Chapter 9: Europe’s Forgotten Crisis: Eastern Europe, Crashed

Chapter 9 EUROPE’S FORGOTTEN CRISIS: EASTERN EUROPE

By October 2008 the Fed’s swap line facilities defined a relationship of dependence and interdependence between the US central bank and an exclusive club of privileged central bank counterparties. But that posed a question. Who was in and who was out? What were the criteria of membership in the swap line club?^{¹ On October 28, 2008, Nathan Sheets, the director of the Division of International Finance at the Fed, set out a short list of three criteria.² The recipients of swap lines must be:}

Of significant economic and financial mass so that there can be spillover to the US.
Well-managed with ‘prudent’ policies so that the problems they have encountered are clearly the result of contagion from US and ‘other advanced economies’ and therefore warrant US assistance.
The problem faced by local banks should be one of dollar funding stress so that swap lines would actually make a difference.”

Ultimately, the Fed had to justify its measures in terms of benefits to the US economy. There were economies that were too small to warrant action. There were countries that were experiencing stress as a result of a collapse of trade or commodity prices that could not be helped by swap lines. But it was point 2, with its stress on “prudent policy,” that offered the scope for political discrimination. What was a prudent policy was very much in the eye of the beholder. As two US analysts attached to the National Intelligence Council remarked at the end of 2009: “Artificial divisions between ‘economic’ and ‘foreign’ policy present a false dichotomy. To whom one extends swap lines” is as much a “foreign policy as economic decisions.”³ The Fed was well aware that with the swap lines it was treading onto the terrain of geopolitics. Each of the fourteen European, Latin American and Asian central banks included in the swap network was approved by the Treasury and the State Department. They were clearly safe bets. The Fed did everything it could to dissuade further applications. Nevertheless, two further countries did apply and were denied. Their identities are shrouded in secrecy. But there were clearly some countries that were never going to make it onto the Fed’s list, no matter how large or hard hit by the crisis they were.

I

On November 14, 2008, Sarkozy hosted President Medvedev of Russia, who was en route to the first leader-level G20 summit in Washington. Sarkozy and Medvedev exchanged congratulations over the peace settlement that Sarkozy had brokered in Georgia in August. But this was not the only topic of Franco-Russian backslapping. Sarkozy also expressed his agreement with recent initiatives from Moscow on the currency question.⁴ Over the summer, with the price of oil at all-time highs, Medvedev had been pushing for a diversification of reserve currencies and a greater use of the ruble. Days before arriving in France, Medvedev had given a speech to the Russian parliament in which he drew parallels between the crisis in Georgia and the global financial debacle. They were “two very different problems,” as Medvedev told the Federal Assembly in November 2008, but they had “common features” and a “common origin”: the presumption of an American government that “refuse[d] to accept criticism and prefer[red] unilateral decisions.”⁵ This played well with the nationalist gallery in Russia, but there was not much dissent from the European side either. At their summit in Nice, Medvedev noted that on currency issues “the Russian and European positions were practically the same.” What he did not mention was that whereas France’s banks could count on limitless dollar liquidity from the Fed, the Russians were on their own.

If Moscow’s increasing assertiveness had been buoyed by oil prices surging to $145 per barrel, the crisis was a severe setback. By the end of 2008 oil prices had plunged, reaching their nadir at $34 on December 21. With natural resource rents accounting for 20 percent of Russian GDP, the impact of the commodity price crash was devastating. Tax revenue per metric ton of oil fell by 80 percent.⁶ But the Russian state had the resources to cope. Unlike in 1998, by 2008 Moscow had accumulated enough financial reserves to withstand the pressure of the global crisis. At their peak, Russia’s foreign currency holdings were estimated at $600 billion. It was not the state but Russia’s globalized business sector that was in trouble.

Source: World Bank in Russia, *Russian Economic Report* 17 (November 2008), figure 2.1. Data: RTS, Thomson Datastream.

