“Financial dollarisation” – domestic borrowing and lending in foreign currency (FX), even when the borrower’s income is in domestic currency – is back on the policy agenda. Unlike the 1990s, the victims of financial dollarisation are not longer mainly in Asia – which suffered particularly in its 1997-98 crisis – or even in Latin America.  Instead, “currency mismatches” (another expression for unhedged borrowing in FX) struck most harshly in emerging Europe. They aggravated the 2008-09 crisis in countries with large currency depreciations (Ukraine), complicated the crisis response and monetary policy effectiveness in many countries with significant FX exposures, and induced highly contractionary macroeconomic policies in countries that defended their pegs (Latvia).

As a result, the question of how these economies can “de-dollarise” (or in some countries, “de-euroise”) is receiving much policy attention: particularly, in the form of tougher regulation and even bans on foreign exchange borrowing. For example, in December 2009, Hungary adopted new regulations that require higher household debt servicing capacity and lower loan-to-value ratios for consumer and mortgage borrowing denominated in foreign exchange. In June 2010 the new Hungarian government went further: it announced a ban on the registration of FX-denominated mortgage loans. Some other transition countries also are moving in the same direction in the area of regulation.                                                                                                                                         

But is tough regulation necessarily the right answer? In a recently published EBRD Working paper, we argue that if emerging European policy makers want to get the policy response right, they would do well to look at the international experience on dollarisation, reflected in a large literature on the subject, which was written largely in the decade between the 1997-98 Asian and the 2008-09 European crisis. This literature, combined with our own evidence on emerging Europe and Central Asia, leads to three main conclusions.

First, financial dollarisation is primarily, if not exclusively, a macroeconomic phenomenon. This is most obvious today in the less developed countries of Eastern Europe and Central Asia, which suffer from high inflation volatility. In such countries, writing long-term financial contracts using local currency units simply does not make sense, because the future real value of interest and principal payments in local currency is very uncertain. As a result, long term FX borrowing may actually be safer than local currency borrowing over the same maturity – even if it exposes borrowers to the threat of insolvency in the (comparatively rare) event of a large depreciation.

What about the highly “euroised” countries further west, where inflation had been much lower and quite stable since the late 1990s? Here, the link between macroeconomic policies and FX borrowing was more subtle. Notwithstanding low inflation, local currency lending rates in these countries tended to be much higher than FX lending rates. In part, this reflected a lack of monetary policy credibility: while inflation was relatively low, and currencies were generally expected to appreciate, this could not be taken for granted. At the same time, pegged or heavily managed exchange rates gave FX borrowers a false sense of security, particularly in EU countries, which viewed themselves on a straight path to euro adoption. In such countries, the temptation to borrow much more cheaply in FX was simply overwhelming.

Second, while weak macroeconomic policies and institutions were an important factor in fostering dollarisation in emerging Europe, they were not the only factor. It would otherwise be impossible to explain why, for example, FX lending as a share of total bank lending doubled in Hungary between 2004 and 2008 (see chart), a period in which macroeconomic policies (particularly monetary policy, but after 2006 also fiscal policy) generally improved. The driving factor here (and in other of more financially integrated emerging European economies in the Baltic region, and in south-eastern Europe) was a foreign-financed credit boom (for a comprehensive documentation, see a recent IMF working paper). In their rush to expand credit, banks relied largely on cheap FX funding either from parent banks, or borrowed in international capital markets, rather than by building their local deposit base. To avoid currency mismatches on their own balance sheets, the preferred lending currency was also foreign. Hence, rising euroisation was a by-product of the 2004-2008 lending boom, which turned out more extreme in emerging Europe than in any other region of the world.  

Source: EBRD, Transition Report 2009 based on data from national authorities. Click on image to view full-size.

