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Post-Communist Economies
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Central and Eastern European countries in the global financial crisis: a typical twin crisis?
Diemo Dietrich
a b a b

, Tobias Knedlik & Axel Lindner

Halle Institute for Economic Research, Germany Martin Luther University Halle-Wittenberg, Germany

Available online: 07 Nov 2011

To cite this article: Diemo Dietrich, Tobias Knedlik & Axel Lindner (2011): Central and Eastern European countries in the global financial crisis: a typical twin crisis?, Post-Communist Economies, 23:4, 415-432 To link to this article: http://dx.doi.org/10.1080/14631377.2011.622561

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Post-Communist Economies Vol. 23, No. 4, December 2011, 415432

Central and Eastern European countries in the global nancial crisis: a typical twin crisis?
Diemo Dietricha,b, Tobias Knedlika* and Axel Lindnera
a Halle Institute for Economic Research, Germany; bMartin Luther University Halle-Wittenberg, Germany

(Received 21 March 2011; nal version received 19 April 2011) This article shows that during the Great Recession banking and currency crises occurred simultaneously in Central and Eastern Europe. Events, however, differed widely from what happened during the Asian crisis that usually serves as the model case for the concept of twin crises. We look at three elements that help to explain the nature of events in Central and Eastern Europe: the problem of currency mismatches, the relation between currency and banking crises and the importance of multinational banks for nancial stability. We show that theoretical considerations concerning internal capital markets of multinational banks help us understand what happened on capital markets and in the nancial sector of the region. We discuss opposing effects of multinational banking on nancial stability and nd that institutional differences are the key to understanding different effects of the global nancial crisis. In particular, we argue that it matters whether international activities are organised by subsidiaries or by cross-border nancial services, how large the share of foreign currency-denominated credit is and whether the exchange rate is xed or exible. Based on these three criteria we give an explanation why the pattern of the crisis in the Baltic countries differed markedly from that in Poland and the Czech Republic, the two largest countries of the region.

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The consequences of the global nancial crisis which spread outward from the US from 2007 are among the most serious in history. Not only did banking systems experience serious difculties but public debt crises also arose and currencies came under pressure. Moments of crisis can arise in different sectors of the nancial system. During a banking crisis, entire banking systems may be unable to perform their function as nancial intermediaries, which interrupts the channelling of individual savings into individual investments. In the case of debt crises, borrowers are suddenly unable to repay debt; as a result, potential lenders may be disinclined to continue lending. In the case of a currency crisis, a country suddenly loses the condence of international investors, which leads to a sharp depreciation or devaluation of the currency of the country concerned, or to a reduction of its international reserves (Gerber 2010). Often different kinds of nancial crisis occur simultaneously. In such a case the real economic costs are even higher. A joint currency and banking crisis is referred to as a twin crisis.

*Corresponding author. Email: Tobias.Knedlik@iwh-halle.de

ISSN 1463-1377 print/ISSN 1465-3958 online q 2011 Taylor & Francis http://dx.doi.org/10.1080/14631377.2011.622561 http://www.tandfonline.com

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This article deals with the question whether the Central and Eastern European countries were hit by such a twin crisis during the recent global nancial crisis. We take account of country specics by considering the structure of the banking systems in the region, as well as the extent of external debt. Our core hypothesis is that the presence of international banks did not pose very much of a problem in the sense of being an additional transmission channel of the global crisis but instead helped to stabilise these economies. We begin with a review of the literature on the relation between currency crises, debt crises and banking crises. This is followed by a concise overview of the structure of the banking systems and exchange rate regimes of selected Central and Eastern European countries up to the onset of the crisis. We then use observations of developments from 2007 to 2009 to answer the question whether the region faced a twin crisis. The nal section sets out our conclusions. Financial crises in emerging economies Currency and debt crises: the problem of currency mismatches In many cases currency mismatches were at the core of nancial crises (Allen et al. 2002, Goldstein and Turner 2004). An economy is subject to a currency mismatch if its households, nancial and non-nancial rms and governments have to borrow in foreign currency whilst most of their assets (or incomes) are denominated in local currencies. This makes real wealth (or income) strongly dependent on exchange rate movements: when the local currency depreciates, the real debt burden of a country increases, which may result in a debt crisis and may affect the countrys entire nancial system a phenomenon prevalent in many emerging countries.1 Currency mismatches have been a central element in most of the nancial crises in the last few decades.2 They are considered to pose a critical risk to the worlds nancial system. The problem of foreign government debt drove Mexicos Tequila crisis (1994/95) and the Argentinean crisis (2001/02).3 In Russias nancial crisis (1998), not only foreign government debt but also the foreign indebtedness of Russian banks turned out to be problematic. In the Asian crisis (1997/98) currency mismatches on the balance sheets of non-nancial rms were crucial, for example, in South Korea, Thailand and Indonesia. There, it became evident that banks individual hedges against currency mismatches did not sufce to shield the entire economy as banks only rolled over the currency mismatch to their borrowers. Banks thus exchanged their exchange rate risk for credit risk, which still depends on exchange rate developments. An intense debate arose about diagnosis and cure during the years following the Asian crisis. This debate was based on the observation that the willingness of international lenders to accept the denomination of debt in the currencies of emerging economies is very limited. Eichengreen et al. (2005)4 coined the term original sin for this problem, based on the notion that countries may simply have inherited the inability to borrow in their own currency and thus cannot escape their past even if they switch to stability-oriented macroeconomic policies. Thus the emerging economies did not choose the risk of currency mismatches.5 However, economic development and especially macroeconomic policies of countries can, if they aim at macroeconomic stability, mitigate the adverse consequences associated with currency mismatches and thus lower the probability that currency mismatches will turn into crises. Goldstein and Turner (2004) have shown that the extent of the mismatch may indeed vary in accordance with an emerging countrys economic development and economic policy. Accordingly, simple measures such as the share of foreign currency-denominated debt in total debt outstanding understate the impact of economic development and

