The impact of the Global Finanical Crisis in Europe & CIS

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This article is based on the attached original pdf UNDP RBEC Brief The Regional Impact of the Global Financial Crisis, written by Ben Slay, Senior Economist in UNDP/BRC Regional Bureau for Europe & CIS.


>Tables | Broader Considerations.

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Overview

Although the full extent and implications of the global financial crisis are difficult to anticipate, it is already affecting the RBEC region. This is most apparent in the region’s stock markets (which are generally in free fall or have hit multi-year lows) and currencies (which are facing sometime strong downward pressures). It is also clear that the decade-long recoveries from the transition recessions of the 1990s are coming under threat. Very few RBEC countries seem likely to emerge from these developments unscathed; and absolute poverty levels are almost certain to rise across the region. As such, the global financial crisis could wipe away a significant portion of the gains made by the region’s transition and developing economies during the past 10-15 years.


This paper briefly describes the causes of the global financial crisis and the nature of the region’s vulnerabilities to global financial contagion. It suggests which RBEC countries may be more or less susceptible to its impact, and speculates on possible implications for the global financial system and for policy in the region. The paper concludes by proposing some possible implications for UN(DP) programming.

The Global Financial Crisis: Causes and Characteristics

Reasonable people will disagree about whether current developments in the world economy constitute a “crisis”, and if so, about the most appropriate ways to describe its drivers and laws of motion. That said, three important triggers can be identified:


1. Bursting housing and stock market bubbles: Many of the world’s central banks have been pursuing easy money and credit policies for the past decade or more, seeking to keep interest rates low and to expand flows of/access to bank finance.[1]. As energy and commodity prices had, until recently, stayed low and as new technologies and global supply chain management techniques placed downward pressures on production costs, this liquidity did not translate into general rises in prices (i.e., inflation). Instead, it led to increased borrowing to finance investments in/purchases of housing, stocks, and other assets. The balance sheets of banks— particularly New York-and London-based investment banks, but also of mortgage lending institutions—became highly leveraged; debt was increasingly used to finance additional asset purchases. Eventually, banks’ capital bases became too small to support their leveraged balance sheets. This left financial institutions particularly vulnerable once asset bubbles popped, and the income-generating side of their balance sheets began to shrink. By most accounts, this process began in 2007 and accelerated into 2008. Loss-making banks found it difficult to extend credit to new borrowers. Less credit in turn meant less spending on houses, cars, and consumer durables. Likewise, households whose consumption is influenced by the value of their homes and stock market portfolios reduced their spending when the asset bubbles popped. This retrenchment distressed the manufacturing and nonfinancial service sectors within the G32 economies, reducing production, incomes, and employment. Since these countries constitute the dominant sources of investment finance and export demand for developing and transition economies, the spread of this distress (“contagion”) to RBEC countries is a matter of time, speed, and extent.


2. Financial market complexity overwhelms the regulators: This debt-financed asset growth was accompanied by an explosion in the quantity and varieties of financial instruments. Investment banks increasingly purchased mortgage loans from originating commercial or savings banks, bundled them together into new “structured” financial derivatives, and resold them, either in whole or in parts (“strips”) to other financial institutions, for whom the interest rate and terms structures of the new instruments looked appealing. When these instruments’ growing complexity and non-transparency led to concerns about possible associated risks, the use of instruments like credit default swaps (“tranches”) expanded, ostensibly helping to protect investors against this risk. The markets, ratings companies, and the business press increasingly came to believe that investors could hedge any risk by holding the right combination of structured financial instruments. The regulatory agencies in the G3[2] countries (particularly in the US and UK, where these products took root most quickly) responsible for monitoring overall financial stability lost sight of possible systemic risks associated with this complexity. As a result, the balance sheets of US and European investment and commercial banks and insurance companies were increasingly “contaminated” with non-transparent derivatives whose true risk and associated market value were difficult to accurately assess. When the squeeze in underlying asset values began (e.g., as real estate values dropped and more homeowners began to default on their mortgages) and these institutions began to sell assets in order to raise the cash needed to service or amortise their debts, many of these derivatives could not be sold for the prices at which they had been purchased. Some could not be sold at all. Assets that had previously backed long-term credit arrangements were no longer acceptable as collateral. Many banks have stopped lending to one another this fall; credit markets ground to a halt; and investment banks and mortgage lenders without strong capital bases faced insolvency or bankruptcy. Although central banks responded by pumping liquidity onto bond and inter-bank markets, many banks were unwilling to borrow these funds in order to relend them (To whom? Against what collateral? At what risk?). As a result, expansionary central bank monetary policies are currently unable to reverse the credit contraction that is affecting the construction and manufacturing sectors, and increasingly household and business spending more broadly.


