Special Conference Paper. Special Conference Paper

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1 BANK OF GREECE EUROSYSTEM Special Conference Paper Special Conference Paper Inernaional banking and sovereign risk calculus: he experience of he Greek banks in SEE Panayois Kapopoulos Sophia Lazareou Discussion: Panagiois Chronis FEBRUARY

2 BANK OF GREECE Economic Research Deparmen Special Sudies Division 21, Ε. Venizelos Avenue GR Ahens Τel: Fax: Prined in Ahens, Greece a he Bank of Greece Prining Works. All righs reserved. Reproducion for educaional and non-commercial purposes is permied provided ha he source is acknowledged. ISSN

3 Ediorial On November 2009, he Bank of Greece co-organised wih he Bank of Albania he 3 rd Annual Souh Easern European Economic Research Workshop held a is premises in Ahens. The 1 s and 2 nd workshops were organised by he Bank of Albania and ook place in Tirana in 2007 and 2008, respecively. The main objecives of hese workshops are o furher economic research in Souh Easern Europe (SEE) and exend knowledge of he counry-specific feaures of he economies in he region. Moreover, he workshops enhance regional cooperaion hrough he sharing of scienific knowledge and he provision of opporuniies for cooperaive research. The 2009 workshop placed a special emphasis on hree imporan opics for cenral banking in ransiion and small open SEE economies: financial and economic sabiliy; banking and finance; inernal and exernal vulnerabiliies. Researchers from cenral banks paricipaed, presening and discussing heir work. The 4 h Annual SEE Economic Research Workshop was organised by he Bank of Albania and ook place on November 2010 in Tirana. An emphasis was placed upon he lessons drawn from he global crisis and is effecs on he SEE macroeconomic and financial secors; adjusmen of inernal and exernal imbalances; and he new anchors for economic policy. The papers presened, wih heir discussions, a he 2009 SEE Workshop are being made available o a wider audience hrough he Special Conference Paper Series of he Bank of Greece. Here we presen he paper by Panayiois Kapopoulos (Emporiki Bank) and Sophia Lazareou (Bank of Greece) wih is discussion by Panagiois Chronis (Bank of Greece). February, 2011 Alin Tanku (Bank of Albania) Sophia Lazareou (Bank of Greece) (on behalf of he organisers)

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5 INTERNATIONAL BANKING AND SOVEREIGN RISK CALCULUS: THE EXPERIENCE OF THE GREEK BANKS IN SEE Panayois Kapopoulos* Emporiki Bank Sophia Lazareou** Bank of Greece ABSTRACT Beween 1996 and 2003 emerging marke economies all over he world experienced major financial crises wih boh high frequency and severiy. Since hen and ill he recen bou of financial urbulence iniiaed by he sub prime crisis in he US, he drop off in he frequency of such crises has been noably marked. However, he absence of a crisis episode does no in any case mean ha here are no some poenial risks looking forward. In his paper we use he heoreical framework of inernaional banking and he sovereign risk calculus in an effor o sudy he experience of he Greek banks in SEE over he las decade. A rivial way o do ha is viewing i as he produc of wo facors. The firs facor refers o he value a risk, namely he banks exposure, and he second o he probabiliy of a sovereign risk even. We focus on boh facors. Firs, we find ha lending concenraion is high. Second, by using he well known capial asse pricing model (CAPM) and implemening a wo sep idenificaion process, we deec a diversificaion effec of his concenraion risk. Third, we sudy he counry specific feaures ha may deermine a high probabiliy of a sovereign risk even. We place an emphasis on he counries fiscal srucure in a comparaive perspecive. We find ha alhough all counries in he sample have made effors owards a successful fiscal consolidaion largely suppored by srong growh and low real ineres raes he empirical evidence, however, is suggesive of a weak link beween public deb susainabiliy and he shor-run conduc of fiscal policy. Key words: emerging SEE economies, banking exposure, sovereign risk, public deb dynamics JEL classificaion: H3, G1, G2 Acknowledgemens: Special hanks are due o Alina Blejan, Kalina Dimirova, Yüksel Görmez, Gjergji Mano, Milan Sojic and Risan Shllaku for kindly providing a par of macroeconomic daa for Romania, Bulgaria, Turkey, Albania and Serbia. Wihou heir help, his paper would no have been possible. The paper has been presened in he SSEM Euro Conference 2010 on he Challenges and Opporuniies in Emerging Markes, Milas, Turkey, July. We are graeful o all conference paricipans for heir remarkable insighs and especially o Ahme Faruk Aysan, Musafa Disli, Ali Kuan and Ravikesh Srivasava. An earlier version was presened a he 3 rd SEE Economic Research Workshop, co-organized by he Bank of Greece and he Bank of Albania, in Ahens on November We are graeful o all workshop paricipans for heir valuable commens and suggesions and especially o our discussan Panayois Chronis and o Theodore Papaspyrou and Thomas Scheiber. Special hanks should be aribued o Heaher Gibson for her comprehensive commens ha improved considerably he paper. We are also graeful o Ioannis Papadakis for a fruiful discussion and encouragemen. The views expressed in his paper are hose of he auhors and do no necessarily reflec hose of he Emporiki Bank and he Bank of Greece. We alone are responsible for he remaining errors and omissions. *Risk Managemen Division, kapopoulos.p@emporiki.gr ** Economic Research Deparmen, slazareou@bankofgreece.gr

