Europe is in a deep recession. Adverse feedback between the financial and real sectors and across borders is likely to delay the recovery and create downside risks. Unprecedented policies have been undertaken to address the crisis-but are they likely to be successful and sufficiently coordinated for a tightly integrated region? To restore trust and confidence in financial markets, additional and forceful action will be essential. Maintaining fiscal support should help soften the downturn, in particular if sustainability is supported by solid medium-term strategies and fiscal frameworks. To be effective, these policies require coordination across advanced and emerging economies. The report's analytical work underpins the link between fiscal sustainability, coordination, and effectiveness, and stresses that emerging markets have been affected differently by the crisis, with the quality of policies and external vulnerabilities being key factors.
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Note: The main authors of this chapter are Martin Čihák and Srobona Mitra.
37Emerging European economies are defined to include (1) countries that joined the EU in 2004 or thereafter and had not joined the euro area by end-2008 (Bulgaria, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, and the Slovak Republic), and (2) the non-EU countries of Albania, Belarus, Bosnia and Herzegovina, Croatia, FYR Macedonia, Moldova, Montenegro, Russia, Serbia, Turkey, and Ukraine. In the subsequent econometric analyses, some countries were dropped due to lack of data.
38In fact, the average ratio of government debt to GDP in countries that had to resort to official financial assistance has been less than half of the euro area average.
39Bank-related capital inflows are defined as the balance of payments item “other investment, liabilities,” aggregating the subitems “loans” and “currency and deposits.” These two items capture loans comprising inflows from parent banks into emerging market subsidiaries and cross-border loans to banks and corporates, excluding portfolio and foreign direct investment inflows. The breakdown of this category into bank and nonbank flows is not available consistently across countries, but available data and anecdotal evidence suggest that the bankrelated portion is large, reflecting the central roles of the banking sector and the high degree of foreign ownership in most emerging European banking systems.
40The European Central Bank and the European Commission provide assessments for the NMS on their progress toward meeting the criteria for convergence to euro adoption (the “convergence criteria”). The five criteria are the fiscal deficit (less than 3 percent of GDP), government debt (less than 60 percent of GDP), inflation (less than 3.2 percent for 2008), the long-term interest rate (less than 6.5 percent for 2008), and the exchange rate (participation in the Exchange Rate Mechanism (ERM) II).
41Different authors have interpreted the halo effect differently. Hauner, Jonas, and Kumar (2007) posit that it is linked to EU membership, in particular the effect of better institutions and processes, such as fiscal rules, that have been put in place since EU accession. This would suggest that the halo effect may be lasting. Luengnaruemitchai and Schadler (2007) point out that the halo effect is essentially an unexplained residual that may turn out to be temporary.
42The econometric analysis involves robust ordinary least squares (OLS) estimates on pooled data of 43 European countries, covering three main subgroups: euro area members, NMS, and other emerging Europe. Episode fixed effects were used to control for common factors that affected all countries. Country-specific variables were used to explain cross-country differences in performance.
43Each convergence criterion (see footnote 40) is assigned one point. If the country meets a criterion, it gets 0; otherwise, 1. Therefore, the variable used in the regression takes values from 0 (for a country fulfilling all criteria) to 5 (for a country meeting none of the criteria).
44The estimates use an augmented version of the methodology by Laeven and Majnoni (2003). A limitation of the estimates is the shortness of the time series as well as the fact that eastern European banks have not yet been through many business cycles. The estimates therefore need to be treated only as illustrative.
45See De Nicolò (2000); and Maechler, Mitra, and Worrell (forthcoming) for a discussion of the z-index and its various forms. Here, z = (return on assets + equity/assets)/mean deviation of return on assets within a bank. Higher z should in general indicate greater stability or lower risk of insolvency.
46To give an example based on the empirical model, a decrease in Latvia’s growth rate from 10.0 percent in 2007 to −4.6 percent in 2008—a decline of about 15 percentage points—would mean an increase in provisions by 1.05 percentage points—for a total of 1.26 (=0.21+1.05) percent of 2007 assets. For most countries, such an increase is beyond two standard errors of average provisions. The quantitative impact modeled in the regression is linear, and hence probably on the lower side. During a crisis, the effects could be nonlinear mainly for two reasons: first, second-round effects of reduced credit flows on output and employment would cause further distress on bank balance sheets, and, second, widespread balance sheet mismatches in foreign currency of the private sector could be exacerbated through large-scale exchange rate depreciations generating further credit risk for banks. These second-round effects have not been modeled here due to lack of data.
47In a bivariate vector autoregression of consumption growth and income growth in the United States, Blanchard (1993) shows that shocks to consumption could be long-lasting and could delay recovery from crises.
48The correlation between consumption and retail sales growth is, on average, higher than 50 percent (and significant) for the emerging European economies.
49The methodology follows Bacchetta and Gerlach (1997) and Bayoumi and Melander (2008), who estimate the effect of predictable changes in credit on consumption growth. It augments these regressions with measures of consumer sentiment about unemployment expectations following Carroll and Dunn (1997). To address the shortness of the time series for emerging European markets, monthly series on retail sales and real wages are used, with the latter approximating movements in income.
50Because there could be reverse causality from retail sales to current income growth, instrumental variables were used to substitute for current real wages. Instruments included real wage growth and retail sales growth lagged by one through three, six, and nine months. Granger causality tests show that credit growth, on average, does a much worse job at predicting future wage growth than past wage growth or retail sales growth. This finding supports the interpretation that the significance of credit growth in the regression reflects its ability to explain retails sales growth beyond its role in explaining current income growth.
51Carroll and Dunn (1997) show that, for the United States, when uncertainty about future labor income increases, consumers postpone purchases of durable goods until their balance sheet condition improves. Another result suggests that durables consumption was more sensitive to this uncertainty measure after financial liberalization. The sensitivity could have increased over time for emerging markets too as their financial systems were gradually liberalized over the last decade.
52Under Basel II Pillar 2, bank supervisors need to evaluate banks’ internal capital adequacy calculations and compliance, and could require higher capitalization for individual banks if their risk profiles are higher. Supervisors need to determine this risk by conducting stress tests. But countries need to have the supervisory capacity to make the necessary assessments and the adequate legal framework to take action.
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