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Tuesday, February 26, 2008

Latvia Employment, External Trade and Producer Prices

Unemployment in Latvia seems now to have started to rise steadily accoring to the latest data from the Latvian State Employment Agency (NVA). Although slight, the increase in unemployment in Jan 2008 to 5 pct points to qualitative economic and labor market change, NVA said. And I completely agree. The market seems to have turned in November.

The level of registered unemployment had declined steadily from 8.7 pct in late May 2004 to 4.8 pct in November 2007. Since November the tendency is now up again. This is yet more indication of the presence of an economic slowdown in Latvia.

The unemployment rate in Latvia at the end of 2007 was 4.9 pct of the economically active population, while at the end of 2006 it was 6.5 pct. The unemployment rate increased 0.1 percentage point in January 2008 over December and reached 5 pct of the economically active population. There were 53,325 unemployed registered with NVA in late January 2007.

So my feeling is that Latvia is now out of the "extreme overheating" stage - and probably came out around in May-June (which isn't to say there wasn't a lot of momentum left in the system at that point). If you look at the charts included in my December Retail Sales post earlier this month you will see that retail sales growth really peaked during the first quarter.

Also manuafacturing output has been in fierce retreat since July, while the property market seems to have turned around May-June. In part this exiting from overheating will have happened becuase a process as fierce the one which took place in Latvia almost has to choke itself out of its own accord, and also possibly because of the tightening of the credit conditions applied after April, and the impact of this tightening on the housing market.

Also if we look at this unemployment data, it is clear that the labour market turned in October/November, and employment is normally a lagged indicator, which means it only responds after the horse has started to bolt. So my feeling is the overheating situation is now dead and gone, and what people need to think about are cushions to try and soften the landing. Which is why I am not 100% opposed to the idea of fiscal loosening at this point.

Exports and Imports

According to the latest data from Latvijas Statistika:

Compared to November 2007, the value of exports in current prices in December 2007 decreased by 10.8% or 39.8 mln lats, but in comparison with December 2006 it increased by 12.9 % or 37.4 mln lats, reaching 328.0 mln lats, according to Central Statistical Bureau data.

However, the value of imports in current prices in December 2007 was 8.4% or 54.3 mln lats lower compared to November 2007, but in comparison with December 2006 the decrease comprised 6.2% or 39.5 mln lats, reaching 593.0 mln lats.

The total foreign trade turnover in December 2007 was 0.2% or 2.1 mln lats lower than in the corresponding period of the previous year and its value was as high as 921.0 mln lats.

The value of exports in current prices in 2007 reached 4025.2 mln lats – more by 732.0 lats or 22.2% compared to 2006.However, the value of imports in current prices in 2007 was more by 1342.5 lats or 21.0% compared to 2006 and reached 7721.0 mln lats.

So while year on year exports were still up by 12.9% year on year, they were DOWN by 10.8% on November, and indeed exports in November were down on those in October. And although the trade deficit reduced slightly, this is not the result of exports powering ahead to drive growth.

In fact the reduction in the trade deficit is basically a result of the fact that imports were falling even faster than exports, and indeed the year on year rate for imports is now negative. Which is a reflection I feel of the way in which internal demand in Latvia is now contracting rapidly. But if internal demand is contracting, and exports start to fall, then, if the governemnt go for a fiscal surplus, we should expect Latvian GDP to start to contract at some point, shouldn't we?

What we should note about the above chart is the slope of the imports chart. We should be getting used to seeing this in internal demand charts for the Baltic economies at the moment. We may also not that while year on year the rate of export growth was positive, the rate of increase is slowing by the month. One reason, apart from the slowdown in Germany, that this shouldn't surprise us is the degree of trade interlocking among the Baltic states. Latvia's two most important export destinations - and by quite a long way - are Estonia and Lithuania, and if internal demand is about to subside in these two countries, then so are Latvian exports.

Producer Prices
Latvian producer prices in January were up 10.9 pct year on year and 1.3 pct compared with December last year, according to the latest data from the country's central statistics office.

Obviously the rate of increase in the PPI is now slowing rapidly, although there is still some considerable distance to go. Perhaps the most noteworthy trend in January was that export prices reversed to downward trend of recent months, and were up 1.7% on December. This is not good news. It certainly won't help to reverse that downward trend in exports.

Bottom line, the Latvian economy is now cooling rapidly, and looks to be headed towards contraction at some point in the not too distant future.

Monday, February 25, 2008

Hungarian Central Bank Removes Trading Band

The Hungarian central bank unexpectedly allowed the forint to trade freely on currency markets this morning, according to official explanation "to help Hungary's euro adoption preparations".

“The abolishment of the exchange rate band is an important step towards the adoption of the euro in Hungary. A floating exchange rate regime creates more favourable conditions for the central bank to achieve its inflation target, and via this to meet the nominal Maastricht criteria and to enter the ERM-2."

“Given the openness of the Hungarian economy, the exchange rate will continue to play an important role in forming inflationary processes. If other developments in the economy fail to counterbalance, a sustained and considerable change in the nominal exchange rate will be reflected in the central bank's inflation prognosis and as such will exert an impact on monetary policy."

The forint's trading band is going to be scrapped with effect from tomorrow, with the bank adding that the decision was made jointly with the government. (So all those who were forecasting "not under this government they won't" got this one wrong too). The forint climbed as much as 2.3 percent in the trading session which followed the announcement, rising as high as 258.5 per euro at one point, and trading at 262.15 as of 7:05 p.m. in Budapest, which was up from 265.14 on Feb. 22. It was the currency's biggest daily gain since June 28, 2007, and in fact the forint has been falling of late, dropping 3.4 percent this year, the third- biggest drop among the nine European emerging-market currencies which are openly traded. The euphoria however may be short lived, since Hungary continues to face substantial economic problems, inflation is continuing above the central bank target, and under the stagflation dynamic which the economy now seems to have fallen into we are far more likely to see increased downward pressure emerging now that the theoretical safety net effectively provided by the band has been removed.

Hungary set the existing trading band seven years ago as part of its preparations for adopting the euro. Under the system, the forint was allowed to trade between 240.01 and 324.71 per euro. As can be seen this was a rather theoretical limit, since the forint was in fact trading well into the upper half of the band. Now of course the sky is the limit, in either direction.

The central bank has missed its 3 percent target for inflation in both of the past two years, and the current forecast is that consumer prices will rise by 5.9 percent this year and 3.6 percent in 2009.

The biggest challenge facing policy makers at present is to turn round an economy that expanded by a year on year rate of only 0.8 percent in the fourth quarter of last year - which was the slowest pace in the European Union. Annual inflation was running at 7.1 percent in January, down from the annual rate of 7.4 percent attained in December.

This development certainly makes my "three tipping points" argument advanced some ten days ago look not too bad at all, since this unexpected movement coincides exactly with the second of the forthcoming critical moments I identified, namely the rate-decision announcement from the central bank (although it appears from statements from central bank sources that the decision was taken on Sunday in consultation with the government, and thus policy deliberations at this weeks meeting already had the decision as a backdrop).

Portfolio Hungary quote Nigel Rendell, Royal Bank of Canada, London as follows:

“By scraping the HUF band the central bank hopes that an appreciating currency will do the trick. However, the risk remains, particularly against an uncertain global environment, that the HUF rally runs out of steam. This would leave the NBH in a very difficult situation, particularly if there are disappointments on the inflation side."

Basically I think this is the point, when the HUF rally runs out of steam the NBH is going to be in a very difficult situation indeed, and it will run out of steam when Hungarian housholds let up on their frenzy to borrow money in Swiss Franc denominated loans, a decision which may be made easier for them now that the band has been removed and the currency risk is evident to all. A difficult decision, but then maintaining the band was only encouraging people to keep going on contracting the loans.

Statement wat NBH's post-meeting press conference were hawkish, trying to create the impression that that rates would be raised if upcoming macro data (e.g. CPI, wages) failed to indicate a lower risk of second round effects - ie that rate policy is going to be driven by macro data. This is really near bravado on their part, since the reality is, and they must know this, that the decision to remove the band means that it is policy towards the HUF that is now going to be the main focus of interest rate decisions.

