Chapter

4. East-West Economic and Financial Linkages in Europe

Author(s):
International Monetary Fund. European Dept.
Published Date:
October 2011
Share
  • ShareShare
Show Summary Details

Trade and financial linkages between Western Europe and Central, Eastern, and Southeastern Europe (CESEE) have increased sharply over the past one and a half decades.48Production chains of Central Europe have become integrated with those of Germany, and Western European banks have come to dominate banking systems in most CESEE countries. As a result, east-west spillovers have become much stronger and no longer go from west to east only. Financial shocks and trade shocks have become interdependent, with shocks to credit flows in one direction quickly followed by shocks to trade flows in the other direction.

This chapter takes stock of the economic and financial ties between CESEE and Western Europe and assesses the associated spillovers. The first section documents stylized facts about trade, foreign direct investment (FDI), and banking linkages between the two parts of Europe. It goes on to quantify how shocks originating in Western Europe affect economic developments in CESEE and vice versa. A final section offers policy conclusions.

Stylized Facts

The economies of Europe are highly open and strongly trade-integrated with one another. Trade in goods is equivalent to about 60 percent of GDP—more than in any other region of the world, except for the Middle East and North Africa, where oil exports account for a large share of GDP (Figure 4.1). Three-fourths of European trade is trade within Europe, making its intraregional trade the largest of all regions in terms of GDP, as well as relative to total trade.

Figure 4.1Selected Global Regions: Total Trade Flows, 2010

(Sum of imports and exports of goods relative to GDP, percent)

Sources: IMF, Direction of Trade Statistics; IMF, World Economic Outlook database; and IMF staff calculations.

Western Europe dominates intra-European trade. The bulk of European trade takes place within Western Europe, and Western Europe is CESEE’s premier export market. In 2010, Western European nations exported goods worth 18.5 percent of GDP to other Western European nations—more than twice as much as they exported to the rest of the world and far more than the 3.3 percent of GDP that went to CESEE (Figure 4.2). Conversely, Western Europe is easily CESEE’s main trading partner, ahead of trade within CESEE, owing to its larger economic size.

Figure 4.2Europe and Rest of the World: Trade Flows of Goods, 20101

Sources: IMF, Direction of Trade Statistics; IMF, World Economic Outlook database; and IMF staff calculations.

1 The thickness of arrows reflects the magnitude of trade flows relative to exporting country’s GDP. The size of bubbles reflects the share of individual region’s GDP in the world’s GDP (Western Europe: 25 percent; CESEE: 6 percent; rest of the world: 69 percent).

CESEE’s importance has increased rapidly. Economic and financial ties between the countries of Europe have become much stronger since the mid-1990s. The general globalization trend was accentuated by the liberalization of the economies in CESEE, the eastward expansion of the EU, the deepening of integration within the EU, and closer ties of the EU with non-members in the region. Moreover, the economies of CESEE grew much faster than those of Western Europe, lifting their relative economic weight to almost 30 percent of Western Europe (Figure 4.3).

Figure 4.3CESEE: GDP Relative to Western Europe, 1995–20151,2

(Percent)

Sources: IMF, World Economic Outlook database; and IMF staff calculations.

1 Includes Serbia from 1997; Bosnia & Herzegovina from 1998; Kosovo from 2000; and Montenegro from 2001.

2 Projections from 2011.

Western Europe’s exports to CESEE are growing the fastest, and CESEE has become a more important export destination for Western Europe than the Asia and Pacific region or the Western Hemisphere (Figure 4.4). CESEE’s role as a source for Western European imports has also increased rapidly, although it remains less important in that role than the Asia and Pacific region. CESEE sources a rapidly growing share of its own imports from the Asia and Pacific region, which now accounts for 15 percent of all CESEE imports, up from 6 percent in 1995.

Figure 4.4CESEE and Western Europe: Import and Export Shares by Region, 1995–2010

Sources: IMF, Direction of Trade Statistics; IMF, World Economic Outlook database; and IMF staff calculations.

Trade interconnectedness—Europe as a whole

Germany, Italy, and the Netherlands are the economies most tightly connected through trade linkages with the rest of Europe, but Hungary and Poland have begun to play important roles too. Trade interconnectedness is gauged by an index that takes into account trade flows relative to economic size, import and export market shares relative to what would be expected on the basis of relative economic sizes, and trade flows in absolute terms. For each country, it is measured by averaging that country’s interconnectedness with all its partner countries in Europe or a subregion.49 Looking at all intraregional trade in Europe, Western European economies are the ones most tightly connected in this way with their partner countries across the continent. Belgium, Germany, Italy, and the Netherlands come out on top (Table 4.1, column 1). However, Hungary and Poland also have leading positions and, indeed, score higher than many Western European economies.

