Central and Eastern European Economies
Introduction
As discussed in earlier chapters, the Central and Eastern Europe (CEE)1 bloc is a generic term that defines the group of countries in central, south-east, northern, and eastern Europe, commonly meaning former communist states in Europe. It is in use since the collapse of the Iron Curtain2 in 1989 to 1990, when more than 20 nations emerged from the isolation that had largely hidden them, and their citizens, from the rest of the world for more than 4 decades. As argued by Lerman, Csaki, and Feder (2004), in each of these former Soviet States, remnants of tradition and economic organization have prevented them from stepping out, beyond the curtain and onto the world stage. Nonetheless, some have been extremely successful.
The CEE bloc of countries includes all the Eastern Bloc countries west of the post-World War II border with the former Soviet Union. The Eastern Bloc was the name used by North Atlantic Treaty Organization (NATO)-affiliated countries for the former communist states of CEE, which generally included the Soviet Union and the countries of the Warsaw Pact.3 The terms Communist Bloc and Soviet Bloc were also used to denote groupings of states aligned with the Soviet Union, although these terms might include states outside CEE. Figure 3.1 depicts a map of countries that declared themselves to be socialist states under the Marxist– Leninist or Maoist definition, in other words communist states, between 1979 and 1983. This period marked the greatest territorial extent of communist states.4
Figure 3.1 Countries that declared to be socialist and communist between 1979 and 1983
Source: Busky (2000).
In addition, the CEE Bloc also includes the independent states in former Yugoslavia, which actually were not considered part of the Eastern Bloc, and the three Baltic States—Estonia, Latvia, and Lithuania, which chose not to join the Commonwealth of Independent States (CIS) with the other 12 former republics of the former Union of Soviet Socialist Republics (USSR).5
Recently, during the summer 2015, the Russian government publicly stated to the world that the Soviet government who gave away the Baltics was illegitimate and its decisions were illegal. Russia’s Prosecutor General’s Office launched at the time an improbable but nonetheless serious investigation into the legality of the independence of the three Baltic countries. The Russian trial on the legal status of their independence is based on the idea that the interim Soviet government in place in 1991 was illegitimate and its decisions therefore also illegitimate.
Since then, the three countries, whose national cultures are clearly northern European rather than Slavic, have been outstanding success stories, implementing economic reforms, and gaining membership of NATO, the European Union (EU), and the United Nations. The Baltic states are located in the northeastern region of Europe, on the eastern shores of the Baltic Sea, bounded on the west and north by the Baltic Sea, which gives the region its name, on the east by Russia, on the southeast by Belarus, and on the southwest by Poland and an exclave of Russia. Figure 3.2 depicts a map of the location of the Baltic States.
Figure 3.2 Location of the Baltic states in Europe
Source: UN (1995).
Transition Countries
Both the CEE and the CIS country blocs are considered transition countries in Europe. These transition economies are economies, which are undergoing a change from a centrally planned economy to a market economy.6 These economies are undertaking a set of structural transformations intended to develop market-based institutions. These include economic liberalization, where prices are set by market forces rather than by a central planning organization.
In addition, a major effort is placed to remove trade barriers, while pushing to privatize state-owned enterprises and resources. State and collectively run enterprises are restructured as businesses, and a financial sector is created to facilitate macroeconomic stabilization and the movement of private capital.7 This process is not only being applied in Eastern Bloc countries of Europe, but has also been applied in China, the former Soviet Union and some other emerging and frontier market countries.
The transition process is usually characterized by the change and creation of institutions, particularly private enterprises; changes in the role of the state, thereby, the creation of fundamentally different governmental institutions and the promotion of private-owned enterprises, markets, and independent financial institutions.8 In essence, one transition mode is the functional restructuring of state institutions from being a provider of growth to an enabler, with the private sector its engine. Due to the different initial conditions during the emerging process of the transition from planned economics to market economics, countries uses different transition model. Countries like China and Vietnam adopted a gradual transition mode, however Russia and some other east-European countries, such as the former Socialist Republic of Yugoslavia, used a more aggressive and quicker paced model of transition. These transition countries in Europe are thus classified today into two political-economic entities: CEE and CIS.
