Central and Eastern European countries in the global financial crisis ...

Central and Eastern European countries in the global financial crisis: A typical twin crisis?

Diemo Dietrich, Tobias Knedlik, Axel Lindner* Abstract This paper shows that during the Great Recession, banking and currency crises occurred simultaneously in Central and Eastern Europe. Events, however, differed widely from what happened during the Asian crisis that usually serves as the model case for the concept of twin crises. We look at three elements that help explaining the nature of events in Central and Eastern Europe: the problem of currency mismatches, the relation between currency and banking crises, and the importance of multinational banks for financial stability. It is shown that theoretical considerations concerning internal capital markets of multinational banks help understand what happened on capital markets and in the financial sector of the region. We discuss opposing effects of multinational banking on financial stability and find that institutional differences are the key to understand differing effects of the global financial crisis. In particular, we argue that it matters if international activities are organized by subsidiaries or by cross-border financial services, how large the share of foreign currency-denominated credit is and whether the exchange rate is fixed or flexible. Based on these three criteria we give an explanation why the pattern of the crisis in the Baltic States differed markedly from that in Poland and the Czech Republic, the two largest countries of the region. JEL classification: G01, G15, G32

*

PD Dr. Diemo Dietrich (Halle Institute for Economic Research and Martin Luther University Halle-Wittenberg, Germany), Dr. Tobias Knedlik and Dr. Axel Lindner (Halle Institute for Economic Research, Germany). Corresponding author: [email protected], +49345-7753740. We are indebted to Katja Drechsel for our fruitful discussions and her comments, and to Marcus Gedai for his assistance.

1. Introduction The consequences of the global financial crisis, which spread outward from the US from 2007, are among the most serious in history. Not only did banking systems experience serious difficulties, but public debt crises also arose and currencies came under pressure. Moments of crisis can arise in different sectors of the financial system. During a banking crisis, entire banking systems may be unable to perform their function as a financial intermediary, which interrupts the channelling of individual savings into individual investments. In the case of debt crises, borrowers are suddenly unable to repay debt; as a result, potential lenders may be disinclined to continue lending. In the case of a currency crisis, a country suddenly loses the confidence of international investors, which leads to a sharp depreciation or devaluation of the currency of the country concerned, or to a reduction of its international reserves (Gerber 2010). Often different kinds of financial crisis occur simultaneously. In such a case, the real economic costs are even higher. A joint currency and banking crisis is referred to as a twin crisis. This paper deals with the question of whether the Central and Eastern European countries were hit by such a twin crises during the recent global financial crisis. We account for country specifics by considering the structure of the banking systems in the region, as well as the extent of external debt. Our core hypothesis is that the presence of international banks did not pose so much of a problem in the sense of being an additional transmission channel of the global crisis, but rather stabilized these economies instead. We begin with a review of the literature on the relation between currency crises, debt crises, and banking crises. This is followed, in Section 3, by a concise overview of the structure of the banking systems and exchange rate regimes for selected Central and Eastern European countries up to the onset of the crisis. In Section 4, we use observations of developments from 2007 to 2009 to answer the question whether the region faced a twin crisis. Section 5 sets out our conclusions.

2. Financial crises in emerging economies 2.1. Currency and debt crises: the problem of currency mismatches In many cases, currency mismatches were at the core of financial crises (Goldstein and Turner 2004, Allen at al. 2002). An economy is subject to a currency mismatch if its households, financial and non-financial firms and governments have to borrow in foreign currency whilst most of their assets (or incomes) are denominated in local currencies. This makes real wealth (or income) strongly dependent on exchange rate movements: When the local currency depreciates, the real debt burden of a country increases which may result in a debt crisis, which may affect the country’s entire financial system - a phenomenon prevalent in many emerging countries.2 Currency mismatches have been a central element in most of the financial crises in the last few decades.3 They are considered to pose a critical risk to the world’s financial system. The problem of foreign government debt drove Mexico’s Tequila crisis (1994/95) and the Argentinean crisis (2001/02).4 In Russia’s financial crisis (1998), not only foreign government debt but also the foreign indebtedness of Russian banks turned out to be problematic. In the Asian crisis (1997/98) currency mismatches on the balance sheets of non-financial firms were crucial, for example, in South Korea, Thailand, and Indonesia. There, it became evident that banks’ individual hedges against currency mismatches did not suffice to shield the entire economy as banks only rolled over the currency mismatch to their borrowers. Banks thus exchanged their exchange rate risk for credit risk, which still depends on exchange rate developments. An intense debate arose about diagnosis and cure during the years following the Asian crisis. This debate was based on the observation that the willingness of international lenders to accept the denomination of debt in the currencies of emerging economies is very limited. Eichengreen, Hausmann and Panizza (2005)5 introduced the term ‘original sin’ for this problem based on the notion that countries may simply have inhe-

2

3 4 5

In a debt crisis the problem is that borrowers are unable to serve existing debt obligations; lenders respond to this debt overhang by cutting new loans. By contrast, in a banking crisis the problem is that banks are unable to raise funds for new loans. See Goldstein and Turner (2004) and Allen et al. (2002). See Dietrich and Lindner (2002) for a discussion of the Argentinean crisis. The term was introduced by Eichengreen and Hausmann (1999).