Table 4.1Europe: Degree of Trade Interconnectedness1,2
Within EuropeWith Western EuropeWith CESEE
Germany0.457Netherlands0.620Hungary0.467
Netherlands0.382Germany0.570Slovenia0.406
Italy0.353Belgium0.547Russia0.392
Belgium0.327United Kingdom0.480Austria0.362
Hungary0.308France0.404Germany0.354
Poland0.296Italy0.383Poland0.353
Russia0.288Sweden0.351Ukraine0.339
Austria0.288Denmark0.345Italy0.325
Slovenia0.278Switzerland0.322Bulgaria0.314
United Kingdom0.264Spain0.313Slovak Republic0.306
Sweden0.243Norway0.298Serbia0.292
France0.235Finland0.248Romania0.269
Denmark0.229Poland0.239Belarus0.261
Czech Republic0.226Luxembourg0.219Czech Republic0.261
Slovak Republic0.224Ireland0.211Lithuania0.250
Bulgaria0.215Austria0.205Macedonia, FYR0.242
Lithuania0.214Czech Republic0.192Moldova0.231
Romania0.200Iceland0.190Croatia0.222
Finland0.197Russia0.183Latvia0.208
Ukraine0.186Lithuania0.178Bosnia & Herzegovina0.204
Serbia0.183Estonia0.175Turkey0.181
Latvia0.178Portugal0.152Estonia0.178
Estonia0.176Slovenia0.150Netherlands0.168
Spain0.169Hungary0.150Greece0.153
Switzerland0.168Latvia0.147Finland0.151
Norway0.163Slovak Republic0.142Sweden0.146
Croatia0.157Malta0.135Belgium0.128
Macedonia, FYR0.157Romania0.131Denmark0.124
Belarus0.142Bulgaria0.117Montenegro, Rep. of0.119
Moldova0.138Greece0.112Albania0.112
Turkey0.135Cyprus0.109France0.082
Greece0.134Croatia0.092United Kingdom0.070
Bosnia & Herzegovina0.134Turkey0.089Cyprus0.047
Luxembourg0.112Montenegro, Rep. of0.083Norway0.040
Iceland0.107Albania0.078Spain0.038
Montenegro, Rep. of0.101Serbia0.075Malta0.034
Ireland0.100Macedonia, FYR0.072Iceland0.032
Albania0.095Bosnia & Herzegovina0.064Switzerland0.029
Malta0.081Moldova0.044Luxembourg0.015
Cyprus0.076Ukraine0.033Ireland0.000
Portugal0.072Belarus0.022Portugal0.000
Sources: IMF, Direction of Trade Statistics; IMF, World Economic Outlook; and IMF staff calculations.

The index is the weighted average of indicators representing the importance of bilateral trade between countries within Europe. See section (a) of the Annex for more detail.

Names of countries in Western Europe are in blue, and those in CESEE are in red.

Sources: IMF, Direction of Trade Statistics; IMF, World Economic Outlook; and IMF staff calculations.

The index is the weighted average of indicators representing the importance of bilateral trade between countries within Europe. See section (a) of the Annex for more detail.

Names of countries in Western Europe are in blue, and those in CESEE are in red.

Trade interconnectedness—East-West

Among countries of CESEE, those located in Central Europe and the Baltics are the most intertwined with Western Europe through trade. Focusing on trade flows with Western Europe, other countries from Western Europe (rather than from CESEE) show the highest degree of trade interconnectedness, indicating that trade ties within Western Europe are still stronger than between Western Europe and CESEE (Table 4.1, column 2). Poland and the Czech Republic are the two CESEE countries with the closest trade connections with Western Europe, although Russia is also important owing to its sizable energy trade. The importance of Central Europe, the Baltics, and Russia is also apparent from their relatively high trade in relation to their own GDP and/or that of their trading partners alone (Tables 4.2 and 4.3).

