Transcript An Eastern European Perspective on the Recent Financial

An Eastern European Perspective on the Recent Financial
Crisis and Poland’s Exceptionalism
Nigel F. B. Allington and John S. L. McCombie
Centre for Economic and Public Policy Research, University of
Cambridge and Downing College
INTRODUCTION
• Consider the impact of the financial crisis and Great Recession on the
Eastern European Economies (EEEs)
• These are Bulgaria, Czech Republic, Estonia, Latvia, Lithuania, Hungary,
Poland, Romania, Slovenia and Slovak Republic
• Review their growth since transition, during and post crisis
• What economic policies did they implement
• Case of Poland and why this economy proved to be an exception compared
with the rest of the EEEs
BACKGROUND TO TRANSITION
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During transition to market economies growth plummeted, but the recovery to
pre-transition rates had been rapid in most cases
After accession to EU in 2004 spurt in growth
Certainly EEEs achieved high rates of growth before crisis
They liberalised trade, encouraged competition through the privatisation of
SOE, maintained a stable macroeconomic environment, deregulated labour
markets, reformed their tax systems and protected property rights
Aghion et al. (2010) growth in EEEs faster than in Eurozone and above world
average as they were middle-income countries catching up with the advanced
economies
EU membership raised FDI as investor confidence grew paralleling
developments in SEA during their rapid economic growth phase
Borrowed technology from West and achieved significant TFP growth
Also strong domestic demand: consumption and investment
With the liberalisation of capital accounts in 1990s, capital inflows intensified
the financial linkages with WEEs and international economy
BUILD-UP TO THE CRISIS
• Contrarian view of Darvas (2010) that growth due to foreign trade to a
greater extent than was the case in other emerging economies
• Two views only agree on the resulting balance of payments deficit on the
current account
• Certainly the integration process intensified international trade and
investment before the financial crisis
• Abiad et al. and ECB (2012) attribute growth before the crisis to rapid
financial sector development
• Before September 2008 EEEs equity markets out-performed stock markets
in WEEs and US
• By 2007 EEEs vulnerable to external and domestic shocks connected with:
high current account deficits, increased private sector debt, greater trade
integration with WEEs, a house price bubble and high levels of borrowing
in foreign currencies
• The financial crisis thus raised fundamental questions about the future
sustainability of economic growth and the policies to maintain it
CREDIT AND TOTAL FACTOR PRODUCTIVITY
• Financial integration with WEEs fuelled a credit boom in EEEs
• Expectation that this would raise productivity and further incentivise
foreign investors
• The Baltic States and Czech Republic had the highest TFP growth of
between 3% and 4% per annum
• The differences between states are explained by whether foreign investors
undertook green-field investment (higher TFP) or simply acquired
industrial plant and built on extant technology (Timmer et al., 2012)
• Fixed exchange rate also elicited higher TFP
• EEEs twice the rate of TFP growth of WEEs
• Manufacturing TFP critical in Poland, Czech Republic, Slovakia and
Slovenia and contribution of TFP to growth highest in the export good
sector
PRE AND POST CRISIS
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Following the subprime financial crisis, average growth in Eurozone fell from
3% in 2007 to 0.4% in 2008 and -4.6% in 2009
EEEs more severely affected: negative average growth of -7.8% in 2009 with
the single exception of Poland that recorded +2.6%
Largest falls in growth 2009: Lithuania -14.8%; Estonia -14.7%; Latvia
-14.2%
EEEs affected more than WEEs had been in Great Depression and SEA in 1997
Crisis slowed reforms, led to expansionary macroeconomic policies and
curtailed FDI
Econometric analysis shows that the crisis had a long-term impact on output:
output might be lower by 1% after one year, but by 12-17% five years after the
crisis
The impact on the EEE greatest because they were more vulnerable: smaller
economies and more prone to banking crises
Vulnerabilities: banks’ exposure to currency and maturity mismatches,
disruption of international capital markets, bank panics and sudden stop in
capital inflows (Furceri and Zdzienicka, 2011)
CRISIS AND POST CRISIS: EXCHANGE RATE
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Countries with floating exchange rates less affected and fiscal policy proved
more effective than monetary policy in dealing with the crisis
The alignment of the financial and sovereign debt crisis meant that in the
longer term the Eurozone economies were more adversely affected than the
EEEs
But Czech Republic and Slovenia double-dip recession in 2012-13
