Back in 1997 the young transforming economies of Central Europe were buffeted by the waves of the faraway Asian financial crisis. Today many analysts are warning that not only is Central Europe much more vulnerable to any future emerging-market financial crisis but that it could even be the trigger for such a crisis.
In recent months the political mood has turned sour right across Central Europe: Budapest has been convulsed by riots sparked by the prime minister's admission that he lied over the critical state of the public finances. In Warsaw the right-wing populist coalition has collapsed and investors are frightened by plans to limit central bank independence. In both countries the post-communist political consensus seems to have all but broken down.
The former Czechoslovakia is a more settled picture, though still alarming in contrasting ways. The Czech Republic has been without a proper government for more than four months, graphically symbolizing the long-term political deadlock that has blocked fundamental reform. In Slovakia, this summer's elections produced a government all too quickly, one viewed as the nightmare scenario by investors: a left-populist coalition pledging to reverse liberal reforms for which there had been little popular mandate in the first place.
This political turbulence is encouraging populism and delaying tough economic decisions. Fiscal deficits are ballooning as weak governments give up trying to slash public spending. Inflation is also on the rise, pushed by unsustainable wage rises and runaway consumer spending.
Rising inflation and fiscal deficits are forcing governments to abandon their timetables for adopting the euro, except for Slovakia where doubts remain over whether its 2009 target is still achievable. Hungary once planned to adopt the euro in 2006 but many analysts now predict 2014 could be the earliest date, later even than Bulgaria, which is not even a European Union member yet.
While long-neglected political and economic problems have piled up, Central Europe's vulnerability to a sudden loss of investor confidence has increased since 1997.
The foreign exposure of Central European countries has deepened, with the region's debt market soaring from 4 billion euros in 1999 to 35 billion euros today, according to the ING bank. The kind of investor has also changed, with huge volumes of "hot," footloose, leveraged money, particularly hedge funds, pouring into a region seen as a no-brainer investment play because of its yield convergence with the rest of the EU.
As the international financial environment turns less benign because of rising interest rates and a potential slowdown in the United States, some analysts predict that Central Europe's woes — or a future external event — could trigger a stampede of hot money. This would affect every country regardless of its individual circumstances because of the way the region is viewed a whole.
Yet, Central Europe seems to have emerged virtually unscathed from its autumn of discontent. The Hungarian forint — the most vulnerable regional currency — has now recovered virtually all its losses, while bond yields are up only 30 basis points and shares are down just 2 percent.
One reason for the calm is that investors tuned out most of the political noise. They were delighted that at last a Hungarian premier had acknowledged the need for radical fiscal reform and were only worried that he would fall before he could launch it. Polish politics is regarded as one long mess and early elections could only bring about an improvement on the current government. In Slovakia, investors returned once they realized that the government's bark was worse than its bite. As for the Czech Republic, the election deadlock was seen as a no-change scenario because there has not been a strong reforming government since the early 1990s.
Secondly, economic fundamentals remain strong when compared to the Asian economies of the late 1990s and floating exchange rates give the Central European currencies much more of a cushion.
Hungary remains the exception because of its anemic growth, worrying budget and current-account deficits and the amount of consumer borrowing in foreign currencies. However, even before last month's riots many foreign investors had already scaled back their exposure there and gone short on the forint because of their concerns over the country's fiscal position.
Central Europe escaped this round of serious turbulence but this is not to say it will next time, particularly if populist politics block reform just when its currencies have to spend two years locked into the ERM II exchange-rate band preparing for euro adoption.
Central Europe's problems are deep-seated but long-term. In particular, state pension systems face crisis in the long term in the Czech Republic and Hungary, as the European Commission reported recently. Investors may not panic now but they will start to lose confidence if there are no plans at least to reform these costly state programs in the short to medium run.