Transcript Financial Crisis and the Serbian Economy

Implications of Global Financial
Crisis on South East Europe:
Lessons Learned by Serbia
Diana Dragutinovic
Main Themes




Serbia before the crisis
Crisis imported into SEE
• Serbia hit at an unfortunate moment
Solid banking system, but with typical weak spots
So far mostly indirect contagion channels related to
credibility of the FX denominated banking system,
compounded by
• Macroeconomic vulnerabilities
• Behavior of mother banks towards the local banking
systems
Main Themes


Policy responses involve:
 central bank measures addressing the liquidity
situation
 fiscal policy adjustment
 IMF program
International coordination may be needed, when the
second wave comes
Serbia Before the Crisis

Economic growth in Serbia is among the highest in
Eastern Europe
Selected Countries: Average GDP Growth Rate, 2004-2007
8,0
6,0
4,0
2,0
0,0
SK
RS
RO
BG
CZ
PL
HR
MK
HU
4
Serbia 2004-2007: Brief Background


Growth fueled mainly by domestic demand (both private
and government spending driven by election cycles )
Domestic demand fueled by:

Strong external financing / capital inflows such as:
 Privatization of socially-owned companies, banking sector /
insurance companies
 FDIs
 Banking sector recapitalization

Foreign borrowing by banking sector

Cross-border loans to private sector
5
Serbia 2004-2007: Brief Background

Competitiveness and export growth did not follow

Low level of exports in GDP




Slow progress of structural reforms
Undersized private sector (which remains one of the smallest in the
region)
Low competitiveness of the economy (85th by World Economic Forum
Global Competitiveness Report)

Strong wage growth

Appreciation of Dinar
Opportunities lost to increase competitiveness of the economy
6
Weak External Position Limits Policy
Response to the Crisis

Side effects of high, but
unbalanced growth - rising
external disequilibrium


CA deficit has almost
doubled since 2005,
reaching 18% of GDP
Serbia was not able to
avoid the problem of
rapid debt accumulation
by the private sector
…but Some Good Achievements

Recent achievements of the Serbian economy, such as





Low sovereign debt level
Comfortable level of FX reserves
Strong capital and liquidity position of the banking system
…will help the economy to adjust in an orderly manner
Shallow domestic capital markets protected the Serbian
economy from the abrupt capital flight experienced by
other emerging market economies
Genesis

Roots of the crisis lie in the developed world





macroeconomic problems and imbalances
imprudent behavior of financial sector
lax regulatory environment with built in automatic destabilizers
In the developed world, this is a solvency crisis that was first
mistaken for liquidity crisis only
In the emerging world, it was first a liquidity crisis (through
contagion and drop of confidence) that threatens to turn into
solvency crisis, as the receding economy compounds the
financial turmoil (second wave)
Emerging Markets as Victims



EMs entered the turmoil with relatively sound and solvent
banking systems
However, big differences among EMs in vulnerabilities of
macroeconomic policies, exposures to FX and roll-over risk
Elements speeding up the contagion
 high current account deficit and procyclical fiscal policy
 currency overvaluation
 highly euroized banking sector with large indirect FX
exposure of private sector's balance sheets without the
central bank as the lender of last resort in FX




bank business model dependent on roll-over of foreign
FX borrowing rather than domestic deposits
Cross – border borrowing by non – financial institutions
high growth of FX denominated private debt
Many of the elements present in South-Eastern Europe and
Serbia
Serbia: Solid Banking System (I)




Privatization and cleaning up of balance sheet in early
2000s.
Domestic financial institutions without substantial
exposure to the U.S. sub-prime mortgage-linked toxic
assets.
Low direct exchange rate risk exposure in the banking
sector
Local banking system with a strong liquidity position
reflected by sizeable reserves with central bank.
Serbia: Solid Banking System (II)

Dynamically growing economy provided good profit
opportunities from traditional retail activities


Relatively prudent lending standards



low penetration of exotic instruments
credit standards until recently relatively strict
transfer risk of credit risk outside the banking portfolios via
securitization nonexistent,
Balanced credit growth rates
…with Weak Spots