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economic policy on risks associated with a currency mismatch. A more appropriate measure of the extent of a currency mismatch is net foreign currency assets times the share of foreign currency-denominated debt, divided by the countrys exports. Such a measure has been dened by Goldstein and Turner (2004, p. 44). The indicator takes into account that 1) a country may also possess assets denominated in foreign currency, including the central banks international reserves, 2) foreign currency-denominated debt contributes only little to nancial vulnerability if it constitutes only a small share in total debt, and 3) income from exporting goods and services can be used to back foreign currencydenominated debt. According to this indicator, currency mismatches have been reduced, in particular in the countries which were hit hardest by the Asian crisis. Whilst that result is plausible, the approach also has its disadvantages. On the one hand, net liabilities denominated in foreign currency can only be estimated; on the other hand, the indicator is not formally derived from theory but follows plausibility considerations. The relation between currency and banking crises

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A currency mismatch may lead to a currency crisis if nancial markets lose condence in the ability of a country to service foreign currency-denominated debt; the currency crisis is then accompanied by a debt crisis. However, the stability of banks is also in danger if the creditors of a bank value their deposits in foreign currency. In their seminal work on these interdependencies, Chang and Velasco (2000) analyse the impact of the exchange rate regime on the vulnerability of banks to self-fullling crises. The starting point of their analysis is Diamond and Dybvigs (1983) model, which explains that for banks the transformation of illiquid assets into liquid liabilities may lead to multiple equilibria caused by asymmetric information. One of these equilibria constitutes a coordination failure of depositors and results in bank runs. Using a simple macroeconomic model of an open economy, Chang and Velasco (2000) show that, in a case of a xed exchange rate regime, banking crises and/or currency crises may emerge independently from the way in which the exchange rate is xed. However, in the case of exible exchange rate regimes, a lender of last resort (LLR) can ensure that multiple equilibria are avoided. Investors would expect the LLR to provide banks with liquidity in the case of a bank run. The investments of all investors measured in foreign currency would be devalued to the same degree in the case of a bank run, because the increase in liquidity provided by the central bank does not result in declining foreign exchange reserves but in a depreciation of the exchange rate. The devaluation of investments would also affect investors who withdraw early. For that reason, there is no incentive to withdraw more than the individual liquidity demand from banks. Bank runs may thus be avoided. Chang and Velasco (2000) consider only the case in which banks perform liquidity transformation for the sole purpose of serving the liquidity preferences of the investors. Diamond and Rajan (2001a), however, pointed out that the fragile capital structure of banks could be caused by the incentive and enforcement problems associated with nancial contracting. In many emerging market economies legal and corporate governance systems are poorly developed: on the one hand, this leads to a dependency on nancial intermediation as banks specialise in gathering information and thus solving contractual problems (Diamond and Rajan 2001b); on the other hand, short-term debt of banks constitutes under such institutional conditions a necessary disciplinary element for banks to full their intermediation tasks. However, short-term debt may also cause higher vulnerability to bank runs caused by fundamental shocks to the banking system.

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Short-term renancing of banks is not the only consequence of the need to discipline banks. In principle, short-term renancing could be done in domestic or foreign currency. However, often banks can only renance themselves in foreign currency (leading to a currency mismatch) because of limited condence in the countrys macroeconomic policy. Thus the existence of an LLR implies not only that bank runs as a result of a coordination failure are eliminated. The LLR also gives banks a good reason to speculate on a public bail-out. They therefore have little incentive to follow a prudent ` -vis business policy, so banks potentially still suffer from a commitment problem vis-a investors. This problem is particularly severe if prudential bank regulation and supervision are insufcient or if the legal system is not adequately developed to ensure that contracts will be enforced (Diamond and Rajan 2006). Therefore, investors usually respond by accepting only short-term debt denominated in foreign currency for which help by a lender of last resort is limited by the amount of foreign exchange reserves. Eventually bank liabilities have to be covered by export returns in emerging markets, placing disciplinary pressure on macroeconomic policy (Diamond and Rajan 2001b). This in turn makes banks vulnerable to exchange rate volatility and can cause the simultaneous emergence of banking and currency crises.6 It has been shown empirically that in most cases currency crises follow banking crises and that banking crises become more serious if they are followed by currency crises (Kaminsky and Reinhart 1999). Moreover, twin crises are more likely to occur in a situation after liberalisation of nancial and capital account transactions and when a country enters a recession that follows a capital inow-fuelled boom with an overvalued currency. These ndings are supported by Glick and Hutchison (2001). Their study identies banking crises as an indicator for currency crises, and the liberalisation of nancial and capital account transactions increases the vulnerability of countries to twin crises. Hutchison and Noy (2005) have shown that twin crises cause much higher real costs than if only one of the two kinds of crisis occurs. The average loss of production adds up to between 5% and 8% during the rst two years after a crisis. Falcetti and Tudela (2008) have shown a strong relation between banking and currency crises, because both can largely be explained by the same fundamentals. However, they do not conrm the ndings of Kaminsky and Reinhart (1999) that currency crises follow banking crises; they explain Kaminsky and Reinharts result as possibly being due to misspecied econometric models. The importance of multinational banks for nancial stability Hitherto currency and banking crises have been analysed on the implicit assumption that a banking system consists mainly of domestic banks. The inuence of multinational banks on the (in)stability of a countrys banking system and the stability of the currency is still a largely unsolved research question. Among the different modes of banks entry into foreign markets, two are particularly important, each having different stability implications. First, banks can organise their international activities by establishing local subsidiaries or branches that are to some extent nancially, organisationally, as well as legally, independent; this mode is called multinational banking. Second, banks can offer banking services to foreigners directly from the banks home country; this mode is called cross-border nancial services. Banks decision on their mode of foreign market operation is closely related to nonnancial rms decision on whether to serve foreign markets by exporting goods or by establishing foreign representations (Helpman 2006).7 In particular, banks tend to serve foreign markets through subsidiaries if they have a strict productivity margin over

