Before the PIIGS entered the collective consciousness of European elites, the East-Central European member states of the E.U. were supposed to be at the root of the European financial woes. Just as the beginnings of the Great Depression were tied to the financial imbroglio of a Viennese bank, it was Austria’s massive exposure to the financial sectors of countries like Hungary or Romania by 2008 that was expected to trigger collapse in the rest of Europe. Yet this did not happen. Why not and with what costs for the economies of the region?
The story of this averted meltdown in the East begins years before Lehman entered a tailspin. After the end of state socialism and especially as these states ran for E.U. membership, the I.M.F. and the E.U. abetted and at times coerced a wholesale transformation of their banking systems. The rules of the game were clear: privatization, deregulation, central bank independence, and trans-nationalization of the interbank market.
It took a little more than a decade for this transformation to occur. Financial systems that had been 100 percent owned by domestic state capital in 1990 had become almost entirely foreign owned within 15 years. A recent report found that two thirds of transition countries in 2005 had banking systems controlled by foreign banks. With the exception of Slovenia-the only eastern social-democracy-all other new E.U. members from the East became little more than subsidiaries of (largely) West European banks. What was even more striking was that the share of foreign-owned assets in total banking assets was unprecedented among middle-income countries, with most banking sectors in new E.U. member states reaching between 80 and nearly 100 percent foreign ownership.
So what’s wrong with this picture? After all, the privatization of East European banking systems with foreign capital was a brilliant idea because this privatization broke the links between government incumbents, state banks and state-owned enterprises, right? This creative destruction was credited with ending seemingly endless cycles of non-performing loans, bank recapitalizations, and inflation. Local private capital was weak and tempted to play dirty in politics so turning the new member states into subsidiaries of modern Western banking seemed preferable to developments in countries like Russia or Ukraine. Moreover, since some of the states had major issues with their EU application files, selling state owned banks – usually for a good price – to Western European banks helped to reduce the uncertainty of the membership negotiations. Don’t think of it as a bribe or insider trading. Think of it as “signaling credibility.’ In sum, the Easterners got the coveted E.U. membership and modern finance while the Westerners got as big a market share as one could get anywhere. What could be wrong with that?
Well, pretty much everything – the most problematic issue being how these transformations ended up being key to the crisis generators in the region. First, even during the pre-Lehman boom, while foreign ownership in the financial industry blew a huge consumer credit bubble in Eastern Europe, it made only a marginal contribution to industrial investment. The boom in industrial investment witnessed there had little to do with the presence of foreign banks and much to do with integration into Western supply chains where foreign firms brought their credit lines with them, rather than finance their needs from local banks. Foreign credit was primarily consumer credit. It turns out that the most pernicious aspect of this was that the consumer boom in “hard” currency loans before 2008 made devaluation much more tricky when the crisis struck since devaluations raised the debt burden in domestic currency terms.
Second, while foreign banks channeled excess savings through their East European subsidiaries in good times, in times of crisis they had strong incentives to pull out their money from them in order to consolidate the situation at the “home” parent bank. And indeed in 2008-9 many of them threatened to use this option, triggering fears that the ensuing capital outflow would shut down the economies of the region.
Given this implicit capital flight risk generator, the much-vaunted considerations about the superior efficiency of Western banking pale next to the long-term macro costs. For it is at this point the E.U. and IMF intervened and orchestrated a massive bailout of these financial systems. But of course, they made states pay for it.
Ironically, it was in Vienna (remember the trigger of the Great Depression?) where an agreement was signed in 2009 with banks, the European Central Bank, the European Commission, the EBRD, the IMF and the states in question sitting around the table. The core of the agreement was that West European banks committed to stay if ECE governments reiterated commitments to austerity and stabilizing the banks’ balance sheets while the IMF and the E.U. put the corresponding bill (fiscal austerity, high interest rates, constraints on mortgagees’ rights, recapitalization I.M.F./E.U. loans deposited with the central bank) on the balance sheet of the states.
It was no surprise then that as the West European sovereign debt crisis hit, another major vulnerability emerged: that foreign banks in Eastern Europe could become the transmission belts for the troubles of Western sovereigns. Following Greece’s tailspin and Austria’s downgrading in the spring of 2012, S&P turned Romanian bonds into junk status because the Romanian banking sector had too much Greek and Austrian financial capital.
It has now become obvious that in a world in which much of Western Europe is treated by the markets in the same way developing countries are, the creation of a financial enclave in Eastern Europe made this region more rather than less crisis prone. Trapped in pro-cyclical macroeconomic programs and dependent on investment decisions made in Western Europe, the region’s immediate economic future looks indebted and closely tied to the fate of the euro, a realm of policy over which East European societies have no control.
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