THE ECONOMIC LANDSCAPE OF EAST CENTRAL EUROPE – FIVE YEARS AFTER THE FINANCIAL CRISIS

DIVERGENCES IN THE MYTHICAL “EASTERN BLOC”


Five years on the advanced West continues to struggle after the surprisingly deep contraction of 2008/2009 while the global economy keeps growing, albeit at a slower pace. The performance gap has thus remained wide between the West and the rest: the world economy has expanded around three per cent annually in recent years, the Euroland grew by two percent in 2010 then contracted slightly both in 2011 and 2012, and 2013 looks fragile too. The US economy has grown by around two percent annually in the recent couple of years. Japan experienced a mild recession in 2011 and is now on a two per cent growth path. All three big advanced economies have remained under- achievers. Closer to home: Germany has hardly managed to grow (0.7 per cent in 2011 and a microscopic 0.1 per cent in 2012); this year is not much better, with a modest 1.5 per cent output increase forecast for 2014 by Deutsche Bank in its July 2013 Focus.

This is the background against which the economic performance of Eastern Europe should be judged. As a whole, Eastern Europe, and within it the East Central Europe (ECE) region is growing faster than Western Europe, a pattern which has been established for nearly two decades now. The region’s vital signs have prompted Anders Åslund, the Swedish economics professor (who formerly served as an advisor to the Yeltsin government in Russia during the ill-fated shock- therapy after 1991) to declare Eastern Europe’s victory over the crisis. In his 2010 book, titled The Last Shall Be the First, Åslund says that “by March 2010 the crisis in the central and eastern European region had more or less abated, and public attention moved to the PIGS (Portugal, Italy, Greece and Spain), in particular to Greece”. Soon few will remember there was a crisis in Eastern Europe – claims Åslund on the first page of his book. He dryly notices that even if there remain some problem economies, they are smallish by European standards: “The three main crisis countries, Hungary, Romania and Latvia, together accounted for only 2 per cent of EU GDP, approximately as much as Greece.”

He is not alone in praising ECE’s progress: László Andor, EU commissioner for social issues and employment, opined some years back as a university lecturer (and a colleague of mine) in his 2010 book on transition that if the Great Recession had not happened or the turbulence had avoided the region, the twenty-year transition would have been a great success.

Well, the financial crisis did happen, and the region contracted more in 2009 than the advanced core. True, recovery in some transition countries has been faster than in advanced Europe. Still, this region faces several complications, think of the protracted socio-economic tension in Ukraine and in Bulgaria, or the recent financial problems in transition star Slovenia. Hungary, as we have been discussing in these columns, lost momentum in 2006 and has not yet regained it. Yet, others are performing well: Poland has done nicely until very recently, while Latvia has managed to meet the entry conditions of the Euroland and could adopt the euro from 2014.

These contradictory facts do not allow for a simple statement about where we stand now: a detailed analysis of trends and policy events in European transition economies is needed before concluding who is right. Here I will concentrate on ECE, the more advanced core region of former communist planned economies. But first, let us revisit the financial crisis that has changed the overall European landscape so much.

It takes a long time for a particular set of financial disturbances to evolve into what you can call a genuine crisis, as is the case with the most recent one, which started sometime in 2007 in the US. It is much easier to pinpoint when the crisis actually hit the ECE region. It was the day after 15 September 2008 – the collapse of Lehman Brothers, the leading American investment bank. Fund owners and moneymen immediately concluded that if such an esteemed financial institution can go bankrupt overnight, you’d better be as cautious as possible with inherently risky assets and counterparties. Anyone for Hungarian or Romanian government bonds, or property development projects in the Baltic countries? Irrational exuberance vanished, bank treasurers ran for the exit. The uncoordinated capital movements (or more simply put: the panic) led to a near full stop in flows of funds to our region. As a consequence, the Hungarian government was forced to turn to the IMF and the EU for financial help in October 2008. Soon after, Romania and Latvia, also EU member states, followed suit.

