UK ANALYSTS ASSERT CENTRAL AND EASTERN EUROPEAN

UNCLAS SECTION 01 OF 04 LONDON 001369

SENSITIVE
SIPDIS

E.O. 12958: N/A
TAGS: EFIN ECON EINV XG UK
SUBJECT: UK ANALYSTS ASSERT CENTRAL AND EASTERN EUROPEAN
BANKING SYSTEM FACES PROBLEMS BUT NOT COLLAPSE

REF: LONDON 1321

LONDON 00001369 001.2 OF 004



1. (U) SUMMARY: Compared to the acutely fragile economic
climate in Central and Eastern Europe from November 2008 to
February 2009, UK-based market watchers now feel the worst is
behind them. Their views are spurred in part by positive
news on U.S. and UK banks in recent weeks and assumptions
that European banks will be fine as well. Though the risk of
a slow recovery still looms, analysts generally felt
confident the largely foreign-owned Central and Eastern
European banking sector, backed by commitments from foreign
parent banks and IMF/EC financing, had the tools needed to
cope with the ongoing economic crisis. End Summary.

The Banking Sector May Be Out of Acute Danger
--------------



2. (SBU) Market analysts from Royal Bank of Scotland, Credit
Suisse, and HSBC told us recently they felt Central and
Eastern European banks had gotten past the worst of the
credit crunch. Troubles in this region's banking sector now
center around liquidity--not solvency--for emerging Europe,
said RBS' Head of Central and Eastern Europe Middle East and
Africa Research, Timothy Ash during a May 14 meeting. He saw
positive indicators, namely that Eastern European banks were
not highly leveraged and governments had maintained lower
levels of public sector debt. Compared to Western Europe,
public sector debt to GDP in Eastern Europe is only 40
percent vice 70 percent. Moreover, even in case of a bank
failure and the need for recapitalization, Ash pointed out
Eastern European banks are small relative to Western European
institutions, with bank assets to GDP reaching 100 compared
to 215 and higher in some Western European countries. Ash
implied, consequently, they are not too big to fail or too
problematic to rescue.

Central European Banks on Solid Ground
--------------


3. (SBU) Contrary to worrying Central Europe's banks could
fail, the key for Central Europe is whether foreign-owned
parent banks will drag down their Central European
subsidiaries, HSBC and Credit Suisse analysts told us on May
22 and June 2, respectively. Jacqueline Madu, Emerging
Markets Analyst at Credit Suisse asserted Czech subsidiaries
are in fact net creditors to their foreign parent banks. She
also pointed out that some of the journalists who used Bank
of International Settlement (BIS) data on liabilities used
the wrong table, exaggerating the exposure of Austria's Erste
bank's exposure to the Czech banking sector. On Poland, Madu
said only a severe contraction could lead to deterioration in
portfolios of Polish banks, and this seemed unlikely as the
crisis bottoms out in Western Europe. In addition, despite
the exposure of Polish banks to foreign exchange mortgage
loans (denominated in Swiss francs),Maciej Baranski, Central
Europe Analyst in HSBC's EMEA Equities division, told us he
sees no major deterioration in the quality of those loans
because the decline in Swiss interest rates.


Non Performing Loans Bound to Rise but Not Alarming
-------------- --------------


4. (SBU) Rising non-performing loans (NPLs) represent one
challenge for the banking system but the cleansing needs to
happen, according to RBS analysts. RBS estimates Ukraine's
NPLs at above 20 percent and Lithuania at 8 percent, with
Latvia and Kazakhstan also at high levels. Turkey,s NPLs of
around 5 percent are less of a risk. Russia falls in the
middle of the extremes, but bankers are nervous, says RBS.
Economists who use a baseline scenario of a two percent
contraction in GDP in 2009 predict Russia will see NPLs
reaching ten percent. If, however, the Russian economy
contracts 6 to 7 percent this year (as expected from first
quarter 2009 figures),NPLs will likely rise to 15 percent or
more and banks will need to recapitalize, according to Ash.


5. (SBU) NPLs in Poland, Hungary and Czech Republic have been
rising and are likely to increase further as economic growth
slows and unemployment rises, but they are lower than NPL
rates in 2007 and analysts do not foresee markets reacting
badly. In Poland, Jacqueline Madu from Credit Suisse
stressed to us NPLs have reached 5.5 percent this year but
are still lower than the 8 percent level two years ago when

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unemployment hovered around 13 percent. She said NPLs in the
three central European countries will likely peak in the
third quarter of this year, eroding profitability, but will
not instigate bank insolvency. Maciej Baranksi from HSBC
projected nine percent NPLs and single digit loan growth in
Poland this year, but he saw Polish banks as generally
stable.

