beyondbrics

Hand-wringing over the eurozone crisis dominated the headlines as the International Monetary Fund published its regional report on Europe on Wednesday.

Inside the 110-page document are some salutary warnings for central and eastern Europe. Watch out for the trade, investment and financing links with crisis-hit western Europe, says the Fund. And don’t give up on fiscal prudence, banking sector stability or market-oriented reform.

While the IMF expects GDP in western Europe to increase by 1.6 per cent this year and just 1.3 per cent in 2012, its projections for central and eastern Europe (including Turkey) are far more buoyant. It’s projecting 4.4 per cent for 2011, the same as last year, and 3.4 per cent for 2012 as “rebounds run their course and the global slowdown makes itself felt.”

Also, with the Baltic states and the Balkans catching up with earlier recoveries in central Europe, economic growth across the region should be more even than before.

But – there is always a “but” in an IMF report and in this case there are lots of them. One is that some CEE countries aren’t achieving their full economic potential because of “poor macroeconomic policies and barriers to growth”.

The Fund doesn’t name names, but the states of the former Yugoslavia come to mind. The IMF says:

Heavily regulated goods and labor markets and inadequate institutions and macroeconomic policies have kept some countries less flexible, less competitive, and less integrated into the global economy than their better-performing peers, and this explains much of their inferior growth performance.

However, the real dangers come from outside the region, with the eurozone in crisis. The report says:

Downside risks to the outlook are significant and larger than at the time of the previous edition of the Regional Economic Outlook. Although more sluggish global economic growth has always been a possibility, quelling the tensions in euro area debt markets has proved increasingly challenging. If tensions were to escalate further, the economic and financial outlook for the euro area would darken considerably and the repercussions for emerging Europe would be dire.

Now, “dire” is a strong word for the IMF. But it is justified in the circumstances. More from the report:

Exports and cross-border production chains with emerging Europe’s premier partners would suffer. More importantly, much of emerging Europe’s financial sector would likely come under pressure.

Strained banks in advanced Europe would likely scale back exposure to subsidiaries, nonaffiliated banks, and nonbanks in emerging Europe.

A large and sudden disengagement from subsidiaries, though, is unlikely even in a highly adverse scenario. Western banks would first turn to domestic support mechanisms, including liquidity from the European Central Bank (ECB) as collateral allows, lending of- last-resort from their central banks, and any government schemes that would be put in place in the circumstances.

Scope for recourse to funding from subsidiaries would be rather limited as host country regulators would step in if regulatory liquidity or capital limits were at risk.

The most likely impact would therefore be a renewed credit crunch. Subsidiaries would see a measured but persistent funding drain from their parents, and nonaffiliated banks that rely on wholesale funding would have to struggle even more. Both would have little choice but to curtail their own lending activities.

As the report says, 2011 started well for the region but things began to turn ugly mid-year with the escalation of the euro crisis. Sovereign spreads widened, for example, in Hungary and Croatia, two debt-dependent states.

The risk that financial tensions will spread to emerging Europe is heightened by a number of legacies left by the 2008/09 crisis: fiscal vulnerabilities that were low before the crisis have increased sharply, and nonperforming loans (NPLs) have shot up. And western European banks continue to play a key role in emerging Europe’s financial sectors. In addition, the strong Swiss franc remains a challenge for households and banking sectors in Croatia, Poland, and especially Hungary, where a large share of mortgages are denominated in that currency.

Overall, fiscal deficits are improving, with a regional decline forecast to 2.1 and 2.3 percent of GDP in 2011 and 2012, from 4.5 percent of GDP in 2010 and 6.2 percent in 2009. But within this regional average are some states with budgetary challenges, including Albania, Croatia, Turkey and Russia, where the non-oil defict is far above pre-2008 levels.

Meanwhile, banks have been left with the burden of non-performing loans, notably in Latvia, Lithuania, Montenegro, Serbia, and Ukraine (see chart below).

The report says that high NPL levels aren’t currently a threat to financial stability. Banks are well capitalised.

Nonetheless, supervisors must remain on their toes as the financial turmoil in euro area debt markets evolves and further local surprises cannot be ruled out, such as the need for a bailout of the fifth largest Russian bank this July.

But, high levels of unresolved NPLs can hold back recovery because banks will be cautious about lending. So the time has come for action, says the Fund, which urges banks to take the hit and governments to allow them to go ahead with suitable tax policies on write-offs.

There is a carrot for hard-pressed policymakers. The region should see further catch-up growth with western Europe because of the strong trade, investment and financial links with advanced economies.

But even here there is a but. The high level of integration means that “shocks in one region increasingly affect the other, with spillovers progressively travelling both ways”.

That complicates life for policymakers. For example, it is harder to manage monetary policy in an economy open to external financial flows. But it is worth persevering, given the many advantages of integration.

In any case, in a small crowded continent, the alternatives are much worse.

Related reading:
IMF warns on global financial system, FT
beyondbrics IMF file