Central and Eastern Europe and the financial crisis

21 April 2009 Central and Eastern Europe and the financial crisis 1 About ACCA ACCA is the global body for professional accountants. We aim to offer businessrelevant, first-choice qualifications to people around the world who seek a rewarding career in accountancy, finance and management. We have 29,500 members, students and affiliates across Central and Eastern Europe (CEE), and have offices in Ukraine, Poland, the Czech Republic, Russia and Romania. This paper is one in a series that aims to provide recommendations to policy makers on moving forward by examining issues relating to the financial crisis. Summary of key points 1. The situation is urgent, but there are no easy solutions or quick fixes. 2. The economic crisis may see an escalation in political tensions and social unrest. Governments need to act quickly and with resolve. 3. The European Bank for Reconstruction and Development (EBRD) and International Monetary Fund (IMF) have already joined forces with the European Investment Bank (EIB) to provide up to € 24.5 billion (33 billion dollars) over two years to banks and companies in the region, but more needs to be done to support these economies. . 4. The European Central Bank (ECB), IMF, structural funds, the EBRD and the EIB all need to better coordinate their support, and must act quickly. However, it will take more than loans to secure long term recovery. 5. Not all CEE countries are struggling for the same reasons and not all are struggling as badly as Ukraine and Latvia. The countries of CEE are as different from each other as they are from ‘Western Europe’ and a ‘one-size fits all’ approach will not resolve its difficulties. 1 Central and Eastern Europe comprises the following countries: Russia, Ukraine, Estonia; Latvia; Lithuania; Poland; Czech Republic; Slovakia; Hungary; Romania; Bulgaria; Albania; Slovenia; Croatia; Bosnia and Herzegovina; Serbia; Montenegro; Republic of Macedonia 1 21 April 2009 6. A sustained recovery depends on swift implementation of the measures agreed at the G20 summit, and on coordinating them with other medium to long term measures. 7. In the short-term, bailouts by the IMF and others could increase the effects of the financial crisis in CEE economies, due to the strings currently attached (such as an obligation to reduce the public deficit). 8. Several CEE countries have called for ‘fast track’ entry to the Euro. The EU will have to consider the impact of weaker currencies joining the eurozone; if they are really able to meet the economic criteria for joining, if they will drag the Euro down, and what the likely impact on all eurozone economies will be. 9. The EBRD and EU structural funds could both play bigger roles, while the ECB could amend its rules to enable it to provide support to countries outside the eurozone. 10. Making more structural funds available may be difficult in a climate where corruption has not been completely eliminated. This may also be true of international funds. Many CEE countries continue to suffer from relatively high levels of corruption. As the financial crisis bites, eastern Europe can ill afford to have funds withheld due to corruption. Current situation Following the collapse of the Soviet Union, CEE provided the world with cheap new sources of skilled labour, low-tax locations and raw materials. In the 1990s, the recession in Western Europe saw factories relocating to the CEE, and there followed a decade of massive development across the region with some countries seeing annual growth of nearly 10 per cent a year. However, the latest IMF survey has identified 26 countries that are particularly vulnerable to the financial crisis, and several of them are in CEE. The global financial crisis is hitting the region hard. Currencies, shares and bonds are plummeting and CEE economies are estimated to face a finance gap of $100bn in 2009. In Russia, 7.5 per cent of the labour force is now officially unemployed, the highest rate since November 2005. Unofficial figures point to a much higher level, and the Rouble is falling, which has forced the Kremlin to pour in over $200 billion of its reserves to slow devaluation and avoid panic. The outlook for the most vulnerable states is not good. Hungary faces a drop in GDP of about 5 per cent. Ukraine faces a 10 per cent drop and Latvia 12 per cent this year. At a time when strong leadership and public trust are needed more than ever, governments across the region are looking shaky or collapsing, for example, in the Czech Republic, Latvia and Hungary. 