1. An Eastern European Perspective on the Recent Financial Crisis and Poland’s Exceptionalism Nigel F. B. Allington and John S. L. McCombie Centre for Economic and Public Policy Research, University of Cambridge and Downing College

2. INTRODUCTION Consider the impact of the financial crisis and Great Recession on the Eastern European Economies (EEEs) These are Bulgaria, Czech Republic, Estonia, Latvia, Lithuania, Hungary, Poland, Romania, Slovenia and Slovak Republic Review their growth since transition, during and post crisis What economic policies did they implement Case of Poland and why this economy proved to be an exception compared with the rest of the EEEs

3. BACKGROUND TO TRANSITION During transition to market economies growth plummeted, but the recovery to pre-transition rates had been rapid in most cases After accession to EU in 2004 spurt in growth Certainly EEEs achieved high rates of growth before crisis They liberalised trade, encouraged competition through the privatisation of SOE, maintained a stable macroeconomic environment, deregulated labour markets, reformed their tax systems and protected property rights Aghion et al. (2010) growth in EEEs faster than in Eurozone and above world average as they were middle-income countries catching up with the advanced economies EU membership raised FDI as investor confidence grew paralleling developments in SEA during their rapid economic growth phase Borrowed technology from West and achieved significant TFP growth Also strong domestic demand: consumption and investment With the liberalisation of capital accounts in 1990s, capital inflows intensified the financial linkages with WEEs and international economy

4. BUILD-UP TO THE CRISIS Contrarian view of Darvas (2010) that growth due to foreign trade to a greater extent than was the case in other emerging economies Two views only agree on the resulting balance of payments deficit on the current account Certainly the integration process intensified international trade and investment before the financial crisis Abiad et al. and ECB (2012) attribute growth before the crisis to rapid financial sector development Before September 2008 EEEs equity markets out-performed stock markets in WEEs and US By 2007 EEEs vulnerable to external and domestic shocks connected with: high current account deficits, increased private sector debt, greater trade integration with WEEs, a house price bubble and high levels of borrowing in foreign currencies The financial crisis thus raised fundamental questions about the future sustainability of economic growth and the policies to maintain it

5. CREDIT AND TOTAL FACTOR PRODUCTIVITY Financial integration with WEEs fuelled a credit boom in EEEs Expectation that this would raise productivity and further incentivise foreign investors The Baltic States and Czech Republic had the highest TFP growth of between 3% and 4% per annum The differences between states are explained by whether foreign investors undertook green-field investment (higher TFP) or simply acquired industrial plant and built on extant technology (Timmer et al., 2012) Fixed exchange rate also elicited higher TFP EEEs twice the rate of TFP growth of WEEs Manufacturing TFP critical in Poland, Czech Republic, Slovakia and Slovenia and contribution of TFP to growth highest in the export good sector

6. PRE AND POST CRISIS Following the subprime financial crisis, average growth in Eurozone fell from 3% in 2007 to 0.4% in 2008 and -4.6% in 2009 EEEs more severely affected: negative average growth of -7.8% in 2009 with the single exception of Poland that recorded +2.6% Largest falls in growth 2009: Lithuania -14.8%; Estonia -14.7%; Latvia -14.2% EEEs affected more than WEEs had been in Great Depression and SEA in 1997 Crisis slowed reforms, led to expansionary macroeconomic policies and curtailed FDI Econometric analysis shows that the crisis had a long-term impact on output: output might be lower by 1% after one year, but by 12-17% five years after the crisis The impact on the EEE greatest because they were more vulnerable: smaller economies and more prone to banking crises Vulnerabilities: banks’ exposure to currency and maturity mismatches, disruption of international capital markets, bank panics and sudden stop in capital inflows (Furceri and Zdzienicka, 2011)

7. CRISIS AND POST CRISIS: EXCHANGE RATE Countries with floating exchange rates less affected and fiscal policy proved more effective than monetary policy in dealing with the crisis The alignment of the financial and sovereign debt crisis meant that in the longer term the Eurozone economies were more adversely affected than the EEEs But Czech Republic and Slovenia double-dip recession in 2012-13 The key vulnerability indicators in econometric analysis are the external and banking sectors, aspects of monetary indicators including the growth of bank credit (Gallego et al., 2010) GDP fell most where financial system highly leveraged and credit growth most rapid before the crisis (Berkmen et al., 2009) Countries with pegged exchange rates and high levels of foreign trade suffered most Latvia and Estonia pegged currencies to Euro, Lithuania and Bulgaria currency board with Euro Baltic States found imports fell more than exports, so BoP actually improved

