Chapter 2

Capital flows and credit growth

In addition to depressing export levels, the ongoing turmoil in the eurozone has prompted the first overall private capital outflow6  from the transition region since the global financial crisis of 2008-09. At that time substantial capital inflows, previously amounting to 2-3 per cent of annual GDP each quarter, had turned sharply negative. By late 2009 capital inflows had resumed, albeit at modest levels, helping to support nascent recoveries in many transition countries. Then, in the second half of 2011 as the eurozone crisis intensified, overall flows turned negative again. Just as in 2008-09, the reversal was driven by debt and portfolio flows, while FDI into the region dropped substantially but remained slightly positive. 

The headline capital flow figures, however, mask important differences between transition regions and countries. Chart 2.13 shows both FDI and non-FDI private capital flows – reflecting mainly bank debt, portfolio investment (bonds and equities) and capital flight – for the main destinations of capital within the region. The drop in non-FDI flows in the second half of 2011 was largest in those countries and regions most integrated with the eurozone. In the CEB and SEE regions flows turned slightly negative, and in Turkey, where they had previously fuelled rapid expansion in an overheating economy, they halved. However, flows to these countries have subsequently started to recover, suggesting that the impact of the eurozone situation may have been temporary and peaked in the third quarter of 2011, when the eurozone crisis initially worsened. 

Source: National authorities via CEIC Data.
Note: Data are from the capital and financial account of individual EBRD countries. Private non-FDI flows are the sum of the capital account, portfolio investment, other investment and net errors and omissions, excluding flows to governments, flows to monetary authorities and trade credits. Net errors and omissions are included as this can be a significant channel of current account deficit financing or a major channel of capital flight in some countries.

In contrast, non-FDI flows in Russia have been consistently negative since the third quarter of 2010 –  a full year before the eurozone crisis intensified – due to portfolio outflows and also capital flight. This may reflect idiosyncratic Russian factors, including the outflow of resource revenues in an environment of high political uncertainty and elevated investment costs, as well as a more flexible exchange rate regime that is now discouraging “one-way bets” on the rouble. For the transition region as a whole, outflows from Russia more than offset inflows to CEB and SEE countries and Turkey in the second half of 2011. By mid-2012 outflows from Russia had eased. As CEB, SEE and Turkish flows began recovering, total flows into the region turned marginally positive in the first half of the year. 

Following strong inflows in 2011, FDI declined sharply in the CEB and SEE countries and slowed in Turkey in the first half of 2012 (see Chart 2.14), coinciding with a drop in outward investment from the eurozone. Statistical analysis shows that FDI flows into these countries over the previous decade had been affected by economic conditions in the source country rather than by prevailing or past growth rates in the recipient state.7 This suggests that FDI will not be insulated from weaknesses in the eurozone in countries where it has remained strong so far, particularly if a large share of that investment comes from the eurozone’s periphery that entered, or remains in, recession in 2012.

Source: National authorities via CEIC Data.
Note: Chart shows net FDI flows in the second half of 2011 and first half of 2012 as an index with average net FDI flows in 2007 equal to 100.

Regions less affected by the eurozone crisis witnessed some significant increases in FDI flows. Countries in the EEC region saw substantial increases in 2011 but FDI declined in the first half of 2012, coinciding with a drop in outward FDI from Russia. Central Asia continues to see a rapid expansion. FDI rose in Mongolia where inflows in 2011, mainly into the natural resource extraction sector, were around 50 per cent of GDP. These are the only transition regions where FDI flows have returned to pre-crisis levels. In SEMED there has been an ongoing decrease in FDI since 2008, with political uncertainty leading to acceleration of the decline in 2011, followed by a slight recovery in the first half of  2012.

Unlike private capital flows, remittances to the majority of transition countries have remained broadly stable as the eurozone crisis has thus far not had a significant impact through this channel. Despite the crisis, both remittance outflows from the eurozone and inflows to the transition region, increased in the second half of 2011 and first quarter of 2012. These aggregates, however, conceal a considerable degree of variation, which indicates that certain bilateral remittance corridors have been affected. Remittances from countries in the eurozone periphery have declined significantly; falling in year-on-year terms in Greece, Ireland, Italy, Portugal and Spain in the first quarter of 2012. At the same time, countries in the SEE region which receive a large share of their remittances from the periphery have seen declines. Chart 2.15 shows that remittances from the periphery constitute a substantial source of vulnerability for a handful of transition countries, accounting for between 2 and 10 per cent of GDP in Albania, Moldova, Morocco and Romania.

