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By Tasneem Brogger and Agnes Lovasz Nov. 23 (Bloomberg) — Eastern Europe, where currencies and equities combined to produce total dollar-denominated returns of about 50 percent this year, is showing signs of unraveling as the continent’s favorite investment because of runaway debts. Hungary’s forint is the second-worst performer in the past month of 26 emerging-market currencies, cutting its gain against the dollar since March 10 to 32 percent. Slovakia, Poland, Bulgaria and the Czech Republic are among seven countries showing the steepest increase in credit risk of 21 sovereign credit-default swaps tracked by Bloomberg. The NTX New Europe Blue Chip Index has fallen 2.7 percent after closing at 1,208.60 on Nov. 16, the highest since Oct. 7, 2008. “Some investors might really underestimate the setback potential” for bonds and currencies, said Tim Haaf , who helps oversee $60 billion in emerging-market assets for Newport Beach, California-based Pacific Investment Management Co., a unit of Munich-based insurer Allianz SE . “The world is coming out of the doldrums, but eastern Europe still has to burn off these higher debt levels, the external debt levels, and it will take longer to grow out of that.” Swelling public deficits have forced European Union members, including Poland and Latvia, to shelve euro adoption targets. Romania and Hungary have had to implement budget cuts that exacerbated their recessions to meet requirements for loans of 20 billion euros ($30 billion) each to finance their current- account and budget deficits. Berlin Wall Countries east of the Berlin Wall abandoned communism 20 years ago and embraced free markets with the ambition of achieving Western living standards, leading to expansion at or above double digits. Those countries are now relying on bailouts totaling $100 billion, 69 percent of the global total, from sources led by the International Monetary Fund and World Bank, according to data compiled by Bloomberg. The European Commission forecasts government debt in Hungary will exceed 75 percent of gross domestic product for the next three years, and in Poland debt will rise to as much as 61 percent of GDP in 2011. The commission sees Latvia’s budget deficit at 12.3 percent of GDP in 2010 and Poland’s swelling to 7.5 percent of GDP next year. “Growth is unlikely to recover to pre-crisis levels,” said Arend Kapteyn , chief economist for Europe, the Middle East and Africa at Deutsche Bank AG in London. Emerging European nations benefited from 2002 through 2008 from foreign-capital inflows equal to about 8 percent of the average annual gross domestic product to finance a credit boom, he said. “We don’t think those flows are going to come back at the old level.” Economic Prospects The region’s equity indexes climbed this year even as central and eastern Europe will shrink 6.3 percent in 2009, with the contraction stretching into 2010 in four former communist states, including Hungary, the European Bank for Reconstruction and Development said Nov. 2. It estimates six of the region’s economies will grow 1 percent or less next year, while overall growth will average 2.5 percent. Romania’s Bucharest Exchange Trading Index has risen 77 percent this year in U.S. dollar terms, including reinvested dividends. The index’s top gainers are oil refinery Rompetrol Rafinare SA , up 281 percent this year, and drugmaker Biofarm Bucuresti SA , up 169 percent. The country’s government collapsed last month after Premier Emil Boc lost a confidence vote amid disagreements over budget cuts, and lawmakers have yet to appoint a new coalition. Hungary’s benchmark Budapest Stock Exchange Index gained 89 percent in dollar terms. The nation’s economy will contract 6.5 percent this year and a further 0.5 percent in 2010, the European Commission said on Nov. 3. Ukrainian Bonds Ukraine’s PFTS Index climbed 107 percent since January, with engineering company Motor Sich JSC rising more than 300 percent, even as political wrangling stalled budget cuts needed to draw the next $3.4 billion tranche of a $16.4 billion IMF loan. The country won’t have enough money to pay for Russian gas ahead of winter unless it gets the bailout payment by Dec. 7. Ukrainian bonds fell the most in the world during the past month. The NTX New Europe Blue Chip Index, the region’s benchmark, has almost doubled since it declined to a five-year low in March. The rally stalled in the past month with the index trading between 1,100 and 1,200. It rose above 1,200 four times in the period and then declined. ‘Started to Lag’ “They’ve outperformed for the past six months but have started to lag a little,” said Ralph Acampora , who left Knight Capital Group Inc. in 2007 where he ranked among Wall Street’s most experienced technical analysts and now helps manage money in New York at Geneva-based Altaira Wealth Management SA. “The hot money is getting a little less aggressive.” Radoslaw Bodys , central and eastern Europe economist in London at BofA Merrill Lynch Global Research, said he doesn’t see “significant risks over time.” Eastern Europe will “definitely lag Asia and probably also lag Latin America, at least early on,” because Eastern Europe is more developed, “so by definition, potential growth is lower. Initially it’s going to be slower than western Europe’s recovery, but quite soon I think it’s going to do better.” Rachel Ziemba , senior