It has been almost a decade since the Transition Report last looked in detail at the EBRD region’s financial sectors. In that time, the global financial system has undergone major changes and nowhere have these changes been more profound than in the countries where the EBRD invests. This report looks at the evolution of finance in the transition region following the crisis of 2008-09 and considers the question of how finance should be rebalanced to provide more diverse and stable funding flows in support of economic development.
Diversifying funding to foster growth
It has been almost a decade since the EBRD last published a Transition Report that focused on the financial system. Back in 2006, economic growth in the region was in excess of 6 per cent, several percentage points higher than in the eurozone. The EBRD region was even home to the world’s fastest-growing economy: Azerbaijan. The region’s strong economic growth was underpinned by large inflows of foreign direct investment and rapid growth in domestic credit. The 2006 report’s encouraging conclusion was that economic and institutional reforms were continuing apace across the transition region.
However, it also warned that cross-border capital could be withdrawn very quickly in a crisis and that foreign direct investment, which was underpinning growth and convergence in the region, was more mobile than people generally realised. Two years later, those warnings began to look rather prescient. The global financial crisis and the subsequent eurozone debt crisis have resulted in capital inflows from traditional European sources declining to a mere trickle. The financial world has undergone profound changes, both globally and in the EBRD’s countries of operations.
As we publish this year’s Transition Report, the region’s annual growth rate is hovering around zero. In fact, the region’s income levels have hardly converged at all with those of advanced economies in the post-crisis period. Russia’s economy, which expanded rapidly before the 2008-09 crisis, has experienced a sharp decline in economic growth. Cross-border flows of capital and foreign direct investment have shrunk, while credit growth has been weak (and even negative in some countries). Furthermore, the reform process has stalled across the region, as the 2013 report highlighted.
Although growth has recently picked up among a number of commodity importers in the region, the recession in Russia – which has been exacerbated by declines in commodity prices – has had a negative impact on economies that have close ties with that country on account of trade, investment and remittances. Geopolitical tensions and the expected tightening of monetary policy in the United States are also weighing on the region’s economies. As a result, growth in the EBRD region as a whole has virtually ground to a halt in 2015 and is expected to recover only moderately in 2016.
This is a good time, therefore, to look at how the financial sector can act as a stable and robust engine of economic development in such challenging and uncertain circumstances.
The report begins by showing how far the transition region is currently lagging behind in terms of investment. This investment gap is casting a serious shadow over the region’s long-term growth prospects – a finding echoed in the last two Transition Reports. In order to boost investment and close that gap, new funding sources need to be explored. Indeed, this report suggests that the challenge is not only to increase the quantity of finance that is available to firms and households, but also to rebalance its composition and improve its quality. Such rebalancing and diversification will involve changes in a number of different areas.
First, a key theme of this year’s report is the need to reduce the region’s overwhelming reliance on debt financing and increase the role played by equity. A combination of economic contractions and unfavourable exchange rate movements have resulted in a situation where the total domestic and external debt of households, firms and governments in the transition region is now higher than it was on the eve of the global financial crisis. Despite a decline in the availability of new loans, particularly for small businesses (see Chapter 2), the debt burden has continued to rise.
Against that background, the report highlights the special role that equity financing can play in supporting investment and productivity increases in firms, with a particular focus on private equity. Evidence suggests that private equity investors operating in the region improve firms’ access to credit and help companies to scale up capital expenditure and hire new workers, resulting in higher levels of revenue and productivity. However, relatively few firms in the region have attracted private equity investment to date. There are several ways in which policy-makers could help to improve access to private equity, including tightening rules on corporate governance and making it easier for private equity funds to exit investments through public equity markets. The capital markets union that is currently under discussion could play an important role in improving access to equity in central Europe and parts of south-eastern Europe.
Second, there is a need to shift from foreign currency-denominated finance to local currency credit markets. The dollarisation of credit in the region (that is to say, the percentage of lending that is denominated in a foreign currency) remains exceptionally high by global standards and only a few countries in the region have seen noticeable declines in dollarisation levels in the wake of the global financial crisis. As a result, many firms and households remain vulnerable to sudden exchange rate movements, the risk of which has increased in light of the expected monetary tightening in the United States.
Efforts to reduce dollarisation will be dependent on the gradual rebalancing of banks’ funding sources, with shifts from foreign to domestic channels. The ability of banks – both foreign and domestically owned – to access abundant cross-border funding played an important role in supporting the strong credit growth and economic convergence that was observed prior to the crisis. However, a more balanced funding model is now needed to ensure that local banking systems become more resilient to shocks in the longer term.