Table 4.2CESEE and Western Europe: Bilateral Trade, 2010(Percent of CESEE country’s GDP)
GermanyItalyNetherlandsFranceUnited KingdomAustriaBelgiumSpainSwedenFinlandSwitzerlandGreeceDenmarkNorwayIrelandPortugalLuxembourgCyprusMaltaIcelandTotal
Czech Republic40.95.56.95.74.86.43.52.71.70.61.90.31.00.90.40.40.20.10.00.084.0
Hungary33.27.25.46.45.27.32.83.31.30.51.40.40.90.20.40.40.10.00.00.076.6
Slovak Republic27.67.24.77.83.59.62.32.61.70.41.20.40.80.20.20.30.10.20.00.070.8
Slovenia21.917.33.07.02.011.01.91.80.80.31.20.40.70.20.20.20.20.00.00.070.0
Estonia11.02.53.62.72.60.72.00.915.517.30.60.12.62.90.20.10.00.10.00.265.7
Poland19.44.53.84.03.31.52.21.71.80.60.70.21.10.70.30.20.10.00.00.046.1
Lithuania12.23.25.33.53.70.63.21.23.81.60.40.12.61.70.30.20.10.00.00.544.3
Bulgaria10.78.02.13.51.62.62.52.30.50.20.76.30.40.10.10.30.10.20.00.042.4
Macedonia, FYR14.15.62.10.64.51.91.01.30.30.00.77.10.30.10.20.30.00.00.00.040.1
Romania11.68.42.24.61.82.21.31.60.40.20.70.90.30.10.30.30.00.10.00.037.2
Latvia8.62.32.61.82.30.61.40.83.92.80.90.12.31.40.30.10.00.20.00.132.6
Albania1.916.80.70.40.31.00.21.40.20.10.35.40.10.00.10.00.10.00.00.028.8
Croatia6.47.71.30.90.73.40.60.50.30.10.50.30.20.10.10.00.40.10.30.024.2
Bosnia & Herzegovina7.57.40.90.70.34.50.50.60.30.00.50.40.20.10.10.00.00.00.00.024.1
Moldova7.47.21.31.42.01.00.60.40.30.20.31.00.20.10.10.10.10.00.00.023.9
Serbia6.35.71.21.30.62.70.70.50.00.10.61.00.30.00.20.00.00.10.00.021.3
Belarus5.61.35.70.51.90.60.60.20.30.30.60.00.20.30.00.00.00.10.00.018.4
Turkey4.42.31.21.91.60.31.01.10.40.20.60.30.20.10.10.10.00.00.10.015.8
Russia4.61.72.31.50.70.40.80.70.61.10.20.40.20.20.00.00.00.00.00.015.5
Ukraine5.13.01.31.00.71.10.60.60.20.40.60.20.30.20.00.10.00.10.00.015.5
Montenegro, Rep. of2.04.41.20.50.22.20.20.50.10.00.33.10.10.00.00.00.00.00.00.015.0
CESEE10.63.62.72.61.81.71.31.20.90.80.60.50.40.30.10.10.10.00.00.029.3
Sources: IMF, Direction of Trade Statistics; IMF, World Economic Outlook database; and IMF staff calculations.
Sources: IMF, Direction of Trade Statistics; IMF, World Economic Outlook database; and IMF staff calculations.
Table 4.3CESEE and Western Europe: Bilateral Trade, 2010(Percent of Western European country’s GDP)
RussiaPolandCzech RepublicTurkeyHungarySlovak RepublicRomaniaSloveniaUkraineBulgariaLithuaniaCroatiaEstoniaBelarusSerbiaLatviaBosnia & HerzegovinaMacedonia, FYRAlbaniaMoldovaMontenegro, Rep. ofTotal
Austria1.71.93.30.62.52.20.91.40.40.30.10.50.00.10.30.00.20.00.00.00.016.6
Netherlands4.32.31.71.10.90.50.50.20.20.10.20.10.10.40.10.10.00.00.00.00.012.8
Finland6.91.20.50.50.30.10.10.10.20.00.20.01.40.10.00.30.00.00.00.00.012.0
Germany2.02.72.41.01.30.70.60.30.20.20.10.10.10.10.10.10.00.00.00.00.012.0
Belgium2.52.21.41.60.80.40.50.20.20.30.20.10.10.10.10.10.00.00.00.00.010.7
Malta0.00.40.35.20.30.10.40.10.40.10.12.10.00.00.00.00.00.00.00.00.09.6
Sweden2.01.90.70.60.40.30.20.10.10.10.30.00.70.00.00.20.00.00.00.00.07.5
Italy1.21.00.50.80.50.30.70.40.20.20.10.20.00.00.10.00.10.00.10.00.06.5
Greece1.90.30.20.80.20.10.50.10.11.00.00.10.00.00.10.00.00.20.20.00.05.9
Denmark0.81.70.60.50.40.20.10.10.10.10.30.00.20.00.00.20.00.00.00.00.05.3
Cyprus0.30.50.50.00.20.60.60.10.60.30.00.40.10.30.10.30.00.00.00.00.04.9
Switzerland0.70.60.70.80.40.20.20.10.20.10.00.10.00.10.00.00.00.00.00.00.04.2
Luxembourg0.41.00.60.50.30.20.10.20.00.10.00.50.00.00.00.00.00.00.00.00.04.1
Iceland0.90.70.20.20.10.00.00.00.20.01.30.00.30.10.00.10.00.00.00.00.04.0
France0.80.70.40.60.30.30.30.10.10.10.00.00.00.00.00.00.00.00.00.00.03.8
Spain0.70.60.40.60.30.20.20.10.10.10.00.00.00.00.00.00.00.00.00.00.03.2
United Kingdom0.40.70.40.50.30.10.10.00.00.00.10.00.00.00.00.00.00.00.00.00.03.0
Norway0.70.80.40.20.10.00.10.00.10.00.20.00.10.00.00.10.00.00.00.00.02.9
Ireland0.30.60.40.40.20.10.20.00.00.00.00.00.00.00.00.00.00.00.00.00.02.6
Portugal0.30.40.40.40.20.10.20.00.10.10.00.00.00.00.00.00.00.00.00.00.02.3
Western Europe1.41.31.00.70.60.40.40.20.10.10.10.10.10.10.10.00.00.00.00.00.06.9
Sources: IMF, Direction of Trade Statistics; IMF, World Economic Outlook database; and IMF staff calculations.
Sources: IMF, Direction of Trade Statistics; IMF, World Economic Outlook database; and IMF staff calculations.

