EBRD Says Financial Integration Worsened Crisis, Urges Reform

LONDON -(Dow Jones)- Eastern Europe's rapid integration into the global financial system has been a double-edged sword for the region, but rather than reverse the process, its risks should be better managed, the European Bank for Reconstruction and Development said Monday.

In its annual report on the progress of reform in the 29 countries in which it invests, the EBRD recommended a range of new regulatory measures designed to prevent future booms in credit, and in foreign currency borrowing in particular.

And with the region facing its deepest downturn since shortly after the collapse of Communism almost 20 years ago, the EBRD said that while a reversal of market reforms is unlikely, future progress is likely to be slow.

The EBRD expects the combined gross domestic product of the 29 countries in which it invests to shrink by 6.3% this year, with the region hit harder than other emerging markets, a fact the EBRD attributes to its greater reliance on foreign capital inflows at a time when they have become scarce.

One feature that distinguishes eastern Europe from other emerging-market regions is the prominent role played by foreign banks, and the region's greater reliance on foreign borrowing and foreign direct investment.

The EBRD said financial integration has helped boost long-term growth in eastern Europe, which until 2008 had expanded rapidly. But it said the "catastrophic" impact of the crisis in the region "has cast a shadow over the model."

"There is evidence that the process of financial integration--particularly large inflows of foreign financing--has contributed to credit booms and foreign currency lending," the EBRD said. "These, in turn, made the crisis deeper and complicated its management."

The privatization of local banking systems, and their sale to western European banking groups, was a key element of the development model followed by many eastern European countries, and one supported by the EBRD.

But the bank said that, far from being a source of weakness, the presence of large international banks had helped prevent a deeper downturn and large currency devaluations after the crisis broke in late 2008.

"Foreign bank ownership seems to have helped to stabilize output," the EBRD said. "The likely reason is that the foreign bank presence mitigated the capital outflow, as parent banks continued to refinance their subsidiaries and branches."

While the EBRD said that financial integration shouldn't be reversed, it did acknowledge that measures need to be taken to prevent a recurrence of the high level of borrowing by companies and households in foreign currencies such as the euro and the Swiss franc.

That meant that when eastern European currencies did depreciate in the wake of the crisis, many borrowers were left with debts they couldn't repay, since the local currency value of that debt rose sharply.

The existence of high levels of foreign currency debt also prevented some central banks from responding to the crisis in the same way as their western European counterparts.

In the knowledge that a large currency depreciation would hit companies and households hard, some central banks had to raise their interest rates to defend their currencies at a time when the European Central bank was slashing its key interest rates.

"The .. region must deal with the bias toward FX [foreign currency] lending, which could continue to pose a threat to stability," the EBRD said.

It said one way of doing that would be to give central banks the power to ensure that inflation rates remain low, since high inflation rates make foreign currency borrowing more attractive.

It also recommended flexible exchange rates, which would make foreign currency borrowing more clearly risky. The EBRD said it is possible that the maintenance of stable exchange rates ahead of future membership of the euro zone encouraged companies and households to borrow heavily in euros. A number of eastern European countries have set target dates for adoption of the euro, which they have repeatedly failed to meet.

But the EBRD also said that direct regulation of foreign currency borrowing should be considered. In its mildest form, this could require lenders to make the risks of such borrowing clear.

Tougher alternatives proposed by the EBRD include higher reserve, capital and provisioning requirements for foreign exchange loans. And banks could be forced to agree to automatic restructuring of foreign exchange loans if the local currency were to depreciate beyond a set level.

The EBRD said that despite the severity of the economic downturn, eastern European countries don't appear to be ready to abandon the development model pursued since the collapse of Communism.

"Elections and political turnover during 2008-09 have not produced any evidence of a political shift against market reforms," the EBRD said. "Indeed, the declared policy stance of governments has either remained the same or become more reform-friendly."

However, the EBRD said the costs of the crisis in economic and social terms make it unlikely that significant reform efforts will be a feature of the next few years.

The one exception to that general prediction, is the Balkans, where potential membership of the European Union should act as a driver of reform, it said.

-By Paul Hannon, Dow Jones Newswires; +44 20 7842 9491; paul.hannon@dowjones.com

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November 01, 2009 19:16 ET (00:16 GMT)


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