Deutsche Bank Research -

In Kazakhstan and the Baltic countries the macro-economic adjustment is under way. While Kazakhstan and Lithuania seem to be experiencing an orderly slowdown after years of a credit boom, the intensity of the downturn in Estonia and Latvia is now calling into question the potential for a soft landing.

In Romania, Bulgaria, Ukraine and Russia the economic cycle shows no sign of a turnaround. Accelerating inflation, high real wage growth, still rapid real credit growth and strong growth of imports are common features of all four countries. Despite recent central bank tightening, further measures are required to secure a soft landing.

The global financial crisis and deteriorating asset quality could be a challenging combination. In a worst-case scenario, tougher external financing conditions and deteriorating asset quality in Eastern Europe might put a question mark over the strategic commitment of mother banks from Western Europe.

A financial crisis could prove costly. In this scenario the public debt ratio would shoot up dramatically in Estonia, Kazakhstan, Latvia and Ukraine. But it would still remain below Hungary's current debt level.

Macroeconomic adjustment is under way in the Baltics and Kazakhstan

In the March issue of our Credit Monitor, we commented on tentative signs (i.e. slowing credit, retail sales and real GDP growth) of a soft landing in the Baltics and Kazakhstan. This orderly slowdown scenario has further materialised in Kazakhstan and Lithuania although slower domestic demand has yet to feed through to the inflation and external debt dynamics (and the current account deficit in Lithuania). In Estonia and Latvia, however, the severity of the macroeconomic adjustment over the last few months (see chart) is calling the potential for a soft landing in those two countries into question. We have slashed our baseline full-year GDP forecast to 2% for Latvia and 0.5% for Estonia. Although we now attach a 30-40% probability to a recession scenario, the probability of a crisis scenario (i.e. banking sector distress and sharp currency depreciation over the next 12 months) still remains low in our view.

Romania, Bulgaria, Ukraine, Russia remain in overheating camp

Accelerating inflation, double-digit real wage growth, still rapid real credit growth and strong import growth are common features of all four countries that remain in the overheating camp, namely Romania, Bulgaria, Russia and Ukraine. In order to cool the economies the central banks - in addition to raising key interest rates - have taken the following recent measures: The Central Bank of Romania proposed a regulation which limits the income taken into account by financial institutions to a maximum of 20% over the income declared in the tax bill of the previous year. The Central Bank of Russia increased the obligatory reserve ratio for credit organisations and raised its refinancing rate to 11% in July. The Central Bank of Ukraine envisages a rise in the provisioning rates for consumer and FX loans to borrowers without stable FX income streams. But in our view, given the strongly negative real interest rates in several countries (see chart), further gradual monetary, regulatory and fiscal tightening measures by the authorities are necessary in order to avoid a sharp economic slowdown à la Estonia and Latvia.

Credit crisis, deteriorating asset quality could prove challenging

Much of the recent credit boom has been financed externally driving up banks' aggregate external liabilities to above 40% of total liabilities in the Baltic countries and Kazakhstan. As we have argued previously, strong foreign ownership in the Baltic countries should mean easier and cheaper access to funding for local Eastern European banks, as long as mother banks do not come under pressure as well, which is currently not the case. But deteriorating asset quality in the local Eastern European banks and thus declining profits coupled with tougher financing conditions for the mother banks remains a low-probability risk scenario, in which Western European mother banks' strategic commitment might be questioned. In Kazakhstan, external financing conditions for banks remain tough and are expected to lead to a further consolidation of the banking system. Although reported ratios of NPLs in Kazakhstan are still in the range of 2 to 4%, the actual percentage of loans under stress is estimated to be as high as 15-20% of total loans since banks restructure problem loans and extend grace periods.

A financial crisis could be costly

Alongside increased financial intermediation levels and growing bank balance sheets in the Eastern European countries, the potential cost of bank bailouts for the sovereign in the event of a financial crisis has risen as well. Based on S&P's estimates of gross problematic assets in a reasonable worst-case scenario, we calculated the potential public debt-to-GDP levels for all Eastern European countries in the event of a financial crisis based on 2008 GDP data. The above chart shows that if the sovereign takes over the estimated problem loans, public debt levels in Estonia, Kazakhstan, Latvia and Ukraine would rise sharply, increasing at least fourfold in a financial crises scenario. But overall, they would still remain below current Hungarian debt levels.

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