Tim Gosling in Prague -

Central European countries have few direct links with Greece, and apart from Slovakia and Estonia, have mostly yet to join the euro. Yet there are several Eurozone contagion routes that stand to threaten the economies in the region should Greece be forced out of the single currency, with banks, capital markets and trade presenting the major risks.

Whilst governments in Central Europe are mostly right to point out that they are in better economic shape to face another crisis than in 2008, they're also clearly preparing for a shock of unknown proportions that's likely to reach directly to their core.

By all accounts, Hungary looks the most exposed due to its high vulnerability to all three routes. Hungarian Prime Minister Viktor Orban has claimed that, "work has begun" on strengthening defences "so that such a quake doesn't bring Hungary down on one knee." Capital Economics, in a June report that exhibits its usual dramatics when it comes to the Eurozone by predicting a full break-up of the single currency, also picks the highly open Czech economy. And Mert Yildiz of Renaissance Capital expects in the case of a "Grexit", "definite recession in the Czech Republic and Hungary in 2012, but Poland could still stretch to flat growth."

Banks of the River Styx

A recent World Bank report sketches out a more sober reflection on the ripple-effect that a Grexit would likely have across European banking. "So far, a fair bit of European banking-sector deleveraging has already been undertaken, in a more or less orderly fashion. Nevertheless, the recent developments in Greece have put enormous pressure on an already stressed Euro-area banking system. Deleveraging by Greek-owned banks is likely to accelerate, with possible spill-over effects to other Euro-area banks."

Thanks to a relatively stable banking sector in Central Europe, "the direct impact of any potential Greek exit from the Eurozone [is] likely to be limited," analysts at Citibank Global Research suggested in late May. Strong deposit ratios in the Czech Republic and Slovakia, and robust regulation in Poland having helped shore them up against deleveraging by the Eurozone banking groups that dominate their markets. Budapest's bitter fight with the foreign banks puts Hungary in stark contrast.

However, an indirect risk for Central Europe is that the big names that dominate the region's banking markets, such as UniCredit Group, Raiffeisen Bank International and Erste bank Group, also have high exposure to Southeast Europe. Should the Greek banks that enjoy shares of up to 25% in some these markets pull back funding even further, "this could lead to liquidity problems, which if inadequately managed by local and regional authorities, could lead to a loss of confidence and bank runs," the Citi analysts say.

Citigroup goes on to warn that aside from the banks, the indirect implications of a Grexit on the CEE economies are likely to be more severe, but are difficult to quantify. "CEE exchange rates are likely to weaken, liquidity conditions will tighten, trade flows may be negatively impacted, and confidence will be shaken," they say.

The adverse effects of that blow to confidence have been seen throughout the crisis, with investors over the past four years proving they're always ready to flee perceived riskier assets when news turns negative. The hammerings that the Polish zloty has taken, whether driven by sentiment centred on Brussels or Budapest, despite Poland's casting as a European star, are testament to the likely contagion. A sharp slide in the region's currencies would hurt especially Poland and Hungary, which have significant levels of foreign-currency denominated debt.

Such a sell-off would also hit sovereign debt and raise the cost of borrowing during another year that Central European states need to fund budget deficits. Renaissance's Yildiz says that the current account positions of the Czech Republic and Hungary should offer some protection, but "Poland will find it more difficult to fund its chunky deficit."

Hungary also has to roll over existing debt this year, and the combination of rising costs and shortening maturities on recent state bond issues is rarely sustainable. Already facing yields of close to 9%, Hungary is likely to find that a Grexit will effectively cut access to credit markets altogether, which would likely push it towards finally sealing another bailout loan from the International Monetary Fund (IMF). Yildiz says he's changed his previous view that Budapest will hold out for some time yet, and "sees a deal in the fourth quarter now."

Shrinking markets

Meanwhile, the high dependency of the region's economies to demand in the Eurozone is another huge risk. Some analysts suggest a Grexit could hit German GDP - the driving factor for the region's exporters - by up to 3% or so. That would see the highly dependent Czech, Slovak and Hungarian economies - where exports to the Eurozone amount to over 50% of GDP - struggle in particular. High domestic demand in Poland would offer some protection.

However, huge uncertainty over the actual effect of a disorderly exit for Greece remains, making policy response tricky to form. Russia recently announced it will boost its (already considerable) war chest by $15bn for 2013-15, and Charles Robertson of Renaissance suggests it "would be wise for others in Emerging Europe to follow... in preparing contingency plans to address a Eurozone break-up scenario".

Plans, he suggests, could include fiscal tightening, maintaining high real rates and building up forex reserves. "The result would be more modest growth than in 2005-07, higher bank deposits and a cap on currency appreciation by central banks; all factors that coincidentally will improve credit ratings as Eurozone members suffer downgrades," he says. "[Emerging market] debt issuers should target maturities of at least five years to avoid refinancing risk, while equity issuance will need to continue being very flexible in timing."

Poland's hawkish central bank is unlikely to persist with keeping monetary policy on a tight leash. Although the slowing European economy is likely to cap the inflation it has been fighting, zloty weakness has been another driving point in pushing rates up to 4.75%. The same pressures on the currency mean Hungary already has little room to ease, despite having the highest interest rates in the EU. In fact, the opportunity to cut rates to promote growth in the region is really only limited to the Czech Republic, although with rates at 0.75% there isn't far for the Czech National Bank to go either.

Analysts at Commerzbank argue that for as long as Grexit fears and contagion risk dominate, growth and inflation fundamentals won't dictate monetary policy in the region, except perhaps in the Czech Republic. "Others will have to run increasingly tight, interventionist monetary policy in order to ward off currency spikes and inflation pass-through," they say. "We do not expect large changes in policy rates - it is in market interest rates that we expect the divergence among countries to manifest."

Meanwhile, all of Central Europe's governments have committed to reasonably ambitious fiscal tightening, whilst apart from Poland they all run significant trade surpluses currently, which should offer the chance of raising reserves. Yet full blown recession - the Czech Republic entered technical recession in the first three months of 2012 and Hungary is likely to have joined it in the second quarter- remains the real concern.