rited the inability to borrow in their own currency and thus cannot escape their past even if they switch to stability-oriented macroeconomic policies. Thus, the emerging economies did not choose the risk of currency mismatches.6 However, economic development and especially macroeconomic policies of countries can, if they aim at macroeconomic stability, mitigate the adverse consequences associated with currency mismatches and, thus, lower the probability that currency mismatches turn into crises. Goldstein and Turner (2004) have shown that the extent of the mismatch may indeed vary in accordance with an emerging country’s economic development and economic policy. Accordingly, simple measures such as the share of foreign currency denominated debt in total debt outstanding understate the impact of economic development and economic policy on risks associated with a currency mismatch. A more appropriate way to measure the extent of a currency mismatch are net foreign-currency assets times the share of foreign-currency denominated debt, divided by the country’s exports. Such a measure has been defined by Goldstein and Turner (2004, p. 44). The indicator takes into account that 1) a country may also possess assets denominated in foreign currency, including central banks’ international reserves, 2) foreign currency denominated debt contributes only little to financial vulnerability if it constitutes only a small share in total debt, and 3) income from exporting goods and services can be used to back up foreign currency denominated debt. According to this indicator, currency mismatches have been reduced, in particular in the countries which were hit hardest by the Asian crisis. Whilst that result is plausible, the approach also has its disadvantages. On the one hand, net liabilities denominated in foreign currency can only be estimated; on the other hand, the indicator is not formally derived from theory, but follows plausibility considerations. 2.2. The relation between currency and banking crises A currency mismatch may lead to currency crises if financial markets lose confidence in the ability of a country to serve foreign currency-denominated debt; the currency crisis is accompanied by a debt crisis. However, the stability of banks is also in 6

Eichengreen et al. (2005) argue in favour of a solution on the international level. As an intermediate step to establishing international bond markets for different emerging market currencies, they propose that international financial institutions should create bonds based on an index of the most important emerging market currencies (p. 266 ff.).

danger if the creditors of a bank value their deposits in foreign currency. In their seminal work on these interdependencies, Chang and Velasco (2000) analyse the impact of the exchange rate regime on the vulnerability of banks to self-fulfilling crises. The starting point of their analysis is Diamond and Dybvig’s (1983) model, which explains that for banks the transformation of illiquid assets into liquid liabilities may lead to multiple equilibria caused by asymmetric information. One of these equilibria constitutes a coordination failure of banks and results in bank runs. Using a simple macroeconomic model of an open economy, Chang and Velasco (2000) show that, in a case of a fixed exchange rate regime, banking crises and/or currency crises may emerge independently from the way in which the exchange rate is fixed. However, in the case of flexible exchange rate regimes, a lender of last resort (LLR) can ensure that multiple equilibria are avoided. Investors would expect the LLR to provide banks with liquidity in the case of a bank run. The investments of all investors – measured in foreign currency – would be devalued to the same degree in the case of a bank run, because the increase in liquidity provided by the central bank does not result in declining foreign exchange reserves, but in a depreciation of the exchange rate. The devaluation of investments would also affect investors who withdraw early. For that reason, there is no incentive to withdraw more than the individual liquidity demand from banks. Bank runs may thus be avoided. Chang and Velasco (2000) consider only the case in which banks perform liquidity transformation for the sole purpose of serving the liquidity preferences of the investors. Diamond and Rajan (2001a), however, pointed out that the fragile capital structure of banks could be caused by the incentive and enforcement problems associated with financial contracting. In many emerging market economies, legal and corporate governance systems are little developed: on the one hand, this leads to a dependency on financial intermediation as banks specialize in gathering information and thus solving contracual problems (Diamond and Rajan, 2001b); on the other hand, short-term debt of banks constitute – under such institutional conditions – a necessary disciplinary element for banks to fulfil their intermediation tasks. However, Short-trem debt may also cause a higher vulnerability to bank runs caused by fundamental shocks to the banking system. Short-term refinancing of banks is not the only consequence of the need to discipline banks. In principle, short-term refinancing could be done in a domestic or foreign currency. However, often banks can only refinance themselves in foreign currency (leading

to a currency mismatch) because of limited confidence in the country’s macroeconomic policy. Thus, the existence of an LLR implies not only that bank runs – as a result of a coordination failure – are eliminated. The LLR also gives banks a good reason to speculate on a public bailout. Hence, banks have little incentive to follow a prudent business policy so that banks potentially still suffer from a commitment problem vis-à-vis investors. This problem is particularly severe if prudential bank regulation and supervision is insufficient or if the legal system is not adequately developed to ensure that contracts will be enforced (Diamond and Rajan, 2006). Therefore, investors usually respond by accepting only short-term debt denominated in foreign currency for which help by a lender of last resort is limited by the amount of foreign exchange reserves. Eventually bank liabilities have to be covered by export returns in emerging markets, placing disciplinary pressure on macroeconomic policy (Diamond and Rajan, 2001b). This in turn makes banks vulnerable to exchange rate volatility and can cause the simultaneous emergence of banking and currency crises.7 It has been shown empirically that in most cases currency crises follow banking crises and that banking crises become more serious if they are followed by currency crises (Kaminsky and Reinhart 1999). Moreover, twin crises are more likely to occur in a situation after a liberalization of financial and capital account transactions and when a country enters a recession that follows a capital inflow-fuelled boom with an overvalued currency. These findings are supported by Glick and Hutchison (2001). Their study identifies banking crises as an indicator for currency crises; and the liberalization of financial and capital account transactions increases the vulnerability of countries to twin crises. Hutchison and &oy (2005) have shown that twin crises cause much higher real costs than if only one of the two kinds of crisis occurs. The average loss of production adds up to between five and eight per cent during the first two years after a crisis. Falcetti and Tudela (2008) have shown a strong relation between banking and currency crises, because both can largely be explained by the same fundamentals. However, they did not confirm the findings by Kaminsky and Reinhart (1999) that currency crises fol-