Third, the right balance needs to be struck between public debt, household debt and corporate debt. The analysis in this report shows that firms in many countries – particularly small and medium-sized enterprises – remain relatively underserved by the financial sector. Survey evidence suggests that in many cases these firms are discouraged from applying for credit by cumbersome and lengthy application procedures.
Lastly, rebalancing also involves a shift towards a more diverse network of cross-border investment partnerships, complementing the strong existing links with advanced European economies. There is scope for stronger economic ties between the transition region and both the other emerging markets and non-European advanced economies, which would make overall funding flows more stable. Intra-regional links could also be strengthened.
Rebalancing does not mean shifting from one extreme to the other. Instead, this Transition Report calls for the gradual and sustainable optimisation of the financial system structure. Even if more equity financing does become 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 a foreign currency – serving the needs of companies with key markets abroad, for instance – but such lending would normally make up a small percentage of total credit in the financial systems of more advanced economies. And economic forces of gravity dictate that advanced European economies will remain important trade and investment partners for the region, even as economic links with other countries multiply and grow stronger.
The optimal situation in terms of debt instruments, currency breakdowns, sources of funding and investment partners will be different in each country, being shaped by local factors, and it will evolve over time. Nevertheless, this report provides general guidance that, taken together, will help to ensure that financial systems offer a diverse range of funding options that meet the demands of small businesses, larger firms and households, thereby helping income levels to continue converging with those of advanced economies. In this regard, this report develops themes highlighted as part of the Addis Ababa Action Agenda that was adopted earlier this year, including the contribution that deeper domestic capital markets and cross-border equity flows can make to sustainable development.
This report does not seek to cover all major areas of finance, as that would be impossible to do in any depth. Instead, it focuses on a few specific issues – the geography of foreign direct investment, small businesses’ access to bank finance and the impact of private equity financing – that serve to illustrate its broader arguments.
The report is very much forward-looking. In order to better reflect this approach, this publication has the title Transition Report 2015-16, a convention that we intend to follow in the coming years.
Hans Peter Lankes
Acting Chief Economist, EBRD
The EBRD seeks to foster the transition to an open market-oriented economy and to promote entrepreneurship in its countries of operations. To perform this task effectively, the Bank needs to analyse and understand the process of transition. The purpose of the Transition Report is to advance this understanding and to share our analysis with partners.
The responsibility for the content of the report is taken by the Office of the Chief Economist. The assessments and views expressed are not necessarily those of the EBRD. All assessments and data are based on information as of early October 2015.
AND BOOSTING INVESTMENT
The global financial crisis has triggered a dramatic reduction in external imbalances in the transition region, but this rebalancing has come at the expense of investment. The region needs to invest around US$ 75 billion more per year to bring investment back to the levels expected of economies at this stage of development. However, despite those lower levels of investment and the credit crunch, the debt of the non-financial sector in the region has actually increased. Meeting those additional investment needs will require financial sector rebalancing.
SMALL BUSINESSES AND
THE CREDIT CRUNCH
Credit conditions for small businesses have tightened significantly in recent years, both during and after the global financial crisis. Structural adjustments in banking systems – particularly reduced reliance on cross-border and wholesale funding – explain a large part of this tightening. The composition of local banking markets also plays a role since small businesses are more likely to borrow from banks that have less hierarchical lending procedures, a greater focus on building relationships with clients and more confidence in local courts. Access to credit may therefore benefit from both stronger legal enforcement and more effective and efficient bank lending techniques.
in private equity
Private equity can generate both financial value for investors and economic value for the companies involved. Despite the strong growth of private equity globally, the transition region receives only a small share of these global flows. Compared with advanced economies, private equity funds in the transition region rely less on debt financing and more on selecting high-growth companies and implementing operational improvements to create value.
PRIVATE EQUITY AS
A SOURCE OF GROWTH
Private equity funds in the transition region not only target companies with high growth rates but also assist their growth by implementing operational improvements. They also relax companies’ credit constraints and increase both employment and physical investment. The transition region is home to a sizeable pool of companies that could potentially benefit from these positive growth effects associated with private equity investment.
Over the past year the economic outlook in the transition region has been shaped by a significant decline in the price of oil, persistent geopolitical uncertainty, the launch of a quantitative easing programme in the eurozone and the ongoing crisis in Greece. Although economic growth in many commodity-importing countries has picked up, average growth in the region has been weighed down by the negative shocks faced by Russia, other commodity exporters and countries with strong economic ties to Russia. As a result, the annual growth rate of the transition region as a whole is projected to decline for the fourth consecutive year in 2015.