The key vulnerability indicators in econometric analysis are the external and
banking sectors, aspects of monetary indicators including the growth of bank
credit (Gallego et al., 2010)
GDP fell most where financial system highly leveraged and credit growth most
rapid before the crisis (Berkmen et al., 2009)
Countries with pegged exchange rates and high levels of foreign trade suffered
most
Latvia and Estonia pegged currencies to Euro, Lithuania and Bulgaria currency
board with Euro
Baltic States found imports fell more than exports, so BoP actually improved
CRISIS AND POST CRISIS: CREDIT FLOWS
• EBRD (2009) showed that capital inflows maintained at start of crisis so it
took time for the crisis to hit EEEs
• Credit growth in retreat after tighter lending standards imposed by
regulators in EEEs and the banks themselves
• Capital switched to safer havens, syndicated bank lending fell with the
collapse of Lehman’s: sudden stop in bank capital flows from WEEs to
EEEs and drop in trade credit
• From 2008Q4 exports contracted sharply with the decline in manufacturing
in WEEs affecting the Czech Republic, Hungary and Slovakia hard
• Crisis a classic credit boom and bust accompanied by a current account
deficit – emerged early in the case of Latvia and Estonia
• As lending fell consumption and investment collapsed, followed by output
• Rather like the SEA banking crisis, the crisis in the EEEs abated after two
years: one bank failure, Parex Bank in Latvia financed by short-term loans
on European wholesale markets
• By 2010Q3 all economies growing apart from Romania
CRISIS AND POST CRISIS: CREDIT
• Lending rates had fallen between 2005 and 2007 so boom in cheap credit
• Domestic banks relaxed lending standards using cheap credit from foreign
banks
• However, in early 2007, Poland, Romania and Baltic States tightened loanto-value ratios for financial institutions
• Failure of regulators to monitor banks and regulatory capture
• Also much borrowing in foreign currencies where interest rates were low
(mainly unhedged borrowing)
• Exchange rate risk ignored given pegged currencies or currency boards
• Intense competition amongst foreign banks to provide more credit
• As credit dried up, domestic banks forced to reduce lending and as house
prices fell ratio of non-performing loans increased
• Credit boom in the private sector: government debt low with the exception
of Hungary and fiscal policy had been mainly counter-cyclical
• While the private sector accumulated the debt, the public sector had to
make the necessary adjustment
BANKING SECTOR
• These factors point to tighter regulation and supervision in future
• Too many firms relied on bank loans to finance investment and credit boom
here contributed to the crisis (Aslund, 2012)
• The ratio of bank credit to the private sector to GDP rose most in Bulgaria,
Estonia and Latvia (11%, 22% and 17% respectively) Cottarelli et al. 2005
• This was fuelled by domestic savings, but also heavy overseas borrowing
• Foreign banks drawn to EEEs by their high growth and interest rates and
WEE banks and the Eurozone’s monetary policy had a major impact on the
operation of foreign-owned banks
• WEE banks increased the availability of credit and also accessed
international capital markets
• Only in the case of Poland did special regulations prevent excessive foreign
borrowing by banks (regulations S and subsequently T)
• Through competition the level of credit increased: but potential for sudden
stops
BANKING SECTOR
• Poland again an exception having gained a commitment from WEE banks
to continue funding under the Vienna Initiative 2.0
• De Haas et al. (2014) showed that foreign-owned banks reduced credit
growth to 5.2% in 2010 compared with domestic banks that reduced theirs
by 19.9%: credit growth fell most in 2008, 2010 and 2011
• Foreign-owned banks looked for high worth companies to lend to and
therefore tended to lend less compared with the privately owned domestic
banks
• The expansion in the money supply in the Eurozone and the size of the
parent bank dictated the lending of WEE owned banks and these tended to
use the international capital markets as well (Caporale et al., 2009)
• While credit increased with a business cycle upturn in the parent country,
there was no evidence that a downturn led to lower credit growth
• While banking stocks fell in the EEEs after the crisis erupted, the profit
potential in these economies persuaded foreign-owned banks to continue to
lend particularly to Poland and the Czech Republic (only Latvia and
Lithuania experienced falling capital flows
BANKING SECTOR
• Capital inflows fell and demand for credit fell with rising unemployment
and falling real wages impairing borrowers debt repayment capacity
• The average level of non-performing loans increased particularly in Latvia
and Lithuania, but also Bulgaria and Romania
• The level of non-performing loans increased least in Poland and Slovenia
