How Emerging Europe Came Through the 2008/09 Crisis
Front Matter

Front Matter

Bas Bakker, and Christoph Klingen
Published Date:
August 2012
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    © 2012 International Monetary Fund

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    Joint World Bank–International Monetary Fund Library

    How emerging Europe came through the 2008/09 crisis : an account / by the staff of the IMF’s European Department ; edited by Bas B. Bakker and Christoph Klingen. – Washington, D.C. : International Monetary Fund, 2012.

    Includes bibliographical references.

    ISBN 9781616353810

    1. Global Financial Crisis, 2008–2009. 2. Financial crises – Europe. 3. Financial crises – Developing countries. 4. International Monetary Fund – Europe. 5. International Monetary Fund – Developing countries. I. Bakker, Bas Berend. II. Klingen, Christoph. III. International Monetary Fund. IV. International Monetary Fund. European Dept.

    HB3717 2008 .H69 2012

    Disclaimer: The views expressed in this book are those of the authors and should not be reported as or attributed to the International Monetary Fund, its Executive Board, or the governments of any of its members.

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    With the continued turmoil in the euro area, one might easily forget that only a few years ago the other part of the continent, emerging Europe, went through a deep economic and financial crisis. The global financial crisis and its aftermath were challenging the world over, but emerging Europe was particularly hard hit. After a long stretch of prosperous years, a sudden stop of capital inflows in the fall of 2008 triggered a sharp contraction of domestic demand, just when the slump in global trade hit the region’s exports. This “perfect storm” resulted in an unprecedented economic contraction. By the time the region started to turn the corner, GDP in some countries had declined by as much as 25 percent, although a few economies managed to escape relatively unscathed.

    This book recounts the crisis—its origins and the precrisis policy setting, the crisis triggers and the scramble by governments and the international community to avoid meltdown, stabilization and the subsequent recovery, and the remaining challenges. It distills the lessons for the future from the diversity of country experiences within the region. The book argues that while the crisis was triggered by external shocks, its seeds were sown over many years as economic policies failed to recognize and address the buildup of vulnerabilities.

    The policy response to the crisis was swift and forceful. Countries’ determined adjustment programs and unprecedented financing from the international community prevented looming financial meltdown, but it was too late to forestall a deep recession. Corrective action was not easy and often demanded that societies make extraordinary sacrifices, but in 2011 economic growth had returned to all countries in the region and income convergence with western Europe had resumed.

    Nonetheless, continued efforts are needed to bring down further long-standing vulnerabilities and firmly entrench robust growth. Many of the imbalances that characterized much of emerging Europe prior to the crisis have disappeared. But public finances are significantly weaker than in 2008, nonperforming loans have increased in all countries, and high external debt continues to expose the region to spillovers from volatile global financial markets. Growth needs to be reoriented toward the tradable sector in many countries and the region will have to adapt to the reality of more muted cross-border bank financing.

    This book should be viewed as an interim stock-taking exercise by a team of IMF staff that worked on emerging Europe during the crisis. It contains information on what happened in individual countries, and aims at being a useful reference for economists and historians studying the crisis in emerging Europe. Its analysis is by no means the final word, and insights will inevitably evolve further in the years ahead. Many important lessons have nonetheless already emerged, both in crisis prevention and crisis resolution, which makes this book relevant not only for emerging Europe but for many other countries as well.

    Reza Moghadam


    European Department

    International Monetary Fund


    This book brings together the extensive work that has been done in the IMF’s European Department on the 2008/09 crisis in emerging Europe. It is written by a group of IMF staff who worked on emerging Europe during the crisis. It contains both a regional perspective, which builds on the work done in the Emerging Europe Regional Division of the European Department, and detailed country-by-country accounts, authored by the respective IMF country teams.