Third, domestic capital market development is a critical component of de-dollarisation policy, particularly in countries that already have reasonable macro stability. From what has been said so far, this is not entirely obvious: a country with credibly low and stable inflation, a floating exchange, and macro prudential tools that dampen credit booms and discourage their financing in FX should not have a dollarisation problem, regardless of whether it has well-functioning capital market. However, capital market development is nonetheless important, for two reasons. For one, longer-dated bonds are a bellwether of macro credibility. Their yield is reflection of faith in the governments’ ability to keep inflation low and stable, and an incentive to maintain stabilisation on track. Most importantly, domestic capital markets help overcome the shortage of domestic currency long term funding that biased emerging Europe’s lending booms in the direction of FX. Banks that wish to expand their lending are less likely to resort to FX funding if there is a domestic investor base – for example, pension funds and insurances – that is interested in longer dated debt instruments,  and if there is a market that makes these instruments liquid and easy to price.

With this in mind, is the current focus on regulatory responses to financial dollarisation a good idea or not? The answer depends in part on the country. In countries in which inflation volatility continues to be a problem, making FX lending illegal (or prohibitively expensive) is downright counterproductive: it may destroy longer term lending altogether. However, more subtle forms of regulation can play a useful role, particularly in more advanced countries, and particularly when they complement good macro policies, and are embedded in a more general set of macro prudential instruments. For example, these could include risk weights and reserve requirements on banks that are higher for FX loans and FX funding, respectively; and setting maximum payment-to-income and loan-to-value ratios that guard against household overborrowing, particularly in FX. While regulation need to be country-specific, its coordination is essential in order to limit regulatory arbitrage. Such coordination is taking place, for example, under the European Bank Coordination (“Vienna”) Initiative.

In sum, our analysis suggests that the fight against emerging Europe’s addiction to FX needs to be country-specific and multipronged. Regulation may be justified, particularly in the more financially integrated countries. But it should never carry the sole burden of the fight against addiction to FX. Depending on the country, the main focus of de-dollarisation could be to stabilise and reform macroeconomic institutions; or it could be a combination of regulation, macroeconomic credibility-building, building the legal and institutional underpinnings of local currency money and bond markets, and developing the demand side of these markets and making them more liquid.

In recognition of these links and complementarities, the EBRD has recently launched a new Local Currency and Local Capital Market Development Initiative. In the next 12 months, at the request of country authorities, the EBRD will conduct country-by-country diagnoses of the causes of financial dollarisation in many of its countries of operation, jointly with other IFIs such as the IMF and the World Bank, as well as private sector associations. All key factors will be considered: macroeconomic volatility and credibility; FX regulatory conditions; local currency market development; and associated legal, regulatory, and infrastructural requirements. Based on these diagnoses, the EBRD will support the development of local capital markets by using the lending and funding instruments at its disposal, in coordination with other investing IFIs; and through technical cooperation.

The crisis has put financial dollarisation at the centre of attention in emerging Europe. That is a good thing. Ten years ago, emerging Asia and Latin America were in a similar situation. By and large, they drew the right consequences, and today, financial dollarisation is no longer the first-order problem in these regions that it once was. There is no reason why emerging European countries should not follow their example. The political will to do something about the problem is there, and macroeconomic conditions are favourable. But in order to make the most of their historic opportunity, they will need to be patient, avoid quick fixes and focus on the hard work of improving macroeconomic policies and institutions and developing local capital markets.

The Dom Tuškanac is a residence funded by the Croatian Ministry of Health and Social Welfare. With a dedicated and caring staff, it provides a home for children and young adults with a variety of mental disabilities, helping them to integrate into society while looking after their special needs.

The home’s current heating and hot water system is outdated, inefficient and costly. Together with environmental partner ‘City Center one’, the EBRD will contribute to help install a system of modular, highly efficient boilers that will save energy and reduce carbon emissions.

This investment in energy efficiency will bring real savings to this worthy institution. More importantly though it will make life a little more pleasant for a group of special young people.

Today, on the eve of the opening of the EBRD’s Nineteenth Annual Meeting, EBRD President, Board members, staff and meeting participants visited Dom Tuškanac. Read more

The volcano was symbolic perhaps, reflecting my mental state, since the height of the eruption occurred in parallel with April 15th, a key day in the calendar of Americans around the globe, the last day to file US income taxes. Volcanos, taxes, whatever, there is some kind of poetic justice here. As the impact of both became clearer, my sleep became more and more fitful. I woke up every morning at three to watch live photos of billowing smoke. No information was to be had online or by phone from Air Canada (nor, for that matter, from the Internal Revenue Service) and my departure date came and went as the realisation sunk in that I might be in here for the long haul.