Among countries of Western Europe, Austria, Germany, and Italy are most enmeshed with CESEE through trade. Nevertheless, in trade with CESEE countries, economies from CESEE itself are again the most trade interconnected (Table 4.1, column 3), with Hungary, Russia, and Slovenia more involved in trade with CESEE than any country in Western Europe. The importance of Austria, Germany, and Italy is already apparent from their sizable trade with CESEE relative to their GDP. Trade between Germany and CESEE corresponds to 10.6 percent of CESEE’s GDP and 12 percent of Germany’s GDP. For Austria, trade with CESEE is equivalent to 16.6 percent of its GDP.

Cross-border production chains

Cross-border production chains appear to play an important role in Europe, but there is little evidence that they are being ramped up there as they are in Asia. The importance of cross-border production chains can be measured by the size of trade in intermediate goods.50 In intra-European trade, they account for about 7 percent of GDP, which is higher than in Asia or in North America (Figure 4.5). However, this share has remained largely constant over time, in contrast to Asia, where it has been growing rapidly as the international division of labor has taken off (IMF, 2010d). This picture does not change dramatically if one focuses on trade between Western Europe and CESEE. Again, the share of intermediate goods trade remains rather constant over time (Figure 4.6).

Figure 4.5Selected Global Regions: Intraregional Trade of Intermediate Goods, 1996–2009

Sources: IMF, World Economic Outlook database; United Nations Comtrade database; and IMF staff calculations.

Figure 4.6CESEE and Western Europe: Trade of Intermediate Goods in Europe, 1996–2009

Sources: IMF, World Economic Outlook database; United Nations Comtrade database; and IMF staff calculations.

Within the European cross-border production chain, Western Europe occupies an upstream position, that is, it contributes predominantly core components rather than specializing in final assembly. According to a study by Koopman and others (2010), the indirect exports of the old EU member states (the EU-15), representing exports used by importing countries to produce goods for export to third countries, are more important than the imported contents embodied in their exports. By contrast, for the EU’s new member states (NMS), the relative importance of indirect exports and imports embedded in exports is reversed. In other words, on balance, EU-15 countries take the upstream position of the production chain, while the NMS occupy a more downstream position (Table 4.4). Similarly, Japan and the United States hold upstream positions in Asia and North America, respectively, while newly industrialized countries and emerging markets in Asia, as well as Canada and Mexico, specialize in downstream activities.51

Table 4.4Selected Countries: Measures of Vertical Specialization across Borders, 2004
Imported contents embodied

in gross exports (percent)
Indirect exports sent to third

countries (percent)1
Upstream or downstream

position2
Asia
Japan12.230.82.5
Hong Kong27.519.50.7
Philippines41.929.40.7
Korea33.923.10.7
Taiwan41.427.20.7
Malaysia40.525.00.6
Thailand39.718.40.5
China35.712.50.4
Europe
Russia10.231.23.1
European Union (EU-15)11.420.91.8
EU New Member States30.811.30.4
North America
United States12.926.92.1
Canada28.112.20.4
Mexico48.010.00.2
Sources: Koopman and others (2010); and IMF staff calculations.

