BT: Europe in for '97 Asian crisis-like situation? (07 Jul 2006)

Europe in for '97 Asian crisis-like situation?

Financial troubles in Turkey and Hungary also fuel concern about political turmoil there

By MATTHEW LYNN

FIRST Iceland. Now Turkey. And Hungary is looking wobbly. Europe is increasingly encircled by financial woes. Its emerging markets are being hit by a wave of speculative selling, pushing currencies into freefall and prompting big increases in interest rates.

The worrying questions now are: will those crises turn out to be contagious, as they did in Asia in the past decade?

And, if that is a risk, is there anything the rest of Europe should be doing to support those economies?

After all, economic chaos has a nasty way of leading to political turmoil. And while nobody gets worked up about what happens in Iceland, neither the European Union (EU) nor the United States can afford political instability in Turkey or Hungary.

The sense of trouble brewing can hardly be avoided.

First, Iceland fell into crisis earlier this year when a ballooning trade deficit, accelerating inflation and a credit-rating downgrade spooked the markets, prompting a run on its currency, the krona. In response, the central bank has been forced to raise interest rates to 12.25 per cent. It probably has not finished yet.

In the past month, Turkey has run into trouble. During the past year, the Muslim nation had been among the beneficiaries of the investment surge in emerging markets. Now, with interest rates rising globally, sentiment has turned - and Turkey has been one of the hardest hit.

The Turkish lira has dropped 14 per cent against the dollar since the start of May. In response, interest rates have been raised twice in the past month, and are now at 17.25 per cent. And the Turkish central bank has been buying liras for dollars in order to stop the currency's slide.

Nobody would blame Turkey for that. The country has been making solid progress building a modern, competitive economy, and has been inching its way towards joining the EU.

'Turkey should have been treated differently from many emerging markets because of all the prudent reforms it has made in the last two years,' Serhan Cevik, an analyst at Morgan Stanley in London, said in a telephone interview. 'Unfortunately that hasn't happened.'

International investors have been jittery for the past month, and appear to have picked on Turkey as a market they can easily leave. Next up? Maybe Hungary.

The Hungarian forint was the world's worst-performing currency in June, dropping 7.4 per cent in value against the euro, largely on concern that the government's budget deficit was running out of control.


Domino effect

In response, the central bank has already started increasing interest rates for the first time in 2 1/2 years. OTP Bank says the central bank may raise them again, even ahead of its next scheduled rate-setting meeting. That would have the whiff of crisis about it.

True, by the end of the week the markets were rallying as it looked as if the US Federal Reserve may be coming to the end of the current round of interest-rate increases.

And while all the emerging markets have been volatile, it is around the peripheries of Europe that the worst of the turmoil is being felt.

For the rest of Europe, trouble in markets such as Iceland, Turkey and Hungary has two important consequences.

First, it might be contagious.

In the Asian financial crisis of 1997, crashes rippled out from one country to another in a domino effect. As investors lose confidence in one nation, they start to question the finances of another. Very quickly, a whole region is in trouble.

There are plenty of differences between the Asian crash almost a decade ago and the volatility of the past few weeks - yet there is little doubt that a domino effect is emerging. When will it stop? Nobody can say for certain.

Next, none of the countries involved may be that important economically but they are all significant geopolitically. Nobody will worry that much if Iceland gets into trouble. They will worry a lot if Turkey does.

In a region where Europe and the US are very short of reliable friends, Turkey has been a rare ally. If economic turbulence was to be followed by political turmoil, that would destabilise the entire region.

And Hungary is already a member of the EU. It sits right on the edge of the new Europe and the old.

It is unlikely that anyone could sit back comfortably and watch that country slip into financial chaos either.

Of course, the volatility of the past month might just blow itself out. If it does not, there are two steps that might need to be taken.

First, central banks might have to intervene directly in the currency markets. It might prove tough, for example, for the Turks to defend the lira by themselves. If the European Central Bank stepped in, it would be a lot easier.

Next, European governments might need to consider emergency loans - a financial bailout could prop up an economy that would otherwise sink.


Intervention risks

Neither option would be perfect. 'If Turkey and/or Hungary were to run into really serious financial trouble, there would not be much that the multilateral agencies could do to help,' Stephen Lewis, chief economist at Insinger de Beaufort Holdings SA in London, said in an e-mailed response to questions.

'They could announce their confidence in the underlying economic fundamentals of the hard-pressed nations,' he added, 'but there is no guarantee the markets would pay heed.'

Intervention in the markets is notoriously tricky. It ends in failure more often than not. The trouble is, doing nothing may not be a very attractive option either.

For the rest of Europe, the crises in the markets on the periphery of the region are not just a spectator sport. Soon they might demand some action. - Bloomberg

Matthew Lynn is a Bloomberg News columnist. The opinions expressed are his own

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