Reigniting Growth in Emerging Europe

IMF Blog, February 10, 2010

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Exports are rebounding, and domestic demand is showing signs of stabilization.
Most countries will see positive GDP growth this year—a stark difference from 2009.
A return to the high growth rates that preceded the crisis is highly unlikely.

During the boom years, Eastern Europe grew rapidly but growth was often unbalanced: large capital inflows went largely to the “non-tradable” sector—real estate, construction, and banking.
Capital flows boosted domestic demand rather than supply, leading to a surge in imports and unprecedented current account deficits.
The domestic demand boom ended in the fall of 2008; capital flows plunged after the demise of Lehman Brothers, causing a sharp decline in domestic demand and, together with falling exports, a deep downturn.
In the Baltics and Ukraine, GDP declined between 14 and 19 percent last year.
Exports are now recovering, but domestic demand will likely stay weak: “experience tells us that once credit booms end, consumers tend to rein in their spending for a long time as they pay off their debts.”
Policy implication: Emerging Europe needs to diversify away from non-tradables to tradables—growth should come from manufacturing and services rather than construction, real estate, and banking.

The region’s past transitions demonstrate economic flexibility: “It is only twenty years ago that the region began the transition from a centrally planned economy to a market-based one.”
The private sector will be central to reallocating resources from non-tradables to tradables as profitability patterns change.
Empirical example: when the U.S. housing price boom ended, residential construction declined by 75 percent—illustrating how profitability shifts can sharply reduce investment in non-tradable sectors.

Well designed macroeconomic policies and structural reforms can help restore growth and prevent future overheating.
Fiscal policy should play a more active role: when revenues grow strongly, use them to build fiscal buffers instead of increasing spending and public wages.
During boom times, small fiscal surpluses may not be sufficient; “sometimes large or very large surpluses may be needed.”
A large fiscal buffer reduces the need for sharp expenditure cuts during recessions.
Competitiveness concern: unit labor costs in manufacturing increased relative to trading partners between 2003 and 2008—Latvia 90 percent, Bulgaria 40 percent, Estonia 30 percent, Romania 30 percent.
Although market share of most countries continued to rise, continued deterioration in competitiveness would become a problem.
Tighter fiscal policy during boom years will help moderate wage growth; wage catch-up with Western Europe should be paced with productivity increases in manufacturing.
Warning: if wages rise by over 20 percent annually—as happened in Bulgaria and the Baltics during the boom—competitiveness will deteriorate quickly and deter investors from building new export plants.

Emerging Europe should not rely solely on competing on low wage costs; competition against countries such as China and emigration pressures make low-wage strategies unsustainable.
Strategy: move up the quality ladder and produce increasingly sophisticated products.
Structural reforms to bolster the business climate, improvements in education, and, in some countries, combating corruption will assist in this shift.

Foreign capital can be helpful when it boosts supply rather than demand.
Foreign direct investment in external trade–oriented sectors is particularly beneficial: it boosts growth, transfers technology, and improves labor force skills.
Experience from the Czech and Slovak Republics: growth during the boom was more balanced (smaller credit boom, small current account deficits, exports as important as domestic demand). While their boom growth looked weaker than countries with strong domestic demand booms, their recessions were much less deep and, over a longer period, they have actually grown faster than countries that relied on the non-tradable sector.

Reigniting Growth in Emerging Europe — Marek Belka, February 10, 2010