I’ve covered eastern European markets for about eight years, and all of those eight years, the region has been on a growth trajectory, either because it is converging with the EU, or, in the case of Russia and Kazakhstan, because it has lots of natural resources. It’s been a boom region, with GDP growth averaging above 6% for the last eight years.

In the last two months, the region has been hit by the global financial crisis, and engulfed by it. Now, many analysts say that of all the emerging markets, the CEE (central and eastern Europe) region is the most vulnerable and exposed.

The main reason is that several CEE countries have very high current account deficits, which mean that they rely on FDI to get foreign currency to pay off their FX liabilities. Countries with current account deficits over 5% include Hungary, Ukraine, all the Baltics, Romania, Bulgaria, and Serbia.

The FDI that used to flow to these countries was mainly foreign currency loans – syndicated loans from western banks, or Eurobond borrowing. But the credit markets have completely closed. Now these countries are facing real difficulties in meeting the FX gap, and their currencies are coming under severe pressure.

All these countries have banking sectors that are dominated by western banks. These banks have high levels of foreign currency loan exposure to CEE countries. They want to stop the CEE countries from devaluing, because then their foreign currency loans would be worthless, and some of the foreign banks might even go bust.

However, the CEE countries I mentioned earlier might be forced to devaluate sharply in 2009, because their economies are now grinding into severe recessions, with economies shrinking by up to 4% next year. In the words of one analyst ‘they will have to devalue, otherwise their economic systems might break’.

Another analyst told me, ‘Next year for the CEE region will be like 1998 for the Asian economies. A number of currency collapses and severe recessions.’

The western banks that are heavily involved in the CEE region are desperately trying to prevent an Asia style crisis happening within the EU. Those banks are mainly Austrian (Raiffeisen, Erste Bank, Bank Austria Creditanstalt), but also Italian (Unicredit, which owns Bank Austria) and French (Societe Generale, BNP Paribas).

A senior banker at Unicredit, which is the biggest bank in the CEE region, told me: ‘We have about six months to stop the region from imploding. The EU and ECB need to do more. So far they have felt, it is not in the eurozone, it is not our business. But if there is a crisis in eastern Europe, it will affect western banks, and then it will affect western Europe.’

He also told me there was the real threat of nationalism in eastern Europe, with foreign banks being nationalised for not lending more to CEE economies.

The international financial system is straining, because it depends on international banks, on banks acting as bridges between countries. Now, however, both sides of those bridges are crumbling – western governments are demanding that semi-nationalised banks do more at home; while eastern governments are demanding they support their foreign subsidiaries. It is difficult to obey both.

If the CEE region did collapse, it could put great strain on the local political systems in these countries, and could give rise to isolationist, xenophobic governments, as it did in some CEE countries in the early 1990s. We should remember that the last time there was a major Austrian / CEE banking collapse was in 1931, with the fall of Creditanstalt, which helped give rise to the Nazi Party.

The EU should have the firepower to stop such a crisis from happening – the Baltic and Balkan economies are not that big. The EU or ECB may need to provide major bail-outs or guarantees to the local CEE banking system, in order to help local banks raise credit. Otherwise we are faced with an asymmetric bail-out, where western banking is guaranteed and eastern banking is left to rot.

Another pressing question is what happens in Ukraine, which looks set for a serious devaluation in the new year, and which is now struggling to pay its debts for Russian gas. Much of the EU depends on the gas that comes through Ukraine from Russia, so the EU needs to make sure its supply is protected there.