Financial Crisis in Eastern Europe Do Impact and Transmission Links Differ for EMU Members?

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1 I N T E R N A T I O N A L B U S I N E S S P R O G R A M S Master Program in International Finance and Economics (MiFE) R E S E A R C H P A P E R S I N I N T E R N A T I O N A L F I N A N C E A N D E C O N O M I C S Center for Applied International Finance and Development (CAIFD) Financial Crisis in Eastern Europe Do Impact and Transmission Links Differ for EMU Members? Author: Markus Kaluza Research Paper 1/2010 ISSN

2 II Foreword to the first issue This paper represents the start of a new publication series which is to reflect the ongoing research in the Master program in International Finance and Economics as well as in the associated Centre for Applied Finance and Development. The list of authors will cover independent research by researchers, professors and lecturers as well as our own graduate students. It is my pleasure to start this series with research undertaken by our very first graduate. Markus Kaluza studied at the Cooperative State University Villingen- Schwenningen and the École de Management Strasbourg before entering the Master program in International Finance and Economics in After his graduation in 2010, Markus Kaluza began his professional career as an investment controller at Baader Bank AG in Munich. Uwe Mummert (Director of the Master program in International Finance and Economics)

3 III Abstract In the final quarter 2008, the worst financial crisis since the Great Depression has hit global markets with full force. Emerging Europe which has attracted attention through considerable growth rates during the last decade has been one of the regions hit hardest on a global scale. This paper studies the causes for this development by examining essential pre-crisis indices of country vulnerability as well as main channels of transmission. It finds that membership in the EMU is no panacea but has helped to dampen the impact by reducing vulnerabilities. Furthermore, contagion to Eastern Europe has been channelled through both real and financial linkages after the collapse of Lehman Brothers. In this respect, countries demonstrating high levels of geographic and commodity export concentration have especially suffered from the sharp decline in global demand, whereas a high percentage of foreign-ownership in the domestic banking sector has exerted a stabilizing role. Keywords: Contagion, Financial Crisis, Vulnerability Indicators, Emerging Europe

4 IV Table of Contents Table of Abbreviations... V Table of Figures... VI List of Tables... VII Index of Annex... VIII 1 Introduction Contagion and External Vulnerability Definition of Contagion Channels of Transmission Real Linkages Financial Links Herding Political Links Global Factors Vulnerability and Economic Characteristics Current Account and Budget Deficits Composition of Capital Inflows Foreign Currency Reserves Domestic Banking System Contagion during the Current Financial Crisis: the Case of Eastern Europe Impact of the Crisis on EE: a Synopsis Financial Stress in Eastern Europe Impact on Growth Rates Pre-Crisis Vulnerability Current Account and Budget Deficits Composition of Capital Inflows Foreign Currency Reserves Domestic Banking System Essential Channels of Transmission Real Linkages Financial Links The Danger of Negative Political Contagion Conclusions Appendix... IX Bibliography... XX

5 V Table of Abbreviations AREAER CA CAD CEE CIS CL CLC DLD EBRD ECB EE EM EM-FSI EMPI EMS EMU ERM EU FED FX GDP ICC IMF LTD NBER NMS NPL SME U.S. = Annual Report On Exchange Arrangements and Exchange Restrictions = Current Account = Current Account Deficit = Central and Eastern Europe = Commonwealth of Independent States = Common Lender = Common Lender Channel = Domestic Liability Dollarization = European Bank for Reconstruction and Development = European Central Bank = Emerging Europe = Emerging Market = Emerging Markets Financial Stress Index = Exchange Market Pressure Index = European Monetary System = European Monetary Union = Exchange Rate Mechanism = European Union = Federal Reserve Bank = Foreign Exchange = Gross Domestic Product = International Chamber of Commerce = International Monetary Fund = Loan-to-Deposit Ratio = National Bureau of Economic Research = New Member States = Non Performing Loans = Small and Medium Enterprises = United States

6 VI Table of Figures Figure 1: EM-FSI, Eastern Europe 33 Figure 2: CA and General Government Balance in EE (Country Groups) 39 Figure 3: Inward FDI and net PFI in Eastern Europe 42 Figure 4: Inward FDI / CAD Ratio in EE (2007) 46 Figure 5: Exposure to Exchange Rate Volatility, Figure 6: Ratio of Foreign Currency Reserves to Import of Goods and Services 50 Figure 7: Change in Deposit and Credit to GDP (Percentage points, ) 52 Figure 8: Credit Growth and House Prices in EE (Percent, ) 53 Figure 9: Total Merchandise Exports in EE 57 Figure 10: Merchandise Exports per Commodity (% of Total Exports, f.o.b., 2008) 59 Figure 11: Foreign-owned banks in EE (2004 vs. 2008) 67 Figure 12: Cross-border Bank Lending (Quarter-on-Quarter Change) 69 Figure 13: Concentration of EE Exposure to Western Europe (June 2007) 71

7 VII List of Tables Table 1: Selected Aggregate Variables of Vulnerability 28 Table 2: Eastern European Expansion of the EU (2004, 2007) 30 Table 3: Actual and Predicted CAD in EE (% of GDP, 2007) 40 Table 4: Net PFI and Vulnerability in EE 44 Table 5: M2 to Foreign Currency Reserves (Q2, 2008) 54 Table 6: Summary of Country-specific Vulnerabilities in EE 55 Table 7: SMEs in EE (1999) 64 Table 8: Index of Exposure to Regional Contagion via the CLC in EE, end

8 VIII Index of Annex Appendix 1: EM-FSI - Subindices X Appendix 2: Financial Stress in Emerging Economies XI Appendix 3: Annual GDP Growth in EE (Percentage Change) XII Appendix 4: Current Account and Government Balance in EE XIII Appendix 5: FDI and PFI to EE countries (% of GDP) XIV Appendix 6: Total and Short-Term External Debt in EE XV Appendix 7: Currency Composition of Household Debt in EE XVI Appendix 8: Trade Openness (Merchandise Exports and Imports as % of GDP) XVII Appendix 9: Geographic Export Concentration of EE, 2008 XVIII Appendix 10: Absolute Dependency and Absolute Exposure in EE, end-2007 XIX

9 1 1 Introduction Financial crises are not a new phenomenon to current financial systems. However, recent crises seem to differ from past periods of financial turmoil regarding an important aspect: the global spread among different countries. 1 Although there have been previous examples of emerging markets (EM), especially in Latin America and Asia, falling like dominoes into deep financial and economic problems in the 1980s, research on the phenomenon of contagion only gained in popularity during the Mexican Crisis ( Tequila contagion ) of Due to the potentially farreaching implications for policymakers in both emerging and developed countries, research on contagion has been intensified since the devastating Asian Crisis. The EMS Crisis of as well as the Russian Default of 1998 followed by the near-bankruptcy of the U.S.-based hedge fund LTCM are further examples of recent crises frequently referred to as contagious in literature. 2 Despite ongoing research on the spread of financial crises across borders, there is still little agreement on how and why some initial shocks could have led to such important adverse effects around the globe. 3 This debate is supported by the fact that some crises in relatively large and economically well integrated countries did only lead to limited international repercussions. Often cited examples include Brazil s devaluation of the real in 1999, Turkey s devaluation of the lira in February 2001, and the Argentine default in December Thus, two important questions arise: (i) what makes an individual country vulnerable to the propagation of crises originating elsewhere in the world, and (ii) what are the channels transmitting financial turmoil from a crisis-country to seemingly unrelated regions around the globe. Whereas the first question provides important inferences for policymakers 5 by tackling areas such as a country s structure of foreign debt or weaknesses of the domestic financial and banking system, the latter examines the particular 1 Cf. IMF: WEO 1998, p. 74 and Goldstein, I., Pauzner, A.: Self-Fulfilling Financial Crises, p Cf. Kaminsky, G., Reinhart, C.: Contagion, p. 1 and Balakrishnan, R. et al.: Financial Stress, p. 3 and Dornbusch, R. et al.: Contagion, pp Cf. Forbes, K.: Country Vulnerability, p Cf. Kaminsky, G. et al.: Unholy Trinity, pp Cf. Perry, G., Lederman, D.: Financial Vulnerability, p. 1 and Gavin, M., Hausmann, R.: Preventing Crisis, pp. 4-5.

10 2 transmission links of a certain shock which has been triggered in a distant region. This analysis is all the more important as no two episodes of severe financial distress are exactly alike 6 and hence, the specific channels respectively their importance are likely to differ during each period of financial stress. However, the answer to these questions is made even more difficult, as the notion of contagion is not defined unambiguously in literature. 7 Numerous approaches range from a very broad definition of contagion as any transmission of shocks across countries 8 to more sophisticated ones defining this phenomenon as the transmission of a crisis to a particular country due to its real and financial interdependency with countries that are already experiencing a crisis. 9 Within this framework the following thesis is intended to contribute to the research of contagion by analysing the spread of the most severe financial crisis since the Great Depression 10 to Eastern Europe, which has been one of the regions hit hardest by the crisis initially triggered by turmoil in the U.S. subprime market. 11 Hereby, special attention is attributed to possible variations between member states of the European Monetary Union (EMU) and non-member countries. Given this objective, the paper does not detail the sequence of preceding events that have led from the initial turbulences in the U.S. market for subprime lending to the crisis in the financial sector. These difficulties are rather taken as given in the context of this paper. The remainder of the thesis is as follows: Chapter 2 reviews in detail the issue of contagion and country vulnerability. Chapter 3 discusses the contagion of the current financial crisis to emerging Europe by examining the pre-crisis vulnerability of the individual economies and main channels of transmission. Special attention will be attributed to possible differences between the respective countries. The main findings of the paper are outlined in chapter 4. 6 OECD: Financial Market Trends, p Cf. Edwards, S.: Contagion, p. 5 and Sell, F.: Contagion, p Edwards, S.: Contagion, p Fratzscher, M.: Currency Crises, p Cf. Evaluation of former Nobel Prize Laureate J. Stiglitz, in: Anon.: Financial crisis and B. Bernanke, in: Anon.: Crisis. 11 Cf. Bolli, J.: Europe.

11 3 2 Contagion and External Vulnerability This chapter is intended to discuss different approaches of defining contagion before turning to the analysis of diverse channels potentially propagating financial stress across borders. The following section further concisely addresses indicators demonstrating external vulnerability of a country. 2.1 Definition of Contagion As it has already been indicated above, there is no generally accepted interpretation of the notion contagion in literature. In contrast, various approaches each accentuating a different angle of this phenomenon exist, which can be referred to the fact that research on contagion is still rather new in the field of economics , 14 Hence, the notion of contagion has taken several meanings due to its liberal use. In this respect, the World Bank provides three distinct definitions of contagion: a broad, a restrictive as well as a very restrictive definition. The broad definition of this phenomenon emphasizes the cross-country transmission of shocks or the general cross-country spillover effects. 15 This broad view of contagion is in line with the definition presented in the introductory part of this thesis defining contagion as any transmission of shocks across countries. 16 The essential proposition of this aspect is that contagion must not necessarily be connected with periods of financial distress. Thus, contagion is occasionally used as a simple synonym for spillover effects. 17 Those effects, however, are usually distinguished from contagion with regard to the following characteristics: spillover effects are not 12 Cf. Edwards, S.: Contagion, p Cf. Kaminsky, G. et al.: Unholy Trinity, p Despite different approaches of defining contagion in economics, it is worth reminding its linguistic roots. Due to the Latin expression contagiare, the phenomenon of contagion, which has initially been used in relation with currency crises, will always be somehow related to the spread of a kind of disease whose consequences are likely to exceed what was expected ex ante. Cf. Sell, F.: Contagion, p. 92 and Edwards, S.: Contagion, p World Bank: Contagion - Definition. 16 Edwards, S.: Contagion, p Cf. Tschabold, H.: Contagion-Effekte, p. 3 and Sell, F.: Contagion, p. 91.

12 4 necessarily connected with severe consequences 18 much slower than in the case of contagion. 19 and their propagation might be The restrictive definition provided by the World Bank describes contagion as the transmission of shocks to other countries ( ) beyond any fundamental link among the countries and beyond common shocks. 20 Thus, a crisis triggered in one country could spread to other economies not only via fundamental channels, but also by herding behaviour of international investors. This emphasize of the role of international investors clearly distinguishes the restrictive definition of the World Bank from the second definition provided in the introductory part of the thesis, which only traces contagion back to real and financial links between the affected countries. In this context, Sell differentiates between fundamental or direct contagion, which is caused by direct links between the country originating the crisis and the countries affected by its consequences, and non-fundamental or indirect contagion, which could be due to a general shift in risk perception of international investors. 21 The very restrictive definition by the World Bank describes contagion as an increase in the cross-country correlations in crisis times compared to tranquil times. 22 Thus, following this narrowest definition, the spread of certain shocks across borders would systematically increase during turbulent times. 23 This effect can be explained by so-called crisis-contingent mechanisms, which rely on the assumption that the behaviour of the agents, who ultimately determine the prices, changes during crises. As a consequence, correlation coefficients of assets might change during these periods. This type of contagion is also referred to as shift-contagion. 24 As one of the main objectives of this paper is to identify both direct as well as possible indirect channels transmitting the current crisis to Eastern Europe, the 18 Cf. Perry, G., Lederman, D.: Financial Vulnerability, p In contrast to the idea of spillover effects, contagion is characterized by significant immediate effects in numerous countries after an initial shock. Thus, the consequences are fast and furious. Cf. Kaminsky, G. et al.: Unholy Trinity, p World Bank: Contagion - Definition. 21 Cf. Sell, F.: Contagion, p Cf. World Bank: Contagion Definition. 23 Cf. Gravelle, T. et al.: Shift Contagion, pp Cf. Forbes, K., Rigobon, R.: No Contagion, p. 1 and Jong, E. et al.: Behavioural Heterogeneity, p.1.

13 5 definition coming closest is the World Bank s restrictive definition of contagion in combination with Sell s differentiation between fundamental and non-fundamental contagion. 2.2 Channels of Transmission Although there are as many transmission channels as there exist windows from one country to the world economy 25 the following chapter is intended to systematically explore a high number of transmission mechanisms significant for the contagion of financial crises. However, literature does not provide a definite distinction between the different groups of channels. Whereas the World Bank discerns fundamental transmission links comprising real, financial and political channels from herd behaviour, 26 the IMF differentiates among global (such as commodity prices, global output or interest rates) and country-specific factors (including a country s vulnerability, economic characteristics as well as trade and financial links). 27 Hence, the paper will primarily focus on a detailed analysis of each of the respective channel of transmission including a review of recent literature on contagion and will thus be influenced by the grouping of transmission links by both the World Bank and the IMF. In the following, real linkages, financial links, herding behaviour as well as political links and global factors will be distinguished Real Linkages The first possible transmission mechanism of financial distress to be analysed are real (or trade) linkages. This relatively direct form of connection between a numbers of economies is counted by the World Bank among the fundamental causes of contagion and as it differs from one country to another as country-specific reason by the IMF. 28 Generally, two distinct types of real linkages essential for the research on contagion can be identified: bilateral trade and competition in third markets. 25 Sell, F.: Contagion, p Cf. World Bank: Contagion Definition. 27 Cf. IMF: WEO, April 2009, p Cf. World Bank: Contagion Definition and IMF: WEO, April 2009, p. 143.

14 Bilateral Trade Countries relying heavily on bilateral trade with a country experiencing a financial crisis, which might have additionally led to large currency depreciation, will be adversely affected through an actual or incipient decline in the demand for domestic exports. 29 Hence, a comparatively large degree of bilateral trade (measurable as total exports to crisis country as percentage of domestic GDP 30 ) makes a country vulnerable to the spread of a crisis through income effects Competition in Third Markets In regard of contagious effects through competition in third markets with the firstvictim country, recent literature often traces back to the research on competitive devaluation conducted in the interwar period. 32 The rational behind this idea is that countries competing on a common market with the crisis-country, whose currency has already been devalued, will be negatively affected by a decline in their own competitiveness. Due to the increasing pressure to devalue in order to protect own exports, to improve the current account 33 and to minimize adverse effects to domestic employment, this relatively costly policy option can be decided on. 34, 35 This kind of contagion through price effects 36 is also referred to as voluntary contagion 37 or beggar-thy-neighbour effect. This is due to the fact that the option to devalue will only operate at the expense of other economies and could invite retaliation. 38 The pressure to opt for a devaluation of the domestic currency will be intensified even more, if the country s currency is not freely floating. Especially because of the noncooperative character of such competitive devaluations, the depreciation of the 29 Cf. Rijckeghem, C., Weder, B.: Finance or Trade, pp. 4-5 and IMF: WEO, April 2009, p Cf. Balakrishnan, R. et al.: Financial Stress, p Cf. Fratzscher, M.: Currency Crises, p Cf. Nurkse, R.: Currency experience, p The current account will be improved, as a devaluation makes own exports relatively cheaper and at the same time discourages imports, because foreign products become relatively more expensive. Cf. FED of New York: Currency Devaluation. 34 Cf. Fratzscher, M.: Currency Crises, p. 8 and Kaminsky, G. et al.: Unholy Trinity, pp Main reasons why devaluation might be a very costly policy option include a potentially higher rate of inflation due to increasing demand for domestically-produced products and the danger of a loss in creditworthiness if the devaluation is regarded as a sign of weakness. Cf. FED of New York: Currency Devaluation. 36 Cf. Fratzscher, M.: Currency Crises, p. 8. This mechanism is also labelled competitiveness effect, cf. Forbes, K.: Country Vulnerability, p Cf. Kaminsky, G. et al.: Unholy Trinity, p Cf. Nurkse, R.: Currency experience, p. 129.

15 7 domestic currency is likely to be greater than necessary with respect to the deterioration in fundamental aspects due to the crisis. 39 In recent literature, a number of authors stress the importance of trade linkages. Thus, Eichengreen, Rose and Wyplosz compare the significance of trade channels with similarities in macroeconomic variables. Their research using quarterly panel data from 20 industrialized countries from 1959 through 1993 demonstrates that contagion through trade linkages is stronger than contagion resulting from macroeconomic similarities. 40 Glick and Rose are in line with these findings when analysing the importance of trade linkages during five crises between 1971 and Their results suggest that the linkage via trade is intuitive, economically significant, statistically robust, and important in understanding the regional nature of speculative attacks. 41 Hence, the latter contributes to the research on contagion in an important aspect: the regional character of contagion, which is contributed to the fact that trade tends to be strongly negatively affected by distance. 42 In addition to these results, Forbes similarly concludes that trade linkages are able to explain contagion (measured as variations in stock market returns) across borders when analysing data on trade flows for a global sample of developed and emerging markets between 1994 and Forbes research, however, indicates that there might also be other channels playing an important role in the transmission of financial stress. Furthermore, the respective policy reactions of a country affected by a crisis have to be considered as an integral aspect of how financial turmoil will affect other economies. 43 Generally, there is evidence in literature that trade linkages are likely to play a crucial role in the contagion of financial crises. This is in line with recent findings of the IMF pointing out that the role of those channels of transmission has increasingly 39 Cf. Dornbusch, R. et al.: Contagion, p Cf. Eichengreen, B. et al.: Contagious Crises. 41 Glick, R., Rose, A.: Contagion and Trade, p Glick, R., Rose, A.: Contagion and Trade, p Cf. Forbes, K.: Country Vulnerability. Thus, only the policy decision on a sharp devaluation of the domestic currency in the crisis country will result in a large and significant competitiveness effect.