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7 1. Inroducion Beween 1996 and 2003 emerging marke economies all over he world experienced major financial crises wih boh high frequency and severiy. Since hen and ill he recen bou of financial urbulence iniiaed by he sub prime crisis in he US, he drop off in he frequency of such crises has been noably marked. However, he absence of a crisis episode does no in any case mean ha here are no some poenial risks looking forward. Indeed, some pressure has been associaed wih very large privae capial inflows and a weaker han expeced growh performance in he developed world. During recen years, SE European economies experienced favourable prospecs for fuure growh: large ne capial inflows 1, high growh raes, success in conaining inflaion, seadily increasing foreign exchange reserves, closer insiuional links wih he EU and a very high foreign ownership in heir banking sysems. 2 Sill, however, here are some worries going forward ha will acivae poenial vulnerabiliies, especially a a ime when he growh rae in advanced Europe is falling (see Bank of Greece 2009, Gardó and Marin 2010). These worries are: high curren accoun deficis weakening he counry s exernal financing requiremen; he srong economic downurn pus addiional pressure on general governmen balances; a resurfacing of inflaion pressures 3 ; high unemploymen raes; a large exernal gross borrowing requiremen; high privae credi growh; whereas a healhy, compeiive and a dynamic privae secor has no been fully esablished ye. 4 1 During he recen years ne privae inflows o cenral and souheas Europe rose o billion $ in 2007 and billions in 2008, from a low of 5.6 billions in Imporanly, he increase in foreign privae porfolio invesmen was significan: from 0.2 billion $ in 2001 o 17.0 billions in 2004 and 18.3 billions in However, in 2006 i was reduced o 0.6 billions while in 2007 and 2008 was furher reduced o -3.6 billions and billions, respecively. See, IMF World Economic Oulook, April According o he EBRD daa, in 1995 only 21 banks were foreign owned (8.6% of he oal banks). In 2007, he number of foreign banks increased rapidly o 139 (67% of he oal) and hey possessed 80% of he oal asses. For an analysis of he presence of foreign banks in SEE, see Kapopoulos and Lazareou (2007). 3 Alhough he oulook of inflaion remains weak in mos SEE counries, here are concerns abou inflaion in Turkey where srong economy means ha he economy is now operaing a close o poenial and in Romania where currency furher weakens (Capial Economics, Emerging Europe Cenral Bank Wach, July 2010). 4 The fall in exernal demand and he cu off in capial inflows caused a reducion in expors and invesmen. A he same ime, domesic privae consumpion also fell as he resul of he sharp rise in he world prices of foodsuffs and raw maerials in The fall in he oupu growh rae was he ulimae resul. Beween he years he mean annual rae of oupu growh in he counries of cenral and 7

8 While mos of he 1990s had been characerized by an expansion in privae infrasrucure invesmen and in aggregae demand and supply, emerging Europe had experienced many episodes of economic and poliical crises. Pas financial crises were driven by facors such as poorly developed financial sysems, excessively volaile macroeconomic policies, a weak domesic banking secor, dependence on exernal money flows and uncerain growh prospecs. The underlying riggers of hese crises were likely o operae simulaneously in he foreign exchange marke, he marke for bank asses and for sovereign deb paper. 5,6 These crises involved real losses, increased invesors percepion of marke risk and heir awareness of he need for adequae counry risk managemen. In his paper we use he heoreical framework of inernaional banking and he sovereign risk calculus in an effor o sudy he experience of he Greek banks in SEE over he las decade. In paricular, we ry o assess any poenial pressure and sudy is key deerminans. A rivial way is viewing i as he produc of wo facors. The firs facor refers o he value a risk, namely he banks exposure, and he second refers o he probabiliy of a sovereign risk even. We focus on boh facors. Since a sovereign or a counry risk even is in large par independen of he credi sanding of he individual loan o he borrowers, a lending decision o a pary residing in a foreign counry should be a wo-sep decision (see Saunders and Corne 2003). Firs, he lender assesses he underlying credi risk qualiy of he borrower, as i would do for a normal domesic souheas Europe was 6.6%. In 2007, i was reduced o 5.5% and in 2008 i was furher curailed o 3.0%. In 2009, all counries in he region suffered by depression (-3.6%), while for 2010 i is projeced ha he growh rae will urn o a posiive sign (3.2%). See, IMF World Economic Oulook Updae, 7 July This is because here are cerain repercussion effecs of a paricular crisis episode. According o he balance shee approach o financial crises (see iner alia Claessens e al. 2008, Goldsein 2007, Bordo 2006, 2008, Borio 2004, Beim and Calomiris 2001, Allen a al. 2002), a financial crisis can be considered as a chain and can emerge from weaknesses in banks balance shees, from vulnerabiliies in corporae and household balance shees and from problems in he governmen s balance shee. In paricular, a financial crisis occurs when a shock exposes he vulnerabiliy of one secor or more in he economy and hus he demand for financial asses sharply declines. For example, invesors and crediors can loose confidence in he governmen s abiliy o service is deb obligaions. The resuling capial ouflow leads o increasing balance shee problems. As foreign invesors pull ou of he counry, he exchange rae comes under pressure. Ineres raes increase due o a higher risk premium or due o he effors of he moneary auhoriies o slow capial ouflow. The sharp fall in he exchange rae and he rise in he ineres raes mean ha he banks, he households and he corporaions face increasing lending coss and heir deb obligaions in local currency increase noably. 6 I is worhy o noe ha alhough all pas crises evens were in heir majoriy an emerger s sory, he recen financial and economic urbulence was an advance counry sory ha hi emerging economies. 8

