Bangkok 28 April 2009
Mr. Jan KUBIS
UNECE Executive Secretary
I. Introduction and overview
The ECE region which is composed of 56 economies is a very diverse area with advanced, emerging and a few rather poor developing countries. The nature of the crisis in terms of how it entered and impacted these different economies varies considerably, and the policy options available to these countries also vary considerably due to differing economic circumstances and institutional constraints. As such it is difficult to generalize about the economic situation and policy responses of the ECE economies overall; at a minimum North America, the advanced western Europe countries and the European emerging economies must be treated separately.
The ECE region entered in 2008 what is forecast to be the worst economic downturn since the Second World War. Each of the sub-regions of the ECE is either experiencing or expecting to experience negative growth in 2009. The decline in growth has been accompanied by rising unemployment, and especially large declines in international trade and capital flows. Government fiscal positions have deteriorated significantly. In fact, the declines in economic growth in the emerging economies of the ECE are likely to be greater than in the advanced economies where the crisis originated.
The severity of the crisis in Europe has been due to the fact that: 1) many European banks owned a surprisingly large share of the toxic assets, 2) the national regulatory and institutional structure of the financial sector in most European economies was poorly designed for dealing with financial market turmoil, 3) regional or pan-European institutions and regulatory systems were inadequately designed for the financial situation that developed, 4) European banks were more highly leveraged than US banks, 5) in some cases European banks were overly reliant on international wholesale financing, 6) European banks had lent far more to emerging markets (than US banks) and were thus much more exposed to the downturn in these economies, 7) even in those economies that escaped the initial financial shocks, the regional trade linkages were quite large, 8) the design of the European Monetary System essentially eliminated lender of last resort backing for national commercial banks and sovereign debt, 9) European policy makers generally did not appreciate the importance or necessity of counter-cyclical macroeconomic policy, 10) the European emerging economies were particularly vulnerable to a crisis due to large current account deficits and extensive foreign-currency denominated debts, 11) market participants treated the eastern European economies as emerging markets which limited their policy space, 12) several European economies had their own housing bubbles combined with weaker mortgage lending standards, and 13) government assistance to the sectors (i.e., automobiles) most negatively impacted was constrained by nationalistic competitive concerns.
II. The impact of the crisis
At a general level, although the shock was smaller in Europe than in the US, the European policy response was more delayed and considerably weaker and as a result their decline in GDP has been as large or even larger than in the US. For the advanced economies this will be their deepest recessions since the Great Depression of the 1930s, although unemployment may not reach the levels of the 1981-82 downturn. In emerging Europe, which experienced a “sudden stop” in terms of capital inflows, the magnitude of the shock was large, although of a different nature than in the advanced economies. These emerging economies have been unable to implement counter-cyclical macroeconomic policies and as a result their economic declines have been quite large, generally larger than in the advanced economies. Their downturns, however, will not be as severe as their transitional recessions of the early 1990s.
Once the value of the US mortgaged-backed securities began to fall, the crisis moved to the wider-European region quite rapidly through a surprisingly large number of different channels. In some countries the banks owned large quantities of the toxic U.S. assets (i.e., Belgium, Germany, Switzerland), in other cases the countries had their own bursting housing bubbles (i.e., Ireland, Spain, UK), in other cases, banks and companies were dependent on global capital markets which seized up (Russia and most of east-central Europe), in other cases, domestic banks had foreign subsidiaries exposed to non-performing loans from countries negatively impacted by these already mentioned channels (i.e., Austria, Greece, Sweden), in other cases there were large declines in remittances which had been a significant component of their gross national incomes (Armenia, Georgia, FYR of Macedonia, Moldova, Serbia, and Tajikistan), and in almost every case countries were negatively impacted by declining exports and commodity prices and declining tourism.
