Press Releases 1997

[Index]

ECONOMIC BULLETIN FOR EUROPE 1997 (VOL. 49)

In the latest issue of its Economic Bulletin for Europe, the United Nations Economic Commission for Europe (UN/ECE) discusses recent economic development in the western market economies and in the transition economies of central and eastern Europe and the Commonwealth of Independent States (CIS).

Chapter 1 reviews the principal macroeconomic developments in the world economy, Europe (east and west), North America and in the CIS in 1997 and discusses some of the possible effects of global financial turmoil, especially on the transition economies.

Chapter 2 reviews recent developments in the international trade of eastern Europe, the Baltic states and the CIS, including their mutual trade, and Chapter 3 does the same for current account balances and external financial developments.

Chapter 4 surveys the surge in capital inflows into eastern Europe between 1990 and 1996 and discusses the dilemmas and problems they pose for macroeconomic policy, and the responses of the monetary authorities.

Finally, the Bulletin contains an extensive Statistical Appendix containing, inter alia, key macroeconomic series for all the transition economies for the period 1982 to 1996. (Data for the first half of 1997 are given in the body of the text.)

This Press Release focuses on some of the main points discussed in Chapter 1 of the Bulletin.

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Western Europe and North America

Recent developments and the short-term outlook

In western Europe, the cyclical recovery has gathered momentum in 1997 and the average annual growth rate of real GDP is now forecast at 2.6 per cent, slightly higher than forecast in the spring, and clearly better than the modest 2 per cent in 1996. The improvement is also mirrored in rising business and consumer confidence.

The strong cyclical expansion in the United States has continued and there has been a sharp cyclical rebound in Canada so that the average annual growth rate of GDP in North America in 1997 is now forecast at 3.7 per cent.

The strengthening of economic growth in western Europe in 1997 has been mainly due to a sharp increase in exports, stimulated by the strong growth of domestic demand in the United States, the United Kingdom, and in the developing countries. There was also continuing strong import demand in the transition economies. A major stimulus to exports was the gain in price competitiveness stemming from the sizeable appreciation of the dollar and the pound sterling.

The current economic outlook for 1998 is for a moderate acceleration in GDP growth in western Europe. In the four major economies, real GDP growth should be about 2¾ per cent which is about half a percentage more than in 1997. Higher output growth in France, Germany and Italy will be somewhat offset by a deceleration in the United Kingdom. The economic performance of the smaller economies is expected to remain quite favourable, with an average growth rate of some 3 per cent in 1998, broadly the same as in 1997. The upshot is that there is expected to be a slight acceleration in the average GDP growth rate for western Europe as a whole, to somewhat less than 3 per cent. This improvement is based on the assumption of a strengthening of domestic demand and a continuing strong growth of exports. Private consumption expenditure is expected to gain some momentum as a result of the favourable impact of higher employment growth on aggregate personal incomes and, on average, a slight decline in the savings ratio. It is also expected that there will be a marked strengthening of business investment in machinery and equipment. Export growth is expected to remain, on average, quite strong, albeit slightly less than in 1997. This deceleration reflects in the main the waning influence of the depreciation of west European currencies against the dollar, and the slowdown of domestic demand growth in the United States and the United Kingdom.

The rise in output, however, is unlikely to lead to a major improvement in the labour markets. Employment could rise by some 1 per cent in 1998 and the average unemployment rate might fall slightly below 11 per cent. Inflationary pressures are likely to remain subdued.

In the United States, the rate of economic growth is expected to slow down to some 2.5 per cent in 1998. The factors behind this deceleration are an assumed moderate tightening of monetary policy, the restraining effect of the dollar appreciation on exports, some cyclical weakening of investment, and a slowdown in personal consumption expenditures due to a lower growth of employment and a rise in the savings ratio.

Risks and uncertainties

The short-term economic outlook for the world economy, however, is now surrounded by a large margin of uncertainty because of the turbulence in global financial markets. This crisis is not yet over. Stock markets are still very volatile and the economic crisis in east Asia has spread recently to South Korea, a country with considerably more economic weight than the countries so far affected. A lot will depend on whether the fall in stock prices will continue with ensuing negative effects on the balance sheets of the financial and banking sector, notably in Japan.

