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REBALANCING FINANCE AND BOOSTING INVESTMENT

Introduction

Transition report 2015-16 Rebalancing finance


 * 
 * Investment gap
 * Credit crunch
 * Private equity
 * Growth capital
 * Outlook
 * Reforms
 * Countries

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INTRODUCTION

HANS PETER LANKES

Hans Peter Lankes is the Managing Director, Corporate Strategy and Acting Chief
Economist at the EBRD. From July 2012 until June 2013 and again in
October-December 2014 he served as Acting Vice President, Policy with the task
of reorganising the Vice Presidency into the Bank’s hub for strategy and policy
coordination.

Prior to joining the EBRD in 2007, Hans Peter worked at the International
Monetary Fund in Washington, D.C., where he was Chief of the Trade Division and
Adviser in the Policy Development and Review Department. He holds academic
qualifications from Université de Grenoble and Albert Ludwigs Universität
Freiburg and an M.P.A. and Ph.D. from Harvard University.



It has been almost a decade since the Transition Report  last looked in detail
at the EBRD region’s financial sectors. In that time, the global financial
system has undergone major changes and nowhere have these changes been more
profound than in the countries where the EBRD invests. This report looks at the
evolution of finance in the transition region following the crisis of 2008-09
and considers the question of how finance should be rebalanced to provide more
diverse and stable funding flows in support of economic development.




REBALANCING FINANCE


DIVERSIFYING FUNDING TO FOSTER GROWTH

It has been almost a decade since the EBRD last published a Transition Report 
that focused on the financial system. Back in 2006, economic growth in the
region was in excess of 6 per cent, several percentage points higher than in the
eurozone. The EBRD region was even home to the world’s fastest-growing economy:
Azerbaijan. The region’s strong economic growth was underpinned by large inflows
of foreign direct investment and rapid growth in domestic credit. The 2006
report’s encouraging conclusion was that economic and institutional reforms were
continuing apace across the transition region.

However, it also warned that cross-border capital could be withdrawn very
quickly in a crisis and that foreign direct investment, which was underpinning
growth and convergence in the region, was more mobile than people generally
realised. Two years later, those warnings began to look rather prescient. The
global financial crisis and the subsequent eurozone debt crisis have resulted in
capital inflows from traditional European sources declining to a mere trickle.
The financial world has undergone profound changes, both globally and in the
EBRD’s countries of operations.

As we publish this year’s Transition Report, the region’s annual growth rate is
hovering around zero. In fact, the region’s income levels have hardly converged
at all with those of advanced economies in the post-crisis period. Russia’s
economy, which expanded rapidly before the 2008-09 crisis, has experienced a
sharp decline in economic growth. Cross-border flows of capital and foreign
direct investment have shrunk, while credit growth has been weak (and even
negative in some countries). Furthermore, the reform process has stalled across
the region, as the 2013 report highlighted.

Although growth has recently picked up among a number of commodity importers in
the region, the recession in Russia – which has been exacerbated by declines in
commodity prices – has had a negative impact on economies that have close ties
with that country on account of trade, investment and remittances. Geopolitical
tensions and the expected tightening of monetary policy in the United States are
also weighing on the region’s economies. As a result, growth in the EBRD region
as a whole has virtually ground to a halt in 2015 and is expected to recover
only moderately in 2016.

This is a good time, therefore, to look at how the financial sector can act as a
stable and robust engine of economic development in such challenging and
uncertain circumstances.

The report begins by showing how far the transition region is currently lagging
behind in terms of investment. This investment gap is casting a serious shadow
over the region’s long-term growth prospects – a finding echoed in the last two
Transition Reports. In order to boost investment and close that gap, new funding
sources need to be explored. Indeed, this report suggests that the challenge is
not only to increase the quantity of finance that is available to firms and
households, but also to rebalance its composition and improve its quality. Such
rebalancing and diversification will involve changes in a number of different
areas.

First, a key theme of this year’s report is the need to reduce 
the region’s
overwhelming reliance on debt financing and increase the role played by equity.
A combination of economic contractions and unfavourable exchange rate movements
have resulted in a situation where the total domestic and external debt of
households, firms and governments in the transition region is now higher  than
it was on the eve of the global financial crisis. Despite a decline in the
availability of new loans, particularly for small businesses (see Chapter 2),
the debt burden has continued to rise.

