Crash or Crunch in CEE?

By bne IntelliNews September 2, 2011

Ben Aris in Moscow -

I was having fun until about three weeks ago," says Roland Nash, sitting in a café next to the new Hermitage theatre. One of Russia's best known analysts, Nash left his job as head of research at Russian investment bank Renaissance Capital earlier this year to join the up-and-coming Verno Capital, a fast growing fund that immediately took in $100m of Arab investment and quickly raised another $70m.

His move was illustrative of an optimistic and buoyant mood in Russia in the leadup to the summer, despite alarm bells sounding of a growing sovereign debt crisis in the West. Smoke from protests and rioting might have been rising over Athens, London and Dublin, but Moscow was calm and upbeat as both confidence and growth returned. The reason is that Russia has few of the problems that plague much of the EU and the US. Thanks to Alexei "Mr Prudence" Kudrin, deputy prime minister and minister of finance, Russia's economy is among the most robust on the planet with one of manufacturing data for Germany, Hungary, Czech, Poland, Slovakia, Turkey, Romania and Russia appears to show is happening. "The real financial crisis only starts after the real shock of the slowing pace of the economy has done its damage; thus it serves as an amplifying mechanism rather than a trigger," the economists say in their book. Does this mean we are headed into a second wave of the 2008 financial crisis, a double-dip recession or just a soft patch from which the global economy will recover fairly soon? A crash in Central and Eastern Europe at any rate seems unlikely, as most of the other preconditions that precede crises, identified by Reinhart and Rogoff, are missing.

The root causes

What actually causes a crisis? Annoyingly each time the trigger is something different, but Reinhart and Rogoff highlight several different factors that occur regularly.

One common trigger is a financial market liberalisation or the introduction of financial "innovations." And few would argue that the securitisation of mortgage-related financial products was the villain in this most recent riches-to-rags story.

Another culprit is what the authors dub a "capital inflow bonanza." In a boom, conditions conspire to attract significant inflows of money to some hot idea - be it a country, an asset class, or a product - that ramp up prices and make success a self-fulfilling prophecy. As Plamen Monovski, chief investment officer of Renaissance Asset Managers, pointed out recently in a paper, the human brain is set up to reward investment themes that lead to "irrational exuberance" and bubbles.

This physiology fed the US housing price bubble and the craze a decade earlier, as well as the intoxication that took over investors into Russia in 1997 and between 2004 and 2007 when they were both pulled into Russian equities by stellar returns and pushed out of the developed markets by the low rates of return.

Too much cash in the system usually sends something through the roof during the early stage of the bonanza, but eventually reality reasserts itself and the market typically begins to sell off six to nine months prior to the ultimate collapse and crisis. "Equity prices tend to lead commodity prices, in oil as in other commodity prices: the reason why is clear - commodity prices reflect demand today, while equity prices seek to discount how they will be in the future. As investors realise the cycle is weakening, they sell cyclicals; only once demand is weaker do spot prices actually fall," says Kingsmill Bond, a strategist with Citigroup.

Russia's stock market provided a textbook example of this in the run-up to the August 17, 1998 crisis. The RTS index peaked at about 500 in October 1997 before beginning a long descent that continued through the actual epicentre of the crisis before reaching a low of 36 in October the following year. The pattern was repeated in 2008, but the action went a bit faster: the RTS began selling off from its all-time high of 2488 on May 19, 2008, and was falling when Lehman Brothers collapsed, causing the massive global sell-off. The index reached a low of 500 in February 2009.

A fall of 25% is painful, but this current sell-off doesn't look like one of the early warning signals of an impending crash; all the RTS has done is give up all its gains made this year and is back at the level it was in October 2010.

Another classic asset bubble caused by a capital inflow bonanza is housing. The Russian real estate market exploded after mortgages appeared in 2003 with prices quintupling. But here too, while the current sell-off has knocked the froth off the market, prices have already recovered and passed the pre-bubble trend line. Demand is still running significantly ahead of supply, argues property broker Richard Ellis.

Debts to society

The other two important recurring causes of crisis are also muted in most of CEE: the build-up of debt (sovereign or private, external or domestic) and large current account deficits.

