T he current financial crisis: Eastern Europe and Russia

Jörg Mayer UNCTAD Study Tour for Russian Member Universities of the Vi Network Geneva, 13 April 2010 The current financial crisis: Eastern Europe and Russia

Overview • UNCTAD’s take on the crisis • Main transmission channels • Vulnerability to crisis • Dealing with adverse oil-price developments • Dealing with financial vulnerability • Accumulating foreign-exchange reserves • Regional monetary integration • Conclusions

1. UNCTAD’s take on the crisis • Faith in efficiency of deregulated financial markets created illusion of risk-free profits through speculative finance in many areas • Financial deregulation enhances the pro-cyclicality of financial markets (caused by pro-cyclical risk assessments by lenders and investors) • The absence of an international monetary system facilitates speculation on currency markets • The financialization of commodity futures trading has reinforced the proneness of commodity markets to overshooting

The subprime credit collapse highlighted the exposure to risk in many areas and triggered the unwinding of speculative positions in different markets The global financial crisis Commodity market Stock market Currency market Unwinding of speculative flows Subprime credit collapse

2. Main transmission channels • Trade (global economic slowdown): • Decline in global aggregate demand • Sharp decline in primary commodity prices • Finance (global deleveraging): • Sharp reduction in working capital credit and in cross-border lending to banks and non-financial firms causes difficulty in rolling over external debt • Hedge funds and institutional investors exit emerging markets • Depreciation of financial (e.g. equities) and real (e.g. in extractive industries) assets forces a rouble depreciation

3. Vulnerability to crisis • Integration of emerging economies in Europe into world markets largely based on: • Exports of primary commodities • Financial integration (large debt flows, foreign direct investment, increasing presence of foreign banks)

4. Dealing with adverse oil-price developments • The financialization of commodity trading makes price movements less predictable • Accumulating fiscal reserves (including abroad through stabilization funds) reduces de-industrialisation effects during upswings and increases the scope for expansionary fiscal policy during downswings • Issue of impact on exchange rate

Rouble REER and oil prices are linked Rouble exchange rates and oil price, Jan. 2000 – Jan. 2010

5. Dealing with financial vulnerability • The financialization of commodity trading makes price movements less predictable • Accumulating fiscal reserves (including abroad through stabilization funds) reduces de-industrialisation effects during upswings and increases the scope for expansionary fiscal policy during downswings

Emerging market bond spreads have risen sharply, but less than in 1997–1998 Emerging markets bond spreads, selected countries, basis points, 01/2003 – 04/2010

3. The sharply increased external indebtedness of firms and households • Low international interest rates and ample liquidity made portfolio managers look for new markets; • Improved risk rating of emerging markets following financial liberalization and sustained fast growth; • Firms choose foreign borrowing to finance investment if useful for managing exchange-rate risk (e.g. their cash inflows are in foreign currency); • Empirical evidence: mostly done by large firms in banking, infrastructure or extractive industry sectors.

Foreign borrowing by financial and non-financial firms strongly increased after 2001 Foreign borrowing by firms, selected regions, $ bn, 1999–2006

Risks of firms borrowing overseas • Fairly stable exchange rates may lead firms with cash inflows in domestic currency to hold unhedged foreign positions – vulnerable to depreciation; • Sudden decline in mineral and petroleum prices: • Reduced foreign-currency cash inflows; • Reduced value of collateralized assets in extractive industries • Reduced value of equity holdings in extractive industries • Sudden change in external financial conditions can make (short-term) liability positions unsustainable; • Balance sheets of banks that borrow overseas but lend to households for consumption, or in construction or other non-tradable sectors are subject to currency mismatch.

5a. Accumulating foreign-exchange reserves • Lessons of Asian and Russian crises in 1997-1998 include need to: • prevent vulnerability from currency and maturity mismatches in private balance sheets and external payments; • check financial and investment bubbles; • build adequate self-insurance against sudden stops and reversals of capital inflows through the accumulation of foreign exchange reserves at times of surges in capital inflows.

Russia’s foreign exchange reserves had strongly increased, but recently sharply declined Foreign exchange reserves, Russian Federation, 2000 – 2009

Large reserves cannot solve all problems • Foreign-exchange reserves are subject to exchange-rate risk and sterilized intervention may cause inflation; • Net amount of capital inflows can be reduced by allowing private capital outflows – but difficult to reverse when inflows stop; • Official reserves cannot prevent: • Currency and maturity mismatches in balance sheets; • Vulnerability to shocks associated with greater presence of foreigners in domestic asset markets; • Financial integration raises capital account volatility.

5b. Regional monetary and financial cooperation • Motivation: addresses risks stemming from volatility of (short-term) private capital flows, from wide swings in exchange rates, etc. • One way of dealing with financial openness is to “tie one’s own hands”: • Attaching firmly the own national monetary system to the monetary system of an important economy – dollarization, euroization; • Allowing the use of the dollar or the euro for some domestic purposes, for example for holding bank deposits; • Such measures put serious constraints on the independence of domestic monetary policy; • Regional monetary and financial cooperation may provide better results than national actions and help in dealing with shortcomings in international monetary and financial system.

Regional monetary and financial cooperation can take various forms and rely on different instruments • Provision of long-term financing through sub-regional development banks and regional bond markets (e.g. Asian Bond Market Initiative); • Short-term credit and payment mechanisms among member central banks, which reduce transaction costs and save foreign exchange; • Reciprocal balance-of-payments financing through swap agreements or the pooling of reserves; • Mechanisms to stabilize exchange rates, which may lead to monetary union (e.g. European Monetary Union).

Monetary union:stability conditions related to external accounts • Minimization of asymmetric external shocks (related to trade pattern of member states) • Avoiding divergence in external competitiveness (unit labour costs) among member states: • national nominal wages must grow in accordance to national productivity growth plus common inflation target

External imbalances of EMU member states have strongly increased since 1999

EMU trade imbalances are related to differences in wage developments

6. Conclusions • Impact of global economic slowdown depends on extent of trade and financial integration and scope for counter-cyclical, particularly fiscal, measures • Need for global monetary and financial rules and re-assessment of benefits of national and international financial liberalisation • Need to strengthen prudential regulation and supervision particularly to avoid currency and maturity mismatches by firms • Need to re-consider potential scope and benefits of regional monetary integration

Большое спасибоза вниманиеjoerg.mayer@unctad.org

T he current financial crisis: Eastern Europe and Russia