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competing banks that supply nancial services across borders (Dietrich and Vollmer 2010). This productivity margin is necessary, in part because subsidiary structures have a comparative disadvantage with respect to their ability to settle country-specic liquidity shocks. Buch et al. (2009) have conrmed this argument empirically and show that, although almost all German banks hold claims against foreign countries, only those banks with productivity advantages are also present in foreign countries. Buch et al. also suggest that German banks establish subsidiaries more often in countries that are geographically close to Germany, have a comparable cultural background and are economically strong.8 Internationally active banks increase the efciency of the international allocation of nancial resources, because parent banks can adjust capital allocations if the expected returns of different subsidiaries change (Stein 1997). In addition, the parent bank can raise funds against assets in one country and transfer them to subsidiaries that face underdeveloped nancial and legal systems or a local nancial crisis. Thus, multinational banks improve the supply of credit, compared with national banks, because assets and returns in other regions can be used as collateral to renance banking activities in a given host country.9 From this point of view, stability implications are not straightforward. On the one hand, banks aim at balancing marginal returns across borders. For a given amount of capital, countries where the expected marginal return increases will be allocated more funds at the expense of the other countries (substitution effect). On the other hand, banks take into account the effects that this kind of bank internal re-allocation has on the funding constraint of the entire bank. Thus the credit activities in developed countries have priority over balancing marginal returns (renancing effect). This is the case because liquidity and solvency risks are higher in developing countries and, therefore, cause higher renancing costs for the bank.10 Whilst these general ndings are valid for both multinational banking and cross-border nancial services, there are differences in their relative weights. In the case of cross-border nancial services, a decline in expected returns due to a downturn of the business cycle in the home country of the bank should lead to a better credit supply in the foreign country, via the substitution effect. However, because of the associated worsening in pledgeable income, the total amount of funds available to the entire bank will decline and may thus constrain lending in the foreign country despite the increased relative attractiveness of the foreign market. If, however, the expected returns increase in the foreign country due to an upturn in its own business cycle, the overall renancing conditions remain almost unchanged, since they largely depend on the nancial conditions of the parent bank. In that case, the substitution effect should dominate. Banks offering cross-border nancial services may therefore contribute to nancial stability if an emerging host country is hit by a banking crisis. Because of the crisis, only domestic banks face a tightening in their ability to renance loans.11 If, however, a banking crisis occurs in a banks home country, its supply of cross-border nancial services will be strongly affected via the renancing channel, notwithstanding the fact that the foreign business of the bank might prot, relative to the home business, via the substitution effect.12 In the case of multinational banking the substitution effect tends to be smaller, because bank internal capital markets are imperfect and hampered by potentially conicting interests of the managers of different subsidiaries (Stein 2002, Dietrich and Vollmer 2010). However, this could also be an advantage, because it reduces the effects of countryspecic shocks and prevents internal contagion, because affected subsidiaries can be ner 2008; DellAriccia and Marquez 2010). If a banking crisis quarantined (Fecht and Gru

