Emerging Europe and South Africa: How Vulnerable Are They?

The more difficult external environment seen in 2001 and the weakening of global growth prospects in 2002 in the aftermath of the terrorist attacks in the US raise questions about the external vulnerability of the countries in emerging Europe. The recent literature on emerging market crises suggests that the authorities’ response to a rapidly changing policy environment is key in determining a country’s ability to cope with adverse shocks. The aftermath of the Asian financial crises and the subsequent episodes in Russia (1998), Brazil (1999) and, more recently, Argentina and Turkey (2000-01) have led to an emerging consensus on the sorts of policies which can help countries prevent or mitigate the effects of financial crises. We look briefly at the key elements of this consensus and ask how each of the countries in our region measures up against this “collective wisdom.”

In one form or other many of the following factors have been present in the recent emerging market crises: vulnerable exchange rate regimes which contributed to unsustainable current account deficits; weak domestic banking systems; poor fiscal performance, including poor debt management; and policy mistakes which aggravated the crisis once it started. The vulnerabilities associated with pegged regimes are well-known: the tendency by market players to underestimate currency risk and avoid hedging; the loss of competitiveness that may lead to a deterioration of the current account; the fact that there is no graceful way to exit such a system other than through floating in the midst of a crisis. Indeed, defending the currency through FX intervention and high interest rates, are both very costly when the country has a weak banking system. These vulnerabilities can be heightened when the country is going through massive fiscal adjustment and implementing long-delayed structural reforms (Russia in 1998, Turkey more recently).

These considerations have resulted in a body of policy recommendations that include: a reassessment of the virtues of exchange rate flexibility (or, absent this, the desirability of credibly hard pegs, as in a currency board); the need to build a significant cushion of liquid reserves, to act as a line of defense against speculative attacks and shocks; the need to improve banks’ lending standards and to strengthen the prudential environment; to encourage early fiscal adjustment to reduce the need for access to debt markets and to reduce currency exposure. The table in the next page presents a list of forecasts for five macroeconomic indicators typically used to monitor a country’s vulnerability to external shocks. We examine these in turn.

Current account. The Czech Republic, Hungary and Poland are all running current account deficits in 2001, ranging over 4-6% of GDP. None of these, however, is seen as posing any serious threats to external sustainability. In Poland and Hungary 75% of the deficit is expected to be covered by FDI and the rest is largely covered by other non-debt capital inflows. In the Czech Republic FDI more than covers the current account deficit and the country is thus building up reserves. As future members of the EU all three countries are projected to continue to receive large FDI inflows over the medium-term and this is expected to boost reserves. Of the three other countries Russia has by far the largest current account surplus, reflecting recent large terms of trade gains and imports still below 1997 levels. While on a downward trend, the latest IMF medium-term projections envisage a current account surplus through 2006. Turkey is expected to show a small surplus this year, reflecting mainly a sharp contraction of imports associated with a 7% GNP drop.

External debt. The levels of external indebtedness are manageable in all countries except Turkey, where the debt-to-exports ratio has been rapidly on the rise, reflecting major lending by the international financial institutions. Reflecting investor concerns about the debt carrying capacity of the government, debt prices in the secondary market have fallen by 20% in the past year and a recovery in 2002 seems to be predicated on the infusion of yet more multilateral debt. Russia’s debt service payments peak in 2003 but, by running a budget surplus this year and actually targeting a surplus next year, the government is making provisions to meet these payments without recourse to exceptional financing. Poland’s debt is relatively high, but carries low interest and much of it is long-term, reflecting favorable terms received at the time of its last Paris Club rescheduling. Short-term external debt is a potential problem in South Africa and Turkey, although in the latter case a more serious one given the sharply negative level of net reserves.

Vulnerability to external shocks

Exchange rate. All countries other than Hungary have floating rate regimes (with varying degrees of intervention) and Hungary allows the forint to fluctuate within a wide band. Russia and Turkey abandoned pegged regimes in the aftermath of major currency crises that had costly consequences, including sharp rises in the public debt, a loss of output and falls in real wages. While the real exchange rate has appreciated in Poland and Hungary (and to a much lesser extent in the Czech Republic), gains in productivity have preserved export competitiveness and nowhere (including South Africa) is the level of the exchange rate today seen to pose serious risks for the current account.

Budget balance. Although the Czech Republic, Hungary and Poland all are running budget deficits (and in Poland at roughly twice the level of 2000), the public finances are largely under control. In Poland and Hungary the authorities are dealing with debt management issues (ability of the domestic market to absorb larger levels of debt in Poland; currency composition in Hungary), but this is being done against the background of a sustainable fiscal position. Russia is running large budget surpluses and the domestic debt is equivalent to 7% of GDP. Turkey’s public finances – a perennial source of inflationary pressures – are under great stress; the government is having to run large primary surpluses to make room for roughly 22% of GDP of annual interest payments on the public debt. Indeed, interest payments are taking up close to 90% of total budget revenues. With a contracting economy, revenue targets are under pressure as well, significantly worsening the fiscal outlook.

Conclusion. Russia has the strongest macroeconomic fundamentals in the region, having built up large cushions in the budget and in international reserves. While the budget and the current account remain sensitive to energy price movements, the economy is growing and revenue collection has improved in a major way. Poland, Hungary, and the Czech Republic are vulnerable to a weakening of economic activity in Europe, their main export market. But this is offset by growing FDI inflows which are less dependant on the cycle and respond more to long-term incentives, such as much lower labor costs and future EU entry. South Africa is vulnerable to drops in commodity prices. The most vulnerable economy in the region is Turkey, whose only lifeline in 2002 seems to be (yet another) package of international support aimed at preventing financial collapse. Turkey has the highest level of external debt, the weakest reserve position, the largest budget deficit, and the only contracting economy in the region. Its banking system is in deep crisis, notwithstanding efforts by the authorities to restructure the state bank sector.