No economy remained intact from the shock waves of what politicians and the media of the advanced nations called a global crisis – even though it was global neither in its nature nor in its economic consequences. Nor did all European countries experience a recession. The Polish economy even managed to grow, albeit at a much slower pace than before, in 2009 – the year that goes down in economic history books as a year of Europe-wide recession. Albania also remained in the black in 2009. Still the general picture is that most former planned economies – transition success cases among them – suddenly experienced a fall from grace as soon as the inflows of bank loans and foreign direct investments (FDI) suddenly dried out.

Now, five years after the events, we are at a certain distance from the shock year to examine what has happened to the region. Starting with the simplest performance measure of the region’s economies: statistics on gross domestic product (GDP). A quick glance is enough to reveal that the ECE countries have not behaved as a bloc. This won’t come as a surprise for anyone who knows the region: the countries east of the West and west of Russia (Soviet Russia, Soviet Union, and again Russia) have never been even close to identical, even if commentators like to refer to them as members of a bloc.

The figures show that some have not recovered yet from the 2008/2009 contraction, while others have enjoyed a respectable compound growth rate. Compared to 2007, the last year of “peace”, the Hungarian gross national product stood at a meagre 95 per cent at year-end of 2012, while the corresponding Romanian and Czech performances were about 100 per cent, Slovakia‘s 110 per cent, and Poland’s as high as 120 per cent. This variation is not entirely surprising: the same countries also had different growth performances in the five-year period prior to the crisis. Some economies had grown much faster than others after the accession to the EU in 2004 up until 2009. Slovakia’s cumulative increase of GDP amounted to 35 per cent, Poland’s 30 per cent, Slovenia’s 22 per cent, and Hungary’s 10 per cent.

Let’s frame this again in an international context. The GDP of the old member states grew just eight per cent in the 2004/2008 period. In contrast, this pre-crisis period was the golden era for most of the new member states (with the exception of Hungary, unfortunately). Between 1995 and 2007, that is, after the end of the transition crisis and before the European turbulences, ECE outgrew all emerging market regions, with the exception of China and India. Looking back, it is obvious that such an impressive growth performance was partly due to a rebound of economic processes after a deep-going transition crisis, and partly due to massive inflows of credit and FDI. Also, in some countries, fiscal policy fuelled the growth, and thus contributed to the overheating of the economy.

POST-GOLDEN-YEARS BLUES IN THE PERIPHERY

Hence, five years after the outbreak of the financial mess, we see a mixed bag of performances, just as there was during the preceding five years. Half a decade is admittedly short by historical standards, but the range of 95 to 120 per cent from 2007 through 2012 is telling: with the success of Slovakia and Poland, and the relative decline of the Czech and particularly of the Hungarian economy especially stark.

Yet, the verdict on economic success or failure must not be based on GDP growth indicators alone. Also, the period is too short to properly evaluate the performances of nations. This is particularly true for the European periphery where uneven development is the rule rather than the exception. For this reason, I invite the reader to apply a longer time framework to the economic and social indicators of material progress of ECE societies even if we do not have space here for a comprehensive analysis.

The ECE countries, which returned to market economy status in or around 1990, all started from levels of development well below the average of advanced Europe. Still, all have consistently managed to grow faster than advanced Europe in the two decades since the political regime change. A convergence to the core has taken place both in terms of economic performance and social structure. Convergence is, of course, a complex phenomenon. Measures of comparison are always open to dispute, and your verdict depends on the benchmarks, indicators and time framework chosen. What is probably a more important caveat is that these vital years have not been only or even mostly about economic matters. History posed a unique set of challenges faced by the region and economics was but one aspect of many.

In the case of the new EU-8, any meaningful performance comparison must take into account the historical legacies of these former planned economies and the various challenges set by history. For several nations, the regime change around 1990 meant more than replacing a socio-economic system: the new era made state creation possible. The political geography of today’s Europe has changed dramatically since 1990, particularly of course in ECE. The Soviet Union, Czechoslovakia and Yugoslavia no longer exist: their constituent parts function now as fully independent states, some very small by European standards. Old and new states alike are much dependent on foreign trade and international finance.

