Problems in Eastern Europe and How It Could Spill Over Into the US

The following from the NY Times addresses an often disregarded issue of the financial problems in eastern Europe. Often in the US we are so consumed with our mortgage problems that we fail to recognize that other parts of the world have their own problems, which could spill over on to the US. Text in bold is my emphasis.

Since the fall of the Berlin Wall, the countries of Eastern Europe have emerged as critical allies of the United States in the region, embracing American-style capitalism and borrowing heavily from Western European banks to finance their rise. Now the bill is coming due.

The development boom that turned Poland, Hungary and other former Soviet satellites into some of Europe’s hottest markets is on the verge of going bust, raising worrisome new risks for the global financial system that may ricochet back to the United States.

Last week, Wall Street plunged after Moody’s Investors Service warned that Western banks that had recently beat a path to Eastern Europe’s doorstep now faced “hard landings,” spooking investors with new fears that the exposure could spread beyond Europe’s shores.

“There’s a domino effect,” said Kenneth S. Rogoff, a professor at Harvard and former chief economist of the International Monetary Fund. “International credit markets are linked, and so a snowballing credit crisis in Eastern Europe and the Baltic countries could cause New York municipal bonds to fall.”

The danger is on several fronts. The big European economies, including Britain, France, Germany and Spain, are already in recession, and many of their largest banks have curbed lending at home and abroad.

For Central and Eastern Europe, which enjoyed breakneck growth thanks to a wave of credit from these banks, the squeeze could not have come at a worse time. Already bruised by the global downturn, they are on the verge of a downward spiral as the flow of credit dries up. Average growth among countries in the region slid to 3.2 percent last year, from 5.4 percent in 2007. This year, it is forecast to contract by 0.4 percent — and very likely more.

“These numbers will be coming down,” said Charles Collyns, deputy director of the research department at the International Monetary Fund.

Add to that a new worry: International finance officials fret that the worst regional economic crisis since the Berlin Wall came down could set off a contagion among the region’s currencies, with echoes of the Asian financial crisis of the late 1990s. Then, emerging markets like Thailand borrowed in foreign currencies to fuel growth, but suddenly owed more than they could afford to pay back once their own currencies lost value.

Since peaking last summer, Poland’s currency has slumped 48 percent against the euro; Hungary’s has fallen 30 percent and the Czech Republic’s is off 21 percent. “Very simply, Eastern Europe has become Europe’s version of the subprime market,” said Robert Brusca of FAO Economics in New York.

On Monday, the central banks of Poland, Hungary, Romania and the Czech Republic sought to restore calm by issuing statements arguing that the recent sell-off was not justified by economic fundamentals.

In addition, Western banks could very likely suffer a further increase in nonperforming loans. “Most of the banks in this region are from the euro countries and will have to undergo further recapitalization,” Gillian Edgeworth, an economist with Deutsche Bank in London, said.

Another problem is that big institutional investors in Western Europe — banks, pension funds and insurance companies — have large holdings of East European debt. If the banks need further infusions of capital from Western governments already straining to pay for stimulus packages and to maintain their social safety nets, it could put additional pressure on the euro as well.

“The threat to more developed economies goes through the banking channel,” Dominique Strauss-Kahn, the head of the monetary fund, said in a recent interview.

As the downturn worsens across the Continent, Mr. Rogoff explained, risk aversion can quickly spread to other parts of the world. Some investors hurt by plunging markets in Europe are having to sell American assets to raise money, adding pressure to a United States stock market already weakened by fears of nationalization.

“It’s one big trans-Atlantic money market out there, and these banks lend money to each other all the time,” said Simon Johnson, another veteran of the monetary fund who is a now a professor at the Sloan School of Management at the Massachusetts Institute of Technology. “Deutsche Bank and UBS and Goldman Sachs and Citi are all intertwined.”

In Eastern Europe itself, the risks for Western companies doing business there have also surged.

Until recently, for example, Eastern Europe and Russia were rare bright spots for the beleaguered American automakers Ford Motor and General Motors. In Poland, where G.M. has a major factory, sales rose 10 percent last year to 38,000 cars, while sales in Russia soared 30 percent to 338,000 vehicles.

Since then, demand has fallen sharply. In the Baltic countries, which were among the first to feel the chill, G.M.’s sales dropped an average of 57 percent in the final months of 2008.

Among the biggest victims of the crisis are tens of thousands of workers who had clawed their way to more prosperity, only to see their dreams crumble as jobs and the financial system eroded.

Because their declining currencies make it more expensive to import goods and to pay off foreign debts, governments have cut spending and reduced public services, leading to a wave of increasingly violent protests across the region that is threatening governments.

On Friday, the coalition government in Latvia — where the economy contracted more than 10 percent on an annualized basis last month — became the second European government, after that of Iceland, to collapse.

Meanwhile, in the Ukrainian capital, Kiev, demonstrators took to the streets Friday as depositors rushed to pull their money out of local banks.

The crisis has forced the monetary fund to step into the breach. In recent months, it has extended Ukraine, Iceland, Hungary and Latvia billions in aid. “I’m expecting a second wave of countries to knock at the door,” Mr. Strauss-Kahn said.

Two years ago, “the idea was very, very consistently projected that the I.M.F. would not have to help emerging countries any more,” and that the “financial markets would take care of it,” Jean-Claude Trichet, president of the European Central Bank, said Friday. Now, he said, this has proved to be “totally false.”

For Mr. Johnson and other students of financial history, the latest developments in Europe — especially in Austria, whose banking industry is heavily exposed to its Eastern neighbors — raise eerie parallels with the 1930s. Mr. Johnson notes that it was the failure of a Viennese bank, Creditanstalt, in 1931 that was a turning point in what became the Great Depression.

Mr. Johnson said he did not expect a repeat of that calamity, but he does foresee a long period of minimal growth, akin to Japan’s “lost decade” of the 1990s, in both the United States and Europe.

And while the United States may have been the trigger for this international financial crisis, it is hardly alone in shouldering the blame. “We set off the sticks of dynamite, but a lot of people had tinderboxes under their houses,” he said.