The world has been abuzz with discussions about the implications of both simultaneous quantitative easing (QE2) in the US, UK and Japan, and capital controls and competitive depreciations in emerging markets (EMs).

What would such a scenario imply for the transition region?

In brief, most transition countries have smaller incentives to participate in a currency war compared to other EMs.

Many of them are certainly less equipped to join the war even if they wish to. However, not all the effects of a currency war would be bad for the region – as long as it does not degenerate into a full-scale trade war.

Currency wars to accelerate the return of capital to the transition countries?
The currency wars scenario implies very easy monetary policy in the countries engaging in quantitative easing. The resulting stimulus will be exported through capital flows, as investors search for yield.

While this is bad news for many countries in Emerging Asia and Latin America, whose currency inflows have rebounded strongly, putting pressure on currencies (see chart 1, below), it is not necessarily bad news for the transition region, where capital inflows and domestic demand are only just turning the corner. [1]

click on chart to enlarge

 Emerging Europe to lose some exports to other EMs?
If the dollar depreciates further relative to other major currencies, many EMs may attempt to maintain a stable exchange rate to the dollar to protect their non-commodity exports to the US and other depreciating countries.

With transition country exports far more concentrated on the Eurozone markets than those of other EMs (see chart 2, below), most of Emerging Europe’s exporters will not lose competitiveness directly due to dollar depreciation.  

(Commodity sectors, which sell at world prices, are in any case largely immune to appreciation.)

Emerging Europe exports subject to stiffer competition from other emerging market exporters into the Eurozone [2]
For some economies, stuffer competition from other emerging market exporters into the Eurozone may provide an incentive for their authorities to try to depreciate their currencies.

Any such effort, however, may prove to be difficult in an environment where the dynamics of many transition countries’ currencies tend to follow the Euro (see chart 3, below).[3]

Even should they not succeed in lowering the value of their currency, intervention may in fact be desirable for some countries, as it allows them to accumulate additional foreign reserves that proved insufficient during the crisis.            

click on chart to enlarge

click on chart to enlarge

Greatest risk of a currency war for the transition region to come from a slowdown in Eurozone growth
Growth in Germany in particular, which in turn drives growth in Central Europe and South-Eastern Europe, depends on its exports.

These may stall if most of non-Eurozone export markets depreciate relative to the Euro, resulting slowdown in transition countries that depend on German demand.

Currency wars are a mixed bag for the region, with significant risks
Most transition countries are thus unlikely to participate in any currency wars, due both to limited incentives and limited capacity.[4]

In the short run, the stimulus associated with accelerating inflows in a currency war scenario may benefit the region. However, there are significant downside risks, particularly associated with a possible German slowdown. Furthermore, an escalation of currency wars into a full-blown trade war, including introduction of reciprocal trade restrictions, could be very destructive: in such a calamitous case, transition countries would suffer as much as the rest of the world in yet another world-wide slowdown.

[2] It is not clear what portion of EM exports to the Eurozone would be directly affected.

For example, Box 2.2. in the EBRD Transition Report 2007 shows that Chinese export growth to the EU coincided with a similar growth surge from Central Europe and South-Eastern Europe, in the areas where exports of both are most concentrated (and where they are most likely to compete).

[3] Chart 3 displays the period since the beginning of 2010, which has been volatile for the Euro thanks to the Greek sovereign debt crisis.

Its depreciation and subsequent appreciation relative to the dollar was, however, mirrored by similar movements in currencies of transition countries with fundamentals largely unaffected by the Greek crisis.

[4] Again, Turkey, as a large EM country with fairly developed financial markets, may be an exception.

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Serbia is one of the most euroized economies in Eastern Europe.

At more than 70 per cent, loan euroization in Serbia is higher than in most Eastern European countries, be they fixed exchange rate regimes or inflation targeting regimes.

Deposit euroization is similarly high. In addition, the median household euro cash holdings exceed those in any other central and south-eastern European country.

Anecdotal evidence suggest that “real” euroization is pervasive: the common practice is to set prices and wages in foreign currency and denominating them in dinars only for legal purposes.

Payments for large consumer durables and household investment goods such as cars and houses can legally be made and are, in practice, virtually exclusively made in foreign currency.

While financial and real euroization runs high, banks themselves do not maintain open net foreign currency positions. 

Precisely because it stands out among its peers, Serbia is an interesting case to study the causes and policy challenges of euroization.

The policy challenges raised by high euroization were brought to the fore during the financial crisis but are also present during more tranquil times.

