Argentina on the Danube?

Feb 19th 2009 From The Economist print edition Europe is facing nightmarish problems in its east. With help from the West, meltdown can be avoided IF YOU mix East Asia from 1997 with Latin America in 2001, do you get eastern Europe in 2009? Already worried, financial markets are pricing in the likelihood that one or more of the ex-communist countries in the region will default on its debt. The biggest weakness lies in a financial system that has combined badly run local banks with loosely overseen subsidiaries of Western ones. During the boom years, this system gobbled up credit from abroad, leading to yawning current-account deficits. Both kinds of banks now have souring loan books—the result of reckless lending, often in foreign currencies. Some local banks have failed; many of the foreign-owned ones now depend on their parents’ willingness to keep financing them—and those parents have plenty of problems at home. The Greek government has told its banks to draw back from their lending in the Balkans. Austria’s lending to eastern Europe is equivalent to about 80% of its GDP. If finance is the immediate worry, the global downturn is causing plenty of other problems. Exports of manufactured goods to western Europe have plummeted; remittances from migrant workers employed there will also surely fall. Ukraine, dependent on exports of steel and coal to Russia, seems to have abandoned the deal it struck with the IMF only three months ago as part of a $16.4 billion bail-out. Latvia, also rescued by the IMF, is expecting a 12% fall in GDP this year. The collapse in output is likely to be as big as Asia’s ten years ago—but with a twist. The Asian countries recovered thanks to export-led growth. Now the whole world is in a mess. What can the governments do? In many places the policy levers look flimsy. Countries such as Poland and the Czech Republic have cut interest rates to help ease the pain—but this has sent their currencies tumbling, increasing the agony for households that have mortgages in Swiss francs or euros. Some countries have an extra problem of big external government debts (in Hungary’s case, the gross figure is near 100% of GDP). Even those that could perhaps afford to run a counter-cyclical policy to offset the effects of the downturn are squeezing public finances—in part because they think that cutting deficits will help them reach the (presumed) safety of the euro zone. For four countries—the three Baltic states plus Bulgaria—the strong euro is a problem; they have pegged their currencies to it. Some fear a repeat of the doomed struggle to keep Argentina’s currency board afloat in 2000-01; or perhaps worse if one currency’s collapse swamps others. As for help from abroad, the IMF can give instructions to individual countries, but it cannot run the whole region. The European Central Bank, which is not a lender of last resort even to banks in the euro zone, has been sniffy about lending to countries outside it. Worse for some, much worse for others A very nasty recession is inevitable, but regional catastrophe is not. For a start, talk of “eastern Europe” is imprecise. The woes of Kazakh banks or of Ukraine’s public finances have little to do with the countries, mainly smaller, richer and better governed, that are already in the EU. If Ukraine defaults or (more likely) is forced to restructure its debt, it need not hurt others. Though the region has allowed startling imbalances to develop, foreign-exchange reserves are generally stronger than in Asia ten years ago; and there is less light-footed “hot money”. For the new EU members, there is also the prospect of help from the West. Their banking systems are far more intertwined than Asia’s were—and the foreign banks are less likely to walk away (see article). The Baltic countries have been bolstered by a Swedish guarantee covering Swedish banks that operate there. Although the EU and the ECB may not want to get involved in bigger bail-outs, they will have to. Even the most short-sighted west European politician will surely not send his neighbours into economic and political anarchy. This is the most perilous period for east European countries since the collapse of the Soviet Union. People there are going to be a lot poorer and (justifiably) crosser. But it would take a bout of wilfully destructive protectionism and the demise of the EU’s main institutions to turn that into disaster.