Politicians and central bankers sitting in capitals across central and eastern Europe could be forgiven for thinking to themselves, “Not again”.
As the New Year euphoria across financial markets in the wake of the European Central Bank’s extraordinary E3 trillion injection of liquidity faded in the first quarter, it quickly became clear that for a third year running winter warmth had turned into an unseasonal spring freeze.
“The eurozone debt crisis is back in investor focus,” says Michael Ganske, head of emerging markets research at Commerzbank. But while in 2010 and 2011 the downturn was driven by a perceived failure of political leaders to take action, this time the decisions taken by the zone’s leaders are the ones unnerving its neighbours.
“Clearly the discussion we have in the eurozone is related to austerity,” says Ganske, referring to the German-led decision by the EU to put in place a fiscal pact that demands steep cuts in public spending to bring down ballooning deficits.
This has had a clear knock-on effect on domestic demand in “old” Europe that has hurt its emerging neighbours through weaker demand for imports. “There is less support for exports,” says Raffaella Tenconi, a senior CEE economist at Bank of America Merrill Lynch, who expected the eurozone economy to contract by 0.5% this year. “The deterioration in Italy, for example, is very visible in terms of car production in Poland.”
The EBRD publishes its economic forecasts on Friday, but chief economist Erik Berglof agrees the region has taken a hit: “There is an impact, and it is on several levels.” But he adds, “We should not underplay the impact, but the region has shown itself to be very resilient since the very significant impact after Lehman.”
Commerzbank has cuts its economic forecasts for the region over recent quarters. It has pencilled in “mild” contraction in the Czech Republic and growth of just 0.5% in Hungary, while Poland, the only CEE country to escape recession, has “surprised on the positive side”.
“The region is not all bad or all good,” says Ganske. “There are weaker and stronger economies, but the dependency on global developments is the biggest problem for emerging markets.”
Still, the outlook is not as bad as 2009 when fears of imminent economic Armageddon in the wake of the collapse of Lehman Brothers pushed all but a handful of EBRD-area countries into recession. Last month the IMF raised its forecast for GDP growth in central and eastern Europe this year by almost a percentage point to 1.8%, and 2013 growth to 2.9% from 2.4% in January.
Christian Schulz, a senior economist at Berenberg, a German bank, says all bets are off if the euro were to break up, which he says would be a “cataclysmic catastrophe”. CEE countries would be affected through a drop in confidence leading to a slump in orders that would in turn hit manufacturing.
Berglof agrees but insists this is not his main scenario: “The downside scenario [from the euro crisis] is more present than in the past. There are concerns over the entire euro project. This is something that is hovering over markets and policymakers at this very juncture.”
Meanwhile Schulz points out that many of those countries are primarily dependent on German demand. “That should be one of the best performing markets in the eurozone,” he said. “The direct impact via the economy should be relatively limited for those countries that have Germany as a major trading partner.”
On top of the impact on cross-border trade from the economic slump across the eurozone is the knock-on effect of stress in the capital markets – what economists called the financial channel. “You can see the volatility in the market for sovereign credit default swaps [investors’ bets on the chance of government defaults],” he says, pointing to Hungary and Ukraine as two countries whose refinancing needs make them stand out.
Ganske says that amid such uncertainty and risk aversion by investors, any emerging market is likely to be affected. “You should bear in mind that even when a country offers idiosyncratic strong fundamentals, when there is risk aversion it becomes more difficult to roll over their debt.”
BANKING-SECTOR FORCE
But the more powerful force exerted by the financial channel is through the banking sector. “The banking sector in the region is largely foreign-owned and indeed largely eurozone-owned,” says Schulz. “The unfortunate thing is that Greek banks and Italian banks are quite significant players in these markets, so if the eurozone gets worse, anyone who is dependent on Greece is in trouble.”
He warned that Italian banks that are “fighting” to keep access to funding might be “tempted to once again cut lending outside their home markets, and that could lead to a credit crunch in central and eastern Europe”. One country hit especially hard by bank deleveraging has been Hungary, which the EBRD’s latest January forecasts projects to see contract by 1.5% this year, a drastic two percentage points turnaround from the previous forecast of 0.5% growth.
“There is certainly a lesson to be learned about the credibility of fiscal execution,” says Tenconi, contrasting the achievements of countries such as Poland and the Czech Republic with Hungary, where the stance has been “volatile”. “Sometimes they are fiscally austere, sometimes they are fiscally loose and sometimes they change their targets. This inconsistency comes with a high price,” she says.
