Losing Their Halo

• Author: Martin Cihák; Srobona Mitra
• Position: Senior Economist; Economist in the IMF’s European Department
• Pages: 12-14

Page 12

Many countries in central and eastern Europe are finding it hard to adjust to the new economic reality

THE new central and eastern European members of the European Union had it very good for a while. EU membership spurred economic and financial integration, leading to rapid economic growth and large capital inflows. It also created a “halo effect,” shielding some countries from paying more to borrow external funds in spite of growing vulnerabilities.

But the good times didn’t last. The new member states’ initial resilience to the global financial turmoil gave way to deep crisis in a few of them. When the global crisis hit in 2007, emerging Europe initially seemed immune because it did not have direct exposure to U.S. subprime assets. But as the crisis deepened in 2008, exports slowed and capital inflows came to a virtual standstill in some countries. Unfortunately, the economic and financial integration that had helped emerging Europe catch up with advanced Europe during the good times made them more vulnerable as the global economic climate worsened.

The new EU members must now not only overcome the current crisis but also build on the gains of recent years. They need to put in place more prudent policies and stronger policy frameworks, especially with respect to fiscal policy and financial supervision. And they must do so in a far more difficult global economic environment. The good news is that the flexibility of their economies may help them adjust more quickly than the more advanced European countries.

Catching up, and fast

The accession of eight new member states—the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, the Slovak Republic, and Slovenia—to the European Union in 2004 represented the biggest ever enlargement of the European Union in terms of population (19 percent) and area (22 percent), but a smaller increase in terms of economic output (9 percent). Two more countries from the former Soviet bloc, Romania and Bulgaria, joined in 2007. For all these countries, EU membership represented a major milestone in their transformation to market-based economies.

Increased economic integration and successful reforms fostered faster than expected growth in the new member states— by 1 percent, on average—given their economic fundamentals (see Chart 1). This rapid growth allowed the new EU countries to increase their share in global economic output. Greater access to western markets led to a rapid rise in exports and improved access to foreign financing helped boost consumption.

EU membership has been particularly favorable for Slovenia and the Slovak Republic, which have managed to meet all of the Maastricht criteria and enter the euro area. Slovenia was the first new member state to adopt the euro, in January 2007. The country’s per capita income, the highest among the new member states, reached about 80 percent of the EU average in 2006, putting it on a par with Greece and above Portugal. The Slovak Republic, the most recent entrant to the euro area in January 2009, has been one of the...