Two years ago, as the global financial crisis laid waste to the economies of central and eastern Europe, the future hardly seemed a bright place.
At the time the fear was of a wave of social unrest that would trigger populist revolutions across the region, as economies crumpled and mass unemployment reared its head.
But it didn’t quite happen that way: despite the regional meltdown and the subsequent heavy doses of austerity forced on weary populations, the region survived largely intact – no widespread revolution, no currency collapses and not even a sovereign default.
Now, two years on from the depths of the crisis, central and eastern Europe’s economies are undergoing something of a rebound. A recovery in industrial output since December 2009 has helped propel growth across the region, while a skyrocketing energy prices have buoyed oil exporters in the CIS.
The EBRD predicts that the region will grow by 4.6% this year, up from its January forecast of 4.2%, but will then slow marginally to 4.4% in 2012. “It’s not fantastic momentum but it’s robust,” says Michael Ganske, head of emerging markets research at Commerzbank.
Capital too has gushed back to the region. From E16.6 billion in total inflows in 2009, capital inflows hit E72.3 billion last year, of which portfolio flows accounted for E48.6 billion, according to data from Unicredit.
Fiscal deficits in the region should decline from 4.5% of GDP in 2010 to 2.5% this year and next, the IMF says. Indeed, tough measures in resolving the region’s crisis have meant that eastern Europe looks better off fiscally and structurally than the eurozone economies.
Some argue the fiscal austerity implemented by governments across the region is paying off, at least in macroeconomic terms. “We’re beginning to see the outcomes of policy choices made in 2009, the year where we had a test of Keynesian fiscal policies in western Europe,” says Lars Christensen, chief emerging market strategist at Danske Bank.
“Central and eastern Europe did not have that option because the market did not allow it. And paradoxically those that could not pursue Keynesianism in 2009 now seem to have come out doing better.”
BOUNCE BACK DOWN
But despite the bounce back, the region’s performance risks being overshadowed by that of other emerging regions, including Asia and Latin America, whose sustained high growth rates have attracted unprecedented levels of capital and investment.
In sharp contrast with the recovery in portfolio flows to the region, foreign direct investment flows have fallen short. Having peaked at E76.3 billion in 2007, FDI to the region reached a paltry E16.5 billion in 2010, according to Unicredit.
“[Emerging Europe] is kind of ‘in between’,” says EBRD president Thomas Mirow. “It consists partly of relatively mature markets that cannot grow that quickly and partly of emerging markets which grow very quickly, in central Asia and some countries in between.
“The growth prospects are clearly higher than in the west of Europe. But these countries have to accept that they’re different to what they were twenty years ago. It’s not just about catching up with the West but also about competing with other emerging markets and in this respect they have some homework to do.”
Mirow says the lack of long term capital investment is a key factor constraining growth relative to the pre-crisis boom years.
“Competition is stronger. Risk awareness has increased. And therefore it’s more difficult to convince a global company to invest in this region compared to in countries which grow very quickly.”
EBRD chief economist Erik Berglof says authorities need to step up efforts to attract long term foreign capital. “Clearly policymakers have to ask themselves what the reasons are [for a lack of FDI].” He adds: “Competitiveness issues are serious.”
SHORTLIVED REBOUND?
The recovery in industrial output was the principal driver of economic growth across emerging Europe. The region’s close integration into supply chains of major manufacturers in western Europe has helped boost demand for industrial goods over the past year.
But signs are emerging that the region’s bounce back might itself be tapering off. A growing number of analysts expect industrial output growth to fall as external demand slows this year. “This [fall] will cut the pace of overall economic activity [in central and eastern Europe],” research firm Capital Economics said in a recent brief.
Much of the region was pulled from recession in large part thanks to Germany’s export-led economic recovery. This was especially so in the Czech Republic, Hungary, Poland and Slovakia. But Capital Economics expects growth in central and eastern Europe’s economies to ease this year on the back of slowing western European demand for the region’s exports.
Industrial order from Germany dropped 4% in March, and manufacturing surveys suggest sentiment might have peaked. Meanwhile, industrial confidence has registered sharp falls in recent weeks.
GERMANY FACTOR
One of the biggest risks to the region’s growth rebound would come if Germany’s expansion slowed. Says Mirow: “Should there be another cycle in which Germany would face more problems then [eastern European countries with close links to Germany] would be affected.”
“If Germany were to slow substantially then I think most countries would go back to recession relatively fast, with very few exceptions,” says Danske Bank’s Christensen. While not his base case, this is nevertheless “something that could easily happen, then the whole recovery would look very vulnerable”.
For now, that prospect might seem remote. The German economy grew by a surprising 1.5% in the first quarter of 2011 and recorded a robust – by western standards – 3.6% growth in 2010.