8. CRISIS AND POST CRISIS: CREDIT FLOWS EBRD (2009) showed that capital inflows maintained at start of crisis so it took time for the crisis to hit EEEs Credit growth in retreat after tighter lending standards imposed by regulators in EEEs and the banks themselves Capital switched to safer havens, syndicated bank lending fell with the collapse of Lehman’s: sudden stop in bank capital flows from WEEs to EEEs and drop in trade credit From 2008Q4 exports contracted sharply with the decline in manufacturing in WEEs affecting the Czech Republic, Hungary and Slovakia hard Crisis a classic credit boom and bust accompanied by a current account deficit – emerged early in the case of Latvia and Estonia As lending fell consumption and investment collapsed, followed by output Rather like the SEA banking crisis, the crisis in the EEEs abated after two years: one bank failure, Parex Bank in Latvia financed by short-term loans on European wholesale markets By 2010Q3 all economies growing apart from Romania

9. CRISIS AND POST CRISIS: CREDIT Lending rates had fallen between 2005 and 2007 so boom in cheap credit Domestic banks relaxed lending standards using cheap credit from foreign banks However, in early 2007, Poland, Romania and Baltic States tightened loan- to-value ratios for financial institutions Failure of regulators to monitor banks and regulatory capture Also much borrowing in foreign currencies where interest rates were low (mainly unhedged borrowing) Exchange rate risk ignored given pegged currencies or currency boards Intense competition amongst foreign banks to provide more credit As credit dried up, domestic banks forced to reduce lending and as house prices fell ratio of non-performing loans increased Credit boom in the private sector: government debt low with the exception of Hungary and fiscal policy had been mainly counter-cyclical While the private sector accumulated the debt, the public sector had to make the necessary adjustment

10. BANKING SECTOR These factors point to tighter regulation and supervision in future Too many firms relied on bank loans to finance investment and credit boom here contributed to the crisis (Aslund, 2012) The ratio of bank credit to the private sector to GDP rose most in Bulgaria, Estonia and Latvia (11%, 22% and 17% respectively) Cottarelli et al. 2005 This was fuelled by domestic savings, but also heavy overseas borrowing Foreign banks drawn to EEEs by their high growth and interest rates and WEE banks and the Eurozone’s monetary policy had a major impact on the operation of foreign-owned banks WEE banks increased the availability of credit and also accessed international capital markets Only in the case of Poland did special regulations prevent excessive foreign borrowing by banks (regulations S and subsequently T) Through competition the level of credit increased: but potential for sudden stops

11. BANKING SECTOR Poland again an exception having gained a commitment from WEE banks to continue funding under the Vienna Initiative 2.0 De Haas et al. (2014) showed that foreign-owned banks reduced credit growth to 5.2% in 2010 compared with domestic banks that reduced theirs by 19.9%: credit growth fell most in 2008, 2010 and 2011 Foreign-owned banks looked for high worth companies to lend to and therefore tended to lend less compared with the privately owned domestic banks The expansion in the money supply in the Eurozone and the size of the parent bank dictated the lending of WEE owned banks and these tended to use the international capital markets as well (Caporale et al., 2009) While credit increased with a business cycle upturn in the parent country, there was no evidence that a downturn led to lower credit growth While banking stocks fell in the EEEs after the crisis erupted, the profit potential in these economies persuaded foreign-owned banks to continue to lend particularly to Poland and the Czech Republic (only Latvia and Lithuania experienced falling capital flows

12. BANKING SECTOR Capital inflows fell and demand for credit fell with rising unemployment and falling real wages impairing borrowers debt repayment capacity The average level of non-performing loans increased particularly in Latvia and Lithuania, but also Bulgaria and Romania The level of non-performing loans increased least in Poland and Slovenia The fall in GDP drove the increase in NPL (Skarica, 2014 and Klein, 2014) The EEEs did not have significant exposure to the exotic derivatives associated with the subprime crisis Rather domestic lending provided more opportunities for banks in the region, although banking regulations were tighter, particularly in Poland The crisis had more to do with the deterioration in investor confidence in the foreign exchange, equity and housing markets Capital flowed out and asset prices fell leading to a liquidity crunch and lower consumption (through wealth effects) and investment

