The Eastern European Tinderbox: How Explosive Could It Get?

The Central and Eastern Europe (CEE) region is the sick man of emerging markets. While the global crisis means few, if any, bright spots worldwide, the situation in the CEE area is particularly bleak. After almost a decade of outpacing worldwide growth, the region looks set to contract in 2009, with almost every country either in or on the verge of recession. The once high-flying Baltics (Estonia, Latvia, Lithuania) look headed for double-digit contractions, while countries relatively less affected by the crisis (i.e. Czech Republic, Slovakia and Slovenia) will have a hard time posting even positive growth. Meanwhile, Hungary and Latvia’s economies already deteriorated to the point where IMF help was needed late last year.

The CEE’s ill health is primarily driven by two factors ”“ collapsing exports and the drying-up of capital inflows. Exports were key to the region’s economic success, accounting for a significant 80-90% of GDP in the Czech Republic, Hungary and Slovakia. By far the biggest market for CEE goods is the Eurozone, which is now in recession. Meanwhile, the global credit crunch has dried up capital inflows to the region. An easy flow of credit fueled Eastern Europe’s boom in recent years, but the good times are gone. According to the Institute of International Finance, net private capital flows to Emerging Europe are projected to fall from an estimated $254 billion in 2008 to $30 billion in 2009. Whether or not this is formally considered a ”˜sudden stop’ of capital, it will necessitate a very painful adjustment process.

What is especially worrisome is that the days of easy credit flows were accompanied by rising external imbalances that rival or even exceed the build-up of imbalances in pre-crisis Asia ”“ e.g. current account deficits in Southeast Asia from 1995-97 fell within the 3.0-8.5% of GDP range, while those in CEE were in the double-digits in Romania, Bulgaria and the Baltics in 2008. As examined in a recent RGE analysis piece, the vulnerabilities in many CEE countries ”“ high foreign currency borrowing, hefty levels of external debt and massive current-account deficits ”“ suggest the classic makings of a capital account crisis a la Asia in the late 1990s.

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