Affiliated with the University of Nicosia | |||||
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The World Crisis and its Impact on the New Member States of the European Union By Michael Sarris
Former Minister of Finance of the Republic of Cyprus
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The
Situation Prior to the Crisis
The 2004 fifth wave of
EU accession, the largest in terms of population and number of
countries, was one of the most important events in the history of the
European Union. It brought
together countries which had experienced very different political,
social and economic developments.
Before accession to the EU, implementation of domestic structural
reforms, which improved the functioning of markets, had already put the
new member states on the path of nominal and real convergence towards EU
averages. As expected,
enlargement and adoption of the
acquis brought faster economic growth, thereby helping to narrow the
gap in living standards with those of the old member states.
Underscoring the importance of having in place appropriate
macroeconomic policies and implementing structural reforms, real
convergence evolved at different speeds across countries.
In general, improved economic performance was helped by the
adoption of sounder fiscal, monetary and structural frameworks.
Furthermore, economic restructuring and modernization in new
member states was supported by increased local and foreign investment,
attracted by EU product market rules and enhanced competitiveness.
Foreign direct investment boosted the expansion of
knowledge-intensive and service-based sectors, playing an important role
in reducing the very high levels of unemployment, that had been
prevalent in these countries, and in expanding significantly trade
opportunities.
While substantial foreign direct investment and trade openness were key
drivers of faster economic growth, they also allowed total investment to
substantially surpass domestic savings, current account deficits to
widen significantly, real exchange rates to appreciate in some countries
and real interest rates to remain relatively low over extended periods.
Current account deficits in Latvia, Estonia and Bulgaria were in
double digits and in Romania and Lithuania close to 10%.
The corresponding capital inflows and rapid credit expansion
contributed to the build up of inflationary pressures, strong wage
demands and real estate bubbles.
With about 70% of the banks in Central and Eastern Europe owned
by Western European Banks (in some cases such as the Czech Republic,
Slovakia, Estonia and Lithuania close to 100%), financial integration
and borrowing in foreign currencies has also been substantial.
In sum, the higher degree of economic and financial integration
in the new member states had resulted in substantial economic benefits,
but it also created important vulnerabilities linked to increased
exposure in foreign exchange and rising external indebtedness.
Businesses and households in many new member states (outside the
euro area) became highly vulnerable to currency depreciation.
As excessive fiscal deficits were also recorded in some countries
(notably in Hungary and Poland) these countries faced higher costs of
financing their debt. Thus,
while the benefits in employment, trade, investment, rising living
standards and enhanced political stability were broadly uniform,
widespread complacency about extremely large current account deficits,
inaction in the face of property booms and, in some cases, lax fiscal
policies meant that EU membership achievements were not equally
sustainable everywhere.
The Economic
and Financial Crisis
Arguably the starting point and the
most significant underlying factor behind the recent severe world
financial and economic crisis were the persistent global current account
imbalances. In 2006, the
historically large US current account deficit was nearing
$900
billion, with its counterpart being found in surpluses mainly in Asia
and in oil–exporting countries.
Global financial integration made possible larger and more
persistent current account imbalances for more countries than in the
past. Specifically,
surpluses were invested mainly in the United States, thereby funding
most of the US current account deficit, creating massive liquidity and
sustaining low interest rates.
At the same time, financial innovation amplified and accelerated
the consequences of excess liquidity and rapid credit expansion.
As inflation remained low, central banks, especially the Federal
Reserve System in the US, felt no need to tighten monetary policy but
excess liquidity showed up
in rapidly rising asset prices.
Aided by very low interest rates,
inadequately regulated and supervised mortgage lending, and strong
political pressure to promote low income home ownership, helped create
widespread housing bubbles (unsustainable increases in housing prices)
in the US and in several EU member states.
As China and other surplus countries pegged their currencies to
the dollar, there was no mechanism to correct global imbalances.
With surpluses invested in low risk US government securities
depressing their yields, investors turned to riskier assets in search of
higher yields. These were
offered in the form of complex instruments, often under-pricing risk and
generating a dramatic expansion in leveraging in the financial system as
a whole. High leveraging
ratios (approximating 50) made financial institutions vulnerable to an
even modest fall in asset values.
Both financial institutions, and those who regulated and
supervised them, overestimated their ability to manage risk and
underestimated the capital they should hold.
When monetary policy started to
tighten in mid-2006 in response to inflationary pressures, interest
rates started to rise, the housing bubble began to burst leading to bank
losses on mortgages and triggering a widespread disruption of credit
markets. The impact of these
losses quickly spread to financial institutions in Europe and other
parts of the world leading to asset sales and further lowering of asset
prices. Loss of confidence,
triggered by uncertainty about the ultimate location and size of credit
losses, led to a near total freezing of the inter-bank credit market.
To maintain required capital levels, banks sold more assets and
begun reducing their loan volume.
