The issue of crisis in the East is really about the ability of the EU to take on obligations in the areas covered by the common market principles irrespective of whether these arise in one or the other region within the EU and even in countries outside of the EU. The current crisis within the financial sector that is spilling over into the real sector is difficult to tackle because of the duality between common market policies and national structure of governance. One indication of this problem is the limited responsibilities of the Brussels’ budget; another is the limited reach of the ECB in the domain of financial sector supervision. Other complications are connected with the slow process of euro enlargement, which has ramifications both for the euro zone and for the EU member states (as well as some non-member states) outside of that zone.
In that context, dealing with the current problems in the New Member States (NMS) and the Future Member States (FMS) are in part the responsibility of the EU, but cannot be addressed by the EU, at least not in a straightforward way. In the case of NMS, there is at least a forum to discuss these problems, while in the case of the FMS (the group consists of candidate and potential candidate countries in the Balkans) there is little that can be done. Indeed, there is little public attention paid to this region. The crisis there could have serious economic, social, and political consequences.
What distinguishes the NMS and the FMS from most other countries afflicted with the economic downturn is the main channel of transmission of the crisis and the main instrument of adjustment. These countries have high or very high current account deficits and thus rely on foreign credit or investments. The drying up of foreign inflows leads to real exchange rate adjustment. That can be managed through the use of foreign exchange reserves, but the adjustment has to take place. In that, there is a difference between countries with fixed and flexible exchange rate regimes.
If the developments so far are consulted, it is clear that countries with flexible exchange rate regimes have been able to depreciate their real exchange rates. Countries with fixed exchange rates have been less successful because the adjustment has to come via deflation. Though inflation is slowing down in most countries, there are only a few which are already experiencing deflation. Given that inflation is slowing down fast in the euro area too, even relatively sharp disinflation has yet to lead to real exchange rate depreciation. This process of adjustment has two consequences – whether the exchange rate depreciates or prices fall, the costs of refinancing increase for the public and private sectors alike. Devaluation increases the costs of servicing of debts in local currency while deflation increases costs relative to sales or incomes or public revenues, which all fall in any case in the current economic climate. In both cases, there can be widespread bankruptcies. In the case of countries with fixed exchange rates, there is the additional risk of abrupt exchange rate adjustment.
Constraints on policy responses
This process of correcting external imbalances constrains policy responses. On one hand, countercyclical fiscal policy and monetary policies may prove hard to implement. On the other hand, banks may want to deleverage in light of rising risks of defaults on their investments. The latter process is not driven only by the recession in the NMS and FMS, but also by the recession in the EU as a whole and indeed by the global financial crisis. The former problem, the unavailability of expansionary monetary and fiscal policies, is induced by limited options for local central banks and by rising country risks that limit the possibilities for public borrowing.
Thus, it is hard for these countries to deal with problems in the banking sector and governments’ attempts to support growth are hampered by constraints on expansionary fiscal policy. Indeed, the policy that these countries are pressured to follow is pro-cyclical (quite the opposite of what is pursued in Western Europe, the US, and Japan), which tends to deepen recessions rather than spur growth. This does not necessarily lead to lower fiscal deficits and to a decrease of country risk on that account; quite to the contrary, fiscal deficits are increasing with declining public expenditures as government revenues fall and the costs of debt repayment rise. In addition, the incentive for banks to speed up the process of deleveraging increases. That, in turn, puts pressure on the exchange rates even further and increases the risks of one or another type of crisis erupting.
What can the EU do?
Given this macroeconomic situation, there are two things to do. One is to support struggling fiscal policies in these countries. This is already being done by the international financial institutions, but much more will have to be done. This also makes sense in light of the need for all the countries to contribute to the increase of regional and global demand. Otherwise, these countries will only be able to revert to ‘beggar-thy-neighbour’ measures either through devaluations or through deflations.