13. CRISIS AND POST CRISIS Nevertheless the EEEs, even those on pegged exchange rates did not have to devalue – they attempted to remain on course to join the Euro by abiding by the Maastricht criteria. The Baltic States joined during the crisis They preferred to follow a policy of internal devaluation by lowering public expenditure and wages Those on floating exchange rates witnessed rising inflation as import prices rose Money market rates rose reaching their highest levels in 2007 in Slovakia and in 2008 in the Czech Republic, Lithuania, Hungary, Poland and Romania Some economies had vibrant manufacturing and sound macroeconomic fundamentals, others were more vulnerable exhibiting credit, consumption and house price booms

14. CRISIS AND POST CRISIS The crisis therefore caused a correction that might have been anticipated and changed the growth path of some EEEs The exchange rate regime adopted also had an impact on their growth prospects Those that pegged their exchange rates found that convergence with the WEEs resulted in higher inflation rather than an appreciated currency The credibility of the exchange rate increased borrowing in Euros where the interest rate was lower: as inflation exceeded nominal rates real rates were negative This fuelled the credit boom, consumption, construction and house prices Wages rose in response and so did inflation fuelling a growing balance of payments deficit FDI in manufacturing increased where there were floating exchange rates while FDI increased in the financial sectors and housing where rates were fixed (Aslund, 2010) This had implications for the competitiveness of the economies

15. CRISIS AND POST CRISIS Also, real wage increases in excess of productivity caused problems where the exchange rate was fixed These economies also had large non-tradable sectors creating a competitiveness gap Those with floating rates did much better Generally the EEEs needed to improve their competitiveness in the wake of the financial crisis to avoid higher unemployment, particularly in the countries with fixed exchange rates Infrastructure needed to be improved and this would improve their competitiveness too FDI important contribution to EEEs growth Their banking sectors opened up to foreign investment By 2008 foreign banks owned 80% of banking sector assets in most EEEs Largest recipients FDI: Bulgaria, Czech Republic, Estonia and Slovakia Less volatile and more beneficial for growth (von Hagan and Siedschlag, 2008)

16. CRISIS AND POST CRISIS: FDI What determined FDI? Traditional variables: market size, trade costs, plant and firm specific costs Transition-specific variables: privatisation (share of private businesses), method of privatisation, risk factors Carstensen and Toubal (2004) find both important in EEEs Rapid growth depended on domestic demand financed by capital inflows that generated large external imbalances with the exceptions of Poland, Czech Republic, and Slovenia Expansionary effect of capital inflows partially offset by tight fiscal policy FDI covered current account deficits in Poland, Czech Republic and Bulgaria, whereas produced a surplus in Romania

17. CRISIS AND POST CRISIS As wages and house prices rose, economies became less competitive and with the financial crisis output fell, unemployment rose (worst in Baltic States and Slovakia where in excess of 15% and remained elevated until 2013 With fall in exports and outflow of capital EEEs on the brink of their own crisis with unsustainable current account deficits Gallego et al. (2010) date crisis in EEEs from September 2008 with collapse of Lehman’s and retrenchment in capital flows Most vulnerable economies exported-orientated or financially dependent (Aslund, 2010) Crisis policy measures a mixture of tax rises and expenditure cuts Those on fixed exchange rates cut wages and expenditure rather than devalue

18. CRISIS AND POST CRISIS Reforms in public administration, health care, education and further labour market deregulation took place Taxes switched away from income and profits to consumption (excise and VAT) and property, with the tax burden increasing Flat taxes remained popular Migrant remittances from WEEs fell from 2008Q4 Despite the depth of the crisis, recovery was swift as growth returned and current account balances improved from mid-2010 Baltic States recorded turnaround growth above 20% 2009 to 2010 Hungary, Latvia and Romania accepted IMF emergency programmes