Meanwhile the eurozone crisis has had a negative impact on its banks’ balance sheets, thanks to the tumble in the value of sovereign bonds that many of them hold.
The recent focus on debt sustainability in Spain and Italy allied to the election upset in Greece has reminded investors that, if the crisis is not contained before spreading to larger euro members, it may leave several large European banks insolvent. Major parent banks would accelerate deleveraging in the region, triggering a credit crunch and recession in emerging Europe.
THE NEW REGULATIONS
The last time that foreign-owned banks in the EBRD area cut lending and repatriated capital was in the wake of the September 2008 collapse of Lehmans that caused a freeze in global capital markets. This time the pressure is driven by the impact on banks’ balance sheets in the collapse in the prices of sovereign bonds combined with the gradual implementation of the Basel III regulations that require banks to build greater capital reserves, especially against more risky assets.
While the requirements do not kick in until next year, banks are already taking pro-active measures to clean up their balance sheets. “There is a multi-year process of deleveraging, and that is visible across countries,” says Tenconi. “We begin to see western European banks gradually taking money out of eastern Europe – even countries that have IMF agreements and are being shielded, such as Romania.”
Ganske points to a ruling by the European Banking Authority (EBA) that banks must meet a tier 1 capital ratio of 9% by end June 2012 as accelerating deleveraging. Nouriel Roubini estimates it will require recapitalization of $100–250 billion.
Berglof says it is more complex than that as the EBA wanted to enforce a level as well as a ratio to ensure banks raised capital and avoided large executive compensation payouts. “What EBA tried to do was the right thing, but it was undermined by national authorities and in the end contributed to the deleveraging,” he says.
“It is wrong to blame the EBA as there was a need to recapitalize those banks. It is unfortunate timing, but I think there is no alternative.”
CHANGING DIRECTION
One area where there is contagion from the eurozone to the CEE is on the political front. With the defenestration of pro-austerity governments in Holland, France and Greece and talk from both the ECB and the European Commission and even from Chancellor Angela Merkel about the need for more growth-oriented policies, the wind direction is clearly changing.
On the other side of the old Iron Curtain, governments have fallen in Slovakia, Slovenia and Romania in the past few months, with the Czech governing coalition just surviving a no-confidence vote.
Berglof says that countries in eastern Europe have been good at implementing fiscal consolidation. “It is quite remarkable what they have done,” he says, referring to the Baltic states that embarked on draconian austerity but which are now growing. “Looking at our region, in most cases consolidation is probably warranted, but we cannot forget the growth dimension.”
The other major political issue is the accession of CEE countries to the eurozone. Last year saw Estonia follow Slovenia and Slovakia and adopt the single currency.
“In the longer run, the crisis creates the strategic question for central and eastern European countries whether membership of the eurozone is desirable,” says Schulz.
Currently Estonia’s Baltic neighbours, Latvia and Lithuania, have set a target for joining of 2014, while Bulgaria, the Czech Republic, Hungary, Poland and Romania are looking at 2020. “It is still on the table,” says Tenconi. “We have not had any of these countries saying ‘no, we do not want to come into the euro ever’, but we have more realistic goals for euro adoption.”
She says that the lengthening of the timeframe for accession is a result of the crisis. She expects only Romania is likely to join the single currency this decade. She adds, “From an electoral point of view all of eastern Europe does suffer from a little bit of euro fatigue. Voters don’t understand why they should get the euro very quickly, given what is going on in the eurozone.”
In the meantime the desire for accession combined with a need to stop investors fleeing the CEE area highlights the pressure on eurozone leaders to regain control of the debt crisis. “For central and eastern Europe to stay attractive, they need a eurozone that is solving its problem,” Ganske says.
Clearly countries in the EBRD region are concerned that old Europe resolves the crisis. Berglof says that the eurozone authorities could look to what the EBRD did in its region. “Countries in southern Europe like Greece need capital coming in with a lot of governance with heavy conditionality and which crowds in rather than crowds out private capital,” says Berglof.
“That is our role in our region, and that is the sort of mechanism that Europe needs to think about to bring growth to Greece and places like Portugal, and maybe even Spain.”
One concern that remains is how much the crisis has hampered the EBRD’s mission to foster transition towards open and democratic market economies as well as its goal of improving economic standards.
“The impact on material wellbeing is unfortunate, but in terms of achieving transition, they have shown considerable resilience,” concludes Berglof.
He says the bank has learned about weaknesses that were always there but which did not come to light until the crisis hit, particularly how financial systems were organized and supervised. But he adds: “In terms of things we care about like systemic change, in some sense it has moved the region along. We have learned.”