Tuesday, November 20, 2007

The world in 2008--predictions for CEE

Unoriginal sins
Edward Lucas
From The World in 2008 print edition
For eastern Europe the EU’s “halo effect” is set to fade
The ex-communist countries of eastern Europe will start the year with some good news: on January 1st most of them will join the Schengen passport-free area, removing the last obstacles to frontier-free travel within the European Union. That will help remove the lingering feeling that the eight new member-states from the region that joined in 2004 are second-class citizens.
White-hot speculation has sent prices and rents soaring
The EU’s decision will be followed by yet more good news in the spring, when Congress will vote to give the citizens of many ex-communist countries visa-free travel to America. That will remove another lingering feeling: that their help in Afghanistan and Iraq was taken for granted. As other allies depart from Iraq, the east Europeans—notably Poles, Romanians, Georgians and Bulgarians—will stand out as America’s most resolute European friends.
The dying months of the Bush administration will also be marked by another attempt to establish some kind of “legacy” in eastern Europe, by setting Georgia, along with Croatia, Albania and Macedonia, further on the road to membership of NATO. That will infuriate the hawks in the Kremlin, who will use it as an excuse to edge closer to America’s rivals and bugbears such as China and Iran.
But the big story of the year will be a different one: of popping bubbles and slowing economies. In 2008 the truth will start to hurt: the ex-communist countries have botched reform, made sham improvements and fudged hard choices. For four years, that has been covered up by the “halo effect” of joining the EU, and by exceptionally favourable external conditions.
As liquidity drains away from global markets, the ex-communist countries’ lack of competitiveness will become increasingly exposed. Fast wage growth means that they are no longer sources of cheap, unskilled labour. Simple manufacturing and services are moving elsewhere—to Morocco and Ukraine, for example, where workers are more plentiful. Employers in industries that add lots of value, such as sophisticated services and high-tech manufacturing, are worried too: they complain that east European universities are not turning out the graduates they need. These disadvantages will be underlined in 2008 by the lack of progress in other areas, such as roads (especially in Poland, the biggest country in the region) and bureaucracy (almost everywhere).
The sharpest pain will be in the economies that have seen the most furious growth, notably the Baltic states, and particularly in property, where white-hot speculation has sent prices and rents soaring way above comparable cities in western Europe. The foreign banks that own most of the ex-communist world’s banking system will find themselves bailing out local subsidiaries that have lent rashly. Their shareholders’ willingness to suffer for local managers’ imprudence will provide a big cushion. If that fails, disaster looms for countries such as Latvia, whose inflation hit 11.4% in September 2007 and where the current-account deficit was over 22% of GDP.
Rocketing growth has fuelled inflation, killing the ex-communist countries’ hopes of joining the euro any time soon (though in 2007 Slovenia squeaked in). The good news from the 2008 slowdown will be that the best-run countries will have at least some chance of getting inflation down to the low single digits needed to be allowed into the single-currency zone. That may be unwelcome news in parts of rich Europe, where many feel that the euro area has too many wobbly members already.
Wise politicians in the region will use 2008 to restart reforms, chiefly of an education system which is all too often fossilised and ridden with cheating. But they will be the exceptions: squabbling, self-indulgence and short-termism are the defining characteristics of post-communist politics now. Western Europe may be little better—but it is richer and can afford bad government. Regaining eastern Europe’s competitiveness will require the hard choices that usually stem from a real crisis; 2008 is unlikely to provide it.

Edward Lucas: central and eastern Europe correspondent, The Economist; author of “The New Cold War” (to be published in February by Palgrave and Bloomsbury)


Cicero said...

While I agree with your general analysis of the problems, I am somewhat more sanguine about what the results next year may be, at least as far as the Baltic is concerned. Arguably, the worst is already passing in the Baltic- with both CA deficit and Inflation set to fall pretty strongly over the next two quarters. The key issue with the halo effect is that of course monetary policy is set by the ECB. The ECB asks the impossible from the prospective entrants: level up your living standards before you join, without inflation. Yet, despite the inflationary bubble, it is hard to argue that investment has created over capacity, so the housing boom aside, the general tenor of policy has been reasonable. The CA deficit is at least as much function of significant capital payments (expansion of Air Baltic and Estonian Air fleets for example) as of consumption.

Meanwhile the tiny size of the economies and the poor liquidity of the currencies makes it all but impossible to short the currencies- and the hedge funds that have been trying have not been able to fight the combined forces of the Central Banks, the Swedish Banks and the local Treasuries. So my money is on a fairly orderly correction in the housing market, and an overall slowdown, rather than the volatility and hard landing that these few hedge funds have traded on.

martins said...

I dont see what hedge funds have to do with a hard landing, and thats not really what the scenerio is. GDP has been driven in the Baltic states by consumption fueled by falling unemployment and credit. We've reached the end of that, the labor market is very tight and wages are climbing at an incredible rate, credit has also been restricted. As economic growth drops and the housing bubble deflates, what could be an orderly landing could easily turn into a disorderly one or a hard landing and hedge funds have nothing to do with it. All this talk about currencies avoids the issues, which is that the Baltic economies are hugely unbalanced economies with massive external liabilities in private debt and could face a balance of payments crisis. The idea that hedge funds play a role in any of this is a red herring and has nothing to do with the dangers the economies face.