Transition since Fall of Berlin Wall Shapes Today’s Crisis and Recovery

November 3, 2009

WASHINGTON, November 3, 2009―The economic policy choices made by some countries of Europe and Central Asia (ECA)* during the transition from centrally planned to market economies contained the seeds of vulnerability when facing the global economic crisis, and are also likely to shape the recovery, says a new World Bank report issued on the eve of the 20th anniversary of the fall of the Berlin Wall.

The report, Turmoil at Twenty: Recession, Recovery, and Reform in Central and Eastern Europe and the former Soviet Union, says many countries in ECA are well integrated today into global markets. While this integration brought many benefits and drove the region’s spectacular growth in the decade since the Russia financial crisis of 1998, it also exposed ECA countries to three channels through which the crisis has hit the region hard: financial, market, and labor.

Excessively rapid catch-up towards Western European living standards by countries that had suffered deep or double transition recessions in the late 1990s, enabled by bank lending at a time of unusually high global liquidity, led to rapid growth, but also created serious macroeconomic imbalances when facing the 2008-09 global crisis. Short-term maturing debt reached extremely high values. But not all financially integrated countries in the region were equally vulnerable. Their experience suggests that tighter fiscal policies, without necessarily insulating countries from the crisis, could have played a stabilizing role, even though the imbalances did not generally originate in the public sector.

The report says that international collective action comprising generous official financing and coordination by Western European parent banks to maintain their exposures in Central and Eastern Europe has allowed maturing external debt to be rolled over, at least so far. Those parent banks were crucial in hardening budget constraints and attaining macroeconomic stability during the first decade of transition.

“The outlook for economic growth in emerging Europe and Central Asia is considerably weaker than that in the years before the crisis,” said Pradeep Mitra, one of the authors of the report and former World Bank Chief Economist of the Europe and Central Asia Region. If parent banks reduce exposures in countries of the region due to recognition of losses in their home market, continuing collective action will be necessary to make this process gradual and less disruptive.”

According to the report, the weak outlook for growth highlights the urgency of proceeding with bank, corporate, and household debt restructuring. Government should set up enabling frameworks for debt restructuring, but resist using public resources since household debt is typically not concentrated among the poorer households.

The poorer countries of the former Soviet Union that are financially less integrated are experiencing the crisis primarily as a result of a downturn in exports and decline in workers’ remittances due to the recession in the Russian Federation. Thus, in Tajikistan, the poorest country of the region, it is estimated that a 30 percent decline in remittances would reduce the consumption of the bottom fifth of households by around 20 percent. While some countries have safety net programs that deliver a substantial proportion of benefits to poorer households, more resources are necessary to scale up these programs where they exist, and introduce targeted programs where they do not. Official financing for a number of years will be necessary to support desirable social spending until a durable recovery is in place.

The report recommends that with capital flows likely to be considerably lower than pre-crisis levels, and financial markets already differentiating across countries, policy makers need to address the most binding constraints to growth in order to improve their business environment and remain competitive.

“It is remarkable that business surveys show infrastructure and labor skills – formerly the main assets of transition countries – not only to be the tightest bottlenecks to the operation and growth of firms, but also more constraining than in non-transition economies at similar income levels. These sectors require urgent reforms,” said Mitra. “However, the surveys also show significant progress after two decades of transition in building institutions of the market economy. For example, tax administration and customs regulation which have traditionally ranked high among constraints to the operation and growth of firms are now seen as less constraining and indeed in line with non-transition economies at similar income levels.”

* The ECA countries include Albania, Armenia, Azerbaijan, Belarus, Bosnia and Herzegovina, Bulgaria, Croatia, the Czech Republic, Estonia, FYR Macedonia, Georgia, Hungary, Kazakhstan, Kosovo, the Kyrgyz Republic, Latvia, Lithuania, Moldova, Montenegro, Poland, Romania, the Russian Federation, Serbia, the Slovak Republic, Slovenia, Tajikistan, Turkey, Turkmenistan, Ukraine, and Uzbekistan.

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