The Second Decade of Transition in Emerging Europe

Professor Miodrag Zec, Faculty of Philosophy, Belgrade, Serbia

The above analysis, inspired by Minsky's financial instability hypothesis and extended to financially integrated emerging economies has yet had little echo in the literature dedicated to the crisis effects in Central, East and Southeast European transition economies. ...The present study addresses precisely this perspective. Through a very rich and detailed country data analysis, the build-up of the fragility as well as the consequences of the U.S. banking crisis is exemplified, analyzed and explained. The analysis confirms the interest and accuracy of a Minskyan perspective in understanding the transition economies of Europe. ...The robustness of the analysis leads to a severe report of the situation in emerging Europe countries and singularly in Serbia. The policy prescriptions, which arise from the analysis, are all the more interesting and promising. Professor Christine Sinapi, Burgundy School of Business, Dijon, France The authors of the book in front of you enter innovative territory in the attempt to apply the Minsky's financial instability hypothesis – developed in the context of advanced economies – to emerging economies. Analyzing a range of macroeconomic indicators for eleven Eastern European economies in more detail the publication sheds light on similarities and differences in their economic experiences during the latest crisis. ... Overall, the publication is a valuable contribution to a more nuanced view of Eastern Europe amongst economists and investors. Emerging markets particularly if members of one regional group are typically lumped together by investors, neglecting often stark differences in economic fundamentals. The latest crisis and more recently the European sovereign debt problems have demonstrated that regional blocks are not necessarily characterized by economic convergence. ...For now, the authors have provided a well-rounded piece of work on the impact of the global economic crisis in Eastern Europe. Ewa Karwowski, Economics Department, School of Oriental and African Studies, London, UK

The Second Decade of Transition O. Radonjić and S. Kokotović / in Emerging Europe

In this book Ognjen Radonjić and Srdjan Kokotović reject widely prized and adopt paradigm of efficient markets and universally undisputed measures of economic success of small open economies, such as macroeconomic stabilization and full liberalization and deregulation of financial and trade flows. In contrast, as authors emphasize, if policy creators do not limit the level of debts of local market participants, most importantly the short-term debts and debts denominated in foreign currency, which is in the most cases directed towards consumption and development of non-tradable sectors, crisis is certain. This is because, prior to and during massive capital inflows, local economy has not created foundations for sustained development necessary not only because debts have to be repaid, but also to provide more economic independence in the future. All in all, this book represents refreshment in both domestic and international literature and indisputably bears scientific contribution to present and future analysis of this quintessential economic issue.

Ognjen Radonjić (1975) is assistant professor of Economics at the Faculty of Philosophy, University of Belgrade. He is a member of the Institute for Sociological Research, Belgrade, Scientific Association of Economists of Serbia, World Economics Association, Bristol, UK and editorial board of the Sociology, journal of sociology, social psychology and social anthropology. He is the author of the book Financial Markets: Risk, Uncertainty and Conditional Stability (in Serbian) and a number of articles on macroeconomics and financial markets related topics. Radonjić received a PhD in economics from the Faculty of Economics, University of Belgrade.

Ognjen Radonjić and Srdjan Kokotović

The Second Decade of Transition in Emerging Europe The Age of Capital Inflows, Macroeconomic Imbalances and Financial Fragility

ISBN 978-86-86563-99-6

UNIVERSITY OF BELGRADE

FACULTY OF PHILOSOPHY

UNIVERSITY OF BELGRADE

FACULTY OF PHILOSOPHY

Srdjan Kokotović (1976) is an economist in the Resident Representative Office of the International Monetary Fund in Serbia in charge of monetary and financial issues. Previous engagements include bank supervision within the National Bank of Serbia and managing Risk Controlling Department and Office of the Chief Economist in Hypo Alpe Adria Bank, Belgrade. He also managed privatization projects and financial analysis within the Deposit Insurance Agency. Srdjan Kokotović was a member of editorial board of the Quarterly Monitor of Economic Trends and Policies, journal published by the Foundation for the Advancement of Economics (FREN). He wrote a number of articles in the field of financial stability and development, economic policy and real sector development. Kokotović obtained a MSc degree in quantitative finance from the Faculty of Economics, University of Belgrade.

Faculty of Philosophy, University of Belgrade | 2012

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he Second Decade of Transition in Emerging Europe: The Age of Capital Inflows, Macroeconomic Imbalances and Financial Fragility Ognjen Radonjić Srdjan Kokotović

Ognjen Radonjić Srdjan Kokotović The Second Decade of Transition in Emerging Europe: The Age of Capital Inflows, Macroeconomic Imbalances and Financial Fragility First edition, Beograd 2012 Publisher Faculty of Philosophy, University of Belgrade Čika Ljubina 18–20, Beograd 11000, Srbija www.f.bg.ac.rs For the publisher Vesna Dimitrijević, Dean of the Faculty of Philosophy Reviewed by Christine Sinapi Miodrag Zec Edited by Milica Naumović Design by OCM Set and printed by Dosije studio, Beograd Print run 300 ISBN 978-86-86563-99-6

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Acknowledgements

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here is a number of our friends and respected colleagues whose valuable comments and support inspired us and improved quality of this book. In fear that we may miss someone, we thank professors Miodrag Zec, Christine Sinapi, Boško Živković and Pavle Petrović. We also owe gratitude to hosts of Minsky Summer Seminar and Conference held in The Levy Economics Institute of Bard College (June 27–29, 2010) professors Dimitri B. Papadimitriou, Jan Kregel and L. Randall Wray and all lecturers and participants especially Ewa Karwowski, Leonid Okneanski and Hee Young Shin. We have to acknowledge professors and fellow students of the IMQF program at the Faculty of Economics in Belgrade, as well as Bogdan Lissovolik and Srboljub Antić and the other members of staff from the International Monetary Fund for exchanging interesting insights and suggestions that have helped in our efforts. Finally, we would like to thank professor Miloš Jagodić for valuable technical assistance. Analysis, findings, and conclusions expressed in this book are entirely those of the authors and do not represent the views of either the International Monetary Fund or the University of Belgrade. Any error remains an exclusive responsibility of the authors.

To Anka and Neva, my source of love and inspiration Ognjen Radonjić

I dedicate this book to my wife Milica and my daughters Dunja and Nadja. Without their patience, love and care I would have never been able to come this far. I owe eternal gratitude to them Srdjan Kokotović

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able of contents

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Foreword by Christine Sinapi

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Introduction

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I Minskian Model of Financial Crises in Emerging Markets 1. Minsky’s Financial Instability Hypothesis and Endogeneity of Financial Crises 2. The Financial Instability Hypothesis in Open Economy 3. Investment and Liquidity Model of Capital Flows from Developed to Developing Countries 4. Liquidity Model of Genesis of Financial Fragility in Emerging Markets 5. After a Prolonged Period of Expansion Comes Crash

30 | 32 | 33 | 35 | 39 | 43 | 50 | 53 | 55 63 68 75 82 89 96 102 108

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II Global Liquidity Cycle in the Early 2000s: From Dawn Till Dusk 1. Economic Boom, Accumulation of Macroeconomic Imbalances in the Emerging Europe and Credit Crunch 2. Preventing Global Debt Deflation Episode III Cross-Country Analysis of Financial Fragility in the Emerging Europe 1. The Euro Area 2. The Czech Republic 3. Poland 4. Slovakia 5. Hungary 6. Bulgaria 7. Croatia 8. Latvia 9. Romania

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10. Russia 11. Ukraine

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IV Cross-Country Analysis of Individual Determinants of Crisis Impact in the Emerging Europe 1. Factual Results and the Analysis of Individual Vulnerabilities

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V Political Economy of Serbian Ponzi-Style Economic System and Global Financial Crisis 1. Economic Paradigm in the Age of Communism 2. Serbian Economy After 2000 3. Economic Growth and Government Expenditures 4. Rise of Non-Tradable and Decline of Export-Oriented Sectors 5. Monetary Policy, Inflation, Real Exchange Rate Appreciation and External Debt 6. The Credit Crunch and Serbian Response

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Conclusion and Policy Recommendations Policy Recommendations for Developing Countries

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References

154 157 157 162 166

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Foreword

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he current and still unfolding financial crisis has sparked renewed interest in Minsky’s analysis and predictions. Both financial regulators and economists have drawn attention to the interest of Minsky’s Financial Instability Hypothesis (FIH) to describe, explain and sometimes prescribe solutions to the current situation. We may exemplify this renewed interest by quoting Christian Noyer, the Governor of the Banque de France (2009), who refers to the FIH1 or to the use of “Minsky Moment” to qualify the current crisis in the scientific literature (Whalen 2007).2 The accuracy and interest of Minsky’s analysis both in terms of crisis analysis and in terms of economic policy thus seems reaffirmed today. The present book chooses this perspective to analyze the pre– and postcrisis periods in Central, East and Southeast Europe, promising and at the same time new perspectives opened by this theoretical posture. Numerous criticisms or limitations may nonetheless arise when discussing Minsky’s FIH applicability to today’s context, characterized by international financial integration (globalization and liberalization). This takes a specific signification in “transition” Central, East and Southeast European countries, which also needs to be addressed. The recent literature provides, in this respect, significant contributions: Arestis and Glickman (2002) demonstrated, that the criteria of financial fragility gain by being redefined and extended in terms of maturity and currency mismatch in 1 2

Banque de France. 2009. “Quel avenir pour la régulation financière?”, Revue de Stabilité Financière, Sept. Whalen, Charles J. 2007. “The U.S. Credit Crunch of 2007.” The Levy Economics Institute of Bard College, Public Policy Brief No. 92.

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the context of emerging financially integrated countries.3 Their analysis is particularly compelling with regards to an analysis of transition in Central, East and Southeast Europe. In addition, the primary role of capital flows in, on the one hand, financial fragility development prior to a crisis and, on the other hand, illiquidity mechanisms during the crisis, has proved determinant in developing and financially integrated countries.4 More specifically, massive inflows of capital may contribute to the conditions and realization of a financial fragility development process, as predicted by Minsky’s FIH: during a prolonged period of prosperity, fragility develops. Fragility takes, in this context, the form of growing indebtedness, maturity mismatch and currency mismatch on external capital inflows, triggered by the so-called capital surge and the composition of these capital inflows. Following Minsky’s prediction, this fragility inevitably leads to a financial crisis, endogenously or triggered by an even “small” external shock. The cycle reversal takes the form of international financial illiquidity: in this context, the illiquidity crisis includes a sudden stop, the effect of which, in worst scenarios, may follow Minsky’s FIH “dreadful prophecy”: selffulfilling financial crisis, debt deflation, economic recession. These predictions have mainly, in literature, been applied to understanding of the crises of the late 1990’s, which hit Latin American and East Asian countries in a particularly severe way. To some extent, they also have been used in analyzing the origin and mechanisms of the current crisis, mainly in the originating developed countries (especially the USA). The above analysis, inspired by Minsky’s FIH and extended to financially integrated emerging economies has as yet had little echo in the literature dedicated to the crisis effects in Central, East and Southeast European transition economies. However, its predictions and theoretical framework are promising, in terms of analysis and policy prescriptions. The present study addresses precisely this perspective. Through a very rich and detailed country data analysis, the build-up of the fragility as well as the consequences of the US banking crisis is exemplified, 3

4

Arestis, Philip, and Murray Glickman. 2002. “Financial Crisis in Southeast Asia: dispelling illusion the Minskian Way.” Cambridge Journal of Economics, Vol. 26 (2): 237–60. Calvo, Guillermo.1998. “Capital Flows and Capital-Market Crises: the Simple Economics of Sudden Stops.” Journal of Applied Economics, Vol. 1(1): 35–54; Chang, Roberto, and Andres Velasco.1999. “Liquidity Crises in Emerging Markets: Theory and Policy.” Federal Reserve Bank of Atlanta, Working Paper No. 99–15; Sinapi, Christine .2010.”Crises financières et gouvernance mondiale: Intégration financière des économies émergentes et crises d’illiquidité: une analyse en termes de fragilité financière internationale”, Sciences Humaines Combinées [en ligne], numéro 6, Sept.

Foreword by Christine Sinapi

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analyzed and explained. The analysis confirms the interest and accuracy of a Minskyan perspective in understanding the transition economies of emerging Europe. It also sheds a new light on the “Vienna Initiative”, its interest and results. The robustness of the analysis leads to a severe report of the situation in emerging Europe countries and singularly in Serbia. The policy prescriptions, which arise from the analysis are all the more interesting and promising. Professor Christine Sinapi Head of Finance-Law-Control Department, Burgundy School of Business, Dijon, France

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Introduction

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he collapse of several large banks in developed countries, which occurred in the autumn of 2008, led to a global credit crunch and a sudden stop of international capital flows. Aggregate demand in developed countries contracted strongly, including the demand for goods and services exported by developing countries. This resulted in a strong output contraction in many developing countries, a severe reduction in global trade, a steep rise in unemployment, and in several cases, a full– blown financial crisis. Crisis did not only affect highly financially fragile countries; its effects however threatened to spillover to many other countries with stable macroeconomic fundamentals and currencies. This required massive simultaneous financial assistance from the International Monetary Fund and other international institutions to many hard-hit countries. The need to prevent a large scale global contagion was so urgent and stand– by arrangements agreed with the IMF had more flexible conditionality than in any of previous crises. This cascade of events and their strong impact reminded policy makers and academicians once again that the issue of financial crises is still not completely understood and that there is a need for a deeper research of the global and national determinants and vulnerabilities that increase probability of financial crises in developing countries. Naturally, in order to prescribe adequate remedies to minimize negative effects of financial crisis one has to understand what, in the first place, went wrong, since a disease cannot be cured without an accurate diagnosis. According to mainstream efficient markets hypothesis, selfregulated financial markets led by Smith’ “invisible hand” are optimal mechanism for rational and productive allocation of scant resources to the most productive uses. Financial crises are consequence of a sudden

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effect of some unanticipated exogenous shocks. Consistently, capital will flow towards developing markets only if universally accepted macroeconomic market-led policies are properly implemented. Thus, the achieved macroeconomic stabilization naturally results in improved profit opportunities, which would attract rational investors, who will, in search for ever rising profits, react in no time and direct capital flows to poor counties. Therefore, improved economic conditions precede investment inflows. In this study, we reject the mainstream “efficient markets hypothesis” both as inadequate theory and description of real world outcomes. Our analysis relies on theoretical framework of seminal Post Keynesian economist Hyman Minsky who, by embracing Keynes’ theory of fundamental uncertainty and investments, rejected the “Smithian” view that free decentralized markets, if let alone, inherently, i.e. endogenously generate equilibrium. According to Minsky’s interpretation of Keynes, ups and downs are natural product of unregulated free markets. Or, to put it more precisely, if let alone, endogenous market processes generate financial and economic instability. Since his model of crisis generation refers to closed economy with developed financial markets, several authors (Philip Arestis and Murray Glickman 2002; Jan Kregel 1998; Michael Pettis 2001) further developed Minsky’s financial instability hypothesis in order to make it applicable to open developing economy, in which most of the debt is a foreign short-term debt or debt set on roll over basis (floating-rate debt) and a debt denominated in hard currency. In such a way, as Pettis (2001) argues, expanded Minskian liquidity model emphasizes source and not the destination. Namely, displacement or event that triggers massive capital movements towards developing countries is liquidity expansion in rich countries. In other words, movements of capital towards developing countries are exogenous, i.e. developing countries actions do not influence movements of international capital, which are the result of liquidity changes in developed world. On the other hand, liquidity expansion in developed world and following capital flows into shallow financial markets of developing countries produce positive effects only in the short run. In the medium run, unless external borrowing of local market participants is adequately constrained and controlled, disastrous debt deflation episode might take place. Further on, we conduct a rigorous factual analysis of pre-crisis and post-crisis developments in fundamental economic indicators in selected number of Central, East and Southeast European Economies (CESEEE) in order to prove that current crisis conforms with the Minskian liquidity model of crisis generation. As our study shows, by deployment Asian current account surpluses, conducting overly expansive monetary policy

Introduction

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and massive securitization of illiquid assets, the U.S. economy put in motion global liquidity cycle in the beginning of the 2000s. In line with liquidity model, liquidity expansion in the most developed economy in the world led in no time to liquidity expansion in other developed countries exposed to financial markets in the U.S. and further, due to increased optimism and consequently profit appetites of western investors, to massive capital flows towards developing countries. Dynamic growth of developed world stirred up developing countries’ growth by increasing export revenues and commodity prices, foreign direct investments (FDI), portfolio investments, cross-border lending and workers’ remittances. In that way, simultaneously with dynamic economic growth and progressiveness in enforcing efficiency and effectiveness of internationally desired market policies, developing CESEEE massively build-up vulnerabilities to capital inflow sudden stop. Unfortunately, seemingly unexpectedly, the U.S. financial markets contracted sharply in 2007 and crisis instantaneously spilled-over to a large number of developed and developing countries. The most important result of the capital inflow sudden stop that happened after the Lehman Brothers collapse in September, 2008 was a strong adjustment of the domestic demand, investments and imports across the Central, East and Southeast European region (the emerging Europe). Output declined in almost all of CESEEE, as well as the exchange rates in countries with floating exchange rate regimes. Nevertheless, given that at least some countries in this region cope relatively well with the crisis implies that there are measures and policies that can be implemented during the non-crisis times in order to minimize serious damage when the exogenously generated crisis hit. Consistently, we find no evidence that factors like credible and sustainable fiscal and monetary policy, the quality of market institutions and the rule of law attracted capital inflows in pre-crisis period or offset negative effects of global liquidity contraction during the crisis. On the other hand, we find that pre-crisis dynamics of the stock of foreign debts, the credit boom and the leverage of the banking sectors which, in the most CESEEE led to excessive output growth coupled with the large current account deficits, were good determinants of the crisis impact. Financial distress coupled with ensuing deep contraction of the domestic demand and the free-falling exports and commodity prices, caused a deep output contraction. The rate or credit euroization, one of the corollaries of the excessive reliance on foreign borrowings, seems to have exerted only limited discriminatory impact on different countries. The surprising absence of greater negative effects of a high level credit euroization is a consequence of the limited nominal currency depreciations and the absence of currency devaluation in CESEEE, which is the result

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of massive liquidity injections and fiscal stimulus measures put in place by authorities in developed and developing countries as well as international financial institutions. What would then be the implication of current financial crisis and liquidity model of financial crisis generation in general for developing countries, which are, as the famous Serbian writer, philosopher and bishop of Montenegro Petar Petrović Njegoš would say, only “wisps of straw tossed on the wind” of volatile and capricious capital flows? To repeat it once again, according to liquidity model of crisis generation, investment movements of capital from rich to poor countries follow its own exogenous pattern. Therefore, emerging markets are powerless in controlling these flows and minor changes in developed markets have capacity to overwhelm shallow markets of developing countries, which directly implies that developing countries are not able to prevent crises. It, however, does not mean that developing countries are completely powerless, since they are, on the other hand, capable of designing capital structure aiming at minimizing negative effects of external shocks on internal market. Thus, sustainable economic growth is no doubt the most efficient mean to offset future external shocks in the long run. Still, since we are all dead in the long run, it is of crucial importance to control an increase in external debt in the first place, and in the second to minimize share of a short-term debt or a floating-rate debt and debt denominated in hard currency in total debt as much as it is possible in the short run. The structure of the book is as follows: In the first chapter, depending on assumptions of the model, we make distinction between the mainstream theory of efficient markets and the Minskian theory of instable financial markets. We argue that efficient market hypothesis is not a theory of crises. On the other hand, we elaborate on Minsky’s “financial instability hypothesis” and expand it in order to incorporate specific economic circumstances of open developing economies. In the second chapter we argue that Minskian theoretical framework of crisis generation adequately explains liquidity cycle that was put in motion in the beginning of the 2000s and the global credit crunch that followed sharp liquidity contraction in the U.S., which emerged as a consequence of real estate bubble bursting. In the third section we conduct a rigorous analysis of the pre-crisis and post-crisis developments of fundamental economic indicators in a selected number of countries of the emerging Europe. This will enable us to observe the magnitude of the accumulated vulnerabilities in individual countries and to pinpoint the differences in pre-crisis developments among them. In the fourth section we explore the impact of the crisis on different economies in the emerging Europe in

Introduction

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order to reach an insight into which variables mattered the most. Notably we analyze why there is a large variability of the output decline among countries in the region, which macroeconomic variables and vulnerabilities have played important roles, and to what extent different countries have been susceptible to main channels of the crisis impact. In the fifth section we analyze Ponzi-style economic system of Serbia and argue that global financial crisis per se has not caused financial difficulties in Serbia, but only shed light on them sooner than it was expected. Serbian model of economic development is unsustainable in the short and long run and core of the problem lies in unsound local macroeconomic policies and practices. We finish with a conclusion and policy recommendations.

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I Minskian Model of Financial Crises in Emerging Markets

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epending on the assumptions of the model, there are, broadly speaking, two fundamental approaches to financial markets. The first one is an efficient markets approach and the second one is a theory of instable financial markets. The theory of efficient financial markets is based on an assumption that future is risky, i.e. economic agents are perfectly rational, perfectly informed and capable of forming rational and, on average, true expectations. In this view, self-regulated financial markets led by Smith’s “invisible hand” are an optimal mechanism for rational and productive allocation of scant resources to the most productive uses. Market-clearing equilibrium is an aggregate outcome of choices made by myriad rational decision makers. (Paul Davidson 2002; Eugen Fama 1965, 1970; Ognjen Radonjić 2007c; Andrei Shleifer 2000). On the other hand, in this view, financial crises emerge as a consequence of a sudden effect of some unanticipated exogenous shock. This is, in most cases, the interference of government in free functioning of omniscient markets or implementation of inadequate policy regime (for example, dissonance between fiscal and exchange rate policy). Should unanticipated exogenous shock disrupt normal functioning of markets, corrective forces that at least in the long run restore market clearing conditions, would be activated. In a word, the problem is not rooted in systematic flaws in the functioning of free

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markets, but in the lack of freedom for market forces. Thus, in neoliberal view1, prescription for stabile and rapid growth of economy and living standards is a rather simple one: balanced fiscal policy, anti-inflationary monetary policy, privatization of state owned enterprises, deregulation and liberalization of financial flows and world trade and stabile foreign exchange rates. In other words, favorable economic results are assured in case of minimized government’s control and market regulation. In parallel, at the international level, mainstream orthodox (efficient markets) crisis models have been created in order to explain recurrent financial boom-bust episodes in mainly developing countries. So-called “first generation” crisis models depart from conflicting internal policies and a fixed exchange rate regime. This model was first developed by Paul Krugman (1979). It assumes a perfect foresight of traders, which speculate against fundamental inconsistency between internal and external objectives of monetary authorities, that arise from a central bank’s commitment to defend a particular exchange rate of domestic currency against some foreign currency or a basket of currencies (“peg”), while at the same time it continues to expand its monetary base because of the monetization of fiscal deficits. In order to defend the peg, central bank is forced to intervene in the foreign exchange market and eventually runs out of foreign currency reserves. Since the model assumes that speculators perfectly anticipate the timing of the crisis, they start accumulating foreign currency by purchasing the central bank’s reserves as soon as they become aware of the inconsistency existence. This puts additional pressure on domestic currency even though the volume of central bank’s reserves could be sufficient to finance balance of payments deficits for years. Finally, the domestic currency gets devalued, which is often due to a faster than justified depletion of the foreign exchange reserves. In general these models are one-dimensional and assume a simple inconsistency between monetary and exchange rate policy and central bank ameliorating the pressures on the exchange rate by selling foreign reserves regardless general developments in the economy. However, it has become clear that some countries that ran fixed exchange rates, did not engage in conflicting fiscal and monetary policies, and, nevertheless, experienced financial crisis. This type of crisis was clearly different from the first generation and these crises were classified as the “second generation” or the self-fulfilling crises. Such a model was first developed by Maurice Obstfeld (1986). Models of the second generation 1

James Crotty and Gary Dymski argue that “the hallmark of neoliberalism is the existence of unregulated markets almost everywhere for almost everything.” (James Crotty and Gary Dymski 1999, p. 3).

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assume inadequate credibility of the central bank’s and government’s commitment to fully defend the peg. Even though the commitment seems credible in the short run, the volume of foreign exchange reserves that the central bank has at its disposal is fairly large and only a few minor vulnerabilities can be observed (Richard Caves, Jeffrey Frankel and Ronald Jones, 2001). This lack of credibility of the policy makers stems from the opposed incentives they face. On one hand they have incentives favoring devaluation, like a high debt burden denominated in domestic currency that can be reduced by inflation or a trade deficit that can be ameliorated by the devaluation. On the other hand they might have the incentive not to devalue the currency, which is the case when foreign or domestic debts are denominated in foreign currency or when authorities need to preserve a stable economic environment in order to attract foreign investments and facilitate foreign trade. Consequently, in case of growing external pressures, authorities’ decision to maintain the fixed exchange rate results in excessive volatility of the output. Under the currency peg, rising foreign interest rates force domestic interest rates to rise. Such a rise of domestic interest rates could increase the interest expenditure on government’s debt implying that the stock of domestic debt may be one of the leading currency crisis indicators. On the other hand, holding on tightly to the announced currency peg provides additional credibility to the policy makers in their efforts to curb the inflation. Since the abovementioned variables might increase the cost of defending the parity, speculators begin anticipating a potential unwillingness of the authorities to pay such a high price to defend the currency peg. This causes depreciation expectation to emerge, requiring higher interest rates to compensate for this perceived risk. It reinforces the vicious circle and once the interest rates exceed certain level, the cost of maintaining the parity become unbearable for the authorities and they become prone to abandon the parity. After short period of intense pressures this turns into a large scale speculative attack and a self-fulfilling prophecy comes true despite the fact that the fundamentals may still remain fairly sound. Since the attack happens because it is expected to succeed and not because the monetary policy was inconsistent with the peg, this type of crisis is therefore said to be self-fulfilling. The main issue with the self-fulfilling type of crises is that they are very hard to predict. This is due to their elusive nature stemming from the fact that it is hard to find a stable relation between the fundamentals and occurrence of crises. These crises can happen without a major change in economic fundamentals prior to the onset of a crisis. The fact that crisis may occur even in case of a prudent monetary policy and sound macroeconomic fundamentals is what distinguishes this type of crisis

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from the first generation crisis models. Closely linked to the second generation crisis models is the “panic view” of crises in emerging markets (Steven Radelet and Jeffrey Sachs 1998). According to this explanation, crisis in emerging markets erupts after lenders launch massive withdrawal of funds from the country or the region. Since fundamentals of the economy or the economies in the region are sound in general, and since there were no warning signals of deteriorating fundamentals and the crisis was resultantly unexpected, massive escape of the investors is due to irrational behavior on the part of the lenders. As Arestis and Glickman (2002) argue, this view implies that most of the time investors are rational, that fundamentals determine value of the assets, that investors are capable of accurate pricing of fundamentals and that their decisions do not affect future outcomes. It has though not been explained why irrationality from time to time posses a large number of investors. In the end, one more efficient markets-style popular explanation of crises in emerging markets is that governments of emerging and transition countries are often corrupted, and corruption is fertile ground for moral hazard and excessive risk taken by local business closely tied to the government officials. In contrast to the efficient markets theory, Hyman Minsky, the most prominent proponent of the theory of instable financial markets and seminal interpreter of economic thought of great English economist John Maynard Keynes, rejected the “Smithian” view that free decentralized markets, if let alone, inherently, i.e. endogenously generate equilibrium. In his view, business ups and downs are a natural product of unregulated free markets. Or, to put it more precisely, if let alone, endogenous market processes generate financial and economic instability. In his, by mainstream economists widely neglected “financial instability hypothesis” (FIH), Minsky argues that financial markets are the heart of modern capitalist economies, which, thanks to non-neutrality of money and fundamental uncertainty, are prone to fragility.2 In a word, dynamic 2

Fundamental uncertainty must not be confused with the efficient markets concept of risk. In neoclassical theory (Leon Walras, Alfred Marshall, Irving Fisher), School of Rational Expectations (John Muth, Robert Lucas, Thomas Sargent) and in New Keynesian theory (Ben Bernanke, Joseph Stiglitz, Frederic Mishkin, Gregory Mankiw) the future is risky. It means that future is preprogrammed and human actions cannot change future path of economy. In the case of Rational Expectations and New Keynesians, future can be reliably predicted by “statistical analysis of past data with market signals providing information about objective probabilities.” (Davidson 1991, p. 129). In contrast to risk, Keynes’ concept of fundamental uncertainty embraced by Hyman Minsky and other post-Keynesian economists means that the future path of economy is not preprogrammed and immutable, but is transmutable as human actions create future. That is why past experiences and statistical analyses of past data are not reliable guide to the future. It is not possible to assign numerical probabilities to a

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financial systems are in a constant flux, whereas equilibrium is only a transitional phase. Unstable optimistic and pessimistic expectations of debt financed economic units endogenously lead financial system from the state of robustness towards financial fragility, in which a sudden, unexpected appearance of endogenously or exogenously created shock has the power to push the system into financial instability. Since we find it more appropriate and productive to try to understand financial crises in emerging markets in general and CESEEE in particular within Minskian analytical framework we have to, in the first place, explain in more details his theory of financial instability of closed developed economies.

1. Minsky’s Financial Instability Hypothesis and Endogeneity of Financial Crises In Minsky’s words the FIH is “...a theory of the impact of debt on system behavior and also incorporates the manner, in which debt is validated” (Minsky 1992, p. 6) and “model of capitalist economy which does not rely upon exogenous shocks to generate business cycles of varying severity.” (Ibid, p. 8). The FIH consists of two theorems. The first one is that system can both be stable and unstable. The second one is that stability is destabilizing, i.e. that during a prolonged period of prosperity, conditions emerge that cause system transition from the environment of stable towards environment of unstable financial relations. In order to measure degree of financial (in)stability, Minsky (1986, 1992) makes difference between three kinds of debt structures on the basis of margin of safety3: Hedge units are expected to generate cash flow

3

potentially infinite number of outcomes that we are capable of imagining. There are also outcomes we cannot even think of at the present moment and it is thus needless to speak about probabilities (Davidson 2002). According to Keynes uncertain knowledge does not merely “distinguish what is known for certain from what is probable. The game of roulette is not subject, in this sense, to uncertainty; ...The sense in which I am using the term is that in which the prospect of a European war is uncertain, or the price of copper and the rate of interest twenty years hence....About these matters there is no scientific basis on which to form any calculable probability whatever. We simply do not know.” (Keynes 1937, p. 213–214). For more details on distinction between risk and fundamental uncertainty see Davidson 1991, 2002; James Crotty 1994; Radonjić 2007а, 2009a, 2010. Margin of safety is equal to difference between expected cash inflow that investment will generate and the sum of financing costs and operating expenses.

