Worry in the West as Eastern and Central European Economies Head SouthPublished: March 04, 2009 in Knowledge@Wharton
Formerly economic backwaters, many Central and Eastern European nations have boomed in recent years, offering a growing list of exports and eagerly buying Western goods and services in return. Now the gains are unraveling, another casualty of the world financial crisis.
With the region no longer isolated, an economic collapse could reverberate in the West, as Central and Eastern European borrowers default on an enormous volume of loans that Western banks were all too eager to grant just a few years ago. Many economists warn of a treacherous feedback loop, with problems in each region compounding those in the other, and some fear that Western Europe could even be flooded by economic refugees from Ukraine or other Eastern countries, as it was during the breakup of Yugoslavia in the 1990s.
"The whole world is interlinked now, so we have to care about Eastern Europe," states Wharton finance professor Franklin Allen.
Financial intertwining can have much more profound effects on emerging economies than on resilient developed economies, says Philip M. Nichols, professor of business ethics and legal studies at Wharton. "When your institutions are as vulnerable to external influences as they are in emerging economies, bad things that happen elsewhere have an effect on you."
Though conditions vary, Central and Eastern European countries tend to have narrowly based economies centered on manufacturing and agriculture, he notes, adding that many are characterized by unstable currencies and "issues with debt." On top of that, many of the former Soviet bloc countries can claim little experience with market economies. "They are new to it all. That obviously creates vulnerabilities as well."
"Eastern European countries have high levels of export dependency and large current account deficits, and they are more leveraged than other emerging markets," says Heather Berry, a management professor at Wharton, referring to economies that import more than they export, causing money to flow outward.
"Rapid growth in the Eastern European countries came from Western investment and demand for [their] goods," she adds. "Both of these are now in question. As Western European countries face their own downturns, there is decreased demand for Eastern European exports, and plans for further foreign direct investment have all but stopped. In addition, many Western companies could be under pressure to keep bail-out money in their home country."
The most hard-hit in the region are the Baltic states -- Estonia, Latvia and Lithuania -- where an analysis by the Economist Intelligence Unit forecast an 8.3% decline in gross domestic product this year. A 0.4% GDP decline is projected for East-Central Europe, which includes the Czech Republic, Hungary, Poland, Slovakia and Slovenia. The Balkan countries -- Bulgaria, Croatia, Romania and Serbia -- are expected to contract by 0.2%. The former Soviet states of Russia, Azerbaijan, Kazakhstan and Ukraine are expected to contract 2.2%.
Debt is a big part of the problem. In recent years, Central and Eastern European businesses and consumers were attracted to loans from Western banks, denominated in dollars and euros, because interest rates were lower than on loans in their own currencies. "An Austrian bank could originate a euro-based mortgage to a Polish homeowner at a very low interest rate, particularly compared to what it would cost in zloty," says Mark Zandi, chief economist and cofounder of Moody's Economy.com.
Lenders in Austria and other Western countries were eager to meet this demand. But the international economic crisis has caused many Central and Eastern currencies to fall in relation to the dollar and euro. That makes loan payments soar when borrowers' earnings in domestic currencies have to be converted to euros or dollars for loan payments. Recently, for example, it has taken about 11 Ukrainian hryvnia to buy one euro, compared to about seven just 12 months ago.
"There is a flight to quality, and that means that everyone is running to the dollar and euro, and away from emerging economy currencies ... and they are caving," says Zandi. "And because a lot of debt taken on by Eastern European households and financial institutions are denominated in the euro, they are being crushed. If you thought the subprime mortgage was a problem, these mortgage payments are going through the roof."
This could cause deep losses for Western banks and, indirectly, American ones, Zandi believes. "The key problem for the U.S. is that if these [loans] bring Western Europe to its knees, then that becomes a problem for us. We do sell a lot to Europe and the UK." Says Nichols: "It's like asking, 'Why would a huge depression in California affect Oregon?' Well, of course it would."
Many economists have likened problems in Central and Eastern Europe to the Asian financial crisis of 1997 and 1998. That began with the collapse of the Thai baht, effectively bankrupting the country when it could not meet its payments to foreign lenders. The crisis spread through Asia. "It's a very similar, analogous situation," says N. Bulent Gultekin, a Wharton finance professor.
In Ukraine, for example, more than 90% of government debt is denominated in foreign currency, according to a report by Citigroup Global Markets. Based on one estimate, more than half of all debt in Romania, Hungary and Bulgaria is in foreign currency. In India, which is weathering the financial storm relatively well, the figure is around 5%.
"Just like in East Asia in 1997-98, too much foreign debt can lead to a rush out of the local currency," notes Wharton finance professor Richard Marston. "It's very dangerous."
While the Asian countries were able to work out of the crisis with strong exports, Gultekin worries that Central and Eastern European countries will find slack demand for exports because their Western European trading partners have little money to spend.
