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East Weakness Could Hamstring West: Moody's

Eastern Europe will suffer a more serious recession than Western Europe and the weakness in the region’s banks could drag on their Western counterparts, Moody’s said in a research note Tuesday.

“The recession in Eastern Europe will be more severe on average given the region's generally large macroeconomic imbalances, such as fiscal and current account deficits,” Carola Schuler, senior vice president at Moody’s, said in the note.

The scarcity of funding will force budget deficits in Eastern Europe to contract abruptly, causing a more significant decline in domestic demand and overall gross domestic product, Schuler wrote.

Countries in Eastern Europe with refinancing pressure will eventually have to tap their foreign exchange reserves, Luis Costa, emerging market debt strategist from Commerzbank, told CNBC.

Those countries with limited reserves might be forced to knock on the doors of the International Monetary Fund, Costa added.

Video: watch the full interview with Luis Costa to the left.

Western European banks with exposure to the region will suffer from “negative spillover” and may be forced to cut ties with the banks, according to the report.

The “deterioration may lead to more selective support provided by West European parent banks to their subsidiaries,” Schuler said.

European Europe’s banking system has not yet reached the maturity of the West’s and is more vulnerable in times of economic stress, according to Moody’s.

Many of the regions banks have received ratings downgrades since the onset of the credit crisis, but those downgrades could be passed on to Western ‘parent’ banks as the risks mount, the report added.

The weakness can flow the other way, however, and weakness in Western parent banks could see ratings on the subsidiary banks be cut as support becomes more scarce, Moody’s said.

The problems facing Eastern Europe were underscored last week by news that Estonia suffered a record 9.4 percent fall in its gross domestic product in the last quarter of 2008. Neighboring Latvia saw a 10.5 percent drop in GDP in the final months of last year.