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Eastern Europe Seeks to Avoid EU Contagion

Banks and regulators in Central and Eastern Europe are working hard to prevent the EU’s sovereign debt crisis from slowing credit and economic growth.

For policymakers in Central and Eastern Europe, it seemed like déjà-vu all over again earlier this year. For the second time in three years, the region’s economy was threatened by a crisis not of its own making — this time, the debt turmoil in the European Union. Once again, government officials and bankers scrambled to prevent an external credit crunch from throttling activity in the region.

So far, the efforts have managed to avoid a contagion effect largely because the European Central Bank’s €1 trillion ($1.3 trillion) liquidity infusion into euro zone banks has calmed markets in the West. But with yields on Spanish and Italian bonds rising again in recent weeks, the threat of a fresh eruption of tensions that could roil economies in Central and Eastern Europe hangs in the air. “The situation in the CEE region has improved, but it is way too early to call the crisis over,” warns Erik Berglöf, chief economist at the European Bank for Reconstruction and Development in London.

Recent statistics underscore the risks of renewed deleveraging. Euro zone banks withdrew $35 billion from their CEE operations in the third quarter of 2011 alone, according to the Bank for International Settlements. Even with the greater liquidity of recent months, Western parent banks have become more discriminating in the region, maintaining the flow of capital and loans to profitable markets such as Poland and Turkey while cutting back in more-troubled countries like Hungary and Ukraine.

“Banks no longer have the luxury of operating everywhere,” says Timothy Ash, London-based head of emerging-markets research at Royal Bank of Scotland Group. That view is echoed by longtime CEE veterans. “Banks will most likely concentrate on the most-profitable business segments and disinvest from less profitable, capital-consuming segments,” says Herbert Stepic, CEO of Raiffeisen Bank International, the biggest CEE lender. Raiffeisen trimmed its lending and branch network in Hungary over the past year while expanding its presence in Poland with an acquisition.

Tougher capital requirements and regulatory scrutiny back home are pushing banks to make some hard choices about their CEE operations. Last November the Austrian central bank told Erste Group Bank, Raiffeisen and UniCredit subsidiary Bank Austria — the three biggest lenders in Central and Eastern Europe — to restrict new credit to their CEE subsidiaries to bring their loan-to-deposit ratios below 110 percent. In Hungary the banking sector’s ratio stands at 130 percent, while the comparable figure in some Balkan countries is more than 200 percent (see sidebar, below). “All of us are asking banks to be more aware of risk,” says EBRD president Thomas Mirow. “But unilateral measures imposed on banks can be detrimental in this environment.”

To prevent such unilateral action, the European Commission, the EBRD and the International Monetary Fund recently convened bank executives, officials and regulators from Western Europe and the CEE region in a bid to prevent the euro area’s credit crunch from affecting the economies of emerging Europe. Dubbed the Vienna 2.0 Initiative, the March effort sought to reprise the coordination that saw those institutions funnel more than €77 billion to CEE governments and regional banks in 2009 to support them in the wake of the global financial crisis. The latest initiative didn’t include any fresh money, but it did commit all the parties to trying to maintain credit conditions and to cooperate on banking regulation and supervision to prevent euro area credit problems from spilling over into the East.

The initiative also urged CEE governments not to take discriminatory measures against the nations’ banks, most of which are subsidiaries of Western lenders. The effort sought to avoid the spread of regulatory moves like those adopted by Hungary, which imposed a levy on bank profits to help close its big budget deficit and forced banks to accept haircuts on mortgages denominated in foreign currencies. The temptation to resort to such measures is clear, though. Many mortgages in CEE countries are denominated in Swiss francs or euros, and homeowners have struggled to service their loans as those currencies have risen against the Hungarian forint, Polish złoty and other local units. The EBRD reports that 38 percent of CEE households have reduced food consumption over the past three years as a result of the crisis, compared with 11 percent in the euro zone. Almost 20 percent of CEE households have at least one unemployed adult, nearly twice the proportion of the euro zone.

The economic outlook for the region, although brighter than in the EU, remains subdued. The EBRD forecasts that growth in the 29 countries in which it operates will average 3.1 percent this year, down from 4.8 percent in 2011. That number largely reflects strong, oil-driven growth in Russia and Central Asian countries. Growth in the eight countries of Central Europe and the Baltic states is expected to slow to 1.4 percent this year from 3.4 percent in 2011; countries in southeastern Europe are projected to grow by just 1 percent, down from 2.2 percent last year.

