X. 2008–2013: Crisis
- James Roaf, Ruben Atoyan, Bikas Joshi, and Krzysztof Krogulski
- Published Date:
- October 2014
The imbalances that built up in the “Great Moderation” period left the transition economies highly vulnerable. The combination of these initial conditions and external shocks—from Lehman Brothers’ collapse in 2008 and the euro-zone crisis in 2010–12—had devastating effects, hitting CEE hardest among the emerging markets regions. The impact still resonates, manifested in continued below-potential growth, high unemployment, and fragile financial markets. Moreover, region-wide economic convergence with Western Europe has stalled since the crisis.
Source: WEO. CEE average weighted by GDP, others unweighted.
Impact of the crisis
The global financial crisis, which began in advanced economies in the summer of 2007, spread to most emerging markets—including those in the CEE region—with a lag. This initial resilience, when regional growth remained robust, credit growth was still buoyant, and foreign capital continued to flow, led to claims that the region had “decoupled” from developments in advanced economies. However, after the collapse of Lehman Brothers in September 2008 and the ensuing increase in global risk aversion, capital inflows to the CEE region came to a sudden stop and global trade collapsed, placing the region at the epicenter of the emerging market crisis. This “recoupling” with advanced economies continued through the euro area crisis. The growth slowdown in the euro area and deleveraging by Western European banks gave further negative shocks to the region, and have continued to weigh heavily on macroeconomic and financial developments.
Source: JP Morgan, CEIC, Markit, and IMF staff calculations.
1/ TED spread up to end-2009, Euribor -German T-Bill after.
The immediate macroeconomic impact of the global financial crisis varied substantially across the CEE countries, in large part reflecting the degree of imbalances that had built up during the boom. The Baltic countries experienced the greatest peak-to-trough contractions in output, with Latvia contracting by as much as 25 percent of GDP. On average, the non-EU SEE region experienced the smallest output loss, at less than 5 percent, although at the individual country level Poland escaped recession along with Albania and Kosovo. The CEE region as a whole suffered much larger output declines than other emerging market regions.
Impact of the global financial crisis:
Foreign funding and real GDP growth
Note: See country code box for country flags.
Source: WEO; BIS.
With the onset of the crisis, the region experienced a protracted reversal of the strong capital inflows that had occurred in the boom: as with the bank flow component covered in Chapter IX, over half of the increase in the ratio of total foreign funding to GDP during the boom was subsequently gradually unwound.2 This sudden stop in inflows contributed to deep recessions as the lack of new funding triggered declines in credit and domestic demand. In this context, countries with fixed exchange rate regimes typically had greater capital inflows during the pre-crisis years, but also deeper and more protracted slowdowns in the aftermath of the crisis.
Econometric analysis confirms the link between pre-crisis fundamentals and vulnerabilities and the severity of output contractions.3 In addition to the financial linkages described above, other significant determinants of the impact of the crisis in the region were:
External vulnerabilities. High current account deficits, high external debt, and low levels of reserve coverage were associated with sharper output declines. Excluding Russia’s oil-related surplus, the average current account deficit in the CEE region stood at over 12 percent of GDP in 2007, compared to close to balance in Latin America and surpluses in most emerging Asian economies.
Trade linkages. Countries whose exports make up a larger share of aggregate demand saw greater output losses, reflecting the growth slowdown in advanced European trading partners and the increasing interconnectedness and responsiveness through supply chains. Commodity exporting countries such as Russia and Ukraine were also affected by sharp corrections in commodity prices.
Governments responded to the collapse in economic activity with significant fiscal accommodation and monetary stimulus, and quickly adopted emergency measures to stabilize financial sectors. However, their ability to pursue countercyclical policies at the onset of the crisis was limited by the policy space and financing available. Countries that entered the crisis with stronger fundamentals and more buffers—better external and fiscal balances, lower public debt, and lower inflation—were able to respond with greater and more credible countercyclical easing. In cases where policy adjustment needs were large or external financing needs were insurmountable, countries requested IMF program support to smooth the required macroeconomic adjustment and secure additional external financing.
Since the financial sector bore the initial brunt of the crisis in the region, measures to safeguard financial stability and maintain the confidence of depositors and debt holders became the authorities’ first line of defense:
Reserve requirements were relaxed to pump liquidity in the financial sector in Belarus, Bosnia and Herzegovina, Hungary, Latvia, Romania, Serbia, and Ukraine. Similarly, new fixed-term domestic and foreign currency liquidity supply operations were introduced. These operations were often made possible through swap and repo arrangements with Western European central banks: for Hungary and Poland with the ECB and the Swiss National Bank, and for Latvia and Estonia with the Central Bank of Sweden.
