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 treading precariously.  

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 account deficit.  

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 three-pronged. 

‘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.