The Impact of the Current Financial Crisis on the Region of Central and Eastern Europe

Vladimír Dlouhý

seminar of the Informal Meeting of the EU Council Working Group on Export Credits

Prague, May 22, 2009Data source: World Economic Outlook, IMF, April 2009

GS Economic ResearchEurostatHaver AnalyticsWorld Bank

The world

Global framework (1)

US• Origin of crisis triggers: housing market, securitization

techniques, accommodative monetary policy• In the short-term, real economy suffered most (+

weakening the geopolitical position)Western Europe + developed Asia• Suffering from collapse of global trade + own financial

problems + (in some countries) need for housing market corrections as well

Emerging markets (notably CEE and emerging Asia)• Suffering from collapse of trade as well + problems

with access to external financing

Global framework (2)

• Deflationary dangers– Commodity prices remain weak– Wages and profits curtailed

• Public policies so far less efficient– Globally expected write-downs: 4 T (1012) USD

• Uncertainty - private capital not active– No issuance of new securities, limited bank-

related flows, bond spreads up, equity prices down, depreciation of many of EM currencies

– Flight to safety: USD, Euro, Yen appreciated, as well as pegged currencies (Rmb)

Outlook - data

2009 2010World -1.3 1.9Advanced economies -3.8 0.0Emerging and Dev.Ec. 1.6 4.4USA -2.8 0.0Euroarea -4.2 -0.4CEE -3.7 0.8Japan -6.2 0.5China 6.5 7.5India 4.5 5.6

Outlook - risks (1)

• Financial stabilization - longer than expected– Developed economies: slow-down in credits BOTH

in 2009 and 2010– EM: curtailed access to external financing

• Existing policies will continue– Monetary: interest rates 0 and monetary easing

via central banks’ B/S– Fiscal stimulation: G20 2% GDP in 2009, 1.5% GDP

in 2010

• Truly global crisis– Commodity prices will remain week– Negative growth will cover about 75% of global

economy

Outlook - risks (2)

• Policies not efficient enough or even counterproductive– Low fiscal multipliers– Monetary easing and capitalization of financial

institutions slow down in deleveraging

• Both for financial institutions and corporate sector, risk on the downside– Estimated need for recapitalization of banks - US:

275-500 BUSD, Europe (with UK): 475-950 BUSD, UK: 125-250 BUSD

– Rising corporate and housing defaults further fall asset prices and losses across corporate B/S’s

• Danger of trade and financial protectionism

Outlook - risks (3)

• Financial restructuring– Dealing with distressed assets– What are weak, but viable institutions?– EM: corporate sector faces much higher risk from

collapse of financial sector

• Monetary policies– Specific for EM, fragile financial flows,danger of

sudden stops, much more careful easing

• Fiscal policies– Short-term efficiency?

• Prevailing view: yes

– Medium-term sustainability: budget deficit, inflationary pressures

European Union

Main facts• Deeper and longer recession• Both industrial production and exports still

suffer• Increase of unemployment to the level close

10%• Core inflation beyond 1%• Paradox: “well behaving” countries, with

strong export potential, suffer most (Germany)• Signs of improvement (PMI, etc.)?

– Too early to call– Be realistic

Background for realism (1)

Industrial production, %, q-o-q

-20

-15

-10

-5

0

5

10

Jan-97 Oct-98 Jul-00 Apr-02 Jan-04 Oct-05 Jul-07 Apr-09

Private consumption, %, q-o-q

-2

-1

0

1

2

3

4

5

Jan-97 Oct-98 Jul-00 Apr-02 Jan-04 Oct-05 Jul-07 Apr-09

Real GDP, %, q-o-q

-5

-4

-3

-2

-1

0

1

2

3

4

5

6

Jan-97 Oct-98 Jul-00 Apr-02 Jan-04 Oct-05 Jul-07 Apr-09

Fixed investment, %. q-o-q

-15

-10

-5

0

5

10

Jan-97 Oct-98 Jul-00 Apr-02 Jan-04 Oct-05 Jul-07 Apr-09

Background for realism (2)

