Implications of the Global Crisis for the Black Sea Region. A Report by the Commission on the Black Sea (3)


Satellite image of the Black Sea in winter 2008, from rapidfire.sci.gsfc.nasa.gov

By Panayotis GAVRAS. The Commission on the Black Sea

The Commission on the Black Sea presents a series of four policy-oriented reports which reassess the economic, social, regional political and military developments in the region.

This report is the first one, providing a better understanding of the parameters of the economic developments in the Black Sea. The Commission on the Black Sea does not take a collective position with this paper. This text represents only the views of its author.

Content

Executive Summary / (A) The Historical Context of Economic Development in the Black Sea Region/ (B) The Economic Transformation of the Black Sea Region. Overview / (C) Implications of the Global Crisis for the Black Sea Region / (D) Challenges and Issues for the Black Sea Region / Long-Term Demographic Trends and Economic Reforms / Dealing with the Global Economic Crisis / The Evolution of Relations with External Players, and Especially Relations with the EU / Promoting Regional Cooperation / (E) Concluding Remarks / Policy Recommendations for the Economic Development of the Black Sea Region / (a) Recommendations for the Countries in the Black Sea Region / (b) Recommendations Designed to Promote Economic Developmentin the Black Sea Region Through Cooperation / (c) Recommendations for a European Union Approach to the Black Sea Region

C. Implications of the Global Crisis
for the Black Sea Region

As we have seen, the Black Sea region’s current economic phase began quite suddenly in the last quarter of 2008.

Since the global financial markets were near collapse in September 2008, access to financing became virtually impossible and risk aversion reached panic proportions. There was no ‘decoupling’ between the developed markets of the West and the rest of the world, and in Eastern Europe the global contagion threatens to reverse years of economic progress12.

It is hardly surprising that the impact on the Black Sea region has been negative, although the extent of the damage varies from country to country. The financial systems remain under stress, lending to private companies is still limited, and in some countries there has been a painful process of deleveraging that has led to a downturn in economic activity.

However, the financial systems have not collapsed, and they have managed to avoid the bank insolvencies that marked previous crises and led to panic in places like Russia in 1998 or Turkey in 2001.

Despite fears about larger losses in the future as the effect of recession hits companies and consumers, and unless the economic downturn results in a sharp rise in non-performing loans, most of the banks in the Black Sea region seem to be well positioned to weather the storm, either on their own, or with the open or covert backing of their governments.

Significantly, in many Black Sea countries much of the banking system was foreign-owned (mainly by west European entities), and there were fears that the parent banks might withdraw support for their local branches or subsidiaries.

Hitherto this has not happened, and with the cautious return of investor appetite for risk in the second quarter of 2009and many similar predictions for 2010 parent banks have continued to support their local holdings or pledged to do so, thus maintaining their exposure and in certain instances injecting additional capital.

Whilst the global crisis has certainly created dysfunctionality in the financial systems of the Black Sea region, it has not manifested itself as a full-scale financial crisis.

In fact, the impact of the global crisis has been felt most acutely as an economic crisis. As global financial markets were on the verge of collapse, bank lending to businesses and consumers dried up, thus reducing liquidity and demand and creating uncertainties that severely impeded investment.

There was a drop in international trade flows, and the ensuing economic contraction in key western European markets led to a reduced demand for goods and resources from the region. The situation was exacerbated by a slump in commodity prices.

An additional factor for certain countries was a decline in remittances from migrants and co-nationals living abroad, which also contributed to the reduction in domestic demand.

The nature of the crisis and the difficulties encountered in trying to deal with its root causes and agreeing on appropriate measures and their implementation point to the possibility of a lengthy period of economic decline or stagnation followed by a feeble and slow recovery.

The global financial crisis reaffirmed that there is a hierarchy of access to financing based on perceptions of country risk which are determined by a combination of credit ratings, levels of development, and overall economic size.

This has led to a global ‘financial food chain’ in which those with the highest ratings have the best seat at the table, and at a reduced price, while those with lower ratings have to scramble over the remainder and are forced to pay more.

Thus, while the restoration of credit flows to the region represents a critical element in the recovery from the crisis, Black Sea countries, none of which enjoys an AAA or AA rating, and their companies face the real threat of being crowded out of credit markets by the record volumes of borrowing planned by countries with higher ratings as they try to stem the economic decline and stimulate their own economies.

