Rebalancing finance and boosting investment

This raises a number of interrelated questions. Have similar trends been observed in the region where the EBRD invests? Has indebtedness continued to rise? And if so, has it reached excessive levels? How have savings, investment and investment needs evolved since the crisis? And if both investment needs and debt levels are high and rising, how can these trends be reconciled, both historically and in the future? Answering these questions may provide some insight into how finance in the post-crisis world can be rebalanced, made more diverse and better support the long-term convergence of incomes with the levels of more advanced economies.

This chapter starts by looking at the savings-investment balance in the region and the rapid adjustment of countries’ external positions following the 2008-09 crisis. It considers the implications of this adjustment for investment financing needs, showing that the region needs to considerably increase investment. It then looks at the evolution of total debt, finding that this has continued rising steadily, despite the fact that credit granted to companies (adjusted for inflation) has been contracting in many countries. The discussion then moves on to the factors that explain how lower investment levels and the credit crunch can co-exist with rising debt levels. The chapter then assesses the implications that this has for the financing of future investment needs, considering both debt and equity instruments. It first looks at how overall debt levels in the region compare with those in other emerging markets (examining the quantity of debt, the composition of debt and, importantly, the quality of debt) before looking at alternative financing options involving a greater role for equity. Lastly, in light of the current shortage of domestic savings, the chapter turns its attention to foreign-financed equity, examining the levels of foreign direct investment (FDI) after the crisis and opportunities for the geographical diversification of FDI flows.

To a large extent, those strong capital inflows came in the form of FDI and were accompanied by deeper institutional integration with more advanced European economies in the context of the EU accession of countries in central and south-eastern Europe.4 Inflows of FDI, as well as other capital inflows, enabled Europe’s emerging markets to sustain relatively high levels of investment given their traditionally low levels of domestic savings (see Chart 1.1). In turn, these high investment levels supported growth. Most capital inflows in the region came from countries in the eurozone, such as Austria, Germany and Italy.

Increased foreign ownership of banks played a very important role, both as a form of FDI in the financial services sector and as a channel for the financing of investment.5 Foreign banks’ access to parent funding improved the availability of credit in the host economies and helped to reduce the adverse impact of local financial shocks, including the impact of the Russian crisis of 1998.6 However, this then increased the vulnerabilities that are associated with having a higher percentage of debt denominated in or indexed to a foreign currency.7

In the face of this major shock, external adjustment in the region has been impressive. In many countries, vast current account deficits (which in some cases exceeded 20 per cent of GDP before the crisis) declined swiftly and large external imbalances were eliminated or dramatically reduced within months.

The fact that a large proportion of foreign investment in emerging Europe came in the form of FDI played a stabilising role during the global financial crisis, since FDI is less prone to sudden reversals than other types of capital inflow, such as portfolio investment.9 The Vienna Initiative – coordinated efforts by host and home supervisors, cross-border banks and international financial institutions – helped to ensure that foreign banks did not embark on an immediate large-scale withdrawal from the region. That initiative helped, at least temporarily, to stabilise lending by the 17 banks that signed commitment letters.10

At the same time, banking sectors across the transition region – particularly in central Europe and the Baltic states (CEB) and south-eastern Europe (SEE) – have continued to deleverage, as discussed in the Macroeconomic Overview. As a result, average real growth in domestic credit granted to companies (that is to say, growth adjusted for inflation and exchange rate movements) has been negative in the CEB and SEE regions, as well as in the southern and eastern Mediterranean (SEMED; see Chart 1.2). Small and medium-sized enterprises (SMEs) in these regions have been particularly affected by this credit crunch, as discussed in Chapter 2.

At the same time, the increase in domestic savings (calculated as the sum of household savings, corporate savings and government savings) in emerging Europe has been very limited. Marked increases in domestic savings rates have mostly been limited to economies where levels of domestic savings before the crisis were particularly low – such as the single digit figures observed in Bulgaria and Lithuania.

In some ways, this type of adjustment may not be particularly surprising. In a crisis, governments typically seek to stimulate aggregate demand in the short term by boosting consumption (both private and public) at the expense of savings. In the longer term, however, higher levels of savings are needed to sustain adequate levels of investment without accumulating ever larger stocks of debt. Thus, short and longer-term policy objectives may be at odds with each other and may need to be reconciled.

