Western Banks Must Take Their Own Medicine

Erik Berglöf
Erik Berglöf Director of the Institute of Global Affairs - London School of Economics and Political Science, Former Brookings Expert, Former Chief Economist - European Bank for Reconstruction and Development

February 28, 2008

For decades westerners have lectured central and eastern European policymakers on how to regulate and supervise, balance their budgets and stem credit expansion. Now they must deal with the consequences of a global crisis triggered because the west broke all the rules it preached. Worse, it is a crisis they cannot do much to resolve. They cannot even benefit from the bargains of distressed assets. Unlike some resource-rich neighbours in the east, they are not sitting on huge reserves that could bail out western institutions.

Much is at stake for these economies. Elsewhere countries have lost decades of development in a single crisis. Most eastern Europeans still have the Asian and Russian crises of 1997-98 fresh in their minds. They have been told they are vulnerable – in fact, according to the International Monetary Fund last year, the world’s most vulnerable.

Some countries in the region are already feeling the pinch with higher interest rates and pressures on their exchange rates. Thanks to strong fundamentals and much-improved institutions, they have so far weathered the storm. But they are bracing themselves for a second wave of impact through lower growth in export markets.

The stakes are also high for western Europe – much higher than in 1997-98. These emerging economies are no longer just growing fast; they are also beginning to matter economically. Central and eastern Europe, including Russia, have surpassed the UK and the US jointly as the largest export market for the eurozone.

A new Europe is emerging with deeper economic and financial integration. Massive foreign investments have given rise to production patterns that have brought western and eastern Europe much closer together. Look at Volkswagen, which has invested heavily in the Czech carmaker, Skoda. Initially many critical components came from Germany, but local Czech suppliers upgraded and western subcontractors migrated to the Czech Republic. Today car components are an important Czech export.

Or take SEB. The Swedish bank acquired several Baltic banks. These highly profitable subsidiaries were first run as independent banks, but gradually activities have been integrated under the motto “One SEB”. Today SEB, with two other Swedish banks, is in effect the monetary authority of the Baltic states, with main regulators and supervisors based in Stockholm.

This new Europe is highly competitive. While Chinese exports have gained ground in western European markets, so have those from central and eastern Europe; the only big product category in which Chinese producers have advanced at their expense is garments. Competitive labour costs, productivity improvements driven by foreign investments, and proximity to export markets explain the success.

We are seeing the dividends from the end of the cold war and more than a decade of painstaking European Union accession. The countries of central and eastern Europe have perhaps not always followed the straight and narrow path, but they have in the end, more or less, done everything they were asked to do. Unprecedented institutional progress has laid the groundwork for even more integration in the future.

But this integration is also what makes the new Europe more vulnerable. While the region’s banks are in good shape, questions are emerging about the ability of the parent banks in western Europe to support their offspring. Deplorably, some parent banks are finding increasingly innovative ways to undermine local regulators and the rules the west has preached about, for example, capital adequacy and foreign exchange exposure.

All this leaves local policymakers with a sense of powerlessness. They have perhaps not always been model students, but they have opened up their economies, exposing them to international competition. Their state sectors still need reforming, but most budgets are holding up reasonably well, given the pressures for compensation after years of hardship. Still they know that they have yet to be tested in a sustained global downturn.

So far the economies of central and eastern Europe are doing remarkably well, but our crisis could become their crisis. For our common good we must quickly mend the global financial system. Meanwhile, to sustain growth in the new Europe we must repeat the old prescription of stronger regulation, vigilant supervision, fiscal discipline and careful credit expansion – and make sure we take the medicine ourselves.