Estonia ahead

Baltic economies

The Estonian exception
Oct 29th 2009 | RIGA AND TALLINN
From The Economist print edition


Estonia gets a boost, but worries persist about its Baltic neighbours
SMUGNESS is Estonians’ least attractive feature, at least in the eyes of their Baltic neighbours, Latvia and Lithuania. A surprise endorsement by the International Monetary Fund of Estonia’s plans to join the euro in 2011, coupled with gloom about the other two countries, will only make that worse.

All three Baltic states are facing double-digit economic declines in GDP this year, following the collapse of credit bubbles created by reckless lending and spending. Many outsiders have wondered if the three countries can maintain their fixed exchange rates, which peg the national currencies to the euro. A currency or banking collapse in the Baltic would spook markets elsewhere in the region, threatening wobbly economies such as Hungary’s.

So for the past year the focus has been on averting disaster. Plunging tax revenues made the chances of any Baltic states meeting the criteria for joining the euro look slim. In Latvia, for example, the government is struggling to keep next year’s budget deficit down to 8.5% (see chart)—a condition for the continuation of a €7.5 billion ($11 billion) IMF-led bail-out package. To join the euro, the deficit must be sustainably below 3%.



But it now looks as if, barring upsets, Estonia by the middle of next year will have met all the criteria for joining the euro. Inflation is low; government debt is negligible (indeed the country still has net public assets) and next year’s budget sets a deficit of 2.95%. That is thanks, the IMF says, to Estonia’s thrifty habits in public finances. The government has cut spending hard and early. It sped through modernisation projects financed by the European Union. This acted as an economic stimulus. Latvia and Lithuania have found it much harder to follow the same path. Lithuania has dodgy banks and spiralling debts; Latvia has lost credibility among outsiders because of its failure earlier this year to cut spending as promised.

For safety’s sake, the IMF still wants Estonia to raise and broaden taxes a little. Car-owners, for example, pay no car or road tax. But Andrus Ansip, the prime minister, already feels vindicated. He says the prospect of euro adoption will boost investors’ confidence and speed the country’s recovery.

Attention now shifts back to Latvia, where the IMF and EU are holding up a new budget, due to be passed on October 28th. They worry that the precarious governing coalition lacks political will, and that the crisis is unfairly hitting the poor. They want Latvia to dump its flat tax for a more progressive system. But Latvia says higher taxes would discourage entrepreneurs and that chaos in the state revenue office means that the higher rates would bring in little extra cash. No reason to feel smug there.

Latvia (from Economist website

Ailing fast

Oct 7th 2009
From Economist.com


Bad news from Latvia raises fears of contagion across eastern Europe

THE patient emerges from intensive care, hurls the medicine at the doctors and bites his blood donor. That may be an unfair characterisation of the recent news from crisis-stricken Latvia, but it is pretty much how outsiders see it. The prime minister, Valdis Dombrovskis, is refusing to make the spending cuts mandated by international lenders and has floated a new law that would partially expropriate foreign banks’ loan books.

It would be worrying enough if the European Union’s weakest economy defaults, devalues or implodes. But what scares outsiders more is the effect of Latvia’s latest wobble on other ex-communist economies, which until this week seemed to be surviving the financial crisis with less trouble than some had feared.

In recent weeks, the news from Latvia had seemed mildly encouraging, after a year during which the country has been kept afloat thanks to an $11.1 billion international bail-out. The breakneck decline has slowed: the economy is expected to contract by 17.5% this year, but by only 3% in 2010 and to return to growth in 2011, according to a forecast by SEB, a Swedish bank (and big lender to Latvia). The current account, which showed a yawning deficit of 1.42 billion lats ($3 billion) in the first seven months of last year has been transformed to show a 581m lats surplus in the same period of 2009.

The main outstanding issue is next year’s budget deficit. International lenders had softened the target to a mere 8.5% of GDP; the government still had to push through spending cuts of 500m lats to meet this.

But this week Mr Dombrovskis startled outsiders by saying that cuts of only 225m lats would be necessary. He has pencilled in a further 100m lats in better tax revenues—counting, apparently, on a faster economic recovery than anyone expects. The hesitation has brought stern warnings. Sweden’s finance minister, Anders Borg, said outsiders’ patience was “limited”—his country is due to provide SKr10 billion ($1.45 billion) in a loan tranche in early 2010. The EU’s monetary affairs commissioner, Joaquín Almunia, has publicly rebuked the government too. Mr Dombrovskis has now backtracked, saying that if the cuts are necessary, they will be made.

But doubts remain. Mr Dombrovskis lacks the authority to push tough measures through parliament and his public wobble could be seen as an attempt to summon up another burst of international pressure on the government to do the right thing. If so, it is risky.

The same could be said about another of Mr Dombrovskis’s moves—calling for a draft law that would restructure domestic assets of foreign banks. Borrowers would be liable only for the collateral value of their loan (eg, a house bought with a mortgage) rather than the whole amount. Banks would also be unable to evict defaulters from their homes without rehousing them. A fall in property prices of over 50% has sent Latvia’s private-sector debts to foreigners ballooning. They will need restructuring eventually. But this proposal looks unworkable, clumsy and damaging. Shares in Nordic banks, which have been the biggest private-sector lenders to Latvia, dipped on the news.

If Latvia fails, with a strike by international lenders prompting a debt crisis or a bank run, the spotlight then turns to the neighbouring Baltic states of Estonia and Lithuania. They are not in the same political mess, but both have also pegged their currencies to the euro and are facing huge and painful adjustments. Some wonder if the EU might accelerate its recognition of Estonia’s impressive progress in sorting out public finances by giving it early approval of its plans to join the euro in 2011. But where would that leave Lithuania, which is nowhere near balancing its books and borrowing expensively from private lenders instead of turning to the IMF?

An even bigger question involves the future co-operation between the IMF and EU. They worked together closely during the emergency rescue of Latvia in December. Now ties are strained: the IMF thinks Latvia should devalue its currency. EU officials are determined that it should not, for fear of the wider effect on ex-communist countries that are trying to join the euro zone. That has led the EU to squeeze the IMF into accepting softer conditions on Latvia than it would have wished for. For all those involved, in Brussels, Washington, DC, and Riga, patience is running out.

Baltic turnaround?

Baltic economies

Feeling a bit fragile

Sep 24th 2009
From The Economist print edition

A Baltic meltdown has been averted, but the gloom may yet last a bit longer

WORRIES about a financial meltdown across eastern Europe have receded, thanks to generous outside support, some canny policies and the start of a recovery in western Europe. Poland, the region’s biggest economy, has managed to avoid recession altogether. But even the worst-hit countries are breathing more easily.

This week Moody’s, a rating agency, noted a “fragile stabilisation” in the three most vulnerable: Hungary, Latvia and Iceland. Some mildly encouraging signs are visible. Thanks to plunging imports, and foreign investors refinancing local subsidiaries, Latvia’s second-quarter current account showed a surplus of 14.2% of GDP. A year ago it was a 15.1% in deficit. The economy shrank by a grim 18.7% year-on-year, but the worst seems to be over and some industries are picking up.

The slowdown has hurt the banks, which have lost nearly $1 billion this year. That is a big hit for the shareholders, mainly Nordic, whose managers lent so recklessly. But contrary to expectations, only one big local bank had to be rescued and nobody has pulled out. Doomsters who forecast bank runs and devaluation in Latvia (followed by Estonia and Lithuania, which also have currencies pegged to the euro) have little to show for their gloomy prophecies.

Yet Latvia, in particular, is still in an economic and political mess. It survives because outside lenders, chiefly the European Union and the IMF, think it worth propping the country up with smallish loans (by bail-out standards). The European Commission lent €1.2 billion ($1.8 billion) in July, following an IMF-led €7.5 billion agreement in December. In theory, the money is conditional on spending cuts and tax rises. The IMF agreed, reluctantly, to a budget deficit of 8.5% of GDP in 2010, down from 10% this year. The measures have been striking: some civil servants’ pay is down by a third. But that followed big rises during the boom years.

