The EBRD's new growth forecasts: "bearish", or turning point?

By: Jeromin Zettelmeyer Director for Policy Studies

Following the release of our latest growth forecasts for the EBRD countries of operations on Thursday, Reuters reported that emerging European currencies had retreated on “bearish EBRD forecasts.”

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.

 

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.

First, growth takes much longer to turn positive again in a recession triggered by a financial crisis compared to a regular recession: on average, 6 quarters rather than 3 quarters. If we were to apply this average mechanically to our countries – which we don’t, but suppose we did – we would be predicting a return to positive quarter-on-quarter growth in mid-2010.

Second, an important cause of this sluggish recovery is lack of credit. The raw data supports this idea: credit remains depressed for much longer in a recession triggered by a financial crisis than in a normal recession. Correlation, of course, is not proof of causation: it could be that it is low output that depresses the demand for credit. But industry-level evidence strongly backs the idea that credit availability constrains the recovery after financial crises.[1]
 

Third, output after financial crises typically begins to stabilise and grow several quarters before credit stabilises and grows. At first blush, this seems to contradict the idea that credit availability holds back recoveries. But not all firms are credit constrained, and some are helped by recovering external or public demand. The bottom line is that while credit constraints make the recovery slower and weaker after a financial crisis, the credit recovery is not a necessary condition for growth to stabilize and pick up again.

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

In light of the typical duration of recessions in financial crises, a sustainable recovery this quarter, would be highly unusual. And we know why: credit is still extremely tight and weak. This argues against the “green shoots” view.
 

At the same time, the third finding – that output tends to recover after financial crises before credit does – gravitates against the “you ain’t seen the worst” view. Unless, of course, the second round corporate and financial sector stress gets so bad that it triggers wholesale collapses of banking systems.

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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