Financial Crisis and Consequences

1. Financial Crisis and Consequences Vladimir Gligorov wiiw Spring Seminar 2009 27 March 2009, Vienna

2. Causes of Current Crisis Lax monetary policy: low interest rates and strong credit expansion Global imbalances Deficit countries in Central, Eastern and South-eastern European Countries In the Balkans: low export capacity

3. Monetary policy

4. Boom-bust in housing starts compared with the counterfactual

6. Why contagion? • A more cautious banking sector puts the brakes on funding of • Private consumption, private investment, exports and imports • Real estate transactions • Investors in financial markets have become more risk-aware; the destination and composition of flows have changed to the disadvantage of emerging markets

7. 1. Evidence from most recent developments Decline in industrial output Decline in foreign trade Decline GDP Decelerated inflation Real depreciation (not everywhere)

8. Industrial output declineRates of change in %, monthly, year-on-year Candidate countries Potential candidates 40.9 Source: wiiw Monthly Database incorporating national statistics.

9. Exports of goods: decline after mid-2008 EU candidate countries, euro-based, January 2006 = 100 Source: wiiw Monthly Database incorporating national statistics.

10. Exports of goods: decline after mid-2008 Potential candidate countries, euro-based, January 2006 = 100 Source: wiiw Monthly Database incorporating national statistics.

11. GDP - shift from expansion to contraction Candidate countries, change in %, annual, year-on-year* Macedonia Turkey Croatia * 2008 wiiw estimate, 2009 wiiw forecast Source: wiiw Annual Database incorporating national statistics.

12. GDP - shift from expansion to contraction Potential candidate countries, change in %, annual, year-on-year* Montenegro Serbia Albania BA * 2008 wiiw estimate, 2009 wiiw forecast Source: wiiw Annual Database incorporating national statistics.

13. Decelerating inflationCPI, monthly, change year-on-year in % 16 * wiiw forecast Source: wiiw Monthly Database incorporating national statistics.

14. Exchange rate nominal Exchange rate real Currency Board or euro as legal tender:Producer prices vis-à-vis EU: mainly upEUR per unit of national currency, Jan 2007 = 100 Source: wiiw Monthly Database incorporating national statistics.

15. Countries with de-facto EUR pegProducer prices vis-à-vis EU: various patternsEUR per unit of national currency, Jan 2007 = 100 Exchange rate nominal Exchange rate real Source: wiiw Monthly Database incorporating national statistics.

16. Exchange rate nominal Exchange rate real Countries with flexible exchange rate: Producer prices vis-à-vis EU: strong reversal EUR per unit of national currency, Jan 2007 = 100 Source: wiiw Monthly Database incorporating national statistics.

17. 2. Imbalances Imbalances: Fiscal imbalances less alarming – so far Alarming external deficits

18. Relatively low government deficits, government debt and overall external debt in % of GDP, 2008 * External debt at end of 2007 Source: wiiw Database incorporating national statistics.

19. Imports of goods: intensity and coverage by exportsin % of GDP, 2008 Source: wiiw Annual Database incorporating national statistics.

20. -1 5 11 2 8 4 6 Deficit in trade with goods: coverage, 1-9 2008 Deficit in Trade with Goods = 100 Increase in currency reserves in % of trade deficit Source: wiiw Database incorporating national statistics.

21. 3. Potential trouble • Lack of external means for the financing of external deficits and debt refinancing • More balanced current account becoming a must • Either more exports or less imports (goods and services) • Allowing for nominal depreciation as one alternative (additional burden to households and companies with foreign currency debt) • Wage deflation in the context of strong GDP decline as a second alternative

22. 4. Southeastern Europe’s prospects • 2009 GDP decline • 2010 GDP stagnation • 2011 some GDP growth again, provided the international business climate improves • 2012 ff. growing GDP, but at rates lower than in 2003-07 • Gradual return of FDI inflow

23. 5. Financial risks

24. What do we see in the financial indicators? • High current account deficits • In most cases – worsening • So, financing them is the key issue

25. Current account balance in % of GDP Source: National bank of the respective country.

26. Governments’ foreign debt • Mostly not very high • And the share in total foreign debt - declining

27. General government share in gross external debt in % Source: National bank of the respective country.

28. Short-term debt • In a couple of cases too high • In a number of cases increasing

29. Short-term foreign debt in % of foreign exchange reserves (excluding gold) Source: National bank of the respective country.

