We all know about the mess the United States, Britain, Spain and some other countries have gotten themselves into thanks to overenthusiastic housing bubbles.

Investors who have studied the global trade figures lately are no doubt also aware that East Asian countries are in an entirely separate mess since their exports have dropped 30%-40% – or even more – in the past few months, because U.S. and European consumers have stopped buying their manufactured goods.

However, there is a third global disaster, equally intractable, in Eastern Europe – and it has nothing to do with the housing bubbles, falling exports, or the massive layoffs that are becoming problems everywhere. This third global disaster is being caused by a regional balance of payments problem and a localized currency crisis.

Internationally, that disaster is this week’s worry.

As the Eastern European countries closed in on membership in the European Union (EU) after 2001, preparatory to entering it in 2004 or 2007, they kept their currencies as stable as possible against the euro. At the same time, the economies of these countries were growing rapidly, so Western banks bought local operations and expanded their lending.

Local consumers heard from their governments that their currencies were now stable against the euro and noticed that local currency interest rates were much higher than euro, dollar or Swiss francs. Naturally, they borrowed from local banks in euro, dollars or Swiss francs.

This would all have turned out fine if the local currencies had indeed been stable against the euro (borrowers in dollars would have made out like bandits until last summer, and lost since, as the dollar reversed course and strengthened). However, in addition to foreign currency consumer loans, foreign investment of all kinds flooded into these countries; after all, they were EU members – or would soon become so – and yet they were growing much faster than Western Europe.

With all this money coming in, local wage rates and other costs rose. As a result, many Eastern European countries ran huge balance-of-payments deficits: For Latvia and Bulgaria, for example, the deficits were more than 20% of each country’s gross domestic product (GDP).

This all didn’t seem to matter too much at a time when world trade was robust and lending flowed freely (although those of us familiar with periodic Latin American catastrophes sucked through our teeth in a suitably concerned manner – we had seen it all before).

Since last September, however, world lending has stopped flowing freely – as has world trade. European, U.S. and Asian companies that had been madly keen to invest in Eastern Europe put their expansion plans on hold, as they discovered they had big problems of their own at home. Naturally, the Eastern European currencies started to decline.

This brought a horrible problem for the local banks, most of them owned by Western European banks. If they lent to local borrowers in euro, Swiss francs or dollars, their borrowers are suddenly in trouble.

For example, the Polish zloty has dropped by about a third against the euro in the last six months. Even without any decline in local real estate prices, an apartment in Warsaw is thus worth 33% less in euros, so the euro loan against it has suddenly become subprime. What’s more, the salary of the borrower has also dropped 33% in euro terms, so his ability to service the loan has declined correspondingly.

Conversely, if the foreign-owned banks lent primarily in local currencies, they internalized the problem if they borrowed in euros from their parent to do so; in that case, the bank is directly insolvent or close to it, rather than merely having a bunch of defaulting borrowers on its books.

The solution everybody is looking at is a bailout, and it will again have to be a big one. World Bank President Robert B. Zoellick is putting together a $25 billion trade facility, but he wants the EU to help with more money. Austria has tried to put together a $200 billion loan for Eastern Europe – not unreasonably, as Austrian banks have about $300 billion in loans outstanding to that area – equal to about 70% of Austria’s GDP.

Total Eastern European debt is reckoned to be around $1.7 trillion, with about $400 billion of it maturing this year.

With the EU, Austria and Eastern Europe all looking for money, the eyes of the region automatically turn to Germany. Germany has an almost balanced budget, and the German finance minister called British stimulation policies “crass Keynesianism” as recently as December. If it weren’t for Eastern Europe, Germany would be in pretty good shape. However, with 10 Eastern European countries among the 27 EU members, Germany’s finance minister better be concerned about getting his pocket picked.

My own guess is, the less the EU and the unfortunate Germans are forced to subsidize their neighbors, the quicker the problem will sort itself out, albeit at the cost of a lot of defaults on Polish home mortgages. In a world where all major countries are providing “stimulus” and bailouts for everything, the ultimate winner will be the country that bails out the least.

Bottom line? You might look at Brazil …

Source: Eastern Europe’s Banks are Next in Line for a Bailout