Includes indirect exports that return to home country.

Based on indirect exports sent to third countries divided by imported contents embodied in gross exports.

Sources: Koopman and others (2010); and IMF staff calculations.

Includes indirect exports that return to home country.

Based on indirect exports sent to third countries divided by imported contents embodied in gross exports.

Germany and Central Europe hold key positions in cross-border production chains

Production chains between Western Europe and CESEE run primarily between Central Europe and Germany. The extent of intermediate goods trade varies dramatically between the different parts of CESEE and Western Europe. It exceeds 10 percent of GDP in the case of Central Europe and is also substantial in the Baltics (Figure 4.7). Its role is more subdued for Southeastern Europe and low for the European CIS countries. From Western Europe’s perspective, intermediate goods are much more prominent in Germany’s trade than in that of other Western European countries. The growing importance of cross-border production chains for Central Europe and Germany is also reflected in a high rate of import growth relative to domestic demand growth in these countries.

Figure 4.7Selected European Regions: Imports and Exports between CESEE and Western Europe by Components, 2009

(Percent of GDP)

Sources: IMF, World Economic Outlook database; United Nations Comtrade database; and IMF staff calculations.

Cross-border production between Germany and Central Europe primarily involves transportation equipment and capital goods, which account for more than half of the trade between these countries. For automobiles, which account for 14 percent of German exports to Central Europe and 18 percent of Central Europe’s exports to Germany, two-thirds of German exports are parts and components, whereas the remaining third is final vehicles. For Central Europe, the composition is about 50 percent each. Production chains are highly interwoven and Central Europe does not act simply as an assembly location. Nevertheless, Germany supplies more intermediate inputs. This pattern of production chains broadly applies to electrical equipment and other machinery as well.

FDI of Western Europe in CESEE is sizable, further boosting East-West trade

FDI also binds the economies of Western Europe and CESEE together. While the FDI of CESEE countries in Western Europe is negligible, its flow in the other direction became substantial as CESEE economies liberalized, state-owned enterprises were put up for sale, their domestic markets became attractive for retail activity, and cross-border productions chains were set up. FDI in CESEE comes almost exclusively from Western Europe and reaches a considerable size, especially in Bulgaria, the Czech Republic, Estonia, Hungary, and the Slovak Republic (Figure 4.8). Over time, the destinations of this investment changed as the appeal of Southern Europe started to pale in comparison with that of CESEE. For example, German FDI flows into CESEE were strong during 2007–10, but negative in Portugal (Figure 4.9).

Figure 4.8CESEE: Inward Foreign Direct Investment Stock by Origins of Funds and Sectors, 20081,2

(Percent of GDP)

Sources: Central banks of Russia and Turkey; IMF, International Financial Statistics; IMF, World Economic Outlook database; Vienna Institute for International Economic Studies (wiiw), Database on Foreign Direct Investment; and IMF staff estimates.

1 The number of total stock is based on international investment position data; the composition is based on the breakdown available from wiiw data.

2 The tradable sector comprises agriculture, manufacturing, mining, and trade. The nontradable sector comprises communication and transportation, construction, financial intermediation, real estate, and utilities.

Figure 4.9Europe: Accumulated German Foreign Direct Investment, 2007–10

(Percent of recipient country’s average GDP)

Sources: Deutsche Bundesbank; IMF, World Economic Outlook database; and IMF staff calculations.

FDI linkages tend to reinforce and cement trade linkages over time. FDI in the tradable sector boosted CESEE’s imports and exports. A sizable part of FDI was directed toward the tradable sector as firms from Western Europe outsourced parts of their production processes to CESEE. Once production facilities in CESEE came onstream, they sourced inputs from their western parents and shipped much of their output back to Western European markets. FDI in the nontradable sector did not boost CESEE’s exports, but did lead to increase of imports—at least in the short term.

