Financial Integration in Emerging Europe: an Enviable Development Opportunity with Tail Risks

CASE latest post conference paper has been published in CASE Network Studies and Analyses series. This paper by Aleksandra Iwulska, Naotaka Sugawara and Juan Zalduendo builds on work presented in a World Bank report titled “Golden Growth: Restoring the Lustre of the European Economic Model” (2012) and on Juan Zalduendo’s presentation on “Financial integration. Lessons from CEE and SEE” delivered at the CASE 2011 International Conference on “Europe 2020: Exploring the Future of European Integration” held in Falenty near Warsaw, November 18-19, 2011.

This paper draws on the experience of emerging Europe and argues that foreign capital is an enviable development opportunity with tail risks. Financial integration and foreign savings supported growth in the EU12 and EU candidate countries. The authors argue that this was possible because of EU membership (actual or potential) and its role as an anchor for expectations. In contrast, the eastern partnership states did not benefit from the foreign savings-growth link. But financial integration also led to a buildup of vulnerabilities and now exposes emerging Europe to prolonged uncertainty and financial deleveraging due to eurozone developments. Nonetheless, the authors believe that external imbalances should not be eradicated—nor should emerging Europe pursue a policy of self-insurance. Instead, what the authors refer to as an acyclical fiscal policy stance could serve to counterbalance private sector behavior. Going forward, a more proactive macroprudential policy will also be needed to limit financial system vulnerabilities when external imbalances are large.