3. Global inflation, and especially energy and food prices, spike in mid-2008: Although energy prices have been rising gradually for the past five years, this growth accelerated sharply after mid-2007, and peaked during the summer of 2008. Global food prices also rose sharply during this time. For the G3 energy importing countries, this price shock was a drag on household spending and business profits, hitting just as the effects of the financial crisis were starting to make themselves felt. It is now clear that, as they entered the fourth quarter of 2008, most of the G3 countries are slipping into recession, with falling output, incomes and employment.

How does this affect us?

With the exception of the inflation/food-energy price shock, developing/transition economies in general, and in the RBEC region in particular, until recently had been spared the worst of this crisis. Noting the continuing strong economic growth in China, India, Russia, and many other middle income countries during the first half of 2008, some observers suggested that prospects for developing economies have been “decoupled” from trends in the G3 economies[3]. And while food price inflation raised food security concerns in a number of RBEC countries, higher energy and commodity prices have been a boon to our region, which relies heavily on resource-based exports (particularly in the CIS countries; also Albania and Poland). During the first 6-9 months of 2008, therefore, strong economic growth continued in much of the region. Many RBEC countries during the past decade benefitted from extremely favourable “emerging market” conditions. These were characterised by virtuous circles of strong economic growth, rising commodity prices (boosting export revenues and foreign exchange inflows), and low or falling inflation rates. When combined with ample global liquidity, these positive feedbacks helped attract significant capital inflows, which in turn strengthened their exchange rates and further reduced inflation, boosting growth and reducing poverty.


Regrettably, this “virtuous emerging market circle” is now reversing itself: slowing export growth and capital outflows are weakening exchange rates, boosting inflation, and squeezing production, output, and incomes. Some countries (e.g., Hungary) are raising interest raise sharply in order to defend their currencies and limit inflation, thereby increasing their risk of currency crisis. Others (e.g., Ukraine, Turkey) are permitting their currencies to depreciate, further exacerbating inflationary pressures and feeding this vicious cycle. In either case, economic growth is increasingly coming under threat. By the fourth quarter of 2008, economic growth had begun to slow in many RBEC countries, and had come to a halt in others. Some countries (e.g., Latvia, Estonia) are already in recession in 2008 (see Table 1); GDP in Hungary, Ukraine, and elsewhere seems likely to shrink in 2009.


More specifically, the global financial contagion is affecting our region via four primary transmission mechanisms:


1. Trade shocks: Virtually all RBEC countries are small open economies: net exports comprise a large share of GDP; and export/import prices are determined on markets over which traders have little control. As the G3 core of the global economy contracts, growth in the demand for exports from the region will likewise slow or contract. This shock could be particularly important for the new EU member states and the Western Balkan economies, for which exports to the EU15 comprise significant portions of total spending[4]. Moreover, the global deleveraging and spending reductions are reversing the inflationary spike of 2007-2008: commodity, food, and energy prices have been falling sharply since mid-year; by mid-November, spot prices on world oil markets had dropped nearly two thirds from their July 2008 highs. Should they continue, these trends could devastate the external positions of oil, metal, and food exporters like Russia, Kazakhstan, Ukraine, and Azerbaijan. Ironically, gas prices within the region are set to rise in 2009, thanks to Gazprom’s long-term contracts with its European customers and its recent promises to resell gas exported to Europe from other Caspian Basin countries (Azerbaijan, Kazakhstan, Turkmenistan, Uzbekistan) at “European” prices. This will drive up energy costs for importing countries like Ukraine, Belarus, Georgia, Armenia, and Moldova, as well as Tajikistan and Kyrgyzstan in 2009— even as the prices of their agricultural, mineral, and metallurgical exports fall.