The regime change suddenly offered the chance to a new generation of politicians to build a state out of scratch in Estonia, Latvia, Lithuania. There is a deep logic behind the adoption of “neo-liberal” economic policies in the Baltic states since the outset of the transition: without much to preserve and a lot to create, nation builders needed foreign funds and institutional support – immediately. They aspired to be accepted by the West, at the earliest possible date, into their political, economic, security and monetary integration frameworks. Hence the intentional dependence on foreign capital inflows as drivers of accelerated modernisation in the Baltic states.

Other new entities had very different backgrounds. Hesitant Slovakia under Mečiar first tried to follow a certain third path, but soon hit upon the risks and costs of staying out of the Western mainstream. After 2000, Slovakia’s national elite recognised the necessity of a genuine policy turn – and an FDI-driven modernisation strategy soon hauled the new republic into the rank of transition stars. Slovenia also emerged as a special case by deliberately avoiding over-dependence on capital import and its concurrent risks. Compared to these two new states, the Baltic Three applied strong measures to put the past behind them altogether. We can generalise: when nation builders are genuinely determined to build a state that has few historical antecedents, they are more likely to decide to take the fast lane.

Others saw history’s challenges and policy options differently. Elites of older states (Hungary and Poland) also faced conflicting social and economic goals from the very start in 1989/1990: the challenges included restoring full national sovereignty and defining a societal system, but also the task of anchoring a new republic firmly into Western alliances and business networks. Let’s put it this way: tasks of creating, on the one hand, and tasks of assimilating or borrowing, on the other. You may say that the second set of tasks proved to be paramount due to the realpolitik of the early 1990s: the Antall cabinet in Hungary, just like the first Polish governments, followed policies that turned out to be more in conformity with the Western mainstream than originally planned and promised in election programmes. Certain theorists – Béla Greskovits among them – contend that all ECE countries, with the single exception of Slovenia, acted in a “neo-liberal” manner in the first two decades of transition. That may be too much of generalisation, given the strong presence of the Social Market Economy concepts and policies during Antall’s time: see Otto Hieronymi’s recent essay in the previous issue of this Review.

Ironically, the very successes of the first governments in Hungary and Poland in tying the newly independent nations to Western institutions and business networks, is what contributed to the lack of focus of the general public in matters of nation building and state (re-)creation. The fact is that after the first heroic years, public debates and policy clashes predominantly centred around distributional issues (welfare spending, ownership patterns) or ideological debates, rather than elementary questions of sovereignty. The issue of entry into the eurozone for example never made headlines in the Hungarian political media, in contrast to more emotional events of so ephemeral significance that we cannot even recall them a couple of years later. But in Poland or in particular in the Czech Republic, the common European currency has remained a distant, highly technical issue – rather than a symbol of being integrated into a prestigious European club and of a national achievement in competitive environment.

Now, we have seen various transition paths and highly differing attitudes to the complex challenges of history – and also heterogeneity in economic growth achievements. One can venture a hypothesis about the link between the success of the transition and state creation: nations that embarked on state building seem to have generated internally surplus energies vis-à-vis countries with more historical continuity. In the latter you hardly experience broad understanding of, and willingness to, accepting short term personal sacrifices as an investment into long term national progress. Certainly, where the focus is not on state creation but on material progress, you will find less social readiness for structural change. Think of the transition success stories: Estonia, Latvia, Slovenia, and later Slovakia – all new entities. This “new state” factor is, of course, hard to quantify as a growth enhancer, and one should not overestimate the importance of any single social or economic factor what you can say with certainty is that socio-economic development in the region studied here has been influenced by various factors and movers, inner and external alike. There has been no case of linear, uninterrupted economic growth, or smooth social progress towards the (promised) state of advancement (“transition completed”).

