Is Eastern Europe On The Brink Of An Asia-Style Crisis?

[Mid]

Doctor Doom

Is Eastern Europe On The Brink Of An Asia-Style Crisis?
Nouriel Roubini
06.11.09



The collapse of the Thai baht in July 1997 helped spark the Asian financial crisis. Could events in Latvia spawn a similar contagion? Eyes are focused on this small Baltic economy--amid growing talk of a devaluation--because of the potential for spillover effects into its fellow Baltic states, Sweden and the broader Eastern European region.

Strong trade and financial linkages, not to mention similar macroeconomic vulnerabilities, mean a Latvian crisis would almost surely have knock-on effects on neighboring Estonia and Lithuania. A Latvian crisis would also have negative spillover effects into Sweden via Swedish banks' heavy exposure to the Baltic trio. The wild card is how a Latvian crisis would affect the greater Central and Eastern European (CEE) region. Direct trade and financial linkages between Latvia and the CEE economies, excluding the Baltics, are limited. Nevertheless, many of these countries--particularly Bulgaria and Romania--share similar macroeconomic vulnerabilities with Latvia, meaning a crisis there could awaken investors to the potential for crises in the rest of the region.

What's the Matter With Latvia?

Once an investors' darling, Latvia's booming, double-digit growth earlier this decade was accompanied by massive imbalances--a current account deficit approaching 25% of GDP (among the world's widest) and an external debt load that peaked at over 140% of GDP. The correction in these imbalances would have been challenging under any circumstances, but the global financial crisis and consequent drying up of capital inflows have raised the likelihood of a full-blown balance of payments crisis. Latvia's currency, the lat (LVL), is pegged to the euro within a 1% (plus or minus) fluctuation band, and such pegs do not tend to survive harsh economic adjustments like that now under way. In countries with flexible exchange rates, domestic demand does not have to bear the full brunt of correction in external imbalances as currency depreciation can shoulder some of the burden.

Latvia's economy is currently on life support. Although agreement was reached in December on a 7.5 billion euros ($10.4 billion) IMF and E.U.-led rescue package, the government is now forecasting an 18% contraction in growth in 2009, making it one of the world's fastest-shrinking economies. The immediate focus is on whether Latvia will receive the 1.7 billion euros ($2.4 billion) installment of its loan package due in late June. The key stumbling block is Latvia's ability to meet the 5% of GDP budget deficit limit laid out in the loan terms. The problem is not that Latvia's government has been spending recklessly. Rather, the issue is that the drop-off in Latvian growth has been so precipitous, far beyond that envisioned when the loan agreement was signed just six months ago, that extreme fiscal belt-tightening is now required to meet the loan terms. A 5% GDP contraction was assumed in the original agreement, as compared to the 18% now forecast.

Latvia has been going to agonizing extremes to make the June payout happen, dramatically slashing public-sector salaries. More spending cuts are in the works. As Prime Minister Valdis Dombrovskis has pointed out, these belt-tightening measures will likely trigger an even deeper recession. Even with the cuts, Latvia's budget deficit is still expected to come in above the limit, and it remains unclear whether the IMF and European Commission are willing to relax the loan conditions. If Latvia does not receive the latest tranche of its IMF-led loan, the country will likely be facing a double whammy of default and devaluation.

Signs suggest that even with the June payout, Latvia may not avert devaluation. On June 3, the government failed to find any takers for the 50 million lats ($101 million) in bonds it was hoping to sell. While government officials still speak out adamantly against devaluation, many commentators now see devaluation as inevitable. A former prime minister has called for a 30% devaluation, and Bengt Dennis--a former Swedish central banker who now advises Latvia--recently said devaluation is unavoidable. At the same time, Latvia's central bank has been burning through its foreign reserves in its efforts to maintain the currency peg. From a peak of around $6.6 billion in mid-2008, foreign reserves had plunged to $4.1 billion at the end of May.

Why Hasn't Latvia Already Devalued?

A key part of Latvia's motivation in keeping its peg was its desire to adopt the euro early next decade. That goal, however, increasingly looks like wishful thinking given the current economic woes. Some have argued that Latvia is clinging to its currency peg to avoid mass defaults, owing to the high level of foreign currency-denominated lending there (around 90% of total loans). However, mass defaults will occur, regardless of whether Latvia devalues or adjusts via internal deflation. The key difference is that devaluation will likely lead to a more rapid wave of defaults over a shorter period of time, which could magnify stress on the banking system.

