Information about Europe Europa
Chapter

VII. Trade and Capital Flows

Author(s):
James Roaf, Ruben Atoyan, Bikas Joshi, and Krzysztof Krogulski
Published Date:
October 2014
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Trade and investment links with Western Europe have been among the most important factors behind the growth of the past 25 years. Some countries have been able to exploit these opportunities much more effectively than others, due to location, initial conditions, and the policy environment. Looking forward, countries that have benefited less so far need to develop a more external orientation and a more conducive environment for foreign investment, while the more successful countries need to focus on building markets globally and advancing to higher value production.

After decades of closed borders, creating an environment of free-flowing goods, services, and capital in post-Communist Europe was key to integration with Western Europe and the rest of the world. Accessing the open markets of Western Europe would result in increased investment and economic growth, greater product choices and quality for consumers, and improved standards of living. All transition countries began their journey to integration with these goals in mind.

Trade in the region had been focused inward during the decades preceding transition. This was particularly the case for the Soviet republics. In 1990, approximately 80 percent of exports from the Baltics and CIS republics went to Russia. Not surprisingly, these countries experienced a dramatic drop in exports with the dissolution of intra-USSR trade links, resulting in large income drops and a shortage of foreign currency in the early 1990s. Some other transition countries had already begun diversifying their trade destinations toward broader Europe in the decade leading to transition. As a result, these countries did not experience a noticeable drop in exports in the early 1990s.

Gross exports of selected CEE countries

(1990=100)

Source: Direction of Trade Statistics and Foreign Trade Statistics in the USSR (World Bank)

Membership in international institutions offered not only new markets and increased movement of goods, but also strong regulatory and political frameworks to build sound market institutions, support sustainable structural reforms, and increase competitiveness across sectors. Central European countries started joining the World Trade Organization as early as 1995, and by 2000 half of the region had joined, lowering tariff rates, harmonizing legislation, and signing up to independent dispute settlement mechanisms. Although full economic integration into the EU would take years for most transition countries, integration through trade and investment began almost immediately. By the mid-1990s, many Central and Southeastern European countries had implemented bilateral trade agreements with the EU as a precursor to actual membership. In contrast, CIS countries signed partnership agreements with the EU that did not include significant trade liberalization components. Six countries are also now members of the OECD, a sign of sustained progress and convergence.

Investment needs were overwhelming, given underdeveloped infrastructure and dilapidated industrial capacity. Capital from Western Europe infused the region, playing a key role in development. Over the transition period, the region moved from relative isolation to become highly financially integrated with the rest of the world, particularly the EU. Total stocks of external capital reached levels significantly higher than the average for emerging markets, and as high as 150 percent of GDP for Central Europe and the Baltics. About three-quarters or more of external capital came from EU member countries, highlighting the overwhelming dependence of the region on the EU.

The bulk of external capital into the region has taken the form of FDI and cross-border bank flows. The dominance of FDI has been partly a result of the large scale privatization that followed transition, but also of greenfield investment, particularly in Central Europe. And as countries opened their financial sectors to privatization, much of the sector became owned by Western parent banks. To take advantage of lending and profit opportunities in these new markets, large shares of cross-border flows were intermediated through subsidiaries. However, countries differed in terms of the relative importance of FDI and cross-border bank flows in external capital composition, ranging from FDI being much more significant than bank flows in Central Europe to the opposite in CIS countries. Portfolio flows, which make up a little more than one-fifth of total inflows to the region, have been significant only in Russia and in some Central European countries with more developed financial markets.

* CIS excluding Russia

Source: CESEE Regional Economic Issues Spring 2014.

There are several factors that contributed to the differing dependence on FDI in transition economies. First, the depth of initial reforms mattered. As discussed in Chapter IV, only a few Central European countries made early progress in the “difficult” structural reform areas such as competition policy, governance and enterprise restructuring. The resulting improved business environment helped attract FDI into these countries in significant quantity, making them less reliant on cross-border bank flows. A second factor that favored Central Europe was the state of the manufacturing sector. Countries with a better-functioning manufacturing base that could readily link up to neighboring Western countries’ manufacturing sectors drew FDI into the tradable sector. Others drew FDI more in favor of utilities and other non-tradable sectors.

