Fabrizio Coricelli and Debora Revoltella -

Until a few months ago Eastern Europe was considered relatively immune from the international financial crisis. Against a backdrop of high energy prices and a huge stock of foreign reserves, Russia was even considered a "safe heaven." For different reasons, countries of Central and Southeast Europe were also considered rather safe, being either members of the EU or candidates to join it. The EU umbrella was considered an effective institutional protection against the global storm.

After June, the landscape drastically changed for Russia, hit by a collapse in the stock market and a sudden stop in capital inflows. Starting in September, the scenario became darker in most CEE countries, as in the rest of the emerging world. The first victims of the financial turmoil were Hungary and Ukraine, which had to be rescued by the IMF. Interestingly, the two countries are very different.

Ukraine is a country highly dependent on production and exports of metals and thus vulnerable to the volatility of the commodity price cycle. Moreover, it has a long way to go in its process of reform and it is very weak and unstable in its political system. Since the start of the financial turmoil, the markets had discounted a high country risk, with spreads on Ukrainian bonds being the highest in the transition world. Hungary, on the other hand, is a member of the EU and one of the most advanced among the countries in CEE in terms of reforms and institution building. The fiscal correction plan implemented in 2006 had restored confidence of the country fiscal position, while signs of economic recovery were starting to materialise.

A legitimate question is why these two countries were the first victims of the global financial turmoil. An even more pressing question is whether these two countries are just the first victims of a list that is quickly going to increase. Our goal is not to forecast future crises, but to identify some key elements that can help understand the nature of the risks faced by emerging European countries and highlight some possible policy measures to avoid other crises.

Our main point is that fundamentals and the extent of external imbalances measured by aggregate variables, such as the current account deficit, are not the only determinants of the probability of getting into a currency/financial crisis in the current context of global crisis.

1. The re-pricing of risk in emerging markets

The first element to stress is that the current crisis has its centre in the core markets. In addition to lower international growth, re-pricing of risk and strong risk aversion in international markets are leading to a sizable reduction in capital flows to emerging markets. After the bankruptcy of Lehman Brothers in September, the liquidity crunch spread to emerging markets and the risk perception on all emerging markets sharply increased.

The synchronization in the increase in CDS spreads clearly shows the common global shock. The ranking among country groups remained broadly unchanged, with the only difference with the pre-September situation being that Central Europe surpassed emerging Asia. Among transition countries, the larger increase in spreads occurred in Russia and Ukraine, followed by Southeast Europe and the Baltics, with Central Europe still well below the other regions. However, the crisis in Hungary raises serious doubts on the ability of market spreads to predict a currency crisis.

2. Vulnerabilities to a sudden stop in capital inflows

One, rather obvious, observation is that countries with larger external financing requirements are more vulnerable. Most of the CEE countries are running wide current account deficits. Economic growth has been financed by "importing" external savings - mostly (at least in Central Europe and in Southeast Europe) in the form of FDI or private debt. The banking sector has played a key role, with strong lending growth, largely financed from abroad. The re-pricing of risk at the international level has led to an increase in the cost (and more generally availability) of such external financing, meaning a tightening of monetary and credit conditions.

Countries with greater dependence on foreign capital, usually associated with large current account imbalances, are more exposed to a correction. The work by Calvo and others on the impact of a sudden stop in capital inflows suggests that the relevant measure of sensitivity to a sudden stop in capital inflows is given by the ratio of the current account deficit in terms of the absorption of tradable goods. The idea is that the adjustment in the current account induced by a dry up of capital inflows is much more costly when the absorption of tradable goods is low. To emphasize the risks associated to a sudden stop in foreign loans and foreign portfolio investments, we subtract FDI flows from the current account deficit. However, we do not subtract FDI in real estate and the financial sector, as we consider such inflows as volatile as loans and portfolio investments in the current circumstances. Figure 2 links such measure of sensitivity to sudden stop in capital inflows to the risk premia prevailing in the market, with risk premia measured by the spreads in CDS.