9 loan. And second, he lender assesses he sovereign or counry risk qualiy of he counry in which he borrower resides. Broadly speaking, counry risk is he risk of he business loss due o counry specific facors relaed o poliical, financial and economic insabiliy which impac on he value of he counry s bonds and equiies (Harvey 1995, 2004). Here, we focus mainly on macro economic hreas, such as economic crises ha are imporan o all invesors and lenders and no on micro hreas such as discriminaory axaion or regulaion. Counry risk includes sovereign risk, i.e. he risk ha a governmen would fail o honour is sovereign obligaions, due o eiher unwillingness or inabiliy o pay 7 ; ransfer risk, i.e. he risk of resricions on he inernaional ransfer of funds; and collecive debor risk, i.e. he hrea counry wide evens will cause simulaneously defaul by a large number of privae debors. Hence, couny risk is high when currency mismach 8 is high; he real exchange rae is overvalued; and large porfolio capial inflows paired wih a weak banking sysem make i less likely ha credi expansion will go owards he mos efficien borrowers (Goldsein 2007). Analyically, when financial liabiliies are mosly denominaed in domesic currency while asses are mainly denominaed in foreign currency, hen depreciaion of he local currency will resul in balance shee problems ha cause economic growh o decline. This is because if a sharp deerioraion in he borrowers prospecs is expeced, porfolio inflows quickly may reverse, he overvalued local currency plunges and asse losses may rise. Ulimaely, bank failures happen and bankrupcies muliply, aggregae demand declines and growh falls. Concepually, we can nominae hree basic ypes of counry risk facing foreign banks ha operae in SEE. Firs, as he local economic condiions deeriorae households and firms migh face increasing 7 Poliical risk is associaed wih unwillingness o pay while financial and economic risks are associaed wih inabiliy o pay. For a horough analysis of counry and poliical risks wih pracical insighs o global finance, see Wilkin (2004). In general, a sovereign counry s negaive decision on is deb obligaions may ake wo forms: repudiaion and rescheduling. Repudiaion is an ourigh cancellaion of all curren and fuure deb obligaions by a borrower. While rescheduling is ha sovereign risk even when he borrower counry firs declares a moraorium or delay on is paymens and hen seeks o renegoiae he credi erms, i.e. mauriy and he ineres rae. For a heoreical analysis on counry risk, see Saunders and Corne (2003, ch. 6). 8 I is a currency mismach when an eniy s ne worh and ne income are no well hedged agains a change in he domesic currency rae. Currency mismach was a common feaure in all emerging marke economic crises in he 1990s. This was he case of Mexico in , of he Asian crises in , of Russia in 1998, of Brazil in and again in , of Turkey in and of Argenina in

10 difficulies in meeing heir obligaions, leading o a rise in non-performing loans. 9 Second, as he gap beween asses denominaed in foreign currency and liabiliies denominaed in domesic currency becomes larger, he exchange rae risk increases. And hird, in he view of a bank deposi wihdrawal foreign banks migh face liquidiy problems. 10 We firs presen he key characerisics of he geography of he Greek banking sysem exposure in SEE. We find ha lending concenraion in his paricular European periphery is high. Second, given he high degree of lending concenraion we aim a deecing a diversificaion effec of his concenraion risk. In a porfolio framework for counry risk analysis, he risk of holding a well-diversified porfolio of loans may be smaller han ha of having a porfolio heavily concenraed in a few counries. Our idenificaion analysis has wo seps. The firs sep is o pick a se of macroeconomic variables ha may be imporan in explaining rescheduling probabiliies and may direcly or indirecly affec a sovereign risk even. The second sep is o divide oal risk ino a non diversifiable sysemaic risk elemen and o an unsysemaic or counry risk elemen. To his end, we consider he well-known capial asse pricing model (CAPM). Based on a panel daa for 8 counries in he region and for 10 risk indicaors over he period , empirical resuls suppor he view ha, for he mos SEE counries in he sample, he unsysemaic risk is much more imporan. Third, we sudy he counry specific feaures ha deermine a sovereign risk elemen. We place an emphasis on he counries fiscal srucure in a comparaive perspecive, since public deb has ofen had more immediae consequences for economic performance and deb crisis is a recurring phenomenon of he hisories of many of hese counries. Moreover and more imporanly, a high probabiliy of a sovereign risk even 9 According o Capial Economics (January 2010), he non-performing loans for all foreign banks funcioned in SEE increased rapidly over he las year. In Bulgaria and Romania, hey amouned o 16.5% and 12.3% of he oal loans, respecively. This rise migh cause a possible erosion of he banks capial base and herefore bank porfolios migh come under increasing pressure. 10 However, a high degree of overall banking sabiliy is suppored by he coninued sound capialisaion levels and he commimen (see he Vienna iniiaive ) of he paren banks o keep he capialisaion of heir subsidiaries a sound levels (see Gardó and Marin 2010, EBRD 2009). Wih regard o he Greek banking presence, sress ess ha were conduced in collaboraion wih he IMF confirmed ha he Greek banking sysem had enough buffers o wihsand even a very big rise in non-performing loans under a wors-case scenario (see Bank of Greece Financial Sabiliy Repor, June 2009). 10

11 implies deerioraion in he governmen balance shee ha will evenually adversely affec he healh of he balance shee of boh households and firms and ulimaely he healh of he balance shee of he banks. And his happens because an increase in he deb raio oday implies ha axes will go up omorrow impairing firms profiabiliy and reducing heir abiliy o repay heir debs o he banks. Alhough all counries in he sample have made effors owards a successful fiscal consolidaion largely suppored by srong growh raes and low real ineres raes over he las few years - he empirical evidence, however, is suggesive of a weak link beween public deb susainabiliy and he shor-run conduc of fiscal policy. 2. The geography of he presence of he Greek banks: key characerisics One of he main feaures of he Greek banking sysem is is rapidly increasing exposure o he emerging marke economies of SEE, daing from he mid 1990s. This developmen has been driven by several facors. Firs, afer he liberalizaion of he Greek banking sysem in he mid 1990s, many new producs appeared in he domesic money marke making he access of households and firms o credi much easier and cheaper. A he same ime, banking compeiion was enhanced resuling in an improvemen in he services provided boh wih respec o qualiy and price. Furher, banking inermediaion measured as he raio of privae lending o oupu grew quickly. 11 Second, given he number of he Greek banks relaive o he size of he domesic money marke, he possibiliy o exploi furher economies of scale and scope was deemed o be exremely limied. Therefore, many Greek banks firs proceeded o consolidaion via mergers and acquisiions, srongly suppored by he privaizaion policies of he governmens and, second, exended heir presence in he Balkan Peninsula where privae bank lending was sill a very low levels The raio of privae bank loans o GDP increased rapidly afer While in he 1990s i was only 36.6% on average, in he firs half of he 2000s i increased o 54.4%. Thereafer, i increased even more rapidly, approximaing 84% in 2008 and 81% in Beween 2006 and 2008 bank credi o he privae secor (firms and households) as per cen o GDP was more han 3 imes lower han he respecive rae in he euro area. 11

