Sunday, November 08, 2009

CEE economics

Eastern Europe's economic woes

Down in the dumps

Nov 5th 2009
From The Economist print edition

The ex-communist economies have not collapsed. But finding new ways to catch up with the West will be hard

Illustration by Peter Schrank
Illustration by Peter Schrank

EVEN at the height of the ex-communist countries’ boom in 2006, almost half their citizens felt they lived worse than in 1989. Yet that glum verdict on 17 years of liberalisation, privatisation and stabilisation was tempered by another finding. Most of those polled by the World Bank and European Bank for Reconstruction and Development (EBRD) said they were optimistic about their children’s prospects.

The worry is that the global economic crisis has dented confidence in the future and intensified gloom about the present. Fast growth eased dissatisfaction with corrupt politicians and bossy bureaucrats. It offered at least the chance of better health care and education, which lag far behind western standards. But the average decline in GDP this year is a whopping 6.2%; recovery is expected to be slow. So east Europeans face higher taxes, bigger debts, less public spending, lower pay and fewer jobs. They do not have the same shock-absorbers as in the west—which is where, in the eyes of many, the crisis originated.

That could prove a toxic mix, yet so far the fallout has been limited. Support from the European Union, the IMF and other lenders, after initial hesitation, was unprecedented in size, scope and speed. Tens of billions of dollars of outsiders’ money staved off a catastrophe. So far, no currencies have collapsed; no country has defaulted; no banks have faced runs, or been cut adrift by foreign owners. Politicians preaching protection, state control or other charlatanism have remained on the fringes. In its latest annual transition report, the EBRD says reform has largely stalled, but not reversed. In countries such as Latvia and Hungary, governments have shown a masochistic delight in following IMF prescriptions for fiscal tightening, even at the cost of likely electoral oblivion.

It makes little sense to talk of the ex-communist countries as a single region. Resource-dependent economies such as Russia and Kazakhstan have one set of problems (such as diversifying and spending export revenues wisely). Open manufacturing economies such as Hungary and Estonia have another (chiefly, maintaining competitiveness). Poland, bolstered by strong domestic demand, will be the only economy in the EU to grow this year (though its rising public debt is a worry). Two ex-communist countries, Slovenia and Slovakia, have already adopted the euro. Estonia may be next. Countries to the east and south tend to be poorer, glummer and worse-run.

For those in or close to the EU, growth came from strong exports of goods and services and big inflows of capital. The net effect was beneficial but the disadvantages are now apparent: heavy dependence on single industries (eg, cars in Slovakia) and on west European demand. Foreign capital inflows may have been too big or too quick, leading to a consumption and construction splurge, fuelled by reckless lending to firms and households, often in foreign currencies. Inflows of money from abroad have fallen dramatically, or in some cases even reversed. The volume of syndicated loans going to the region, for example, has fallen to roughly a sixth of the pre-crisis level. Restarting these capital flows is a high priority—preferably with more prudent rules for the credit market.

Alongside this problem is another: finding a way to share the pain of restructuring private-sector debts among governments, borrowers and bankers. Dealing with this product of past excesses causes much headscratching for policymakers. Debt overhangs—of over 100% of GDP in some countries—will curb growth in future years, hurting everyone.

Outside support has headed off a vicious circle of falling exchange rates, lower investor confidence and failing banks (though that may still loom in Ukraine, where vote-hungry politicians have just shredded a deal with the IMF). But many states face another grim outcome: years of low growth caused by uncompetitive exchange rates and sluggish productivity. That is what happened to Portugal after it joined the euro in 1999. For ex-communist countries in the euro, pegged to it or hoping to adopt it soon, the Portuguese example merits careful study.

The ex-communist economies’ competitive advantage may have shrunk, but it is still a big asset. Cost-cutting in western Europe may produce more outsourcing to the east. Some also hope to find new niches, based on brainpower and creativity. But they must also make their countries work better. According to the EBRD, four areas stand out. One is improving the legal system. Slow and unpredictable justice is a turn-off for foreign investors worried about contracts and property rights (see article). Second is better regulation. Despite improvements from EU membership, businesses still battle with profit-choking red tape. Third is a better social safety-net. A feeling that life is unfair and precarious sharpens the divide between winners and losers and risks political upsets. Fourth is competition. Informal barriers to entry and old networks of communist-era pals keep bits of the economy off limits to outsiders, at huge cost to efficiency.

Getting state institutions to function better is easier to discuss than to accomplish. It has long been clear that intangible factors to do with national culture and levels of social trust play a bigger role than explicit rules in ex-communist countries’ fortunes. The EBRD highlights “values, attitudes and practices” in determining what constitutes “acceptable behaviour within a firm…or by government officials”. Economics offers little guide to that.

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