CEE countries have so far not experienced any heavy deleveraging. Countries which introduced a ban on new FX loans for households may face smooth reduction of foreign funding. Combined FDIs and net EU flows, which represent non-debt financing, now cover the entire current account in almost all CEE6 countries
Global deleveraging has raised concerns about the CEE region and its funding. Over the last year, international banks have been reducing their cross-border lending to banks almost everywhere in Europe, apart from countries with a triple A rating (the core euro area plus Scandinavia). The euro area periphery was hit hard. UK investors were among the most active in reducing their large exposures. We analyzed cross-border lending to the CEE6 region represented by Croatia, Czech Republic, Hungary, Poland, Romania and Slovakia. Fortunately, CEE6 has not been neither in the direct nor indirect axis of this heavy deleveraging. This is because Austrian banks, which dominate in funding of the CEE6 region, do not rely too much on funding from the UK and the periphery. Outstanding direct funding to the CEE6 region by Italian banks, which are heavily involved in the region through their subsidiaries, is at a very low level and does represent a slight risk for a reduction of overall external funding.
Despite that, foreign liabilities of banks have been declining in some CEE6 countries, especially in those with a large share of FX loans which have been declining due to regulatory constraints or intervention. Countries which introduced a ban on new FX loans for households may experience a smooth reduction of foreign funding which becomes obsolete once the bank cannot rollover redeeming FX loans for households into a new business. But no massive reduction of exposure to CEE6 is expected from parent banks. Furthermore, the domestic deposit base has been increasing across the board, shifting the weight more towards the desired model of domestically- funded assets. Hungary was a special case, where the early repayment scheme for Swiss franc loans reduced the overall balance sheet of the Hungarian banking sector, including FX liabilities and deposits over the last year.
Given that many CEE6 countries have efficiently narrowed their current accounts deficits, the slowdown of capital inflows does not endanger the economic and financial stability of the CEE6 region as much as in the period right after the Lehman collapse. Demand for net external financing halved compared to the pre-Lehman period (to about EUR 25bn). In the meantime, net EU flows have more than doubled in the last year (to EUR 18bn). Countries enjoy a strong portfolio capital inflow, especially into government bonds, which offset denting cross-boarder loans. But more important is that combined FDIs and net EU flows, which represent non-debt financing, now cover the entire current account in almost all CEE6 countries.
Data recently published by the Bank for International Settlement revealed that global banks scaled back their cross-border asset holdings by USD 800bn in 4Q11, the sharpest decline since the global interbank market froze in 4Q08, shortly after the collapse of Lehman Brothers. Euro area banks were strongly affected by deleveraging; cross-border claims on banks in the euro area fell USD 364bn, according to a BIS report1. Deepening of problems in peripheral euro area countries and fears of contagion among sovereigns and banks could be blamed for that. Last but not least, higher capital requirements to be met by EU banks by the end of June 2012 could spark deleveraging as well. The World Bank report2 released in June concluded that syndicated loans to Emerging Europe have shrunk considerably in the first four months of 2012.
British banks most aggressive in cutting cross-border lending
It is quite fascinating to look more deeply at the origin of deleveraging. The geographical breakdown of cross-border liabilities of BIS reporting banks hints that British banks and US investors were the most aggressive in squeezing their cross-border lending to other banks across the globe in 4Q11, followed by German and Dutch banks. The ECB quarterly data3 on the balance sheets of European banks reveal that almost the entire reduction of cross-border lending to German banks in 4Q11 was triggered by UK investors.
Cross-border lending to safe havens has been increasing at expense of peripheral countries
However, the decline of cross-border lending of UK banks to German banks was very short-lived. The quarterly balance sheet data collected by the ECB shows a sharp rebound of lending of UK investors to German banks, on the back of further deleveraging in peripheral euro area countries. It is hard to overlook the pattern among European banks, according to which foreign liabilities increased only for banks operating in countries with a triple A rating. It is very important for the CEE region that Austria and Germany, the two main trading partners and investors in CEE, have been among the most resilient to global deleveraging.
