Abstract

Emerging Europe is likely to face higher risk premiums and a more volatile environment in the aftermath of the financial crisis. While the global crisis might be receding, investors are paying increased attention to domestic factors and policies, creating significant cross-country differences in sovereign spreads. Higher and more volatile spreads increase the variability of inflation and output over the cycle, with further deleterious effects on investment, growth, and prospects for convergence. Restoring the normal functioning of the financial system where needed, and strengthening financial stability and fiscal sustainability frameworks will go a long way toward addressing these concerns. Such policies could yield a “double dividend” by lowering the volatility of the business cycle and improving prospects for long-term growth.

Facing a Riskier Environment

Even though the appetite for risk has moved away from its crisis-induced lows, emerging markets face a significantly more volatile external environment in the aftermath of the crisis. Interest rate spreads on sovereign bonds have increased, and interest rates and exchange rates have become more volatile (Figure 20).37 Behind this dramatic shift in market risks lies a change in investor attitude. While global factors and market liquidity clearly play a role, investors are increasingly differentiating among countries according to their fundamentals and the soundness of their policies and in the process are dismissing the “European Union (EU) halo effect” (IMF, 2009d). Taking their cue from the crisis, investors have become more “conscious of tail risks” (Blanchard, 2009) and charge higher risk premiums. Thus, even with the dissipation of the global financial shocks, interest rate spreads and volatilities related to country-specific vulnerabilities are likely to remain elevated in the medium term.38

Figure 20.
Figure 20.
Figure 20.
Figure 20.
Figure 20.
Figure 20.
Figure 20.
Figure 20.
Figure 20.
Figure 20.
Figure 20.
Figure 20.
Figure 20.

Selected European Countries: Bond Spreads–Level and Volatility, January 2006–June 2009 1/

Sources: Bloomberg L.P.; and IMF staff calculations.1/ EMBI Euro spreads for most countries; CDS 10-year for the rest.

Among the country-specific factors financial markets are focusing on, the state of private balance sheets and the financial system, as well as the closely related issue of fiscal sustainability, play an important role.39 The factors that make foreign investors wary include, for example, the uncertainty about filling gaps in the financing needs of banks and the government, the rollover of maturing corporate and government debt, the capacity for dealing with household indebtedness and associated foreign-currency mismatches (see Box 3, Chapter 1), and the eventual contingent liabilities of the government. Even though all countries coming out of the crisis are likely to face a higher risk premium, emerging economies dependent on capital inflows for growth and development are especially affected, since their ability to attract capital inflows at a reasonable and steady price is at stake.

The combination of a more volatile environment and the vulnerabilities created by the crisis puts policymakers in a bind. Under fixed exchange rates, stabilizing output and inflation in the face of external shocks is intrinsically difficult under the best of circumstances because monetary policy takes its cues from the country to which the currency is pegged. The traditional policy advice is for fiscal policy to step up. But under the heightened post-crisis scrutiny of international investors, a more activist use of fiscal policy tools may cast doubt on fiscal sustainability and backfire in the form of higher and more volatile interest rate spreads in the medium term. This could add to the volatility of the economy rather than countering it, and lower growth, especially in emerging economies depending on capital inflows for growth. The same mechanism also limits the ability of governments to intervene in the financial sector through direct interventions or guarantees, both of which can have large fiscal consequences. And even under flexible exchange rates, the possibilities for financial sector intervention or macroeconomic stabilization can be limited, for instance in the presence of large foreign currency debt overhangs that can make exchange rate depreciations costly or when exchange rate changes pass through quickly to inflation.

The solution to these policy dilemmas is to reduce uncertainties about fiscal policy and the financial sector. While reforming fiscal policy frameworks would ease concerns over fiscal sustainability and decrease the level and volatility of the risk premium, proper disclosure of financial sector risks that could burden public finances down the road would help lower fiscal risks as well. In addition, improving the supervisory and regulatory policies that prevent the buildup of credit and liquidity risks, as in the years leading up to the crisis, would directly help lower the volatility of the financial market in the medium term.

