As Crisis Flu Affects Eastern Europe, Differences Among Countries Becoming Clearer

An Interview with Orsalia Kalantzopoulos, World Bank Country Director for the EU10 Countries

March 11, 2009

1: How is the global economic crisis affecting the EU10 countries*?

A: There are some key channels that are common, not just for the EU10 countries but for the global community – the collapse of export demand, the stalling of international capital flows, and a burgeoning crisis of confidence.

And there certainly is an important common story for the EU10 countries – ambitious reforms and EU accession, excellent well-educated labor forces, and fairly well-developed infrastructure, which fostered tremendous potential for private sector growth. The opening of the European markets presented very fertile ground for exports from these countries. So, we saw the private sector responding to these opportunities with tremendous foreign direct investment – either through specific economic activities or through the banking sector—and, more recently, rising levels of foreign borrowing, especially by banks. And, now, with the international financial crisis escalating, foreign capital inflows are drying up, and the private sector has become exceedingly risk averse – in some cases, rightly so. First credit, then output, income, and now employment in these countries, as in the rest of the world, are feeling the shock.

2: There was recently a statement put out by several Central European countries that said observers are not differentiating enough between the different countries in the region. Is that true and can you elaborate on that?

A: What is becoming clearer to careful observers as the crisis progresses is that the differences between these 10 countries are as important as the similarities. And these differences are mostly in ‘initial conditions’, that is, the situation in each country before the crisis hit, rather than how governments have responded during the crisis.

Some countries, especially the smaller ones, had fostered fast growth driven by very high levels of exports, especially exports to the rest of the EU. For these, the drying up of export markets has been a heavy blow. Others accumulated high levels of foreign borrowing by the private sector, including borrowing in foreign currencies. The mortgage markets in a number of countries were bolstered by this type of borrowing. And, of course, some countries ran much more conservative fiscal and monetary policies.  

On one hand, there are several countries in the region that allowed very large imbalances in terms of current account deficits, which were mostly financed with foreign capital. Or they had very large budgetary deficits which again were financed from abroad, and also they preserved very limited foreign reserves. These countries need to adjust their policies sharply and quickly to cope with the crisis. On the other hand, there are countries in the group that implemented strong economic policies and kept high levels of reserves, and now require smaller adjustments in their policies.

And yet, nobody is immune to the crisis – everyone is affected. It is a case of a flu in the region – some people are catching a cold without really having any systemic or policy problems themselves, but they are affected because of what is going on around them.

So it is important to remember that not everybody should be put in the same basket.

3: So which countries are relatively better off at this point in the crisis?

A: Take the case of Czech Republic. This is a country that has a very well-managed economy in terms of macroeconomic policies – both on the fiscal side and on the monetary side, as well as on banking supervision. Its policy mix is very sound: a flexible exchange rate regime, strong fiscal discipline and consolidated financial supervision. These factors have helped Czech Republic weather the initial shock of the financial crisis. As economies in the region slow and even go into recession, the Czech Republic and its neighbors will all be severely affected. But here too, Czech Republic is well prepared. Despite having the highest share of industrial production to GDP in the EU, the Czech Republic has deliberately avoided artificially manipulating the exchange rate to the advantage of the export industry and has thus prepared businesses and unions to be ready and resilient in the face of external shocks.

It is unfortunate that too many observers have failed to distinguish the better-managed economies such as those of the Czech Republic, Bulgaria, Poland, Slovakia and Slovenia.

4: What is the World Bank advising these countries to do now to weather the crisis?

A: To some of the good performers, like the Czech Republic, we recommend marginal changes on the economic policy front that would pay off in the long-term. Let me emphasize, not because there is an emergency today, but something that will bear fruit in five and ten years – for example, long-term care for the aging.

In the short-term, we are advising countries to look at their social safety nets. Because of the economic downturn, they will have more people becoming unemployed. Are these countries well-equipped in terms of social safety nets? Are their social safety nets well targeted to make sure that the poor and vulnerable are covered? Can we make sure that there is sufficient money going to health and education, so social systems will survive this difficult period?

In addition, it is critically important to preserve the productive spending that is taking place, so that in a difficult environment like this where you may be forced to cut spending in order to maintain the necessary fiscal discipline, these cuts do not end up being made across the board. Instead, they should be based on the rationalization of inefficient spending programs that will leave enough funding to both finance the ongoing reforms and to protect productive spending in health, education, and infrastructure.

Periods like this are seen very negatively normally, but they also present tremendous opportunities. If we take these as opportunities, we can really help to increase the efficiency of spending, and to do more with less. This is advice we have given to Bulgaria consistently, and that they have taken up through the years. Now one can see that this country has tremendously improved its efficiency of spending in the social sectors, and they have a more effective social safety net, so are able to reach more people with fewer resources.

In addition, there are other ways in which one can alleviate the overall cost of doing business for the private sector. And this is something that many countries are pursuing, but where probably more could be done.

So using this as an opportunity, one can increase the efficiency of the bureaucracy and the efficiency of public spending.

One additional area that we feel quite compelled to be in, together with our development partners, is to inject liquidity through well-managed banks so that the private sector in general is not completely crowded out or suffocated during these difficult periods.

5: The World Bank recently joined forces with the EIB and EBRD on a joint initiative aimed at helping the banking sector in the region. How will this help?

A: This initiative has both public sector and private sector dimensions. While the private sector dimension is likely to take the form of support, in particular, to systematically important banks operating in Central and Eastern Europe, a lot of the attention and the first efforts to help re-energize the economies will happen through the public sector, which is fine provided that it has adequate fiscal space and the focus is on activities that make good economic sense.

At the same time, you want to be able to substitute for the decreased foreign capital that has dragged down the private sector. This is exactly what the initiative tries to address – it tries to address the lack of liquidity towards the private sector and help preserve its role in the economy.

A key part of this new approach is the coordination between institutions, because there’s no doubt that the financial sectors in many of these countries, if not most, are under some degree of pressure. In addition, the financial integration across Europe that has benefited Eastern and Central Europe has also led to great interdependence across the banking sector. All the countries, irrespective of their diverse situations, have an interest in ensuring a regional approach to systemic banking issues. In some countries, the financial sector has expanded very quickly in very aggressive ways; and in others, the financial sector is feeling the impact of the local real economies’ fall into recession. Having a joint response makes sense for everyone because of the heightened impact of coordination, because it’s easier for governments, and because we can leverage resources to different areas to be more effective.

*EU10 countries include Bulgaria, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, Slovakia, and Slovenia.