The transition region’s adjustment through low investment rates stands in stark contrast with the post-crisis experiences of emerging markets in Asia and Latin America (see Chart 1.1). The majority of emerging Asian economies traditionally enjoy much higher levels of domestic savings, which are more than sufficient to finance the high levels of investment in these countries.11 This trend has hardly been affected by the 2008-09 crisis. Indeed, investment has actually increased somewhat as a share of GDP as a result of the large public capital spending programmes that were adopted in China and a number of other countries in the region in the wake of the global crisis. In Latin America, on the other hand, investment levels were somewhat on the low side throughout the 2000s but they have, if anything, increased since the crisis. This underscores the unique nature of the post-crisis external adjustment observed in Europe’s emerging market economies.

Is this adjustment a cause for concern? The answer depends on whether those reduced investment levels are broadly typical of economies at this stage of development and whether a protracted period of low investment puts long-term growth in emerging Europe at risk.12

The second panel of Chart 1.3 shows the average annual rate of gross fixed capital formation (that is, investment net of change in inventory levels) as a percentage of GDP for various countries in the post-crisis period (2009-13), plotted against those countries’ GDP per capita at the start of the period, adjusted for differences in purchasing power. The figures take account of various economic characteristics of those countries. The first panel depicts the same relationship in the build-up to the financial crisis (2004-07). Countries with a lower income per capita – typically economies in the catching-up phase – tend to have higher rates of investment,13 and this relationship has become more pronounced since the global financial crisis.

While countries in emerging Europe and Central Asia used to invest roughly the same amount as their peers around the world before the financial crisis, they have invested significantly less in the post-crisis period. This decline appears to be particularly large in the CEB and SEE regions (with the corresponding dots in Chart 1.3 dropping from around the fitted line to below the fitted line). This is a first piece of evidence suggesting that the sustained decline in investment may indeed be a cause for concern and that the region’s investment needs will rise substantially in the future.

This analysis is supported by a regression framework that relates investment (gross fixed capital formation as a percentage of GDP) in the pre and post-crisis periods to the initial levels of income per capita and capital stock as well as various other country-level characteristics. For instance, countries that have experienced stronger economic growth in the preceding period – a proxy for investors’ perceptions of growth potential – tend to invest more.14 Higher average inflation (a reflection of a lack of macroeconomic stability) is associated with lower investment levels, while greater political stability is associated with higher levels of investment.

According to this regression analysis,15 investment levels in the region in the mid-2000s were a little higher than would be expected on the basis of countries’ economic characteristics, although the differences between the observed and expected levels of investment were not statistically significant. Meanwhile, even during the pre-crisis period, investment levels in Russia were markedly lower than those of its peers.16

However, since the 2008-09 crisis economies in the CEB and SEE regions have been investing, on average, 3 to 4 percentage points of GDP less than comparable emerging market economies elsewhere (with these differences being statistically significant). In eastern Europe and the Caucasus (EEC; excluding Belarus) the corresponding gap is as much as 7 percentage points of GDP. Estimates also point to weaker than expected investment in other regions in the post-crisis period (see Chart 1.4) – with the exception of Belarus, Mongolia and Morocco, where investment levels have remained relatively high (see Chart 1.3).

Reflecting broader trends in investment, recent spending on infrastructure – a particular type of investment which benefits large numbers of businesses and consumers – has also been low by historical standards (see Box 1.1). Estimates based on long-term trends suggest that infrastructure spending needs to rise by at least half a percentage point of GDP, unless significant improvements can be made in terms of the cost-efficiency of infrastructure spending.17

This shortage of investment is unlikely to be sustainable in the long term without negative implications for growth, so the investment rate will need to increase accordingly. Indeed, Table 1.1 (left-hand columns) indicates that the region requires around US$ 75 billion of additional investment per year. The cumulative shortfall for the period 2016-20 is estimated at over US$ 400 billion (using IMF World Economic Outlook assumptions about the growth of economies’ nominal GDP).

Another way of estimating shortfalls in investment relative to peers is to individually match countries from the region where the EBRD invests to groups of countries outside the region that have similar economic characteristics, rather than accounting for differences in economic characteristics by means of a regression analysis. Average differences in investment rates between groups of countries from the region and their matched peers from outside the region provide an alternative set of estimates of investment shortfalls.

The overall estimates reported in Table 1.1 (right-hand columns) are similar to the estimates obtained using the regression analysis (both in terms of levels and in terms of their statistical significance). If anything, they are somewhat larger, doubling the estimated investment needs for some regions. The estimated investment needs are higher in the case of both the CEB and SEE regions, but somewhat lower for Russia.

