Родіонова Т.А. External debt dynamics as a factor of the current account sustainability in the central and eastern european countries

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Родіонова Т.А. External debt dynamics as a factor of the current account sustainability in the central and eastern european countries
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  1 УДК 339.727.22 T. A. RODIONOVA Odessa National Mechnikov UniversityDepartment of World Economy and International Economic Relations EXTERNAL DEBT DYNAMICS AS A FACTOROF THE CURRENT ACCOUNTSUSTAINABILITY IN THE CENTRAL AND EASTERN EUROPEAN COUNTRIES  Abstract Current accounts have diverged substantially among the Central and Eastern European Countries (CEECs). This divergence has raised concerns about the sustainability of countries’ external indebtedness. In this paperthe external imbalances ofCEEeconomies are discussed. Avector autoregression (VAR) model is used to test the causal relationships between the current account and the external debt in five CEECs. Namely, using VAR framework, Granger causality testing is performed and variance decomposition is undertaken to see the relative contributionof three different sources of debt (government, banking sector or corporate sector’s debt) to the current account deficits. The results of theresearch show that high external debt accumulation may be a major cause of current accounts instability in CEECs. The recommendations todecrease dependence of the CEE economies on external financing to prevent national economies from currency, debt and financial crisesaresuggested. Key words: external imbalances, current account deficits, capital flows, external debtAfter the European Union accession, the Central and Eastern European countries (CEECs) have been runninglarge external imbalances which facilitated a more rapid convergence rate in economic development of these countriescompared with other EU members. Sizeable and persistent current account deficits, experienced by most of the CEEcountries since the beginning of the transition process, increasingly cause concerns regarding the sustainability of thecountries’ external balances. Certain factors, which contribute to the country’s saving and investment, set the new EUmembers apart from other emerging market economies: transition from socialism required higher investment owing toan overhauling of theexisting capital stock and institutional reforms associated with the EU membership.By EU accession CEE countries fully liberalized their capital accounts during the transition period. Robusteconomic growth was accompanied by substantial capital inflows and large current account deficits in some countries.This is a standard case in economic theory explaining countries with insufficient domestic savings employing importedcapital to increase investments and finance economic growth. With a lack of absorptive capacity of the CEE financialsystems to properly channel the inflowing capital, an ensuing over-investment, and consumption boom gave rise tocurrent account deficits. Persistently high level of capital inflows needed to finance these deficits in the CEE countriescaused a substantial increase in the level of external liabilities, particularly external debt. In the 90’s large currentaccount imbalances and a high level of external debt in emerging markets triggered financial crises: balance of  payments or debt crises.External imbalances in the CEE countries and the question whether recent current account deficits as well aslevel of external debt are sustainable are becoming a key policy issue for these countries. Current account deficits must be carefully monitored, since they might be especially dangerous for the countries which do not posses substantialreserve assets and whose currencies are not actively used in international settlements. Such countries include emergingmarket economies, the CEECs being among them (except for the Slovak Republic and Estonia who joined theeurozone). In case of instability ofthenationalfinancialsystemsorinternationalcapitalmarketsturbulence,the presenceofthecurrentaccountdeficit leads to a rapid depreciation of the national currency (Hungary and Ukraine in2008, Belarus –2011), devaluation of the national assets, sharp increase of the debt-servicing burden (public and private) and, consequently, to rising costs of production, losing national competitiveness and falling living standards.This is exactly why the problem of the current account sustainability is important.Prior to EU membership large capital inflows financing current accounts were inevitable in the transition period when capital markets became open, exchange rate flexibility was limited and interest rates were higher comparedto the EU levels. The consumer price inflation in all CEE significantly decreased during the transition period. Interestrates declined but real interest rates increased to relatively high levels during the process of disinflation. Given the  2 sufficient interest rate differentials, compensating investors for exchange rate risk, huge amount of foreign capital wasattracted to CEE countries. Liberalization associated with the transitional process implied a higher level of inflation for the domestic country compared to its trading partners, leading to the appreciation of the real exchange rate under the policy of fixed nominal exchange rate. This created a macroeconomic pressure on the banking system: real appreciationmeans that