by Anders Aslund, Peterson Institute for International Economics
Article in the newsletter of the United Nations Development Programme and London School of Economics and Political Science
© United Nations Development Programme and London School of Economics and Political Science
The current global financial crisis is the worst the world has seen since the Great Depression in 1929–33. It has hit Central and Eastern Europe harder than any other region of the world. The region's forecasted drop in GDP this year is about 4 percent, and at least Latvia and Ukraine are likely to face double-digit declines.
Until fall 2008, the Eastern European countries had enjoyed a wonderful decade, with an average growth rate for the whole region of 7–8 percent a year thanks to three factors. First, in the 1990s these countries had undergone a successful transition to market economies, with deregulation, privatization, and financial stabilization. Second, they benefited from vast underutilized real and human capital. Third, their exports drove growth through international integration and a global boom.
But overheating was apparent in 2006, when my colleague at the Peterson Institute for International Economics, Morris Goldstein, warned that Eastern Europe would be the focal point of the next financial crisis because of large current account deficits, large foreign debt, currency mismatches, and misaligned exchange rates.
Eastern Europe was making one classical policy mistake. Many countries had fixed exchange rates, notably Estonia, Latvia, Lithuania, Belarus, Russia, Ukraine, and Bulgaria. The illusory safety of the pegged exchange rate attracted large inflows of short-term lending from European banks. The currency inflows boosted the money supply, and inflation surged with money supply growth from 2006. The inflation was worst in Ukraine, peaking at 31 percent in May 2008.
The temptation for international banks was irresistible. They could lend to consumers in Ukraine for 50 percent per annum with minimal financing costs. But this was a dangerous speculative scheme. The foreign exchange inflows accelerated imports and boosted balance of payments deficits. High inflation priced countries with fixed exchange rates out of the market. Sooner or later, they would be forced to cut costs by devaluation or other means.
In the summer of 2008, the whole region was overheating massively. Real estate prices had spiraled out of control, but even so few properties were available. The salaries of young professionals were outlandish, as skilled labor was desperately scarce. Yet stock markets were already plummeting, indicating that something was seriously wrong.
On 15 September 2008, Lehman Brothers went bankrupt, and financial markets throughout the world froze up. Suddenly, Eastern Europe found itself with little or no international finance. In early October, the first countries, Ukraine and Hungary, applied for fresh financial support from the International Monetary Fund (IMF).
The unprecedented global boom had left the IMF dormant, but it quickly woke up and agreed on new stand-by agreements for Ukraine, Hungary, and Latvia. Other countries with new IMF agreements are Georgia, Belarus, Serbia, and Romania. Poland has concluded a precautionary arrangement, and Turkey and Armenia are about to make new IMF agreements. Presumably, a few more countries will follow.
By and large, the Eastern European financial crisis of 2008–09 resembles the East Asian crisis of 1997–98. The fundamental problem then and now was excessive inflows of short-term bank credits, enticed by pegged exchange rates, leading to large private foreign debt. Public finances, by contrast, were mostly in excellent shape with the exceptions of Hungary and Romania, which had significant budget deficits, but only Hungary had a worrisome public debt.
The domestic vulnerabilities were aggravated by the worst financial panic of our lifetime. Capital fled to the perceived safe havens: gold, the dollar, the euro, the yen, and the Swiss Franc. Even the British pound and the Swedish krona plummeted. A financial panic is a market failure that needs to be cured by the state, and internationally the IMF is supposed to provide countervailing financial flows.
The IMF acted fast and well. In the East Asian crisis, the IMF was perceived as excessively intrusive, adding many demands for structural reforms to its traditional agenda. This time, the IMF returned to the more elementary Washington Consensus cure of the early 1990s. Essentially, the IMF posed three demands: a budget close to balance, a realistic exchange rate policy, and bank restructuring with recapitalization. In return for the fulfillment of these conditions, the IMF offered far larger loans than previously.
As the crisis erupted, excellent ad hoc cooperation developed between the IMF and the European Commission (EC). The IMF had the staff, rules, and procedures for handling a financial crisis, while the EC had neither, so it conceded and assisted instead. The EC has cofinanced the IMF programs for Hungary and Latvia, and several European countries, notably the Scandinavians, contributed substantial financing to the Latvian program.
Three other international institutions have played a substantial role, namely the World Bank, the European Bank for Reconstruction and Development, and the European Investment Bank. Their main focus has become bank recapitalization.
One of the greatest worries has been that the Western European banks that had bought most Eastern European banks would withdraw from the region. So far, no European bank has done so, and the peak of the crisis has hopefully passed. In Ukraine, 17 European banks with subsidiaries in the country have even committed themselves to recapitalizing their Ukrainian subsidiaries with $2 billion in 2009.
Exchange rate policy has become the bone of contention in the new stabilization programs. The pegs were clearly causes of the crisis, but that does not necessarily mean that they should be abandoned in the midst of a crisis. If a country devalues, its banks could be squeezed on all sides. The local cost of the loans the banks had taken abroad would sharply rise, and many would default. Their domestic customers that had taken loans in foreign currency would also be unable to repay them with revenues in the devalued currency.
Hungary and Romania had floating exchange rates, which plunged along with the floating rates of other currencies not facing a crisis, such as Poland and the Czech Republic. The IMF forced Ukraine to float and Belarus to devalue, but the Baltic states offered a stumbling block. They have long tied their currencies to the euro, in hopes of adopting the euro as early as 2006—hopes that were frustrated by the rising inflation rates that took hold during 2007–08. As Latvia still aspires to join the euro in 2012, it opposes any devaluation.
For a small open economy that is extremely flexible, devaluation would hardly solve any problems, while the banking system would collapse, causing many bankruptcies and wreaking havoc. The Latvian government, supported by the Scandinavians and the EC, offered to undertake an “internal devaluation” by cutting salaries and public expenditure as much as was necessary. The IMF accepted with astonishment Latvia's severe austerity program as an alternative to devaluation. Although economic results so far have persistently been worse than forecasted, Latvia is cutting as much as it takes.
For Eastern Europe, the G-20 meeting on April 2 was vital. Hitherto, the IMF only had $250 billion of funds, which could easily run out. In London, the G-20 agreed to quadruple the IMF's funds to over $1 trillion, giving it enough money to keep Eastern Europe out of any liquidity trap. As a consequence, Eastern European bond and stock markets rallied in April; the devastated Ukrainian stock market was the best performing stock exchange in the world, reporting a rise of 70 percent in a month. The London summit may mark the end of the acute crisis in Eastern Europe, even if more IMF programs are to be expected.
Many worried that the crisis would cause social unrest and even regime change, but so far unrest has been very limited. People appear to understand the severity of the crisis and demand forceful action. Four crisis countries have changed governments in the last half year. Lithuania and Romania had parliamentary elections late last year, and their new governments are more free-marketeering than their predecessors. In Latvia, the most liberal party has joined the center-right coalition government and taken the lead in explaining to the public why wage and expenditure cuts are needed. In Hungary, admittedly, one socialist prime minister has replaced another. By and large, the Eastern European politics have responded adequately to the crisis.
The big question mark is how the EC and the European Central Bank (ECB) will adapt to the crisis. The EC has sensibly increased its balance of payments fund for member states from €12 billion last summer to €50 billion, and it has given large credits to Hungary, Latvia, and Romania. Yet the ECB has done very little. It should prepare for the expansion of the eurozone to the most faithful countries: Estonia, Latvia, Lithuania, and Bulgaria, as well as Denmark. It should also develop its own bonds and broaden the range of its available tools. For the eurozone, the current crisis is a great opportunity that must not be missed.
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