Notwithstanding the official efforts to encourage banks to maintain their presence in Central and Eastern Europe, the operating environment remains challenging. Banks cannot count on the easy profits they enjoyed in the past as the spread of capitalism in the former communist countries of Europe boosted activity. “If you look at CEE growth over the past decade, it was driven by catch-up borrowing and the integration of the region into the Western European supply chain,” says Neil Shearing, chief emerging-markets economist at Capital Economics, a London-based research outfit. “These are no longer the key drivers of CEE growth.”

Still, Western bankers contend that most CEE countries will continue to outperform the euro zone and provide better opportunities for growth. “This is a market that still offers attractive margins and in which it is easier to bring costs under control,” says Andreas Treichl, CEO of Erste Group, the second-largest lender in Central and Eastern Europe. “CEE labor markets are much more flexible than in Western Europe, and there is still substantial underpenetration of all banking products.” In addition, Treichl points out, most CEE countries have made fiscal adjustments over the past three years “that are deeper and prompter than those in Western Europe, leaving the region better prepared to weather a second storm.”

There are also new entrants looking to invest in the region even though Western lenders have turned more cautious. Sberbank, the state-controlled Russian banking giant that posted record earnings of 316 billion rubles ($10.7 billion) last year, paid €505 million in February to acquire Volksbank International, the CEE subsidiary of Austria’s Österreichische Volksbanken, which has 295 branches and more than 600,000 clients in seven countries.

Romania offers a good example of the recent evolution of the CEE’s economy and banking market. The global financial crisis of 2008–’09 hit the country hard and prompted the government to impose tough austerity measures, including steep cuts in social spending and public sector salaries, to comply with the terms of a €4.9 billion lending package from the EU and the IMF. Romania suffered a severe recession, with output falling by 7.1 percent in 2009 and 1.3 percent in 2010, but the measures succeeded in reducing the current-account deficit to 4 percent of GDP last year from 12 percent in 2008 and helped cut inflation in half, to 4 percent. The economy has rebounded slowly, however. Growth hit 1.5 percent last year, and the EBRD forecasts the rate will drop to just 0.8 percent this year. Opposition to the austerity measures caused the government to collapse in April for the second time in two months and will probably force early parliamentary elections this year.

The crisis was costly for Erste, which spent €3.75 billion in 2005 to acquire 61 percent of the country’s largest lender, Banca Comercial   a˘  Româna ˘. Last year Erste wrote down its goodwill in BCR by €700 million, a major factor behind the Austrian bank’s swing to a net loss of €719 million in 2011 from net income of €879 million the year before. Erste also reduced its credit exposure at BCR by €600 million, or 3.9 percent, to a total of €14.7 billion — part of a wider retrenchment that saw Western banks cut lending in Romania by $2.1 billion in 2011. The bank has tightened risk management in its lending operations and introduced credit bureau scoring for clients. Yet Erste is maintaining its presence in Romania and betting on an economic turnaround. The bank has restructured loans for both retail and corporate borrowers in a bid to contain defaults.

Former Soviet Baltic republics Estonia, Latvia and Lithuania have experienced an even more dramatic rebound. Those countries had expanded aggressively in the past decade on the back of a lending boom fueled by foreign banks. They suffered the steepest recession in Europe during the financial crisis and imposed some of the harshest austerity measures in the region. But the three Stockholm-based banks that dominate Baltic lending — Nordea Bank, Skandinaviska Enskilda Banken and Swedbank — never wavered in their commitment despite experiencing steep losses. “Some European banks have spent significant amounts of money and effort on building networks and are unlikely to walk away from such endeavors,” says RBS economist Ash.

Consider the case of Swedbank. Estonia, Latvia and Lithuania served as the bank’s biggest growth drivers in the past decade, when lending, much of it tied to property, was exploding at annual rates of 40 percent or more. The region generated 63 percent of the bank’s earnings at the peak in 2007. When the global crisis struck a year later, however, the Baltic boom turned to bust and the region’s real estate bubble burst. In 2009 economic output shrank by 17.1 percent in Latvia, 14.7 percent in Lithuania and 14.3 percent in Estonia. Swedbank suffered 6.3 billion kronor ($934 million) in Baltic losses between 2008 and 2010, and its ratio of nonperforming loans hit a peak of 16.8 percent in the second quarter of 2010.

