20 Europe and Central Asia: A Time of Reckoning Luca Barbone When the Europe and Central Asia (ECA) region celebrated the 20th anniversary of the fall of the Berlin Wall on November 9, 2009, the celebration occurred, in one of those coincidences of history, when the region was in the midst of its first generalized recession and the most serious one that most countries had seen since the Soviet Union crumbled. The convergence toward western European living standards lifted millions out of poverty and created, in recent years, a rapidly growing middle class. This happened in the context of, and facilitated, a remarkable process of (a) political democratization and creation of new institutions that have made governments more accountable to the population; and (b) for several countries, integration into the European Union. But the achievements, of which the region is proud, also masked significant structural weaknesses. Because of its success in integrating into the world economy and in international financial markets, the region had become heavily dependent on external savings and external capital flows. Rapid growth increased public revenues, and this permitted fiscal consolidation, but also postponement of needed program reforms and even unsustainable increases in wages and transfers. When the recession struck, the fiscal position of most countries deteriorated sharply, presenting realities that necessitated sharp adjustments. As a result of the recession and 351
352 The Day after Tomorrow the fiscal retrenchment, some 40 million people now find themselves among the ranks of the poor, and many more are vulnerable. As the economic performance of the region begins to turn around, these newly manifested weaknesses cast a shadow on the prospects of future growth and social development and point to the need for governments to demonstrate determined leadership and strategic vision. The trajectory over the next decade crucially will depend on how well significant long-term challenges will be tackled. These challenges include the following: The aging of the population and the related stress on labor markets, social protection systems, health, and the sustainability of the fiscal accounts The challenge of raising productivity in an increasingly interconnected world The effects of global warming on the environment and the economic structure of the region. The Crisis of 2008 10: A Wake-up Call A Large and Differentiated Region. Spanning from within the European Union to the borders with China, the ECA region is a large (30 countries, 480 million people), economically important (US$3.7 trillion gross domestic product [GDP]), and politically sensitive region that is most noteworthy for its extreme diversity. Hence, it provides both substantial opportunities for and challenges to integration. It includes the world s largest country, the Russian Federation, and some of its smallest, such as Montenegro. Three countries Russia, Turkey, and Ukraine account for more than half the region s population, while the smallest 15 account for less than 10 percent. The region ranges from institutionally weak, low-income countries, such as Tajikistan (US$600 per capita), to postconflict countries, such as Bosnia and Herzegovina (US$4,500 per capita) and Kosovo, to high-income European Union (EU) member states, like Slovenia (US$24,000 per capita). While some ECA countries, particularly Kazakhstan, Russia, and Turkmenistan, hold almost one-third of the world s gas reserves and are key suppliers to Western Europe, energy security is a major concern for others. Reorientation of trade was a key
Europe and Central Asia: A Time of Reckoning 353 driver of the transition to market economies, but the region now ranges from some of the most open economies in the world, including five EU member states where trade exceeds 100 percent of GDP, to far less integrated economies where trade is less than half of GDP. After the economic problems experienced during the 1990s, following the break-up of the Soviet Union and the implosion of the economic institutions and arrangements that underlay it, the region s performance starting from 2000 had been impressive. High and sustained growth rates contributed to lifting some 50 million people out of poverty, and they facilitated important social and political transformations, exemplified by the accession to the EU of eight countries in 2004 (the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Slovak Republic, and Slovenia), followed by two more in 2007 (Bulgaria, Romania), and credible applications for membership from several others. The emergence of a new middle class has generally but not everywhere contributed to the creation of new institutions that have increased accountability of governments. The Crisis of 2008 09. Despite the positive accomplishments just cited, the ECA region experienced the largest reversal in economic growth from 2007 to 2009 of any region in the world. GDP growth declined by 12 percentage points, compared to 5 percentage points in Latin America, 4 percentage points in Africa and the Middle East, and 3 percentage points in developing Asia (figure 20.1). Even though precrisis fiscal deficits were overall smaller than in other regions (with the exception of the Middle East), the sharper economic contraction has led to much larger fiscal deterioration (more than 5 percent of GDP) than in other regions (2 to 4 percent of GDP). The recession hit the region in different ways, laying bare structural and financial weaknesses that had accumulated during the high-growth years of 2000 07. In some of the most advanced countries, which had integrated into the global financial markets, the effects of the global deleveraging, together with the reversal of the real estate booms, reduced the willingness of creditors to finance current account deficits. These deficits were, as a percentage of GDP in 2008, at double digits in countries such as Bulgaria, Latvia, Lithuania, Romania, and Serbia and in the high single digits in Estonia, Hungary, and Ukraine.
