DP4413 | Managing Volatility in Transition Economies: The Experience of the Central and Eastern European Countries

Publication Date

23/06/2004

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Abstract

We discuss sources of volatility and vulnerability in the CEECs during the transition and leading up to EU accession. The Paper emphasizes the role of the transition shock as a source of extreme volatility on a much larger scale than the one observed during crises in emerging markets. The low degree of financial and institutional development, which lagged behind the opening of domestic markets to foreign trade, was of paramount importance for the severity of the economic contraction. Pro-cyclical fiscal policy and institutional uncertainties amplified output volatility. Many factors will contribute to more stability in the CEECs in the years ahead. EU integration has given a credibility bonus to the reform efforts of the CEECs, has driven the process of institutional convergence to EU structures, and has led to improvements in the functioning of markets, protection of property rights, contract and law enforcement. Convergence to EU macroeconomic targets has also taken place, reflecting remarkable progress in economic reform, while the deepening of real integration with other EU countries will sharply reduce the magnitude of idiosyncratic shock to CEECs. EU accession criteria will facilitate trade by reducing transaction costs and introducing common standards, and continue to attract capital flows. Still, as long as financial markets in the CEECs remain much less developed than those in the EU, output volatility is bound to remain higher in the CEECs than in the EU. Although our analysis indicates that at present the risk of capital flow reversal is low, with their complete liberalization financial capital flow volatility in the CEECs may increase, and if not adequately regulated, financial markets may become more vulnerable to turbulence in international markets. Greater openness of the capital account will constrain the flexibility of the CEECs in using macroeconomic and monetary policy, leaving fiscal policy as the only additional instrument to deal with conflicting domestic and external priorities. The adoption of existing rules in the EU is unlikely to overcome the pro-cyclical stance of fiscal policy displayed by CEECs during the transition period. Off-budgetary expenditures and contingent liabilities that may become explicit government liabilities also pose a risk to state finances.