FINANCE AND ECONOMICS
Something horrible out there
L O N D O N , W A R S A W A N D K I E V
Will Eastern Europe be the next region to suffer exchange-rate turmoil?
South-East Asias painful slowdown
TIMES are heady in Eastern Europe. Tourists throng the centre of Tallinn, in Estonia. New cars jam the streets of Warsaw. Eight years after the fall of the Berlin Wall and six since the collapse of the Soviet Union, most of the regions economies are growing smartly.
Perhaps too smartly. Economic growth is goodbut too much, too soon, can transform fantasies of prosperity into nightmares. Mexico learned that lesson in December 1994, when the crash of its peso threw the economy into a deep depression. Last May a currency crisis brought an abrupt end to the boom in the Czech Republic, and the economies of Thailand and other South-East Asian nations are being laid low by the currency bug (see article). Now several East European countries look as if they are heading in the same direction. Crises are not inevitable. But, although Asia and Latin America offer lessons aplenty about dealing with the problems at hand, many of Eastern Europes politicians seem disinclined to learn them.
In the view of many analysts and policymakers, there is no cause for concern. Forced devaluation of the Polish zloty is impossible, argues Krzysztof Rybinski, chief economist at ING Bank in Warsaw. Ukraines central-bank governor, Viktor Yushchenko, insists the countrys currency, the hryvna, is rock-solid. There are few signs anywhere in the region that people have panicked. When the National Bank of Poland started accepting long-term deposits from ordinary Poles last month, the queues were endless, an indication of faith in the value of the zloty.
The dry economic statistics, however, offer less cause for optimism. To the contrary, they suggest that alarm bells should now be ringing throughout Eastern Europe.
When their exchange-rate crises struck, both Mexico and Thailand had current-account deficits of 7-8% of GDP. This is an ominous precedent: 18 of the 26 former communist economies had current-account deficits of above 7% of GDP in 1996, and several topped 10%. By itself, a large current-account deficit does not foreshadow a currency crisis. But look where the money comes from. If its current-account deficit is financed by flighty short-term capital rather than long-term foreign direct investment, a country is vulnerable to sudden capital outflows. Slovakia, Estonia, Lithuania and the Czech Republic all look highly dependent on hot money.
If a currency starts to wobble, foreign reserves are a central banks first line of defence. Hungary and Poland have plenty of ammunition. But this does not mean much. Thailand also held lots of foreign reserves on the eve of its currency crisis, far more than most East European countries. They were dissipated quickly when the Thai baht came under serious attack.
The more an exchange rate has risen in real terms, and hence the less competitive a countrys exports, the greater the risk that speculators will attack. Like Thailand and Mexico, most East European countries peg their currencies to one of (or a combination of) the main currencies. But since their inflation rates are higher than in America or Germany, their real exchange rates have appreciated, albeit from undervalued levels. Only Hungary, which has seen a big devaluation since 1994, looks safe by this test. All the other currencies have seen real gains of between about 20% and 100% against the D-mark over the past three years.
A country whose current-account deficit reflects a big budget deficit is likely to have the greatest difficulty holding its exchange rate. By this criterion, the worst offenders are Hungary, Ukraine and Slovakia, which all have budget deficits of 5-6% of GDP. But figures need to be handled with care. Polands forecast budget deficit of 3% of GDP in 1997 is flattered by the inclusion of privatisation proceeds. If these are excluded, as they should be, the true budget deficit amounts to 6.5% of GDP. One more reason for alarms to sound.
The other sign of impending trouble is rapid monetary growth. This can fuel a consumer boom, causing the current-account deficit to widen, and may also inflate the prices of shares and property. Fast growth in bank lending is a clear sign of such an asset-price bubble, and throughout Eastern Europe lending has been expanding far too quickly. Estonias money supply has grown by 60% over the past year.
Signs of trouble
The Economist has assembled the latest figures for these six indicators in eight East European economies (see table). For purposes of comparison, we give similar figures for Mexico in 1994 and Thailand in 1996. No single indicator can reliably predict a crisis, but economic studies suggest that, if several early-warning signals are flashing red, then there is a high risk that a currency crisis may follow. The final column of the table gives a crude overall measure (out of a maximum possible score of 12) of how many of the early-warning indicators are flashing. A country scores 0, 1 or 2 on each indicator, and then these scores are added together. This suggests that Estonia, Latvia, Lithuania, Poland, Slovakia and Ukraine could face exchange-rate crises. Only Hungary and perhaps the Czech Republic, which has already abandoned its currency peg, look to be safe.
