Peter Attard Montalto of Nomura -
At the start of the year we argued that there would be no sovereign default in Central and Eastern Europe given explicit backing from the International Monetary Fund (IMF) and the EU, as well as potential bilateral support. On May 12, we visited Brussels to get a better understanding of some of the issues facing the region and came back a little less sanguine.
We were struck by the apparent lack of clear leadership on economic policy in the EU. This is in part because of rules against favouring individual countries. Such constraints limit the EU's role to the coordination of rescue/stimulatory policy across countries. Also the initiative in the economic policy response to the crisis has arguably been the domain of the countries. That said, we consider the existence of an EU emergency balance of payments support to be a definite positive. CEE does not appear to have a strong voice in the Council of Ministers, the principal decision-making institution of the EU, even where policy affects the region, though Poland, given its size, has more of a voice in the European Parliament.
Overall, we came away from the trip a little bearish on the ability of the EU institutions to deal with another leg down in the crisis or to provide help to foster a sustainable recovery in CEE. Member states seem to a large extent to be expected to fend for themselves. This should be fine as long as they are not hampered by excessively tight EU regulations or a new direction at the European Parliament and European Commission after June's elections.
The EU has no formal mandate to bail out any struggling state. Contagion risk has spurred some action, though such moves are heavily constrained. The European Commission has admitted that the EU's response to the current financial crisis has been slow and uncoordinated. But it has also noted that, given Treaty rules on competition and state aid, the EU is limited in what it can do beyond coordinating policy (and stimulus) between member states. There have been only a few key central policies. The first is the acceleration of structural fund payments. This allows CEE countries to draw on the pool of funds decided during accession negotiations. So far, Poland, for instance, is getting around an extra €500m per month. Member states with balance of payments problems may also borrow up to €50bn from a newly expanded fund for this purpose. Finally, there are capital injections to supranational organisations: from the EU to the European Investment Bank (expanding the capital base to €230bn) and then coordinated contributions to the IMF (of around €100bn).
The Commission views the IMF as the principal support channel to EU neighbours, including Ukraine and the Balkans, given the level of contagion risk back to the EU. Commission officials do not believe there was much else they could have done on the policy front (except, perhaps, acted earlier). The bulk of their effort seems to be on ensuring competition and preventing unfair state aid or protectionism. CEE member states have pushed unsuccessfully for extra money for key projects or more directed supranational investment. Supranational investment policy is independent from EU institutions and based purely on investment criteria. That said, these supranationals are pumping a significant amount of money into CEE banks and infrastructure projects: some €75bn has been pledged already. CEE countries have also been urging, with limited success, for the approval process for structural fund payments to be speeded up. There has been some softening of rules on state aid, but the Commission has stressed that this does not mean prioritisation of policy for euro vs non-euro member states or crisis (CEE/Portugal/Ireland/Greece/Spain) versus non-crisis states. This strikes us as a mistake. Given the extreme circumstances and that the Commission is trying to coordinate an EU-wide response, we think each country should be allowed to respond with suitable measures even if these contravene some EU rules (as long as they do not affect other members).
We sensed deep unease in Brussels about the situation in Latvia. This seems to stem mainly from the fall in growth and Latvia's possible difficulty in maintaining its peg to the euro and servicing its debt. The Commission has highlighted the risk of contagion to CEE, especially to Hungary. Hungary, however, has said it believes that assistance would be given to Latvia before it defaulted. We agree with this assessment, but find the level of concern interesting. We note that the Commission has expressed confidence in the plans of the new Latvian and Hungarian prime ministers.
The Commission believes in short, sharp shocks to unwind imbalances in CEE countries while preserving stability. Some in the European Parliament are more sceptical, given the potential for electoral pain. There is some concern in the Parliament and Commission about the lack of leadership given the collapse of the Czech presidency of the EU. This may be one reason for the lack of a forward-looking EU policy on CEE and the lack of a counter-proposal to Hungary's suggestion of an emergency rescue package back in March. Sweden, which takes over the presidency in July, seems to be trying to provide some leadership, but the situation remains cloudy. Asked what they might do if the current crisis worsened, Commission officials suggested closer coordination of fiscal stimuli and other measures across member states, and use of the emergency balance of payments instruments as needed. There are no contingency plans or further policy tools left in the European arsenal. Any future policy reaction will likely have to be led by the Council.
Commission officials reiterated their wish to see all CEE countries join the euro. The officials believe that euro entry will be a key part of economic recovery of the region in the medium term. We agree, although we have highlighted in the past our reservations about the ERM-II mechanism and the potential for speculative attack. Indeed, the Commission wishes to see credible plans and credible central parity targets for euro-entry, and no rushing. Officials conceded that Poland's plan for 2009/2012 ERM-II/euro entry did not look achievable and that the target dates could slip. Although the EU does not have formal euro entry currency targets, officials said they thought ours looked broadly sensible: 280 for Hungary, 3.8 for Poland and 26.0 for Czech Republic. The Commission has said it will not consider any alteration to the ERM-II procedure or Maastricht criteria. It was clear from Council members that candidate states are pushing for more flexibility but getting strong pushback. Poland's Ministry of Finance has begun informal talks on the issue. The Commission is worried about some of the domestic constitutional hurdles and believes these should be sorted out to smooth the path towards the euro. For Hungary, the Commission is waiting for the next government to clarify policy and wants to see a credible implementation timetable. The Commission does, however, welcome Hungarian Prime Minister Bajnai's long-run aim for euro entry. For Czech Republic, the Commission said in its 2009 Convergence Report that it wants a more structured plan. Commission officials were adamant that "euroisation" was unacceptable to all EU member states. They said that although euroisation has been done by small open economies outside the EU, it would not work for larger EU states given larger cross-border flows.
Financial sector bailouts
Coordinating financial-sector bailouts has been the cornerstone of EU policy. We noted that declarations on maintaining parent-company support to CEE have not yet been reflected in policy. Commission officials responded that it is monitoring bailouts to ensure that governments do not include protectionist clauses. The Commission appears content with the political declaration and the bilateral approach that CEE states have taken on the issue (mainly with Austria, Germany and Italy). We suggested that perhaps this should be made into a multilateral policy with a view to bolstering investor sentiment towards the region, but there seemed to be no appetite for such a move, despite the urging of CEE states. We find this slightly worrying, though the EU is overseeing some bilaterals between, for instance, Hungary and its parent-company banks. The Commission believes, however, that, save for genuine commercial decisions to pull CEE business, there has been no capital flight from the region. In the absence of any broader agreement, CEE central banks are having to monitor compliance with bilateral agreements on a daily basis, raising the prospect, in our minds, of capital controls if capital flight does begin.
The Commission has broadly welcomed the De LarosiÃ¨re report on financial services regulation. But some CEE member states fear potential over-regulation of their still-young financial markets and how this may hamper the ability of domestic companies to obtain credit and for the economy to fund its way through recovery. Concern runs along the traditional spectrum, with Czech Republic and Poland near the UK end of lighter regulation and Hungary closer to Germany and France, looking for more regulation. Poland believes - and we agree - that its domestic markets are deep enough to sustain it via domestic uptake of bonds by pension funds and other investors. CEE countries are also worried about a shift to the left after European Parliament elections and the further push for tax harmonisation and tighter competition policy that could result. CEE representatives in the Council are of the view that tax competition and attracting FDI through other incentives will be key to sustaining CEE economies.
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