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Franz Nauschnigg1 European Economic Integration - Economic benefits and risks – Fast credit growth, volatility of capital flows and foreign currency circulation Financial stability around the Euro area in the context of global market turmoil Euro 50 Group Meeting Budapest – July 1-2, 2008 Abstract The countries in the Central, Eastern and South Eastern Europe (CESEE) region developed successfully and increased their integration with the EU and especially the euro area substantially. The deepening of financial integration contributed to high GDP growth which enabled these countries a convergence process towards the euro area average. This successful catching up strategy of deeper EU integration, especially the financial and capital market integration is not without risks. The main risks are: First, fast credit growth with a high share of foreign currency loans. As a measure against this risk, I propose the introduction of a credit growth stabilisation tax (CGST) whose receipts should be put into a countercyclical stabilisation fund (CSF). Second, volatility of capital flows. Due to high current account deficits the countries need to attract significant amounts of foreign capital. The stability of capital flows is essential and I argue against the standard assumption that Foreign Direct Investment (FDI) flows are stable. FDI can be as volatile as other forms of capital flows and does not necessarily protect a country from sudden stops and capital outflows. Third, substantial foreign currency circulation (Euroization) in this region with the problem of currency mismatches, is shown by a new OeNB survey. 1 Head of European Affairs and International Financial Organizations Division, Oesterreichische Nationalbank (OeNB). The views expressed in this paper are those of the author and do not necessarily represent those of the Oesterreichische Nationalbank. C:\Docstoc\Working\pdf\1fca2d03-f00c-4353-8157-69c325db417d.doc 2 In recent years most of the countries in the Central, Eastern and South Eastern Europe (CESEE) region developed successfully and increased their integration with the EU and especially the euro area substantially. 1. Economic benefits of European Economic Integration The countries of the CESEE region have successfully liberalised, opened their financial markets and implemented EU rules and regulations. Especially the financial and capital market integration is now well advanced. This deepening of financial integration contributed to high GDP growth which enabled these countries a convergence process towards the euro area average. Slovenia in 2007 joined the Euro area and Slovakia will follow in 2009. Other countries joined the EU in 2004 Poland, Czech Republic, Hungary, Estonia, Latvia, Lithuania or 2007 Bulgaria, Romania. Some other CESEE countries are well advanced EU candidate countries, like Croatia some will take some time like the FYR Macedonia, Turkey. Others have an EU accession perspective and are potential candidate countries such as Albania, Bosnia-Herzegovina, Kosovo, Montenegro and Serbia. In Europe capital has been flowing from rich to poorer countries, enabling them to increase investment and consumption simultaneously. Elsewhere capital has flown “uphill” from poorer, mainly Asian and oil producing countries to the US. EU integration has generally been very beneficial for CESEE countries. The Austrian economic research institute (WIFO) calculates that the new EU member countries have grown on average 1%point annually faster due to EU membership (Breuss, 2007). For the old EU 15 member countries the growth benefit was on average 0.1 %points annually, the biggest beneficiary being Austria with 0.25 %points annually. These countries are mostly following the Austrian example of EU integration which has been economically beneficial for Austria, especially compared to Switzerland, which did not join the European Economic Area (EEA) and EU. Austria was growing more or less at the same rate as Switzerland in the 1980ies but could gain a decisive advantage in the 1990ies with a cumulated growth differential in its favour of 28 %points from 1990 to 2006, see Annex 1. The different integration strategy of Austria (EEA, EU, and EMU membership