Not long ago everyone was talking about "decoupling", the supposed ability of emerging market economies to keep growing even if other economies fell into recession.

That was then. Now the "hard landing" in emerging markets may become the second epicentre of the global crisis and Central and Eastern Europe looks like it may take centre stage. After years of credit excesses, few places look more vulnerable than the countries from the Baltics to the Black Sea.

CEE's Achilles heel(s)
Precise predictions are tenuous at the moment since the crisis is far from over. Yet most conference participants in the Euromoney Central & Eastern European Forum, held on January 21 in Vienna, cited the most obvious risks for the region. First, there is the risk of a rapid slowdown in credit expansion. The huge credit expansion of the past few years is turning into a problem for foreign banks as the quality of outstanding loans is deteriorating rapidly. Many of those banks are going through a process of rapid deleveraging in their home countries. The scarcity of global liquidity and global capital affects many parent banks, prohibiting them from transferring liquidity to CEE, especially to the countries with loans that exceed deposits. Thus, credit expansion in CEE is expected to be based on domestic means, i.e. domestic deposit expansion.

UniCredit board member Erich Hampel said that the bank was committed to fund its subsidiaries in those countries and would continue to lend to consumers and companies. "Co-ordination is essential and a `Plan for CEE' should be designed," said Hampel. He called on other international banks active in the region, as well as the European Union, the International Monetary Fund and other institutions, to launch a joint plan to stem the threat that funds could stop flowing and choke economic growth.

FX mismatches
A a second risk, and a main reason for the growing number of defaults, is the large FX (foreign exchange) exposure of firms and households in CEE. The rapid depreciation in some CEE currencies is creating problems in firm and household debt servicing. This is particularily true for the Baltics, Hungary, Romania and Ukraine.

According to an analysis from Deutsche Bank, foreign currency loans amount to more than 50 per cent of total loans in these countries. In Latvia and Estonia this ratio is 80 per cent.

The Czech Republic is an exception in that regard, according to Zdenek Tuma, governor of Czech National Bank: "Czech banks are not reliant on international funding.

The main source of credit is customer deposits, the ratio of loans to deposits in the Czech banking system is still well below 100 per cent. Bank loans are predominantly denominated in Czech koruna and so are the customers' deposits held with domestic banks. We do not face the usual problem of emerging economies with households and firms getting credit that is sourced in foreign currencies. This is simply an outcome of the credibility that our monetary policy and relatively long period of low inflation, as well as of nominal interest rates, has gained."

Disappearing investor base
A third risk is that of a sudden stop in capital inflows. The astonishing supply of developed government debt that is poised to flood the market over the next couple of years will surely crowd out money that could be put to work in markets such as CEE. Real estate FDI is declining fast, as is bank capital infusion, whereas new green field investments are very questionable. The countries of CEE run high current account deficits and have a large exposure to foreign debts. If capital from abroad dries up, it may generate a large domestic recession. Markets are already aware of this risk, driving the interest rates of credit default swaps a lot higher for those countries that have higher exposure.

Austria and CEE
One country's banking system looks particularly vulnerable. Austrian banks have dominated the surge of foreign currency loans to former regions of the Habsburg Empire. The failure of Credit Anstalt in May 1931 brought the Great Depression's financial crisis to Central Europe. Viennese banks may find themselves playing a similar role as the current disaster unfolds.

According to the Austrian Financial Market Authority, the total amount of outstanding loans of Austrian banks to the CEE region (including Russia and Ukraine) is US$300 billion. This amount equals 68 per cent of Austrian GDP. It also makes Austria the leader in terms of total exposure of EU banks to CEE (20 per cent), followed by Germany (15.8 per cent) and Italy (15.6 per cent).

Conclusion
What will happen next? In light of all the calls for state intervention and the multi-billion infrastructure programmes that are proposed to boost the economy in the region, we are reminded of Frenchman Frederick Bastiat, who grimly joked 200 years ago that breaking windows might also be a good way to stimulate the economy, as glaziers will have more money to spend. The fallacy Bastiat wanted to highlight was, of course, that such policies ignored the loss for the homeowner who had to pay the glazier.

As Europeans consider the way forward, it's not too late for them to also consider Bastiat's famous description of the state as "the great fictitious entity by which everyone seeks to live at the expense of everyone else". Indeed, current economic policy is full of schemes for getting something for nothing, with government bonds clearly looking like the next bubble in the making. Banks and bond markets are being reduced to mere channels for the financing of huge public sector deficits. Some argue that the government can spend without taxing at all; that it can continue to pile up debt without ever paying it off because "we owe it to ourselves". However, such pleasant dreams in the past have always been shattered by national insolvency or runaway inflation - all government expenditures must eventually be paid out of the proceeds of taxation; with inflation itself being merely a form, and a particularly vicious form, of taxation.

Martin Kolmhofer is director of CEE PORTAL (cee-portal.at), an Austria-based business platform for Central and Eastern Europe.