The Recession in Central Europe, Part 1: Armageddon Averted?
Central Europe has borne the brunt of the global financial crisis, and countries that were once flying high on foreign direct investment are now receiving direct assistance from the International Monetary Fund. Burdened by $870 billion in external debt, a large portion of which is denominated in foreign currency, Central European countries are scrambling to keep their currencies strong to avoid a crisis caused by appreciating foreign debt. Ultimately, the only remedy is a mad dash to the eurozone. Editor's Note: This is part of an ongoing series on the global recession and signs indicating how and when the economic recovery will begin.
To download a PDF of this piece click here. While there is consensus that the housing crisis in the United States and the subsequent collapse of Lehman Brothers in September 2008 were triggers for the global financial crisis, the greatest region-wide damage from the worldwide recession has thus far been in Central Europe. Since October 2008, Hungary, Romania, Serbia, Bosnia and Latvia have all received direct assistance from the International Monetary Fund (IMF) while Poland has tapped the IMF's Flexible Credit Program. Meanwhile, a slew of other countries in the region (Bulgaria, Croatia and Lithuania) are currently debating the merits of asking for international help. Before the crisis, the region was flying high on foreign direct investment, overtaking East Asia as the main destination for international capital in 2002. However, the massive influx of foreign capital that made the boom years possible is now the source of a very large problem for the region. Central Europe is indebted externally to the tune of approximately $870 billion dollars (77 percent of the region's combined gross domestic product), of which around a third comes due for repayment in 2009. Most of this debt is held privately, which means that governments themselves are not greatly indebted. However, massive defaults in the private sector are a problem for the government, which, at the end of the day, is the guarantor of last resort. Furthermore, a large proportion of the debt, taken out by both households and businesses, is denominated in foreign currency. Because of this, Central European governments have to make sure that their own domestic currency does not depreciate, since this would appreciate the real value of the debts and cause a cascade of defaults throughout the system. Click image to enlarge Indeed, STRATFOR considers Central Europe "ground zero" of the global recession. This analysis on the recession in Central Europe introduces the current problems facing the region and describes policy choices that the various governments have. The second part will examine the economic and political situation country by country. For purposes of both analyses, Central Europe is defined as Bosnia, Bulgaria, Croatia, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Macedonia, Poland, Romania and Serbia.
Global Credit Boom and Regional Geopolitics
The boom years between 2001 and 2007 for Central Europe led to a surge in borrowing from abroad to spur consumption at home. The region has traditionally been credit-starved due to decades of communist rule and subsequent political instability, first during the Cold War and then during the tectonic political changes of the 1990s that led to violence in the Balkans. However, geopolitical changes in the region in the early 2000s coincided with cheap global credit pumped out after 2001 by the developed nations trying to overcome the fear that the post-9/11 recession would be a severe one. To understand how Central Europe became the emerging market and main destination for international capital, one has to understand the scope of geopolitical changes worldwide. First, the 1990s saw the decline of Russian power in what has traditionally been its sphere of influence, allowing most Central European countries to consolidate politically under the twin EU and NATO umbrellas between 2004 and 2007. The scope of Russian withdrawal from the region was massive and unprecedented, and seemed permanent at the time. The Baltic states in particular, under tight and direct control by Moscow for more than 80 years, were suddenly open for business from the West, with Scandinavian banks first to cash in, reestablishing what had been Stockholm's sphere of influence in the 17th century. Global credit expansion post-2001 also happened to roughly coincide with the fall of Serbian strongman Slobodan Milosevic in October 2000, which greatly relaxed political instability in Southeast Europe. Suddenly, even the Balkans were open for business. Geopolitical changes in the region therefore acted as a funnel for international capital, diverting much of the money available after 2001 into Central Europe. The region was seen as one of the last true unexploited lending markets in the world.
Unfortunately for Central Europe, the abundance of cheap international credit made it possible to gorge on foreign credit without much thought of the consequences. Consumers in the region, some of whom had never taken out a mortgage or car loan, were suddenly introduced to consumer loans, while businesses flocked to corporate loans for infrastructure and real estate development. Western countries at the edge of the region — particularly Italy, Sweden, Austria and Greece — looked to profit from geopolitical changes by reestablishing their former spheres of influence through financial means. The end of the Cold War meant that these former Central European powerhouses could once again carve out an economic niche without competition from more powerful banking centers like the United Kingdom, the United States, France and Switzerland. Banks from Milan, Vienna and Stockholm, in particular, hoped to use cultural and historical ties — in some cases to their pre-World War I territorial possessions — as an advantage. Therefore, Sweden rushed into the Baltic states, Greece into the Balkans and Italy and Austria pushed into the entire Central European region (save for the traditionally Scandinavian-dominated Baltics). These foreign banks brought with them a concept perfected in Europe by the Austrian banks: foreign currency-denominated lending. Austrian banks had experience with the financial mechanism of lending low interest-rate currency in a higher interest-rate country due to Austria's proximity to Switzerland, which traditionally has had low interest rates. Italian, Austrian, Swedish and Greek banks therefore bought up local Central European banks, or simply established subsidiaries of their own banks, and began offering loans in euros and Swiss francs. A Hungarian, for example, could purchase an apartment in Budapest by applying for a euro-denominated, low interest-rate mortgage in a Milan-based bank branch in his home town. This financial tool allowed Central European countries with endemically unstable currencies and/or high interest rates to piggyback on the low interest rates of the euro and Swiss franc to spur consumption, which subsequently led to overall economic growth and a real estate bubble in the region. The danger of foreign currency loans, however, is that they are exposed to the fluctuations of exchange rates. The Hungarian enjoying his new apartment does not get paid in euros, since Hungary is not in the eurozone, but receives his salary in forint. As long as the Hungarian economy grew faster than the eurozone economy, foreign investment flowed, economic activity surged and the forint was stable or strengthening, allowing the euro-denominated loan to be serviced. However, the collapse of Lehman Brothers in September 2008 precipitated a global financial panic that exposed deep-rooted problems in Central Europe. Such panics almost inevitably spur investors to pull their investments from what are considered to be riskier locales, which usually means emerging markets, and in the case of 2008 the panic was particularly bad. As the mass exodus of foreign capital from emerging-market economies caused domestic currencies to depreciate, the loans that consumers and corporations took out in foreign currency started to balloon in real terms due to the foreign exchange discrepancies. The Hungarian getting paid in forint suddenly realized that his monthly paycheck no longer covered his euro-denominated monthly mortgage payment. Click image to enlarge To preempt a deluge of defaults by both consumers and corporations, governments across the region (Hungary, Latvia, Romania, Bosnia and Serbia) immediately looked to the IMF for help in shoring up currency reserves, increasing foreign confidence in their systems and defending their slumping currencies. Even though most governments in the region have a very low debt exposure (except Hungary), the high private-sector exposure is threatening the creditworthiness of the countries themselves.
