2. Emerging Europe: Toward Self-Sustained Growth
- International Monetary Fund. European Dept.
- Published Date:
- October 2010
Emerging Europe (EE)7 is recovering from its deepest recession in the post-transition period. GDP in the region is likely to grow by 3.9 percent in 2010 and 3.8 percent in 2011—a marked difference from the 6 percent contraction in 2009. The recovery is export-led, while domestic demand remains subdued, particularly in countries where the deflation of precrisis asset and credit booms has been most severe. Policymakers in emerging Europe face the difficult challenge of dealing with the legacies of the crisis, while not hurting the recovery. Fiscal consolidation is needed to bring down fiscal deficits, which rose sharply during the crisis, and remain high in 2010. To a large extent, these deficits are structural: although headline deficits were low in most countries before the crisis, a temporary boom in revenues masked the underlying deterioration that resulted from rapid expenditure growth. Beyond the short term, the region will need to find new growth engines, as the capital flows-driven domestic demand boom needs to give way to more balanced growth. In sum, the region faces difficult adjustments in the short term, but the adjustments will help set the stage for a more durable catch-up with advanced Europe.
Outlook for 2010 and 2011
The Region Is Recovering …
Year-on-year real GDP growth for the region turned positive in the first quarter of 2010, for the first time since the third quarter of 2008, and strengthened further in the second quarter of 2010.8 The recovery was led by the European CIS countries,9 Turkey, and central European countries, while real GDP in southeastern Europe and Latvia continued to fall (Figure 18). However, real GDP levels remained far below the precrisis levels in all countries, except for Albania, Belarus, Poland, and Turkey (Figure 19).
Figure 18.Emerging Europe: Real GDP Growth
Sources: Eurostat; Haver Analytics; and IMF staff calculations.
1Data refer to 2009:Q2–2010:Q1.
Figure 19.Emerging Europe: Real GDP, 2008:Q3–2010:Q2
Sources: Eurostat; Haver Analytics; and IMF staff calculations.
… On the Back of Higher Exports …
So far, the recovery has been based mostly on a rebound in exports, with the exception of Turkey (Figure 20).10 Exports had fallen very sharply in the fourth quarter of 2008 and the first quarter of 2009. Starting in the second half of 2009, trade volumes started to rebound, boosted by a recovery in output growth in both the advanced and emerging economies and a rebound in demand for trade-intensive capital and durable goods. Nominal export growth for some countries has been further boosted by the rise in oil and nonfuel commodity prices, which resulted in strong terms-of-trade improvements in the region’s commodity exporters—primarily Russia and Ukraine.
Figure 20.Emerging Europe: Real Exports, 2008:Q3–2010:Q2
Sources: Eurostat; Haver Analytics; and IMF staff calculations.
… Rather than Domestic Demand
Domestic demand growth, however, has remained weak in most countries. Domestic demand continues to fall in Croatia, Estonia, and Hungary, and, following only a mild recovery in the last few quarters, remains some 20–30 percent below precrisis levels in the Baltics and Bulgaria (Figure 21). Only in Poland and Turkey has domestic demand recovered to precrisis levels. Fixed investment is particularly weak in most countries in the region, although there was an uptick (quarter-on-quarter basis) in the second quarter in Lithuania and Poland, and a continuing rebound in Turkey (Figure 22). Private consumption shows signs of recovery in the first half of 2010 in a number of countries, but continued to decline on a quarter-on-quarter basis in the Baltics, Bulgaria, Croatia, and Hungary (Figures 23 and 24).
Figure 21.Emerging Europe: Real Domestic Demand, 2008:Q3–2010:Q2
Sources: Eurostat; Haver Analytics; and IMF staff calculations.
Figure 22.Emerging Europe: Real Investment, 2008:Q3–2010:Q21
Sources: Eurostat; Haver Analytics; and IMF staff calculations.
1Real investment is private and public excluding inventories.
Figure 23.Emerging Europe: Real Private Consumption, 2008:Q1–2010:Q2
Sources: Eurostat; Haver Analytics; and IMF staff calculations.
Figure 24.Emerging Europe: Contributions to Year-over-Year GDP Growth, 2010:Q11
Sources: Eurostat; and Haver Analytics.
1Contributions from inventories and statistical discrepancy not shown.
There are several reasons for the weakness in domestic demand:
Net capital inflows remain weak in most countries, and private sector credit growth is subdued. Net foreign direct investment (FDI) inflows are well below precrisis levels, and other investment flows are negative in many countries, notably in Bulgaria, Estonia, and Lithuania, likely reflecting continued deleveraging by banks and corporations. Private sector credit growth remains subdued as high nonperforming loans (NPLs) and funding costs (especially from overseas sources) are likely constraining loan supply (see section on reviving credit growth, page 34).
Investment is likely to have been held back by excess capacity, as output is still below precrisis levels in most countries. This may be the case particularly in the nontradable sector, where the precrisis boom has come to an end (see also Chapter 3).
Consumption is being restrained by poor labor market conditions, low confidence, and the destruction of consumer wealth. Real wages are falling in many countries (Figure 25), and the unemployment rate has increased sharply (Figure 26). Private sector confidence remains low compared to historical levels, even after the recent improvement (Figure 27). Stock exchanges in the Baltics and Romania have lost about half their value (up to 80 percent in Bulgaria, since end-2007), and real estate prices are down some 30 percent from their peak.
