Nicholas Watson in Prague -

Emerging Europe had a much better year than most countries to the west, and a combination of factors point to a repeat of that in 2011. For all that, the region is still facing a twin-speed recovery.

A major theme for 2011 in emerging Europe, as it is over much of the world, is a continuation of Keynesian re-flation giving way to Germanic fiscal restraint - and this fiscal tightening is, if anything, even stronger in the emerging markets. "We're all Germans now," states Mark Cliffe, chief economist at ING, in a take on the monetarist economist Milton Friedman's comment that, "We are all Keynesians now."

The reason why countries in emerging Europe are proving better able to push through deeper cuts more swiftly than are being attempted elsewhere on the continent is that it's much easier to tighten fiscally if you have strong economic growth - and that's exactly what emerging Europe has, unlike Western Europe.

With a variety of institutions, from the European Commission to the World Bank, continually issuing and updating GDP forecasts, it can be a little confusing, but all tell a similar story: the older EU member states will mostly either contract or grow slowly in 2011, while newer members and candidate countries will mostly grow relatively quickly - albeit at lower, but more sustainable, levels than before the global economic crisis hit.

In November, the World Bank said it now projects the EU as a whole to grow by 1.7-1.8% in 2010. The previous month, the European Bank for Reconstruction and Development (EBRD) put 2010 GDP growth for the emerging markets it covers at 4.2% - a significant improvement on the developed markets and an impressive turnaround from the 5.5% contraction the region suffered in 2009.

For 2011, the European Commission (EC) said in November that it now expects the Eurozone to grow 1.5% and the EU to grow 1.7%. In emerging Europe, only Romania and Croatia will fail to exceed the EU average, the EC says, with Turkey putting in the most growth at 5.5% (after surging 7.5% in 2009), followed by Estonia with 4.4% and Poland, the only EU country to avoid recession in 2009, with 3.9%.

As such, the region is facing a twin-speed recovery. While some economies will impress, others will be held back by the legacy of the last decade's credit bubble. "Turkey and Poland will continue to lead the way, followed by Slovakia and the Czech Republic," says Neil Shearing of Capital Economics. "Elsewhere, however, vulnerabilities are much greater... A combination of weak banks, competitiveness problems and hefty external financing requirements mean that the Balkans still face a long slog back to health."

Engine of the locomotive

The standout performer in the Eurozone in 2010 has been Germany, and the performance of the world's largest exporter has been key to the revival of the countries to its east.

The rebound in world trade has been particularly beneficial for the world's exporting economies. As such, the German economy recovered remarkably swiftly and vigorously from the crisis, posting six consecutive quarters of export-led growth that is above what many consider to be the economy's long-term output potential. The EC expects German GDP growth to come in at 3.7% in 2010 and 2.2% in 2011. That's good news for Central Europe, investing in which is sometimes referred to by fund managers as a "leveraged play on Germany."

The outlook for European exporters in 2011 could be improved further if, as many expect, there is a revaluation of Asian currencies over the coming months. With Germany a member of the euro, which is a freely floating currency, the bulk of the adjustment has to come from Asia, particularly China, whose renminbi, the US claims, is being kept artificially low.

Chinese manufacturing data for November suggest that GDP growth is accelerating, putting further upward pressure on inflation, which has already surged above 4%, meaning the government will miss its inflation target in 2010 and possibly also in 2011. "The bad inflation number could eventually contribute to easing tensions between China and the US, as it will increasingly be in China's own interests to let its currency appreciate to ease inflationary pressure," reckons Flemming Nielsen, a senior analyst at Danske Bank.

Though the signals are still weak, analysts believe the ground is being prepared by the Chinese for a sustained and significant appreciation of the renminbi over the next year or so, which should be particularly beneficial for Germany and other exporters in the Central and Eastern European region. "The Chinese are not arguing about the principle of revaluation, but the pace... and are probably trying to extract some political concessions along the way," ING's Cliffe told investors at the ING 13th Annual EMEA CEO/CFO Forum in Prague at the end of November. "This is good news for Europe, and especially Germany, as they try to penetrate these Asian markets."

With a continued cost advantage making it a magnet for foreign direct investment, CEE is, in the words of one Asian executive quoted recently by the Financial Times, "the factory of Europe, just as China is the factory of Asia."

The problems ahead for the region, therefore, are likely stem from success rather than failure.

Icebergs ahoy!

Timothy Ash, emerging markets economist at Royal bank of Scotland, argues we are in bubble territory: "We all know it - it feels like a bubble, it smells like a bubble and it probably is."