Adverse Effects on the Path to Recovery

Fiscal and Financial Sector Problems Are Linked to Higher and More Volatile Interest Rates…

While common global shocks have increasingly affected the volatility of interest rate spreads and other financial indicators, an important factor behind the turbulence are banking and fiscal developments. When the crisis intensified in late 2008, liquidity and capitalization strains in particular in the banking sector shook financial markets. This led to interventions by the central bank and fiscal authorities (sometimes with support from the international financial institutions), which added to interest rate volatility through their impact on the government budget. And concerns about the cyclical effects of the recession, continue to contribute to the unsteadiness of the fiscal situation. These developments are illustrated by unusually large and frequent revisions in the Consensus Forecasts of the budget balances of many emerging economies and new European Union (EU) member countries (Figure 21). For example, the average of the Consensus Forecasts of the 2009 fiscal balance for Hungary in July 2009 was almost 4 percentage points lower than the average forecast for March 2009.40

Figure 21.
Figure 21.

Selected European Countries: Quarterly Revisions in Fiscal Balance Forecast, 2004:Q1–2009:Q2 1/

Sources: Consensus Economics; and IMF staff calculations.1/ Change (in percentage points) in the fiscal balance forecast for the year, average of the Consensus Forecasts.

The higher volatility in interest rates is tightly linked to the level of interest rate spreads. One reason is that investors demand higher returns to compensate for more volatile asset prices. Another is that the financial and fiscal developments associated with the higher interest volatility directly influence interest rate levels through the stock of public debt. While the use of fiscal stimuli in emerging Europe and new EU member states has not been as high as in advanced countries, some discretionary fiscal expansion occurred, automatic stabilizers were at work, and government interventions in the financial sector added to the increase in government debt (Figure 22). Empirically, higher projected debt tends to increase long-term borrowing costs (IMF, 2009d), with the strength of the effect reflecting, among other things, the elasticity of supply and the perception of risks stemming from the long-term sustainability of the public finances.41

Figure 22.
Figure 22.

Selected European Countries: WEO Revisions in Projected Government Debt for 2010 in April 2009 over September 2008

(Percentage points of GDP)

Sources: IMF, World Economic Outlook; and IMF staff estimates.

…And Are Associated with Exchange Rate Instability

Higher and more volatile interest rates—in particular changes in the sovereign risk premiums—are also associated with higher exchange rate volatility (Figure 23). While some of the exchange rate movements could be attributable to short-lived reactions of investors to news, the part of exchange rate changes associated with the upward shift in the risk premium and its volatility is likely to remain high, in particular if fiscal and financial sector worries linger. In fact, empirical observations of higher exchange rate volatility have often been associated with the downward revisions in the forecast of the fiscal balance in recent years.42 While it is difficult to infer causality among movements in exchange rate, interest spreads and fiscal projection revisions, especially during ongoing extreme events, they clearly could be mutually reinforcing. Higher volatility in exchange rates and spreads worsen economic performance, raise risk and contingent liabilities in the financial system, and heighten concerns about fiscal sustainability, which, in turn, may lead to a further rise in spreads and volatility and so on.

Figure 23.
Figure 23.

Selected European Countries: Exchange Rate Volatility, 2004:Q1–2009:Q1 1/

Sources: Bloomperg L.P.; and IMF staff calculations.1/ GARCH estimates on log-changes of the national currency/USD (period average) exchange rate.

In countries with sizable foreign currency mismatches in the private sector, large movements and higher volatility of exchange rates or pressure on pegs is putting banks and fiscal authorities on alert: inability to service the higher principal payments of the corporate and the household sector would lead to sharply higher nonperforming loans and adversely affect capitalization of banks. If banks need to be recapitalized but parent banks are unable to provide fresh capital to their subsidiaries, the ultimate burden could be on the fiscal authorities.43 This also holds in the handful of countries that have systemically important domestic banks. In smaller and more open economies, a more volatile exchange rate could also impart this volatility to the inflation rate and to the output gap through the trade channel, if the economy is highly dependent on exports.