How long? That was what was (actually still is) the issue, though it now appears that I am booked (THANK YOU, EBRD TRAVEL OFFICE) on tonight’s 6.15pm flight to Heathrow. The past few days have been strange as I began to make extensive use of the hotel’s laundry services and shop for undergarments at that North American paragon of value, Sears, a stone’s throw from my room. Barriers imposed by the hotel’s business centre sent me to “Best Buy” to buy a laptop (we needed one anyway) and set up shop.

I have now adjusted to life in 412 on day 3 after my planned departure and day 7 of life in Canada. The representatives from the IMF and World who also attended the conference are long gone (Washington!), and I have started sussing out the pros and cons of the three food courts and shopping malls which surround my hotel, planning the logistics of a longer, even indefinite stay.

Who knows if I’ll actually leave? Another plume, another cloud of ash might change everything. I anticipate utter chaos at Lester B. Pearson International Airport, where I will stock up on maple syrup, baseball caps and relentless Canadian friendliness and optimism while praying that I actually take off. In any case, I consider myself lucky. I might have gone on mission to Zagreb with our colleagues from the Bank. After days of waiting, they apparently spent 26 hours on a bus and, I hear, are in the UK as I type these lines. They no doubt hated that bus by the end; I, on the contrary, have come to love 412.

Wednesday 21st April update: A Room with a View

Funny how crisis drives one to literary allusions. Anyway, though the reservation was confirmed and the BBC announced that UK airspace would re-open, I arrived at the Toronto airport to find any flight to London inexplicably cancelled. (I immediately regretted joking with the taxi driver about seeing him again soon.) And there I was again at the mercy of the Marriott lady, whose voice I know so well and who took me back at the same preferential rate, this in spite of a meeting of the Funeral Service Association of Canada (Association Funeraire du Canada) — meaning that the entire hotel is now inhabited by undertakers, many of whom wear black suits even when “off duty”, and all of whom seem quite jolly, in the lifts and especially at the bar. Needless to say, philosophical, even existential thoughts have begun to intrude onto what has become a surreal routine, with surreal encounters punctuated by live shots of billowing smoke wherever I go.

In the film version of E. M. Forster’s 1908 novel “A Room with a View”, the rooms have lovely views of Brunelleschi’s masterful cathedral in Florence and of idyllic English countryside. I too asked the endlessly accomodating Canadian staff of the Marriott for a room with a view. I was assigned room 1506, eleven stories above the fabled 412 (see yesterday’s entry), which paradoxically has exactly the same view as 412, i.e., of the parking structure next door from a much higher angle (no hint of Lake Ontario). I have set up shop again and am happily working via a remote connection (THANK YOU, EBRD IT HELPDESK), and have had words of encouragement from across the Bank, including sage words from the IT director on how to penetrate the anti-Citrix barriers in business centres around the world: “Download the Java client,” he writes. No need to do this now, since all is well, but in my now perverted mind, I associate “Java” with Krakatoa and am superstitious enough to not dare to tempt the gods by even trying something like this at this point in my life.

I return to my parting lines of yesterday: “Who knows if I’ll actually leave? Another plume, another cloud of ash …” Will I? Find out tomorrow. I am though much more relaxed, for at least now I have solid routine: arise at 6.38, drink coffee in Eaton shopping centre, work via EBRDremote, check BBC, check out, cab to airport, note flight cancellation, call Marriott, return to hotel, consider fast food options, avoid undertakers, ponder meaning of life. Repeat.

Ger – a portable, felt-covered dwelling – in rural Mongolia

Although microfinance has grown rapidly over recent years, hard evidence on its socio-economic impact is only emerging slowly. To what extent does microfinance lift people out of poverty by allowing them to generate income from small-scale enterprises? And is group lending (‘joint-liability’) or individual lending the best way to reach out to borrowers? These are questions that XacBank, a leading microfinance institution in Mongolia, has been grappling with as well. The bank wanted to expand its outreach to indigent rural borrowers, in particular female ones, who hitherto had only limited access to financial services. But what is the best way to expand lending to such ‘difficult’ customers?