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that will, at any future moment, be above operating expenses (including dividend costs) and financing costs (debt principle and interest) for the amount of margin of safety big enough to absorb unforeseen changes either in cash inflows or in cash outflows. Thus, net present value of hedge unit is always positive. Even though future returns are uncertain, soundness and solvency of hedge unit does not depend on financial market conditions, but only on the conditions in product and factor markets, i.e. they are vulnerable to rise in costs of production and decline in revenues. Speculative units are expected to generate cash flow that will not at any future moment be sufficient to pay out debt commitments. In a word, some time in the future, generated cash flow will be sufficient to meet interest, but not the principal commitment. Therefore, speculative unit will, from time to time, when margin of safety does not exist, be forced to roll over maturing debt in order to meet its principal commitment. In contrast to hedge unit, viability of speculative unit depends on financial market conditions as well as on normal functioning of product and factor markets. Namely, vulnerability of speculative units is triple. Firstly, if short-term interest rates increase above the expected level over a period when unit is, in order to refinance a short-term debt, forced to borrow, debt burden increases. At the same time it is possible that cash inflow remains unchanged. In that case, margin of safety may turn negative. Secondly, since speculative finance “involves the short financing of long positions” (Minsky 1986, p. 231), it becomes clear that margin of safety may turn negative in case of simultaneous rise in short-term and long-term interest rates. Rise in short-term interest rates increases debt payment commitments in a short run, whereas rise in long-term interest rates leads to rise in discount factor, i.e. decline in present value of assets. Thirdly, acceptable structure of debt depends on subjective judgment, so that divergences between realized and expected profits might lead to revision of acceptable financial structure. If any of three events happens, speculative units become Ponzi units. Ponzi units4 can emerge independently of internally or externally generated disturbances (transformation of speculative units to Ponzi units). Usually, on the basis of euphoric expectations, Ponzi units get into debt today in expectation of high profits that will be realized at some, unknown future moment (high capital gains). In other words, to keep Ponzi units afloat, prices of assets need to continue to rise. In the case of Ponzi units, during most of the time or in the course of the whole period 4

Unit was named after Charles Ponzi, infamous Bostonian speculator in the 1920s who invented pyramidal scheme of paying out existing depositors by funds raised from newcomers. When new depositors stop to arrive, scheme collapses.

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of life of the loan margin of safety is non-existent. Ponzi units are not able to meet its principle and interest obligations, and since “financing costs are greater than income... ...the face amount of outstanding debt increases” (Ibid, p. 231). Consequently, in relation to speculative units, survival of Ponzi depends even more on financial markets conditions. Refusal of granting new short-term debt for financing existing debt obligations leads Ponzi units, in short run, into bankruptcy. In a word, survival of Ponzi units critically depends on possibility to acquire new debt and to sell quickly capital goods and various assets in possession. Proportion of hedge, speculative and Ponzi units in the economy is a measure of the robustness of the financial system. Overall, the higher the proportion of hedge units, the more stable the system. On the other hand, the higher the proportion of speculative and Ponzi units, the more dominate forces that in the event of endogenously or exogenously generated shock further destabilize system.5 Minsky’s analysis of transition of the system from robust financial relations to financial fragility starts in the period of recovery of the system after a financial breakdown that took place in not too distant past. An outside shock to the system is necessary in order to shift from the track of slow to track of accelerating economic and investment growth. The nature of the outside shock powerful enough to cause displacement of the system and consequently dramatic change in profits horizons and expectations of agents varies from one crisis to another. Such shock might be beginning or end of a war, abundant or insufficient harvest, some revolutionary far reaching invention (railway, automobile, radio, film, computers), political event (Charles P. Kindleberger and Robert Z. Aliber 2005) or, most frequently, expansion of liquidity in major financial centers. Expansion of liquidity might take form of increase in traditional measures of money or more complex changes in financial structure induced by change in regulatory framework or profit-seeking activities of “merchants of debt” (Minsky 1992, p. 6). For example, change in regulatory framework such as financial deregulation and liberalization stimulates creation of new banks and deposits thus expanding monetary base and therefore money supply. On the other hand, profit-seeking activities of merchants of debt usually end in considerable increase in the turnover of some liquid assets or in

5

As Irving Fisher argues in his debt deflation theory of the Great Depression, overinvestment, over-speculation and over-confidence are not a serious danger to stability per se, but in combination with over-indebtedness: “I fancy that over-confidence seldom does any great harm except when, as, and if, it beguiles its victims into debt.” (Irving Fisher 1933, p. 341).

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transformation of illiquid assets into liquid ones.6 Increase in liquidity of financial markets has the same effect as increase in supply of money – decline in real interest rates and consequently rise in asset prices. This process is potentially self-reinforcing since rise in asset prices leads to rise in investments and rise in investments to further rise in assets prices, which now makes increasing amount of assets more liquid.7 Therefore, stability is destabilizing, because, in an environment of fundamental uncertainty, ignorant human beings have no other choice but to extrapolate stability into infinity. Naturally, with calendar flow of time, when agents extrapolate stability and increasing liquidity into infinity they become more confident and, as their aim is to pursue ever higher profits, they become more and more willing to increase their liabilities relative to income.8 As time passes, euphoric expectations “beguile its victims” more and more into a debt. Opportunity to “make on the carry”, that is “a greater use of short-term debt to finance positions in capital assets and in longterm debt” (Minsky 1986, p. 235) induces speculative financing practices. In time, debts begin to rise faster than profits.9 As a debt increases, speculative and Ponzi units become dominant, liquidity stretches and maximum interest rate that system is able to bear declines. In that way, business units become increasingly vulnerable to even a small increase in interest rates or/and unanticipated fall in profits. In such a fragile situation “not unusual” event which usually occurs “...after the increase in demand financed by speculative finance has raised interest rates, wages of labor, and prices of material so that profit margins and thus the ability to validate the past are eroded” (Ibid, p. 245) is capable of pushing the system over the brink into financial instability. The term “not unusual” indicates that, as a result of excessive optimism and over6 7

8

9

Example of turning illiquid assets into liquid ones is massive securitization of real estate assets that occurred over the past twenty years in developed world. Assets that move up in liquidity hierarchy could perform function of collateral for new debt or could, like money (money-like asset), be directly exchanged for some other asset. (Pettis 2001). When one party wishes to undertake some costly investment project, it rarely has sufficient amount of money to execute it on its own. It needs external funds and usually gets connected with bankers (or financial institutions in general), which are “merchants of debt”. The real problem is that at the moment when a lender (merchant of debt) and a borrower (party that buys capital or financial assets) get into contract neither party, due to fundamental uncertainty, can be sure that investment project will, in future, generate sufficient cash flow to make good on debt used to finance investment. If borrower fails, lender, who now has some bad debt in its assets, might not be able to meet its obligations against other parties and thus snowball of defaults might gain momentum. The raise of profits is constrained by the rise in productivity whereas expansion of money is much more flexible.

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indebtedness (melting of margin of safety), it is rational to expect but hard to predict occurrence of the event that will make visible inescapable divergence between expectations and reality: “...fragility of the system makes the appearance of such a surprise event likely ...the existence of such an event should best be understood as ... endogenous reaction to the pressures building in the financial system.”10 (Martin Wolfson 2002, p. 394–395). Also, in the event of exogenously generated shock, for example if restrictive monetary policy were implemented (which would rise interest rates) in order to constrain inflation, number of speculative and Ponzi units would tend to increase in relation to hedge units, which might as well trigger crisis.11 However, it is important to note that external shock has the power to destabilize system only because fragility had already been generated endogenously. Consequently, as agents notice that expectations have been overoptimistic and as realized profits are disappointing12, they start to protect their position by attempting to raise their liquidity. To increase liquidity, financial mediators are forced to reduce supply of credit to hedge and speculative units and/or to shorten the maturity of new loans at increasing borrowing costs (in that case speculative units tend to transform into Ponzi units) and to deny new short-term credit to Ponzi units since interest rate high enough to compensate lender for increased risks would push Ponzi borrower into bankruptcy. (Kregel 1998; Pettis 2001). Existing and newly established Ponzi units (emerged as a consequence of transformation of speculative units) will, in attempt to meet their debt commitments, decrease production in order to cut expenses, decrease inventory, sell their product at a significant discount, suspend ongoing investment ventures, lay off workers and “make position by selling out position.”13 (Minsky 1992). Intensified selling of assets by Ponzi units causes, at first, a halt in previously dynamic rise in asset prices, immediately followed by a sharp fall in prices of assets. The markets have gone down. Investment ratio falls, investment activity depresses, and consequently expected profits fall and optimism evaporates. Positive feedback is activated, economy is in a downward vicious circle. If in this downward movement, authorities do 10 For example, this surprise event might be a failure of a big company or some big financial institution. 11 When the system is fragile, in an environment of monetary constraint “...speculative units will become Ponzi units and the net worth of previously Ponzi units will quickly evaporate.” (Minsky 1992, p. 8). 12 Due to euphoria, investments are “...prompted by expectations which are destined to disappointment.” (Keynes 1936, p. 348). 13 Fire selling of various assets and physical capital in possession.

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not implement an expansive fiscal and monetary policy, debt-deflation will come to the scene. As Irving Fisher (1933) argued in his debt deflation theory of the Great Depression fall in asset prices raises the real value of money and at the same time the real value of debts. In this way, the more debtors try to decrease their debt, the more value of their debt rises. Decrease in asset prices, contrary to Say’s Law, causes further decrease in assets prices, aggregate demand, output and employment. Falling prices are followed by declining aggregate demand due to general decline not only in investments, but also in consumption, which is a result of a fall in household incomes and rise in unemployment.

2. The Financial Instability Hypothesis in Open Economy Minsky’s model of crisis generation in closed economy with developed financial markets Kregel (1998) expands to open developing economy, in which most of the debt is a foreign short-term debt or a debt set on roll over basis (floating-rate debt) and a debt denominated in hard currency. To potentially dangerous exogenous shocks Kregel (1998) adds three more:14 increase in interest rates and interest rate differentials in international financial markets; depreciation of local currency; and worsening of terms of trade or decrease in demand for core exports products. All three shocks have negative impact on the margin of safety. Rise in international interest rate differentials and foreign interest rates increases short-term debt commitments, while revenues are unchanged or drop in the event of looming crisis. Depreciation of local currency implies a rise in value of the debt denominated in hard currency in local currency terms. Also, if a local industry is dependent on imported inputs, depreciation of local currency rises costs of production and consequently lowers the margin of safety. Furthermore, profits may fall further, if import costs rise by the full amount of depreciation, whereas, on the other hand in an attempt to increase its foreign incomes producer increases foreign sales. Increase in foreign sales in the most cases leads to decreasing prices in international markets. It is usual that depreciation of local currency goes together with the rise in domestic interest rates since higher interest rates are seen by monetary authorities as a powerful weapon against weak currency and evaporating confidence of foreign investors. Since, in 14 Beside restrictive monetary policy in the case of closed economy.

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contrast to units in closed economy, units in open market economies are also vulnerable to international interest rate and exchange rate shocks, Arestis and Glickman (2002) call such organizations super-speculativefinancing units. Lastly, worsened terms of trade or fall in demand of the core export products directly decrease incomes and narrow margins of safety. Banks that raise funds in international markets, where most of the debt is short-term and denominated in hard currency are exposed to one additional risk, risk of reducing its credit rating. Namely, exogenous shocks cause reduction of liquidity and soundness of domestic bank’s borrowers, and consequently reduction in quality of the bank’s assets. Due to rising proportion of non-performing loans in bank’s portfolio, lenders will rise interest rate spreads on international funding. On the other hand, due to rising difficulties in real sector (as a consequence of exogenous shock), higher interest rate spreads bank will not be able to recover by charging higher interest rates to its distressed domestic borrowers. If the change of interest rate credit spread is sufficiently high, a bank can be transformed into a Ponzi unit in a very short period. If this happens, the bank, confronted with the lack in liquidity, will increase financing costs and simultaneously shorten maturity of new loans and reduce financing of hedge and speculative units (speculative units tend to transform into Ponzi units) and require repayment of Ponzi debt commitments. At the same time, it might happen that international creditors refuse any further short-term financing of domestic bank. In that case, the bank will stop financing real sector, require immediate repayment of debts and will often take over collateral and try to sell it as quickly as possible (under significant discount, i.e. at fire-sale prices).15 Also, domestic banks will be unwilling to lend one to another, which may lead to sharp contraction of domestic interbank market. It is important to point out that external shock would have destabilizing power only if national economy was simultaneously financially fragile, that is, as Pettis (2001) suggests, if inverted capital structure is put in place. Inverted capital structure refers to a design of liability side of national economy’s balance sheet, which transmits external shocks into internal economy in way that increases earnings volatility, i.e. causes borrowers’ revenues and financing costs to move sharply in opposite directions.16 Moreover, in case of open economy, excessively optimistic expectations 15 “Make position by selling out position”. 16 Dominant share of short-term or floating-rate debt and/or debt denominated in hard currency in total debts are examples of inverted liability structure at sovereign level.

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created in an robust internal environment are highly correlated with stable and robust external environment. Namely, when economy is robust and environment is stable, agents do not expect occurrence of any negative external shock. Rising optimism and confidence of officials and big business in developing country and thus extrapolation of good times infinitely into future, make inverted capital structure seem as a rational way to lower financing costs over time.

3. Investment and Liquidity Model of Capital Flows from Developed to Developing Countries Before we set the model of development of financial fragility in emerging markets, it is important to understand why capital flows from rich to poor countries. Pettis (2001) argues that there are two main theoretical models usually used to explain this issue. The first one is a mainstream model or, as Pettis (2001) calls it, “investment model”, which stresses the importance of local economic reforms aiming at achieving macroeconomic stability and liberalization and deregulation of domestic financial markets and trade. If properly implemented, desired market reforms would lead, in near future, to prolonged period of sustainable economic growth simultaneously creating profit opportunities for international investors. Widely prized economic reforms in international community are centered around diminishing role of the state in economic life and typically include privatization; restrictive monetary and fiscal policy aiming at taming and eliminating of inflation; achieving and sustaining of fiscal balance or surplus; trade and financial liberalization and deregulation; and pegging of local currency against the U.S. dollar or some other hard currency or adjusting the exchange rate within the prevailing band. Once these marketled stabilization policies deliver first positive results, investors confidence boosts and capital inflow gains momentum (Wolfson 2002). Investment model stresses rationality of investors seeking new opportunities to earn profits, who respond to improved economic prospects in countries, which were, up to that moment, excluded from major capital centers. In such a way, improved economic conditions precede investment inflows. However, Pettis (2001) holds that although appealing, real world experiences do not support investment model. There are numerous examples of experimenting with desired economic reforms in Latin American countries, which were not followed by capital inflows. One would expect that capital inflows into developing countries are more

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random then actual experience shows, i.e. highly correlated with timing of implementation of economic reforms. However, as Pettis (2001) stresses, there is little evidence that capital flows respond to desired policy decisions in developing countries. On the contrary, what can actually be seen is that timing of capital inflows towards developing countries is virtually identical although there is no reason to assume that different countries around the world simultaneously undergo preferable political and economic changes. Therefore, capital movements to poor countries are better explained with “liquidity model”, which emphasizes the source and not the destination.

4. Liquidity Model of Genesis of Financial Fragility in Emerging Markets According to the liquidity model, displacement or event that triggers massive capital movements towards developing countries is Minskian liquidity expansion in rich countries. As liquidity in rich countries rises, financial markets take off and real interest rate drops, more and more assets become more money-like, which further reinforces liquidity expansion. As liquidity of financial markets and thus turnover increase, volatility of risky assets starts to decline which makes them more attractive investment destination in comparison to traditional assets. In response to lower volatility, over-optimistic investors systematically underestimate risks or overestimate prospective earnings in nontraditional sectors. As in time investors start to exhaust local higher risk investment opportunities, some of capital finds its way toward developing countries in order to “make on the carry”.17 Still, an important precondition for capital inflows is macroeconomic and foreign exchange rate stabilization as well as financial liberalization and deregulation of a host country. Deregulation opens all doors to foreign wealth owners since it enables them to do business in different types of financial and real estate markets within country. In their profit-seeking activity, foreign investors will buy domestic financial assets18 and domestic corporations and financial intermediaries will, due to high local interest rates, refrain from raising debt domestically and, in order to maximally exploit arbitrage opportunities, borrow short-term funds in low interest major financial centers and lend locally 17 In case of open economies “making on the carry” means borrowing short-term funds in developed low-interest rates markets and their investment at higher interest rates in developing countries. 18 Predominantly loans to domestic banks and firms and portfolio and real estate investments.

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these funds later at higher interest rates or finance buying of long-term securities, real estate and capital assets. Rise in price of local financial, real estate and capital assets has two important effects. Firstly, it implies rise in demand price of capital assets in relation to the supply price of investment output causing rise in investment activity and consequently employment, consumption and output. Also, exports grow since liquidity expansion in major financial centers entails higher consumption and increased import demand usually leads to higher commodity prices. However, since the other side of the massive capital inflow coin is a trade deficit, imports goes up faster than exports. Secondly, it increases turnover of local financial and real estate assets and therefore their liquidity. New liquid assets can now perform function of collateral and rise in the value of collateral justifies increased value of loans demanded. Growing capital inflows as well as ever rising leverage ratio (debt to equity) are order of the day, since, in booming market, financial and real estate assets could always be sold at inflated prices. As liquidity rises, interest rates and spreads fall. Large capital inflows in economies with floating exchange rate regime and balanced current account cause their currencies to appreciate, whereas those that suffer a persistently high current account deficits see, at least, stable nominal exchange rate levels. Also, no matter whether economy implements fixed or floating exchange rate regime, central banks usually sterilize capital inflows in excess relative to their current account deficits in order to avoid appreciation of real foreign exchange rate19 and thus to preserve competitive position in international markets.20 In that way quasi fiscal costs simultaneously increase with country’s margin of safety (foreign exchange reserves). All in all, growing economy and stable or appreciating currency creates impression of improved economic conditions which further reinforces capital inflow and optimism of market participants. (Arestis and Glickman 2002). Stimulated by economic growth and rising profits local politicians and elite agitate and call for broadening scope and further deepening of internationally preferable economic reforms believing 19 The nominal exchange rate is the rate, at which one can trade the currency of one country for the currency of another. The real exchange rate is the nominal exchange rate adjusted for relative prices among countries under consideration. 20 Immediate consequence of massive capital inflows is a sharp rise in demand for local currency. In order to prevent nominal exchange rate appreciation, central banks intervene in foreign exchange market, i.e. buy foreign currency and sell local currency, which, in the final instance, leads to rise in money supply and foreign exchange reserves. However, in order to prevent inflation driven by such a rise in the money supply, central banks often conduct process of sterilized foreign exchange operation in money markets. For example, by selling repos, central bank withdraws domestic currency from circulation and in such a way, leave monetary base and money supply intact.

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that it was the reforms that were attracting capital inflows and not vice versa – that in truth increasing volume of capital inflows had created new profit opportunities which further stimulated local officials and big business to give up resisting economic changes and agitate and insist on further perseverance in deepening desirable economic reforms. On the other hand, international investors further increase their investments in developing country since, as they claim, applied policies are valid and future advancement in reforms will provide permanent economic growth and thus capital inflows. (Pettis2001). Extrapolation of good times and stability into infinite future in concert with flourishing optimism and confidence usually lead to inverted capital structure seen as a rational way to lower financing costs over time. Meanwhile, in parallel with intensive capital inflows and resultant advancement in market reforms, externally financed dynamic increase in aggregate demand leads to increase in local price level, especially, due to lack of international competition, in non-tradable sectors.21 (Roberto Frenkel and Martin Rapetti 2009). Rise in prices of non-tradable sectors further attracts new, mainly speculative investments and thus provokes further rise in inflation pressures. Increase in price level usually leads to appreciation of real exchange rate and thus worsening of trade balance. Again, foreign exchange rate appreciation stimulates further inflow of speculative capital in search for capital gains by holding local assets, thus further supporting expansion of credit and aggregate output. Increase in burden of interest and dividend payments in combination with worsening trade balance leads to current account deficit. Progressive worsening of current account and increase in foreign liabilities, and in particular shortterm liabilities denominated in hard currency, leads to rise in external debt to foreign exchange reserves ratio. Moreover, in case of emerging Europe countries, a real wage growth was another factor that significantly contributed to increasing trade deficits and real foreign exchange rates. Namely, even though the privatization and foreign investments propelled the productivity increase during the pre-crisis years, it was not rapid enough to justify the excessive wage growth. Large part of the wage growth was driven by rapidly increasing wages in public sectors that caused the surge of household consumption and hampered the competitiveness of tradable sectors.22

21 Construction, financial intermediation, real estate, renting, wholesale and retail etc. 22 On the other hand, during the 2000s wage growth in key European Union economies was flatlined.

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5. After a Prolonged Period of Expansion Comes Crash In the end, after several good and seemingly prosperous years, system collapses under unsustainable level of debt burden. Pettis (2001) makes difference between two types of shocks that might trigger crisis in emerging markets. The first one is occurrence of a not unusual event in major financial markets after several good years that leads to long-term sharp reversion of excess liquidity. Long-term retreat of risk-prone capital results in rise in real interest rates whereas decline in global aggregate demand leads to sharp fall in commodity prices and export revenues of developing countries. Reluctance of international lenders to refinance debts and sharp fall in export revenues might end in defaults and restructurings of sovereign borrowers. During global debt crisis refinancing problems affects all high-risk assets and borrowers.23 The second type of triggering event is a short-term collapse in financing at the margin caused by sudden external shock24 combined with internally accumulated financial difficulties reflected in deteriorating of the external balance. As consequence of reversed market optimism, in fear of huge capital losses, international investors massively start to sell risky and buy low-risk assets in developed financial markets thereby causing temporary capital outflow.25 This type of crisis could, in the event of internally built unstable (inverted) capital structure lead to solvency crisis, i.e. market collapse and widespread defaults and bankruptcies. However, since these shocks occur in an environment of stabile global liquidity conditions, if market defaults are not devastating26 or if outside lender of last resort injects liquidity after the debt deflation took its toll, the recovery of a crisis-hit country might be unexpectedly swift.27 In contrast 23 Examples of a long-term liquidity contraction are the Great Debt Crisis in the early 1980s and the current Great Recession that started in 2007. 24 For example political crisis, war, natural disasters, sudden disruption of markets in another part of the world or of the major financial market etc. 25 Examples of short-term collapses are Mexico in 1994 and Asia in 1997. 26 In case of correlated capital structure where majority of debt is medium or long-term fixed rate debt denominated in local currency. (Pettis 2001). 27 As example of the Great Asian crisis shows, unnecessary restrictive policy measures imposed after the crisis erupted aiming at restoring foreign investors’ confidence and reverting capital outflows actually aggravated problems and resulted in a full-fledged solvency crisis, i.e. massive bankruptcies and debt deflation and consequently drastic fall in imports which led to large current account surpluses. (Kregel 1998; Radonjić 2007b). Combined current account deficit of 26 billion US$ of five most afflicted Asian countries in 1997 (South Korea, Thailand, Malaysia, Philippines and Indonesia) transformed into combined current account surplus of 69 billion US$ in 1998. These surpluses were latter used for repaying debts and investing in the

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to a long-term liquidity contraction, short-term collapses usually do not end in global defaults. No matter whether triggering event is a long-term liquidity contraction or a short-term flight to quality, their common feature is massive escape of international capital from local emerging markets, i.e. massive sale of local currency denominated assets. Since in such a situation “there is no such thing as liquidity of investment for the community as a whole” (Keynes 1936, p. 194) win-win strategy is to liquidate positions in local assets before competitors. In this beauty contest game, if an agent thinks that average agent thinks that local market will fall, in anticipation of decrease in price of local assets and currency, he will, in order to avoid capital losses and acquire accumulated capital gains, rush to sell local assets as soon as possible (Crotty 1994; Keynes 1936; Radonjić 2009c). If other agents form the same or similar expectation too, they will all, in attempt to be one step ahead, also rush for exit thereby pushing prices down. Even if evidence that balance sheets of domestic financial intermediaries and corporations deteriorated is absent, rush to exit will cause collapse of prices of domestic assets and thus deterioration of domestic financial conditions. Selling of domestic assets on a massive scale will put heavy depreciating pressure on domestic currency. In an unsuccessful attempt to protect currency, central bankers will deplete foreign exchange reserves and sharply raise interest rates aiming at stopping the dramatic fall. As we already said, dramatic fall in the value of local currency and significant increase in interest rates when most of the debt is short-term or set on adjustable basis and denominated in hard currency instantly melt margins of safety and transform speculative and super-speculative units into Ponzi units. Ponzi units will further, in attempt to meet their hard-currency denominated debt commitments, sell domestic currency and thus put additional downward pressure on exchange rate, thus increasing debt burden of borrowers. Fisher’s (1933) paradox is under way: the more debtors try to decrease their debt, the more value of their debt rises and the more value of local currency is reduced. In order to prevent debt-deflation and a consequent sharp fall of investments, output, consumption and employment, central bank as the lender of last resort has to provide liquidity to indebted units, whereas U.S. Treasury bonds which further led to significant increase in liquidity of the U.S. financial markets and consequently to the global credit crunch that took place in 2007. (Pettis 2001).

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the government should support aggregate demand and corporate profits through massive deficit spending at the same time. (Minsky 2008b). Since most of the debt is denominated in foreign currency and stability of exchange rate has to be preserved, the central bank’s function of lender of last resort in emerging markets is severely constrained. Therefore, massive financial support of developed countries and international financial institutions is needed. However, the IMF as international bailing-out institution usually imposes restrictive fiscal and monetary policy measures in order to restore a sustainable balance of payment dynamics and avert inflation spikes, thereby amplifying debt-deflation difficulties.28, 29

28 This was the case in Mexico in 1994 and Asia in 1997. In contrast to those sudden stop episodes, the IMF refrained from imposing austerity measures when financial crisis hit CESEEE in 2008 which is why, as we will see later, the debt deflation episode has been successfully avoided so far. 29 Dissatisfied with models that saw financial crisis as consequence of either government policy mistakes, exogenous shock or simply self-fulfilling prophecies some economists developed “third generation” crisis models in mid and late 1990s. Third generation models recognize importance of speculation, liquidity, “making on the carry”, asymmetric shocks, debt-deflation and interdependences between markets and unit’s balance sheets in explaining financial crises. Crisis may not only be consequence of some government misconduct such as large current account deficits which may be an outcome of the poor domestic competitiveness policy and large tariff protection but also a consequence of a poorly designed capital structure (high share of hard currency denominated debts), which internally amplifies external shocks and in that way might lead to a burst of a real estate or share price bubble, collapse of some big corporations and bank runs. Also, in many cases, an external shock, like worsening of the terms of trade or an internal non-economic shock, like a political crisis, war or some natural catastrophe could trigger crisis. For more details see Guillermo Calvo 1999; Roberto Chang and Andres Velasco 2000; Guillermo Calvo, Alejandro Izquiredo and LuisFernando Mejia 2008.

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II Global Liquidity Cycle in the Early 2000s: From Dawn Till Dusk

O

nly a decade before global financial crisis erupted in August, 2007, David Shulman, chief equity strategist of Salomon Brothers had claimed that we lived in a new age of the brave new world, age of New Paradigm – the world had become a much safer place thanks to ability of central bankers and governments to tame inflation and avoid deep recessions. (Edward Chancellor 2007). This argument was also used as justification of rapid growth of the U.S. stock prices, especially in technology sector. Surprisingly enough, only several years later, stock market crashed, but liquidity expansion of the U.S. financial markets continued thanks to cheap money policy of the Fed in next five years30 and massive securitization of house mortgages, students’ loans, auto finance, credit card debts, etc. On one hand, as we have explained, through process of massive securitization previously illiquid mortgage, students and car loans and credit card debt were transformed into liquid securities that trade readily, which has the same effect as increase in supply of money. On the other hand, cheap money policy and consequent dynamic increase in indebtedness of the U.S. market participants was enabled by a massive deployment of trade surpluses of Asian and oil exporting 30 The Fed reduced fed funds rate 27 times from the beginning of 2001 until summer 2003, thereby reducing it from 6.5 percent to 1 percent. (Justin Yifu Lin 2008).

