The Hangover after the Party Eastern Europe's Economic Crash

The global downturn has hit Eastern Europe with particular vengeance. Countries that profited more than many others from globalization and were previously capitalism's rising stars are now seeing demand for exports collapse, along with their currencies. They are bracing for a hard landing.

Ryszard Delewski is a businessman on the verge of bankruptcy. After spending anxious months worrying about the future of his company, it seems to be all over.

Delewski was meeting with a customer in Minsk, Belarus when the telephone rang and the crisis hit home. His bank was calling to inform him that his company, Delkar, was in the red to the tune of 4 million zloty, or about €850,000 ($1.1 million). The amount had accumulated because Delewski had used foreign exchange options to hedge against an appreciation of the zloty. But now the Polish currency had lost almost a quarter of its value against the euro. And no one had explained to Delewski that, if this happened, he would owe compensation payments.

Each month the 150 employees at Delewski's plant, near the central Polish city of Kielce, stamp 250 tons of sheet metal and aluminum into gutters, lightning rods and other building elements. About half of the finished products are exported to France, Portugal, Germany and other European Union countries, while the remainder is sold in Poland. "Exports have declined sharply in the past few months. But that alone would not have finished us off," says Delewski.

Given the magnitude of the current crisis, he can understand that demand for his products in the West is down. But why the zloty is falling and why he suddenly owes money is a mystery to him. "We Poles work hard," he says. "Our products are as good as those in the West, and we service our loans." Delewski feels taken in by his lender, Millennium Bank.

It took Eastern Europe 20 years to overcome the old, inefficient structures of the state-run planned economy. The big, unprofitable combines were privatized, and, as Eastern European companies moved into new markets, the region became integrated into the globalized economy.

After joining the EU, the Baltic countries in particular made enormous progress in catching up with their Western neighbors, sometimes growing at double-digit rates. Romania, a latecomer to the EU, recorded the largest number of new registrations of Porsche Cayennes worldwide in 2008. In downtown Warsaw, the Stalin-era Palace of Culture and Science, once the city's only skyscraper, disappeared behind new steel-and-glass office towers within the space of a few years. The Czech Republic still enjoyed almost full employment in 2008.

Now the once-booming Eastern European economy has ground to an abrupt halt. The worldwide economic crisis , which began with the bursting of the real estate bubble in the United States, is now making itself felt in the former communist countries. And it is hitting them with more force and more quickly than the newcomers to capitalism, spoiled by success, had expected.

The Estonians, Latvians and Lithuanians, who for years could enjoy growth rates of between 7 and 10 percent, must resign themselves to the fact that their economies are shrinking. Hungary has already tapped the International Monetary Fund, the World Bank and the EU for €20 billion ($27 billion), and Romania will need just as much. In the fourth quarter of last year alone, the Poles produced 5 percent less than in the same period in 2007. In the Czech Republic, unemployment has risen to 12 percent.

Is it now up to the Western European countries, which already have their hands full dealing with the worst economic crisis since World War II, to pay Eastern Europe's bills? On the other hand, what happens if no one helps? Could the crisis in the EU's new member states jeopardize the cohesion of the union as a whole? One thing is clear: Western Europe cannot simply abandon the new member states to their fate.

Aid for the East was one of the key topics of discussion at the EU summit in Brussels  late last week. At the suggestion of the European Commission, an emergency loan fund for distressed members that have not yet joined the euro zone was increased to €50 billion ($68 billion). Commission President José Manual Barroso called the decision a "signal of strong support."

That signal was urgently needed. Eastern Europeans have long wondered how resilient the rich Western Europeans' solidarity really is. They accuse their EU partners of recapitalizing only domestic companies with -- in part lavish -- bailout packages, while at the same time eliminating the competition from the East.

The view in the East is that the onset of the world economic crisis has suddenly reversed globalization. Hundreds of thousands of Poles, Bulgarians and Romanians had found relatively well-paid jobs in western EU countries, but now an army of migrant workers is making its way back home  to the East. At the same time, the capital the region so desperately needs is flowing in the other direction, as Western banks and investors pull out their money.

The fact that the crisis in the West is now pulling down the East is largely attributable to a single mistake. For years, Eastern Europeans took out loans denominated in euros, Swiss francs and Scandinavian kroner. The loans stimulated domestic consumption and allowed the economies to grow. Many new member states imported more goods than they exported. Now the mountains of debt are high, and the current account deficits of countries like Lithuania and Bulgaria are a massive 15 percent of GDP.