High financial sector euroization



Exposes the banking sector to FX liquidity risks, because the NBS is not
a lender of last resort in FX
Low deposit base



High indirect ex rate risk exposure through the unhedged
positions of the real economy
necessitating foreign borrowing to finance mortgage lending and
other small retail business
Exposes to liquidity dry up and roll-over risks
Large proportion of direct foreign lending going outside the
banking system
First Wave Contagion Channels and
Other Contributing Factors




Drop in market confidence
Local banking sector forced to change behavior
following the problems of mothers in home countries
Home (EU and Eurozone) national regulators and
authorities focusing strictly on Eurozone (home)
problems, leaving the EMs largely on their own and thus
indirectly compounding the EMs problems
Dependence of Eastern Europe on a common lender
exposing the vulnerability to a regional contagion
Drop in Confidence

Domestic money, bond and FX market participants




Because of uncertainties about parent companies,
exchange rate risks etc.
International investors’ aversion towards the region
(flight to quality)
Long-term investment sentiment (drop in expected FDI
inflows)
Depositors’ confidence (especially in terms of FX)
Local Banking Sector Changing Following the
Problems of Mothers in EU Countries






Cutting all but the most essential credit lines on shortest maturities to
their daughters (without daughters having first order problems)
Applying pressure on daughters to change the business model from the
one based on a roll-over of FX borrowing to the one dependent on a
local deposit base
Applying pressure on daughters to apply more prudent lending
standards
Cutting counterparty and trading limits for both secured and nonsecured transactions
Withdrawing free FX liquidity from daughters
Hedging out exposures to daughters’ capital in domestic currency
EU Authorities Focusing Strictly on Home
Problems, Leaving the EMs Largely on Their Own





EU regulators encouraging (through moral suasion and perhaps
other means) to limit the exposures of mother banks to the
Central and Eastern Europe
EU public money used in propping up the capital adequacy of
Eurozone banks are not designed to support the banks’ business
in emerging Europe
Local EM currency bonds not accepted by ECB as a collateral
Missing swap FX links between ECB and EM banks in need of
FX liquidity (exception Poland and Hungary)
Coordination of policies and activities limited to Eurozone or EU,
non-EU left out
Dependence on a Common Lender Exposes
Vulnerability to a Regional Contagion




In many EMs loan-to-deposit ratios increased rapidly in the recent decade
Exposures of many SEE and CEE countries to EU banking groups are
geographically concentrated.
 Austria, Germany, and Italy account for more than 40% of EU bank claims on
emerging Europe; Sweden is the largest lender to the Baltics
Some small lender countries exposure to emerging Europe is large in terms of
their GDP
 for instance for Austria, it is more than 70%
The concentrated home-host country exposure derives from concentrated activities
of individual bank groups.
 The regional giants derive much of their operational income (often more than
50%) from the Eastern European markets
Macroeconomic Vulnerabilities in
Serbia Contribute to Contagion

High current account deficit



Continued high inflation following the oil and food prices
shocks from 2007/8



Financed through FDI and foreign borrowing
Sustainability dependent on continued high export growth
Does not provide much room for relaxing monetary policy
High risk premium and exchange rate pressures
Worsening fiscal position

the macroeconomic situation puts pressure on fiscal policy to
adjust and allow monetary policy relaxation
First Wave Effects: Money and FX
Markets

After long-lasting nominal and real
appreciation of CEE currencies
(including dinar), the crisis led to
strong currency depreciation
Pressure on the currency
 Sudden stop of external
financing
 Cross-border lending to
corporation stalled
 FDIs stopped
 Fall in external demand
 Falling exports
 Rising currency risk premiums
115
110
RSD/EUR exchange rate
(positive slope = depreciation)
105
31-12-2007 = 100

100
95
90
85
31.12.07
31.3.08
RSD
30.6.08
30.9.08
HUF
First Wave Effects: Money and FX
Markets




Drop in liquidity and volumes in money and FX
markets
Rising bid/ask spreads
Shortening maturities
Rising credit spreads
First Wave Effects: Banking Sector

