Dealing with V olatile Capital Flows – the central bankers’ perspective

1. Dealing with Volatile Capital Flows – the central bankers’ perspective Maja Kadievska-Vojnovik, MSc Vice-governor National Bank of the Republic of Macedonia Sarajevo, June 6, 2014

2. Content • External funding structure in SEE countries • Crisis effects - capital flows volatility • Macroeconomic policy measures • Potential risks and vulnerabilities • Policy priorities

3. 1. External funding structure in SEE (1) • Both Southeastern European EU members (SEE-EU) and SEE non-EU countries are almost equally dependant on FDI and cross-border lending, with each accounting for 50-60% of their respective GDP • Portfolio investment is less important, and consists mostly of sovereign bonds • European Union countries are the main foreign creditors (90%)

4. 1. External funding structure in SEE (2) • High reliance on foreign funding makes the SEE region sensitive to changes in external financial conditions, as well as to rollover and FX risks (having in mind the high level of financial euroization in the region) • The SEE-EU and SEE non-EU countries are highly financially opened, with gross external debt between 40% up to 120.4% of GDP SEE- non EU SEE-EU

5. 2. Crisis effects - capital flows volatility • Gross capital inflows to Emerging Europe* have declined strong in 2008, and again in 2013. • The key driver of the recent reverse trend in gross capital inflows were higher U.S. returns, that were pushed up by the “taper talk” *Turkey, Poland, Romania, Hungary, Bulgaria, Serbia, Croatia, Lithuania, Albania, Bosnia and Herzegovina, Kosovo, Macedonia, and Montenegro

6. 2. Crises effects - capital flows volatility– impact through CA channel – • The SEE countries were hit hard by the global financial crisis in 2008-2009, as exports shrunk due to collapse in the global trade. • After a brief recovery, in 2012 there was a renewed slowdown as the region felt the effects of the euro area crisis but, the slowdown was far less dramatic than in 2009.

7. 2. Crises effects - capital flows volatility – impact through CA channel – • Some of the SEE countries depend significantly on income transfers as external funding source.... • ....but, this exposes countries to economic conditions in Diaspora’s host countries

8. 2. Crisis effects - capital flows volatility – impact through financial channel – • Remarkable increase in financial inflows to developing countries implied investment and growth opportunities in “normal” times... • ...but, it also amplified the transmission of global financial shocks, when financial inflows fell abruptly.

9. 2. Crisis effects - capital flows volatility – impact through financial channel – • The sharp tightening of the financial conditions on the global markets after 2007 resulted in decreasing of FDI in the SEE. • In such circumstances, SEE countries mostly relied on official borrowing as a source for external funding.

10. 2. Criss effects - capital flows volatility- Countries risks - • Revisions occurred in credit ratings of the SEE countries during the financial crisis in 2009 and economic and sovereign crisis in 2011

11. 2. Crisis effects - capital flows volatility - public finances under pressure - • The public debt went on a rising track, contributing to external vulnerabilities build-up. • As governments of SEE countries were undertaking discretionary fiscal stimulus to support economy, the fiscal balances deteriorated sharply. • Fiscal policies are under pressures as the countries struggle to reduce their budget deficits or to comply with loan requirements by the IMF. • In Macedonia, fiscal policy was actively used to give impulse to economic growth, through large-scale public investment projects.

12. 2. Crisis effects - capital flows volatility – impact through banking/credit channel – • As capital flows fell in 2008, decline in available financing particularly from parent banks was registered and credit conditions tightened significantly.

13. 2. Crisis effects - capital flows volatility – impact through banking/credit channel – • Worsened economic outlook pushed credit markets into bust cycle and triggered a rise in NPL`s. • Sound initial conditions (high capitalization levels), traditional banking model and low exposure to riskier financial instruments contained direct spillovers during the early stage of the crisis. Vienna Initiative –helped countries to avoid a massive and sudden deleveraging by cross-border bank groups.

14. 3. Macroeconomic policy measures Allow exchange rate depreciations Prudential measures Macroeconomic policy measures Stricter capital requirements FX interventions Increase interest rates Limits on bank`s open FX position Easing capital inflow regulation Counter cyclical fiscal policy Temporary restriction on capital outflow Source: World Bank

15. 3. Macroeconomic policy measures - interventions on FX markets - • Different impacts on FX markets among SEE countries: • In countries with floating exchange rate, currency depreciation was allowed in order to mitigate the impact on crisis. • In countries with fixed rates, interventions on the FX market enabled stability of domestic currency.

16. 3. Macroeconomic policy measures - monetary policy responses - • From the conventional measures almost all countries adopted easing cycle of interest rates of the monetary policy. • However, in some countries major consequence of the limitations faced by monetary policy, macro prudential measures (mostly in RR) were extensively employed by all SEE countries to address inflation and financial stability risks.

17. 3. Macroeconomic policy measures – case of Macedonia – In recent years, NBRM undertook few changes in the RR structure in order to address some structural issues in the Macedonian economy and banking system:

18. 3. Macroeconomic policy measures – case of Macedonia – Source: NBRM Source: NBRM

19. 4. Potential risks and vulnerabilities • While a large share of FDI in total external financing for the region provides a degree of stability, high reliance on foreign funding exposes countries to external shocks • Sizable gross external debt and rollover needs • Foreign currency exposure compounded by a high degree of euroization of the domestic financial system • Countries tend to borrow from relatively few common creditors and some depend on income transfers • Vulnerabilities may stem from three sources-stock, flow, and external fundamentals Source: CESEE REI SPRING 2014

20. 5. Policy priorities • “Lessons” in coping with sudden stops in capital inflows • Monetary and exchange rate policies can and should be used during episodes of market volatility. • Preventive measures (such as securing external credit lines) and targeted liquidity provision could be helpful. • Structural priorities for SEE economies: • Most countries still need to address crisis legacies, including high levels of NPL`s. • Strengthening fiscal positions without jeopardizing the ongoing economic recovery. • Boost growth potential through structural reforms. • Greater use of macroprudential tools to prevent external vulnerabilities building up again and to improve external funding structure.

21. THANK YOU FOR YOUR ATTENTION http://www.nbrm.mk VojnovicM@nbrm.mk