The Global Economic Crisis and the Transition Economies by Robert C. Shelburne United Nations Economic Commission for Europe

Transcription

1 The Global Economic Crisis and the Transition Economies by Robert C. Shelburne United Nations Economic Commission for Europe Project LINK Conference Bangkok, Thailand October 26-28, 2009

2 The Global Economic Crisis and the Transition Economies by Robert C. Shelburne 1 I was asked to speak today on how the current economic and financial crisis has impacted the transition economies, to provide a short-term outlook for their recovery and to discuss what might be some medium-term implications for these countries. Technically, in UN parlance, the economies in transition (EiT) covers the economies in south-east Europe which are not in the EU (SEE-6), and the CIS. Therefore I will concentrate my remarks today on those economies. However, I will also say a few things about the EU new member states (NMS) because they have been particularly affected by this crisis and their situation therefore needs to be discussed, but no one else in this conference has said anything about them. In addition, at the UNECE, these economies are included in our group of European emerging markets (EEM) and, as such we often include them in discussions about SEE and the CIS. 2 Let me begin with this map of the world, I think it summarizes quite clearly a major point I want to make today, that being that the EiT and NMS have suffered disproportionately from the current crisis. The tan and green areas represent countries 1 United Nations Economic Commission for Europe. This paper is the text of the comments made with the accompanying power-point slides at the LINK meeting in Bangkok, Thailand on October, 27, The follow-up comments made by participants at the conference (especially those of Martin Linpere (Bank of Estonia, Tallinn, Estonia), Andras Simon (Corvinus University of Economics, Budapest, Hungary), and Kirill Mikhaylenko (Center for Macroeconomic Analysis and Short-term Forecasting, Moscow, Russia) have been incorporated into this paper. My opinions on this subject have also benefited from my daily discussions with my UNECE colleague Jose Palacin. 2 A broader analysis of the impact of the crisis on the entire ECE region can be found in Robert C. Shelburne, The Global Economic and Financial Crisis: Regional Impacts, Responses, and Solutions: The ECE Region (Europe, North America, and the CIS), New York: United Nations, 2009, chapter II, pp Also see the UNECE July 2009 report (E/2009/16) on the economic situation in the region which was prepared for the annual meeting of UN Economic and Social Council (ECOSOC). 1

3 expected to have positive growth in 2009, the tan represents growth over 3%, and the darker the tan the higher the growth. The blue and black represent negative growth; in black are those expecting a real decline in GDP of 6% or more. A growth decline of six percent or more is quite large by almost any standard. Other than Mexico, the black area is almost exclusively in the European emerging markets. The worst hit economies have been Ukraine (expected GDP of -14.0% in 2009) and Armenia (- 15.6%) in the CIS and the three Baltic economies, Estonia (-14.0%), Lithuania (- 18.5%), and Latvia (-18.0%). The Russian economy dominates the region and is expecting a GDP decline of 7.5%. There are a few exceptions to this bleak pattern, however, as the central Asian CIS along with oil-rich Azerbaijan are likely have positive growth in 2009; Kazakhstan is the one exception with a growth decline of - 2.0%. Poland and Albania are the only European economies expecting growth in Poland not only avoided creating vulnerabilities for itself prior to the crisis (although foreign currency-denominated debt was an exception) but also benefited (as did Albania) from a flexible exchange rate that was allowed to depreciate during the crisis. What is also a bit surprising about the map is that the European emerging markets are the only region to be really seriously negatively impacted that did not own significant amounts of the sub-prime assets that were at the center of the crisis. Asia has continued to grow fairly rapidly, Africa and the Middle East are doing OK and although some of the economies in Latin America may experience negative growth, they are just barely negative. In fact the last speaker (Osvaldo Kacef, UN- ECLAC) suggested that the region s largest economy, Brazil, will actually achieve positive growth in 2009 (although I have it in negative territory). We would expect the US and western Europe to be negatively affected since they owned almost all of the sub-prime assets. The basic question then is why did the EEM region that owned few sub-prime assets experience the worst of the financial crisis? There are several significant reasons; the region traded heavily with western Europe which suffered extensively, and some economies, especially Russia, were major exporters of oil, and the price of that commodity collapsed in the spring of this year. But the major reason was that the EEM region was heavily dependent on external capital to finance its development, and when global capital markets froze after the collapse of Lehman Brothers, their domestic capital markets also froze as did their economies. This was the case not only for those economies running large current account deficits and thus dependent on net capital inflows, but even Russia and Kazakhstan, which had an overall surplus on their current accounts, nevertheless had private financial sectors that were heavily dependent on foreign capital inflows. In more traditional economic language, these economies experienced a sudden stop which precipitated a hard landing. 2