12 Figure 1 The geography of he Greek banking sysem presence (% in oal foreign claims) June % 1% 2% 7% 3% 40% Developed counries & inernaional organisaions SE Europe Developing Europe Offshore counries 44% L. America & Caribbean Asia & Pasific (% in oal asses) December ,4 2,1 Emerging Europe 42,7 euro area UK oher counries 37,8 Noes: consolidaed daa on group level, unweighed counry sum. Turkey is included in SEE. Developing Europe does no include SEE counries. Mala, Slovenia, Slovakia and Cyprus are included in he developed counries. Sources: own calculaions based on daa provided by he Bank of Greece (Financial Sabiliy Repor, June 2009), he BIS and he banks balance shees. 12

13 Figure 2 Type of foreign claim, 2009 local claims in foreign currency local claims in local currency Developed conries and inernaional organisaions SEE Developing Europe cross-border claims 0% 20% 40% 60% 80% 100% Noes: consolidaed daa on group level, end of June, unweighed counry sum. Turkey is included in SEE. Developing Europe does no include SEE counries. Mala, Slovenia, Slovakia and Cyprus are included in he developed counries. Sources: own calculaions based on daa provided by he BIS and he banks balance shees. Figure 1 plos he evoluion over ime of he exposure of he Greek banks o various geographical peripheries. Exposure is measured by oal foreign claims, i.e. cross border claims, local claims in foreign currency and local claims in local money. Beween and 2009, lending exposure o SEE counries increased by a facor of 3. From 17% of he oal foreign claims a he end of 2004, i rose o 57% in 2007, 49% in 2008 and 44% a he end of June In erms of oal asses, he presence of he Greek banks in emerging Europe has increased o 43% a he end of In 2004, he annual rae of lending growh was 30%; in 2007 i reached a peak of 66%, while a he end of June 2009 i was negaive (-4.4%) (see Table 1). Lending exposure was 20.8% of GDP in June Furher, as seen in Figure 2, more han 80% of he oal foreign claims o SEE concern local claims denominaed eiher in local or in foreign currency (mainly euros and Swiss francs). I should be noed ha he percenage of claims denominaed in foreign currency reflecs he exposure of he Greek banks o 13 Daa do no exis prior o Thus, 2004 is used as a reference year. 13

14 credi risk since, in he ligh of he poenial for devaluaion of he domesic currency, he cos of loan servicing rapidly increases. Figure 3 Lending exposure o SEE (%) Albania Bosnia-Herzegovina Bulgaria Croaia Romania FYROM Serbia-Monenegro Turkey Noes: oal foreign claims, consolidaed daa on group level. (%) in New Europe; Turkey is included in SEE. Sources: own calculaions based on daa provided by he BIS and he banks balance shees. A simple inspecion of he daa (see Table 1) reveals firs, ha claims are almos equally disribued beween claims in foreign and local monies: 2008 (41.9% versus 41.7%), 2009 (35.8% versus 38.7%). Second, he coverage raio, i.e. he rae of domesic liabiliies (deposis) o domesic claims, boh denominaed in local currency, was more han 60% in Third, he peneraion raio was high as depiced by a rapid credi expansion. Indeed, as seen in Table 1, local claims denominaed in local currency were, in 2008 and 2009, 2 and 1.5 imes, respecively, as high as local bank deposis, also 14

15 denominaed in local currency. 14 Fourh, he raio of foreign claims o prudenial own funds was 8 imes as high in 2008 as in Finally, he raio of foreign claims o oal asses was 6 imes as high in June 2009 as in Table 1 Toal foreign claims o SEE Annual average growh (%) Local deposis in local currency/local claims in local currency (%) Local claims in local currency/local deposis in local currency (%) Raio of oal foreign claims o prudenial own funds (%) Raio of oal foreign claims o oal asses (%) (163.3) (61.2) 26.1 (71.2) 2.2 (6.0) (87.8) 14.2 (6.3) 65.1 (143.5) (69.7) (139.5) 12.9 (8.1) 69.1 (112.7) (88.7) (141.0) 11.3 (9.4) Noes: 1 end of Sepember 2008; 2 end of June 2009; 3 oal foreign claims, i.e. cross-border claims, local claims in local currency and local claims in foreign currency; consolidaed daa on group level. The respecive rae o developed Europe appears in he parenheses. Sources: own calculaions based on daa provided by he BIS and he banks balance shees. Lending is no uniformly disribued in all SEE counries. The main bulk is locaed in Bulgaria, Romania and recenly in Turkey (Figure 3). Furhermore, as seen in Figure 4, more han 2/3 of oal claims accoun for lending o he privae secor (firms and households). 14 A more concree picure would be deeced if we could also assess he raio of local claims in foreign currency over local deposis in foreign currency. However, daa for hese variables do no exis. 15

