The Depression's Already Here for Some Countries in Europe

Includes: CEE, EZU, FXE, IEV, VGK
by: Reggie Middleton

This is the second to last installment in my pan-European sovereign debt crisis series. After covering western and southern Europe, we are moving eastward. Before we go any further, be sure you have caught up on the previous portions:

  1. Can China Control the "Side-Effects" of its Stimulus-Led Growth? Let's Look at the Facts - Explains the potential fallout of the excessive fiscal stimulus in China. While not European, it is quite likely to kick off the daisy chain effect.
  2. The Coming Pan-European Sovereign Debt Crisis - introduces the crisis and identified it as a pan-European problem, not a localized one.
  3. What Country is Next in the Coming Pan-European Sovereign Debt Crisis? - illustrates the potential for the domino effect
  4. The Pan-European Sovereign Debt Crisis: If I Were to Short Any Country, What Country Would That Be.. - attempts to illustrate the highly interdependent weaknesses in Europe's sovereign nations can effect even the perceived "stronger" nations.
  5. The Coming Pan-European Soverign Debt Crisis, Pt 4: The Spread to Western European Countries

Austria, Belgium and Sweden, while apparently healthy from a cursory perspective, have between one quarter to one half of their GDPs exposed to central and eastern European countries facing a full blown Depression!



These exposed countries are surrounded by much larger (GDP-wise and geo-politically) countries who have severe structural fiscal deficiencies and excessive debt as a proportion to their GDPs, not to mention being highly "OVERBANKED" (a term that I have coined).

So as to quiet those pundits who feel I am being sensationalist, let's take this step by step.

Depression (Wikipedia): In economics, a depression is a sustained, long-term downturn in economic activity in one or more economies. It is a more severe downturn than a recession, which is seen as part of a normal business cycle.

Considered a rare and extreme form of recession, a depression is characterized by its length, and by abnormal increases in unemployment, falls in the availability of credit, shrinking output and investment, numerous bankruptcies, reduced amounts of trade and commerce, as well as highly volatile relative currency value fluctuations, mostly devaluations. Price deflation, financial crisis and bank failures are also common elements of a depression.

There is no widely agreed definition for a depression, though some have been proposed. In the United States the National Bureau of Economic Research determines contractions and expansions in the business cycle, but does not declare depressions.[1] Generally, periods labeled depressions are marked by a substantial and sustained shortfall of the ability to purchase goods relative to the amount that could be produced using current resources and technology (potential output).[2] Another proposed definition of depression includes two general rules: 1) a decline in real GDP exceeding 10%, or 2) a recession lasting 2 or more years.[3][4]

Before we go on, let's graphically depict what a depression would look like in this modern day and age...

A depression is characterized by its length, and by abnormal increases in unemployment.


Price deflation, financial crisis and bank failures are also common elements of a depression.


A depression is characterized by shrinking output and investment and reduced amounts of trade and commerce.


... as well as highly volatile relative currency value fluctuations, mostly devaluations.

A former premier has called for a 30% devaluation and a sitting minister said in June that there should be a "debate." Meanwhile, chief executive of SEB, Sweden’s number two bank, says total loan losses would ultimately be little different if the Baltics stayed the course or devalued now – though rapid devaluation might be tougher to deal with. (Lex/


The global slowdown coupled with the unprecedented financial crisis has uncovered significant vulnerabilities that can currently be witnessed in central and eastern Europe in the form of structural imbalances and growing foreign indebtedness.

Not surprisingly, the region, which until a couple of years back was forecasted to be one of the most profitable investment avenues, now stands out as the hardest hit with many countries such as Hungary, the Ukraine, Latvia, and Romania forced to seek IMF and foreign aid and bail-outs. Heavy reliance on exports and foreign capital (especially from Western Europe), which fed the economic growth in the pre-crisis period, has backfired when peak global demand dried up and the liquidity crunch hit the global financial system.

Countries in this region are highly dependent on foreign trade, with exports accounting for more than 50% of GDP for many countries. Sharp declines in exports have triggered a series of internal predicaments including rampant and rising unemployment as well as declines in domestic demand that exacerbate trade account imbalances through declines in imports.

However, the problems for these countries have been aggravated by huge foreign indebtedness and the resultant interest and income payments that put additional pressure on the balance of payments. While currency depreciation could have provided some much needed respite (although that can be seriously debated), for countries like Latvia, Estonia, Lithuania, Bulgaria and Ukraine which have a fixed currency peg to Euro, the option is not available.