Reinhart and Rogoff found that once public debt reaches 58.9% of GDP (just below the 60% cap set by the euro's Maastricht criteria), the chances of a crisis increase significantly. All but three of the EU member states (and the US) have already breached this level, putting the whole of Western Europe squarely in crisis-prone territory, but none of the CEE countries are anywhere near this level of debt; indeed, Russia has one of the lowest debt levels in the world thanks to Mr Prudence. "While government gross debt has increased over the last three years by $70bn, Russia's total level of debt is still only $160bn, or 9% of GDP... If one places these numbers in the international context, the Russian government looks to be one of the best placed in the world," says Citigroup's Bond.

Economists tend to focus on external borrowing when looking at the health of a country's finances, but one of Reinhart and Rogoff's insights is to take domestic debt into account too, which is a lot harder to measure. (And remember that all of the US' debt is domestic - it has no external debt at all). But even on this score, most of CEE and Russia in particular look strong. "In the middle of 2008, Russian corporate debt from the banks and abroad was $800bn. It declined to $650bn during the global financial crisis (mainly because of the falling ruble, of course) and has now increased to $860bn. The split of foreign to domestic debt is 38%, similar to that pre-crisis," says Bond.

The picture for current accounts is mixed. Since oil prices recovered from a low of $40 per barrel in 2009 to around $100, Russia's current account has been positive to the point where the Ministry of Finance has started to replenish the reserve fund after expecting to exhaust it this year. But Belarus and Turkey are clearly in trouble. Belarus is teetering on the edge of a crisis as the International Monetary Fund estimates it needs some $6bn of cash in the second half of this year to avoid another forced devaluation.

Turkey too has seen its current account deficit mushroom despite putting in a strong performance for most of the other indicators. Both these countries are now crisis candidates.


The crash in stock markets around the world has spooked investors, as previous sell-offs have heralded nasty recessions. But fund managers like Nash can take comfort in the fact the stock market is a very poor indicator of what is coming next. "The stock market has predicted nine of the last five recessions," the economist Paul Samuelson wryly observed in 1966.

Even so, the bottom line is that while only a few of the CEE countries remain vulnerable to another crash, most are unlikely to escape unscathed if the West endures another major crisis. "In general, the economies of Emerging Europe look most vulnerable, for four reasons. First, they rely more heavily on exports to the troubled Eurozone. Second, they are more dependent on foreign capital to finance spending (particularly Turkey) and roll over external debt. Third, high budget deficits (if not debt) mean that there is limited scope for policy stimulus, if needed. And finally, the region's largest economy, Russia, will be hit hard if oil prices fall back, as we expect," argues Neil Shearing, head of research at Capital Economics.

How does a crisis in one country or region spread? Cross-border bank ownership is one of the main ways, as a bank in a crisis-struck country will not only curtail lending at home, but also in foreign-owned subsidiaries, even if they are located in healthy economies. The Central European states could well rue their decision to sell off their entire banking sectors in the early 1990s to Austrian and German banks; countries like Russia, Ukraine, Belarus and Kazakhstan, where foreign capital makes up less than a quarter of the sector, will be much better insulated.

A curtailing of trade is another channel through which crises are transmitted. An obvious strategy to climb out of the postcrisis abyss is to export to those parts of the world unaffected. The reason why this past crisis was so nasty was that it was global. Yet currently countries like Russia can increase exports to other emerging markets like India and China, which are continuing to grow at a good clip. While a slowdown in the traditionally dominant developed markets will clearly be extremely painful, the medium-term effect will surely be to drive the emerging markets further into each others' arms.

Russia is also a special case here, as its economy is heavily dependent on oil exports. Citigroup released a report in August that drew up two scenarios with oil at $80 and another at $50, which seems to be the lower limit for forward looking forecasts with the consensus at the higher limit. The Kremlin currently needs oil at $120 a barrel for the budget to break even, against $62 oil in 2008 pre-crisis. However, if oil does fall to $50 would that really be so bad? In 2006, the government needed oil to be $24 to break even.

In the short term, the developed markets' failure to deal with their structural problems will mean pain for Emerging Europe, but a crash in the West does not necessarily translate into a crash further east, especially given that many of the early warning signals of an impending crash don't exist in CEE. So while 2008 may be remembered as a year of a bad, but relatively common, crisis, it might also be noted as a transformational year that marked the beginning of a seismic shift in the centre of global economic gravity to the east.

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