The impact of the Global Finanical Crisis in Europe & CIS/Broader Considerations

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What follows highlights issues that may be worthy of consideration over and above the country risks documented in The impact of the Global Finanical Crisis in Europe & CIS:

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Whither Russia?

Will Russia escape the worst of the global financial crisis? In a number of respects, prospects do not look terribly promising. Despite extensive intervention by the Central Bank of Russia (CBR) on the foreign exchange market, the rouble lost some 15% of its value against the dollar between the Russo-Georgian war in mid-August and the mid-November. Russian stock markets lost two thirds of their capitalisation between mid-July and mid-October; and slumping world oil and metals prices could (according to some forecasts) push Russia’s perennial current account and budget surpluses into deficits in 2009. Standard and Poor’s on 23 October downgraded Russia’s sovereign credit rating from stable to negative, echoing sentiments of investors who began dumping Russian assets during the Russo-Georgian war in August. The CBR’s reserves, which had climbed to a record high of $594 billion in July, had dropped by $110 billion (to $485 billion) by mid-November. On the other hand, since most Russian companies do not raise capital on Russian capital markets or borrow abroad, the ultimate impact of these developments on production, incomes, and employment may be less than the headlines suggest. Likewise, Prime Minister Vladimir Putin does not believe that Russia’s financial straits are serious enough to preclude offering rescue packages to the governments of Iceland (€4 billion) and Belarus ($2 billion). Nor has Moscow felt a need to touch the $80 billion (and growing) in foreign exchange held in its off-shore reserve and national wealth funds. Moreover, the government and Central Bank of Russia (CBR) have set aside some $200 billion to shore up the banking system and help large corporate borrowers repay their external debt obligations.


Of greater importance may be the fact that many of Russia’s most important companies are facing sharp declines in export prices. Russia’s oil industry is feeling the effects of sharply lower oil prices; press reports indicate that Russia’s oil output in 2008 may decline, for the first time in nearly a decade[1]. JPMorgan’s global industrial metals price index (i.e., prices for steel, aluminium, nickel, platinum, copper) dropped by more than a third between mid-July and mid-October. Russian press reports describe growing numbers of layoffs and arrears to electricity suppliers from mining and metallurgical companies. Measures to stabilise the Russian banking system could turn out to be irrelevant if world oil and metals prices don’t bottom out soon.


The importance of these questions goes well beyond the welfare of the 143 million citizens of the Russian Federation. As the events following Moscow’s August 1998 default on its roubledenominated debt showed, when Russia catches cold, the rest of the CIS sneezes. Russia has been a key driver for the other CIS economies’ recovery from the transition recession during the past decade: according to CBR data, Russia’s imports from other Soviet successor states19 more than tripled during 2000-2007; products that can not be easily sold on other markets comprise an important share of these imports. The stock of foreign direct investment by Russian companies in other Soviet successor states had reached $33 billion by the end of 2007; annual service exports from Russia to these countries rose to $8 billion last year; while remittances paid out to other Soviet successor states soared to $14 billion. A significant growth slowdown in Russia could therefore have major implications for poverty across the CIS.

Kazakhstan: Success story, or harbinger of things to come?

In many respects, the financial crisis for Kazakhstan began in mid-2007, as a splurge of borrowing by leading banks and companies caused Kazakhstan’s foreign debt to triple, from $33 billion in 2004 to some $100 billion in 2007. As the data in Table 2 show, Kazakhstani borrowers face a tough repayments schedule in 2008-2009. These trends already in 2007 convinced foreign lenders (and the ratings agencies) that many of these borrowers had lost their creditworthiness; external refinancing for these companies therefore dried up. At the same time, inflationary pressures accelerated, with the run-up in global energy and food prices (and thanks also to a real estate bubble, boosting housing costs). The government and National Bank of Kazakhstan (NBK) responded by slowing monetary growth and raising interest rates to defend the tenge and reduce inflationary pressures. Official foreign exchange reserves were used to refinance Kazakhstan’s banks and corporate borrowers, while budget subsidies for construction, agriculture, and other credit-sensitive sectors increased. A year later, the dire outcomes predicted by some commentators had been avoided—thanks in part to continued high prices for Kazakhstan’s oil and metal exports. Official reserves (held by the NBK and in the off-shore national reserve fund) continued to grow, the exchange rate held, and inflation did not spiral out of control. Still, GDP growth had by mid-2008 been cut in half, and outgoing remittances from Kazakhstan to other CIS countries had dropped—even before the economy began to absorb the terms-of-trade shock associated with falling energy and metals prices. At the October 2008 IMF/World Bank meetings in Washington, officials announced the creation of a $1 billion fund to support Kazakhstani banks, backed if necessary by monies from the reserve fund.