In fact, both sets of estimates in Table 1.1 are fairly conservative. They do not involve any assessment of the required level of investment and are based entirely on comparing investment levels in the region with those in other economies that are comparable in terms of their income per capita, capital stocks and other characteristics, assuming that the region’s economies need to gradually scale up investment to the average levels observed in countries with similar economic characteristics.18

Chart 1.5 confirms that average debt increases in the region have outpaced those observed elsewhere. Excluding Cyprus and Greece, debt levels have increased most strongly in Ukraine, Mongolia, Armenia and Slovenia (the countries that lie furthest away from the 45-degree diagonal line), while in terms of aggregate debt levels, the most indebted countries are Hungary, Jordan and Croatia.

In fact, annual changes in the region’s debt-to-GDP ratio before and after the 2008-09 crisis have been fairly similar (see red dots in Chart 1.6). Before the crisis, the nominal stock of debt expanded very rapidly but so did nominal GDP. And since the crisis, growth in nominal debt has slowed significantly, but economic growth has slowed as well.

What explains this rapid increase in total gross debt against the background of weak investment, continued deleveraging by parent banks with subsidiaries in the region (see Macroeconomic Overview) and the severe credit constraints faced by firms? To answer this question, it is important to look not only at the quantity of debt, but also at its composition and its quality. Three developments in particular have played a key role in this regard. First, the prevalence of debt denominated in foreign currency has led to revaluations of the stock of debt when currencies have depreciated. Second, increases in public debt and active use of external borrowing by larger companies have added to the stock of debt. Third, non-performing loans (NPLs) continue to clog up the balance sheets of banks and companies and inflate the debt-to-GDP figures, while at the same time weighing on the flow of fresh credit to the economy. The next few sections explore these various factors in turn.

The level of dollarisation (that is to say, credit denominated in US dollars or another foreign currency as a percentage of total credit) is high in most countries in the region (see Chart 1.7). Indeed, it is now significantly higher than in most emerging market or advanced comparator economies. While dollarisation ratios in Latin American countries, for instance, have been steadily declining since the mid-1990s, dollarisation levels in the region where the EBRD invests have barely changed (as can be seen from the fact that the diamonds in Chart 1.7 corresponding to 2007 figures tend to be close to the bars indicating the latest data). Even in countries which have seen significant declines in dollarisation (such as Albania, FYR Macedonia, Georgia and Tajikistan), the initial levels were exceptionally high, so dollarisation remains at elevated levels.

Dollarisation ratios are even higher if they are calculated on the basis of the entire stock of debt (rather than just domestic debt), as external debt of governments and companies denominated in foreign currency represents a significant proportion of total debt in many countries. This is also true of other emerging markets. However, even using this broader measure, the level of dollarisation in the region where the EBRD invests remains significantly higher than in other emerging market economies (the averages of 51 and 28 per cent, respectively).

The second round of the EBRD’s Banking Environment and Performance Survey (BEPS II), which was conducted in 2011 across the region where the EBRD invests, provided insight into the main reasons for the high levels of dollarisation in the region. As part of the survey, banks’ CEOs were asked to assess the importance of various factors in terms of explaining the underlying trends in foreign currency lending. The factors can be grouped together in three main categories. The first related to funding – the availability of funding in foreign and local currencies from parent banks, international markets and domestic depositors. The second captured the relative terms of loans in foreign and local currencies (as regards their interest rates and maturities) and demand from clients (including the competitive pressures that banks face to respond to clients’ demand for foreign currency denominated loans). The third group reflected changes in the perceived riskiness of foreign currency lending according to the respondent, the regulator or risk managers.

Their answers suggest that clients’ demand for foreign currency lending (owing to lower interest rates and/or longer maturities on offer) and competitive pressures are the main factors driving up dollarisation, while declines in dollarisation are mainly due to the increased riskiness of foreign currency lending as perceived by risk managers and regulators (see Chart 1.8). Funding conditions also play a role, particularly in encouraging dollarisation.

