Why red lights are flashing in the old Communist bloc

In one of the weirdest twists of hedge fund globalism, Swiss loans are now funding the housing booms of Eastern Europe. This is Europe's match for sub-prime folly in America, and just as dangerous.

If you are wondering where the next shoe might drop as global markets rediscover risk, keep an eye on the old Communist bloc.

"All the red lights are flashing. A lot of these economies are seriously over-heated," says Carsten Valgreen, chief economist at Danske Bank. "The markets have been forgiving so far but it's now going to become much harder to find financing. The region looks very like East Asia before the crisis in 1997."

Politics are turning sour almost everywhere. The great reform drive has petered out as free-market governments give way to populist backsliding. In Poland, the Kaczynski twins are bent on a blood-feud with Germany. They preside over a cabinet lacking a single minister able to speak English, let alone speak the language of modern finance.

"These countries are like marathon runners who drop down at the end of the race and grab a beer. Are they willing to take the painful steps needed now to avoid a crisis?" says Mr Valgreen.

In Hungary, it is hard to get a mortgage in local forints. Banks making bonus margins on foreign loans have shunted borrowers into francs and euros. Forint mortgages run at 12pc or so, while Swiss loans are nearer 6pc, so who can resist?

By late 2006, over 80pc of new home loans and half of small business credit in Hungary was being issued in francs. Poland and the Balkans are catching up fast. While there is no exact breakdown, the Bank for International Settlements says Swiss franc loans abroad reached $138bn (£71bn) in late 2006, up from $61bn in late 2002.

Hungary's central bank warns that this will end in tears as Switzerland pulls out of its 10-year mini-slump, cutting off the cheap credit. But nobody is listening. There is little the bank can do to stop the inflows under EU law.

Latvia has the added spice of mortgages in yen. Japanese rates are even lower, and the yen is even weaker, shaving the value of the debt. A double freebie -- at least until two weeks ago when Latvia's lat lost 7pc against the yen in five days.

For the time being, Riga is humming. Hanseatic apartments near Petera Baznica now cost more than posh flats in Frankfurt or Berlin. Fitch Ratings says mortgage growth ran at 90.7pc in the third quarter of last year.

The current account deficit has reached 24pc of GDP. This is la-la land. Latvia's central bank belatedly raised interest rates to 5.5pc last week, still below inflation at 7.3pc.

Estonia and Lithuania are not much better. In a report entitled "Risk rising in the Baltic States?", Fitch said Latvia was heading for a downgrade, and warned of "psychological contagion" across the region. It likened credit explosion in Eastern Europe to "pre-crisis Mexico or Asia".

Throw in Turkey, Ukraine, and Kazakhstan, where property is up over 900pc in five years, and one starts to discern a problem big enough to bother western banks. Sweden, Austria, and Germany are the most exposed.

"The alarm bells are ringing," says Tim Ash, a strategist at Bear Stearns, warning Latvia may set off the chain reaction.

"Turkey is expected to be on the front seat of the rollercoaster, given its wide current account deficit, and continued reliance on hot money inflows."

The markets seem to assume that the Swiss National Bank will keep supplying cheap credit for ever. Inflation has slipped back to zero, so rates will stay low, or so they think. Jean-Pierre Roth, the SNB's president, has been trying to disabuse the markets of this illusion in speech after speech. The exchange rate is "out of line with economic fundamentals," he says.

"The current interest rate level is not high enough to ensure price stability in the medium term."

Or board member Thomas Jordan: "The weaker the franc gets, the higher the risks investors take when they engage<