Debora Revoltella of UniCredit Group -

The credit and liquidity crisis in the US sub-prime mortgage market that has been spreading since the middle of July is so far having only moderate repercussions on Central and Eastern Europe and overall we do not expect it to endanger the strong growth and rapid financial deepening scenario in the region. In fact, with the underlying prospects for world growth remaining positive, the very good economic fundamentals in CEE have promoted and continue to promote stability.

Nevertheless, we recognise that risks have grown and constant monitoring and prudent strategies should be on the agenda of both policymakers and market players. CEE banks' exposure to asset-backed securities (ABS) and collateralized debt obligations (CDOs) was negligible, given the banks' need/opportunity to finance credit growth in the region. However, the re-absorption of the excess liquidity, which has characterised the international financial markets in recent years, has brought widening credit spreads, a correction in some of the local foreign exchange markets and in most of the regional equity markets, with investors clearly starting to discriminate among countries.

While the Hungarian forint, Turkish lira and the Romanian lei have depreciated quite significantly, the Polish zloty and the Slovak crown have emerged essentially unscathed given the strong fundamentals, and the Czech crown even strengthened on the back of the interest rate hike at the end of July and global investors' diminishing interest in carry trades. Turkey was hurt relatively more at the beginning, as the international turmoil coincided with a period of political upheaval. Given the decision of the ruling AKP to name the former islamist Abdullah Gul as their candidate for president, the markets were concerned about possible tensions between the AKP government and the army. The forint has paid the cost of the ongoing fiscal restructuring process, reflected in a worse-than-expected performance of the economy, while the reaction of the lei was partly due to a long period of over-appreciation. All the regional equity markets have been hit by the crisis.

Homemade slump

On top of international drivers, however, the recent slump in the CEE stock markets was also partly homemade, given the underperformance of some blue chips in the first half of the year (eg. oil companies) and record highs posted by share indices in the past few months. It is interesting to note that the correction recorded in CEE in July-August was lower than the one recorded in the two most recent sell-off phases of May-June 2006 and February-March 2007. Moreover, some more developed financial markets (ie. Japan) and other emerging markets experienced an even bigger correction.

Very strong macroeconomic fundamentals have indeed proved to be a strong stabilising factor for the CEE region. Economic growth is expected to reach an average of 6.4% in the CEE-16 this year, while corporate finances, alongside full order books, remain healthy. Moreover, foreign direct investment inflows continue to represent a key element of financing the transition/convergence process in CEE, with no sign of slowing or reversal.

Our baseline scenario assumes that the current developments will be largely reabsorbed over the coming months and that the effects on the real economy will mostly be limited to a slowdown in US growth and some easing of the Federal Reserve's monetary policy stance, compared to what we were previously expecting. The real effects will remain negligible. Under this assumption, we continue to expect a scenario of strong growth and moderate (albeit rising) risks to hold for the region in the years to come.

The times of excess liquidity in the international financial markets are most probably over and the recovery, following the current phase of turbulence, will take place in a new context, characterised by relatively higher spreads and lower risk appetite. We also expect investors to be more selective than in the past, discriminating among countries and penalising those with higher intrinsic vulnerabilities. In the medium to long term, apart from the cost related to a deceleration of US and world demand, we believe the main risk for the CEE region comes from a potential credit squeeze. The widening of credit spreads increases the cost of financing in the region. This might become an issue particularly in countries which currently have external imbalances (ie. the Baltic states and Southeast European countries) or where banks rely on external funding to finance their lending growth (again the Baltic states, Southeast Europe and the CIS - Russia, Ukraine or Kazakhstan).

The risks of a boom/bust cycle in the CEE housing market appear to be under control at present. The existing imbalance between housing demand and supply still provides stimulus for construction activity, with no clear evidence of a house price bubble despite the fast growth observed in recent years, even though some countries (eg. the Baltics, Bulgaria and Romania) might encounter risks of overheating on their real estate markets in the medium term.

Moreover, economic factors such as growth and employment should continue to provide support at regional level. A major disruption could only occur if foreign demand slows down. Overall, given the information currently available regarding the international growth outlook, we do not see any serious systemic shock for CEE countries, although risks have clearly risen. The shock-absorption capacity of the region remains high, but prudent macro policies and strong credit risk monitoring will be essential in order to avoid any major deviations from a sustainable pattern of development.

Debora Revoltella is CEE Chief Economist at UniCredit Group

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