Worst Outcome Was Avoided in Emerging Europe, New IMF Study Finds

Credit, demand booms driven by capital inflows proved unsustainable

Emerging Europe avoided currency crises, financial sector meltdowns

Fiscal policy, prudential measures key to avoiding future boom-bust cycles

Two years after the collapse of Lehman Brothers, the report takes stock of emerging Europe’s experience before, during, and after the global financial crisis. It concludes that credit booms can be very costly: they bring high output volatility that often result in deep recessions, and do not seem to be associated with higher average growth.

Boom driven by large capital inflows

During 1995–2008, emerging Europe enjoyed exceptionally high growth. It was initially driven by the external sector, but from 2003 onwards, a domestic demand and credit boom increasingly took over as capital poured into the increasingly financially integrated region from highly liquid global markets. A large part of these inflows was intermediated by the local affiliates of western banks, which had come to dominate most local banking systems.

The boom years left much of the region addicted to a continuation of foreign-financed credit growth. Large current account deficits, high external debt, and homegrown asset price bubbles all indicated a high level of vulnerability. In Russia and Ukraine, the economies relied on energy and steel exports continuing to fetch favorable prices on global commodity markets.

It is therefore not surprising that emerging Europe was particularly hard hit by the financial turmoil that followed the collapse of Lehman Brothers in September 2008. Although western banks stood by their local affiliates and broadly maintained exposure, the sudden lack of new inflows, together with the freezing-up of the wholesale funding and syndicated loan markets, was a major disruption. The subsequent collapse of global trade and commodity prices compounded the problems.

Avoiding the worst outcome

Policymakers and international financial institutions responded swiftly to the crisis—defusing the risk of full-scale currency crises and financial sector meltdowns. Given the scale of the adverse shocks and the vulnerabilities built up in the boom years, there was no escaping a major setback. However, an even worse outcome was avoided.

Policymakers moved quickly to stabilize their banking systems. Monetary policy was adjusted to either guard against excessive currency depreciation or stimulate domestic demand, depending on country circumstances...