Are Eastern Europe's Economic Problems Overstated?

This week, many markets woke up to the fact that Eastern Europe was having severe problems. Moody's said the recession in the region could be more severe than previously thought. Economies, especially in the Baltic countries, in Hungary and Ukraine are contracting at an alarming rate. This has brought to the markets’ attention that many European Banks have a large exposure to Eastern Europe. The exposure to Eastern Europe, including Turkey, is estimated to be $1.5 trillion. The problems with European banks’ eastern loans have been touted as major threat to the financial stability of Europe and the euro. It has been compared to the Asian crises of 1997, when many banks in Asian countries made loans in foreign currencies that could not be serviced when their currencies collapsed.

Although the economic situation in Eastern Europe looks pretty bleak, what appears to be a major risk may have another effect. One of the best things that happened to the banking sector of EU Eastern Europe is that it is largely controlled by western European banks. Many commentators have worried about large foreign currency loans specifically loans denominated in Swiss Francs to borrowers in Hungary. Certainly this is something to worry about but it is nothing new. The banks that made these loans are European banks from Austria, France, Italy, Belgium, Germany and Sweden. [iShares MSCI France Index (EWQ), iShares MSCI Italy Index (EWI), iShares MSCI Belgium Investable Mkt Idx (EWK), iShares MSCI Germany Index (EWG), iShares MSCI Sweden Index (EWD)]. One must remember that the Euro has not been around that long and that most EU Eastern European currencies have been fluctuating, sometimes drastically (in the case of the Hungarian forint) over the past ten years. These banks are certainly used to dealing with currency fluctuations. Some of these problems were certainly clear in 2007. It is not that there wasn’t sufficient warning.

Second, it has to do with information. The US banks' problems with toxic asset occurred because the incentives to find good lenders and to monitor them were divorced in the process of securitization. US banks were compensated for finding any debtors and their economic incentives to monitor the debtors theoretically ceased when the loans were removed from their books. The loans made by European banks in Eastern Europe were normal loans.

European banks in Eastern Europe were supervised not by the local country’s regulators but by the regulators in their home country. Regulators in western Europe are far more established, professional, and are not subject to the politics or influence of the country where the loans were made. So there is a higher probability that the loans were made to debtors with less risk. These problems have happened before. The regulators in Sweden were especially sensitive to their banks' presence in the Baltic countries and took action much earlier. In contrast, the banks in Asia are owned locally, often by the government, making them susceptible to government pressure or local influence.

For political reasons, the EU and European governments are very aware of the financial situation of their Eastern neighbors. The last thing any European government wants is a total banking and economic collapse in Eastern Europe, which could stimulate economic and social instability on their borders, resulting in more migration. The ECB and the EU provide a framework for concerted action, which has never existed in Asia.

Of course, the extent of the problem depends on the country. Some countries in Eastern Europe have been tidying up their balance sheets to join the Euro and are in relatively good economic shape. What the Eastern EU does share in common are their laws. In order to join, these countries had to adopt over 80,000 pages of rules and regulations. While enforcement and policy decisions will vary from state to state, at least investors can be relatively secure in something that is relatively rare in emerging markets - that the rules of the game are known.

Commentators have specifically pointed out Austria's banks, (which have loans to the wider region of €230 billion [$293.5 billion], equivalent to about 80% of Austrian GDP) specifically Raiffeisen International (RAIFF.PK), as a potential problem. Raiffeisen has been doing business quite profitably in Eastern Europe over the past ten years. Although the present recession is much worse than prior downturns, the past ten years have hardly been smooth sailing for Eastern Europe.

There have been many currency issues, political and economic problems that have made Eastern Europe a difficult place to business. The American problem occurred because something that should have been expected, falling real estate prices, wasn’t. In Eastern Europe, downturns and currency fluctuations occur annually.

Although Raiffeisen has asked Austria's Finance Ministry to buy its preferred shares for €1.75 billion, this money can be used in Eastern Europe. And it should be pointed out that Raiffeisen’s latest report showed that its net profit rose 17% in 2008 resulting a 10% rise in its stock, something that would be a welcome relief for an American bank.

Disclosure: No positions.

Comments

[Dave Wrixon:]

Good to hear some informed analysis.

Feb 26 02:53 PM

[Dave Wrixon:]

Good to hear some informed analysis.