Certainly, the tide of money that has flowed into emerging markets, which only picked up as the US embarked on another round of quantitative easing (QE2), has been huge. The fund tracker EPFR reported that by November emerging market equity funds had taken in $84.3bn for the year, putting it ahead of last year's record-setting $83.3bn. "For the third year running, cash in the developed world is returning close to nothing. And this is turning into a significant problem because ageing populations in the rich world need income to supplement their falling retirement plans. Financial assets seeking income must now travel further afield," says Plamen Monovski, chief investment officer of Renaissance Asset Managers.

That of course has resulted in surging stock and bond markets, which brings with it risks as well as benefits. The MSCI Emerging Markets Index was trading around 1,130 on December 7, which is up about 140% from its low hit in the depths of the financial crisis in 2008. "Most of QE2 has gone to emerging markets, and this is not a short-term phenomenon but a long-term shift, and that causes a number of difficult policy implications," Dr Nouriel Roubini, professor of economics at New York University's Stern School of Business and the man who has acquired the nickname Dr Doom after predicting the financial collapse, grumbled to investors at the ING conference. "In some countries [price/earnings] ratios in emerging markets are very high and in some cases may not be justified by GDP differentials. In some countries currencies are already overvalued... and in some countries the reduction in credit spreads has been excessive and is unjustified."

Others dispute this, pointing out that the while the markets are certainly not as cheap as they once were, the MSCI EM Index is still well below its pre-crisis peak of 1,340 and these countries still have scope for export-led growth and an improved trade performance based not on undervalued currencies but rapid productivity growth capitalising on FDI inflows. "Look at the MSCI - we are not back to the peak despite strong economic growth, profit growth and strong fundamentals in the fiscal condition and fiscal reserves," says ING's Cliffe.

Perhaps, but few doubt that the capital markets will be volatile as long as the spectre of sovereign debt default hangs over the Eurozone, meaning that periodic setbacks from the developed markets should be a perennial problem throughout the year. The most bullish, of course, would argue that these setbacks present buying opportunities.

Roubini touches on another potential problem for some of the countries in emerging Europe, which is "reform fatigue." The region's countries have, by and large, put the Eurozone periphery to shame with their swift and decisive actions to cut spending to meet budget deficit ceilings imposed either by the International Monetary Fund (IMF) as part of a bailout plan or in the context of the EU's Maastricht Criteria for joining the euro. Even so, the EC forecasts have only six countries out of the 27 member states posting a deficit below the 3% ceiling required by the EU's Growth and Stability Pact. While none of the emerging European countries run deficits as high as Ireland, UK, Spain and Greece have, inflated deficits remain a big issue and further steps need to be taken. "The EC acknowledges the efforts undertaken by the Romanian authorities in the summer of 2010 to consolidate public finances, but at the same time sees substantial risk that some unpopular measures could be reversed," says Eugen Sinca of Banca Comerciala Romana.

So while the fundamentals of most of these emerging markets are sound, or at least sounder than those of the advanced economies, no country is an island and there are many risks - macro risk, sovereign risk - that will have a bearing on these markets throughout 2011. Those economies that have stronger macro, financial and policy fundamentals are going to do better than those in this region that display financial rigidities and macro-policy uncertainties, which will make them prone to greater corrections. "Over the next few quarters, investors in emerging markets have to ask tough questions: which of these economies are becoming overvalued in terms of their equity markets, fixed-income markets and currencies, and what are the risks that shocks coming from advanced economies have the potential for causing a correction in these emerging market economies," Roubini concluded.

With that in mind, the following is a look at the various countries in more detail:

Baltics bank on being boring in 2011

The last 12 months have seen the Baltic states shed their reputation for boom-and-bust economics. Estonia, Latvia and Lithuania had already started cleaning up their economies while the likes of Greece, Ireland and Portugal were still partying. But after nearly two years of austerity, the most comfort the Baltics can take is that they are probably past the halfway mark as far as painful reforms are concerned.

"Austerity will continue, perhaps somewhat more hesitantly, but still stronger than almost anywhere in Europe," says Marcus Svedberg of East Capital, before pointing out that although they "seem more serious about their Eurozone timetable than the Central Europeans," the Latvians and Lithuanians won't face extra pressure from that quarter in the coming year.