• Euroization limits the use of the exchange rate as a crisis management tool because of the vulnerabilities created by currency mismatches in private and public sector balance sheets. In Serbia, currency risk is concentrated with household and corporate borrowers – not the banking sector. A sharp devaluation could trigger defaults of borrowers, which in turn would deepen banking problems.
• Euroization restricts the central bank’s ability to act as lender-of-last resort in the case of depositor loss of confidence to its foreign exchange reserves.
• Euroization weakens the monetary transmission channel and reduces the effectiveness of monetary policy. Monetary policy rates may be reflected in lending rates for local currency-denominated loans, but the sheer volume of these loans is much less than foreign-currency denominated loans with little response to monetary policy rates.

A shift away from loan euroization would therefore have important benefits but, to be successful, would need to address its root causes. A successful de-euroization/dinarization strategy has to alter the motivation of borrowers and lenders, in a way that possible negative side effects are minimized.

A dinarization strategy would not necessarily weaken the goal of eventual euro adoption in the longterm. On the contrary, greater monetary policy control would facilitate the process of achieving the macro economic stability that is the precondition for euro adoption. Serbia has applied for EU membership in December 2009.

Loan euroization in Serbia is particularly deep-rooted. Therefore, even in the ideal policy environment, it will only decline gradually over time as the credibility of macroeconomic policies grows.

In the meantime however, several regulatory measures (for example consumer protection and regulatory limits) and policy steps (such as support for longterm local currency savings), outlined in our Working Paper , can be put in place that make the environment more conducive to loan dinarization.

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Capital inflows have returned to many emerging markets since mid-2009.

Fuelled by abundant global liquidity and more favourable growth prospects and debt dynamics, they present better risk-return prospects than advanced economies (Chart 1) [1]

Large emerging markets in Latin America and Asia have received strong capital inflows and many of them have reacted by intervening in foreign exchange markets to avoid currency appreciation, whilst several of them have resorted to restrictions on capital inflows.

Capital inflows are also starting to return to the EBRD region, with a lag and a different composition from that seen in other emerging markets.

In the EBRD region, capital inflows are bolstered by foreign direct investment (FDI), whereas in emerging Asia and emerging Latin America they have been led mainly by more volatile non-FDI inflows.

In fact, many countries in the region have continued to experience non-FDI outflows, as also reflected in outflows of BIS reporting banks (Annex Figure 1).

However, two countries (the “magnets” of the EBRD region) have been exceptions both in size and composition: Turkey and Poland. These have both received strong non-FDI capital inflows, including through banks.

These two countries seem to be part if the global emerging market story. 

Chart 1a. Capital inflows (Balance of payments data)

Chart 1b. Cross border BIS-reporting bank lending flows (Exchange rate adjusted changes in cross border assets of BIS-reporting banks, in per cent of previous quarter stocks)

Source: IMF BoP statistics and official authorities, Bank for International Settlements (BIS).

Note: Latin America includes Brazil, Mexico and Columbia; Emerging Asia includes India, Indonesia and Thailand; EBRD region magnets include Poland and Turkey. In Chart 1b, the definition of regions from the BIS, for example emerging Europe, excludes Caucasus, Central Asia, Mongolia.

Net FDI inflows proved resilient during the crisis: they declined but did not reverse on a sustained basis.

In the majority of EBRD countries FDI inflows remained positive in 2009 and in 2010 to date.[2] Net FDI outflows on a substantial scale were confined to six countries (Bosnia and Herzegovina, Hungary, Latvia, Lithuania, Russia, and Slovenia) and in most of these from the financial sector as the sector deleveraged.[3]

While net FDI inflows typically remained positive, they shrank sharply and have not recovered to pre-crisis levels—with some exceptions:

• In Armenia, and Belarus average quarterly FDI inflows never turned negative, as energy-sector related investment, the sale of Beltransgas and investments to “Armrusgasarda”, respectively, proceeded.[4]
• In Kazakhstan and Mongolia post-crisis FDI inflows have begun to exceed average quarterly flows before the crisis due to investments in the commodity sector.[5]
• In Albania, FDI remains the main source of current account financing due to continued privatization in telecommunications and FDI in the hydro-fuel sectors.

Non-FDI inflows have been more volatile than FDI in the region.

Non-FDI capital inflows have two main components: direct cross-border lending to banks and corporates and flows intermediated by local capital markets. Direct cross-border lending to banks and corporates has been the main source of non-FDI capital inflows for most countries in the region (except Slovenia and Poland) given that local capital markets are generally underdeveloped (Chart 3).