The real shortcoming is that Latvia’s squabbling politicians have ducked deeper changes in the public sector and the civil service. The People’s Party, supposedly part of the ruling coalition, says it may block a planned property tax. The government promised its lenders it would implement this, but it has to secure support in parliament. Some senior politicians in the People’s Party want to swap the currency peg for a band. The EU’s monetary affairs commissioner, Joaquín Almunia, lectured the Latvian prime minister, Valdis Dombrovskis, recently about the need for “national consensus” behind the austerity plan. But the prime minister cannot crack the whip over his coalition’s powerful party chiefs, who prefer carping about government policies to voting for them.

Outsiders find Latvia’s politicians unimpressive and exasperating. But they are unwilling to cut the country adrift or to push it into a devaluation. Turmoil in Latvia could easily spread to the neighbours, or even to Hungary (see article). Latvia’s biggest asset is its neighbours’ popularity, says one weary international banker. Foreign money may plug the public finances for a bit and so avert disaster. But it is not a recipe for prosperity. Latvia did not solve its growth-choking problems, such as corruption and poor public services, when times were good. Nor is it solving them when they are bad.

CEE economics

Central and Eastern Europe

No panic, just gloom

May 14th 2009
From The Economist print edition

The region as a whole may have avoided economic meltdown, but several countries still face a painful slump

THANKS to a mix of luck and good decisions, the economic apocalypse that loomed over central and eastern Europe seems to have been averted. But dizzy current-account deficits, wild foreign-currency borrowing and reckless fiscal policy are leaving a horrible hangover for some. The IMF forecasts a 4.9% average fall in GDP, with far bigger falls for some. The European Bank for Reconstruction and Development (EBRD) reckons on a 5.2% drop. The downturn is certainly nasty; but some changes have staved off the worst.

One change is that outsiders now assess risk more calmly and rationally. All the former planned economies remain capital-thirsty. But otherwise they are all different. Indeed, a rare common factor among 20-odd countries in the region with the “ex-communist” tag is that they dispute its relevance. Tarring all with the mistakes of overheated Latvia, chaotic Ukraine or debt-sodden Hungary makes no sense. Nor does lumping together rich and poor countries, or those in the European Union and those outside. Exchange-rate regimes vary: two countries are in the euro; five countries have pegged their currencies to it; others float.

So far at least, speculators who counted on contagion toppling countries like dominoes have little to show for it, while those who bet the other way have juicy gains. Poland’s stockmarket is up by nearly 40% since its low in February, Hungary’s has risen by half and Russia’s by nearly 90%.

Outside help is also now better co-ordinated. The previously standoffish IMF co-operates with the European Commission, national governments and the banks. Once seen as a lender of last resort, it now acts pre-emptively. In May it gave a $21 billion credit line to Poland, the biggest and strongest economy in the region. That is quite different, officials stress, from the emergency rescues of Belarus, Latvia, Hungary, Romania, Serbia and Ukraine.

The IMF is also behaving more gently. Ukraine was originally told to balance its budget this year. Now the IMF says a deficit of 4% of GDP is realistic; this month it released its latest $2.8 billion tranche. Officials are uneasy about insisting on fiscal tightening that may aggravate recession. Latvia is likely to be allowed to run a 7% deficit for this year—in return for promising, really and truly, to reach 4% in 2010.

A third change is that more aid has been given to western banks that face souring loans, typically to clients in Hungary and the Baltic states who borrowed in euros or Swiss francs. As outsiders cut back, a credit squeeze is threatening even healthy borrowers. A joint initiative by the EBRD, the World Bank and the European Investment Bank (which used to lend only to state-backed infrastructure projects) has raised $24.5 billion for banks and other firms across the region. The EBRD is putting €432m ($590m) into UniCredit, an Italian bank heavily exposed in eastern Europe. It is thinking of investing in 12 other west European banks. Countries such as Sweden have national schemes too.

In a new report, the IMF argues that European banks still need a lot more help. But the cash and guarantees given already have eased the greatest threat to the region: that western banks might pull out or sink under the weight of their eastern loan books. Meanwhile central Europe, home of many big car factories, has gained from rich-country governments’ efforts to help their car industries. Neil Shearing of Capital Economics, a consultancy, reckons that German and other scrapping schemes to boost car sales will add fully 1% to GDP in Slovakia, and 0.5% in the Czech Republic and Hungary.

The biggest worry now is the Baltic three, which are seeing the sharpest falls in GDP. Estonia’s first-quarter figures showed a year-on-year decline of 15.6%. The fall in Latvia was a stunning 18% and in Lithuania 12.6%. Monetary policy cannot counteract this, since all three are pegged to the euro. And fiscal policy offers no respite. Politicians are pushing through spending cuts, not only to reassure external lenders, but also to meet the Maastricht deficit target of 3% of GDP so as to adopt the euro soon (by 2011, Estonia hopes).

“The crisis is even good if it makes the state more efficient,” says Andrus Ansip, the Estonian prime minister, who is cutting overall public spending by nearly 12%. He has slashed a fifth of the posts in his own chancellery, he says proudly. “Inefficient” spending will be cut; budgets vital for future growth will be preserved, he insists.

Devaluation is still largely taboo in the Baltics. The national currencies are not just economic symbols of solidity, but political ones too. Instead, they hope to regain competitiveness through wage cuts and greater efficiency. Such an “internal devaluation” is possible in theory, but it is unusual (and painful) in practice. It may work: Latvia now has a current-account surplus as its exports rise. Outsiders are awed by the Balts’ determination, though sceptical that the sacrifice will pay off.

Still, while industries such as construction collapse, others, such as alternative energy, are growing. Mr Ansip cites Estonia’s niche in windpower technology. In Latvia a firm called Carbon Neutral Biofuels has raised money for a $10m plant to turn low-grade wood into fuel pellets for Dutch power stations. Adrian Riley, the boss, says the crunch is “a return to reality after a period of acute silliness” when high costs threatened his project’s viability.

The Baltics may be a special case: small, relatively well run, with flexible economies and friendly Nordic neighbours. The broader worry across the region is political. Street protests have been muted so far, and some anger against the smug, corrupt and incompetent politicians who squandered the chances of the past decade is anyway healthy. But the European elections in early June may show how voters are reacting to hard times.

Government crises have not brought big changes. The Czech Republic’s centre-right coalition lost its majority in March amid a row with the headstrong president, Vaclav Klaus. But the result has not been chaos. Until elections in October, a competent-looking caretaker government will run the country, headed by the chief statistician, Jan Fischer. In Hungary a discredited Socialist prime minister, Ferenc Gyurcsany, resigned, nominating an economist, Gordon Bajnai, to run the government until an election next spring. He is pushing through tough spending cuts, with GDP likely to fall 6% this year.

Ivan Krastev, a Bulgarian-based analyst of the region’s politics, says the fear of unemployment will disillusion middle-class voters and stoke protest voting. A bigger problem may be the fear among political elites, some of whom will stick at nothing to stay in power and out of jail. “The model is Berlusconi,” he says glumly.

Polish economy

Poland's economy

Not like the neighbours

Apr 23rd 2009 | WARSAW
From The Economist print edition

Most east European economies look sickly, but not Poland—so far

A LOT like South Korea, a bit like Mexico and not at all like its neighbours. That is how Poland wants to be seen after it set up a $20.5 billion credit line from the IMF. This was not a bail-out like those for Ukraine, Hungary and Latvia. It was a precautionary and unconditional overdraft offered only to top-quality borrowers, say officials. The only other country to get similar treatment is Mexico.

A more flattering comparator is South Korea which, like Poland, has let its currency slide, while shunning the deficit-swelling policies of Britain and America. The zloty has fallen by 30% from its peak. The central bank has cut interest rates from 6% in October to 3.75%. Poland faces the crisis in a stronger position than many. Krzysztof Rybinski, a partner at Ernst & Young in Warsaw, points to consumption of 61% of GDP in 2008, close to Western levels. Rapid wage growth and low debt make consumers more robust.

