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, [email protected] ** Economic Research Deparmen, [email protected]

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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

31 5. Assessing deb susainabiliy 5.1 Acual and deb sabilizing primary balances Wha are he specific feaures of he fiscal srucure in SEE counries ha deermine he level of public deb ha hey can susain? We can nominae he following: (i) (ii) SEE counries generally have lower and more volaile revenue raios (see Figure 10). On average, he revenue o GDP raio is abou 33 per cen for he period , compared wih 45 per cen in he euro area during he same period. There are, however, considerable differences among he counries wih, for example, Serbia and Bosnia-Herzegovina having raios almos par wih he euro area. 24 On he oher hand, Turkey, Albania and FYROM are he counries wih he lowes revenue raio. The volailiy of revenues measured as he coefficien of variaion in SEE counries is generally much higher han in he euro area. Volailiy is four imes as high as in he euro area. 25 Ineres coss accoun for a high proporion of governmen expendiure in SEE counries (see Figures 11.1 and 11.2). A 11 per cen of oal expendiure, ineres coss are 1.5 imes as high in SEE counries as in he euro area, even hough hey accoun for an average of 3.5 per cen of GDP, which is a par wih he EA-16. Ineres expendiures are also more volaile because of he srucure of public deb. As seen in Figure 11.2, he coefficien of variaion is 2.5 imes as high in SEE counries as in he euro area. Currency mismaches and mauriy mismaches can explain in a grea exen high volailiy. Wih a large proporion of public deb eiher 24 I may be more imporan o assess he effecive direc and indirec ax rae in an aemp o deec he reasons of he observed low revenue raios. However, lack of daa on key variables for many counries in he sample does no allow us o carry ou his ask. According o he mehodology proposed by Mendoza, Razin and Tezar (1994), he effecive direc ax rae is calculaed as he raio of oal ax and non ax revenues ne of domesic axes on goods and services divided by he sum of compensaion of employees and oal operaing surplus. The effecive indirec ax rae is calculaed as he raio of all domesic axes on goods and services divided by privae consumpion. 25 I has been empirically shown (see IMF 2003, Kose, Prasad and Terroner 2003) ha, for mos of he emerging economies, he impac of commodiy prices and commodiy expors on governmen revenues and hus on primary budge balance is imporan even for he emerging marke economies ha have diversify heir expors away from primary commodiies. 31

32 exernal or denominaed in foreign currency, 26 and governmen revenues in domesic currency, high exchange rae volailiy resuled in large spikes in ineres paymens relaive o governmen income. Furher, domesic deb is ofen of a shor mauriy so ineres coss are more sensiive o changes in he domesic ineres raes. Figure 10 Revenue raios in SEE, in per cen SEE-8 Romania FYROM Bosnia-Herzegovina Albania raios of public revenue o GDP coefficien of variaion Noes: gross public deb o oal governmen revenues, mean averages and simple arihmeic unweighed counry averages. The coefficien of variaion measures he sandard deviaion relaive o he series mean. End of period daa. The sample period for Serbia is and for Croaia is See also he daa appendix. Sources: IMF Counry Repors, SDW ECB, AMECO General Governmen Daa (spring 2009) and naional cenral banks. 26 For all counries, foreign currency denominaed deb accouns for a very large proporion of oal public deb. For example, in Bulgaria, Croaia, Bosnia-Herzegovina, Serbia and FYROM he sock of deb ha is denominaed in foreign currencies accouns for more han wo hirds of he oal sock. 32

33 Figure 11.1 Ineres coss in SEE, EA-16 SEE-8 Turkey Romania Serbia FYROM Croaia Bosnia-Herzegovina Bulgaria Albania % o GDP % o governmen expendiure Noes: simple arihmeic unweighed counry averages. The sample period is for Serbia (Monenegro is excluded). Daa enries for he year 2008 are preliminary, esimaes or projecions. See also he daa appendix. Sources: IMF, World Economic Oulook (April 2009), AMECO General Governmen Daa (spring 2009), IMF Counry Repors, Cenral Bank of Bosnia-Herzegovina Annual Repor, Minisry of Finance of he Republic of Serbia, Minisry of Finance of Croaia. These differences in public deb srucures may have imporan implicaions for deb susainabiliy. A quie simple approach o public deb susainabiliy sars from he basic accouning ideniy ha links he public secor budge balance o he change in he deb sock. A fiscal policy can be viewed as susainable if i delivers a raio of public deb o GDP ha is sable. The difference beween he acual and he deb sabilizing primary balance indicaes he degree of fiscal adjusmen ha is needed o achieve a consan deb o GDP raio (see Blanchard a al. 1990). 27 If he acual primary balance is less han he 27 The budge ideniy indicaes ha he sock of public deb a he beginning of period +1 (B +1 ) resuls from he inheried deb (B ) o which he period ineres requiremens are added. Since ineres coss are no a fiscal policy variable bu depend on he sock of deb, he ideniy can be re-wrien relaing he primary (non ineres) balance, P (surplus), o he change of public deb sock: 33

