Irrational exuberance about Central and Eastern Europe’s sovereign risk

There has been a lot articles in recent days suggesting the possible collapse of Central and Eastern European (CEE) countries and a possible domino effect taking down the entire European Union. We think that these calls are not justified, especially if regional governments, the European Commission and the European Central Bank take appropriate measures to fight the crisis.

First, countries in the region should be differentiated – the situation in Poland and the Czech Republic is much different than elsewhere, mostly because of a strong banking sector, comfortable fiscal position and low current account deficits. Slovakia and Slovenia, both members of the euro zone, are already on the safe side.

Second, foreign external debt is largely intercompany debt between local and Western European subsidiaries, mostly banks. Standard&Poor’s scenario that foreign banks could fail to raise capital of their CEE subsidiaries can’t be excluded, but is unlikely. It is because letting local subsidiaries starve to death would ruin the parent’s reputation and market value. Moreover, foreign banks are not likely to be able to be selective about which local banks to support – a failure of any subsidiary in any CEE country could lead to a run on subsidiaries in other countries. Also public external refinancing needs are not large – Poland, for instance, needs only an additional 3 billion euro this year. This could be financed even without recourse to private markets by EBRD, WB and EIB. Finally, foreign currency reserves in many countries in the region are large, covering short-term debts.

Third, banks in the region have low ratios of non-performing loans (NPLs), strong capital positions, and no toxic assets. Even with an expected increase in NPLs owing to economic slowdown and exchange rate depreciations, likely losses in relation to assets will be by an order of magnitude smaller than bank losses in Western Europe. A lot of companies with foreign debt are exporters and are naturally hedged.

Fourth, thanks to exchange rate depreciations exports from Central and Eastern Europe are likely to decline less than elsewhere. Weak exchange rates will also attract FDI, as evidenced by a recent relocation of a Dell factory from Ireland to Poland, and increase the local currency value of more than 20 billion euro of EU funding for infrastructure this year.

Finally, labor and product markets in the region are more flexible than in many Western European states. Public debt, with the exception of Hungary, is lower than the EU average. The CEE corporate sector is modern and competitive, as evidenced by the rising share of its exports in global trade. These factors will help CEE countries deal with the inevitable painful adjustments to the balance of payments. Even if the fundamentals minimize the risk of a sudden capital stop and sovereign default in Central and Eastern Europe, market perceptions and expectations matter. If there is a perceived risk of European wide meltdown triggered by a CEE crisis, we should not sit on our hands but act to change this perception. The following steps can be considered:

  • First, to ensure that foreign banks continue to finance the region, CEE governments should take actions to prevent large defaults in household and corporate sector, including through state guarantees. They should also establish frameworks for direct government support for the banking sector to ensure its viability even in the worst case scenario. Poland is implementing such plans right now. Policy coordination among CEE governments would be helpful, too. Investors will look for concrete actions, not words.
  • Second, central banks in CEE countries should expand eligible collateral for open market operations, decrease reserve requirements, buy up assets FED-style, and be ready to start lending directly to local banks, if needed. It is better to err on the side of doing too much than too little.
  • Third, the European Central Bank should offer euro swap facilities to all endangered EU member states and expand eligible collateral for open market operations to include non-euro denominated debt, with an appropriate haircut. Reforming euro entry criteria would also be beneficial, particularly scrapping the ERM2 purgatory since the euro itself would not pass the ERM2 stability test. Who needs purgatory when all hell just broke loose?
  • Fourth, European Union’s medium-term financial assistance facility should be augmented from 25 billion euro to 100 billion euro. It should be available not only for supporting member states’ balance of payments, but also to refinance public debt. Only overwhelming financial force could ensure that the facility would not have to be used.

Finally, all member states should support efficient functioning of the single European market. Nothing can do more harm to both Eastern and Western Europe than protectionist measures. In particular the upcoming EU summit on 1st March should remind French policymakers about key messages from economics course 101.

If leaders of member states agreed on the measures proposed above, the perception of possible CEE sovereign default and the self-feeding market panic would fade away. There would be no need to discuss EU and—who knows?—EMU meltdown scenarios. Do the right thing and do it now.


Originally published at Euro Intelligence and reproduced here with the author’s permission.

2 Responses to "Irrational exuberance about Central and Eastern Europe’s sovereign risk"

  1. Matthew   February 27, 2009 at 3:01 am

    “central banks in CEE countries should expand eligible collateral for open market operations” ????Bad idea.What is the impact on central banks balance sheets in case of pay back default or collapse and assets collateralized are either illiquid (e.g. due to market conditions) or significantly decrease in value?Too risky for a central bank to endorse the whole market risk.

  2. optimist   February 27, 2009 at 9:51 am

    Ode sve u krasni kurac