by Adam Tooze
The Shock: October 2009 Forecasts for GDP in 2010 compared to Octoer 2007 Forecast, Percentage Difference
Source: Zsolt Darvas, “The EU’s Role in Supporting Crisis-Hit Countries in Central and Eastern Europe,” Bruegel Policy Contribution 2009/17 (December 2009), figure 1.
Individually, the East European states are not big economies. But taken together they formed a substantial unit comparable in economic heft to France or the state of California. They were the pride of Europe’s transformation process, and the battleground in the new confrontation with Russia that had taken shape between 2007 and 2008. They were eager disciples of market liberalization and financial globalization. That put them especially at risk as global financial markets collapsed. The situation was made even worse, however, by the source of the capital that fueled their growth: the overleveraged banks of Western Europe. In total, the West European banks and their local branches had $1.3 trillion at stake in emerging Europe, $1.08 trillion excluding Russia.27 As the balance sheets of the European banks were being crushed on the other side of the Atlantic, the risk was that they would dramatically curtail their operations in Eastern Europe.
Before the crisis struck it was normal to see an average of $50 billion flowing into the emerging markets of Eastern Europe and the post-Soviet world every quarter. In the last quarter of 2008 that suddenly reversed, with an outflow of $100 billion and a further $50 billion in the first quarter of 2009.28 The pyramid of credit established over the previous fifteen years was shaking. In a “natural” process of adjustment, the floating currencies of Eastern Europe plunged. The result was a catastrophic increase in the local currency cost of servicing international loans.29 In Bulgaria, Romania, Hungary and Lithuania, foreign loans made up more than half of all credit. As the forint plunged, in a matter of weeks Hungarian families saw their mortgage and car loan bills surge by 20 percent. The worst affected were the Hungarian families whose debts were denominated in Japanese yen. They faced a 40 percent increase in their debt burden as the yen soared.30
Whereas Russia had reacted to its humiliation in the 1990s by accumulating a substantial currency reserve, the East European states had no such defense. For them security lay in integration with the West, or at least so they imagined. With the Fed having used swap lines to stabilize a core group of economies in which American interests were undeniable, one might have expected the ECB to extend similar support to the East European neighbors of the eurozone. Certainly this was the expectation of the Fed. If one applied the three criteria set out by Nathan Sheets to Eastern Europe, the case for ECB assistance was clear-cut.31 The East Europeans were EU members and aspired to future eurozone membership. As such, the respectability of their economic policy was vouched for in general terms. The crisis in Eastern Europe was immediately caused by a sudden stop in foreign credit supply. And the eurozone’s own banks were deeply involved and stood to suffer substantial losses. The risk of blowback was acute. As Sheets remarked to the FOMC: “I think it is very appropriate for all the European EMEs to report to the ECB for their liquidity needs.”32 But whereas the Fed had effectively licensed the ECB to issue dollars, the ECB had no intention of extending equivalent privileges to Poland or Romania. With Sweden and Denmark the ECB established publicly announced swap lines. Their banks would supply liquidity to Eastern Europe. Meanwhile, the central banks of Poland and Hungary were fobbed off with repo arrangements that treated them no better than stressed commercial banks in need of extra liquidity. The only assistance that the ECB was willing to provide was to give them short-term funding in exchange for first-class euro-denominated securities. When the problem was a shortage of euro funding, that was not a great help. What they needed was a swap facility for Hungarian forint or Polish zloty. Even the limited facilities offered by the ECB were extracted only thanks to urgent pressure from the Austrian and French central banks, which had particular reason to worry about the losses their banks might suffer on their East European portfolios.33 Austria’s banks were in particular difficulty because they had made loans in Swiss francs, funding them with borrowing in Switzerland, where interest rates were low. Now the Swiss franc was soaring and funding was scarce. To tide them over, the Swiss Central Bank offered full currency swap lines in exchange for euros, but not for Polish zlotys or Hungarian forints.34
Membership in the EU and NATO was supposed to have promoted Eastern Europe from their inferior status in the global pecking order. Ex-members of the Warsaw Pact and former Soviet republics had eagerly refashioned themselves as exponents of Donald Rumsfeld’s new Europe. They now found their prospects for growth shattered and their governments thrown back to where their post-Communist careers had begun, as lesser sovereigns, and more or less resentful supplicants for international financial assistance. The IMF was their last resort. This was traumatic. No one in Eastern Europe wanted to relive the bitter aftermath of the collapse of communism, with which the IMF was indelibly associated.