7

These considerations may help to explain that in the Asian crisis, local banks raised much short-term debt on international capital markets and invested into projects that, under normal conditions, would not be creditworthy: governments were seen by international investors as being responsible for their countries’ banks, both in terms of regulating their lending and in terms of backing their debt.

low banking crises; they explained Kaminsky and Reinhart’s result as possibly being due to misspecified econometric models. 2.3. The importance of multinational banks for financial stability Thus far currency and banking crises have been analysed under the implicit assumption that a banking system consists mainly of domestic banks. The influence of multinational banks on the (in)stability of a country’s banking system and the stability of the currency is still a largely unsolved research question. Among the different modes of how banks enter foreign markets, two are particularly important, each having different stability implications. First, banks can organize their international activities by establishing local subsidiaries or branches that are to some extent financially, organisationally, as well as legally, independent; this mode is called multinational banking. Second, banks can offer banking services to foreigners directly from the bank’s home country; this mode is called cross-border financial services. The decision of banks on their mode of foreign market operation is closely related to non-financial firms’ decision on whether to serve foreign markets by exporting goods or by establishing foreign representations (Helpman 2006).8 In particular, banks tend to serve foreign markets through subsidiaries if they have a strict productivity margin over competing banks that supply financial services across borders (Dietrich and Vollmer 2010). This productivity margin is necessary, in part because subsidiary structures have a comparative disadvantage with respect to their ability to settle country-specific liquidity shocks. Buch, Koch, and Kötter (2009) have confirmed this argument empirically and show that, for example, almost all German banks hold claims against foreign countries, but only banks with productivity advantages are also present in foreign countries. Buch et al. also suggest that German banks, for example, engage more often in countries

8

Gray and Gray (1981), Sagari (1992), and Buch and Lipponer (2007) have transferred models of non-banks to the international banking question. Dietrich and Jindra (2010) have shown that for non-banks financial aspects also play a crucial role in the choice of an internationalization strategy.

that are geographically close to Germany, have a comparable cultural background, and are economically strong.9 Internationally active banks increase the efficiency of the international allocation of financial resources (Stein 1997), because parent banks can adjust capital allocations if the expected returns of different subsidiaries change. In addition, the parent bank can raise funds against assets in one country and transfer them to subsidiaries that face underdeveloped financial and legal systems or a local financial crisis. Thus, multinational banks improve the supply of credit, compared to national banks, because assets and returns in other regions can be used as collateral to refinance banking activities in a given host country.10 From this point of view, stability implications are not straightforward. On the one hand, banks aim at balancing marginal returns across borders. For a given amount of capital, countries where the expected marginal return increases will be allocated more funds at the expense of the other countries (substitution effect). On the other hand, banks take into account the effects that this kind of bank internal re-allocation has on the funding constraint of the entire bank. Thus, the credit activities in developed countries have priority over balancing marginal returns (refinancing effect). This is the case because liquidity and solvency risks are higher in developing countries and, therefore, cause higher refinancing costs for the bank.11 Whilst these general findings count for both multinational banking and cross-border financial services, there are differences in their relative weights.

9

10

11

There is also evidence that countries’ regulatory framework, political risk and economic risk influence the mode of foreign market entry of international banks. In particular, it is found that banks are more likely to establish a branch network if there is discriminating regulation that treats branches preferentially, if taxes are high, and if political risk is relatively more important than economic risk (Cerutti, Dell'Ariccia and Peria 2007). The reason for the latter effect is that, in contrast to branch networks, the limited liability associated with a subsidiary structure allows the international bank to protect against country-specific economic risks while being more prone to the risk of expropriation often associated with political risks (Dell'Ariccia/Marquez 2006). Regarding the cross-pledging of returns, see Inderst and Müller (2003). Regarding the crosspledging of assets, see Dietrich (2007). A formal model of the substitution and refinancing effects in an international context can be found in Dietrich (2004).

In the case of cross-border financial services, a decline in expected returns due to a downturn of the business cycle in the home country of the bank should lead to a better credit supply in the foreign country, via the substitution effect. However, because of the associated worsening in pledgeable income, the total amount of funds available to the entire bank will decline and may thus constrain lending in the foreign country despite the increased relative attractiveness of the foreign market. If, however, the expected returns increase in the foreign country due to an upturn in its own business cycle, the overall refinancing conditions remain almost unchanged, since they largely depend on the financial conditions of the parent bank. In that case, the substitution effect should dominate. Banks offering cross-border financial services may therefore contribute to financial stability, if an emerging host country is hit by a banking crisis. Because of the crisis, only domestic banks face a tightening in their ability to refinance loans.12 If, however, a banking crisis occurs in a bank’s home country, its supply of cross-national financial services will be strongly affected via the refinancing channel, notwithstanding the fact that the foreign business of the bank might profit, relative to the home business, via the substitution effect.13 In the case of multinational banking, the substitution effect tends to be smaller, because bank-internal capital markets are imperfect and hampered by potentially conflicting interests of the managers of different subsidiaries (Stein 2002; Dietrich and Vollmer 2010). However, this could also be an advantage, because it reduces the effects of country-specific shocks and prevents internal contagion, because affected subsidiaries can be quarantined (Fecht and Grüner 2008; Dell’Ariccia and Marquez 2010). If a banking crisis arises in one of the subsidiaries’ host countries, the subsidiary can expect being supported by the parent bank as long as the existence of the bank as a whole is not endangered. This applies particularly where the banking crisis rather leads to refinancing problems and not to a loss of earnings. This implies that subsidiaries are able to continue business and might even be able to gain market share from crisis-ridden domestic competitors. Thus, there is an argument in favour of the stabilizing role that multina12