On the one hand, individual loans may be more suitable in a country in which the nomadic lifestyle may have limited the build up of social capital outside of the family structure. On the other hand, group lending may work well if the looser ties within groups reduce the risk of collusive behaviour. Moreover, since monitoring costs are particularly high – loan officers have to travel extremely large distances to reach remote clients – the reduction of such costs through a group lending structure may be particularly valuable.

To help XacBank with its strategic decision making and to assess empirically the impact of access to microfinance on small business development and poverty reduction, a project team at the EBRD (Ralph De Haas and Heike Harmgart) and the Institute for Fiscal Studies (Orazio Attanasio, Britta Augsburg and Emla Fitzsimons) designed a so-called randomised field experiment. The design entails an experimental set up involving 40 soums (villages) across 5 aimags (provinces). Together with the Mongolian Women’s Federation (MWF) a list was drawn up in each village with the names of relatively poor women who were interested in a XacBank loan to expand or set up a small business. These women were also asked to form preliminary borrowing groups. All 1,148 of them were then interviewed by a survey company in March 2008 (the baseline survey).

Session of MWF representatives involved in the field experiment

The 40 soums were then randomly divided into 10 ‘control soums’, 15 ‘group lending soums’ and 15 ‘individual lending soums’. Information from the baseline survey confirmed that the randomisation worked well: the participating women in all three types of villages were on average very similar across a wide range of observable characteristics.

In a next step, all women in group-lending soums were visited by a XacBank loan officer and groups that were deemed credit-worthy were offered a group loan. In the individual lending soums, women were offered an individual loan, while in the control soums XacBank delayed the roll-out of lending for the duration of the experiment. Importantly, when the women signed up to the project it was carefully explained to them that they would only have a 75 per cent change of actually obtaining a loan during the first year (since XacBank would delay the introduction of lending in 10 out of 40 villages).

A follow-up survey was conducted in October/November 2009, about 20 months after the baseline survey. Four interview teams re-interviewed 982 of the initial respondents; a re-interview rate of 86 per cent. This means that for 982 respondents we have detailed information from both the baseline and follow-up surveys on income, consumption and saving patterns, asset ownership, (in)formal enterprises, and exposure to shocks. Respondents were also asked about their income expectations and attitudes towards risk. Finally, novel questions were asked to gauge how well group members knew their co-borrowers, with the aim of allowing us to make inferences about the ‘information asymmetries’ within joint-liability groups. Detailed information was also gathered on the characteristics of villages and loan officers that participated in the experiment, while XacBank provided the project team with comprehensive repayment data on all loans.

Respondent being interviewed. The stones are used to answer questions about the respondent’s own expectations about her future income.

The project team is currently combining and analysing all of these data. This should allow us to compare how the respondents in the control soums (no loans offered) and the treatment soums have developed over time. Since the women in the treatment and the control villages were on average very similar before the experiment, differences in their subsequent development and outcomes will only be related to whether or not they received a loan.

This comparative analysis is of particular interest given the global financial crisis, the impact of which was felt in rural Mongolia in the period between the two survey rounds. Cashmere prices dropped by more than one third over a short period of time, adversely affecting many herder families. We hope that our results shed light on the question of whether the availability of microfinance has alleviated – or maybe even increased – rural households’ financial vulnerability during the crisis. Complete results are expected to be available in June of this year and will be summarised on this blog. For now, the data collected during the baseline survey already provide some insights into the state of rural microfinance in Mongolia. Three observations stand out:
First, we find that only 44 per cent of respondents had no outstanding debt at the time of the first interview while 46 per cent already had a loan. Almost ten per cent of respondents even had two or thee loans. Contrary to popular perception, penetration of microcredit was already quite advanced across rural Mongolia, even among our sample of relatively poor women who were selected because of their supposedly limited access to finance.

Second, virtually all respondents with a loan took out that loan in 2007 or 2008. Almost half of the respondents had not had another loan (whether repaid or not) in the last five years. Competition for rural customers – in particular between Khan Bank, XacBank and Mongol Postbank – had intensified in recent years. In our sample, Khan Bank has by far the largest market share: we find that just over one half of those with an outstanding debt owe it to Khan Bank.