Banking system linkages are strong—much of CESEE’s banking system is owned by Western European banks

Financial linkages of Western Europe with CESEE increased rapidly from 2003 onward. Western banks acquired subsidiaries in CESEE to which their head offices would extend ample financing for local credit expansion. Direct cross-border lending to nonbanks in CESEE also took off. As a result, exposure of BIS-reporting banks, most of them headquartered in Western Europe, became large relative to the size of CESEE banking systems, easily exceeding 50 percent of local banking system assets in a number of countries (Figure 4.10). The importance of Western Europe’s banks to CESEE is even greater when the locally funded assets of Western European-owned subsidiaries are also taken into account. According to that yardstick, Western Europe’s banks account for the vast majority of banking sector assets everywhere in CESEE, except in Turkey and the European CIS countries (Figure 4.11). Austrian-owned, French-owned, and Italian-owned banks are particularly active in CESEE.

Figure 4.10CESEE: Funding from BIS-Reporting Banks, 2010

(BIS-reporting banks’ exposure relative to banking system’s total assets, percent)

Sources: BIS, Locational Banking Statistics (Table 6); IMF, International Financial Statistics; and IMF staff calculations.

Figure 4.11CESEE: Consolidated Claims of BIS-Reporting Banks by Country of Bank Ownership, 2010

(Relative to banking system’s total assets, percent)

Sources: BIS, Consolidated Banking Statistics (Table 9B); IMF, International Financial Statistics; and IMF staff calculations.

Reverse financial linkages from CESEE to Western Europe are much less pronounced. While Western European banks dominate CESEE banking systems, their operations in the region make up only a small fraction of Western Europe’s banking systems, and their asset exposure to CESEE represents less than 3 percent of their assets on average (Figure 4.12). Only the CESEE operations of Austrian and Greek banks are considerable relative to their domestic banking systems, corresponding to about 30 percent and 15 percent of their assets, respectively. The funding of banks in the west from CESEE sources, mainly in the form of nonbank deposits, is also small relative to the funding provided by Western European banks to CESEE and especially relative to the size of Western Europe banking system assets.

Figure 4.12Western Europe: Consolidated Claims of BIS-Reporting Banks on CESEE by Country of Bank Ownership, 2010 1

(Relative to banking system’s total assets, percent)

Sources: BIS, Consolidated Banking Statistics (Table 9B); IMF, International Financial Statistics; and IMF staff calculations

1 Total assets for Western Europe do not include Norway due to data unavailability.

The expansion of Western European banks in CESEE boosted Western Europe’s exports. Much of the ample financing that was made available by Western Europe’s banks to CESEE during the boom period of 2003–08 was spent on imports from Western Europe. The more financing CESEE countries received from western banks, the stronger their imports from Western Europe grew. An estimated 57 cents per euro of western bank financing ended up being spent on imports from Western Europe (Figure 4.13). The boom period boosted trade and financial exposure at the same time, just as the slump in the wake of the global financial crisis dealt a simultaneous blow to both.

Figure 4.13CESEE: Funding from Western Banks and Imports from Western Europe, 2003-08 1

(Percent of GDP)

Sources: BIS, Locational Banking Statistics (Table 6); IMF, Direction of Trade Statistics; IMF, World Economic Outlook database; and IMF staff calculations.

1 For Estonia, Latvia and Lithuania, 2002–07.

Spillovers and Quantifications

Economic and financial linkages between the two parts of Europe are obviously significant, but what can be said about the strength of spillovers from economic developments in Western Europe to CESEE and vice versa? Europe’s experience in the run-up to and the aftermath of the global financial crisis suggests that spillovers are large. For example, exports to CESEE lifted Germany’s annual export growth during 2003–08 from 6½ percent to 8¼ percent, thereby directly adding ¾ percentage points to GDP growth. And in the 2009 recession, exports to CESEE worsened the contraction of Germany’s exports from 16¼ percent to 12¼ percent. This directly added 1¾ percentage points to the fall of German output.52 Similarly, because buoyant financing from western banks during 2003—08 played a pivotal role in CESEE’s economic boom, the sudden end of that financing from late 2008 helped plunge the economies of CESEE into a deep recession (Bakker and Gulde, 2010).

This section offers three approaches for the quantification of spillovers. First, it quantifies the size of output spillovers through the trade channel based on import elasticities and the structure of bilateral trade relationships. Second, it employs a vector autoregression (VAR) framework to study the dynamics of growth shocks originating in one part of Europe on GDP in the other part of Europe. Third, it uses a dynamic panel regression to quantify the effects of a funding shock from Western European banks on credit growth and economic growth in CESEE.