13

This stabilizing effect is present as long as only the refinancing possibilities are reduced, but the expected returns remain stable. This is true as long a deterioration of the refinancing possibilities at home do not lead to a simultaneous and disproportionally high improvement of refinancing conditions in the foreign country.

tional banks can play in the case of local banking crises. Nevertheless, the parent bank may also withdraw resources from the subsidiaries when funding problems emerge in the home country. However, any bank-internal redistribution of funds shall be limited by the organizational structure of financially and legally independent subsidiaries when a country-specific shock puts the existence of the bank as a whole at risk. In the worst case scenario, the subsidiaries have to take care of their own refinancing and cannot count on support from the parent bank. Regarding the relation between banking and currency crises, we need to consider the denomination of credit provided by the subsidiaries. If loans are supplied in the currency of the subsidiary’s host country, while refinancing is done in the currency of the parent bank’s country, than a serious currency mismatch could arise. However, as long as liabilities can be covered by returns in other currency areas, the assets of the subsidiaries that have been hit by the crisis would be of small importance to the bank’s creditors. An additional melt-down of the value due to a depreciation of the currency would have little impact on the bank as whole. The lending business in the subsidiary’s country would profit, because the substitution effect is more dominant than the refinancing effect. If the subsidiary issues loans in a foreign currency, the default risk would increase, due to the transfer of the currency mismatch from the bank to the non-banking sector. This should cause withdrawals from the subsidiary to the parent bank to ensure the parent bank’s stability. The withdrawal would be less significant if the subsidiary is less significant to the refinancing of the bank as a whole. The theoretical findings can be summarized as follows: internationally active banks should – irrespective of the particular form of their organization – stabilize banking systems in emerging market economies, including transition countries, if a banking crisis arises in these countries. If, however, a banking crisis occurs in the home market of the bank, which leads to worse refinancing conditions, we can expect contagion to the host economies in the case of cross-border financial services, whilst contagion via subsidiaries or branches is limited, if any occurs at all. Empirical findings before the recent global financial crisis did indeed suggest that multinational banks would have a stabilizing effect on banking systems in CEEC. Survey results show that western banks are, in general, willing to support subsidiaries in

CEEC in times of financial difficulty to avoid liquidity and solvency problems. This does not, however, apply in situations in which support of a foreign subsidiary would endanger the stability of the bank as a whole (De Haas and &aaborg 2006). Moreover, it has been shown that domestic banks in CEEC reduced lending during periods of financial turbulence, whereas in some cases, western banks even increased lending (De Haas and Van Lelyveld 2006). In these cases, refinancing was mainly conducted via the parent banks and bank-internal transfers (De Haas and Van Lelyveld 2010). Nevertheless, the financial status of the parent bank has also been important for the credit business of foreign subsidiaries, not only in CEEC. In particular, favourable returns, as measured by interest rate spreads, of the parent bank have been an advantage for subsidiaries. Furthermore, the lending business of the subsidiaries is negatively correlated with economic growth in the home market of the banks, which supports the outcome of the substitution effect discussed above (De Haas and Van Lelyveld 2010). 3. The integration of the Central and Eastern European banking sector into the global financial system: some facts The importance of internationally active banks has increased in recent years (McGuire and Tarashev 2007). This is particularly true of Central and Eastern European countries in the period preceding the global financial crisis. The market share of banks owned by foreigners is very high, accounting for more than 90 per cent in Estonia, Lithuania, Hungary, and Slovakia (see Table 1, Column 2). In larger countries, such as Poland and the Czech Republic, the business is to a very large extent conducted via subsidiaries and branches (Column 3). The share of short-term lending differs between Central and Eastern European countries, but is not exceptional in any way; indeed, short-term debt is higher in Germany than in any Central and Eastern European country (Column 4). The high share of foreign currency-denominated loans as a percentage of total loans seems to be more problematic. It is particularly countries that are regarded as very vulnerable since the outbreak of the financial crisis, namely the Baltic states, Bulgaria, and Romania, that display a large percentage of foreign currency-denominated debt. For the entire banking sector in Central and Eastern European countries (including domestic banks) the foreign currency share of assets and liabilities is almost equal, pos-

ing little risk to banks’ balance sheets.14 However, this does mean that debtors of the banks bear most of the risk of currency mismatches and are vulnerable to exchange rate volatility. This is particularly true for the three Baltic States and to a lesser extent for the Czech Republic and Poland. The Central and Eastern European countries represent a wide range of exchange rate regimes, from currency boards to flexible exchange rates (and also include Euro members). Countries with currency boards, such as the Baltic states and Bulgaria, show higher shares of foreign currency-denominated debt than countries with flexible exchange rates.

14

Own calculations based on BIS (2009).

Table 1:

Selected financial market indicators in the Central and Eastern European countries (end of 2007) Market share of foreign banksa)

Share loans by subsidiaries of multinational banks in total loans by foreign banksb)

Share of short-term loans in total loans by foreign banksc)

Share of foreign currency denominated loans in total loans by foreign banksd)

Exchange rate regimee)

Bulgaria

78%

63%

41%

64%

Currency board

Estonia

99%

43%

23%

75%

Currency board (ERM II)

Croatia

82%

54%

33%

58%

Other Managed Arrangement

Latvia

63%

62%

31%

81%

Conventional peg (ERM II)

Lithuania

90%

41%

23%

64%

Currency board (ERM II)

Poland

69%

73%

28%

41%

Free floating

Romania

60%

61%

56%

66%

Floating

Slovakia

94%

70%

50%

29%

Pegged with horizontal band (ERM II)f)

Slovenia

NA

43%

29%

52%

Euro

Czech Rep.