Economic growth in 1998 will be affected to some extent by the wealth effect of the sharp fall in equity prices. This will tend to dampen the spending propensity of private households. The slowdown in economic growth in Asia will, moreover, curb the region’s demand for foreign goods. In view of the excess industrial capacity generated in several of these countries in recent years, it can be expected that there will be a much reduced demand for western investment goods. This is likely to mainly affect Japan, but it will also remove a source of dynamic demand growth for producers in western Europe and the United States. Depending on the extent of the slowdown of export demand, there will be second-round effects. A stronger than expected slowdown in domestic demand in the United States could lead to reduced import growth and subsequent negative effects on exports from western Europe and Japan. Similarly, continuing weak domestic demand in Japan could have negative spillover effects in western Europe and North America. A further risk is the spillover of the crisis to Latin America, a market which is important for United States producers. In Brazil growth forecasts have already been cut against a background of higher interest rates and fiscal policy measures introduced to curb the budget deficit.

The sharp depreciation of their currencies and the associated improvement in price competitiveness is very likely to lead to an export offensive by Asian exporters in western markets. Exports are likely to be the main source of their economic growth given the depressed state of their domestic demand. This, in turn, will put downward pressure on domestic prices and profit margins of competing producers in the industrialized countries and the transition economies. The depreciation of the Asian currencies will probably put downward pressure on the yen, as well as on exchange rates in Latin America and in the transition economies.

The outlook for interest rates is subject to at least two countervailing tendencies. The process of portfolio diversification underway has so far tended to favour the demand for government bonds in western countries, which in turn will put downward pressure on long-term bond yields. So far, however, investors seem to have favoured mainly dollar-denominated bonds. Although there could be downward pressure on nominal interest rates in 1998, falling inflation could well mean that real interest rates will not fall proportionately and may even increase. The restraining impact of the fall in stock prices and the Asian crisis on United States economic growth could eliminate the need for a further tightening of United States monetary policy. This could also put downward pressure on yields at the longer end of the maturity spectrum.

However, the recent sharp fall in the Nikkei stock index has highlighted once again the balance sheet problems of Japanese banks and insurance companies. To this is now added their significant exposure to bad loans in south-east Asia. An important factor in this connection is that Japan’s banking system depends significantly on unrealized gains in stock values to meet the BIS capital adequacy ratio. Since these unrealized gains have been significantly reduced by the recent sharp fall in stock prices, there is now a danger that the erosion in the value of such collateral will lead to the liquidation of foreign assets (stocks and bonds), which are predominantly dollar-denominated. Any large-scale selling of these would put downward pressure on bond prices with a concomitant rise in effective interest rates that would have spillover effects on other parts of the world economy.

It is still very difficult to judge the likely overall impact of recent developments in the international financial markets on economic developments in the ECE region in 1998. In western Europe, the issue is whether or not the trade effects and the downward correction in the stock market will affect business and consumer confidence with negative effects on spending behaviour. The impulses which exports have provided to economic activity in 1997 will probably be weaker due to the forecast slowdown of import demand in the United States. More generally, this raises questions as to the robustness of the current recovery and whether it can be sustained in the face of a deteriorating external economic environment in 1998 and, possibly, higher interest rates at home.

The run-up to EMU must necessarily involve a convergence of short-term interest rates in countries adopting the single currency. Based on rough rules of thumb the average to which rates will converge is reckoned to be around 4-4.5 per cent. This would be tantamount to a further tightening of monetary policy in France, Germany and several other countries. But such a tightening would not be appropriate given the tendency of inflationary pressures to fall and given the risk that domestic activity may weaken as a result of the crisis in international financial markets.

