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.