16 8 become important for emerging market economies during the last two decades. 44 It has to be noted that with respect to real linkages second-round effects from EMs back to advanced economies and within the group of EMs are possible Financial Links A further potential linkage propagating financial shocks from one country to another is the existence of financial links. This channel has been classified by the World Bank (fundamental link) and the IMF (country-specific) in the same way as real linkages. 46 With increasing economic integration of a nation, covering trade as well as financial linkages, the vulnerability to financial contagion rises. This is especially the case for countries which are heavily engaged in international financial flows by the global trade of their own financial assets and by disposing of highly liquid financial markets. 47 Hereby, the absolute level of integration into global capital markets can be defined as the sum of gross international financial assets and liabilities. Related data clearly indicate that the current wave of financial globalization has its roots in the 48, 49 mid-1980s. Further approaches of measuring the financial openness of an economy include the examination of legal capital controls (de jure), as proposed for example by the IMF s AREAER 50, or the assessment of the financial integration de facto, which seems to constitute a more relevant figure in practice. 51 More specifically in the context of contagion financial stress in a highly integrated country could easily spread directly to other economies via changes in foreign direct investments (FDI), trade credits or other capital flows comprising portfolio 44 Cf. IMF: WEO, April 2009, p According to these calculations, the exports from emerging markets to advanced economies have increased from less than 10% to nearly 20% of the emerging markets GDP. 45 Cf. IMF: WEO, April 2009, p Cf. World Bank: Contagion Definition and IMF: WEO, April 2009, p Cf. Dornbusch, R. et al.: Contagion, pp Cf. Kose, M. et al.: Financial Globalization, p In order to quantify the relative importance of financial linkages for an individual country, the sum of gross foreign financial assets and liabilities can be related to the country s GDP. Cf. IMF: WEO, April 2009, p The IMF s Annual Report on Exchange Arrangements and Exchange Restrictions (AREAER), which has been published since 1950, examines more than 60 diverse types of capital controls. 51 Cf. Kose, M. et al.: Financial Globalization, pp

17 9 investments, and bank lending. 52 Further transmission links relying on financial aspects of contagion include the problem of asymmetric information potentially resulting in herding behaviour, the role of liquidity of international investors including commercial banks, as well as the rules and practices of the international financial system. Whereas direct financial contagion frequently has its origins in a shift in fundamentals, the latter forms of transmission are founded in the rules of institutional market participants and changes in expectations. 53 Thus, the paper continues by analyzing the distinct propagation mechanisms via financial links. Comparably to contagion via real linkages, second-round effects may also occur when shocks are transmitted via financial links across borders Trade Credits By analysing real linkages on the one hand and financial links potentially propagating financial shocks across borders on the other hand, it is essential to mention that those two channels might interact with one another. 55 This can be attributed to the fact that international financial links do not necessarily require the existence of financial intermediaries. In fact, also non-financial firms build up financial links by providing (trade) credit to their customers. Thus, an unanticipated liquidity shock to a company participating in such a business can easily spread to other firms having claims on the affected company. This will lead to relatively high losses as trade creditors usually operate on an unsecured basis. Furthermore, trade credits are likely to be withdrawn in periods of financial distress. Thereby, often no distinction is made between customers with high or low firmspecific risk. However, firms possessing of a relatively high amount of trade receivables are more likely to be adversely affected by a withdrawal of trade credits. This mainly relies on the uncertainty concerning the anticipation of the next default by the trade creditor Cf. Dornbusch, R. et al.: Contagion, p. 6 and Balakrishnan, R. et al.: Financial Stress, pp Cf. Tschabold, H.: Contagion-Effekte, p Cf. IMF: WEO, April 2009, p Cf. IMF: WEO, April 2009, p Cf. Tsuruta, D.: Credit Contagion, pp These results rely on research conducted during the Japanese recession of covering especially small businesses.

18 10 The rational behind this linkage is that a decline in international trade could be at least partly the result of a decrease in the supply of trade credit, as the availability of trade credit is linked to trade volume Performance Based Arbitrage One of the essential preconditions that performance based arbitrage can lead to the propagation of financial turmoil is that this type of arbitrage is not in line with the classic definition of arbitrage promising a guaranteed profit without the necessity of engaging money. 58 It rather relies on the idea of risk arbitrage occurring in the complex real world, where investors do need high amounts of money to execute their trades and to possibly cover suffered losses, as profits can not be taken for granted. 59 Although this theory of arbitrage has not solely been developed for the purpose of describing financial contagion, it is indeed appropriate to demonstrate that the transmission of financial stress can be caused by arbitrageurs liquidating large positions in countries initially not affected by an adverse shock. 60 The main idea behind this claim is explained in the following. A fundamental fact concerning this kind of arbitrage is that brains and resources are separated. 61 This means that the investment is conducted by a small number of highskilled and specialized arbitrageurs managing the funds provided by wealthy individuals or institutions. As capital owners often tend not to be experts in the complex field of risk arbitrage, they may start withdrawing funds if prices further move out of line. Thus, they might only see the arbitrageur losing money at a first glance and continue withdrawing although the prospects of positive returns have increased due to the increasing mispricing the arbitrageur initially has betted on. This allocation of funds due to past returns of specialized arbitrageurs and thus the responsiveness to past performance is known as performance based arbitrage. 57 IMF: WEO, April 2009, p In this respect, classic arbitrage is defined as a simultaneous purchase and sale in two separate markets in order to profit from a price difference existing between them. Cf. Moore, K.: Risk arbitrage, p Cf. Shleifer, A., Vishny, R.: Limits of Arbitrage, p Cf. Kaminsky, G. et al.: Unholy Trinity, p Shleifer, A., Vishny, R.: Limits of Arbitrage, p. 36.

19 11 Empirical evidence of this phenomenon is provided through the research conducted by Froot, O Connell and Seasholes testing the correlation between net inflows and past equity or currency returns. Their sample aimed at exploring the behaviour of international investors comprising daily portfolio flows into and out of 46 countries between 1994 and 1998 proves that international investors can be regarded as trend chasers. 62 Hence, the fear of increasing fund withdrawals from investors in the future, possibly owing to a shock in one country which has lowered returns, might lead arbitrageurs to liquidate investments in other (volatile) regions of the portfolio under their administration The Role of Liquidity A further reason for the transmission of financial stress across nations can be identified when the role of liquidity is examined. Main actors affected by an actual or anticipated decline in liquidity during turbulent times include leveraged investors as well as open-end mutual funds or portfolio managers. If those investors face margin calls due to an initial shock to one of the countries within their portfolio, they will be forced to sell at least a certain percentage of their long positions in order to raise the cash needed. Recent research, admittedly, further specifies that, in those circumstances, leveraged investors will always tend to reduce risky positions independently from the occurrence of margin calls. 64 However, as informational asymmetries are likely to exist, 65 well-informed investors will only be able to sell those assets to market participants who are less informed. Consequently, the investments are to be liquidated at a large discount. Given this situation as well as the fact of increasing global diversification of portfolios, a possible reaction of fund managers will be not to dispose of the assets in the crisis-country whose prices have already collapsed. They rather opt to sell other assets of the portfolio and thus 62 Cf. Froot, K et al.: Portfolio Flows, pp Cf. Shleifer, A., Vishny, R.: Limits of Arbitrage, pp and Kaminsky, G. et al.: Unholy Trinity, p Cf. Schinasi, G., Smith, T.: Portfolio Diversification, p The role of asymmetric information ( Lemons problem ) with respect to financial contagion will be further analyzed in chapter Herding.

20 12 causing a substantial decline in prices in countries initially not affected by the adverse shock. 66 Another important group of financial market participants faced with the importance of liquidity constraints are (commercial) banks. As banks obviously play a crucial role in propagating financial shocks, 67 this channel is extensively discussed in chapter Rational Hedging and Global Diversification In literature, a number of studies exist examining the behaviour of investors and thus trying to provide an answer to the question whether they act in a rational or irrational manner. In this section, financial contagion may occur due to rational behaviour of international investors when aiming at cross-market hedging. In this context, the rational expectations model developed by Kodres and Pritsker 68 will serve as a basis for the explanation of contagion through this channel. In their model, the value of assets held by investors is determined by country-specific factors as well as by common macroeconomic risk factors 69 which are shared across regions. A further feature of the model is the assumption of informational asymmetries: the country-specific (idiosyncratic) component is only observable for informed investors. Any adverse shock affecting the country-specific factor of the asset will lead informed investors to rebalance their portfolio across markets in order to hedge the altered exposure to the macroeconomic risk. This might, for example, be necessary if the investment strategy of the affected portfolio is based on fixed country-weights. 70 Consequently, uninformed investors in the countries hit by those rebalancing activities are likely to react as if the source of the changed asset demand is related to 66 Cf. Calvo, G.: Capital Market Contagion, in: Fernandez-Arias, E., Hausmann, R.: Stability, pp and Dornbusch, R. et al.: Contagion p For the importance of bank lending in spreading financial stress cf. for example Rijckeghem, C., Weder, B.: Finance or Trade and Kaminsky, G., Reinhart, C.: Contagion, p. 7 et seqq. 68 Cf. Kodres, L., Pritsker, M.: Rational Expectations. 69 With respect to the measurement of changes in fundamentals, the following has to be stated: most often, only infrequent measures exist. Thus, some authors argue that news releases in media, which are available at a daily basis, could serve as an appropriate proxy. Cf. Baig, T., Goldfajn, I.: Russian Default, pp Cf. Hernández, L., Valdés, R.: What Drives Contagion, p. 5.

21 13 their own country. Thus, idiosyncratic shocks followed by portfolio rebalancing activities can cause excess comovement. Naturally, the extent of contagion depends on the ability of cross-market hedging. Thus, as it has already been indicated above, highly integrated financial markets are prone to financial contagion whereas relatively isolated and illiquid markets tend to be relatively more protected owing to their under representation in international portfolios. 71 Although individually rational, an idiosyncratic shock can be transmitted to different countries without the existence of similar real fundamentals. Quite often, this part of the investors practice channel 72 is initiated by investors managing funds in financial centres around the globe. This model of rational expectations which relies on the differences between macroeconomic as well as country-specific risk factors determining the long term value of an asset can also lead to the implication that countries showing relatively high degrees of correlation with the first-victim country during tranquil periods, are likely to be more vulnerable to contagion. 73 This is mainly due to the fact that hedging macroeconomic risks is possible in times of financial integration. A further specification of this kind of investors behaviour transmitting shocks without the existence of the same fundamental risk factors could be seen in the possibility of self-fulfilling crises due to portfolio diversification. 74 In this respect, a reduced wealth of investors due to a crisis in one country will probably initiate them to withdraw funds invested in another country and thus causing higher correlation. This, indeed, tremendously weakens the benefits from diversification The Common Lender Channel As the role of a common lender, especially commercial bank lending, seems to be crucial in the propagation of financial crises across borders, it is worth analyzing this 71 Cf. Kodres, L., Pritsker, M.: Rational Expectations, pp. 1-2 and Kaminsky, G. et al.: Unholy Trinity, pp Dornbusch, R. et al.: Contagion, p Cf. Kaminsky, G., Reinhart, C.: Contagion, p For an extensive discussion of this issue, cf. Goldstein, I., Pauzner, A.: Self-Fulfilling Financial Crises, p. 1.

22 14 channel separately, although it is closely connected to the issues of liquidity constraints and global diversification. The behaviour of foreign banks which are engaged in diverse markets across the globe could not only aggravate the initial crisis but also transmit the crisis to other economies. The rational of this assertion is as follows: a commercial bank facing losses in the initial crisis-country 75 has to rebalance overall risk inherent in the bank s portfolio and readjust capital asset ratios. This can be either done by calling loans and drying up credit lines in the country adversely affected by the initial shock (and thus exacerbating the crisis) or by calling loans in other regions the bank is exposed to and whose assets are regarded as relatively more risky (and thus spreading the crisis to countries which heavily rely on the same lender as the first-victim country). 76 Thus, the strength of financial linkages via the common lender channel has two crucial dimensions: the indebtedness of a country to the lender and from the angle of the lending bank the relative weight of the country in the lender s portfolio. 77 In line with these two dimensions, Sbracia and Zaghini 78, who find that the possibility of contagion substantially increases if a country heavily depends on a single source of financing, propose indexes of vulnerability combining both a country s dependency and a lender s exposure. Hence, the dependency of a country can be calculated in relative or absolute terms, whereas the former is the ratio between the liabilities owed to the common lender and a country s total liabilities and the latter is the ratio between the liabilities owed to the common lender and a country s GDP. Similarly, the exposure of the lender vis-à-vis a certain country is calculated as the ratio between the lender s assets to the respective country and its total claims with regard to a group of countries (relative exposure). The absolute exposure is measured as the ratio between the common lender s assets to the respective country and its capital and reserves (own funds). 79 By combining those 75 In order to justify the rational of this channel, it has to be presumed that the exposure of the bank in the crisis country has been large leading to high percentages of non-performing loans. Cf. Rijckeghem, C., Weder, B.: Finance or Trade, p Cf. Kaminsky, G., Reinhart, C.: Contagion p. 7 and Fratzscher, M.: Currency Crises, p Cf. Caramazza, F. et al.: Trade and Financial Contagion, p Cf. Sbracia, M., Zaghini, A.: Banking System. 79 Cf. Sbracia, M., Zaghini, A.: Banking System, pp

23 15 ratios determining the relative / absolute dependency and the relative / absolute exposure, the authors construct different indexes of vulnerability for the common lender channel, of which one is presented in this thesis. The following index of susceptibility to the common lender channel combines the absolute dependency ( ad ) of country i on the common lender ( CL ) with the absolute exposure ( ae ) of the lender ( CL ) to the trigger country 80 ( crisis ). Analytically, Formula 1 illustrates the calculation. I ad 1 i i CL ae CL crisis (1) By using this index of vulnerability to the common lender channel, the following can be stated: if a country belongs to the same cluster of common lenders, differences in the vulnerability will only be due to diverse levels of dependency from this lender Wake-up Call A further channel in close connection with the issue of international investment and shifts in investors risk aversion are so-called wake-up calls. This hypothesis traces back to the research conducted by Goldstein during the Asian Crisis when private creditors and rating agencies were asleep prior to the outbreak of the Thai crisis. 82 In respect to this hypothesis, international investors might reassess their investment models for a number of countries after having suffered losses from a crisis in another country. If this crisis has revealed weaknesses in a country s fundamentals, investors tend to withdraw funds from those other countries sharing similar characteristics. Such weaknesses include large current account deficits, rigid exchange rates, export slowdowns, and large shares of short-term (foreign) liabilities or low levels of international reserves. 83 Major characteristics of vulnerability will be extensively analyzed in chapter The trigger country is the country with which the common lender has the highest exposure. 81 Cf. Sbracia, M., Zaghini, A.: Banking System, p Goldstein, M.: Asian financial crisis, p Cf. Goldstein, M.: Asian financial crisis, p. 18 and Caramazza, F. et al.: Trade and Financial Contagion, p. 6.

24 Changes in the Rules of the Game The last transmission link to be discussed in the framework of financial linkages and investors behaviour is possible changes in the rules of the game in international finance. Especially with respect to the Russian default in 1998, research is aware of this potential channel. International investors anticipation could trigger the following mechanism leading to contagion: the increased fear that other countries could follow similar unilateral policies like Russia concerning foreign private investors as well as the doubt that international financial institutions may not be willing or able to bail out other countries, when they have already assisted one crisis-country, could induce international investors to start withdrawing funds from those other countries. 84 Following the Asian Crisis, the discussion has even been extended towards the architecture of the international financial system itself and the question of an international lender of last resort. During this period, the usage of resources by the IMF has been considerably high. This has led to the question, if an international lender of last resort would be able to assist all countries facing liquidity constraints. This fear, however, could persuade investors to withdraw funds from countries which might not be eligible for assistance in their opinion and thus causing a run on those countries Herding Beside real and financial linkages, it is worth discussing the phenomenon of herding behaviour which is sometimes referred to as true contagion. 86 Although herding in financial markets challenges the efficient market hypothesis, this behaviour might be rational at an individual level. Yet, at an aggregate group level, herding will lead to negative externalities comprising tremendous mispricing. Generally, true and spurious herding can be distinguished. Whereas the former relies 84 Cf. Claessens, S., Forbes, K.: Financial Contagion, p. 9 and Dornbusch, R. et al.: Contagion,p Cf. Dornbusch, R. et al.: Contagion, p Frankel, J., Schmukler, S.: Crisis, p. 5.