As oil prices plunged, so did the Russian stock market. By September 15 the Russian market was already 54 percent off its peak in May 2008. In the days after Lehman, trading was so jumpy that Moscow regulators took the decision to suspend trading. When the markets reopened on September 19, jitters continued, with October 6 seeing a single-day fall of 18 percent.⁷ According to one widely quoted estimate, Russia’s oligarchs saw their combined wealth slashed from $520 billion at the beginning of 2008 to a mere $148 billion by early 2009.⁸ What was spooking investors, apart from oil, was the likely impact of a sharp ruble devaluation on Russian balance sheets. It was the private, not the public, sector that was in danger.

By the third quarter of 2008, Russia’s banks, raw material producers and industrial conglomerates had run up external debts of $540 billion, half owed by Russian industrial corporations and the rest by banks. This debt mountain matched Russia’s official reserves and was roughly equivalent to Lehman’s balance sheet. A substantial fraction was short-term debt. Having adopted the market-based banking model, Russia’s banks were particularly at risk, needing to refinance as much as $72 billion due by the end of 2008.⁹ Apart from the banks, the list of stressed dollar borrowers included all the major Russian oligopolies: Gazprom ($55 billion), Rosneft ($23 billion), Rusal ($11.2 billion), TNK-BP ($7.5 billion), Evraz ($6.4 billion), Norilsk ($6.3 billion) and Lukoil ($6 billion). Collapsing commodity prices slashed their revenues and a slide in the ruble would put even heavier pressure on those that billed in local currency rather than dollars—a major issue for Gazprom, Russia’s largest gas supplier.

As in the West, the crisis and the terms of the bailout opened the question of the balance of power. To some it seemed that the Kremlin was bent only on saving the skins of its cronies at the expense of the Russian taxpayer.¹⁰ On this reading, the Russian story was an even more corrupt and brutal version of the drama played out in America.¹¹ Like the barons of Wall Street, Russia’s oligarchs needed state aid and the regime came to their rescue. It is certainly true that Russia avoided dramatic bankruptcies, and considerable state resources were deployed to make sure of that. But putting events in Russia side by side with those in the United States or Europe, one is struck less by the self-dealing of Russian crisis management than by the frankness with which the question of power was ventilated in Russia and the obvious willingness of President Medvedev and Prime Minister Putin to use the occasion to shift the balance in their favor. Since the breakup of oil conglomerate Yukos in 2003, none of the oligarchs had dared to challenge the Kremlin. Now Medvedev and Putin were turning the screw. They offered financial protection, but they exacted a price.

The cornerstone of the Kremlin’s crisis-fighting strategy was to prevent a death spiral of devaluation and bankruptcy. In the first phase of the crisis, the central bank deployed its ample foreign currency reserves to stem the fall in the ruble. As a result, as oil prices plunged by 64 percent between October and December 2008, the ruble lost only 6 percent against the dollar.¹² Only in January did Moscow let the ruble go, allowing it to devalue by 34 percent before stabilizing in February. Like any successful rearguard action, it came at a price. The central bank burned $212 billion of its reserves, 35 percent of the total, to slow the slide. But by so doing it bought time, allowing dollar-exposed borrowers to pull in their horns and giving the state some time to launch its own response.¹³

A key element of this program was a demand from the Kremlin that the oligarchs sink a large part of their fortunes into stabilizing the stock market. There were rumors of an “all-night mandatory meeting held in the Kremlin” on September 16, the day of the AIG rescue, at which “oligarchs were ordered to plunge cash into their own faltering stocks, buy collapsing financial institutions directly, or simply fork over the cash and/or shares.”¹⁴ Following this “bail-in” of the oligarchs, the government targeted takeovers and bailouts at the smallest and weakest Russian banks. Coordination was provided by state-owned Vneshekonombank (VEB), where Putin, as Russian prime minister, served as chairman of the board. Five billion dollars was used to take over Sviaz Bank, Globex bank and Sobinbank. Then the deposit insurance fund was recapitalized and the insurance limit raised to $28,000. A $50 billion central bank facility put VEB bank in a position to act as the backstop, with a further $35.4 billion in subordinated debt available at tough rates for troubled oligarch enterprises. The loans would be repayable within a year and otherwise convertible into controlling shares.¹⁵ It was not a government takeover, but a conditional threat and a stark demonstration of where power lay.

