There are three channels of potential contagion
from the European periphery to
There are three channels of potential contagion from the European periphery to Emerging Europe-Outlook
RBS - 18.07.2011
Given that periphery Europe is dominating headlines again, in this note we evaluate the channels/impact of possible contagion to Emerging Europe. In our view, there are three channels of potential contagion: public sector debt/financing; the banking sector and the real economy/trade. We contend that any possible impact on the public sector/financing front is likely to be limited given the generally low public sector debt to GDP ratios, the fact that many of the sovereigns in the region have substantial fiscal reserves/have already financed themselves for this year while many also retain access to multilateral financing through existing lending arrangements. On the banking channel, while Emerging Europe does have high foreign ownership, banking sectors are small while foreign parents have remain committed even through the worst of the global financial crisis. Further, given that many sovereigns have relatively better fiscal/debt dynamics, in addition to treasury reserves, this significantly reduces vulnerability on this front. Notwithstanding the above, where Emerging Europe is vulnerable is on the growth/trade front. This is reflective of the fact that domestic demand continues to remain anaemic almost across the board, while headline growth has been led by exports. The growth impact is also likely to be accentuated by the fact that while the global financial crisis has neutered the traditional sources of growth (FDI, bank credit, real estate and construction), policymakers have shied away from reforms that would create new growth drivers.
There are three channels of potential contagion from the European periphery to Emerging Europe: (a) public sector debt/financing; (b) the banking sector and (c) the real economy/trade.
Public sector debt/financing. We think that the chances of a domino effect through the sovereign debt/financing channel to Emerging Europe are limited this time around. True, in the immediate aftermath of the Lehman crisis, concern over the ability of sovereigns in Emerging Europe to fund themselves was real. Indeed, countries as diverse as Belarus, Hungary, Romania and Ukraine were forced to seek external financing support from the EC/IMF to cover short-falls on the budget and balance of payments. However, it is important to note that perhaps with the exception of Hungary in 2008, the need for official financing was not reflective of a solvency crisis surrounding public finances, but more a liquidity shortfall. Indeed, in 2008, and still currently, Emerging Europe does not face serious public sector insolvency risk, as public sector debt/GDP ratios are modest by comparison to the current norm in Western Europe. For example, the average ratio of public sector debt/GDP in Emerging Europe is only around 40% at present, half the average for the EU as a whole, and significantly below the likes of Greece (145%+, et al). Hungary is perhaps the exception, with its ratio of public sector debt/GDP standing at around 78%, but nevertheless still just below the EU average.
Hence, in 2008-09 Emerging Europe's problem was not one of public sector solvency, but rather liquidity. The region's problem was that years of prudent fiscal policy had meant that many countries had either been running near balanced budgets or budget surpluses. They thus had under-developed domestic capital markets and limited access to international capital markets - they had little need for such access in the run up to the crisis. The region's problems rather were more similar to the Asian crisis of the 1990s, i.e. rapid growth/development had been driven by aggressive (foreign) banking sector expansion, much of which had been funded by external borrowing. This had enabled rapid economic growth funded by imports and to the neglect of efforts to boost domestic competitiveness. The result was wide current account deficits, and external financing requirements bolstered by a weight of external debt service payments - significantly due to banks borrowing offshore. As the global financial crisis hit and global liquidity tightened, countries struggled to fund these large external financing gaps. The result was that exchange rates adjusted weaker, and domestic demand was deflated.
This deflation in domestic demand was all the more extreme where exchange rates were not able to take the burden - e.g. with fixed exchange rate regimes in the Baltics/Balkans. The result was deep recession which impacted heavily on the revenue side of budgets, thus widening deficits rapidly. An external financing/balance of payments crisis was thus transferred into a budget liquidity crisis. Lack of market sources of budget financing saw countries resort to the IMF/EC for short term liquidity support. This bought countries time to undertake fiscal adjustment and cultivate market access. Subsequently budget deficits have been significantly reduced across the region, and most economies have been able to tap international capital markets. Public sector debt ratios have risen but remain modest, while budget financing needs are now much reduced. Emerging Europe thus does not have similar budget solvency issues to periphery Europe. And while a deepening of European periphery problems could well see recovery slow in these economies pushing budget deficits wider, we think that likely deficits resulting would be much more easily financeable than in 2008-09.
Note that countries have also been able to build up their fiscal defences, with Poland, for example, now having access to an enlarged IMF FCL and having already significantly covered its budget financing needs for 2011 by pre-emptively tapping the market. Bulgaria still has over EUR3bn in its fiscal reserve, while even Hungary has been able to pre-finance its 2011 external budget financing needs, while the abolition of the second tier pension system in effect in that country has helped reduce both the stock of debt and given the government access to relatively liquid pension fund equity assets equivalent to around 6% of GDP. The region also generally still has access to IMF/EC financing facilities. And, note from the experience from 2008/09, the small scale of the region means that even in times of crisis the cost of any bail-out for emerging Europe is modest compared to that for the European periphery; totalling the programmes extended across the region from 2008-2009, they still only total as much as those extended to Greece.
