Nicholas Watson in Prague -

How often a touted strength is revealed to be a weakness. The latest example could be the dominance of foreign banks in emerging Europe, which shored up these countries' banking sectors after the collapse of communism and helped fuel a period of phenomenal growth, but their overexposure to the region could now exacerbate the growing crisis there.

"The large foreign bank ownership [in emerging Europe] is a problem that again was recognised in advance," Nouriel Roubini, Professor of Economics at the Stern School of Business, NYU, and the chairman of RGE Monitor, tells bne. "There's been studies for years, including from the New York Fed[eral Reserve], suggesting that the credit cycle of advanced economies bangs into their affiliated emerging markets. It's pro-cyclical - in good times they over lend and in bad times they try to cut back significantly, creating these cyclical effects. The idea that you have foreign banks and everything is fine would not be correct."

One of the main reasons behind the relatively sanguine attitude in much of Central and Eastern Europe during last summer's financial meltdown in the US, was that European banks, which dominate the region's banking industry, had little or no exposure to those toxic mortgage-backed securities, but instead had invested heavily in the new markets to the east. According to the latest data from the Bank for International Settlements (BIS), emerging Europe had accumulated total external liabilities to BIS banks of $1.656 trillion as of September, of which $1.511 trillion is owed to European banks. This is equivalent to about 40% of emerging Europe's GDP in 2008.

"While there is a growing feeling that the worst phase of the financial-system meltdown may be over in the US, unease is mounting that here in Europe the worst may be yet to come," says Edward Hugh, an emerging market economist. "The reason? Europe's commercial banks have more exposure to distressed emerging markets than their US counterparts. It is quite likely that the emerging-markets exposure of European banks exceeds even that of US lenders to Alt-A [Alternative-A] and sub-prime loans."

The BIS reports that the largest individual country exposures of European banks are to: Poland ($279bn); Russia ($215bn); Hungary ($145bn) and Turkey ($133bn). European countries with the largest exposure to the region by assets include Austria ($277bn); Germany ($220bn); Italy ($220bn); and France ($155bn). Relative to GDP, Austria appears by far the most exposed with a ratio of lending to the emerging European region of 75%, followed by Sweden with 30%; and Greece with 19%.

Timothy Ash, head of CEEMEA research at Royal Bank of Scotland, notes that European bank exposure tends to reflect historical ties. Swedish banks, for example, have $80bn in exposure in the Baltic Republics, equivalent to 92% of the three countries' GDP, while some two-thirds of Austrian banks' exposure is across countries that formed part of the former Habsburg Empire.

No place like home

This heavy exposure of European banks to emerging Europe was a natural consequence of the growth opportunities offered there, coupled with ample global liquidity. The region was, by and large, under-banked at the same time as the region's populations were clamouring for credit to buy homes and consumer goods. "As a bank, there is no better place to be than Central and Eastern Europe - that was obvious when strong capital inflows and investors' expectations of growing demand fuelled high growth rates," Manfred Wimmer, CFO of Erste Bank, one of the biggest lenders in the region, tells bne. "We believe that the catch-up potential is still there... but today uncertainty seems to have taken over the stage."

That uncertainty is being fired by the steep decline in CEE countries' economic growth as their largest trading partner, the Eurozone, founders. The Eurozone recorded its biggest-ever GDP decline in the fourth quarter when the various economies shrank by 1.5%. Capital Economics forecasts that the emerging European economy will shrink by 3% this year, with no meaningful recovery until 2011. Many economists now say that rather than a safe haven, emerging Europe will actually be the region most damaged by the global economic crisis. Unlike emerging markets elsewhere, CEE economies are heavily dependent on external financing and many have large current account deficits, so the sharp drop-off in capital inflows expected in 2009 won't just be a major blow to growth, but could also potentially trigger a regional financial crisis.

"The strong foreign banking presence in the region, long hailed as a strength, now increasingly looks like a potential weakness," says RGE Monitor. "Depending on the country, foreign banks hold about 60-90% market share. These foreign parent banks, under pressure from the global financial crisis and slowdowns in their home countries, are reducing lending to their Eastern European offspring."

With sudden contractions in production and consumption, businesses and households are struggling and, inevitably, banks are seeing the number of non-performing loans (NPLs) on their books grow. "As the region slows down rapidly, asset quality is likely to deteriorate quite significantly, which will likely see rising NPLs and the need for increased provisioning," says Ash.

One of the underpinnings of investor confidence in emerging Europe was that if growth in the region slowed and NPLs rose, the foreign parent banks would put more money to work in the region by recapitalising their local subsidiaries. However, these parent banks are themselves suffering stress on their wider credit portfolios and some analysts say that this could force strategic rethinks in terms of their commitment to home versus overseas markets. "In an extreme - albeit unlikely - scenario, there is the risk that foreign parent banks, in the face of rising defaults and prohibitively expensive refinancing, could pull out of these markets," says RGE.

Ash agrees. "The question is, if there's a bank failure in Western Europe, what happens to the local subsidiaries? There's no legal obligation there - the parent can walk away from the subsidiaries. Lending is from parent to subsidiary, they're inter-company loans. You have to assume that no one will walk away, but it's a very difficult environment."

Gunter Deuber of Deutsche Bank Research/Economics stresses that it's important to differentiate between these emerging European markets, both in terms of how they will fare over the next 12 months and how these parent banks view the separate markets. "First, I don't think that the EU will let any of these big banks fail," Deuber says. But if they do have to recapitalise their subsidiaries with sizable amounts, he continues, they and their governments will regard those new EU members such as Poland and the Czech Republic as more like core markets, while those countries less integrated with the EU and worse hit by the crisis, such as Ukraine, could be let go.

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