Figure 25.Emerging Europe: Gross Real Wage Growth
Sources: Haver Analytics; EMED Emerging EMEA; and IMF staff calculations.
Figure 26.Emerging Europe: Unemployment Rate
Sources: IMF, World Economic Outlook database; Haver Analytics; EMED Emerging EMEA; and IMF staff calculations.
Figure 27.Emerging Europe: Confidence Indicators
Sources: IMF, International Financial Statistics; Haver Analytics; EMED; and IMF staff calculations.
Projections for 2010 Have Been Revised up—although Differences within the Region Remain Substantial
For 2010 as a whole, output in the EE region is now projected to grow by 3.9 percent, a half percentage point upward revision from the projections in the April 2010 World Economic Outlook (IMF, 2010h) and the May 2010 Regional Economic Outlook:Europe (IMF, 2010g) (Table 4). The upward revision is largely the result of better-than-expected outcomes in the first half of 2010 and is in spite of this spring’s financial market turbulence. The regional growth average masks wide variations in prospects for individual countries or subregions, reflecting different economic structures and imbalances built up during the boom years.
|Real GDP Growth||Real Domestic|
|Real Exports Growth1||Real Private|
|Bosnia and Herzegovina||30||-3.1||0.5||3.0||-6.7||-1.4||3.5||-4.0||4.2||3.3||-2.6||0.2||4.6|
|Montenegro, Republic of||7||-5.7||-1.8||4.5||-22.1||-1.9||1.0||-18.8||6.6||11.6||-7.7||-0.1||2.0|
|Serbia, Republic of||78||-3.0||1.5||3.0||-6.7||-0.9||1.3||-12.4||5.7||13.7||-3.0||-2.4||1.7|
|European CIS Countries2||2,536||-8.3||4.1||4.5||-14.4||4.6||6.4||-7.3||8.7||4.7||-8.0||6.2||6.2|
|New EU Member States2,4||1,753||-3.4||1.8||2.9||-7.0||0.2||2.7||-9.4||10.0||6.6||-3.1||-0.2||2.6|
Growth Will Be Strongest in the European CIS Countries and Turkey
Russia and Ukraine are poised for relatively strong recoveries on the back of rebounding commodity prices. Strong growth in Russia will have spillover effects on the rest of the CIS subregion, whose links with Russia are far more important than with the euro area.
Turkey is projected to post the highest growth rate in the region this year (7¾ percent). Prior to the crisis, the more restrained magnitude of foreign inflows, better focus of macro policies on leaning against the cyclical upswing, and a more restrictive regulatory environment for credit preserved the strength of bank and household balance sheets. This—as well as weaker dependence on EE export markets (see Box 4)—helped Turkey set the stage for a strong rebound.
Outside the CIS Countries and Turkey, Growth Will Be Weakest in the Countries That Had Deep Recessions and Strongest in Countries with Mild Recessions
The dichotomy in the recovery reflects the different nature of the downturn. Countries with the deepest recessions are those that experienced not just a decline in exports, but also a collapse of domestic demand, as the credit-fueled domestic demand boom of the precrisis years came to a sudden end (see Chapter 3). Such countries include Latvia (where output fell the most in 2009 and is expected to decline once more in 2010), Bulgaria, Croatia, Estonia, Lithuania, and Romania. In contrast, countries that had the mildest downturn are now seeing the strongest recovery (Figure 28).
Figure 28.Emerging Europe: GDP Growth 2009 vs. 2010–111
Source: IMF, World Economic Outlook database.
1Excludes Russia, Turkey, and Ukraine.
Box 4.Emerging Europe Trade Linkages: The Pull from Within?
The main export market for emerging Europe (EE) countries is Europe—advanced and emerging (see figure below on left). On average, half of all EE exports go the euro area, while intraregional trade accounts for a further third of exports.
Germany is a key market for EE countries, including through strong automotive industry linkages. About half of Hungarian exports go to Germany—equivalent to about 20 percent of GDP (see figure). Italy is another important export destination, particularly for southeastern Europe. Trade links with Russia are important for the Baltics—Russia absorbs some 15 percent of exports from Latvia and Lithuania. Turkey is an important export market only for Bulgaria; more generally, Turkey’s intra-EE trade links are the second weakest among EE countries—only 15½ percent of Turkey’s total exports go to the region.
Direct and indirect exposures to the Asian market are both small. In 2008, 7 percent of all EE exports went to Asia, of which 40 percent went to China. In addition to Russia’s oil exports to China, wood, lumber, and cork, chemicals and fertilizers, metal and metal scrap account for about 80 percent of exports to the Chinese market. Indirect trade links raise the importance of Asia; about 10 percent of euro area exports go to Asia,1 and it is likely that at least part of the inputs for these exports is imported from EE.
However, Asia is playing an important role in the current recovery, as its contribution to export growth has been picking up sharply (second figure). Some of this historically high contribution is likely to be temporary, reflecting a postcrisis rebound in demand. However, indirect exposure to the Asian market (not accounted for in the above decomposition) could be increasing, as Germany’s market share in a few key import categories has been steadily rising, with transport equipment rising to over a quarter of total Chinese transport equipment imports (text table). Exports in these categories could stand to benefit further from a growing luxury items market in China, particularly as a rebalancing away from high savings rates takes place in the future.
