The troubles facing central and eastern Europe intensify on Tuesday with news of further downgrades to western banks by Moody’s due to losses in the region. As Bloomberg reports (our emphasis):
Feb. 17 (Bloomberg) — Austrian, Swedish and other banks with subsidiaries in eastern European may face rating downgrades as economies in the region deteriorate, according to Moody’s Investors Service. East European banks, which are mainly subsidiaries of financial institutions such as Raiffeisen Zentralbank Oesterreich AG and Swedbank AB, are likely to come under “downward pressure” which may also weaken their parent companies, Moody’s wrote in a report released today in London.
Banks from Austria, Italy, France, Belgium, Germany and Sweden account for 84 percent of western European bank loans in eastern Europe. The region’s economies are weakening, with the International Monetary Fund already offering aid to Latvia, Hungary, Serbia and Ukraine. Bailouts may be extended to Bulgaria, Romania, Lithuania and Estonia as the global recession derails more banks, according to Capital Economics research. “The downturn in eastern Europe will be more severe as a consequence of many countries’ dependence” on capital flows from west Europe banks, Moody’s analysts led by Reynold Leegerstee wrote in the report. West European banks might become selective in supporting their subsidiaries and “banks in countries that are associated with higher systemic risks might face reduced support,” the report said. Western governments may also establish rules to ensure banks receiving state support do not aid foreign subsidiaries, Moody’s said. On the other hand, limiting support for a subsidiary could hurt confidence in the parent.
All of which has echoes of a “black swan” event – that is, something none of the banks invested in the region would have accounted for (even six months ago). TD Securities analyst Bartosz Pawlowski sums up just how much of a tail-event all of this is in his morning note:
Judging by implied volatility curves that could be observed in the middle of 2008, recent developments in Central Europe have been in excess of 10 sigmas, which means that they – according to the theory of standard distribution – should never have happened. Yet they have happened and Central Europe has received a lot of negative press recently, which seems to have reinforced moves on local currency markets.
Oh dear. Pawlowski’s view of the potential consequences is also hardly reassuring. In fact, he joins the Ambrose Evans-Pritchard camp of how this could mean outright collapse of the financial system in the region with dire implications for the west. As he explains:
Firstly, we would like to stress that the recent rout could potentially lead to substantial problems, if not an outright collapse of the financial system. A huge exposure to fx moves via foreign currency denominated mortgages and corporate fx options will boost the proportion of non-performing loans in banks’ portfolios to levels previously unseen. To make matters worse, falling GDP is usually associated with rising default rates on local currency denominated debt even despite recent interest rate cuts.
Secondly, given the slump in Western Europe , a weak exchange rate does not necessarily mean a revival of exports. However, a slump in imports is inevitable, which will generate job losses in the trading sector thus pushing the economies further into a recession.
Thirdly, we see a substantial risk of rating downgrades in CEE, which would worsen economic prospects further limiting access to foreign funding.
Finally, a reaction of foreign banks that own local banking systems is uncertain and they may well decide (or be forced) to try and sell their holdings even at depressed prices to avoid association with the region (please refer to today’s report by Moody’s saying that Austrian and Swedish banks could face downgrades on Eastern Europe). In the meantime, a substantial decline in activity on the local derivatives market is more than likely.
So what to do?
According to Pawlowski there is actually very little that can be done at face value. Interest rates, for one, are not a useful lever anymore. The surprise Hungarian interest rate increase back in October showed a 300bp hike could, for example, only safeguard the forint for a few months. Furthermore, raising rates now would probably be the worst solution says Pawlowski. Instead, if anything, he recommends some sort of co-ordinated action between the central banks in the region. Further relief could also come from greater ECB and SNB swap facilities and eventually a much larger role for the IMF in the region.
On this front Pawlowski admits even Poland, which had long been regarded as a stellar performer in the region, could be forced to ask for external support too - something unthinkable even a few months ago.
Related links:
Forex failure continues in Poland – FT Alphaville
Another Eastern European meltdown? – FT Alphaville
The big Le-borrow-ski – FT Alphaville