The European Debt Crises and Its Impact on Southeastern Europe and Eurasia May 18, 2011

1. 6th Annual Event on Competitiveness, Finance, and Economic Growth The European Debt Crises and Its Impact on Southeastern Europe and Eurasia May 18, 2011 Anthony Sinclair Macroeconomic and Financial Markets Advisor USAID Serbia Business Enabling Project Implemented by Cardno Emerging Markets Ltd/ t.sinclair@bep.rs

2. The Happy Days Prior to 2008, we had… • Low rates • Lots of liquidity • Regional stability • Profit-seeking bankers • “Euroization” • Export-driven growth • Relaxed regulators This fueled… • Increased capital flows • Increased borrowing • Increases in public spending • Consumption-led growth • Commodity boom • Rising living standards – and wages! • Deficits • Structural reform can being kicked down the road • Increased vulnerability to market shocks And this led to…

3. The Rough Days Market Shock - Crises develops in the U.S Part 1 (Pre-Lehman) • Country specific impacts (Lithuania, Romania, Bulgaria, and Latvia) • Western European banks with toxic US exposures Part 2 (Post-Lehman) • Risk spreads shoot up • Capital flows halt • Export activity halts • GDP slows Tsunami - Effect • Credit crises • Liquidity crises • Growth crises • Confidence crises • Drop in commodity prices

4. Risk Transmission • Euro exposure • Foreign bank exposure (also linked to confidence) • Access to external borrowing (Governments and Enterprises) • Capital flows • Economic effects on demand and trade (e.g. export) • Confidence

5. Risk Transmission – FX Exposure Source – EBRD, BIS, Author calculation, and other

6. Risk Transmission – Balance Sheet Mismatches (Banks and Borrowers) Loans Deposits Source – EBRD, BIS, Author calculation, and other

8. Risk Transmission – Foreign Banks (% ownership) Albania BiH Bulgaria Croatia Macedonia Montenegro Romania Serbia Armenia Georgia Ukraine Azerbajan Kazakhstan Kyrgyzstan Tajikistan Uzbekistan 94 90+ 85 91 92 92 88 75 65 88 25 or less Small 20 70-80 Small Small Exposure to PIIGS • In Balkans, Greek and Italian Banks pose largest exposure (e.g. to Albania and Serbia) • Not extensive risk links to Eurasia

9. Risk Transmission – Major Euro Area Bank Investors in Emerging Europe

10. Risk Transmission – Export Dependence By Areas

11. Risk Transmission – Export Dependence on Italy and Greece

12. Risk Transmission – NPL Levels (% of loans) Albania BiH Bulgaria Croatia Macedonia Montenegro Romania Serbia Armenia Georgia Ukraine Azerbajan Kazakhstan Kyrgyzstan Tajikistan Uzbekistan 12 10 12 10 10 17 15-20 17 15 8 10 25+ 32 15+ - - More real sector affect from crises and drop in commodity prices

13. Risk Transmission – Capital Flows • Capital flows in SEE dropped substantially, but they have stabilized • Complex problem of needing to raise external finance for growing deficits – fiscal risks and inflation starting to undermine recovery • Rising spreads in Europe will affect demand and cost for debt in Balkans

14. Risk Status – Generalized Summary of Euro-Contagion Risk in SEE and Eurasia SEE Transmission Channel Eurasia Widespread Negligible • Euro FX • Euro Banks • External Borrowing (Governments and Enterprises) • Investment and Other Capital flows • Economic (e.g. export demand) • Confidence Negligible Some to Greece, Italy, (Maybe Austria in worst case) Negligible Some Some Widespread, but not directly from Euro zone Widespread – made worse by fiscal austerity and FX exposure Indirect, via impact on commodity prices Indirect Widespread – jittery markets

15. Questions Is there another financial shock looming? • Euro/dollar exchange rate says no, or it expects “healthy” Europe to pay up at any cost • Greece has already “defaulted” with yields reaching 15%, and yields on debt of Portugal and Ireland aren’t far off so next hit may not be a shock but a long slog • Portugal and Ireland are on the line

16. Questions Are Central Banks better prepared for second round of crises? In one sense, yes: • They have market support mechanisms in place and benefit of hindsight. In another sense, no: • Not dealing seriously with systemic risk • Supervision still too much rules based; provisioning by regulation doesn’t work; • Too much forbearance going on – not a credible situation; few actual bank failures (central banks don’t always make good regulators) • NPLs probably underestimated

17. Questions What if Foreign Banks Decide to Pull Out? • They can’t pull out all at once – repatriation of capital would crush markets and any value banks have remaining • No banks would want to be among the last, so there are no conditions that would allow for an orderly pull out • Vienna Initiative commitment still standing • European parent banks have large loan exposures to their subsidiary banks in emerging Europe. They will wait.

18. Questions What Measures Should be Taken? • Adopt a more holistic and qualitative approach to regulation – get better at systemic risk assessment; understand limitations of prudential regs • Have separate accountability for regulation of systemic risk and regulation of sectors or institutions • Closer examination of economic structure and macroeconomic policies when setting development strategy – be aware of the risks; calibrate regulation according to the growth models being used • Institutionalize risk management; develop markets/products for risk intermediation • Less institutionalization of trust (e.g. securitization) • Better monitoring of risk linkages – of the 1st,2nd, 3rd order