Austerity measures backed by strong international support have sparked a turnaround in the Baltics and a revival in the fortunes of its banks. In 2009, Latvia received €7.5 billion from the IMF and the EU — an amount equivalent to 35 percent of GDP — to prop up the banking system, avoid bankruptcy of the public sector and maintain the country’s exchange rate peg to the euro. “The EU and the IMF were concerned that if Latvia collapsed, the contagion would spread to the other Baltic countries and even Sweden,” says Morten Hansen, head of the economics department at the Stockholm School of Economics branch in Riga, Latvia. The program proved more than sufficient, with Latvia drawing less than €4.5 billion of the aid. Last year, after three years of decline, economic output expanded by 5.5 percent in Latvia, 5.9 percent in Lithuania and 7.6 percent in Estonia. “The crisis is mostly over,” says Hansen, “but we are still waiting to see if sustainable growth has returned.”

Swedbank has enjoyed an equally strong rebound in its results. The Baltics contributed net profits of Skr2.1 billion, or 17.9 percent of the bank’s overall earnings, last year even though Swedbank’s loan portfolio in the region had fallen by a third since 2009. The NPL ratio also dropped, to 12.6 percent at the end of 2011. So has the Baltic roller coaster been a worthwhile investment for the bank? “That’s a very difficult question to answer,” says Birgitte Bonnesen, Swedbank’s Riga-based head of Baltic banking. “But we chose to make these three countries part of our core market, and we have every intention to stay.”

Growth never stopped in neighboring Poland, the only European nation not to suffer a recession during the global crisis. One reason for this unique performance was the fact that Poland had maintained a much tighter grip on credit growth in the precrisis years than most other countries in the region. “We were also looking closely at the growth of foreign-currency-denominated mortgages and imposed regulations to slow them down,” says Leszek Balcerowicz, head of FOR, a Warsaw-based economic think tank, and a former president of the National Bank of Poland.

Poland’s economy grew by 4.3 percent in 2011, and economists expect the country to outpace most of Europe again this year with growth of up to 3 percent, according to Marek Belka, the current central bank president. “We are more optimistic than others about Poland’s export potential,” he says. “Over the past dozen years, every time there is a slowdown in Western Europe, our exporters manage to expand their market share because they are cost-competitive.”

The signs of Polish prosperity are on display everywhere. Warsaw is in the midst of its greatest postwar construction boom, with dozens of new high-rise buildings altering the skyline. The most prominent is a 54-story luxury residential complex designed by Polish-born American architect Daniel Libeskind that is due to be completed next year. This spring work crews were busily putting the finishing touches on a variety of highways, stadiums and other infrastructure projects built for the June opening of the Euro 2012 soccer tournament, which Poland is cohosting with Ukraine.

The global financial crisis raised Poland’s status and clout in Europe. In a statement already deemed to be of historical importance, Polish Foreign Minister Radosław Sikorski helped goad Germany into taking a more active political and financial role in confronting the euro zone’s troubles by asserting at a Berlin conference last December, “I fear German power less than I am beginning to fear German inactivity.” At a summit in January, Prime Minister Donald Tusk insisted that Poland be included in any high-level euro zone meetings — even though it is not a member of the zone — in exchange for giving its support to the so-called fiscal compact that EU countries are adopting to enforce budgetary discipline.

The Polish banking sector increased net profits last year by a heady 37.5 percent, to a record 15.7 billion złoty ($5 billion). The country’s largest bank by assets, state-owned PKO Bank Polski, showed an 18.4 percent rise in net profits, to 3.8 billion złoty, while the No. 2 lender, Bank Pekao, which is majority-owned by UniCredit, posted a 16 percent rise in earnings, to 2.9 billion złoty.

Poland is one country where troubled Western parent banks have no problem selling assets. In February, KBC Group, a financially strapped Belgian bank and insurance combine, agreed to merge its Polish subsidiary, Kredyt Bank, with Bank Zachodni WBK, the Polish unit of Spain’s Banco Santander. The all-share transaction left Santander with 76.5 percent of the enlarged Zachodni. KBC made a deal in January to sell Warta, Poland’s second-largest insurer, to Germany’s Talanx International for €770 million.

Raiffeisen, meanwhile, outdueled Italy’s Intesa Sanpaolo to purchase a 70 percent stake in Polbank, a subsidiary of troubled Greek lender EFG Eurobank Ergasias, for €490 million. Polbank will be merged into Raiffeisen Bank Polska, which increased its net profits by 47.7 percent last year, to €82 million.

