IMF blogger puzzled by Central Europe and Baltic experience in crisis

By Zdenek Kudrna

Ajai Chopra, Deputy Director of the IMF’s European Department, is puzzled by the different performance of Central European 3 (CE3 - Czech Republic, Poland and Hungary) and Baltic 3 (B3 - Estonia, Latvia, Lithuania) in the current crisis. He provides an elegant macroeconomic analysis and contrasts their experience to that of the Asian Crisis a decade ago. However, his analysis fails to note important differences in CE3 and B3 industrial structures that influence the sustainability of their respective economic models throughout the crisis and subsequent recovery. Over the last two decades, the CE3 economies developed traditional economic model based on manufacturing that makes them less vulnerable to financial crisis then is the service-led model of the B3.


Chopra finds that CE3 avoided the much greater currency collapses witnessed in East Asia by ‘luck’ stemming from:

• First, in contrast to the soft pegs in Asia, the CE3 currencies were floating.
• Second, the CE3 economies never suffered a full “sudden stop” of capital inflows as in Asia. Wholesale funding markets dried up, but western European parent banks maintained credit lines to their central European subsidiaries. In addition, bank supervision and capital levels in emerging Europe have been better than in Asia in the 1990s, helping limit financial sector strains.
• Third, the task for external financial assistance was therefore mostly limited to replacing temporarily impaired wholesale funding markets.
• And fourth, EU membership may have instilled confidence in the region’s long-term stability and catch-up potential due to an accelerated convergence process.

He then turns attention to the question why Baltics 3 have not been similarly ‘lucky’ and finds the key difference in:

• Hard currency pegs and expectations of early euro entry had helped attract large capital inflows, but these often fed real estate bubbles, caused heavy exchange rate overvaluations, and fostered a substantially larger accumulation of foreign-currency denominated private debt than in any other region.
• Current account deficits not only dwarfed those in central Europe, but also those in Asia in the late 1990s.

These explanations scratch the surface of the more important differences that stems from export structures. It is true that 2 of the 3 Baltic countries operated euro pegs, but this hardly justifies their higher suggested propensity to (i) join euro, (ii) attract capital inflows, (iii) borrow in foreign currencies. The CE3 currencies were reasonably stable in pre-crisis years, likelihood of joining euro was not substantially different, capital inflows comparable and, at least in case of Hungary, unhedged forex borrowing by households was equally prevalent. Thus we are left with the current account deficit to explain the difference in CE3 and B3 crisis experiences.

The difference in past current account deficits as well as present crisis experiences has a lot to do with different proportions and types of manufacturing established in these economies. Over the last two decades, Baltic countries were busy building service oriented economies, much to the applause of the outside world. They were providing logistical services to booming Russian exports and turned capital inflows into asset bubbles. They inflated their amicable growth rates by selling overvalued real estate to each other. Such growth drivers all but evaporated in the crisis and they offer limited opportunities for export-led recovery that are already hampered by the need to sustain the currency peg.

The CE3 built old fashion manufacturing economies that produced “stuff” for exports. Much of the capital inflow were direct investments into export-oriented production facilities. They have also achieved some progress in upgrading into more sophisticated export goods and are thus more tightly integrated into global supply chains. In crisis their industries proved more susceptible to stimulus packages in their export markets (such as cash for clunkers subsidies in Germany) and to replenishment of inventories that seem to drive the recent “green shoots”. Moreover, depreciation of their currencies puts their export industries into a promising position for export-led recovery once their export markets (Germany) start to recover.

The scholars who stubbornly insisted that there is no sustainable development without industrialization and industrial upgrading seem to be vindicated by this comparative experience.

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G20 summit, crisis measures and what is in it for EU10

By Zdenek Kudrna

The G20 leaders agreed on their London summit to the following commitments:

Restore confidence, growth, and jobs by:

• fiscal expansion in 2009 of up to $5 trillion, plus $1 trillion package added at the summit;
• exceptional easing of monetary policy by central banks;
• recapitalisation, liquidity and impaired assets removal from banks;
• commitment to cooperation in order to return to trend growth;
• promise of credible exit strategies to ensure long-term fiscal sustainability and price stability of the above;
• commitment to refrain from competitive devaluations.

