FINANCIAL SYSTEM IN REPUBLIC OF MOLDOVA vs OTHER COUNTRIES

2012

ANGAN OLGA FB 10 G 29.11.2012

Republic of Moldova Background Moldovas economy grew by an impressive 14 percent cumulatively in 201011, spurred by booming exports and domestic demand, recovering external inflows, and improved policies. Since January 2010, the authorities efforts to restore fiscal, external, and financial sustainability and promote growth were supported by two arrangements with the IMF: the Extended Credit Facility and the Extended Fund Facility, amounting in total to SDR 369.6 million (US$562.5 million at present). Five reviews have been completed so far, releasing SDR 320 million to support the balance of payments. Economic activity slowed markedly in early 2012 due to weakening external conditions and harsh weather conditions, driving real GDP growth down to 0.8 percent in 2012 relative to a year ago. The slowdown was reflected in dwindling exports to the EU and domestic demand in line with weakening remittances. The economy is expected to pick up in the second half of the year, supported by resilient conditions in the CIS and investment in infrastructure. However, a severe drought that has hit Moldova over the summer and a deterioration of conditions in the EU could dampen this outlook. Twelve-month inflation decelerated to 4.4 percent in August, and is expected to remain anchored around the National Bank of Moldova (NBM) target of 5 percent during the remainder of 2012 and 2013. Fiscal consolidation in 201011 has been strong, bringing the fiscal deficit down to 2.4 percent of GDP at end-2011. However, revenue shortfalls, due partly to the slowing economy and partly to increased losses from tax loopholes and collection problems, and new spending commitments have slowed down fiscal adjustment. The authorities have implemented corrective measures to safeguard the programs fiscal consolidation objective in the context of the fifth program reviews. Monetary policy was eased aggressively in late 2011 and early 2012 in response to the rapidly falling inflation, supporting credit growth and thus cushioning the slowing economic activity. The banking sector is sound overall. Banks have remained generally liquid, wellcapitalized, and profitable, although their nonperforming loans (NPLs) have risen somewhat as the economy slowed. The euro area debt crisis has had little direct effect on the financial system owing to limited links with banks in affected countries. However, risky lending practices and poor governance have significantly weakened the asset portfolio of the state-controlled Banca de Economii and necessitated a large increase in provisions. The bank, which accounts for about 13 percent of total assets in the banking sector, requires urgent measures to repair its balance sheet.

Executive Board Assessment In concluding the 2012 Article IV consultation with the Republic of Moldova, Executive Directors endorsed staffs appraisal, as follows: Moldova enjoyed vigorous economic growth in 201011, supported by appropriate macroeconomic policies and structural reforms. Implementation of the ECF/EFFsupported program over that period has been strong. The economy is slowing down in 2012 due to weakening external conditions, with serious downside risks. GDP is expected to grow by 3 percent in 2012, and inflation should settle close to the NBM target of 5 percent. Economic deterioration in the EU could significantly depress growth. However, with a lower structural fiscal deficit, improved monetary policy framework, and an overall sound banking sector, Moldova is in a much better position to withstand shocks than in 2009. The amended 2012 budget puts fiscal consolidation back on track, while accommodating cyclical effects and supporting important reforms. Strong corrective measures have been taken to close tax loopholes and offset unbudgeted expenditure commitments that emerged in early 2012. Continued improvements in tax and customs administration, and reforms in the key areas of the pension system, education, and public administration will be needed to maintain fiscal sustainability in the medium term as foreign assistance declines. The current monetary stance is consistent with the NBMs inflation target, while the conduct of monetary policy could be honed further. After the aggressive easing in early 2012, the financial system has all it currently needs to support credit demand at advantageous interest rates. Further policy changes could be warranted if the economic outlook deteriorates or demand-driven inflation pressures re-emerge. To avoid unnecessary policy volatility, more weight should be given to demand-driven core inflation trends relative to supply shocks in determining the policy stance and in communications with the public. The external position of the economy gives rise to some concerns. The large current account deficit, rising short-term private debt, and external risks call for augmentation of the NBMs international reserves. The real effective exchange rate is moderately overvalued relative to underlying fundamentals, although it is expected to self-correct gradually, in light of falling inflation, slowing capital inflows, and a higher pace of reserve accumulation. Moldovas financial system is stable overall, but the deteriorating situation at the majority state-owned Banca de Economii (BEM) must be promptly addressed. Banks have generally remained liquid, well-capitalized, and profitable. Swift legislation

