Lecture by EBRD President Thomas Mirow at London School of Economics

Victims or Survivors? The Emerging Economies and the Economic Crisis
18 months into the worst financial crisis since the 1930s, which countries seem to have made the grade? And how have they done so?

Professor Chalmers,
Ladies and Gentlemen!

Many thanks for the kind introduction and good evening. It is an honour for me to address you again today. Our subject is how the emerging economies have been affected by the global financial crisis, how they are dealing with this challenge and what lessons we can learn.

Allow me to start with one word about the EBRD itself: The EBRD invests and works in Central, Eastern and South Eastern Europe, Russia, Ukraine, the Caucasus and Central Asia. My comments will therefore focus on this region, which I will call “Emerging Europe” for simplicity.

After the demise of communism, these countries embarked on the transition from state-run to market-based economies. The growing integration into the global economy enabled the countries to expand strongly and brought significant progress in raising living standards.

This integration rested on three main pillars: (1) trade integration into the world economy, (2) financial integration, particularly with Western Europe and (3) institutional development and integration, in many cases with the EU accession process as an anchor.

As a result of trade integration, Western Europe became the most important market for exports from the EBRD region, be it natural resources (especially oil and gas) or products and services.

Financial integration led to a massive inflow of foreign direct investment and capital into the region. The countries offered many attractive prospects for Western investors: competitive labour costs, favourable tax codes and high pent-up domestic demand. Western banks expanded rapidly and became the dominant players in many Emerging European markets.

When the financial crisis started in the United States in 2007 and later reached Western Europe, many economies in Emerging Europe at first demonstrated remarkable resilience. However, in the fourth quarter of 2008 the region succumbed to huge external pressure and suffered the worst decline in output since the beginning of the transition process. As a consequence, we recorded a slump in GDP of about 6 per cent in the 29 countries where the EBRD invests in 2009.

The crisis hit Emerging Europe particularly hard, because it exposed imbalances which had piled up in the previous period of rapid growth. These had either not been detected or not been dealt with. They had either been overlooked or underestimated during the period of rapid growth. But they were brought to light very clearly when the global economic climate radically deteriorated.

Those imbalances can be identified in at least four areas:
• (1) at a macroeconomic level, with widening external deficits, extraordinary credit booms and rapidly rising private debt, much of it denominated in foreign currencies;
• (2) at a sectoral level, with the expansion of nontradables - in particular the construction and property sectors - far outpacing growth in manufacturing in the boom years;
• (3) at a regional level, with widening gaps between booming and stagnant regions and an uneven distribution of growth within countries
• (4) most significant of all: financial integration was often outpacing the institutional ability to manage it.

Importantly, however - and this refers directly to the question you have put to us today: “Victims or Survivors?”- these imbalances were not equally present in all countries in our region. Indeed some countries largely managed to avoid them – notably, some countries in Central Europe. This was the consequence of regulatory institutions that discouraged credit booms and foreign currency lending, and countercyclical monetary and fiscal policy frameworks.

These softened the blow from the crisis through several channels: more liquid banking systems; smaller external and fiscal financing needs; and more solvent households and enterprises. In addition, sound fiscal management provided governments with leeway for anti-cyclical measures. As a result, one can observe a clear correlation between output declines and pre-crisis imbalances. One country with relatively strong pre-crisis policies and low imbalances – Poland – managed to avoid a recession altogether.

For the most part, however, Emerging Europe suffered dramatic output declines in the fourth quarter of 2008 and the first quarter of 2009. Subsequently, most economies have gradually started to stabilise and recover. We are now expecting a return to growth in most countries of Emerging Europe in 2010.

Since January, we have seen a recovery in much of the region, especially in commodity exporters and recipient countries of capital inflows. Several countries - including Turkey, Russia, Ukraine - now have better growth prospects than we had projected in early January, both as a result of returning capital inflows and as a result of rising commodity prices.

Others, however, especially in South Eastern Europe, show little sign of a sustained recovery. Although this group is likely to see positive growth in 2010, the recovery is likely to be slow and protracted as imbalances unwind, unemployment and nonperforming loans level off at high levels and fiscal consolidation gathers pace.

This leads us to the conclusion that the recovery among the countries of the region will be protracted and volatile. With the exception of important outliers like Russia or Turkey, growth will remain well below previous levels. And significantly, comparing the EBRD region to other Emerging Economies, the IMF’s latest World Economic Outlook is predicting a “multi-speed recovery” in which Eastern Europe is clearly lagging behind.

