The global financial crisis originated in the US sub-prime mortgage market, where banks had gradually relaxed their screening and monitoring standards (Keys et al., 2010). In a recent working paper, Neeltje van Horen (Dutch central bank) and myself analyse whether, when sub-prime losses materialised in the autumn of 2007, banks reassessed their screening and monitoring standards (De Haas and Van Horen, 2010). To answer this question we study changes in the syndicated loan market. This market is particularly well-suited to assess changes in screening and monitoring because the structure of lending syndicates reflects the importance that banks attach to the screening and monitoring of borrowers (Sufi, 2007). A short primer on syndications will make this clear.

Syndicated lending and “skin in the game”

Syndicated loans are provided by a group of financial institutions – the syndicate – to a single borrower. A typical syndicate consists of two tiers: arrangers and participants. The arrangers comprise the senior tier and negotiate the lending terms with the borrower. Arrangers usually allocate a substantial part of a loan to a junior tier of syndicate members, the participants. Participants have a more passive role: they buy a portion of the loan but are neither involved in its organisation nor in the screening and monitoring of the borrower.

Participants use arrangers as delegated monitors (Diamond, 1984). A downside of this functional division is that arranging banks have a reduced incentive to screen and monitor. To resolve this agency problem arrangers can retain a large enough loan portion on their own balance sheet (retention rate). Such “skin in the game” is an efficient mechanism to ensure that arrangers sufficiently screen and monitor (Pennacchi, 1988). We consequently argue that if participant banks became more concerned about screening and monitoring at the start of the crisis – a wake-up call – this should be reflected in a significant increase in retention rates.

By syndicating part of the loans they structure, arrangers free up space on their balance sheet. This allows them to originate additional loans and earn fee income. When arrangers only need to retain a small portion of each loan, they can originate many syndicated loans and the supply of lending is high. Conversely, when capital-constrained arrangers are required to retain a large loan portion, they can syndicate fewer loans and the supply of syndicated credit is lower. Fluctuations in retention rates may thus be inversely related to the supply of syndicated lending. Indeed, Chart 1 shows how at the onset of the crisis in mid-2007 a sharp increase in retention rates was accompanied by a steep decline in syndicated lending.#

  Graph 1. Retention rate and syndicated lending volume (click to expand)

Main findings

The econometric analysis in our paper shows that – even when we control for changes in inter-bank liquidity and borrower risk – the outbreak of the crisis led to a significant and robust increase in arrangers’ retention rates. This increase materialised during the early phase of the crisis – before the collapse of Lehman Brothers and the ensuing sharp output decline – and persisted over time.

In a next step we test whether loan retention increased in particular when information asymmetries between the syndicate and the borrower were large. Lenders likely became most concerned about adequate screening and borrowing in the case of such opaque loans. Similarly we expect that when information asymmetries were large within a syndicate – that is: between participants and arrangers – retention rates increased more as well. To analyse both layers of agency problems – between lenders and borrowers and among lenders – we exploit detailed information on market, borrower and lender heterogeneity.

As expected, we find that retention rates increased significantly more – both in statistical and economic terms – when information asymmetries were high. Table 1 shows the economic magnitude of some of the significant differences we document in the working paper. While the retention rate for loans to first-time borrowers increased by almost 11 per cent, arrangers of syndicated loans to borrowers with average borrowing experience (two and a half loans) only needed to increase their retention rate by 7.6 per cent. The necessary increase in loan retention was even much smaller in case either the arrangers or the participants themselves had previously lent to a specific borrower (or in case they had substantial prior experience in lending to a borrowers’ industry or country). Finally we find that experienced arrangers needed to increase their retention rates much less than less experienced arrangers. Reputation limited the crisis-related increase in agency problems within lending syndicates.