Third, we find that between 70 and 80 per cent of the debt outstanding at the start of the experiment was used for consumption purposes and not for financing micro-entrepreneurial activities. This is an important finding since it shows that even though microfinance in rural Mongolia has advanced rapidly in recent years, the vast majority of loans has been used for consumption rather than income-generation. That is not to say that these loans have not been ‘useful’: the ability to smooth consumption is particularly important at low income levels. But it will be interesting to see whether the crisis has impacted households with varying debt levels differently. Moreover, it will be of interest to find out to what extent the individual and group loans disbursed during our experiment, which were intended to finance businesses, have indeed been used for such income generating purposes.

Stay tuned for more…

]]> http://www.ebrdblog.com/wordpress/2010/02/mongolian-microfinance-some-first-insights-from-a-randomised-field-experiment/feed/ 6 http://www.ebrdblog.com/wordpress/2009/11/kazakhstan%e2%80%99s-missing-middle/ http://www.ebrdblog.com/wordpress/2009/11/kazakhstan%e2%80%99s-missing-middle/#comments Fri, 27 Nov 2009 13:58:52 +0000 Ralph De Haas Senior Economist http://www.ebrdblog.com/?p=750 By Ralph De Haas and Asel Isakova

Why do private equity funds have difficulties with finding interesting mid-sized investment opportunities in Kazakhstan? And why does economic diversification remain such an elusive policy goal for the Kazakh government?

These are complex…

Peer pressure, positive market reaction to previous stress tests, and risks of leaks in the European multi-player setting can argue for publishing the results of the CEBS stress tests in some form, and back them up financing plans. These can include raising capital from markets and use of unutilized national bank support packages (raising the issue of burden sharing between home and host authorities); at the margin, IFI/EBRD equity support for bank subsidiaries in the region can also help. Careful use of new EU competition policy to avoid abrupt deleveraging will be very important. Coordination with the IMF with regards to both the results and their communication would be also necessary.

Background Central banks and regulators increasingly use stress testing to assess the quality of their banks’ portfolios in the wake of the ongoing financial crisis. This is used to determine the amount of any additional capital that banks may need so as to reach an acceptable level of capitalisation in the face of shocks.   In the face of persistent uncertainty about bank portfolio quality, markets have learnt to expect these assessments. Many observers consider that such information and ensuing measures are critical to reduce market uncertainty so that banks can resume lending with reasonably “clean books.” 

  Currently, two major Europe-wide stress testing exercises are underway with very similar timetables.   At the request of the EFC, stress tests are being performed on the 22 EU-based largest bank groups that, as with the US, also cover over 60% of EU banking sector assets (the list is not public). There is no plan for publication of the results at this point. In parallel, the IMF is also conducting a regional stress test. As before, the IMF is expected to publish its results at least at the aggregate level, also in the autumn. Finally, several Central European countries (Czech Republic, Hungary, Poland, etc) have embarked on a harmonized stress testing of their banks, but it is unclear how far this exercise is going.

Three issues to consider:

1. Communication/publication of the results.

  2. Financial plan for the results. The real challenge for policy makers is to prepare for the results with a credible financing plan. As with the US, financing could be a combination of private solutions and access to unutilized portions of already announced national bank support packages:

  3. Careful application of the European Union’s Competition Policy.  The Commission has just revised, with effect through end-2010, its competition policy in the financial sector, with the objective of addressing earlier serious concerns over applying “corrective measures” that normally accompany the approval of state aid for an economic entity in an EU member state for Europe’s crisis-ridden banks of systemic importance.  The new policy appears to be more flexible – providing more time for adjustments –; focussing more on competition issues and less on “corrective measures” to cut exposures; and it is also more explicit in discouraging home-bias (see for example para. 33). That said, the new rules are likely to be tested in the context of possible recapitalisations using state aid in the context of stress tests and it will be important to ensure that EU competition policy does not encourage home market-oriented, disruptive exposure cuts to emerging Europe.

When the  global financial crisis hit the transition region, worries among policy makers  centred on the local banking systems and the potential for financial contagion  from west to east. And when unemployment started to rise and output declined sharply  as of Q4 2008, the attention shifted towards the real-economic impact of the  crisis.