Repair the financial system to restore lending by:

• establishing a new Financial Stability Board (FSB) with a strengthened mandate including all G20 countries, Financial Stability Forum (FSF) members, Spain, and the European Commission;
• ensuring that the FSB collaborates with the IMF to provide early warning of macroeconomic and financial risks and the actions needed to address them;
• reshaping regulatory systems so that the authorities are able to identify and take account of macro-prudential risks;
• extending regulation and oversight to all systemically important financial institutions, instruments and markets, including systemically important hedge funds;
• endorsing and implementing the FSF’s strict new principles on pay and compensation and supporting sustainable compensation schemes;
• taking action, once recovery is assured, to improve the quality, quantity, and international consistency of capital in the banking system so that regulation prevents excessive leverage and require buffers of resources to be built up in good times;
• ending the era of banking secrecy by taking action against non-cooperative jurisdictions (on OECD black list), including tax havens to protect public finances and financial systems;
• calling on the accounting standard setters to work urgently with supervisors and regulators to improve standards on valuation and provisioning and achieve a single set of high-quality global accounting standards; and
• extending regulatory oversight and registration to Credit Rating Agencies to ensure they meet the international code of good practice, particularly to prevent unacceptable conflicts of interest.

Strengthen financial regulation to rebuild trust by:

• providing up to $750bn of new funds to IMF which shall provide it via Flexible Credit Line and reformed lending and conditionality framework;
• completing the next review of IMF voting quotas by January 2011 and ensure open, meritocratic selection of leadership for IMF and the World Bank;
• deliberating on a new global consensus desirable on the key values and principles that will promote sustainable economic activity.
• Promote global trade and investment and reject protectionism by:
• refraining from measures that in their consequences reduce trade and investment flows (even though they may be acceptable under the WTO rules);
• supporting trade financing with to $250 bn channeled through export credit agencies and multilateral development banks; and
• remaining committed to Doha Round of WTO negotiations.

Build an inclusive, fair, green, and sustainable recovery by:

• limit the impact of the crisis on poorest countries and people by sticking to pre-existing commitments for development and social financing and using additional $6 bn of IMF surplus and proceeds from gold sales to this end over next 2 to 3 years;
• channel the stimulus funding towards sustainable green projects as much as possible.

What is in it for EU10?

• The EU10 development models are crucially dependent on their connections to global economy via open trade and capital flows. Commitment to preserve the former and provide better institutional underpinnings for the latter must be welcome in EU10 capitals. EU10 economies are bound to benefit from increased demand for their exports that stimuli are likely to deliver, providing that their trading partners do not impose any "buy American" or "build in France" type of restrictions. This may be especially relevant in respect to stimuli focused on European car demand.
• Given that Hungary, Latvia and Romania depend for elementary macroeconomic stability on IMF lending, beefed up IMF is good news. It is likely that more countries will have to reach for a stand-by agreements. If they can do so under more creative and flexible conditions, then reforms of IMF practices are welcome.
• None of the EU10 economies is a member of G20 (although Czech Prime Minister was present in London as he holds the rotating EU presidency now). EU10 have limited role in global affairs and will have to adjust to whatever the new regulatory regime evolves. However, better regulation will definitely reduce the uncertainty stemming from gaping holes in the EU and global banking regulation that keeps host-country supervisors on the sidelines. In case of failures of foreign banks dominating EU10 financial sectors, the host country regulators, central banks and governments can only hope that their home-country counterparts, will succeed in restructuring and limit the spillover-effects on EU10 economies. Improvement of the international regulatory regime that would strengthen involvement of host-country authorities and define credible ex ante rules for burden sharing is better than current vagueness and uncertainty.