In international context, deleveraging very limited in CEE6, apart from Hungary
Despite massive cross-border deleveraging in peripheral euro area banks, we could see hardly any substantial reduction of foreign funding of banks in CEE, except for Hungary. In Poland, foreign assets have remained flat y/y as of March 2012; in the Czech Republic, they even slightly increased (despite the country not having a triple A rating). The low level of public debt and relatively small size of the banking sector put CEE economies at lower risk compared to many highly-leveraged euro area economies, where problems in the banking sector (Ireland, Spain) or public finances (Greece) caused a negative feedback loop between both sectors. Fortunately, in this respect, Hungary is an outlier in CEE. Relatively high public debt and the low predictability of economic governance, in addition to unorthodox measures resulted in a reduction of both sides of Hungarian banks' balance sheets (by a little more than the early repayment of Swiss franc loans would imply).
Austrian banks get minor funding from banks that might be in hotspot of deleveraging
The speed of deleveraging in the euro area banking sector will be decisive for the future development of cross-border lending to the CEE6. The hottest candidates for primary deleveraging are UK banks; the next in line are banks in peripheral euro area countries, which will be under pressure, on concerns of a vicious circle of mounting sovereign debt, low growth outlook and struggling banks. Fortunately, CEE6 and even Austrian banks, which are the backbone of funding of the CEE6, only get a little funding from the above- mentioned countries that are prone to deleveraging.
Parent banks keep their funding relatively stable
It is a little bit of a surprise that Italian banks, which are also strongly present in the region via their subsidiaries, provided very little of direct funding to the CEE region. Thus, the increased pressure on Italian banks does not necessarily put their CEE subsidiaries under funding pressure (size-wise).In any case, how firmly will Austrian banks hold onto their exposure in CEE6 if there is renewed pressure? Given the absence of a new Vienna Initiative, parent banks are no longer obliged to explicitly keep their stable exposure. We think that the Vienna Initiative played a crucial role during the assembly of the IMF & EU programs three years ago, without which the IMF could not be sure whether the financial package would have been big enough for smooth financing of the balance of payments. Today, the situation is slightly different, as the original IMF programs have already matured and CEE countries have considerably reduced their external imbalances.
Ban on FX loans might contribute to reduction of foreign funding in mid run
But even without a new Vienna Initiative, it is unlikely that European parent banks would spontaneously liquidate their exposure to CEE markets. However, there is a chance that parent banks might reduce the funding of their subsidiaries, if there is strong deposit growth on the domestic market and FX liquidity cannot be placed in new FX loans. Given that many CEE countries introduced restrictions on FX lending to households in recent years, FX debt redemptions can indeed slowly contribute to a reduction of foreign liabilities in the mid run (unless the FX liquidity is used for funding FX credits to the corporate & public sectors). But no massive reduction of exposure to CEE (especially on a consolidated basis) is expected.
Net capital inflows into CEE6 totaled EUR 36bn in 2011
While we do not see a major risk of abrupt deleveraging in CEE, the capacity of European banks to increase their cross-border lending to CEE seems to be rather limited. The global deleveraging raised concerns about the CEE region and its funding. Last year, CEE6 countries attracted net foreign capital inflow worth EUR 36bn in total - about half of the inflows in the peak year of 2007, but about the average volume in the period of 2002-06.
Asian companies start to rank high among top exporters in CEE
It is very likely that CEE countries will witness a moderation of FDI inflow, due to the negative effect of the global economic slowdown on investments and profits in 2011. However, having German and Austrian companies among their top investors has an advantage, as their production is highly competitive and companies there are among the least stressed by deleveraging in the banking sector. After the integration of new member states into the EU, we could see an increased footprint of Asian companies in the region. Their presence in the CEE region offers perfect access to the common EU consumer market, with labor costs at a reasonable level. At present, two of the top three exporters in Slovakia and the Czech Republic are Asian companies, so the CEE is no longer solely a German manufacturing hub. We expect that Asian companies will continue to reinvest their profits in the CEE region in future years.
