Speakers:

Aasim Husain, Deputy Director, European Department, International Monetary Fund Christoph Klingen, Deputy Chief, Emerging Economies Unit, European Department, International Monetary Fund Piroska M. Nagy, Director, Country Strategy & Policy Department, European Bank for Reconstruction and Development Debora Revoltella, Director, Economics Department, European Investment Bank Silvia Zucchini, Senior Communications Officer, International Monetary Fund

MS. ZUCCHINI: Good morning. This is Silvia Zucchini from the IMF’s Communications Department. Welcome to the conference call with media on the release of the quarterly Deleveraging and Credit Monitor for Central, and Eastern, and Southeastern Europe.

We have here staff of three international financial institutions (IFIs) that participate in the Vienna Initiative’s Steering Committee. Aasim Husain, Deputy Director of the IMF European Department, will deliver opening remarks followed by Christoph Klingen, Deputy Unit Chief in the European Department here at the IMF, Debora Revoltella, Director, Economics Department, EIB, and Piroska Nagy, Director of Country Strategy and Policy Initiative, Office of the Chief Economist at the EBRD.

For the format of the call, after opening remarks from the speakers, we will open for questions. And when we do so, please introduce yourself, if you have a question, and mention your affiliation.

I will leave the floor now to Aasim Husain.

MR. HUSAIN: Good morning, good afternoon, to all of you. A warm welcome from me, as well.

Let me give you a very short background on the Monitor, and how it fits into the overall work of the Vienna Initiative. The main purpose of the Monitor is to inform about developments in cross-border banking operations in the region. The Monitor tries to identify, early on, possible pressure points in cross-border banking flows, and areas where better coordination among banks, policy-makers, regulators, supervisors, and IFIs could be useful.

Fostering cooperation between the different players in home and host countries has been at the heart of the Vienna Initiative from the outset, when it was first set up at the height of the global crisis, in early 2009. Today, four years on, the Monitor continues to keep tabs on developments in cross-border funding provided by Western banks to the region— to the Central, Eastern, and Southeastern European (CESEE) region. But it also looks at the still very low credit growth in the region, and also the strategic repositioning of banks across the countries within the region.

Let me now hand over to the authors of the report. Christoph will speak first about the latest developments in cross-border bank funding and credit growth in the region. Deborah will then tell you about results of a Vienna Initiative Bank Lending Survey that offers a glimpse of where banking in CESEE might be headed. And then Piroska will conclude the opening remarks by speaking about related activities of the Vienna Initiative.

MR. KLINGEN: Thank you very much, Aasim.

Let me talk first about cross-border funding from Western banks to CESEE. The good news here is that funding reductions have remained orderly, and are currently at a moderate size. As you can see in Figure 1 of the report, they amounted to .3 percent of GDP in the second quarter of 2013. This is a lot less than in the second half of 2011, when the euro area crisis spiked and there was a concern that reduction of funding would become disorderly.

It's also worth noting that the funding reductions did not pick up in the second quarter, even though there was a lot of financial market turmoil for emerging markets at the time, related to the possible tapering of unconventional monetary policy in the United States.

Having given you this generally good news, I need to give you three important qualifications.

The first one is that we have seen funding reductions by foreign banks for eight consecutive quarters now. These reductions have cumulated to a sizeable amount—6 percent of GDP—for CESEE, excluding Russia and Turkey. And for some countries the effect was even larger than that.

Second, there seems no end in sight to funding reductions any time soon. Banks seem not yet done with rebalancing the funding of their subsidiaries away from parent funding, and toward domestic sources.

Third, there remains the risk that funding reductions could re-accelerate in the nearer term, including for instance, related to uncertainties surrounding the European Bank asset quality review and the stress tests, and also the tapering of unconventional monetary policy.

Turning now to credit development, the fact is that credit growth in the region remains very low—at just 1.2 percent, in nominal terms—for CESEE, excluding Russia and Turkey. The concern here is, of course, that this holds back economic recovery, or at least a sustained recovery.

In the short run, there are a host of demands and supply-side factors that are responsible. But if you take a step back, it becomes clear that the more fundamental challenge here is to find enough funding to fund significantly higher credit growth than currently. If you look at the two main factors that fund banks in the region, it is funding from foreign banks and deposit growth. You see this in Figure 9 of the Monitor. And while foreign bank funding continues to shrink, domestic deposit growth is positive, but it is only so much. So, together, the envelope is limited.

This is a good opportunity to now turn over to Debora, and the result of the bank lending survey, which holds a lot of additional clues as to where banking in the region is headed.