Chart 1. Economic significance of crisis impact on retention rates (click to expand)

Policy implications

We find that more transparent borrowers, more experienced participants, and more reputable arrangers all helped to contain the crisis-related correction in screening and monitoring intensity and thus in retention rates. This strong link between the severity of information asymmetries and the increase in retention rates further underlines that the overall increase in retention rates at the onset of the crisis, and the subsequent decline in syndicated lending, was at least partially caused by stricter screening and monitoring. To the extent that this reflects a reversal of the pre-crisis loosening of lending standards, banks’ continuing reluctance to lend may prove to be quite persistent even when banks’ own funding constraints would gradually become less binding.

Our findings also bear on the current regulatory debate about minimum “skin in the game” retention rates for originating banks. In July 2009 the European Parliament amended the Capital Requirements Directive by including a 5 per cent retention requirement for securitisations, while in May 2010 the US Senate passed the Financial Reform Bill which announces the introduction of similar regulations. Earlier plans to let minimum retention requirements not only apply to securitisations but also to syndicated loans have (at least for the time being) been shelved. At first sight our results confirm that regulatory retention requirements may indeed not be necessary for syndicated loans. After all, we document a strong, broad-based but market-driven increase in retention rates among syndicate arrangers. Participants, concerned about arrangers’ lax screening and monitoring, were in many cases able to take corrective action without regulatory intervention. Although syndicated lending declined sharply, the market did not break down. This stands in contrast to the securitisation market, where the link between the originator and the ultimate investors was too severed to make any corrective (and collective) action possible.

However, when the market for syndicated lending will expand again, and financial institutions once more start to compete heavily to participate in (oversubscribed) syndicated loans, the pressure on arrangers to retain loan portions that are high enough to guarantee sufficient screening and monitoring may gradually erode. Without the introduction of some form of mandatory retention rates for syndicated loans, the risk exists that old practices will soon return. This may in particular be the case if the secondary market for syndicated loans, where both arrangers and participants can offload their loan stakes, revives again. One way to reduce such a negative impact of subsequent loan sales is to require arrangers to hold on to the loan portion they retained at origination. Although such a requirement could be introduced through legislation, participants themselves could also more often demand that restrictions on subsequent loan sales by arrangers are included in loan contracts.

References

De Haas, R.T.A. and N. Van Horen (2010), The crisis as a wake-up call. Do banks tighten screening and monitoring during a financial crisis? EBRD Working Paper No. 117, London.

Keys, B.J., Mukherjee, T., Seru, A. and V. Vig (2010), “Did securitization lead to lax screening? Evidence from subprime loans”, Quarterly Journal of Economics 125, 307-362.

Pennacchi, G. (1988), “Loan sales and the cost of bank capital”, Journal of Finance 43, 375-396.

Sufi, A. (2007), “Information asymmetry and financing arrangements: Evidence from syndicated loans”, Journal of Finance 62, 629-668.

We’ve just published our latest update on Emerging Europe and Central Asia’s economic outlook which indicates that the recovery in the transition economies is progressing with important exceptions, and highlights the key factors behind this diverse picture.In many countries economic activity was strong in the first half of the year, but the outlook is dimmer, due to the short-term negative demand impact of fiscal austerity  packages and/or global exiting from crisis-related macro policy loosening: (i) in advanced EU countries (main export markets for emerging Europe), (ii) in transition countries themselves  (dampening domestic demand); and (ii) globally, as the rest of the world exits from crisis-related expansionary macro economic policies, weakening global demand for natural ressources and commodities.  Balance sheet pressures on banks active in the region also weigh on credit growth. Significant uncertainty remains both on the downside and upside; however, the balance of risks has shifted to the downside since May.

As a result, the growth forecast for the EBRD’s region of operations has been revised downward by 0.2 percentage points since the last EBRD forecasts in May to 3.5 per cent in 2010, and by 0.1 percentage point to 3.9 percent in 2011:

• The downward revision is most pronounced in both years for South-Eastern Europe where the recession appears to be lingering.
• In Central-Eastern Europe, stronger than projected recent growth, while lifting 2010 growth, is expected to fade in 2011. Some Central European countries have recently witnessed stronger than expected growth, which may spill into 2011; at the same time policy uncertainty can also affect investor confidence in cases such as Hungary.
• Central Asia is expected to grow somewhat more than previously projected on the back of good prospects for commodity exports.

