Which country will be the next Iceland?

BY MATT HUTCHINS

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Last weekend, leaders from across Europe gathered in Brussels for an emergency conference to discuss the measures needed to prevent recession-fuelled protectionism. When the gathering convened, however, the subject which dominated discussions was the looming risk of a currency crisis in one of the European Union’s eastern member states or neighbors. Hungarian Prime Minister Ferenc Gyurcsany called for the EU to agree to a 180 billion euro ($226.3 billion) aid package for distressed Eastern European economies, but Western member states rejected the idea, indicating that the International Monetary Fund (IMF) would continue to be the primary vehicle for aid to troubled states. Hungary warned that without an aid package or the immediate extension of the Eurozone to troubled countries, a new “Iron Curtain” would divide the Union in two, but Western nations renewed their emphasis on the aid-channeling powers of institutions such as the European Bank for Construction and Development, which extended a 24.5 billion euro ($31 billion) package to Eastern European countries on Friday, February 27th.

One need look no further than Iceland to see why troubled EU nations are seeking shelter from the storm. A currency crisis may be looming on the horizon for nations with faltering economies and overwhelming foreign debt, such as EU member states Hungary and Latvia or the Union’s eastern neighbor, Ukraine. The IMF has already intervened once in both Hungary and Ukraine, with Hungary having received $25 billion and Ukraine getting $4.5 billion. Now 2009 is looking especially bleak, with Hungary facing a 6% contraction of GDP, Ukraine predicting a fall of 10%, and Latvia’s economy collapsing by 12%.

Large foreign debt payments make it difficult if not impossible for these nations to spend the money necessary to stimulate the domestic economy, because failure to maintain a balanced budget would weaken the value of floating currencies, causing a corresponding increase in the burden of foreign debt.

At the same time, with export-oriented businesses encountering contracting consumer spending abroad and falling commodity prices, sources of foreign reserves and economic growth are quickly drying up. Each nation will need to plan carefully and draw on all its resources to roll over short-term debt and avoid a default on foreign payments this year, but as this year’s economic chaos continues to unfold, the pillars upholding one of these weak economies may crumble and collapse.

When sources of foreign credit lose faith in a nation’s economic system and currency reserves are insufficient to support debt service, a default on national debt can trigger a currency crisis and economic meltdown. As the value of the nation’s currency falls, prices on imported consumer goods and manufacturing inputs shoot upwards. Inflation spirals out of control as consumers and businesses begin hoarding valuable commodities and the falling value of savings denominated in the national currency encourages spending. Banks quickly see their capital base disappear, worsening the blockage of the financial markets. Ultimately, devaluation is the only way to put the economy back in parity with foreign markets, but in the process, foreign debt must be restructured or dissolved and restrictive policies put in place to prevent the flight of foreign-owned capital.

It remains to be seen whether the EU can contain a collapse within one of its eastern members or prevent a cascade from Ukraine into Hungary and other troubled economies. Such an event would put the open market to its hardest test yet and could weaken nations like Poland that have been more disciplined and are closer to euro adoption. Nations like Latvia, which pegs its lat to the euro, may be forced to float or devalue if not granted emergency approval to switch currencies. The circulation of the euro in Slovakia will provide significant protection to that nation from any currency challenges but may expose the euro to weakness regardless of the direct effects on western states. If one nation’s collapse puts further pressure on a weak neighbor, the ripple effects of a single crisis could spread across Europe, triggering a domino effect through troubled nations as a growing regional catastrophe overwhelms otherwise sound economies.

Regardless of where the first alarm bells sound, all signs indicate that somewhere this year the EU’s open economy and its currency will be tested like never before. Any debt default by an eastern state would trigger massive losses to Western European banks that are heavily invested in the region. Calamity is also brewing within the Eurozone itself, with protests in Ireland and serious budgetary problems there indicating a need for foreign assistance. Affluent member states like France and Germany should take caution to avoid thinking parochially about their economic woes, and look beyond their borders to all 27 members and their allies for the greater dangers looming on the horizon. If the United States can be used as an analogy, a Union-wide stimulus package may be the best way to shore up short-term losses and sow the seeds for long-term growth that are needed to restore confidence in private markets. Failure to develop a coordinated response which is inclusive of distressed nations will only heighten the danger that integrated financial and economic relations will make it impossible to compartmentalize a catastrophic situation along the lines of political division.

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