25 17 on the idea that herding has its roots in the mimicking of other investors, the latter refers to the fact that it could be triggered by any common external factor or information. 87 In literature, herding behaviour has intensively been discussed. Models further assessing this phenomenon of large movements into certain types of assets, followed by equally large movements out, with no apparent reason 88 include the work of Bikhchandani et al. who stress the impact of informational cascades. In this case, individuals are likely to follow the observed action of a preceding individual and even neglect ones own information. 89 Thus, decisions made at an early stage are likely to have a disproportionate effect. 90 Banarjee adds to this by emphasizing that the informational content inherent in the observable decisions made by others will decrease with more individuals solely following the herd instead of acting in the sense their own information would have suggested. 91 In the following, the paper examines informational asymmetries tracing back to increasing costs of gathering and processing information, incentive problems as well as the role of reputation and competition as possible arguments for increased herding behaviour over time. The existence of asymmetric information in financial markets can have considerable negative effects. Thus, an initial crisis in one country could induce investors to withdraw funds from other countries though they might not have a full picture of the condition of each and every country. 92 Generally, high costs for gathering and processing information on country-specific characteristics are blamed to prompt relatively uninformed investors to rationally follow supposedly informed investors. 93 If those investors, however, move to a bad equilibrium, less informed individuals tend to completely ignore their own information in order to follow the supposedly 87 Alemanni, B., Ornelas, J.: Herding Behaviour, pp Agénor, P.: Adjustment and growth, p Cf. Bikhchandani, S. et al.: Fads, p Cf. Sell, F.: Contagion, p Cf. Banerjee, A.: Herd Behavior. 92 Dornbusch, R. et al.: Contagion, p Cf. Dornbusch, R. et al.: Contagion, p. 9

26 18 informed group, which will finally cause a bad equilibrium. 94 Hence, herding becomes inefficient and fragile, as it is only based on very little information. 95 It might, indeed, make countries vulnerable to become subject to false fads and rumours. 96 Ongoing financial globalization, which is closely connected to an increase in the number of countries where funds can be transferred to, is one of the main causes reducing incentives for collecting appropriate information. 97 A further argument comprises the issue of principal-agent relations and performance measurement in financial markets. Thus, most funds traded on global markets are administrated by professional managers (agents) on behalf of their customers (principals). Moreover, the performance (and thus the compensation) of the respective funds manager is usually not measured in absolute but relative terms with respect to a benchmark, which could be a market or an other agent s portfolio. Consequently, it is far less risky for the individual manager to behave similarly to others in order not to risk being the only one betting on any false development. Thus, investors tend to mimic the market or imitate the portfolio of the agent which has been set up as benchmark, even if they possess information that the market could show any undesirable development. 98 Moreover, the role of reputation is closely linked to the patterns of behaviour concerning the compensation scheme of investors. As the number of diverse global investors rises, the cost of establishing reputation increases as well. Due to the fear of losing the individual reputation if the own portfolio negatively develops in comparison to the benchmark, especially institutional investors prefer following the herd. 99 A final remark on herding in financial markets should be owed to a study conducted by Kim and Wei who analyzed monthly data of foreign trading behaviour in the KSE 100 between January 1997 and June One of their main findings suggests 94 Cf. Dornbusch, R. et al.: Contagion, p Cf. Bikhchandani, S., Sharma, S.: Herd Behavior, p Cf. Edwards, S.: Contagion, pp Cf. Calvo, G., Mendoza, E.: Rational Contagion, p Cf. Bikhchandani, S., Sharma, S.: Herd Behavior, p Cf. Dornbusch, R. et al.: Contagion, p Korea Stock Exchange.

27 19 that individual investors tend to herd significantly more than their institutional counterparts and that non-resident investors (including both individual and institutional) tend to herd significantly more than investors residing in the respective country Political Links Although the discussion of political linkages in the propagation of crises is less extensive in literature than the previous channels assessed in this paper, it is worth analyzing this kind of transmission link. Those channels are likely to have played a crucial role in Europe during the EMS crisis. In this respect, the interaction between economic decisions and the objective of achieving political goals should not be neglected. There might be cases in which decisions are primarily political 102 and hence could be conflicting to economic goals. In this case, the costly stabilization of the exchange rate in order to enhance political integration can serve as a good example. This aim could be justified by the desire to adhere a currency area such as the EMU. The concrete argument why political linkages can play a crucial role in the contagion of crises is explained in the following. If speculators doubt on the real commitment of a country to adopt a fixed exchange rate, they might start exercising pressure on the respective currency. A successful attack would reveal that the commitment for political integration is weaker than preliminarily assumed. This, indeed, could elate speculators to attack the currencies of (all) potential members by assuming lowerthan-expected commitment for political integration as well. Thus, contagion via political linkages, which is also referred to as membership contagion, underlines the assumption that crises tend to be clustered Global Factors In addition to those channels of transmission, there are so-called global (or common) disturbances potentially propagating financial turmoil from one country to another. 101 Cf. Kim, W., Wei, S.: Foreign Portfolio Investors, pp Drazen, A.: Political Contagion, p Cf. Drazen, A.: Political Contagion, p. 9 et seqq.

28 20 Those factors exert very similar effects across a multitude of markets and comprise global shocks such as rocketing commodity prices, considerable changes in global interest rates or general shifts in investors risk aversion. Common examples in this regard are the 1973 and 1979 oil price shocks. 104 The existence of such global factors might entail herd behaviour, cross-country contagion, or tremendous withdrawals of highly exposed financial institutions (common lender effect). Recent research indicates that the importance of common factors is likely to be related to the increase in financial globalization, which has been discussed in chapter Vulnerability and Economic Characteristics Beside the channels of transmission examined in detail in the previous chapter, country-specific indicators of vulnerability can make certain countries more prone to the propagation of external shocks than others. The knowledge of these indicators, ranging from current account and fiscal deficits to a country s composition of its foreign obligations and its level of international reserves, is not only essential in order to develop early warning systems for financial crises 106 but also to explain the contagion of financial distress. The following section systematically explores those risk factors which may lead to an increased susceptibility of infection Current Account and Budget Deficits The view on current account deficits (CAD) 107 has changed several times in an historical context and illustrates the ongoing debate on the role of current account and fiscal deficits as appropriate indicators of vulnerability to external shocks. 108 Thus, in the period following World War II research mainly focused on the issue of 104 Cf. Edwards, S.: Contagion, p. 6. Such major economic shifts in developed markets causing crises in EMs are also referred to as monsoonal effects. Cf. Masson, P.: Monsoonal Effects, p Cf. Balakrishnan, R. et al.: Financial Stress, p. 12 and Edwards, S.: Contagion, p. 6 and IMF: WEO, April 2009, pp Cf. Edwards, S.: Current Account, p Analytically, a CAD is measured as Exports Imports + Net unilateral current transfers. A deficit indicates that current payments exceed current receipts and that a country has used more output than it produced. Cf. Krugman, P., Obstfeld, M.: International Economics, pp The following section relies on an extensive overview and discussion about different approaches on how to interpret a CAD in an historical context provided by Edwards, S.: Current Account, pp

29 21 competitive devaluations leading to potential ameliorations in the current account. 109 A study conducted by Kamin comprising more than 60 devaluations supports this relationship, which is known as the elasticities approach. 110 In the late 1970s, the interpretation of a CAD significantly altered shifting its focus of discussion to the intertemporal dimension of the current account. This modification of public perception was partly triggered by large changes in the current accounts of several countries due to the oil price shocks. The approach mainly supported in this period argues that relatively high deficits reflecting new opportunities for investment will automatically lead to aggravations in a country s current account. This has entailed the opinion that an increasing CAD due to investment possibilities does not signal a higher degree of vulnerability. If this idea is related to potential fiscal imbalances of the respective economy one can state what is known today as the Lawson s Doctrine: it is not worth worrying about large deficits in the current account if a country s fiscal account is balanced. 111 A balanced fiscal account, however, can not always be taken for granted as the analysis of Eastern European countries will reveal in chapter Simultaneous deficits on both the current and fiscal account are commonly referred to as twin deficits. 112 Yet, after the 1982 debt crisis has even affected countries showing considerable CADs while having high investment rates and balanced fiscal accounts, the relevance of the Lawson s Doctrine has been challenged. Henceforward, a certain number of authors have advanced a more conservative view by arguing that CADs might serve as appropriate indicators pronouncing future crises. In this period, the debate moved away from analyzing the absolute amount of a CAD to the question of its sustainability. Following the Mexican Crisis, where large portfolio inflows have notably contributed to a tremendous CAD, research has come to the conclusion that 109 The issue of competitve devaluation and its effects on the current account have been discussed in chapter Cf. Kamin, S.: Devaluation, p This view is also supported by Corden arguing that a CAD should not be a matter of concern if it is due to an investment boom and fiscal budgets are in balance. Cf. Corden, M.: Economic Policy, p Cf. IMF: WEO, April 2009, p. 147.

30 22 relatively large CADs will more probably be unsustainable than not. 113 This leads to the fact that, most commonly, current account reversals can be observed in the aftermath of an adverse shock. 114 However, there is little accord on an exact threshold signifying unsustainable deficits. 115 It seems to be all the more important to compare the size of the CAD with the ability and willingness of a country to repay its external debt with future trade surpluses as well as the willingness of borrowers to continue lending to the country on current terms. Further factors that should catch some attention are a country s exchange-rate policy, structural factors comprising the degree of openness, as well as the situation of a country s financial system. 116 Despite the different approaches of interpreting a CAD as an indicator of vulnerability presented above, it can be stated that in the case of contagious effects (e.g. a decline in the demand of a country s liabilities due to a crisis elsewhere) drastic adjustments of the current account in the short-run are necessary. 117 This brief overview presenting different approaches on how to read CADs as useful proxies of deducing vulnerability indicates the complexity of this issue. Even current literature does not provide a distinct answer on this issue. Whereas Frankel and Rose conclude that neither current account nor fiscal budget deficits are likely to be significant in a typical crash 118, Perry and Lederman argue that prudent policies are necessary to remain a stable macroeconomic environment. Those policies include among others - the prevention of high CADs. 119 Balakrishnan et al. state that relatively low CADs and fiscal deficits will not shelter EMs from the transmission of financial stress originated in advanced economies but will indeed provide some protection by restricting adverse effects on the real economy This is all the more the case if GDP growth in the years before the crisis shows a decline. Cf. IMF: WEO 1999, p However, there is no common reasoning on how current account reversals affect economic growth: whereas Milesi-Ferreti and Razin argue that those reversals are not necessarily connected with a decline in domestic GDP, Edwards finds that current account reversals have a negative effect on GDP growth per capita. Cf. Edwards, S.: Current Account, pp Thus, especially investment banks are eager to develop models analyzing current account sustainability. Cf. Edwards, S.: Current Account, p. 16 et seqq. 116 Cf. Milesi-Ferretti, G., Razin, A.: Sustainability, pp. 1-2 and Cf. Edwards, S.: Current Account, p Cf. Frankel, J., Rose, A.: Currency Crashes, p Cf. Perry, G., Lederman, D.: Financial vulnerability, pp Cf. Balakrishnan, R. et al.: Financial Stress, p. 5.

31 23 To sum up, CADs have to be carefully investigated before making any decision about their meaning and sustainability. This is all the more important if it is taken into account that current account balances tended to diverge over the past few years. 121 Moreover, it is essential to notice that CADs have to be financed by financial or capital account surpluses, i.e. by financial inflows which may rapidly reverse under specific circumstances. Thus, the structure of external debt seems to be a further indicator potentially increasing a country s exposure to external shocks Composition of Capital Inflows The fact that the financing of a CAD is closely connected with the inflow of foreign capital inevitably leads to the need of analyzing the composition of those capital flows with respect to several characteristics. This is all the more important as in some cases markets are likely to react excessively 122 and external funds will not be provided endlessly. 123 In this respect, the maturity of a country s foreign debt plays a crucial role when analyzing the occurrence as well as the severity of both currency and financial crises. 124 In general terms it can be stated that the higher the fraction of short-term debt, the higher the possibility of sudden stops 125 which may lead to major disruptions in the domestic financial markets. 126 In this context, mainly bank lending to EMs tends to be characterized by short-term maturities. 127 One of the consequences usually observed in combination with sudden stops is a significant improvement of the current account. 128 However, a country s room for improving the term structure of its 121 Cf. Balakrishnan, R. et al.: Financial Stress, p Cf. Fischer, S.: Capital Account, p Cf. Eichengreen, B.: Global Imbalances, p Cf. Prasad, E. et al.: Financial Globalization, p Sudden Stops are not defined uniformly in literature. They can be broadly described as a situation where the flow of capital coming into a country is reduced significantly in a very short period of time. This could be triggered by large business cycles or crises in developed countries. Cf. Edwards, S.: Sudden Stops, p. 13 and Prasad, E. et al.: Financial globalization, p Cf. Caramazza, F. et al.: Trade and Financial Contagion, p Cf. Prasad, E. et al.: Financial Globalization, p. 47. Thus, the source of funds might directly influence a country s term structure of external debt. Similarly, concessional debt and inflows from multinational development banks might even increase in times of financial distress. Cf. Frankel, J., Rose, A.: Currency Crashes, p Cf. Eichengreen, B. et al.: Sudden Stops, p. 11.

32 24 external debt might be limited, as especially for countries showing relatively weak fundamentals, the access to longer-term borrowing possibilities could be restricted. 129 In addition to the maturity of external debt, the following characteristics have attracted high attention when analyzing the contagion of crises: Regarding the ratio between FDI and portfolio investments flowing into a specific country, it can be argued that the former type of investment is safer as it usually tends to be linked to real investment projects instead of financing consumption. Furthermore, FDI can not be withdrawn that easily and rapidly as portfolio investments in the case of a crisis. Regarding the positive aspects of FDI, J. Stiglitz correctly observed that foreign direct investment brings with it not only resources, but also technology, access to markets, and (hopefully) valuable training, an improvement in human capital. Foreign direct investment is also not as volatile and therefore as disruptive as short-term flows that can rush into a country and, just as precipitously, rush out. 130 The most volatile kind of a country s external financing seems to be international bank lending. 131 Moreover, a country s vulnerability can increase if a high ratio of its external obligations has been negotiated in the form of variable-rate arrangements aiming at protecting the creditor. 132 Additionally, it is possible that countries may be exposed to tremendous currency risks, if a high percentage of their external debt is denominated in foreign currency. Especially EMs seem to suffer from a so-called domestic liability dollarization (DLD). 133 Hence, if the domestic currency depreciates against the main currency of external debt, the real debt servicing burden might considerably increase. 134 In general, a tight local monetary policy signifying high interest rates can equally contribute to an increase in the exchange rate risk of individuals because foreign 129 Cf. Detragiache, E., Spilimbergo, A.: Crises and Liquidity, pp Filippov, S., Kalotay, K.: Foreign Direct Investment, p Cf. McKenzie, D.: External Finance, p Cf. Frankel, J., Rose, A.: Currency Crashes, pp Cf. Calvo, G. et al.: Sudden Stops, p Cf. Radelet, S., Sachs, J.: East Asian Financial Crisis, p. 20.

33 25 currency credit is becoming relatively more attractive to the private sector. A high private sector exposure to exchange rate risk could therefore indirectly threaten domestic banks if their clients face liquidity problems. 135 The relevance of the composition of external debt in the propagation of financial crises has led to broad debates on how to prevent extreme swings of capital flows. 136 An extensive and continuative discussion of capital controls avoiding capital flights as well as aiming at reducing excessive capital inflows is provided by Edwards Foreign Currency Reserves The issue of the level of foreign currency reserves in periods of contagion is most prominent for economies defending a fixed exchange rate or countries operating a floating exchange rate regime which are currently in transition from an EM to an advanced economy. Thus, they have not yet been able to prove their long-term stability. 138 The rational of this idea is that a crisis in one country may invite (e.g. via wake-up calls, as argued in chapter ) speculators to attack countries officially defending their peg at the high cost of a loss in international reserves. Therefore, low levels of foreign reserves are likely to indicate financial vulnerability. 139 As it is difficult to judge whether a country s reserves are high or low in absolute terms, it is useful to relate the level of foreign reserves to appropriate macroeconomic indicators. Common relations comprise the months of import coverage 140 (foreign exchange 135 Cf. Piterman, S.: Vulnerability, p Cf. Mishkin, F.:Financial Instability, p Cf. Edwards, S.: Capital Flows, pp Cf. Piterman, S.: Vulnerability, pp It has to be admitted, however, that recent research differs about the relevance of a country s exchange rate regime in the propagation of shocks. Whereas Prasad et al. find that especially developing markets maintaining a relatively inflexible exchange rate system are often subject to the risk of attacks on their currencies, Caramazza et al. come to the conclusion that exchange rate regimes seem to play a minor role in the transmission process. Sell concludes that anything between full flexibility and totally fixed parities is prone to contagion under specific conditions. Cf. Prasad, E. et al.: Financial Globalization, p. 49 and Caramazza, F. et al.: Trade and Financial Contagion, p. 30 and Sell, F.: Contagion, p Cf. Caramazza, F. et al.: Trade and Financial Contagion, p Cf. IMF: WEO, April 2009, p. 147.

34 26 reserves divided by monthly imports) or the coverage of short-term liabilities and maturing long-term debt by foreign reserves. 141 Finally it should be mentioned that, when trying to identify a country s optimal level of resources to maximise their net benefit, several factors have to be taken into account. Those parameters not only include a country s macroeconomic stability and creditworthiness, the development of domestic financial markets, changes in the global economy and a reduction of external vulnerability but also the costs of holding these reserves. 142 In this respect, the weight on the return objective has generally increased 143 during the last years. As the first signs of weakness are likely to appear in the market for foreign exchange, it can be summed up that it is essential for a country to maintain a strong foreign liquidity position in order to assure its economy s health Domestic Banking System A further factor in the context of determining a country s vulnerability to the propagation of (financial) shocks, which is worth being introduced in this context, is the stability of its domestic banking system. A comparatively high growth of real domestic credit 145 may signify a commercial lending boom due to financial liberalization in the respective country which will probably not be sustainable in the future. Such a development might reduce investors confidence as it could indicate future problems and weaknesses within the banks balance sheets. Thus, the number of bad and non-performing loans might considerably increase if borrowers are affected by adverse developments. Depending on the specification of the loan contracts, increasing interest rates or changes in the value of the domestic currency can be regarded as possible triggers. 141 Cf. Perry, G., Lederman, D.: Financial vulnerability, p Cf. Francia, M.: Foreign Reserve Accumulation, pp Borio, C. et al.: FX reserve management, p Cf. Piterman, S.: Vulnerability, p Measurable as net domestic credit to private sector as percentage of GDP, cf. Walker, C.: Contagion, p. 9.

