Monday, 12 June 2017
Economic and Financial Challenges in South East Europe
Speaker: Gent Sejko, Governor, Bank of Albania
Chair: Othon Anastasakis, St Antony’s College, Oxford
Building on its long association with the Bank of Albania, PEFM was delighted to welcome its Governor, Mr. Gent Sejko, for a discussion on the role of central banks as guardians of price and financial stability. In his talk, he presented Albania’s experience in addressing the global financial crisis and its aftermath and highlighted some of the lessons learned from the perspective of a small South East European economy.
Governor Sejko began by presenting the general regional dynamics. Initially, strong financial integration with the EU benefited South East Europe, particularly through rapid credit growth. However, integration turned into a shock propagator in the aftermath of the global financial crisis. Inflation, previously a significant concern, fell across the Western Balkans. In addition, an increase in NPLs also contributed to lower growth, particularly in Albania and Serbia, while unemployment and emigration remain a challenge for the whole region. Finally, the crisis has had a structural impact on South East European economies, halving growth to 3.5% annually, and leading to declining productivity and investment rates.
The crisis transmission mechanisms in Albania mostly reflected those for the region. Deteriorating financial conditions and tighter regulations led to a deleveraging among EU headquartered banks. This reflected a combination of a changed strategy and tighter criteria, which was detrimental to lending in South East Europe. These problems were compounded by a rapid depreciation of the exchange rate and generally bleak expectations due to the pessimistic outlook for the EU. The result was deteriorating public and financial sector balance sheets as NPLs peaked at 25% in 2013 and public debt reached 71% of GDP.
In addition, due to strong cyclical convergence, the crisis in the EU represented a negative shock to GDP. The transmission of disinflationary pressures across the EU led to a deviation from the inflation target for Albania. The shock also revealed structural problems and an unbalanced growth model. Prior to 2008, there was heavy reliance on the non-tradable sector, especially construction. The rise of real estate prices by about 20% annually stimulated people to take loans to buy additional apartments. However, once the crisis hit, many of those loans became the main contributor to NPLs. Therefore, after the crisis GDP growth declined due to lower productivity growth and investment and skill mismatches. This means that with current GDP growth the country would need around 100 years to converge to EU standards.
In responding to these challenges Albania had to navigate a number of policy constraints outlined by Governor Sejko. First, there was a lack of fiscal space due to already high public debt. Second, the monetary policy transmission mechanism was impaired by the highly euroized financial system, where almost half of deposits and credit was denominated in foreign currency. This also generated significant currency risks in repayment performance. Third, the credit slowdown was driven mostly by risk aversion and tightening of criteria in the banking side, in particular among EU-based banks. Fourth, structural imbalances and sectorial overinvestment were leading to a deleveraging in sectors such as construction, pointing to the need to reorient the economy.
In this context, a lot of the pressure of addressing the crisis fell on the Bank of Albania. Its institutional setup is similar to other central banks, with a price stability objective through an inflation targeting regime and full independence. It pursued a countercyclical expansionary monetary policy, lowering the interest rate to the lowest ever level of 1.25% in order to incentivize lending, consumption, and investment, coupled with liquidity injections and forward guidance. This was effective in reducing financing costs, preserving inflation expectations, and encouraging credit growth. In addition, it made extensive use of macroprudential tools, particularly adjusting risk weights to enhance credit growth, to correct lending practices, and to preserve capital adequacy ratios. It also implemented a detailed plan to reduce NPLs by improving the regulatory framework and reviewing bankruptcy law, and it is beginning to implement a plan to discourage foreign currency lending by increasing regulatory reserve ratios.
In addition, the Bank of Albania worked closely with the government on accompanying measures to fight the crisis. Initially, fiscal policy was accommodative and there was debt-financed expenditure on infrastructure projects, but by 2013 the fiscal space has been depleted as concerns over sustainability began to appear. The government also began to implement growth-enhancing reforms, particularly in addressing persistent education and skill mismatches, but also in improving labour market policies, the judicial system, and the energy sector. Finally, it began to address sustainability issues in the pension system and to implement administration and territorial reforms. By addressing the most problematic areas Albania hopes to reorient its economy. This appears to be working, with a return to equilibrium conditions expected by mid-2018 and with financial stability largely restored.
In closing, Governor Sejko sought to distil some lessons learned from Albania’s crisis experience. First, he notes that EU integration entails both benefits and challenges. Second, in dealing with a crisis, the initial conditions can impose important fiscal and financial constraints, which highlight the need to increase economic resilience and to protect the credibility of monetary policy. Third, good economic policy is proactive in pursuing reforms, countercyclical in macroeconomic management, and aware of interlinkages. Finally, optimal effects require maximum internal and external coordination. These lessons demonstrate the difficulties that small open economies with limited policy space might have in navigating external shocks in highly integrated regions.
Ivaylo Iaydjiev (St Antony’s College, Oxford)