Reigniting Growth in Emerging Europe

As the deep recession in Europe’s emerging market countries finally comes to an end, the question on everyone’s minds is where  growth in the region will come from in the years ahead. Exports are rebounding, and domestic demand is showing signs of stabilization. Most countries will see positive GDP growth this year—a stark difference from 2009. But a return to the high growth rates that preceded the crisis is highly unlikely.

An unbalanced picture

During the boom years, Eastern Europe grew rapidly, but growth in many countries was rather unbalanced. Capital inflows were large, but to a great extent went to the “non-tradable” sector—in particular, real estate, construction, and banking. Capital flows boosted domestic demand rather than supply—leading to a surge in imports, current account deficits that widened to unprecedented levels, and overheating economies.

This kind of growth will not come back. The domestic demand boom came to an end in the fall of 2008.  In the global financial turmoil that followed the demise of Lehman Brothers, capital flows to Eastern Europe plunged, leading to a sharp decline in domestic demand. Further exacerbated by a decline in exports, this contributed a deep economic downturn—in the Baltics and Ukraine, GDP declined between 14 and 19 percent last year.

Exports are now recovering, but domestic demand will likely stay weak: experience tells us that once credit booms end, consumers tend to rein in their spending for a long time as they pay off their debts.

Instead, Emerging Europe will need to need to diversify away from non-tradables to tradables. Growth will need to come from manufacturing and services, rather than construction, real estate, and banking. Emerging Europe will need to find niches in the world market in which it can specialize and catch up by increasing its share in world markets, rather than by boosting its non-tradable sector.

Going back to basics

How can Emerging Europe do this? In short, by going back to basics. Emerging Europe has transformed itself many times before. It is only twenty years ago that the region began  the transition from a centrally planned economy to a market-based one. Its economies are very flexible, and policymakers have repeatedly demonstrated that when things get tough, tough actions can be implemented quickly.

Most important in this transformation will be the private sector. Market forces will help in transferring resources. During the boom years, real estate, construction, and finance were very profitable—much more so than manufacturing. Now that the boom in the non-tradable sector has come to an end, it is no longer as profitable. It is likely that this will have a stark impact on investment in this sector. When the housing price boom ended in the United States and the construction sector no longer was so profitable, residential construction declined by 75 percent.

Saving for a rainy day

Of course, public policies are important as well. Well designed macroeconomic policies and structural reforms can help restore growth.

Macroeconomic policies can help prevent the overheating that pulls resources from the tradable to the non-tradable sector. Fiscal policy in particular could play a much more active role than it has in the past. When revenues are growing strongly, they should be used to build up fiscal buffers instead of  increasing  spending and boosting public wages.

This may mean that during boom times small fiscal surpluses may not be sufficient: sometimes large or very large surpluses may be needed. This may sound unattractive to policymakers during boom times. But a large fiscal buffer also means that there is no need to cut expenditure sharply during a recession—as several countries were forced to during the current crisis.

Preventing  a repeat of the past overheating is particularly important as competitiveness of the manufacturing sector in many countries in Emerging Europe deteriorated during the boom years. Latvia was the most extreme case (according to European Union data, between 2003 and 2008, unit labor costs in manufacturing in Latvia increased by 90 percent relative to its trading partners), but  Bulgaria (40 percent), and Estonia and Romania (30 percent) also lost competitiveness. That does not mean that competitiveness has already become a problem—the market share of most countries has continued to rise—but it is clear that if this deterioration continues it will certainly become a problem eventually.

Tighter fiscal policy during boom years will help moderate wage growth. Yes, over time, wages will catch up with those in Western Europe. But this catch-up cannot happen overnight—it should go hand in hand with productivity increases in manufacturing. If wages rise by over 20 percent annually—as happened in Bulgaria and the Baltics during the boom—competitiveness will deteriorate quickly, and many investors may think twice before they start building a new export plant.

Finding the right niche

That’s not to say that Emerging Europe should compete on low wage costs only. Not only will be it hard to compete against countries such as China which are also active in this segment; emigration to Western Europe will also make it difficult to keep wages low for very long.

Instead, the region should aim to move up the quality ladder, and produce increasingly sophisticated products.

Here, structural reforms can help. According to the World Bank’s Doing Business Indicators, Emerging Europe’s ease of doing business cannot compete with the best in the world. The highest ranking country, Estonia, ranks only 24th out of 187, closely followed by Latvia and Lithuania. Other countries rank lower—Romania, at 55, is listed just before Fiji and after Peru. Moreover, some of the subcomponents suggest that it may be easier to do business in the non-tradable than in the tradable sector. Bulgaria, which has an overall rank of 44, is ranked 4th in ease of getting credit, but 106 in trading across borders. Improving education and—in some countries—combating corruption will also help.

Still a role for foreign capital

Foreign capital inflows can play an important role as well. Not capital inflows that boost demand, but capital inflows that boost supply. Foreign direct investment in the external trade-oriented sector is particularly helpful, as it will not only boost growth, but also transfer technology and contribute to an improvement of  labor force skills.

Some countries in the region have already been following this growth model. In the Czech and Slovak Republics, growth during the boom was much more balanced than in the other countries. The credit boom was much less severe, current account deficits remained small, and exports were as important to growth as domestic demand. During the boom years, it looked like this growth strategy did not produce growth that was as strong as in the countries with strong domestic demand booms. But the recession has been much less deep, and seen over a longer time period, these two countries have actually grown faster than the countries that relied on the nontradable sector.

Originally published at iMFdirect and reproduced here with the author’s permission.