speeches

Stabilising Eastern Europe: The EBRD’s View

The Group of Thirty, Rome, 22 May 2009

Mr Chairman, Professor Balcerowicz, Ladies and Gentlemen,

Good afternoon and thank you for inviting me to attend this year’s plenary meeting of the Group of Thirty. I am grateful for the opportunity to make a few remarks on “Stabilising Eastern Europe” from the EBRD’s perspective.

This year marks the 20th anniversary of the fall of the Iron Curtain. Huge progress has been made in establishing the foundations of societies based on the rule of law. Today a generation has grown up in liberty, its human rights protected, free to pursue its own aspirations. And the countries and peoples opened themselves enthusiastically to the outside world from which they had been artificially cut off for decades.

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 many countries succumbed to the turmoil and are now suffering a recession that is more severe than in most other parts of the world.

At this point we expect no country in the region, except for some Central Asian countries, to exhibit positive growth this year. Ten countries – including the largest, Romania, Russia, Turkey, and Ukraine – are expected to suffer severe recessions or depressions, with growth in the order of -4 to -15 percent in 2009.

Why so severe? For many years the countries of our region benefited from strong capital inflows, high demand for their goods and high prices for commodities. But this abundance also put a veil on existing vulnerabilities and reduced the incentives to diversify economies and implement reforms. Thus these years created an increasing dependence on external demand and foreign financing, while the broadening of production structures and the development of local capital markets lagged behind. Once the external funding dried up, these weaknesses were not only exposed but made the impact of the crisis even harder.

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.

What explains this is first, 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, not “hot money”, as emerging market financing has so often been.

But secondly, broader democratic forces have also been at work. Close political and institutional ties proved to be instrumental in mobilising unprecedented international support, with the EU as a key anchor. Thus increasing integration is giving resilience to the way the EBRD countries are coping with the crisis. This is a testimony to the achievements of twenty years of transition.

Short-term prospects

Like elsewhere, there are now some “green shoots” and a number of analysts have voiced hopes that the worst may be behind us. Some countries in the region have shown signs that the output decline is decelerating. Financial markets have improved almost across the board. Risks of a macroeconomic collapse in Ukraine – which seemed palpable in February and March – have recently receded. And several other countries have reached agreements on IMF support, which will help limit downside risks particularly in south-eastern Europe.

But despite these hopeful signs, I would guard against excessive optimism. The social impact of the crisis will come with a time-lag, but it will undoubtedly be severe. And there will be challenges to this fledgling stabilisation in the next 3-9 months, as the output collapses of the last two quarters feed their way back into the financial system. Non-performing loans are still significantly below their expected peaks. And corporate defaults could have knock-on effects on supply and payment chains.

The question is whether financial systems will be able to withstand these stresses without a new breakdown in confidence. Some countries – probably Russia, certainly Ukraine and Kazakhstan – are particularly at risk in this respect as a result of the size of the shocks suffered, weak banking systems, or both. In central and eastern Europe, the continued stability of banking systems will depend on continued support from parent banks.

Policy response

Let me turn to the policy response to the crisis in our region. The international engagement has picked up since the beginning of the year, and has become both more forceful and more coordinated.

At the macro level, the response has been led by the IMF and (for EU countries) the European Commission; at the micro level, by a triumvirate of IFIs – the EBRD, the EIB, and the World Bank/IFC. In late February, these three IFIs launched a €25 bn Joint IFI Action Plan to stabilise the financial sector in emerging Europe.

The action plan is on track, in part thanks to new, innovative instruments that deliver fast and significant funding – for instance with EBRD investments in systemic banks such as Parex banka in Latvia and Ukreximbank in Ukraine. Most recently our Board approved financing of €430 million for on-lending to businesses in the region through 12 subsidiaries of Italy’s Unicredit Group. And more such activity will follow with other systemic banks.

These efforts are being complemented by an initiative, joint with the IMF and financial authorities in east and west, to coordinate with major foreign-owned banks so that they maintain their exposures in emerging European countries. Such commitments have now been agreed for Hungary, Romania and Serbia.

External assistance has generally been matched by reasonably competent and mature domestic policy responses. With few exceptions, countries have not resorted to confiscatory or fiscally unaffordable crisis measures, which were the staple of previous emerging market crises.

This said, huge challenges remain. In several countries, managing the fiscal implications of the crisis will require difficult fiscal-structural reforms. In others, notably Ukraine, a destructive political infighting could be an obstacle to financial stabilization and to securing a continued international commitment. Finally, even some of the better managed countries are struggling to maintain functioning money and foreign currency markets, and to encourage effective private debt restructuring in ways that are not fiscally unaffordable and do not create new distortions.

Next Steps in the International Response: Open Questions

Notwithstanding some successes, the international crisis response faces formidable challenges going forward. We need to prepare for, and mitigate, the coming wave of corporate defaults and non-performing loans. If not addressed, these could be a threat to financial stability and trigger a new round of output declines. An effective response is likely to require additional action on at least two fronts:

First: restructuring corporate and household debt, so that corporate defaults, nonperforming loans, and rising unemployment remain contained. Doing so is very difficult, particularly in an environment where a significant share of debt burdens is in foreign currency and governments have to carefully weigh fiscal sustainability. At the EBRD, we are considering how to address this issue in the context of the joint IFI action plan. There may also be a good rationale for swap lines from western central banks for central banks in Central and Eastern Europe to improve bank access to foreign currency funding

Secondly: Action is required to ensure adequate capitalisation of banking systems even after non-performing loans rise sharply. How could additional capital injections be financed? And how big are the remaining cushions in parent banks? The EBRD is in close contact with a wide range of banks in the region – it own shares in some 60 and has lending relationships with 300. But its resources will of course be insufficient and broader support may be needed.

Looking beyond the immediate crisis

Finally, let me briefly look forward, beyond the immediate firefighting phase of this crisis. At the EBRD, we are now predicting a slow “bottoming-out” of the recession this year, followed by the beginnings of recovery in 2010.

It would be unrealistic, however, to expect a return to double-digit growth, record levels of investment and readily available finance. Our task over the coming years is to help make growth sustainable and lasting. And for this, we have to draw the right lessons from the crisis.

A fundamental question is the future role of the state in the economy: While the current degree of intervention is clearly not a permanent solution, neither are unregulated markets the answer. A key task therefore will be to improve the quality of institutions and regulations.

Other tasks ahead of us are, for instance, the strengthening of the capacity for domestic financing in order to reduce dependence on external capital. Innovation and diversification will empower the region to make best use of its human resources and limit reliance on commodities. Greater energy efficiency and the promotion of sustainable forms of energy must be a central priority for the region to improve and strengthen transition, competitiveness and security.

The EBRD will seek to play an active role through its investments in promoting such change. We have raised our investment target this year by 30% to € 7 billion and expect medium-term demand to remain strong, in the absence of significant commercial capital flows. At our Annual Meeting last week, we received a clear mandate to review medium-term demand for the Bank’s services and resource implications.

In closing, let me remind you that the EBRD region has come a long way. Like for other economies around the world, the global crisis is a serious setback for these countries, but I have no doubt that the region’s confidence and dynamism will reassert themselves.

Thank you for your attention.