EU newcomers on economic alert

The public finances of some eastern European countries are giving cause for concern - both to the European Commission and to rating agencies. Simon Taylor takes stock.

The EU’s newer member states have economic growth rates that are the envy of western Europe, but last week they were the subject of a spate of warnings.

On Wednesday (30 January) Joaquín Almunia, the European commissioner for economic and monetary affairs, said that Romania’s increasing budget deficit was "a matter of serious concern".

On the same day, French-owned credit ratings service Fitch Ratings changed its outlook for the credit ratings for four east European economies - Romania, Bulgaria, Estonia and Latvia from "stable" to "negative", citing concerns about the countries’ high current account deficits (CAD) on their balances of payments, which measure trade flows into and out of a country.

Bulgaria’s CAD reached 19.5% of gross domestic product (GDP) in 2007, one of the highest among the 105 countries rated by Fitch. The figure for Romania was 14% of GDP last year.

Fitch said it was concerned that the four countries might find it difficult to finance their current account deficits given the global credit crunch caused by the subprime lending crisis in the US and growing risk aversion among lenders.

"External deficits that were easy to fund in times of abundant liquidity and risk appetite may be harder to finance following the global credit shock," warned Edward Parker, a Fitch analyst.

If a country’s credit rating is downgraded, it could have to pay lenders a higher rate of interest, making it more expensive to raise funds.

But some financial analysts are less pessimistic than Fitch.

On Romania, Juraj Kotian, head of central and eastern European macro and fixed income research at Austrian Erste Group bank, said: "I would be very cautious regarding a downgrade. Policy actions which have been taken by the authorities, especially monetary tightening and administrative measures to curb foreign lending, are very promising." Despite being singled out by Fitch, he said that Romania was "in better shape than others" because it has a flexible exchange rate (compared to Bulgaria which operates a currency board to maintain a fixed exchange rate against the euro) and the lowest current account deficit. Under a flexible exchange rate regime, balance of payments problems lead to a depreciation of the currency on the foreign exchange markets. Under fixed regimes, deficits have to be financed by reserves of foreign cash.

Rising inflation is a problem everywhere with the eurozone rate up to 3.1% in December 2007, well above the European Central Bank’s target of 2%. Increased demand for grain, meat and dairy products from emerging economies, particularly China and India, is pushing up food prices while energy prices have also risen as the price of a barrel of oil has surged to €100. These commodities often account for a higher proportion of household expenditure in the central and east European economies than in western Europe.

Prices are also driven higher by strong domestic demand as these economies have strong growth and wages are starting to converge, albeit gradually, on west European levels.

Nevertheless, on inflation, Romania is also performing relatively well, with the annual increase in prices falling from 12% in 2005 to 6.7% last year. RZB, another Austrian bank, forecasts that it will drop to 4.5% in 2009.

Erste’s Kotian forecasts growth in Romania to be 6% in 2007.

Martin Stelzeneder, a central and east European economies analyst at RZB in Vienna, said that the markets’ reaction to Fitch’s announcement was "a little surprising" given that it was already well-known that Romania was heading for a high current account deficit. He predicts that Bucharest would manage to get its CAD down in the next few years.

RZB expects the National Bank of Romania to raise interest rates to 9% from 8% to tackle inflation and to stem currency depreciation, which can increase costs for households that have borrowed euros from international banks.

Some analysts believe that Bulgaria faces a more difficult situation than Romania because the currency board rules out the depreciation of the exchange rate, making it more difficult to address domestic economic problems.

Inflation is relatively high, forecast to be around 8.0% in 2008. But the country has been running a tight fiscal policy, cutting government debt levels. Compared to other countries in the region it has relatively low levels of foreign currency denominated debt and its current account deficit has been fully balanced by inflows of foreign direct investment which do not generate costs in debt servicing. The country’s economic record points to a possibility of Bulgaria joining the European exchange rate mechanism by 2009 and the euro in 2012, although meeting these deadlines would depend on managing to get its inflation rate down to closer to the EU’s target of within 1.5% of the average of the best performers of the EU27.

The EU’s newest member states are struggling with significant economic challenges. But many of the difficulties they face - like high inflation and large deficits - are common to all fast-growing countries of the Union. Even though eurozone membership is still several years away for most of them, they may be in better economic condition than some long-standing EU members, despite the alarm bells being rung by ratings services.

The public finances of some eastern European countries are giving cause for concern - both to the European Commission and to rating agencies. Simon Taylor takes stock.

• Primary Source