35 27 Yet, when determining the potential vulnerability of a country s banking sector, it is crucial to additionally include both real exchange rate appreciations and the development of the banking sector s liabilities which are not backed by foreign currency reserves. 146 If investors start withdrawing domestic assets and converting them into foreign currency, a country s central bank can chose between the following options: it can either finance those withdrawals by providing additional credit to commercial banks or allow bank runs which might indeed lead to severe adverse effects on the domestic real economy. As the former option is likely to be a more realistic case, the central bank is forced to sell own reserves in order to prohibit a devaluation of the domestic currency. Thus, the stability of the domestic banking system is closely connected to the level of international resources. 147 The predictive power of this variable combining not only internal and external imbalances but also the possibility of a shift in investors sentiment is regarded as reasonable for EMs but seems to be less applicable for advanced economies. 148 With respect to the indicators of vulnerability analyzed above, the following can be stated: evidence suggests that although all indicators are higher for crisis than for non-crisis countries on average they may considerably vary during each period of financial distress. Moreover, it has to be taken into account that variables which are not significant on an individual basis could gain in importance owing to potential interactions with others. One possibility of handling this drawback is aggregating these variables. Table 1 shows a selection of important aggregate variables They can be measured as the ratio of the monetary aggregate M2 to international reserves. It thus proxies the ability of the banking sector to withstand currency pressures. The rational behind this idea is that a country not only suffers a sudden stop of capital inflows during a crisis. Even more, liquid domestic liabilities are likely to be withdrawn and converted into foreign currency. Consequently: the higher the value of this ratio the higher the vulnerability to self-fulfilling panics among depositors. Cf. IMF: WEO 1999, p. 76 and Sachs, J. et al.: Financial Crises, p Cf. Sachs, J. et al.: Financial Crises, pp Cf. IMF: WEO 1999, pp Cf. IMF: WEO 1999, pp

36 28 Table 1: Selected Aggregate Variables of Vulnerability Aggregate Variable consists of 1. External Imbalances - 3-yr appreciation of the real effective exchange rate - Negative of the 3-yr growth rate of exports relative to GDP - CAD in relation to GDP in the year prior to the crisis 2. Domestic Macroeconomic Imbalances - Fiscal deficit in relation to GDP - Growth rate of broad money (M2) relative to GDP in the 3 years prior to the crisis 3. Reserve adequacy - Ratio of broad money (M2) to reserves - Ratio of short-term external debt to reserves in the year prior to the crisis 4. Composite of credit expansion, exchange rate appreciation, and ratio of M2 to reserves Source: IMF: WEO 1999, pp yr growth of domestic credit deflated by the consumer price index in the years prior to the crisis - 3-yr appreciation of the real effective exchange rate - Growth of unbacked domestic banking sector liabilities in the year prior to the crisis (M2 / international reserves)

37 29 3 Contagion during the Current Financial Crisis: the Case of Eastern Europe Since 9 August 2007, the world is facing its worst financial crisis since the Great Depression in the 1930s. 150 Although the initial turmoil in the U.S. subprime mortgage market has already started two months earlier, this date is commonly referred to as the beginning of the current financial crisis. On that day, several central banks including the ECB and the FED took measures in order to resolve disorder in the interbank market which has been triggered by the temporary denial of redemptions from a small number of funds which were backed by U.S. subprime mortgage debt. 151 In the following months, fears of liquidity constraints and bank losses increased uncertainty. As the demise of Lehman Brothers affirmed the prevailing fear on 15 September 2008, the crisis tremendously intensified and spread across countries. 152 The global loss of confidence could only be curtailed by vast policy interventions. Since mid-march 2009, markets started to show first weak indicators of increasing optimism. 153 In this respect, the following section is intended to identify and examine main indices of vulnerability prior to the contagion of the current crisis as well as potential transmission mechanisms to Eastern Europe. This emerging region has been hit with full force in late 2008 and is counted among the regions most adversely affected on a global scale. 154 This seems to be surprising at a first glance, as Eastern Europe has shown record growth rates and tremendous improvements in the standards of living after the fall of the Iron Curtain. Financial and economic integration of Emerging Europe has even been intensified after the eastern European expansion of the EU in Cf. Evaluation of former Nobel Prize Laureate J. Stiglitz, in: Anon.: Financial crisis and B. Bernanke, in: Anon.: Crisis. 151 Three funds of BNP Paribas were affected. In a press release, the French bank announced that it is no longer possible to value fairly the underlying US ABS assets, cf. BNP Paribas: Net Asset Value. 152 Hence, when analyzing country-specific vulnerabilities in EE before the financial crisis erupted in this region, figures representing the year 2007 will be used. 153 Cf. Cecchetti, S.: Monetary Policy, pp and BIS: AR 2008/09, pp and BIS: AR 2007/2008, p Cf. Bolli, J.: Europe. Roubini even blames Eastern Europe to be the sick man of emerging markets, cf. Roubini, N.: Economic Crisis. 155 Cf. Čihák, M., Fonteyne, W.: Five Years After, pp and Fabrizio, S. et al.: Second Transition, pp

38 30 The following arguments underlie the importance of understanding the causes of contagion to Eastern Europe during recent financial turbulences. Owing to the high integration of Eastern European markets with Western Europe, especially because of trade and financial linkages, there is the danger of second-round effects back to the old member states of the EU. Moreover, partially violent protests have erupted in countries comprising Latvia, Lithuania and Bulgaria indicating the potential menace of political destabilization. As these negative developments dramatically slow down the convergence of Eastern Europe to the Euro Area, the crisis has not only become a challenge for the European Union but also for the stability of the Euro. Hence, a stronger support for the economies of Central and Eastern Europe 156 has been agreed upon by the members of the European Parliament. 157 In the subsequent analysis, the countries of the 2004 / 2007 expansion of the EU have been assorted into three distinct groups. This is mainly due to the fact that possible differences in the impact and transmission linkages during the contagion of the current financial crisis are to be examined. Hence, inferences can finally be drawn whether the current level of a country s integration into the EU plays a significant role. Table 2 provides an overview of the different groups. Table 2: Eastern European Expansion of the EU (2004, 2007) Source: Own illustration following European Commission: Economic and Financial Affairs. 156 European Parliament: Financial crisis. 157 Cf. Roubini, N.: Economic Crisis and Schwartz, N.: Eastern Europe and European Parliament: Financial crisis.

39 31 Group 1 comprises all new member states which have already adopted the Euro (Slovenia and Slovakia) without Malta and Cyprus. These Mediterranean islands will not be included in the analysis as the focus of this paper is clearly on developments in Eastern Europe. 158 By combining the Baltic States of Estonia, Latvia and Lithuania, the second Group comprises those new member states which have not yet been admitted to the Euro Area but currently participate in the ERM II. 159 Group 3 includes all other countries, which are neither part of the Euro Area nor participating in the ERM II (Poland, Czech Republic, Hungary, Bulgaria 160, and Romania). The analysis in the following section will be organized as follows: at the outset, it is determined to which extent Emerging Europe (EE) has been hit by the crisis. Thereafter, potential macroeconomic imbalances before the breakout of the crisis are analysed to test whether certain economies have been more prone to contagion then others. Then, it will be discussed which channels of transmission have played a crucial role in the process of propagation Impact of the Crisis on EE: a Synopsis This section is intended to provide a well-founded evaluation of the current overall situation in Eastern Europe by employing appropriate measures indicating the level of financial stress as well as the impact of the crisis on growth rates in EE Financial Stress in Eastern Europe In this respect, financial instability can be defined as the opposite of financial system stability, i.e. the financial system of a country is not capable of facilitating ( ) the 158 Thus, the notion Eastern Europe is used for all countries which have been admitted to the EU in 2004 and 2007 without Malta and Cyprus. The notions Central and Eastern European Nations (CEE), Eastern Europe as well as Emerging Europe will be employed as synonyms throughout this paper. 159 Successful participation in the ERM II for at least two years is part of the convergence criteria for adopting the euro. All EU member countries except Denmark and the United Kingdom ( optout ) are obliged to adopt the common currency. Thus, countries currently participating in the ERM II have to avoid severe deviations from the central rate to the euro. Their currencies are allowed to fluctuate by +/- 15%. Cf. European Commission: Economic and Financial Affairs. 160 As the focus of the country-grouping relies on the current level of economic integration into the EU, Bulgaria has been asserted to group 3 although this country has been operating a currency board since 1997 pegging the Bulgarian lev to the Euro (initially pegged to the Deutsche Mark). 161 All figures used within this paper are the most recent figures available. If actual numbers for 2009 have not yet been available, those figures are well-founded preliminary estimates relying on actual figures for the first three quarters of 2009.

40 32 performance of an economy, and of dissipating financial imbalances that arise endogenously or as a result of significant adverse and unanticipated events 162 any longer. Thus, a country s financial system is under strain and unable to efficiently perform its economic functions. Generally, financial stress tends to arise suddenly and to usually hit several sectors of the financial system simultaneously. 163 In order to cope with this definition, the Emerging Markets Financial Stress Index (EM-FSI) developed by Balakrishnan et al. appears to be an appropriate measure for analyzing the current overall financial situation in emerging Europe. 164 The index comprises the sum of five distinct standardized subindices which capture the developments in three segments of the financial market: banking sector, securities market, and exchange market. Formula 2 illustrates the aggregate financial stress index for an individual emerging market. EM-FSI = β + Stock market returns + Stock market volatility (2) + Sovereign debt spreads + EMPI where: β is the banking-sector beta EMPI is the exchange market pressure index For the purpose of interpretation it has to be noted that positive values of the EM-FSI indicate financial stress, whereas a value of zero describes neutral financial market conditions on average. Values exceeding +1.5 (i.e. a 1.5 standard deviation from average conditions across the five subindices) have implied a crisis during past periods of financial turmoil. Appendix 1 provides additional information on the calculation and interpretation of each single subindex. The possibility to decompose the aggregate index allows a detailed analysis of periods of financial stress. In this respect, Appendix 2 shows the period of recent financial turmoil in EE in comparison to emerging economies of Asia, Latin America and other EMs. Obviously, all emerging markets have been hit relatively simultaneously by the transmission of financial stress with its peak in October Although differences among the countries of each individual group should not be neglected, the region of Emerging 162 Schinasi, G.: Financial Stability, p Cf. Balakrishnan, R. et al.: Financial Stress, p. 6 and Deutsche Bundesbank: Stability, p. 8 and IMF: WEO, April 2009, p For the subsequent analysis and interpretation using the EM-FSI, cf.: Balakrishnan, R. et al.: Financial Stress, p. 7 et seqq. and IMF: WEO, April 2009, p. 136 et seqq.

41 33 Europe has been hit hardest. Moreover, it can be concluded from Appendix 2 that the banking sectors have already been affected by turbulences in the second quarter 2008 thus constituting a potential catalyst in the current financial stress. Additionally, EE seems to suffer especially from increased pressures on the exchange markets and increased sovereign spreads during and after the peak in October However, the current financial crisis is characterized by the fact that it has affected all components of the EM-FSI. In order to provide an overview of the differences of current levels of financial stress in Eastern Europe, Figure 1 compares the aggregate EM-FSI during the current crisis. EM-FSI data are not available for Estonia, Latvia, Lithuania, and Bulgaria. Figure 1: EM-FSI, Eastern Europe Source: Own illustration, data provided by IMF along with Balakrishnan, R. et al.: Financial Stress. According to Figure 1, important discrepancies within the group of Eastern European countries are apparent. Whereas Hungary constantly shows considerably higher values of financial stress than any other state in the sample during the time period, Poland seems to be relatively less affected by financial stress. The impact of financial stress on the Slovak Republic is characterized by relatively high volatility Impact on Growth Rates In the following, the study of the current situation in EE goes briefly one step beyond the existence of financial stress in order to provide a clear picture of how the crisis

42 34 has affected growth rates in this region. Moreover, annual GDP growth rates are available for all ten countries subject to the analysis in this paper. A diagram debriefing annual GDP growth rates in Eastern Europe, is provided in Appendix 3. It can clearly be stated that all three countries of Group 2, namely Estonia, Latvia and Lithuania show by far the poorest performance figures. The sharp decline of Latvia, which has constantly shown record growth rates after the admission to the EU in 2004, has already begun in 2007 and eventually resulted in a highly negative estimated growth rate of 18% in The findings regarding those countries already examined concerning financial stress lead to a similar interpretation. Whereas especially Hungary, Bulgaria and Romania attract attention by considerably negative growth rates (- 6.73%, - 6.5% and 8.46% respectively for 2009), the Czech Republic, the Slovak Republic and Slovenia are able to attain relatively higher growth rates. However, the economy of Poland is likely to experience the most moderate decline in its growth rates. The above analysis briefly examining the overall impact of the current financial crisis on financial stability (measured by the EM-FSI) and on growth rates (measured by annual GDP growth rates) of Emerging European countries has demonstrated that these economies in transition can definitely be regarded as one of the regions hit hardest on a global scale. 165 Furthermore, it can be stated that the impact tremendously differs across countries. The initial results indicate that the Baltic countries (group 2), which have pegged their currency to the Euro by participating in the ERM II, as well as Hungary, have been hit hardest, whereas Poland, the Czech Republic as well as the two Euro Area member states Slovenia and the Slovak Republic (group 1) seem to experience relatively lower turbulences. The impact of the crisis on the new 2007 member states of Romania and Bulgaria appears to be comparable to the situation in Hungary when considering contractions in annual 165 With Hungary, Latvia and Romania three countries of the sample have already been supported by joint international rescue packages. Hungary has been granted a rescue deal amounting to $25.1bn in October 2008 (thereof $15.7bn provided by the IMF, $8.1bn by the EU and $1.3bn by the World Bank): Latvia s rescue package of December 2008 has been the biggest ever rescue package for a Baltic state comprising 7.5bn in total ( 1.7bn by the IMF and further cash from the EU, World Bank and other countries). Romania has been supported by a consortium of the IMF ( 12.95bn), the EU ( 5bn), the World Bank ( 1bn) and the EBRD ( 1bn) on March 25, Cf. IMF Survey Magazine: Hungary, Eglitis, A.: Latvia and IMF: Romania.

43 35 GDP growth. Hence, the following sections are dedicated to analyse in detail if country-specific vulnerabilities and channels of transmission prominent during recent financial turmoil can help explaining why certain countries have been more prone to contagion from recent financial turmoil than others. 3.2 Pre-Crisis Vulnerability As the extensive discussion of country-specific indicators of vulnerability in chapter 2.3 has shown, the ongoing pursuit of poor domestic policies can lead to increased susceptibility to infection through home-grown crisis triggers. 166 Given the preliminary results presented in the previous chapter, the subsequent analysis intends to investigate if inconsistent macroeconomic policies in Emerging Europe have led to heightened vulnerability helping to explain the distinct impact of the current contagious crisis on EE economies. This section will therefore systematically apply the indicators of vulnerability identified in chapter 2.3 to the Eastern European countries subject to the analysis Current Account and Budget Deficits Although research on the issue of CADs has permanently shifted its focus during the past decades, the question of the sustainability of a deficit in a country s current account seems to be prevailing in today s studies. Thus, a large CAD is likely to be unsustainable in the long run pronouncing increased vulnerability to crises. This is all the more the case, if GDP growth has already experienced a decline before the crisis erupts. 167 In this respect, the following section will explore the respective current account figures of Eastern European countries for the period of financial turmoil. It will further include current developments in the countries fiscal balance in order to answer the question, if the problem of twin deficits in EE has been of importance during recent financial turbulences. 166 Ghosh, A.: Crisis Prevention. 167 Recall the discussion provided in chapter

44 36 Figure 2 provides an overview of the mean CA and fiscal balance of the three distinct country groups identified in this paper for the years 2004 to 2010 (forecast). Although country-specific differences with respect to the CA balance exist within each individual group, Figure 2 allows drawing the following conclusions. The mean CAD of the new member states (NMS) which have already been admitted to the Euro Area, Slovakia and Slovenia (first country group), fluctuates between (2004) and -6.2 (2010) percent of GDP and is thus relatively low as compared to the countries of group two and three until the crisis fully hit emerging Europe in the final quarter The relative stabilization of the CAD within this group can mainly be referred to considerable improvements in the trade balance, which in turn were primarily fostered by roaring exports. Strong growth rates in the export volume, increased market shares, high and growing shares of technology-intensive products as well as tremendous growth rates in productivity favouring the tradable sector are counted among the main reasons entailing to this export boom. 168 Interestingly, there has not been a CA reversal 169 with respect to the mean CAD of this group in Appendix 4, which expands the analysis by illustrating the developments in the CA and the government balance on an individual country basis, reveals that Slovenia faced an increase by 2.6% in its CA between 2008 and If the general government balance is included in the analysis, it can be stated that Slovenia and Slovakia have consistently been running a deficit and have thus been subject to a persistent twin deficit before the crisis erupted (except Slovenia 2007). Although there have been signs of regeneration before the crisis even permitting Slovenia to register a small surplus of 0.26% of GDP in 2007, the government balance tremendously deteriorated when financial turmoil spread to global markets in late 2008 leading to deficits reaching -5.3% for the Slovak Republic and -5.9% of GDP for Slovenia in Comparable to other countries, the remarkable decline in Slovakia s general government balance can largely be traced back to the adoption of anti-crisis measures backing economic growth and employment Thus, the share of technology-intensive products in total manufacturing exports rose from 42% (2000) to 53% (2005) in Slovakia and from 40% (2000) to 42% (2005) in Slovenia. Cf. Rahman, J.: Current Account Developments, pp and IMF: REO April 2008, p The definition of current account reversal used in this paper relies on Edwards, who either defines a CA reversal as a reduction in the deficit by at least 3% of GDP in one year or as a reduction of the deficit of at least 3% of GDP in a three year period. Cf. Edwards, S.: Current Account, p Cf. Šmál, M.: Excessive Deficit Procedure.

45 37 With respect to the second country group, comprising the Baltics Estonia, Latvia and Lithuania, the diagram draws a different picture. The mean of their CAD has consistently and tremendously been below the respective figures of the other NMS until reaching its negative peak in 2007 with deficits ranging from (Lithuania) to percent of GDP (Latvia). In all countries but Latvia, the CAD gradually widened during 2005 and Latvia s exceptionally high deficit, however, only showed a slight recovery (cf. Appendix 4). These comparable high deficits in the Baltic s current accounts until 2007 can be attributed to the fact that the trade balances of these countries gradually deteriorated as exports failed to keep up with soaring imports. Furthermore, in contrast to Slovenia and the Slovak Republic, the share of the Baltic states technology-intensive products in manufacturing exports is still at a low level and even declined in the case of Estonia between 2000 and 2006 (from 43% to 36%). 171 Hence, in the period before the crisis erupted, the Baltics large CADs can be interpreted as an additional source of vulnerability. This conclusion seems to be justifiable all the more if it is taken into account that the GDP growth rates of Estonia and Latvia started declining already after reaching their peak in 2006 (cf. Appendix 3). In contrast to Slovenia and Slovakia the Baltics have experienced noticeable CA reversals leading to a surplus in all three states in With regard to the general government balance of Estonia, Latvia, and Lithuania the following can be stated: as the respective balances for all three countries have continuously been close to equilibrium until 2007, 173 the Baltic States have not been subject to severe twin deficits before the eruption of the financial crisis. Although adverse effects of the financial crisis have led to sharply deteriorating government balances in the Baltics, Estonia is likely to only experience a modest decline due to its commitment to keep on track to the envisaged euro adoption in January Thus, Estonia has even succeeded in registering a small surplus in Q Cf. Rahman, J.: Current Account Developments, p These tremendous reversals can not only be explained by the global credit crunch, steep declines in domestic demand leading to a fall of imports and thus export growth rates exceeding that of imports but also by declining outflows of investment income and growing transfers received from the EU budget. Cf. Bank of Lithuania: BoP and Bank of Latvia: BoP and Saarniit, A.: Current account. 173 Estonia s general government balance has even been in surplus from 2004 through The balances of Latvia and Lithuania have merely demonstrated marginal deficits. Cf. Appendix Cf. Statistics Estonia: Budgetary position and Estonian Government: Adoption of the euro.