84%

70%

46%

23%

Free Floating

Hungary

97%

51%

33%

62%

Floating

Germany

6%

33%

60%

55%

Euro

a)

Percentage of the banking systems’ deposits in banks that are 50% or more foreign-owned as of the year-end 2005. b) including cross-border financial services (percentage). c) Loans by internationally active banks with a maturity of up to a year, including cross-border financial service (percentage). d) Loans of internationally active banks to non-banks in foreign currency (percentage). e) Definition of the International Monetary Fund, all fixed regimes against the euro. f) Introduced 1 January 2009.

Sources: Own calculations based on BIS (2009), Caprio, Levine and Barth (2008), IMF (2009b, Appendix II), Thomson Reuters Datastream.

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Diemo Dietrich / Tobias Knedlik / Axel Lindner

In summary, the presence of international banks in Central and Eastern European countries is significant. While the kinds of presence of such banks differs in the Central and Eastern European countries, local subsidiaries and branches of foreign banks are important in all these countries. The share of short-term lending which might constitute vulnerability to crises is high only in a few countries. The share of foreign currencydenominated loans granted by foreign banks is also high in some countries. The Czech Republic, Poland and Slovakia stand out in this regard, insofar as their share of subsidiaries and branches of foreign banks is high, while their share of foreign currency denominated-debt is low. 4. Central and Eastern European countries in the global financial crisis 4.1. Loss of confidence in the Central and Eastern European economies Currency mismatches have not been at the core of the current global financial crisis. This position was filled by structured products, such as mortgage-backed securities (MBS), which are mainly denominated in US dollars. Still, even though the crisis emanated from the US market, the dominant world reserve currency managed to appreciate even during the darkest phase of the crisis (September 2008 and March 2009).

15

Banking and currency crises

Current account balancea) and cumulative increases of CDS pricesb) for Central and Eastern European countries

Figure 1:

increase of CDS prices

1200

1000

800

600

400

200

0 0 a)

-5

-10 -15 -20 current account balance

in 2007, relative to the GDP (percentage). Germany).

b)

-25

-30

in 2008/09 (basis points). Countries: see Table 2 (without

Sources: Own calculations based on IMF (2009c), Thomson Reuters Datastream.

Even though the crisis posed no immediate threat to Central and Eastern European countries via derivatives market, the crisis did spread to these countries as well. The Central and Eastern European countries were regarded as potentially unstable even during the upswing before the crisis. During the global financial crisis, Central and Eastern European countries quickly lost confidence on the financial markets. This loss of confidence was reflected by increasing prices for credit default swaps (CDS) on government bonds. In particular in the Baltic states, Bulgaria, and Romania, risk premiums rose dramatically (Table 2, Column 2). These countries have in common exorbitant current account deficits (double digits in terms of the percentage of their GDPs). These high deficits and the related need for international finance has been central to risk assessments on the international capital markets (see Figure 1).15 The majority of the increases of CDS prices were corrected in many countries at the start of 2009.

15

The regression of CDS price increases on current account deficit yields of positive coefficient with R2=0.46 on a five per cent level of significance.

16


Table 2:

CDS prices for 10-year government bonds in selected countries Cumulative

Country

Months with extraordinary increases in CDS prices

Number

increase of a)

CDS prices

of 3/2008

10/2008

11/2008

12/2008

2/2009

3/2009

months

Bulgaria

644

X

X

2

Estonia

732

X

X

2

Croatia

552

X

X

3

Latvia

1189

X

Lithuania

837

X

Poland

380

X

Romania

735

X

Czech Rep.

330

Hungary

618

X

X

X

2

X

2

X

X

3

X

X

3

X

X

2

X

X

3

Germany 90 X X X 3 a) Difference between the highest value during the crisis and the value prior to the crisis (in basis points). Source: Own calculations, based on Thomson Reuters Datastream.

Months with extraordinary increases in CDS prices can be identified by statistical methods.16 Such extraordinary increases were observed in October 2008, the month after the Lehmann Brothers’ collapse. There are only limited differences regarding the number of the crisis months. These initial findings show that Central and Eastern European countries were heavily affected by the global financial crisis, however, to a different extent. The next question that arises is whether the international financial crisis caused banking crises, currency crises, or even twin crises in Central and Eastern European countries, and, more specifically, what role internationally active banks played. 4.2. Banking crisis? A banking crisis occurs when banks are unable to fulfil their intermediation function and credit supply collapses. However, there is also a banking crisis if the collapse of the banking system is prevented by public intervention only. By contrast, a simple shrinking of credit expansion is not a sufficient condition for a banking crisis, since reduced credit demand could also explain slumping credit expansion. It is generally agreed that

16

In line with the Exchange Market Pressure Index (introduced below), a crisis is identified if the increase of the CDS price exceeds the mean of the time series by a multiple of its standard deviation (see also Footnote 23).