To minimize the risk of disorderly withdrawals of capital, the Vienna Initiative (see Box 8) helped ensure parent bank groups’ commitment to maintain their exposures and recapitalize subsidiaries in, the context of macroeconomic support programs with the IMF and EU.
The countries that had higher foreign reserves going into the crisis made greater use of them when the crisis hit, to avoid sharp depreciations that could have damaged corporate, household, and bank balance sheets. In particular, Russia made substantial use of its very high reserves to create space for corporates and banks to adjust to a revised global outlook with lower oil prices.
The monetary policy response to the crisis had to strike a balance between supporting the economy with easier monetary conditions and preserving financial sector stability by avoiding excessive exchange rate depreciation. As with other emerging markets, monetary responses to the crisis reflected differences in exchange rate regimes, external funding costs, and the level of pre-crisis policy rates:
Countries where sharp exchange rate overshooting would have led to serious balance sheet effects raised policy rates temporarily (Hungary, Russia, Serbia, and Ukraine) or left them unchanged (Latvia and Romania). In general, countries with pegged exchange rates or those that were perceived by markets to be more risky—as reflected in higher bond spreads—had more limited space for monetary stimulus.
On the other hand, countries with more credible monetary policy frameworks (such as Poland and the Czech Republic), reflected in low or falling inflation, provided more monetary stimulus.
The extent of fiscal accommodation depended on the available fiscal space in the given country. Higher pre-crisis primary balances and lower public debt levels allowed for greater fiscal accommodation during the crisis. Conversely, countries with limited fiscal space (like Hungary, which had run much larger deficits than other countries during the boom) or needing to support fixed exchange rate regimes (the Baltics) were forced to adopt fiscal adjustment measures to boost market confidence in their policy frameworks.
Given the scope and magnitude of the crisis, many countries turned to the IMF for financial or policy support. The design and purpose of their IMF-supported programs reflected countries’ specific circumstances. Many of them (Belarus, Bosnia and Herzegovina, Hungary, Latvia, Romania and Ukraine) were approved in the immediate aftermath of the global crisis, and took the form of large and front-loaded support packages aimed at avoiding crippling recessions. For EU members states these were joint programs with the EU. An arrangement with Serbia was first treated as precautionary but was quickly augmented and drawn upon. In 2009, Poland qualified for the newly-introduced Flexible Credit Line, a precautionary arrangement with no requirement to take additional measures, underscoring its very sound economic fundamentals and policy frameworks. Additionally, FYR Macedonia adopted a Precautionary Liquidity Line (which it later drew upon), an arrangement that recognized its sound fundamentals with focused and limited conditionality.
Almost all countries in the region saw a return to growth in 2010 and early 2011, with the rebounds tending to be strongest in the countries that had seen the largest output falls in 2009—notably the Baltic and CIS countries.5 But a range of factors increasingly took their toll. The lingering effects of weak private and public balance sheets, along with the emerging euro area crisis, damaged growth through financial sector retrenchment and withdrawal of fiscal stimulus (as discussed in Chapters IX and XI) as well as effects on confidence, investment and trading partner demand. The result was a marked slowdown in growth in 2012 affecting every country of the region, with nine slipping back into recession.
The easing of the euro zone crisis since mid-2012 has given some respite. But the shocks have left lasting damage to regional growth prospects. While subject to a high degree of uncertainty, IMF estimates suggest that potential output for the region has declined sharply since 2008, and is likely to remain subdued going forward.6 This contrasts with relatively unchanged estimates of potential output for many other emerging markets. The growth model that yielded increased income levels and economic convergence prior to the crisis is unlikely to be available going forward because the elements underpinning this model—strong trading partner growth and ample foreign bank financing—will probably not return soon. Instead, strengthening global competitiveness through renewed efforts to implement structural reforms, and restoring the capacity of the banking system to supply credit to the economy, are likely to be key prerequisites for raising potential growth in the future.
Potential output slowdown
Source: WEO and IMF staff calculations.
Note: “Other Emerging Markets” includes Argentina, Brazil, Chile, India, Indonesia, Malaysia, Mexico, South Africa, and Thailand.
The strength of recovery in Latvia, notwithstanding aggressive fiscal adjustment, has been the subject of considerable debate. Blanchard et al. (2013) set out the discussion and the evidence.
See IMF (2013b).