Ben Aris in Moscow -

"The Russian economy has stabilised, but that is only because the Central Bank of Russia is running a very tight monetary policy to support the ruble. I think that the underlying economy is not doing so well and the situation may actually be getting worse," says Ilkka Salonen the deputy chairman of Sberbank.

The first wave of the economic crisis to hit emerging Europe has receded, but the damage it has caused has started a rot that is eating into the fabric of economies across Central and Eastern Europe - consumer spending has evaporated and without sales no one can do business.

There is much talk about a possible second wave to the crisis - especially in Russia - as bad debts at banks across the region grow. But underlying the poor macro numbers and strains in the bank system are the empty markets; consumers right across the region are terrified of yet another economic collapse and are husbanding their resources. Unless shoppers go back to the newly built malls that dot the region, the prospect of more economic shocks will turn into a self-fulfilling prophesy.

The collapse in consumer confidence started with the rapid devaluation of currencies across the region after trillions of dollars of wealth was destroyed over the last six months. However, as this process is now coming to an end, analysts are hoping that the cash still in the system will start looking for something more productive to do. Rising amounts of investment and acquisitions as businesses in the region are reshuffled to represent the winners and losers should drive a recovery that could arrive as soon as this autumn.

However, this ignores the plight of the consumer. If, in Russia's case, oil revenues have been the fodder that fed economic growth and reforms to the financial sector since 2004 the pitchfork that distributed the food, then the consumer has been the workhorse of economic growth for several years.

Once again the value of savings has been decimated (or worse), while unemployment soars everywhere. In Russia, the number of people out of work topped 6m in March, or 8.5% of the workforce, while almost everyone throughout new Europe has been forced to take a pay cut of some sort.

Consumer spending has dropped like a stone and this is where the real danger lies. Unless governments across the region can reassure their populations that the crisis won't be that bad, shops will remain empty and the belief that economies will collapse will become a self fulfilling prophesy.

Demand off a cliff

No one is shopping, or at least if they are, then they are buying big ticket items, as investing into a washing machine looks like a better currency hedge at the moment than buying dollars. "The January retail sales were pretty strong, but some of this was simply people trying to protect their money from devaluation by putting it into goods," says Anatoly Landsman, chairman of SDM Bank in Moscow, which deals with medium-sized enterprises. He says that his customers are in relatively good financial health, but everyone has seen sales tumble.

The same thing happened in the 1998 crisis. Russians rushed to buy cars or white goods as the surest way to park currency in something that would hold its value irrespective of what happened to currencies and could be readily converted back into cash later at any outdoor market.

Retail turnover numbers in January were still in positive territory, but bankers report this is being driven by people investing their free cash in "white-good convertibles" for want of a better term. However, in February Russian retail sales fell by 2.4%, according to the official statistics - the first fall since 1999 after nearly a decade of double-digit gains - and are expected to remain depressed for months.

The result has been to squeeze both companies and the banks. Probusinessbank was set up in the 1990s in anticipation of a coming boom amongst small and medium-sized enterprises and has since morphed into a financial group catering to all the needs of small business. Presciently, Sergei Leontiev, president of Probusinessbank, saw the international financial crisis coming in 2007 and cut all his foreign borrowing, rapidly building up domestic deposits, which provide all the funding the bank needs. "We have plenty of money, but we have no one to lend to," says Leontiev. "The small- and medium-sized enterprises we deal with have all seen sales collapse. No one is expanding, no one is seeing sales growth, so no one needs to borrow. We are being squeezed as a result."

Straw poll

The same phenomenon can be seen across the entire CEE region, although the degree to which countries have been affected varies widely.

In general, the further west you go the better the situation, as the economies are better balanced. But the fall in consumer spending is also a function of where the floods of incoming capital went in recent years. Part of the reason that places like Latvia are in so much trouble now is most of the investment went into speculative investments in things like real estate rather than productive sectors. However, even Slovenia, which is by far the most developed of all the socialist bloc countries, went into recession for the first time ever since independence as a result of the consumer blues.