A recovery appears to be underway in the second quarter of 2010, although with notable exceptions. On the back of a global recovery in trade, growth in industrial production and exports increased in most countries in the second quarter. In the largest emerging market countries of the region (Russia, Turkey and, since the presidential election, Ukraine), a return of capital inflows has also contributed to growth. Strong commodity prices, despite some market volatility, have benefited commodity exporters (Russia, Kazakhstan, Armenia and Mongolia).

In contrast, output growth continues to be near zero or negative in most countries of south-eastern Europe, and neighbouring Croatia and Slovenia. Here, recovering exports were offset by weak domestic demand, and financial systems suffered some pressure from the turmoil in Southern European sovereign debt markets. In several countries, net capital inflows remain subdued and credit to the private sector contracted or stagnated. In addition, flood damage reduced GDP in some countries. Another exception to regional recovery is the Kyrgyz Republic where political turmoil has disrupted economic activity.

Inflation pressures continued to subside across the region. In those countries where inflation has picked up since end-2009, the increase was caused by hikes in administered energy prices (FYR Macedonia, Kazakhstan, Moldova and Slovenia), VAT and excise tax rises (Bosnia and Herzegovina, Bulgaria and Estonia), or sharp depreciations (Georgia).

Source: CEIC database and national statistical offices.

The outlook for the remainder of 2010 and for 2011 is generally weaker than recent economic activity suggests. Central and Eastern European countries depend heavily on trade and financial links with the EU. Given the weakening outlook for the Eurozone – as fiscal austerity programmes are implemented and financial markets are likely to remain volatile – the external environment may be less benign than previously projected. Credit growth is expected to remain weak as long as banks’ balance sheets remain under pressure, regulatory uncertainty lingers, and the cost of capital are elevated. In addition, country-specific developments will constrain growth. Several countries have announced additional fiscal tightening measures (e.g., Lithuania, Romania and Serbia). Resource-rich countries in the Caucasus and Central Asia will be affected by a slowdown in commodity prices resulting from shrinking demand from Asia.

Downside risks, mostly due to the external environment, have intensified. The “fan chart” below, which is estimated for EU member states in the transition region plus Croatia, illustrates how the risks have become increasingly tilted to the downside. Fiscal consolidation in Europe and monetary tightening in China may still trigger a sharper slowdown in global growth than currently projected. In this downside scenario, trading partner growth could turn negative in the second half of 2010 and remain negative in 2011. This could be compounded by further deleveraging in the financial sector if capital and liquidity remain scarce and risk aversion rises. Financial market volatility could rise significantly. In addition, if market nervousness over fiscal sustainability intensifies, several countries may require austerity packages to convince markets of the sustainability of public finances. While expenditure-based fiscal consolidation may benefit competitiveness in the medium-term, it would dampen growth in the short-term.

At the same time, prospects for fiscal sustainability are better than in many advanced economies and may result in upside risks. Compared with advanced economies and other emerging markets, public debt-to-GDP ratios in the region are generally low. Many countries are implementing significant fiscal consolidation programmes which, if focussed on expenditure cuts that typically produce more lasting improvements in fiscal balances than revenue increases, should improve fiscal sustainability as well as competitiveness. In addition, medium-term growth prospects are typically stronger than in advanced countries which are planning to implement austerity programmes. As a result, capital flows in search of yield may be attracted to debt markets in the EBRD’s region of operations, helping to push growth in the whole region possibly above 4 per cent this year and closer to 5 per cent next year.

Participants will be able to assess the latest political, economic and social changes and business opportunities in the country and across our region of operations, as well as a chance to network and to enjoy the host country’s cultural programme.

