Fitch Downgrades Reaffirm the Case to Exit Eastern Europe

Finally, the rating agencies are seeing the light. Perhaps belatedly, Fitch has downgraded its ratings for Bulgaria, Hungary and Romania. The fact is that none of the economies of Eastern Europe (GUR, IEER.LSE) have succeeded in completing the socialism-to-free market transition. On the contrary, virtually all former Soviet Republics are well on their way to become basket cases when compared to their counterparts in Western Europe, with the possible exception of the Czech Republic and Poland.

Fitch Ratings stated that "Emerging Europe" is most vulnerable to the global recessionary environment due to high levels of debt and current account deficits. But, debt and current accounts apart, it is gradually becoming evident that the economic criteria applied to the break-up of the Soviet Union in 1990-1991 were influenced more by Cold War political considerations than by reasonable inferences governing the viability of the residual constituents as independent, modern-day nation states.

In fact, in view of the debacle in Ukraine, it was surprising that credit default swap traders were pricing the three downgrade targets below 500 basis points (5-year sovereign risk) just two weeks ago; Ukraine CDS prices, at that juncture, had moved swiftly, from 900 to 2100 basis points within days.

This is not the forum to engage history in any detail. However, it is relevant to point out that the economic status of Bulgaria, Hungary and Romania in 1990 was entirely a consequence of a heavily integrated economic system (i.e. the COMECON) established in 1949, and expanded in the 1970s to include Cuba and Vietnam. Besides trading amongst its own members, the COMECON had access to other major non-hard-currency markets, like India, for almost forty years.

Most importantly for our present purposes, it is absolutely critical to recognize that specific multilateral agreements under the COMECON mechanism were designed to implement the concept of industrial and agricultural segmentation, e.g. trolley cars and heavy-duty trucks in Czechoslovakia (today's Czech Republic and Slovakia), cotton in Uzbekistan, fruit and vegetable packaging in Hungary, light arms in Romania and steel products in Ukraine. The objective clearly was to avoid any unnecessary, and wasteful according to Karl Marx, competition amongst COMECON members, in addition to achieving efficiencies enabled by access to raw materials.

Naturally, the disintegration of the Soviet Union left the countries of Eastern Europe with the challenging task of adjusting to the free markets. Huge segments of industry and agriculture were rendered useless, almost overnight, in qualitative terms. Soft currency sales of goods came to a grinding halt. And, while the catch-all welfare net of communism was abandoned, real household incomes for the majority of the populations declined steadily. Over the last decade, pockets of extreme poverty have developed in Bulgaria, Romania, Ukraine, Hungary, Latvia, Lithuania and the Balkans.

The euphoria enveloping Emerging Europe equities and debt was founded solely in the belief that the "union with Europe" would set the former Soviet States on the same economic and social path as post-World War II Germany, Austria and France. Today, as the economic and financial fabric of the EU is itself disintegrating, it is not too late to exit Eastern Europe equities and ETFs, losses notwithstanding.

In the meanwhile, since CDS spreads for Estonia, Latvia and Lithuania are expected to widen this week, with Latvia leading the charge towards 700 basis points, the short call on Eastern Europe risk is compelling indeed.

Disclosure: Short IEER.LSE.

Comments

[Echo To All:]

why in the world would you or anyone take note of anything a rating agency states after all that has happened?

their opinion is worthless, and again very late to the game.

2008 Nov 10 08:36 AM

[Rakesh Saxena:]

On Nov 10 08:36 AM echotoall wrote:

> why in the world would you or anyone take note of anything a rating
> agency states after all that has happened?
>
> their opinion is worthless, and again very late to the game.

Dear echotoall: You are correct in stating that the rating agencies are coming late to the party. But, with respect to Eastern Europe, the discreet point I am making is that the rating agencies continue to speak in "general" terms like debt and deficits, without addressing the fundamentals. Just a caution to those who continue to position themselves based on ratings. Many thanks - Rakesh

2008 Nov 10 01:21 PM

[doorapan:]

You write : "The fact is that none of the economies of Eastern Europe (GUR, IEER.LSE) have succeeded in completing the socialism-to-free market transition. On the contrary, virtually all former Soviet Republics are well on their way to become basket cases when compared to their counterparts in Western Europe, with the possible exception of the Czech Republic and Poland" --- do you imply ?? that the Czech Republic, Poland, Hungary, etc were Soviet Republics? And that sweeping statement that none succeeded to free market economy? On what criteria? Either extremely sloppy -- too bad, or simple ignorance -- even worse. Neither helps to entangle a situation which is indeed problematic...

2008 Nov 15 01:04 PM