Emerging Europe. Geographical Orientation and Export Share
Emerging Europe. Export Destination Within Euro Area
Sources: IMF, Direction of Trade Statistics database and World Economic Outlook database; and IMF staff calculations.
Historical and Current Contribution to Exports Growth, by Region
EE. Increase in Nominal Exports, in Euros, Since the Crisis Trough
Increase is calculated as percent change in nominal level of exports in respective month relative to level during crisis trough (average level, Q1 2009).
Sources: IMF Direction of Trade Statistics database; and IMF staff calculations.
|Top Chinese Imports (In percent of total imports)|
|Electrical machinery, apparatus and appliances||25||26||28||27||23||24|
|Machinery, other than electric||17||15||14||13||13||13|
|Metalliferous ores and metal scrap||4||5||5||7||9||9|
|Petroleum and petroleum products||8||9||11||10||14||11|
|Scientific and controlling instruments, photographic goods, clocks||7||7||7||7||7||6|
|Total for subcategories||77||78||80||80||80||78|
|Imports from EE (In percent of total Chinese imports for commodity group)|
|Electrical machinery, apparatus and appliances||0||0||0||0||0||0|
|Machinery, other than electric||1||0||1||1||1||1|
|Metalliferous ores and metal scrap||2||3||2||3||3||3|
|Petroleum and petroleum products||9||11||11||10||7||8|
|Scientific and controlling instruments, photographic goods, clocks||0||0||0||0||0||0|
|Imports from Germany (In percent of total Chinese imports for commodity group)|
|Electrical machinery, apparatus and appliances||3||3||3||3||4||4|
|Machinery, other than electric||13||13||12||12||13||14|
|Metalliferous ores and metal scrap||1||1||1||1||0||2|
|Petroleum and petroleum products||0||0||0||0||0||0|
|Scientific and controlling instruments, photographic goods, clocks||4||3||3||3||4||4|
The Recovery Is Expected to Broaden in 2011
GDP growth for the region in 2011 is projected at 3.8 percent. Although the growth rate is virtually the same as in 2010, the recovery is expected to broaden, with all countries projected to see positive growth in 2011 (Table 4). Indeed, growth differentials among countries would be the lowest since 2006, with no country in recession and few standouts in terms of strong growth. The recovery is expected to broaden also in terms of drivers of growth: domestic demand is projected to contribute about 1.5–3.5 percentage points to growth in 2011 in most countries; private consumption should resume positive growth, although it will likely remain subdued in Bulgaria, Croatia, Hungary, Lithuania, Romania, and Serbia (Table 4).
Growth Could Be Stronger than Projected …
There are upside risks to the projection. The recovery’s momentum could be stronger than projected as financial conditions normalize, precautionary savings fall as household balance sheets improve, and firms raise investment more quickly than expected. The recovery in Germany in the second quarter of 2010 was particularly dynamic, and the much stronger growth outlook is likely to spill over to the region.
… But Downside Risks Remain Significant—and Would Be Particularly Harmful if They Materialized
The main downside risk for emerging Europe is the revival of sovereign stress in advanced Europe, which could depress growth in the euro area and lead to adverse spillovers for the region:
Transmission to emerging Europe would be not only through lower exports; lower growth in the euro area could also increase banking sector stress in advanced Europe, and reduce capital flows to emerging Europe, delaying the revival of credit growth and domestic demand. If reduced capital inflows were to be accompanied by depreciation of domestic currencies, household and corporate balance sheet mismatches could further weigh on the recovery.11
It would be even more harmful if the market turbulence itself were to spill over to emerging Europe. The consequences of such sovereign risk contagion would include both higher financing costs and greater difficulty in financing still high deficits. In addition, financial sectors would be particularly affected, especially in those countries where banks hold a large portion of their assets in the form of government securities (Albania, Hungary, Poland, and Turkey). In such countries, bank capitalization could be significantly impacted if the value of government securities declined. This in turn could curtail the supply of bank credit.
Inflation Is Projected to Remain Benign …
Despite pressures from rising food prices, with still large output gaps and high unemployment, average 2010 headline inflation is projected to fall from 8.5 percent in 2009 to about 6 percent in both 2010 and 2011 (Table 5). Countries with fixed exchange rates are projected to have the lowest inflation rates, with the consumer price index (CPI) in Latvia projected to decline by 1½ percent in 2010 and rising by only 1 percent in 2011, reflecting the strong adjustment that has occurred in these countries. Inflation in the CIS countries is also declining sharply, to 7 percent in 2010. An exception is Turkey, where large excise increases, in combination with a strong recovery, are exerting upward pressure on prices.
|Current Account Balance to|
|Bosnia and Herzegovina||-0.4||2.4||2.5||-6.9||-5.5||-5.5|
|Montenegro, Republic of||3.4||0.6||1.0||-30.3||-17.0||-12.0|
|Serbia, Republic of||8.1||4.6||4.4||-6.7||-9.6||-9.4|
|European CIS Countries1||12.2||7.0||8.0||2.9||3.7||2.7|
|New EU Member States1,3||3.2||2.8||2.8||-1.7||-1.7||-1.9|
… While the Current Account Balance of the Region Is Near Zero
Current account deficits are projected to show little change in 2010 and 2011, following a substantial crisis-induced narrowing in 2009. For the emerging Europe region as a whole, a zero average current account balance is projected for 2010, unchanged from 2009 (Table 5). In the Baltics, current account surpluses are projected through the medium term, reflecting the very sharp improvement in its trade balance that has taken place.12 One exception to this trend is Turkey, where a rapid rebound in domestic demand is leading to a wider current account deficit.