Hurting Long-Term Growth and Convergence

The higher risk premium and its volatility are likely to affect long-term growth directly. Particularly at risk are the European emerging economies heavily dependent on capital inflows, especially foreign direct investments, for growth and for convergence to higher-income countries. A higher risk premium and its volatility would increase the cost of capital and the variability of consumption and hurt the recovery of long-run growth (Fernandez-Villaverde and others, 2009). As foreign investors demand higher compensation for risk (while having difficulty in gauging its magnitude), domestic institutions, including banks, will not find it easy to attract foreign direct investment (FDI) and banking flows at reasonable rates. Because of higher volatility in risk premiums, domestic institutions will also find it difficult to plan for the future. A lower FDI inflow could hurt both medium-term growth and the convergence process for emerging Europe (see Chapter 2).

Higher volatility in the business cycle and the associated increase in the volatility of shocks (or higher uncertainty) during the crisis also have a direct effect on growth (Ramey and Ramey, 1994). A 1-percentage point higher standard deviation in growth of output is estimated to lower long-term growth by two-fifths of a percentage point in OECD countries. In particular, fiscal policy uncertainty that raises uncertainty about growth outcomes (through its higher volatility) lowers long-term growth, since such uncertainty makes it difficult for firms to plan for the future.44 This particular channel operates in addition to any adverse effects from investment or FDI effects of higher volatility.

Moreover, higher government debt and deficits by themselves could have additional damaging effects on long-term growth through permanently higher borrowing costs and crowding out. For example, a 20-percentage point increase in the level of government debt as a share of GDP would lower annual long-term growth by 0.6 percentage point (see Chapter 2).

Challenging Policymakers

Emerging Economies Are Historically Subject to Relatively Large Shocks…

Even before the crisis, emerging economies (EM) were operating in a more volatile environment than the euro area. The EM faced less stable aggregate demand due to fickle world demand for the EM’s exports or discretionary fiscal expansions and contractions. The supply side and the external environment has also been more volatile historically owing to the substantial structural changes associated with the transition from a centrally planned to a market economy, higher exposure to world trade and financial flows relative to GDP, and weaker policy transmission mechanisms. And, as already discussed, EMs that receive large capital inflows into the banking and the corporate sectors and run large current account deficits are vulnerable to the changes in investor sentiments leading to large changes in the exchange rate or in country risk spreads or both.

Indeed, based on an estimated macroeconomic model, the volatility of shocks are measurably higher in the EM than in the euro area.45 With an estimated Global Projection Model (Carabenciov and others, 2008) of the euro area, Japan, the United States, and a medium-sized European emerging economy (EM) with a flexible exchange rate, the standard deviation of the shocks to aggregate demand, supply, the exchange rate, and the equilibrium risk premium were derived (Table 8).46 Aggregate demand and aggregate supply shocks were historically more volatile in the EM than in the euro area. The largest difference, however, was in the volatility of exchange rate shocks, while the volatility of shocks to the risk premium was not very different from those faced by the euro area.47

Table 8.

Volatility of Shocks in the Euro Area versus Shocks in the Emerging Economy, Precrisis and Crisis

article image
Source: IMF staff simulations.

Structural shocks from the Global Projection Model of the Euro area, Japan, the United States, and the emerging economy (EM), Carabenciov and others, forthcoming. The precrisis period is 2001:Q3–2007:Q2; crisis is 2007:Q3–2009:Q1.

As a consequence, emerging economies have historically had more variability in inflation and output than the euro area. This point is illustrated by comparing “efficiency frontiers” for policy for the euro area and the EM (Figure 24). An efficiency frontier is a way of showing the lowest combination of output and inflation volatilities achievable by policymakers, given their preferences and the magnitude of shocks hitting the economy.48 The euro area’s frontier lies far to the southwest of the EM’s frontier. Roughly speaking, policymakers in the EM will generally have to accept twice the volatility in output and about 1½ times the volatility of inflation of the euro area.49

Figure 24.
Figure 24.

Emerging Economies Have Higher Volatility

Source: IMF staff simulations.