VEB pumped $4.5 billion into Rusal, the aluminum company majority owned by Oleg Deripaska, to allow it to unwind foreign financing, which it had used to buy a 25 percent stake in mining giant Norilsk Nickel. VEB also put $2 billion into Mikhail Fridman’s Alfa Group to help it to pay off Deutsche Bank and rescue Alfa’s large stake in Russia’s number two mobile phone firm, VimpelCom, which might otherwise have been forfeited as collateral. As investment plunged and domestic economic activity began to spiral downward, unemployment rates doubled. This was particularly worrying in the so-called monotowns—the urban legacy of Stalinist industrialization.¹⁶ On October 16, 2008, Igor Sechin, Putin’s right hand, convened an industrywide brainstorming session on the car industry at Togliatti, the company town of AvtoVAZ, the bankrupt inheritor of the Soviet car industry. He announced an immediate $1 billion loan for AvtoVAZ from VEB that would keep the factory and its staff of 100,000 working.¹⁷ By the end of the crisis, $1.7 billion would be pumped into the Russian auto bailout.

In the wake of the oil price shock, the Russian federal budget was reset on the assumption of an average oil price of $41 per barrel by contrast with the June 2008 budget, which had assumed $95 per barrel. With tax revenues plunging, Putin, as prime minister, took credit for a large fiscal stimulus. A quarter of the government’s 9.7 trillion ruble budget was dedicated to crisis spending on work creation, industrial subsidies and tax cuts. Relative to the size of its economy, commonly compared with that of Spain and roughly comparable to that of Texas, the Russian crisis response was one of the largest in the world, dwarfing those undertaken by West European governments.¹⁸ It was heavily skewed toward the largest, best-connected corporations that were included in a list of 295 nationally important corporations and 1,148 regionally important firms. It was a top-down, corporatist stimulus, and Moscow made clear that it expected the oligarchs to reciprocate. Indeed, it was unafraid to call them out by name. On one notable occasion, Putin singled out four of them as follows: “Vladimir Potanin (Interros Holding), Leonid Lebedev (Sintez Group), Mikhail Prokhorov (Onexim Group), and Viktor Vekselberg (Renova Group) . . . I have known all of you for many years; in essence, we have been working jointly. Let me repeat that during the difficult conditions of the crisis we have made every effort to support you in the various directions of your business. The crisis is waning. It’s not yet over, but it’s on its way.” Now Putin expected them to make good on their commitments. “We agreed to meet you half-way in this area as well. We postponed the deadlines for investments. There will be no more such adjustments of schedules. Please focus your utmost attention on meeting your commitments.”¹⁹ What would happen if an oligarch failed in his responsibilities was demonstrated in June 2009 when Putin descended on Pikalevo, a small town south of St. Petersburg dominated by the metallurgical empire of Oleg Deripaska. Deripaska, who had once been listed as the richest man in Russia, with a fortune estimated at $28 billion, had seen it reduced to $3.5 billion. But that was no excuse for not paying wages.²⁰ Indignant workers were blockading the Moscow highway, causing a 250-mile traffic jam. In front of the TV cameras Putin upbraided Deripaska. Tossing him a pen, the premier demanded that the oligarch sign the paychecks there and then. It was economic management by personal intimidation of the telegenic tub-thumping variety.²¹ The message was clear. Ten years on from the humiliation of 1998, there were men in charge who would see to it that things “got done.”

In its way, it was effective. It demonstrated leadership. It humbled the oligarchs. It rallied Russian social interests around the state that provided for them. It kept Prime Minister Putin in the limelight. But was it a long-term strategy for growth? Liberal economists were skeptical. So too was Medvedev, who had succeeded Putin as president in 2008. Even before the crisis, the expert advisers that Medvedev cultivated in his personal entourage had been calling for a new course.²² In the wake of the crisis their message was even louder. What had made Russia so vulnerable in 2008 was its lopsided integration into the world economy: on the one hand, its excessive reliance on oil and gas; on the other hand, the corrupt culture of capital flight, in which Russian oligarchs sluiced money in and out of the country through the off-shore banking system. How else could one account for the bizarre anomaly that made tiny Cyprus into one of Russia’s main sources of foreign investment? What Russia needed was modernization. As Medvedev remarked on September 10, 2009: “Can a primitive economy based on raw materials and economic corruption lead us into the future?”²³ Two-fisted crisis fighting was not enough. A mere recovery from the shock of 2008 would lead “nowhere. We need to get out of the crisis by reforming our own economy.”²⁴ What Russia needed was economic transformation, and for that it needed not less but more interaction with the world economy, and above all with its technological leaders. And this had wider implications. After the shocking confrontation with the West in August 2008, Moscow needed to change course. With the crushing of Georgia, the Kremlin had made its point. In the future, Medvedev asserted, the success or failure of Russian foreign policy should be judged by a single criterion: “whether it contributes to improving living standards in our country.” Rather than “puffing out its cheeks” to threaten others, Russia should concentrate on attracting foreign technology and capital.²⁵ It was a message of modernization and partnership that was eagerly taken up both in European capitals and by the new administration in Washington.