the depreciation of the local currency is smaller than the inflation differential, which gave a strong incentive both for companies and for banks to refinance themselves in foreign currency, as Schröder (2001) points out. Capitalinflows led to growth of foreign exchange denominated lending. This in turn led to the external debt accumulation.Such lending might be interrupted by real depreciation as a consequence of correcting accumulated imbalances whicharose as a result of previous real appreciation.Analysis of the sources, magnitude and composition of capital flows is extremely important for determining if the balance of payments is sustainable. Clearly, when countries simultaneously offer high real interest rates and the prospect of steady real appreciation, they are likely to attract substantial portfolio and shorter-term capital inflows. Thenon-FDI inflows -portfolio and other investments -usually pose more difficulties to monetary authorities in terms of economic policy, external vulnerability, and financial stability than direct investment flows. It is generally recognizedthat FDI are much more stable compared to portfolio and other investments: FDI flows have provided transitioneconomies with more opportunities to share risk with and obtain technology from their trading partners than have non-FDI flows. The profitability of the FDI is likely to be linked to the performance of the domestic economy: higher returnon FDI is likely to be associated with a higher rate of domestic output growth, making repayments more affordable as pointed out by Lane and Milesi-Ferretti (2007). Moreover, inflow of the FDI is much less dangerous for the balance of  payments sustainability, as these investments can’t be withdrawn rapidly, as opposed to portfolio and other investments.Given the substantial interest rate differentials in CEE countries large interest-rate-sensitive financial inflows(portfolio and financial credit flows), which can be highly volatile, contributed to credit booms, complicating monetaryand exchange rate policies. As the burden of interest on debt and principal repayments increases over time, borrowingcountries need to ensure that trade surpluses allow the external position to stabilize or decline, relative to the size of economy. The size of the needed trade surpluses depends on the outstanding stock of accumulated liabilities andeconomic growth. However, as will be shown in the following analysis, the external borrowing mainly in the form of financial credits of the banking sector boosted consumption in CEE, the major pat of which was spent on importedgoods, and did not produce sources to finance external liabilities.The notion of current account sustainability has come to be of considerable interest in the context of recentepisodes of macroeconomic turbulence in many emerging markets. Consequently, studying the behaviour of the currentaccounts in the CEECs and assessing their sustainability is of high importance due to its implications for the economicgrowth and overall external sustainability of an economy. The purpose of this paperis to analyze factors contributing tothe current account deficits, find the relationship between current account deficit and foreign debt accumulation, whichcould have important policy implications for the CEECs that in the conditions of international debt crises need todecrease their dependence on external financing to enhance the resilience of the national economies to external shocks.The methodological approach is different from the existing empirical literature in that this study focuses on the particular determinant of the current account balances –external debt, and how the different components of the debt(government, banking sector or corporate sector’s debt) influence the current account dynamics in the CEECs. Theresults of the research show that high external debt accumulation could be a major cause of current accounts instabilityin CEECs.The organization of this paper is as follows. First,ananalysis of the external imbalances in CEECs is performed. The analysis highlights the most salient features of the capital flows structure in terms of relative importanceof FDI, portfolio and debt categories in the overall level of externalliabilities of the CEECs. Analysis of the sources of the current account deficits, as well as sectoral breakdown of the external indebtedness of the CEECs is performed. Inwhat followsthe empirical methodology is discussed, methods used in this study are justified, data and its sources aredescribed and findings of the econometric analysis are presented. The paperconcludes with a summary of main resultsand economic policy recommendations.  