The global crisis hits Eastern Europe: Now what?

Twenty years after the post-communist revolutions, Eastern Europe is in the middle of another maelstrom. The Eastern European countries are now seeing the global economic and financial crisis wipe out many of their hard-earned gains achieved during the period of liberalization, privatization and structural adjustments to meet the European Union (EU)'s accession criteria. They have embraced openness and integration into the global economy, only to find themselves especially vulnerable to the crisis within the emerging-market universe.

Eastern Europe (also called "emerging Europe") entered the crisis in a weak position — with relatively high current account deficits, low foreign exchange reserves, very rapid credit growth, and a consumption boom financed by foreign currency borrowing. With the unfolding of the global crisis, they have experienced sharp economic contraction, currency depreciation, and even risks of sovereign default. A comparison of Eastern Europe now with Asia in 1997-98 indicates that the drop in economic activity has actually been sharper and deeper in Europe than in Asia, according to research by Danske Bank. Eastern Europe's high vulnerability is primarily driven by two factors: collapsing exports; and the drying up of capital inflows. Eastern Europe's real GDP growth is expected to fall from 5.7 percent in 2007 to 4.2 percent in 2008 and 2.5 percent in 2009, according to IMF November 2008 estimates.

As Tolstoy wrote in his masterpiece, Anna Karenina, "All happy families are alike; every unhappy family is unhappy in its own way." The same holds true for Eastern European countries today, some of which are doing much worse than the others. The hardest-hit countries are undeniably Latvia, Hungary and Ukraine, though for different reasons. Latvia's woes started with its real estate market and its housing bubble, which popped in 2008. Furthermore, Latvia's current account deficit reached a colossal 25 percent of GDP in 2007. Hungary's debt-heavy economy and currency crash are the defining features of its dire situation. Ukraine suffered tremendously due to its high levels of corruption, chaotic governance and the slowdown in its main export market, Russia.

For some observers, Eastern Europe has become Europe's version of the subprime market. As Jack Ewing wrote in BusinessWeek.com: "The Continent's banks may not have written subprime mortgages, but it turns out they financed something worse: subprime countries." Over the last ten years, foreign and domestic banks have offered cheap loans and mortgages to consumers in Eastern Europe, and a lot of this credit was lent in foreign currency, primarily euros and Swiss francs, which offered lower interest rates than local currency equivalents. According to experts at Morgan Stanley, Eastern Europe has borrowed $1.7 trillion abroad, much on short-term maturities. It must repay — or roll over — $400 billion in 2009, equal to a third of the region's GDP. Good luck. With local currencies in a tailspin, many consumers in Eastern Europe are unable to pay their debts. Poland's zloty has dropped 29 percent against the euro and 41 percent against the dollar in the past six months, and the Hungarian forint, the Romanian leu, and the Czech koruna have dropped by 20 percent, 17 percent and 12 percent against the euro, respectively. Banks from Austria, Italy and Sweden which have invested and lent heavily in Eastern Europe, could end up with catastrophic losses. Austrian banks are in a particular danger &— they have lent 230 billion euros to the region, equal to 70 percent of Austria's GDP.

Overall, businesses in Eastern Europe have to deal with a double whammy: on the one hand, a slowing demand for goods; and, on the other, difficulties in meeting their payments to foreign lenders with the fall of local currencies. Repaying the foreign-currency debt has become a huge mountain to climb. Today's downturn in the global economy is much more synchronized compared with the situation in the 1990s, and Eastern European economies and businesses cannot so easily export their way out of recession, as Asia did in the 1990s. Demand for goods is plummeting almost everywhere in the world.

For the second and third group of countries — the new EU member states — help will come not only from the IMF and the international financial institutions, but from the EU's structural funds and the European Central Bank as well. It took some time for the EU leaders to arrive at that conclusion. Many of them view help for Eastern Europe as highly unfair, given the fact that some Eastern European countries have spent the money available from the EU structural and cohesion funds not for reforms but for construction/real estate and consumption. Facing recession at home, some of the Western European leaders further acted exclusively in defense of their national interests. France, for example, has ordered CEOs to close factories in Eastern Europe in order to save jobs at home. The crisis has thus turned into an existential test for the EU, posing the most significant challenge in decades to its founding principle of solidarity.

But the issue here is, can the EU afford not to provide assistance? The latest developments in Eastern Europe and its western neighbors, especially Austria, whose banking industry is so heavily exposed to its Eastern neighbors, raise depressing parallels with the 1930s: It was the 1931 failure of a Viennese bank, Creditanstalt, that was a turning point in what became the Great Depression. Such historical comparisons have helped West European leaders realize that bailing out Eastern Europe has nothing to do with European solidarity; it is a matter of their own countries' survival. In March 2009, they pledged support for Eastern Europe on a country-by-country basis, while rejecting Hungary's proposal for a regional bailout of $230 billion. This has left a lot of room for the IMF and other multilateral institutions. The IMF has already provided financial assistance to Latvia and Hungary, in addition to Ukraine, Belarus, Iceland, and Serbia. And it is looking to double its lending capacity to $500 billion.

Another remedy for the second group of countries is to accelerate their path to the euro zone. Poland and Hungary are already considering pegging their currencies to the euro in 2009. In order to join the euro zone, aspiring EU members have to meet the tough convergence criteria which include keeping budget deficits, government debt, and inflation below certain specified ceilings, and holding national currencies within a preset range to the euro for two years. In early April 2009, with the potentially disastrous impact of the global crisis in mind, Germany and France cautiously supported a Hungarian proposal that countries that fulfill the requirements of entry into the euro zone should not have to spend two years waiting in the ERM-II Exchange Rate Mechanism. They should be allowed to join immediately.

Having lived through communism, dictatorship, and 300 percent inflation, the Eastern Europeans have become very resilient to turmoil. Luckily for the Austrian and other foreign banks with high exposure to the region, so far the crisis has not translated into populist or protectionist politics that could, in effect, lead to the expropriation of their loan books. The biggest casualty of the crisis in Eastern Europe could be deregulated capitalism, so earnestly embraced during the post-communism transition. That model is now badly tarnished and open markets are no longer viewed as the natural panacea to all economic illnesses.

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