Should the present recovery falter again, as it did in 1994, there are likely to be serious consequences for the labour markets and, probably, for social peace as well. At present there are some important differences in the cyclical positions of different countries in western Europe and, partly related to this, in the situation in the various labour markets. It is also likely, that some will be more vulnerable than others to the changing economic conditions in Asia. Similarly, any rise in long-term interest rates in the United States, would have spillover effects in western Europe, which, as in 1994, could be quite different from country to country and disturb the current pattern of convergence. In addition, any rise in long-term interest rates could trigger significant negative wealth effects associated with falling bond prices, which would also be likely to put downward pressure on stock prices. More generally, there could be a danger of conflict among EU members about the appropriate economic policy response to changes in short-term economic prospects. This would not be a favourable environment for the introduction of a single currency in the European Union at the beginning of 1999.

Eastern Europe and the CIS

Growth in 1997

For the first time since 1989 aggregate output in the ECE transition economies was growing in 1997. While there has been positive growth in most of the ECE transition countries during the last two years, the major change in 1997 is that the economic decline in Russia finally seems to be coming to an end. Although there has still not been a start to the recovery in Russia, there was no further deterioration either - and this contributed to the positive outcome for the aggregate output of the transition economies as a whole. In the first half of 1997 the average rate of GDP growth in eastern Europe decelerated slightly from 1996 and performance in a number of countries was weaker than expected. In contrast, the process of recovery accelerated substantially in the Baltic states: the three economies performed strongly and much better than expected. The picture in the CIS region was mixed but output grew in most countries.

Economic growth continued in 1997 in most parts of eastern Europe. Aggregate GDP grew by 3.6 per cent in the first half of the year, which was slightly less than the 1996 average but substantially below the ex-ante forecasts. The divergent patterns of output performance among the east European transition countries, however, became even more pronounced in 1997. In addition, the central European region was badly hit in 1997 by the worst floods in decades. But the lower rate of growth was mainly due to the economic downturn in parts of south-eastern Europe where the economies of Albania and Bulgaria suffered from major financial crises and Romania barely escaped a similar fate at the beginning of the year.

The growth of output in the Baltic states has been especially impressive in 1997. The upturn was particularly strong in Estonia where the growth of GDP in the first half of the year (12 per cent) was well above earlier forecasts. The unexpected strength of the boom has raised concerns that the economy may be overheating, concerns which are underlined by the fact that the Estonian monetary authorities, which operate a currency board, have very few policy instruments with which to dampen expansionary pressures.

Widespread expectations that growth would resume in Russia in 1997 have failed to materialize but the decline does finally appear to have come to a halt. Although in aggregate the Russian economy was still stagnating in 1997, there were some positive changes in output together with a notable degree of macroeconomic stabilization. After a somewhat uneven performance during the first two quarters (there was a marginal -0.2 per cent decline of GDP in the first half of the year after growth of 0.3 per cent in the first quarter), some signs of recovery or near-recovery became more pronounced in the second half of the year (the January-September rate of growth of GDP was again positive, at 0.2 per cent).

However, at the moment of writing this Bulletin, there were still no clear indications that the Russian economy had definitely turned upwards and the outlook for a sustained recovery is still uncertain. It remains an open question as to whether the first signs of recovery will gain momentum and, if they do, how fast the Russian economy can grow in the post-stabilization phase.

The growth of many of the central European and Baltic states has been based on both a strong export performance and a continuing recovery in domestic demand. A return of consumer confidence reflects both the progress achieved in implementing market reforms and positive expectations for the future. However, large and rising current account deficits, an unexpectedly rapid rise of consumer spending, including spending on durables, as well as a boom in household credit in some countries (Poland, Croatia, some Baltic states, and the Czech Republic before the currency crisis) have raised concerns about the pressure of demand and the sustainability of current performance. In the course of 1997 the central banks have intervened on a number of occasions to try to cool down overheating economies.

Mixed inflation performance ...

