Implications of Global Financial Crisis on South East Europe: Lessons Learned by Serbia

1. Implications of Global Financial Crisis on South East Europe:Lessons Learned by Serbia Diana Dragutinovic

2. Main Themes • Serbia before the crisis • Crisis imported into SEE • Serbia hit at an unfortunate moment • Solid banking system, but with typical weak spots • So far mostly indirect contagion channels related to credibility of the FX denominated banking system, compounded by • Macroeconomic vulnerabilities • Behavior of mother banks towards the local banking systems

3. Main Themes • Policy responses involve: • central bank measures addressing the liquidity situation • fiscal policy adjustment • IMF program • International coordination may be needed, when the second wave comes

4. Serbia Before the Crisis Economic growth in Serbia is among the highest in Eastern Europe 4

5. Serbia 2004-2007: Brief Background • Growth fueled mainly by domestic demand (both private and government spendingdrivenby election cycles ) • Domestic demand fueled by: • Strong external financing / capital inflows such as: • Privatization of socially-owned companies, banking sector / insurance companies • FDIs • Banking sector recapitalization • Foreign borrowing by banking sector • Cross-border loans to private sector 5

6. Serbia 2004-2007: Brief Background • Competitiveness and export growth did not follow • Low level of exports in GDP • Slow progress of structural reforms • Undersized private sector (which remains one of the smallest in the region) • Low competitiveness of the economy (85th by World Economic Forum Global Competitiveness Report) • Strong wage growth • Appreciation of Dinar • Opportunities lost to increase competitiveness of the economy 6

7. Weak External Position Limits Policy Response to the Crisis • Side effects of high, but unbalanced growth - rising external disequilibrium • CA deficit has almost doubled since 2005, reaching 18% of GDP • Serbia was not able to avoid the problem of rapid debt accumulation by the private sector

8. …but Some Good Achievements • Recent achievements of the Serbian economy, such as • Low sovereign debt level • Comfortable level of FX reserves • Strong capital and liquidity position of the banking system • …will help the economy to adjust in an orderly manner • Shallow domestic capital markets protected the Serbian economy from the abrupt capital flight experienced by other emerging market economies

9. Genesis • Roots of the crisis lie in the developed world • macroeconomic problems and imbalances • imprudent behavior of financial sector • lax regulatory environment with builtin automatic destabilizers • In the developed world, this is a solvency crisis that was first mistaken for liquidity crisis only • In the emerging world, it was first a liquidity crisis (through contagion and drop of confidence) that threatens to turn into solvency crisis, as the receding economy compounds the financial turmoil (second wave)

10. Emerging Markets as Victims • EMs entered the turmoil with relatively sound and solvent banking systems • However, big differences among EMs in vulnerabilities of macroeconomic policies, exposures to FX and roll-over risk • Elements speeding up the contagion • high current account deficit and procyclical fiscal policy • currency overvaluation • highly euroized banking sector with large indirect FX exposure of private sector's balance sheets without the central bank as the lender of last resort in FX

11. bank business model dependent on roll-over of foreign FX borrowing rather than domestic deposits • Cross – border borrowing by non – financial institutions • high growth of FX denominated private debt • Many of the elements present in South-Eastern Europe and Serbia

12. Serbia: Solid Banking System (I) • Privatization and cleaning up of balance sheet in early 2000s. • Domestic financial institutions without substantial exposure to the U.S. sub-prime mortgage-linked toxic assets. • Low direct exchange rate risk exposure in the banking sector • Local banking system with a strong liquidity position reflected by sizeable reserves with central bank.

13. Serbia: Solid Banking System (II) • Dynamically growing economy provided good profit opportunities from traditional retail activities • low penetration of exotic instruments • Relatively prudent lending standards • credit standards until recently relatively strict • transfer risk of credit risk outside the banking portfolios via securitization nonexistent, • Balanced credit growth rates

14. …with Weak Spots • High financial sector euroization • High indirect ex rate risk exposure through the unhedged positions of the real economy • Exposes the banking sector to FX liquidity risks, because the NBS is not a lender of last resort in FX • Low deposit base • necessitating foreign borrowing to finance mortgage lending and other small retail business • Exposes to liquidity dry up and roll-over risks • Large proportion of direct foreign lending going outside the banking system

15. First Wave Contagion Channels and Other Contributing Factors Drop in market confidence Local banking sector forced to change behavior following the problems of mothers in home countries Home (EU and Eurozone) national regulators and authorities focusing strictly on Eurozone (home) problems, leaving the EMs largely on their own and thus indirectly compounding the EMs problems Dependence of Eastern Europe on a common lender exposing the vulnerability to a regional contagion

16. Drop in Confidence • Domestic money, bond and FX market participants • Because of uncertainties about parent companies, exchange rate risks etc. • International investors’ aversion towards the region (flight to quality) • Long-term investment sentiment (drop in expected FDI inflows) • Depositors’ confidence (especially in terms of FX)

17. Local Banking Sector Changing Following the Problems of Mothers in EU Countries Cutting all but the most essential credit lines on shortest maturities to their daughters (without daughters having first order problems) Applying pressure on daughters to change the business model from the one based on a roll-over of FX borrowing to the one dependent on a local deposit base Applying pressure on daughters to apply more prudent lending standards Cutting counterparty and trading limits for both secured and non-secured transactions Withdrawing free FX liquidity from daughters Hedging out exposures to daughters’ capital in domestic currency