354 The Day after Tomorrow Figure 20.1 The Great Recession, 2009 GDP Growth by Region percent 10 8 6 4 2 0 2 4 6 8 Africa Developing Asia Latin America Middle East Europe and Central Asia average 2005 08 2009 Source: World Bank staff calculations. A second transmission channel came from the sharp drop in exports to Western Europe and the rest of the world, and had a particularly negative impact on output and employment in small open economies such as the Czech Republic, Estonia, Hungary, and the Slovak Republic, where exports accounted for 70 percent to 80 percent of GDP in 2008. To a somewhat lesser extent, this was also the case in larger economies such as Poland and Romania, where the corresponding share ranged between 30 and 40 percent, and in Turkey. For the low-income and lower-middle-income countries of the Former Soviet Union, such as Armenia, Georgia, the Kyrgyz Republic, Moldova, and Tajikistan, lower remittance flows (with reductions of some 30 percent or more) severely affected the living standards of the population. Finally, resource-dependent countries were hit by the sharp declines in commodity prices. In Russia, GDP contracted by more than 7 percent in 2009, a decline compounded by the sharp reduction in credit flows. In Kazakhstan, the crisis started earlier in 2007 with a sudden stop in capital flows that had financed much of domestic growth, which was then compounded by the commodity crisis of the following year. The social and economic consequences of the recession have predictably been severe. Households have been hit hard by growing unemployment, poverty, and as a perverse result of success in building up financial
Europe and Central Asia: A Time of Reckoning 355 markets household indebtedness. Unemployment has risen throughout the region, with registered unemployment increasing by about 3 million and millions more in unregistered joblessness. The region s dramatic reduction in poverty has also been partially reversed. The number of poor and vulnerable in 2010 is projected to be higher by almost 30 million compared to precrisis expectations. As a result, 40 million people live below US$2.50 per day in the ECA region, and about 150 million live below US$5.00 per day (figure 20.2). What Have We Learned from the Crisis? Many observers in the ECA region have pointed out that the origin of the crisis was largely external. While this is certainly true, it is also true that the crisis unmasked structural weaknesses that could be ignored in the boom times. These factors are not new, but the crisis has refocused attention on the unfinished reform agenda and put a premium on faster reform given the tougher growth environment. The first lesson is that the region s savings deficit was unsustainable. Overreliance on foreign savings particularly foreign borrowing by the private sector left both households and firms particularly vulnerable in a world of tighter and more discerning capital markets. The market dominance of foreign banks itself the result of years of reform and consolidation of domestic banking systems has been a plus since they were instrumental in the past in introducing better credit instruments and more modern appraisal techniques. Foreign banks have generally maintained their exposure in the region during the crisis, but excessive credit growth destabilized financial sectors in many countries prior to that time. The precautionary fiscal stance needed to offset unsustainable private inflows was largely absent, as governments found it difficult to resist pressures for higher social spending. The second lesson is thus that the lack of reforms in social sector institutions was masked by high growth rates in the precrisis years. Public expenditures, mostly on account of social spending, rose in real terms and as a percentage of GDP throughout the region, particularly in the second half of the 2000s. As growth rates declined, the fact that social spending is a bigger share of government expenditure than elsewhere, but lacks better results, has become more apparent. ECA countries spend
356 The Day after Tomorrow Figure 20.2 The Effect of the Crisis on Poverty a. Percentage of total population living below US$5 per day 34 32 30 30.7 28.6 31.1 30.0 percent 28 26 24 26.3 24.0 22 20 2007 2008 2009 2010 b. Total population living below US$5 per day 160 150 146 148 143 140 136 millions 130 126 120 114 110 100 2007 2008 2009 2010 current projections precrisis projections Source: World Bank staff calculations. more on public education than their developing-country counterparts, but outcomes are no better. Hospital-centric systems often result in poor outcomes in basic health indicators despite high levels of public spending. Social protection programs are often poorly targeted and social insurance programs are fiscally unsustainable, but high growth rates and buoyant tax revenues before the crisis decreased the urgency for reform.