What Can Policymakers Do to Sustain the Recovery and Minimize Risks?
Resolute domestic policy responses to the crisis—as well as large official financing packages from multilateral institutions—helped prevent a cascade of bank and currency crises (see Chapter 3). Still, these policies themselves, and the deep economic downturns, have had some side effects that policymakers in the region will now have to deal with. The short-term policy challenges—which are similar to those in advanced Europe—present difficult balancing acts, along the following dimensions:
Reducing fiscal deficits to ensure sustainable public debt while minimizing the negative impact on growth. Several emerging European countries need to rein in large public sector deficits to secure debt sustainability and avoid negative market reactions as experienced earlier in 2010. The timing and pace of the consolidation will ultimately need to be tailored to individual country circumstances, and countries at high risk of market concerns about sovereign debt sustainability may need to proceed with fiscal consolidation at a faster rate.
Repairing banking systems while reviving credit. The crisis has weakened the EE region’s financial sectors, with many countries experiencing sharp increases in NPLs. The dilemma facing banks is how to strengthen their balance sheets while reviving their lending operations.
Beyond the short term, most of the EE region will need to find new growth engines. In a number of countries, the growth model of the boom years—driven by capital inflows, rapid credit growth, and domestic demand booms—will need to shift toward a model more reliant on the tradable sector as an engine of growth. While this shift will in large part be the result of private sector decisions, government policies, in particular structural reforms and prudent wage policies, can also help.
Restoring the Health of the Public Finances
Prior to the Crisis, Headline Fiscal Deficits Were Low in Most EE Countries …
In 2007, emerging Europe as a group recorded a fiscal surplus of about 2 percent of GDP. Moreover, debt levels—at roughly 23 percent of GDP for EE countries—were low compared with other emerging market economies, with the important exception of Hungary (Table 6).
|General Government Overall Balance||Public Debt|
|Bosnia and Herzegovina||-0.3||-3.6||-5.7||-4.5||-3.0||32.9||30.8||35.4||39.1||43.0|
|Montenegro, Republic of3||6.3||1.5||-4.4||-7.1||-7.7||27.5||29.0||38.2||43.5||49.4|
|Serbia, Republic of3||-1.9||-2.6||-4.1||-4.8||-4.0||35.2||33.4||35.6||40.5||41.6|
|European CIS Countries2||5.4||3.2||-6.0||-4.8||-3.6||15.3||15.5||14.3||15.3||17.1|
|New EU Member States2,8||-1.7||-3.2||-6.3||-6.6||-5.6||35.7||37.4||43.4||47.9||50.4|
… But the Underlying Fiscal Position Worsened Due to Rapid Expenditure Growth
However, these seemingly healthy fiscal balances were inflated by high temporary revenues related to domestic demand booms; the underlying fiscal positions had actually deteriorated as a result of rapidly growing expenditures (Figure 29). The rapid growth of expenditures during the boom years had set the stage for large deficits when revenues collapsed with the implosion of credit and domestic demand.
The Deterioration of the Fiscal Position Became Visible in 2009, when Large Deficits Emerged …
As a result of the crisis, public sector deficits and debt levels shot up in 2009. EE countries’ average headline balance deteriorated from about zero in 2008 to a deficit of 6 percent of GDP in 2009, with a wide range—from a low of 0.7 percent in Belarus to a high of nearly 9 percent in Lithuania (Table 6).13 Average public debt levels rose from about 24 percent of GDP in 2008 to nearly 30 percent of GDP in 2009, again, with substantial intraregional variation. Those countries that had allowed their expenditures to grow more rapidly during the boom years tended to experience a larger fiscal deterioration. Thus, in hindsight, fiscal policy was too loose in most EE countries, reducing the scope for countercyclical fiscal policy during the crisis.14
… And in 2010, when Deficits Remain High
Deficits remain high in 2010—with only a modest reduction—while debt levels continue to rise (Table 6). EE countries’ average headline deficit is projected to fall to 5¼ percent of GDP in 2010, but there is considerable intraregional variation. While deficits in some countries, notably Bulgaria, but also in Belarus, Kosovo, Montenegro, and Serbia, are projected to widen significantly, in several others, particularly those facing binding financing constraints, large fiscal adjustments are taking place in 2010. In Latvia, the widening headline deficit masks substantial fiscal effort: Latvia is on track to take another 4 percent of GDP in fiscal consolidation measures in 2010, following measures of approximately 8 percent of GDP in 2009.