18. EU Authorities Focusing Strictly on Home Problems, Leaving the EMs Largely on Their Own EU regulators encouraging (through moral suasion and perhaps other means) to limit the exposures of mother banks to the Central and Eastern Europe EU public money used in propping up the capital adequacy of Eurozone banks are not designed to support the banks’ business in emerging Europe Local EM currency bonds not accepted by ECB as a collateral Missing swap FX links between ECB and EM banks in need of FX liquidity (exception Poland and Hungary) Coordination of policies and activities limited to Eurozone or EU, non-EU left out

19. Dependence on a Common Lender Exposes Vulnerability to a Regional Contagion • In many EMs loan-to-deposit ratios increased rapidly in the recent decade • Exposures of many SEE and CEE countries to EU banking groups are geographically concentrated. • Austria, Germany, and Italy account for more than 40% of EU bank claims on emerging Europe; Sweden is the largest lender to the Baltics • Some small lender countries exposure to emerging Europe is large in terms of their GDP • for instance for Austria, it is more than 70% • The concentrated home-host country exposure derives from concentrated activities of individual bank groups. • The regional giants derive much of their operational income (often more than 50%) from the Eastern European markets

20. Macroeconomic Vulnerabilities in Serbia Contribute to Contagion • High current account deficit • Financed through FDI and foreign borrowing • Sustainability dependent on continued high export growth • Continued high inflation following the oil and food prices shocks from 2007/8 • Doesnot provide much room for relaxing monetary policy • High risk premium and exchange rate pressures • Worsening fiscal position • the macroeconomic situation puts pressure on fiscal policy to adjust and allow monetary policy relaxation

21. After long-lasting nominal and real appreciation of CEE currencies (including dinar), the crisis led to strong currency depreciation Pressure on the currency Sudden stop of external financing Cross-border lending to corporation stalled FDIs stopped Fall in external demand Falling exports Rising currency risk premiums First Wave Effects: Money and FX Markets

22. First Wave Effects: Money and FX Markets Drop in liquidity and volumes in money and FX markets Rising bid/ask spreads Shortening maturities Rising credit spreads

23. First Wave Effects: Banking Sector • Problems with handling FX deposit withdrawals in October and November ‘08 of almost 1 bn euro • with limited credit lines because of mothers’ problems • without a central bank as the lender of last resort • Difficulties in rolling over FX debt, even to mothers • Difficulties in obtaining additional FX sources to support the continuation of lending or trading • Lending more based on the deposit base • More prudent lending standards

24. NBS measures provide additional FX liquidity Banking sector liquid, but does not lend Credit to non-government sector stopped 24

25. First Wave Effects: Real Economy • Falling export growth following the world output contraction • despite currency depreciation • Slowing down in FX lending • though still not yet credit crunch • Dinar lending impeded by high interest rates • Balance sheet concerns of a depreciating currency for unhedged sectors of the economy • both households and businesses

26. First Wave Effects: FX Policy • Problem of a lender of last resort in FX • insufficient FX reserves make the role of a lender or market maker of last resort difficult • Dilemma: • let the exchange rate depreciate in order to adjust the external imbalances and preserve the FX reserves for more difficult times • limit the extent of depreciation out of concern for inflation and balance sheet effects

27. First Wave Effects: Monetary Policy • Inflation still high and exchange rate has depreciated • Effects of economic downturn on inflation not yet being felt • Policy transmission more difficult • money market situation and ex rate expectations make lending interest rates less sensitive to key policy rates • exchange rate less sensitive to interest rate movements (because of high risk aversion and complications in hedging exposures) • Dilemma • to cut in anticipating the recession and credit crunch, and falling inflation • tighten to fight the capital flight and inflationary implications of depreciating ex rate.

28. First Wave Effects: Fiscal Policy • Dilemma • be prudent to decrease vulnerabilities and external imbalances, and help support looser monetary policy • support economic recovery, possibly beyond the effect of automatic stabilizers

29. Policy Responses • Policy options limited owing to the initial sources of the contagion – trust into FX • Monetary policy measures - addressing the FX market liquidity • Allowing banks to use FX reserves to address the liquidity problems • Reducing reserve requirements to facilitate borrowing from abroad • Frequent interventions injecting FX liquidity and cushioning the speed of the FX adjustment • Interest rates remaining high • Fiscal policy measures • Rebalancing the budget for 2008 and moderate budget deficit for 2009 • Coordinated actions • IMF program • Inflation Targeting declaration

30. Risks for The Future: Second Wave • Further contagion channels may hit the economy • More of the world recession: • Slowing export growth, exposing CA imbalances • Rising default rates • Sudden stop: principal channel through which crisis hits Serbia • Fall in FDI • Pressure on the exchange rate • Pressure on the public revenues • Pressure on the monetary policy • Capital outflows • e.g. through transfers of retained earnings from the banking sector • Banking sector stability affected by rising default rates

31. Risks of The Second Wave for SEE • Multiplication of interactions between the receding economy and the financial sector within each economy • Banking sector stability will be hit by rising default rates during the recession. • Fiscal policy may be put on further strain by the need to help recapitalize the banking sector • This will further spiral the drop of confidence characterizing the first wave • Potential second round contagion through regional interlinkages • systemic solvency problems in EMs may destabilize the mothers and the financial system of home (EU) countries

32. International Response Needed to Address SEE Vulnerabilities • Public sector assistance and/or international coordination may be needed to handle the second wave • most EMs and some small EU countries-concentrated lenders may be unable to cope with the implications. • The real danger of the second wave is that the situation in EMs may soon look like that one in US or Western Europe • however without the fiscal pockets or monetary credibility to allow extraordinary measures on the scale seen in the West • It would pay off by starting now – addressing the first wave problems through • better coordination between host-home countries • being more forthcoming in terms of emergency swap lines and local currency collateral • applying equal treatment to Eurozone (domestic) as well as non Euro businesses of Eurozone banks