Challenges to CEE economies

For over three years now, Europe has been beset by an economic cataclysm the like of which has not been seen since the 1930s. The European Union (EU), particularly those member-states within the euro currency union, is faced with an unprecedented set of problems and seems to lack any agreed upon vision of how to find a way through them.

The apparent inability of European leaders to understand the root causes of the crisis, let alone propose swift and workable solutions, has led to turmoil in the financial markets in recent months, as well as credit rating downgrades for several European states and for the EU’s financial stability fund. The euro currency union has lacked rigorous central budgetary controls. A single interest rate and currency policy cover vastly divergent economic needs in the Eurozone, the space within the EU where the euro is used. Combined with the budgetary or banking recklessness of several member-states, this has led to what is called contagion — debt crisis in one or two Eurozone states leading to the undermining of market confidence in the ability of the currency bloc as a whole to fund itself. Countries that could traditionally devalue their way out of crisis no longer have such an option, while one member-state’s trouble affects the viability of the entire bloc. It’s a seemingly intractable mess that some regard as the inevitable result of squeezing so many countries into a one-size-fits-all currency policy.

A “fiscal compact” has been proposed by France and Germany, allowing for moves toward fiscal union and tougher budgetary control. Some, however, believe that the measures proposed are too weak and the processes involved too cumbersome. Division exists even between these two states on how to proceed. Germany has resisted allowing the European Central Bank (ECB) to produce so-called Eurobonds (replacing the theoretically weaker individual national bonds) and opposes measures that could lead to inflation. The French idea of a “transfer union” in which there are systemic transfers of wealth from the core economic powerhouses to the debt-laden periphery is viewed, probably not unreasonably, as a means of institutionalizing moral hazard — the cautious and industrious Germans writing blank checks for the reckless Mediterranean nations in perpetuity, according to this perception. Italy, for example, alarms market analysts because, unlike Greece, Ireland and Portugal, it is simply too large for the EU to be able to lend sufficient funds to, should borrowing on the bond markets become too expensive. Meanwhile, Greece moved to strike a deal to write off the most outstanding money owed to bondholders, a move that might allay fears and provide breathing space for EU leaders to come to a more impressive and permanent agreement. It is difficult to predict with any confidence what will happen to the euro in the coming months — whether there will be multiple defaults, countries leaving the bloc, a complete break-up or a relatively rapid return to stability.


Central and Eastern Europe

Why does the Eurozone crisis matter in relation to the emergent economies of Central and Eastern Europe (CEE)? The CEE region — which we shall take in this article to include those already in the EU or anticipating accession in the foreseeable future and to exclude nations such as Russia and the Ukraine — has become increasingly intertwined with the countries that now make up the Eurozone since achieving freedom from the Soviet sphere of influence in the early 1990s. Ex-communist countries such as Estonia, Slovakia and Slovenia have already adopted the euro currency, while several other former Warsaw Pact nations are obliged to work toward convergence with the currency in order to join it in due course.

Some nations in the region, such as Poland and Hungary, have been hit hard by the Eurozone crisis due to the amount of domestic debt held in foreign currencies. Nonetheless, at the Euromoney Central and Eastern European Forum in Vienna on January 18, 2012, central bank members from within the CEE reiterated their desire to join the euro currency bloc despite the current uncertainty about its future. The deputy head of Croatia’s central bank reaffirmed his belief that Croatia’s accession to the euro is in Croatia’s best interests. Hungary’s central bank head went further, stating that Hungary is already more integrated with the economic core of the Eurozone than the smaller peripheral nations of the Eurozone are, and that western Eurozone nations should take into account the views of non-Eurozone CEE states for this reason. It might indeed be argued that the old East-West split that has for decades divided Europe is being replaced by the divide between those at the economic core of Europe and those at the periphery, particularly the Mediterranean nations and possibly Ireland. Latvia, recently bailed out by the International Monetary Fund (IMF), is looking to join the euro by 2014, as Romania is by 2015, while the slightly more cautious Poles and Czechs still intend to at least meet the criteria for joining by 2015.

