Capital flows and growth in Central and Eastern Europe

Some of the fastest growing CEE economies have also seen large fluctuations in GDP growth with adverse consequences on unemployment and migration

A recent paper entitled „Economic Growth and External Financing in Central and Eastern Europe” by Karsten Staehr of the Tallinn University of Technology investigates the link between capital inflows into the Central and Eastern Europe (CEE) region and levels of growth in the pre-EU accession decade and post-EU accession decade. The paper discusses the relationship with a particular emphasis on the effects of the availability of external financing.

Staehr argues that growth in CEE coincides in large part with growth in capital flows – at least as reflected in the current account balance.

„High rates of growth have typically coincided with large or increasing capital inflows, while low or negative rates of growth have typically occurred after capital outflows,” she writes.

A corollary of this, she notes, is that the relatively high growth rates in several CEE countries have come at the cost of an accumulation of foreign liabilities and exacerbated vulnerability to changes in international capital flows.

EU accession

In total 11 countries from Central and Eastern Europe (CEE) joined the EU in 2004, 2007 or 2013. „Whereas most have seen relatively rapid growth, others have seen less rapid growth and relatively slow convergence,” she writes.

„Moreover, some of the fastest growing economies have also seen large fluctuations in GDP growth with adverse consequences on unemployment and migration. Finally, the growth performance has overall been unimpressive in the period after the global financial crisis,” she notes. „It is pertinent to tie the growth performance of the CEE countries together with their access to external resources.”

Up to 2008 all the CEE countries experienced strong capital inflows, reflected in large current account deficits.

„The capital inflows arguably contributed to an expansion of the productive capacity, but also increased demand from domestic consumption and non-productive investment. With the outbreak of the global financial crisis many CEE countries experienced a sudden stop as previous large current account deficits were reduced and even turned into surpluses within a year or two.”

The paper goes on to ask which developments in the current account balance can be linked to growth in the CEE countries?

„The main concern is whether economic growth in the countries has been dependent on access to external financing,” the paper suggests, noting that this is not exclusive to CEE countries and points to the growth performance of the Turkish economy after the global financial crisis, highlighting the importance of the current account balance.

The paper notes that the neo-classical model of capital flows predicts that capital will flow from high-income countries to lower-income countries where the marginal product of capital is higher. This prediction is often not confirmed in empirical studies, the paper notes. „Why does capital in many cases flow from low income countries to high-income countries?” it asks.

„Capital inflows are pro-cyclical, which is not immediately consistent with the neo-classical model,” the paper notes. The conclusion is in all cases that external factors, such as world interest rates and foreign business cycles, play a dominant role, while domestic factors are far less important.

Balance of payments constraints

A body of literature going back to the 1970s focuses on constraints on economic growth afforded by the balance of payments. The starting point is the finding that net exports are typically closely related to income level in the short term. Higher income implies lower net exports and potentially a current account deficit. A current account deficit is only possible insofar as it can be financed either by capital inflows or drawing down international currency reserves.

„The upshot is that the balance of payments may constrain output growth in the short term,” the paper argues. „This view on the importance of external financing for economic growth is also behind the lending policies of the IMF and the World Bank as formalized in the Two-Gap Model.”

Empirical studies tend to find that there is substantial co-variation between capital flows and economic growth, the paper notes. Cardarelli et al. (2010) discusses the macroeconomic consequences of capital inflows in emerging-market economies and find that inflows have often been associated with rapid GDP growth followed by declining growth rates.

Meanwhile, Prasad et al. (2007) found no evidence of capital inflows contributing to economic growth, although their sample included a number of East Asian countries that rely on an export-oriented economic model.


Turning to the countries in Central and Eastern Europe, a number of studies have emphasized the importance of the current account for growth performance.

Bajo-Rubio & Diaz-Roldan (2009) uses the idea of the balance of payments constraint and use information on trade elasticities to provide estimates of the average growth rate that would prevail under a regime without access to international capital. They found that economic growth was constrained in their sample up to 2007.

Brixiova et al. (2010) found evidence of a boom-bust cycle in Estonia in large part driven by capital flows. Ghosh et al. (2011) meanwhile found that capital inflows into the post-communist countries were beneficial to economic growth but also made the countries more vulnerable to external shock.

GDP growth and the current account balance in the CEE countries since the mid-1990s has on average been relatively rapid but also highly fluctuating, the study notes.

„This pattern is most pronounced for the Baltic and Balkan groups which are comprised of countries that were particularly affected by first the Russian crisis and later the global financial crisis. The strong growth performance of the Baltic countries in the period from 2000 to 2007 is noticeable and so is the output collapse in the countries in 2009 after the outbreak of the global financial crisis. The recovery after the crisis has been relatively timid in all country groups with growth rates of around 2-3 percent in 2013 and 2014.”

