The east is in the red
By Stefan Wagstyl
Published: October 16 2008 20:11 | Last updated: October 16 2008 20:11
When Lev Partskhaladze, a Ukrainian property developer, was preparing to float his company on the London stock market three years ago, he saw no end to his country’s home and office construction boom. Today, with cranes standing idle over Kiev building sites and property sales evaporating, he admits the global credit crunch is bringing the boom to a halt.
“We are seeing a financial crisis transforming into an economic crisis in the world. It has not fully hit Ukraine yet but it’s close,” says the chairman of XXI Century Investments. With its shares down 97 per cent from their peak, the company is trying to raise cash by offloading projects to other developers.
Comment: Panic passes but the causes remain - Oct-14John Gapper: Some blame lies closer to home - Oct-08Editorial Comment: Fighting the fire calls for boldness - Oct-07Editorial Comment: Russia finds it is in same sinking boat - Oct-07Analysis: Short shrift - Oct-05Analysis: Europe in it together - Oct-03Mr Partskhaladze is not alone in having to confront the region’s changed realities. Across central and eastern Europe, the global crisis is biting hard, albeit very unevenly. In Russia, the authorities have set aside nearly $200bn (£116bn, €149bn) for a financial market rescue, Ukraine is in talks with the International Monetary Fund over emergency loans of up to $14bn, Hungary was on Thursday bailed out with a €5bn ($6.7bn, £3.9bn) loan facility from the European Central Bank.
Below: Baltic states
Latvia and Estonia are suffering the region’s first recessions in a decade, while growth in oil-rich Kazakhstan has slowed to a crawl. Even in Poland, where Donald Tusk, the prime minister, insists his country is “an island of stability”, the crisis has raised doubts about Warsaw’s euro entry plans.
Stock markets have plunged accordingly, with Polish shares trading at less than half their peak levels and Ukraine’s down by three-quarters. Property markets have slowed, even if developers are still trying to hold up prices. After riding high earlier in 2008, some currencies have come under pressure, notably the Hungarian forint. In Ukraine, where the central bank has intervened to support the hryvnia, the credit default swap rate, a risk measure, has soared 1,400 points to 1,900, among the world’s worst.
Graphic: Forecasts for growth
The financial whipsaw has cut billionaires down to size, not least Oleg Deripaska, the Russian metals oligarch, who has sold valuable stakes to raise cash. Others are grabbing opportunities to buy cheaply: Mikhail Prokhorov, the Russian nickel investor, acquired 50 per cent of Renaissance Capital, a Moscow bank, for $500m – about one-quarter of its value of a year ago.
With the global crisis still raging, despite the calming effects of this week’s support moves in the US and the European Union, it is impossible to predict how events will play themselves out in a region increasingly important to the west as an export market and low-cost production base. But hopes it might escape unscathed have evaporated. Apart from corporate casualties, some countries could run into difficulties funding current account deficits. Erik Berglof, chief economist of the European Bank for Reconstruction and Development, says: “There is enormous uncertainty right now ... These countries could deal with rising borrowing costs and an economic slowdown coming from the US and western Europe, but a complete shutdown of international borrowing – nobody can withstand that.”
The result of this shock will, as in the west, increase the state’s role in the economy once more – and possibly provoke political conflicts over the share-out of scarce financial resources. As in the west, there could be public anger against those who profited from the boom years, often spectacularly so. Hungary, which first ran into economic trouble two years ago, has already experienced social tensions.
Economic growth is slowing sharply, with the IMF forecasting a decline in real gross domestic product growth for central and south-east Europe from 5 per cent this year to just 3.5 per cent in 2009. For Russia and the former Soviet Union, it predicts around 7 per cent for this year and 5.5 per cent for 2009.
Also, the region as a whole is less exposed to financial turmoil because companies and households have mostly taken less credit than in the west. Raiffeisen International, the Austrian bank, says bank assets were just 90 per cent of GDP in 2007 in central Europe and 65 per cent in Russia, compared with 250 per cent in the eurozone.
But these generalisations conceal many country risks. As Jan Krzysztof Bielecki, chief executive of Poland’s Bank Pekao, says: “The development of the situation over the last few weeks has shown that there is nothing more mistaken than calling this a single region. The differences between Poland and Kazakhstan are like the difference between heaven and hell.”
A key danger is the region’s dependence on external finance, especially bank credit. According to the Institute of International Finance, total private capital and credit flows into “emerging Europe” (including Turkey) are likely to fall from a record $394bn last year to $322bn in 2008 and $262bn in 2009. Given that $262bn is still a high figure by historical standards, there is great scope for a much bigger drop. Within this total, bank credit is set to fall particularly fast, from $219bn in 2007 to $155bn in 2008 and just $74bn next year.
While foreign direct investment is forecast to increase modestly to nearly $90bn next year, it cannot compensate for the dramatic decline in bank lending. Nor will portfolio investment save the day: the flows are far too small, peaking last year at just $8.5bn.
The biggest financing needs are in Russia, where the central bank estimates $39bn in debt falls due this year and $116bn in 2009. Little wonder that bankers and oligarchs are queuing for credits the authorities are distributing from their $560bn in foreign exchange reserves. Russia is in no danger of default but banks are under pressure – with fears of a panic increasing this week after Globex, a midsized lender, banned depositors’ withdrawals.
If the crisis persists, even the wealthy Russian state will have to count its roubles. Relative to the size of the national economy, Moscow’s financial rescue package is bigger than the $700bn programme launched by the US. Russia’s budget spending is more than doubling to $586bn in 2010, just as the oil price has roughly halved from its peak. Further declines will put spending under pressure. But with inflation high, driving up pay and pensions, there is little scope for painless cuts, especially as Russia is committed to huge infrastructure projects, including the Sochi 2014 winter Olympics.
