Just one year out from the fall of Lehman Brothers and the beginning of the crisis, economists in the Czech Republic have had time to evaluate the effects of the housing crisis and the resulting recession. Martin Kupka, Chief Economist at CSOB (Ceskoslovenska obchodni banka, a.s.), gives us a closer look at the main economic concerns resulting from the crisis. The following is an exploration of current trends within the country and financial sector, and some thoughts on the nation’s direction and future outlook.

16 November, 2009

Introductory remarks about the crisis.

I think the first point that should be mentioned is that the crisis has two parts, at least. The first part was the financial crisis, and then we have been now enjoying the general economic recession. There is a big difference between the financial crisis in Central Eastern Europe, or at least in the Czech Republic, and in Western Europe, for instance, and the United States. For, the Czech banks were not hurt by the financial crisis as much as their counterparts in the Western countries were for many reasons.

One [reason], perhaps most important, is that the financial market here hadn’t been that developed, or in other words the banks were able to generate profits without being involved in that risky, or potentially risky as it has been perceived now (it was perceived less at that time), operations than the banks in Western Europe and in the States. So it was a big advantage. For instance in the Czech Republic the banks didn’t receive any help from the state. There was no need to recapitalize the banks or to use some dumping for bad loans or to offer extensive guarantees to the population, companies or the interbank market, etc. So this was a big advantage, which doesn’t mean that we were not touched by the financial crisis, for the population here was aware and reading newspapers that something was wrong. I think at that time we were a bit angry with the journalists for we thought that they were exaggerating that [fact]. And of course some people started to ask themselves whether their deposits are safe in the bank or whether their investments are safe, investment funds. And also if they looked at the development market price in some funds they had to notice that, for instance, in some money market funds that they were used to seeing increasing all the time (and it was alternative to saving accounts), that they showed a decrease in price because part of their investments were for instance in Iceland, and just by the fact that it was not a bulk of the investment, there were portfolios that were broad enough, then the impact of the price was significant or visible and this was enough to give some people reason to think about that.

Fortunately, after some time the situation has calmed and this was fine. But, I think of course, it was not possible not to react to what had happened abroad. There were two channels how the reaction has arrived. One channel is that the banks in this country have been owned by mother banks in Western Europe. I think that also these mother banks, (I don’t say that the management here wouldn’t do that themselves but perhaps to a slightly lesser extent) tightened credit conditions; there has not and will not be a credit crunch, but the risk premiums have increased and it’s not that easy to get a loan as it had been the case before. Also, the demand for loans has decreased, so both the supply side and demand side of the loan market have experienced a change. As a result, the growth rate of loans has been decreasing. This aspect – why there is a decrease in demand for loans – is because the companies in the Czech economy, which is very much open and export oriented, suffered a blow from dropping demand, and from first of all Western Europe, our main trading partner. This means that their quality of clients has also decreased and this is the reason why we also had here a recession. It’s a relatively deep recession, close to 5% this year, and it’s to a large extent an important recession.

And what’s the outlook: there is a big degree of uncertainty about the future. I think that we can do hardly more to join what the majority believes will be the case, and this is that the worst is behind us. We have two quarters of growth and we think that probably in the first half of 2010 we can experience another weakening, but after that we could return to a growing economy again. However, of course, at lower growth rates and GDP than we were used to since the beginning of this century. And for 2010 our forecast is 1% GDP growth, something like that. But I think that really it’s very hard to predict what will happen.

When the crisis first manifested in the Czech Republic, what were you and your colleagues most worried about?

I personally started to perceive that something went wrong when we heard about this mortgage crisis and subprime [mortgages] in the United States. We were asked then to write a short memorandum on that: how we perceived the situation was serious and what the implications and consequences could be. I remember that we also used an input from our colleagues in Belgium. The outcome was that, we said, well, this subprime market is a relatively small segment even in the United States of the whole residential housing, and the whole residential housing, again, is a small part of the big United States economy, and so we think that implications or consequences for the European economy and the Czech economy would be rather small.

This was probably the prevailing belief among most economists, at least those I know or have been surrounded by. Then the situation changed on the 15th of September 2008, when Lehman Brothers collapsed. Perhaps even before when Bear Stearns showed what they showed. At that time we thought that it wouldn’t be that banning, that something bad happened. But we couldn’t imagine the true depth of the problems until perhaps November, December of last year. And it was interesting, I don’t want to defend ourselves, but if you want to go through the forecasts prepared by various sources and institutions, (there is for instance a material called consensus forecast where you will find forecast of many institutions involved in these markets, analysts from various institutions) they tried to guess the GDP growth rate, unemployment, and other macroeconomic indicators in various time horizons. For instance, in GDP you could observe the month-by-month outlook percentage. We started with, I don’t know, 4% growth for 2010, and then it was 3%, 2% and so on. I think that really there were not many analysts, observers or politicians who would believe or were afraid that what did happen could happen. So we really underestimated the true extent of the problem.

As the outlook worsened, how did you have to change your long-term strategic plans?