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arises in one of the subsidiaries host countries, the subsidiary can expect to be supported by the parent bank as long as the existence of the bank as a whole is not endangered. This applies particularly where the banking crisis leads to renancing problems rather than loss of earnings. This implies that subsidiaries are able to continue business and might even be able to gain market share from crisis-ridden domestic competitors. Thus there is an argument in favour of the stabilising role that multinational banks can play in the case of local banking crises. Nevertheless, the parent bank may also withdraw resources from the subsidiaries when funding problems emerge in the home country. However, any bank internal redistribution of funds will be limited by the organisational structure of nancially and legally independent subsidiaries when a country-specic shock puts the existence of the bank as a whole at risk. In the worst-case scenario, the subsidiaries have to take care of their own renancing and cannot count on support from the parent bank. Regarding the relation between banking and currency crises, we need to consider the denomination of credit provided by the subsidiaries. If loans are supplied in the currency of the subsidiarys host country, while renancing is done in the currency of the parent banks country, then a serious currency mismatch could arise. However, as long as liabilities can be covered by returns in other currency areas, the assets of the subsidiaries that have been hit by the crisis would be of small importance to the banks creditors. An additional melt-down of their value due to depreciation of the currency would have little impact on the bank as whole. The lending business in the subsidiarys country would prot, because the substitution effect outweighs the renancing effect. If the subsidiary issues loans in a foreign currency, the default risk would increase, due to the transfer of the currency mismatch from the bank to the non-banking sector. This should cause withdrawals from the subsidiary to the parent bank to ensure the parent banks stability. The withdrawal would be less signicant if the subsidiary is less signicant to the renancing of the bank as a whole. The theoretical ndings can be summarised as follows: internationally active banks should irrespective of their particular form of organisation stabilise banking systems in emerging market economies, including transition countries, if a banking crisis arises in these countries. If, however, a banking crisis occurs in the home market of the bank, which leads to worse renancing conditions, we can expect contagion to the host economies in the case of cross-border nancial services, whilst contagion via subsidiaries or branches is limited, if any occurs at all. Empirical ndings before the recent global nancial crisis did indeed suggest that multinational banks would have a stabilising effect on banking systems in CEE countries. Survey results show that Western banks are, in general, willing to support subsidiaries in CEECs in times of nancial difculty to avoid liquidity and solvency problems. This does not, however, apply in situations in which support of a foreign subsidiary would endanger the stability of the bank as a whole (De Haas and Naaborg 2006). Moreover, it has been shown that domestic banks in CEECs reduced lending during periods of nancial turbulence whereas, in some cases, Western banks even increased lending (De Haas and van Lelyveld 2006). In these cases renancing was mainly conducted via the parent banks and bank internal transfers (De Haas and van Lelyveld 2010). Nevertheless, the nancial status of the parent bank has also been important for the credit business of foreign subsidiaries, not only in CEECs. In particular, favourable returns, as measured by interest rate spreads, of the parent bank have been an advantage for subsidiaries. Furthermore, the lending business of the subsidiaries is negatively correlated with economic growth in the home market of the banks, which supports the notion of the substitution effect discussed above (De Haas and van Lelyveld 2010).

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The integration of the Central and Eastern European banking sector into the global nancial system: some facts The importance of internationally active banks has increased in recent years (McGuire and Tarashev 2007). This is particularly true of Central and Eastern European countries in the period preceding the global nancial crisis. The market share of banks owned by foreigners is very high, accounting for more than 90% in Estonia, Lithuania, Hungary and Slovakia (see Table 1, Column 2). In larger countries, such as Poland and the Czech Republic, the business is to a very large extent conducted via subsidiaries and branches (Column 3). The share of short-term lending differs between Central and Eastern European countries but is not exceptional in any way; indeed, short-term debt is higher in Germany than in any Central and Eastern European country (Column 4). The high share of foreign currency-denominated loans as a percentage of total loans seems to be more problematic. It is particularly countries that have been regarded as very vulnerable since the outbreak of the nancial crisis, namely the Baltic countries, Bulgaria and Romania, that display a large percentage of foreign currency-denominated debt. For the entire banking sector in CEECs (including domestic banks) the foreign currency shares of assets and liabilities are almost equal, posing little risk to banks balance sheets.13 However, this does mean that debtors of the banks bear most of the risk of currency mismatches and are vulnerable to exchange rate volatility. This is particularly true for the three Baltic countries and to a lesser extent for the Czech Republic and Poland. The CEECs exhibit a wide range of exchange rate regimes, from currency boards to exible exchange rates (and also include Euro area members). Countries with currency boards, such as the Baltic countries and Bulgaria, show higher shares of foreign currencydenominated debt than countries with exible exchange rates. In summary, the presence of international banks in Central and Eastern Europe is signicant. While the kinds of presence of such banks differ in individual CEECs, local subsidiaries and branches of foreign banks are important in all these countries. The share of short-term lending which might constitute vulnerability to crises is high only in a few countries. The share of foreign currency-denominated loans granted by foreign banks is also high in some countries. The Czech Republic, Poland and Slovakia stand out in this regard, insofar as their share of subsidiaries and branches of foreign banks is high, while their share of foreign currency-denominated debt is low.

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Central and Eastern European countries in the global nancial crisis Loss of condence in the Central and Eastern European economies Currency mismatches have not been at the core of the current global nancial crisis. This position was lled by structured products, such as mortgage-backed securities (MBS), which are mainly denominated in US dollars. Still, even though the crisis emanated from the US market, the dominant world reserve currency managed to appreciate even during the darkest phase of the crisis (September 2008 to March 2009). Even though the crisis posed no immediate threat to CEECs via derivatives markets, the crisis did spread to these countries as well. The CEECs were regarded as potentially unstable even during the upswing before the crisis. During the global nancial crisis CEECs quickly lost the condence of the nancial markets. This loss of condence was reected in increasing prices for credit default swaps (CDS) on government bonds. Particularly in the Baltic countries, Bulgaria and Romania, risk premiums rose dramatically (Table 2, Column 2). These countries have in common exorbitant current

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Table 1. Selected nancial market indicators in the Central and Eastern European countries, end of 2007. Share of foreign currencydenominated loans in total loans by foreign banksd 64 75 58 81 64 41 66 29 52 23 33 60 62 55

Market share of foreign banksa 63 43 54 62 41 73 61 70 43 70 51 33 29 46 28 56 50 23 31 33 41 23

Share of loans by subsidiaries of multinational banks in total loans by foreign banksb

Share of short-term loans in total loans by foreign banksc

Exchange rate regimee

D. Dietrich et al.

Bulgaria Estonia

78 99

Croatia

82

Latvia

63

Lithuania

90

Poland Romania Slovakia

69 60 94

Slovenia Czech Rep. Hungary Germany

NA 84

Currency board Currency board (ERM II) Other managed arrangement Conventional peg (ERM II) Currency board (ERM II) Free oating Floating Pegged with horizontal band (ERM II)f Euro Free oating Floating Euro

97 6

Notes: aPercentage of the banking systems deposits in banks that are 50% or more foreign-owned at end 2005. bIncluding cross-border nancial services (percentage). cLoans by internationally active banks with a maturity of up to a year, including cross-border nancial services (percentage). dLoans of internationally active banks to non-banks in foreign currency (percentage). eDenition of the International Monetary Fund, all xed regimes against the euro. fIntroduced 1 January 2009. Sources: Own calculations based on BIS (2009), Caprio et al., (2008), IMF (2009b, Appendix II), Thomson Reuters Datastream.

