LONDON - A new report suggesting eastern Europe's economic slump will drag Western banks further into the red fanned fears on Tuesday that emerging economies will deepen the recession in the West.

The euro fell to 10-week lows and European bank stocks were hit by the Moody's report, which one analyst said showed the market believed emerging Europe is the subprime of Europe and now everybody is running for the door.

The combination of higher provisions for bad debt, the rise in banks' borrowing costs and falling currencies will weigh down banks' profitability and help erode their capital base, Moody's said in a statement released overnight.

Much of the world has been pushed into recession by a credit crisis, prompted by the collapse in the U.S. housing market and the flow of bad subprime mortgages -- extremely risky loans -- around the financial system.

Eastern Europe has been particularly badly hit. Former Soviet Ukraine reported industrial output shrinking by over a third -- the worst drop in over a decade.

Governments have employed a mixture of measures -- from stimulus packages to bank bail-outs -- to try to ease the deepening recession, but some have been criticized for putting national interests before trade commitments.

ACT TOGETHER

What shocks me, you see, what bothers me a bit is that in the international arena ... everyone agrees that we need to work and act together, IMF chief Dominique Strauss-Kahn told France Inter radio.

Then when everyone goes home, everyone has his national constraints, everyone does things a bit differently and sometimes with a little contradiction, and it is for this reason that there are some risks.

The U.S. $787 billion stimulus package, due to be signed by President Barack Obama later on Tuesday, has been criticized for its Buy American clause that says firms must use U.S. steel and other U.S.-made goods. French and Italian auto bail-outs have also been criticized by European policymakers.

The United States also hopes a $17.4 billion bailout will help its auto industry, which some U.S. companies have argued employs as many as one in 10 U.S. jobs.

But General Motors Corp and Chrysler have been asked to submit survival plans to justify the loans, and are due to present the measures to cut costs later on Tuesday.

In Europe, German premium carmaker Daimler was the latest to suffer, posting a fourth-quarter loss before interest and tax of 1.95 billion euros ($2.47 billion).

German Chancellor Angela Merkel again said that banks should not be absolved from their responsibilities and the state should not take on bad assets.

It should allow financial institutions to hold on to good ones, she said, announcing that the government was trying to take a controlling stake in lender Hypo Real Estate.

BALANCE SHEETS

Concerns over banks' balance sheets helped send European shares to a three-week low. U.S. shares were expected to open lower.

With government measures so far failing to stem the downturn, some policymakers have started discussing alternatives.

European Central Bank governing council member Ewald Nowotny said Europe had some room to cut interest rates but basically I am not an advocate of nominal zero interest rates, which would mean negative real interest rates.

There is, as we are going down with interest rates, the discussion on whether there are additional, more unconventional measures. This is a discussion that is going on in the ECB and we have to see how things develop, he said in an interview with the Financial Times. [nLH339086]

In Asia, Japan has suffered a sharper contraction than other major economies because of its heavy dependence on exports combined with persistently soft domestic demand.

Japanese Prime Minister Taro Aso named 70-year-old Economics Minister Kaoru Yosano as finance minister after Shoichi Nakagawa resigned. Nakagawa was forced to deny he was drunk at a G7 news conference in Rome.

With Nakagawa quitting, the government lacks a person in charge to come up with further steps to support an economy that is worsening sharply, said NLI Research Institute chief economist Koichi Haji.

(Additional reporting by Reuters bureaux around the world; Writing by Elizabeth Piper; Editing by Giles Elgood)

Ukraine Germany Barack obama