Flags of the European Union fly in front of the headquarters of the European Commission in Brussels, Belgium on May 5, 2021. REUTERS / Yves Herman

LONDON, Nov. 19 (Reuters) – The normally predictable financial markets of Eastern and Central Europe are suddenly facing the most diverse geopolitical and economic risks that the region has faced for decades, and international investors are starting to pay attention.

The list makes reading disturbing.

The European Union is facing a migrant crisis at its eastern borders which the bloc says is fomented by Belarus, tensions between Ukraine and Russia have resumed, Brussels is in conflict with the Polish and Hungarian governments in subject of the rule of law and democracy, and Romania has no government.

Fund managers have long viewed the region as a sort of hybrid satellite block – part of the eurozone with ultra-low interest rates to boot, but also not completely out of Russia’s orbit, in particular. at the margins.

However, the latest round of events, which, importantly for market watchers, comes against the backdrop of one of the strongest spikes in inflation since the end of the Cold War and the surge in inflation. of COVID-19 cases, has been impossible to compartmentalize.

The Hungarian forint, the lowest Polish zloty in 12 years, the Romanian leu, and the Russian and Belarusian rubles are five of the eight worst performing global currencies this month and Eastern European stocks (.MIME00000PUS) know their worst in over a year.

Government bonds have suffered as rising inflation crushes the real income they provide. Polish, Hungarian and Romanian bonds now have some of the most negative “real yields” – the interest rate after inflation is factored in – anywhere in the emerging world, even lower than Turkey.

Ukrainian bonds fell 10% as Russian tanks moved closer to its borders again, as the threat that Western governments could prohibit banks and funds from fully holding Russian sovereign debt hit the Moscow market. .

“Welcome to emerging markets,” JPMorgan headlined Wednesday in a report on mounting pressures in the region after years of relative calm.

This week’s flash points saw the EU tighten sanctions against Belarus for encouraging thousands of people fleeing war-torn countries to try to travel to EU countries like Poland, a claim denied by Belarusian President Alexander Lukashenko. Read more

Meanwhile, NATO Secretary General Jens Stoltenberg warned Russia on Monday that the Western military alliance stands alongside Ukraine amid what he called a “significant” troop build-up. Russians near the border. Read more

Romania is still trying to tinker with a government while calls for separatism in Bosnia have warned of a return to ethnic strife in the Balkans. Read more

“We have seen an effect on most assets,” said Viktor Szabo, portfolio manager of investment firm abrdn, citing declines in the Ukrainian hryvnia currency, the Russian ruble and some government bonds of the region.

STRONG DETERIORATION

As geopolitical tensions grabbed the headlines, Manik Narain, Head of Emerging Markets Strategy at UBS, warns of a sharp deterioration in broader economic fundamentals in the EEC.

An increase in imports and supply chain problems in key export sectors like car manufacturing are expected to lead to Poland’s first negative trade balance since 2012, Narain said. A long-standing dispute with Brussels over Warsaw that prevails over parts of EU law could also be costly if not resolved. Read more

The EU is currently retaining Poland’s 36 billion euros ($ 40.7 billion) share of its Covid-19 stimulus fund, which is equivalent to around 1% of the country’s GDP. This could reach 4-4.5% of GDP if traditional EU development funding, worth over € 120 billion over the next six years, is also stopped.

JPMorgan estimates that the deterioration in current account positions implies a GDP deficit of 2.3% in Poland, 1.8% in the Czech Republic and 2.9% in Hungary.

This could see currencies weakening further and, with gas prices soaring 300% this year, fueling inflation and forcing central banks to keep raising rates.

“If the deterioration in the balance of payments proves to be more permanent, we expect higher currency volatility in the region,” JPMorgan said.

Every 1% of GDP deterioration in the current account requires interest rates to be 50 basis points higher than they otherwise would have been, JPMorgan calculates.

Borrowing costs are also expected to increase. Inflation for the three major economies of Central and Eastern Europe – Poland, the Czech Republic and Hungary – currently averages around 6.5%. If it ends up settling between 3% and 5%, 10-year bond yields in the region would rise to 3.9% to 5.2% – far more than in recent years.

Lyubka Dushanova, emerging markets specialist at State Street Global Advisors, believes that the delay of the central banks of the EEC and the loss of their credibility in the fight against inflation is causing market weakness.

“It is difficult to dissolve geopolitical tensions from the macroeconomic context,” Dushanova said. “We’re probably going to see some tough times in the region.”

($ 1 = 0.8849 euros)

Reporting by Marc Jones and Karin Strohecker; Editing by Emelia Sithole-Matarise

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