Foreword

Crossborder integration – An important response to the crisis

This is the fourth consecutive Transition Report to be written in the shadow of an economic crisis in the transition region. Our 2008 report, dedicated to how growth in the region could be made more sustainable, was written as the storm was brewing. The 2009 report was entirely dedicated to the crisis – its causes, its impact and its possible long-term effects. In 2010, as the region was entering a fragile and uneven recovery, we focused on the postcrisis reform agenda, only to find new clouds gathering in 2011, when our report documented the effects of the 2008-10 crisis on households – both in economic terms and in their attitudes towards markets and democracy.

The nature of the crisis has changed fundamentally since 2008. What started as a banking crisis in a small group of countries has transformed into a sovereign crisis in the eurozone which has in turn weakened European banks and led to a withdrawal of funding from emerging Europe and to some extent from the southern and eastern Mediterranean (referring to Egypt, Jordan, Morocco and Tunisia and covered in full for the first time in this report). Unlike 2008, the new crisis has not hit emerging Europe at the height of an unsustainable boom. External imbalances have decreased and most governments have undertaken significant fiscal adjustment, some involving considerable sacrifice and leading to remarkable results. Yet, as Chapter 2 discusses, the region is still vulnerable, both because of legacies from the previous crisis and pre-crisis periods – high nonperforming loans and foreign currency-denominated debt – and its strong dependence on the eurozone. Some of the southern and eastern Mediterranean countries which have experienced popular uprisings have also developed large fiscal deficits and would benefit from adjustment supported from the outside.

Slow-downs are projected in every central European, Baltic, and south-eastern European country and negative or near-zero growth in 2012 is expected in eight out of the 17 countries in this group . Importantly, the slow-down has begun to extend beyond the area most closely integrated with the eurozone, as growth in Russia has begun to decelerate, and with it economic activity in countries that depend on it through remittances and trade. In contrast, some southern and eastern Mediterranean countries are projected to recover somewhat this year as their economies emerge from the economic dislocation associated with political and social turmoil in 2011.

How the region will evolve in 2013 will depend largely on the policy response, both inside the region and particularly outside. An important dimension of this response, and one which will have implications beyond the crisis, is institutional integration: attempts to build stronger supranational institutions and legal frameworks. The foremost such attempt within the eurozone – which by now encompasses three transition countries: Estonia, the Slovak Republic and Slovenia – is the September 2012 “banking union” proposal made by the European Commission at the behest of the European Council. It suggests a single supervisory mechanism for the eurozone, with an “opt in” option for non-eurozone countries, which would potentially allow direct recapitalisation of eurozone banks using funds from the European Stability Mechanism (ESM).

To the extent that the proposed mechanism backstops European sovereigns in their current efforts to resolve failing banks – which was not assured as this report went to press, with some eurozone countries arguing that the proposed backstop should not apply to “legacy debt” – it could prove essential in stopping the ongoing crisis. This would benefit all of Europe, including emerging European countries that are outside the eurozone. At the same time, the proposed plans leave significant gaps and have raised concerns among emerging European countries. One concern is that the single supervisor will pay attention mainly to eurozone-wide stability threats and not sufficiently to financial system soundness for each member country. Another fear is that emerging European countries may become fiscally responsible for crises elsewhere. This is compounded by the fact that the banking union plans would, for the foreseeable future, leave the responsibility for resolving failing banks in national hands. Given that ultimate fiscal responsibility could be eurozone-wide, this creates a potential for moral hazard.

There are also concerns on the side of host countries of eurozone banks that do not expect to join the banking union anytime soon. Among them is a worry that supervisory coordination failures, which marred attempts to control national credit booms before the crisis, will persist when eurozone home supervisors are replaced by a single, powerful home supervisor – the ECB. Another fear is that the banking union would tilt the competitive balance inside the European Union against banks headquartered outside the banking union, as the latter would not be covered by the fiscal safety net provided to banking union members.

CROSSBORDER "STABILITY GROUPS"

We argue in this report that it is possible to address both sets of concerns. A move towards supranational resolution mechanisms remains essential over the medium term, but if it cannot be achieved in the short term, the current proposal can be improved by other means. Moral hazard could be addressed by requiring countries receiving ESM fiscal support to share banking-related fiscal losses up to a pre-determined level. Coordination gaps can be reduced by cross-border "stability groups" that include home and host country authorities (including Ministries of Finance), the ECB and the European Banking Authority (EBA). These could draw up plans on how failing cross-border banks would be resolved. The governance structure of the single supervisory mechanism can and should be designed to give sufficient voice to smaller member countries. Lastly, non-eurozone countries that opt into the single supervisory mechanism should also be allowed to opt into the ESM. Apart from full membership, intermediate options could also be considered which would extend some but not all benefits and obligations of membership to all financially integrated European countries – including countries outside the European Union (EU).

While the EU is focused on the institutions that manage financial integration, a different sort of institutional integration is unfolding further east. In November 2009 Belarus, Kazakhstan and Russia agreed to establish the Eurasian Economic Community (EEC), reinforcing the customs union between the three countries from 1999. A common external tariff was introduced in 2010, and further steps, including new supranational institutions, have since been taken. Initial concerns that the customs union would slow down, even prevent, Russia’s World Trade Organization (WTO) accession turned out to be exaggerated; as it finally joined the organisation in August 2012 after 18 years of negotiations. Yet, important questions remain as to whether the customs union will facilitate or hinder the further integration of its members into the global economy. We present an early assessment of the arrangement, focusing on changes in tariff and non-tariff barriers, trade patterns and the geographical structure of exports.

Although the main rationale for the EEC was not the crisis but rather long-term economic and institutional benefits, we find evidence that its introduction helped the post-2009 recovery of trade in the three member countries. The driving force behind this was not so much the change in tariffs as the removal of non-tariff barriers such as trade regulations and customs. The report also presents evidence that suggests many of the non-tariff benefits of the arrangement may still lie ahead: for example, by helping to coordinate better cross-border infrastructure.

REGIONAL INTEGRATION

Perhaps most encouragingly, the report presents evidence that regional integration can act as a springboard for exports. Higher-value-added goods that are initially exported within the customs union can subsequently be exported elsewhere. Export patterns currently observed for Belarus and Russia suggest that this effect may already be at work. This means, for example, that the customs union might help Russia diversify its export structure away from natural resources. It might also help improve economic institutions in its member countries, although this will be challenging. International evidence suggests that customs union membership can enhance the institutions of its weaker members, but within the Eurasian Economic Community there is currently little variation in terms of institutional quality. However, it is possible that supranational institutions with strong governance at the level of the Community could trigger improvement in domestic institutions.

Many transition countries may go into a second dip of the crisis, with uncertain prospects of recovery. The outlook in the southern and eastern Mediterranean region, where countries are struggling with their respective political and economic transformations, is similarly unsettled. At the same time, the cliché that crisis breeds opportunity seems to hold some truth particularly when it comes to the new integration efforts. This is true in the east, where both institutional integration and actual economic integration have lagged, the new regional trade arrangement is reducing nontariff trade barriers and may help its members become more competitive. In the west, the lag between financial integration and institutional integration has been threatening the sustainability of the former. A carefully executed banking union would address this tension. In the south, intraregional trade and investment are miniscule relative to potential, as are institutional structures supporting such integration, but in the wake of the Arab uprisings the governments of the southern and eastern Mediterranean are undertaking renewed efforts to revive regional cooperation. They are also seeking to expand and deepen their ties to the EU. Together, these new efforts could give Europe, its neighbourhood and the transition region at large a better foundation from which to resume its quest for prosperity and convergence.