Whether these measures prove sufficient remains to be seen. Despite this, the Kazakhstani case may be of broader regional importance for two reasons: (1)as an example of a relatively successful policy response to the financial tensions now affecting other transition and developing economies; and (2) as a bellwether for what could happen in other, similar economies. Should similar trends take hold in Russia, for example, declines in outgoing remittances and investment flows could have a significant impact on poverty in neighbouring countries—particularly in Central Asia, the Caucasus, and Moldova.

Is market reform the solution—or the problem?

Some observers have argued that the severity of the impending financial crisis seems to be positively correlated with the extent of market reforms adopted by transition economies—particularly in the financial sector. On the one hand, countries like Turkmenistan and Uzbekistan that have been relatively uninterested in economic integration (global and regional) and have often refused the financial assistance and policy advice offered by the Bretton Woods Institutions seem to be relatively unaffected by global financial developments. At the other end of the spectrum, many of the countries now taking the biggest hits—the Baltic States, Hungary—have until now been seen as transition successes, having attracted some of the region’s highest levels of cumulative per-capita FDI. Within the CIS, some of the economies that now seem most vulnerable (e.g., Kazakhstan, Ukraine) also have the CIS’s most developed financial systems.


Such comparisons are certainly provocative, and may be particularly useful in forcing deeper reflection about regional drivers of contagion. But on deeper reflection, they prove wanting, in a number of respects. First, most of the region’s wealthiest, most successful transition economies (e.g., Czech Republic, Poland, Slovakia, Slovenia) have also remained largely immune (thus far) from the global financial crisis[2]. Second, while Turkmenistan’s and Uzbekistan’s relative economic isolation affords them certain insulation from global financial turmoil, it is really their very large (15-25% of GDP) current account surpluses, reflecting their status as exporters of gas, cotton, metals, and other primary products, that provide this protection. These large surpluses come at a cost, in terms of significant capital exports, lower domestic living standards, and higher income poverty levels than would otherwise be the case. It is telling that Belarus—which since the mid-1990s has pursued broadly similar economic policies (and not without some measure of success)— but which has typically reported current account deficits, has requested assistance in covering its financing gap from both the IMF and Russia. The Belarusian example suggests that the retention of Soviet-type financial institutions by itself does not offer much protection from global financial instability.


Third, a closer look at the Hungarian, Estonian, and Latvian cases underscores the damage that can be done by ineffective (or unwise) macroeconomic policies during period of heightened global risk. Hungary in the current decade has been a perennial under-performer in terms of growth and fiscal management. Almost alone in the region, and despite exceptionally benevolent global emerging market conditions, Hungary since 2001 allowed unfavourable public debt dynamics to take hold, on the back of large fiscal deficits. While Hungary’s current account deficits have not been the region’s largest, they have been driven in part by the capital inflows needed to finance fiscal imbalances. In Estonia and Latvia, by contrast, the recessions of 2008 reflect the inevitable contraction of unsustainably large current account deficits that were due almost exclusively to private sector borrowing—often times within the confines of the (Scandinavian) multinationals that privatised the Baltic States’ financial and energy sectors. Offsetting the “overheating” effects of these inflows would have required the adoption of fiscal policies that, in the EU27 context, can only be described as exceptionally tight[3]. Popular expectations about catching up with living standards in the EU15 (and especially Scandinavian) countries, and legitimate concerns about the effects of exceptionally tight fiscal policies on poverty and social exclusion, made very large fiscal surpluses political non-starters. Whether the social hardship now resulting from the Estonian and Latvian recessions exceed what would have happened earlier in the decade if even tighter fiscal policies had been adopted is an interesting question that is difficult to answer unambiguously.


Rather than denying the desirability of financial market reform and integration, current developments in the region seem on balance to reinforce old lessons about the risks of permitting easy money and buoyant asset markets to generate large macroeconomic balances. Still, should matters deteriorate further and growth in more countries falter—particularly in the event of a pan- European downturn, or capital outflows from local subsidiaries of distressed G3 banks and other multinationals—provocative arguments about the links between financial sector reform, regional and global economic integration, and macroeconomic stability will be difficult to dismiss.

