VIII. 2002–2007: Boom
- James Roaf, Ruben Atoyan, Bikas Joshi, and Krzysztof Krogulski
- Published Date:
- October 2014
The mid-2000s saw extremely rapid growth across the region, spurred by the benign global environment and ever-increasing confidence in the process of convergence with the EU. However, growth was driven largely by external borrowing for consumption and construction, and became increasingly unsustainable. Even for those countries that heeded the dangers, it was very difficult to devise policies that could push back against the tide of capital flowing into the region.
Source: WEO. CEE average weighted by GDP, others unweighted.
The “Great Moderation” period was marked by strong growth and high optimism across emerging markets globally. But it was particularly marked in the CEE countries, where there was seen to be strong convergence forces driving the economies towards Western European income levels. For the region as a whole, growth averaged almost 6 percent a year over the period—a rate at which incomes would double every 12 years, putting Western livings standards seemingly within the grasp of a generation. A major milestone was passed with the accession of 10 countries from the region to the EU (see Box 7). Financial markets shared in the optimism of the region, with ready access to private financing enabling almost all the transition economies to “graduate” from IMF-supported lending programs during the period: the number of CEE program countries fell from 13 in 2001 to three by mid-2007.
However, in hindsight, the optimism of this period was in part misplaced. The pace of economic reform generally slowed in this period, and the strong growth was based on a rapid increase in domestic demand, with credit booms fueling consumption growth and investment directed towards construction and real estate. The flipside was the emergence of very large external imbalances, as productive capacity struggled to keep up with the pace of demand. When the credit bubbles eventually burst in late 2008, triggered by the global financial crisis, the region suffered devastating losses in output, and also in confidence in the convergence process and prospects.
Across the region as a whole, the average current account deficit increased dramatically, while credit growth rose to extreme rates. The link between the two at the individual country level is clear: over 2002–07, annual average increases in the credit/GDP ratio corresponded closely to the current account deficits in the period. The most extreme cases were the Baltics and Bulgaria, where credit ratios increased by 8–10 percent a year, accounting for most of the huge external imbalances the countries were running. Given that the credit growth was in large part funded by foreign capital, as Western European banks competed for market share, the credit growth also provided the needed financing for countries to run such large external deficits. This ease of financing added to complacency about the risks involved. These risks were compounded by the attractions of borrowing in foreign currency (typically euros or swiss francs): for borrowers used to seeing the local currency appreciate, foreign-currency loans appeared to carry both lower interest rates and the prospect of diminishing principal when measured in local currency. Only when many exchange rates depreciated sharply in the bust did these products show they had a dangerous sting in the tail.
Bank lending and the current account
Note: See country codes box for country flags.
Source: WEO; World Bank.
This is not to say that the unsustainability of the boom period was unnoticed or ignored at the time. Among others, the IMF issued warnings of the risks posed by rapid credit growth and the associated demand booms and external imbalances.1 However, views differed even within the IMF, and traction of this advice was difficult. Explanations of rapid credit growth as a natural catching-up to Western European levels of financial intermediation were politically attractive. And the naysayers’ arguments were also undermined by the fact that the boom itself tended to flatter prudential indicators, by raising bank profitability, reducing bad loan ratios (through the rising denominator) and increasing collateral valuations as asset prices rose.
Even when countries recognized the dangers, it was difficult to identify means to address the problem. The scale of the inflows into the European transition economies tended to overwhelm the policy levers available to the authorities. Monetary policy was constrained either because it had been ceded to fixed exchange rate regimes or because raising interest rates would only attract more inflows. With public debt and deficits mostly appearing to be sound, the kind of fiscal tightening that would be needed to offset the inflows—multiple percentage points of GDP—was politically infeasible.2 Many countries did tighten prudential policies considerably, including via raised capital and liquidity requirements, but this did little to dampen the appetite for lending. It also led to diversion of flows around the local banking system, either via nonbank lending (notably leasing) or by Western European parent banks—which were beyond the reach of local regulators—lending directly to firms in CEE. Finally, capital controls on inflows were seen as inconsistent with countries’ commitments as new or prospective EU members, and also likely to be subject to circumvention.
