The European Bank for Reconstruction and Development: Going East

Europe's ex-communist economies are changing. So must the EBRD

WHEN the European Bank for Reconstruction and Development (EBRD) holds its annual meeting in Belgrade this weekend, it will have good reasons to celebrate. The bank, founded in 1991 to help free markets take root in the ex-communist countries of central and eastern Europe, now counts eight members of the European Union among its clients; others are knocking on the EU's door.

However, such developments raise awkward questions about the future. “The EBRD was never meant to be a permanent institution,” explains Mark Sullivan, America's director at the bank. When, therefore, should the EBRD declare its job in a country done, and withdraw? And how far and fast should it shift its operations eastwards, within Europe and into central Asia?

The bank is bound by its constitution to promote private enterprise in countries “committed to and applying the principles of multi-party democracy, pluralism and market economics”. The political upheavals in Georgia and Ukraine, by this standard, are encouraging. Russia, the recipient last year of about one-third of the bank's investment, looks less promising. Uzbekistan, where government troops killed hundreds of people last week, is downright grim. The EBRD has put a little money into businesses there - enough to make the bank the country's largest foreign investor - and to the consternation of many held its annual meeting in Uzbekistan two years ago.

Because of its private-sector focus, the EBRD is not a traditional development bank. It hands out no grants for broad goals such as the alleviation of poverty. Almost all its investments, made alongside private banks and companies, are in for-profit ventures. And it is expected to make money itself. It is in decent shape, with a profit of €298m ($370m) last year. This marks a good recovery from 1998, when the Russian crisis cost the bank more than €500m, drove it to a loss of €261m and wiped out its reserves. Stricter cost-control, better risk-management - cutting non-performing loans from 12% of the total in 1999 to 4% - and sounder investments have helped repair the damage. Reserves are now €1.8 billion; at €2 billion, the bank could in theory pay a dividend, although it would probably plough money back into the business instead.

The EBRD's biggest challenge is not one of money but of vision. As its operations migrate from central Europe to the Balkans, Russia, the Caucasus, central Asia and, soon, Mongolia, what sort of institution will it, and should it, become? Arguably, Hungary, Poland and others are ready for “graduation ” - -EBRD argot for the winding-down of operations in a country deemed to have made the transition to a free-market system. The share of the EBRD's investments going to central Europe (under which heading it includes the Baltic states and Croatia) is falling, to 23% in 2004, against 40% in 1998. The share of Russia and others has been on the rise.

Some shareholders, led by America, believe that the bank should set a firm deadline for withdrawal from the most advanced countries. This, they say, will allow it to focus its cash and its staff's brains where help is needed most. They also worry that lingering in advanced countries might crowd out the private sector - even though the EBRD says it takes pains to tread only where private lenders will not go alone, acts in partnership with private institutions and prices its investments at market rates.

Others argue that even in the countries that have joined the EU there is still plenty to do. Some regions, such as rural Poland, lag behind. Some financial services, such as small-business lending, are not yet well developed. Bond markets lack liquidity. Many private-sector banks like to have the EBRD alongside them: “It protects us from reputational risk should something go awry,” says one investment banker. “The EBRD is a stamp of good housekeeping.”

A shift in region will require a shift in strategy too. In the Caucasus and central Asia, especially, the private sector is tiny, crony capitalism is rampant and public-sector loans may well end up in officials' and politicians' pockets. So the EBRD says it must switch to more traditional development work and grants, for example to strengthen legal or regulatory institutions. For-profit ventures will focus on micro-finance and small-business lending, which will require more time, staff and risk and, at least initially, will produce less profit. Last year, the bank launched an initiative for its seven poorest client countries, financed by grants from shareholders' donations and concentrating on microloans and lending to small businesses.

The push eastwards is spurring a rethink of the EBRD's political mandate too. So far, the bank has chosen to treat Russia with mild remonstrations. It has a formal ban on public-sector loans to Belarus and Turkmenistan, and is not making such loans to Uzbekistan either. Whether this will have any effect is moot. After all, says Laurent Guye, another director of the bank, “the success in central Europe was mostly due to the carrot and stick of EU membership - not EBRD prodding.”

Most bankers seem to think that the EBRD has a role to play farther east. That might turn out to be correct. Simon Ray, the British director of the bank recalls that, in the wake of the Soviet Union's demise fourteen years ago, “Romania and others, too, seemed impossibly difficult. Look at them now.”

Europe's ex-communist economies are changing. So must the EBRD.