Key macroeconomic indicators
Annual real growth in the ECE region in the three years prior to the beginning of the crisis (2005-2007) averaged 3.2 per cent but this fell to half of that (1.5 per cent) in 2008 and is forecast to fall to negative 3.5 per cent in 2009 before recovering slightly to about one-half per cent in 2010. In 2009 growth in each of the ECE’s sub-regions is forecast to be in the range of minus three to minus five per cent. Not only is growth forecast to be lower in the European emerging economies but their declines relative to their recent historical experience will be much larger as well. In addition the emerging economies have weaker social safety nets than the advanced economies and have a larger percentage of their populations nearer subsistence levels
Figure 1 –Real Growth in the Major ECE Sub-regions, 1999-2010
Growth turned negative in the US beginning in December 2007, in the eurozone in the second quarter of 2008, and in Russia and most of the emerging economies in the last quarter of 2008. In 2009, growth is expected to be negative 5.1 per cent in the CIS, negative 5.1 per cent in Turkey, negative 4.2 per cent in the eurozone, negative 2.8 per cent in the U.S., and negative 2.4 per cent in the EU new member States. The economic downturn has been quite severe in the Baltic economies and Iceland where growth is forecast to be close to negative 10 per cent and somewhat severe in Germany, Ireland, Russia, and Ukraine. A few of the smaller ECE economies such as Albania, Azerbaijan, Cyprus, Tajikistan, Turkmenistan, and Uzbekistan may have positive growth in 2009; it may be especially strong in the latter two economies. Although a slow recovery is expected for 2010 with positive but low growth throughout most of the region, there is considerable uncertainty surrounding this forecast
Unemployment rates in the U.S, Europe, Turkey, and the CIS are likely to reach double digits by 2010; in some European economies the situation is much worse, for example unemployment in Spain may reach 20 per cent by 2010.
By March 2009 the level of employment in the US had declined by 5.1 million jobs since its recession began in December 2007; unemployment increased to 13.1 million, which translates into an unemployment rate of 8.5 per cent which is the highest in 25 years. The unemployment rate for men was approximately 2 percentage points higher than for women. In the EU the unemployment rate was 7.9 per cent in February 2009; 7.8 per cent for men and 8.0 per cent for women. It varied considerably from 15.5 per cent in Spain, 14.4 per cent in Latvia, and 13.7 per cent in Lithuania to a low of only 2.7 per cent in the Netherlands. Currently there are 19.2 million unemployed in the EU. The Russian unemployment rate rose to 8.5 per cent in Feb. 2009, the highest rate since March 2004; unemployment is expected to increase to 12 per cent by the end of 2009.
The European emerging markets were initially sheltered from the first wave of financial instability, as their banking activity was based on traditional lending models, with no exposure to the toxic assets. However, the situation deteriorated dramatically in late 2008, as global capital markets came to a standstill as a result of increased risk aversion and the accompanying “flight to quality”. Private capital flows to the world’s emerging markets declined from $929 billion in 2007 to $466 billion in 2008 and are forecast be only $165 billion in 2009.
The decline in economic growth in Russia during the current crisis has been extraordinary, and represents probably the greatest “reversal of fortune” of any of the world’s major economies. GDP is likely to decline 6.0 per cent in 2009; in 2007 growth was 8.1 per cent.
For the advanced economies, the crisis has moderated inflation that had begun to increase above target levels in early 2008; although they may experience a short period of deflation during 2009, this is unlikely to be persistent. For emerging Europe, however, the crisis by leading to significant currency depreciations, has in some cases increased inflation. Thus for example, average consumer prices were 14 per cent higher in the CIS in January 2009 than a year earlier, and inflation may be over 5 per cent in most of south-east Europe in 2009.
Some sectoral impacts
The decline in manufacturing activity has been particularly large in the advanced economies. In the eurozone new orders in January 2009 were 34 per cent lower than a year earlier; this represented the largest monthly y-o-y decline since Eurostat began compiling this data in 1996. Especially hard hit were European exporters of manufactured capital goods such as Germany which is the world’s largest exporter of manufactured goods. By February 2009 US manufacturing output was down 14.0 per cent and manufactures employment had declined by 1.5 million (or 11 per cent) since the recession began. In Ukraine, the declines in steel and metal production have been especially large, declining 43.3 per cent in the first quarter of 2009 y-o-y.
In March 2009 car sales were down 23.5 per cent the US and 47 per cent in Russia than a year earlier. In the final quarter of 2008 European new car sales were down 19.3 per cent (y-o-y). In the EU, automobile production, which accounts for 6.5 per cent of the manufacturing sector, has declined significantly and some of the governments have provided various types of support. In the EU, Germany is by far the largest producer of automobiles; in February production was down 65 per cent from a year earlier. Car production per capita is even larger in several of the NMS, including Slovakia, Slovenia, and the Czech Republic, and accounts for a sizeable percentage of their industrial production. By January 2009 automobile production had declined by 60 per cent (y-o-y) in Turkey.
