Loan Crisis Looming in Eastern Europe?

Will West European banks stand by their Eastern subsidiaries? This was question No. 1 once the global financial crisis crossed into Central and Eastern Europe last fall, with behemoths such as Unicredit (CRDI.MI) of Italy and Austria's Erste Group (ERST.PR) so entrenched in the region's banking sector.

So far, the answer has been "yes." West European sovereigns have maintained capital flows to the East, despite initial fears of protectionism, mostly because cutting the umbilical cord would have been catastrophic for both sides given these banks' ownership and lending exposure here.

The salient question now, though, is whether they can continue to do so if economic downturn in the post-communist countries brings a wave of non-performing loans (NPLs) in the coming months, as some economic watchdogs fear. A spike in NPLs would undermine the region's banks without considerable cash injections from their parent companies, threatening a new liquidity crisis that could undercut Europe's entire banking system.

If there "were a problem of bad loans or bad debt due to a high recession in some countries, then that could spread through the network," says Vladimir Gligorov of the Vienna Institute for International Economic Studies, adding that West European banks may lack "the capital to cover this kind of crisis."

For certain, this is a worst-case scenario. But if the global financial crisis has taught us anything, it's how quickly the doomsday prophecies of "alarmists" such as New York University's Nouriel Roubini can become reality.

And indeed, there is legitimate cause for concern. Of all the loans made in Central and Eastern Europe in the last decade or so, around 180 billion euros' worth are considered "at risk" today. European Union banks, primarily those in old member states, are exposed to the overwhelming majority of this debt, according to a February paper by Daniel Gros, director of the Center for European Policy Studies (CEPS), a Brussels-based think tank.

Nobody knows just how fast these "at-risk" loans are turning into NPLs, just that they are. The European Bank for Reconstruction and Development (EBRD), which warned of a potential emerging-Europe banking crisis in a May report on the region, says NPLs are up in the last few months. EBRD analysts are crunching numbers now to get a clearer sense of the problem, but current data are soft, many economists concede.

NPL volumes are nevertheless expected to increase as Central and Eastern Europe's economies contract – around 5 percent on average this year, according to the EBRD – as unemployment continues to rise and banks cut lending during the credit crunch. Foreign currency lending – many Hungarians, for instance, have taken loans in euros at lower interest rates than would be offered domestically, betting that the forint would remain strong – poses less of a threat. That's because, with the exception of the Baltic states, these loans comprise a relatively small percentage of GDP in the region's economies. It's worth noting, however, that any sharp depreciation in domestic currencies would be a shock.

What should be done? Though Central and Eastern Europe's banks look largely healthy at the moment, some economists have suggested pre-emption because it's unclear whether West European sovereigns – which since the crisis broke have received less than 200 billion euros in new capital from various government rescue plans to support the entire euro zone – would have the money to head off an emerging Europe-originated liquidity crisis.

"With regard to the western banks, while there is general support, notably in Austria, to support the banks if needed, there is still a capacity variable – the cost could simply be too large," says Jon Levy, an analyst at the Eurasia Group global consultancy in New York.

Institutions such as the EBRD and European Investment Bank have already stepped up with billions of euros in new loans to support Central and Eastern European banks, but more aggressive action might be wise. Think-tank head Gros has recommended a massive, EU-backed aid fund for the region's banks.

The so-called European Financial Stability Fund would be as large as 700 billion euros. It would be used to support new lending in Central and Eastern Europe, and for capital injections.

This might be more money than would be ultimately needed. But, as Gros points out, "the crisis is certain to get worse before a recovery sets in and it will thus be better to have such an instrument ready to face further emergencies."

After all, we don't want the "alarmists" proven right again.

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