In general, the progress towards price stabilization has continued in most of the ECE transition countries in 1997 although there were some disappointing reversals. While the majority of these economies are either already within or approaching 1-digit rates of inflation, 3-digit rates re-emerged in Bulgaria, Romania and Tajikistan in 1997; inflation was also on the rise in Albania, Armenia and Belarus. These reversals - which resulted either from financial crises or from a considerable softening in the stance of economic policy - indicate the difficulties that the authorities in the transition countries are still facing in their attempts to establish macroeconomic stability. In general, further and concerted policy efforts will still be needed in order to preserve and reinforce the degree of disinflation and price stabilization that has already been achieved.

... and a sluggish demand for labour

The recovery of output in the transition countries has so far been mostly driven by steady productivity gains: these have been generated in the process of economic restructuring which has led to a more efficient allocation of productive resources. As a result, the aggregate demand for labour has been quite sluggish during the recovery. Despite the relatively strong output growth in eastern Europe in the first half of 1997, total employment in the region has increased only marginally and in the Baltic states as a whole it even declined. The speed of restructuring in the CIS countries seems to be much lower than in eastern Europe, although total employment in the CIS region continued to fall in the first half of 1997. In September 1997 the average unemployment rate in eastern Europe was just over 11 per cent and about 6 per cent in the Baltic states. Official rates for the CIS average just over 6 per cent, but these almost certainly understate the true level by a significant margin.

Trade and current account deficits

The international trade of the east European and, especially, of the Baltic states continued to grow rapidly in the first half of 1997, both in volume and in value, with aggregate volumes growing at 2-digit rates. Rising domestic demand for final as well as for intermediate goods contributed to the persistence of high import demand in these economies. In turn, the strong growth of exports from the transition countries was stimulated by the cyclical expansion and somewhat stronger import demand in western Europe. However, trade in a number of east European and Baltic states remained highly imbalanced in 1997; the large and in some cases widening external deficits are becoming a major concern to policy makers in these countries. Current account deficits in the first half of 1997 averaged some 5 per cent of GDP in eastern Europe, with figures as high as 10 and 16 per cent in Slovakia and Croatia respectively. In the Baltic states the ratio varied from nearly 7½ per cent in Latvia to nearly 15 per cent in Estonia. These deficits have been accompanied by record financial inflows, which have both supported and resulted from the eastern countries’ strengthening economic positions. This has allowed many of them to increase reserves and sustain output growth despite the deficits reaching a high proportion of GDP. However, the persistence of large capital inflows into several countries risks overheating domestic demand, placing upward pressure on the real exchange rate and, thus, indirectly exacerbating the current account imbalances.

Within the CIS countries, the process of restructuring the geographical composition of trade is still underway and the main tendency for a switch in trade from intra-CIS to non-CIS countries deepened in 1997. The value of total Russian trade (both imports and exports) declined in the first half of 1997 (compared with the same period of 1996), after several years of continuous growth. This development was mostly due to reduced trade with other CIS countries whereas trade with non-CIS countries was less affected. As to the rest of the CIS, the value of their aggregate trade with non-CIS countries increased substantially in the first half of 1997.

Prospects for 1998

The authorities in most ECE transition economies seem to be quite optimistic about economic prospects in 1998. In practically all the transition countries where official forecasts are available, governments expect either an acceleration of economic growth in 1998 or slightly lower rates than in 1997, although these should still remain quite high. Among the east European countries, the forecasts are somewhat more cautious for the Czech Republic and Romania, countries which are undergoing a process of macroeconomic adjustment. The authorities in Bulgaria hope that the slump is coming to an end and that a significant recovery will start in 1998. Fairly strong growth is expected in most of the other east European and Baltic states. The economic outlook for the CIS countries is also positive, not least because of the expected - albeit modest - recovery in Russia and the bottoming out of recession in Ukraine. If they perform as currently forecast, aggregate GDP in the transition economies could grow by as much as 3 per cent in 1998, which would be the best performance since the start of their economic and political transformation.