Substantial Fiscal Consolidation Is Needed over the Next Few Years
With deficits generally still at very high levels, and a permanent loss in revenues resulting from the end of the demand boom, it is clear that substantial fiscal consolidation is needed over the next few years to reduce vulnerabilities. Deficits and debt levels in EE countries are generally not as high as in euro area countries, but deficit levels are high by emerging market standards (Figure 30). Moreover, several countries in the region face difficult medium-term debt dynamics, reflecting an aging population,15 while medium-term growth prospects for most EE countries have worsened significantly after the crisis.
Figure 30.Selected Regions: Deterioration of Public Finances
Sources: IMF, World Economic Outlook database; and IMF staff calculations.
Although Fiscal Consolidation May Hurt Growth in the Short Term, Market Concerns about Weak Public Finances Could Be Even More Damaging…
Even though fiscal consolidation is likely to be beneficial over the long term, fiscal retrenchments tend to have contractionary effects on output in the short term.16 At the same time, recent events have shown how weak public finances can destabilize financial markets. Financial markets are increasingly focusing on fiscal vulnerabilities.17 In emerging Europe, in the early stages of the crisis, investors were more focused on external imbalances and private sector credit growth and the nature of its funding, and sovereign credit default swaps (CDS) spreads were not associated with the level of fiscal vulnerability at that time (see the May 2009 Regional Economic Outlook: Europe; IMF, 2009b). However, since the outbreak of sovereign debt concerns in western Europe in May 2010, this seems to have changed, with the level of sovereign CDS spreads increasingly associated with the levels of fiscal vulnerability (see Figure 31).
Figure 31.Emerging Europe: Financial Markets and Fiscal Vulnerabilities
Sources: Bloomberg; IMF World Economic Outlook database; and IMF staff calculations.
1The Fiscal Vulnerability Index is a weighted summary indicator of fiscal vulnerability using a number of fiscal variables, including the overall fiscal balance, the primary gap, debt ratio, and exposure to currency and rollover risks.
… Suggesting that Fiscal Consolidation Is Most Urgent in Countries with Weak Public Finances
To prevent the emergence of market concerns, countries with high fiscal vulnerabilities may need to proceed with fiscal consolidation at a faster rate. Indeed, EE countries faced with relatively high deficits are generally projected to make larger fiscal adjustments, and in Bulgaria, Romania, and Ukraine the consolidation is front-loaded (Figure 32). Countries with low debt and deficit levels, and hence low perceived risk of sovereign default, could delay fiscal consolidation, especially where recoveries are fragile.
Figure 32.Emerging Europe: Fiscal Adjustment, 2010–13
Source: IMF, World Economic Outlook database; and IMF staff calculations.
Expenditure-Based Consolidation Is Likely to Be Less Harmful for Growth
As discussed in Chapter 1, fiscal contractions that rely on spending cuts tend to have a less contractionary impact than tax-based adjustments. Current fiscal adjustment plans across the region are to a significant degree expenditure-based, although large adjustments, especially in the face of revenue erosion, would inevitably contain some tax-based components (Figure 33).
Figure 33.Emerging Europe: Composition of Adjustment Plans, 2010–13
Source: IMF staff calculations.
Fiscal Consolidation Is Likely to Be More Successful if It Is Embedded in Medium-Term Plans
The pace of fiscal adjustment in some countries is likely also driven by the trade-offs between speed of adjustment on the one hand and quality and durability of adjustment on the other. Some consolidation measures could have an immediate impact that quickly translates into improved market confidence, but these measures might not be sustainable and could possibly be harmful in the medium to long term. Other measures could involve more fiscally sustainable, “high quality” adjustments, but their substantive effect on the budget deficit might not materialize until later years. Given this trade-off, it is all the more important to anchor fiscal policy in the context of a well laid out medium-term fiscal strategy. In that context, some countries are also trying to bolster fiscal credibility by adopting fiscal rules.18 Indeed, past experience shows that fiscal rules—in particular those that have expenditures as a focus in combination with deficit rules—can have a positive impact on the effectiveness and duration of the consolidation effort, especially when accompanied by stronger monitoring and enforcement mechanisms (IMF, 2009a).
Reviving Private Sector Credit
Private Sector Credit Growth Has Been Weak since the Onset of the Crisis
The credit boom in many EE countries came to an abrupt end after the Lehman Brothers collapse and its aftermath (see also Chapter 3). Credit growth in 2009 was very low, and in many countries even turned negative. Private sector credit levels continue to decline in 2010 in the Baltics, and have remained flat at end-2009 levels in Bulgaria (see chart in Box 5).
Initially, Weak Credit Was the Result of Supply Factors, in Particular the Decline in Capital Transfers from Western European Banks …
Credit growth stopped when banks in advanced countries, confronted with liquidity and capital shortages, advised their subsidiaries and branches in the EE region that new credit would henceforth need to be financed from an increase in local deposits. This effect was compounded by the freezing of the international syndicated loans market and the halt in the growth of direct cross-border loans.
