First, let me thank the Bank of Albania and the IMF, the organizers of this event, for the invitation to be here as part of this excellent event, and share with you the thoughts of the Central Bank of Macedonia on the implications for the Western Balkan region of the recent very accommodative ECB monetary policy. In particular, I will focus on Macedonia.
As it has been already extensively discussed, the ECB has recently provided an unprecedented monetary stimulus via a package of different standard and nonstandard policy measures. This monetary stimulus is contributing to the improvement of the real economies in the eurozone and has helped overcoming impairments in the functioning of financial markets. Given the strong trade and financial links of our region in general, including the Republic of Macedonia, with the European Union (EU), spillover effects of ECB policies are one of the key policy questions that we, as policymakers, are confronted with and need to assess and anticipate.
Some figures may help quantify the regional trade and financial links to the euro area. Trade exposure of the region with the euro area represents 62 percent of GDP, with the highest exposure recorded in Bosnia and Macedonia. Also, the financial channel is a source of important linkages. The main source of FDIs and private transfers is the EU. Banks headquartered in the EU hold a predominant market share in most of the countries in the region.
As a small and open economy, Macedonia has high and rising trade links with the EU. Some figures may corroborate this statement. For example, 80 percent of the stock of the FDIs comes from the EU, about 80 percent of our exports goes to the EU, about 60 percent of our banking system is owned by European banking groups, and about half of the private transfers, which are a very important overall financing source of the economy, comes from the EU. Therefore, in this context, it is not a surprise that the assessment of the spillover effects of ECB policies is a very topical issue for us and for all countries in the region. This is not only from the point of view of the benefits that our economy has enjoyed, or of the extent it can enjoy the benefits of very accommodative ECB policy, but also from the perspective of risks that we might face when the course of the ECB monetary policy changes.
In light of the multiplicity of the linkages with the EU, the spillover effects can take place through a number of different channels. They include the capital inflows channel, that is, the re-allocation of part of the liquidity injected by the ECB on the financial markets in the region. Such a re-allocation mechanism may engender and fuel cross-border capital flows, leading to a compression of the yields and lower risk premia on different kinds of asset classes. Furthermore, lower ECB interest rates provide room for downward adjustments of the main policy rate of all the countries in the region, which are, subsequently, transmitted to lending rates in the region as a whole, and in particular, in the countries with some form of fixed exchange rate arrangement. Lower ECB policy rates, therefore, allow room for downward policy adjustment without encouraging capital outflows or further euroization, which is an issue in all the countries in the region.
Positive spillover effects also take place via the trade channel. Recovery of the foreign demand provides positive impulse for the export sector. The improved economic prospect for the EU, as our main trading partner, positively affects not just the export segment of the economy, but it has wide-ranging effects throughout the whole economy, through the investment channel, or through the labor market to consumption. Therefore, a pickup in foreign demand underpins a faster recovery of the real economy of the Western Balkans. Furthermore, consumer confidence and business sentiment are other transmission channels. Prospects for stronger recovery of the main trading partners can also positively affect the expectations of the domestic agents. And last, but not least, one should not forget the exchange rate channel.
After having discussed the possible spillover effects of loose ECB monetary policy in theory, let’s have a look at their effects in practice. In my presentation, I will first analyze whether the loose ECB policy has led to capital inflows in the region, what their dynamics are, and what their structure is. First of all, I have broken down the after-financial-crisis period in two sub-periods to see whether the ECB large-scale asset purchase programs (LSAP) in the past couple of years have resulted in larger capital inflows in the countries in the region. To this end, I use the Balance of Payments (BOP) data as a rough indication of the capital inflows. They are on an accrual basis and their recent dynamics may reflect several contributing factors, but at least they provide an aggregated picture of what has been taking place in the region as a result of the loose ECB policy.
We can see from Figure 1 that capital inflows in the region have continued, although at a somewhat slower pace, across all countries in the region. For example, if in the pre-crisis period they accounted for about 16 percent of GDP, in the post-crisis period they have decelerated to about 6 percent of GDP. This deceleration is evident across almost all the countries in the region, although it appears to be larger in the case of Bulgaria and Serbia. In the case of Bulgaria, there is a downward adjustment close to 30 percentage points, and in Serbia close to 20 percentage points. On the other hand, the adjustment in Macedonia is smaller. Capital inflows decline just a couple of percentage points of GDP. It is interesting to note, however, that the deceleration of the capital inflows continues in the second sub-period when, pursuant to the launch by the ECB of the large-scale Asset Purchases (LSAP), one would expect to see larger cross-border flows.
