Focus in the financial crisis shifted to Central and Eastern Europe (CEE) during the past week - and to the large bank exposure to the region for Euroland banks. The CEE countries are caught in a very negative spiral of deleveraging, heavy amounts of foreign debt and economic crisis. With little room for manoeuvre in economic policy to underpin the economies, the economic outlook has turned increasingly gloomy. Ukraine, with a population of 45m, could be on the verge of defaulting. Austria's finance minister warned last week of the risk of an economic 'catastrophe' triggering a "domino effect" of problems further west. Ukraine is arguing with IMF over budgetary policies in order to get a second tranche of USD16.4bn due this weekend. A compromise will probably be found and the money released but tensions are running very high.
Attention returned to European bank exposure to CEE after a Moody's report said that western European banks with subsidiaries in CEE were at risk of being downgraded. Austrian banks in particular have significant exposure in CEE with loans to this area as high as 55% of Austrian GDP. The turmoil hit European bonds where spreads widened to Euroland - and Austrian bonds were hit particularly hard. The euro also weakened on the news.
About half the loans in CEE come from European banks which expanded markedly during the boom years. This now creates the risk of a very hard credit crunch in CEE as European banks are likely to focus more on lo-cal markets and are under pressure from local gov-ernments to increase domestic lending as govern-ments are helping banks with capital and loans. At the end of the week the president of the World Bank, Robert Zoellick, called for the EU to help CEE countries. He said the World Bank is working with IMF and other institutions to help the region but needed more backing from the EU. Hopefully they get it soon.