The CEE Bloc
As mentioned earlier, the CEE is a bloc of countries comprising Albania, Bulgaria, Croatia, the Czech Republic, Hungary, Poland, Romania, the Slovak Republic, Slovenia, and the three Baltic states: Estonia, Latvia, and Lithuania. But the CEE countries are further subdivided by their accession status to the EU.
The eight first-wave accession countries that joined the EU in May 2004 includes Estonia, Latvia, Lithuania, Czech Republic, Slovakia, Poland, Hungary, and Slovenia. The two second-wave accession countries that joined in January 2007 include Romania and Bulgaria. The third-wave accession country that joined the EU in July 2013 includes Croatia. According to the World Bank,9 “the transition is over” for the 10 countries that joined the EU in 2004 and 2007, which can be also understood as all countries of the Eastern Bloc.10
After 15 years of economic boom in central eastern Europe, during which the countries in the region enjoyed growth levels twice as high as in western Europe, the development came to an abrupt halt as the effects of the global financial crisis that started in 2007. Several states in CEE were struck hard as many of these countries were in a state of rapid development fuelled by foreign direct investment (FDI) inflows when the crisis hit.
More recently, the CEE countries have been showing signs of recovery, some faster than others, reading themselves once again for the numerous opportunities for future economical development. One of the main drivers for economic growth is the regions’ great location, opened to a market of over 200 million consumers. In addition, the region enjoys a large qualitative labor force at relatively low costs, which provides an inviting atmosphere for foreign investments and business development. There are still plenty of unexploited opportunities in CEE, whether in its huge surfaces of arable land, in its strong skills in technical and technological areas, numerous investment incentives or unique touristic destinations. Figure 3.3 shows a map of the CEE country blocs.
Figure 3.3 The Central and Eastern Europe country bloc
Source: Stepmap.de
As a whole, the CEE includes the following former socialist countries, which extend east from the border of Germany and south from the Baltic Sea to the border with Greece: Estonia, Latvia, Lithuania, Czech Republic, Slovakia, Hungary, Poland, Romania, Bulgaria, Slovenia, Croatia, Albania, Bosnia-Herzegovina, Kosovo, Macedonia, Montenegro, and Serbia. The fundamental conditions for growth in this region are strong, especially so in the reform-oriented countries that had introduced business-friendly politics and low tax rates in the run up of their EU accession. In effect, several countries, such as the two largest economies Poland and Czech Republic but also Slovakia, handled the global financial crisis surprisingly well. Even the countries hit hardest like Hungary will most likely turn the crisis into an upswing in a few years time. The growth potential of these countries is also intensified by the integration of CEE countries into the Eurozone and Schengen area.11 Please refer to Appendix A for a brief scanning of the CEE countries.
Economies at War
This currency crisis challenges in the CEE region (more on this in the next section) are in fact a result of a much bigger threat to the global economy, often dubbed by economists at large as a result of currency wars. For the past few years, at least since 2010, government officials from the G7 economies have been very concerned with the potential escalation of a global economic war. Not a conventional war, with fighter jets, bullets, and bombs, but instead, a “currency war.” Finance ministers and central bankers from advanced economies worry that their peers in the G20, which also include several emerging economies, may devalue their currencies to boost exports and grow their economies at their neighbors’ expense.
Brazil led the charge, being the first emerging economy to accuse the United States of instigating a currency war in 2010, when the U.S. Federal Reserve bought piles of bonds with newly created money. From a Chinese perspective, with the world’s largest holdings of U.S. dollar reserves, a U.S.-lead currency war based on dollar debasement is an American act of default to its foreign creditors, no matter how you disguise it. So far the Chinese have been more diplomatic, but their patience is wearing thin.
These two countries are not alone, as depicted in Figure 3.4, several other emerging markets, such as Saudi Arabia, Korea, Russia, Turkey, and Taiwan, have also been impacted by a weak dollar. That “quantitative easing” (QE) made investors flood emerging markets with hot money in search of better returns, which consequently lifted their exchange rates. But Brazil was not alone, as Japan’s Shinzo Abe, the new prime minister, has also reacted to the QEs in the United States and pledged bold stimulus to restart growth and vanquish deflation in the country.