since the early 1990ies) and Switzerland (no to EEA membership in 1992) - is one of the most important factors for this difference (Nauschnigg, 2004, 2008). C:\Docstoc\Working\pdf\1fca2d03-f00c-4353-8157-69c325db417d.doc 3 2. Risks in European economic integration – fast credit growth, volatility of capital flows and foreign currency circulation This successful catching up strategy of deeper EU integration, especially the financial and capital market integration is however not without risks. Capital movement and financial and capital market liberalisation can increase the vulnerability of the economy and amplify already existing problems in other sectors (Nauschnigg, 2005). We have experienced in many countries volatile capital flows with boom and bust cycles which easily lead to banking crisis. We should take care to avoid such an outcome. The Oesterreichische Nationalbank (OeNB) is carefully analysing the CESEE region as Austrian banks are very active in and have a significant exposure to this area. High GDP growth in the CESEE region was fuelled by high investment and consumption growth, financed by high credit growth. As domestic savings were not sufficient to finance this high credit growth foreign savings are used, leading to significant current account deficits. This has led to financial vulnerability in these countries due to high credit growth, the need to attract significant amounts of foreign capital and substantial foreign currency lending. Substantial financial imbalances have developed in recent years in the CESEE region. Compared to other regions like Asia or Latin America the CESEE region is potentially more vulnerable, due to high credit growth, substantial foreign currency lending, significant current account deficits and high degree of Euroization. As the World Bank (World Bank, 2007 page 35) has stated “In conclusion, a balanced approach between ensuring the benefits of convergence are reaped on the one hand, and ensuring its sustainability on the other hand, is required in the Emerging European Countries where the risk that the current rapid credit growth and macroeconomic imbalances lead to a painful adjustment is not to be excluded”. Despite these vulnerabilities the negative spill over from the global financial turbulences on the CESEE region, except the Baltic States seems to have been limited up to now. It remains to be seen if also the countries of the CESEE region, on which the paper concentrates, will also be affected at a later stage. This paper concentrates on three of these risks and potential vulnerabilities in the countries of the CESEE region around the euro area. - First fast credit growth with a high share of foreign currency loans C:\Docstoc\Working\pdf\1fca2d03-f00c-4353-8157-69c325db417d.doc 4 - Second volatility of capital flows - due to high current account deficits with the need to attract significant amounts of foreign capital. The stability of capital flows is essential - Third substantial foreign currency circulation – Euroization 3. Fast credit growth and foreign currency loans Most countries in the CESEE region have experienced rapid private sector credit growth in the last years. Whereas earlier this process was seen as a necessary financial deepening to catch up with credit-to-GDP levels seen in the Euro area, in recent years the question has arisen if some countries have not already arrived at their long run equilibrium levels, or are in the process of overshooting them. An OeNB study (Backé, Égert, Walko, 2007) found that already in 2006 the development in Croatia and Latvia may be interpreted as pointing to a risk of overshooting private credit levels. As table 1 shows private sector credit growth was still very fast throughout the region in 2007, especially in Bulgaria with over 45 % and in Romania with over 50 %. Only Croatia experienced a significant slow down to over 8 % which was mainly due to a number of administrative measures that had been introduced. However, overall various macro- and prudential measures by the authorities, to lower private sector credit growth have not been very successful. So far, the global financial turbulences seem to have been of limited importance for the countries in the region in 2007. It remains to be seen if we will see stronger reactions later in 2008. Table 1 Growth of Domestic Credits to private Non Banks Real Credit growth in % 2004 2005 2006 2007 Bulgaria 43,2 23,4 17,5 45,7 Croatia 11,0 13,4 20,7 8,8 Poland 2,1 8,5 22,3 26,2 Romania 26,2 33,7 46,4 50,1 Slovakia. 