Figure 2 shows that in terms of sensitivity to capital inflows, Kazakhstan, the Baltics and Southeast Europe appear the most vulnerable countries. Indeed, Kazakhstan has been the first country entering into a crisis, with a strong deceleration in economic growth arising already in 2008, resulting from a severe credit tightening, as local banks were unable to tap international capital markets for their funding and a burst of the real estate bubble. In the Baltics as well, a correction in the real estate market (also due to lower capital inflows) has been combined with lower lending growth, as the foreign owned banks (largely owned by Nordic banks) have been aggressively tightening credit policies, while reducing their funding to the local daughter companies. The result has been a quick cooling of the economy.

3. Aggregate numbers on current account deficits are not the whole story

A less obvious observation is that aggregate, net, figures such as CAD or net flows are not the end of the story. When large segments of the economy have over-borrowed, with a sudden stop it is not ensured that these sectors will be helped and rescued by the surplus sectors, being other private sectors or the state. This might well explain the case of Russia today.

In spite of positive current account balances, the over-borrowing of some specific sectors of the Russian economy has triggered a generalised correction. Increased borrowing costs and limited access to international and domestic capital markets have led to a tightening of credit conditions for the corporate sector. With a highly imperfect and segmented inter-bank market, the liquidity crunch has spread to the banking industry, with even the large banks sitting on their liquidity and refraining from lending. Massive government intervention to support the banks and the major corporations may avoid a full-fledged financial crisis, but at the cost of a return to a dominant role of the state in the economy.

4. Contagion from global financial markets

A final point to consider is that in the current global context countries might be hit more than justified by their macroeconomic fundamentals, simply because they are more exposed to international financial markets. As a result of the global credit squeeze, the countries that are going to be hardest hit are those with relatively large and liquid capital markets. We can think of investors who might be forced to realize investments (eg. hedge funds or mutual funds having to face unexpected redemption flows), as well as speculative attacks against specific currencies.

Hungary is a case in point. The country was emerging from a period of low economic growth, which was due to a strong fiscal correction plan implemented in order to correct the internal and the external imbalance. The fiscal correction plan had been successful, and brought clear improvements in macroeconomic disequilibria. Nevertheless, the high external debt, in combination to a relatively liquid (for the region) debt and equity markets, made the country vulnerable to capital flow reversals. In recent weeks, the bond market collapsed and the exchange rate constantly depreciated. As most debt, both public and private, is in foreign currency, currency depreciation sharply increased the debt burden for debtors. The country had to resort to the help of the IMF for a rescue package to avoid a currency and financial crisis.

If one looks at the role of different debt and equity markets in international portfolios and thus at their liquidity, it is easier to understand why Hungary was hit before and harder than the high current account deficit countries in the Baltics and in Southeast Europe. Figure 3 measures the vulnerability of different countries to capital flows reversals in terms of the share of foreign investors in local debt and stock markets. This indicator is linked to the variability of exchange rates in relation to the relevant foreign currency. Of course, countries with a currency board or with fixed exchange rates do not show any exchange rate volatility even if they might be exposed to strong pressures for devaluation.

Looking at Figure 3, the Hungarian crisis seems less surprising. Furthermore, the higher risks seem to be associated with larger and more liquid markets, such as Poland, Turkey and Russia. Figure 3 indicates as well that exchange rate volatility may end up being a major risk for the countries. It is interesting that among the countries with hard pegs only Estonia seems to be exposed to high risk of contagion.

If the picture depicted in this note has some truth, countries that occupy a more relevant place in international portfolios are likely to be more at risk, irrespective of their fundamentals. This suggests that international institutions, especially the European Central Bank, should help preventing possible currency crises. Setting up an exchange rate stabilization fund, financed by the ECB, would help preventing currency crises in emerging European countries. Alternatively, the announcement that the ECB is ready to step in to support the exchange rate of new EU members and candidate countries, such as Turkey, would discourage currency attacks.

Fabrizio Coricelli is Research fellow at the Centre for Economic Policy Research (CEPR), London, and Debora Revoltella is the Head of New Europe Research in Unicredit Group. This article first appeared on RGE Monitor

Send comments to The Editor