Revisiting the growth model in Central and Eastern Europe

1. Revisiting the growth model in Central and Eastern Europe Daniel Daianu November 2009

2. Plan of the Presentation • How to read the current crisis • Why worry about CEEEs • Isn’t it wrong to cluster all CEEEs together? • What can be done? • Return to common sense

3. 1. How to read the context (the crisis) • 1.1 complacent view: recovery is underway and, with a lag, CEEEs will start growing fast again (catching up be resumed); but need for prudent policies • 1.2 the somber/realistic view: this crisis has structural roots: apart from global imbalances the financial intermediation system has got rotten (waves of deregulation; over-leverage; toxicity of products; lack of transparency and non-tradeability of derivatives; neglect of systemic risks, etc) + we might be on the downswing of a secular (Kondratieff) cycle • the costs of bail outs…international crowding out effect (for the private sector and less potent economies) • a looming big debt problem (compounded by aging of population and effects of climate change); • lack of burden sharing arrangements in the EU…”renationalization of policies”, re-localization of markets; “standalone subsidiaries” (Lord Turner) • entering an age of diminished expectations and growing uncertainties

4. 2. A fundamental problem raised by this crisis: how do financial markets function? • the efficient markets hypothesis (Eugene Fama & Co.) vs. the view that financial markets are inherently unstable (Keynes, Hyman Minsky, etc.) • rationality vs. bounded rationality (H.Simon) and “animal spirits” (Akerloff and Shiller, 2009) • the “Great Moderation” obscured the rising tension…lessons from previous crises were ignored? (A. Lamfalussy, Lyle Gramlich, Paul Volcker, P. Krugman, N. Roubini …) • the role of vested interests (of financial industry) • a change of zeitgeist and policy implications; • the Asian crisis (97/98) did produce, however, a policy turnabout: the response of Asian governments and IMF’s second thoughts about premature capital account liberalization (capital controls) • now: a rethinking of systemic risks, of regulation and supervision of financial markets; • rethinking monetary policy conduct (focus on financial stability…prick bubbles) and controlling fickle capital flows (Brazil, South Korea, etc.) • the single market logic in the EU (Mario Monti’s observation)

5. 2.1 The wake up call in Asia, a decade ago • after the crisis increasing reluctance to deepen financial markets integration as the main lever for bolstering economic growth; • avoiding the overvaluation of exchange rates in order to enhance export-driven growth and accumulate reserves; • capital account opening is quite risky • pragmatic/gradual opening of economies • thinking about increasing cooperation in the Region (an Asian Monetary Authority?)

6. 3. Specifics of CEEEs (NMSs) (I): deep financial integration (openness) • complete financial integration has been seen as a means to foster catching up (premise of convergence); • total opening of the capital account: a rule in the EU (the single market logic) • massive euroization of local financial markets (except Czech Republic)….complications for the conduct of monetary policy (the Tosowky dilemma) and financial stability

7. 4. CEEEs specifics: Heavy reliance on capital imports • massive capital inflows until the crisis due to: EU proximity/ accession; perception that growth is durable because markets function efficiently and CEEEs are “special” (capital flows conforming with traditional theory…Lipschitz, Lane and Mourmouras, 2002) • rising current account deficits; CA deficits caused, in most cases, by private sector borrowing • overvalued exchange rates in both floaters and peggers (Anton Brender and Florence Pisani, 2009; A. Winkler); it is like CEEEs were immune to the Asian and other crises syndromes and betted on the EU shelter; • capital inflows drove consumption and asset prices (bubbles emerged); the “Great Moderation” and simplistic understanding of financial markets made monetary policy one-sided; • stocks and not flows got the upper-hand in banks’ internal prudential rules

8. 4.1 The “exceptional” CEEEs Source: Brender & Pisani, 2009

9. 5. CEEEs specifics: foreign banks dominate local markets • foreign banks have brought pluses in modernizing local banking services and may have helped withstand shocks, but • they create a major vulnerability when are tempted to relocate capital to home, or perceived safer locations…Thence the need for the Vienna Accords (a capital account restriction? Dealing with a market coordination failure); interpreting the BIS data… • they have driven foreign currency denominated lending • parent banks are in a process of deleveraging which will take time • the lack of burden sharing arrangements in the EU enhances fragmentation of markets, and de facto policy renationalization