1,3 23,5 18,5 19,2 Slovenia 19,9 21,5 22,5 26,2 Czech Republic 10,6 19,2 20,1 21,8 Hungary 12,5 15,1 9,5 10,7 Source: Eurostat, National Central Banks, OeNB As domestic savings were not sufficient to finance this high credit growth foreign savings are used, leading to significant current account deficits. C:\Docstoc\Working\pdf\1fca2d03-f00c-4353-8157-69c325db417d.doc 5 What is more worrying for financial stability is that a sizeable part of these credits was in foreign currency, mainly euro. Over 50 % of credits in Bulgaria, Romania, Hungary and Croatia were 2007 in foreign currency as table 2 shows. In the Czech Republic due to low domestic interest rates the incentive for foreign currency loans has been limited. Only Slovenia has been able by joining the Euro area to reduce this risk substantially and Slovakia should do so in 2009. Table 2 Domestic Credits to private Non Banks in foreign Currency in % of all Domestic Credits to private Non Banks 2003 2004 2005 2006 2007 Bulgaria 43,6 48,2 47,3 45,1 50,0 Croatia 76,6 77,0 77,8 71,7 61,4 Poland 30,6 25,3 25,9 27,0 24,2 Romania 55,4 60,8 54,7 47,4 54,3 Slovakia. 18,8 21,5 22,5 20,0 21,3 Slovenia 27,1 43,1 55,7 63,4 7,3 Czech Republic 12,8 11,2 10,0 10,4 9,1 Hungary 33,7 39,0 45,9 49,6 57,2 Source: National Central Banks, OeNB Especially households and small and medium sized enterprises oriented to the domestic market face a substantial exchange rate risk as they usually have unhedged positions. Despite the high risks, private household have a substantial exposure to credits in foreign currency, see table 3. Over 50 % in 2007 in Croatia, Romania and Hungary as the following table shows. So households tend to underestimate the exchange rate risk and look only at the interest rate differential. Table 3 Domestic Credits to private Households in foreign Currency in % of all Domestic Credits to private Households 2003 2004 2005 2006 2007 Bulgaria 8,9 11,0 15,4 19,0 20,0 Croatia 81,2 79,4 80,0 77,7 67,3 Poland n.a. 27,2 28,4 30,9 27,9 Romania 29,3 45,9 44,1 41,2 53,1 Slovakia. n.a. 0,6 1,1 1,7 3,0 Slovenia 1,0 22,5 37,4 41,7 15,2 Czech Republic 0,5 0,3 0,3 0,2 0,2 Hungary 4,6 12,9 29,2 42,7 55,0 Source: National Central Banks, OeNB Various macroeconomic- and prudential measures by the authorities have not been successful in dampening credit growth. As a study (Herzberg, Watson, 2007) concludes “There may be limited scope to C:\Docstoc\Working\pdf\1fca2d03-f00c-4353-8157-69c325db417d.doc 6 restrain credit or current account imbalances through macroeconomic and financial policies”. My proposal would be to use the tax system and introduce a credit growth stabilisation tax (CGST). If credit growth is deemed excessive e.g. compared to nominal GDP growth, a tax on all private sector credit could be introduced. It would start with a tax rate of 1 %point for all new credits allocated. If this is not sufficient to curb the excessive credit growth the tax rate could be increased to 2, 3, 4, 5 or more %points if necessary. If deemed necessary one could also start with a higher tax rate. To especially discourage foreign currency loans the tax rate should be substantial higher e.g. by 1 - 3 %points, for such credits compared to credits in local currency. Also lower tax rates for credits for economically beneficial and necessary investments could be considered. To avoid circumvention through other instruments e.g. leasing these instruments could also be taxed. The tax should be collected by the banks but ultimately owed by the debtor. It should also apply also to credits taken in foreign countries, with reporting requirements and payment by debtor, to avoid that residents just take a credit in another country, to circumvent the tax. The receipts from this tax should not flow into the budget but into a cyclical stabilisation fund (CSF). This would allow countries to create reserves in the boom phase and help to avoid overheating. The reserves in the CSF could be used in the downswing or bust phase. These counter cyclical