Firms and households may continue to demand foreign currency credit that appears to be cheaper as they often fail to take into account the high costs of servicing foreign currency debt when domestic currency depreciates. This creates negative externalities for the economy as a higher debt burden, following depreciation of the local currency, leads to weaker aggregate demand which in turn makes it even harder for firms to service their obligations. Reducing the dollarisation of lending in the region may therefore require a more proactive stance by regulators, as well as the fine-tuning of risk management practices within banks. It also requires an established track record of sound macroeconomic policies, which will help to anchor the inflation expectations of both lenders and borrowers.20

In most countries in the region, both public and private-sector debt levels increased over the period 2007-14 (see red arrows in Chart 1.9). In almost all countries where private debt-to-GDP ratios did decline, public debt increased. The only exception was the Kyrgyz Republic, which benefited from a partial write-off of its debt owed to Russia. In fact, in almost all of those countries, public debt increased by more than private debt declined (see orange arrows), sometimes by a large margin (particularly in Slovenia and Latvia). Only in Egypt, Jordan and Lithuania did the shift from private to public debt result in an overall reduction in the level of debt (see green arrows).

Furthermore, in some countries where debt levels were relatively modest at the start of the 2008-09 crisis, policy responses included measures to encourage credit growth. This helped to boost aggregate demand in the economy in the short term but potentially with the effect of increasing vulnerabilities in the longer term. Turkey, for instance, relaxed restrictions on the provision of foreign currency-denominated lending to unhedged borrowers in 2009, subject to certain conditions. The net foreign currency-denominated liabilities of Turkey’s corporate sector have since risen significantly, from around 10 to 20 per cent of GDP (see Chart 1.10). Indeed, Turkey stands out as one of only two countries in the region where public debt has declined since 2007 but private debt has increased significantly (see purple arrows in Chart 1.9).

Seven years after the crisis began, NPL ratios (that is to say, NPLs as a percentage of total loans) remain above 15 per cent in many countries in the SEE region, as well as Kazakhstan and Ukraine (see the Macroeconomic Overview for a more detailed discussion of this issue). More generally, countries in the region where the EBRD invests are among those with the highest NPL ratios worldwide (see Chart 1.11). Indeed, of the 25 countries with the highest average NPL levels (as a percentage of GDP) during the post-crisis period, 16 are from emerging Europe or Central Asia.

On average, higher initial levels of indebtedness at the time of the global financial crisis are associated with higher subsequent levels of NPLs (both relative to the total stock of loans and relative to the country’s GDP; see Chart 1.11). This relationship holds across a sample of more than 100 countries worldwide and is especially pronounced in the region where the EBRD invests.

Although the overall ratio of corporate debt to GDP in central and south-eastern Europe may not be too high, as Chart 1.11 suggests, outstanding debt has a disproportionate tendency
to be owed by firms with poor cash flows and/or low levels of equity capital. This concentration of debt in firms with poor liquidity and solvency indicators is greater in parts of the transition region than, for instance, in southern Europe.22 As a result, even as firms’ average profitability has improved, NPL levels have continued to rise.

Higher levels of NPLs are, in turn, associated with weaker subsequent growth in domestic credit to the private sector (see Chart 1.12 and Chapter 2). Furthermore, high NPL levels are associated with weak investment, both across a large sample of developed and developing countries and within the specific region where the EBRD invests (see Box 1.2 for a discussion on how rising NPLs and weaker growth can reinforce each other in a vicious circle).

Thus, removing NPLs from the balance sheets of banks and companies could help to reinvigorate credit growth while achieving overall private-sector deleveraging – thereby making more funds available to finance investment. In order to effectively deal with overhangs of NPLs, countries must: (i) tighten provisioning requirements and eliminate forbearance; (ii) facilitate out-of-court restructuring and simplify bankruptcy procedures for firms; (iii) avoid unfavourable tax treatment of NPL write-offs; and (iv) develop a market for NPLs involving specialist asset management companies (see also Box 1.2).23

The assessment of the overall level of debt depends on various country-level characteristics that make it easier – or more difficult – for households, companies and the government to service their debts. For instance, debt-to-GDP ratios tend to be higher over the longer term in countries with higher per capita income and superior economic institutions.25  In this regard, the Transition Report 2006 noted that levels of private-sector debt in the region were significantly lower than the region’s income levels would imply.26

With this in mind, this section looks at levels and determinants of public debt, corporate debt (domestic and external) and household debt across a sample of more than 70 developed and developing countries over the period 2005-14.27 In each case, the ratio of debt to GDP is explained by a number of economic variables, including the level of income, the quality of economic institutions, the flexibility of labour markets, openness to trade, the average rate of inflation and an index of creditor rights. The analysis focuses on each country’s macroeconomic and demographic characteristics but does not cover elements of the structure of each country’s banking system that may affect access to credit (which are discussed in Chapter 2).

