Wednesday, December 7, 2011

South East Europe Regular Economic Report

The recovery of global growth that started in 2010 began to weaken in 2011. During the first half the falloff was linked to the Tohoku nuclear disaster in Japan and high oil prices, but by the end of July, temporary effects from Tohoku were starting to fade and global industrial production was rising.However, since August the global economy has come under increasing stress from the sovereign debt problems in Europe, anemic growth in the US, and a slowdown in China and other main emerging markets. The latest leading indicators and forecasts point to a further slowdown in growth in Europe. Meanwhile, risks remain of a double-dip recession in the US and sharper slowdown in the large emerging economies.

Near term developments for SEE6 depend critically on factors that are largely beyond the control of SEE6 governments. As this is being written, leaders of the major EU countries are still seeking to implement a set of credible policies to establish an orderly process for managing sovereign debt in Greece, to prevent risks from spreading to other economies in the euro zone, to recapitalize banks affected by likely sovereign debt write downs, and to establish a more unified and effective fiscal framework for euro zone (EZ) states. Uncertainty over their ability to successfully conclude this process, as well a series of ratings downgrades, stock market volatility and uncertainty over US deficit policies have shaken investor and business confidence and kept consumers wary. Most forecasters have already reduced their projections for global growth in the US and the EU by a percent or more. Our projections are for SEE6 growth of 2.5 percent in 2011 and 2.1 percent in 2012, well below the pre-2008 rates of 6-10 percent.Even these modest growth projections assume that European leaders are able to resolve the crisis in a manner that does not involve a disorderly default and avoids contagion effects. However, should the policy makers fail and the crisis worsen, performance, and the rest of world’s, could be much worse.

The effects of a further global slowdown and the deepening EZ crisis will be communicated to the SEE6 through several channels. The EU, and EZ countries in particular, are the largest trade partners of all the SEE6, countries: trade with the EU is equivalent to between 30 percent and almost half of the SEE6 GDPs. Beyond trade, the EU is also the largest aggregate FDI provider to the region, with net FDI inflows worth over 2 percent of the SEE6 GDP. The presence of foreign banks creates another channel of potential transmission of the EZ crisis to the SEE6: not only is the share of foreign banks in the total assets of the regions’ banking system very large (at around 89 percent of the total), but this foreign presence in some cases involves substantial foreign funding of subsidiary operations. The EU is also a significant source of remittances to the region. All these transmission channels would be affected by deeper EU/EZ economic and financial tensions.

At the moment, banking systems in SEE6 countries appear resilient, with high liquidity and significant capital buffers, but this could change abruptly, especially for specific banks. The SEE6 region is characterized by a comparatively high share of Greek- and Italian-owned banks. Austrian banks also have a significant presence in the region although these banks face less risk in their own sovereign debt market. In tandem with EU-wide calls to increase leading banks’ capital, further stress on their respective parent banks’ funding may put pressure on their local subsidiaries to provide liquidity or dividends to their parents. Moreover, starting in 2009, there was a rapid increase in non-performing loans (NPLs) throughout the SEE6 countries. NPLs have since stabilized in some, but not all of the countries, and they remain significantly above pre-crisis levels. These factors could potentially cause another credit crunch in the region. On the other hand, local subsidiaries currently appear liquid and well capitalized. In addition, most of these banks are subsidiaries, rather than branches and are thus subject to monitoring and regulation by local SEE6 regulators so that rapid unwinding of their positions is not likely. Also the overall level of dependence on foreign funding of SEE6 banks is less than in EU10 countries. This in part reflects the reliance of foreign-owned banks in SEE6 on domestic deposits for funding. There is currently no indication of a run on deposits of the sort that accompanied the 2008 turbulence, although the situation needs careful monitoring. However, foreign financing is an important source for banks’ funding of real sector lending, as direct foreign borrowing by the real sector in SEE6 amounts to about 18 percent of GDP. FDI and portfolio flows typically constitute a more stable funding source. However, FDI to SEE6 has slowed down since the second half of 2008, and is now at about 60 percent of the pre-crisis levels.

The fiscal situation remains fragile and the authorities need to rebuild fiscal buffers and be prepared for further expenditure consolidation should revenue forecasts not be fulfilled as a result of worsening global conditions. During the last few years, SEE6 countries exhausted the modest buffers created in the pre-crisis period of high growth and buoyant revenues. With the exception of Kosovo, no country has sizable deposits to draw down. In addition, the domestic capital markets are shallow and while banks appear to have strong liquidity at the moment, this may rapidly change in case of a sharper slowdown in economic activity. Moreover, access to external financing markets will remain difficult for SEE6 countries in the period ahead. This means few SEE6 countries still have room to accommodate a worsening of the crisis through fiscal stimulus or even through allowing automatic stabilizers to operate and several countries should accelerate fiscal consolidation, especially reforms to enhance longer-term fiscal sustainability. Monetary policy is also constrained in several SEE6 countries by virtue of the exchange regimes they have adopted.

It is important to keep in view the fact that, despite recent turbulence, the growth model based on deeper integration with the EU in terms of finance, trade, labor markets and institutions remains the best one for SEE6 over the longer term. There are two basic lessons to be learned from the recent events that will enable the SEE6 to better exploit the benefits of this growth model. The first is that future growth will need to be driven more by investment and improvements in productivity that enhance competitiveness and productive capacity, and less by the externally financed consumption and investment in real estate and other bubble assets that characterized the pre-2009 period. The second is that there remains in most of the SEE6 countries a lengthy unfinished agenda of structural reforms. These urgently need to be addressed in order to take advantage of the access to markets, and to FDI, bank finance and remittances that the integration-based growth model offers.
World Bank. Document Date:  2011/11/15.Document Type:  Working Paper.Report Number: 65918.Volume No:  1 of 1