Spillovers through the trade channel are considerable, ranging from 0.3 percent to 2.4 percent additional growth in individual countries for a 1 percent growth shock in the rest of Europe. The quantification exercise first estimates the effect of an output shock on countries’ imports and then calculates the effect on partner countries’ exports using historical trade shares. Their export multipliers are set equal to 1—essentially assuming that income effects are offset by higher imports of final goods and intermediate inputs embedded in exports.53 On this basis, spillovers can be quite high, especially for small, highly-open economies, such as Malta and Moldova.54 Larger economies that have considerable trade relations with non-European countries, such as Russia and Turkey, are subject to much lower spillovers (Figure 4.14). Aggregation across the countries of Western Europe and CESEE suggests that a 1 percent growth shock in Western Europe would add 0.4 percentage point to growth in CESEE. Conversely, a 1 percent growth shock emanating from CESEE would entail additional growth of just 0.1 percentage point in Western Europe.

Figure 4.14Asia and Europe: Impact of Output Spillovers through the Trade Channel 1

(Percent)

Sources: IMF, Direction of Trade; IMF, World Economic Outlook database; United Nations Comtrade database; and IMF staff calculations.

1 Section (b) of the Annex explains the methodology of the analysis.

Western growth shocks are felt one-for-one in the CESEE

The VAR framework confirms strong spillovers from Western Europe to CESEE, but reverse spillovers are manifest only when they emanate from Central Europe. The exercise explains growth in Western Europe and CESEE in terms of past growth in the two parts of Europe while controlling for growth in the rest of the world. It then studies the dynamic response of growth in one part of Europe to a growth shock in the other part of Europe.55 A growth shock in Western Europe essentially translates one-to-one into additional growth in CESEE (Figure 4.15, panel 1). The effects on Central Europe and the rest of CESEE seem to be in the same order of magnitude, although the effect on Central Europe has higher statistical significance (Figure 4.15, panel 2). A growth shock in CESEE has no significant effect on growth in Western Europe (Figure 4.15, panel 3). However, given the closer ties between Central Europe and Western Europe, a shock emanating from the former does have a statistically significant effect on the latter. Over time, growth in Western Europe is lifted by about one-third of the increase in growth in Central Europe (Figure 4.15, panel 4).

Figure 4.15Europe: Growth Spillovers between CESEE and Western Europe 1

(Accumulated response of GDP, percent)

Sources: IMF, World Economic Outlook database; and IMF staff calculations.

1 Section (c) of the Annex explains the methodology of the analysis.

Funding shocks from western banks have a big impact on credit in CESEE

Funding from western banks has a strong impact on credit and domestic demand growth in CESEE. The exercise first estimates the dynamic response of credit expansion to changes in the exposure of western banks to banks in CESEE countries, using data on 15 countries in the region during 2003–10.56 Over time, about 80 percent of any exposure increase is found to translate into additional credit (Figure 4.16, panel 1). In a second step, the exercise considers the association of credit growth with domestic demand and GDP. Over time, a 1 percentage point increase in real credit growth is associated with a 0.35 percentage point increase in real domestic demand and a 0.28 percentage point increase in real GDP (Figure 4.16, panel 2). Putting the two steps together suggests that the financial spillovers from western banks to economic activity in CESEE are strong. Indeed, the financing provided by western banks during 2003–08 added 1½ percentage points to CESEE’s annual GDP growth according to these estimations.57

Figure 4.16Europe: Credit Spillovers from Western Europe to CESEE 1

Sources: BIS, Locational Banking Statistics (Table 6); IMF, International Financial Statistics; IMF, World Economic Outlook database; and IMF staff calculations.

1 Section (d) of the Annex explains the methodology of the analysis.

Despite the pivotal role of western banks in CESEE’s banking systems, several factors mitigate concerns that financial stability in CESEE would be at risk in an adverse scenario where western banks came under intense strain at home; for example, in the context of a sharp escalation of the tension in euro area debt markets. Multiple lines of defense in home and host countries and the experience during the 2008/09 crisis suggest that such severe spillovers would not materialize easily. Pressured western banks would in the first instance turn to support available at home, such as liquidity from the ECB against eligible collateral, emergency liquidity assistance from their central banks, and any government support schemes that would be put in place under the circumstances. Scope for obtaining funding from their subsidiaries in CESEE would be rather limited, as host supervisors would step in if compliance with liquidity and capital ratios of subsidiaries were at risk. Violations would ultimately lead to a painful loss of managerial control by parent banks.

An adverse scenario would, however, likely trigger a renewed credit crunch, as western parent banks would persistently scale back their exposure to subsidiaries, and cross-border loans to nonbanks would be rolled over only sparingly. Moreover, unaffiliated banks in CESEE countries that rely heavily on wholesale funding could come under pressure. In sum, the outcome would not be unlike the experience during the global financial crisis in 2008/09 when CESEE escaped financial meltdown, and banking crises occurred only in the two countries where reliance of local banks on wholesale funding was particularly high (Latvia and Ukraine).

