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Central & eastern EuropeSeptember 1 2015

What now for development banks in central and eastern Europe?

International financial institutions remain crucial in central and eastern Europe as the fallout from the financial crisis continues to make its presence felt. But just how far should these development banks go in helping to resolve the various crises that have hit the countries of this region in recent years?
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Central and eastern Europe (CEE) is a region of great diversity. From ‘old’ EU member states such as Poland to ‘new’ ones such as Bulgaria, to EU candidate states such as Serbia, Ukraine and Turkey – some 21 countries* with a cumulative gross domestic product (GDP) of $2577bn as of 2014, according to data from the International Monetary Fund (IMF).

With the fall of the Soviet Union and efforts to transform the eastern European countries into market economies, a large range of international financial institutions (IFIs) emerged in the region ready to offer their support. Some 25 years later, however, there still is a ‘market’ for IFI capital.

From the European Investment Bank (EIB), the largest lender with about €10bn of CEE assistance every year – although mainly going to EU member states – to the European Bank for Reconstruction and Development (EBRD) and International Finance Corporation (IFC) as well as the International Investment Bank (IIB) to national development banks such as Germany’s KfW, the Netherlands Development Finance Company and funds such as the European Fund for Southeast Europe (EFSE), there is an abundance of funds available – and that is without even mentioning EU structural and cohesion funds, which give the European Commission scope to invest hundreds of billions of euros in EU member states between 2014 and 2020.

A question of need

Yet, receiving finance is not just a question of need. “If you have a well-prepared investment project, you will always get it funded somehow,” says Tilman Seibert, deputy director-general at the EIB. “As a rule, there are fewer well-prepared projects around than financial resources available – the funding of projects is [not a] worry.”

The environment is competitive but not comparable with the pre-financial crisis years, according to Piroska Mohacsi Nagy, former economist at the IMF and the EBRD. “When the global crisis hit emerging Europe, we had to deal with this global event and show further co-operation,” she says. “It was really something quite unique.”

IFIs had to put their rivalries to one side and start collaborating through the so-called Vienna Initiative in 2009, seeking to keep the banking sector stable through a public-private coordination framework.

With the subsequent Vienna Initiative 2.0 in 2012, some legacy issues, including banks’ non-performing loans, still required some level of dialogue. “IFIs have raised their game during the [financial] crisis response tremendously,” says Ms Nagy. “The quantity, and especially the quality of work, have both changed for the better.”

Chasing SMEs

While collaboration between the different institutions has become more standard, small and medium-sized enterprises (SMEs) remain the most contested area of financing across the board.

Today, apart from the three largest institutions (the EIB, the EBRD and the IFC), the EIB’s European Investment Fund (EIF), the IIB and the EFSE are all also providing support for SMEs through intermediary finance.

The EFSE has disbursed more than 630,000 sub-loans worth more than €4.4bn to SMEs and to its second target group, private households for housing modernisation, through intermediary banks in the past 10 years, according to Monika Beck, chairperson of the board of EFSE. “The EFSE was set up out of four funds investing in SMEs and private households in Kosovo, Montenegro, Serbia and Bosnia-Herzegovina managed by KfW,” she says. “Today we invest in 16 countries.”

The EFSE is a public-private partnership (PPP) fund, which works through a waterfall structure: the seed-funding through Germany’s Federal Ministry for Economic Co-operation and Development, the EU and others is in the first loss tranche; additional funds through KfW, the EBRD and the EIB, among others, are in a second, mezzanine tranche; while private investors hold the third, senior tranche.

IIB funds SMEs in its member states such as Romania, while at the EBRD one-fifth of its annual investments support SME finance. Alongside SME finance, IFIs are providing technical assistance to intermediary banks to improve credit decisions for those interested. 

Too many cooks?

Other widely provided services by IFIs are climate-related investments, such as investments in renewables, energy efficiency and cleaner production technologies – the IFC committed more than $500m to this area in 2014 – and funds for inclusion of women in business – an initiative both the EBRD and the IFC are implementing across Turkey.

There is a clear gap in infrastructure finance, however, according to Tomasz Telma, director for eastern Europe and central Asia at the IFC. “In times when growth levels are slow, the fiscal space of governments is limited and the private sector is more cautious, the opportunities and the need for combined private-public structures is much greater,” he says. “We are advising more and more governments on how to structure these PPPs.”

For the EBRD and the IFC, the level of involvement in different countries can differ regionally or even on a country-by-country basis. Countries such as Romania, Bulgaria and Croatia offer opportunities for advanced products as demonstrated by the development of capital market instruments in Romania, but at the same time remain in need of further improvements to public infrastructure – transport and energy – and municipal services, according to Jean-Marc Peterschmitt, managing director, countries of operations, at the EBRD. This allows the EBRD to intervene on a wide spectrum of activities.

In the western Balkans, the agenda is focused on supporting critical infrastructure, to get the region better integrated within itself, including better transport networks and electricity interconnections, as well as ways to better channel funding for the development of SMEs, the other main priority in the region.

