Wednesday, April 8, 2009

Debt In The East

Eastern eggshells
By Stefan Wagstyl

Published: April 8 2009 19:21 | Last updated: April 8 2009 19:21

T he financial stability report regularly published by the Hungarian central bank is not a document that usually makes compelling reading. But this week’s, bearing the results of an assessment of the country’s banks, was different.

At first glance, all seemed reassuring. If the economy performed in line with mainstream forecasts and contracted by 3.5 per cent this year – and if the exchange rate stabilised at 290 forints to the euro – banks would keep their capital ratios above 10 per cent of total assets, the report found. Comfortably higher, in other words, than the international regulators’ 8 per cent minimum.

But under a “stress scenario”, with gross domestic product plunging 10.5 per cent and the forint sliding 15 per cent, capital adequacy would drop to that 8 per cent level. Banks accounting for nearly half the total assets would fall below the minimum, it disclosed.

Hungary’s economy is indeed deteriorating faster than expected. The forint trades at about 6 per cent below the central bank’s baseline forecast, while a 29 per cent decline in industrial production for February, also announced this week, has pushed economists to cut their GDP forecasts to minus 5 per cent or worse. Nor is this the whole story. As the central bank’s report says: “The calculations described above are characterised by considerable uncertainty . . . [making] credit risk forecasts very uncertain.”

The Hungarian National Bank is addressing questions that bankers, business people and political leaders around the world are trying to answer. The search is particularly acute in central and eastern Europe (CEE) because the region has been especially reliant on credit – foreign credit in particular – for its recent rapid development.

At last week’s London summit of the Group of 20 industrial and developing nations, world leaders promised extra money for the International Monetary Fund – much of which is likely to be used to support CEE. Even after this week’s sell-offs, regional currencies and stock markets are comfortably above the lows seen in February and early March. But the crisis is not over. As Andreas Treichl, chief executive of Austria’s Erste Group, a big investor in CEE, says: “Nothing has improved over the past few weeks but the market sentiment which was worse than it should have been.”

There is still plenty to worry about, not least the possible knock-on effects on western Europe and its banks, which dominate banking in most CEE countries. Dominique Strauss-Kahn, the IMF managing director, told the Financial Times in an interview last week: “The risk of spillovers or contagion in central and eastern Europe exists . . . One issue is what might happen in these countries. Another is the possible impact on other countries whose banks have a big exposure to central and eastern Europe. We are not saying something is going to happen but it could, so the situation needs to be watched carefully.”

As Mr Strauss-Kahn knows well, CEE countries are not equally vulnerable. Six states are already in IMF anti-crisis programmes – Hungary, Latvia, Ukraine, Belarus, Georgia and Armenia. Three more are close to starting programmes – Romania, Serbia and Bosnia. But at the other end of the scale, Poland and the Czech Republic have said they do not need such assistance and Poland has actually contributed to Latvia’s programme.

In politics, too, there are wide differences: Russia and Poland, the region’s two largest economies, seem stable, as does Romania following recent elections. The Czech Republic and Hungary have had their governments collapse in recent weeks and Ukraine is in prolonged crisis, with its leaders divided and Russia breathing down its neck.

Economic and political difficulties are not unique to the region. In western Europe, one country has already required an IMF rescue (Iceland), two have lost governments (Iceland and Belgium), several have been forced to rescue ailing banks (including Ireland, the UK and Germany). As elsewhere, global events will also be important in determining how the crisis develops locally. But the CEE states are generally more fragile – as new democracies with immature market economies and, crucially, their high dependence on foreign credit. Having borrowed abroad, largely to finance their post- communist transformations, almost all CEE countries face a hard task in refinancing their external obligations.

The IMF spells out the risks in a report disclosed this week in the FT: “The financial crisis is putting severe strains on the pre-existing vulnerabilities of emerging European economies . . . Credit losses at foreign subsidiaries of west European banks are threatening to start a vicious downward cycle . . . Regional currencies have come under pressure and tension among currencies is increasing.” The authors estimate the region (excluding Russia because of its huge foreign exchange reserves but including Turkey) must roll over $413bn (£281bn, €311bn) in maturing external debt this year and finance $84bn in current account deficits, with smaller amounts due in 2010. Assuming debt rollover rates decline to 50 per cent for private debt and 90 per cent for sovereign this year, with modest improvements in 2010, the IMF estimates the region’s financing gap – the money that cannot be found in the market – could be $123bn in 2009 and $63bn next year, or $186bn altogether.

