Baltic Sea region financial sector in light of financial storm

Highlights of the speech given by Johnny Åkerholm, President and CEO of the Nordic Investment Bank, at the Baltic Development Forum Summit in Copenhagen on 1 December 2008.

Global crisis, global reasons
The financial crisis is global, and so were the reasons behind it. One of the reasons for the global turmoil was the abundance of liquidity that was created by loose monetary policy combined with financial innovations, which led financial institutions to think that they could redistribute the risks to others, thus increasing the appetite for risk. As a result, economic growth was high, but a number of financial bubbles were created. When these started to bust beginning with the collapse of the subprime market, mistrust within the financial system arose.

Baltic sea region affected
The Baltic Sea region is no exception to the rule that the larger the bubble, the bigger the burst. Iceland was affected early on because of its high risk and highly leveraged investments. Denmark was affected by adjustments in the housing market. The Baltic countries have been affected by a drain in capital inflows, forcing a rapid adjustment in the current account. The other countries in the region have also been affected, although to a lesser extent, since they had fewer imbalances.

Not served by finance, real economy to collapse
The next phase, both globally and in the Baltic Sea region, will be a negative interaction between the real economy and the financial system. Concerned about their own liquidity and higher funding costs, banks are reluctant to take on new risks. The support packages have helped, but they have not done away with the problem.

What might seem to be prudent at the micro-level does not add up at the macro-level. If the real economy is not served by the financial sector, the ensuing liquidity problems will lead to failures in the real economy and credit losses in the financial system. In an effort to avoid further risks, the collective behaviour of the financial institutions will aggravate the very risks they fear.

Basel II will also give a further push to the negative spiral. As the real economy collapses, counterparty risks increase, and banks have to tie up an increasing amount of capital in the existing engagements. So at the end of the day, the fear of the banks will turn out to be a self-fulfilling prophecy.

Baltic Sea region in a better position?
Is the Baltic Sea region in a better position than others to deal with this? Yes and no.

No, because we are all open economies dependent on the fortunes of the global economy. We have some opportunities to offset a shortfall in export demand with increased domestic demand, but we do not consume the same products at home as we export.

Yes, because some countries can support domestic demand through fiscal policies. Sweden, Finland, Denmark and Norway have this room to manoeuvre because of their prudent policies in recent years and strong external balances. But also in these countries, the recession will entail a severe shift of economic burdens to future generations.

Also the Baltic countries have strong budget balances. Even so, there is no room for expansion, given the weak external balances and the dependence on foreign finance.

Can monetary policy help?
It can, but it does not solve the problem. One cannot push with a string. The euro has been a tremendous fortune for the region. Without the euro, Europe would have seen erratic capital flows, a currency crisis and higher interest rates. This zone of stability has also benefited those outside.

The test lies ahead for the euro zone as well as for economies outside. Monetary policy will be challenged by slow or no growth, long-term inflationary risks and increased divergence within the euro area. Economies outside the euro zone will find it harder to attract investors, as already evidenced in Denmark, where interest rates have had to be raised, and in Sweden where the exchange rate has depreciated. But the jury is still out.

International financial institutions to prive stability
International financial institutions (IFIs) can provide stability to the system. Their good rating provides them with access to the funding markets even in difficult times. This has been sustained, even if also IFIs have lately been affected by the turbulence and the rapidly increasing financing needs of sovereign borrowers. Hence, the IFIs still have the possibility to provide finance, also with longer maturities. IFIs can also play a catalytic role: their participation enhances the opportunities for the private sector to finance projects.

However, they are most efficient in their respective focus areas. The Nordic Investment Bank has in the last few years focused on supporting competitiveness and the environment, establishing environmental lending facilities—CLEERE and BASE—to support these focus areas. The Bank has also set up a carbon trading scheme for the post-2012 period together with the European Investment Bank, Kredit für Wiederaufbau and other financial institutions.

The environment, energy, renewable energy, energy saving, transport and logistics all figure high on the political agenda and they will no doubt also be part of the Baltic Sea strategy. At the same time, as public finances weaken and social needs grow, the competition for financing will become more intensified. This will only increase the relative importance of financing from IFIs, including NIB. As we fulfil our mission as an IFI, the mandate of the Bank to promote competitiveness and the environment will remain at the core of our activities well into the future.