2016 EEAG Report
Western Balkans: Coming Together
Torben M. Andersen, Giuseppe Bertola, John Driffill, Harold James, Hans-Werner Sinn, Jan-Egbert Sturm and Branko Uroševic
The Western Balkans (WB) region, with a current population of around 20 million, is the gateway between Europe and the Middle East. As the recent refugee crisis underscores, this region, consisting of Albania, Bosnia and Herzegovina (BiH), Croatia, Former Yugoslav Republic (FYR) Macedonia, Montenegro, and Serbia1 , is strategically important for the stability of Europe. It has undergone a momentous transformation: from brutal wars in the 1990s to increasing regional cooperation and relative political and economic stability in 2000s. This column outlines some of the key features of the economic transformation of the region, its achievements and the challenges that lie ahead.
Strong but unsustainable pre-crisis growth followed by change in growth paradigm
From 2001 until the inception of the global crisis the region of Western Balkans (WB), along with the rest of emerging Europe, experienced strong growth (Figure 1).2 At that time ample money had become available for investment throughout emerging Europe. The privatization of companies led to an increase in total factor productivity, which, along with strong growth in private consumption, fuelled the boom. The consumption-led growth was in no small measure driven by exporters, banks and the financial investors of developed economies. Clearly, there was a desire in the region's population to catch up with "Western" consumer goods, so the "push" from exporters was warmly welcomed by the "pull" from WB consumers. Financial investors, expecting a repetition of experiences in Central and Eastern Europe, were banking on a gradual convergence of local financial markets with those of Europe, while getting a lot of "bang for their buck" from high local interest rates and foreseeable foreign exchange trends. With all that in mind and "easy money" from both money markets and Western depositors, foreign banks that set up shop locally stood by to provide financing, hence reinforcing this one-sided trend.
Figure 1:
The growth in several WB countries was also strong during that period on a per capita basis, especially in Albania and Serbia (Figure 2). In the case of Albania, per-capita growth was partly also due to a net reduction in the population through massive emigration. As a result of these processes, the region's poorer countries gradually caught up with their richer counterparts in terms of living standards.
Figure 2:
On the other hand, the region's industrial capacity, already seriously impaired and technologically out-of-date, shrank even further in that period. Local currency appreciation and wage increases financed by the inflow of foreign capital went beyond productivity increases and re-valued the economy, partially depriving it of its international competitiveness. The problems were, in that sense, similar to those in southern European countries, which also experienced an inflationary credit bubble due to the abundance of cheap foreign capital and resulting wage increases.3 Private trading companies, protected from true competition, created oligopolies. Their business model was largely to import foreign products and sell them for a hefty premium while, at the same time, squeezing domestic suppliers utilising market power.
All this led to large and unsustainable current account deficits in both the WB and Baltic regions (Figure 3). A particularly extreme example of such practices is that of Montenegro where the deficit reached almost 50 percent of GDP in 2008. The situation was structurally different in many Central European countries, since a large share of their deficits came from importing machinery needed to build a large tradeable goods sector (in Slovakia, for example). When the influx of foreign credit dried up, most countries significantly and painfully reduced their current account deficits by sliding into recessions and curtailing their imports. A borrow-and-spend strategy did not help Serbia and Croatia to return to growth. In the period of 2012–2014 Serbia dipped in and out of recession a couple of times, while Croatia's economy contracted for 4 consecutive years. A change in the economic model was clearly needed in order to address unsustainably high current account deficits.
Figure 3:
Countries like FYR Macedonia that were reforming their business environment experienced healthier growth than those lagging behind in reforms. In Serbia, the decision was made to refocus on the production of tradeable goods and services by attracting large multinationals. The free trade agreement that Serbia has with Russia, Belorussia and the Ukraine, as well as with the EU, the proximity to key EU markets and relatively low labour costs (see Figure 4), make Serbia a potentially attractive destination for foreign direct investment. Over the past couple of years the new strategy has started to pay off: Large German and Italian multinationals are cautiously moving parts of their production into Serbia and Macedonia (Siemens, Bosch, and Fiat, among others).
