Europe Needs a Jubilee too

Europe is also facing a financial catastrophe because of excessive debt, in their case given to Eastern European countries. The economies in the region are collapsing because of the withdrawal of funding and the collapse of prices (i.e. deflation). Yup, debt deflation depression there too, and the only solution is Jubilee! Why is no one talking about this???

The headline writers are calling it Europe's own subprime. Basically, what has happened is that banks in the more developed Western Europe have lent huge amounts of money to consumers in Eastern Europe.

The banks which have lent money belong to countries like Austria, Belgium, Greece, Italy and Sweden. Consumers who have borrowed from these banks belong to countries like Poland, Hungary, Romania, Ukraine and other countries which were a part of the erstwhile Union of Soviet Socialist Republics (USSR).

Stephen Jen, managing director and chief currency economist, Morgan Stanley estimates that Eastern Europe has borrowed around $1.7 trillion and needs to repay or roll over around $400 billion this year, which is around one-third of the entire gross domestic product (GDP) of the region. That's a lot of money to be repaid.

But how did it start in the first place? As the stock market and the real estate market boomed across the world, Western European banks saw a huge opportunity in lending in Eastern European countries where the financial system was not very developed. A majority of the lending happened for construction and consumer loans. With real estate prices on their way up, people were happy to go out and borrow.

Also, these loans were made primarily in euros or Swiss francs, and not in the local currencies of the countries. These loans were also at a lower rate of interest compared with local currency loans.

What also encouraged people to borrow in foreign currencies is something experts are now calling "convergence play." Most Eastern European countries over the next few years were hoping to move to euro as their currency from their current currencies. This encouraged borrowers to borrow in euros, and pay a lower interest rate, rather than borrow in their domestic currencies and pay a higher interest rate. Banks giving out these loans assumed that as these countries moved to the euro currency, the standard of living will also move towards the more developed, Western European countries.

And now, it is this foreign currency borrowing that is causing all the problems. Take the case of a country like Poland, where almost 60% of the home loans taken were in Swiss francs. Around one year back, 100 Polish zlotys (the currency of Poland) fetched 45 Swiss francs; today, 100 Polish zlotys are worth 30 Swiss francs.

What does that do for a Polish citizen who is earning in zlotys and is expected to repay his loan in Swiss francs? Let us say the equated monthly instalment (EMI) to repay a loan stood at 1,000 Swiss francs a month. Around a year back, he would have needed 2,222 zloty (1000 x 100/45) to buy 1000 Swiss francs. Now, he would need 3,333 zloty (1000 x 100/30) to buy 1000 Swiss francs. This means the EMI has gone up by 1,111 zloty or 50% in just one year.

Why has this happened? As I mentioned earlier, most of the loans given out in Eastern European countries were given out as real estate loans and consumer loans. The real estate bubble the world over burst around one and a half years back and since then, prices have been falling. Western European banks obviously saw this, and more or less stopped lending in Eastern European countries. Also, with so much of debt denominated in foreign currencies, there was a mad scramble among the citizens of Eastern European countries to buy and hold foreign currencies like euro and the Swiss franc. When that happened, the demand for the foreign currencies increased, leading to their value against currencies like the Polish zloty going up. This basically meant that people who were earning in zlotys and had borrowed in euros or Swiss francs saw their EMIs go up dramatically.

This humongous increase in EMIs does not go down well for economies whose GDP is contracting, which basically means that people are losing jobs and those who have jobs are seeing their incomes come down. This increases the chance of people defaulting on these loans. Take the case of a country like Ukraine, whose economy contracted by 12% in the three months from October to December. This has primarily been on account of steel prices crashing. Steel is a major export for the country.

Or take the case of Latvia, whose economy shrank by 10.5% in the December quarter. Most of these Eastern European countries are essentially commodity exporters and as you would know, commodity prices the world over have crashed. On the whole, these countries are expected to contract by 3% this year.

So banks which have lent to borrowers in these countries are in huge trouble. Take the case of Austrian banks. Estimates suggest that they have lent $289 billion to Eastern Europe. A large portion of this lending is in Swiss francs, which these Austrian banks have borrowed from Swiss banks. The Austrian finance minister, Joseph Proll, recently said that even if 10% of this lending goes bad, the Austrian financial system will go broke. With much of this money borrowed from the Swiss, the Swiss might also get into some trouble.

Now you might ask, why not just rescue these banks, like they have in the United States and the United Kingdom, by simply printing money?

The trouble is most of the Western European nations have euro as there currency. For the European Central Bank to print money, it would need each of its 16 members to say "Yes" to the decision. And that, as you would agree, is easier said than done.

The other problem is that most of these banks are too big for the countries they are domiciled in. The lending of the Austrian banks to Eastern European banks stands at $289 billion, as I mentioned earlier. This is equivalent to 70% of the Austrian GDP.

Given this, it is very difficult for the host countries to rescue these banks. They would need help from larger countries like France and Germany, which are steeped in their own problems, and are not in a mood to oblige. Other than this, most European banks have exposure to all the trouble in the United States. Not a good scene at all.

How about the International Monetary Fund (IMF) coming to the rescue of these countries? I guess it's well beyond the IMF as well. The IMF has reserves of around $200 billion. Of this, it has already exhausted a huge amount in rescuing countries such as Belarus, Hungary, Iceland and Ukraine.

Most of the Eastern European countries were formerly communist countries and have only recently moved to be being democracies with elected governments. Some experts feel the governments in these countries could pass laws to allow repayment of foreign loans in local currencies, and that would hurt the Western European banks even more.
And as if all this was not enough, European banks have given out nearly three-fourth of the loans worth $4.9 trillion given out to the emerging markets. Most emerging markets are in big trouble now. I guess I will leave that for the next email. Or maybe you could tell me about it.

That's it for now. I'll try to miss you, as much as you do.

Take care.

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