Once the financial crisis broke out in 2008, investors immediately sold their emerging market (EM) assets since this segment traditionally was considered as one that used to suffer most from exogenous shocks. However, the escalating problems within the Economic Monetary Union (EMU) financial sector and the collapse of the housing market in several countries also put strong pressure on respective countries’ public finances. Especially the EMU periphery countries – a term which wasn’t even known before the crisis – suffered dramatic fiscal imbalances, as governments gave large guarantees to their banking sectors in a phase of severe economic turndown. The Central and Eastern European (CEE) region was also hit hard by the financial crisis, as some countries like Hungary, Romania and Latvia needed foreign financial help to cover their economic external imbalances when they suddenly ran short of liquidity. However, while the EMU periphery countries are economically more developed with a higher GDP per capita, the market has been pricing in higher sovereign risk in comparison to the CEE countries for many months now. Investors are particulary concerned that Portugal or even Spain might need help from the European Financial Stability Facility (EFSF) after Ireland as well as Greece asked the other EMU countries for financial aid. As market quotes are to a certain extent also psychologically driven, we ask ourselves: what are the reasons for this varying perception, how long will these differences last and – more importantly – are these differences fundamentally justified?
|Chart 1: 5Y Spreads in the EMU Periphery Hiking North…
|| Chart 2: …Clearly Underperforming the CEE Region
Fundamental differences between CEE and the EMU periphery – do they exist?
For a fundamental analysis on the credibility of CEE and EMU sovereigns we take a look at their fiscal situation, indicators on competiveness, foreign trade numbers as well as the health of their financial systems.
The picture that can be drawn when we compare the fiscal/public debt situations with the EMU periphery and the CEE countries (in relative terms) is pretty unambiguous. Generally speaking, public debt in percent of GDP is lower in the CEE countries compared with the EMU periphery. Except for Hungary,Spain as the least indebted EMU periphery country with a public debt of “only” 70.6 percent of GDP is more indebted than all other CEE countries. Among the CEE countries, Bulgaria is the model student with only 19% public debt (in percent of GDP.) This relatively low number is explainable with Bulgaria’s currency board and its high current account (C/A) deficit in previous years that forced the government to keep the fiscal budget balanced. On the other side of the fence, Ireland (125.2% of GDP) and Greece (145.7% of GDP) stand out with a soaring stock of public debt.
|Chart 3: Higly Indebted EMU Periphery Countries: In Relative…
||Chart 4: …And Nominal Terms
Looking at just these figures, the verdict was simple: The high stock of public debt within the EMU periphery (that is expected to continue soaring in the coming years due to further high budget deficits) clearly speaks against these countries. However, these numbers do not take into account the ability of a country to deal with indebtedness. Apart from the country’s net private assets, it is particularly important to compare budget deficits with private savings amounts. If private savings still outweigh the state’s budget deficit, a country has at least the economic strength to finance it’s state, although the willingness of privates to do so remains of course questionable.
Chart 5: National Savings (% of GDP) Minus Budget Balance (% of GDP)
Comparing aggregate national savings with budget deficit numbers, the picture becomes more differentiated. In all CEE countries including the highly indebted Hungary, private savings in 2009 and 2010 were higher than the state’s budget deficit. In contrast to this within the EMU periphery group, only Spain and Italy could theoretically finance its state budget deficit by private savings. In Greece and Portugal, numbers have improved this year, while in Ireland the situation has deteriorated despite the high GDP per capita that allows private households to save more money of their disposable income than for instance relatively poor Bulgaria.
This comparison points to a mismatch within the EMU periphery between the highly indebted states and more wealthy private households that are possibly able to save more money than the state actually would require keeping its budget balanced. The key problem is of course that these private households may see a better risk/return ratio lending their money to other borrowers, given that the business sector also demands debt for their investments. The increasing competition between the state and private companies on scarce savings may have the effect of rising yields and shortage of capital for both.
|Chart 6: Average Labour Costs (2009): A Heterogenic Picture
||Chart 7: Growth of Labour Costs and Labour Productivity Between 2004-2009
The question of competitiveness – Productivity vs. labour costs
Another fundamental aspect that needs to be considered is the level of labour costs as well as the development of wages and productivity. Except for Portugal, all CEE countries have far lower labour costs in comparison to the EMU periphery. Average labour costs in Turkey are for instance only one-tenth of average labour costs in Ireland. However, even within the CEE and the EMU periphery, segment differences are enormous. Average labour costs in the Czech Republic are four times higher than in Turkey, while Irish average labour costs exceed average costs in Portugal by more than three times. Despite weaker infrastructures and on average less educated work forces, great comparative cost advantages have made CEE attractive especially for industrial investments.
