Ewald Nowotny: Austria's role in the international financial system
Speech by Mr Ewald Nowotny, Governor of the Austrian National Bank, to representatives of
official Austrian institutions, New York, 28 April 2009.
* * *
Ladies and gentlemen,
It is my pleasure to speak to such a distinguished audience tonight on Austria's role in the
international financial system. Essentially, I would like to give you a brief overview on the key
figures of the Austrian financial market and elaborate in more detail on the historical chances
Austrian banks have found in Eastern Europe since the fall of the iron curtain. Then I would
like to talk about the consequences of the current crisis for Austria, and the policy measures
which have already been taken to stabilize the situation in Europe in general and in my
country in particular. Finally, I want to share some ideas with you on how we might prevent
such a crisis in the future.
The most significant difference between the financial market in Austria and the U.S.A. - next
to the difference in sheer size, which is hard to ignore - is the structural importance of banks
for financing the private sector in Austria, whereas the financial system in the US is a lot
more market-based. This difference is probably most visibly reflected in the volume of
outstanding bank loans to the private sector, which currently amounts to 120% of GDP in
Austria and to only 60% in the U.S.A. On the other hand, the market capitalization of the
stock exchange is 140% in the U.S.A. and only 60% in Austria.
The assets of Austrian banks have been increasing steadily over the last decade, and in
2008 they exceeded 1 trillion euro for the first time; banks assets amounted up to 373% of
the Austrian GDP. This expansion was supported by the increase in foreign assets, which
accounted for 361 billion euro in 2008 or 128% of GDP. More than half of the foreign assets
of Austrian banks were located in Central and Eastern Europe (some 200 billion), thereof 3⁄4
in EU Member States.
Austrian banks in Eastern Europe
The end of communism in Europe in 1989 and the transition of Central and Eastern
European economies provided Austrian banks with a historic opportunity. To that very
moment, their business had been more domestically oriented, but all of a sudden the
demand for banking services was increasing tremendously in their closest neighborhood.
Over night, Austria changed from being a frontier state of the cold war and became a hub of
European integration. To show you how close many of the newly emerging opportunities
were located, let me give you some comparisons: Vienna is no further from Bratislava, the
capital of Slovakia, than Stamford1 is from New York; getting to Budapest, the capital of
Hungary, from Vienna is like getting to Albany for you; Prague, the capital of the Czech
Republic, is as far as Boston; and Ljubljana, the capital of Slovenia, as far as Washington.
The proximity together with cultural similarities and a shared history gave Austrian banks
some advantages on these new markets, and they did not miss their chance. Their strategy
for the years after 1989 clearly was: Go east!
The engagement of Austrian banks in the Central and Eastern European countries has been
very successful, and it has been beneficial for all parties involved - and even for some
uninvolved. For Austrian banks, the investments in the region proved to be highly profitable
and contributed most favorably to their earnings over the past years.
At the beginning of the transition in Central and Eastern Europe the domestic financial
corporations in these countries were unable to fund the elevated rates of economic growth
sustainably; in some cases, banks as we know them hardly existed. Even ten years after the
beginning of transition, the ratio of private credit to GDP was much lower in these countries
than in the mature EU economies. Therefore, foreign investors and financial intermediaries
were highly welcome to fill the gap. After decades of centrally planned economic activities,
domestic banks in these countries often lacked the experience or the corporate governance
to support the establishment of dynamic markets. Foreign banks contributed to the
necessary financial deepening in the region and thereby allowed for a smoother transition
process.
But in many Eastern European countries, access to financial intermediation is still far beyond
the levels in OECD countries, and therefore the extension of financial activities in that region
will offer an attractive business opportunity for Austrian banks and other international
intermediaries in the future.
This financial strengthening of transition economies provided positive spillover effects by
raising the demand for imported goods and services from the mature economies which were
already members of the European Union. Thus, the financial integration of Central and
Eastern Europe fuelled the prosperity of the whole continent. Around 20% of all euro area
exports went to the 10 new EU member states in Central and Eastern Europe. The trade
surplus of the euro area with those countries added up to 60 billion euro.
As countries in that region on average have higher trend growth rates than the "old" EU
Member States, because they are still in the process of convergence towards higher GDP
per capita, Central and Eastern Europe will remain a driver of economic growth in Europe for
the foreseeable future.
I do not want to suggest that no mistakes were made. In some countries credit volumes were
probably expanded too fast, and the capital inflows contributed to overheating; the
widespread allocation of foreign currency credits made some countries rather vulnerable for
macroeconomic shocks. But this happened only in a small part of Central and Eastern
Europe, and above all the bigger economies experienced balanced growth over the past
decade.
In this respect I also want to stress the very fact that Austrian banks have been prudently
pursuing their cross-border financial intermediation: their exposure in Eastern Europe is the
largest in Europe, but it is also well diversified over the whole region with a particular focus
on countries which are members of the European Union - or even members of the European
Monetary Union - already. Only 15% of Austrian banks' assets in Eastern Europe are
located outside EU boundaries. Even a recent IMF Paper2 drew the conclusion that "Austria
(...) has the most diversified loan portfolio among the major home countries".
