East Europe Risks New Funding Shock on Tapering, IMF Says

Eastern Europe’s vulnerability to sharp withdrawals of foreign capital has been heightened as the U.S. Federal Reserve scales back stimulus and the standoff over Ukraine escalates, the International Monetary Fund said.

Developing nations in Europe are more exposed than other emerging markets to external funding risks, the IMF said in a report published today. Gross external liabilities, including foreign direct investment, cross-border lending and portfolio investments, were at about 90 percent of the region’s gross domestic product at the end of 2012, about 20 percentage points higher than at end-2008, the IMF said.

The region was the hardest hit in the world after the 2008 demise of Lehman Brothers Holding Inc. A sudden halt of foreign capital inflows and financing between western European companies and banks and their local units triggered recessions and pushed lenders near collapse. Managing the crisis since then has prompted governments to pile on more debt, the IMF said.

“It’s important to bear in mind that the risks that the region is facing are significant,” Aasim Husain, deputy director of the IMF’s European department who supervised the report, said at a news conference in London yesterday. “It’s difficult to say if they are more significant or less significant than in other periods in history but clearly important risks loom ahead.”

‘Unusual Constellation’

While growth is picking up in the region, helped by the recovery in the euro area, an “unusual constellation” of external funding risks “clouds the outlook,” according to the report. GDP will probably grow 2.3 percent this year in eastern Europe, excluding Turkey and Russia, the region’s largest economies, compared with 1.2 percent in 2013, the IMF predicts.

In addition to “an orderly” reduction in funding by western European banks to their eastern units, portfolio flows to eastern Europe, excluding Russia and Turkey, turned negative in the third quarter of last year for the first time since 2009, triggered by the first signal by the Fed in May that it was considering a pullback in asset purchases, Husain said.

While flows stabilized in the last quarter, they may have dipped again in the first three months of 2014, Husain said.

“Pressures may re-emerge if risks stemming from potential escalation of geopolitical tensions in the region, further bouts of financial volatility along the path toward monetary policy normalization in advanced economies, and the possibility of protracted weak growth in the euro area were to materialize,” the IMF said in the report.

Ruble, Peso

The Russian ruble has lost 8.4 percent this year against the dollar, the second-most after the Argentine peso among 24 emerging market currencies tracked by Bloomberg.

U.S. and European Union sanctions against Russia after President Vladimir Putin’s annexation of Crimea from Ukraine last month triggered a selloff of ruble assets. The Hungarian forint and Polish zloty are also among the 10 worst-performing emerging-market currencies this year.

The susceptibility of eastern Europe to funding shocks derives from “relatively high” stocks of external debt, large refinancing needs and foreign-currency exposures, the IMF said in the report.

This vulnerability is deepened by other factors, such as increased foreign investor participation in local bond markets, which poses the threat of outflows if developed economies begin to offer higher yields after a tightening of monetary policy. The increased role of foreign institutional investors also adds to the risks, the IMF said.

Eastern European nations rely on a small number of creditors, “making portfolio flows sensitive to allocation decisions of a few fund managers,” according to the report.

To mitigate risk of external shocks, authorities may consider greater exchange-rate flexibility and higher policy rates to fend off pressure on currencies, the IMF said.

Central banks may also provide liquidity support in domestic or foreign-currency markets through reduction of reserve requirements and similar measures, according to the report.

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