The economies of central and eastern Europe that powered ahead in the benign global conditions of recent years are now being put to the test in far more difficult economic circumstances.
The global credit crunch, mounting inflation driven by rising energy and food prices, and a likely recession in the US are all having an effect on the economic climate of the former communist countries.
So far the impact has been limited. Specific banks and companies have run into financing difficulties. A handful of countries with big current account deficits – and external financing needs – have come under pressure, notably Romania, Bulgaria, Latvia and Hungary. But overall, the region is weathering the storm.
Economists have, since the autumn, shaved 0.5 to 1 percentage points off economic growth forecasts for the region for 2008, down from around 6 per cent to 5 or 5.5 per cent, compared with about 7.5 per cent in 2007.
The region’s leading financiers are cautiously optimistic that these predictions will prove correct. Jean Lemierre, president of the European Bank for Reconstruction and Development, the multilateral bank, says: “The view I have is positive. These countries have robust growth prospects. There will be effects on financing. I don’t see a credit crunch in central and eastern Europe but the costs of financing have increased and will increase further. We need to pay attention to this.”
Herbert Stepich, chief executive of Raiffeisen International, the Austrian bank, says: “Of course, events in the global economy have an effect in central and eastern Europe but they can only change the rate of development, not the trends – and, in any case, the speed of development will stay ahead of the industrialised west European countries.”
Like China, India and other fast-growing emerging economies, the east European states are catching up with the west, with the advantage that they are running the race with higher general education standards than other emerging nations. They were held back not by deep-rooted social and economic disadvantages but by the artificial barriers of communism. Now those barriers are mostly gone, they are free to move ahead, albeit with many diversions along the way.
Many ex-Communist states also benefit from increasingly diverse economies. There is a huge difference between the resources-dominated authoritarian states of Russia and Kazakhstan and the economically-diversified democracies of central Europe.
There are also big economic distinctions even among states with similar backgrounds: while Hungary struggles with a legacy of sizeable current account and budget deficits and slow growth, neighbouring Slovakia is set to join the euro next year, with a likely 2008 gross domestic product increase of 8 per cent. A few years ago, Hungary was booming and Slovakia was struggling.
The region is coming out of a particularly strong surge in its economic growth – many economists would say it has been too strong, with GDP growth rates as high as 11 per cent in Latvia last year. Growth was fuelled by big increases in consumption financed by credit. For example, credit grew by more than 50 per cent in Russia and by 76 per cent in Ukraine.
Even before last summer, central banks were worried about inflation. Ukraine finished 2007 with an inflation rate of nearly 13 per cent, with Russia not far behind on 12 per cent.
Leszek Balcerowicz, the former Polish finance minister, argues that the global credit squeeze has come at a good time for the region and will help cool over-heated markets. Whether that is true or not, the difference between a soft and a hard landing would be enormous.
In the fast-growth early 2000s, investors became increasingly careless about risk – and about differentiating between safe and less safe economies, companies and projects. Now risk awareness has soared around the globe, investors are more choosy.
Federico Ghizzoni, head of central and east Europe at Italy’s Unicredit, says: “Before, there was a real problem in that there was no differentiation between customers, no difference. It was a borrowers’ market. Now we see increases in differentiation, which is good.”
The effects are already apparent. Since January 2007, stock markets have fallen by more than 30 per cent in Romania and Bulgaria, which are burdened by high current account deficits, and by more than 25 per cent in Hungary but have barely moved in Slovakia.
The currencies of countries with big current account deficits have been hit – including Romania and Serbia and, to a limited extent, Hungary. Bulgaria and the Baltic states have so far been protected by fixed-rate exchange regimes, but have come under financial pressure in other ways.
Higher-risk corporate borrowers are running into difficulties. The most dramatic case is Kazakhstan, where banks dependent for funds on international markets failed to refinance themselves last year and the authorities were forced to intervene, promising $4bn to $5bn in emergency support. In Russia, the authorities have aided some smaller banks after Russian Standard Bank, a consumer bank, encountered rising refinancing costs.
Big differences have emerged in the costs of credit default swaps – a measure of the risk premium over US treasury bonds – with spreads widening dramatically by more than 150 basis points since last summer for Kazakhstan, Romania, Bulgaria, Serbia, Ukraine and Hungary. But for Russia the increase was only 100 basis points and for the Czech Republic fewer than 40.
The region’s central banks are taking action, raising interest rates almost across the board, including in Poland, Romania, Serbia, Ukraine, and, more modestly, Russia. Some governments are considering trimming budgets, notably in Hungary, but generally they are slow to impose politically-unpopular fiscal cuts.
Much depends on the extent to which economic growth slows in vulnerable countries with high current account deficits. A rapid growth decline might help fight inflation but it could easily make financing budget and external deficits much harder. A key uncertainty concerns exports, which have so far performed well because the main markets are in western Europe, which has not yet followed the US into a sharp decline in growth. But the dangers of further economic fall-out from the US are stark.
Any decline in either economic or financial market conditions would put further pressure on eastern Europe, initially through capital markets. As Standard & Poor’s, the rating agency, reported last month: “The worsening growth outlook for the US and the global economy will create significant challenges for capital-addicted emerging European sovereigns, particularly those with large economic imbalances such as Estonia, Iceland, and Latvia. The slowdown will principally affect emerging Europe via reduced capital inflows into the region.”
Altogether, central and east Europe last year received an estimated $365bn in private capital flows, including direct and portfolio investment and loans, according to the Institute of International Finance, the US-based research group. The region (including Turkey in IIF figures) passed emerging Asia as the top destination for foreign funds.
With the global credit squeeze biting, the IIF forecasts this year’s inflow to fall to $333bn but to remain far ahead of east Asia on $227bn. While this reflects the region’s investment attractions, it is also a potential weakness, as S&P pointed out. Foreign investment is growing strongly, from $48bn in 2006 to $61bn last year and a forecast $89bn in 2008. But local borrowers are piling up debt even faster – with total external debt from private sources growing from $187bn in 2006 to $304bn last year. IIF predicts a decline this year to $245bn.
If IIF’s forecasts are over-optimistic, deficit-burdened countries will struggle to attract funds without raising interest rates and run the risk of damping economic growth, just as exports start slowing.
The outlook for these countries is not healthy. But it is not fatal either. The region’s economies have proved their resilience more than once – notably in the 1998 Russian crisis. Nobody is immune to a complete global financial disaster but these countries have better records than many in dealing with economic trouble.
