Nicholas Watson in Prague -

In a new take on the old maxim about Germany sneezing and Europe catching a cold, investors are asking whether the same can be said of the Eurozone and Emerging Europe.

In the lead up to the latest package of measures agreed by the leaders of the Eurozone on July 22, the markets of Central Europe and Southeast Europe - which have performed relatively well since coming out of the 2008 economic crisis - were wobbling. By mid-July, the New Europe Blue Chip Index was down almost 10% from the end of May as investors continued to pull money out. Global fund tracker EPFR reported that equity funds dedicated to Europe, Middle East and Africa saw their outflow streak hit 10 consecutive weeks in the second week of July - their worst performance since a 26-week run of losses ended in late January 2009.

The region's currencies were also suffering, with Bloomberg reporting that the Hungarian and Polish currencies both hit their weakest levels against the Swiss franc on July 18 since the newswire began tracking them more than 13 years ago. In a report released on July 14, Citigroup picked Hungary's forint and Poland's zloty (together with South Africa's rand and Brazil's real) as the emerging-market currencies most vulnerable to a new credit crisis like that sparked by Lehman Brothers' collapse in the autumn of 2008.

However, the deal hammered out by the Eurozone members, which will force private lenders to contribute to an aid package designed to give Greece decades more to repay its debts, offered some relief. Mildred Hager of Erste Group describes the deal as an important step towards a clarification of the debt situation, which "should calm down the markets for now."

However, she, like many others, warn: "Whether this will be the last word in the medium term remains uncertain." Indeed, the chief economist of the European Bank for Reconstruction and Development (EBRD), Erik Berglof, was warning on July 21 that the risks to the bank's 2011 economic growth forecast of 4.8% for the 29 countries in which it invests are continuing to mount. "An escalation of the Eurozone crisis would pose serious risks to growth and recovery across the region, especially in Southeastern Europe and the new EU members."

Channels of contagion

Investors remain worried by three main channels through which the crisis could arrive on Emerging Europe's shores: public sector debt/financing, the banking sector and the real economy/trade.

Looking at the debt/financing angle, Emerging Europe is not facing a solvency crisis like many of those countries in the Eurozone; save for Hungary, debt is much lower than in the Eurozone. According to Royal Bank of Scotland (RBS), the average ratio of public sector debt/GDP in Emerging Europe is only around 40% at present - half the average for the EU as a whole and significantly below the likes of Greece at 145%. "Hungary is perhaps the exception, with its ratio of public sector debt/GDP standing at around 78%, but nevertheless still just below the EU average," says Tim Ash of RBS.

Regarding financing, RBS notes that many of the sovereigns in the region have substantial fiscal reserves and have already financed themselves for this year, while many also still have existing lending arrangements with multilateral lenders like the International Monetary Fund (IMF). What's more, while Emerging Europe's external financing requirement is large relative to its GDP, it is small in dollar terms and, if necessary, could be met with fresh help from the IMF.

Even so, Neil Shearing of Capital Economics argues it would be complacent to assume that these relatively sound fiscal positions will enable Emerging Europe to sail through the euro crisis unscathed. "While the solvency of the region's governments is not in doubt, high external financing requirements mean the region is vulnerable to a fresh liquidity squeeze," Shearing says. "With the crisis in the Eurozone now threatening to engulf the likes of Spain and Italy, there is plenty of reason to be cautious on this front."

The region is probably most vulnerable through the real economy/trade channel. The relatively strong recovery of the economies of Emerging Europe compared with their western peers has been almost entirely driven by the resurgence in exports to Western Europe, particularly Germany, rather than from any improvements in domestic demand. "Most CEE countries have profited from strong export growth towards the Eurozone, while their domestic demand and investments are lagging behind and are not contributing much to GDP growth," says Wolfgang Ernst of Raiffeisen Bank International, a big lender in the region.

At particular risk are the smaller and more open economies of Slovakia, the Czech Republic and Hungary. In 2008, the share of exports in Slovakia's GDP stood at 74%, Hungary's at 72% and the Czech Republic's 66%. Poland, on the other hand, only had an export/GDP ratio of about 33% that year, and it was largely because of its large domestic market that it managed to be the only EU country to avoid recession during the recent crisis and is better placed to withstand a future one.

Even so, while countries with a larger domestic demand base may be able to counter negative external effects more efficiently than the smaller and less diversified economies, the overall region will continue to depend on economic trends in the Eurozone, and especially Germany, given their strong reliance on exports. And while it's fiendishly difficult to figure out how exactly the Eurozone crisis is going to pan out (a debt restructuring, a break-up of the Eurozone, or its survival in present form through a move to fiscal federalism), analysts say one thing is clear: in the near term at least, under almost any scenario, European growth and recovery looks set to lag. "For Emerging Europe, which has become increasingly integrated into the European economy, this has to be bad news, adding an additional brake to an already disappointing rate of recovery," says Ash.

Shearing agrees that at the very least, strong trade ties should ensure that growth in the region slows over the next year as demand in the Eurozone softens. However, he says the potential for the euro crisis to spread to the region's banking sectors poses a far more dangerous channel of contagion, which could ultimately tip some economies in Emerging Europe back into recession and - in the extreme - require fresh bailouts from the IMF.

The results of the most recent bank stress tests, designed to assess whether European banks have enough capital, that were released on July 15, aren't particularly encouraging.

Out of the 90 European banks participating in the 2011 stress tests, eight failed, of which five were Spanish, two Greek and one Austrian. Two other Greek banks, Piraeus and TT Hellenic Postbank, just scraped through. Greek banks have been major investors in the Southeast Europe, particularly Bulgaria (where their share is over 25% of the market), Romania (over 15%) and Serbia (over 15%), and there is some evidence over recent months to suggest that they have used regional subsidiaries to secure cheap financing for the parent. "While strict regulations should prevent parent banks from withdrawing capital from their subsidiaries in the east, the risk is that a messy ending to the euro crisis causes interbank markets in Western Europe to freeze in much the same way as they did post-Lehman," warns Shearing.

Pot, kettle, black

On July 23, Hungarian Prime Minister Viktor Orban, made a typically bombastic speech in which he predicted the sovereign debt crisis would turn the world on its head and "states thought to be strong earlier will weaken and countries seen as weak will turn out to be strong."

That is indeed what is happening as many emerging markets are finally being rewarded by global investors for their much sounder fiscal positions and stronger economic growth. However, if Citigroup's 'Contagion Index" is any guide, Hungary's PM is in danger of speaking too soon.

Citigroup's index tries to present a picture of the vulnerabilities that would emerge if the Eurozone starts to produce more contagion than we've witnessed so far. The index is made up of indicators of each type of contagion already mentioned: i) the ratio of liabilities to European banks as a share of reserves; ii) the debt/GDP ratio; and iii) the contribution of exports to the Eurozone to GDP growth. In addition, Citigroup adds two further indicators that would become relevant during a more general fall in risk appetite: i) the size of each country's external financing requirement, and ii) the share of non-FDI capital flows as a percentage of GDP.

Putting these variables together into a "Contagion Index", and it appears that Hungary, then the Czech Republic, Poland and Turkey are at most risk if the Eurozone crisis. Russia is notable by its place as least at risk.

Citi's "Contagion Index" highlights vulnerability in CEE