AFTER firefighters extinguish a blaze they usually look carefully for glowing embers before rolling up their hoses and heading off. With the worst of the banking crisis now receding in most rich countries, it is tempting to send the financial firefighters home. But wafts of smoke from eastern Europe suggest the job of stabilising Europe’s banking system is not yet done.
In early August a number of banks operating in the region reported sometimes startling rises in loan losses. Among them were UniCredit, Erste Group and OTP. It had been hoped that loan losses would start falling. Instead they have continued to climb—alarmingly in some cases. In Kazakhstan more than a third of outstanding debt is non-performing. In Latvia, almost a fifth of debt is going bad.
In Hungary and Poland the proportion of debt that is souring is below 8%, though in both countries it is still rising and, because their economies are bigger, their bad debts can cause more havoc. Non-performing loans in Ukraine are officially below 10% of the total, but quirks in the tax law punish banks for writing off loans. The IMF reckons the true figure is closer to 30%.
The main reason for the sharp rise in bad debts is that borrowers had became unhealthily addicted to loans in foreign currencies, such as the Swiss franc, which offered lower interest rates than local-currency debt. In Hungary almost two-thirds of household debt is in foreign currencies (see chart). In Latvia about 90% of all private borrowing is. A steep rise in the value of the Swiss franc against local currencies has increased the burden of debt and interest payments on the region’s borrowers. The strains have been made worse by collapsing housing markets and the general economic slowdown. A big share of loans to companies in some countries is in foreign currencies, too, though devaluation is a two-edged sword for corporate borrowers. Many are exporters and so also benefit from a weaker currency.
That said, the dangers that loan losses in the region pose to Europe’s staggering banking system can be overstated. A recent round of bank stress tests in the European Union and Switzerland suggested that almost all banks have enough capital to absorb quite severe shocks, including big loan losses in eastern Europe. The chances that Latvia’s bad debts could overwhelm Sweden’s banks, say, or that souring loans in Hungary might cripple Austrian lenders, seem rather low.
A bigger threat is that European banking will be paralysed if lenders are weighed down with bad debts that steadily erode their capital buffers. “The risk is of a Japanese-type frozen situation,” says Piroska Nagy, of the European Bank for Reconstruction and Development. “We don’t worry about a banking crisis but a very stalled recovery.”
There are few easy choices when it comes to damping the burning fuse on eastern Europe’s bad debts. Governments are unwilling to force an immediate conversion of foreign-currency loans into local currencies, because that would crystallise paper losses that would then have to be borne immediately by either banks or borrowers. Hungary has banned the issue of new foreign-currency mortgages and Poland is regulating them more strictly by, for instance, insisting that borrowers put down bigger deposits. That is akin to installing sprinklers after the house has burned down. In the short term such measures may further damp the supply of credit to economies that sorely need it.