The figure also shows that Albania seems to be an outlier, since, unlike in other countries, there is a pickup in the capital inflows in both sub-periods. The colleagues from Albania can better explain the reasons underlying this observed trend. Despite the lower pace of capital inflows, the deceleration that we are seeing in the region is lower compared to the Central European countries and the Baltics. In the Central European countries, capital inflows have overall stalled, and in the Baltic States there is a significant downward adjustment, partially reflecting the pre-crisis period dynamic of particularly large inflows.
If we now turn to the structure of the capital inflows, we can see that the deceleration on average for the region is taking place across almost all types of capital inflows. For example, if you look at Figure 2, the blue bar represents the FDIs. The FDIs decelerated roughly from 9 percent of GDP to about 5 percent of GDP. The largest drop is taking place for other financial flows. This category, other financial flows, is a residual category representing everything that is not portfolio or FDI investment. It reflects different kinds of financial or commercial loans. Other financial flows declined from about 7 percent of GDP to about 1 percent. More structurally, if you look at the sectorial composition of this category in the BOP data, you can clearly conclude that the decline can be explained to a large extent by the process of deleveraging of the banking system. One could therefore preliminarily conclude that accommodative ECB monetary policy and the LSAP have not benefited the bank lending channel in the region. The liquidity injected via the ECB measures in the European banking sector has not been redeployed in the region. On the contrary, in most countries, we are witnessing a continuous process of banks deleveraging, which can be explained by the new, tighter regulatory framework banks are confronted with. The implementation of the new Basel III standards in the medium term will obviously increase the resilience of the banking system, but, in the short term, it has some negative effects for the countries in the region.
Looking at portfolio flows, it seems that on average they have remained broadly stable, at around 1 percent of GDP. However, the average hides heterogeneity across countries. Looking at more granular data in terms of the sectorial composition, it appears that a downward adjustment of portfolio inflows in the private sector has been compensated by a pickup of portfolio inflows in the government sector.
Despite the lack of the counterfactual of what would have taken place without ECB accommodative monetary policy, overall BOP data supports the notion that ECB policy underpinned capital inflows in the region. Despite the banking system’s deleveraging process, capital inflows continued in the region, albeit at a somewhat slower pace, and no reversal took place. In particular, capital inflows were underpinned by still solid FDIs, as well as portfolio inflows toward the government sector, which was one of the main beneficies, via both a quantity and price effect.
The conclusions apply equally well to the case of Macedonia, which I will now discuss in greater detail. Capital inflows in Macedonia decelerated, although the pace of the deceleration was lower compared to the average deceleration for the region. One of the reasons are FDIs. As we look at the composition of the FDIs, as evidenced in Figure 3, I would like to underline the positive structural shift. If, in the pre-crisis period, we had about one third of FDIs channeled toward the tradable sector, in the post-crisis period we have roughly half of the FDIs being channeled in this sector. This contributes diversifying the structure of the export sector, as well as the structure of the whole economy, making it more resilient to any future potential shocks. Such developments help in addressing the structural problem of our economy, represented by a high structural trade deficit.
Concerning the portfolio flows, there is some volatility in the post-crisis sub-periods, mostly explained by the government borrowing. This is visible in Figure 4. Immediately after the crisis, portfolio inflows accelerated, driven by countercyclical fiscal policy. The government increased investment expenditure in large infrastructure projects to offset the negative effect of the crisis on domestic growth. This required financing for which the government stepped up foreign currency borrowing. The government, in our case, had space for more accommodative fiscal policies thanks to very prudent fiscal policies followed for years also in support of the de facto fixed exchange rate.
As regards to other debt flows, their dynamic is also volatile. In the first period, they picked up, then they slowed down. This dynamic is, however, also explained by the government policies. In fact, other debt flows are driven by government borrowing either directly or indirectly through a development bank that has kept borrowing to offset the effects of the banking system’s deleveraging process. Overall, ECB policies seem supportive of the capital inflows in Macedonia, mostly through the channels of FDIs and through sovereign borrowing. As regards the FDI channel, the change in their composition toward the tradable sector can be explained, instead by government policies, which were aimed at attracting foreign direct investments in the free economic zones.
So far, we have seen the pattern of the capital inflows in the region. Let’s look now at the implications of these capital inflows on the financial conditions in the region. ECB non-conventional measures, including the asset purchase programs and the negative interest rates, provide room for prolonged accommodative monetary policy across all countries of the region. Regardless of the heterogeneity in the exchange rate and monetary regimes, all countries have loosened monetary policy since the beginning of the crisis. This is evidenced by Figure 5.
