Public Policies Can Steer Eastern Europe to Sustainable Growth

Domestic demand will likely stay weak as consumers continue to rein in spending

Future growth will need to come from exports rather than domestic demand

Balanced macroeconomic policies, wage moderation can help prevent overheating

Exports are rebounding and domestic demand is showing signs of stabilizing. The IMF predicts the region will grow by 3.3 percent in 2010.

Still, emerging Europe cannot return to business as usual. Future growth—especially in countries that had built up large imbalances during the boom years of the mid-2000s—must rely more on capital flows into the tradables sector and less on flows into the nontradables sector. In these countries, exports are recovering but domestic demand will likely stay weak as consumers continue to rein in spending to pay off debt.

Eastern Europe was hit hard by the global crisis. The region grew very rapidly in the decade and half that preceded the world economic downturn but, in 2009, GDP declined by 6 percent.

Economic theory predicts that capital should flow from richer to poorer countries. That is what happened in eastern Europe. Capital flows to the region had always been high, but from 2003 onwards, they accelerated even further. Western European banks began to invest vigorously in eastern Europe’s growing markets—and in the ensuing competition, credit conditions loosened and growth became unbalanced. Capital inflows went largely to sectors such as real estate, construction, and banking that did not produce tradable goods—boosting domestic demand but not supply. That led to a surge in imports, unprecedented current account deficits, and overheating economies.

In the fall of 2008, the capital inflows came to a sudden stop. The decline in capital inflows caused a sharp drop in domestic demand. Domestic demand contracted most in countries that previously had the biggest increases in domestic demand, the large current account deficits, and the highest raise in the credit-to-GDP ratio. In countries without large imbalances, domestic demand held up better.

New export markets

Private sectors in countries that experienced the boom must develop new markets for exports of manufactured goods and services, which will require restructuring of their economies. That is no mean task, but it is achievable. Restructuring will be helped by market signals that will change as profits in the nontradables sector shrink and investments seek more promising venues.

But the process may be difficult...