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Sudden Stop anno 2008:
Why Emerging Europe
was different
Erik Berglof
Chief Economist
European Bank for
Reconstruction and Development
Sudden Stop anno 2008:
Emerging Europe was different
Percentage changes in external assets of BIS-reporting banks
Per cent
15
Avg 2007Q4/2008Q1
Avg 2008Q4/2009Q1
10
5
0
-5
-3.4
-4.4
-7.8
-10
-11.1
-11.9
-15
Emerging
Europe
CA and
Caucasus
Russia &
Ukraine
Latin America Emerging Asia
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
Outline
1. Financial integration and the European
transition model: introduction
2. Did financial integration have any tangible
benefits?
3. What role did financial integration play in
the transmission of the crisis?
4. Did financial integration generate macrofinancial vulnerabilities?
5. Policy Response and Lessons
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
Political, trade, and financial integration have
gone hand in hand
Exports to the EU (left axis)
Assets of EU banking groups (right axis)
Per cent of total
exports
100
Per cent of GDP
200
80
150
60
100
40
50
20
0
0
New EU
Members
Official EU
Candidates
EU
Aspirants*
Eastern
Partnership
Countries
Other
Financial integration has been rapid, with a
boom period from 2004 onwards.
External assets and liabilities as a share of GDP
Per cent
250
CEB
EEC
Turkey
200
SEE*
Russia
CA
150
100
50
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
0
In CEB and SEE, financial integration has
been led by foreign banking groups
Foreign bank asset share, 1998-2008
Per cent
100
80
CEB
EEC
Turkey
Foreign bank asset share, end-2008
SEE
Russia
CA
Per cent
100
CEB
SEE
EEC
Other
80
60
60
40
40
20
0
0
1998
2000
2002
2004
2006
2008
Sl
ov
Es aki
to a
A ni
Li lba a
th ni
ua a
C nia
r
R oa
om ti
a
C an
ze i
a
H ch
un R
.
B ga
ul ry
g
Po aria
la
Se nd
rb
La i a
U tvi
k a
A rain
rm e
K e
yr n
gy ia
z
R R
us .
K T sia
az ur
ak ke
hs y
ta
n
20
Outline
1. Financial integration and the European
transition model: introduction
2. Did financial integration have tangible
benefits?
3. What role did financial integration play in
the transmission and magnitude of the
crisis?
4. Did financial integration generate
vulnerabilities that aggravated the crisis?
5. Policy Response and Lessons
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
Growth in transition has been associated with
capital imports—unlike other regions
Current account balance, per cent of GDP (simple average)
10
5
0
-5
-10
-15
1994
1997
Latin America
2000
2003
Emerging Asia
2006
CEB + SEE
Rising current account deficits have reflected
mainly higher investment
Saving and investment, per cent of GDP
Current account balance, per cent of GDP
35
0
30
-5
25
20
-10
15
10
-15
1994
1997
Saving
2000
Investment
2003
2006
Current account (right scale)
In non-transition developing countries,
CA surpluses correlated with higher growth
… but not in the European transition region.
Transition sample
14
14
12
12
y = 0.1681x + 5.0106
R2 = 0.1201
10
10
8
8
6
6
4
4
2
2
0
0
-2
-2
-20
-10
0
10
CA/GDP, % (av. 1994-2008)
Growth GDP per cap, PPP
(av.1994-2008)
Growth GDP per cap, PPP
(av.1994-2008)
Non-transition sample
20
18
16
14
12
10
8
6
4
2
0
20
18
16
14
12
10
8
6
4
2
0
y = -0.3442x + 5.2813
R2 = 0.2697
-15
-10
-5
0
5
CA/GDP, % (av. 1994-2008)
10
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
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
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)
Conclusion (1): Financial integration had
tangible growth benefits in the EBRD region