34 deb sabilizing balance, curren fiscal policy implies an increasing raio of public deb o GDP. Based on he hisorical averages for he years , one can conclude ha mos counries in he sample had run primary (non ineres) balances consisen wih wha was required o sabilize or reduce he deb o GDP raio (see Figure 12). In all cases, public deb was below 60 per cen of GDP, i.e. he benchmark esablished for he EU members in he Maasrich Treay. In Serbia and Turkey, boh counries wih a high deb raio, he acual primary balance was more han he deb sabilizing balance, meaning ha fiscal policy pursued over he pas few years implied a decreasing raio of public deb o GDP and herefore, i was viewed as susainable. The reverse, however, is rue for Romania or even Albania. 28 Many facors migh explain he favourable prospecs for SEE governmen deb dynamics. All counries had recenly made considerable effors o increase heir primary fiscal surpluses. Furher, a smaller primary surplus would be needed o sabilize or reduce he deb raio as real growh was sronger and he real ineres rae was much lower in he pas few years. B +1 = (1+r ) B - P (1) or in erms of raios o GDP o accoun for he effec of growh on borrowing capaciy (1+g) b +1 = (1+r) b - p (2) where g is he nominal growh rae and r is he nominal ineres on governmen deb. From equaion (2) he primary surplus ha sabilizes he deb raio (b +1 ) is given by p* = b (r-g) (3) where g and r can be also measured in real erms as he effec of inflaion disappears wih he use of GDP raios. From equaion (3), he primary surplus consisen wih a consan deb o GDP raio increases wih he iniial deb sock and he difference beween he real ineres rae and he real growh rae, insofar as ha he real ineres rae is higher han real growh. The main drawback of his simple indicaor of deb susainabiliy is ha is based upon an arbirary definiion of susainabiliy (i.e. o sabilize he deb o GDP raio). This is because i is unlikely a counry o mainain a sable deb raio a all imes while incurring emporally high deb levels may be appropriae in some circumsances (see IMF 2003). 28 Romania had he lowes deb raio, bu acual primary balance was less han he deb sabilizing balance. Albania had he highes deb raio among all counries in he sample while he difference beween acual primary balance and deb sabilizing balance was near zero. 34

35 Figure 11.2 Volailiy of ineres coss in SEE, (Coefficien of variaion) EA-16 SEE-8 Turkey Romania Serbia FYROM Croaia Bosnia-Herzegovina Bulgaria Albania % o GDP % o governmen expendiure Noes: simple arihmeic unweighed counry averages. The sample period is for Serbia (Monenegro is excluded). The coefficien of variaion measures he sandard deviaion relaive o he series mean. Daa enries for he year 2008 are preliminary, esimaes or projecions. See also he daa appendix. Sources: IMF, World Economic Oulook (April 2009), AMECO General Governmen Daa (spring 2009), IMF Counry Repors, Cenral Bank of Bosnia-Herzegovina Annual Repor, Minisry of Finance of he Republic of Serbia, Minisry of Finance of Croaia. 5.2 Fiscal policy response o deb accumulaion A more formal approach o assessing deb susainabiliy is o look a he relaionship beween he fiscal policy ools and objecives. In oher words, we esimae he fiscal policy rule or he fiscal policy reacion funcion. 29 In he conex of he fiscal policy decision making process, we consider primary fiscal surplus as he key operaing 29 For fiscal policy sudies for he indusrial counries see, Bohn (1998), Méliz (1997), Debrun and Wyplosz (1999) and Gali and Perroi (2003). For a comparison beween indusrial counries and emerging marke economies, see IMF (2003). 35

36 arge ha reflecs he acions of he fiscal auhoriies and mainaining deb susainabiliy as heir primary objecives. Therefore, we assume ha primary fiscal surplus responds o public deb changes (see Bohn 1998). Shor-run consisen borrowing schedule requires ha he primary balance sysemaically and posiively responds o pas changes in he public deb, ha is he parameer λ in equaion (4) (see foonoe) 30 akes a posiive value. Specifically, we refer o he associaion beween he primary surplus as per cen of GDP and he raio of public deb o GDP observed a he end of he preceding year. For assessing his connecion, we used pooled daa for 8 SEE counries over he period Primary balance minus 'deb sabilizing" balance Figure 12 Acual and deb sabilizing primary balances (8 SEE counries, % of GDP, ) BH 2 FYROM BG CR AL 0 RO increasing deb Deb raio decreasing deb RS TU Noes: real ineres rae= nominal rae on public deb minus change in GDP deflaor. See also he daa appendix. Source: Own calculaions (see eq. 3) based on daa from IMF Counry Repors. 30 Following Bohn (1998), he fiscal policy reacion funcion can be wrien as follows p i = a i + Σ j b i X ij + λ b i-1 + u i (4) where p i is he primary surplus of counry i a period, X ij is a vecor of emporary facors (j=1..n), b i-1 is he deb level a he end of he previous period, a i is he counry specific consan (fixed effec) accoun for heerogeneiy in he group of he counries in he sample and u i is an error erm. 36