Now, notwithstanding more frequent discussions about green shoots and a  bottoming-out of the crisis, the focus is   moving back again to the financial sector. The main question is to what  extent the problems of (credit-constrained) households and firms may backfire and  lead to a second round of financial-system stress. The development of banks’  non-performing loans (NPLs) may provide a partial answer to the question of where we are going to end up in 2010.

To this  end, this blog takes a look at recent detailed information on the development  of NPLs in 21 of EBRD’s countries of operation. A methodological caveat upfront:  widely differing definitions and limited data availability pose serious  constraints to this kind of exercise¹.

Given these challenges it is advisable to focus the analysis of NPL ratios on  relative rather than absolute changes. Moreover, the NPL numbers presented here  only present the ‘official’ picture: rating agencies have repeatedly underlined that ‘true’ NPLs may be substantially  higher in a number of countries. An important reason for the sometimes diverging  official and unofficial statistics is that some banks pre-emptively restructure  or roll-over bad loans. In such cases official NPL figures are edging up only  slowly. Our focus on relative changes can alleviate but not solve this  information problem. With that out of the way,  a number of interesting patterns emerge:

First, Figure 1 reflects the wide variation in NPL  dynamics across the transition region. Roughly speaking there are – as yet –  moderate increases in Central Europe, more pronounced dynamics in South-Eastern  and Eastern Europe, and stronger increases in the Baltics, Russia, Central Asia  and Mongolia. While it is too early for a final verdict, there seems to be a  negative correlation between the increase in NPLs and the foreign ownership of  local banking systems. Latvia would be  the main exception to this observation.

Figure 1: Relative changes of non-performing loan ratios since June 2008

The strongest dynamics are seen in Russia,  Central Asia, Mongolia,  Georgia and Latvia.  In all of these countries NPLs increased more than two-fold between June 2008  and March 2009. For instance, Mongolia’s NPL indicator climbed to 3.6 times its June 2008 value,  reflecting the liquidity and solvency crisis in the Mongolian banking system in  the wake of a protracted period of very high inflation, increasingly  overindebted borrowers, and tugrug depreciation. Also in Latvia NPLs increased  more than 3 times,  followed by Estonia (2.6x), Russia (2.4x), Kazakhstan (2.4x), and Tajikistan (2.2x). Georgia is an interesting outlier in the sense that NPLs doubled  immediately after the armed conflict in August 2008 and then continued to  increase at a slower pace.

Second, and in sharp contrast to the above, the increases  in the three Central European countries in our sample have so far been much  smaller. The Hungarian NPL ratio fell during the second half of 2008 and showed  only a slight uptick in Q1 2009. The Slovak NPL ratio increased to  only 1.4 times its June 2008 level. The Polish NPL ratio has barely moved. The  pessimist will note that this reflects a strategy of procrastination among  banks as they consistently and persistently roll-over their dubious loans. The  optimist, however, will point out that this pattern may also reflect that the  upgrading of risk-management systems by foreign parent banks across Central Europe  is bearing fruit in these difficult times. The jury is still out and more  information will become available in the coming months.

Third, the South-Eastern and Eastern European countries are  sandwiched somewhere between Central   Europe on the one side and the  harder-hit countries further east on the other side. Countries like FYR  Macedonia (1.1x), Bulgaria (1.4x) and Serbia (1.6x) appear to be closer to  Poland and the Slovak Republic, while Albania, Romania, Turkey and Ukraine saw  their NPL ratios double.

Fourth, NPL ratios  increased across the board in April and May this year. On the low end, we find  (again) Poland and the Slovak Republic with only moderate increases. On the high end, we find a  remarkable increase in Kazakhstan from 15.2 per cent in April to 29.2 per cent in May, i.e.  5.7 times the June 2008 level. Three factors are likely to have contributed to  this sharp recent increase.

First, some of the large banks have been in debt  restructuring talks and as such may have had to come clean about their  portfolio quality. While Kazakhstan was hit by the crisis as early as August 2007 NPL ratios  did not move much for about a year, a period during which some banks rolled  over past due loans to both corporate and retail clients. Second, the February  2009 Tenge devaluation has gradually been feeding through the real economy as  unhedged FX borrowers found it difficult to repay their bank loans. Third, the  increasing NPLs also reflect further price declines of Kazakh real estate, a  sector to which the main Kazakh banks were overexposed.