Against that background, the report highlights the special role that equity
financing can play in supporting investment and productivity increases in firms,
with a particular focus on private equity. Evidence suggests that private equity
investors operating in the region improve firms’ access to credit and help
companies to scale up capital expenditure and hire new workers, resulting in
higher levels of revenue and productivity. However, relatively few firms in the
region have attracted private equity investment to date. There are several ways
in which policy-makers could help to improve access to private equity, including
tightening rules on corporate governance and making it easier for private equity
funds to exit investments through public equity markets. The capital markets
union that is currently under discussion could play an important role in
improving access to equity in central Europe and parts of south-eastern Europe.

Second, there is a need to shift from foreign currency-denominated finance to
local currency credit markets. The dollarisation of credit in the region (that
is to say, the percentage of lending that is denominated in a foreign currency)
remains exceptionally high by global standards and only a few countries in the
region have seen noticeable declines in dollarisation levels in the wake of the
global financial crisis. As a result, many firms and households remain
vulnerable to sudden exchange rate movements, the risk of which has increased in
light of the expected monetary tightening in the United States.

Efforts to reduce dollarisation will be dependent on the gradual rebalancing of
banks’ funding sources, with shifts from foreign to domestic channels. The
ability of banks – both foreign and domestically owned – to access abundant
cross-border funding played an important role in supporting the strong credit
growth and economic convergence that was observed prior to the crisis. However,
a more balanced funding model is now needed to ensure that local banking systems
become more resilient to shocks in the longer term.

Third, the right balance needs to be struck between public debt, household debt
and corporate debt. The analysis in this report shows that firms in many
countries – particularly small and medium-sized enterprises – remain relatively
underserved by the financial sector. Survey evidence suggests that in many cases
these firms are discouraged from applying for credit by cumbersome and lengthy
application procedures.

Lastly, rebalancing also involves a shift towards a more diverse network of
cross-border investment partnerships, complementing the strong existing links
with advanced European economies. There is scope for stronger economic ties
between the transition region and both the other emerging markets and
non-European advanced economies, which would make overall funding flows more
stable. Intra-regional links could also be strengthened.

Rebalancing does not mean shifting from one extreme to the other. Instead, this
Transition Report calls for the gradual and sustainable optimisation of the
financial system structure. Even if more equity financing does become available,
debt will continue to play a major role, often helping to leverage the benefits
of equity financing. Some lending will always be conducted in a foreign currency
– serving the needs of companies with key markets abroad, for instance – but
such lending would normally make up a small percentage of total credit in the
financial systems of more advanced economies. And economic forces of gravity
dictate that advanced European economies will remain important trade and
investment partners for the region, even as economic links with other countries
multiply and grow stronger.

The optimal situation in terms of debt instruments, currency breakdowns, sources
of funding and investment partners will be different in each country, being
shaped by local factors, and it will evolve over time. Nevertheless, this report
provides general guidance that, taken together, will help to ensure that
financial systems offer a diverse range of funding options that meet the demands
of small businesses, larger firms and households, thereby helping income levels
to continue converging with those of advanced economies. In this regard, this
report develops themes highlighted as part of the Addis Ababa Action Agenda that
was adopted earlier this year, including the contribution that deeper domestic
capital markets and cross-border equity flows can make to sustainable
development.

This report does not seek to cover all major areas of finance, as that would be
impossible to do in any depth. Instead, it focuses on a few specific issues –
the geography of foreign direct investment, small businesses’ access to bank
finance and the impact of private equity financing – that serve to illustrate
its broader arguments.

The report is very much forward-looking. In order to better reflect this
approach, this publication has the title Transition Report 2015-16, a convention
that we intend to follow in the coming years.



Hans Peter Lankes
Acting Chief Economist, EBRD

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ABOUT

The EBRD seeks to foster the transition to an open market-oriented economy and
to promote entrepreneurship in its countries of operations. To perform this task
effectively, the Bank needs to analyse and understand the process of transition.
The purpose of the Transition Report  is to advance this understanding and to
share our analysis with partners.

The responsibility for the content of the report is taken by the Office of the
Chief Economist. The assessments and views expressed are not necessarily those
of the EBRD. All assessments and data are based on information as of early
October 2015.




