Tougher Times Blowing In On Europe's Eastern Frontier

[Crvena zvezda]

Tougher Times Blowing In On Europe's Eastern Frontier

By Christopher Emsden

DOW JONES NEWSWIRES

April 16, 2008

The steam may be running out of the investment case for debt-driven economies on Europe's eastern fringe as global credit winds shift and highlight differences in emerging markets, says a report Wednesday from ratings agency Standard & Poor's Corp.

Growth will slow for 27 of the 42 countries in question from 2007 to 2009 with Hungary, Turkey, Ukraine and Serbia looking particularly vulnerable as their governments "are poorly placed...to trim their sails if the winds shift," said John B. Chambers, chairman of the rating agency's Sovereign Ratings Committee.

"Many particular credit stories are nuanced," he added.

The report comes amid a raft of rating agency actions on Europe's frontier. Outlooks have been downgraded in the past two months for Turkey, Romania and Bulgaria as well as more exotic names such as Montenegro and Kazakhstan. The subjects share large and growing current account deficits that need financing, the prospect of tougher terms for runaway credit growth offered by international banks, and robust inflationary pressure.

"Pockets of weakness within emerging markets seem to be multiplying," said RBC Capital Markets analysts Nick Chamie and Paul Biszko.

They expect emerging markets to stop outperforming their G-7 peers as the credit crunch that began in the U.S. spills over in the rest of the world.

Signs of growing urgency are evident. Romanian banks, no longer able easily to tap international markets for funds to maintain credit growth of 67% a year - the highest in the European Union - are competing for local deposits by offering double-digit interest rates as well as one-off cash bonuses or prizes.

More deposits will dampen domestic spending, the main driver of Romania's growth. Moreover, banks will probably find their non-performing loan portfolio is higher than currently assumed, further reducing credit flows, according to a senior industry executive in Bucharest.

That's already happening in the once-fashionable "frontier" market of Kazakhstan, according to Unicredit economist Vladimir Osakovsky. Loan growth ground down to zero while bad loans jumped in the first quarter and that will probably knock real economic growth down to 1.4% this year from more than 8% in 2007, he said.

Economic news from the region are eyebrow-raising. Bulgaria, which has a current account deficit of 21% of GDP, posted a 14.2% inflation rate in March, the highest in a decade. Inflation in Ukraine rose to 26.2%. In Turkey, builders have to offer cheap loans in order to sell completed properties, or offer rebates of up to 30%.

Political strain and shaky governments in Hungary, Turkey, Romania, Serbia, Ukraine and Macedonia don't help their case, credit analysts say.

Sovereign issuers are still able to go to market, as witnessed by Georgia's sale of $500 million five-year bond, a first for the embattled former Soviet republic. While its current account deficit is 20% of GDP and inflation has risen to 12.3%, it has relatively low public-sector and overall external debt, said Bear Stearns analyst Tim Ash.

Montenegro, which became an independent country in 2006 acquired its first rating this month as Moody's Investors Services Corp gave it a Ba2 core, warning of rapidly growing debt but also noting its unilateral adopting of the euro and plans to join the European Union are positive anchors.

But just days later, Standard & Poor's Corp revised its outlook to Montenegro to negative. Analyst Sladana Tepic cited "rising macroeconomic imbalances," noting that the country's current account deficit hit a gigantic 44% of GDP last year and that total domestic credit will likely reach 120% of GDP this year, up from 20% in 2005.

Vulnerable countries can of course reduce borrowing, pull back on consumption and focus on boosting exports, although that's a bitter pill for politicians.

Some also have attractive supply-side prospects - Georgia's hydroelectric capacity - or demand-side needs such as Turkey's power shortage that could attract foreign investors.

But the systematic deleveraging occurring in the banking system of the wealthier world suggests investors will be pickier. Tightening global liquidity suggests portfolio inflows into emerging markets this year could decline by more than half, said Chamie and Biszko of RBC.

Indeed, Turkey's Treasury noted Wednesday that net foreign direct investment has declined 80% in the first two months of the year.

Better access to external finance for countries and corporations could require policy makers to offer better returns, either by pushing through structural reforms to boost profitability for equity investors, or by raising real yields for fixed-income funds, either by raising interest rates or clamping down on inflation.

Reflecting the "nuances" Standard & Poor's Corp noted among emerging markets, policy response has been varied: Kazakhstan is blocking grain exports while Ukraine, where the central bank governor has warned of the risk of stagflation and has vocally criticized the government's wage and pension hikes, is vowing to avoid the temptation of tapping international capital markets.

But those countries all have the temporary safety cushion of sky-high prices for the commodities they export. Russia's hefty oil surpluses largely inoculate it from short-term volatility and large Russian corporates aren't feeling any pinch.

Most European countries aren't raw material exporters and will have to be more orthodox.

Hungary's central bank has already moved into hawkish mode, hiking interest rates aggressively on March 31 while explicitly acknowledging that risk premia are rising.

Turkey's central bank may serve as a bellwether this week. Its monetary policy committee meets Thursday amid market expectations it will keep interest rates at 15.25%.

"Given the adverse turn in credit winds, that's too passive," said Lehman Brothers economist Tolga Ediz.

Turkey's central bank should "get ahead of speculative attack," and hike by 100 basis points, he said. "Failure to get ahead of the curve may necessitate more drastic action later."