By Jonathan Anderson

From Caijing Magazine

In the past week or two, financial markets have been buffeted by fears that Eastern Europe is now facing a financial “meltdown”, and one that threatens to take the stability of Western European banking systems down with it. This theme has had a heavy impact on bank stocks, overall equity indices, gold markets and even the euro.

Based on a slew of articles in the popular press, the basic story runs as follows: Eastern Europe is essentially bankrupt. It needs to repay more than US$400 billion in short-term debt to Western commercial banks this year, and it owes another US$1.5 trillion in longer-term exposure. These sums represent a very onerous share of their GDP to begin with, and with both exchange rates and growth now collapsing, there’s very little chance that any of this can be repaid. The looming outcome is a tidal wave of default that could easily overwhelm developed European banking systems, and in particular countries like Sweden, Austria, Greece, Italy and Spain.

And that’s just Eastern Europe. Once we add in European banks’ exposures to Asia and Latin America (the story goes), the size of the threat doubles or even triples; added all together, this could absolutely dwarf the impact of sub-prime debt on the global economy.

This is heady stuff, and of course has helped call attention to the state of Eastern European economies. However, we need to stress that the conclusions above are also highly exaggerated, with at least as much “hype” as hard analysis. And the irony here is that all the press notice and market turmoil come at a time when nothing has really changed in terms of the underlying regional situation; most economists have been writing about Eastern Europe’s problems for a good long time now.

So how should we think about what’s going on, and what is the real threat to Europe? Here’s a quick guide to understanding the issues:

We’ll start with three pieces of bad news. The first is that for a broad swathe of Eastern European economies (the Baltics, the Balkans, the former Yugoslav states, Ukraine and to some extent Hungary and Kazakhstan) the situation is indeed very severe. These countries have extremely high external debts, very levered financial systems, generally low FX reserve levels and now rapidly contracting economies – in short, there are clear concerns about the capacity to repay and a marked increase in default rates is very likely. Most of these countries also have a very concentrated group of commercial bank creditors.

Moreover, the remainder of Eastern Europe also has visible fragilities. Currencies in Poland, Turkey, Russia and the Czech Republic have all depreciated, and Russia’s domestic banking system has also come under stress. In the case of Turkey and Poland, there is also a possibility that the IMF or the EU will have to provide additional financial support. In short, none of these is a perfectly stable economy with no domestic or external imbalances.

And finally, some European banks do indeed have very high exposures to Eastern Europe. For example, the Austrian banking system has amassed claims on its emerging neighbors worth a stunning 67 percent of GDP. Belgian banks’ total exposure is around 28 percent of its economy. For Sweden the number is 22 percent, and Switzerland 12 percent of GDP. If all of these loans went bad in a short period of time, the economic impact would be enormous.

And now for the good news. To begin with, the most onerous problems are in small countries. Whether we look at financial leverage ratios, external debt as a share of GDP, current account deficits, FX reserve coverage or any number of other stress indicators, the Eastern European countries with the most severe problems (basically the list we gave above) have an average GDP of around US$50 billion, i.e., very small indeed compared to the US$10 trillion-plus Western European economy.

Meanwhile, more than half of short-term external debt is held by the larger, lower-risk Eastern European countries, i.e., Russia, Poland and Turkey, together with the Czech and Slovak Republics (see chart). And these are fundamentally different cases from the “severely” impaired group in the earlier paragraph: they have less levered banking system, less concentrated debt exposures, fewer pressures on growth, and in the case of Russia what is still a large stock of outstanding reserves and a current account surplus. So while there are clear risks here, we’re not talking about anything close to the same level of payment incapacity, and the gap between these country groups is still relatively wide.

And this has a meaningful impact when we go back and examine Western European banks’ exposures. Mind you, Austria and Sweden do still look very troubled, with 40 percent and 20 percent of GDP respectively in claims to the higher-risk Eastern group – but for Belgium and Switzerland the numbers are much lower, and by our count there’s not a single other Western European country with high-risk exposures of more than 5 percent of GDP. In other words, even if we do get a “meltdown” in the East, the financial impact on Europe as a whole would likely be less than catastrophic.

Which brings us to the next point: Even in the most distressed country cases above we’re probably talking about “orderly” default rather than an outright “meltdown”. The Baltics and the Balkans, for example, have seen surprisingly few signs of strain to date on pegged exchange rates or currency board arrangements, and in the absence of a mass exit from the local currency or an explosion in local interest rates the rise in non-performing loans will likely be a more gradual process tied to the contraction of the economy rather than a sudden macro balance sheet collapse. In our view, it’s really the Ukraine where we see the largest risks of a more wrenching impact from currencies and rates at this stage.

And finally, remember that it really is just about Eastern Europe. Once we turn our attention away from emerging Europe and towards Asia and Latin America, there are very few economies indeed that would fall into the same category on any of the above stress metrics: Average external debt levels are much lower, domestic credit exposures are far less, most countries have balanced or surplus trade positions, higher FX reserves and access to financing. Of course emerging economies everywhere are suffering from the impact of falling exports and worsening global growth, but this is a very different issue from a wholesale collapse in credit quality in a financial crisis scenario. So for developed commercial banks, the message is simple: watch Eastern Europe, and hope for the best.

Jonathan Anderson is Head of Asia-Pacific Economics for UBS.

Full Article in Chinese: http://magazine.caijing.com.cn/templates/inc/chargecontent2.jsp?id=110075358&time=2009-03-01&cl=106