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Central and Eastern Europe has certainly been spared the worst of what has befallen some western economies, but a couple of recent reports highlight some worrying weaknesses.

A new report from Moody's Investors Service found that macroeconomic stress is approaching critical levels in 10 emerging European economies. Of the countries in the so-called "danger zone," Hungary, Latvia and Lithuania are at the greatest risk of a hard landing.

LIkewise, on June 2, the Centre for European Economic Research and Erste Bank released its monthly report on the economic outlook for CEE countries. After a continuous improvement of the economic expectations for the region during the last three months, experts surveyed appeared to have turned more cautious in May, with the indicator for the region declining by 11.6 points to minus 24.1 points. The balance for the Czech Republic dropped the most, falling by 20.3 points to minus 39.0 points. Slovakia's indicator decreased by 17.8 points to minus 35.2 points, while Poland's indicator fell by 17.4 points to minus 28.0 points. Although Slovakia has fulfilled all of the conditions for joining the euro on January 1, 2009, the surveyed experts have doubts concerning the government's ability to sustain the current low inflation rate.

Moody's identifies 11 countries - all, with the exception of Iceland, from emerging Europe - where high credit growth and several years of current account deficits have led to growing economic imbalances. With credit readily available, banks in all these countries have borrowed heavily, ploughing this money into their domestic economies through loans to households and businesses. Their loans have funded a boom in investment and consumption, and rapid economic growth which has, however, been accompanied by soaring current account deficits.

Although macroeconomic pressure has been building for several years, this has only recently been highlighted by the turmoil in world financial markets. Capital flows into these countries have so far been maintained, but Moody's warns that international banks and investors have become more risk averse and capital constrained, which could lead to difficulties in future. Many of the "danger zone" economies are now in danger of a hard landing.

Painful contractions

In the three most vulnerable economies, Hungary, Latvia and Lithuania, there is the highest risk of a sudden contraction of the economy, and sharp decline or reversal of the current account deficit. "A severe hard landing would probably cause a significant increase in public debt, leading to a material reduction in the government's financial strength. Given the expected size of the financial shock, policy reactions would likely be insufficient to regain the previous level of strength in a reasonable period of time," Moody's says.

A second group of countries, Romania, Poland and Croatia, are in a somewhat stronger position. However, they still face the risk of a medium to large increase in public debt in the event of a hard landing, which could put downward pressure on sovereign ratings.

Bulgaria, the Czech Republic, Estonia, Iceland and Kazakhstan are in the best position of the "danger zone" countries. According to Moody's their economies demonstrate "excellent financial strength," and as a result are likely to withstand even a high level of macroeconomic stress.

Moody's has not yet downgraded the sovereign ratings of any of the eleven countries, but it warns this could happen in the event of a hard landing. "Such a scenario would place negative pressure on ratings and could lead to downgrades, even though the current ratings already factor in the probability of a hard landing to some extent," it says.

However, sovereign ratings for these countries are in general more positive than those for credit default swaps (CDS) markets. CDS-implied ratings were previously more optimistic than sovereign ratings but, with a risk of debt default factored in, for several of the countries in question they are now much more pessimistic.

If the situation worsens, governments may need to step in to provide banks with additional capital and liquidity. According to their bank financial strength ratings (BFSR), Kazakhstan is the most at risk, with Bulgaria and Romania also falling into the high-risk category. Croatia is assessed as medium-risk, with the remaining countries having only a low degree of banking sector risk.

The continued availability of financing will be crucial, due to the need to roll over maturing debt. Moody's points out that governments are especially vulnerable to a contraction in liquidity, since most of their assets are fixed and, therefore, illiquid.

The small size of most of these economies is an advantage in this respect. While their debt is high compared to GDP, it is small in absolute terms. It's thus likely they will still be able to obtain finance, even if the situation on international capital markets worsens.

This risk is somewhat higher in the larger economies, which have higher financing requirements. Among these countries, Romania and Hungary, with their relatively shallow domestic investor bases, are probably the most vulnerable. However, outright defaults are "remote and unlikely", Moody's says, given that international financial institutions, the European Central Bank (for EU member states), or neighbouring central banks would certainly step in to prevent this.

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