This article is published in collaboration with Vox EU.
The Global Crisis has been a pivotal point for emerging Europe and Central Asia. Before the Crisis, annual economic growth in the region exceeded 6%, several percentage points higher than in the Eurozone and broadly at a par with other emerging markets. The region’s fast convergence towards income levels in advanced European economies was underpinned by sizeable inflows of foreign direct investment (FDI) and cross-border bank lending. These strong capital inflows were accompanied by deeper institutional integration with the EU15 economies (Friedrich et al. 2013). The Global Crisis and the subsequent Eurozone crisis have reduced the inflows of capital from traditional European source countries to all but a trickle. Credit growth has slowed down and in some countries has even become negative. And although emerging Europe has avoided balance of payments or debt crises, economic growth in the region as a whole is now hovering around zero.
A post-Crisis investment gap
As capital inflows dried up, most economies in emerging Europe managed to quickly eliminate large current-account deficits, which in some cases had exceeded 20% of GDP before the Crisis. As domestic savings increased little, the adjustment of current-account deficits mainly happened at the expense of investment. The resulting marked drop in investment following the Crisis casts a severe shadow over the region’s medium-term growth prospects. A comparison of current investment levels with those in economies at similar levels of development reveals a significant investment shortfall in emerging Europe and Central Asia. This shortfall amounts to about 3% to 6% of GDP a year and adds up to at least $75 billion (EBRD 2015).
Limited room for further debt
To boost investment and close the gap, new funding sources need to be explored. Notwithstanding the credit crunch faced by many small businesses, total indebtedness of households, enterprises, and governments in the region is now about 25 percentage points higher than it was on the eve of the Global Crisis (Figure 1). The increase in debt-to-GDP levels is driven by a combination of much slower growth in nominal GDP, disadvantageous exchange-rate movements, and increases in public debt as a result of economic stimulus programmes. The post-crisis debt growth has even outpaced the global increase in debt (McKinsey Global Institute 2015, Lo and Rogoff 2015).
Figure 1. Exchange-rate depreciations and increasing debt-to-GDP ratios
Source: IMF, national authorities via CEIC Data, BIS and authors’ calculations.
Note: Simple averages across countries in Emerging Europe, Central Asia and South-eastern Mediterranean. Debt comprises public debt, domestic private sector debt and external corporate debt.
Rebalancing finance towards equity
As many countries display a limited capacity to take on more debt, financial systems may need to rebalance towards a greater use of equity. Equity does not only bring in new funding, it often also comes with expertise that helps firms to improve their performance (Kaplan and Strömberg 2009). This year’s EBRD Transition Report (EBRD 2015) shows that firms in emerging Europe that received private equity investments subsequently saw a 40 percentage points faster growth in capital stock compared with similar firms that did not have private equity participation (Figure 2). These firms also enjoyed a faster growth in employment, labour productivity, revenues, and profits.
Figure 2. Impact of private equity on fixed capital investment
Sources: EBRD, Orbis and authors’ calculations.
Note: Shaded areas indicate standard errors.
Unfortunately, only very few firms in the transition region have so far managed to attract private equity investments. The region accounts for 7% of global GDP but less than 1% of global private equity inflows. Countries can take several measures to improve access to private equity, such as tightening the enforcement of corporate governance rules and supporting exits through public equity markets. A Capital Markets Union could also be an important step in improving access to equity in Central Europe and parts of Southeastern Europe, for instance by facilitating the cross-border marketing of investment funds.
Rebalancing finance towards local currencies
Financial systems in emerging Europe and Central Asia will also need to rebalance from foreign-currency finance to local currency markets. Dollarisation of credit (referring to the share of lending denominated in any foreign currency) in emerging Europe and Central Asia remains exceptionally high by global standards. On average, around half of all debt in the region is denominated in foreign currency, compared with 37% in Latin America, and 21% in other emerging markets. Moreover, only a few countries in the region have experienced significant reductions in dollarisation levels since the Global Crisis. As a result, exchange rate depreciations continue to add to the overall debt burden (Figure 1) – highlighting the region’s vulnerability to capital outflows that may intensify as monetary policy in the US gets tightened.
De-dollarisation efforts will also depend on a gradual rebalancing in the funding sources of banks away from foreign funding towards domestic sources. The ability of banks – both foreign- and domestically owned – to access abundant cross-border funding played an important role in supporting the rapid credit growth and economic convergence before the Crisis. However, a more balanced funding model is needed to ensure that local banking systems become more resilient to shocks in the longer term.
Rebalancing finance towards diversified cross-border flows
Financial rebalancing will also need to involve a shift towards a more diversified network of cross-border investment partnerships, complementing the existing strong links between emerging European and advanced European economies. A gravity model of global bilateral FDI flows highlights the scope for building stronger economic ties between, on the one hand, emerging European economies and, on the other hand, other emerging markets and non-European advanced economies. Such diversification can make overall funding flows more stable.
Rebalancing: Up to a point
Rebalancing does not mean shifting to the other extreme – it refers to the need for gradual adjustments of the structure of the financial system. As more equity financing becomes available, debt will continue to play a major role, often helping to leverage the benefits of equity financing. Some lending will always be conducted in foreign currency – serving the needs of companies with key markets abroad, for instance – yet the share of such lending in the financial systems of advanced economies is typically small. Furthermore, advanced European economies will remain important trade and investment partners for countries in emerging Europe, Central Asia, and North Africa even as other bilateral economic linkages become stronger.
The optimal mix of debt versus equity, currency composition, funding sources, and investment partners will be shaped by local characteristics. They will thus differ from country to country and will keep evolving. Nevertheless, the key directions of change outlined above can help to ensure that local financial systems can offer diversified funding options to meet the demand of small businesses, larger corporates and households – thus supporting growth and economic convergence.
EBRD (2015), Rebalancing finance, Transition Report 2015-16, London.
Friedrich, C, I Schnabel and J Zettelmeyer (2013), “Financial integration and growth—Why is Emerging Europe different?” Journal of International Economics 89, 522-38.
Kaplan, S, and P Strömberg (2009), “Leveraged buyouts and private equity”, Journal of Economic Perspectives 23, 121-146.
Lo, S, and K Rogoff (2015), “Secular stagnation, debt overhang and other rationales for sluggish growth, six years on”, BIS Working Paper No.482.
McKinsey Global Institute (2015), Debt and (not much) deleveraging.
Publication does not imply endorsement of views by the World Economic Forum.
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Author: Çağatay Bircan is a Principal Economist at the EBRD. Ralph De Haas is a Director of Research, EBRD. Hans Peter Lankes is an Acting Chief Economist, Managing Director of Corporate Strategy member of the Executive Committee, EBRD. Alexander Plekhanov is a Lead economist in the Office of the Chief Economist, EBRD.
Image: European Union flags fly outside the European Commission headquarters in Brussels. UNICS REUTERS/Thierry Roge