3 1. Evolution of the external imbalances of the CEECs The problem of external imbalances is one of the central points when assessing the economic developmentof the Central and Eastern European countries that joined the European Union and committed to join Europeanmonetary union. The main aim of this section is to view the external position of the CEE countries since their EUaccession and during and after the Global financial crisis. The section highlights the most salient features of the capitalflows structure in terms of relative importance of FDI, portfolio and debt categories in the overall level of externalliabilities of the CEECs. Analysis of the sources of the current account deficits, as well as sectoral breakdown of theexternal indebtedness of the CEECs is performed. The CEE countries included throughout this study are the CzechRepublic, Hungary, Poland, Slovak Republic, Bulgaria and Romania.The international capital flows contribute significantly CEE countries and help to finance their current accountdeficits. Due to the general lack of domestic savings in these countries, capital inflows are necessary to financedomestic investments and thus economic growth. The financial account of the balance of payments (Figure 1.1)measures the net effects of financial investment flows: Figure 1.1 shows that all countries experienced net capitalinflows and therefore a surplus of the financial account balance, which had an increasing pattern after the EU accession,and rather unsustainable surge in net inflows just before the global financial crisis. The cumulativefinancial account balance in the years from 2004 until 2009 shows remarkably high values for Bulgaria, Romania and Hungary (see Table1.1), compared with Poland, Slovak Republic and Czech Republic, ranging from 18% to 120% of GDP. 05000100001500020000250003000035000400002000 2001 2002 2003 2004 2005 2006 2007 2008 2009Bulgaria Czech Republic Hungary Poland Romania Slovak Republic Figure 1.1: Financial Account (In millions of U.S. dollars) Source IMF  International Financial Statistics Looking at Figure 1.1 it can be seen that the highest surge of net inflows was experienced by Poland, where in2007 it amounted to US$38.8 billion, which is a 197% increase compared to previous year’s net inflows. Other countries, except for the Czech and Slovak Republics, experienced similar problems: in 2007 there was a huge netcapital inflow to Romania, Bulgaria, and in 2008 to Hungary. Then, for these countries net capital inflows likewise plummeted in the aftermath of the global recession. It should be also noted that in Poland there was no capital flightcompared to other CEECs. It will be discussed later what stands behind this observation. All in all, such a hugevolatility of capital inflows can not be sustainable for an economy and requires identification of the sources leading tosuch high fluctuations.Looking at the structure of the financial account provides further insights in the composition of foreign capitalflows. Table 1.1 shows that all the countries experienced net capital inflows of FDI, portfolio and other investments(exception is Bulgaria, where there was a net outflow of portfolio investments, though not substantial). Ifin the period before EU accession FDI significantly dominated other and portfolio investments which was indicated in the research of Arvai (2005), in the period from 2004 until 2009 structural shift took place in the financial accounts towards other   4 investments, which are now prevailing over FDI in some countries: in Hungary other investments amount to 72% of total inflows, in Romania –51%, Slovak Republic –47%. On the other hand, in Czech Republic major capital inflowsare in the form of FDI –90%, Bulgaria –73% of the capital inflows are from FDI, Poland –43%. Table 1.1 Breakdown of Cumulative Net Capital Inflows 2004-2009 Source: IMF,  International Financial Statistics , UNCTAD, own calculations.  Note : Financial derivatives are not reported as their weight is negligibleThe external debt of CEE countries reached levels that give rise to serious concerns about the risks for their financial stability. The external debt ratio (relative to GDP) can be used as a measure of the vulnerability of theeconomies to changes of the external value of their currencies. As a result of capital inflows, a large stock of foreigndebt was accumulated: as it can be seen from Figure 1.2, Bulgariaand Hungary have external debt levels higher than100% of GDP. For Bulgaria up to 97 percent of debt was denominated in foreign currency in 2010 Q3 according to theWorld Bank quarterly external debt statistics.For Hungary foreign currency debt amountsto 82% of the total external debt, Romania –89%.In suchsituation a depreciation of the national currency can have a dramatic impact on the debt service these countries have to bear, what in particular happened in Hungary, where as a consequence of the Forint huge depreciation in 2008, theexternal debt level surged to over 150% of GDP in year 2009. 74.87106.72142.83151020406080100120140160    2   0   0  6  Q  1   2   0   0  6  Q   2   2   0   0  6  Q  3   2   0   0  6  Q  4   2   0   0   7  Q  1   2   0   0   7  Q   2   2   0   0   7  Q  3   2   0   0   7  Q  4   2   0   0   8  Q  1   2   0   0   8  Q   2   2   0   0   8  Q  3   2   0   0   8  Q  4   2   0   0   9  Q  1   2   0   0   9  Q   2   2   0   0   9  Q  3   2   0   0   9  Q  4   2   0  1   0  Q  1   2   0  1   0  Q   2   2   0  1   0  Q  3 % Romania Bulgaria Hungary Poland Czech Republic   Figure 1.2: Gross External Debt as a percentage of GDP Source: ECB Statistical Data Warehouse The depreciation of thenational currencies laid a heavy burden on domestic borrowers, who took the loans inforeign currencies. While in Poland, Slovak Republic and Czech Republic the share of mortgages taken in foreigncurrencies was not significantly large –26, 20 and10% respectively, in Hungary and Romania 59% of mortgages wereCountryFDIPortfolioinvestmentOther InvestmentTotal amount(in millions of U.S. dollars)Sumin % of GDPBulgariaCzech RepublicHungaryPolandRomaniaSlovak Republic73%90%19%43%48%47%-7%2%10%17%1%6%34%8%72%40%51%47%56406.035833.078781.8156039.6109960.231089.9120%18%61%36%69%35%
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