2. Remittances: In many RBEC’s economies (Albania, Armenia, Azerbaijan, Bosnia and Herzegovina, Georgia, Kosovo, Kyrgyzstan, Macedonia, Montenegro, Moldova, Serbia, Tajikistan, Ukraine, Uzbekistan) remittance incomes (sent by labour migrants and diasporas) provide critical support to the balance of payments, household incomes, or both. In the new EU member states, free(r) access to EU15 labour markets has allowed for labour migration that has provided important employment opportunities for workers that had previously been excluded from domestic economic recoveries. In Tajikistan (the RBEC region’s poorest country), estimates of the size of remittances commonly range from 33% to 50% of GDP [5]. The bulk of these incomes are generated from three sources: EU15 countries, Russia, and Kazakhstan (mostly for migrant workers from other Central Asian countries). Kazakhstan has been one of the first RBEC countries to feel the effects of the global financial crisis— Kazakhstani borrowers effectively lost access to global capital markets in the second half of 2007. Not surprisingly, the side effects of these developments are already apparent in Kazakhstan’s balance of payments data for the first half of 2008, which show remittance incomes dropping 26% from the levels recorded during the first half of 2007. Should Russia and the EU15 countries register similar declines in remittance outflows, the impact on external positions and household incomes in most RBEC countries could be substantial.


3. The refinancing squeeze: Large banks and companies in many RBEC countries borrowed abroad extensively, in dollars or euros, during the past decade[6]. These countries’ large capital needs, small savings pools, and shallow domestic financial systems combined withvtheir currency’s appreciation against the dollar and euro, low global interest rates, the large volumes of liquidity sloshing around the global financial system convinced many companies (and, in some new EU member states, households) to take the risk of borrowing (without hedging) in foreign currency. However, the global financial conditions that have now taken hold make it extremely difficult for corporate borrowers—especially in Russia, Kazakhstan, Ukraine, Turkey, Hungary, the Baltic States, and Serbia —to (ideally) refinance or (with more difficulty) repay these obligations (see Table 2). As global capital markets at present are only willing to buy long-term debt issued by (or loan money to) “emerging market corporates” at very high interest rates (if at all), these debtors—which are among the region’s largest and best-known banks and companies—are facing a financial squeeze. Some are being bailed out by their governments or central banks. Others will go bankrupt, or will be acquired by stronger rivals (foreign or domestic). Either way, their lending and production activities will fall. As many of these companies make significant contributions to GDP, incomes and employment are also likely to fall, and poverty will rise. The countries with large “financing gaps”—in the form or large current account deficits or large foreign debt repayments to make in late 2008 and 2009 (see Table 2)—seem particularly vulnerable to this form of global financial contagion.


4. Intra-bank finance: Will subsidiaries refinance parents? During the 1990s many RBEC countries experienced repeating cycles of crises, collapses, bailouts, and renewed crises of state-owned banks. Prodded by the International Monetary Fund (IMF), World Bank, and European Commission, these countries—particularly the new EU member states, Turkey, and the Western Balkan countries—sold their banks to multinational financial institutions based primarily in EU15 countries. Until now, this seemed to be a great solution: unlike their state-owned predecessors, the parent banks resisted pressures for unprofitable bailouts, providing instead the capital needed to finance the region’s post-communist economic recoveries. Large investments by parent banks and insurance companies strengthened their subsidiaries’ capital bases, and provided millions of households and small and mediumsized enterprises with access to credit and financial services. Unfortunately, recent developments now raise the possibility that the local subsidiaries could fall victim to unwise decisions made by their parent banks in their G3 home countries—particularly in the areas of mortgage lending or structured finance[7]. As European governments have made it clear that they will use taxpayer money to bail out “their” large banks, subsidiaries in the RBECcountries are likewise unlikely to fail. However, the inter- and intra-bank flows that have until now financed credit expansion in our region could undergo contraction or reversal in the months ahead.