Capital flight and declining demand from the West have pushed down exchange rates. The currencies that are not pegged to the euro have experienced particularly drastic slumps in value. In the last six months, the Romanian leu lost more than 16 percent of its value and the Hungarian forint close to 20 percent. Private citizens and even governments can no longer service their foreign-currency loans.

Massive bankruptcies in the East are now affecting the reckless lenders in the West, which also happen to control about 70 percent of all banks in Eastern Europe. Austrian banks alone have outstanding loans in Eastern Europe worth €293 billion ($396 billion). Thomas Mirow, the president of the European Bank for Reconstruction and Development in London, expects that up to €76 billion ($103 billion) in Western loans will come due this year in EU members in Eastern Europe and Ukraine. Concerns about the creditworthiness of Eastern businesses could deter cash-strapped Western banks from issuing loans for investments. According to Mirow, a vicious circle is developing as Eastern European economies run out of steam and the crisis gains momentum.

At any rate, it will not be possible to fulfill the promise of the revolution of 1989 -- freedom and prosperity for all Europeans -- as quickly as promised. Instead, citizens in the new EU member states can expect to see their wages stagnate at lower levels compared with those in the West, assuming they have not already been cut drastically. In addition to mass layoffs, ailing Eastern European business owners have resorted to wage cuts of up to 30 percent in recent months. And someone who is out of work in the east quickly finds him- or herself in a very tight spot. Governments are out of money, and social services were cut back in many places during the boom years.

From Boom to Bust

Now trouble is beginning to brew in these young democracies. In Bulgaria, Latvia and Lithuania, angry citizens have taken to pelting government buildings with eggs, rocks and -- weather permitting -- snowballs. In the Latvian capital, the government of Prime Minister Ivars Godmanis was even forced to step down. Meanwhile in Hungary, Prime Minister Ferenc Gyurcsany announced Saturday he was resigning, saying he was an "obstacle" to the reforms needed to help his country overcome the financial crisis.

The new EU countries, after experiencing a dizzying boom, are in trouble once again. But in contrast to the recession in the early 1990s, there are different reasons for their problems today. In fact, the face of the crisis varies from country to country.

In the Baltic states, it was primarily cheap money from Scandinavia that ignited a consumption-driven flash in the pan. After 40 lean years of communism, Hungary, the Czech Republic and Slovakia had a great deal of catching up to do, and yet the manufacturing industry's share of growth in recent years was disproportionately greater than in the Baltic states. However, companies and private citizens there, as well as in Romania, have also incurred too much debt. Unfortunately, much of that debt is denominated in euros, Swiss francs or dollars. Foreign banks muscled their way into the new markets in the East and were simply able to offer better terms than their domestic competitors. But now that the forint and the leu have lost value, many borrowers can no longer afford to make their loan payments.

Poland, the Czech Republic and Slovakia are in better shape than their northern and southern neighbors. The major automakers from Western Europe and Asia have built new plants in these countries, such as Korean carmaker Kia's plant in Zilina, Slovakia, which opened in 2007 -- and where employees have now been put on short-time as a result of the crisis. Nevertheless, these plants are often more modern than those in the West, and wage costs are much lower. This fuels hopes that these countries will come out of the crisis in a more favorable position for the future.

The Polish economy is currently in the best shape. An independent small- and medium-sized business sector has developed there in the last two decades, and the country is big enough that domestic demand can support the economy for the time being. Even though the Finance Ministry in Warsaw had to revise its growth forecast downward on Thursday, experts still expect to see growth of 1.5 percent in the coming months.

Entrepreneurs like Ryszard Delewski, with their hard work and ingenuity, are the ones who helped produce the Polish economic miracle. But since receiving the call from his bank in Minsk, he too is at a loss. The Millennium Bank is now demanding payment of 8 million zloty, money that Delewski does not have. "I am liable with my personal assets," he says, glancing at a photo of his sailing yacht on the wall. "I'm not worried about myself, but I have 150 employees."

About 10,000 Polish companies entered into such currency transactions, and now they could face bankruptcy while thousands of workers risk losing their jobs.

This has already been the fate of many workers in the Baltic states. In Latvia, unemployment rose from 5 percent in 2007 to 12 percent today. To make matters worse, private citizens are deeply in debt. "Some people are so broke that they have to spend the night in Internet cafes," says a German real estate agent in Riga. Many brand-new office buildings on the outskirts of the city's picturesque downtown are half-empty. "The market for houses is dead at the moment," says the broker.