17

since the autumn of 2007, banking systems in most developed economies underwent a banking crisis. Whilst governments provided the historically highest volumes of support for banks, many banks still failed.17 The crisis led to an abrupt shrinkage in the risk appetite, a reduction of credit supply, and more pessimistic expectations outside the financial sector too, which eventually resulted in a sharp recession.18 It can thus be asked whether the banking crisis that emanated from the USA, the United Kingdom and the Euro countries also spread to banks in Central and Eastern European countries. A first clue would be the valuation of banks on local stock markets. Hungary and Poland are used as examples (see Figure 2). The price development of bank shares was similar to developments in the euro area. The valuation of the banking sector deteriorated from the summer of 2007 onward. In the autumn of 2008, after the Lehmann Brothers’ insolvency, share prices almost went into free fall. The drop in the prices of bank shares was sharper than the drop in the prices of broader stock indices, which include non-banking corporations. If the price drop is measured as a difference between the peak levels in the summer of 2007 and the trough in the first quarter of 2009, the drop was more massive in Hungary (-86%) and in Poland (-72%) less severe as compared to that in the Euro area (-82%). Apparently the majority of banks in Central and Eastern European countries were considered to be at risk of going into insolvency. The banking crisis was such that a systemic collapse could only be prevented by massive public interventions in the USA and western Europe, and it clearly also spilled over to Central and Eastern European countries.

17

18

According to the Federal Deposit Insurance Corporation more than 100 banks failed in the USA in the month of October 2009 alone. Compare Almeida et al. (2009) regarding the effects of the world financial crisis on the real economy in the USA.

18


Figure 2:

Price indices for bank shares in Hungary, Poland, and the Euro area (April 2005 = 100)

250

200

150

100

50

0 Jan-05 Jun-05 Nov-05 Apr-06 Sep-06 Feb-07 Jul-07 Dec-07 May-08 Oct-08 Mar-09 Aug-09 Jan-10 Poland Hungary Euro area

Source: Own calculations, based on Thomson Reuters Datastream.

It appears logical to assume that internationally active banks played an important role as transmission channels of the banking crisis because of their high importance for the region.19 However, the theoretical discussion in Section 2.3 has shown that the potential for contagion depends on the relative importance of the substitution and refinancing effects. Thus, one can reach a very different conclusion. Multinational banks could have been the dominant transmission channel, since the capital base of the parent banks was narrowed due to the enforced accumulated depreciation of assets caused by the crisis. Moreover, banks’ liquidity and profit expectations worsened. These effects caused the dramatic decline of refinancing possibilities for western parent banks and led to a withdrawal from subsidiaries in Central and Eastern European countries to stabilize the parent banks in Western Europe. In view of the high importance of multinational banks for the domestic banking systems in Central and Eastern European countries, the credit supply was significantly reduced in these countries and economic growth expectations declined. This caused foreign exchange traders to induce heavy depreciations in some Central and Eastern European countries.20

19

20

Such transmission effects have been shown earlier for other regions of the world. Peek and Rosengren (2000) show that the banking crisis in Japan in the 1990s led to a reduction of credit supply in the USA, which had an effect on the real economy. This argument is taken from Gabrisch (2009).


19

By contrast, it could also be argued that multinational banks stabilized the situation, at least in some countries, during the world financial crisis (ECB 2010). The relatively prosperous developments in Central and Eastern European countries that continued even during the crisis year of 2008 and the poor profit prospects in Western Europe and the USA may have led Western banks to shift activity to Central and Eastern European countries. This would have helped to delay the transmission of the crisis into Central and Eastern European countries. Only at the turn of the year from 2008 to 2009 were Central and Eastern European countries affected by the international crisis due to the international business cycle effects. This was followed by reduced credit expansion and pressure on national currencies. Some observations support the latter argument. Although the credit drop from foreign banks was dramatic, amounting to more than 25% in some countries, considering this figure alone may be too simplistic and obscures information that could inform an assessment of the role that foreign banks played. Foreign banks expanded their credit business by 50% (between the second quarter of 2007 and the second quarter of 2008), mainly in Poland and the Czech Republic, i.e. after the summer of 2007, which was marked by the first strong turbulence in the Western financial markets, and the first effects on bank share prices in Central and Eastern European countries became noticeable. The resulting drop of claims of foreign banks accounts for less than half of the earlier increase. A further phenomenon was the fact that, after the bail-out of Bear Stearns in March 2008, loans granted in terms of cross-border financial services decreased by 25%. However, the loans of subsidiaries of foreign banks (measured in US$) declined only from the autumn of 2008 onwards and amounted for significantly less, namely 18%. When one takes into account that a large part of the claims of subsidiaries of foreign banks is denominated in local currencies, the decline was largely driven by currency depreciations. It was only in the Baltic states that the loans granted in the local currency by the subsidiaries of multinational banks was lower in the second quarter of 2009, as compared to the spring of 2008. By contrast, the declining trend in Latvia and Lithuania started even before the financial crisis. In all other countries, previous credit levels were again reached after, at most, six months. In the second quarter of 2009, these levels even exceeded the previous year’s levels by between 4% (Croatia) and 18% (Romania).

20


In some countries, multinational banks played a stabilizing role, if one compares their credit expansion to that of domestic banks. Taking the credit volume measured in US$ as a base, in five out of nine countries, the credit expansion of domestic banks was lower between the spring of 2007 and the spring of 2009 than that of foreign banks. This finding is not altered by the fact that foreign banks may also provide credit in foreign currency: if one considers only credit in domestic currency, the picture changes only in the case of Estonia (see Table 3). Table 3:

Changes of credit claims of domestic banks and branches and subsidiaries of multinational banks (Q2:2007-Q2:2009). Credit of a)

domestic banks

Credit of

Credit of domestic

Credit of

multinational

banks (in local

multinational banks

currency)

denominated in

a)

banks

local currency Bulgaria

99,0%

41,3%

96,8%

38,8%

Estonia

15,7%

22,7%

14,6%

-22,1%

Croatia

-15,4%

25,8%

-16,1%

14,4%

Latvia

23,7%

3,4%

22,8%

-54,4%

Lithuania

52,1%

10,5%

50,9%

-30,1%

Poland

28,4%

44,9%

48,6%

51,4%

Romania

70,2%

28,1%

114,9%

55,8%

0,6%

26,3%

-6,0%

28,4%

-9,0%

43,0%

3,9%

50,6%

Czech Rep. Hungary a) accounted in US$.