The increased competition for financial resources has resulted in higher interest rates for Black Sea countries. And a lower rating for a country automatically implies higher costs.

Currently the markets are still dysfunctional and risk averse, with disproportionately high spreads as one moves down the ‘financial food chain’, and for this reason official sources of financing represent the primary option for most Black Sea countries.

In contrast to the United States or Western Europe, Black Sea countries are on the whole unable to adopt measures designed to encourage lenders to return to the market. Their economies are too small for capital injections to achieve the required degree of stimulus.

Moreover, their currencies do not have reserve currency status, and as such they are unable to inject sufficient liquidity into the financial system without depleting the reserve levels and risking severe capital flight.

Only Russia, by far the largest regional economy, has attempted to introduce a sizeable fiscal stimulus package, though in the process it experienced a large drop in reserves and increased rouble volatility.

D. Challenges and Issues
for the Black Sea Region

Because the countries of the Black Sea region are diverse in terms of size, economic structure, and the level of development, there may well be challenges which are peculiar to a particular country or a small sub-set of countries.

For example, the EU members (Romania and Bulgaria) and Turkey are in general more developed and integrated into the global economy on account of their relationships with the EU and the greater openness of their economies. This allows them to benefit from greater global opportunities, but also means that there is a higher risk from economic shocks (such as contagion) which have their origins elsewhere.

Moldova and the Caucasus countries are small and far less open, and while this has insulated them to some extent from the global economic turmoil, it is also a key aspect of their underdevelopment and persistently high poverty rates, particularly outside major urban centres.

The two energy exporters, Russia and Azerbaijan, continue to face the challenge of diversifying their economies.

Ukraine, for its part, faces a unique set of challenges resulting from its social diversity, political system, and economic structure, and is very much dependent on low value added ‘heavy’ industry.

Diversity and attitudinal differences in the various countries makes it difficult to identify issues which may be considered to be challenges for the region as a whole.

Thus it is important to define general topics which may well manifest themselves in different ways and be determined by a country’s specific characteristics.

There are certain issues which represent important challenges for the countries of the region. However, they are either not particularly urgent, or in theory permit individual countries to exercise a greater degree of national control over their development.

These include

1. Long-term demographic trends and the threat they pose for the quantity and quality of the workforce, and the financial sustainability of social security programmes;

2. The need for ongoing economic reforms in order to improve the competitiveness and productivity of regional economies.

Two crucial issues are critical challenges for the Black Sea region both now and throughout the next decade. Whilst the region’s countries will have some influence in this area, external factors and decision-making will also be important, possibly to an even greater degree.

They are

3. The current global economic crisis, how it affects individual states and the region as a whole, and the kind of policy responses which may emerge;

4. The long-term evolution of economic relations with important external players. For the Black Sea region, the future evolution of relations with the EU is by far the most significant parameter.

5. Finally, that is the promotion of regional cooperation. This contains certain unique elements and will therefore be discussed separately.

Long-Term Demographic Trends and Economic Reforms

These issues are of secondary importance, at least for the time being. Demographic trends in the Black Sea region represent a ‘time bomb’ type of issue which will grow in the years to come and may well end up by becoming the principal challenge for most countries in the region.

Birth rates have declined throughout the region, as in western Europe, and the actual population size is becoming smaller in a number of countries which, in addition to precipitate drops in the birth rates, have witnessed net emigration, and, in some transition countries, declines in life expectancy and rises in the death rates from the 1990s onwards which were stabilized only during the years of robust growth.

The implications of such negative demographic trends are wide-ranging, and will affect the economy with regard to the quality and quantity of the workforce, the business environment, pension systems and government finances, and make themselves felt directly or indirectly in many other sectors of economic life.

However, while demography-related issues will become more important in the years ahead, they are not as pressing as the other challenges alluded to above, though of course individual countries can and should take them into account as a long-term trend.

The questions of competitiveness and productivity are key ‘second generation’ reforms for many countries of the region. They are required in order to safeguard what has already been achieved, to sustain growth in the long term, and to promote convergence with western European income levels and living standards.

