EUROPE

Autumn 2009

by Michalis Sarris

The global economic crisis has affected the EU’s member states in different ways, says former Cypriot finance minister Michalis Sarris, but he warns that the policies needed to address their problems will be unpalatable for all

The economic crisis has brought to the surface pre-existing homegrown problems in a number of European countries, in particular those with large external current deficits where domestic consumption and investment have substantially exceeded domestic production and savings to reveal competitiveness and productivity problems, an overvalued currency (at least implicitly in the case of eurozone members) and lax credit conditions. The countries experiencing these problems include a number of longstanding EU and eurozone members mostly in southern Europe, as well as new EU member states.

For most of them, the crisis has chiefly manifested itself through steep declines in foreign direct and portfolio investments, and through worsening foreign borrowing conditions. Its pressures have been especially severe for countries with large current account imbalances because typically they have relied excessively on capital inflows to expand economic activity and domestic financing. In many of them, these external imbalances are narrowing fast, chiefly because of sharply falling imports caused by significant slowdowns in economic activity. But in most cases the improvement in the country’s external position has been more modest than was to be expected in light of the rates at which economic growth slumped.

Advertisement These countries have, meanwhile, been introducing a range of policy actions to counter both falling output and rising unemployment resulting from the crisis. These include increased government spending, and in some cases measures to avoid any perceptions of vulnerability to a bank credit crunch. But with the duration of the crisis still so uncertain, and with the now relatively modest remaining capital inflows still at risk, longer term policy responses are called for. Devaluation is not an option, either for eurozone countries or because that would have a devastating effect on businesses and households on account of the large scale of foreign currency borrowing. A more appropriate policy response therefore seem to be the adjustment of fiscal policies together with structural reforms to help correct underlying, and indeed pre-existing, economic imbalances and to enhance competitiveness, restore macroeconomic stability and improve medium-term prospects for balanced growth. The sort of adjustments needed will require bold and politically sensitive policy reforms, and for countries with large imbalances these will be very daunting. The fifth wave of EU accessions in 2004 was the largest in terms of population and the number of countries, and also brought together countries that had themselves experienced very different political, social and economic histories. To no one’s surprise, the “big bang” enlargement and the adoption of the acquis communautaire brought with it much faster economic growth in the new member states and helped to narrow the gap in living standards between them and the 15 older member states. The EU newcomers’ improved economic performance was helped by the adoption of sounder fiscal, monetary and structural frameworks and was supported by trade expansion and increased foreign investment. Underscoring the importance of appropriate macroeconomic policies and timely structural reforms to improve the functioning of markets, a very real economic convergence began to take place, even if, at different speeds in different countries. Substantial inflows of foreign direct investment coupled with trade openness were the key drivers of faster economic growth in the new member states, but they also allowed total investment to surpass domestic savings substantially while letting real exchange rates appreciate in some countries, with real interest rates remaining relatively low over extended periods and, most important of all, letting current account deficits widen significantly. In Latvia, Estonia and Bulgaria the current account deficit grew to double digits, and in Romania and Lithuania came close to 10%. The corresponding capital inflows which financed these current account deficits, together with the rapid bank credit expansion made possible by these inflows, contributed to the buildup of growing inflationary pressures, strong wage demands and widespread real estate bubbles. In Cyprus notably, but also in Malta and Slovenia – the three new EU members that went on to adopt the euro – similar developments were characterised by substantial and growing current account deficits. Current account deficits were in many cases financed by substantial borrowing in foreign currencies, and this was facilitated by another form of financial integration in which Western European banks took ownership of about 70% of the banks in Central and Eastern Europe, rising in the case of the Czech Republic, Slovakia, Estonia and Lithuania to close to 100%. These countries' growing external indebtedness resulted in vulnerabilities because of their increased exposure to foreign exchange and exchange rate fluctuations. So while the benefits of the new member states’ greater financial and economic integration were broadly the same in terms of new jobs, trade, investment, rising living standards and political stability, some of these countries also showed complacency about extremely large current account deficits, inaction in the face of property booms and, in some cases, lax fiscal policies. The result has been that EU membership has yielded achievements that are not equally sustainable everywhere. Much the same story of large and growing current account deficits unfolded in many southern eurozone countries notably Greece, Italy, Portugal and Spain. These deficits first appeared in some as far back as the mid-1990s and started to widen almost everywhere after 2000, to reach double digits by 2008. These deficits contrasted sharply with current account surpluses in the rest of the northern eurozone, and especially Germany. In most cases, when real interest rates declined sharply increases in current account deficits reflected a decline in savings rather an increase in investment. In those cases where there was an increase in investment, this was mainly concentrated in construction. And as the fiscal situation of most of the current account deficit countries was improving significantly, the decline in savings was reflected almost entirely in the behaviour of the private sector. Rapidly growing current account deficits are often the result of acceleration in the economic growth rate, and in countries intent on catching up with average European income levels. This in many cases causes imports to grow faster than exports. Economic growth rates in southern European countries, although above the European average, remained stable during this period, so the widening of the current account deficits cannot be explained by their faster growth. Productivity and unit labour costs, which affect export competitiveness, are also factors that contribute to worsening external balances. Price increases and unit labour costs in southern European countries were significantly above the eurozone average during this period and can account for some of the deterioration in current account balances. But it is highly unlikely that productivity growth in southern European countries fell so far behind that of their competitors in such a relatively short period of time. What all this adds up to is that the southern European countries' growing external imbalances cannot be explained by income growth and competitiveness alone. The key reasons for these countries’ widening current account deficits are the euro-related availability of international capital and an expansion of domestic bank credit, accompanied in most cases by greater government spending. More specifically, the opening of the capital account connected with the preparation for the euro, together with declining private savings because of falling real interest rates and more cheaper foreign financing, probably explains a large part of the increase in the current account deficits of southern European countries. All these conditions combined to boost private consumption and construction activity with high import content, and contributed further to price and unit labour cost increases, and thus the erosion of competitiveness. These growing current account deficits were financed largely through portfolio investment, non-resident deposits, loans and trade credits. Foreign direct investment (FDI) played a relatively minor role, and as the global financial crisis has shown, non-FDI deficit financing is unstable and prone to becoming more expensive. Also, rapid credit growth due to low interest rates and capital inflows typically erodes loan quality and creates vulnerability on the asset side of banks’ balance sheets. The balance sheets of households and businesses may become vulnerable, too, because of over-optimistic expectations. Finally, wage and price rigidities suggest that when adjustment becomes necessary, because of a slowdown in capital inflows, the risk of a serious recession is substantial. For all these reasons, large current account deficits matter very much and need to be corrected in an orderly manner. The impact of the global economic crisis and the slowdown in capital inflows has meant declining domestic demand and de-leveraging, so current account deficits are starting to decline. But in spite of the abrupt adjustment of these external imbalances, without firm policy action these deficits are projected to remain unsustainably high. As real interest rates are likely to remain low for some time, and in the absence of any chance of exchange rate adjustment, tough policies will be needed on fiscal consolidation and structural reform. This will mean a significant spending slowdown for governments as their fiscal revenues are unlikely to rebound soon. Policymakers, particularly in the new EU member states, will also need to look for non-distortionary ways to limit credit expansion and foreign currency borrowing, and at structural reforms to improve competitiveness through productivity and innovation. And to add to the political challenges that must be addressed, strong action is needed to reduce labour market rigidities and a social consensus achieved to contain nominal wage growth and reduce real unit labor costs. Bitter medicine it may be, but it’s the least painful way out of the devaluation dilemma for fixed exchange rate new member states and of deeper recession for eurozone countries.