Global financial crisis: An emerging European perspective

Erik Berglof, Chief Economist, EBRD

Comparing to the Great Depression: World industrial production, now vs. then

Source: Eichengreen, O´rourke (2010)

Comparing to the Great Depression: Volume of world trade, now vs. then

Source: Eichengreen, O´rourke (2010)

Comparing to the Great Depression: World equity markets, now vs. then

Source: Eichengreen, O´rourke (2010)

Smaller economies, then and now

Belgium

SwedenPoland

Czech and Slovak Republics

Outline

A bad crisis, but stopped in its tracks Policy response strong, but left scars Dealing with aftershocks

– Unemployment

– Fragile banks + regulatory tsunami

– Fiscal – Greece, Eurozone…

Altered prospects for emerging Europe – and the Euro

The phases of the crisis

0

200

400

600

800

1000

1200

Jan 07 Jul 07 Jan 08 Jul 08 Jan 09 Jul 09 Jan 10 Jul 10

EMBI EuropeEMBI Global

I. Financial crisis

build-up

II. Systemic outbreak

III. Systemicresponse

VI. Sovereign

Crisis?

Source: IMF

Phase 1: Financial crisis build-up

-20

-15

-10

-5

0

5

10

15

Mar

-07

May

-07

Jul-0

7

Sep-

07

Nov

-07

Jan-

08

Mar

-08

May

-08

Jul-0

8

Sep-

08

Nov

-08

Jan-

09

Mar

-09

Per cent

Turkey and CEB

Russia and EEC

SEE

Euro Area

U.S.

Period of decoupling

A fleeting moment of decoupling, followed by precipitous recoupling…

Industrial production 2007-2009 (y-o-y)

Phase II: Systemic outbreak

Emerging markets more resilient

Average response of EMBI to daily changes in the VIX during periods of financial volatility in the United States

Jan-Mar91 1/ Jul97-Feb98 Jul98-May03 Jul07-Sep08 Sep08-Jan090

2

4

6

8

10

12

14

16

18

Note: Based on regression of daily changes in EMBI spreads on changes in the VIX in periods during w hich the VIX consistently exceeded 20 points. 1/ Constrained by data availability. Turbulence period started in July 1990.

EMBIEMBI Europe

EMBI Poland

Crisis challenge:Systemic problem – systemic response

Source: Bankscope, bank websites

Phase III: Systemic response

Crisis response: massive, comprehensive and coordinated Domestic policies: Massive in western Europe and

mature in central and eastern Europe Massive & coordinated international support

– IMF resources tripled from $250 to $750 bn

– EU BOP support quadrupled from €12.5 to €50 bn

– G20: capital to multilateral development banks

Parent banks maintained exposures A new coordination platform – Vienna Initiative

Magnitude of official support massive

Official support (percent of GDP)

0.0 1.0 2.0 3.0 4.0 5.0 6.0 7.0

Q3 1997: Asian currenciesdevalue sharply

Q4 1997: Closure of Ind. and Thaifinancials, Korean won devalues

Q1 1998: Social unrest in Ind.,Korean debt restructuring,

Q2 1998: Social unrest in Ind.,Russian stock market crash

Q3 1998: Russia default, Braz.stock market crash, LTCM

Q4 2008: Gov. support for largeUS, UK and Swiss banks

Q1 2009: Drop in foreign inflowsand trade

Q2 2009

Korea Thailand

Philippines Indonesia

Hungary Latvia

Romania Ukraine

Improvised response: The Vienna Initiative

Fill institutional vacuum - coordinate– Bring together authorities (home and host)– Private and public sector

Incentivise banks to coordinate– Regulatory incentives (IMF/EU prog rams)– Contingent capital (Joint IFI Action Plan)– “Naming/shaming” (memoranda of understanding)

Intensify Information-sharing– Coordinate within IMF/EU programs + IFI collaboration

Sudden Stop in Emerging Europe muted

-3.4 -4.4

-11.1

-7.8

-11.9-15

-10

-5

0

5

10

15

EmergingEurope

CA andCaucasus

Russia &Ukraine

Latin America Emerging Asia

Per centAvg 2007Q4/2008Q1 Avg 2008Q4/2009Q1

Percentage changes in external assets of BIS-reporting banks

Currency shooting avoidedCurrency overshooting avoided

Past crises

Current programs

Nominal effective exchange rates

Median and interquartile ranges

Output drop deep, sudden, and varied

-25

-20

-15

-10

-5

0

5

10

Latv

ia

Esto

nia

Ukr

aine

Turk

ey

Hun

gary

Geo

rgia

Arm

enia

Lith

uani

a

Slov

enia

Cze

ch R

ep.

Cro

atia

Kaz

akhs

tan

Rus

sia

FYR

Mac

edon

ia

Slov

ak R

ep.

Pola

nd

Serb

ia

Rom

ania

Bul

garia

Mon

golia

Mol

dova

Bel

arus

Q4 2008 Q1 2009 Q2 2009

Per cent

Phase IV: Towards sovereign crises in advanced economies?

