Financial turmoil and Transition Countries Fabrizio Coricelli University of Siena and EBRD Istanbul June 25, 2008

No decoupling, but transition countries have weathered the storm…so far Spreads have increased, from extremely low levels Stock markets have been hit Growth forecast revised downward, but moderately With a few exceptions foreign lending has continued Some countries, Russia in primis is seen as a “safe heaven” by international investors and rating agencies (high commodity prices, large stock of foreign reserves main strength, large presence of the state in the economy)

CDS spreads significantly increased (latest data for March 2008)

Equity markets fell

But risks have increased The transition region has benefited from the surge in capital flows to emerging markets in the past few years Domestic credit has boomed, funded by foreign lending In most countries, credit --and growth-- has been concentrated in real estate, construction and financial sector Transition countries the only area in the emerging world with a current account deficit Largest imbalances in the Baltic states, Bulgaria, Romania and Kazakhstan

Capital inflows: A large share to transition countries (US$ bn )

Current account balance (% of GDP)

Extremely rapid credit growth, though from a low base

Key risks have not been sufficiently noted We may have been looking at the wrong indicators (CA, borowing requirements) Recycling of petrodollars, the cycle in commodity prices and associated inflationary pressure, are perhaps the key issues to look at. Relevance of the Calvo-Talvi view for transition countries (for the commodity exporters of the CIS): they question the relevance relevance of aggregate current account and net capital flows for countries that experienced positive developments in the terms of trade

Recycling of petrodollars IMF estimates that 50% of foreign deposits of oil exporting countries have been channelled through credit to Central-Eastern Europe Credit boom in transition countries funded through foreign borrowing If commodity prices reverse their trend, CEE countries that absorbed large share of commodity surpluses will suffer Commodity exporters in the CIS will suffer as well, if not more

Highest share of bank loans in transition countries Shares in total capital inflows to each region (2007)

Sectoral imbalances and sudden stop (Calvo-Talvi view) Large surplus in the energy sector, combined with growing indebtedness of non-energy sectors, especially non tradables (financial sector, construction and real estate) A sudden stop in capital inflows in these sectors may induce a sharp fall in output Resources of surplus sectors may not be easily transferred to sectors starved with funds. One reason is that the surplus sector may invest abroad (capital outflows). If surplus is in the hand of the state, the transfer may be easier. Example of Kazakhstan

Inflows and outflows

Inflation accelerating Monetary expansion fuelled inflation, together with boom in commodity prices Large share of food in CPI, especially in CIS countries Inflation accelerated especially in countries with peg to the US$: see comparison between Russia and Ukraine Response to inflation: tightening of monetary policy in several transition countries, which combined with possible stop in foreign financing could imply a sharp contraction in output

Share of food and non-alcoholic beverages in CPI basket

Inflation (12-month changes)

A few comments on the episode of sudden stop in Kazakhstan Kazakhstan an interesting case, as it is the only country that experienced a sudden stop following the financial turmoil Such sudden stop has induces a slowdown of the economy but not a deep crisis

Sudden stop in Kazakhstan After the summer of 2007 foreign inflows stopped and domestic credit stopped as well In real terms there was a decline in the stocks Growth slowed down but there was no crisis

Sharp decline in growth rates, but no recession thanks to commodity production

No crisis yet, thanks to high commodity prices High oil and gas prices have helped to avoid a deep crisis, in spite of a sudden stop in capital inflows Role of the State: initial defence of the exchange rate followed by commitment to bail out banks, real estate companies and the construction sector

Government steps in Targeting of resources raised from the energy sector to other sectors in needs of financing Pledge budgetary funds for construction sector Announce readiness to use oil stabilization fund to support banking sector Benefits in the short run, but risks in the longer run, as the reform process slows down.