Crunch time for emerging Europe

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A reduction in foreign capital flows means that many banks in eastern Europe are indirect victims of the credit crunch.

The US and western Europe are not the only regions facing a credit crunch. Parts of central and eastern Europe are undergoing financial stresses of their own – and in some cases the situation is getting very ugly.

As the IMF’s recent Global financial stability report makes clear: eastern Europe includes several countries that have been heavily dependent on foreign capital flows, largely debt, in financing big current account deficits, and they are now acutely vulnerable.

To make matters worse, many of these countries have seen strong credit growth over the past few years. A dramatic slowdown in private flows to the region could lead to a painful adjustment.

The banking community remains optimistic. The Institute of International Finance, for example, is forecasting only a moderate reduction in capital flows to the region this year, although, as the US sub-prime crisis has demonstrated, bankers can get it wrong.

The Baltic states, Romania, Bulgaria and Turkey have most to worry about. Each has unique problems: falling property prices in the Baltic states, political tension in Turkey, muddled economic policies in Romania and Bulgaria.

They have a number of challenges in common too, including big current account deficits, weak currencies, financial assets undergoing a repricing and, with the possible exception of Turkey, fragile banking systems.

The problem facing the banks is a familiar one: they are overstretched. With both local and foreign-owned banks finding it difficult to fund themselves in the international capital markets, one or two might face a liquidity squeeze. The spreads of local banks in Latvia have widened by as much as 500 basis points, according to the IMF, because of the turmoil in the markets.

In addition, given the rapid growth in credit in these countries in recent years, there is a concern that the quality of banks’ assets could deteriorate sharply if the economic environment continues to weaken.

These countries are not alone in suffering from the credit crunch. Even commodities-based economies, such as Russia and Kazakhstan, are feeling some of the pain. Again, both countries have experienced a rapid growth in private credit – 51% up in 2007 on 2006 and a 55.2% increase in Kazakhstan, according to the IMF. The multilateral suggests that anything more than 20% year-on-year growth should set alarm bells ringing.

As in the Baltic states and southeastern Europe, the banks in Russia and Kazakhstan can no longer rely on the international bond markets to finance themselves.

None of the leading banks in Russia has issued a Eurobond this year, while in Kazakhstan only Halyk Bank has done so. Of course, in Russia the big state-owned banks have less need to worry than their private-sector counterparts and can wait to access the market when pricing becomes favourable again.

Others are in a less fortunate position and, with the domestic capital markets still underdeveloped – it’s impossible to get long-term finance in local currency – some bank chiefs might start to get nervous about growth prospects.

Institutions such as Russian Standard Bank, Kazkommertsbank and BTA Bank all face big funding challenges. Kazkommertsbank, for example, still needs to refinance $1.7 billion of foreign debt this year – something it managed to do through one issue in February 2007.

Halyk’s $500 million, five-and-a-half year bond offering in early April shows that the market is open. But for now that issue remains the exception rather than the rule.