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The deterioration of Eastern European economies poses a major threat to the Western European financial system.  During the boom years leading up to the financial crisis Western European banks were the primary lenders fueling Eastern Europe’s growth.  Now, the stagnation of Eastern European economies, coupled with decline in the value of many of their currencies, relative to the Euro and Swiss Franc, has turned banks’ exposure to this region into a massive liability.  Austrian banks alone have more than $293 billion of exposure to Eastern Europe, roughly 80% of the Austrian GDP.  Banks throughout Western Europe have both direct loan exposure and exposure through their Eastern European subsidiaries.

In recent years Eastern Europeans have increasingly taken out loans denominated in Euros, attracted by low EU interest rates.  The IMF puts the amount of private debt denominated in foreign currencies within Eastern Europe at roughly 15% and the absolute figure has been put at close to $1.7 trillion.  These borrowers have effectively been shorting foreign currency, which has turned out to be a very bad bet.  For instance, over the past 6 months the Polish Zloty and the Ukraine Hryvnias have both declined over 30% against the Euro and the Swiss Franc.  In Poland close to 60% of debt is denominated in foreign currencies.   Those with loans denominated in these currencies have seen their debt burden rise correspondingly.  Additionally, as these economies continue to contract individuals and corporations will be increasingly strained to repay their debt.  Austria’s finance minister, Josef Proell, fears that Eastern European default rates above 10% will be sufficient to destroy his nation’s banking industry.

It is clearly in Western Europe’s best interests to avert crisis in Eastern Europe.  Even so,a rescue is unlikely to be forthcoming.  Western Europe has pressing economic problems, independent of their Eastern European exposure.  Most Western European countries have fallen into a recession.  The debt that they are taking on to finance their domestic fiscal stimulus will make it extremely difficult to produce meaningful aid for their Eastern neighbors.  Additionally, the European Central Bank (ECB) does not have a mandate to act as a lender of last resort for the EU financial industry, let alone that of Eastern Europe.  Meanwhile, the IMF is struggling: it has already provided $39 billion in emergency loans to countries in Eastern Europe.  With reserves standing at a little over $200 billion, the IMF will be hard pressed to support Eastern European economies if their deterioration continues.  Europe’s economy continues to spring leaks, and its stewards are rapidly running out of fingers to plug the holes.

Garrett McIntyre