Eastern Europe: On Crisis Watch

There is no question that growth is deteriorating across Eastern Europe, but are these countries facing outright financial crises? Hungary and Latvia have already turned to the IMF for rescue packages, and other countries in the region exhibit similar vulnerabilities.

Of particular concern for Eastern Europe is the expected steep drop-off in net private capital inflows. According to the IIF, net private capital flows to the region are projected to fall from an estimated $254 billion in 2008 to $30 billion in 2009. Whether or not this is formally considered a ‘sudden stop’, it will necessitate a very painful adjustment process.

There is no defined set of early warning indicators that perfectly predicts which countries are at risk of crisis, but some indicators have stronger predictive power than others. In a 2007 IMF staff paper, Marcos Chamon, Paolo Manasse and Alessandro Prati found a ‘robust leading indicator role’ for three variables in predicting capital account crises – international reserves, current account balance and short-term external debt. External indebtedness and domestic GDP growth forecasts were also important predictors of vulnerability. We look at variants of these indicators below for countries in Eastern Europe.

In terms of mitigating factors not mentioned below, countries in Eastern Europe have very low levels of government debt/GDP (with Hungary being an exception) and do not have major fiscal imbalances (albeit budget deficits are projected to rise in 2009). But as was seen with the Asian crisis, fiscal imbalances are not a necessary precondition for crisis. Private sector imbalances were at the heart of Southeast Asia’s problems in the 1990s, and this seems to be the case in Eastern Europe as well.

External Vulnerability Indicator


Moody’s Statistical Handbook, November 2008

*Defined by Moody’s as Short-term External Debt + Currently Maturing Long-Term External Debt +Total Nonresident Deposits Over One Year)/ Official Foreign Exchange

Estonia stands out on this indicator with a ratio of 388.7%, dwarfing those of its Eastern European peers, which in turn have much higher ratios on average than other EM regions. This ratio is an indicator of a country’s vulnerability to the drying-up of foreign capital inflows – a real vulnerability in Eastern Europe given the sharp drop-off in capital flows to the region the IIF is projecting.

According to Moody’s, this ratio measures a country’s capacity to withstand a temporary loss of investor confidence or heightened risk perception or a general liquidity squeeze. A high ratio can be a signal of vulnerability, resulting either from excessive short-term debt or a bunching of repayments on LT debt, possibly exacerbated by insufficient reserves.

Current Account/GDP


Moody’s Statistical Handbook, November 2008

The Baltics, as well as Bulgaria and Romania, all have double-digit current-account deficits. Countries in the rest of the region are all running deficits too, albeit smaller ones. Persistent current-account deficits can lead to a buildup of external debt, unless the deficits are financed by FDI or equity positions in local companies.

To some extent, current account deficits were considered a normal part of Eastern Europe’s catching-up process with the EU. Nevertheless, the size of most of these deficits makes these countries extremely vulnerable to foreign capital reversals. To put their size into perspective, current account deficits in Southeast Asia from 1995-97 and in Mexico prior to the 1994 crisis fell within the 3.0-8.5% range.

One concern is that a large part of recent investment in these countries has funded activities in the non-tradable sector, the productivity enhancing capacity of which is unclear. Most worrisome is that the drop-off in FDI inflows has meant increased debt financing of these current account deficits, which in turn is adding to many of these countries’ already heavy external debt loads.

External Debt


Moody’s Statistical Handbook, November 2008

Eastern European countries have high external debt-to-GDP ratios, well above those in other emerging market regions. For 2008, Moody’s estimates the external debt/GDP ratio above 50% in almost every Eastern European country. Latvia’s ratio is seen as the highest at about 135%, but Bulgaria, Estonia, and Hungary also have dangerously high ratios above 100%.

In comparison, Mexico’s external debt-to-GDP ratio was around 20% (prior to the 1994 debt crisis), Thailand’s was around 49% in 1997 (as the Asian crisis was hitting), while Finland’s was around 50% in the early 1990s (ahead of the 1992-93 EMS Crisis).

As Seppo Honkapohja stated in a paper examining the Nordic crises of the 1990s, “A country may be able to withstand a relatively high level of international indebtedness, provided its economic growth remains solid, the debt is largely long-term, and the confidence of international investors remains intact.” Given today’s global risk aversion, sharply slowing economic growth, and Eastern European countries’ high external vulnerability indicators, these high external debt-to-GDP ratios seem unsustainable.

Currency Mismatches


Source: Fitch Ratings, Emerging Europe’s Current Account Deficits: Mind the Gap!, January 2008

While the data in the chart above is from late 2007, it shows that Hungary and Romania – with higher than average interest rates compared to their regional peers – have particularly large amounts of fx-denominated loans, accounting for over 50% of total household loans. Not surprisingly, fixed exchange rate countries – Bulgaria and the Baltics – also have high percentages. In contrast, less than 10% of total loans in the Czech Republic are fx-denominated.