Potential for Contagion

Among the numerous reasons the IMF's senior representative for Central Europe and the Baltics, Christoph Rosenberg, gave in January for supporting Latvia in its desire to maintain the peg was the idea that devaluation in Latvia would have far-reaching effects beyond this small Baltic country. "[D]evaluation in Latvia would have severe regional contagion effects, especially given the fragile global funding environment. The spillovers could well go beyond pressures on countries with fixed exchange rate in the Baltics and Southeast Europe. For example, market confidence in foreign banks invested in the Baltics and similar countries would likely be affected, with implications for their ability to access wholesale financing."

Estonia and Lithuania

Strong trade and financial linkages, not to mention similar macroeconomic vulnerabilities, mean a Latvian crisis would almost surely spread to Estonia and Lithuania. Latvia's fellow Baltics are its top trading partners. Meanwhile, the same Swedish banks that dominate Latvia's banking system also dominate those in Estonia and Lithuania, providing another channel for contagion. Latvia is the weakest link of the three, having built up the largest imbalances. Nevertheless, the other two Baltics also experienced booming growth earlier this decade, along with double-digit current account deficits, and all three are in the midst of severe recessions. Most important, Estonia and Lithuania also have currency pegs to the euro, and Latvia's struggles are raising questions about the sustainability of their fixed exchange rates.

Sweden

While Sweden is not looking at a full-blown crisis, its strong financial linkages with the Baltics could dramatically cut into the Nordic country's growth prospects. Swedish banks have issued loans to Baltic borrowers equivalent to more than 20% of Sweden's GDP. According to Danske Bank, the loans could cost Sweden a total of 2% to 6% of its GDP over several years, depending on how many Baltic borrowers default. Fitch Ratings recently used a number of stress test scenarios to examine Swedish banks' ability to absorb losses in the Baltics. According to the results, Swedbank--one of Sweden's largest banks--could be particularly affected. Nevertheless, in late May, Danske said that all Swedish banks operating in the Baltics should remain solvent in a devaluation scenario. Some analysts have speculated that it may not be long before the Swedish state has to step in with direct financial assistance to help its banking sector.

Central and Eastern Europe (CEE)

The broader CEE region has minimal trade and financial linkages with the Baltics. So the key channel of contagion between the Baltics and the broader CEE region would be via the "wake-up channel," meaning a crisis in Latvia could serve as a wake-up call to investors, alerting them to similar vulnerabilities elsewhere. So far, the evidence suggests the rest of the CEE will not go unscathed if Latvia devalues, despite their limited linkages. For example, the recent sell-off in the Polish zloty and Hungarian forint was largely attributed to concerns over potential spillover effects from a Latvian crisis.

CEE countries are not a homogeneous bloc. Bulgaria and Romania, in particular, share a similar boom-bust trajectory to that being played out in the Baltics. External imbalances in these five countries rivaled, and in some cases exceeded, the build-up of imbalances in pre-crisis Asia. For example, current account deficits in Southeast Asia from 1995 through 1997 fell within the 3.0% to 8.5% of GDP range, while those in Romania, Bulgaria and the three Baltics were well over 10% of GDP in 2008. Like the Baltics, Bulgaria operates a fixed exchange rate system, and a key concern is whether a Latvian crisis would shake confidence in Bulgaria's currency board.

Romania and Hungary may have flexible exchange rates, but like Latvia, they have needed IMF-led rescue packages. If Latvia descends into crisis, it would highlight the fact that a rescue package, in and of itself, is not sufficient to avert economic meltdown.

Other countries in the region--Czech Republic, Poland and Slovakia--also built up imbalances in recent years and are in the midst of their own sharp slowdowns. Nevertheless, their imbalances never reached the same proportion as those in the Baltics and Balkans. Overall, their economies are in stronger positions to weather any contagion. Slovakia successfully entered the Eurozone earlier this year, while Poland qualified for a $20.5 billion flexible credit line from the IMF. An FCL is a precautionary facility, available only to countries with very strong fundamentals, which can be drawn upon at any time and without meeting any specific conditions. Such a facility should help provide Poland with a bulwark against contagion.