The interesting question is what happens next? Clearly, simply indicating that they want the currency to rise on its own won't get the currency to rise. It had been falling in recent weeks, and this is the tonic - in the absence of future rate rises from the bank - that we could expect to see continue. Really this decision has been taken - as I am suggesting - to avoid taking another one, which is whether to raise or lower interest rates. It seems the bank would like to give the impression that it wants to be firm on the rates front (which would imply rate rises) since otherwise talk of upward movement in the forint doesn't make sense, but that it could only get the government to agree to scrapping the band by holding fire. In fact the few that the HUF is about to weaken significantly seems to be strongly held by one group of analysts. Citigroup's Budapest-based Eszter Gargyan for example, who is cited by Bloomberg as saying.

``Rate hikes in the coming months cannot be avoided...Those who favored keeping rates on hold wanted to see the initial market reaction before taking further policy action, but the'' central bank ``is likely to act if the forint fails to strengthen.''

JPMorgan analyst Nóra Szentiványi is saying she expects a 50 base point rate increase spaced across the next two meetings assuming there is no HUF rally (which she doubts there will be).

Skandinaviska Enskilda Banken (SEB) have also stated that it is their view that the forint will remain vulnerable to any reduction in risk appetite, given the macroeconomic situation in the country and rising political risks in the run-up to the referendum on 9 March. (Hard to say whether they are reading me, or I am reading them at this point, since our views coincide entirely in this regard).

On the other hand, the economy itself continues to head downwards, and with more fiscal tightening on the agenda and a more difficult extrenal environment as the eurozone economies themselves slow it is hard to see where growth can come from, and the economy seems in bad need of some sort of stimulus shot or other. So we really now move over to the political front, and need to ask ourselves how much more of this type of medicine with no tangible results is the Hungarian voter actually going to put up with without making some sort of protest. Which brings us back to the third tipping point, the proposed referendum for March 9th.

The History of the Band

The HUF trading band system was effectively created as part of what has become known as the Bokros package, which was announced in the spring of 1995. The key component of this package for our present purposes was the shift to a crawling peg exchange rate regime with a narrow (+/-2.25%) fluctuation band.

In May 2001 the HUF band was widened to +/-15% from the original +/-2.25% (at EUR/HUF of around 273.50), but the crawling peg devaluation system remained in effect. The expansion of the band was followed by a considerable HUF strengthening.

The crawling peg devaluation system was abandoned on 1 October 2001, and the central parity of the band “settled down" at 276.10, allowing an effective fluctuation in the HUF between 234.69 and 317.52. In January 2003, the (NBH) thwarted a "hot money" attack against the top end of the currency band, by buying EU 5.2 b in the open market and slashing interest rates. In late May, the bank annouced that it had resold EUR 3.8 bn and stopped currency market interventions.

In early June 2003 the central bank and the cabinet devalued the central parity rate by 2.3% to 282.36 against the euro from 276.10. While this did not constitute an official forint devaluation, it still triggered a massive slide of the HUF to below 270 vs. the EUR. By this action the central bank effectively allowed the HUF to fluctuate in a band ranging from 240.01 to 324.71.

The official rationale behind the parity shift was that an overly strong forint (below 240 vs EUR) was not in the interest of economic policy The move - as iw wryly noted by Portfolio Hungary (to whome many thanks for the background information which forms the basis for these notes) was later called a mistake by both the NBH, government officials and economists.

Finally, on Monday 25 February 2008 the band was scrapped.

Sunday, February 24, 2008

Estonian Wages Q4 2007 and The Growing Credit Squeeze

Christoph Rosenberg has a post up on the RGE Europe EconMonitor where he argues he thinks a soft landing for Estonia is both possible and likely, always given, as he says, that the right policy options are adopted.

In fact Christoph is reporting on an academics and policy makers seminar on Baltic Convergence recently held in Brussels. The seminar was jointly organized by the IMF and Eesti Pank, and both he and his fellow blogger Karsten Staehr attended.

The gist of the argument presented by the participants was with the right policy mix a hard landing can be avoided in the Baltics. I have serious doubts about this, and in particular due to the relative time scales of the remedies being proposed and the rate at which the slowdown is taking place. That is, most of the remedies being offered appear to be longer term in their horizon of operation, whilst the crunch is actually coming in the Baltics over the next six months or so, ie in the comparatively short term.

What I feel for the "soft landing" argument to be more convincing is that we would need to be seeing more evidence for it in the data. But if we look at what we have, we can see that the deterioration is continuing, and at a pretty rapid pace.

Noone seems to be addressing head-on the central issue which would seem to be whether or not what we had in the Baltics was a demand bubble inspired by the designation of certain categories of property lending as worthy of investment grade, and a low interest inward flow of funds and loans in non-local currencies which appeared to be underpinned and guaranteed by the condition (ie not the option) of euro membership for all the new EU10 accession countries. What noone seems to have thought about was the impact on the macro economic dynamics in the short run of a rapid transition from win-win to loose-loose as the door has been steadily closed in the applicants face. Slovenia seems to have been the last one in before the door was temporarily closed, with Slovakia poised perilously like a man on a ledge half way up a cliff face, not knowing whether to continue climbing tenaciously upwards (or to jump now before he gets any higher), even as the ever stronger inflation-driven-gusts of wind and rain make his footing weaker and more tenuous with every passing step.

And if the whole thing was a bubble, what can we ultimately expect from the reversal of fortune, and the schocking grip of debt deflation? Obviously any such thing seems a long way away at the present moment, as what we are faced with is an exceedingly hard to eradicate bout of inflation. Just how serious this position is in the face of the continuing slowdown is brought home by the last set of inflation figures, and todays announcement from the statistics office that wages actually rose in Q4 2007 at a year on year rate of 20.1%. Estonia's inflation rate rose to almost a 10-year high of 11 % in January (see chart below) following a 9.6% annual rate in December. So while domestic demand is rapidly slowing, inflation is still accelerating.

This process will not, of course, continue indefinitely, and at some point we will see the reverse face of this, as price deflation gets its grip when demand falls below capacity, as it obviously is going to do. We have two lines moving in opposite directions and at some point they will cross. What we can say is that given the major suplly side capacity constraint has been labour, it should not surprise us if we find the phenomenon of extremely "sticky wages" in the Baltic context. And so, it is, indeed, wage growth in Estonia, as I have said above, remained virtually unchanged in the fourth quarter from the previous one. The average monthly gross salary rose 20.1 percent from a year earlier to 12,270 krooni ($1,161), compared with an increase of 20.2 percent in the third quarter, accdoring to the statistics office in Tallinn earlier today.

Wages have risen due to labor shortages as Estonia's ageing population and an outflow of workers to wealthier countries have steadily pushed unemployment to a 15-year low of 4.1 percent in the fourth quarter. The impact of these ongoing increses in wages can be seen in the continuing high inflation in producer prices , and even more importantly in the continuing increase in export prices. Since domestic demand (ex government spending, and EU fund transfers) may well start to contract at some point, exports are the only real hope for the Estonian economy in sustaining GDP growth in positive territory, but just how far Estonia has to go in putting things into line to do this can be seen from the comparison between export producer prices in Hungary and Estonia shown in the chart below. Export prices have been falling in Hungary for nearly a year now, and as a result Hungary now has a small goods trade surplus. Estonia has still to really start this process.

And remember, with each month that passes and producer prices continue to rise (ie the PPI index remains above zero price growth), the more pressure there is on the competitivity of Estonian exports and logically the more pressure there is on the kroon peg. Enough said, I think.

Strong Growth Slowdown

Estonian economic growth more than halved last year reaching a year on year rate of 4.5 percent in the 4th quarter (according to preliminary data), and this was an eight-year low, in the fourth quarter. A rapid decline in the rate of wage growth is crucial if Estonia is to avoid a sharp slowdown as even central bank Vice Governor Marten Ross admitted earlier this week. If we look at the quarter on quarter growth rate chart, the dramatic nature of the decline is evident. As I keep saying, I don't know what sort of charts the people who argue the soft landing view are accustomed to looking at, but I humbly suggest that the sloe is a lot softer than the one we are looking at here. And the fact that year on year Estonia is still growing at 4.5% is hardly reassuring, since we are only in the early throes of the slowdown at this point, and there is no sign in the line of any significant slackening of pace. When we get to see some "bottoming" then we will be able to make some initial damage assessment, but the airplane is still loosing height, and fast, at the moment.