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G20 on banking regulation and leadership responsibility of EU

By Zdenek Kudrna

The G20 meeting this weekend was more important for the fact that major emerging economies were invited than for the substantive decisions. It all makes sense to get India and China at the same table with G8, but it does not make it easier for the US to swallow any kind of supranational financial regulation. I guess we need to wait for the new brand of Obama multilateralism to see any progress on this front.


The G20 statement is thick on good intentions, but thin on specific proposals: Increased transparency of financial sector, regulation of rating agencies, avoiding pro-cyclical regulation, increased information sharing between national authorities, expanding the FSF to include emerging economies and ensuring that IMF and other multilateral institutions to have sufficient resources to support emerging economies capital needs. It practically shifts the ball to the Financial Stability Forum that should develop substantive proposals for the next meeting of G20 in April 2009.

I doubt that FSF would be able to cut through the complexity of the global financial markets and formulate the future vision of the global financial architecture that could deal with all aspects listed by G20. Actually, I believe the EU 27 should be the leader in terms of substance of the new financial regulations. If EU cannot make progress towards supranational regulatory regime, than chances for global progress are slim.

Today EU is composed of both developed (EU15 + 2) and emerging economies (EU10) and its financial sectors cover the full spectrum from cutting edge of finance in the City of London, to rather sleepy backwaters in Prague or Bratislava (Today the 'advantage of backwardness' is worth billions of dollars as it means little exposure to 'innovative' financial products that proved 'toxic'. So Czech and Slovaks may still hope to get through the financial crisis without involvement of state finance). At the same time, EU financial markets are highly integrated, but the regulation is still based on home-country supervisors and its supranational dimension did not progress beyond vague memoranda of understanding and more or less informal consultation process.

EU is well aware of the discrepancy between the financial integration and fragmented regulation. A few years ago it even devised the so-called Lamfalussy procedure to be able to catch up on the regulatory side. However, even before the financial crises the regulatory integration hit the wall. Even the idea of regulatory colleges for major internationally active banks that now seems a nobrainer proved too politically contested to be passed.

As is often the case, lack of compromise boils down to interest-group politics. The political cleavages among vested interests in different countries proved too numerous. Brits, like Americans on the global scale, are suspicious of the supranational regulators. French push for centralized heavy-handed approach. Germans worry about their parastatal landes banks. The EU10 countries are not quite sure whether they should try somehow to adjust their regulatory regimes to the fact that all their banks are controlled from abroad (so they just hope for the best now). Moreover, the non-euro countries are not keen on letting ECB (which usurped the bank supervision responsibilities) to supervise their banks. Moreover, the retail banks are not keen on reducing regulatory barriers to competition, whereas wholesale banks support it. Moreover, parties on each side of these plentiful cleavages are shifting all the time. No wonder EU did not make much progress.

the other hand, times of crisis force some clarity of thinking and make clearer the relative costs and benefits of various arrangements. Some refined objections to supranational regime lose their persuasiveness as bad news keeps coming. Some political compromises (such as principles for agreements on burden-sharing of fiscal cost of bailout of banks active in many EU countries) that would be unthinkable in the normal times may be possible in extraordinary times. Economists call this benefit of crisis. If EU could seize on it, the rest of the globe would be more likely to follow.

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Hungarian promises to IMF and future trends in EU10 banking regulation

By Zdenek Kudrna

Hungary had signed a Stand-by agreement with IMF on November 4, 2008. Apart the standard clauses on the fiscal and monetary policy, it includes a section on the financial sector policies. Although, these commitments are made under pressure to fence off the impact of the global financial crisis, they may foreshadow future changes of the EU10 banking regulatory regimes.

The reason why Hungary is threatened by the financial crisis more than her Visegrad neighbors is fiscal profligacy of her government. High debts and high deficits of public finance over the last few years induced the independent central banks to restrictive monetary policy. In turn, high interest rates (and rather stable exchange rate of forint) motivated households to borrow in euro, Swiss francs or even yen. This resulted in the much higher vulnerability of household balance sheets as they essentially bear unhedged exchange rate risk. Both of these risks were exacerbated by the financial crisis that triggered liquidity trap and capital outflows from emerging markets.