…And the Crisis Has Increased the Magnitude and Volatility of Shocks

With the crisis, long-term credit default swaps (CDS) and bond interest spreads of European emerging economies have increased from a precrisis average of about 75 basis points to a crisis average of about 330 basis points. The new average was accompanied by higher volatility of the risk premium with the standard deviation of spreads going up from about 4 to 30 basis points. The higher variability in the exchange rate can be explained partly by changes in the real interest rate differentials between the emerging economy and the rest of the world and partly by changes in the risk premium, along with short-lived fluctuations. While movements of the real interest rate are due to, say, changes in monetary policy, there could be large and infrequent shifts in the risk premium itself accompanied by high volatility, resulting in a highly variable exchange rate. Shocks to the risk premium will have repercussions throughout the economy. Aggregate demand for output comprising both consumption and investment demand could be quite volatile as well, especially when these demand components rely on capital inflows, as they do in emerging economies. If the shocks to the level and the volatility of the risk premium are long lasting (as is shown for some Latin American countries by Fernandez-Villaverde and others, 2009), then they could have long-lasting and detrimental effects on the growth and volatility of output.

Against this background, model analysis shows that the efficiency frontier of the EM has indeed shifted further northeast in the aftermath of the crisis because of the larger incidence of shocks and their higher volatilities. Based on the extreme scenario in which all the increase in the average interest spreads translates into a shift in the equilibrium risk premium, then almost all the shift in the frontier can be accounted for by the higher risk premium and its volatility (Figure 25). Indeed, even though the precrisis volatility risk premium shocks in the EM was almost the same as that in the euro area, the effects of the crisis were strongly differentiated among countries and regions (Table 8). If the policy regime and its preferences were the same as before the crisis, then the lowest achievable variability in output would be one and one-fifth times more than before the crisis.

Figure 25.
Figure 25.

Effect of the Crisis in the Emerging Economy

Source: IMF staff simulations.

The Policy Dilemma

Policymakers need to ensure that the recovery from the crisis is solid, sustainable, and smooth, but this change in environment greatly complicates their task. In terms of stabilizing the business cycle, trying to stimulate the economy by lowering interest rates while taking care to limit inflationary pressures triggers parallel movements in the risk premium, which could add to output volatility. In addition, the crisis will also cause pain along another dimension. The higher variability could shave about 0.1 percentage point from long-term growth (using findings from Ramey and Ramey, 1995, cited earlier). The adverse effect on growth operates mainly through the elevated uncertainty reflected in the risk premium. A higher government debt could (separately) erase about 0.3 percentage point from medium-term growth (using the growth regression in Box 5, Chapter 2) through crowding-out effects.

Monetary policymakers are limited in their options by the twin problems of low growth and high exchange rate volatility. Although policy rates can be lowered, central banks fear excessive depreciation of the exchange rate. If policy rates are increased to stem capital outflows, growth could suffer. And once a recovery gets underway, inflation pressures could start building up when policymakers try to stimulate growth. In fact, the crisis forces the efficiency frontier to move further northeast of the precrisis one (Figure 25), even though monetary policy is doing the best job possible under the circumstances.50 With policy preferences constant, if the central bank were to increase focus on the output gap to refuel growth, it would have to do so with a more volatile rate of inflation than would be acceptable.

Adjusting the frameworks for financial stability and fiscal sustainability to meet the challenges posed by the crisis could be the more promising course of action. As highlighted earlier, uncertainty about the course of fiscal policy with lingering uncertainties about the financial sector has been part of the problems triggered by the crisis; reversing this uncertainty should prove helpful now. For instance, good fiscal policy that underpins long-term sustainability can help reverse some of the upward shift in spreads and their volatility over time. In the new regime, even if there are short-term setbacks in fiscal balances, uncertainty about fiscal sustainability could be avoided by setting credible lower deficit and debt targets and implementing them so that investors can believe in them. The increase in credibility associated with good fiscal frameworks could lower long-term interest rates and their volatility (Debrun and Joshi, 2008). In addition, lowering volatility induced by government spending could significantly improve long-term growth (Ramey and Ramey, 1995).