16 Figure 4 Lending exposure by counerpar, 2009 Turkey Romania Serbia-Monenegro FYROM Croaia Bulgaria Bosnia-Herzegovina credi insiuion public secor privae secor unclassified Albania 0% 20% 40% 60% 80% 100% Noes: (%) in counry s oal, end of June, consolidaed daa on group level. The loans o he public secor refer o governmen bonds and Treasury Bills; o loans o insurance insiuions of he public secor; and o loans o municipaliies and public enerprises. The loans o credi insiuions refer o bank bonds and posiions on he inerbank marke. Privae credi includes loans o households and firms. All iems ha he Greek commercial banks have no classified in one of he above menioned caegories are labelled as unclassified. Sources: own calculaions based on daa provided by he BIS and he banks balance shees. Table 2 presens he n-counry concenraion raio, namely he op-10 and op-5 marke raios. We noe ha beween 2004 and 2009 he degree of lending concenraion of he Greek banks considerably increased and imporan changes occurred regarding is geographical disribuion. In paricular, while in 2004 only one SEE counry, namely Romania, shows a high marke share, in 2009 hree SEE counries alone (Romania, Bulgaria and Turkey) record he highes lending marke shares The Herfindall index which is he sum of he squared marke shares of all banks in he marke indicaes wheher and how much a marke is concenraed. However, we are ineresed in seeing in which counries he Greek banks are mosly concenraed. Therefore, he use of he n-counry concenraion raio which is he sum of he n-larges marke shares is more preferable. 16

17 Table 2 Lending concenraion risk (per cen in oal foreign claims) Counries 2009* 2008** 2004 Cyprus France The Neherlands Germany (ECB) UK USA Ialy Luxemburg Liberia Bulgaria Romania Serbia-Monenegro Turkey Poland CR CR Noes: (*) end of June 2009; (**) end of Sepember The concenraion index (CR) is defined as he sum of he larges 10 or 5 marke shares (op-10 or op-5). I is considered as a measure of lending concenraion in a cerain sub se of he counries in he sample. 3. Assessing counry risk: porfolio aspecs Having so far found a high degree of lending concenraion of he Greek banks in SEE, we nex aim o deec a risk diversificaion effec. In a porfolio framework for counry risk analysis, he risk of holding a well-diversified porfolio of loans may be smaller han ha of having a porfolio heavily concenraed in a few counries. In paricular, he lender may disinguish beween hose key risk indicaor variables having a sysemaic effec on he probabiliy of repaymen across a large number of counries o which he lender makes loans, and hose variables having an unsysemaic effec by impacing a few counries (see Goodman 1986, Palmer and Saunders 1996, Saunders and Corne 2003). 17

18 Therefore, he lender should be really concerned wih he sysemaic variables since hey canno be diversified away in a muli-counry loan porfolio. In comparison, unsysemaic or counry specific risk elemens can be diversified away. In oher words, he sysemaic risk elemen measures he exen o which ha counry s risk indicaor moves in line wih he risk indicaor of all oher counries o which he lender has made loans. Whereas, he unsysemaic risk elemen measures he impac for each counry independenly and, herefore, ha par of risk can be diversified away. The greaer he size of he unsysemaic risk elemen relaive o he sysemaic one, he less imporan his risk indicaor variable is o he lender since he can diversify i away by holding a broad array of loans. The firs sep in his idenificaion process is o pick a se of macroeconomic variables ha may be imporan in explaining rescheduling probabiliies. These variables may be considered as leading counry risk indicaors and usually refer o exernal deb variables, public deb variables, income, liquidiy variables, moneary variables and oher macroeconomic variables ha could give useful insighs on he probabiliy of enering ino a deb crisis and may direcly or indirecly affec a sovereign risk even. In oher words, hese key variables measure he weigh of he counry s indebedness, he flow of financial resources ha are desined for deb repaymens, he revenue-generaing capaciy of a counry, and he volailiy of domesic economic policies or he changes in inernaional financial condiions. I has been shown ha he levels of some imporan macroeconomic variables migh deermine he occurrence of a financial crisis (see Deragiache and Spilimbergo 2001). The heoreical and empirical lieraure highlighs he role played by inernaional illiquidiy in deermining a crisis. From a heoreical poin of view, he relaionship beween liquidiy variables and financial crises has been modelled hrough self-fulfilling crediors run (Chang and Velasco 1998, 2000, Radale and Sachs 1998). In paricular, when he amoun of a counry s deb is small, he bad equilibrium disappears and here is no a sovereign risk even; he reverse is also rue. Thus, measures of liquidiy could be correlaed wih financial crises. 18

19 For he purposes of our analysis, we examine a series of indicaors belonging o a wide caegory of macro variables such as fiscal variables, income, moneary variables, exernal financing and he balance of paymens. However, due o serious daa consrains we evenually chose he following se of variables (see Table 3): fiscal balance o GDP raio, public deb o GDP raio, real GDP growh rae, invesmen o GDP raio, rade openness and curren accoun o GDP raio. Some of hese variables such as deb variables and exernal financing are considered measures of liquidiy and could be correlaed wih financial crises, meaning ha he less liquid a counry he more likely a deb crisis. Ohers such as money growh, inflaion or real oupu growh may be considered as indicaors or sources of macroeconomic volailiy in he counry. Their variaions are deemed o have an adverse effec on boh deb-servicing capaciy and sovereign risk hrough heir impac on fiscal revenues and he real exchange rae. 16 The second sep in our idenificaion process is o divide oal risk ino a non diversifiable sysemaic risk elemen and o an unsysemaic or counry risk elemen. To his end, we consider he well-known capial asse pricing model (CAPM) 17, i.e. X i = consan + b i (X ) + e i (1) where X i is a key risk variable for counry i, (X ) is he weighed average index of his risk variable across all counries o which he lender makes loans. The weighs are each counry s share o oal lending exposure and e i is he residual erm conaining all he oher facors impacing X i. 16 One poenial pifall in using hese macro variables as leading counry risk indicaors is ha hey reflec a hisorical picure whereas decisions on invesmen and lending require a more forward looking approach. 17 See Palmer and Saunders (1996) and Goodman (1986). The CAPM is a marke or a single index model ha saes ha he reurn on asse i (R i ) over period depends on he reurn on he marke porfolio (RM ) and he marke sensiiviy index (b i ), i.e. R i =consan +b i RM + e i, where e i is a disurbance erm ha includes all oher facors ha will affec he reurn on asse i and which are 2 Var R b Var R + Var e. Namely, he oal = i Μ unrelaed o he marke. In variance erms we ge ( ) ( ) ( ) risk associaed wih he reurn on asse i is decomposed ino a sysemaic par, he marke-relaed risk, and o an unsysemaic or company specific risk. i i 19

