sudden stop anno 2008: why emerging europe was different

1

Sudden Stop anno 2008: Why Emerging Europe

was different

Erik BerglofChief Economist

European Bank for Reconstruction and Development

Sudden Stop anno 2008: Emerging Europe was different

-3.4-4.4

-11.1

-7.8

-11.9-15

-10

-5

0

5

10

15

EmergingEurope

CA andCaucasus

Russia &Ukraine

Latin America Emerging Asia

Per cent

Avg 2007Q4/2008Q1 Avg 2008Q4/2009Q1

Percentage changes in external assets of BIS-reporting banks

Why Emerging Europe was different

• Massive output decline, but

• No traditional emerging market “twin crises” - Despite magnitude of shock

Why?

• Nature of European financial integration

• Policy response – massive and comprehensive

Outline

1. Financial integration and the European transition model: introduction

2. Did financial integration have any tangible benefits?

3. What role did financial integration play in the transmission of the crisis?

4. Did financial integration generate macro-financial vulnerabilities?

5. Policy Response and Lessons

The three pillars of the European transition and convergence model

Political, legal-regulatory integration with EU

Trade integration (both opening, and specifically with the EU)

Financial integration

– Growing external assets and liabilities (but primarily liabilities: via FDI and debt inflows)

– Growing role of EU banking groups

Political, trade, and financial integration have gone hand in hand

0

20

40

60

80

100

New EUMembers

Official EUCandidates

EUAspirants*

EasternPartnershipCountries

Other

0

50

100

150

200

Exports to the EU (left axis) Assets of EU banking groups (right axis)

Per cent of total exports

Per cent of GDP

Financial integration has been rapid, with a boom period from 2004 onwards.

External assets and liabilities as a share of GDP

0

50

100

150

200

25019

94

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

Per cent

CEB SEE*EEC RussiaTurkey CA

In CEB and SEE, financial integration has been led by foreign banking groups

0

20

40

60

80

100Per cent CEB SEE EEC Other

Foreign bank asset share, 1998-2008 Foreign bank asset share, end-2008

0

20

40

60

80

100

1998 2000 2002 2004 2006 2008

Per centCEB SEEEEC RussiaTurkey CA

Outline


2. Did financial integration have tangible benefits?

3. What role did financial integration play in the transmission and magnitude of the crisis?

4. Did financial integration generate vulnerabilities that aggravated the crisis?

5. Policy Response and Lessons

The ultimate objective of financial integration: economic growth

Loosen domestic savings constraints to allow more investment

Financial development

– Access to credit allows individuals to access entrepreneurial and educational opportunities,

– Reduced macroeconomic volatility encourages investment

Transfer of skills, technology, and institutions (corporate governance) via FDI

Growth in transition has been associated with capital imports—unlike other regions

Current account balance, per cent of GDP (simple average)

-15

-10

-5

0

5

10

1994 1997 2000 2003 2006Latin America Emerging Asia CEB + SEE

Rising current account deficits have reflected mainly higher investment

10

15

20

25

30

35

1994 1997 2000 2003 2006

-15

-10

-5

0

Saving Investment Current account (right scale)

Current account balance, per cent of GDPSaving and investment, per cent of GDP

In non-transition developing countries, CA surpluses correlated with higher growth

y = 0.1681x + 5.0106

R2 = 0.1201

-2

0

2

4

6

8

10

12

14

-20 -10 0 10

CA/GDP, % (av. 1994-2008)

Gro

wth

GD

P p

er

ca

p,

PP

P

(av

.19

94

-20

08

)

-2

0

2

4

6

8

10

12

14

y = -0.3442x + 5.2813

R2 = 0.2697

02468

101214161820

-15 -10 -5 0 5 10

CA/GDP, % (av. 1994-2008)

Gro

wth

GD

P p

er

ca

p,

PP

P

(av

.19

94

-20

08

)

02468101214161820

… but not in the European transition region.

Non-transition sample Transition sample

Did capital inflows and financial integration cause higher growth in transition countries?