Latvia's woes are turning into a cautionary tale for other CEE countries vigorously pursuing euro adoption and could force a reassessment of the benefits. E.U. newcomers that have not yet adopted the euro are expected to participate in ERM II, a required currency stability test of at least two years for EMU hopefuls in which currencies are required to trade against the euro in a limited fluctuation band. A devaluation would force Latvia to start the challenging ERM II process anew.

Could a Latvian crisis Affect the Eurozone?

If a balance-of-payments crisis occurs in the Baltics and it spills over into other Eastern European economies (and note that this is a big "if"), then the Eurozone could be affected. The Eurozone's exposure results from Western European banks' heavy exposure to Eastern Europe, via subsidiaries, where they hold 60% to 90% market share (as a percentage of assets), depending on the country. Given the CEE's strong financial linkages with Western Europe, the health of Eastern Europe's economies and its banks could potentially afflict Western European banks.

Nouriel Roubini, a professor at the Stern Business School at New York University and chairman of Roubini Global Economics, is a weekly columnist for Forbes.
(Analysts at RGE Monitor assisted in the research and writing of this piece.)

forbes.com

[ItsRobsLife]

If a balance-of-payments crisis occurs in the Baltics and it spills over into other Eastern European economies (and note that this is a big "if"), then the Eurozone could be affected.

That 'if' is like a big pink elephant in the room. European banks hardly have enough funds to cover their own financial predicaments let alone support the looming crisis in the previously up and coming satellite states.

The UK's big 'if' over triple A status is starting to cut deep into local council budgets as the gov starts to enforce extreme spending restrictions, with healthcare and social support being the major target, local civil engineering projects are being shelved and there are even cutbacks in the extent of the olympic projects.

If other European countries are in a similar situation then the satellites can expect little support in a meltdown and indeed the Eurozone will find themselves dragged further toward that big 'if'.

[mrsquirrel]

Banks' exposure to eastern Europe
Stand by me

Jun 11th 2009
From The Economist print edition
Western banks have supported their eastern European subsidiaries—so far



WHEN it comes to banking crises, “Latvia on the brink” doesn’t really cut the mustard. At worst Western banks and their subsidiaries in the country could faces losses of $10 billion—about the same amount as a typical investment bank wrote off during a bad quarter in 2008. Yet the tiny Baltic state’s continuing battle to defend its currency peg cannot be dismissed: it is a reminder of the wall of bad debts faced by banks across central and eastern Europe (CEE), many of which have western European parents (see map).
Contagion is a risk. If Latvia’s peg goes, others in the Baltics and beyond may come under pressure, making it harder for those who have borrowed in hard currencies to avoid default. A Western bank could even abandon a local subsidiary, although Mark Young of Fitch, a credit-rating agency, thinks that is pretty unlikely as it would create wider fears among depositors and counterparties about foreign parents’ resolve to stand by their CEE operations.
An obvious test-case is the three Swedish banks that dominate lending in the Baltic states. Nordea, SEB and Swedbank own local lenders and, because their loans exceed deposits by a factor of two or more, also extend funding to them. They have prepared for rising losses by issuing a combined €5 billion ($6.9 billion) through rights issues in the past six months, adding almost a fifth to their tier-one capital.