But what’s widely characterised as a German boom also has a downside: higher prices and wages could undermine the competitiveness of German companies; and wage growth has added to inflation risks, as has continued pressure on commodity prices for food and oil. Recent data show German inflation jumping to 2.7% in April from 2.3%, largely as a result of rising energy prices.
This has made it more likely that the European Central Bank will hike interest rates further in coming months. The central bank has already raised its key refinancing rate by a quarter of a percentage point to 1.25% in April and economists have been expecting another quarter-point increase in July.
“We don’t know exactly how hawkish the ECB will be,” says Ganske.
Ganske says the tightening cycle will “clearly have an impact on the euro/dollar exchange rate and if the euro appreciates a lot this will be very negative for German exports. And if the German economy slows that will have a real economic impact on central Europe.”
LOOKING EAST
Also of concern is the fate of Germany’s third-largest trading partner – China. In 2010, Germany exported $74billion of goods to China and the same year, the total value of trade rose 35%. Although there was a contraction in 2009, growth in trade between the two countries has averaged 20% since 2004.
But Chinese growth is now beginning to fray as Beijing responds to high inflation amid fears that price pressures could fuel wage demands, thereby entrenching an upward price spiral. China has raised reserve requirements for its banks eight times since October in a bid to dampen inflation.
As MIT professor Yasheng Huang explained to Emerging Markets recently: “The Chinese government itself is now engineering a slowdown of the economy, so a slowdown is to be expected. The uncertainty is how sharp the deceleration will be: that’s the critical issue.”
The government has lowered its growth target to 7% in the 12th Five Year Plan, as part of a commitment to rebalancing the economy towards more balanced, domestic demand driven growth. But Commerzbank’s Ganske points out that policy risks remain for China and other emerging markets which complicate the outlook. He says: “The risk is that emerging market central banks think they are behind the curve [in combating inflation] and tighten policy too much. That would derail [global] growth.”
But given the likelihood of monetary tightening, the spectre of a global manufacturing slowdown still looms. “Is the global manufacturing recovery losing steam? Is it happening too early, before these recoveries have become more sustainable? Obviously that’s the risk,” says Christensen. “I’m pretty optimistic we’re not falling back into recession but it’s becoming more challenging.
“The Chinese are tightening monetary policy, the Japanese disaster had a big impact on the supply chain, and oil prices are rising. All this has had an impact on manufacturing globally.”
EUROZONE PRESSURES
Berglof plays down worries about the interest rate cycle in Europe. “I don’t think that’s the main concern.” But he says the fear “that there could be a major disruption” as a result of a worsening eurozone sovereign debt crisis “is certainly something to bear in mind.”
The IMF warned in May of a broadening of the eurozone’s debt crisis. “In advanced Europe, policymakers need to take steps to restore confidence — structural reforms, fiscal consolidation, and strengthening of the financial system, most notably in the euro area periphery,” Antonio Borges, director of the IMF’s European Department said in a statement.
There are also fears that eastern Europe’s recovery could be undermined by a possible Greek debt restructuring. Such an event would likely hit credit markets, cutting lending by western banks and sapping investor appetite for regional assets.
Unicredit says that “this cocktail is very likely to spill over into general risk aversion and also some concerns about the broader European growth outlook, on worries the debt problem will impede investment decisions.”
Capital economics warned recently that each worsening leg of the eurozone crisis “has had a progressively smaller impact on financial markets in emerging Europe” to the extent that Portugal’s bailout in April “barely registered on the radar of investors in the region.”
But Ganske says the financial markets in the region are right to have shrugged off the eurozone travails because the real economic linkages are minimal. “The main contagion channel is the financial sector. It would have a credit growth impact. But real economic links are not so strong,” he says.
“I’m more concerned about a manufacturing slowdown than about a possible Greek spillover,” says Christensen.
He argues that the systemic consequences of a Greek restructuring will be limited because people will have had sufficient time to hedge against any possible risks. “I’m getting frustrated when I hear people say that when Greece falls the next domino will fall. We’ve known this for two years. Who should be surprised? What kind of risk would you have that has not been taken into account?
“We’ve just had a bubble that burst and now suddenly everyone’s concerned about bubbles that will burst. It could hardly now get worse that it did in Latvia.”
NEW REALITY
The IMF said recently that regional authorities must do what they can to limit domestic vulnerabilities to external shocks, especially given the possible pressures from a worsening eurozone crisis.
But even if such scenarios never come to pass, the longer term picture for the region remains the most challenging. “This boom, this major growth momentum that we saw before the crisis is gone in the long term,” says Ganske.
Adds Berglof: “It’s about the ability of these countries to stay competitive. We’ve tried to point to that for many years, before the crisis and now in the period when the worst of the crisis is over, we’ve been emphasizing the need to focus on key aspects of competitiveness, education, skills.
It’s about the business environment, it’s about making sure that you are not losing this opportunity to reform that the crisis presented. We risk not exploiting the crisis not in terms of reform.”