Supported by econometric tests using several
methodologies

Magnitude is economically significant
Outline
1. Financial integration and the European
transition model: introduction
2. Did financial integration have tangible
benefits?
3. What role did financial integration play in
the transmission and magnitude of the
crisis?
4. Did financial integration generate
vulnerabilities that aggravated the crisis?
5. Policy response and lessons
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
Per cent
15
Avg 2007Q4/2008Q1
Avg 2008Q4/2009Q1
10
5
0
-5
-3.4
-4.4
-7.8
-10
-11.1
-11.9
-15
Emerging
Europe
CA and
Caucasus
Russia &
Ukraine
Latin America Emerging Asia
…so was the collapse of trade in Q4 and Q1…
Index
240
220
Index
110
Trade credit*
Commodity price
World trade volume
EU real GDP (right axis)
108
200
180
106
160
140
120
104
102
100
20
04
20 Q4
05
20 Q1
05
20 Q2
05
20 Q3
05
20 Q4
06
20 Q1
06
20 Q2
06
20 Q3
06
20 Q4
07
20 Q1
07
20 Q2
07
20 Q3
07
20 Q4
08
20 Q1
08
20 Q2
08
20 Q3
08
20 Q4
09
20 Q1
09
Q
2
80
100
…resulting in a sharp economic contraction in
many countries in the region.
Chart 1: Real GDP Growth
(Year-on-year, in percent)
10
5
0
-5
-10
-15
Q4 2008
Q1 2009
Q2 2009
-20
Source: EBRD. Note: For Armenia, Georgia, Kazakhstan, FYR Macedonia,
Serbia, and Moldova 2009 Q2 numbers are EBRD projections.
Belarus
Moldova
Mongolia
Bulgaria
Romania
Serbia
FYR Mac.
Slovak
Rep.
Poland
Russia
Kazakhstan
Croatia
Czech Rep.
Slovenia
Lithuania
Armenia
Georgia
Hungary
Turkey
Ukraine
Estonia
Latvia
-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.
Foreign bank presence is associated with
better output performance during the crisis
Output growth over Q4/08Q1/09, qoq, s.a.
5
5
Alb
Pol
BiH
Mne
Geo
Kaz
Kgz Srb FYR
Blr
Hun
Cze
Aze
BgrHrv
Taj
Rom
Svk
Tur Mol
Slv
Rus
Est
Ltu
Arm
Lva
0
-5
-10
-15
-20
0
-5
-10
-15
-20
Ukr
-25
-25
0
20
40
60
80
100
Foreign bank ownership, 2007
120
However, external debt levels are a robust
predictor of worse output declines in crisis
Output growth
over Q4/08- Q1/09, qoq, s.a.
5
Pol
BiH
Geo FYRM
Kaz
Kyr
Bel
Hun
Ser
Cze
Azer Ro
Bul
Taj
Cro
Slk
Sln
Mol
Ru
Tky
Lit
Est
Arm
Alb
0
-5
-10
-15
Lat
-20
Ukr
-25
0
20
40
60
80
100
120
140
External debt in percent of GDP, 2007
Both effects hold up when considered jointly, and with other controls.
Conclusion (2): Financial integration had a
mixed direct role in the crisis
1. Provided a conduit for financial shocks; (obvious:
in financial autarky, no contagion)
2. Some aspects of financial integration made the
crisis worse: external debt
3. However, foreign bank presence mitigated the
output decline
– Interpretation: foreign banks buffered the financing
shock because of commitments to subsidiaries.
Outline
1. Financial integration and the European
transition model: introduction
2. Did financial integration have tangible
benefits?
3. What role did financial integration play in
the transmission and magnitude of the
crisis?
4. Did financial integration create
vulnerabilities that aggravated the crisis?
5. Policy response and Lessons
Financial integration and crisis vulnerabilities:
potential channels
1. Led to higher private external debt: a direct
expression of financial integration
2. Did financial integration fuel credit booms?