This is partly luck. An overly tight monetary squeeze early in this decade headed off an asset-price bubble. Bureaucratic government checked the property boom; so did tough bank regulation that restrained the borrowing, chiefly in foreign currency, that plagues Hungary. “The things that you criticised Poland for in the past are now proving a blessing,” says a senior official.

The government’s gloomiest forecast is of a rise in GDP this year of 1.7%. Neil Shearing of Capital Economics thinks GDP is more likely to fall by 3%. Unemployment, swollen by returning migrants from western Europe, is already 11.2%. Exports have stalled. Industrial production in the first quarter was down by a tenth on a year ago. Ill-considered currency hedges have hit some firms. Tax revenues are sagging. The government’s efforts to prepare for euro entry by 2012 look “fairly futile”, says Mr Shearing. He thinks 2015 is more realistic.

Yet firms that survived the bureaucratic and other problems of the past 20 years are a resilient lot. Krzysztof Sklorz, whose Katowice-based company exports bricks and tiles, says zloty instability is a problem. But, he adds, “I took out a loan in euros and that’s what my clients pay me in as well, so that’s all right.” Unconsciously echoing Schumpeterian notions of creative destruction, Jozef Przyblya, a hotelier in another Silesian town, Pszczyna, says the crisis has weeded out the “weak and reckless”. The strong euro brings new guests from Germany and even Slovakia (now in the euro). One survey found that over 60% of big firms plan new investment this year. German subsidies to car buyers have stoked demand at Polish factories.

Unlike others in eastern Europe, Poland’s government is strong and stable. But its main contribution, says Marcin Piatkowski, a former IMF economist now at Warsaw’s Kozminski Academy, has been “brilliant PR”. Downplaying the crisis has been good for confidence, but doesn’t help promote much-needed reforms, he notes. One such is of bureaucracy: Poland comes 76th in the World Bank’s ranking for ease of doing business, below Kazakhstan. Mr Rybinski calls this “shameful”.

At least limited reforms to health care, pensions and the labour market are under way. One excuse is that President Lech Kaczynski vetoes laws put forward by a government he detests. Yet by the standards of the region, both Poland’s politics and its economy look pretty good.

Baltic economics

[sorry for lack of activity. I am taking longer than expected to get over my hospital excursion]

The troubled Baltics

Still afloat in the Baltic, just

Apr 8th 2009 | TALLINN
From The Economist print edition

The three Baltic economies face a spiralling economic downturn

ONCE the fastest-growing economies in Europe, the three Baltic countries are now the opposite. Latvia, which in December received a €7.5 billion ($10 billion) bail-out led by the International Monetary Fund, is basing its budget on a 13% decline in GDP. Estonia and Lithuania expect a decline of a tenth. A conventional response might be devaluation and fiscal stimulus. But the Baltics’ currency pegs to the euro are a matter of national pride. Moreover, most private borrowing is in euros, so devaluation would mean beggary for many. Instead, the response has been wage cuts meant to regain competitiveness.

Fiscal stimulus is tricky too. Estonia ran a budget surplus during the boom, so has some room for manoeuvre, but even it can risk only a deficit of 3% of GDP permitted by the rules for joining the euro. All three countries want to adopt the single currency as soon as possible, though not by bending the rules: the whole point is to gain credibility, not to enter the club “on a stretcher”, as one official puts it. But as economies shrink, it gets harder to meet deficit targets. Latvia’s new government has been haggling over a 5% ceiling agreed with the IMF, missing last month’s €200m instalment of the bail-out as a result.

The Baltics have no shortage of external support. The European Bank for Reconstruction and Development this week agreed to bail out Parex, a Latvian bank. The IMF has more money to help. But the economic adjustments are still unimaginable in old Europe. Having soft-pedalled reform after joining the European Union, the Baltics now have to make up for lost time, in a climate where they are perilously exposed to the global downturn.

Belatedly, some progress is visible. Inflation and current-account deficits are falling. Latvia has begun unpicking a network of sinecures in nationalised industries. But overdue reforms such as simplifying local government in Estonia are still on hold. Yet compared with the polarised politics and debt-soaked economy of Hungary, the Baltics’ outlook is not bad. None of the three is much exposed to the international financial markets. Their stocks, bonds and currencies are thinly traded. Most of their external debt is owed by local bank branches of Swedish parents. Bits of those loan books have soured, particularly in property and construction. But other parts are still sound. So long as the Scandinavian banks stand by their investments, the Baltics should be all right.

Public protests have been muted and peaceful except for two bust-ups in Lithuania and Latvia. Estonia’s politics look the most solid, with a well-regarded coalition government. Latvia’s government, in office for just a month, is more broadly based than its predecessor and has shed some incompetent figures. Lithuania faces a presidential election in which the front-runner is the EU budget commissioner, Dalia Grybauskaite. Her financial skills may soon be tested, since after the election Lithuania may well turn to the IMF for help.

Belatedly, some progress is visible. Inflation and current-account deficits are falling. Latvia has begun unpicking a network of sinecures in nationalised industries. But overdue reforms such as simplifying local government in Estonia are still on hold. Yet compared with the polarised politics and debt-soaked economy of Hungary, the Baltics’ outlook is not bad. None of the three is much exposed to the international financial markets. Their stocks, bonds and currencies are thinly traded. Most of their external debt is owed by local bank branches of Swedish parents. Bits of those loan books have soured, particularly in property and construction. But other parts are still sound. So long as the Scandinavian banks stand by their investments, the Baltics should be all right.

Public protests have been muted and peaceful except for two bust-ups in Lithuania and Latvia. Estonia’s politics look the most solid, with a well-regarded coalition government. Latvia’s government, in office for just a month, is more broadly based than its predecessor and has shed some incompetent figures. Lithuania faces a presidential election in which the front-runner is the EU budget commissioner, Dalia Grybauskaite. Her financial skills may soon be tested, since after the election Lithuania may well turn to the IMF for help.

Europe view 124--time to boycott France?

Europe.view

Plus rien de français?
Mar 26th 2009
From Economist.com


Skoda, blancmange and the price of principle

FRENCH politicians seem to see no benefit from economic integration with eastern Europe. The industry minister wants to “repatriate” jobs from Slovenia. President Nicolas Sarkozy says it is unacceptable that French manufacturers make cars for the French market in the Czech Republic.

That may just be rhetorical pandering to the protectionist views of the French public. But it is still offensive to the east Europeans, and could prompt a severe response—such as a boycott of French-made products.

Since 1989, the ex-communist countries have played by western rules. They have stabilised, privatised, liberalised, and opened up—the kind of wrenching economic reform that is the stuff of nightmares for the cosseted workers of old Europe. True, the easterners could have gone further (especially in reforming public finances, state bureaucracy and education). With pitifully little debate, they had to swallow a colossal (and largely French-drafted) European rulebook, with an array of stupid and unpleasant rules and penalties for breaking them, on everything from sugar prices to school kitchens.



While countries such as Britain sit neurotically on the sidelines, the new members yearn to gain admission to EU clubs such as Schengen (visas), Prüm (policing) and of course the euro zone.

That was in these countries’ own interest. Paying a price to be in the clubs that matter was better than staying outside. Yet the easterners’ feel their enthusiasm and cooperativeness have met little gratitude in the west. Their occasional bouts of chippiness and clumsiness are blown out of all proportion. The failure of Romania and Bulgaria to meet anti-corruption targets has tainted the whole region’s image. The Atlanticist loyalties of the new members have been mocked and distrusted.

France was in the forefront of such criticism, and also led the resistance in “old Europe” to the extension of the single market to labour and services. The new member states are still second-class citizens of Europe when it comes to working abroad or exporting their brainpower.