46 38 When analysing the third country group in EE, it is essential to recognize that this group is far less homogeneous than the previous groups assessed concerning their CA and government balance. Consequently, the mean of this group s CA and government balance has to be carefully interpreted. It is rather appropriate distinguishing between the new 2007 member states (Bulgaria and Romania) and Poland, the Czech Republic, and Hungary. Bulgaria and Romania show significant similarities to group 2 (Baltics) regarding their exorbitant levels of CAD (Bulgaria -25.2% and Romania -13.5% of GDP in 2007), the CA reversals in 2009 and the relative healthy situation of their government balances before the crisis. 175, 176 Poland, the Czech Republic and Hungary can rather be compared to group 1 (Slovenia and Slovakia) demonstrating comparable lower deficits in the current account. 177 Yet, Hungary and Poland have been subject to CA reversals in When analysing the general government balance of the Czech Republic, Hungary and Poland it should be stated that all countries faced twin deficits prior to the crisis. However, the Hungarian deficit has been by far the largest reaching its negative peak already in This development can be attributed to fiscal stimulus plans trying to improve the fragile economic condition prevailing in Hungary during that time The arguments explaining the large CADs in Bulgaria and Romania are similar to those of Estonia, Latvia and Lithuania. 176 Regarding the general government deficit, Bulgaria is expected to be the only EU member state not having a deficit in excess of the 3% of GDP reference value foreseen in the Maastricht Treaty in Cf. European Commission: European Economic Forecast autumn 2009, p The relative lower deficits of the Czech Republic, Poland and Hungary can be explicated in the same way as for Slovenia and Slovakia. 178 Cf. European Commission: European Economic Forecast autumn 2009, p. 120.

47 39 Figure 2: CA and General Government Balance in EE (Country Groups) 10 Current Account Balance (% of GDP) mean country-group 1 (Euro) mean country-group 3 (no Euro, no ERM II) max mean country-group 2 (no Euro, but ERM II) mean all countries min 4 General Government Balance (% of GDP) mean country-group 1 (Euro) mean country-group 3 (no Euro, no ERM II) max mean country-group 2 (no Euro, but ERM II) mean all countries min Source: Own calculation and illustration. Data obtained from IMF: WEO database, October 2009, Eurostat: Government Balance, and European Commission: Economic Forecast autumn Although the previous analysis of deficits in the current and government account in the NMS of the EU has demonstrated that a number of countries ran large CADs 179 before the financial crisis, it is worth adding one important aspect to the interpretation: the issue of convergence. In this respect, converging economies generally tend to widen their CAD due to the attraction of foreign capital seeking high returns in the respective nation. 180 However, numerous models aiming at predicting the sustainability of a deficit in the current account including the issue of regional convergence indicate that several EE 179 When compared to other emerging economies in Latin America, Asia, Middle East and North Africa, Sub-Saharan Africa and CIS deficits in the CA of EE countries are significantly higher. Cf. IMF: WEO, April 2009, p Cf. Vamvakidis, A.: Convergence, p. 13.

48 40 countries demonstrated excessive external imbalances on the eve of the crisis. Hence, Table 3 provides the divergence of the actual CA balance in Eastern Europe from its model prediction before the eruption of the crisis using two different models. 181 Table 3: Actual and Predicted CAD in EE (% of GDP, 2007) Actual CAD Structural CAD Divergence Model of Regional Divergence Convergence Slovak Republic Slovenia n.a. n.a Estonia Latvia Lithuania Poland Czech Republic Hungary Bulgaria Romania Source: Own illustration. Data obtained from IMF: WEO database, October 2009, IMF: REO April 2008, p. 50, and Ionut, D.: Current account sustainability, p. 17. Red figures in Table 3 point out that the value of the deficit predicted by the two models is lower than the actual value for In these cases, unsustainable and excessive deficits are to be assumed. Both models indicate significant imbalances especially for Estonia, Latvia, Lithuania (group 2) as well as for Bulgaria and Romania. The respective deficits for the Euro Area member states of Slovenia and Slovakia (group 1) appear to be relatively moderate. Exclusively for Hungary, Poland and the Czech Republic the divergence is positive concerning at least one of the model predictions. Taking the precedent analysis of CA balances in EE into consideration, the following can be concluded: despite the fact that Slovenia and Slovakia (group 1) have shown persistent twin deficits in the period preceding the financial crisis, these countries 181 The first model predicting the structural CAD is based on a dynamic model of the permanent income theory assuming that temporary shocks to income are offset by temporary variations in aggregate savings and CA. The explanatory variables used in this specification are the previous value of the CA, the fiscal balance as percentage of GDP, the relative income, the investment rate, the public spending rate, the delta of net output as percentage of GDP and the real effective exchange rate. Cf. Ionut, D.: Current account sustainability, pp The second model is based on the macroeconomic balance approach relating a set of fundamentals explaining a nation s saving and investment position to its CA. For EE, the old age dependent population and the low net foreign assets position appear to constitute the most important variables in the specification. Cf. IMF: REO April 2008, pp

49 41 seem to be relatively less vulnerable. This is mainly due to the fact that the CADs appear to be moderate when accounting for the issue of convergence. Although the Baltic States (group 2) have not experienced high deficits in the fiscal balance, their deficits in the CA come out to be exorbitant even after controlling for the issue of regional convergence. Therefore, the preliminary results relying on the interpretation of the CA and fiscal balance suggest increased susceptibility to infection for Estonia, Latvia and Lithuania. The situation in group 3 is rather heterogeneous. Whereas Bulgaria and Romania show comparable figures to the Baltic States rendering those two countries relatively more vulnerable to the propagation of financial crises, Poland, the Czech Republic and Hungary are more comparable to group 1 showing persistent but moderate twin deficits. Thus with the exception of Hungary this subgroup is likely to be less vulnerable. The likelihood of increased vulnerability of Hungary is founded in its disproportionate general government deficit in response to prevailing weak economic conditions. The analysis presented in this section has provided useful but preliminary results demonstrating that the probability of infection greatly differs across Eastern European countries. However, as it has already been discussed in chapter 2.3.1, a CAD has to be financed either by a financial or a capital account surplus. Hence, the study of the composition of a country s capital inflows following in the subsequent chapter might increase the informative value when making conclusions about external vulnerability Composition of Capital Inflows Net PFI and Inward FDI In order to add to the analysis of current account sustainability in Eastern European countries by examining capital flows to this region, the subsequent section begins with distinguishing foreign direct investment and portfolio investment flows. As the discussion in chapter has demonstrated, FDI flows tend to be longerterm real investments in a country usually closely connected to the exercise of

50 42 significant influence by the foreign investor, 182 whereas PFI financing consumption can be withdrawn more easily and rapidly by impatient investors usually exercising only minority participation. Thus, high levels of PFI before the crisis might indicate increased vulnerability to extensive credit withdrawals. 183 Figure 3 illustrates the overall positive trend of inward FDI and net PFI flows to Emerging Europe since Figure 3: Inward FDI and net PFI in Eastern Europe Source: Own calculation and illustration. Data obtained from UNCTAD: WIR 2009 (FDI) and IMF: Balance of Payments Statistics 2009 (PFI). The diagram clearly supports the aforementioned assumption: although FDI flows to EE declined after the region was adversely affected by the propagation of financial turmoil during the final quarter 2008, net portfolio investments, which have climbed to new heights when eight of the ten countries analyzed within this paper have been admitted to the EU in 2004, have reacted excessively and sharply contracted from $27.55bn in 2007 to only $0.12bn in Negative values of PFI (i.e. net capital outflow) in 2008 have been reported by Bulgaria (-$0.14bn), Estonia (-$1.2bn), Latvia (-$0.07bn), Lithuania (-$0.38bn), and Poland (-$6.63bn) Cf. Kant, C.: Foreign Direct Investment, p Cf. Hawkins, P.: Open Economy, p Cf. Appendix 5. The highly negative value for Poland relies to an important extent on PFI liabilities amounting to -$4.42bn in 2008.

51 43 Appendix 5 provides additional information by illustrating the country-specific development of inward FDI and net PFI. Regarding net PFI, the situation within the first group is quite heterogeneous. Whereas net PFI in Slovenia rocketed to more than 12% of GDP between 2003 through 2007, the respective figure for Slovakia fluctuated around 2% of GDP. Consequently, Slovenia has been relatively more vulnerable to funds withdrawals immediately before the crisis. 185 The significant fluctuations of PFI in this country between 1994 and 1997 can at least be partially attributed to sporadic activities of international portfolio investors. Generally, the comparable stable figures until 2001 can be explained by the existence of restrictions on portfolio investment in Slovenia which have only been abolished in June Net PFI in the second country group (Baltic States) is marked by a joint start of the downward trend already after 2006 indicating the imminent acceleration cumulating in negative values for all three countries in Concerning the situation in the third group, the following can be stated: with the exception of the Czech Republic, which has recorded an increase in its net PFI between 2006 and 2007, all countries have already experienced noticeable declines before As Bulgaria and Romania have not been able to attract sizeable amounts of foreign portfolio investment capital during the whole period, their vulnerability to sudden liquidity constraints in 2007 is assumed to be limited. One potential approach in explaining the steep decline in net PFI in Hungary already before the crisis constitutes the excessive budget deficit following the April 2006 elections, which has led to severe concerns about Hungarian convergence. 187 As far as Poland is concerned, net PFI have already tremendously dropped in This considerable deterioration might include immediate reactions of international 185 Appendix 5 underlies the increased vulnerability: after the crisis has fully hit EE, net PFI in Slovenia dropped by 10%. 186 Cf. Dimireva, I.: Slovenia Investment. 187 Cf. European Commission: Economy of Hungary.

52 44 investors on a new Act approved in June 2005 restricting the free movement of capital. 188 When summarizing the issue of net PFI in Eastern European countries, it can be noted that the assumption that PFI tend to be withdrawn immediately in the case of a crisis holds in the case of EE. However, the analysis has clarified that the situation greatly differs across countries. Hence, the three country groups are rather heterogeneous with respect to net PFI. The following table (Table 4) provides a summary demonstrating the implied level of vulnerability to extensive credit withdrawals. Table 4: Net PFI and Vulnerability in EE Source: Own calculation and illustration. Data obtained from IMF: Balance of Payments Statistics 2009 (PFI) and IMF: WEO database, October A further important issue when analyzing a country s vulnerability to the propagation of external shocks in regard of capital inflows is the extent to which FDI, which developed differently to portfolio flows during the contagion of the current crisis, are able to cover CADs. Commonly, FDI inflows have been vital for the economies of EE during the 1990s in order to accelerate post-communist economic restructuring. Thus, FDI flows are assumed to exert a significant impact on the catch-up rates of this region. In this respect, the 1994 Essen European Council concluding that the associated States of 188 As the Polish Act on Special Powers of the Treasury and their Exercise in Companies of Special Importance for Public Order or Public Security is assumed to deter FDI as well as PFI in Poland, the European Commission has referred Poland to the Court of Justice. Cf. Anon.: Free movement of capital.

53 45 Central and Eastern Europe can become members of the European Union 189 marks a milestone in the economic integration of Central and Eastern Europe. This announcement has positively influenced longer-term capital flows to EE (cf. Figure 3) 190. Yet, as it can be concluded from Appendix 5, the positive influence on inward FDI has mainly been limited to some front-runners namely the Visegrád group comprising Poland, Hungary, the Czech Republic and Slovakia. The start of negotiations for accession in 1997 has further boosted inward FDI into the concerned countries (Slovenia, Estonia, Czech Republic, Hungary, and Poland). In contrast, FDI flows to the 2007 member states Bulgaria and Romania have considerably been lagging. Another crucial explanation for the differences in inward FDI to EE constitutes the diversity of the respective national economy. 191 As it has already been analyzed in the previous chapter, Eastern European countries significantly differ with respect to the share of technology-intensive production. Furthermore, a number of countries in this area have been selected for important projects in the automotive industry since the 1990s promising high amounts of FDI. 192 Due to these differences, the ratio of inward FDI covering the CAD in the year before the crisis hit EE considerably diverges. Figure 4 summarizes the respective values varying from 190% (Czech Republic) to 35% (Lithuania). The diagram allows the conclusion that Slovakia and Slovenia (group 1) are relatively less vulnerable to immediate liquidity constraints in financing the CAD than the Baltic States (group 2). In group 3, the differences in the FDI / CAD ratio are remarkable. Whereas Poland, Bulgaria and the Czech Republic have even been able to over compensate their CAD by attracting high amounts of FDI, Hungary s ratio only amounts to 67%. The level of Romania s ratio is comparable to those of Latvia and Lithuania. 189 European Parliament: Essen European Council. 190 Research conducted by Bevan, A. and Estrin, S. reveals that EU announcements about potential accession have significant independent effects on FDI flows to transition countries by increasing FDI to countries whose likelihood of accession is enhanced. Cf. Bevan, A., Estrin, S.: Determinants of FDI, p CF. Filippov, S., Kalotay, K.: Foreign Direct Investment, p. 8 and Bevan, A. et al.: EU accession, pp Countries hosting crucial investment projects connected with significant FDI include: Czech Republic (VW/Skoda, Toyota/PSA, Hyundai), Hungary (Suzuki, Audi), Poland (Fiat, VW, Daewoo FSO, GM/Opel), Romania (Renault Dacia), Slovakia (VW, PSA/Peugeot, Hyundai/KIA), and Slovenia (Renault). Cf. Filippov, S., Kalotay, K.: Foreign Direct Investment, p. 14.

54 46 Figure 4: Inward FDI / CAD Ratio in EE (2007) Source: Own calculation and illustration. Data obtained from IMF: WEO database, October 2009 (CAD) and UNCTAD: WIR 2009 (FDI) Total External Debt and Maturity A further aspect being worth included in the context of external vulnerability regarding the composition of capital inflows is the maturity of foreign financial flows. As it has been discussed earlier, higher fractions of short-term external debt increase the probability of sudden stops. Appendix 6 allows the following two important conclusions. First, all countries demonstrate a clear and considerable rise in their total external debt in the years before the crisis reaching transitional peaks in the second quarter of The respective increases between Q3, 2003 and Q2, 2008 have been highest for the Baltic States (group 2) (Latvia + 522%, Estonia + 490%, Lithuania + 477%) followed by group 1 and Hungary (Slovenia + 410%, Hungary + 404% and Slovakia + 365%). By experiencing an increase of 306%, Poland shows the most modest increase when compared to the other countries of the sample. 194 Moreover, by amounting to 39%, Slovakia s share of total short-term debt as a percentage of total gross external debt has been the highest of all countries in the quarter immediately before the crisis has hit EE (Q2, 2008). Slovakia is followed by Latvia, Estonia and 193 Hungary is the only exception, as the increase in its total external debt has not been interrupted in Q Source: Own calculations. Data obtained from World Bank: Quarterly External Debt Statistics. Due to data availability and comparability, the calculation is based on Q3, Data for Romania are only available since Q2, 2008.

55 47 Bulgaria (36%). With respect to this indicator of vulnerability, Hungary seems to be relatively less prone to the danger of sudden stops as the country s share of shortterm debt only amounts to 16% of total external debt Exposure to Exchange Rate Volatility Finally, capital inflows to EE on the eve of the crisis should be analysed regarding the (unhedged) share of debt denominated in foreign currency, as potential depreciations of the domestic currency due to a crisis will result in increased debt service burdens. 196 As the following section will illustrate, this risk has been of importance before the contagion of the crisis for certain countries in CEE. Generally, taking loans in currencies other than the domestic currency has been attractive in most economies of EE due to high interest rate differentials between domestic and foreign rates. 197 Missing experience with this relatively novel instrument has increased susceptibility to herd behaviour especially in the household sector, where foreign currency denominated loans have mainly been used for funding home purchases. 198 However, Appendix 7 shows that there are significant differences across the NMS in Eastern Europe with respect to the currency composition of the household debt. Very high levels of foreign currency borrowing are not only apparent for Estonia and Latvia but also for Hungary (mainly in Swiss franc), Lithuania and Romania and to a certain extent Poland. This phenomenon seems to be practically absent in the Czech Republic and Slovakia. As Slovenia has been admitted to the Euro Area in 2007, the risk of currency fluctuations has nearly been eliminated, because the largest share of foreign currency borrowing has been undertaken in euros. 195 Source: Own calculations. Data obtained from World Bank: Quarterly External Debt Statistics. Total short-term external debt has been calculated as the sum of general government, monetary authorities, banks and other sectors short-term debt. 196 Thus, a devaluation of the domestic currency might lead to macroeconomic rebalancing (in the form of improvements in the CA) but will entail high risks for the financial stability, if a country has sizeable FX debt on its balance sheets. Cf. Anon.: External Financing Risks. 197 Cf. Scott, M.: Economic Problems. 198 Cf. Holland, B. et al.: Panic, and Barrell, R. et al.: Foreign Currency Borrowing, p. 11.

56 48 Yet, when finally drawing conclusions about the real exposure of a country s debt to exchange rate risks potentially reducing the capability of households to repay loans, the exchange rate regime has to be added to the analysis. Thus, although households in Estonia, Latvia and Lithuania (group 2) have substantial amounts of foreign currency denominated debt, they appear to be less exposed to currency fluctuation leading to the possibility of default as the main part of foreign debt is denominated in Euro. By the peg of the Baltic States currencies to the Euro through participation in the ERM II the risk of devaluation has basically been mitigated. Due to the Bulgarian currency board, the situation in this country is similar. However, the exposure to a possible realignment appears to be slightly increased when compared to the Baltic States, as Bulgaria still remains outside the ERM II. Due to their floating currencies and the relative high values of foreign denominated debt, the NMS Romania, Hungary, and Poland faced substantial risk in case of changes in the exchange rate on the eve of the crisis. 199 Figure 5 clearly summarizes differences in the exposure to devaluation of the domestic currency. Figure 5: Exposure to Exchange Rate Volatility, Source: Barrell, R. et al.: Foreign Currency Borrowing, p Foreign Currency Reserves As argued in chapter countries defending a peg and economies in transition are likely to be most vulnerable to the propagation of external shocks with regard to the level and the development of foreign currency reserves. Thus, it seems to be appropriate to briefly introduce a classification of the countries examined throughout 199 Cf. Barrell, R. et al.: Foreign Currency Borrowing, pp

57 49 this paper. When referring to the current arrangement provided by the IMF, only Slovakia, Slovenia and the Czech Republic are counted among the group of advanced economies. All other countries (i.e. Estonia, Latvia, Lithuania, Poland, Hungary, Bulgaria and Romania) have been added to the group of emerging and developing nations. 200 Indeed, the EBRD classifies all but one country (Czech Republic) in the CEE region as economies in transition rendering nearly the whole region vulnerable. 201 Countries officially defending a peg include the Baltic States (by participating in the ERM II) and Bulgaria (currency board pegging the Lev to the Euro). Furthermore, as it has been discussed previously, first weaknesses of a country s macroeconomic situation are likely to occur in the FX market. This argument can even be strengthened when examining the EMPI 202 being one of the subindices of the EM-FSI which has been introduced earlier. As Appendix 2 demonstrates, the pressure on the FX market of Eastern European countries has by far been the highest when compared to other EMs around the globe. Already in August 2008, the EMPI for EE started to rise significantly and continued fluctuating around relative high levels. Immediately before the global contagion of the crisis, the pressure on the Czech Republic, Hungary, Slovenia, and Poland has been highest. 203 Figure 6 further details the analysis by showing the development of the countries quarterly ratio of foreign currency reserves to the import of goods and services. 204 Although Slovakia and Slovenia (group 1) are found to have the lowest ratio when compared to the countries of group 2 and group 3, these two countries appear to be less jeopardized to financial instability regarding the indicator of foreign exchange reserves, as both have already been admitted to the relatively safe harbour of the Euro Area. Low levels of foreign currency reserves in relation to imports are also apparent for the Czech Republic, Poland, and Hungary as well as for two of the 200 Cf. IMF: WEO, October 2009, pp In 2007, the Czech Republic has graduated from the bank. Cf. EBRD: Countries. 202 Exchange Market Pressure Index. For the calculation and interpretation, refer to Appendix Source: data provided by IMF along with Balakrishnan, R. et al.: Financial Stress. 204 The increase in the respective values for EE countries beginning in the final quarter 2008 is mainly due to a sharp contraction in the volume of imports. This already provides a hint that real linkages, which will be discussed in chapter 3.3.1, are likely to have played a significant role in the contagion of the financial crisis to Eastern Europe.