HIGHLIGHTS




PRIVATE EQUITY AS
A SOURCE OF GROWTH

Private equity funds in the transition region not only target companies with
high growth rates but also assist their growth by implementing operational
improvements. They also relax companies’ credit constraints and increase both
employment and physical investment. The transition region is home to a sizeable
pool of companies that could potentially benefit from these positive growth
effects associated with private equity investment.

Read more


MACROECONOMIC
OVERVIEW

Over the past year the economic outlook in the transition region has been shaped
by a significant decline in the price of oil, persistent geopolitical
uncertainty, the launch of a quantitative easing programme in the eurozone and
the ongoing crisis in Greece. Although economic growth in many
commodity-importing countries has picked up, average growth in the region has
been weighed down by the negative shocks faced by Russia, other commodity
exporters and countries with strong economic ties to Russia. As a result, the
annual growth rate of the transition region as a whole is projected to decline
for the fourth consecutive year in 2015.

Read more


STRUCTURAL
REFORM

While the political and economic environment remains challenging, the outlook
for market reforms appears to have improved. There are opportunities for reform
in many sectors and countries that could help to bring economic structures and
institutions more into line with those of advanced market economies. However,
many transition countries still lag behind best practices when it comes to
promoting the sustainable use of resources and inclusion.

Read more


REBALANCING FINANCE
AND BOOSTING INVESTMENT

The global financial crisis has triggered a dramatic reduction in external
imbalances in the transition region, but this rebalancing has come at the
expense of investment. The region needs to invest around US$ 75 billion more per
year to bring investment back to the levels expected of economies at this stage
of development. However, despite those lower levels of investment and the credit
crunch, the debt of the non-financial sector in the region has actually
increased. Meeting those additional investment needs will require financial
sector rebalancing.

Read more


SMALL BUSINESSES AND
THE CREDIT CRUNCH

Credit conditions for small businesses have tightened significantly in recent
years, both during and after the global financial crisis. Structural adjustments
in banking systems – particularly reduced reliance on cross-border and wholesale
funding – explain a large part of this tightening. The composition of local
banking markets also plays a role since small businesses are more likely to
borrow from banks that have less hierarchical lending procedures, a greater
focus on building relationships with clients and more confidence in local
courts. Access to credit may therefore benefit from both stronger legal
enforcement and more effective and efficient bank lending techniques.

Read more


TRENDS AND
VALUE CREATION
IN PRIVATE EQUITY

Private equity can generate both financial value for investors and economic
value for the companies involved. Despite the strong growth of private equity
globally, the transition region receives only a small share of these global
flows. Compared with advanced economies, private equity funds in the transition
region rely less on debt financing and more on selecting high-growth companies
and implementing operational improvements to create value.

Read more


PRIVATE EQUITY AS
A SOURCE OF GROWTH

Private equity funds in the transition region not only target companies with
high growth rates but also assist their growth by implementing operational
improvements. They also relax companies’ credit constraints and increase both
employment and physical investment. The transition region is home to a sizeable
pool of companies that could potentially benefit from these positive growth
effects associated with private equity investment.

Read more


MACROECONOMIC
OVERVIEW

Over the past year the economic outlook in the transition region has been shaped
by a significant decline in the price of oil, persistent geopolitical
uncertainty, the launch of a quantitative easing programme in the eurozone and
the ongoing crisis in Greece. Although economic growth in many
commodity-importing countries has picked up, average growth in the region has
been weighed down by the negative shocks faced by Russia, other commodity
exporters and countries with strong economic ties to Russia. As a result, the
annual growth rate of the transition region as a whole is projected to decline
for the fourth consecutive year in 2015.

Read more


STRUCTURAL
REFORM

While the political and economic environment remains challenging, the outlook
for market reforms appears to have improved. There are opportunities for reform
in many sectors and countries that could help to bring economic structures and
institutions more into line with those of advanced market economies. However,
many transition countries still lag behind best practices when it comes to
promoting the sustainable use of resources and inclusion.

Read more


REBALANCING FINANCE
AND BOOSTING INVESTMENT

The global financial crisis has triggered a dramatic reduction in external
imbalances in the transition region, but this rebalancing has come at the
expense of investment. The region needs to invest around US$ 75 billion more per
year to bring investment back to the levels expected of economies at this stage
of development. However, despite those lower levels of investment and the credit
crunch, the debt of the non-financial sector in the region has actually
increased. Meeting those additional investment needs will require financial
sector rebalancing.

