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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Welcome to Regional Development section

Were you ever gazing through the window of a train observing the changing landscape, which, like a giant conveyor belt, kept bringing you still images of villages, towns and cities, remote places and densely populated ones? Did you have an impression that in the end all of this merged into a colourful order of roads, buildings, factories and agricultural lands scattered among rivers and lakes, fields and forests, hills, mountains and lowlands? In short, did you ever notice how human activity varies across geographical space?


Were you ever gazing through the window of a train observing the changing landscape, which, like a giant conveyor belt, kept bringing you still images of villages, towns and cities, remote places and densely populated ones? Did you have an impression that in the end all of this merged into a colourful order of roads, buildings, factories and agricultural lands scattered among rivers and lakes, fields and forests, hills, mountains and lowlands? In short, did you ever notice how human activity varies across geographical space? I am pretty sure that you did. If so, then most probably you also noticed the sometimes really striking differences between the levels of development of two different locations. If you think of your home country, it is very likely that you already have a clear idea about which part of it is well-developed and which is lagging behind.

It is quite common to compare and analyze cross-country differences but it makes a lot of sense to go one level deeper and observe regional disparities as well within a given country. By giving it a further twist, one may also analyze cross-country regional differences of development. This is what regional scientists do and this is also what I am especially interested in. What makes a particular region develop while its neighbour may experience crisis at the same time? What causes the patterns of regional development within one country and what could account for cross-country regional differences? Is this related to the diverse local endowments, state-level development policies, historical and cultural traditions, local entrepreneurial and innovative skills or are there external, transnational forces that have crucial impact on the local level? Most probably all of these factors exert substantial influence on regional and local development but the above list is still far from exhaustive.

Those who study regional development tend to claim that development patterns demonstrate a path-dependent character. This implies that historical legacies and certain crucial events in the past influence the choices made in the present. Briefly, already existing regional disparities are more often being reinforced over time than not. In Central and Eastern Europe (CEE) this issue may be even more salient than in some Western European countries. The experience after the change of regime suggests that the location choices of foreign investors have to a great extent reinforced regional disparities in CEE countries and laggard regions are less and less able to catch up.

However, I am not convinced at all by such arguments. Be it wishful thinking or not, I would like to see regions that are able to overcome their inherited disadvantageous positions. I would like to understand what makes a region successful and what the reasons are for eventual failures. How do local, national and transnational forces interact at the local level and how do they influence regional development? What is the potential role of local governments and their associations in this process? How do national and EU-level development policies contribute to success stories or breakdowns? Ultimately, is it possible to beat path-dependent trajectories?

In this blog, I am going to discuss these issues, focusing on the Central and Eastern European countries, while paying particular attention to the Visegrad group, to Poland, the Czech Republic, Slovakia and Hungary. Special attention will also be devoted to local cross-border cooperations and other initiatives that are “bottom-up” movements aiming at overcoming regional disparities. Given the highly complex nature of the problem, the blog is also intended to be complex and I will attempt to address the above issues from several perspectives. In sum, I invite you, dear reader, for an exciting adventure into regional science!

Gergő Medve-Bálint

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