The first and most desperate application for assistance from within the EU was Hungary’s.35 On October 27, 2008, Budapest reached agreement with the IMF and the EU (as opposed to the ECB) on a $25 billion loan package. At 20 percent of Hungarian precrisis GDP, it was a very substantial commitment and an unusually generous multiple of Hungary’s IMF capital quota.36 The IMF considered the program to be unusually lenient. Unsurprisingly, the Hungarians did not see it in such favorable terms. Hungarian politics polarized as the austerity program bit. The nationalist daily Magyar Hírlap described Hungary as being slowly garroted by a “credit noose around our necks.”37 For the extremists of Hungary’s Far Right it was a short step back in time from the “neocolonialism” of the EU and the IMF to the Treaty of Trianon, which had eviscerated Hungary after World War I. In 2010 the right-wing Fidesz party would reap the benefits with a crushing electoral victory, setting Hungary on the path to a self-declared illiberal democracy.
IMF Crisis Programs (as of August 2009)
Source: IMF, Review of Recent Crisis Programs (September 14, 2009), Appendix I, https://www.imf.org/external/np/pp/eng/2009/091409.pdf.
The IMF’s Hungarian aid package of October 2008 was followed by programs for Iceland, Latvia, Ukraine and Pakistan.38 In 2009 Armenia, Belarus and Mongolia would be forced to apply to the IMF for help. Less than a year after it had played host to the contentious NATO summit, Bucharest found itself negotiating an IMF program. Precautionary credits would be offered to Costa Rica, El Salvador, Guatemala, Serbia, and Bosnia and Herzegovina. Additionally, at the urging of Washington, a new, minimally invasive flexible credit facility, offering a total of more than $80 billion in ready cash, was made available to Mexico, Poland and Colombia. Mexico thus had the singular distinction of receiving both a swap line and an IMF credit facility.
Thanks to the IMF and EU intervention, an immediate meltdown was avoided on the East European periphery of Europe in the fall of 2008.39 But the situation remained extremely precarious. And it was dangerous not only to the borrowers. Austria’s adventurous banks had since the 1990s accumulated claims on Eastern Europe equal to more than 55 percent of Austrian GDP. The exposure of Austrian banks to Hungary and Romania, the countries with flexible exchange rates that seemed most likely to suffer payment shock, came to 20 percent of Austria’s GDP. German, French and Italian banks all had large claims on Eastern Europe, but these were manageable in relation to domestic resources. The other lender that was seriously exposed was Sweden, whose banks had almost entirely monopolized the banking markets of the Baltics, feeding a roaring real estate boom. There was acute anxiety on the part of international agencies such as the World Bank and the Bank for European Reconstruction and Development that an abrupt withdrawal by one or more stressed West European banks could precipitate a chain reaction that would overwhelm the modest resources provided by the IMF and the EU Commission. Desperate to reduce leverage on all fronts, West European banks would pull out of Eastern Europe en masse, unleashi
ng a ruinous rush to the exit. Bob Zoellick, George Bush’s nominee to head the World Bank, was deeply concerned about Europe’s future. “It’s 20 years after Europe was united in 1989,” Zoellick reminded the readers of the Financial Times in early 2009, “what a tragedy if you allow Europe to split again.”40 The new Europe, which the United States and the two Bush presidencies in particular had been fostering since the end of the cold war, was in jeopardy. Evoking a different chapter in Europe’s history, the Viennese press was warning of a “monetary Stalingrad” that threatened Austria’s and Italy’s banks.41
The situation was serious. But the alarmist talk in Central Europe was also a reflection of the fact that Western Europe wasn’t listening. Berlin was no more enthusiastic about a collective European solution in Eastern Europe than it had been in the eurozone. Germany shot down Austrian and Hungarian initiatives for a common support fund.42 “Not our problem,” Peer Steinbrück announced. East Europeans did not fail to notice that as a eurozone member, Greece seemed to be weathering the storm rather better than Hungary, even though its financial fundamentals were no better.43 In early 2009 there were calls, ironic in light of later events, for Poland and other East European EU members to be put on a fast track to eurozone membership, thus bringing them under the protective umbrella of the ECB.44 A confidential IMF staff report backed the proposal arguing that “[f]or countries in the EU, euro-isation offers the largest benefits in terms of resolving the foreign currency debt overhang [accumulation], removing uncertainty and restoring confidence. Without euro-isation, addressing the foreign debt currency overhang would require massive domestic retrenchment in some countries, against growing political resistance.”45 But no help was to be expected from the ECB. It had no interest in entangling itself in Eastern Europe.
