The recent bouts of sharp lari depreciation caused much anxiety among the Georgian population, prompting fears of inflation, loan defaults, and bank failures, on the one hand, and the typically Georgian political speculations over “who is to blame”, on the other.
In and of itself, a moderate lari depreciation is not necessarily a bad thing for the Georgian economy. It makes Georgia cheaper and more competitive relative to the rest of the world, reducing the current account deficit and carrying a promise of future investment and jobs. That said, a deep and protracted depreciation could also trigger a veritable financial crisis – clearly the worst possible outcome in Georgia’s current situation.
Analytically, we can identify three main types of financial crises: currency crises, banking crises, and “twin crises”, i.e. a banking crisis brought about by a currency crisis.
- A currency crisis can start with a panic or a speculative attack on a currency, resulting in significant currency devaluation despite (futile) attempts by a country’s national bank to stabilize the currency by selling foreign exchange reserves. A currency crisis is more likely to occur in a country suffering from chronic balance of payments deficits.
- A banking crisis may develop in a situation when popular trust in the banking system deteriorates, causing a “run on the banks”. If a sufficiently large number of people lose faith in banks and attempt to withdraw their deposits at the same time, the banking system will indeed collapse.
- Finally, a twin crisis may occur when a worsening of fundamental economic factors (reflected in banking sector performance) brings about capital flight and a sharp currency devaluation. What is likely to follow, under these conditions, is default by domestic debtors (both companies and households) who earn their income in local currency but carry debts denominated in foreign currency.
While all three types of crises do damage to the economy, the twin crises are known as the most severe – they are typically associated with significant and protracted recessions lasting as long as 4 years and eating up about 20% of GDP (cf. Bordo et al., “Is the Crisis Problem Growing More Severe?”, Economic Policy 16, 2001).
How likely are these doomsday scenarios in Georgia? Specifically, how vulnerable is the country’s financial sector to speculative attacks on the Georgian currency and/or a bank run? One of the best ways to quickly assess the health of the banking sector of a country is to look at a set of figures commonly known as Financial Soundness Indicators (FSIs). The FSIs are compiled according to IMF guidelines and are comparable across countries. Let us check some of them.
HOW VULNERABLE ARE GEORGIAN BANKS?
The capacity of the banking sector to cope with a worsening of the financial climate is captured by the Capital to Risk-Weighted Asset Ratio (CRAR) shown for several countries in Figure 1. Under the Basel III international regulatory banking standard (adopted after the financial crisis of 2008), bank capital should be equal to at least 8% of the risk-weighted assets of a bank. As we can see, in Georgia this ratio stands at well above 8%, similar to that of Denmark and Germany.
The CRAR indicator tells us how much capital the banks have relative to their risky assets, such as loans, which are weighted with their risk exposure. Everything being equal, the riskier the loans, the higher is their weight and the lower will be the CRAR. Higher risk requires a bank to retain more capital to safeguard against potential losses, and thus the CRAR summarizes how well a banking sector is prepared to deal with a worsening financial environment.
Another indicator to inform us about risk exposure – and thus the vulnerability – of the banking sector is the share of non-performing loans to total gross loans. Yet again, the Georgian situation is quite unproblematic, as can be seen in Figure 2. In Georgia, the share of non-performing loans is low, both compared with other countries and compared to previous points in time (e.g. 2013). This is true whether one applies the very strict NBG standard (which classifies a loan as nonperforming if the payment is overdue by 30 days) or the laxer IMF standard (90 days).
The share of nonperforming loans to total loans is an important indicator for the general climate in which banks are operating. If the share of nonperforming loans increases, banks, particularly those already suffering on other fronts, may run into serious trouble. Those countries whose financial sectors are in “stormy waters”, like Greece and Cyprus, have indeed very high rates of non-performing loans of more than 35% and 40%, respectively.
Finally, one may be concerned about the trust economic agents have in the banking sector. This is an important issue, as every financial system, even the most solid one, can be brought down if it runs into a trust crisis. In finance, pessimism can quickly turn into a self-fulfilling prophecy if people are concerned about the safety of their deposits.
Once more, we can see that, at least for the time being, Georgia appears to have little reason for concern. ISET’s Business Confidence Index (BCI) for the Georgian financial sector, shown in Figure 3, is not bad at all. In fact, almost a year ago, business confidence within the financial sector is considerably higher than general business confidence. In addition, further decomposition of the data reveals that financial sector firms also have strongly positive expectations about the future (not shown in the figure), and these expectations have taken another upturn in the first quarter of 2015.
The financial sector BCI is a measure of how financial professionals assess the current situation in their sector.
HOW TO PREVENT A FINANCIAL CRISIS?
The Georgian financial system appears to be quite robust according to available data. Yet, the fast deepening of lari depreciation (much of which happened in very recent weeks and is yet to be reflected in financial sector data) could potentially trigger a wave of defaults in the future.
The Georgian regulator should take extra precautions because the rate of nonperforming loans is not a linear function of lari depreciation. Rather, it can evolve explosively once a certain threshold is crossed. Almost all loans will be served while the lari depreciates up to a certain degree, yet whole categories of debtors may default at the same time when that threshold is exceeded. And, given that more than half of all loans in the Georgian economy are denominated in foreign currency, the risk of further devaluation for the stability of the Georgian banking system is quite severe indeed.
One possible policy solution to prevent such a development would be to extend the maturity of current dollar-denominated loans. This would clearly be a win-win solution for both debtors and banks. While an extension of maturities is roughly cost-neutral for the banks, it would relieve the pressure on debtors and reduce the risk of default.
At the current level of foreign currency indebtedness in Georgia (around 4.123bln USD in mortgages and consumer loans), the average maturity (16.7 months), and the average interest rate (12.3%) on dollar-denominated loans, we estimate the total Georgian borrowers’ bill to the banking sector at about $270mln per month (red bar in Figure 4). Figure 4 also shows how maturity affects the level of monthly payments on outstanding foreign currency-denominated loans.
If average maturity is extended from the current 16.7 months to 24 months, total monthly payments on outstanding foreign currency-denominated loans will be reduced from $270 to $195mln; if maturity is extended to 3 years, monthly payments will drop to $138mln.
It should also be noted that extending maturities of existing loans tends to provide greater relief for borrowers than the alternative of subsidizing the interest on loans. First of all, a subsidy is expensive, and it would either have to come from the government or the banks, both of which might need the money to counter the consequences of negative economic developments in the future. More importantly, however, even heavy subsidies would not reduce monthly payments by a great deal. Reducing the interest rate three times, to 4%, will decrease the borrowers’ monthly payment bill only by $20mln – from $270 to $250mln.
NO REASON TO PANIC, MANY REASONS TO ACT
Lari depreciation is disconcerting for more than one reason, but not because Georgia is on the verge of a financial crisis. A thorough analysis of the fundamentals of Georgia’s financial system provides no reasons to suspect an imminent crisis. Mostly certainly, it does not furnish any rationale for bank runs and panic. Nevertheless, the Georgian regulator (the National Bank of Georgia) and commercial banks would do well to pro-actively relieve the financial pressure bearing on debtors and in this way keep the rate of non-performing loans at their currently low levels. This would be an effective way to make sure that even fears of a crisis are nipped in the bud.