Figure 3.4 Emerging market currencies inflated by weak dollar
Source: Thompson Reuters Datastream.
As advanced economies, like the first three largest world economies— United States, China, and Japan, respectively—try to kick-start their sluggish economies with ultralow interest rates and sprees of money printing, they are putting downward pressure on their currencies. The loose monetary policies are primarily aimed at stimulating domestic demand. But their effects spill over into the currency world.
Japan is facing charges that it is trying first and foremost to lower the value of its currency, the yen, to stimulate its economy and get the edge over other countries. The new government is trying to get Japan, which has been in recession, moving again after a two-decade bout of stagnant growth and deflation. Hence, it has embarked on an economic course it hopes will finally jump-start the economy. The government pushed the Bank of Japan to accept a higher inflation target, which has triggered speculation that the bank will create more money. The prospect of more yen in circulation has been the main reason behind the yen’s recent falls to a 21-month low against the dollar and a near 3-year record against the euro.
Figure 3.5 Central banks in the United States and Japan has flooded their economies with liquidity
Source: WSJ Market Data Group.
Since Shinzo Abe called for a weaker yen to bolster exports, the currency has fallen by 16 percent against the dollar and 19 percent against the euro. As the yen falls, its exports become cheaper, and those of Asian neighbors South Korea and Taiwan, as well as those countries further afield in Europe, become relatively more expensive. As depicted in Figure 3.5, central banks in the United States and Japan have flooded their economies with liquidity since mid-2012 into 2013, causing the yen and the dollar to weaken against other major currencies.
In our opinion, common sense could prevail, putting an end to the dangerous game of beggar (and blame) thy neighbor. After all, the International Monetary Fund (IMF) was created to prevent such races to the bottom, and should try to broker a truce among foreign exchange competitors. The critical issues in the United States, as well as China and Japan, stem from minimally a blatantly ineffective public policy, but over-ridingly a failed and destructive economic policy. These policy errors are directly responsible for the opening salvos of the currency war clouds now looming overhead.12
So far, Europe has felt the impact of the falling yen the most. At the height of the Eurozone’s financial crisis in 2012, the euro was worth $1.21, which was potentially benefitting big exporters like BMW, AUDI, Mercedes, or Airbus. However, at the time of these writing, December 2013, the euro is at $1.38 even though the Eurozone is still the laggard of the world economy.
Across the 17-strong euro area a recovery has got under way following a double-dip recession lasting 18 months, but it is a feeble one. For 2013 as a whole GDP will still continue to fall by 0.4 percent (after declining by 0.6 percent in 2012), but it is expected to rise by 1.1 percent in 2014.13 A rise in the value of euro, which is also partly to do with the diminishing threat of a collapse of the currency, will do little to help companies in the Eurozone—and will hardly help getting it growing again.
Chinese policymakers reject the conventional thinking proposed by advanced economies. How about the yen’s extraordinary rise over the last 40 years, from JPY360 against the dollar at the beginning of the 1970s to about JPY102 today?14 Not to mention that despite this huge appreciation, Japan’s current-account surplus has only got bigger, not smaller. They could also argue that the United States’ prescription for China’s economic rebalancing, a stronger currency, and a boost to domestic demand, was precisely the policy followed by the Japanese in the late-1980s, leading to the biggest financial bubble in living memory and the 20-year hangover that followed.
Furthermore, the demand by the United States, which is backed by the G7 for a renminbi revaluation, is, in our view, a policy of the United States’ default. During the Asian crisis in 1997 to 1998, advanced economies, under the auspices of the IMF, insisted that Asian nations, having borrowed so much, should now tighten their belts. Shouldn’t advance economies be doing the same? In addition, Chinese manufacturing margins are so slim that significant change in exchange rates could wipe them out and force layoffs of millions of Chinese. As it is, labor rates are already climbing in China, further squeezing margins. Lastly, a revaluation of the yuan would only push manufacturing to other cheaper emerging markets, such as Vietnam, Cambodia, Thailand, Bangladesh, and other lower paying nations without improving the advanced economies trade deficits.