37 However, surpluses are also affeced by oher macroeconomic variables ha explain changes in primary balances unrelaed o deb susainabiliy. According o Barro s ax smoohing policy (1979) hese variables reflec emporary shocks o governmen spending ha are due o business cycle flucuaions or excepional evens (such as warime emergencies, naural disasers or economic crises and financial panics) ha increase spending o abnormal levels. Therefore, apar from he raio of public deb o GDP, we consider wo emporary facors ha affec he primary balance: he business cycle and he inflaion rae. Specifically, he oupu gap defined as he deviaion of real GDP from is H-P filered rend is included o capure he impac of he business cycle on he primary surplus. The CPI inflaion rae accouns for shocks o seigniorage revenues. Figure 13 brings ogeher he primary balance 31 and public deb. As seen, he link beween hem seems o be posiive a almos any level of deb below 50 per cen of GDP. However, he response of he primary surplus weakens and urns o be negaive as he deb o GDP raio exceeds ha level and i sops alogeher when he deb raio exceeds 60 per cen of GDP. We should menion ha his behaviour ress on he average of he counries in he sample and i does no refer o each individual counry. The empirical resuls presened in Table 5 verify he above conclusion. Taking ino accoun he influence of emporary facors and he exisence of a non linear relaionship (quadraic and cubic powers of public deb have been added in he regression equaion) beween he primary surplus and public deb (boh as per cen of GDP), we find ha a low levels of deb he primary surplus does respond posiively alhough slighly o a rise of he deb o GDP raio. A mid levels, his response weakens and urns o a negaive sign while a higher levels i seems ha he primary surplus does no a all reac as deb rises. I is worh noing ha boh ransiory facors of he fiscal policy have he expeced signs bu only inflaion is saisically significan. In paricular, in line wih he effec on seigniorage revenues, higher inflaion is associaed wih a larger primary surplus. By conras, he primary surplus appears o be only slighly reacive o cyclical flucuaions. 31 No adjused for he influence of ransiory changes. 37

38 5 4 3 Figure 13 Public deb and primary balance (8 SEE counries, , % of GDP) BG TU primary surplus RO FYROM BH AL RS -2 CR deb Noe: The Kernel is he funcion used o weigh he observaions in each local regression; mean averages, end-of-year daa. These resuls sugges ha on average he conduc of fiscal policy in SEE counries is no consisen wih ensuring susainabiliy when deb exceeds a hreshold of 50 per cen of GDP. However, he validiy of his finding could be also aribued by he presence of wo oher facors. Firs, we examine developmens over a shor ime period ( ) and second, during ha period, all counies in he sample reduced heir deb raios by aking measures owards fiscal resrucuring and consolidaion. Broadly speaking, he resuls are suggesive of a weak link beween deb susainabiliy and he shor-run conduc of fiscal policy. They are primarily driven by he behaviour of primary spending, which, as per cen of GDP, appears o be slighly procyclical (see Table 5, block II). 32 This means ha in cyclical upswings primary spending increases slighly faser han oupu and fall faser in a downurn when revenues also decline and lending condiion ighen. Pro-cyclical fiscal policy likely reflecs he inabiliy o conrol spending and hus reflecs he absence of he auomaic sabilizers ha 32 The coefficien of oupu gap is posiive and saisically significan only a a level higher han 10%. 38

39 give o governmen spending a sabilizing role agains macroeconomic volailiy. Finally, he resuls in Table 5 also sugges ha SEE counries reac o deb accumulaion by decreasing spending while inflaion has a negaive effec on spending. Table 5 SEE counries: fiscal policy reacion funcions and expendiure equaions Block I. Fiscal Policy Reacion Funcions Dependen variable: primary surplus as per cen o GDP Block II. Expendiure Equaions Dependen variable: primary (non ineres) spending as per cen o GDP Explanaory variables Explanaory variables (1) (1) (2) consan (-1.854) (87.625) (3.953) Operaional fiscal arge Lagged public deb (% GDP) Lagged public deb^2 (% GDP) Lagged public deb^3 (% GDP) (1.875)** (-1.596)*** (0.760) (1.817)*** (-1.854)*** Conrol variables Oupu gap (1.505)*** (1.753)*** (1.752)*** CPI inflaion (3.627)* (-2.156)** (-1.818)*** Lagged spending (3.497)* Adjused R Se Hausman saisic No endogeneiy (0.358)** No endogeneiy (0.187)** No endogeneiy (0.227)** Number of observaions Noes: pooled cross secion and ime series daa. The equaions have been esimaed wih GLS allowing for fixed effecs (counry and period) and using a heeroskedasiciy-consisen Whie variance-covariance marix. se is he sandard error of he regression. A consan erm is auomaically included so ha he fixed effecs esimaes sum o zero. They should be inerpreed as deviaions from an overall mean. A Hausman (1978, Davidson and Mackinnon 1989, 2003) specificaion es has been also carried ou esing wheher he esimaes are consisen. Deb service paymens are chosen as an insrumen in he auxiliary regression. The p-values of rejecing he hypohesis of consisen esimaes are repored in he parenheses. (*) significan a 1%, (**) significan a 5%, (***) significan a 10%. See also he daa appendix. Sources: IMF Counry Repors and World Economic Oulook, April

