Europe is going through a deep recession, driven by a collapse in confidence and global demand, and by adverse feedback effects between its financial system and the real economy. Unprecedented policy actions have brought about a measure of stability and cushioned the downturn. However, establishing a solid economic recovery will require additional and effectively coordinated policy interventions. The crisis provides an opportunity to strengthen economic and financial integration in Europe, including by strongly supporting emerging economies, that should not be missed.
For the countries of central Europe—the Czech Republic, Hungary, Poland, the Slovak Republic, and Slovenia—this is the Accession decade. By contrast with the uncharted waters of transition in the 1990s, the approaches to European Union (EU) membership—and beyond that the euro—are, in many respects, mapped out in advance. And the prospect of EU membership, from the early days of transition, has served as a policy anchor, helping to catalyze and sustain coalitions for reform. But policymakers face continuing challenges as they frame macroeconomic and financial sector policies during the run-up to accession and, in due course, monetary union. These challenges are the subject of the studies presented here.
The principle of an EU enlargement toward central and eastern Europe was first announced at the European Council meeting of Copenhagen in June 1993. This committed the European Union to admitting countries that had signed association agreements with it.2 Also of considerable significance, the European Council established the so-called Copenhagen criteria for EU accession. These criteria represented an understanding that central and eastern European countries would be admitted to the European Union once they had met certain conditions. This criteria established a number of benchmarks for assessing their progress toward economic and political compatibility with the EU.
On the heels of the global financial crisis, active fiscal policy is back on the agenda of the advanced European economies. Indeed, a fiscal expansion could be particularly effective in the near-term economic environment: the recent tightening of credit constraints could make spending more sensitive to current income and, thus, taxes and subsidies. Given the increased integration of European economies, policy coordination is nonetheless key to magnifying the effects of national fiscal expansions. While it is important for countries to support their economies in the face of this unprecedented slowdown, a clear and credible commitment to long-run fiscal discipline is now more essential than ever: any loss of market confidence may raise long-term real interest rates and debtservice costs, partly offsetting the stimulus effects of measures taken to deal with the crisis and further adding to financing pressures. Hence, it is particularly crucial that any short-term fiscal action be cast within a credible medium-term fiscal framework and envisage a fiscal correction as the crisis abates.
A short period of apparent resilience to the global financial turmoil has given way to a deep crisis in several European emerging markets, though with substantial differentiation across the region. The crisis has put an increased premium on sound macroeconomic and macroprudential policies: countries with lower inflation, smaller current account deficits, and lower dependence on bank-related capital inflows in recent years have so far fared better. While the external environment and structural reform efforts will matter, the banking sector, which has played a central role in the run-up to the crisis, holds a key to the speed of recovery from the crisis. In the short term, bank recapitalizations seem unavoidable to prevent recessions from becoming protracted. In the medium term, recovery efforts need to be supported by a strengthening of financial stability arrangements, including for cross-border activities, and the introduction of more forward-looking provisioning policies.
Mr. Peter Doyle, Mr. Guorong Jiang, and Louis Kuijs
For transition countries in the process of joining the EU, the prospects for the real sector will be critical in determining the appropriate policy frameworks both before and after accession. This chapter discusses the key factors likely to shape the nature and pace of growth in five of these countries in central and eastern Europe that form the focus of this book: Poland, the Czech Republic, the Slovak Republic, Hungary, and Slovenia—known collectively as the CEC5.
In the run-up to EU accession—a setting of real convergence and sizable, possibly volatile, capital inflows—the role of the financial sector in supporting broadly based and stable growth will move to center stage for a number of reasons. First, successful reform of the banking sector is a necessary condition for fiscal and monetary stabilization. Second, a well-functioning financial sector helps enforce corporate control, contains potential quasi-fiscal losses in the enterprise sector, and is, therefore, key in fostering sound enterprise development. Third, financial sector resilience is crucial for a flexible interest rate policy and a predictable and effective monetary transmission. Fourth, effective supervision, regulation, and risk management can help mitigate vulnerabilities associated with capital flows. More broadly, empirical evidence has shown convincingly that countries with better developed financial systems enjoy substantially faster and stable long-run growth through channeling savings into productive investments.
Enhancing financial stability and reducing the vulnerability of financial systems—with particular emphasis on the banking sector—are key aims in each of the CEC5. In addition to the reform priorities discussed previously, they face additional challenges in securing the path to financial stability: successfully coping with potentially strong capital flows, building up risk management capacity, ensuring the provision of adequate financial safety nets without encouraging moral hazard behavior, and striving to meet international financial market standards. An overarching priority in this regard is to put in place an effective legal and institutional framework, with a focus on the supervisory role in preventing a build-up of risks. The IMF has also been actively developing a broader framework for assessing financial vulnerability to assist its member countries in identifying areas for improvement to enhance stability.
Rachel van Elkan, Robert A. Feldman, Louis Kuijs, and C. Maxwell Watson
The policy challenges confronting monetary authorities in central Europe over the next few years—as they design and modify their monetary and exchange rate regimes—are in many respects similar to those facing other emerging market economies.61 The central challenge is to complete and consolidate disinflation, and secure financial stability, against the backdrop of major structural changes in the real economy and sizable—possibly volatile—international capital flows. But the CEC5 are undertaking, in addition, a specific policy agenda: the reforms required for EU and, ultimately, euro area membership. Policymakers, therefore, must also be attentive to developing monetary, exchange rate, and financial frameworks that are consistent with these goals.