There's a new subprime crisis in the news. Unlike the US original, however, which has sparked the worldwide recession, this one doesn't involve only falling home prices but also falling economies. The countries of Central and Eastern Europe, after years of high growth fueled by investment from Western Europe, are now heading towards a recession. The banks that provided much of the credit in the booming period, already hit by liquidity pressures due to events in the US and their home countries, are now faced with the prospect of big losses on the loans made in the Eastern half of the continent.
With the downturn in the US and the developed economies of Western Europe also came the end of the boom in the emergent Eastern European economies. The freezing of money markets in the United States and Western Europe in the summer of 2007, followed by a sharp increase in credit risk subsequent to the Lehman Brothers bankruptcy, drove investors into a liquidity scramble. In Eastern Europe, these events translated into capital repatriations, lower foreign investment and higher risk premiums. The slowdown in the developed economies and, finally, the onset of the recession in the second part of last year brought a fall in Eastern European exports, which further exacerbated the downfall. The region's currencies plummeted.
In Eastern Europe, banks were privatized during the 1990s and early 2000s. The preferred method of privatization was the sale — either by direct negotiations with the government in place or through a public auction — of a majority stake in a local state-owned bank to a big foreign banking group, deemed capable of restructuring it and making it profitable. Consequently, nowadays most banks in the region — and especially in those countries that are now members of the European Union — are owned by big Western Europe groups, such as Raiffeisen Zentralbank or Erste Bank of Austria, Swedbank of Sweden, Société Générale of France, Unicredit of Italy, KBC of Belgium, Bayern Landesbank of Germany and others. The Eastern European subsidiaries of all of these banks, often among the largest in their home countries, form a significant share of their assets. And because of this huge exposure, the growing crisis in Eastern Europe is now proving critical to their financial health. Furthermore, a fall of any one of these banks due to losses on their operations in Eastern Europe will add a new threat to the stability of the European financial system.
Thus, it turns out that Eastern Europe has now become the subprime borrower of Western Europe. As was the case with the US mortgage borrowers, both the public and private sector in Eastern European countries are highly leveraged while falling currencies and declining output mean lower income in the immediate future. Because of the deepening recession in the United States and Western Europe, the Eastern European countries are moving quickly into negative growth rates as well. And with them comes the increased risk of default on debts.
The banks now realize the gravity of the situation. Nine of the most exposed Western Banks in the region, led by the Raiffeisen group of Austria, have already called on the European Commission and the European Central Bank (ECB) to come to the rescue of Eastern European economies in order to avoid, later on, the repercussions that the loan defaults in the region will have on the financial health of economies in the west of the continent. The most exposed countries to a fallout in Eastern Europe are Austria, France, Italy, Belgium, Germany, and Sweden. Austria alone made loans of $297 billion to Eastern Europe, according to Josef Pröll, the Finance Minister in Vienna. This is the equivalent of 70% of the country's GDP.
However, Switzerland, a nonmember of the European Union, is also among the big creditors of Eastern Europe. The low interest on Swiss francs made it the main currency for mortgage credit in the region. Lending in Swiss francs reached around 50% of the total in some countries such as Hungary or Poland. According to a Morgan Stanely report based on the Bank of International Settlements' data on international lending, total foreign borrowing in Eastern Europe has reached $1.6 trillion as of September 2008, of which $1.5 trillion have been provided by Western European creditors.[1] Between 2005 and 2008 alone, the volume of foreign credit absorbed by the region grew three times. All this credit brought huge profits to the Western banks present in the region and was, to a large extent, responsible for the average growth rates of around 6% real GDP that Eastern Europe experienced during the last 7–8 years. Housing, cars, and other consumer durables were booming. At the same time, the lending standards became lax. In Romania, for instance, banks advertised that having an ID card was all you needed to get a loan. This worked well as long as growth was strong. But now Eastern Europe's economies are sinking, unemployment is rising, and the debt accumulated in these past years might not be repaid.
Loan Portfolios of Western European Banks' CEE Subsidiaries, H1 2008 (in millions of euros)
Sources: Company data, Merill Lynch estimatesCompiled by IMF Central Europe and the Baltics Office, November 7, 2008The prospect of a debt default is real. The local currencies are falling rapidly against the euro, the dollar, and the Swiss franc, making it harder for individuals, companies and governments to repay their debt denominated in Western currencies. The Baltic countries are the most indebted in the region. Estonia's foreign debt represents 131% of its GDP, for Latvia it is 116% and for Lithuania is 72%. Together, Eastern European countries have to repay $400 billion worth of debt this year alone.