II

It might be tempting to conclude that by taming Russia, the effect of the crisis was to calm international relations. And in the short run this was surely true. But in the international sphere, power is judged by relative standards. And if Russia was hard hit by the 2008 crisis, the impact on Eastern Europe was even worse. The shock to the most highly leveraged transition states of the former Communist bloc was staggering. If we compare the forecasts for 2010 made in October 2007 with the expected outturn two years later, we see how radically the crisis changed the outlook for the worst-hit countries in the region.

The most extreme case was Latvia. One year into the crisis, in October 2009, the IMF’s forecast for Latvia’s GDP in 2010 was 39 percent lower than it had been in October 2007. Over the same two-year period, Estonia’s and Lithuania’s GDP expectations were revised downward by a whopping one-third. Slovenia, the Czech Republic, Slovakia, Hungary, Bulgaria and Romania all experienced downward shocks of between 15 and 18 percent, more than twice that suffered by the United States. In the adjoining post-Soviet Commonwealth of Independent States (CIS), the downward revision of growth expectations ranged from 18 percent for Russia to 32 percent for Armenia. The pattern was not uniform. Poland, notably, escaped largely unscathed.²⁶ But all the most severe casualties of the 2008–2009 crisis are to be found among the transition economies of the former Eastern bloc.

Source: Zsolt Darvas, “The EU’s Role in Supporting Crisis-Hit Countries in Central and Eastern Europe,” Bruegel Policy Contribution 2009/17 (December 2009), figure 1.

Individually, the East European states are not big economies. But taken together they formed a substantial unit comparable in economic heft to France or the state of California. They were the pride of Europe’s transformation process, and the battleground in the new confrontation with Russia that had taken shape between 2007 and 2008. They were eager disciples of market liberalization and financial globalization. That put them especially at risk as global financial markets collapsed. The situation was made even worse, however, by the source of the capital that fueled their growth: the overleveraged banks of Western Europe. In total, the West European banks and their local branches had $1.3 trillion at stake in emerging Europe, $1.08 trillion excluding Russia.²⁷ As the balance sheets of the European banks were being crushed on the other side of the Atlantic, the risk was that they would dramatically curtail their operations in Eastern Europe.

Before the crisis struck it was normal to see an average of $50 billion flowing into the emerging markets of Eastern Europe and the post-Soviet world every quarter. In the last quarter of 2008 that suddenly reversed, with an outflow of $100 billion and a further $50 billion in the first quarter of 2009.²⁸ The pyramid of credit established over the previous fifteen years was shaking. In a “natural” process of adjustment, the floating currencies of Eastern Europe plunged. The result was a catastrophic increase in the local currency cost of servicing international loans.²⁹ In Bulgaria, Romania, Hungary and Lithuania, foreign loans made up more than half of all credit. As the forint plunged, in a matter of weeks Hungarian families saw their mortgage and car loan bills surge by 20 percent. The worst affected were the Hungarian families whose debts were denominated in Japanese yen. They faced a 40 percent increase in their debt burden as the yen soared.³⁰