Now France is close to a head-on clash with the fundamental principles of the single market in goods. The next stage could be preferential treatment of domestic producers in government tenders. After that, it is easy to see a slide towards real protectionism in Europe. With the economic glue that holds the EU together weakening, the political links will fray too. In a race to the bottom, the biggest and richest countries will do best (or least badly). The poorer and smaller ones will be left humiliated, impoverished and resentful.

It would be rash to rely on the competition directorate and EU law to stop this dangerous drift. Much better would be to apply a sharp dose of economic pressure. Stroppy French workers may not realise it, but the ex-communist countries are one of their country’s biggest export markets. Renault, for example, sells more than 1m vehicles in eastern Europe. In 2008, France exported €21 billion ($28.5 billion) to the new member states of the EU (compared with €23 billion to the United States).

Boycotting all “French” goods would be a blunt instrument. Many French-badged cars are actually made in places like Poland. And many French-made products are not easily substitutable (Lithuanian šampanas has its charms, but even its die-hard fans don’t quite consider it an alternative to champagne).

But a slogan on the lines of “Aux armes, citoyens de la nouvelle Europe! Plus rien de Français!” would deliver a timely message. Georgian wine, Hungarian foie gras, Polish salami, Skoda cars, Italian fashion and skiing in Slovakia are all alternatives to the French-made offerings. Even—if you want to be really insulting—British cuisine.

europe view column

Europe.view

Put the beam before the mote
Mar 12th 2009
From Economist.com


Eastern Europe should not be tempted by paranoia

WAS it all a conspiracy? It is not the first time in east European history that the question has been asked. Wicked western manipulators were a staple of communist-era propaganda. Before that, anti-Semitic politicians used to blame Jews (and Freemasons) for manipulating the destiny of other countries. In the 19th century, the German, Austro-Hungarian, Czarist and Ottoman empires kept almost the whole region from the Baltic to the Black seas divided up between the great outside powers.

Now the conspiracy theory is back again. Somebody was spreading rumours. Somebody with foreknowledge or malevolent intent was shorting currencies, stocks and bonds. Someone was using sinister-sounding financial instruments such as credit-default-swaps so that whatever happened, they would profit from a panic. These somebodies could be anywhere, but they are certainly foreign.

Or maybe it is all a plot by Germans to push the Austrian banks into bankruptcy so that they can buy them up cheaply. Or maybe it is a means for “old Europe” to destroy the competitive threat from the unloved “new Europe”. Or a French-German plan to create a core Europe round the euro zone, excluding the troublesome countries farther east. Or it is all some super-clever plot by the ex-KGB regime in Russia, details to be announced later. All that is missing is hook-nosed men in ringlets drinking the blood of Christian children.

The truth is more prosaic. Financial markets are usually wrong, often hugely so. When greed trumps fear they are over-enthusiastic, believing all kinds of positive nonsense and pouring money into dodgy companies and countries. Then the tide turns and they overreact, dumping perfectly good assets in an attempt to get their books in order.

Anyone tempted by the idea that outside conspiracy is to blame for eastern Europe’s woes should first reflect on the past. Was it an outside conspiracy that led supposedly sane Western institutions to lend tens of billions of dollars to Russian companies notable for their weak corporate governance and cash-splattered business models? Was it a western conspiracy that made supposedly sane people buy homes in derelict rural slums in Bulgaria in the belief that it was the new Dordogne? Was it a Western conspiracy that equated the reforms that were promised in the run up to European Union membership with actually making government transparent and efficient?

The right word for this is not “conspiracy”. Something like “groupthink” or the “madness of crowds” would be a better term. In any market movement, there will always be people who profit by betting against the herd. The wise investors who bailed out of the Russian short-term treasury bill market in early August 1998 made a packet. Those who stayed in lost a fortune. They left for the airport, in one case vowing that they would rather “eat nuclear waste” than invest in Russia again.

Conversely, savvy investors who bought at the bottom of the market in late 1998 have done well. A few years later nuclear waste was back on the menu, as investors praised the stability and prosperity of Vladimir Putin’s regime and guzzled anything in sight. Anyone who said that the good times came from rising oil prices rather than real reform was drowned out in a chorus of hurrahs. Again, some people sold their Russian assets in time. No conspiracy there, just foresight, or luck.

As so often with market downturns, the pain and unfairness now seem intolerable. It may perhaps be some consolation that the gloomiest and most ignorant outsiders are those most likely to lose out.

earlier leader (editorial) piece on CEE

Eastern Europe

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

Correction to this article

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 [bad wording here--I meant for Hungarian and Polish households, not Czech ones.EL]. Some countries have an extra problem of big external government debts (in Hungary’s case, the gross figure is near 100% of GDP)[another mistake, I meant gross as in private and public combined]. 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.

Briefing (three-pager) on CEE Economies

Having dropped everything because of the libel suit, I undropped it all briefly to write this piece which actually came out a week ago. Sorry for not posting it earlier

Ex-communist economies

The whiff of contagion

Feb 26th 2009
From The Economist print edition

Eastern Europe’s woes are not unmanageable. But they are not being managed. The result could be catastrophe

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Correction to this article

Sarah Hanson

AMID the wreckage of Latvia’s retailing industry, which has declined 17% year on year according to the latest figures, one item is selling well: T-shirts with seemingly mysterious slogans such as “Nasing spesal”. Latvians are glad to have something to laugh about, even if it is only their finance minister, Atis Slakteris. In an ill-judged foreign television interview, using heavily accented and idiosyncratic English worthy of the film character Borat, he described his country’s economic problems as “nothing special”.

Put mildly, that was an original interpretation. Fuelled by reckless bank lending, particularly in construction and consumer loans, Latvia had enjoyed a colossal boom, with double-digit economic growth and a current-account deficit that peaked at over 20% of GDP. Conventional wisdom would have suggested applying the brakes hard, by tightening the budget and curbing borrowing. But the country’s rulers, a lightweight lot with close ties to business, rejected that. Fast economic growth made voters feel that European Union membership was at last producing practical benefits, after a disappointing start when tens of thousands of Latvians went abroad in search of work, leaving rural villages and small towns depopulated.

The central assumption, in Latvia and many other countries in or near the EU, was that convergence with rich Europe’s living standards and other comforts was inevitable. Lending in foreign currency went from 60% of the total in 2004 to 90% in 2008. Why pay high interest rates in the local currency, the lat, when the cost of a euro loan was so much cheaper? In a few years Latvia would surely join the euro anyway. Similarly, worries about financing the inflows were dismissed: Swedish banks would no more abandon their subsidiaries in Latvia than they would pull out of, say, southern Sweden.

Last year tested those assumptions nearly to breaking point. First, Latvia’s housing bubble popped. Then the main locally owned bank, Parex, went bust and had to be nationalised, amid fears that it could not pay two syndicated loans due this year. In December Latvia accepted a humiliating €7.5 billion ($9.56 billion) bail-out led by the IMF.

The big cuts in social spending that the package entailed led to vigorous public protests. Now the government has resigned. At a time when strong leadership and public trust are needed more than ever, the country’s squabbling and discredited politicians look hopelessly out of their depth. Latvia is an economic pipsqueak, with just 2.4m people. But the rest of the region is watching nervously, fearful that more bad news from the Baltics could bring others crashing down too.

It is easy to be pessimistic. This is indeed the worst economic crisis since the collapse of the communist planned economies and the wrenching process of privatisation, liberalisation and stabilisation that followed. The main ex-communist economies are likely to contract by 3% this year, according to Capital Economics, a consultancy. Yet the picture is not uniform.


Only a few countries have needed an IMF bail-out. One is Latvia, whose economy is set to contract by at least 12% this year, and whose credit rating has just been downgraded by Standard & Poor’s to junk. Another is Hungary, burdened with a larger debt-to-GDP ratio than almost any other new EU member. It received $25 billion in October and faces a contraction of up to 6%. A third is Ukraine—chaotically run, corrupt and badly hit by the slowdown in its main export market, Russia. Ukraine’s IMF deal brought it $4.5 billion in November. But a second tranche of $1.9 billion is stuck; the deal is unravelling as politicians squabble over spending cuts. Its economy is likely to shrink by 10% this year. Other countries with IMF packages agreed or pending include Belarus (a Russian ally which is still expected to see growth this year), Georgia (which was bailed out after last year’s war with Russia) and Serbia.

