Bojan MarkovicEBRD

Rebalancing finance in Emerging Europe

Financial and macroeconomic challenges

ICTFDublin, 10 October 2016

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2

Outline

• Finance and growth•Need for structural reforms•Rebalancing finance in post-crisis period

• Financial challenges•Cross-border banking, global vs local •Funding structure•Currency composition of funding and loans•NPLs

• Macroeconomic prospects and challenges•Macroeconomic prospects•Oil prices•Brexit

3

Outline

• Finance and growth•Need for structural reforms•Rebalancing finance in post-crisis period

• Financial challenges•Cross-border banking, global vs local •Funding structure•Currency composition of funding and loans•NPLs

• Macroeconomic prospects and challenges•Macroeconomic prospects•Oil prices•Brexit

4

Economic growth slowed markedly since 2008, and finance is not sufficient to revive growth

Sources: IMF, EBRD and authors’ calculations.

5

Convergence was traditionally driven by productivity growth in EBRD regions…

Sources: Transition Report 2013

Grow

th 1

993-

2010

Total growth of real GDP (PPP) from 1993 to 2010

…due to catch-up in total factor productivity until mid-2000s

6

Income per capita (log)

Tota

l fac

tor p

rodu

ctiv

ity

(log)

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Outline

• Finance and growth•Need for structural reforms•Rebalancing finance in post-crisis period

• Financial challenges•Cross-border banking, global vs local •Funding structure•Currency composition of funding and loans•NPLs

• Macroeconomic prospects and challenges•Macroeconomic prospects•Oil prices•Brexit

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However, reforms stagnated in most EBRD regions, hampering stronger growth prospects

Sources: Transition Report 2013

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While current pace of structural reforms is not enough to expedite convergence…

Sources: IMF, EBRD and authors’ calculations.

Inco

me

as a

shar

e of

EU1

5 in

com

e

10

…reinvigoration of reforms can help achieve higher growth rates

Sources: IMF, EBRD and authors’ calculations.

Inco

me

as a

shar

e of

EU1

5 in

com

e

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Outline

• Finance and growth•Need for structural reforms•Rebalancing finance in post-crisis period

• Financial challenges•Cross-border banking, global vs local •Funding structure•Currency composition of funding and loans•NPLs

• Macroeconomic prospects and challenges•Macroeconomic prospects•Oil prices•Brexit

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• Large post-crisis investment gap: Limited new funding flows

• Stock of outstanding debt keeps growing and weighs on firms

• Credit growth constraints

Key issues in rebalancing finance in post crisis period

Swift external adjustment after the crisisin the new EU member states

Sources: IMF and authors’ calculations. Simple averages

Pre-crisis convergence largely driven by economic integration, high FDI and other capital inflows – which have dried up since 2009

In Emerging Asia investment levels, if anything, are up

13

-5

0

5

10

15

20

25

30

35

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

Unw

eigh

ted

aver

age,

% o

f GDP

New EU member states

FDI, net Other capital flows, net

Investment

Savings

-5

0

5

10

15

20

25

30

35

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

Unw

eigh

ted

aver

age,

% G

DP

Emerging Asia

Investment

Savings

Investment fell too far; needs to be scaled up by US$ 75 billion a year (conservative estimate)

Sources: Author’s calculations

14

Estimated investment surplus/shortfall , 2009-13

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• Large post-crisis investment gap: Limited new funding flows

• Stock of outstanding debt keeps growing and weighs on firms

• Credit growth constraints

Key issues in rebalancing finance in post crisis period

In EBRD region, debt-to-GDP ratios increased at almost pre-crisis speed

Sources: IMF, national authorities via CEIC Data, BIS and authors’ calculations. 16

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 201590

100

110

120

130

140

150

Debt

(% o

f GDP

, unw

eigh

ted

aver

age)Level of debt (right)

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015-30

-20

-10

0

10

20

30

90

100

110

120

130

140

150

Contribution of exchange rate Contribution of nominal debt Contribution of nominal GDP

Chan

ge in

deb

t -to

-GDP

, % p

oint

s

Debt

(% o

f GDP

, unw

eigh

ted

aver

age)Level of debt (right)

In Emerging Asia, debt accumulation has accelerated post-crisis (less so on account of dollarization)

Sources: IMF, national authorities via CEIC Data, BIS and authors’ calculations. 17

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• Large post-crisis investment gap: Limited new funding flows

• Stock of outstanding debt keeps growing and weighs on firms

• Credit growth constraints

Key issues in rebalancing finance in post crisis period

Credit growth continues to decelerate

Sources: IMF, national authorities via CEIC, BIS and authors’ calculations. Refers to Emerging Europe.