The current crisis and its impact
When the financial crisis started to unfold, it hardly affected the financial corporations in my
country at all initially, as they did not hold lots of securities that originated from the U.S.
mortgage market. Most of them were heavily engaged in Eastern and Central Europe, with
little resources left to invest in assets which might turn out to be toxic ex post. But as the
crisis spread around the globe and especially after the collapse of Lehman Brothers caused
major disruptions on the interbank market, our banks were also suffering from the worsening
conditions. The rising uncertainty on financial markets would in the end turn against every
bank, regardless how prudent its business model might have been. In previous financial
crises hot money flew out of certain countries or regions and made those economies suffer
from an under-supply of capital, but this time liquidity evaporated globally. The financial
stress caused asset prices to decline further as many financial institution tried to reduce their
leverage by a kind of fire sale.
Of course, the financial crisis had its consequences for the real economy. Non-financial
corporation saw their access to needed funds dwindle as the liquidity of the markets dried up;
households saw the present value of their savings decline as asset prices dropped. Together
these factors caused the effective demand in most economies simultaneously to stay behind
their productive potential, resulting in a major global recession. As the whole crisis had
started with a bubble on the housing market, some countries have also been hit by a slump
of their property prices; this is true not only for the coastal areas of the U.S.A., but also for
some European countries like Spain or Ireland. The burst of a bubble, the financial market
crisis and the recession of the real economy all at the same time make the current situation
particularly challenging. We know from historical comparison that a recession which goes
along with a banking crisis tends to be especially long and severe3; we have seen this
phenomenon in Sweden, Norway or Japan. Therefore, governments all over the world are in
charge to take the required measures and to do so timely and well targeted. If we want to
adhere to the audacity of hope, we also need the audacity for change; therefore, new
instruments are needed and brave steps are warranted.
The neglect of risk and its consequences
One of the main reasons for the mess we are in now has been a general misperception of
risk. In the financial industries, many believed that innovations like structured asset-backed
securities would improve the diversification of risks and thereby help to reduce the markets'
vulnerability to adverse shocks. However, the risks were never actually traded away, but
stayed concentrated on the books of the financial corporations involved. There is nothing
wrong with risk diversification, but obviously something is wrong with innovative products that
are too complex to be understood by the very people who originate and distribute them. And
there is something wrong with markets that are not properly understood by their participants
and with participants who know the party must come to an end soon but keep on dancing just
because the music is playing4.
A second misperception with respect to risk was the belief that financial globalization would
reduce country risks by the growing opportunities of international risk sharing. The core idea
of risk sharing is that individual country risks should be negatively correlated, so if the home
country is affected by a negative shock, some foreign countries face a positive shock at the
same time, and the returns from those countries would protect internationally diversified
investors from domestic income losses. But the increased financial globalization not only
made it easier for investors to invest in different countries, it also made it easier for financial
crises to spread across borders. If international investors have to recover from a crisis in
country A, they might start selling assets from country B, which was until then in no way
affected by any sign of crisis. This kind of crisis transmission, sometimes also referred to as
contagion, has so far mostly affected emerging markets; now for the first time we witness this
phenomenon on a global scale.
As a consequence of the crisis, the global risk perception has shifted towards a more prudent
assessment, and like so often in financial markets, the market has tended to overshoot,
going from risk ignorance to a very high degree of risk aversion. Such overshooting is
currently taking place with regard to the spreads on government bonds in Europe. Whereas
the interest on German 10-year government bonds has been decreasing, several European
countries now face higher interest rates, which can partially be explained by the soaring
demand for liquidity, which is of course highest for German papers. The rather unusual
increase of the interest spread of Austrian sovereign debt versus Germany has in addition
been associated with the exposure of Austrian banks in Central and Eastern Europe.
In this respect I want to clarify again that Central and Eastern Europe's economic potential is
still intact, and that growth rates in that region will exceed those in Western Europe and the
U.S. for the years to come, so these investments are still to be viewed as assets rather than
liabilities.
The euro as a shield in stormy times
Referring to a particularly negative episode in Austrian and in world financial history, Paul
Krugman correctly stated: "Smaller countries - like Austria in 1931 - may once have been at
the mercy of financial tides, unable to control their economic destiny"5. Now, Austria has not
become a bigger country than it was in those unhappy days, but something else has
changed in our favor since then: we are now members of the European Union and part of the
euro area. In contrast to previous crises, this time our efforts to fight the recession are part of
a coordinated European macroeconomic recovery plan upon which the European
Commission and the EU member states already agreed in November 2008.
If we compare the situation with our last recession before entering the EU, which took place
in the early 1990s, monetary union with our key trading partners is very helpful as it prevents
competitive devaluations by some neighboring countries that harmed our economy back
then. In that sense, the euro has worked as a shield for small open economies all over
Europe.
What needs to be done now?
Policy makers are confronted with two main tasks at the moment. On the one hand they must
restore stability in financial markets by bringing back liquidity, recapitalizing banks and
getting toxic assets off banks' balance sheets. In Europe, we have some examples that can
serve as guidance for how to deal with a banking crisis, for instance the Swedish and the
Finnish experience of the early 1990s. (If anything, our own Austrian experience from the
1930s would rather qualify as an example of how not to save banks.)