No sharp sell-off of CEE6 government bonds
Despite persistent tensions on the sovereign bond market in peripheral countries and ongoing deleveraging in the European banking sector, we have not seen any sharp sell-off of government bonds in the CEE6. There were some periods in 4Q when governments were facing lower demand in primary auctions in some countries, due to elevated uncertainty in Europe. However, since the beginning of this year, demand has resumed.
Boosted foreign demand for government securities after two rounds of LTROs
The LTRO programs launched by the ECB in December and February helped to increase foreign demand as well. Domestic yields have collapsed and CEE governments have good access to foreign markets. Almost every government was active on foreign markets issuing Eurobonds in 1Q12. The European Commission has been positive on fiscal consolidation in CEE so far and predicts that countries will bring their deficits below 3% of GDP by 2012 (or 2013 at the latest).
Net inflow of EU funds has doubled over last three years
It seems that, besides the moderated FDI inflow, portfolio investments will be the main source of external funding of the CEE region. Will it be enough? Given that many CEE countries have efficiently narrowed their current accounts deficits, the slowdown of capital inflows does not represent a big risk to the economic and financial stability of the CEE region, in contrast with the period right after the Lehman collapse. The financing of the balance of payments has improved, due to the sizable inflow of EU funds in recent years. That is a game-changer in the external financing of the CEE region. Net EU flows, which are channeled through the current account and capital account, have more than doubled for the CEE6 (to EUR 18bn in 2011) over the last three years.
Less external borrowing is needed, due to narrowed CA deficits and boosted inflow of EU funds
The need for external borrowing has been substantially reduced for CEE6 countries. This makes the region less vulnerable to global deleveraging compared to 2008. Combined FDIs and net EU flows, which represent non- debt financing, now cover almost the entire current account in all CEE6 countries. This is not the case for Romania, which has been lagging in drawing EU funds compared to its regional peers. It also took several years for other NMS countries that joined the EU three years earlier to improve the quality of projects and increase absorption capacity.
Polish government bonds looks to be most neutral investment for coming months
Europe has apparently been moving faster toward the crossroads of deeper integration or disintegration. While cross-border deleveraging within the euro area and home-bias investment policies of local banks and their regulators could be seen as effective (financial) disintegration, at the end of the day, we bet on deeper integration. However, a lot of volatility is expected to continue on the market. If the ECB restored some of their extraordinary tools (LTRO, SMP), it would have a positive impact on portfolio capital inflows. We see the highest investment opportunity in investing in 10Y Hungarian government bonds, where the yield is to collapse below 7% (-100bp) once the new IMF program is put in place. Yields have already declined 100bp relative to levels seen in 1Q, but any serious conflict hindering negotiations with the IMF could send yields back to these levels. Czech bonds would be a very conservative investment for investors who want to bet on persisting high risk aversion in Europe. However, if European policy makers make progress towards higher risk sharing in the euro area, Czech yields would likely follow the upward correction of German yields. Polish government bonds looks to be the most neutral investment for the coming months. The deeper view on EU flows into Poland's economy shows that financing of the widened CA does not need to be as challenging as one would have thought. The inflow of EU funds, which was boosted by construction works ahead of the Euro Championship, is likely to decelerate, with the lower investment activity to result in a narrowed CA deficit.
Country specific comments of country analysts:
Alen Kovac on Croatia: Banking sector related deleveraging risks so far have not materialized, as foreign banks increased their exposure over the last 4Q by approx. 10% (EUR 1bn ~2% of GDP). Increased foreign liabilities were utilized to allow modest growth on the credit side, as deposits struggled to maintain growth rates amid suffering liquidity in the corporate sector. Talking in terms of euroization, one should note that a historically high level of euroization is predominantly driven by strong local preferences towards FX (predominantly euro) savings, while from a historical perspective the euroization level tends to increase during periods of uncertainty. Access to FX liquidity via external funding plays a secondary role from our point of view. In terms of FX structure, developments were broadly stable in recent quarters, despite nominal figures for FX loans being inflated by a stronger EUR and CHF vs. HRK. A stable proportion of domestic currency loans thus suggests somewhat stronger bank efforts in this segment.