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Table 2. CDS prices for 10-year government bonds in selected countries.
Months with extraordinary increases in CDS prices Cumulative increase in CDS pricesa 644 732 552 1189 837 380 735 330 618 90

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Country Bulgaria Estonia Croatia Latvia Lithuania Poland Romania Czech Rep. Hungary Germany
a

3/2008

10/2008 X X X X X X X X X X

11/2008

12/2008

2/2009 X X X

3/2009

Number of months 2 2 3 2 2 3 3 2 3 3

X X X X

X X X X X X X

Notes: Difference between the highest value during the crisis and the value prior to the crisis (in basis points). Source: Own calculations, based on Thomson Reuters Datastream.

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account decits (double digits in terms of the percentage of their GDPs). These high decits and the related need for international nance have been central to risk assessments on the international capital markets (see Figure 1).14 The majority of the increases in CDS prices were corrected in many countries at the start of 2009. Months with extraordinary increases in CDS prices can be identied by statistical methods.15 Such extraordinary increases were observed in October 2008, the month after the Lehmann Brothers collapse. There are only limited differences regarding the number of crisis months. These initial ndings show that Central and Eastern European countries were heavily affected by the global nancial crisis, although to differing extents. The next question that
1200 1000 Increase in CDS prices 800 600 400 200 0 0 5 10 15 20 25 30 Current account balance Note: Current account balance in 2007 relative to GDP (percentage). Increase in CDS price in 2008/09 (basis points). Countries as in Table 2 excluding Germany. Sources: Own calculations based on IMF (2009c), Thomson Reuters Datastream.

Figure 1. Current account balance and cumulative increases in CDS prices for Central and Eastern European countries.

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arises is whether the international nancial crisis caused banking crises, currency crises or even twin crises in CEECs and, more specically, what role internationally active banks played. Banking crisis? A banking crisis occurs when banks are unable to full their intermediation function and credit supply collapses. However, there is also a banking crisis if the collapse of the banking system is prevented only by public intervention. By contrast, a simple shrinking of credit expansion is not a sufcient condition for a banking crisis, since reduced credit demand could also explain slumping credit expansion. It is generally agreed that from the autumn of 2007 banking systems in most developed economies underwent a banking crisis. Whilst governments provided the historically highest ever volumes of support for banks, many banks still failed.16 The crisis led to an abrupt shrinkage in risk appetite, a reduction of credit supply and more pessimistic expectations outside the nancial sector too, which eventually resulted in a sharp recession.17 It can thus be asked whether the banking crisis that emanated from the USA, the United Kingdom and the Euro area countries also spread to banks in Central and Eastern European countries. A rst clue would be the valuation of banks on local stock markets. Hungary and Poland are used as examples (see Figure 2). The price movements of bank shares were similar to developments in the Euro area. The valuation of the banking sector deteriorated from the summer of 2007 onward. In the autumn of 2008, after the Lehmann Brothers insolvency, share prices almost went into free fall. The drop in the prices of bank shares was sharper than the drop in the prices of broader stock indices, which include nonbanking corporations. If the price drop is measured as the difference between the peak levels in the summer of 2007 and the trough in the rst quarter of 2009, the drop was more massive in Hungary (2 86%) and less severe in Poland (2 72%) than in the Euro area (2 82%). Evidently the majority of banks in Central and Eastern European countries were considered to be at risk of insolvency. The banking crisis was such that a systemic collapse could only be prevented by massive public interventions in the USA and Western Europe, and it clearly also spilled over to CEECs.
250

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200

150

100

50 Poland Hungary Euro area

0 Jan-05 Jun-05 Nov-05 Apr-06 Sep-06 Feb-07 Jul-07 Dec-07 May-08 Oct-08 Mar-09 Aug-09 Jan-10

Source: Own calculations, based on Thomson Reuters Datastream.

Figure 2. Price indices for bank shares in Hungary, Poland and the Euro area (April 2005 100).

