Trouble Ahead in Eastern Europe?

Early Warning Signals of the London-based Magazine, The Economist

When their exchange rate crises struck, both Mexico and Thailand had current-account deficits of 7 to 8 percent of GDP. This is an ominous precedent: 18 of the 26 former communist economies had current-account deficits of above 7 percent of GDP in 1996, and several topped 10 percent. If the current account deficit is financed by flighty short-term capital rather than long-term foreign direct investment, a country is vulnerable to sudden capital outflows. The Czech Republic, Estonia, Lithuania, and Slovakia all look highly dependent on hot money.

If a currency starts to wobble, foreign reserves are a central bank's first line of defense. Hungary and Poland have plenty of ammunition. But this does not mean much. Thailand also held lots of foreign reserves on the eve of its currency crisis, far more than most East European countries. They were dissipated quickly when the Thai baht came under serious attack.

The more an exchange rate has risen in real terms, and hence, the less competitive a country's exports, the greater the risk that speculators will attack. Like Mexico and Thailand, most East European countries peg their currencies to one of (or a combination of) the main currencies. But since their inflation rates are higher than in America or Germany, their real exchange rates have appreciated, albeit from undervalued levels. Only Hungary, which has seen a big devaluation since 1994, looks safe by this test. All the other currencies have seen real gains of between about 20 percent and 100 percent against the deutschemark over the past three years.

A country whose current account deficit reflects a big budget deficit is likely to have the greatest difficulty holding its exchange rate. By this criterion, the worst offenders are Hungary, Slovakia, and Ukraine, which all have budget deficits of 5 to 6 percent of GDP. But figures need to be handled with care. Poland's forecast budget deficit of 3 percent of GDP in 1997 is flattered by the inclusion of privatization proceeds. If these are excluded, as they should be, the true budget deficit amounts to 6.5 percent of GDP.

The other sign of impending trouble is rapid monetary growth. This can fuel a consumer boom, causing the current-account deficit to widen, and may also inflate the prices of shares and property. Fast growth in bank lending is a clear sign of such an asset-price bubble, and throughout Eastern Europe lending has been expanding far too quickly.

The Economist has assembled the latest figures for these six indicators in eight East European economies. For purposes of comparison, it gave similar figures for Mexico in 1994 and Thailand in 1996. No single indicator can reliably predict a crisis, but economic studies suggest that, if several early-warning signals are flashing red, then there is a high risk that a currency crisis may follow. The final column of the table gives a crude overall measure (out of a maximum possible score of 12) of how many of the early-warning indicators are flashing. A country scores 0, 1, or 2 on each indicator, and then these scores are added together. The table suggests that Estonia, Latvia, Lithuania, Poland, Slovakia, and Ukraine could face exchange-rate crises. Only Hungary and perhaps the Czech Republic, which has already abandoned its currency peg, look to be safe.

Early-warning signals are for policymakers as well as investors. All of Eastern Europe's governments still have time to avoid currency crises. But budget cutting and monetary tightening are always painful. It is easier for governments to cross their fingers and publicly deny the warning signs. Of all the indicators of trouble ahead, this may be the most reliable.

From the Economist, October 18, 1997.