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February 2, 2012

Regional Focus: Another Credit Crunch for Eastern Europe?

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The unravelling of the eurozone sovereign debt crisis throughout 2011 and 2012 is placing increasing pressure on Eastern Europe, as Western European banks continue to withdraw liquidity from the region. An ensuing credit crunch could potentially halt economic growth across a number of regional economies, with both businesses and consumers hit by credit restrictions and falling expenditure levels. Nonetheless, Eastern Europe is expected to see positive annual real GDP growth in 2011 and 2012.

Key Points
  • The eurozone sovereign debt crisis has seen a number of Western European nations unable to refinance their debts, beginning with Greece in 2009. With some of Europe's largest economies, such as Spain and Italy, now caught up in the expanding fiscal instability, the crisis is beginning to impact the global economy as a whole. It is already forcing an outflow of liquidity from Eastern Europe, as investors and financial institutions look to minimise their exposure to a region that is most closely connected to Western Europe. Foreign Direct Investment (FDI) inflows declined by 16.9% in real terms over 2005-2010 in Eastern Europe;
  • Eastern Europe suffered the greatest from the global economic downturn of 2008-2009, with annual real GDP falling by 6.2% in 2009, the greatest decrease worldwide. However, the region rebounded strongly in 2010 and is expected to see further economic expansion in 2011, despite a looming credit crunch being a strong possibility for the region in 2012;
  • The region is extremely exposed to weaknesses in Western European economies, with the crisis-hit region the primary destination for Eastern European exports. With debt-stricken nations such as Spain, Greece and Portugal likely to see major cuts in public and private expenditure in 2012, EU-reliant Eastern European exporters will likely be severely affected;
  • Latvia and Hungary have been some of the most affected Eastern European nations by the eurozone crisis fallout as of January 2012. Hungary's large dependence on foreign credit, especially from the Eurozone, has undermined its economy, while Latvia's weak fiscal position and shrinking economy has continued to be exposed. Both countries are reliant on EU and IMF bailouts. Romania was the worst performing economy in the region in 2010, with its annual real GDP shrinking by 1.3%;
  • However, several Eastern European nations remain attractive to investors and businesses alike, and are in a strong position to ride out the economic turbulence. Poland's dynamic consumer market should protect the country from external crises, while Russia stands in good shape due to its low levels of exposure to foreign banks and high liquidity from its energy industry. Russia was the destination for 50.0% of total FDI inflows into Eastern Europe in 2010.

Dependence on eurozone banks

  • Western banks have been an essential platform for the development of emerging Eastern European economies, providing liquidity and credit through their subsidiaries since the collapse of communism in the region. German, Italian and French banks have been especially active, yet it is these nations that are now mired in their own financial turmoil;
  • Around 12 major Western European banks have already announced contractions of operations in Eastern Europe in 2011 and 2012 following pressure from their domestic regulators to recapitalise. As of January 2012, Italy's UniCredit is looking to pull its operations from 16 Eastern European countries, while Germany's Commerzbank has frozen its lending operations in the Czech Republic and Slovakia, with both banks attempting to plug massive capital shortfalls. Austrian regulators imposed tight lending conditions on the country's future banking activities in Eastern Europe in November 2011;
  • Romania, Bulgaria and the Balkan countries remain extremely exposed to the crisis in Greece, as the country continues to stand on the verge of default, with a number of Greek parent banks holding subsidiaries there. Around three-quarters of Eastern Europe's banking sector was owned by Western companies in 2011, according to the European Bank for Reconstruction and Development;
  • Hungary, exposed both by its high share of external debt and loans in foreign currencies, has already been the first Eastern European victim. According to the Bank of International Settlements, European banks have provided US$120.0 billion out of US$140.0 billion in total lending to the country. As these banks remove their funding, Hungary is facing tight austerity measures and a full-blown economic crisis;
  • However, the eurozone debt crisis, having exposed Eastern Europe's vulnerability to Western European banks, could provide the incentive to greater self-regulation and domestic banking reform in the region. The exit of eurozone banks from oversaturated banking markets such as Hungary and Romania could also provide opportunities for local lenders and firms to fill the vacuum and profit from rising demand in the case of recovery.

