A shift to Eastern Europe and emerging markets too

By Edward Harrison On Oct 21, 2008

Yesterday, I made the case for us to be less concerned about the U.S. and even Western Europe, but to be very concerned about a slowdown in Asia. The reasons for this are simple: most analysts now understand the extent of problems in the U.S. and Western Europe.

This, is part of the reason I am more optimistic about financial markets in Europe and the U.S. I am even bullish on some sectors of those economies despite the slowdown. However, less is known outside of the U.S. and Western Europe. Expectations are too high and disappointment is likely.

Today, I want to continue the theme of looking outside Europe and North America, but this time I want to focus on Eastern Europe and Emerging Markets. And to get right to the point, these areas will see a very marked slowdown, leading to very hard landings in some cases.

We have seen what can happen in a small country like Iceland when the macroeconomic data show an economy out of control. Iceland was the first small country to melt down because it had the biggest imbalance with its gaping 14.6% current account deficit. The results are especially dire for these small nations because they do not have the world’s reserve currency like the United States does. And, thus, they are more likely to feel the full force of a loss of confidence.

But, unfortunately Iceland is not an isolated case. In Eastern Europe, it’s all about overvalued currencies and poor macroeconomics. For instance, Estonia has a massive 11.8% current account deficit, Latvia’s is 13.8% and Lithuania’s is 14.0%. In Slovakia, it is 5.6%, Slovenia 6.6%, Hungary 5.9%, Poland 4.9%, and in the Czech Republic 2.8%. All across Eastern Europe there is a massive capital account surplus (hot money from abroad) to match this current account deficit. Western European Banks have been speculating in Eastern Europe and are sure to get burnt when things start to unravel there.

In July, I noted the problem in the Baltics in particular:

The Baltics are looking a lot like Argentina was before it collapsed at the beginning of the decade: fixed exchange rate, large current account deficit, significant foreign bank lending, overheating economy turning to bust.

This combination is a toxic mix that will certainly end in the disaster it did for Argentina. I have a vivid memory of being in Buenos Aires when workers were rioting in the streets, knocking over cars and setting them on fire. Foreign banks were littered with Graffiti, including the word “ratas,” scrawled across them. Many banks were shut down and closed and too many bank I could see had armed guards with submachine guns out front to protect them. I can’t say this same disastrous scenario awaits the Baltics, but things could get pretty dicey there in any event.
–Are the Baltics the new Argentina?

For other countries, it s not as much the current account as it is falling commodity prices. All across Latin America, commodity prices are important — in Chile, Peru, Argentina, Brazil, Venezuela and Mexico to name the biggest economies in the region.

As you can see from the graph above, commodity prices are falling across the board as the global economy heads into a recession. This has had different but equally staggering effects on various parts of the globe.

In Western Europe and the U.S., deleveraging is going to slow credit growth and reign in consumer spending, leading to recession across the board.
In South Africa, Australia, New Zealand and Canada, a combination of lower commodity prices and tighter credit will cause housing bubbles to burst and lead to deep recessions.
In Africa, Latin America, Russia and the Middle East, commodity deflation is going to kill the commodity-dependent economies.
In Eastern Europe, excessive current-account deficits due to hot money is going to lead to capital flight and depression as we have seen in Iceland. The most overexposed here are the Baltics. As Sweden is a major lender there, it is no wonder they are putting a massive $200 billion prop under their financial services sector.
In Asia, slowing demand worldwide will not be offset by increased domestic demand. We have already seen Singapore enter recession, South Korea bail out its banking sector China begin to experience a stock market and housing bubble unwind, and Japan suffer recession. Growth there will be much slower than expected.

Make no bones about it, we are headed for a major global recession and no economy will be spared. This is one major reason governments are cushioning the blow with stimulus packages. As for the emerging markets and Eastern Europe in particular, the headlines below in related posts from today and yesterday should make clear that there is a crisis of confidence in those regions. Anyone investing there should beware, lest they find another Iceland on their hands.

Source
Trade, exchange rates, budget balances and interest rates – The Economist
Commodity Futures – Bloomberg