… And the Increase in NPLs …
As NPLs rose with the recession and exchange rate depreciations, the supply of credit was further affected by increases in banks’ provisioning needs. The increase in provisions was particularly high for countries with double-digit percentage drops in real GDP in 2009 (Figure 34), but even for countries with less severe recessions, such as Hungary, Moldova, and Russia, provisioning has more than doubled since 2007. The increase in provisioning led to a drop in retained earnings, further reducing the room for credit growth. Banks that had already built loan loss reserves (as a precaution against future NPLs) fared better. Indeed, higher loan loss reserves in 2007 are associated with a lower drop in (nominal) credit growth in 2009 (Figure 35). Part of the reason is that there was less of a need for banks with higher reserves to form extra provisions during the crisis.
Figure 34.Emerging Europe: Loan Loss Provisions1
Sources: Bankscope; and IMF staff calculations.
1 Data on biggest banks (accounting for 60–90 percent of banking system assets) are aggregated (weighted by assets) to derive a figure for the country. The number of banks reporting data for 2009 is less than those in 2007.
Figure 35.Emerging Europe: Provisions and Loan Loss Reserves1
Sources: Bankscope; and IMF staff calculations.
1Data on biggest banks (accounting for 60–90 percent of banking system assets) are aggregated (weighted by assets) to derive a figure for the country. The number of banks reporting data for 2009 is less than those in 2007.
… But Demand Factors Have also Played a Role
Analysis of large banks shows that while supply-side factors were very important in explaining loan growth in 2009, declining credit demand played a role as well (Box 5). In the first half of 2010, the effect of both supply and demand factors on private sector credit continued to be felt: bank deleveraging continues, increasing net credit to the public sector likely reflects some rebalancing of banks’ portfolios towards safer assets, and lending rates, particularly in those countries with weak credit growth, continue to fall.
The Revival of Credit Growth Would Help Support the Recovery
“Creditless” recoveries in GDP growth are generally slow and shallow.19 It is therefore important that credit growth picks up to support financing to firms that cannot access funding from capital markets.
Looking ahead, as the Economy Recovers, Supply Factors Are Likely to Be the Main Constraint on Credit Growth
As capital inflows are likely to remain weak, the funding of credit growth will have to rely more on domestic deposit growth, which could remain subdued due to the relatively high unemployment levels.
NPLs typically react with a considerable lag to changes in GDP. They continue to rise in most of emerging Europe (with the notable exception of Turkey), from levels that are already high (Table 7). The related provisioning for these new NPLs will further weigh on banks’ capital and their ability to lend.
|Country||Capital Adequacy Ratio||Provisions to Nonperforming Loans||Nonperforming Loans to Total Loans|
|Bosnia and Herzegovina||17.1||16.3||16.1||37.2||37.9||34.4||3.0||3.1||5.9|
If sovereign debt concerns were to increase, banks with sizable exposures to government securities (Figure 36) would need higher capitalizations to sustain large increases in sovereign risk premiums, and would need to rely less on sovereign bonds as liquid assets.
Figure 36.Emerging Europe: Holdings of Government Securities by Banks, 2009
Sources: Bankscope; National Bank of Serbia; and IMF staff calculations.
Box 5.Why Is Credit Growth Weak—Demand or Supply?
Why did credit growth slow down in 2009—was it lack of demand or lack of supply? And why did it remain weak in 2010?
To disentangle demand and supply factors in 2009, a bank-level regression was run, using data on 63 big banks in the region—the largest banks in each country accounting for assets comprising 60–90 percent of banking system assets in each country. The analysis suggests that in 2009 supply-side factors (in particular higher costs of funds and higher loan loss provisioning) were the most important factors holding back loan growth, although the contraction of GDP also played a role (first figure). The higher cost of funds is likely to have been the result of the drop in cross-border funds, as domestic deposit growth was still positive.
Disentangling demand and supply factors in 2010 is more difficult, as bank-by-bank data are not yet available. Weak demand is likely to have gained in importance, as lending rates, which had increased during the crisis, came down in a number of countries. On the supply side, aggregate banking system data show that bank deleveraging continued (second figure), especially in the Baltics and Bulgaria. Crowding out by the public sector could have played a role as well, as net credit to the public sector has increased in a number of countries, but it is difficult to disentangle potential crowding out effects from portfolio rebalancing toward safer assets. Evidence from Senior Loan Officers’ surveys (available for only a few countries) shows that banks are continuing to tighten standards in 2010:Q2 but significantly less so than in Q1, amidst rising demand for loans, particularly from firms. Higher capital and funding costs in Lithuania and a high nonperforming loans ratio in Romania are contributing to tighter lending standards for corporate loans.
Emerging Europe: Factors Explaining Nominal Bank-by-Bank Loan Growth in 20091
Sources: Bankscope; and IMF staff estimates.
1Derived from an OLS regression of 2009 loan growth in 63 largest banks in the region. Each bar denotes the amount by which loan growth would change following mean percentage point change in each of the factors in 2009.
2Cost of funds derived by dividing interest expenses by total funds in each bank, multiplied by 100.
Emerging Europe: Private Credit Growth and Bank Deleveraging
Sources: IMF, International Financial Statistics; and IMF staff calculations.