Economic growth does not automatically translate into poverty alleviation or sustainable human development. But its absence is almost certain to mean higher absolute poverty levels, both in terms of incomes and access to social services. Except for some of the new EU member states and candidate countries, social safety nets in RBEC countries do not, as a general rule, keep the unemployed (or those working only in the informal sector) out of poverty. As the World Bank data in Table 3 show, poverty rates (defined as those living below PPP$2.15/day) rose in the wake of the recessions or growth slowdowns precipitated by macroeconomic shocks (e.g., the Russian, Bulgarian, and Romanian banking and currency crises) during 1997-1999. World Bank data also show that, thanks to strong growth in incomes and employment between 1998-1999 and 2005-2006, the numbers of those living in poverty in RBEC countries fell by 50 million, while the numbers of those vulnerable to falling into income poverty (defined as those living below PPP$4.30/day) fell by48 million. The problem is not only that growth slows in such circumstances, but also that its composition changes—countries facing this vicious circle must devote larger shares of GDP to net exports; fewer resources remain to meet domestic consumption and investment needs (public and private). For economies experiencing rapid population growth (Central Asia, Azerbaijan, Turkey, Albania, Kosovo), slower economic growth during a period of external adjustment can easily mean declines in per-capita public and private consumption.

Country Risk Factors

Three factors seem particularly important in determining the risks facing individual RBEC countries: financing gaps, inflationary pressures, and inherited growth momentum:

  • Financing gaps: Countries with large current account deficits (particularly if they are not financed by inflows of foreign direct investment), or with large foreign debt service or repayment obligations (see Table 2), are particularly vulnerable to global financial contagion. These vulnerabilities (which seem particularly important in Russia, Kazakhstan, and Ukraine) may be further exacerbated by significant unhedged household or small business borrowing in foreign currency (e.g., for mortgages), as is the case in some of the new EU member states.[8] At present, Azerbaijan, Kazakhstan, Russia, Turkmenistan, and Uzbekistan are the only RBEC countries with current account surpluses; the rest of the region is consuming and investing more than it is producing, and is financing the difference with debt and equity inflows. However, many of the countries with current account deficits are quite small with under-developed financial systems (e.g., the Western Balkans[9], Moldova, Georgia, Armenia, Tajikistan, Kyrgyzstan). As such, they have been able to rely on concessional lending from the Bretton Woods institutions, Asian Development Bank, the European Bank for Reconstruction and Development, and bilateral donors. Managed correctly, this assistance should help shield these countries from the worst of the global financial contagion. By contrast, Hungary whose current account deficits have in the past five years been accompanied by large fiscal deficits and unfavourable public debt dynamics—has been shown to be particularly vulnerable. The authorities in Budapest therefore in mid-October raised interest rates significantly, and requested and received financial assistance from the IMF and ECB.


  • Inflation/policy space: Keynesian economics argues that government spending should be increased (or taxes cut) when private consumption and investment are falling, in order to prevent large declines in production, incomes, and employment. The deficits produced by expansionary fiscal policies can be financed either by monetisation (i.e., printing money), or by reducing the public sector’s net worth (i.e., by selling public assets or increasing public debt). At present, the G3 economies and China seem to have decided to try to “spend their way” out of the global financial crisis, primarily via a mixture of borrowing (in the US case, this is helped by the fact that interest rates on government debt are currently near historic lows) and monetisation. In addition, governments and central banks in China, the Gulf states, and other non-G3 countries that have accumulated large holdings of dollar-denominated assets could finance increased public spending by liquidating these assets.


