reduce the role of EU-specific foreign savings. If this is not the case, then other EU-specific factors may be more instrumental.

The main conclusion is that what matters for growth are institutional factors and that these are likely to be EU-specific. Specifically, two thresholds are used; a threshold defined when financial depth belongs to the top two quartiles (Table 6, column 2) and a threshold for the top quartile only (Table 6, column 3). In either case, the importance and magnitude of the EUspecific foreign savings interaction remain unchanged when financial development is used to construct the threshold variable (i.e., it barely changes from -0.164 without thresholds effects to a coefficient of -0.169 when using the quartile 4 threshold definition). This suggests that financial development is not the driver of the foreign savings and growth link. Slightly different is the conclusion reached using measures of institutional development. We use the first principal component of six ICRG indicators on institutional development to construct the threshold variable. Again, two thresholds are used; a threshold defined when institutional development belongs to the top two quartiles (Table 6, column 2) and a threshold for the top quartile only (Table 6, column 3). The impact of the EU-specific foreign savings interactions weakens for the highest quartile (column 6 compared to the benchmark in column 4); the relevant coefficient changes from -0.674 to -0.505, but remains statistically significant). This suggests that EU membership might reflect institutional development factors. But the observed weakening is also limited, suggesting that EU-specific factors are still at play. The fact that institutional indicators do not eliminate the effect of EU-specific regressors might reflect that EU membership (actual or prospective) acts as an anchor for expectations of improved institutional quality even if actual change on the ground improves more slowly.

# _<u>Unsustainable Pre-Crisis External Imbalances</u>_

The next step is to investigate whether the estimation results are driven by outlier observations. The collapse of output in 2009 among some emerging European countries undoubtedly exceeded the experience of most advanced and developing countries. Thus, it is fair to argue that the growth benefits we have observed might have been eliminated by the global financial crisis and the unique impact it had in some emerging European countries. To test for this, we proceed to drop what could be considered outlier observations. We do so by dropping from the sample the (i) above average growth observations among emerging European countries, (ii) above average plus 1 standard deviation growth countries, and (iii) plus-minus 1 standard deviation growth countries. In effect this is equivalent to dropping between 15 and 35 percent of the observations available for emerging European countries and, in particular, those where growth was the highest and accompanied by unusually large and unsustainable external imbalances.<sup>10</sup> To be sure, the approach is somewhat mechanical. But attempting to explain the great recession with a growth equation is clearly inappropriate. Instead, we simply wish to understand better if it is the outliers of the pre-crisis period what drives the results we have discussed so far.

> 10 Dropping all the observations of the 2005-08 period would have been also useful, but would reduce the power of the test as we would only have two 4-year periods. Thus, eliminating the high growth cases only seemed like a better alternative as it allowed us to maintain those emerging European countries that, for the most part, were engaged in sustainable foreign financed growth. The countries dropped through the three methodologies outlined above include the Baltic countries, and some of the countries that at the peak of the global financial crisis required financial assistance from the IMF (such as Romania and Serbia).

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