Central and eastern European governments and central banks made urgent calls this week for eurozone authorities to do more to help countries outside the currency union amid mounting fears of a systemic meltdown. Hungary, Poland and Romania are lobbying the European Central Bank to broaden the list of eligible collateral for monetary operations by including their local currency bonds, EuroWeek has learnt.
Meanwhile, Gediminas Kirkilas, the Lithuanian prime minister, met European Commission president José Manuel Barroso in private last week to try and convince him of the need for emergency euro liquidity support.In addition to providing more direct support, European regulators should pressure the parent banks of cross-border operators to do more to support subsidiaries in central and eastern Europe, senior Bulgarian and Hungarian central bank officials said.
"Parent banks should accept full responsibility for helping their subsidiaries by providing capital since they should remember the long term viability of central and eastern European economies," Ferenc Karvalits, deputy governor of the Central Bank of Hungary, told EuroWeek this week. Consumers and companies in these countries have in recent years taken advantage of cheap credit to borrow heavily, contributing to very high debt levels and external imbalances. Bulgarian and Estonian external debt levels are 101% of GDP, while Hungary’s debt stands at 96%.Local subsidiaries of Swedish, Austrian and Italian banks have largely funded the consumer spending and private investment boom that has powered regional growth.
Now the global credit party is over, a dramatic cutback in funds from parent banks is on the way and local currencies have plummeted. This is paralysing efforts to service the large stock of foreign currency debt, while policy tools to boost euro liquidity in transitional economies are limited.
Rescue for Hungary
Hungary was forced to secure a $25bn rescue package from the IMF and the European Union in October to stave off financial collapse. Earlier that month, the ECB provided around Eu5bn of foreign exchange swaps. However, Hungary’s high level of financial integration with the euro area — just like other regional economies — has increased the risk of financial dislocation despite its near term budgetary support.
For example, foreign investors hold about 40% of forint-denominated government bonds and as the flight to the safety of US Treasuries and German bunds takes hold, spreads have widened and sovereign credit protection.
EU and ECB attempts to stabilise banking systems in eurozone economies have undermined the relative positions of central and eastern Europe’s external financing. Local subsidiaries of foreign banks in the region are generally not covered by deposit guarantee schemes of the parent country, making those operations riskier and putting them at a competitive disadvantage.
As the ECB has provided direct liquidity for eurozone banks, external banks have found it more difficult to obtain foreign exchange liabilities on the interbank market. This has made local operations particularly illiquid since parent banks supply foreign exchange to their eastern European subsidiaries via short term instruments. Moveover, the eligibility conditions for ECB refinancing preclude holdings of local currency denominated bonds of the new, non-eurozone members.
These measures — together with the unprecedented deleveraging of financial institutions as they shore up their capital base — have made parent banks more reluctant to commit their balance sheet to local subsidiaries.
Demands for equal treatment
Karvalits called for the EU and ECB to "consider supporting liquidity in the banking system in non-euro areas". He argued that European banking regulators should pressure parent banks to commit balance sheet strength to local operations.
Tsvetan Manchev, deputy governor of Bulgaria’s central bank, echoed these calls, but was confident that western banks would stay committed to the region because of its stronger relative growth prospects.
"The managers of these banks know the profitability and opportunities in regional markets so they should be able to agree good budgets with their headquarters," he told EuroWeek.
Emerging European economies have limited capital to provide refinancing tools for banks and they are unable to guarantee credit activities since this would cause contingent liabilities to impair sovereign creditworthiness.
Hungarian, Polish and Romanian authorities are lobbying the ECB to start accepting local currency denominated bonds of non-EMU member countries for monetary operations. However, analysts are sceptical about the chances of this plan being taken up. "This is not politically feasible because of the enormous financial commitments," Klaus Schmidt-Hebbel, chief economist of the OECD told EuroWeek.
"The moment Austrian banks get coverage due to their exposures in places like Hungary and Bulgaria, the Spanish banks will claim some rights to give subsidiaries guarantees on their exposure to local currency in Argentina and Brazil," he said.
The same eastern European authorities are calling for foreign exchange swap arrangements between economies outside the eurozone and the ECB to boost euro illiquidity.
This is analogous to the US Federal Reserve’s dollar swap line to systemically important economies, such as Brazil, Mexico, South Korea and Singapore, which was announced in November. Poland — which is expected to record positive economic growth next year along with the Czech Republic and Slovak Republic — secured a temporary euro/Swiss franc swap line with the Swiss National Bank to boost Swiss franc liquidity in the country last week.
However, the ECB is reluctant to offer similar support. "I am not sure if the ECB would do anything like that for these countries since they are relatively small so are less systemically important in international financial markets," said Schmidt-Hebbel.
EuroWeek has learnt that Lithuania’s met European Commission president José Manuel Barroso in private last week to convince him of the need for emergency euro liquidity support. But European authorities are reluctant to take such measures because of concerns of moral hazard and the subsequent spike in contingent liabilities in supporting non-eurozone economies.
Painful adjustment looms
Eastern European finance ministers and central banks do not have the policy tools to stabilise credit conditions in domestic markets. For example, Hungary and Romania have a large stock of foreign currency financing, so lower interest rates would further weaken their currencies and increase the cost of debt in euros and Swiss francs. Currency volatility would trigger capital outflows as well as household and corporate defaults, hitting financial stability.
Bulgaria and Romania have powered through the global downturn and registered growth rates of 7.1% and 9.3% in the second quarter of this year, respectively. But with unsustainable double-digit current account deficits, analysts say fears of a systemic meltdown have overtaken concerns of a hard landing.
"Bulgaria has significant imbalances that need to be funded, but since the country has a fixed exchange rate, the economy will bear the brunt of the serious adjustment once capital outflows take effect next year," said Lars Christensen, chief analyst at Danske Bank. But Bulgaria’s Manchev said, "We will not be that badly impacted in deleveraging since the savers and investors in Bulgaria are the one and the same," he said.
In the Baltics, Latvia and Estonia are already in recession. As exports and credit expansion drop, there are growing expectations that Lithuania will be next. These states have fixed exchange rates to the euro. As a result, they have no independent monetary policy and exchange rates cannot act as a shock absorber against capital volatility and external pressures. A painful and abrupt adjustment in wages, nominal prices and a jump in foreign currency debt servicing costs are therefore expected.
Against this backdrop, there is mounting discontent that western policymakers are failing to help after forcing transitional economies to chain their fiscal and monetary policies as a pre-condition for eurozone convergence. Eastern European authorities are accusing the EC and ECB of being distracted by the meltdown in developed markets and of banking on the IMF as lender of last resort to provide aid in the event of financial collapse.
"Ever since the enlargement of European agenda, they have promoted the openness of the banking system and the idea that the eurozone was mutually beneficial on both sides," said deputy Hungarian central banker Karvalits. "The integration that serves us in the good times should not change when things go sour, especially given the level of EMU integration since a chain reaction could result in serious dislocation for those in the euro zone and outside."