False Alarms in the East

in financial circles, the mere mention of Eastern Europe these days conjures up images of collapsing banking systems, currency in-stability, and capital flight. The travails of the Baltic states have come to symbolize all that has gone wrong with Eastern Europe's high-growth economic model. Some analysts even believe that the region is now the weakest link in the global economy and could be the source of yet another financial contagion.

At the center of the storm are small countries like Latvia, now paying the price for the heady growth of the past few years, which was fueled by unbridled household consumption and property investment. With capital flows drying up of late, Latvia is under pressure to break the peg with the euro and devalue the exchange rate—a move that could lead to widespread losses for many of its households and banks, as the country's debt is largely held in foreign currency.

Latvia is trying to stick with the peg, relying on billions of Euros' worth of assistance from the International Monetary Fund and European Union, which come with the usual strictures of fiscal discipline entailing painful spending cuts. The suspense relating to the fate of Latvia's peg is indeed intense, because any devaluation of the lat would make currency pegs in nearby Estonia, Lithuania, and Bulgaria more vulnerable.

Yet even if this happens, the size of the problem won't match the hype. These are $25 billion to $50 billion economies, which means that the repercussions for the world economy will be limited. Western European banks, which own nearly half of Eastern Europe's banking assets, have the most to lose. But assuming the value of nonperforming loans in all of Eastern Europe totaled 10 percent of the region's total economy, parent banks in Western Europe would suffer losses of only about $60 billion—less than a quarter of those incurred from their exposure to toxic U.S. banking assets.

The key reason that Eastern Europe's problems aren't quite as serious as generally believed is that the bigger economies in the region never got caught in the credit boom-bust cycle. The $500 billion-plus Polish economy—which is the biggest in Central and Eastern Europe—has no banking problems, and didn't rely on hot money to rapidly boost consumption growth. Instead, Poland spent much of the past decade reforming and instituting Western European laws, which subsequently helped pull large amounts of foreign direct investment into its manufacturing and service sectors.

The Czech Republic, which at $220 billion is the region's second-largest economy, didn't overextend itself either. Credit penetration in the Czech economy remains low, at 50 percent of GDP, and the pace of credit expansion during the boom years of 2003–07 was well below the 20 to 25 percent annual rate that usually leads to trouble over time.