Whereas Russia had reacted to its humiliation in the 1990s by accumulating a substantial currency reserve, the East European states had no such defense. For them security lay in integration with the West, or at least so they imagined. With the Fed having used swap lines to stabilize a core group of economies in which American interests were undeniable, one might have expected the ECB to extend similar support to the East European neighbors of the eurozone. Certainly this was the expectation of the Fed. If one applied the three criteria set out by Nathan Sheets to Eastern Europe, the case for ECB assistance was clear-cut.³¹ The East Europeans were EU members and aspired to future eurozone membership. As such, the respectability of their economic policy was vouched for in general terms. The crisis in Eastern Europe was immediately caused by a sudden stop in foreign credit supply. And the eurozone’s own banks were deeply involved and stood to suffer substantial losses. The risk of blowback was acute. As Sheets remarked to the FOMC: “I think it is very appropriate for all the European EMEs to report to the ECB for their liquidity needs.”³² But whereas the Fed had effectively licensed the ECB to issue dollars, the ECB had no intention of extending equivalent privileges to Poland or Romania. With Sweden and Denmark the ECB established publicly announced swap lines. Their banks would supply liquidity to Eastern Europe. Meanwhile, the central banks of Poland and Hungary were fobbed off with repo arrangements that treated them no better than stressed commercial banks in need of extra liquidity. The only assistance that the ECB was willing to provide was to give them short-term funding in exchange for first-class euro-denominated securities. When the problem was a shortage of euro funding, that was not a great help. What they needed was a swap facility for Hungarian forint or Polish zloty. Even the limited facilities offered by the ECB were extracted only thanks to urgent pressure from the Austrian and French central banks, which had particular reason to worry about the losses their banks might suffer on their East European portfolios.³³ Austria’s banks were in particular difficulty because they had made loans in Swiss francs, funding them with borrowing in Switzerland, where interest rates were low. Now the Swiss franc was soaring and funding was scarce. To tide them over, the Swiss Central Bank offered full currency swap lines in exchange for euros, but not for Polish zlotys or Hungarian forints.³⁴

Membership in the EU and NATO was supposed to have promoted Eastern Europe from their inferior status in the global pecking order. Ex-members of the Warsaw Pact and former Soviet republics had eagerly refashioned themselves as exponents of Donald Rumsfeld’s new Europe. They now found their prospects for growth shattered and their governments thrown back to where their post-Communist careers had begun, as lesser sovereigns, and more or less resentful supplicants for international financial assistance. The IMF was their last resort. This was traumatic. No one in Eastern Europe wanted to relive the bitter aftermath of the collapse of communism, with which the IMF was indelibly associated.

The first and most desperate application for assistance from within the EU was Hungary’s.³⁵ On October 27, 2008, Budapest reached agreement with the IMF and the EU (as opposed to the ECB) on a $25 billion loan package. At 20 percent of Hungarian precrisis GDP, it was a very substantial commitment and an unusually generous multiple of Hungary’s IMF capital quota.³⁶ The IMF considered the program to be unusually lenient. Unsurprisingly, the Hungarians did not see it in such favorable terms. Hungarian politics polarized as the austerity program bit. The nationalist daily Magyar Hírlap described Hungary as being slowly garroted by a “credit noose around our necks.”³⁷ For the extremists of Hungary’s Far Right it was a short step back in time from the “neocolonialism” of the EU and the IMF to the Treaty of Trianon, which had eviscerated Hungary after World War I. In 2010 the right-wing Fidesz party would reap the benefits with a crushing electoral victory, setting Hungary on the path to a self-declared illiberal democracy.

Source: IMF, Review of Recent Crisis Programs (September 14, 2009), Appendix I, https://www.imf.org/external/np/pp/eng/2009/091409.pdf.

The IMF’s Hungarian aid package of October 2008 was followed by programs for Iceland, Latvia, Ukraine and Pakistan.³⁸ In 2009 Armenia, Belarus and Mongolia would be forced to apply to the IMF for help. Less than a year after it had played host to the contentious NATO summit, Bucharest found itself negotiating an IMF program. Precautionary credits would be offered to Costa Rica, El Salvador, Guatemala, Serbia, and Bosnia and Herzegovina. Additionally, at the urging of Washington, a new, minimally invasive flexible credit facility, offering a total of more than $80 billion in ready cash, was made available to Mexico, Poland and Colombia. Mexico thus had the singular distinction of receiving both a swap line and an IMF credit facility.