There are some striking characteristics common to most of the CEE region. One is the demographic timebomb facing much of the region. A collapse in the birthrate in many post-communist nations since 1991 has led to a structural imbalance that could cause a pension and health care crisis in the near future. This problem has been exacerbated by the emigration of young, educated people to other areas of the EU. Latvia is a striking example of this phenomenon. Its EU entry in 2004 led to a hemorrhaging of young people to other parts of the EU. 10% of the population left in seven years, with perhaps 100,000 expected to follow them in the next four years. Latvia is an extreme case, but other nations also have to deal with an aging population. In 2007 the World Bank predicted that over one-fifth of the population of Poland and nearly a quarter of the population of Slovenia will be over 65 by 2025. One consequence of this is that much of the CEE region will become even more export-dependent than it already is. Balkan nations such as Serbia, Croatia and Bosnia have staggering levels of unemployment among young people, in excess of 50% across the region. Serbian graduates exhibit the second-highest “brain drain” in the world, according to the United States Agency for International Development. This problem will become worse if and when Serbia accedes to the EU.

The CEE region shares a common history of Soviet domination followed by a rapid correction — some might say over-correction — toward free-market liberalism. Since 2007, several states have suffered from the collapse of speculative bubbles, particularly in property, and from banking crises caused by excessively lax regulation. The EU and the euro itself have been regarded within CEE as important guarantors of liberty from Russian domination. This perhaps explains the relative eagerness displayed by CEE politicians and bankers for membership of the euro currency.

CEE has also commonly seen high inward investment in recent years, particularly in the banking sector, which has led to credit-driven demand and subsequent debt problems. In much of the region, foreign banks control between 60% and 90% of banking assets. Swedish banks are prominent in the Baltic countries, while Greece’s largest banks have expanded into the Balkans and Romania. CEE was seen as a fast-growing and profitable area to expand into from the over-saturated West. The economic crash revealed high levels of debt created by cheap credit from western banks combined with much private debt being held in foreign currencies and capital flight from the domestic currencies. The IMF-backed Vienna Initiative of 2009 led to a relatively successful effort on the part of the banking industry to promote local capital markets, funded by domestic savings rather than cheap foreign credit. A second initiative this year faces a tough challenge, though, as struggling Western banks freeze lending and, in some cases, leave the CEE area altogether. One possible solution might involve EU institutions providing direct funding to replace the withdrawal of bank liquidity.

Living standards throughout CEE continue to lag behind those of Western Europe. Welfare benefits and public sector jobs and pay are a fraction of what they are in the West. Despite this, and somewhat controversially, Eastern members of the EU, whether or not members of the Eurozone, have been asked to contribute toward an EU loan of up to 200 billion euros to an IMF fund to help bail out indebted Eurozone nations in Southern and Western Europe. Even though most of this money is expected to come from Eurozone members, many non-euro EU nations in this region are hostile to the plan. The Czech Republic, Slovakia and Hungary are all reluctant to help alleviate a crisis that they see as being none of their making. They regard a wealth transfer to subsidize the perceived profligacy of countries such as Italy as obscene. Some, particularly the Czechs, also have an eye on their own credit ratings on the bond markets, hoping to avoid anything that might worsen their own debt position.

The Polish Prime Minister, however, perhaps eager to establish Poland’s credentials as an EU power, has argued that contributing to such a fund involves a self-interested selflessness in that helping prevent an economic disaster for Poland helps prevent one for the Eurozone. There is also recognition that the EU previously contributed 100 billion euros toward a rescue fund for CEE economies in distress, used to aid Romania, Hungary and Latvia. This division in CEE views mirrors the division in the West — a struggle of ideas between unilateralism and communitarian spirit.

Individual economies

It is necessary to assess each country (and even areas within a country) on its own merits, despite regional commonalities. The Baltic nations provide a stark example of this. While Latvia, as previously mentioned, has suffered an economic and demographic catastrophe in recent years, its neighbor Estonia seems to be weathering the storm well. The crash of 2008 hit Estonia hard, with unemployment reaching nearly 20% and high private debt figures, but it then experienced a remarkable, export-led recovery. This regrowth is expected to slow down in the coming year, but will still, if predictions by the Organisation for Economic Co-operation and Development (OECD) are borne out, outperform most other European economies. The export-led growth is leading to a growth in domestic demand too, given an improvement in incomes, though wages have been kept relatively low to improve competitiveness. Emphasis has been placed on “business friendly” regulation, and there has been targeted investment in the export-driven manufacturing sector. The OECD has encouraged Estonia to market itself as a base for export-oriented investment in the region. Estonia’s adoption of the euro, which has experienced a prolonged period of extremely low interest rates and a depreciating value, will serve to encourage further growth in exports beyond the Eurozone, but that situation cannot last forever. Germany’s traditional abhorrence of inflation is bound to reassert itself in terms of a pressure on the ECB to gradually increase interest rates in coming years.

