The plague heads east

The IMF has bailed out Hungary and Ukraine but it could have plenty more work to do in 'subprime' Eastern Europe. Which other countries in the region are in danger?

The credit crunch is comparable to a "plague" being passed from sector to sector of the global financial system, says Roger Bootle in The Daily Telegraph. It has now begun to affect whole countries, with the main flashpoint in Eastern Europe, which is a continent-sized equivalent of subprime mortgage lending. The main problem is huge current-account deficits: countries are living beyond their means. The estimated shortfalls in Hungary, Turkey, Lithuania and Romania are 5.5%, 6%, 10% and 16% of GDP respectively for 2008. Latvia's deficit peaked at a colossal 26% of GDP last year. High current-account deficits mean that these countries depend, to a large extent, on external borrowing to fund increases in their standard of living. But now, access to those funds has dried up as global liquidity has disappeared and aversion to risky assets risen.

Stocks and currencies have slid the NTX index of 30 regional firms lost around 40% in October with fears of Iceland-style financial meltdowns and economic slumps growing as capital has fled. A particular worry was consumer and company exposure to foreign-currency loans; 90% of new mortgages taken out since 2006 have been in Swiss francs or euros. Tumbling currencies thus increase debt burdens. There was also concern that cash-strapped foreign banks would cut lending sharply.

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Now "the flames" are out, says The Economist, but smoke is "still rising". Austria has offered its banks (owed $290bn across Eastern Europe) $129bn, while the IMF has bailed out Hungary and Ukraine. The latter is in line for a total of $16.4bn and Hungary look set for almost $16bn as well as $8.4bn from the EU and $1.3bn from the World Bank. This should avert an immediate financial meltdown, as it covers over half of Hungary's external financing requirement for this year, notes Capital Economics. But the IMF's work in the region may not be over.

Turkey's corporations have gorged on easy foreign debt, with the gap between their obligations and their dollar assets around $73bn. A further slide in the currency, under pressure from the large current-account deficit, implies "a slew of corporate defaults and bank losses", says Constantine Courcoulas on Breakingviews. Bulgaria's current-account deficit is tipped to reach 24% of GDP this year. The gap has been filled with foreign direct investment (a third of which went into real estate and inflated a bubble that has now burst), which looks set to slide now that shrinking Western European economies will export less capital. Bulgaria, Hungary and Romania had their credit ratings downgraded by ratings agency Fitch this week due to the threat of global recession and dwindling capital flows. Fitch now classifies Romania's debt as junk.

As far as the Baltic states are concerned, Fitch reckons that the money needed to repay foreign debts and plug current-account deficits next year amounts to 400% of likely year-end foreign exchange reserves in Latvia, 350% in Estonia, and 250% in Lithuania. This week the reliance on foreign funding was highlighted by Parex, Latvia's second-largest bank, which thanks to frozen global credit markets was nationalised following jitters that it would default on $1bn of loans that matured next year. It was not foreign-owned and thus unable to tap a parent bank (the Baltic banking sector is largely owned by Swedish banks).

Confidence in the Baltics is also being hit by the deepening recession. Latvia's GDP fell by 4.2% year-on-year in the third quarter following the implosion of the easy credit-induced housing bubble. The recession is unlikely to end anytime soon. The Baltic currencies are pegged to the euro, and a devaluation of the peg would be humiliating, so falling domestic demand is the only way for the huge current-account deficits to be reduced. At best, the Baltics face "big cuts in public spending and lower output... while they pay off their debts and regain competitiveness", says The Economist.

The economic outlook elsewhere is also grim. Hungary may be back from the brink, but will be forced to make large cuts in public spending by the IMF, which also expects bank lending to contract as funding costs rise, says Capital Economics. The upshot is a fall in GDP of 1% next year, reckons the IMF. Deleveraging at Western banks implies a clampdown on foreign lending across the region. Countries whose currencies have slumped will have to keep interest rates high, thus dampening growth, to rectify this situation witness Hungary's latest rate rise to 11%.

Then there's the Western European recession to consider. This explains why Hungary's industrial production is falling at the fastest rate in 16 years and why the Czech Republic, whose current account is in surplus, has just had to cut rates. On top of all this, earnings downgrades are just getting under way in the region, says Citigroup. Turbulence in Eastern European stock and currency markets is far from over.