As is usual in an economic downturn, world commodity prices have declined considerably, and that has meant that those commodity exporters, which are primarily in the CIS, have suffered a large decline in export earnings. The decline in energy prices has been especially large, and that has had large repercussions for Russia and the energy abundant CIS in central Asia.
Trade for the ECE economies has declined significantly over the last year, generally declining by a quarter to a half. This has been due to both the decline in national incomes and consumption and the collapse of trade financing as credit markets seized up. In February 2009 US merchandise exports were 22.6 per cent lower than a year before and US imports were 30.4 per cent lower. For the same period, Russian merchandise exports declined by 47.5 per cent and imports declined by 36.5 per cent. In January 2009 EU exports were down 24.8 per cent and imports were down 22.1 per cent from a year earlier.
The condition of the financial sectors
The equity markets in the ECE’s advanced economies have lost more than one-half of their value since their peaks in 2007 while those in many of the emerging economies have lost three-quarters of their value. A large percentage of the equity capital of the banking sector in the US, Western Europe and the European emerging markets has been wiped out by the crisis. Currently interbank markets in the US and Europe remain dysfunctional and any newly created debt requires a government guarantee to be marketable. Domestic credit expansion in Europe and the US has essentially collapsed.
The US losses are due primarily to subprime mortgages although commercial real estate and credit card debt has increasingly become problematic. The European banks also owned sizeable amounts of subprime securities but, unlike their American counterparts, also have large exposures to non-performing loans in emerging markets throughout the world. Of the $4.6 trillion of foreign bank loans to emerging economies, eurozone banks account for $3.4 trillion or 73.4 per cent while US banks account for only $475 billion or 10.3 per cent; UK banks also have exposure. By March 2009, EU governments had provided $380 billion for bank recapitalizations and guaranteed $3.17 trillion of bank loans.
In Europe, there has been an issue regarding the absolute size of their banks because they are exceedingly large relative to their home countries’ GDP. This problem was most apparent with Iceland where the banks had assets ten times the GDP of the country. The assets of Fortis were several times the GDP of Belgium, those of Barclays were over 100 per cent of the UK’s GDP, and those of Deutsche Bank were over 80 per cent of Germany’s GDP. European governments therefore could not reasonably be expected to guarantee the liabilities of their banks, especially retail deposits, but were nevertheless forced to do so as the potential for global bank runs developed in the autumn of 2008.
Effects on achieving the Millennium Development Goals
The current crisis has already and will further retard or even reverse the recent progress in achieving the Millennium Development Goals (MDGs) in the ECE region. For the ECE region, extreme poverty had almost been eliminated by the end of 2007 but with higher food prices, falling employment opportunities, reduced remittances, and strained safety nets, it is estimated (by UNDP) that already another 10 million people in the region have been pushed back into extreme poverty.
One of the MDGs for which progress has been disappointing has been in controlling HIV/AIDS and tuberculosis in the European emerging markets.
Another MDG objective that is likely to be reversed is the progress recently made on improving gender equality in the region. Since women are more likely to be in the informal sector, they receive few benefits when laid off, and thus the rate of poverty for them or single parent households will increase.
An important financial flow for a number of the European emerging economies has been remittances; for some, these are the largest external financial inflow and are larger than either capital inflows or official developmental assistance (ODA). Remittances are expected to decline significantly in the next two years In Moldova; remittances fell from 35 per cent of GDP in 2006 to 25 per cent in 2008 and are likely to fall further in 2009 and 2010. The central Asian economies, especially the poorest of them like Tajikistan are particularly dependent on remittances and will especially feel the impact of their decline.
III. Policy responses to the crisis
Country specific responses
Economic policy in North America and western Europe has concentrated on addressing the meltdown in their financial sectors and accompanying recessions by providing governmental support for the financial sector, attempting to provide additional macroeconomic stimulus to minimize the recession, and reforming the governance structure and regulatory apparatus of their financial markets to avoid a repeat of the current crisis. The US has been far more focused on macroeconomic stimulation in order to get out of the current crisis while the focus in Europe (especially continental Europe) has been on regulatory reform to avoid a future crisis. Their macroeconomic policies for addressing the economic slowdown have varied significantly. Macroeconomic policy in the Euro zone has essentially been neutered by the limitations on fiscal policy imposed by the Growth and Stability Pact while monetary policy is restricted to a narrow focus on medium term inflation under the charter of the European Central Bank. Neither region has been particularly successful in recapitalizing their banking systems.