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It appears logical to assume that internationally active banks played an important role as transmission channel of the banking crisis because of their high importance for the region.18 However, our theoretical discussion above has shown that the potential for contagion depends on the relative importance of the substitution and renancing effects. Thus one can reach very different conclusions. Multinational banks could have been the dominant transmission channel, since the capital base of the parent banks was narrowed due to the enforced accumulated depreciation of assets caused by the crisis. Moreover, banks liquidity and prot expectations worsened. These effects caused the dramatic decline of renancing possibilities for Western parent banks and led to withdrawals from subsidiaries in Central and Eastern European countries to stabilise the parent banks in Western Europe. In view of the high importance of multinational banks for the domestic banking systems in CEECs, the credit supply was signicantly reduced in these countries and economic growth expectations declined. This caused foreign exchange traders to induce heavy depreciations in some CEE countries.19 By contrast, it could also be argued that multinational banks stabilised the situation, at least in some countries, during the world nancial crisis (ECB 2010). The relatively prosperous development in CEECs that continued even during the crisis year of 2008 and the poor prot prospects in Western Europe and the USA might have led Western banks to shift activity to CEECs, which would have helped to delay the transmission of the crisis there. Only at the turn of the year from 2008 to 2009 were Central and Eastern European countries affected by the international crisis due to the international business cycle effects. This was followed by reduced credit expansion and pressure on national currencies. Some observations support this latter argument. Although the fall in credit from foreign banks was dramatic, amounting to more than 25% in some countries, considering this gure alone may be too simplistic and obscure information that could inform an assessment of the role foreign banks played. Foreign banks expanded their credit business by 50% between the second quarter of 2007 and the second quarter of 2008, mainly in Poland and the Czech Republic, i.e. after the summer of 2007, which was marked by the rst strong turbulence in Western nancial markets and was when the rst effects on bank share prices in CEECs became noticeable. The resulting drop in claims of foreign banks amounts to less than half of the earlier increase. A further phenomenon was the fact that, after the bail-out of Bear Stearns in March 2008, loans granted in terms of cross-border nancial services decreased by 25%. However, the loans of subsidiaries of foreign banks (measured in USD) declined only from the autumn of 2008 onwards and amounted to signicantly less, namely 18%. When one takes into account that a large part of the claims of subsidiaries of foreign banks is denominated in local currencies, the decline was largely driven by currency depreciation. It was only in the Baltic countries that the loans granted in local currency by the subsidiaries of multinational banks were lower in the second quarter of 2009 than in the spring of 2008. By contrast, the declining trend in Latvia and Lithuania started even before the nancial crisis. In all other countries, previous credit levels were again reached after, at most, six months. In the second quarter of 2009 these levels even exceeded the previous years levels by between 4% (Croatia) and 18% (Romania). In some countries multinational banks played a stabilising role, if one compares their credit expansion with that of domestic banks. Taking the credit volume measured in USD as a base, in ve out of nine countries the credit expansion of domestic banks was lower between the spring of 2007 and the spring of 2009 than that of foreign banks. This nding is not altered by the fact that foreign banks may also provide credit in foreign currency: if

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Table 3. Changes in credit claims of domestic banks and of branches and subsidiaries of multinational banks (Q2:2007 Q2:2009) (%). Credit of Credit of domestic banksa multinational banksa Bulgaria Estonia Croatia Latvia Lithuania Poland Romania Czech Rep. Hungary 99.0 15.7 2 15.4 23.7 52.1 28.4 70.2 0.6 2 9.0 41.3 22.7 25.8 3.4 10.5 44.9 28.1 26.3 43.0 Credit of domestic Credit of multinational banks denominated in banks (in local local currency currency) 96.8 14.6 2 16.1 22.8 50.9 48.6 114.9 2 6.0 3.9 38.8 2 22.1 14.4 2 54.4 2 30.1 51.4 55.8 28.4 50.6

Notes: aAccounted in US$. Source: Own calculations based on BIS (2009) and Thomson Reuters Datastream.

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one considers only credit in domestic currency, the picture changes only in the case of Estonia (see Table 3).

Currency crisis? In the case of a currency crisis, a country suddenly loses the condence of international investors, leading to serious depreciation or devaluation of its currency. For the purposes of this denition, the terms sudden and serious need to be differentiated with regard to the history of exchange rate uctuations in a specic country. In a country with xed exchange rates, even small deviations from the target exchange rate may constitute a crisis, whilst for countries with exible exchange rates normal uctuations have to be taken into account. This can be achieved by weighting the depreciations of different currencies with the inverse standard deviation of past periods. The empirical treatment of currency crises usually also takes into consideration central bank interventions to prevent the depreciation of a currency. Therefore, the standard instrument to identify currency crises, the exchange market pressure index (EMP), is a linear combination of changes in exchange rates, interest rates and foreign exchange reserves (Eichengreen et al. 1996). Using the EMP, currency crises can also be identied if the depreciation is slight but there are unusual interventions, for example, if the central bank intervenes heavily by increasing interest rates or selling foreign exchange reserves. The EMP indices developed very differently in the selected countries (see Figure 3). The main reason is the more enduring problems, of varying severity, with exchange rate stability. An increase in the index suggests increased exchange market pressure, due to depreciation, increased interest rates and/or reduced foreign exchange reserves. Extraordinary increases in the index are referred to as currency crises.20 Currency crises were identied in most countries at the end of 2008 and early in 2009 (see Table 4). The Polish crisis started relatively early (September 2008) while only Lithuania faced no crisis at all. To identify the causes of currency crises, different methods, such as signal approaches or Probit and Logit approaches can be used (see Knedlik and Scheufele 2008). With these approaches signicant results were not obtained, due to a lack of data and the limited sample. Hence, exchange rate regimes could not explain the duration of crises, since, for

