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Eastern European bailout proposed

by Open-Publishing - Tuesday 24 February 2009

Economy-budget Europe

Sebastian Moffett
The Wall Street Journal

EUROPEAN leaders called for doubling the International Monetary Fund’s war chest for bailing out financially stricken nations, amid new signs that Europe’s former Communist East is sliding into a full-blown economic crisis with worrying implications for the continent as a whole.

Europe’s developing economies from Poland to Ukraine are facing their worst economic crisis since the fall of the Berlin Wall 20 years ago. Capital is fleeing Europe’s east, sending currencies sliding and threatening the region with deep declines in output and employment, and a deluge of debt defaults. Poland’s industrial output in January fell at a painful 15 per cent annual rate; its currency last week hit an all-time low against the Swiss franc.

The spreading trouble — which on Friday claimed the government of Latvia — could force more countries on Europe’s periphery to seek help from the international community. Latvia’s economy alone could shrink by as much as 10 per cent this year, according to some estimates.

The IMF already has bailed out four ex-Communist countries, as well as Iceland and Pakistan in recent months.

This weekend’s call by the leaders of Europe’s major economies to double the IMF’s war chest, to $US500 billion ($774 billion), highlights their concern about the financial trouble brewing to the east. The statement however, was short on specifics. For instance, it didn’t say where fresh funds might come from at their Berlin meeting.

The West European leaders’ brief proposal falls short of demands by the World Bank and governments including Austria and others for Europe’s wealthy West to prop up the continent’s vulnerable East.

Until the past couple of weeks, the turmoil mainly hurt Eastern Europe’s most financially overstretched countries, such as Latvia and Hungary. But collapsing currencies and markets even in hitherto robust economies, such as Poland and the Czech Republic, show that investors are now fleeing the whole region.

The market slump in Europe’s East threatens to undermine years of hard work in former Soviet satellites to build a Western market economy and way of life.

It could also sour the heavy investments by Western European banks in the region. Some analysts are now describing the region as Europe’s own "sub-prime" loan market, an analogy to the US sub-prime mortgage market whose collapse beginning in 2007 triggered the global financial crisis.

"There is no doubt that this is the biggest economic crisis in Central and Eastern Europe since the end of communism," says Lars Christensen, chief emerging-markets analyst at Danske Bank. Economies from the Baltic to the Balkans face contractions of up to 15 per cent in gross domestic product, he says. That would be comparable to what Indonesia suffered in 1998, in the thick of the Asian economic crisis.

Central and Eastern Europe today have some features similar to emerging-markets crises in Southeast Asia, Argentina and Mexico in the past 15 years: Risk-wary investors are pulling out money en masse, which weakens local currencies. Weaker currencies make it tougher for locals to pay off their foreign-currency debts. That spurs fear of widespread loan defaults and strips economies of the capital inflows that sustained them.

In much of Eastern Europe, individuals and businesses have sought to catch up with Western living standards by borrowing heavily from overseas. The 10 former Communist countries that have joined the European Union since 2004 have attracted huge amounts of credit and other investment from Europe’s wealthier West.

The implied stability of EU membership allowed East European firms and individuals to borrow in foreign currencies such as the euro, the Swiss franc and the yen, which offered lower interest rates than local currencies.

That kind of cross-border borrowing worked fine in smoother times, when local currencies were relatively stable. But now, as the currencies in the East weaken sharply, people who borrowed abroad are seeing their loan payments balloon.

Eastern European borrowers need to repay about $US400 billion in debt owed to Western banks this year. Much of that is denominated in foreign currencies, according to a report by Swiss bank UBS.

Rafal Lyczek did what seemed like the sensible thing last May: He converted the loan on his home in Poland into Swiss francs, using Switzerland’s lower interest rates to cut his mortgage payments. The bet seemed safe, since the Polish zloty has been a strong currency in recent years.

But the zloty has weakened severely since July. That means monthly repayments for the 31-year-old economist have jumped around 50 per cent since last summer, now that it takes about 3.20 zloty to purchase one Swiss franc, compared with only 1.98 in July.

"I switched because everybody did it at the time," he says. "My mistake was that I did not take into consideration the stability of the zloty, which is the currency of my pay cheque."

Mr Lyczek says he’ll survive. But market fears that many Polish and other regional debtors will default have battered the stocks of West European banking groups that own the bulk of Eastern Europe’s lenders.

Debt isn’t the only problem. Many Polish companies also face heavy losses on currency options that they bought last year on the assumption that the zloty would keep strengthening. By some estimates, these losses alone could wipe out about 1.5 per cent of GDP.

Poland and others in Europe’s East emerged from massive economic contractions after the fall of communism in 1989. Poland, Hungary, Romania and Bulgaria suffered double-digit declines in output in 1990-92, according to the IMF, when their moribund, Soviet-era industries were exposed to market forces.