However, these policy options are by and large not available in most RBEC countries. Instead of loosening fiscal and monetary policies, many RBEC countries may have to tighten them, in order to prevent inflation or disorderly currency devaluations from further constraining their growth prospects. The large capital outflows the region is now experiencing show that borrowing to finance deficit spending is not an option for many RBEC countries. The same goes for monetisation, for a number of reasons. First, economies that have adopted the Euro (Cyprus, Malta, Montenegro, Kosovo, and Slovenia—and Slovakia as of January 2009) or currency board (Bulgaria, Estonia, Lithuania) have surrendered the ability to pursue discretionary monetary (and exchange rate) policies. For many other RBEC countries, accelerating monetary growth will put downward pressure on the exchange rate and boost inflation. For much of the world, inflation and downward exchange rate adjustments during a period of global disinflation may not be a serious concern. But as the data in Table 1 show, inflation had become a serious problem in much of the region before the onset of the global financial crisis. While some of the new EU member states have managed to keep annual consumer price inflation rates at 5% or less, inflation in much of the region—particularly in CIS countries—has remained high or accelerated dramatically in the last two years (see Table 1). In some of these countries (Ukraine, Kyrgyzstan, Tajikistan), year-on-year consumer price inflation rates are now approaching levels (25-30%) that may themselves damage growth prospects[10]. In current circumstances (e.g., upward pressures on imported gas prices, downward pressures on exchange rates) inflation could stay high or accelerate further if governments do not tighten (rather than loosen) fiscal and monetary policy. This even applies to countries with otherwise favourable public debt positions (e.g., Russia, Kazakhstan), whose stressed domestic banks and capital markets can not finance significant accumulations of additional public debt.


Such fiscal and monetary tightening means higher interest rates, reduced access to credit, higher taxes, less employment, and reductions in government spending—all of which can be expected to increase poverty. But even if such steps are not taken, inflation rates of these magnitudes can themselves increase poverty, by reducing the real incomes of vulnerable households whose nominal wages and social benefits do not keep up with inflation. As a result, with the possible exception of some of the new EU member states that have kept inflation and foreign debt low, and whose domestic banking systems and capital markets are deep enough to purchase additional emissions of domestic-currency debt, counter-cyclical policy responses are weak or absent. Inherited inflationary inertia, and immature financial systems, seem set to deprive policy makers in many RBEC countries of the policy space they need to effectively respond to the global financial crisis.


  • Growth momentum: Most of Kazakhstan’s private banks and companies have since mid- 2007 been unable to externally refinance their foreign debt obligations. They have had to dig into their pockets (or those of the government and the National Bank of Kazakhstan) to avoid defaulting on these payments. Significant slowdowns in construction, real estate, and other credit-sensitive sectors have ensued, cutting some 4-6 percentage points off GDP growth rates. But because growth was running at 10% annual rates before the onset of these financial tensions, GDP still grew by some 5% during the first three quarters of 2008. Such growth (if it continues) is unlikely to produce significant declines in employment or increases in poverty. By contrast, macroeconomic mismanagement in Hungary had pushed annual GDP growth below 2% during 2007-2008—before the most recent financial shocks hit. A full blown recession—with accompanying increases in unemployment and poverty—now seems inevitable. Demographics also play a role here: everything else equal, poverty reduction in the context of rapid population growth requires faster economic growth, in order to generate significant increases in employment and per-capita GDP, thereby reducing absolute income poverty. Annual GDP growth of 1-2% in Central Asia, Azerbaijan, Turkey, Albania, or Kosovo therefore carries greater poverty risks than similar growth rates in economies like Moldova (with shrinking population).



  • Country risks: Table 5 above presents a rough-and-ready, heuristic guide to country[11] risk levels, in line with the key risk variables suggested above. These are not meant as definitive, stateof- the art assessments; more serious poverty risk assessments could be developed upon request. These ratings likewise do not reflect political factors, which can have an important impact on prospects for obtaining external financing from the IMF and other prospective lenders and donors. Nor do they reflect other important factors that can have a significant impact on prospects for economic growth and poverty reduction, such as the water and energy shortages that have taken hold in Tajikistan and Kyrgyzstan. More rigorous risk estimates would need to be based on more precise estimates of:
  • National poverty/growth elasticities (i.e., by what percentage does income poverty rise when GDP declines or growth slows?);
  • Anticipated declines in the demand for exports to, and remittances from, the Russian and EU15 economies; and
  • Possible declines in world prices affecting the region’s key exports (and imports).


