The EU summit this past week did nothing to address the underlying causes of the eurozone debt crisis, which leaves the global economy looking increasingly wobbly. Central and Eastern Europe (CEE) has particularly close ties to the eurozone and suffered a disproportionately sharp economic downturn in 2008-09. So how will the CEE region fare this time around?
Erste Bank argues in a new CEE Special report that the region is now better prepared to weather global turbulence. However, I see some major flaws in their argument.
Most egregiously, the author – Juraj Kotian – uses the eurozone as a basis for comparison, rather than other EMs, thereby painting a rosier picture of the region than is warranted. As the eurozone is in the midst of a battle for its very survival, it should be no surprise that the CEE economies appear resilient by comparison.
So why does Erste believe this time is different?
1) CEE countries are far less indebted than the governments or the private sector in the eurozone.
2) High current account deficits in the region have narrowed, and many CEE countries now hold bigger caches of international reserves.
3) CEE economies are in a different stage of the economic cycle. In 2008-09, these economies were running above potential (i.e. overheating). Now these economies are running close to potential or slightly below.
As a result, Kotian concludes that CEE economies “should do much better (relative to the Euro Area) than in the post-Lehman recession.”
There’s more to the story
Erste Bank is not a disinterested observer. As FT’s Beyond Brics notes, the bank has extensive operations across the CEE, providing it with an incentive to accentuate the positive. The author Juraj Kotian’s arguments can not be dismissed entirely, but there’s more to the story.
1) Yes, CEE economies are far less indebted than advanced economies, as Kotian notes, but…
…they have higher external debt burdens than other emerging markets, as seen in Figure 1. In fact, external debt has increased, as a % of GDP, across all the five CEE countries surveyed since 2007.
Figure 1: External debt burdens remain higher than in other EMs
Source: National central banks, IMF, Emerging Market Musings
As for public debt, levels in the region are largely in line with those in other EMs, but CEE countries have added debt at a much faster pace. Levels are now significantly higher than before the onset of the global financial crisis, as seen in Figure 2 (Bulgaria is an exception). This negative trend is due, in large part, to the region’s sharp GDP contraction in 2008-09.
Figure 2: Public debt levels have risen sharply in most CEE countries since 2007
Source: IMF
2) Current account deficits have narrowed across the region, while international reserves have increased. But…
…the stock of external debt has also risen. This means that reserves coverage of the external debt has not changed significantly compared to pre-crisis levels. As seen in Figure 3, Hungary’s ratio has increased, but those in Bulgaria, Czech Republic and Romania have declined.
Figure 3: Despite increases in international reserves, the reserves coverage of external debt has fallen in several countries
Source: Emerging Market Musings, national central banks, IMF
Kotian has a point when he notes that current account positions across the region have improved. In fact, surpluses have replaced deficits in Bulgaria and Hungary. However, one of the main driving factors behind this improvement is weak domestic consumption (with the exception of Poland), which has limited import growth. In both Bulgaria and Hungary, consumption contracted on an annual basis in 2010. So, while the current account improvement is generally positive, it’s due in part to underlying economic weakness, which is not positive.
International reserves positions and current account deficits are important early warning indicators of a country’s susceptibility to a sudden stop in capital flows. (See my recent post: Which Emerging Markets Appear Vulnerable? A Look at Early Warning Indicators)
3) What about banking system health?
Kotian lists three reasons why the CEE should prove more resilient this time around. However, he overlooks an important weak spot – the banking system. Another credit squeeze is a very real possibility.
Non-performing loans remain elevated. Meanwhile, the persistence of high loan-to-deposit ratios leaves CEE banks reliant on external funding (see Figure 4), either from foreign parent banks in Western Europe or from wholesale markets.
Figure 4: High loan-to-deposit ratios signal CEE banks’ reliance on external funding to finance lending
Source: Fitch Ratings
Western European banks dominate the CEE market via subsidiaries. If the euro area debt crisis intensifies, these banks are unlikely to pull out of the region, but they will still likely scale back support for their subsidiaries. As the IMF notes in its latest Regional Economic Outlook for Europe:
“The most likely impact would therefore be a renewed credit crunch. Subsidiaries would see a measured but persistent funding drain from their parents, and nonaffiliated banks that rely on wholesale funding would have to struggle even more. Both would have little choice but to curtail their own lending activities.”
Signs of a credit squeeze are already apparent. According to the IIF’s latest Emerging Markets Bank Lending Conditions Survey, 81% of emerging European banks reported a tightening of external funding conditions in Q3 2011. This tightening will exert a major drag on economic growth across the region.
From our analysis at http://blog.frontierstrategygroup.com:
Greece leaving the Euro increases the likelihood of a double dip recession across Europe. European banks will take major losses in the their bond portfolios. Markets will also view a Greek exit from the Euro as a precedent for similar action in Portugal, Spain and potentially Italy. Exposure to derivates on bad debt is still unknown, compounding the uncertainty that will cause lending to dry up in both Western and Eastern Europe. Last time Europe went into recession, CEE markets, Russia and Turkey suffered disproportionately. This time, many emerging markets are more linked than before.
While many emerging markets will be impacted by the crisis, leading companies have already identified winners and are prioritizing resource allocations for those markets. India, Indonesia and Africa are set to be the biggest winners as domestic demand is driving robust growth in those markets. The Middle East and Brazil will also carry on through the crisis although they have higher linkages to developed markets because of commodities exports. China, on the surface, is positioned to outperform, but bad domestic debt and a slowing manufacturing sector are causes for concern.