Europe's Fallen Angels; The EU's newest economies may be headed for trouble.

Byline: Emily Flynn Vencat

It's no secret that emerging markets have had an easy ride for the last few years, as the search for double-digit profit margins has pushed investors into riskier areas. Foreign direct investment in developing countries reached $542 billion in 2005, up 37 percent year-on-year. The numbers are stellar, so much so that many economists have begun taking bets on which country will be the first to falter. But instead of the usual suspects in Asia or Latin America, many experts are pointing to Eastern Europe. There, states like Poland and Hungary, long buffered by their EU membership, are in danger of losing their economic halos as a combination of populist governments, reform fatigue and chronic overspending threaten their prosperity. As Neil Shearing, an analyst at London-based Capital Economics, puts it, "All the dynamics are there for a complete meltdown."

You wouldn't guess it at first glance. The four biggest economies to join the EU in 2004--the Czech Republic, Hungary, Poland and Slovakia--averaged a robust 5 percent GDP growth last year. The boom is, of course, fueled by record levels of foreign capital--up 19 percent to $57 billion, more than twice the amount flowing into the whole Middle East. What's more, the capital is cheap, thanks to the "halo effect"; that is, the perception that these countries are inherently less risky because they are European. According to an IMF report due out this week, borrowing costs in Central Europe are a full percentage point less than one would expect given the economic, financial and political risks the countries pose. It seems that markets mistakenly perceive EU membership as providing some sort of implicit guarantee against sovereign risk, says Susan Schadler, deputy director of the European Department at the IMF.

You only have to look southward (think Greece and Italy) to realize that it doesn't. Even as East Asia, Latin America, sub-Saharan Africa and Central Asia are improving their current account balances, Eastern Europe continues to consume much more than it produces, with average ...