Thanks to the IMF and EU intervention, an immediate meltdown was avoided on the East European periphery of Europe in the fall of 2008.³⁹ But the situation remained extremely precarious. And it was dangerous not only to the borrowers. Austria’s adventurous banks had since the 1990s accumulated claims on Eastern Europe equal to more than 55 percent of Austrian GDP. The exposure of Austrian banks to Hungary and Romania, the countries with flexible exchange rates that seemed most likely to suffer payment shock, came to 20 percent of Austria’s GDP. German, French and Italian banks all had large claims on Eastern Europe, but these were manageable in relation to domestic resources. The other lender that was seriously exposed was Sweden, whose banks had almost entirely monopolized the banking markets of the Baltics, feeding a roaring real estate boom. There was acute anxiety on the part of international agencies such as the World Bank and the Bank for European Reconstruction and Development that an abrupt withdrawal by one or more stressed West European banks could precipitate a chain reaction that would overwhelm the modest resources provided by the IMF and the EU Commission. Desperate to reduce leverage on all fronts, West European banks would pull out of Eastern Europe en masse, unleashing a ruinous rush to the exit. Bob Zoellick, George Bush’s nominee to head the World Bank, was deeply concerned about Europe’s future. “It’s 20 years after Europe was united in 1989,” Zoellick reminded the readers of the Financial Times in early 2009, “what a tragedy if you allow Europe to split again.”^{⁴⁰ The new Europe, which the United States and the two Bush presidencies in particular had been fostering since the end of the cold war, was in jeopardy. Evoking a different chapter in Europe’s history, the Viennese press was warning of a “monetary Stalingrad” that threatened Austria’s and Italy’s banks.⁴¹}

The situation was serious. But the alarmist talk in Central Europe was also a reflection of the fact that Western Europe wasn’t listening. Berlin was no more enthusiastic about a collective European solution in Eastern Europe than it had been in the eurozone. Germany shot down Austrian and Hungarian initiatives for a common support fund.⁴² “Not our problem,” Peer Steinbrück announced. East Europeans did not fail to notice that as a eurozone member, Greece seemed to be weathering the storm rather better than Hungary, even though its financial fundamentals were no better.⁴³ In early 2009 there were calls, ironic in light of later events, for Poland and other East European EU members to be put on a fast track to eurozone membership, thus bringing them under the protective umbrella of the ECB.⁴⁴ A confidential IMF staff report backed the proposal arguing that “[f]or countries in the EU, euro-isation offers the largest benefits in terms of resolving the foreign currency debt overhang [accumulation], removing uncertainty and restoring confidence. Without euro-isation, addressing the foreign debt currency overhang would require massive domestic retrenchment in some countries, against growing political resistance.”⁴⁵ But no help was to be expected from the ECB. It had no interest in entangling itself in Eastern Europe.

In December 2008 the most exposed Italian and Austrian banks began clamoring for a concerted program of international assistance. Finding the door closed in Brussels, they turned to Vienna, which, given the extent of Austria’s entanglement, could not afford to let things slide. Circumventing Brussels, the Austrian government announced what became known as the Vienna Initiative. This multilateral scheme committed the World Bank, the European Bank for Reconstruction and Development and the European Investment Bank to a program of 24.5 billion euros in new lending and capital injections. Crucially, it was flanked by an agreement with at least some of the leading private banks. On a case-by-case basis the Vienna Initiative extracted pledges from the leading lenders that they would maintain their lines of credit to the region, thus preventing an even more dramatic credit stop.⁴⁶ UniCredit and Banca Intesa of Italy, Raiffeisen of Austria and Swedbank of Sweden all participated. Commerzbank of Germany and Deutsche Bank did not.⁴⁷