CPI, %, yoy

-0.5

0

0.5

1

1.5

2

2.5

3

3.5

4

4.5

Jan-97 Jul-98 Jan-00 Jul-01 Jan-03 Jul-04 Jan-06 Jul-07 Jan-09 Jul-10

Unemployment, %, quartely

5

5.5

6

6.5

7

7.5

8

8.5

9

9.5

10

Jan-97 Jul-98 Jan-00 Jul-01 Jan-03 Jul-04 Jan-06 Jul-07 Jan-09 Jul-10

Government balance, %GDP

-6

-5

-4

-3

-2

-1

0

1

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Current Account, %GDP

-1.5

-1

-0.5

0

0.5

1

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Exports collapse

-15

-10

-5

0

5

10

15

20

Mar-95 Sep-96 Mar-98 Sep-99 Mar-01 Sep-02 Mar-04 Sep-05 Mar-07 Sep-08 Mar-10

-3

-2

-1

0

1

2

3

4

5

6

Global domesticdemand

Euroland exports (rhs)%, yoy

%, yoy

Forecast

Outlook for 2009 - dataselected countries

2009 2010Germany -5.6 -1.0France -3.0 0.4Italy -4.4 -0.4Spain -3.0 -0.7Netherlands -4.8 -0.7Ireland -8.0 -3.0Greece -0.2 -0.6Portugal -4.1 -0.5UK -4.1 -0.4Sweeden -4.3 0.2Switzerland -3.0 -0.3

Background: banking sector

• Bank's losses and over-leveraging self-protecting tightening of credits, well

beyond a cyclical one

• Extraordinary reaction to shore up confidence in banking system so far without effect

• Financial conditions to stay tight for whole 2009 and first half of 2010

• German and Austrian banks?

Credits: loans and securities(bn Euro, net monthly flows)

-20

0

20

40

60

80

100

120

140

Jan-99Jul-99Jan-00Jul-00Jan-01Jul-01Jan-02Jul-02Jan-03Jul-03Jan-04Jul-04Jan-05Jul-05Jan-06Jul-06Jan-07Jul-07Jan-08Jul-08Jan-09Jul-09

Background: fiscal and monetary policies

• Fiscal policies:– Strong automatic stabilizers dampening downturn -

contribution to growth: +2.4 pp in 2009, +0.4pp in 2010

– Discretionary: fiscal packages in several EU countries

• Monetary policies:– ECB cutting down– Considering unconventional easing

Central and Eastern Europe

CEE Region

• All countries - similar features of past 5 years of economic development: fast growth– driven by external demand– with deficits and often debt (of households,

corporation and governments) financed from external resources

• in many countries the situation substantially worse than in CZ: deficits, debts, reliance on external financing, loans in foreign currencies, vulnerability of banking sector, distortion of industrial structure, mandatory budget expenditures, etc.

• Global markets until recently, unified view on the region– Not distinguishing enough among the countries– General view influenced by the worst performing

country (“contagion” danger)

Crisis - two basic facts (1)

1. External shock slow-down of economic growth• Fall of demand for exports• Lower profits, lower wages decline of

consumption• General consequences of global financial crisis

– uncertainty investment decline (including sharp decline in FDIs)

– Collapse of equity markets– Banking sector problems, „almost“ credit crunch– Unemployment, social consequences, etc.

