Will high oil prices hammer Central Europe? The big shock?

Spiralling oil prices, crisis in the Middle East, currencies gone haywire...anyone would think this was the 1970s, when two oil price shocks plunged the world into years of economic turmoil.

Back then the crisis drove the first nail into the coffin of communism. Could the latest turmoil be similarly fatal to Central Europe's economies

Spiralling oil prices, crisis in the Middle East, currencies gone haywire...anyone would think this was the 1970s, when two oil price shocks plunged the world into years of economic turmoil. Back then the crisis drove the first nail into the coffin of communism. Could the latest turmoil be similarly fatal to Central Europe's economies? The world economy certainly faces its biggest risks since the Asian and Russian financial crises of 1997-98. The oil price has risen from $13 a barrel in 1998 to over $30 today. Meanwhile, the slumping euro adds to the sense of instability. All the same, mainstream forecasts predict rapid growth for the world economy next year. In fact, today's oil price rise is much less dramatic than the shocks of the 1970s.

On the other hand, the impact will be particularly great in emerging economies. Central Europe is still relatively industrialised, and its industries are often old and inefficient, so they guzzle energy. Oil consumption represents almost 2% of GDP in Central Europe, compared to 0.7% in the EU.

Already, economists are starting to worry about the latest data from Central Europe. High oil prices have pushed up import bills and trade deficits. They have also boosted inflation, which is still in double figures in Hungary and Poland. The fall in the euro adds to the problem. Central Europe's currencies follow the euro closely, so there has been little loss in competitiveness in EU markets. But this also pushes up the cost of imports priced in dollars, adding to the inflationary effect of the oil price hike.

The problems should be put into perspective, argues Charles Robertson from ING Barings, an investment bank in London. In fact, it is mainly high food prices caused by this summer's drought that are pushing up inflation. The drought is unlikely to repeat itself next year, so inflation should moderate.

Others are less optimistic. The full effects of higher oil prices have yet to feed through into inflation, according to Schroder Salomon Smith Barney, another investment bank (see table). Everyone agrees, though, that the greatest risks are faced by those countries that had the biggest problems to start with. In particular, that means Poland, even though it is less dependent on oil than other countries in the region.

Even before the rise in oil prices, economists were worried about Poland's large current-account deficit, now 7.5% of GDP. Its government, facing elections next year, is not in the mood to tighten fiscal policy. Nor is Poland carrying out the structural reforms economists say are necessary.

The oil price shock reinforces the need for greater competition. Several of Poland's sectors remain heavily monopolised, including energy. The government is also adding to regulations in the labour market. This inflexibility creates the risk that inflation will become entrenched, as higher prices are passed on as higher wages. It also makes any slowdown in growth dangerous. Even now, Polish unemployment is around 15%, and it will rise if growth slows.

For other countries, too, the shock reinforces the need for liberalisation and structural reforms. Hungary's attempt to cap gas prices makes problems worse in the long run, by discouraging people from using less energy. In Bulgaria, meanwhile, inefficient heavy industry is particularly vulnerable to higher energy costs.

Still, most forecasters believe that the region's growth will only slow by about half a percentage point or so next year. But there are "significant risks on the downside", they add. It all depends on what happens in Western Europe, which buys most of the region's exports. If rising inflation brings down growth there, then Central Europe will suffer. The oil shock also increases the risk of a hard landing in the US.

For the moment, though, Western Europe is still expected to grow at over 3% next year, while oil prices should come down (to about $25 a barrel), and the euro should recover. If that's right, then Central Europe's problems should be temporary. Unfortunately, the forecasters have a habit of getting it wrong.

http://www.bcemag.com/1100/politics/01.html

-- Martin Thompson (mthom1927@aol.com), November 03, 2000