What definitely was done was there were some attempts to work out some alternative scenarios of what could happen, and to start talking with the management at lower levels, also in various segments, and ask them what and how they would react if this or that scenario turned true.

The bank as such, as I already mentioned before, tightened the credit policy. I think also that also after the experience of people’s fear that was voiced, manifested in various ways, also in the press, the safety of investments was increasingly stressed at the cost of market share or aggressive policy and risky business. What was very important was not to lose confidence of investors for this is death for all financial institutions.

So there was an immediate reaction to keep the confidence, to stop risky activities, to wait what happens when the situation will evolve, and then a longer term effort to start thinking about what the implications of that could be and what adjustments can be made or should be made to stay among the leading bank here in times when the dust settles and the new landscape is to live in.

Could you be more specific about how they planned to go about doing that – to keep stability?

I can’t, for I am just an analyst. I am not a member of the country team.

How did the CSOB’s [outlook and policies] differ given that KBC got money from Belgium? As you mentioned earlier, the Czech banks did not receive any money from the Czech government. Did any of that money come through here from the mother bank?

No. I think that what our Belgian friends would like is for the money to come from here to Belgium, not the opposite.

I think that here the situation is different from the Belgian or Western Europe situation in the sense that banks here are over liquid since the transition. So there have been many more deposits than loans. Our loans savings ratio is some 70%, so we were not forced to borrow money from someone else or from the central bank for we had enough liquidity. This was a big advantage, I think. The question one could put on the table is, when we were over liquid, why the mother banks did not suck the money off the daughters and in the Czech Republic it’s impossible by law, so to say; the regulatory principles don’t allow the banks to move money out, so it was fine and we never had trouble with liquidity.

I read that the CSOB had some troublesome assets they had to get rid of. Was this problematic?

Ah you mean the CDOs? Of course we had a small portion of those toxic assets, but it was a much smaller fraction [as compared to], for instance, the [amount] KBC had. We had to, or we have written it off already. As the rating worsened for those assets, we have decreased their value in our portfolio. So it was the reason why – in one quarter we had much lower profits than analysts were used to. But still we ended with a [positive outcome], not with a loss. I think that now the situation is such that what we can expect nice surprises because, not that in the accounting the value of some of those assets is zero, but the true value is hopefully not zero. It will be obvious, not now but in the future, so it was a precautionary measure, so to say, to set [those assets] to zero. We then would have some items that were valued at zero but will now have some extraordinary profits. I think that really from that side we don’t have to worry.

For Czech citizens, most of their interaction with the bank concern standard procedures such as deposits and loans; they are charged high fess and there isn’t much transparency of those fees. Do you expect there to be a big change in this regard?

I don’t think there will be a big change due to the crisis, also for the reason that the crisis was a rather mild financial crisis.

There will be changes, [for one], due to the competition which is here. We can discuss how feared the competition is, but definitely there are six large banks, or large enough that they are able to compete. There will be also another factor which I think is perhaps more important and that is that the structure of the banking receivable, so the revenues, will change overtime. I think, and again I am not a director of the bank but this is a consensus here, that banks here are earning money from a different structure of operations compared to the UK, for instance, or the United States. For here there is a much lower share of sophisticated banking services that obviously are bearing high margins to the banks in developed countries, so there is a much larger [amount] of this low cost, easy, simple operations like credit account, private banking, etc.

The banks are at the pressure of the shareholders to generate above average profits for otherwise why would you invest in a risky region without receiving extra ordinary high profits. The only solution is that you will have to earn money also on the class of operations that haven’t been taxed or charged with such high fess in countries where there is another way to get money from investors like funds or asset managements of various kinds.

This is perhaps a region [in which] I suspect, while also despite the existing competition among the banks, the fees are still relatively high because all the banks here have been under the same pressure under their respective share holders to generate profits and profit growth, so they have no other way to reach the tasks and get bonuses…but this can change and this will change as the living standards and wealth in this country increase, it’s just a matter of time.

Do you see regulation playing a role in this, either from the EU or from the Czech government?

The third party’s pressure of the banks playing a role? I don’t think so. I think that what’s fine is that the Czech government is pushing on more transparency and things like this. I think it’s fine, on the other hand I think most problems in this area were not originating in the segment of banking institutions, but rather non-banking financial institutions because there is a relatively strong market of credit-offering institutions that haven’t been subject to such strong regulation. If you read these horrible stories in newspapers about these interest rates, maybe dozens percent per annum or of very strange contracts, then it’s mostly originating in these institutions, not the banks. Which doesn’t mean the banks or insurance companies would always prepare very simple, transparent contract for their clients, definitely not. And I am not very much afraid of that; I think it is gradually improving regardless of the crisis.

You spoke about the Czech Republic being a developing market. Do you think the crisis has affected its potential as an emerging market?