policies would act as a countervailing force to pro cyclical forces in the financial system like mark-to-market accounting and value-at-risk models. Such a system consisting of a CGST and a CSF would be especially useful for countries with pegs or hard pegs as in this case the use of the interest rate instrument is very limited. It could also be used for countries in the Euro area. For example Austria has such a credit tax – Kreditvertragsgebühr – which is however not used for countercyclical purposes, but could be adapted to function countercyclical. Austria has already a countercyclical instrument in the financial sector which I constructed and negotiated when I was Economic Adviser to the Minster of Finance. This countercyclical instrument is already functioning for 10 years successfully. Austria had since after the Second World War a system of state subsidies for a savings system to further the construction of residential property (Bausparen). Saving in this system is subsidised so it is very popular and nearly all Austrians do it. We C:\Docstoc\Working\pdf\1fca2d03-f00c-4353-8157-69c325db417d.doc 7 reformed the system so it became countercyclical by linking the subsidy to interest rates. Higher subsidy when interest rates are high, lower subsidy when interest rates are low, on the basis of an automatic formula adjusted each year. One additional prudential measure which should be considered is also that home country supervisors require higher capital ratios for exposures to countries in the CESEE region. This was required by Spanish supervisors and helped to cushion Spanish banks when they incurred heavy losses on their investments in Latin America. 4. Volatility of capital flows Most countries in the CESEE region need to attract significant amounts of foreign capital to finance their high current account deficits. The stability of capital flows is essential to avoid sudden stops or reversals of capital flows. As the IMF remarked concerning the convergence in emerging Europe (IMF, 2008, page 38) “The convergence path may be volatile in countries with large external imbalances, with risks of a hard landing. Current account deficits are well above estimates justified by fundamentals and subject to risks of an abrupt adjustment in most cases”. The IMF (IMF, 2007, page 3) also warned that “External stock and flow imbalances in SEE are now larger than those in East Asia in 1996”. The argument used by these countries and others against the riskiness of these external imbalances is that the huge current account deficits are financed by FDI inflows and FDI inflows are less volatile than other capital flows. The IMF also supports this view (IMF, 2008, page 43 ff) “FDI is less volatile than other capital flows as it cannot leave the country on short notice”. “FDI financed current account deficits are generally more sustainable and tend to adjust more gradually than deficits financed by debt or portfolio flows”. And also (IMF, 2007, page 11) “In Bulgaria and Romania, the probability of a sudden stop has partly been kept in check by high FDI”. When I chaired an UNCTAD expert meeting after the Asian crisis (UNCTAD, 1998) on – The growth of domestic capital markets, particularly in developing countries, and its relationship with foreign portfolio investment - we first also had the expectation that FDI was the most stable form of capital flow. However after long enquiries and discussions we came to a different conclusion. Agreed conclusions (UNCTAD, 1998) of the expert meeting: “as the domestic financial C:\Docstoc\Working\pdf\1fca2d03-f00c-4353-8157-69c325db417d.doc 8 system becomes more sophisticated, the distinction between foreign direct investment and foreign portfolio investment may become blurred due to the fact that direct investors can use financial engineering techniques to convert foreign direct investment into a more liquid form of investment.” FDI can therefore be as volatile as other forms of capital flows and does not necessarily protect a country from sudden stops and capital outflows. 