emerging-markets research analyst at New York-based Roubini Global Economics , is less optimistic and says some assumptions about the drivers of growth may be overblown. Eastern Europe is “lagging and will continue to lag behind the rest of the emerging markets,” she said. “There are a lot of expectations of an export-led recovery, but western Europe is only going to be able to absorb so much of their goods.” Export Economies Exports account for about three quarters of the economies of the Czech Republic, Hungary and Slovakia. That compares with about 50 percent in Germany, according to data compiled by the Organization for Economic Cooperation and Development . Ziemba’s skepticism about the region’s resurgence by selling more overseas is shared by economist and Nobel laureate Paul Krugman . “How can we have an export-led recovery unless we find another planet to export to,” he said in a Sept. 21 speech in Helsinki. Eastern Europe got a boost in exports after Germany and France handed out checks to people trading in used cars for new models — the equivalent of the cash-for-clunkers program in the U.S. The stimulus temporarily increased demand and production for the Czech Republic’s Skoda cars and Audis made in Hungary. The rate of decline in industrial output eased to an annual 15 percent in Hungary during September from 25 percent in April. It dropped to 11.9 percent in the Czech Republic in September, compared with a 22 percent slump in April. Auto Stimulus The auto program “explains about 50 percent to 80 percent of the improvement,” according to Deutsche Bank’s Kapteyn. “Profitability of exports will largely depend on exchange rates, which in our view could be too strong,” said Bartosz Pawlowski , senior currency and fixed-income strategist at BNP Paribas SA in London. The Czech koruna, Polish zloty and Hungarian forint have all gained ground against the dollar this year. The cost of insuring against risk is rising with credit- default swaps tied to Ukrainian government debt rising 395 basis points to 1,548 on Nov. 20 from 1,153 two months ago. Poland CDSs advanced to 126 basis points on Nov. 20 from a six-month low of 110 on Oct. 15, data compiled by Bloomberg show. A basis point on swap contracts protecting 10 million euros of debt from default for five years is equivalent to 1,000 euros a year. Flow of Investments The region’s bonds may not be a safer bet for emerging- market investors as deficits threaten to hamper the flow of investment to companies, Pawlowski said. The European Commission estimated Nov. 3 that Hungary’s deficit is 4.1 percent of GDP this year, Poland’s shortfall is 6.4 percent and the Czech Republic’s is 6.6 percent, all above the EU’s threshold. Governments across the region “will have to issue very sizable amounts of debt and that debt will probably be snapped up by banks, which in turn means there won’t be much left to lend to the economy,” Pawlowski said. “There are still substantial issues with the fiscal outlook, which isn’t the case in Asia or Latin America.” The yield on Romania’s 8 percent note due October 2011 has risen 8 basis points, or 0.08 of a percentage point, since the beginning of November. The yield on Bulgaria’s 4.75 percent note due February 2011 gained 25 basis points in the same period, Bloomberg data show. Yields move inversely to bond prices. Credit Risks Adding to credit risks is a reliance on foreign-currency loans. Consumers and companies in Latvia, Lithuania, Estonia, Hungary, the Czech Republic and Poland borrowed in euros, which carried lower interest rates than debt in their own currencies, after the countries joined the EU in 2004. Romania and Bulgaria followed suit in 2007. A 19 percent drop in the zloty against the euro during the second half of 2008, an 11 percent slide in Hungary’s forint in the same period and a 9.5 percent decline in Romania’s leu left borrowers struggling to service debt. Latvia, Lithuania, Estonia and Bulgaria all peg their currencies to the euro. Maintaining those pegs proved costly as the governments cut budgets to satisfy EU rules. Foreign-currency borrowing by businesses and households, including mortgages, is about 48 percent of GDP in Hungary and 28 percent in Poland, according to a report by Bodys . “This region will again be more vulnerable if there’s a setback in the markets for whatever reason,” Pimco’s Haaf said. Political Instability Political instability is another malaise. Since the onset of the credit crisis, the government has fallen in Latvia and Hungary’s Prime Minister Ferenc Gyurcsany was ousted, as was the Czech Republic’s Mirek Topolanek , who didn’t have to turn to outside sources for a bailout. Romania’s Boc lost a no- confidence vote on Oct. 13, and Romanians went to the polls yesterday to elect a president, the next step before lawmakers can agree on a new government. Presidential elections are due in 2010 in Ukraine and Poland. “The problem at the moment is there are a lot of elections in the next year and there are very difficult macro stories,” said Tim Ash , chief emerging Europe economist at Edinburgh-based Royal Bank of Scotland Group Plc. “The region is underperforming. In terms of the export story, we’re not seeing very much of a recovery. I don’t really see a compelling bounce- back story.” To contact the reporter on this story: Tasneem Brogger in London at tbrogger@bloomberg.net Agnes Lovasz in London at alovasz@bloomberg.net