More evidence of the way things are slowing down comes from industrial output data. Output is in free fall downwards (see chart below, as are retail sales which is showed in a chart above), until we can see some sign that this rapid rate of deterioration is slowing it is far too premature for people to start arguing they have evidence of a soft slowdown (rather than expressing their hope that his will be the case, but here as ever, hope is one thing, and evidence to justify the hope quite another).

The important point to grasp here is that this is now all about timing, the whole drama looks likely to be played out over the coming six months, and unfortunately many of the remedies being advocated by Brussels and the IMF, including facilitating the switch of production and investment from non-tradable sectors to tradable sectors, and the strengthening financial supervision are longer term measures. And in any event are so obviously commendable (I mean, who at the end of the day would disagree that the violent husband SHOUL stop beating his wife) that they risk being platitudes: the question is the how.

And one of the recommendations, that "wages should be flexible and remain in line with companies’ competitiveness and productivity conditions, just went out of the window, at least as far as this downturn is concerned".

Which leaves us with the fourth recommendation, that "fiscal policy should not seek to offset a contraction in demand, even if the Baltic economies enter a period of slow growth". Being very contrarian, even here I have my doubts. We need to take into account that the recommendation to increase the fiscal surplus was issued in one situation, and we are now very rapidly entering another one. Before the problem was excess demand, and now the problem is going to be lack of it (again in the short term). Unless the Estonian authorities plan to do something more radical than I am contemplating they will do in the short term about the peg, Estonia will effectively be without conventional monetary policy tools in this situation (as it was in the situation which lead up to it). To deny the Baltic economies fiscal alternatives given the gravity of the sitiuation they face would, to my mind, be unduly conservative. Demand management is about just that, slackening demand when there is too much of it, and increasing demand when there is insufficient. So for exactly the same reasons the IMF were argeuing for fiscal tightening one year ago (that there was no effective monetary policy tool available) I would suggest we could consider the opposite policy now, especially since the global credit crunch is now steadily tightening its vice across Eastern Europe. Basically if it makes sense to brake at the end of the straight as you enter the curve, it also makes sense to accelerate and not hit the brake even harder as you go round it. You don't have to be Fernando Alonso to know that. And of course we are only talking about short term stimulus here, not long term structural policies, but since the Baltic economies - unlikely Hungary and Portugal, have comparatively low levels of debt to GDP, then they could well permit themselves this option I feel (according to Eurostat data, accumulated government debt as a % of GDP - ie not the annual deficit, the entire sovereign debt - for Estonia in 2006 was only 4.1% of GDP, for Latvia it was 10% and for Lithuania it was 18.2%, ie this is a pittance, and there is leeway for demand management cushioning, which is why I did not look so negatively on the proposal from the Latvian government to change tack at this point, of course they should have been braking hard six months to a year back, but we are now past that point, and it really isn't useful at this stage to be simply crying over spilt milk. There will be plenty of time for post-mortem's later).

And doubly so, since one of the other favoured arguments about why the Baltic countries can avoid a sharp slowdown - namely that the Scandinavian Bakns will help them manage the situation - is looking wobblier by the day. Cristoph advances what is a very common argument:

In particular, the financial sector is de facto owned and operated by Nordic banks. Since these banks have a strong stake in the Baltics’ economic future, a sudden Asian-style stop of funding seems unlikely. By the same token, however, these close ties put the fate of the Baltic banks into the hands of just a few Nordic parents and their ability to weather the global financial turmoil.

What this argument tends to forget, however, is that these banks themselves are not charitable institutions, but have their own balance sheets and credit ratings to think about. This point was brought home ealrier this week by Moody's Investors Service that it is cutting its ratings for Estonian banks on concerns of weakening asset quality due to high exposure to the cooling property market. Moody's assigned a negative outlook to Estonian banks, including AS Sampo Pank, fully owned by Danske Bank A/S, and Balti Investeeringute Grupi Pank AS.

Virginie Merlin, senior analyst with Moody's in London and author of the report, is quoted as saying that the move ``naturally'' follows the decision on Jan. 18 to lower the outlook of AS Hansapank, the top Baltic lender and a fully owned unit of Swedbank AB, to ``negative'' from ``stable.'' Hansapank accounts for more than half of Estonia's banking industry assets.

According to the report "Moody's primary concern is that the rapid loan growth has led to unseasoned portfolios with high concentration on the mortgage and real estate sectors....We therefore see a growing risk of a deterioration in the banks' asset quality if the economic outlook continues to soften"

And I think this is hardly unsurprising news, these banks cannot simply sit bank and watch their credit rating and asset quality deteriorate simply because it would be the "politically correct" thing to do.

Cooling Down in Eastern Europe?

by Claus Vistesen

Just as we are nearing the transition from Winter to Spring here in Europe which traditionally promises to bring more pleasant and mild weather it seems as if Eastern Europe might just be getting a much welcome dose of cold air to quell its many overheated economies. This fresh breeze of cold air was inevitably coming in helped along from the breath of the illusive credit crunch and essentially it is also, in this respect, much welcome.

Yet, the issue which now confronts Eastern Europe and many of her economies is not so much the confusing sequence of seasonality but rather how not to freeze over completely and tumble into a hard landing. Here at Alpha.Sources and elsewhere I have been adamant in my description of the issues in Eastern Europe and how I think the situation may turn out worse than many observers think. None of us know of course; we can merely asses the facts as they are presented for us and follow closely the incoming data. Two recent very worthwhile contributions to the debate on Eastern Europe and more specifically the Baltics are presented to us in the context of RGE's Euromonitor where Christoph Rosenberg and Karsten Staehr posts separately on the topic at hand. Christoph and Karsten seems to more or less agree with respect to the main thrust of their arguments. Both authors write in the context of a recent conference organized by the IMF and Eesti Pank where the Baltic situation was discussed. Karsten also refers to his recent article in the monetary review from the Danish Central Bank.

Both the authors in question field arguments which are somewhat different from my own and my colleague Edward's and in this light I think it would be most interesting to go through some of the points and see whether we cannot learn something from each other?
Let us commence with the question of whether the Baltics will experience a hard or a soft landing? At this point in time it is very difficult to see. It is certain that we are now seeing signs of significant slowdowns not only in the Baltics but across the whole Eastern European edifice. The tricky question we all want to answer is the extent to which this slowdown will turn into a rout and a possible economic crisis of some sorts. In this entry I will focus on the Baltics as I try to scrutinize this question although I need to emphasise the need, in this context, to keep a weary eye on Hungary and Romania where especially the former is beginning to look increasingly shaky by the day. Regarding the Baltics Christoph makes the following important point ...

In particular, the financial sector is de facto owned and operated by Nordic banks. Since these banks have a strong stake in the Baltics’ economic future, a sudden Asian-style stop of funding seems unlikely. By the same token, however, these close ties put the fate of the Baltic banks into the hands of just a few Nordic parents and their ability to weather the global financial turmoil.
The dynamics here represent a very important point to take aboard. The past years' expansion and subsequent build-up of large negative external positions in the Baltics have mainly been driven by consumer and mortgage credit supplied by foreign (most notably Scandinavian) banks and credit institutions. In this way, the Baltic economies are very dependent on this link not only to keep the external position from not correcting too quickly which would happen if the foreign banks suddenly closed shop and retreated their fangs but also in order to keep and restore confidence in their economies and most importantly the currency boards tying their currencies to the Euro.

Quite simply, the Baltics need these banks to now follow them down into whatever the current slowdown will bring. Will the banks be ready for this? So far, there has been no obvious signs of distress from the banks operating in the Baltics apart from words of warning from the rating agencies directed towards Hansa Bank and its operations in the Baltics. Some would even point to an upside in all of this. The recent 4th quarter results by two of Scandinavia's biggest banks Nordea and Danske Bank suggest, that they, contrary to their continental and transatlantic peers, have been dodging the incoming bullets from the credit market turmoil to such an extent that even Neo from the Matrix should be nodding approvingly. But the global credit market environment is only now waking up to the hangover from the past 5 years' exuberant credit expansion and we have already seen how the credit crunch has affected anything from regional cajas in Spain to indebted Hungarian households.

In this light I remain less sanguine but concur that each day passing without further signs of distress is a good one. It remains certain then that a lot of importance can be hinged on the extent to which the foreign banks are willing to continue their operations in the Baltics as well as the extent to which they are willing to let the credit taps stay open. Karsten seems to be rather optimistic in the face of the credit market turmoil.

