Until well into the summer, things were looking up for central and eastern Europe. After two years of painful austerity, a consensus was emerging that tough fiscal action followed by a welcome pick-up in export demand would see the region return to healthy levels of growth. As late as July, the European Bank for Reconstruction and Development (EBRD) was forecasting that the region would see average growth of 3.4% in 2011 and 3.5% in 2012.
But with growing uncertainty about the region’s response to the crisis in the eurozone’s southern periphery and signs pointing towards a double-dip recession in the core economies of the eurozone, the consensus outlook has darkened. In August, the Czech Republic, Hungary, Poland and Romania all reported slower growth in the second quarter, and analysts are beginning to revise down growth forecasts for the region.
Erik Berglof, the EBRD’s chief economist, now expects the bank’s next report on the region, due in November, to offer a much less sunny outlook.
WHEN GERMANY SNEEZES
While an escalation of the eurozone crisis is a global risk, a slowdown in the core European economies would have a disproportionately large impact on non-eurozone members in central and eastern Europe, especially on those economies such as the Czech Republic and Hungary, which are heavily dependent on exports to the core eurozone economies, Germany in particular.
According to the European Central Bank, around 50% of the Czech Republic’s GDP derives from exports of goods and services to the euro area, and 45% of Hungary’s. By contrast, Poland, with almost four times Hungary’s population, derives only 20% of its GDP from the exports to the eurozone. Germany is far and away the largest export market for countries across the region.
“It’s quite clear that the slowdown in Germany will have a very serious negative impact on the entire central and east European region,” says Gábor Ambrus, an analyst at the London-based economics consultancy 4Cast. “The impact will be especially serious in the case of countries which have no other source of growth other than exports.”
While some countries in the region have economies that are heavily export-oriented, in Poland and Romania domestic demand plays a larger role, with exports accounting for closer to 40% of GDP.
In Poland, where consumer spending has held up, this has been good news. In Romania, which has been undergoing two years of painful deleveraging after years when lending growth peaked at 40%, this has proven to be more of a curse. This stronger domestic demand should help to insulate them somewhat from a eurozone slowdown, although even in these countries, economists are quick to warn of the dangers.
“If external demand falls, we will be influenced, since about three-quarters of our exports go to the EU. This will have the main impact on our economy,” says Lucian Anghel, an economist at BCR, the Romanian subsidiary of Austria’s Erste Bank.
CAPITAL FLIGHT
But while the impact of a eurozone slowdown on the real economy is unavoidable, two other channels of contagion – the credit markets and the banking system – have been preoccupying policymakers across the region since the full extent of the eurozone crisis gained widespread acceptance.
While sovereign debt was the issue that kicked off central and eastern Europe’s crisis in 2008, this time around, with debt levels trending downwards across the region, investor flight seems less of an immediate threat. “Risk aversion has been affecting almost every asset class apart from emerging market debt. So long as that continues, central and eastern Europe will get its part of that investor interest, and that will only change if there’s a global change in risk appetite towards the major emerging markets,” says Péter Duronelly, CIO of Budapest Asset Management, a Hungarian subsidiary of GE Money Bank.
In fact, analysts stress that falling debt levels across the region are one of the few sources of optimism. According to Andrzej Halesiak, an economist at Poland’s Bank Pekao, of which Italy’s Unicredit is majority owner, the average debt-to-GDP ratio in central and east European EU member states is around 55%, well below the eurozone average of 80% and the 100%-plus debt-to-GDP ratios in the PIGS (Portugal, Ireland, Greece, Spain) countries. Furthermore, many countries in the region have reduced their debt burdens over the past 12–18 months.
“The economic situation in central and eastern Europe is much stronger now than it was [pre-crisis],” says the EBRD’s Berglof. “There are fewer deficit vulnerabilities. In particular, current account deficits are lower today, and things are also being helped by falling commodity prices.”
György Surányi, a former Hungarian central bank governor and now head of Italian bank Intesa Sanpaolo’s CEE operations, echoes this view: “Countries that were running excessive imbalances like Bulgaria and Romania have now improved their fiscal positions dramatically. Other countries, like Hungary, are already running a current account surplus, as a result of the export-driven recovery.”
This is not to say that there is no risk of contagion via the debt markets. A serious crisis in the eurozone could yet spook investors to an extent that they avoid the region’s debt.
“You never know how much the herd instinct will hurt the region. The fundamentals are stronger, but we may not return to pre-crisis fast growth levels soon or ever,” Surányi adds. “But we need to be realistic: if western European markets don’t recover, if the debt crisis hits further countries, then central and eastern Europe cannot be isolated from this.”
PROBLEM PARENTS
The banking system, too, is a thorny issue. Last time around, the fear was that growing non-performing loan portfolios at subsidiary banks in eastern Europe might drag down parent banks in western Europe.
