Turmoil at Twenty: Recession, Recovery and Reform in Central and Eastern Europe and the Former Soviet Union

Half Title

Turmoil at Twenty

Recession, Recovery, and

Reform in Central and

Eastern Europe and the

Former Soviet Union

Title

Turmoil at Twenty

Recession, Recovery, and

Reform in Central and

Eastern Europe and the

Former Soviet Union

Pradeep Mitra, Marcelo Selowsky,

and Juan Zalduendo

Copyright

© 2010 The International Bank for Reconstruction and Development/The World Bank

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ISBN: 978-0-8213-8113-7

eISBN: 978-0-8213-8114-4

DOI: 10.1596/978-0-8213-8113-7

Cover photo shows Riga, Latvia. © istock/Sergey Skleznev

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Table of contents

Table of contents

Acknowledgments

Acknowledgments

We would like to thank the many authors who contributed background papers and notes for this study: Miroslav Beblavy, Thorsten Beck, Andres Bernasconi, Eduardo Bitran, Mario Blejer, Robert Branda, Wendy Carlin, Zsolt Darvas, Santiago Fernandez de Lis, Timothy Frye, Charles Griffin, James Hanson, Valerie Herzberg, Robert Holzmann, Patrick Honohan, Ira Lieberman, Kathy Lindert, Anil Markandya, Mathilde Maurel, Martin Melecky, John Nellis, Trang van Nguyen, James Parks, Aleksandra Posarac, Mark Schaffer, Velimir Sonje, Naotaka Sugawara, Ramya Sundaram, Gyorgy Suranyi, Claudia Vasquez, and Michel Zarnowiecki.

We owe Shigeo Katsu an enormous debt. He conceived the idea for this book while serving as vice president of the Europe and Central Asia region and was a strong intellectual force during the book's execution. He encouraged us to take a broad historical view of the issues, and he provided constant support and guidance.

Many colleagues shared their findings with us. We wish to thank Gavin Adlington, Stijn Claessens, George Clark, Itzhak Goldberg, Christos Kostopoulos, Arvo Kuddo, Patricio Marquez, Fernando Montes-Negret, Mamta Murthi, Ernesto Porta, Roberto Rocha, Pedro Rodriguez, Gevorg Sargsyan, Lars Sondergaard, Victor Sulla, Erwin Tiongson, and Sarah Zekri. Our understanding of the region has benefited over the years from interactions with country economists in the Europe and Central Asia region's Washington and country offices, a number of whom provided inputs to the study. We owe a special thank you to colleagues in the Europe and Central Asia Office of the Chief Economist: Indermit Gill, Elena Kantarovich, Rhodora Mendoza Paynor, Bryce Quillin, and Willem van Eeghen for their friendship and support.

We are grateful to the central bank and financial sector authorities in Bulgaria, Croatia, Estonia, Hungary, Kazakhstan, Latvia, Lithuania, FYR Macedonia, Poland, Romania, Serbia, and Ukraine for making available consolidated banking system balance sheet data, and to colleagues in ECA's private and financial sector unit for following up on these and other requests.

Helpful comments on earlier drafts were received from Asad Alam, Tamar Manuelyan Atinc, Luca Barbone, Sudarshan Canagarajah, Indermit Gill, Daniela Gressani, Roumeen Islam, Philippe Le Houérou, Fernando Montes-Negret, John Pollner, and Martin Raiser. We have also benefited from discussions with participants in early brainstorming sessions in Almaty and Moscow.

Research analysis was done by Lauren Elizabeth Clark and Thi Trang Linh Phu. Charito Hain and Rhodora Mendoza Paynor provided administrative support. Bruce Ross-Larson and Allison Kerns edited the book, and Elaine Wilson was responsible for its design and layout. The World Bank's Office of the Publisher coordinated the design of the book, production, and printing.

Pradeep Mitra

Marcelo Selowsky

Juan Zalduendo

Overview

Overview

The countries in the World Bank's Europe and Central Asia (ECA) region, among all emerging and developing economy regions, are forecast to experience the deepest contraction as a result of the global economic recession of 2008–09. This is partly due to the region's deep integration into the global economy across many dimensions—trade, financial, and labor flows.¹

Trade integration in the transition (formerly centrally planned) ECA countries—measured by the sum of merchandise exports and imports as a share of GDP in purchasing power parity—rose from 20 percent in 1994 to around 50 percent in 2008, about 10–15 percentage points higher than in developing East Asia and Latin America. Turkey saw an increase from 10 percent to 30 percent over the same period. The averages mask substantial variation across subregions—the ratio ranged from a median value of around 35 percent in the South Caucasus, Central Asia and Moldova, where exports are generally intensive in natural resources and unskilled labor, to nearly 85 percent in the new member states of the European Union and Croatia, where exports are intensive in capital and skilled labor.²

Financial openness in ECA's transition countries, as measured by the sum of foreign exchange assets and liabilities as a share of GDP, was 30 percent in 2008—twice that for developing East Asia, with the ratio being as high as 45 percent in the new member states of the European Union and Croatia. Turkey's financial openness, at 18 percent of GDP, is closer to that of developing East Asia.

Labor and remittance flows have followed a broadly biaxial pattern, being dependent on the European Union for the countries of Central and Eastern Europe and on the resource-rich countries of the former Soviet Union for the South Caucasus and many of the Central Asian republics. Indeed, the ratio of remittances to GDP for the poorest countries in the region is among the highest in the world, ranging, for example, between 30 and 35 percent for Moldova and Tajikistan in 2008.