These large caveats aside, Table 5 does suggest some initial conclusions:


  • Not surprisingly, the countries with the greatest prospective risks of experiencing significant increases in absolute income poverty are those that are already in recession (e.g., Estonia, Latvia), or for which a recession seems inevitable (e.g., Hungary, Ukraine) or likely (e.g., Lithuania). Bulgaria, Georgia, Moldova, Montenegro, Romania, and Serbia could also be at risk, because of their relatively large current account deficits, high rates of inflation, and large remittance inflows (which could now be jeopardised). Kyrgyzstan and Tajikistan could likewise be at particular risk, due to their reliance on remittances and their overall high rates of income poverty and vulnerability; even a moderate growth slowdown could push many vulnerable people (living on daily incomes estimated between PPP$4.30 and PPP$2.15) below the PPP$2.15/day threshold. Because of its relatively weak overall growth momentum, population growth, significant regional disparities, and relatively large public debt, Turkey also seems to be relatively vulnerable to increased poverty risks.
  • Countries with the smallest assessed risk of experiencing significant increases in absolute income poverty tend to fall into two groups:
    • The region’s wealthiest, most successful transition economies, such as the Czech Republic, Poland, Slovenia, and Slovakia (here Hungary is a conspicuous exception);[12] and
    • The region’s least reformed economies (e.g., Uzbekistan, Turkmenistan), whose strong external positions and isolation from the global financial system have provided a certain measure of protection from global financial contagion.

Broader Considerations

In addition to the prospective country risks presented above, additional issues that may be worthy of further consideration include the following.

References

  1. ↑ The European Central Bank (ECB) has been a notable exception
  2. ↑ The US, EU, and Japan
  3. ↑ For more on this, see Economist Intelligence Unit, Heading for the Rocks: Will Financial Turmoil Sink the Global Economy?, London, 2007
  4. ↑ According to Fitch, merchandise exports to other EU countries in 2007 represented at least 50% of GDP for the Czech Republic, Hungary, Slovakia, and Slovenia (Fitch Ratings, Emerging Europe Sovereign Review: 2008, 28 August 2008)
  5. ↑ According to National Bank of Tajikistan data, net inflows from current transfers in 2007 ($1.6 billion) completely financed Tajikistan’s merchandise trade deficit. Total remittances, including wages officially paid to Tajikistani citizens working abroad and repatriated through the banking system, would have been significantly higher
  6. ↑ In this respect, the unfolding emerging market crisis in the RBEC region (as elsewhere) differs from similar events in the past, where excessive borrowing by governments (e.g., Russia, Brazil, Argentina, Turkey), rather than by banks and corporates, undermined financial stability.
  7. ↑ This could be a particularly serious issue for Austria’s Raiffeisen and Erste banks, for whom assets in RBEC countries constitute 43% and 34% of total assets, respectively (source: Fitch Ratings, Emerging Europe Sovereign Review: 2008). Fortunately, there is little indication to date of serious trouble with these institutions.
  8. ↑ According to one source, the share of (hedged and unhedged) loans denominated in foreign currencies in 2005 in the new EU member states was roughly double the share for Latin America, and triple the share for East Asia. The share of such loans in Russia and Ukraine was likely above Latin American and East Asian levels. (Source: Christophe Rosenberg, “Central and Eastern Europe: Vulnerabilities in the Run-Up to Euro Adoption”, 15 October 2008, IMF Regional Office for Central Europe and the Baltics).
  9. ↑ Croatia is an exception
  10. ↑ Annual industrial producer price inflation rates, and GDP deflator rates, are typically 5-10 percentage points greater than annual consumer price inflation rates
  11. ↑ This formulation is meant to be neutral with regards to Kosovo’s status
  12. ↑ Whether the Central European countries continue to weather the global financial storm remains to be seen. The large shares of these open economies’ exports that go to the EU15 countries underscore their vulnerability to a deep, prolonged pan-European downturn

See also

The impact of the Global Finanical Crisis in Europe & CIS/Tables


The impact of the Global Finanical Crisis in Europe & CIS/Broader Considerations

External Resources

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