The positive side effect of this [the subprime crisis] is that indebted borrowers in Estonia, Latvia and Lithuania will not face larger debt servicing payments, which again may reduce the likelihood of widespread bankruptcies. The global financial setback may thus have led to exactly the form of financial restraint that the overheating Baltic countries need.

This is kind of reverse causality relative to the way I have traditionally narrated the credit crunch in the context of the Baltics and Eastern Europe. However, this does not mean that Karsten is not right in the main. My main gripe would be that the slowdown was bound to come anyway as the labour market tightening and subsequent credit fuelled wage growth was bound to finish at some point entirely because of reasons endogenous to the Baltic situation. In this light, the credit crunch hardly comes at a convenient time since it may lead to the credit and financing of the external balance being pulled too quickly.

The second point I want to discuss is relates to the whole situation surrounding the currency pegs in the Baltics. Many commentators, including yours truly, have emphasised the risk of a run on one of the Baltic currencies which would take the form of a Asian crisis style test of the currency boards and thus ultimately by derivative the ECB's willingness to provide assurance. Christoph however seems to be lees convinced ...

These pegs have proven to be remarkably resilient, surviving the Russian crisis as well as recent attempts by outside market players to take positions. Speculators have not found a chink in the armor because the spot market is tiny and a forward market non-existent (contrary to the impression generated by those quotes on Bloomberg screens). From the Baltic governments’ point of view, abandoning the euro pegs, even in the face of mounting external pressures, would likely create more problems than it solves, given that many households and enterprises have borrowed in euros.

The illiquidity, or in the case of the forward market non-existence, of the FX market in the realm of the Baltic currencies is an important case in point. It is unlikely that the Baltics will be the first in line in connection with a potential currency run in the context of Eastern Europe. That dubious honor seems to have landed at the front step of Hungary and Romania. However, the fixed exchange rate regime represents another mounting problem for the Baltics in the current situation. How are they going to correct? This brings us into the heart of the predicament in my opinion and thus how the Baltics are in a bit of a bind. Consequently and as Christoph himself points out fiscal stimulus can not be used to counter the current downturn since in the end we are talking about a deficiency of external and not internal demand. Yet, this is also a textbook case of the ever recurrent trilemma often cited in the context of international economics. With free capital movement and a fixed exchange regime monetary policy is out as well as is de-valuation. Moreover and as noted, since fiscal policy also seems to be out of the question (some are even talking about a contraction) we are basically letting the reigns go hoping that the chariot won't fly off the cliff.

Those of you with Austrian inclinations would undoubtedly be cheering away at this point emphasising out that this is the one and only way that these economies can correct. This is a discussion for a separate post but suffice to say that there is a distinct possibility that all this will end in deflation since absent the adjustment mechanisms cited above this is the only conceivable way to break the vice. It is important to note that there is nothing deterministic about this scenario but it may in fact happen. And once we allow ourselves to consider the possibility we need to ask whether it wouldn't really be better to devalue in order to restore external competitiveness? However, this can hardly be seen as an ideal outcome either since as Christoph notes in a faint sentence, and as I have analysed extensively, Baltic enterprises and households would be severely exposed as a large part of the outstanding stock of loans are denominated in Euros. This brings us back to the question of deflation and whether the foreign banks would stay put in such an execrable macro environment and ever so important how such an environment would affect the tendency of net outward migration. I cannot say that the chain of events will play out as I am suggesting. But there is a risk. In the concrete context of Karsten and Christoph they both seem to end their analyses on a somewhat open note with a tendency to lean towards the soft landing scenario.

So, if this was the immediate cyclical perspective how might the longer term structural perspective aid us in the answer of whether in fact this will be a soft or hard landing. Following a graph of quarterly growth rates (y-o-y) in the Baltics Karsten makes the following noteworthy point ...

The figure clearly shows the very high trend growth in the Baltic countries, only interrupted by the downturn in 1999 as fallout from the Russian crisis. Given the low initial income levels, part of the impressive growth performance can probably be explained by ‘catch up’, where import of technology and organisational knowledge speed up growth. In 2006, the purchasing power adjusted GDP per capita in the Baltic countries still amount to approximately 50-60% of the EU27 average.

The important point here is the idea of catch-up growth and more specifically how catch up growth is related to the demographic profile of almost all Eastern European countries. You see, the very impressive growth spurt we have observed since the Baltics' accession into EU has not come without a cost. Two stylised facts are important to tune into here. Firstly, there is the steady trickle of labour out of the CEE and Baltic economies into Western Europe. All these 'Polish plumbers' which has become the catch-all phrase for the east-west migration have undoubtedly aided in amending supply side issues in the receiving countries and in some cases even boosted trend growth (e.g. in the UK). However, it has also intensified the pressure on wages and thus inflation in Eastern Europe not only because of their physical numerical absence but also because of the human capital component as many of these workers are those in the highest end of the value chain (i.e. most productive) relative to the countries they are leaving.

The second point we need to remember is quite simply the point that the Baltics and their Eastern European peers have moved through the demographic transition far more quickly than economic development has had time to really sink in. Notable and important differences clearly exist between the Baltics and many Eastern European countries but the stylised facts remain. So, this is, in fact, not a question of being right or wrong in terms of calling the immediate cyclical outcome of the slowdown but about a deeply structural problem. In this specific light it would be most severe if the Baltics and/or Eastern European countries tumble into deflation since this would potentially intensify the emigration as well as make it much harder to accomplish that much allured catch up growth. In essence, I agree then with Christoph when he concludes ...

The lesson for the governments and citizens in the Baltics is that they should lower their expectations, be it with respect to income growth, large-scale public investment projects or speedy euro adoption. Modesty and prudence are the best insurance against falling into the Portuguese slow growth trap—or experiencing a sudden Asian-style output contraction.
This is indeed the case but take note. The lowering of these expectations may be much more permanent and enduring than you might imagine and as such it is rather important that the tumble is not too rough. I guess that my main addition to Christoph's list of solutions as he presents them is quite simply that we take a look at the demographic edifice of the region and individual country since if we don't, the situation is not likely to improve much in the long run.

In Summary

In this note I have reviewed a number of arguments recently made on the Baltics from Karsten Staerh and Christoph Rosenberg over at RGE's Euromonitor. I think the two authors' analyses are very solid but I do have a few objections and niggles when it comes to the main conclusions. I concur that the extent to which the Baltics or one of three will experience a hard landing is a difficult question to answer at present. It is clear that Q4 2007 marked the beginning of a notable slowdown across most parts of the Baltics and Eastern Europe and now we will see how 'bad' it turns out. Above, I have highlighted reasons as to why I tend to lean towards the pessimist narrative but also realise that both Christoph and Karsten field arguments to the contrary. There are three main reasons why I am on the pessimistic side of the median ...
The risk of contagion. Events in Hungary and Romania point to a deterioration of economic fundamentals by the day. The laws of economics do not as such prescribe that this need to affect the Baltics but since the underlying issues are much the same I do think that the risk of contagion is there. The most important potential transmission channel of such contagion would be the extent to which a debt crisis and subsequent withdrawal of foreign credit in one country could lead to similar events in another country.

The lack of adjustment mechanism due to a fixed exchange regime and translation risk due to unhedged cross-currency liabilities of households and corporations. The main risk as I see it is that one or more of the Baltic countries will slip into deflation on the back of the current slowdown. The alternative which would be to un-shackle from the Euro hardly seems positive for two overall reasons. Firstly, the ensuing debt burden levied on economic agents in possession of Euro denominated loans would be quite severe and secondly there would be political issues as the prospect of future entry into the EMU would be seriously dimmed.

Finally, I tend to assign a rather strong weight to demographics as a variable in this whole situation. In my opinion a large part of debacle many Eastern European countries now find themselves in is due to their unique demographic situation. Focus is needed here I believe and especially we need focus on attempts to raise fertility and to keep people from leaving. As a Dane I see how those Polish plumbers have been a most welcome addition to an overheated Danish construction industry and I can also see how Ireland and the UK have benefited from Eastern European labour. But, we need a more balanced focal point on this and one which also takes into account the impact on the sending country. Remittances are fine indeed and so are claims that migration is temporary but this is also part of the whole edifice. In this way, the degree to which Eastern Europeans choose to stay in their current country of residence seems to be somewhat proportional to the potential severity of the current slowdown.

