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Europe's Eastern periphery

Latvian students protest at government spending cuts
Image caption The Baltic states have paid a heavy price for their euro dreams

"There are more risks to being inside the eurozone than being outside."

Those were the words of the Polish central bank governor, Marek Belka, earlier this month, echoing the private thoughts of leaders across Central and Eastern Europe.

Many of them are thinking long and hard about the promise to join the euro that they made (or will make) when they signed up for the European Union (EU).

They will certainly be watching the fates of Portugal, Ireland, Italy, Greece and Spain (PIIGS) with some trepidation.

Long grass

The PIIGS are now caught in a euro-trap. The boom years swelled their labour markets and their public finances.

Now the bust leaves them uncompetitive and with a major debt hangover.

But the usual cheap cure to these ailments, currency devaluation, is not an option inside the euro.

So does this mean the EU's newcomers and wannabes have decided to kick their own euro-membership plans into the long grass?

"The consensus has pushed back right to the end of this decade," says Martin Blum, economist at Ithuba Capital, an Austrian hedge fund that specialises in the region.

The Czech Republic and Poland, countries with notable Eurosceptic politicians, do not especially want to join the eurozone at all, he adds.

Both did very well outside the euro during the 2009 downturn, thanks in part to the sharp drop in their currencies, which helped them keep a competitive edge, he explains.

Poland did not even experience a recession, an almost unique achievement in Europe, though government spending had a lot to do with this.

Devaluation dilemma

But for some East European countries it may already be too late to escape the same euro-trap now afflicting their Mediterranean peers.

Although technically outside the single currency, many have pegged their currencies to the euro.

Estonia, which will join the euro in January, saw its economy shrink by a cumulative 20% in 2008-09, after it slashed government spending and refused to devalue the kroon.

Its Baltic neighbour Latvia fell a whopping 25% over the same period.

For others, notably Hungary, devaluation was not the easy option that it would have liked.

For years, ordinary Hungarians had taken out their mortgages in foreign currencies, such as the euro, Swiss franc or even the yen.

The Hungarian forint was going to join the euro eventually anyway, so why pay the much higher interest rates demanded in their own currency?

The reason, as so many were to discover, is that their foreign currency mortgage payments became unaffordable when the forint lost a quarter of its value.

That gave the authorities in Budapest a nasty dilemma: keep the forint strong and suffer a deeper collapse in exports, or let the forint fall and watch its banking system sink under a mountain of unrepayable mortgage debts.

In the end, they called in the International Monetary Fund (IMF).

Playing catch-up

While playing the devaluation card may have helped some countries in the region ease the short-term pain of the recession, what about the longer term?

"They need to think about other drivers [of competitiveness] than low cost," says Erik Berglof, chief economist at the European Bank for Reconstruction and Development (EBRD).

Romania, for example, whose currency dropped 20% last year, has seen a big rise in labour costs wipe out much of its price advantage.

More importantly, the entire region still suffers from a huge "convergence gap" with the West, marked by lower living standards and poorer infrastructure.

Normally this would create the potential for a lot of catch-up growth.

But Mr Berglof says the crisis in the eurozone, the region's biggest export market by far, is bad news.

What a drag

If Europe's leaders fail to deal with the weaknesses in the single currency exposed by the crisis, the continent could face years of grindingly low growth.

And slow growth in Western Europe will inevitably be a serious drag on Eastern Europe's exports.

Selling their wares to other parts of the world could provide an alternative, but only in theory.

"In our region there's not much of an option," says Mr Berglof. "It's like asking Mexico to diversify away from the United States."

The nearby Russian market may at least be one alternative, as the country has very little manufacturing industry of its own and pays for a lot of imports with all the oil and gas it exports.

But Russia is not a big market, cautions the EBRD economist.

German model

A path already well-trodden by the Central Europeans, such as the Poles, Czechs and Hungarians, is closer integration into the German manufacturing leviathan, says Mr Blum at Ithuba Capital.

"I wouldn't undercut the importance of the German recovery," he advises.

The Central Europeans now do a lot of business selling equipment to West European manufacturers, or playing host to factories that form part of Western companies' supply chains.

As such, a lot of the European demand for these countries' exports is actually driven by global demand for the German export machine.

The biggest crisis may instead be faced by their Balkan cousins, the Romanians and Bulgarians, to the south, according to Peter Brezinschek, chief economist of Austrian bank RZB.

"In Central Europe, most foreign investment went into greenfield sites, promoting exports," says Mr Brezinschek.

But in the Balkans, he says, money poured into sectors such as housing construction, utilities or telephone networks that were oriented towards the domestic economy and did little to improve export competitiveness.

Investment binge

Mr Brezinschek thinks the Balkans would do well to follow the Central Europeans' lead.

But he says there is also still a shortage of basic infrastructure.

"The infrastructure is really terrible," says Mr Brezinschek, who points as an example to the near absence of motorways in Romania.

He says there also need to be major improvements in energy efficiency.

Mr Berglof at the EBRD agrees that serious investment spending is needed across the whole of Eastern Europe, with one big area being education.

"Managers typically list skills as being the number one obstacle they face," he notes.

So could these countries copy China's example, and offset weak export demand by ramping up government investment spending?

"An investment binge is not an option," cautions Mr Berglof. Why? Because the money simply is not there.

Just like their West European counterparts, governments in the region are busy cutting back their spending.

And, says Mr Berglof, private investment spending is also more difficult "in an environment of no very well functioning institutions" - a well-known euphemism for corruption and organised crime.

Home grown

Borrowing from abroad is less of an option these days. It was an abuse of cheap foreign loans that helped push Hungary and others into the arms of the IMF during the 2008 crisis.

Instead, with their own citizens likely to be a lot more cautious with their money in the coming years, governments will need to find better ways of funnelling those savings into local businesses.

Mr Berglof points out that, unlike many of its eastern neighbours, the Czechs have been borrowing and lending to each other in their own currency - the koruna - for years.

Because of this, "the least affected by the financial aspect of the crisis was the Czech Republic", he points out.

In its latest transition report, the EBRD recommends other countries follow the same route of financing themselves in their own currency, using their own domestic savings and home grown capital markets.

So is this a tacit recognition by the multilateral agency that euro membership is now off the cards?

"No," insists Mr Berglof. "It is an important step on the way to the euro."

The Czechs may beg to disagree.

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