Political risk is back

By bne IntelliNews February 25, 2010

Nicholas Watson and Ben Aris -

The Ukrainian elections in January that finally brought the curtain down on the Orange Revolution could be a taste of things to come in 2010.

A toxic blend of an International Monetary Fund-supported economy in recession and politicians who want to avoid hard choices led voters to return to the past and plump for the villain of the 2004 Orange Revolution: twice-convicted Viktor Yanukovych, who was premier during the corrupt reign of former president Leonid Kuchma, narrowly won the presidency over Prime Minister Yulia Tymoshenko, a leader of the popular uprising that ousted the old guard.

Political risk in Central and Eastern Europe is back with a vengeance this year. Six more countries in the region are due to hold elections this year - possibly more if 2009 is any guide; several governments were toppled last year as the global economic crisis took its toll on people's patience with their elected leaders. Latvia, the worst-hit EU member state by the crisis, saw its government under former prime minister Ivars Godmanis resign in February 2009 as it struggled to convince people of the necessity of the cuts demanded by an International Monetary Fund (IMF) bailout programme. A few weeks later, governments in Hungary and the Czech Republic fell too, leading to caretaker governments who are holding the fort until fresh elections can be held later this year. Then in June, Bulgaria got a new centre-right minority government headed by Boiko Borisov. Bosnia-Herzegovina and Croatia changed also their prime ministers (though in both the parliamentary majority stayed the same). The Estonian ruling party is now a minority government. Romania's government collapsed in October and only recently got a new one after President Traian Basescu won re-election in a close-fought race in December.

The crisis has destabilised the politics of this region at a time when governments need to be tough: most of the emerging European economies could rebound strongly this year from the crisis, but almost all the governments in the region are trying to engineer a recovery at the same time as coping with bloated deficits. Spending needs to be cut and/or taxes raised just as the population is feeling more vulnerable than it has done in years.

Just how the trade-off between the benefits of growth and the pain of increased austerity plays out in each country remains to be seen, but the countries with elections definitely set for the rest of this year - Hungary, Czech Republic, Slovakia, Latvia, Poland and Bosnia-Herzegovina - can be divided into two groups: those with fragile economies (Bosnia, Hungary and Latvia) and those with relatively stable ones (Czech Republic, Poland and Slovakia).

All the countries with fragile economies have IMF programmes in place to keep them afloat, putting them at the sharp end of cuts. "And the stronger the need for fiscal adjustment, the tougher the pressures on the political and social front," say analysts at UniCredit Group.

Latvia's problems are so severe and the population so disillusioned with its politicians the odds are that the present government under Prime Minister Valdis Dombrovskis won't even survive until the general elections. A fall in the government would put adherence to the IMF programme in doubt again, as well as the ability of the country to keep its currency, the lat, tied to the euro, something that's causing so much pain now but which, argue its supporters, will allow the country to flourish in the long run.

The expected (though not yet scheduled) parliamentary elections in Moldova too will be pivotal. The new reformist, EU-oriented government has in a few short months managed to slash the budget deficit and undertake long-overdue reforms, but these are hurting the population and the fear is that rather than strengthen the hands of the reformers, the voters will punish them by voting back in the Communist Party. "People see the new alliance, and see the new prices," sighs Anatol Gremalschi of the Moldovan think-tank Institute for Public Policy. "It's a natural reaction."

But even the more stable countries could face similar risks. With more resources, these countries can absorb more of the pain, but if predictions of a double-dip recession pan out, then the instability will spread across the region like stomach flu in a class of primary school children.

Greece's fiscal woes have only heightened awareness of the wobbliness of the situation. Greece's ballooning budget deficit and debt levels are shaking the very foundations of the Eurozone, and some sort of EU or IMF bailout will almost certainly be necessary. But Greece is only an extreme case; the acronym that groups the emerging market powerhouses of Brazil, Russia, India and China (BRIC) may be intimately associated with the recovery, but the new (rather insulting) one of PIGS (Portugal, Ireland, Greece and Spain) is the main talking point now. In mid-February, the cost of hedging against a default in a number of EMU countries was higher than, for example, for Romania or Russia.

