A bleak outlook in the east: Paul Durman reports on the problems of changing banking systems

FALLING output, high inflation, sharply declining exports, mounting budget deficits and insolvent banking systems - the economies of central and Eastern Europe and the former Soviet Union present a dismal picture of financial disarray.

In addition to the many difficulties they face in making the transition to a market system, these former planned economies have to contend with the weakness of the German and other Western European markets and a rash of protectionist trade restrictions.

The latest economic review from the European Bank for Reconstruction and Development reports that central and Eastern Europe has made a 'somewhat discouraging' start to 1993, with only Poland clearly pulling out of recession. The region suffered a 4 per cent decline in real gross domestic product last year and an 11 per cent fall in 1991.

The outlook for the former Soviet Union is, if anything, bleaker. Whereas inflation in central and Eastern Europe eased towards 60 per cent last year, the EBRD estimates prices in the nations making up the Commonwealth of Independent States rose by more than 1,300 per cent.

This year inflation in many CIS republics is averaging 20-25 per cent a month - higher in Ukraine. After real GDP fell by 11 per cent in 1991 and 19 per cent last year, industrial production seems to have steadied. Oil output continues to decline.

Russia's decision 10 days ago to withdraw pre-1993 notes in an attempt to curb inflation came too late to be covered by the report, but John Flemming, EBRD's chief economist, described the move as 'half-baked'.

Mario Sarcinelli, vice-president with responsibility for development banking, said: 'It is very difficult to say anything complimentary about it.

'Unfortunately, it has an appeal whenever some groups are identified as speculators, profiteers, if not bandits. There is a widespread belief that those economic activities which take place at the margin of the law, or outside it, give rise not only to huge profits but also to holdings of banknotes.'

These sums can be 'taxed' by changing the notes or the currency. But Mr Sarcinelli added: 'Where a profiteer might have x per cent of his wealth in the form of cash, poor people have 100 per cent. It is one of the most regressive forms of taxation.'

Some republics have introduced their own currencies in exchange for the rouble. But instead of returning the roubles to Moscow they have used them to buy Russian goods, further fuelling Russian inflation.

The EBRD review highlights the difficulties of transforming the banking system. In a planned economy banks extend credit to enable state enterprises to achieve their planned targets rather than choosing between proposals on commercial criteria.

Consequently, the ability of Eastern European banks 'to judge lending opportunities from a commercial perspective tends to be weak'.

This has led to a huge bad debt problem. The EBRD believes doubtful loans typically make up 25-60 per cent of the banks' loan portfolios.

Inter-company debts have soared, many businesses expecting the state to continue the practice of ultimately bailing out enterprises that cannot pay for their deliveries. It also makes it very difficult for banks to assess or diversify lending risks.

The EBRD is trying to act as a catalyst for banking reform by taking equity stakes. Largest is its 28 per cent holding in Wielkopolski Bank Kreditowy of Poland. Mr Sarcinelli said strengthening banks' credit departments and risk assessment was the key to the success of these investments.

----------------------------------------------------------------- THE DECLINE OF THE EAST ----------------------------------------------------------------- Real GDP 1 Retail prices 2 Population 1991 1992 (est) 1991 1992 (est) 1992 % change % change millions Albania -30 -8 36 200 3.1 Bulgaria -12 -8 334 83 8.7 Croatia -29 -11 123 664 4.8 Czechoslovakia -16 -7 59 11 15.6 Estonia -13 -26 212 1050 1.6 Hungary -12 -5 35 23 10.3 Latvia -8 -44 172 952 2.7 Lithuania -13 -35 225 1021 3.7 Poland -7 1 70 43 38.4 Romania -14 -15 161 210 23.2 Russia -11 -19 93 1354 150.0 Slovenia -9 -7 115 207 2.0 Ukraine -14 -14 91 1450 51.9 Central & E. Europe 3 -11 -4 85 60 96.2 The former Sov Union -11 -19 97 1303 291.0 ----------------------------------------------------------------- 1. Figures for ex-Soviet states refer to real net material product with the exception of Estonia, Latvia, Lithuania and 1992 Russia. Figures for Croatia refer to real gross value added. 2. Annual average 3. Bulgaria, former Czechoslovakia, Hungary, Poland and Romania. -----------------------------------------------------------------

(Photograph omitted)