speeches

The role of the EBRD in overcoming the financial crisis in
Central and Eastern Europe

EBRD President Thomas Mirow

Joint Vienna Institute, Vienna, 24 July 2009

Governor Nowotny,
Director Hochreiter,
Distinguished guests,
Ladies and Gentlemen,

Thank you for the invitation to address you today. It is a great honour for me to deliver the Joint Vienna Institute’s Annual Lecture. For us, this is welcome and distinguished recognition of the European Bank for Reconstruction and Development. Our institutions are closely linked; the EBRD is one of the founding sponsors of the JVI and we are proud of this association. Through your training programmes and numerous other activities, your contribution to the transition process in Eastern Europe has been invaluable.

1. The EBRD region and the crisis

This year marks the 20th anniversary of the fall of the Iron Curtain. Austria played a special role during the historic events of the summer and autumn of 1989. Twenty years on Austria again is in a special position. More quickly and more comprehensively than many others your country grasped the huge opportunities which arose from the opening of Eastern Europe. Today your country is playing a leading role in combating the crisis in the region in many ways, including through the so-called Vienna Initiative to which I will return later.

In light of today’s crisis I believe it is very important not to forget what has been achieved in the past 20 years. Huge progress has been made in establishing the foundations of societies based on market principles and the rule of law. Today a generation has grown up in liberty, its human rights protected, a generation free to pursue its own aspirations. The countries and peoples opened themselves enthusiastically to the outside world.

Strong fundamentals initially allowed the EBRD region – which ranges from Central, Eastern and South Eastern Europe to Turkey, the countries of the former Soviet Union and Mongolia – to withstand the crisis when it started in the West in 2007. However, in the last quarter of 2008 the turmoil spread to our region and today many countries are suffering from a recession that is more severe than in most other parts of the world.

At this point we expect only a few countries in the region – some Central Asian countries and, perhaps, Poland – to record positive growth this year. Many countries – including the largest, Romania, Russia, Turkey and Ukraine – are expected to suffer severe recessions, with output contracting between 4 and 15 percent in 2009.

Why is the crisis in the EBRD region so severe?

For years, Eastern Europe benefited from strong capital inflows, high international demand for their goods and high prices for commodities. Many of these countries brought their legal and regulatory regimes in harmony with Western Europe even before EU membership for ten EBRD countries of operations was achieved. Meanwhile two of them, Slovenia and the Slovak Republic, successfully adopted the euro.

But rapid convergence in a benign global financial environment put a veil on the emerging vulnerabilities which had accompanied this process. Dependency on foreign financing increased sharply, while the broadening of production structures and the development of local capital markets lagged behind.

Much of the external financing was provided by Western parent companies to their subsidiaries in the East, but a significant part was also wholesale funding or portfolio inflow. Once these funds dried up in the period after the collapse of Lehman Brothers these weaknesses were exposed and the impact harsh.

But the crisis is just as noteworthy for what we have not seen in the EBRD region: there have not been systemic banking and uncontrolled currency collapses, reform reversals, or challenges to democratic systems. Notwithstanding exposure to external shocks and a deep recession, the standard elements of past emerging market crises have been largely absent so far.

Why is this so?

• First, because of the level and quality of trade, financial, and – in many cases – institutional integration with Europe and the global economy over the past 20 years. Bank financing and foreign direct investment in the EBRD region are based on long-term commitments, often by large EU-based groups that consider emerging Europe their “second home market”, and not by “hot money”, as emerging market financing has so often been.
• Second, the domestic policy responses of crisis-hit countries have been broadly appropriate. With few exceptions countries have not resorted to confiscatory or fiscally unaffordable crisis measures, which were the staple of previous emerging market crises.
• Third, broader democratic forces have also been at work. Close political and institutional ties proved to be instrumental in mobilising unprecedented international support: the IMF, the European Commission and International Financial Institutions such as the EBRD, the EIB and the World Bank Group have all intervened early and decisively to tackle the crisis. .The European Central Bank is also playing an important role well beyond the eurozone as its monetary easing and liquidity support is reaching Eastern Europe through Western-based banking groups.

