What Will Economic Recovery Look Like in Eastern Europe?

Editor's Note: The following post was contributed by Paulo Correa, Lead Economist for Private Sector Development in the Europe and Central Asia Region of the World Bank.

International debate on the financial crisis has shifted attention to the potential drivers of the future economic recovery. The countries of Eastern Europe were hit hard by the global financial crisis, after having long enjoyed abundant international financing and large inflows of foreign direct investment that brought them high rates of growth, mainly through the expansion of domestic consumption. With the slowing of international trade and the indefinite tightening of financial conditions, sustained economic recovery will depend to a greater extent on productivity gains and growth in exports. 

Two important sources of expansion in firms’ productivity are learning and R&D. Economic research tells us that, depending on size and survival rate, younger firms tend to grow faster than older firms. Because the learning process presents diminishing returns, younger firms, which are in the early phases of learning, will learn faster and thus achieve higher productivity gains than older firms. Innovative firms are expected to grow faster too – R&D tends to enhance firm-productivity, while innovation leads to better sales performance and a higher likelihood of exporting.

An important element in understanding Eastern European growth prospects, therefore, is to find out how the crisis has affected innovative and young enterprises. This is in addition to other factors that could have an important effect on the recovery, such as declining investments (due to lower profitability and higher costs of capital); lower quality and quantity of labor (due to the level and duration of unemployment); and the structural change of economic activity away from non-tradables, such as finance, real estate and construction, to the tradable sector.

Has the current financial crisis had a disproportionately stronger impact on innovative and younger firms, thereby negatively affecting the potential growth of Eastern European countries? Mariana Iootty and I tried to address this question (download Working Paper) using a balanced panel dataset for 1,686 firms in six countries (Bulgaria, Hungary, Latvia, Lithuania, Romania, and Turkey) covering manufacturing, retail and other service sectors; and resulting from the matching of two datasets: the World Bank’s Financial Crisis Survey (FCS),  implemented in June/July 2009 and designed to capture the effects of the crisis on key aspects of the enterprise sector, and the World Bank’s Enterprise Survey (ES), which was carried out in 2008 and provided us data on firm characteristics and on the pre-crisis scenario (FY2007 or before).

Looking more specifically at the sales growth of innovative and young firms¹in the region, before and after the crisis, we applied two methods:

• Panel-data estimators to assess the difference in sales growth performance between innovative (young) and non-innovative (older) companies over the period, controlling for firm characteristics;
• The Juhn-Murphy-Pierce technique of decomposing the difference in sales growth performance between groups of firms, before and after the crisis, into:
  • differences in the distribution of observed characteristics (the characteristics effect);
  • differences in the “market value” of such characteristics (the returns effect); and
  • differences in unobservable attributes and “market values” (the unexplained effect).
     

This decomposition technique enabled us not only to check the econometric findings but helped us to assess the sources of sales differentials between the firm cohorts.

The panel data analysis shows that the sales growth rates of innovative firms declined more than those of non-innovative companies – a result that is robust regardless of the estimator applied or the criteria used to categorize innovation (introduction of a product/process, or development of R&D activities), after controlling for firm characteristics including export orientation, size, industry and country. Our analysis also found the decrease in sales growth rates of younger firms to be more severe than those of older companies.

The decomposition exercise confirmed that the positive, pre-crisis differences in sales growth rates in favor of both innovative and young companies were subsequently reversed. On average, sales at innovative firms were about 13% higher than at non-innovative firms before the crisis as compared to 1% lower in 2009. A similar result was found for young firms: on average, sales at younger firms were about 19% higher than at older firms before the crisis as compared to 10% lower in 2009. 

For innovative companies, we found evidence that the post-crisis reduction in the “premium” for the ability to innovate – which we interpret as Schumpeter’s “entrepreneurial ability” – helped to explain why innovative firms performed worse. Conversely, in the case of young enterprises, results suggest that their “ability to learn” served to mitigate the negative impact of the crisis on sales growth performance.

Given these negative outcomes, it seems natural to expect that the exit of potentially viable young firms and the consequent premature “aging” of the enterprise sector will serve to soften market selection and reduce productivity gains, and that the “dulling” of innovation among firms may reduce sales and consequently serve as a disincentive for investment in R&D. These factors suggest it will be difficult for the countries of Eastern Europe to achieve their pre‐crisis growth rates.

But there is a caveat to such bleak forecasting: what if the crisis were to have a purgative effect, by eliminating less efficient companies and thus increasing average productivity? Will the surviving firms not emerge from their ordeal stronger and wiser for having labored through it, and thus better equipped to navigate a turbulent recovery? The argument has already prompted some discussion in the popular media, and is one worth keeping in mind when assessing the economic prospects ahead.

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¹ We defined “young” firms as those no more than five years old before the crisis (i.e., in 2007). “Innovative” firms were those that introduced new products or processes, or performed R&D, between 2005 and 2007.