Marc Jones, Karin Strohecker

LONDON, (Reuters) – The normally predictable financial markets of Eastern and Central Europe are now experiencing the greatest geopolitical risks and economic opportunities the region has seen in decades. International investors are beginning to notice.

This list is alarming.

A migrant crisis is facing the European Union’s eastern borders. The bloc claims it is being fomented in Belarus. Tensions between Ukraine, Russia and Brussels have flared again. Brussels and the Hungarian and Polish governments are locked in a dispute over democracy and rule of law, while Romania doesn’t have a government.

Since long, money managers have viewed this region as a kind of hybrid. It is part Euro zone satellite bloc with extremely low interest rates. But it’s not completely out of Russia’s orbit, especially on the fringes.

However, the latest events, that are important for market watchers, occur against the backdrop of one the strongest inflation surges since the Cold War.

The forint of Hungary, which is a low 12-year-old Polish zloty; the leu of Romania, Russia, and Belarus’ rubles are all five worst-performing world currencies. Eastern European stocks have had their worst year in more than a decade.

Rising inflation has caused government bonds to suffer as the real-term income that they generate is being eroded. The emergence world’s worst’real yields, or the rate at which inflation has been factored into the interest rate, is now Romania, Poland, Hungary, and Romania. This makes them even worse than Turkey.

As Russian tanks approach Ukraine again, Ukraine’s bonds are in decline by 10%. Meanwhile, Moscow is facing the possibility that Western countries might prohibit banks from having Russian sovereign debt and threaten to ban funds.

JPMorgan (NYSE 🙂 announced Wednesday that it had released a report about the increasing pressures on emerging markets following years of relative peace.

Flash points this week saw the EU tighten its sanctions on Belarus, for encouraging thousands to flee war-torn areas to try and cross into EU countries like Poland. The accusation is being denied by President Alexander Lukashenko.

NATO Secretary-General Jens Stoltenberg also warned Russia that Monday’s western alliance would stand by Ukraine in the face of what he described as a “significant” increase in Russian troops at the border.

Romanian officials are still struggling to form a government. Meanwhile, calls for independence in Bosnia raised alarms about the possibility of ethnic violence in the Balkans.

Viktor Szabo (a portfolio manager for investment firm abrdn), said that there has been an impact across all assets. He cited the declines in Ukraine’s currency and Russia’s ruble, as well as some regional government bonds.

DETERIORATION SHARP

While geopolitical tensions dominate the news, UBS’s chief of emerging market strategy Manik Narain cautions against a rapid deterioration in the economic fundamentals of CEE.

Narain indicated that Poland is likely to experience its first negative balance trade since 2012. This could be due to a rise in imports as well supply chain issues in important export sectors such as car manufacturing. If the long-running conflict with Brussels regarding Warsaw’s infringement of EU law is not settled, it could also prove to be expensive.

The EU withholds Poland’s 36-billion euro share (or $40.7 billion) from its Covid-19 recovery funds. This is roughly 1% of Poland’s GDP. This could rise to 4-4.5% of the GDP if EU traditional development funding (worth more than 120 million euros in six years) is stopped.

JPMorgan projects that the decline in current accounts positions will lead to a GDP deficit in Poland of 2.3%, 1.8% in Czech Republic, and 2.9% for Hungary.

It could cause currencies to weaken further. This, combined with the 30% increase in gas prices for this year, will fuel inflation. Central banks may need to continue raising rates.

JPMorgan reported that “if balance of payment deterioration proves to be more severe, we expect greater FX volatility in this region.”

JPMorgan calculates that interest rates must be increased by 50 basis points for every 1% in GDP current account decline.

The cost of borrowing would also have to increase. The inflation rate for the three largest CEE countries – Poland and Hungary – is currently at 6.5%. It is possible for it to settle between 3 and 5%. If that happens, the 10-year yields on bonds in this region will be 3.9%-5.2%. This would be a significant increase from recent years.

Lyubka dushanova is an emerging market specialist. State Street Global Advisors believes that market weakness is caused by CEE central bank being out of the loop and their loss of inflation-fighting credibility.

Dushanova explained that “it is hard to disentangle the geopolitical conflicts from the macroeconomic context.” “We will probably see some rough times in the region.”

($1 = 0.8849 euros)