The results confirm that richer countries tend to have higher debt-to-GDP ratios. Macroeconomic instability, which is reflected in higher average inflation rates, is associated with significantly lower levels of domestic corporate debt.28 Long-term debt levels tend to be higher where creditors’ rights are better protected;29 this effect appears to be particularly strong in the case of household debt. Superior institutions – resulting in reduced incidence of corruption as captured by the World Bank’s Worldwide Governance Indicators – are associated with higher levels of domestic corporate and household debt but lower levels of government debt. A higher labour-to-national-income ratio is associated with higher levels of household credit, as households are in a better position to service debt. It is also associated with higher levels of corporate debt, as firms’ retained earnings (an alternative source of financing) are lower. Corporate debt also tends to be lower where labour markets are less rigid, as firms enjoy greater flexibility when it comes to investment and hiring decisions and need to borrow less during downturns.30 More favourable demographic conditions – such as a larger working population as a percentage of the total population – are associated with lower levels of government debt, as are abundant natural resources. In addition, firms in countries with greater openness to trade tend to have higher levels of credit – both domestic and external.

As the Transition Report 2006 showed, prior to the onset of the financial crisis most economies in the region had aggregate debt levels that were below what would be expected on the basis of the experience of other emerging markets (particularly in the case of household debt, but also in the case of domestic corporate debt).

In this regard, the severity of the crisis in the region and the subsequent increase in NPLs reflects not so much the overall levels of debt as the very strong credit growth in the mid-2000s, which was accompanied by the relaxation of underwriting standards, heavy reliance on parent bank funding and large amounts of debt denominated in foreign currency.

That said, a number of countries appear to have been significantly overleveraged relative to their economic fundamentals in 2007, including Bulgaria, Moldova, Mongolia and Kazakhstan. All of these countries saw major banks fail in subsequent years.

On balance, analysis suggests that in a number of countries there appears to be substantial scope for increasing domestic corporate debt (Chart 1.15). There is also some room to increase household debt, although evidence strongly suggests that domestic credit to firms has a much greater bearing on economies’ growth prospects than credit to households.31

The countries that appear to have the greatest scope to increase domestic corporate debt are Slovenia, Poland, Estonia, Lithuania, the Slovak Republic, Croatia, Bosnia and Herzegovina, Georgia and Egypt. In other countries, the estimated scope for growth in domestic corporate debt-to-GDP ratios is smaller or even negative. Here, credit growth would be dependent on improvements in fundamental factors determining countries’ ability to sustain debt (such as the quality of institutions), as well as structural shifts in the financial sector (as discussed in Chapter 2), including those related to cross-border deleveraging by parent banks with subsidiaries in the region.

Equity enables investors and financiers to share the upside and downside risks associated with investment projects more evenly. It plays a particularly important role in industries where firms cannot easily provide collateral against loans.32 In addition to financing, equity may also result in non-financial benefits such as higher standards of corporate governance and transparency (see Chapter 3).

A number of policies can help both to boost domestic savings and accelerate the development of domestic equity markets. Pension reform can strengthen individuals’ incentives to save for retirement and catalyse the development of pension funds – institutional investors with a long-term approach. Policies supporting the development of capital markets from the supply side (such as simplified listing procedures for SMEs) and the demand side (such as favourable tax treatment for investment income) can also play an important role. And rationalising government spending can boost public savings – the difference between tax receipts and current expenditure such as public-sector wages.33 Increasing domestic savings is the only way of meeting an economy’s rising investment needs without exacerbating external imbalances.

Besides increases in domestic savings, additional equity investment can also come from abroad in the form of private equity, allocations by international institutional investors or FDI. Private equity can bring in managerial expertise, help to strengthen corporate governance and play a particular role in supporting change in firms (aspects that are discussed in more detail in the last two chapters of this report). FDI, meanwhile, can also support the transfer of skills and technologies, help companies gain access to foreign markets and facilitate development of cross-border economic linkages.34

Inward FDI in the region where the EBRD invests totalled on average 20 to 25 per cent of the value of economies’ gross capital formation in recent years. At first glance, sources of FDI in the region where the EBRD invests appear to remain strongly concentrated. Even in the post-crisis environment, the EU-15 economies account for around 60 per cent of total FDI inflows in the EBRD’s countries of operations, according to UNCTAD data.35 Other advanced economies, including the United States, Canada and Japan, account for a further 15 per cent. FDI flows from elsewhere in the region account for around 20 per cent of total inward investment and around 5 per cent of FDI comes from other emerging markets, including China, India and Brazil (“south-south flows”).