    The authors include, in alphabetical order, Athanasios Arvanitis, Ruben V. Atoyan, Bas B. Bakker, Gerwin Bell, Alina Carare, Chuling Chen, Lone Christiansen, Costas Christou, Milan Cuc, Xavier Debrun, Peter Dohlman, Arbër Domi, Christoph Duenwald, Natan Epstein, Jeffrey Franks, Michael Gorbanyov, Manuela Goretti, Mark Griffiths, Nikolay Gueorguiev, Anne-Marie Gulde-Wolf, David Hofman, Plamen Iossifov, Albert Jaeger, Christopher Jarvis, Phakawa Jeasakul, James John, Yuko Kinoshita, Christoph Klingen, Dimitry Kovtun, Julie Kozack, Mark Lewis, Eliza Lis, Ricardo Llaudes, Wes McGrew, Tokhir Mirzoev, Pritha Mitra, James Morsink, Zuzana Murgasova, Jürgen Odenius, Catriona Purfield, Jesmin Rahman, Christoph Rosenberg, Stephane Roudet, Linda Spahia, Gabriel Srour, Alexander Tieman, Anita Tuladhar, Jérôme Vandenbussche, Delia Velculescu, Johannes Wiegand, and Daria Zakharova.

    The production of this book involved many people. In particular, the book owes much to Anne-Marie Gulde-Wolf for providing guidance and support, Amara Myaing and Lauren Stewart for administrative assistance, and Cleary Haines, Xiaobo Shao, and Jessie Yang for research assistance. Joanne Blake of the External Relations Department coordinated the editing and production.

    This book benefited from the constructive and frank discussions on the crisis in emerging Europe that the authors have had over recent years. Besides the numerous country authorities across the region, and without implicating anyone and with inevitable risks of omission, we would in particular like to thank Anders Åslund, Eric Berglöf, Zsolt Darvas, Willy Kiekens, Christian Keller, Russell Kincaid, Leslie Lipschitz, Reiner Martin, Piroshka Nagy, Max Watson, Beatrice Weder di Mauro, Onno Wijnholds, and Jeromin Zettelmeyer. The book also benefited from feedback on an earlier paper presented at conferences at the European Central Bank and the Österreichische Nationalbank, and from feedback from audiences at events presenting various issues of the IMF’s Regional Economic Outlook for Europe.

    Bas B. Bakker and Christoph Klingen

    Introduction and Overview

    The Precrisis Years

    Between 1995 and 2007, emerging Europe grew faster than all other emerging market regions, with the exception only of China and India. As the region made the transition from central planning to market economies, institutions were modernized, often in the context of an EU accession process. Foreign direct investment poured in to benefit from highly skilled and inexpensive labor.

    Until 2003, growth was driven largely by exports, but from 2003 onward, growth in the region was increasingly due to a credit-fueled surge in domestic demand. Rapid credit growth partly reflected catch-up, with less prosperous countries experiencing faster credit growth and financial deepening. However, in many countries the speed of credit growth was too rapid and jeopardized macroeconomic stability.

    The domestic demand boom was fueled and financed by unprecedented capital inflows. Emerging Europe as a whole had been the beneficiary of large capital inflows since the late 1990s. With low wages and low capital-labor ratios, returns on investment in emerging Europe were highly attractive. Capital inflows were further stimulated by post-transition reforms. From 2003 onward, push factors—low interest rates in advanced economies and low global risk aversion—added more fuel to capital inflows, as did the dismantling of barriers to capital flows in the context of EU accession, and the expectation of euro adoption. As a result, capital flows to emerging Europe became very large by historical standards and compared with other emerging market economies.

    The size of the capital inflows varied significantly across countries, and some countries managed to avoid excessive capital inflows altogether. Capital inflows were particularly large in the Baltic countries and southeastern Europe, whereas the more mature economies of the Czech Republic and Poland, which had flexible exchange rate regimes and small interest rate differentials with the euro, as well as Russia and Turkey, received much more moderate inflows.

    Capital flows from western European banks were a key conduit for the credit and demand boom in emerging Europe. Western European banks expanded aggressively in emerging Europe, aiming to gain market share in a growing region. With low margins in western Europe, western banks became increasingly interested in expanding in eastern Europe and came to dominate much of the region’s banking systems as they acquired local banks that were privatized or put up for sale by their private owners. Western European banks financed much of the credit increase through loans, deposits, and capital provided to their local subsidiaries.

    The credit booms contributed to rapid GDP growth, but the flip side was overheated economies and sharply increased current account deficits. Overheating was particularly pronounced in the Baltic countries, in Bulgaria and Montenegro, and in the European countries of the Commonwealth of Independent States (CIS).1 Overheating was not only visible in inflation and wages, housing prices were also increasing rapidly.