20 Table 3 Seleced key counry risk indicaors Group of macro variables 1. Fiscal variables Fiscal balance o GDP raio Public deb o GDP raio 2.Income Real GDP growh rae Invesmen o GDP raio 3. Moneary variables Money growh CPI inflaion 4.Exernal financing Foreign reserves growh Impors o reserves raio 5. Balance of paymens Curren accoun o GDP raio Trade openness (expors o GDP raio) Commens Liquidiy measures: he less liquid a counry he more likely a deb crisis. A high rae of GDP growh drives governmen revenues higher and hus helps o guaranee a counry s abiliy o service is liabiliies. The invesmen raio measures he degree o which a counry is allocaing resources o real invesmen raher han o consumpion. The higher he raio, he more producive he economy should be in he fuure and he lower he probabiliy of deb rescheduling. The faser he money supply growh, he higher he inflaion rae and he weaker ha counry s currency becomes in domesic and inernaional markes. The higher he raio of impors o foreign exchange reserves he higher he probabiliy no o service exernal deb liabiliies. Measures of exernal illiquidiy. Expressing equaion (1) in variance erms we ge Var(X i )= b 2 i Var(X) + Var(e i ) (2) where Var(X i ) is he oal risk, b 2 i Var(X) is he sysemaic risk and Var(e i ) is he unsysemaic or counry specific risk elemen. We esimae by leas squares equaions (1) and (2) using quarerly daa over he period for 8 SEE counries and for 10 risk indicaors. The resuls are presened in Table 4. For esimaing he above equaions, we need firs o consruc he weighed average index (X ). The weighs are he counry s share o he oal foreign claims (cross border claims and local claims boh in domesic and foreign currency) a he las available observaion (end of June 2009). For he calculaion of he weighs we include only hose 20

21 counries (19) o which he lending exposure of he Greek banks is equal or larger han 0.5% of he oal foreign claims. 18 Looking carefully a Table 4 some ineresing conclusions emerge. Firs, imporan differences are deeced among counries for he same risk indicaor and beween risk indicaors for he same counry. In paricular, concerning he fiscal variables and when fiscal balance is used as a risk indicaor, we find ha Albania has he highes, relaively o he oher counries in our sample, sysemaic risk elemen while Croaia has he lowes. However, when public deb is considered as a risk indicaor, he picure differs noably. Turkey appears o have he highes sysemaic risk while Albania exhibis he lowes. In pracice, his means ha, for he Greek banks, lending of one more euros in Albania may offer more possibiliies of risk diversificaion han invesing he same amoun of money in Turkey. Second, regarding income, we find ha almos all counries show low sysemaic risk implying ha he high concenraion risk can be successfully diversified away. Third, money supply, inflaion and exernal financing seem o be generally characerized by very low sysemaic risk elemens. This is no surprising since he conrol over he money supply and he use of he counry s foreign exchange reserves are relaively discreionary variables for developing and emerging marke economies. Impor raios also appear o have low sysemaic risk elemens. This migh be explained by he fac ha he counries in quesion may have differen demand for impors according firs o heir differen consuming aiudes and, second, o he differen degree of heir dependence upon vial impors such as energy and capial goods. Finally, as far as regards he balance of paymens and when expors are used as a risk indicaor, we find ha, for all counries, he sysemaic risk is relaively low. 18 The counries are: Cyprus, France, Germany, Ialy, Luxemburg, he Neherlands, Porugal, Swizerland, he UK, he US, Albania, Bulgaria, FYROM, Poland, Romania, Russia, Serbia, Turkey and Ukraine. 21

22 Table 4 Sysemaic and unsysemaic risk elemens 10 key counry risk indicaors, 8 counries (per cen in oal variance, 1995Q1-2007Q4) 1. Fiscal Variables Fiscal balance o GDP raio, % (*) Public deb o GDP raio, % (**) Counries SR USR SR USR Albania Bosnia-Herzegovina Bulgaria Croaia FYROM Romania Serbia*** Turkey Noes: SR= sysemaic risk elemen, USR= unsysemaic risk elemen, (*) general governmen budge balance. The sample period is 2004Q1-2007Q4 for Albania; 2002Q1-2007Q4 for Romania; 2001Q1-2007Q4 for Serbia; 2000Q1-2007Q4 for Croaia and Bulgaria. (**) general governmen oal public deb. The sample period is 2004Q1-2007Q4 for Albania, 2000Q1-2007Q4 for Bulgaria, Croaia and Turkey. (***) Monenegro is no included. The daa for Croaia refer o budgeary cenral governmen and for Turkey o he non financial public secor. 2. Income Real GDP growh rae, % Invesmen raio, % (**) (*) Counries SR USR SR USR Albania Bosnia-Herzegovina Bulgaria Croaia FYROM Romania Serbia*** Turkey Noes: (*) The sample period is 2004Q1-2007Q4 for Albania; 2002Q1-2007Q4 for Bulgaria, Serbia and Turkey; 2001Q1-2007Q4 for Romania. (**) Gross fixed capial formaion o GDP raio. The sample period is 2004Q1-2007Q4 for Albania, 1997Q1-2007Q4 for Romania and Croaia. (***) Monenegro is no included. 22