After decades under communist rule, the Latvians and their neighbors embarked on a wild party, paid for with borrowed money. In Estonia, it was even possible to secure a loan by cellphone text message. A would-be borrower simply had to send a message to a lender asking for a specific amount, and the money would be wired to his bank account.

"In only a few years, the Balts have developed a tremendous sense of entitlement," says a software entrepreneur, "that was often no longer in line with performance." Everyone, says the businessman, expected the boom to last forever and wages to rise automatically.

Meanwhile, say experts, important work was left undone. Although the Estonians, Latvians and Lithuanians liquidated the big state-owned businesses after the fall of communism, they failed to develop new products for export. Instead, the governments in Tallinn, Riga and Vilnius focused on a radical course of deregulation, which included the introduction of a uniform flat tax throughout the Baltics. It was enough to attract capital to the region, but not enough to stimulate sustainable industrial growth, says Sten Tamkivi, a 30-year-old Estonian who works for the IT firm Skype.

Tamkivi is one of the few people doing well in the crisis. Estonia is banking on widespread broadband penetration and likes to advertise itself as "E-stonia." Almost all banking in the country is done online. Estonians use their mobile phones to pay for movie and parking tickets, and they can even vote on the Internet.

Nevertheless, Skype is the country's only global success story. The company offers a program on the Internet that allows computer users to make telephone calls and videoconference for free. "The number of Skype users has grown since the crisis began," says Tamkivi. "Companies are apparently saving on business trips, and many meetings are now conducted through Skype."

But now the Balts are also feeling helpless. The krone, lats and litas are tied to the euro. To stimulate exports, the Baltic currencies would need to be devalued. But then many banks and businesses with large amounts of foreign-denominated debt could face insolvency -- a difficult dilemma.

Romania and Bulgaria are reacting to the crisis by investing billions in infrastructure, education and environmental protection, and both countries expect a small amount of growth this year. So far other new EU member states have rejected such stimulus programs, although they could hardly come up with the necessary funds even if they wanted to.

"Economic stimulus programs increase debt, and their effects fizzle out very quickly," says Vratislav Kulhánek. His comment reflects a widely held attitude in the East.

Kulhánek was a senior executive with Czech carmaker Skoda before striking out on his own as a business consultant in Prague. "The government cannot really run the economy. That much we learned in 40 years of communism." He does concede, however, that the Czech Republic benefits from Germany's so-called "scrapping bonus," a new initiative to promote consumption whereby owners of old cars are paid €2,500 to junk their wrecks and buy a new car. Indeed, Skoda, a subsidiary of Volkswagen, sold 9190 units of its Fabia model in Germany in February -- almost three times as many as it did in January.

But the Skoda example is an exception. Many new EU states, scenting protectionism, are deeply mistrustful of the Western stimulus programs. In early February, the governments of the Czech Republic and France became embroiled in a battle of words. French President Nicolas Sarkozy has promised government help for his domestic auto industry -- but only if companies agreed to produce all their products at home in the future and no longer outsourced production to the Czech Republic.

Last week, Czech Prime Minister Mirek Topolánek described debt-financed stimulus packages as a "deadly idea." Even a normally mild-mannered man like Polish Prime Minister Donald Tusk  takes on a sharper tone when commenting on the German and French crisis policies. "We see the biggest risk in crumbling solidarity in Europe, and in growing national egoism," Tusk told SPIEGEL, noting that he fears the possibility of a "virtual division."

For years, the West imposed a strict course of privatization on Eastern European countries aspiring to join the EU. It was the condition for joining the exclusive Brussels club in 2004. This makes it all the more irritating to the East to see the West, once the role model when it came to capitalism, now seeking to combat the crisis with nationalization and government bailouts. Eastern Europe overcame the decades-long, ongoing crisis of communism because "we worked very hard for 20 years," says Tusk. "We are deeply convinced of that."

The question is whether this conviction among his fellow Poles can remain truly unshakeable, especially if the zloty continues to fall while the number of bankruptcies and the unemployed rises.

The government in Prague, at any rate, despite all professions of faith in the liberal market economy, approved a small rescue package for an ailing domestic industry last week: Workers in the deeply traditional Bohemian glass industry had not received wages in months.

Translated from the German by Christopher Sultan
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