Read more


SMALL BUSINESSES AND
THE CREDIT CRUNCH

Credit conditions for small businesses have tightened significantly in recent
years, both during and after the global financial crisis. Structural adjustments
in banking systems – particularly reduced reliance on cross-border and wholesale
funding – explain a large part of this tightening. The composition of local
banking markets also plays a role since small businesses are more likely to
borrow from banks that have less hierarchical lending procedures, a greater
focus on building relationships with clients and more confidence in local
courts. Access to credit may therefore benefit from both stronger legal
enforcement and more effective and efficient bank lending techniques.

Read more


TRENDS AND
VALUE CREATION
IN PRIVATE EQUITY

Private equity can generate both financial value for investors and economic
value for the companies involved. Despite the strong growth of private equity
globally, the transition region receives only a small share of these global
flows. Compared with advanced economies, private equity funds in the transition
region rely less on debt financing and more on selecting high-growth companies
and implementing operational improvements to create value.

Read more


HIGHLIGHTS


STRUCTURAL
REFORM

While the political and economic environment remains challenging, the outlook
for market reforms appears to have improved. There are opportunities for reform
in many sectors and countries that would help to bring economic structures and
institutions more into line with those of advanced market economies. Significant
progress has been made with the enhancement of infrastructure in the last year,
with cash-strapped governments increasingly realising the value of fostering
private-sector involvement in the building and maintenance of transport links
and municipal services. However, many transition countries still lag behind best
practices when it comes to promoting the sustainable use of natural resources
and economically inclusive growth.




REBALANCING FINANCE
AND BOOSTING INVESTMENT

Prior to the financial crisis, a credit boom in the region boosted levels of
investment and growth, but resulted in large and ever-increasing external
imbalances financed by cross-border capital flows. With the crisis came a swift
external adjustment, as cross-border capital flows declined dramatically and
multinational banks withdrew funds from the region. That external adjustment has
largely been successful, bringing domestic investment into line with the –
predominantly low – levels of domestic savings. However, after years of sparse
investment (compared with the levels observed in other emerging markets with
similar characteristics) the region now has substantial investment financing
needs, requiring an extra US$ 75 billion per year.

Despite investment levels declining and firms in many countries facing a credit
crunch, the region’s overall indebtedness (measured as the sum of public and
private debt, both domestic and external) has continued growing at approximately
the same rate as before the crisis. In fact, indebtedness has increased by 25
percentage points of GDP since 2007, reaching 123 per cent of GDP in 2014. This
reflects the substantial weakening of growth in nominal GDP, the revaluation of
a large percentage of debt denominated in foreign currency, significant
increases in public debt following efforts to stimulate the economy after the
crisis and the fact that NPLs are weighing heavily on banks’ balance sheets.

Notwithstanding those increases in the total level of debt, in some economies –
particularly in central Europe, the Baltic states and south-eastern Europe – the
ratio of domestic corporate debt to GDP remains below the levels that would be
expected on the basis of those countries’ per capita income, the strength of
their economic institutions and other relevant characteristics. In other
countries, however, scope for raising debt levels appears to be more limited.

In order to meet the region’s vast investment needs, local financial systems
will need to be rebalanced further. In countries where NPL levels are high,
dealing with that overhang is a priority. In addition, a further shift towards
local currency-denominated funding has the potential to reduce credit risk and
improve the sustainability of debt. Looking beyond debt, increased use of equity
instruments, measures to boost savings and the diversification of cross-border
funding could all strengthen financial resilience, underpin investment and help
to revive income convergence.




SMALL BUSINESSES AND
THE CREDIT CRUNCH

This chapter uses a combination of macroeconomic, firm-level and bank-level data
to gauge the extent to which firms across the transition region have become more
credit constrained in the seven years since the onset of the global financial
crisis. The analysis shows that while credit conditions for small businesses
have tightened overall, there is substantial cross-country heterogeneity. Access
to credit has deteriorated most in those countries that have experienced a
decline in cross-border borrowing by banks, a decline in wholesale (rather than
deposit) funding and/or a decline in bank leverage.