The Bank’s shareholders will be making important decisions about the strategy of the EBRD for the coming years and how it can be best equipped to carry out its role. The Board of Governors’ sessions will be chaired by the EBRD Governor for France Christine Lagarde, who is also France’s Minister of Economy, Industry and Employment.

A further 19 country presentations will give the Bank’s countries of operations a chance to articulate current investment opportunities. In parallel with the official AM programme, the EBRD and Croatia will co-host an informal meeting of heads of government of South-Eastern Europe on 14 May. The meeting is held in the format of the South East Europe Cooperation Process, which includes Albania, Bosnia and Herzegovina, Bulgaria, Croatia, FYR Macedonia, Greece, Moldova, Montenegro, Romania, Serbia, and Turkey.

At the start of this year, the global economic crisis was hitting central and eastern Europe with unimaginable force. Any illusion that this region was somehow immune from the “western” credit crunch and the subsequent financial squeeze was definitively quashed. Output was declining at startling rates that would only become apparent much later in the Spring.

But the danger signs were everywhere. There was real risk of a genuine emerging market crisis – that financial systems in a number of countries would collapse entirely, that currencies would run out of control, that there could be sovereign defaults.

That this horror scenario didn’t happen was a result partly of unprecedented international support, with the EU and organisations like the IMF providing huge macroeconomic packages that were flexible and tailored to specific country needs. Other IFIs, including the EBRD, stepped into provide micro support to banking groups and corporates with little or no access to liquidity. Crucially western banks, a dominant force in financial sectors in many countries in central and eastern Europe, did not retrench as feared. The authorities in eastern Europe responded with policies aimed at dealing promptly and effectively with the crisis, even though those responses were in some cases immensely painful and politically unpopular.

These economies are not yet out of the woods. The EBRD forecasts show that the contraction of the economy this year will on average be worse than expected just five months ago and while a modest recovery has started to set in, a number of countries will only show full year growth in 2011.

Most importantly it will take several years before economies start growing again at levels where they have even the prospect of catching up with European Union norms. This means that the sacrifices that have been taken will take even longer before they are translated into standards of living that the people of the region aspire to and deserve.

Before the crisis, government officials liked to muse about developing break-through projects in high-tech sectors such as biochemistry and space technology. About 30 to 50 ‘corporate leaders’ were the be hand-picked by the government, receive preferential treatment, and develop into competitive players in the regional and even global economy. So far this program has been disappointing, perhaps because the coveted industries are too far removed from Kazakhstan’s current technological frontier.

The ‘corporate leaders’ concept was no longer mentioned in a recent speech by President Nazarbayev. Instead, he focused on developing sectors that are closer to Kazakhstan’s current or potential comparative advantage given the country’s existing capabilities and resource endowments:

(1) Agriculture and agri-processing. Kazakhstan’s vast land mass gives it a comparative advantage in agriculture, but substantial investments are needed to improve the productivity of primary agriculture and agri-processing. Better infrastructure (such as sufficient railway capacity to export grain) is needed as well.

(2) Construction industry and building materials. Although the construction sector and the manufacturing of building materials is currently hit hard by the bust in the real estate market, there is still a need to increase the quantity and quality of commercial and residential real estate.

(3) Oil refining and the infrastructure of oil and gas industry. The three oil refining and processing facilities in the country are in desperate need of upgrading. Kazakhstan also needs to increase and diversify its oil export capacity to allow for increasing oil production during the next years.

(4) Metallurgy and manufacturing of finished metal products. Sensible given the large-scale mining industry (copper, iron ore).

(5) Development of the chemical, pharmaceutical and defence industries. The development of a (petro-)chemical cluster makes sense given the abundant hydrocarbon and mineral wealth. The development of a viable pharmaceutical industry is less likely. Eventual WTO accession will be problematic for this sector.