Figure 4:
Inflation is tamed, the banking system is integrated into the large pan-European networks, but the high level of euroisation remains a key challenge for policymakers
The 1990s were very challenging for the financial sector in WB countries. Large state banks in Serbia and Montenegro collapsed and the two republics experienced one of the most severe and protracted episodes of hyperinflation in their history. Domestic private banks offered poor alternatives: large pyramid schemes in Albania, Serbia, and Montenegro also wiped out a large share of of the population’s savings. In such an environment, only the entrance of reputable foreign banks was able to gradually rebuild lost trust. By 2005, foreign banking groups dominated the market in all countries of WB.
With the political normalisation in the 2000s, the introduction of market reforms in the financial sector and an independent central banking function, inflation was gradually brought under control. Arresting inflation in the WB states significantly boosted the credibility of the region's central banks. In the period from 2005 to 2014, measured in the local currency, Serbia and Romania had the highest aggregate inflation in our sample (see Figure 5). However, both countries substantially depreciated their currencies with respect to the euro. This, in turn, helped them stay relatively competitive (see Figure 4). Measured in terms of the change in prices expressed in euros, Albania had by far the smallest aggregate inflation rate in that period among the 19 countries presented here.
Figure 5:
The high level of euroisation of loans and deposits in the WB countries (see Figure 6) is making large devaluations potentially costly. Due to a history of hyperinflation, depositors in the WB prefer to save in euros. This, in turn, drives banks to issue hard currency-denominated loans in order to match the currency structure of their assets and liabilities. On the other hand, a sudden appreciation of the anchor currency can significantly constrain borrowers' ability to pay, if borrower income is not hedged against such risks. Thus, by issuing hard-currency-pegged loans banks reduce their exchange rate risk (which could potentially be hedged relatively easily) and create highly correlated potential credit events (which banks have more difficulty hedging against).4 An important demand-side reason for issuing hard currency-pegged loans is that they often have, ex-ante, more attractive interest rates.
High levels of loan euroisation limit a central bank's scope to conduct an independent monetary policy by imposing a limitation on the exchange rate depreciation a country may allow without seriously impacting its financial stability. In addition, a central bank policy rate can only directly impact local currency-denominated loans. Therefore, the highly euroised economies of the WB bear many of the costs of being in the Eurozone, without enjoying any of the potential benefits of being actual members.
Figure 6:
Concluding remarks and recommendations
Over the past 15 years, the WB countries have made considerable progress towards building market economies. However, sustainable growth would require reindustrialisation of the region. Since its population is continuing to fall (for both natural reasons and as a result of net emigration), the region needs to focus on the creation of higher value-added tradeable goods and services. In order to ensure the necessary political and economic stability of the region and to increase its attractiveness for investment, the intra-regional cooperation should go beyond the free flow of goods and services to include the free movement of capital, people and ideas, thus making the borders within the region increasingly irrelevant without formally changing them.
In parallel, through cooperation with the EU, the regional physical, institutional, financial and educational infrastructure needs to be dramatically improved and brought up to European standards. More specifically, with the exception of Croatia, the physical infrastructure in the WB is still lagging behind EU norms. The public sector needs to be streamlined and become an efficient provider of services to citizens. Banks need to clean up their balance sheets in order to resume lending to the productive sector of the economy. Education reform is one of the key preconditions to the long-term viability of the region. In this area a shift away from memorising facts and towards creative problem-solving is paramount. The creation of a regional labour market should be supported by the establishment of a regional market for higher education.
References
Božović, M., B. Urošević and B. Živković (2009), "On the Spillover of Exchange Rate Risk into Default Risk," Economic Annals 183, pp. 32–55.
Murgasova, Z., N. Ilahi, J. Miniane, A. Scott, I. Vladkova-Hollar and an IMF Staff Team (2015), The Western Balkans 15 Years of Economic Transition, Regional Economic Issues Special Report, International Monetary Fund, Washington, D.C.
Sinn, H.-W. (2014), The Euro Trap. On Bursting Bubbles, Budgets and
Beliefs, Oxford University Press, Oxford.
1 Geographically, the province of Kosovo also belongs to this region. Since its unilateral secession from Serbia is not recognised by Serbia itself, by some members of the European Union, or by the United Nations, we exclude it from consideration. For consistency's sake, all data on Serbia in this paper excludes Kosovo.
2 In a recent IMF report, Murgasova et al. (2015) provide a detailed account of the transition experience of the WB in the past 15 years.
3 See Sinn (2014), Chapters 2 and 4.
4 See Božović et al. (2009).