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 Asia’s painful slowdown
Perhaps too smartly. Economic growth is good—but 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 Europe’s 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. Ukraine’s central-bank governor, Viktor Yushchenko, insists the country’s 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 bank’s 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 country’s 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. Poland’s 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. Estonia’s 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.