Saturday, February 16, 2008

The Czech Republic, A Classic Case Of Bad Timing?

The Czech Republic's economy unexpectedly expanded accelerated in the last quarter of 2007, graowing at the fastest pace in two years, fueled by investment, solid exports and rising employment. Gross domestic product grew at a 7.0 percent annual rate on a seasonally and working day adjusted basis (preliminary data), compared with a revised 6.4 percent in the third quarter, the Czech Statistical Office said today. The Office also announced that the economy grew 6.6 percent in 2007.

The quarterly rate of expansion accelerated from the 1.4% achieved in the third quarter to a full 1.9% in Q4.However it should be noted that the statistics office single out expenditure by health insurance companies, which are classified as part of the general government sector, as contributing to the GDP increase by approximately 0.5 percentage points (ie a good part, if not all, of the acceleration). They suggest that this is probably due to higher demand for health services which remained free till the end of the year and in anticipation of the introduction of medical fees for certain services in 2008. So much of this may well be "one off".

Following the news the koruna had its biggest weekly gain in 5 1/2 years - rising for a fourth succesive week - and at one point was up by as much as 0.7 percent on the day (at 25.080, its highest level ever against the euro), before closing at 25.193 by 4 p.m. in Prague. In the last week it has advanced by 2.4 percent, the fastest rate since June 2002. So far this year the koruna has been the best-performing of the nine European emerging-market currencies, gaining 5.5 percent against the euro.

Household consumption has bolstered the Czech economy's expansion for almost two years now, and is driven by accelerating wage growth, a 30% y-o-y rate of increase in lending and a decade-low jobless rate. The very low number of people now remaining unemployed has given rise to concerns that if the economy should continue to grow as quickly as it is doing currently, then wage-cost driven inflation may get the economy in its grip in the way it has done in other EU10 economies. The average nominal hourly wage in industry rose by 11.3% in December 2007 over December 2006, while the average monthly nominal wage in industry rose by 7.4% in 2007 when compared with 2006.

The extra growth is certainly creating employment, and there were 1.9 percent more people working in the economy during the last quarter of 2007 than there were one year earlier. Still, the statistics office (although it gave no details, for thpse we will have to wait till March) stated that household spending growth slowed in the fourth quarter (retail sales, for which we do now have December figures, rose only at an annual rate of 4.3%), dropping back from the 5.6 percent rate of increase of the previous three months, discouraged perhaps by the 4.4 percent inflation rate experienced over the period.

This change in the structure of Czech GDP growth, with consumer demand accounting for a smaller portion of expansion, and exports and capital investment accounting for more, is fueling central bank optimism that the inflation rate can gradually be clawed back to the mid-point 3 percent target by next year, from the whopping 7.5 percent registered in January.

The bank predicts GDP will grow 4.1 percent this year after an estimated 6.1 percent in 2007, thus being a touch more skeptical than the Finance Ministry who are currently advancing a 4.7 percent growth outlook for this year.

Long Term Structural Problems On The Fiscal Side

There is however still plenty of room for concern about the medium term evolution of the Czech economy. Only last week the European Union reiterated its call for the Czech government to address underlying fiscal pressures linked to the pace of population ageing in the Republic, and stressed that the administration needed to do more to prevent the creation of excessive budget surpluses. The call was made as part of the EU Commission periodic assessment of individual country convergence programmes.

The Czech Republic is by no means the oldest of the EU10 societies, indeed at around 40 the Czech median age is not especially high at this point (even by EU10 standards) - and Slovenia and Bulgaria have higher median ages.

(please click over image for better viewing)

But life expectancy in the Czech Republic is significantly higher than the rest of the group (coming second in this respect only to Slovenia) and hence the weight of pensions expenditure is likely to be greater than in many other states in the region.

As a result of this higher than average EU10 life expectancy, and many years of lowest-low fertility, the Czech population median age is set to rise very rapidly - to around 44 in 2020 - which means that the Czech Republic will soon be older than several West European societies (where there has been higher fertility and more substantial immigration) like France or the UK. And this despite the fact that the Czech Republic has been one of the few EU10 societies to be really proactive on the immigration front in recent years.

The Czech Republic's budget deficit is now within the EU 3 percent of GDP limit, but this is not the Commission's real concern in this report. Rather what are being raised are longer term structural and sustainability questions. The Czech government should "exploit the likely better-than- expected 2007 budgetary outcome to bring the 2008 deficit below the 3 percent of GDP reference value by a larger margin" the EU said in the report since "The Czech Republic remains at high risk with respect to the sustainability of public finances".

Essentially the EU is criticising the Czech Republic for failing to take advantage of the record economic growth to cut spending, overhaul the pension and health-care systems and reduce the deficit so it may be used as a stabilising cushion in the event of an economic slowdown. The Czech Cabinet has responded to the ongoing criticism from the Commission by amending the tax code, cutting welfare spending and imposing health-care fees. But the Commission is far from satisfied, and in particular they have said the following:

The Czech Republic appears to be at high risk with regard to the sustainability of public finances. The initial budgetary position in the programme is not sufficiently high to stabilize the debt ratio over the long-term. The long-term budgetary impact of ageing is well above the EU average, influenced notably by a substantial increase in pension expenditure as a share of GDP as well as a significant increase in health care expenditure. Implementation of structural reform measures notably in the field of pensions and health care aimed at containing the significant increase in age-related expenditures would contribute to reducing risks to the sustainability of public finances. While initial steps have been made to reform the health care system, reform of the pension system still lacks implementation against a definite timetable.
To date the Czech Cabinet has pledged to trim the public deficit to 2.6 percent of GDP in 2009 and to 2.3 percent in 2010, but given the rate of GDP increase, and the rapid rise in the koruna, a strong move in the direction of a budget surplus would seem to be called for.

The Czech administration, which in 2006 abandoned 2010 as the country's euro-adoption date, has pledged to overhaul the welfare, pension and health-care systems in an attempt to ensure that country is in a position to fulfill the EU fiscal rules after it accepts the common currency. One of the problems being faced is that the ruling coalition lacks a sound majority in the Czech Parliament, and has to rely on two former opposition deputies, which makes progress on serious reform an uphill struggle.

But if it remains substantially unamended, the current pensions system will weigh heavily on state finance during the coming years due to the rapidly increasing number of retired people and the shrinking number of potential contributors. The working age population - 15 to 64 - is set to shrink from around 7.25 million now to around 6.4 million in 2025.

While the elderly dependent population - defined as being over 65 - is set to rise from around 1.5 million currently, to around 2.25 million in 2025.

Now the numbers involved here are not excessively large, and the situation can to some extent be eased by immigration, raising participation rates, and raising the retiremnt age beyond 65. But it is important to note that all the countries in the region are facing - to a greater or a lesser extent - the same problem, so it isn't clear where the migrants are to come from, and if they ultimately will arrive from another continent, then this has implications for the cultural model on which these societies have been based to date. Which is not to say that such an outcome is unattainable, but simply that it is not going to be as easy in practice as it perhaps appears to be on paper.

On the pensions side the current problems are threefold: i) the excessive reliance on a PAYGO system, ii) the high level of contrubutions, iii) the low level of the retirement ages. Pension contributions currently total around 30% of employee earnings, of which 7.5 percentage points are paid by employees and 22.5 points by employers. These contribution levels are among the highest in the OECD, and only Hungary, Italy and Slovakia have higher contribution rates.

Following an earlier reform, the retirement age is gradually being increased from 60 to 63 years for men and from a range between 53-57 years to one between 59-63 for women (with the retirement age depending on the number of children they have had) between now and 2013. But such age increases are clearly far from sufficient. As a result the Czech cabinet agreed last Monday to raise the retirement age and lay the basis for wider pension reforms to secure the system's long-term financial stability.

The cabinet sent a bill to parliament which envisages a gradual increase in the retirement age to 65 by 2030 and an extension of the required length of employment. A further proposed step will follow later which involves moving from the current pay-as-you-go scheme to a partially fund-based system where people save for their own pensions. Czech pension payments are expected to reach 306 billion crowns ($17.34 billion) this year, taking up nearly 30 percent of the national budget, and will grow rapidly as the population ages if nothing is done.