MS. REVOLTELLA: I think the picture that Christoph has presented is very much confirmed by the results of the Bank Lending Survey that we run under the Vienna Initiative. In fact, now, we are at the third run of the Survey. Every six months we interview all the international banks active in CESEE and all their subsidiaries. And what we gain is a good understanding of their commitment to the region, and the constraints they face in lending activities in each of the market of presence.

At the group level, all the international groups which are active in CESEE confirm that they remain committed to the region. But they are becoming more selective in terms of operations in different countries. Specifically, 30 percent of the banking groups tell us they will reduce or selectively reduce operations in the region; 38 percent will tell us that they may think about selectively expanding; and 8 percent tell us they are expanding in the region.

So we have, on the one side, a group that is selectively reducing their operations, and on the other side, other groups that are selectively increasing their operations.

When we ask to the parent banks what are the market opportunities for the region, there are countries where they see low potential. Approximately 30 percent of the subsidiaries in CESEE are considered to be either in a low-potential market or not adequately positioned in terms of size and the capacity to extract value from the market.

This is a reason for concern, and is one of the elements where we see that we need to continue to have a closer monitoring.

When we look at the country-level analysis-the subsidiaries in the Survey—what we are interested in is understanding the constraints to lending activities. Traditionally, since the first reading of the Survey, banks have always told us that both demand and supply elements are representing a constraint to lending.

The good news is that both demand and supply constraints are less tightened, with the demand side easing relatively faster than the supply side. And in this reading, the banks are telling us, for the first time, that they expect for the next six months some real relaxation of the demand side. When we look at the supply side, we specifically ask to the banks whether they believe that the domestic or international factors are representing a constraint to their capacity to lend. And they say both elements are important. And when we ask which elements are particularly important, they all point to the non-performing loans, both at the subsidiary and the parent level as the most relevant factor constraining the capacity of banks to lend.

The important element to note is that banks recognize that the non-performing loans have not reached the peak yet. However, the peak may be close to being reached in the sense that the expected deterioration is slowing, and the banks are becoming more optimistic. Still, in general, credit quality, is the biggest constraint for the capacity of banks to lend.

The other constraint that is highlighted by the Survey is regulation and, in particular, unpredictability of regulation. Interestingly, funding is not considered to be a constraint to lending activities. The parent banks declare that they have been able, as Christoph was saying earlier, to substitute with domestic funding the decrease in international funding.

The challenge that we see from the policy point of view is still that this funding is mostly short-term funding. And the other question mark is whether this funding is sufficient to support lending activities, which is currently low, but will pick up when economic activity improves. Thus this funding may not be enough.

So, as I was mentioning, the Survey very much confirms the message that Christoph was passing at the beginning. Basically, we see that moderation of funding is reducing, but we need to keep vigilant on the phenomenon.

We see that credit is still very low in the region, and this is an area of concern. Non-performing loans, unpredictability of regulation are the main constraints that should be addressed, and there is a role also for local capital market development.

The last point is to keep vigilance on those countries where all the international players today assess that market potential is limited.

With that, I hand it over to Piroska.

MS. NAGY: Good afternoon, good morning from me, as well, from EBRD.

My task here is, just very briefly, to link what you have heard already to the broader objectives and other activities on the Vienna 2 Initiative.

We can recall briefly that the Vienna 2 Initiative was launched with two major objectives. One is to monitor deleveraging, to avoid excessive deleveraging and systemic shock from deleveraging, and to support an orderly rebalancing of funding models.

On this you have heard so far from the Deleveraging and Credit Monitor and the Banking Survey Report. In the area of monitoring deleveraging and credit, we plan to do further work in two sub-areas. One is to work on policies and approaches to try to tackle the very high non-performing loans in several countries, particularly in Southern Eastern Europe. So that's one work stream. The other is to work on approaches and new innovative instruments for providing credit, including credit enhancement and risk mitigation instruments. This would be another new work stream for us, on which we hope to deliver some very concrete operational results in a few months from a new working group that has been created.

The second big objective of the Vienna 2 Initiative has been to improve home-host country coordination. You may recall that this was at its lowest point, with strong national bias, at the end of 2011 and early 2012, when we launched Vienna 2. In this regard, we have already produced a number of reports for the attention of European leaders, informing the evolving banking union project as it is advancing, first on the single-supervisory mechanism and then on the single-resolution issues.

We are very close to finalizing our latest report on the bank resolution and recovery framework and the single-resolution mechanism. We will make it public, and if there is interest, perhaps we can have also a conference call on that.

MS. ZUCCHINI: I think this is a good time to open the floor to questions. When asking questions, please identify yourself and indicate you affiliation.

QUESTIONER: I would like to ask for a clarification on two points. On page 6, the Monitor says that credit is currently expanding at the rate of 1.2 percent. So, it doesn't say over what period. Is it the second quarter?

Second question, the 6 percent of GDP figure, how much is that in actual terms, approximately?