Moreover, the growing contraction in output is pushing up the already high deficits in government spending at a time when borrowing costs and risk premiums have increased considerably. Given the capital exodus underway and the significant current account deficits, the Eastern European currencies will continue to lose value against the euro and the dollar even if the Hungarian forint, the Polish zloty, or the Romanian leu have already reached historical lows. Although the central banks in some countries, like Russia, Poland, the Czech Republic, or Romania, have significant foreign-exchange reserve and have used them to shore up some of the fall in their currencies, the macroeconomic imbalances are generally so great that the current crisis in Eastern Europe has the potential of surpassing the Asian currency crisis of the mid-1990s.
Under these circumstances, the banks are not the only ones that are calling on the wealthier European Union (EU) countries, the ECB, IMF, and the World Bank to bail out Eastern Europe. In the fall of last year, the IMF approved a $16.4 billion loan to Ukraine, whose currency, the hryvna, has lost half its value in the last six months, triggering a run on exchange houses. But the government is unable to reduce its deficit, and inflation is well over 20% per year. Hungary, the country with the biggest government debt, also received a $12.5 billion IMF loan, ten times it's normal quota, as well as an $8.1 billion loan from a special EU borrowing facility and a $1.3 billion credit from the World Bank.
In mid October, at the height of the credit freeze, the ECB also came to the rescue of Budapest and provided 5 billion euros in a swap arrangement with the Hungarian central bank to ease liquidity in the money market. This event marked a significant extension of ECB's role. It was the first time the bank, which oversees monetary policy for the 16-nation Eurozone, lent to a country outside the European Monetary Union. The ECB subsequently extended swap arrangements to the Polish central bank and, despite its reluctance, it will probably do so with other central banks in the Eastern part of the EU. In December last year, the IMF, together with the EU, the World Bank and Sweden, also loaned $10.5 billion to Latvia. On the other hand, Georgia got a ¾-billion-dollar credit line to prop up its currency, followed by Belarus, which received $2.5 billion in January of this year. Finally, Serbia is in the process of acquiring a $2 billion loan. But the other two Baltic states, Estonia and Lithuania, are next in line for IMF, World Bank, and EU help, followed by Bulgaria and Romania. Since the start of the Eastern Europe crisis in the fall of last year, the IMF has lent $40 billion. Counting the loans granted to Iceland and Pakistan, the figure has reached $50 billion.
The leaders of the richest EU countries, who gathered in Berlin before the second G20 summit since the world economic crisis began, now say they want to increase the IMF lending capacity from its current level of $250 billion to $500 billion. Japan has already pledged another $100 billion, but the big Western European countries might not be able to raise additional money, even as they discuss the possibility of issuing a new euro bond designed to reduce the risk premiums borne by the governments with lower sovereign credit ratings.
The United States is already in a mountain of debt, while China and Middle Eastern countries — which have the reserves needed — refuse to supplement IMF funding without receiving in exchange more voting power in the international body, a concession that the big European countries, whose voting rights will therefore be diluted, don't want to make.
Concentration of Emerging Europe's Exposure to Western Europe, H1 2008
Source: Bank for International Settlements, Quarterly Review, June 2008Note: Country names are abbreviated according to the ISO standard codes.Emerging Europe exposure to western European banks is defined as a share of the reporting banks in each western European country in the total outstanding claims on a given emerging European country (both bank and nonbank sectors). For example, about 42 percent of Croatia's exposures to western European reporting banks is owed to Austrian banks, 38 percent to Italian banks, 13 percent to French banks, etc. For the Baltic countries, 85 percent or more of exposures to the reporting banks is owed to Swedish banks.At the same time, within the EU, the southern countries (Spain, Italy, Portugal, Greece) and Ireland, confronted with severe turmoil in their banking system due to falling mortgage assets and rapidly contracting economies, want the ECB and the EU to channel their resources primarily into bailing out their banks. The politics of who is bailing out whom will become ever more complex as the economic crisis in Europe and the rest of the world deepens.
The current crisis in Eastern Europe, just like the one in America or the western part of the old continent, is a painful process, but a concerted international bailout of the irresponsible banks and governments of the region is not the solution. It was precisely such expectations, coupled with years of loose monetary policy in the United States and Europe, that created a chain of moral hazard which led to the current economic crisis.
The gradual lowering of interest rates by the Fed, the ECB, the Bank of England, and other independent European central banks, such as Riksbank and the Swiss National Bank, in the aftermath of the dotcom bubble and the 9/11 events, provided the incentive for Western European banks to overleverage their assets and then, through their subsidiaries, to begin extending poorly underwritten loans into a virgin Eastern Europe.