Notwithstanding, some G7 policymakers believe these grumbles are overdone; arguing that the rest of the world should praise the United States and Japan for such monetary policies, suggesting the Eurozone should do the same. The war rhetoric implies that the United States and Japan are directly suppressing their currencies to boost exports and suppress imports, which in our view is a zero-sum game, which could degenerate into protectionism and a collapse in trade.
These countries, however, do not believe such currency devaluation strategy will threaten trade. Instead, their believe seems to be that as central banks continue to lower their short-term interest rate to near zero, exhausting their conventional monetary methods, they must employ unconventional methods, such as QE, or trying to convince consumers that inflation will raise. Their goal with these actions is to lower real (inflation-adjusted) interest rates. If so, inflation should be rising in Japan and in the United States, which according to Figure 3.6 it is.
As Figure 3.6 also shows, over the past decade, Japan has seen the consumer price index (CPI) for most periods hover just below the zero-percent inflation line. The notable exceptions were in 2008, when inflation rose as high as 2 percent, and in late 2009, when prices fell at close to a 2 percent rate. The rise in inflation coincided with a crash in capital spending. The worst period of deflation preceded an upturn. Of course, the preceding figure does not provide enough data to infer causal effects, but it seem, however, that the relationship between growth and Japan’s mild deflation may be more complicated than the Great Depression-inspired deflationary spiral narrative suggests. The principal goal of this policy was to stimulate domestic spending and investment, but lower real rates usually weaken the currency as well, and that in turn tends to depress imports. Nevertheless if the policy is successful in reviving domestic demand, it will eventually lead to higher imports.
Figure 3.6 Japan’s inflation rate has been climbing since 2010 as a result of economic stimulus
Source: Trading Economics,15 Japan’s Ministry of Internal Affairs and Communications.
At least that’s how the argument goes. The IMF actually concluded that the United States’ first rounds of QE boosted its trading partners’ output by as much as 0.3 percent. The dollar did weaken, but that became a motivation for Japan’s stepped-up assault on deflation. The combined monetary boost on opposite sides of the Pacific has been a powerful elixir for global investor confidence, if anything, to move hot money onto emerging markets where the interests were much higher than at advanced economies.
The reality is that most advanced economies have over-consumed in recent years. It has too many debts. But rather than dealing with those debts—living a life of austerity, accepting a period of relative stagnation—these economies want to shift the burden of adjustment on to its creditors, even when those creditors are relatively poor nations with low per capita incomes. This is true not only for Chinese but also for many other countries in Asia and in other parts of the emerging world. During the Asian crisis in 1997 to 1998, Western nations, under the auspices of the IMF, insisted that Asian nations, having borrowed too much, should now tighten their belts. But the United States doesn’t seem to think it should abide by the same rules. Far better to use the exchange rate to pass the burden on to someone else than to swallow the bitter pill of austerity.
Meanwhile, European policymakers, fearful that their countries’ exports are caught in this currency war crossfire, have entertained unwise ideas such as directly managing the value of the euro. While the option of generating money out of thin air may not be available to emerging markets, where inflation tends to remain a problem, limited capital controls may be a sensible short-term defense against destabilizing inflows of hot money. Figure 3.7 illustrates how the inflows of hot-money leaving advanced economies in search of better returns on investments in emerging markets have caused these markets to significantly outperform advanced (developed) markets.
Figure 3.7 In 2009 emerging markets significantly outperformed advanced (developed) economies
Source: FTSE All-World Indices.
Currency War May Cause Damage to Global Economy
As more countries try to weaken their currencies for economic gain, there may come a point where the fragile global economic recovery could be derailed and the international financial system thrown into chaos. That’s why financial representatives from the world’s leading 20 industrial and developing nations, spent most of their time during the G20 summit in Moscow in September 2013.
