Eastern Europe, which narrowly escaped financial meltdown early in the year, is looking wobbly again. The International Monetary Fund has delayed aid to Romania amid political turmoil. Hard-pressed Latvia is trying to avert a sharp devaluation of its currency. And Ukrainian leaders are backstabbing each other as energetically as ever. A crisis in any of these countries once could have sent Eastern Europe into a tailspin. Yet in contrast to early 2009, there is little fear that foreign investors will flee en masse or that dozens of banks in the region will fail. What changed? The rebound of the global economy helps, of course. But part of the explanation can be found in a modern building on Mariahilfer Strasse in downtown Vienna. There, on Mar. 26 of this year, at an institute normally used to teach Eastern European bureaucrats about market economics, roughly 40 bankers and public officials gathered to find a way to avert a regional financial disaster that could have had global implications. The meeting attracted more people than organizers expected, and the small classroom quickly grew uncomfortably warm. The tone was businesslike, but stress and overwork showed on the faces of the participants as they sat shoulder to shoulder around a large U-shaped table. "There was an enormous amount of uncertainty. People were really afraid to think beyond the next two or three weeks," recalls Anne-Marie Gulde, a senior adviser in the IMF's European Dept. who attended the sessions. "A Very Real Risk"By the end of the day, participants had launched a rescue effort known as the Vienna Initiative that continues to underpin Eastern Europe's banking system. In subsequent months the IMF, with financial backing from the European Union, pumped $78 billion into Eastern Europe to stabilize national economies. In return, Western European banks operating in the region, such as Italy's UniCredit (CRDI.MI) and Vienna-based Raiffeisen International (RIBH.F) agreed to continue supporting their Eastern European subsidiaries. The actions averted widespread bank failure that could have fed a disaster as big as the Asian financial crisis in the late 1990s. "It was a very real risk," says Erik Berglof, chief economist for the European Bank for Reconstruction & Development (EBRD). If one bank had panicked and withdrawn support for its subsidiaries, "that would be a trigger for a complete run for the exits." Managers of banks in the region deny that they ever considered pulling out, but they agree the situation was grave. "It was clear after the collapse of Lehman Brothers that if we managers of systemic banks didn't take the future in our hands, then we might have run into serious troubles in Central and Eastern Europe," says Herbert Stepic, chief executive of Raiffeisen, the second-largest bank in Central and Eastern Europe after UniCredit. Unsung Midlevel HeroesThe success of the Vienna Initiative was a minor miracle, largely overlooked amid bigger crises in the U.S., Western Europe, and China. The rescue attracted scant notice in part because it was the work largely of midlevel officials, such as the IMF's Gulde, who are little known outside their own fields. The Western European heads of state, the Central Bank presidents, and the high-profile investment bankers were too busy trying to save the global banking system. Yet Eastern Europe owes its salvation to people like Thomas Wieser, a civil servant in the Austrian Finance Ministry. The U.S.-born Wieser, an economist by training who is the equivalent of an under secretary, played a key role in organizing the Mar. 26 meeting. Austria had a national interest in stabilizing Eastern Europe, because its banks have expanded aggressively in the region. "We needed to move," he says. But the low-profile nature of the Vienna Initiative also means there has been little pressure on political leaders to address the weaknesses that the crisis exposed—in particular a lack of adequate regulatory supervision. Although Western European banks operate regionally and globally, government oversight takes place at the national level, with little coordination. "You need not just similar rules but identical rules, and the more identical the better," Wieser says. There has been talk of creating pan-European financial regulatory boards, but proposals have already run into political opposition from members of the British Parliament and others. For now, nothing prevents banks in the region from resuming some of the practices that fueled the crisis in the first place, such as making loans to Eastern European customers denominated in euros or Swiss francs. Such loans, which offered lower interest rates in inflation-prone countries such as Romania, backfired when the domestic currencies plunged. Little Help from the EUThe crisis also exposed the European Union's inability to cope with problems in its own banking system. While the EU provided most of the money for the rescue of Eastern Europe, the Washington-based IMF did most of the work, negotiating and enforcing the terms of loans to EU members such as Hungary and Latvia. The IMF—much maligned for its handling of the Asia financial crisis in the late 1990s—gets kudos for its recent work in Eastern Europe. "The IMF's help was very welcome," says Jean-Didier Reigner, head of Europe at Société Générale (SOGN.PA), which operates banks in the Czech Republic, Romania, and other countries. The wealthy members of the EU, meanwhile, have not shown much concern for the banking problems of their poorer relations. "They had their hands full stabilizing their own economies and were not very receptive to a new request," recalls Raiffeisen CEO Stepic. On the contrary, the national governments sometimes undermined one another. Wieser, the Austrian Finance Ministry official, recalls getting a panicked call in late 2008 from a Slovenian minister wondering why capital was suddenly flooding out of his tiny country. It turned out that Ireland had boosted deposit guarantees to stabilize its domestic banks. The unintended side effect was to suck capital from other EU countries such as Slovenia. So why are investors more confident in the region now? While the crisis exposed weaknesses, it also highlighted strengths. Earlier this year, investors feared that a currency devaluation in a highly indebted country such as Latvia could set off a panic that would race across the region. "Eastern European crisis may put us all in the goulash," warned a headline in The Times of London in February. In fact, it turned out that countries such as the Czech Republic, Slovakia, and Poland were in decent shape, with open economies and low debt. All three are growing again, and Poland is the best-performing economy in the European Union. "The region proved to be stronger and more in equilibrium than some analysts and economists expected," says Federico Ghizzoni, UniCredit's head of Central and Eastern Europe banking operations. The crisis also demonstrated that the Western European banks that dominate financial services in the region were on firmer footing than some economists feared. One oft-quoted figure was that lending by Austrian banks in Eastern Europe equaled up to 80% of the country's gross domestic product. The implication was that exposure to the region could cripple Austria. Overlooked was the fact that some two-thirds of lending by Austrian bank subsidiaries in the region is funded by local depositors. In Slovakia, for example, deposits by Erste Group's (ERST.F) local customers exceed the amount the bank has loaned out. "Subprime is not what we're doing" in the region, says Erste Chief Risk Officer Bernhard Spalt. "We are doing a very boring plain-vanilla retail business." Troubled GovernmentsEastern Europe also has benefited from massive financial largesse. In addition to the IMF, institutions such as the EBRD and European Investment Bank pumped money into the region. For example, the EBRD lent $639 million to UniCredit subsidiaries so they could in turn step up lending to Eastern European customers. The EBRD also lent directly to businesses in the region. Examples range from $1.5 million to finance expansion by a Macedonian cheese producer to $296 million to build a gas storage facility in Hungary. Yet it would be premature to sound the all-clear. Latvians, who took to the streets early in 2009, remain restive as the government makes draconian budget cuts to avoid currency devaluation. The Ukrainian government remains dysfunctional, with continuous feuding between Prime Minister Yulia Timoshenko and President Viktor Yushenko. "In a country with 46 million people, this [is] a very alarming situation," reports one senior banker who visited Ukraine at the height of the crisis and asked not to be identified. Hungary, once one of Eastern Europe's great success stories, is still trying to dig itself out of debt. Citizens of Central and Eastern European countries will feel the effects of the crisis for months and years. Unemployment may continue to rise and so will loan defaults. "The pain ordinary people will feel through unemployment or reduced income or higher taxes—probably most of that still lies ahead," says Thomas Mirow, president of the EBRD. Adds Mary Stokes, an analyst at New York-based global economy watcher RGE Monitor: "Even as economies recover, there are still skeletons in the closet."
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