Dismissing Decoupling and Deleveraging

Decoupling was the most popular catchword among emerging market experts a year ago. But as deleveraging, another popular buzz word, brought much of the emerging world to its knees, even the staunchest supporters of the idea that emerging and developing economies were no longer dependent on the development in mature economies began to doubt. The most faithful believers have regained some faith lately but just as the idea of universal decoupling was exaggerated and premature, so is the notion that all emerging markets will go through a prolonged suffering due to deleveraging. Even though almost all emerging economies have been adversely affected by the reduced risk appetite and unwinding of debt during the financial crisis, it would be a mistake to conclude that emerging economies are worse off than their developed peers as a group. As a matter of fact, the largest and most important emerging economies are in a relatively good position to bounce back faster and stronger than their developed peers.

China is the most obvious out-performer. Although some uncertainties remain, the economy is expected to grow somewhere between 6-8% this year following a massive, and so far seemingly successful, domestic stimulus program. But it is also possible to find examples of large economies in emerging Europe (one of the regions hit the hardest by deleveraging due to its profound external debt burden), which could surprise on the positive side.

Small and vulnerable

Before discussing the potential out-performers in the region, one should note the extraordinarily difficult position in the most leveraged economies in Eastern Europe, most notably the Baltic States, Ukraine and Hungary. Even though the worst-case scenario of sovereign default has been avoided, primarily because of the strong and fast rescue packages from the IMF and other international financial institutions, these economies are in a difficult situation, as neither exports nor domestic demand will be strong growth drivers in the near future. These economies tend to be very export-orientated and coupled to Western Europe where demand has been, and will probably remain, very low for some time.

This is not new, although it is sometimes forgotten that these troubled economies in emerging Europe also happen to be among the smallest. Eastern Europe was approximately a USD 4,500bn economy last year, which is about the same size as the Chinese economy, and of which the three Baltic States made up 2.3%. The combined size of the 12 economies in the region with stand-by arrangements or other emergency lending facilities[1] from the IMF, which are arguably the most troubled, is 16.5% of the total or a little smaller than the Dutch economy. And none of these except for Hungary have sizable equity markets included in the MSCI Emerging Europe index.

Big and strong

If one instead focuses on the four largest economies in the region – Russia, Turkey, Poland and the Czech Republic – it is striking to note that they make up more than 70% of the region’s total GDP (see graph below).


These economies have not been spared from the global crisis. All four economies will contract this year and deleveraging has had a painful impact on their markets. But initial conditions should start to matter once the most acute phase of the global crisis subsides, and the recovery should be faster after the bottom has been reached. If recovery for the former group of countries is L- or at best U-shaped, then the largest economies should be able to rebound like a V.

These economies entered the crisis without major imbalances and public finances were in good condition. The total external debt was below 40% of GDP in these economies in 2008, which can be compared to over 100% in the most leveraged economies in Eastern Europe and around 130%, 150% and 300% in Germany, France and the UK respectively. Moreover, the banking sectors in the big four are relatively sound, which is not to say that they are without worries. Previous banking crises in Central Europe and Turkey have resulted in more cautious lending, especially in foreign currencies, even though the banking sectors are dominated by foreign banking.

The Russian case is slightly different and deserves some attention. The average Russian has USD 900 in personal debt, including USD 340 in mortgage loans. The household credit market is simply not as developed in Russia as elsewhere in the region, and consumption is therefore less likely to fall dramatically in a recession.

Markets are on to something

Although Eastern Europe has been hit harder than most other emerging and developed regions during the past 12 months, there is reason to believe that the largest and most important economies will be able to surprise on the positive side in the next 12 months. The market has partially realized this already, as the Russian and Turkish markets have outperformed most others this year, with 74% and 31% gains respectively and with price earnings ratios remaining in single digits. Moreover, many large pension and investment funds have not yet entered the market after the sell-off last year and may thus add more momentum to the rebound.

Even if global equity markets may be in for a slow walk this summer after the strong spring rally, the big four Eastern European markets look quite well prepared to start running again on the back of the faster-than-expected economic recovery and increased risk appetite for unleveraged markets, combined with attractive valuations.

[1] Armenia, Belarus, Bosnia & Herzegovina (pending), Georgia, Hungary, Latvia, Romania, Serbia and Ukraine have Stand-By Arrangements; Moldova and Tajikistan have Poverty Reduction and Growth Facilities; and Kyrgyzstan has an Exogenous Shocks Facility.