    By 2007, the growth pattern of many countries was unsustainable and vulnerable to a sudden decline in capital inflows. Growth had become reliant on domestic demand, supported by a continued rapid expansion of credit, large capital inflows, and continued asset price appreciation, and any slowdown or reversal of foreign financing was bound to hit the economy hard.

    Procyclical fiscal policy further exacerbated imbalances. Indeed, there was not only a boom in private sector demand, public expenditure grew rapidly as well. The boom in domestic demand and the increase in commodity prices (in commodity exporters such as Russia) led to buoyant government revenues—a windfall that was generally recycled right back into public spending.

    Many country authorities grew concerned about the unfolding credit boom, but the prudential measures that were adopted in response generally proved toothless. Restrictions on credit growth were easily circumvented as inflows moved to less supervised channels.

    Until mid-2007, risk premiums in the region continued to decline uniformly, and some countries with very high vulnerabilities continued to enjoy investment grade status. The high ratings received intellectual endorsement by many economists who argued that rapid credit growth and large current account deficits were part of rapid catch-up—an equilibrium phenomenon. Even when vulnerabilities were recognized, it was difficult to envisage a shock severe enough to trigger an actual crisis, and few recognized the risk that a shock to the region could originate from the western financial system. Had risk premiums risen in line with the increasing imbalances, capital flows would have slowed, credit growth would have been more moderate, and private sector demand would not have expanded as rapidly.

    Gathering Clouds

    Between the onset of the global financial crisis in August 2007 and the default of Lehman Brothers in September 2008, the region was little affected by the global turmoil. Capital continued to flow into emerging Europe, and credit was still growing strongly. As inflation was rising rapidly, controlling inflation was seen as the most pressing challenge for policymakers.

    The Baltic countries and Hungary were the only economies in which the impact of the global financial crisis made itself felt well before the default of Lehman Brothers. The former experienced an economic slowdown when Swedish banks, concerned about their exposure, started to rein in credit growth in the summer of 2007. The housing bubble burst, and domestic demand started to decline, with Estonia and Latvia already entering a recession in the first half of 2008.

    Hungary experienced a short episode of financial stress in March 2008, when a government debt auction ran into trouble. Although Hungary was not showing signs of overheating and its private sector flow imbalances were smaller than elsewhere, public debt stock vulnerabilities were unsettlingly high. Public debt at end-2007 amounted to 66 percent of GDP, and about one-third of it was held by footloose foreign investors.

    The Default of Lehman Brothers and the Aftermath

    It was in mid-September 2008, when Lehman Brothers collapsed, that the global crisis arrived in emerging Europe with a vengeance. Global financial markets froze; international trade came to a standstill; and commodity prices collapsed, hitting the whole region on a scale beyond the most pessimistic expectations. Sovereign credit default swap (CDS) spreads jumped; issuing of international sovereign bonds became next to impossible; and countries with relatively more developed markets faced a reversal of international portfolio flows. In countries with floating exchange rate regimes, currencies fell sharply, while most countries with fixed exchange rate arrangements suffered significant reserve losses.

    Emerging Europe’s banks came under funding pressures when the capital flows of western European banks to the region dropped sharply. In a change of strategy, many advanced-country banks, which were confronted with liquidity and capital shortages, gave their subsidiaries and branches in emerging Europe new marching orders: new credit would henceforth need to be financed solely from local deposit growth. They also halted cross-border loans to nonbanks. Banks’ funding pressures were further exacerbated by the freezing of the international syndicated loans market and by local deposit withdrawals in October and November, in particular in the European CIS countries, the Baltic countries, and non-EU southeastern Europe.

    Output in most countries declined very sharply when the collapse in global trade caused exports to plummet, just when domestic demand reeled from the sudden slowdown in credit growth and the bursting of the real estate bubbles. The output decline in emerging Europe as a whole was larger than in other emerging market regions, mainly because capital inflows corrected from a higher level in emerging Europe than elsewhere. Countries that had the largest credit and domestic demand boom in the precrisis years experienced the largest contractions in GDP in 2009. A few countries escaped severe recession—Poland due to its contained precrisis boom and fortuitously countercyclical policies, as well as the less interconnected economies of Albania, Belarus, and Macedonia.