Policy Implications

Linkages give rise to good and bad spillovers…

Spillovers, which are the inevitable side effect of linkages, entail challenges for policymakers. Strong linkages mean that economic developments and policies in one part of Europe have considerable repercussions in other parts. This by itself is neither good nor bad, because favorable developments can spill over as much as unfavorable ones can. However, it complicates macroeconomic policymaking, because when economies are buffeted by far-away shocks, traditional policy tools might become less effective and business cycles are amplified. For example, the guardians of financial stability in Western European countries with banking sectors heavily exposed to CESEE need to monitor possible repercussions for the domestic financial system closely. Conversely, policymakers in CESEE might find it difficult to control a credit boom through traditional monetary policy tools if domestic banks have ample access to financing from foreign parent banks. And the interactions between financial and trade spillovers might exacerbate business cycles.

…as economies advance through cross-border integration…

These policy challenges should not distract from the fundamental benefits of economic and financial integration between Western Europe and CESEE. Tight integration is the result of economic liberalization and reform across CESEE, as well as in Western Europe, together with deliberate integration efforts as the EU expanded eastward. This has allowed countries to specialize according to their comparative advantages, firms to exploit economies of scale, and consumers to benefit as firms have faced stiffer competition. In particular, it has allowed western firms to extend their production chains to the east, thereby improving their competitiveness in global markets while contributing to the economic development of host countries. From this perspective, integration has been mutually beneficial and was rightly embraced by policymakers.

…and policymakers need to take note

Economic policies need to be fully attuned to the presence of spillovers to be effective. This requires three things. First, a broader range of economic and financial developments needs to be monitored and the linkages and associated spillovers have to be properly understood. This way, the domestic repercussions from seemingly faraway developments will not come as a surprise and can be addressed by domestic policies in a timely manner. Second, policymakers need to switch to tools that are still effective in an interlinked economic setting. For instance, if traditional monetary policy could not contain the overheating associated with a foreign-funded credit boom, perhaps fiscal tightening and prudential measures—possibly coordinated with home supervisors—still could. Third, if linkages lead to an amplification of business cycles, policymakers must be prepared to use tools more aggressively.

Note: The main authors of this chapter are Özge Akinci and Phakawa Jeasakul.
48The Western Europe and CESEE regions closely match the regions referred to elsewhere in this report as advanced and emerging Europe, with important exceptions. Western Europe comprises Austria, Belgium, Cyprus, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Malta, the Netherlands, Portugal, and Spain in the euro area; and Denmark, Iceland, Norway, Sweden, Switzerland, and the United Kingdom. CESEE comprises the Czech Republic, Hungary, Poland, the Slovak Republic, and Slovenia in Central Europe; Estonia, Latvia, and Lithuania in the Baltics; and Albania, Bosnia and Herzegovina, Bulgaria, Croatia, FYR Macedonia, Montenegro, Romania and Serbia in Southeastern Europe; and Belarus, Moldova, Russia, and Ukraine in the European CIS; and Turkey.
49Section (a) of the Annex describes in greater detail the construction of the trade interconnectedness index, which is based on the methodology for assessing trade interconnectedness in IMF (2011a).
50Intermediate goods are the sum of the following categories in the Comtrade statistics: processed nonfuel industrial supplies (BEC 22), parts and accessories for capital goods (BEC 42), and parts and accessories for transportation equipment (BEC 53).
51Table 4.5 also indicates an upstream position for Russia. However, this primarily reflects Russian exports of energy and raw materials rather than critical intermediate goods.
52During 2003—08, Germany’s GDP grew by an annual average of 1.9 percent. In 2009, it contracted by 5.1 percent. The quantifications of the contributions from exports to CESEE are meant to give a sense of the orders of magnitude involved. They do not take into account second-round effects through changes of income and imports.
53Section (b) of the Annex explains the methodology, based on that in the U.S. Spillover Report (IMF, 2011h), in more detail.
54Spillover coefficients can exceed one as shocks to trading partners’ GDP tend to raise their imports more than one-for-one.
55Section (c) of the Annex explains the methodology in more detail.
56Suitable data for the other CESEE countries are not available. Section (d) of the Annex explains the methodology in more detail.
57During this period, annual average growth in CESEE was 6½ percent.

    Other Resources Citing This Publication