Most other countries in the region are faring much better, though. Poland—by far the largest economy of the new EU members—is nowhere near collapse. Unlike its central European neighbours, it is big enough not to depend chiefly on exports to the rest of the EU. By European standards, its public finances are in fairly good shape. Its debt-to-GDP ratio is below 50%. Growth will be negligible, or slightly negative, but nobody is forecasting a big decline. Some Polish firms and households have taken out foreign-currency loans—but the figure is around 30% of all private-sector lending, compared with twice that in Hungary.

The second-biggest economy, the Czech Republic, is in good shape too. Its economy may shrink by 2%, but it has a solid banking system and low debt. Its neighbour Slovakia is in better shape still: it managed to join the euro zone this year. Like Slovenia, which joined two years ago, Slovakia can enjoy the full protection of rich Europe’s currency union, rather than just the indirect benefit of being due to join it some day.

Farther afield, the picture is very different. For the poorest ex-communist economies, the problem is not financial meltdown. They lack much to melt. Their exports are raw materials, agricultural products and people. In six countries, money sent home by foreign workers counts for more than 10% of GDP (in Tajikistan and Moldova it is more than 30%). Outsiders who agonise over the Latvian lat or Hungarian forint are rarely bothered with worries about the somoni (Tajikistan), leu (Moldova) or manat (Turkmenistan).

That highlights an important problem. Outsiders tend to lump “the ex-communist world” or “eastern Europe” together, as though a shared history of totalitarian captivity was the main determinant of economic fortune, two decades after the evil empire collapsed. Though many problems are shared, the differences between the ex-communist countries are often greater than those that distinguish them from the countries of “old Europe” (see table).

They range from distant, dirt-poor despotic places to countries in the EU that are not just richer than some of the old ones, but have better credit ratings, sounder public finances and stronger public institutions. In almost any contest for good government, stability or prosperity, Slovenia (under a sort of communism until 1991) looks better than Greece, which invented democracy and was never communist.

The thirst for capital

Historical and geographical quibbles aside, what the ex-communist countries have shared over the past decade is a mighty thirst for capital. Having missed out on decades of growth and integration with the outside world, almost all (a few oddballs in Central Asia aside) are trying to catch up. Money from abroad has come in from borrowing on the bond market, from foreign direct investment or from selling shares. Most often it has come through bank loans.

At one extreme is Russia, which enjoyed huge external surpluses thanks to its wealth of raw materials. But its big companies borrowed lavishly on the strength of that, creating a potential short-term debt problem. Russian corporate borrowers have to pay back around $100 billion this year. At the other extreme lie countries such as Slovakia. They attracted billions from foreign car manufacturers, drawn by a skilled workforce, low taxes and decent roads in the heart of high-cost Europe.

Countries that relied chiefly on foreign direct investment are the least vulnerable now. The new factories may shut down. But it is harder for that capital to flee. Those that rely on foreign investors buying their bonds, such as Hungary, are the most vulnerable: their fortunes vary with every twitch of a trader’s fingers. In the middle are those that rely on lending from foreign banks to their local subsidiaries. That looked solid in the boom years, as Western banks scrambled to win market share by offering good terms to borrowers and lenders in the fastest-growing bit of Europe. It is still highly unlikely that any Western bank will pull the plug on a subsidiary anywhere—even in troubled Ukraine.

But nerves are jangling. The ex-communist countries have survived the first phase of the crisis, thanks to their own policies and some external support. The second phase, in which the rich world is turning stingier and possibly more protectionist and lenders are scurrying to safety, may be harder. The ex-communist economies must repay or roll over a whopping $400 billion-odd in short-term borrowings this year. Coupled with the lazy but easy lumping of nearly three dozen countries together, that creates the region’s biggest danger: contagion (see article). In other words, failure in one place sparks a disaster in another, even though it may be far away and have the same problem in a far more manageable form.

Contagion could happen in many ways. One is if depositors lose confidence that their savings are safe. So far, Western-owned banks have enjoyed rock-solid credibility: more so, in many cases, than governments or other public institutions. But that confidence could be undermined. If only one foreign bank pulls the rug from under one local subsidiary, leaving depositors stranded, it will cloud perceptions of banks’ reliability across the region. The most dangerous kinds of bank runs would be those in which depositors try to pull out either their foreign currency, or local currency which they would then attempt to convert into hard currency. In some countries that could overwhelm the ability of the central bank to support the financial system.

Another weak point is where shareholders take fright. If a foreign bank with big exposure to the region—Swedish, Austrian or Italian—needs to raise more capital but finds that outsiders think its loan book is too risky, what happens? The price of rescue may be that it sheds a troubled foreign subsidiary. Signs of shareholder twitchiness are growing (see chart).

For now, the most likely source of contagion is collapsing currencies. The paradox is that for countries with floating exchange rates, an orderly depreciation would in normal circumstances be a good way of cushioning an external shock, such as the slump in export markets now hitting the ex-communist economies. It stokes competitiveness and, along with lower interest rates, it lays the foundations for a return to growth. Governments with sound public finances might also consider running a looser fiscal policy to counteract the downturn.

Propping up the currency

For most of the countries in the region, such a textbook response is out of the question. Some have currency boards, or pegged exchange rates. In the Baltic states these have been the centrepiece of economic policy for more than 15 years. Abandoning them would not only bankrupt big chunks of the economy that have borrowed in euros. It would also be a huge psychological blow to public confidence in the whole idea of independent statehood. These countries have suffered the most painful part of being in the euro zone—the inability to devalue and regain competitiveness—without getting all the benefits.

Countries with floating exchange rates have a bit more room for manoeuvre. Their problem (a big one in Hungary, a lesser one in Romania and Poland) is that falling exchange rates may bankrupt the firms and households which have, in past years, taken out unwise loans in foreign currencies, chiefly euros and Swiss francs. That was, in effect, a convergence play. If you believed your country was heading for the euro zone some time in the next few years, then why not take advantage of the low interest rates there, rather than suffer the higher ones in your domestic currency?

What seemed a minor risk back then now looks painfully mistaken. For those earning forints or Polish zloty, the big swings in exchange rates in recent weeks have sent the size of both loans and repayments spiralling upwards. The zloty has dropped 28% and the forint 22% against the euro since the middle of last year. If the East Asian crisis of 1997 is any guide, these and other currencies may yet have further to fall.

This risk of a currency collapse will limit these countries’ options. So far many big central European countries have cut interest rates heavily to try to boost their economies—Poland’s central bank cut its policy rate again this week. But currency weakness will limit their room for manoeuvre. The Czech, Hungarian and Polish central banks issued a co-ordinated statement this week hinting they might intervene to support their exchange rates. But that route is tricky. Russia has blown half its reserves in a series of unsuccessful attempts to try to prop up the rouble.

Spending and tax policies would be another way of dealing with a downturn. But these are constrained, too. Those countries with a chance of joining the euro are scrambling to cut their budget deficits to get them in line with the 3% of GDP target set by the EU’s Maastricht treaty. Yet that aggravates the problem. The danger for Latvia and Ukraine is a downward spiral, where cuts in public spending damage the economy in a way that helps to entrench the deficit.

So far, the economic crisis has not translated into populist or protectionist politics. It is the east European countries that have been demanding that the rest of the EU stick by the rules of the single market. Their development over the past decades has been thanks to the free movement of capital, goods and labour. They would like a lot more of it: in a contest to subsidise industries, rich countries always win.

But that stance will not hold indefinitely if things get worse. Willem Buiter, a prominent economist, believes it is only a matter of time before some of the ex-communist countries introduce capital controls. That, in theory, would allow them to concentrate on stabilising their economies without worrying so much about the external value of their currency. If voters find the economic pain of adjustment unbearable, politicians can pass laws that will make foreign-currency borrowings repayable in local currency. That would be met with fury by the foreign banks, who would in effect see their loan books expropriated. But it could happen.