Two approaches

Growth regressions

– Used standard set of controls: initial GDP per capita, life expectancy, trade openness, fiscal balance to GDP ratio, measure for institutional quality

Sector approach

– Key idea: if FI has benefits, it should make sectors with high dependence on external finance grow faster

– Controls for full set of industry and country dummies

Examine effect of capital inflows; levels of financial integration; and asset share of foreign banks

Results: robust evidence backing growth effects of FI in transition economies

Find growth effects in both approaches, and across several proxies for financial integration

Size of growth effect is respectable

– 1 percent of GDP in capital inflows raised average annual growth by 0.15-0.4 percentage points per year

– 10 percentage point higher asset share of foreign banks raised average growth by 0.2-0.4 percentage point per year

– Output in manufacturing firms with average financial dependence grew faster by about 1.5 percentage points per year in high capital inflow countries (75 percentile) than in low capital inflow countries (25 percentile)

No such effects found in non-transition sample

Why is the transition region different?

Hypotheses:

Higher level of financial development

Better institutions (or EU commitment) effect

Threshold effects in financial integration

Find some support for the last idea (with respect to foreign bank presence)

Conclusion (1): Financial integration had tangible growth benefits in the EBRD region

Supported by econometric tests using several methodologies

Magnitude is economically significant




4. Did financial integration generate vulnerabilities that aggravated the crisis?

5. Policy response and lessons

Outline

Financial integration was one of the conduits of the international crisis…

But outflows were comparatively modest in parts of the region

-3.4-4.4

-11.1

-7.8

-11.9-15

-10

-5

0

5

10

15

EmergingEurope

CA andCaucasus

Russia &Ukraine

Latin America Emerging Asia

Per cent

Avg 2007Q4/2008Q1 Avg 2008Q4/2009Q1

Percentage changes in external assets of BIS-reporting banks

…so was the collapse of trade in Q4 and Q1…

80

100

120

140

160

180

200

220

240

100

102

104

106

108

110Trade credit*Commodity priceWorld trade volumeEU real GDP (right axis)

Index Index

…resulting in a sharp economic contraction in many countries in the region.

Source: EBRD. Note: For Armenia, Georgia, Kazakhstan, FYR Macedonia, Serbia, and Moldova 2009 Q2 numbers are EBRD projections.

Chart 1: Real GDP Growth (Year-on-year, in percent)

-25

-20

-15

-10

-5

0

5

10

Latv

ia

Esto

nia

Ukra

ine

Turk

ey

Hungary

Georg

ia

Arm

enia

Lithuania

Slo

venia

Czech R

ep.

Cro

atia

Kazakhsta

n

Russia

FY

R M

ac.

Slo

vak

Rep.

Pola

nd

Serb

ia

Rom

ania

Bulg

aria

Mongolia

Mold

ova

Bela

rus

Q4 2008 Q1 2009 Q2 2009

Statistical analysis suggests that foreign bank presence attenuated the outflow

Robust effect

– True for both transition sample and broader developing country sample

– True for both initial shock (Q4 2008 outflows) and Q4 and Q1 2009 combined

Higher foreign bank share of 10 percentage points of assets attenuated Q4 lending outflow by 1.4 percentage points*

*average outflow in transition region was about 6 percent in Q4 2008.

Foreign bank presence is associated with better output performance during the crisis

CzeFYR

GeoAlbBiHPol

MneSrbHun

Kgz

MolSlvRusTur

KazBlr

AzeTaj

BgrHrvRom

EstLtu

Svk

Ukr

LvaArm

-25

-20

-15

-10

-5

0

5

0 20 40 60 80 100 120

Foreign bank ownership, 2007

Ou

tpu

t g

row

th o

ve

r Q

4/0

8-

Q1

/09

, q

oq

, s

.a.

-25

-20

-15

-10

-5

0

5

However, external debt levels are a robust predictor of worse output declines in crisis

-25

-20

-15

-10

-5

0

5

0 20 40 60 80 100 120 140

External debt in percent of GDP, 2007

Ou

tpu

t g

row

th

ov

er

Q4

/08

- Q

1/0

9,

qo

q,

s.a

.