Source: World Bank data.
Note: This chart shows remittance inflows from the eurozone in 2010 as a share of 2010 GDP. The World Bank's estimates of bilateral remittance flows are based on migrant stocks, host country incomes and origin country incomes. Periphery includes Greece, Ireland, Italy, Portugal and Spain.

However, the eurozone crisis did significantly affect cross-border bank financing for the transition region. International bank claims on the region fell sharply in the third quarter of 2011 and continued to decrease at slower rates in the first half of 2012 (see Chart 2.16). The reduction in cross-border exposures has been most striking for the CEB region, whose banking systems are very closely integrated with eurozone parent banks. It started with a slight drop in the second quarter of 2011 followed by a very large flight in the second half of the year. The first half of 2012 saw a significant deceleration of outflows, but the decrease in exposures continued. This dramatic pattern was mostly driven by the largest CEB country, Poland, although all CEB economies witnessed slower cross-border deleveraging in the first half of 2012.

Source: Bank for International Settlements.
Note: This chart depicts the change in foreign bank claims as a percentage of previous period’s stock, adjusted for foreign exchange movements.

Elsewhere, Ukraine also saw significantly slower falls in international bank exposures after the outflows peaked in the third quarter of 2011, and Turkey returned to an increase in claims in the first two quarters of 2012. Deleveraging in the SEE region, however, has not showed signs of slowing and outflows from Serbia in particular worsened in early 2012.

The cross-border deleveraging of the past 12 months has had a negative impact on credit growth (see Chart 2.17). According to the most recent available data, real credit contracted by at least 5 per cent in August 2012 relative to a year earlier in all CEB countries except Poland and the Slovak Republic (which, among the CEB economies, have been the least affected by the eurozone turmoil to date). In the larger SEE countries – Bulgaria, Romania and Serbia – credit growth never fully recovered from the 2008-09 crisis and has since lingered close to zero. Negative growth figures in August 2012 for Romania and Serbia, following several months of meagre real credit growth, suggest that the eurozone crisis has stymied whatever recovery may have been taking place in their lending markets. 

Source: National authorities via CEIC Data.
Note: Growth rate of credit is adjusted for foreign exchange movements and inflation.

Elsewhere in the transition region, real credit growth has been decelerating in Turkey, where the credit market is cooling after a capital inflow-driven boom in 2011, but has remained positive in Ukraine, despite its banking links with eurozone parent institutions. Ukraine, together with Bulgaria and Poland, saw a recent rise in domestic funding through bank deposits just about compensate for the loss of cross-border financing, which likely contributed to the positive growth. Real credit has meanwhile expanded in Central Asian and other EEC countries, which have more limited financial exposure to the single currency area, with the exception of Belarus where high inflation levels have eroded real lending increases. 

Apart from lower cross-border funding availability, credit growth has also been dampened by high non-performing loan (NPL) ratios, which persist as a legacy of the 2008-09 crisis in many countries. In 2011 and the first half of 2012, there were further increases in the SEE region (see chart 2.18) where the average ratio is now above 15 per cent (compared with 4 per cent in 2008). A similar rise was seen in Croatia and Slovenia as well as in Hungary, where loans denominated in the appreciated Swiss franc are an ongoing concern. By contrast, efforts at resolution achieved some successes in the Baltic states, where NPLs fell over the past year. Further east, ratios remained broadly stable except in Moldova, where a sharp increase in the share of NPLs is partly due to a shift in reporting standards, and in the Kyrgyz Republic, which saw a decline as a result of economic recovery in 2011.

Source: National authorities via CEIC Data.

Throughout this section, capital flows refer to net, rather than gross flows.

7A panel regression using annual data on bilateral flows from six large eurozone economies to countries in the transition region between 2001 and 2010 shows that an increase in the source country’s growth rate of 1 percentage point increases its stock of FDI in the receiving country by 5.9 per cent.


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