A bearish view on Eastern Europe

This morning you may have read Gideon Rachman’s positive view on Hungary.  He said the panic is all but over and it looks like Hungry is going to get through this debt crisis.

The horror scenario envisaged a Hungarian banking collapse that would ripple back into the rest of Europe and then around the world. Many EU banks have lent heavily in central Europe. Austrian banks are thought to have lent the equivalent of more than 70 per cent of their country’s gross domestic product to the region. This idea – perhaps combined with a folk memory that the Great Depression had something to do with the collapse of an Austrian bank – helped heighten the panic about Hungary.

But, having just visited Budapest, I can return with good news. The immediate crisis is over. There was a moment when there was a real fear of a bank run. One Hungarian financier is quite precise about the date: Friday, March 13. However, confidence just about held up, the moment passed and so has the threat of imminent collapse.

The unfolding of the Hungarian crisis now looks like a microcosm of the world crisis. Fear of financial collapse is gradually giving way to worries about an unprecedented contraction in the economy – with all the social and political consequences that could imply.

The Hungarian government has predicted that the country’s economy will shrink by 6 per cent this year. It has not performed that badly since 1945. Unemployment is rising and so is inflation, because of the fall in the Hungarian currency.

Hungary has no room for the kind of counter-cyclical Keynesianism that is being tried in the US and the UK. Nobody thinks the markets would tolerate huge fiscal deficits, so instead the government is cutting spending and raising taxes. State pensions were sliced by about 8 per cent last week. Sales tax has just been increased. And this is just the start of an austerity drive.

So, to recap what Rachman is saying, Hungary is looking pretty awful, but it could be worse. But, is that really true?  I’ll come at this question via Latvia and the troubles now ongoing there.  Yesterday, we learned that Latvia’s economy shrank 18% in the period from Q1 last year to Q1 2009.  This is a Great Depression scenario for Latvia.  But, the other Baltics, Estonia and Lithuania, are imploding as well.  For example, at the end of April, Lithuania reported a 12.6% drop in year-on-year GDP – not as bad as Latvia, but a Depression with a Capital ‘D” nonetheless.  I had asked in July if the Baltics were the next Argentina.  The answer is obviously, yes.

So what does this have to do with Hungary?  A lot. Western banks piled into the former Soviet bloc in Eastern Europe during this decade’s boom.  And with growth coming off the boil those bets are coming a cropper.  Certainly, things look much worse in Latvia than they do in Hungary.  Hence, the optimism from Rachman.  But, the guys at Brown Brothers Harriman are not onboard with the all clear call.  They have a bearish view on Eastern Europe. Here’s what they had to say regarding sovereign credits today:

Moody’s has been busy today, downgrading Ukraine to B2 from B1 and Kazakhstan to Baa1 from A2.  Interestingly, Moody’s damned Mexico with faint praise yesterday by saying that it couldn’t see Mexico losing its investment grade rating.  Of course, that doesn’t rule out downgrades from the current Baa1 rating, and we note S&P just put its BBB+ on negative outlook.  Our EM sovereign rating model puts Mexico at BBB-/Baa3, and so the case is strong for a downgrade.  However, Moody’s appears to be correct about Mexico hanging on to its investment grade rating.  Our model puts Kazakhstan at BB+/Ba1, and so significant downgrades are warranted.  Again, we are incredulous that Moody’s put it at A2 in the first place.  We also put Ukraine at B-/B3, and so another downgrade there is warranted.  Given how poor 2009 is shaping up to be in terms of growth, capital flows, etc., we believe the rating agencies will continue to downgrade the weaker EM credits into 2010.  And it’s not just EM that the agencies are going after, with Fitch today moving Greece’s outlook to negative from stable (Greece was already downgraded by S&P in 2009, with agencies cutting Ireland, Portugal, and Spain this year too).  We reprint below our ratings outlook that was in the latest quarterly, since these views still hold:

The Baltics:  Despite seeing some downgrades already, Estonia, Latvia, and Lithuania remain highly overrated.  All still face serious crisis risks in 2009, and it’s likely that the other two will eventually follow Latvia into an IMF program.  None of them deserves an investment grade rating, and we look for multiple downgrades in 2009.  Note that IMF programs did not prevent downgrades during the Asian crisis.

EMEA:  Most of the other countries in this group are facing significant downgrade risk this year too, though perhaps the Czech Republic slightly less so.  Hungary’s rating is the most out of line and faces the most downgrade risk in 2009, followed by Iceland, Bulgaria and Romania.  We believe Poland and South Africa face moderate downgrade risk.

You should notice that Hungary is an outlier in their analysis with significant downgrade risk.  So, it is not a case of all clear at all, not for the Baltics and not for Hungary either.  Edward Hugh at “A Fistful of Euros” has been chronicling these events. Read his posts on these events over the last two days:

So, while the outlook is much improved, the risks are far from over.  With regard to the crisis in Eastern Europe, most people had been focused on Austrian banks and Central Europe (Hungary, Poland, Slovakia, Czech Republic).  I have written on this on a few occasions as well, even throwing in a vague reference to the Great Depression a post called, “1931.”  But, the Scandinavian banks’ exposure to the Baltics is just as worrying and should be the place to watch before we give a definitive all-clear.

  1. aitrader says

    SEB and Swedbank in Sweden wrote 80% of the mortgages in Latvia according to recent press reports. The Eastern European mortgages made up 20% and 25% of the banks’ 2007 profits respectively.


    According to Danske Bank, the loans could cost Sweden a total of 2% to 6% of its GDP over several years, depending on how many Baltic borrowers default during the recessions. (RGE Monitor)

    Swedish unemployment will be upwards of 11% by year end according to a recent (April 2009) JP Morgan report on the Swedish economic outlook.

    Swedbank and SEB jointly control btwn 50-75% of bank lending market in each Baltic country; Baltic operations account for about one-third of Swedbank’s operating profit and one-fifth of SEB’s (Bloomberg)

    Sweden has the third-largest exposure of all European countries to emerging-market bank debt, as a proportion of GDP (behind Austria and Switzerland), with total bank lending amounting to 25% of Swedish output (EIU)

    Anyone arguing for green shoots, especially in Europe, is spouting gobbledygook. I would liken the current economic situation to folks running out to gather fish and gawk at the receding ocean prior to a tsunami’s arrival.

    Sweden is a mirror of what is happening in most European economies. Switzerland and Austria have barely even begun to feel the economic pain of Eastern Europe’s looming mortgage crisis. These defaults will especially stress the Swedish Krona and Swiss Franc driving them, I believe, to severe weaknes vis-a-vis the Euro and Dollar in the next 12-18 months.

    This tsunami has not yet arrived but is now unavoidable in my opinion. The only question is when and how hard it hits.

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