Definitely, yes, in a broad sense. Yea, sure there was this negative impact on industry, exports, and unemployment. There was also a negative impact on currency so it has contributed to currency volatility, for the Czech Republic has been perceived as an emerging market so potentially risky that at the moment there is increasing risk aversion in the world. This means that investors are selling off these potentially risky assets and they don’t always differentiate between the Czech Republic, Hungary, Latvia and Poland. This then [brings] a decreasing value of the currency, or depreciation.

But now, for instance, since the situation started to improve in the States, the opposite process is taking place, so these currencies are again gaining strength. This is interesting -this increased volatility has its cost in terms of, for instance, planning in companies, planning revenues, and all that. Now the discussion is legitimate – whether it would be better to have a singular European currency instead of the Czech crown. There is no consensus on that, for there are people who say, look, the Czech crown is fine, it could depreciate, and others say, well, but we have this benefit of a stable currency and you have this increased volatility. [This discussion] has no clear outcome because it is more based on ideological prejudices and things like this that on economic analysis.

But this was also a cost of the financial crisis. In broad terms that [the crisis] is perhaps, I would have to excuse [the following] to all who lost their jobs, […] to some degree positive [with regards to] the problems that were on the surface copulating for a long time. They became obvious and hopefully we will improve the business environment based on the crisis, and this is not bad. The problem is that some companies also disappeared that were cautious, that were reasonably managed, or that had a vision, but they had the pity of being swept down by the 5% average.

Do you anticipate the level of foreign investment fluctuating?

I think yes, sure. For instance I think one of the most obvious consequences of this crisis was that volume of transferable transactions fell. All transferable transactions, so foreign trade but also foreign capital flows. We don’t have data for 2008, and what’s available is preliminary data, but I am sure that the volume of foreign direct investments (FDIs) inflow and also outflow (but inflow is more important for us) definitely had decreased. But I am not that skeptical about that for we have been now living in a world of overcapacity. When Bernanke, too, points to future Monetary Policy and interest rate settings, he says that there are very low dangers of increasing inflation in the near future because there are strong slacks in the economy and I think the same holds here. So we can live without a steady flow of FDIs if that’s just an interruption and it’s not a general change in the direction of the flow from CEE Economies to the Balkans or the Ukraine, of which I am not afraid. It’s a long-term issue, definitely, whether we will be able to lure investors that would require more sophisticated production.

[…] Perhaps if we are able to produce a competitive labor force here for such sophisticated, high value added, productions… but this is more about education.

What opportunities for the country’s growth excite you most?

There is one general argument why the financial sector could prosper here. There is an empirical fact that if your wealth increases and society gets more rich, then the volume of financial assets compared to GDP increase. So financial depth of the market increases with increasing wealth of the country. As the emerging markets are still […] catching up to developed Western Europe, for instance, then based on that there should be space for further expansion of financial services. So this is one reason.

Second reason is that I think there is still an underlying hypothesis that in these countries, and the Czech Republic is no exception, it should be possible to increase productivity faster than in the developed Western Economies. […][1] There is potential for these CEE countries to strengthen in the long run against the Euro, for instance, or dollar. If this is true, then the growth rate in this country should be above the growth rate of Western Europe or of the United States. This is again a reason why these faster growing economies should acquire more financial services, and also a different structure of financial services

So this is, I think, mainstream reasoning which hopefully will confirm itself in the future, but it’s rather general.

You seem very optimistic generally about the country’s prospects despite the pessimistic outlook for growth. But is there anything that keeps you awake at night?

Optimistic prospects: I think that really this country should be able, under normal circumstances, to reach some growth rate, sustainable growth rate, of 3% to 4 %. We had 7%, it was too much, it was this bubble that was growing in the world and of which we were a part, but I think 3%, 4%, which is more than the European percentage, should be achievable.

The risks are twofold. My impression is that the number of recessions and sharp turns in the business cycle has been increasing in the past decade. This is for many reasons, which go beyond this discussion. I can’t exclude that after this originally dot com bubble, stock bubble and housing bubble there will be another bubble waiting around the corner, and we will suffer through that new bubble in two or three years. Again nobody would be prepared … and this would be a problem for this region.

Second problem, this time internal, is what happens with public finance and the balance of the public budget. We were able to live with a 3% deficit in terms of 7% GDP growth. Now, when facing the recession, we will have some 6% public budget deficit and fast growing mandatory expenditures, also due to demographic changes and an aging population. If the interest rates would increase on the market, then it would mean we would pay more to service the debt. What I am still missing is will, political will, and some national consensus to implement fiscal reforms that would make it easier for the finance minister to balance the budgets and expenditures. And I am afraid that in this region, which I know best, we have an example of Slovakia, and another one of Hungary, where they also had problems including fiscal problems, but were able to address them only when the situation turned really bad. Until then, the population is calm and quiet and not ready to sacrifice anything. I am afraid that this scenario could turn into a reality also in this country, for I cannot see any improvements in the budget policy for the years to come. So this is, I think, the most serious issue or macroeconomic issue we observe here. There may be others emerging which we can’t recognize for the time being, which are much more dangerous, but this one has been with us for many years, this [issue of] fiscal policy.

[1] 32.40, indecipherable sentence.

 

Advertisement