EU New Members' Economy most at Risk to global Stock Drop

The economies of the European newest members are the most vulnerable in the 27-nation bloc to a future extended drop in global stock prices if investors become more worried about risk, a confidential report by the European Commission said. cited by Bloomberg.

Economic growth could slow in the new EU members in Eastern Europe and the region's currencies may fall unless governments move to better prepare for the effects of a potential slide in world equity markets that is more pronounced than this month's drop and reflects a rise in investors' risk aversion, according to the draft report obtained by Bloomberg News. Global equities are recovering from a sell-off that erased $3.3 trillion in market value from February 27 through March 5, triggered by a decline in Chinese stocks and concern US economic growth is slowing. The Morgan Stanley Capital International Inc. World Index fell 6% in that period. The commission report, which will be discussed at a meeting of euro-area finance ministers on March 26 in Brussels, said a simulation model indicated an even larger drop in global stocks would have only limited impact on Europe's growth.

According to the model, a global stock-market drop of 20% would result in a decline of 0.15 to 0.2 percentage point in euro-area growth the first year after the shock, the report said. The report contained several caveats, noting the model took into account only a limited number of factors such as household wealth and omitted others including company balance sheets and confidence among consumers or businesses. „The impact may be significant if the episode were to be only the beginning of a re-pricing of risk by investors,” the report said. Growth would rebound in the second year after the shock, according to the commission's model. Nonetheless, „if international financing conditions were to become substantially tighter, investors would be expected to scrutinize national policies” of the new EU members „more closely,” the report said. „The risk of contagion is not negligible,” according to the confidential document. The new EU states, mostly in Eastern Europe, must focus on controlling government spending, strengthening judicial systems and improving corporate governance to reduce the risks, the report said.

Some countries, such as Bulgaria and Latvia, are vulnerable because of wide current-account deficits and growing government debt. Others, including Poland, Hungary and Romania, may suffer because their currencies are now buoyed by investors attracted to interest-rate differentials, the report said. For countries such as Estonia and Lithuania, whose economies are growing by 10.9% and 6.9%, respectively, and where the currencies are tied to the euro, „urgent policy measures are required” to avoid overheating, according to the commission report.

More flexible exchange-rate systems, such as the Czech Republic's free float or Hungary's 30% trading band, and interest-rate action by central banks can help reduce risks, according to the report. Still, the same countries are running the largest budget deficits, which leads to volatile interest rates and exchange rates, it said. „These countries have had less virtuous policies than those operating fixed exchange-rate regimes, and growth has been less impressive,” the report said. „The result is that even after several years of strong gross-domestic-product growth, there is little margin for automatic stabilizers to play in case of an economic downturn.”

East European stock markets have largely withstood the global declines over the past month. The benchmark Slovak index is the world's fourth-best performer over the last month, having gained 5.2%, while the Czech PX-50 is eighth-best with a 3.4% rise. Both the Polish WIG and the Hungarian BUX also gained in that period. In comparison, the Dow Jones Industrial Average plunged 3.5%, the UK benchmark FTSE 100 and Japan's Nikkei 225 Stock Average both declined 1.5% and Germany's DAX dropped 2.3% in the past month.

Still, the combined stock value of Eastern Europe's three biggest markets - Poland, the Czech Republic and Hungary – is $217 billion, less than a fifth of the UK's. The region's largest company, Czech power producer and distributor CEZ AS, is worth $25 billion, compared with $143 billion for Electricite de France SA, Europe's largest power company by market value. In a review of how the European economy weathered the recent slide in stocks, the commission report said the euro area's expansion had placed it „in a position to better withstand adverse shocks” after growth of 2.6% in 2006, the best in six years. The decline in stocks might „even be welcomed as a necessary 'shake-out' of markets if it reflected an increase in risk aversion after some investments failed to reflect economic fundamentals,” the report said. „A more sustained rise in investor risk aversion would be of greater concern.”

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