Sheltered from the Storm

• Author: Bas B. Bakker and Christoph Klingen
• Position: an Advisor and is a Deputy Chief, both in the IMF's European Department.

Central, eastern, and southeastern Europe have been notably absent from the euro area crisis. Financial markets have been very concerned about Greece, Ireland, Portugal, and—more recently—Italy and Spain. But they do not yet appear overly concerned about the 22 countries in central, eastern, and southeastern Europe (see box), despite their close ties with the euro area.

In a radical break with the past, investors are often demanding lower risk premiums for the debt of these smaller, less affluent European countries than for that of western European nations: Estonian risk premiums have at times been lower than those paid by the Netherlands and those of Bulgaria and Romania lower than for Italy and Spain.

That wasn’t the case a few years ago, when the turmoil in western Europe that followed the onset of the global financial crisis in 2008 quickly spilled over to the central and eastern European economies. The region had many prosperous years, supported largely by easy credit from western Europe. But after the failure of Wall Street investment bank Lehman Brothers in September 2008, banks in the euro area countries abruptly stopped new lending, triggering a sharp contraction in domestic demand in most central and eastern European economies. A massive slump in global trade exacerbated the crisis, battering the region’s exports. As a result, the countries in the region suffered an unprecedented economic contraction in 2008 and 2009. By the time the region started to recover in 2010, GDP had declined by as much as 25 percent in some countries, although a few, such as Albania and Poland, escaped relatively unscathed.

Except for a scare in late 2011, countries in the region have been largely untouched by the euro area crisis that began two years ago—mainly because they rely far less today on easy credit from western European banks to support domestic spending and because they have taken steps to rein in government deficits.

Links still strong

This seeming ability to sidestep the euro area turmoil is occurring despite continued strong links between western and eastern countries. Since the Soviet Union dissolved two decades ago, western and eastern Europe have become increasingly interconnected, through both trade and financial channels.

Western Europe is the region’s largest export market. Some of the exports are inputs for western Europe’s exports. Many of the countries in the region have become part of a supply chain that provides inputs to final...