As it turned out, the most important battleground for East European stabilization was a long way from Vienna. As the twenty-first century began, Latvia, Lithuania and Estonia had seemed like the lucky ones. Unlike other former Soviet republics, such as Ukraine, Georgia or Belarus, they had successfully transitioned to full membership in both the EU and NATO. Furthermore, unlike Hungary or Poland, the Baltics were eager to join the euro as soon as possible. In anticipation they had pegged their currencies. In 2008, despite the sudden stop to foreign capital inflows, they were under great pressure to remain on their convergence track. But as foreign credit dried up, maintaining their fixed exchange rates became ever more painful. When in early 2008 the IMF had contemplated the possibility of a crisis triggered by macroeconomic imbalances, Latvia, with its yawning current account deficit, had been singled out as particularly vulnerable.⁴⁸ Then it had been viewed in isolation as a national problem case. Now Latvia faced the unwinding of its huge deficits in the context of a comprehensive global crisis that had forced its regional competitors in Poland, Hungary and Romania to devalue. If the Baltics did not follow suit, how were they to keep up? How would they cope without foreign funding? How could they regain export competitiveness and shrink imports if they could not adjust their currencies against the euro? Without devaluation the only way to right the trade balance was by rebalancing domestic demand, cutting wages, raising taxes and slashing government spending. This was painful, but given the advanced stage of financial integration that the Baltic countries had already reached, devaluation was dangerous too. With 80 percent of credit outstanding sourced from their European neighbors, any substantial depreciation was likely to trigger wholesale default. The cost of servicing their debts in euros would simply have become prohibitive. Though they were not yet members of the eurozone, in early 2009 the Baltics faced a predicament that was a grim precursor of things to come.

Because of the scale of its debts and the deep involvement of Scandinavian banks, Latvia was commonly seen as the key to stability in the Baltics.⁴⁹ If it abandoned its peg, contagion would most likely spread to Estonia and Lithuania, and from there to Slovakia and Bulgaria, which were also struggling to hold their currencies in line with the euro.⁵⁰ Once a wave of further devaluations began, it would be impossible to uphold the defenses put in place by the Vienna Initiative. Fire sales would sweep Eastern Europe. Some might get out alive. But for two of Sweden’s most important banks, Swedbank and Nordea, the entanglement with the Baltics was existential.⁵¹ If their loans were written off, the capital of both banks would be completely wiped out. As a BNP Paribas analyst put it, “Latvia may be a small country but it has vast repercussions.”⁵² One Central European minister of finance, who preferred to remain anonymous, predicted that the chain reaction across Central and Eastern Europe would take down at least half a dozen European banks. Latvia would play the role of a Lehman, or, even more ominously, that of the infamous Austrian Kreditanstalt in the financial crisis of 1931, the failure of which had precipitated Weimar Germany’s final slide toward disaster.

For the IMF, the standard prescription for a country in Latvia’s position was a one-off devaluation followed by debt restructuring or rescheduling. But the European Commission dug in its heels. Latvia was en route to eurozone membership. It must stay the course. If it needed to rebalance its current account it must do so through deflation and austerity. The results for Latvia were drastic. By the summer of 2009 house prices had plunged by 50 percent. Civil servants, including one-third of the country’s teachers, were fired and public salaries were slashed by 35 percent. Unemployment surged from 5 to 20 percent.⁵³ Remarkably, Latvia clung on, as did its neighbors. In mounting its defense, Latvia received aid totaling 32 percent of its precrisis GDP: 3.1 billion euros came from the European Commission; the IMF provided 1.7 billion; 0.8 billion came from the World Bank and the European Bank for Reconstruction and Development; and 1.9 billion came from Sweden, Denmark, Finland, Norway and Estonia.⁵⁴ They all preferred to fight the crisis in Latvia rather than bailing out their banks at home. Significantly, the ECB absented itself from the crisis-fighting coalition.

The financial austerity course imposed a huge pressure on the new democracies of the Baltics.⁵⁵ In Latvia popular discontent with the new austerity line and accusations of corruption against the political class led to two referenda calling for protection of pensions and a public right to dissolve the parliament by plebiscite. In January 2009 Riga was rocked by mass protests that escalated into rioting and a night of street battles with police. In February a conservative coalition government took office under the high-profile member of the European Parliament Valdis Dombrovskis. His government’s objective was to stay the course of austere conformity. “We are facing national bankruptcy. It’s going to be tough,”⁵⁶ Dombrovskis told the nation. What, after all, was the alternative? The legacy of the Soviet period hung over Latvia. Georgia was a reminder. For the Baltics the choice was between a Western or an Eastern hegemon. Since the 1990s they had managed miraculously to navigate their way under the umbrella of the EU and NATO. At least as far as the Latvian political class was concerned, they intended to stay there.