40 6. Conclusions The main purpose of he paper is o assess any poenial pressure on Greek banks from heir aciviies in SEE and sudy he key risk deerminans. We focus on wo facors: he exposure of he banks and he probabiliy of a sovereign risk even. In paricular, we are firs ineresed in deecing a diversificaion effec of he concenraion risk facing he Greek banks ha operae in SEE. And second, we examine he counry specific facors ha may deermine a sovereign risk even. We place an emphasis on he counries fiscal srucure in a comparaive perspecive since a high probabiliy of a sovereign risk even implies deerioraion in he governmen balance shee ha will evenually adversely affec he healh of he balance shees of boh households and firms and ulimaely he healh of he bank balance shees. This happens because an increase in he deb raio oday implies ha axes will go up omorrow impairing firms profiabiliy and hus reducing heir abiliy o repay heir debs o he banks. Our main empirical findings are as follows. Firs, even hough he degree of regional lending concenraion of he Greek banking sysem is high, a diversificaion effec is presen. Specifically, we use he well-known CAP model o divide oal counry risk ino a non diversifiable sysemaic elemen and o an unsysemaic counry specific par. Based on a panel daa for 8 SEE counries and 10 seleced leading risk indicaors over he period , empirical resuls suppor he view ha, for he mos SEE counries in he sample, he non sysemaic risk is much more imporan han he sysemaic one. This implies ha a mechanism for balancing he adverse effecs of a counry specific and a non sysemic shock is se in moion. Second, examining he sovereign risk qualiy, we conclude alhough all SEE counries have made recenly significan effors owards successful fiscal consolidaion largely suppored by srong oupu growh and low real ineres raes over he las few years he empirical evidence is, however, suggesive of a weak link beween deb susainabiliy and he shor-run conduc of fiscal policy. This finding is validaed by he evidence on he pro-cyclical characer of primary governmen spending. However, some caveas are in order. Firs, he empirical findings are only suggesive, enaive and in no way definiive. This is due o he exisence of serious 40

41 consrains on daa availabiliy and o he shor ime horizon ha we choose o sudy hese developmens. Second, we rely on he analyical framework of he CAP model. However, his model is a single index marke model and i suffers from cerain limiaions: (i) i is a linear model whereas he real world is non linear; (ii) we are only ineresed in examining he riskiness of he Greek banks abroad and no he riskiness of a paricular counry in which a Greek bank resides. To his end, we use complemenary risk facors ha allow us o reach cerain conclusions ha may be helpful in an exper s judgemen; (iii) he CAP model canno be used o rae counries. There are concerns, for example, abou how can we weigh he relaive imporance of each risk indicaor? How can we define overall riskiness? How can we rea he exisence of unobservable relaions beween seleced risk facors? And (iv) he model is ofen used o compare differen porfolio srucures. However, in our analysis a porfolio manager does no exis. This means ha we canno compare differen porfolio srucures bu can only ake as given a cerain porfolio srucure ha holds a a cerain ime. Third, we look a he variance of some macroeconomic variables hus disinguishing beween he sysemaic and he unsysemaic par of he risk. Alernaively, following Genberg and Sulsarova (2008), we could assume ha he risk of sovereign bonds depends no only on he expeced fuure pah of deb bu also on is enire probabiliy disribuion. This is because even if he expeced ime pah of he deb raio looks susainable, i is possible ha some realizaions of he underlying macroeconomic variables will bring i o levels ha are considered oo high. The enire disribuion of he fuure deb raio can be seen as a funcion of he naure of he sochasic process ha governs he macro variables aking ino accoun heir ineracions. And finally, since SEE counries are characerized by boh domesic and foreign (public and privae) deb, a possible way of examining susainabiliy would be o examine he link beween fiscal and exernal susainabiliy. This involves he naional income ideniy, he evoluion of ne foreign liabiliies and he governmen s budge consrain. In his laer case, he credi risk is covered by he exchange rae risk wih wo pars o be sudied: (i) he probabiliy of he domesic currency depreciaion and (ii) currency mismach. 41