30. Banks and risks • Credit expansion decelerating • Leverage ratios relatively low • Risks, however, increasing by most measures • Some countries facing bigger problems than others • Banks rely significantly on foreign liabilities • Foreign currency loans important • Not enough data to say something on non-performing loans

31. Bank loans to non-financial private sector growth in %, eop month (year-on-year) Source: National bank of the respective country.

32. 3m...BOR-3mEURIBORspread in percentage points, eop month Source: National bank of the respective country.

33. TED spread (3m...BOR-3mT-Bill)spread in percentage points, eop month Source: National bank of the respective country.

34. Leverage, banking sector assets to capital ratio, eop month Source: National bank of the respective country.

35. Share of banks’ external debt in assets in %, eop month Source: National bank of the respective country.

36. Share of loans in foreign currency in % of total loans, eop month Source: National bank of the respective country.

37. Share of non-performing loans in % of total loans, eop month Source: National bank of the respective country.

38. Real estate bubble? • Construction slowing down • Prices for apartments declining • However, not enough data to say more on that

39. Growth in apartment prices in %, CPI deflated (year-on-year) * Data refer to half year. Source: National bank of the respective country.

40. Construction sector growth less GDP growth in % (year-on-year) * Data refer to half year. Source: National bank of the respective country.

41. Development of income inequality in Central Europe, Baltic States, SEE and CIS, 1989-2006unweighted averages of Gini coefficients (income based)

42. 55 Sub-Saharan Africa Latin America 50 China 45 South Asia East Asia Russia 40 CIS Middle East USA Gini coefficient & North Africa 35 SEE 30 Western Europe Central Europe & Baltics 25 Source: UNU-WIDER: World Inequality Database Version 2.0b , own calculations. Income inequality in world regions unweighted averages of Gini coefficients (income based), 2003

43. R = 0.27 Distribution of income & source of income Correlation of functional distribution and inequality in transition countries CE & Baltics, SEE and CIS 50 2002 45 y = -0.40x + 48.75 2 40 35 Gini coefficient 30 25 20 15 15 20 25 30 35 40 45 50 55 Compensation of employees, in % of GDP Sources: AMECO database, CIS STAT database, UNU-WIDER: World Inequality Database Version 2.0c .

44. Role of labour market institutions

45. Main causes of inequality developmentin transition • Loss in output and increase of unemployment • Rising wage inequalities due to liberalization of labour market regulations • Industrial employment and productivity growth reducing inequality • Dampening effect of public expenditure • While price and trade liberalization reduced inequality via job creation, (public utilities infrastructure) privatization did opposite • Economic integration via exports had positive effects on equality

46. The outcome • Croatia: Under the assumption of a mild recession, the Gini increases by 0.3pp to 31.2 • Hungary: Under the assumption of a strong recession, the Gini increases by 0.9pp to 27.0 • Ukraine: Under the assumption of a heavy recession, the Gini increases by 1.2pp to 31.1 • Doubling the drop in industrial & overall employment and the increase in unemployment raises the Gini to: HR 31.6; HU 27.3; UA 31.9

47. Crisis impact on inequality • Given the extent of the recession, the model suggest an increase of inequality from 0.3pp to 1.2pp (0.7pp to 2pp) • In general income inequality does not change rapidly • Still absolute poverty will be on the rise with average income levels falling • Stronger fiscal expansion could reduce the increase of inequality • 1pp more government expenditures reduces Gini by 0.1pp

48. Conclusions • Risks have increased • Not primarily because of the health of the banks (though Montenegro is different) • But because of high demand for foreign financing that has become scarce • Which drives growth down • Which in turn pushes the risks up

49. What is to be done? • Stabilization is the key in the short run • In the medium run, it is a question whether it might be necessary to move from a neoclassical to a mercantilistic growth strategy • The choice may depend on the policy of the EU

50. Rast na kratak rok • Trenutna kretanja, ocenjena na osnovu dostupnih podataka, su veoma negativna • Industrijska proizvodnja se smanjuje po visokoj stopi gotovo svuda – takođe u Hrvatskoj • Spolja trgovina se takođe smanjuje gotovo svuda – isto i u Hrvatskoj • Inflacija se usporava, a preti i deflacija, praktično svuda • Ova kretanja implicraju značajnan pad bruto domaćeg proizvoda, praktično svuda, a u Hrvatskoj do 4 ili 5%