Western banks fueled economic growth in the former Communist Bloc, but now they're blamed for the real estate and credit crises. The reality is more complex
Foreign banks have been one of the main drivers of economic growth in the EU countries of Central and Eastern Europe. They privatized moribund state-owned banks and set up greenfield operations across the region, bringing with them innovations in technology, management, and products, and giving credit-hungry consumers and businesses access to easy and cheap finance. In short, they allowed the economic desires unleashed by 1989 to become a reality.
But they have also been an easy target. Nationalistic and dirigiste governments resented the power wielded (and profits gleaned) by these foreign financial giants. Small businesses complained that their credit needs were ignored, while consumers chafed at high charges.
Today, in the wake of the global financial crisis, the role of foreign banks in the region is coming under greater scrutiny than ever before and some policy makers are questioning the assumption that foreign ownership always means best.
In order to build their presence and seize market share – so the charge sheet runs – foreign banks expanded credit too fast and made the wrong kind of loans, both with grave macroeconomic consequences.
The net cumulative capital flows into Central and Eastern Europe from 2003 to 2007 were three times greater than those into Asia before the 1997 crisis there, according to an International Monetary Fund working paper published in May, with the Baltics, Bulgaria, and Romania experiencing particularly fast growth.
Capital inflows into these countries – most of which was bank lending – were running at an annual rate equal to 15 percent of gross domestic product by 2007. In Bulgaria the cumulative flow almost doubled over the period to reach 192 percent of GDP.
Secondly, say critics, the banks focused too much on consumer lending and particularly mortgages, while neglecting corporate lending that could have generated long-term sustainable growth.
In the Baltics mostly Swedish-owned banks competed to extend cheap and easy mortgages, sometimes for more than 100 percent of the value of the property when other loans are included. A large part of corporate lending went into real estate development as well.
In Estonia mortgage lending was more than twice corporate lending from 2003 to 2008. Overall, total lending almost doubled to more than 100 percent of GDP during that period, around 40 percent of which was mortgages.
The lending boom helped the Baltic economies grow by double digit rates but it also fuelled housing and consumption booms as Balts made up for lost time under communist rule. Annual house price inflation in Riga, the Latvian capital, peaked at nearly 60 percent during 2006.
Thirdly, the consumer boom stimulated wage rises and inflation, and sucked in imports and stunted exports, creating trade deficits and worsening competitiveness. External indebtedness also made the economies more vulnerable, with Latvian and Estonian foreign debt hitting around 120 percent of GDP in 2008, one-third of which had been added in the boom years beginning in 2003.
What is worse, most of the debt was in foreign currencies, leaving borrowers exposed in the global downturn when bank lending dried up, property prices and wages plunged, economic growth went into reverse, and floating currencies depreciated.
Once the tap was shut off as credit dried up across Europe, countries that had enjoyed the biggest consumer booms had to make the biggest macroeconomic corrections, as well as service huge debts. Capital inflows into Latvia plunged by 30 percent in 2009 from the year before, pushing GDP down by 18 percent last year.
The IMF paper calculates that this has meant that the average growth from 2003 to 2008 was actually higher for those countries such as the Czech Republic that did not have a credit boom, than for the Baltic and Balkan states, which enjoyed soaring growth before the crash.
Countries where credit grew fastest not only experienced the highest volatility in their economies, but also saw lower average growth, the authors write. In other words, the foreign bank-led credit boom made these countries poorer than they would have been with more moderate lending. This conclusion will be even starker when the ongoing Baltic slump of 2009 to 2011 is included in the figures.
To be fair, regulators and policy makers must share some of the blame for permitting the explosion of credit and failing to counterbalance it with fiscal and monetary policy. "Regulators and politicians need to make a mea culpa too," says Patrick Butler, board member at Austria's RZB, a member of the Raiffeisen (RAIFF) group.
Further, foreign banks have to some extent redeemed themselves by stabilizing the region's banking sector during the global crisis and resisting the temptation to pull out. Their domestic problems have not usually infected their Central and Eastern European operations.
Precisely because the region's banking sector was so foreign-dominated, it was able to weather the financial crisis. Parent banks recapitalized their subsidiaries and supplied them with funds when wholesale markets were shut.
The worst affected countries were those, such as Ukraine and Kazakhstan farther east, where banks remaining under domestic ownership were not able to access outside funding.
There were initial scares that foreign banks would cut their Central and Eastern European operations adrift but last year, in the "Vienna Initiative," they agreed not to withdraw funding. Concerns, however, remain over the commitment of Greek banks to Bulgaria and Romania, given Greece's huge foreign debt. "Foreign owners so far remained committed," says Debora Revoltella, head of strategic analysis for Central and Eastern Europe at UniCredit (UNCFF).
Despite this, we have probably seen the end to the assumption that foreign ownership of banks is automatically a good thing and that supervision of these banks should be left purely to their home countries. The region's governments will keep a close eye on what foreign banks are up to and some may even begin to openly favor domestic ownership.
Poland may already be moving in that direction. Its center-right government is encouraging state-owned PKO to bid for Bank Zachodni WBK (BKZHF), which has been put up for sale by Ireland's biggest bank, Allied Irish Bank (AIB). "It is not irrelevant for Poland, for our banking system, who buys that bank," the country's treasury minister warned this month.