Foreign Banks and Multilateral Institutions Remain Committed
-------------- --------------


6. (SBU) The banking sector in Eastern and Central Europe is
largely foreign-owned, mainly by Nordic, Austrian, Greek, and
Italian banks. The consensus among the analysts is parent
banks will not allow subsidiaries to fail. (Comment: As an
example, on May 19, the parent banks of nine large
foreign-owned banks in Romania reaffirmed their commitment to
subsidiaries and agreed to increase capital ration from 8 to
10 percent in conjunction with IMF/EU financial support. End
Comment.) Madu told us Hungary's central bank and
supervisory authority ran stress tests with a very severe
10.5 percent contraction scenario, and the results suggested
banks need 1 billion euros, which corresponds to the amount
received from the IMF/EU. Baranski also agreed and told us
Western European banks will not let Polish subsidiaries fails
as this would gravely impact pension funds invested by
Western banks in Polish subsidiaries. The parent banks may
force Polish banks to find other sources of funding such as
local deposits; the ensuing competition for local deposits
will kill profitability as net interest margins decline.


7. (SBU) Foreign banks will remain active in the region
because of the competitive tax advantage Eastern Europe
provides compared to Western Europe, labor market
flexibility, and home market sentiment, analysts said. RBS'
Ash acknowledged his bank was cutting operations from 70 to
56 units in the region, some of which were inherited from its
merger with ABN Amro. RBS is looking to reduce risk in the
region but maintain presence. Analysts expect some sell offs
in Kazakhstan Czech Republic, Azerbaijan, and Uzbekistan, but
RBS is committed to the big emerging markets in the region,
namely Russia, Turkey, and Poland. HSBC's Baranski, citing
AIG as an example, told us sell offs of Central European
subsidiaries will be strategic in nature with financial
institutions looking for buyers to pay a decent price vice a
fire sale. Juliet Sampson, HSBC Chief Economist, Emerging
Europe, Middle East and Africa Economics and Investment
Strategy told us May 20 the only "pulling out" scenario she
can envision is if the parent banks are going out of
business. Austrian and Swedish banks, in Central Europe and
the Baltics respectively, consider the region as home
territory so they cannot pull out without "shooting
themselves in the foot." These parent banks are playing a
long game and not willing to concede territory to
competitors, she said, and commented the banks may be less
committed to investments further afield, such as those in
Ukraine and Kazakhstan.


8. (U) Multilateral institutions will continue to support
small and medium-sized enterprises (SMEs) through local bank
lending. Sampson points to the European Investment Bank's
(EIB) 440 million euros agreement with Erste Group Bank and
the EBRD's 432 million euros loan to Unicredit in early May.
(Comment: EIB will grant loans to four local Erste
branches--including Ceska Sporitelna, Erste Hungary, and
Immorent--to provide funding for SMEs projects in the Czech
Republic, Hungary, Slovakia, Poland, Romania, Bulgaria,
Slovenia, and Austria. The Unicredit loan is part of a joint
effort of EBRD, the World Bank, and EIB to provide over 24
billion euros in support of banks in the region and to fund
lending to companies hit by the crisis.)



The Need to Recapitalize Banks May Be Easing in Some Parts
-------------- --------------


9. (SBU) Baranski asserts the capital position of Central
European banks is good, thus alleviating the need for bank
recapitalization in Central Europe, even for Hungary's OTP
Bank. Earlier this year, Poland's financial regulator
requested banks not pay out dividends from 2008 profits.
Such actions combined with continued, albeit reduced,
profitability and slower loan growth give Baranski confidence
that Polish banks' capital positions are strong enough to