UNEVEN DEVELOPMENT – AGAIN

But let us get back to the more technical aspect of development: economic growth. We saw a promising landscape in the region before the crisis broke out and turbulences hit Europe, and particularly – but not evenly – the new member states. But that growth period ended abruptly in 2008. What came after that turned out to be even more varied across nations, and recent figures released by the European Commission and the IMF depict a region facing a plethora of serious challenges – and differing policy courses in the states concerned.

The Baltic states were particularly hard hit during the 2009 recession; it is not obvious whether their societies were paying the high price for having been “model children” of transformation or they were just suffering from the dire consequences of a series of policy mistakes. Certainly, their rapid growth in the early 2000s was a text book case of overheating and financial bubble. Such phenomena are always followed by a phase of correction – the Baltic region is still in the middle of it.

Slovenia, an atypical success story ran into problems in recent years, suffering it appears from structural problems. The economy has been hit hard by a boom- and-bust cycle, compounded by reform backlogs and the euro area sovereign debt crisis. The reduction of public and private sector indebtedness is significantly weighing on Slovenian growth amid high unemployment and lacklustre export performance. But these factors are not unique in the ECE region. Unlike the structure of the banking industry: Slovenia’s is very different from that of other new member states: 58 per cent of loans are granted by state owned (relatively large) banks, eight per cent by small domestic banks, and 34 per cent by foreign banks – while in most other ECE countries foreign banks dominate the banking industry. With such state dominance in Slovenia, the cost of bank recapitalisation in the likely case of business downturn or build-up of bad loans will fall on the owner of the banks: the state. Now the catch is that the share of bad loans amounts to 15 per cent of all loans in Slovenia. This is a high figure, only Ireland, Greece and Hungary record worse figures of nonperforming loans (but in the Hungarian case the bulk of the costs of the recapitalising of the banks rests on the foreign owners rather than on the national budget). The view of the OECD, the professional association of the advanced countries, is that in Slovenia, despite a recent cut in unemployment benefits, social transfers are still generous; this fact leads to high average effective tax rates which hamper the transition of inactive and unemployed persons to the labour market. To rephrase it in a more subjective tone: this sub-Alpine republic has gradually become a financially unsound welfare state, and is now suffering from a weak material base.

Slovakia emerged as another transition star in early 2000s, and it continues to grow. Even during these recent years, the Slovak economy has expanded by around two per cent annually, relying on growth in the car industry. But it is still struggling with an unemployment rate of 14 per cent. Second: dependence on one single economic sector (automotive) involves obvious risks. Still, its membership of the eurozone and its close ties to the German economy are stabilising factors.

The Polish economy is also growing at a similar pace; not as impressive a feat as its growth performance during the crisis but still a notable achievement. Poland is less open economically than the Visegrád 4 average; before the crisis, some regarded this fact as a handicap or a sign of relative underdevelopment but the advantage is clear: the resilience that the Polish economy showed during and after the financial crisis underlines the importance of having a vibrant domestic economy. To put it another way: in crisis times it pays to be less dependent on foreign markets and on borrowed foreign capital – be it in the form of debt transactions or foreign direct investments (FDI).

Romania had grown relatively fast before the turning point in Autumn 2008, but only by running a frighteningly high current account deficit (which amounted to 15 per cent of the GDP in 2007). High external debt and general dependence on borrowed funds left the country at the mercy of foreign investors and of international financial institutions. Dependence is hard to shake off: the Romanian government has just concluded a new agreement with the IMF, which provides more stability – at a price of reducing the margin of manoeuvre of the government. The Baltic Three have been above discussed as an extreme case of external economic openness, involving exposure to volatile forces and, as a consequence, boom-and- bust cycles. Still, some strategy goals have been met: Latvia is to become the 18th member of the eurozone. The country has just emerged from a trying period of shocks. Like other Baltic states, Latvia has lived beyond its means for years: the current account deficit in 2007 was nearly 25 per cent of GDP – anything, according to a practical rule of thumb, above five per cent deficit is a risk. From a peak in 2007, Latvian GDP fell 20 per cent to the bottom in 2010 and the unemployment rate reached nearly 20 per cent. Now, the growth figures are again impressive, as can be seen from the chart below – but the volatility of the performance of small open economies needs to be kept in mind.