5. Substantial foreign currency circulation There was and still is wide spread use of foreign currencies in the CESEE region (Nauschnigg, 2003), with the potential problem of currency mismatches. With the successful cash change over the euro replaced its legacy currencies also outside the euro area and became the dominant foreign currency in the CESEE region, a phenomenon that it is called Euroization. As I already wrote earlier (Nauschnigg, 2003) “The dominant position of the euro area in Europe and close economic integration with other European countries will favour the euro against the dollar in Europe and will allow the euro to become the dominant foreign currency in other European and neighbouring countries. Accompanying network effects and close regional trade and financial links should ensure that over time the euro will most probably replace the dollar in Europe”. The problem for the countries of the CESEE region is that a sizeable part of their credits is given in foreign currency, mainly euro, which creates substantial risks for financial stability, see chapter 3. A new OeNB survey on foreign currency holdings, which was conducted in 2007 in 11 countries, reveals that euro ownership is more widespread in south eastern European (SEE) countries than in central and eastern (CEE) countries and shows that the euro is the dominant foreign currency, see chart 1. For further information also see (Dvorsky et al., 2008). C:\Docstoc\Working\pdf\1fca2d03-f00c-4353-8157-69c325db417d.doc 9 Chart 1 Share of respondents holding foreign cash in % of respondents 50 45 40 35 30 25 20 15 10 5 0 Czech Hungary Poland Slovakia Bulgaria Romania Albania Bosnia- Croatia FYR Serbia Republic Herzegovina Macedonia EUR US D CHF GBP OTHER Source: OeNB Euro Survey 2007. Note: GBP only asked in Poland. Euro cash holdings show marked differences between countries and are ranging from EUR 100 in the case of Hungary to more than EUR 650 in Serbia, see chart 2. Chart 2 Respondents holding euro cash: median amounts in EUR 700 600 500 400 300 200 100 0 Czech Hungary Poland Slovakia Bulgaria Romania Albania Bosnia- Croatia FYR Serbia Republic Herzegovina Macedonia Source: OeNB Euro S urvey 2007. Note: The figure shows median holdings of euro. Values are based on categorical answers. The median is calculated by linearily interpolating between class boundaries. C:\Docstoc\Working\pdf\1fca2d03-f00c-4353-8157-69c325db417d.doc 10 Savings deposits denominated in euro are even more sizeable than euro cash holdings and show also marked differences between countries, see chart 3. Chart 3 Respondents holding euro savings deposits: median amounts in EUR 4000 3500 3000 2500 2000 1500 1000 500 0 Czech Hungary Poland Slovakia Bulgaria Romania Albania Bosnia- Croatia FYR Serbia Republic Herzegovina Macedonia Source: OeNB Euro Survey 2007. Note: The figure shows median holdings of euro savings deposits. For some countries (Bosnia and Herzegovina, Bulgaria, the Czech Republic, Hungary, Poland) the number of observations is low (less than 30 obs) and hence medians may be unreliable. Also the motives for holding euro cash and saving deposits differ markedly between countries, see chart 4 and 5. Chart 4 Motives for holding euro cash disagree agree Czech Republic Hungary Poland Slovakia Bulgaria Romania Albania Bosnia-Herzegovina Croatia FYR Macedonia Serbia -2,0 -1,5 -1,0 -0,5 0,0 0,5 1,0 1,5 2,0 normalized sample means for each country (-3.5 fully disagree, 0 neutral, +3.5 fully agree) as a general reserve to make payments in my country to make payments abroad, for holidays Source: OeNB Euro Survey 2007. Note: Respondents who held euro cash were asked whether they agree or disagree on a scale from 1 (fully agree) to 6 (fully disagree) to the statement that they hold euro cash as a general reserve, etc. C:\Docstoc\Working\pdf\1fca2d03-f00c-4353-8157-69c325db417d.doc 11 Chart 5 Motives for holding euro savings deposits disagree agree Czech Republic Hungary Poland Slovakia Bulgaria Romania Albania Bosnia-Herzegovina Croatia FYR Macedonia Serbia -1,0 -0,5 0,0 0,5 1,0 1,5 2,0 normalized sample means for each country (-3.5 fully disagree, 0 neutral, +3.5 fully agree) to make payments abroad, for holidays to make payments in [my country] as a general reserve Source: OeNB Euro Survey 2007. Note: Respondents who held euro savings deposits were asked whether they agree or disagree on a scale from 1 (fully agree) to 6 (fully disagree) to the statement that they hold euro savings deposits because the euro will be introduced sooner or later, etc. Furthermore, for some countries (Czech Republic, Hungary and P oland) the number of observations is very low (less than 40 obs.) The results of the survey on cash holdings and deposits show that the euro plays an important role in the CESEE region, but a more substantial role in SEE than in CEE. This high degree of Euroization increases the risk of currency mismatches substantially. 