The diverging pattern of capital flows also had a lasting impact on overall export and growth performance in the region.1 Broadly speaking, countries fall into three groups based on their growth experience and the role of the external sector in growth.

  • Export-driven robust growth: The reform progress and manufacturing conditions discussed above, along with geographical proximity, served to strongly link the Central European countries to the German supply chain, granting access to more dynamic markets in Asia and elsewhere (see Box 6). This ushered in an era of export-driven growth, particularly of machinery and transport equipment manufacturing. Over time, these countries have not only moved up the production value chain, but also created areas of new comparative advantage.

  • Domestic demand-driven high paced growth: The Baltic countries, as some of the early reformers, attracted a lot of external capital. But due to a small manufacturing base and the small size of the economies, a significant part of foreign capital took the form of cross-border bank flows channeled into very high domestic credit growth. Although income convergence in these countries leading up to 2008 financial crisis was the fastest in the region, they also saw by far the largest output declines during the crisis.

  • Domestic demand-driven slower growth: Most Southeastern Europe countries had a late start in transition due to political turmoil. The region received significant FDI as well as cross-border flows. But these were mostly concentrated in the non-tradable sector, partly due to lagging reforms. Convergence since the financial crisis has essentially stopped in these countries.

Tradedirections in CEE region, 2013

Source: IMF, Directions of Trade; WEO.

Countries vary strongly in their degrees of export orientation, only partly on account of country size, with particularly low shares in the Western Balkans. Trade flows to Western Europe and Russia (important for CIS countries and the Baltics) dominate intra-regional flows, which are strong only within the “German supply chain” countries and among the Baltics. Import demand from EU countries accounts for a significant share of GDP, rising as high as 20–25 percent for countries that have joined the EU.

While trade and financial integration has been a strong source of convergence, it has created vulnerabilities as well. As described in Chapter VIII, several countries in the region ran double-digit current account deficits during the boom years. External debt reached record high levels relative to their emerging market peers in other parts of the world. Although dependence on parent institutions assuaged concerns of sudden withdrawal and roll-over risks, high indebtedness has been a drag on recovery.

The crisis did succeed in correcting the flow imbalances, although in a brutal manner in some cases. Nevertheless most countries in the region are having a hard time returning to robust broad-based growth. From the trade perspective, the exposure to the EU, a region with persistent weaknesses, is creating headwinds. Countries with a more diversified export market, or countries whose exports are linked via Germany to final demand outside Europe, have fared better. And as discussed in Chapter IX, the financial interlinkages to Western European parent banks have been associated with slow credit growth, another factor constraining recovery in the region.

As post-transition countries move forward, the challenge is to take advantage of European integration without building further vulnerabilities. Outside Central Europe, this requires a higher orientation toward the tradable sector. Inside Central Europe, it means moving up the value added chain and creating new areas of comparative advantage. The days of very rapid and indiscriminate capital inflows are most likely over. At the same time, the EU is moving toward greater integration, with banking union and steps towards fiscal union, which pose new challenges for countries outside the euro zone or EU. To navigate in a world of more integration, countries in the region will need to have greater structural flexibility and competitive strength to ensure a durable convergence.

Box 6.Central Europe: Benefiting from the German Supply Chain

Being part of supply chains has benefited Central Europe (CE) countries enormously. Over time, these countries have increased their domestic value added from exports in line with increase in Germany and much more than in other European countries. While exports increased across all categories during 1995–2008 in CE countries, the increase in knowledge-intensive manufacturing sectors, namely machinery and transport equipment, was spectacular. Between 1995 and 2008, exports from these niche sectors multiplied many times over in these countries.

Increasing role of exports in the economy

Change in value added from exports as a share in GDP, 1995-2008

CE countries have also managed to create new areas of comparative advantage over time. In 1995, the revealed comparative advantage of these countries lay in labor- and capital-intensive manufacturing. By 2008, they managed to create comparative advantage in knowledge-intensive manufacturing. This was largely due to being part of the German supply chain. Cross-country econometric regressions show that factors that helped them to link up include close proximity to Germany, competitive unit labor costs, and a strong trade-enabling environment.1

1 See Rahman and Zhao (2013).

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