Turning the Corner in Eastern Europe

LONDON – There are various kinds of facts, the Russian satirist Mikhail Saltykov- Shchedrin once quipped: “There are convenient facts and inconvenient ones; and there are some that aren’t even facts.”

As we enter 2010, a convenient fact is that the world economy has stopped its dramatic decline and started to recover. An inconvenient fact is that the recovery remains fragile. And a non-fact is that the next 12 months will be smooth sailing. On the contrary, serious challenges remain, and they must be addressed with urgency.

The region covered by the European Bank for Reconstruction and Development – Central, Eastern and South-Eastern Europe, Russia, the Caucasus and Central Asia – has been hit particularly hard by the financial and economic crisis that began in 2008. Massive and determined state intervention (Russia and Kazakhstan), or unprecedented coordinated support by international financial institutions (Ukraine, Hungary, and Latvia), has been necessary to prevent even more dramatic falls.

As the real economy adjusts to changed circumstances and much weaker domestic and global demand, we at the EBRD expect an increase in non-performing loans in our region. In addition, companies will be forced to restructure in order to cut costs and increase competitiveness. This will lead to higher unemployment, with inevitable social strains and further stress on already heavily burdened state coffers.

As credit markets remain squeezed, retaining liquidity, and rolling over and refinancing debt, will also pose serious challenges. Credit growth has already fallen close to zero in many countries and is contracting in many others as debts levels are reduced for households and companies. In addition, some governments in the region are under the double pressure of having to reduce their budget deficits and pay back debt; precious little will be left for expenditure that could stimulate economic activity, such as investments in infrastructure or energy efficiency.

All this will put further strain on the financial sector, which to a large degree in Central and Eastern Europe is owned by major Western banking groups. Thanks to a coordinated effort by all major players under the Vienna Initiative, these banks’ large-scale withdrawal – with potentially far-reaching consequences for the region – was averted in 2009. But the region’s financial sector remains under stress, and a protracted adjustment process still lies ahead in response to rising levels of non-performing loans and banks’ recapitalization needs.

Another unresolved issue is the foreign-currency burden that many financial institutions still carry. Many local currencies in the EBRD region (such as the Hungarian forint, the Ukrainian hryvnia, and the Russian ruble) have suffered severe depreciation since in the last quarter of 2008. That is a boon for exporters, but it is a bane for banks in countries that binged on foreign-currency loans before the global crisis hit.

In Hungary, for example, foreign-currency lending amounted to 34% of the country’s GDP at the end of June 2008. With such vulnerability to adverse currency movements, Hungary was forced four months later to sign an IMF-led rescue package worth $25 billion as the financial crisis reached Eastern Europe.

One answer to this challenge is to strengthen domestic capital markets. This will be one of the EBRD’s strategic priorities in 2010. We intend to take a two-pronged approach: significantly increase our local-currency lending and explore new avenues within the framework of the Vienna Initiative to tackle the crisis and prevent its recurrence.

Developing local-currency capital markets is a long-term endeavor that requires the commitment and resolve of a larger group of players. Drawing on our experience with the Vienna Initiative, we have seen that there are crucial benefits to be gained from coordinating our efforts and involving the private sector as much as possible.

One element that central banks and regulators frequently mention is a new regulatory regime: the crisis revealed that institutional and regulatory frameworks in the EBRD region need to be reformed to introduce macro-prudential standards more systematically and effectively. These could include higher capital or provisioning requirements as buffers for more difficult times, or the stipulation of liquidity standards and special requirements for systemically important banks in order to avoid a recurrence of the “too big to fail” dilemma that many countries – not only in the EBRD region – have been facing.

It is, however, beyond doubt that in a financially integrated Europe, attempts at new and better regulation will be effective only if such reforms are not limited to the national level. International solutions are critical to prevent cross-border “regulatory arbitrage” – for example, the circumvention of host-country regulation by borrowing directly from the parent bank.

International financial institutions such as the EBRD and supranational bodies such as the European Union and the G-20 will play a key role in tackling such challenges in coming years. Within the framework of enhanced and improved integration and cooperation, we will have to find solutions to put recovery on a safer and more sustainable footing. As Saltykov- Shchedrin would say: convenient or not, that is a fact.