Nonetheless, cost differences are decreasing sharply. Wage growth in CEE has outpaced the EMU periphery strongly in recent years and even more important, labour costs in CEE exceeded productivity more sharply than in Western Europe. The CEE countries are therefore losing their cost advantages to a growing extent. Despite the sharp increase of wage growth in CEE, the process may still take many years, as labour cost growth in the high wage level EMU periphery countries still outpaced productivity growth in past years, though to a much smaller degree. Latest numbers for the current year show that average labour costs in Ireland and Greece especially will sink in absolute terms which should help to improve their competitiveness at least marginally.
Labour costs are of course only one major aspect of competitiveness. Other important factors include infrastructure, availability of qualified workforce, selling markets, judiciary but also corporate taxes. Infrastructure and selling markets are for obvious reasons far more developed in the EMU area, although many CEE countries have invested large amounts in their traffic systems. Looking at corporate tax levels again there is a clear difference. Except for Ireland, corporate tax levels within CEE are lower than in the EMU periphery. On average the tax burden for corporates in the EMU periphery is more than 50% higher than in CEE. What is not taken into account yet, but should increase the spread of the tax burden, is EU subsidies from which the new EU member states in particular benefit.
Chart 8: Corporate Tax Levels (2009)
Current accounts and credit growth
Several CEE countries had to ask for international aid when the financial crisis peaked, as their external financial imbalances led to a dry-out of liquidity. Especially the Baltic countries, but also the Balkan countries, had huge C/A deficits. This was for two main reasons: first, a lot of capital flooded into these countries, as investors (many of them from Western Europe) hoped for a higher return than in their homelands. Secondly, high wage and credit growth fuelled domestic demand and therefore soaring imports. The competitiveness of their export industries was not able to prevent the trade balance from turning more negative.
But is this a typical problem of only emerging economies? Indeed, credit growth was far less pronounced in recent years in the EMU area. However, in 2005-2006, credit growth in Ireland and Spain exceeded annual rates of more than 20% due the boom in the housing markets. Looking at C/A balance numbers one may be surprised to see Greece and Portugal having the highest C/A balance deficits in past years. As most of their C/A balance is due to trade with other countries within the Euro area, the numbers seemed not that worrisome. For many years, politicians but also economists followed the argument that within a currency union, trade deficits don’t put the economy on a subsidence slope. Far from it! The high C/A deficits were the first warning signs of decreasing economic competitiveness in the industrial and the services sectors. This development is the flip side of average wage growth in the EMU periphery outpacing productivity gains. This was especially the case in Ireland and Spain where C/A deficits were overshadowed by a booming housing market and high capital inflow.
|Chart 9: Current Account Balances in the Recent Past
||Chart 10: Credit Growth in the CEE Countries Slowed Down Noticeably
For that reason the development in some of the CEE and the EMU periphery countries do show parallels. Both regions borrowed capital abroad to finance consumption or booming housing markets and both developments turned out to be not sustainable. A major difference, of course, arose when it came to the question of how to deal with these imbalances. While some CEE countries were able to improve competitiveness through the devaluation of their currency like in Romania, the Baltic countries and Bulgaria decided not to devaluate because of their fixed currency regimes. In this case, internal consolidation via cutting public expenditures and raising taxes was the only option. The Baltic countries but also South Eastern Europe did this, while the EMU periphery is just at the beginning of this process.
The soundness of financial markets
So far we have concentrated our analysis on fiscal and fundamental differences between the CEE and the EMU periphery area which may already explain to some extent why CEE assets have performed so much better in recent months. To have a more differentiated picture it is also important to take a closer look at their respective financial systems as they have been the starting point of the world financial and economic crisis. Moreover, sovereign guarantees to prevent banks from collapsing have already brought fiscal budgets in many European countries out of balance and the fear of more banks in need of financial aid is still present.