There is a need to

(i) strengthen public and private governance,

(ii) undertake difficult structural reforms in key sectors, with energy and agriculture ranking as the most difficult,   

(iii) continue to invest in maintaining and expanding infrastructure, the current state of which is a key potential constraint on growth.

It should be borne in mind that the fiscal capacity of Black Sea states is insufficient to meet such long-term goals. However, the ability to deal with these issues depends to an important extent on the impact of the current economic crisis, as well as the economic relationships with countries which determine factors such as policy limitations, obligations, privileges and prospects of access to decision-making forums and assistance.

Dealing with the Global Economic Crisis

The current global economic crisis has adversely affected the region in general, and certain countries in particular. The restoration of credit flows to the region is a critical element in its recovery from the crisis.

And while it is certainly necessary, it is not sufficient. Yet even this may prove to be a major obstacle for Black Sea countries, since most of them do not have a currency with reserve status, and access to foreign currency is expensive. This leaves them with only limited options.

Individual country options

Despite increased reserves and the high growth levels of previous years, the lack of reserve currency status and perceived external vulnerability limit the scope for options such as fiscal stimulus packages or the easing of monetary policy adopted by more developed economies.

Thus for most Black Sea countries the most probable responses will include traditional austerity to restrict demand, maintain revenue flows, reduce debt servicing requirements and regain or increase the confidence of the markets.

Countries can do a lot to help themselves by ensuring that there are domestic laws and frameworks designed

(i) to improve the business environment, including the establishment of companies and their operation

(ii) to upgrade the transparency and quality of public and private governance

(iii) to facilitate rapid debt restructuring and corporate reorganization, including bankruptcy

(iv) to establish defined social security nets with the fiscal resources available, to assist unemployed workers and disadvantaged groups and to mitigate some of the worst effects of the crisis

(v) to institute mechanisms to help restore the functionality of domestic financial systems, including measures such as ensuring the capitalization of banks, improving regulatory supervision, enforcing rules fairly and objectively, establishing or improving credit and collateral registries, etc.13

Regional options

In theory the Black Sea countries could gather around a regional institution such as BSEC in order to seek ways in which to cooperate and coordinate their activities.

This could begin with a policy dialogue and information exchange, and continue with institutional cooperation or policy coordination. And it could eventually embrace (i) institutional harmonization, (ii) organizational structures, and (iii) the commitment and/or pooling of resources, such as multilateral swap arrangements14.

As yet there has been no such action on a regional level, apart from a financial sector dialogue within BSEC. Nor does there appear to be any discernible political will to do this which means that it is a highly unlikely scenario.

Externally supported options

This covers official bilateral and international financial assistance as well as externally initiated institutional structures.

For many sovereign borrowers in the Black Sea region, official lending is the only realistic option when accessing external financing.

In the first half of 2009 only Greece, a Eurozone member, issued bonds for substantial amounts15.

International financial institutions (IFIs) and donors, including the EU, have an important ‘counter-cyclical’ role to play by increasing lending levels when private sources are beginning to diminish. Thus IFIs significantly increased their commitments, which reached record levels.

The International Monetary Fund (IMF) persuaded its members to quadruple the available resources early in 2009, and it has concluded agreements worth tens of billions of dollars with a number of Black Sea countries16.

The World Bank, the European Investment Bank, the European Bank for Reconstruction and Development and others have also stepped up their lending.

Nevertheless, even at this rate official flows fell far short of the levels of private financing provided in previous years.

It is expected that for 2009 they reached only about 10–15 % of the levels of private financing provided in 200717.

Assistance provided by IFIs is currently the main form of EU involvement. It has supported IFIs (as a key shareholder and funding provider), it has contributed an additional US$ 100 billion to the IMF, and it has accelerated balance of payments facilities it offers to non-Eurozone EU members (for example, Bulgaria and Romania).

A distinct (though similar) measure would be the establishment of ‘swap lines’ between regional central banks and those central banks which control key reserve currencies (e.g. the European Central Bank for the Euro, the Federal Reserve for the dollar) in order to ensure that there is sufficient liquidity and access to foreign reserves whenever global liquidity is restricted18.

However, no such scheme has been contemplated for any of the countries of the Black Sea region.    Indirectly, a related development has been observed in the case of Eurozone-based banks. They have accessed ECB facilities and used the money to support subsidiaries and branches throughout    Eastern Europe, as well as to roll over loans.

