beyondbrics

By Christian Keller, head of emerging Europe research, Barclays Capital

An overly indebted, uncompetitive economy, after years of soaring labour costs, growing current account deficits, and with seemingly no export products to sell. A banking system at the brink of runs and a sovereign in need of a massive IMF-EU bail out. Default and devaluation seem the only way out. Greece today? No, Latvia in early 2009.

That was then, when Latvia’s 5-year CDS spreads peaked at 1200bps. Roughly two years later, Latvia has been moved back to investment grade rating, CDS spreads are close to 200bps and the government recently successfully issued an international bond.

Indeed,  CDS spreads in CEE  today are a fraction of  those in Greece, Ireland and Portugal, and most of them trade even inside Italy and Spain these days.  Sovereign ratings are also moving in opposite directions.

Are there lessons to learn from the CEE’s rebound?

Economics first. The CEE economies with currency pegs—the Baltic States and Bulgaria—faced a challenge similar to the euro periphery. They could not re-gain competitiveness and adjust external imbalances through currency depreciation.

Instead, they had to do it the hard way: Cutting domestic costs, mainly by cutting wages, pension and social benefits. Latvia’s government labelled this strategy ‘internal devaluation’ in response to those who saw Latvia as another ‘Argentina at the Baltic Sea’, which ultimately would have to devalue its currency in order to re-start the economy.

‘Internal devaluation’ has been painful. The government has taken fiscal tightening measures of around 13% of GDP during the IMF program, including large wages and pension cuts and tax increases. This added to a massive output contraction of 18% in 2009 alone, an unemployment surge to over 20% and (temporary) deflation.

As previous excesses in Lithuania and Bulgaria had been less drastic, the subsequent fall out was still painful but less extreme and they managed without EU-IMF support.

Even the CEE economies with flexible exchange rates were limited in as how much they could allow for their currencies to weaken. Local balance sheets in countries like Romania and Hungary were just too exposed to the exchange rate swings as households and corporates had highly indebted themselves in foreign currencies. Thus, these countries as well needed EU-IMF financial support to replenish FX reserves, provide FX liquidity to local banks, and bolster market confidence.

Moreover, governments often faced a ‘twin deficit’ problem, as not only the current accounts showed wide gaps, but the recession also created large holes in fiscal budgets. The EU-IMF programmes prescribed combinations of tax hikes, expenditure cuts and accelerated of structural reforms.

Aided by the recovery in growth, these fiscal reforms are showing results. Last year’s fiscal deficits in CEE typically came in below official targets.

Certainly, the fiscal efforts will have to be sustained in coming years, and some fiscal measures were also of doubtful quality, such as the suspension contributions to second pillar pension funds (or even confiscating these assets, as done in Hungary). However, on balance, it is fair to say that only a bit more than two years after serious fears about financial meltdowns in CEE, the region has made it over the hill.

We draw lesson number 1: Radical economic adjustment programs are possible and can be successful, even under adverse economic conditions.

‘Politically impossible to implement’ was a key argument by those who believed countries like Latvia would fail in their efforts. The painful policies required would not be acceptable to suffering populations and ultimately result in civil unrest, the toppling of governments and the abandonment of reforms.

These scenarios never played out in the CEE. In fact, not only was civil unrest avoided, but the Latvian government that implemented harsh expenditures cuts and tax increases was re-appointed in democratic elections.

In Romania, the government faced several confidence votes but to date survived them all. Greece’s poor northern neighbour Bulgaria has suffered enormously in the post–Lehman world, but thus far has managed without external help and without street riots.

In Hungary, elections did lead to an overwhelming victory of the opposition and the expulsion of the IMF. However, after initially scaring markets with controversial policies, Hungary’s government has recently started to promise structural reforms very similar to those recommended by EU and IMF earlier.

We draw lesson number 2: Painful reforms are implementable even in democracies, if populations see them as necessary and unavoidable. Memories of ‘tougher times’ and less developed entitlement cultures help.

Domestic efforts notwithstanding, financial collapse would likely have been unavoidable in cases like Latvia and Hungary had it not been for the large, frontloaded financial assistance from IMF and EU.

Even where financial assistance was not necessary, another form of external support has been crucial for the economic recovery: export demand from key trading partners, notably Germany.

We draw lesson number 3: External support in form of financial help but also export demand plays a crucial role for the success of the adjustment.

Investors’ attitude to the region has changed significantly. While CEE currencies and CDS were favourite shorts in the wake of the Lehman crisis, investors have since been rushing back into local bond markets and governments find it easy to place international bonds. Although the close linkages to European banks, some of them Greek, remain a concern, CEE currencies have held up remarkably well during recent periods of peripheral euro area debt fears.

Lesson number 4: Market sentiment can change drastically, long before the actual economic adjustments process has fully matured, rapidly improving debt management conditions.

These lessons are far from comprehensive and important differences exist between CEE and the euro area periphery. The fact that CEE entered the crisis with much lower public debt ratios than Greece is just one. However, the transformation of the CEE states from the ugly ducklings of the EM universe into swans within Europe is remarkable.  It seems a dose of that emerging Europe market spirit could do the euro area periphery well.

Related reading:
Latvia’s lessons, Lex
Special report: CEE banking and finance
Eurozone crisis curtails EU policy leverage over CEE countries, beyondbrics