Neil Shearing of Capital Economics -

• The turmoil in global markets has raised concerns about a funding crisis in Emerging Europe, with some investors fearing that Hungary could be the next Iceland. In fact, Ukraine appears the more vulnerable to a balance of payments crisis, although risks also exist in the Baltics, Balkans and Turkey.

• We have been warning about a hard-landing in parts of Emerging Europe for some time. In contrast to most of Asia and large parts of Latin America, some countries have been running huge current account deficits. In other words, they have been borrowing from abroad in order to finance increases in standards of living. This in turn makes them vulnerable to a global liquidity crunch. The steep falls in Hungarian markets suggest that investors believe that it is most exposed to a funding crisis. But is this justified?

• A country's dependence on foreign finance is a function of its current account deficit plus the size and structure of its external debt. As we have noted before, the Baltics and Balkans run the largest current account deficits (around 15-20% of GDP), while the deficits in Ukraine (c.10% of GDP) and Turkey (c.6% of GDP) are also pretty hefty. Meanwhile, Hungary's current account deficit is smaller (4.5% of GDP).

• Unsurprisingly, those countries with the largest current account deficits also have the largest stock of external debt (see Chart 1). But it is not so much the level as the structure of a country's external debt that matters. In particular, a large share of short-term debt (with a maturity of less than twelve months) increases a country's immediate dependence on foreign capital. The 'external financing requirement' (the sum of its current account deficit plus its short-term external debt) is therefore the best measure of an economy's overall dependence on foreign funding.

• As Chart 2 shows, Hungary does have a reasonably high external financing requirement relative to GDP. This reflects a high external debt burden caused by the large current account deficits it ran in the early part of this decade. But other countries - notably the Baltics and Balkans - have much larger funding gaps as a share of GDP. And in plain dollar terms Turkey has a huge external financing requirement. (By way of reference Thailand's external financing requirement was 35% of GDP just before the Asia crisis in 1997.)

• Of course, this says nothing about the ability of countries to attract finance. Scandinavian banks will continue to play a critical role in funding deficits in the Baltics. Meanwhile, EU membership may help shore up investment in Central Europe. In fact, once political risk is factored in, Ukraine could be most vulnerable to a balance of payments crisis, despite the fact that it's overall external deficit is smaller.

• The good news is that the IMF has ample funds to bail out the Ukraine, or indeed any country in the region that comes under funding pressure: it has total loanable funds of $250bn, more than one-third of the combined financing requirement of Emerging Europe. What's more, early intervention could help avoid the poisonous cocktail of currency devaluations, spiraling inflation, sharp increases in bond yields and steep drops in output that tend to typify balance of payments crises.

• The bad news is that even if the worst case scenario is averted, GDP growth in the 'super-deficit' countries is likely to slow sharply next year. With the exception of the Baltics, outright recession is not yet our central forecast for these countries. But it is looking more possible by the day.

Neil Shearing is Emerging Europe Economist of Capital Economics

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