• The fall in GDP drove the increase in NPL (Skarica, 2014 and Klein, 2014)
• The EEEs did not have significant exposure to the exotic derivatives
associated with the subprime crisis
• Rather domestic lending provided more opportunities for banks in the
region, although banking regulations were tighter, particularly in Poland
• The crisis had more to do with the deterioration in investor confidence in
the foreign exchange, equity and housing markets
• Capital flowed out and asset prices fell leading to a liquidity crunch and
lower consumption (through wealth effects) and investment
CRISIS AND POST CRISIS
• Nevertheless the EEEs, even those on pegged exchange rates did not have
to devalue – they attempted to remain on course to join the Euro by
abiding by the Maastricht criteria. The Baltic States joined during the
crisis
• They preferred to follow a policy of internal devaluation by lowering
public expenditure and wages
• Those on floating exchange rates witnessed rising inflation as import
prices rose
• Money market rates rose reaching their highest levels in 2007 in Slovakia
and in 2008 in the Czech Republic, Lithuania, Hungary, Poland and
Romania
• Some economies had vibrant manufacturing and sound macroeconomic
fundamentals, others were more vulnerable exhibiting credit, consumption
and house price booms
CRISIS AND POST CRISIS
• The crisis therefore caused a correction that might have been anticipated
and changed the growth path of some EEEs
• The exchange rate regime adopted also had an impact on their growth
prospects
• Those that pegged their exchange rates found that convergence with the
WEEs resulted in higher inflation rather than an appreciated currency
• The credibility of the exchange rate increased borrowing in Euros where
the interest rate was lower: as inflation exceeded nominal rates real rates
were negative
• This fuelled the credit boom, consumption, construction and house prices
• Wages rose in response and so did inflation fuelling a growing balance of
payments deficit
• FDI in manufacturing increased where there were floating exchange rates
while FDI increased in the financial sectors and housing where rates were
fixed (Aslund, 2010)
• This had implications for the competitiveness of the economies
CRISIS AND POST CRISIS
• Also, real wage increases in excess of productivity caused problems where
the exchange rate was fixed
• These economies also had large non-tradable sectors creating a
competitiveness gap
• Those with floating rates did much better
• Generally the EEEs needed to improve their competitiveness in the wake of
the financial crisis to avoid higher unemployment, particularly in the
countries with fixed exchange rates
• Infrastructure needed to be improved and this would improve their
competitiveness too
• FDI important contribution to EEEs growth
• Their banking sectors opened up to foreign investment
• By 2008 foreign banks owned 80% of banking sector assets in most EEEs
• Largest recipients FDI: Bulgaria, Czech Republic, Estonia and Slovakia
• Less volatile and more beneficial for growth (von Hagan and Siedschlag,
2008)
CRISIS AND POST CRISIS: FDI
• What determined FDI?
• Traditional variables: market size, trade costs, plant and firm specific costs
• Transition-specific variables: privatisation (share of private businesses),
method of privatisation, risk factors
• Carstensen and Toubal (2004) find both important in EEEs
• Rapid growth depended on domestic demand financed by capital inflows
that generated large external imbalances with the exceptions of Poland,
Czech Republic, and Slovenia
• Expansionary effect of capital inflows partially offset by tight fiscal policy
• FDI covered current account deficits in Poland, Czech Republic and
Bulgaria, whereas produced a surplus in Romania
CRISIS AND POST CRISIS
• As wages and house prices rose, economies became less competitive and
with the financial crisis output fell, unemployment rose (worst in Baltic
States and Slovakia where in excess of 15% and remained elevated until
2013
• With fall in exports and outflow of capital EEEs on the brink of their own
crisis with unsustainable current account deficits
• Gallego et al. (2010) date crisis in EEEs from September 2008 with
collapse of Lehman’s and retrenchment in capital flows
• Most vulnerable economies exported-orientated or financially dependent
(Aslund, 2010)
• Crisis policy measures a mixture of tax rises and expenditure cuts
• Those on fixed exchange rates cut wages and expenditure rather than
devalue
CRISIS AND POST CRISIS
• Reforms in public administration, health care, education and further labour
market deregulation took place
• Taxes switched away from income and profits to consumption (excise and
VAT) and property, with the tax burden increasing
• Flat taxes remained popular
• Migrant remittances from WEEs fell from 2008Q4
• Despite the depth of the crisis, recovery was swift as growth returned and
current account balances improved from mid-2010
