TURBULENCES ON THE AMERICAN CREDIT MARKET AND ITS INFLUENCE ON ECONOMIES ACROSS EUROPE

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TURBULENCES ON THE AMERICAN CREDIT MARKET AND ITS
INFLUENCE ON ECONOMIES ACROSS EUROPE

• IVAN ISKROV
• GOVERNOR OF THE
• BULGARIAN NATIONAL BANK
• 16 May 2008

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CHARACHTERISTICS OF THE TURBULANCES ON THE GLOBAL
MARKETS (1)

• The tension on the international financial
  markets, unlike the turbulences and the crises in
  1990s (Mexico 1994-95 Asia 1997-98, Russia 1998,
  Brazil 1999), started namely in a developed
  economy (USA) and not in a developing one.
• The problems in the USA are a result from low
  credit standards, distorted incentives for banks
  and borrowers due to the massive credit
  securitization, historically low interest rates
  in the USA, due to the Central banks policy and
  the high level of savings in Asia economies, and
  the rich-in-resources countries, which created
  a strong demand for such instruments. Last but
  not least important weaknesses of the
  supervisory policy in the USA (above all
  weaknesses in the supervision of the so-called
  originators )
• The disturbances in the USA were partially
  carried over to Europe and the rest of the world
  via the exposures of some banks (mainly
  investment banks) to American securities backed
  by sub-prime mortgages and revaluation of risk
  premiums for all countries and instruments.
• Due to the lack of information about commercial
  banks exposures there is a growing tendency in
  retaining liquidity and increasing the
  three-months interest rates. This lead to
  widening of the spread between the overnight and
  the three-months interest rates as well as an
  intensive short term liquidity lending by the
  main central banks (FED, ECB, Bank of England,
  Bank of Canada), including the introduction of
  new instruments for liquidity lending.

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INTEREST RATES IN THE EURO AREA
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SHORT TERM INTERESTS IN GREAT BRITAIN
5
SHORT TERM INTERESTS IN THE USA
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SOVEREIGN RISK PRIMIUMSJ.P.Morgan Emerging
Market Bond Index
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CHARACHTERISTICS OF THE TURBULANCES ON THE GLOBAL
MARKETS(2)

• The initial expectations and speculations were,
  that turbulences in the USA will affect very
  quickly the developing markets, especially those
  with relatively high deficits on the Balance of
  Payments current account. This view was based on
  the general assumption that these economies need
  a strong inflow of capital, in order to cover the
  deficit on the current account, and in times of
  crisis the access to capital would be difficult.
  The above does not take into account the fact
  that these economies (Bulgaria included) have
  marked a strong inflow of direct investment,
  which created the deficit on the current account
  themselves, i.e. the relation is contrary to the
  general view.
• In addition, as by rule, these economies had a
  stable fiscal position, low public debt,
  favourable tax and business environment, growing
  productivity and relatively inexpensive labour.
  In effect the crisis did not stop the capital
  inflow to the fast-developing economies.

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CHARACHTERISTICS OF THE TURBULANCES ON THE GLOBAL
MARKETS (3)

• The developing economies with stable
  macroeconomic policy continued to have access to
  global financial markets, as the crisis influence
  manifested itself mainly by increasing the risk
  premiums and the price of financing based on the
  market assumption that the risk for those
  economies have grown.
• The risk premia for the new EU member states,
  measured by the spreads of their global bonds
  (JPMorgan Emerging Market Bond Index), have
  increased, again under the influence of the
  deeply rooted assumption, that countries with
  high deficit on the current account are a bigger
  risk, irrespective of the fact that their public
  debt is smaller, i.e. the risk of default is less
  probable for those economies. This is an
  irregularity caused by the automatic application
  of standard models by the participants on the
  market, without taking into consideration the
  driving factors of large deficits on the Balance
  of payments of those economies.
• Similar volatility showed the credit default
  swaps, driven by similar factors and line of
  though and analysis. The premiums on them grew
  quicker, but those instruments are less liquid
  and very often the data include only quotations,
  and not the actual transactions.

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GLOBAL GROWTH(IMF forecast for 2008 and 2009 )
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CHARACHTERISTICS OF THE TURBULANCES ON THE GLOBAL
MARKETS (4)

• The second channel which could be considered a
  possible conduit for the USA pressure influence
  onto the developing economies, including the New
  Member States, is the international trade
  influence. The assumption, that the slowdown of
  the economic growth in the USA (or the recession)
  due to the very tightened access to credit, could
  lead to a slowdown in economic growth in the euro
  area and in Asia (mainly China). Historical data
  show strong dependence between the growth rates
  in the USA and in Europe. These correlations are
  also factual grounds of the IMF forecasts for a
  slowdown in the euro area growth rates.
• It is believed that, since the new EU member
  states, Bulgaria included, trade mainly within
  the euro area, then a potential slowdown in the
  growth could reduce the demand for goods from
  these countries and to influence negatively their
  export.
• In addition, there exist as well the assumption,
  that a great part of the foreign investment
  (including the direct and portfolio investments)
  in the countries are coming from the euro area
  economies, therefore the deterioration of access
  to credit in the euro area countries will
  probably influence the capital inflows in the new
  member states.

