Morgan Stanley economists say that the Central European economies (Czech Republic, Hungary, Poland, Romania) are heavily influenced by developments in their richer western neighbours. Developed Europe accounts for around 70% of all CE exports; its banks dominate lending, with a market share of around 80% on average; migrant remittanceshave flowed East since 2004 and FDI inflows from Western European companies have proved to be a significant engine of growth over recent years. Meanwhile, Deutsche Bank Research says Austria is facing headwinds as financial markets have become increasingly worried about Austrian banks’ large loan exposure to the region. The strong financial and trade links with Eastern Europe, which have boosted Austrian growth over the past few years, have now become the Achilles’ heel of the Alpine Republic.

MS says remittances inflows will slow markedly in the coming months. This is due to the fact that economic conditions in the countries where most Poles and Romanians migrated to have turned sour, so there will be less money to send home. Also, especially for Poles in the UK, the slide in GBP makes working abroad less attractive: in 2004, GBP/PLN was trading at around 7.0; currently it is around 4.85, after approaching 4.0 last summer (when PLN strength was at its peak).

Local press (especially in the UK) have claimed that large numbers of migrants seem to have already headed back. Thus far, the evidence on "reverse migration" is patchy at best, because there never was any agreement on how many migrants moved to Western Europe in the first place, and people are not required to de-list when they leave the country. The Annual Population Survey shows that 460,000 people with Polish nationality lived in the UK in mid-2008. National stats offices estimate that there are around 730,000 Romanians in Spain and 620,000 in Italy. Working populations are 17 million in Poland and 10 million in Romania, so these numbers are significant. Moreover, official numbers most likely vastly underestimate the true influx of foreign labour. In the UK, for instance, many self-employed migrants may never have registered on arrival.

MS says it is not clear how many workers have returned home or plan to do so. That said, UK data show that the influx of new applicants for a work permit has definitely slowed; the economists say they think it is therefore plausible that outflows have also risen. The Federation of Poles in the UK claims that around 200,000 Poles left the UK over the last 12 months.

The Macro Effects of Dwindling Remittances and Reverse Migration

While there is a lot of uncertainty around actual numbers and estimates, it seems clear that remittances will drop, perhaps by as much as 50% over the next year. This would take them to the levels last seen pre-EU accession in both Poland and Romania. The main consequences from a currency and macro standpoint are:

• Weaker local FX, but no C/A "hole": It is tempting to assume that with remittances dropping, the C/A deficit will get even larger, as some key inflows are removed from the equation. In reality, the economists say they suspect that much of the money sent home "leaked out", and was used to purchase imported goods. Therefore, they believe the impact on both local FX and the C/A deficit will be negative, though less than one may have thought.

• Lower wage growth, higher unemployment in CEE:Migration abroad, combined with strong growth at home, was likely an important reason why bottlenecks and labour shortages emerged in some CEE labor markets. In Poland, for instance, obvious bottlenecks emerged in construction, though tensions look to have abated in that sector already. In a situation where labour markets are worsening fast already, reverse migration should magnify the downward pressure on wage growth, which is already evident.

• Budget pressures: A return of workers from abroad could boost domestic consumption. However, it is unclear whether the new job-seekers will be able to find a job easily. If they do not, they may have to rely on state benefits.  While some working migrants are still registered as unemployed at home, reverse migration will still have some impact on social benefits claims. With budgets already under stress this year from weaker tax revenues, this may push deficits even wider.

• The silver lining: a boost to potential growth? Survey data show that post-accession migrants were better educated than average. True, in some cases they were not employed in the fields in which they specialized. However, they likely acquired new entrepreneurial skills during their stay abroad, are young and flexible, and could apply for more qualified work than the jobs they had abroad. A boost to labor supply and productivity would boost potential growth.

Conclusion

Diana and Slyusarchuk say the likely increase in IMF support signalled at the recent G-20 finance ministers' meeting, combined with significant support from the EU, will limit the downside for the CE currencies, in their view. However, the economists say they still see no obvious reasons to turn optimistic on these currencies: private sector capital flows have eased dramatically, the growth outlook remains bleak and overall risk appetite is jittery, despite the recent improvement.

The drying up of remittances inflows, which are particularly significant in Poland and Romania, represents yet another drag on these currencies (though the impact is probably smaller than most people think). There is some anecdotal evidence that former migrants from CE to Western Europe are returning to their home countries: in the near term, this will likely put significant downward pressure on wages, increase unemployment and put pressures on the budget; from a more medium-term perspective, it will likely mean a bigger talent pool in the home countries, and a boost to growth and entrepreneurship.

