USAIDKYIV June 2009 Causes of the Crisis, Transmission to EE, Impacts & Recommendations Paul Marer, Ph.D. Business School Central European University, Budapest USAID Conference: Competitiveness & Growth

USAIDKYIV June 2009 Outline Causes of the global crisis; remedies Transmission to WE and EE –10 EU members – 7 West Balkans – 4 Other Eur: Russia, Ukr, Bel, Moldova – 8 Caucasus (Arm, Az, Ga) & Central ___ Asia (the 5 “stans”) 29 countries

USAIDKYIV June 2009 Outline (cont’d) Commonalities in EE Differences Economic & social impacts of the crisis Outlook Recommendations

USAIDKYIV June 2009 Global Crisis: Causes & Consequences Causes: –Persistent global S imbalances between Asia vs America and Europe, incl EE. –Financial manip. system-wide problems –Authorities were dozing at the wheel Consequences –Huge losses for financial institutions; credit markets froze –Fin. crisis spread to global real economy

USAIDKYIV June 2009 Global Crisis: 3 Remedies Massive additional fiscal spending (if the resulting deficits can be financed) Easy monetary policy Restore the financial sector’s health –Establish potential losses (“stress test”) –Remove losses from bank balance sheets –Recapitalize the banks (private or public) The US is moving faster than Europe

USAIDKYIV June 2009 Transmission to WE & EE UK, Irish, German (!) banks also made poor investments before the crisis. As world markets slumped, WE’s trade- dependent economies turned south. With a delay, EE’s even more trade- dependent economies also plunged.

USAIDKYIV June 2009 Pre-Crisis Commonalities in EE Rapid integration into EU & global economies –Increase of X + M as % of GDP –Even more rapid increase of foreign financial assets + liabilities as % of GDP –Large net FDI inflows productivity growth Net importers of K (except Russia) Large CA deficits, financed by K inflows Foreign ownership of the banking sector Rapid domestic real credit growth

USAIDKYIV June 2009 Foreign Banks Dominate

USAIDKYIV June 2009 Commonalities in EE During the Crisis Banking problems are not as bad as in the US or WE (few toxic assets, low leverage); Ukraine the main exception. Foreign bank ownership an advantage IMF & others IFIs are helpful –During past 9 months, more than 50% of IMF’s $155b in new loans were committed to EE

USAIDKYIV June 2009 Differences in EE 1.Fiscal deficits & public debt especially high in Hungary; current-account deficits very large in some countries (Bu, LA, Es, Lit, Ro)

USAIDKYIV June 2009 Differences (cont’d) 2. Different ER regimes –Euro: Slovenia (2007) & Slovakia (2009) –Pegged to Euro: Baltic states, Bulgaria –Most others: “managed floating” (Pros and cons of adopting the Euro)

USAIDKYIV June 2009 Differences (cont’d) 3. FC borrowing vulnerability if (1) local currency ER and (2) the country has insufficient FC to service foreign debt. Large differences among 11 EE (no data for others) –Very high: Latvia, Estonia –High: Hu, Bul, Rom, Lith, Slovenia, Croatia –Low: Czech (!), Slovakia, Poland Especially vulnerable are countries with high private FC borrowing + high government debt (some of which is in FC), e.g., Hungary

USAIDKYIV June 2009 Economic Impacts of the Global Crisis on EE All EE suffered 3 big external shocks: 1.Plunging demand for X 2.Dramatic decline in K inflows 3.Severe contraction of domestic credit (reflecting in part the lower availability & higher cost of credits from abroad) Ave. GDP 6% (same as WE); double digits in the Baltic countries & Ukraine

USAIDKYIV June 2009 Social Impacts Extreme hardships for many people. Populations not aware that most countries face similar problems. So far, the chief protest in the voting booths, few violent street demos. Especially impressive is the Ukrainians’ and Latvians’ patience.

USAIDKYIV June 2009 Outlook for West Europe EE’s econ. fate is tied to WE (Central Asia’s is tied mostly to Russia) For West Europe - the worst decline is probably over, but - recovery’s timing & shape uncertain; - medium-term prospects: slow growth ( What will replace the growth engine of excess C in America and Europe? Also, rigidities)

USAIDKYIV June 2009 Outlook for EE Prognosis for WE is unfavorable to EE!! Consider EE’s apparently successful growth model (mid-1990s through 2008) 1. Rapid trade/finance integration w/WE (made possible by globalization) 2. Large K-inflows Δ productivity & improved SOL & financed CA deficits 3. Appreciating real ERs improved SOL EE’s growth model to date meant that sources of growth, productivity and competitiveness (1 + 2) were largely externally generated.

USAIDKYIV June 2009 Outlook for EE (cont’d) This growth model is not sustainable: 1. Globalization will slow, so further rapid integration (growing trade/GDP ratios) will be much more difficult. 2. Large K inflows are likely to slow, for the above reason and because wage rates have become more attractive in Asia & LA. And diminished K inflows will make it more difficult to continue to finance large CA deficits and thus excess C.

USAIDKYIV June 2009 Dramatic Slowing of K-inflows to EE

USAIDKYIV June 2009 Recommendation to Policymakers in EE In the future, EE must rely more on internally-generated sources of productivity and competitiveness. The list & cross-country measurement of practically all the important domestic factors of competitiveness are found in the annual Global Competitiveness Reports ( World Economic Forum ).

USAIDKYIV June 2009 Recommendation to USAID In each target country, USAID should identify, in cooperation with the local authorities, select a few factors of competitiveness where the country lags and do what it can -- in partnership with the authorities and with the private sector -- to transform competitive disadvantage factors into new sources of productivity & comp. advantage.