Western European Banks' Exposure to Eastern Europe

This article is a translation of an article on my Swedish language blog.

Last week I wrote about Eastern Europe's loans from Western European Banks (in Swedish). Now I've taken the latest figures from BIS and made graphs to illustrate how the situation is. Please note that the figures are only for claims from banks. There may be other lenders too, but it's not as easy to find statistics for them.

First I'll present an illustration of which Eastern European countries have borrowed most. The colours indicate which in Western European countries the they have borrowed from belong. Click the graph for a sharper version.This graph shows clearly that we don't need to worry too much about Western Europe's banks if Macedonia, Moldova, Montenegro, Belarus, Albania, Bosnia or Serbia should be hit by a collapse of the economy and currency, since their loan volumes are relatively small. The other countries, however, are potential threats to Western Europe's banks. This becomes especially clear when one Western European country has a large proportion of the lending to a certain Eastern European country, e.g. Sweden to Estonia, Latvia and Lithuania.

Huge figures have been floating around when it comes to the exposure of Western European banks to Eastern Europe, but the total sum of bank lending is "only" slightly more than 1.4 trillion dollars, which should be quite close to the actual figure. This is still, however, a very large figure.

Now I'm going to look at it from "the other side", i.e. divided per lender country instead.Here you can see that Austria is at the top of the risk list for lending to Eastern Europe. As for Sweden we can note that the major part of the lending is to the three Baltic states. Since these three economies risk following each other, Sweden is much more exposed to a single risk factor.

However, absolute numbers don't often say that much. If Italy lends a bit over 200 billion dollars that's a larger share of the country's GDP than if Germany lends the same amount. So below I compare the banks' lending to Eastern Europe to the GDP of the countries (taken from the 2008 GDP estimates from the CIA Factbook).Then you suddenly see what a huge risk Austria is taking! Their banks have lent roughly 64% of the country's GDP just to Eastern Europe! Even a mild crisis in Eastern Europe would thus probably suffice to topple Austria's banks - we don't even need a serious crisis. The biggest Austrian claims are on Czechia, Romania and Hungary. At least Romania and Hungary are already on the problem radar...

By Austrian measures the other Western European countries have taken limited risks towards Eastern Europe, even if they definitely aren't negligible. Belgium's banks have lent about 25% of Belgium's GDP to Eastern Europe, and Swedish banks about 20% of our GDP, most of it to Estonia, Latvia and Lithuania.

Let us also take a look at which Eastern European countries have borrowed the most in relation to their GDP, and thus have taken a large risk. This is according to my usual identification mechanism for potential problems in this crisis. Large loans = large problem risk.Here you can see that Croatia and Estonia are in a risk class of their own. Their claims from foreign banks are more than 120% of their GDP. But Latvia, Hungary, Czechia, Slovakia, Lithuania and Bulgaria are also risk factors that cannot be ignored (the nominal sum of their borrowing according to the first graph in this article also plays a part here). Add to this the fact that GDP for many Eastern European countries is now falling rapidly, and we will quickly get even bigger loans-to-gdp ratios.

Part of the risk is also the currency risk. A large part of the loans from Western to Eastern Europe are denominated in euros or Swiss francs. This causes payment difficulties when the local currency sinks against the euro and/or the franc. Unfortunately I don't have any figures for how much of the loans are denominated in foreign currencies, but we can take a look at how some currencies have moved against the euro since the end of August last year.Here you can see that Ukraine's hryvnia and Poland's zloty have fared worst. We have all heard about Ukraine's problems, but there has not been much mention of Poland during this crisis. Hungary, Romania, Russia and Czechia have also been hit by falling currencies, though not as badly.

To conclude, we can see that the banks of several Western European countries have taken large risks towards the now faltering economies of Eastern Europe. There is an immediate risk that for example a currncy and/or economic collapse in one of the risk countries I've presented above could topple e.g. Austria's banks. This in turn would probably give serious repercussions for the whole euro area (Austria is part of it). As I see it it is only a matter of time before something drastic happens. Exactly what will happen is hard to predict, but Sweden is definitely also in the risk zone.

In this context it is interesting to note that the bank crisis of 1931 had its origins in Austria, where their then largest bank Creditanstalt went bankrupt in May of that year. Will we get a replay?

P.S. I recommend the following two articles by Ambrose Evans-Pritchard at the Telegraph for those who want to read more about the risks from Eastern Europe:
Failure to save East Europe will lead to worldwide meltdown
Eastern European currencies crumble as fears of debt crisis grow

Credit Derivative Woes

My first Flute Thoughts are on what's currently happening in the financial markets, though I'll go into other subjects later. This article is a summary of stuff I've written on various forums over the last few days. I'll try to include links to pages explaining any difficult terms I'm using.

Last week was eventful in the financial markets, to say the least. Read about it in Financial Times for example.

