Edward Lucas

Eastern Europe's economies

Hot and bothered

Mar 8th 2007
From The Economist print edition

Overheating economies, slow reform and messy politics make a grim mixture

NEVER before has eastern Europe enjoyed such good fortune. Most of the region is anchored in NATO and the European Union; it is prosperous, stable, democratic and secure. GDP growth is surprising everyone. Even a supposed sluggard such as Macedonia is growing at 4%, much faster than “old Europe”. In most other countries growth is above 5%; in the Baltic stars of Estonia and Latvia it is over 10%.

Yet the mood is surprisingly gloomy. Across the region, millions have left to work abroad, sending wages soaring, threatening competitiveness and worrying investors. Countries not yet in the EU fear that even rapid reforms may not help them join. In the ten ex-communist countries already in the club, reform has largely stalled. In Romania the political discipline that preceded accession has ended spectacularly. In Slovakia reforms may be reversing. As for the euro, nowhere in the region looks likely to follow Slovenia's example and join soon.

The immediate fear, stoked by choppy markets and memories of financial crises in East Asia in 1997 and in Latin America more often, is of an economic crash. It might start in the Baltics. This week Fitch, a rating agency, warned Latvia that it faced downgrades if it did not get its economy under control. In 2006 Latvia's current-account deficit was 20% of GDP, the highest in the EU. That reflects a ballooning in foreign banks' mortgage lending to locals, denominated mostly in euros, which has fuelled a property boom. The story in Estonia and Lithuania is similar—and looks equally unsustainable. For all their gorgeous architecture, it is hard to see why the Baltic capitals should be pricier than Berlin, Vienna or Frankfurt.

It is also easy to imagine how the property bubbles might pop. Construction firms are finding it hard to hire the workers they need to finish the apartments that the property companies have already paid for, using money their customers have already borrowed from abroad. In a bizarre sign of overheating, some Estonian firms are even importing workers from Finland. A harder question is what might happen next. The Baltic banks are largely foreign-owned by solid Scandinavian banks. They can afford to bail out their local subsidiaries if they need to. Only Latvia has a big locally owned bank, Parex, but it has been a relatively cautious lender.

All three countries have fixed exchange rates (currency boards in Estonia and Lithuania, a currency peg in Latvia) fully backed by foreign-currency reserves. It is reassuring that none of them has much foreign debt, and that their currencies and securities are only lightly traded, creating little scope for a speculative attack. Less reassuring, however, their exchange-rate regimes leave little room for monetary tightening. And weak coalition politics undermine hopes of a tight fiscal policy or of structural economic reforms that would maintain competitiveness as costs rise.

Edward Parker of Fitch says that a Baltic crash might mean that some countries have to follow the example of Portugal, which has been stuck with high costs and low growth after an unsustainable boom. That would be sad for the Balts. But need it spread to other east European countries?

On the face of it, no. Only Slovakia has Baltic-style growth (an annual rate of 9.6% in the fourth quarter of 2006, with industrial production up by 17.4% year-on-year in January). It is more flexible (with a floating exchange rate) and its central bank is still soundly run. The government insists that it wants to join the euro in 2009. But some in the euro area mutter that Slovakia's low inflation will be deemed “unsustainable” when the time comes.

A bigger worry is Hungary. The government is trying to regain control of public finances after a splurge to win last year's election. Hungarians have borrowed hugely in foreign currency, assuming the euro is a certainty. That creates all the conditions for a nasty crunch, with devaluation, possible default and recession. After some perilous wobbles last year, the government's austerity programme has won plaudits from bankers. But planned reforms of public spending have yet to bite, and the government has been timid in conceding higher public-sector pay.

The underlying failing is weak and indecisive government across the region, which needs years of good government if it is to catch up. Romania, the second-largest east European EU member, is paralysed by a political feud between the prime minister and president. As a by-product, the upper house of parliament has voted to dismiss the justice minister, Monica Macovei. In sunny economic weather, such political shenanigans would be mere details. In a chillier climate, they make east Europe's future more worrying.