Crisis - two basic facts (2)

2. Macroeconomic destabilization• Lack of confidence, danger of “sudden stop” of

external financing sustainability of (even short-term) debt

• NPL share in domestic banks has dramatically increased (with notable exception of some countries, namely CZ) impact on large, Eurozone based banks

• Dramatic decline of capital inflow in general• In some countries an outflow simultaneously

Short-term consequences

• October 08 - March 09: speculation on destabilization of some CEE economies + unnecessary media hysteria with quite unfortunate consequences– Depreciation of all floated currencies in the region– Real economy adjustment more pronounced for

economies with pegged currencies (SK, SLO less so)

– Problems of some short-term governmental bonds issue, increase of spreads

– All this at quite low inflation• Slow pass-through into prices + decrease of commodity

prices

Economic policy difficultiesContradictory requirements on economic policy• General impact of the crisis:

– Monetary easing (including so called non-traditional steps)

• Region's Central Banks could have - at the beginning - decreased interest rates disregarding the depreciations (on the contrary, some positive effects on exports)

• Fiscal policy pressure (higher social expenditures, automatic stabilizators, calls for fiscal incentives)

– Generally: anti-cyclical policies required

• Short-term destabilization:– Very restricted space for increase of deficits, but even -

at least within past weeks - for monetary easing as well

Selected data (and what they imply)

• Region has better basic macro-parameters than most of Eurozone countries (with important exceptions)

• CEE is not a consistent group of countries• Different countries suffer with different level of

economic vulnerability• Sub-group of Eurozone (IRL and a so-called

”southern flank”) - reveal an extreme worsening of basic macroeconomic forecasts– However, risks covered by Eurozone

Basic forecasts 2009

HDP % PubFinDef State debt CurrAcc Inflation Unemplom.%GDP %GDP %GDP CPI, % %

CZ -3.5 -3.0 29.4 -2.7 1.0 8.2PL -0.7 -4.1 47.7 -4.5 1.8 11.0SK -2.1 -2.8 30.0 -5.7 2.0 11.5SI -2.7 -3.2 24.8 -4.0 0.5 6.2H -3.3 -2.9 73.8 -4.0 4.2 9.1RO -4.1 -7.5 21.1 -9.0 4.5 6.1BG -2.0 -0.5 12.2 -14.1 2.0 7.4EST -10.0 -3.2 6.1 -5.7 -0.5 11.8LAT -12.0 -6.3 30.4 -6.5 -1.0 10.3LTU -10.0 -3.0 20.0 -7.0 1.5 15.7

Real GDP growth, %forecast 2009

-14

-12

-10

-8

-6

-4

-2

0EuroD F NL UK CZ PL SK SI IRL GR E I P H RO BG ESTLATLTU

General Government Balance% of GDP, forecast 2009

-14

-12

-10

-8

-6

-4

-2

0EuroD F NL UK CZ PL SK SI IRL GR E I P H RO BG ESTLATLTU

Government Debt, % of GDPforecast 2009

0

20

40

60

80

100

120

EuroD F NL UK CZ PL SK SI IRL GR

E I P H RO BG EST LAT LTU

Current Account, % of GDPforecast 2009

-16

-14

-12

-10

-8

-6

-4

-2

0

2

4

Euro

D FNL UK CZ PL SK SI

IRL GRE I P H

RO BG ESTLATLTU

Region‘s vulnerability• At some countries (Baltics, H, but to some extent RO

and BG as well) lack of credibility still prevails– Short-term debt sustainability more important than basic macro-

parameters– „Sudden stop“ fears

• Market sentiment to much extent determined also by countries outside EU (Ukraine, Turkey)

• Recent weeks - stabilization– International institutions ready to provide support– Risks still exist– Uncertainty around large banks in the region (Erste, KBC,

Unicredit, Raiffeisen, …)

• Useful (despite many differences) comparison with selected south-Asian countries prior to 1997-8 crisis

Credit tightening• Lower Central Banks’ rates did not translate

into lower borrowing costs• On the contrary

– Credit cycle turned swiftly down, no bottom in sight

– Lending rates increased

• Demand or supply credit shock?– Supply!– Reasons: sharp increase of NPLs and tighter

external funding

• Czech banks probably positioned best in the whole region, but credit tightening will continue in CZ as well