Possible implications for the global financial architecture

For much of the past decade, the IMF and World Bank seemed to have been marginalised, both globally and in the region. Policy makers in many developing and transition economies saw the lessons of the Asian and Russian financial crises of 1997-1998—which IMF/World Bank financial support was unable to prevent, and whose “Washington consensus” was blamed for causing or exacerbating the crises—as underscoring the imperative of developing massive foreign exchange reserves. The size of these war chests, along with the huge volumes of private capital being invested in emerging markets globally, seemed to make IMF and World Bank lending irrelevant or unnecessary. The strong regional and global growth also removed many countries’ eligibility for concessional lending, allowing many of them to attract private capital at lower interest rates[4]. This shrinking pool of interested borrowers also weakened the Bretton Woods Institutions'abilities to lend concessionally to low income and less developed countries (via implicit cross-subsidisation from income earned on loans made to middle income countries). By highlighting its weaknesses in graphic detail, the current crisis has (once again) underscored the need for reform of the global financial architecture. Closer regulation of global financial flows, better macroeconomic policy coordination among the world’s largest economies, and possibly an international lender of last resort—these reform themes suggest a renewed role for the Bretton Woods Institutions. Likewise, the numbers of developing and transition economies—now including Hungary (and possibly the Baltic States), as well as “traditional” borrowers in the Balkans (including Turkey), Western CIS, the Caucasus, and Central Asia—whose need for balance-of-payments and development lending now seems set to expand. This could put the Bretton Woods Institutions “back in business”.


On the other hand, the mid-November “Bretton Woods II” G20 summit in Washington underscored the ambitious (if not unrealistic) nature of such arguments, in a number of respects. First, it is not clear that the additional funds that would be needed to discharge a broader or deeper set of responsibilities will be forthcoming. This is particularly the case since: (i) the largesse of the Bretton Woods Institutions' traditional supporters—the G3 countries—seems likely to be constrained by the same crisis phenomena that are (arguably) making the Bretton Woods Institutions more necessary; and (ii) it is not clear that the countries with the greatest abilities (at the margin) to increase the Bretton Woods Institutions' capitalisation (e.g., China, India, the Gulf States) are in fact willing to doing so in the absence of a more fundamental rebalancing of the global governance architecture (including reform of the United Nations Security Council). Instead, the growing role of sovereign wealth funds may signify new inroads of bilateralism into global governance structures. In any case, the lessons of the 1997-1998 East Asian and Russian financial crises strongly suggest that, in an era of global capital mobility, the demands for increased balanceof- payments and development lending could easily overwhelm even an expanded supply of such funds—particularly if (as does not seem impossible) a number of large emerging market countries were to undergo full blown currency crises simultaneously. Instead, like other global governance institutions (e.g., the post-Doha WTO, or the UN), the Bretton Woods Institutions seem likely to find themselves without the resources or instruments needed to effectively combat the staggering challenges now being placed before them.

Whither the Euro zone?

The ECB’s money and credit policies have until now possessed certain “regional public goods” properties vis-à-vis the new EU member states and candidate countries. Because investors have viewed the ECB as guarantor of price and financial stability in Europe and because they have believed that the new member states will one day adopt the Euro, investors have been willing to take long positions in assets denominated both in Euros and in “near-Euros” (e.g., the zloty, forint, koruna). This helped boost foreign direct and strategic (e.g., pension fund) portfolio investment in the new member states and candidate countries, which in turn deepened financial systems, provided (apparently) long-term financing for current account deficits, and ensured price and exchange rate stability within the EU27. Some of the benefits of the Euro zone have therefore spilled over to new member states and candidate countries—many of which had experienced speculative attacks on their currencies in the 1990s.