The US government’s decision not to save Lehman Brothers,
especially its bond holders, resulted in a breakdown of confidence that
shut down inter- bank money markets. In the fall of 2008, the commercial
paper market also froze and the effects on the real economy soon became
much more pronounced.
There were of course many other
contributing factors to the world crisis, including corporate governance
failures and the proliferation of derivative investments.
But the key lesson, which applies to the global economy as well
as to the countries of Central and Eastern Europe, is that large,
lingering and unsustainable imbalances can either be corrected with
policy actions (in which case adjustment will be gradual and orderly) or
a correction will be forced on the economies of the world by a sudden
change in the sentiments of financial markets, in which case adjustment
is much more likely to be disruptive. The world economic situation
leading up to the current crisis was unsustainable and required
significant policy adjustments on the part of many governments.
The same was true for many of the economies of the new member
states.
The Effect of the Crisis on Central and East European Countries
Initially, the financial crisis
affected the advanced economies of Western Europe but had little effect
on the emerging economies of Central and Eastern Europe.
Until September 2008, these countries did not experience any
major turbulence, partly because banks in the new member states had
negligible exposure to toxic assets and financial innovation was very
modest. This rather slow
spread of the crisis was surprising because, as noted earlier, many
countries in the region exhibited significant macroeconomic imbalances.
Amongst the new member states, only Latvia suffered financial
strain as early as 2007. But
the situation changed dramatically in mid-September 2008, when in most
new member states currencies depreciated sharply, foreign currency
financing became scarce, domestic inter-bank monetary markets collapsed,
stock markets declined sharply and spreads on government debt widened
significantly. The situation
worsened so quickly and significantly as to call for strong and
immediate action. Several
countries started immediate discussions with the International Monetary
Fund and Hungary and Latvia and, later on, Romania entered into IMF –
led agreements.
Thus, since the fourth quarter of
2008, the steady convergence and integration of the new member states of
Central and Eastern Europe, characterized by more rapid growth,
employment creation and trade expansion, has been looking vulnerable.
Latvia and Hungary were hardest hit and the need for adjustment
in these countries was most apparent, but the stability of the entire
region came under serious stress.
There is no doubt that institution building and policy reform
associated with EU membership as well as the ongoing integration process
helped the region to cope better with the crisis.
Similarly, widespread bank ownership by western banks in the
region and the commitment not to let any systemically important bank in
the euro area fail has helped assure the flow of liquidity to their
subsidiaries in the new member states.
Also, EU support to the IMF and the World Bank in agreeing to
substantial financing packages to Hungary and Poland has helped send a
clear message of international determination to contain the crisis.
Commercial banks in these countries were also supported by the
ECB to roll over their debt.
On the other side of the coin, heavy
dependence for trade and foreign direct investment on the rest of the
EU, which had been hit hard earlier by the recession, has meant that
exports from, and capital inflows to, the new member states were
seriously affected. Similarly, the flight to quality, most commonly to
government securities and bank deposits in the United States and Germany
because of credible policies, institutions and guarantees, has affected
most new member states. But again, this effect was more pronounced (as
symbolized by the higher cost of credit default swaps) in those
countries with larger current account deficits, as country-specific
conditions shaped market perceptions of sustainability.
Finally, with growing public recapitalization of banks in western
European economies, and unless the easing of bank liquidity in those
economies continues, there could be a substantial reduction of liquidity
support to subsidiaries in the new member states.
The
Impact of the Crisis on the Outlook for Convergence
Once the crisis took hold of the
entire region in 2008 and into 2009, there was a broad-based and severe
downturn in all new member states.
Latvia, Estonia, Lithuania and Hungary were particularly hard hit
with negative growth rates near or at double digits, while Bulgaria,
Poland, the Czech Republic and Romania were also experiencing negative
year to year GDP growth.
Financial market conditions became even tighter with substantially
increased short-term interest rate spreads.
The exchange rates in all states with flexible exchange rate
systems (Poland, Romania, Hungary and the Czech Republic) depreciated
sharply and risk perceptions, as summarized by the 5-year credit default
swaps, increased in all countries.
On the positive side, external imbalances are narrowing fast
because of a sharp decline in imports but even the modest remaining
necessary capital inflows are at risk.
Some states have large short-term external financing needs, while
faced with sizeable external imbalances and a large debt stock.
The EU is providing a medium-term assistance facility to help
contain the risks of a balance of payments crisis, conditional on strong
policy commitments to correct the underlying imbalances.
With respect to the convergence
criteria, inflation in most countries is declining fast amid the serious
economic downturn, although in some cases this drop is moderated by
exchange rate depreciation.
Fiscal positions are deteriorating rapidly everywhere with substantial
deficits being forecasted through 2010.
Overconfidence in non-structural increases in revenues during the
boom years is now amplifying the fiscal reversal.
Exchange rate floaters are experiencing high volatility while
those on fixed exchange rate systems have to withstand external
vulnerabilities and to look forward to protracted and severe recessions.
