Towards a new international financial architecture Peter Sanfey Lead Economist, EBRD 19 November 2009

The transition region is in deep crisis 2009 average output decline: 6.3 per cent Double-digit declines expected in 5 countries (Baltic countries; Ukraine, Armenia). Crisis is not over: rising non-performing loans and unemployment Slow recovery expected for 2010 Romania among the countries hardest hit (minus 8% in 2009, plus 1% in 2010)

Output declines were deep, sudden, and heterogeneous… Quarter on quarter GDP growth, per cent (seasonally adjusted)

…but no full-fledged twin crises. Why? 1.Net capital outflows were less sharp than in previous crises (e.g. Asia) and other regions. 2.Financial systems were comparatively sound (high foreign bank presence, small non-bank financial sectors) 3.Forceful, coordinated and comprehensive crisis response

In most transition countries, net capital outflows were comparatively modest Percentage changes in external assets of BIS-reporting banks

Crisis response has been effective Domestic policies: Massive in western Europe and mature in central and eastern Europe Forceful & coordinated international support –IMF resources tripled from $250 to $750 bn –EBRD investments up more than 50% this year –EU BOP support quadrupled from 12.5 to 50 bn Parent banks maintained exposures New coordination platform – Vienna Initiative

External balance of payments support (Percent of GDP) International support packages are much larger than in the Asian crisis

The Vienna Initiative has helped maintain foreign bank funding Coordination among banks to maintain exposures Joint IFI (EBRD/EIB/WB) support to bank groups Home country authorities allow parent bank support of subsidiaries Host country authorities to provide liquidity equally to foreign and domestic owned banks

The CEB and SEE growth model has three components 1.Political, legal-regulatory integration with EU 2.Trade integration (particularly with the EU) 3.Financial integration, led by EU banks External assets and liabilities, Foreign bank asset share,

In transition countries, capital inflows are correlated with higher growth … in contrast with the experience in other emerging market regions. Non-transition sample Transition sample

Financial integration is good for long- term growth in transition economies Financial integration associated with growth –1 per cent of GDP in inflows raised annual growth by percentage points per year –10 percentage point higher foreign bank share raised growth percentage points per year Financially dependent firms grew faster in financially integrated transition economies –1.5 percentage points per year faster in high capital inflow countries than in low inflow countries

Foreign banks are associated with better output performance in the crisis

But capital inflows fed credit booms and external (over-)indebtedness… Cross-border debt inflows and domestic credit growth,

… and contributed to FX lending in domestic financial systems Foreign bank asset share and share of FX lending in total lending

Financial integration: policy implications Continue to integrate –Only region in the world where financial integration mostly worked the way it was supposed to Manage risks and unintended consequences –Take away the froth through tougher lending standards, and use of macro-prudential instruments –Reduce FX liabilities via better macro institutions, local currency market development, regulation.