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Chief Economist, Erik Berglof.

What the global financial situation means for the EBRD region

The financial turbulence that has grown out of the US subprime mortgage crisis is making itself felt around the world and the EBRD's countries of operations are no exception. Chief Economist Erik Berglof explains how the global tightening of credit supply is affecting the region.

What impact has the credit crunch had on the Bank’s countries of operations?

First of all, it’s important to note that our countries are doing extremely well and growing at record rates. The forthcoming Transition Report will show that the region is growing at its fastest pace since transition started. Secondly, most of our countries have so far weathered this turbulence in the financial markets very well, thanks to institutional reforms that have left them with much stronger regulation, better fiscal discipline and stronger market economies.

That said, we are certain that the crisis in the West will be a serious one which will last for some time and this means it will definitely have an impact on our countries. We distinguish between two different effects: short-term liquidity problems and more long-term increases in borrowing costs. Some countries are showing signs of liquidity problems, but we believe that with a few exceptions this will not be the most serious issue for the countries in our region. The more important effects will come in the longer term as growth will come down, from very high levels, due to the difficulties and higher costs associated with obtaining credit.

Which countries have been the most affected so far and why?

Latvia, Hungary, Bulgaria, Romania and Serbia have all come under pressure at some point. Latvia has benefited from very rapid growth, credit expansion and a housing boom, but is this sustainable? The compensating factor is that Latvia’s financial sector is controlled by very solid Swedish banks with a strong interest in supporting their subsidiaries.

Hungary has been under pressure for some time due to large current account and budget deficits, but has managed to implement the first phase of a tight fiscal programme. The country is now paying the price in terms of low growth, by the standards of the region, but international financial markets seem to have acknowledged the positive steps and show confidence in the government’s ability to pursue fiscal austerity.

Bulgaria, Romania and Serbia have also enjoyed very rapid growth and credit expansion and have benefited from large inflows of foreign direct investment (FDI). The main effect of the crisis in the West will be the reduced appetite for risks in emerging markets, which means that countries representing a higher level of risk or which have large external financing needs will be the most affected.

Which sectors are particularly vulnerable?

We expect that the very rapid growth in credit in the region will now slow down somewhat. Riskier financial institutions and those offering complex products may find it more difficult to finance themselves in the international debt markets. For example, institutions that depend on a lot of securitisation or that are highly exposed to property markets will suffer now that there is an element of distrust in the system. At the same time, we think that the presence of foreign-owned bank subsidiaries will underpin stability in financial systems. In Ukraine, for instance, this should help protect the banking system as these banks can obtain funds from their parent banks relatively easily, although they will not get unlimited support.

But eventually a financial shock such as we are experiencing now will work its way through to all sectors of the economy. Funding costs go up, and risky or first-time borrowers may find external credit curtailed. Eventually, this will be reflected in investment behaviour.

Is Russia insulated from the credit crunch thanks to its huge oil and gas revenues?

Russia is in very good shape in many ways and the federal government is in a good position to support the financial system, but there are some liquidity problems. The market for government securities remains very shallow and there is some distrust between Russian banks and foreign institutions and between Russian banks themselves.

The banks you particularly worry about in Russia are those that have expanded consumer lending very rapidly. One of them is already restricting its lending. It will become harder for customers to get credit to buy consumer durables.

What are the long-term consequences of the financial turbulence likely to be?

Countries with large financial sectors will see a slowdown in growth rates. This is particularly true of Kazakhstan, where a fifth of GDP growth has come from the financial sector.

A slowdown in the US economy will not affect the region directly as it is not a major trading partner for our countries of operations, but it could dampen growth in the EU which is already weak. That would have an impact on central and eastern Europe, which is very dependent on exports to the EU. It could also hit Russia, which does more than 50 per cent of its trade with EU countries. The key question for the CIS is how commodity prices will react. In past US recessions this was an important link. Today, a lot of world growth comes out of Asia.

But some cooling off may be a good thing for these countries. Their economies, particularly in sectors like real estate and construction, have been growing fast, perhaps too fast, reaching sometimes unsustainable levels. In the credit markets, the cost of risk was unreasonably low and prices did not reflect the different levels of risk. Now this is coming back into the system.

How will the EBRD itself be affected by what is happening?

Lower growth in the region will probably curtail the number of projects from which the Bank can choose. However, we will become more additional because fewer banks will be willing to lend to our countries of operations. And as other lenders become more costly, the EBRD will become more competitive.

We need to use this opportunity to strengthen our transition impact. Before, cheap credit was easy to come by so it was hard for us to push for change. Now we can make sure our projects have more impact on transition when we lend money.

You said that the FIs most at risk were those that had expanded very quickly, particularly in consumer lending. Does the Bank share some responsibility for encouraging this rapid expansion?

FIs have played an important role in developing our countries of operations. It is good that people now have access to mortgages and loans and there is still room for further growth, compared with other emerging markets.

But we have had concerns about financial stability and questioned whether we should be part of this rapid growth. It is a difficult balance to strike; it must be based on an assessment of the quality of banking supervision in the country and the ability of a particular institution to improve its credit procedures. However, we now see some cooling down in the sector and this is probably a good thing.

By Mike McDonough, Communications Adviser.
3 October 2007