(6) Energy sector, including the development of clean power. Reducing the economy’s energy intensity by 10 per cent by 2015. Important given the capacity constraints in the power sector and low energy-efficiency of the industrial and manufacturing sectors.

In addition, the government announced reforms in infrastructure and the financial system, two sectors that are key for the emergence of new industries and a better utilisation of domestic and foreign saving than in the past. The further development of transport infrastructure (including the Western Europe – Western China highway corridor) is crucial to unlock export potential (and related economies of scale in production) in light of Kazakhstan’s limited domestic market. The need to create a ‘new national financial architecture’ is obvious as well, now that Kazakh banks no longer have access to virtually unlimited amounts of foreign funding. Banks will need to develop a deeper and stable deposit base and reduce their dependence on foreign wholesale funding. This will also allow them to bring down their FX lending.

So how actively should the Kazakh government promote the growth of these industries? There can be good reasons to use industrial policy to further economic diversification. Kazakhstan will substantially expand its oil production between now and 2015 and this means that the underlying tendency for the economy is to become more, not less, dependent on the hydrocarbon sector. A sensible form of industrial policy may assuage this underlying trend and partially prevent its harmful impact on other economic sectors.

The economics profession also increasingly recognises that industrial policy may help to overcome market failures in emerging markets, such as when various projects require simultaneous large-scale investments in order to become profitable (see also Chapter 5 of EBRD’s Transition Report 2008 for an overview of industrial policy in a range of transition countries). However, recipes on how to practically implement industrial policy remain scarce. For instance, while a recent book by Dani Rodrik – professor of international political economy at Harvard University – argues why carefully crafted and country-specific industrial policies may be necessary to kick-start economic growth, it is less convincing in the practical recipes that it prescribes. Rodrik argues that governments in emerging markets should not simply hand-pick companies that will get government support. Instead, there should be a continuous process of national economic ’self-discovery’ in which the government in consultation with the private sector discovers the productive potential of the country.

While Rodrik acknowledges that ‘embedding industrial policy within a network of linkages with private groups’ may facilitate corruption and rent-seeking, it remains difficult to see how this interactive process of economic self-discovery will not be captured by vested interests and political elites that dominate many transition and emerging countries. However, even when taking these caveats into account, there are still a number of general ‘do’s and don’ts’ of successful industrial policy that can be distilled from the current state of the economic literature:

]]> http://www.ebrdblog.com/wordpress/2009/06/kazakhstans-industrial-policy-between-pipedream-and-pipelines/feed/ 0 http://www.ebrdblog.com/wordpress/2009/05/in-defense-of-foreign-banks/ http://www.ebrdblog.com/wordpress/2009/05/in-defense-of-foreign-banks/#comments Tue, 19 May 2009 11:45:51 +0000 Ralph De Haas Senior Economist http://www.ebrdblog.com/?p=384 ‘Banker’ has recently become somewhat of a dirty word and ‘foreign banker’ a most reviled sub-species. Over the last months foreign banks have, amongst other things, been accused of abandoning some of the emerging markets that have contributed so much…

‘Banker’ has recently become somewhat of a dirty word and ‘foreign banker’ a most reviled sub-species. Over the last months foreign banks have, amongst other things, been accused of abandoning some of the emerging markets that have contributed so much to their profitability over the last decade. When the going gets tough, so the story goes, foreign banks quickly cut back their lending abroad and refocus on domestic clients. Indeed, a recent blog entry by my colleagues at the EBRD Piroska Nagy and Stephan Knobloch nicely illustrates how fast international lending to emerging markets shrank in recent months. Is foreign bank lending really inherently instable? If so, large-scale foreign bank entry, as seen in Central and Eastern Europe and to a lesser extent Latin America, may seriously undermine the stability of emerging banking systems. In answering this question, two issues should be kept in mind.

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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As the creators of these forecasts, we found this both flattering and dismaying. Flattering, because it is nice to be taken seriously. Dismaying, because it was not the reaction we had hoped for.

