economic development in Central and Eastern Europe and its effects on Austria

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1 economic development in Central and Eastern Europe and its effects on Austria Brief Analysis June 2010 Austria s highest Triple-A sovereign rating is not at risk even in the face of the exposure of its commercial banks in Eastern Europe. Austria is rated as resistant in the current crisis and amongst those countries with the highest overall adjustment capacities. (Rating agency Moody s; quoted by Austria Press Agency, Feb. 20 th 2009) Key content: Key statements 2 The Austrian success story in Central and Eastern Europe 4 Assessment of the current situation 5 Risk factors for Austria and for the CEE countries - adjusted 7 The big picture of Austria s foreign financial exposure 11 Conclusions and outlook 13

2 Key statements As early movers, Austrian companies identified and successfully took advantage of the opportunities which arose from the EU expansion. More than 23% of domestic goods exports (EUR 25 billion) now go to Central and Eastern Europe and more than 20% of Austrian GDP (EUR 59 billion) has already been invested in Central and Eastern Europe. Austria s companies are the largest investor in Bosnia- Herzegovina, Slovenia, Bulgaria, Romania, Serbia and Croatia and are ranked among the top 3 investors in Slovakia, the Czech Republic and Hungary, as well as in Macedonia. The fall of the iron curtain, Austria s EU accession and the EU expansion 2004 and 2007 have provided Austria with additional economic growth of 0.5 to 1% per year. Although the catch-up process of the CEE countries will come to a standstill during the years 2009 and 2010, the positive growth differential towards the euro area will be re-established by the year 2011 according to the latest IMF economic outlook (April 2010). The main risks for the CEE countries are capital outflows and lack of liquidity, or higher liquidity premiums when borrowing debt capital. However, the non-debt-creating net capital inflows into the CEE region (including CIS) such as direct or portfolio investments will still amount to 126 billion USD in 2009 and 143 billion USD in 2010 according to the IMF and thereby carry on from the volume of the years before The currency depreciation represents a distinct, but manageable risk with respect to recovering foreign currency loan claims, while, at the same time, currency depreciation in countries with a flexible exchange rate regime (majority of CEE countries) provide a significant improvement in price competitiveness, growth in exports and therefore a healthy improvement in the balance of trade. Therefore, the depreciation of currencies in these countries provides an opportunity to find their way back to new growth. The deficits in the state budgets and the total foreign indebtedness as % of GDP are consistently lower in the CEE countries (except for Hungary) than in the EU Member States and have declined significantly in the past years. The Austrian banks in Eastern Europe have acted responsibly and will survive the current crisis, just as they did the Russian crisis 10 years ago or as other investors survived the Asian crisis a year earlier. The conclusion of the European Council in its Spring Summit of 2009 to double the aid fund for EU members affected or seriously at threat from trade balance or capital account difficulties from EUR 25 billion to EUR 50 billion and the decision of the G-20 Summit in London to triple the IMF-Ressources to bail out nations in crisis (which has recently been granted particularly to nations in Eastern Europe) up to USD 750 billion, has additionally eased the risk of the Eastern European exposure. Despite the crisis and the risk provisions and value adjustments it entailed, the consolidated profits of all Austrian banks reached 0,6 billion Euros in In the first half of 2009, Austrian banks improved their consolidated profits to 1,5 billion Euros. Both rising net interest income and financial income contributed to this increase. 2

3 Even horror scenarios of average loan defaults of 10% in the entire region would be buffered by profits from the Austria business and through strengthening of equity capital of EUR 15 billion as part of the Austrian bank package, which means that the banking sector is not jeopardised. The reports by international media, based primarily on the analyses of the Moody's rating agency, have led the international financial world to make completely exaggerated risk assessments of the entire CEE region as well as Austria's Eastern European exposure. After Moody s international credibility became jeopardised due to these exaggerated assessments, Moody s clarified in a further report that Austria, Germany, France and Switzerland were AAA-rated countries and were best positioned to survive the financial crisis. The Austrian Banks are strongly committed to the CEE region. Parent banks continued to provide liquidity to their subsidiaries especially at the height of the crisis, which increased their share in the interbank liabilities of the subsidiaries by about 13 percentage points to 79% (Q4 2009). The Austrian economy (companies, private households and the state) currently invests around 66% of its financial assets (securities, direct investments and loans) in Western Europe and only 20% in Central and Eastern Europe. The economic crisis in the Western European countries therefore affects Austria more severely even than something as severe as an extensive economic downturn in Eastern Europe. The macroeconomic country risk of the new EU Member States has continuously and significantly improved since the mid-1990s. The spread of the financial market crisis makes a deterioration of the risk position likely - particularly regarding international liquidity. However, the region has been able to abandon its status as high-risk investment region. Central and Eastern Europe remains a region with strong fundamental data and excellent long-term growth and income opportunities. The CEE countries now have highly efficient industrial facilities, a competitive wage level, higher productivity growth than the West as well as a well-trained, flexible and dynamic workforce. The catch-up process will continue for at least another two generations. However, it is important that the Growth engine of Central and Eastern Europe is kept running. 3

