The leaders of Europe will meet this weekend to respond to the rapid deterioration of the economic situation in Emerging Europe. The situation varies a great deal; some countries have been more prudent in their policies than others. But all are joined, more or less strongly, through the deeply integrated European banking system.
Western banks and the Eastern economies
This relationship between the Western banks and the Eastern European economies, to date so mutually beneficial, is now being put to a test. It is not hard, as many commentators have done over the past week, to paint a negative scenario where one or more Western banks drastically cut their support to subsidiaries in the East and trigger nationalisations of these banks in the name of financial stability, setting off chain reactions across the region. The end result would be a massive contraction in credit available to Eastern Europe and enormous losses to Western banking systems.
But this is not what has been happening so far. Lending to the region has contracted, but the fact is that Western parent banks are standing by their subsidiaries. Most banks have to date been refinancing and recapitalising subsidiaries. In some cases the parent banks are actually looking at increases in credit this year. Even in Ukraine, arguably the country in most serious trouble, the foreign banks have committed to recapitalising their subsidiaries to the tune of 2bn euros this year.
Yet, the requirements for the region as a whole are very large. Excluding Russia and Kazakhstan, which can draw on their own resources, the region will need some 150 billion dollars in refinancing and recapitalisation this year alone. This number most likely underestimates the deterioration of bank portfolios, but does not take into account the reduction in credit demand as the recession starts to bite – some reduction in capital flows is only natural as the appetite for new investments dampens in the economic downturn.
The bulk of capital needs will have to come from the Western parent banks and their home country governments. Most of these banks are now under state-led rescue programmes and with some important exceptions the capital requirements in Eastern Europe are modest compared to the size of the parent bank balance sheets and the state programmes. The refinancing and recapitalisation needs of local banks without foreign parents should be addressed by their shareholders or their governments. Shortfalls can be covered by the international financial institutions, primarily the European Investment Bank, European Bank for Reconstruction and Development and the World Bank Group.
Unilateral actions by nations or banks could trigger a banking crisis
The situation is manageable, but it needs to be managed. Unilateral actions by individual countries or banks easily spill over across borders and across institutions. A sudden decision by an international bank to discontinue its support to foreign subsidiaries or restrictions imposed by home countries on the use of state funds for support to these subsidiaries abroad could easily trigger banking crises in the countries where these subsidiaries operate. Similarly, measures by host countries, like nationalisations of subsidiaries or forced conversions of foreign exchange exposures into local currencies, could set off chain reactions either through the balance sheets of the parent banks or simply by inspiring bank runs in other countries.
To date none of these things have happened either, but the pressure is rapidly building up as the global financial crisis deepens. The relations between home and host countries, and between host country governments and their banks, local or foreign, also need to be coordinated. Here again the international financial institutions are playing an important role. Steps have already been taken. In a joint initiative that has been informally underway for some time and was officially announced on Friday, they have been working closely together to bring together the various actors home country by home country, and host country by host country. The have also pledged $25 billion in funding to support the Eastern European banking systems. The additional capital these institutions bring to the table provides valuable incentives for the individual banks to collaborate.
What EU leaders must do
But this coordination, crucial as it is, may not be enough. This is where EU’s leaders come in.
- They must provide a backstop to these efforts and put their weight behind the coordination.
- They must also clearly signal that government-imposed restrictions on parent support for subsidiaries are not acceptable.
In fact, countries that are home to cross-border banking groups must not only tolerate, but encourage flows to subsidiaries in the East.
- They should encourage the European institutions to play their part in this difficult exercise.
This applies to the European Commission, but also to the ECB which may help support a select group of central banks outside the Eurozone with liquidity and foreign currency credit lines.
- The leaders should also indicate that if there is a serious shortfall, additional resources will be available to support the economies of Central and Eastern Europe.
But in order to encourage early action and collaboration it should be made clear that any additional resources will be made available only on conditions that are likely to be much less favourable for all parties concerned. Such additional funds could be channelled under strict conditionality through the IMF or possibly through the other international financial institutions. Conditions might well include forced conversions of foreign exchange exposures into local currency or nationalisations of foreign subsidiaries - all to secure fair burden-sharing between home and host countries and between the banks and the governments.
There is much to suggest that it was the belief that EU’s leaders will stand by Eastern Europe that prevented a full-blown meltdown last week. A failure to show substantive progress this weekend or over the next few weeks could well trigger a new round of speculative attacks. Strong leadership, on the other hand, would likely calm markets and signal that Europe stands behind its model of growth based on openness and integration.