Do We Need State Owned Banks in Transition Economies?

Do We Need State Owned Banks in Transition Economies?

By Rafael Abbasov

Over fifteen years after the collapse of Soviet Union one may question: “why are some state owned banks still alive? Do we need these state owned banks in transition economies?” These are central questions to be carefully addressed in states like Azerbaijan, which is blessed by enormous hydrocarbon reserves sufficient to double its GDI’ within a next five years. However, the fundamental question is about the role of stale owned bank(s) in the context of this economic reforms and development.

In past several years the harshest criticism by all international watchdogs was about state dominance in the banking sector unlike other similar states. Indeed, the state owned banking assets in Azerbaijan are astonishingly high and account for over 40% of total banking assets in 2007. One of two state owned banks – International Bank of Azerbaijan (1BA) – remains the largest by set of indicators not only on domestic market but in the Caucasus. Operationally speaking, 1BA is a source of funding for various state projects in transport, energy, construction, agriculture and food processing, sometimes competing with international development banks. The most recent transaction was concessional lending (comparable with IDA terms of World Bank) of over $200 million for regional railroad connecting Azerbaijan with Europe via Georgia and Turkey.

So, let’s rephrase the question – could state ownership of bank potentially work? Most of international watchdogs still say “no”. Even more – some of those would add: “continued state ownership in banking systems in transition economies has undermined reforms efforts and distorted emerging markets”. Mow far is it true?

Azerbaijan’s banking sector continued its almost five years’ rapid expansion in 2007 as well, boosted by further strong economic growth and greater public confidence in the financial system. In 2007 total assets increased by 78% to AZN 6.7billion, equivalent to 26% of GDP. Despite these success indicators, Azerbaijan National Bank (ANB) still laments that there are remarkably high number of private banks (over 44) and ANB’s primary’ goal is to consolidate those “dwarf stars” in order to foster competition on domestic market and financial integration and cooperation on regional scale. Ironically, so far none of top five leading private banks was able to penetrate the regional markets (Caucasus states or Caspian basin countries) unlike banks from neighbor countries like Georgia or Kazakhstan. Interestingly, I13A remains only Azeri bank operating in CIS markets via own subsidiaries or representative offices expanding regional financial cooperation.

The second argument against of state dominance in banking – monopolization – is very intriguing in the context of emerging markets. It is well known perception that most of big state banks are noticeably sleepier bureaucratic institutions, attracting deposits only on a basis of their low risk, to recycle them in mispriced loans – typically to failing industries that politicians want to prop up to keep

voters employed. In theory, it could be potentially true. Indeed, small private banks in Azerbaijan look smarter by various criteria. But operational gap with state bank is not really huge – state bank is still profitable, transparent and competitive in terms of services and products. Not surprisingly, in some segments (for example – mortgage and car lending) IBA remains even more conservative due its potential market exposure.

In the context of current credit crunch characterized with failure of free market principles of pricing and investment by world financial powers, the role of state owned bank is being advanced and potentially appreciated in transition economies. Let me be specific: some indigents of credit crunch could be consolidated as fear of market players extensively swamped in book losses of future loans which is being resulted in rapid decline in lending and upscale in pricing accordingly. Of course, the single fear is not enough and apparently greater uncertainty by financial institutions or equivalent of additional risk must be compensated by protective covenants and tightening lending standards and amounts, particularly for borrowers in transition states, like Azerbaijan or Russia.

Although Azerbaijan’s banking sector is far from reaching the same level of external indebtedness like Kazakhstan (external debt owed by Kazakh banks was equivalent to around 45% of GDP as of June 2007, whereas Azerbaijani banks’ foreign liabilities amounted only to around 3.5% of GDP in 2007), the sector has not been restructured or reformed to the same extent as its Kazakh counterpart and could be affected by a tightening of global liquidity. According to country’s statistics, the growth rate of external borrowing by private banks in 2006-2007 was the highest among most of former USSR countries and equivalent to top performers, like Kazakhstan and Russia. Therefore, an increase in appetite for external borrowing to bolster own double digit growth of performance by private banks most likely will be diminished due to credit crunch; and closing international funding markets for

Azerbaijan private banks would be potentially compensated by I BA’s inter-bank lending. Ultimately, benefiting from its political status and credit ratings by Fitch and Moody’s, not surprisingly IBA’s cost of borrowing remains unchanged during the credit crunch unlike private banks from Georgia or Kazakhstan.

Finally, state capitalism has more validity in a country as Azerbaijan, where population is under-provided with simple banking products. Despite remarkable increase in number of banking services (consumer loans, mobile loans, etc.) and innovative financial products pioneered by private banks; these are not much focusing operationally on rural and remote areas and very minimal by size. Also, these activities in rural districts are relatively costly and some of products are being subsidized by headquarters in Baku. Interestingly, only state owned banks reaches out to rural population, implementing various state programs (pension transactions, money transfers, etc.) due to most diversified branch network.

In conclusion my proposed argument is to change the definition of state bank’s role in context economic development. In 2008-2025, Azeri banking system has to meet the challenge of becoming the main funding source for the economy in general and promote faster development of the non-oil sector. Though the growth of the banking sector is ahead of other macroeconomic indicators, its potential is still lagging behind the economic needs of the country. The Government of Azerbaijan, as majority shareholder, must undertake necessary reforms to strengthen the state banks in order to foster economic development and widen bank service penetration in the country. Apparently, re-configuring state institution of financial intermediation requires more systemic and comprehensive vision of the government to carefully address issues of management and governance in the medium term. Ultimately, privatization of state owned bank will be key issue in the long term period.