Central & Eastern Europe: No Capital, No Growth
At a recent eastern European banking sector conference, I was struck by the lack of doom and gloom among many of the fellow delegates. Yes, there was expressed concern about falling share prices and declining asset growth, but there was also an almost mantra-like quality about the way I was repeatedly told: ‘the fundamentals are solid’ (McCain eat your heart out) and ‘there is no direct exposure to subprime within our banks’. This seems to me to be another variation of the ‘decoupling’ theory, which makes very little sense in the emerging Europe context.
I start from three very simple premises:
- demand in the US and eurozone is imploding;
- this is linked to major wealth destruction on the back of declines in leveraged real estate assets;
- the resulting instability in the global banking system is destroying liquidity and constricting credit.
From here, I extrapolate what this means for the emerging Europe region and quickly come to several strategic conclusions:
- Foreign lending into emerging market banking systems will dry up
- Foreign investment inflows will decline, both in the direct and portfolio component
- Commodity prices will collapse (more)
- Exporters will have serious difficulty sustaining any growth
- Remittance growth will drop off as job opportunities decline in the developed world
In other words: whither capital?! What all of these points ultimately pertain to is a steady closure of the sources of capital CEE economies have relied upon to fuel growth over the past several years. Since 2002, emerging markets across the world have benefited from a confluence of factors which have contributed to an unprecedented flow of wealth from the developed world to the developing. Steadily increasing risk appetite had funnelled foreign direct and portfolio investors from New York hedge funds to Canadian pension plans to Japanese housewives into ever more exotic regions, pushing credit spreads to historic lows. At the same time, the expansion of the European Union into central and south-eastern Europe and the liberalisation of labour markets had taken the concept of foreign workers to a new dimension, driving remittances ever higher. The commodity price bubble too, spurred by global demand helped push countries like Russia to the top of the league in gross capital inflows.
Now though, all these avenues of obtaining capital are drying up. In some cases, like the Czech Republic and Poland, this shouldn’t do any more damage than shaving a few percentage points off GDP growth. In others though, where the built-up external asymmetries have reached seriously worrying proportions, such as Estonia, Hungary, Iceland, Latvia, Ukraine and Bulgaria, the potential for a systemic crisis is very real. Particularly worrying is that a capital shortage will target and accentuate pre-existing macroeconomic weaknesses. Thus, we have seen how in Hungary it has manifested in the form of a severe weakening of the bond market and elevated risks of a fiscal crisis. In Iceland, with its humongous external debt loads and current account deficit, it is playing out in the form of a classic balance of payments crisis. In Ukraine, the lack of confidence in the banking system and high level of dollarisation of loans has meant that a currency sell off has catalysed panic among depositors.
So, when can we expect capital to return? Not for a couple of years at least, and even then I doubt that developed world banks will be as quick to lend to emerging economies, especially if it is to finance double-digit asset growth. The model of borrowing foreign to lend local is over, at least to the extent to which it was practiced over the past several years. As such, when capital does return beyond 2010, don’t expect credit growth or even economic growth in emerging economies to return to their 2007 peak.