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Emerging Markets

Shifting gears

Central and eastern Europe are in economic free fall. The region needs a new growth model – fast

In the spring of 2008, most central and eastern European policy-makers were grappling with the fallout from the region’s frenetic growth of recent years: high inflation, asset bubbles, currency strength, and tight labour markets.

As the global crisis raged, emerging Europe enthusiasts argued low public debt, mature institutions, and enduring foreign investment – hot on the heels of the region’s march towards the eurozone – would provide a strong buffer from the storm.

Just a few short months later, the region’s currencies were in free fall while domestic financial markets crashed as cross-border bank lending and portfolio investment vanished, in part because of the region’s vast stock of short-term debt as the western financial meltdown intensified.

“Credit-fuelled domestic demand fuelled by foreign banks has driven growth in recent years,” says David Lubin, chief EMEA (Europe, Middle East and Africa) economist at Citigroup. “We are now seeing a painful reversal of capital flows and subsequent deterioration in output.”

Despite the diversity in size and structures of economies in central and eastern Europe, the global downturn has now stalled all engines for growth. Abrupt credit contraction has strangled corporate activity and domestic consumption while exports to western Europe have collapsed amid the recession. So far, the IMF has bailed out Belarus, Hungary, the Kyrgyz Republic, Latvia, Romania, Serbia and Ukraine, while Poland has applied for the lender’s flexible credit line facility.

The EBRD says emerging Europe is set to contract by an average of 5% this year after 4% growth in 2008 and around 7% in 2007. The bank estimates that regional growth will pick up in the second half of 2010 to rack up an annual rate of 1.4% – if western Europe’s demand for imports recovers.

Future shock

But in many ways, the economic pain for the average citizen has yet to be felt. Faced with strict budget deficit rules for eurozone entry as well as collapsing revenues, governments have to rely upon regional aid to cushion the downturn. However, the small size of EU structural funds and the bureaucratic delivery process provides little ammunition to power a short-term fiscal stimulus.

As governments slash spending, the region is now locked into a self-reinforcing recession. “As the economy slows and spending decreases, poverty, bankruptcies and social tensions will increase,” says Zsolt Darvas, researcher at European think-tank Bruegel.

The global credit party urged banks to push out cheap foreign-currency denominated loans to household and corporate borrowers. Emerging Europe became more reliant on external financing than other emerging regions. According to the IMF, the ratio of short-term debt compared to foreign exchange reserves stands at 132% for Estonia and 116% for Ukraine compared with South Korea at 89% – the largest figure outside the region. In Latvia, Hungary and Poland, up to 90% of all consumer loans are denominated in foreign currency such as euros, Swiss francs and even Japanese yen.

Growth can only recover when local banks become cleaner, better capitalized and confident in the health of their own balance sheets and their borrowers. But faced with high interest rates, lower salaries and weaker currencies, debt-servicing costs have now jumped. A mountain of non-performing loans could place more stress on beleaguered local subsidiaries of foreign banks, says Ed Parker, chief emerging Europe sovereigns’ analyst at Fitch.

The region’s near-term fate rests on the commitment of the IMF, Brussels and western banks to address further sovereign bankruptcies, as well as corporate and consumer indebtedness.

“Eastern Europe is now dependent upon the propensity of the ECB [European Central Bank] and EU to provide euro liquidity support,” says Philippe Aghion, economics professor at Harvard University. If external financing is not forthcoming, the region could be set for another banking and currency crisis – triggering a second wave of declines in economic output across the region.

In any case, “there is still a long way to go in rebalancing the region’s economies after several years of wage increases outstripping productivity and unsustainable current account deficits,” says Parker.

On the bright side

Optimists could argue the worst of the crisis is over. The rate of economic contraction in the region has begun to moderate compared with the freefalls in the last two quarters. There are also some tentative signs of recovery in industrial activity, while foreign investors are tiptoeing back to domestic currency, equity and bond markets.

“Investors are soon going to add exposures to the healthier economies in emerging Europe due to the double-digit yields now on offer,” says Robert Parker, vice-chairman at Credit Suisse Asset Management.

In addition, weaker currencies and lower wages have boosted the region’s international competitiveness. Meanwhile, deleveraging and lower domestic demand will help to correct yawning current account deficits in the region.

But this is scant consolation for citizens from Tallinn to Bucharest who are faced with job insecurity, lower wages and falling prices, while domestic discontent will destabilize governments.

“Economic policy paralysis is currently a bigger threat than political mayhem,” says Darvas. Countries with lower debt levels and stronger domestic liquidity sources such as Poland and Slovakia will ride through the maelstrom more comfortably than the Baltics and Balkans.

But every country in the region will be challenged by fierce global competition for investment and trade in a world of tighter liquidity once global economic conditions normalize. “With continued access to EU markets and a well-educated skill force relative to wage levels, central and eastern Europe’s long-term real economic convergence story should stay on track,” says Dmitry Gourov, Ukraine-based EMEA economist at UniCredit.

But Darvas warns that the need to move towards a knowledge-based economy with citizens employed in high-value jobs is more important than ever. But for Europe’s battle-weary officials, riding out a historic recession as painlessly as possible while crafting a more sustainable growth model for the future remains an unenviable task.

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