58 50 Baltic States (Estonia and Lithuania). In those countries, FX reserves were lower than quarterly imports at the end of Q3, While the respective ratio for Latvia is 122%, Bulgaria and Romania are able to cover a significantly higher percentage of imports with FX reserves in the 3 rd quarter 2008 than any other country in the sample. Generally, it seems to be difficult to draw final conclusions about vulnerability when analysing the indicator of FX reserves. Due to the fact that all countries except the Czech Republic are classified as economies in transition the following tendency might be summarized: as Slovakia and Slovenia (group 1) have already been admitted to the Euro Area, their risk tends be lower. Comparably, the vulnerability of Bulgaria and Romania is likely to be limited due to relative high FX reserves. The exposure of all other countries (comprising the Baltic States (group 2), as well as Poland, the Czech Republic and Hungary) tends to be higher. However, it should not be neglected that the respective values in EE though they vary considerably are extremely low when compared to other EMs. 205 Figure 6: Ratio of Foreign Currency Reserves to Import of Goods and Services 250% 200% 150% 100% 50% 0% 2007Q Q Q Q Q Q Q Q Q01 Bulgaria Czech Republic Estonia Latvia Lithuania Hungary Poland Romania Slovenia Slovakia Source: Own calculation and illustration. Data obtained from Eurostat: Balance of Payments and Eurostat: Foreign Official Reserves. 205 Thus, yearly data of the ratio of reserves to imports of goods and services proves that the respective figures for Central and Eastern Europe are tremendously below those of other emerging and developing economies in Cf.: IMF: WEO, October 2009, p. 195.

59 Domestic Banking System The final section exploring the most important macro-financial vulnerabilities in EE before the onset of the global financial crisis deals with the stability of the domestic banking system. Potential weaknesses in this area appear to be especially of importance for EE, because a sharp increase in private indebtedness has been the counterpart of the boom in capital inflows during the last decade including the subsequent rapid growth rates of investment and consumption. 206 Furthermore, as it has already been indicated during the discussion in chapter 2.3.4, the vulnerability of the domestic banking system is closely connected to other indicators of vulnerability including the level of foreign currency reserves. In a first step, it is to be examined which countries of the sample are likely to have experienced potentially unsustainable growth rates in private credit markets in the years before the crisis. Thus, Figure 7 relates the growth rate of credit to the growth of deposits during Obviously, credit growth has tremendously overtaken deposit growth in nearly all CEE countries. Thus, the Loan-to-Deposit ratio (LTD) has been relatively high and rising in all transitional economies of EE subject to the analysis within this paper signifying a shortage of capital in domestic markets. This has led to a considerable dependency on foreign funding, which has mainly been channelled through the banking sector. The Baltic States of Estonia, Latvia, and to a slightly lower degree Lithuania (group 2) demonstrated the highest increase in their LTD making this region especially exposed to concentrated foreign funding mainly arising from Western European banking systems. Yet, it is important to notice that countries comprising Bulgaria, Hungary and the Czech Republic have also experienced large increases in domestic credit. However, these figures have to be carefully interpreted owing to the fact that the exposure of EE countries to Western banking systems has not only taken the form of direct loans, but can also be explained through indirect exposure through foreign owned banks in Eastern Europe. 207 As certain countries have (directly or indirectly) concentrated their funding exposure to a small number of Western European economies, they appear to 206 Cf. Berglöf, E. et al.: Crisis in emerging Europe, p Cf. IMF: REO April 2008, pp

60 52 be highly vulnerable via the common lender channel, which will be examined in chapter Figure 7: Change in Deposit and Credit to GDP (Percentage points, ) Source: IMF: REO April 2008, p. 28. A further indicator proxying unsustainable growth of private credit and the possibility of resulting domestic imbalances in EE is the development of house prices in this region. Generally, the sharp increase in credit growth has to an important percentage been due to a raise in housing loans. Figure 8 monitors the average growth of house prices and credit during 2002 and 2006 in a number of countries examined in this paper. Similar to the results provided by the LTD analysis, Estonia, Latvia, Lithuania (group 2) as well as Bulgaria, Hungary and the Czech Republic show the highest growth rates of house prices when compared to average credit growth supporting the concern of real estate bubbles. As these assets are frequently used as collaterals for bank loans, a decline in their prices might lead to considerable weaknesses in the domestic banks balance sheets and contribute to the possibility of financial vulnerability Cf. IMF: REO April 2008, p. 22.

61 53 Figure 8: Credit Growth and House Prices in EE (Percent, ) Source: IMF: REO April 2008, p. 15. The last indicator making an individual country vulnerable with regard to its domestic banking system is the ratio of the banking system s liquid liabilities which are not backed by foreign currency reserves in the year prior to the contagion of the crisis. This fraction is closely connected to a country s level of foreign currency reserves and can be calculated by relating the monetary aggregate M2 to foreign currency reserves. 209 Table 5 provides the respective M2 to foreign exchange reserves data for the countries of all three groups in the second quarter Apparently, no country of the sample disposes of enough FX reserves to cover the monetary aggregate M2. This can serve as evidence that the whole region has been vulnerable to financial market contagion due to existing pre-crisis domestic imbalances. However, clear differences exist between the transitional economies of Eastern Europe. The comparably lower figures of Romania and Bulgaria 210 are followed by Latvia, Lithuania and Estonia (group 2) and Hungary. Both, the Czech Republic and Poland demonstrate figures well above 400%. Slovakia s M2 to FX reserves ratio amounts to an exorbitant value exceeding 8400%. 209 For the explanation of this ratio, refer to chapter The relative low ratio for Bulgaria is likely to be founded in the country s currency board. Cf. Raiffeisen Research: Bulgaria.

62 54 Table 5: M2 to Foreign Currency Reserves (Q2, 2008) Source: Own calculation and illustration. Data obtained from Eurostat: Foreign Official Reserves and Eurostat: Monetary aggregates. Having examined the stability of the domestic banking systems in EE before the eruption of the global financial crisis, the following conclusion appears to be justified: although the expansion of private household debt in these economies in transition greatly differs and can partially be referred to the ongoing process of convergence, it has culminated in booms in both the credit and the real estate market especially in the Baltic States (group 2) which accompanies the risk of financial instability in the case of a crisis. 211 Taking all the aspects discovered within the analysis of country-specific vulnerabilities to the propagation of external shocks into consideration, one can draw the conclusion that the situation of macroeconomic imbalances of the economies in transition in Eastern Europe has been characterized by significant variations before the eruption of the current financial crisis. Although all countries show certain classic macro-financial weaknesses in at least three of the fields examined within this chapter, especially Estonia, Latvia, Lithuania (group 2) and Hungary (group 3) appear to have been more prone to contagion than the Czech Republic, Poland, Romania, Bulgaria (group 3) as well as the Euro Area member states Slovenia and Slovakia (group 1) (Cf. Table 6). 211 Cf. Barrell, R. et al.: Foreign Currency Borrowing, pp This argument can be backed by the fact that the ratio of non-performing loans to total loans significantly increased after the crisis hit EE in late Cf. Berglöf, E. et al.: Crisis in emerging Europe, p. 7.

63 55 Table 6: Summary of Country-specific Vulnerabilities in EE Source: Own illustration based on the analysis in chapter 3.2. By keeping those results concerning country-specific vulnerabilities in Emerging Europe on the eve of the propagation of the financial crisis in mind, the subsequent chapter is intended to further examine the recent contagious period by exploring the most essential channels of transmission. As it has already been the case during the previous analysis, special attention will be attributed to potential differences between the three country groups. 3.3 Essential Channels of Transmission As it has already been indicated, the number of linkages potentially able to propagate external shocks across borders tends to be compelling for highly integrated economies. 212 Furthermore, those channels are not mutually excluding. 213 Therefore, the subsequent section is intended to identify and examine those channels of transmission which have played a crucial role during the recent contagious period to Eastern Europe. 214 Thus, before paying attention to financial linkages including the aspect of herding, the relevance of real links will be investigated in detail. Although the phenomenon of political contagion appears to be negligible with respect to the contagion of the current crisis to EE, the subsequent chapter concludes by briefly commenting on the potential danger of negative political contagion in the case of Eastern Europe. 212 Sell, F.: Contagion, p Glick, R., Rose, A.: Contagion and Trade, p Due to the fact that global factors as discussed in chapter do not seem to have played an important role during the recent contagious period, they will not be subject to the subsequent analysis.

64 Real Linkages This section reviews the importance of trade linkages during the propagation of the current financial crisis to Central and Eastern Europe. It starts by determining the degree of trade openness in this region before continuing the analysis by providing relevant figures examining when and how external trade has been adversely affected by the consequences of the financial crisis. An explanatory approach including the commodity composition of exports and main trading partners will determine potential cross-country differences and conclude the investigation about the relevance of real linkages Trade Openness and Decline in Merchandise Exports The starting point of the analysis is to assess whether trade constitutes an essential part of the economic activity in Eastern European countries. The metric employed in this paper to proxy the respective significance is the conventional output-based method of trade openness, which is defined as the sum of total (merchandise) exports and imports as a percentage of GDP. 215 The results indicating considerable differences regarding trade openness in EE not only among but also within the three distinct country groups are provided in Appendix 8. Thus, the respective figures indicate an increased relevance of trade openness especially for group 1 (Slovakia and Slovenia) as well as for the Czech Republic and Hungary in Likewise, the figures of trade openness surpass 100% for Estonia, Lithuania (group 2) and Bulgaria. In contrast, external trade is assumed to be relatively less important in Romania, Poland, and Latvia. In order to explain this tremendous variance the analysis goes one step further by relating the level of trade openness to the size (measured by its total population) as well as to the welfare (proxied by its GDP per capita) of a country. Generally, larger countries tend to trade less whereas comparably rich economies tend to trade more. 216 Thus, the relative low trade openness of Poland and Romania can at least be partially explained by their large population while the lower relevance of trade for Latvia and 215 Cf. Broadman, H.: From Disintegration to Reintegration, p Cf. Broadman, H.: From Disintegration to Reintegration, pp

65 57 Lithuania can be influenced by their below-average GDP per capita. The increased importance of trade for Estonia, Hungary, the Czech Republic as well as Slovenia and Slovakia seems to be mainly due to their relative high income level. A comprehensive overview about trade openness comprising data covering population and GDP per capita is provided in Appendix 8. While keeping the varying relevance of external trade for Eastern European countries in mind, Figure 9 illustrates that the decline in the region s total merchandise exports has been relatively homogeneous across all countries. Merely the Baltic States of Estonia, Latvia and Lithuania (group 2) have experienced slightly above-average rates of decline. Figure 9: Total Merchandise Exports in EE 260% 240% 220% 200% 180% 160% 140% 120% 100% 80% 2006m1 2006m3 2006m5 2006m7 2006m9 2006m m1 2007m3 2007m5 2007m7 2007m9 2007m m1 2008m3 2008m5 2008m7 2008m9 2008m m1 2009m3 2009m5 2009m7 2009m9 2009m11 Czech Republic Estonia Hungary Latvia Lithuania Poland Slovak Republic Slovenia Bulgaria Romania Source: Own illustration. Data obtained from: WTO: Trade Statistics Obviously, external demand for Eastern European merchandise goods has not been adversely affected at the beginning of the crisis in August 2007 but only started suffering after the collapse of Lehman Brothers. Thus, the spread of the financial crisis to EE via the trade channel has led to declines in merchandise exports ranging from 40% (Czech Republic, Poland, Slovenia, and Romania) to 48% (Latvia) between September 2008 and January Given this development, insufficient 217 Source: Own calculation based on WTO: Trade Statistics.

66 58 demand which considerably widened in the first months of 2009, has to be regarded as one of the main barriers of growth in this region Commodity and Geographic Export Concentration Despite these results indicating high importance of trade linkages during the propagation of the current crisis to Eastern European economies in transition, the investigation will try to further detect differences in the explanation for this sharp decline by analysing the composition of the countries exports as well as their main trading partners. Figure 10 starts by detailing the countries total merchandise exports per commodity. Obviously, all countries which have been selected as host countries for crucial investment projects in the car industry accompanied by large inflows of foreign direct investment during the last decades (especially Poland, the Czech Republic, Hungary, Slovenia, the Slovak Republic, and Romania) 219 show significantly higher shares of automotive exports as percentage of total merchandise exports. Thus, although a country s diversification of the composition of its exports is usually positively correlated to economic development, it worsened especially in those Eastern European economies in transition. However, a heightened dependency of a country on global demand for its concentrated exports can be regarded as a major risk factor in case of adverse developments in global market conditions. In contrast, export diversification remained higher in the Baltic States (group 2) and Bulgaria. 220 Furthermore, the onset of the financial crisis coincided with further essential developments in the automotive industry including excess capacities 221 as well as major structural changes, which made adoptions inevitable in the sector of the former star performers of the global economy. 222 Hence, the simultaneous fall-off in international demand especially for long-lasting goods like automotives as well as the industry-wide credit crunch have made the car industry one of the branches hit 218 Cf. Tůma, Z.: Crisis Propagation, p In CEE, carmakers especially benefited from comparably cheap but high-skilled work force, low tax burdens, good infrastructure as well as a strategic positioning in the geographic heart of Europe which is close not only to the European Core, but also EMs including Russia and the Ukraine. Cf. Filippov, S., Kalotay, K.: Foreign Direct Investment, p Cf. Broadman, H.: From Disintegration to Reintegration, p Cf. Alpern, P.: Over-Capacity. 222 Filippov, S., Kalotay, K.: Foreign Direct Investment, p. 3.

67 59 hardest by the consequences of the financial crisis. These developments have not only adversely affected car manufactures but also suppliers bringing some of them on the verge of bankruptcy. Although demand for automotive exports has tremendously declined on a global scale, mature markets comprising the United States and Western Europe have particularly been affected. 223 Figure 10: Merchandise Exports per Commodity (% of Total Exports, f.o.b., 2008) 100% 25% 90% 80% 20% 70% 60% 15% 50% 40% 10% 30% 20% 5% 10% 0% Bulgaria Czech Estonia Hungary Latvia Lithuania Poland Romania Slovak Slovenia Republic Republic 0% Total Manufactures Fuels and mining products Agricultural products Automotive products (right axis) Source: Own calculation and illustration. Data obtained from WTO: Trade Statistics. Given the increased commodity export concentration in the automotive sector of several countries in Eastern Europe as well as sharp declines in demand in important mature car markets, the analysis will provide additional information on the individual dependency of Eastern European countries on those markets by examining their geographic export concentration. In this regard, Appendix 9 summarizes the most important destinations of EE countries exports by providing the share of exports to the European Union, Central and Eastern Europe, the first-crisis country (United States), as well as to the five 223 Cf. WTO: Trade Situation , p. 2 and KPMG: A rough road, p. 2. Thus, in October 2008, the sales of BMW plummeted by 5% in the U.S. and by 10% in Europe, VW sales dropped by 6% (U.S.) and 8% (Europe). The respective declines for Daimler amounted to 25% in the U.S. and 17% in Europe as opposed to October Moreover, inventories of German car manufacturers deteriorated to the lowest level since the end of the 1980s. Cf. Hawranek, D.: German Auto Industry and Anon.: Auto-Krise.

68 60 most important individual trading partners (country) as a percentage of the country s total world exports (f.o.b.). Apparently, all new member states in this region are Eurocentric with respect to their export orientation. Although average exports remaining within the European Single Market amount to 75% across all countries of the sample, the respective figures greatly differ among the three country groups. Hence, the Euro Area member states Slovenia and Slovakia show the highest value (83%), which is closely followed by Poland, the Czech Republic and Hungary (81%). Only 68% of the Baltic States exports remain within the EU. The respective figure for Bulgaria and Romania is even lower and merely amounts to 65%. Regarding exports to Central and Eastern Europe, Poland, the Czech Republic and Hungary demonstrate considerable lower figures than the other economies in the sample. When examining the share of exports as percentage of a country s total exports (f.o.b.) to the first-crisis country the United States the following can be concluded: as direct trade linkages of Eastern European countries to the U.S. are generally low (averaging 2%), EE has not been adversely affected by contagion via the trade channel immediately after initial turbulences in the financial system occurred in August Only since the financial crisis has spread to global markets in the final quarter 2008, the trade channel appears to be highly relevant for CEE (also cf. Figure 9). This could at least be partially explained by the high relevance of Germany as a trading partner for Eastern Europe. Whereas average export to Germany amounts to 18% of the countries total exports, 224 the role of Germany appears to be especially of relevance for those countries hosting large plants of the automotive industry. Thus, Germany is the most important individual trading partner for Poland, the Czech Republic, Hungary, Romania, as well as Slovenia and Slovakia concerning their exports. Varying between 16% (Romania) and 31% (Czech Republic), average export to Germany amounts to 24% for these economies. Taking all these arguments provided within this chapter into consideration, one can draw the following conclusion concerning the relevance of real linkages during the 224 Only countries where Germany is among the five most important individual trading partners have been taken into account, i.e. all EE countries of the sample except Estonia.