In addition, there is the need to get credit going. This means support for EU-based banks. The situation in these banks is far from clear. There are indications that they are undercapitalised, some of them perhaps severely so. They are also looking at rising risks to their investments throughout the EU and beyond. At the moment, the classical run on the banks is not an immediate threat because deposits have been guaranteed by all the respective governments. Therefore, the issue is the need for new capital and for the support of their investments.
The natural way to deal with that would be for the affected governments to put aside money to invest in these banks; in addition, they could refinance their debtors, perhaps with some rescheduling of these debts. The idea would be for the various EU governments to recapitalise and refinance the balance sheets of the banks that face solvency and liquidity problems. Indirectly, they would be supporting the corporate and the household sector in the troubled countries. One can also envisage the support of newly set-up financing institutions to channel money to support infrastructure projects, small and medium enterprises, and labour market measures. The advantage of these is that their lending operations will not be hampered by the legacy of inherited balance sheet burdens.
The issue of sustainability
Support for fiscal expansion has to satisfy the requirement of sustainability. In some EU and European countries, mostly not to be found among the NMS and FMS, sustainability is an issue due to high public-debt-to-GDP ratios. This is also reflected in the decompression of spreads on sovereign bonds inside and outside the EU. Most of the NMS and FMS, however, have low debt-to-GDP ratios and fiscal sustainability is not really an issue. The main problem, as argued here, are the external balances. Probably the extreme examples are the Baltic countries that have close to zero public debt but rather less-than-favourable ratings for their sovereign bonds. Similarly, fiscal sustainability is not an issue in most Balkan countries, though they can hardly approach the private credit market.
There is a difference between the Balkan countries and Central European new member states. The former have high current account deficits driven by even higher trade deficits. The latter run current account deficits, but those are mostly driven by the deficits on the income account. In the case of the Balkan countries, real exchange rate adjustment will lead to lower imports, but increasing exports will take some time, in order to build export capacity in terms of volume and diversity. Therefore, real exchange rate adjustment should be more effective in Central Europe than in the Balkans, in Baltic countries, and in other countries further to the east.
This difference is important also in terms of sustainability. The fiscal risk is probably higher in countries with higher current account deficits and lower export capacity. This is especially true for countries that rely on fixed exchange rates. In case of sharp adjustment in the exchange rate and the decline of consumption, mass bankruptcies may lead to fast increase in public obligations, and the fiscal position may become unsustainable. For that reason, it is necessary to support both the public and the private sector in these countries in order to keep the economy growing and prevent deflation. A support package to allow a measured real devaluation – abandoning unsustainable fixed exchange rate regimes and supporting monetary stability at a new level – will be necessary in such circumstances.
In the medium run, there is a difference between countries that can devalue and countries that will try to deflate (for which there are limited possibilities in the current global climate of inflation rates close to zero). Recovery is stronger after devaluation, while deflation can drag on well past the medium run. This seems to be the lesson from the deflationary adjustments in some euro member states, e.g., Portugal. In the time of crisis, countries within the euro area are sheltered due to unacceptably high cost to leaving the euro. Their sovereign bonds are better rated and flow of credit suffers less. In the medium run, however, return to higher growth rates tends to be more difficult. Similarly, countries with fixed exchange rates and with currency boards may have a difficult time returning to high growth in the medium run.
If that is true, the EU and the ECB, together with the international financial institutions, could support programs of fiscal expansion coupled with increased exchange rate flexibility. Clearly, one should aim for an exchange rate depreciation floor, which could be supported by the appropriate foreign reserve position and monetary policy. In that case, the export-led recovery and growth strategy seems the proper one for the Balkans and for the catching-up process in general.
There is room for the EU to support adjustment and recovery of countries that are constrained in their policy options due to high external imbalances. Banks could be set right and countercyclical fiscal policy could be supported. The EU and its member governments will have to rise to the challenge of a substantial and determined effort of policy coordination in this area to avoid a much deeper and prolonged economic crisis in both NMS and FMS, which would have negative spillover effects on re-establishing financial stability, the prospects for a recovery of the European economy as a whole, and the historic gains made in European integration.
Vladimir Gligorov, Michael A. Landesmann, VOX, 16 March 2009.