It is questionable, however, whether the optimistic official views are fully justified. These forecasts generally assume a continued strong recovery in the main trading partners of the transition countries. But, as mentioned earlier, it is still unclear to what extent the global financial turmoil in the second half of 1997 will affect economic performance in the developed market economies and what spillover effects this might have on the transition economies. If the financial crisis continues and deepens, it is likely to have wide-ranging repercussions on economic performance in all parts of the world. Since the transition countries are highly dependent on import demand in the developed market economies, especially in western Europe, any eventual slowing down of growth in this region could have a negative effect on the transition economies.

The vulnerability of the transition economies to global financial disturbances

The financial crisis which has swept across south-east Asia in 1997 with repercussions on financial markets around the world has inevitably raised concerns about the stability of the currencies and the financial systems in the transition countries. In fact some transition economies have already been subject recently to financial turmoil of their own: Bulgaria was hit by a major financial crisis in 1996; and the collapse of large-scale pyramid schemes in Albania resulted in a grave economic and political crisis at the beginning of 1997. In the first half of 1997, speculative attacks on currencies caused serious disturbances in the financial markets of Romania and the Czech Republic; in the latter, the authorities were forced to abandon the fixed exchange rate regime which had been in place since 1990, whereas in Romania the exchange rate crisis resulted in a large devaluation and an upsurge in the inflation rate. These developments have attracted a lot of public attention as to the likely causes of the financial turbulence in the emerging markets, especially in south-east Asia but also in Europe, and have led some observers to ask whether currency-cum-financial crises may spread to other transition economies as well.

One of the sources of concern for the European transition countries are their growing external imbalances. As noted above, a number of these countries have been running sizeable and increasing trade and current account deficits in recent years. External imbalances per se do not necessarily lead to currency collapse and/or financial turmoil. As a matter of fact, they are a natural consequence of a process of recovery (as is the case in eastern Europe), which may result from the strengthening of consumer and investor confidence and a rate of growth of domestic demand which exceeds the growth of domestic output. On the other hand, balanced trade and current accounts per se are not a safeguard against financial distress: for example, Bulgaria, which experienced the most serious financial crisis among the European transition economies, was not among those with large external deficits. Current account deficits were not the main – or at least not the sole – determinants of the collapse of the south-east Asian currencies either.

External imbalances – although useful as warning indicators – therefore need to be considered in the framework of a whole set of macro- and microeconomic issues which may contain the underlying factors behind currency and/or financial turmoil. Several can be mentioned. One concerns the sources of financing of the current account deficit. If the latter is predominantly financed by a steady inflow of long-term capital and, in particular, by FDI which enhance the future growth potential of the country, then it should not, in general, be a cause for concern. Conversely, a high level of exposure to short-term capital inflows may increase the financial vulnerability of the country. Short-term flows, driven to a large extent by interest rate differentials, are characterized by high volatility which may induce an overreaction to a perceived problem; if such flows are sufficiently large, their sudden retreat may result in "overshooting" and a currency crash. For example, the relatively large share of short-term capital flows in the Czech capital account in recent years (see chapter 4) was one of the factors that undermined the stability of the Czech exchange rate regime resulting in a run on the currency in May 1997. The share of short-term capital inflows has been quite significant also in Croatia, Russia, Slovakia, Slovenia, the Baltic countries and – after the exchange rate adjustment in February 1997 – in Romania as well.

Another factor is related to the sources of the boom in domestic demand that causes the imbalance. If the trade and current account deficits are used to finance investment in productive capacity, this can be expected to generate future returns in the form of an acceleration in the growth of domestic, tradeable output (eventually closing the deficits), and the country may then be on the safe side. On the other hand, if the inflows are mainly driven by persistent "consumers’ exuberance", then there exists the danger that the deficits will also become persistent as they will not generate the compensatory expansion and upgrading of the productive capacities of the economy. A boom in consumption demand has been in place for some time in some of the east European transition countries. It became even more pronounced in 1997; moreover, in some cases it has been accompanied by a rapid expansion of consumption-related credit (Croatia, Estonia and Poland). This may be a warning to policy makers in the affected countries.