Within countries, the composition of local banking markets also plays a role.
Analysis shows that when SMEs have a choice of various banks in their town or
city, they tend to borrow from financially sound banks that have less
hierarchical lending procedures, greater confidence in the quality of legal
enforcement and a focus on establishing long-term lending relationships. This
suggests that financial matters are not the only consideration in this regard
and that organisational and institutional issues also have a key role to play in
the debate about reviving lending to SMEs in the EBRD’s countries of operations.

To stimulate SME lending, banks themselves can make additional efforts to
streamline their loan application procedures. Surveys of firms reveal that many
SMEs are discouraged from applying for credit by cumbersome and lengthy
application procedures. The findings of this chapter also suggest that
relationship banks have a special role to play as a stable source of SME
finance. This highlights a potential downside of any short-term focus by banks
(and their shareholders) on reducing the numbers of loan officers and other
frontline staff who work directly with borrowers. Lastly, effective and
efficient SME lending can also be stimulated by the establishment of
well-functioning credit registries and decisive action to deal with NPLs, which
are continuing to weigh on the balance sheets of many banks.




TRENDS AND
VALUE CREATION
IN PRIVATE EQUITY

The private equity sector has grown steadily across the transition region over
the last two decades, in terms of both the volume of assets that it manages and
the impact that it has on local economies. However, private equity remains an
underutilised source of external funding for companies in the EBRD region. This
chapter considers how private equity funds could help contribute to more diverse
financial infrastructure, thereby stimulating growth and efficiency
improvements.

Prior to the crisis, the EBRD region accounted for close to one-fifth of all
private equity capital invested in emerging markets. This share has recently
dropped to less than one-tenth. Sluggish economic growth in the region has had a
negative impact on returns on private equity investment. Cross-border
deleveraging by parent banks present in the region and the resulting reduction
in the availability of credit has also affected the investment strategies of
private equity funds. The use of debt in private equity transactions – a common
method of generating financial returns in advanced economies – has always been
more limited in the transition region and has declined further since the global
financial crisis. Instead, private equity funds focus more on implementing
operational improvements in investee companies. This typically involves
identifying companies with considerable growth potential, scaling up investments
and sales, entering new markets and aligning company managers’ interests more
closely with those of shareholders.

An estimated US$ 1 trillion remains available to private equity funds for
investment in companies around the world. A more outward-oriented approach and
greater emphasis on innovation could help companies in the EBRD region attract a
larger share of those funds. Export activity increases the size of companies’
markets, which is particularly important for firms in smaller economies with
limited domestic growth potential. Meanwhile, innovative companies could attract
venture capital – an area where the region lags behind other emerging markets.




PRIVATE EQUITY AS
A SOURCE OF GROWTH

Private equity can be a useful source of external finance for companies. Perhaps
more importantly, the active involvement of private equity fund managers can
also assist investee companies to reach new customers, run operations more
efficiently and improve their management of cash and inventories. Private equity
support also tends to help companies to gain better access to credit.

The analysis in this chapter, and elsewhere in the report, shows that private
equity investment in companies in the transition region has a positive effect on
employment, capital investment and productivity. These positive effects, in
turn, translate into higher levels of revenue and profit relative to similar
companies that do not receive such investment. Furthermore, the results suggest
that capital spending following private equity investment supports job creation.
In contrast, capital expenditure and job creation tend not to coincide in
advanced economies, where private equity funds typically target mature firms and
focus on cutting costs and restructuring the labour force.

The number of companies in the region that have strong growth prospects and
could potentially attract private equity investment is more than 10 times the
number of companies that have actually received investment in recent years.
Enabling more companies to attract financing from private equity funds could
potentially generate additional employment and investment in the region.

Levels of private equity financing are sensitive to the region’s growth
prospects. Thus, a return to growth is likely to result in an uptick in private
equity flows. However, policy-makers can also support such flows by
strengthening the protection of minority shareholders, improving corporate
governance and fostering the development of public equity markets. In addition,
improving the enforcement of information disclosure rules can help shareholders
to have a greater say in the management of companies. Meanwhile, the
establishment of specialist stock exchanges for SMEs that reduce listing costs
and the regulatory burden can improve access to equity financing. The latter can
also make SMEs more attractive as investment targets for private equity funds,
as they increase the likelihood of those funds exiting their investments with
higher valuations.