4 Before going into more detail about this, let s look at the forecast for As you see on the map, growth returns to most of the world and is expected to be quite robust in most of the developing world in Asia, Africa and Latin America. Growth returns to the EEMs except for those that have been particularly impacted in the Baltics, Bulgaria, and Hungary. Central Asia has quite strong growth. Note also that a few of the worst hit economies in western Europe Iceland, Ireland, Spain and Greece may also still have negative growth for In this next chart I provide some more historical background on the recent performance of the transition economies. Since 2000 the transition economies (in red) have performed roughly similar or even slightly better than the world s emerging and 3

5 developing economies (in blue) overall. However, in 2009 the EiT decouple completely and not only do much worse than the developing economies but even worse than the advanced economies. The actual decline in growth rates in the EiT is over twice that experienced elsewhere in the world. Thus the EiT go from a growth rate of around 8% prior to crisis (i.e., 2007) to -7% in 2009; that s a 15 percentage point turnaround. The emerging/developing economies and the advanced economies experienced only a 6 percentage point turnaround, i.e., from 8% to 2% for the former and 2.5% to -3.5% for the latter. By this measure then, the EiT experienced twice as much of a decline as everybody else. The next chart provides the medium-term growth record of the various subregions of the UNECE. Clearly the CIS was the fastest growing sub-region over the last decade followed by the EU new member states (NMS) and south-east Europe (SEE-6). It is somewhat surprising that SEE has performed as well as the NMS over this period given the supposedly large benefits of EU accession; this is all the more the case given the political instability in SEE. Although every region, including the two advanced economy regions, is forecast to have negative growth in 2009, the decline is greater in the CIS. For 2010 all are forecast to be close to 2% although the CIS might do slightly better and old Europe (EU-15) slightly worse. 4

6 Both the IMF and EBRD have released growth forecast in the last few weeks for 2009 and Generally they are quite similar. For those that differ between one and two percentage points, I have highlighted in yellow, and those with a difference greater than 2 percentage points I have highlighted in tan. There is not a systematic difference between the two organizations; the EBRD is more optimistic for some and less so for others. Sometimes a higher prediction one year is matched by a lower one the next, so they even out over time. However, over the EBRD is slightly more optimistic about Montenegro and Moldova and more pessimistic about Azerbaijan and Belarus. Over the last 20 years the transition economies have experienced a difficult time. There have now been three major crises and a few more minor and countryspecific ones in-between. In this chart I have compared the current economic crisis (in 5

7 blue) to the Russian currency crisis of 1998 (in green) and the transition recession that followed the breakup of central planning in 1989 (in red) 3. The current crisis is projected to be more severe than the 1998 currency for which recovery was rather rapid. However, compared to the transition crisis the current crisis seems almost insignificant. During the transition crisis the real GDP of the CIS economies fell almost in half and it took 16 or 17 years to get back to the real income they had prior to the crisis. In the current crisis the CIS should be back to the their pre-crisis level in three years or by Given that Russia dominates the CIS, the story is quite similar if only the GDP declines in Russia are compared. 3 The UNECE and the IMF date the beginning of the transition crisis differently as the UNECE has estimated that income began to fall (on an annual basis) in 1990 while the IMF believes that 1991 was the first year of negative growth. As such both are graphed but it doesn t appear to matter a lot. 6