In theory the same effect could be achieved by sovereigns using Eurozone-based banks as intermediaries to purchase Black Sea bond issues through targeted placements.

It is the strategy which Greece, a member of the Eurozone, has employed with Greek banks, which in turn have significantly increased their share of government bond purchases. 

However, this trick is more difficult for other Black Sea countries since they do not exercise regulatory    control over Eurozone-based banks, and thus have no way of forcing anyone to make such    purchases. They would have to give the banks special incentives, and the cost would be much higher. 

As for institutional frameworks which might give support to the region, an assistance programme    would work either bilaterally between a country and an assisting entity/ donor, or, if under the    auspices of a multilateral framework, would probably be implemented by the EU, e.g. based in  Brussels and with the participation of all 27 EU members, though it is highly unlikely that any other  states would be involved.

Any moves to include non-EU states would probably be on a ‘take it or leave it’ basis, with terms and conditions determined by the EU and little room for meaningful negotiation. 

Such a framework might emerge if the downturn drags on and creates new crises, or a sudden wave of enlightened self-interest and prescient thinking strikes key EU decision-makers.

But as things stand at the time of writing there do not appear to be any supranational or multilateral financial support schemes in the offing that might include Black Sea countries19.

During the current crisis the EU has in general treated eastern Europe (including the states of the Black Sea region) as four groups:

”Eurozone members, where they intend states to back each other, without IMF help; EU members beyond the Eurozone, which will be supported in conjunction with the IMF .... rescue; future members …which could win limited backing; and countries without membership prospects, notably Ukraine, which will receive even less attention”20.

Thus even within the EU there is no    institutionalized framework and its support has come either in the form of

(i) ad hoc assistance for EU members provided in conjunction with the IMF (e.g. Hungary, Romania) or

(ii) implicit guarantees emanating from nebulous statements that Eurozone countries would support each other, and /or that they would support non-Eurozone EU members in need.

Once the markets return to functioning in a normal manner, both globally and in the Black Sea region, they will probably be more risk averse.

It will then be possible to project how much ‘bottoming out’ still lies ahead, and to adopt the requisite measures and reforms needed to promote    recovery, and to improve competitiveness and productivity.

Once this stage has been reached, more traditional kinds of development assistance and support will probably play a role, though hopefully as time goes on they will no longer be required.

As private sector risk aversion abates, private flows in the form of lending, direct investment, portfolio investment and remittances will probably pick up. However, a return to the rapid growth of the 2000–08 period would require foreign capital flows returning to the levels last seen at the peak of the boom.

Such a reversal  of current trends appears highly doubtful since net financial flows to emerging markets have fallen sharply, and those to ‘emerging Europe’ (including most of the Black Sea region) have    dropped precipitously21.

 Furthermore, the recovery may take longer than anticipated because “recessions associated with financial crises have typically been severe and protracted, whereas recoveries from recessions associated with financial crises have typically been slower, held back by weak private demand and credit.

In addition, highly synchronized recession episodes are longer and deeper than other recessions, and recoveries from these recessions are typically weak.”22

The Evolution of Relations with External Players, and Especially Relations with the EU

From an economic perspective, the key external actors for the Black Sea region are, in order of importance, the EU, the US, China, the Middle East, and Central Asia. Of these, the EU is by far  the most important actor in economic terms and dwarfs the rest.

EU decisions have a major and direct impact on the Black Sea region, and often create an externality effect. Thus EU decisions have a significant indirect impact on non-EU countries in the region. Sometimes this is positive, but it can also be divisive or negative.

The EU is also a critical market for the Black Sea region. It is the main destination for exports from the Black Sea region, and is its principal source of financing  in the shape of lending, investment, and official assistance23.

A prolonged economic recession in the EU would have a negative effect on growth prospects for the Black Sea region, whereas a rapid recovery would be an undoubted boost.

Ever since the EU has expanded to the shores of the Black Sea as a result of the accession of Bulgaria  and Romania, and the area has seen rapid economic growth, interest in the region has increased  and can be expected to continue to increase.

Despite the current economic crisis, and the varied nterests and priorities of various EU member states, the EU and western and central European countries have steadily developed closer economic ties with the Black Sea region in recent years in the process of seeking new opportunities for investment and expanding markets.

