Eastern Europe's exchange rate regimes and currency volatility are a root cause of the region's liquidity and credit crisis. But with all of Eastern Europe legally bound to join the euro zone, there is a path out of the crisis—albeit one that depends heavily on politics.
A significant proportion of bank lending to businesses and households in Eastern Europe is denominated in foreign currency. Since Sept. 1, 2008, the Polish zloty, the Hungarian forint, and the Romanian leu are off 40%, 28%, and 22%, respectively, against the euro. That means if you are a Polish homeowner with a euro-denominated mortgage, your payments are 40% higher than they were six months ago. Businesses, too, are seeing their margins ground away by borrowing costs.
This adjustment implies a higher risk to lenders that borrowers won't be able to make repayment. As a result, lenders are curtailing lending, which compounds the effect on credit through increased borrowing costs. Eastern European central bank rates also are relatively higher than European Central Bank (ECB) rates—in some cases dramatically so. But cutting rates risks prompting currency depreciation, which would in turn raise borrowing costs—the exact opposite of a central bank's objective in cutting rates. This paradox leaves Eastern European central banks with fewer monetary policy tools at their disposal.
Giving Up Their Home Currency
It's a nasty situation, but there is a way out: Joining the euro zone, as all of the countries that have acceded to the EU since 2004 eventually are obliged to do, will eradicate currency risk. It will mean the ECB's interest rate policy will apply to Eastern Europe, as well. Given current interest rates, this implies a significant reduction in central bank interest rates in Eastern Europe.
Indeed, even before formal adoption of the euro, the accession process provides benefits. The first step toward joining the euro zone is entering the European Exchange Rate Mechanism (ERM-2), which typically occurs 30 months or more before actually adopting the common currency. When a country enters ERM-2, it does so at a rate agreed with the European Commission and the ECB. Once a country is in ERM-2, the ECB and the central bank of the applicant country intervene to ensure that the currency does not fluctuate more than 15% in either direction from that rate. This helps banks mitigate risk by putting a floor under (and a ceiling over) the currency, a stabilizing factor that enables borrowers to assess the impact of currency fluctuations on their loans better. This would facilitate lending.
In order finally to adopt the euro, each country must comply with the tough Maastricht criteria, which measure inflation, deficits and debt, long-term interest rates, and exchange rate volatility. The prospects for meeting these criteria vary by country, which means the actual timing of when a country adopts the euro—or joins ERM-2—also varies.
Political Will in a Down Market
What's more, a country's prospect for meeting these criteria is heavily shaped by domestic politics. As late as August 2008, there was little in the way of political will to make policy adjustments to meet the Maastricht criteria. It was simply not a priority for most governments in Eastern Europe. Indeed, over the past few years, Eastern European currencies tended to appreciate relative to the euro, reducing borrowing costs—thus fueling a credit boom and further deflating political will to join the euro zone.
The situation changed when Eastern European currencies began to depreciate steadily.
Governments detected the effect on companies and households and identified the exchange rate as critical—both to the well-being of their economies and to their own ability to survive politically. Stabilizing currencies took priority over wage hikes and public spending.
While the political shift is moving toward action to meet the Maastricht criteria, there are hiccups. One has been an effort to cajole the euro zone authorities into relaxing the criteria. Euro zone authorities have strongly signaled that this will not happen, in order to keep the pressure on Eastern European governments to take steps to meet the criteria. At the same time, the EU also has begun to provide emergency funds to Eastern Europe—thus far to Hungary, Latvia, and Romania. In each case, the conditions attached to these funds are explicitly structured to bring countries into compliance with the Maastricht criteria.
Joining the euro is not a magic bullet, but it will help mitigate vulnerabilities and restore liquidity. In this, the crisis is unique; it is a European crisis, not an emerging-market crisis.
There are still major risks in Eastern Europe. One in particular stems from the nature of the European banking sector. Western European banks dominate Eastern European markets, with such outfits as Unicredit (CRDI.MI) and Erste Bank (ERST.F) operating in several countries there. Yet should these firms seek significant government support, there is no clear division of responsibility as to which national government should provide what form of support. In this area, Europe's preexisting policy mechanisms could prove insufficient—and might require more aggressive coordination among governments.