Political risk has returned to central Europe as riots in Budapest and shaky governing coalitions elsewhere remind investors that joining the European Union guarantees neither wealth nor stability.

In Hungary, violent street protests and calls for the prime minister's head two weeks before local elections underline the region's mounting risks, until recently a favourite for investors betting on good returns from rising asset prices as euro zone entry neared.

In the past year elections have brought to power fractious coalitions, often with hardline politicians aggressively pushing for greater social spending, endangering euro adoption targets.

For central Europe as a whole politics is a headwind and something that's worrying for longer term investors, said Martin Blum, head of emerging markets at Bank Austria CA IB. Throughout 2006 it's been the case that we had a general backtracking of (euro accession) timings for the region.

The riots in Hungary, in which over 150 people were hurt, followed the leak of a tape on Sunday in which Prime Minister Ferenc Gyurcsany said he and his Socialist party had lied for four years about Hungary's budget in order to win a general election last April.

Gyurcsany won the election partly on a promise of tax cuts but has since imposed tax increases and benefit cuts worth $4.6 billion (2.4 billion pounds) in 2007 alone to curb Hungary's budget deficit which will surge to 10.1 percent of GDP this year, the biggest in the European Union.

In Poland, the ruling conservatives are tussling with radical coalition partners who are threatening to withdraw support if budget spending is not increased. And Slovakia's aim of joining the single currency in 2009 could be thrown off course by a coalition that includes leftist and far right nationalist parties.

And adding to Tuesday's gloom, Czech central bank chief Zdenek Tuma said his country's goal of euro adoption in 2010 is looking unrealistic.

I think the party is not totally over but it's definitely become a less happy party, said Lars Christensen, senior analyst at Danske Bank in Copenhagen.

Politics are moving in the wrong direction and in view of the global liquidity environment tightening, central Europe stands out for investors as a region that is doing worse, rather than better, in terms of policy, he added.

Investors dumped currencies, bonds and stocks across central Europe on Tuesday amid fears Gyurcsany could be forced out of office, endangering a reform package that is key to tackling the country's fiscal problems.

Hungarian forint bond yields have jumped 250 basis points in the past year, according to Reuters data, as investors priced in its enormous current account deficit.

Polish and Czech 5 year yields are up roughly 100 points while Slovak yields have risen almost 200 bps since last September partly a result of worsening politics at a time when global emerging market sentiment has also weakened.


Populist, euro sceptic political parties have prospered in recent elections, boosted by voters' weariness after years of painful reforms, and political wrangling, far from abating after each election, has often intensified amid coalition infighting.

There was a certain amount of hardship before EU accession, now there is no rush to get into the euro zone neither from the central European side nor from Western Europe, Dresdner Kleinwort strategist Jon Harrison said, forecasting losses on Polish and Hungarian assets as local elections approach.

Optimists argue that little has changed for the worse.

There has been no explosion in spending or significant fiscal slippage so far, they say, and Hungary has even introduced measures to clean up its act.

Economic growth is also buoyant, running at more than five percent a year in Poland and six percent in the Czech Republic and Slovakia.

But potential spending increases may fuel inflation and current account deficits are worsening. Rising interest rates are expected to slow growth and hit bond and stock markets.

The long view is that these countries will still eventually join the euro new EU member states do not have the option of not joining the single currency so convergence at some point is inevitable.

But in the meantime investors who bet billions that their economies would converge with those already in the euro zone between 2009 and 2012 are being forced to push back those dates further and further.

There is no political will, that's visible from euro adoption dates that keep getting pushed out, said Rob Drijkoningen, head of emerging markets debt at ING Investment Management. As long as the EU does not stand firm, none of them will have an incentive to do anything and that's disappointing.

Investors had been pricing in risks as bond spreads demonstrate. Most speculative players were flushed out during mid year market reversals, potentially reducing the impact of further political setbacks.

Some (investors) will sell out and some won't, but net net the risk premium has been increasing because of the postponement so its not as good as it might have been, Drijkoningen said.

But on the whole if people invested in convergence they made a fair amount of money in comparison to say (euro zone) Bunds so the story in itself has definitely paid off so far.