beyondbrics

Could the spreading eurozone woes precipitate a second wave of crisis in “emerging” Europe? It’s not hard to see the warning signs – central and east European currencies have dropped sharply as investors have sought safe havens such as the Swiss franc.

But at least one analyst argues that contagion remains limited and, so far, a “domino effect” looks unlikely.

There are certainly jitters around. On Monday, Hungary’s forint and the Polish zloty both extended their weakness from last week and touched new record lows against the Swiss currency.

Erik Berglof, chief economist at the European Bank for Reconstruction and Development, warns that the spread of the eurozone to Italy took the crisis into “uncharted territory”. He told Bloomberg last week there were dangers of contagion into central and eastern Europe through banking and trade links.

Yet for now, according to an analysis by Tim Ash, head of emerging markets research at Royal Bank of Scotland, the risk is focused mostly around one channel of transmission. That is central Europe’s reliance on the eurozone for growth, with domestic demand still weak.

Two other channels – sovereign debt/financing, and foreign-owned banks in the region – have limited scope for contagion, he suggests. Sovereign debt averages only about 40 per cent of gross domestic product – half the European Union average, and far below the 120 per cent-plus levels of Greece or Italy.

The problems that hit some countries in the region during the 2008-09 financial crisis were essentially an issue of liquidity, not of solvency, Ash argues: CEE countries had underdeveloped domestic capital markets and limited access to international capital markets, even before international capital flows seized up. Countries have built up their fiscal defences since then, and in many cases still have access to multilateral financing, making them a bit less susceptible to a new liquidity squeeze.

On the banking side, Ash may understate the risks posed by an average of 70 per cent of banking assets across the region being owned by foreign banks. He suggests banking sectors in the region are generally “small”, and notes international banks remained invested in emerging Europe right through the crisis. Yet while it is true that in countries such as Poland, for example, many businesses use non-bank financing sources such as borrowing from family members, bank lending is still an important contributor to growth. And, as the EBRD’s Berglof points out, it was only just starting to recover in many CEE countries when the eurozone problems escalated this year.

South-east Europe and the Balkans, moreover, are heavily exposed to Greek banks – while the strength of Italian banks across central Europe makes the spread of the eurozone crisis to Italy a particular concern.

But the idea that the biggest potential source of contagion is through the real economy and trade is persuasive. Austerity measures and weak sentiment are likely to depress growth in the eurozone and, by extension, in emerging European economies that are heavily integrated into it. While that might not spell a crisis, it does mean emerging Europe will continue to be the “growth laggard” among emerging markets, says Ash. And it will put pressure on regional policy makers in the region to find new drivers of growth – and particularly to stimulate sluggish domestic demand.

Related reading:
Eastern Europe feels chill of eurozone crisis, FT
CEE: Swiss rolled, beyondbrics