42 References Allen, M., C. Rosenberg, C. Keller and N. Roubini (2002), A Balance Shee Approach o Financial Crises, IMF Working Paper 02/210. Bank of Greece (2009), Challenges and Prospecs of SEE Economies in he wake of he Financial Crisis, Conference joinly organised by he Bank of Greece and he Universiy of Oxford (SEESOX), Ahens, 16 Ocober. Barro, R. J. (1979), On he Deerminaion of Public Deb, Journal of Poliical Economy, 87, Beim, D. and C. Calomiris (2001), Emerging Financial Markes, London, McGraw Hill. Blanchard, O. J., J. C. Chouraqui, R. P. Hagamann and N. Saros (1990), The Susainabiliy of Fiscal Policy: New Answers o an Old Quesion, OECD Economic Sudies, 15, Bohn, H. (1998), The Behaviour of US Public Deb and Deficis, Quarerly Journal of Economics, Bordo, M. (2006), Sudden Sops, Financial Crises and Original Sin in Emerging Markes: Déjà vu? NBER Working Paper no Bordo, M. (2008), Growing up o Financial Sabiliy, SEEMHN Bank of Greece Working Paper no 85. Borio, C. (2004), Marke Disress and Vanishing Liquidiy: Anaomy and Policy Opions, Bank for Inernaional Selemens Working Paper no 158. Chang, R. and A. Velasco (1998), The Asian Liquidiy Crisis, Federal Reserve Bank of Alana, Working Paper no Chang, R. and A. Velasco (2000), Banks, Deb Mauriy and Financial Crises, Journal of Inernaional Economics, 51, Ciarlone and Trebeschi (2004), Currency and Deb Crises: A Review of he Early Warning Sysems in S. Wilkin (ed.), 12, Claessens, S., M. Ayhan Kose and M. E. Terrones (2008), Wha Happens During Recessions, Crunches and Buss? IMF Working Paper, 08/274, Ocober. Debrun, X. and C. Wyplosz (1999), Onze Gouvernemens e une Banque Cenrale, Revue d Economic Poliique, 109, Deragiache, E. and A. Spilimbergo (2001), Crises and Liquidiy: Evidence and Inerpreaion, IMF Working Paper no WP01/2. 42

43 Diamond, D. W. and P. M. Dybvig (1983), Bank Runs, Deposi Insurance and Liquidiy, Journal of Poliical Economy, 91, EBRD (2009), EBRD Transiion Repor 2009: Transiion in Crisis? Gardó, S. and R. Marin (2010), The Impac of he Global Economic and Financial Crisis on Cenral and Souh easern Europe. A Sock-aking Exercise, ECB Occasional Paper Series, no 114, June. Gali, J. and R. Peroi (2003), Fiscal Policy and Moneary Inegraion in Europe, CEPR Discussion Paper no Genberg, H. and A. Sulsarova (2008), Macroeconomic Volailiy, Deb Dynamics and Sovereign Ineres Rae Spreads, Journal of Inernaional Money and Finance, 27, Goldsein, M. (2007), Emerging Marke Financial Crises: Lessons and Prospecs, speech delivered a he 25 h Anniversary Membership Meeing of he Insiue of Inernaional Finance, 20 Ocober. Goldsein, M., G. Kaminsky and C. Reinhar (2000), Assessing Financial Vulnerabiliy: An Early Warning Sysem for Emerging Markes Insiue for Inernaional Economics, Washingon, June. Goodman, L.S. (1986), Diversifiable Risks in LDC Lending: A 20/20 Hindsigh View, Sudies in Banking and Finance 3, Fabozzi, F.J. (1999), Invesmen Managemen, 2 nd ediion, Prenice-Hall. Farell, J. R (1997), Porfolio Managemen. Theory and Applicaions, 2 nd ediion. McGraw Hill. IMF (2002), Early Warning Sysem Models: he Nex Sop Forward, Global Financial Sabiliy Repor, March. IMF (2003), Public Deb in Emerging Markes: Is i oo High? World Economic Oulook 3, , Sepember. Kapopoulos and Lazareou (2007), Foreign Bank Presence in SEE: he Experience of he Counries in Transiion Bank of Greece, Economic Bullein, 29, Kindleberger, C. (1978), Manias, Panics and Crashes: A Hisory of Financial Crises, New York, Basic Books. Kose, M. A., E. S. Prasad and M. E. Terrones 2003), Financial Inegraion and Macroeconomic Volailiy, IMF Saff Paper, 50,