Fifth, the  fate of the Kazakh banks reveals a broader relationship between NPL increases  and real estate developments. We find that collapsing real house prices and  relative increases in NPLs go hand in hand in other countries, too (Figure 2).

Figure 2: Correlation between house price collapses and relative changes in non-performing loans

It is a well-known fact that loan quality lags the business  cycle. During good times banks quickly expand their credit portfolios, the age  of the average loan is low, and non-performing loans are few and far between. In  contrast, during a business cycle downturn or a crisis, the inflow of ‘fresh’  loans is reduced, the average loan portfolio of banks matures and loan problems  become increasingly apparent over time. NPL  ratios increase particularly fast as they combine the effect of weaker loan quality in  the numerator with lower loan growth in the denominator. We expect therefore  that during the next couple of months, when economic ‘green shoots’ will hopefully  become increasingly visible, we may be confronted with the lagged legacy of the  2007-2009 crisis in the form of a further increase in non-performing loans.

¹ Only half of the countries use 90 days as the threshold  after which an overdue  loan is considered non-performing, for 6 countries  there is no methodological information, and 9 countries offer no monthly or  quarterly data. In this blog, we use March 2009 as the latest date since data  availability is spotty afterwards.

However, there is an invisible channel through which advanced country quantitative easing can benefit emerging markets. Through advanced country based international banking groups, quantitative easing in those countries has been quietly trickling down to subsidiaries of these bank groups in emerging markets. This is true for subsidiaries of large US-based banks in Latin America or Asia, or of large euro-zone based international banking groups.

This “invisible hand” of the European Central Bank is particularly important, given that Europe appears to have the highest propensity among regions to do cross-border lending (see below chart). In the euro zone, ECB refinancing rates have been slashed. Eurobor interest rates have also come down dramatically from about 5.5 per cent just nine month ago to 1.5 per cent. Parent banks can obtain funds at these rates and use it for their whole bank group. The extent to which this benefits their subsidiaries depends on the risk pricing parent banks attach to exposure to their subsidiaries that are located in a region which has been subject to heavy downgrades. Risk pricing is based on prudential considerations as well as strategic decisions. Some bank groups may charge below CDS levels, others apply CDS – and actually can make good profit on it, particularly where domestic policies are generally appropriate and international support is overwhelming. Be it as it may, this has helped strategic bank groups to stay engaged in the battered emerging European markets. Moreover, as a smart banker pointed out to me the other day, under pegged currency arrangements, the lower euro cost funding may outweigh the impact of higher risk premium for a given country, leading to a significant decline in the nominal value of debt service. This can help unhedged borrowers – particularly those with young exposures where the interest payment portion is larger – to cope with necessary real adjustments through nominal income decline in the context of the pegged arrangements of Latvia and others.

(Source: IMF)

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First, one needs to make a clear distinction between cross-border foreign bank lending and local lending. In the former case, multinational banks lend from their headquarters to a company abroad. In the latter case, they use a local network of branches and subsidiaries. The latter form of foreign bank lending is much more stable than the former (García Herrero and Martinez Peria, 2007). Peek and Rosengren (2000) find for Latin America that cross-border lending did in some cases diminish during economic slowdowns, whereas local lending by foreign banks was much more stable. For Central and Eastern Europe, De Haas and Van Lelyveld (2004) find that reductions in cross-border credit were generally met by increases in lending by foreign bank subsidiaries, either because new subsidiaries were established or because the lending of existing affiliates increased.

Emerging markets that allow cross-border bank lending, but put up (in)formal barriers to brick-and-mortar foreign bank entry thus do themselves a disservice. Of course, such countries could choose to not allow any form of foreign bank lending, neither cross-border nor through local affiliates. This brings me to a second important issue.

