Since January the economies of East and Central Europe, including the Baltic Republics and the Balkans, have started to rapidly deflate as banks crash, stock markets collapse and local currencies plunge. In many ways, what’s happening now across Eastern Europe, including Russia, is reminiscent of the Asian economic depression that began in Thailand in July 1997.

Punch-drunk amid easy credit in the 2002-2007 period, regional economies aggressively borrowed from abroad, mainly from Austria and other EU members that included leveraged mortgage loans tied to low interest rate currencies like the Swiss franc. That strategy has violently backfired since last summer as investors fled risky assets en masse.

In some East European countries, Swiss franc-denominated mortgages comprised more than 50% of all outstanding mortgage loans; combined with plunging local currencies this year the cost to service those loans has surged as foreclosures and defaults skyrocket.

Auf Wiedersehen Bull Market

After a multi-year bull market against most major currencies since 2002, the euro is now hemorrhaging since last July as Europe’s economic miracle comes undone with lightening speed. The euro’s decline pales compared to the outright plunge of numerous currencies in emerging Europe, especially since mid-January.

Eastern Europe’s largest economies – core manufacturing hubs for many Western European companies – have seen their currencies crash almost 20% versus the euro already this year as funding concerns grow louder amid a rapid acceleration of deflation across local economies. In December, Hungary received assistance from the International Monetary Fund (IMF). Now governments in the region, including the Austrians, are pressuring the European Union (EU) and specifically, Germany, to open its vast purse strings to save Eastern Europe from collapse and preserve the euro.

Against the sagging euro, many of the regions’ once fast-growing economies in East and Central Europe are now in the midst of significant economic contraction and sharply declining currencies. Credit spreads have surged, credit default swaps are widening and rapidly dwindling foreign-exchange reserves in the region threaten market capitalism, which, until recently, served as a model for emerging economies in the post-1991 Communist era.

Austrians Plea for Euro Zone Bailout

A fresh full-scale banking crisis affecting Western European institutions is now accelerating this month with Austrian banks on the hook for €278 billion ($354 billion) to Eastern Europe – the largest exposure among euro-zone members. Western banks are saddled with $1.6 trillion dollars’ worth of Eastern European loans, mostly tied to banks in Austria, Germany, Italy, France, Belgium and Sweden, according to the Bank of International Settlements.

Austrian bank losses are enormous and the cry for help couldn’t be louder. Austria has been the most aggressive investor in Eastern Europe over the last decade. Local banks rank as the largest investors in the Czech Republic, Hungary and Romania ($142 billion dollars) with several Austrian banks now attempting to secure government guarantees – including Raiffeisen Zentralbank, one of the largest lenders in the region along with Erste Bank.

Emerging European Collapse

Whereas the Austrians -- harboring strong historical trading ties to the region -- were heavily exposed to Eastern European banks, Swedish banks lent heavily to the Baltic Republics.

Lithuania, Latvia and Estonia are also fiercely contracting since October with banks struggling to maintain solvency. Other countries in the region, including Ukraine, are barely solvent and require additional IMF funding while Kazakhstan’s largest bank saw on run on its deposits earlier this week. The list goes on and on with several other markets in trouble as funding gaps widen in an environment of tight credit and shrinking bank capital.

Teutonic Shift as Euro Must Survive

Germany, the euro zone’s largest economy measured by output, is now at the forefront of the crisis since earlier this month. Over 25% of Germany’s exports head to Eastern Europe – a vital market for her multinationals. As the region heads quickly into a full-blown fiscal and currency crisis, Germany, and, possibly, even France might have to bailout the former Soviet satellite states that are part of the wider European Economic Area (EEA).

German finance minister, Peer Steinbrueck, breached the subject on February 18, stating “some of the 16 euro nations are getting into difficulties and may need help.” He went further, adding “Germany would act if fellow euro members got into financial trouble.”

The markets are screaming for an Eastern European rescue and fast. Thus far, European deficits have ballooned with more than $1.5 trillion dollars committed to fiscal spending packages, including bank rescues and partial or full government bank nationalization.

Credit spreads for the most troubled economies in the region continue to rise vis-à-vis German bunds, the euro zone’s largest and most liquid government bond market. And it’s not just Eastern Europe that’s feeling the pain; several high deficit countries in the euro zone, including Greece, Ireland, Italy, Portugal and Spain have seen their financing costs rise on the heels of credit downgrades or failed bond auctions.

Inevitably, the Germans will finance most of a pan-European rescue for the weakest economies, especially those already part of the single currency euro zone. That’s because the euro’s viability is at stake; the Germans would rather keep the most vulnerable euro zone members a part of the single currency. The consequences of losing one or more euro zone members would imply higher funding costs for healthier members while probably devastating the economies of those members that abort the euro as financing costs skyrocket.

The endgame for the Europeans is inevitably higher long-term interest rates for all government bond markets. Like the United States, the Europeans will spend a record sum of capital in 2009 and 2010 to fund unprecedented fiscal spending plans and bank bailouts. This includes the Germans, who have now abandoned their mantra of fiscal responsibility to save the euro zone from near financial ruin.

Germany might have been reluctant at first to participate in a broad based European rescue effort. That tone has decidedly changed since January as the Merckel government unloads a tirade of spending ultimately leading to the first German budget deficit in decades.

Now Europe watches and waits for the Germans to come to the rescue. The future of the euro depends on Berlin’s quick response.