Can the East Really Sink the European Union?

For years before the crisis, the new European Union members in Central and Eastern Europe (CEE) enjoyed strong growth, boosted by booming exports and enthusiastic domestic consumption.

And for years, the money kept pouring in, in search of fantastic returns, oblivious to the holes in the fabric of the new-found prosperity.

But as the crisis widened, the once-booming CEE is stealing the limelight again; this time, for


less palatable reasons.

"I really do feel that Eastern Europe's problem is a greater weight on the Western European nations than the subprime is in the United States," Jeffrey Halley, senior manager for foreign exchange trading at Saxo Capital Markets, told CNBC.

Foreign banks vied to set foot in and to grow in Eastern Europe, with richer neighboring countries among the first to set up in a region where populations wanted a piece of Western lifestyle after 45 years of communism.

Austrian banks' exposure to Central and Eastern Europe now represents more than 60 percent of that country's gross domestic product, according to research by Credit Agricole – Cheuvreux.

Belgian banks' exposure to the region represents nearly 30 percent of GDP, Swedish banks about 20 percent, Greek banks less than 20 percent and Dutch and Swiss banks' exposure makes up around 10 percent of their GDP. Italian, German, French and British banks are also present in Central and Eastern Europe, but on a smaller scale.

"We're still worried about those European banking exposures to Eastern Europe," Dominick Stephens, research economist at Westpac Institutional Bank, said after a G20 meeting in London boosted the reserves of the International Monetary Fund to help fight the crisis.

Risk-Free Carry Trade

As Western banks grew their presence in the region they started to lend at double-digit interest rates, while the cost of the money they borrowed was in the lower part of single digits, since it was coming from rich parent companies in the West.

It was an apparently risk-free carry trade in which euros, Swiss francs and dollars became the norm for loans in many Eastern European countries, where volatile local currencies had never enjoyed much acclaim since communism fell 20 years ago.

People rushed to take the loans, spurring an unprecedented boom in consumption and in the real-estate sector, with house prices advancing by as much as 500 percent in a few years in some countries.

Both foreign bankers and local authorities appeared to brush off the fact that salaries were still paid in zlotys, forints, lei or crowns. The logic was that the countries would join the euro as soon as the criteria were met.

Even in countries with fixed pegs to the euro, such as Bulgaria and the three Baltic states, lending in foreign currency instead of the local money was far more popular.

In Hungary around 60 percent of total loans are in foreign currency while in Bulgaria and


Romania it was about 50 percent. Poland with about 30 percent and the Czech Republic with under 10 percent are in less dangerous waters, research by Cheuvreux shows.

"It had been very clear for several years that this was going on, but nothing was done," Simon Quijano-Evans, head of EME economics and strategy, Credit Agricole Cheuvreux, told

The Flight of Capital

As the credit crunch turned into a full-blown crisis the faults of Eastern Europe -- overheated economies, gaping current account deficits and over-borrowing in foreign currencies -- could no longer be overlooked.

For more than a year, foreign investors have been pulling their money out of these countries, leaving them even more vulnerable. In 2007, current account deficits in the region were 100 percent covered by foreign direct investment -- a level that has now dropped to a little more than 50 percent.

Given those figures, there is fear that the worst is still to come and more investors are trying to take their money to safety across the borders. In addition, the foreign banks' Western parents now need their cash back.

EU 'Has to' Go On

Quijano-Evans said it is unlikely the region will be allowed to get into deep trouble, and recent IMF aid packages for Hungary, Latvia and Romania lend weight to that theory.

Bulgaria may be next in applying for IMF cash and Poland may join a list of potential candidates for flexible credit lines designed for countries with better fundamentals, according to various reports.


"The EU, the IMF are not going to let this thing implode," Quijano-Evans said. "This is about the future of the EU project. There's no way they're going to throw the project overboard. The EU project is a peace project, this has to continue."

So far, Latvia has received loans from the EU, IMF and other financial institutions worth over 30 percent of its GDP, Hungary and Romania more than 15 percent of GDP.

No Sovereign Defaults

The floating currencies of the Czech Republic, Hungary, Poland and Romania have depreciated since the onset of the crisis, while countries with a fixed exchange rate such as the Baltics and Bulgaria suffered a sharp drop in growth. Latest forecasts put Latvia's economic drop at 13 percent this year.

Despite all this, they will not be allowed to default, some analysts say.

"Sovereign defaults? No, I don't see it. The EU and the IMF made it very clear in October when they moved into Hungary that they won't let this happen," Quijano-Evans said.

But for others, the only way to deal with Central and Eastern Europe is to let them learn painfully from their mistakes.

"What they do need to do is get competitive, and they need to get competitive in a hurry. And devaluation is the only way," Roger Nightingale, global economist at Pointon York, said.

"It's no solution to have somebody walk in and pay their debts for them, that'll just make them borrow even more in future."

"Teach them not to borrow this currency again, teach them not to try and link their currencies to the euro," he added.