David Lubin of Citigroup Global Markets -

Summary:

--The story leading up to emerging Europe's crisis has a number of parallels with the build-up to the financial crisis that hit the "Asian 5" economies in 1997, particularly in terms of the scale of the pre-crisis capital inflow, and the way in which this increased each region's dependence on external financing.

--If Emerging Europe's vulnerabilities have echoes in the Asian crisis, does that mean Emerging Europe can enjoy an Asian-style recovery? The Asian 5 went through a deep recession in 1998, when GDP contracted on average by almost 8%, but their recovery thereafter was rapid and sustained.

--Yet Emerging Europe's chances of a V-shaped recovery are constrained by the contraction in external demand and a very weak international financial sector. A V-shaped recovery for Emerging Europe would, we think, at least require further real exchange rate depreciation than we have seen so far.

--If the balance of payments adjustment process in Emerging Europe remains limited, its crisis might end up having more in common with the Latin American debt crisis of the 1980s than with the Asian crisis of the 1990s. Western European banks with exposure to CEE have total loans outstanding there of some €474bn (end 2008), compared with Equity Tier 1 capital of just under €200bn: a multiple of 238%. We think this is a higher level of exposure than the large US banks had to Latin America.

--Net private capital flows to Latin America after the 1982 debt crisis remained negative for four consecutive years. This is a fate that Emerging Europe will hope to avoid, and its ability to do so will depend on the combination of official financing and balance of payments adjustment that comes through in the next few months.

Lessons from Asia?

The story leading up to Emerging Europe's crisis has a number of parallels with the build-up to the financial crisis that hit the "Asian 5"1 economies in 1997.

In Asia, the period leading up to the crisis was characterised by a very large net capital inflow that was dominated by FDI and by cross-border bank lending. This inflow sustained domestic spending growth in the Asian 5, which in turn helped to generate relatively large current account deficits; a phenomenon that was reinforced by the appreciation of real exchange rates in the region.

Moreover, the combination of pegged exchange rates, high nominal interest rate differentials, and a generalised exuberance about growth prospects in the region led to an accumulation of large currency mismatches on the balance sheets of corporates in the region (and on the balance sheets of some Korean banks). A decline in export growth in 1996 created doubts about the sustainability of the region's current account deficits, and this prompted a capital outflow which drained these countries of foreign exchange reserves, leading to the collapse of their pegged exchange rates and a very sharp recession.

One clear parallel between Asia and Emerging Europe lies in the scale of the capital inflow, and the way in which this increased each region's dependence on external financing. Figure 1 shows the increase in foreign banks' claims on the two regions in the run-up to their crises. In the case of the Asian 5, cross-border claims by foreign banks rose to 45-50% of these countries' GDP at the point of crisis, almost doubling in five years. The accumulation of cross-border liabilities to banks in Emerging Europe has been similar: gross international claims rose from 20% of Emerging Europe's GDP in 2003 towards 40% in 2007 (ex-CIS). Yet it is also clear from the data in Figure 1 that the absolute numbers involved are much higher in Emerging Europe. "International" claims - that is, cross-border claims plus the value of local claims by foreign subsidiaries in forex - rose to only $274bn at their peak for the Asian 5, but rose to over $773bn for Emerging Europe (excluding over $205bn for Russia). Both in Europe's case and in Asia's the share of short-term claims in the total was around half.

Emerging Europe's external vulnerability has evolved in a way similar to the Asian 5. Figure 2 provides data which show the some of the overall story for each crisis: rapid GDP growth accompanied by an increase in current account deficits (particularly in the case of Emerging Europe), together with a rise in the real exchange rates for each region (ditto). The main consequence of this story is a rise in external vulnerability, which we measure simply by adding a country's current account deficit to its stock of short-term external debt, and dividing that number by each country's stock of foreign exchange reserves (Figure 3).

