Economic Problems Threaten Central and Eastern Europe

Posted by: Mark Scott on October 17

First, the financial crisis hit the U.S. Second, the fallout made its way across the Atlantic to Europe. Now, the credit crisis has its sights set on Central and Eastern Europe (CEE) — to date, the fastest growing region of the Old World. Yet this time around, it’s not subprime assets or now-toxic sophisticated financial instruments that are causing headaches from Latvia to Romania. Instead, the more traditional problem of currency instability has reared its head — and the CEE’s economy now is under threat.

The key problem is credit. Over the last ten years, foreign and domestic banks have outdone themselves to offer cheap loans and mortgages to consumers across Central and Eastern Europe. A lot of this credit was lent in foreign currency – primarily Euros and Swiss Francs — which offered interest rates that were roughly two-thirds less than local currency equivalents. According to Morgan Stanley, these countries now hold roughly $1.6 trillion of foreign currency debt — most of which is tied to the consumer, not corporate, market.

With access to capital now drying up worldwide, banks have stopped lending in foreign currencies and are calling in outstanding debts as they look to raise capital anyway they can. To make matters worse, the CEE economies are faltering due to the global financial crisis and their currencies are in a tailspin. That has left many consumers unable to pay their debts, raising concerns that Central and Eastern European countries may start defaulting on their foreign currency-related debt.

“The effects are going to be extreme, there’s no more access to foreign exchange,” says Morgan Stanley banking analyst Ronny Rehn. “These countries are super short of money just when new money isn’t available.”

In a precursor of possible future problems, Hungary announced a €5 billion ($6.7 billion) loan from the European Central Bank on Oct. 16 to service foreign currency-dominated debts. Approximately one third of the country's public debt and almost two-thirds of private loans are in currencies other than the Hungarian Forint. A day later, Ukraine reportedly said it had negotiated a $14 billion loan from the International Monetary Fund to help refinance foreign currency-dominated public and private debt. According to estimates, half of the country's total banking loans in 2008 are in foreign currencies. Other countries similarly are at risk.

These currency-related problems are set to get worse. Across the CEE region, the average current account deficit (the trade balance plus proceeds from foreign investments and net inflow of transfer payments) rose from 2% of GDP in 2000 to 9% in 2008. In certain countries, the figure is a lot higher -- Latvia and Bulgaria's estimated 2008 current account deficits are 22.9% and 21.4% respectively. That means countries are importing a lot more foreign currency-denominated goods than they’re exporting, reducing foreign exchange reserves and leading to the depreciation of local currencies.

The second problem relates to what happens to all that foreign currency-denominated debt if CEE consumers start to default. Of the estimated $1.6 trillion of foreign currency debt that is held within the region, Morgan Stanley reckons Euro Zone, Swiss, and Swedish banks lent $1.5 trillion (U.S., British, and Japanese institutions provided most of the rest). That includes $297 billion of loans from Austria, $214 billion from Germany, and $212 billion from Italy. Sweden also accounts for $83 billion of the $123 billion of foreign debt that the Baltic states (Estonia, Latvia, Lithuania) now owe.

If defaults start to rise, Central and Eastern European countries will be left in a bind. With new credit in short supply, governments may have to dip into their capital reserves to bail out cash-strapped consumers. Yet many of these CEE states lack sufficient foreign currency stocks to make up the shortfall. A similar lack of available credit led to the virtual bankruptcy of Iceland. Now analysts reckon more countries could be on the chopping block.

The possible bankruptcy of Central and Eastern European countries took center stage when central bankers, finance ministers, and leading bankers met in Washington, DC on Oct. 11 and Oct. 12. According to people familiar with the discussions, the idea of extending existing currency swap arrangements to emerging economies was floated. That would give CEE countries access to much-needed foreign currency. Policy-makers also discussed providing liquidity to these states through IMF credit lines -- similar to the $14 billion loan to Ukraine reported on Oct. 17.

Whatever measures are taken, analysts say something must be done quickly. With mounting foreign currency-dominated debt, depreciating local currencies, and domestic economies on the skids, time could be running out for Central and Eastern Europe.