Europe's financial crisis is spreading eastward

A rapidly mounting currency crisis within Eastern Europe is threatening to spill across the wider European Union, an event that could spark a second epicenter in the global financial crisis, economists say.

That's why the International Monetary Fund (IMF) moved quickly to approve loans to Ukraine and Hungary Sunday. Belarus and Serbia are also asking for assistance.

The IMF loan helped stabilize Hungary's currency on Monday. But many Eastern European currencies have fallen as much as 25 percent against the dollar and euro. The euro's own devaluation of late is part of the problem.

The euro hit a two-year low against the dollar Monday, reflecting new concern that Western European banks are too exposed to the emerging economies of Eastern Europe, having lent heavily to many when they joined the European Union (EU) in 2004.

With currencies there diving, and credit drying up overall, the fear is that these countries will soon not be able to finance their debts, threatening Western Europe with large losses.

Economists say the currency panic recalls the "Black Wednesday" collapse of the European Exchange Rate Mechanism 18 years ago. Neil Mellor, an analyst at Bank of New York Mellon, told London's Daily Telegraph Sunday, "This is the biggest currency crisis the world has ever seen."

So, the IMF is stepping in to help some countries finance their debts. On Sunday, the IMF closed bailout deals with Ukraine and Hungary, agreeing to loan Ukraine $16 billion and Hungary an unspecified amount that's likely to be more than $10 billion, say some analysts. Belarus is asking the IMF for a $2 billion loan, and Serbia is expected to make a formal loan request soon; an IMF team arrives in Belgrade Wednesday to begin talks with the government.

Eastern European economies that only a month ago seemed fundamentally sound are now foundering, not because of toxic mortgage loans as in the United States, but rather because of the credit crisis' impact on capital markets. Governments in the region borrowed and spent heavily to improve institutions and infrastructure ahead of European Union membership.

After joining the EU, foreign investment poured in, property values soared, housing markets boomed, and ordinary consumers found themselves with access to credit that was unthinkable during the dark days of communism.

The Baltic countries of Latvia, Estonia, and Lithuania, for example, boasted annual economic growth of nearly 10 percent in recent years.

But as European economies slow, and credit tightens, stock markets have fallen. The market is down 50 percent in Poland and Latvia, 72 percent in Romania, and nearly 80 percent in Ukraine.

The Baltic countries, Romania, and Bulgaria have current account deficits – the net flow of goods, services, and transactions between countries – in double-digit percentages to their gross domestic products (GDP). Hungary's public debt is now roughly 60 percent of its GDP.

"No matter how well your economy is doing you will have problems as soon as you have debt and are not able to refinance it," says Vasily Astrov, an expert in the region's economies at the Vienna Institute for International Economic Studies.

Why Western Europe is worried

In many cases, the loans Western European banks have made to Eastern European customers for mortgages were made in foreign currencies – euros, dollars, Swiss francs, and others – at substantially lower interest rates than they would have received in their own currencies, which were strengthening rapidly.

That wasn't a problem, as long as those Eastern European currencies remained strong, says Katinka Barysch, the chief economist at the Center for European Reform in London.

"But now these currencies are under pressure," Ms. Barysch says, "and you will really struggle to service your mortgage if the value of your own salary is collapsing vis a vis your mortgage payments in Swiss francs or euros."

For example, if a Hungarian had a home mortgage payment of €300 per month, that's equivalent to 73,200 forints. If the forint drops 11 percent against the euro, that means his monthly mortgage bill goes up to 81,300 forints. But his salary, in forints, doesn't increase.

Eastern European countries currently hold about $1.6 trillion in foreign currency debt, according to Morgan Stanley, and it's overwhelmingly owed to Western Europe, whose large banks own 60 to 80 percent of Eastern Europe's banking sector.

Western Europe is among the world's most exposed regions to debt from emerging markets, not just in Eastern Europe but in Latin America and Africa. While exposure to emerging markets accounts for about 4 percent of the USs' gross domestic product, in countries like Switzerland it's as high as 50 percent, according to the Bank for International Settlements.

The concern in Western Europe now is whether Eastern European countries will begin defaulting on those loans.

Not all Eastern European countries are struggling for the same reasons.

Ukraine has been hit hard by sharply falling commodity prices, especially for steel, an major export. The Baltics are seeing a housing bubbles burst. The Czech Republic, Slovakia, and, to a lesser extent, Poland are in better shape because their economies are considerably more export-driven, which reduces the need for borrowing.

Those three countries also chose to keep their currencies floating, rather than fixed, against the euro, which gives them a degree of flexibility when the euro heads south. They can devalue their own currencies as an offset, which helps exports.

A rush to adopt the euro?

Eastern Europe's woes are sparking a fresh debate about the wisdom of pegging currencies to the euro. Economists predict that a currency crisis will drive more countries to adopt the euro, citing the safety net against currency runs. Iceland, Sweden, and Denmark are weighing this. Poland is now planning a referendum on euro adoption next spring. In January, Slovakia will formally adopt the euro, the first ex-Soviet bloc country to do so.

"If that goes through without trouble, it will be an extremely important sign for other countries," says Daniel Gros, director of the Center for European Policy Studies in Brussels. "If you want to be safe, you better be in the euro zone."