The European emerging markets, like all emerging markets, have had far less policy space in terms of macroeconomic stimulus and little influence in discussions about financial market reforms. They have been essentially forced to tighten fiscal and monetary policy to demonstrate to world capital markets that there will be no defaults or inflation that would destroy asset value. The NMS have additional institutional constraints in that a number of the economies have committed to fixed exchange rates or currencies boards. Finally, a number of the emerging economies are under IMF programs, which have strict macroeconomic requirements to fulfill. The difference in the economic policy options available to advanced and emerging economies in the region has been stark.
The US has taken the lead in stressing the importance of fiscal stimulus and has implemented the largest program in the ECE economies. A $787 billion package (about 6 per cent of GDP) was agreed to in early 2009, and by comparison this was slightly larger than Japan’s package of 4.5 per cent of GDP but less than the Chinese plan. The US package included $507 billion of additional spending and $282 billion in tax cuts.
The Europeans were much more restrained in their use of fiscal policy. The European Commission proposed in late November 2008 a European Economic Recovery Plan which included a fiscal stimulus of €200 billion or 1.5 per cent of GDP. The boost in demand was to be “in full respect of the Stability and Growth Pact”.
The fiscal positions of the European emerging economies have also deteriorated considerably. However for them, this was generally not the result of increases in government spending but decreases in tax revenues. In Russia there has been a massive swing in the federal budget from a surplus of 4.1 per cent of GDP in 2008 to a deficit of 7.4 per cent of GDP in 2009.
Interest rates in the advanced ECE economies have been reduced to historic lows; in the US, UK and Switzerland rates fell effectively to zero, and in the eurozone, although they were still above one per cent in the early spring of 2009, they are expected to fall further in the coming months. As with fiscal policy, European monetary policy was eased later and more slowly. With interest rates near zero, traditional monetary policy has reached its limit. As a result, the US, UK as well as Switzerland has implemented additional measures, referred to as quantitative easing, to inject additional liquidity into their financial systems. Although the ECB currently appears opposed in general to quantitative easing, if it ultimately needed to implement this type of policy, it would face a number of implementation issues not faced by national central banks.
Once the crisis had firmly extended its way into the European emerging economies (including the NMS) by mid-2008, the central banks of these economies had very limited monetary policy options for addressing the crisis. Given the flight to quality, interest rates had to be kept high to avoid capital outflows. Those that had fixed exchange rates or currency boards had to set monetary policy to maintain the exchange rate. Foreign currency-denominated loans were prevalent in a number of economies and thus, even in those with flexible rates, monetary policy had to be cautious to avoid large exchange rate depreciations that would have created “balance sheet” effects for the borrowers. A significant increase in the domestic costs of servicing these debts would increase non-performing loans and potentially threaten the stability of their banking systems. Thus although interest rates were near zero for most of the advanced economies (except, Iceland whose interest rate was 17 per cent in the spring of 2009), they were often quite high in the emerging economies.
The large number of trade and investment agreements that cover the ECE economies have severely constrained the ability of governments to aid specific sectors, but they did help keep more overt trade protectionism under control. In the EU, the provision of state aid to support domestic industries was largely considered to be a violation of existing EU agreements, and any provision of EU-wide aid was financially impossible and any coordinated government response proved to be too complicated and controversial to undertake. The European Commission agreed to some emergency measures (only valid through 2010) that relaxed the rules on state aid by increasing the ceiling on aid that required Commission approval and by loosening the restrictions on state guarantees and subsidized loans.
The crisis especially impacted the automobile sector, and policies initiatives to subsidize that sector were the first to appear, and the conflicts that arose there largely limited government attempts to aid other sectors. The US government provided large subsidies to two of its big three domestic automobile firms so that they could avoid bankruptcy. As part of the French stimulus package, the government established a €6 billion package of assistance for the domestic automobile industry (Renault and Peugeot) if they agreed not to close any French factories for the next five years; the Italian, Spanish, Swedish and United Kingdom governments also provided government aid to their automobile sectors. The Swedish government, however, decided not to bail out or buy Saab once GM decided it could no longer continue to carry the company. The German government established a €1.5 billion subsidy program for consumers to buy a new car if their old car (over 9 years old) was scraped; there was no preference for buying a German car. Because of its popularity, this program was tripled to €5 billion in the spring of 2009.
Russia and a number of the CIS which are not members of the WTO were less constrained, but the European emerging economy governments generally did not have the financial resources to provide much aid to industrial sectors.