Speaking of the euro, in Estonia all eyes that can still focus after midnight on January 1 will be looking at an unassuming ATM beside the National Opera building in Tallinn. Eleven minutes into the New Year (00.11 on 01/01/11), Prime Minister Andrus Ansip will put his credibility on the line by attempting to withdraw the country's new currency. If he succeeds, he will not only be able to pay the bar bill at the party happening next door, but he will be a shoo-in for a fresh term in office when parliamentary elections take place on March 6. If he fails, he will look a bit of a chump, but may still fancy his chances of re-election - provided the Eurozone doesn't collapse before polling day.

While Tallinn will be in celebratory mood to mark the start of its year as one of two European Capitals of Culture for 2011, the travails of the Eurozone have taken the edge off the revels. The bailouts of Greece and Ireland plus ongoing suspicion of Portugal, Spain and Italy mean many Estonians remain to be convinced that ditching the kroon right now is a good idea. It's not hard to see why: one of the first things Estonia will do as a full member of the eurozone is contribute €800m to the

new €440bn European Financial Stability Facility - a war chest to prop up member states less scrupulous about balancing their books than Estonia. "I am thinking about comparing the Baltics with other EU members rather than with peers in Eastern Europe. A country like Estonia, with top class institutions and low levels of corruption should perhaps be considered a graduate of the transition class by now. If we compare Estonia with its peers in Western Europe, it certainly looks quite attractive," says Svedberg.

Even with their neighbour graduating, Latvia and Lithuania are no longer terribly upset about being left out of the euro club for the moment. Their currencies remain pegged to the euro while they continue with "internal devaluation" strategies, but they at least have the appearance of retaining both monetary and fiscal independence. Having suffered two of the deepest economic contractions in the world in 2009 (18% and 15% respectively), they have shown slow but steady signs of recovery in 2010. Their central banks predict growth of 2% and 3.1% respectively for 2011.

Since October's general election, much of the Latvian government's time has been spent trying to get a budget together for 2011 that will satisfy international lenders while avoiding widespread social opposition. That means more tax hikes (including raising VAT to 22%) and more spending cuts, but as long as unemployment falls through the winter months, the two-party coalition headed by Valdis Dombrovskis should be confident of staying in power at least until the sap starts rising. "The current proposal looks like a messy compromise that does not bode well," says Morten Hansen of the Stockholm School of Economics in Riga. "I very much hope there will no loosening of the fiscal stance - there is still a lot needed to get spending and revenues in the public sector to a sustainable level and to create a public sector that does not just tax but that spends on forward-looking measures."

One revenue stream that should come online in the second half of the year will be a major privatisation programme. Telecommunication companies Lattelecom and LMT will likely be among the offerings, but before they're placed on the market the government would be well advised to take care of important outstanding business concerning two other state companies.

First, there's a legal wrangle over who actually owns the airBaltic brand. Chairman Bertolt Flick cannily acquired the rights for his own private company last year and isn't rushing to hand such a valuable asset back to the state. Potentially more serious is the second dispute surrounding Ventspils Nafta, which has upset international energy giant Vitol Group.

Vitol owns a 49.5% share in VN, which operates oil terminals in the Latvian port of Ventspils and which in turn owns a 49.9% stake in Latvijas Kugnieciba (Latvian Shipping Company, LSC). Vitol is incensed at the treatment it says it's received since making major investments in Latvia. A leaked letter from Vitol President and CEO Ian Taylor addressed to PM Dombrovskis, and copied to EU Commissioner Olli Rehn and Meg Kinnear of the International Center for the Settlement of Investment Disputes, outlines a catalogue of "discrimination, harassment and unfair treatment," along with a threat to recover $300m via international courts unless the situation is resolved. "Vitol intends to inform the international financial community of its wrongful and discriminatory treatment as a foreign investor by Latvia," the letter says.

Adding extra spice, among the main targets of Vitol's ire are the other big shareholders in VN and LSC - companies linked to Ventspils mayor Aivars Lembergs, who also happens to be the leader of the ZZS political party with which Dombrovskis is allied. As a result, Dombrovskis faces an unenviable Catch-22: ignore Vitol to keep his coalition together and damage Latvia's investment reputation, or try to sort the matter out and risk the collapse of his coalition.

Over in Lithuania, Prime Minister Andrius Kubilius also faces some tricky choices as he starts the second half of his four-year term. Relations with Poland need to be rebuilt, and that includes deciding once and for all the future of Lithuania's biggest single business, the huge Mazeikiu Nafta oil refinery, which is owned by Poland's PKN Orlen. Unless the Lithuanian government is more supportive of PKN Orlen, a sale to Russian companies is possible. While that would be politically unpopular, it might be good for the piggy bank, as chances are that the spur of Russia's Druzhba pipeline that feeds the refinery, which was closed for temporary repairs in 2006, might suddenly spring to life once more. On top of that, plans for a new nuclear power plant (also involving Poland and the other Baltics) in the north of the country need to be sorted out quickly if they are to retain any credibility at all.

