Posted by: Dirk | November 28, 2011

Will Emerging Europe ’12 follow Emerging Asia ’97?, or: “How to make friends and socialize losses”

More than two years ago, the IMF published an article on why Eastern Europe is not following the script from the Asian crisis. Ajai Chopra argued that some exchange rate flexibility might be good in a crisis, if balance sheets’ liability sides are not dominated by foreign currencies. Lately, the Central and Eastern European countries (CEECs) found themselves in more and deeper trouble, as the FT reports. Austrian banks limit their lending, two Baltic banks go bust – the dynamics are frightening.

The ongoing crisis of the euro seems to have caused the recent signal of retreat in the CEECs. Since banks are required to hold more equity, some of them cannot uphold their loan portfolios in the east. Until now, the Vienna Initiative saved the CEECs from repeating the Asia ’97 script, as the NY Times reminded us some weeks ago:

In March 2009 about 40 bankers and government officials crowded into a classroom at an economic institute in Vienna to talk about how they might save Eastern Europe from financial Armageddon.

In the months that followed they forged a pact that became known as the Vienna Initiative, which is widely credited with preventing a bank run and economic catastrophe in new members of the European Union like Hungary and Romania.

Lending in foreign currency is one of the biggest problems in the CEECs. Attracted by low interest rates in Switzerland and the euro zone, many borrowed in Swiss francs or euros. Lending in foreign currency is what constitutes the ‘original sin‘ in development economics. You are dependent on getting your hands on foreign currency to repay loans, and there is some exchange rate risk involved.

From the banks perspectives, increasing the risk of the borrower made sense because the loans gets fatter and so do the commissions. As long as the borrowers repay, everything is fine. When finally the exchange rate collapses or exports collapse, the increase in risk has finally turned a good into a bad loan. Time to socialize losses, with the sovereign bailing out the domestic banks via which the households borrowed in foreign currency. The increase in sovereign debt will make the CEECs dependent on the same banks that financed this lending in the first place. Which will demand austerity.

If the CEECs are let down, nobody there will want to borrow in euros anymore. At least no one in the real economy, as there are always speculators willing to borrow at low interest rates and do the carry trade. One of the problems in Europe is an abundance of (notional) savings, and not enough vehicles to translate these savings into investments. (This reminds me of the baby-sitting coop article by Paul Krugman.) Another problem is a lack of demand. A meltdown of the CEECs would – apart from the dire consequences there – make both things worse for the rest of Europe.

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