The economic situation in Central-Eastern Europe (CEE) continues to deteriorate rapidly and unpredictably. This is already affecting bank earnings, and prudent crisis management requires action and agreements for action to be made now, if major output losses and financial sector contractions are to be avoided. This provides both a threat and an opportunity for the EU and its institutions.
Banking problem. The bulk of banking in CEE is undertaken by West European-based banks or their CEE subsidiaries. It was chronic and acute bad debt problems in home-grown banks that led to this dominance. Until recently, the benefits to CEE were obvious. Financial services were delivered by or under the supervision of experienced banks that were not amenable to the influence of local politicians, and access to international capital markets was cheaper and guaranteed.
However, 84% of West European loans from these banks to the CEE came from six countries: Austria, Belgium, France, Germany, Italy and Sweden. Austrian banks' exposure is especially significant, and is equivalent to 70% of national GDP. Swedish banks' exposure is 30% of GDP, and is concentrated in the tiny Baltic economies. Risk exposure to CEE loans is concentrated in a small number of Western banks, from a handful of countries.
CEE risk. From the CEE viewpoint, a large proportion of their supply of credit depends on a small number of geographically concentrated sources. Some 90% of their foreign loans come from euro-area countries. In the present circumstances, that increases risk and so depresses CEE expectations. Although there is as yet little evidence of pressure from the lending banks' parent banks or countries of origin to repatriate capital, cautious risk managers are likely counseling some reduction in exposure to mostly small and unexpectedly volatile markets, many of which have currencies that have fallen significantly against the euro.
Given the concentrated nature of CEE countries' financial services, it makes sense to have agreements in place that will cover emergencies. On the CEE side, governments will want to know that foreign-headquartered banks will not discriminate against them in a crisis. An agreement with the authorities of the foreign state in question may help, if only to provide some compensatory loans should private banks cut access to credit. The agreements should be bilateral, and ideally formal, because Western EU members have so far proved incapable of coordinating either fiscal stimuli or cross-border banking crises. Where the particular bank may prove to be too large for either or both parties to save, precautionary agreements with other governments or EU institutions are needed. Such agreements may reduce the current flight of capital from CEE, which has somewhat unfairly become associated in investors' minds with the riskier emerging markets.
Wider issues. CEE states' positions would be much improved if the EU implemented the sort of coordinated fiscal stimulus that they themselves dare not risk. The rush of world capital into dollar-denominated assets contrasts starkly with recent euro falls. The EU has a budget of barely 2% of its GDP and no significant tax-raising powers. The contrast with the dollar and the United States could not be harsher. If the United States had a tiny, vestigial federal government, and the response to the credit crisis and recession lay with its 50 states, it is hard to imagine nervous investors choosing it as a safe haven.
This crisis threatens the euro and the euro-area. Some sort of fiscal coordination is required, because at the moment that is the only weapon that seems to have a chance of limiting the scale of the damage. Therefore, the crisis may offer an opportunity for the EU. Failure to take it will further isolate CEE. It is reassuring that Germany has stated that it will not allow the euro-area to disintegrate, but action now might preclude the need to test that pledge.