Europe and Central Asia: A Time of Reckoning 357 High growth rates in the precrisis years largely the result, on the supply side, of total factor productivity catch-up after the break-up of the early 1990s masked what have become important barriers to competitiveness in many ECA countries. Infrastructure and a skilled labor force, the positive legacy of socialism, have emerged as the tightest bottlenecks to the growth of firms as indicated by a survey of 10,000 firms in 28 ECA countries. Remarkably, two decades after the fall of the Berlin Wall, infrastructure and labor skills are identified as a bigger constraint in the ECA region than in nontransition economies at similar income levels. Going Forward A Renewed Emphasis on Modernization and Integration in an Aging Region Current growth projections for 2010 14 show that the ECA region is coming out of the recession, but also that its short-term growth prospects are modest, with growth rates averaging 3 to 4 percent during this period, or only half the precrisis level. This year, 2010, is expected to be particularly difficult, with GDP growth forecasts for the ECA of between 1 and 2 percent, less than half of the forecast for the rest of the world. The reason for such sober forecasts is that many of the factors that contributed to growth during the precrisis years are unlikely to return, at least in a majority of ECA countries. The high growth prior to 2009 was financed by large capital inflows fueled by world liquidity pressures, euro adoption prospects for some, and commodity price booms for others. World growth (which was exceptionally high during 2000 07), access to capital, and commodity prices are not likely to regain precrisis levels for some time. Foreign direct investment is expected to recover, but most likely not to the levels seen in the precrisis years. In a postcrisis world that is projected to have less global liquidity and more risk aversion, returning to the precrisis model of growth will simply not be an option. This economic environment will challenge governments throughout the region to create the necessary environment to facilitate a more diversified and competitive economy. Social inclusion and equity issues will likely grow in importance. The increased unemployment, poverty, and household indebtedness arising from the crisis have refocused attention on social issues. In addition,
358 The Day after Tomorrow social inclusion and equal access to opportunities will be critical in order to ensure the human capital needed for future growth, particularly in rapidly aging societies. The political economy is also likely to drive the social inclusion and equity agenda, since the political sustainability of economic reforms will require better social outcomes in a world of slower growth and potentially rising inequality. Hot-button issues such as cross-border migration flows and their regulation are bound to come even more to the fore, as the largest countries and economies in the region are projected to lose population (figure 20.3) and labor force in important numbers. The closely linked growth and social agendas will be more difficult to address in a period of inevitable fiscal consolidation. The crisis-driven fiscal deterioration will require fiscal consolidation across the region. Four underlying factors will make such consolidation in a period of slower growth particularly challenging: a history of big government (government expenditure averaging 37 percent of GDP over the past decade), social spending that is more than half of government expenditure (higher than other countries at this level of income), a rapidly aging population that will further strain fiscal sustainability of social insurance programs, Figure 20.3 Demographic Projections for Europe and Central Asia Countries 50 percentage change in population 40 30 20 10 0 10 20 30 Ukraine Bulgaria Georgia Belarus Latvia Russian Federation Lithuania Romania Estonia Hungary Moldova Armenia Croatia Czech Republic Slovenia Poland Serbia Bosnia and Herzegovina Slovak Republic Kazakhstan Macedonia, FYR Albania Azerbaijan Kyrgyz Republic Turkey Turkmenistan Uzbekistan Tajikistan Source: World Bank staff calculations based on United Nations 2005.