Chart 11: Customer Deposits to Total (Non-Interbank) Loans
Taking the strong credit growth throughout CEE and the EMU periphery in recent years into account, it is little surprising that most banking systems have deposit/loan ratios below 100. In particular the Baltic banks but also Italy as well as the Iberian countries are dependent on external financing. In good times, a deposit/loan ratio far below 100 was not a problem by itself. However, due to the financial crisis, market participants have been more restrictive in lending money. Therefore, banking sectors which are dependent on external financing may face severe problems when market trust in the system and sovereign debt deteriorates. This may be the case if market rumours increase about Spain or Portugal possibly needing to ask the EFSF for a bail out. CEE banking (and above all the Baltic banking) sectors are dominated by subsidiaries of Western European parent banks. Here, Scandinavian, Italian and core European firms play a decisive role. Therefore, CEE banks are dependent on liquidity flows from abroad. So far we haven’t seen any strategic change to close CEE operations; the Scandinavian banks especially committed to holding up their Baltic operations in spite of soaring non-performing loan numbers.
|Chart 12: Tier-1-Ratios: CEE Banks Better Capitalised
||Chart 13: Non-Performing Loans Still Heading Upwards
More critical may be conditions in Hungary that installed Europe’s highest banking levy. Since Hungary – being the most indebted country within CEE – has still not solved its mid- and long-term financial needs, a further extension of the levy cannot be ruled out. This would, however, weaken the banking sector as some foreign parent banks may rethink their Hungarian operations.
Looking at Tier1-ratios, the picture delivers a clear message. EMU periphery banks are less well capitalized giving them a smaller buffer to cope with possible further major write downs. The capitalization of CEE banks looks better but may reflect conditions of their parent banks. Class winner in terms of banking sector stability is clearly Turkey. The country’s banking sector is dominated by domestic institutes that are on average very well capitalized. This is particularly outstanding since Turkey slid around the millennium into a severe banking crisis from which it has recovered recently. Since Turkey’s banking sector counts as one of Europe’s healthiest, it may be no surprise that its sovereign credits default swap spreads are quoting, despite a BB+ average rating, well below most of the CEE and the EMU periphery countries. Apart from Turkey, the Czech banking sector appears well capitalized and less dependent on external liquidity flows. For that reason it may not be surprising that investors already qualify Czech credit as on a par with European countries like Austria or France.
Chart 14: Major Rating Revisions Ahead? CEE Countries With Tighter Spreads But Weaker Rating
Economic and financial difficulties within parts of the CEE region and the EMU periphery do show parallels. In particular, both regions had faced growing imbalances in foreign trade and a high dependency on capital/liquidity inflow. Several countries in both regions boosted their economic progress with credit-fuelled demand for consumption or the housing market. Therefore, it is little surprising that market assessment of the EMU periphery now has reached the levels that CEE countries already faced when they were hit by the financial crisis in 2008 and early 2009.
Given that most of the CEE countries that were hit badly by the crisis have already implemented austerity measures and seem to have passed the trough, the question is now whether severely hit EMU countries will take required action. In some ways, it may be easier for the EMU periphery countries to do so, as their economic strength is by far greater. But apart from the willingness to accept cutbacks in the standard of living, there are major doubts whether the EMU periphery can achieve the same rebound in their financial markets as the CEE countries did.
The CEE countries are very small open economies that were rescued by financial aid from the western countries and international institutions. However, the EMU periphery countries perhaps might not have the chance to rely on external help to the same extent, simply as there is possibly not enough money for all of them. At least this is a fear investors have and consequently why they demand higher risk premia. Secondly, because of the already-high level of indebtedness, the stock of debt will soar so dramatically in several of the EMU periphery countries that they may struggle to service all interest payments. A realistic chance to even reduce the stock of debt in relation to GDP seems out of reach in the foreseeable future.
To sum it up: the CEE region is heterogeneous. There are countries whose economic and financial fundamentals are substantially better than most of the EMU periphery countries. And though they are still emerging, they probably will preserve their sovereign credibility in the upcoming years. These countries include the Czech Republic and (perhaps surprisingly) Turkey. Their lower spread compared with the EMU periphery is justified and may be sustainable for the coming months, perhaps even years. This will also have an impact on rating levels that currently lag behind this development. There are other countries within CEE like the Baltic countries that faced a crisis that is to some extent comparable with the situation in the EMU periphery. While the Baltic countries are already on track again, the EMU periphery countries are just about to start their consolidation efforts. The challenges will be great. A negative example for the EMU may be Hungary which still struggles to maintain its financial stance despite having already achieved fiscal saving efforts.