So, was the reaction justified? Or, to put the question differently: are our forecasts in fact “bearish”, and if so, in what sense?

It makes sense to answer the question by taking the 2009 and the 2010 forecast separately. For 2009, we forecast a deep regional recession, with growth of about -5 per cent on average. This is driven by a -7.5 per cent forecast for Russia and -10 for Ukraine. These numbers are 1.5 and 2 percentage points below, respectively, the latest published IMF forecasts. Because they refer to large countries, they pull down the 2009 regional average below that announced by the IMF, and also below the recent forecast of the European Commission.

Does this make us bearish? Yes and no. Among the published 2009 IFI forecasts for “emerging Europe” right now, ours seems to be the most negative. But this is not driven by a particularly pessimistic view of the future. It is simply an acknowledgment of what we know has happened in the last quarter of 2008, and what we think may have happened – in the case of Russia, based on a government estimate – in the first quarter of this year. Because growth in 2008 was still buoyant in the region until the second quarter and in some countries even the third quarter, the large declines in output in the fourth quarter of last year and the first quarter of this year have a huge impact on the ultimate growth figure for the year, almost irrespective of what happens in the remaining quarters. Even if there is a sharp recovery in the rest of the year, the large contractions we have witnessed in the last two quarter will depress the base from which this recovery happens. The result is a large negative year-on-year growth number.

So, conclusion number one is: for 2009, we are not really bearish. We are simply looking at how much output has already declined (or seems to have declined in the first quarter), and doing the math.

This leads to the more interesting question: our forecasts for 2010. Unlike the 2009 number, which is largely a carryover story, the 2010 number is truly about the future. It reveals what we think about the duration of the recession, and the path to recovery.

On this point, we were torn, reflecting the exceptional uncertainty of the moment. This is described by two polar stories: “You ain’t seen the worst” on the one hand; and “Watch those green shoots” on the other.

“You ain’t seen the worst” points to the fact that the output declines that we have observed in the last two quarters represent the impact effect of the crisis. It is the direct, combined effect of a drop in demand for exports, a sharp financing shock, and a large retreat in commodity prices. The collapse in demand and financing is generating stress in the corporate and household sector. This will result in corporate defaults, rising unemployment, and much higher non-performing loans, putting banking systems under stress, lead to a further tightening in credit, and possibly disrupting corporate supply and payment chains. As a result, there could be a second round of output collapses. The implication of this view is that we may not see a recovery until the financial system has dug itself out from under a pile of bad loans.

“Watch those green shoots” points to recent signs of stabilisation. In most countries for which month-on-month seasonally adjusted industrial output data is available, output does in fact appear to have stabilised beginning in February. In some countries, such as Poland and Turkey, there are even signs of a recent upturn. At the same time, consumer confidence has been stabilising and even turning around in most central European countries (the main exception being Hungary). And except for Lithuania, most of countries on which Eurostat reports are showing tentative revivals of industrial confidence. The green shoots story views this as evidence that the recession has bottomed out, and that the recovery must be just around the corner.

(click to enlarge)

(click to enlarge)

In our forecasts, we are going with neither of these stories. We are taking the middle ground. Why are we doing that? Part of the reason may be that we are a stodgy old IFI (OK, a stodgy young IFI), so we like to be conservative. But for the most part, the reason is that the middle-ground is backed by the latest and most comprehensive general evidence on the subject available, and that this evidence jives well with what we see on the ground in our countries.

The general evidence on patterns of recovery following financial crises are nicely summarised in Chapter 3 of the IMF’s latest (April 2009) World Economic Outlook. For our purposes, the chapter has three important findings.

Now consider the two polar stories. Clearly, the evidence cuts both ways.