1 For Hungary, credit growth to the private sector in H1 2010 reflects largely exchange rate changes.
Repair of Banks’ Balance Sheets Will Help Alleviate Supply Constraints…
A key precondition for credit growth to revive is the repair of bank balance sheets. The sooner banks recognize loan losses and raise additional capital, the sooner they will be able to regenerate loan growth—and the sooner also will uncertainty about financial sector health be reduced. At the same time, current market conditions could make it more difficult to raise fresh capital. Moreover, there may be competition for funds, as many banks need to raise capital to meet the strengthened Basel requirements.20
… And Policymakers Can Contribute by Reducing Policy Uncertainty
Credible fiscal consolidation plans should reduce sovereign debt concerns and put less pressure on both capitalization and liquidity in banks. Credible macroeconomic policies would also make it possible to keep policy interest rates low, which would not only stimulate demand for credit but would also encourage bank funding through domestic sources and support lending in local rather than foreign currency.
Enhanced International Cooperation on Financial Sector Policies Would Help Further Reduce Uncertainty
Cross-border cooperation on the amount and duration of new financial sector levies would reduce speculation on regulatory arbitrage as is the case in Hungary (Box 6). Cross-border agreements on cooperation to prevent future crises could build on the example set by the recent Nordic-Baltic Cooperation Agreement. The latter not only provides clearly delineated rules for burden sharing but also establishes a permanent regional institution to discuss financial stability issues of regional interest.
Shifting Growth Toward the Tradable Sector
During the Boom Years, Growth in Many Countries in Emerging Europe Was Driven by the Nontradable Sector
During the boom years, a capital inflows-fueled domestic demand boom resulted in strong GDP growth, particularly in the nontradable sector, a growth pattern that contributed to rising current account deficits, increasing imbalances, and significant vulnerabilities (Figure 37 and Chapter 3).
Figure 37.Emerging Europe: Precrisis Real GDP Growth and Contribution of Domestic Demand
(Average 2003–08, percent) 1
Sources: IMF, World Economic Outlook database; Haver Analytics; and IMF staff calculations.
Growth Will Need to Shift to the Tradable Sector
Capital inflows are unlikely to return to precrisis levels, and domestic demand is likely to remain depressed. Future growth must rely more on the tradable sector and less on the nontradable sector—especially in countries that had built up large imbalances during the boom.
The Adjustment Will Need to Be Made by the Private Sector…
Restructuring should be helped by market signals that will change as profits in the nontradable sector shrink and investments seek more promising venues in the tradable sector. But the process may be difficult. Even in the tradable sector, new projects may have to compete for much scarcer financing. Inflows will remain subdued as banks in advanced Europe struggle to rebuild their balance sheets and risk-adjusted returns in emerging Europe seem less attractive.
… But Public Policies Should Aim to Prevent a Repeat of the Overheating that Pulls Resources from the Tradable to the Nontradable Sector
Fiscal policy in particular could play a much more active role—saving money when revenues are growing instead of increasing spending and boosting public wages. This may mean that during boom times small fiscal surpluses are not sufficient—that large surpluses are needed. Policymakers may prefer to spend in boom times, but the payoff from savings that a large fiscal buffer will reduce the need to cut expenditure sharply during a recession—as several countries had to do during this crisis.
Box 6.Financial Sector Levies in Europe
Across Europe, governments have been exploring ways to involve the financial sector in sharing the burden of the crisis, and in meeting the costs of future financial crises. Several EU countries have moved ahead with financial sector levies. In western Europe, Austria, France, Germany, Sweden, and the United Kingdom have all taken steps in this direction (both actual and proposed). In emerging Europe, so far only Hungary has introduced a financial sector levy, while Poland and Croatia may be considering it in the near future. The approaches vary, but there are some common elements. In general, the tax is applied to some portion of liabilities, and applies to both banks and nonbank financial institutions. In some countries (Germany and Sweden), the proceeds from the tax flow (or are expected to flow) to an ex ante fund to finance future crises, while in others (Austria, France, Hungary, and the United Kingdom) they flow into general government revenue. Hungary’s financial sector levy stands out in terms of size (0.7 percent of GDP each year, more than three times higher than the largest tax among the other countries), and the lack of an exact timetable for scaling it back risks further deleveraging.
A fully harmonized approach is still lacking, but international coordination is under way. The lack of a common approach reflects (i) the recognition that a one-size-fits-all approach is unlikely to work; and (ii) the lack of consensus (including in the public finance literature) on how taxation should address the distinct problems posed by the financial sector. Nevertheless, given the need to ensure a level playing field, some degree of international coordination has taken place at the G-20 and EU levels. The G-20, at its leaders’ June 2010 summit in Toronto, discussed an IMF staff report it had commissioned in 2009, and agreed that the financial sector should make a “fair and substantial contribution” toward paying for any burdens associated with government interventions to repair the banking system or fund resolution in a financial crisis.1,2
Looking ahead, further efforts at international coordination would be beneficial to promote a level playing field. Unilateral actions by governments risk being undermined by tax and regulatory arbitrage. Effective cooperation does not require full uniformity, but agreement on broad principles, including bases and minimum rates. Given their close integration with the rest of Europe, emerging European countries would be well advised to await the outcome of ongoing discussions at the EU level—which may, however, be protracted—before implementing financial sector levies.Note: The main authors of this box are Christoph Duenwald and Jérôme Vandenbussche.1IMF (2010a). The report proposes two forms of contribution from the financial sector: (i) a “financial stability contribution” (FSC), a levy to pay for the fiscal cost of any future government support to the sector; and (ii) any further contribution from the financial sector that is desired should be raised by a “financial activities tax” (FAT) levied on the sum of profits and remuneration of financial institutions.2France, Italy, and the United Kingdom have also adopted taxes on bonuses in the financial sector. In early 2010, the U.S. government discussed the introduction of a “financial crisis responsibility fee” in the form of a 0.15 percent tax on uninsured liabilities (defined as total assets net of tier I capital and insured deposits).