23 Table 4: coninued 3. Moneary Variables Money growh, % (*) CPI inflaion, % (*) Counries SR USR SR USR Albania Bosnia-Herzegovina Bulgaria Croaia FYROM Romania Serbia** Turkey Noes: Broad money. (*) The sample period is 2001Q1-2007Q4 for Serbia and 1997Q1-2007Q4 for Bosnia-Herzegovina. (**) Monenegro is no included. 4. Exernal Financing Foreign exchange reserves growh, % (*) Impors/foreign exchange reserves, % (*) Counries SR USR SR USR Albania Bosnia-Herzegovina Bulgaria Croaia FYROM Romania Serbia** Turkey Noes: Foreign exchange reserves minus gold, impors of goods and services. (*) The sample period is 1997Q1-2007Q4 for Croaia and Romania and 2003Q1-2007Q4 for Serbia. (**) Monenegro is no included. 5. Balance of Paymens Curren accoun o GDP raio, %(*) Expors o GDP raio, % (*) Counries SR USR SR USR Albania Bosnia-Herzegovina Bulgaria Croaia FYROM Romania Serbia** Turkey Noes: expors of goods and services. (*) The sample period is 1997Q1-2007Q4 for Croaia and Romania; 2001Q1-2007Q4 for Serbia and 2004Q1-2007Q4 for Albania. (**) Monenegro is no included. A dash implies ha monhly or quarerly daa do no exis for he respecive variable; herefore, he counry is excluded from our sample. Sources: IMF (IFS daa base, November 2009), naional cenral banks, naional saisical services, he counries minisry of finance and ECB (SDW). 23

24 In general, we conclude ha, for he mos counries in he sample, he unsysemaic par of he risk facing he Greek banks ha operae in SEE is much more imporan han he sysemaic one. However, some excepions are presen. For some counries, such as Bulgaria, Romania and Turkey he value of he sysemaic par of a specific (and no for all) risk facors is found o be higher. For insance, even hough Turkey exhibis a higher par of sysemaic risk wih respec o fiscal variables, he unsysemaic par for he res of he risk indicaors is considerably lower. The same is rue for Romania and Bulgaria when risk is proxied by foreign exchange reserve growh. Neverheless, he larger par of he unsysemaic risk for he majoriy of he counries and variables implies firs ha he high risk of lending concenraion in SEE is considerably reduced so ha, in he face of a counry specific (and no global)shock, a mechanism for balancing he adverse effecs on oal lending porfolio comes ino operaion. 19 And, second, SEE counries seem o be a group of quie dissimilar economies having differen srucural feaures. 4. The probabiliy of a sovereign risk even : public deb dynamics We urn nex o sudy hose counry specific feaures ha deermine a high probabiliy of a sovereign risk even. We place an emphasis upon he counries fiscal srucures in a comparaive perspecive. 20 Following a period of decline in he curren N 19 Defining a = p w as he porfolio alpha and i = ia 1 i bp = i = wib 1 i as he porfolio bea, we can direcly represen porfolio reurn as a porfolio alpha plus bea imes expeced marke reurn, as shown E( Χ ) = α + b E( X ) (3) p p p Because of he assumpion ha securiies are relaed only hrough a common marke effec, he risk of a porfolio is also simply a weighed average of he marke-relaed risks of individual securiies plus a weighed average of he specific risks of individual securiies in he porfolio: As seen, he diversifiable risk componen 2 2 Var( Χ ) = b Var( X ) + = w Var( e ) (4) p p 2 w i N i 1 i N i will become smaller as securiies are added o he porfolio. This is because, according o he single index model, hese risks are uncorrelaed. See, Fabozzi (1999, ch. 5) and Farell (1997, ch.3). 20 Few sudies have empirically examined public deb susainabiliy or large public deb reducions in emerging marke economies. For an examinaion of he episodes of large exernal deb reducions in hese counries, see Reinhar, Rogoff and Savasano (2003). More recenly, Reinhar and Rogoff (2009, 2010) analyse he cycles underlying serial deb and banking crises across a large sample of boh emerging and maure economies and over a long ime span. For an assessmen of deb susainabiliy in emerging marke economies, see IMF (2003, ch. II and III) as well as Sheikh and Heijmans (2004). 24

25 decade, recen developmens in he view of he curren global financial crisis brough again o he scene he issue of public deb in SEE emerging marke economies. Public deb had sharply increased since he mid-1990s in many ransiion economies wih cosly deb defauls (Russia, Ukraine) and severe fiscal difficulies (Turkey) in he very early years of he 2000s. However, his is no o say ha here have no been success sories. For example, Bulgaria has succeeded o reduce significanly is excessively high public deb raio, from close o 160 per cen of GDP in he early 1990s o less han 20 per cen in Anoher success sory is Serbia; is high public deb has been reduced from around 240 per cen of GDP in 2000 o close o 30% in The poliical economy aspecs of public deb have received increased aenion over he las years. In his lieraure, deb is seen in a sraegic conex where he governmen can use i o finance higher spending or ax cus o boos is re-elecion prospecs or o ry o consrain he acions of successor regimes (see Rogoff 1990, Persson and Svensson 1989). Why migh a governmen choose o borrow and accumulae deb? Firs, deb may be used o fund spending ha conribues o broader economic and social objecives such as physical infrasrucure, populaion s educaion and healh. Second, deb may be used as a buffer o limi he need o immediaely raise axes o finance increased spending in he view of a sudden and emporary even, for example a war or a naural disaser (see Barro 1979). Third, financing couner-cyclical fiscal policy by issuing deb helps o sabilize he economy and o smooh he business cycle. However, high public deb requires high axes o repay he deb and pus upward he real ineres raes crowding ou privae invesmen. A highly indebed governmen ha is no longer able o finance is deficis should raise axes or curail spending ofen a a ime when fiscal policy is needed o help sabilize he economy. In oher words, fiscal policy becomes pro-cyclical insead of being couner-cyclical. When he governmen canno find revenues o finance deb issue, a deb crisis occurs and he governmen is forced o defaul or inflae he deb away. Boh acions enail large economic and social coss due o resuling painful periods of financial consolidaion and economic adjusmen. 21 The excessively high raes of he public deb raio are mainly aribued o he war of