    Policy Reactions

    Stabilizing the financial sectors was the first order of the day. The most commonly used tool to provide systemic liquidity was the relaxation of reserve requirements. Several countries also introduced new domestic and foreign currency liquidity supply operations. To contain the risk of bank runs, deposit insurance coverage was increased. To strengthen banks’ capital positions, many supervisors urged a zero-dividend policy and sometimes requested preemptive recapitalizations based on stress tests. National authorities also intervened directly in selected individual distressed institutions to provide them with fresh liquidity or capital.

    Monetary policy reactions were circumscribed by depreciation pressures and the exchange rate risks on balance sheets. Where large exchange rate depreciations or devaluations would have threatened private sector balance sheets because of direct or indirect foreign exchange risk, policy rates were temporarily increased (as in Hungary, Russia, Serbia, and Ukraine) or put on hold (as in Latvia and Romania). In other countries, policymakers decreased policy rates (the Czech Republic, Poland, and Turkey). Monetary and exchange rate policy frameworks were generally maintained, but circumstances in Belarus, Russia, and Ukraine necessitated steep depreciations of their heavily managed exchange rates.

    The immediate fiscal policy response depended on precrisis fiscal buffers, the exchange rate regime, and the position in the political cycle. Few could afford fiscal expansion, and many needed to implement fiscal adjustment. Russia, Turkey, Poland, and the Czech Republic were exceptions because of flexible exchange rate regimes, small deficits, and limited debt.

    Large, front-loaded financial assistance packages from the IMF, often in close cooperation with the European Union and other multilateral institutions, provided external funding and smoothed the required policy adjustments in several countries. A total of 10 countries secured critical external financing under IMF-supported arrangements. Considerably larger amounts of financing were made available than in earlier crises. Moreover, disbursements were much more front-loaded in the programs in emerging Europe, with the first disbursement accounting for a very large share of overall financing committed under the programs.

    From Crisis to Recovery

    By early 2009, the panic that had gripped global financial markets began to abate. As tensions in global financial markets eased, financial conditions in emerging Europe started to improve as well. In some countries, CDS spreads fell to half their peak levels during the spring months. At the same time, global economic activity started to rebound, while the forceful and internationally coordinated policy response further bolstered confidence and reduced uncertainty.

    The resurgence of world trade and global manufacturing output led to an export-led recovery in emerging Europe, and in 2010 GDP in the region grew by 4½ percent, after having contracted by about 6 percent in 2009. Domestic demand, however, remained weak in many countries, particularly in those that had seen the strongest domestic demand booms in the precrisis years. Domestic demand in countries where imbalances in the precrisis years had been more contained (including Poland and Turkey) remained quite strong and received further support from an early revival of capital inflows.

    By 2011, the recovery had broadened from exports to domestic demand, and all crisis-affected countries had emerged from recession. The recovery of domestic demand was particularly strong in the Baltic countries, while it remained more subdued in southeastern Europe. Despite the economic recovery, large differences in cyclical positions and growth rates remained, with GDP flat in Croatia and growth hitting 8½ percent in Turkey.

    The crisis left much of the region with three legacies: deteriorated public finances, high unemployment, and increased nonperforming loans.

    • Public finances deteriorated sharply. Before the crisis, headline fiscal balances in the region looked much better than in other emerging market regions. In 2007, the average headline balance in the region showed a surplus of about 2 percent of GDP. By 2009, the fiscal balance in the region had deteriorated to a deficit of 6.2 percent of GDP—despite significant fiscal adjustment. In Latvia and Lithuania, deficits approached double digits. Significant fiscal consolidation, together with the economic recovery, reduced the region’s deficit to 4.4 percent of GDP in 2010 and 0.5 percent of GDP in 2011, but fiscal vulnerabilities remain high in a number of countries. Some countries still had a deficit in 2011 in excess of 5 percent of GDP (Poland, Croatia, Lithuania, and Montenegro), and some countries (notably Hungary, Albania, and Poland) continued to have high public debt. In Hungary and Albania relatively high shares of short-term debt further exacerbated vulnerabilities.

    • Unemployment rates shot up sharply. This was most dramatically the case in the Baltic countries. Unemployment rates dropped in 2010 and 2011 but remain well above precrisis levels. The rise in unemployment in southeastern Europe was less dramatic, but with that subregion’s much weaker recovery, unemployment had declined only little by 2011 and had been uncomfortably high even before the crisis.