Lat

Ukr

EstSln

ArmLit

Mol

Hun

CroBul

SerKyrKaz

Alb

AzerBel

Geo

Ru TkySlk

Ro TajCze

FYRM

PolBiH

Both effects hold up when considered jointly, and with other controls.

Conclusion (2): Financial integration had a mixed direct role in the crisis

1. Provided a conduit for financial shocks; (obvious: in financial autarky, no contagion)

2. Some aspects of financial integration made the crisis worse: external debt

3. However, foreign bank presence mitigated the output decline

– Interpretation: foreign banks buffered the financing shock because of commitments to subsidiaries.

Outline




4. Did financial integration create vulnerabilities that aggravated the crisis?

5. Policy response and Lessons

Financial integration and crisis vulnerabilities: potential channels

1. Led to higher private external debt: a direct expression of financial integration

2. Did financial integration fuel credit booms? Higher output declines (cf. private external debt)

3. Did financial integration bias the currency composition of borrowing toward FX?

No statistical link with output declines; but probably exacerbated decline in some countries, and complicated the management of the crisis

Capital inflows strongly correlated with credit growth during 2005-08

(Per cent)

Hungary

Slovenia

BiH

CroatiaCzech Rep.

Poland

FYR

Bulgaria

Russia

Tajikistan

Serbia

Albania

Lithuania

Moldova

Estonia Romania

KazakhstanAzerbaijan

Ukraine

Latvia

R2 = 0.2988

0

10

20

30

40

50

60

70

80

90

-20 0 20 40 60 80 100 120 140 160 180 200

Median growth of BIS lending between mid-2005 and mid-2007

Av

era

ge

cre

dit

gro

wth

be

twe

en

mid

-20

05

an

d m

id-

20

07

0

10

20

30

40

50

60

70

80

90

Number of credit boom years (= year with credit growth > 2 p.p. of GDP)

0

1

2

3

4

5

6

7

Slo

ve

nia

Cro

ati

a

Es

ton

ia

La

tvia

Po

lan

d

Hu

ng

ary

Slo

va

k R

ep

.

Cze

ch

Re

p.

Lit

hu

an

ia

FY

R M

ac

ed

on

ia

Se

rbia

Bu

lga

ria

Ro

ma

nia

Alb

an

ia

Ka

za

kh

sta

n

Mo

ldo

va

Ru

ss

ia

Tu

rke

y

Uk

rain

e

Mo

ng

oli

a

Arm

en

ia

Ge

org

ia

Ky

rgy

z R

ep

.

1996 - 2001 2002 - 07

CEB SEE EEC and other

Did financial integration contribute to (excessive) credit booms?

Initial levels of financial integrationbelow median 10.9 10.1 29.0 36.2at or above median 13.8 14.5 39.1 31.9

Change in financial integrationbelow median 10.9 14.5 26.1 34.1at or above median 13.8 10.1 42.0 34.1

Initial levels -0.03 0.08 0.04 0.01Change 0.14 0.09 0.52 -0.10

Cross country-correlations with number of credit boom years

Relative frequency of credit boom years (%) 1

1996-2001 2002-07External Assets + Liabilities

Foreign bank share

External Assets + Liabilities

Foreign bank share

Did financial integration encourage FX lending?Background

Standard causes of “liability dollarisation”:

1. Low monetary policy credibility and/or high inflation volatility;

2. Moral hazard associated with pegged regimes (implicit guarantees)

Did foreign financing make liability dollarisation worse?

If foreign financing is in FX (either through parent bank or wholesale market), and banks want to avoid mismatch, they may want to push FX lending.

Foreign bank presence is correlated with a higher share of lending in FX

AZE HUN

LAT

LIT

RUS

UKR

ALB

ARM

BULCRO

EST

KAZ

FYRM

MOLPOL

SER

SLV

TUR

0.0

0.2

0.4

0.6

0.8

1.0

0.0 0.2 0.4 0.6 0.8 1.0

Asset share of foreign-owned banks

Sh

are

of

fore

ign

cu

rren

cy

len

din

g in

to

tal d

om

esti

c

len

din

g

(but so is L/D ratio, and various other measures of foreign financing)

Did financial integration encourage FX lending? Approach:

