Analysis - Politics, austerity raise concern over Eastern Europe

PRAGUE (Reuters) - Warnings by Hungary’s new government about the risk of a debt crisis have caused investors to reassess the safe-haven status of Eastern Europe, and may fuel more volatility in markets as the region struggles through economic recovery.

A money changer cleans his window in downtown Budapest June 7, 2010. REUTERS/Laszlo Balogh

Shunned by the markets during the global financial crisis, when Hungary, Latvia and Romania were bailed out by the International Monetary Fund, the European Union’s ex-Communist east has in the past 18 months regained investor trust by tackling big fiscal and external deficits.

But the region’s image suffered a blow last week when two officials in Hungary’s new, centre-right Fidesz government suggested the country was close to a Greek-style economic meltdown, sending currencies, stocks and bonds reeling.

Many private economists believe Hungary is far from becoming another Greece, noting its budget deficit and public debt ratios are much lower. As recently as last month, Eastern European government bonds were attracting fund flows from investors fleeing instability in the euro zone.

But last week’s turmoil illustrated how political change, popular fatigue with austerity, and tough 2011 budget choices may make it hard for Eastern European countries to follow through on their policy commitments.

“Previously people had seen eastern Europe as the place that had done austerity and made progress. It was seen as relatively safe,” said RBC strategist Nigel Rendell.

“But now that this has resurfaced in Hungary, people will reevaluate the situation, and they might come to see that Central and Eastern Europe is not the safe haven that they had been thinking it was.”

Hungary’s forint fell more than 2 percent against the euro on Friday, while Hungarian bond yields surged 40-70 basis points. The Polish zloty, Romania’s leu and the Czech crown fell between 0.5 and 1 percent against the euro.

Hungary’s government tried to contain the damage on Saturday, saying any comparisons with Greece had been “exaggerated”, and that Fidesz was still determined to hit a 2010 budget deficit target agreed with international donors. But markets may take months to settle down.


EU-IMF bailouts in 2008 and 2009 helped Hungary, Latvia and Romania avoid potential balance of payments and banking crises, and halted a free-fall in the region’s currencies.

Hard work by governments to slash budget deficits also helped shield the region from a sell-off in the periphery of the euro zone when investors dumped Greek, Spanish and Portuguese assets this year.

But while public debt and deficits compare favourably with the euro zone’s worst-off countries -- Hungary’s public debt was 80 percent of gross domestic product last year, against 120 percent for Greece -- the growth outlook is still sluggish, and may be worsened by budget austerity.

In Romania, the government is set to face a confidence vote and a general strike this week over austerity steps that include sacking tens of thousands of public workers.

Last week the Romanian government rejected all bids in a bond auction for the third time in a month, because investors were unwilling to accept yields which it considered reasonable. The Greek crisis was triggered when investors became unwilling to accept yields which Greece could afford to pay.

The IMF says Lithuania, which shrank 15 percent in 2009 on the back of severe state cost-cutting, needs to push through austerity measures worth 5.5 percent of GDP to hit its goal of a public sector shortfall of 3 percent in 2012.

But the government will have difficulty doing this after losing its majority in parliament in March.

Latvia’s coalition also lost its majority in March in a dispute over a plan to hike taxes and cut public pay and welfare, raising questions about Riga’s ability to keep its 7.5 billion euro bailout deal on track ahead of an October 2 election.

“The budget situation is challenging in a number of central and eastern European countries and the wider European sovereign debt worries could soon again include worries over public finances in a number of CEE countries,” Danske Bank said in a research note.


At present, Poland and the Czech Republic have avoided serious punishment from markets, but they too face risks.

A surprise victory by Czech centre-right parties who aim to slash the budget deficit and public debt, which is now half the EU average at 37 percent of GDP, has boosted markets.

But some analysts warn that a plan to cut the public finance gap too quickly could hit growth, now projected at around 1.4 percent for this year.

Poland, the only EU state to avoid an economic contraction last year, is expected to grow about 3 percent in 2010. But the approach of elections next year, and the lack of clear plans to cut a budget deficit of 7 percent of GDP, may push public debt over a constitutional limit of 55 percent of GDP, forcing painful spending cuts.

Changes of government can cause market jitters even when the new governments espouse market-friendly policies, in a region where politicians are relatively inexperienced in democratic transitions and economic institutions are young.

That may be what happened in Hungary last week. While some analysts think Fidesz may have been setting the stage to backtrack on earlier promises of deep tax cuts, inexperienced politicians appeared to misjudge the impact of their rhetoric on markets.

Political transitions prompted two bruising confrontations between governments and central banks this year. Poland’s central bank was embroiled in a spat over how much money it would contribute to the government budget, while in Hungary, Fidesz has put pressure on central bank governor Andras Simor to quit -- a challenge to the bank’s independence.

Simon Quijano Evans, an economist for Cheuvreux, said he expected a rebound in markets on Monday following the Hungarian government’s clarification of last week’s statements.

But he added, “Any political communication blunders or dissonance...will face strong negative reaction especially in those countries with higher public sector debt/FX lending/external debt ratios.”

Editing by Andrew Torchia