United they fall: post-communist states pull EU into the red

United they fall: post-communist states pull EU into the red

There is a new divide in Europe with eastern nations emerging as poor relations
David Gow in Brussels
The Guardian, Saturday 21 February 2009

The Berlin Wall was torn down 20 years ago this autumn, heralding the reunification of Germany and an end to the post-war division of Europe.

That historic process culminated, 15 years later, with the entry of eight post-communist states to the EU.

But, as the EU's "big four" leaders Gordon Brown, Nicolas Sarkozy, Angela Merkel and Silvio Berlusconi gather in Berlin this weekend to prepare for the April 2 G20 summit in London, a new divide in Europe is uppermost in their minds: between east and west, and between eurozone and non-eurozone.

The meeting has ostensibly been called to discuss how to resume bank lending to the real economy by resolving institutions' exposures to trillions of euros of toxic assets, and to avert rising protectionism.

But the four will devote much of their time on how to rescue central and eastern Europe and, beyond the Balkans, Russia and Ukraine.

This week, with some respite in the past two days, the euro has plunged on fears that deepening recession, rising unemployment and social unrest, currencies in free fall, stock markets in meltdown and budget deficits spiralling out of control in the region will force governments to default on their debts.

Exposed

European stocks fell to a six-year low yesterday as the flight into the dollar and US and German government bonds intensified and Russia, where unemployment rose by more than half a million last month, reported a 2.4% month-on-month contraction. In Latvia, where social and political tensions led to a riot last month, the four-party ruling coalition collapsed. The fear is that the crisis in central and eastern Europe will spill over to the west, prolonging and deepening the recession and bringing down several banks heavily exposed to it.

"Argentina on the Danube?" was the title of an Economist leading article yesterday that looked back to the Latin American currency crisis of 2001 and that of east Asia in 1997.

"Looking ahead, the emergence of a new economic and political divide within Europe has become a distinct possibility," wrote Zsolt Darvas and Jean Pisani-Ferry of Brussels thinktank Bruegel in December last year.

This week, as the OECD spoke of a record 1.5% contraction in its area in the last three months of 2008 and every indicator pointed to a worse than expected shrinkage of the EU economy, two rating agencies (Moody's and S&P) added to the darkening gloom by voicing concerns over default risks and downgrading several west European banks that have lent €1,500bn (£1,300bn) to the region.

Yesterday, in a sober but highly uncertain assessment, the World Bank said six countries - the Czech Republic, Poland, Bulgaria, Romania, Slovakia and Slovenia - would grow by between zero and 2%. The governments of several of those countries are less sanguine.

The bank, giving a more optimistic outlook than its sister body, the IMF, said Hungary would contract by 3% despite its $20bn co-ordinated bail-out. The three Baltic countries - Estonia, Latvia and Lithuania - would shrink by between 5 and 7%. Latvia, also IMF-rescued, has forecast a 12% contraction.

It was, of course, never meant to be like this. Indeed, two senior EU commissioners - Joaquín Almunia (economic and monetary affairs) and Olli Rehn (enlargement) - issued a voluminous report extolling the political, economic and social benefits brought for the whole EU and its now 500 million citizens by its 12 new members. (Bulgaria and Romania also joined in 2007; Cyprus and Malta in 2004). Their message was clear: enlargement to east and central Europe has brought consolidated democracy, stability and security to Europe; it has made the EU bigger, stronger, more dynamic and richer, culturally and economically.

It has made the EU the world's biggest economic bloc, accounting for 22.2% of GDP and more than 17% of trade, for 18% of imports and 17% of exports and a half of global foreign direct investment.

But, with Poland's zloty, for example, losing between a quarter and a third of its value against the euro in less than a year, is this four-year "paradise regained" turning into "the road to hell?" Almunía, a Spanish socialist, was clear: No, but only if Europe avoids turning in on and tearing itself apart with intra-European protectionism.

"Divided we will achieve nothing," he told reporters.

Panic

Even with yesterday's further volatility, nay panic, on stock and forex markets, there are signs that the threat of a renewed division in Europe is enforcing a more co-ordinated, pro-active response. Almunía enumerated recent examples of increased aid for the afflicted countries: a further €7bn from structural-cohesion funds; European Investment Bank loans of €11.5bn, up €3.3bn on 2008; and an EU balance of payments facility raised from €12bn to €25bn, of which €9.3bn has been given to Hungary and Latvia, two of the most vulnerable members.

Citing increased lending by individual governments, he demanded more from them and international bodies and urged private sector investors to step up to the plate.

West European banks - in Austria above all, Sweden, notably in the Baltics, Italy, the Netherlands, France, Germany and Belgium - have exacerbated the crisis through rash lending policies in central and eastern Europe. Consumers living beyond their means have, for example, taken out huge mortgages in euros or Swiss francs or dollars they are unable to service as they become jobless or their pay is slashed.

Austrian banks have lent €250bn and are sitting on €150bn of losses at least. Anything up to 70% of an individual country's GDP is out on loan. But, with more than 90% of banks in the Baltics, Czech Republic and Slovakia in foreign hands, the west European banks are being driven to recapitalise their subsidiaries - and downsizing them, too.

Daniel Gros, head of the centre for European Policy Studies (CEPS) in Brussels, thinks the pessimism is exaggerated even while admitting that the crisis is more deep-rooted and spread more widely than in East Asia eight years ago. "The Asian banks held out and lost nothing if they were patient," he said.

"They adopted tough adjustment policies and the global boom elsewhere helped too.

"Now the banks will lose a bit."

The central player, as ever in Europe, is Germany and Peer Steinbrück, the finance minister, and his boss, Merkel, have indicated a U-turn before Sunday's big four meeting: it is now willing to ignore the "no bail-out" clause in the Maastricht treaty and lend to eurozone countries in severe difficulties. Gros and others think this will spill over in its effects to non-euro countries such as Poland which are clamouring to join, and are held at bay so far by the European Central Bank as they are years off meeting the tight criteria for entry.

"Outright default of any EU country is not on the cards," Gros told the Guardian. "And, anyway, these countries are economic midgets."

The ECB itself has proved resistant, like Germany, to seeing collective eurobonds issued or to accepting temporary currency swaps. But the 16-strong zone's central bank already agreed late last year to repurchase agreements for both Hungary and Poland. Gros says emergency lending packages from the ECB and IMF should be on the cards: Bruegel says the ECB should accept non-euro denominated government bonds as eligible securities.

One outcome is certain. The four-year "stag party" for central and east Europeans is over. The EC calculates that income per head among them rose from 40% of the EU-15 in 1999 to 52% in 2008 but this was aided by unfunded consumption and spurred by unchecked credit growth and excessive pay increases resulting in overheating and huge external imbalances.

The EU, like the IMF and ECB, is now insisting that government spending be slashed and wages cut as the price for rescue. Gros says: "If you have a 15% current account deficit like Estonia and want to get back to balance you have to cut consumption by a corresponding 15% of GDP and they're already doing it." If it's tough in the west, it's going to be a nightmare in the east.

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