8 A similar analysis is provided in the next slide for south-east Europe. Given aggregation difficulties with this group of countries they are plotted individually with the lower set of darker colors representing the transition crisis and the lighter colored set of shorter lines representing the current crisis. The story is similar. Especially noteworthy is the significant difference amongst the SEE-6 in their transition experiences where Albania was back to its pre-crisis GDP level in 6 years while Serbia is still significantly below its pre-crisis level even today, twenty years later. Thus to just summarize the recent growth experiences of the region: for most of the EiT the crisis did not really hit hard until the bankruptcy of Lehman Brothers so that most of them experienced growth on an annual basis in There will be significant declines in 2009 but growth returns in The situation is largely similar for the NMS, but the Baltic economies were hit early and experienced declines in 2008, even larger declines in 2009 and are expected to still experience negative growth in Over the three years, the real decline in GDP may be 21% in Estonia, 23% in Lithuania, and 27% in Latvia. In a recent study of severe financial crises by Reinhart and Rogoff, 4 the two worst multi-year declines were the US during the great depression which suffered a 29% decline and Argentina in which had a 22% decline. Thus what is happening in the Baltics is comparable to the worst financial crises of the past century. 5 Thus not only is the current crisis from a global perspective the worst in 50 years but the worse hit economies in this crisis compare rather similarly to the worst hit economies in any crisis of the past century. However, as bad as it is for the Baltic economies it is still not as bad as their transition recessions. It should also be noted that throughout 2009 there has been a debate as to whether these economies, but especially Latvia, should follow the Argentina example and devalue and default on their external obligations or if it should attempt to 4 Carmen M. Reinhart and Kenneth S. Rogoff, The Aftermath of Financial Crises, American Economic Review, Vol. 99 (2), pages , More technically, the economic declines in the Baltics have not resulted from the actual collapse of its financial system; thus it is debatable as to whether their economic crises should be classified as financial crises. 7

9 maintain their exchange rate pegs, service their debts with IMF financing and attempt to restore equilibrium through domestic deflation. They have so far done the latter, but as the growth numbers suggest, it may not matter that much; either way you experience a really severe downturn. The lesson would appear to be that once a crisis hits, it s too late and it doesn t matter what you do; the thing to do is to avoid getting into a bad situation to begin with. Before proceeding, let me just point out that in discussing the EiT, Russia really dominates any aggregate. Russia accounts for two-thirds of the GDP (on a PPP basis) of the EiT, while SEE-6 accounts for only 7%. Without Russia, the EiT have a combined GDP smaller than that of Spain. There has been and continues to be significant variation in the growth experiences of the EiT. In this chart the range of yearly growth experiences is plotted 8

10 with the top (in red) providing the highest growth rate and the lower line (in blue) the lowest. For most years this range is almost 15 percentage points. If anything, it has narrowed during the current crisis. I have also plotted the weighted and non-weighted averages. Although this does not follow in a strictly logical sense, I nevertheless take the close similarity of the two curves as circumstantial evidence that Russia is the regional driver of growth throughout the EiT. Let me now return to the primary vulnerability that existed in the region, that being the region s dependence on capital inflows, which for most of the economies, corresponded to large current accounts. 6 In the chart the unweighted average current accounts for several sub-regions are plotted for the last decade. Most of the regions have been running fairly large current account deficits throughout this period, but these began to become much larger after 2005, and in the NMS, SEE-6, and the nonresource CIS, were greater than 10% of GDP in By any standard, current account deficits of this amount are unsustainable. These are forecast to decline somewhat in 2009 and beyond. They decline most noticeably in the NMS; some of the turnarounds in these economies have been really astounding. For example, Latvia had a deficit of almost 22% of GDP in 2007 but is expecting a surplus in 2009 of over 4% of GDP. This is a turnaround of 26% of GDP in an economy with a fixed exchange rate. Although this has been due significantly to the decline in real output, surpluses are being forecast in 2012 and beyond even after growth has returned. Likewise, Estonia had a deficit of almost 18% of GDP in 2007 but is forecast to have a surplus of 2% in 2009 and If nothing else, this reflects some extraordinary flexibility in these economies. Very little turnaround is expected in the two relatively poor CIS economies (Kyrgyzstan and Tajikistan) which are expected to continue to have 6 For a detailed study of the vulnerabilities being created in the region prior to the crisis, see Robert C. Shelburne, Current Account Deficits in European Emerging Markets, UNECE Discussion Paper No ; and for a shorter essay see, Robert C. Shelburne, A Note on the Changing Nature of Financial Vulnerability in the Transition Economies, For an analysis of the underlying causes of the current account deficits in the EU new member states see, Robert C. Shelburne, Current Account Deficits in the EU New Member States: Causes and Consequences, Intereconomics: Review of European Economic Policy, March/April 2009, Vol. 44 (2), p

