Several countries in developing Europe participated in the excesses of the pre-crisis boom period, with both households and firms taking on high levels of debt often denominated in foreign currency and often used to finance consumption rather than investments in new productive capacity. In addition, the banking sectors in many of these countries had close relations with European banks. As a result, their own difficulties in dealing with rising quantities of nonperforming loans were magnified by a drying up of external funding sources upon which many banks had relied. As in high-income Europe, the adjustment that ensued following the crisis was brutal. Unemployment soared to record levels, as banks deleveraged and households and firms cut into spending in an effort to repair damaged balance sheets. Fiscal conditions deteriorated throughout the region, with severe consequences in a few countries where public debt levels had risen even during the boom years.
The good news is that growth rates for many of the hardest-hit countries have recovered to levels close to their underlying potential output. However, growth has not been strong enough to make significant inroads into existing unemployment and spare capacity.FN7 Arguably, these economies have been caught in a high unemployment equilibrium. Traditional policy advice in situations like this would be to use fiscal and monetary policy to stimulate growth and help close output gaps, but for many countries already high fiscal deficits and the necessity of restoring bank balance sheets limit the scope for such actions (figure 15). For these countries, policy may have to focus on increasing economic flexibility (including labor retraining) to promote improved competitiveness and take advantage of faster growth elsewhere.
Fiscal space is limited among many economies with large output gap
Source: World Bank
Output gaps are small and appear to be closing for the majority of developing countries
The bulk of developing countries are in a relatively positive place, with modest output gaps (countries close to the center of the figure 16), that are closing (countries in the green-shaded portions of the graph), either because output growth has slowed below potential and is therefore easing inflationary pressures, or because output is growing somewhat faster than potential. In these economies, policy appears to be broadly on track, although authorities may need to examine the overall stance of fiscal policy to evaluate whether there is scope for a gradual tightening to regenerate buffers consumed during the crisis period or to tighten monetary policy and in some cases rebuild reserves to provide room for a monetary policy easing should the global economy weaken sharply.
Output gaps are small or closing in the majority of developing countries
Source: World Bank