The ongoing credit crunch is drawing the “goldilocks” period of the last half-decade or so to a rather dramatic close. The combination of low inflation, high growth and rising nominal and real asset prices has already unravelled in parts — and whether you look at the US, Europe, Japan or the UK, the outlook for the next twelve to eighteen months is soft. Risk appetite is sharply down, with further to go.
My conclusion from a two-day conference on emerging Europe in Vienna this week is that the region — particularly the CEE and Baltic states — looks more vulnerable than many presume. CDS spreads, a good proxy for underlying sovereign risk, have widened across the board as shown in the chart above — and are likely to widen substantially more over the course of 2008.
First, most CEE economies show very large current account deficits, so are the borrowers and spenders that suffer most in tightening credit conditions. The average current account deficit as a proportion of GDP for the CEE-plus-Baltics is about 9% for 2007 and over 20% for some such as Bulgaria and Latvia. This compares with just 2% for the CIS countries and a surplus in most of Asia (India does run a deficit, but this is under 2% of output). According to the latest IMF World Economic Outlook, the transition countries have been the largest net recipients of external borrowing of all emerging market regions.
Second, for some such as Hungary and Poland, large chunks of borrowing are in foreign currencies. For instance, 45% of Hungarian housing loans outstanding and 60% of Polish mortgages are financed in external currencies, mostly Swiss francs. Reminiscent of Thailand in the late 1990s, this represents a huge added risk — the Swiss franc has already appreciated more against the euro in the last three weeks than in any of the risk aversion episodes in 2007. Hungary looks particularly exposed — the country still runs twin deficits on the fiscal and current accounts (which despite recent commendable improvements are high in both a global and CEE-4 context1), output growth is very weak (annual growth has barely nudged 1% for the past two quarters), inflation is rising with risks to the upside, and the stifling mix of tight fiscal and monetary policy is likely to be poorly perceived as risk appetite falls. And finally, most are massively open, trade-dependant economies. Exports weigh close to 100% of GDP in for example Hungary, Slovakia and the Czech Republic, so they are far more exposed to a global economic slowdown than some other emerging markets such Brazil or India.
Even Russia, which has limited external financing needs and huge reserves, is vulnerable. We expect oil — the lynchpin of Russian growth — to fall to $70/bbl by this summer as demand wanes, a 30% drop from the recent peak. Emerging Europe is set for a difficult ride in 2008, and the probability of at least one country in the region experiencing a financial crisis is significant.
Maya Bhandari
Lombard Street Research
