Maastricht on its head

By bne IntelliNews January 20, 2010

Ben Aris in Moscow -

If the euro were being launched this year, which European states would be allowed to adopt it? The answer is that only Finland, Bulgaria and Luxembourg currently meet the euro convergence, or Maastricht, criteria.

Bulgaria? This new EU member state is supposed to be a basket case, bucolic economy riddled with corruption. Perhaps, but it also has low inflation of 0.3%, low public debt of only 13.5% of GDP, and low interest rates of 0.8% - all way under the Maastricht limits of 3.2%, 60% and 6.5% respectively.

The international financial crisis has turned Europe on its head and made a mockery of the old division of east (read: "backward") and west (read: "developed") that existed only two years ago. Indeed, any lists that rank the economic health of all the countries on the Continent is now a mash-up of eastern and western names. Many of the so-called "industrialised" countries of the west now have structural problems more typical of Europe's "emerging markets", whereas many emerging markets in Europe sport much better fundamentals than their western cousins.

The result is the current crisis will accelerate the catch-up of east with west. And the process is already well advanced, as several emerging European markets are already on the verge of meeting the Maastricht criteria, while their western peers are moving further away from those limits.

Take public debt, for example (not to be confused with total external debt - several pundits have confused the two: the latter includes commercial debt, much of which is offset by the ownership of foreign assets). Hands down, the debt basket case of Europe is Italy, which owes more than the value of its entire economy (115% of GDP). This is closely followed by Greece, which is in such a poor state that there's even talk of it abandoning the euro to return to the drachma. Both these countries will see their public debt increase to 120% and 125% of GDP next year - more than double the Maastricht limit.

On the other hand, all the countries of Central, Eastern and Southeast Europe (except Hungary) are well below the Maastricht limit of 60% of GDP. Russia is way out in front with a total public external debt of a mere 6.7% of GDP. Given that even after dropping over $200bn of its hard reserves on a gradual devaluation of the rouble at the start of 2009, as well as tens of billions of dollars on supporting the bank system and rescuing companies, the state still had over $440bn in reserves at the end of 2009, making it the world's third-richest country in terms of cash in the bank after China and Japan. (The UK and the US have just under $90bn in reserves, putting them well down on the list.)

And although they are already overextended, all of the 27 existing EU members will see their debt get further away from the Maastricht limits. (The only exception is again Hungary, which hopes to reduce its borrowing from 75.9% of GDP to 72.2%.)

Inflated worries

Where the EU members do a lot better is on inflation. Here almost all the existing members have inflation below 1% - way below the Maastricht criterion of no more than 1.5 percentage points higher than the average of the three best performing member states, which is 3.2%: the exceptions are Poland, Romania, Ireland and, predictably, Hungary again. But the low rates in the west are artificial, caused by a collapse in consumer spending as locals worry about keeping their jobs and hanging onto their homes. Once things get back to normal, the problems of rising food and fuel prices that caused a spike in inflation in the summer of 2008 will almost certainly reassert themselves.

Inflation remains a problem for most of emerging Europe. While the global slowdown has brought down inflation rates in the almost all the Balkan countries to below the Maastricht cap, it remains more than twice this in Eastern Europe. However, inflation is continuing to fall. Russia is expecting 8.8% inflation this year - the lowest rate in its modern history and inflation was actually zero for the last four months. Even in Ukraine, which had the highest level of inflation in Europe in 2008 at over 25%, inflation fell to 14.9% at the end of 2009. All the countries of the east are expecting this trend to continue.

Finally, the place where the division between east and west is least pronounced is with budget deficits. The UK and Ireland have the biggest deficits, which are at emerging market levels of over 12% of GDP. But these two countries are joined in their fiscal woes by a very mixed bag from east and west: Ukraine, Russia, Serbia, Latvia, Lithuania, France, Italy, Poland and Spain - all of which have deficits twice as much as the Maastricht's limit of 3%. The only difference between the countries in this list is that all the western countries are expecting to see their deficits increase this year, whereas two-thirds of the "eastern" countries (and that includes the new members of the EU) expect to see their deficits decrease in 2010.

On the face of it, CEE has taken much more of a beating than Western Europe, as most of emerging Europe's economies saw catastrophic economic collapse. Russia's economy came to a complete standstill last winter, turning the 7%-plus economic growth into a contraction of 8%, while Ukraine's GDP fell a gut-wrenching 20% in a single quarter. The economic slowdown in the West was only a few percentage points.

However, going forward the continent's emerging markets are much better placed to bounce back. The key to a turnaround will be the universally low level of sovereign debt, which allows the governments of the east to continue cutting interest rates, borrowing to fund deficits, and spending money on stimulus packages. The West, on the other hand, has its hands tied by huge levels of debt and large deficits. It will have to raise interest rates to stave off inflation and hike taxes to reduce both deficits and debt. (Greece has already seen rioting to protest against its emergency austerity package.) In short, CEE can follow policies to promote growth, while the West has to follow policies that will stifle it.

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