“Our mission is to focus where we are critically needed to provide a service that is otherwise not available,” says Mr Peterschmitt. “Evidently, while some clear needs still exist, the scope of our engagement in the EU countries of central Europe is narrowing over time and we are trying to shift more of our attention and resources to where we are needed the most. Over time, the centre of gravity of our activities has shifted further east and south.”

Apart from financing, the EBRD is also keen to involve interested parties in value-added initiatives, such as the legal transition programme, which aims to help countries achieve a more sound and better-functioning legal system, or anti-corruption initiatives, which should contribute to a better investment climate. 

Local capital markets

An initiative taken very seriously by both the EBRD and the IFC is improving local capital markets. Both are forerunners in issuing local bonds in local currencies – including in Hungarian forint, the Russian rouble, the Romanian lei, the Armenian dram and the Georgian lari – in attempts to help the de-dollarisation process, particularly in Armenia and Georgia.

“The IFC can participate in the development of local capital markets as issuer of securities, but also supporting bonds of other issuers through credit enhancement schemes and other instruments,” says Mr Telma.

In addition to bond issues, the EBRD is increasingly taking stakes in local stock exchanges with the aim of deepening bond and equity markets as well as promoting local currency lending. The EBRD invested in the Bucharest Stock Exchange and undertook a pre-initial public offering investment in the Moscow Exchange. It is also supporting SEE Link, an order-routing system established by the Bulgarian, Macedonian and Zagreb stock exchanges, and has signed a term sheet for an equity investment in Borsa Istanbul. 

Even IFIs are just banks

While both the EBRD and the IFC are more private sector focused and can make direct equity investments, the EIB brings its special relationship with the EU to the table. The EIB can extend complementary funding to projects receiving grants from the EU structural and cohesion funds. Its traditional lending focus is in the area of cohesion policy – creating equal economic and social standards.

Another area of importance for the EIB and the EBRD is innovation – providing financial support to education, science and research and development. “Unfortunately, innovation is an area where CEE is lacking,” says Mr Seibert. “Innovation is a very small area, both as a share of GDP as well as in driving the economy in the region.”

Yet, despite all the support provided, the idealistic perspective of IFIs and development banks supporting the most pressing investment needs across the most vulnerable regions in CEE does not always stand up.

Out of the EIB’s more than €10bn invested in CEE in 2014, it allocated about €5.5bn to projects in Poland – which accounted for $546.6bn, or 21%, of 2014’s cumulative GDP in the region.

In 2014, the EBRD’s top-funded country was Turkey (which had a GDP of $806.1bn), after sanctions imposed by western European governments on Russia in 2013 left the development bank needing to find a jurisdiction able to substitute Russia as its top investment destination. Turkey also was number one recipient of funding in the region for the IFC, and its third largest country by investments globally.

“The Turkish banks are so much more sophisticated than banks in central Europe, but there is still a role there when you look at the amazingly successful Women in Business programme, particularly in [Asian Turkey], and energy efficiency,” says Erik Berglöf, director at the Institute of Global Affairs at the London School for Economics and a former chief economist at the EBRD.

“Even though there are different challenges in Turkey compared with a country such as Ukraine, there are specific things that IFIs can do in terms of financial sector. For the EBRD, expanding in Turkey was a must to sustain the entire business of the bank because of the loss of Russia. It was very important to expand in Turkey, so that [it could] create enough business to support the whole organisation.”

As much as IFIs would like to support the countries or projects most in need, they still have to make strategic business decisions. Projects supported have to be “economically and financially viable”, says the EIB’s Mr Seibert, “after all we are a bank and need to get our money back.”

He adds that IFIs cannot invent and promote projects themselves, even though they might feel there is a need to invest in a certain sector. “There needs to be a project to invest in,” says Mr Seibert. “If a country or investors do not have clear investment plans and priorities, we can’t just allocate money to them and say ‘do it’.” 

International financial institutions in CEE

Added value

Meanwhile, IFIs’ added value and prerequisite conditions, which underlie investment decisions, can also cause a region seemingly in ‘more’ need than others to miss out on funding. For lenders such as the EBRD to be involved with governments, they need to show an interest in promoting transparency and good corporate governance.

“It is easy to spend money and invest; it is more difficult to do it on a sound basis within the right policy framework,” says Mr Peterschmitt at the EBRD. “We work with reform-oriented governments that are supportive of a healthy, well-governed private sector-led economy.

“When that is not the case, we try to find the niche, of receptive clients and counterparts who we can work with. The more favourable the policy environment, the more investment opportunities will emerge and the more support we can offer.” 

Moldova has recently showcased an example for a difficult environment. In 1995, the EBRD took a 15.06% stake in Victoriabank, the third largest lender in the country, and after a series of non-transparent stake sales since 2005, resulting in governance issues, the EBRD in 2015 was granted approval to increase its stake in the bank to up to 100%.