Unemployment high - still rising in SEE and the Baltics

Unemployment rates (Per cent)

4

6

8

10

12

14

16

18

Aug

-08

Sep

-08

Oct

-08

Nov

-08

Dec

-08

Jan-

09

Feb-

09

Mar

-09

Apr

-09

May

-09

Jun-

09

Jul-0

9

Aug

-09

Sep

-09

Oct

-09

Nov

-09

Dec

-09

SEE Baltics CE EEC CIS Russia Turkey

Source: CEIC.

Europe’s banks in unclear state Weak balance sheets

– Total loan write-downs (IMF: USD 442 bn) + higher unrecognised share than in other markets

Still net tightening (ECB lending survey) Compounded by regulatory reform in full swing:

– Capital positions and liquidity – costs for growth

– Uncertainty over bank tax, requirements of bank restructuring, and collaboration between supervisors

Emerging Europe still depend on bank finance

Regulatory tsunami

Stronger financial regulation needed Financial sectors must share eventual crisis costs

But… Timing in a world of multi-speed regional growth May stunt market development (e.g., restricting

liquidity risks and maturity transformation) Regional differences lost in global regulation

(cross-border banking worked for Emerging Europe before and during crisis, but not everywhere else)

Debt increase follows banking crisisCumulative increase in real public debt in the three years following the banking crisis

Source: Reinhart and Rogoff (2008)

What if the crisis had not happened?

Greece

0

50

100

150

200

2001

2003

2005

2007

2009

2011

2013

2015

General Government Debt: WEO April 2010 Projection and Counterfactual(Per cent of GDP)

Spain

-20

30

80

130

180

2001

2003

2005

2007

2009

2011

2013

2015

Portugal

-20

30

80

130

180

2001

2003

2005

2007

2009

2011

2013

2015

Italy

-20

30

80

130

180

2001

2003

2005

2007

2009

2011

2013

2015

Actual Counterfactual

Note: Calculations based on assumption that (1) half the actual structural fiscal loosening (estimated as in WEO April 2010) in 2009 and none thereafter and (2) unit revenue elasticity.

Emerging Europe recovery lagging

90

100

110

120

130

2008 2009 2010 2011

Middle East And North AfricaLatin AmericaDeveloping AsiaEBRD region

Recovery lagging, particularly in south-eastern Europe and the Baltics

80

85

90

95

100

105

110

2008 2009 2010 2011

Central EuropeThe Baltic StatesSouth-eastern Europe

SEE: Compared to January, revised 2010 growth down; negative or flat growth projected for Bulgaria and Romania.

Baltic countries: growth outlook remains negative on average

Why recovering more slowly?

Export dependence on EU limits export demand Follows from exceptionally large output drops:

– High unemployment weighs on domestic demand

– Risk perceptions, non-performing loans → credit growth

– Fiscal consolidation 2010-11 → contractionary

Corporate credit stagnating/contracting

-15

-10

-5

0

5

10

15

20

25

30

35

-7 -6 -5 -4 -3 -2 -1 0 1 2 3 4 5

Corporate credit growth,Q3-09 to Q1-10, annualised

Slovak Republic

PolandLithuaniaLatvia Hungary

Estonia

Croatia Romania

GDP growth, Q4-09 to Q1-10, annualised

Ukraine

Russia

Moldova

Kazakhstan

Belarus

Serbia

Bulgaria

Albania Slovenia

Source: National authorities via CEIC data service, EBRD staff calculations.

Large deficits lead to fiscal contractions

Structural Fiscal Balance (Per cent of GDP)

-8-7-6-5-4-3-2-10

Kaz

akhs

tan

Rus

sian

Fede

ratio

nS

lova

kR

epub

lic

Ukr

aine

Cze

chR

epub

licS

lova

kR

epub

lic

Slo

veni

a

Pol

and

Hun

gary

2009 2010 2011

Source: IMF, European Commission.

Emerging Europe out of sync Slower monetary easing, but quicker ‘fiscal

exit’ in Eurozone – premature for emerging Europe

Divergence also within Emerging Europe with some countries getting large capital inflows

Regulation with increased capital requirements risks coming too early

Is there a Phase V of sovereign crises in emerging Europe…?

Emerging Europe and the Eurozone

Eurozone at a crossroads

€750bn buys time to build fiscal sustainability So far only €60bn – not enough given pressures ECB shift to purchases of sovereign debt critical Large permanent mutual fiscal insurance

mechanism with rigorously enforced rules… …or a break up with unimaginable

implications for European project…

Eurozone as an optimal currency area

Optimal currency areas partly endogenous Significant convergence since formation

– Real business cycle

But also persistent or increasing differences– Diverging inflation => real exchange rates misaligned

Eurozone as the end zone

Costs and benefits of accession shifted:

(1) Costs of loss of flexibility and premature entry?

=> Prepare better (local capital markets)

(2) Commitment value of Euro anchor?– Benefits smaller

– Uncertainty about rules and long-term future

– Timing for entry more distant

=> Strengthen/clarify architecture

Thank you

Needed: a new growth agenda

Safer growth after the ‘great moderation’:– Medium term, counter-cyclical macro policies

– Diversify funding sources - local capital markets

– Diversify exports and develop intra-regional trade

Strengthened competitiveness: – Preventing a rapid rise of wage costs

– Stimulating firm entry and exit, and SME growth

– Exploiting cost advantages in the periphery