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0.5

1.5

1.5

0.5

0.1

0.2

0.02 0 0

0.04

0.06

0.1

0.05

0.15

0.02

0.04

0.06

0.08 01.01.2006 01.01.2006 01.01.2006 01.04.2006 01.07.2006 01.10.2006 01.01.2007 01.04.2007 01.07.2007 01.10.2007 01.01.2008 01.04.2008 01.07.2008 01.10.2008 01.01.2009 01.04.2009 01.07.2009 01.10.2009 01.04.2006 01.07.2006 01.10.2006 01.01.2007 01.04.2007 01.07.2007 01.10.2007 01.01.2008 01.04.2008 01.07.2008 01.10.2008 01.01.2009 01.04.2009 01.07.2009 01.10.2009 01.10.2009 01.07.2009 01.04.2009 01.01.2009 01.10.2008 01.07.2008 01.04.2008 01.01.2008 01.10.2007 01.07.2007 01.04.2007 01.01.2007 01.10.2006 01.07.2006 01.04.2006 01.04.2006 01.07.2006 01.10.2006 01.01.2007 01.04.2007 01.07.2007 01.10.2007 01.01.2008 01.04.2008 01.07.2008 01.10.2008 01.01.2009 01.04.2009 01.07.2009 01.10.2009 01.01.2006

0.06

0.04

0.02

0.15

0.05

0.08

0.06

0.04

0.02

0.07 0.06 0.05 0.04 0.03 0.02 0.01 0 0.01 0.02 0.03

01.01.2006

01.04.2006

01.07.2006

01.10.2006

01.01.2007

01.04.2007

01.07.2007

01.10.2007

Bulgaria

Croatia

Romania

01.01.2008

Lithuania

01.04.2008

Czech Republic

01.07.2008

01.10.2008

01.01.2009

01.04.2009

01.07.2009

01.10.2009

0.1

0.2

0.1

0.2

0.1

0.05

0.15

0.1

0.05

0.15

0.002 0.0015 0.001 0.0005 0 0.0005 0.001 0.0015 0.002 0.0025

0.25 0.2 0.15 0.1 0.05 0 0.05 0.1 0.15 01.01.2006 01.01.2006 01.03.2006 01.05.2006 01.07.2006 01.09.2006 01.11.2006 01.01.2007 01.03.2007 01.05.2007 01.07.2007 01.09.2007 01.11.2007 01.01.2008 01.03.2008 01.05.2008 01.07.2008 01.09.2008 01.11.2008 01.01.2009 01.04.2006 01.07.2006 01.10.2006 01.01.2007 01.04.2007 01.07.2007 01.10.2007 01.01.2008 01.04.2008 01.07.2008 01.10.2008 01.01.2009 01.04.2009 01.07.2009 01.10.2009

0.05

0.15

0.05

0.08 0.06 0.04 0.02 0 0.02 0.04 0.06 0.08 0.1

01.01.2006

01.01.2006 01.04.2006 01.07.2006 01.10.2006 01.01.2007 01.04.2007 01.07.2007 01.10.2007 01.01.2008 01.04.2008 01.07.2008 01.10.2008 01.01.2009 01.04.2009 01.07.2009 01.10.2009

01.01.2006 01.04.2006 01.07.2006 01.10.2006 01.01.2007 01.04.2007 01.07.2007 01.10.2007 01.01.2008 01.04.2008 01.07.2008 01.10.2008 01.01.2009 01.04.2009 01.07.2009 01.10.2009

01.04.2006

01.07.2006

Source: Own calculations, based on Thomson Reuters Datastream.

Latvia Estonia Poland Russia Hungaria

01.10.2006

01.01.2007

01.04.2007

01.07.2007

01.10.2007

Figure 3. Exchange market pressure in selected countries (1/2006 10/2009).

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01.07.2008

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01.01.2009

01.04.2009

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example, Bulgaria (which has a currency board) was affected relatively seriously, whilst Lithuania (which also has a currency board) faced no crisis. Countries with oating regimes were also affected in different ways. Further potentially explanatory variables,

01.10.2009

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Table 4. Currency crisis in selected countries. Months with strong increases in EMP Country Bulgaria Estonia Croatia Latvia Lithuania Poland Romania Czech Rep. Hungary Number of Cumulative depreciationa 09/2008 10/2008 11/2008 12/2008 01/2009 04/2009 crisis months 0 0 4 2 0 32 28 16 24 X X X X X X X X X X X X X X 2 1 2 1 0 3 2 2 1

Notes: aDepreciation against the euro, based on monthly average exchange rates, between the lowest value during the crisis and the highest value before the crisis (percentage). Source: Own calculations, based on Thomson Reuters Datastream.

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such as public debt, current account decit, share of foreign banks and share of credit denominated in foreign currency, provided no signicant results.21 Conclusions The previous section has demonstrated that banking and currency crises occurred simultaneously in Central and Eastern European countries. The characteristics of these crises were, however, very different from what theories developed after the Asian crisis describe regarding twin crises. The epicentre of the nancial crisis was located in the nancial centres of the world, i.e. in the US and Western Europe. Emerging market regions, such as the ones considered in this article, were only a sideshow. In the course of 2008 the belief arose that international investors would have to reduce activity in all risky markets, including emerging markets, to consolidate their positions. It was for this reason that the government bonds of emerging market countries came under pressure, particularly in the countries with the highest current account decits and xed exchange rates. Banking crises in Central and Eastern European countries were caused at the beginning of the world nancial crisis because banking systems in the centre of the worlds nancial markets were shaky and because many multinational banks that were affected also dominate the nancial sector in CEECs. Thus, the heavy interventions in Western banking systems during the winter of 2008/09 also had a stabilising effect on the banking systems in CEECs. That helped international banks in CEECs to bear more burdens. The gain in condence was also larger than it would have been if the banking systems had been dominated by local banks. However, the capacity to deal with stress in the Central and Eastern European countries varies, as is evident from a comparison of the Baltic countries with Poland and the Czech Republic. The Baltic countries were able successfully to defend their xed exchange rate regimes (the number of crisis months was low) but the loss of condence (measured in terms of CDS prices) was high. The currencies of Poland and the Czech Republic depreciated heavily (and the currency crises lasted longer) but the loss of condence in these countries ability to repay public debt was lower. One reason for the unequal developments might rest in the different structures of the nancial systems of these countries. The Baltic countries have very rigid exchange rate

