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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.

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