10. 6. Bunching together or several clusters? (I) • why bunching together may be wrong (the case of NMSs) • different magnitude of disequilibria (current account and budget deficits, inflation differentials); • Sk and SL are members of the EMU (currency risk); • the fiscal burden varies significantly… • CB arrangements are more burdensome; • the Czech republic is little euroized • not all NMSs have needed external IFIs supported financial assistance • financial assistance

11. 7. Bunching together or several clusters?(II) • capital flight is ubiquitous; risk aversion • CDSs have returned to lower levels, but they have revealed the power of contagion effects • deleveraging by parent banks will last • a fiscal crisis is a common threat; • a possible feeble recovery in the EU impacts on all NMSs • crowding out in international credit markets

12. 8. What can be done? • approaches: a/ hope that rising seas will lift all boats (the complacent/benign view); b/ come to grips with a new reality; c/ distinguish between crisis management and rethinking the growth model • What is, arguably, the new reality in the making? - no return to pre-crisis-condition (“This time is different”, Reinhart and Rogoff, 2009) : scarcity of capital and re-localization of markets; rising indebtedness of industrial economies…intense crowding out (OECD governments will borrow more than 25% of global savings)…. - permanent output loss + lower economic growth paths (Phelps, structural slumps?) - markets will tolerate considerably smaller external deficits (the drastic fall of current account deficits due to lack of funding); - systemic risks will get a much higher profile in policy; stricter regulation and supervision of markets; the nature of banking… - growing uncertainties and diminished expectations; the role of ethics (Adam Smith) - will EU rules be reexamined? (Maastricht criteria, S&GP, etc)

13. 9. Crisis management in CEEEs • avoiding a financial collapse…the rationale of IFIs, EC and ECB supported financial assistance • dealing with liquidity and solvency risks (debt restructuring?)….The Vienna agreements • budget consolidation reconciled with the need to be not pro-cyclical during the downturn • use of EU funds as a counter-cyclical tool

14. 10. Revisiting the growth model in CEEEs 1/ mechanisms for resource allocation (markets vs. state): the issue at stake is not so much taking sides but a proper understanding of how markets function (ex: is the EMH correct? If not, what are policy implications? Is market deregulation, ipso facto, market friendly (since deregulations can cause market breakdown)? Is industrial policy needed within the EU (The Lisbon Agenda) and who would undertake it? - dealing with state inefficiency (streamlining and strengthening public institutions) correcting market failures and provision of public goods directing resources to sectors which are neglected by markets public financial institutions where markets do not deliver: EIB, IFIs vs local institutions (KfW, Rural Credit, etc) 2/ regulations and policies a structure of incentives (including taxation) which stimulates domestic saving and investment concern about the indebtedness of public and private sectors; strict regulation and supervision of financial markets preventing market abuse (the case of utilities, etc redesign welfare systems (“premature welfare states”, Kornai); dealing with social tension….

15. 11. Revisiting the growth model 3/ openness of the economy -- (finance, trade, investment,) • disincentives for lending in foreign currency (restrictions on the capital account?) • taxes on speculative capital • avoiding an appreciation of the real exchange rate (capital controls, wage restraint…. • EU funds: a substitute for the “missing capital” (see the fiscal crisis constraint) • Euro adoption: a catch 22 • resilience of economy as a major issue; role of domestic capital…

16. 12. Limits of openness • pitfalls of unmanaged globalization • a new zeitgeist and new policy approaches • a return to common sense is needed (ex: restricting casino-type operations in finance) • the growth model of the CEEEs may have served them relatively well, on balance; its future suitability, however, has to be judged according to a new reality in the making and return to common sense!!! • how would this crisis change the EU dynamics, its single market logic? • the center of economic gravity in the world is shifting; the EU and the G20 • “clashes of capitalism” (from JJ.S. Schreiber, Michel Albert, F. Fukuyama (The End of History) to K. Mahbubani, G. Soros, ….) PS: Daniel Daianu, “Which way goes capitalism/”, Budapest/New York, CEU Press, 2009

17. Revisiting the growth model in Central and Eastern European Economies (CEEEs) Daniel Daianu 11 November, CEI conference, Bucharest