While the American economy continues to suffer the fallout of the busted bubbles in housing, investment, and consumer debt, the European economies are going through their own post-bubble recession. But their economic downturns may soon worsen because of a major debt crisis in Eastern Europe.

Since the collapse of communism in Eastern Europe in the early 1990s, each of the former “captive nations” that had been locked behind the Iron Curtain have moved in the direction of market-based reforms of their economies.

Some of them, most noticeably Poland, the Czech Republic, Hungary, and the Baltic Republics of Estonia, Latvia, and Lithuania, made significant strides in overcoming decades of failed socialist central planning.

Direct foreign investment and domestic capital formation breathed new life into these long-stagnant economies. Industry and agriculture flourished following the restoration of private property rights and relatively wide degrees of market competition. They also experienced dramatic increases in tourism, as the old-world charm of cities such as Prague and Budapest annually attracted tens of thousands of visitors from around the world.

But a good portion of this economic vibrancy was financed by borrowed capital, much of it from banks and other financial institutions in Western Europe. These former Soviet-bloc countries have a total debt of between $1.5 trillion and $2 trillion to their Western creditors. Of this total, around $400 billion needs to be repaid or rolled over in 2009.

The table below shows that many of these countries face a significant debt financing burden as a percentage of their Gross Domestic Product (GDP), and are heavily dependent on export sales to pay what they owe.

Source: Economist.com

Latvia and Hungary are facing some of the worst of the domestic crises because of their debt burdens. Latvian and Hungarian investors and consumers found it more attractive to borrow money from Western European banks and other lending sources that were offering lower interest rates than their own domestic financial markets.

The problem is that these loans were denominated and a payable in Euros, not the local currencies. If export sales were to decline or the value of  local currencies were to fall relative to the Euro, the costs of financing these debts would become more difficult. That is exactly what has been happening.

Over the last half year, the Latvian economy went into a tail spin. The economy is likely to contract by 12 percent in 2009, according to the International Monetary Fund (IMF). The Hungarian economy is projected to contract by 6 percent this year. Most of this is being caused by declines in export sales.

In Latvia, violent demonstrations broke out last month when the government proposed to implement IMF demands for fiscal austerity to receive financial assistance. It led to the toppling of the government in Riga. The IMF had already lent around $4 billion to Latvia, but has delayed any further assistance until cuts are made in the county’s welfare and other government programs.

At the same time, many of the Eastern European currencies that have not yet joined the Euro zone have been experiencing significant falls on the foreign exchange markets. In the last six months, for example, the Polish Zloty has fallen nearly 30 percent against the Euro. The Hungarian Forint has decreased by 22 percent, and the Czech Koruna by more than 12 percent. The Ukrainian Hryvnia has lost about 40 percent of its value in exchange for the Euro.

This has impacted governments, private investors, and consumers. In Hungary, many home owners borrowed foreign money and have their mortgage payments denominated in Euros. As the Forint has fallen in value, it has dramatically raised the cost of meeting monthly house payments, with defaults and forfeitures growing. The IMF has lent the Hungarian government, so far, over $8 billion to help cover government debt costs.

The degree to which this debt crisis is sweeping Eastern Europe is not uniform. The Polish and Czech economies remain relatively strong compared to some of their faltering neighbors. Both nations may even end 2009 with modest economic growth if the global recession does not dramatically worsen.

The impact on banks in Western Europe is not uniform either. The financial institutions that may be hardest hit are in Italy and Austria, which have the largest exposure. Austrian banks, for example, have lent sums in Eastern Europe equal to almost 70 percent of that nation’s GDP, and the Italian banks are not too far behind.

In early March, J.P. Morgan’s analysts projected that European banks would need as least $50 billion in new capital by 2010 to compensate for the worst of emerging Eastern European “toxic loans” that are on their books. Many of these banks have criticized Morgan’s estimates as exaggerated. But whatever the final numbers may turn out to be this year and next, Eastern European borrowers and their Western European financiers are in for a rough ride.

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