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.

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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.

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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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