While currency mismatches are not one of the ‘robust leading indicators’ described by Chamon, Manasse and Prati, I feel they are a significant risk factor for Eastern European countries. As Christoph Rosenberg notes, foreign currency borrowing raises the region’s exposure to banking crisis. Foreign currency loans became popular in certain Eastern European countries given their lower interest rates. The problem is that many borrowers have been unhedged and thereby exposed themselves to currency depreciation. Banks, in turn, are potentially vulnerable, as currency swings are likely to result in a jump in non-performing loans (NPLs). (See related spotlight issue: Eastern European Currencies: Under Pressure)

Krugman notes that the high foreign currency lending seen in certain Eastern European countries was also a risk factor in late 90’s Asia and Argentina in 2002. “The key to the Asian crisis — and of Argentina’s collapse in 2002 — was the way domestic players leveraged themselves up with foreign-currency loans. When the capital inflows dried up, and the Asian currencies plunged, these debts suddenly became a much bigger burden, decimating balance sheets and causing a downward spiral of deleveraging.”


The extent of external imbalances – as shown above – are not the only determinants of the probability of getting into a financial crisis. But what the indicators above do show is that countries in the region are extremely vulnerable to the drying-up of foreign capital inflows. That’s why the IIF’s projection that net private capital inflows will drop off from some $254 billion in 2008 to some $30 billion in 2009 is such a major concern. Moreover, given the similar vulnerabilities across the region, my concern is that a crisis in one country has the potential to blow up into a regional financial crisis.

4 Responses to "Eastern Europe: On Crisis Watch"

  1. Jan C. Lundberg, petroleum-industry analyst   February 11, 2009 at 2:09 am

    Dear Ms. Stokes,When you conclude that there’s “potential to blow up into a regional financial crisis” is this an attempt to soft-pedal what is already a global crisis?To think outside the box, and even forget the box, is to look at the bigger picture.You write for the financial interests interested in growth, but growth is history because the cheap petroleum is gone. I speak of the energy value and retrievability of oil, not the nominal price (which is unreliable in that it does not reflect massive subsidies especially in the U.S). The global peak in oil extraction has hit and there’s nowhere for an economy dependent on petroleum to go but down, fast. The high prices that peaked last summer did their damage to the economy and finances; this is what petrocollapse looks like. There is no technofix on the order desirable for resumed growth.Endless growth is the philosophy of the cancer cell. We are entering in a new era of local economies that strive to provide the necessities of life rather than crass materialism or unnecessary gadgets and appliances that toxicy landfills and generate greenhouse gases.As you can tell by now I see something good in “vulnerability to the drying-up of foreign capital inflows” but I agree with you on one thing: “heavy external debt loads” are bad news any day.For more information on the bigger picture for a sustainable society, please visit http://culturechange.orgRespectfully yours,Jan C. Lundberg, petroleum-industry analyst

  2. cdulan   February 16, 2009 at 5:20 pm

    Ms Stokes,Great article. The key indicators mentioned in your article are logical symptoms of a systemic crisis in each of these local economies. I am curious if the measure of short term borrowing as an indicator of the situation is underrepresented right now because of the overall lack of liquidity and aversion to risk in the market? If Western European banks who were so lax and contributed to the original circumstances of the problem are tightening their reins, then the options for short term financing for these places should be reduced significantly.

  3. Mary Stokes
    Mary Stokes   February 17, 2009 at 4:43 pm

    Very good point, cdulan.I think the measure of short-term borrowing is a key indicator of the critical situation of these economies and tried to capture this by highlighting the external vulnerability indicator for these countries ( calc, by Moody’s: Short-term External Debt + Currently Maturing Long-Term External Debt +Total Nonresident Deposits Over One Year)/ Official Foreign Exchange).As you point out, Western European parent banks, via subsidiaries, played a role in the expansion of credit to these countries in recent years, these foreign banks dominate CEE banking systems (holding 60-90% market share depending on the country).As Western European parent banks now seem to be in the process of having to tighten their reins on credit, you’re absolutely right in pointing out that ‘the options for short term financing for these places should be reduced significantly.’As a result, the CEE economies look headed for very large contractions. Those with the largest imbalances and heaviest dependence on foreign capital inflows will experience the steepest falls in output. The similarities between the situation in the CEE today and that during previous EM crises (i.e. Asia of 1997) – in terms of large external imbalances, currency mismatches, and general vulnerability to liquidity squeeze – concerns me that the CEE is on the brink of a regional financial crisis.

  4. Tristan   February 23, 2009 at 2:09 pm

    I thiink we have more economical problem here in UK to keep us busy solving our problems rather than to spend most of our time worry about all these Ex commonist countries