New Europe Catches Old Europe’s Cold

As governments across Western Europe began bailing out banks and their depositors, Eastern Europeans watched nervously, unsure about what the global financial storm would mean for them. Now that the storm has hit them, the fragile bonds of European solidarity are being tested.

LONDON – As governments across Western Europe began bailing out banks and their depositors, Eastern Europeans watched nervously, unsure about what the global financial storm would mean for them. Now that the storm has hit, the fragile bonds of European solidarity are being tested.

Two countries – Hungary and Ukraine – have already asked for large packages of support. Several more could do so over the next month if frozen credit markets do not thaw. If the situation continues until the end of the year, which cannot be ruled out, many more countries could experience serious banking crises.

Over the last two decades, Eastern Europe has undertaken wide-ranging reforms and embraced global financial integration. Foreign, mostly European, banks have entered these markets with unprecedented speed and force. These banks have increasingly reached out to more risky small- and medium-sized enterprises and helped people buy their own houses and start new businesses. But successful financial development is now coming back to haunt these countries.

Until now, the countries of emerging Europe withstood the global financial squeeze remarkably well, coping with the slowdown in important export markets and increased borrowing costs. But no open economy can resist a complete shutdown of the lending markets. Perhaps they became too dependent on cheap credit, but they were not alone in this respect.

Some foreign banks are now withdrawing liquid funds from subsidiaries in emerging Europe. According to the National Bank of Russia, foreign banks withdrew more than $10 billion in that country in September alone. Other central banks make similar claims. To be fair, Raiffeisen International has announced that it was supporting its Ukrainian subsidiary, Bank Aval, with an additional €180 million. Whether other parent banks active in the region stand by their subsidiaries depends on how severe the crisis in Western Europe becomes.

But the Western European bailout packages could make the situation in emerging Europe worse. While most parent banks in the region are likely to benefit from these measures, this does not necessarily translate into support for their foreign subsidiaries. In fact, there is a serious risk that these bailouts will come at the expense of Eastern Europe. Several governments have declared that taxpayer money cannot go into operations abroad.

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Governments in emerging Europe should, of course, play their part in stabilizing their financial systems. But at this point there are severe limits to what they can do. Most do not have the financial clout to counter the extraordinary pressures from financial markets. An offer by Hungary’s government to extend a general guarantee of deposits or to ensure liquidity in interbank markets has limited credibility.

To survive this crisis, emerging Europe needs support from outside. First and foremost, West European leaders must ensure that the crisis is resolved at the core, and many observers doubt that they have done enough. Second, they must prevent the crisis measures already taken from discriminating against subsidiaries in Central and Eastern Europe, independently of whether they are within or outside the European Union. Third, they must combine forces, as in Hungary, with international financial institutions in supporting these economies.

Georgia’s experiences following its recent war with Russia offer a possible model. The International Monetary Fund provided an emergency credit line to support the currency, the World Bank coordinated the relief effort (much of it financed by the United States and the EU), and the European Bank for Reconstruction and Development used its knowledge and resources to lead the effort to save the financial system. The Georgia package is not a done deal, and circumstances elsewhere are different, but it shows that standard instruments can go a long way.

Yet more resources and new instruments will be needed. The case of Hungary shows that the EU can tweak an existing instrument – balance-of-payment support – and use it creatively. For non-EU countries, like Turkey and Ukraine, innovative ideas are also urgently needed.

There should be no doubt about what is at stake. It is has been little noticed, but in the last few years, Eastern Europe, including Russia, surpassed the US and the United Kingdom as the euro zone’s most important export markets. Many of these markets now face slowdown or even negative growth. Moreover, Western European companies have invested on a previously unimaginable scale. There is a serious risk that, if the crisis becomes even worse, East European governments will see no alternative but to nationalize some institutions, particularly some of the foreign-controlled banks.

But, even more importantly, decades of financial development and broad economic reforms could unravel. As in Western Europe and the US, governments will again play a larger role in the economy, but state involvement has different connotations in these former socialist economies, particularly as they now face a backlash against financial development and against reformers.

As if this was not enough, Western governments and businesses should ponder what kind of offers may come from Russian sources, private or public, for distressed banks and companies. No doubt with strings attached.

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