In this context, the Stand-by agreement reviews what by today counts as standard firefighting measures including:

• IMF stand-by of up to 12.5 bn euro for the next 17 months;


• ECB lending facility of up to 5 bn euro;


• EBRD is also mentioned as ready to step into banks;


• doubled deposit insurance from 6 to 13 million HUF, topped by blanket guarantee of all deposits;


• providing a support package for systemically important banks that contains provisions for added capital and funds a guarantee fund for interbank lending (up to 600 billion HUF in total); this support could increase banks' CAR to 14 pc.

To address the foreign lending problem of households, the agreement envisages that banks and indebted families would

• at the request of the debtor, allow the duration of the loan to be extended with fixed monthly installments;
• debtors who deem that exchange rate fluctuations carry excessive risks will be allowed to convert their foreign currency-based loan to a forint loan, without extra charges; and
• in the event that a debtor is unable to service the existing loan, the banks will be amenable to transitionally reducing the installments at the request of the debtor.

The crisis also induced the Hungarian government to submit laws to the parliament that would allow Hungarian Financial Service Authority and financial infrastructure to catch up with what most of their EU10 neighbors have done a few years ago.

• introducing well defined triggers of remedial actions and emergency powers;
• improving the efficiency of the bank resolution regime to facilitate paying out quickly to depositors in case of need,
• introduction of a positive credit registry for households,
• modification of the Central Bank Act to allow the MNB to request individual but unidentifiable data to adequately analyze credit risk,
• enhanced regulation of insurance and credit brokers and their products,
• introduction of maximum loan-to-value ratio requirements for new mortgage loans,
• close monitoring of banks’ foreign exchange exposures, and
• strengthening communication with financial authorities in home and host countries regarding risk assessments and liquidity contingency plans.

Judging what all this means for the future of banking regulation in EU10 is fraught with uncertainties. However, unless we see major moves on the EU level and providing that existing regulatory regime will only be patched not scrapped, we could observe the following:

• a comfortable capital adequacy for turbulent times in emerging markets is neither 8 pc required by Basel Accord, nor 9 to 12 pc. observed across EU10, but more (Hungarian government is betting on 14);
• reintroduction of some simple regulatory measures such as loan-to-value ratios that fell out of fashion during the good times;
• to make the EU10 regulatory regime credible vis-a-vis parent banks and their home-country regulators, a rigid trigger of regulatory action may be needed;
• more transparency and data sharing to monitor system level risks;
• integration of regulation of banking and other financial services;
• stronger regulatory cooperation on EU level.

All of this has always been on the table. However, the unpleasant experience of Hungary and also Baltic states, Romania, and Bulgaria, may help to turn proposals into action in other EU states and on the EU level.

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How to pay for ECB failure?

Buiter likes to provoke and think the unthinkable. He does do that exactly in his CEPR piece that ask the question whether ECB can be in need of bail out after taking dubious assets as collateral to its liquidity-enhancing loans. He argues that EU27 governments should come up with the fiscal formula splitting the burden of ECB bailout.

He has a point. However, what seems to be much more likely than ECB going under is one of the medium sized banking groups that control banks in EU10 going belly up. Many of them are big enough in quite a few EU countries to be counted as too-big to fail. So now, you have a bank operation, say in 10, of the EU27 countries in need of bail out. Who is going to pay for it? The home-country government? A syndicate of home- and host-country government? How would they share the bill?
Time is a precious commodity, when a bank is sinking. There might be a window of a few days to agree on the cost-sharing formula, but it is unlikely that governments could strike reasonable agreement under such time pressure. Without pre-agreed formula, the ad-hoc agreement would be a sure recipe for endless disputes, litigations and arbitrations, that would leave noone but bunch of well paid lawyers happy. The political fallout of such disputes on the European integration project would be ugly (Euroskeptics might be the only ones to rejoice).
An alternative would be to let the ECB to step in. Instead of bunch of squabbling governments, the ECB could lead the rescue efforts in multiple EU countries. Given the nature of the financial integration within the EU, shifting the task to ECB would increase chances of a successful solution. However, the ECB would need to pass the costs to governments. At the end, this might be the more important reason to start thinking about the formula for splitting the costs of bail out.