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ECONOMIC GROWTH OF BULGARIA
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FISCAL POSITION OF BULGARIA
13
INFLATION RATE IN BULGARIA
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BULGARIAN BALANCE OF PAYMENTS
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IS BULGARIAN ECONOMY INFLUENCED BY TURBULENCES?
(1)

• 2007 was the first year of Bulgarias membership
  in the EU. Citizens, companies and international
  investors were very optimistic about the
  development of the economy.
• By mid-2007 the external environment was quite
  favourable, and this together with the optimism
  of households and companies speeded up investing,
  employment, wages and the economic growth, as
  well as the falling rates of inflation due to the
  subsiding effect of the increased indirect taxes
  in early 2006.
• This beneficial environment considerably
  accelerated the private sector lending and the
  continuing increase in the current account
  deficit as a result of the massive inflows of
  capital.
• From July 2007 the inflation trend changed
  because of the higher prices of foodstuffs
  (determined by global and local factors), energy
  resources and the fast rise in wages which kept
  consumers demand at high levels despite the
  increased consumer prices.
• At the end of July 2007 the BNB Governing Council
  decided to raise, from the beginning of
  September, the minimum required reserves which
  commercial banks hold with the BNB from 8 to 12
  percent. As a result, commercial banks reserves
  with the BNB went up by BGN 1.8 billion. The
  purpose of this measure was to withdraw liquidity
  from the banking system and thus influence the
  cost of credit and the growth rate of credit, as
  well as store liquidity at the BNB.

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SOVEREIGN RISK PREMIUMSJPMorgan Emerging Market
Bond Index
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PREMIUMS ON CREDIT DEFAULT SWAPS
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SHORT-TERM INTEREST RATES IN BULGARIA AND THE
EURO AREA
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QUARTERLY INTEREST RATES IN BULGARIA AND THE EURO
AREA
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SHORT-TERM INTEREST RATES IN BULGARIA
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IS BULGARIAN ECONOMY INFLUENCED BY TURBULENCES?
(2)

• Bulgarias fiscal position was stable, and the
  wage growth rate in the private sector was
  outpacing that in the public sector.
• In these conditions, at the beginning of August
  2007 we saw the first disruptions in
  international financial markets.
• The spread on the Bulgarian global bonds, as a
  measure of the country risk market assessment,
  rose from 18 b.p. in mid-2007 to 150 b.p. at the
  beginning of 2008, and fell under 90 b.p. in the
  last few weeks (by the JPMorgan Emerging market
  Bond Index). The premiums on Bulgarias credit
  default swap also rose from about 20 b.p. in
  mid-2007 to nearly 150 b.p. at the end of the
  year. This trend carried on into the first three
  months of 2008 as the CDS premium for Bulgaria
  reached 200 b.p., and thereafter it fell to 140
  b.p. in early May 2008.
• The turbulences in international markets directly
  affected short-term interest rates in the
  country. The average spread between the overnight
  rate in Bulgaria and that in the euro area from
  January to August 2007 was 1 b.p. (5 b.p. only
  for August). From September to December 2007 the
  spread increased to 48 b.p., and from early 2008
  until now to 84 b.p.
• This spread increase was determined by several
  factors

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IS BULGARIAN ECONOMY INFLUENCED BY TURBULENCES?
(3)

• To a small extent (up to about 20 b.p.) as a
  result of the increased minimum reserve
  requirements, although the MRR in Bulgaria were
  higher than those in the euro area even before
  September 2007, but there was no premium in the
  Bulgarian short-term interest rates.
• Risk premiums increased because of the
  international financial turbulences and the
  greater uncertainty and speculations about its
  possible effect on the developing economies.
• Some commercial banks refrained from opening long
  positions in BGN and covered their purchases in
  Euro for BGN with spot repurchases. This
  groundless fear caused, as we already saw, by the
  speculative statements about the vulnerability of
  the countries having high current account
  deficits, led to a decrease in the BGN supply
  and an increase in the BGN interest rates.
• The ECB was massively providing liquidity and
  this brought the European market interest rates
  down even below the reference rate which
  contributed to widening the spread with the BGN
  interest rates.