The Austrian bank Erste Bank has invested heavily in CEE and took a straw poll of its country managers in March. The result was the same story repeated itself almost everywhere. Lucian Anghel who runs Erste bank's Banka Commerciala in Romania, reported retail sales were down 13.7% in January year on year. Orsolya Nyeste, who runs Erste Bank in Hungary, said retail sales grew by only 1.3% in January and expects sales to fall from here. And Jana Krajcova, who works at Ceska Sporitelna in Prague, said retail turnover fell 10.7% on year for the first two months of 2009. "Withdrawn deposits from the banking system are being exchanged for foreign currencies and consumer goods, as people are trying to protect themselves from inflation and the devaluing currency," Krajcova concluded.

Bad loans

The collapse of consumer confidence is already feeding through into the banking sector and threatens to bring the entire financial system down. The problem is partly due to the inability of consumers to pay off their loans, but just as damaging is the speed of the change, as banks were still in high growth mode until last September and have debt schedules to match.

The predictions for the level of non-performing loans (NPLs) by year-end range in Russia from Sberbank's 10% of the total loan book going bad (manageable) to chief economist at Alfa Bank Natalia Orlova's prediction of 16% (big problem). The reason the spread in the estimates is so big is that the spending habits of the populations in all the countries in the region are completely unpredictable. It boils down to how depressed the people will be and how long the blues will last.

And this is just Russia. The situation in Ukraine is far worse where NPLs are already soaring; Russia probably has the wherewithal to avoid a systemic collapse of the banking sector, but the National Bank of Ukraine is being asked to bail out banks or take them under external administration on nearly a weekly basis. Likewise, in Kazakhstan the sector average NPLs hit 12.1% by the start of March -- well into the danger zone -- and in the case of market leader BTA already approaching 16%, which means it is fighting for its life.

Even if Russians cheer up and get their chequebooks out again, the up-tick in consumption will be limited by the lack of credit. In the white goods sector, for example, stores like M-Video report that between a quarter and third of their sales were made on the never-never last year. Between 2007-2008, the nominal amount of credit in Russia increased to a peak of $167bn in October from $72bn in January 2007 - equivalent to about 10% of GDP. A very large amount of that spending will now disappear.

Against this, average retail borrowing in Russia is only 9% of GDP compared with about 25% in Western Europe, so the average Russian is much less exposed to consumer credits than his peer in say Paris or London; the recovery of consumption should come faster as a result.

Falling incomes and rising unemployment will also make it harder to climb out of the hole most countries find themselves in. In Russia, a poll conducted in March found more than half of the country's households had seen their incomes fall, while the official figures say that disposable incomes shrank by 7.2% between January and February year on year after growing by 11.2% in the same period a year earlier. More worryingly, Russians are now tapping savings to maintain their standard of living.

The Kremlin has hiked public sector incomes by a quarter (which affects about the third of the population) to offset the collapse in consumption, but analysts are still expecting private consumption to fall by 3.5% this year.

All these problems combine to form a gloomy prognosis. A raft of Russian officials predicted in March that the problems with NPLs will become acute in the second half of this year and could lead to another bout of instability, or even a full-blown bank crisis. According to First Deputy Prime Minister Igor Shuvalov, the current situation is relatively stable, but the state is ready to spend up to RUB200bn (€4.4bn) to support the banking system, should banks face a massive expansion in NPLs.

Deputy Prime Minister and Finance Minister Alexei Kudrin said in the middle of March: "We're expecting a second wave of problems in the financial system, due to the non-repayment of loans by the real sector. There are some who have waited until the last moment in the hope the market livens up," Kudrin said, adding that those hopes have not been justified and there aren't any serious grounds to expect demand for real sector goods to strengthen in the short term.

All the countries of CEE are in the same boat and many of them are worse off than Russia, where at least the state still has over $600bn in reserves to tackle the problem.