In addition, it should be noted that the true fundamental determinants of an external imbalance might not be easy to detect in "real time". The detailed statistics that would allow the market participants to draw analytically sound conclusions are usually available only with a considerable lag, whereas investors have to make day-to-day decisions on their portfolios, usually on the basis of limited and incomplete information. Thus the market may tend to overreact to any perception of an "excessive" current account deficit regardless of its main determinants.

External imbalances and capital inflows are usually accompanied by a real appreciation of the exchange rate, which is a macroeconomic consequence of this type of disequilibrium. This takes place through different channels – either through inflation or through nominal appreciation – depending on the exchange rate regime and on the policy response. Regardless of the actual mechanisms of real appreciation, it may lead to a loss of competitiveness in the tradeables sector and a further deterioration of the external balance.

As discussed in chapter 2 of this Bulletin, there has been a trend towards real appreciation in most of the European transition countries in recent years. It has occurred both in countries which adhere to a fixed or pegged exchange rate (the Czech Republic, Poland, Slovakia and the Baltic states) and in those which maintain a floating exchange rate regime (Croatia and Slovenia). In the Czech Republic, Slovakia and Slovenia this process was accompanied by a marked deterioration in competitiveness; Poland was less affected because of a higher rate of productivity growth. On the other hand, Hungary which avoided a large real appreciation and had the highest rate of productivity growth, also achieved the largest gains in competitiveness.

External imbalances may in principle also reflect overspending by the government (the so-called "twin deficit" problem). Twin deficits indicate simultaneous domestic and external weaknesses of the economy and if left unchecked, may eventually pose a serious threat to macroeconomic stability. Persistent, large fiscal deficits alone may lead to similar results, especially if they are monetized. Most of the transition countries which adhere to (or have completed) reform programmes monitored by the international financial institutions, have made substantial progress in reducing their fiscal deficits. However, given the fragility of their macroeconomic environment and the ongoing and turbulent process of restructuring, the potential dangers still exist. An unsustainable fiscal and quasi-fiscal deficit was one of the fundamental sources of the financial crisis in Bulgaria; the financial destabilization in Romania at the beginning of 1997 was also partly due to a dangerous escalation of the quasi-fiscal deficit. The emergence of a twin deficit problem was one of the important macroeconomic signals that prompted the stabilization programme in Hungary in 1995 resulting in a major macroeconomic adjustment. Judging by the developments in 1996-1997, it appears that the Republic of Moldova may also be starting to develop a twin deficit problem.

While external imbalances may be an important ingredient of a currency-cum-financial crisis they are by no means the only possible source. A major role in the currency crisis in Asia was played by the underlying structural weaknesses of the domestic banking and financial sectors against the background of a rapid expansion of credit and inadequate banking supervision. Among the European transition countries, the financial crises in Bulgaria and Albania were also caused mostly by domestic factors (such as the weakness of the financial system and a lack of progress in restructuring).

The state of the banking system is one of the fundamental determinants of overall financial stability. Experience in a number of countries shows that financial turmoil often develops as a "double drain" crisis, that is, a simultaneous run on the currency and on the banking system as investors trying to escape from a depreciating currency withdraw their funds from the banking system. If the banks have been weakened by incautious lending and the low quality of their assets, they may collapse, even in the face of a minor run, and this will trigger an additional loss of investors’ confidence and more instability. In fact, this is how the currency-cum-financial crisis in Bulgaria escalated very rapidly in mid-1996. A number of banks and, hence depositors, also fell victim to such a process in the wake of the currency crisis in south-east Asia.

The banking sector in most of the transition countries is still rather weak: banks are burdened with inherited and new bad loans; bankers are still learning how to implement sound banking practices in a market environment; and regulation and supervision are not always adequate for dealing with the specific situation of the transitional environment. Thus, a strengthening of the banking system should be a priority concern to policy makers in these countries trying to attain overall financial stability.