In April, necessary amendments to Moldova’s financial institutions law to allow the takeover were blocked by the government, leaving the situation unresolved. The EBRD now needs to wait and see if the country’s new prime minister, Valeriu Strelet, will help support the EBRD’s aims to restore corporate governance at the lender. 

Shareholder has the last word

However, regardless of the level of investment an institution deems necessary for a certain pressing issue, it can only start pursuing this if it has a mandate from its shareholders.

Ukraine is one such case. The EBRD and the IFC have worked in the country since 1992 and 1993, respectively, but the EIB only received its mandate from the European Commission to enter the country in 2010. It has since invested €3.1bn in Ukraine and has a €3bn mandate to support the ailing economy’s lending to SMEs, the energy sector and for investments in transport between 2014 and 2016. Some €1.3bn of this had already been disbursed by mid-August.

The EBRD’s mandate for Ukraine is focused on the private sector, where it has nearly equal levels of investment in energy, financial institutions, industry and infrastructure, with a portfolio of €5.1bn of current commitments and €10.4bn of cumulative investment.

Meanwhile, the IFC is active across all sectors in Ukraine, according to Mr Telma, adding that agribusiness is standing out. The IFC has so far invested $3.2bn in Ukraine, according to its website. The IFC generally works on projects without government guarantees, and in Ukraine (in the current market conditions) bankable projects are difficult to find, according to Mr Telma. 

Equity rather than debt

The CEE region's IFIs are investing in a large field of strategic sectors and are providing advice, as well as structural and technical assistance, across many areas of expertise. But the needs do not stop there.

The region’s private sector requires more capital, rather than liquidity, through direct investments, both from the EBRD and the IFC, according to Ms Nagy. The difference in impact of a €100m debt or equity investment can be significant, but equity investments are more risky and costly, especially in the preparation phase.

“IFIs post crisis are very mindful of their AAA rating, so the pressures are on not doing too much equity funding,” she says. “But this could really help post-crisis restructurings, so the focus is going the wrong way. The system is not conducive, not rewarding enough those who put the effort into an equity investment.”

The region also lacks indigenous private equity and venture capital funds, according to Mr Berglöf. “Even a country such as Poland has basically not attracted any domestic funding for venture capital and private equity firms,” he says. “So when the appetite of foreign investors is coming down there is nothing to rely on locally to compensate for it.”

IFIs are participating in regional private equity funds such as the EIF’s Baltic Investment fund of funds, or the EBRD, which has invested in more than 150 funds since inception, over 70% of which were invested in CEE, the Caucasus region, Turkey and central Asia. Initiatives to develop regional capital markets can also support the process of regional venture capital firms. 

Mitigating the Greek impact

An area that needs immediate assistance is finding a solution for the Greek banks’ subsidiaries in CEE. Between National Bank of Greece, Alpha Bank, Piraeus Bank and Eurobank Ergasias, Greek banks operate in Albania, Bulgaria, Macedonia, Romania, Serbia, Turkey and Ukraine in CEE, as well as having some operations in western Europe.

While CEE’s domestic central banks ringfenced the banks well, according to Ms Nagy, these subsidiary banks have since faced trouble raising deposits, while still representing about 15% to 20% of these countries’ banking systems.

Mr Berglöf notes that there is a role for IFIs such as the EBRD or IFC to support this process, as both institutions can take equity stakes. “This is something one should look at in the medium term – maybe alongside a strategic investor,” he says.

With the EU’s banking union, the European Central Bank (ECB) now is directly involved in the Greek banking problem, as the supervisor of the large Greek bank groups. However, the ECB does not have a resolution mandate to deal with the problem, Ms Nagy points out.

“What is missing is a comprehensive approach," says Mr Berglöf. “A Vienna-style collaboration could be useful because it provides some support and risk sharing across the IFIs.” Ms Nagy adds that there is an increasing realisation among central banks and regulators in southern Europe that such a resolution needs to happen.

“We have been supporting banks, including Greek bank subsidiaries, extensively in south-eastern Europe, through trade facilities, credit lines and in some cases, equity to support growth, change of ownership or consolidation,” says EBRD’s Mr Peterschmitt, who adds that alongside other IFIs, the EBRD will continue to consider such opportunities where this makes sound commercial sense.

“The region is going through a spot of trouble,” says the IFC’s Mr Telma. “How do you get engaged at that time when the private sector is more reticent? A big part of that is that the IFIs, which were created by various countries, are expected to work together. And since 2008, we are working with the EBRD better than ever before because operationally, we are facing similar issues.” 

* For the purpose of this article, CEE countries are defined as: Albania, Belarus, Bosnia-Herzegovina, Bulgaria, Croatia, Czech Republic, Estonia, Hungary, Kosovo, Latvia, Lithuania, Macedonia, Moldova, Montenegro, Poland, Romania, Serbia, Slovakia, Slovenia, Turkey and Ukraine.

Note: This article was amended on September 3, 2015, to remove the description of International Investment Bank as being "Russia's IIB".

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