Eastern Europe's Economies: Some Calm amid Storms

From The Economist Print Edition

The EU's newer members are not its most troubled - but they have problems

Wobbly finances, low living standards and weak institutions are a bad mixture. The ten "new" (a relative term: most joined in 2004) ex-communist members of the European Union were once seen as its most troubled economies. In 2008-09 Hungary, Latvia and Romania needed bail-outs. Across the region unemployment rose and growth slumped. Western European policymakers worried about contagion.

Now those fears seem distant. Even as ratings agencies humble mighty economies like America's and Japan's, they are upgrading the EU's newcomers: Standard & Poor's recently raised Estonia to AA-, only two notches below America. All ten have growing economies, shrinking budget deficits and falling unemployment. The three in the euro zone—Estonia, Slovakia and Slovenia—are contributors to the bail-outs, not supplicants. Poland, by far the biggest, is growing at a healthy annual rate of 4% and celebrating a lower-than-expected budget deficit. Many feel that the whole idea of "eastern Europe" is out of date.

Yet it is too early to forget the toxic legacy of 50 years of state planning and international isolation. As Neil Shearing of Capital Economics, a consultancy, points out, the ten new members share some gloomy features. They are still poor by the standards of the advanced industrialised world. In GDP per head only Slovenia is ahead of the poorest "western" economies, Malta and Portugal. (Adjusting for purchasing power puts the Czech Republic there, too.) In Romania, the second-biggest country in the region, average monthly pay after tax is a mere ?320 ($460).

Optimists argue that low living standards, coupled with high education levels and proximity to rich markets, mean potential for continued rapid growth of the kind seen until the financial crisis. The recent bounce in output seems to support that. But it was partly a natural response to a severe contraction (in the Baltics, for example, GDP fell by up to a fifth from peak to trough). It also comes from strong industrial-production numbers, stemming from booming exports, chiefly to Germany, and in Poland's case from a big fiscal stimulus (the deficit peaked at 7.9% of GDP).

The fatal weakness of the old model was its reliance on rapid credit growth. That worked when mainly foreign-owned banks were willing to risk their shareholders' money to chase market share. In an era of deleveraging it is unlikely to return. Another prop was exports. But the boom is tailing off. Czech industrial production grew by 7.4% in the year to June, but that was down from a stonking 12.6% in the year to May. The Slovak figure in May was 10.7%; the year-end figure is likely to be 6%. Other components of demand, such as consumption and construction, are recovering slowly, if at all.

Governments have little room for manoeuvre. Those outside the euro zone are trying hard to meet its deficit targets, limiting any scope for fiscal policy. Cutting interest rates risks inflation (which would stymie entry into the euro). And it weakens exchange rates, hurting households that borrowed in foreign currency (a big problem in Hungary, and, to a lesser extent, in Poland). Three countries—Bulgaria, Latvia and Lithuania—have currency pegs, meaning little monetary-policy flexibility. The Czechs could at a pinch turn to quantitative easing, but elsewhere the macroeconomic policy locker looks bare.

One remedy would be more reform, both in liberalising markets and strengthening institutions. That does not seem likely. Politicians between the Baltic and the Black seas showed grit in dealing with the economic emergency (and voters displayed remarkable tolerance of the pain involved). The same willpower has yet to be applied to long-term problems. A big issue across the region is low labour-market participation, particularly among the over-50s in Poland and Roma (Gypsies) everywhere. Others include low birth rates, pension and health-care reforms, corruption and weak public administration. To be fair, few countries in the region have all these problems, and nor are they unique to the ex-communist world: western Europe suffers too. But they are big obstacles to healing the continent's historic east-west rift.

There are more immediate worries, too. As the crisis bites in the rich world, lower demand is hurting the east; the most recent GDP figures showed a fall in growth across much of the region. A credit squeeze will hit those still depending on external financing. Here, notes Mr Shearing, Hungary could be the most vulnerable, thanks to a combination of indebtedness and political unpredictability. Foreign-currency borrowing, 95% of it in Swiss francs, accounts for over two-thirds of total lending.

The government in Budapest is offering to take on the burden for three years by fixing an exchange rate at which some households can pay mortgage interest. Any shortfall will be guaranteed by the state, in return for a fee levied on the banks. But this is a temporary palliative. Transferring all foreign-currency debt into local currency could cost 7% of GDP, the central bank reckons. Jittery investors will not be reassured. If Hungary again needs outside support, it may gain a less sympathetic hearing than it did in 2008.

The risk of contagion aside, the region's biggest weakness is the grim combination of rich-country demography with poor-country living standards, with migration as the best answer. Poland's population has fallen from 38m to 36m since 2004; several other countries have similar losses. Politicians have yet to show that they can persuade these lost compatriots to vote with their feet and head home.

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