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regimes. In the case of turbulence in the nancial markets, this exerts higher pressure on banks, according to the theory. However, the banking sector in the three countries is characterised by the small share of branches and subsidiaries of foreign banks in the overall activity of foreign banks. Most of the international banking business functions as cross-border business (see Table 1). It follows from the theoretical consideration above that this kind of banking structure is particularly vulnerable to the transmission of banking crises from foreign countries. The situation was exacerbated by the fact that the share of foreign currency-denominated credit was high (over 60%). With shrinking export returns caused by the global recession, bank balance sheets were burdened with larger credit default risks. Banks reacted with a reduction of credit expansion; the credit supply grew by less than that of domestic banks (see Table 3).22 According to these three criteria, the situation was very different in Poland and the Czech Republic. Both countries have more exible exchange rate regimes, subsidiaries and branches of foreign banks dominated the international banking business, and the share of foreign currency-denominated credit is low. According to the theoretical considerations, multinational banks may have contributed to the stabilisation of the credit supply, which is conrmed by the fact that in these countries the expansion of credit by multinational banks was larger than that of domestic banks. In summary, the experiences of the Central and Eastern European countries imply that the integration of emerging market banking systems into the world nancial system may have very different implications. There are indications that the specic way in which the integration occurs makes a considerable difference. However, neither the theoretical considerations nor the empirical evidence permit certainty regarding the conclusions on the role that international banks play in how simultaneous currency and banking crises arise.

Notes
1. In a debt crisis the problem is that borrowers are unable to service existing debt obligations; lenders respond to this debt overhang by cutting new loans. By contrast, in a banking crisis the problem is that banks are unable to raise funds for new loans. 2. See Allen et al. (2002) and Goldstein and Turner (2004). 3. See Dietrich and Lindner (2002) for a discussion of the Argentinean crisis. 4. The term was originally introduced by Eichengreen and Hausmann (1999). 5. Eichengreen et al. (2005) argue in favour of a solution on the international level. As an intermediate step to establishing international bond markets for different emerging market currencies, they propose that international nancial institutions should create bonds based on an index of the most important emerging market currencies (p. 266 ff.). 6. These considerations may help to explain why, in the Asian crisis, local banks raised much short-term debt on international capital markets and invested in projects that, under normal conditions, would not be creditworthy: governments were seen by international investors as being responsible for their countries banks, both in terms of regulating their lending and in terms of backing their debt. 7. Gray and Gray (1981), Sagari (1992) and Buch and Lipponer (2007) have transferred models of non-banks to the international banking question. Dietrich and Jindra (2010) have shown that for non-banks nancial aspects also play a crucial role in the choice of an internationalisation strategy. 8. There is also evidence that countries regulatory framework, political risk and economic risk inuence the mode of foreign market entry of international banks. In particular, it is found that banks are more likely to establish a branch network if there is discriminating regulation that treats branches preferentially, if taxes are high, and if political risk is relatively more important than economic risk (Cerutti et al. 2007). The reason for the latter effect is that, in contrast to branch networks, the limited liability associated with a subsidiary structure allows the

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international bank to protect itself against country-specic economic risks while being more prone to the risk of expropriation often associated with political risks (DellAriccia and Marquez 2006). ller (2003). Regarding the crossRegarding the cross-pledging of returns, see Inderst and Mu pledging of assets, see Dietrich (2007). A formal model of the substitution and renancing effects in an international context can be found in Dietrich (2004). This stabilising effect is present as long as only the renancing possibilities are reduced but the expected returns remain stable. This is true as long as a deterioration of the renancing possibilities at home does not lead to a simultaneous and disproportionally high improvement of renancing conditions in the foreign country. Own calculations based on BIS (2009). Regression of CDS price increases on current account decits yields a positive coefcient with R 2 0.46 at a 5% level of signicance. In line with the Exchange Market Pressure Index (introduced below), a crisis is identied if the increase in the CDS price exceeds the mean of the time series by a multiple of its standard deviation (see also note 20). According to the Federal Deposit Insurance Corporation more than 100 banks failed in the USA in October 2009 alone. Compare Almeida et al. (2009) regarding the effects of the world nancial crisis on the real economy in the USA. Such transmission effects have been shown earlier for other regions of the world. Peek and Rosengren (2000) show that the banking crisis in Japan in the 1990s led to a reduction of credit supply in the USA, which had an effect on the real economy. This argument is taken from Gabrisch (2009). As a threshold, we used the mean plus 1.645 times the standard deviation of the EMP index. On the assumption of a normal distribution, this threshold would lead to identication of 5% of the periods as crisis periods. For a discussion of different thresholds see Knedlik (2006). The absence of signicant results is not sufcient to conclude that there is no relationship between the variables in the data-generating process. That the massive increase in Latvian risk premiums did not lead to a collapse of the nancial system might be attributed to the support of the International Monetary Fund in December 2008 (IMF 2009a).

9. 10. 11. 12. 13. 14. 15. 16.

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17. 18. 19. 20. 21. 22.

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