4 The Austrian success story in Central and Eastern Europe In spite of the financial crisis, the markets in Central and Eastern Europe (CEE countries) are the security for our future growth and prosperity: Nowhere, other than in Central and Eastern Europe, do Austrian investments have greater chances of success: While the investments in Central and Eastern Europe 15 years ago showed negative return on equity at -1.3%, they generated a return of 10.4% in 2000 and as much as 15.6% in A comparison: The investment yields in the EU-15 in 2005 were only at 4.1%. Every domestic euro invested in Central and Eastern Europe was more than three times as profitable as a euro invested in the old EU Member States. For the years after 2010, a similar yield difference can be expected between investments in Western and Eastern Europe. In macro economic terms, according to WIFO (Austrian Institute of Economic Research), the Eastern Europe effect (opening of Eastern Europe, Austria s EU accession and EU expansion) has provided Austria with additional economic growth of 0.5 to 1% per year and has created around additional jobs in Austria. GDP growth in Austria with and without the Eastern Europe effect 4 3 Austria with Eastern Europe Effect 2 Euro area Eastern Europe Effect in % compared to previous year Austria without Eastern Europe Effect With the Integration-effct of the CEE countries, Austria s GDP growth has constantly been above the average of the Euro area (blue line) Source: European Comission, WIFO, IV 4

5 Assessment of the current situation Although the catching-up process of the CEE countries will come to a standstill during the years 2009 and 2010, the positive growth differential towards the euro area will be re-established by the year 2011 according to the latest IMF economic outlook (April 2010). Real GDP-growth-projections real GDP growth % 5% 4% 3% 2% 1% 0% -1% -2% -3% -4% -5% CEE euro area G source: IMF outlook April 2010 The main risks for the CEE countries are capital outflows and lack of liquidity, or higher liquidity premiums when borrowing debt capital. However, the non-debt-creating net capital inflows into the CEE region (including CIS) such as direct or portfolio investments will still amount to 126 billion USD in 2010 and 143 billion USD in 2011 according to the IMF and thereby carry on from with the volume of the years before Foreign Investment (*) in the CEE region (in billions of USD) FOREIGN INVESTMENT (*) IN THE CEE-REGION (in billions of USD) CEE (excluding CIS) CIS (Russia, Ukraine, Belarus, etc.) Forecast *Non-debt-creating inflows (FDI, Portfolio Investments) Source: IMF Outlook, April

6 The partially high foreign trade deficits are a weak point of the CEE economies. With the exception of the Czech Republic, the trade deficits in all CEE countries are above 5% of GDP. The economic growth was thus primarily financed by the import of foreign capital in the form of direct investments or debt in the public and private sector. If the balance of trade is significantly in deficit and foreign currency indebtedness is high, a fixed exchange rate, as in Bulgaria and Croatia, can pose an additional problem. However, this risk does not apply at all to the euro Member States, Slovakia and Slovenia. As for private households, the strong growth in wages since the loans were taken out have in any case been able to partially compensate the increased probability of default through currency devaluation. Currency depreciation in countries with a flexible exchange rate regime provides a significant improvement in price competitiveness, growth in exports and therefore a healthy improvement in the balance of trade. As mentioned above, the real challenge for Eastern Europe is that the region cannot count on such strong capital inflows as in the past years, due to the squeeze from the global savings glut, which enabled some countries to run relatively large current account deficits in the past years. Given the slowdown of capital inflows and currency depreciation, we should see a significant improvement of current account deficits over this year and the next. The IMF predicts a decrease of the current account deficit of more than 50% on the CEE-average by This means that the depreciation of currencies in these countries will provide them with an opportunity to find their way back to new growth. 5,0 2,5 0,0-2,5-5,0-7,5-10,0-12,5-15,0-17,5-20,0-22,5-25,0 CURRENT ACCOUNT BALANCE (in % of GDP) Hungary Romania Serbia Bulgaria Ukraine Forecast Source: IMF Outlook, April 2010 However, on international financial markets, risk assessments pay more attention to the degree of foreign indebtedness than to the deficit in the balance of trade. The deficits of the state budgets in proportion of GDP are consistently lower in the CEE countries (except for Hungary) than in the western EU Member States and have continued to decline significantly in recent years (Poland 55% of GDP; Czech Republic 38%, Slovakia 40%, 6