Basically the big problem with moving from PAYGO to partially funded schemes is maintaining the payments from the PAYGO system during the transition. As a way of trying to get round this problem the government proposes to set up a fund fed by income from privatisations, with the idea being that the shortfall caused in the old system by the payment diversion into would be made up from the reserve fund. Many Czechs already have private pensions savings, which are supported by government subsidies and tax breaks, but the volume is too low to support them in retirement. The average Czech state pension is 9,111 crowns ($515.9) per month, about 42 percent of the average salary.

Bad Timing or Bad Decisions?

So much for the longer term issues, but the real danger facing the Czech economy at the present time is that a number of faulty short-term decisions, and a certain tardiness in reform coupled with an unhelpful external environment, may well cost the Czech Republic dear in the longer term.

In the first place the recent decision to raise administered prices in January has produced a sharp 2% hike in the annual inflation rate (from 5.4% in December to 7.5%in January). In particular the government raised value-added tax on basic items such as food to 9 percent (up from 5 percent), and introduced a 30 koruna ($1.71) fee for doctor's visits. In total the health service increases added 0.5% to the annual inflation rate. The price of electricity also went up 9.5 percent and natural gas 7.8 percent. State-controlled rents jumped 18.9 percent from their December level.

So the danger is that the application of such measures in an environment where growth is strong, and possibly even above capacity, and the labour market is extremely tight, may simply lead to an ongoing process of second round effects, where wage rises to compenate for inflation (or over and above the inflation rate) simply add more fuel to the underlying inflation dynamic. In order to try and avoid this outcome the central bank will undoubtedly continue raising interest rates. The bank has already raise rates five times since last June - at quarter point intervals (with the last raise being on the 8 February - and the current rate is at 3.75%. The prospect of the bank doing just this, coupled with the comparatively high rate of GDP growth, is already pushing - as we have seen above - the koruna ever onward and upward. If, as now seems likely, the Czech base interest rate should pass an ECB refi rate which was on the way down as the eurozone economy slows, then this upward pressure on the koruna might well accelerate, and the central banks attempts to restrain inflation with conventional monetary policy might well prove thwarted.

Added to this problem of inflation and a rising koruna, is the associated one of the evolution of the Czech trade balance. While the Czech Republic has so far enjoyed a fairly healthy goods trade surplus, this does not come by divine fiat, and changes in relative prices can erode the situation quite rapidly. Exports in December were up 5.2 percent year on year down down substantially from the 20 percent rate in November and the smallest figure in the whole of 2007. For the time being this is simply a seasonal blip, but the whole Czech external trade situation will now need monitoring carefully, and in particular given that the German economy now seems to be slowing, and the Czech economy is inter-locked with Germany (31% of the CRs exports went to Germany in 2007) to a very high degree.

In this context the position of the fiscal deficit of the Czech administration takes on even more importance. As indicated above, the Czech Republic's budget deficit is certainly likely to fall with the EU limit of 3 percent of gross domestic product this year, although the deficit may in fact widen to 2.95 percent of GDP from an estimated 1.9 percent in 2007. The original goal for 2007 was 4 percent of GDP, so the outcome is, in terms of the EU convergence process, not especially bad. But in terms of the current short and medium term macro environment, the projected level of deficit is certainly fraught with risk. Ideally the objective for 2008 should be a budget surplus. This would act as a brake on excessive growth as the koruna rises (since capital funds into the CR in search of yield will definitely increase in the short term) and both the surplus and the newly higher interest rates would provide something of a cushion should further deterioration in the external environment (and especially in Germany) lead the Czech economy to start to slow too rapidly. However, as noted above, the extent of the danger does not seem to be appreciated, and we are still looking at a deficit in the 2 to 3% range. The risk that this may provoke excess inflation which will be hard to eradicate later is real and present, and hence the evolution of the Czech CPI will need to be monitored closely, especially given that January's large base effect is now built in for the whole of 2008. We can only realistically expect inflation to start to come seriously down as we get towards the autumn, and only then if.......

Wednesday, February 13, 2008

Turning The Screw on Hungary; Three Possible Tipping Points

Hungary's forint firmed slightly today after standing up to several waves of pressure, settling around what still amounts to a one-week low against the euro. The mildly favourable retail sales data that came out in the US during the afternoon eased some of the pressures on emerging market economies and in the collective upswing the forint managed to get back below the 262 to the euro level. Just enough to knock out stop-loss levels, but hardly anything to get excited about. The forint had been as far down as 266 to the euro earlier last week - amid a spate of rumours which included the idea that the prime minister was about to resign, and that the central bank was about to announce an emergency rate cut (or was that increase, I never was sure which possibility was most in people's minds at that point). Indeed it was clear that a general downturn in global risk appetite which struck all across emerging market instruments was hitting Hungary's long-unsteady markets the hardest.

Hungary's economy has slumped to decade-low in growth following a government belt-tightening campaign aimed at straightening out its public finances.

Danske Bank Analysis

Portfolio Hungary reports this morning on the view of Danske Bank analyst Lars Christensen. Christensen's argument is that it is only a matter of time before the forint follows the leu, the kronur and the rand in weakening significantly. In particular he argued that the forint is not sufficiently protected by adequately high interest rates.

Since the outbreak of the global credit crunch in August 2007 many currencies in the EMEA countries which have been running large current account deficits and/or have accumulated large ratios of foreign debt have been under significant selling pressures. According to Christiansen:

“Most notable has been the weakening of the Romanian leu, Icelandic kronur and the South African rand, which have all weakened around 15% since the beginning of August. The lira has more or less been flat against the euro since early August and the forint has “only" weakened around 5%".

“While we clearly see a risk that these currencies can weaken significantly more, there is also a risk that this weakening will spread to other EMEA economies with similar problems. In particular, the Turkish lira and the Hungarian forint stand out,"

“While high interest rates in Turkey give some protection, it is hard to use the same argument for the forint and hence we believe that it is only a matter of time before the forint follows the leu, the kronur and the rand and weakens significantly."

(The base rate is currently 13.75% in Iceland, 11.00% in South Africa, 9.00% in Romania, 15.75% in Turkey and 7.50% in Hungary.)

As he points out, imbalances have been reduced in the Hungarian economy on the back of last year's tightening of fiscal policy, but the markets have also 'rewarded' the Hungarian government for this by not selling the forint as much as the continued large imbalances and large foreign debt could 'dictate'.

Also, as the global credit crisis drags on there is an “increasing risk that we will have a repeat of the forint 'crisis' of 2006", where the HUF fell sharply from around 250 against the euro to 285 in a comparatively short space of time. And the global financial environment at that time was significantly more benign than is the case at the moment. So a forint at 280 or below to the euro hardly seems an unlikely level at this point in time, and indeed Lucy Bethell from RBS was arguing exactly this earlier in the week.

In particular, Christiansen stressed that any “slippage" on fiscal policy in Hungary would hit investor confidence hard and this would also “likely lead to downgrades of Hungary's credit ratings". And this is just why tomorrows Q4 2007 preliminary GDP data will be so important, since if the figure slips to any great extent on the downside this is bound to place strong question marks around Hungary's 2008 budget targets which are - let us remember - based on government estimates of GDP growth in the 2.8 to 3% range.

And before we leave Christiansen's analysis, I would like to draw attention to one point: the comparison with Turkey. Back in August 2007, just after the credit market crunch started to close its grip, I wrote a long post (and an even longer analysis) of Turkey, where I tried to argue that even though Turkey's economy would come under pressure just like those of its East European neighbours, the underlying soundness of Turkey's demography, and hence the element of homeostatic regulation which it would enjoy following from any significant downward correction, meant that it could well emerge with a lot less medium term damage from the coming global storm than the rest of Eastern Europe. This view is now about to be tested, as indeed is the whole thesis that demography and fertility don't matter to economics. As I wrote at the time:

There are good theoretical reasons - at least if you take demography seriously there are - for imagining that the Turkish economy might well prove to be more robust than some of the Eastern European ones will under the strains the various economies are under and about to receive. These latter economies, despite their apparent vibrance are actually much more fragile under the surface, and it is for this very reason that the observed response differences bear examination day by day.

I Suppose That's The Hill Sergeant, and I Guess You Are Going To Make Me Climb It.

The most probable scenario we now face is for the forint to experience a succession of waves of attack, and a systematic attempt to knock it of the perch on which it is so delicately poised. All free-market economists of course believe in the workings of financial markets as a regulatory mechanism, but we don't have to believe they are fair, kind or forgiving.