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countries by the U.S. financial markets.31 Namely, seeking to avoid financial breakdowns and imposing of austerity measures in the future, East Asian countries gave themselves a task to accumulate large stock of the U.S. dollar reserves as well as to stimulate export growth aiming at increasing their employment and economic growth. They were aggressively buying dollars in order to prevent appreciation of their own currency and used those dollars for buying the U.S. Treasury debt instruments. In that way Asian countries sterilized their dollar purchases and thus prevented inflation to erode their export competitiveness. (Robert Skidelsky 2009) At the same time, since the U.S. is the issuer of the world’s key currency and since it has been able to borrow its own currency without limits at low interest rates it could live beyond its means, i.e. run persistent current account deficits for a long period of time without disruptions in real exchange or interest rates.32 31 Between 1973 and 2005 total debt in the U.S. rose from 140% to 328.6 % of gross domestic product (GDP) and financial sector debt grew much faster that debt of nonfinancial sector. Debt of financial sector increased from 15% in 1973 to 104% of GDP in 2005. Increase of debt of financial sector significantly accelerated between 2000 and 2005 when it rose from 88% to 104% of GDP. In 2006 financial sector debt was 14.2. trillion US$. In the same period debt of non-financial sector increased from 142% to 216% of GDP. Debt of non-financial corporations rose from 30.3% in 1973 to 42.4% of GDP in 2005 and reached 9 trillion US$ in 2006. At the same time, increase in debt of households has been striking – from 45.2% to 94% of GDP and only between 2000 and 2005 it increased 67% and amounted to 12.8 trillion US$ in 2006 (9.7 trillion US$ housing loans and 2.4 trillion US$ in credit card loans). Household-sector debt to disposable income ratio rose from about 90% at the end of 1990s to 122% in 2005. During the 1990s compound annual growth of debt to income ratio was 1.25% and in period between 2000 and 2005 it grew at annual compound rate in excess of 5%. Although in this five year period interest rates were at historically low levels debt payments-to-disposable-income ratio reached record highs of 13.55%. Fastest growing component of household debt was mortgage debt. Consequently, household-sector mortgage debt to disposable income ratio rose from about 60% at the end of 1990s to 90% in 2005. Additionally, in 2006, the U.S. public debt was 5 trillion US$ of which 2.2 trillion US$ was financed by foreign investors. About 64% of this 2.2 trillion US$ was held by foreign central banks. Japan hold 612 billion US$ and China 420 billion US$. At the same time, foreigners owned 46% of the U.S. Treasury bonds, 27% of corporate bonds and 14% of government agency bonds. For more details see Dimitri Papadimitriou, Edward Chilcote, and Gennaro Zezza 2006; Thomas Palley 2007; Michael Lim Mah-Hui 2008. 32 Accumulated current account deficit of the U.S. economy in the period between 2000 and 2006 was about 4 trillion US$ and only in 2006 it reached 800 billion US$ (6% of GDP). The biggest import items were oil products at about 300 billion US$, vehicles at 123 billion US$, electrical and electronic equipment at 83 billion US$ and different consumer products at about 200 billion US$. (Charles Morris 2008). In 2007 the U.S. current account deficit amounted to 790 billion US$ and 93% of this amount was financed by combined current account surpluses of China, Japan, Germany and Saudi

II Global Liquidity Cycle in the Early 2000s: From Dawn Till Dusk

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Thus, not only that thanks to cheap money policy and massive securitization of illiquid assets post dot-com crash recession was successfully avoided but also The New Paradigm took a new form of life as well. Ben Bernanke himself, governor of the Fed, under liquidity illusion, announced in 2004 that we lived in the age of the Great Moderation, age of controlled inflation and low volatility of financial markets. Since volatility and risk are synonyms in financial vocabulary, this actually meant that investment business became less risky. Suddenly, future became less uncertain and vague. Causes for the decline in financial markets volatility were straightforward: improved monetary policy constrained inflation and extended business cycles; globalization made possible efficient spread of the risks worldwide; more efficient communication and risk assessment thanks to significant improvements in information technology; securitization of former illiquid and risky mortgages that allowed dispersion and transfer of risks to those who are best equipped to bear it; explosive growth of derivative instruments aimed at hedging undesired risks. We cannot but admit these reasons sound convincing, having in mind the fact that in several occasions in last ten years, skillful and decisive U.S. monetary authorities have succeeded in preventing financial crisis and spreading of its effects worldwide.33 Consequently, as the world allegedly became safer and a more stabile place, inflation was under control, and business cycles were extended and bankruptcies became matter of the past, the Government, corporations and households found it acceptable to increase their debt burden. (Radonjić 2009b; Ognjen Radonjić and Miodrag Zec 2010; Charles J. Whalen 2007; Randall L. Wray 2007). But, as Minsky (1986) predicted, ignoring Cassandra-like warnings in concert with the rise in economic growth infallibly led to excessive increase in indebtedness. The only problem was that in the period of 2002– 2006 debt grew by three times faster rate than the economic activity.34 In Arabia. (Lim Mah-Hui 2008). Estimation of the U.S. Treasury in 2007 was that total accumulated surpluses in all reserve currencies owned by foreign governments reached 7.6 trillion US$ or more than 60% of global savings. Of this amount 2.2 trillion US$ was owned by oil exporting countries, 2.2 trillion US$ by East Asia excluding Japan and India (of which around 1.1 trillion US$ was owned by China) and around 1 trillion US$ by Japan. (Morris 2008). 33 For example, failure of the LTCM in 1998, the dot-com crash in 2000, instability that took place after the terrorist attacks in 2001, the collapse of Enron and WorldCom, etc. 34 In the 2002–2006 period debt in the U.S. increased by more than 8 trillion US$ whereas at the same time GDP increased by 2.8 trillion US$ (Chancellor 2007). That is why

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Ognjen Radonjić and Srđan Kokotović

other words, Americans increased debt only to finance consumption and not investment, since share of investment in GDP in the U.S. and other developed countries was stable for years. (Skidelsky 2009). What actually happened was that even though monetary expansion prevented a deeper downturn by stimulating the real estate market, it caused an inception of the real estate price bubble, which burst several years later. This bubble compensated for the wealth losses in the stock market, since housing stock comprised large share of households’ wealth. Higher housing prices coupled with the Fed’s aggressive expansive monetary policy that swamped the U.S. with excess liquidity fueled a surge in private consumption. Thus, household consumption accounted for two-thirds of the U.S. GDP growth in 2004 and home equity loans alone, i.e. mortgage equity withdrawals used for buying consumer durables and second homes skyrocketed from 20 billion US$ in the early 1990s to 700 billion US$ or 5% of GDP in 2004. (Lim Mah-Hui 2008; Skidelsky 2009). However, this was not a problem for conventional thinkers since deepened financial markets were capable of supporting more debt for the same level of economic activity.35 Gerald Epstien (2001) have been warning about the perils of growing financialization of the world and in particular U.S. economy. Epstien (2001) defines financialization as process that leads to increased importance of financial markets, financial motives, financial institutions and financial elites in shaping economic policy at the national and international level. This process increases benefits of money rentiers and makes that rich people become even richer and poor even poorer. Rapid increase in debt of financial and non-financial sector, trading volumes in word financial markets, growing inequality in distribution of incomes and redirecting of incomes from real to financial sector and from labor to capital are principal impacts of financialization. For example, growth of wages have been completely detached from growth in productivity in last 40 years. In this period productivity of the U.S. workers nearly doubled whereas growth of wages has been stagnant. Magnitude of those disproportions is the most conspicuous if the average salaries in financial and real private sector are compared. Thus, in 2006 average salary of average investment banker was 435,000 US$ per year compared to 40,368 US$ per year for the average worker in the private sector. Also, although returns in hedge funds industry fell for about 50% in comparison to the 1990s, top 25 hedge fund managers earned on average 570 million US$ and top 3 over 1 billion US$ each in 2006. (Lim Mah-Hui 2008) 35 Rajan G. Raghuram, then chief economist of the IMF, in 2005, at a celebration honoring Alan Greenspan, who was about to retire as chairman of the U.S. Federal Reserve, warned the U.S. policy makers that “even though there are far more participants today able to absorb risk, the financial risks that are being created by the system are indeed greater. And even though there should theoretically be a diversity of opinion and actions by participants, and a greater capacity to absorb the risk, competition and compensation may induce more correlation in behavior than desirable. While it is hard to be categorical about anything as complex as the modern financial system, it is possible these developments may create more financial-sectorinduced procyclicality than in the past. They may also create a greater (albeit still

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Still, events that caused the worst crisis in last eight decades proved that the Great Moderation misled many policy makers into underestimating macroeconomic risks and relaxing rules on many items of their concern, from leverage of the financial institutions to the exposure to foreign exchange risks (Olivier Blanchard, Giovanni Dell’Ariccia, and Paulo Mauro 2010). In the end, this turned out to be a very ill-designed macroeconomic policy and regulation practice (Vladimir Čupić, Srdjan Kokotović, Nenad Milojević, Tatjana Orozović, and Dušan Tončić 2009). Moreover, it is clear now that the Great Moderation itself was just an illusion happened to be a consequence of beneficial but lucky coincidence of events and shocks, which were erroneously perceived as permanent. Unfortunately, as Minsky warned, string of good days lulled regulators in and crucially shaped and calibrated existing policy tools.

1. Economic Boom, Accumulation of Macroeconomic Imbalances in the Emerging Europe and the Credit Crunch In line with liquidity model, liquidity expansion in the most developed economy in the world led in no time to liquidity expansion in other developed countries exposed to financial markets in the U.S. and further, due to increased optimism and consequently profit appetites of western investors, to massive capital flows towards investment outlets – developing countries. Resultantly, developing countries exhibited similar or even more pronounced economic growth in the period between 2002 and 2007 in comparison to rich countries (Figure 1). Dynamic growth of developed world stirred up developing countries’ growth by increasing export revenues and commodity prices, FDI, portfolio investments, cross-border lending36 and workers’ remittances. Developing countries’ exports accelerated more rapidly comparing to the 1990s, which led to increased share of exports in aggregate developing countries’ GDP from 29 percent in 2000 to 39 percent in 2007. (Lin 2008). New private capital inflows to developing countries increased in 2007 by 269 billion small) probability of a catastrophic meltdown. ...The absence of volatility does not imply the absence of risk, especially when the risk is tail risk, which may take a long time to show up.” (Raghuram 2005, p. 4 and 27). 36 Cross-border lending denotes direct lending of non-resident banks to local banks and companies.

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Ognjen Radonjić and Srđan Kokotović

US$ and reached a record high 1 trillion US$, which was more than 7% of aggregate developing countries’ GDP.37 (World Bank 2008). Remittances followed the suit and increased sharply reaching a total of 240 billion US$ worldwide. Upswing of capital inflows led to an investment boom in many developing countries, mostly in transitional countries of Central, East and Southeast Europe, Russia, China, Brazil, India, South Africa and others. This provided additional support to developed countries’ growth through increased export demand for their capital goods and this demand originated from developing countries’ investment boom. As a result of these reinforcing flows, developing countries as a group achieved highest output growth in decades. From 2003 to 2007, developing countries’ GDP grew more than 5 percent annually, and peaked at 8 percent in 2006, where investments alone delivered roughly 4 percentage points of GDP growth. At the same time, small U.S. fiscal surplus in 2001 overturned into a sizeable deficit from 2003 onwards mainly due to reduction in taxes and increase in defense expenditure. As the U.S. was already exhibiting low interest rates as well as low rate of savings, the fiscal deficit contributed to an increase in current account deficit and higher import demand for developing countries goods and again, through increased demand for capital goods of developing countries to further economic growth of developed economies.

37 Emerging Europe was especially attractive destination for foreign capital. In the period between 2002 and 2007 countries of emerging Europe received more than 500 billion US$, which was approximately close to one-third of all private flows to emerging markets. Only Asia received around 100 billion US$ more during the same period. (IMF 2009).

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II Global Liquidity Cycle in the Early 2000s: From Dawn Till Dusk

Figure 1. GDP Growth Rates for Major Economies and Regions38 Euro area GDP grow th rate, in percent

Advanced economies GDP grow th rate, in percent

World GDP grow th rate, in percent 6

6

6

5

5

5

4

4

4

3

3

3

2

2

2

1

1

1

0

0

0

Japan GDP grow th rate, in percent

US GDP grow th rate, in percent

CEE GDP grow th rate, in percent 10

6 4

5

8

4

3

3

2

2

1

1

0

0

-1

6 4 2 0

-2 Western Hemisphere Developing Countries GDP grow th rate, in percent 6 5 4 3 2

CIS GDP grow th rate, in percent

Developing Asia GDP grow th rate, in percent

12 10 8 6 4

12 10 8 6 4

1

2

2

0

0

0

Source: International Financial Statistics.

As liquidity model suggests, growing GDP and asset prices in developing countries created impression of improved economic conditions which further reinforced capital inflow and optimism of market participants. On the other hand local politicians and elite, stimulated by economic growth and rising profits insisted on expanding the scope and deepening of economic reforms and further progress in strengthening 38 Advanced economies – Austria, Belgium, Cyprus, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Malta, the Netherlands, Portugal, Slovakia, Slovenia, Spain, Australia, Canada, Hong Kong, Denmark, Iceland, Israel, Japan, South Korea, New Zealand, Norway, San Marino, Singapore, Sweden, Switzerland, the United Kingdom, the United States; CEE – Albania, Bulgaria, Croatia, the Czech Republic, Poland, Hungary, Slovenia, Latvia, Lithuania, Estonia, Macedonia, Romania, Turkey; Western Hemisphere Developing Countries: South and Central America and Caribbean countries; CIS – Russia, Ukraine, Belarus, Kazakhstan, Kirgizstan, Georgia, Mongolia; Developing Asia – Bangladesh, Bhutan, Brunei Darussalam, Cambodia, China Mainland, China Macao, Fiji, India, Indonesia, Lao, Malaysia, Maldives, Myanmar, Nepal, Pakistan, Papua New Guinea, Philippines, Samoa, Salomon Islands, Sri Lanka, Thailand, Vanuatu, Vietnam.

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Ognjen Radonjić and Srđan Kokotović

efficiency and effectiveness in enforcing internationally preferable economic policies, believing that it was the reforms that were attracting capital inflows. International investors responded positively and further increased their investments in developing countries since, as they claim, applied policies were valid and future advancement in reforms would provide permanent economic growth and thus capital inflows. But, it seems that foreign investors did not discriminate among countries concerning to the volume of investments as all CESEEE received significant inflows. The only difference that may have been made is the distribution of inflows between the more stable and risk-sharing FDI and more volatile but more risk-averse credit inflows. However, this issue should be subject of a more rigorous statistical analysis which is beyond the scope of this book. Therefore, according to the European Bank for Reconstruction and Development’s (EBRD) transition indicators scores, in parallel with dynamic capital inflows in the period between 2002 and 2008, selected CESEEE made on average considerable progress in market reforms39 which further brought them closer to their aim of achieving full compliance with standards of developed industrial economies (Table 1).40 Another EBRD’s measure of transition progress is a progress in economic governance, i.e. progress in strengthening market-supporting institutions, such as a fair and uncorrupted judicial system and regulatory bodies that ensure a level playing field for business.

39 Especially the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland and Slovakia. 40 The EBRD assesses progress in transition through a set of several transition indicators. Progress is measured against the standards of industrialized market economies. Assessments are made in nine areas which together cover the four main elements of a market economy — markets and trade, enterprises, financial institutions and infrastructure. The reform of markets and trade is measured by the liberalization of prices, the liberalization of trade and access to foreign exchange, and the effectiveness of competition policy in facilitating market entry and combating the abuses of market dominance by large conglomerates and monopolies. The reform of enterprises includes separate indicators for large and small-scale privatization and a measure of governance and enterprise restructuring, which assesses progress in cutting production subsidies, introducing effective bankruptcy procedures and applying sound corporate governance practices. The reform of financial institutions is measured by the development of the banking sector, including the quality of regulation and the development of securities markets and non-bank financial institutions.

EBRD index of

4.15

4

3

4.3

4.3

3.7

4.05

Serbia

Slovakia

Slovenia

Ukraine

Average 14 Countries

3.3

3.4

3

3

4

2

3.3

Czech Republic figures refer to 2007.

4.3

4.3

3.7

4

3.7

3.3

3.7

3.3

4

4

4

3

3.7

2002

3.55

3

3

4

2.7

3

3.7

3.3

4

3.7

4

4

4

3.3

4

2008

privatisation

EBRD index of large-scale

EBRD index of

2.75

2

3

3.3

2

2.3

2

3.3

3

2.7

3.3

3.3

3.3

2.7

2.3

2002

3

2

3

3.7

2.3

2.3

2.7

3.7

3

3

3.7

3.7

3.3

3

2.7

2008

enterprise reform

4.19

4

4

4.3

4

4

4.3

4.3

4.3

4.3

4.3

4.3

4.3

4

4.3

2002

4.19

4

4

4.3

4

4

4.3

4.3

4.3

4.3

4.3

4.3

4.3

4

4.3

2008

liberalization

EBRD index of price

EBRD index of fx

4.02

3

4.3

4.3

3

3

4.3

4.3

4.3

4.3

4.3

4.3

4.3

4.3

4.3

2002

4.19

4.3

4.3

4.3

3.7

3.3

4.3

4.3

4.3

4.3

4.3

4.3

4.3

4.3

4.3

2008

and trade liberalization

EBRD index of

2.51

2.3

2.7

3

1

2.3

2.3

3

3

2.3

3

2.7

3

2.3

2.3

2002

2.9

2.3

2.7

3.3

2

2.3

2.7

3.3

3.3

3

3.3

3.7

3

2.7

3

2008

competition policy

EBRD index of

EBRD index of refom of

3.21

2.3

3.3

3.3

2.3

2

3.3

3.3

3

3.7

4

3.7

3.7

3.7

3.3

2002

3.58

3

3.3

3.7

3

2.7

3.3

3.7

3.7

4

4

4

4

4

3.7

2008

2.69

2

2.7

2.3

1.7

2.3

2

3.7

3

3

3.7

3.3

3

2.7

2.3

2002

3.15

2.7

3

3

2

3

3

3.7

3.3

3

4

3.7

3.7

3

3

2008

banking sector reform non-bank financial institutions

Sources: EBRD Transition Report 2005, 2008 and 2009 and authors’ calculations.

Note: The transition indicators range from 1 to 4+, with 1 representing little or no change from a rigid centrally planned economy and 4+ representing the standards of an industrialized market economy. “+” and “-” ratings are treated by adding 0.33 and subtracting 0.33 from the full value. Averages are obtained by rounding down, for example. a score of 2.6 is treated as 2+, but a score of 2.8 is treated as 3-. For a detailed breakdown of each of the areas of reform, see the methodological notes on web page http://www.ebrd.com/pages/research/analysis/surveys/ti_ methodology.shtml

1

4

3.7

4.3

4.3

4.3

Russia

4.3

Latvia

4.3

Romania

4.3

Hungary

4.3

4.3

4.3

4.3

Estonia

4.3

4.3

Czech Republic

4.3

Poland

4.3

Croatia

4

2008

Lithuania

3.7

2002

small-scale privatisation

Bulgaria

Country

Table 1. Transition Indicator Scores for Selected CESEEE in 2002 and 2008

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Ognjen Radonjić and Srđan Kokotović

Thus, for example, corruption of local government is a major obstacle to doing business since it imposes significant costs on firms and increases uncertainty of business environment. From Table 2 we can see that again, in parallel with dynamic increase in capital inflows, there were significant reductions in the burden imposed by corruption across selected CESEEE between 2002 and 2005. What is more, five most advanced transitional countries (the Czech Republic, Hungary, Poland, Slovakia and Slovenia) compared favorably with advanced market economies such as Germany, Greece and Portugal in 2005. Table 2. Corruption in CESEEE in 2002 and 2005

1

Bribe tax refers to typical unofficial payments/gifts to public officials as a percentage of annual sales. The figures reported are unweighted country averages. 2

The kickback tax refers to the percentage of contract value that is typically paid in additional or unofficial payments/gifts to secure government contracts. The figures reported are unweighted country averages.

3

The frequency of bribery is the percentage of respondents who agreed they have to pay some irregular payments/gifts for activities related to customs, taxes, licences, regulations or services frequently, usually or always. Sources: EBRD Transition Report 2005 and authors’ calculations.

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On the other hand, simultaneously with dynamic economic growth and progressiveness in enforcing efficiency and effectiveness of internationally desired market policies, CESEEE massively build-up vulnerabilities to capital inflow sudden stop. Unfortunately, in August, 2007, seemingly suddenly, reality brutally bit. Financial markets in the U.S. came to a sudden stop. Although the first signs of accumulated difficulties became visible in 2006 when house prices peaked,41 in March, 2007 when debtors in subprime mortgage market started to declare bankruptcy, and in July, 2007 when big banks found that they could not sell anymore existing buyout loans, credit crunch finally arrived in August, 2007. Monetary authorities and mainstream economists were stunned and surprised. Crisis erupted in subprime mortgage market and afterwards, as quick as lightning, it spread to the other U.S. financial markets and markets worldwide. The first hit took money market, namely the asset-backed commercial paper market. When it became clear that subprime borrowers would defaulted massively, and that situation would not improve in time, big banks stopped buying commercial papers of hedge funds and big investment banks, because they used short-term funds raised in money markets to buy huge long-term subprime mortgage packages and various exotic debt instruments created to support blooming of low quality mortgage loans. Consequently, several major financial institution in the United States were on the verge of collapse,42 and, most notably, prominent global financial giant Lehman Brothers went bankrupt in September, 2008. Furthermore, markets for different structured packages (mortgage-backed securities, collateralized debt obligations – CDO, CDO2, CDO3, etc.) broke down and interbank lending was brought to a halt because, hedge and money market funds faced with drained commercial paper market were forced to use their credit lines in order to finance their long-term mortgage positions. Interest rate spreads soared and panic swept equity markets. (Whalen 2007; George Soros 2008).43 Due to financial integration and cross-border network of investment funds, hedge funds, insurance companies and most importantly bank subsidiaries owned by banks from developed countries, shock was 41 A significant change in monetary policy that contributed to bursting of housing bubble was decision of the Fed to, in order to dampen inflation, raise federal funds rate from 1% to 5.25% in period between June, 2004 and July, 2006. (Skidelsky 2009). 42 Bear Stearns, Fannie Mae, Freddie Mac, AIG, etc. 43 From autumn to the end of 2008 DJIA and London’s FTSE 100 fell by a 30%, Frankfurt’s DAX by 40.4%, Paris’ CAC by 42.7% and Tokyo’s Nikkei by 42%. This fall of stock market worldwide continued in 2009. (Skidelsky 2009).

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instantaneously transmitted to a large number of developed and developing countries, easily and quickly. The world’s economy entered era of the Great Recession (Figure 1). What is more important is the fact the U.S. economy had to adjust swiftly and substantially. The adjustment had to be made because the U.S. households were forced to reduce spending driven by decline in their credit-worthiness, which was translated into forced increase in personal savings from current income needed to make up for the wealth loss. Because the import demand of developed countries collapsed, developing countries and particularly commodity exporting countries, faced severe export volume contraction and decline in the terms of trade. Finally, investments slumped in developing countries due to cessation of previously abundant capital inflows used to finance investment boom. Enlarged risk aversion of investors gave rise to excessive increase in risk premia, which spilled over into steep increase in interest rates charged on loans extended to developing countries’ business entities. Developing countries, which ran high current account and fiscal deficits at the same time, turned out to be the most vulnerable to a sudden stop of capital inflows. Reduced domestic consumption as well as export and investment demand, rendered many bank assets and credits non-performing.

2. Preventing Global Debt Deflation Episode It seems so far that depression and deflation episode will be avoided thanks to the policy coordinated actions of governments of developed nations and international financial institutions (Ludovic Desmedt, Pierre Piégay, and Christine Sinapi 2010). In order to stimulate banks to start lending again and to prevent solvency problems of big banks governments in the U.S. and the EU recapitalized their banking systems, i.e. bought shares of troubled banks and in parallel accepted responsibility to guarantee, insure and buy exotic assets from potentially insolvent banks. Thus, in September, 2008, the U.S. Government took into public ownership Fannie Mae and Freddie Mac and AIG, the world largest financial insurer. In the same month, it was allowed to Goldman Sachs and Moran Stanley to change their legal status from investment to holding banks, which made them eligible to borrow from the Fed on more favorable terms. (Skidelsky 2009). At the end of September, 2008, the Treasury announced 700 billion US$ worth bail out package to buy up illiquid exotic assets. In parallel with conducting expansive monetary policy, governments of developed countries also implemented fiscal stimulus packages. The U.S. February

II Global Liquidity Cycle in the Early 2000s: From Dawn Till Dusk

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2009 fiscal stimulus amounted to 787 billion US$ and was blend of tax cuts, energy and infrastructure investments, emergency spending for unemployment benefits, health care, etc. Similar actions were undertaken by the British government, the EU, China and so on. So, from this point of view it seemed that the worst scenario was remote. However, although cheap money prevented debt-deflation, a factor that needed to be restored as soon as possible was the business confidence. This is important precondition for boosting investment activity. Moreover, a huge public spending raised the question of potentially problematic government deficits, since developed countries had already been running sizeable deficits when stimulus packages were adopted.

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III Cross-Country Analysis оf Financial Fragility in the Emerging Europe

C

ountries of the CESEEE achieved significant macroeconomic stability in terms of fiscal deficits, monetary development, inflation, output growth and productivity since they started their transition from centrally planned to market economy two decades ago. However, when financial crises erupted most countries in the emerging Europe faced severe consequences of sudden reversal of foreign capital inflows. This happened during the Asian crisis and it happened again after the Lehman Brothers collapse. What made these countries very vulnerable to a sudden stop of capital inflows were very large current account deficits financed by massive capital inflows and particularly considerable share of short-term and floating-rate debt it total debt (around 90%), as well as widespread credit euroization of the real sector’s balance sheets. In early 2009, most of the CESEEE were in the midst of a deep output and export contraction. Final consumption, investments and imports were at far lower level comparing to the pre-crisis levels, and many enterprises and households struggled with increased credit obligations stemming from the high rate of credit euroization. (Ognjen Radonjić and Srdjan Kokotović, 2010b). However, due to a coordinated policy response of governments of developed nations

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Ognjen Radonjić and Srđan Kokotović

and international financial institutions the impact of the crisis was milder than expected. There were no fixed exchange rate devaluations, floating currencies depreciated moderately, foreign exchange reserves remained relatively high despite heavy interventions and there were no systemic banking crises. The purpose of this section is to provide a rigorous analysis of the pre-crisis and post-crisis developments of fundamental economic indicators in a selected number of countries in emergent Europe. We will present an overview of average pre-crisis developments and the crisis impact on 17 countries of the Euro Area44 and ten transitional countries that have distinct characteristics making them more or less susceptible to the sudden stop episode. This will enable us observe the magnitude of the accumulated vulnerabilities in individual countries and pinpoint the differences in pre-crisis developments among them. Our sample is limited by the availability of monetary, balance of payments and financial statistical data. It covers 10 countries in the CESEEE: the Czech Republic, Poland, Slovakia, Hungary, Bulgaria, Croatia, Latvia, Romania, Russia and Ukraine.45 The analysis is performed on quarterly statistical data from 2000 to third quarter of 2009 which provide sufficient details needed to explore changes in trends and relate them to actual events. Due to unavailability of the quarterly data, Serbian economy has not been included in this part of statistical analysis. We shall, however, analyze it in more details in the fifth chapter of the book. Economic fundamental indicators, which will be used in our crosscountry analysis of financial crisis in CESEEE are the following: 1. The external indicators include financial account balance relative to GDP, current account balance relative to GDP, change of foreign exchange assets and foreign exchange liabilities of banking and real sector as a proxy for cross border lending, exports, imports, 44 The Euro Area countries: Austria, Belgium, Cyprus, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Malta, the Netherlands, Portugal, Slovenia and Spain. Slovakia joined the EMU in 2009 and Estonia in 2011, but these countries were, for the sake of our analysis, treated as non-EMU countries up to the end of 2008 in the case of Slovakia and up to the end of 2009 in the case of Estonia. 45 Even though countries in this region used to be socialist economies under the communist rule until 1990, they embarked on a transition to market-based economy with significantly different approaches. These differences resulted in different outcomes. Some of them reached by the end of the 2000s the status of advanced economies (The Czech Republic, Slovakia, Hungary, Poland) while others remained developing economies. In that context, the term emerging Europe is more precise for denoting the beginning of the decade, when they shared similar imbalances.

III Cross-Country Analysis of Financial Fragility in the Emerging Europe

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foreign exchange reserves, FDI, real exchange rate and nominal exchange rate. 2. Real sector variables include real GDP growth and expenditure contribution to GDP growth. 3. Fiscal variables include general government fiscal deficit relative to GDP, general government revenues and general government expenditure.

1. The Euro Area Following the emergence of banking and financial market tensions in advanced countries due to subprime mortgage market crisis, developed countries in Europe fell into deep recession. This deep downturn was triggered by a global financial crisis and a sharp drop in international trade. This twin shock was particularly hard for developed Europe because of its deep integration in the global economy (Figure 2). Figure 2. The Euro Area: Expenditure Contribution and Quarterly GDP Growth

Source: Authors’ calculations based on International Financial Statistics.

After several years of rapid export expansion, exporters have been hit hard by the sharp drop of global spending on capital and durable goods (Figure 3).

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Figure 3. The Euro Area: Exports and Imports of Goods

Source: Authors’ calculations based on International Financial Statistics.

Not only export volumes, but also unit values dropped (worsening terms of trade) and they went down much more than volumes (Figure 4). On top of that, many European countries had their own, homegrown problems like real estate bubbles or fiscal deficits. Figure 4. The Euro Area: Exports and Imports, Volumes and Prices (2005=100)

Source: Authors’ calculations based on International Financial Statistics.

Many of the largest European banks became overleveraged in the run up to the crisis and invested in doubtful projects with high initial returns but even higher risks, much like their U.S. counterparts. Financial sector was at the heart of developed Europe’s problems and still remains there.

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Financial woes started in the mid–2007, firstly in the form of disappearing confidence between the banks themselves, which effectively curtailed trading in interbank money markets. The next step was a steep rise in interest rates, which put pressure on both domestic and foreign borrowers. Finally, a credit crunch ensued after the Lehman Brothers shock (Figure 5). Figure 5. The Euro Area: Quarterly Imports to Quarterly GDP and Loans to Non-Financial Sectors

Source: Authors’ calculations based on International Financial Statistics.

This, coupled with free falling exports, caused significant adjustments of imports. Even more important effect of this crisis is the massive adjustment of the financial account, especially in the Eurozone, which turned positive after many years (Figure 6). Figure 6. The Euro Area: Financial and Current Account in Balance of Payments

Source: Authors’ calculations based on International Financial Statistics.

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This financial account adjustment had an impact on all of its constituting items: FDI (Figure 7), portfolio investments (Figure 8) and credit (Figure 9). Figure 7. The Euro Area: FDI Flows

Source: Authors’ calculations based on International Financial Statistics.

Figure 8. The Euro Area: Portfolio Investment Flows

Note: Liabilities include investments of non-residents into the Euro Area securities and assets include investments in securities of the Euro Area residents into rest of the world. Source: Authors’ calculations based on International Financial Statistics.

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Figure 9. The Euro Area: Change of Foreign Exchange Assets and Liabilities of Banks and Non-Financial Sector

Note: Change of foreign exchange assets denotes credit outflows to the rest of the world and change of foreign exchange liabilities denotes credit inflows into the Euro Area from the rest of the world. Source: Authors’ calculations based on International Financial Statistics.

Moreover, financial account adjustments had particularly severe impact on countries in the emerging Europe. Former communist countries had to face the reality of dried up capital inflows, which seriously constrained their ability to continue with their current account deficits. They had to abolish their previous patterns of consumption as well as investment plans, which were financed to a great extent by funds coming from the EU and the Euro Area. Ailing banks from the Euro Area suffered a liquidity crisis due to paralyzed home money markets. They sought rescue from their highly liquid subsidiaries in emerging Europe, from which they drew large amounts of liquidity reserves in order to meet their home country liabilities (Figure 9). The first most obvious effect was a massive depreciation of floating foreign exchange rates coupled with equally massive drop in foreign exchange reserves throughout the CESEEE. Subsiding credit activity in the Euro Area along with adjusted household consumption dragged down the level of imports in the Eurozone, which was reflected in a rapid slowdown of previously rapid growth of export from the emerging Europe. For those countries in “new” Europe (CESEEE), as some used to call it, which have had floating exchange regimes, depreciation of their currencies did not bring any benefits. Due to subdued demand in developed countries, even this large increase in price competitiveness was not enough to offset curtailed private consumption and investments in developed world. Finally, despite a sharp reduction in the Euro Area

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interest rates enabled by rapid disinflation46 (Figure 11), sudden surge of the so called risk premiums, or interest margins charged to sovereigns and private borrowers, further exacerbated financial difficulties stemming from diminishing sales and profits (Figure 10). Figure 10. EMBI Spread – Europe

Note: Emerging Market Bond Index (EMBI) spread denotes the spread in yields on the Government bonds of the respective CESEEE over the yield on Government bonds of the investment grade countries, i.e. Germany and the USA. Source: www.cbonds.info

Figure 11. The Euro Area: Disinflation and Monetary Easing

Source: Authors’ calculations based on International Financial Statistics. 46 Disinflation denotes deceleration of price increases that still remain above zero.