• Direct cross border inflows, which remained positive even during the crisis in all but the hardest-hit economies (Ukraine, Baltics, Kazakhstan, but also Azerbaijan and Slovenia), have increased again since the crisis in many countries or outflows have shrunk. Net inflows remain below their pre-crisis levels in all but a few countries (in the Caucasus, the Slovak Republic and Turkey) or even negative (in the Baltics except Latvia, Slovenia, Ukraine, Russia, and Kazakhstan).[6]
• Following sharp contractions during the crisis, inflows through local capital markets have returned to a few countries in the region, attracted by sovereign debt issuance (Lithuania, Hungary, Poland, Kazakhstan), rebounding equity markets (Poland). The recovery in equity markets in the deeper and more developed financial markets in the region (Poland and Turkey) has been accompanied by a flurry of M&A activity that had dried up during the crisis. In Poland, for example, 443 M&A deals were completed in 2009-2010 to date well above the pre-crisis level of 238 deals in 2008.

Bank for International Settlements (BIS)-reporting banks have continued to reduce their assets in the region by 1.9% in the second quarter of 2010 – and even in advanced Europe –whereas they continued their inflows into other emerging markets (Chart 2).

The continuing deleveraging in the region reflects predominantly developments in Ukraine, Kazakhstan, and Russia. However, even excluding these outliers, BIS-reporting banks deleveraged in all countries but Turkey.  This is partly the reflection of the kind of banks present in emerging Europe and present in Asia: deleveraging in emerging Europe has been similar to that in advanced Europe given the involvement of the same banks.[7]

Chart 2a. Total flows from BIS reporting banks since 2008 Q4 (Sum of exchange rate adjusted changes in cross-border assets of BIS reporting banks, in per cent of 2007 Q4 stocks)

Chart 2b. Total flows from BIS reporting banks since 2008 Q4 (Sum of exchange rate adjusted changes in cross-border assets of BIS reporting banks, in per cent of 2007 Q4 stocks)

Annex Figure 1. Net Capital Inflows into EBRD Region

Net capital inflows including FDI

Net FDI inflows excluding FDI

Net FDI inflows

Net portfolio investment inflows

Net other investment inflows

Pre-crisis buildup of external debt

Sources: IMF Balance of Payments statistics, official authorities.

Note: Overall flows including and excluding FDI, net FDI, portfolio and other inflows: Pre-crisis period defined as Q1 2005 – Q2 2008, crisis period as Q3-2008 and Q2 2009, and post-crisis period as Q3 2009 – Q2 2010. The selection of countries is determined by data availability for 2010. Capital inflows defined as a sum of net capital account, net FDI, net portfolio investments, net other investments, and errors and omissions excluding net trade credits and use of IMF resources. For Azerbaijan, Croatia and Poland, net trade credit could not be excluded. For Albania, data for 2010 include net trade credits. For Azerbaijan and Poland, no data on the use of IMF money is available in national BoP statistics. For Albania, Macedonia, Hungary and Slovenia data in 2010 include use of IMF money.

Footnotes:

[1] See IMF World Economic Outlook and Global Financial Stability Report, October 2010.

[2] Stocks of inward FDI reported in the International Investment Position have fallen significantly in 2008-2009 in CEB, Romania and Russia. This was not so much due to FDI outflows, but rather to valuation effects as equity markets corrected sharply. In a few countries the decline in FDI stocks is also related to a decline in intercompany loans.

[3] In Hungary annual FDI inflows stayed positive in 2009, but individual large deals introduced volatility, for example, the restructuring of the General Electric companies registered in Hungary or specific real estate transactions. In Bosnia, capital repatriation occurred mainly in the basic metals sector. 

[4] Other sector which continued to receive FDI inflows in 2009-2010 were the telecoms in Armenia and the financial sector in Belarus.

[5] In October 2009, the government of Mongolia completed a US$ 4 billion investment agreement for the Oyu Tolgoi copper-gold mine with Canada-based miner, Ivanhoe Mines, backed by Anglo-Australian mining giant, Rio Tinto. Kazakhstan has been buoyed by a number of long-term bilateral financing agreements with China, Korea, Russia, and UAE for the oil and gas sector (USD$18 billion long-term investment expected).

[6] The large outflows for Azerbaijan are a reflection of the asset build-up in response to strong current account inflows.

[7] Corporates have generally deleveraged in fewer countries thus far.

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If you are a citizen of one of the EBRD’s countries of operations that has a communist legacy and you are celebrating your 20th birthday at any point in 2009, we’d like to invite you to submit an essay sharing your thoughts on how life in your country has evolved in the past two decades. We’ve assembled an international panel of prominent writers to select the finalists, and we’ll be compiling the best writing into a special publication.

Next spring the EBRD will hold an award ceremony at our London headquarters for the best essay writers. An array of prizes will be handed out including an internship at the Financial Times newspaper for the overall winner. Interested? Visit our main website for details on how to enter.

Here’s the perspective from one of the judges. Andrey Kurkov is a Ukranian novelist who also edited the EBRD publication Histories of Hope.

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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:

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