Thursday, February 25, 2010

Weekly Forbes column: How far will Greek contagion spread?

Below is the unedited version of my column for this week. You can read the final version at the Forbes website. As usual, the unedited and final versions are a lot different. The editors always do a very tedious job over there, so I'd always recommend you to read the final version; the drafts are for my archiving purposes only. Feel free to comment or rate the article over there; remember that bad ratings are even more appreciated than good ones, provided they come with an explanation on why you don't like the article.

As loyal readers will notice, the topic is the same as the Forbes column, but the angle is a but different. At Hurriyet, I spent a lot of time discussing lack of trade and FDI contagion as well as Bulgaria's soundness, whereas the Forbes article was mainly on finance linkages.

When the Greek crisis hit, contagion to the Balkans seemed like a clear and present danger. That has not materialized yet, as markets in the region are taking their cues from global sentiment rather than regional concerns for now. But Balkan countries are facing significant risks through their financial sector linkages with Greece.

Greek banks had been aggressively expanding into the Balkans in the last few years, buying local banks and expanding their balance sheets, particularly in high-growth areas like consumer and mortgage lending. As a result, they now have significant market share in the region: Around 30% in Bulgaria and in the FYRM, 23% in Albania and then 11% in Romania, all in terms of assets.

The main concern is that widening spreads on Greek sovereign debt could lead to increased funding costs for Greek banks. Faced with such a liquidity squeeze, Greek banks could drain liquidity from their operations in the Balkans. As these banks have managed their expansion mainly through external funding, as evidenced by very high loan-to-deposit ratios, the pullback could be rather rapid.

Such a liquidity pullout would disrupt not only the financial sectors in the region, but also have a large impact on the economies, given that all of these countries have bank-based financial systems, where much of the borrowing activity is made through banks rather than equities or corporate bonds.

Such destabilizing capital outflows would obviously affect overnight interbank rates first, as banks in the region scramble for cash. But the spillover to interest rates that matter more for the real economy, such as lending rates, would be rather quick. In addition, firms could find themselves increasingly credit-constrained in such a scenario.

Pressures would ultimately appear on exchange rates. The region’s currencies have proved to be stable so far with the exception of the Serbian dinar, down 15% in the last three months. But even there, it is not certain whether the dinar is depreciating because of domestic factors or contagion from Greece. But I definitely would not want to be long in any of the region’s currencies in the short-term.

To their credit, Greek parent banks remain well-capitalized and liquid for now, but this could change rather quickly, as the Lehman collapse has shown. Moreover, developments in the local markets are making their job rather difficult.

During the 2008-2009 credit crunch, the main worry about the region was that foreign banks would be adversely affected by the deterioration in their loan books. While those fears have subsided in the face of other risks, loan deterioration is very much alive for Greek banks in the Balkans, which had aggressively expanded their loan portfolios, and are now facing sharply-rising non-performing loans in Bulgaria, Romania and Serbia.

In short, as Mary Stokes, senior analyst for Roubini Global Economics recently noted, Greek banks in the Balkans are facing a double whammy: “Adding to their woes of future asset quality deterioration is the fact that they are heavily reliant on external funding, meaning these banks could see funding issues in the short-run.”

Then, the billion-dollar question becomes which country would be the first to fall, if dominoes start falling. Bulgaria seems to be the country most exposed to Greek banks, but it has an enviably sound fiscal position, meaning that it has the resources to prop up the banking system or the economy if needed. While the other Balkan countries are in better shape fiscally than the ill-famed (and arguably also ill-named) PIGS, none is as strong as Bulgaria and would be able to significantly jumpstart their economies if push comes to shove.

An interesting case is Turkey, the only country where Greek banks do not have significant market share. It is often ignored that gross issuance and redemptions as a share of GDP are higher than PIGS this year, under the assumption that local banks will be able to gobble up whatever the Treasury has to offer- a rosy assumption, as I detailed in my last Forbes column.

To sum up, another bout of risk aversion could expose the Achilles’ heel in each Balkan country. While most countries in the region would suffer from funding problems of Greek banks, Turkey’s fiscal vulnerabilities could suddenly come to investors’ attention despite the country’s sound banks. Even Bulgaria might not be fail-proof: Its external accounts are weak, and the currency board is depriving the country from exchange rate flexibility.

It is comforting to see that the Balkans have not been hard-hit by Greece’s woes for now. But that is no reason to ignore the Damocles’ sword hanging over each country.

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