If Kubilius faces a tough slog this year, finance minister Ingrida Simonyte should enjoy a smoother ride, even though she has hinted that she'll quit unless parliament backs her firm-but-fair budget plans. Lithuanian politicians are generally of an easy come-easy go disposition, but Simonyte is an exception and the markets would react badly to a forced departure, as she has proved herself to be exceptionally capable, repeatedly raising money by issuing paper and keeping the likes of the IMF at bay.

"In Lithuania, we still hear more populist options to reduce the budget deficit. Hence, the state of public finances remains challenging and further austerity measures are likely," says Danske Bank's Violeta Klyviene. "If domestic demand were to recover in line with our forecasts, then the negative side effect will be a renewed increase in external imbalances. This also means that there is absolutely no room for easing of fiscal policy in the coming years if the Baltic governments want to maintain the present fixed exchange rate regimes."

There is also the small matter of the appointment of a new governor for the Lithuanian central bank. Incumbent Reinoldijus Sarkinas has had enough of the job he has held since 1996. His term expires on February 14 and it would make many investors' hearts beat faster on Valentine's Day if darling of the markets Simonyte could be persuaded to say "I do" to the job and lead Lithuania towards a lifelong monetary union with the Eurozone some time around 2015. (Mike Collier in Riga)

Ice Poles

Poland's recovery should continue to strengthen in 2011 and 2012, but the large budget deficit remains a worry.

Most predictions put Polish growth at or around 4% for 2011, supported by gradually improving labour market conditions and increasing consumer demand and foreign capital inflows. Public investment will grow on the back of continued infrastructure projects, a number of which are connected to the Euro 2012 football championships, which the country is co-hosting with neighbour Ukraine.

However, growth is likely to remain at or just below its potential rate in the coming years due to structural weaknesses in the economy that the government hasn't the political will to address, especially with elections looming next year; Capital Economics estimates the output gap currently at around 0.5% of GDP.

The government also needs to start taking the consolidation measures that it has put off for too long. The EC forecasts that Poland will run the sixth highest budget deficit in the EU in 2010 at 7.9% of GDP and the fourth highest structural deficit (one that's adjusted for cyclical effects), while its worsening fiscal situation and sluggish consolidation efforts is likely to bring public debt up to 60% of GDP by 2012. "While strong economic growth helped to mask the deterioration of the fiscal structural deficit in Poland, and fiscal loosening supported growth during the global economic downturn, now having one of the highest deficits poses a relatively big risk to future Polish growth," says Juraj Kotian of Erste Bank.

In terms of the capital markets, the increase in risk appetite by foreign investors has been an important variable for bond yields and the zloty. Even so, the spread of Polish bonds to German bonds has remained relatively wide and the zloty still has a long way to go to return to its pre-Lehman levels, while the Polish stock market was trading at a PE ratio of 17x in November, around the level at which the likes of China and India are trading.

Czechs cling to the coattails of Germany

Capital Economics describes the Czech Republic as "clinging to the coattails of Germany," and indeed the prospects for the very open economy remain closely tied to the performance of key export markets in the Eurozone. The EC puts growth in 2011 at 2.3%, following the expected 2.5% in 2010.

The problem for the Czech economy is that there's little sign of the strong rebound in industry spreading into other sectors of the economy. October retail sales data were dismal, unexpectedly dipping by 0.7% on year, showing that the consumer sector remains weak, and there's little prospect of a marked improvement, with substantial amounts of slack in the labour market keeping wage growth at a minimum in the near term. "What's more, if the recovery in Germany slows next year as we expect, the economy will lose the key prop to growth too," says Capital Economics' Shearing.

Further constraining growth will be the government's fiscal austerity plans, which include a 10% cut in public sector wages and other reductions in social spending. This has brought workers out onto the streets, something that will likely continue into the new year. The EC sees the general government deficit falling to 4.2% in 2011, while analysts like Erste are more optimistic, putting it at 3.6% and well on its way to meeting the 3.0% ceiling.