    • Banks’ nonperforming loans increased sharply. The average reported non-performing loan ratio in emerging Europe increased from 3½ percent at end-2007 to over 11 percent at end-2011. Ratios peaked at about 20 percent in Montenegro, Lithuania, and Serbia. While considerable provisioning and strong capitalization provide important buffers, it is likely that the high non-performing loans will hold back credit growth and economic recovery if allowed to linger.

    How Meltdown was Avoided

    In the aftermath of the Lehman Brothers collapse, concerns about meltdown were not far-fetched considering the many vulnerabilities that had built up in most countries of the region in the precrisis years. Yet the feared financial meltdown did not materialize. The fixed exchange rate regimes weathered the crisis, and floating exchange rates generally rebounded quickly from their troughs (except in the large European CIS countries). Similarly, the strain in banking systems morphed into outright systemic banking crises only in Latvia and Ukraine.

    Why is it, then, that emerging Europe escaped financial meltdown? Decisive domestic policy responses certainly played a key role. However, they would have stood much less of a chance had it not been for large-scale international support, policy easing in the advanced economies, and western banks that remained committed to the region.

    • Large external financing packages helped reassure jittery financial markets that exchange rates and the funding of domestic spending plans were indeed sustainable. When it became clear that the financial crisis was spreading from the advanced economies to emerging markets, the international community acted quickly to shore up the economies in emerging Europe. One prime vehicle of assistance was large IMF-supported programs, which were joint with the European Union in the case of EU member countries. Other international financial institutions also stepped up their efforts.

    • Policy easing in advanced economies also helped. The interest rates of the major currencies were cut to extremely low levels, and fiscal stimulus measures were put in place in most of the advanced economies. Both had positive spillover effects to emerging market economies.

    • The commitment of foreign banks to stay in the region was another key stabilizing factor during the crisis. No parent bank allowed a single one of its subsidiaries to fail in the entire region, and in most cases parent banks provided additional liquidity and capital to their subsidiaries in emerging Europe, as needed. IMF-supported programs and the so-called Vienna Initiative helped avoid an uncoordinated pullout of western banks from emerging Europe. The large-scale programs significantly reduced the odds of financial meltdown occurring, but there were also more direct efforts to keep banks engaged. As part of an overall effort to coordinate the crisis response under the Vienna Initiative, key foreign banks pledged in writing that they would keep net exposure to their subsidiaries at prespecified levels.

    Country Experiences

    How did the events surrounding the 2008/09 crisis play out concretely at the country level of the 19 economies that make up emerging Europe? What exactly were the pressure points, were they recognized at the time, what kind of policy response did they engender, and what were the economic outcomes? The broad thread—easy global financing conditions and an optimistic perspective on income convergence with western Europe that allow imbalances to persist or escalate so that a soft landing becomes extremely difficult—runs through all country experiences. However, there were important cross-country differences in the size of the boom-bust cycles and economic outcomes, and these differences reflected the strength and type of linkages with the rest of the world, precrisis policies, and the crisis response.

    Ten countries in emerging Europe availed themselves of IMF-supported arrangements during 2008–10. Hungary, Ukraine, Latvia, Belarus, Serbia, Romania, Bosnia-Herzegovina, and Moldova received critical financial support under adjustment programs designed to forestall financial meltdown, mitigate the fallout from the crisis, and lay the foundations for lasting recovery. Poland secured a Flexible Credit Line (FCL) from the IMF to provide additional cover for its crisis-response policies, although no need arose to draw on it. The primary purpose of the program with Kosovo was to provide a framework for its large post-independence infrastructure spending, rather than to respond to the crisis.

    Three weeks after the collapse of Lehman Brothers, Hungary became the first country to request financial assistance from the IMF and the European Union when it found its gross financing needs impossible to meet on its own. Longstanding vulnerabilities from high public and external debt were the key problem rather than a pronounced precrisis demand boom. A €20 billion external financing package and a determined policy response restored financial stability and mitigated the downturn. However, a change of government led to partial policy reversals and the premature lapse of the program in mid-2010, leaving Hungary ill-prepared to weather the spillovers from the euro area crisis.