The fact that the EBRD region has gone through unprecedented shocks in the past few months without systemic crises is a testimony to the achievements of twenty years of transition.

2. Taking stock: Where do we stand?

First quarter 2009 results for the EBRD countries of operations show steep output contractions almost everywhere. Asset prices have fallen sharply and stock markets declined, while capital inflows – which used to play such a crucial role in the recent period of rapid growth – have declined, or even reversed.

There are also some encouraging signs: In several countries the output decline has started to stabilise, we are seeing rapid reductions in previously large external current account deficits, exchange rate pressures have lessened and confidence indicators have improved lately.

In the financial sector, and this is the most important piece of good news, we are seeing a broad stabilisation: Despite severe shocks there has been no systemic collapse and only a limited number of bank failures. All of them have been locally owned, while most big West European banking groups have been willing and able to maintain their exposures to the region and recapitalise their subsidiaries. However, the availability of loans has steeply declined with severe impacts for business as well as private customers.

This is why I would dissuade you from premature optimism. We must not underestimate the severity, complexity and depth of the current situation. The crisis started in the financial sector, it then affected the real economy. The ensuing feedback to the financial sector will no doubt hit bank balance sheets again.

Most of this is still ahead of us and we have to prepare ourselves for the next challenges, challenges which have the potential to create serious social tensions.

Among the immediate challenges we face are:

• A severe rise in non-performing loans and possible corporate defaults, resulting in rising unemployment, knock-on effects on other companies and on bank balance sheets.
• Difficult fiscal reforms in several countries to manage the fiscal implications of the crisis.
• Maintaining functioning money and foreign currency markets. Ways will have to be found to encourage effective private debt restructuring within the limits of financial affordability and without creating new distortions.
• And we need to address a long-standing vulnerability in the region: foreign exchange exposures of unhedged borrowers such a household mortgage loans denominated in euros, the US dollar or the Swiss franc.
• And finally a long term challenge: the diversification of economies to lessen dependency on commodities and broaden export structure.

3. The EBRD’s role

Allow me to briefly outline the EBRD’s response to the current crisis. Last December we adopted a crisis response package which focuses on the financial, enterprise and infrastructure sectors and we increased our planned investment volume for 2009 by 30 percent to some €7 billion.

With investment commitments of more than €3.5 billion to date we are well on target and the demand for EBRD finance and activities is stronger than ever. Our priorities are support for systemic banks and viable enterprises, especially in the SME sector, which are suffering under current market conditions. While it is true that the financial sector is the lifeblood of our economies, it is equally important that we limit the damage the crisis is doing to the real economy.

The demand for our equity and loan investments is higher than ever and is likely to remain so for the foreseeable future. We have the ability to support projects that lead the market, but these are inevitably more risky. We are prepared to take more risk while remaining firmly committed to sound business practices and rigorous standards.

Among the projects we approved in recent weeks are:

• .A $500 million long-term loan to Russian Railways (RZD) to restructure its balance sheet and support the completion of reforms of the world’s second largest rail system. The loan is the largest single investment we have ever made, but its size is commensurate with the needs in the sector and the reforms that this support can unlock.
• We have provided €432 million to Unicredit subsidiaries across eight East European countries to support the financing of vital and viable small and medium sized enterprises, lease finance and energy efficiency projects in the region. Similar packages are in preparation. They are our share of the Joint IFI Action Plan which I will describe later.
• We are actively supporting locally owned banks and have, for example, made a significant equity investment in Latvia’s Parex Banka to help restructure the bank’s corporate governance and readjust its business structure.
• And in mid-June we signed a €200 million loan to MOL, Hungary’s leading energy company, to finance the completion of a strategic gas storage facility in the southern part of the country which is expected to be completed by end of the year.

These are just a few examples of what we have done so far this year. We have also created a €250 million facility to provide finance for existing clients who have been negatively affected by current market conditions. And we have increased our investments in energy efficiency and renewables projects and signed our first projects in Turkey, which became a country of operations only last October.

Looking ahead, we expect demand for EBRD financing and other services to remain high. At our Annual Meeting in May we received a clear mandate from our shareholders to review medium term demand for the Bank’s services and subsequent resource implications. This process has just commenced and we will report back to our shareholders at the 2010 Annual Meeting in Zagreb.