2 21 April 2009 Signs of social unrest are increasing, and this will only get worse as governments across the region cut spending to reduce deficits. There have already been riots, including one in Riga in which more than 40 people were hurt and 106 arrested. Ukraine also saw 20,000 protesters gather in Independence Square in Kiev on April 3, angry at the economic contraction. In Lithuania, public discontent with the government's austerity programme will intensify as the economic downturn gathers pace. The World Bank, the EBRD, EIB announced loans of up to € 24.5 billion for eastern European banks on 27 February 2009. The emergency funding available for CEE has been doubled from € 25bn to € 50bn, and European leaders have also agreed to substantially increase IMF lending facilities by pledging it € 75bn. The EU has so far disbursed about € 10bn from this fund to Hungary and Latvia, and Romania is also receiving assistance. Hungary, Latvia, Serbia, Romania, Belarus and Ukraine have all received support loans from the IMF, the EU and other sources - Lithuania may well apply for assistance in the next few months and more countries are likely to follow suit. In the short-term however, these bailouts could increase the effects of the financial crisis, due to the strings attached – such as an obligation to reduce the public deficit. These bailouts have been seen as necessary, but alone they will not be sufficient to secure economic recovery in CEE. Consequently, there are complaints from some CEE leaders that richer nations are not doing enough to help them through the crisis. The EU, for example, rejected a March Hungarian proposal that it set up an emergency fund of up to € 190 billion for CEE. European Commission President Manuel Barroso said there was no reason to single out CEE for special help, saying: “We are one union, not two unions or three unions2 .” He went on to say that aid would be allocated on a country-by-country basis. The European Commission, in common with EU leaders, has little appetite for a regionwide package. As a consequence of this, the CEE countries are becoming more coordinated, for example, holding a mini-summit on March 1. They have also begun to support each other, with the Czech Republic and Estonia being among those contributing to the Latvian bail-out. But given how serious the problem is, the solution ultimately lies outside the region. European and global institutions will need to continue helping the worst affected countries – but with greater co-ordination, and it will take more than just loans to secure a long term recovery. 2 European Commission President Manuel Barroso speaking after the EU emergency summit, 1 March 2009, Brussels 3 21 April 2009 Not all of CEE is in trouble However, the situation is not so bleak everywhere. In Poland for example, economists still expect growth of 1 per cent, which is greater than in some Western European countries. This illustrates the fact that not all CEE countries are struggling for the same reasons, and that they are not all struggling as much as Ukraine and Latvia. The CEE countries are as different from each other as they are from ‘Western Europe’, and a ‘one-size fits all’ approach will not resolve their problems. Some CEE countries have been implementing measures to meet criteria enabling them to join the Euro and are therefore in relatively robust economic shape.  Poland, for example, has relatively fairly healthy public finances and a low debt-to-GDP ratio, and the Czech Republic has a strong banking system and low debt.  Some of the countries of CEE, including the. The Czech Republic, Slovakia, and Poland, are in reasonable shape due to their more export-driven economies, which means that they need to borrow less. Broadly speaking, these countries have engaged less in lending in foreign currencies and have implemented tighter fiscal policies.  Russia is handling the financial crisis without considering recourse to IMF funding, while Poland has been giving money to the IMF rather than receiving it, which demonstrates the strength of its position.  The Czech Republic, Slovakia and Poland chose to keep their currencies floating against the Euro, which means they can still devalue their own currencies and assist their exporters if the Euro falls. But these countries are not immune to the crisis - the Polish zloty has dropped 30 per cent against the Euro in the past six months, making it the worst-performing emerging- market currency. The Czech government has had to adjust its fiscal targets for 2009 to incorporate an anti-crisis package. One of the key threats to these countries is the danger of contagion, when difficulties in some countries negatively affect their neighbours. This could involve a loss of depositor confidence resulting in a run on the banks, collapsing currencies or the withdrawal from the area of foreign banks. The supervisory authorities of the Czech Republic, Slovakia, Poland, Romania and Bulgaria therefore issued a joint statement on 4 March 2009, asking that investors differentiate between the stronger and weaker economies in the region. Their concerns are that recent warnings from ratings agencies and headlines describing the region as the ‘sub-prime of Europe’ tars all of CEE with the same brush, and could lead to speculation that will damage them. 4 21 April 2009 Rather than it being one homogenous bloc, there are three distinct groupings of countries in CEE: 1. EU members. It must be the EU that takes responsibility for supporting these countries and ensuring that they survive the crisis. 2. The smaller non-EU members. It should be the IMF that is responsible for assisting these countries. 