Today we focus on those emerging economies that are falling victim - or are at risk of fall victim - to the ongoing global financial crisis. The escalation of the crisis revealed or exacerbated existing vulnerabilities such as current account deficits that were ignored when times were good - i.e., capital was plentiful. Emerging Market sovereign bond spreads over U.S. Treasuries significantly more than doubling since late August. Several emerging economies - including Iceland - are in talks with the IMF or regional institutions to provide capital in the face of the global liquidity shortage. While it is still unclear what the role the IMF will have in resolving the crisis, there is no doubt that the debate on its role in international crisis management has been revived.
Iceland
Iceland has been at the forefront of the global credit crisis. What was essentially a banking crisis has turned into a national crisis as Iceland's banks appear too big for the government to rescue.
Highly leveraged, Iceland's banks heavily relied on wholesale funding to finance their aggressive expansion abroad. With the rapid depreciation of the local currency and the seize-up of credit markets, Iceland's banks were having trouble refinancing their debt and appeared headed for collapse when the government stepped in and nationalized the three biggest lenders.
Now reports suggest Iceland's government is poised to announce a reported $6 billion rescue package from the IMF. While such a package would be a positive step in providing liquidity, there is no question that a severe economic contraction is coming. Some analysts predict Icelandic GDP could shrink by 5-10% after almost 5.0% growth in 2007.
Hungary
Also hard hit by the global credit crisis is Hungary. While it's not suffering a banking crisis a la Iceland (in the sense that its banking sector is mostly foreign-owned, rather than made up of highly leveraged, internationalized domestic banks), it is similar to Iceland in that the global credit crisis has exposed long-simmering vulnerabilities. High levels of foreign currency lending, slow growth (1.3% in 2007), twin deficits (both current account and budget), and heavy reliance on non-deposit foreign funding all contributed to making Hungarian assets sell-off targets.
The ECB came to Hungary's rescue last week, saying it would lend as much as EUR5 billion ($6.7 billion) to Hungary's central bank to help revive the local credit market. But the verdict is still out on whether the ECB credit line and government measures are enough to prevent Hungary from becoming an ongoing hotspot.
Given Hungary's woes, eyes are focusing on the rest of Eastern Europe for signs of trouble. The slowdown in the region's key export market, the Eurozone, is expected to dent growth across the region. Meanwhile, high current-account deficits and widespread foreign currency lending are particular risk factors. Poland and the Czech Republic are considered among the least vulnerable, but they are far from immune. Meanwhile the Baltics, Bulgaria, and Romania have long been on analysts' radar as particularly weak links.
Baltics
All three Baltics (Estonia, Latvia, and Lithuania) boomed over the last seven years and posted double-digit growth rates at their peak, helped by cheap credit from Scandinavian parent banks and EU membership in 2004. Now these economies are in the midst of a sharp slowdown, with Latvia and Estonia officially in recession.
There is no question that the Baltics are in for hard times. In the context of the global credit crisis, the risk is that foreign capital inflows could dry up and lead to an even sharper slowdown that could infect the financial sector. But there are some factors that suggest the sharp slowdown might not evolve into a full-fledged, Iceland-level crisis. One, external deficits in the Baltics are funded to a large extent by inflows from Swedish parent banks, and sharply cutting off credit would hurt these banks. Two, substantial foreign ownership of banking assets limits the governments' contingent liabilities, as Swedish parent banks would be expected to provide support to their Baltic subsidiaries if they get into trouble. Three, the Baltics' sharp slowdowns have led to speculation that devaluations (they have exchange rates pegs to the euro) could be in the offing. While devaluation cannot be completely ruled out, such fears may be overblown as these countries tend to have shallow financial markets, relative little hot capital, and successfully defended against speculative attacks earlier this year.
Bulgaria and Romania
Bulgaria and Romania - the so-called 'gravity defiers' - are also on the short-list of CEE economies most at risk of being the next hotspots in the global credit crisis. Despite massive current-account deficits (projected to hit 23% of GDP in Bulgaria and 16% of GDP in Romania this year), booming credit growth, and high inflation, these economies have not hit slowdown mode yet - hence the term 'gravity defiers'.
In the case of both countries, the financing of their current-account deficits has deteriorated, with foreign direct investment (seen as less subject to reversal than other forms of financing) only plugging about a third of Romania's current account gap and over half of Bulgaria's. As a result, these economies are highly susceptible to capital outflows, which would trigger a harsh real adjustment.
Another risk is these countries' high degree of foreign currency lending, particularly notable in Romania which has a flexible exchange rate, meaning unhedged borrowers are highly exposed to currency swings. Romanian households' high levels of foreign currency lending are similar to those in Hungary (55% in Romania vs. 60% in Hungary of total household loans). And like Hungary, Romania has a budget deficit of over 2% of GDP. Meanwhile, Bulgaria has a budget surplus, which potentially gives its government more room to maneuver if outflows trigger a sharp slowdown. Bulgaria and Romania will be key countries to watch as the global credit crisis unfolds.
Balkans
The negative effects from the credit crunch on the Balkan region have been limited so far. Growth has remained strong, ranging between 4.3% for Croatia and 8.2% for Serbia in Q1 08. Nonetheless, the significant widening of the current account deficit experienced by most of the countries is a source of concern as both external credit and FDI inflows are likely to slow. Croatia may feel severe pressures since it has the highest foreign debt in the region, at 90% of GDP, and the share of foreign currency mortgages and personal loans is near the level seen in Hungary.
Turkey
A number of analysts have cited Turkey as particularly vulnerable to global market turmoil given its large current account deficit. At 5.8% of GDP in 2007, Turkey's deficit - while substantial - is lower than many of its emerging Europe peers though. The financing quality, however, has deteriorated of late and it will be important to watch how this trend evolves. Compared to other CEE countries, however, Turkey is less likely to face a bank-related credit squeeze, since the banking sector is relatively liquid with a loan-to-deposit ratio well below 100% and since wholesale borrowing is a smaller fraction of banking sector liabilities. So while Turkey is not immune to the global credit crisis and will experience slower growth, it is much better placed than earlier in this decade to weather the storm.
Ukraine
Ukraine's high reliance on external finance makes it particularly vulnerable in this global economic downturn and credit crunch, leading it to seek financial assistance from the IMF. Worsening macroeconomic fundamentals including persistent inflation and a widening trade deficit and domestic and regional political uncertainty have contributed to deposit outflow, tighter domestic money market rates and exchange rate volatility, increasing near term risks for Ukraine's banking sector. The value of the Ukrainian currency, the hryvnya, sank by 20% so far in October forcing the National Bank of Ukraine to intervene and sell dollars at an artificially low rate. Moreover, the equity markets fell over 70% this year.
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