Sweden’s central bank and banking supervisor have both recently published the results of stress tests which judge that, in the words of the latter, the system can “withstand extreme pressure”. The tests look fairly conservative, assuming loss rates on loans of up to a third in the Baltics and 60% in Ukraine. Tier-one capital ratios in the worst case drop to 6%, about the same level as permitted in America’s recent stress tests. For good measure Sweden has in place funding guarantees to help big lenders borrow and has also said it will inject more capital into banks if necessary. On June 10th its central bank borrowed a further €3 billion from the European Central Bank, in order to be able “to provide liquidity assistance” to banks.
Beyond the Baltics, funding from foreign banks to subsidiaries also looks solid. Romania, Serbia and Hungary have extracted commitments from lenders to maintain their exposure. This, along with help from the IMF, has been “an incredibly stabilising factor” for the wider region, says Manfred Wimmer, chief financial officer of Erste Group, an Austrian bank with big eastern European operations.
Experts have long warned against generalising about the region. So far this advice has proven right, with big discrepancies in impairment levels between countries. In the first quarter UniCredit, an Italian bank, recognised bad debts in Ukraine and Kazakhstan equivalent to an annualised rate of about 5% of loans. Yet the number for Poland was just 0.5%, and for its CEE unit overall 1.7%. The same variety typifies the other three Western banks that are most active in the region, KBC of Belgium, and Erste and RZB of Austria.
Bad debts everywhere will soar, however. There will be “serious pressure” on provisioning, says Federico Ghizzoni, who is responsible for UniCredit’s CEE operations. Is there enough capital to absorb the losses? Taking UniCredit, KBC, Erste and RZB together, and assuming a 40% loss rate in high-risk countries like the Baltics and Ukraine and a 10% loss rate elsewhere in the CEE region, the hit would eat up about a third of their combined tier-one capital—bad, but not terminal. Again, governments are standing by, having already injected funds into KBC and the Austrian banks. UniCredit is in negotiations to secure a combined €4 billion capital injection from Italy and Austria. As for funding, these lenders look in a far better position overall than their Swedish counterparts, with a combined loan-to-deposit ratio in CEE of about 115%. RZB has a bigger funding gap but Austria has said it will guarantee up to €75 billion of its banks’ borrowings.
The response to the crisis so far, with the IMF providing credit to the neediest eastern European governments and western governments offering support to their banks in the region, seems to have worked. That still leaves banks to work through bad debts and build up their local funding levels. Mr Ghizzoni says there is now “fierce competition for deposits”. The spivvy business model of borrowing euros and Swiss francs in the wholesale markets and then ramming them down CEE customers’ throats is dead. But the commitment of most western European banks to the region is, if a little grudging, still alive.

[mrsquirrel]

samvaknin wrote:
June 11, 2009 16:32

In August 2002, I conducted on behalf of UPI an interview with an Austrian banker. Notice his arrogant and hubris-filled, responses as he mocks my concerns (which, alas, turned out to have been prophetic):
http://www.upi.com/Business_News/2002/08/19/Interview-Austrian-bankers-r...
Austrian Banking - Interview with Wolfgang Christl
"Q: Many Austrian banks have aggressively spread to Central Europe - notably the Czech Republic, Slovakia, Poland, Croatia, and Slovenia. Do you think it is a wise long term strategy? The region is in transition and its fortunes change daily. Poland has switched from prosperity to depression in less than 7 years. Aren't you concerned that Austrian banks are actually importing instability into their balance sheets?
A: The move by the Austrian banks into central and eastern Europe is a very good niche market growth strategy. Austrian banks lost a lot of money in the UK, the USA, and in other parts of the world - but were very risk-conscious in central and eastern Europe, where, today, they generate high margins. In the years to come, this will be a strongly growing region. Entering these markets was a very positive decision.
Q: Austria's banks are small by international standards. Do you foresee additional consolidation or purchases by foreign banks, possibly German?
A: I am convinced that there will be additional domestic consolidation coupled with some foreign purchases. The three big German banks - HVB, Bayerische Landesbank, and Deutsche Bank - are already present in Austria.
Q: In 1931, the collapse of Creditanstalt in Vienna triggered a global depression. The markets are again in turmoil, the global economy is stagnant, and trade protectionism is increasing. Can you compare the two periods?
A: Thank you or the honor of triggering a global recession, but Creditanstalt was too small to do so. In my view, you cannot compare the markets today and in 1931. Financial skills and organizations are much more developed today. Social systems are much more secure than in the 1930's."
Sam Vaknin

[barbaro]

Mid, good topic and Mr. Roubini is worth reading and listening to.

Yes, Eastern Europe in general and some nations (mentioned above) in particular are hurting and on the verge of hurting more.

[Butterfly]

yeah Eastern Europe is one big problem for the Euro banks,

maybe we could include them in the EURO directly ? it might be the only solution eventually, if the banks want to recoup their investment

[Rural Surin]

Reality is starting to kick in. Domino theory.

[watterinja]

The reality of over-borrowing & over-lending needs to kick in. Hard lessons need to be learned.

"Get rich schemes are a disaster".

[Rural Surin]

The reality of over-borrowing & over-lending needs to kick in. Hard lessons need to be learned.

"Get rich schemes are a disaster".

Agreed. Borrowing and lending from what? There isn't any wealth to be borrowed nor lent {from}. Imaginary wealth and credit only props up the world's economic infrastructure for a time until it begins to crack.