Eastern Europe: the sick man of the developing world

Emerging markets have bounced back sharply as global risk appetite has recovered and eastern Europe has been no exception. The MSCI regional index has almost doubled from its low earlier this year. The long-term outlook remains compelling. Eastern Europe has a long way to go to catch up with western European wealth levels, while in Russia there are still just 40 supermarkets per one million people, compared to 180 in the West, as Elena Shaftan of the Jupiter Emerging Europe fund points out. But for now, the region faces an uphill struggle.

How it got into trouble

Eastern Europe was highly exposed to a eurozone downturn, and unlike Asia or Latin America, it borrowed heavily from abroad to fuel growth. Banking systems depended on wholesale funding and money from western European banks, which own many of their eastern European counterparts. Worse, a large chunk of loans are denominated in foreign currencies. So when local currencies tanked against western ones, defaults jumped as borrowers paying off debts in local currency saw their bills rocket. Regional banks are still "not out of the woods", says Erik Berglof of the European Bank for Reconstruction and Development. The bank has just asked for a 50% capital increase from member states to ease the impact of the crisis.

Credit will stay tight

Banks are worried that bad loans, sharply up all over the region, have yet to peak. That fear looks justified, given that unemployment will keep climbing and currencies are likely to fall back again as global risk appetite wanes, says Capital Economics. So the damaged banking system is set to keep credit conditions tight, hampering growth. Interest rates on consumer loans may have fallen recently, but they are still higher than this time last year, although benchmark interest rates have been slashed. Throw in the likelihood of a fragile recovery in western Europe and fiscal policy-tightening across the region often at the behest of the International Monetary Fund (IMF) and it's hard to see growth exceeding 1% next year, a far cry from forecasts for Asia as well as Latin America.

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Trouble in the Baltic states?

Meanwhile, the Baltic states are a potential flashpoint. With their currencies pegged to the euro, they can only restore competitiveness through falls in wages and prices, a so-called 'internal devaluation'. This has resulted in falling domestic demand and growth: in Estonia GDP is set to slide by 14% this year. This sort of devaluation is "painfully slow and very damaging to democratic solidarity", says Ambrose Evans-Pritchard in The Daily Telegraph. For example, in Latvia, which is being propped up by the IMF, the prime minister has had trouble pushing through austerity measures amid resistance from his coalition's "powerful party chiefs", says The Economist.

Further conflict with the IMF could result in Latvia's currency peg with the euro being abandoned, which other Baltic states would be likely to follow. That would trigger "a renewed bout of financial market-selling" in the region and send defaults on foreign-currency loans soaring, says Capital Economics. In short, eastern Europe is the developing world's sick man. Given all the potential pitfalls ahead, it's too soon to join the investors rushing back into the region.