In the long term this will remain an important driver of change helping to bring the Black Sea region closer to the EU. A key question concerns the terms on which this will happen, since the EU insists on ‘exporting’ its own rules, regulations and standards.

In many cases the EU’s rules represent state-of-the-art best practices which allow sectors of the economy to develop and flourish with greater transparency, increased competition, clear legal frameworks, and cross-border inter-applicability. 

However, there are also EU practices which are discriminatory and actually create more problems than they solve, the most notorious of which is the common agricultural policy.

The EU’s institutional relationship with Black Sea states has a profound effect on most of the countries concerned. 

Since 2000, after Greece joined the Eurozone, Bulgaria and Romania entered the EU, and Turkey    became a candidate for EU membership there have been significant and positive economic developments. 

Trade with the EU has increased, investment has soared, and sovereign credit ratings  have improved, thus reducing the cost of borrowing. More recently the introduction of the ENP has  coincided with an increase in trade and investment in Moldova, Ukraine and the three Caucasus  countries, although the degree of causality is open to question. 

All in all the EU’s impact on cooperation in the Black Sea region has not been altogether beneficial, chiefly because its relations with Black Sea countries have developed bilaterally without taking into    account the implications for regional cooperation.

This, interestingly enough, is “in stark contrast   to EU initiatives in other geographic regions, which were conceived from the very beginning in    regional – rather than bilateral – format and have been partly institutionalized”24

The EU bilateral relationship which has turned out to be most contentious, and where the EU has been able to exercise the least influence, is the one with Russia.

Although Russia’s economy is  much smaller than that of the EU, and it depends on the EU for a much greater share of its trade    than the other way round, Russia’s population is larger than that of any individual EU country    (it amounts to nearly 30 % of the EU-27 total), it is politically powerful, and it is rather disdainful    about cooperation with (and even more so about integration into) the EU.

While this is primarily a  political question, it has obvious economic ramifications. There is also a spill-over effect with    regard to other Black Sea Countries, particularly the ENP states.

Closer relations between the EU  and Russia would facilitate closer relations among all the Black Sea countries, while poor EU-Russia  relations and political and economic distance would affect not just Russia, but would also  create competing sources of influence in the case of the ENP states. 

Promoting Regional Cooperation

The issue of regional cooperation is rather unique. It represents a significant challenge in the face  of the economic crisis, the influence of external actors, diverging national economies, and potentially  competing agenda priorities.

However, to an important extent it has already been dealt with in the context of the challenges discussed above. For this reason, and especially in view of the low  level of regional cooperation, it seems more appropriate to see it as a secondary (though growing) challenge and not as a top priority.   

On the one hand, the economic crisis has been an obstacle when it comes to allocating resources for new initiatives that could enhance cooperation, although in certain areas it could in fact encourage    countries to pool resources, undertake joint schemes, or improve coordination in other  ways.

On the other hand, the European Union is the most powerful external influence on Black Sea regional cooperation, even though the EU sometimes makes a distinction between countries that are EU members or candidates, and those that are not, and at other times facilitates increased  cooperation under the auspices of EU frameworks.

Indeed, where there is evidence of greater  regional cooperation, this tends to be incidental, either (i) emanating from a multilateral initiative  inaugurated elsewhere (such as the EU), or (ii) deriving from a bilateral scheme that happens to  contribute favorably to regional cooperation.

However, as the energy pipelines issue has shown, bilateral (and trilateral) cooperation may exclude other regional countries and thus diminish overall regional cooperation even if it enhances collaboration among specific participants.

Nevertheless, regional cooperation is becoming a more important issue since the evolution of relations    among neighbours is always of relevance and there is a great deal of scope for mutually beneficial    cooperation around the Black Sea, given that the starting point is on a rather low level.   

One area in which there is a great deal of room for improvement is the enhancement and systematization of policy dialogue in key sectors.

The current crisis has underlined the importance of a  timely financial sector dialogue. There are numerous forums on a global level, although the EU  dominates the debate on the pan-European level. In the Black Sea region the BSEC Working Group  on Banking and Finance has conducted a regionally focused debate on a couple of occasions since  the outbreak of the crisis. Its key challenge is to upgrade the level of participation and the timeliness  and quality of the information exchanged within the forum so that the participants will perceive the  relevance and usefulness of the dialogue, and continue to invest time and effort in the venture.   

