Emerging Markets Watch: Upcoming Eastern European Economic Cataclysm

As most eyes are glued to CNBC and the exploration of the huge financial problems at home, few follow just how bad the situation is in fledgling developing economies. With news of potential defaults out of Russia, Kazahstan devaluing its currency and begging for handouts, and Baltic states (Lithuania and Estonia) on the verge of downgrade, things in Eastern Europe are getting from bad to worse. This is most obvious when looking at the foreign currency exchange rates of countries in the region: since September 2008 the ruble has lost 32%, the Polish zloty 37%, the Hungarian forint 29% and Ukrainian hryvna 42%.

What are the immediate observable impacts of currency devaluation (this may also be relevant for the U.S. soon):

1. Speeds up asset quality deterioration and write-downs as unhedged corporate and retail customers that have borrowed in foreign currency face a relative increase in their debt burden.

2. Borrowers may choose to withdraw local currency savings to transfer them into a more stable foreign currency, which would shrink banks' funding base.

3. The capital ratio of banks with large foreign currency exposure will fall as a consequence of currency devaluation-related issues.

So as the vicious cycle of risk aversion accelerates in more countries, it results in domestic economies becoming worse off, thereby making traditional international commerce impossible, and impacting larger beneficiaries of globalization such as the G7.

But that is not all: in addition to sovereign risk, external investors also have creditor, liquidity and cash repatriation risk. The is because many West European banks acquired East European banks in the course of of privatization of state-owned banks during the transition from planned to market economies.

According to the Bank for International Settlements, claims of West European banks on Eastern Europe amounted to €1.3 trillion in the first quarter of 2008, which, depending on the degree of contraction and asset write-downs, could be significantly impaired.

As the chart below shows, the countries that stand to be impacted worst by Eastern European bank deterioration (by being domiciles to investing banks) are Austria, France, Italy, Belgium, Germany and Sweden, as banks in these countries account for 84% of Eastern European bank claims. And of these, Austria is most on the hook, as E.E. banks account for half of Austria's global bank claims. Specific bank names that have the most exposure include Raiffeisen Bank (RAIFF.PK), Erste Bank (EBKDY.PK), Soc Gen (SCGLY.PK), Unicredit and KBC.

This presents the case for the unwind of globalization, which is worthy of a much more indepth analysis. Over the past 10 years, as the globalization and credit bubble went hand in hand, we will inevitably see the ripple effects of a globalization in reverse, marked by constrained trade relations and minimized international commerce, in addition to the expected problems of how to deal with a widespread increase of domestic corporate and sovereign defaults, and spiking f/x rates and deflation. The true shape of the global economic problem is only now starting to take gradual shape.

Indicatively, the CDS levels of some Eastern European countries have been the biggest underperformers in recent days, and some are presented below.

Comments

[Dragoman:]

Raises some interesting points, especially for Austrians. Definitely makes the bygone age of local/national banks doing local/national lending look much more attractive. The Austrian banks are putting a lot of pressure on the EU and East European government so cover their exposure. Since the East European EU members (with the exception of Hungary) have quite healthy reserves, not a bad idea...

The banks are still making lots of money in Easter Europe. In Romania, the banking sector reported made capital increases of 1,9 billion euro in response to that global crisis, but, importantly, generated 1,2 billion euro profits in 2008, representing a 67% increase in bottom line yoy, (see www.zf.ro/zf-english/r.../) . Likewise, the Czech banking system, with a 70% loan to deposit ratio is performing well with growing profits and no cataclysmic write-downs.

In many cases today, the Eastern European subsidiaries look a lot more healthy than the Western European parents..

Feb 11 07:12 AM

[2positive:]

2 of the three points are wrong:
2. Borrowers may choose to withdraw local currency savings to transfer them into a more stable foreign currency, which would shrink banks' funding base.

So they transfer one currency into another, but still hold that money in the bank. Where's the shrinkage?

3. The capital ratio of banks with large foreign currency exposure will fall as a consequence of currency devaluation-related issues.

It's not technically wrong actually, but banks are aware of currency risk. I've looked at most major ukrainian banks and their foreign currency assets and liabilities are very well balanced (difference was less than 1%). So there's no real fx exposure in the banking system. At least in Ukraine.

