Europe's 'Asian crisis' will run till 2010

"It's grim out East," as Lex says in the FT. After a six-year boom in 2002-2007, central and eastern Europe (CEE) has hit the skids amid the global downturn and credit squeeze. In Lithuania, Romania and Ukraine stocks fell by 75% in 2008 and elsewhere lost around half of their value. This year, Russian equities have slid by another fifth. Currencies have dived too, with Hungary's forint at a record low against the euro this week. The International Monetary Fund (IMF) now expects the region to slide into recession, shrinking by 0.4% in 2009.

Investors are wary of all markets just now, says Nigel Rendell of RBC Capital Markets. But CEE is "suffering the most". That's partly down to the global downturn, especially the eurozone recession. As Capital Economics points out, exports to the single currency area account for 40% of GDP in the Czech Republic and Hungary; in Bulgaria, Poland and Romania, they comprise 15%-22%. The resulting slump in industrial output, on course to fall by more than 10% in most countries this year, is raising unemployment and denting consumer confidence.

But the main reason investors are jittery is that, unlike Asia or Latin America, CEE is overleveraged. It went on a foreign borrowing spree, leading to "unsustainably high current-account deficits" (Latvia's and Bulgaria's are 16% and 18% of GDP) and sharply rising foreign debt payments, says David Oakley in the FT. And external financing is drying up. Private capital flows into the region are set to slump to $30bn this year, down from $254bn in 2008, according to the Institute of International Finance.

Bank borrowing from abroad funded "a large chunk" of the region's current-account deficits, says Capital Economics. And not only are most banking systems highly dependent on wholesale funding, but they lent out money in foreign currencies too. In Latvia and Hungary, foreign-denominated loans make up 90% and 60% of all loans respectively. With local currencies plummeting against the Swiss franc and the euro, this will give the rise in bad loans as the recession bites additional impetus.

With global credit markets essentially closed, Ukraine, Latvia and Hungary have already had to turn to the IMF to prop up their banking systems and economies, and more IMF deals with the region look likely. An IMF package comes with stringent conditions that tend to exacerbate downturns. Meanwhile, investors are becoming increasingly concerned that Ukraine, set to shrink by up to 10% this year, will default on its sovereign debt, despite recent IMF assistance. It has to pay 26% on its foreign debt (which stands at $100bn between the government and corporate sector), says Bloomberg.com, and needs to roll over $30bn this year. Political turmoil is creating further uncertainty.

CEE is comparable to Asia in 1997; it has large external imbalances and is suffering a sudden funding shock, says Lars Christensen of Danske Bank. In view of what happened to Asian currencies back then, CEE currencies probably still have "significant weakness" ahead. A co-ordinated EU-wide response, hitherto lacking, would boost overall investor confidence, reckons Christensen, while Simeon Djankov and Facundo Martin on Crisistalk.worldbank.org note that emerging-market stocks tend to recover six months before economic activity (represented by industrial production) bottoms out. The upshot? Don't expect a significant recovery in CEE equities before mid-2010.

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