Eastern Europe and the threat from Greece

Alan Beattie, Financial Times

Like a band reforming to trot out the old hits in the hope of funding their impending retirement, the prospect of Grexit somehow doesn’t seem as exciting the second time round.

Back in 2011 and 2012, when the threat of Greece leaving the euro was taken very seriously by investors, the knock-on effects were considerable. The future of the eurozone was held to be at stake; the bond spreads of the other troubled peripheral countries, notably Spain, Portugal and Italy, blew out to alarming proportions.

The complacency about the Greek crisis when it first started to become apparent early in 2010 was striking, and was reflected in the painfully slow international response. A common observation in US political circles at the time was that the Greek economy was the size of Rhode Island’s. Emerging markets similarly appeared not to see the turmoil coming: the links with Greece even of geographically proximate Central and Eastern European (CEE) emerging markets were small.

The damage came from the Greek turmoil creating a crisis of confidence, worries about default and even euro exit from other peripheral countries, and a general flight from risk across the eurozone. The effect of this wider crisis on central and eastern European emerging markets was dramatic. Economies fell into recession; equity markets fell sharply. Economic dislocation was transmitted to CEE countries not just through strong trade links but also through the financial channel, with Western European parent banks cutting exposure to their CEE subsidiaries.

Yet despite the prospect of a radical government being elected on January in Greece, EM investors and policymakers do not seem greatly concerned about another round of Greek-rooted turmoil. CEE equities and bond prices have traded pretty much flat since the new year. Policymakers have signalled awareness of the threat but no more. When cutting interest rates by an expected 25 basis points on January 7, Mugur Isarescu, governor of Romania’s central bank, made a point of noting publicly that the prospect of a Greek exit had raised some concerns but that the central bank stood ready to respond.

Investors and policymakers have good grounds to be more confident. Not only is a Europe-wide financial conflagration less likely, but CEE countries are less vulnerable to shocks through the financial channel. The medium to long-term weakness of the eurozone economy as a whole irrespective of Greece, and the continuing uncertainty about the actions of Russia, are of much greater concern.

Potential channels of contagion from the eurozone to CEE remain, though they are weaker than previously. As the consultancy Capital Economics points out, the trade links to western Europe are still very strong, with the Czech Republic around the top of the list with exports to the eurozone equivalent to 50 per cent of GDP. The correlation of business and consumer confidence also seems still to be high, with indicators of sentiment in CEE closely tracking those in the eurozone. Braving the obvious comparisons to rats joining a sinking ship, Latvia in 2014 and Lithuania this year have adopted the euro, tying their fates firmly to its economy.

However, the banking and capital market links that caused such problems in 2011-2012 (and even more so during the first phase of the financial crisis in 2008) are mercifully somewhat weaker. Still, the CEE economies’ fates remain largely out of their hands. The trade and confidence links are such that renewed turmoil across the eurozone would undoubtedly sweep east as well.

CEE countries’ best guarantee of stability unfortunately remains not mainly the insulation they themselves have installed against eurozone crisis but the likelihood that Greece will stay in the euro (surely still by far the strongest possibility) and that it can be managed without catastrophe if it leaves. The main danger is the unfortunate possibility that Athens, Berlin and so on will countenance a Greek exit because they believe it can be executed without crisis, only to be proved wrong.

Current account deficits on average have fallen across CEE. Taking a simple average of countries, the region is now in current account surplus, meaning less borrowing from abroad. Short-term external debt, which averaged above 20 per cent of GDP when first the 2008 and then the 2011-2012 crises both came, has dropped to around 16 per cent. And while CEE banks remain dependent on their parents for credit lines, they have also increased their local deposits relative to loans, leaving them less vulnerable to parent bank deleveraging.

More likely than a destabilising crisis is that the eurozone will continue to scrape along in recession and deflation or close to it, reducing the prospect of healthy growth in export markets for CEE countries for the foreseeable future. That would be unfortunate, but not catastrophic. More eccentric foreign policy adventurism on the part of Moscow would also be a serious threat, though Vladimir Putin seems to have enough domestic problems of his own, given the falls in the oil price.

It is always wise to say that complacency is unwarranted (indeed, it is close to a tautology). But CEE countries can have some confidence that, compared with the first time that Grexit went on tour, the performance is likely to be quieter and less destructive. Policymakers will be on alert to respond, but need not alter course just yet.