As Brazil slaps on a capital tax to prevent the creation of asset bubbles, governments in emerging Europe can only look on with envy. If only they had a problem of buoyant currencies and strong capital flows.
Still, some analysts believe that financial stresses have eased substantially in the region. They argue that bright spots have emerged, such as the economic upturns in France and Germany, which are key export markets for central and eastern Europe and providers of foreign capital to it. There are signs too that portfolio investors are returning to these markets. In the week ending October 23, flows into dedicated Russia equity funds reached $450 million, according to EPFR Global, the highest weekly inflow since the company began tracking such data in the first quarter of 2002. Flows into EMEA equity funds hit a 71-week high at $677 million. Also, CDS spreads for most sovereigns have come back to their pre-Lehman Brothers’ bankruptcy levels, indicating that investors believe that the worst is over.
Yet anyone that thinks that is either brave or foolhardy. Central and eastern Europe still faces the prospect of further debt crises and devaluations. Take Latvia. Last month, the government announced tentative plans that it would cap the amount that banks could claim from mortgage holders. The move appears to pave the way for a possible devaluation of the lat, although the government denies this is its intention.
Devaluation in Latvia would in all probability lead to similar outcomes in the other two Baltic states and Bulgaria, which have currency pegs. The potential consequences of devaluation in these countries could be devastating, with a wave of defaults on euro-denominated loans and a possible withdrawal by foreign banks. Swedbank, the Nordic bank with the biggest Baltic exposure, has said already that it would reconsider its operations in Latvia if the government were to move ahead with its mortgage plan. On the other hand, if Latvia does not devalue the lat the economic crisis could become even more severe thanks to the austerity measures imposed by the IMF in its programme. As its prime minister said, Latvia faces a choice between a “bad scenario and a worse scenario”.
Then there are the challenges facing Russia. Although the oil price has rebounded in recent months, any recovery in the region’s most important economy risks being derailed by a second-wave credit crunch. Non-performing loans could reach 12% by the end of the year, quadruple the level at the beginning of 2008, and wiping out all bank profits in 2009. Given that NPLs typically lag the economic cycle by at least six months the chances are that they will not peak until some time next year.
Russia is not the only country with a looming NPL crisis. The threat of a big surge in bad debt casts a pall over the entire region, with Deutsche Bank forecasting that levels will jump to 5% to 10% of total loans in the Czech Republic, Poland and Hungary; 15% to 25% in the Baltic republics; 15% to 20% in southeastern Europe; and 30% to 45% in Ukraine.
In countries with relatively big banking systems, these distressed assets could constitute a sizeable contingent liability for the government, assuming they don’t recover. In Slovenia for example, where total bank assets are 132.1% of GDP, the government’s potential contingent liability is 26.4% of GDP or €9.8 billion.
Rapid deterioration in asset quality could lead some foreign banks, which account for 60% to 90% of total bank assets in most countries, to scale back their commitment even further. Many have beaten a hasty retreat already. Bank lending to the region has collapsed to such an extent that the Institute of International Finance estimates net outflows of $47.3 billion this year.
There’s one other consideration that needs to be taken into account in assessing how quickly the region is likely to recover. The free fall in bank lending has happened even before the regulators make life more difficult for banks by ring-fencing capital and liquidity requirements in each country where they operate. If these new rules were implemented they would bring greater stability to what are still relatively small economies but would also lead to a further reduction in financing capacity to a region largely dependent on foreign banks. Central and eastern Europe’s dark days are far from over.