IV

Faced with the double crisis of 2008 the reaction of Eastern Europe was not uniform. The Baltics stayed the course. Hungarian nationalism rebelled. But nowhere was the double shock more jarring than in Ukraine. The coincidence of the escalation of geopolitical tension between Russia and the West with the financial crisis dealt a shuddering blow to its fragile polity. The route to the Ukraine crisis of 2013 was twisted. But the path that it would travel down was mapped out already five years earlier.

In the spring of 2008 the decision by Ukrainian president Viktor Yushchenko to apply for NATO membership—eagerly applauded by the Bush administration, Poland and the other East Europeans—split Ukrainian politics. Whereas President Yushchenko threw in his lot with the West, Prime Minister Yulia Tymoshenko favored the policy of balance between Russia and the West that Kiev had pursued since independence and that had made her personal fortune as a kingpin in the gas trade. The war in Georgia in August 2008 divided what was left of the political legacy of the revolution of 2004.⁵⁷ Then, before the cease-fire in the Caucasus had more than a few weeks to settle, Kiev was rocked by the financial crisis.

Since the 2004 revolution, Ukraine’s economic growth had come to rely on foreign borrowing. By early 2008, foreign funds made up 45 percent of all corporate financing and 65 percent of household loans in Ukraine.⁵⁸ Altogether, European banks had lent Ukraine at least $40 billion, with Austrian and French banks responsible for almost half. The onset of the crisis stopped the credit flow. And it hit Ukraine’s exports hard. As one of the legacies of the Soviet era, steel accounted for 42 percent of Ukraine’s foreign currency earnings. No sector was worse hit by the crash in global investment spending than steel. Prices plunged and industrial output by January 2009 was falling at an annualized rate of 34 percent.⁵⁹ As Ukraine’s economy slid into recession, millions were left without pay, if they were not actually thrown out of work. Of all economies in the world, only Latvia would suffer a more severe contraction.

In October 2008 Ukraine had no option but to follow Hungary to the IMF. Kiev signed up to a $16.4 billion loan package. The IMF’s approach was not demanding by its usual standards. It asked for Ukraine to fully fund its budget, to set a realistic exchange rate and to ensure that its financial system was stable. But even this was more than Kiev could manage. The exchange rate was allowed to devalue from the overvalued rate of 5 hryvnia to the dollar to 7.7, though unofficially it traded as low as 10 to the dollar. The tax increases and subsidy cuts necessary to balance the budget were ruinously unpopular.⁶⁰ Asked in 2009, “Who bears the most responsibility for the difficult socioeconomic situation in Ukraine?” 69 percent blamed the heroes of 2004, with 47 percent singling out Yushchenko and 22 percent naming Tymoshenko. Yushchenko’s personal approval rating hovered between 2.5 and 5 percent.⁶¹ The upshot was paradoxical. On the one hand, the impasse in Ukraine’s post–cold war development was more evident than ever. What hope there was of economic development lay in further integration with the West even at the expense of painful structural adjustment. On the other hand, by the autumn of 2009 the most popular politician in Ukraine was Viktor Yanukovych, the representative of the Russian-oriented “party of the regions” with its base in eastern Ukraine, the thuggish dinosaur of the transition era whose rigged election victory in 2004 had triggered the Orange Revolution.

The one point of relief for Ukraine in 2009 was that geopolitical tension between East and West seemed to be subsiding. With Medvedev in the Kremlin, the West scrambled to “reset” relations with Russia. But the fragility of the situation was painfully exposed in January 2009 when a dispute between Russia and Ukraine over unpaid bills and gas prices left Ukraine without heat in the depth of winter and interrupted flow through the pipelines running west to Europe.⁶² The dispute was resolved only with EU mediation and a price increase for Gazprom that would become an albatross around the neck of Prime Minister Tymoshenko. Though Ukraine was far from being headline news, it was already in 2008–2009 drifting into an explosive state. As Austrian foreign minister Josef Proell presciently remarked in February 2009: “Ukraine is a very important keystone country and we must avoid a domino effect inside the EU, if there is economic and political catastrophe in such a huge neighbouring country. . . . We don’t see this scenario developing now. But we must prepare and keep an eye on Ukraine.”⁶³