4. The Vienna Initiative and international crisis coordination

One of the main elements to distinguish the current crisis from previous ones is the unprecedented coordination and cooperation of all major players. This brings me back to Austria, because it was here in Vienna in January 2009 that the Austrian Ministry of Finance and our own EBRD staff brought together representatives of IMF, World Bank Group, EIB, the European Commission as well as central banks, governments and supervisory bodies from East and West to design a joint approach to tackle the crisis.

More specifically we were asking ourselves what the tasks and responsibilities of each stakeholder in managing the crisis should be and we have defined answers. As a result we are witnessing an unprecedented level of coordination of domestic fiscal responsibilities across Europe. This was strongly supported by the EU Summit in March, when European leaders declared that domestic bank support packages should not be restricted to bank operations in the respective home market.

Today the initiative is playing a major role in European banking sector coordination and has been credited for contributing to the restoration of market confidence in the region. Under the Vienna Initiative umbrella commitments have been agreed which have allowed West European banks to maintain support for their subsidiaries in Eastern Europe.

In the spirit of this cooperation the Joint Action Plan of EBRD, EIB and World Bank Group was launched in February with the aim of providing €25 billion to banks in the region and for lending to the real economy in 2009-2010. The plan is part of coordinated international assistance for the hardest-hit countries that includes IMF and EC support packages.

The implementation of the Joint Action Plan is well on track: the EBRD is set to approve over €1.5 billion worth of projects under the plan by end of July, the World Bank stands at €1.1 billion and the EIB has raised its credit lines to €7.5 billion to date. All three partners report strong pipelines and high demand.

5. Conclusion

The peoples in our countries of operations are experiencing the second deep crisis in 20 years. After communism fell they rapidly and successfully adapted to a market economy. Today they are living through the shock of an unprecedented market crisis. This is a severe challenge which we must not underestimate, neither economically nor politically, and we must not allow a sense of complacency to take hold.

The international crisis response is the right answer and it has produced tangible results. However, additional action will be required on at least three fronts:

• First, restructuring corporate and household debt to contain corporate defaults, non-performing loans and rising unemployment. This is particularly difficult where a significant share of debt is in foreign currency and governments have to carefully weigh fiscal sustainability.
• Second, although a systemic banking crisis has been avoided in the region, adequate capitalisation of banking systems remains a prime task. It will be important to recapitalise banks which have portfolio weaknesses because of the crisis but are otherwise regarded as sound and viable. In this context, stress testing can be an important tool in assessing the banking sector’s resilience. Several countries in our region have undergone stress testing in the context of IMF programmes and recapitalised when and where needed. Also the Austrian Central Bank has published the results of its stress test recently.
• Third, lending to the real economy has come to a halt in the region with many countries starting to experience declines in credit, particularly to households and SMEs. Lending needs to be re-ignited to support future recovery.

The depth and breadth of the crisis means that we may not see a return to double-digit growth rates, record levels of investment and readily available finance. Our task will be to help make growth sustainable and lasting.

For this many steps need to be taken, from the definition of the role of the state to the implementation of more effective regulation. The capacity for domestic financing must be strengthened to reduce dependence on external capital. In the enterprise sector, small and medium sized enterprises must be supported – from improved access to finance to the creation of stronger capital bases to the implementation of better legal frameworks.

Innovation and diversification will empower the region to make best use of its human resources and reduce its dependency on commodities. Greater energy efficiency and the promotion of sustainable forms of energy must be a central priority to improve and strengthen transition, competitiveness and security.

As the region moves beyond the crisis, it will be the private sector that will serve as the engine of growth since fiscal demand will be gradually withdrawn and countries’ capacities will be restrained for many years to come. Supporting development through the private sector is the EBRD’s mission and we are ready to play our part in the recovery process.

Looking beyond the crisis, let us not forget the enormous potential of the EBRD region. Our countries remain well positioned to compete in the global economy and remain attractive economic partners. Their well-being and development is therefore in our best interests. Today’s crisis is a serious setback, but considering what has been achieved since the historic days of 1989 we have every confidence that these countries will emerge stronger than ever.

Thank you for your attention.