Pradeep Mitra, Marcelo Selowsky and Juan Zalduendo November 3, 2009 Book Launch World Bank

1. Pradeep Mitra, Marcelo Selowsky and Juan Zalduendo November 3, 2009 Book LaunchWorld Bank Washington, D.C.

2. The Questions • Why were transition countries hit generally harder by the crisis of 2008―2009 than developing countries, but why not all financially integrated transition countries? • How has the nature of ECA’s financial integration shaped the recovery? What has been the role of international collective action? • How should debt restructuring in banks, corporations and households be expedited to aid the recovery? • How can the poorer countries of the region be best supported? • What structural reforms are needed today to address the most binding constraints to growth in a world where capital flows to transition and developing countries are expected to be considerably lower than before the crisis?

3. Why transition rather then developing countries generally? Demand side • Fast consumption catchup by households (housing, durables) in countries that were late comers to the transition (the Baltic states, Kazakhstan, Russia, Ukraine) and those with double transition recessions (Bulgaria, Romania); • Ability to borrow in foreign currency at low interest rates and long maturities. Supply side • 2003-2006 was a period of historically high global liquidity; • Fierce competition in international banking; • Expectation that borrowers would join the euro area at a fixed rate for peggers and at an appreciated rate for floaters made foreign currency lending profitable. Result: Together these led to excessive growth in private sector credit and serious current account imbalances and vulnerability to reversal in market sentiment.

4. But why not all ECA’s countries even among the financially integrated? What role for policy? Monetary policy was limited by choice of exchange rate regime, but also by global liquidity, and active sterilization of foreign assets, by magnifying interest differentials, would have stimulated even more capital inflows from Western Europe. The limits of monetary policy and prudential measures argue for a stronger role for fiscal policy, and not only in countries with fixed exchange rates. Against the backdrop of an open capital account and abundant global liquidity, fiscal policy—adjusted for the business cycle—should play a stabilizing role in the face of external imbalances even when these are not of public origin. Quite the opposite policy stance was however observed in some vulnerable countries where fiscal policy was pro-cyclical. Fiscal policy alone would not necessarily have insulated countries from the crisis, but it could have made them less vulnerable to a reversal in market sentiment. Prudential measures would eventually have been circumvented: yet putting “sand in the wheels” in the face of massive capital inflows was tried and is worth doing (e.g. increased risk weights for housing loans for capital adequacy ratios, regulations on loan classification, indicative credit growth thresholds, liquidity-asset ratios distinguishing between loan currencies and maturities, varying reserve requirements).

5. Not all funding sources are equally stable in the crisis • Rolling over maturing external debt has so far been easier for crisis-hit countries with majority foreign-owned banking sectors. • Crisis-hit countries with majority domestic-owned banks that are more reliant on volatile wholesale funding face greater rollover difficulty. • This was determined by choices made earlier during the first decade of transition on how to privatize the financial sector. Foreign banks helped harden budget constraints and attain macroeconomic stability and are a distinctive feature of ECA’s financial integration. • At the other extreme, countries with convergent credit growth and predominantly reliant on resident deposit funding―the Czech and Slovak Republics, Poland, and Turkey (a non-transition country)―have so far come through the crisis in better shape.

6. International collective action … adequate so far but must continue • International collective action comprising official financing more generous than in the East Asia crisis, and the European Banking Coordination (Vienna) initiative to ensure that Western European parent banks maintain their exposure to ECA countries and capitalize their banks, has been adequate so far. • The need to reduce overleveraging in Western European parent banks and fully recognizing their estimated losses could cause them to reduce exposure to ECA countries. Since such deleveraging will be necessary and inevitable as banks move resources to countries with more favorable lending opportunities, collective action should continue to ensure such deleveraging remains orderly and gradual. • Collective action by Western European parent banks is less of an option for ECA countries such as Kazakhstan, Russia and Ukraine that do not have majority foreign-owned banking sectors. Their greater reliance on wholesale funding makes it particularly important to calibrate the openness of the capital account to the strength of domestic financial sector institutions and to ensure that monetary, fiscal and prudential measures limit the transmission of risks from international financial markets.

7. The growth outlook is difficult • First, when compared with other types of recessions, those associated with financial crisis that are globally synchronized • witness declines in real GDP from the previous peak to the new trough that are deeper; • take longer to arrive at the new trough; and • require more time for real GDP to recover from the new trough to the previous peak. This is because households increase savings out of disposable income and firms repair their balance sheets, implying deep declines in private consumption and investment. • Second, reducing the excessively high leverage of Western European banks and fully recognizing their writedowns may constrain the ability of fiscally strapped Western European governments to capitalize them fully, leading inter alia to deleveraging, including from ECA countries. • Third, even after world economic growth restarts and Western European banks return to health, pre-crisis growth rate are unlikely since those were underpinned by abundant global liquidity.

8. Slow debt restructuring could further delay recovery Non-performing loans (NPLs) are signaling systemic distress (reportedly between 15 and 25% in Latvia, Ukraine in 2009 Q1, still lower than in East Asian and Latin American capital account crises)—and particularly high in some sectors (construction, retail). Avoid zombie banks and discourage regulatory forbearance; triage banks into those that are (i) viable and meet regulatory requirements; (ii) nonviable and insolvent; and (iii) viable but undercapitalized. Appropriate actions range from liquidation, sale, merge and recapitalization. Establish enabling frameworks for debt restructuring—household and nonfinancial corporate debt difficulties need to be addressed upfront to strengthen the recovery. With some exceptions, indebtedness of non financial corporations is not high. On average, household debt—a distinctive feature of ECA’s crisis—is around 25% of GDP among financially integrated transition countries; not out of line with that of countries at similar stages of development but here too there is variability—10% of GDP in Russia to 50% in Estonia.