Helped by integration, GDP in the ECA region grew from 2000 to 2008 by two-thirds—an enviable growth rate averaging 6.5 percent a year. And the ECA region made remarkable progress in converging to Western European (EU15) income levels since the late 1990s. In fact, no other region converged as much as a group to the average income of EU15 countries even with the GDP declines currently projected for 2009 (map 1). The decade since the Russian Federation financial crisis saw 55 million people moving out of absolute poverty.³ Globalization lifted many boats, since developing East Asia grew at comparable rates; Latin America less so. Yet those regions have not been equally affected by the current global economic crisis. Interestingly, however, a number of advanced countries in Western Europe have been affected: for every Ukraine, Latvia, and Hungary (three of ECA's hardest hit countries), there is an Iceland, Ireland, and Spain.

MAP 1 Income convergence to the EU15 average income, 2000–09 (projection as of October 2009)

Note: The map reflects the change in PPP per capita incomes as a share of the EU15 average between 2000 and 2009. Dark blue countries have converged the most to the EU15 average income per capita over the past decade; those in gray have diverged the most to the EU15 average income per capita or, for countries higher than the EU15 average, that the EU15 is catching up.

Before analyzing crisis and recovery, however, it is worth noting how far the transition economies of Europe and Central Asia have come since the fall of the Berlin wall two decades ago. Price liberalization—together with the disruption of the organizational arrangements that governed production and trade under central planning—made many enterprises inherited from the command economy unviable. These factors also resulted in transition recessions everywhere but particularly deep and protracted ones in the countries of the former Soviet Union. Macroeconomic stabilization was needed to prevent price liberalization from converting the repressed inflation of centrally planned economies into hyperinflation. And budget constraints were hardened to restructure or close enterprises and make possible the transfer of assets and labor to viable enterprises. Private sector development was sought to be accomplished through privatization, an enforceable set of property rights, and the entry of new private firms. Economic and institutional transformation this major created a difficult first decade of transition.⁴ But processes were set that enabled inflation to fall to single digits in many countries by 2006 and raised the share of the private sector in GDP to 80 percent in Central Europe and the Baltic states. Progress was also made in institutional reforms, whether measured by the EBRD transition indicators or by the World Bank's Doing Business, which has found Europe and Central Asia to be a leading reforming region. And further evidence of institutional catchup comes from business surveys, which show that key elements of the business environment (such as competition and market structure, and finance and the structure of lending to firms) have converged toward those in developed market economies, particularly in the new member states of the European Union.⁵

This book, written on the eve of the 20th anniversary of the fall of the Berlin wall in 1989, addresses three questions that relate to recession, recovery, and reform, respectively, in ECA's transition countries.

Did the transition from a command to a market economy and the period when it took place, plant the seeds of vulnerability that made transition countries (the region excluding Turkey) more prone to crisis than developing countries generally?

Did choices made on the road from plan to market shape the ability of affected countries to recover from the crisis?

What structural reforms do transition countries need to undertake to address the most binding constraints to growth in a world where financial markets have become more discriminating and where capital flows to transition and developing countries are likely to be considerably lower than before the crisis?

Plan of the book

Chapter 1 of the book analyses how countries fell into recession and crisis, why not all of them were equally affected, and whether different policies could have positioned them better to face the crisis. Chapter 2 discusses rescue and stabilization and the role of international collective action. The next two chapters focus on policies for recovery—chapter 3 on restructuring bank, corporate and household debt and chapter 4 on scaling up social safety nets. Chapters 5 and 6 focus on reform, examining the binding constraints to growth and the policy agenda in the most important sectors identified by that analysis.

Recession

For the financially integrated countries, the crisis has hit them primarily through two channels.⁶

There was global deleveraging, triggered mainly by distress in home country financial markets, which together with the unwinding of real estate booms in some host countries, reduced the willingness by creditors to finance current account deficits. These deficits were, as a percentage of GDP in 2008, in double digits in such countries as Bulgaria, Latvia, Lithuania, Romania, and Serbia and in the high single digits in Estonia, Hungary, and Ukraine.

A recession-induced downturn in exports to Western Europe had a negative impact on output and employment in small open economies such as the Czech and Slovak Republics, Estonia, and Hungary where exports accounted for between 70 to 80 percent of GDP in 2008. To a somewhat less extent, this was also the case in larger economies such as Poland and Romania, where the corresponding share ranged between 30 and 40 percent.

For the low-income and lower middle-income countries of the former Soviet Union, such as Armenia, Georgia, Kyrgyz Republic, Moldova, and Tajikistan, the reversal in capital inflows has been less important, but they have been hurt by lower exports and lower remittance flows.

The sharp contraction in the Russian Federation's GDP, estimated at more than 7 percent in 2009, has depressed export demand in Armenia, the Kyrgyz Republic, Moldova, and Tajikistan, for which it is the dominant export market. Furthermore, the marked deceleration in growth in Kazakhstan following the sudden stop in capital flows in 2007 has adversely affected the Kyrgyz Republic, which sends a significant share of its exports to that country. Export demand for Georgian goods, for which the CIS countries are not a major destination, is also projected to fall due to recessions in Turkey, the European Union, and the United States. Indeed, export