Euro Crisis in ‘Uncharted Territory’ Menaces Eastern States

The European debt crisis has entered “uncharted territory,” rekindling concern it will spread eastward through banking and trade links, according to the European Bank for Reconstruction and Development.

Italy’s Unicredit SpA (UCG) and Intesa Sanpaolo SpA (ISP), two of eastern Europe’s biggest lenders, fell to the lowest in more than two years July 11 as political infighting threatened to delay efforts to cut the budget deficit in the country with Europe’s largest debt burden. European leaders this week failed to agree on a new aid package for Greece.

“We are in uncharted territory,” Erik Berglof, chief economist at the London-based EBRD, which invests in eastern Europe and Central Asia, said in a July 12 interview. “The source of the contagion seems to be in worse shape.”

The EBRD led efforts to persuade western banks, with 76 percent of the eastern European market, to maintain their commitment to the region when credit dried up in 2008. The debt crisis’s expansion to Italy, Europe’s fourth-largest economy, would increase the risk that lenders facing losses at home would curb lending in the east, stalling the region’s recovery.

Europe’s debt woes have entered a new phase, and policy makers must come up with a “clear” response to stop the contagion that threatens the euro, the European Central Bank’s incoming president, Mario Draghi, said yesterday in Rome.

Resisting the Pressure

Ireland on July 12 joined Portugal and Greece as the third euro-area nation to have its credit rating reduced to below investment grade. All three received bailouts from the EU and the International Monetary Fund.

“The whole effort at trying to resolve the euro zone crisis has been focusing around building a defense between the three countries that already have programs with the EU and the IMF and Spain, possibly Italy,” Berglof said. “There’s now concern about the ability of this wall to resist the pressure.”

Yields on Italy’s 10-year bonds reached an intraday high of 6.02 percent on July 12, widening the spread over German bunds to a euro-area record of 318 basis points. The yield was at 5.69 percent as of 12:43 p.m. today in Milan. Spanish bond yields soared to 6.31 percent on July 12, the most since the euro was created. They traded at 5.91 percent today.

Spanish Finance Minister Elena Salgado said yesterday in Madrid that her country may need deeper spending cuts next year to stave off contagion. Fitch Ratings cut Greece’s credit rating to the lowest for any country yesterday, citing the lack of a “fully funded and credible plan” to reduce debt.

Markets ‘More Pessimistic’

“Suddenly the markets seem to have taken a more pessimistic view on the possibility of resolving the euro zone crisis,” Berglof said. “The potential direct impact is on southeast Europe, and the indirect impact is through banks in western Europe and ultimately also through growth in the euro zone,” the biggest market for eastern European countries.

While southeast Europe is the area that’s most at risk, given its proximity to Greece, an escalation of the crisis would hurt more western European banks, with implications for all of the EBRD’s recipient nations, Berglof said.

Greek bank units in the Balkans, including Bulgaria and Romania, received 630 million euros ($871 million) in loans from the EBRD in October. The EBRD expects the Balkans to expand 1.9 percent this year, half the pace of the rest of central and eastern Europe.

Almost a third of Bulgaria’s banks and 12 percent of Romania’s are owned by Greek parents such as Piraeus Bank SA and Alpha Bank SA. Greek lenders own 15 percent to 25 percent of the banks in the non-EU states of Macedonia, Serbia and Albania.

No ‘Spillovers’ Yet

“We spent a lot of energy trying to build a wall against spillovers into southeast Europe,” Berglof said. “So far we don’t see signs of spillovers in that part of the world. We’re not saying this is the main scenario, just something we have to be worried about.”

The biggest threat is that western European banks, which have increased loans to businesses and consumers this year, will rein in that financing, derailing the recovery, Berglof said.

The EBRD in May raised its 2011 economic-growth estimate for the 29 countries where it invests to 4.6 percent from the 4.2 percent forecast in January. It expects growth to slow to 4.4 percent next year.

While the largest western banks pledged to stay in eastern Europe at the height of the credit crunch, they reduced lending by 15 percent over the last two years, according to IMF data.

“Foreign banks have been quite restrictive with credit, and it’s only recently that they are restarting lending again,” Berglof said. “We are concerned that this will now contract again.”

The ultimate level of contagion would be if western banks had difficulty supporting their eastern units, he said.

“What’s happening now, if it’s sustained, it will weaken for instance Italian banks’ ability to lend to the region, and that’s something that we are, of course, concerned about,” Berglof said. “The funding from parent banks has come down and these subsidiaries are fully contained in the local markets, but there still is a risk of spillovers.”

To contact the reporter on this story: Agnes Lovasz in London at alovasz@bloomberg.net

To contact the editor responsible for this story: Balazs Penz at bpenz@bloomberg.net

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