The Euro Crisis Is Bigger Than You Think

Authors: Uri Dadush, Shimelse Ali
Originally published by the Carnegie Endowment for International Peace

The eight newest European Union (EU) members (Bulgaria, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, and Romania) are committed to eventually adopting the euro. But, all already suffer from the problems that dragged the GIIPS—Greece, Ireland, Italy, Portugal, and Spain—into crisis: lost competitiveness, widening external deficits, and deteriorating public finances. However, the “peggers“—Estonia, Latvia, Lithuania, and Bulgaria, who have fixed exchange rates—are in much worse shape than the “floaters“—the Czech Republic, Hungary, Poland, and Romania. The structural distortions, including external imbalances, in all of the newcomers suggest that none of them will be ready to join the euro soon, as joining would likely only accentuate the distortions. When, or if, they adopt the euro, they should apply valuable lessons from the GIIPS’s experience so as to avoid painful adjustments later on.

The initial boom among the newcomers

The process through which the EU newcomers lost competitiveness was largely similar to the one in the GIIPS: lower interest rates and their expectations of rapid convergence to Euro area members’ economic fundamentals led to a boom in domestic demand. Deepening financial integration and low barriers to incoming capital, as well as reduced perceptions of exchange rate risk, particularly among the peggers, helped attract capital inflows. This furthered the demand surge, which saw domestic demand grow by more than 10 percent annually in the three Baltics (Estonia, Latvia, and Lithuania) and by nearly 9 percent annually in Bulgaria from 2002 to 2007. The price of non-tradables rose compared to tradables and labor markets tightened—inducing wage increases well in excess of productivity. The deterioration of competitiveness soon resulted in large macroeconomic imbalances. Economic activity was pushed above potential, and the output gap (the difference between actual GDP growth and potential GDP growth as a percentage of potential GDP) in the three Baltics grew to be very large. The phenomenon was less pronounced among the floaters, but Romania and the Czech Republic also observed rapid output gap growth.

Real effective exchange rates, based on unit labor costs, appreciated significantly in most of the newcomers, particularly in Latvia and Romania. This was reflected in the deterioration of their export performances, especially among the peggers. The external trade balance widened by 10 percent of GDP in Bulgaria and 14 percent of GDP in Latvia, from 2002 to 2007.

Peggers and floaters

Both external and domestic imbalances have grown to be much more pronounced in the peggers. While a fixed exchange rate appeared advantageous during the pre-crisis boom when the peggers grew faster than the floaters, the downturn that followed has also been much greater in the former.

After joining the EU, the peggers saw wages grow at double-digit average annual rates from 2004 to 2008. The average rate reached about 25 percent a year in Latvia—more than ten times the Euro area average. Unaccompanied by matching productivity increases, this led unit labor costs (in euros) to nearly double in Latvia and grow 45-60 percent in Estonia and Lithuania—significantly faster even than in the GIIPS. While unit labor cost increases were generally moderate among the floaters, Romania saw an increase of about 90 percent.

The sharp drop in capital inflows after mid-2008 to the Baltics, which experienced the largest surge in inflows before the crisis and relied on foreign banks to fund credit growth, resulted in a deeper downturn. In 2009, domestic demand fell by about 25 percent in the Baltics—almost eight times the decline in the Euro area—and by about 15 percent in Bulgaria. Unemployment, which had been declining amid the pre-crisis domestic demand boom, shot up in 2008 and 2009, with the increase ranging from around 9 percentage points in Estonia and Lithuania to double-digits in Latvia.

Change in External Trade Balance, Percentage points as a share of GDP, 2002-2007

The floaters enjoyed a less pronounced boom, but, with a wider range of policy instruments at their disposal, they were also able to moderate their recessions. GDP contracted by 4-7 percent in Hungary, the Czech Republic, and Romania in 2009, still greater than the Euro area’s average contraction of 4.1 percent but much less than that of the peggers. Currency depreciation and expansionary monetary policy helped. The currencies in Hungary, Romania, and the Czech Republic depreciated by 10 to 20 percent against the euro from the third quarter of 2008 to the second quarter of 2009, while Poland’s zloty depreciated by more than 30 percent, giving the economy a needed export boost. Poland was the only EU country to register positive growth in 2009. However, given the severity of the liquidity crunch, several of the floaters were forced to rely on IMF support.

Ready to join the euro

None of the newcomers appear ready to adopt the euro soon, even assuming that the Euro area countries were able to quickly restore stability and investor confidence in their economies. Despite the particular attention on fiscal criteria for joining the Euro area, however, and the painful austerity measures the newcomers undertook during the recession, the core problems in these non-euro economies are a loss of competitiveness and excessive allocation of resources towards non-tradable sectors, not fiscal mismanagement.

Estonia is enjoying a much better fiscal situation than the others and is expected to adopt the euro in January 2011. However, it had been running very large current account deficits—averaging about 12 percent of GDP between 2002 and 2008—and its gross external debt more than doubled, which raised concerns about its external sustainability. While the country managed to turn the current account deficit into a surplus in 2009, it came at the expense of an increase of about 10 percentage points in the unemployment rate. Among the floaters, where competitiveness is a less obvious problem, only the Czech Republic exhibited inflation and interest rates that satisfied the convergence criteria last year.

With gross debt less than the Euro area’s prescribed 60 percent of GDP, the newcomers, with the exception of Hungary, are currently in a much better debt position than the GIIPS. However, their debt is rising rapidly. For example, Latvia’s debt level in 2010 is projected to be about four times its 2000–2007 average and the debt level in Estonia and Lithuania is expected to double over the same period. Though the debt/GDP ratios are low, they can quickly become unsustainable if the competitiveness problems are not addressed. The governance indicators of the newcomers, with the exception of the Czech Republic and Estonia, rank below debt-burdened Greece and lag the other euro countries by a wide margin, suggesting that their capacity to carry large amounts of public debt without alarming the markets is limited.

While devaluation could, combined with other measures to restrain demand and wages, help the peggers regain some lost competitiveness, their large foreign-currency-denominated debt deters them from straying from the euro. Loans denominated in foreign currency amount to nearly 90 percent of total lending in Latvia, 85 percent in Estonia, and 65 percent in Lithuania. Even among the floaters, the scope for exchange rate flexibility is limited by the degree of foreign-currency borrowing. Hungary and Romania, for example, have large euro-denominated debts to Austrian banks.

Lessons from the crisis

One obvious lesson for the Euro area is that it must tighten its criteria for admission. In particular, the Maastricht fiscal deficit criterion of 3 percent of GDP, which has frequently been criticized as too rigid in a downturn, is also misleading for newcomers. Rather than target a small deficit, they should run large fiscal surpluses to offset the demand boom that typically accompanies euro adoption. Furthermore, much like the GIIPS, the EU newcomers have a long road of competitiveness-restoring reforms ahead, including wage cuts and fiscal austerity. At the same time, they can learn from the GIIPS experience. Three other important lessons have emerged for the newcomers:

• First, competitiveness needs to be closely monitored and, since currency devaluation is not an option under the euro, reforms must be made early on. For example, a tax structure that weighs more on construction and services could help moderate the demand for and supply of non-tradables.
• Second, special attention needs to be placed on wage-setting and labor market flexibility, as well as on how to bolster the tradable sector.
• Third, there is a strong case for moderating the inflow of foreign capital, especially debt-creating capital, during the early years of euro adoption via tighter bank regulations on borrowing abroad and general capital controls.

In conclusion, despite their commitment to join the euro, the newcomers need to assess their situation and apply these valuable lessons to avoid much painful adjustments in the future.