Wage Restraint Is Essential…
Over time, wages will catch up with those in western Europe. But they cannot do so overnight—wage increases need to go hand in hand with productivity increases.
… But Emerging Europe Should Not Compete on Low Wages Alone
Although wages in EE are lower than in advanced Europe, other emerging markets have even lower wages. If it cannot compete on low wages alone, the region should instead aim to produce increasingly sophisticated products. Structural reforms could take advantage of the export-led recovery currently under way. This is the time to urgently undertake labor market reforms to address skill mismatches between workers in the nontradable sector looking for jobs and the jobs in the tradable sector waiting to be filled.21
Foreign Capital Inflows, Especially FDI, Can Also Play an Important Role, if They Are Aimed at Enhancing Supply, Especially in the External-Trade-Oriented Sector
Such investment would support growth, transfer technology, and help contribute to an improvement of labor force skills. Recent research shows that for emerging Europe, increases in the share of FDI going to the tradable sector corresponds to an increase in the export-to-GDP ratio (Kinoshita, forthcoming). Improvements in infrastructure and an educated labor force should help attract FDI to the tradable sector.
Balanced Growth Is More Sustainable in the Long Run
In countries where growth during the boom was much more balanced, credit growth was more restrained, and current account deficits were small. They also experienced a less pronounced reversal in growth (Chapter 3). Countries that relied on domestic demand booms for growth, fed by rapid credit growth, were left without sufficient expansion of the economies’ supply potential. Indeed, the average growth over the cycle in these countries is no higher, and in some cases lower, than in countries with more restrained credit increases.
Note: The main authors of this chapter are Christoph Duenwald, Srobona Mitra, and Ivanna Vladkova-Hollar.
Emerging Europe refers to the following countries: Albania, Belarus, Bosnia and Herzegovina, Bulgaria, Croatia, Estonia, Hungary, Kosovo, Latvia, Lithuania, FYR Macedonia, Moldova, Montenegro, Poland, Romania, Russia, Serbia, Turkey, and Ukraine.
Quarter-on-quarter GDP growth had first turned positive in the second quarter of 2009, and has remained positive since.
The European CIS countries comprise Belarus, Moldova, Russia, and Ukraine.
For most EE countries, exports remain overwhelmingly tied to demand conditions within Europe. Exports to the euro area account for some 50 percent, on average, of total EE exports, and intraregional trade accounts for a further one-third of total exports. Trade shares with Asia are low, even accounting for indirect linkages, although demand from Asia appears to be playing an important role in the recovery of exports during this particular upswing (Box 4).
The internal devaluations that have taken place, and continue to take place, in the Baltics have brought about notable improvements in competitiveness. Wages in the Baltics rose between 60 and 100 percent from mid-2005 to mid-2008, far outpacing productivity growth. Nominal wage adjustment since, however, has been significant. In Latvia, unit labor costs (ULC) have come down 20 percent since the beginning of 2009, resulting in about a 14 percent depreciation of its ULC-based real effective exchange rate since its peak.
We focus on overall deficits since it is difficult to distinguish between cyclical and structural components of the fiscal balance in emerging market countries owing to uncertainty about potential output. This argument applies in normal times, but even more so during and following the crisis.
Hungary is a case in point. Deficits and debt levels were high going into the crisis; as the crisis erupted, Hungary was forced to procyclically reduce its deficit (Chapter 3).
This issue is explored in depth in Velculescu (2010).
See the May 2009 Regional Economic Outlook: Europe (IMF, 2009b) for an analysis of the role of fiscal vulnerabilities in driving spreads among advanced economies pre- and post-Lehman Brothers.
For example, Hungary has started implementing the fiscal responsibility law adopted in late-2008, which will become fully effective by 2012. In addition, Latvia and Lithuania are preparing a fiscal responsibility law and a new deficit rule, respectively.
Evidence from Claessens, Kose, and Terrones (2008) shows that on average, the recession ends two quarters before the credit crunch ends and nine quarters before housing prices bottom out; equity prices tend to bottom out just as the associated recession ends. Such “creditless” recoveries are usually slow and shallow.
At its September 12, 2010 meeting, the Group of Governors and Heads of Supervision, the oversight body of the Basel Committee on Banking Supervision, announced a substantial strengthening of existing capital requirements, to be phased in over several years. These capital reforms, together with the introduction of a global liquidity standard, will increase the minimum common equity requirement from 2 percent to 4.5 percent. In addition, banks will be required to hold a capital conservation buffer of 2.5 percent to withstand future periods of stress, bringing the total common equity requirements to 7 percent.
The EE region has large skill mismatches, compared to advanced Europe. See Mitra and Pérez Ruiz (forthcoming).