The European Central Bank (ECB) announced Oct. 16 that it was bailing out Hungary with a 5 billion euro (US$6.7 billion) loan facility, just days after the Hungarian Finance Ministry said it was seeking consultations with the International Monetary Fund (IMF) about a possible support package. The ECB's unprecedented move
in bailing out a non-euro state underlines the crisis unraveling in Hungary and its possible impact on the rest of Central Europe
. Several players will be affected, but at particular risk are the Austrian banks which invested so heavily in the region. A potential serious hiccup of the Austrian banks could mark a significant blow to Europe’s already troubled banking system
When Central Europe turned to market-based economics after the collapse of the Soviet Union and the opening of the Iron Curtain in the early 1990s, Austria was one of the first countries to rush into the region. This was a natural development given that Austria has cultural and historical links there. The expansive Austro-Hungarian Empire dominated the countries of the Danube basin, including portions of modern day Poland and Czech Republic. Vienna-based banks therefore were much more comfortable with the region’s market risks than were many of their larger competitors in France, Switzerland and Germany. Particularly aggressive in moving into the region were Austrian banking giants Raiffeisen, Erste Bank, Volksbank, BAWAG P.S.K. and Bank Austria Creditanstalt (which is part of Italy’s UniCredit Group Central European banking empire). From their initial move into Central Europe in 1991, these banks expanded operations and practically dominated — along with Italian banks UniCredit and Banca Intesa — the banking sectors of all Central European and Balkan states. In fact, Austrian banks as a whole made 35 percent of their profits in Central European and Balkan markets in 2005 and currently dominate claims in inter-bank lending and short-term money market instruments. Overall Austrian bank exposure to the region amounts to nearly $300 billion, with only Italy (at $212 billion) approaching the same level of exposure. No country’s banking system, however, comes close to the total bank asset exposure to Central Europe and the Balkans, with somewhere between 15 percent and 20 percent of total Austrian bank assets being located in the region. This inherently means that if a crisis in the region occurs, Austrian banks will be severely tested, if not completely devastated. Therefore, on Oct. 15, Raiffeisen and Volksbank took precautionary measures by imposing restrictions on foreign currency lending in Hungary, followed Oct. 17 by a similar decision by Volksbank Romania to stop foreign lending in Romania. (Austrian banks control over 60 percent of the Romanian bank market share.) The practice of lending in foreign currency — mainly in euros and Swiss francs — is a popular strategy for retail banking in the region. However, it is becoming increasingly problematic in countries like Hungary, Romania and Croatia, which are facing weakening currencies and have underlying weak economic fundamentals (such as high government budget deficit, high trade deficit and high inflation) that cause wild swings in the value of the currency. Foreign currency lending was a lucrative way for Austrian banks to expand into Central Europe and the Balkans and quickly gain a market share that dwarfs their domestic market. Austria has a population of barely more than 8 million, with a GDP of more than $300 billion, compared to the combined population of 130 million and GDP of more than $1 trillion for Central Europe and the Balkans — making the latter an extremely fertile location for expansion. The strategy of foreign currency lending consists of offering mortgages, personal loans and business loans in euros and Swiss francs. The Swiss franc is particularly enticing because Switzerland has consistently had extremely low interest rates throughout the 1990s and 2000s, mainly in an attempt to stave off deflationary pressures. At one point, the Swiss short-term interbank lending interest rate (Swiss Libor) hit 0.3 percent in 2003. Swiss franc foreign lending is essentially the “carry trade” that caused so many problems in Iceland. In Iceland, however, the “carry trade” involved moving Japanese yen-denominated loans into the United Kingdom and other parts of Europe, a strategy that left Icelandic banks holding original yen-denominated loans — which were essentially their source of credit. In the case of Austria, the exposure is not as enormous relatively — Iceland is a tiny country with a population of 330,000 — although it is still large. This practice was especially lucrative in Balkan countries where long-term lending for mortgages is practically impossible in the domestic currency because of instability and distrust of the monetary system. In Serbia, for example, all mortgages are either denominated in euros or Swiss francs. Because of the Swiss franc's low interest rate, and its relative weakening against most Central European currencies after 2004 due to continuous low interest rates, Swiss franc lending also ballooned in Hungary, Slovakia, Czech Republic, Romania, Croatia and Bulgaria. From 2006, nearly 90 percent of all mortgages in Hungary were denominated in Swiss francs, with similarly high numbers in Romania and Croatia in particular.
Consumers benefit from Swiss franc borrowing because the initial interest rate is much lower than anything they could get from a domestic currency loan or even a euro loan. However, there are two risks the consumer is exposed to through a Swiss franc loan. The first is due to the movement of the Swiss Libor, the interbank lending interest rate priced in Swiss francs. While not a dramatic shift, this rate did jump 3 percent from 2003 to 2008. This means that borrowing in Swiss francs increased by at least 3 percent from 2003 to 2008. The second risk, which is far more serious, involves the fluctuation of the Swiss franc against various Central European currencies. A borrower in Hungary, for example, has to deal with the appreciation of the Swiss franc against the forint in the amount of 7.1 percent on Oct. 15 alone. This jump in the value of the Swiss franc therefore increases the mortgage payment of the Central European or Balkan mortgage borrower. A payment of $1,000 on a mortgage taken out in 2003 could easily increase by more than 10 percent (a 3 percent increase in the Swiss Libor plus an additional fluctuation in the Swiss franc versus the forint), costing the borrower an extra $100. On the positive side, an increase in mortgage payments could cool consumer spending on foreign imports, reducing the huge trade imbalance most Central European and Balkan countries have. But on the negative side, if the forint decreases even further against the franc — as it could with a financial collapse — the increase in mortgage payments could become even greater. To offset an extra $200 to $300 a month on their mortgage payments, consumers will likely cut other spending, almost automatically setting off a recession that could take with it the Austrian banks so vested in the region. As Central European currencies become more exposed to the global credit crunch and are faced with underlying economic deficiencies
, we could begin seeing a dramatic decline in the ability of mortgage owners to finance their monthly payments. Austrian banks would be the most direct victims of such a turn in events because they control more than 20 percent of the banking market share in Albania, Bosnia and Herzegovina, Bulgaria, Croatia, Czech Republic, Hungary, Romania, Serbia and Slovakia. The total claims that Austrian banks have in most of these countries often top 40 percent of total (local) GDP. While other countries are also exposed to the region — particularly Italian banks Banca Intesa and UniCredit — no country except Greece, which is particularly vested in the Balkan nations of Bulgaria, Romania and Serbia, is as involved relative to total overall assets.
The potential for Europe's banking systems to be negatively affected by a crisis in Austrian banks is considerable. The total external lending in Swiss francs, according to some estimates, reached nearly $650 billion in 2006. Essentially, at least $650 billion Swiss francs in the form of credit either is going to be withdrawn from the market or will no longer be available for new spending. This could manifest in two ways. It can either wreck Central Europe as the most favorable form of financing disappears, or it can become an issue of defaulting loans, causing contagion in Austria, Greece, perhaps Italy, and potentially Switzerland — the originator of all the Swiss franc floating around the region.