The alpine region of Carinthia in Austria faces probable bankruptcy after the central government refused to cover bond guarantees issued for failed lender Hypo Alpe Adria. Our local expert updates from the financial frontline.

Some have likened it to the Lehman Brothers crisis, others to the bankruptcy of California's Orange County in 1994 or the US city of Detroit in 2013 – and these are not good comparisons to hear at a time when the Eurozone is still fragile – yet an alpine region in Austria could see Western Europe's economy get into quite a tight spot.

Last week, Austria's finance minister Jörg Schelling said Vienna would not cover €10.2bn in bond guarantees issued by the Carinthian authorities for the failed lender Hypo Alpe Adria. It leaves the 550,000-strong province on the Slovene border to fend for itself as losses spin out of control.

Hypo had moved from sleepy lender to a regional power in a short space of time, but in 2009, after a decade of breakneck expansion, it hit the wall and Austria was forced to nationalise the bank to save it. The region of Carinthia provided debt guarantees for years to fuel Hypo's rapid expansion before such state guarantees were banned in 2004; the last ones expire around 2017. 

Now Austria is winding down what is left of Hypo, surprising markets, and regulators have taken control of Heta, the "bad bank" spin-off, suspending debt payments until 2016 after discovering a further shortfall in capital of €7.6bn. The surge in the Swiss franc in January after the collapse of Switzerland's currency floor against the euro appears to have been the last straw, setting off another wave of likely losses from eastern European mortgages denominated in francs.

Concerningly, the Hypo issue threatens knock-on consequences for public bodies elsewhere, including Bayern Landesbank, owned by the German state of Bavaria and a big holder of Hypo bonds, and the Munich-based FMSW, which is again publicly underwritten.

While Mr Schelling has said neither Heta nor Carinthia are at risk of insolvency and that the federal government would not be hit by the wind-down plan, it did not stop ratings agency Fitch from downgrading Austria's AAA to AA+, saying: "Within a short space of time the debt dynamics of Austria have deteriorated significantly."  Moody's downgraded Carinthia's issuer and debt ratings to Baa3 from A2 and changed its outlook to negative from stable. One commentator has even called it a "mini- Greece going off in the heartlands of Europe".

Fitch said Austria's debt ratio was likely to peak at 89% of GDP this year – 15 percentage points higher than expected just 18 months ago – due to the lingering effects of the banking crisis and weak growth in nominal GDP. The various bank bailouts have cost 11% of GDP, twice as bad as Britain's travails.

Fitch warned that Austrian bank exposure to Russia, Ukraine and the rest of eastern Europe is €194bn, or 59% of the country's GDP, though part of this is acting as a conduit for investors in western Europe.

The International Monetary Fund said in its latest healthcheck on Austria that three large banks – Raiffeisen, Erste and Volksbanken – are vulnerable to any shocks, while Austria's reforms have largely stalled. The country has one of the highest barriers to services in Europe, the worst subsidies at 3.75% of GDP, the highest tax share on labour at 58%c, a high rate of early retirement, and high state spending at 52% of GDP, compared with 45% in Germany.

But on the ground, what's the sentiment?

If you listen to some analysts, while an insolvency of Austria's southern-most province is not at all unlikely, official voices are trying to avoid the topic owing to upcoming elections. If Carinthia does go under the Republic is likely to be liable and the Austrian taxpayer will have to face it.

Austria's Financial Market Authority has ordered payments to Heta's creditors to come to a standstill for at least one year, as auditors are to find out over the next 12 months what further detrimental surprises Heta's financial statements might contain.

It seems with some certainty that Heta's creditors will require good nerves, excellent attorneys and sufficient funds to dive through these coming 12 months.

Despite the threat of insolvency in the regions, Austria remains stable in its economic power and political stability. Still, labour costs remains an issue, and are under discussion between employers' and employees' associations. This is the thing that requires fast resolution to accelerate growth in Europe's most central and previously paragon economy.

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