In December 2008 the most exposed Italian and Austrian banks began clamoring for a concerted program of international assistance. Finding the door closed in Brussels, they turned to Vienna, which, given the extent of Austria’s entanglement, could not afford to let things slide. Circumventing Brussels, the Austrian government announced what became known as the Vienna Initiative. This multilateral scheme committed the World Bank, the European Bank for Reconstruction and Development and the European Investment Bank to a program of 24.5 billion euros in new lending and capital injections. Crucially, it was flanked by an agreement with at least some of the leading private banks. On a case-by-case basis the Vienna Initiative extracted pledges from the leading lenders that they would maintain their lines of credit to the region, thus preventing an even more dramatic credit stop.46 UniCredit and Banca Intesa of Italy, Raiffeisen of Austria and Swedbank of Sweden all participated. Commerzbank of Germany and Deutsche Bank did not.47
As it turned out, the most important battleground for East European stabilization was a long way from Vienna. As the twenty-first century began, Latvia, Lithuania and Estonia had seemed like the lucky ones. Unlike other former Soviet republics, such as Ukraine, Georgia or Belarus, they had successfully transitioned to full membership in both the EU and NATO. Furthermore, unlike Hungary or Poland, the Baltics were eager to join the euro as soon as possible. In anticipation they had pegged their currencies. In 2008, despite the sudden stop to foreign capital inflows, they were under great pressure to remain on their convergence track. But as foreign credit dried up, maintaining their fixed exchange rates became ever more painful. When in early 2008 the IMF had contemplated the possibility of a crisis triggered by macroeconomic imbalances, Latvia, with its yawning current account deficit, had been singled out as particularly vulnerable.48 Then it had been viewed in isolation as a national problem case. Now Latvia faced the unwinding of its huge deficits in the context of a comprehensive global crisis that had forced its regional competitors in Poland, Hungary and Romania to devalue. If the Baltics did not follow suit, how were they to keep up? How would they cope without foreign funding? How could they regain export competitiveness and shrink imports if they could not adjust their currencies against the euro? Without devaluation the only way to right the trade balance was by rebalancing domestic demand, cutting wages, raising taxes and slashing government spending. This was painful, but given the advanced stage of financial integration that the Baltic countries had already reached, devaluation was dangerous too. With 80 percent of credit outstanding sourced from their European neighbors, any substantial depreciation was likely to trigger wholesale default. The cost of servicing their debts in euros would simply have become prohibitive. Though they were not yet members of the eurozone, in early 2009 the Baltics faced a predicament that was a grim precursor of things to come.
Because of the scale of its debts and the deep involvement of Scandinavian banks, Latvia was commonly seen as the key to stability in the Baltics.49 If it abandoned its peg, contagion would most likely spread to Estonia and Lithuania, and from there to Slovakia and Bulgaria, which were also struggling to hold their currencies in line with the euro.50 Once a wave of further devaluations began, it would be impossible to uphold the defenses put in place by the Vienna Initiative. Fire sales would sweep Eastern Europe. Some might get out alive. But for two of Sweden’s most important banks, Swedbank and Nordea, the entanglement with the Baltics was existential.51 If their loans were written off, the capital of both banks would be completely wiped out. As a BNP Paribas analyst put it, “Latvia may be a small country but it has vast repercussions.”52 One Central European minister of finance, who preferred to remain anonymous, predicted that the chain reaction across Central and Eastern Europe would take down at least half a dozen European banks. Latvia would play the role of a Lehman, or, even more ominously, that of the infamous Austrian Kreditanstalt in the financial crisis of 1931, the failure of which had precipitated Weimar Germany’s final slide toward disaster.