44 Krugman, P. (1979), A Model of Balance of Paymens Crises, Journal of Money, Credi and Banking, 11, Krugman, P. (1997), Are Currency Crises Self Fulfilling? NBER Macroeconomic Annals, Cambridge MIT Press, Krugman, P. (1999), Balance Shees, he Tranfer Problem and Financial Crises in P. Isard, A. Razin and A. K. Rose (eds.), Inernaional Finance and Financial Crises: Essays in Honor of Rober P. Flood Jr, Kluwer Academic Publishers. Manasse, P., N. Roubini and A. Schimmelpfenning (2003), Predicing Sovereign Deb Crises, IMF Working Paper no WP03/221. Méliz, J. (1997), Some Cross-Counry Evidence abou Deb Deficis and he Behaviour of Moneary and Fiscal Auhoriies, CEPR Discussion Papers no Mendoza, E. G., A. Razin and L.L. Tesas (1994), Effecive Tax Raes on Facor Incomes and Consumpion, Journal of Moneary Economics, 34, Obsfeld, M. (1996), Models of Currency Crises wih Self Fulfilling Feaures, European Economic Review, 40, Palmer, M. and T. B. Saunders (1996), A Model for Diversifying Inernaional Loan Porfolios, Journal of Financial Services Research, Persson, T. and L. E. O. Svensson (1989), Why a Subborn Conservaive Would Run a Defici? Policy wih Time-Inconsisen Preference, Quarerly Journal of Economics, 104, Radale, S. and J.D. Sachs (1998), The Eas Asian Financial Crisis: Diagnosis, Remedies, Properies, Brookings Papers on Economic Aciviy, 1, Reinhar, C. (2002), Defaul, Currency Crises and Sovereign Credi Raings, NBER Working Paper Series, no Reinhar, C., K. Rogoff and M. Savasano (2003), Deb Inolerance in Brookings Papers on Economic Aciviy, 1, Reinhar, C. M and K. S. Rogoff (2009), This Time is Differen. Eigh Cenuries of Financial Folly, Princeon Universiy Press. Reinhar, C. M and K. S. Rogoff (2010), From Financial Crash o Deb Crisis, NBER WP no 15795, March. Rogoff, K. (1990), Equilibrium Poliical Budge Cycles, American Economic Review, 80,

45 Roubini, N. and D. Seser (2004), Bail-ous or Bail-ins? Responding o Financial Crises in Emerging Economies, Insiue for Inernaional Economics, Washingon, Ocober. Saunders. A. and M. Corne (2003), Financial Insiuions Managemen: A Risk Managemen Approach, 4 h ediion, McGraw Hill. Sheikh, K. and P. Heijmans (2004), New Developmens in Counry Risk: he New Anaomy of Crises, Rising Public Deb Burdens and Basel II, in S. Wilkin (ed.), 3, Sorsa, P., B. Bakker, C. Duenwald, A. Maechler and A. Triffin (2007), Vulnerabiliies in Emerging Souh-easern Europe How Much Cause for Concern?, IMF Working Paper no 07/236, Ocober. Wilkins, S. (ed. 2004), Counry and Poliical Risk: Pracical Insighs for Global Finance, Risk Books. 45

46 Daa Appendix In he empirical analysis we choose a se of macroeconomic variables for which a coninuous daa series is available for all counries in he sample. However, he use of differen daa sources and he frequen updae concerning he variables definiions or he mehod of daa evaluaion raise he problem of he exisence of significan saisical discrepancies. The daa se for public deb (see Secion 5) focuses on gross public secor deb raher han on ne deb (where public secor asses are need ou) or he presen value of he deb because of daa limiaions. The daa are on a general governmen basis. The se of fiscal variables refers o EA-16. Deb: ousanding, general governmen; oal public revenue: oal curren revenue (i.e. oal of curren axes, social securiy conribuion and oher curren revenue received by general governmen, capial ransfers are no included, ESA 95) (SDW ECB, AMECO); ineres includes flows on swaps and forward rae agreemens, excessive defici procedure (AMECO General Governmen Daa, spring 2009). Romania. Deb: consolidaed general governmen, excluding public deb guaranees (SDW ECB, AMECO and Romanian Naional Bank); ineres, oal governmen expendiure: consolidaed general governmen (IMF Counry Repors). Bulgaria. Deb: general governmen, oal public revenue: general govern men (axes, grans and non ax revenues) (IMF Counry Repors); ineres and oal governmen expendiure: excluding social insurance conribuions paid by he general governmen on behalf of is employees (IMF Counry Repors). Croaia. Deb: general governmen, arrears and guaranees sock are excluded; oal revenue: consolidaed cenral governmen (IMF Counry Repors, Croaian Naional Bank); ineres and oal governmen expendiure: consolidaed general governmen (Minisry of Finance). Turkey. Deb: non financial public secor (i.e. general governmen= cenral governmen plus local adminisraion and funds minus financial insiuions), oal cenral governmen revenue (IMF Counry Repors and Cenral Bank of Turkey); ineres and oal governmen expendiure: cenral governmen (IMF Counry Repors). 46