Poland’s newfound confidence and prosperity have made the country less sensitive to foreign domination of its financial services sector. Foreign concerns hold more than 70 percent of banking assets, and the government effectively promoted state-owned PKO BP to become a national champion. Over the past decade the government helped state-controlled PZU, the leading insurer, resist attempts by Dutch shareholder Eureko to assert control, until PZU finally bought out the Dutch group’s 12.9 percent stake in 2010 for 4.1 billion złoty. “Nowadays the Polish government is a lot less combative with foreign investors and is accelerating privatization,” says Mark MacRae, a Warsaw-based analyst with Wood & Co., a CEE investment bank. He points out that the government plans to sell some of its stakes in both PKO BP and PZU.

One potential red flag on the Polish horizon is the government’s budget deficit. After reaching 7.9 percent in 2010, the deficit fell to an estimated 5.2 percent in 2011. Finance Minister Jacek Rostowski asserts it will dip below 3 percent this year, mainly because of increased tax revenue, drawing criticism from former central bank president Balcerowicz. “Fiscal consolidation should be based on reduced spending rather than higher taxes,” he says.

The deficit has made Poland potentially vulnerable to market instability emanating from its economically weaker neighbor Hungary, says Balcerowicz. He points out that the Czech Republic, which ran a more modest budget deficit of 3.1 percent last year, seems relatively immune to currency fluctuations. But according to former Czech Finance minister Pavel Mertlik, the real problem for Poland is that it has the largest and most liquid currency market in Central and Eastern Europe, and investors tend to sell off the złoty when anxiety envelops the region. “A lot more portfolio capital moves out of Poland during regional crises than out of any other CEE country,” says Mertlik, now the Prague-based chief economist for Raiffeisen. The złoty fell from 4 to the euro in April 2011 to a low of about 4.57 in December before recovering to 4.18 last month. 

Despite the złoty’s volatility, adopting the euro is not currently an option, according to Polish officials. “As long as there are sovereign debt and banking problems, it would be unreasonable for us to rush into the euro zone,” says central bank chief Belka.

In contrast to Poland’s outward-looking ebullience, Hungary’s nationalist right-wing government has clashed repeatedly over the past year with its EU partners and euro zone banks. The government of Prime Minister Viktor Orbán, which won election in 2010 by promising to stimulate the economy, cut taxes initially but got only a modest growth bounce before having to tighten its budget. The economy grew by 1.7 percent last year, and the EBRD predicts a decline of 1.5 percent this year.

With little room for fiscal maneuver, Orbán has lashed out at András Simor, governor of the Magyar Nemzeti Bank, criticizing him for not loosening monetary policy. The government passed a law late last year increasing the size of the central bank’s board, a move denounced by the European Commission as a blatant violation of EU rules on central bank independence. Then Orbán decreed a 75 percent cut in Simor’s salary. The central banker responded by offering to accept a monthly salary of just 1 forint — about half a U.S. penny — if the government would end its dispute with Brussels. “There has been no reaction whatsoever to my offer,” Simor tells II. But late last month, after concessions by Orbán, the European Commission said it was “satisfied” by the prime minister’s pledges to alter legislation threatening the central bank’s independence.

Meanwhile, Simor worries about the public deficit, which threatens to exceed 3 percent of GDP this year, and inflation, which hit an EU high of 5.9 percent in March. “We are trying to deliver at the same time fiscal consolidation, deleveraging of the banking sector and improved competitiveness — all in an external environment that is not necessarily supportive,” says Simor. “This is quite a challenge.”

With one of the highest living standards in the former Soviet bloc and a head start on economic reforms, Hungary entered the postcommunist era in 1989 with credible claims that it would become a leading force in the capitalist transformation of the CEE region. But political polarization between former communists and right-wing nationalists has grown more rather than less acrimonious over the years, impeding further economic reform. And neither the Socialist government nor the Fidesz government that succeeded it with a two-thirds majority victory in 2010 have been able to bring public spending under control.

In March the EU announced that it would suspend payment to Hungary of nearly €500 million in development money in 2013 unless the Orbán government shows credible progress in reducing the deficit by half a point, to 2.5 percent of GDP. (Last year the budget was technically in surplus, but only because the government nationalized the private pension fund system to eliminate a 4.2 percent budget gap in 2010.) It was the first time the EU had moved to punish one of its members for defying the bloc’s budget constraints. But under the Fidesz government, Hungary has escalated confrontations with the EU on several political and economic fronts. For its part, the EU has objected to recent legislation that threatens the independence of the judiciary, the media and the central bank.