Against that background, what can be done? The east European countries are, belatedly, co-ordinating their approach within the EU, holding their own mini-summit on March 1st. They want to embarrass countries such as France for what they see as its protectionist approach to the crisis. They are supporting each other: the Czech Republic and Estonia were among those contributing to the Latvian bail-out.

But even co-ordinated local efforts are unlikely to make much difference, given the scale of the problem. The real lead, and the real money, must come from outside the region. That brings into play a slew of political problems. Having trumpeted their free-market principles in past years, and dismissed the stodgy approach of countries such as Germany and France, the new EU members from eastern Europe are now turning to old Europe in the hope that it can hurry up the flow of EU structural funds to counteract the downturn, bail out or prop up over-exposed banks in places like Austria, and stretch the rules of the European Central Bank to let it provide support to countries outside the euro zone. The case for such measures is strong, and it is in the interest of all Europe that contagion is contained. But that does not mean that it will happen.

Europe View

Europe.view

Open sore

Feb 5th 2009
From Economist.com

Unintended consequences of modernisation

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FIRST the financial crisis, then the economic one, then—soon—a social one, and after that a political one. The world economic crisis is hitting the countries of eastern Europe particularly hard. Events such as devaluations, ratings downgrades and shocking economic statistics that would be front-page news in normal times barely make it into a preoccupied world media.

It would be nice to say that the countries that followed the right (ie Western-mandated) policies in past years are surviving reasonably well, while naughty ones that failed to finish their homework are suffering. That’s true up to a point. Reckless policies (especially in the big ex-Soviet countries) are punished particularly hard. Prudent Estonia squirreled away a cushion of savings in good times that will make it a bit less vulnerable than its Baltic neighbours to the south.

The much bigger lesson is that what once looked like the right thing now seems to have been either useless or outright dangerous. As Katinka Barysch, of the Centre for European Reform, a think-tank, points out in a new paper*, the ex-communist countries now in the European Union have made themselves particularly vulnerable thanks to their energetic adoption of open economic policies.

First, they are hugely dependent on exports—close to 100% of GDP in some cases. Foreign trade is a fine thing. It brings in investment from outside and creates a wonderfully competitive environment at home. But when the export markets crash, the effect is immediate.

Secondly, the kind of foreign trade was particularly risky: these countries integrated into the global-supply chain in industries such as electronics and cars, which are proving far more cyclical than anyone suspected. That may prove a near catastrophe for a country such as Slovakia, which is one of the world’s top producers (on a per capita basis) of cars and car parts.

Even worse, it is the auto industry where politics is playing a role in the new era of bailouts. In theory, cash-strapped vehicle producers should be favouring low-cost locations as they try to cut costs. That would mean more investment in Slovakia and Hungary, but cut-backs in high-cost France and Germany. But the rich-Europe bailout packages include clear conditions: save the jobs at home.

Selling the banking system to outsiders is proving to be another vulnerable area. In the 1990s, that looked like pure common sense. Local banks were wobbly and sometimes outright dodgy. Foreign banks promised modernisation and a big capital base: just what an emerging economy needed. For a time that proved a huge success. Foreign banks drove down borrowing costs for firms and households who wanted to borrow, provided attractive investment vehicles for those who wanted to save, and made juicy profits in the process.

Now that looks very different. It is the western banks that look wobbly. Their loans are going sour (especially those made in foreign currency on wildly optimistic assumptions). A harsh political suspicion is in the air: are (say) Polish companies losing vital lines of credit because (say) Austrian managers are pulling the liquidity home?

It’s too late to put the clock back, but demography makes new thinking urgently needed. The great worry for the ex-captive nations was always that they would get old before they got rich. A long slump risks catastrophe.

The best hope now is to stoke competitiveness by improving infrastructure and education, and continuing with structural reforms of pensions, the labour market and so on. But these are painful. And from the public’s point of view, the reformers have some explaining to do.

"New Europe and the economic crisis” by Katinka Barysch is published by the Centre for European Reform.

Lancet rebuttal

Ex-communist reform

Mass murder and the market

Jan 22nd 2009
From The Economist print edition

Economic reform in Russia was accompanied by millions of early deaths. But it was not the cause

MATCHES and even salt were in short supply as the Soviet empire’s planned economies collapsed two decades ago. But blame was plentiful then and now. Millions of people—chiefly men in late middle age—died earlier than their counterparts in other countries. That drop, of fully five years in male life expectancy between 1991 and 1994, demands explanation. A newly published article in the Lancet, a British medical journal that in recent years has used epidemiological analysis to examine political and social questions, argues that the clear culprit was mass privatisation (distributing vouchers that could be swapped for shares in state-owned enterprises). A statistical analysis, it says, shows that this element of the economic-reform package, nicknamed “shock therapy”, clearly correlates with higher mortality rates.

That, says the Lancet, was a shocking failure. It argues that advocates of free-market economics (it cites an article in this newspaper by the economist Jeffrey Sachs) ignored the human costs of the policies they were promoting. These included unemployment and human misery, leading to early death. In effect, mass privatisation was mass murder. Had Russia adopted more gradual reforms, those lives would have been saved.

In fact the blame game must start at the beginning. Why was the Soviet economy in ruins by 1991? Partly because planned economies don’t work (blame Lenin and Stalin for that). Partly because the gerontocratic leadership of Leonid Brezhnev failed to start reforms in the early 1970s, when gradualism might have had a chance of succeeding. By the time Mikhail Gorbachev initiated perestroika and glasnost in the late 1980s, the Soviet Union was all but bust. Worse, by running the printing presses red-hot, his government created a colossal monetary overhang. Russians may have thought that their savings evaporated when prices were liberalised at the start of 1992; in truth, their cash was already worthless.

Surgical alcohol

The second question is the effect of all this on mortality. Soviet public-health statistics show a clear decline from 1965 to the early 1980s, with rising deaths from circulatory diseases (because of poor diet, smoking and, especially, drinking). Mr Gorbachev’s anti-booze campaign—although hugely unpopular—raised life expectancy by fully three years between 1985 and 1987. After 1992 the state monopoly on alcohol (and health checks on its quality) collapsed. As anybody who lived in Russia at the time will recall, the effect was spectacular—and catastrophic. Death rates returned to their long-term trend.

The thorniest question is about economic policy mistakes after 1991. In retrospect, the West failed to prepare for the Soviet collapse. It took too long to recognise that Boris Yeltsin’s first government deserved trust, pressing it too hard on debt repayments and being too stingy with aid. Then it made the opposite mistake, being too trusting and generous when Russia was becoming more hawkish and looting was endemic. Mass privatisation broke the planners’ grip but failed to create the hoped-for shareholder democracy.

Yet the Lancet paper seriously misunderstands both the timing and the effects of economic reform. It states quite wrongly that “Russia fully implemented shock therapy by 1994”. As it happens, in that year life expectancy started rising. But in any case reforms were by then bogged down and advisers such as Mr Sachs had quit in despair. Moreover, mass privatisation had little immediate effect on jobs—or much else. Most Russians exchanged their vouchers for trivial amounts of cash, or even vodka. That may have been marginally bad for their health—but it does not explain the huge jump in the death rate.

Correlation is not causation. Mass privatisation was not the most important or effective part of “shock therapy” and the rise in death rates is out of synch with efforts at economic reform. Furthermore, countries that successfully applied shock therapy, such as Poland, saw improved life expectancy. So did the then Czechoslovakia, which plumped for mass privatisation, albeit not very successfully. Mistakes were made, but Russia’s tragedy was that reform came too slowly, not too fast.