There seem to be three critical tests facing the forint in the short term. The first is the GDP and inflation data coming tomorrow. Starting with the Q4 2007 GDP data, my opinion is that this will surprise on the downside, and possibly give every indication of just how unrealistic most of the 2008 GDP forecasts for Hungary currently are. The second is the inflation data, and here the Hungarian central bank is now almost certainly in a heads I lose, tails I lose situation. If the CPI - Hungarian inflation was running at an annual rate of 7.4% in December - surprises on the downside this may encourage currency dealers to feel that the central bank will bow to political pressures and reduce interest rates - a move which the collapse in Hungarian internal demand suggests is badly needed.

But the reduction in yield differential would make forint denominated assets less attractive, suggesting that the foring would face a more testing toime and that an acceleration in capital exit would probably occur. If, on the other hand, the data surprises on the upside - which after today's December agricultural PPI data (38.1% y-o-y) seems more likely, then this may lead people to feel that the central bank will have no alternative but to increase rates. Indeed many market analysts have now reached the conclusion that such rate rises are more or less inevtiable. The latest of these has been Gillian Edgeworth of Deutsche Bank, who today projected a total of 100-bp rate hikes in the next six months (over the course of the next six policy meetings.), and in this she has joined a fine galaxy of observers including Goldman Sachs and Citigroup - who are projecting a 50-bp hike at the 25 February policy meeting, while Citibank analyst Eszter Gárgyán is on record as saying she does not believe that even a 50-bp hike could be enough to stop the weakening of the forint. I am not sure how much of the macro-economics of what is involved in all this these forecasters understand, but I am quite happy to say that the sort of monetary tightening that Gillian Edgeworth is contemplating is just not posible at this point in the game, since, apart from the fact that it would send Hungary off into one whopping and unholy recession (especially if it was accompanied - as it would have to be - by a continuing tightening of the loan conditions on Swiss Franc mortgages, due to the hightened currency risk default issues), the political dynamics would not accept it. You can only ask people to accept so much belt tightening before they rebel, and we are already over 18 months into this round, so tolerance must be wearing thin, and another year of monetary tightening is most definitely out at this point. If you have any doubt whatsoever on this, look at what has happened in other countries in other epochs.

So, given that not all market analysts are competely devoid of foresight, any move to press the tightening trigger can alos lead to a similar conclusion to a rate cut about the desireability ditching Hungarian assets, since more monetary tightening would only close even further the noose which is currently extending its grip over the internal economy. Such are the difficulties when you back yourself so tightly into a monetary and fiscal corner.

The second hurdle, or critical point, the forint will have to get over - assuming it survives tomorrow - will them be the meeting of the central bank itself on the 25 February, and again rate policy decisions either way can have unpredictable effects, and once more it is likely that an attack will be mounted, regardless of the decision taken, given (as I argue above) there are sufficient reasons for doubting that either policy option is a good one. What all this amounts to is that the Hungarian central bank has now run out of policy options, and it is just a question of time before we get to see what the financial market participants decide to do about the situation.

Finally, and assuming that the currency passes muster relatively unscathed in the first two initial skirmishes, the cherry is most decidedly and firmly likely to be planted on the top of the cake if the proposed referendum on some of the more controversial measures in Hungary's adjustment programme actually gets to be held on March 9th. Since a vote to abandon the contested education and health service charges - which seems on the face of it to be the most probable outcome - would virtually present a frontal challenge to the whole "adjustment" process, it is hard to see how the Gyurcsany government could continue under the circumstances (even if there would be no formal obligation to resign). This kind of situation is, of course, "more power to my elbow material" for those market participants with an acquired taste for warm, freshly-spilled blood, and really if we got through to this point, without anyone having the presence of mind to take the bull by the horns first (by which I mean making a virtue out of a necessity, and openly accepting that policy is now in a no-exit bind, and that a significant drop in the value of the forint is both inevitable and desireable, depite the fact that there will be a lot of renegotiating and cleaning up to do in the aftermath), then the outcome may well not be a pleasant sight to watch.

Bulgaria Inflation and CA Deficit January 2008

Bulgaria's inflation rate was unchanged in January as food and fuel prices stayed put. The inflation rate remained at 12.5 percent, the National Statistics Institute said in a statement today. Consumer prices rose 1.4 percent on the month, following an advance of 1.1 percent in the previous month. The EU Harmonised CPI was up 11.7% year on year in January.

Transportation costs, which include gasoline prices and make up 17 percent of the consumer-price basket, rose 2.6 percent in January, compared with a gain of 1.3 percent in December. Food prices, which account for 35 percent of the consumer-price basket, rose 2.1 percent, after a 1.6 percent increase in December. Shoes and clothing prices fell 0.6 percent in the month.

Widening CA Deficit

Bulgaria's 2007 current-account deficit widened to a 10-year record of 21.6 percent of GDP as imports surged in the first year of the Balkan country's European Union membership.

The 12-month deficit widened to 6.17 billion euros ($9 billion) last year from 3.9 billion euros in 2006, when it was 15.7 percent or GDP, according to data released by the Sofia-based central bank today. The gap expanded to 905.5 million euros in December, after a revised 725.3 million euros in November.

Access to the European single market and cheap lending have fueled consumer demand and imports after the country joined the European Union a year ago. The government, which expects the shortfall to be covered by foreign investment, wants to boost living standards and bring its $31.5 billion economy to EU levels.

The trade deficit widened 27 percent to 7.4 billion euros in last year, the central bank said. Annual exports rose 10.4 percent to 13.4 billion euros, while imports grew 15.6 percent to 20.8 billion euros.

Foreign direct investment in 2007 also reached a record of 5.7 billion euros and covered 92 percent of the current-account gap, the data showed. A year ago, 4.4 billion euros of FDI covered 111 percent of the deficit. The 2007 financial account almost doubled to a 9.4 billion-euro surplus from 5.2 billion euros in the previous year.

Overheating and Risk of Correction

``Strong economic growth has been accompanied with signs of overheating, increasing macroeconomic imbalances reflected in a widening external deficit, re-acceleration of bank credit growth,'' the European Commission said in a Feb. 13 report assessing Bulgaria's economy. ``Safeguarding macroeconomic stability'' requires continuation of tight fiscal policies, according to the commission.

Fitch Ratings on Jan. 31 lowered its credit rating outlooks for both Bulgaria and Romania to negative from stable, citing deteriorating economic imbalances in the two nations.

Bulgaria's record current-account gap and high lending growth have raised chances the economy may be hurt by ``external shocks,'' according to Moody's. On Feb. 5. It raised the Bulgaria's ``vulnerability'' to "medium" from "low" in February 2007.

Bulgaria is in a very similar position to the three Baltic states, since the currency - the lev is effectively pegged to the euro, so there is no way the currency can adjust to take up some of the tension created by the very high internal inflation. Meantime a declining population, long term lowest-low fertility and heavy out migration have left the countries rapidly growing economy extremely short of qualified workers, thus producing pressure to send wages onwards and upwards in ever increasing second round effects. The only real measure available to the Bulgarian government in this situation if the fiscal one, and the government has planned a budget surplus of 3 percent of GDP for this year in an attempt to drain liquidity from the economy. However given the size of the problem, its deep structural character, the availability of credit at rates of interest well below the annual inflation rate and the heavy stream of remittances from migrant workers strung out across the EU, it is really hard to see anyone getting a grip on this increasingly anarchic situation. However, given the presence of the currency pegs, I think it unlikely that the East European adjustment process will kick off in either the Baltics or Bulgaria, and my guess is the most probable initiator of the next stage of the process will be Hungary, and if not Hungary then Romania. Once the process gets under way, then the other aforementioned countires will - unfortunately - be left with no other alternative but to fold their ever more untenable positions.

Political Uncertainty

Of course, it is only to be expected that these growing economic tensions will find their reflection in the political process, and in this sense the news that Bulgaria's parliament is to hold a no-confidence vote in Prime Minister Sergei Stanishev's coalition government next week over allegations of corruption should not come as a surprise. The vote is purely symbolic at this moment, since the governing parties command a strong majority. It is however symbolic of the political uncertainty which can now get a grip on countries with major underlying structural imbalances like Bulgaria.