19

Credit constraints increased (almost) everywhere but to very different extents…

Sources: BEEPS III and V. BEEPS III values are based on simple intra-country means, while BEEPS V values are weighted averages.

20

0 10 20 30 40 50 60 70 80 90 1000

10

20

30

40

50

60

70

80

90

100

62

47

77

45

25

66

57

29

36

55

76

5761

49

57

65 67

34

45

66

51

3736

59

13

75

48

Percentage of credit-constrained firms in 2005

Perc

enta

ge o

f cr

edit-

cons

trai

ned

firm

s in

2013

-14

66

36

76

…driven by supply side adjustment in external funding

Sources: IMF, BIS and authors’ calculations. SE Europe excludes Cyprus and Greece. Percentages refer to the share of 2014 GDP.

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Decline in corporate credit drives growth dynamics of credit…

Sources: National authorities via CEIC, latest data is May 2016

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Outline

• Finance and growth•Need for structural reforms•Rebalancing finance in post-crisis period

• Financial challenges•Cross-border banking, global vs local •Funding structure•Currency composition of funding and loans•NPLs

• Macroeconomic prospects and challenges•Macroeconomic prospects•Oil prices•Brexit

Source: Bankscope, bank websites

Although multinational and cross-border banking expanded in CESEE…

Subsidiaries of Western European parent banks in EBRD region

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• Bright sides of multinational banking• Hardened the budget constraints of large and loss-making firms…• …while improving access to credit for SMEs and retail customers• Stabilising effect during local banking crises• Improving corporate governance in the banking sector

• Dark sides of multinational banking• Exacerbates local business and credit cycles• Transmits financial shocks across borders

Banking integration may be a double-edged sword, at least for emerging markets

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…driven by supply side adjustment in external funding

Sources: IMF, BIS and authors’ calculations. SE Europe excludes Cyprus and Greece. Percentages refer to the share of 2014 GDP.

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After the global crisis, impact of multi-national banking on financial stability was re-assessed

• Parental support for foreign subsidiaries was not forthcoming• Multinational banks stayed put, but deleveraged considerably and faster than domestic banks• Wholesale-funded subsidiaries and subsidiaries of wholesale-funded parents reduced lending

• Banks also reduced cross-border lending to…• …distant countries• …countries where they had less experience• …countries where they did not own a subsidiary• …countries where they had not cooperated much with domestic banks

• Bright examples of regional cooperation that prevented disorderly deleveraging• Vienna Initiative• Nordic-Baltic cooperation

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Outline

• Finance and growth•Need for structural reforms•Rebalancing finance in post-crisis period

• Financial challenges•Cross-border banking, global vs local •Funding structure•Currency composition of funding and loans•NPLs

• Macroeconomic prospects and challenges•Macroeconomic prospects•Oil prices•Brexit

Domestic deposits continued to expand, improving overall funding structure

Source: BIS, National authorities via CEIC

Main bank funding sources

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Stronger growth in deposits lead to a reduction in loan-to-deposit ratios…

Source: BIS, local banking statistics and IMF calculations

Loan to deposit ratio (%)

• Weak credit growth, accompanied with growing deposits, allowed banks to reduce their reliance on foreign funding

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…with latest loan-to-deposit ratios standing below 100% in half of the CESEE countries

Source: BIS, local banking statistics and IMF calculations

Loan to deposit ratio (%)

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Private equity presence is tiny relative to the size of the region’s economies…

Sources: EMPEA, Centre for Management Buy-Out Research, PitchBook, Israel Venture Capital Research Center and IMF.

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…and has been declining

Sources: Euromonitor International, IMF, Asia Private Equity Review, EMPEA, EVCA and PitchBook.

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Investment flows to the EBRD region, by type

Operational improvements and timing of investment drive private equity returns

Sources: EBRD. Gross returns are based on 291 investments by PE funds in 1992-2013. Benchmark is MSCI Eastern Europe.

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Leverage plays a small role compared with advanced markets

High impact: PE investment on average increases labour productivity and profitability

Sources: EBRD, Orbis and authors’ calculations 35

EBRD research suggests that private equity investment leads to higher employment (on average adds 30 jobs over a 5-year period) and increased labour productivity and profitability.

