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Lagarde Says Eastern Europe Faces Risk of Liquidity Squeeze

International Monetary Fund Managing Director Christine Lagarde warned that eastern Europe may face a credit squeeze as western European banks mired in the euro-area debt crisis withdraw liquidity from the region.

“Big fault lines” remain in the former communist bloc’s financial systems, adding to its high dependence on exports to western Europe, Lagarde said today in speech at Moscow’s State University of the Ministry of Finance after meeting President Dmitry Medvedev. The risks include a high share of external debt and loans in foreign currencies, both funded by western banks, she said.

“If the storm strengthens further in the euro area, emerging Europe as its closest neighbor would be severely hit,” Lagarde said. “This time around, western parent banks, which have been instrumental in keeping those economies afloat, would no longer necessarily be here to sustain growth and the health of those countries.”

Lenders that bankrolled eastern Europe’s boom before the 2008 credit crunch are being squeezed by deteriorating loan quality and slowing economic growth. The region was the world’s worst-hit in the aftermath of the collapse of Lehman Brothers Holdings Inc. three years ago and may face the threat of another sharp slowdown as the euro area’s troubles spread.

‘Issue of Availability’

“The issue of availability of liquidity may very well come back as we see some of those western banks withdraw, reduce their activities, reduce their exposure,” Lagarde said, diverging from the text of the speech released by the IMF.

Lagarde’s remarks echoed the European Bank for Reconstruction and Development, which warned last month that regulatory pressure on euro-area banks to raise capital ratios may result in less support to local units. About three-quarters of eastern Europe’s banking industry is owned by western lenders such as Italy’s UniCredit SpA, Austria’s Erste Group Bank AG and France’s Societe Generale SA.

A possible withdrawal of funds by west European banks from Russia is among the country’s “significant vulnerabilities,” Lagarde said, urging the government of the world’s biggest energy exporter to “rebuild fiscal buffers while oil prices are still high.”

Excess Liquidity

Russian units of foreign banks including UniCredit and Societe Generale have started lending excess liquidity to their parents since the middle of the year amid the debt crisis, using “central bank liquidity” and funds from their Russian operations, Deputy Economy Minister Andrei Klepach said Oct. 27.

Foreign banks “facilitated” capital flight three years ago during the country’s record economic slump, Prime Minister Vladimir Putin has said.

Russia, the only one of the so-called BRIC countries without capital controls, may see $70 billion leave the country this year, more than double last year’s $33.6 billion of outflows, the central bank estimates.

“There is no decoupling” between advanced and emerging economies, Lagarde said. “There is close dependency, strong connectedness between economies.”

While eastern European economies have reined in the current-account deficits that plagued them in the runup to the 2008 crisis, their fiscal leeway to counter a downturn has narrowed, Lagarde said.

“Back then, because they had sown in good times, countries were able to reap in bad times, letting public demand expand to partly cushion the decline in private demand,” she said. “That option is no longer on the table.”

‘Vienna Initiative’

The IMF and the EBRD were among the orchestrators of an accord known as the “Vienna Initiative” in 2008 and 2009 that combined emergency loans from public institutions for countries including Hungary, Latvia, Romania, or Ukraine, with pledges by the western banks to roll over financing for their units and recapitalize them as necessary.

That accord has been called into question by banks including UniCredit and Erste, which said they will be more selective in their investments and less reliant on passing on scarce liquidity to their subsidiaries. Western regulators are encouraging those strategies.

Banks in eastern Europe should “lend what is possible based on local refinancing,” the Austrian central bank’s head of banking supervision, Andreas Ittner, said last week. “I consider this a crucial element of a sustainable business model,” he added.

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