Eastern European Finger Trap

Story Highlights:

• Capital flight is pushing down Eastern European currencies and subsequently raising debt default fears. Western European banks, holding the large majority of Eastern Europe's debt, would be especially hard hit if the region collapsed financially.
• The outflow trend looks unlikely to abate soon, but may be less severe than during the Asian Financial Crisis. Plus, Western and Eastern European countries seem ready to take necessary action to prevent a regional financial crisis.
• High volatility and big boom-and-bust cycles are part and parcel when dealing with developing markets. It's key to note trouble in one region doesn't mean a pervasive, similar trouble in all developing worlds.
• Stocks globally re-tested lows, but history shows double- and even triple-bottoms don't mean a bull market can't be on its way.

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The finger trap is a puzzling toy—the more you pull, the tighter the trap. The unintuitive solution is to push the ends toward the middle, expanding the openings and freeing the fingers. But what if one finger pulls and the other stays inert? Unfortunately, cooperation from both sides is needed to succeed.

Eastern Europe's economic development over the past two decades was in no small part funded by investment capital from the West (Europe and North America). Now that relationship is morphing into a perceived financial crisis trap for Western European banks. Investors wary of Eastern Europe's economic deterioration and risk averse to holding its assets are pulling out money. The capital flight is pushing down Eastern European currencies and subsequently raising default fears on foreign currency debt. Western European banks, holding the large majority of Eastern Europe's $1.7 trillion foreign debt, would be especially hard hit if the region collapsed financially. The more capital investors pull out of Eastern Europe, the greater the pressure on Western European banks.

Western Europe's exposure to Central and Eastern Europe (CEE) debt is very concentrated, both in terms of who holds it and how much is held. Six countries (Austria, Belgium, France, Germany, Italy, and Sweden) hold 84% of all Western European loans to the CEE, either directly or through locally established subsidiary banks. Austrian banks' exposure is equal to 70% of the country's GDP; Swedish banks' exposure is 30%. Massive loan defaults would no doubt weigh on these countries' already weakened financial systems.

Capital flight from Eastern Europe looks unlikely to abate soon, but comparisons to the Asian Financial Crisis are likely off-base. Unlike Asia 10 years ago, capital flows to CEE countries over the years were more of the foreign direct investment (FDI) type than portfolio investment. Portfolio flows are much more susceptible to sentiment swings and easier to reverse, whereas FDI tends to be more stable. Plus, CEE countries have the implicit support of Western European countries (the resulting bank losses from an Eastern European financial collapse would be largely born by Western European banks), which have substantial financial firepower.

Already, Western and Eastern European countries seem ready to take necessary action to prevent a regional financial crisis. Western European leaders called for the International Monetary Fund (IMF) to double its available funds for financially troubled nations, and the European Union may extend its own emergency aid to CEE countries. In an unprecedented coordinated move, Eastern European countries voiced intentions to intervene in foreign exchange markets to support battered local currencies.

There's no question Europe will need to undergo an adjustment period—Eastern Europe's boom was largely fostered by heavy borrowing. No doubt less capital will flow into these economies in the periods immediately ahead, though a complete standstill remains unlikely—Western European banks have vested interests in keeping subsidiary banks in CEE countries afloat. Plus, though Western European banks will surely incur some losses tied to Eastern European's financial strains, this outcome is likely already reflected in their share prices.

High volatility and big boom-and-bust cycles are part and parcel when dealing with developing markets. It's key to note emerging markets are very diverse, and trouble in this one region doesn't mean a similar, pervasive trouble in all developing worlds (China, India, and Brazil, for instance). Plenty of headlines in coming months will declare growth submerging in developing regions. But, again, this is the nature of EMs. While their plight is lamentable, outside the financial repercussions tied to their loans, the fact remains Latvia, Poland, and the like are tiny economies with little impact in the context of the global economy.

Stocks globally re-tested lows—as we mentioned earlier they might. But don't let new lows scare you into thinking this bear market is here to stay—history shows double- and even triple-bottoms don't mean a bull market can't be on its way.