Slovakia faces a current-account deficit of more than 10% of GDP this year, of which only one-tenth will be covered by foreign direct investment. The Slovak crown has remained pegged to a basket of currencies, and, as a result, has lost competitiveness against the D-mark and the Czech crown. The government budget deficit is almost 5% of GDP. New measures which threaten to undermine the independence of the central bank are not instilling confidence.
Poland, which has been growing so fast that it is often described as Europes tiger economy, is experiencing a credit boom. This has caused the economy to overheat and the current-account deficit to swell. Central-bank figures show a relatively modest gap, but under the conventional IMF definition the current-account deficit may reach 6% of GDP this year and 9% of GDP in 1998. The zloty, which can float by 7% on either side of a central rate (devalued by 1% every month) against a basket of currencies, is appreciating in real terms.
The view from economists in Warsaw is that the Polish zloty is not under threat from international speculators. For one thing, foreign direct investment finances much of Polands current-account deficit. Secondly, limits on the zlotys international convertibility inhibit speculators from attacking the currency; foreign investors are not permitted to borrow zlotys from Polish banks, making it hard for them to bet against the zloty. But such controls only postpone a crisis. Moreover, these arguments would be more reassuring if the government eliminated its budget deficit. But the new coalition government may not have the political will to swing the axe.
Estonia should be on firmer ground. Since 1992 its currency, the kroon, has been pegged to the D-mark through a currency board, under which all currency in circulation is backed by foreign-exchange reserves. This has helped to reduce inflation. However, the fixed peg has encouraged a huge increase in bank lending. According to David Hale, chief economist at Zurich Kemper Investments, some 80% of the new loans are denominated in foreign currency, as Estonians take advantage of lower foreign interest rates. This problem cropped up in Thailand, where a fixed exchange rate appeared to eliminate exchange-rate risk, encouraging a lending boom. In theory, Estonias currency board is more solid than the sort of exchange-rate peg that Thailand had. But, suggests Mr Hale, the kroon could come under pressure if investors suspect that the banking system is developing Thai-like symptoms.
Latvia and Lithuania, Estonias neighbours, have seen rapid monetary growth, in part because of large capital inflows. Lithuanias currency, the lit, has been pegged to the dollar since 1994, so export competitiveness has been seriously eroded as the dollar has risen against the D-mark. In contrast to Estonia, Lithuania has failed to back its currency board with tough fiscal policies. The government is expected to scrap the board next year, and it may be hard-pressed to keep the exchange rate stable. Latvias government has balanced its budget, but it has a large current-account deficit (almost 10% of GDP) and weak banks.
Ukraines hryvna has traded in a range of 1.7 to 1.9 to the dollar since it was introduced in August 1996. The government has pledged to keep it within that band since April. Such stability, coming after the hyperinflation that ravaged the Ukrainian economy in 1993-94, has been trumpeted as the major achievement of the half-heartedly reformist administration of President Leonid Kuchma. Yet shortly after the hryvna celebrated its first birthday, the supply of dollars on the countrys main currency exchange dried up, forcing the central bank to intervene. The problem is that while the government no longer covers its debts by printing money, the budget deficit that forced it to do so in the first place has not gone away. It is expected to be around 6% of GDP in 1997. A widening current-account deficit, an appreciating real exchange rate and low reserves do not help.
The latest currency scare occurred after the finance ministry tried to drive down interest rates in the domestic bond market. When that reduced the demand for bonds and the government failed to raise enough money to cover its deficit in the last week of September, currency traders got cold feet and dumped hryvnas. On September 15th the central bank was forced to lend $185m to the finance ministry in violation of Ukraines agreement with the IMF.
Early warning signals are for policymakers as well as investors. All of Eastern Europes governments still have time to avoid currency crises. But budget cutting and monetary tightening are always painful. It is easier for governments to cross their fingers and publicly deny the warning signs. Of all the indicators of trouble ahead, this may be the most reliable.
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