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

The financials got whacked again yesterday — taking the market down along with it — on news of further debt downgrades from Standard & Poor’s.

On the i-bank side, Lehman, Merrill and Morgan all saw their credit ratings take a hit. On the commercial bank side, Wachovia and Washington Mutual said sayonara to their current leaders. This implies more bad news in the pipeline.

About a month ago, your humble editor compared Western banks to an old radio filled with cockroaches. (See Banks a Lot archived on the TPG Web site.) Four weeks later, the roaches are still pouring out.

At various times in the past few months, Taipan Daily has pounded the table for shorts on the broader financials. Those shorts are working well now, with XLF (the financial SPDR) trending lower in stair-step fashion and the Philly Bank Index ($BKX) testing its lows.

But in terms of keeping a finger on the pulse, the new bellwether for financial stocks just might be Lehman Brothers (LEH:NYSE).

Lehman is the smallest bulge-bracket investment house on the Street now that Bear Stearns is no more. Many thought it would follow in Bear’s footsteps during the heat of the crisis. (That’s where that big downward spike came from in early Feb.)

So far, Lehman has defied its critics — thanks in part to the smart moves of CFO Erin Callan and CEO Dick Fuld. But the sharks are still circling, and some very smart people think Lehman is still teetering on the brink.

The sharks smelled blood in the water this morning, as news arose that Lehman may be forced to raise billions in fresh capital to shore up its balance sheet.

The big question is how much exposure the investment bank still has to toxic mortgage trades and so-called “level 3 assets” — opaque stuff holdings that are extremely hard to value.

Watch LEH and the $BKX. If one or the other cracks, there could be another big downward whoosh for the financials. (“Whoosh,” of course, being a highly technical trading term.)

Buy One, Get One Free

Meanwhile, the housing bust is still in full swing. The above chart was featured in a recent Chart of the Day, but is worth reposting for those of you who didn’t catch it.

The bank said its annual subprime-related losses were more than 120 billion yen ($1.15 billion) and that it could lose another $480 million this year because of subprime exposure.

According to a report by Thomson Reuters, the bank’s president, Nobuo Kuroyanagi, said: “Subprime had a very broad effect on us. When you start talking about the related impact, the Japanese stock market has fallen a lot and that sparked losses on our stock portfolio.”

This from Thomson Reuters:

[Mitsubishi UFJ] has not been hurt as badly as Mizuho Financial on bets on risky U.S. subprime mortgages. Mizuho, Japan’s No.2 bank, lost 645 billion yen on subprime investments in the year to March, becoming one of Asia’s biggest subprime casualties.

But Mitsubishi UFJ has been dragged down by its consumer finance business after tighter government regulation squeezed profits, and is faced with sluggish lending growth and higher provisions against bad loans as Japan’s economy slows.

Future growth depends on MUFG’s ability to take advantage of opportunities overseas as Western banks, which have been hit much harder than Japanese banks by the credit crisis, become more cautious in extending loans, one investor said.

The loose bilateral trade association between China and Japan could be a major boost to the Japanese economy, which could become part of the world’s next superpower, says Martin Hutchinson in Money Morning.

“Free trade and free movement of labor between the two countries would enable them to deepen their economic relationship still further, making the Japan-China trade axis the most important in the world.

“Longer-term, an EU-style economic union could become the world’s leading economic power, surpassing even the United States and the EU itself. As a U.S. geo-strategist, one worries somewhat about this … As an investor, one rejoices in it and seeks to find sources of future profit from the two countries’ deepening relationship.

Read on here to find out how to profit from this geopolitical development.