Have FDI flows to the EBRD region been low by international standards during the post-crisis period? And should we expect sources of FDI to become more diverse? To see how the current cross-border investment and its composition compare with what could be expected on the basis of the economic sizes and other characteristics of the respective regions, we can use a standard gravity model of FDI. In a gravity setting, aggregate investment from a given source country to a given destination is explained by the size of the two economies (in terms of population), their level of development (in terms of income per capita), the distance between the two countries and a number of other variables. Table 1.2 summarises the results of a simple gravity model of investment estimated for a large sample of developed and developing countries using UNCTAD data for the period 2008-12.

These results confirm that bilateral investment flows are strongly dependent on the size and income levels of both the source economy and the destination economy. Bilateral investment flows increase by an average of more than 90 per cent if countries share a border. Other measures of proximity also matter: a common language increases investment by around 65 per cent, while a common colonial history adds 30 to 40 per cent to investment flows (even after a common language has been taken into account).

What could account for this shortfall? The analysis reveals that the current large share of investment from the EU-15 countries is actually in line with what we might expect when it comes to investment from large, high-income neighbouring economies (see Table 1.3, column “EBRD”). In contrast, the coefficient for FDI from other advanced economies is negative and significant, suggesting that such investment is weaker than one would expect on the basis of countries’ economic characteristics. Investment from other emerging markets has been growing rapidly, albeit from a low base, and remains below the estimated potential. There are some exceptions – notably, in parts of the region, investment from China is already in line with the levels expected.

These trends hold for various regions, with some nuances. The overall “shortfalls” of FDI are highest in the EEC, CEB and SEE regions, mirroring the shortfalls in terms of fixed capital investment estimated earlier. In terms of specific sources of FDI, investment from the EU-15 countries appears to be significantly above the expected level in Russia and Turkey, but significantly below it in the EEC region. China invests more than the model predicts in Central Asia, Russia and Turkey. Investment from other emerging markets is particularly scarce in the CEB and EEC regions but in Turkey it is above the expected levels. Almost without exception, intra-regional investment from other transition countries remains below the levels that would be expected for investment flows between neighbouring countries.

The analysis reveals that there is scope to diversify FDI inflows, which could alleviate the current external financing constraints. Investment from non-EU advanced economies, which is currently below the expected level, could be leveraged further. Growth in south-south investment flows may slow in the future as convergence with the “natural” level of investment begins to play less of a role. This may already have happened in the case of investment from China. However, growth in FDI from emerging markets is still likely to outpace growth in other FDI flows, driven by stronger growth in the size and income levels of these economies (relative to advanced economies) and, in some instances, a greater propensity to save.

The marginal impact that improving institutions has on bilateral investment flows may also depend on the quality of institutions in the partner country.36 To investigate this possibility, regressions in column 3 of Table 1.2 include an interaction term between control of corruption in the country of origin and control of corruption in the country of destination.

The results suggest that the quality of institutions in the country of origin does indeed matter. If a country of origin has relatively strong institutions (for example, a score of 0.5, as in the case of Poland or South Korea), a 1-standard-deviation improvement in the destination country’s control of corruption leads to an increase of around 30 per cent in bilateral investment flows. If a source country’s control of corruption is relatively weak (for example, a score of -0.5, as in the case of China or Russia), a 1-standard-deviation improvement in the destination country’s control of corruption leads to an increase of only around 15 per cent.

In other words, institutional improvements help attract more investment from countries with better institutions, while investment from countries with weak institutions may be unaffected or increase only slightly. This rebalancing of investment relationships may, in turn, help improve business practices, corporate governance and the quality of management, eventually leading to positive feedback regarding the quality of domestic institutions. This could give rise to a virtuous circle of institution building. The opposite scenario (that is to say, a vicious circle of deteriorating institutions) is also a possibility.

Cross-country comparisons are further complicated by differences in cost-effectiveness and the targeting of infrastructure across countries. Infrastructure projects with poor economic justification may inflate headline infrastructure spending figures, without making a sizeable contribution to economic growth. Furthermore, estimates of infrastructure spending often exclude social infrastructure relating to health care and education. When such social infrastructure is taken into account, total infrastructure spending in the new EU member states averaged 4.3 per cent of GDP in the period 2003-14 according to Eurostat estimates – still a modest figure.