19. POLAND’S EXCEPTIONALISM Poland’s transition was painful, but short-lived In 2000s before crisis growth averaged 4% and economy grew throughout the crisis Unemployment remained stubbornly high around 10% (high in most EEEs), but inflation within 2.5% +/- 1% target IMF forecasts growth of 3% pa up to 2019 Growth connected with strong domestic consumption (UE fell in 2007 and 2008) SME sector crucial to growth in employment, consumption and exports (Polish Agency for Enterprise Development, 2010) SME contributed 47% to GDP growth in 2008 Credit expansion in Poland below that in the rest of EEEs and interest rates kept high by Polish Central Bank to bear down on inflation Interest rates consistent with the Taylor rule (Maria-Dolores, 2006 and Frommel and Schobert, 2006)

20. POLAND’S EXCEPTIONALISM Ratio of credit to GDP rose precipitously from 25% to 50% between 2004 and 2009 and lending in foreign currencies increased However, risk mitigated by intervention of Polish Banking Supervision Authority and Liquidity Risk Management Act that lowered volume of lending and Resolution 386 imposed binding liquidity standards on all banks based in Poland Assets and liabilities assessed by liquidity and stability and quantitative and qualitative benchmarks set December 2010 all banks had met the requirements (Kruszka and Kowalczyk, 2011) Moral hazard thus limited Polish Financial Supervision Authority guided banks on derivative markets so toxic assets only 0.2% of total financial assets Bank profits no distributed in 2008 Capital adequacy ratio 12.5% throughout crisis (will be 13% under voluntary Basel III rules)

21. POLAND’S EXCEPTIONALISM But Basel III not to be implemented until 2019 Foreign owners 68% of assets in the Polish banking sector Largest holders: Italy, Germany, Netherlands and France Exposure to single country reduced, but not to the whole Eurozone Expansion in foreign currency lending, but inflow smaller and less volatile than it was in other EEEs FDI the most stable inflow of capital: $US23bn in 2007 Parent banks did not repatriate capital during the crisis, rather increased investment (de Haas and van Lelyveld, 2014 dispute this) Combination of strength of economy and robustness of regulatory regime account for continued support for Poland Foreign exchange lending controlled through Regulation S (management of credit risk) Also Regulation T similar to S, but related particularly to low-income borrowers and stress test of their of ability to repay From 2010 legally binding rules and risk weights introduced

22. POLAND’S EXCEPTIONALISM Poland received FDI before the crisis because of the economy’s perceived strengths and continued to do so during and after the crisis Combination of high investment yields, skilled low-wage labour, natural resources and pivotal position within EU FDI from Germany, Netherlands, Sweden and projects sponsored by US (36), UK (15), Korea (14) and China (13) in 2011 In Ernest and Young’s European Attractiveness Survey 2013, Poland ranked first as destination for FDI In 2012 FDI responsible for 148 new projects (22% up on the previous year) and 13,000 jobs 2011 FDI equivalent to 42% of GDP Poland major centre for out-sourcing and off-shoring (Leven, 2012) Eurozone crisis lowered FDI inflow from area, but special economic zone and more favourable tax regime should reverse this

23. POLAND’S EXCEPTIONALISM Poland less affected by the crisis because less dependent on foreign trade compared with other EEEs (33% of GDP in 2004 and only 45% in 2012 compared with 78% in Czech Republic and 90% in Estonia) Polish exports also more diversified Imports fell during the crisis improving the BoP, but Zloty depreciation nonetheless raised inflation House price boom in Poland given availability of credit and cheap foreign loans Supply side bottlenecks also partly responsible for rise in prices But tight regulations meant bubble less than it might have been Poland’s exceptionalism thus a combination of: high domestic consumption, low export/GDP ratio, a vibrant SME sector, high levels of FDI and macroeconomic prudence

24. CONCLUSIONS EEEs enjoyed rapid economic growth driven by credit growth, large FDI, strong world growth and easy global liquidity Converging with WEEs and prospect of adopting the Euro (Slovenia 2007; Slovakia 2009; Estonia 2011; Latvia 2014; and Lithuania 2015) Vulnerability indicators benign until 2008Q3 Asset prices fell in parallel with collapse in world trade and external demand Contraction in investment and decrease in private consumption Proportion of non-performing loans increased Post 2009Q3 growth outlook improved Institutional reforms delayed during the crisis now need to be introduced Poland was an exception due to its fortuitous policies