Finally, long-term interest rate convergence has been reversed
and, under any scenario, the exceptionally favorable financial market
environment experienced by new member states is unlikely to return in
the foreseeable future.
Cyprus and
the World Crisis
Like the rest of the new member
states, the performance of the Cyprus economy benefited significantly
from the structural reforms leading up to EU membership.
The successful introduction of the euro on January 1, 2008 added
to the momentum of a fast growing economy, characterized by strong
employment growth, macroeconomic stability and social progress.
Meeting the criteria for euro membership prepared the country
well to deal with the impact of the world economic crisis.
Membership of the eurozone has clearly protected the economy from
some of the more serious consequences of the world crisis, as foreign
investor confidence remained strong.
While as a small open economy depending primarily on the export
of services, Cyprus is experiencing a significant slowdown from the 4%
average annual growth rates of recent years, its growth has remained
positive, unemployment has not increased significantly and the soundness
of the banking system has not been affected.
Cyprus has remained a very attractive business address.
At the same time, the significant
increase in capital inflows which accompanied euro membership, made
possible a surge in bank lending, rapid increases in housing prices
and a widening of the current account deficit to an all time high of
about 18% of GDP. An orderly
correction seems to be now on the way, as bank lending is returning to
normal levels, housing prices have stabilized and import growth is
slowing down. Meanwhile,
this has drawn attention to the need for the private sector to continue
to show its ability to adapt to changing economy conditions, supporting
productivity growth and enhancing export competitiveness.
The public sector too is aiming to ensure that Cyprus maintains
the confidence of capital markets, through continued fiscal restraint,
keeping public debt at the recently achieved low levels and initiating
structural reforms to help strengthen the economy’s competitiveness and
improve its prospects to resume robust growth rates as the world economy
emerges from the current crisis.
Euro-area Membership
Euro adoption remains an important
medium-term anchor for policies and expectations in all new member
states. Six of these countries which could have joined by now have
either been rejected (Lithuania) or have chosen to wait (Poland) or have
some way before they can fulfill the criteria for applying. As the
experience of the four new member states which have adopted the euro
demonstrates, membership of the eurozone provides a substantial
advantage to small open economies in times of economic crises.
On the other hand, being in the euro-zone is neither a necessary
nor a sufficient condition for avoiding being seriously impacted by
economic crises and undergoing serious adjustment.
For example, the Czech Republic which has maintained
macro-economic stability (a modest current account deficit, slow credit
expansion and a reasonable budget balance) was relatively moderately
affected by the crisis, while Ireland and Spain (and to a lesser extend
Portugal) had to undergo severe adjustment.
In the light of the recent financial
and economic crisis, the argument for entering the euro-zone by the
new member states as early as possible, which normally would have
been very strong, is now not clear from the point of view of
managing macroeconomic stability and ensuring sustainable growth.
The crisis has shown that, for countries outside the euro zone,
it is not wise to rely excessively on capital inflows.
These inflows are volatile and the risk that they will decline
substantially in the near future has increased considerably.
Therefore for these countries, whose domestic investment is
primarily financed through foreign capital, staying out of the euro-zone
would risk a protracted period of low growth.
On the other hand, entering the
euro-zone with serious imbalances, relatively high inflation and,
therefore, excessively low real interest rates, would encourage excess
investment in non-tradable, such as property and other unproductive
capital, risking the property price boom and bust cycle experienced by
countries which adopted the euro under similar circumstances.
Countries on a fixed-exchange rate
system face a special dilemma: with prices and wages likely not flexible
enough, the reduction of the current account deficit made necessary by
the dry up of capital inflows would imply a serious recession.
But devaluation would also have a devastating effect given the
large scale of foreign currency borrowing by these countries (more than
50% of total loans in 2007 for Latvia, Estonia, Bulgaria, Lithuania,
Romania and Hungary). The presence of western banks in new member
states, their quest for profit together with expectations of real
exchange rate appreciation as a likely outcome of convergence,
encouraged this excessive foreign currency borrowing on the part of
households and corporations in new member states.
For the future, policy makers in new member states should look
for non-distortiancy ways to limit excessive foreign currency borrowing.
Meanwhile, wherever possible, a social consensus to cut nominal wages
would probably be the least painful way out of the devaluation dilemma.
Concluding Remarks
Looking forward, the most serious
policy challenges, which must be met through a country-specific
policy response in new member states but will also require
international support, include the large short-term external
financing needs, which create liquidity and roll over risks; severe
pressure on banking sector stability from both the asset and the
funding side; the urgent need to correct underlying imbalances and
restore macro stability and balanced growth in the medium-term; the
difficult task for the fiscal stance to steer a careful course
between absorbing the serious downturn and preserving medium term
sustainability; the limitations of monetary policy under a fixed
exchange rate system and the challenge of
balancing carefully the tension between internal and external
objectives under flexible exchange rates; and, probably above all,
the essential and universal task of
implementing bold and politically demanding policy reforms to
support adjustment and help relaunch new member states on a
sustainable growth path. | |||||
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