11 deficits over 10% of GDP (due to IMF financing). The resource rich CIS (which includes Russia) had surpluses of 10% of GDP going into the crisis and although these fell slightly in 2009 due to the fall in commodity prices early in the year, the surpluses are expected to start growing again next year. However, just to repeat what I said earlier, although these economies had overall current account surpluses, their private financial sectors were heavily dependent on external capital inflows. Oftentimes when countries have large current account deficits it s due to large government budget deficits, the so-called twin deficits proposition. However, this did not characterize the EiT+NMS. In fact the relationship for these economies was the exact opposite; it was the countries with the best budget situation (often even budget surpluses) which had the largest current account deficits. The one real exception to this was Hungary; it is the point in the upper left (-7.8, -4.5) of the chart. 10

12 A similar conclusion comes from looking at the evolution of public and private debt in the seven years prior to the crisis. During this period, public debt (the red line) actually fell slightly while private debt (the green line) increased by almost six times its initial level in Thus it was the private sector, not the public sector that was dependent on capital inflows. If you believe that most short-term debt is private sector debt, it can be added to reported private debt and represented by the blue line; but the result is largely the same. Capital inflows to the region that were close to 10% of GDP in 2007 are expected to be negative in 2009 before recovering to about 4% of GDP in 2011 and beyond. Thus the dependence of the region on foreign capital to finance their future development will likely be one of the most significant medium-run consequences of the current global economic crisis. Also I have noted that several speakers at this conference, in discussing Asia and Latin America, have raised the issue as to whether some type of constraints should now be imposed on capital inflows into those regions to avoid the boom-bust cycle that so characterizes emerging markets. This would not appear to be an immediate issue for this region, as policy makers in most of these economies would probably like have capital inflows return (at least in the short to medium term) to something closer to the pre-crisis levels as a way to spread out the adjustment process. However the recent experiences of the EiT+NMS would certainly lend support to those suggesting that some type of restriction on capital inflows is warranted. As for the components of these capital inflows, foreign direct investment (in blue) fell to about 2% of GDP in 2009 which is about half of its pre-crisis levels. It is expected to stay at this level for the next several years. The most volatile component of capital inflows was what is labeled in the chart as other inflows; this includes bank loans and bond issues. These are expected to be significantly negative in 2009 as much of this debt that is coming due is not being re-issued. The green section represents the significant official assistance (IMF, EBRD, etc) that has been extended to the region. 11

13 Another major financial inflow that is extremely important for the EiT+NMS is remittances. 7 The map provides remittances as a percentage of GDP in these economies. For the emerging/developing economies overall remittances are equal to only about 2% of GDP, but for the EiT+NMS their size is much greater; many have inflows greater than 5% of GDP, some more than 10% and several more than 20%. Prior to the crisis, Tajikistan and Moldova had remittances over 30% of GDP which were the largest of any countries in the world. There are group of 11 EiT for which remittances are especially important. These are the countries in blue in the small map in the upper right of the chart above; this includes most of SEE, Moldova, the Caucasus, and several of the central Asian 7 For a detailed examination of remittances in the transition economies, see a forthcoming study by Robert C. Shelburne and Jose Palacin, Remittance Flows in the Transition Economies,

