Increase the capital of state-owned BGK bank by 2 billion zloty

### Fiscal Policy — Tax, expenditure, and stimulus measures
- Czech Republic
  - Tax/revenue measures: Tax cuts previously envisaged for 2009 canceled, and commitment not to make changes in the tax code that could lead to lower net revenues.
  - Expenditure/public investment:
    - Primary government expenditure reduced by 2 percentage points of GDP
    - Overall deficit target for 2009 cut to 2½ percent of GDP
    - Announcement of an economic stimulus package
    - Fiscal responsibility law passed by parliament
- Hungary
  - Tax/revenue measures: Excise tax on alcohol and luxury car raised to finance budget reserve for social assistance to the poor.
  - Expenditure/public investment measures: Accelerate EU fund spending (PLN 7 billion beyond 2009 budget and PLN 3 billion advance from the EU).

### International Financial Support
- Hungary
  - (i) Hungary reached agreement on a 17-month stand-by arrangement of SDR 10.5 billion ($15¾ billion, €12½ billion) from the IMF, with the first tranche of SDR 4.2 billion
  - (ii) EU approved a €6½ billion loan, with an additional €1 billion coming from the World Bank

*Source: _wp0968 - APPENDIX II. CRISIS RESPONSE MEASURES IN SELECTED NMS COUNTRIES*

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