On top of this, the region’s banks, largely run by west European groups, could face non-performing loans of about 20 per cent of total loans. West European banks, with a regional exposure totalling $1,600bn, could see losses of $160bn. They might need $100bn in new capital – or $300bn in “a more severe full-fledged regional crisis”.

Opinions about the IMF’s estimates differ vary. Pessimists say the Fund is too positive because it starts with a predicted GDP decline for 2009 of 2.5 per cent. Among the gloomier forecasters is the UK’s Capital Economics, which has pencilled in 6 per cent. As for rollover rates, optimists say success levels in refinancing debt are much higher than the IMF’s 50 per cent for private borrowers. Even if rates dropped sharply in past crises, they argue, this time things will be different given the European Union’s support.

Bankers admit bad debts will climb from about 3 per cent of total loans but say IMF is too negative with its 20 per cent forecast. Erste’s Mr Treichl says this figure is “absurdly high”, since CEE banks do not have the old debts that hang over some west European lenders. Also, with a ratio of total loans to GDP of about 100 per cent against 250 per cent, CEE is less indebted than western Europe, so risks of a spiral of cross-defaults are lower.

But dangers lurk in the rapid annual credit growth some countries saw in recent years, when banks may have cut corners on credit checks – and in the deep economic downturn, which is putting borrowers under more pressure than in western Europe. Neil Shearing at Capital Economics sees nothing absurd in a bad debt figure of 20 per cent. “Russian officials have already admitted that in Russia it could be 10 per cent. It doesn’t seem ridiculous to think that in some other hard-hit countries it could be 20 per cent.”

Whatever happens, the IMF is likely to provide the bulk of any official emergency support. Its capacity has been increased by the G20’s approval of $250bn in new special drawing rights, the IMF’s currency, and a call for $500bn in loans for the Fund.

The IMF is certain to continue playing the lead in assisting CEE on a country-by-country basis, with a strong supporting role for the EU and for individual states, as Sweden has already shown in the Baltic states. This will suit the EU, which has so far resisted IMF demands for a region-wide approach. Mr Strauss-Kahn argues: “Just because some economies are small, it does not mean they will have no impact on the region if their problems worsen . . . That’s why we have a big programme in Latvia although it’s a small, $30bn economy.”

But EU leaders do not want to write blank cheques. They draw distinctions between eurozone members on the one hand, where they intend for states to back each other without IMF help; EU members beyond the eurozone, which will be supported in conjunction with the IMF, as in Latvia’s €7.5bn ($10bn, £6.8bn) rescue where the EU has provided more money than the Fund; future members such as Serbia, which could receive more limited backing; and countries without a membership pledge, notably Ukraine, which will secure even less attention.

Set against this caution is EU members’ readiness to permit their banks to stand by their foreign commitments even if they are drawing on government refinancing funds and guarantees. Austria, with CEE loans equivalent to 70 per cent of GDP, is most exposed, followed by Sweden (30 per cent), Greece (20 per cent) and Belgium (20 per cent). Despite some grumblings from officials, no parent groups have had to stop backing subsidiaries.

At Erste, Mr Treichl says Austrian banks have faced no difficulties. However, the IMF warns in its report that this should not be taken for granted. “Where this burden would fall, and how it would be shared between advanced and emerging markets is an open and critical question.”

Much depends on global markets, where the mood remains nervous, and on the west European economy, where the recession is deepening. However, political and economic events on the ground in CEE also matter. The key question is whether governments can implement the radical restructuring that the more vulnerable economies require. Latvia, Ukraine and Hungary are in political turmoil and have their credit default swaps, a risk measure, trading far above their neighbours.

Demonstrations this year in these three countries, and in Lithuania and Bulgaria, have created a sense of regional ferment. That could deepen following this week’s events in Moldova, where activists stormed parliament and the presidential palace. But Poland’s centre-right government is even more popular than when it won landslide elections two years ago. The Czech government fell last month but investors are unconcerned because the economy is seen as sound.

So for politicians, as for financiers, it is a matter of case by case. But, as Mr Strauss-Kahn suggests, both ignore the risks of contagion at their peril.

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