Wednesday, June 17, 2009

Big Crack In Central & Eastern European Economies

Following the collapse of Soviet Union and Stalinist states, Central and Eastern European Countries (CEEC) provided global capitalism superior access to its cheap labour and raw materials. The recession that plagued many of the Western economies in 1990s had caused influx of capital into the former Soviet states as multinationals seeking to reduce costs by locating in a newly opened up and low tax areas

Giant car companies such as GM and Volkswagen had invested hundreds of millions of dollars into new factories not withstanding the much higher cost of operating in home country due to strong trade unions and legislations favouring employees. In short increasing number of firms around the world is looking at CEEC as a manufacturing hub that have great potential to become the ‘second China’. This together with the European Union (EU) enlargement in 2004 provide rock solid argument for high growth experienced by these economies in the recent few years

Nevertheless, these Central and Eastern European economies had become far too dependent on credit from international market

(1) Deepest cut. This round of recession is the first major downturn since the post-communist chaos in 1990s. As mentioned earlier, these emerging economies of Europe have become highly dependent on financial flow especially from richer Western European countries like Germany, France, Austria etc. However, due to unmanageable recession time bomb and credit crisis from those financiers, there is a severe reversal of inward investment, putting an immediate end to its growth. For instance, President Nicolas Sarkozy was under fire lately for his attempt to cut jobs in the car production plants in Czech Republic and ‘bring home’ some of those jobs to kick start local economy

Besides, Czech Republic together with Hungary and Poland are poised to suffer an economy contraction of more than 5% this year. This has something to do with the underlying structure of these economies. More than 50% of their national income is derived from export activities to richer Europe. Their reliance on exports far succeeded Germany, US and China

(2) Rising unemployment. The jobless rate in these emerging economies of Europe increase as fast as they fall. Again, consider countries like Poland and Czech Republic which have become major centres of manufacturing for the EU market. Over the years, the boom comes from the development of car production plants, electrical equipments and household goods for Western Europe. With ailing demand, many of the labours together with those from other related industries are no longer needed. Not to forget, the economic misfortune of large economies like UK, Germany and France have forced many migrants to return home, thus pushing the jobless figure higher. From the positive note, there will be downward pressure on wages which could be good news to employers

(3) Ballooning fiscal deficit. As level of unemployment increase, income tax revenue falls. Marked slowdown in economic activities automatically reduces corporate tax revenue and VAT. Falling number of property transaction reduces stamp duties. However, the governments at the same time have to pump in more money. Schools, hospitals, construction of roads and bridges are expected to kick start soon to offset the fall in exports and private investment. One must also not forget the extraordinary amount money involved in bailing out failed financial system. In near future, commitments towards the baby boomer generation will be an added burden. Together this means unimaginable budget deficit

Many of these Eastern and Central European economies will soon fall into a deficit-trap like UK- big and ‘irreversible’ sudden rise in public spending. Why? Because, it is politically sensitive and unpopular to cut spending even when the economy may have recovered. Given the nature of these fragile economies many would probably face the crisis of confidence and servicing the national debts is utterly painful

Current account deficit in Baltic states
(4) Depreciating currencies. Perhaps, this is the most dreadful ill of all. Under normal circumstance, weakening exchange rate should be able to boost the export market of Eastern and Central European economies. This is because, lesser euro is required to purchase a unit of say, forint. In current situation, their source of demand has dried up. Fiscal deficit and current account deficit are widening, therefore triggering a fall in confidence towards an already fragile economy. Investors no longer keen to hold these currencies, hence began dumping them in foreign exchange market. Simultaneously, massive capital flight and fall in inward investment further belittle all efforts to maintain the currency within a reasonable range
Therefore, debt servicing in these days have become increasingly difficult especially for countries like Hungary and Poland. Going default seems to be imminent when both forint and zloty fell more than 30% against euro. There are contagion worries to Western European countries like Germany, Sweden and Austria which have more than $1.7 trillion of loan exposure to CEEC. A collapse like this will create another version of Asian financial crisis (1997-1998), but three to four times worse
Fall of house prices in Latvia

Fall of house prices in Estonia

(5) Asset price deflation. The housing markets in the Baltic States have many similar traits with those in UK. Due to highly successful economic reform, enlargement of EU in 2004 coupled with the doubling of income per capita, increasing number of people in countries like Latvia and Estonia have shown great interest in storing their wealth in property market. In such a short period, asset prices skyrocketed in Latvia due overwhelming demand and shortage of supply. Between 2004 and 2007, house prices tripled or even quadrupled in Latvia capital city, Riga. This explains why Latvia is the fastest rising economy in Europe

However, the recent housing market crash of Latvia is a painful one and probably not only the worst in Europe but also in the world. One of the main reasons for collapse is due to the pegging of Latvian lat to euro. With series of hike in interest rates by ECB throughout 2006 and 2007, Latvian mortgage rates rose disproportionately as pressure on the peg rose. Latvian variable rate mortgages peaked at 14.7% by end of 2007, creating the highest level of default in history of housing market. Until today, situation seems to be much worse as banks are reluctant to lend or extend credit. Rising unemployment and oversupply of houses are putting more pressure on the price
(6) Currency pegging. The Baltic countries (Estonia, Lithuania and Latvia) which have expressed their interest to adopt euro at later stage, chose to peg their currencies against it. Recently, officials from these three countries have vowed to protect the peg at whatever cause. However, based on previous experience, chances are the costs outweigh the benefits of doing so. The Baltic members are highly likely to go through the same experience as UK which entered into the ERM (Exchange Rate Mechanism). Expected prolong recession is likely to trigger a continuous attack on local currency. This will cause drainage to foreign reserve

Latvia for instance had spent more than $1 billion last year to defend the peg, in which inevitably it turned to IMF to seek further assistance of $9.6 billion. In return, it is allowed to retain the peg but required to cut wages, raise taxes and reduce public investment which will jeopardise the state of its economy in longer term. Probably its other two neighbours are likely to follow suit in near future

That’s not all. In fact CEEC economies have some other distinct problems such as increasing number of ageing population, widespread of relative poverty etc which I’ll cover in some other posts

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