FACTBOX-Key issues for investors in eastern Europe

Published: 11 Jun 2009 01:59:22 PST

June 11 - The global economic crisis has hit the European Union's eastern members hard, causing governments to collapse and forcing countries to seek international bailouts.

Following are major issues for investors in the region:

EURO ZONE DEMAND

Output has fallen by more than a fifth in industry-heavy countries such as the Czech Republic and Hungary because of the collapse in demand for the cars and television screens they produce for their main export market, the euro zone.

Domestic demand in eastern Europe will remain too small to take up the slack in the foreseeable future, so for the region to resume annual economic growth of above 5 percent a year, German and French consumers must return to buying at pre-crisis levels, analysts estimate.

The European Central bank estimated this month that the euro zone economy would not return to growth until mid-2010. But some indicators of business sentiment and consumer confidence, and surveys of purchasing managers, have suggested a modest economic recovery could start in the next few months after stocks of unsold goods in the euro zone are run down.

THE EURO

The economic crisis has delayed the adoption of the euro, an obligation for all new EU members. Before the crisis, many countries had fiscal deficits below the mandatory 3 percent of gross domestic product required by the euro zone.

But now no country with the exception of Bulgaria meets that target, and analysts say it will probably take several years for governments to bring deficits back down to that level.

The crisis has also caused swings of up to 30 percent in the floating currencies of Poland, the Czech Republic, Hungary and Romania, undermining efforts by several to join the ERM-2, a "waiting room" for euro adoption.

Most states are now expected to join the euro in 2013 at the earliest, and if the crisis persists, it could be later.

CREDIT, INVESTMENT

The credit boom that helped drive economies in the Baltics and Balkan states to double-digit growth rates earlier this decade has disappeared. Although banks still report net credit expansion, it is far lower than the 50 percent annual rate enjoyed by the likes of Latvia and Bulgaria in 2007.

Foreign direct investment -- the driver of the manufacturing explosion in central Europe -- has also slowed. Poland sees FDI falling 40 percent in 2009.

Markets too have seen outflows. Although equities indexes have rallied since March after record drops, emerging Europe funds have seen outflows since the start of the year totalling $792 million [ID:nLS947352].

Barclays strategist Koon Chow said he expected credit and investment to return, but that it would take time.

"There will be a return in FDI flows in the next couple of years. Not to the levels of the bumper years, but, hypothetically half. That's not a bad number."

POSSIBLE LATVIAN DEVALUATION

A possible devaluation of Latvia's lat currency could potentially spread contagion to other countries with fixed exchange rates such as Estonia, Lithuania and Bulgaria, affecting confidence in the rest of eastern Europe. Latvia's currency peg has been a central aspect of the International Monetary Fund's bailout programme there. So if Latvia's economic crisis eventually causes it to drop the peg with IMF approval, investors could become uncertain about the rest of the fund's bailout projects in central and eastern Europe. [ID:nL51021677]

BIG PICTURE REFORMS

Analysts say that, with the crisis having banished the idea of a recovery to growth rates of 6 percent or more for the foreseeable future, the only way for the EU's ex-communist states to catch up with richer western states may be bold social reforms.

Many countries might benefit in the long run from overhauls of inefficient healthcare systems, generous welfare benefits that encourage low employment, and pension plans that face bankruptcy due to ageing workforces which will have fewer new workers to cover them under existing pay-as-you-go systems.

But analysts agree that mustering the political will to take these steps will be tough during the crisis, particularly with parliamentary or presidential elections approaching in Bulgaria, Hungary, the Czech Republic and Poland.

The chances of radical reforms may shrink if the crisis pushes countries towards more consensus-style politics -- or if it entrenches ideological divisions between leftist and rightist parties.

"This is not the moment when you are likely to get radical responses," said Robin Shepherd of the Henry Jackson Institute, a think tank. "The potential for radical economic reforms in central and Eastern Europe is now no greater than it is in Western Europe. That's the central point."

For a story on the outlook for eastern European politics and economic policy, click [ID:nLR24984]