3. Bigger countries that are not members of the EU. It will be a serious problem if these economies fail. Supporting them, where necessary, will involve the ECB, IMF, the EBRD and the EIB. The impact of the April G203 summit Stocks and currencies across CEE and the world soared after the G20 leaders reached several agreements in their plan for reviving growth and stability in the global financial system. In Russia, the dollar-denominated RTS stock index increased by 7.06 per cent; in Poland the WIG20 index rose 6.95 per cent; and in Hungary the Budapest Stock Exchange's benchmark BUX stock index rose 5.4 per cent. The outcome of the G20 summit is particularly important because it was agreed to provide the IMF with an extra $500 billion to give countries including those in CEE with the funding necessary to stabilise their economies. The IMF’s increased budget and the reducing stigma attached to applying for an IMF bailout means that countries needing assistance will apply for it swiftly, something which is beneficial for regional stability. This important injection of international emergency finance reduces the likelihood of capital outflows from CEE, which increases its chances of recovery. In spite of these announcements a sustained recovery remains dependent on their swift implementation, and on their coordination with other medium to long term measures. As it stands, the IMF’s increased budget is just a statement of intent. Only half the money announced has actually been pledged – so CEE cannot rely entirely on this as a path towards recovery. Solving the crisis Throughout history, it has been shown that swift and decisive actions result in a quicker recovery and less long-term damage from banking crises. So what can be done to ensure that this happens in 2009? Included in the G-20 are Argentina, Australia, Brazil, Britain, Canada, China, France, Germany, India, Indonesia, Italy, Japan, Mexico, Russia, Saudi Arabia, South Africa, South Korea, Turkey and the United States. The 27-nation European Union bloc is also a member of the grouping. 3 5 21 April 2009  Excessive exchange-rate depreciations should be avoided. Strong and credible programmes for fiscal sustainability, financial system stability and macroeconomic adjustment are needed to convince the markets that CEE will become stable and resume its growth.  Reduced private capital inflows need to be replaced with public capital inflows. The World Bank, the EBRD and EIB have already issued a joint pledge on 27 February to provide up to € 24.5 billion ($31.2 billion) in aid to support CEE’s banking sector. This has committed the EBRD to providing € billion to financial 6 institutions and in trade finance, the EIB to € billion in loans to small and 11 medium-size enterprises, and the World Bank pledged support of € billion. 7.5 The EU has also extended the availability of its structural and cohesion funds. However, these actions have only had temporary effects – more needs to be done, and in particular:  The EU’s medium-term balance of payments facility for non eurozone member states should be increased.  Disclosing the conditions required to access these funds would increase transparency in the markets.  The ECB could extend currency-swap agreements to other central banks, or accept government bonds denominated in local currencies of non eurozone EU countries as collateral.  The ECB could also offer access to its euro-refinancing facilities to banks from non eurozone EU countries during this difficult period.  The rules of the ECB could be temporarily amended to enable it to provide support to countries outside the eurozone.  The ECB, IMF, structural funds, the EBRD and the EIB need to coordinate their actions better, and this should begin as soon as possible.  The banking sector in CEE is dominated by Western European multinationals, many of which are struggling. These banks must nevertheless continue to lend to their subsidiaries across CEE to enable them to refinance their short-term debt.  Speeding up EU and eurozone membership could help reduce the volatility of some CEE currencies. Hungary, Latvia, Romania and Bulgaria are among those pushing for more flexible joining criteria. However, the EU will have to consider what the impact of weaker currencies joining the eurozone will be, if they will be able to meet the economic criteria, if they will drag the Euro down, and how strong the overall impact on their economies will be. Eurozone finance ministers and the ECB have, however, signalled their 6 21 April 2009 unwillingness to bend current accession criteria, with Jean-Claude Juncker, President of the eurozone finance ministers saying: "There is no question of reducing the rules for joining nor is there any question of reducing ERM-II from two years to one year."4 Of key concern to the eurozone will be the fact that a currency linked to it prematurely could suffer a speculative attack by traders, which could destabilise the Euro itself. The global financial crisis is now understood to have implications that go far beyond the financial and economic sectors, and many Europeans are questioning whether EU enlargement should continue when their first concerns are about the economy, jobs and stability. There were already signs of ‘enlargement fatigue’ before the financial crisis and indeed, the pace of the process has slowed down in recent months. With growing resentment over intra-EU labour migration into countries such as Britain, Ireland, and Spain, and protectionist measures being mooted by countries including France, there is unlikely to be popular support for welcoming poorer economies into the EU and seeing a potential influx of new migrants from CEE or the spending of structural funds outside of today’s EU. The European Commission and the Czech Presidency