Strong exports are also expected to help counter the effects of weaker domestic demand in Poland. Decreased growth due to tax increases and spending cuts, combined with the expected slowing of growth in the Eurozone, is forecast, according to the OECD, to be mitigated by the depreciation in value of the zloty. Poland’s major trading partner is Germany, and its main import/export markets are in machinery, transport equipment and manufactured goods. There are hundreds of small and medium-sized businesses producing car parts for German cars, for example, while Fiat’s one Polish assembly plant produces more cars than its five Italian plants combined, despite a smaller workforce. Poland’s lower-cost labor force has seen manufacturers move in from the higher-waged West. The joint staging with the Ukraine of the soccer European Championships this coming summer is also anticipated to help counter the risk of recession. Infrastructural deficiencies, low-level corruption and oppressive bureaucracy have been said to stand in the way of optimum economic performance, problems typical to many nations in the CEE region.

The Czech Republic, also hugely export-driven, is expected to experience a deterioration in exports in the coming year before picking up again in 2013. 20% of Czech manufacturing is in automobiles and related products; it produced one million cars for the first time in 2010. 80% of those were for export. It is now fifth and Poland sixth, ahead of Italy in European vehicle output. Another sharp Eurozone crisis or a marked increase in world protectionism would undermine the chance of such a revival. The pace of recovery in the Czech Republic has been markedly weaker than that of its neighbors, with growth expected to fall by half a percent to 1.6% in 2012, despite a relatively benign public and private debt situation. The Czech koruna has been rising in value against the euro to the point where some talk of it as a currency safe haven, but this has decreased the competitiveness of exports to its principal trading partner, Germany, and has conversely made Eurozone imports cheaper.

Romania’s exports, mainly in machinery, textiles and metals, have recovered well since the crash of 2008, yet domestic economic performance is sluggish, leaving gross domestic product (GDP) well below what it was in 2007. An IMF assistance package in 2009 has been followed by tough austerity measures, and growth is only beginning to return at a low level. Bulgaria has had slightly better growth, but exhibits many of the patterns common to the CEE region — high dependence on exports, high dependence on the strength of the German economy, high levels of foreign debt held privately and weakened domestic demand. Bulgaria is in the euro convergence group, but inflation is relatively high, worsening competitiveness. Bulgaria is more dependent on Russia for imports than other countries in this region. Corruption and organized crime remain stubborn problems.

Slovakia has been recovering better than its Czech neighbors, despite an expected slowdown in exports in the coming months, high unemployment, and budgetary constriction. Again, an export-driven boost to growth might follow by the end of 2012, but this depends on the state of international trade. One-fifth of exported manufactured goods are vehicles. Slovakia is one of a number of CEE economies that has been encouraged by the OECD to restructure its energy consumption toward renewable energies and to reallocate resources to this end. This sector might, if the pressure from without is insistent enough, prove to be a particularly well-subsidized growth area in years to come.

Hungary is something of a special case within CEE. The ruling Fidesz party, led by Viktor Orban, has implemented a new constitution that has led to accusations of a slide toward autocracy. The EU and the IMF, with which Hungary had been negotiating a credit line to help ameliorate its position as central Europe’s biggest debtor, have suspended talks with the Hungarian government. This was done in protest against moves such as the perceived politicization of Hungary’s central bank. Orban has also merged the central bank with the state regulator, which some see as a state takeover; has changed electoral laws in a manner that critics suggest favors his own party; and has increased state involvement in the national fiscal council and the monetary council. Controversial judicial and media powers have been acquired in addition. Several of these moves break EU treaty obligations.