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Banking sectors in some of the EU member states had, and still do have, a large exposure to their subsidiaries and local banks in many countries in emerging Europe, as well as to corporate sector. One of the consequences of worsening of macroeconomic fundamentals in the CESEEE was a rapid increase in non-performing loans, loan losses and deterioration of banks’ capital bases in the EU advanced countries. This had sizeable impact on those banking sectors in the EU, the exposure of which to the emerging Europe had substantial share in their overall credit portfolios, notably Austria, Greece and Sweden, and to a lesser extent, Germany, France and Italy. In order to avoid a large scale debt deflation episode in Europe and eventual global contagion effect, the international policy response to crisis has been coordinated, timely and involved a large-scale balance of payments support aiming at securing financial sector stability. This is probably one of the most important differences of the ongoing crisis in comparison with the Asian or Russian crisis. The IMF resources were tripled to 750 billion US$ and the European Commission’s resources for balance of payments support quadrupled to 50 billion euro. The two institutions jointly agreed stabilization programmes with Hungary, Latvia and Romania, to which a number of other EU countries and international financial institutions also contributed. The IMF also agreed programmes with Armenia, Belarus, Bosnia and Herzegovina, Georgia, Serbia and Ukraine. The IMF gave Poland access to 20 billion euro under a new flexible credit line designed for countries with sound macroeconomic fundamentals. (EBRD 2009). In addition, governments of the aforementioned EU countries recapitalized distressed banking groups, whereas some, notably Austria and Sweden, whose banking sectors had aggregate exposure to the CESEEE in excess of 70% of their respective GDP, went further and injected capital directly in distressed subsidiaries in the emerging Europe. Governments from the EU had strong and direct economic incentives to provide blanket bail out to former communist countries across the board. However, this is not an exhaustive list of reasons. The EU countries had also a direct mandate to assist ailing fellow member states of the EU such as Romania, Hungary, Baltic countries. Finally, they were in a position to provide help to the countries outside of the EU, but striving to become members, such as Croatia, Serbia and other countries in the region. In the later case, assistance did not (largely) take the form of direct transfers of the EU funds, but rather through bank recapitalization, increased lending activities of national and supranational development banks and through

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the so called “Vienna Initiative” arrangements put in place in Romania, Serbia, Hungary, Bosnia and Herzegovina and Latvia. This arrangement was designed and put in place by the IMF, the EBRD, the European Investment Bank, the World Bank Group, the European Commission and home and host country authorities of the major EU-based bank groups and the bank groups themselves. Aim of the Vienna Initiative was to prevent panic, bank runs and capital outflows en masse, and help steer the equilibrium toward a cooperative approach ensuring the best possible outcome for all. Home governments allowed bank groups to access national packages for their whole operations, that is, without restrictions on funding their subsidiaries. Banking groups with largest exposures were offered to voluntarily maintain their aggregate credit exposure to a distressed country. In return, they were offered some supervisory and regulatory benefits and exemptions47 along with the consent and support of their home supervisors to be a part of the arrangement, while the IMF’s efforts were directed at maintaining financial stability of the distressed country and performing a series of stress tests in order to evaluate the state of local banking sectors. The Vienna Initiative effectively helped bail in all these banking groups and the burden sharing of the “rescue operation” was spread on many participants. By preventing uncontrolled currency depreciations, panic and bank runs, which would wreak havoc in the entire region, the “Vienna Initiative” provided strong assurance that any severe problems in banking sectors across the region would be effectively contained, thereby forestalling potential speculative attacks on banks or currencies. By providing a large scale assistance to its neighbors in the East, the EU demonstrated commitment and willingness to prevent uncontrollable meltdown, which was seen in the Asian and Russian crisis. It was a credible commitment and a credible threat that effectively attenuated any potential speculative attacks and large scale pulling out by investors, unlike in the case of other crisis. Naturally, it took a while before these measures were implemented and the gap, which spanned over the last quarter of 2008 and first quarter of 2009, was large enough to cause massive local currency depreciations, foreign exchange reserve reduction and financial distress throughout the region. It was a sort of a trial period set by the EU policy makers in order to give them enough room to assess how much assistance was needed. 47 Host governments have given assurances to provide deposit insurance and liquidity support for banks regardless of ownership, as well as supportive macroeconomic policies (sometimes in the context of the IMF programmes). (EBRD 2009).

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2. The Czech Republic Prior to the crisis, the Czech Republic benefited strongly from its integration into the EU, which was supported by strong macroeconomic policies. Large FDI inflows facilitated trade integration and export-led growth. At the same time, the country managed to achieve a relatively high standard of living that helped it contain the pressure for fast consumption convergence seen elsewhere in the region. The output grew so much that it is now considered as an advanced economy even though it started a decade being a developing economy just like other CESEEE. Solid fiscal performance contributed to the comfortable balance of payments. All these factors, combined with credible inflation targeting brought a low inflation and interest rates. Well managed, liquid and conservative banking sector curtailed the build-up of vulnerabilities in the balance sheets of private sector. However, following the years of rapid growth in excess of 6% annually, the Czech Republic faced sharp slowdown in 2009. The main difference between the Czech Republic and many regional peers is that, despite persistent appreciation of the koruna, both in nominal and real terms (Figure 12), the Czech economy was very competitive, as reflected in the trade balance (Figure 13) with modest current account deficit (Figure 14) and strong external position in run up to the global crisis. Figure 12. The Czech Republic: Official and Real Effective Exchange Rate

Source: Authors’ calculations based on International Financial Statistics.

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Figure 13. The Czech Republic: Exports and Imports of Goods

Source: Authors’ calculations based on International Financial Statistics.

Figure 14. The Czech Republic: Financial and Current Account in Balance of Payments

Source: Authors’ calculations based on International Financial Statistics.

Financial crisis spillover was observable in the Czech banking sector, which is dominantly owned by large Western European banks. Problems these banks faced in their home countries caused confidence deterioration among their Czech subsidiaries and temporary savings withdrawals. Liquidity in the interbank market dried up and credit crunch ensued in the last quarter of 2008 (Figure 15). In spite of the dominance of foreign owned banks in the Czech banking sector, the majority of loans

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and deposits were denominated in the Czech koruna. Unlike the other countries in the region, this rendered the Czech banks and their clients free of foreign exchange risk driven credit risk. In addition, the volume of cross-border lending remained limited, thereby reducing potential spillover from the Western Europe significantly. Banks’ soundness, low loan-to-deposit ratio, and parent banks’ commitment to the market provided large support and facilitated banks’ ability to resume lending as the economic outlook improved. Figure 15. The Czech Republic: Quarterly Imports to Quarterly GDP and Loans to Non-Financial Sector

Source: Authors’ calculations based on International Financial Statistics.

The Czech Republic maintained prudent fiscal policy, which created buffers for a countercyclical policy when the crisis hit. The country allowed automatic stabilizers to operate fully, targeting 1.6% of GDP deficit in 2009.48

48 Automatic stabilizers are fiscal expenditures such as public sector wages, pensions, social benefits, unemployment benefits, etc., which remain relatively constant despite declining of the output and fiscal revenues.

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Figure 16. The Czech Republic: General Government Revenues, Expenditure and Deficit

Source: Authors’ calculations based on International Financial Statistics.

Even though the Czech Republic remained relatively stable, despite financial turmoil in the rest of Europe, a drop in investments driven by credit crunch as well as export demand for capital goods, like machinery and vehicles, and excessive build-up of inventories led to a rapid slowdown in 2009 (Figure 17). Figure 17. The Czech Republic: Expenditure Contribution and Real Quarterly GDP Growth

Source: Authors’ calculations based on International Financial Statistics.

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Nevertheless, policy makers were under no severe pressure to implement austere crisis measures unlike in other countries, mainly because the external liquidity of the country remained stable (Figure 18), with only a minor reduction in the foreign exchange reserves (Figure 19). Figure 18. The Czech Republic: Change of Foreign Exchange Assets and Liabilities of Banks and Non-Financial Sector

Source: Authors’ calculations based on International Financial Statistics.

Figure 19. The Czech Republic: Foreign Exchange Reserves

Source: Authors’ calculations based on International Financial Statistics.

Since the Czech Republic successfully avoided designing an inverted capital structure and since domestic savings and investment were relatively

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balanced, the Czech’s external position remained robust despite a sharp decline in capital inflows (Figure 20). Figure 20. The Czech Republic: FDI Inflows

Source: Authors’ calculations based on International Financial Statistics.

A large fall in imports (Figure 15) offset the large fall in exports, thereby maintaining relatively balanced foreign trade and low current account deficit. Even though FDI halved and were no longer sufficient to cover the current account deficit, rising inflows of the EU funds filled the gap. The initial depreciation of the Czech koruna was later reversed (Figure 12) and the real exchange rate remained in line with its fundamentals. Market sentiment about the Czech Republic remained favorable, reflecting limited vulnerabilities. (IMF 2009c).

3. Poland When a crisis hits, it is good for a country to have a relatively large economy with a diversified production, as in the case of Poland. It has a large domestic market, but also a diversified export industry. Poland alone constitutes 40% of the regional GDP. Unlike the countries, which had unsustainable fiscal policies prior to the credit crunch (Figure 21) and had been seriously hit by the crisis, notably Hungary or Romania, Poland managed its policies well, which helped the country to remain relatively stable after the Lehman shock.

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Figure 21. Poland: General Government Revenues, Expenditure and Deficit

Source: Authors’ calculations based on International Financial Statistics.

Poland, like the Czech Republic, exhibited signs of recovery very early in the crisis and financial sectors in both countries remained stable. They were both able to preserve access to international capital markets, contrary to many peers in the region. Polish authorities managed to place a 1-billion-Euro bond at 3 percentage points above German Bunds in January, 2009, while domestic Treasury bills and bond issues continued to attract strong demand, including that of foreign investors. Another factor that exhibited a high importance during the crisis was the quality of institutions. Again, Poland and the Czech Republic stood out for that quality. In both countries banking supervision regimes were strict, which helped them avoid a large scale credit euroization and currency mismatches seen elsewhere in the CESEEE. Low interest rates also played their role since there was no incentive for carry-trade and riskfree arbitrages. Nevertheless, even Poland experienced intense pressures against its currency zloty, which depreciated some 35% from September, 2008 to February, 2009 (Figure 22).

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Figure 22. Poland: Official and Real Effective Exchange Rate

Source: Authors’ calculations based on International Financial Statistics.

When, previously abundant, capital inflows dried up and even reversed in the second half of 2008 (Figures 23, 24), the zloty depreciated rapidly. But even though the foreign exchange reserves of the National Bank of Poland declined substantially this was not due to its interventions in the foreign exchange market but to reversal of the liquidity management operations via repurchase agreements (Figure 25). It was a rare case in the emerging Europe that the central bank was not forced to fend-off speculative attacks or prevent currency depreciation. Figure 23. Poland: Change of Foreign Exchange Assets and Liabilities of Banks and Non-Financial Sector

Source: Authors’ calculations based on International Financial Statistics.

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Figure 24. Poland: Financial and Current Account in Balance of Payments

Source: Authors’ calculations based on International Financial Statistics.

Figure 25. Poland: Foreign Exchange Reserves

Source: Authors’ calculations based on International Financial Statistics.

FDI declined rapidly (Figure 26) while portfolio inflows reversed and turned into outflows.

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Figure 26. Poland: FDI Inflows

Source: Authors’ calculations based on International Financial Statistics.

The Polish government resorted to a new lending facility provided by the IMF, the flexible credit line arrangement of 20.5 billion US$, in order to discourage speculators from betting against zloty. (IMF 2009g). Actually, Poland was the second to use this facility after Mexico. It was intended only for countries with sound economic policies. Access to additional foreign currency reserves reassured the market that the National Bank of Poland would have adequate reserves to intervene if the need aroused. This calmed the foreign exchange market down, alleviated depreciation pressure and facilitated continued access to international capital markets down the road. It is important to note that the National Bank of Poland never had to use the funds under the flexible credit line arrangement. Despite its resilience, Polish economy did not escape the consequences of the global financial crisis. The country was hit through the export channel since most of the Poland’s trading partners experienced deep recession (Figure 27). Exports contracted by almost 35% in early 2009 comparing to previous year. Due to the larger size of the Polish economy, the share of exports in GDP was only 40% and it was much lower in comparison with the most other regional economies. The contraction in its exports was very large and had a significant impact on the Polish economy. On the other hand, export contraction was offset by large import contraction, driven mainly by sharp fall in investments. This helped Poland reduce the current account deficit comparing to previous year. Subsequently, the Polish exports recovered quickly and the aggregate fall was much lower than at the beginning of the year.

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Figure 27. Poland: Exports and Imports of Goods

Source: Authors’ calculations based on International Financial Statistics.

Aside from trade channel, Polish economy was also exposed to the fallout of the crisis through the financial channel since a large share of its banking system was a foreign–owned one. The global deleveraging process curtailed capital inflows from parent banks and caused a significant slowdown in credit growth (Figure 28). Figure 28. Poland: Quarterly Imports to Quarterly GDP and Loans to Non-Financial Sector

Source: Authors’ calculations based on International Financial Statistics.

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Nevertheless, the Polish economy was better placed to face the crisis than most of its peers in the region. Country’s macroeconomic performance was impressive prior to the crisis, with large annual output growth of 6% between 2006 and 2008, mostly based on investments, consumption, and only marginally on government consumption (Figure 29). Trade balance was moderately negative while current account deficits stemming from profit repatriation by foreign companies operating in the country were easily financed by substantial FDI inflows. Membership in the EU bolstered business confidence and spurred investments. Even in such a buoyant environment, policy makers managed to avoid typical traps, which caught many policy makers in other countries in the region and Poland managed to keep the acute macroeconomic imbalances at check. Figure 29. Poland: Expenditure Contribution and Real Quarterly GDP Growth

Source: Authors’ calculations based on International Financial Statistics.

The main strongholds of Polish economy, which provided safety during the crisis, were low current account deficits and low level of external debt at about 40% to 50% of GDP. Polish policy makers achieved this by determined anti-inflationary focus through inflationary targeting framework and flexible exchange rate regime. Another stronghold was the government’s commitment to adopt the Euro (that seems to have faded away subsequently, despite obligations set forth in the European Union adjoining documents), which provided a strong anchor for fiscal policy, with deficit reduced to 2% of GDP in 2007. Finally, banking supervision

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was strengthened to be in full compliance with the EU regulation. Moreover, as foreign currency-denominated mortgage lending gained momentum, the central bank acted to slow this trend. Share of foreign exchange denominated loans to households and corporations remained well below loans denominated in zloty. Banks remained well capitalized despite credit expansion. There were some minor negative developments, which provided some incentive for the subsequent speculative attacks after the Lehman shock. This was mainly excessive household consumption growth in the runup to the crisis, driven by rapid growth of real wages, employment and credit. Such consumption growth led to some real effective exchange rate appreciation and worsening competitiveness of Polish tradable sectors. Nevertheless, these attacks quickly subsided after the authorities agreed with the IMF on flexible credit line. Thanks to its strong policies implemented before the crisis, Poland was able to respond to the crisis by loosening of the monetary policy, and some reasonable fiscal loosening by allowing the automatic stabilizers to fully operate.

4. Slovakia Slovakia has been among the best economic performers in the emerging Europe in recent years. During 2004–2008, the country enjoyed a period of rapid economic growth facilitated by sound macroeconomic and structural policies, and buoyed by a strong export sector. Real GDP grew by average 7.4%, which provided a real income convergence between Slovakia and the EU average. At the same, the unemployment rate dropped by 10 percentage points to 9% by the end of September, 2008. Such broad-based economic expansion did not inflict imbalances or unsustainable dynamics like it did in many of the regional economies. Inflation remained relatively low, and credit expansion, although rapid, was consistent with underlying convergence. Moreover, banks remained focused on traditional domestic activities. The current account deficit declined gradually to a level consistent with convergence. It was mainly financed by net FDI (Figure 30), and hence external debt remained low. These favorable factors facilitated a smooth transition to the Euro on 1 January 2009, despite the global financial turmoil. Slovakia is one of few CESEEE, which did not experience either currency crisis or massive fall of foreign exchange reserves, only partly because of the switch to the Euro.

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Figure 30. Slovakia: FDI Inflows, Net FDI and Current Account Deficit

Source: Authors’ calculations based on International Financial Statistics.

Rapid growth helped bring down the government deficit and debt to comfortable level. The general government deficit, as a share of GDP, fell by about 1 percentage point to around 2% during 2006–2008 (Figure 31). This improvement was achieved despite a decrease in the tax revenue-toGDP ratio to the lowest level among the EU countries. Reflecting smaller deficits and accelerating growth, the general government debt relative to GDP declined to 27.8% at the end of 2008. Figure 31. Slovakia: General Government Revenues, Expenditure and Deficit

Source: Authors’ calculations based on International Financial Statistics.

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Wage growth, in line with productivity gains, helped maintain competitiveness despite considerable appreciation of the real effective exchange rate (Figure 32). Slovak market share in world export increased rapidly in recent years, outpacing that of its peers. One of the main tools that provided Slovakia its high competitiveness was a large level of domestic savings and investments, which was not the case in most other countries in the region. Figure 32. Slovakia: Official and Real Effective Exchange Rate

Source: Authors’ calculations based on International Financial Statistics.

However, since Slovakia was deeply integrated in the global trade and finance, it was highly influenced by external economic developments and the global economic slump substantially affected its economy through trade channel (Figure 33).

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Figure 33. Slovakia: Exports and Imports of Goods

Source: Authors’ calculations based on International Financial Statistics.

The magnitude and the extent of the global slump, particularly a pronounced economic weakening in the Euro Area, led to a sharp decline in economic activity in the first quarter of 2009 (Figure 34). Real GDP in the first quarter of 2009 fell by 11.4% q-o-q. Exports, which fell by 16.2% q-o-q, led the decline, followed closely by investments (Figure 34). In addition, even domestic demand, including private consumption, contracted due to rising unemployment, credit crunch and the overall adjustment on the side of consumers. This also impacted imports, which declined strongly (Figure 38).

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Figure 34. Slovakia: Expenditure Contribution and Real Quarterly GDP Growth

Source: Authors’ calculations based on International Financial Statistics.

Still, both the IMF and the government agreed that underlying systemic vulnerabilities appeared to be limited. (IMF 2009l). The projected increases in external and public debts were only temporary and did not reflect structural imbalances or raised any sustainability concerns.49 With Slovakia in the Euro Area, gross external financing requirements for 2009 on the order of 10% of GDP were expected to be easily covered. Furthermore, the government, corporate and household debt ratios were comfortable. Household’s loan-to-value ratio was between 50 and 60 percent range in 2008 and housing prices were broadly stable. The recession was not expected to give rise to social tensions as social partners were cooperative.50 All this provided stable grounds and averted any potential speculative attacks as reflected in modest swings of foreign liabilities of the private sector, FDI and financial account (Figures 35 and 36).

49 Structural imbalances include various indicators of macroeconomic imbalance that may destabilize an economy such as trade deficit, unemployment, fiscal imbalances, inflation, etc. 50 For example, through arrangements to increase working hour flexibility, which was intended to limit the recession’s impact on employment and welfare.

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Figure 35. Slovakia: Change of Foreign Exchange Assets and Liabilities of Banks and Non-Financial Sector

Source: Authors’ calculations based on International Financial Statistics.

Figure 36. Slovakia: Financial and Current Account in Balance of Payments

Source: Authors’ calculations based on International Financial Statistics.

The National Bank of Slovakia was forced to intervene in the foreign exchange market only in the short time window between the Lehman Bothers collapse in September, 2008 and adoption of the Euro in January, 2009 (Figure 37).

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Figure 37. Slovakia: Foreign Exchange Reserves

Source: Authors’ calculations based on International Financial Statistics.

Even though the fiscal position in 2009 weakened rapidly because revenues underperformed, the authorities intended to maintain the budgetary expenditure plan in 2009 and let the automatic stabilizers on the expenditure side to fully operate (Figure 31). By doing this, the government preferred to relax its fiscal stance, along with some minor stimulus measures, rather than to keep the budget deficit at 3% of GDP required by the Maastricht Treaty since the budget deficit at this level would imply significant and unnecessary procyclical tightening. Relaxed fiscal stance was made possible by the investors to whom Slovakia successfully sold its Eurobond in May, 2009 with relatively low spread against German Bunds. Slovakia was one of few countries in the region, where the rapid credit growth (Figure 38) prior to the crisis was largely financed by an equally rapid growth in domestic households’ savings. Because of it, banks were resilient to adverse developments in parent banks, and did not depend on borrowing from non-affiliated banks. Slovakian banks withstood the crisis well, they remained well capitalized, liquid and properly provisioned owing to prudent regulation and supervision. In response to the crisis, National Bank of Slovakia introduced supportive measures, which further eased the tension.

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Figure 38. Slovakia: Quarterly Imports to Quarterly GDP and Loans to Non-Financial Sector

Source: Authors’ calculations based on International Financial Statistics.

5. Hungary Hungary was one of first countries in the region to seek for the IMF and EU financial support in October, 2008. A stand-by agreement, staggering in terms of the funds provided to a country of that size, was signed in November. Aside from the IMF, a substantial financial assistance was also arranged with the EU and the World Bank, which all added up to 20 billion euro. The stand-by arrangement with the IMF consisted of exceptional access to IMF resources, amounting to 1015% of Hungary’s quota, and it was approved under the Fund’s fast-track Emergency Financing Mechanism procedure reflecting the depth and the potential impact of Hungarian financial turmoil. (IMF 2008a, b; 2009d; 2010). Prior to 2007, the country pursued unsustainable policies, due to which fiscal and current account deficits ballooned. The general government deficit averaged more than 8% of GDP between 2002 and 2006 and it tended to surge in the run-up to parliamentary elections. As a result, general government debt amounted to 66% of GDP as of the end of 2007. On top of that, the size of government is relatively large compared to its peers. On the other front, foreign owned banks facilitated steady buildup of foreign currency denominated loans over the same period. Domestic owned banks had to follow the suit. Households and corporate clients found the loans denominated in the Euro or Swiss franc to be more attractive due to lower interest rates, even though these clients had no natural hedge

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against foreign exchange risk. This foreign exchange risk quickly translated into credit risk once the forint depreciated. Sizeable financial inflows led over time to a high level of public and private external debt. However, this unsustainable development model came to an end when a political crisis erupted followed by street rallies, violent on occasion. This forced the government to embark on a long term consolidation path in the second half of 2006 (Figure 39). Macroeconomic and financial policies were strengthened, and the main items were fiscal consolidation, implementation of inflation targeting monetary framework and floating exchange rate regime. Bank supervision, risk management and consumer protection related to foreign currency loans were enhanced as well. Early in 2008, Hungary switched to floating exchange rate regime, which removed conflicts between monetary and exchange rate policies in an inflation targeting environment. Figure 39. Hungary: General Government Revenues, Expenditure and Deficit

Source: Authors’ calculations based on International Financial Statistics.

However, the onset of the global financial turbulence led investors to start differentiating among developing countries, and since Hungary suffered from high external debt level of 96% of GDP, significant balance sheet mismatches and high rate of credit euroization, it was among the first developing countries to suffer from the fallout of the financial crisis. This disrupted previous fiscal and financial consolidation efforts to a great degree. Investors’ risk aversion swelled, government’s bond yields spiked to unprecedented levels while the confidence of households vanished causing a run on deposits soon after the Lehman shock. Along came rapid depreciation of the Hungarian forint (Figure 40) while stock market

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prices precipitated. The EU moved first and provided the assistance in the amount of 6.5 billion euro to the country, the World bank added 1 billion, while the IMF committed to a financial support of 12.5 billion euro. Figure 40. Hungary: Official and Real Effective Exchange Rate

Source: Authors’ calculations based on International Financial Statistics.

A global deleveraging process that started after the subprime mortgage bubble burst, reduced foreign capital inflows to Hungary (Figures 41 and 42), which in turn caused a sharp slowdown of credit growth (Figure 43). The acceleration of fiscal consolidation also hampered domestic demand. Figure 41. Hungary: FDI Inflows

Source: Authors’ calculations based on International Financial Statistics.

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Figure 42. Hungary: Financial and Current Account in Balance of Payments

Source: Authors’ calculations based on International Financial Statistics.

Figure 43. Hungary: Quarterly Imports to Quarterly GDP and Loans to Non-Financial Sector

Source: Authors’ calculations based on International Financial Statistics.

Exports were curtailed by the economic slowdown among the country’s trading partners (Figure 44).

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Figure 44. Hungary: Exports and Imports of Goods

Source: Authors’ calculations based on International Financial Statistics.

Against this backdrop, output precipitated from the last quarter of 2008 onward (Figure 45). Private and public consumption, investments and exports contributed to this severe recession, while imports drop offset this trend to a certain extent. Figure 45. Hungary: Expenditure Contribution and Real Quarterly GDP Growth

Source: Authors’ calculations based on International Financial Statistics.

Since the authorities decided to substantially increase foreign exchange reserves of the Hungarian National Bank as a precautionary measure

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against unexpected outflows (Figure 46), they moved swiftly to ask the IMF for assistance. The stand-by arrangement with the IMF was designed to facilitate rapid reduction of the financial market distress. The longrun objectives were implementation of a substantial fiscal adjustment to ensure that the government’s debt-financing needs would decline as well as to maintain adequate liquidity and strong capitalization in the banking system. Another important goal of the IMF was to prevent any significant crisis spillover from Hungary to its neighboring countries, which were already overwhelmed by their own problems. The loan amount, which was lent at the end of 2008 and beginning of 2009, by the three parties (the IMF, EU and World Bank) committed to assist Hungary (Figure 47) was designed to provide the country with large amount of reserves, that would be sufficient to meet its external obligations, even in extreme market circumstances. Figure 46. Hungary: Foreign Exchange Reserves

Source: Authors’ calculations based on International Financial Statistics.

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Figure 47. Hungary: Change of Foreign Exchange Assets and Liabilities of Banks and Non-Financial Sector

Source: Authors’ calculations based on International Financial Statistics.

Even though the crisis already struck Hungary, the central bank actively sought an agreement with commercial banks to strengthen the supply of forint denominated loans, facilitate voluntary conversion of foreign exchange indexed loans into forint denominated and to put in place a private debt resolution strategy. Their goal was to alleviate the problem of balance sheet risks stemming from the currency mismatches of households assets, income and liabilities. However, a large and persistent interest rate differential between the foreign exchange indexed loans and forint loans, in the context of rapid stabilization of the exchange rate after the agreement with the IMF on stand-by arrangement, complicated the process of de-euroization. Developments in foreign subsidiaries of Hungarian largest domestic owned bank gave rise to liquidity pressures on domestic money market. In order to mitigate the risk stemming from this, the government announced in early October, 2008 a blanket guarantee for all banks’ deposits. To further buttress credibility and ensure soundness of all banks, the program included strong bank-support package. Since the largest domestic-owned bank (OTP bank) was also one of the largest regional banks, program also ensured that this bank would continue to be a responsible parent of its foreign subsidiaries. Other elements of the program included additional capital and funds for a guarantee fund for interbank lending. Also, the IMF assisted the country, like several other countries in the region, to reach an agreement (Vienna Initiative) with largest foreign owned banks

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on maintenance of aggregate exposure to the country. This reduced large external financing requirements of Hungary and preserved the basis for at least some lending activity. Unlike other countries in the region, which sought for the IMF’s assistance, Hungary achieved a high level of integration of its financial sector with that of the EU, which allowed the country to quickly regain the access to financial markets and their resources. Due to these two positive factors Hungary stabilized by mid–2009 (although there were occasional turbulences in 2010) its financial markets, volatility of forint tapered off and the currency appreciated somewhat.

6. Bulgaria Bulgaria reached the agreement on the EU accession in 2004. This marked the beginning of a period of a sudden rise in capital flows into the country and an ensuing credit boom. By 2008, these capital inflows increased to more than 30% of GDP annually (Figures 48 and 49), whereas credit to the private sector grew rapidly from 36% in 2004 to 67% in 2007. Figure 48. Bulgaria: Change of Foreign Exchange Assets and Liabilities of Banks and Non-Financial Sector

Source: Authors’ calculations based on International Financial Statistics.

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Figure 49. Bulgaria: FDI Inflows

Source: Authors’ calculations based on International Financial Statistics.

The surge in capital inflows facilitated rapid GDP growth of more than 6% annually, leading to a significant narrowing of the income gap with developed countries in the EU. Growth remained strong in 2008 in excess of 6% making Bulgaria one of the fastest growing countries in Europe (Figure 50). Figure 50. Bulgaria: Expenditure Contribution and Real Quarterly GDP Growth

Source: Authors’ calculations based on International Financial Statistics.

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Due to faster growth of domestic demand than the output, the trade deficit and the current account deficit widened significantly, from 14% and 5% in 2003, to 29% and 25% in 2008 respectively (Figures 51 and 52). Such a widening of the current account deficit was exacerbated by a concentration of growth in non-tradable sectors like construction, real estate and financial services. Figure 51. Bulgaria: Financial and Current Account in Balance of Payments

Source: Authors’ calculations based on International Financial Statistics.

Figure 52. Bulgaria: Exports and Imports of Goods

Source: Authors’ calculations based on International Financial Statistics.

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Despite this vast current account deficit, financial account surplus was large enough to offset the deficit in the current account (Figure 51) and, on top of that, to induce a steep increase in the foreign exchange reserves of the Bulgarian National Bank (Figure 53), which was needed to maintain the fixed parity to the Euro. Figure 53. Bulgaria: Foreign Exchange Reserves

Source: Authors’ calculations based on International Financial Statistics.

However, in the last quarter of 2008, surge in capital flows reversed driven by collapsing banking sectors in the USA and the Western Europe. FDI declined strongly, while local subsidiaries of the banks from the Western Europe could no longer receive large funds and cross-border loans from their parent banks, which subsequently curtailed credit growth in the coming quarters (Figure 54).

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Figure 54. Bulgaria: Quarterly Imports to Quarterly GDP and Loans to Non-Financial Sector

Source: Authors’ calculations based on International Financial Statistics.

Shrinking foreign demand and free-falling commodity prices led to a drop in Bulgarian exports (Figure 52) and a decline in tourism revenues. Export industries and services were most affected Prior to the crisis, unemployment dropped significantly and labor market tightened, due to which the wage growth was higher than 20% y-o-y in 2008 and it was significantly larger than the productivity growth. Bubbles in the Bulgarian real estate market and stock exchange emerged also as the result of massive portfolio and capital inflows and credit boom. This overheating of the economy, together with rising food and oil prices, resulted in an inflation surge which peaked at 15% in mid–2008. Due to the fixed parity to the Euro of the Bulgarian currency board arrangement, which stood at 1.956 Leva per the Euro, real effective exchange rate appreciated strongly during this period (Figure 55).

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Figure 55. Bulgaria: Official and Real Effective Exchange Rate

Source: Authors’ calculations based on International Financial Statistics.

Driven by the credit boom and wage growth, Bulgarian imports exhibited a rapid growth (Figures 51 and 54), which than reversed after the onset of the crisis mainly because of the falling domestic demand, the credit crunch and the plunge in output. It is important to note that imports have plummeted significantly more than exports, which reduced the current account deficit to half of that from a year earlier, thereby challenging the conventional wisdom of relatively insensitive consumption of currency boards as opposed to a more responsive and adjustable behavior in floating regimes.51 Bulgaria entered the crisis with large war chest. The public finances were in good shape; the country saved a lot during the boom period and posted one of the highest fiscal surpluses in Europe. This gave its government the means to run a countercyclical fiscal policy when the crisis hit (Figure 56). At the same time, the Bulgarian central bank had ample foreign exchange reserves, which stood ready to defend its currency board fix.

