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Saturday, September 1, 2007

Emerging Markets and Safe Havens

Danske Bank's Lars Christiansen had a research note last week which is of some interest for Hungary's current situation. Entitled "Emerging Markets: Looking for the safe haven" (watch out pdf), and published last Thursday, Christiansen accepts that there is a global credit crunch, and that it is now spreading to Emerging Markets (EM), with many of the high-risk EM currencies (the Turkish Lira, the Hungarian Forint, etc) now coming under heavy fire. As to the question what countries may be most at risk, he answers the following:

In a situation where liquidity is tightening there is no doubt that the most liquidity-“hungry” countries are those with large current account deficits and large external debt. In this category we find Turkey, South Africa, Hungary, and Iceland. Furthermore, risks are heightened in the Baltic states, Romania, and Bulgaria.

That would seem to put Eastern Europe pretty generally on the map I would have thought. Chrisiansen seems to accept the arrival of the credit crunch as now a fact:

For the last couple of weeks, we have warned that the global credit crunch could spread to Emerging Markets. This has now clearly happened, but given the major moves in the global credit and equity markets there clearly is potential for even more contagion to Emerging Markets. Therefore, there is also reason to start looking for safe havens within Emerging Markets. Here external funding needs will be the key.


The credit crunch has triggered a strengthening of the yen and to a lesser extent, the Swiss franc. We would in particular watch the Swiss franc as many households in Central and Eastern Europe have funded their property investments with Swiss franc loans. Hence, if the Swiss franc strengthens further then it could put additional pressures on the CEE markets mostly exposed to the Swiss franc.

This is really code language for speaking about Hungary, since in Hungary around 80% of the mortgages which have been taken out in recent times have been Swiss Franc denominated (via Austrian banks I should mention, so the Austrian banking sector is also partially at risk, although the Austrian Central Bank think they can withstand the shock if you look at the "Stress Testing the Exposure of Austrian Banks in Central and Eastern Europe" paper presented here.

So here are Danske Banks recommendations. The countries you are told to avoid are in red:

There is also another conclusion drawn from the dependency on the Swiss Franc:

If the markets continue to run away from the above-mentioned markets then it will also have ramifications for monetary policy in these countries. We would particularly argue that the planned / signalled monetary easing in Turkey and Hungary will be postponed – maybe long into 2008.

That is to say it will not be possible for the Hungarian Central Bank to reduce interest rates as it would like to to support internal demand since this would most likely send the Forint hurtling down, and this would make the position of those on Swiss Franc mortgages well-nigh impossible.

All of which brings us back to Danske Bank Chief Economist Carsten Valgreen, and his widely quoted paper on how in an age of global capital flows the monetary authorities in small open economies may lose effective control over the direction of their domestic economies. In particulatr we might like to examine the following chart, which comes from the paper. entitled The Global Financial Accelerator and the role of International Credit Agencies.

Now the data Valgreen uses comes from 2005, and since that time the position can only have changed in the direction of increased dependence on non-locally denominated currency loans (and especially in those countries who are coming from a lower base). Thus it can be seen that the risk level coming from any currency adjustment is quite significant. The following summary of the content of Valgreen's paper is also interesting, since it reveals to what extent the monetary authorities in a small open economy (and perhaps a not so small one, think Poland) may well lose control in a way which makes any adjustment process very difficult, with or without pegs:

The choice major countries have made in the classical trilemma: ie, Free movements of capital and floating exchange rates – has left room for independent monetary policy. But will it continue to be so? This is not as obvious as it may seem. Legally central banks have monopolies on the issuance of money in a territory. However, as international capital flows are freed, as assets are becoming easier to use as collateral for creating new money and as money is inherently intangible, monetary transactions with important implications for the real economy in a territory can increasingly take place beyond the control of the central bank. This implies that central banks are losing control over monetary conditions in a broad sense. Historically, this has of course always been happening from time to time. In monetarily unstable economies, hyperinflation has lead to capital flight and the development of hard currency” economies based on foreign fiat money or gold.

The new thing – this paper will argue – is that we are increasingly starting to see the loss of monetary control in economies with stable non-inflationary monetary policies. This is especially the case in small open advanced – or semi-advanced – economies. And it is happening in fixed exchange rate regimes and floating regimes alike.

One bright spot - or potential safe haven - does exist in Eastern Europe however: the Czech Republic:

Finally it should be noted that the Czech koruna (CZK) – unlike most other CEE currencies – should be expected to strengthen in the present environment due to unwinding of CZK-funded carry trades. That said, the CZK is fundamentally not undervalued and the Czech central bank should be expected to keep interest rates below the ECB rate – especially if the CZK strengthening accelerates. That will limit the potential for strengthening of the CZK.

In case any of you notice some inconsistency in this view of the Czech Republic, since of course Czechia is also one of the "reds" identified by Christiansen in his CA chart above (though to a much lesser extent than some of the others it needs to be said), I think it should be pointed out that other factors beyond the CA deficit need to be taken into account when evaluating the situation (the value content of exports would be one of these, what the deficit is based on would be another - ie are you importing machinery and equipment which can subsequently be used for exports - and the openness of the labour market to immigration would be another - there is of course an acute labour shortage in the Czechia , but they are they are actively attempting to address this and they are even out trying to recruit in Vietnam). Essentially the Czech economy seems to be on pretty solid ground (as may also be the Slovenian one), and you do need islands of tranquility in Oceans of tempest. So some countries will for this very reason prove to be win-win, while others may well, by the same token, prove to be lose-lose. Unfortunately historic reality is seldom just.

I also would be much more cautious than Christiansen is about Russia, political instability is evident, as are labour shortages. We need to see what happens next to oil and other commodity prices before sticking our necks out on Russia I think.

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