Source: Own calculations based on BIS (2009) and Thomson Reuters Datastream.

4.3. Currency crisis? In the case of a currency crisis, a country suddenly loses the confidence of international investors, leading to a serious depreciation or a devaluation of its currency. For the purposes of this definition, the terms ‘sudden’ and ‘serious’ need to be differentiated with regard to the history of exchange rate fluctuations in a specific country. In a country with fixed exchange rates, even small deviations from the target exchange rate may constitute a crisis, whilst for countries with flexible exchange rates, normal fluctuations have to be accounted for. This can be achieved by weighting the depreciations of different currencies with the inverse standard deviation of past realizations. The empirical


21

treatment of currency crises usually also takes into consideration central bank interventions to prevent the depreciation of a currency. Therefore, the standard instrument to identify currency crises, the exchange market pressure index (EMP) is a linear combination of changes in exchange rates, interest rates, and the foreign exchange reserves (Eichengreen, Rose and Wyplosz 1996). Using the EMP, currency crises can also be identified if the depreciation is slight, but there are unusual interventions, for example, if the central bank intervenes heavily by increasing interest rates or selling foreign exchange reserves. The EMP indices developed very differently in the selected countries (see Figure 3). The main reason is the more enduring problems with exchange rate stability of varying severity. An increase of the index suggests increased exchange market pressure, due to depreciations, increased interest rates, and/or reduced foreign exchange reserves. Extraordinary increases in the index are referred to as currency crises.21 Currency crises were identified in most countries at the end of 2008 and early in 2009 (see Table 4). The Polish crisis started relatively early (September 2008); and only Lithuania faced no crisis at all. To identify the causes of currency crises, different methods, such as signal approaches or Probit and Logit approaches can be used (see Knedlik and Scheufele 2008). In this case, significant results were not achieved, due to a lack of data availability and the limited sample. Hence, exchange rate regimes could not explain the duration of crises, since, for example, Bulgaria (which has a currency board) was affected relatively seriously, whilst Lithuania (which also has a currency board) faced no crisis. Countries with floating regimes were also affected in different ways. Further potentially explanatory variables, such as public debt, current account deficits, share of foreign banks, and share of credit denominated in foreign currency, provided no significant results.22

21

22

As a threshold, we used the mean, plus 1,645 times the standard deviation of the EMP index. Under the assumption of a normal distribution, the threshold would cause an identification of five per cent of the periods as crisis periods. For a discussion of different thresholds, see Knedlik (2006). The absence of significant results is not sufficient to conclude that there is no relationship between the variables in the data-generating process.

22

Table 4: Country


Currency crisis in selected countries Months with strong increases of the EMP

Cumulative depreciationa)

Bulgaria

0

Estonia

0

Croatia

4

Latvia

2

Lithuania

0

Number of crisis

09/2008

10/2008

11/2008

X

12/2008

01/2009

X

04/2009

months 2

X

1 X

X

X

2 1 0

Poland

32

X

X

X

Romania

28

X

X

2

Czech Rep.

16

X

X

2

Hungary

24

X

a)

3

1

Depreciation against the euro, based on monthly average exchange rates, between the lowest value during the crisis and the highest value before the crisis (percentage).

Source: Own calculations, based on Thomson Reuters Datastream.

0,06

Czech Republic

0,04

0,02

-0,02

0

-0,04

-0,06

-0,08

Source: Own calculations, based on Thomson Reuters Datastream. 01.04.2009 01.07.2009 01.10.2009