The experience of Bulgaria provides a case in point. With confidence building in the run-up to expected EU entry in 2007, credit was growing at 30 percent a year or more in real terms, while the current account deficit was increasing alarmingly into double digits. The currency board arrangement tied monetary policy to that of the euro zone. Budgetary policy was already very tight, with an overall surplus close to 3 percent of GDP in 2005–06. Bank capital ratios were high and measures to drain liquidity from the system seemed to have no impact on lending growth. Bulgaria therefore resorted, with IMF encouragement, to imposing direct lending limits on banks. However, while the limits were observed, the desired macroeconomic impact was not achieved: capital inflows continued via nonbanks and parents, and the current account deficit continued to rise, peaking at no less than 25 percent of GDP in 2007.
At the same time, countries’ failure to stem the credit growth did not mean such policy efforts were wasted, since the countries that tightened fiscal and prudential policies were in a better position to weather the storm when the crisis eventually hit: this was an important factor behind the general success in avoiding more severe banking crises in the region in 2008–09.
Whatever the warnings that were made, the sheer scale of the boom and associated imbalances was certainly not adequately appreciated. Estimates made at the time suggested that the cyclical boom was responsible for only a small part of the strong output growth, which was therefore expected to continue at a rapid pace in the future. For the cases where the IMF published estimates, economies were on average thought to be operating at only about 1 percent of GDP above their potential at the peak of the boom in 2007. These estimates have since changed dramatically. Looking back now, the average estimated “output gap” in 2007 has increased to 5 percent, with some countries seeing extremely large revisions. This also had important implications for fiscal policy: as in a number of advanced European countries, the cyclically high tax receipts in the boom masked severe underlying fiscal problems, which were exposed in the aftermath of the crisis.
Revisions to estimates of overheating
Source: WEO, IMF country reports.
Box 7.EU Accession and its Implications
The boom period in the transition countries was closely associated with the accession of 10 of their number to the European Union. Eight were admitted in 2004 and two in 2007, adding 25 percent, or 100 million people, to the population of the union in its most significant expansion since it was founded.1
For the new member states, as for the EU itself, the effects of the accession were profound. The most important effects came through three main channels: liberalization of trade, capital and labor flows; institutional and legal development and integration; and access to EU funding. These effects were not felt only at the time of joining, but rather as a process, starting well before accession and continuing well after.
Joining the single market for trade has brought unambiguous benefit to the new member states, as discussed in Chapter VII. The effects of the other aspects of liberalization have been much more nuanced. In general, advantages of capital account liberalization are much harder to establish than for trade, and the challenges posed by banking inflows to the CEE countries have amply borne this out. Meanwhile the opening of labor markets has been associated with large-scale migration from the new member states to the old—around 2-3 million people by some estimates. The economic benefits of these moves seem to have accrued mainly to the recipient countries, with a negative growth impact in the source countries—though of course benefits to the migrants themselves should not be ignored.2
Raising local institutions and legal frameworks towards EU standards has played a critical role in economic development. Accession required deep and far-reaching improvements to legislation and administration. The actual application of EU norms in practice has been slow in some of the new members, but the process of EU integration remains a key driver of reform.
Financial flows from the EU increased sharply after accession, from below 1 percent of GDP on average before to almost 2.5 percent of GDP within three years, in the form of structural funds, agricultural support, and other subsidies. Perhaps more important than the volume of funds is the effectiveness with which they have been used, which has varied across countries.
The process of further accessions is expected to be relatively protracted. While membership prospects may therefore not yet provide as strong an impetus for reform and investment as they did for the countries that have already joined, the EU remains closely engaged with candidate and potential candidate countries to help them meet accession requirements.1 The Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, the Slovak Republic and Slovenia joined on May 1, 2004. Bulgaria and Romania joined on January 1, 2007. Among the other transition economies, Croatia joined on July 1, 2013, and Albania, Bosnia and Herzegovina, Kosovo, FYR Macedonia, Montenegro, and Serbia have candidate or potential candidate status.2 See for example Holland et al. (2011).
Atoyan et al. (2012) show that a pronounced counter-cyclical fiscal stance would have been effective in leaning against surging capital inflows, but the required magnitude of fiscal tightening for most countries would have been difficult to achieve.