    Ukraine was particularly hard-hit by the crisis and was next to approach the IMF. It not only faced a sudden stop of capital inflows and a collapse of exports like everybody else in the region—on top of that it suffered a major terms-of-trade shock as prices for its key metals exports plummeted and Russia cut its subsidies on Ukraine’s energy imports. Ukraine suffered the second-largest output drop in emerging Europe, a banking crisis, and the demise of its exchange rate peg. The IMF-supported program focused on repairing the financial sector and tightening monetary policy to contain inflation in the wake of the depreciation. Fiscal policy cushioned the downturn. Ukraine recovered strongly in 2010–11, but structural and institutional reforms are still needed to underwrite economic success for the long haul.

    Latvia was arguably the most overheated economy in the region, with a current account deficit that peaked at well over 20 percent of GDP and several years of double-digit output growth. The Latvia program supported by the IMF and the European Union was put in place in late December 2008. Unprecedented external financial support equivalent to more than 30 percent of its GDP, austerity measures worth some 15 percent of GDP, nominal wage cuts, and a host of structural reforms came together in a program that was designed around preserving Latvia’s quasi currency-board arrangement—a key policy anchor since the early days of transition. The costs in terms of peak-to-trough output loss were the largest in the region, and the second largest bank in the country failed. However, notwithstanding Latvia’s enormous precrisis challenges, financial meltdown was avoided, external balance was restored, and the economy grew by over 5 percent in 2011. Defying the skeptics, the exchange rate peg held. The very real risk that a collapse of Latvia’s exchange rate arrangement would set off a contagious domino effect throughout the region’s many fixed exchange rate regimes did not materialize.

    Belarus is a tale of missed opportunities. It was also beset by large precrisis imbalances with persistently high current account deficits and very high growth. Given its limited integration with global financial markets, risks arose mainly from a persistent drain of reserves from the trade account and dependence on substantial energy subsidies from Russia. The stand-by arrangement of January 2009 with the IMF sought external adjustment through a 20 percent devaluation, macroeconomic tightening, and steps to improve the competitiveness of the still largely state-controlled economy. Good progress was made, and Belarus was among the few countries in the region to escape recession in 2009. However, significant policy loosening after the end of the program triggered a major currency crisis in 2011, which raged through much of the year.

    Large structural external imbalances were the Achilles heel of Serbia. The drying-up of external financing put strong pressure on the dinar, and the banking system experienced heavy withdrawals of foreign currency deposits. Large current account deficits predated the boom years and reflected income and consumption habits that were no longer realistic. The stand-by arrangement of January 2009 and a bail-in agreement with foreign banks helped stave off financial instability. Large, front-loaded fiscal adjustment created room for automatic fiscal stabilizers to operate through the remainder of the crisis period. And a significant real depreciation restored external cost competitiveness. These successes notwithstanding, the crisis exposed deep flaws in Serbia’s consumption-based growth model that were still being addressed in late 2011.

    Like Latvia, Romania is another straightforward example of the boom-bust cycle in emerging Europe, but under a flexible exchange rate regime and not quite so extreme. Exuberance about its clear prospects for EU membership in conjunction with ample global liquidity led to internal and external imbalances that were forced to correct abruptly in the wake of the global financial crisis. Despite limited public debt and a generally well capitalized banking system, the government ran into difficulties financing the rapidly widening fiscal deficit, and banks experienced an incipient deposit run. The €20 billion financial support program by the IMF and the European Union of May 2009 forestalled a banking crisis, together with a bail-in arrangement with banks. Measures to address the short- and long-term sources of fiscal deficits, steps to strengthen the prudential framework, and prudent monetary policy restored macroeconomic stability. As elsewhere in southeastern Europe, economic recovery was slow to take hold, but GDP expanded by 2½ percent in 2011.

    The global crisis quickly exposed the fragility of Bosnia and Herzegovina’s growth, which relied on ample foreign-financed credit, inward remittances, and donor-financed reconstruction of the war-torn economy. Balance-of-payments pressures escalated in the first half of 2009 when remittances declined and foreign banks and investors became unwilling to provide the customary funding. The authorities’ stabilization program, supported under the July 2009 stand-by arrangement with the IMF, stabilized public finances and shored up confidence in the currency board and the domestic banking system, thereby limiting the output loss.

