Aug 20, 2009

IMF blogger puzzled by Central Europe and Baltic experience in crisis

By Zdenek Kudrna

Ajai Chopra, Deputy Director of the IMF’s European Department, is puzzled by the different performance of Central European 3 (CE3 - Czech Republic, Poland and Hungary) and Baltic 3 (B3 - Estonia, Latvia, Lithuania) in the current crisis. He provides an elegant macroeconomic analysis and contrasts their experience to that of the Asian Crisis a decade ago. However, his analysis fails to note important differences in CE3 and B3 industrial structures that influence the sustainability of their respective economic models throughout the crisis and subsequent recovery. Over the last two decades, the CE3 economies developed traditional economic model based on manufacturing that makes them less vulnerable to financial crisis then is the service-led model of the B3.

Chopra finds that CE3 avoided the much greater currency collapses witnessed in East Asia by ‘luck’ stemming from:

  • First, in contrast to the soft pegs in Asia, the CE3 currencies were floating.
  • Second, the CE3 economies never suffered a full “sudden stop” of capital inflows as in Asia. Wholesale funding markets dried up, but western European parent banks maintained credit lines to their central European subsidiaries. In addition, bank supervision and capital levels in emerging Europe have been better than in Asia in the 1990s, helping limit financial sector strains.
  • Third, the task for external financial assistance was therefore mostly limited to replacing temporarily impaired wholesale funding markets.
  • And fourth, EU membership may have instilled confidence in the region’s long-term stability and catch-up potential due to an accelerated convergence process.
He then turns attention to the question why Baltics 3 have not been similarly ‘lucky’ and finds the key difference in:
  • Hard currency pegs and expectations of early euro entry had helped attract large capital inflows, but these often fed real estate bubbles, caused heavy exchange rate overvaluations, and fostered a substantially larger accumulation of foreign-currency denominated private debt than in any other region.
  • Current account deficits not only dwarfed those in central Europe, but also those in Asia in the late 1990s.
These explanations scratch the surface of the more important differences that stems from export structures. It is true that 2 of the 3 Baltic countries operated euro pegs, but this hardly justifies their higher suggested propensity to (i) join euro, (ii) attract capital inflows, (iii) borrow in foreign currencies. The CE3 currencies were reasonably stable in pre-crisis years, likelihood of joining euro was not substantially different, capital inflows comparable and, at least in case of Hungary, unhedged forex borrowing by households was equally prevalent. Thus we are left with the current account deficit to explain the difference in CE3 and B3 crisis experiences.

The difference in past current account deficits as well as present crisis experiences has a lot to do with different proportions and types of manufacturing established in these economies. Over the last two decades, Baltic countries were busy building service oriented economies, much to the applause of the outside world. They were providing logistical services to booming Russian exports and turned capital inflows into asset bubbles. They inflated their amicable growth rates by selling overvalued real estate to each other. Such growth drivers all but evaporated in the crisis and they offer limited opportunities for export-led recovery that are already hampered by the need to sustain the currency peg.

The CE3 built old fashion manufacturing economies that produced “stuff” for exports. Much of the capital inflow were direct investments into export-oriented production facilities. They have also achieved some progress in upgrading into more sophisticated export goods and are thus more tightly integrated into global supply chains. In crisis their industries proved more susceptible to stimulus packages in their export markets (such as cash for clunkers subsidies in Germany) and to replenishment of inventories that seem to drive the recent “green shoots”. Moreover, depreciation of their currencies puts their export industries into a promising position for export-led recovery once their export markets (Germany) start to recover.

The scholars who stubbornly insisted that there is no sustainable development without industrialization and industrial upgrading seem to be vindicated by this comparative experience.

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