We do not think this will happen, for two reasons:

First, while output declines in emerging Europe have been severe, this crisis is also notworthy for what has been missing: uncontrolled currency collapses, runs on banking systems, coercive policy actions, and political upheaval. These have been the standard staple of emerging market crises in the past. Not here. At EBRD, we think this has to do with the quality of financial and political integration in our region; particularly parent bank financing, and close political and institutional ties with the West. These sources of stability are likely to persist (knock on wood).

Second, there is an unprecedented level of international support: at the macro level, by the IMF and the European Commission; at the micro level, by a triumvirate of IFIs – the EBRD, the EIB, and the World Bank/IFC. In late February, these launched a €25 bn IFI Joint Action Plan to stabilise the financial sector in emerging Europe. The action plan is on track (see for example, the EBRD’s recent deal with Unicredit subsidiaries). It is being complemented by an initiative, joint with the IMF and financial authorities in East and West, to coordinate major foreign-owned banks to maintain their exposures in emerging European countries.

To conclude: the most likely scenario for emerging Europe today is neither a sustained recovery beginning in this quarter, nor a double dip recession with a further generation of output collapses around the corner. Rather, it is a bottoming out of the crisis this quarter and next followed by a slow recovery beginning next year. This is the basic pattern underlying most of our growth forecasts.

This said, there are clearly risks on both sides. In particular, perhaps for the first time in over a year, there is certainly upside risk. It is possible that the dynamic of inventory rebuilding combined with some export stimulus from expansionary policies in the West will generate a virtuous circle of improving confidence and recovering output, even with the financial constraints imposed by weak balance sheets. We cannot assume so at this point, but we certainly hope to be wrong.

[1] “Is Credit a Vital Ingredient for Recovery? Evidence from Industry Level Data”, Box 3.2.

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New BIS data for the last quarter of 2008 show that BIS-reporting banks significantly reduced their asset holdings across major regions of the world. While in absolute terms most of the reduction took place in advanced countries, in relative terms, emerging markets were hit harder. Our region has thus far been least affected. Furthermore, the decline has been concentrated on a few countries; all others experienced no change or even some increases in net bank capital inflows. Net bank outflows tend to have happened in the most financially integrated countries, but not necessarily in countries with weaker fundamentals; with large outflows both from countries that have already been hard hit by the crisis (Ukraine) and countries that have been resilient so far (Poland).[1]

BIS has reported that, after virtual no change in Q3 2008, the global external claims of BIS-reporting banks shrank by 5.4% in (US$ 1.8 trillion) in Q4 2008, the largest recorded decline ever. The following points are noteworthy:

Among the emerging markets, emerging Asia has taken the hardest hit both in absolute and relative terms. Emerging Europe is the least hit in absolute and relative terms, although the declines (US$ 57 billion) are still very significant.

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Within Emerging Europe, the outflows are concentrated in a few countries: Russia, Turkey, Ukraine, as well as Poland, the Czech Republic, and Slovenia. This is a mixture of countries with very different fundamentals and crisis impact. Russia and Ukraine have suffered large external shocks, where the crisis had been unfolding for some time. On the other hand, countries like Poland and Czech Republic have stronger financial systems, and the direct impact of the crisis had been less pronounced. This is in line with earlier crisis experiences which showed that investors withdraw liquidity not only from countries with weaker fundamentals but also from markets in the same region that are deeper and more liquid.

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Looking forward, similar trends are expected to have continued – if not deepened – in Q1 of 2009. Develeraging is an inevitable part of banks’ balance sheet adjustment in the context of the global financial crisis. As part of Bank’s crisis response, under the Joint IFI Action Plan, the Bank, together with other IFIs, aims to avoid/limit the destructive, uncoordinated develeraging due to failure of collective action by the key stakeholders: bank groups, home and host authorise, and IFIs.

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Footnotes:

[1]. Data refers to all cross-border loans, deposits, and securities held by bank offices located in one of the 41 BIS-reporting countries. This includes assets held vis-à-vis all economic sectors, i.e. private and public, or bank and non-bank. BIS uses the category “developing” countries; this note uses “emerging” countries instead.

