Emerging Europe's deleveraging dilemma
Erik Berglof and Bozidar Delic April 11, 2013Serbia's Tigar Corporation, a privatized automobile tire and tube maker, was a poster child for corporate makeovers in transition economies. Then eurozone deleveraging kicked in, and now the child in the poster is in serious trouble.
When Tigar sold its tire division to France's Michelin, it invested the entire proceeds in new businesses. Perhaps capital expenditures were overly ambitious, but they triggered rapid export growth, and more than 2,000 jobs were created in the small town of Pirot to manufacture boots for European fishermen and New York City firemen, as well as technical rubber products. Expansion was, for lack of other options, financed largely through short-term loans.
Many banks in Serbia and other transition countries in Europe rely heavily on funding from their eurozone parent institutions. But, since the onset of the global financial crisis, eurozone-based banks' subsidiaries in emerging Europe have been reducing their exposure to the region. In 2009-2010, the European Bank Coordination Initiative - known informally as the "Vienna Initiative" - helped to avert a systemic crisis in developing Europe by stopping foreign-owned parent banks from staging a catastrophic stampede to the exits.
But, in the second half of 2011, the eurozone-based parent banks that dominate emerging Europe's banking sector came under renewed pressure to deleverage. Many are now radically changing their business models to reduce risk.
Over the last year, funding corresponding to 4 per cent of the region's GDP - and, in some countries, as much as 15 per cent of GDP - has been withdrawn. Bank subsidiaries will increasingly have to finance local lending with local deposits and other local funding.
Without disputing the need for some deleveraging, a new incarnation of the Vienna Initiative - Vienna 2.0 - seeks to make the process orderly. After all, excessive and chaotic deleveraging by lenders to emerging Europe - and the ensuing credit crunch - would destabilize this economically and institutionally fragile region.
For Tigar, deleveraging has meant that banks that had pursued its business only a couple of years ago have suddenly cut lending - even though the company never missed a debt payment. Previous loans came due, while cash-flow needs grew. Despite its good operating margins, growing markets, and prime international clients, the company experienced a drop in liquidity, requiring serious balance-sheet restructuring. Tigar will make it; but many promising companies that lack its solid financial footing will not.
Of course, after several years of unfettered credit expansion, some retrenchment was necessary and desirable, and Tigar probably overextended itself. But several factors - most of them unrelated to the region - are pressuring banks to pursue faster-than-optimal deleveraging.
For starters, the Basel III package of global banking reforms and the European Union's corresponding Capital Requirements Directive IV rule create disincentives for cross-border financing. To be sure, they will help to prevent banks from using instruments resembling collateralised debt obligations (which banks use to repackage individual loans for placement on secondary markets) to reduce their exposure. But the new regulation also seriously penalises subsidiary financing in new EU member and accession countries. Indeed, in many countries, bank guarantees can be issued only on the basis of local subsidiary equity, without support from the parent's balance sheet.
Furthermore, collateral - especially real-estate assets - will continue to be downgraded. Poor 2012 corporate financial results will further undermine credit ratings. Fewer and fewer companies will meet basic risk criteria. While governments might offer attractive liquidity facilities, banks will be unable to on-lend the funds. And spillover effects from Greece will continue to affect Balkan and other emerging European banking markets.
Indeed, several Western financial groups are considering partial or complete exits from the region - without any clear strategic replacement in sight. The potential systemic crisis threatens to accelerate deleveraging further, with serious consequences for emerging Europe.
That is why the Vienna Initiative must become an effective "voice" for the host countries in the Europe-wide debate on debt resolution and banking union. Every effort must be made to prevent the creation of new barriers within Europe's financial system.
Some progress has been made toward safeguarding emerging Europe's banking system. The European Investment Bank, the World Bank, and the European Bank for Reconstruction and Development have agreed on a new Joint Action Plan, including investment totaling 30 billion euros ($39 billion) over the next two years, as well as policy advice, to support economic recovery and sustained growth in the region. They must now deliver.
The European Commission and multilateral lenders should help to facilitate ongoing structural change in the banking sector, including bank acquisitions and balance-sheet restructuring for viable export-driven companies. In exchange, private banks must live up to their collective responsibility to smooth the deleveraging process and limit the systemic impact of their actions. Under these conditions, deleveraging could put emerging Europe on a more sustainable growth path.
Erik Berglof is Chief Economist of the European Bank for Reconstruction and Development. Bozidar Delic was Deputy Prime Minister of Serbia.
Copyright Project Syndicate