Foreign Currency-Denominated Loans Strike Again

You can't teach an old dog new tricks. At least that is the impression one gets when considering the credit exposure of the two large Austrian Banks still active in the Ukraine (a third one, Erste Bank, wisely shut up shop in Kiev in late 2012).

The two banks concerned are Raiffeisen International (RBI) and Bank Austria (BA), which together have exposure of 8 billion euro (approx. $10.9 bn.)  in the Ukraine. This is only a small percentage of their total loan book, but still, it is quite a bit of money for banks based in Austria. Guess what: 70% of the credit extended to Ukrainian borrowers is denominated in foreign currencies. Right now there is no foreign currency against which the hryvnia is not crashing. Evidently, European banks have learned nothing from foreign currency lending debacles suffered elsewhere, from Hungary (where the government forcibly converted the loans into Forint and saddled the banks with huge losses), to the extremely popular Swiss franc loans they have extended just about everywhere they are doing business.

In the context of the once highly popular CHF loans, the customers the banks favored with these 'excellent opportunities to save money' were as a rule not sophisticated financial market wizards, and so were relying on the 'expert advice' dispensed along with the banks' sales pitch. They were told that the Swiss franc would always remain stable against the euro. Since Swiss interest rates were considerably lower than euro interest rates at the time most of these loans were peddled, there was 'free money' waiting to be picked up. And then the crisis hit, and suddenly the Swiss Franc became worth a lot more. Instead of saving money, borrowers suddenly found themselves in dire straits.

Guess what is going to happen with foreign exchange denominated loans in the Ukraine.

A daily chart of the hryvnia – its  crash continued with gusto on Thursday – click to enlarge.

As noted above, in terms of their total lending, the exposure of Austria's banks is not very large (in RBI's case an estimated 3.5% of its assets). Don't forget though that for fractionally reserved banks the loss of even a small portion of their total exposure is meaningful.

With only about $1 bn. in government debt owed to foreign creditors falling due this year, a Ukrainian government default can probably be avoided for a while yet. However, the Ukraine is bleeding foreign exchange reserves fast. That is eventually going to have an effect on the economy, as imports can obviously not be paid for in hryvnia and the Ukraine has a perennial current account deficit. Press reports meanwhile indicate that businesses in Kiev largely remain closed post revolution, boarded up and guarded by the apparently still ubiquitous street fighters of the revolution.

Shopfront in Kiev. Many shops have been barricaded since the riots began – now they are guarded by people employed by the new rulers.

(Photo via AP / Morenatti)

The Ukraine has a perennial current account deficit, recently amounting to about 6% of GDP – click to enlarge.

Is a Breakup Coming?

More signs of a possible breakup of the Ukraine are emerging as well. Note that the new government immediately declared that Russian will no longer be used as an official language. This order indicates that what has happened in the Ukraine is a struggle along ethnic lines (to be more precise, people's ethnically motivated animosities were used to achieve geopolitical aims).

If not for a split along ethnic lines, why would the newly installed government declare that a language that is predominantly spoken in more than 60% of the country's territory will no longer be recognized as official? This is a highly confrontational decision. Consider South Africa as a pertinent counter-example. There, 11 languages have become official languages after the country's political system was changed – a clear step toward reconciliation. Language is an important part of peoples' identity. Wherever there are conflicts between different ethnic groups within a country, language usually becomes a major bone of contention.

In Simferopol in the Crimea, gunmen said to be supporting Russia have captured the parliament building as well as a major airport, demanding a referendum on independence. In fact, the Crimean parliament has already announced that a referendum will be held. There are Crimean Tartars who are against this move, but in the Crimea, they are the minority. There can be little doubt as to the outcome of such a referendum and it seems possible that other regions with a large Russian majority will follow suit.

The new government in Kiev is repeating its Western supporters verbatim by insisting that the 'territorial integrity' of the Ukraine must be preserved. Somehow we don't think that this concern about the country's territorial integrity is shared by those who have just seen their language demoted. In the meantime it has turned out that ex-president Yanukovich is now holed up in Russia (he is planning to hold a press conference sometime on Friday). Regardless of what part of the Ukraine people are from, they have every reason to have misgivings about Yanukovich and all who were holding the reins of power before him (including Ms. Tymoschenko, who is aligned with the new rulers). The Ukraine is still poorer today than it was on the day it split from the Soviet Union:

The Ukraine's GDP per capita (at purchasing power parity) is still down almost 25% from the time when the country became independent right after the collapse of communism – click to enlarge.

It should be pointed out though that the first decade after the Soviet Union's dissolution was a time of contraction in nearly all the former Soviet Republics, as the malinvestments of the socialist era had to be liquidated. This is still an appalling economic performance even so, and it is undoubtedly a direct result of the ruling elite stealing the country blind from day one. We strongly suspect – given the experience with the 'Orange Revolution' – that the average Ukrainian citizen will soon witness a case of 'new boss, same as the old boss'.

Russian Banks Stop Lending Activities

The exposure of Russian banks in the Ukraine is fairly sizable as well, at about $28 bn. – however, it also represents a fairly small part of their total loan books. According to Reuters they are now belatedly stepping on the brakes:

“Russia's second-largest bank VTB has joined Sberbank in saying it would halt new lending in Ukraine, underlining concerns over financial risks due to political turmoil in Kiev.

Ukrainian President Viktor Yanukovich was driven from power over the weekend after months of upheaval sparked by his decision to spurn deals with the European Union and improve ties with Russia. While the country has an interim leader, a new government is yet to be formed.

"It is hard to evaluate the risk at the moment," VTB Chief Executive Andrei Kostin said at a press conference on Wednesday. While other foreign lenders have cut their Ukraine exposure in the five years since the 2008 collapse of Lehman Brothers – to 20 percent of Ukraine banking sector assets in 2012 from 40 percent in 2008, according to a Raiffeisen Research survey – Russian banks stayed. They now account for 12 percent of the sector.

Russia's President Vladimir Putin said that Russian banks have an estimated $28 billion of exposure to its neighbour, with Gazprombank, Vnesheconombank (VEB), Sberbank and VTB among the main creditors. Ratings agencies Moody's and Fitch this week cautioned of the risks these banks faced in their loans to Ukrainian businesses if the economy slides into recession and the currency continues to plummet.

Kostin said the bank had stopped issuing new loans. VTB later clarified that the bank was no longer issuing new loans to either companies or individuals. The move followed a similar statement from German Gref, head of Russia's largest bank Sberbank, who said on Friday that the bank had temporarily suspended lending, although the bank would continue to extend credit to large enterprises whose financial condition was sound.”

The Russian Ruble has recently weakened considerably as well, but it is debatable to what extent this owes to the troubles in the Ukraine – after all, a great many EM currencies have been falling sharply in recent months. As a monthly chart of the ruble shows, its decline definitely isn't any worse than the falls seen in many other EM currencies since 2011:

The Russian ruble monthly from 2009 to today – click to enlarge.

Conclusion

The foreign banks with large exposure to the Ukraine can probably handle the fallout, as the size of their commitment isn't overly big on a relative basis. Keep however in mind that according to statistical studies, currency crises in emerging markets have invariably been followed by a very large percentage of foreign loans become non-performing (40% on average). In a case like Ukraine's where such a large percentage of foreign loans is denominated in foreign currencies, the portion of outstanding loans likely to become NPLs is probably even higher.