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Outline

• Finance and growth•Need for structural reforms•Rebalancing finance in post-crisis period

• Financial challenges•Cross-border banking, global vs local •Funding structure•Currency composition of funding and loans•NPLs

• Macroeconomic prospects and challenges•Macroeconomic prospects•Oil prices•Brexit

Too much domestic debt is still in FX: Need to develop local currency financial markets

Sources: IMF, national authorities via CEIC, BIS and authors’ calculations37

• Impact on debt servicing particularly high in 2015

% of domestic corporate and household debt denominated in foreign currency

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Despite still high FX debt, credit growth is mainly driven by local currency lending in CESEE

Sources: National authorities via CEIC. Latest data is May 2016.

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Outline

• Finance and growth•Need for structural reforms•Rebalancing finance in post-crisis period

• Financial challenges•Cross-border banking, global vs local •Funding structure•Currency composition of funding and loans•NPLs

• Macroeconomic prospects and challenges•Macroeconomic prospects•Oil prices•Brexit

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NPLs are stuck at high levels across EBRD region, despite some improvement

Source: National central banks via CEIC.

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…NPLs are an issue even when fully provisioned

• NPLs are a cost even when fully provisioned, as they:- waste managerial time in both banks and corporates- render new loans more costly

• No incentives to resolve NPLs in key stakeholders: regulators, banks, corporate managers

- Do we require regulators’ push?

• Important to not spend limited resources for trying to restructure non-viable corporates, but also important to spend resources to restructure viable corporates (and not just wind them down).

• BAMC: yes or no?

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…investor interest is rising with higher transaction dynamics in NPL sector

Source: NPL Monitor for the CESEE Q12016, Vienna Initiative

Realised NPL portfolio transaction (June 2014 to December 2015)

• Investor interest increases on the back of improving macroeconomic backdrop and progress in NPL resolutions and restructurings

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Outline

• Finance and growth•Need for structural reforms•Rebalancing finance in post-crisis period

• Financial challenges•Cross-border banking, global vs local •Funding structure•Currency composition of funding and loans•NPLs

• Macroeconomic prospects and challenges•Macroeconomic prospects•Oil prices•Brexit

Average growth in EBRD region to pick up from 0.5% in 2015 to 1.4% in 2016 and 2.5% in 2017

Low commodity prices prolong recession in Russia and thus weigh on the outlook for Central Asia, Eastern Europe and the Caucasus (EEC), but help oil importers in CESEE and Turkey.

US monetary tightening reduces capital inflows to the region, while ECB QE program supports growth in CESEE.

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Source: IMF WEO; EBRD forecasts

Global capital flows became more volatile, putting pressure on EM currencies

45Source: Bloomberg.

• Perceived hike in Fed interest rate and equity sell-off in China have reduced investors’ sentiment for EMs and sparked increased global volatility in their financial markets, raising volatility of capital flows and putting pressure on EM currencies.

• While large EMs, such as Turkey, South Africa, or Brazil, are more affected, CESEE countries are affected to a lesser extent, due to ECB quantitative easing and investors’ perceiving their fundamentals sounder than other EMs.

Increased expectationsof Fed tightening

BlackMonday

Oil priceplunge

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Capital flows to the region declined as the US Fed started tightening monetary policy

Source: IIF; EBRD calculations

Decline in capital inflows to the region mirrors lower inflows in emerging markets in general, but is milder in CESEE, partly due to the ECB quantitative easing.

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Growth continues to recover, albeit slowly, in the Eurozone and CESEE region…

Growth prospects are improving, albeit slowly, in Eurozone and CESEE…

…with varying prospects in CESEE region.

Source: EC and EBRD. Note: SEE: Albania, BiH, Bulgaria, Cyprus, Greece, FYR Macedonia, Kosovo, Montenegro, Romania and Serbia. CEE: Croatia, Estonia, Hungary, Latvia, Lithuania, Poland, Slovak Republic and Slovenia.

*2016 and 2017 values are forecasts

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… driven mostly by consumption, supported by lower oil prices and ECB QE

Source: EUROSTAT; EBRD calculations. Includes CEB, Romania and Bulgaria.

The economic outlook in the CESEE remains relatively strong, on the back of sustained low commodity prices and further ECB quantitative easing.