This comes at a time when Hungary is seeking between 15 billion and 20 billion euros from the ECB and IMF to help counter public debt standing at 80% of GDP. Its credit rating has been reduced to junk status, bond yields have been at around the 10% mark, and unemployment at 11%. The forint has depreciated markedly in value, and interest rates are rising. There has been a strong capital flight from the forint, and around two-thirds of private debt is held in Swiss francs. The OECD has predicted recession for Hungary, driven by low confidence, investor worry at the political turmoil and a brutal fiscal tightening. Exports, as elsewhere, have been a relatively bright spot, though there are signs that they are beginning to decline along with industrial production. Orban, who inherited much of the economic mess and an utterly neglected eastern half of the country from his Socialist party predecessors, might possibly be using the controversial measures as bargaining chips with which to negotiate a less onerous deal with the IMF and EU, or else is ready to go it alone. The situation has yet to be resolved.

In the Balkans, Slovenia is a member of the Eurozone already — the first of the post-communist states to join, in 2007 — while Croatia is due to join the EU this year. Bosnia-Herzegovina might possibly apply to join the EU this year. Its unique status has led the EU to set relatively lenient requirements for membership application. Croatian accession might cause Bosnia trouble in the medium term, though, particularly in terms of Bosnian farmers conceivably being barred from access to an important export market. Thousands of small farmers could, if special arrangements aren’t negotiated, see their livelihoods jeopardized by not being able to sell meat, eggs and dairy products at a competitive price within the EU’s tariff walls. Business development throughout the Balkans has been slowed considerably by the gap between available jobs and labor-force skills, and unemployment, as mentioned, is horrifically high. The Balkans and southeast Europe do not have the same scope for export-led growth that the increasingly muscular producers of central Europe have. This will hamper their efforts to recover economically.


Future recovery

The ability of the CEE nations to recover further from the economic catastrophe that has occurred depends to a large extent on the ability of the leaders of the Eurozone nations and the EU itself to overcome petty bickering and unilateralism in order to confront the underlying causes of this crisis. The strength of the German economy, as it is the prime economic engine in the EU, is of vital importance to the export-led growth of the CEE states, be they Eurozone members, EU members or EU candidates. The vast majority of auto production in the region, for example, results from German investment, and tens of thousands of jobs depend on it.

Conversely, the strength of the emerging post-communist economies is of vital importance to the West, particularly to Germany and Austria, who themselves rely to an ever-increasing extent on these export markets for their own goods. CEE nations rely on Germany for quality goods. Low domestic demand in many CEE states is bound to affect imports, though the current weakness of the euro offsets that to some extent for Eurozone exporters. Lower wages made the CEE area an attractive base for foreign employers, so it was foreign bank credit that enabled high consumption of German imports. The credit squeeze, combined with unemployment, fiscal retrenchment and high private debt, reduces CEE capacity to maintain that level of imports.

The current emphasis on austerity is in danger of driving the EU back into recession, causing a deflationary spiral and a collapse in aggregate demand. It also risks leading to one or more nations on the Eurozone periphery defaulting on their debts and a possible contagion-led break-up of the Eurozone. The fiscal monitoring measures being proposed to accompany monetary union have been seen by some as insufficient to convince investors and speculators that enough has been done. The inherent contradiction involved in having a single interest rate and a single currency policy for such a wide range of economic needs over such a vast area, and the inherent risk of prudent member-states being held hostage by the reckless profligacy of others, has not been sufficiently addressed. It seems more likely than not, however, that the Eurozone will survive and eventually overcome the crisis that currently besets it, though the contradiction will likely re-emerge in the form of crises in years to come. It is doubtful that the prospect of possible future instability would deter many CEE states from joining the single currency, however. Membership of the euro is, to many people of post-communist Europe, about more than monetary policy. Adopting the currency is seen as a symbol that their future lies with the West, not the East, after so many years spent cut off from those with whom they are now trading so well.

Several CEE nations have the potential to become powerhouses of European production, as well as major consumers of foreign goods. CEE peoples have triumphed over much worse adversity than their present economic fragility. Much will depend on how they deal with their own structural problems, particularly an aging population and the mass exodus of their young, and on how their Western neighbors choose to respond to the problems that threaten the social and economic well-being of all Europeans, no matter where they are.