Five opposition parties introduced the no-confidence vote motion in parliament yesterday, saying the two year-old Cabinet had failed to fight rampant graft and curruption. Prior to its EU entry on Jan.1 2007, Bulgaria was repeatedly urged to deal with top-level corruption.

``The Cabinet's corruption inflicts severe damage on Bulgarian citizens and undermines Bulgaria's authority as EU member,'' the text of the opposition motion reads ``The government creates corruption on all levels.''

This is the fourth no-confidence vote in Stanishev's government, and comes after a Feb. 4 European Union report criticizing Bulgaria for not showing ``convincing results'' in tackling corruption among senior government officials and fighting organized crime.

The EU suspended payments of 250 million euros for three road-construction projects January, after two company officials were arrested on suspicion of bribery. The commission asked the EU anti-fraud office to investigate whether the officials were involved in distribution of EU funds. The EU has earmarked subsidies of 11 billion euros for Bulgaria through 2013.

A corruption perception index published by Transparency International, a Berlin-based anti-corruption watchdog, placed Bulgaria 64th last year, on a level with Turkey and Croatia, and between Poland in 61st position and Romania in 69th. Countries with lowest levels of corruption such as Denmark top the index.

The opposition parties sponsoring the bill include the Democrats for a Strong Bulgaria, United Democratic Forces, Bulgarian People's Union, Attack, and Bulgarian New Democracy, as well as some independent politicians. However the parties can only muster a total 80 seats in parliament compared with the government's 151 seats so the motion as such is unlikely to prosper, unless some of Stanishev's coalition partners start to waver. Stanishev leads a coalition of the Bulgarian Socialist party, the Simeon II National Movement and the ethnic Turk Movement for Rights and Freedoms.

Wednesday, February 6, 2008

Eastern Europe on the Brink?

By Claus Vistesen

I realize that many of regular readers may soon be accusing me of assuming some kind of 'crying wolf' mantle in the context of the my coverage of Eastern Europe and the Baltics. For a long time I (as well as Edward Hugh) have been warning that economic conditions in Eastern Europe were wholly un-sustainable and that an impending crisis was looming somewhere across the ranks of the CEE economies. These kinds of things are of course impossible to predict in terms of timing and as such what we simply have been doing is to follow events as they have unfolded. Even though economists are hoping deep down (when the professional pride has been dispensed with) that such calls are wrong I am afraid that as the data have been rolling in, the edifice has been chipped off its foundation by the day. So, what is it this time you might ask?

Firstly, we should take a brief trip to Lithuania where I recently posted my latest update. In this way, the provisional estimate for Q4 GDP is out and as could have been expected the trend is one of a secular decline. This is hardly surprising and perhaps even welcome news. What remains to be seen at this point is merely how far and how fast and thus the ever so important question of whether it will be a hard or soft landing. Looking at the numbers and graphs we see that Lithuania continued its y-o-y expansion albeit with a much slower pace than in Q3. As regards q-o-q the slowdown was rather stark although I should emphasise how these figures are provisional and that Q3 in itself represented something of a fluke; so there might be some q-o-q high base/pay-off effect here.

(Please go to this link to view charts)

As more data on Q4 comes in I will be moving in with a more detailed analysis.
Another whisper as important as it was disturbing from the great information stream came as we learned a couple of days ago how the Hungarian Forint is coming increasingly under the punters' spotlight as a possible kill. This, in part, was what I ranted about this week when I spoke of the Hungarian Folly as the European Union moved in to levy even more pressure on the Hungarian government to set straight the widening budget deficit. Quite simply, and I am dead serious, Hungary is now at the forefront of the whole global credit crunch/turmoil debacle. Given the amount of household debt denominated in foreign currency a strike on the Forint would essentially push big parts of the Hungarian consumers into technical defaults and once the water is beginning to trickle through the dam it won't be long before the main pillars will cave in. Edward has a very timely post in which he includes a lot of important background material not least a couple of articles by Stefan Wagstyl in the FT which, apart from being good in and of themselves, demonstrate that the main market discourse is now beginning to include the general situation in Eastern Europe. As for the ever debated question of soft v hard landing I am referring to Edward when he says ...

I am not as optimistic as Wagstyl is here that we will see soft landings. The
existence of virtual currency pegs - which will need to be broken during the
correction - virtually guarantees an abrupt change, as does the level of
household debt in non local currency.

Note in particular the currency issues and subsequent translation risk which is a topic that has been subject to extensive scrutiny at this space.

Apart from the focus on Hungary and Lithuania further indications towards the situation in Eastern Europe were also delievered today. Firstly, we have the World Bank who is out yet again warning about the situation in Eastern Europe; quote Bloomberg ...

The 10 ex-communist members of the European Union face ``substantial'' risks to
growth and a threat of inflation from turmoil on global markets, the World Bank
said. ``While globalization offers the prospect of higher sustained growth, it
exposes countries to outside shocks,'' Ronald Hood, a World Bank economist, told
a press conference in Warsaw today. ``There's potential now for some severe
global contraction.'' The bank warned in a report covering the eastern European
countries that joined the EU in 2004 and 2007 that ``a prolonged period of
globally lower risk appetite is likely'' as volatility continues. ``The baseline
scenario is subject to substantial downside risk for economic growth and upside
risk for inflation.''

If the points above have you worried I am afraid that I have left out the worse for last. Back in September I exclaimed that the Squeeze had Begun referring to the point that the credit agencies would be moving aggressively in the context of general country ratings and by derivative sovereign debt. Allow me in that context to quote myself in unusual length ...

Essentially, the stars now seem to be aligning in such a way that at least a respectable chunk of that ever illusive 'credit crunch' will take place on the level of sovereign debt as a derivative of the perceived need for the rating agencies to tighten up what was previously considered overtly lax credit valuations; of course this was mainly in structured finance but this seems of little importance at this point. Let me also take the time to point out the rather clear rational justification for the rating agencies moves on Japan, Eastern Europe and perhaps also Italy at some point. Essentially, from a strict economic point of view it is not at all unjustified. However, there is also the question of timing and general institutional mark-up of the whole role of the rating agencies. Turning first to the latter I am primarily talking about Japan and Italy here (of course other ageing economies too) and the general idea of credit ratings. I mean and as I have argued before, at some point it will cease to make sense to rate Japanese and Italian sovereign debt using the same standards as e.g. USA, Brazil, and India since this could mean at some point that you would have to push them into some kind of state of technical default. However, we also crucially need to think about timing here and what clearly seems to be a somewhat pro-cyclical behaviour of the rating agencies (See e.g. a recent paper by Carsten Valgreen from Danske Bank which has
also been treated here at Alpha.Sources). This seems even more evident at this point in
time since the rating agencies themselves have been on the forefront of the
turmoil in financial markets. So, at the end of the day it is perhaps as the
Economist's ever eloquent financial columnist Buttonwood so neatly put it a while back:

But the agencies tend to lean with the wind, rather than against it. They
upgrade debt when the economy is booming and downgrade it when recession

This small piece then comes with a subtle warning. Whatever the perceived need, be it endogenous or exogenous, for the rating agencies to tighten credit standards at this particular point in time my suggestion is that they don't lean too far with the wind since they might end up pushing somebody off a cliff in the process.

Special attention should be paid to thelast point which is ever so important as we move into what could be coined as the next stage in all of this. Consequently, we learned today that Fitch Ratings recently lowered the broad credit rating outlook across a wide range of Eastern European countries citing specifically the deteriorating global conditions and thus these countries' dependence to external financing to keep the boat afloat. Also, S&P moved in today on the Baltics citing the same reasons as Fitch and thus further highlighting the general state of affairs.

In Conclusion

The noose is tightening by the day now in Eastern Europe. A general slowdown now seems to be a certainty and what remains to be seen is the extent to which this will be a hard and abrupt landing and if so which of the countries will suffer more than others. However, behind the general stylised facts looms a much larger risk, a risk that events in one country may spread to the whole region and thus drag the whole edifice down over Europe's, not to mention the Eurozone's, head. At this point, the consensus is moving closer to an understanding of the risk that some of these countries are faced with. I salute this, especially since what happens in the next months may very well determine the fate of entire economies and societies. I will keep on watching and I'd wish that the ECB/EU also would look a little harder. Perhaps they content that the train has left the station at this point but I don't think we can afford the luxury to assume this.