The Vienna Initiative, a pact between home and host governments and the Austrian and Italian banks that dominate the region’s banking market, was aimed at stabilizing foreign banks’ presence in the region, on the theory that a withdrawal by one could quickly become a rout. Now the worry is that banks with heavy exposure to bad eurozone debt will be forced to cut subsidiaries loose in order to shore up operations at headquarters.
Indeed, many subsidiaries in the region have more liquidity than their parents. “Liquidity in our banking sector is at record heights,” Marek Belka, the governor of the National Bank of Poland, tells Emerging Markets. “Our problem is similar to that found in many advanced economies: the financial position of corporations is the best in history, and demand for credit is quite slow.” He adds that the results of stress tests in Polish subsidiaries were better than those of many parent banks.
Piotr Szpunar of the National Bank of Poland’s macroeconomic and structural analysis department, adds that the biggest banks in Poland base their funding strategies largely on domestic deposits. “Foreign funding is mainly an issue for small and medium banks,” he says.
That these banks are smaller does not make the risks less systemic. “But parent banks will not let their subsidiaries down. If they can’t support them, then the banking supervisor could step in and do some pretty unpleasant things,” he adds.
While there is a real risk of contagion spreading from the most directly exposed parent banks to subsidiaries, Berglof insists this scenario is well understood and is one for which authorities are largely prepared. “There are at least a dozen systemically important subsidiaries of Greek banks in south-eastern Europe, and we need a framework to handle them, one involving both the regulators in the host countries themselves and the IMF,” he says. “But it is a risk we are familiar with.”
Legions of regulators are working hard to prevent serious situations arising ahead of time. The recent merger of Greece’s Alpha Bank and Eurobank, both major players with subsidiaries throughout south-eastern Europe, together with a capital investment by the Qatar sovereign fund, for example, could help strengthen subsidiaries throughout the region.
Nevertheless, there is clear evidence that the travails of the parents are having an impact on credit growth in these countries: the rate in Romania, which was below 10% throughout 2010, was almost flat in June this year, while lending activity in Bulgaria has been down every quarter since 2008.
VIENNA INITIATIVE “INSUFFICIENT”
The risk posed by core eurozone banks which may be affected by an escalation of the debt crisis is of much graver concern: “We’re on less certain ground when it comes to the contagion via the core banks of the eurozone,” Berglof says.
“Both the balance sheets of the banks themselves and government balance sheets are weaker than they were then. What’s more, the fiscal resources available to the host countries have turned out to be weaker than we thought, and they were never very substantial in the first place.”
This means that much of the burden of preventing the adverse effects spreading from the eurozone into central and eastern Europe will continue to fall on banks’ home governments. “What saved the system last time was the guarantees given to banks by the home governments, by Vienna, Rome and Stockholm,” says Berglof. “Without that we’d never have got through this. Governments still have the resources to do this, but the fact is that the fiscal capacity to do large aggregate operations is probably less today than it was then.”
For Belka, the Vienna Initiative is no longer relevant at all: “The Vienna Initiative was a good project and it served its purpose. But today the situation is completely different,” he says. “Today it’s about how to make the private sector contribute to solving the eurozone’s periphery crisis. We now need to deal with the risk of a troubled mother driving her daughters into a hole.”
Foreign-owned banks dominate throughout the region, though even independent banks like Hungary’s OTP Bank, with its own subsidiaries primarily in neighbouring countries, or Romania’s Banca Transilvania, would be hit by a crisis at a major regional bank, given their need for foreign funding. Banks, like Poland’s PKO BP or Romania’s CEC, in which the state still has a majority holding, might prove more resilient under these circumstances.
CONTINGENCY PLANS
The region’s policymakers vary in their level of preparedness for a pan-European slowdown, or worse.
While most analysts remain optimistic about Poland’s growth potential, smaller, export-dependent central European countries may well encounter financing difficulties. Hungary, which is relying on a one-off E10 billion pensions nationalization plan to meet its 3% deficit target for this year, looks particularly exposed, according to Ambrus. “Hungary’s growth came from healthy exports to Germany in the first half, but total new orders were massively negative in July compared to the previous year,” he says.
Romania, with its IMF credit line and track record of tough austerity measures, looks better placed to deal with investor panic, he notes, while Bulgaria, with a currency board and low levels of indebtedness, is also in a strong position on the fiscal front, although its exposure to the Greek banking system could prove to be its Achilles’ heel.
At the same time, the whole range of problems faced by the region – from public debt to non-performing loan portfolios, can only be dealt with in the long run by a return to solid growth, and the rising tax revenues and falling state social expenditures that would result from a fall in unemployment.
But with the news coming out of western Europe and the eurozone looking increasingly grim, this could be a distant prospect.