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Credit Crunch May Start to Bite Eastern Europe

The continuing worsening of global credit conditions could make life harder for the fast-growing economies of Eastern and Central Europe, which until now have largely been unharmed, according to analysts.

The new EU members' rates of growth have been double those in more mature Western European markets, thanks mainly to foreign investment as Eastern European workers are still prepared to work for a fraction of their Western colleagues' salaries.

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But with Western banks reluctant to lend as much as they used to and setting tougher conditions, liquidity may start to dry up, Agata Urbanska, emerging markets economist at ING Bank, told CNBC.com.

"Possibly this is not going to be the best year for the euro zone. We don't see FDI (foreign direct investment) picking up… the source of it is weak," Urbanska said.

Last year, Poland, the biggest of the Central and Eastern European new EU member states, attracted $10 billion in foreign direct investment, according to European Bank for Reconstruction and Development (EBRD) projections.

Second-largest Romania attracted $5.1 billion, the Czech Republic $5.2 billion, Hungary $3 billion and Slovakia $2.6 billion, according to the EBRD.

The Baltic countries, Slovenia and Bulgaria have all attracted healthy levels of FDI, with Bulgaria getting $5.3 billion, tiny Slovenia $1 billion and the Baltics a combined $2.7 billion.

Still Attractive

As the slowdown in the U.S. has not yet hit the euro zone, further predictions about the fate of the Central and Eastern European economies are hard to make. On the surface, they still look attractive, analysts said.

"Across emerging markets, you still have strong domestic growth and in many Central and Eastern Europe countries, this is also the case," William Oswald, global head of emerging markets quantitative strategy, JP Morgan, told CNBC.com.

But turmoil in the financial markets over the past six months has sifted the region's strongest economies from the weakest. Stock markets reacted differently, depending on foreign investors' confidence in the countries' abilities to weather the storm.

Romania's stock exchange was one of the hardest hit, falling nearly 25 percent in six months, while Slovakia's actually gained 5.2 percent in the period.

The Polish stock exchange lost 9.4 percent while Hungary's shed more than 7 percent and the Czech market fell by more than 6 percent.

"Stock exchanges are under pressure, but it's a matter of sentiment" rather than fundamentals, Urbanska said.

Slovakia, with its record economic growth of 14.1 percent in the fourth quarter, is the star of the region, as it prepares to join the euro zone next year.

Despite the fall of the Prague stock exchange, Czech gross domestic product jumped at a pace of 6.9 percent in the final quarter of 2007 on a rise in spending, investment and trade. Hungary's inched up by a mere 0.8 percent, sparking fears that the country is nearing recession.

Poland's economy grew by a healthy 6.5 percent last year, while EBRD data project Romania's economic growth in 2007 at 6.5 percent from 7.7 percent in 2006.

Signs of Trouble

Signs of Trouble

But in Romania's case, a large current account deficit and falling foreign direct investment sparked fears that the country's growth was unsustainable, and its leu currency fell by more than 10 percent over the past six months.

The leu had appreciated steeply before Romania joined the EU in 2007, as investors tried to benefit from higher interest rates than in the euro zone or the United States, and now the balance is restored, analysts said.

"We really see the reversal (in the exchange rate) as rather a normalization of the leu," Oswald said.

At the beginning of February, ratings agency Fitch downgraded its outlook for Romania, Bulgaria, Estonia and Latvia because of the huge external deficits, saying Latvia's was 25 percent of GDP, Bulgaria's was 19.5 percent, Estonia's 16 percent and Romania's 14 percent.

Officials in these countries have maintained they are not worried by the deficits because they are mainly caused by imports of technology as their countries try to catch up with richer EU peers.

But domestic consumption has been booming, and although it has led to higher growth, it also pushed up inflation on the back of a fast expansion in private lending, notably in the Baltics and in Bulgaria.

Bad May Be Good

One beneficial effect of the global credit crunch could be the slowing of this trend in some Eastern European countries, dominated by the presence of Western European banks which have, until now, been pumping money into their cash-hungry eastern branches.

"Because the availability of liquidity and the conditions are different, we hope that banks will limit credit for these countries," Urbanska said. "We have seen that in the Baltics already, not yet in Bulgaria."

The Baltics and Bulgaria have fixed currency regimes, and a current account deficit that is out of control could threaten the sustainability of their currency boards, analysts said.

Economies in the region are not directly affected by the U.S. slowdown, as exports to the world's biggest economy are less than 5 percent of their total sales abroad.

The transmission mechanism for the subprime fallout is likely to be the credit channel rather than the trade channel, as banks become increasingly more reluctant to lend, Oswald said.

Too steep a fall in credit could reduce much-needed investment and depress domestic demand to a point where economic growth would suffer.

"No country can decouple from an economy the size of the U.S. But it matters how big the slowdown is," he added.