Problems with handling FX deposit withdrawals in
October and November ‘08 of almost 1 bn euro




Difficulties in rolling over FX debt, even to mothers
Difficulties in obtaining additional FX sources to support
the continuation of lending or trading


with limited credit lines because of mothers’ problems
without a central bank as the lender of last resort
Lending more based on the deposit base
More prudent lending standards


NBS measures provide additional FX liquidity
Banking sector liquid, but does not lend
Credit to non-government sector stopped
Total credit non government sector,
(quarterly data)
2,500
2,000
Million EUR

1,500
1,000
Total credit
500
0
-500
Q4 06
Q1 07
Q2 07
Q3 07
Q4 07
Q1 08
Q2 08
Q3 08
Q4 08
24
First Wave Effects: Real Economy




Falling export growth following the world output contraction
 despite currency depreciation
Slowing down in FX lending
 though still not yet credit crunch
Dinar lending impeded by high interest rates
Balance sheet concerns of a depreciating currency for unhedged
sectors of the economy
 both households and businesses
First Wave Effects: FX Policy

Problem of a lender of last resort in FX


insufficient FX reserves make the role of a lender or
market maker of last resort difficult
Dilemma:


let the exchange rate depreciate in order to adjust
the external imbalances and preserve the FX
reserves for more difficult times
limit the extent of depreciation out of concern for
inflation and balance sheet effects
First Wave Effects: Monetary Policy



Inflation still high and exchange rate has depreciated
Effects of economic downturn on inflation not yet being felt
Policy transmission more difficult



money market situation and ex rate expectations make lending interest
rates less sensitive to key policy rates
exchange rate less sensitive to interest rate movements (because of high
risk aversion and complications in hedging exposures)
Dilemma


to cut in anticipating the recession and credit crunch, and falling inflation
tighten to fight the capital flight and inflationary implications of depreciating
ex rate.
First Wave Effects: Fiscal Policy

Dilemma


be prudent to decrease vulnerabilities and external
imbalances, and help support looser monetary policy
support economic recovery, possibly beyond the
effect of automatic stabilizers
Policy Responses




Policy options limited owing to the initial sources of the contagion – trust into FX
Monetary policy measures - addressing the FX market liquidity
 Allowing banks to use FX reserves to address the liquidity problems
 Reducing reserve requirements to facilitate borrowing from abroad
 Frequent interventions injecting FX liquidity and cushioning the speed of the FX
adjustment
 Interest rates remaining high
Fiscal policy measures
 Rebalancing the budget for 2008 and moderate budget deficit for 2009
Coordinated actions
 IMF program
 Inflation Targeting declaration
Risks for The Future: Second Wave


Further contagion channels may hit the economy
More of the world recession:



Sudden stop: principal channel through which crisis hits
Serbia




Slowing export growth, exposing CA imbalances
Rising default rates
Fall in FDI
 Pressure on the exchange rate
 Pressure on the public revenues
 Pressure on the monetary policy
Capital outflows
e.g. through transfers of retained earnings from the banking sector
Banking sector stability affected by rising default rates
Risks of The Second Wave for SEE

Multiplication of interactions between the receding
economy and the financial sector within each economy




Banking sector stability will be hit by rising default rates
during the recession.
Fiscal policy may be put on further strain by the need to help
recapitalize the banking sector
This will further spiral the drop of confidence
characterizing the first wave
Potential second round contagion through regional
interlinkages

systemic solvency problems in EMs may destabilize the
mothers and the financial system of home (EU) countries
International Response Needed to
Address SEE Vulnerabilities

Public sector assistance and/or international coordination may be
needed to handle the second wave


The real danger of the second wave is that the situation in EMs may
soon look like that one in US or Western Europe


most EMs and some small EU countries-concentrated lenders may be
unable to cope with the implications.
however without the fiscal pockets or monetary credibility to allow
extraordinary measures on the scale seen in the West
It would pay off by starting now – addressing the first wave problems
through



better coordination between host-home countries
being more forthcoming in terms of emergency swap lines and local
currency collateral
applying equal treatment to Eurozone (domestic) as well as non Euro
businesses of Eurozone banks