In the spring of 2008, most central and eastern European
policy-makers were grappling with the fallout from the
regions 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 regions
march towards the eurozone would provide a strong buffer
from the storm.
Just a few short months later, the regions currencies
were in free fall while domestic financial markets crashed as
cross-border bank lending and portfolio investment vanished, in
part because of the regions 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 lenders 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 Europes demand for imports
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
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
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 regions 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
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 regions 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 regions 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
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
Europes 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 Europes
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.