Recovery: The Global Financial Crisis and Middle-Income Countries

6 alejandro foxleyQuestion 2: Is cumulative learning arising from the financial crises ofthe past, or are we witnessing the same mistakes all over again?The recent experience of one group of middle- income countries, those inEastern Europe, seems to suggest that we still have a limited capacity to learnfrom other countries’ previous crises.The Eastern European countries’ accession to the European Union impliedthat they would open their economies to a huge market and to significantcapital inflows, which took the form of foreign direct investment by Europeancompanies and of loans, both short and long term, from Europeanbanks. Thus, both the governments and private sectors of these EasternEuropean nations thought that belonging to the European Union providedimplicit insurance: Continued, uninterrupted access to markets and financewas guaranteed by signing the respective treaties of accession. Increasingpublic and private spending in the form of a consumption boom did notseem risky at the time.Soon, however, the economies of the new EU member states began to runthe so- called twin deficits: budget deficits and significant imbalances inthe current account of the balance of payments. These deficits were largelyfinanced by incurring external debt— particularly in the form of private foreigncurrency loans. This situation evolved to the point that, by 2007, shorttermexternal debt was equivalent to the total foreign exchange reservesheld by these countries’ central banks. The twin deficits— plus excessiveshort- term debt, the accumulation of repayments of long- term debt upfront, and insufficient foreign reserves— increased the vulnerability of theseeconomies to sudden reductions in the inflow of net capital.The indicators that illustrate this as a possible scenario are given in table 2.When compared with other middle- income countries in Latin America andEast Asia, the Eastern European economies look much more vulnerable. Infact, the Institute of International Finance predicts that, as a consequence,net capital inflows to Eastern Europe will decrease dramatically, from $254billion in 2008 to $30 billion in 2009. Moody’s (2008) shows high ExternalVulnerability Indicators for several countries in the region, including Estonia,Latvia, Hungary, and Lithuania.The accumulation of these types of imbalances is not a new or unique phenomenonin recent history. Chile’s financial crisis in 1982 included some ofcarnegie endowment for international peace