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Outline

• Finance and growth•Need for structural reforms•Rebalancing finance in post-crisis period

• Financial challenges•Cross-border banking, global vs local •Funding structure•Currency composition of funding and loans•NPLs

• Macroeconomic prospects and challenges•Macroeconomic prospects•Oil prices•Brexit

50

Oil prices have recovered somewhat, but remain low

Source: Bloomberg

51

Currencies of major oil exporters adjusted, broadly preserving local currency price of oil

Source: Bloomberg

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Although net oil importers benefit from lower energy prices…

-50

-45

-40

-35

-30

-25

-20

-15

-10

-5

0

5

10

15Tu

rkm

enist

anAz

erba

ijan

Kaza

khst

anRu

ssia

Bela

rus

Alba

nia

Esto

nia

Egyp

tU

krai

neRo

man

iaTu

nisia

FYR

Mac

edon

iaPo

land

Slov

enia

Mon

tene

gro

Bulg

aria

Tajik

istan

Latv

iaCr

oatia

Slov

ak R

ep.

Serb

iaGe

orgi

aHu

ngar

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rkey

Cypr

usLi

thua

nia

Mol

dova

Mon

golia BiH

Mor

occo

Kyrg

yz R

ep.

Jord

an

Per c

ent o

f GDP

Source: IMF World Economic Outlook

Net oil imports

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…this decline revealed more fundamental problems in countries like Turkey

• Current account deficit fell from 5.7% in 2014 to 3.9% of rolling GDP in July 2016, driven solely by the decline in energy import bill on the back of falling oil prices.

• While energy import bill still remains a major contributor to the current account deficit, there is not much improvement in fundamentals.

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Outline

• Finance and growth•Need for structural reforms•Rebalancing finance in post-crisis period

• Financial challenges•Cross-border banking, global vs local •Funding structure•Currency composition of funding and loans•NPLs

• Macroeconomic prospects and challenges•Macroeconomic prospects•Oil prices•Brexit

While Brexit has short and long-term implications for the UK…

Short-term effects (deviations from the baseline growth, all values by 2018)

• 2.5 year cumulative growth effect ranges from -1 to -6 per cent.

Long-term cumulative effects (% of GDP, diamonds denote midpoint estimates)

• Long-term forecasts (up to 15 years) have an even wider range (+4 to -14 per cent)…

• …with the more optimistic scenarios assessing a strong positive impact e.g. from unilateral reduction of import tariffs.

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• In the short term, the EU will be politically weakened and inward looking, as its institutions struggle to come to terms with the new situation. Supporting reforms in partner countries will be less of a priority in comparison.

• In the medium to long term, impact on individual EBRD CoOs can be very substantial and will depend mostly on the EU’s ability to manage Brexit and will be mostly indirect, channelled through:

•Trade, financial and labour links with Eurozone •EU transfers•Support for reforms and reform momentum•Competing geopolitical influences

…it will have several implications for countries in Europe and beyond

1. Well managed divorce and functional extended family – smooth UK exit, with single market, Eurozone and Schengen preserved

2. Messy divorce and dysfunctional extended family – divisive negotiations between UK and EU, putting pressures on the single market, Eurozone and Schengen

3. Further disintegration with geopolitics taking over – UK exits the EU without clear future relationship agreed, triggering political and economic disintegration within the Eurozone and the EU

Three medium-term institutional scenarios emerge

58

Difference in GDP level compared to the no-Brexit baseline by 2021

Source: EPG calculations.

Gree

ce

SEE

excl.

Gre

ece

Ukra

ine

CEB

excl.

Pol

and

Turk

ey

EEC

excl.

Ukr

aine

Cent

ral A

sia

SEME

D

Russ

ia

Pola

nd

-5%

-4%

-3%

-2%

-1%

0%

Financial, trade and labour flows with the UKFinancial, trade and labour flows with the EUEU anchor for reform momentumEU transfers

Well-managed divorce has a limited impact for most EBRD countries

• In case of a “messy divorce”•EU institutions and policies are internally challenged, making common approach to

challenges more difficult•EU becomes less engaged in the enlargement process•Less support is obtained for reforms and transformation•Competing geopolitical influences in neighbouring and partner countries may arise

• In case of “further disintegration”•Disintegration gathers pace and referanda may become likely for common policies•Addressing common challenges in a coordinated manner becomes impossible•Unilateralism prevails•EU ceases being a point of reference for relatively less developed countries/regions•Influence of big countries, like Russia and China, increases in the region

However, impact becomes more significant if Brexit is not contained somewhat

Brexit’s impact will vary among EU members, depending on their connectedness with the UK

Countries with high exposure

Countries with significant exposure

Countries with niche exposure

Countries with low exposure

Source: Global Counsel, “Brexit: The Impact on the UK and the EU”, 2015

Bojan MarkovicEBRD

Rebalancing finance in Emerging Europe

Financial and macroeconomic challenges

ICTFDublin, 10 October 2016

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