World News

Crisis brings Eastern Europe to growth, reform crossroads

Economics Correspondent, Central Europe and the Balkans

A woman changes the rates of a currency exchange rate board in Kiev, February 26, 2009. REUTERS/Konstantin Chernichkin

PRAGUE (Reuters) - Following two decades of unprecedented prosperity, Europe’s emerging economic powers are at a crossroads that could take some on a path to further growth and cripple others.

From the Baltics to the Black Sea, the 10 ex-communist states that joined the wealthy bloc since 2004 may reassess their economic models in the face of a downturn not expected to let up for the best off until late next year.

Other non-EU countries are also caught in the crisis but have not embarked on the market-opening reforms required for EU entry, putting them at a greater disadvantage for recovery.

Now those depending on International Monetary Fund-led bailouts -- EU states Latvia, Hungary, Romania, non-members Ukraine and Serbia, and others -- must find a way to cut state spending as growth and budget revenues fall.

Countries in the European Union must also ask themselves how quick they should seek to adopt the euro and whether the export-dominated model many favor is still the most viable.

Policymakers from across the region are expected to touch on those issues on Friday when they meet at the annual meeting in London of regional investment institution the European Bank for Reconstruction and Development.

Another question is whether they should stick with neo-liberal reforms once pushed by the West -- a theme that now elicits less enthusiasm in Paris than in Prague.

“We are at a crossroads in the convergence process,” said Lars Christensen, chief economist at Danske Bank.

“Now you really are looking at the difference between countries that have continued reforms through the 20 years and those that have simply opened up their economies.”


The EBRD sees emerging Europe contracting 5.2 percent this year, with the biggest economy, Russia, contracting by 7.5 percent, the EU-member Baltic states all by double digits and IMF beneficiary Ukraine by 10 percent.

“We had a disastrous Q4 2008 and a very bad Q1 2009,” the bank’s President Thomas Mirow told Reuters on Tuesday. “We see some bottoming out but it’s not possible to predict anything better than we did.”

Experts say most of the EU’s eastern 10 are best off, having left behind Soviet central planning for a market-based model.

According to Deutsche Bank, the EU members have boosted the standard of living, measured by purchasing power parity, 50-70 percent above the level seen in 1990, just after the fall of communism. Now it is 59 percent of the EU average.

But if there is a difference between the EU and non-EU members, there is also a big divide between countries inside the wealthy 27-member bloc.

Economists split those that slogged on with reforms since EU entry from those who coasted on a wave of foreign investment in a decade of growth that lifted everyone regardless of policy.

The former includes those that reined in finances and lured foreign companies -- the Czechs, Slovaks and Poles -- but are suffering from a collapse in demand that has crippled industry.

The other includes those like Hungary or Bulgaria, which dragged their feet on improving the business climate, as well as Lithuania, Latvia and Estonia, which used cheap borrowing to fuel explosive growth but now face a painful slowdown.

“The countries that are in the worst situation are there because their reform dynamics have been so weak,” said Robin Shepherd, director of international affairs at the Henry Jackson Society think-tank. “But as a consequence of the difficulties they are facing, it becomes even harder to do these reforms.”

Those EU members that built strong industrial bases may resume strong growth in 2011 or 2012 if demand in their main export market, the euro zone, recovers, particularly after the crisis hit their currencies and made them more competitive.

But the Baltics in particular will not be so lucky. Not only have they seen a huge swing into negative growth after expanding by more than 10 percent a few years ago, but they have also pegged their currencies to the euro, making them more expensive.

Latvia saw its economy drop 18 percent last quarter while Estonia on Wednesday reported an almost 16 percent contraction.

“The Q1 GDP data for the Baltics are nothing short of horrific,” said Neil Shearing, from Capital Economics.

“GDP could fall by more than 25 percent peak-to-trough, which would rival the decline witnessed during post-Soviet restructuring. They won’t return to this year’s (GDP) levels until around 2016.”


The economic crisis has shaken politics, sparking violent protests across the region, and playing a role in the fall of governments in Latvia, Hungary and the Czech Republic.

Despite a visible shift toward more state intervention in the West that has included stimulus packages and bailouts for private firms, governments in the east have mostly stuck to the rulebook they followed on their path to joining the EU.

Latvia’s new government is exploring spending cuts of up to 40 percent to get its budget deficit near the 7 percent of gross domestic product asked for under the IMF’s bailout conditions.

Romania and Hungary -- the latter long seen as a reform laggard for refusing to tackle its bloated pension sector, among other reforms -- have also made plans to cut significantly in the face of falling growth and lower revenues.

Economists say those measures may be those countries’ last defense against potential default.

Some are surprised that, where governments have fallen, political powers have chosen to install new technocrat cabinets, despite rising public pressure for more populist policies.

The question is how long politicians will hold that line. Most countries in the region hold elections in the next two years, the outcomes of which hang on how long the economic crisis will endure and whether voters are tired of reforms.

“The big danger I see is that politicians get so scared by the public pressure for more social spending that they abandon the reforms,” said Katinka Barysch, deputy director of the Center for European Reform. “And that could do some medium-term damage to the growth prospects of these countries.”

Reporting by Michael Winfrey; editing by Patrick Graham