In the figure, I have used the policy rate as a proxy of the monetary policy stance, but obviously, besides the policy rate, many countries have used different non-standard measures. Loose ECB policy allowed a decrease of policy rates in the region without having any destabilizing economic or financial consequences. As evidenced by the figure, the highest downward adjustment took place in Serbia and the lowest downward adjustment in Macedonia. In Macedonia, although the policy rate has been lowered less than in other neighboring countries, it is still at its all-time lowest level.
So, there are a lot of questions and ongoing discussions on the scope for additional monetary accommodation and the level of our effective lower policy rate bound. Can we move further down without having destabilizing consequences on the economy and the financial system? One of the problems that we have witnessed in the recent period is the dynamic of banks’ deposits. Although the stock is still solid, in our assessment, their recent dynamic is not fully in line with the movement of the fundamentals, indicating that there is some reallocation of the deposits in other segments of our economy. We were looking at financial markets in general, capital markets and money market funds in particular, to see whether there is some re-channeling in these segments, but even the reallocation that we see cannot fully explain the observed deceleration of deposit growth. Deposit growth is a very important source to support credit to the private sector, for us and for all countries in the region, because bank lending predominantly relies on deposits.
A looser monetary stance has also been conducive to downward adjustment of the bank lending rates, as it is visible across all countries in region. The highest decline in the lending rates can be observed in the case of Albania, and the lowest in the case of Croatia. Macedonia is somewhere in between. The reduced cost of financing supported the credit demand, although credit growth in most of the countries still remains anemic. There are some countries in the region where credit to the private sector has continued contracting even in the most recent period. In Macedonia the lending rates reached historically low levels, leading to solid credit growth, which is in fact the highest in the region. A couple of factors might explain credit growth resilience in Macedonia. First, we avoided a credit bubble fueled by foreign inflows in the pre-crisis period, which limited the post-crisis need to deleverage. Second, only a stable banking system with good asset performances can support higher credit growth.
However, despite the low interest rate environment, public debt in the region rose significantly. This brings us to an assessment of the negative implications of ECB monetary policy. Low interest rates have not been conducive to government fiscal consolidation efforts. In most countries in the region, public debt has been on a rising trend. This is equally true in the case of Macedonia. Public debt almost doubled compared to the pre-crisis period, although it is still one of the lowest in the region. What worries us are the dynamics of the debt increase and the structure of the public expenditures. Increasing expenditures are made up only in a small extent by discretionary spending. This will create significant pressures for the consolidation of the public finances, especially when the interest rates start increasing.
Turning the attention to the overall economic developments, just looking at the data, it seems that improved financial conditions, the recovery of the external demand, and structural factors or structural changes in certain economies have been conducive to the recovery of the economies. All countries have exceeded the pre-crisis level of GDP, with the highest increases recorded in Albania and Macedonia. In Macedonia, I would like to underline that, due to the positive structural shifts in the FDIs, there has been, to some extent, a change in the growth model, which currently relies more on the export sector.
In terms of GDP composition, if we look at the chart on the right-hand side of Figure 6, we can see that there are positive shifts. They include rising shares of export and import as well because export is still significantly dependent on import, but, on a net basis, this is a positive change, while the share of consumption and public and private consumption has been declining.
Given these effects from a looser ECB policy, we should ask ourselves what are the risks arising from a future ECB exit from very accommodative monetary policy. As already mentioned, there are many factors in play. The risks depend on the fundamentals of the economies, their vulnerabilities, the policy buffers, and the size and composition of the capital inflows.
Regarding the size and composition of capital inflows in the Western Balkans, it appears that future tightening of the ECB policies is unlikely to create significant imbalances in our economies. We don’t see much pressure on the current account deficits, and we do not see real estate or stock index bubbles fueled by short-term speculative capital inflows. But, we need to remain very vigilant. If we look at the financial external exposure of all countries of the region, it remains elevated. In fact, the most recent regional outlook of the IMF points exactly to the high external liabilities of all countries in the region as their highest vulnerability, in case of future ECB monetary policy tightening. Figure 7 shows the net international investment position as a rough indication of the extent of this vulnerability. We can see that the process of rapid rise of the negative net international investment position was halted in the post-crisis period, but, still looking at the stock, it points to significant exposure and requires close vigilance from us as policymakers.
To conclude, I think that recent episodes of Fed tapering and US post-election market sell-off may provide some indications on the effects that may be expected by the future ECB exit. Based on the IMF data, US developments had spillover effects in Europe, including some countries in the region. There were capital outflows, although not sizeable, with negative impact on the financing spread of the economies, exchange rate, and some asset classes. There is heterogeneity in the monetary and exchange rate arrangements, as well as in economic and financing structure and fundamentals across the region, but definitely the recent experience calls for policy makers’ vigilance.