MACROECONOMIC
OVERVIEW

Over the last year, the economic outlook for the transition region has been
reshaped by a significant decline in oil prices, increased geopolitical
uncertainty and the launch of a quantitative easing programme in the eurozone.
Although economic growth has picked up in many commodity-importing countries and
is expected to strengthen further, average growth in the region has been weighed
down by the negative shocks faced by Russia and other commodity exporters, and
consequently, countries with strong economic ties to Russia.

As a result, the annual growth rate of the transition region as a whole is
projected to decline for the fourth consecutive year in 2015, falling close to
zero, before picking up moderately in 2016.




STRUCTURAL
REFORM

While the political and economic environment remains challenging, the outlook
for market reforms appears to have improved. There are opportunities for reform
in many sectors and countries that would help to bring economic structures and
institutions more into line with those of advanced market economies. Significant
progress has been made with the enhancement of infrastructure in the last year,
with cash-strapped governments increasingly realising the value of fostering
private-sector involvement in the building and maintenance of transport links
and municipal services. However, many transition countries still lag behind best
practices when it comes to promoting the sustainable use of natural resources
and economically inclusive growth.




REBALANCING FINANCE
AND BOOSTING INVESTMENT

Prior to the financial crisis, a credit boom in the region boosted levels of
investment and growth, but resulted in large and ever-increasing external
imbalances financed by cross-border capital flows. With the crisis came a swift
external adjustment, as cross-border capital flows declined dramatically and
multinational banks withdrew funds from the region. That external adjustment has
largely been successful, bringing domestic investment into line with the –
predominantly low – levels of domestic savings. However, after years of sparse
investment (compared with the levels observed in other emerging markets with
similar characteristics) the region now has substantial investment financing
needs, requiring an extra US$ 75 billion per year.

Despite investment levels declining and firms in many countries facing a credit
crunch, the region’s overall indebtedness (measured as the sum of public and
private debt, both domestic and external) has continued growing at approximately
the same rate as before the crisis. In fact, indebtedness has increased by 25
percentage points of GDP since 2007, reaching 123 per cent of GDP in 2014. This
reflects the substantial weakening of growth in nominal GDP, the revaluation of
a large percentage of debt denominated in foreign currency, significant
increases in public debt following efforts to stimulate the economy after the
crisis and the fact that NPLs are weighing heavily on banks’ balance sheets.

Notwithstanding those increases in the total level of debt, in some economies –
particularly in central Europe, the Baltic states and south-eastern Europe – the
ratio of domestic corporate debt to GDP remains below the levels that would be
expected on the basis of those countries’ per capita income, the strength of
their economic institutions and other relevant characteristics. In other
countries, however, scope for raising debt levels appears to be more limited.

In order to meet the region’s vast investment needs, local financial systems
will need to be rebalanced further. In countries where NPL levels are high,
dealing with that overhang is a priority. In addition, a further shift towards
local currency-denominated funding has the potential to reduce credit risk and
improve the sustainability of debt. Looking beyond debt, increased use of equity
instruments, measures to boost savings and the diversification of cross-border
funding could all strengthen financial resilience, underpin investment and help
to revive income convergence.


Close


BANKING ENVIRONMENT AND PERFORMANCE SURVEY (BEPS) II

The second round of the EBRD Banking Environment and Performance Survey (BEPS)
was conducted in 32 countries among a total of 611 banks.

The BEPS II Survey was jointly undertaken by the EBRD and the European Banking
Center (EBC) at Tilburg University. As with BEPS I, a common questionnaire was
administered to the bank’s CEO in a face-to-face interview.

The purpose of BEPS II was to build on BEPS I and obtain data on the activities,
funding and risk management of banks, their lending technologies, their
competitive environment, the influence of foreign parent banks and senior
management’s perceptions of legal and regulatory systems. Information was
obtained for two points in time: 2007 and 2010. BEPS II also contains a more
detailed follow-up survey which banks completed independently. This follow-up
was completed by 337 banks.

In addition, as part of BEPS II a specialised team of consultants collected
geographical coordinates of over 137,000 bank branches across the EBRD’s
countries of operations.

Read more about BEPS II.



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