Thursday, October 9, 2008

Emerging Europe seen key crisis flashpoint

By Sebastian Tong and Carolyn Cohn
LONDON, Oct 8 (Reuters) - As the global financial crisis sends many emerging markets into tailspin, Eastern European economies are seen as most at risk from unstable exchange rates and a resulting foreign debt exposure of indebted corporates.

Latvia and Ukraine are seeing their currencies strain against targeted trading bands and debt insurance costs soar.

And with Iceland's shocking plunge into a financial crisis this week intensifying market worries over other emerging market flashpoints, there has been widespread scrutiny of countries running current account deficits with large foreign debt.

South Korea and Pakistan are feeling the heat in Asia as their external deficits flag concern. And Latin America, even though regional bourses were down more than 10 percent on Wednesday, has much healthier external national accounts.

But Central and Eastern Europe sticks out and the International Monetary Fund on Wednesday forecast the collective current account deficit for the region to rise to a whopping 7.2 percent of total gross domestic product from 7.1 percent this year and more than twice the shortfall as recently as 2002.

"Eastern Europe is the most exposed region among emerging economies. These countries have large external financing needs and the global environment looks more challenging than ever," said Edward Parker, head of Emerging European sovereigns at Fitch Ratings.

Brown Brothers Harriman data showed Bulgarian and Estonian external debt at 101 percent of GDP, with Hungary's debt at 96 percent.

"Virtually all (Eastern European economies) are running current account deficits...many have very high external debt/GDP ratios. In this region, the International Monetary Fund may end up playing a significant role, particularly with the smaller Baltic countries," it said.

A Credit Suisse table of countries showing most macroeconomic risk leads with Iceland, following by Bulgaria, Estonia, Lithuania, Ukraine, Latvia, Romania and Hungary. South Africa is 10th, below the United Kingdom.

The table of risk rankings includes among its criteria the estimated balance of payments for 2009, and ratios of private sector credit and net external debt to GDP.

"If in the event that counterparty risk should spread from corporates to sovereigns, the countries among the most at risk, in our view, would be Bulgaria, Estonia, Lithuania, Ukraine, Latvia, Romania, Hungary and South Africa," Credit Suisse said in a client note, adding that Russia was at the lower end of the risk spectrum.

Macroeconomic instability is being further exacerbated by the massive unwinding of high-yielding positions by investors seeking the relative safety of the U.S. dollar and Japanese yen.

Emerging currencies have skidded to multi-year lows, worsening the foreign debt burden for some countries but only a handful of central banks in the world have the firepower to defend their currencies.

The cost of market intervention is already eroding the reserves of Russia, which saw its over $550 billion gold and foreign exchange reserves fall by about $25 billion in September alone. The Baltics -- already in recession -- are seen especially vulnerable to a sharp depreciation in their currencies which are fixed to the euro in currency board regimes.

"The Baltic states with pegged exchange rates are living on borrowed time," said Nigel Rendell, senior emerging markets strategist at RBC.

"With current account deficits of their magnitude and inflation rates of 10-20 percent, something has to give."

The Latvian lat has been trading near the floor of its trading band against the euro , hitting 0.7094 on Wednesday compared with a floor of 0.7098.

Ukraine saw its hryvnia currency fall to a record low on Wednesday past the lower end of its trading band, prompting the central bank to intervene a day after widened the band to accommodate increased volatility.

Mounting concerns over its highly leveraged banking sector have sent five-year credit default swaps (CDS) for Ukraine above 900 basis points.

"Ukrainian CDS have decoupled from everything else at this rating level. Economic fundamentalsCommerzbank. are horrible in Ukraine and are likely to be so until the second half of 2009," said Luis Costa, emerging debt strategist at

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