Whether or not external and/or domestic weaknesses will develop into a currency crisis depends on a number of additional factors and features of a given economy. Foreign currency reserves are one of the first shock absorbers at the disposal of the authorities in the event of a speculative attack on the currency. The higher the level of reserves in relation to the domestic money supply, the stronger is the barrier they can provide. But – as has been demonstrated in numerous examples of currency crises in all parts of the world – if the attack is persistent, the authorities must eventually give up such a defence either because they run out of reserves, or because it becomes unacceptably expensive to continue, or because refusing a currency devaluation may have other significant negative side effects. Thus, although most European transition countries at present are endowed with substantial foreign exchange reserves, this is by no means a guaranteed shield against speculative attacks. In coping with such an attack on the currency, the authorities must also be careful not to set in motion another vicious circle: monetary austerity and contraction (which is often the main tool for defending the currency against a run) may tip the economy into a recession which will weaken further the banking system and this, in turn, may put further pressure on the currency.

Finally, with the globalization of financial markets the susceptibility of individual economies to "imported" adverse impacts has increased considerably. Financial turbulence tends to be "contagious" and can spread very fast affecting even economies with sound fundamentals. As is shown by the developments in 1997, the turmoil in south-east Asia started as a local currency crisis in Thailand but soon affected currencies and stock markets all over the world.

Contagion in currency crises can take various forms but two of them seem to be prevailing. First, if a group of countries export similar products on the same markets and one of them devalues, it obtains a unilateral competitive advantage over the others. In turn, the latter will have an incentive to devalue as well in order to restore their competitive position. Such a process of competitive devaluation appears to have triggered a domino effect in south-east Asia once the peg of the Thai baht was abandoned.

It might be questioned whether the run on the Czech koruna in early 1997, which resulted in a similar departure from the currency peg, was contagious for the other European transition economies. Indeed, in the wake of the Czech crisis there were runs on the currencies of some neighbouring countries. However, these were limited, at least so far. The likely reason is that the exchange rate regimes in most of the "competitor-countries" are less rigid than was the case in the Czech Republic (with the exception of Slovakia where it is essentially the same) and allow for possible adjustments of the nominal exchange rate either under a crawling peg (Poland and Hungary) or under a floating regime (Croatia and Slovenia). Actually, in 1997 the direction of causality in central Europe was probably just the opposite: it was the Czech devaluation of 1997 that was influenced by the loss of its competitiveness vis-à-vis the neighbouring countries, a deterioration that had built up in recent years because of its adherence to a fixed exchange rate. However, it remains to be seen whether the currency devaluations in the south-east Asian countries, which are competitors for the ECE transition economies on the west European markets, will lead to a further weakening of currencies in the ECE region.

The second form of contagion is related to investors’ behaviour in a crisis. When signs of trouble are detected in one country, risk averse investors are often inclined to extrapolate them to neighbouring countries (or countries with similar characteristics). This effect has probably intensified with the diversification of investors’ portfolios in the global market when collecting detailed information on the fundamentals of individual countries may be too costly and time-consuming. Investors often tend to display "herd" behaviour so that when one of them panics and starts to sell (or vice versa), it is very likely that others will blindly follow suit. Such types of behaviour may be self-fulfilling and so crises can develop even if all the fundamentals of a given economy are perfectly sound (e.g. when the turmoil initially spreads from a neighbouring country).

Due to their immature markets and weak institutional structures, the transition economies are especially vulnerable to such external shocks and pressures. The recent experience in Albania and Bulgaria shows that once a crisis occurs in such an environment, it can have catastrophic consequences for the economy and for the whole population. Although – as discussed above – there cannot be complete immunity against speculative attacks, governments in the transition economies can still do a lot to minimize the risks of the emergence of a crisis. Adherence to consistent and prudential macroeconomic policies and the avoidance of unsustainable external and domestic imbalances can help to reduce the vulnerability of the economy to currency crises and other unexpected shocks. Institutional and structural reforms – especially the strengthening of the banks and other financial institutions, coherent and effective supervision and regulation of financial markets, enterprise reforms, etc. – are also essential elements of an overall strategy for financial stability. A stable and sound banking and financial system in general is a prerequisite for further financial liberalization and the full opening of the financial markets in the transition countries (including the liberalization of their capital accounts) and their integration into the global financial market.