By January of this year, political and economic uncertainty prompted all three major credit rating agencies to reduce Hungary’s rating to junk status. The forint fell to an all-time low of 324 to the euro on January 4, and the government was able to sell only 35 billion forints ($155 million) of one-year bills at a January 4 auction — 10 billion forints less than intended, despite the bills’ lofty interest rate of 9.96 percent. With panic enveloping the local market, Orbán was forced to retract his anti-IMF rhetoric and declare his intention to seek the agency’s aid. But the IMF did not jump at the request. “The IMF is basically telling Hungary to first sort out its problems with the EU and then come back and negotiate,” says RBS economist Ash.

In the interim the massive liquidity made available to euro zone banks by the ECB beginning in February has at least temporarily brought Europe, West and East, back from the financial brink. In Hungary the sense of urgency abated as the forint recovered somewhat, to about 296 to the euro. “The Hungarians got lucky because of the general improvement in risk appetite and the reduction of tensions in the euro zone,” says Capital Economics analyst Shearing. “But I don’t think that will last forever.”

Largely because of the Orbán government’s policies, commercial banks recorded a combined loss of 92.6 billion forints in 2011, the first year since 1998 that the industry was unprofitable. Banks were forced to pay a punitive bank levy and absorb losses on Swiss-franc-denominated mortgages, which account for two thirds of housing loans. Macroeconomic policies compounded the banks’ problems by leading to steep drops in the forint’s value, weak economic growth and high rates of nonperforming loans. “Hungary is one of those countries that is particularly vulnerable to deleveraging,” says Ash. “Foreign banks have had enough of Hungary’s debt repayment schemes and special taxes.”

Vienna-based Erste Bank, the second-largest bank in Hungary after national champion OTP Bank, is a case in point. Last year Erste took a €450 million write-down at its Hungarian subsidiary, a major factor behind the parent bank’s swing to a net loss of €562.6 million in 2011 from earnings of €1.04 billion in 2010. Erste Hungary had to pay 14.7 billion forints, or about 10 percent of its revenue, under the bank levy, and it had to set aside provisions of 60 billion forints to cover losses as the result of a government decree that allowed holders of foreign currency mortgages to repay their loans at a fixed, discounted exchange rate.

“We don’t expect our bank in Hungary to make a profit in 2012,” says Erste CEO Treichl, who adds that the size of losses may depend on whether the Orbán government reaches an agreement with the IMF. “I am hopeful the government will get its act together and go for an IMF deal, maybe by the fall.” According to the central bank’s Simor, a deal is crucial to the health of the banking system and the economy. “The main benefit of an EU-IMF agreement is economic policy credibility for Hungary, not the loan itself,” he says.

In the meantime, Erste Hungary has announced plans to cut its staff by 450 people, or 15 percent, and shutter 43 of its 184 branches this year. Lending will fall as the Hungarian subsidiary seeks to reduce a loan-to-deposit ratio that stands at a whopping 177 percent, one of the highest among its CEE peers. Raiffeisen has also retrenched in Hungary, reducing its branch network by ten outlets, to 134, and trimming head count by 8 percent last year, to 2,977. The bank’s loan book shrank by 11.4 percent in 2011, to €6.3 billion, and losses ballooned to €328 million in 2011 from €11 million in 2010. “Hungary is without a doubt the most difficult market for us at the moment and indeed for almost all banks active there,” says Stepic.

Domestic lenders have also taken a shellacking from the Orbán government. OTP, Hungary’s largest bank by assets, with a 25 percent market share, suffered a 29 percent plunge in net profits in 2011, to 83.6 billion forints. The new bank levy cost OTP about 35 billion forints last year, and the bank expects to pay a similar amount this year. OTP experienced losses of an additional 33.6 billion forints last year because of the foreign currency mortgage loan repayment program. Like Erste, OTP is hoping the government makes a deal with the IMF this year. “Then market uncertainty will be lifted and a more stable macroeconomic environment will return,” says deputy CEO László Wolf. But even in the case of an IMF deal, a quick economic turnaround is unlikely. “We expect around zero growth this year,” says Wolf. “And this doesn’t make our lives any easier.”

Eventually, banks in Hungary and throughout the region will become healthier by increasing their reliance on local funding — something that is not happening at a fast enough pace. “It would be unreasonable to expect many of these economies to generate sufficient savings at this stage,” says EBRD economist Berglöf. In the meantime, the region must depend on euro zone banks that are none too stalwart themselves. “CEE countries need to be careful not to give foreign banks a reason to withdraw,” says RBS’s Ash. “Especially at a time when European banks are so fragile and have choices elsewhere.”  •  •

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