CEE FX Under Pressure as Fiscal Divergence Widens, BNY Warns of Elevated Carry Risk

Fiscal trajectories across Central and Eastern Europe (CEE) are diverging more sharply than in recent years, creating an uneven landscape for currency investors and elevating carry trade risks, according to a new analysis from BNY. The note highlights that while some regional economies are consolidating budgets, others are loosening fiscal policy, directly impacting the risk premium embedded in their currencies.

Growing fiscal gaps in focus

BNY’s assessment points to Poland and Romania as the primary outliers on the looser side, with budget deficits expected to remain above 5% of GDP in 2025. Hungary, despite recent improvements, still carries elevated debt servicing costs that constrain the central bank’s ability to manage forint volatility. In contrast, Czechia has maintained a more disciplined fiscal stance, contributing to a comparatively stable crown and lower carry risk for investors holding long positions.

The divergence matters because CEE currencies are often grouped together by global investors seeking yield in emerging Europe. When fiscal fundamentals diverge, the correlation that traders rely on for hedging breaks down. This forces market participants to reassess individual country risk rather than treating the region as a uniform asset class.

Carry risk explained

Carry risk, in this context, refers to the potential for sudden currency depreciation that erodes the interest rate advantage an investor earns by holding a higher-yielding CEE currency versus a lower-yielding funding currency like the euro or Swiss franc. BNY notes that the risk is most acute in currencies where fiscal deterioration is not yet fully priced into forward rates.

For example, the Romanian leu has remained relatively stable in recent months, partly due to central bank intervention. However, BNY argues that the gap between spot stability and underlying fiscal weakness creates a vulnerability. If markets begin to price in a higher risk premium, the leu could depreciate sharply, punishing carry traders who assumed the current stability would persist.

What this means for investors

The key takeaway for currency market participants is that a blanket approach to CEE FX carry trades is no longer advisable. BNY recommends a more granular assessment of each country’s fiscal outlook, central bank credibility, and external vulnerability. Poland’s zloty, for instance, benefits from a larger and more diversified economy, but its fiscal trajectory remains a concern. Hungary’s forint is sensitive to EU fund disbursements and political risk, while Czechia’s crown offers lower yield but also lower volatility.

The analysis also underscores that the European Central Bank’s monetary policy path will play a significant role. A faster pace of rate cuts by the ECB could narrow interest rate differentials, reducing the appeal of CEE carry trades generally. Conversely, if the ECB holds rates higher for longer, the divergence in fiscal credibility within CEE becomes the dominant factor for currency performance.

Conclusion

BNY’s warning serves as a timely reminder that fiscal discipline is becoming the defining variable for CEE currency performance. As budget gaps widen in some countries and narrow in others, the era of treating the region as a homogeneous carry trade destination is ending. Investors who ignore this divergence do so at their own risk.

FAQs

Q1: What is fiscal divergence in the context of CEE FX?
It refers to the growing difference in budget deficit levels and debt trajectories among Central and Eastern European countries, which directly affects the risk premium investors demand for holding their currencies.

Q2: Why does BNY consider carry risk elevated now?
Because the gap between stable currency spot rates and deteriorating fiscal fundamentals in some CEE countries creates a vulnerability. If markets reprice risk, currencies could depreciate sharply, eroding carry returns.

Q3: Which CEE currencies are most at risk according to BNY?
The analysis highlights the Romanian leu and Polish zloty as facing higher carry risk due to persistent fiscal deficits, while the Czech crown is seen as relatively more resilient due to better fiscal discipline.