Feb 26 02:53 PM

[IronMeteor:]

This is rubbish that doesn't even answer the problem. Most estimates put the % of bad loans in Eastern Europe at 10%-20%. This pretty much means the whole Austrian banking system is insolvent, along with many others. Who really cares if the banker was local or not, the UK is proof that local bankers making local loans can be morons too.

Securitization is actually a blessing to many US banks. They sold the crap to insurance companies and other funds. Even with that they are practically insolvent. But the Austrian banks with loans to eastern europe totaling over 70% of GDP still hold those loans. This is catastrophic for them and the evidence is shown by how desperate they are for the Euro zone to bail out Eastern Europe.

As for whether they expected this, that’s just stupid. If they did, they wouldn't have loaned the money - period. To make the claim that this is just normal business is crazy. If this is normal business, then I guess the Euro zone was trying to ruin their economies on purpose.

Eastern Europe is just another bubble that burst. Another sure thing like the Internet, Oil, or China. Nobody invests in bubbles expecting to lose, they just do, that's why they are bubbles.

Anyone who has traveled through Poland the last few years could have told you this was a bubble. Same For Ukraine, and the rest. For some reason people can't understand that the credit bubble was world wide, its not only a US problem. Every banker went nuts and loaned more than the entire country is worth.

Eastern Europe is worst than the headlines say, go visit and you will see. The currency devaluation has been devastating to the locals. Imagine your underwater mortgage is even more underwater because you lost an additional 30% against the Franc. The only hope is for the Franc to drop a lot. That would really help the region. But that seems far off.


From the BBC - 2007
Kiev, the capital of Ukraine, is now apparently the “most expensive city in Eastern Europe” in terms of property, says the BBC. Prices at one development start at $1m for a three-bedroom flat, while the cheapest one-bedroom flats start at around $100,000.

This where the average person makes $2400 USD per year. That same apartment was $5K in 1998. So in 2007 at the peak, when many of these loans were made, the average worker paid 40X their income for the cheapest apartment in the city. I guess the local bankers understood the market real well and knew it wasn't a bubble.

This will end badly, very badly.

Feb 26 07:19 PM

[Al-USA:]

Good comments IronMeteor.

That's too bad, because the bought into the "dream" of capitalism and instead are getting a "nightmare"... I wonder what they think of "free markets" now?

Feb 27 05:23 AM

[misiosnechacz:]

It's miles better than it was before "free markets"
I will tell You how it looks from my perspective. I wake up and read economic data every day.
That are results of polish banks (two biggest ones)
2008 2007
PKO BP(net profit) 3 319 131000 2 941 392000
In IVQ they earned 548 mln zlotys. Profit is lower than expected because Bank in ukraine cost them over 300 mln zlotys.
PEKAO(net profit) 3.53 bln zotys 3.55 bln zlotys
In IVq they earned 719.3 mln zlotys
We can see slowdown but system is far from disaster In those rough times those banks make money. PEKAO is owned by UNICREDIT which has big trouble. My question who is going to save who? Because UNICREDIT already pumped out "few" zlotys already from PEKAO.
Current value of zloty 1$=3.65 zlotys
If not help from goverments where would You put your money CITI, RBS or one of those.
On Feb 27 05:23 AM User 270430 wrote:

> Good comments IronMeteor.
>
> That's too bad, because the bought into the "dream" of capitalism
> and instead are getting a "nightmare"... I wonder what they think
> of "free markets" now?

Feb 28 06:46 AM

[William Gamble:]

I first went to Eastern Europe, actually the Baltic countries, in 1994. What was and is impressive is the speed at which they recovered after almost 40 years of communism. An economic meltdown of this magnitude is not something that most people specifically bankers would necessarily prepare for. So Ironmeteor is correct in stating that the problem will be severe. Still when I was speaking before the CFA society in Bucharest Romania last year one of the most interesting facts was that the standard of living had tripled in a very short period of time.

The real difference has to do with information. When banks securitized loans they lost the economic incentive to find good borrowers and the economic incentive to continue to monitor the loans. Since there was no incentive to monitor the loans, the main problem with the situation in the US is that no one really knows the real value of the ‘toxic assets’.

When banks make regular loans that are based solely on economic grounds and are not influenced by local connections or distributional coalitions, the probability will be that the loans will be of a higher quality.