    Contrary to initial hopes, the global financial crisis did not bypass Moldova. The international linkages of its banking system were limited, but a sharp drop of critical remittances and plunging exports put severe pressure on the balance of payments. After an initially incoherent policy response, the IMF-supported program of January 2010 put in place a strategy to correct the structural imbalances at a pace matching the speed of the economic recovery, accelerated a transition to inflation targeting and exchange rate flexibility, and strengthened banks’ capital and liquidity buffers through proactive supervision. Moldova recorded strong growth of 7 and 6½ percent in 2010 and 2011, respectively.

    Poland came through the global financial crisis perhaps the best of all countries in the region. It entered the crisis with relatively contained imbalances and vulnerabilities, owing to relatively tight macroeconomic policies, prudential measures to limit foreign-currency lending, and convergence with western Europe that was already well advanced at the beginning of the boom period. It used its policy space aggressively to minimize the impact of the crisis, using the FCL of May 2009 to bolster confidence further and maintain access to international capital markets throughout. Poland famously became the only country in the European Union to avoid recession in 2009 and posted strong growth of some 4 percent in 2010 and 2011.

    The remaining nine countries of emerging Europe weathered the crisis without arrangements with the IMF, although they too likely benefited from the demonstrated willingness of the international community to step in with large-scale financial support if necessary. Bulgaria, Estonia, and Lithuania all went into the crisis with massive external imbalances, necessitating a vigorous policy response. Precrisis overheating had been less pronounced in Albania, Croatia, and Macedonia, and their economies were less integrated with the rest of the world, so that immediate pressures were less intense. Tiny Montenegro went through its own roller-coaster developments in its brief post-independence history. Russia and Turkey are both special cases because of the key role of oil prices and the precrisis history, respectively.

    Developments in Bulgaria, Estonia, and Lithuania were all marked by deep recessions in 2009, strong fiscal austerity, and sharp external adjustment. Precrisis commonalities across the three countries include currency-board arrangements, a strong foreign-financed credit boom that had spawned outsized current account deficits (some 25 percent of GDP in the case of Bulgaria), bank loans that were primarily euro-denominated in anticipation of accession to the currency bloc, and public finances that looked solid on the surface with Bulgaria and Estonia even posting surpluses. In 2009, all suffered large domestic-demand-driven output contractions as foreign financing for new bank loans was no longer forthcoming. The recession led to a sharp contraction of imports, a key factor in the swift correction of the external imbalances. In Bulgaria, external adjustment also had a self-correcting component, as the sharp decline of hitherto large foreign direct investment was accompanied by an equally sharp decline of the associated imports.

    The recession also unmasked the underlying weakness of public finances, and all countries had to adopt extensive austerity measures to contain the rise of the fiscal deficit. Estonia managed the remarkable feat of keeping the deficit below the Maastricht limit in 2009, allowing it to adopt the euro in 2011. Bulgaria, by contrast, had to withdraw its European Exchange Rate Mechanism II (ERM-II) application and postpone entry to the European Economic and Monetary Union. A high degree of economic flexibility in the Baltic countries fostered the return to strong economic growth in 2011. The recovery was much weaker in Bulgaria, reflecting the shallower recession.

    The crisis impact on Albania, Croatia, and Macedonia was muted by more limited external linkages, although to different degrees. Croatia was least insulated owing to extensive reliance on foreign bank financing of its domestic financial system. Moreover, its stable exchange rate policy and limited fiscal space ruled out a countercyclical crisis response. It suffered the deepest recession of the three countries, and chronic competitiveness problems left it with the weakest recovery in all of emerging Europe. Albania’s banks are much less reliant on foreign financing, and its flexible exchange rate regime allowed a more elastic crisis response. Albania managed to avoid recession in 2009. Macedonia’s international economic ties are weak, but its fixed exchange rate regime and financing constraints to the fiscal deficit limit its policy space. It suffered a mild recession in 2009.

    Russia’s changing fortunes were closely linked to the price of oil. Its precrisis boom was driven by ever-rising prices for Russia’s oil and gas exports, further egged on by procyclical economic policies and capital inflows. The economy overheated, but the current account remained in surplus thanks to favorable terms of trade. By the same token, the economy was hard hit when oil prices collapsed in the wake of the global financial crisis. Russia aggressively deployed its fiscal buffers and ample international reserves built up during the good years to cushion the impact of the crisis. Nonetheless, the recession was deep and the recovery unimpressive, speaking to the slew of longstanding fundamental shortcomings that stand in the way of better economic performance in Russia.