For the IMF, the standard prescription for a country in Latvia’s position was a one-off devaluation followed by debt restructuring or rescheduling. But the European Commission dug in its heels. Latvia was en route to eurozone membership. It must stay the course. If it needed to rebalance its current account it must do so through deflation and austerity. The results for Latvia were drastic. By the summer of 2009 house prices had plunged by 50 percent. Civil servants, including one-third of the country’s teachers, were fired and public salaries were slashed by 35 percent. Unemployment surged from 5 to 20 percent.53 Remarkably, Latvia clung on, as did its neighbors. In mounting its defense, Latvia received aid totaling 32 percent of its precrisis GDP: 3.1 billion euros came from the European Commission; the IMF provided 1.7 billion; 0.8 billion came from the World Bank and the European Bank for Reconstruction and Development; and 1.9 billion came from Sweden, Denmark, Finland, Norway and Estonia.54 They all preferred to fight the crisis in Latvia rather than bailing out their banks at home. Significantly, the ECB absented itself from the crisis-fighting coalition.
The financial austerity course imposed a huge pressure on the new democracies of the Baltics.55 In Latvia popular discontent with the new austerity line and accusations of corruption against the political class led to two referenda calling for protection of pensions and a public right to dissolve the parliament by plebiscite. In January 2009 Riga was rocked by mass protests that escalated into rioting and a night of street battles with police. In February a conservative coalition government took office under the high-profile member of the European Parliament Valdis Dombrovskis. His government’s objective was to stay the course of austere conformity. “We are facing national bankruptcy. It’s going to be tough,”56 Dombrovskis told the nation. What, after all, was the alternative? The legacy of the Soviet period hung over Latvia. Georgia was a reminder. For the Baltics the choice was between a Western or an Eastern hegemon. Since the 1990s they had managed miraculously to navigate their way under the umbrella of the EU and NATO. At least as far as the Latvian political class was concerned, they intended to stay there.
IV
Faced with the double crisis of 2008 the reaction of Eastern Europe was not uniform.
The Baltics stayed the course. Hungarian nationalism rebelled. But nowhere was the double shock more jarring than in Ukraine. The coincidence of the escalation of geopolitical tension between Russia and the West with the financial crisis dealt a shuddering blow to its fragile polity. The route to the Ukraine crisis of 2013 was twisted. But the path that it would travel down was mapped out already five years earlier.
In the spring of 2008 the decision by Ukrainian president Viktor Yushchenko to apply for NATO membership—eagerly applauded by the Bush administration, Poland and the other East Europeans—split Ukrainian politics. Whereas President Yushchenko threw in his lot with the West, Prime Minister Yulia Tymoshenko favored the policy of balance between Russia and the West that Kiev had pursued since independence and that had made her personal fortune as a kingpin in the gas trade. The war in Georgia in August 2008 divided what was left of the political legacy of the revolution of 2004.57 Then, before the cease-fire in the Caucasus had more than a few weeks to settle, Kiev was rocked by the financial crisis.
Since the 2004 revolution, Ukraine’s economic growth had come to rely on foreign borrowing. By early 2008, foreign funds made up 45 percent of all corporate financing and 65 percent of household loans in Ukraine.58 Altogether, European banks had lent Ukraine at least $40 billion, with Austrian and French banks responsible for almost half. The onset of the crisis stopped the credit flow. And it hit Ukraine’s exports hard. As one of the legacies of the Soviet era, steel accounted for 42 percent of Ukraine’s foreign currency earnings. No sector was worse hit by the crash in global investment spending than steel. Prices plunged and industrial output by January 2009 was falling at an annualized rate of 34 percent.59 As Ukraine’s economy slid into recession, millions were left without pay, if they were not actually thrown out of work. Of all economies in the world, only Latvia would suffer a more severe contraction.