The chart provides a snapshot of varieties of European business cycles. Six quarters make a short period, yet the degree of discrepancies in the growth paths of the member states, old and new alike, tells a lot about the lack of convergence in the European Union. Most countries of the EU-8 look better than the EU average but the differences are significant. Six out of eightregistered real economic growth in the period measured, the three Baltic republics are on a very fast recovery path. We had two economies with negative output results however: the Czech and the Hungarian. These two countries are similar in terms of country size and of openness but they also face different socio-economic challenges. The Czech recession appears to be temporary as it has been caused by a particular phenomenon: increased savings of households. Thrift is a virtue but one koruna saved is one koruna not spent. More savings in recent times have led, as an obvious consequence, to a decline in private consumption (three per cent in 2012). The cautious mood is justified by the increase of unemployment (from 6.5 per cent to 7.2 per cent in one year by the end of 2012; high by Czech standards but enviable in Hungary). Households responded to a VAT rate increase and political-economic uncertainties by saving more. The Czech National Bank has cut the policy rate to 0.05 per cent (!), that is practically zero. The strong financial status of the country has allowed government bond yields to decline to record lows: the yield on the 10-year Czech government bond is around two per cent – something again that Budapest can envy. Falling interest rates, however, have failed to translate into fast credit growth: credit to the corporate sector and to households has increased only slightly.

In contrast, Hungarian banks’ lending activity has declined for five consecutive years. Overall FDI inflows have slowed down in spite of a couple of major increases in automotive capacity. Investment has been on the decline for years while business climate indicators remainnegative. This is partly due to frequent taxation changes and regulatory modifications – we have discussed this aspect of Hungarian policy making in previous issues of this Review. The consequences look clear if Hungarian growth performance is compared to other countries of the EU-8 group.

WHERE DO WE GO?

The main theme of this analysis of trends is diversity. The nations of this region may have shared common external shocks under similar historical conditions, yet their inner social dynamics have been different throughout their contemporary history. As we have seen: the ECE economies did not behave as a bloc before the regime change, nor in the first decade of the deep socio-economic transformation. The golden years between 1995–2007 were the closest to a general regional trend (with some exceptions), but the crisis of 2008/2009 again underlined the differences in factor endowment and other macroeconomic variables. The last five year period has similarly been very diverse in this respect.

The second lesson: there is no simple formula for economic success. The Czech, Hungarian and Polish trio performed best at the time of the regime change, but new players joined their rank in the second decade of transition. Lead positions, however, do not last long: Slovenia’s and Hungary’s deep recessions in 2009, and near-stagnation since took away most of the shine from these previous transition stars. The present post-crisis growth competition seems to be a different ball game with new rules; and it is not certain what the new rules are. Some economies seem to perform well again because of their good capabilities to absorb a lot of foreign funds, others seem to fare strongly because they have avoided dependence on capital import. Some economies have been growing strongly under government policies following closely the prescriptions of the neo-liberal tendencies while others claim that going your own way is the only formula for success.

The third message is that economic growth alone does not guarantee social peace and political stability. This should not come as a surprise for those who note the growing inequality in a region which – in spite of its mentioned heterogeneity – has previously experienced a long period with limited (overt) income and wealth inequality under the planned economy regime. Compared to that, the present phase of capitalist development has vastly increased the gap between the rich and the poor. ECE economic growth has not ever been so strong as to silence social complaints; and the present situation – ranging from modest growth to protracted recession – will only fan anti-capitalist and anti-Western feelings.

But the peoples of the region have acquired important social skills that help them endure hard times and identify new options. True, the present economic trends do not promise much. But the recent couple of decades have proved that this region has the capacity to belie solid trends.

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