Monday, 11 April 2011

Capital Returns to Central-Eastern Europe?

One consequence of the global financial crisis was the flow of capital from the peripheries of the world economy back to its centre. However, there is some evidence that this is beginning to change. How may this impact upon the CEE economies?

The economic crisis most harshly afflicted those countries in CEE, that were most dependent upon an inflow of foreign capital. For example, in the Baltic States, there had been a huge rise in foreign borrowing to support the domestic private sector and consumption following EU entry. This helped to stimulate imports, facilitated by fixed and appreciating exchange rates and by the liberalisation of lending. The drying up of liquidity from 2008 therefore caused these ‘financialised’ economies to fall into a sharp downward spiral. Incredibly, in 2009, GDP fell by over 13% in Estonia and by over 18% in Latvia and Lithuania. Furthermore, unemployment rocketed in the Baltic States - increasing by 12% in just one year in Latvia. This outflow of capital also caused large depreciations in countries with floating currencies. Therefore, between September 2008 and September 2009 the Hungarian Forint lost 20% of its value, while the Polish Zloty devalued by 30%. This situation is especially dangerous in CEE as a large proportion of private loans are taken out in foreign currencies.

Over the past couple of weeks there have been some signs that funds are begining to return to emerging markets. The leading destinations for this capital have been Russia, China and S. Korea. Talking to people who understand these moves, then what seems to be occurring is that money is being borrowed in countries where interest rates are close to zero (e.g. the USA, Britain and Japan) and being invested in countries where these are higher. With little prospect for growth in these centres of the world economy - capital is moving to areas where there is greater growth and interest rates and/or commodity prices are higher.

While in 2009 capital inflows fell by 45% in 8 CEE countries - the Czech Republic, Croatia, Hungary, Poland, Romania, Slovakia, Ukraine and Turkey – they rose by 9% in 2010.The most successful of these economies has been the Czech Republic, whose manufacturing export-orientated industries have benefited from the strong recovery in the German economy. In Hungary inward capital flows have increased, as they have in Poland - particularly in government bonds. It also seems that the uncertainty in weaker eurozone economies has encouraged investors to locate money in CEE.

At a time when private investment is supressed it would seem that this is a welcome development for CEE. Yet, despite the increase in capital inflows to CEE this has not reversed the massive decline in Foreign Direct Investment (FDI) that followed the global financial crisis. FDI fell in Poland from €16.7bn in 2007 to €8.4bn in 2009 and then down to €5.5bn in 2010. The vast majority of the current inflows to CEE are portfolio investments and not direct 'green-field' investments in the region's economy.

FDI in CEE has also often been bound up with privatisations and the domestic economies have faced problems once these sales have dried up. This was the case in Hungary in 1998 when it experienced its first financial crisis after FDI slumped once its major privatisation drive had been completed. Poland faced a budget crisis in 2001, as FDI - mainly connected to privatisations - slumped by 30%. In fact studies have shown that during the transition in CEE there was no positive correlation between FDI and fixed capital investment or economic growth. We may expect to see a formal rise in FDI in Poland over the coming year as the the Polish government attempts to carry through CEE's current largest wave of privatisations (this in fact may be the last of its kind as there is very little left to sell in CEE).

The other problem with such an inflow of capital is that it can leave as quickly as it arrives. Once investment and growth begin to pick up again in the USA and beyond then this capital will quickly shift back to the economic centres. The danger exists for the developing markets that they experience a bubble of 'hot money' (as occurred in CEE prior to 2008), which is then followed by a sharp economic downturn as this flow of capital is reversed. Countries are able to offset this somewhat - as Brazil has done through adding capital controls - but the room for such manouver is limited in CEE, especially for those countries belonging to the eurozone or whose currencies are tied to the euro.

Foreign investors are using their leverage to impose policy measures upon the CEE countries that are not necessarily beneficial to their economies. International investors have been quick to scorn the Hungarian and Polish governments for their sensible (and in Poland's case extremely moderate) pension reforms. Pressure is consistently being applied on countries such as Poland to 'bring its public finances into order' and to comply with policies favoured by international investors and financial institutions.

Investment is good for CEE and needed to help boost growth and development in the region. However, the experience of the past few years has shown that there is world of difference between investment and speculation.

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