of the EU argue that enlargement has been positive for the region - by boosting income and trade growth and by increasing stability - and therefore should continue. In a communication in February, the Commission stated that: “The new member states - through their sheer number and dynamism - have made the EU stronger and culturally richer. The enlargement process has helped build and consolidate democracy after the demise of the Communist regimes.”5 And Olli Rehn, EU Commissioner for Enlargement has several times said that: “While combating the economic recession, we must not make EU enlargement a scapegoat for it, as it does not deserve that and as it is not responsible for our social ills. Questioning our commitments on EU enlargement will not help us at all to tackle the economic downturn.”6 However, the Center for European Reform notes in its October 2008 paper: 4 Speaking following a meeting of eurozone finance ministers, 9 March 2009 http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=COM:2009:0079:FIN:EN:PDF 6 Speaking at a European Policy centre Breakfast, Brussels, 31 March 2009 5 7 21 April 2009 “With Europeans now fearing for their jobs and incomes, opposition to the union taking in more poor countries will most likely rise further.”7 This is a debate that will only get more heated in the run up to the European elections. What is possibly a more significant element in terms of EU enlargement, is the Lisbon Treaty. France, Germany and Ireland have all stated their reluctance to accept further enlargement while the EU’s own institutional future is in limbo. Until it is ratified, it is unlikely that there will be any further enlargement of the EU. The European Bank for Reconstruction and Development Charles Robertson, ING's chief economist for Emerging Europe, stated in a recent article8 that banking sector bailouts were essential but that other measures are also necessary – he stated: "IMF support should help vulnerable countries meet their external debt obligations, but EU and EBRD financing is more useful in actually putting cash into these economies to support GDP" In spite of record losses of € 602 million in 2008, the EBRD has recently increased spending in CEE. It provided € 250 million in loans to banks in the region, including Banca Transilvania SA in Romania, Raiffeisen Bank Aval VAT of Ukraine and Bank of Georgia in Georgia. The EBRD is due to increase loans by € 500m in 2009, and expected to invest a total of € billion in CEE, 50 per cent more than planned. The EBRD is set to 1 provide € billion for banks in the form of equity and debt finance: 6 “As a direct reaction to the global crisis9 ”. In addition, ACCA believes that:  The EBRD and EIB should coordinate their financing of projects in CEE to ensure that resources are maximised, and that all deserving cases receive equal attention.  The EBRD is unlikely to continue investing in countries such as Hungary and Romania in the long-term, as it aims to concentrate on accession states. It cannot reduce its investment in any area of CEE until the financial crisis is on its way to being resolved. http://www.cer.org.uk/pdf/pb_fin_crisis_23oct08.pdf www.eubusiness.com/news-eu/1238073422.16 9 http://www.ebrd.com/new/pressrel/2009/090330e.htm 7 8 8 21 April 2009  The focus for the EBRD should be on long-term recovery, providing additional funding for investment in education and infrastructure.  Keeping trade and credit lines open is also crucial. EU Structural funds Structural funds are allocated directly to regions and are predominantly used to support medium-sized companies and educational programmes. The majority of these funds are awarded to regions with GDP below 75 per cent the EU average – which means that CEE countries are significant beneficiaries. In a time of economic slowdown, structural funds are a real opportunity to bolster struggling economies. Many CEE governments have halted infrastructure projects due to the financial crisis. The Commission now intends to finance such projects completely. Previously, recipients were required to provide between 25 and 50 per cent of the total cost of the project themselves. With state budgets decreasing due to financial difficulties, these projects were being put on hold and the funds were not being accessed. Under the new system, there will be an incentive to increase the number of projects, and even restart others. The European Commission is now also offering advance payments for infrastructure and other projects. This means that companies that win a tender can receive payment from the start of their project. Rules stating that funds allocated must be spent within two years have also been waived in response to the financial crisis. This new flexibility is vital. Such projects lead to jobs and investment. Private sources have reduced their funding for many projects, and it would be a mistake if governments also stopped their spending on infrastructure. ACCA believes that:  EU Structural funds, in particular the regional development part of the budget, have provided a lot of support for CEE in recent years. More resources should be allocated to them.  The flow of EU structural funds needs to be speeded up and bureaucracy kept to a minimum in order to bail out or prop up over-exposed banks.  