51 Conventional theory assumes that the effect of depreciation of exchange rate on the increase in exports and decrease in imports should be much more significant in the case of floating currencies in comparison with fixed currencies and currency boards.

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Figure 56. Bulgaria: General Government Revenues, Expenditure and Deficit

Source: Authors’ calculations based on International Financial Statistics.

Accumulated vulnerabilities became apparent only when the capital inflows stopped. One of the most striking one was the difference between country’s private savings and investments rates, which widened to 27% of GDP in 2008. Inability to finance this gap by foreign savings forced Bulgarian private sector to adjust its investments both in fixed capital and inventories, during 2009, and this led to a strong fall in real quarterly GDP growth rates (Figure 50). Two other notable vulnerabilities, which emerged in the last quarter of 2008, were massive external debt of the private sector, which reached 94% of GDP, whereas, despite currency board regime, the level of euroization of corporate sectors’ liabilities reached more than 70% of GDP. The government announced its readiness to make some bold moves after the Lehman shock. One of the most important was a promise to maintain the fiscal surplus even in 2008, and to reduce public expenditure in 2009 to 90% of the 2008 level. This, however, never materialized, and the government embarked on a large fiscal expansion that led to 24% growth in spending despite 10% decline in fiscal revenues. The new government which was elected in the course of 2009, realized that such policy would undermine its ability to maintain the currency board, and promised to rein in the fiscal deficit in 2010, by expenditure reduction, which encompassed downsizing of public administration, public wage freeze, halt on pension growth and other public spending. (IMF 2009a). Bulgarian financial sector remained well capitalized even during the crisis, with capital adequacy ratio of 17.6% as of mid–2009. It was also

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sufficiently profitable before the onset of the crisis and remained so in the first half of 2009 despite rising provisioning for non-performing loans. This helped it weather the crisis comfortably, but due to excessive reliance on foreign funding, the credit crunch was inevitable in the second half of 2008 and throughout 2009 after these flows reversed. That put strains on the households’ final consumption and to the output as well. As elsewhere in the region, Bulgarian banks also experienced run on retail deposits, which called for robust deposits insurance measures aimed at reinstating the clients’ confidence. Authorities responded timely by securing commitments from parents banks to provide adequate liquidity and capital to their subsidiaries, which effectively limited the capital outflows. Massive fiscal reserves allowed the Bulgarian Government to step in and act as a major lender of the last resort backed by real monetary holdings instead of newly created money as it was the case in developed countries.

7. Croatia Global economic crisis affected the country and brought to an end a long-standing expansion fueled by a strong credit growth. The country faced sharp decline in capital inflows (Figure 57) and equally sharp decline in export demand stemming from the slowdown in the Euro Area (Figure 58). Figure 57. Croatia: Change of Foreign Exchange Assets and Liabilities of Banks and Non-Financial Sector

Source: Authors’ calculations based on International Financial Statistics.

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Figure 58. Croatia: Exports and Imports of Goods and Services

Source: Authors’ calculations based on International Financial Statistics.

As in the case of Bulgaria, Croatian imports also contracted to a greater degree than exports, which effectively helped the country adjust its previously substantial current account deficit (from 9.4% in 2008 to around 6.5% of GDP in 2009). Croatia’s financial system has weathered fairly well the first impact of the global crisis despite its immense leverage and dependence on foreign funding. This success can be ascribed to the skillful management and timely measures of the Croatian National Bank. Financial market turmoil and rumors caused sudden retail deposit outflows immediately after the Lehman shock, but this was quickly reversed by measures that increased deposit insurance coverage. The Government revised and implemented a more realistic budget in the spring of 2009 in order to rein its previously loosely planned budget. Nevertheless, private sector, domestic and foreign indebtedness swelled during the previous period of abundant international liquidity flowing into the country (Figures 59 and 60).

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Figure 59. Croatia: FDI Inflows

Source: Authors’ calculations based on International Financial Statistics.

Figure 60. Croatia: Financial and Current Account in Balance of Payments

Source: Authors’ calculations based on International Financial Statistics.

This inflow was also large enough so that the monetary authorities were able to accumulate sizeable stock of foreign exchange reserves (Figure 61) despite substantial current account deficits.

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Figure 61. Croatia: Foreign Exchange Reserves

Source: Authors’ calculations based on International Financial Statistics.

Yet, the largest part of foreign loans ended up in non-tradable sectors and private consumption. When the crisis hit, external financing needs grew very large against a backdrop of very fragile balance sheets of the private sector. It significantly constrained policy options, even though such challenging times required strong policy responses. Croatia was forced to implement more prudent fiscal (Figure 62), monetary and financial policies and address its long-standing competitiveness issues. Fiscal restrictions boiled down to public wage freeze and some cuts in other current expenditures. (IMF 2009b). Figure 62. Croatia: Central Government Cash Receipts, Payments And Cash Balance

Source: Authors’ calculations based on International Financial Statistics.

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Liquidity pressures in the banking sector intensified in the last quarter of 2008, as a reflection of curtailed external funding possibilities, large government financing needs and a shift of corporate sector toward domestic credit. The Croatian National Bank was forced into massive liquidity injecting operations through repo auctions and relaxation of reserve requirements. Against a backdrop of increased foreign exchange rate pressure, the Croatian National Bank was also forced to intervene in the foreign exchange market in order to prevent a large depreciation of its kuna currency. Even though competitiveness of the Croatian economy was severely undermined in the period prior to the crisis due to a real effective exchange rate appreciation (Figure 63), the country was nevertheless forced into maintenance of very tightly managed floating exchange rate, due to high rate of unhedged euroized liabilities of the private sector. Croatia had to rely solely on structural reforms and increased flexibility elsewhere in the system in order to alleviate pressures stemming for lack of competitiveness. Figure 63. Croatia: Official and Real Effective Exchange Rate

Source: Authors’ calculations based on International Financial Statistics.

A sudden stop of capital inflows had a strong impact on the domestic demand in Croatia, mainly through reduced credit and adjusted households’ consumption. This was coupled with the reduced export demand. All these variables exerted a negative contribution to the output rendering it negative throughout 2009 (Figure 64).

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Figure 64. Croatia: Expenditure Contribution and Real Quarterly GDP Growth

Source: Authors’ calculations based on International Financial Statistics.

Banks were able to achieve debt rollover equal to 100% in the period following the Lehman shock. This perfect rollover rate helped Croatia to retain stable balance of payments and also banks’ liquidity. However, the lack of fresh capital inflows caused the credit growth rate drop significantly (Figure 65). It is important to note that banks in Croatia were put under very strict prudential regime by the Croatian National Bank for quite some time before the onset of the crisis, which slowed down the credit growth, unlike in most other CESEEE and created at the same time plenty of buffers to be used when the crisis hit. This reduced the vulnerability of the domestic banking sector, but it provided incentive for a strong rise of direct cross-border lending to corporate sector.52 After the Lehman Brothers collapse, followed by woes in major European banks, the Croatian National Bank and the government reacted swiftly by liquidity injections and increased insured deposit threshold, which reversed drain on households’ savings and major banking crisis.

52 The Croatian National Bank established financial stability through constraints to credit by imposing ceilings on maximum annual lending growth. Resultantly, this constraint posed a strong incentive for corporate borrowers to seek (and obtain) loans directly from non-resident banks. The build-up of such cross-border debts, introduced a significant policy constraints once the crisis hit and inflows stopped. Resultantly, prevention of any currency depreciation and its strong negative balance sheet effects was top priority task for the Croatian authorities.

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Figure 65. Croatia: Quarterly Imports to Quarterly GDP and Loans to Non-Financial Sector

Source: Authors’ calculations based on International Financial Statistics.

8. Latvia In late December 2008, the IMF and Latvia reached an agreement on economic program supported by a stand-by arrangement of 1.7 billion euro. (IMF 2009e, f). This agreement was followed by a period of severe economic and social tensions, which erupted in the country amid the global financial crisis and reversal of capital inflows to the country (Figures 66 and 67). Figure 66. Latvia: Financial and Current Account in Balance of Payments

Source: Authors’ calculations based on International Financial Statistics.

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Figure 67. Latvia: FDI Inflows

Source: Authors’ calculations based on International Financial Statistics.

After August 2008, Latvia experienced precipitous decline in its foreign exchange reserves of 20% (Figure 68) while defending its currency peg. Figure 68. Latvia: Foreign Exchange Reserves

Source: Authors’ calculations based on International Financial Statistics.

Latvia’s banking sector experienced intense foreign exchange liquidity difficulties (Figure 69) because of significant deposit withdrawal of 10% and because lats, local currency, came under pressure because everyone rushed to convert their lats holdings into the Euro.

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Figure 69. Latvia: Change of Foreign Exchange Assets and Liabilities of Banks and Non-Financial Sector

Source: Authors’ calculations based on International Financial Statistics.

Capital was flowing out of Latvia en masse, while real estate bubble burst eroding the collateralization coverage of bank loans. The IMF decided to step in and bail out the country, but it posted strict conditions on competitiveness improvement, stronger domestic policies and wide political and social consensus about the necessity to restore long-term stability of the economy. The immediate goal of the program was to stabilize the financial sector and restore depositor confidence. The final goal of the program was to achieve early fulfillment of the Maastricht criteria to facilitate adoption of the Euro. Prior to the crisis, Latvia recorded unsustainably rapid output growth and credit boom fueled by the EU accession optimism and the capital inflows. Credits to private sector reached 70% of GDP and that was very close to the EU average. Because of large domestic demand, real estate and share prices bubbled. On top of that, fiscal policy contributed to the boom by a real expenditure growth of 80% between 2003 and 2007 as the authorities spent cyclically strong tax revenues and began receiving substantial EU grants. The IMF estimated that the cumulative fiscal stimulus was more than 6% of GDP through the end of 2007, while output growth exceeded its potential by 9%. This led to a build-up of large external debts of 130% relative to GDP and increasing vulnerabilities of Latvia’s private sector. A short-term debt comprised 50% of the entire external debt. Moreover, when the capital inflows dried-up pressures started to mount due to growing concerns about Latvia’s capacity to maintain its external liquidity. Increasing vulnerabilities were mostly reflected in a rapid wage growth in the run up to the crisis. The wages grew much faster than productivity, which

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had a very deep impact on competitiveness of the Latvian economy. Real effective exchange rate (Figure 70), which exhibited sharp worsening starting from 2007 nicely portrays this loss of competitiveness. Figure 70. Latvia: Official and Real Effective Exchange Rate

Source: Authors’ calculations based on International Financial Statistics.

Given the limitations imposed by the currency peg, as well as the high rate of private sector’s liability euroization of nearly 90%, the Latvian authorities and the IMF agreed that a long period of price compression driven by fiscal austerity, including wage reductions, was necessary in order to improve country’s competitiveness, (Figure 71). Consequently, even stronger and longer recession than what anyone would expect was inevitable. Figure 71. Latvia: General Government Revenues, Expenditure and Deficit

Source: Authors’ calculations based on International Financial Statistics.

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Under the arrangement with the IMF, the country had to drastically reduce its fiscal deficit from initially projected 12% of GDP in 2009 to only 5%, mainly through nominal reduction of wages. Aside from that, Latvia was required to conduct serious structural reforms in order to improve its competitiveness and facilitate external adjustment. All these austerities coupled with a credit crunch (Figure 72), brought about a sharp decline in domestic demand. Imports declined more than exports (Figure 73) and led to a strong current account adjustment, which even turned positive. Figure 72. Latvia: Quarterly Imports to Quarterly GDP and Loans to Banks and Non-Financial Sector

Source: Authors’ calculations based on International Financial Statistics.

Figure 73. Latvia: Exports and Imports of Goods

Source: Authors’ calculations based on International Financial Statistics.

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Nevertheless, the country, which used to record impressive growth rates in the run up to the crisis, due to increasing contribution of private and public consumption, fixed capital formation and inventories’ buildup, saw all of these variables reversing. Negative contributions of the aforementioned spending categories led to one of the most severe output contractions of 18% y-o-y for the first three quarters of 2009 (Figure 74), which greatly exceed contraction seen during the Asian crisis. Retail sales dropped 25% y-o-y, reflecting the free fall of households’ consumption and consumer confidence. Construction and consumer durables spending fell even faster, with car sales down by 80%, in part reflecting the credit crunch. The credit crunch was mainly driven by the lack of funds, which itself was a result of domestic banks’ repayment of foreign liabilities, which left them without liquidity needed for lending. Figure 74. Latvia: Expenditure Contribution and Real Quarterly GDP Growth

Source: Authors’ calculations based on International Financial Statistics.

Interest rates on lats loans surged, reflecting the limited lats liquidity and increased risk aversion of the lenders. Rapidly declining confidence in the viability of the currency peg led to a significant decrease of base money, which fell by one quarter in the first half of 2009. This effectively increased the rate of credit euroization of the economy and made it even harder for policy makers to sustain any potential speculative attacks and ongoing rumors and experts’ statements about potential devaluation of lats. The credit crunch induced the implementation of one very helpful tool in addressing the crisis in Latvia. This was the replication of the so called “Vienna Initiative”, which was arranged in September, 2009. It committed foreign parent banking groups to support their local

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subsidiaries by maintaining their pre-crisis exposure levels to Latvia through debt roll-over. Aside from that, the Latvian government was forced to step in and recapitalize the largest domestic owned bank (Parex bank), despite its fiscal limitations. This bank was the second largest bank in the country, and that recapitalization was necessary in order to prevent its collapse and a potential depositor run against the remaining banks. The successful avoidance of the depositor run provided the Latvian Central Bank additional room in terms of foreign exchange reserves. A larger pool of the foreign exchange reserves enabled the central bank preserve and even increase the ratio of foreign exchange reserve to money supply (Figure 68). The result was that the ratio was higher than required by the stand-by program. The need to maintain this ratio stemmed from Latvia’s quasi-currency board exchange rate regime. Due to an increase in external public debt and a sharp fall in output, it is realistic to expect, even after the recovery sets in, an exorbitant external debt of 165% of GDP that was reached in 2010 to remain persistently high for years to come. Even though data show that the output bottomed out in the last quarter of 2009, and that Latvia could expect some stabilization down the road, misfortunes that hit it would have detrimental and permanent impact on Latvia’s potential output.

9. Romania Like many other countries, Romania was significantly affected by the global recession from the last quarter 2008 onward. While the growth remained high in the first three quarters of 2008, output deteriorated rapidly in the last months of the year. Exports began to tumble, large capital inflows dwindled, credit availability tightened for corporations and households, and domestic consumption and investments started falling. Like elsewhere, international problems triggered the downturn, but longstanding imbalances within the Romanian economy aggravated its effects. Balance of payments and government deficits have created the vulnerability to external shocks, while poor track record on structural reforms left the economy less productive and less flexible than its peers. The Government spending doubled between 2005 and 2008, and the public sector wage bill tripled due to high wage increases combined with a large increase in public sector employment. When the economy entered a downturn, an easing of fiscal policy to cushion downturn was not an option any more. Not only that spending was already too high, but also the government’s ability to finance a large deficit dried up. After the crisis and foreign exchange market pressures intensified in the first quarter of 2009, the government agreed a stand-by arrangement with the IMF of 13 billion euro. (IMF 2009h). In addition to this, the Vienna Agreement

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was concluded with parent banks that had subsidiaries in Romania to rollover the existing liabilities and maintain the existing level of exposure, thereby helping the country avoid a deeper balance of payment crisis and a collapse of the banking sector. GDP growth averaged 6.5% annually from 2003 to 2008. Such a rapid growth was made possible by FDI (Figure 75) and credit inflows (Figures 76 and 77). The latter was facilitated by banks that had set up subsidiaries in Romania. Figure 75. Romania: FDI Inflows

Source: Authors’ calculations based on International Financial Statistics.

Figure 76. Romania: Change of Foreign Exchange Assets and Liabilities of Banks and Non-Financial Sector

Source: Authors’ calculations based on International Financial Statistics.

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Figure 77. Romania: Financial and Current Account in Balance of Payments

Source: Authors’ calculations based on International Financial Statistics.

All this foreign capital fueled consumer spending and imports (Figure 78) pushing the current account into deficits larger than 14% of GDP (Figure 77). Figure 78. Romania: Exports and Imports of Goods

Source: Authors’ calculations based on International Financial Statistics.

This facilitated an investment boom driven by local companies from non-tradable sectors (Figure 82). Finally, the overheating economy and

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the rapid capital inflows complicated the monetary policy, resulting in the National Bank of Romania’s inability to achieve its inflation target notwithstanding increases in interest rates and reserve requirements. The real effective exchange rate appreciated by 50% between mid–2004 and mid–2008 (Figure 79). Figure 79. Romania: Official and Real Effective Exchange Rate

Source: Authors’ calculations based on International Financial Statistics.

Such a rapid increase in borrowing left Romania highly exposed when the financial crisis hit. Because of the global credit crunch, the country suddenly began to experience problems in attracting foreign capital, while at the same time existing capital was flowing out of the country. The troubles spilled over into the exchange rate (Figure 79), which depreciated significantly against the Euro since October, 2008. Because Romania, like many other countries in the region suffered from a high rate of euroization of corporate and household liabilities,53 a weaker lei made it more expensive for borrowers to service their debts. Having feared a potential panic from exchange rate overshooting, the National Bank of Romania intervened in the foreign exchange markets heavily and spent considerable portion of its reserves (Figure 80).

53 Nearly 60% of total bank loans were denominated in Euro.

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Figure 80. Romania: Foreign Exchange Reserves

Source: Authors’ calculations based on International Financial Statistics.

Even though the general government deficit remained fairly small, around 1% of GDP, until the last quarter of 2008 when it rose to near 5% of GDP (Figure 81) fiscal policy played a strongly procyclical role in the boom period, by rapid spending of cyclically increased fiscal revenues. Figure 81. Romania: General Government Revenues, Expenditure and Deficit

Source: Authors’ calculations based on International Financial Statistics.

Output growth slowed down drastically in late 2008 and early 2009, which was one of the sharpest turnarounds among developing European

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countries (Figure 82). The decline was spearheaded by a free fall in domestic demand an export demand. Figure 82. Romania: Expenditure Contribution and Real Quarterly GDP Growth

Source: Authors’ calculations based on International Financial Statistics.

However, imports have fallen even more steeply (Figure 83) and this eased the output fall as well as previously high current account deficit. The banking system’s external borrowing, mainly comprising subsidiaries’ borrowings from their parent banks’, drove a rapid credit growth of more than 10% every quarter (Figure 83). Corporate access to foreign credit also contributed to the boom. The National Bank of Romania took a number of measures in order to reduce overheating and inflation by containing the credit expansion, especially lending in foreign currency. In the period between 2004 and 2008, the central bank raised policy interest rates to 10.25%, as well as minimum reserve requirements to 18% on local currency liabilities and 40% on foreign currency liabilities. It also took measures to limit households’ debt exposures and strengthened prudential regulations to limit lending to unhedged borrowers. These measures contributed to a subsequent deceleration in household credit growth, but pressure from expansionary fiscal policy and capital inflows caused the National Bank of Romania to miss its inflation target in 2007 and 2008. However, following cuts in Romania’s credit rating in late 2008, to below investment grade in one case, access to external sources of funds became limited and interbank market liquidity also dried up. Although banks entered the crisis well capitalized, nonperforming loans rose significantly, especially those denominated in foreign currencies. As a result, lending

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to private sector began to shrink in the fourth quarter 2008, reflecting a combination of supply and demand factors on credit markets. Figure 83. Romania: Quarterly Imports to Quarterly GDP and Loans to Non-Financial Sector

Note: Loans to non-financial sector change q-o-q (which is a measure of credit growth) is measured on the right scale and the quarterly imports to quarterly GDP is measured on the left scale. Source: Authors’ calculations based on International Financial Statistics.

10. Russia Against the backdrop of worst global recession since the 1930s, Russian economy was hit even harder than most other economies in the emerging Europe, by both lower oil and other commodity prices and a turnaround in capital flows. Despite prompt and strong policy reactions, Russia’s output turned from growth into a significant decline in late 2008 and 2009. The decline of output was much larger in Russia than in other large economies. This sensitivity to global cycles and to terms of trade reflected Russia’s longstanding policy weaknesses. Contemporaneous fall in oil prices and reversal in capital flows led to painful adjustments and exposed policy weaknesses. One of these policy weaknesses was pre-crisis policy of controlled ruble appreciation, which encouraged, alongside regulatory and supervisory deficiencies, bolstered excessive foreign currency borrowing. The result was credit boom that left Russia highly vulnerable to shocks coming through the capital account. On the positive side, Russia’s prudent fiscal management during the oil boom created room for a fiscal expansion during the crisis (Figure 84).

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Figure 84. Russia: General Government Revenues, Expenditure and Operating Balance

Source: Authors’ calculations based on International Financial Statistics.

Moreover, Russia’s large international reserve cushion, provided a scope for the Central Bank of Russia, to intervene and sell reserves (Figure 85) when exchange rate expectations abruptly and dramatically shifted along with reversal of capital inflows. Figure 85. Russia: Foreign Exchange Reserves

Source: Authors’ calculations based on International Financial Statistics.

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Massive capital outflows and the related liquidity drain from the banking sector, which started in the last quarter of 2008 (Figures 86, 87 and 88) were initially offset by sizeable liquidity injections of the Central Bank of Russia at low interest rates, with simultaneously drawing on its large international reserves to prevent the ruble from quickly depreciating to its new equilibrium. Figure 86. Russia: Financial and Current Account in Balance of Payments

Source: Authors’ calculations based on International Financial Statistics.

Figure 87. Russia: Change of Foreign Exchange Assets and Liabilities of Banks and Non-Financial Sector

Source: Authors’ calculations based on International Financial Statistics.

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However, rapid loss of reserves forced the Central Bank of Russia to tighten its monetary policy in January, 2009, despite the slumping output. On the other hand, a significant countercyclical fiscal relaxation was put in place (Figure 84). The surplus of general government balance declined by 10% in 2009. Half of this decline reflected a fall in oil revenues, while the remainder represented a discretionary relaxation. Figure 88. Russia: FDI Inflows

Source: Authors’ calculations based on International Financial Statistics.

Real effective exchange rate of the Russian ruble appreciated significantly in the run-up to the crisis (Figure 89), due to large inflation rates. Figure 89. Russia: Official and Real Effective Exchange Rate

Source: Authors’ calculations based on International Financial Statistics.

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Still, Russian export increased significantly between 2003 and 2008. This did not reflect any significant improvement in competitiveness or significantly increased productivity of the Russian industry, but only the fact that the largest share of exports comprised oil, which, like any other commodity, was not very sensitive to domestic competitiveness. At the same time, the terms of trade worked in favor of Russia, and its export revenues surged (Figure 90). Figure 90. Russia: Exports and Imports of Goods

Source: Authors’ calculations based on International Financial Statistics.

Yet, global exports declined sharply with global downturn which further caused a sharp fall in both oil prices and oil consumption with significant impact on Russian current account surplus (Figure 86). Confronted with increasing foreign exchange reserve losses, the Central Bank of Russia allowed a one time 10% devaluation of the effective exchange rate band, and declared it would defend the ruble at this level. (IMF 2009i). Furthermore, it started to curtail its liquidity support, allowing interest rates to rise to more fundamentally driven based levels, which at one point meant 28% for overnight interbank deposits. After this move and limited recovery of capital inflows, ruble stabilized and even slightly appreciated. This stabilization of the exchange rate coupled with oil price increases, allowed the Central Bank of Russia to gradually ease their stance starting from the second quarter of 2009.

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Prior to the crisis, large terms-of-trade gains and surging capital inflows followed by accommodative monetary policy fueled rapid credit growth and output growth. However, global recession brought two key problems, which ended the extended boom period in Russia. These were falling oil prices and sharp capital inflow reversal in mid–2008. This triggered an abrupt contraction in domestic demand. Fixed investments plummeted (Figure 91) and previous high growth of productivity ceased along with a significant fall in wages and investments that previously fed into consumption and the output boom. The slowdown in lending and consumption coupled with ruble depreciation had also an offsetting effect on an output through significant import compression (Figures 90, 92). Figure 91. Russia: Expenditure Contribution and Quarterly GDP Growth

Source: Authors’ calculations based on International Financial Statistics.

Due to the slowdown in capital inflows and a rising volume of nonperforming and overdue loans, credit growth decelerated as well (Figure 92). One of the main issues in that respect is the health of Russian banking sector as well as the quality of bank supervision in Russia and related uncertainty about the state bank balance sheets. This added more pressure on the credit markets, and it still remains an unresolved issue.

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Figure 92. Russia: Quarterly Imports to Quarterly GDP and Loans to Non-Financial Sector

Source: Authors’ calculations based on International Financial Statistics.

11. Ukraine Ukraine was among the first counties to suffer from the fallout of the global financial crisis. This led Ukrainian authorities to seek the IMF’s assistance under the emergency financing mechanism involving exceptional finance of 16.5 billion US$ equal to 802% of the country’s quota. (IMF 2008c). Two key objectives of the program proposed by the authorities were to stabilize the domestic financial system against a backdrop of global deleveraging and a domestic confidence crisis, and to facilitate adjustment of the economy to the large terms of trade shock. Ukraine’s economy was growing very rapidly since 2000, with average growth in excess of 7% (Figure 93). Initially, this was reflected in supply side factors like utilization of large excess capacity and productivity gains built on a host of structural reforms. Since 2005, a real demand growth averaged about 15% was propelled by a capital inflow driven credit boom (Figures 94, 95) and a redistribution of the large terms of trade gains to the population through income policies.

III Cross-Country Analysis of Financial Fragility in the Emerging Europe

Figure 93. Ukraine: Expenditure Contribution and Real Quarterly GDP Growth

Source: Authors’ calculations based on International Financial Statistics.

Figure 94. Ukraine: Financial and Current Account in Balance of Payments

Source: Authors’ calculations based on International Financial Statistics.

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Figure 95. Ukraine: FDI Inflows

Source: Authors’ calculations based on International Financial Statistics.

By mid–2008, the economy was overheating. Credit growth exceeded 70% per year or between 10 and 20% quarter on quarter (Figure 96). CPI inflation exceeded 30%, wage growth settled in the 30–40% range, a buoyant property market pushed real estate property values to high levels relative to the incomes, while average quarterly imports surged 50–60% in 2008 relative to 2007 average (Figures 96 and 97), reversing the current account surplus into deficit (Figure 94). Figure 96. Ukraine: Quarterly Imports to Quarterly GDP and Loans to Non-Financial Sector

Source: Authors’ calculations based on International Financial Statistics.

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Figure 97. Ukraine: Exports and Imports of Goods

Source: Authors’ calculations based on International Financial Statistics.

On the other hand, the exchange rate was rigidly managed and supported by the abundant FDI and credit inflows (Figure 98), which, coupled with high inflation led to significantly overvalued real effective exchange rate (Figure 99). Figure 98. Ukraine: Change of Foreign Exchange Assets and Liabilities of Banks and Non-Financial Sector

Source: Authors’ calculations based on International Financial Statistics.

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Figure 99. Ukraine: Official and Real Effective Exchange Rate

Source: Authors’ calculations based on International Financial Statistics.

Ukrainian economy was exposed to several factors that had a very strong impact on its external balance. Terms of trade were one of them. Previous gains in the terms of trade stemmed from a rise in steel prices and protracted Russian energy subsidies. Since steel represented 40% of exports and 15% of GDP, and gas imports some 6% of GDP, any changes in prices of the two represented a major impact. The second factor referred to large capital inflows, which left banks and corporations reliant on external funding, with a large share of short term funding. Thirdly, household and corporate balance sheets weakened with increased borrowing denominated in foreign currency, encouraged by low interest rates and a rigidly managed exchange rate regime.54 Finally, fiscal position deteriorated sharply in recent years. Abundant revenues from commodity boom were spent on higher wages and social transfers, lifting them some 220% from 2004 to 2008. Nevertheless, Ukrainian public debt of some 11% of GDP was the lowest in the entire region, giving the country some tailwind during the crisis, enabling it to pursue a relatively large fiscal expansion. Long feared and anticipated shock to the Ukraine’s terms of trade materialized with considerable impact on the real sector. On the export side, the price of steel declined by 65% from mid–2008 to early October, 2008, while, on the import side, Russia started phasing out any remaining gas subsidies. This impacted trade balance severely (Figure 97) and caused 54 More than 60% of total loans of banking sectors were denominated in Euro.

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manufacturing output to contract rapidly. However, during the later stages of the crisis, import contraction turned out to be greater than export contraction, mostly reflecting drastic fall in investments and durable goods consumption, which require bank financing (Figure 96). As a result, current account improved significantly during 2009 (Figure 94), thereby effectively reducing external financing requirements and foreign exchange market pressure on hryvnia. When the crisis hit, Ukraine became on of the first victims of sharp reversal of external capital flows (Figure 98). Risk premium rose sharply to unprecedented levels, with corporate spread above the German Bunds exceeding 40 percentage points. Ukraine’s credit rating was downgraded by rating agencies and kept on the negative outlook even after the downgrade. Political instability, which intensified in late 2008, began to increasingly affect perception about the course of the country’s policies in the remainder of the year and years to come. The main concern was that the underlying election campaign brought expensive political promises, which proved to be difficult to reverse even though such promises meant ballooning of the public spending and domestic demand (Figure 100). Figure 100. Ukraine: Central Government Cash Receipts, Payments and Cash Balance

Source: Authors’ calculations based on International Financial Statistics.

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Finally, confidence in the banking system deteriorated swiftly after bad news about banking groups, which operated in country swamped local media. The sixth largest bank55 in the country was put under receivership in early October, which ignited a widespread outflow of households’ savings of roughly 20% of all deposits over the next six months. The authorities responded by imposing limits on early withdrawal of time deposits, which slowed the outflow, but confidence remained fragile. The confidence crisis spilled over to the foreign exchange market, where hryvnia started depreciating rapidly (Figure 99). The National Bank of Ukraine intervened with more than 4 billion US$ in the foreign exchange market in October (Figure 101). The National Bank of Ukraine tried to stem the outflows by imposing a set of exchange rate controls, like restriction on early withdrawal of time deposits, prohibition of early repayment of foreign exchange loans by banks, etc. Figure 101. Ukraine: Foreign Exchange Reserves

Source: Authors’ calculations based on International Financial Statistics.

