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The current crisis has come as an unwelcome detour in the path of Central and Eastern Europe's convergence with the developed world. But despite the current talk of "green shoots," all the countries will have to go through a third phase of the crisis before anyone can look forward to a real recovery.

There is a great deal of confusion about what happens next. Portfolio investors are having their first sip of champagne in just under a year after equity markets rallied by as much as 100% in the last few months. Obviously, some investors think the prospects for the region look good in the medium term anyway. But talk to the economists and you will probably just want to go back to bed. The contractions in GDP have been cataclysmic: Latvia down 18% in the first quarter, Ukraine down 21% and Russia down about 10%, to name a few. All the emerging European markets were caught off guard and have been hit a lot harder than they were expecting by America's woes.

Now for the bad news. It could get worse.

The third place

Analysts at Citigroup Global Markets identify three phases to this crisis. The first and most damaging, the Financial Vulnerability Phase, is almost over. In this phase, countries with a high loan-to-deposit ratio were vulnerable to sudden closure of the international credit markets. However, the governments in the region handled themselves surprisingly well, reacted fast with bailout packages and the recapitalisation of big banks. Collectively, they nipped a systemic meltdown in the bud.

Citigroup says we are now in the middle of the second phase of the crisis, the External Vulnerability Phase. In this phase, countries, regardless of the health of their banking systems, became vulnerable to the crisis because of the large size of their external financing needs. However, this phase is coming to an end in most countries, as the new supercharged International Monetary Fund has stepped in (or is in the process of stepping in) to bail out countries in the most danger. The second phase of the crisis is less dramatic than the first, but the economic slowdown it causes as government's impose austerity packages to reduce debt gives it a couple of nasty stings in its tail.

The most obvious is that the slowing real economy causes bad debt to rise and could result in a second-wave banking crisis later this year, which we have written about extensively. Suffice to say that in most countries, the danger of a banking crisis caused by bad debt is receding. The small CIS countries have hardly been affected. Countries like Russia have been affected but look like they will cope. And in a few countries like Kazakhstan, Ukraine and Belarus, a banking crisis in the autumn remains a very real possibility.

"Non-performing loans [in the Russian bank sector] will probably reach 15% this year, which is more than you would like and will force some banks to recapitalise, but I don't expect it will go much beyond that. It will be an uncomfortable situation, but nothing that we can't cope with," Oleg Vyugin, former deputy governor of the Central Bank of Russia and board member of Russia's biggest commercial bank MDM-Ursa Bank, tells bne. "There is very little chance of a second bank crisis in Russia."

The IMF has a big role to play in mitigating this second External Vulnerability Phase, but even if the likes of Latvia and Turkey do get standby loans from the IMF, Citigroup says there is a third phase of the crisis yet to come, the Fiscal Vulnerability Phase.

Falling tax revenues drives this phase and it has yet to start. In the short term, the crisis is actually having some beneficial affects on national accounts: as imports have been falling faster than exports, current account deficits have been shrinking fast - indeed, both Estonia and Lithuania have turned large deficits into surpluses in the last 10 months. But as the tail end of the crisis wears on, slower growth means less taxes, turning the screws on budgets that are already under pressure.

Happily, Citigroup thinks that this problem will also be manageable. "Thanks to budget discipline in many countries during the past few years, we believe the Fiscal Vulnerability Phase poses fewer risks than what has passed before. The countries most at risk here are likely to be ones with unrealistic budget assumptions and high debt/GDP ratios," Citigroup said in a research note in May.

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