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George Soros on the current financial crisis and his new book

George Soros, who is inter alia a founder of CEU, has a new book called "The New Paradigm for Financial Markets: The Credit Crash of 2008 and What It Means". The title pretty much summarizes the topic, although readers might be surprised by his venture into philosophy (of science) in the first part of the book.





Geoge Soros talks about the current financial crisis in the US. Although he does not say anything new that an informed reader would not know, he provides accessible summary of some key issues.

Soros is trying to get across his point that financial models are build on the assumption that markets tend to equilibrium around which prices oscillate randomly are built on the false paradigm. Instead he proposes an alternative paradigm of 'reflexivity' that has a post-modern constructivist flavor (there are no hard facts in social sciences, because people manipulate these facts while trying to comprehend them and act upon such knowledge).

In the interview, he is having hard to explain what is the difference in his line of thinking and the common sense perception of markets (perhaps it is just financial economists who got themselves disconnected from common sense:). At the end he pronounces Basel II failed idea (because it presumes that banks know what they are doing) and calls for the regulation of leverage.

His new book just arrive to the library; I am reading it know an plan to do some review.

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Strongly worded argument for varieties of capitalism in banking

Global financial markets have become “a monster” that “must be put back in its place”, the German president has said, comparing bankers with alchemists who were responsible for “massive destruction of assets”.



.... in banking. Finnacial Times report on the comments of the Horst Kohler, current German president and former head of IMF:
Global financial markets have become “a monster” that “must be put back in its place”, the German president has said, comparing bankers with alchemists who were responsible for “massive destruction of assets”.
In some of the toughest comments by a leading European politician since the start of the subprime crisis , Horst Köhler... called for tougher regulations and the reconstruction of a “continental European banking culture”.

Mr Köhler singled out excessive executive pay, the focus of much public resentment against top managers, as a factor in the subprime crisis and accused bankers of acting irresponsibly.

“The complexity of financial products and the possibility to carry out huge leveraged trades with little [of their] own capital have allowed the monster to grow…also responsible [is] the grotesquely high compensation of individual finance managers.

I do not remember the times when he was at IMF, but from comments at other blogs I gather that he is saying something else in Berlin than he was in Washington.

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Wecome to Banking and Finance Section

Finance is important for economic development. Economists of all stripes and colors consistently find support for this thesis, although they argue loudly on what makes finance work and prevents them form collapsing in a spectacular crises. The EU10 experience in last 20 years actually support this view; finance were key to successful transformations in new Europe, but it has also seen its share of systemic meltdowns almost in every single country.

In EU10 finance means banks. Although financial markets keep developing, they are dominated by banks themselves and this is unlikely to change. The EU10 banking sectors developed towards the universal banking model that will keep banks in the center of economic affairs.

EU10 banking sectors are rather unique. Between 60 and 90 percent of banking sector assets are controlled by a few foreign strategic owners. Although other emerging markets are catching up, nowhere else is the role of transnational banks so profound. This brings a host of questions worth exploring. Does it matter that banks are foreign controlled? Probably not, but the first crisis will test this proposition. Do banks contribute towards economic development? They do, but less than traditional national banks used to; they increasingly finance mortgages and consumer loans, whereas investments are FDI financed (or come as cross-border intra-firm finance).

Is the contagion form the current financial crisis going to get EU10 banks into troubles? Probably not. Can local (host-country) regulators ensure prudential behavior of transnational banks? Probably not; although they remain responsible for safety and integrity of banks in their jurisdiction, they have little leverage over large banks and their home-country supervisors in other EU countries. Then, should the banking regulatory regime switch to supra-national EU level? Probably yes.

These are just some question in the development - finance - regulation&governance nexus, that I explore in my research and thus would explore in this blog. Looking forward to your comments.

Zdenek Kudrna

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