But by the late 1990s, much of the region had recovered and was growing robustly, thanks to exports and foreign investment, including by West European banks and carmakers. From around 2003, the growth turned into a headlong boom as it became increasingly easy to borrow money cheaply. That cheap borrowing contributed to a flood of fresh investment in Eastern Europe’s retail and property sectors.

Governments in the region mostly failed to counter signs of a debt-fuelled bubble. "Policy makers in the region have been cheerleaders of the boom, rather than prudent guardians of growth," says Mr Christensen of Danske Bank.

In Latvia, economic growth topped 10 per cent in 2007 thanks to rampant consumer spending and construction activity. Late last year, Latvia refused to devalue its currency, which is pegged to the euro, despite the country’s struggle to finance its huge import bill. It took out a loan from the IMF and embarked on an austerity program of wage and budget cuts. But its economy declined even faster under the plan, triggering Friday’s resignation of the prime minister and cabinet in the face of rising public anger.

In some ways, Eastern Europe faces bigger challenges than did Southeast Asia after that region’s 1997 financial crisis. Then, the rest of the world economy continued to grow, providing healthy markets for an export-driven recovery. But this time, much of the developed world is in a prolonged funk of its own.

Federico Ghizzoni, manager of Italian bank Unicredit’s central and east European operations (with regional loans totaling some €90 billion euros, or $178 billion), says the biggest problem is the rising loan-default rate. But he adds that Eastern European economies have some advantages.

For one thing, he says, they will be protected to some extent by their EU membership, which provides them with money from Brussels to help build up their economies. There is also the large number of Western companies that have set up in the region.

"We have 1000 companies from Western Europe" that have invested in the East he says. "There are a large number of long-term investors who will continue to stay during the crisis."

Eastern Europe’s problems have the potential to shake public confidence in democracy and market economics, although public anger has so far focused on the mistakes of specific leaders.

In Poland, the fall of the zloty has intensified a long-running debate over whether to join the euro. Because it is the largest, most-open economy in the region, the zloty, along with the Czech currency, has borne the brunt of recent capital flight.

Despite the zloty’s recent nosedive, economists say Poland’s economy is in many ways sounder than more financially overstretched countries such as Latvia or Romania. Poland’s strengths include relatively strong foreign-exchange reserves. In addition, its banks aren’t as deeply in debt as banks in some neighbouring countries.

But in a panicky market, even relatively strong economies such as Poland and the Czech Republic are taking a beating.

Polish borrowers need to repay about $US71 billion of debts owed to Western banks this year, much of it denominated in foreign currencies. Rising unemployment — expected to reach more than 12 per cent in mid-2009, from 9 per cent in September — will also reduce spending.

Last year’s growth of 4.8 per cent could easily be erased. Bankruptcies will rise by at least 20 per cent this year, according to Euler Hermes, a unit of the Allianz insurance group.

Furniture maker Swarzedz Meble. was founded a century ago. It survived war and communism and became one of Poland’s first companies to list on the stock exchange. After several years of sharply declining sales, Lukasz Stelmaszyk, now 34, took over as CEO in October 2007 and embarked on an ambitious turnaround plan.

Last year brought signs of success. Sales in the consumer division doubled in the first three quarters of the year, compared with the year-earlier periods, he says.

But in the final quarter, as the world economy began to stumble, consumer growth slowed, while business customers — especially in Germany, Ukraine and Russia — began to put off purchases being discussed.

Things got so bad, so quickly, that a month ago, Mr Stelmaszyk recommended the company be liquidated.

"Because of euro entry in 2012, we were very optimistic about 2008 and 2009," he says. But, "every week as the crisis evolved, customers cancelled discussions."

Many in Poland fell victim to currency swings. As the zloty rose last year, some companies tried to take advantage of the volatility to speculate — and tripped up.

Sfinks Polska, a restaurant chain, has almost no revenue in euros. But the company in August and October swapped some of its debt into euros. That contributed a loss of 8.8 million zloty ($3.7 million) by the end of the year.

The management was replaced in November, and last week the new management filed for bankruptcy. "In the opinion of the current management, these deals were speculative," wrote Mateusz Sielecki, the current Investor Relations Manager, in an email.

Many Polish borrowers are angry at the banks, who heavily advertised Swiss-franc loans. The trend had started in 2004, but gathered momentum with a real-estate boom from 2005 to 2007, as Poles rushed to buy their own homes. Banks put out posters offering rates as little as 3 per cent for a franc-denominated loan, but included little clear information about the inherent risk of borrowing in another country’s currency.

Many banks force borrowers to buy Swiss francs at a rate they decide — on average 4.5 per cent higher than the commercial rate. The Government has ordered all banks to let borrowers raise their own franc funds, but many don’t know how to do this.

Early this month, Mr Lyczek, who converted to a franc mortgage, set up a website called "kupfranki-buy francs," where he has gathered some 1000 borrowers to pool funds so that they can buy sufficiently large quantities of francs to get a commercial rate.

 Marek Strzelecki in Warsaw and Marcus Walker in Berlin contributed to this story.

http://www.theaustralian.news.com.au/business/story/0,28124,25093112-5017999,00.html