East Capital -

Steadily rising interest rates on the back of strong inflationary pressure are causing concern through the world. Many central banks are facing a difficult dilemma in trying to fight inflation at the same time as growth is slowing down.

The Federal Reserve and the European Central Bank, as well as many independent central banks, are stuck with the difficult choice of raising rates in order to cool down the unusually strong inflationary pressure, which to a great extent comes from food and energy prices, or cutting or at least maintaining rates in order to stimulate the economy to avoid a sharp slowdown. Most central banks seem to be opting for the former strategy, which has spurred fears of stagflation and put pressure on equity markets.

Central and Eastern Europe is no exception to this overall trend. Indeed, the central banks in the region started to raise the policy rates early on and have been quite hawkish. And growth is clearly slowing down in the region as a whole. In some of the smaller economies of the region, the adjustment is quite sharp. There are, however, a number of factors that make CEE less vulnerable than it might seem at first glance. We will go through these factors in some detail below, focusing on how unleveraged the largest economies in the region really are. There are, arguably, some economies in the region that are more vulnerable, but they are both outliers that deserve special analysis and are quite small in absolute terms.

Weathering the storm

First, the public sector in CEE is not very indebted. Poland and Turkey had the highest public debt ratios to GDP of the six largest economies in the region, at 45% and 41% respectively in 2007. In Romania and Ukraine, the public debt ratios were in the mid-teens, and in Kazakhstan and Russia they were in single digits. Such public debt levels can be compared to the 60% in the Maastricht criteria used for qualification into the Eurozone.

Second, the private sector in CEE is not very indebted either. At the end of 2006, loans to the private sector as a whole were below 50% in the largest economies. Consumers in particular were quite unleveraged, with total loans to households below 15% and mortgages well under 10% or almost negligible in the surveyed economies. Loans to households is a rapidly growing segment in CEE, with a compounded annual growth rate of 45% in 2004-2006, according to Bank Austria. But the levels are still marginal compared with that in more established market economies. In the US and UK, loans to households were around 100% of GDP in 2006. Even if the growth rates in household loans are expected to slow down somewhat in the 2007-2009 period, the annual growth rates are expected to be 25% in Central Europe and over 50% in Russia. Mortgages are expected to be the fastest-growing segment.

Only Kazakhstan has a considerable external debt, at 90% of GDP, making it more vulnerable to the global credit crunch. However, a breakdown of the total external debt shows clearly that the government only holds a small, or in the case of Kazakhstan, a negligible part of the debt. Kazakh banks, which hold a large share of the external debt, have been punished quite hard by the market.

The fact interest rates have been raised throughout CEE has had an effect on the markets and on the behaviour of companies and consumers, but it is likely to be much less pronounced than in more developed economies. We have shown that the largest economies in the region are relatively unleveraged, making them less vulnerable to interest rate hikes. Moreover, the fact that the real interest rates in the region are still low, or even negative, illustrates further that the market impact of the recent rate hikes in the region should not be exaggerated. And, finally, as growth in CEE remains very strong - the simple average for the six largest economies was almost 7% in the first quarter - there is no risk of stagflation.

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