ETF Talk: Are We Seeing a New, Economic Iron Curtain?

If you watch CNN, MSNBC and other news channels regularly, you might think that the American economy was on the brink of total collapse. As bad as the 3.8% contraction of the U.S. economy in the fourth quarter of 2008 may seem, the economic slide in Central and Eastern Europe was far worse.

Much like the rest of the Western world, this region was living way beyond its means earlier in the decade. After countries such as Poland, Hungary, Latvia and Lithuania gained acceptance into the European Union, most Western European banks opened their then-bountiful coffers to finance businesses and mortgages in those emerging markets. This capital fueled double-digit percentage economic growth in the region during the bull market years of 2005 and 2006. Unfortunately, that mini-boom was financed in large part by subprime lending. When the credit crunch hit, most of these economies began shrinking.

This unsettling situation has caused exchange-traded funds (ETFs) that focus on the region to take big hits. Here’s an example. The SPDR S&P Emerging Europe (GUR), an ETF which closely follows Eastern European stock indices, dropped nearly 65% in 2008 — almost double the fall of the Dow. Its exposure includes the following countries: Turkey, 13.8%; Poland, 12.2%; the Czech Republic, 7.4%; and Hungary, 5%.

Another such ETF that tracks the region is the Claymore/BNY Mellon Frontier Markets (FRN), which is down 60% since its inception in June 2008, and 18.5% so far in 2009.

The main hope for a regional economic recovery — a multibillion euro bailout plan — was flat-out rejected by the richer (and more powerful) members of the European Union just a couple of weeks ago. The prime minister of Hungary had asked for nearly $240 billion to bail out the region, although some observers estimated that the total should be closer to $380 billion. Government officials in Germany and the Netherlands, however, countered that billions of dollars in aid went to the region last year and a new stimulus package is not needed. The risk for investors is that Europe’s already fragile financial health could be threatened further.

One consequence of the current economic turmoil is that the value of currencies in Central and Eastern European countries have been falling. As a result, the challenge of repayment for the borrowers is worsened because so many of them accepted loans in euros. With their domestic currencies sliding in value compared to the euro, the debt obligations are becoming even more onerous for the borrowers.

Europe now is at the proverbial fork in the road. If the economically stronger countries can muster a bailout for their Central and Eastern European counterparts, a buying opportunity may arise when emerging markets start to recover. But if a new, economic iron curtain develops, the result could be the financial collapse of emerging market European countries. With the region’s economic condition so tenuous right now, you may want to protect your money and avoid the risk altogether.

If you want further guidance about which ETFs to trade, check out my ETF Trader service by clicking here. As always, I am pleased to answer any questions that you have about ETFs. To send your questions to me, simply click here. I will try to follow up in a future ETF Talk.