Europe and Central Asia: A Time of Reckoning 359 and a deterioration in access to financing due to reduced liquidity and more risk-consciousness. Pressures to face climate change challenges will grow rapidly. Inaction will lower future growth and aggravate the global situation. Although the transition to market economies is for the most part accomplished, the central planning legacy of high energy intensity remains. Energy intensity of GDP in the ECA region (0.29 kilograms oil equivalent per dollar of GDP) is similar to that of East Asia or Africa, but double that of Latin America and 50 percent greater than that of South Asia or the Middle East (even taking into account the harsher climatic conditions). Russia alone is the world s third-largest emitter of greenhouse gases. In addition, ambitious EU targets will necessitate enormous smart-energy investments in new member states and candidate countries. Countries will also face near-term challenges brought on by climate change, including winter floods and summer droughts, melting permafrost and glaciers, and hydrological changes. Postcrisis Strategic Choices for the ECA Region In the context just discussed of a more difficult external environment and strong domestic pressures, ECA countries will have to struggle to find consensus to tackle a number of reforms for faster and inclusive growth and to tackle climate change issues. A Long Agenda of Reforms for Faster Growth. Restoring growth and convergence will require tackling bottlenecks to competitiveness, faster productivity growth, and more (not less) integration. The key areas for related sector reform are as follows: Innovative policies to promote economic diversification and higher productivity across sectors from information services to agriculture (an agenda that is shared broadly across the region, but is extremely important for resource-dependent countries such as Azerbaijan, Kazakhstan, and Russia) The composition and efficiency of public expenditure and revenue mobilization (now that the fall in revenues and the reduced capacity for external borrowing are likely to lead to a long period of fiscal consolidation, largely across the region)
360 The Day after Tomorrow Stable and efficient financial intermediation (improving regulatory capacity, including macroprudential regulation, and consolidating banking systems), since the crisis has revealed important weaknesses in both regulation and legislation and in the capacity of regulators (witness the severity of the crises in Hungary, Latvia, and Ukraine, to cite a few) The investment climate for enterprises (reduction of the regulatory burden, streamlining of tax administration, privatization, and trade and customs reforms) Energy and transport infrastructure (ensuring adequate maintenance funding and speeding up implementation of infrastructure projects, improving efficiency in energy production and use, and encouraging private investment through guarantees and improved energy security). Regional integration (critical for achieving faster growth, particularly among the Central Asian countries, which have yet to exploit the potential for trade collaboration and proximity to the huge Chinese market). Inclusive Growth and Better Social Outcomes. Achieving better social outcomes, developing the human capital for growth, and maintaining the political sustainability of reform programs all require better service delivery in education, health, and social protection. Since the low efficiency of public interventions is as big a constraint as the level of resources, the tightening fiscal constraints on ECA countries offers, somewhat paradoxically, an opportunity to address long-standing structural issues in the social sectors. Recent education sector reforms (Bulgaria, Latvia, and Romania), health sector reforms (Latvia and Romania), and pension reforms (Hungary and Romania) exemplify this opportunity to improve the efficiency and quality of public service delivery and continue the convergence to European standards, to face the demographic challenges and ensure sustainability of pensions and social insurance programs, and to strengthen public institutions and governance in the social sectors. Climate Change for Sustainable Growth. The energy intensity of the ECA region is high, and its carbon footprint is large. Economically sound climate change investments constitute big opportunities. Energy efficiency
Europe and Central Asia: A Time of Reckoning 361 investments, in particular, offer significant potential for new sources of growth and efficiency in the postcrisis world. The increase in extreme weather events also increases the need for disaster management investments. But even countries and sectors that might benefit from climate change are poorly positioned to do so. The possible gains in agriculture from a warmer climate and more precipitation in the northern part of the region will require massive efforts to reduce the glaring productivity gap in most ECA agriculture. Conclusion This chapter ends on a cautionary but optimistic note. The ECA region is clearly facing some of the most difficult challenges of its new history. As we have seen, the Great Recession has brought back to the fore old problems and highlighted new ones. The long-term challenges are clearly formidable. However, the region can proudly point to a record of accomplishment over the past two decades that has allowed its radical transformation and catapulting into a new era. The omens for a successful response to the challenges are good. Bibliography Chawla, M., G. Betcherman, and A. Banerji. 2007. From Red to Grey The Third Transition of Aging Populations in Eastern Europe and the Former Soviet Union. Washington, DC: World Bank. Tiongson, E., A. I. Gueorguieva, V. Levin, K. Subbarao, N. Sugawara, and V. Sulla. 2009. The Crisis Hits Home Stress-Testing Households in Europe and Central Asia. Washington, DC: World Bank. United Nations. 2005. World Population Prospects: The 2004 Revision. United Nations Department of Economic and Social Affairs, Population Division. New York: United Nations. http://www.un.org/esa/population/publications/wpp2004/2004 Highlights_finalrevised.pdf.