Emerging Europe—Lessons from the Boom-Bust Cycle

IMF Blog, October 20, 2010

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Emerging economies in central and eastern Europe will grow by 3¾ percent this year and next.
Growth recovery follows a 6 percent decline in 2009.
The crisis severity varied: some countries experienced GDP declines comparable to the Great Depression (Estonia, Latvia, Lithuania, Ukraine), while others avoided declines altogether (Albania, Poland).

The seeds of the crisis were sown, in large part, in the five years before the crisis.
Between 2003 and 2008, much of the region experienced a boom in bank credit, asset prices, and domestic demand.
The boom was fueled and financed by large capital inflows.
Low interest rates in advanced countries prompted banks in western Europe to expand aggressively into emerging Europe, attracted by higher returns.
Consequences of the boom:
- Current account deficits increased to unprecedented levels in some countries.
- Inflation accelerated.
- Substantial vulnerabilities emerged in bank and household balance sheets, particularly because much of the borrowing was in foreign currency.
- The region became addicted to foreign-financed credit growth, increasing vulnerability to disruptions in capital inflows.
After Lehman Brothers defaulted in September 2008:
- Global trade collapsed.
- Capital inflows into the region plummeted.
- Credit growth suddenly stopped.
- Domestic demand plunged.

First lesson: Boom-bust credit cycles can be very costly; preventing credit booms from getting out of hand is essential.
Countries with the fastest credit growth during the boom years saw the deepest recessions.
Average GDP growth over the full business cycle in high-credit-growth countries was no higher, and in some cases was lower, than in countries with more modest credit growth.

Controlling credit growth is difficult; prudential measures alone rarely suffice, especially in small countries overwhelmed by foreign capital inflows.
Fixed exchange rates often impose further constraints:
- Strongest credit growth during the boom years took place in countries with fixed exchange rate regimes.
- Fixed exchange rates are not the cause of credit booms (some fixed-regime countries did not have a boom), but they make it harder to stop credit booms, particularly with large capital inflows.
- Countries with fixed exchange rates don’t have the full range of monetary policy tools to restrain credit booms once they set in.
Closer cooperation with supervisors in western Europe can help make prudential measures more effective, since credit booms driven by capital flows from western European parent banks are hard to stop when recipient-country supervisors act alone.

Second major lesson: the need for more prudent fiscal policy—saving money when revenues are growing rather than increasing spending and boosting public wages.
Prior to the crisis, headline fiscal positions looked good but masked a deterioration of the underlying fiscal position.
Public expenditure was surging, financed by a temporary revenue boom, contributing to overheating and setting the stage for large fiscal deficits.
When revenue plummeted in 2009 and fiscal deficits increased sharply, many countries had no choice but to cut spending precisely when it was most painful.
Policy recommendation:
- When revenue takes off during the next boom, it should be used to build up fiscal buffers rather than boost expenditure.
- Recognize political challenges—pressure to increase expenditure or cut taxes when revenues abound—but building buffers will help dampen the boom and create fiscal space to soften the impact of the next recession.

Growth should become more balanced and less dependent on domestic demand and capital inflows.
Private sector adjustment expected:
- As profits in the nontradable sector (finance, real estate, construction) have shrunk, investments will seek more promising venues.
Policy measures to support balanced growth:
- More balanced macroeconomic policies.
- Wage restraint to prevent overheating that pulls resources from the tradable to the nontradable sector.
Cautionary guidance:
- Be wary of claims that “this time will be different.”
- Use careful analysis of drivers of growth, current account deficits, asset price developments, and credit growth as a “reality check.”

Ajai Chopra, October 20, 2010 — Emerging Europe—Lessons from the Boom-Bust Cycle