14 CIS. The chart provides the magnitude of FDI inflows, official aid, and remittances for these 11 economies over the seven years prior to the crisis. For these economies remittances are larger than aid and FDI combined. Thus for the transition economies, remittances are not some secondary financial flow that needs to be considered as an after-thought, but are often the largest and most important financial flow. For the EiT overall, Russia is the major destination country for foreign workers; however those in SEE have more of a tendency to go to western Europe. In the chart, Russian money transfers (which are an excellent proxy for remittance outflows) are plotted from 2006 to the second quarter of Due to their exponential growth logs have been taken and due to their seasonality, a backward moving window of four quarters is plotted. By the second quarter of 2009 Russian remittance outflows were down 31% year on year, and down 39% from the expected trend. When a financial inflow that is 10% to 20% of GDP declines by 39% it represents a serious economic shock. This was a major transmission channel for spreading the crisis throughout the EiT. 8 The relationship between remittances and money transfers is examined in depth in Robert C. Shelburne and Jose Palacin, Remittances in the CIS: Their Economic Implications and a New Estimation Procedure, UNECE Discussion Paper No

15 Trade flows in the EiT also fell substantially. In the chart Russian trade in the first two quarters of 2008 (the dark colors) are compared to the first two quarters of 2009 (the light colors). Exports (in green) are down by 46.9% and imports (in blue) are down by 42.6%. Although Russia still has a positive trade balance, it is now much smaller than prior to the crisis. What is somewhat surprising given these large changes in trade is how little the sectoral and geographical changes have been. For example for exports, the shares in the three basic sectors of energy commodities, machinery and other goods experienced only minor changes. For some items these declines represent large quantity falls with minimum price changes while for others (energy exports in particular) the declines are on the price side with more minimal declines in quantities. There was a little more change on the import side, where car imports fell due to the 14

16 collapse of that market more generally but also to new import restrictions on used car imports. The geographical distribution of Russia s trade to the CIS, the EU, China and the rest of the world was likewise relatively stable. Trade did fall more to those areas (the other CIS and the EU) that were most negatively impacted by the crisis. Thus to summarize, all the major external components of demand declined quite dramatically; this includes capital inflows, remittances and trade. As these fell domestic income and thus domestic demand began to fall as well. The financial systems were crippled by the loss of access to external funding and as the domestic economies began to deteriorate, non-performing domestic loans started to escalate. 15

17 Going forward, the weakest link in returning to prosperity in the transition economies is probably their weakened financial systems. So let me say a few things about that. Prior to the crisis credit growth had been increasing quite rapidly in most of the EiT+NMS. For example it was increasing by 40% a year in Russia. The funds to finance this expansion were only partially coming from increased domestic deposits; instead the banks had relied heavily on obtaining funds from abroad, either by issuing bonds or borrowing from foreign bank syndicates. In the NMS and SEE and to a lesser degree Ukraine, bank subsidiaries got funds from their western European parents. In order to minimize their foreign exchange risk, bank loans were often denominated in foreign currency. Consumers and businesses were not particularly averse to this since domestic currencies were either fixed or had been gradually appreciating. In Russia for example approximately one-third of loans were denominated in foreign currencies. Once the crisis hit, consumers became concerned about the safety of their savings. Given weak or non-existent deposit insurance or historical memories of losses from previous crises, consumers began to withdraw their funds. For example, Russian banks lost 15% of their domestic deposits in the early months of the crisis. The deteriorating economic conditions have led to a substantial increase in non-performing loans. In Russia they have now doubled since the beginning of the year and are being forecast to double again in the coming year. They are at double digit levels in a number of the EiT and in Ukraine may reach an almost unbelievable level of 30-45%. Bank losses have exposed a number of poor governance issues for their financial systems, such as a tendency to have made a large number of loans to related-party clients. Some banks have failed; in Russia this includes about 20 which is not all that great. The government has provided bailouts to systemically or regionally important banks. Depositors have generally been protected and have not lost their money as they did in some previous crises. However there were some minor problems; for example in Ukraine there were restrictions on bank withdrawals for a time. In a few cases, however, foreign bond holders or bank syndicates have had to take a haircut. This is not only regarding foreign-sourced loans by banks but for loans by the corporate sector. Given the large international reserves of some economies like Russia and 16

