Friday, March 6, 2009

Austrian Spread Spikes

“For Austria, the actual crisis is yet to come. The decline of the eastern European economy will hit Austria in 2009".
Peter Eigner, Professor of economic history at the University of Vienna”

The yield difference, or spread, between 10-year Austrian securities and benchmark German bunds have been rising substantially of late, and hit 137 points on Feb. 18, the widest yet recorded (see chart below). At the same time Austria now has a higher default risk than those Mediterranean "laggards" Italy, Portugal and Spain, at least according to credit-default swap prices as quoted by CMA Datavision. Austrian swaps were trading at 253.3 basis points on March 3, compared with 17.5 points 12 months ago. That means it costs 253,300 euros a year to protect 10 million euros from default for five years.

The reason for this sharp spike in spreads is, of course, the heavy exposure the Austrian banking system has to the risk of defaults in the East. Austria’s banks have about 201 billion euros ($254 billion) oustanding in loans in Eastern Europe, equal to about 71 percent of gross domestic product, according to data from the Bank for International Settlements. Shares of Austria’s Erste Group Bank, which made more than two-thirds of its profit from emerging European economies in 2008, and Raiffeisen International Bank-Holding AG, which operates only in the region, have both dropped more than 85 percent from their peaks.

To put this in perspective, Austria’s banks could withstand losses of up to 31 billion euros on their outstanding loans, according to stress testing carried out last month by Austria’s central bank. But what if the defualt figure rises beyond this?

Now all these numbers have been causing some controversy of late (see Izabella Kaminska's piece in FT Alphaville ) and Erik Berglof, Chief Economist at the European Bank for Regional Development has taken issue with some critics, specifically referring to the widely quoted BIS figure of $1,700bn, (cited among others Morgan Stanley's Stephen Jen, Yours Truly here, and The Anthropologist's Grandson Ambrose Evans Pritchard in the Daily Telegraph. Specifically, Berglof asks the following question:

The $1,700bn, which is taken from Bank for International Settlements statistics, represents the total claims of foreign banks and their affiliates on eastern Europe. Western banks own some 80 per cent of the region’s banking sector. The BIS figure therefore simply reports the region’s bank balance sheets. At $18,000bn the equivalent figure for western Europe is more than 10 times higher — should we be concerned?

My answer is, yes, we should be concerned, and more importantly, Austria's citizen's should. Let's look at what Berglof says next:

A much better measure of refinancing need is short-term external debt owed by the region’s banking sectors to foreign creditors. According to central bank data, this is about $200bn for all of central and eastern europe.

Thinking about his argument here, a lot of things make sense to me, in a sort of flash of lightening. You see, we are talking about two different things here, one is the level of exposure to default on the loans, not sovereign default, but default by households and companies as the economies contract, and as the currencies slide (or, in the case of the Baltics and Bulgaria, internal deflation is carried out), and the other is the issue of speculative attacks on currencies and reserves due to the gap in the current account deficits. But this would be the point, we are not dealing here with a 1960s type balance of payments crisis (although you wouldn't know that from looking at the measures the EU has been taking, and from the language which constantly refers to balance of payments loans.

What we have is a regional deleveraging process, as economies which have expanded well beyond their short term capacity level of output now contract sharply, in many cases with a boom bust dynamic. This is inevitably going to produce a steady stream of defaults over the next two to three years. One extaimate has been in the (worst case scenario) context of Ukraine that defaults may rise as high as 60%, but lets just imagine they rise above 20% - that would be around a 40 billion bill for Austria, and a 350 billion euro bill for Western Banks in the Context of Eastern Europe as a whole. And if we get a worst case scenario of 40% default, then you just double those numbers. Of course, no one at this point has any idea of the actual level of default we are going to see, or of the posterior recovery rate on the assets, but it doesn't help restore confidence if leading authorities essentially address the secondary issue and not the primary one. That presumeably is why Austrian spreads have risen and continue to rise. It is also why Eastern Europe needs a collective solution to its problems, and it needs one now.

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