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What’s ahead for central Europe?

Capital flows | What’s ahead for central Europe? Anthony Harrington

In a presentation made at the end of 2010, Steven Cecchetti, the Head of the Monetary and Economic Department at the Bank for International Settlements, pointed out that to the surprise of many, the monetary policy frameworks in Central and Eastern Europe held out pretty well through the crash of 2008.

“Contrary to widespread expectations, there have been no currency collapses and no banking crises,” he says. Well, not in Central Europe anyway. Austrian banks took a real pasting when the Hungarian economy and property market went into a tailspin, since many of them had been lending euro-denominated home loans all over the shop. When the values on the assets underpinning those loans went south, Austrian banks had a few very uncomfortable moments.

However, Cecchetti is a very perceptive analyst. He led the brilliant BIS report into the debt paths being pursued by developed countries, which was the subject of an earlier blog and also featured strongly in John Mauldin’s recent book Endgame, about which I also blogged. His main point in his presentation was that Central Europe is going through a transition period and could expect to be hit, shortly, by the same inward flows of cash that were already causing severe problems for emerging market countries such as Brazil and China. Capital flows to Asia, Cecchetti pointed out, are already running at around $20 billion per quarter while flows to Latin America are running at $10 billion per quarter. As yet, investors are not rushing to throw funds at Central and Eastern European assets, but the day is coming, he predicted.

In a more recent paper, published as part of the IMF Working Papers series in March 2011, Pritha Mitra reminds readers that much of the damage done to emerging Europe, comprising the new accession countries of central and eastern Europe, through the 2008 downturn was caused by the sudden choking off of easy credit, in other words, by the sudden halt to inward capital flows. Mitra puts a considerable amount of analytical work into trying to determine whether it matters to a country’s economy where inward investors choose to invest. Does “hot money” flowing into one sector rather than another impact GDP differently? The short answer Mitra finds, is yes, it does matter. Money flowing into real estate has a more profoundly positive effect on GDP than money flowing into any other sector. So conversely, real estate, or property bubbles, are dramatically impacted by the sudden choking off of these flows through some external shock (such as the impact of the US sub-prime fiasco on global credit markets).

Like Cecchetti, Mitra predicts that sluggish recoveries in developed countries will push capital towards higher growth areas in emerging markets and central Europe, with a higher growth rate potential than the developed markets of France, Germany and the founding member countries of the eurozone can expect for their share of hot money flows. It’s not happening yet: Hungary, for example, saw net outflows of -2.9% year on year for 2010, while Estonia and Latvia had even larger capital outflows, of -5.4% and 4,0% respectively. However, Poland and Slovakia both saw inflows of 2% or more, which could well presage the flood to come.

One of the biggest issues large inflows will present to the new EU member states of central and eastern Europe is the higher price volatility that such inflows bring. As Mitra notes, high output volatility has a pronounced effect on a small country’s GDP. Strong inflows increase GDP quite sharply but then leave the economy shaken and bruised if they suddenly dry up. The damage this does means that the country concerned usually has lower GDP after the inflows crash, than before the inflows arrived in the first place. All of which puts an absolute premium on managing capital inflows – which is something central banks are still grappling with and have yet to make a convincing fist of.

Further reading on capital flows and emerging markets:



Tags: capital flows , central Europe , eastern Europe , GDP , Hungary , IMF , inward flows , Latvia , Poland , Slovakia
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