Monster under Hungary's bed escapes to spook world

The country's new government told a whopper about fears of default, hoping to prepare the electorate for budget cuts, but the region's markets are paying the price for it.

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The country's new government told a whopper about fears of default, hoping to prepare the electorate for budget cuts, but the region's markets are paying the price for it Recent market panic about eastern Europe being on the brink of a debt crisis that could engulf western banks is unwarranted and stems from an ill-judged warning by the Hungarian government to scare voters into accepting budget cuts.

Senior officials from the new Hungarian government unnerved markets by saying the nation's finances were in much worse shape than thought and that its predecessor had falsified fiscal data as Greece had. The comments led the Hungarian forint to slump to a 12-month low against the euro and triggered a sell-off in financial markets across the region, with stock markets also falling sharply in Poland, Romania and the Czech Republic.

Markets have since recouped some of their losses but investors remain jumpy. The sell-off rekindled bad memories of 2008 when eastern Europe felt the full force of the financial crisis and several nations were forced to call in help from the IMF. Many foreign investors tend to regard eastern Europe as a unit. If one country gets into trouble, they are tempted to retreat from all main markets in the region. In reality, the region's economies have not all been performing the same.

Poland, for example, was the only EU country to avoid recession last year and led the bloc with 1.7 per cent growth. But the Baltic states of Latvia, Lithuania and Estonia suffered double-digit declines in GDP. Slovakia and Slovenia are recovering quickly while Bulgaria remains mired in recession and Hungary and Romania are expected to stagnate this year. The European Bank for Reconstruction and Development expects 2.6 per cent GDP growth in Poland this year, and 3.4 per cent growth in Slovakia. Ukraine, which slumped 15 per cent last year, is forecast to grow 4 per cent this year.

Eastern Europe's economic fundamentals remain so solid that a full-blown debt crisis is unlikely. Hungary is far from defaulting and the comments from members of the right-wing Fidesz party, in office for only a few weeks, were designed to prepare the population for budget cuts. East European banks have an advantage in that they were not exposed to US subprime mortgages, and government debt levels in most countries in the region remain in line with EU rules.

The region only experienced trouble in 2008 because trade with the euro zone collapsed and there were fears western banks would withdraw capital to strengthen their declining liquidity. The main weakness now is current account deficits. After the fall of the Iron Curtain, eastern Europeans gorged themselves on consumer products of which they had been deprived under communism. Imports surged and direct investment by foreign companies lured by the prospect of low-cost skilled labour covered trade deficits.

Those investments dropped in the financial crisis and in some cases western firms pulled out completely. Governments have had to respond by tightening belts and increasing their borrowing, in many cases by issuing bonds in foreign currency. Private households also borrowed money in foreign currency from western banks, lured by the lower rate of interest on euro loans, for example. About 60 per cent of all outstanding loans and mortgages in Hungary are in euros or Swiss francs. As local currencies across eastern Europe depreciated against the euro, dollar and other foreign currencies, repaying that debt become more expensive.

The prospect of repayment problems poses potential credit risks for western banks active there but fears of major loan defaults in the region are still overblown. What eastern European governments and market regulators need to do now, apart from curb their deficits and debts, is to develop their own capital markets to lessen their dependency on foreign banks and credit. Local lenders and companies must set an example by refinancing their investments in local currency.

That will help put east European economies on a stronger footing and make debt crises there even less likely.