The next global economic shock?

As American financial strains have at last begun to show some signs of healing, another risk from the European side of the ocean has become more evident. For some time now, America's friends and associates on the other side of the Atlantic have, as is their habit, enjoyed blaming all problems on America's risky ways.

But of late, it has become clear that Europe's own financial wizards have opened their financial institutions to a potentially bigger problem: Eastern European and Asian debt. The losses could even surpass those of the subprime meltdown. Though at present the potential problems deserve the tag "risk" and not "probability," investors need to remain alert to the situation.

The problem for much of the emerging world is that the global economic downturn has severely hurt exports, their main – and in some cases, only – engine of economic growth.

Take China. Its exports have fallen by about 17 percent, as have Singapore's. Others have fared a lot worse. South Korea's exports have plunged by 21 percent, and Taiwan's by 36 percent. Similar figures typify the situations elsewhere in Asia and in Eastern Europe.

Not surprisingly, given the export-oriented growth model of these economies, overall economic growth has also turned sharply downward. Singapore's gross domestic product (GDP) declined 11.5 percent from a year ago, while South Korea's economic output sunk 4.2 percent.

In the Ukraine, December industrial production registered a 26.6 percent decline from a year ago. Other nations, from the Czech Republic to Hungary to Russia, have experienced sharp contractions, too.

The problem for Western European finance is that it holds most of the international loans in these sinking economies. European banks, for instance, hold some 54 percent of the $1.4 trillion of foreign bank loans residing in the Asian emerging economies. (For perspective, American banks hold only 15 percent of such debt.) Of the $1.8 trillion of foreign bank loans in Eastern Europe, more than 70 percent resides in Western European banks.

The economic difficulties in these regions are bound to pressure European finance, where, according to the International Monetary Fund, bank leverage exceeds that of American banking by 50 percent. It is hard to make American banks look prudent, but the Europeans seem to have managed.

The aggressive nature of European lending has created a particularly difficult regulatory situation should circumstances require a rescue operation, as the American subprime excesses did in the United States. Because European banks are far more extended than American banks are, their governments and even the European Central Bank lack sufficient resources to replace lost capital, as the Federal Reserve and the Treasury are doing in the United States.

In contrast to American banking, which holds assets equal to some 85 percent of US GDP, Eurozone bank assets in total amount to 330 percent of Eurozone GDP. What makes matters still more precarious, these aggregate figures look moderate when compared to the lending ratios of some individual Eurozone members. Irish banks, for instance, took on debt equal to almost 11 times their national GDP. Dutch banks took on debt equal to seven times their national GDP, and Belgian banks took on debt equal to four times their national GDP.

The potentially troubled loans in Eastern Europe and Asia could amount to some 33 percent of Eurozone GDP, a far higher figure than subprime in the United States, which, in the worst calculated scenarios, amounts to some 8 percent of American GDP.

So far, these borrowers, if they have not managed to remain entirely current on their obligations, have paid sufficiently well to avoid the troubles implicit in these comparisons. If, as expected, the American economic situation can stabilize in the second part of this year, and China can sustain an adequate growth rate as it reorients its economy toward a domestic growth engine, there is a good chance that European finance and, by implication, global finance, will avoid the dangers implicit in these great vulnerabilities. But still, for the time being, investors need to recognize the significant risks.

This vulnerability may also explain why the Europeans are so focused on regulation and have chosen to emphasize it above the kinds of fiscal stimulus that the Obama administration has pushed. On the one hand, they want to garner all the resources they have should the banking sector need them at some future date. On the other, the emphasis on regulations might well reflect an urgent need to prevent this from happening again.

Milton Ezrati is senior economic strategist at Lord Abbett, a money management firm.