The banking sector turned out to be scarcely capitalized. This effectively curtailed lending which was anyway decelerating (Figure 96) due to overleveraged bank balance sheets with loan to deposit ratio in excess of 140%. Another problem in respect of lending was a high concentration of foreign currency loans to non-tradable sectors, such as trade and consumer business or construction. Non-performing loans increased 5–fold until the end of 2009 in comparison with the beginning 55 Prominvestbank.

| 127 of 2008 and this required an estimated capital increase in both domestic and foreign owned banks of approximately 8% of GDP. The driver behind rise in non-performing loans, aside from contracting output and demand was large rate of loan euroization of 63%, most of it on the part of unhedged borrowers. On top of that, corporate sector had large external debt (cross-boarder debt), out of which 30 billion US$ was coming due in 2009. Because of all these factors, Ukrainian output contraction exceeded 15% in the first three quarters of 2009 (Figure 93). All spending categories slumped, including imports which had offsetting effect on the aggregate output fall.

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hat we can see clearly, in this moment, is that while some of the CESEEE only have to wait patiently for the crisis resolution in developed countries, others have to reinvent their growth model from scratch if they want to avoid constant “boom and bust” cycles. The purpose of this section is to explore impact of the crisis on different CESEEE and provide an insight into which variables matter the most. Notably, we will analyze why there is a large variability of the output decline between the countries in the region, which macroeconomic variables and vulnerabilities have played important roles and to which extent different countries have been susceptible to main channels of the crisis impact. We will also compare the findings of this analysis with recent findings of other authors on the same topic, which, however, did not have the opportunity to include the actual macroeconomic data spanning to one full year following the Lehman shock, but rather relied on projections and the projection revisions or the actual data covering only two quarters after the shock. By doing this, we actually distinguish between determinants

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that really turned out to be relevant for the time being and ones, which were simply adding noise. Abovementioned research papers recently published that will be used both as a model, in terms of the included variables and research methodology, as well as for comparison of the observed results, are those of Pelin Berkmen, Gaston Gelos, Robert Rennhack, and James Walsh (2009) and Erik Berglöf, Yevgeniya Korniyenko, Alexander Plekhanov, and Jeromin Zettelmeyer (2009). The first paper, analyzes, inter alia, the impact of financial and external vulnerabilities, financial and trade links to advanced countries, exchange rate regimes, fiscal positions and few other variables on the output of developing countries. To measure the strength of the impact, these authors focus on the output growth forecasts in April 2008, before the peak of the crisis, and on the forecast revision in April 2009, after the peak of the crisis. (Berkmen et al. 2009). Both the domestic credit to deposit ratios before the onset of the crisis and the cumulative bank credit growth in the period of 2005–2007, which were used to gauge the level of financial vulnerability were shown to be clearly positively correlated with the size of the downward growth forecast revisions. The impact of trade links to advanced countries was measured by the composition of exports, i.e. the share of food and manufacturing commodities in total exports, and they found weak correlation between the larger share of manufactured goods and the growth forecast revisions. Borrowings from advanced countries, representing a measure of the financial linkages, were shown to be a very important link for crisis transmission. The deleveraging that started with the crisis had much greater impact on countries in the emerging Europe given that they relied more heavily on these borrowings than other countries. The current account deficit that was taken as a proxy of the external vulnerability had a moderate impact on the output forecast revisions. These authors found that the flexibility of the exchange rate regime as well as a strong fiscal position in the run up to the crisis were positively correlated with a milder growth forecast revisions. Finally, the EU accession countries were hit much harder than other countries, due to their stronger linkages with the EU countries. The second research paper (Berglöf et al. 2009), focuses on the group of developing countries in the emerging Europe. The most important finding of these authors was that although the crisis in advanced countries had been severe, the Central, East and Southeast European region was surprisingly resilient, despite considerable accumulation of vulnerabilities in pre-crisis period and that the regional crisis failed to exhibit some of the attributes of past crisis in developing countries. They reiterated that no country in this region experienced a disorderly depreciation of foreign exchange rates, there were no systemic banking crises and no exchange rate overshooting. They related the resilience to the European integration model, particularly

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the financial integration through banking groups as well as the political and institutional integration. The financial integration moderated the impact of the capital flow reversals and helped to avoid twin crises, while the other integration processes explained why there were no destructive and protectionist policy swings, like capital and trade controls. Like in the abovementioned paper, Berglöf et al. (2009) also found a very strong link between pre-crisis debt levels, rapid credit growth and severity of the output decline, which they dubbed as the “mixed blessing” in the crisis. Concerning the actual output, which was measured as the cumulative output decline in the fourth quarter of 2008 and the first quarter of 2009, they found that several determinants exhibited a statistically significant association with the output decline. These were the domestic credit growth during 2005–2008 and the foreign bank ownership, whereby the later had a stabilizing effect. Other variables like the rigid exchange rate regime, the foreign debt to GDP, the cross-border lending and a few others remained statistically insignificant. Extending their analysis to the world-wide sample, they found that previous positive output gap, GDP per capita as a measure of the overall development, the stock of private sector debt to GDP as a measure of the financial development, the loan-to-deposit ratio, the financial integration and the external debt to GDP (the last two only for the emerging Europe) were significantly correlated to the output decline, whereby the financial integration56 had a positive sign, i.e. it was again a stabilizing determinant. In order to conduct empirical research, we will partially replicate the methodology of these two papers by using some of the variables that they used, notably the GDP growth rates, the current account deficits, the exports, the imports, the exchange rate regimes, the real effective exchange rates, the growth of domestic credit to private sector, the domestic loanto-deposit ratio, the net foreign debt, the foreign capital inflows to banking and non-financial sectors, the loan euroization and the fiscal deficit. However, we will extend the research in order to match the actual quarterly data for these variables up to the end of the third quarter of 2009 against the actual output decline data, also up to the end of third quarter. To explore the impact of the abovementioned determinants we will group the countries with similar features and observe the differences between the groups in terms of the output decline as well as other relevant variables. In order to compare different groups of countries we will calculate the average value for the analyzed variable for every group and compare it to the average values for other groups. Also, to number of already analyzed we will add four more countries for which there is sufficient quarterly data in period between 2000 and the third quarter of 2009: Estonia, Lithuania, 56 Measure of financial integration is ratio of country’s foreign assets and liabilities relative to GDP.

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Slovenia and Turkey.57 The composition of groups will be as coherent as possible, given that some countries exhibit dual features. For example, Bulgaria is in many aspects similar to the Baltic countries but it is very much different in some other important aspects, notably the behavior of domestic credit and bank foreign borrowings. Therefore it will frequently change groups to which it is assigned. Another example is Slovakia, which is very similar in many aspects to the Czech Republic and Poland, but it adopted the Euro as of January, 2009, whereas the other two remained on the floating exchange rate regimes. Therefore, it will also be assigned to different groups, depending on the issue being analyzed.

1. Factual Results and the Analysis of Individual Vulnerabilities The most obvious impact of the crisis was on the output, not only in the emerging Europe, but across the globe. However, the emerging Europe stands out in terms of the depth of output contraction. As Figure 102 shows, there is a considerable variability of the crisis-driven output contraction across the region. Figure 102. Output Growth Before and After the Crisis

Groupings: CEE includes Poland, the Czech Republic and Slovakia. Baltic includes Estonia, Latvia and Lithuania. Commodity exporters group includes Russia and Ukraine. Other floaters group includes Romania, Turkey and Hungary. Other fixers group includes Bulgaria, Croatia and Slovenia. Source: Authors’ calculations based on International Financial Statistics. 57 Turkey was included in the group because of its similarities to transitional CESEEE in terms of excessive borrowing, rate of euroization and current account deficits, even though it was never a centrally planned economy.

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This variability reflects a link between the rapid pre-crisis growth rates and the deeper contraction following the sudden stop, which is in line with the finding of Berglöf et al. (2009). It is not the growth per se that is responsible but its composition and the drivers behind it. Some countries, notably the Czech Republic, Slovakia and Poland, based their growth model on a balanced development of both tradable and nontradable sectors. It enabled them to be less dependent on foreign capital inflows to finance their investments and consumption. This implies that their domestic savings and investment were relatively balanced, as well as the current accounts, while the stocks of foreign debt were moderate. The most important was that their growth was constrained only by the changes in domestic and export demand and not by the availability of the foreign capital. On the other side were countries, which pursued the income convergence model by higher growth rates, but based on the faster growth of the non-tradable than tradable sectors. Such a growth was financed by the foreign borrowings, because the domestic savings fell short of the investment needs, which led to a steady accumulation of foreign debts. It hampered export competitiveness because of the real foreign exchange appreciation and caused wide current account deficits. Such current account deficits could only be financed by constant foreign capital inflows. In the later group of countries, all expenditure items including investments, changes in inventories, domestic consumption and imports depended strongly on the availability of foreign capital as well as the cyclicality of domestic and export demand. Following the Lehman shock and a sudden stop of the capital inflows such countries experienced a much deeper output contraction than those which had a more balanced growth. Another group of countries, which have been heavily affected by the crisis, are the commodity exporters, notably Russia and Ukraine. Favorable terms of trade and global demand before the crisis, caused the “Dutch disease”58 in Russia and led to underdevelopment of manufacturing tradable sectors, while Ukraine depended heavily on the cycle in global industries that consume steel. Once the terms of trade reversed due to the global output slump, Russia and Ukraine experienced a sharp reversal of the export revenues, which had more detrimental effect on their output comparing to the other countries. Aside from the output growth another variable that was driven by the chosen growth model was the current account deficits. The current account deficits in the run up to the crisis were closely related to the 58 Dutch disease signifies the deindustrialization of a nation’s economy that occurs when the discovery of a natural resource raises the value of that nation’s currency, making manufactured goods less competitive with other nations, increasing imports and decreasing exports. The term originates from Holland after the discovery of the North Sea gas in 1959.

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growth model that countries ran, excluding the commodity exporters Russia and Ukraine. This was reflected in the negative association between the growth rates and current account deficits (Figure 103). Figure 103. Output Growth and Current Account Deficits Before the Crisis

Groupings: Export-led growth group includes Poland, the Czech Republic, Slovakia, Turkey, Slovenia, Croatia and Hungary. Consumption-led growth group includes Estonia, Latvia, Lithuania, Romania and Bulgaria. Commodity exporters group includes Russia and Ukraine. Source: Authors’ calculations based on International Financial Statistics.

Those countries, that had sustainable growth based on the balanced development of tradable and non-tradable sectors, as reflected in satisfactory growth rates coupled with the low current account deficits, managed to contain the accumulation of vulnerabilities. The low current account deficits implied the low external debts and less reliance on the foreign borrowings. Hungary and Slovenia are included in this group, even though they accumulated large stock of foreign debt, since this accumulation was, to a significant extent, used for reinvestments abroad, and not exclusively for domestic consumption and investments, like in the case of countries that ran a consumption-led growth model. Croatia is also included in this group because it seems that, at least, a part of its rapidly accumulating foreign debts were predominantly used for investments in the tradable sectors, mostly tourism, resulting in a much lower current account deficits comparing to consumption-led growth cases. On the other hand, countries that pursued consumption-led growth, experienced much deeper current account deficits, reflecting not only the growing investments but also the rapidly growing domestic consumption, both of which were faster than the export growth and both facilitated by the abundant foreign capital inflows, mainly in the form of cross-border loans to banks and real sector.

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However, once advanced countries underwent a sharp liquidity contraction, one of its main results was a steep and prolonged compression of their consumption and investment expenditures. The immediate consequence was a considerable decline in export demand for the goods and services produced in emerging Europe (Figure 104). Figure 104. Cumulative Fall of Exports

Groupings: CEE includes Poland, Slovakia and the Czech Republic. Baltic and Bulgaria group includes Estonia, Latvia, Lithuania, Bulgaria. Commodity exporters group includes Russia and Ukraine. Other floaters group includes Romania, Turkey and Hungary. Other fixers group includes Slovakia, Croatia and Slovenia. Sources: Authors’ calculations based on International Financial Statistics and Eurostat.

Notwithstanding a considerable depreciation of almost all floating currencies throughout the region, there is no major difference in terms of export performance between countries with floating and those with fixed exchange rates. This is in line with conclusion of Marek Belka (2009), who suggested that even improved export competitiveness did not help much when the export demand from advanced countries was deeply subdued and did not produce positive supply response. Berglöf et al. (2009) also failed to find a statistically significant impact of the exchange rate regime on the level of exports. Moreover, numerous depreciations across the globe simultaneously improved competitiveness in many export competing countries, unlike in the case of a short-term collapse in financing like in Mexican, East Asian and other crises in the past. However, once recovery takes hold, those countries that experienced currency depreciation will likely benefit more than those with rigid exchange rate regime. On the other hand, only commodity exporters, in this case Russia and Ukraine, whose respective export structures are dominated by the energy and steel,

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posted significantly deeper export contraction, probably reflecting the depth of the global slump of industrial production. When it comes to imports, the crisis was more discriminatory. As shown in Figure 105, the most affected were the countries with rigid exchange rates, which contrasts the expectations that these countries will continue to have elevated import demand. Figure 105. Cumulative Fall of Imports

Groupings: CEE includes Poland, Slovakia and the Czech Republic. Baltic and Bulgaria group includes Estonia, Latvia, Lithuania, Bulgaria. Commodity exporters group includes Russia and Ukraine. Other floaters group includes Romania, Turkey and Hungary. Other fixers group includes Slovakia, Croatia and Slovenia. Sources: Authors’ calculations based on International Financial Statistics and Eurostat.

Moreover, there is not much difference between floaters and fixers. The only other group that stands out are commodity exporters, because of Ukraine’s exceptionally large import compression, whereas Russia is in line with the average. It points to a possibility that some other factors underpin a more pronounced import adjustment in some of these countries. One of these factors is the capital inflow sudden stop, which left the recipient countries without the inflows of the foreign exchange needed to finance the current account deficits. It implies that those countries that had run a larger current account deficits relied more on the foreign capital. Following the Lehman shock, these countries had to sustain a deeper import contraction. This is in line with findings of Calvo, Izquiredo, and Mejia (2004) that the cessation of the capital inflows forces a country with larger current account deficit to a sharper reduction of the absorption of the tradable goods.

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Having in mind the previous findings about the impact of the crisis on the exports and imports, it is logical that the countries with larger trade deficits exhibited a larger trade balance improvement leading to a larger current account improvement (Figure 106). Figure 106. Current Account Adjustment After the Crisis

Groupings: Small CA deficits group includes Poland, Slovakia, the Czech Republic, Turkey, Hungary, Croatia and Slovenia. Large CA deficits group includes Estonia, Latvia, Lithuania, Bulgaria and Romania. Commodity exporters group includes Russia and Ukraine. Notes: CA denotes current account deficit; commodity exporters have recorded approximately zero CA deficit in 2008Q4–2009Q3. Sources: Authors’ calculations based on International Financial Statistics and Eurostat.

The level of the current account deficits prior to the crisis is one of the most important determinants of the size of its subsequent adjustment. This is related to the fact that after the Lehman shock and the ensuing cessation of foreign financing, developing countries could no longer afford to run large current account deficits. However, one has to have in mind that this mechanical improvement in trade and current account deficit does not reflect an increasing competitiveness and shifting of the demand towards domestic goods, but rather a steep and painful adjustment of the personal consumption. One seemingly puzzling result of our analysis is the fact the countries with rigid exchange rates, which did not exhibit any real effective exchange rate depreciation, did exhibit the strongest current account improvement (Figure 107).

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Figure 107. Real Effective Exchange Rate and Current Account Adjustment during the Crisis

Groupings: Floating group includes Poland, the Czech Republic, Romania, Turkey and Hungary. Fixed group includes Estonia, Latvia, Lithuania, Bulgaria, Croatia, Slovenia and Slovakia. Commodity exporters group includes Russia and Ukraine. Note: Increase of the real effective exchange rate denotes real appreciation while decrease denotes real depreciation. Sources: Authors’ calculations based on International Financial Statistics and Eurostat.

What is more, some of the countries with fixed exchange rates exhibited considerable real exchange rate appreciation after the Lehman shock, mostly because of persistently higher inflation rates in comparison with their major trading partners, despite a severe output contraction and steep unemployment growth. Data for the last quarter of 2009, which is available for some of these countries show that only recently the real effective exchange rate has started to depreciate as these countries entered deflation. Even though the countries with currency board arrangements or hard pegs rejected the idea about devaluation stating that their fixed regimes were the most important nominal anchors and symbols of the stability, it seems that their strategies of “internal devaluation” through large deflation would come, as Minsky suggested, at a very high cost in terms of the output contraction, employment, consumption and living standards, as well as large implementation risks. (IMF 2009e). One of the main risks is that once the global recovery takes hold, these countries will suffer a subdued export increase and a very slow growth. Looking at other countries in the region, the size of the real effective exchange rate depreciation does not correspond to the size of the current account adjustment. This shows that, so far, the compressed imports and other

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factors have had more influence on the current account than the real exchange rate depreciation. Even though the current account balance had an important role when the crisis hit, another set of vulnerabilities was much more important. These are the financial vulnerabilities, which have accumulated in most of the countries in the emerging Europe during the 2000s. In order to analyze the impact of the financial vulnerabilities we will use two representative variables, used by other authors as well, the credit to deposit ratio and the credit growth. As we mentioned earlier, countries which embarked on the consumption-led growth model driven by the credit boom, experienced the higher output growth but at the same time suffered from the larger current account deficits (Figure 108). Figure 108. Average Quarterly Current Account Deficits and Growth of Domestic Credit to Private Sector Relative to GDP Before the Crisis

Groupings: Rapid credit growth group includes Estonia, Latvia, Lithuania, Bulgaria and Romania. Moderate credit growth group includes Poland, the Czech Republic, Slovakia, Turkey, Hungary, Croatia and Slovenia. Commodity exporters group includes Russia and Ukraine. Sources: Authors’ calculations based on International Financial Statistics and Eurostat.

Leaving aside Russia and Ukraine, which benefited from favorable terms of trade, there was an observable relation between current account deficits and the credit boom, which occurred in many countries in the region in the pre-crisis years. This is in accordance with findings of Berkmen et al. (2009) and Berglöf et al. (2009). Such a credit boom facilitated the rapid increase of private consumption, investments, inventories and imports, which all spilled over into rapid output growth as well as the rapid current account deficit growth. As we saw in the previous chapter, this credit boom was dominantly financed by the foreign borrowings. The countries in the region enjoyed a comfortable position, as

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low interest rates in the international financial markets and the easy access to foreign liquidity provided them with an opportunity to decouple their investments from domestic savings by borrowing heavily from abroad. However, once the crisis hit, the countries in the region were discriminated in terms of the impact of the financial vulnerabilities on the output. The capital inflows suddenly stopped and left the countries relying on a consumption-led growth model without foreign borrowings needed to continue financing their credit booms. This, coupled with a fall of the export demand, exerted a much larger pressure on the output of consumption-led countries (Figure 109) than on the countries, which financed their expenditures largely from their domestic savings. Figure 109. Domestic Credit to Non-Financial Sector and the Output Decline During the Crisis

Groupings: Severe credit crunch group includes Estonia, Latvia, Lithuania, Bulgaria and Romania. Moderate credit crunch group includes Poland, the Czech Republic, Slovakia, Turkey, Hungary, Croatia and Slovenia. Commodity exporters group includes Russia and Ukraine. Sources: Authors’ calculations based on International Financial Statistics and Eurostat.

Moreover, as real sector’s solvency deteriorated, banks’ credit standards tightened and additionally reinforced this downward spiral. The capital inflow sudden stop inflicted a credit crunch and dragged down the investments, the inventories and the domestic consumption. Those countries, which relied more on domestic savings tended to exhibit a weaker contraction of the credit enabling them to get by with a more moderate consumption and investment decline, resulting in a milder output contraction. This result is in line with that of Berkmen et al. (2009) and Berglöf et al. (2009).

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In line with the previous findings, the credit crunch caused a much stronger current account improvement in those countries that were running larger current account deficits prior to the crisis. This, coupled with the finding of the impact of the credit crunch on the output, supports the notion that the large current account deficits in the run up to the crisis were a byproduct of the unsustainable output growth model, based on the excessive investments in the production of the non-tradable goods and their consumption. Once the crisis erupted, the domestic savings became the only source of financing but they were far from sufficient to facilitate previous consumption and investment patterns. The financing became a main constraint for the output growth and caused a deep contraction of all expenditures. Due to the deep contraction of all expenditure items, imports declined much more than in the case of countries with more balanced growth in terms of the investments-savings balance. Aside from that, the group of countries with the rapid credit growth accumulated larger stock of foreign debts, which raised their foreign debt service outflows to a very high level comparing to the export revenues, and crowded out the imports. The immediate consequence was the significant current account adjustment proportional to the credit growth adjustment (Figure 110). Figure 110. Domestic Credit to Non-Financial Sector and Current Account Improvement During the Crisis

Groupings: Severe credit crunch group includes Estonia, Latvia, Lithuania, Bulgaria and Romania. Moderate credit crunch group includes Poland, the Czech Republic, Slovakia, Turkey, Hungary, Croatia and Slovenia. Commodity exporters group includes Russia and Ukraine. Sources: Authors’ calculations based on International Financial Statistics and Eurostat.

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Furthermore, another determinant of output decline turned out to be important in the wake of the crisis. The leverage of the banking system, measured as the ratio of domestic loans to deposits was one of the most important vulnerabilities and this confirms (Figure 111), the findings of Berglöf et al. (2009) and Berkmen et al. (2009). Figure 111. Domestic Credit to Deposit Ratio (Leverage) and the Output Decline During the Crisis

Groupings: More leveraged group includes Romania, Estonia, Latvia, Lithuania, Hungary, Bulgaria and Slovenia. Less leveraged group includes Poland, the Czech Republic, Slovakia, Turkey and Croatia. Commodity exporters group includes Russia and Ukraine. Sources: Authors’ calculations based on International Financial Statistics and Eurostat.

Those countries that exhibited the largest leverage saw a rapid and deep deleveraging when the crisis hit. The high leverage seen in these countries was an outcome of the rapid credit growth coupled with insufficient domestic savings, which were replaced by foreign borrowing. When foreign capital suddenly stopped flowing in, it inflicted the credit crunch and severe consequences on the real sector comparing to the less leveraged countries in the region. Another interesting result from this analysis is that Slovenia and Hungary suffered considerably larger output fall than the Czech Republic, Poland or Slovakia although we classified them as well as export-led countries since they both had moderate balance of goods and services deficits and strong exports.59 Even though these five countries are 59 Average balance of goods and services deficit in the period between 2001 and 2008 was 1.8% of GDP in Hungary and 0.6% of GDP in Slovenia. Also, average share of exports

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commonly treated as a homogenous group of most successful developing countries in the emerging Europe, because they share many similarities, there are two distinctive differences, which explain the different rates of output contraction between the two subgroups. Slovenia and Hungary have had much more leveraged banking systems, with ratios of domestic loans to deposits around 1.6 whereas for the other three countries this ratio was close to 1. Also, these two countries had much larger stocks of foreign debts (over 100% of GDP) than the other three (around 50% of GDP). The former group exhibited a faster domestic credit growth in the run up to the crisis than the later. Slovenian banks have been highly leveraged, much more than the banking sectors in other Euro Area countries, which reflected the decoupling of the rapid domestic and crossborder credit expansion from the increase of domestic deposits. One third of the Slovenian banking sector’s liabilities were foreign debts, of which one third was short term. (IMF 2009m). Slovenian banking sector was deeply engaged in the “leveraged management buy-outs” and other forms of asset-backed lending, with largest exposure to an individual group (the Balkan countries) of roughly 800 million US$. When real estate and share price bubbles burst, many of these loans turned non-performing. Foreign investors considered large exposure of the Slovenian banking sector to other Balkan countries as a possibly strong contagion channel, which caused risk premiums to surge. Additionally, Slovenia suffered from the largest inflation in the Euro Area and recorded largest wage growth. Because of that, the external competitiveness of Slovenian exporters diminished significantly. It resulted in a steady increase of the current account deficit in the years leading-up to the crisis. The deleveraging process that spread throughout the global banking sector and the ensuing credit crunch, affected Slovenia and Hungary much more, because their banking sectors were relying more on the “wholesale” credit market, i.e. bond issuance and direct bank borrowing from abroad rather than domestic deposits. Slovenian enterprises were hit hard because of their heavy reliance on the bank credit of almost 80% of GDP, which was greater than in any other Euro Area member country (average 75%) or new EU member states (less than 50% except in Bulgaria, Latvia and Estonia). One of the consequences was significantly deeper fall of consumption in the case of Hungary and investments in the case of Slovenia, comparing to the other three countries. The fall of consumption led to a fall of the imports, because of which the current accounts of Slovenia and Hungary improved more than in the other three Central European countries. of goods and services in GDP in the same period was 71% in Hungary and 62.3% in Slovenia. International Financial Statistics.

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What made the credit boom in most of the countries in the region unsustainable was the fact that it was decoupled from domestic savings, meaning that it had to be mainly financed by the cross-border credit flows, i.e. the foreign savings (Figure 112). Once the crisis hit, foreign capital stopped flowing in and the credit crunch ensued across the region. Countries that had more leveraged banking system, as measured by the domestic loan to deposit ratio, tended to accumulate more foreign debts. The logic here is straightforward: banks had to borrow from abroad since the domestic savings, reflected in the bank deposits, were not sufficient to finance the credit activity. The Czech Republic is an outlier in that sense, since its ratio domestic credits to deposits is lower than one, which is reflected in the negative net foreign debt, i.e. the Czech Republic is a net creditor. Figure 112. Net Foreign Debt to GDP and the Domestic Credit to Deposit Ratio

Groupings: More leveraged group includes Romania, Estonia, Latvia, Lithuania, Hungary, Bulgaria and Slovenia. Less leveraged group includes Poland, the Czech Republic, Slovakia, Turkey and Croatia. Commodity exporters group includes Russia and Ukraine. Notes: Net foreign debt is equal to the stock of foreign debt, including the issued debt securities less the claims against foreign debtors and the foreign exchange reserves. For countries for which data is not available for 2008Q3, the net foreign debt is calculated from data for 2007 year-end, which was corrected for relevant flows from the balance of payments section of the IFS. For consistency purpose, the data for Ukraine was corrected by the exclusion of the foreign currency holding of households (“mattress money”). Sources: Authors’ calculations based on International Financial Statistics and web sites of central banks.

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One more outlier is Hungary. Its stock of net foreign debt was much larger than suggested by its domestic loans to deposits ratio. This was due to highly developed capital market and the stock of debt security liabilities as well as considerably larger government foreign debt comparing to other countries. The country exhibited large general government deficits throughout the 2000s, between 4% of GDP and 9% while general government expenditure stayed close to 50% of GDP and it was dominated by the current expenditure. The public debt reached 70% prior to the Lehman shock and than jumped to more than 82% by the end of the first quarter 2009 due to the forint deprecation and a large foreign exchange rate risk exposure of the Hungarian Government. During the pre-crisis years Hungary was able to finance these deficits and the debt amortization, totaling 25 billion US$ on average, by issuing new bonds. However, when the crisis hit, foreign creditors changed their sentiment and rushed to sell their stock of government bonds. Portfolio bond investments reversed sharply reducing the stock of respective liabilities by 20 billion US$ in less than a year from the second quarter 2008. The immediate effect was the Hungarian Government suddenly faced a financing gap of 54 billion US$ at the end of 2008 (IMF 2009d). Even though the country ran a flexible exchange rate its high rate of debt euroization constrained significantly the tolerance to the exchange rate variability. This was confirmed by a sudden jump of public debt as well as the foreign debt relative to the GDP, from 97% in 2007 to 137% at the end of 2009 (IMF 2010). These debts became unsustainable and the country had to ask for a large bailout loan from the IMF and the EU, even though this did not prevent a considerable damage to be inflicted on unhedged non-financial debtors that borrowed in the Euro and Swiss francs. Finally, Russia is another outlier because it had abundant official foreign exchange reserves that influenced the stock of the net foreign debts, but on the other hand its banking sector was highly leveraged. The strong relation between the domestic loan to deposit ratio and the net foreign debt indicates why the capital inflow sudden stop was an important channel for crisis spillover. It directly affected the lending activity of the local banks. This confirms the findings of Berkmen et al. (2009) and Berglöf et al. (2009). The dependence of the banking sectors in the emerging Europe on foreign borrowings took its toll when the crisis hit. Local banks, especially in those countries whose banking sectors were more dependent on foreign borrowings, like the Baltic countries or Slovenia (Figure 113), could no longer increase their loan books and the credit crunch ensued.

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Figure 113. Reversal of the Foreign Credit Inflows to Banks and Other Non-Financial Sectors

Groupings: More indebted group includes Romania, Estonia, Latvia, Lithuania, Hungary, Bulgaria and Slovenia. Less indebted group includes Poland, the Czech Republic, Turkey and Croatia. Commodity exporters group includes Russia and Ukraine. Data for Slovakia is unavailable. Note: Slovakia is excluded since, due to the Euro adoption in 2009, data is not comparable. Source: Authors’ calculations based on International Financial Statistics.

These bank capital flow reversals had a strong impact on the level of the foreign exchange reserves of central banks throughout the region, as well as on the exchange rate of the floating currencies. On the other hand, reversal was milder when it comes to the foreign borrowings of other sectors, i.e. the direct cross-border loans to enterprises. Finally, the FDI flows rarely turned negative, and in the cases when they did, it reflected changes in the inter-company lending flows that were statistically recorded as the FDI. Poland is a special case as the crisis did not affect bank foreign borrowings as strongly as did in the other countries but it had a strong impact on the portfolio debts investments, i.e. on the bond issuance, therefore hampering the ability of bond issuers to finance their projects. Credit crunch and ensuing sharp reversal of foreign credit inflows to banks and other non-financial sectors had a very strong impact on the output, and those countries that relied more on the foreign borrowings before the crisis, as reflected in their net foreign debts, suffered a deeper output decline (Figure 114).

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Figure 114. Net Foreign Debt and the Output Decline

Groupings: More indebted group includes Romania, Estonia, Latvia, Lithuania, Hungary, Bulgaria and Slovenia. Less indebted group includes Poland, the Czech Republic, Slovakia, Turkey and Croatia. Commodity exporters group includes Russia and Ukraine. Note: Average quarterly GDP decline y-o-y, for the period 2008Q4–2009Q3, given in reverse order. Sources: Authors’ calculations based on International Financial Statistics and web sites of central banks.