Discussions about the supposed fickleness of foreign banks often ignore the question of what is an adequate comparison group or counterfactual. Since all bank lending tends to be procyclical, in particular during crisis periods, an important question is whether foreign bank lending is less (or more) stable compared to lending by domestic banks. It may be less stable, because parent banks reallocate capital to other countries when an emerging market goes through a business cycle downturn. Parent banks redistribute group capital across various subsidiaries on the basis of expected investment opportunities (De Haas and Naaborg, 2006). It may be more stable, because parent banks usually can support subsidiaries that somehow get into financial difficulties (domestic banks lack such parents with deep pockets). This latter argument has often been used to argue why foreign bank entry in transition countries has contributed to more stable financial systems in this region.

In a forthcoming article, Iman van Lelyveld and myself analyse a large bank-level dataset of foreign bank subsidiaries across the world, to compare lending by foreign bank subsidiaries with lending by domestic banks. The dataset includes 45 multinational banks from 18 home countries with 194 subsidiaries across 46 countries (see figure 1). For each host country, we also collect data for a benchmark group of up to five of the largest domestic banks. In the empirical analysis, we look at how yearly credit growth is affected by a number of bank-specific financial variables, macroeconomic determinants, as well as an indicator of whether the host country is experiencing a banking crisis.

We find that subsidiaries of stronger parent banks – with high net interest margins or low loan loss provisioning – grow faster and that parent banks trade off lending across countries. Importantly, as a result of parental support, foreign bank subsidiaries do not typically rein in their lending during a financial crisis. In sharp contrast, we find that domestic bank lending decreases substantially during local banking crises. Apparently, subsidiaries can rely on parental support during a financial crisis, a form of support that is not available to domestic banks. This finding confirms similar results reported by De Haas and Van Lelyveld (2006) for a sample of transition countries.

Figure 1: Parent banks (black) and their foreign subsidiaries (white)

(click to enlarge)

These findings imply that across the board, openness to multinational bank subsidiaries may actually benefit host countries. Multinational banks provide a stabilizing factor during local financial turmoil in particular. Our results also show, however, that the health of parent banks matters a lot: weak parent banks can provide less support and their subsidiaries grow more slowly. Lending by foreign subsidiaries may even be scaled back in order to free up capital for the parent bank, leading to contagion from home to host countries. Of course, this caveat has become quite acute during the current global financial crisis, which has clearly been testing the resilience of the support effects that we document in our research.

So far, however, the anecdotal evidence suggests that multinational banks and their foreign subsidiaries have been behaving more or less as can be expected on the basis of historical patterns. That is, cross-border lending – in particular syndicated lending – has decreased significantly, but many multinational banks have so far continued to support foreign subsidiaries. Given the extreme circumstances of the current crisis, in some cases this parental support has been complemented by coordinated efforts of a number of International Financial Institutions. And, as in earlier crises, lending by domestic banks seems to have been hit equally hard, if not harder. Across many transition countries – from Latvia, to Hungary, Ukraine, and Kazakhstan – the domestic shareholders of some of the largest domestic financial institutions have been unable to come up with the additional capital support that these systemic banks needed. As a result, bank lending by these banks has contracted severely, some of them (almost) defaulted, and local governments needed to step in. While foreign bank entry is not a panacea to all banking problems emerging markets struggle with, the empirical evidence seems to suggest that the presence of foreign bank subsidiaries may add to financial stability rather than reduce it.

References

De Haas, Ralph and Iman van Lelyveld (2004), Foreign bank penetration and private sector credit in Central and Eastern Europe, Journal of Emerging Market Finance, 3(2), 125-151.

De Haas, Ralph and Iman van Lelyveld (2006), Foreign banks and credit stability in Central and Eastern Europe. A panel data analysis, Journal of Banking and Finance, 30, 1927-1952.

De Haas, Ralph and Iman van Lelyveld (2009), Internal capital markets and lending by multinational bank subsidiaries, Journal of Financial Intermediation, forthcoming.

De Haas, Ralph and Ilko Naaborg (2006), Foreign banks in transition countries: To whom do they lend and how are they financed?, Financial Markets, Institutions and Instruments, 15(4), 159-199.

García Herrero, Alicia and Maria Soledad Martínez Pería (2007), The mix of international banks’ foreign claims: determinants and implications, Journal of Banking and Finance, 31(6), 1613-1631.

Peek, Joe and Eric Rosengren (2000), Implications of the globalization of the banking sector: The Latin American experience, New England Economic Review, September/October, 45-63.

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