    Turkey suffered only a very brief recession in 2009, and its growth went into overdrive thereafter. Turkey largely avoided overheating in the years prior to the global financial crisis as it was still recovering from its own crisis of 2001. The extensive repair of public finances, disinflation policies, and financial sector reform kept domestic demand in check. Despite reasonably solid fundamentals, Turkey’s long history of economic crisis meant that confidence evaporated quickly in the wake of the Lehman Brothers bankruptcy. But when the banking sector held up, public finances remained in order, and the authorities deployed countercyclical policies, confidence returned equally fast. The result was a V-shaped recovery. As the global financial crisis eased, Turkey’s newly demonstrated resilience made it a magnet for capital inflows. Growth surged to 8–9 percent in 2010 and 2011, with the policy challenge shifting to managing the success and avoiding overheating.

    Lessons from the Crisis

    Four important and interrelated lessons can be distilled from the pronounced boom-bust cycle that emerging Europe experienced in the past decade:

    • Strive for more balanced growth. Growth that is driven by capital inflows fueling domestic demand creates a series of vulnerabilities, inflates the nontradable sector, and is ultimately unsustainable. While policymakers cannot and should not mandate a particular growth model at the micro level, there is much they can do to nudge broad developments in the right direction.

    • Keep credit growth in check. Rapid credit growth is not only a chief culprit for unbalanced growth, it also plants the seeds for future problem loans that complicate recovery from economic downturns. Building safeguards against excessive credit growth requires combining macroeconomic and supervisory measures. Effective coordination of home and host supervisors is essential if cross-border banking groups are important.

    • Discourage lending in foreign currency. The surge in foreign currency loans in the precrisis years created credit risks for banks and limited macroeconomic policy space during the crisis. During the boom years, with exchange rates either fixed or appreciating as a result of convergence, the risks associated with foreign currency lending were not taken seriously.

    • Fiscal policy needs to limit expenditure growth. The rate of precrisis public expenditure growth in many countries was imprudent. With booming revenues, the large increases in fiscal spending fueled overheating and set the stage for large deficits when part of the revenue surge turned out to be temporary. Fiscal policy could play a much more active role—building buffers when revenues are growing instead of increasing spending and boosting public wages. This may mean that during boom times small fiscal surpluses are not enough—large surpluses are called for.

    Many of the imbalances that characterized much of emerging Europe prior to the crisis have unwound, but some precrisis vulnerabilities remain, and new vulnerabilities have emerged as a result of the crisis. Current account deficits in most countries have come down, inflation has receded, and excessive credit growth has given way to flat or declining credit. Gross financing requirements in many countries remain important, rollover risk in the domestic debt markets persists, and the share of foreign currency loans remains close to peak levels. Public finances are significantly weaker than in 2008, and nonperforming loans have increased in all countries.

    This crisis made plain that policymakers need to reconsider how best to achieve lasting convergence. “As fast as possible” is not always the best approach. A holistic approach is called for, in which policies in a broad range of areas may need to be adjusted to achieve the desired goal. Key planks of a policy agenda for resilient convergence include:

    • Policies to contain domestic consumption and strengthen domestic saving. They include tax policy, pension plans, and not least fiscal savings, especially in cases where the change in private savings behavior is difficult to achieve. Supporting measures include the development of domestic debt markets, to encourage private savings and foster the emergence of institutional investors for an efficient allocation of savings.

    • Policies to discourage excessive foreign debt in favor of foreign direct investment. Relevant measures include all structural efforts to increase the attractiveness of countries for investment. Those measures should be supported by regulatory and prudential measures to discourage excessive foreign borrowing by banks, including from parent banks.

    • Measures to support broader based growth. Increasing the flexibility of the workforce through appropriate schooling will increase the resilience of economies and allow for a smoother shift from the once booming property and financial sectors to other activities. Similarly, measures to prevent unbalanced growth concentrated in a few sectors—including, for example, through a strict adherence to sectoral exposure limits in lending—will help avoid the reemergence of bubbles in narrow parts of the economy, especially in housing. Finally, an open and competitive environment fostered by deregulation of product and service markets will support the overall economic environment and allow the efficient reallocation of resources in line with changing economic opportunities.


    Belarus, Moldova, Russia, and Ukraine.

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