While the political and economic environment remains challenging, the outlook for market reforms appears to have improved. There are opportunities for reform in many sectors and countries that could help to bring economic structures and institutions more into line with those of advanced market economies. However, many transition countries still lag behind best practices when it comes to promoting the sustainable use of resources and inclusion.
AND BOOSTING INVESTMENT
Prior to the financial crisis, a credit boom in the region boosted levels of investment and growth, but resulted in large and ever-increasing external imbalances financed by cross-border capital flows. With the crisis came a swift external adjustment, as cross-border capital flows declined dramatically and multinational banks withdrew funds from the region. That external adjustment has largely been successful, bringing domestic investment into line with the – predominantly low – levels of domestic savings. However, after years of sparse investment (compared with the levels observed in other emerging markets with similar characteristics) the region now has substantial investment financing needs, requiring an extra US$ 75 billion per year.
Despite investment levels declining and firms in many countries facing a credit crunch, the region’s overall indebtedness (measured as the sum of public and private debt, both domestic and external) has continued growing at approximately the same rate as before the crisis. In fact, indebtedness has increased by 25 percentage points of GDP since 2007, reaching 123 per cent of GDP in 2014. This reflects the substantial weakening of growth in nominal GDP, the revaluation of a large percentage of debt denominated in foreign currency, significant increases in public debt following efforts to stimulate the economy after the crisis and the fact that NPLs are weighing heavily on banks’ balance sheets.
Notwithstanding those increases in the total level of debt, in some economies – particularly in central Europe, the Baltic states and south-eastern Europe – the ratio of domestic corporate debt to GDP remains below the levels that would be expected on the basis of those countries’ per capita income, the strength of their economic institutions and other relevant characteristics. In other countries, however, scope for raising debt levels appears to be more limited.
In order to meet the region’s vast investment needs, local financial systems will need to be rebalanced further. In countries where NPL levels are high, dealing with that overhang is a priority. In addition, a further shift towards local currency-denominated funding has the potential to reduce credit risk and improve the sustainability of debt. Looking beyond debt, increased use of equity instruments, measures to boost savings and the diversification of cross-border funding could all strengthen financial resilience, underpin investment and help to revive income convergence.
SMALL BUSINESSES AND
THE CREDIT CRUNCH
This chapter uses a combination of macroeconomic, firm-level and bank-level data to gauge the extent to which firms across the transition region have become more credit constrained in the seven years since the onset of the global financial crisis. The analysis shows that while credit conditions for small businesses have tightened overall, there is substantial cross-country heterogeneity. Access to credit has deteriorated most in those countries that have experienced a decline in cross-border borrowing by banks, a decline in wholesale (rather than deposit) funding and/or a decline in bank leverage.
Within countries, the composition of local banking markets also plays a role. Analysis shows that when SMEs have a choice of various banks in their town or city, they tend to borrow from financially sound banks that have less hierarchical lending procedures, greater confidence in the quality of legal enforcement and a focus on establishing long-term lending relationships. This suggests that financial matters are not the only consideration in this regard and that organisational and institutional issues also have a key role to play in the debate about reviving lending to SMEs in the EBRD’s countries of operations.
To stimulate SME lending, banks themselves can make additional efforts to streamline their loan application procedures. Surveys of firms reveal that many SMEs are discouraged from applying for credit by cumbersome and lengthy application procedures. The findings of this chapter also suggest that relationship banks have a special role to play as a stable source of SME finance. This highlights a potential downside of any short-term focus by banks (and their shareholders) on reducing the numbers of loan officers and other frontline staff who work directly with borrowers. Lastly, effective and efficient SME lending can also be stimulated by the establishment of well-functioning credit registries and decisive action to deal with NPLs, which are continuing to weigh on the balance sheets of many banks.
in private equity
The private equity sector has grown steadily across the transition region over the last two decades, in terms of both the volume of assets that it manages and the impact that it has on local economies. However, private equity remains an underutilised source of external funding for companies in the EBRD region. This chapter considers how private equity funds could help contribute to more diverse financial infrastructure, thereby stimulating growth and efficiency improvements.
