Eastern Europe’s heavy reliance on external financing may be its Achilles Heel, as it looks set to be the hardest hit of emerging market regions as such financing dries up. Almost every country in the region is either in or close to recession, and the sharp drop-off in capital flows is both a reflection of, and a contributor to, the region’s deteriorating growth prospects.

For the last decade, a bonanza of foreign financing has helped the region grow faster than the world average. The region’s capital account liberalization, financial sector reforms and its prospects for convergence with the EU made it an attractive destination for inflows. But that ‘attractive’ status is changing, given the current environment of global credit tightening and given investors’ waning EUphoria. Net private capital flows to the CEE-6 (Poland, Czech Republic, Hungary, Romania, Bulgaria, Turkey) are forecast to fall to around $60 bn in 2009, less than half that received in 2008, according to the Institute of International Finance (IIF).

Besides boosting growth, the stream of foreign capital inflows contributed to a build-up of external imbalances in recent years, specifically high current-account deficits. Such deficits are the norm in the region, but the Baltics (Estonia, Latvia, Lithuania), Bulgaria, and Romania stand out for their sky-high deficits (in the double-digits as a % of GDP in 2008), making them particularly vulnerable to a drop-off in capital inflows. While current-account deficits are expected to narrow across the board in Eastern European countries in 2009, the adjustment is painful and has led to concerns over a full-blown balance of payments crisis. Latvia and Hungary have already turned to the IMF for financing.

While the region’s heavy dependence on foreign financing has been apparent for years, alarm bells were muted. The rationale was two-fold. One, the region was playing catch-up to the EU and current-account deficits were seen as a normal part of that process. Two, the inflows to the region consisted of relatively ‘safe’ forms of financing. That is, FDI – generally considered more stable and less susceptible to rapid outflows than other capital flows, like portfolio investment - accounted for the majority of inflows, although that is now changing. FDI inflows covered almost 100% of the EU newcomers’ current-account deficits from 2003-2007. However, in 2008, FDI coverage dropped to an estimated 55%, according to the Economist. The recession in Western Europe, the source of the bulk of the region’s FDI inflows, is not helping matters.

With the drop-off in FDI, debt - particularly intra-bank lending - has been financing an increasing portion of these countries’ current-account deficits. Nevertheless, intra-bank lending – that is, lending between foreign parent banks and their subsidiaries in the region – is also set to drop off sharply in 2009. Net bank lending to emerging Europe, excluding Russia, is projected to be a meager $22 bn in 2009, down from $95 bn in 2008, according to the IIF. Foreign parent banks, who dominate the region’s banking systems, have pledged to continue to support their CEE subsidiaries, but the global credit crisis has made it difficult for them to maintain previous levels of lending. With the slowdown in both FDI and intra-bank lending, central banks in the region are increasingly being forced to tap their foreign reserves. As for growth, the sharper the decline in capital flows, the sharper the contraction in growth. Future growth prospects hinge on a recovery in capital inflows to the region.