Sudden Stop anno 2008: Why Emerging Europe was different

1. Sudden Stop anno 2008: Why Emerging Europe was different Erik Berglof Chief Economist European Bank for Reconstruction and Development

2. Sudden Stop anno 2008: Emerging Europe was different Percentage changes in external assets of BIS-reporting banks

3. 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

4. Outline Financial integration and the European transition model: introduction Did financial integration have any tangible benefits? What role did financial integration play in the transmission of the crisis? Did financial integration generate macro-financial vulnerabilities? Policy Response and Lessons

5. 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

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

7. Financial integration has been rapid, with a boom period from 2004 onwards. External assets and liabilities as a share of GDP

8. In CEB and SEE, financial integration has been led by foreign banking groups Foreign bank asset share, 1998-2008 Foreign bank asset share, end-2008

12. Outline Financial integration and the European transition model: introduction Did financial integration have tangible benefits? What role did financial integration play in the transmission and magnitude of the crisis? Did financial integration generate vulnerabilities that aggravated the crisis? Policy Response and Lessons

13. 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

14. Growth in transition has been associated with capital imports—unlike other regions Current account balance, per cent of GDP (simple average)

15. Rising current account deficits have reflected mainly higher investment

16. In non-transition developing countries, CA surpluses correlated with higher growth Non-transition sample Transition sample … but not in the European transition region.

17. 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

18. 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

19. 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)

20. Conclusion (1): Financial integration had tangible growth benefits in the EBRD region • Supported by econometric tests using several methodologies • Magnitude is economically significant

21. Financial integration and the European transition model: introduction Did financial integration have tangible benefits? What role did financial integration play in the transmission and magnitude of the crisis? Did financial integration generate vulnerabilities that aggravated the crisis? Policy response and lessons Outline

22. Financial integration was one of the conduits of the international crisis… But outflows were comparatively modest in parts of the region Percentage changes in external assets of BIS-reporting banks

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

24. …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.

25. 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.

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

27. However, external debt levels are a robust predictor of worse output declines in crisis Both effects hold up when considered jointly, and with other controls.

28. Conclusion (2): Financial integration had a mixed direct role in the crisis • Provided a conduit for financial shocks; (obvious: in financial autarky, no contagion) • Some aspects of financial integration made the crisis worse: external debt • However, foreign bank presence mitigated the output decline • Interpretation: foreign banks buffered the financing shock because of commitments to subsidiaries.

29. Outline Financial integration and the European transition model: introduction Did financial integration have tangible benefits? What role did financial integration play in the transmission and magnitude of the crisis? Did financial integration create vulnerabilities that aggravated the crisis? Policy response and Lessons

30. Financial integration and crisis vulnerabilities: potential channels Led to higher private external debt: a direct expression of financial integration Did financial integration fuel credit booms? Higher output declines (cf. private external debt) 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

31. Capital inflows strongly correlated with credit growth during 2005-08

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

33. Did financial integration contribute to (excessive) credit booms?

34. Did financial integration encourage FX lending?Background • Standard causes of “liability dollarisation”: • Low monetary policy credibility and/or high inflation volatility; • 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.

35. Foreign bank presence is correlated with a higher share of lending in FX (but so is L/D ratio, and various other measures of foreign financing)

36. Did financial integration encourage FX lending? Approach: • 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 • Test robustness using macro data for same period • LHS variable is FX share of bank lending • Macro regression over longer (2000-2008) period.

37. 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

38. 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

39. Outline Financial integration and the European transition model: introduction Did financial integration have any tangible benefits? What role did financial integration play in the transmission of the crisis? Did financial integration generate macro-financial vulnerabilities? Policy response and Lessons

43. 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

44. The magnitude of official support unprecedented Official support (percent of GDP)

45. …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

46. 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…)

47. 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)

48. 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…

49. 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

50. 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…