9. Household debt: incidence of mortgage interest service • The share of indebted households increases in the higher quintiles. Mortgage interest service as a share of income is small and generally decreases with income. • The shock is an increase of 5 percentage points in the interest paid on mortgages with variable interest rates. • The interest rate shock increases the share of vulnerable households and raises the interest service ratio. Note that Hungary has a large share of vulnerable households in lower quintiles, reflecting a more even distribution of households with mortgage debt. • About half of indebted households in Estonia and Hungary in the first quintile were vulnerable even before the shock. But very few of there are at risk due to the shock, being risky borrowers at loan origination. • Set up enabling frameworks but resist calls for the use of public resources other than for the relief of the poorest households.

10. The low and lower middle-income CIS countries in crisis Crisis hit the low and lower middle income CIS countries through: • Recession-induced downturn in exports to Russia (for Armenia, the Kyrgyz Republic, Moldova, Tajikistan), Kazakhstan (for the Kyrgyz Republic), Turkey, EU and USA (for Georgia)1/; • Sharp fall in workers’ remittances. Example: A 30 percent decline in remittances to Tajikistan reduces the consumption of the poorest quintile of households by around 20 percent. 1/ Georgia is not part of the CIS but is included in the group because its economy shares many features of the other countries.

11. Official financing in support of targeted safety nets Many countries (including poorer countries such as Armenia, Georgia and the Kyrgyz Republic) have means-tested programs with desirable properties. Well-targeted safety nets should be scaled up. Where they do not exist, new poverty-focused programs should be introduced, untargeted privileges eliminated and design and eligibility criteria refocused. Official financing in the poorer ECA countries should be stepped up to support desirable social spending if expected private flows do not materialize and continue till a durable recovery is in place.

12. Infrastructure and labor skills constraints must be addressed to stay competitive On the eve of the crisis, 10,000 firms in 28 transition economies (TEs) were asked (BEEPS, 2008) which elements of the business environment—taxation, labor regulation, customs administration, infrastructure, labor skills, licensing, the rule of law, finance—were the most problematic for the operation and growth of their businesses. Because all of these elements, with the exception of finance, resemble public goods whose supply is common to all firms in the economy, firms’ responses are a measure of the cost imposed on the operation and growth of their businesses. Their responses are compared with those of 51,000 firms in 74 non-transition economies (NTEs) under the World Bank’s Investment Climate Assessments. Two decades since the fall of the Berlin wall, the superior endowment of infrastructure and labor skills with which countries started transition is now gone. And these are now the tightest constraints to growth. Urgent reforms are needed in these sectors―and described in the book―if countries are to stay competitive in a world where capital flows are likely to be lower. Note: The vertical axis is a measure of the reported severity of the constraint.

13. And progress in building market economy institutions is mixed Institutions of the market economy, such as tax administration and customs regulations, which had ranked high among concerns in TEs, are seen as less constraining for business and have fallen in line with NTEs at similar per capita incomes. However, strong economic growth appears to have increased the cost of weak market economy institutions such as the legal environment in the lower middle-income TEs and concerns regarding corruption have increased in the low-income and lower middle-income TEs, apparently reversing a trend of improvement in both elements of the business environment observed till 2005.

14. CONCLUSIONS • Excessive credit growth was fed on the demand side by households attempting to catch up to Western Europe living standards in countries that had suffered deep or double transition recessions. In that sense, transition partly shaped the nature of vulnerability. On the supply side, the ECA countries were integrating into the world economy at a time of historically high global liquidity, where fierce competition in international banking provided an abundant supply of credit to emerging market economies. However, countries could have done more to manage risks: in particular, fiscal policy could have played a greater role in limiting vulnerability to a change in market sentiment. • Crisis-hit countries with majority foreign-owned banking sectors have so far been able to roll over maturing external debt to parent banks more easily than those with majority domestic-owned banking sectors, which relied more heavily on wholesale funding. The decision to privatize banks to foreign investors had been taken during the first decade of transition to harden budget constraints and attain macroeconomic stability and is a distinctive feature of ECA’s financial integration. International collective action comprising generous official funding and coordination by parent banks to maintain exposures has been adequate so far but collective action will need to continue to make deleveraging, as banks move resources to countries with more favorable lending opportunities, orderly and gradual.

15. CONCLUSIONS • The growth outlook for the region is weak as firms and households repair their balance sheets after the excesses of the boom years. Non-performing loans in ECA’s banks are signaling systemic distress. Banks need to be divided into those that are (i) viable and meet regulatory requirements; (ii) nonviable and insolvent; and (iii) viable but undercapitalized and, as appropriate, liquidated, recapitalized, sold and merged rapidly, and regulatory forbearance discouraged to avoid the emergence of zombie banks. Governments should set up inability frameworks for households and corporate debt restructuring but resist using public resources, since household debt is typically not concentrated among poorer households. • The poorer countries of the former Soviet Union have been hit mainly by a downturn in exports and declining remittances. Official financing for a number of years will be necessary to scale up well-targeted safety nets where they exist and introduce poverty focused programs where they do not. • Infrastructure and labor skills―the positive legacy of socialism―have emerged not only to be the tightest bottlenecks to the operation and growth of firms but, remarkably, are also more constraining then in nontransition economies at similar income levels. These sectors require urgent reform if countries are to stay competitive in a world where financial markets are already differentiating across countries and capital flows are likely to be considerably lower than before the crisis. Substantial progress has been made in building institutions of the market economy but more remains to be done.