Since last September when the collapse of Lehman Brothers triggered global financial turmoil, policymakers have lain awake at night fretting over where the shock waves would next be felt. The answer came earlier this year when Central and Eastern European (CEE) economies crashed, driven by a slump in demand from the EU. 


Ukraine has been among the worst hit. Demand for its steel and agricultural products collapsed, driving GDP down 15%. Like other countries in the region, it had been bingeing on credit. Since 2006, its mortgage bill soared by more than 4,000%.


Trouble is also brewing in Latvia, whose sovereign debt crisis in June looked certain to lead to a devaluation of the lat by as much as 30%, compounding predicted GDP contraction this year of 18%. The immediate effect was a sharp fall in the Swedish krona, reflecting Swedbank, SEB and other Swedish banks’ exposure to the Baltic States of €53bn. 


Members of the EU but not yet the euro, Latvia, Estonia and Lithuania may all experience devaluations this summer – a necessary pain according to the IMF, and a calamitous threat to the EU’s fixed exchange rate mechanism according to Brussels. Either way, the Baltic summer of discontent is just the latest chapter in a saga that could unravel Western European banks, whose exposure to CEE totals €1.3tn.


Those banks that fuelled explosive growth in CEE now fear a tsunami of defaults, which could cripple already-fragile balance sheets. 


Austria, in particular, is home to three of the largest banks in CEE – Erste Bank, Raiffeisen Zentralbank Oesterreich, and Bank Austria. Excluding the latter, owned by Italy’s UniCredit, estimates put Austria’s lending to the region at more than 70% of its GDP. 


It is not alone. Sweden, Greece and Italy all joined the lending spree following the fall of the Berlin Wall. They in turn have borrowed heavily from German investors and banks.


But just how bad is the situation really in CEE? Some argue that the crisis has been exaggerated by the Western media. Ionut Stanimir, a spokesman for Erste Group, says: “One cannot say it is fine, but it is not the apocalypse.” He rejects claims that funding has dried up entirely. Companies that have settled in the low-cost region are likely to stay and can provide loans to their subsidiaries. Some foreign banks have local divisions funded by local deposits, so have no reason to flee. He also warns against lumping the fortunes of the whole region together. 


Mark Young, managing director in Fitch Ratings’ financial institutions team, agrees the markets should be looked at individually, but warns the potential for contagion is high. “A problem in one market will have a ripple effect from a confidence perspective. If there were concerns that one of the Western European banks were not supporting their subsidiary in CEE, that would contribute to depositor flight from banks in the region.” 


The flow of funds has already reversed. Western banks have taken fright and stopped lending abroad, many of them too busy grappling with problems at home to focus on other markets. The UK’s HSBC recently confirmed that it had abandoned consumer lending operations in Hungary and will have pulled out of the country completely by 2012. Erste Bank, meanwhile, is shutting down branches in Ukraine and postponing any expansion plans in the country. 


Meyrick Chapman, a fixed-income strategist at Swiss bank UBS, says the crisis is particularly acute in Ukraine, Hungary, Kazakhstan and Azerbaijan. “I’m talking about the local economies and the sort of pain the local population is likely to suffer over the next six to 10 years because of borrowing habits over the last six years,” he says. “The trend at the moment is that cross-border lending is out. These countries have depended on cross-border lending to finance their economies.” 


To compound the problem, many CEE countries have debts in Swiss francs or euros, making bankruptcies much more likely as their currencies collapse. Once again, it was Latvia that blazed the trail to euro, yen and Swiss franc denominated mortgages, now undone by a house price crash in the order of 50%, the most spectacular anywhere.


The prospect of EU integration buoyed local currencies in CEE, so borrowing in foreign currencies seemed like a one-way bet. Hungarian homeowners earning forints saw the relative cost of their euro mortgages get smaller as the forint rose towards its March 2009 peak. Now, however, the forint is falling and the reverse is true. Just as thousands are losing their jobs, the relative cost of their mortgages is soaring. 


As a result, CEE governments are damned if they do and damned if they don’t. Devaluation will cause a slew of bankruptcies, but anything policymakers do to protect their currencies, such as cutting public sector wages, will only deepen the recession. 


Western European banks that extended these loans and mortgages must now deal with debtors falling behind on payments and sinking into bankruptcy. So-called non-performing loans (NPLs) have remained relatively low so far – Erste Bank says they rose to just 3.3% in the first quarter of this year –but it is still early in the credit cycle. Analysts suggest NPLs may well reach an average of 33% across CEE, in line with the Asian financial crisis of 1997–1998. If that were to happen, it would essentially bankrupt Austria’s three largest banks. Fitch Ratings warns that the ensuing credit losses would swallow up all three banks’ Tier 1 capital, the cushion against unexpected losses. 


Chapman says he “wouldn’t be surprised” if some banks collapsed as a result of their exposure to CEE, but says the banks are small enough that bail-outs would be manageable. 


“The European Central Bank [ECB] has been very, very quick to lend assistance to the banking sector...It has been remarkably successful at containing what could have been a very serious banking crisis.”


In the hope of preventing the need for such a bail-out, the World Bank, European Bank for Reconstruction and Development and the European Investment Bank have launched a joint programme to provide more than €24bn in support to banks in CEE this year and next. This follows multibillion-dollar IMF loans to Hungary, Latvia, Ukraine and Serbia. Fears that the IMF would not have sufficient funds to prop up other countries across the region were quelled at the G20, with a $750bn (€530bn) injection of money into the fund. 


Chapman, for one, is not concerned. Nor will he condemn the rush to lend to emerging Europe over the past two decades. “Hindsight is a wonderful thing,” he says. “What was happening was part of the extension of capitalism following the fall of the Berlin Wall. It was a policy entirely endorsed by the ECB. 


“In terms of a banking business it wasn’t very successful. But in terms of political integration of Europe as a whole, this is going to bind the economic fortunes of the East to the economic fortunes of the West. In the long-term that’s probably a positive.”