Europe’s Emerging Markets: Hot Spots, or Not?
By Michael Deppler
Those in the
crisis-spotting business increasingly point the finger at Europe’s
emerging market economies as next in line for a bust. They suggest that
after opening themselves to global capital markets in a bid to progress
rapidly to western European income levels, some former transition
countries in the Baltics and central and southeastern Europe are now
This may be true, but
it’s not the whole story. Clearly, several countries appear to have the
same symptoms as did a number of Asian countries before that region’s
financial crisis a decade ago. Common symptoms are yawning current
account deficits financed by foreign funds and high and rising levels of
private debt. And some of the countries with the most pronounced
indicators operate fixed exchange rate regimes.
But in their hurry to
lump the region with pre-crisis Asia, critics overlook the important
differences. First, the world has moved on. Confidence in the policy
management of emerging market economies is now much higher than 10 years
ago. In particular, domestic policies and frameworks are stronger and
subject to much greater transparency—the direct fruit of lessons learned
internationally from the earlier crises. Accordingly, investor
confidence in the region has withstood two international shocks
recently. Second, investors find actual or prospective EU membership by
many European emerging economies reassuring. This seems rooted in
greater confidence around issues like property rights, sound economic
policies, regulatory requirements and evenhanded treatment of domestic
and foreign investors. As a result, and with the prospect of very high
rates of return to capital, foreign investors have opened their wallets.
And the capital inflows are largely long term.
Large current account
deficits are a natural outcome of this process. Inflows induce a demand
for imports. Improved prospects for real incomes prompt greater
consumption, which further fuels import demand. In time, however, the
investments will generate increased exports and consumption behavior
should stabilize, helping to contain and eventually reverse the current
Does this mean one can
disregard the large current account deficits in the meantime? Obviously
not. It is increasingly difficult to ascertain just how high current
account deficits can go in today’s globalized and transparent context
and still remain sustainable. Nonetheless, the levels in some countries
are uncomfortably high, reaching in some cases one-fifth of national
income. One might presume that long-term foreign investors have on
average gauged their involvement correctly. But the same may not
necessarily apply to the income expectations of households or to
investors with more liquid claims. These may indicate an undue reliance
on foreign financing and vulnerability to sudden stops.
More generally, the
escalating claims of non-residents need to be serviced—something that in
time will require a trend improvement in the other components of the
current account. The only question is whether this will occur naturally
or whether it will be forced on countries because of a sudden change in
investor sentiment. One way or another, policymakers need to guard
against excesses and prepare for this turnaround.
Against this background,
the International Monetary Fund’s advice to countries has been
‘Do no harm.’ This requires that macroeconomic policies avoid
adding fuel to private sector-driven demand booms. This essentially
means that countries must calibrate budgets to allow ample room to
accommodate the rise in private sector demand, and build buffers to
serve as a bulwark against possible crises. Thus, the tax exemptions and
distortions some countries have introduced are a step in the wrong
direction. They only compound problems by attracting even more inflows.
They undermine the solution by weakening the budget and distorting
incentives. This is typically in favor of non-tradables, notably
housing. The public sector also needs to follow a cautious incomes
policy to limit the risk of wages outstripping productivity. All this is
especially critical in countries that have chosen to fix their exchange
rates, thereby losing the strengthening of the exchange rate as a tool
to control demand. And precisely because the only alternative to
this—namely, tight monetary policies—is difficult to achieve when
capital markets are free, we emphasize fiscal restraint.
‘Trust but verify.’
A sound and well-supervised financial sector is a must. Countries should
upgrade prudential standards and ensure that they are applied
rigorously. Credit decisions must be anchored by realistic expectations
on the part of borrowers and lenders and allow ample buffers in
countries with fixed exchange rates in the event higher interest rate
come to be required. Timely and frequent risk assessment is vital.
‘Reform to grow.’
Countries must continue reforming their institutions and give foreign
investors the reassurance they need that their expectations of high
returns will be realized. Countries must thus forge ahead in reforming
goods and factor markets, in order to strengthen productivity,
flexibility, and competitiveness, and ensure a more level playing field
between tradables and non-tradables.
The road to convergence
is challenging, but in a globalized world it need not be slow. Europe’s
emerging economies are currently reaping the rewards of past reforms
through high growth, rapid improvements in standards of living, and
investor confidence. But private sector behavior can overshoot and
prompt abrupt reversals. Countries must sustain reforms and build
shock-absorbing buffers. Ounces of prevention today are well worth
avoiding pounds of cure later.
The author is
Director of the International Monetary Fund’s European Department.