6. Conclusion Through currency pegs and the euro circulation in the CESEE region an extended euro zone is created around the euro area as the core. This benefits regional economic, especially trade and financial links. The substantial risks for financial stability in the countries of the CESEE region need to be well managed to avoid costly financial crisis. The benefits of convergence must be reaped and its sustainability ensured, so that a painful adjustment is avoided. If this is done well, substantial welfare gains for the CESEE region, the euro area and other countries in this extended euro zone could be achieved. C:\Docstoc\Working\pdf\1fca2d03-f00c-4353-8157-69c325db417d.doc 12 References Backé, Égert, Walko (2007). Credit Growth in Central and Eastern Europe Revisited. In: OeNB, Focus on European Economic Integration 2/07 Breuss, F. (2007). Erfahrungen mit der EU-Erweiterung. In: WIFO Monatsberichte 12/2007 Dvorsky, Sandra, Scheiber, Thomas and Helmut Stix. 2008. (forthcoming) Euroization in Central, Eastern and Southeastern Europe – First Results from the New OeNB Euro Survey. In: Focus on European Economic Integration 1. Vienna. Herzberg, Watson (2007). Economic Convergence in South-Eastern Europe: Will the Financial Sector Deliver? In: SUERF Studies 2007/2 IMF, (2007). Vulnerabilities in Emerging Southeastern Europe – How much Cause for Concern? IMF Working Paper WP/07/236, October 2007 IMF, (2008). Regional Economic Outlook Europe – Reassessing Risks Nauschnigg, F. (2003). Kapitalverkehrsliberalisierung – Die österreichischen Erfahrungen. In: Wirtschaft und Gesellschaft, 29(1) Nauschnigg, F. (2003). Kapitalverkehrsliberalisierung. In: Globalisierung und Kapitalverkehr, Wirtschaftspolitische Blätter 4/2003 Nauschnigg, F. (2003). The Euro and the Use of Foreign currencies in Central and Eastern Europe. In: INFER Studies Vol. 8, The Euro in Eastern Europe: Options for the Monetary and Currency Regime Nauschnigg, F. (2004). Fast alle haben gewonnen - Eine wirtschaftliche Kosten-Nutzen-Rechnung des EU-Beitritts für Österreich. In: Arbeit & Wirtschaft, November 2004 Nauschnigg, F. (2005). The Austrian Experience with Financial Transformation through EU/EMU Membership – Possible Lessons for CEE Countries. In: Financial Sectors Development in Central and Eastern European Countries and EU Integration; Workshop and Conference proceedings organised by the Economics Policy Institute C:\Docstoc\Working\pdf\1fca2d03-f00c-4353-8157-69c325db417d.doc 13 (Sofia) and the Institute for World Economics of the Hungarian Academy of Sciences (Budapest) UNCTAD, (1998). Report of the expert meeting on the growth of domestic capital markets, particularly in developing countries, and its relationship with foreign portfolio investment. TD/B/COM.2/12, TD/B/COM.2/EM.4/3; 17 June 1998 World Bank, (2007). Credit Growth in Emerging Europe; A Cause for Concern? Policy Research Working Paper 4281, July 2007 C:\Docstoc\Working\pdf\1fca2d03-f00c-4353-8157-69c325db417d.doc Abbildung 178,5 180 173,2 Vergleich: Wirtschaftswachstum 169,8 170 164,0 165,8 Österreich, Schweiz 161,2 160 Index 1981 = 100 % des BIP 162,5 151,0 155,9 150 ÖSTERREICH 143,1 145,7 136,9 137,1 137,3 147,0 140 132,9 139,5 143,1 129,8 131,1 133,3 137,6 140,4 130 125,3 125,9 135,8 122,9 129,4 119,8 121,1 120 115,7 122,4 123,5 111,8 121,3 110,2 122,3 121,3 Differenz Wachstum 105,1 107,8 117,8 110 101,9105,1 Österreich - Schweiz 112,6 109,0 SCHWEIZ entsteht vor allem in 100 107,6 105,8 90iger Jahren - EWR, 100 102,3 100 98,7 99,2 EU Beitritt 90 Jahre 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 20 20 20 20 20 20 20 Quelle: Eurostat, eigene Berechnungen (für diese bin ich Dr. Herbert Nekvasil zu Dank verpflichtet) C:\Docstoc\Working\pdf\1fca2d03-f00c-4353-8157-69c325db417d.doc
"Financial stability around the Euro area"