The main reason for this is that the key drivers of growth in the pre-crisis period such as foreign direct investment and credit-driven investment and household consumption will remain subdued. At the same time external demand, especially in Western Europe, is far from what we have seen in the past as these economies too are emerging only slowly from a deep recession.

The crisis in Greece is a sharp reminder of the volatility of the external economic environment and repercussions cannot be excluded, especially in South Eastern Europe. Finally, commodity exporters remain dependent on the volatility of world market prices.

Taking all these circumstances into account - the state of the economies in the EBRD region, the global economic climate and the fierce competition with other Emerging Markets - it is imperative that we move towards a New Growth Agenda which will allow the countries of the EBRD region to enjoy better managed and safer, yet vigorous growth.

This New Growth Agenda would be based on progress in three areas:

First, we must prevent a return of macroeconomic and financial imbalances. This means strengthening macroeconomic frameworks in order to avoid excessive external deficits and unsustainable credit booms. Crucial in this respect is the development of local currency capital markets to create a domestic source of funding. Such markets would complement and eventually help to reduce the dependence on external sources of funding that proved so costly during the crisis. However, local currency markets can only flourish within a stable economic environment. For this reason we are calling for a coordinated effort to establish a strengthened institutional framework that will provide an economic backdrop to encourage private domestic savings and a regulatory environment that deters excessive growth in credit especially in foreign currencies.

Second, there is a clear need to address bottlenecks that stand in the way of long term competitive success. This includes strong competition policies and lower non-tariff trade barriers to foster the creation and growth of small and medium-sized enterprises; much stronger education, particularly at the secondary level, but also at university level; labour market institutions and social safety nets that slow rises in unit labour costs while limiting the individual risks associated with flexibility and infrastructure policies that address geographic imbalances.

Third, many of these measures will cost money. The perhaps biggest challenge of all will be to undertake them in an environment of reduced fiscal means. To meet this challenge, countries in Emerging Europe, as is the case in the West, will need to undertake fiscal reforms. But even with effective reforms, much of the funding of critical investment will need to come from the private sector. Private sector development therefore remains of crucial importance to the economic progress of Emerging Europe’s economies.

Therefore, at the same time as developing this new growth agenda, we must not overlook or ignore the genuine successes of the transition period. Market-oriented reform and economic integration have been the main pillars for the rapid rises in living standards since the mid 1990s. What is needed is not the reversal of integration but a reform agenda that leads to stronger integration combined with better risk mitigation.

Looking ahead - and answering the second part of your question “Victims or Survivors?” - we have to be realistic because of the size of the challenges that lie before us. The global crisis has been so fundamental and deep that a simple return to the boom times is not an option. The status quo ante does not exist anymore.

That said, we are also confident that these challenges will be overcome as lessons are drawn from the crisis and steps are implemented towards the New Growth Agenda that in the long run is both broader-based and more sustainable.

This confidence is - not the least - based on the mature and resilient response of Emerging Europe to the global crisis itself. The last 18 months have not only laid bare vulnerabilities and imbalances, but also demonstrated remarkable strengths:

• The resilience to deal with enormous adjustment burdens without large-scale social and political upheaval.
• The readiness to seek joint solutions with the involvement of the international community and to stick to agreements rigorously.
• The determination to see the crisis as an opportunity - for instance, to use it as a driver for the implementation of (often overdue) steps towards diversification and modernisation.
• Finally, the level of integration achieved by Emerging Europe in the last 20 years. This has anchored the region into wider Europe, institutionally and in the minds of investors. Emerging Europe is not a destination for “hot money”, but regarded as a long term investment for mutual benefit.

More fundamentally, the growth potential in the region remains much higher than in the advanced economies of the West. The countries still have enormous needs, ranging from infrastructure investments to pent-up consumer demand.

At the same time, the economic fundamentals in most cases are sound and, where they are not, the countries have embarked on ambitious adjustment programmes.

The task ahead is still large, but not insurmountable. Looking back at what has been achieved in the past 12 months gives us the confidence that Emerging Europe can again be put on track. It is going to be a long and hard process, but today more than ever we believe that these countries will succeed in establishing sustainable and broad-based growth.

Thank you for your attention.

Last updated 22 June 2010