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New Europe Weekly

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Painful rebalancing ahead

Fri, Jun 12 2009, 12:24 GMT
by Lars Christensen

Danske Bank A/S

In recent years there has been a very significant increase in economic imbalances in most CEE countries. However, we are now in a rebalancing phase, in which these imbalances are being reduced. In some countries this rebalancing process is proving to be quite swift, but also painful. One only needs to point to the massive drop in domestic demand in countries like Latvia to demonstrate how painful this adjustment can be.

Fundamentally, what we are now witnessing across CEE is an unavoidable process. Imbalances had reached an unsustainable size, and the rebalancing had to happen sooner or later – one way or another.

There are basically three ways to adjust large external imbalances. First, external demand boosts exports. This should currently be seen largely as a hope rather than a realistic option. With the global economy still in crisis, this option is not a feasible solution to CEE imbalances.

Second, and more realistically, external imbalances can be reduced by a drop in domestic demand. This has already happened across CEE, but there are very large differences across the region in the magnitude of this adjustment. Most notable has been the slump in domestic demand in the Baltic countries where the adjustment has been underway since mid-2007. In other countries in the region that badly need to adjust, this process has only started within the last couple of months. Especially in Romania and Bulgaria, the adjustment process has been long overdue, but is now happening very fast. Hence since Q4 08, domestic demand has fallen sharply in both Romania and Bulgaria. However, compared to the adjustment in the Baltic States, the unavoidable fall in domestic demand in Romania and Bulgaria is far from over.

The third channel by which to rebalance the CEE economies is through a sharp currency depreciation. This option can be “utilised” in the CEE countries that are running floating exchange rate regimes. Paradoxically, those CEE countries with floating exchange rate regimes also tend to be those with the smallest external imbalances (like Poland and the Czech Republic) while the countries with the largest imbalances (like the Baltic States and Bulgaria) have opted for fixed exchange rates regimes. Therefore – at least for now – the Baltic States and Bulgaria have decided to make the entire adjustment of their external imbalances via a sharp drop in domestic demand, and have refused to use currency adjustment. However, the recent turmoil in Latvian markets shows that the markets are not convinced that it is possible reduce large external balances by relying only on a major decline in domestic demand.

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Published on  Fri, Jun 12 2009, 12:27 GMT