How Eastern Europe Damped the Downturn

One year ago this week, a group of finance officials and bankers from multilateral institutions and Western parent banks with operations in Central and Eastern Europe (CEE) sealed a little-known agreement called the "Vienna Initiative." In brief, the deal committed Western lenders to maintain exposure to the region in exchange for financial assistance from multilateral bodies. Not only was it a rare example of swift and effective burden-sharing, the pact helped avert a potentially devastating financial crisis.

While emerging Europe has been particularly hard-hit by the global downturn, the post-mortem on the region's biggest test since the end of communism is likely to vindicate the policies undertaken over the last two decades. Behind bleak headlines, a more differentiated and discerning view of CEE is emerging. This is helping counteract some common misconceptions about the region.

One of the misconceptions is that CEE has just relived the 1997-1998 Asian financial crisis. Closer inspection suggests that—as the European Bank for Reconstruction and Development notes—CEE did not suffer the disruptive and prolonged currency devaluations that occurred in Asia. Excepting a few countries, notably Russia, capital outflows were fairly limited. They averaged 1% of gross domestic product across the region in the last quarter of 2008 and first quarter of 2009, compared with an average of 4.5% of GDP among Asian countries at the height of their 1997 crisis.

Despite severe external imbalances in many CEE countries due to housing and credit booms, emerging Europe's financial sector wasn't hit as hard as Asia's was in the late 1990s. The EBRD attributes this to the smaller size of banks' assets in CEE, stronger support from multilateral institutions, and the dominance of foreign-owned banks. While criticized for exacerbating the downturn by fueling rapid growth in credit—a large portion of it imprudently denominated in foreign currency—Western parent banks have stood by their subsidiaries and may have helped cushion the impact of deleveraging.

current debt-to-GDP ratios are low

A second misconception is that emerging Europe is mired in debt and high deficits. This view stems from a failure to distinguish between sharp increases in household and corporate indebtedness on the one hand, and relatively low government debt burdens and budget deficits on the other. Among the region's main economies, Russia—which suffered a brutal recession—stands out for its extremely low level of public debt (currently under 10% of GDP) and a fiscal deficit that is expected to be below 5% of GDP in 2010.

Indeed, set against the fiscal positions of many advanced economies, CEE countries are, for the most part, in much better shape. This is because their balance sheets were stronger at the time the crisis erupted. While such countries as the Baltic states, Ukraine, and Romania face rapid increases in debt burdens in the coming years, their current debt-to-GDP ratios, as UBS (UBS) notes in a recent report, are still among the lowest in the emerging world.

Hungary is arguably most at risk, due to a government debt level that's on par with the euro zone average (currently almost 80% of GDP) and the prospect of a further increase in its debt burden. Yet the scale of Hungary's fiscal adjustment, recently under the International Monetary Fund's tutelage, has been remarkable. In one of the most dramatic fiscal turnarounds in emerging markets—and at huge cost to the economy—Hungary's budget deficit has shrunk from over 9% of GDP in 2006 to roughly 4% in 2009. The structural fiscal balance may even move into surplus this year.

European integration remains the key

A third misconception is that the capital-importing development model pursued by many CEE countries is flawed. True, the speed and intensity of capital flows to the region from 2002 to 2007 were undoubtedly key factors in causing some economies to overheat. But the rate of development earlier this decade was unprecedented and is unlikely to repeat itself soon—no bad thing, given the scale of imbalances before the crisis.

The fortunes of Central and Southeast European countries are inextricably linked to the process of European integration. The long-term economic benefits of EU membership, notwithstanding the current turmoil in the euro zone, are palpable. If disbursed and used efficiently, EU funds will help finance much-needed investment in infrastructure. International companies will continue to seek cost-saving manufacturing and outsourcing opportunities across the region.

The challenge for emerging Europe is to push ahead with reforms at a time of considerable global uncertainty. Structural changes, notably in the sensitive area of social entitlements, are crucial to raise the region's low employment rates and increase competitiveness. Russia needs to diversify away from oil, while the main Central European countries have to prepare their economies for membership in the euro. These are all huge undertakings, but the region confronts them with some degree of confidence now that it has weathered its first major crisis.