Declining investments and exports

  • Western Europe is the primary destination of Eastern European exports, largely due to regional proximity, EU trade links and high levels of demand from major economies such as Germany and France. However, as a frugal tone sets over the EU, amid recession and possible debt crisis contagion, Western European economies are likely to significantly reduce their imports, hitting Eastern European exporters. In 2010, Eastern Europe's exports to the EU-27 reached US$712.2 billion, accounting for 64.4% of the region's total exports for the year;

Largest Eastern European Exporters to the EU-27: 2010

 

ScreenHunter_02 Jan. 31 12.03

Source: Euromonitor from trade sources/national statistics

  • Worst hit are likely to be exporters of foodstuffs and low-cost consumer goods, as well as construction materials and commodities like metals, with an economic slowdown in the eurozone downsizing construction activities and household expenditures. However, major energy exporters, namely Russia, should still benefit from high oil and gas prices, which are unlikely to fall. Russia was Eastern Europe's largest exporter in 2010, with exports to the value of US$400.4 billion;
  • A significant drop in FDI inflows and capital flight by investors from riskier emerging economies in Eastern Europe could facilitate mass unemployment and stock market crashes, akin to the ones seen during the global economic downturn of 2008-2009. According to Russia's central bank, around US$70.0 billion in liquidity could have left the country in 2011;
  • However, emerging markets outside of Europe could provide Eastern European economies with some respite. Keen to expand their global investment activities, the likes of China and India may see opportunities in sectors vacated by Western firms. Likewise, the growing economies of well-positioned developing nations may also swallow up abandoned Eastern European exports to some degree. FDI outflows from Asia Pacific expanded by 94.8% in real terms over 2005-2010.

Impact on consumers and businesses

  • A mass exodus of eurozone banking credit facilities would launch a renewed credit crunch across Eastern Europe. This would severely limit the ability of consumers to take out commercial loans or mortgages, while businesses could struggle to finance operations or use the credit markets. Although the region overcame the credit crunch launched by the global economic downturn of 2008-2009, this was following a number of boom years that generated high liquidity levels, a buffer that would no longer be there in 2012;
  • Dwindling exports and potential austerity measures would hit government and manufacturing business revenues, resulting in cuts in social spending, job losses in both private and public sectors, and an increase in already-high budget deficits. Hungary had the highest public debt as a % of GDP in 2010 in Eastern Europe, with 81.3%;

Eastern Europe's Public Debt as a % of GDP and FDI Inflows: 2005-2010

ScreenHunter_03 Jan. 31 12.04
Source: Euromonitor International from National Statistical Offices/Eurostat/International Monetary Fund/OECD/UNCTAD

  • Regional stock market declines and eurozone crisis contagion fears are already undermining investor, consumer and business confidence, with almost all consumer markets across Europe expected to suffer in 2012 as a result. Lower consumer expenditure levels would damage businesses, although potentially higher savings by frugal households could assist debt-laden economies over the longer term. Consumer expenditure expanded by 23.4% in real terms in Eastern Europe over 2005-2010;
  • With the eurozone crisis threatening the formation of the EU itself, it is unlikely that new members will be accepted in the medium term. Businesses and workers in countries on the verge of membership, such as Croatia, will thus have to put off any potential trade agreements or labour exchanges that might have occurred otherwise;
  • Nonetheless, the region's primary fundamental advantages remain for many investors. Eastern Europe recorded a lower unemployment rate (9.0%) than both Western Europe and North America in 2010, while seeing stronger annual real GDP growth (3.3%) than the two regions. The emerging nature of the region also means that greater growth rates and returns can also be accumulated in a variety of sectors, from communications to transport.
Prospects

Despite the very real threat of a credit crunch in 2012, Eastern Europe as a whole is expected to perform relatively well in the medium term, seeing average annual real GDP growth of 3.7% over 2011-2015. While not spectacular, this rate of economic expansion exceeds most advanced economies, many of which are now facing a recession. Nonetheless, the eurozone crisis contagion has already spread into Eastern Europe, with Hungary potentially becoming the first EU nation to default. As of mid-January 2012, the country is in negotiations with the IMF for a financial package as its domestic currency continues to plunge and borrowing costs soar.

Although many Eastern European nations were bailed out by the “Vienna Initiative” in 2008 and 2009, which combined international organisations and Western banks, a similar action seems highly unlikely in 2012. Most Western regulators are supporting a strategy of reducing exposure to brittle emerging markets, believing that Eastern European banks should lend based on local refinancing conditions, without relying on Western subsidiaries.

Countries with high budget deficits and an overreliance on Western lenders remain most vulnerable to further shocks, with Romania and Latvia especially at risk. Russia and Poland, due to their large domestic markets and strong economic growth, are best placed to ride out the storm, with Russian investors in a strong position to expand operations across the region. Eastern European consumer expenditure is projected to expand by 16.3% in real terms over 2011-2015, far outperforming Western Europe's anticipated 4.5% in real terms over the same period. 

 


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