amendments to facilitate owner disclosure requirements and introduce fit and proper criteria for bank managers and board members would further strengthen confidence in the banking system. However, urgent progress is needed to repair BEMs balance sheet and improve its risk management. The new management, the Board of Directors, and the NBM should ensure that BEM cleans up its portfolio, quickly disposes of foreclosed collateral, and ends its risky lending practices before seeking recapitalization. The authorities efforts to improve the business climate and promote exports have been productive, but important challenges lie ahead. Wide-ranging structural reforms have enhanced competitiveness and fostered investment. However, further improvements in several key areas, including protection of property rights, a transparent and stable policy environment, effective governance, and a reliable judicial system, are essential to attract investors. A decisive energy sector reform should finally commence. The authorities should persevere with establishing payment discipline among both households and public entities, and implement their energy sector restructuring strategy to reduce losses and resolve historic arrears. Staff recommends completion of the fifth reviews and approval of the requests for a waiver of non-observance of the end-March 2012 performance criterion (PC) on the general government budget deficit and modifications of the end-September 2012 PCs on the general government budget deficit, the NBMs net domestic assets, and net international reserves. Program implementation has been generally good. The authorities maintain the commitment and the capacity to implement their Fundsupported program. The slippages in early 2012 have been adequately addressed, and the policies planned for the remainder of 2012 and beyond, including the requested new targets, support the programs objectives. The capacity to repay the Fund remains strong. Italy Italy's financial system weathered the initial phase of the global credit crisis in 200809 better than those of most other European countries and the US, thanks mainly to Italian banks' traditionally cautious borrowing and lending. Write-downs were announced by several Italian banks between mid-2007 and early 2009, but these were generally smaller than those by US or other large European financial institutions. According to the Banca d'Italia (the central bank), Italian institutions used fewer complex credit-risk products than banks in many other countries, and have generally relied more heavily on retail deposits and bonds for their funding. Moreover, the central bank regards its prudential rules on securitisation and consolidation of offbalance-sheet vehicles as being more conservative than elsewhere. According to Banca d'Italia figures, the ratio of wholesale funding to total outstanding funds at end-2008

was 29%, compared with an average of 41% in the euro area. At end-2009 it was 27% in Italy compared with an average of 39.4% in the euro area. In 2009 Italian banks increased their capital reserves mainly by retaining generated profits and raising capital on the markets, rather than through state support. At the end of last year the Tier 1 capital ratio was estimated to be 9% for the entire sector, up from 7.6% at end-2008. This was lower than the average of 11.6% for 12 of the largest European banking groups, but regular stress testing by the Banca d'Italia has implied that the balance sheets of the country's banks remain sufficiently strong to survive a period of "unfavourable economic conditions". Investors will be waiting to see how these results compare to a new round of stress tests currently being conducted on as many as 100 large financial institutions across Europe by the Committee of European Banking Supervisors, in a desperate effort by EU policymakers to calm financial market concerns about bank's exposure to rising sovereign debt levels in the euro zone and EU. It is thought the results of the tests will be published on July 15th. Feeling the pressure? Italian banks may have escaped some of the worst effects of the financial turmoil, but they have certainly not been immune, particularly as the crisis triggered a deep recession in Italy. The level of non-performing loans has increased (albeit from a relatively low level to 4.7% of total bank lending at end-2009), while profits have shrunk. After falling by 60% in 2008, bank profits declined by a further 15.6% in 2009, mainly reflecting a large increase in provisioning for bad loans. The banking sector will continue to face a more strained business environment, with the prospect of higher funding costs, global regulatory demands to meet tighter capital and liquidity requirements (although recent moves by the G20 suggest a significant watering-down of earlier proposals) and growing pressure in some European countries to introduce bank levies, transaction taxes or similar measures in order to build up a fund to finance future bank interventions. The Italian government has underlined its support for tighter regulation and supervision coordinated at the EU level or through agreements at international level through bodies such as the G20. Tensions may also arise as growth disappoints, risking an increase in insolvencies and loan defaults. After contracting by 5.1% in 2009, the Italian economy is projected to recover only very sluggishly, expanding by about 0.5% a year in 2010-12 and by about 1% a year in 2013-14. Moreover, there is a considerable risk of another sharp dip in economic performance over the next year or so, given the likely negative impact on demand of fiscal tightening in Italy, elsewhere in the EU and in the US. Despite the unprecedented stimulus across the euro area over the past 18 months, there is still very little sign of any recovery in employment or money data. Indeed, the latest Conference Board leading indicator for the euro area fell 0.5% in May, its first decline in 12 months. An unavoidable burden The trigger is likely to have been rising concerns over levels of debt, both private and sovereign. There is now a substantial risk of risk of contagion from the Greek

