Financial crisis will shape the Czech presidency

By Vladimír Dlouhý

The forthcoming European Union presidency has created controversy. The Czech government, the argument goes, is not ready for the job as it is politically weak and does not have the expertise to manage the financial crisis and, in any case, the Czechs are European troublemakers. The crisis is now moving east and this small country is facing too tough a task.

All this is an exaggeration. In the past two decades, the central and east European (CEE) economies have done their homework, introducing reforms and learning painful lessons, with bank bail-outs and privatisations. As a result, they have much lower subprime exposure than they might have because their banks had tighter lending criteria and employed less securitisation. Capital is almost exclusively based on shareholder equity and CEE banks display a healthy loan/deposit ratio.

However, even CEE countries enjoyed the great credit binge and must now pay the bill. The problem is that these countries do not form a unified block: Poland, the Czech Republic, Slovakia and Slovenia are robust and the crisis is hitting them as an external shock. The others are much more vulnerable, as that external shock arrived at a time when accumulated domestic problems would have forced policymakers to take painful decisions anyway.

Recently, even in economically robust countries, sovereign spreads have widened and there has been a weakening of currencies across all CEEs. The pressures have abated in the past few days after Hungary adopted the International Monetary Fund's rescue package. In reality, the actual risks are overpriced. The widening of credit default swap spreads was more the result of global deleveraging. In central Europe, macroeconomic fundamentals are strong. There are differences among the countries and all this limits the policy options of their central banks; Hungary's is forced to increase interest rates while the Czech National Bank cut them on Thursday to try to head off a recession.

There is no doubt that all CEEs will suffer from the secondary impacts of the financial crisis, namely from the sudden decrease in export demand if western Europe falls into deep and prolonged recession. Also, some CEE countries depend on high levels of foreign direct investment to finance current account deficits; a quick decline in FDI, together with tighter credit conditions, will lead to painful adjustments.

The Czech presidency will therefore face problems from three areas. The first is the eurozone, where the exposure of banks to distressed debt and the need for recapitalisation is still unknown. The second is the central European EU members, which have relatively robust banks but which would be sensitive to recession in the eurozone (probably more than their present officials are prepared to admit). The third is the other new EU members, which might need support.

Probably the most sensitive issue is the anticipated global effort to strengthen international finance and regulation. This will involve the eurozone, UK and the US and crucial emerging markets countries. Co-ordinating the EU position is an unenviable job for any small member country. It might be useful for the Czech administration to request that the UK, France and Germany prepare their positions. Second, co-operation and support from the non-EU CEE countries and Russia will be of paramount importance because of both their economic and political influence on Europe.

Recent calls for extending French EU leadership beyond January 1 were disturbing, not only because they make a mockery of the European integration process. This is also an attempt to generalise about recent regulatory and behavioural failures and to draw a hasty conclusion about the need for a much larger and deeper governmental presence in the economy. This is a mistake. Yes, we need to improve regulation. Yes, we must accept annoying state ownership in the financial sector. But the Czech presidency should perhaps initiate discussions about how governments can eventually withdraw from the financial institutions.

Still, this is no time for ideological heroism. Large bail-outs and state intervention are a lesser evil than inaction. European economies are facing difficult times and the priorities for the Czech presidency must be to negotiate appropriate action to mitigate the impact of the financial crisis.

The author is international adviser to Goldman Sachs, teaches macroeconomics at Charles university in Prague and is a former member of the Czechoslovak and Czech governments