East European economies

To the barricades
Jan 22nd 2009 | VILNIUS
From The Economist print edition


Economic pain brings political ructions

IN INTENSIVE care but angry: that describes Latvia’s economy after its dramatic rescue by the IMF and other foreign lenders. Now the question is whether the tough conditions imposed by the bail-out are politically tolerable. A riot in Riga, in which more than 40 people (including 14 police officers) were hurt and 106 arrested, suggests there is a bumpy ride ahead.

Latvia, a country of 2.4m that may soon be the sixth-biggest debtor to the IMF, is not alone. Lithuania has pushed through similarly tough wage and spending cuts and tax rises. A protest on January 16th turned violent, with protesters pelting the police with snowballs and stones. After a decade in which breakneck growth made up for political weaknesses, pessimists fear that the post-cold war settlement across eastern Europe may now be at risk.

That settlement rested on three notions. One was that Western-style politics was both trustworthy and efficient, in contrast to the failures of communism. The second was that welfare capitalism and integration into Western markets would produce prosperity. And the third was that joining the European Union would provide a guarantee of economic and political security. All three now look wobbly.

In 2006 Latvia’s economy was still growing by an astonishing 12% a year. One reason was that locally owned banks—comprising some 40% of the financial system—took deposits from foreigners (chiefly Russians) and invested in an increasingly frothy property market. The government not only failed to supervise them properly. It also inflated the bubble by running a loose fiscal policy.

The biggest local bank, Parex, collapsed and has been largely nationalised. Outsiders going through the books are finding much to be glum about. At worst, the Latvian taxpayer faces a bill of up to $3 billion. Even at best the country faces several painful years as it tries to regain competitiveness. Such pain may have been tolerable after 1991 when problems could be blamed on communist times. Nobody knows where public anger will focus now.

The IMF and others believe that the best solution would have been immediate devaluation of the national currency, the lat, accompanied by its replacement by the euro. That would have hurt the many households and businesses that have borrowed in foreign currency. But calculations published by the IMF suggest that the recovery thereafter would have been quicker and steeper.



Yet euroisation has proved impossible. The European Central Bank and the European Commission were unwilling to change their rules. And the overwhelming consensus in Latvia favours keeping the lat’s currency peg. Neither the protesters in Riga nor opposition politicians want a devaluation. Their most controversial demand is for a progressive income tax (Latvia, like its neighbours, has a flat tax).

Ainars Slesers, the transport minister, is suggesting legal action to protect creditors of the Nordic-owned banks that make up most of the rest of the financial system. He blames their irresponsible lending for stoking the boom. Yet it is only foreign banks’ willingness to stump up for their losses that is keeping Latvia afloat. Shares in Nordic banks such as Swedbank and SEB have plunged because of worries about their exposure to bad Baltic loans.

Latvia’s prime minister, Ivars Godmanis, is widely seen as a competent heavyweight. But he depends on powerful political barons such as Mr Slesers to support his governing coalition. The president, Valdis Zatlers, wants a cabinet shuffle to dump discredited figures. Failing that, an early election in the summer looks likely. Yet Latvia’s opposition parties are a motley lot; and no policy mix can now avoid economic pain.

Most other east European EU members are in a better way, at least for now. Estonia was more prudent during the boom, building up net public assets equivalent to 7% of GDP. It can now run an expansionary fiscal policy that offsets the recession, rather than a tight one that aggravates it, as in Latvia and Lithuania. Estonia’s banks are almost all foreign-owned. Even Lithuania’s dodgiest local bank is nothing like as troubled as Parex in Latvia.

Not that the foreign-owned banks are in great shape. Across the region cash-strapped banks are cutting business loans, worsening the downturn. No international or national institution has the authority to deal with banks that take deposits in one country and lend in another, often with managers in a third country and shareholders in a fourth. Neither the IMF nor the ECB is set up to deal with these beasts.

The biggest concern is how far the economic weakness will spread. Poland, the biggest regional economy, has looked fairly safe. The central bank has even cut interest rates sharply, after raising them in 2008. But industrial production is plummeting, with inevitable effects on tax revenues. By the summer the government will have to choose between maintaining a tough fiscal stance (a condition for joining the euro) and easing the pain of recession. At least Poland has a choice. Hungary, the most indebted country in the region, has little option but to tighten its belt further.

Governments normally respond to recession by loosening fiscal policies to preserve jobs and output. But most in eastern Europe cannot do this. Their debts make it hard to borrow more. Currency pegs in the Baltics and Bulgaria that once seemed to offer stability and a smooth path to the euro now put the burden of adjustment wholly on wages and output. The voters, many of whom suffered gas cut-offs in Russia’s gas spat with Ukraine, won’t like it. What will they do? Nobody knows.

Europe view--change the Euro rules

Europe.view

Time to change the rules
Dec 18th 2008
From Economist.com


The EU is asking too much of the ex-communist states that want to join the euro

MOST people who give the matter any thought agree: one of the main rules for countries wanting to join the euro is perverse. Yet adopting the common currency has gone from seeming a matter of national pride to national necessity, as the financial turmoil has highlighted the costs and risks that small countries face by keeping their national currencies. For places like the Baltic states and Bulgaria (which already peg their currencies to the euro) maintaining the current regime carries extra burdens and no benefits.

But euro-adopters must meet a European Union (EU) rule that stipulates a “high degree of price stability”, meaning that inflation must be no more than 1.5 percentage points higher than the three best-performing countries. (The other rules are less controversial. The second is sound public finances, meaning a government deficit below 3% of GDP and government debt below 60%. The third is stable exchange rates and the fourth is low long-term interest rates.)

The inflation rule is arbitrary in the sense that the benchmark is not the performance of the three best-performing (ie, lowest-inflation) countries actually in the euro zone, but rather the best three in the entire EU. So to join the euro, you might have to lower your inflation to the level of three countries that don’t use the common currency (eg Britain, Sweden and Denmark).

It is also harsh: as poor countries (such as the ex-communist states of eastern Europe) get richer, they should enjoy an appreciating exchange rate if their currency floats. But if they have their currency pegged, then it can’t appreciate. So prices and wages measured in the local currency will rise instead (economists call that the Balassa-Samuelson effect). That is not inflation of the kind that the euro zone’s managers should mind about.



Thirdly, the risk now is that the three benchmark countries may be suffering deflation. That is a nasty state of affairs which most countries would do much to avoid (because it leads consumers to postpone consumption while they they expect prices to fall further, thus triggering a long slump). It would be truly bizarre if countries battling for survival were to force deflation on themselves willingly.

So what to do? Andrus Ansip, Estonia’s commendably blunt prime minister, recently questioned the value of the current approach. But the European Central Bank and the EU’s monetary minders are not in the mood for treaty-tweaking. A better idea would be for the non-euro countries in the EU (ie, all the ex-communist ones bar Slovenia and Slovakia—plus Britain, Sweden and Denmark) to get together and warn the ECB that they will support any member that adopts the euro unilaterally. Then Estonia, Latvia and Lithuania, for example, could euro-ise on their own. Countries with currency boards and similar arrangements can do that almost at will: the money in circulation is covered by the central bank’s reserves, so you just substitute one for another.

That would turn the tables on the gnomes of Frankfurt. But it requires leadership. Only with one or more big countries—preferably Poland and Sweden—giving the small countries political cover will they have the nerve to take a step like this. The ECB could complain loudly, while privately accommodating the change. Then it would say that it had to change the rules to reflect the fait accompli.

This would not solve the underlying problems of the euro zone. Nor would it cure the ex-communist countries’ economic hangovers, which are the result of reckless borrowing and slow reforms. But it would at least remove the risk that some of the most vulnerable countries in Europe’s east suffer needless harm—at a time when the rich half of the continent is ill-placed to help them.

CEE Economics/Romania-Bulgaria

Eastern Europe’s woes

Stopping the rot
Nov 27th 2008
From The Economist print edition


East European economies crack, with Romania and Bulgaria the worst off

JUST another week’s news in eastern Europe: Latvia, after vehement denials, starts talks with the IMF; Bulgaria loses €220m ($286m) in promised payments from the European Union because of its failure to tackle corruption; and the European Bank for Reconstruction and Development cuts its growth forecast for the region by half. But the good news is that worries of a huge meltdown, from the Baltic to the Black Sea, now look overblown.