• Baltic States recorded turnaround growth above 20% 2009 to 2010
• Hungary, Latvia and Romania accepted IMF emergency programmes
POLAND’S EXCEPTIONALISM
• Poland’s transition was painful, but short-lived
• In 2000s before crisis growth averaged 4% and economy grew throughout
the crisis
• Unemployment remained stubbornly high around 10% (high in most
EEEs), but inflation within 2.5% +/- 1% target
• IMF forecasts growth of 3% pa up to 2019
• Growth connected with strong domestic consumption (UE fell in 2007 and
2008)
• SME sector crucial to growth in employment, consumption and exports
(Polish Agency for Enterprise Development, 2010)
• SME contributed 47% to GDP growth in 2008
• Credit expansion in Poland below that in the rest of EEEs and interest rates
kept high by Polish Central Bank to bear down on inflation
• Interest rates consistent with the Taylor rule (Maria-Dolores, 2006 and
Frommel and Schobert, 2006)
POLAND’S EXCEPTIONALISM
• Ratio of credit to GDP rose precipitously from 25% to 50% between 2004
and 2009 and lending in foreign currencies increased
• However, risk mitigated by intervention of Polish Banking Supervision
Authority and Liquidity Risk Management Act that lowered volume of
lending and Resolution 386 imposed binding liquidity standards on all
banks based in Poland
• Assets and liabilities assessed by liquidity and stability and quantitative and
qualitative benchmarks set
• December 2010 all banks had met the requirements (Kruszka and
Kowalczyk, 2011)
• Moral hazard thus limited
• Polish Financial Supervision Authority guided banks on derivative markets
so toxic assets only 0.2% of total financial assets
• Bank profits no distributed in 2008
• Capital adequacy ratio 12.5% throughout crisis (will be 13% under
voluntary Basel III rules)
POLAND’S EXCEPTIONALISM
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But Basel III not to be implemented until 2019
Foreign owners 68% of assets in the Polish banking sector
Largest holders: Italy, Germany, Netherlands and France
Exposure to single country reduced, but not to the whole Eurozone
Expansion in foreign currency lending, but inflow smaller and less volatile
than it was in other EEEs
FDI the most stable inflow of capital: $US23bn in 2007
Parent banks did not repatriate capital during the crisis, rather increased
investment (de Haas and van Lelyveld, 2014 dispute this)
Combination of strength of economy and robustness of regulatory regime
account for continued support for Poland
Foreign exchange lending controlled through Regulation S (management of
credit risk)
Also Regulation T similar to S, but related particularly to low-income
borrowers and stress test of their of ability to repay
From 2010 legally binding rules and risk weights introduced
POLAND’S EXCEPTIONALISM
• Poland received FDI before the crisis because of the economy’s perceived
strengths and continued to do so during and after the crisis
• Combination of high investment yields, skilled low-wage labour, natural
resources and pivotal position within EU
• FDI from Germany, Netherlands, Sweden and projects sponsored by US
(36), UK (15), Korea (14) and China (13) in 2011
• In Ernest and Young’s European Attractiveness Survey 2013, Poland
ranked first as destination for FDI
• In 2012 FDI responsible for 148 new projects (22% up on the previous
year) and 13,000 jobs
• 2011 FDI equivalent to 42% of GDP
• Poland major centre for out-sourcing and off-shoring (Leven, 2012)
• Eurozone crisis lowered FDI inflow from area, but special economic zone
and more favourable tax regime should reverse this
POLAND’S EXCEPTIONALISM
• Poland less affected by the crisis because less dependent on foreign trade
compared with other EEEs (33% of GDP in 2004 and only 45% in 2012
compared with 78% in Czech Republic and 90% in Estonia)
• Polish exports also more diversified
• Imports fell during the crisis improving the BoP, but Zloty depreciation
nonetheless raised inflation
• House price boom in Poland given availability of credit and cheap foreign
loans
• Supply side bottlenecks also partly responsible for rise in prices
• But tight regulations meant bubble less than it might have been
• Poland’s exceptionalism thus a combination of: high domestic
consumption, low export/GDP ratio, a vibrant SME sector, high levels of
FDI and macroeconomic prudence
CONCLUSIONS
• EEEs enjoyed rapid economic growth driven by credit growth, large FDI,
strong world growth and easy global liquidity
• Converging with WEEs and prospect of adopting the Euro (Slovenia 2007;
Slovakia 2009; Estonia 2011; Latvia 2014; and Lithuania 2015)
• Vulnerability indicators benign until 2008Q3
• Asset prices fell in parallel with collapse in world trade and external
demand
• Contraction in investment and decrease in private consumption
• Proportion of non-performing loans increased
• Post 2009Q3 growth outlook improved
• Institutional reforms delayed during the crisis now need to be introduced
• Poland was an exception due to its fortuitous policies