In Austria we have already taken measures to establish confidence among savers, and our
government has also presented a stabilization package for banks, to which it has allotted 100
billion euro, which is roughly 1/3 of the Austrian GDP; 15 billion euro are reserved for
recapitalizing banks, 75 billion for bank guarantees and an additional 10 billion for insuring
the domestic deposit protection.
In terms of GDP, the Austrian banks' stabilization package is among the biggest in the EU.
BIS Review 79/2009
The second task we now face is to fight the global recession and prevent it from turning into
a lasting depression. This is a challenge for both monetary and fiscal policy. The main
objective of monetary policy in the euro area has always been to preserve price stability, in
the current state of affairs means to prevent deflation. I can assure you that, at the Governing
Council of the ECB we will take all available measures to stabilize the inflationary
expectations in the euro area and keep them anchored in positive terrain. We will keep the
interest rate very low for as long a time as is required, and we stand ready to use
unconventional measures of quantitative easing to assure European firms and consumers
access to credit at appropriate conditions.
As for fiscal policy, the necessity of a large and timely stimulus package is most obvious.
Olivier Blanchard and others from the IMF6 explained concisely late last year how such a
stimulus package should look like. It should be broad-based as the crisis will hit each
economy as a whole; it should be fairly long-term as this crisis won't go away next quarter;
and it should be supported by as many countries as possible as this is a global crisis and it is
not the time for beggar-my-neighbor policies. Although the automatic stabilizers in most
European countries help to adjust for the loss in effective demand, some additional
discretionary spending is now needed.
The crisis also highlighted differences between the EU and the U.S. in terms of fiscal policy.
While the two regions are roughly comparable in economic size, the EU lacks a federal
budget like the U.S. In times of crisis, when timely and targeted action is warranted, the EU
with its budget of 1% of total GDP is rather shiftless compared to the U.S. Federal budget of
more than 20% of GDP. In terms of fiscal policy, European countries are mostly on their own
when fighting recessions. Like in the U.S., not all states within the EU are affected in the
same way by the crisis; but those EU Member States which are hit most severely by the
crisis now are also the ones which will amass high budget deficits very quickly and therefore
find it harder to finance their stimulus spending. Some of the new EU Member States have
been affected rather harshly by the crisis already, and unfortunately it has not been
understood yet by all remaining countries that assisting those countries is not only an act of
European solidarity, but that it is also in their economic interest to support those countries
which have relatively high import demand for their products. Like in the so-called "tequila
crisis" of 1995, it was not immediately understood by all politicians in Washington that
helping Mexico was in the best interest of the U.S., but thankfully those in charge in the
administration knew how to deal with the situation. It also took some time before policy
makers in Europe did recognize that it was in the best interest of Europe to pave the way for
a European initiative for economic stabilization and recovery. For instance, the European
Council at the level of heads of state and government, has already decided to double the
ceiling for the EU's support facility for balance-of-payments assistance to 50 billion euro.
What shall be done in the future?
If macroeconomic policies work together in a well-coordinated way globally, I am convinced
we will master this crisis and successfully prevent a global depression. But then we should
also change the financial system in such a way that such a crisis will not occur again. Now in
concluding, let me briefly point out some ideas how these changes in the global financial
system should look like.
First, we need more cooperation or even integration of international financial supervision
authorities. That means an end to the formerly common practice of some institutions to shop
around for the lowest level of regulation on the globe and hence minimize their degree of
supervision. Next, I think we must increase the number of institutions subjected to
regulations which are at the moment reserved for commercial banks. Putting it simple, every
single institution that has the capacity to create the kind of trouble a failing bank may create
should be regulated like a bank; I am thinking here of highly leveraged institutions such as
hedge funds, the need to regulate which is now generally understood. Then we should take a
close look at the functioning of the rating agencies. They were wrong on Enron, they were
wrong on the subprime market and yet their ratings continue to be of enormous importance
for access to credit for many firms and even governments. As this importance is based on
the assumption of superior information held by these agencies, I really wonder how such an
assumption can be sustained any longer.
The crisis has shown the importance of international cooperation and the importance of
financial institutions like the IMF, the EIB or the EBRD, as they have been able to help
quickly and provide countries in need with appropriate credit lines. Whereas the European
Union should consider establishing certain institutions of its own or at least funding the
existing institutions more generously, on a global level the IMF has re-established its
essential role. With respect to the conditionality of IMF loans we might as well question the
wisdom of the market whether it is useful to contain public spending strongly in what has
turned out to be the most severe crisis for generations. But the results of the G20 summit
have shown that the willingness necessary for close cooperation among the big economies is
there. The agreed upon increase in credit lines, the additional funding of the IMF and the
creation of more Special Drawing Rights, all these measures will provide some stimulus to
effective global demand, and the new approach to financial market regulation will help us to
ensure financial stability and to control and trim the shadow banking system. Therefore, we
can be confident that this crisis will be contained, and that recovery won't take too long a
time coming; and once prosperity is growing again, it will do so more sustainably and in a
more balanced manner.