The most likely outcome is several years of low or no growth, with bigger hiccups in countries that have the shakiest financial systems and biggest imbalances. The outside world (ie, the IMF, the EU and the European Central Bank) is ready to help when necessary and—more usefully—even before problems hit markets. The ECB has opened a €10 billion credit line to Poland, which saw its currency, the zloty, fall sharply earlier this month. Hungary’s central bank was even able to cut its interest rates by half a point from the 11.5% rate that it set last month, as part of a $25 billion international bail-out. And foreign banks have stood by their subsidiaries in the ex-communist countries. It was their risky lending that inflated the property bubbles, now popped, and also financed huge current-account deficits in such places as Latvia and Bulgaria.

The biggest worries are now focused on Bulgaria and Romania, the poorest and worst-governed new members of the EU.

The Bulgarians have their hands tied by a currency board that pegs the lev rigidly to the euro. That rules out devaluation to restore competitiveness, which is a concern as exports sag. It also removes a potential buffer, because the central bank cannot adjust interest rates. A current-account deficit worth a quarter of GDP looks alarming.

At least Bulgaria’s fiscal position is strong. The state has little foreign debt and runs a budget surplus. That should allow it to increase public spending as the economy slows. It can also borrow abroad (though the authorities say they have no plans to approach the IMF). The loss of some EU money is embarrassing, but Bulgaria is still in line to get €11 billion in the years up to 2013. Oriens, a Hungarian-based merchant bank that specialises in the Balkan region, reckons that growth next year will be 2.3%: low but not awful.

Romania has a current-account deficit of only 14% of GDP; a floating currency that gives it more flexibility; and is less dependent on exports to the slowing euro area than Bulgaria. But it may have a harder landing. Oriens forecasts GDP growth of just 0.9% next year. Its banking system is less profitable than Bulgaria’s. Although it is mostly foreign-owned, it looks wobblier; inter-bank rates have nearly doubled this year to 15%. Foreign reserves are scantier and the IMF reckons that the currency, the leu, may be overvalued by 19%.

Thanks to populist spending in the run-up to this week’s parliamentary election, the budget deficit may reach 3.9% of GDP by the year-end. That is not a lot by some standards, but it may still cloud outsiders’ willingness to provide more cash. Whatever coalition the election produces, serious reform is a long way off. Bulgaria’s politics are also troubling. Politicians’ ties to organised crime remain scandalous; the main populist party seems to blame the country’s Turkish minority as the economy slumps. Meltdown may have been averted, but the eastern Balkans still face bleak times ahead.

Smouldering

Eastern Europe
Nov 6th 2008 | RIGA
From The Economist print edition


The ex-communist economies have been steadied. Deeper worries remain

How much will you give me to stop playing?

FLAMES out, but smoke still rising. That is how eastern Europe looks after huge outside intervention to douse worries in debt and currency markets. An IMF board meeting on November 5th approved a lightly conditioned $16.5 billion bail-out for Ukraine. Austria has offered a €100 billion ($129 billion) package for its banks, which are owed $290 billion by east European borrowers: Erste Bank took up a €2.7 billion equity injection on October 30th. In Hungary, which has also received an IMF bail-out, markets firmed as parliament passed a tough fiscal package, based on an expected 1% fall in GDP. Serbia, which is in talks with the IMF, said it would not need extra cash, though it might draw on its $695 billion deposit at the fund.

In London Latvia’s central-bank governor, Ilmars Rimsevics, sought to quell fears that his country faced a meltdown on Icelandic lines.

Flanked by representatives of Swedbank and Nordea, two Nordic banks which own a large chunk of the local banking system, he said Latvia’s currency peg to the euro was not in doubt. Unlike Iceland, Latvia has little external public debt and a thinly traded currency. But questions remain over some locally owned banks and the legacy of reckless fiscal policies (described by one minister as “hitting the gas pedal”). That brought double-digit growth, but did little for competitiveness. The coming months could bring a contraction of up to 5% in Latvia’s GDP.

The intricacies of Latvian economic policy may no longer hold foreigners’ attention. “We were getting a lot of calls about the Baltics and Scandinavian banks a couple of weeks ago. Now attention has shifted to Bulgaria,” says Neil Shearing of Capital Economics, a consultancy. Bulgaria has a large current-account deficit (expected to be 24% of GDP this year). So far, this has been filled by inflows of foreign direct investment. That looks good on paper (it is reliance on short-term borrowing that sets red lights flashing). But up to a third of that money went into property, inflating a bubble that has now popped.

Neighbouring Romania, the poorest country in the European Union, has problems too. Standard and Poor’s, a rating agency, downgraded its debt to junk last month. And the slowdown in “old Europe” will hit remittances from the many Romanians working abroad.

Foreign investment flows to eastern Europe may be shrinking too, now that businesses in the rich half of Europe have less cash to spare for foreign expansion. Having neglected competitiveness-stoking reforms in education, infrastructure, and public administration, ex-communist countries may find it harder to attract companies needing to cut costs. Governments in eastern Europe are now hurrying to adopt the macroeconomic policies necessary to speed the adoption of the euro. But their countries’ deeper problems remain.

from this week's Europe section

The euro

Seeking shelter
Oct 30th 2008
From The Economist print edition


Countries outside the euro zone are worried, but joining may not be easy

SHARING a currency but not a government—the hybrid arrangement for the 15 countries that use the euro—may look less than ideal in times of turmoil. But from the outside, the single currency looks like an increasingly attractive shelter.



Even solid ex-communist countries such as Poland want to speed up their preparations to meet the conditions for joining the common currency. And rich EU members that stayed out by choice, Sweden and Denmark, are thinking again. Joining the euro, at least in some eyes, means a loss of national identity. It also means governments cannot devalue or change interest rates to suit economic needs. During the sunny financial weather of the past years, that seemed to argue for staying out. The balance of the argument is now changing.

Denmark twice raised interest rates in October to help protect its currency, the krone, which is pegged closely to the euro. Sweden’s krona fell to a record low against the euro in October as the central bank there cut interest rates in the hope of fending off a recession. The Danish prime minister, Anders Fogh Rasmussen, says that being outside the euro zone during the financial crisis is “detrimental” to the economy, and he wants a referendum by 2011. Even in non-EU countries, such as Iceland, adopting the euro is now a hot topic.

In eastern Europe, meanwhile, Slovenia has already adopted the euro and Slovakia will do so by the end of the year. But no other country looks close. Standard & Poor’s this week cut Romania’s credit rating to “junk” status, blaming politicians’ irresponsibility about public-sector wage increases. Poland, ambitiously, says it wants to meet the criteria and set a fixed rate for the zloty against the euro in 2011. The government is now seeking cross-party support for the necessary constitutional amendments.

To join the euro, countries are required to have inflation and budget deficits at sustainably low levels (“low” is an average based on other countries’ performance). In past years, eastern European countries have missed that because roaring growth pushed up prices. Foreign investment is likely to fall sharply. Soaring tax revenues once shrank budget deficits—but now the tax take is falling, exposing unreformed public finances. In Poland, these include wastefully untargeted social benefits such as early retirement.

Talking about a quick move to the euro may be a good gimmick for politicians, but the practical difficulties are huge. The countries of the euro zone are not longing for troubled new members; its existing ones, such as Greece and Italy, are worry enough. The higher taxes and lower spending needed to satisfy the entry criteria are not the choices that a country would normally make in a recession.

The prospect of euro membership in three years’ time is unlikely to calm panicky financial markets now. That requires, at a minimum, large quantities of cash—as seen in this week’s bail-out of Hungary (see article). This week the European Union said it would raise its own rescue fund from €12 billion ($15 billion) perhaps to €25 billion. Yet even with such outside help, running an independent currency is beginning to look too risky for all but the biggest economies.