Baltic tigers

Interesting Times in Europe's Other Periphery

By ALEN MATTICH

While the countries on the southern and western edges of the euro zone have captured all the headlines with their woes, those on the European Union's eastern periphery have been going through a purple patch.

Indeed, Eastern Europe has been a rare glimmer of good news against the backdrop of an increasingly gloomy global economy. This, though, is unlikely to last. What's more, longer-term problems—notably ageing populations—will continue to hang over these economies.

Poland's performance has been particularly stellar, given that it's one of Europe's largest, albeit relatively undeveloped, countries. By the end of the second quarter, the economy had expanded 4.5% on the same point a year earlier. Slovakia managed 3.5% on the year. And while the Czech Republic's 2.4% was relatively disappointing—largely because of a very subdued second quarter this year—it was handily better than the 1.6% registered by the euro zone generally.

But the real blowout performers were the Baltic states: at the end of the second quarter Estonia had grown by 8.4% on the year, Latvia by 5.7% and Lithuania by 6.2%.

Not all of Eastern Europe did well. The Hungarian and Bulgarian economies were lackluster while Romania barely grew on the year.

With virtually the whole of the region experiencing an export boom, such differences in performance are largely attributable to the relative performances of domestic demand.

Poland has a sizeable enough domestic base to keep up some internal momentum. Elsewhere, consumption has been flagging while some countries have struggled with large government deficits, heavy burdens of external debt or a combination of the two.

All of which makes Germany a big worry for these countries. In the absence of sufficient domestic demand, and given their dependence on German demand for their exports—in part feeding Germany's own industrial boom, any wobble by their giant neighbor would have serious repercussions on their own economies.

And now Germany faces serious headwinds, says Charles Dumas at Lombard Street Research, a consultancy. Solid recent German industrial production data notwithstanding and a good second quarter overall, the latest purchasing managers' report suggests the country's manufacturing sector is running out of momentum.

An inventory overhang and slowing demand, compounded by anemic consumer spending and weakening productivity growth, will prove serious drags on Germany, Mr Dumas wrote in a recent report.

This bodes ill for eastern Europe. For example, 26% of Polish and 32% of Czech and Slovak exports go to Germany. Any weakening of German exports, which is likely to come about with a wider weakening of the global economy, will have a knock-on effect on imports from Germany's suppliers.

But unlike the euro zone's basket cases, which will suffer even more if Germany slows, countries like Poland, the Czech Republic, Hungary and Romania have a valuable safety valve: their own currencies. And these have fluctuated significantly as needed. For instance, the Polish zloty is down 8% this year, while the Czech koruna has strengthened a little more than 2% thanks in part to the country's solid domestic finances.

That, of course, doesn't help the rest, which are either members of the euro—Estonia, Slovakia and Slovenia—or, in the cases of Bulgaria, Latvia and Lithuania, are pegged to the currency.

Of the bigger euro-linked economies, only Slovakia's has been notably strong. In the second quarter it registered the second best year-on-year growth rate in the euro zone, only behind Austria. Both countries have firmly benefited from being within Germany's industrial orbit.

But how to account for the stellar performance of the Baltic states? After all, they have relatively smaller exposure to Germany—which for example, makes up just under 10% of demand for Lithuania's exports. And they face the same pressures of being in the euro as, say, Greece or Ireland.

It could be that these countries are further along the recovery curve because they had deeper and faster declines than the others in the wake of the financial crisis. Their economies contracted by some 20% to 25% under the weight of collapsing domestic assets markets and drastic government austerity programs. Although they maintained their pegs to the euro despite huge pressure to devalue, they forced through an internal devaluation through huge pay cuts—in Latvia pay for public sector workers dropped more than a quarter on average—and rocketing unemployment.

While Ireland has also been doing considerable internal devaluation, and is now benefiting from export growth, other troubled economies have been much more reluctant to take such aggressively painful economic medicine.

Meanwhile, some of these countries will benefit from the alleviation of one major source of recent pain: the Swiss franc's relentless appreciation.

During the boom times before the financial crisis, homeowners across Eastern Europe took out Swiss franc-denominated mortgages because the interest costs were cheaper than the

ones on offer in their home currencies. In some of these countries the household exposure to currency risk became enormous, with estimates that Swiss franc loans made up 30% of all Hungarian borrowing and 15% of Polish borrowing at the peak in 2007.

Before the Swiss National Bank's decision to cap the franc's strength this week, currency movements was proving increasingly damaging to households in these countries. For example, the Hungarian forint depreciated by 23% against the Swiss franc between the start of the year and its weakest point in early August.

But even if Germany manages to maintain its export performance, the countries of Eastern Europe face another struggle. Given their relative lack of development, they have old and shrinking populations, which will put a brake on how fast they can grow, warns Edward Hugh an economist and blogger.

If its eastern periphery has been a rare economic bright spot for Europe, that glow is likely to fade.