7 Romania under 27%, Bulgaria 15%; Ukraine 35% and Russia 10% of GDP (wiiw forecast for 2010). Compare the above to: Austria: 70% of GDP, euro area 84% of GDP). The total foreign indebtedness (including companies and private households) only reaches the 100% of GDP mark in few CEE countries (Hungary 121%, Bulgaria 112% and Slovenia 104%). In comparison: Germany had gross foreign indebtedness of more than 150% of GDP in 2008 and Austria even had 211% of GDP. Risk factors for Austria and for the CEE countries adjusted According to the Bank for International Settlements in Basel, the Austrian banking institutions have around 20% of all loans by EU banks in Eastern Europe (including Russia) on their books. Therefore, Austria s banks are the largest lenders in the CEE countries. In absolute terms, the outstanding loan volume of Austrian banks in Eastern Europe amounts to EUR 204 billion at the end of December CEE-Exposure of EU-15 Banks Sweden 8% Rest 12% Austria 22% Netherlands 7% Belgium 7% France 14% Italy 16% Germany 13% source: BIS/4Q/2009 For the banks that are exposed to the CEE countries, there is a risk of loan defaults through foreign currency loans and imminent insolvencies and a certain balance sheet risk due to the currency devaluations in Eastern Europe. This is due to the fact that the foreign currency investments of the Eastern European banks are on the books of the Austrian parent. The EBRD estimates that the domestic institutions in Eastern Europe are at risk of a loss of EUR 15 to 20 billion in the worst case. Raiffeisen International quantifies the outstanding claims of Austrian banks in Eastern Europe at 18%, measured as percentage of the balance sheet total. However, even if such worst-case scenarios should occur, they would be manageable, according to the stress tests of the National Bank of Austria: Any defaults in Eastern Europe could be compensated by profits from the Austria business and the government bank assistance package, which envisages capital injections of EUR 15 billion. 7

8 The balance sheet results of the Austrian banks are consistently solid: Austrian banks have strong fundamentals Despite the crisis and the risk provisions and value adjustments it entailed, the consolidated profits of all Austrian banks reached Euro 0,6 billion in This is of course a sharp decline compared with the record results of 2007 but must also be put into perspective of the losses suffered by many large foreign banks In 2009, Austrian banks improved their consolidated profits to Euro 1.5 billion. Both rising net interest income and financial income contributed to this increase. At some 9.3%, Austrian banks average tier 1 ratio is more than twice as high as the regulatory minimum requirement. By adopting a bank support package worth Euro 100 billion, Austria has responded swiftly to the financial crisis, thereby ensuring stability in the domestic financial sector. Apparently, the measures helped prevent depositors from losing confidence and enabled the government to strengthen some banks capital base (by providing participation capital). The bank package is designed to benefit banking groups as a whole, which means that Austrian parent banks may use the funds to provide further support to their subsidiaries in CESEE. If Austrian banks would fully utilize the 15 billion Euros earmarked for recapitalization measures, their solvency ratio would increase to even 13.2% and their tier 1 ratio to 9.9%. The majority of Austrian large banks expect their nonperforming loans ratios and loan loss provisions in CESEE to rise in 2009 and These increases have been factored into the bank package, i.e. it covers writedowns in the amount of the forecasts. The analyses of Moody s - and particularly the media reports based on these - led the international financial world to make completely exaggerated risk assessments of the whole CEE region and Austria s Eastern Europe exposure. The spreads of the 10-year Austrian government bonds to Germany subsequently increased by an amazing 134 basis points. In the meantime, the spread narrowed back to he pre-crisis-level of below 40 bp (June 2010). The usual, historical liquidity premium until this date was at a realistic basis points. After Moody s international credibility became jeopardised due to these exaggerated assessments, Moody s clarified in a further report that Austria, Germany, France and Switzerland were AAA-rated countries and were best positioned to survive the financial crisis. 8