The leverage of the banking sector acted as an intermediary here, since it is related to the output decline, on one side, and to the net foreign debt on the other side which reflected the previous reliance on foreign capital inflows. This is the most important crisis transmission channel. It explains the causal relationship between stock of the net foreign debt, and an output decline following a sudden stop of capital inflows. Driven by credit boom financed by foreign borrowing, the countries that had larger stock of the net foreign debt experienced a larger output growth in the run up to the crisis. Once the foreign borrowings were cut, the credit crunch ensued and these countries suffered a deeper downturn. Another interesting finding from this analysis is that most of countries that concluded arrangements with the IMF had the stock of net foreign debt close to or above 20% of GDP, with four exceptions. One exception is Romania whose stock was considerably below this threshold, while Turkey, Croatia and Bulgaria refrained from seeking the IMF assistance even though their respective stocks were above or at the threshold. Turkey did not seek IMF assistance and tried to weather the crisis on its own. Croatia and Bulgaria did experience a severe impact on their foreign currency

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reserves, but they opted to wait and see how the crisis would unfold given that they still had ample foreign currency reserves while their currencies were pegged to the Euro. On the other side, Romania quickly sought an arrangement with the IMF since its freely floating currency depreciated swiftly hurting the unhedged corporate and household borrowers. As a corollary to the output decline caused by the credit crunch, more leveraged countries experienced a larger current account improvement (Figure 115). The strong fall of the export demand from advanced countries caused an indiscriminate and roughly equal fall of exports, of approximately 30%, in all countries in the region, except Russia and Ukraine, which suffered a more pronounced fall. On the other hand, decline of imports exhibited larger variability across the countries. Those economies that financed their consumption and investment growth by foreign borrowings, suffered a much deeper contraction of all expenditure items, which was reflected in a stronger current account improvement comparing to export-led countries. Figure 115. Net Foreign Debt and Current Account Adjustment

Groupings: More indebted group includes Romania, Estonia, Latvia, Lithuania, Hungary, Bulgaria and Slovenia. Less indebted group includes Poland, the Czech Republic, Slovakia, Turkey and Croatia. Commodity exporters group includes Russia and Ukraine. Sources: Authors’ calculations based on International Financial Statistics and web sites of central banks.

Additionally, once foreign financing stopped, more leveraged countries had to cut their expenditures more than the less indebted economies, in order to be able to service their foreign debts that could no

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longer be refinanced by fresh foreign borrowings (speculative and Ponzi financial units). The euroization of bank credits is frequently reiterated as one of the most important determinants of a sudden stop crisis. Even though the data presented in the Figure 116 suggest that there is a link, we find that this could be a misleading relation. This is because only three countries in this dataset, which had large rate of credit euroization, suffered the currency depreciation, and these were Romania, Hungary and Ukraine. Other countries with large output contraction did not suffer any changes in the exchange rate. We can infer that this seeming relation should actually be attributed to the domestic credit to deposit ratios, which were higher for those countries that relied more on the foreign borrowings. The credit euroization will take its toll over the medium run in those countries whose currencies depreciated significantly by putting pressure on real sector’s cash flows and through that, on the investments and consumption. Figure 116. Loan Euroization in 2008 and the GDP Decline

Abbreviations: Cz – the Czech Republic, Sk – Slovakia, Pl – Poland, Ru – Russia, Ro – Romania, Hu – Hungary, Hr– Croatia, Sl– Slovenia, Bg – Bulgaria, Lt– Lithuania, Et – Estonia, Lv – Latvia. Note: Data for Slovakia and Slovenia is excluded since they are members of the Euro Area, while data for Turkey and Russia is not available. Source: Authors’ calculations based on International Financial Statistics.

In most countries we have analyzed, the credit euroization was above 50%, and would be much higher if we included the direct cross-border loans to the real sector. Given such a high rate of credit euroization any

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larger depreciation or devaluation would lead to heavy balance sheet effects and large financial losses in the real sector. This would certainly wreck havoc in the affected economies, cause large spread bankruptcies and decimate the output. Depreciation of local currencies would not exert positive influence on exports, since indebted units would have not enough breathing space to save production and jobs. In addition, if we made an unrealistic assumption that majority of producers would survive drastic increase in real value of debt, weak export demand would certainly strongly constrain the positive effects of declining value of local currency. Naturally, the “fear of floating” was clearly visible in some of the countries like Romania and Hungary that quickly turned to the IMF and the EU for rescue. Romania had relatively low level of net foreign debt relative to the GDP, while Hungary had large stock of debt but well balanced foreign trade. Even though, one could conjecture that both countries had no apparent reason to fear the foreign exchange depreciation, based on the stock of net foreign debt or the current account deficit, it was most likely that the high rate of credit euroization scarred policy makers and compelled them to ask for international assistance. On the other hand, countries with fixed exchange regimes but high rate of credit euroization, fearing harsh consequences of a potential real foreign exchange rate devaluation on their unhedged real sector, opted for harsh and counterproductive measure of “internal devaluation” through deflation, which they saw as the only remaining option to improve their external competitiveness (Bulgaria, Latvia, Lithuania, Estonia). Concerning the fiscal position before the crisis, Berkmen et al. (2009) found that the fiscal balance was positively associated with the better output performance, but our analysis of the general government fiscal balance did not support that finding (Figure 117). This probably reflects two facts: prior to the crisis, most countries had acceptable fiscal deficits or even small surpluses, but some of them owed that to the good fiscal policy while others to the consumption and import boom which temporarily raised their fiscal revenues. The other fact is that the impact of the credit crunch on the final consumption, the investments and the exports was much stronger than the effect of the fiscal expansion. Additionally, only a few countries were able to pursue a real fiscal expansion, beyond the automatic stabilizers. On top of that, the aggregate demand is relatively less responsive to fiscal stimulus in developing countries in comparison to advanced ones.60 60 Due to the fact that in the case of a small country most of the fiscal stimulus spills over into imports.

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Figure 117. Fiscal Positions and the Output Decline

Abbreviations: Cz – the Czech Republic, Sk – Slovakia, Pl – Poland, Ro – Romania, Hu – Hungary, Hr– Croatia, Sl– Slovenia, Bg – Bulgaria, Lt– Lithuania, Et – Estonia, Lv – Latvia. Notes: Data for Turkey and Ukraine is not available. General government fiscal balance available for the Czech Republic, Slovakia, Poland, Romania, Hungary, Bulgaria, Slovenia, Lithuania, Estonia and Latvia. For Croatia, only fiscal cash flow statement for central government was available and therefore included in the analysis. Source: Authors’ calculations based on International Financial Statistics.

Summarizing the analysis presented in this section we can conclude that liquidity contraction in advanced countries, that led to severe credit crunch and consumption slump, had a very strong impact on the export demand for developing countries products. The impact was strongest on the durable consumption and investment goods, whose purchase was usually financed by bank credits. Countries in the emerging Europe experienced the large and indiscriminate fall of their exports in the wake of the crisis, which was close to 30%. This had a very strong impact on the output. However, in the relatively short period of one year following the spill over of the crisis to the region, there was no strong evidence of a differentiated impact of the export demand slump on the CESEEE. Put differently, the impact of the trade link on the output was relatively equally dispersed throughout the region. Financial vulnerabilities, on the other hand, were much more important determinant since they exerted strong discriminatory power in explaining the cross-country differences in the output decline. Based on the analysis presented in this section, we found that vulnerable countries in the region exhibited a rapid growth of the loans to non-financial sector throughout most of the 2000s, financed by foreign borrowings.

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This was reflected in domestic credit to deposit ratio, which grew rapidly in that period. Moreover, such a rapid credit growth was used to finance the investments as well as the household and, indirectly, the government consumption. Countries that pursued a sustainable exportled growth model managed to keep the domestic credit to deposit close to one, and used foreign borrowings only to finance long-term projects and mortgage lending. Financial turmoil that struck banks in advanced countries delivered the shock to regional banking systems, through the abrupt credit inflow reversal. This reversal left domestic banks, including the subsidiaries of foreign banks without financial means to continue with the rapid credit expansion. The credit crunch that ensued had stronger impact on the more vulnerable countries through a deep contraction of the household consumption as well as the investments. We find that those countries that exhibited a faster credit growth in the run up to the crisis, exhibited a larger output growth, wider current account deficits and larger net foreign debts. Once the capital stopped flowing in, these countries experienced a much deeper output contraction and a more pronounced current account improvement. The depth of the output contraction was moderated to some degree by the large import contraction, whereby the import contraction was also caused by the credit crunch. Other variables like the rigidity of the exchange rate regime, the real effective exchange rate, the level of credit euroization and the fiscal balance before the crisis, did not exert discriminatory power. Nominal exchange rates depreciated significantly in countries with flexible exchange rate regimes. The same is true for foreign exchange reserves, which declined rapidly following the capital inflow reversal. Nevertheless, no country with the fixed exchange rate regime was forced to devalue, indicating that loss of foreign exchange reserves was not large enough to deplete the entire stock. Real effective exchange rates depreciated significantly only in those countries that suffered the nominal depreciation. In the countries with fixed exchange rate regimes, the real effective exchange rate did not change much, reflecting that the “internal devaluation” through deflation was either not working or it was a very slow process. (Mark Weisbrot and Rebecca Ray 2010). The level of credit euroization did not exhibit a discriminatory power so far when it comes to the output decline since national governments and international financial organizations in concert injected significant doses of liquidity and successfully coordinated agreements aiming at rolling over of debts in order to prevent massive debt deflation episode. Yet, there is no doubt that the level of credit euroization has been very important factor when it comes to the expected output impact and the expedience of the authorities to reach for international

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assistance. In that sense, countries with the high rate of credit euroization and flexible exchange rate regimes suffered more than those with fixed regimes, because they were forced to strongly increase their external debts nominally and relative to the GDP by borrowing from the IMF and other institutions, however without the offsetting gains from the improved competitiveness. After all, providing a major change of the existing growth model, the foreign exchange depreciation that occurred could turn out to be an advantage in the long run, as it might shift the demand towards tradable sectors and facilitate more balanced current accounts.

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V Political Economy of Serbian Ponzi-Style Economic System and Global Financial Crisis

M

ain task of any economic authorities should be to establish economic structure capable of generating a sustainable economic growth. Sustainable economic growth is by definition economic development that leads to the fulfillment of current needs, without jeopardizing future consumption of younger generations. In order to achieve this task in the long run, it is necessary to create a system that produces more than it consumes. Unfortunately, for the time being, Serbian authorities failed to achieve macroeconomic stability and, in general, to provide fertile macroeconomic environment for sustainable economic growth. Therefore, in our opinion, the global financial crisis per se has not caused financial difficulties in Serbia, but only shed light on them sooner than it was expected. As was the case with countries we classified as consumptionled in previous section, the Serbian model of economic development is unsustainable in the long run and core of the problem lies in local macroeconomic policies and practices. In last six decades Serbia had two economic regimes: socialistic (bureaucratic and self-management in period from 1945 to 2000) and capitalistic (from 2000 till today). In both regimes, the state was a key actor, and the final outcome has been a continual accumulation

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of systematic deficit61 and usage of different mechanisms in order to temporary cover deficit or to transfer this deficit into future at the expense of the forthcoming, not even yet born, generations. Result of the Serbian Ponzi-style economic paradigm has been creation of imbalances in almost all key social and economic sectors: imbalance between production and consumption, domestic accumulation and required level of investments, imports and exports, fixed and working capital in enterprises, employed and unemployed, employed in industry and employed in state administration, center and periphery, etc. (Radonjić and Zec 2009).

1. Economic Paradigm in the Age of Communism The main characteristic of the whole period of socialistic economy (1945–2000) was an imbalance between desired rate of economic growth and pace of accumulation of domestic savings, i.e. inability to finance, from domestic accumulation, the whole specter of built-in rights of different social groups. In addition to insufficient accumulation, this system produced suboptimal allocation of savings, thus multiplying already existing imbalances. From the beginning of communist ruling, paradigm “savings – investments – increase in wealth” clashed with insufficient domestic savings. This clash, was, of course, consequence of the fact that strategic problem of the Serbian society was invalidity of model of accumulation which was based on the state and collective ownership. Unsuccessful quest for a rational model of accumulation, in which many different variations had been tested62, has been the main trait during the whole post World War II period. In the midst of fundamental lack of “capability” to create sufficient level of accumulation and to provide its rational allocation, the state became a key economic actor (ruling party nomenclature). Again, the state wasted its entire energy in idle attempts to find perpetuum mobile mechanism aiming at continual covering of ever rising deficits at the individual level, and after, at the level of enterprises and finally at the level of the state (escalation of external illiquidity). This economic model, based on unstable and insecure sources of accumulation permanently caused instability and cyclical crises and, finally, breakdown of the system in 2000. 61 Synthetic expression for all imbalances accumulated in the age of communism. 62 For example, the state forced enterprises to save and pay interest rate on forced savings or method of programmed accumulation, i.e. the state determined proportions between consumption and accumulation in process of income distribution.

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In the period between 1945–1960, development was financed by forced savings, free of charge labor (labor actions) and considerable, never publicly announced, transfers in the form of aid from abroad (from the USSR until 1948, and the USA afterwards). Change of geostrategic environment and deteriorating of position of a “non-allied” country in international community during the 1960s led towards cumulating of “systematic deficit” i.e. incapability to finance rate of economic growth required to achieve a full employment. Term “crisis” was still, due to ideological reasons (crisis were inherent to capitalistic and not socialistic economic model), out of usage, but in everyday vocabulary entered term “reform” which, from those days until today, has became the most exploited word, where, the content of this word has still remained vague. Crisis of insufficient accumulation and escalation of unemployment did not activate process of system reforms (model of accumulation and ownership liberalization), but solutions were to be found in pragmatic political adjustments, i.e. by quite liberal procedure of a passport issuance and significant “temporal” exodus of labor force abroad. In that way, “two birds were killed with one stone”: surplus of labor force left the country, thereby lowering political discontent and, until today, the most important new source of capital inflow aimed at financing high local consumption has been established through the cash remittances of diaspora. Absence of real radical reforms, again dramatized fundamental imbalance produced by the system, and already in 1971 the SFR Yugoslavia was again hit by shocks based on discrepancies between small production and income and high consumption aspirations. That was the period when relations between republics became highly complicated (new constitution and amendments) and when ruling nomenclature tried to finalize the model of an uneconomic “system of associated labor” (passing law of associated labor). Flows of redistribution escalated and missing accumulation was to be covered by increasing of the foreign debt that reached a climax in 1980. Death of Josip Broz Tito, father of the Yugoslav nation and key arbiter that guaranteed political balance, signaled forthcoming eruption of political imbalances, which was sufficient reason for foreign creditors to stop with permanent doping of the system fundamentally projected to consume above its productive powers. Crash of economic model caused breakdown in political configuration of relations between republics and, in the late 1980s, Yugoslav federation took the road without any way back. Economic difficulties became more and more intensive, inflation soared and foreign reserves started to melt. In order to attract funds of diaspora, the state made desperate move and offered interest rate that was above the comparable one in Western European countries. This decision gave results, considerable amount of diaspora’s savings was attracted and imminent crash was delayed. Absence

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of reforms practically supported collapse of the Socialist Federative Republic of Yugoslavia and in 1990 system, as integrated social, political and economic entirety, finally fell apart. (Zec and Radonjić 2010). In the 1990–2000 period, Serbian quasi-socialistic authorities avoided to undertake key economic and political reforms. During civil wars in ex-Yugoslavia (Slovenia, Bosnia and Herzegovina, Croatia and Kosovo) Serbian ruling structures financed current state needs and personally acquired enormous amount of wealth through: one of the most devastating hyperinflations in the modern human history; spending citizens’ foreign savings; robbing citizens through the system of the parastate Ponzi banks (Dafiment bank and Jugoskandik); the sale of state property (family silver – Telekom). Due to internationally imposed embargo and war destructions, economic activity was completely devastated whereas financial flows between Serbia and national and international financial institutions were terminated. Since 1992 Serbia did not meet any debt repayments obligations against international creditors and did not acquire new credits. In the meantime, due to accumulation of regular and penalty interest rates debt, value of Serbian external debt increased dynamically. In the end of 2000 external debt amounted to 10.83 billion US$ and share of public debt was 9.35 billion US$. In same year GDP was 23.4 billion US$, value of exports was 2.1 billion US$ and ratio of external debt to exports amounted to 516%, which classified Serbia among the most indebted countries in the world.63 To conclude, functioning of this uneconomic and in essence destructive system for half a century has created huge distortions of economic, political and system of values model of Serbian society which, unfortunately, have not been removed yet. Distortions could be seen through distortions of prices, exchange rate, interest rates, ownership structure of the society, ownership structure of individuals and enterprises, decomposition of motivation system as the result of separation between true efficiency and outcomes (labor and incomes) and, in the end, social distortions in which political executors and lobbyists became new business elite and the state and the state orders primary business. Platform in which political rents were transformed into business ones and the state basically redistributed all production results was a starting point for beginning of the transition process based on “anticommunist communism”. Naturally, this starting point to a great extent shaped character and tempo of reforms undertaken after 2000.64 (Ibid). 63 According to World Bank methodology, country that has ratio of external debt to exports above 220% is over-indebted. 64 The key attributes of our up to 2000 experience were “soft communism”, soft budget constraint (for individuals, enterprises and the state) and, in political positioning, socalled third way (non-allied country).

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2. Serbian Economy After 2000 In 2000, the Serbian society, seemingly, voted for elimination of a half– century long soft budget constraint and building up of a modern market economy based on a sustainable economic growth model. It supposed to be the end of the state, as a predominant economic actor. Building up the market and market institutions, passing and implementing laws that stimulate economic activity and uncompromisingly protect private ownership and business contracts, merciless war against corruption, investments in education, science, imports of modern technologies and expansion of tradable sectors, as well as increase in domestic savings were, in the first place, seen as effective remedies against almost a six-decade long disease of continual deficit accumulation. However, although in the course of eight years which preceded global financial crisis one could, on daily basis, read in newspapers and hear in the news bold announcements of Serbian officials about dynamic and sustainable economic growth of domestic economy, truth is that old matrix of economic functioning has not been changed yet: Serbian citizens still consume more than they produce and external debt has been increasing continuously, while export-oriented sectors have remained uncompetitive and underdeveloped. Reasons for growing difficulties Serbian economy have been facing lie in lack of strategic approach to the issue of economic development, overly expansive fiscal policy, inconsistent monetary policy and political factors that promote dynamic development of non-tradable sectors and speculative activities.

3. Economic Growth and Government Expenditures In order to understand whether economic growth is sustainable, sources of this growth should be explored in more details. In the period of 2001–2008 pace of growth of real GDP of around 6% annually was very high and promising. (Figure 118).

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Figure 118. Serbia: Expenditure Contribution and Real GDP Growth

Sources: Statistical office of the Republic of Serbia and authors’ calculations

As we can see from Figure 118, there were two main sources of this dynamic growth: high and expansive public spending and high consumption of household sector. Figure 119. Serbia: Central Government Receipts, Spending and Balance

Sources: Ministry of Finance of the Republic of Serbia and authors’ calculations

Since public spending grew faster than GDP (Figure 119), and because this spending was predominantly used for increase in final consumption, strong inflation pressures were created, and consequently, due to, among other things, increase in a real foreign exchange rate (Figure 120) deficit of current account and trade balance was growing continually, which, in the final instance, led to increase in external debt (Figures 121, 122, 123, Table 3).

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Figure 120. Serbia: Official and Real Effective Exchange Rate

Sources: The National Bank of Serbia and authors’ calculations.

Figure 121. Serbia: Financial Account and Current Account Balance

Source: Authors’ calculations based on International Financial Statistics.

On the other hand, again, since monetary authorities only partially sterilized65 capital inflows, an increase in external debt resulted in the rise of the money supply, which led to another round of rising inflation pressures, an increase in real exchange rate and further deterioration in trade and current account deficit. 65 High interest rate on repos issued by the National Bank of Serbia (annual interest rate on repo operations maturing in two weeks was 17.75% in 2008 and 9.5% in 2009) further attracted foreign speculative capital and, in that way, further aggravated problem of external indebtedness and continual loss in foreign exchange reserves (in the period of 2006-July 2010 the National Bank of Serbia spent around 3 billion euro in order to defend dinar, and only in 2010 up to August half of this sum).

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Figure 122. Serbia: Exports and Imports

Source: Authors’ calculations based on International Financial Statistics.

If we pay a close attention to the use of GDP (Figure 118) we will clearly see that, for example, in 2007 and 2008, share of household consumption expenditure in GDP was 79% and 75.3% and share of final consumption expenditure (sum of household and government expenditure) in GDP was 98% and 94.4% respectively.66 Equally important, sum of final consumption expenditure and gross fixed capital formation (gross capital investments) exceeded GDP in 2007 and 2008 by 22% and 23% respectively, leading to conclusion that excessive consumption was financed by rise in external debt and privatization incomes. Figure 123. Serbia: Cumulative Deficit of Current Account and External Debt (in billions of euro)

Sources: The National Bank of Serbia and authors’ calculations. 66 In 2007, household consumption and final consumption in Bulgaria was 69.2% and 85% of GDP respectively, Croatia 60% and 79%, The Czech Republic 49% and 68%, Hungary 65% and 75%, Romania 75% and 83%, Slovakia 56% and 73% and Slovenia 52% and 70%. IMF, International financial statistics online.

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Table 3. Serbia: GDP, Current Account Deficit, Deficit of Goods and Services Balance and External Debt 2001 2002 2003 2004 2005 2006 2007 2008 2009 GDP (in bilions of euro) Current acount deficit (as %GDP) Deficit of goods and services balance (as %GDP-a) Exports/Imports of goods and services (in%) External debt/Exports of goods and services (in%)

12.9

16

17.3

19

20.3

23.3

28.8

33.4

29.9

2.3

4.2

7.8

13.8

8.8

10.1

17.5

21.1

7

17.8

20.4

19.4

26.7

21.1

21.6

25.5

26

17.1

48

48.9

53.4

46.9

55.4

58

54.2

53.9

62.4

456.4 300.9 251.6 211.5 228.8 204.1 197.3 207.6 265.2

External debt (in bilions of euro)

12.5

9.4

9.7

9.5

12.2

14.2

17.1

21.1

22.5

External debt (as %GDP-a)

96.6

58.8

55.9

49.8

60.1

60.9

59.5

63.1

72.2

Public external debt (as % of external debt)

93.5

91.8

88.1

76.9

64.7

46.5

36.7

30.9

34.5

Private external debt (as % of external debt)

6.5

8.2

11.9

23.1

35.3

53.5

63.3

69.1

65.5

Private external debt (in bilions of euro)

0.7

0.8

1.2

2.2

4.3

7.6

10.9

14.6

14.7

External debt of banking sector (in bilions of euro)

0.1

0

0.2

0.7

1.8

3.5

3.6

3.5

4.3

Cross-border loans - external debt of enterprises (in bilions of euro)

0.6

0.7

1

14

2.5

4.1

7.2

11

10.4

Sources: The National Bank of Serbia and authors’ calculations.

Serbian economy did not posses numerous and competitive enough production capacities mostly due to the unfinished and poorly designed privatization and large share of inefficient state-owned enterprises. Significant gap between consumption and production that had been filled with high and growing imports, would have been sustainable if most of the expenditures had been directed towards gross capital investments and inventories. In a word, if machines and equipment had been mainly imported that would have in, later stages of development, generated export revenues. However, gross capital investments have been, in comparison with similar countries in region, insufficient.67 Share of consumption goods and oil and fuels in imports has been dominant in whole period after 2000. Consequently, share of imports in GDP has been almost twice as much as share of exports (Table 3).

67 In 2007, gross capital investments in Bulgaria were 30% of GDP, Croatia 29%, Hungary 24%, Romania 31%, Slovakia 26% and Slovenia 27.5%. Ibid.

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4. Rise of Non-Tradable and Decline of Export-Oriented Sectors Serbian investments in capital funds have been insufficient, and furthermore its structure has been unfavorable. Table 4. Serbia: Private Sector’s Foreign Debt by Classification of Activities in 2007 mil. of euro Tradable sector total Agriculture, hunting, forestry, and water works supply Fishing Mining and quarrying Manufacturing

7,778

74.5

691

3.7

18

0.1

627

3.3

5,713

30.5

Electricity, gas and water supply

532

2.8

Hotels and restaurants

197

1.1

10,942

58.5

Non-tradable sector total Construction

1,549

8.3

Wholeasale and retails trade; repairs

4,216

22.5

Transportation, storage and communications

2,366

12.6

154

0.8

Financial intermediation Real estate, renting and business activities

2,532

13.5

Public adiminstration and defense

0

0

Education

8

0

Health and social work Other communal, social and personal activities Total tradable and non-tradable sectors 1

% of total

9

0

107

0.6

18,720

100

Debts to domestic and foreign banks are not included.

Sources: The National Bank of Serbia and authors’ calculations.

Concept of development, whereby 80% of the sum of foreign debt and FDI has been directed towards non-tradable sectors, did not promise highly needed development of export-oriented production (Vladimir Čupić and Srdjan Kokotović 2009) nor could it lead to a sustainable development of a country that suffered from very large current account deficits (Tables 4 and 5).

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Table 5. Serbia: FDI by Classification of Activities in 2007 (in % of total) 2004 Agriculture, hunting, forestry, and water works supply Mining and quarrying Manufacturing

2005

2006

2007

1

0.7

0.2

0.6

0.2

0.02

0.05

0.9

30.2

19.4

18.2

14.1

0.007

0.04

0.02

0.04

Hotels and restaurants

1.4

0.02

0.07

1.3

Tradable sector total

32.8

20.2

18.5

16.9

1.8

0.8

0.6

5.2

Electricity, gas and water supply

Construction Wholeasale and retails trade; repairs

36.1

22

8.5

7.7

1.5

0.7

28.9

20

Financial intermediation

10.7

38.7

36.8

32.1

Real estate, renting and business activities

13.9

11.6

6.6

15.9

64

73.8

81.4

80.9

3

5.9

0.04

3.1

100

100

100

100

Transportation, storage and communications

Non-tradable sector total Other Total

Sources: The National Bank of Serbia and authors’ calculations.

Resultantly, share of non-tradable sectors in Gross Value Added (GVA= GDP minus taxes plus subsidies) was around 60% (Table 6). EU member countries share a similar structure of GVA, but, unlike Serbia, they have already built up strong export-oriented production basis.68 Primary causes of dynamic growth of non-tradable sectors were overly expansive fiscal and covertly expansive monetary policy, which resulted in a significant increase in domestic demand. 69 Consistently, part of this increase was directed towards non-tradable, and the other part towards tradable sectors. However, due to lack of international competition, as well as notable monopolization and oligopolization of this sectors (control of prices), this increase in demand had stronger effects on non-tradable sectors. Consequent 68 In the EU 15 share of agriculture, hunting and fishing and manufacturing in GVA was 1.6% and 19.7% in 2007 and 1.6% and 19.6% in 2008 respectively. In, for example, Slovak Republic share of agriculture, hunting and fishing and manufacturing in GVA was 3.5% and 30.9% in 2007 and 3.1% and 29.7% in 2008 respectively. (Eurostat). Also, share of machinery and transport equipment, intermediate manufactured products, miscellaneous manufactured goods and chemicals in total exports in Slovakia was 88.5% in 2008. (Stamer Manfred 2009). 69 Monetary policy has been only seemingly restrictive. In essence, it has been, indirectly, expansive. Namely, as it will be shown later on in the text, monetary authorities did not even try to put under control a dynamic rise in cross-border crediting of local enterprises, which led to a sharp rise in money supply and, consequently, domestic demand.

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rise in prices of non-tradable products and services, made these sectors very attractive investment destinations. (Radonjić and Kokotović 2010a). Table 6. Serbia: Share of Tradable and Non-Tradable Sectors in Gross Value Added and Exports 2005

2006

2007

2008

% of % of % of % of % of % of % of % of GVA exports GVA exports GVA exports GVA exports Tradable sector total 1. Agriculture, hunting, forestry, and water works supply 2. Fishing 3. Mining and quarrying 4. Manufacturing 4.1 Manuf. of textile and textile products 4.2 Manuf. of wood and wood products 4.3 Manuf. of machinery and equipment 4.4 Manuf. of office, machinery and computers 4.5 Manuf. of motor vehicles and trailers 5. Electricity, gas and water supply

373

200

36

100

33.5

100

33.6

100

12

4.5

11.4

4.7

10.2

4.5

10.6

3.6

0.04

0.02

0.03

0.02

0.02

0.02

0.03

0.02

2.1

0.5

1.8

0.5

1.5

0.6

1.3

0.6

17.6

95.5

17.4

93.7

17.3

94.3

17

93.6

0.7

2.9

0.6

2.3

0.5

3

0.9

2.9

0.4

1.7

0.3

1.6

0.3

2.3

0.3

1.8

0.7

6.5

0.6

6.3

1

6.8

0.9

7.3

0.4

0.2

0.4

0.5

0.4

0.6

0.4

0.5

0.4

1.5

0.2

1.4

0.3

2.3

0.4

2.7

4.2

0.76

4.2

1.1

4.1

1.2

3.8

1.4

6. Hotels and restaurants

1.4

1.2

1

0.9

Non-tradable sector total

62.7

64

66.5

66.4

4.9

4.8

5.1

5.5

12.7

12.6

12.2

12.8

9.2

8.4

8.7

8.5

2.8

3

3.1

3

7. Construction 8. Wholeasale and retails trade; repairs 9. Transportation, storage and communications 10. Financial intermediation 11. Real estate, renting and business activities 12. Public administration in defense, compulsory social security

16.2

0.2

4.3

4.5

18

0.02

17.9 4.3

0.01

17.9 5

13. Education

4.2

4.8

6

4.7

14. Health and social work

5.6

5.4

6.1

6.4

2.8

2.5

2.6

2.6

1.4

1.2

1.6

1.3

15. Other communal, social and personal activities 15.1 Recreational, cultural and sporting activities

0.05

Sources: Statistical Yearbook 2006 and 2009, Communication No. 67 (National accounts statistics) March 2010, Statistical Office of Republic of Serbia and authors’ calculations.

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On the other hand, increase in demand for products of tradable sectors has been divided between domestic and foreign producers (imports). Increase in demand for foreign products further unfavorably influenced trade balance and current account. Additionally, due to a strong inflow of foreign capital, salaries in non-tradable sectors grew faster than labor productivity, which consequently created strong inflationary pressures. At the same time, due to the above mentioned lack of international competition, producers in non-tradable sectors have been in position to transfer this increase in costs (rise in salaries) to buyers through generally higher price level. Also, having in mind that producers from tradable sectors are big consumers of non-tradable outputs, this rise in non-tradable prices increased unit costs of export-oriented enterprises, which further deteriorated their competitiveness in international markets. Furthermore, due to strong emulation effect, rise in real salaries in nontradable sectors and struggle for skilled labor force put additional upward pressure on tradable sector’s production costs (Table 7). Therefore, exportoriented producers were forced either to raise salaries of their employees, which further deteriorated their financial condition, or face losing best educated and most productive personnel. Table 7. Serbia: Average Net Salaries by Fields of Activities (in Serbian dinars) 2001

2002

Total average

8,961

9,208

11,5 14,108 17,443 21,707 27,759 32,746

1. Agriculture, hunting, forestry, and water works supply

7,541

8,512

9,076 10,658 13,835 17,683 21,244 26,696

7,614

7,661

2. Fishing

2003

2004

2005

8,99 11,034 13,945

2006

2007

2008

17,71 22,066 26,391

3. Mining and quarrying

14,910 16,847 24,157 30,347 38,852 48,896 58,951 65,419

4. Manufacturing

17,023 15,272 26,867 31,566 35,075 41,494 48,482 50,196

Sources: Statistical Yearbook 2001, 2002, 2003, 2004, 2005, 2006, 2007, 2008 and 2009, Statistical Office of Republic of Serbia.