MR. KLINGEN: On the credit growth, this is year-on-year growth, in nominal and exchange rate-adjusted terms. And it's a weighted average between all the countries in the region, excluding, I mean, Russia and Turkey, where developments are a little bit different.

QUESTIONER: What's the period it refers to?

MR. KLINGEN: Okay, it's June 2013 compared to June 2012. And as far as the 6 percent is concerned, it relates to Figure 3, where you see the red line, which refers to the region, excluding Russia and Turkey. There you see the reduction in the second wave of funding reductions which is, to be precise, not 6 percent of GDP, but 5.8 percent of GDP. And it corresponds to about $100 billion U.S.

QUESTIONER: Do you see deleveraging also as a positive, natural normalization process phenomenon? Because some countries, like Poland and Hungary, are curbing, or have already curbed currency loans. And deleveraging is part of the process. Polish banks, for instance, do not really require loans from the parent bank to the domestic bank.

And I have also a second question. You spoke about the risks in the short term from Fed tapering, but also from the asset quality review in the euro zone. How big are those risks? And could you somehow put any numbers on those risks?

MR. KLINGEN: Is deleveraging a good or a bad phenomenon? That's, of course, a tricky question that we discuss a lot within the Vienna 2 Initiative, but also at the IMF. I might want to point you, for the IMF, to the Regional Economic Issues (REI) paper that was one on the Future of Banking, in the spring of 2013. That has a lot of discussion on this very issue.

But, in a nutshell, to some extent, this deleveraging is unavoidable, and it's good. There wasn't a high degree of excess funding in the boom years. Some rollback of that certainly is necessary.

So, what we concluded in the REI was, in the end, that, we just have to make sure that in this process of correction we don't go too fast and too far.

Maybe others want to add something later on, but maybe Aasim has a few words about the risks from re-acceleration of deleveraging first.

MR. HUSAIN: On your risks question, one thing that the Deleveraging and Credit Monitor highlights is the risks related to the forthcoming asset quality review and stress test, but also it identifies risks related to the tapering by the Fed, when it actually does get underway.

All of these are actions that could potentially affect parent banks and, therefore, their appetite for lending to the CESEE region. They could also affect their own balance sheets, and therefore necessitate actions to shrink those balance sheets.

At this stage it is, of course, not possible to quantify the magnitude of these risks. But it's something to remain on guard for. And, indeed, that is the purpose, one of the purposes of the Deleveraging Monitor.

On your first question, let me just add one footnote to Christoph's answer. In addition to parent funding, which has proven to be much more stable than wholesale funding by sources other than parents of bank subsidiaries. So this has been, in some respects, actually, good news following the global crisis. As you might recall, in 2008-9, when the global crisis first got underway, there was concern that there could be a very rapid and prolonged pullback of that funding. To some extent, it started to happen, but it quickly tapered off and, for the most part, at least for the region as a whole, that withdrawal of funding has been gradual and reasonably orderly.

But, as you point out, some aspects of it have actually been good, to the extent that it has helped banking systems achieve more balanced, for example, foreign currency positions, that has actually helped reduce risks.

MS. ZUCCHINI: Debora and Piroska, would you like to add anything?

MS. REVOLTELLA: Yes, I can add something on deleveraging and whether it can be considered as a positive element.

I think, on the banks' point of view, the rebalancing of the funding model of the subsidiaries is considered to be something positive. And so they basically recognize that more domestic funding via deposits is a positive and stabilizing factor for their own banks.

On the other side, there is one element, that I mentioned in discussing the Survey and that is important, namely that domestically, in most of the countries, you only have short-term funding and not long-term funding. And that's a constraint, as long as the local capital market will not be developed.

So this is another element to consider. Local banks can not only fund themselves domestically. The optimal solution is probably a balance in which we have some domestic funding, some international funding, which brings the long-term component to funding.

MS. NAGY: Maybe one footnote to all these very good explanations, to which we fully subscribe, is to mention that emerging Europe is an exception to the rule in terms of the relationship between capital inflows and growth among emerging markets. Typically, there is no direct relationship, or a very ambiguous relationship between capital inflows and growth in an emerging market, if you look worldwide. However, as we discussed a couple of years ago in the EBRD Transition Report, there is a clear positive relationship for emerging Europe, between capital inflows and growth.

So, while it is absolutely necessary to have a much more healthily balanced funding model, with heavier reliance on domestic sources and funding, let's not forget that capital inflows trickling down to higher productivity regions in emerging Europe have proven to be very positive for growth. And we believe that the healthy and less risky elements of this type of model should be kept to the benefit of both emerging Europe and advanced Europe in the end.

MS. ZUCCHINI: Thank you very much for participating to this conference call. Have a good rest of the day.