LONDON 00001369 003.2 OF 004


withstand rising NPLs. In addition, a greater weighting of
government securities in their balance sheets may further
help the capital ratios. Nonetheless, in his May 5 report on
Polish banks, Baranski points out a number of banks--namely
PKO and BRE--are seeking to use various forms of funding to
boost their capital positions; these capital raisings are
more to maintain lending in Poland vice solvency concerns.
He views Russia as a different "kettle of fish" than Central
Europe. Most of the liquidity in the banking system is
focused on the largest banks. Foreign exchange reserves have
been used to protect the ruble. Russian banks lack
alternative resources such as raising funds overseas, so the
government will have to recapitalize if NPLs rise or banks
will have to sell assets said Baranski. (Comment: Earlier
this year, the Russian government put forth a 900 billion
ruble bank recapitalization plan for commercial banks, with
state-controlled banks receiving the largest share. Russia
also dipped into its sovereign wealth funds putting 400
billion rubles of the National Wealth Fund's money on
deposits at state bank Vneshekonomobank (VEB) as part of
Moscow's crisis rescue package and a further 225 billion
rubles to be given to VEB for subordinated loans to banks.
Nonetheless, President Medvedev announced last month that the
government will no longer offer large bailouts to businesses
and state-owned companies.)


Potential Knock-on Effects from Troubles in the Baltics
-------------- --------------


10. (SBU) Despite gaining IMF/EU loans, Lativia remains a
weak link in Eastern Europe. A Latvian devaluation could put
pressure on other fixed exchange rate regimes in the region,
particularly Estonia and Lithuania (Ref London 1321). A
renewed crisis in the Baltics potentially brings heavy losses
to Western European banks, especially Swedish ones, and
dampens some of resilience shown in recent months. Following
Latvia's failed debt auction on June 3, Sweden's Finance
Minister attempted to reassure the market that Swedish banks
could ride through the crisis with a public statement that
the government of Sweden is prepared to take stakes in
Swedish banks if they fail to manage mounting losses. In his
June 3 markets report, RBS' Ash suggested the lack of vocal
EU, IMF and Swedish officials' support of Latvia's peg
implies an underestimation of the size of the problem and a
failure to realize the extent of the potential regional
currency corrections making the adjustment in Latvia more
brutal. Ash, however, argues Latvia's 7.5 billion euros
IMF/EU program -- while maybe not the right mix of policies
to bring Latvia out of the crisis -- allowed other economies
in the region and foreign banks to build up defenses. Ash
does not believe a Latvian devaluation will necessitate
immediate devaluation of other fixed exchange rate regimes in
the region. The key risk will be capital flight vis-a-vis
local currency deposits. Overnight deposit rates which
doubled to 24 percent on June 3 rose to 25 percent June 4
amid fears of capital flight. During our May 20 meeting,
Sampson said the mounting troubles in Latvia could be handled
in a "controlled explosion" and maintained this view in her
June 4 HSBC Global Research Flashnote. Sampson argues a
devaluation before April would have produced more devastating
fallout. With the banking sector "on the mend" and risk
appetite improving, the threat of an extra-regional collapse
is limited. Like Ash, Sampson asserts banks with exposure in
the region have had ample time to assess their risks and
prepare for such an event.


11. (SBU) Also, if Latvia devalues and region-wide currency
sell-offs ensue, Poland may have to tap the IMF's Flexible
Credit Line (FCL),according to Madu and Baranski. Poland's
fiscal deficit has widened significantly, already reaching
3.8 percent and likely to increase to 4.8 percent by year
end. RBS' Ash, however, views the FCL as free money since
the there is no conditionality attached and consequently
believes there's a greater likelihood officials may take the
money to address budget financing problems. IMF money
technically is not meant for fiscal support; however, the IMF
cannot do anything if Warsaw uses it for the budget. He told
us IMF officials have privately commented they do not really
care if Poland uses the money for fiscal support. As for
investors, Ash does not believe the market will react
negatively if Poland taps the FCL money. The money will go
into central bank reserves, the central bank will issue local
currency and reserves stay the same. This type of scenario
allows Poland to cover its budget deficit cheaply if needed.

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12. (U) Comment: Central and Eastern Europe,s banking
sectors generally appear more resilient than several month
ago and market confidence has held -- so far -- even under
pressure of Latvian devaluation. It remains to be seen
whether the Latvian problem can be contained, with IMF
officials and European Commission representatives demanding
meaningful fiscal reform prior to handing out more
assistance. While London analysts generally do not see
spill-over effects, uncertainty remains as demonstrated by
the cost of insuring sovereign debt in Eastern Europe.
Moreover, with no clear and transparent Europe-wide bank
stress tests, it is uncertain which individual foreign parent
banks are poised to withstand further market strain.


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