As a result, Latvia, Lithuania and Estonia have witnessed double digit negative real growth in GDP and are witnessing structural issues of deflationary pressures (owing to price and wage cuts) and very high unemployment levels.

click any graphic to enlarge



Source: IMF, European Commission


Notably, except for Hungary with a public debt-to-GDP of nearly 80%, government debt is within manageable limits for most of the countries in the region. This is most likely due to the fact that these countries did not have an overdeveloped banking system that required bailing out.

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This relative benefit was not without its costs, though. Without heavily developed banking sectors of their own, these countries turned towards outside banking institutions for their financing needs.

The major financial risk, therefore, surrounding this region is the high foreign debt to private sector. Foreign banks (mainly western European banks) play a major role in the CEE region and account for approximately 60-80% of total bank assets in most CEE countries.

While significant leverage was built up through massive foreign lending to the private sector in this region during the pre-crisis period, the same has now become a major source of external imbalance and financial risk. Claims of the foreign banks exceed 100% of GDP for countries like Estonia, Latvia, Lithuania, Hungary and Croatia. Loans denominated in foreign currency amount to nearly 90% of the total lending in Latvia, 85% in Estonia and 65% in Lithuania.

While on one hand, the high reliance on foreign lending puts a lot of pressure on the current account balance and balance of payments, the increased financial risk of a pull back of foreign capital can seriously jeopardize growth in these countries. Deleveraging and de-risking by the foreign banks through reducing their exposure to these countries as well as curtailing lending will certainly hamper the prospects of recovery for these sovereign entities.

The simultaneous PIIGS crisis in western Europe adds to the pressures on western European banking sector, providing an added impetus to hasten the de-risking process.

Further, for countries like Estonia, Latvia, Lithuania, Bulgaria and Ukraine which have a fixed currency peg, high foreign debt restricts the possibility of devaluation of currency as the devaluation will lead to increased debt and interest burdens and shall add to the pending and inevitable slate of defaults.

Thus, these countries are deferring the devaluation of their currency and are following the painful internal adjustment process of contraction in domestic demand to counter the high current account imbalances.

This is, in turn, impacting the loan performance leading to the inevitable increase in defaults. Research by Danske Bank in early 2009 estimates that under an adverse scenario, loan losses can reach 30% in Baltic countries (Estonia, Latvia, Lithuania), Bulgaria, Ukraine and Romania while loan losses in other CEE countries will range between 10-20%.

It should be made clear that the current PIIGS/Greece developments have caused the Euro to slide aggressively anyway, thereby applying the unwanted currency devaluation to the distressed CEE countries. From an academic perspective it appears as if the outstanding (non-euro denominated) debt service just got that much more difficult.


Source: Bank for International Settlements, IMF

Austria, Sweden and Belgium stand out at the top the list of western European countries having relatively outsized exposure to CEE nations. Total CEE exposure of the banks in Austria stands at 53.4% of the GDP of Austria while it is 22.8% and 20.4% for Swedish banks and Belgium banks, respectively. Major Austrian and Swedish banks have high exposure to high risk countries like Croatia, Hungary, Romania and Ukraine and Baltic countries (Estonia, Latvia, Lithuania). Professional and institutional subscribers can download the 30 page Austrian/Swedish/Greek bank exposure and comparative valuation tear sheet to view the stats and our opinions on who the highest risk banks are.

Yes, the highly levered Greek banks have significant CEE exposure as well, as if they don't have enough problems of their own: Banks exposed to Central and Eastern Europe 2010-02-22 03:55:38 1.46 Mb

There are several banks included in the study that:

  • Have ADRs
  • Have credit exposure to high sovereign risk nations including amounts to 762% and higher of the total tangible equity with the total non-performing and sub-standard (but performing) exposure standing at 96% of the tangible equity.
  • Have Texas Ratios approaching nearly 100%
  • Have NPAs growing nearly 500%
  • Have leverage rations of over 80x
  • Are trading at BV multiples that apparently ignore the potential credit contagion, etc.


My next and final post on the pan-European sovereign debt crisis will attempt to tie all of the pieces together along with middle-eastern and Asian risks to illustrate a road map of the various stress points in global sovereign debt and related bank exposure.

While I am not saying any particular country will bring about the end of the world as we know it, there are simply too many risks and contingent crashes waiting to happen, all inter-connected, levered and amplified across dozens of borders and financial systems to simply assume that not one country will falter.

That faltering could very well be the first domino to fall among many...

Interested parties can feel free to contact me by phone or email.

Disclosure: No stocks mentioned, but I am short Europe

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