sovereign debt crisis that has spread to several other peripheral euro area countries since the beginning of 2010. Italy has the second highest government debt in GDP terms in the EU after Greece and the largest debt burden in value terms. At the end of 2009 the stock of Italian public debt amounted to 116% of the country's GDP and onequarter of total government debt in the euro area. In early May, when the EU and IMF announced a massive financial support package for Greece, Portugal, Ireland and Spain, Italy appeared to have escaped the worst of the financial market turmoil. But over the past month markets concerns over Italy's creditworthiness have increased. Fragile public finances in the EU and concerns about Italy's creditworthiness will affect the financial system in several ways. For one, it will hurt banks in Italy (and elsewhere) that have large Italian government debt holdings. According to the Bank of International Settlements' June 2010 Quarterly Review, Italian banks have low exposure to the public sectors in the three countries worst affected by the euro area sovereign debt crisis: Spain, Greece and Portugal. However, the exposure of Italy's two main banking groups, Unicredit and Intesa San Paolo, in crisis-hit Hungary amounts to about 25bn, just under 20% of the total exposure of European banks to the country's banking system. Exposure to struggling Bulgaria and Romania will also be of concern. Moreover, according to the Banca d'Italia, Italian banks have to roll over some 800bn in debt by 2012. This means Italian banks will be competing for funds at a time when the Italian state and other cash-strapped governments will be making large debt issues to meet their financing needs. All this against a backdrop of spreading fiscal austerity: plans being enacted to address daunting budget deficits across the developed world will continue to weigh on economic growth prospects, restraining demand for new loans and challenging borrowers' ability to service existing debts. Italy's financial sector may have weathered the initial deluge, but the storm clouds are still gathering. Germay The global financial crisis severely affected the German economy, especially due to the contraction in world trade in 200809, but recently the recovery has been strong. Exports initially declined, but have since led the recovery. Employment was robust in the face of a sharp contraction followed by a rebound. The fiscal balance deteriorated and the public debt stock jumped due to financial stability support measures, stimulus measures and cyclical factors. The policy of the European Central Bank (ECB) allowed interest rates to fall to unprecedentedly low levels, and also facilitated the availability of liquidity in euros and U.S. dollars. Germanys financial system is complex and dispersed. The banking system is based on a three pillar system (private banks, savings banks and the associated Landesbanken, and cooperative bank networks) with a relatively high portion of public banking. The savings bank and cooperative pillars are each bound together through mutual guarantees, vertical ownership ties, integrated operating systems, the regional principle whereby members do not compete with each other, and legal restrictions on changing ownership form. The banking sector accounts for the majority

of total financial sector assets, serving as a backbone to the German industry, which is more reliant on bank financing than that in many other advanced economies. The smaller banks are domestically oriented, while the major banks, including most apex organization of cooperative and savings banks, have significant exposures abroad through branches and subsidiaries, cross-border lending, and market operations, both in Europe and worldwide. Some German insurance and reinsurance companies are among the largest in the world. Securities markets are active and wellintegrated into world markets, and assets under management are large. The structure of the system has remained broadly unchanged over the past decade, with some consolidation and foreign entry. Consolidation has continued in all pillars, and some foreign entry has occurred. The privatization of the postal savings bank reduced the share of government-owned banks, and several of the Landesbanken were incorporated and/or integrated vertically with Sparkassen from the respective regions. Nonetheless, the structural issuesand indeed the stability issues identified in the 2003 FSAP remain broadly relevant. At that time, Germanys banking sector and financial system was under strong pressure, but stress tests suggested that there was no major threat to overall financial stability. Regulation was assessed to be well-developed, comprehensive, and broadly effective (with the exception of reinsurance sector). The main recommendations were to (a) enhance competition and structural development by reducing the rigidity of the three pillar system (with the aim to reform the Landesbanken in particular); (b) increase the transparency of public banks; and (c) improve specific aspects of the legal framework, regulation, and, especially, supervision. As summarized in Appendix I, the authorities have made efforts to enhance supervisory practice. However, the three pillar system and the supporting institutions (such as the mutual guarantees among savings banks and among cooperatives, respectively, and limits on competition) are largely intact. Parts of Germanys banking sector were hit hard during the financial crisis, but with strong policy support channeled through exceptional measures, the condition of the financial sector has stabilized. Banks, including some large banks, suffered market losses and difficult access to, and high costs of financing; those that were perceived to have lower capitalization or lower quality capital were most at risk. As the recession deepened, banks exposed to the export sector faced deteriorating loan quality. Several banksincluding certain Landesbanken but also a major issuer of covered bondshad to be intervened, at significant costs to the German taxpayer. Following some initial ad hoc rescues of troubled banks, the authorities moved to a more comprehensive approach to addressing the financial crisis. A new financial stability framework was introduced in October 2008, including the

establishment of the Federal Agency for Financial Market Stabilization (FMSA) to administer the Special Fund for Financial Market Stabilization (SoFFin). Financial stability support

France