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The crisis has changed the way we operate. Today’s EBRD is different from that of a year ago. The intensity of work has increased dramatically. Signings of projects are up by more than 30 per cent in the first quarter this year, and the pipeline of projects in preparation has grown far beyond anything previously seen in the twenty-year history of the Bank. Corporate recovery is preparing for a possible increase in demand slumber since the last crisis in the region, and the group responsible for financial institutions is working around the clock.

The changes are equally visible in my own office as we strive to meet the demands of an increased business volume and understand the increasingly complex and rapidly changing context of our projects. The frequency and scope of risk assessments have increased dramatically. There is a heightened sense that things matter – that speed of delivery, but also accuracy, are more important than before. Pressure levels are definitely up, but so is our motivation.

This transformation should not be surprising. In fact this “state-contingent” or “countercyclical” nature, as economist jargon would have it, is what the founders of the EBRD had in mind, at least intuitively, when they signed the Articles Establishing the Bank in 1991. Like the other multilateral development institutions, the EBRD has built up massive stakes in the health of its countries of operation. And like the other regional banks, when its region is particularly affected, as Eastern Europe is by this crisis, the EBRD does not have the option to diversify or concentrate on other parts of the world. As the single largest financial investor in Eastern Europe and with a third or so of its portfolio in equity, the ups and downs of its countries matter greatly.

It is not only that the EBRD by design is vulnerable to economic downturns in its countries of operations, the institution also internalises the many conflicts within and across countries brought out by the crisis. As for the conflicts within countries, the EBRD has a large stake in defending the interests of private entrepreneurs as government bureaucrats may exploit the crisis to expand their empires.

Equally important, national policy responses often also have consequences on other countries, particularly when countries are as closely integrated as in Europe. For some time these interdependencies led to paralysis. Eastern European governments did not address the increasing vulnerabilities in their banking sectors as they thought it was a problem caused by the dominant international banks and their home regulators and supervisors. Governments in Western European felt they could not act without some signs of engagement from their Eastern European counterparts. In the meantime the situation was deteriorating.

When the Western European governments started to address their own banking problems their actions had direct impact on their Eastern European neighbours. Generous deposits guarantees attracted depositors from countries without such guarantees or without the resources to back such guarantees. Over the past six months important bank bailout programmes in Western Europe have helped stabilise the international banks operating in Eastern Europe. Still, there is increasing concern that these programmes will discriminate against subsidiaries abroad.

Moreover, Eastern European governments can also damage the international bank groups by preventing them from transferring profits or adjusting their exposures. The public pressures to interfere are great. Actions by a bank, or a government, in one host country can have consequences for other host countries, either directly or through the balance sheets of the parent banks.

The EBRD with its direct engagement in the countries and through its interests in the health of the international banking groups was set up to internalise these cross-country spillovers. That is the way the Bank has been so active in promoting coordination among regulators, supervisors and banks in Western and Eastern Europe. Through the so-called Vienna Initiative we have – in concert with the other international financial institutions active in our region – brought together the parties in home-host country discussions, public-private sector dialogues and conversations within and among the banks.

A series of meetings in Vienna have produced agreements on the sharing of information and broad outlines of principles for how to share the burden of refinancing and recapitalising the international banks and their subsidiaries between home and host countries. They have also brought about signed commitments in particular countries from the banks to achieve certain levels of refinancing and recapitalisation and from individual governments to implement certain policies.

No matter what their original mandate was the international institutions the global crisis is now testing them. The example of the EBRD illustrates how an institution, in much closer collaboration with its peers, quickly can fill some of the gaps in the European architecture. As the world’s leader further contemplate whether to provide additional capital to these institutions they should also look more closely at how to improve their governance and strengthen their incentives and capacity to respond in a timely and effective manner. There is much to suggest that the international financial institutions will also have a greater role to play in the recovery and in the post-crisis world.

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