Currency Stability vs. Growth
While currencies have stabilized as a result of the external bailouts and no sudden devaluations are expected in the near future, the threat of further currency collapses will continue in the medium and long term, particularly in countries that are maintaining a peg (such as Latvia to the euro). This has created a difficult political dilemma for the governments in the region: defend their currencies or stimulate growth. According to Fitch Ratings, only the Czech Republic has sufficient foreign currency reserves to cover foreign debt maturing in 2009, should today's problems evolve into a crash that forces the state to step in. That said, foreign banks and foreign companies with subsidiaries in the region holding most of the debt will not bolt or ask for their loans back en masse; they will be amendable to rolling over the debts or restructuring them so as not to pull the rug out from under their own markets in Central Europe. However, these foreign "parent" banks active in the region cannot afford to refinance during the global financial crisis, and since the Central European states cannot help them finance by setting aside funds, that leaves the IMF and the EU. Ironically, this means that the only way to stave off an economic Armageddon characterized by widespread defaults is to take out more foreign loans from the IMF and EU. Meanwhile, the very method by which growth could be spurred, lowering interest rates, would lead to currency devaluation, which could worsen such a default crisis. Lowering interest rates encourages domestic-currency borrowing. However, the looming foreign currency debt makes this strategy extremely risky because lowering interest rates also makes holding domestic currency unprofitable (since return on investment is lower) and could precipitate further capital flight. Central Europe has to depend on outside factors, in this case the return of global demand for their exports, to pull them out of the crisis. Meanwhile, foreign currency loans are not being curbed — in fact, they are increasing across the region. By keeping interest rates high compared to the eurozone interest rate, Central Europe is simply continuing to encourage borrowing in euros at home. While there is some anecdotal evidence in the region that banks, on an individual basis, are trying to shift customers to domestic currency-denominated loans, the costs for any wide-scale, government-led program to encourage lending in domestic currency would be far too great — indeed, the difference in rates alone would make such an option less than attractive for customers. And with Western Europe flush with credit, the pressure to prop up Central Europe's debt is present and ongoing.
A Way Out?
For Central Europe, interest rate discrepancy with the eurozone is not a simple problem to overcome. The interest rates are essentially a price one has to pay for money. Larger, more stable economies have lower rates, while smaller, less stable economies have higher rates because investors demand a better return for the risk. Central Europe has to compensate for latent political risks and inflation concerns with high rates, while in the eurozone, the robust and inflation-averse German economy allows the euro to enjoy low rates. Of course, it is always going to be tempting to borrow in euros at low interest rates instead of in forints, dinars, kunas, lei or leva at higher interest rates. Central European countries therefore have two choices: They can either legislate against foreign-currency lending, which would severely curtail credit in the region and thus stunt economic growth (and violate EU rules on the free flow of capital), or they can make a mad dash for the eurozone. The latter, of course, depends on the eurozone's accepting Central European countries into the club, which would require the EU to significantly curb its eurozone accession requirements to lower the bar for a Central Europe rocked by recession. Central Europe is essentially stuck with its $870 billion in external debt and eurozone membership as the only way to remove the risk of the loans ballooning in real value. Taking out IMF loans to protect against potential defaults shifts the burden to cover the debt from the private sector to the entire public. And IMF loans come with conditions that usually require governments to make extreme cuts in politically sensitive spending (pensions, unemployment benefits, public-sector jobs and the like). The EU may provide a lending alternative to the IMF, but Brussels has its own conditions, including the requirement that EU banks operating in the region can be bailed out only with money that Brussels provides. This has been the case in Latvia, where Sweden (currently the president of the EU) ensured that half of the EU's substantial 1.2 billion-euro injection into the country went to mostly Swedish-owned foreign banks at the risk of rising default rates due to the potential collapse of Latvia's currency peg to the euro. These injections of capital with strings attached may have political consequences as well, particularly when populations across Central Europe realize they are essentially paying for foreign-bank bailouts through cuts in pensions and social welfare.
The Recession in Central Europe, Part 1: Armageddon Averted?