The global financial crisis and transition economies: Which initial conditions mattered?

This paper sheds new light on the effect of the Global Financial Crisis of 2007-2009 on the countries of the former Soviet bloc.  Liberalization of financial systems at the end of the 1980s, beginning of the 1990s and their subsequent integration into global markets had opened up these economies to foreign capital flows and thus stimulated their financial development and economic growth. At the same time, however, financial liberalization and integration promoted greater dependency on exports and capital inflows making these economies more vulnerable to external shocks. Subsequently, the Washington Consensus that stressed interest rate liberalization, trade liberalization, privatization, and deregulation of markets came under attack from within.  These fundamental issues, neglected by the Washington Consensus, became a reality for many former socialist countries that had struggled to create a proper balance between sound government policies and adequate supervisory and regulatory structure on the one hand and an ‘invisible hand’ on the other.  As a result, liberalization of financial markets and economic integration exposed those countries to greater risks of ‘catching a virus’ from the outside.  The impacts of the East Asian crisis of 1997-1998, the Russian crisis of 1998, and the Global Financial Crisis of 2007-2009 on the transition economies had revealed their particular vulnerability to such external shocks.  This research offers a novel approach by focusing on cross-regional comparisons. Twenty-eight countries of the former Soviet bloc are grouped according to different criteria (European Union membership, former Soviet Union membership, sovereignty prior to transition, timing of the financial reforms, geography, etc.) and the corresponding vulnerability of each group is compared. The research links the variability in the groups’ responses to the European Union membership, the degree of the transition and economic freedom, and the sectoral composition of GDP on the onset of the crisis. The research finds that what is considered to be an advantage during the ‘normal times’ – high degree of transition and financial liberalization, more ‘sound’ and ‘effective’ banking system, high volume of credit flows, large service sector, and EU membership – became a serious disadvantage during the Global Financial Crisis. In fact, countries that reached a high degree of economic freedom and liberalization were the ones that were hit the most.