Due to the bureaucracy involved, funds should be targeted at helping to build future competitiveness through infrastructure and education.  Attention should be paid to the environmental lobby which is concerned that the new practices would weaken transparency. It worries that if projects require less scrutiny from the European Commission, then their environmental impact assessments will be compromised. Investment driven by finding a way out of the financial crisis should rather be seen as an opportunity to promote a ‘green’ infrastructure. 9 21 April 2009  Structural funds should be seen as a tool to mitigate, rather than a substitute for, market liquidity.  Short-term solutions – including bailouts - are necessary, but we cannot ignore the need to pursue medium and long-term goals. Fiscal and structural reforms will be required in some CEE countries, including reforms in healthcare and education.  In the long term, funding needs to be bolstered by continuing to pursue the key aims of the Lisbon agenda - modernisation and reform – which will help CEE nations adapt to new economic conditions. However, making more structural funds available may be difficult in a climate where corruption has not been completely eliminated. This may also be true of international funds. Many CEE countries continue to suffer from relatively high levels of corruption. This resulted, for example, in the EU's decision in November 2008, to freeze structural fund payments to Bulgaria. The cost of corruption is extraordinary. The World Bank estimates that $1 trillion is paid in bribes every year, which represents 3% of the world’s gross domestic product. The cost can translate to depletion of national wealth, distortion of fair competition and the rules of free market economy, deterrence of investment and international aid, damage to the public’s trust in political and other institutions and environmental degradation. Accountants play a key role in promoting good governance in their societies. ACCA’s core activity of qualifying and supporting professional accountants makes a direct contribution to elevating individuals and whole societies. Benefits of adequate levels of skilled accounting professionals include greater transparency and accountability, which improve the investment climate and promote better stewardship of donor funds. As the financial crisis bites, eastern Europe can ill afford to have funds withheld due to corruption. Conclusion Much of CEE – the non EU members in particular – is suffering more than Western Europe. This is a situation will only increase as the impact of the financial crisis deepens. CEE economies staying afloat in 2009 will require increased support from the international banks that dominate the region, and from multilateral institutions such as the EU, the IMF, the World Bank and the EBRD. EU policymakers and the IMF are likely to step in to shore up the worst hit economies and back big foreign banks before every country faces bankruptcy, debt restructuring, currency collapse and depression. A unified response is needed in order to ensure that the banking sector is supported and that Western banks keep lending both in home countries and abroad. 10 21 April 2009 In the short-term, CEE will not be able to survive without Western Europe's support. Though the bill will be huge for bailing CEE countries out, it cannot be avoided. If a way is not found to support CEE and refinance countries’ short-term debt, this will lead to a massive global problem which will impact on Western Europe particularly hard, and political and social unrest are likely to follow. For further Information, please contact: Veena Hudson Public Affairs Manager Email: Veena.Hudson@accaglobal.com Tel: +44 (0) 20 7059 5615 Mob: +44 (0)7736 800 393 Clive Booth Director Public Affairs and Media Relations Email: clive.booth@accaglobal.com Tel: +44 (0) 20 7059 5511 Mob: + 44 (0)7913774053 Country heads Roger Acton – Regional Director – Europe actonr@accaglobal.com +353 872 577 159 Katka Benesova – Head of ACCA Czech Slovak Republics and Hungary katka.benesova@cz.accaglobal.com +420 2 2224 0855 Malgorzata Sawicka - Head of ACCA Poland malgorzata.sawicka@pl.accaglobal.com +48 (0)22 692 41 10 Andreia Manea - Head of ACCA Romania andreia.manea@ro.accaglobal.com (+4021) 312 79 45 Nataliya Vovchuk - Head of ACCA Ukraine, Baltic, Caucasus States nataliya.vovchuk@ua.accaglobal.com (+3) 8 067 761 6801 & Technical specialists Steve Priddy - Director of Technical Policy and Research steve.priddy@accaglobal.com (+) 44 (0) 207 059 5971 Caroline Oades - Head of Research Caroline.Oades@accaglobal.com (+) 44 (0) 207 059 5740 Chas Roy-Chowdhury - Head of Taxation Chas.Roy-Chowdhury@accaglobal.com (+) 44 (0) 207 059 5976 David York - Head of Auditing Practise David.York@accaglobal.com (+) 44 (0) 207 059 5977 John Davies - Head of Business Law John.Davies@accaglobal.com (+) 44 (0) 207 059 5972 Paul Moxey - Head of Corporate Governance and Risk Management Ilya Yuferev - Head of ACCA Russia Paul.Moxey@accaglobal.com Ilya.Yuferev@ru.accaglobal.com (+) 44 (0) 207 059 5794 (+7) 495 737 5542 Rachel Jackson - Head of Social and Environmental Issues Rachel.Jackson@accaglobal.com (+) 44 (0) 207 059 5845 Richard Martin - Head of Financial Reporting Richard.Martin@accaglobal.com (+) 44 (0) 207 059 5748 Robin Jarvis - Head of Small Business Affairs Robin.Jarvis@accaglobal.com (+) 44 (0) 207 059 5975 11