February 14, 2008
ORTHODOX economics suggests that big current-account deficits, high inflation and fixed exchange rates are a lethal combination. But after a scary year, the east European countries that looked most likely to tumble seem to be heading for a softish landing. In Estonia growth has dropped from double digits to a mere 4.5%. In Latvia retail sales, rising by as much as 25% last summer, are growing by only 10%. The foreign banks that own most of the financial system in both countries have tightened lending. Even if some housing borrowers default, the pain is manageable.
The European Commission continues to fret, particularly about Latvia. It gave warning this week of a “hard landing” if the government does not tighten fiscal policy again. But Neil Shearing of Capital Economics in London says that only the collapse of a big bank in the Baltics could prompt a crisis that would break the local currencies’ peg to the euro.
Most other countries in the region have floating exchange rates. Many have raised interest rates recently—by a full percentage point in Romania—to head off inflation. Price rises endanger both competitiveness and their chances of adopting the euro. Hungary has the lowest growth and the highest inflation in central Europe; its currency, the forint, has been sliding. “If America has stagflation-lite, Hungary has stagflation-heavy,” says Mr Shearing.
Markets are proving remarkably tolerant of the east Europeans’ diminished zeal for reform after their rush to membership of the European Union. With labour costs still a small fraction of the euro area’s, the prospects for growth look good on the surface. But worries about longer-term competitiveness are growing. Employment rates are still low—at 50%, Poland’s is the second-lowest of any economy in the EU. But like its predecessor, the centre-right government in Warsaw shows little appetite for painful structural reforms.
The most solid prospect in the region now is Slovakia, thanks to the rigorous (and unpopular) policies of the previous government. Slovakia hopes to adopt the euro in 2009; the EU is scrutinising the figures now and will give its verdict in April. Soaring foreign investment and strong growth have stoked tax revenues, cutting the budget deficit. Slovakia’s problem is inflation. It should fall to 2.7% this year, which is tiny by other countries’ standards, and comfortably under the EU’s target for euro membership—but it reflects artificial (and unsustainable) one-off controls on energy prices.
Countries that have pegged their currencies to the euro, or are shadowing it, lose their independence in monetary policy without gaining all the benefits. Willem Buiter, a former chief economist at the European Bank for Reconstruction and Development, thinks some would do better to adopt the euro unilaterally. The European Central Bank and European Commission would hate this, but they could not stop it, he argues.
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