By Marcin Goettig and Sujata Rao
WARSAW/LONDON (Reuters) - The currencies of emerging European countries such as Poland and Hungary have dodged the giant selloffs hitting other emerging markets, and their links to a steadily recovering euro zone are likely to keep them insulated.
For years, Europe's slump and cautious monetary rules have dragged down economic growth in the region, making these countries less exciting for investors than destinations in Asia and Latin America. Now that curse is turning into a blessing.
Former investor darlings such as Brazil and India have seen currencies tumble as investors flee their stocks and bond markets in fear of a sharp growth slowdown. Their peers in central Europe, however, are largely holding steady.
Hit by the U.S. Federal Reserve's plans to reduce the flow of cheap money it pumps into the global economy, currencies such as South Africa's rand, India's rupee and Brazil's real have fallen 15-18 percent against the dollar this year.
By contrast, Poland's zloty has eased 3 percent against the dollar since January, while Hungary's forint, considered the riskiest regional bet because of Prime Minister Victor Orban's unorthodox policies, is down 2 percent
"This is due to a combination of a better outlook for core Europe, where the economy seems to be recovering, and an improvement in the underlying fundamentals of most of these countries," said Thanasis Petronikolos, head of emerging debt at Baring Asset Management in London.
He said his investment portfolio was factoring in that central Europe would perform better than emerging markets in Asia and some in Latin America.
No doubt, there are some clouds on central Europe's horizon - uncertainty about the impact of upcoming Fed measures and political instability ahead of elections next year.
But barring surprises and as long as the euro recovery stays on course, the region could stay stable for currency investors.
"We expect CEE currencies to continue to outperform other emerging markets until the end of next year," says Commerzbank currency strategist Lutz Karpowitz.
EURO ZONE ORBIT
Germany, the powerhouse of the euro zone and the source of most of emerging Europe's investment, posted forecast-beating business sentiment data on Thursday, leading improvements across the single currency bloc.
As the euro zone starts to emerge from recession, that translates into more growth for its central European neighbors, and therefore stable currencies.
As European Union members, Poland, Hungary and the Czech Republic are bound by the bloc's rules on fiscal consolidation. For the past several years, that has constrained their governments from running big deficits to boost growth.
But it also means countries in the region have small current account deficits, and some, like Hungary, even run a surplus. That spares their currencies the risk of a sharp decline if flows of foreign capital needed to fund a trade imbalance were to dry up.
An example of a currency hit by a current account deficit is the Indian rupee: with a gap equal to almost 5 percent of its economic output, the currency has fallen 15 percent this year, marking successive record lows in the past three months.
By comparison, Poland's current account deficit has shrunk to 1.9 percent of gross domestic product (GDP) from 5 percent in less than three years.
Hungary's current account surplus acts as a counter-weight to the perceived risks of Orban's policies, which include slapping heavy taxes on foreign banks.
"Countries with relatively good growth and few funding issues will do fine," said Carlin Doyle, emerging markets strategist at State Street Global Investments.
"Countries like South Africa and Turkey look a bit vulnerable, but Hungary does not have funding issues."
Central Europe is not entirely without risk, however. Economic recovery could be hit if foreign banks, under pressure to fix their balance sheets, keep cutting lending to the region. Many banks in these countries are fully or partly owned by western parents [ID:nL6N0G04NQ].
Poland faces elections in 2015 and opinion polls show Prime Minister Donald Tusk will lose. Investors see him as a guarantor of stability and predictable policies.
And while the zloty and forint have not been as sensitive to the Fed signals so far, they would not withstand a widespread market panic, analysts say, noting that even relatively "safe" assets such as the Mexican peso and Korean won have fallen prey to the storm in recent days.
Poland, with its large and liquid financial markets would be most at risk if redemptions from emerging market funds spiral.
"If the wave spreads, these countries will also get hit," said Societe Generale strategist Guillaume Salomon. "The difference is they will sell off less than other markets."
(Additional reporting by Carolyn Cohn in London)