There are, clearly, some important differences between Asia's experience and that of Emerging Europe. The most obvious difference is the nature of the exchange rate regimes in existence: while the Asian 5 operated more or less pegged exchange rates, a much greater variety of exchange rate regimes can be seen in Emerging Europe, including more or less pure floats (Poland, Czech); banded exchange rates (Hungary, until February 2008); currency boards (Bulgaria, and to some extent the Baltics); and de facto pegs (Ukraine, Kazakhstan until recently). The difference in exchange rate regimes between the two episodes is important, because it means that the currency mismatches that were built up have different explanations. In Asia's case, the currency mismatches that grew on corporate balance sheets are easy to explain in the context of pegged exchange rates, which encouraged borrowers to forget that currency risk existed, and therefore created strong incentives for short forex positions. For a country like Hungary, however, the incentive to borrow in foreign exchange resulted not so much from the disappearance of currency risk, but from the conviction that the economic convergence process guaranteed an appreciation of the local currency against that of its trading partners. Another important difference between Asia and Emerging Europe is the location of currency mismatches. Household borrowing in foreign exchange was not an important phenomenon among the Asian 5, but Figure 4 shows that it was in the case of some Emerging European economies.

If Emerging Europe's vulnerabilities have echoes in the Asian crisis, does that mean Emerging Europe can enjoy an Asian-style recovery? The Asian 5 went through a deep recession in 1998, when GDP contracted on average by almost 8%, but their recovery thereafter was rapid and sustained. Among the factors that supported this rapid recovery were: very sharp real exchange rate depreciations, an export-oriented economic structure which allowed these economies to take advantage of a very favourable international environment; efforts to stabilise the financial system; and a loosening of policies by most Asian 5 governments during the course of 1998. This combination of factors allowed the Asian 5 to quickly generate current account surpluses which helped to minimise external vulnerability, and that in turn helped to catalyse a new capital inflow which supported real economic activity in the region. One possible source of hope for Emerging Europe is that it is as open a set of economies as the Asian 5: for Emerging Europe as a whole, exports account for around 30% of GDP, a number similar to that of the Asian 5 in 1997. Yet the chances of Emerging Europe enjoying a V-shaped recovery are probably quite low, in our view.

Emerging Europe's chances of a V-shaped recovery are constrained by the contraction in external demand and a very weak international financial sector. With this in mind it is worth noting that the exchange rate depreciation that has taken place so far in Emerging Europe has been rather modest by the standards of the Asian crisis. Figure 5 shows the amount of real, trade-weighted exchange rate depreciation that took place in Asia (from the pre-crisis peak to the trough) and in CEE (from the pre-crisis peak to February 2009).

The lesson here is that Emerging Europe's currencies have depreciated by much less since the crisis began than the "Asian 5" currencies did. On average, the peak-to-trough move in Asian currencies was, in real terms, over 40%. By contrast, the average move in the currencies shown in Figure 5 is under 20%, and many currencies remain at stronger levels than their long-run average.

If Emerging Europe has much chance of enjoying a V-shaped recovery, further exchange rate depreciation might be necessary. Perhaps one reason for the very sharp fall in Asia's currencies is that they had been largely pegged pre-crisis, and their devaluations took place only after forex reserves had been badly depleted: a currency might well fall by more if its descent only begins when forex reserves have disappeared. This isn't the case for Emerging Europe. Yet even with the support of more depreciated exchange rates, Emerging Europe will still be constrained by the much uglier international environment that exists today in comparison with the late 1990s: global GDP growth averaged 3% in 1998 and 1999, while Citi's average growth forecast for 2009 and 2010 is 0.4%, including a 1.5% contraction this year. Moreover, Emerging Europe's fate will be partly determined by the weakness that exists in the European financial sector, since the bank lending which has been at the heart of the capital inflows that Emerging Europe enjoyed have been largely sourced by a relatively small number of Western European financial institutions.

Currency risk in the region might also be accentuated by the mixed evidence so far regarding balance-of-payments adjustment. The reason why the exchange rate data in Figure 5 might be disheartening is that exchange rate depreciation is an important tool of adjustment: at a time when external financing has disappeared, it behoves countries to shrink their need for financing quickly, and exchange rate depreciation can facilitate this. The speed of Emerging Europe's recovery from this crisis for Emerging Europe lies partly in how quickly this adjustment can be achieved. To date, however, the evidence of adjustment is mixed. Figure 6 shows the average trade deficit in the most recent three-month period, compared to a year-ago levels. Turkey and Russia appear to have gone through a rather impressive adjustment process so far - their recent trade deficits are low relative to year-ago levels - but central European economies have found it more difficult to adjust: the depth of the collapse in exports makes it that much more difficult to shrink imports by enough to generate a fall in the trade deficit.

