Europe’s Danube Blues

The parallels are eerie. In 1931, the collapse of an overleveraged, undercapitalized Vienna-based financial institution named Creditanstalt triggered a chain of worldwide bank defaults and set off the darkest days of the Great Depression. Now, once again, it's Austria's banks—including, amazingly, the successor bank to the infamous Creditanstalt—that find themselves center stage of the next act in the worldwide economic crisis.

This latest phase unfolding in the middle of Europe won't be as destructive as the subprime debacle, and by itself certainly doesn't herald another Depression. But it has all the hallmarks of the kind of emerging-markets crisis that until now was confined to Latin America or Southeast Asia: collapsing currencies, reversing capital flows and markets speculating on government default. Like the subprime crisis in the U.S., it started with billions of profitable but risky loans, this time made by Western European banks to Eastern European markets. During the boom days, the money rolled in; now, as the global recession exposes all economic fault lines, Western European banks stand to write off between $100 billion and $300 billion of their $1.7 trillion in outstanding emerging Europe debt.

For the first time in decades, it's not just European banks but entire countries that investors worry could be insolvent. Last week Latvia became the second European Union member after Romania to have its government bonds downgraded to junk by the rating agency Standard & Poor's. The IMF has already had to bail out Hungary, Latvia and Ukraine, and is in talks with Romania and other countries in the region. What's more, the contagion threatens to spread westward into the heart of Europe. In recent weeks, investors have steadily bid up bond spreads—the premium investors demand to compensate for the risk of default—for Austria, Greece, Italy and Ireland, mainly due to those countries' worsening public finances; additional problems with their banks only heighten investors' unease. Investors have also been fleeing the euro, which has dropped 22 percent against the dollar since July.

As bad as the economic fallout is, the crisis has turned into something more: an existential test for the European Union. Already it has laid bare growing rifts between members, and exposed how woefully underequipped the EU's institutions are to deal with the situation. For all their lectures about global solutions to the economic crisis, EU members have mainly acted to save themselves. A number of Western governments have ordered their banks to pull back funds from foreign subsidiaries in the East and elsewhere, choking off capital to the region. France has ordered CEOs to close factories in Eastern Europe in order to save jobs at home. Last week World Bank chief Robert Zoellick warned Europe that unless it acted decisively to reverse this course, it risked the "tragedy" of once again splitting into two economic and political blocs—exactly 20 years after the fall of the Berlin Wall. By the end of the week the World Bank, along with two EU public-investment banks, finally scrambled to raise a €25 billion loan package for Eastern Europe's banking systems. But calls for a much bigger bailout have so far gone unheeded.

The new problems in the East could hardly come at a worse time. Like the U.S., Europe is still reeling from the effects of the subprime disaster; European banks bought up some 40 percent of the toxic securities made in America, but have been slower to write off losses and recapitalize than their American rivals. On average, they also remain substantially more leveraged than American banks, making write-downs and restructuring much more painful—and likely to be dragged out.

Meanwhile, European banks bet much more heavily than American banks on profitable but risky credits to emerging markets, including mortgages, but also many other kinds of corporate and consumer loans. Worldwide, some 73 percent of the $4.6 trillion lent to emerging markets came from banks in Europe, compared with just 10 percent from the U.S. and 5 percent from Japan, according to the Bank for International Settlements' figures.

Naturally it's EU banks that now face the biggest risks in these markets. The European Bank for Reconstruction and Development expects defaults of up to 20 percent on Eastern European loans, with the Baltics, Romania and Ukraine hit especially hard. Of the $100 billion to $300 billion in write-downs by Western banks expected by Danske Bank analyst Lars Christensen, Austria will take the biggest hit. Its banks lent some $284 billion (equal to about 60 percent of Austrian GDP) to the East.