To be clear, since development of non-tradable sectors is complementary to development of tradable sectors, investments in non-tradable sectors are desirable. It is certain that without qualitative enough roads, highways, railroads, telecommunications, financial and community services, sources of energy and residential apartments and houses, there will be no FDI. Therefore, a policy mix that will provide sufficient amount and appropriate ratio of investments in tradable and non-tradable sectors is needed, whereas, at the same time, domestic household consumption must be, in certain proportions, reduced.

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5. Monetary Policy, Inflation, Real Exchange Rate Appreciation and External Debt Monetary policy was not effective enough to counter effects of expansive government expenditures. The National Bank of Serbia (NBS) switched in 2006 from quantitative targeting of money supply to the inflation targeting regime and the reference rate on reverse repo operations as the main policy tool. But the instruments to permit a full-fledged inflation targeting are largely not yet operational. Namely, out of four monetary policy transmission channels (asset prices, interest rates, bank credit and exchange rate channel) only the exchange rate channel functioned, whereas the other three were impeded by the undeveloped capital market and dinar credit market. Moreover, the measurement of the Consumer Price Index at that time was questioned by some observers in Serbia. Since only one channel worked, it might have forced the NBS to impose a somewhat restrictive monetary policy stance and set a very high reference interest rate. It is important to note that this channel operated by appreciating the dinar exchange rate and lowering the dinar prices of imported goods and services, whereas the mirror image of that are more expensive prices of Serbian goods expressed in foreign currency.70 By raising the reference rate on reverse repo transactions it managed to partially mop-up excess dinar liquidity from the market but it has attracted even more capital to flow into the country, especially the shortterm speculative capital that was seeking arbitrage opportunities. In parallel, Serbia was in the middle of privatization process, which attracted additional foreign capital. On top of that, after years of isolation and lack of funds, the Serbian credit market was underdeveloped and it provided plenty of growth and profit opportunities, which were exploited by banks. They were drawing large foreign borrowings (Table 3) and extending foreign exchange indexed loans to households and enterprises (Figure 124). All these factors added up and caused a surge in money supply so that the NBS considered these to be able to generate inflation pressures in the medium run. (NBS 2007). This forced the NBS to further increase its reference rate, thereby creating a vicious circle. On the one hand, capital inflows were sufficiently large to offset one of the worst export performances and related current account deficits in the region whereas on the other hand the dinar exchange rate vis-à-vis the Euro was appreciating, even in nominal terms. (Čupić and Kokotović 2009). Finally, the combination of a high inflation and a stable and appreciating nominal exchange rate had a strong impact on the real effective exchange rate (Figure 120). Continual real appreciation of Serbian currency 70 Nominal appreciation of exchange rate lowers import prices expressed in the local currency (dinar). Having in mind that share of imported products in Serbian GDP have been around 45%, nominal appreciation of local currency significantly reduced inflation.

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in the period between 2001 and 2008 had unfavorable effect on development of export-oriented sectors (Figures 121 and 122). In that way, imports became cheap and exports expensive, which further negatively influenced current account and trade balance71 and, consequently, stock of external debt. Thus, a persistently high inflation,72 resulted in a drastic deterioration of current account deficits, accumulation of short term speculative capital and wrong impulses sent to the market participants that foreign exchange indexed or foreign exchange denominated loans were cheap and effective replacement for the non-existing dinar denominated loans. The result was a high growth rate of private sector’s debt during a few years in the run-up to the crisis. It is worth mentioning that the private sector was largely free of any debt before 2000 and this was supposed to be one of its strong points. In parallel, banks, both foreign and domestic, tended to invest in risk free NBS’ notes that were, due to the nominal appreciation of the dinar, even more profitable if proceeds were expressed in Euro.73 Having in mind that the abovementioned obstacles remain unresolved, the future success of Serbian inflation targeting regime remains uncertain. Figure 124. Serbia: Growth of Credit to Non-Financial Sector

Source: Authors’ calculations based on International Financial Statistics. 71 As a consequence of high trade balance deficit, current account deficit of Serbia in 2008 was among the highest in the region and amounted to 21.1% of GDP (recently revised figure of the National Bank of Serbia). In the same year, current account deficit of Romania was 12.2% of GDP, Bulgaria 25.2%, Slovenia 6.2%, Croatia 9.4%, Albania 15.1%, Hungary 8.6% and Slovakia 6.3%. EBRD economic statistics and forcasts. 72 Measured by the number of years when the inflation ended the year within target corridors. 73 During some months in 2007 and 2008 the risk free interest rates expressed in Euro terms were larger than 20% annually.

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At the same time, the tight macroprudential policy was appropriate. The NBS imposed a very strict prudential standards in front of the banking sector in its efforts to reduce the credit growth and level of financial vulnerability. Tightness of supervision policy has been reflected through high capital adequacy requirements, high risk weights for foreign currency denominated loans, a high provisioning requirement and debt-to-service ratios. Even though the Lehman shock caused massive distortions, and despite rapid depreciation of the domestic currency and a deep fall of trade and production, none of the banks came even close to a collapse. In the pre-crisis period, the abundant equity capital flowed into the banking sector driven by some well-suited regulation of the NBS (Kokotović and Čupić 2008).74 Most of it was kept in the liquidity reserves in the accounts with the central bank. When the crisis hit, large portion of these reserves were run-down but they were not depleted. Sufficiently capitalized and very liquid, banks did not need any government bailout measures except the increase of contingent deposits insurance coverage. Even though one year after the crisis non-performing loans increased three-fold and risk premium four-fold, banks still do not exhibit any major weakness, which proves the need for strong bank supervision. As a result, banks were, on average, strongly capitalized, highly liquid and well provisioned. That, along with ample foreign exchange reserves of the NBS, served as the first line of defense for the country (Figure 125). All these buffers allowed Serbia to relax the monetary restrictiveness relatively soon after the first impact of the global crisis. But there were drawbacks to this policy as well. Due to the previously restrictive monetary and the supervisory policies of the NBS, the largest, most significant agents in the private sector shifted their credit demand directly to foreign banks across the border. This allowed them to bypass the reserve requirements and thereby reduce their costs of financing (Čupić and Kokotović 2008). The incentive was so large, that the corporate sector’s foreign debt exceeded the stock of domestic loans, and in that respect Serbia was among the largest recipients of cross-border loans in the region (Table 3). This was yet one more vulnerability, which demonstrated its power when dinar started depreciating and caused a near-panic, or we better say almost panic among all agents both local and foreign. In response, the Serbian authorities concluded the Vienna Initiative and the arrangement with the IMF. Balance sheet mismatches (both currency and maturity 74 Two main drivers of equity capital were the larger required Capital Adequacy Ratio that was set at 12% whereas in most other countries it was 8% and the other one was the ratio of Household Loans to Equity which could not exceed 150%.

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mismatches) in the corporate sector started to take their toll and many previously well functioning corporations experienced large losses, some of them even went bankrupt.75 Thus, currency risk has been particularly significant since, for example, in 2007 approximately 70% of domestic loans to legal entities and 100% cross-border obligations of companies were denominated in the Euro or denominated in dinar but linked to the Euro value of dinar; they amounted to 13.8 billion euro, that is 47% of GDP. (NBS 2007). Figure 125: Serbia: Foreign Exchange Reserves

Source: Authors’ calculations based on International Financial Statistics.

6. The Credit Crunch and Serbian Response Following a serious distress in the banking sector which reflected the spillover effects from the turmoil faced by parent banks from Western Europe, Serbia sought a precautionary loan from the IMF in early November 2008. (IMF 2009j, k). Households, mindful of their 1990s experiences of pyramid Ponzi schemes, deposit freezes and financial collapse, withdrew almost 1 billion euro from their savings accounts, while local bank subsidiaries repayed another half a billlion euro of their liabilities to parent banks (Figure 126). 75 Consequently, unemployment rate in Serbia in early 2011 was among the highest in Europe and equaled 20%. In parallel, unemployment rate in Bulgaria equaled 10.2%, Hungary 12.6%, Romania 7.3%, Slovenia 7.8%, Croatia 13.3% and Turkey 9.8%.

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Figure 126. Serbia: Change of Foreign Exchange Assets and Liabilities of Banks and Non-Financial Sector

Sources: The National Bank of Serbia and authors’ calculations

This had a severe impact on the foreign exchange market where trading volumes slumped while the exchange rate against the Euro surged (Figure 120). At the same time, costs of foreign financing surged as foreign lenders began to differentiate among the countries in the region according to the sustainability of their balances of payments. The NBS reacted by massive injections of the foreign exchange liquidity (Figure 125) and dinar sterilization, while the government increased the insured amount per savings account from 3 to 50 thousand euro. Even though the panic abated by early December, 2008, sliding of exchange rate did not stop until Serbia, facing a much deeper contraction, decided to seek an augmented arrangement and convert its precautionary credit line into a more binding stand-by arrangement including much higher loan of approximately 2.9 billion euro. Furthermore, Serbia, soon after Romania, signed Vienna Initiative in late March, 2009. In addition, the NBS launched other measures in the monetary and supervisory domain, which intended to stimulate the revival of lending and lower lending interest rates.76 These were key ingredients to successful stabilization of the Serbian financial market, especially the exchange rate as well as the financial account balance. The foreign exchange liquidity, which stayed in the country was subsequently 76 The NBS removed maximum Households’ loans to Bank Equity ratio and reduced mandatory reserve requirements and reference interest rate.

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the basis for the renewed lending to the private sector albeit strongly supported by interest rates subsidies from the budget. It became evident in the aftermath of the crisis, that countries like Serbia will have to find way to control external indebtedness and capital structure on the one side and to thoroughly overhaul its growth model on the other. It is obvious that small countries with unsatisfactory share of exports in GDP that mainly use capital inflows to import consumption goods and services do not have a chance to generate stable and sustainable growth in the long run. Instead of development based on investments into non-tradable sectors, experiences of successful transition countries unambiguously refer to a quite opposite solution: massive investments into export-oriented sectors, education, science, infrastructure, etc. What is more, overall impression becomes even worse if we include into consideration structure of exports, degree of finalization and value added in export products, share of exports in imports, etc. It is important to notice that dominant contribution to already very low exports comes from foreign companies, which in essence perform final processing jobs. Products of a low degree of finalization have a significant share in exports. What Serbian economy desperately needs is a reform of the state administration and state policy aiming at becoming a place where it is possible to organize low cost production of qualitative enough products and services which can be profitably sold abroad. Such a spectacular u-turn in distribution between accumulation and consumption demands completely changed position of the government (fiscal, monetary and developmental policy) and, instead of fiscal and current account deficit, generation of surpluses that will be directed towards investments. The complexity and the sheer impact of the subprime financial crisis called for a global response and provided countries across the board with exceptional means to overcome the crisis. Some of these exceptional means were more relaxed conditions of the IMF’s stand-by arrangements, surge in lending of other international financial institutions and the willingness of large banking groups to rollover their claims against ailing nations and clients. This crisis also brought unprecedented emergency measures of central banks of developed nations as well as an exorbitant fiscal stimulus. However, if a country like Serbia does not draw lessons from this crisis and remains committed to current growth model, which boils down to massive build-up of external vulnerabilities, it will very likely not be provided again with a massive financial assistance such as the one being provided now, more so in the case of an event of isolated endogenously generated financial crisis.

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Conclusion and Policy Recommendations

A

ccording to the mainstream efficient markets hypothesis, selfregulated financial markets led by Smith’ “invisible hand” are optimal mechanisms for rational and productive allocation of scant resources to the most productive uses. Financial crises are consequence of a sudden effect of some unanticipated exogenous shock. In most cases, this is interference of government in free functioning of rational self-corrective markets, implementation of inadequate policy regime, self-fulfilling prophecies, panic escape of irrational investors or crony capitalism. In a word, the problem is not rooted in systematic flaws in the functioning of free markets, but, on the contrary, in the lack of freedom for market forces. Thus, in neoliberal view, prescription for a stable and rapid growth of economy and living standards is implementation of set of macroeconomic market-led policies widely accepted in international community as universal remedy for different types of inefficient economic systems. Consistently, if properly implemented macroeconomic marketled policies result in improved profit opportunities in developing country, rational investors will, in search for ever rising profits, react in no time and direct capital flows to poor countries. Thus, improved economic conditions precede investment inflows. On the other hand, we reject the mainstream “efficient markets hypothesis”, both as inadequate theory and description of real world outcomes. Our analysis relies on theoretical framework of seminal Post Keynesian economist Hyman Minsky. During the 1970s, Minsky was among the first economists who, by embracing Keynes’ theory of

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fundamental uncertainty and investments, rejected the “Smithian” view that free decentralized markets, if let alone, inherently, i.e. endogenously generate equilibrium. According to Minsky’ interpretation of Keynes, ups and downs are a natural product of unregulated free markets. Or, to put it more precisely, if let alone, endogenous market processes generate financial and economic instability. In his, by mainstream economists widely neglected FIH, Minsky argues that financial markets are the heart of modern capitalist economies, which, thanks to non-neutrality of money, division of ownership and management in big corporations and financial institutions, ever growing and massive debt financing of uncertain investment projects over the business cycle, continual financial innovation and fundamental uncertainty, are prone to fragility. Unstable optimistic and pessimistic expectations of debt financed economic units endogenously lead financial system from the state of robustness towards financial fragility, in which a sudden, unexpected appearance of endogenously or exogenously created shock has the power to push the system into financial instability. Resultantly, Minskian liquidity model of capital flows from developed to developing countries emphasizes source and not the destination. As Pettis (2001) argues, displacement or event that triggers massive capital movements towards developing countries is Minskian liquidity expansion in rich countries. In other words, movements of capital towards developing countries are exogenous, i.e. developing countries actions do not influence movements of international capital, which are the result of liquidity changes in developed world. Namely, historical analysis shows that timing of capital inflows into developing countries is virtually identical although there is no reason to assume that different countries around the world simultaneously undergo preferable political and economic changes. We must note that hypothesis of exogenously led capital movements toward developing markets concurs with our findings since transitional countries simultaneously experienced dynamic capital inflows during several years that followed 2002, but, as our analysis of EBRD’s transition indicators and corruption scores shows, there were significant differences in achieved level of desired market reforms among them.77 As liquidity in rich countries rises, financial markets take off, real interest rate drops and over-optimistic investors systematically underestimate risks or overestimate prospective earnings in non-traditional sectors. As in time investors start to exhaust local higher risk investment opportunities, capital starts to flow in direction of developing countries. 77 For example, between the Czech Republic and Slovenia on the one side, and Serbia and Ukraine on the other in 2002.

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Dynamic capital inflows into shallow financial markets of developing countries produce positive effects in the short run. Increase in commodity prices and exports, economic growth, output and employment and stabilization of exchange rates stimulate local officials and elite to agitate and insist on further perseverance in deepening desirable economic reforms, which further reinforces capital inflows. This is also in line with our findings on behavior of EBRD’s transition and corruption indicators scores in CESEEE. Namely, in parallel with dynamic capital inflows in the period between 2002 and 2008, selected CESEEE made, on average, a considerable progress in market reforms and reductions in costs burden imposed by corruption, which further brought them closer to their aim of achieving a full compliance with standards of developed industrial economies. It is also notheworhy that the Czech Republic, Hungary, Poland, Slovakia and Slovenia, five most developed transitional countries compared favorably in terms of achieved level in market reforms and corruption reduction with advanced market economies in the EU. Nevertheless, the environment of flourishing optimism of market participants led to inverted capital structure, i.e. to a massive building-up of vulnerabilities to capital inflow sudden stop. In time, one of two potential events that may trigger crisis occurs. The first one is a long-term sharp reversion of excess liquidity in major advanced countries. A long-term retreat of risk prone capital results in rise in real interest rates, whereas a decline in global aggregate demand leads to a sharp fall in commodity prices and export revenues of developing countries. Reluctance of international lenders to refinance debts and sharp fall in export revenues might end in devastating debt deflation episode. The second type of triggering event is a short-term collapse in financing at the margin caused by a sudden external shock combined with internally accumulated financial difficulties reflected in deterioration of the external balance. Since these shocks occur in the environment of stabile global liquidity conditions, provided a country designed correlated capital structure or if an outside lender of last resort injects liquidity after debt deflation has taken its toll, crisis country might restore stability in the short run. No matter whether triggering event is a long-term liquidity contraction or a short-term flight to quality, their common feature is a massive escape of international capital from local emerging markets, i.e. massive sale of local currency denominated assets. In order to prevent debt-deflation, domestic central bank, in coordination with foreign governments and central banks as well as international financial institutions has to provide liquidity to indebted units, whereas through massive deficit spending

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at the same time, government has to provide a floor to ensuing fall in aggregate demand and corporate profits. In our study we showed that 2008 CESEEE’s crisis can be adequately described within Minskian theoretical framework.78 Deployment of the Asian current account surpluses, expansive monetary policy of the Fed and massive securitization of real estate put in motion liquidity cycle in the beginning of the 2000s in the USA. In line with liquidity model, liquidity expansion in the most developed economy in the world led in no time to liquidity expansion in other developed countries exposed to financial markets in the U.S. and further, due to increased optimism and consequently profit appetites of western investors, to massive capital flows towards developing countries. Dynamic growth of developed world stirred up developing countries’ growth by increasing export revenues and commodity prices, FDI, portfolio investments, cross-border lending and workers’ remittances. In that way, simultaneously with dynamic economic growth and progressiveness in enforcing efficiency and effectiveness of internationally desired market policies, the CESEEE massively build-up vulnerabilities to a capital inflow sudden stop. Unfortunately, seemingly unexpectedly, the U.S. financial markets contracted sharply in 2007. Due to financial integration and cross-border network of investment funds, hedge funds, insurance companies and most importantly bank subsidiaries owned by banks from developed countries, the shock was instantaneously transmitted to a large number of developed and developing countries, easily and quickly. In order to discover the most important economic determinants of the scope of output decline in the CESEEE that closely followed global liquidity contraction, we presented, in the first stage of the factual analysis, findings about the macroeconomic developments and the crisis impact on a selected number of the Central, East and Southeast European countries based on their monetary, financial, external, fiscal and national accounts quarterly data, starting from 2000 until the end the third quarter of 2009. This enabled us to observe the magnitude of the accumulated vulnerabilities in individual countries and to pinpoint the differences in pre-crisis developments among them. In the second stage of our factual analysis, we grouped the Central, East and Southeast European countries according to the level of accumulated vulnerabilities. We found that those economies which ran 78 For more details on application of Minskian model of crisis generation as appropriate theoretical framework for explaining crises in emerging markets see, for example, Arestis and Glickman 2002; Moritz Cruz, Edmund Amann, and Bernard Walters 2006; Frenkel and Rapetti 2009; Kregel 1998; Anastasia Nesvetailova 2007; Radonjić 2007b, 2008.

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larger current account deficits and relied more on foreign borrowings to finance these deficits suffered much deeper crisis impact in terms of the output contraction than those countries that had a more balanced pre-crisis output growth. Berkmen et al. 2009 and Berglöf et al. 2009 discovered that the CESEEE suffered more during the current crisis than other regions exactly because of their much greater reliance on foreign credits that dried up following the Lehman shock. Also, the first group of authors noted that the flexibility of the exchange rate regime facilitated a more successful crisis management in CESEEE, which is in line with the literature. However, our findings are different, i.e. the exchange rate regime did not exert a discriminatory power in the current crisis. Regarding the crisis spill-over from developed countries, the trade links had a strong impact on the exports but it was not a discriminatory factor. The export fell equally across the region, exerting a greater leverage on the countries that were more open and had greater share of the exports in their output. The determinants that mattered the most and had a discriminatory power were the financial ones. The pre-crisis dynamics of the stock of foreign debts, the credit boom and the leverage of the banking sectors which, in the most CESEEE led to excessive output growth coupled with large current account deficits, were good determinants of the crisis impact. Financial distress coupled with ensuing deep contraction of the domestic demand and the free-falling exports and commodity prices, caused a deep output contraction. The rate or credit euroization, one of the corollaries of the excessive reliance on foreign borrowings, seems to have exerted only limited discriminatory impact on different emerging European countries. The surprising absence of a larger negative effects of high level of credit euroization suggested by the literature (Kregel 1998; Pettis 2001; Calvo, Izquiredo, and Mejia 2008) was consequence of the limited nominal currency depreciations and the absence of currency devaluation in the CESEEE. However, the credit euroization did cause the “fear of floating” and pushed authorities in some of the countries in the region to intervene heavily in the foreign exchange markets and obtain additional foreign exchange reserves from international institutions, mainly the IMF and the EU. Concerning the fiscal balance, Berkmen et al. (2009) found that there was a positive impact of a better pre-crisis fiscal position on the output performance during the crisis, but our analysis reached no such conclusion. This might reflect the fact that those countries that experienced excessive output growth exhibited better fiscal revenue performance as a corollary to the excessive consumption. Therefore some of them probably exhibited good fiscal performance before the crisis only to see a deeper output contraction when the crisis hit.

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In general, considerable foreign debt accumulation made the emerging European countries much more vulnerable to capital inflow sudden stops than the countries that have suffered such crises in the past. Mounting of debt was made possible by the deeper financial integration between the emerging and West European countries in comparison with other countries and regions. On the other hand, deep financial integration provided that, when the crisis hit, countries in the Central, East and Southeast Europe remained more resilient than countries which have experienced similar crisis in the past. This resilience was the result of massive liquidity injections into financially fragile systems of developed and developing countries by governments of developed nations and international financial institutions. In addition, governments of developed countries implemented fiscal stimulus packages, which were permitted by more flexible conditionality of the IMF during this unprecedented crisis. That is why the capital inflow reversal was moderate comparing to the past crises and did not cause massive depreciations or devaluation previously seen. Moreover, the financial integration turned out helpful for credit roll-over rates that enabled the emerging European banking sectors weather the crisis well. In some of the countries this was formalized by the Vienna Initiative agreement. Because of the absence of massive currency deprecations or devaluations seen in the past, the real exchange rates did not depreciate much. This enabled an orderly adjustment of the current accounts and helped avoid large inflation surges.

Policy Recommendations for Developing Countries A standard question to ever rising volatility of global economy and emerging markets in particular in the last three decades is how to prevent financial crises in the future. From the perspective of the emerging markets this is a stale question since investment movements of capital from rich to poor countries follow its own exogenous pattern and emerging markets are powerless in controlling these flows. In that way, minor changes in developed markets have capacity to overwhelm shallow markets of developing countries. Thus, developing markets are not able to prevent crises but are capable of designing a capital structure aiming at minimizing negative effects of external shocks on internal market. Therefore, sustainable economic growth is no doubt the most efficient mean to offset future external shocks in the long run. Economic growth of small economies is sustainable if it is based on expansion of exports and, at the same time, steady and decreasing external debt and, on average, continuous generation of trade and current account surpluses, i.e. domestic savings. On the other hand, expansion of exports, and consequently, rise in

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competitiveness of local producers critically depends on macroeconomic stability. In other words, factors that strongly influence competitiveness of domestic producers are fiscal policy, monetary policy, development of infrastructure, education and science, rule of law and law enforcement, level of corruption, etc. However, as Keynes put it, the long run “...is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is past the ocean is flat again.” (Keynes 1923, p. 65). Namely, as Pettis argues: “In the end, an optimal capital structure is not enough to ensure that an economically backward country will develop rapidly. The wrong capital structure, however will guarantee that, no matter what policy mix, its economy will break before it can achieve its goals.” (Pettis 2001, p. 199). In other words, it is of crucial importance to control increase in external debt in the first place and in the second to minimize share of a short-term debt or floating-rate debt and debt denominated in hard currency in total debt as much as possible. This is because, an inverted capital structure amplifies intensity of external shock so that debt obligations balloon in the short run, whereas, in parallel, due to dramatic increase in uncertainty, revenues of business units are in free fall.79 This situation leads indebted units into bankruptcy in the short run. In that sense, one of the options for minimizing negative impacts of external shocks can be a return to the capital controls, which existed during the 1960s, and prevented massive inflows or outflows of short-term foreign currency investments. Even though some economists find that restricting capital mobility is a very efficient measure, Sebastian Edwards (2004) finds very little proof of its efficacy since agents find the way to circumvent the restrictions, while authorities might become too confident about restrictions and implement riskier policies than justified. Measures of capital controls include reserve requirements on banks’ liabilities, the Tobin tax such as taxes on short term foreign exchange operations that were recently implemented by Brazil and Taiwan, and the outright prohibition or limitation of the capital flows. Recently, even the IMF, known as a fierce enemy of the capital controls in the past, recognized that developing countries have to stand ready and use all available tools and even keep an open mind concerning the capital controls in order to stem the unproductive and disruptive capital inflows, which exacerbate 79 In the event of sharp depreciation of local currency, ensuing inflation works for the benefit of the indebted unit providing its debt is, for example, medium or longterm fixed-rate debt denominated in local currency, since inflation simultaneously erodes burden of debt and nominally increases revenues of non-tradable sectors. Not less important, weaker currency increases competitiveness of tradable sector in international markets.

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boom and bust cycles. (Belka 2010). Yannick Kalantzis (2004) finds that the productivity gains stemming from the capital inflows are the most important predictor of future balance of payment crisis in an economy suffering from a surge in capital inflows. This implies that policy makers should asses with scrutiny the productivity gains from any investments, especially in the non-tradable sector, and approve or support the foreign financed investment only if the productivity gain is large. While some researchers find very little empirical evidence that the fiscal policy has an impact on the trade balance, others find strong evidence that better fiscal positions improves the current account balance. (Abdul Abiad, Daniel Leigh and Ashoka Mody 2009). Until this dilemma is resolved it seems like a wise policy to run an countercyclical fiscal policy as the most effective tool for controlling the aggregate demand given the existing monetary policy and exchange rate regimes in place. Controlling the aggregate demand will most likely result in a more controllable current account deficit. Necessary measures to reduce the credit euroization encompass a long-standing and credible commitment of policy makers to preserve the value of a domestic currency in real terms and maintain low inflation rates. Credible long-term policies in this sense are the preference of public borrowing in local currencies, encouragement of foreign owned banks to borrow and lend in the local currency, deepening of local capital market with the focus on bonds and the strict bank supervision regarding the foreign currency exposure and the foreign currency lending to the nontradable sector. However, some authors claim that credible policies are not sufficient. Barry Eichengreen, Ricardo Hausmann and Ugo Panizza (2003) describe the phenomenon of the “original sin”, i.e. inability of emerging and developing countries, but also developed but small economies to borrow in their own currency either in domestic or international financial markets. The main reason why they cannot borrow in their own currency, at least in the sufficiently large amounts and with long maturities, is their small economic size, which fundamentally diminishes their attractiveness as means of diversification. We have to note that if we accept hypothesis that capital movements are largely exogenous to developing countries, and therefore developing countries are very sensitive to changes in external factors and that liquidity contraction in major financial centers results in rise in interest rates and decline in commodity prices and terms of trade, it is dubious that diversification among different developing countries will bring any benefits to investors since during times of financial turmoil they all react in roughly same manner. Be as it may, by comparing countries like South Korea and Chile with Indonesia or Venezuela, these authors find that, as liquidity model suggests, conventional hypothesis about the credible and sustainable fiscal and monetary policies, the quality of

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institutions and the rule of law, have little, if any explanatory power of this phenomenon. Due to “original sin” emerging economies are forced to borrow in foreign currencies, which implies the high rate of dollarization of financial and real sector balance sheets. This fairly pessimistic view implies that these counties have several options at their disposal. The first one is to accept the dollarization and costly crisis that come along and the second is to close their capital account, thereby forgoing the benefits of the access to foreign savings. Third option is to accept dollarization and amass large foreign currency reserves, which usually yield negligible returns. Fourth and last option would be to rely on the short-term or floating-rate borrowings denominated in domestic currency which implies large and volatile interest rates and the significant roll-over risk in the case of long-term investments funded by such borrowings. The only way out of this situation is to encourage large multinational corporations and international financial institutions to borrow or issue bonds denominated in emerging and developing market currencies in order to enlarge international holdings of such currencies and reduce the importance of the original sin. Such borrowings or bond issues are not unheard off, and do occur from time to time. Stronger banking sectors, which can be achieved through stronger bank supervision, would certainly enable policy makers to conduct more aggressive measures when speculations against local currency arise. Tight bank supervision is very important before the onset of the crisis, since it will help reduce the vulnerability of the country in terms of risk mismanagement, balance sheet mismatches and high level of liability euroization and excessive credit growth. High capital adequacy requirements, high risk weights for foreign currency denominated loans, a high provisioning requirement and debt-to-service ratios are probably the best choices for building a safe and sound banking system. One measure, which is necessary, but does seem to be insufficient to mitigate the vulnerability of the country, is a high risk-weight for foreign currency denominated loans especially to the unhedged corporate and household clients and those from the non-tradable sectors. Central, East and Southeast European banks did obey this requirement but it did not seem to have slowed-down or averted them from providing such loans. Most likely, this vulnerability has to be treated with much stricter measures like a very high provisioning requirement upfront or straightforward limitation of such loans coupled with an increased transparency in reporting these balance sheet mismatches and currency exposures. Cooperation and co-ordination with home country supervisors in the case of foreign banks operating in the developing countries could bring some benefits. The idea is to impose strict standards on direct cross-border lending in terms of the foreign exchange risk, which can only be enforced

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by the home country supervisors. The benefit would be lower levels of foreign debt, while the cost would imply limited financing opportunities and higher domestic interest rates. The improvement in the transparency and credible financial reporting would expose the currency mismatches in private sector’s balance sheets. Greater transparency of a developing economy in question would certainly lead to much more cautious investments and capital inflows during the good times, and therefore, much less capital flight when the economy experiences a recession. Emergency credit lines or foreign exchange swap facilities should be established between central banks or large commercial banks in order to scare off speculators and assure investors that a developing country facing difficulties has substantial resources, which can be drawn in order to defend the currency. Probably, just a mere existence of these lines would suffice to avert any speculative attack, like in the case of Poland and its unused flexible credit line arranged with the IMF. Accumulation of foreign exchange reserves and their maintenance at the optimal level is an additional tool, which would discourage the speculative attacks, at least the milder ones. Additional benefit from large stock of foreign exchange reserves is smoothening of sudden stops and capital inflow reversals. The cost of holding large stock of foreign exchange reserves implies large opportunity costs from unrealized investments. There are no strict rules on how high reserves should be, but two most often used rules of thumb are coverage of short-term maturing debt and coverage of monetary aggregate M2. (Calvo 2006). Reliance on equity and direct investments instead of borrowing from abroad is one of the most important tools for policy makers in a developing country, provided they want to secure sustainable capital movements. In this case, a probability of a default is much lower, as investors accept their share of burden in bearing whatever problems the economy is facing. Since dividends certainly do depend on the profitability of the investments, unlike interest and principle payments, capital outflows during the economic downturn will be much lower than in the case of foreign borrowings.

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