WIIW The Vienna Institute for International Economic Studies - Wiener Institut für Internationale Wirtschaftsvergleiche

After a long period of convergence, Central, East and Southeast Europe experienced a deep recession in 2009. The relatively moderate GDP decline (-3.6%) on average for the new EU member states (NMS) reflects Poland's weight in the group, the only EU country to have recorded positive GDP growth last year (Albania and Kazakhstan registered positive growth rates as well - see Table). In most other countries the catching-up process was interrupted, in particular the Baltic States were thrown several years back - more than Russia and Ukraine. The most conspicuous response to the crisis was a radical depletion of inventories and, closely related to this, a dramatic improvement in net exports since the contraction of imports was much larger than that of exports. This, together with less profit realized by foreign companies operating in the region, resulted in a sizeable reduction of current account deficits.

Most countries in the region have emerged from the trough of the crisis already at the end of 2009. Several leading indicators point to a modest upswing. Poland's growth will once again boost the NMS average in 2010, while the rate of expansion in the Czech Republic, Slovakia and Slovenia will be meagre. Hungary, Romania and Bulgaria are still expected to stagnate in 2010, the Baltic States will record further negative growth rates - just as Croatia, Bosnia and Herzegovina and Montenegro. Russia, Ukraine and Kazakhstan will rebound more strongly. We expect all countries in the region to be growing again only by 2011. That growth may accelerate slightly in 2012, but will in general be slower than in the pre-crisis period. The main prerequisite of an upturn is a marked recovery in global trade, including a rise in demand for imports from the region. Increases in private consumption are not likely to be very pronounced as long as employment fails to grow. Investment will not act as a strong engine of growth either. Given the generally weak rebound of economic activities, unemployment will continue to rise, probably peaking in 2010, before falling slowly to pre-crisis levels. The most vulnerable group of workers affected by the crisis are again those with low skills.

China's economy expanded at a rate of 8.7% in 2009, more than earlier expected. This fast growth despite a slump in exports was due to massive government stimulus measures driving investment and supporting private consumption. With the expansionary fiscal policy still in place and foreign demand picking up, the Chinese economy may grow even faster in the coming years.

There are several downward risks to our forecast. The revival of financial intermediation may turn out to be sluggish. With the upturn of economic activities more firms may find it difficult to secure funding. Withdrawal of demand-supporting schemes and the need to consolidate fiscal balances may delay or weaken recovery in the EU and put a brake on export-driven growth of the region. A possible revival of cross-border capital flows would again exert strong pressure on exchange rate appreciation - with all the familiar negative effects. The main risk associated with the current problems in Greece is that the extension of the euro area may be delayed. That may well cross the plans of those NMS that have based their medium-term economic strategy on the earliest possible adoption of the euro.

'Redirecting the growth model?' Until the recent economic crisis, the countries of Central, East and Southeast Europe benefited for a long period from a process of 'catching-up' based on two pillars: (i) a high degree of liberalization of trade, capital movements and financial market integration, and (ii) membership in the EU or the prospects of either accession or a strong association with the EU. Both these two sets of factors will still be in operation also after the crisis, but there will be some significant changes in the way the 'integration growth model' will function. A combination of both changed external conditions (for example slow growth in main export markets, more difficult EMU entry) as well as internal behavioural responses to the crisis (for example more difficult financing conditions, increasing savings rates of the household sector, constraints of fiscal spending) will shape the growth paths of the region. The paper elaborates on policy issues that arise from the necessary 'redirecting of the growth model': the need for countercyclical fiscal policy, the importance of an adjustment in the real exchange rate and getting the credit system going in the short and medium run, as well as the issue of changes in regulatory frameworks and shared responsibilities in an integrated financial market context. The EU can play important roles in assisting these economies in their adjustments to the new situation and allowing them to return as quickly as possible to a sustainable catching-up growth path.