Prior to the crisis, the EBRD region accounted for close to one-fifth of all private equity capital invested in emerging markets. This share has recently dropped to less than one-tenth. Sluggish economic growth in the region has had a negative impact on returns on private equity investment. Cross-border deleveraging by parent banks present in the region and the resulting reduction in the availability of credit has also affected the investment strategies of private equity funds. The use of debt in private equity transactions – a common method of generating financial returns in advanced economies – has always been more limited in the transition region and has declined further since the global financial crisis. Instead, private equity funds focus more on implementing operational improvements in investee companies. This typically involves identifying companies with considerable growth potential, scaling up investments and sales, entering new markets and aligning company managers’ interests more closely with those of shareholders.
An estimated US$ 1 trillion remains available to private equity funds for investment in companies around the world. A more outward-oriented approach and greater emphasis on innovation could help companies in the EBRD region attract a larger share of those funds. Export activity increases the size of companies’ markets, which is particularly important for firms in smaller economies with limited domestic growth potential. Meanwhile, innovative companies could attract venture capital – an area where the region lags behind other emerging markets.
PRIVATE EQUITY AS
A SOURCE OF GROWTH
Private equity can be a useful source of external finance for companies. Perhaps more importantly, the active involvement of private equity fund managers can also assist investee companies to reach new customers, run operations more efficiently and improve their management of cash and inventories. Private equity support also tends to help companies to gain better access to credit.
The analysis in this chapter, and elsewhere in the report, shows that private equity investment in companies in the transition region has a positive effect on employment, capital investment and productivity. These positive effects, in turn, translate into higher levels of revenue and profit relative to similar companies that do not receive such investment. Furthermore, the results suggest that capital spending following private equity investment supports job creation. In contrast, capital expenditure and job creation tend not to coincide in advanced economies, where private equity funds typically target mature firms and focus on cutting costs and restructuring the labour force.
The number of companies in the region that have strong growth prospects and could potentially attract private equity investment is more than 10 times the number of companies that have actually received investment in recent years. Enabling more companies to attract financing from private equity funds could potentially generate additional employment and investment in the region.
Levels of private equity financing are sensitive to the region’s growth prospects. Thus, a return to growth is likely to result in an uptick in private equity flows. However, policy-makers can also support such flows by strengthening the protection of minority shareholders, improving corporate governance and fostering the development of public equity markets. In addition, improving the enforcement of information disclosure rules can help shareholders to have a greater say in the management of companies. Meanwhile, the establishment of specialist stock exchanges for SMEs that reduce listing costs and the regulatory burden can improve access to equity financing. The latter can also make SMEs more attractive as investment targets for private equity funds, as they increase the likelihood of those funds exiting their investments with higher valuations.
Over the last year, the economic outlook for the transition region has been reshaped by a significant decline in oil prices, increased geopolitical uncertainty and the launch of a quantitative easing programme in the eurozone. Although economic growth has picked up in many commodity-importing countries and is expected to strengthen further, average growth in the region has been weighed down by the negative shocks faced by Russia and other commodity exporters, and consequently, countries with strong economic ties to Russia.
As a result, the annual growth rate of the transition region as a whole is projected to decline for the fourth consecutive year in 2015, falling close to zero, before picking up moderately in 2016.
While the political and economic environment remains challenging, the outlook for market reforms appears to have improved. There are opportunities for reform in many sectors and countries that would help to bring economic structures and institutions more into line with those of advanced market economies. Significant progress has been made with the enhancement of infrastructure in the last year, with cash-strapped governments increasingly realising the value of fostering private-sector involvement in the building and maintenance of transport links and municipal services. However, many transition countries still lag behind best practices when it comes to promoting the sustainable use of natural resources and economically inclusive growth.
Banking environment and performance survey (BEPS) II
The second round of the EBRD Banking Environment and Performance Survey (BEPS) was conducted in 32 countries among a total of 611 banks.
The BEPS II Survey was jointly undertaken by the EBRD and the European Banking Center (EBC) at Tilburg University. As with BEPS I, a common questionnaire was administered to the bank’s CEO in a face-to-face interview.
The purpose of BEPS II was to build on BEPS I and obtain data on the activities, funding and risk management of banks, their lending technologies, their competitive environment, the influence of foreign parent banks and senior management’s perceptions of legal and regulatory systems. Information was obtained for two points in time: 2007 and 2010. BEPS II also contains a more detailed follow-up survey which banks completed independently. This follow-up was completed by 337 banks.
In addition, as part of BEPS II a specialised team of consultants collected geographical coordinates of over 137,000 bank branches across the EBRD’s countries of operations.
The EBRD is investing in changing people’s lives and environments across a region that stretches from central Europe to Central Asia, the Western Balkans and the southern and eastern Mediterranean.