Feb 11 07:23 AM

[Fabien Hug:]

Glass half full of half empty. Beware of most of Eastern Europe anyway. Most of its growth during the last 10 years is the consequence of credit availability. The plan was to lend them money so that a market economy could emerge (like East Germany). The tangible economy didn't have time to emerge.

Feb 11 09:11 AM

[realbazaar:]

"This presents the case for the unwind of globalization".....

Hopefully the scurge of globalization will unwind. This would quickly thwart the efforts of corporate greed maniacs & their government lackies from sucking the planet dry. So far, they have succeded in destroying our monetary system; continued to drive employment over-seas; have made bankrupcy as common as dirt; have created a deeper hatred of America; allowed our infrastructure to deteriorate; kept the fires of global warming burning; ..... and on it goes.
Great job guys!

Feb 11 09:31 AM

[Ferdinand E...:]

Brilliant comment, realbazaar. It sounds to me like the lectures I used to give my colleagues at the university from time to time, although your language is mild as compared to mine. I don't call globalization it a scourge, however. I call it a ____ curse, and I have a similar description of the academics who endorsed it..

Feb 11 09:46 AM

[Dave Wrixon:]

Short-term capital flight means very little in reality.

This crisis is primarily about unsustainable levels of debt both Government and Personal.

The fact is that some western economies are sinking under the weight of debt and everyone else is feeling the turbulence. But don't get confused about whose problem it is and whose boats are sinking.

The US Dollar will plummet. Short-term trends can mean very little. Did you follow the price of oil last summer and listen to all the commentary about it going over $200 dollars a barrel?

The bottom line is that Reserve Currencies are the most vulnerable simply because the more people that hold them, the more currency there is available to be dumped onto the markets. At the moment, the US dollar is seen as a safe haven, but the fundamental clearly indicate that is prospects are very poor.

The US Government is going to have expand the money supply exponentially to try to keep its tax base from imploding. Price inflation and probably wage inflation will take off and value of the dollar will plummet. No foreign investor in really has a vested interested in seeing the dollar crash, but ultimately they will all protect their own interests and rush for the door whilst there is chance of salvaging something.

We are definitely going to see the Euro at $2 and maybe even $3 or $4. OK, the Europeans will not wish to see their exports priced out in this way, but frankly there isn't going to be much exporting going on at any price. As for China, it balance of payments is going to be more balanced. If the economy is going to be more driven by internal demand then there is much rational in a hardening currency that makes imports cheaper.

Feb 11 12:51 PM

[rationalist:]

this is another shallow "analysis" of East Europe. First - it puts all the countries into one bucket, although there are substantial differences between them.

Second - while some countries like the baltics have clearly overheated economies by too lax domestic monetary policies, others have had quite prudent domestic monetary policy (E.g. Romania), but have been impacted by the easy money flowing from Euro-zone.

The second type of overheating is less damaging to the economy (it is less pervasive), although it creates large FX exposure.

FX now is the largest problem, because it can cause defaults and some cleaning in the economy. However - those that have been sticking to the domestic currency are nt impacted directly.

This is balanced by the fundamentally good position of most countries in the region (comparing to the US). These countries have competitive advantages in form of cheaper labor markets and in the same time are located in close proximity to large potential clients in western Europe. The workforce is educated and becoming more mobile. The drag could be bad government policies, but actually in the last couple of years these countries have become the lowest-taxed in Europe (e.g. Slovakia 19% flat tax, Romania 16% flat tax) - so the policy trend is positive. Those contries that are in the EU are additionally facing an increased scrutiny on their economic policies by other member-states. Budget deficits are largely under control (copare that to the US!).

So - while there are panics in Ukraine and Russia, which can be explained in large part by recent experiances of these populations with bad government policies, most countries in the region are fairly safe. My Polish friends are actually joking that there is a crisis, but no one has seen it yet. Some industries are impacted - notable financial industry - but this is due to precautionary actions and often an order from western-based owner, rather than a worsening of potfolio quality. As long as currency panic will be avoided (which seems likely except for Ukraine and Russia), the slowdown will be rather mild comparing to what will be happening in the US, UK, Spain, Ireland, etc.

Feb 11 07:08 PM

[ROLEX18:]

This is pennies compared to China's and Asian claims on America, Eastern Europe will pay back as debtors will become owners off all assets, otherwise government's of indebted must pay, America on other hand can not pay.
This is the global problem nobody can deal with but the market, when all assets will depreciate by 90% the bottom will be reached.

