The Risks of a Crisis in Central and Eastern Europe Are Bigger Than You Think

Posted by on 24 June 2010


This article points out that the eight newest members of the European Union (EU) (Bulgaria, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, and Romania) face very high vulnerabilities.  It is known that the Central and Eastern Europe (CEE) countries have severe structural distortions, including external imbalances: lost competitiveness, widening external deficits, and deteriorating public finances.  While some of the risks are well known, this article presents new factors that compound the risks, such as the condition of the banking system in Western Europe. The estimates of the ex-ante external financing shortfalls suggest that support needed is of a scale that is not within the capacity of official community.

Recently there have been several papers that try answering the question “Why did some countries fare better than others?” such as Berglöf, Korniyenko, and Zettelmeyer (2009) [1] .  The short and not unexpected answer is that this was due to differences in financial openness leading to capital inflows, underlying vulnerabilities to external forces such as capital flows reversals, and the strength of their economic policies. The CEE countries entered the crisis with all of those vulnerabilities. Capital inflows were larger in emerging Europe before the crisis and fell more severely during the crisis than in other emerging economies. Bank inflows have been an important source of funding for many countries in the region in the past. Capital inflows were larger in emerging Europe and fell more severely during the crisis than in other emerging economies (IMF 2010) [2]. Prior to the crisis, cross-border loans from Western European parent banks to their emerging European affiliates accounted for a large share of the flows. The latest data (2009Q4) shows that cross-border loans into banks and corporates continue to fall in many countries across the region even as foreign direct investment equity inflows continue to hold up. With lackluster foreign borrowing by banks, private sector credit growth is still negative in some emerging EU member states and Ukraine.

Prior to the crisis, cross-border loans from Western European parent banks to their emerging European affiliates accounted for most of the difference. The large inflows created macroeconomic and financial sector vulnerabilities – larger current account deficits, rapid credit growth, worse fiscal positions, and heavier indebtedness (often in foreign currencies) of households in a large part of the region.  The vulnerabilities lead to a particularly sharp adjustment when international sentiment reversed with the onset of the crisis.

The eight newest European Union (EU) members (Bulgaria, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, and Romania) are the most vulnerable within this group [3]. They already suffer from the problems that dragged the GIIPS—Greece, Ireland, Italy, Portugal, and Spain—into crisis: lost competitiveness, widening external deficits, and deteriorating public finances. The “peggers”—Estonia, Latvia, Lithuania, and Bulgaria, who have fixed exchange rates—are  possibly  in worse shape than the “floaters”—the Czech Republic, Hungary, Poland, and Romania due to exchange rate adjustment mechanism.

Hungary is the poster child for the countries that were adversely affected during the global financial turmoil due to underlying vulnerabilities.  While the immediate trigger was a liquidity squeeze prompted by the global financial turmoil, the country had a number of vulnerabilities leading to the Hungarian debacle.  The list of “cardinal sins” applies to a larger or lesser extent to all the CEE countries. Despite Hungary’s fiscal austerity measures, Hungary suffers from twin deficits - the current account deficit mentioned above, as well as a budget deficit.    Hungary’s current account deficit was high, but nothing compared to the double-digit deficits in Bulgaria, Romania, and the Baltics.  With public debt standing around 65% of GDP, Hungary was an outlier among its regional peers.  Hungary’s short-term debt (18% of GDP) was roughly covered by net international reserves, according to the IMF.  Finally, as in other countries in Eastern and Central Europe, Hungarian banks were vulnerable on several counts: High Foreign Currency Lending; Domestic Banks had heavy reliance on non-deposit, foreign financing; Domestic Banks had a deteriorating maturity structure throughout Eastern and Central Europe; and finally there is a potential spillover from foreign parent banks that account for the majority of the financial system. 

At this stage, the potential spillover risks from foreign parent banks are very high in the CEE countries.  11 Western European banks headquartered in 9 Western European countries collectively control 133 banks in CEE. They represent more than 50% of the banking sector in 10 CEE countries.   In Serbia, for example, 74% of banking sector assets owned by foreign banks, while 72% by banks headquartered in EMU and approximately 75% of banking loan portfolio is denominated in FX or FX indexed and most of it representing exposure to unhedged borrowers.  The CEE area is vulnerable to any difficulties confronted by the major foreign parent banks that dominate the region’s banking systems.

Prospective problems in the EU banking sector could adversely impact CEE economies and vice-versa. The draft Basel 3 capital accord and liquidity proposals have adverse implications for European Banks and consequently for CEE. According to a Credit Swiss analysis the estimated impacts are very material for European Banks: The revisions will reduce Tier 1 to 2.6% and require €600- €1,000Bn of new capital for European banks to comply with capital proposals. The liquidity provisions will require    €3,500-5,500Bn of new long term funding. Finally the impact on European bank earnings is estimated at €250 Bn (equivalent to 37% of 2012 Earnings), with a drop in Return on Equity of 4-5%. Under such circumstances a retrenchment of European banks   from CEE is inevitable. We will know after the European authorities release the stress tests, but given official pronouncements from the European Central Bank it is likely that the growing concerns about the stability of the EU banking sector are warranted.  

A second concern is that even under the present conditions, select countries in the CEE   have a capital shortfall. Using the Bankscope financial statements data, I conducted a simple stress test based on the latest available data. I find that most banking systems in the developing world were reasonably capitalized going into the crisis and therefore absorbed the shock reasonably well. There are 3 countries in CEE were there are   capital shortfalls: Czech Republic ($4,112 MM); Hungary ($5,161MM) and Poland ($2,127MM).

Based on the current account deficit projections for 2010, along with schedules of private foreign debt coming due, the total external financing needs of developing countries (4) are expected to be on the order of $1.1 trillion in 2010 of which a disproportionate amount- $492 billion-   are due in Central and Eastern Europe. While capital inflows declined sharply,  the ex ante financing needs of CEE countries have not changed significantly due to the need to roll over of sovereign and private debt.   At the same time Western European banks are no longer in a position to provide funding for reasons presented later on. Therefore, in contrast to much of the emerging world, capital inflows to emerging Europe continue to be weak and mixed (Mathisen and Mitra 2010)[5].  

The vulnerabilities, as well as the dependence on externally funded credit growth denominated in foreign currency will lead to further financing difficulties as the parent banks in Western Europe go through increasing demands for capital and funding due to Basel 3, domestic losses and potential sovereign losses in Greece and elsewhere. The risks in the CEE are compounding.  









[1] Berglöf, Erik, Yevgenia Korniyenko, and Jeromin Zettelmeyer (2009), “Crisis in Emerging Europe: Understanding the Impact and Policy Response,” unpublished manuscript.

[2] International Monetary Fund (IMF), 2010, Regional Economic Outlook: Europe, May.

[3]The Euro Crisis Is Bigger Than You Think  International Economic Bulletin - Carnegie Endowment for International Peace


[4] The external financing need and gap projections are based on the methodology developed in World Bank (2009a) and assess the extent to which capital flows from private sources will meet developing countries' external financing needs defined as current account deficit and scheduled principal payment on private debt. 


[5] Managing capital inflows: Emerging Europe is different, again Johan Mathisen, Srobona Mitra, 25 May 2010