Against the tide: Emerging Europe set for credit crunch contagion


David Roche
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Eastern Europe has borrowed cheaply this decade to fund a credit binge. Now, as the global credit crisis starts to bite, the region’s economies are becoming increasingly vulnerable.

The credit crunch is spreading around the globe. No region will escape its impact. The areas that will suffer most are those countries newly freed from Marxism that have empowered their people for the first time to purchase their own homes and invest in shares (financed by credit cards and bank loans). They have binged.

The property boom of 2000–05 enveloped eastern Europe in a big way. As these economies experienced accelerated growth and increased household incomes, easy money flowed in. Borrowing cheaply in Swiss francs or euros and lending for more in Polish zloty, Hungarian forint or Romanian leu, credit providers swept the property market upwards in a wave of liquidity.

Current accounts moved sharply into deficit, reaching more than 20% of GDP in some of the small Baltic states. Emerging Europe’s current account deficit is nearly 7% of GDP for the region as a whole. Sure, the region has enjoyed substantial improvements in economic fundamentals, such as export competitiveness, net foreign direct investment, banking systems and convergence with the eurozone. Even so, the extent of the liquidity boom has stretched these fundamentals to breaking point.

The credit boom is starting to bring inflation back onto the agenda. Hungary, Romania and the Baltic republics have inflation rates well above their respective central bank targets, and inflationary pressures are also rising in the Czech Republic and Poland. So central banks are under pressure to raise interest rates, just when the credit squeeze bites and the cost of global liquidity rises.

If you analyse the region’s economies by their vulnerability to the global credit crunch, several are at high risk. The Baltic states lead the list but Turkey, Hungary, Bulgaria and Romania are not far behind. The least vulnerable are the Czech Republic, the Slovak Republic and Poland but even they could suffer from contagion.

Hungary, Romania and Turkey have twin deficits (budget and external) and Hungary’s property market, like those of the Baltic states, has been financed by "cheap" foreign-currency loans. As these get significantly more expensive to service, property markets will roll over and external financing needs will expand.

Emerging markets

Net external financing requirement

* net external financing requirement (NFR) = current account balance + net FDI – annual debt amortisation

Source: IMF, Independent Strategy

The region’s banks (mainly foreign-owned) will come under the greatest pressure. Bank credit to GDP is now at 40% of GDP. That’s still low by global standards but credit has been expanding at the fastest rate in the world, with a significant share of this growth in foreign currency.

Political action will be of little help in resolving any property/credit crisis in the region. Many countries have weak government coalitions (Czech Republic, Hungary, the Baltic states and the Balkan states) without the nimbleness to take action in any crisis. The Romanian government, for example, commands only 20% of votes in parliament.

The most likely outcome is the one that is already under way in the Baltic states. An economic slowdown has started. Bank credit is tightening sharply. The foreign-owned banking system is drawing in its horns as it is hit by the global credit crunch. And rising wage costs coupled with accelerating inflation are fast putting pressure on export competitiveness. A long and severe slowdown seems inevitable.

The Riksbank, Sweden’s central bank, claims that the Swedish banks, which own much of the Baltic banking system, have not suffered from the global sub-prime mortgage crisis as much as others and so should be in a position to fund their subsidiaries. But it’s a moot point.

Hungary also remains highly vulnerable. Consumer demand is already contracting and yet the current account deficit is still above 5% of GDP and inflation has accelerated to more than 6% year on year, making it difficult for the central bank to ease rates to help domestic demand. With domestic demand weak, Hungary’s dependence on net trade makes it particularly vulnerable to global slowdown.

Romania is another that will be hit. Inflation has accelerated to 6% year on year, well above the central bank target of 4%. The bank wants to increase interest rates but with the current account deficit already at 12% of GDP and being financed more by debt, the central bank is increasingly in a quandary.

Turkey offers the biggest financial asset market in the region. Its direct exposure to a US-led economic slowdown at first sight seems limited. But Turkey’s economy is now highly correlated with global growth, particularly with Europe, where 60% of its exports go.

The real damage to Turkish financial assets would come from a decline in global risk appetite. It’s here that the global liquidity crunch will hurt by worsening the inflationary outlook, weakening the Turkish lira and leading to slower output growth.

David Roche is president of Independent Strategy Ltd, a London-based research firm.