Feb 12 01:51 AM

[Local:]

The problem is that there is certain (reappearing) mistrust towards the banking system, at least in Ukraine...People are not just converting local currency deposits, they also are withdrawing money since they believe that keeping money “under the mattress” could be a safer alternative for now... There is deposit insurance and its amount has been recently increased and it helped to prevent panic but the system has not been tested and is not widely trusted …

On a second point (and I am not a banker): assets would be loans made in FX? I would think some amount of loans in FX made to individuals or business that have earnings (revenues, salaries) in FX but most not. So as local currency depreciated by 42% what is going to happen to their (individuals, business) ability to repay those FX loans?

On Feb 11 07:23 AM 2positive wrote:

> 2 of the three points are wrong:
> 2. Borrowers may choose to withdraw local currency savings to transfer
> them into a more stable foreign currency, which would shrink banks'
> funding base.
>
> So they transfer one currency into another, but still hold that money
> in the bank. Where's the shrinkage?
>
> 3. The capital ratio of banks with large foreign currency exposure
> will fall as a consequence of currency devaluation-related issues.
>
>
> It's not technically wrong actually, but banks are aware of currency
> risk. I've looked at most major ukrainian banks and their foreign
> currency assets and liabilities are very well balanced (difference
> was less than 1%). So there's no real fx exposure in the banking
> system. At least in Ukraine.

Feb 12 03:58 AM

[misiosnechacz:]

My advice is to not put every country into one basket. Do your own diging and you will find few things worth making a longterm investment (short term just for people with steel nerves).
Ukraine is going down big time. Doesn't matter what You are saying. they are looking for money everywhere they aked even their bitter enemies russians and that mean that things are bad there. They can't afford new gas prices as well. They are going to pull back from organization of EURO 2012 (Euro cup football championship). Banks are not willing to pay money to the customers and cash mashines are empty.
I think that the most safe country now is Czech Republic. Stable economy, most of the problems is just becouse is eastern europe.
slovakia is very safe espacialy with Euro as currency. Euro means that you dont have a currency gamble. But neighbours with very weak money might take over local market and make export even more difficult in those thogh times.
Poland is worth watching as well but I would wait till march with investments because some companys have huge options problems and we will find out which ones I think after IV Q results. Some nut cases are trying to force the law that would cancel those options agreements. That would put a lot of presure on zloty and it would go down big time.
I would try to avoid Latwia, Estonia, Hungary, Lithuania and Bulgaria.

Feb 15 07:03 PM

[Mark Anthony:]

You made a very good call. Tonight surely people are watching East Europe as events unfolds.
tinyurl.com/d25abb

Feb 17 01:12 AM

[PROXIMO:]

Well said D.W.


On Feb 11 12:51 PM Dave Wrixon wrote:

> Short-term capital flight means very little in reality.
>
> This crisis is primarily about unsustainable levels of debt both
> Government and Personal.
>
> The fact is that some western economies are sinking under the weight
> of debt and everyone else is feeling the turbulence. But don't get
> confused about whose problem it is and whose boats are sinking.<br/>
>
> The US Dollar will plummet. Short-term trends can mean very little.
> Did you follow the price of oil last summer and listen to all the
> commentary about it going over $200 dollars a barrel?
>
> The bottom line is that Reserve Currencies are the most vulnerable
> simply because the more people that hold them, the more currency
> there is available to be dumped onto the markets. At the moment,
> the US dollar is seen as a safe haven, but the fundamental clearly
> indicate that is prospects are very poor.
>
> The US Government is going to have expand the money supply exponentially
> to try to keep its tax base from imploding. Price inflation and probably
> wage inflation will take off and value of the dollar will plummet.
> No foreign investor in really has a vested interested in seeing the
> dollar crash, but ultimately they will all protect their own interests
> and rush for the door whilst there is chance of salvaging something.
>
>
> We are definitely going to see the Euro at $2 and maybe even $3 or
> $4. OK, the Europeans will not wish to see their exports priced out
> in this way, but frankly there isn't going to be much exporting going
> on at any price. As for China, it balance of payments is going to
> be more balanced. If the economy is going to be more driven by internal
> demand then there is much rational in a hardening currency that makes
> imports cheaper.

Feb 17 05:21 PM