47 FYROM. Consolidaed cenral governmen for domesic and oal deb while general governmen for exernal deb, cenral governmen revenue (oal revenues and grans), (IMF Counry Repors); ineres and oal governmen expendiure: consolidaed cenral governmen (IMF Counry Repors). Albania: Deb: general governmen, including arrears; oal governmen revenue: axes and grans (IMF Counry Repors and Bank of Albania); ineres and oal governmen expendiure: general governmen (IMF Counry Repors). Serbia (Monenegro was excluded). Governmen guaraneed deb was included while IMF was excluded, general governmen (IMF Counry Repors); ineres and oal governmen expendiure: Minisry of Finance. The daa on primary surplus and primary spending for he years prior o 2003 refer o Serbia and Monenegro. Bosnia-Herzegovina. Deb increases in 2007 reflec he esimaed recogniion of domesic claims and in 2008 he projeced recogniion of domesic claims, consolidaed general governmen (IMF Counry Repors and he Cenral Bank of Bosnia-Herzegovina, Annual Repors); ineres and oal governmen expendiure: consolidaed general governmen (IMF Counry Repors and he Cenral Bank of Bosnia-Herzegovina, Annual Repors). For SEE counries, he daa for GDP (a curren and consan marke prices in naional unis) and for CPI inflaion (2000=100, year averages) are from he daabase of World Economic Oulook, IMF, April For EA-16, GDP ime series (a curren marke prices, ESA 95) are from AMECO. 47

48 48

49 Discussion Panagiois Chronis* Bank of Greece 1. Shor descripion of he paper This paper focuses on deermining he concenraion raes of he Greek banking sysem in he Souh-Eas Europe. In his aemp, he auhors use macroeconomic variables and paricularly fiscal ones, like public deb and deficis as an insrumen in order o deermine he benefis and risks for he Greek banks ha operae in souh-easern European counries. The paper is very ineresing and i clearly required a lo of work by he auhors. In my discussion, I focus on a couple of exensions. Before doing ha and in order o ease my way o hese poins I will go hrough he framework of he paper, seen from anoher poin of view. Le me sar wih he governmen s budge consrain: i shows he relaion beween revenues (composed of axes (T), governmen bonds (B) and seigniorage (S)) and spending (including public spending (G) and he ineres (r) paid on governmen s deb). These can be expressed by he following equaion: ( 1 ) 1 T + B + S = G + + r B where afer he appropriae rearrangemens and dividing by GDP we ge he governmens budge consrain a ime : 1+ r b = ( g ) + b 1 s 1 n τ (1) + *Economic Research Deparmen. [email protected] 49

50 which can also ake he following form. r n b = ( g ) + b 1 s 1 n τ (2) + From hese equaions we can observe ha fiscal policy variables (b, g and τ) are relaed o moneary policy variables (r and s), as well as o he rae of growh of he economy (n). Le me now urn o he banking secor: since he banks include among ohers governmen deb in heir porfolio, he relevan arbirage equaion relaes posiively he ineres rae on governmen s bond (r b ) o he probabiliy of defaul (p) and o he risk free ineres rae (r f ) for example he German ineres rae rb = f rf, p + + Thus, unsusainable public deb, which is relaed o higher probabiliy of defaul, is linked wih a higher ineres rae on governmen s bonds. This explains he way in which he risk for he banking secor is relaed o he macroeconomic as well as o he fiscal variables, and i jusifies he heoreical framework of he paper jus presened. Having said his, I wan o urn now o my suggesed exensions. These include an alernaive way for evaluaing he risk and a suggesion regarding he ineres rae and deb susainabiliy. 2. An alernaive way o evaluae risk In order o esimae he risk, he auhors look a he variance of macroeconomic variables (using he Capial Asse Pricing Model - CAPM) hus disinguishing beween he sysemaic and he unsysemaic par. Alernaively, hey could assume ha he risk of sovereign bonds depends no only on he expeced fuure pah of deb, bu also on is enire probabiliy disribuion. This is jusified by he fac ha, even if he expeced ime 50

51 pah of deb looks susainable, i is possible ha some realizaions of he underlying macro variables (and heir ineracions) will bring i o levels ha are considered (by he crediors) oo high. The likelihood of such realizaions depends on he variances and covariances of he underlying deerminans of he deb raio. The enire disribuion of he fuure deb raio can (alernaively) be seen as a funcion of he naure of he sochasic process ha governs hese variables (aking ino accoun heir ineracion). Thus (following Genberg and Sulsarova 2008) a risk index (for counry i a ime ) can be consruced, as shown: Risk i, b = 1 b i, h i, b i, : he mean of deb o GDP raio for i counry a ime b : he 95 h percenile (or whichever is appropriae) of he disribuion of he deb o h i, GDP raio for counry i a he horizon h. 3. Ineres rae for susainabiliy My second poin is relaed o he real ineres rae he auhors use in order o make inferences regarding he susainabiliy of he governmen s deb. Souh-easern European counries are characerized by boh domesic and foreign deb, each relaed o a corresponding ineres rae (on domesic denominaed deb and on foreign denominaed deb). Hence, (insead of looking a he ineres rae as being composed by he nominal ineres rae less he percenage change of GDP deflaor), an ineres rae ha incorporaes boh a domesic and a foreign componen can be used. In ha case, he real ineres rae can be wrien as he weighed sum of he real ineres on domesic denominaed deb ( d r ) and he real ineres on foreign denominaed f deb ( r ), i.e. 51