In Ukraine, banks have also borrowed heavily overseas to finance credit growth and are struggling to refinance themselves. At the same time, the current account deficit is widening as prices for steel, Ukraine’s main export, plummet. So Kiev’s external financing needs are growing just as credit is short and foreign direct investment, a big source of finance in recent years, is slowing.
Ukraine’s authorities insist the economy is in good shape. The central bank has maintained order by taking control of one bank and supporting 20 other lenders. But efforts to ease the crisis are hampered by political turmoil, with president Viktor Yushchenko calling early parliamentary elections for December. Yulia Tymoshenko, prime minister, on Thursday confirmed Kiev was turning to the IMF, which she said was considering lending “$3bn-$14bn”.
In central and south-east Europe and the Baltic states, many economists assumed countries would be protected from the global storm because their banks’ finance came not from markets but from the multinational banks that have bought most local lenders. But as Mr Berglof of the EBRD says, with parent banks now under pressure, this assumption may no longer apply. “This strength is turning into a vulnerability,” he warns.
Individual banks deny they have plans to pull out. But they have been raising the costs of foreign exchange denominated loans, which account for around half of corporate and household lending in central Europe. This week, leading Hungarian banks cut such foreign exchange lending, in moves which on Wednesday precipitated the biggest daily drop in the forint in five years. On Thursday the currency rallied sharply after the authorities announced public support from the ECB – unprecedented for a country outside the eurozone – and liquidity boosting measures. Janos Veres, finance minister, says the IMF stands by to support Hungary but will intervene only in extremis.
Poland, the Czech Republic and Slovakia are in better economic condition than Hungary, having avoided the profligate public spending in which Budapest indulged until running into financial difficulties in 2006. The Czechs, with low local interest rates, are free of foreign exchange loans. But like Hungary, these countries are exposed to another painful shift – an expected steep decline in demand from western Europe. Slovakia, with its heavy dependence on a single industry – cars – is particularly vulnerable.
Except for Hungary, however, bankers are less concerned about central Europe than the Baltic states and south-east Europe, where current account deficits are high. All have relied heavily on a mix of foreign direct investment and credit for financing recent rapid growth. But with economies slowing, bankers wonder which countries can avoid a hard landing – or worse. Estonia and Latvia, which ran into financial difficulties even before the global crisis, are already in recession. Lithuania is not far behind. But at least Baltic current account deficits are falling, from 18 per cent of GDP on average last year to 8.6 per cent in 2009, according to the IMF.
In south-east Europe, the Fund predicts deficits to stay at 14 per cent next year, including 21.5 per cent for Bulgaria. “Action is needed to rein in rising external and internal imbalances, mindful of more volatile external financing conditions,” the IMF says But whether that action will come in time is a moot point. Analysts at Citigroup rank Romania and Bulgaria alongside the Baltic states, Hungary and Ukraine as countries vulnerable to “a risk to financial stability”.
As credit growth decelerates across the region, putting a brake on economies, current account deficits should decline as credit-financed imports fall. So soft landings are certainly well within reach. The difficulty comes in bridging the financing gaps that are bound to emerge in the most hostile financial conditions in 60 years. If there is a crumb of comfort, it is that these ex-communist states have more experience than most of implementing tough economic policies under pressure.
BALTIC STATES: Climate turns harsher but Icelandic conditions are a way off
The Baltic states appear at first sight to have all the ingredients to make as explosive a cocktail as Iceland, writes Robert Anderson. Easy credit, amassed since Latvia, Lithuania and Estonia joined the European Union in 2004, created housing bubbles and the highest inflation rates and current account deficits in the bloc.
Boom turned to bust at the end of last year, pushing Estonia and Latvia into recession and leaving households and the nations themselves heavily indebted. In Estonia, domestic credit soared to 95 per cent of 2007 gross domestic product from 51 per cent in 2003, while gross external debt almost doubled to 112 per cent of GDP.
Yet the Baltic states also have significant differences from Iceland. Estonia and Lithuania operate currency boards that fix their exchange rates against the euro and cover with foreign exchange reserves the amount of local currency in circulation. The Latvian central bank, which runs a euro peg system, has had to intervene to prop up the lat this month but its strong reserves have enabled it do so with ease.
The Baltic states have tended to run responsible budgets, while the countries’ banks have conspired to block hedge funds taking short positions on local currencies. Credit default swap spreads on Baltic state debt have widened significantly, signalling that they seen as are less safe than before, but this matters little so long as the nations do not need to borrow.
That may soon change, however, as slowing economic growth pushes budgets into deficit. Lithuania’s deficit looks set next year to breach the EU’s limit of 3 per cent of GDP and the government needs to make a €400m ($541m, £313m) bond issue when conditions permit. This will test investors’ appetite for Baltic risk.
Another big strength of the Baltic states compared with Iceland is that their banks are largely foreign owned – funded by solid Swedish lenders that have been less affected by the global financial crisis than their European peers. So far they have borne the pain of the Baltic slowdown without flinching, though questions remain over how long they can continue to do so.
Swedbank, which has more clients in the region than in Sweden, has seen its share price halve this year because of its Baltic exposure, cutting its valuation to just four times forecast earnings. The bank’s ratings were downgraded this month by all three big rating agencies, pushing up the cost of its wholesale funding.
Swedbank points out that Baltic unemployment remains low and there have been few company insolvencies or mortgage foreclosures so far. That is even though apartment prices in the Estonian capital, Tallinn, for example, have fallen by one-quarter since their peak in April last year. The bank is forecasting modest losses of 1.2 per cent of its Baltic loans next year, enough to halve its operating profit from its subsidiaries there.