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INTERBANK MARKET VOLUMES
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NET CURRENCY PURCHASES BY THE BNB
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IS BULGARIAN ECONOMY INFLUENCED BY TURBULENCES?(4)

• On the whole, Bulgarian banks kept their trust of
  each other and the volumes in the interbank
  market even rose in early 2008, after a slight
  decline in the last quarter of 2007 due to some
  uncertainties as well as excess liquidity at the
  end of 2007 caused by end year government
  spending.
• The BNB is still buying the reserve currency (the
  euro) from commercial banks, and in 2007 these
  purchases reached a record level of Euro 2.5
  billion (8.6 of GDP). This trend continued in
  the first four months of the year 2008.
• The banks operating in the country still have
  access to international financial markets. From
  August 2007 to March 2008 they increased their
  loans from abroad by Euro 2.2 billion. The
  expectations were that the new financing would be
  at a much higher cost. The data on the foreign
  loans (including the subordinated term debt)
  registered by commercial banks at the BNB do not
  show a large increase in the cost of funding from
  international markets. The data is very volatile
  but what we see as a trend is a very small rise
  in the cost of external financing.

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ACCES OF COMMERCIAL BANKS TO INTERNATIONAL MARKETS
27
PRICE OF FOREIGN FINANCING OF THE BANKING
SYSTEM(Based on data of the Balance of payments)
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IS BULGARIAN ECONOMY INFLUENCED BY TURBULENCES?
(5)

• The increased uncertainty concerning the access
  to and the price of foreign financing, forced
  banks to enter into more severe competition
  regarding the local deposits, which have been
  growing in a steady rate.
• This lead to an increase in the price of local
  deposits (denominated both in BGN and in EUR) to
  a degree much higher that the price increase of
  foreign markets financing.
• The higher price of the commercial banks resource
  naturally reflected in the price of household and
  business loans this trend is very explicit in
  the area of euro-denominated consumer loans and
  in the lev-denominated mortgage loans.

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HOUSEHOLD DEPOSIT INTEREST RATES
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IS BULGARIAN ECONOMY INFLUENCED BY TURBULENCES?(6)

• The higher price of loans, combined with the
  relatively high level of loan to GDP reached so
  far, creates conditions for the slow down of
  private sector credit growth rate. This
  development, was recommended by the BNB, and
  results both from the developments in the
  international financial markets and the BNB
  policy decision to increase the level of minimum
  required reserves. There was a slight slow down
  in the credit growth rate in the beginning of
  2008 (the growth of household loans is also
  influenced to a small degree by portfolio sale,
  but adjusted for this effect there is a tendency
  of growth rate to slow down), and by the end of
  the year it is expected to be around 40.
• The growth of loan interest rates does not lead
  to deteriorating of the quality of loan
  portfolios. The wage increase has a steady growth
  rate (around 17.6 in 2007). The profit in the
  corporate sector allows a higher interest expense
  to be made.

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ANNUAL PERCENTAGE OF EXPENSES ON THE NEWLY
GRANTED HOUSEHOLD LOANS
32
CREDIT GROWTH RATE
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STATUS OF THE BANKING SYSTEM(1)

• Despite the tension on the international markets,
  the favourable internal economic environment
  provided a good basis for the growth of the
  banking sector and preserving of its stability.
• As a consequence of the euro area interest rates
  increase and the reassessment of the risk
  premium over the second half of the year, as well
  as of the increase of minimum required reserves
  from the beginning of September the price of the
  commercial banks resource has gone up slightly
  (from the average of 2.6 in 2006 to 2.9 in
  2007, and 3.4 in the first quarter of 2008).
• The banking system profit continue growing as a
  result of the increased volume of loans, the
  growth of yield on the rest of interest bearing
  assets, and to a very small extent due to the
  slight increase of loan interest rates.
• In 2007 the return on assets (ROA) grew to 2.37
  (2.15 in 2006), and the return on equity (ROE)
  remained at a level close to the one it had over
  the past year 23.9 in 2007,( 23.7 in 2006).
• The quality of portfolios remain unchanged, and
  the percentage of the standard loans even grew
  from 93.9 at the end of 2006 to 95.4 as at
  2007.

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STATUS OF THE BANKING SYSTEM(2)

• 6. The fast loan portfolio growth over the year
  was compensated partially by the increase of bank
  capital, which lead to maintaining a good capital
  adequacy of the system - 13.9 as at 2007, from
  14.5 at the end of 2006.
• 7. These trends continued into the first quarter
  of 2008.
• 8. The Bulgarian banking system is dominated by
  European banks, which had no direct exposures and
  suffered no losses from the turmoil in the USA
  mortgage market. Therefore they continued
  providing liquidity to their Bulgarian
  subsidiaries and branches. Bulgarian banks have
  no direct exposures of securities backed by
  sub-prime mortgage loans. Furthermore, the
  lending practices in the country are
  substantially different than the ones common for
  the USA over the past few years, and which are in
  the heart of current American problems.
  Bulgarian banks follow the classical model of
  banking, maintaining high credit standards,
  irrespective of the strong competition. Banks
  operating in Bulgaria, with domestic and foreign
  shareholders, are healthy, and have an adequate
  level of liquidity, capital adequacy and profits.
  