Czech bonds, like those of Poland and Slovakia, have seen a remarkable stability in spreads. "Central Europe has been keeping up with the Germans," says ING's Cliffe. Martin Lobotka of Erste says the bond market reflects the fact that foreign investors like Czech assets, as well as the overall preference for the (perceived) safety of its sovereign debt. "At one point this year, they drove the Czech yield as low as 3.20%," he says, although he adds that these levels - driven to a good extent by lower German yields - won't hold, as the Czech government still has a large financing need for 2011.

The crown too is in danger of being overbought to below CZK25 to the euro - the rate that is deemed the most appropriate level right now. "The risks are substantial and mainly in the direction of faster strengthening - the crown is perceived as a regional safe haven; investors like it (see bonds) and hence it does not get pummelled as the forint and zloty do when risk aversion shoots up," says Lobotka.

Tired and Hungary

Hungary appears to be headed in the opposite direction to the rest of the region. While December saw Latvia upgraded by Standard & Poor's, Moody's Investors Service chose to downgrade Hungary two notches to 'Baa3', which puts it perilously close to losing its prized investment-grade status.

Will 2011 see the country downgraded to junk? It should probably just hang on, but it will be a close-run thing. The new centre-right government of Fidesz that won a landslide victory in the April elections is, depending on which analyst you talk to, flying by the seat of its pants, thinking outside the box and possessing worryingly centralising, almost autocratic tendencies - none of which inspires much confidence.

On one level, the government says it wants to stick to the conditions of the IMF/EU bailout programme and has subsequently announced an economic plan that holds to the 3.8% deficit target. However, it wants to achieve this without any of the pain associated with such an ambition and instead has embarked upon various fiscal wheezes that most consider unsustainable over the longer term.

As well as windfall taxes on various sectors such as banks and telecommunications, on November 24 the Hungarian parliament voted to shift HUF3 trillion (€11bn) of private pensions back under state control. This is 10% of Hungarian GDP and it aims to reduce short-term contributions by the state, while automatically increasing substantially its long-term liabilities. "This move is yet another of the botched short-term policies of the Fidesz government to plug the holes in the accounts of a country which was run irresponsibly over the last few years," says Monovski of Renaissance Asset Managers.

In general terms, RBS' Ash says it appears the Hungarian government has decided that it has had enough of what it sees as the "unfair" and inappropriate policy advice/framework provided by the IMF, and has decided to go it alone, "going for broke by pump-priming growth in the short term in the hope that Hungary grows out of its debt sustainability concerns."

The recovery in Hungary is indeed gathering pace, and most have nudged up their GDP growth forecasts for the coming years; the EC reckons Hungary will grow 2.8% in 2011. "But the government's fiscal plans have cast fresh doubts on the medium-term sustainability of the public finances, and the economy remains vulnerable to the expected slowdown in the Eurozone," says Shearing of Capital Economics. "All told, growth is set to remain below its potential rate of around 3.5% until 2013 at least."

Ash says "time will tell if the government's strategy will work," but even so it's a risky bet. As such, analysts now expect higher yields and a weaker forint in 2011-12. "The situation is very uncertain and may become more critical if structural reforms (expenditure cuts) are not crystallized soon. Thus, we continue to advise investors not to go long on Hungarian bonds at the moment," says Zoltan Arokszallasi of Erste Bank. "They should instead wait until reassuring comments arrive from the government or international sentiment improves significantly."

Don't hold your breath.

Slovakia has the goods

Here the economic recovery continues, driven mostly by demand for Slovak goods from abroad. The world's biggest per-capita producers of cars, like its neighbour the Czech Republic, has been a big beneficiary of the recovery in Germany, though of course this means it is also susceptible to the expected slowdown in key export markets in the Eurozone. The EC puts growth in 2011 at 3.0%, though others, like Capital Economics, thinks it will be closer to 2.0% in both 2011 and 2012. GDP is on track to expand by around 4% in 2010 - one of the fastest rebounds in the region.

"We doubt that the economy will be able to maintain its recent pace of growth for much longer. With the global recovery likely to fade next year, external demand and Slovakian exports are set to slow sharply," says Capital Economics's Shearing.

Putting a further brake on growth will be the government's fiscal consolidation programme, which intends to cut the budget deficit to 4.9% of GDP in 2011, though many expect that will be a bit of a reach for an unstable coalition and the deficit will likely end up being nearer 6.0%.

One particular weak point of the Slovak economy is that so far the recovery has largely jobless, with the unemployment rate still far above its historic lows, at about 14.3% this year. This means that while household consumption should play a somewhat more important role in 2011, analysts still expect it to pick up only gradually.