26 As seen in Figure 5, afer a peak in 2000 oal public deb as per cen of GDP followed a downward rend during he period , largely as he resul of he painful fiscal consolidaion process pursued over he las years. Compared wih he value ha he raio akes for he euro area over he same period (70%), we see ha for he SEE counries he mean rae was 1.5 imes lower (Figure 6). Deb as a percenage of oal public revenues is also lower in SEE (see Figure 7). However, Albania and Turkey have higher raios; hey are more han 2.5 imes higher. Moreover, as seen in Figure 8, exernal deb was 2 imes as high as inernal deb, wih Serbia, Bulgaria and FYROM show a higher proporion of exernal o inernal deb. Figure 5 Public deb in SEE (% of GDP, 8 counries ) oal deb exernal deb domesic deb Noes: gross deb of general governmen, simple unweighed counry averages, end of period daa. For Turkey, he daa refer o he non financial public secor and for FYROM, o consolidaed cenral governmen. The daa enries for he years 2007 and 2008 are preliminary, projeced or esimaed. The ime period for Serbia (Monenegro is excluded) is ; for Bosnia-Herzegovina, See also he daa appendix. Sources: IMF Counry Repors, SDW ECB, AMECO General Governmen Daa (spring 2009) and naional cenral banks. 26

27 Figure 6 Comparison of public levels in SEE and EA (% of GDP, ) SEE-8 EA-16 Noes: simple arihmeic unweighed counry averages. Sources: IMF Counry Repors, SDW ECB, AMECO General Governmen Daa (spring 2009) and naional cenral banks. Wha are he main explanaions behind he developmens in SEE markes public deb? Figure 9 highlighs he changes in he deb sock by using a simple public deb dynamics equaion using he 2008 daa enries. In paricular, i gives a quaniaive expression of he deb dynamics, giving he influence of he flow variables on he evoluion of he ousanding sock of governmen deb. According o he deb dynamics or he budgeary consrain of a counry, public deb changes are influenced by he primary fiscal defici (non ineres expendiures less revenues), he nominal GDP growh rae and he ineres rae and oher facors. The las iem capures a wide range of facors, including he accumulaion of financial asses, exchange rae depreciaions, and fiscal coss arising from he resoluion of banking secor crises and receips from 27

28 privaizaion deals (off-balance shee iems, coningen liabiliies as well as remaining saisical adjusmens). 22 Figure 7 Public deb, raio o revenue (% average, ) EA-16 SEE-8 Turkey Romania Serbia FYROM Croaia Bosnia-Herzegovina Bulgaria Albania Noes: simple arihmeic unweighed counry averages. General governmen oal deb; oal public revenues. End of year daa. Sources: IMF Counry Repors, SDW ECB, AMECO General Governmen Daa (spring 2009) and naional cenral banks. 22 I is known as sock-flow adjusmen or deb-defici adjusmen (SFA). I ensures he consisency beween a flow variable such as ne borrowing and he variaion in he sock of gross deb. Analyically, SFA is made up of he following elemens. Firs, he ne acquisiion of financial asses leads o changes of he sock of deb even hough i does no conribue o he primary defici. Second, he appreciaion or he depreciaion of foreign currency deb reflecs he impac of changes in exchange raes on hese deb componens ha are denominaed in foreign currencies. Third, correcions are also needed due o he fac ha he deb is measured a face value and herefore accrued ineres is excluded. Fourh, adjusmen may arise due o changes in secor classificaion and volume changes in financial liabiliies. The las elemen of SFA is he saisical discrepancy which reflecs differences arising from he diversiy of daa sources and saisical pracices. For an analysis of he elemens of FSA for he EU27 for he period , see Eurosa (2009), April, EDP noificaion. 28

29 Figure 8 Public deb in SEE (average, ) (% GDP) Albania Bulgaria Bosnia-Herzegovina Croaia FYROM exernal deb Serbia Romania domesic deb Turkey SEE-8 Noes: year averages and simple arihmeic unweighed counry averages. The sample period is for Romania, and for Croaia, Sources: IMF Counry Repors, SDW ECB and naional cenral banks. We noe ha in almos all counries in he sample, wih he exempion of Turkey, he impac of oupu growh and he ineres rae was favourable in reducing he sock of deb. The conribuion of he primary balance, however, was no srong enough so as o cu deb. This was rue paricular for Turkey, bu no for Bulgaria. The broad picure is ha he primary governmen balances were ofen insufficien o significanly reduce he deb-o-gdp-raio. Primary deficis in Albania, Croaia, Serbia and Romania eiher consrained he downward rend of deb or reinforced is upward movemen. In Turkey, in paricular, he conribuion of he primary surplus, even hough i was large in value, did no seem srong so as o evenually conain deb. Wih regard o he oher facors, in only wo cases, Albania and FYROM, seemed o have conribued o deb fall. In all oher 29

30 cases, heir conribuion was posiive and paricularly srong in Bosnia-Herzegovina 23, Bulgaria and Turkey. Figure 9 Conribuion o changes in he oal governmen deb sock (2008, % of GDP) Albania Bulgaria Bosnia- Herzegovina Croaia FYROM Serbia Romania Turkey change in gross deb raio nominal growh and ineres conribuion primary defici oher conribuion Noes: The deb dynamic equaion emphasizing he role of he primary (non ineres) defici can be wrien in erms of oupu: or D Y D Y D Y = P Y D Y i y P Y SFA Y (1 + ) 1 (1) 1 (1 + SFA Y + ) D Y + i y y 1 1 (2). Based on equaion 2, he oal change in 1 = he gross deb raio has been assessed as he conribuion of primary balance (P, defici), he sock flow adjusmen and he conribuion of nominal oupu growh and he nominal ineres rae. The implici ineres rae i is derived as he nominal ineres expendiure divided by previous period deb sock. For he mos counries in he sample, daa enries for he year 2008 are preliminary, esimaes or projecions. Source: Own calculaions based on daa from IMF Counry Repors. 23 Till 2006, he counry s oal public deb was dominaed in foreign currencies and in conjuncion wih he srong devaluaion pressures agains he dollar, sock flow adjusmen was high. 30