01.07.2009

01.10.2009

Hungaria

01.04.2009

0,25 0,2 0,15 0,1 0,05 0 -0,05 -0,1 -0,15

01.01.2009

-0,1

01.01.2009

-0,15

01.10.2008

-0,05

01.10.2008

-0,1

01.07.2008

-0,05

01.07.2008

0

01.04.2008

0,05

01.04.2008

0,15

01.01.2008

0,15

01.01.2008

0,2

01.10.2007

Romania

01.10.2007

0,2

01.01.2009

01.11.2008

01.10.2009

01.07.2009

01.04.2009

01.09.2008

01.10.2008

01.07.2008

01.04.2008

01.01.2008

01.10.2007

01.07.2007

01.04.2007

01.01.2007

01.10.2006

01.01.2009

Poland

01.07.2008

01.05.2008

01.03.2008

01.01.2008

01.11.2007

01.09.2007

01.07.2007

01.05.2007

Lithuania

01.03.2007

-0,15

01.07.2006

Croatia

01.07.2007

0,1

01.10.2009

01.07.2009

01.04.2009

01.01.2009

01.10.2008

01.07.2008

01.04.2008

01.01.2008

01.10.2007

01.07.2007

01.04.2007

01.01.2007

01.10.2006

01.07.2006

01.04.2006

01.01.2006

Bulgaria

01.07.2007

-0,1

-0,08

01.01.2007

-0,06

01.04.2007

-0,05

01.04.2007

0

-0,04

01.11.2006

-0,02

01.01.2007

0,05

01.01.2007

0,1

0

01.09.2006

0,15

01.10.2006

0,02

01.10.2006

0,04

01.07.2006

0,2

01.07.2006

0,06

01.07.2006

0,07 0,06 0,05 0,04 0,03 0,02 0,01 0 -0,01 -0,02 -0,03

01.04.2006

-1

01.05.2006

-1,5

01.01.2006

0

01.03.2006

-0,5

01.01.2006

01.10.2009

01.07.2009

01.04.2009

01.01.2009

01.10.2008

01.07.2008

01.04.2008

01.01.2008

01.10.2007

01.07.2007

01.04.2007

01.01.2007

01.10.2006

1

01.04.2006

01.10.2009

01.07.2009

01.04.2009

01.01.2009

01.10.2008

01.07.2008

01.04.2008

01.01.2008

01.10.2007

01.07.2007

01.04.2007

01.01.2007

01.07.2006

01.04.2006

01.01.2006

0,5

01.01.2006

01.10.2009

01.07.2009

01.04.2009

01.01.2009

01.10.2008

01.07.2008

01.04.2008

01.01.2008

01.10.2007

01.07.2007

01.04.2007

01.01.2007

01.10.2006

01.07.2006

01.04.2006

01.01.2006

1,5

01.04.2006

01.10.2009

01.07.2009

01.04.2009

01.01.2009

01.10.2008

01.07.2008

01.04.2008

01.01.2008

01.10.2007

01.07.2007

01.04.2007

01.01.2007

01.10.2006

01.07.2006

01.04.2006

01.01.2006

2

01.01.2006

01.10.2009

01.07.2009

01.04.2009

01.01.2009

01.10.2008

01.07.2008

01.04.2008

01.01.2008

01.10.2007

01.07.2007

01.04.2007

01.01.2007

01.10.2006

01.07.2006

01.04.2006

01.01.2006

Figure 3:

01.10.2006

01.07.2006

01.04.2006

01.01.2006


23

Development of the exchange market pressure in selected countries (1/2006-10/2009) 0,002 0,0015 0,001 0,0005 0 -0,0005 -0,001 -0,0015 -0,002 -0,0025

Estonia

0,08 0,06 0,04 0,02 0 -0,02 -0,04 -0,06 -0,08 -0,1

Latvia

Russia

0,05 0,1

0

24


5. Conclusions The previous section has demonstrated that banking and currency crises occurred simultaneously in Central and Eastern European countries. The characteristics of these crises were, however, very different from what theories developed after the Asian crisis describe regarding twin crises. The epicentre of the financial crisis was located in the financial centres of the world, i.e. in the US and in Western Europe. Emerging market regions, such as the ones considered in this contribution, were only a sideshow. In the course of 2008, the belief arose that international investors would have to reduce activity in all risky markets, including emerging markets, to consolidate their positions. It is for this reason that the government bonds of emerging markets came under pressure, particularly in the countries with the highest current account deficits and fixed exchange rates. Banking crises in Central and Eastern European countries were caused at the beginning of the world financial crisis, because banking systems in the centre of the world’s financial markets were shaky and because many multinational banks that were affected also dominate the financial sector in Central and Eastern European countries. Thus, the heavy interventions in Western banking systems during the winter of 2008/09 also had a stabilizing effect on the banking systems in Central and Eastern European countries. That helped international banks in Central and Eastern European countries to bear more burdens. The gain in confidence was also larger than it would have been if the banking systems had been dominated by local banks. However, the capacity to deal with stress in the Central and Eastern European countries varies, as is evident from a comparison of the Baltic states with Poland and the Czech Republic. The Baltic states could successfully defend their fixed exchange rate regimes (the number of crisis months was low), but the loss of confidence (measured in terms of CDS prices) was high. The currencies of Poland and the Czech Republic depreciated heavily (and the currency crises lasted longer), but the loss of confidence regarding these countries’ ability to repay public debt was lower. One reason for the unequal developments might rest in the different structures of the financial systems of these countries. The Baltic states have very rigid exchange rate regimes. In the case of turbulence in the financial markets, this exerts higher pressure on


25

banks, according to the theory. However, the banking sector in the three countries is characterized by the small share of the branches and subsidiaries of foreign banks in the overall activity of foreign banks. Most of the international banking business functions as cross-border business (see Table 1). It follows from the theoretical consideration above that this kind of banking structure is particularly vulnerable to the transmission of banking crises from foreign countries. The situation was exacerbated by the fact that the share of foreign currency-denominated credit was high (over 60%). With shrinking export returns caused by the global recession, bank balance sheets were burdened with larger credit default risks. Banks reacted with a reduction of credit expansion; the credit supply grew by less than that of domestic banks (see Table 3).23 According to these three criteria, the situation was very different in Poland and the Czech Republic. Both countries have more flexible exchange rate regimes, subsidiaries and branches of foreign banks dominated the international banking business, and the share of foreign currency-denominated credit is low. According to the theoretical considerations, multinational banks may have contributed to the stabilization of the credit supply, which is confirmed by the fact that in these countries the expansion of the credit supply by multinational banks was larger than that of domestic banks. In summary, the experiences of the Central and Eastern European countries imply that the integration of emerging market banking systems into the world financial system may have very different implications. There are indications that the specific way in which the integration occurs makes a considerable difference. However, neither the theoretical considerations nor the empirical evidence permit certainty regarding the conclusions on the role that international banks play in how simultaneous currency and banking crises arise.

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That the massive increase in Latvian risk premiums did not lead to a collapse of the financial system might be attributed to the support of the International Monetary Fund in December 2008 (IMF 2009a).

26


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