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PRAGUE, Dec 9 (Reuters) - Economic and financial conditions have improved in European Union states outside of the euro zone, but the vulnerabilities seen at the height of the global crisis broadly persist, the European Central Bank said on Thursday. In its biannual Financial Stability Review, the ECB named a high level of foreign currency loans, a deterioration in credit quality and potential investor uncertainty over policy as risks that could undermine recovery.
It did not name specific states, but its comments appeared focussed on the EU's emerging east, where Hungary, Romania and Latvia turned to Brussels and the International Monetary Fund for bailouts during the crisis and other countries suffered painful economic contractions.
"Strains could reappear quickly if investor risk aversion were to rise as a result of uncertainties about economic policies or political tensions in some countries (particularly those with IMF/EU financial assistance programmes)," the ECB said.
"In addition, risk aversion towards the countries could also increase as a result of spillovers from tensions in other EU countries or a reassessment of risk in general." Hungary, in particular, has faced market turmoil in recent weeks over the unorthodox policy mix of Prime Minister Viktor Orban's seven-month-old right-of-centre government, aimed at raising state revenues and avoiding budget cuts.
Romania, too, has struggled to build confidence among investors during a string of no-confidence votes against its fragile government, which is trying to push through unpopular austerity measures prescribed by its IMF and EU aid deal.
The ECB said banks exposed to non-euro area EU states also faced deteriorating loan quality because of high unemployment.
Non-performing loans are expected to peak in low double digits in many emerging EU states, but one of the biggest lenders in central Europe, Italy's UniCredit (CRDI.MI), said last month it expects the deterioration to end by early 2011.
The ECB said there had been a virtual halt in foreign currency lending, a pre-crisis favourite that saw borrowers in Hungary, Romania and Poland take loans in euros or Swiss francs in the hope their domestic currencies would strengthen.
But it said there was still a "substantial currency mismatch" on private sector balance sheets.
Economists say that is a main risk for Hungary, where some 55 percent of all mortgages are denominated in francs, and the forint has lost 28 percent against the Swiss currency since August, 2008, causing a spike in borrowers' monthly payments.
"There is an ongoing concern that potential currency depreciations could significantly add to the debt burdens of households or companies that are exposed to this mismatch, in particular in view of some recent volatility in exchange rates in a number of countries," the ECB said in the report. (Reporting by Michael Winfrey; editing by Patrick Graham)