While it's too early to gauge the ultimate effect of Greece's problems on neighbouring countries and the rest of Europe, fourth-quarter GDP numbers released in mid-February were far from encouraging about the state of the continent's economies, and offer further proof that the recovery here will, for the most part, be a slow, hard grind and lag other emerging market regions of the world.

And then there's Turkey, which withstood the crisis fairly well but has now seen the perpetually simmering conflict between its secular and religious forces flare up again. February saw an unprecedented series of arrests of military personnel that culminated in the charging on February 24 of seven senior officers over an alleged 2003 plot to stir up chaos in Turkey and justify a military coup.

This current "Sledgehammer" investigation is part of a wider "Ergenekon" investigation over similar plots to bring down the mildly Islamist AK Party government, whose claim that it's trying to modernise Turkey and move it closer to EU membership is dismissed by nationalists, who accuse it of having secret plans to turn secular Turkey into an Islamic state.

The current military leadership issued a press release on its website on February 23 saying that senior generals and admirals viewed the situation as "serious," with analysts likening the situation to April 2007 when the then head of the Turkish military, General Buyukanit, issued a statement that signalled the military's unease over what it saw as the government's efforts to reign-in Turkey's secular traditions. Tensions were only eased by a closed-door meeting between Buyukanit and PM Recep Tayyip Erdogan, and then by parliamentary elections that the AK Party won with a large majority, in effect winning a vote of confidence for its reform agenda from the population. "Beyond the next few days, there are now serious questions about how this situation will be resolved in a more meaningful way. From one perspective the government is under some obligation to press on with the Ergenekon/Sledgehammer investigation to demonstrate to the EU that it is serious about finally bringing the military under full civilian control. At the same time, further arrests will just further accentuate tensions. It's a difficult balancing act and indeed this might provoke a counter reaction from the secular establishment, for example another party closure case against the AK Party," says Tim Ash of Royal bank of Scotland.

Closing the gap

How well the countries of the region cope with this bought of instability will determine how fast they can close the income gap with their more mature peers in Western Europe.

Jim O'Neill, head of research at Goldman Sachs and the man who coined the BRIC acronym, has already shaved about a decade off the time it will take those countries to represent the major part of the world's economy.

The former head of the World Bank James Wolfensohn told bne last year that the BRIC nations will make up over half the world's economic output by 2050, but will still be trying to catch up with the West in terms of per-capita GDP. "By 2050, India will account for about 25% of the world's economy with China accounting for another 22%. Brazil and Russia will account for another 2%," said Wolfensohn. "But even then, the per-capita income in America will have risen from about $45,000 now to $95,000. India and China will have per-capita incomes then of only about $40,000, while in Africa it will closer to $3,000. China and India will make up a big share of global GDP simply because they have so many people, but they will still be in catch-up mode."

Edward Pockney, a Hong Kong-based banker who lives in the heart of the Chinese miracle, points out that despite the dynamism of Asia, western nations remain robust and mature economies that have been built up over 300 years. They have a lot of problems now, such as dealing with the huge amounts of debt, their main challenge is to draw up new regulations to prevent the recent excesses occurring again. The emerging markets have the opposite problem: they are not suffering as much from these structural problems, but their main challenge is to put in place run-of-the-mill regulations that allow their markets to function.

How well the countries of CEE cope with the political instability now will affect how much progress they make over the coming decades. Ukraine has wasted most of the last five years, as the politicians spent most of their energy on infighting. Russia has made some progress, but also wasted a lot of time as the oil revenues made policymakers lazy. Slovakia and Slovenia are arguably at the top of the class when it comes to implementing reform. A boon from this crisis is that these differences have been highlighted in the most dramatic way possible and will re-focus everyone's attention on the need for prudent management and effective markets. Well, we can hope anyway.

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