beyondbrics

This post is the ninth of a series – 12 for 2012 – that beyondbrics is running on key emerging markets topics for the new year.

By Michael Landesmann of the Vienna Institute for International Economic Studies

Until quite recently the picture which forecasters painted of the likely business cycle dynamic in central and eastern Europe (CEE) was the following: 2009 saw a deep decline in economic activity; 2010 was in many countries an export-led recovery; in 2011 there was some shift towards domestic demand components (consumption, investment); and for 2012 one expected the recovery would remain relatively steady.

Those expectations have been substantially revised downwards over recent months and most forecasters now warn that the down-side risks are higher than the up-side risks.

In August 2011 consensus forecasts for the year 2012 had growth for the CEE and SEE (south-eastern European) regions at 3.4 per cent and 3.3 per cent, respectively. But by November these numbers were cut to 1.9 per cent 1.8 per cent (see table).

What are the reasons for the dramatic downward revisions of growth prospects in the CEE and SEE regions? How fragile is the situation? And how likely is it that long-term growth rates can recover to a level at which the process of catching up with western European income levels can continue?

In 2012 we are certainly going to witness a milder re-run of the situation in 2008, when the sharp recession in western Europe (particularly in Germany) strongly affected export growth in CEE, particularly those economies which had built up strong export capacities and linkages to west European countries (ie the Czech Republic, Slovakia, Hungary and, to a lesser extent, Poland).

Meanwhile, in south-east Europe, there is a second group of economies, which in the period prior to 2008 had high and sharply-growing deficits on their trade and current accounts. These imbalances were largely due to very weak export sectors which in turn had resulted from earlier periods of prolonged ‘deindustrialisation’ during the wars in the former Yugoslavia. To make things worse, these imbalances were exacerbated by distorting capital inflows that went mostly into the non-tradable sector (real estate, finance, distribution). All this resulted in non-competitive, misaligned real exchange rates (not unlike the eurozone countries of Greece, Spain and Portugal).

These economies suffered the impact of a ‘sudden stop’ when the financial crisis hit. They could no longer finance large current account deficits and were forced to contract. The legacy of these past developments is high external debt positions, particularly of the private sectors (see the chart below, which shows comparative data for Portugal, as well as for Bulgaria, Estonia, Latvia, Poland, Romania and Croatia).

Source: World DataBank - Quarterly External Debt Statistics, National Banks, wiiw calculations

The second key factor is the weak banking system – largely foreign-owned – operating in CEE and SEE countries. Given the high debt position in some of these economies, the ailing situation of the west European banking system as well as much reduced European economic growth prospects, net aggregate lending by banks to the private sector is very low, zero or negative. See the chart below with data on the Czech Republic, Hungary, Poland, Slovakia, and Slovenia, followed, underneath, by Bulgaria, Romania, Estonia, Latvia, Lithuania and Croatia (HR).

This is both due to low credit demand and reduced credit supply. Surveys report a ‘credit-constrained’ situation faced by local firms and households in most economies. This factor will very likely persist. Any extra shocks to the balance sheets of western banks resulting from a further deterioration of the crisis in the eurozone would significantly worsen the situation.

What about longer-term growth in CEE and SEE? The growth drivers in the past were a fast catch-up in productivity, facilitated in large measure by foreign direct investment and integration into cross-border production networks. FDI inflows following the recent crisis are much reduced and we expect this to remain so over the next couple of years.

High debt countries (mostly private debt with the exception of Hungary which has high public debt) will undergo a sustained period of deleveraging, exerting a dampening effect on domestic demand. Many of the weak exporting countries (especially in south-eastern Europe with Serbia and Romania as exceptions) are also economies with fixed exchange rate regimes and the path towards real exchange rate readjustment will be slow; hence low income growth will be the only way to keep current accounts manageable.

So, we shall see the immediate impact of reduced growth/recession in western Europe hitting all economies in CEE and SEE, with particularly severe effects on the stronger export-based economies.

The weaknesses of the European banking system as well as further eurozone shocks will affect particularly the economies with high accumulated private and public sector debt (such as Hungary, Croatia and Latvia).

Depending on the size of the external shock, a move into recession in some of these economies is possible (again, Hungary and Croatia being prime candidates). In any case, deleveraging will persist almost everywhere.

In the longer term, the strong reliance on FDI and on net capital inflows as main drivers of growth will not resume for the next few years. Similarly, a reliance on export-led growth will be hampered by low growth and possibly recession in the eurozone.

So, short-term growth prospects are vulnerable to shocks and resumption of longer-term growth might require a re-orientation of the growth model. Countries must focus on an indigenous attempt to improve the supply side of the economy in the weaker CEE economies – including infrastructure, education levels and business conditions.  Much stronger attention should be given to the longer-term performance of the export sector.

Rather than just waiting for the impact of another boost of FDI,  governments should use fiscal reforms and any extra public resources to fight the effects of the crisis on the population; and to finance infrastructure investment and regional, education and labour market policies. Better use should be made of EU structural funds. All efforts should be directed towards a resumption of a sustainable catch-up process in the medium to longer term.

Michael Landesmann is the scientific director of the Vienna Institute for International Economic Studies (wiiw) ( www.wiiw.ac.at )

Related reading:
Series: 12 for 2012
Chill wind from west threatens CEE, FT
Czechs and CEE: all in it together, beyondbrics
CEE banks: Austria lays down the law, beyondbrics