In the financial sector, longer-term policies aimed at limiting credit booms—fueled by the debt-creating capital inflows at the heart of the crisis in emerging Europe—should fortify measures to restart credit in the short term. These vulnerabilities also led to differences among countries during the crisis. Moreover, disclosing the risks could reduce the uncertainty surrounding the strength of the financial sector. These policies will help lower the risk premium and its volatility.

Policy Options

Limiting Discretionary Fiscal Policy During the Recovery Could Help

The EM’s volatility of aggregate demand shock remains high compared to the precrisis average of the euro area, a difference largely attributable to the behavior of fiscal policy (Table 8).51 This holds true, even though, unlike the euro area, the EM did not engage in substantial fiscal stimulus, and the volatility of the aggregate demand shock has changed little (or even declined somewhat) during the crisis. If it could lower the volatility of this shock to equal the euro area’s precrisis volatility, then the efficiency frontier could start shifting away from its elevated crisis position (Figure 26). As a consequence, policymakers would be able to achieve both a lower variance of output and a lower variance of inflation than that during the crisis.

Figure 26.
Figure 26.

Limiting Discretionary Fiscal Policy Shocks in the Emerging Economy

Source: IMF staff simulations.

A rules-based, fiscal policy that limits changes in deficits to automatic stabilizers and thereby helps clarify expectations regarding the direction of the fiscal deficit while the economy is recovering would reduce the discretionary part of the aggregate demand shock.52 Such an approach would provide a framework for making policies credible and reducing long-term government debt and deficits without having to follow greatly contractionary or expansionary policies during crisis. According to previous research, “tightening” the fiscal rules framework would immediately reduce the long-term interest rate between 10 and 40 basis points, while in the long run, a permanent shift to stricter and more encompassing fiscal rules suggests a reduction in long-term government bond yields of up to 65 basis points (Debrun and Joshi, 2008). A downward shift in interest rates would also reduce the volatility of the long-term interest rate, given the close links between the two seen during this crisis and established in the empirical literature (Fernandez-Villaverde and others, 2009).

In addition, given the empirical links between spreads and financial sector vulnerabilities in emerging Europe (IMF, 2009d), implementing lasting improvements in supervision of the sector to avoid uncontrolled credit booms and unmanageable debt-creating inflows would reduce both spread and volatility in the future. Thus, the efficiency frontier would move further back with a permanent reduction in the risk premium and its volatility because of medium-term fixes in both the fiscal and the financial sectors. In addition, the lower long-term interest rate and the reduced volatility of business cycles would also promote long-run growth.

Explicit Reaction to the Exchange Rate Is Unlikely to Help

Given the heightened role of exchange rate volatility during the crisis, monetary policymakers in the EM might be tempted to respond when exchange rates fluctuate along with changes in inflation and output. Could EM central banks lower volatility by doing so? Not always. If society still cares about variability in inflation and output, and if the shocks to the economy mainly affect the equilibrium risk premium, a central bank can do little by explicitly reacting to exchange rate changes.

Indeed, returning to the model simulation, if the central bank reacts to large increases (depreciations) in the exchange rate by increasing the policy rate neither inflation nor output volatility is reduced significantly (Figure 27). The efficiency frontier shifts very little from its crisis position because forward-looking agents have already incorporated information on exchange rates and formed expectations about the inflation rate and the output gap. Any extra reaction to movements in the exchange rate does not change outcomes in equilibrium. Where risk perceptions have become embedded in private sector expectations, nothing short of fundamental changes in the way fiscal and financial sector policies are made could shift the frontier back.

Figure 27.
Figure 27.

Reacting to the Exchange Rate in the Emerging Economy

Source: IMF staff simulations.

This point is all the more emphatic for countries in fixed exchange rate regimes. The reaction of “monetary” policy in such countries could be simplified so that the policy rate moves only to fight fluctuations in the exchange rate. Obviously, inflation and output volatility will remain unaffected by such exchange rate defenses, and the familiar conclusion holds that fiscal, financial, and other structural policies will need to bring about the necessary adjustment.

Conclusions and Policy Implications

Even though tensions in the global financial system have receded and the volatility of asset prices and interest rates appears to be past its peak, the low precrisis levels of risk premiums and volatility are not likely to be seen again. The counterpart of these price movements is that capital inflows and their reliability have diminished. And while global factors were initially the dominant driving forces, investors have begun to differentiate appreciably among countries on the basis of domestic factors and policies.