18 Kazakhstan, I think there was an expectation that governments would have provided more support than they actually have for their corporate sector in servicing their foreign loans. 9 The lack of support for some publicly owned firms has been especially surprising. Concerns about property rights and governance in the EiT may have actually worked toward their benefit in this crisis, as creditors have been reluctant to call in loans or ask to liquidate companies, since they are uncertain as to what type of assets they may end up with, given their uncertainties about the legal system. Given the large multinational presence in the banking sectors of the NMS and SEE, there were questions as the crisis developed as to whether this would be an asset or liability. In other words, would the parents come to the aid of their subsidiaries (by continuing to fund operations even as the solvency of the subsidiary deteriorated) or would the parent withdraw funds from the subsidiary to support the weakening position of the parent. Generally, the experience has been that the parents have supported their subsidiaries as they have viewed their market presence as a long-term commitment. Emergency funding provided by EBRD has also been important in this respect. The current financial situation in the EiT+NMS is largely similar to that in the advanced economies. The risks of a systemic collapse of the financial systems have passed (although some additional individual banks are likely to fail) but the banking systems seem unable or unwilling to make enough loans to maintain domestic demand. This is in spite of the fact that some governments have mandated lending by state-owned banks. The region has received substantial assistance from the International Monetary Fund. I think it is safe to say that this has been critical and without it there would have 9 There was however, no legal requirement for them to do so. By comparison, however, there was no legal requirement that the government of the US would provide deposit insurance for money market mutual funds, but the US government decided that such a move was desirable to promote stability and thus undertook this obligation. Likewise, as the crisis developed, many European governments provided bank deposit insurance although there was no existing legal requirement to do so. 17

19 been a major economic collapse in a significant part of the region and this could have easily spilled over into the rest of the world. The tripling of IMF resources at the London G-20 meeting in April 2009 was the turning point in the crisis, since this increase made it clear that the IMF would have the funds necessary to address the crisis. A dozen of the economies in the region have received some type of IMF support. This includes Armenia, Belarus, Bosnia and Herzegovina, Georgia, Hungary, Kyrgyzstan, Latvia, Romania, Serbia, Tajikistan, and Ukraine. Poland, however, only asked for a precautionary facility and it is unlikely that this will actually be used. After the Asian crisis of late 1990s, the IMF was criticized, and rightly so, for the strongly pro-cyclical or contractionary policies it imposed on countries as a condition for receiving assistance. The IMF has been far more flexible during this crisis not only in terms of the initial conditionality required but also in relaxing the requirements as the situation deteriorated. For example budget deficit targets were increased for Hungary, Latvia, Romania, Serbia and Ukraine. However, to say that the IMF programs were less harsh than in previous crisis is not to say that they were actually counter-cyclical. I do not say this necessarily as a criticism; given the nature of world capital markets emerging economies are somewhat limited in their policy space even with IMF resources. A recent analysis of recent IMF programs concluded that most of the programs implemented by the EiT+NMS were contractionary in terms of their fiscal, monetary and public wage conditionality. 10 Only Armenia and Georgia had expansionary fiscal policies as part of the plan and only Serbia was allowed a monetary expansion. 11 Those economies not under an IMF program generally were able to implement stronger counter-cyclical policies. In the case of Russia its fiscal expansion was quite large as spending was 10 Mark Weisbrot, Rebecca Ray, Jake Johnston, Jose Antonio Cordero, and Juan Antonio Montecino, IMF-Supported Macroeconomic Policies and the World Recession: A Look at Forty-One Borrowing Countries, Center for Economic Policy Research, Washington, DC, October Note that a distinction is being made between the country s overall macroeconomic policy and the IMF agreements. 18