Social protection and labour policies
Although the advanced economies in the ECE are implementing fiscal stimulus programs that often have a component for providing additional assistance to those most harmed by the crisis (i.e., extended unemployment insurance as in the US), the European emerging economies have been forced into fiscal retrenchments and as a result are having to reduce funding for social and safety net programs. The decline in economic growth is especially critical in the European emerging economies because the primary policy mechanism for addressing poverty in them has been one based upon “trickle-down economics” from increased growth instead of policies to promote pro-poor growth and redistribution.
Given the severity and extent of the crisis, the need for cooperation amongst the countries of the ECE has been great. The major economies of the region were involved in the G-20 process which required a number of compromises as their initial positions often varied.
In early 2009, EBRD (€6 billion), EIB (€11 billion), and the World Bank (€7.5 billion) put together a €24.5 billion package of support for the European emerging economies, especially their financial sectors. The EU enlarged its balance of payments assistance fund for non-euro economies to €25 billion in early 2009 and then doubled it to €50 billion in March.
There has been only limited regional cooperation or coordination in addressing the crisis amongst the CIS. Russia, despite its own serious economic situation, nevertheless has increased its financial support for neighboring economies. In early 2009 it proposed an anti-crisis fund within the framework of the Eurasian Economic Community (EurAsEC) of about $10 billion to aid primarily the other CIS economies. This fund is supposed to work with the Eurasian Development Bank
It is likely that a significant number of the European emerging markets will need some type of multilateral support before the crisis is over. By March 2009, six economies (Hungary, Latvia, Ukraine, Belarus, Georgia, and Armenia) already had IMF programs and others were close to concluding an agreement (Bosnia, Romania, and Serbia). The sizes of the packages were in the range of 5 to 10 per cent of their GDPs. Several of the countries have experienced difficulties in meeting IMF agreed targets and their disbursements have been temporarily put on hold (Latvia, Hungary, and Ukraine). These are in addition to the IMF rescue of Iceland, a European advanced economy. Several other countries established new flexible credit lines from the IMF as a precautionary move; Poland obtained $20.5 billion to boost the reserves of its national bank so as to provide more support for its currency.
IV. The way forward
Prospects for economic recovery
The current economic situation in the spring of 2009 appears to have plateaued; the rapid falls in output, trade and financial flows that occurred in the last quarter of 2008 and the first of 2009 appear to have mitigated. It remains uncertain whether this will be a temporary landing to be followed by another downward plunge as was the case with the stability experienced in the summer of 2008 or whether this represents the bottom from which a recovery can begin. In case of further problematic developments, there is a high probability it will involve the economic vulnerabilities that currently exist in the European emerging economies. Growth may resume in the US in the second half of 2009, but the recovery will likely be delayed in Europe because of their much weaker policy response.
Once the recession is over, it will be necessary to unwind any stimulus quickly in order to avoid inflation and limit the excessive growth of government debt. However, this will probably prove to be very tricky, because macroeconomic policy was tightened prematurely during the Great Depression in the 1930s, which caused the world to have a relapse into several more years of depression, and the same thing happened as well in Japan in the 1990s.
The crisis has also exposed once again the international monetary systems’ inadequacy in being able to provide emerging markets external finance in order to promote their development. This will have important implications for some European emerging economies, particularly those in south-east Europe since it will mean that they will not be able to follow in the footsteps of the NMS and copy their development model. There is therefore a need to redesign the international financial architecture so that emerging economies can safely rely on external capital, or alternatively, some mechanism must be established that will keep large imbalances from developing. The actions of the G-20 or individual governments have so far not addressed this important concern. The tripling of IMF resources was one very important and useful reform that has been significant in minimizing the negative consequences of this crisis for the European emerging economies.
The advanced economies of the ECE have responded to the crisis with unprecedented fiscal stimuli and monetary easing. The European response is often considered weaker than optimal, that is due significantly to institutions inadequately designed for conducting macroeconomic policy. There are, however, long-run costs in terms of potential inflation and debt repayment that result from the aggressive use of macroeconomic stimulus. Only after the crisis is completely over and many of the longer-term complications of debt and inflation have been resolved will it be possible to fully evaluate whether the more aggressive response of the US was preferable to the more cautious European approach.
Finally, the advanced economies of the ECE have dominated the world’s international economic organizations over the last half century. This situation is no longer consistent with the underlying economic realities of the world economy. The ability of the international economic institutions to continue to play their coordinating and regulatory role, which is required for a well functioning global economic system, will require further reform to make them more effective and legitimate.