This now appears to be changing: the forint has come under attack, and investors are questioning the sustainability of the Baltic and Bulgarian currency boards. This raises some big questions for the ECB, both in terms of its credibility within the Eurozone and in terms of its ability to provide “regional public good” services. For example:

  • How much liquidity would the ECB be willing to provide the National Bank of Hungary, in order to protect the outer defences of Europe’s exchange rate system?
  • Would a full blown currency crisis within the EU (e.g., affecting the forint) seriously damage the ECB’s credibility?
  • How much would a full blown currency crisis in one of the new member states affect the Euro zone’s prospects for expansion? If Brussels were to “permit” (or be unable to prevent) he forint or one of the region’s currency boards to collapse, would this further weaken interest in Euro adoption in Warsaw, Prague, and elsewhere (London? Copenhagen?)?
  • So far, prevailing sentiment would seem indicate that, on balance, developments have strengthened the desire of EU countries that are not in the Euro zone (e.g., Denmark) to adopt the Euro. On the other hand, the flight from Euro- and into dollar- and yendenominated assets (since mid-July the Euro has lost more than 20% of its value against the dollar) suggests that the ECB’s credibility, and the Eurozone’s attractiveness, is in fact being threatened by the global financial crisis.

Possible implications for UN(DP)

These could occur along a number of dimensions:

First, the global financial crisis seems likely to give the World Bank and IMF a new lease on life, at least initially. The current account deficits and refinancing burdens facing so many RBEC countries make greater roles for the Bretton Woods institutions inevitable. This will increase the importance of working well with these institutions, particularly within the context of macroeconomics for poverty reduction, economic governance, and sectoral reform, particularly in the energy sector[5].


Second, the impact of the global financial crisis will push poverty reduction programming (and related activities) closer to the heart of UN(DP) programming in the RBEC region. PRSPs, national development strategies (maybe even including the MDGs!), and clearer programmatic linkages between poverty reduction and our governance, energy and environment, gender, capacity development, and (especially) crisis prevention work seem likely to become more important. In contrast to the 1990s (when the UN system’s presence in much of our region had a less mature character), we now seem much better placed to understand the complexity of these issues, and to provide more value added to national and regional partners. Our abilities to link macro policy dialogue on poverty and vulnerability (in which we will nearly always play a junior role vis-à-vis the Bretton Woods Institutions) with the capacity to work effectively on poverty reduction and social inclusion at sub-national levels (where the Bretton Woods institutions typically do not go) could be extremely important. In particular, the design and implementation of projects to measure and monitor poverty and vulnerability by gender, ethnicity, age, and locational criteria, and with capacity development projects for the national and sub-national institutional consumers of the data produced by these instruments, could be particularly important.


Third, the global financial crisis underscores the importance of integrating macroeconomics into UNDP’s crisis prevention work. While the recent publication of Post Crisis Economic Recovery: Enabling Local Ingenuity is a hopeful development in this respect, it is ironic that this should be published on the eve of a global economic crisis that could produce development setbacks on an unprecedented scale—setbacks that would have little, if anything, to do with armed conflicts (or natural disasters). UNDP’s risk management work that focuses on threats to human development and human security should therefore be broadened to encompass macroeconomic early warning and financial stability. While we will never be able to compete with the Bretton Woods institutions in these areas, our work in crisis prevention, the macroeconomics of poverty reduction, or economic governance may not be complete if we don’t address these risks more directly.


Finally, a global recession means that less income will be captured as tax revenues by the OECD-DAC governments that provide the bulk of the voluntary contributions that fund the UN’s work. This could easily translate into reductions in core project and administration budget funding across the UN system, including in UNDP-RBEC. It could also make the mobilisation of non-core project funding more difficult—especially from G3 countries. This will only increase the importance of raising funds from non-traditional donors, and of doing more with the (limited) resources at our disposal.

References

  1. Spot prices on the world oil market dropped from $150/barrel in July to under $60/barrel in mid-November
  2. Whether the Central European countries continue to weather the global financial storm remains to be seen. The large shares of these open economies’ exports that go to the EU15 countries underscore their vulnerability to a deep, prolonged pan-European downturn
  3. Whereas Latvia reported small and declining (as shares of GDP) general government budget deficits during 2001-2007, Estonia reported general government budget surpluses in excess of 2% of GDP during this time
  4. For the RBEC countries that joined the EU in 2004 and 2007, access to significant post accession grant finance under the structural and cohesion funds further reduced the de facto cost of capital
  5. Whether these institutions will be able to take advantage of their new “lease on life” may depend on their ability to obtain significant and durable increases in their capital bases (as argued above, there are reasons to be doubtful about this), and whether viable “alternative” development paradigms emerge and consolidate

See also

The impact of the Global Finanical Crisis in Europe & CIS


The impact of the Global Finanical Crisis in Europe & CIS/Tables

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