CEE: Proportion of loans, denominated on FX

0

10

20

30

40

50

60

70

80

90

100

Czech RepCroatia Russia Poland

KazakhstanBulgariaRomaniaUkraineHungaryLithuania

Estonia Latvia

CDS spreads

0

100

200

300

400

500

600

700

800

900

1000

10/25/05 4/25/06 10/25/06 4/25/07 10/25/07 4/25/08 10/25/08

Czech Hungary Poland Slovakia Estonia Latvia Lithuania

Sharp depreciation in CEChart 1: Depreciations in the CE3 have

been sharp

80

90

100

110

120

130

140

150

160

00 00 01 01 02 02 03 03 04 04 05 05 06 06 07 07 08 08 09

Jan 1 2000=

CZK (Real TWI)HUF (Real TWI)PLN (Real TWI)

Depreciation

Source: GS Global ECS Research

External debt, % of GDPAsia 1996, CEE 2008

0

20

40

60

80

100

120

140

160

S KoreaRussiaMalaysia

Czech RepRomaniaIndonesia

PolandUkraineThailandSerbia

LithuaniaSlovakia

Kazakhstan

CroatiaHungaryBulgariaEstoniaLatvia

% of GDP

Source: GS Global ECS Research, Haver Analytics

Current account, % of GDP Asia 1996, CEE 2008

-30

-25

-20

-15

-10

-5

0

5

10

15

Russia

KazakhstanSlovenia

Czech RepIndonesia

South Korea

MalaysiaPolandUkraineSlovakiaHungaryThailandEstonia

RomaniaLithuaniaLatvia

Bulgaria

% of GD

Current accountNBoP*

Europe (year to 3Q 08) and Asia (1996) * Narrow Balance of Payments = CA + Net FDISource: Goldman Sachs, Haver Analytics, WB

Conclusions for region (1) • Different level of stability

– Some countries (CZ, PL) very solid short-term debt sustainability

• Vulnerable industrial structure– Sluggish export demand beyond January 1, 2010

• Credit tightening will continue– Despite historically low Central Banks’ interest rates

• GDP contraction from around -1% (PL, SLO) to more than -10% (Baltics), low inflation, substantial increase of unemployment– Regional and structural differences

• Currencies - depend on stability in the region and potential “contagion” effects– The fate of pegs?

Conclusions for region(2)

• Still possible adjustment on equity markets– Autumn 2009?– Forced sales

• Both 2009 and 2010: Government Balance and Current Account probably beyond Maastricht criteria– Much better than most of EU countries– Is it a problem?– Link to Euro

• Momentum for medium-term reforms?

Economic policies (1)

• Solution to today‘s crisis is outside CEE– Mostly small open economies, dependent on the re-start of

Eurozone economic growth– Stabilization and adjustment homework in countries that are

most unstable

• Crucial role - Central Banks– Monetary policies, facing contradictory requirements– Regulation and supervision

• Fiscal policies - contradictory pressures again– Political pressure to increase expenditures - stimulative, social,

etc.• For some countries , violation of Masstricht criteria is not - in the

short-term - any tragedy• In other group of countries, Maatricht can serve as a political

imperative to defend adjustment policies

– On the other hand, for all countries, the „contagion“ danger is not over - macroeconomic stability requirements should prevail

Economic policies (2)

• Short-term measures:– Danger of politicization– Demand-side stimulation

• Efficiency?– Only when there are no doubts– Infrastructural projects - yes, but time-lags problem – Future deficits

– Supply-side policies• Yes, but even here time-lags danger• Opportunity to pursue the reforms

– Problem of political will

– Social policies - targeted to affected groups and regions

Economic policies (3)

• In multilateral framework:– Avert trade protectionism

• All available resources to foster trade

• Trade financing is crucial

• Insurance and guarantees of trade and financial risks

– Crucial: EU policies towards banking sector and impact on behaviour of banks present in the region

– Adjustment policies in problem countries– Active discussion on Euro - potential anchor for

expectations• Maastricht's criteria - for another countries and another

time

Thank you