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STATUS OF THE BANKING SYSTEM
36
ECONOMIC GROWTH
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EXPECTATIONS ABOUT THE DEVELOPMENT OF THE
BULGARIAN ECONOMY (1)

• Current developments do not justify any
  presumptions that the instability in the global
  financial markets will have a tangible negative
  effect on the Bulgarian economy. Data for the
  first four months of 2008 show no signs of any
  negative developments in the countrys economy.
  As already mentioned, a process of risk
  reassessment is underway with a consequent upward
  trend in interest rates. This is a process of
  very gradual adaptation as part of the overall
  mechanism of operation of the currency board.
• This is the tenth month from the start of the
  turbulences in the international markets. This
  has been a sufficiently long period during which
  the Bulgarian economy demonstrated it was built
  on sound fundaments and there should be no doubts
  as to the adequacy of the countrys macroeconomic
  framework and policy.
• Naturally, there will always be institutions
  voicing negative or more conservative forecasts
  the IMF among them. We believe some of these
  projections are unjustifiably pessimistic a
  view already expressed by Mr. Bernanke and Mr.
  Trichet.

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EXPECTATIONS ABOUT THE DEVELOPMENT OF THE
BULGARIAN ECONOMY (2)

• The BNB has positive expectations for the
  economic developments in the current and the next
  year. We can already see some developments that
  confirm our view
• The countrys fiscal position is stable and the
  tax revenues in the first quarter of the year are
  steady, as evidence that economic activity keeps
  growing at sustainable rates.
• Data to March show indications of stabilization
  and slight improvement of the BoP current
  account. The countrys exports have been growing
  at high rates, with decelerating growth rates of
  imports. Capital inflows, including FDIs remain
  strong.
• Inflation rate monthly data already show signs of
  abating inflationary impulses, which allows us to
  expect that inflation will decline to the range
  of six seven percent by the year end.

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CONCLUSIONS (1)

• We evidence the first signs of remission of the
  financial market turmoil in the US, but it is
  still early to make any definitive conclusions.
• The Bulgarian economy demonstrated its resilience
  to the externalities of financial market
  developments and the commodity and food market
  dynamics. The macroeconomic framework based on
  the fixed exchange rate of the lev to the euro
  within the currency board arrangement, prudent
  fiscal policy and the structural reforms proved
  its sustainability and ability to ensure
  macroeconomic stability and growth.
• The currency board and the fixed exchange rate of
  the lev to the euro at the existing parity (BGN
  1.95583 to EUR 1) will underlie the
  macroeconomic policy to be pursued by the time
  Bulgaria joins the euro area.

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CONCLUSIONS (2)

• 4. The regular convergence reports of EC and ECB
  of May 2008 assessing the compliance with the
  convergence criteria and the consistency of
  national legal frameworks with regard to the
  monetary and economic union contain, in their
  part on Bulgaria, positive assessments of both
  our progress and of the degree of meeting
  convergence criteria. Inflation remains our
  fundamental challenge. The reports rightly
  underscore that the persistent strict fiscal
  discipline, the labour market reforms aimed at
  enhancing economic activity, the restructuring of
  the health and education systems, and the
  increased efficiency of public administration
  (including taking care salary growth not to
  outpace the rate of productivity growth) underlie
  the increase in productivity and efficiency in
  the economy and will help us meet the inflation
  criterion. In terms of convergence of the legal
  framework, although noting some specific
  imperfections, both reports stress that the
  Bulgarian legislation is compliant with the
  requirements for joining the EMU.
• 5. The banking system is in a good condition, but
  we should not feel complacent. Instead, we should
  keep up the high level of credit standards. Banks
  belonging to international groups should not try
  to balance their weaker results in other parts of
  the world by pursuing a very aggressive credit
  policy in Bulgaria and trying to slacken their
  credit standards as the price for a bigger market
  share.

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FISCAL POSITION OF BULGARIA
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INFLATION RATE IN BULGARIA
43
DIRECT FOREIGN INVESTMENTS IN BULGARIA
44
BALANCE OF PAYMENT OF BULGARIA
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• WE SHOULD STAY PRUDENT AS WE HAVE BEEN SO FAR
• THANK YOU FOR YOUR ATTENTION