In addition to finance, sectors such as transport, energy, telecommunications, the environment and    the facilitation of trade can become the subjects of debates and formal exchanges, and perhaps even coordination. ‘Talking shops’ for a range of sectors and issues already exist in various forms.   

The most prominent of these are the approximately 20 BSEC working groups and specialized    committees for key sectoral initiatives. Improving their effectiveness is an important issue, and     here two of the principal challenges are maintaining their relevance and streamlining overlapping     areas.   

A step up from a regional policy dialogue is the adoption of more enhanced forms of cooperation  such as

(i) institutional measures that lead to the harmonization of legal rules and frameworks,

(ii) informal or formal agreements on pursuing specific policies and courses of action,

(iii) the establishment  of specific-purpose institutions or organizations,

(iv) the pooling of resources in order to achieve a common aim

(v) the commitment to undertake joint projects in priority areas that may confer benefits upon all participants. Cross-border infrastructure development is an area with great potential for such cooperation.   

Moreover, there is a powerful rationale for cooperation, which is the search for cost-effective solutions.

The amount of funding that is needed is very high given the level of overall regional requirements, and for nearly all of the countries the mediocre or dilapidated infrastructure is a  potential bottleneck that can hold up the post-crisis resumption of healthy economic growth.   

12  See the IMF report “Crisis and Recovery,” in World Economic Outlook, April 2009

13 See also ‘Coping with the Crisis: Policy Options for Emerging Market Countries’ by Ghosh, Atish R. et al. 23 April, 2009, IMF Staff Position Note.

14 It would resemble ASEAN’s Chiang Mai Initiative – see http://www.aseansec.org/17902.pdf 15 During this period Turkey was the only other Black Sea country to float a couple of Eurobond issues for minor amounts.

16 At the time of writing Albania and Moldova are implementing IMF concessional programmes, while Armenia, Georgia, Romania and Ukraine are implementing non-concessional programmes.

17 See ‘Capital Flows to Emerging Market Economies’, Institute of International Finance Report, 11 June 2009; World Economic Outlook (WEO), April 2009; “Crisis and Recovery,” IMF Report; and WEO update, 8 July 2009.

18 The model for this could be the dollar swap lines put in place by the US Federal Reserve for Brazil, Mexico, South Korea and    Singapore in late October 2008. See “Currency swap eases emerging economy jitters”, Financial Times, 31 October 2008. 

19 Despite this fact, there have been numerous proposals for a ‘European Financial Stability Fund’ (see http://shop.ceps.eu/    BookDetail.php?item_id=1804 ) and for common Eurobonds (see http://shop.ceps.eu/BookDetail.php?item_id=1823 ). Nothing is  in the offing at the time of writing. 

20 See Stefan Wagstyl, ‘Prospects hinge on global markets,’ Financial Times, 12 May 2009.   

21 See ‘Capital Flows to Emerging Market Economies’, IIF Report.

22 World Economic Outlook, April 2009, “Crisis and Recovery,” IMF Report, p. 106.

23 The EU is the largest external source of remittances, though Russia is far and away the largest overall source of remittances for    a number of Black Sea countries. 

24 Vasily Astrov and Peter Havlik, ‘Economic Developments in the Wider Black Sea Region’ in The Wider Black Sea Region in the    21st Century: Strategic, Economic, and Energy Perspectives, ed. Daniel Hamilton and Gerhard Mangott, Center for Transatlantic    Relations, The Johns Hopkins University and the Austrian Institute for International Affairs, 2008, pp. 137–9.

About the author

Panayotis Gavras has been with the Black Sea Trade and Development Bank (BSTDB) since its start-up in 1999. He is currently co-Head of the Policy and Strategy Department and has directed a variety of strategic and operational activities, including the preparation of country strategies, economic analysis of member countries.

He has also directed the Bank’s economic research on the Black Sea Region. Prior to the BSTDB, he worked at the World Bank and the National Foundation for the Reception and Resettlement of Repatriated Greeks. He holds a Bachelor of Arts degree from Princeton University, and a Masters in Public Policy from the Kennedy School of Government.

www.blackseacom.eu

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