20 increased by 30% while tax revenues declined by 30%; the difference was financed from its reserve fund. Some normality has returned to global capital markets for sovereign debt. As the chart (from the Financial Times) shows, the spread on Russian sovereign debt has followed the average for emerging markets overall; the spread reached 8 percentage points at the end of 2008 and has been drifting down throughout 2009 and is now about 2 percentage points. The Russian government has recently announced its intention to return to global capital markets in 2010 with a flotation of $17.8 billion to help cover its projected fiscal deficit next year of 7.5% of GDP. This will be the first foreign borrowing by the government since its default in The logic of issuing debt when they still have substantial international reserves in various funds is really not clear to me given they will pay higher interest rates than they are receiving on their assets; but the argument seems to be that it will make pricing Russian corporate debt easier and thus allow the private sector a smoother return to global capital markets. 19

21 Speaking of Russia s international reserves, an interesting issue of relevance for the energy rich CIS concerns how they used their sovereign wealth funds (SWF) during this crisis. Along with Russia, Kazakhstan and Azerbaijan have substantial SWF; they were equal to 15.9%, 20.6% and 23.6% of GDP, respectively. An important reason for having funds of this type is to give a government a cushion in difficult times. So to what degree were the funds used and what impact have they had? Overall these funds allowed these three countries to implement large fiscal expansions. This chart produced by my colleague Jose Palacin for an upcoming box in the World Economic Situation and Prospects (WESP) provides a look at Russia s reserve fund. 12 In January it was split into two funds, the top one (in yellow) is for macroeconomic or commodity cycle smoothing while the bottom one (in red) is more for intergenerational equity. Visually when you look at the chart you might think that it is strange that Russia did not use more of it given their deep recession. However, as I have drawn in on the right side, if they continue to spend for one more year (July 2009 to July 2010) at the rate they did in the first six months of 2009, the top fund (Reserve Fund) will run out of money. Thus they really have used this fund in a matter that anything more would not have been prudent. Given that oil prices have now returned to much higher levels than in the early part of 2009, the fund may not decline as much as I project. Nevertheless they did not know the oil price increase would happen, and thus their spending pattern seems reasonable given what they knew at the time. 12 Jose Palacin, Public Finances during the Crisis in Resource-Dependent Economies: The Case of the CIS. 20

22 A stronger argument can be made that perhaps Kazakhstan should have spent more of its fund to avoid going into a recession. Although they have implemented a fairly large fiscal program, perhaps more support could have been provided to its banking system. Inflation in the CIS has been higher than in the advanced economies and is currently in the moderate 10% to 12% range. Some of this is due to the general trend of depreciating currencies. Inflation is much lower in SEE and the NMS. As a general point, I believe that the region has had more policy space in using fiscal policy than monetary policy as the later was needed for managing the exchange rate. 21

23 Generally the currencies of the EiT have depreciated against the major western currencies (either the dollar or euro) during this crisis. The declines have been significant for a few of the hardest hit economies. For example, the Ukrainian hryvnia declined 34% against the dollar in 2008 and another 6.2% so far in 2009 (to October 19). As shown in the chart, most of the CIS currencies have declined against the euro in 2009, some by almost 30% (i.e., the Kazakh tenge). Although the Russian ruble declined substantially in 2008, it has maintained its value against the euro in Let me summarize the short-term prospects. Impaired financial systems will limit investment and demand over the next year; non-performing loans are a problem. However, external capital markets are normalizing and will allow the private sector to recycle many of their loans, but overall capital inflows will remain depressed. Deteriorating fiscal positions are widespread; they may require some sovereign 22