52 b r r r b d f d 1 f 1 = + b 1 b 1 where d r : real ineres on domesic denominaed deb f r : real ineres on foreign denominaed deb d b : domesic currency denominaed deb f b : foreign currency denominaed deb b : public deb 4. Susainabiliy Turning now o my las poin, le me firs say ha susainabiliy shows a long-run relaionship ha requires shor-run primary surpluses a a cerain level given by he following equaion: PS * r n = b 1+ n 1 In he paper, i appears ha, a leas for some counries, he snowball effec is very imporan for susainabiliy and also ha here are counries wih primary deficis. This fac reveals he srucural problems relaed o public finance, ha is, he srucure of he ax sysem and spending. These problems are relaed o economic as well as o social facors and heir relaion. They are usually problems ha come from he pas and hey ake a long ime o be resolved (for example, hey require a legal framework, a change on he behavior of he economic agens ec.). However, since he counries are characerized by boh domesic and foreign deb, I would like o sugges an alernaive way of examining he link beween fiscal and 52

53 exernal susainabiliy. This involves he naional income ideniy, which relaes he rade balance o privae invesmen and saving and o primary balance, TB : Trade balance in real domesic currency I : Privae invesmen S : Privae saving D : Primary balance ( ) TB S I D = (3) he evoluion of ne foreign liabiliies, given by he following equaion: e F = e R F TB * + 1 (4) F : Ne foreign liabiliies e : Inverse of average real exchange rae R = 1+ * * r : World ineres facor * r : Foreign real ineres rae and he governmen s budge consrain, B : Governmen s deb B = 1 (1 + r) + B + D (5) R = 1+ r Combining equaions (3) o (5) and afer he appropriae rearrangemens, we end up wih: 53

54 * ( + 1) ( ) ( + 1) e FR F = S I + B R B, Forward ieraion of which, gives he following dynamic equaion: ( S+ j I+ j) F T 1 B T+ 1 e F lim lim * B T R (, j) = T R (, j) + (6) + + j= 0 R (, + j) Thus boh fiscal and exernal susainabiliy requires ha hese wo condiions hold, F R j + T+ 1 lim = 0 T * (, + ) and B R lim + T+ 1 = 0 T (, + j) Or, in oher words, ha in his case he dynamic equaion akes he form shown e F = B + S I + j + j + j + e j F = B + j= 0 R(, + j) j= 0 R(, + j) S I (7) 54

55 Special Conference Papers 3 rd Souh-Easern European Economic Research Workshop Bank of Albania-Bank of Greece Ahens, November Hardouvelis, Gikas, Keynoe address: The World afer he Crisis: S.E.E. Challenges & Prospecs, February Tanku, Alin Anoher View of Money Demand and Black Marke Premium Relaionship: Wha Can They Say Abou Credibiliy?, February Koa, Vasilika The Persisence of Inflaion in Albania, including discussion by Sophia Lazareou, February Kodra, Oriela Esimaion of Weighs for he Moneary Condiions Index in Albania, including discussion by Michael Loufir, February Pisha, Ara Eurozone Indices: A New Model for Measuring Cenral Bank Independence, including discussion by Eugenie Garganas, February Kapopoulos, Panayois and Sophia Lazareou Inernaional Banking and Sovereign Risk Calculus: he Experience of he Greek Banks in SEE, including discussion by Panagiois Chronis, February Shijaku, Hilda and Klii Ceca A Credi Risk Model for Albania including discussion by Faidon Kalfaoglou, February Kalluci, Irini Analysis of he Albanian Banking Sysem in a Risk-Performance Framework, February Georgievska, Ljupka, Rilind Kabashi, Nora Manova-Trajkovska, Ana Mireska, Mihajlo Vaskov Deerminans of Lending Raes and Ineres Rae Spreads, including discussion by Heaher D. Gibson, February Kriso, Elsa Being Aware of Fraud Risk, including discussion by Elsida Orhan, February Malakhova, Taiana The Probabiliy of Defaul: a Secoral Assessmen", including discussion by Vassiliki Zakka, February Luçi, Erjon and Ilir Vika The Equilibrium Real Exchange Rae of Lek Vis-À-Vis Euro: Is I Much Misaligned?, including discussion by Dimirios Maroulis, February Daponas, Dimirios Currency Crises: The Case of Hungary ( ) Using Two Sage Leas Squares, including discussion by Claire Giordano, February