Higher output declines (cf. private external debt)
3. 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
Capital inflows strongly correlated with credit
growth during 2005-08
(Per cent)
90
90
Average credit growth between mid-2005 and mid2007
Ukraine
R2 = 0.2988
80
Azerbaijan
70
70
Kazakhstan
Albania
60
Romania
60
Latvia
Lithuania
Serbia
50
Estonia
80
50
Russia
40
40
Tajikistan
Bulgaria
Moldova
FYR
30
30
BiH
Croatia
20
Poland
Slovenia
Czech Rep.
Hungary
20
10
10
0
-20
0
20
40
60
80
100
120
140
Median growth of BIS lending between mid-2005 and mid-2007
160
180
0
200
1996 - 2001
2002 - 07
Kyrgyz Rep.
Georgia
Armenia
Mongolia
Ukraine
Turkey
SEE
Russia
Moldova
Kazakhstan
Albania
Romania
Bulgaria
CEB
Serbia
FYR Macedonia
Lithuania
Czech Rep.
Slovak Rep.
Hungary
7
Poland
Latvia
Estonia
Croatia
Slovenia
Number of credit boom years
(= year with credit growth > 2 p.p. of GDP)
EEC and other
6
5
4
3
2
1
0
Did financial integration contribute to
(excessive) credit booms?
1996-2001
External
Foreign
Assets + bank share
Liabilities
2002-07
External
Foreign
Assets + bank share
Liabilities
Relative frequency of credit boom years (%)
1
Initial levels of financial integration
below median
10.9
at or above median
13.8
10.1
14.5
29.0
39.1
36.2
31.9
Change in financial integration
below median
10.9
at or above median
13.8
14.5
10.1
26.1
42.0
34.1
34.1
Cross country-correlations with number of credit boom years
Initial levels
Change
-0.03
0.14
0.08
0.09
0.04
0.52
0.01
-0.10
Did financial integration encourage FX lending?
Background

Standard causes of “liability dollarisation”:
1. Low monetary policy credibility and/or high inflation
volatility;
2. 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.
Foreign bank presence is correlated with a
higher share of lending in FX
Share of foreign currency
lending in total domestic
lending
(but so is L/D ratio, and various other measures of foreign
financing)
1.0
LAT
BUL EST
CRO
SER ALB
0.8
0.6
UKR
LIT
HUN
KAZ
ARM
MOL
TUR
POL
FYRM
RUS
AZE
0.4
0.2
SLV
0.0
0.0
0.2
0.4
0.6
0.8
1.0
Asset share of foreign-owned banks
Did financial integration encourage FX lending?
Approach:
1. 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
2. Test robustness using macro data for same period

LHS variable is FX share of bank lending
3. Macro regression over longer (2000-2008) period.
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
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
Outline
1. Financial integration and the European
transition model: introduction
2. Did financial integration have any tangible
benefits?
3. What role did financial integration play in
the transmission of the crisis?
4. Did financial integration generate macrofinancial vulnerabilities?
5. Policy response and Lessons
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
The magnitude of official support unprecedented
Official support (percent of GDP)
Q2 2009
Q1 2009: Drop in foreign inflows
and trade
Q4 2008: Gov. support for large
US, UK and Swiss banks
Q3 1998: Russia default, Braz.
stock market crash, LTCM
Q2 1998: Social unrest in Ind.,
Russian stock market crash
Q1 1998: Social unrest in Ind.,
Korean debt restructuring,
Korea
Thailand
Philippines
Indonesia
Hungary
Latvia
Romania
Ukraine
Q4 1997: Closure of Ind. and Thai
financials, Korean won devalues
Q3 1997: Asian currencies
devalue sharply
0.0
1.0
2.0
3.0
4.0
5.0
6.0
7.0
…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
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…)
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)
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…
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
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…
ANNEX
Unfolding of the crisis in the region
Unfolding of the crisis in the region
Unfolding of the crisis in the region