Sebastian Becker of Deutsche Bank Research, says that due to high household indebtedness and the sharp economic downturn in Emerging Europe, financial markets have become increasingly worried about Austrian banks’ large loan exposure to this region. The strong financial and trade links with Eastern Europe, which have boosted Austrian growth over the past few years, have now become the Achilles’ heel of the Alpine Republic. Given the high importance of Germany and Eastern Europe for Austria’s export sector, the economy is highly vulnerable to the current growth weakness of these countries.

Due to high household indebtedness and the sharp economic downturn in Emerging Europe, financial markets have become increasingly worried about Austrian banks’ large loan exposure to this region.

Financial markets have sharply re-priced the risk for Austrian government debt over the past few weeks. At times, Austrian 10-year sovereign bond spreads climbed to fresh multi-year highs of more than 130 bp vs. German Bunds. 5-year sovereign CDS spreads soared to around 270 bp and are still on par with highly-indebted Greece and only topped by Ireland. However, Becker says one has to bear in mind that the CDS market may not be solely driven by default risks but also by other factors. Very recently, sovereign bond and CDS spreads have narrowed again to around 110 bp and 180 bp, respectively.

The strong financial and trade links with Eastern Europe, which have boosted Austrian growth over the past few years, have now become the Achilles’ heel of the Alpine Republic.

With foreign bank lending of $278 bn or 65% of Austria’s GDP, Austrian banks are by far the biggest foreign players in the transition economies, both in absolute terms and relative to GDP, according to the Bank for International Settlements’ consolidated banking statistics.

Emerging Europe has become the most important foreign region for the Austrian financial sector and Austria the most important financier for this region. Accounting for almost 50% of total Austrian foreign bank assets, Eastern Europe clearly stands out. Around 45% of Austria’s lending to Eastern Europe goes to economies such as Romania ($43.7 bn), Hungary ($36.9 bn), Russia ($22.4 bn), Ukraine ($14.3 bn) and Bulgaria ($5.5 bn). Since all these economies are currently facing severe economic slowdown or are suffering from painful economic adjustments of past exuberance in private sector credit, Austrian banks are exposed to rising household and business loan defaults.

Becker says, in light of already high household sector indebtedness and a heavy debt service burden (for many households at 30% of disposable income in some economies), there is further pressure from the high prevalence of FX household loans, not least as a result of significant domestic currency depreciation over the past few months (see chart). Overall, as a result of the large banking sector exposure the government faces relatively high contingent liabilities. Recently, Standard & Poor’s estimated the banks’ gross problematic assets at around 12-24% of the domestic credit stock, which is equivalent to approximately 14-29% of GDP. Hence, the sovereign faces potential recapitalisation costs of 2% and 5.3% of GDP in S&P’s base and worst case scenario, respectively.

As a result of the global financial and economic crisis the public debt ratio already rose to 62.6% of GDP in 2008 from 61.9% in 2007 (according to the OECD) and is expected to climb further to slightly below 70% of GDP by 2010. Austria’s fiscal deficit is forecast to soar to around 4-5% in 2009/10 from 1.2% of GDP in 2008 due to rising expenditures and falling tax revenues (similar to that of its neighbour Germany).

Austrian banks have increasingly relied on short-term debt securities over the past few years.

DB Research says on a positive note, Austrian banks rank relatively well among other Western European economies in terms of bank capitalisation ratios, according to the ECB’s MFI balance sheet data. In December 2008, their capital & reserves ratio stood at a relatively high 7.1% of total assets. However, these figures are on a non-risk-adjusted basis. Although the share of deposit refinancing only fell moderately over the past ten years to 55.1% of total assets (December 2008) from 61.9% (January 1999), Austrian banks increased the share of debt securities refinancing over the same period to 24.6% of total assets from 17.5%. In light of relatively strong reliance on capital market funding – only topped by Denmark and Sweden – the share of short-term debt securities (i.e. debt with a maturity of less than two years) climbed to 11.6% at the end of 2008 from 1.5% of total securities issued in January 1999.

Given the high importance of Germany and Eastern Europe for Austria’s export sector, the economy is highly vulnerable to the current growth weakness of these countries.

Sebastian Becker says due to exceptionally strong trade links with Germany and Eastern Europe (which account for around 30% and 25% of total exports, respectively) Austrian exports are vulnerable to the deep recession in Germany and the pronounced downturn in Emerging Europe. Although Austria has outperformed Germany’s real GDP growth since 2002, Austria has always closely followed the German cycle. Given the deep German recession and significant economic adjustments in its Eastern European trading partners, the Austrian economy is likely to also follow Germany down this time and hence looks set for one of the deepest recessions of the past few decades.