24 borrowing (from global capital markets or the IMF). An alternative is that privatizations may be used to obtain funds. The weak recovery in western Europe will limit export growth although current energy prices are at levels consistent with solid growth in the energy-rich CIS. Depreciated currencies will help in increasing export demand but the export boost after the 1998 crisis is unlikely. Since employment is a lagging indicator remittances will stay depressed for some time. The question here is similar to that in the advanced economies: will the private sector be able to take over by the time the limits of government stimulus are reached? Finally let me say a few things about the medium-term prospects. There are a number of growth limiting factors which existed before the crisis and remain important. Governance is a problem although progress is being made. Political instability and frozen conflicts in SEE, the Caucasus, and central Asia create uncertainty and limit investment and economic integration. Russia and a number of the CIS need WTO accession in order to diversify their economies and exports which are overly concentrated in commodities. 13 Increased trade with China, however, may provide them an opportunity for increasing their exports of low-quality products. Earlier today we heard from David Turner of the OECD about concerns that they have that the crisis may reduce medium-term growth in the advanced economies. The current and projected high levels of unemployment will reduce human capital formation and through these labor market hysteresis reduce medium-term growth. Although this may be a factor for the EiT+NMS, a much greater concern is how the crisis will limit capital inflows in the future and thereby reduce investment and growth. As explained earlier, the region has been quite dependent on external capital to finance its growth, and this model of economic development is likely to be significantly moderated by the current crisis. In addition the large fiscal deficits created by the crisis will ultimately lead to crowding out, which will further reduce 13 For a detailed examination of the trade of the CIS economies, see Robert C. Shelburne and Oksana Pidufala, Evolving Trade Patterns in the CIS: The Role of Manufacturing, UNECE Discussion Paper No

25 investment and growth. The IMF has recently estimated that as a result the mediumterm growth rate of EiT may decline by.5 to 2 percentage points a year. 14 This is likely to be especially important for SEE, which had a proven economic model to follow, that being to simply duplicate what the NMS have already done. However, it is now likely that they will not be able to rely, as the NMS did, on foreigners to largely finance their growth. Although I generally believe, as most do, that FDI has been important in promoting growth in the region, the actual statistical support for that is much weaker than is commonly believed. For the transition economies, there is really no positive relationship between the level of FDI and the level of gross fixed capital formation. For a larger group of countries there is, so there is a question of judgment as to what is the most appropriate statistical test for assessing this relationship. But I have no time to discuss this today. 14 See Srobona Mitra, Risks to Medium-Term Growth and Convergence in Emerging Europe, Box 5 (pages 35-36) in the IMF s Regional Economic Outlook: Europe, October

26 In terms of saving and investing there is a fundamental difference between the NMS and the CIS (data for SEE is more limited). Investment has been high in the NMS, their problem has been low domestic savings, thus their dependence on capital inflows. Going forward, a major challenge for them (as well as the US) will be to find a way to increase domestic savings. 15 In the CIS the problem is not savings but investment. It has been relatively low since the transition to market economies. Thus their major challenge is how to raise 15 For a fuller analysis, see Robert C. Shelburne, Financing Development in Europe s Emerging Markets, an essay in the United Nations Economic Commission for Europe s Annual Report for 2008, United Nations, New York and Geneva, 2008, p

27 investment. Improving governance, financial intermediation, and diversification would appear to be the most important next steps. Finally let me point out that in economies with weak social safety nets, an economic crisis can harm human capital formation through health effects. During the transition crisis and again during the 1998 currency crisis, public health deteriorated substantially in the CIS as shown by the declines in life expectancy. 16 Although this may not be a factor in the advanced economies with their well-developed welfare states, this could prove to be an additional factor causing the medium-term growth rate in the EiT to decline. 16 See, Robert C. Shelburne and Claudia Trentini, Public Health in Europe: The Financial Crisis and UNECE Activities, UNECE,