Is Eastern Europe doing well?
It has been. Shaking off the shackles of communism and then joining the European Union has helped many Eastern European countries expand at a spectacular pace. GDP growth of 5% or more has been common and wages have risen even faster – by up to 30% in Latvia last year. That, combined with easy access to credit, has encouraged consumers to spend, spend, spend: domestic demand, together with foreign investment, has been a bigger engine of growth than exports.
Can the good times last?
No. Over reliance on credit and consumer spending to drive growth has resulted in enormous current-account deficits building up – Latvia’s peaked at 28.2% of gross domestic product (GDP) and Estonia’s at 22.9% – as countries have imported far more than they exported. Public finances aren’t in great shape either: Hungary ran a budget deficit of 5.8% of GDP last year.
Then there’s inflation. Consumer price index (CPI) inflation rates of 8% or more are widespread, and in many cases there is clear evidence that it is broad-based inflation, rather than just the external effect of commodity prices. Consequently, central banks are being obliged to tighten monetary policy significantly, despite the obvious weaknesses of many economies and the headwinds that they face from both the slowing global economy and the credit crunch-induced slowdown in the flow of foreign investment and lending. In short, things are about to get tough.
How bad will it get?
Depends on the country. The Czech Republic, Poland and Slovakia suffer least from the imbalances and deficits that threaten most of the region, and their growth has largely come from productive investment, rather than an overheated, debt-fuelled consumer-spending binge or an asset-price bubble. Growth will slow, but overall the effects should be fairly mild. Hungary is already weak and likely to trudge along at a sluggish pace for a couple of years, while the consensus on Bulgaria and Romania sees them slowing from their current 6% growth, but remaining fairly strong.
On the other hand, the Baltic states of Estonia, Latvia and Lithuania “have been living beyond their means” for years, as Neil Shearing of Capital Economics puts it. The bursting of a vast property bubble – flat prices rose by 385% in the Latvian capital Riga between 2005 and 2007 – has hit hard. So, too, has the associated collapse in construction – 20% of Estonian GDP – and savaging of consumer confidence. The result? Estonia and Latvia are already in recession and Lithuania is set for a sharp slowdown.
Could it get worse?
Possibly. There are some echoes of the 1997 Asia crisis in Eastern Europe today. Like some of the Asian tigers, these are fast-growing countries that have developed severe imbalances with overheated domestic economies or real estate bubbles. Also like Asia, several countries – the Baltics and Bulgaria – peg their currencies to their dominant trading partner (the euro this time, instead of the dollar).
Finally, there has again been substantial foreign currency borrowing, mainly in euros. Foreign currency-denominated loans make up a large proportion of loans to households in these countries. In Estonia and Latvia, they are more than 80% of household credit, according to Morgan Stanley, while in Hungary, Romania and Lithuania they are 55%-60%.
Why does this matter?
Borrowers in foreign currencies are exposed to currency risk: a devaluation of their domestic currencies would increase their debt burdens, with potentially severe knock-on effects on their local economies. In the case of Hungary and Romania, the free-floating forint and leu mean borrowers are always at risk of a devaluation. Countries with pegged currencies are not, unless the governments are forced to abandon their currency pegs, in which case borrowers would receive an unexpected shock.
A sharp drop or a forced devaluation in one of the Eastern European currencies may be unlikely, but the lesson from Asia is that if this does happen to one country, investor panic can encourage it to spread through the region, causing widespread damage to economies.
Does this affect the euro?
Only Slovakia is due to join in the near future (January 2009) and with its economy generally in good shape, there is little risk of it not joining. But for the other candidates, accession is getting further away. Inflation has pushed the Baltic states’ entry back to 2012, while that and fiscal imbalances mean that a 2013-2014 start is the likely outcome for most. Which stocks will suffer from the slump?
Banks that have provided the wherewithal to power consumer spending and the property bubble are especially vulnerable to the slowdown, says Michael Wang of Morgan Stanley. Not only will their business growth slow, but they are also likely to suffer losses on loans they made during the boom.
While many of these banks are local, investors should be aware that some Western European and Scandinavian groups have expanded into these markets. Swedish banks have been major players in the Baltics and some are now significantly dependant on the region – Swedbank drew 20% of its earnings from there last year and SEB 31%. Austrian groups, such as Erste Bank and Raiffeisen, are also exposed.