You wouldn’t guess it at first glance. The four biggest economies to join the EU in 2004–the Czech Republic, Hungary, Poland and Slovakia–averaged a robust 5 percent GDP growth last year. The boom is, of course, fueled by record levels of foreign capital–up 19 percent to $57 billion, more than twice the amount flowing into the whole Middle East. What’s more, the capital is cheap, thanks to the “halo effect”; that is, the perception that these countries are inherently less risky because they are European. According to an IMF report due out this week, borrowing costs in Central Europe are a full percentage point less than one would expect given the economic, financial and political risks the countries pose. It seems that markets mistakenly perceive EU membership as providing some sort of implicit guarantee against sovereign risk, says Susan Schadler, deputy director of the European Department at the IMF.
You only have to look southward (think Greece and Italy) to realize that it doesn’t. Even as East Asia, Latin America, sub-Saharan Africa and Central Asia are improving their current account balances, Eastern Europe continues to consume much more than it produces, with average current-account balances of negative 5 percent of GDP. Meanwhile, government debt is out of control, with many countries racking up deficits two or three times what the EU condones. Over the long run, Eastern Europe’s heavy debts will result in higher interest rates on loans, or even a credit cutoff, which could trigger an economic meltdown à la Italy in the mid-1990s.
The worst offender so far is Hungary–last year the deficit reached a whopping 10.1 percent of GDP, the highest in Europe. Government debt has grown from about 60 to 70 percent of GDP since 2005. The problems came to a head in the fall, when a leaked tape revealed that Prime Minister Ferenc Gyurcsany had lied “morning, noon and night” about the state of the country’s finances to win a second term. The resulting scandal finally prompted the government to launch a “fiscal austerity package” aimed at bringing the deficit down to 3.2 percent by 2009.
The goal of the new plan is to move Hungary into the single currency. So far, Slovenia has been the only one of the new EU members to accomplish this. Poland, originally slated to join by 2009, now isn’t expected to do so until 2012; the Czech Republic looks likely to push back from mid-2009 to 2011. That means local currency fluctuations will continue to be a risk to foreign investors.
A new round of market liberalization could help offset that-but reform fatigue has catapulted a host of left-leaning leaders into power. Communist-style spending on bloated local government and inefficient health-care projects is on the rise; research-and-development spending is down. Poland has gone through six Finance ministers in two years. Slovakia’s new government is unraveling the flat taxes and looser labor laws that made it so popular with foreign investors. “I think every one of these countries is going to have some sort of fiscal crisis in the next 10 years,” says Simeon Djankov, chief economist at the World Bank. Given the amount of money now swirling around Eastern Europe, it’s a fall from grace that’s bound to touch us all.