The other point about loans is that usually they are made with some sort of collateral. If there are strong property rights and efficient methods of attaching the collateral, then the value of the bad loans will be reduced. Despite the numbers produced by agencies and Wall Street banks, no one really knows how bad the loans are until you try to collect them. Toxic assets may be bad but they are still based on real estate that has not disappeared, It is just the vast legal overlay has made them more difficult to collect. The existence of the EU and more professional methods of western banking will make the probability of collecting collateral more successful than in other emerging markets like Asia.

Also although the situation in Eastern Europe is dire, it does benefit from distinctions between countries. There are vast differences between the healths of various economies. There are also vast differences in size. Latvia is about the size in population of Nevada.

The Europeans community after this article was posted announced a package of loans for the banking system as predicted amounting to 24 billion Euros.
My point is not that the problems of Eastern Europe will not be severe.

My point is that they will most likely be solved faster than people expect because the design mechanism (i.e. the laws) work better than in similar emerging markets. Over time, (not tomorrow), perhaps by the middle of 2010, the growth will resume and it will be robust than a simple look at the numbers might presently suggest

Feb 28 04:58 PM

[William Gamble:]

What economists and analysts fail to recognize is that a bad debt in Hungary is different from a bad debt in the UK, from a bad debt in Italy, from a bad debt in Florida and a bad debt in China. Further, a comment just published by the Financial Times makes the point that Poland, the Czech Republic, Slovenia, Slovakia are not Hungary, Bulgaria or Romania. Information is and always has been qualitative not quantitative. Broad brush assumptions and projects are the fastest way to get it wrong and lose money.

Mar 01 02:12 PM

[Mad Hedge F...:]

NM Poland ..While American banks have their subprime crisis, European banks are being dragged under by their lending to emerging economies in Eastern Europe. Ledd by UniCredit in Italy, Austria’s Erste Group Bank and Raiffeisen International, France’s Societe Generale, Belgium’s KBC, and Hungary’s OTP, banks have lent $1.6 trillion to companies in these formerly communist countries at cheap rates, with minimal documentation, and few questions asked. The easily available credit caused local money supplies to explode, and sparked bull markets in both stocks and currencies. Emerging Europe grew at rates double and triple rates in the West, as local companies pumped up on steroids became the master of leverage. Now $400-$600 billion is due for rollovers this year from nonexistent credit markets, and the chickens….make that vultures have come home to roost. Economic growth has fallen off a cliff, with Poland’s seasonally adjusted industrial output down in December a precipitous 7.4% YOY. The Polish stock market fell 48% last year, and the zloty of off 40% again the dollar from its June peak. The Central European Equity Fund (CEE) has crashed 80% in eight months. The crisis is so severe, it may postpone Poland’s entry into the Euro block, which had been scheduled for 2011. Home mortgage borrowers are in especially bad shape. Up to 50% of their loans were denominated in Swiss francs, so the collapsing Polish currency has caused a near doubling of borrowers’ monthly payments and principals since last year. Austria really has its knickers in a twist, as these heavily syndicated loans account for 80% of GDP. A 10% default rate could wipe out the entire banking system there. Germany has the smallest loan exposure, but has the most to lose, with 25% of its exports headed east. It is now in negotiation with its partners in the EC to cobble together a bailout with the help of the IMF to provide bridge financing for these loans, and hopefully ward off a further economic collapse. It looks like the headlines in Europe are about to get uncharacteristically sensational.

Mar 01 11:10 PM

[William Gamble:]

It is true that Eastern European countries have to roll over billions this year but so does western Europe. Germany’s foreign borrowings of $2.3 trillion, Britain’s figure of $4.5 trillion and Belgium’s need to repay or roll-over $375 billion this year. So Eastern Europe's borrowings put in perspective are not that horrific.

Another country, although in the EU, Greece has recently had a successful auction for its sovereign debt. It had to pay more for it, but they were able to sell their paper. Greece's banking system also has exposure to southern Eastern Europe.

At the summit on March 3, Poland and the Czech Republic made the point that they felt their economies were stronger than that of Ireland and other countries in the EU and rejected the bailout requested by Hungary.

According to the Wall Street Journal of February 18th actually Germany has the second largest loans to Eastern Europe after Austria followed by Italy,

According to the Financial Times Czech Republic has almost no foreign currency in its total bank lending, Poland has about 30 per cent and Hungary 70 per cent.

The Poles maintain that they are on track to join the Euro in 2012.

The simple point is that Eastern EU should be looked at separately. Some economies are in relatively good shape while others are not

Mar 11 03:38 PM