69 61 contagion of the current financial crisis to the economies in Eastern Europe: according to the analysis of commodity export concentration, especially Poland, the Czech Republic, Hungary, Romania (group 3) as well as Slovenia and Slovakia (group 1) heavily depend on global demand for automotive products. However, in the course of the current crisis, this industry is facing severe challenges and is to be regarded as one of the sectors hit hardest. Additionally, those countries seriously rely on a single trading partner (Germany) and tend to be Eurocentric regarding their export destinations. This region, indeed, has equally been hit hard by the crisis. When including the relative importance of trade for the economic activity in the respective country proxied by the trade openness, the Euro Area member states Slovenia and Slovakia (group 1) as well as the Czech Republic and Hungary are likely to be hardest hit via the trade channel. 225 Furthermore, low direct trade between Eastern European countries and the first-crisis country (United States) might help to explain why trade linkages have not been of immediate importance after the crisis has erupted in the United States but gained in popularity since the crisis has shown global repercussions after the collapse of Lehman Brothers Financial Links After having analysed prominent linkages in the area of trade channels, this section will explore essential financial linkages of Eastern European countries which have exerted a crucial role during the recent period of contagion. It will therefore accurately examine the development of trade credits as well as the role of crossborder bank lending and the common lender channel which is likely to be one of the major channels of transmission. The subsequent chapter will conclude by discussing the relevance of wake-up calls in Eastern European countries Please note that the analysis of trade openness has revealed that the relevance of trade for Poland and Romania is likely to be relatively less important. 226 Due to its subordinated importance during the recent contagious period, the impact of changes in the rules of the game, as it has been discussed in chapter , will not be further detailed in the subsequent chapter. Moreover, due to data availability and overlapping similarities (cf. chapter ), the analysis of the common lender channel will also contain elements of liquidity constraints, rational hedging and global diversification as well as performance based arbitrage. Aspects of herding will be apparent within the common lender channel as well as the in the analysis of wake-up calls.

70 Trade Credits The first section is intended to review the copula between real links and financial channels of transmission: the existence of trade credits. Due to a lack in the availability and reliability of appropriate data, this section will not exclusively illuminate the issue of trade credits agreed upon between suppliers and buyers (corporate corporate) but will rather expand its view including the intermediation of financial institutions in the business of trade finance. 227 In addition to that, the possibility of clearly distinguishing between country-specific characteristics will be limited. Therefore, the objective of the subsequent section is to draw an overall picture of the development of trade finance during the current financial crisis by notably emphasizing the situation in and the consequences for the economies of Emerging Europe of this channel of contagion. Owing to its importance of ensuring liquidity and security which fosters the shipping of goods and services across borders, the availability of trade finance lies at the heart of the global trading system. 228 In this context, a survey conducted by the ICC reveals that a considerable deterioration in the supply of trade credit could threaten global trade as a whole and be especially devastating for Emerging economies. 229 Recent figures suggest that approximately 80 90% of global trade rely on the various forms of trade finance. Moreover, this kind of financing is becoming especially important for globally integrated supply chains, where shortages in the availability of trade finance could lead to contractions in output. 230 Put into a historical context, trade finance has been highly vulnerable in previous times of financial crises, which is mainly due to its increased risk in those periods. 231 A similar development can be observed during the recent period of financial turmoil. Although the sharp decline in global demand accounts to an important percentage for the drop in the international shipping of goods and services, the fall in trade has been 227 Thus, depending on the level of trust between the business partners and the volume of financing needed, the forms of trade finance can considerably vary. They can reach from cash-in-advance or open-account transactions without the intermediation of financial institutions to instruments of risk mitigation provided by banks including documentary collection, letters of credit, export credit insurance and trade lending (export working capital lending). Cf. Dorsey, T.: Trade Finance, p Chauffour, J., Farole, T.: Trade Finance in crisis, p Cf. ICC: Trade Finance in Crisis, p Cf. Auboin, M.: Boosting trade finance, p Cf. Chauffour, J., Farole, T.: Trade Finance in crisis, p. 2.

71 63 far greater than the decline in the economic activity would have suggested. Hence, this disproportionate effect on global trade can at least be partially referred to difficulties in financing trade activities. 232 Estimates provided by the World Bank suggest that roughly 85 90% of the contraction in global trade since late 2008 can be explained by declining demand whereas 10 15% is likely to have been triggered by deteriorations in the supply of trade finance. 233 Hence, different assessments imply that the current trade finance gap the volume of trade that would have taken place if sufficient credit was available, despite the existence of demand shocks ranges between $25 500bn. 234 In order to be responsive on these developments and to promote international trade and investment, leaders at the April 2009 G20 summit in London agreed on a $250bn support package for trade finance. Additionally, the EBRD considerably expanded its trade finance program in order to facilitate trade in Eastern Europe. 235 Generally, Emerging Markets, SMEs as well as firms operating in international supply chains appear to be confronted with the highest difficulties concerning declines in the market for trade finance. 236 In this respect, Table 7 clarifies that the structure of the industry in Bulgaria and Romania as well as in the Baltic States especially Estonia is dominated by rather small enterprises. Whereas Hungary s share of SMEs as a percentage of all firms is equally high, the Czech Republic, Poland and most notably Slovenia and Slovakia appear to be less endangered by financial constraints due to declining supply of trade credit. 232 Cf. Dorsey, T.: Trade Finance, p. 18 and Knapp, W.: Current Financial Environment, p Cf. Auboin, M.: Boosting trade finance, p Cf. Chauffour, J., Farole, T.: Trade Finance in crisis, p Cf. Schepers, M.: Central and Eastern European Forum and Chauffour, J., Farole, T.: Trade Finance in crisis, p Cf. Knapp, W.: Current Financial Environment, p. 2 and Chauffour, J., Farole, T.: Trade Finance in crisis, p. 25.

72 64 Table 7: SMEs in EE (1999) 237 SMEs Country All Firms Agriculture Industry Service % of all firms Estonia 5, ,889 2, % Bulgaria 15,123 2,225 5,976 6, % Romania 25,535 3,037 13,943 8, % Latvia 1, % Hungary 3, , % Lithuania % Czech Republic 4, ,422 2, % Poland 6, ,202 3, % Slovakia % Slovenia % Source: Klapper, L. et al.: Small- and Medium-Size Enterprise, p. 31. Given the high importance of SMEs in a number of Eastern European economies in transition, the accelerating decline in the availability of trade credit between October 2008 and January 2009 which goes along with increasing costs of financing is likely to be an essential part of the crisis propagation to Eastern Europe. This assumption appears to be justified even more when comparing the changes in value of the trade finance business across different regions. Obviously, all regions have been affected by partially double-digit rates of decline in the value of trade finance. Yet, by having experienced a fall of 13% between October 2008 and January 2009, Eastern Europe has been hit hardest on a global scale. As it has already been indicated, the costs of financing have evenly augmented primarily in EMs since the final quarter Although the price of nearly all trade instruments has increased, the respective raise has been highest for export credit insurances. Higher costs of funds for the intermediating institutions are generally blamed to constitute the main reason for this development. Further explanations include the rise in capital requirements and higher default rates. When analysing the composition of trade finance during the propagation of the current financial crisis, the following can be stated: there has been relatively little change in the way trade finance is conducted. Although open-account transactions declined by 3% between October 2008 and January 2009, they are still the most popular form of transaction. This is especially true for SMEs and firms operating in 237 SMEs are defined as firms with less than 250 employees.

73 65 global supply chains. Cash-in-advance and bank-intermediated transactions rose by 2% and 1% respectively in this timeframe. 238 However, this slight shift towards intermediated trade transactions might also be taken as an indicator for a rise in the corporations risk aversion. 239 To sum up, the role of trade finance in global transactions appears to be formidable. Shortages in this market, which seem to be inevitable in periods of financial turmoil, are likely to exert negative consequences especially on Emerging economies, small and medium enterprises as well as on companies operating in global supply chains. In the recent period of financial distress, deteriorations in the availability of trade finance coupled with higher costs have played a crucial role in Eastern Europe starting in the final quarter Proxied by the share of SMEs as a percentage of all firms, the Euro Area member states Slovenia and Slovakia (group 1) as well as Poland and the Czech Republic appear to be relatively less affected. In contrast, contagion to the economies of Bulgaria, Romania, Hungary as well as the Baltic States (group 2) via the trade credit channel is likely to be more significant Foreign Bank Lending and the Common Lender Channel The following section is intended to accurately investigate the relevance of crossborder bank lending and the common lender channel (CLC) during the recent contagious period to Eastern European economies. This appears to be all the more important as close banking ties among Eastern and Western Europe have continuously developed during the years prior to the crisis. Moreover, as it has already been indicated in chapter , the rational of the CLC also includes aspects of further channels of transmission related to investors behaviour, namely the issue of the role of liquidity, hedging and global diversification as well as the phenomenon of herding. However, the adherence of essential facets of those channels of propagation to the subsequent chapter is not only due to extensive similarities but also to the improved quality, availability and reliability of necessary data of the CLC. 238 Cf. IMF BAFT: Trade Finance Survey, pp and Chauffour, J., Farole, T.: Trade Finance in crisis, p Cf. Knapp, W.: Current Financial Environment, p

74 66 The remainder of this chapter is as follows: after the analysis of the role of foreignowned banks in Emerging Europe including recent crucial developments in the EE banking sector, the section will continue to analyse the importance of the CLC by computing an index of susceptibility to regional contagion as introduced in chapter The chapter concludes by summarizing the main findings Stabilizing Role of Foreign-owned Banks By commencing already in the late 1990s, liabilities of Eastern European countries in transition to advanced economies banks have rapidly and steadily increased. When compared to the respective development of other emerging regions around the globe, like Emerging Asia and Latin America, the respective increase in Eastern Europe s bank liabilities has been the highest rendering this region relatively more susceptible to contagion in the case of external banking crises. Moreover, as Western European banks have gradually raised their dominating roles in controlling banking flows, the source of potential common-lender effects is most likely to be detected in the Western part of the European continent. 240 In order to benefit from the region s transition process, several banks have partly shifted their business focus to Eastern European countries by intensifying their presence in the host countries banking system. In this connection, the main mode of entrance has been the acquisition of newly privatized banks in EE. 241 Meanwhile, the share of those banks operations in EE accounts for a significant percentage of the groups operating income. 242 This situation heightens the risk of contagious effects in the case of adverse developments in the host country for the domestic financial system. Similarly, difficulties primarily occurring in the domestic banking system might easily spread to EE and could even trigger contagion among Eastern European economies. 243 A supplementary indicator of the massive growth in financial interlinkages between Eastern and Western Europe is the number of foreign-owned banks operating in 240 Cf. IMF: WEO, April 2009, p Cf. Čihák, M., Srobona, M.: Losing their halo, p Thus, for Unicredit and Societe Generale, the share of operating (net banking) income earned in this region is roughly twice as high as Eastern Europe s share in the group s total assets. Cf. Árvai, Z. et al.: Financial Contagion Within Europe, pp Cf. Árvai, Z. et al.: Financial Contagion Within Europe, p. 12.

75 67 Central and Eastern Europe. Figure 11 further illustrates this phenomenon. Generally, the share of foreign-owned banks as a percentage of the total number of a country s banks has increased between 2004 and 2008 in all economies but Hungary, Slovakia, and Lithuania. Concerning the asset share of foreign-owned banks in EE, the following can be concluded: the foreign ownership level in Eastern Europe is considerably high exceeding 60% in all economies but Slovenia in The respective increase between 2004 and 2008 has especially been remarkable in Romania, Hungary, Latvia and Slovenia. The current level of foreign-owned banks assets is close to 100% in the Slovak Republic and Estonia. Figure 11: Foreign-owned banks in EE (2004 vs. 2008) 100 Foreign-owned banks (% of total banks) Asset share of foreign-owned banks (in per cent) Estonia Poland Romania Czech Bulgaria Hungary Slovak Republic Republic Latvia Slovenia Lithuania 0 Slovak Republic Estonia Lithuania Romania Czech Hungary Bulgaria Poland Latvia Slovenia Republic Source: Own illustration. Data obtained from EBRD: Structural Indicators. In addition to these developments, the Eastern European banking sector has generally undergone profound changes since the 1990s. As it has been examined in chapter 3.2.4, the sharp growth rates of credit to GDP have often not been backed by domestic deposits to an important extent. This phenomenon has inevitably led to high and increasing LTD and essential reliance on foreign funding in order to finance domestic credit growth. Owing to the relative underdevelopment of domestic capital markets, those external funds have mainly been attracted via the banking sector. This has even been fostered by the comparably easy access of foreign-owned subsidiaries to capital provided by their parent banks. Hence, net foreign liabilities (NFL) of the banking sector as a percentage of private sector credit have been rising in recent years and have especially been high in the Baltics (exceeding 55% in Latvia), Romania, Bulgaria, Hungary and Slovakia in

76 68 June Foreign funding through the banking sector has only played a minor role in the Czech Republic and Poland. 244 Given this evolution in the years prior to the crisis, those countries heavily dependent on foreign funds from the banking sector in order to finance domestic credit growth are more likely to be hit by the common lender effects in the case of external bank crises. 245 Yet, when the consequences of the financial crisis fully hit Eastern Europe in the final quarter 2008, outflows of foreign bank loans have surprisingly been resilient. In this regard, the presence of high percentages of foreign-owned banks has exerted visible effects. Thus, especially smaller economies in EE with a large proportion of foreign-ownership in the banking sector appear to have been at least temporarily less affected by decreasing cross-border loans. These countries include the Baltic States as well as the south-eastern EU member states of Bulgaria and Romania. In contrast, larger economies where the role of foreign-ownership in the banking sector has generally not played a decisive role, comprising Poland and the Czech Republic 246, have been confronted with relatively higher contractions in cross-border bank loans. 247 The stabilizing role of foreign-owned banks which has been observable during the contagion of the current crisis in Emerging Europe is in line with recent research finding that subsidiaries of multinational banks, in sharp contrast to domestic banks, do not tend to reduce their credit supply when the host country is hit by a banking crisis. 248 Additionally, the relative large withdrawal of cross-border bank loans from the Czech Republic and Poland during the third quarter 2008 can also be referred to the comparable high soundness and liquidity of these countries banking systems. 249 Yet, when comparing EE to other global emerging regions it becomes obvious that Eastern European countries have been less adversely affected by cross-border bank 244 Cf. Árvai, Z. et al.: Financial Contagion Within Europe, pp Cf. IMF: WEO, April 2009, pp and IMF: REO April 2008, p The Czech Republic has to be regarded as an exception in this case, as foreign-ownership in the banking sector has indeed been relatively important. 247 Cf. BIS: AR 2008/09, pp Haas, R., Lelyveld, I.: Internal capital markets, p Cf. BIS: AR 2008/09, pp

77 69 lending outflows immediately after the crisis has spread to global markets than other emerging regions around the world (Figure 12). Figure 12: Cross-border Bank Lending (Quarter-on-Quarter Change) Source: Berglöf, E. et al.: Crisis in emerging Europe, p Regional Contagion through Concentrated Funding Despite these facts including the stabilizing effect of foreign-owned banks, the risk of (regional) contagion via the CLC has still remained relevant in EE. This is mainly due to the relative high levels of exposure of certain Western European banks in the CEE region. As these common lenders constitute the main source of funds for several Eastern European countries, they could play a crucial role in the transfer of shocks from one country to another in this region. If a foreign bank is highly exposed to a country in EE, an adverse shock in this country could create immediate liquidity constraints within the foreign bank s group and spill therefore over to other economies within the region, where the bank has substantial operations as well. Additionally, a shock that has been triggered by difficulties in Western European banks might be transmitted to EE. 250 Hence, at a first step, it appears to be obligatory to determine the degree of interdependency between Western European banking groups and Eastern European economies. Figure 13 provides a general overview about the exposure of EE 250 Cf. Árvai, Z. et al.: Financial Contagion Within Europe, p

78 70 economies to Western European banks. 251 Obviously, most Eastern European countries in the sample have concentrated their funding activities on Austria, Italy, and Germany. Whereas the Baltic States Estonia, Latvia, and Lithuania (group 2) mainly rely on foreign funds originating from Swedish banks, several countries appear to be more diversified than others. This applies exemplary for Poland and the Czech Republic. 252 Thus, adverse developments in one of the Swedish banks highly exposed to Eastern Europe will be felt most severely in the Baltic States whereas liquidity pressures in Austrian banks are likely to exert significant difficulties for example in Slovakia. In this respect, it has to be emphasized that also a more diversified CL can easily get into trouble, if an adverse development in one country the lender is exposed to has already been transferred to other markets where the CL has crucial operations as well. 253 Major banking groups whose operations in CEE are non-negligible economically include Unicredit, Raiffeisen, Erste Bank, KBC, Société Générale, Intesa Sanpaolo, OTP, Swedbank, ING, Citibank, Commerzbank, National Bank of Greece, Bayerische Landesbank, SEB, and EFG Eurobank. 254 Although the impact of the financial crisis has differed across those financial institutions, they have generally been seriously hit signifying potential danger of contagion to the main borrowers of these banks in EE The exposure is defined as the share of the reporting banks in each Western European country in the total outstanding claims on a given EE economy. 252 Cf. IMF: REO April 2008, p This can, for instance, be the case if markets only poorly distinguish between different countries during periods of financial turmoils. 254 Cf. Árvai, Z. et al.: Financial Contagion Within Europe, p Thus, exemplary, Unicredit admitted to have underestimated the financial crisis; Raiffeisen and Erste Bank have applied for governmental support in Austria; the Belgian bank KBC has been granted a 3.5bn recapitalization; the profit of Société Générale (France) has declined by 84% in Q3, 2008; Germany s second-biggest bank Commerzbank AG got a 8.2bn capital injection; the Dutch government invested 10bn in ING to boost its capital position; the Swedish government prepared to part-nationalise banks affected by the collapse in the Baltics; and the Bayerische Landesbank has been one of the first German banks applying for governmental support. Cf. New York Times: Unicredit and Boerse-express: Österreichisches Bankenpaket and European Commission: KBC Group and Valentini-Benedetti, F.: Societe Generale and Welt Online: ING and Evans-Pritchard, A.: European banks and Spiegel: BayernLB.