Western European countries, preoccupied with their own problems, are offering minimal support to their Eastern neighbors. On March 1, European Union leaders turned down a request by Hungary for a $241 billion bailout for Eastern Europe. Hungary was part of a block including Poland, Slovakia, the Czech Republic, Bulgaria, Romania and the Baltic states that insisted immediate help was needed. German Chancellor Angela Merkel, representing Europe's most powerful economy, argued that any aid should be on a case-by-case basis, since problems differ from country to country. Hungarian Prime Minister Ferenc Gyurcsany responded by warning that if the West refuses his request, a "new Iron Curtain" would divide the two regions, setting back economic development in both.
"I think they are worried about the moral-hazard issues -- that if they write a blank check they will end up paying much more than they should have to," Allen says of the West's position. Eventually, he adds, Western European countries will have to face facts: Allowing Eastern Europe to collapse will cause destructive losses to Western banks that have lent to the East, and to Western businesses with operations in the East.
To get banks to resume lending, European Union governments have pumped nearly $400 billion into their banks and guaranteed more than $3 trillion in bank loans. That should offer some protection against losses from the East. And on February 27, the European Bank of Reconstruction and Development, the European Investment Bank and the World Bank announced $31 billion to support Eastern European countries, though many experts think much more will be needed. "They tend to be slow in response to crisis, in part because it is not one country, it is a lot of different countries," says Zandi.
Some economists worry that a wave of protectionism will get in the way of joint efforts. The EU, for example, approved loans to prop up French car makers on condition they keep French factories open, drawing protest from the Czech Republic, which has its own car industry.
Of the 27 European Union countries, 16 use the euro. Among the emerging Central and Eastern European countries, that includes only Slovakia and Slovenia. The economic decline prevents many other countries from meeting the qualifications for using the euro, such as keeping government debt and budget deficits below certain ceilings. The European Union has shown little interest in loosening the requirements, despite requests from Hungary, Poland and the Baltic states.
Strong, Weak and Inbetween
While Central and Eastern European countries tend to get lumped together, they vary considerably.
Ukraine's economy, for example, is dominated by steel and chemical exports. Both industries are shrinking and laying off workers, and the country is suffering water and heating energy shortages. The currency is tumbling and many experts worry the government will default on its loans. In January, a dispute with Russia over natural gas payments and transport through Ukraine left consumers in some European countries without heat, underscoring the West's stake in the East. The International Monetary Fund has forecast a 6% decline in the Ukrainian economy this year, but it has held up part of a rescue loan because the government has not met budget-cutting requirements.
"Ukraine is one of the oddest economies you ever want to meet," notes Nichols, citing an unusual amount of decentralization and dependence on countries with which Ukraine has poor relations, such as Russia. "An economy like Ukraine's has a very narrow base," making it especially vulnerable to an economic downturn.
In Central Europe, the Czech Republic and Poland are doing relatively well, though Poland's currency is tumbling. Hungary, Romania and the Baltic states are in a tailspin. Latvia is in such deep trouble that Standard & Poor's cut its credit rating to junk status, making it nearly impossible for the heavily indebted country to continue borrowing.
According to Nichols, Slovenia is faring relatively well, largely because of its ties to Austria next door. "As far as I can tell, they are just chugging along." Poland, too, is comparatively healthy because it has a vibrant democracy and has rooted out corruption, says Nichols. "Poland has done a great job of broadening the economy."
At the other end of the scale, says Nichols, is Byelorussia. "It still has an authoritarian, non-democratic government that really sends mixed signals about joining the market-oriented world economy." To the south, some countries seem like Europe of 50 or 60 years ago, he suggests. Bulgaria, which is declining fast, depends on agriculture -- and still uses draft animals and other old-fashioned techniques. Hungary is torn by ethnic troubles.
"Every one of those places is markedly different," Nichols says.
In the long run, he suggests, the developing Central and Eastern European nations need stronger links to the West -- by joining the European Union, adopting the euro and expanding trade. But the economic crisis is making this harder. People in Western nations are hunkering down, protecting their own economies and losing enthusiasm for links to poor relations to the East, while the Eastern countries are short on the resources they need to implement changes to qualify for the EU or to adopt the euro. Furthermore, the battle against corruption and expansion of democratic principles are more difficult amid economic stress.
"The European Union is a market-oriented democracy, and they want to make sure that if you come in, you are a market-oriented democracy," Nichols says. "They don't want someone like Byelorussia coming in and having a full vote and saying, 'Yeah, but we're a dictatorship.'"
To prevent the crisis from turning into a catastrophe, Western nations should provide at least enough help to prevent Central and Eastern European governments from defaulting on their sovereign debt, which would be like the U.S. government defaulting on Treasury bonds, according to Zandi.
Ultimately, adds Gultekin, the West must recognize the facts of life. "If you allow these countries to go under, you are just going to start a chain reaction. If you're a creditor, you don't want your borrower to die."