The EBRD Increases Activity

Interview with EBRD's Chief Economist Nicholas Stern

by Richard Hirschler

The European Bank for Reconstruction and Development (EBRD) is not "abandoning" Central Europe, though it is pushing the frontier of its lending and investment activities farther east. It wants to increase the share of equity investment and preserve the two-thirds proportion of the private sector in its total commitment. EBRD Chief Economist Nicholas Stern was interviewed by Transition editor Richard Hirschler following the organization's annual meeting in London. (The next annual meeting is scheduled for May 11-12, in Kiev, Ukraine.)

Q. What will be the topic of the next EBRD Transition Report?

A. The next Transition Report will be on restructuring and growth. It's clear that enterprise restructuring is under way throughout the region. But it has a long way to go, even in such "transitionally advanced" countries as the Czech Republic, Hungary, and Poland. While market experience can now enable investors to assess the likely costs and benefits of enterprise restructuring fairly well, it is still a risky venture. Although some blue chip companies can borrow at low interest rates, for three to four years, long-term capital—either as equity or loans—is still not readily available for everybody. So restructuring will remain an important issue and we want to analyze its relationship to the growth prospects of the region. We want to learn more about the sources of growth to better understand the prospects of the individual countries and predict the likely development of their investment markets. Macroeconomic stabilization and the first stage of structural reform generated some growth, but the growth potential in the CIS countries, not to mention Hungary and others, is certainly higher than we have seen so far. This is an area that we have to investigate more closely. How much of the growth is simple recovery, how much is the result of productivity increase, and how much is coming through reallocation across sectors and through growth in new sectors? Once we assess potential sources of growth more clearly we will be able to assess the economic prospects and investment potential of the individual countries. We also want to analyze more carefully the time lag between investment and growth. Since the EBRD finances investment, we are trying to understand more profoundly the determinants of investment opportunities and the influence of investment on growth.

Q. What are other major features of the EBRD's research program?

A. The department is primarily strategic and operational, but we are also conducting some research. We are trying to learn more about ownership trends in the transition economies and their influence on governance. In another project, we will evaluate the availability of financing in these economies, examining both direct investment and the lending capacities of the financial institutions. With respect to the approaching enlargement of the European Union, a third project will examine, through a survey, the competitiveness of Central and East European enterprises, the challenges they are facing, and their expected response to accession. We are also doing research on how we could support most effectively small and medium-size enterprises.

Q. Will these projects be concluded in the current financial year?

A. No. We will be getting results on all of them during the current year, but they will probably continue into 1998.

Q. And how will the results be communicated to the interested public?

A. Through our working paper series, and also through our Journal, Economics of Transition. Part of the findings will be integrated in the Transition Reports, and some researchers will publish their studies in the various journals.

Q. During the annual meeting, there were some hints that the EBRD's lending and equity investment activity will move farther east, to Ukraine, Russia, the Central Asian countries. Most Central European economies will be declared "success stories," that is, "graduated" to private capital. In this sense they will not need more EBRD money. The Economist also asked why the EBRD is still lending in countries that now have easy access to international capital markets?

A. In fact, over the next couple of years we plan to boost our annual lending and investment capacity to around $3 billion across the region, compared with some $2.6 billion in commitments to borrower countries in the past financial year. True, within this increased activity, our commitments to countries farther east will rise faster. But in the next two years Central and Eastern Europe can expect further EBRD support targeting enterprise restructuring, investment in the environment and energy sector, efficiency in infrastructure in general, privatization of utilities, and strengthening of the financial institutions. We will basically commit our resources in those areas where private investors need encouragement, where without our assurances they would hesitate to commit their long-term capital, and also where we can be useful providing advice, for example, on the way public utilities should be commercialized. As long as we have something to bring to the table, and that would be more than just money, we will be present in this region.

Q. Analysts warn the EBRD that "farther east" it will face more difficult environments: the economies are more unstable, the state sector is still overwhelming, and private companies are small and weak—and that therefore the Bank's loan and equity portfolio could worsen. This could mean that the Bank would not be able to preserve its "golden rule"—to commit at least two-thirds of new investment to the private sector.

A. Some of these concerns are understandable, but I'm still convinced that there are plenty of sound opportunities "farther East." We will participate only in sound projects that have the potential to stand on their own feet. We have to be convinced that a project will pay back from its own revenues. I do not foresee any problem in repeating the performance of last year when the private sector received 66 percent of our commitments.

Q. Has the EBRD assessed the success rate of its projects?

A. We evaluate a project in detail only after completion. Public sector projects have quite a long life time, more than five years, and the Bank is only six years old. Although we started lending from the beginning, it is the last four years that have seen the strongest activity. So we are only now actually accumulating sufficient data to be able to draw lessons of experience. By the way, I am always a little skeptical about the words "successful" and "not successful"—you have to consider a number of different dimensions. Some of our loans are bound to go bad. If none went bad then probably we would not be doing our job. We would not be taking enough risks. It is hard to cover the loan risks in terms of the interest spreads. Therefore, having a direct stake in the company, and thus sharing in the upside, could serve us better.

Q. Will the EBRD shift away from co-financing toward equity investment?

A. Yes, we would like to see an increase of the equity share in our total investments—the share now accounts for about 20 percent. We never take more than 35 percent of any private sector project. An EBRD representative then can participate at board meetings and be directly involved in the decisionmaking process. The enterprise can also benefit from opening up to the scrutiny and examination of an "outside" shareholder. Many enterprises can obtain loans, but have difficulties raising money alone on the stock exchange. However, we want to be a partner that does not dominate the activity.

Q. But if the equity investment is a success, after a couple of years the Bank sells its share and winds up its engagement...

A. That can happen. We sold our share in the Hungarian pharmaceutical manufacturer EGIS last year, and we have just sold our stake in a Polish bank. It is a question of timing. It doesn't make sense to disappear instantly as soon as the company starts to a make profit. At the same time, you don't want to outstay your welcome. After all, opening new opportunities for domestic and foreign private capital is our job.

Q. It boils down to the fact that the EBRD has to perform a tough balancing act: trying to be profitable but also looking out for territories where private business would not dare to go...

A. Exactly. We have to identify the frontier in terms of the investments that are sensible but not yet quite sound enough for the private sector to engage in without us. And we must constantly push out the frontier.

Q. One great advantage of the EBRD is its relatively small size; responsibilities are more easily identified in a smaller organization.

A. Personal responsibility is very important and is a very strong principle of merchant banking. This means that while any loan can get into difficulty, it is the responsibility of the person who made that loan to sort it out.

Q. The World Bank is making efforts to develop partnership programs with other international financial institutions such as the EBRD. What are the results so far?

A. In Russia, for example, the World Bank is supporting reform in the bank sector, while the EBRD is investing in specific financial institutions. We also participate jointly in Russian infrastructure projects. The IFC and the EBRD are working together to strengthen regional venture funds that invest in private enterprises. During the annual meetings of the EBRD in April, we organized a joint seminar with the World Bank and the IMF on the obstacles to economic growth. Participants included Johannes Linn, Joe Stiglitz, and Marcelo Selowsky from the World Bank; and Stan Fischer and John Odling-Smee from the IMF. As participants of a Development Committee Task Force, we are also exploring—together with other regional banks—how we could increase our effectiveness as a group.