CEE Losing Momentum

Not long ago everyone was talking about „decoupling“, the supposed ability of emerging market economies to keep growing even if other economies fell into recession. That was then. Now the “hard landing” in emerging markets may become the “second epicenter” of the global crisis and CEE looks like it may take center stage. After years of credit excesses, few places look more vulnerable than the countries from the Baltics to the Black Sea.

 

 

CEE´s Achilles heel(s)

 

Precise predictions are tenuous at the moment since the crisis is far from over. Yet most conference participants in Vienna pointed at the most obvious risks for the region: First there is the risk of a rapid slowdown in credit expansion. The huge credit expansion of the past years is turning into a problem for foreign banks as the quality of outstading loans is deteriorating rapidly. Many of those banks are going through a process of rapid deleveraging in their home countries. The scarcity in global liquidity and global capital affects many parent banks, prohibiting them from transferring liquidity to CEE, especially to the countries with loans that exceed deposits. Thus, credit expansion in CEE is expected to be based on domestic means, i.e. domestic deposit expansion. UniCredit board member Erich Hampel said that the bank was committed to fund its subsidiaries in those countries and would continue to lend to consumers and companies. "Coordination is essential and a 'Plan for CEE' should be designed” said Hampel. He called on other international banks active in the region, the European Union, the International Monetary Fund and other institutions to launch a joint plan to stem the threat that funds could stop flowing and choke economic growth.

FX mismatches

A second risk, and a main reason for the growing number of defaults, is the large FX exposure of firms and households in CEE. The rapid depreciation in some of the currencies of CEE is creating problems in firm and household debt servicing. This is particularily true for the Baltics, Hungary, Romania and Ukraine. According to Analyst of Deutsche Bank foreign currency loans amount for more than 50 % of total loans in these countries. In Latvia and Estonia this ratio is 80%.
The Czech Republic is an exception in that regard, according to Zdeněk Tůma, Governor of the Czech National Bank: “Czech banks are not reliant on international funding. The main source of credit is customer deposits, the ration of loans to deposits in the Czech banking system is still well below 100%. Bank loans are predominantly denominated in Czech koruna and so are the customers´deposits held with domestic banks. We do not face the usual problem of emerging economies with households and firms getting credit that is sourced in foreign currencies. This is simply an outcome of the credibility that our monetary policy and relatively long period of low inflation, as well as of nominal interest rates, has gained.”

Disappearing investor base

A third risk is that of a sudden stop in capital inflows. The astonishing supply of developed government debt that is poised to flood the market over the next couple of years will surely crowd out money that could be put to work in markets such as CEE. Real estate FDI is declining fast, bank capital infusion as well, whereas new green field investments are very questionable. The countries of CEE run high current account deficits and have large exposures in foreign debts. If capital from abroad dries up, it may generate a large domestic recession. Markets are already aware of this risk, driving the interest rates of credit default swaps are a lot higher for those countries that have higher such exposure.

 

Austria and CEE

 

One country´s banking system looks most vulnerable. Austrian banks have dominated the surge of foreign currency loans to former regions of the Habsburg Empire. The failure of Credit Anstalt in May 1931 brought the Great Depression´s financial crisis to Central Europe. Viennese banks may find themselves playing a similar role as the current disaster unfolds.

According to the Austrian Financial Market Authority (FMA) the total amount of outstanding loans of Austrian banks to the CEE region (including Russia and Ukraine) is USD 300 billion. This amount equals 68 % of Austrian GDP. It also makes Austria the leader in terms of total exposure of EU-banks to CEE (20 %), followed by Germany (15,8 %) and Italy (15,6 %).

 

Conclusion

 

What will happen next? In light of all the calls for state invention and the multi-billion infrastructure programs  that are proposed to boost the economy in the region we are reminded of the Frenchman Frederick Bastiat, who grimly joked 200 years ago that breaking windows might also be a good way to stimulate the economy, as glaziers will have more money to spend. The fallacy Bastiat wanted to highlight is of course that such policies ignore the loss for the homeowner who has to pay the glazier.

As Europeans consider the way forward, it´s not too late for them to consider also Bastiat´s famous description of the state as “the great fictitious entity by which everyone seeks to live at the expense of everyone else.” Indeed, current economic policy is full of schemes for getting something for nothing, with government bonds clearly looking like the next bubble in the making. Banks and bond markets are being reduced to mere channels for the financing of huge public sector deficits. Some argue that the government can spend without taxing at all; that it can continue to pile up debt without ever paying it off because “we owe it to ourselves.” However, such pleasant dreams in the past have always been shattered by national insolvency or runaway inflation - all government expenditures must eventually be paid out of the proceeds of taxation; with inflation itself being merely a form, and a particularly vicious form, of taxation.