Nicholas Watson in Prague -

With the collapse in less than a week of the governments of Hungary and the Czech Republic, there's no doubt, as Tim Ash of RBS puts it, that "the ongoing recession in emerging Europe is likely to have significant social and political consequences both in Hungary and the wider region."

On Tuesday, March 24, the centre-right minority government of the Czech Republic, headed by Prime Minister Mirek Topolánek, lost a no-confidence motion as 101 lawmakers, the minimum needed, voted to oust the government. Opposition Social Democrat chief Jiri Paroubek has been gunning for the PM since the minority government emerged from the October local elections even more weakened. And as the country finally succumbs to the recession gripping much of the region, Paroubek has stepped up his accusations that the government has mishandled the economic crisis. What makes the situation particularly awkward is that the Czech Republic currently holds the EU rotating presidency, though this is likely to be more embarrassing than anything more serious. Regular polls are due in mid-2010, but early elections may be necessary if there's no agreement on a new government. "Early elections (most likely at the end of 2009) are the most likely outcome of the current situation," says Jiri Stanik of the Prague brokerage Wood & Company.

The collapse of the Czech government comes after the failures of four other European governments, two in Central Europe. On March 21, Prime Minister Ferenc Gyurcsany stunned party colleagues by announcing his intention to resign from the post he has held since 2004. While some might argue that the fall of the Czech government had little to do with the crisis, there's no arguing that Hungary's economic problems were behind Gyurcsany's decision. "I hear that I am the obstacle to the co-operation required for changes, for a stable governing majority and the responsible behaviour of the opposition," he was quoted as saying by Reuters. "I propose that we form a new government under a new prime minister."

Hungary's economic problems are considerable and mounting. It is by far the weakest of the four "Visegrad" countries, which also include the Czech Republic, Poland and Slovakia, officially entering recession for the second time in two years in the fourth quarter of last year when GDP contracted 2.1%. The day after Gyurcsany dropped his resignation bombshell, he admitted that Hungary's economy could contract this year by more than the official forecast of 3.5%.

The median estimate of analysts in a Reuters poll published toward the end of March puts Hungary's economic contraction at 4.5% in 2009, with the most pessimistic prognosis being for a 5.6% fall. "And I'd have to admit, despite being reasonably positive about the export potential for the Hungarian economy in the mid term, that from the data I am seeing, the 5% to 5.5% contraction range doesn't look at all exaggerated," Edward Hugh, a widely read emerging market economist, wrote on his blog.

Deputy Finance Minister Laszlo Keller has begged economists to "stop the race" to the bottom of economic forecasts for Hungary, but it's become irresistible as the dreadful data flow in: the output of Hungary's construction sector fell 16.0% in January from the same month a year earlier; the number of new cars sold in February fell 46% on year; gross wages in January fell by 5.2% on year.

The big problem is that Hungary, like other Visegrad countries, is highly dependent on exports to the Eurozone. But what sets Hungary apart are its financial vulnerabilities - principally high short-term external debt levels - that are constraining the government's policy response. For a start, the government may have to cut spending by a total of 4% of GDP in order to meet the target for the budget deficit under the terms of its $25.1bn IMF-led rescue package it agreed at the end of last year, which had helped to stabilise the situation in the country.

Furthermore, Hungary's fragile financial system will prevent large interest rate cuts; the central bank on March 23 kept rates steady at 9.5%, "While rates could still hit a record low of 6% by the end of the year, the pace of easing will be much slower than in the rest of the region," says Neil Shearing of Capital Economics.

Worries about the banking system are growing as the gloom deepens. On March 9, Laszlo Urban, CFO of the country's largest lender OTP Bank, told a meeting on March 9 of the American Chamber of Commerce in Hungary that if the government fails to halt the slide in the local currency, the sector could collapse. The forint tumbled to a record low of 317 per euro on March 6 and ranks as the worst-performing emerging market currency this year. "If the population begin to convert their savings because they fear a fall to HUF350 or HUF400 [to the euro], then nothing can save the banking system," Urban said.

While most analysts reckon Hungary will avoid the worst-case scenario of a complete financial meltdown, the big wild card could contagion if the teetering Ukraine or Latvia fall.

With Gyurcsany's resignation and the IMF strictures of its loan beginning to look suffocating, Hungary is indeed starting to look more like Latvia by the day. Like Hungary, the Baltic country was bailed out by the IMF to the tune of €7.5bn and its government collapsed on February 20 amid worries it won't be able to implement the austerity measures associated with the IMF deal. "We now have a clear pattern being established following the recent IMF interventions in Iceland, Latvia, Hungary - the government collapses under the weight of the measures," says Hugh.

New men in the bloc

Attention will now turn to whether Gyurcsany's successor - whoever that will be, though the former governor of the central bank, Gyorgy Suranyi is being widely touted - can implement the required IMF spending cuts to keep the budget deficit under 3% of GDP. But that is looking increasingly forlorn. "The budget parameters agreed with the IMF now appear moribund, and unless more IMF/EU money is put on the table covering a likely budget financing shortfall, the prime minister will have to secure backing for yet more austerity which is likely to be difficult to achieve in practice," says RBS' Tim Ash.

What Hungary now needs more than anything else, says Hugh, is "incubation," as the current measures can't work, the 3% deficit is almost unattainable, and more cuts would be counterproductive. "What Hungary needs isn't 'balance of payments' assistance, but real economic support. Nice words don't help here, what we need are facts and deeds. A tragedy is about to happen, it would be more than a pity if it wasn't averted," he says.

With Latvia, Hungary and the Czech Republic fallen, other governments in the region could follow suit. Lithuania's centre-right governing coalition, in power less than two months, has struggled to persuade its citizens that austerity measures are needed to rebuild the economy and there have been large protests. On March 24, the rating agency Standard & Poor's cut Lithuania's rating one notch to 'BBB', saying the country's "political and economic capacity to adjust to a sharp fall in capital flows continues to be constrained by the high stock of foreign currency-denominated private debt and the rigid exchange rate regime."

Bulgaria too has been hit by protests in January as anger over corruption, crime and the slowing economy spilled over. This growing public discontent ahead of an expected summer election is unlikely to cause the government to fall, say analysts.

RGE Monitor identifies other weak governments in the region in Romania, Estonia and Ukraine.

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