The arguably most notable observation is the relative stability of GDP growth in Poland. Poland is the largest of the CEE countries and is less open for trade and capital flows than most other CEE countries.

„The very large and rapid reversals of the current balance in 2008 and particularly in 2009 are also notable. These sudden stops affected the Baltic group the hardest but also the Balkan group and to a lesser extent the group of Central European countries. The sudden stops precipitated deep economic severe economic downturns as has been the cases in other situations of sudden stops (Calvo 1998),” the paper notes.

It posits a negative relationship between the two variables: current account surpluses have appeared in periods of relatively low GDP growth and large current account deficits in periods of relatively high GDP growth.

At this stage there is relatively little to suggest the direction of causality and for that matter possible economic mechanisms behind the results, Staehr suggests.

„One possible reason for the negative correlation between the current account and economic growth is that the capital flows which finance or make up the current account balance in large part are used for investments that may drive economic growth. These growth effects of investment must materialize very fast, i.e. within the first year, which is arguably not very probable,” she writes.

The effect of the contemporaneous current account balance on GDP growth is negative and substantial, while the effect of the one period lagged current account balance is positive and substantial although smaller in numerical terms than the contemporaneous effect. „The upshot is that, say, a current account deficit is only associated with higher growth within the same year, whereas the effect is negative the following year. This casts doubt on the hypothesis of supply side effects due to investment financed by current account deficits or capital flows. „

Consumption and domestic demand  

Another approach entails that demand proxies such as private consumption and domestic demand are used instead of GDP when the effect of the current account balance is estimated. This makes it possible to ascertain the relationship between the current account balance and demand more precisely than if GDP is used.

The conclusion Staehr draws is that the contemporaneous current account balance is closely connected to proxies of domestic demand, while lags in the current account balance do not affect GDP growth in ways that would lead to the conclusion that current account movements lead to economic growth due to expansion of production capacity.

How would the average growth rate and the variability of the growth rate have been affected if the current account balance had taken a fixed value throughout the two decades?

Staehr suggests that the main difference appears for some of the countries with the lowest GDP per capita in the beginning of the sample, i.e. the Baltic states, Bulgaria and Slovakia.

„The mean GDP growth is around half of a percentage point lower in the scenario with the current account balance fixed at 4 per cent of GDP. The compounded effect on GDP would be quite sizeable. For two countries, the Czech Republic and Slovenia, which were those with the highest GDP per capita in 1995, strict adherence to a current account deficit of 4 per cent of GDP would have entailed higher mean growth.”

By construction the variability of GDP growth is reduced when the variability from the current account balance is eliminated. The effect is largest for the Baltic states, for which the standard deviation is reduced by 1-1.5 percentage points. The Czech Republic stand out with a very small reduction in the variability of GDP growth, reflecting that fact that the country already had a very stable current account balance. Other countries typically see a reduction of the standard deviation by around 0.5 percentage points.

As earlier, the overall picture is the availability of external financing has been of particular importance for the growth performance of CEE countries with initially relatively low GDP per capita, while it has been less important for better-off countries such as the Czech Republic and Slovenia.

The results also highlight the “trade-off” associated with the availability of external finance: countries where capital flows have been most important for mean GDP growth are also the countries where the impact on growth variability has been the largest.


The paper concludes by suggesting that for the 11 CEE countries the current account balance does help explain annual GDP growth, according to panel data estimations on a time sample from 1995 to 2014.

„Using a model with country fixed effects, the lagged dependent variable and various other control variables, it appears the changes in the current account balance play a key role while the level of the current account balance also plays a role although less significant in economic and statistical terms.”

Counterfactual simulations suggest that growth would have been lower but also less volatile in those CEE countries which had the most disadvantageous starting points, including the Baltic states, Bulgaria, Romania and Slovakia. „For other countries with more advantageous starting points, in particular the Czech Republic and Slovenia, but also Poland, capital flows appear to have had a relatively modest effect on the mean and variability of economic growth.”

The main conclusion is that there appears to be a trade-off between average volatility in trade balances and economic growth in most CEE countries.

„This result, derived from the simulation of counterfactuals, is broadly in line with the narrative that emerged after the global financial crisis. The pre-crisis period was characterized by rapid economic growth but also large current account deficits and accumulation of imbalances that made the countries vulnerable to the fallouts from the global financial crisis.”

The severe financial crises and economic downturns experienced in many countries in CEE after the global financial crisis have indeed led scholars and policy-advisors to rethink economic and structural policies for the region, the aim being to device policies that reduce vulnerability to disruptions in external financing while sustaining high trend growth.

Typical policy recommendations include rounds of deeper and more “qualitative” reforms in education, justice, etc., but there are also calls for measures to increase domestic savings and avoid excessive reliance of external financing.