9 Austria has the most diversified loan portfolio among the major home countries. International Monetary Fund Foreign Banks in the CESE Countries ; March 2009 The exposure of Austrian banks to the CEE is broadly diversified across regions, which means that risks are well diversified. Moreover, the bulk (85%) of loans in these countries is funded by deposits in local currency. The CEE-exposure of other countries is regionally much more concentrated than the Austrian banks, such as: Sweden (75% of the CEE-exposure is in the Baltic States) Greece (96% in South-Eastern Europe) Germany (29% in the CIS) Diversification of the Austrian Exposure in CEE Countries (in percentage of total Austrian exposure) Because of their strong focus on European growth markets in CEE, Austrian banks are hardly exposed to Western crisis markets. Their exposure to Ireland comes to no more than 1%, and their exposure to the U.S. to 4% of their total claims outstanding. Also, Austrian banks has hardly any investments in toxic assets. Out of the EUR 199 billion of total exposure of Austrian Banks in Central and Eastern Europe 71% are placed in EU-member countries 40% are placed in A-rated countries by Moody s and even 16% are placed in EURO-member countries (Slovakia, Slovenia) 9

10 Allocation of the Austrian Exposure in CEE Countries CIS 9% SEE 20% EU 71% New EU-member states % New EU-member states % Source: BIZ 4Q/2009 More Facts about Austria s Situation Austria comfortable current account surplus of 3.1% of GDP in 2010 reflects its strong international competitiveness. Austria has been acting as a net lender in international capital markets rather than having to borrow from them. Austrian investment continues to be channeled above all to foreign enterprises (direct investment) or to cross-border lending. The savings ratio of households of 12% of their disposable income is very high by international standards. Due to the fact that real estate prices developed rather moderately in Austria in recent years, no real estate bubble evolved and there is no danger of a massive slump in real estate prices. In contrast to many other industrialised countries, the balances of Austrian households, enterprises and banks are not exposed to real estate-related risks. The financial position of the private households is far more stable than in the rest of the euro area. The debt-level of the private households in Austria are below 90% of the GDP 10 percent less than in the euro area. The Austrian companies are also much better prepared for a liquidity squeeze than the euro area. Whereas the corporate debt-level in the euro area bounced from 80% to nearly 100% of the GDP in this decade, the corporate indebtedness in Austria remained stable around 80% of the GDP. Austria s economy is forward oriented and prepared for the future: The national spendings on research and development have outperformed the EU average in the last 10 years and rank today, at 2.8% of GDP (2010), among the top 3 in the EU. 10

11 The big picture of Austria s Foreign Financial exposure Overall, the Eastern European exposure of Austrian companies has been increasing massively since the opening up of Eastern Europe, albeit, starting from a very low level. In fact, neither the twelve EU countries that have acceded since 2004, nor the growth markets of Eastern and South-eastern Europe currently have a sufficiently high weighting in the country portfolio to influence Austria s overall risk from international financial assets in a precarious manner. The Austrian economy (companies, private households and the state) currently invests around 66% of its financial assets (securities, direct investments and loans) in Western Europe and only 20% in Central and Eastern Europe. Weighted by country risk classes and according to the National Bank of Austria, 53% of the total foreign capital risks of the Austrian economy are located in Western Europe and around 34% in Central and Eastern Europe (however, with regard to loan exposure, the risk concentration in Eastern Europe is significantly higher, because the region was and still is a preferred target for loans and direct investments as it lacks a fully developed stock market). The economic crisis in the Western European countries therefore affects Austria more severely even than something as severe as an extensive economic downturn in Eastern Europe - an event which cannot be ruled out entirely. Austria s External Financial Assets before the crisis (in billion EUR) Source: OENB It must also be emphasised that the macroeconomic country risk of the new EU Member States has continuously and significantly improved since the mid-1990s. The most important contribution was made by the often substantial decline in inflation, the high GDP growth and the high income growth per capita. The spread of the financial market crisis makes a notable deterioration of the risk position likely - particularly regarding international liquidity. The region has, however, been able to abandon its status as high-risk investment region. 11