The mammoth changes in the structure of the global economy mean most countries will be forced to reengineer their economies. Russia needs to boost domestic demand and, happily, the Kremlin has already started down this path by using oil windfalls to subsidise the taxes on the rest of the economy. However, the crisis has shown that it didn't go far enough. "We need a different model - one that is oriented toward domestic demand," Shuvalov said, a bit belatedly.

China too has been following an export-led strategy, fuelled by keeping the currency undervalued. But domestic consumption is underdeveloped, as the vast majority of people are so poor, and it must now reinvent its economy if it's to replace its export revenues, says a Sinologist at the university of Leiden, Dr Axel Schneider. Germany is in the same position; albeit the country has a much stronger consumer base to work with so is in a much better position to weather the storm. Most CEE countries find themselves somewhere between these two extremes and many - like Russia, Ukraine and Kazakhstan - are reliant on a single export, which makes their recovery dependant on the vagrancies of the commodity markets. Even so, re-engineering an economy towards more domestic consumption will take years to implement.

Just how fast the process goes will determine whether this crisis is one of the alphabet of options suggested. Clearly the 'V' version (fast collapse, fast recovery) is not going to happen. More popular are the 'U' variety (fast collapse, extended recession, strong recovery) and 'L' versions (fast collapse, very long recession). But the rise in NPLs means CEE is also facing a 'W' option (fast collapse, bounce back, second crisis later this year, then real recovery). It is still too early to say which way it will go, although we seem to be at or near the bottom of the first trough now, if it is going to be a W.

A survey of expectations by the Post-Crisis World Institute and the Public Opinion foundation in March found populations in the Commonwealth of Independent States are universally pessimistic about the next few months, ranging from the most pessimistic in Ukraine (61.1%) to the most sanguine in Kazakhstan (16.6%). Likewise, a similar poll conducted in Poland by the Pentor institute found the consumption climate indicator was down 6.2 points and still falling, which is indicative of the glum mood of consumers across Europe.

The author of the Hitchhiker's Guide to the Galaxy, Douglas Adams, had a joke about distressed economies. What do depressed consumers do? They tend to look down at their shoes. What do they do to cheer themselves up? Go and buy a new pair. Everyone is hoping that's exactly what they do.

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Trading places - Russian discount supermarkets flourish

The silver lining in the black clouds of global recession is that Russians have traded down en masse from expensive imported goods to made-in-Russia products. The strength of the ruble used to make imports cheap, but after the currency lost a third of its value in recent months imports are expected to drop 20% this year.

The big winner has been low-end Russian supermarket chains; Russia imports about 40% of its processed foodstuffs (and Moscow about 60%), but suddenly everyone is buying homemade cheese and sausages. Food processing is one of the few really competitive sectors in the Russian economy and has flourished in recent years. The crisis is turning into a big fillip for already profitable local producers.

While almost all of Russia's companies have seen sales collapse, leading discount supermarket Dixy Group posted a 21% increase in sales between January and February to RUB8.6bn (€190m) and says it plans to open 100 new stores this year. Likewise, sales at rival Seventh Continent were up 12%, but the biggest gains were in the regions where sales were up by almost a third.

Supermarket king Magnit is doing best of all. The company bypassed big cities like Moscow and St Petersburg to build up a business in Russia's 83 regions. While most companies have slashed investment plans, Magnit will continue to expand this year and said in February it was going ahead with $660m of investment to add 400 new discount stores, up from the 371 stores it opened in 2008, although it has axed plans to build six new hypermarkets.

Crises are good for food producers in general, as food is the last thing consumers cut if they need to save money. Indeed, sales often increase because although you can't afford to go out anymore, why not treat yourself to a good dinner at home instead? This is especially true in Russia where consumers still spend about three-quarters of their income on staples - more than in Thailand, India, Ukraine and even Belarus - while in the West consumers spend no more than 20% on food, say analysts at Renaissance Capital. And food producers are already feeling the benefits, as almost all February's gains in industrial production came from the food processing industry.

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