Petr Bittner on the Czech Republic: Czech banks remain in a very comfortable liquidity position. With the loan-to- deposit ratio remaining at the same level of around 75% for four years, they have no need to finance client loans externally. In addition, there are no signs of a noticeable slowdown of client deposit growth. As for external financing, Czech banks are quite isolated from foreign markets, with a positive net external position around 5% of GDP and total external liabilities at 10% of GDP (or 8% of total assets). Moreover, with less than 1% of households loans denominated in foreign currencies, Czech banks do not face threats resulting from abrupt changes in the exchange rate.
Zoltan Arokszallasi on Hungary: Foreign liabilities of the banking sector in Hungary, unlike in other CEE countries, declined notably in recent quarters. Between 1Q11 and 1Q12, foreign liabilities of other Monetary Financial Institutions (MFIs) fell by around HUF 980bn (or EUR 7bn, adjusted for EUR/HUF movements). It is important to note that around 60% of this decline is attributable to a decline in FX loans (including the controversial FX prepayment scheme), while deposits in Hungarian forints also increased. An orderly decrease in foreign liabilities can be a natural process after an excessive increase of leverage from foreign sources prior to the crisis, but after recent trends in Hungary, the extent of the drop could be unnecessarily painful for the Hungarian economy. In addition, compared to regional peers (as is visible from this report) this process should not be inevitable. The consequences are dire: Hungary's gross capital formation to GDP is quite low (between only 16-17% in 2011-12), which may further increase the gap between Hungary's potential growth rate and that of the CEE region. The positive current account balance, while by itself a positive phenomenon, is also a flipside of poor domestic demand and poor investment figures. As a small, open economy, with saving levels not high enough to maintain the required level of investments, Hungary is reliant on foreign funding, be it capital or credit. It would thus be necessary to have a predictable, credible economic policy, which could prove a stable economic framework that could enhance investments and also slow down the current decrease of foreign liabilities.
Petr Bittner on Poland: As for the liquidity position of Polish banks, it did not change much. The growth of both loans and deposits decelerated in 2009, more visibly on the loans side. Since the first quarter of 2010, when the growth of loans nearly stopped, it bounced back, and now both deposits and loans are growing at a similar pace, around 10% y/y. As a result, the loan-to-deposit ratio remains rather stable, oscillating between 105% and 110%. Closely observed FX loans of households started to decline in mid-2011 (even adjusted to currency exchange rates changes), although the total credit to households is growing. This is also visible in the external position of the Polish banking sector, as external liabilities are declining.
Dumitru Dulgheru on Romania: As highlighted in the present paper, foreign liabilities of Romanian banks declined only marginally over the last year (-0.6% of total assets). The latest data shows that resident LCY-denominated deposits picked up significantly in 2012 (+15.9% y/y in April) and this is good news for offsetting potentially denting foreign liabilities. Drawing more on RON deposits could create more breathing space for local currency lending that has been strongly advocated by the central bank.
Maria Valachyova on Slovakia: Foreign debt of Slovak banks is relatively low, reaching 8% of GDP and has declined in recent quarters. The Slovak banking sector is in a sound liquidity position, with L/D ratio hovering around 85-90% over the past three years. If necessary, Slovakia, as a member of the euro area, has the advantage of having access to ECB tenders. Hence, in the event of a liquidity squeeze, it has an additional cheap source of funds. In summary, the risk of negative impact of potential deleveraging on the Slovak banking sector is rather small.
Ozlem Derici on Turkey: The capital account structure is far from providing relief in Turkey, as it highly depends on short-term flows (e.g. portfolio flows, short-term loans), while the share of FDI and long-term corporate borrowing as a reliable source of financing is only around 28%. FDI coverage of the current account, at 23% as of April, has been steadily increasing since the last quarter of 2011, mainly thanks to ongoing energy investments. A recent central bank study revealed that some 20% of foreign private debt was acquired from EU banks that need recapitalization, which is not too high, given that Turkey's financing need decelerates as economic activity slows down and the main source of widening in the current account (i.e. energy prices) eases considerably.