As I see it it's just a matter of time before we get the next bad news that will sink the markets. A hedge fund or bank will come out and say that they have big problems. Maybe already tomorrow, Monday? Or Tuesday?

Though we might see a short rally up in the stock markets until the next bad news comes out.

The liquidity injections into the markets by the central banks on Thursday and Friday probably averted a number of acute liquidity squeezes and gave banks and and funds a chance to get out of their most catastrophic positions. The biggest injections were by the ECB (€95 billion on Thursday, €61 billion on Friday) and the U.S. FED ($24 billion on Thursday, $38 billion on Friday). The ECB action was the largest one ever. Some really important institutions (e.g. major banks) must be in big trouble. To quote Erik Nielsen, the chief European economist at Goldman Sachs: "Someone must have called them and said 'we need liquidity now,' They did what a central bank is supposed to do."

These liquidity injections are extreme measures, that the central banks only take in extreme situations. These actions have a number of effects. First of all they save the banks from sudden unexpected liquidity crunches, which could very well topple them. Public faith in the banking system is vital, without it our current economic system won't work. Secondly it temporarily stabilises the markets, and might also imbue some optimism. But it also signals "danger", since it is an extreme measure, and many investors become scared and sell off their equities. In the long run, of course, it might lead to other side effects, such as more imbalances in the financial system. Anyway, these emergency actions by the central banks might mean that we won't get a fast financial crash, but rather a slow scenario.

However, I see some serious problems building up:

1. "Hedge Fund" has suddenly become synonymous to "toxic waste" and many investors will withdraw their funds from anything that smells of hedge funds. Since the hedge funds work with high leverage, often borrowing 5-10 times their capital, or even more, this means that they must sell off a lot to redeem those who wish to get out. Selloffs = markets down. Besides, certain financial instruments cannot currently be sold, since nobody wants to buy them, so they'll have to sell more liquid instruments, such as stocks or commodities (oil, metals, etc). If enough investors try to withdraw from a hedge fund, it could go bust, leading to more panic among investors. There's already a Hedge Fund Implode-o-meter to report on hedge funds that have hit the wall. The French bank BNP Paribas stated quite clearly what the problem was when they suspended three of their hedge funds last week: "The complete evaporation of liquidity in certain market segments of the U.S. securitisation market has made it impossible to value certain assets fairly regardless of their quality or credit rating,".

2. What's happening in the credit default swap (CDS) markets? These have not been mentioned much yet, with most of the focus being on the U.S. subprime mortgage markets. Mike Shedlock wrote a good article about a month ago which mentions the CDS problem - "Who's Holding the Bag". The global market for CDSs is mindbogglingly huge. As of 2006-12-31, there were $34 trillion in CDSs outstanding globally. For comparison, the total world GDP was $48 trillion in 2006. Now that the global credit markets are drying up investors and funds will start reviewing their positions on the CDS markets too. It's already doubtful whether many issuers of CDSs can live up to their promises. Besides CDSs were never very liquid instruments to begin with, and even less now. This could lead to a crisis where further liquidity injections by central banks won't be of much avail. Note that the CDS market has grown explosively over the last few years - in December 2003 there were only $3.6 trillion in outstanding CDSs.

3. So far only a few hedge funds of a few billion dollars each and one smaller bank (German IKB) have gone belly up, and also a large number of subprime lenders (see the Mortgage Lender Implode-o-meter). The markets can handle this, but what happens if a larger bank hits the wall? There will be an unprecedented domino effect, considering the fact that most major banks and insurance companies in the world are interconnected by various loans and other contracts. Besides, there are probably lots of credit default swaps connected to banks, see #2 above.

4. Another issue connected to lending is that over the last few years there have been many loans issued to companies with bad credit ratings, so called junk bonds, and to rather low interest rates, since credit spreads have been so narrow. These are the company equivalent of subprime mortgages, and not much has been written about them yet. But there will be bad news soon here too, rest assured. Many funds and banks are now probably trying to get rid of these loans and their derivatives, e.g. collateralized debt obligations (CDO) and other funny abbreviations. This before the searchlight starts illuminating this part of the credit markets.
During the last few years, the percentage of company bankrupts has been low in the world (including the USA) because it was easy and cheap to get a loan. Now when credit spreads are increasing and credit is drying up we will instead see bankrupts increasing to above their historic averages. Especially since there is a "backlog" of companies with problems that have been saved by the easy credit of the last few years. This, of course, will be a long process, since all badly run companies don't run into problems at once, but rather gradually. Then remember that many of these junk bonds are "insured" through credit default swaps (see #2 above).

Number 1 is probably already happening. Number 2 can happen any time. We might have to wait a couple of weeks or months for number 3, or even a year. Number 4 will probably evolve slowly over the next year, gradually replacing the subprime mortgage crisis as a major concern for the financial markets.