The Eastern European central bankers also joined in the effort of their Western counterparts in stimulating global demand, but their cuts were smaller and their interest rates remained comparatively higher. Consequently, some of the cheap money in the West was carry traded by sophisticated financiers in the East, making the local currencies, like the Romanian leu for instance, look strong. When the financial crisis unfolded in the United States and Western Europe in the summer of 2007, the reverse carry trade kicked in as investors drew on their money in Eastern Europe to cover their liquidity shortages. Then the funding lines of the parent banks (who now had problems of their own) to their local subsidiaries were cut back. The boom was now coming to an end in Eastern Europe as well. As interest rates went up, the housings and residential markets in Poland, Bulgaria, Romania, the Baltics, and Russia came to a halt and began to decline. The local banks were left with a pool of loans of uncertain value.
In many cases, high levels of government debt were a big part of the problem. Even though the region's economies experienced high growth rates in the previous years, in many countries the public debt grew. Hungary is the most prominent example among the Eastern European countries that are members of the EU, but relatively high government deficits were also the case in Romania. Among the non-EU members, Ukraine stands out as the country ravished by government spending excesses.
The main floating Eastern European currencies: Czech koruna, Romanian leu, Russian ruble, Hungarian forint, and the Polish zloty
Source: Danske BankHowever, the economic slowdown will increase budget deficits even in those countries where fiscal policy was relatively well balanced. In the case of Russia, which, unlike almost every other Eastern European country, has a current account surplus, the sharp fall in oil prices in the second part of last year considerably reduced revenues. This coincided with a significant deterioration of the business environment following the short war with Georgia, its small southern neighbor. The government's hostile policies led investors to pull their money out of the country, provoking a spectacular fall of the Moscow stock market and a plunge of the ruble.
There is tremendous pressure in Europe not to allow the bankruptcy of any banks that expect massive write-downs on their Eastern European operations; and, in the case of Bulgaria and the Baltic countries, the pegs to the euro formally exclude the devaluation of the currency. But a joint EU, IMF, and World Bank bailout for the region will amount to a continuation of the risk-subsidizing policy and market-discipline erosion that gave birth to the current turmoil in the first place.
The banks that gambled on ill-conceived loans would be rewarded for their inefficiency and kept alive through wealth redistribution from those businesses and individuals who were comparatively more prudent. The net effect of such policies is to encourage moral hazard in the future, which, in turn, will induce a higher unpredictability in the financial system.
However, Eastern Europe is not a homogeneous or even clearly definable entity.[2] The situation differs from one country to another. In same cases, particularly in non-EU ex-Soviet countries, such as Ukraine or — beyond strictly geographical Europe — Kazakhstan, governments might default on their foreign debt. Elsewhere some form of debt restructuring will be pursued, while in some places a combination of currency devaluation and refinancing would solve the problem.
The reality is that there is no costless solution out of the current mess. But using the ECB, the IMF, or the World Bank to absorb the losses of insolvent banks in the guise of smoothing temporary imbalances in the balance-of-payment system is the worst solution one can think of. In time, most of the external imbalances will work themselves out. Already, the economic slowdown is shrinking the region's current account deficits.
The rapid growth in prosperity that took place in most Eastern European countries during the last eight years has fueled high hopes of catching up with Western living standards. Not surprisingly, the economic downturn is sparking anxiety and, in some countries, even civil unrest. Although the situation will get worse before it gets better, the fear of an economic collapse that would transport the region back to the conditions experienced shortly after the fall of the communist central-planning system are exaggerated.
This doesn't mean, however, that there is no reason to worry. The policy choices enacted in the face of the current crisis will shape the potential for prosperity in the future. A full-blown bailout of the banks responsible for making bad loans will only further an economic system of private profits and socialized losses. Such a system is as incompatible with the free-market economy that many Eastern Europeans thought they were adopting after 1989 as is the old Marxist-Leninist socialism.
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Notes
[1] Stephen Jen and Spyros Andreopoulous, "Europe More Exposed to EM Bank Debt than the US or Japan," Global Economic Forum, October 27, 2008.
[2] A marvellous description of how, long before the advent of communism and the Cold War, 18th-century travellers from the French, British, or Austrian royal courts literally invented Eastern Europe as an imaginery buffer zone between the West — or, in short, civilization — and Oriental or Asian despotism is Larry Wolf's book, Inventing Eastern Europe: The Map of Civilization on the Mind of the Enlightenment (Standford University Press, 1994).