1. Firm level regressions based on BEEPS data for 2002-05 LHS variable is currency denomination of last loan

Firm level controls; standard macro + institutional controls (inflation volatility, exchange rate volatility …); add FI variables

2. Test robustness using macro data for same period LHS variable is FX share of bank lending

3. Macro regression over longer (2000-2008) period.

Did financial integration encourage FX lending? Results:

Clear evidence that financial integration had an effect over and above standard causes

Approaches disagree on which measure is main (culprit):

– Firm level regressions: foreign banks (even controlling for other FI measures)

– Macro regressions: more mixed results

– Measures of debt inflows (BIS; L/D ratio) matter more than gross financial integration levels

Conclusion (3): Did financial integration generate macro-financial vulnerabilities?

Yes, but …• Drivers of credit booms and FX lending were fast

inflows, not so much higher levels/stocks• To the extent that stocks were a problem,

it was debt, not FDI stocks• Results not conclusive on role of foreign banks

– Contributed to vulnerabilities as conduits of credit and foreign financing, but little evidence of other effects

– Firm-level evidence on contribution to FX lending – but not always robust in macro regressions

Outline


2. Did financial integration have any tangible benefits?

3. What role did financial integration play in the transmission of the crisis?

4. Did financial integration generate macro-financial vulnerabilities?

5. Policy response and Lessons

Crisis response has been impressive…

• Mature domestic (home and host) policies

• Massive & coordinated international support – IMF resources increased from $250 to $750 bn– EU BOP support raised from €25 to €50 bn– G20 held out substantial rise in MDB funding

• Parent bank engagement

• A new coordination platform– IFI “Vienna Initiative” filled institutional vacuum

The magnitude of official support unprecedented

Official support (percent of GDP)

0.0 1.0 2.0 3.0 4.0 5.0 6.0 7.0

Q3 1997: Asian currenciesdevalue sharply

Q4 1997: Closure of Ind. and Thaifinancials, Korean won devalues

Q1 1998: Social unrest in Ind.,Korean debt restructuring,

Q2 1998: Social unrest in Ind.,Russian stock market crash

Q3 1998: Russia default, Braz.stock market crash, LTCM

Q4 2008: Gov. support for largeUS, UK and Swiss banks

Q1 2009: Drop in foreign inflowsand trade

Q2 2009

Korea Thailand

Philippines Indonesia

Hungary Latvia

Romania Ukraine

…yet no time to be complacent

• Second and third round effects of the crisis– Quality of banking portfolios uncertain; rising NPLs– Risks of credit crunch– Rising unemployment

• Regulatory framework still uncertain

=> Use crisis response institutions to mitigate risks to recovery

The Vienna Initiative: Basic Approach

• Incentivise banks (do internalise spillovers)– Regulatory incentives (IMF/EU programs)– Capital infusions (Joint IFI Action Plan)– “Naming/shaming” (memoranda of understanding)

• Intensified collaboration among IFIs– Information-sharing– Within IMF/EU programs (Serbia, Romania…)

Vienna Initiative – next steps

• Weather “second round” effects

• Group “stress testing” – reduce uncertainty

• Manage “controlled deleveraging” of banks

• Restructure real sector and FX exposures

• Build local currency markets (Vienna Plus)

Remaining challenges

• Find appropriate regulatory framework

• Counter unavoidable rise in unemployment

• Shift from private to public sector crisis– Fill large fiscal gaps emerging (Ukraine, Latvia…)– Ensure fiscal burden of bailouts end up in the West

• Build local capital markets…

EC and ECB much needed EC to lead EU response, particularly on

fiscal issues; competition policy evolving ECB targeted liquidity support outside Euro

zone (see Denmark, Sweden or US Fed to Mexico, Brazil)

Reaffirm Euro entry objectives with clear timetable (no rule change) and

De-dollarise and develop domestic capital markets

Lessons

• Financial integration worked but must mitigate risks• Rebalance growth model: more domestic sources• Revamp cross-border collaboration: crisis model• IFI collaboration part of new financial architecture• European integration come out stronger from crisis

… but this is far from over - focus on the next steps…

Unfolding of the crisis in the region

sudden stop anno 2008: why emerging europe was different

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