The banking sector. As far as contagion through the banking system is concerned, at face value significant foreign (West European) ownership of local banking sectors across Emerging Europe does leave the region vulnerable to contagion. Note that foreign ownership ranges from over 90% of assets in the case of Estonia and Bulgaria to as little as 5-10% in the case of Kazakhstan. The regional average though is around 70%. Austrian, Belgian, Swedish, Italian and Greek banks have been amongst the most active in expanding into Emerging Europe. That said, as far as equity and asset exposure to the region is concerned, the experience through the Lehman crisis was relatively encouraging in the sense that Western banks remained invested. Indeed, despite high NPLs across the region (as high as 30% in Ukraine to as little as 3.5% in Turkey, averaging perhaps around 7-8%), foreign banks have remained invested. This willingness to remain invested reflects a range of factors including:
* The success of the Vienna initiative, reached in the spring of 2009, whereby Western banks agreed to remain invested in the region in exchange for a commitment from the EU/IMF that they would roll out support programmes;
* Exposure to Emerging Europe was still relatively modest compared to West European banks' total loan books;
* West European banks had worked hard/invested heavily over the past decade to develop footprints in the region, and given that it is still under-banked offering strong long term growth potential, banks were still loathed to cut and run;
* Arguably Western banks were "captive" in the region by the fact that there were/are still few potential bidders to buy them out of their local operations. Arguably the only banks who can expand in the region are state-owned Russian banks, and Turkish banks, but even their appetite to expand in the region seems very limited; and,
* In the case of Austrian and Swedish banks, there was strong support from parent governments for banks to continue operations in Emerging Europe. Governments in both cases indicated that if need be they would be willing to provide funds to recapitalise parent banks for losses suffered by subsidiaries in Emerging Europe. Perhaps due to historical (colonial) legacies, governments saw parent bank expansion/presence in the region as fitting in with broader sovereign geopolitical/business interests.
Reflective of the above, while there has been some balance sheet shrinkage across the region by Western banks, it has been relatively modest at around 5-10%. Western banks have instead focused on balance sheet cleansing, and positioning for future expansion - albeit unlikely very near term. However, it can be agued that countries such as Austria, Italy and Sweden have not yet suffered stress to public sector accounts/finances and banking sectors sufficient enough to re-evaluate their decision to remain invested in the region. Greece has though, and the experience therein is somewhat mixed. Greek banks have expanded aggressively in recent years in the Balkans, taking significant stakes in the banking sectors of Bulgaria (>25%), Romania (>15%) and also Serbia (>15%). While Greek banks have remained invested in the region in recent months there is some evidence to suggest that they have used regional subsidiaries to secure cheap financing for the parent. In the case of Serbia and Romania this has seen pressure on interbank markets, with some resultant pressure on exchange rates - aggressive weakening of both the RON and the CSD over the past year seems to have been partly explained by the activities of Greek banks on domestic markets. Hence, an extension of European periphery problems to Italy could mean that Italian banks see a repeat of the Greek bank experience in the Balkans. That said, some re-assurance can perhaps be taken from the fact that aside from Greece and Italy, other European periphery nation banks (Ireland, Spain and Portugal) have been marginal players in the Emerging European banking scene.
Further arguments suggesting that fall-out through the banking sector channel from the European periphery could be limited/manageable come from the fact that banking sectors across the region still remain small/manageable (on average banking sector assets/GDP are around 60%), and even in a worst case crisis unlikely to pose a systemic risk to public sector accounts/finances. In this respect, the example of Ukraine is particularly pertinent. Even though its banking sector suffered a grievous blow from the global financial crisis, the costs of recapitalising banks on the sovereign has thus far been contained to only around 10% of GDP - hardly a game changing sum in terms of public sector debt sustainability. More re-assurance can perhaps also be taken from the fact that regulation/supervision/surveillance of banking sector activities in Emerging Europe has been significantly tightened over the past few years. We would also expect European authorities, IMF and ECB to respond leniently to support emerging European economies experiencing fall-out through the banking sector channel, e.g. through the provision of emerging financing facilities, and the extension of swap lines to central banks.