In our view, policymakers are focusing on the wrong issue. Rather than focus on currency manipulation, all sides would be better served to zero in on structural reforms. The effects of that would be far more beneficial in the long run than unilateral United States, China, or Japan currency action, and more sustainable. The G20 should focus on a comprehensive package centered on structural reforms in all countries, both advanced economies and emerging markets. Exchange rates should be an important part of that package, no doubt. For instance, to reduce the current-account deficits of the United States, Americans must save more. To continue to simply devalue the dollar will not be sufficient for that purpose. Likewise, China’s current-account surpluses were caused by a broad set of domestic economic distortions, from state-allocated credit to artificially low interest rates. Correcting China’s external imbalances requires eliminating all of these distortions as well.
As long as policymakers continue to focus on currency exchange issues, the volatility in the currency markets will continue to escalate. It actually has become so worrisome that the G7 advanced economies have warned that volatile movements in exchange rates could adversely hit the global economy. Figure 3.8 provides a broad view (rebased at 100 percent on August 1, 2008) of main exchange rates against the dollar.
When it became clear that Shinzo Abe and his agenda of growth-at-all-costs would win Japan’s elections, the yen lost more than 10 percent against the dollar and some 15 percent against the euro. In turn, the dollar has also plumbed to its lowest level against the euro in nearly 15 months. These monetary debasement strategies are adversely impacting and angering export-driven countries such as Brazil, and many of the Brazil, Russia, India, China, and South Africa (BRICS), Association of Southeast Nations (ASEAN), Colombia, Indonesia, Vietnam, Egypt, Turkey, and South Africa (CIVETS) and Middle East—North Africa (MENA) blocs. But they also are stirring the pot in Europe. The Eurozone has largely sat out this round of monetary stimulus and now finds itself in the invidious position of having a contracting economy and a rising currency.
Figure 3.8 Exchange rates against the dollar
Source: Bloomberg.
James Rickards, author of Currency Wars: The Making of the Next Global Crisis, expect the international monetary system to destabilize and collapse. In his views, “there will be so much money-printing by so many central banks that people’s confidence in paper money will wane, and inflation will rise sharply.”16
If policymakers truly want to stage off this currency war, then it is a matter of doing what it was done in 1985 with the Plaza Accord.17 This time, however, we will need a different version, as it will not be about the United States and the G5 of the time, in 1985. It will have to be an Asian Plaza Accord under the support and auspices of the G20. It will have to be about the Asia export led and mercantilist leadership agreeing amongst them. The chances of this happening, of advanced economies seeing the requirement for it, or these economies relinquishing its powers in any measurable fashion are not at all possible under the current political gamesmanship presently being played.
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1 In scholarly literature the abbreviations CEE or CEEC are often used for this concept.
2 The notional barrier separating the former Soviet bloc and the West prior to the decline of communism that followed the political events in Eastern Europe in 1989.
3 The Warsaw Pact, formally known as the Treaty of Friendship, Co-operation, and Mutual Assistance, and informally as WarPac, was a collective defense treaty among Soviet Union and seven Soviet satellite states in Central and Eastern Europe in existence during the Cold War; Hirsch, Kett, and Trefil (2002).
5 A former communist country in Eastern Europe and northern Asia; established in 1922; included Russia and 14 other soviet socialist republics (Ukraine and Byelorussia and others); officially dissolved 31 December 1991.
10 OECD (2015).
12 Our opinion expressed here is from the point of you of international trade and currency exchange as far as it affects international trade, and not from the geopolitical and economic aspects of the issue. We approach the issue of currency wars not from the theoretical, or even simulation models undertaken from behind a desk in an office, but from the point of view of practitioners engaged in international business and foreign trade, on the ground, in four different countries.
13 The Economist’s Writers (2013).
14 As of December 2013.
15 www.tradingeconomics.com (accessed December 9, 2013).
17 The Plaza Accord was an agreement between the governments of France, West Germany, Japan, the United States, and the United Kingdom, to depreciate the U.S. dollar in relation to the Japanese yen and German Deutsche Mark by intervening in currency markets. The five governments signed the accord on September 22, 1985 at the Plaza Hotel in New York City.