79 71 Figure 13: Concentration of EE Exposure to Western Europe (June 2007) Source: IMF: REO April 2008, p. 30. Furthermore, as it has already been denoted in chapter , potential contagion via the CLC when the trigger is one of the EE economies affected by the crisis is all the more relevant for a country, if several essential preconditions have been satisfied: the exposure of the CL to the country which has initially been affected by adverse effects arising from the crisis has to be substantial signifying large losses (i); the CL is one of the most important sources of funds for other economies in EE (ii); and the potentially affected economies are not able to immediately shift their funding source towards different lenders (iii). 256 Hence, it will be determined for which countries in EE this channel is most relevant by using the index combining the absolute dependency of a country on the CL and the absolute exposure of the CL to the potential trigger country which has been presented in chapter The respective figures for Eastern European economies are outlined in Appendix 10. Obviously, the Czech Republic, Hungary, Romania (group 3) as well as the Euro Area member states of Slovakia and Slovenia (group 1) heavily depend on funds from Austrian banks. Furthermore, Hungary and Slovenia show large dependencies on Germany whereas Slovakia additionally depends on Italy and the Czech Republic on Belgium. Indeed, all countries of group 2 (Baltic States) greatly rely on the CL Sweden (upper table in Appendix 10). 256 Cf. Árvai, Z. et al.: Financial Contagion Within Europe, p. 14.

80 72 The picture of absolute exposure of Western European countries slightly differs (lower table in Appendix 10). Measured as the percentage of domestic banking sector assets, Germany s exposure to EE is comparably low whereas Austria is heavily exposed to Poland, the Czech Republic, Hungary, and Romania as well as to Slovenia and Slovakia. Moreover, Belgium s exposure to Poland, the Czech Republic and Hungary is above average. Sweden s exposure is concentrated on Estonia, Latvia and Lithuania. In order to derive the relevance of the CLC and thus the potential danger of regional financial contagion within Eastern Europe, an index is calculated by multiplying the absolute dependency of a country on the CL with the CL s absolute exposure to a potential trigger country. Table 8 provides the results proxying the relevance of the CLC for the individual economies in EE. The interpretation of the data is as follows: generally, the higher the respective figure the higher the susceptibility for the country to be hit by regional financial contagion via the CLC. If the consequences of the financial crisis in EE have led to massive losses for the common lender in one country, financial stress is likely to spread to economies which heavily depend on the same lender and to which the CL is exposed to. Exemplary, the high figures for Sweden (Common Lender) regarding the Baltics indicate that an economic downturn in e.g. Latvia (which then is to be regarded as the trigger country) might easily and heavily spread across borders to the other Baltic States via a Swedish bank, as both Estonia and Latvia also depend on Sweden and Swedish banks are heavily exposed to the Baltic States at the same time. In contrast, it is improbable that the CL Sweden will spread difficulties to the whole CEE region, as its exposure to other EE countries is comparably low. 257 Beside the crucial role of Sweden for Estonia, Latvia and Lithuania, Table 8 allows to draw the conclusion that the role of Austria is equally of major importance for a high number of countries in EE. The results indicate that initial losses for Austrian banks triggered by downturns in the Czech Republic, Romania or Slovakia are likely to spread to nearly all countries in EE, except the Baltics. 257 For Sweden as CL, an exemplary calculation is as follows: if Latvia is the trigger country (middle column) and the danger of contagion via the CLC for Estonia is to be estimated, then the absolute dependency of Estonia on Sweden (133.5, Appendix 10) is multiplied by the absolute exposure of Sweden to Latvia (2.36, Appendix 10).

81 73 Table 8: Index of Exposure to Regional Contagion via the CLC in EE, end-2007 Austria Germany Italy France Sweden CZ Romania Slovakia Poland Hungary Slovenia Poland Slovakia Hungary CZ Romania Estonia Latvia Lithuania Poland Czech Republic Hungary Romania Slovakia Latvia Estonia Lithuania Bulgaria Slovenia Common Lender Hypothetical Trigger Country Source: Own calculation based on Appendix 10. Taking the arguments discussed in this chapter into consideration, the subsequent results can be retained: in the years prior to the crisis, the Eastern European banking sector has undergone profound changes. Partially, domestic credit booms have been financed by foreign bank lending which went hand in hand with a gradually increasing presence of Western European banks in the EE region. Since the contagion of the financial crisis in the final quarter 2008, high percentages of foreign-owned banks have indeed exerted a stabilizing effect in EE and have especially protected the Baltics as well as Romania and Bulgaria from excessive declines in cross-border bank lendings. Larger and liquid markets as Poland and the Czech Republic have been hit more seriously by withdrawals. Moreover, due to the systematic nature of difficulties in the banking sectors of advanced economies, crossborder bank lending flows are likely to recover only slowly. 258 Although bank lending outflows from EE have surprisingly been resilient when compared to other EMs, Eastern Europe is still exposed to crucial risks arising from the high concentration of foreign funding. Thus, negative developments in one country signifying possible losses for a common lender could easily spread to other economies in this region. Difficulties triggered by one of the Baltic States are therefore likely to spread to the other two Baltic States via the CL Sweden. Similarly, Austria s large exposure to a high number of EE countries creates the danger of regional financial contagion, if Austrian banks were affected by serious losses arising from adverse developments in one of these countries. An increasing share of NPL after the collapse of Lehman Brothers in Eastern Europe especially in Latvia Cf. IMF: WEO, April 2009, p Cf. Berglöf, E. et al.: Crisis in emerging Europe, p. 7.

82 74 seems to certify that the risk of regional financial contagion via the CLC still remains present in Emerging Europe Wake- up Calls The fact that the issue of wake-up calls in periods of financial turmoil has first been observed and extensively discussed with regard to the Asian Crisis (cf. chapter ) has led to several attempts of detecting both similarities and differences between the Asian Crisis and the crisis currently unfolding in Eastern Europe. Current research goes from focusing on the partially excessive imbalances prevailing in a number of emerging European economies, which have even dwarfed those of certain Asian countries, to deliberating on the question whether Latvia could be the new Thailand triggering severe contagion across CEE. 260 In the context of this paper, however, the focus will be on a channel which has supported the propagation of financial stress not only during the Asian Crisis but has also been of relevance in the case of the current contagion to Eastern Europe: wakeup calls. 261 In this respect, the initial resilience of cross-border bank lending in EE, which has been elaborately examined in the previous chapter, appears to be all the more surprising, if one is aware of the fact that general investors confidence in the stability of the region gradually diminished after the collapse of Lehman. The international investors reassessment of risk exposing particulate large imbalances in EE was followed by dwindling risk appetite. Furthermore, banks have generally started to systematically implement higher standards of screening during the crisis. The respective increase in monitoring has been higher, the higher the existence of informational asymmetries Cf. exemplary Roubini, N.: Eastern Europe and Chopra, A.: Emerging Europe and Maasdam, R.: Eastern Europe. 261 As indicated in the introductory part of financial linkages during the contagion to EE, certain aspects of herding behaviour can bee attributed to this channel. 262 Cf. Haas, R., Horen, N.: Wake-up call, p. 24.

83 75 Moreover, the increase in risk aversion to the CEE region has not only affected professional investors but led to declining clients trust, which has mainly been true in the case of mutual funds. 263 This shift in market sentiment has consequently caused liquidity pressures especially in those countries having experienced a large CAD before the crisis. 264 Thus, it has to be emphasized that regarding the relevance of wake-up calls the CEE region shows a relatively high degree of heterogeneity, justifying the assumption that only those economies having experienced excessive imbalances in the years before the crisis are likely to be adversely affected by swings in investors sentiment. Furthermore, the role of Latvia, which has been seriously hit by the consequences of the financial crisis, must not be underestimated concerning contagion to the broader EE region via wake-up calls. Although Latvia is struggling to defend its currency and is eager not to quit the ERM II, 265 the consequences of potential devaluation in Latvia might especially spread to countries showing similar imbalances and fundamentals. The fear of contagion via wake-up calls has already materialized in the speculation against the Hungarian forint, the Polish zloty and concerns about the stability of the Bulgarian currency board. Hence, the Baltic States (group 2) as well as Bulgaria, Romania and Hungary appear to be most affected by this channel, whereas the Czech Republic, Poland as well as Slovakia and Slovenia (group 1) are less endangered owing to better fundamentals. 266, Cf. exemplary: European Commission: European Economic Forecast autumn 2009, p. 120 and Tůma, Zdenĕk: Crisis Propagation, p. 4 and BIS: AR 2008/09, p Cf. BIS: AR 2008/09, p A full-scale participation in the EU including the accession to the EMU ranks among Latvia s most significant strategic goals. However, both a former prime minister of the country and a former Swedish central banker now advising Latvia have suggested devaluation. Cf. Roubini, N.: Eastern Europe and Bitans, M., Kauzens, E.: Impact of the Euro Adoption, p Cf. Chopra, A.: Emerging Europe and Roubini, N.: Eastern Europe. 267 The increase in risk aversion to EE is at least partially reflected in the sharp declines of net PFI to this region (cf. Figure 3).

84 The Danger of Negative Political Contagion Beside the examination of real and financial linkages, the role of political contagion during the recent contagious period will briefly be discussed in the subsequent section. Generally, the pertinence of political channels in transmitting current financial stress to Eastern Europe appears to be rather limited. As the investigation in the previous chapter has already briefly indicated, only a currency crisis triggered by a devaluation of the lat (Latvia) could potentially exert negative repercussions on Eastern European economies operating a fixed exchange rate as well. However, this chapter is intended to briefly provide a broader outlook for the EE region in the field of political contagion by commenting on a phenomenon which is commonly referred to as negative political contagion. These effects advert to the possibility of increasing anti-capitalist populism and anti-liberalism having its roots in the consequences of the financial crisis. 268 The inclusion of this aspect appears to be all the more of importance in the case of Eastern Europe when taking into account that the democracies which have emerged after the fall of the Iron Curtain are still relatively young and to some extent fragile. Numerous protests which partially turned violent have not only been observable in Latvia and Lithuania (group 2) but also in Bulgaria, the Czech Republic and Hungary (group 3). By the surge in public discontent Eastern European economies increasingly face the danger of deep political destabilisation and a revival of ethnic conflicts. 269 In spite of these critical developments, however, it appears to be unlikely that they will generally end up by triggering major reversals in reform. So far, protests in EE have been characterized by a lack of ideology and nationalist movements in public anger challenging the foundation of democracy and the essential dominance of freemarket economics. In contrast, recent protests have mainly been addressed to the widespread problem of corruption of the governing authorities and have been fostered by the populations dashed economic hopes and unfulfilled promises. 268 Cf. Tschabold, H.: Contagion-Effekte, p Cf. Pan, P.: Unrest in E. Europe, and Burke, J.: Eastern Europe.

85 77 Thus, despite intensified uncertainty for Eastern European governments owing to the populations discontent with domestic policies, the danger of negative political contagion seems to be limited. Recent government changes in the EE region have not primarily benefited anti-reform movements. Compared to earlier crises, this positive development can be referred to a relatively increased maturity of economic institutions and political systems, a better reaction to the crisis circumventing high inflation and a collapse of the domestic banking system as well as to better regional and global institutional integration. 270 The latter emphasizes the crucial role of and the trust in the EU during recent financial turmoil in Eastern Europe. Thus, when integrating the peoples experience of past Communist rule, it becomes obvious that at the end of the day, they know there s no alternative to the market economy. 271 Taking into account the results of the analysis conducted within this chapter, the conclusion can be drawn that both real and financial linkages are likely to have exerted a decisive role during the contagion to Emerging Europe. Although trade linkages appear to be relevant for all countries within the sample, they seem to be especially important for group 1 (Slovenia and Slovakia) and Hungary. Concerning financial links, especially the Baltic States (group 2) as well as Hungary, Bulgaria and Romania (group 3) are likely to be affected by declining trade credits. Whereas the high percentage of foreign-owned banks has exerted a surprisingly stabilising role within EE, the region is still susceptible to be hit by regional contagion through concentrated funding activities. Wake-up calls appear to be especially dangerous for those countries having accumulated excessive imbalance prior to the eruption of the financial crisis. Finally, the precedent chapter has revealed that severe and sustainable consequences due to negative political contagion are rather unlikely in the case of EE. These main findings are briefly summarized in Table Cf. EBRD: Transition Report 2009, and Pan, P.: Unrest in E. Europe, and Burke, J.: Eastern Europe. 271 Pan, P.: Unrest in E. Europe.

86 78 Table 9: Summary of Transmission Linkages in EE Source: Own illustration based on the analysis in chapter 3.3.

87 79 4 Conclusions A number of recent crises have been characterized by the phenomenon of contagion transmitting financial distress to seemingly unrelated economies. However, research on the global spread of crises has only gained in popularity during the 1990s following the Tequila contagion and the devastating Asian Crisis. Due to the fact that there are as many channels potentially propagating crises as there exist windows from one country to the world economy 272 and that no two periods of financial turmoil are alike, 273 this paper contributes to the research on contagion by examining the transmission of the worst financial crisis since the Great Depression to Emerging Europe. The economies of the 2004 / 2007 expansion of the European Union including former star performers like the Baltic Tigers 274 have been one of the regions hit hardest by the financial crisis on a global scale. Although the results provided in this paper partially suggest cross-country variations regarding the impact and transmission mechanisms of the current financial crisis it becomes obvious that meaningful similarities within the three predefined country groups exist. In spite of the fact that all countries within the sample have shown several classic macro-financial vulnerabilities prior to the current contagious period, certain economies have been more prone to contagion than others. The investigation of various indices of vulnerability has demonstrated that all states classified into group 2 (Baltic States) as well as Hungary appear to have been considerably more vulnerable to contagion than the other economies of the sample. Thus, the paper indicates that excessive macro-economic imbalances which have already been accumulated prior to the current crisis have not only heightened the susceptibility of infection but also the degree of impact of the financial crisis. In this regard, especially the Baltic States (group 2) are likely to experience a very sharp reversal of their growth rates in the near future. This finding is also in line with empirical data Sell, F.: Contagion, p Cf. OECD: Financial Market Trends, p Cf. Andersen, C.: Baltic Tiger. 275 In its WEO of April 2009, the IMF predicts the real GDP to shrink by 10.6 per cent in 2009 and by 2.3 per cent in 2010 for the Baltic States. Cf. IMF: WEO, April 2009, p. 78.

88 80 The analysis further reveals that Eastern Europe except the Baltic States where first signs of the crisis have already been visible in 2007 has rather been resilient to the initial pressures in financial markets. Only after the collapse of Lehman Brothers has spread uncertainty across global markets, Emerging Europe has been adversely affected by contagion via both real and financial linkages. Generally, the relative importance of each channel of transmission for the economies in EE has inter alia not only been influenced by the structure of the economy but also by the structure of the country s banking sector. Regarding trade linkages, significantly reduced demand from Western European recession countries has especially led to contractions in relatively open economies with high levels of commodity export concentrations in the car industry (namely the states of group 1 (Slovenia and Slovakia) as well as the Czech Republic and Hungary). The examination of the relevance of financial linkages has demonstrated that deteriorations in the trade finance market as well as the investors reassessment of risks are primarily affecting the Baltic economies (group 2), Hungary, Bulgaria and Romania. In contrast, the high percentage of foreign-ownership in the banking sector especially in the countries of group 2 (Estonia, Latvia, Lithuania) as well as in Bulgaria and Romania has exerted a stabilizing role during the current contagion by protecting these economies from excessive declines in cross-border bank lending. However, the partially high concentration of foreign funding increases the risk of regional financial contagion within all countries of Eastern Europe. In this respect, the role of Sweden and Austria in transmitting financial shocks within the region but also in creating possible second-round effects back to the Western European banking system appears to be of major importance. When referring to the pertinence of political contagion, the paper suggests that this channel has not exerted a dominant role during the recent contagious period. Additionally, the danger of negative political contagion in Emerging Europe appears to be rather limited. Furthermore, the examination of the propagation of current financial stress to Emerging Europe strongly supports the assumption that the level of Eastern European economic and political integration with Western Europe has

89 81 helped reducing pre-crisis vulnerabilities and thus mitigating adverse effects of the crisis. This has especially become obvious in the stabilizing role of foreign-owned banks or in the analysis of foreign currency denominated external debt in the case of Slovenia. Moreover, immediate and EU co-financed rescue packages provided to Hungary, Latvia, and Romania have virtually provided a safety cushion for the affected economies. However, those economies which are currently en route to the EMU by participating in the ERM II, namely the Baltic States, tend to be more exposed to speculation against their currencies. Looking forward, the devastating impact of the current crisis to the economies in transition in Eastern Europe equally constitutes a challenge for the cooperation within the European Union. Beside the danger of second-round effects back to the Euro Area via highly interconnected banking systems, an increased ambition to access the Euro Area might reduce the effectiveness of fiscal stimulus plans and thus endanger convergence within the European Union. Hence, a joint European policy reaction appears to be necessary in order to prevent a deepening gap between Old Europe and New Europe.

90 APPENDIX IX

91 X Appendix 1: EM-FSI - Subindices I. Banking-sector beta - Calculation: in line with standard CAPM COV ( r i, t M i, t 2 i, M, r B i, t ) where: r is the y-o-y banking (B) or market (M) returns - Interpretation: a beta value greater than 1 indicates that banking stocks move more than proportionately with the overall stock market, i.e. the banking sector is relatively risky II. Securities Markets A. Stock market return - Calculation: y-o-y change in the stock index multiplied by minus one - Interpretation: a decline in equity prices corresponds to increased stress B. Stock market volatility - Calculation: GARCH(1,1) specification, using month-over-month real returns and modelled as an autoregressive process with 12 lags - Interpretation: higher volatility indicates increased uncertainty C. Sovereign debt spreads - Calculation: bond yield minus 10-year U.S. Treasury yield (using JPMorgan EMBI Global spreads and 5-year CDS spreads) - Interpretation: relatively higher bond yields indicate higher uncertainty III. Foreign Exchange Markets - Calculation: where: e and EMPI i, t ( ei, t i, e i, e ) ( RESi, t i, RES i, RES RES are the monthly percentage changes in the exchange rate (against an anchor country) and total reserves minus gold. μ and σ denote the mean and the standard deviation - Interpretation: financial stress increases if the exchange rate depreciates and / or international reserves decrease ) Source: IMF: WEO 2009, pp and Balakrishnan, R. et al.: Financial Stress, pp. 7-9.

92 XI Appendix 2: Financial Stress in Emerging Economies Latin America: Argentina, Brazil, Chile, Colombia, Mexico, Peru. Emerging Asia: China, India, Indonesia, Korea, Malaysia, Pakistan, Philippines, Sri Lanka, Thailand. Emerging Europe: Czech Republic, Hungary, Poland, Romania, Slovak Republik, Slovenia. Other Emerging economies: Egypt, Israel, Morocco, Russia, South Africa, Turkey. Source: Source: Balakrishnan, R. et al.: Financial Stress, p. 41.

93 XII Appendix 3: Annual GDP Growth in EE (Percentage Change) Figures for 2009 and 2010 are estimates. Source: Own illustration, data obtained from: IMF: WEO Database, October 2009.

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