Policymakers in a typical emerging economy are thus confronted with a lower rate of potential growth (see Chapter 2), more fickle investors, and, consequently, a less favorable trade-off between inflation and output volatility. Further complicating matters are uncertainty about the potential for postcrisis output and the resilience of the financial system to higher interest rates and depreciated exchange rates, as well as the increased volatility of those variables. At the same time, policymakers are being called upon in several cases to use fiscal resources to repair financial systems and, more widely, to help support economic activity in the aftermath of the crisis.

Policymakers need to tailor their responses to country circumstances, particularly to the state of the financial system, the degree of access to financing, and the extent of the collapse in private demand. Yet, all countries are facing heightened risk and a more volatile environment, triggered, among other things, by a substantial increase in the risk premium and its volatility. What can policies do to promote a smooth recovery, help reestablish sustainable convergence, and improve the trade-off between output and inflation volatility? A number of policy options are available:

  • As in advanced economies with impaired financial systems, evaluating, and disclosing risks, and, more important, recapitalizing or resolving financial institutions are essential. The ongoing stress tests in the Central, Eastern, and Southern European countries, currently coordinated by the IMF, will recognize bank losses and recapitalization needs that, if properly disclosed, would help lower uncertainty about the banking sectors in those countries and indirectly address volatility in the risk premium. Where needed, a restructuring of the liabilities of overstretched households and corporations should accompany such actions. For emerging economies, the cross-border dimension is particularly relevant because it is important to keep parent banks engaged in the countries.

  • Increasing the transparency of contingent fiscal liabilities that emanate from the stresses in the financial system or other sources and properly disclosing the risks surrounding those estimates will reduce the uncertainty about the fiscal outlook (Box 4, Chapter 1).

  • A rules-based fiscal policy that limits deficits mostly to automatic stabilizers would help to anchor long-term fiscal sustainability and predictability. Some countries have already adopted such rules or credible medium-term targets (Hungary, Poland, and Romania).53 Avoiding the surprises inherent in discretionary fiscal policy would lower volatility of shocks to aggregate demand, and help reduce volatility in the business cycle. At the same time, such policies would help reduce the sovereign risk premium and its volatility.

  • Reforms for improving financial sector supervision and regulation to reduce vulnerabilities and avoid boom-and-bust cycles would directly lower the risk premium and its uncertainty. Capital injections into banks in the short-term would help restart lending. But such capitalizations would be wasteful if not accompanied by a strengthening of the supervisory, regulatory, and macroprudential framework (IMF, 2009d). Some examples include the ability to impose stricter capital requirements for weaker banks under Basel II Pillar 2 while strengthening cross-border cooperation between home-host supervisory and financial stability authorities and implementing forward-looking (countercyclical) provisioning policies to reduce volatility of bank profits. A few countries have already received technical assistance from the IMF on new supervisory architectures.

Adopting such changes would help move the trade-off between inflation and output variability in emerging markets considerably closer to the position of their advanced-economy peers, especially for the more open economies operating under flexible exchange rates. It would free monetary policy to focus on its primary role of providing price stability and smoothing fluctuations in the output gap. Model simulations further suggest that virtually nothing can be gained from attempting to stabilize fluctuations in the exchange rate, if the source of fluctuation is the risk premium. For countries with fixed exchange rate regimes, the well-known need for more flexible labor and product markets emphasizes the heightened importance of strengthening frameworks for fiscal sustainability and financial stability.

The adoption of robust frameworks not only yields benefits in cyclical trade-offs but is also helpful for long-term growth. The emerging economies are heavily reliant on capital inflows, both bank-related and FDI inflows, for convergence to the higher income levels of their Western European neighbors; stronger frameworks will enhance their prospects. In addition, lowering government debt and deficits through better fiscal frameworks would directly improve the outlook for growth. Thus, credible fiscal and financial frameworks that impart a sense of long-term fiscal sustainability and financial stability will yield a double-dividend in long-term growth.

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