Information about the stock of infrastructure is also scarce. The World Economic Forum estimates the quality of infrastructure on a scale of 1 to 7. Estimates for the EBRD region vary greatly, from 5.2 in Cyprus (which is ranked 30th in the world) to 2.9 in Egypt (which is ranked 125th).

Increasing investment in infrastructure presents significant challenges. Currently, the majority of infrastructure investment in the region comes from public budgets. The limited data available suggest that in many transition countries 60 to 70 per cent of infrastructure is government-financed, compared with between 15 and 60 per cent in the EU-15 economies. Indeed, in some transition countries the government’s share exceeds 90 per cent.39 Given the tight fiscal constraints in many countries and the rapidly rising public debt levels, public resources may, in many cases, be insufficient to pay for additional infrastructure.

Consequently, substantial funding needs to come from private sources and be delivered through mechanisms that involve the private sector, such as public-private partnerships. In addition, capital markets can be used to channel the large and growing pool of global savings into debt and equity financing for infrastructure, which offers stable returns in the long term.40 This may improve the exit prospects of dedicated infrastructure equity funds, thereby catalysing the development of this type of infrastructure financing.

Lastly, the key policy challenge is to build an institutional environment that helps to deliver infrastructure at a lower cost and sustain efficiency gains over time. Improvements in the overall quality of governance that reduce corruption and strengthen the rule of law can help to reduce the cost of infrastructure. Improvements in technical skills as regards the evaluation, preparation and implementation of infrastructure projects can help to improve the prioritisation of projects and help to design better maintenance contracts for existing infrastructure.

And yet, in 2010 the region’s laws and institutions were still largely incapable of effectively dealing with the problem of NPLs. Legal frameworks governing restructuring and insolvency suffered from uncertainty, which was exacerbated by capacity constraints in the judiciary. Private creditors lacked experience of restructuring viable but overleveraged companies. Standards governing the classification of loan quality differed widely and supervisors were initially reluctant to enforce requirements of broader provisioning.

Since then, some economies in the region have taken steps to address the NPL problem. The Baltic states, for example, have seen a sizeable reduction in NPLs over the last four years, following the very sharp increases observed between 2008 and 2010. Slovenia reformed its legal framework governing restructuring in 2013 and has established an asset management company, into which banks (primarily state-owned banks) have transferred distressed assets. Meanwhile, Hungary has made efforts to reduce NPLs arising from foreign currency-denominated household lending by requiring that such loans be converted to domestic currency (albeit levels of corporate NPLs remain high).

Progress with the reduction of NPLs may be accelerating. The European Central Bank’s (ECB’s) asset quality review and stress tests for the largest banks in the eurozone (the results of which were published in October 2014) have resulted in a substantial upward correction of loan provisions, which have increased by €136 billion. This correction stems largely from the application of the new common methodology for loan classification, forbearance and provisioning developed by the European Banking Authority. Now that the ECB has taken on its new supervisory role within the eurozone, it will increasingly encourage the enforcement of stricter standards for loan classification and provisioning. This will directly affect all banks with a balance sheet in excess of €30 billion, which includes most banking groups that operate in the transition region.

EU regulators in the host countries of bank subsidiaries will apply this methodology for regulatory reporting, and regulators with close links to the EU may increasingly do so as well. Over time, this may be reflected in banks’ own financial reporting. Banks, in turn, are likely to become more proactive when it comes to provisioning and portfolio sales. In Romania, for example, such transactions considerably reduced NPL levels in 2014. This may mark the beginning of a broader trend.

There has also been encouraging progress (in Serbia and Slovenia, for instance) with the reform of frameworks governing private restructuring. However, this will only succeed if there is greater certainty surrounding the court-led restructuring and insolvency process, as well as sufficient capacity within the judiciary and among insolvency professionals to handle the substantial caseload.

Specialist state-owned asset management companies (such as the one established in Slovenia) can accelerate corporate restructuring, although ownership transfers for distressed assets will be subject to constraints safeguarding competition within the banking sector. There is generally a need for governments to coordinate the resolution of systemic NPL problems, bringing together the financial sector, banking supervisors and tax authorities. While measures to reduce NPLs may be associated with certain fiscal costs in the short term, in the longer term reviving financial intermediation and corporate investment will support growth and fiscal revenues.