12 When only the credit-exposure of the banking sector is taken into account, Austria s banks are much less exposed to the international financial market risks than those of other European countries and are only marginally exposed to Western crisis markets such as Ireland, Spain, UK or the USA. The total foreign credit claims of Austria s banks amount to 120% of the GDP compared to 125% in the UK; 200% in the Netherlands; 173% of GDP in Belgium and even 381% in Switzerland. Consolidated foreign claims of selected countries - immediate borrower basis More Facts about the Austrian Banking Sector: Austrian banks pursue the traditonal originate and hold business model in the CEE region and their porfolio therefore entails only traditional banking risks. 65% of their net profit stems from net interest income and 22% from fees and commissions. Only the small remainder are trading results. The Austrian Banks are strongly committed to the CEE region. Parent banks continued to provide liquidity to their subsidiaries especially at the height of the crisis, which increased their share in the interbank liabilities of the subsidiaries by about 13 percentage points to 79% (Q4 2009). Austria s GDP is well diversified and barely exposed to the financial sector. Only 5.3% of the national gross value added is contributed by the financial sector and 30.5% by industry. 12

13 Conclusions and outlook The markets in Central and Eastern Europe are still going to be the growth engine for Europe in future, despite the financial market crisis, with a significantly higher growth potential than other regions. The catch-up process will continue for at least another two generations. Therefore, it is important that this engine continues to run. Catch-up process of GDP per capita (in PPP) in the CEE countries (IMF-Scenario) Western EU-Member States Level (=100) Western EU-Member States 3% growth differential % growth differential Source: OeNB The conclusion of the European Council in its Spring Summit to double the aid fund for EU members affected or seriously at threat from trade balance or capital account difficulties from EUR 25 billion to EUR 50 billion and the decision of the G-20 Summit in London to triple the IMF-Ressources to bail out nations in crisis (which has recently been granted particularly to nations in Eastern Europe) up to USD 750 billion, has additionally eased the risk of the Eastern European exposure. The discussions regarding the assessment of the Eastern European risk of Austrian banks and the creditworthiness of the state depends less on the risks in the portfolio of the Austrian banks or the strength of the economy, than on the geographical proximity to Eastern Europe. In fact Austria has the fourth-highest prosperity and second-lowest unemployment rate in the EU, the second-highest growth in the research rate within the EU, a government debt rate below the average for the euro area and higher productivity than in Germany. There is a certain risk of a rise in loan defaults through the strong exposure of domestic banks in Eastern Europe, however, the banks have acted responsibly and will be able to survive the current crisis, just as they did the Russian crisis 10 years ago or other investors survived the Asian crisis a year earlier. The financial risks in Russia in 1998 and in Asia were characterised by rapid capital outflow and currency devaluation. Those banks and companies that remained loyal to these regions at that time, were able to establish and assert their current, excellent market position in the following years. Eastern Europe remains a region with strong fundamental data and excellent long-term growth and income opportunities. If we lose sight of the enormous potential of this region in the current crisis, we will damage our own interests. After all, we have long been living in an integrated and interwoven economy, in which one side cannot grow and flourish without the other. The CEE countries now have highly efficient industrial facilities, a competitive wage level, higher productivity growth than in the west as well as a well-trained, flexible and dynamic workforce. 13

14 The financial experts business outlook for the CEE region has turned positive in May 2009 for the first time since September 2007 and has turned strongly positive in the second half of The survey for the individual CEE countries is now characterised by optimistic assessments of the financial experts with regard to the economic development on a six month horizon (a survey conducted monthly since May 2007 by ZEW Mannheim and Erste Group Bank among financial market experts) ECONOMIC EXPECTATIONS IN THE CEE REGION The CEE region observed in the ZEW-Erste Bank survey of financial experts consists of Bulgaria, Croatia, Czech Republic, Hungary, Poland, Romania, Serbia, Slovakia and Slovenia. -22,7 12/07 01/08 02/08 03/08 04/08 05/08 06/08 07/08 08/08 09/08 10/08 11/08 12/08 01/09 02/09 03/09 04/09 05/09 06/09 07/09 08/09 09/09 10/09 11/09 12/09 01/10 02/10 03/10 04/10 05/10 35,2 Source: ZEW/Erste Group Bank sentiment indicator (expectations 6 months ahead) responsible for the content: Dr. Clemens Wallner c.wallner@iv-net.at 14