The speed and amount of balance of payments adjustment is only part of what might help stabilise Emerging Europe; another part of the story is the amount of financing that's available to these countries. As far as financing is concerned, there are two dominant sources of foreign exchange that can help plug the gap left by exiting private creditors: the IMF and the EU itself. However, the EU's usefulness in this process is clearly limited to those countries in Emerging Europe that are members of the EU. The only formal means by which the EU can support members outside the Eurozone is through its recently augmented Balance of Payments Facility, which now has just over €40bn left to disburse. We believe further injections of financing, from the EU and the IMF, will on balance help smooth the adjustment process, and possibly reduce its extent.

Single goal

Perhaps the ultimate form of "financing" that the EU can offer to Emerging European states would be accelerated adoption of the euro. This is certainly a policy option that emerging EU members would welcome, and many of them have publicly urged the EU to relax the rules governing euro adoption. Yet doing so would require some renegotiation of the Maastricht Treaty, and this might have negative consequences for the euro's credibility. For that reason alone, we think it unlikely that accelerated euro adoption will be offered any time soon. In any case, rapid euro adoption might be a solution to some, but not all, of Emerging Europe's problems. While it would clearly solve the problem of currency mismatches on private sector balance sheets, early euroisation could limit the competitiveness gains that a country can generate through currency depreciation. In other words, early euro adoption might solve a short-run balance sheet problem at the cost of creating a long-term growth problem.

There is a trade-off between extra financing and extra adjustment. It almost goes without saying that the more financing that's available, the less a country needs to shrink its need for financing. How much would be enough? Figure 7 shows one way of calculating the external financing requirement this year for Emerging Europe, which is simply to sum the current account deficit, the rollover of short-term debt, and the repayment of medium- and long-term debt coming due. If financing isn't available on this scale for these countries, then the only options are i) further adjustment - implying greater recession and further exchange rate depreciation; or ii) some form of default on capital payments, whether through debt restructuring, capital controls or both. If that is the result, then the evolution of Emerging Europe's crisis might end up having more in common with the Latin American debt crisis of the 1980s than with the Asian crisis of the 1990s.

Lasting Latin

If Emerging Europe has any parallels with Latin America's experience in the 1980s, the crisis will be long and painful. After the 1982 crisis net private capital flows to Latin America collapsed, remaining negative for four consecutive years (Figure 8); and the region's debt problems remained unresolved until the end of the beginning of the 1990s. One reason why Latin America's crisis persisted was that it wasn't until 1987 that international banks with exposure to the region were able to afford to build large reserves against their bad debt; it was only when these provisions were in place that the banks could, realistically, afford to write off a portion of the debt. In 1982, the nine largest US banks had exposure to Latin America equal to 177% of their capital.

By 1988 that had fallen to 84%, thanks partly to the raising of provisions, and this helped facilitate the debt-reduction initiatives that eventually helped Latin American debtor countries regain access to international capital markets.

Western Europe's banks' exposure to Emerging Europe is high, creating possible parallels with Latin America in the 1980s. The Asian crisis didn't threaten to bring banks down, but the Latin American debt crisis did. The Western European banks with exposure to CEE have total loans outstanding there of some €474bn (end 2008), compared with Equity Tier 1 capital of just under €200bn: a multiple of 238%. To be sure, there are big differences between Latin America's experience and Emerging Europe's. In the first place, Latin America's debt crisis was essentially a crisis of public-sector indebtedness, while Europe's external liabilities are dominated by private sector debt. Second, while banks' exposure to Latin America was almost entirely in the form of cross-border exposure, much of Europe's banks' exposure to Eastern Europe is in-country. From the point of view of potential loss, these distinctions may not be significant. What's important is that the scale of this exposure as a share of capital creates incentives for banks to reduce net exposure. And just as Latin America's external creditors sought opportunities to reduce net exposure over an extended period of time - thanks to the sheer size of their claims as a share of capital - similar behaviour on the part of Western European banks is a risk worth considering seriously, particularly if there is an insufficient combination of external adjustment and official financing.

David Lubin is head of CEEMEA Economic & Market Analysis at Citigroup Global Markets

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