The real economy/trade. So if we do not expect that much contagion from to Emerging Europe from the periphery through the sovereign debt/banking channels where will contagion be felt? In our view, the key channel of the transmission could be real economy and trade. Indeed, and while it is acutely difficult to figure out how the European periphery crisis is going to pan out (restructuring or not, break-up of the Eurozone, or indeed its survival through a move to fiscal federalism perhaps), one thing is clear: in the near term at least, under almost any scenario, European growth and recovery looks set to lag driven by sustained fiscal austerity and generally weak sentiment on the back of concern over the region's outlook and risks to banks. For Emerging Europe, which has become increasingly integrated into the European economy this has to be bad news, adding an additional brake to an already disappointing rate of recovery. Thus, we expect Emerging Europe to continue to be the growth laggard amongst its Emerging Markets peers. This should be reflected still more subdued inflation pressures and generally the maintenance of looser monetary stances for the region. Already higher frequency indicators are beginning to show that the low base driven recovery across the region may be running out of steam, constrained perhaps also by the concern over the outlook for the broader European economy.
The fact that problems in the European periphery will only likely add to the region's woes on the growth front reinforces the importance for policy makers to look to new drivers for growth. Indeed, if over the past decade the drivers of growth were FDI, bank credit, real estate and construction, and these are expected to be lagging, what are the region's new drivers likely to be? Herein, and frustratingly, we see a dearth of debate amongst regional policy makers, with the view too often being that these economies will be lifted along by the resilience of core Europe. This appears nave, and indeed thus far even strong export growth to core Europe (e.g. the Czech Republic and Hungary) is failing to create broader economic growth as domestic demand is all but dead -suffering from a legacy of high unemployment and weak banks/weak credit growth. The one clear exception in the region is Hungary, where the Fidesz government has (after much delay) announced a radical structural reform agenda, which does offer hope of raising the economy's long term growth potential - albeit it might well further shock the economy and growth in the short term.
Now while the above presents the broad outline for the region, some individual country perspective is perhaps useful to understanding regional dynamics.
Bulgaria: Vulnerable primarily through the banking channel as both Greek and Italian banks have sizeable shares of the domestic banking market. Bulgaria's strength though is in public finances as it has one of the lowest public sector debt/GDP ratios in the EU (~16%) while it has around 10% of GDP (over EUR3bn) in its fiscal reserve. Arguably therefore it has the ammunition to ride through potential banking sector contagion from problems in periphery European banks. Additional support would also likely be forthcoming from Bulgaria, if needed from the EC, ECB and IMF.
Croatia: Italian banks are significant players on the domestic banking market, and contagion therein could be more significant - watch for further pressure on the HRK, similar to experience with the CSD and RON. The state of public finances is already much weaker than that of Bulgaria - albeit still better than the EU average with a public sector debt/GDP ratio of just under 50% - and the close proximity of parliamentary elections might act as a drag on decisive policy action if European periphery problems came to a head sooner rather than later. The hit to the growth channel would though be serious/significant as Croatia is already suffering one of the least convincing recoveries in the region, and as yet there is a distinct absence of coherent thinking/countermeasures from policy makers on how to address deep-seated structural problems. Meaningful change is unlikely this side of elections.
Romania: Significantly exposed through the banking channel due to large Italian/Greek banking exposure in the country. This has already been felt through the exchange rate channel as Greek bank subsidiaries are thought to have drained liquidity from the domestic market to help "parents". Overall though Romania is an improving credit story, and continued strong adherence to the IMF programme provides a significant line of defence. Romania would likely get access to additional IMF/EC/ECB resources if need be. It still has a sizeable stockpile of FX reserves (~USD38bn) and FX weakness beyond the RON4.3:Euro1 level might just see the BNR weigh in to defend the currency for fear of both pressure on the exchange rate accentuating (a vicious cycle) and to cap potential pass thru to inflation which remains relatively elevated. We would tend to be buyers of Romanian risk on sell-offs given our overall constructive view on this credit.
Serbia: Exposed through significant Greek/Italian bank exposure in the country, albeit arguably the latter banks pulled liquidity already in late 2010 which was a major driver of the CSD sell-off. The banking sector though remains small and manageable especially if the government remains engaged with the IMF - a new precautionary IMF agreement would provide a useful added line of defence
Turkey: Is currently basking in the limelight as the new "Eurasian Tiger", with fast-track growth helped by a combination of factors, including a strong majority government, favourable demographics, strong banks, a favourable location and dynamic domestic business elite (old guard secular and a new Anatolian business elite developing on the back of the ruling AK party). Foreign ownership of Turkey's banks stands at around 40%, and while Greek/Italian banks have significant investments in the economy, overall foreign ownership is fairly diversified. Turkey's banks are well regulated and supervised, while the sector remains small/manageable, especially given that the public sector debt/GDP ratio is now below 40%. While Europe is an important trade partner, Turkey's trade is relatively well diversified, which might provide some insulation. Finally, it can also be argued that since Turkey's economy is already growing at a breakneck pace, some moderation might be advisable given concerns over current account sustainability.
Source : bne