Central and Eastern Europe and the Global Financial Crisis: Heightened Risks and Rising Vulnerabilities

To varying degrees, the global economic crisis has not only stalled the dramatic economic growth of postcommunist East Europe, but has also pushed some countries into recession. Sharon Fisher presented an in-depth analysis of the economies of Central and Eastern Europe and assessed their ability to recover from the recession.

From 2002 to 2006, GDP growth in East Europe surged while unemployment rates dropped sharply. Most of the Central and East European EU member states were actively striving to adopt the euro, though only Slovenia and Slovakia had been admitted to the eurozone. Yet, even during these good times, GDP growth was driven by heavy external borrowing, which made the countries vulnerable to the current crisis. Except for Russia and the Czech Republic, all the states of East Europe had current account deficits above 5 percent of GDP in 2008. Deficits of Montenegro, Bulgaria and Serbia were as high as 20 percent of GDP. With current account deficits rising rapidly, the region was especially vulnerable to the current global credit crisis.

The Baltic states were first to suffer when their housing bubbles burst in 2008. For most of last year, the economic fallout seemed to be contained to Estonia and Latvia, and many of the other states' governments continued to project high growth rates and anticipate that they could weather the storm. But by the end of the year, the steep decrease in consumption began to affect the entire region. In recent months, the countries of the region have begun to witness declines in exports of up to 30 percent and unemployment rates have risen steadily everywhere. Falling fuel and commodity prices have been particularly detrimental to Russia and Ukraine.

The credit crunch has limited household borrowing and investment. Since most of the banks in East Europe are subsidiaries of West European institutions, parent banks are now less willing to offer domestic loans and FDI inflows are slowing sharply. Highly-indebted countries are particularly exposed, since creditors have re-priced regional risk and countries' credit ratings are declining. The limited capital inflows have forced a correction of domestic demand and markets have contracted rapidly. Currently, business and consumer confidence is very low, and the region's recovery in the second half of 2009 depends almost entirely on events in West Europe.

Fisher explained that the countries that are already in the eurozone have a significantly higher chance of weathering the current economic storm than those who have not yet been admitted. Countries with floating exchange rates (such as the Czech Republic, Poland, Hungary, Romania, Russia, Ukraine and Serbia) have seen sharp and destabilizing depreciations. Nevertheless, they are still better off than countries with fixed exchange rates (the three Baltic States, Bulgaria and Bosnia) which will have problems maintaining the current peg and may see a sharper decline in GDP growth due to severe currency devaluation. The regional outlook is better for countries that are in the EU, since they have an additional source of assistance not available to non-members. In the best case scenario for the region, banks will gain control over default risks and resume lending, which would allow companies to stay afloat and prevent large numbers of households from defaulting on foreign-currency debts. With a little help from the EU and the IMF, currencies throughout the region would be stabilized and over time, markets could regain their lost momentum.

Martin Sletzinger, Director, East European Studies, 202-691-4000